Main Theories of FDI

1. Main Theories of FDI Ing. Tomáš Dudáš, PhD.

2. Structure of the presentation FDI theories – introduciton and main questions FDI theories on macro level Development theories of FDI FDI theories on micro level Eclectic FDI theory (OLI theory)

3. The basic questions of FDI theories (6W+H) Who? (is the investor) What? (kind of FDI) Why? (are we investing) Where? (is the FDI going) When? (do we invest) How? (the mode of entry)

4. FDI theories on macro level Capital market theory One of the oldest theories of FDI (60s) FDI is determined by interest rates Dynamic macroeconomic FDI theory FDI are a long term function of TNC strategies The timing of the investment depends on the changes in the macroeconomic environment „hysteresis effect“

5. FDI theories on macro level FDI theory based on exchange rates Analyses the relationship of FDI flows and exchange rate changes FDI as a tool of exchange rate risk reduction FDI theory based on economic geography Explores the factors influencing the creation of international production clusters Innovation as a determinant of FDI – „Greta Garbo effect“

6. FDI theories on macro level Gravity approach to FDI The closer two countries are (geographically, economically, culturally ...) the higher will be the FDI flows between these countries FDI theories based on istitutional analysis Explores the importance of the institutional framework on the FDI flows Political stability – key factor

7. Development theories of FDI

8. Life cycle theory Raymond Vernon – 1966 It can be used to analyse the relationship of product life cycle and possible FDI flows FDI can be seen mostly in the phases of maturity and decline The conclusions of this theory are questionable nowadays

9. Japanese FDI theories Were initially developed in the 70s of the last century Main representant – Terumoto Ozawa He analysed the relationship of FDI, competitiveness and economic development based on the ideas of Michael Porter He identified three main phases of development when he analysed the waves of FDI inflow and outflow from a country

10. Japanese FDI theories I. phase of economic growth The country is underdeveloped and is targeted by foreign companies wanting to use its potential advantages (especially low labour costs) Almost no outgoing FDI II. Phase of economic growth New FDI is drawn by the growing internal markets and by the growing standards of living Outgoing FDI are motivated by the raising labour costs

11. Japanese FDI theories III. Phase of economic growth The competitivness of the country is based on innovation The incoming and outgoing FDI are motivated by market factors and technological factors

12. Five Stage Theory - John Dunning Stage 1 Low incoming FDI, but foreign companies are beginning to discover the advantages of the country No outgoing FDI – no specific advantages owned by the domestic firms Stage 2 Growing incoming FDI do the advantages of the country - especially the low labour costs The standards of living are rising which is drawing more foreign companies to the country Still low outgoing FDI

13. Five Stage Theory - John Dunning Stage 3 Still strong incoming FDI, but their nature is changing due to the rising wages The outgoing FDI are taking off as domestic companies are getting stronger and develop their competitive advantages Stage 4 Strong outgoing FDI seeking advantages abroad (low labour costs)

14. Five Stage Theory - John Dunning Stage 5 Investment decisions are based on the strategies of TNCs The flows of outgoing and incoming FDI come into equilibrium

16. Incoming and outgoing FDI in South Korea between 2001-2004

18. FDI theories on micro level Existence of firm specific advantages (Hymer) Access to raw materials Economies of scale Intangible assets such as trade names, patents, superior management etc Reduced transaction costs when replacing an arm's length transaction in the market by an internal firm transaction FDI and oligopolistic markets In oligopolistic markets the companies follow the actions of the market leader Mutual threats – game theory

19. FDI theories on micro level Theory of internalisation Due to market imperfections, there may be several reasons why a firm wants to make use of its monopolistic advantage itself (or organise an activity itself) Buckley and Casson (influenced by Coase), suggested that a firm overcomes market imperfections by creating its own market - internalisation he theory of internalisation was long regarded as a theory of why FDI occurs By internalising across national boundaries, a firm becomes multinational

20. Eclectic FDI theory – John Dunning John Dunning attempts to integrate a variety of strands of thinking He draws partly on macroeconomic theory and trade, as well as microeconomic theory and firm behavior (industrial economics)

21. O = Ownership advantages Some firms have a firm specific capital known as knowledge capital: Human capital (managers), patents, technologies, brand, reputation… This capital can be replicated in different countries without losing its value, and easily transferred within the firm without high transaction costs

22. L – Localization advantages Producing close to final consumers or downstream customers Saving transport costs Obtaining cheap inputs Jumping trade barriers Provide services (for most services production and delivery have to be contemporaneous)

23. OLI approach - conclusions The eclectic, or OLI paradigm, suggests that the greater the O and I advantages possessed by firms and the more the L advantages of creating, acquiring (or augmenting) and exploiting these advantages from a location outside its home country, the more FDI will be undertaken Where firms possess substantial O and I advantages but the L advantages favor the home country, then domestic investment will be preferred to FDI and foreign markets will be supplies by exports

24. I – internalization advantages Why don't a firm just sign a contract with a subcontractor (external agent) in a foreign country? Because contracting out is risky: it implies transferring the specific capital outside the firm and revealing the proprietary information (e.g. how to use the technology or the patent). Problem: If the agent interrupts the contract it can use the technology to compete with the mother company In the case of brands/reputation: if the agent damages the brand reputation

25. 25 4 types of FDI derived from OLI theory The typology of FDI was developed by Jere Behrman to explain the different objectives of FDI: Resource seeking FDI Market seeking FDI Efficiency seeking (global sourcing FDI) Strategic asset/capabilities seeking FDI

26. 26 Resource seeking FDI To seek and secure natural resources e.g. minerals, raw materials, or lower labor costs for the investing company For example, a German company opening a plant in Slovakia to produce and re-export to Germany

27. 27 Market seeking FDI To identify and exploit new markets for the firms` finished products Unique possibility for some type of services for which production and distribution have to be contemporaneous (telecom, water supply, energy supply) Automotive TNCs have invested heavily in China

28. 28 Efficiency seeking FDI To restructure its existing investments so as to achieve an efficient allocation of international economic activity of the firms International specialization whereby firms seek to benefit from differences in product and factor prices and to diversify risk Global sourcing – resource saving and improved efficiency by rationalizing the structure of their global activities. Undertaken primarily by network based MNCs with global sourcing operations.

29. 29 Strategic asset/capabilities seeking FDI MNCs pursue strategic operations through the purchase of existing firms and/or assets in order to protect O specific advantages in order to sustain or advance its global competitive position Acquisition of key established local firms Acquisition of local capabilities including R&D, knowledge and human capital Acquisition of market knowledge Pre empting market entrance by competitors Pre empting the acquisition by local firms by competitors