Chapters 5, 11: International Investment

1. Chapters 5, 11: International Investment

2. Lesson Outline • Overview of international investment • definition, types, growth over time • The eclectic paradigm • the 3 conditions to be met before a firm engages in FDI • Factors influencing FDI

3. Lesson Outline • Selecting national markets • The urgency & importance of the task for firms • the importance of economic growth & stability • Applications of today’s material to understanding the prospects of nations

4. Overview of international investment • International investment, in which residents of one country supply capital to a second country, is another major form of international business (in addition to trade).

5. Overview of international investment International investment can be divided into portfolio investment and foreign direct investment (FDI). Portfolio investments are passive holdings of foreign stocks, bonds, or other financial assets which entail no active management or control of the issuer of the securities by the foreign investor. FDI represents acquisition of foreign assets for the purpose of control.

6. Overview of international investment • FDI may take many forms including: purchases of existing assets in a foreign country; new investments in plant, property and equipment; or participation in joint ventures with a local partner.

7. Overview of international investment • See Table 5.4, p.141 • Note the huge jump in the value of global FDI from 1967 to 1997. FDI is still growing in size and importance. • outward FDI usually originates from within developed nations • developed nations also receive most inward FDI

8. Eclectic Paradigm • Two “components” of the eclectic paradigm • Ownership Advantages • Researchers trying to explain why FDI occurs initially focused on the impact of firm-specific (or monopolistic) advantages. They argued that a firm that owned a superior technology, a well-known brand name, or economies of scale that created a monopolistic advantage could clone its domestic advantage to penetrate foreign markets.

9. Eclectic Paradigm • Two “components” of the eclectic paradigm • Internalization Theory • This theory suggests that FDI is more likely to occur (a firm will internalize a set of activities to be performed overseas within the boundaries of the firm) when the costs of negotiating, monitoring, and enforcing a contract with a second firm are high.

10. Eclectic Paradigm • Dunning’s eclectic paradigm ties together location advantages, ownership advantages, and internalization advantages. • Dunning proposes that FDI will take place when three conditions are satisfied: • 1. The firm must own some unique competitive advantage that overcomes the disadvantages of competing with foreign firms in their own market.

11. Eclectic Paradigm • 2. It must be more profitable to undertake a business activity in a foreign location than a domestic location. • 3. The firm must benefit from controlling the foreign business activity, rather than by hiring an independent local company to provide the service.

12. Factors influencing FDI • See Table 5.6, p 145 • Note that there are many potential reasons to engage in FDI.

13. Selecting National Markets: FDI • To successfully increase foreign market share, firms must assess alternative markets; evaluate the respective costs, benefits, and risks of entering each; and select those that hold the most potential for entry or expansion.

14. Selecting National Markets: FDI • There are first mover advantages to entering new markets. Better to spot opportunities before your competition, in other words. • The above means that differing levels of skill across firms (especially across the senior management team in firms) in gathering and interpreting country-level data can have a big influence on competition in the long run.

15. Selecting National Markets: FDI • Even in the short run, decisions about the nations in which to enter and compete sometimes prove to be make-or-break decisions for firms. • Continual monitoring can help firms identify new opportunities.

16. Selecting National Markets: FDI • Factors to consider when selecting foreign markets • A firm must consider a variety of factors, including market potential, levels of competition, the legal and political environment, and sociocultural influences when assessing alternative foreign markets. • Information on some of these factors is easily obtainable from published sources in the firm’s home country. Other information may be subjective and difficult to obtain. In fact, it may be necessary to visit the foreign location in question. • See Table 11.1 on p. 311 (no need to try to memorize all that, its just for reference)

17. Selecting National Markets: FDI • Market Potential • The first step in foreign market selection is assessing market potential. Variables a firm might wish to consider include population, GDP, per capita GDP, public infrastructure, and ownership of goods such as automobiles and televisions. Students can refer to the Building Global Skills on pp. 50-51 in Chapter 2 for a list of some publications that provide this type of information.

18. Selecting National Markets: FDI • Next, a firm must collect information relating to the specific product line under consideration. It may be necessary for a firm to use proxy data in some cases. • Note that economic growth is a particularly important part of figuring out whether a market is attractive or not. For example, the demand for automobiles went from 1.9 million vehicles in Brazil in 1998 when the economy was doing well down to 1.2 million vehicles in 1999 (almost a 40% drop) after there was a sudden and large currency depreciation, interest rates shot upwards, and economic growth stalled.

19. Selecting National Markets: FDI • Levels of Competition • Firms assessing their competitive environment should identify the number and sizes of firms already competing in the potential market, their relative market shares, their pricing and distribution strategies, and their relative strengths and weaknesses.

20. Selecting National Markets: FDI • Legal and Political Environment • It is important that a firm understand the host country’s policies toward trade as well as its general legal and political environment prior to making an investment. • Trade barriers, for example, might induce a firm to enter a market via FDI as opposed to exporting. In some countries legal and political issues will impact both entry methods and the repatriation of profits. A country’s tax policies and government stability may also affect a firm’s strategy.

21. Selecting National Markets: FDI • Sociocultural Influences • Culture has a particularly strong impact on whether or not the production (ch 17) and marketing functions (ch 16) need to be modified, as well as personnel-related policies if local employees will be hired (ch 14, ch 20). • In many cases, firms will attempt to minimize the potential impact of sociocultural differences when they first venture overseas by focusing on countries that are culturally similar to their home nation.

22. Selecting National Markets: FDI • Evaluating Costs, Benefits, and Risks • The next step in foreign-market assessment is an evaluation of the costs, benefits, and risks associated with doing business in a foreign market.

23. Selecting National Markets: FDI • Costs • There are two types of relevant costs: direct and opportunity. • - Direct costs include costs associated with setting up a business operation, transferring managers to run it, and shipping equipment and merchandise. • - A firm incurs opportunity costs when entering one market precludes or delays its entry into another, or when it limits opportunities to invest more in countries in which it already operates. The profits it could have earned through alternative investments are opportunity costs.

24. Selecting National Markets: FDI • Benefits • Benefits from entering a foreign market may include higher expected sales and profits, lower acquisition and manufacturing costs, foreclosing of markets to competitors, access to new technology, better communication with customers, and the opportunity to achieve synergy with other operations.

25. Selecting National Markets: FDI • Risks • A firm entering a new market incurs the risks of opportunity costs, additional operating complexity, and direct financial loss due to mistakes in assessing market potential. In some extreme cases a firm may also risk loss due to government seizure of property, war or terrorism. • It is important that firms carefully assess foreign markets prior to making strategic decisions. Poor strategic judgments may rob a firm of (potentially) profitable operations and a continued inability to reach the right strategic decisions may threaten the firm’s existence.

26. Selecting National Markets: FDI • Closing Note: • Nowhere in this section does currency value or stability appear. That is because currency value is not terribly important for selecting nations in which the firm will sell. • However, it does have some influence regarding the way in which particular national markets will be served. For example, if a firm decides to enter a nation which they regard as having a persistently strong currency, they will be less likely to build a factory in that nation (in general) because they would be concerned that relative production costs would rise in that nation in the future. The reverse is also true.

27. Selecting National Markets: Portfolio Investment • Note that currency stability (per se) doesn’t even enter the analysis when selecting national markets, although it does affect *how* national markets are served. Portfolio investors care relatively more about the strength or weakness of a nation’s currency than those considering FDI.

28. Selecting National Markets: Portfolio Investment • In general terms, international portfolio investors either invest in foreign stocks or purchase debt instruments issued by foreign borrowers. • Those purchasing international debt securities look primarily at interest rates, inflation, and the overall strength or weakness of the national currency. They also care about economic growth as that affects the solvency of their debtors, but not as much as those who invest in stocks.

29. Selecting National Markets: Portfolio Investment • Because depreciation of a country’s currency can hurt the value of their portfolio (if it is not hedged) they are not likely to want to invest in countries which they see as having unstable, weak currencies. If they do, they will tend to demand a higher rate of return to offset their perception of a higher level of risk. The reverse is also true. • Note that nations with a traditionally weak, unstable currency have a disadvantage in attracting investment capital, at least from portfolio investors.

30. Selecting National Markets: Portfolio Investment • Those investing in overseas stocks prefer to see strong, stable economic growth, as that has a critical influence on corporate profitability and the value of national stock markets. They also like low and relatively predictable inflation because that helps keep interest rates under control, which in turns helps corporate profitability and liquidity. • They also care a great deal about the strength of currencies in the nations in which they invest, although relatively less than those investing in debt instruments.

31. Applications of Today’s Material to Understanding The Prospects of Nations • The issue of what drives international investment flows matters to nations because pulling in international investment increases the pool of investment capital in their nation, which can help reinforce or bring about a “virtuous cycle” (see class notes, trade theory lesson) which promotes economic growth.

32. Applications of Today’s Material to Understanding The Prospects of Nations • FDI also brings in technology and ideas from abroad, which can help the global competitiveness of national industries. • By first looking at the concerns of investors, one can then change one's point of view to that of nations and see what nations need to offer if they want to attract investment from abroad.

33. Applications of Today’s Material to Understanding The Prospects of Nations • The eclectic paradigm neatly encapsulates the reasons why a firm might engage in FDI, providing a window into understanding the perspective of firms regarding FDI. FDI investors like steady economic growth, large markets, inexpensive and abundant factors of production, and all the other issues given earlier.

34. Applications of Today’s Material to Understanding The Prospects of Nations • Portfolio investors like to invest in countries with a strong currency, in general, and which have strong, stable economic growth, and low inflation. High interest rates are particularly attractive to those purchasing debt instruments. • Strong and rising inward investment flows tend to be a good sign about that nation’s prospects over the near to medium term, in general.

35. Applications of Today’s Material to Understanding The Prospects of Nations • “Caveats” • Most nations seek to attract inward investment, particularly inward FDI, because it increases the pool of investment capital in the nation. • However, inward FDI does grant foreigners a measure of control over the national economy. Also, portfolio investment from abroad can flow out of the country, perhaps very rapidly in response to a crisis, potentially driving down the value of the national currency very rapidly.

36. Applications of Today’s Material to Understanding The Prospects of Nations • “Caveats” • There is no clear evidence that high levels of inward FDI hurt a nation’s economic growth. The “control” issue is more closely related to concerns about national defence capabilities, policy autonomy, and national pride. So, when analyzing numbers for a country, high flows and stocks of inward FDI probably indicate that country is an attractive location for investment, rather than something negative.

37. Applications of Today’s Material to Understanding The Prospects of Nations • “Caveats” • Because portfolio investors are highly sensitive to changes in exchange rates, and because their investments are more liquid than those engaging in FDI, portfolio investors are far more likely to pull their money out of a country if a crisis occurs. They also tend to be quicker to desert a nation than citizens of that nation. • Sudden swings in portfolio investments from the actions of foreigners can destabilize a nation's currency and destabilize national debt and equity markets.

38. Applications of Today’s Material to Understanding The Prospects of Nations • “Caveats” • That is why some nations have gone out of their way to keep foreign portfolio investors at bay. • For example, China has historically sought to prevent foreign portfolio investors from destabilizing their financial system by prohibiting or limiting their participation in various national debt and equity markets.

39. Applications of Today’s Material to Understanding The Prospects of Nations • “Caveats” • This is why it makes sense to compare the flows and volume of FDI to total inward investment, as well as examining the level of inward portfolio investment, as doing so provides evidence useful in assessing the stability of the value of the national currency. A very high proportion of inward FDI and a very low proportion of portfolio investment enhances currency stability, and vice versa.