FOREIGN DIRECT INVESTMENT

FOREIGN DIRECT INVESTMENT J. Peter Neary University of Oxford and CEPR 5 February 2009

Introduction: FDI “OLI” or “Eclectic” Paradigm of FDI • Dunning: Ownership; Location; Internalisation • Focus on firms rather than factor movements Compare Mundell (AER 1957) Dominant View of FDI: • Mostly horizontal rather than vertical • Determined by proximity-concentration trade-off [“L” versus “O”] Paradoxical Implication: • Falls in trade costs should reduce FDI • BUT: Many counter-examples e.g., in 1990s, trade costs fell yet FDI boomed Resolution?

Plan • Horizontal FDI: The Proximity-Concentration Trade-Off • Vertical FDI • Export-Platform FDI • Cross-Border Mergers and Acquisitions

2. Horizontal FDI: The Proximity-Concentration Trade-Off Simplest framework: • Partial equilibrium • Monopoly firm • How best to serve a foreign market? • External trade barrier: t (Tariffs, transport costs etc.) • Plant fixed costs: f • Operating profits from serving the market:p(t), p'<0

Profits from Exporting: P X = p(t) • Independent off • Decreasing in t • Positive for t < t ~ f X O t

p(0) • Profits from FDI: PF = p(0) – f • Independent of t • Decreasing in f • Positive for f < p(0) f O F t

Tariff-jumping gain O f = p(0)–p(t) PF – PX= g(t,f ) g(t,f )p(0) – f –p(t) f [Increasing int] X p(0) FDI t Fig. 1: The Proximity-Concentration Trade-Off I: The Tariff-Jumping Motive

Implications: • Fixed costs favour X over FDI • Trade costs favour FDI over X i.e., trade liberalisation discourages FDI Plausible and consistent with much empirical evidence • Econometric Studies: • Brainard (1993): trade costs   level of FDI  BUT share in FDI+X • Carr/Markusen/Maskus (AER 2001), Yeaple (REStats 2003) • Distance … • Case Studies: • Ireland in the 1930s: protection but no FDI Neary and Ó Gráda (IHS 1991) • Japanese electronics firms in EC in 1980s: FDI but no protection Belderbos/Sleuvagen (IJIO 1998) But: How is this consistent with EU/Ireland in the 1990s? • Surely tariffs and transport costs fell, but FDI rose faster than X?

Offshoring gain 3. Vertical FDI Comparative advantage rather than market access Simplest example: • “HQ” services incur no variable costs • Production uses only labour with a unit output coefficient • Operating profits from serving source-country market facing labour + access cost c: p*(c) • No sales in host country • Profits from staying at home: PD = p*(w*) • Profits from FDI: PF = p*(w+t*)–f  PF– PD = m(w+t*,w*) –f [decreasing in t*]

f = p*(w+t*) f = p*(w+t*)–p*(w*) f D FDI t* Fig. 2: Vertical FDI

+ Offshoring gain Trade-cost jumping gain 3. Vertical FDI (cont.) Host market non-negligible:  PF– PDX =g(w, w*+t, f ) +m(w+t*,w*) • [Total gain: Increasing in t, decreasing in t*] • Empirical evidence: • Brainard (AER 1997), Markusen (2002): U.S. foreign affiliates export only 12-15% of output back to U.S. • Brainard (1997): FDI high in industry-country pairs with high trade costs & low plant scale economies; unaffected by intl. differences in factor endowments • Markusen (2001): Bilateral FDI encouraged by similarities in market size and relative factor endowments • BUT: Yeaple (REStats 2003): U.S. MNEs in less skill-intensive industries invest more in skill-scarce countries

Tariff jumping gain Export platform gain 4. Export-Platform FDI Suppose that host country is one of 2 identical countries in a potential economic union. • Previous analysis still holds when intra-union barriers = t Now: Suppose intra-union barriers are reduced to t < t P X = 2p(t) [before: p(t)] P F1 = p(0) + p(t) – f [before: p(0) – f ] ==> P F1 – P X =p(0) + p(t) – f –2p(t) = [p(0) – f –p(t)] + [p(t) –p(t)] • FDI now more attractive relative to X • Export-platform gaindecreasing in trade cost t

f = p(0)+p(t)–2p(t) p(0)+p(t) FDI (1) p(0)–p(t) t f X O p(0) FDI (2) t Fig. 3: The Proximity-Concentration Trade-Off II: External Trade-Cost-Jumping + Export-Platform Motives

4. Export-Platform FDI(cont.) Exports & FDI now complements: • For individual firms (though not across same frontier) • In aggregate data Empirical evidence: • Fits stylised facts of EU Single Market e.g., “Celtic Tiger” boom: Barry (1999) • Head/Mayer (REStats 2004): Japanese FDI in EU encouraged by GDP in host and adjacent regions • Blonigen et al. (2004): U.S. FDI in EU: • discouraged by U.S. FDI in neighbouring countries • encouraged by higher GDP in neighbouring countries • Evidence on plant consolidation mixed: • Pavelin/Barry (ESR 2005) contra; Belderbos (1997) pro

5. Cross-Border Mergers and Acquisitions So far: Greenfield FDI only BUT: Cross-border M&As are quantitatively much more important Now: Oligopoly model essential (almost) • No: Barba Navaretti/Venables (2003), Nocke/Yeaple (JIE 2007, RES 2008), Head/Ries (JIE 2007) • Yes: Long/Vousden (RIE 1995), Falvey (WE 1998), Horn/Persson (JIE 2001), etc. • Here: Neary (RES 2007) Model of 2-country integrated market: • Cournot oligopoly • Home: n firms with cost c; Foreign: n* with cost c* • Absent mergers: “Cone of diversification” in {c, c*} space

p(c,c*;n,n*)=0 p*(c,c*;n,n*)=0 c F: Foreign production only O: No home or foreign production Fig.4: Equilibrium Production Patterns in Free Trade without FDI H: Home production only HF: Home and foreign production c*

5. Cross-Border Mergers and Acquisitions (cont.) Merger gains: • For an acquisition of a home by a foreign firm: GFH(c, c*; n, n*) = D*(.)  (.) • Always negative between identical firms Salant/Switzer/Reynolds (QJE 1983) “Cournot merger paradox” • Positive for a sufficiently large cost advantage

p Dp* GFH <0 GFH >0 a–c Q R a–c* Fig. 5: The Components of Gain from a Cross-Border Acquisition by a Foreign Firm

Incentives for foreign firms to take over home p=0 GFH=0 Incentives for home firms to take over foreign GHF=0 c F O Fig. 6: Cross-Border Merger Incentives H HF c*

5. Cross-Border Mergers and Acquisitions (cont.) So: Autarky to free trade encourages cross-border M&As Further results: • GFHdecreasing in n:Merger waves • GFHdecreasing in t (definitely for high t) So partial trade liberalisation encourages cross-border M&As Empirical evidence: • Brakman/Garretsen/van Marrewijk (2005): Evidence in favour of comparative advantage and merger waves

R' p Dp* a–c Q R a–c* Fig. 5a: Merger Waves: Effects of a Fall in n

Conclusion Paradox resolved? • Vertical FDI may be quantitatively important after all • Export-Platform FDI encouraged by intra-bloc trade liberalisation • Cross-border M&As encouraged by trade liberalisation General conclusions: • Horizontal vs. vertical distinction useful (especially pedagogically) but don’t expect too much of it • MNE’s engage in “complex integration strategies” U.N. (1998); Yeaple (JIE 2003) • Lots more work to be done!

FOREIGN DIRECT INVESTMENT