Foreign Direct Investment: a tool for sustained competitive advantage

1. MGTECON 580: Class 4 Foreign Direct Investment: a tool for sustained competitive advantage and/or for technology diffusion Definition: acquisition of controlling assets of a firm in another country FDI in perspective is one alternative strategy to internationalize: - exports - licensing - sourcing abroad - distribution subsidiary - production subsidiary • Relation to location theory: • One step more complicated • Different functions at different location • Centrifugal versus centripetal forces; transport costs

2. The firm perspective and the country view Strategic importance for firms Lowering costs Increasing market share Diversification Acquiring strategic assets Securing long-run profitability Old style firm vs. new Old: one region, one country production and demand overlap New: optimizing jointly production, transport, marketing, sourcing The policy issue (country perspective) There are usually arguments against both types: - Inward investment (IDI) implies “Foreign dominance” specifically in sophisticated, strategic industries - Inward investment implies “development trap” if only low-skill industries come in - “Investing abroad” implies employment loss

3. Technicalities and indicators Investment vs. stocks Flows in a year, stocks accumulated Acquisition value vs. net addition to stock Buying price (investment) in % of national (physical) investment Alternative indicator: capital stock in % to GNP Investment is recorded (via National Bank) Divestment often not, if bankruptcy Sales of a firm can comprise: Sales = SHD + SHF + SAF + SAH Sales at home for domestic market Sales at home for foreign market Sales abroad for foreign market Sales abroad for home market

4. The many faces (types) of FDI • According to activity • Production • Upward activities (sourcing) • Distribution, logistic • Research • Headquarters • According to investment mode • Greenfield investment • Merger/acquisition • Joint venture • Note: portfolio investment (small shares) is not FDI • According to motives • Cost-driven • Market-driven (serve better the market) • Infrastructure-driven (business environment) • According to trade effect • Import substituting • Export increasing • According to financial transaction • Equity capital (share) • Reinvested earnings • Intra-company loans • According to firm’s internal structure • Horizontal FDI • Duplicating plans to get rid of tariffs and trade costs • In principle substitute to exports • Vertical FDI • Part of the supply chain is “outsourced” • In principle complement to exports • Horizontal FDI • Duplicating plans to get rid of tariffs and trade costs • In principle substitute to exports • Conglomerate

5. The eclectic OLI Model by John Dunning • The basic theoretical challenge • Indigenous, domestic firms should have a priori advantage • Knowledge of environment • Distance HQ -- production site • What compensates this advantage • Ownership advantages: firm-specific knowledge • Patents, expertise of organization and learning • Location advantages: cheaper/better inputs • Internalization advantages • Better use inside the firm than through the market (licensing and pricing) • OLI paradigm: you need all three

6. Other determinants of FDI Rate of return difference FDI goes in countries with higher expected return Portfolio diversification: investments to diversify risks Market size attracts investment Product cycle explanation Each product passes three phases: • Oligopolistic interaction • Investment is a commitment • Which puts other firms in worse position • Other strategic factors • Defend markets, get foothold, complementing, committing • Internal financing: free cash flow looks for opportunities • Policy related determinants: better business conditions

7. Five Stage Theory: Net FDI depends on stages of development, by John Dunning • Stage 1: No location bound asset • At least no created ones, ev. Natural resources • Prediction: Neither IDI nor ADI • Stage 2: Inward FDI attracted by cheap inputs or resources • Possibly government helps (involuntarily) with import taxes • Outward investment starts, but well behind inward • Prediction: FID-deficit • Stage 3: Upcoming ownership advantages: ADI rises faster than IDI • Surpluses with poor countries, deficits with rich ones • Prediction: FDI stock becomes balanced • Stage 4: Ownership advantages and search for low cost production sites • Further push outward investment up to maximum surplus • Intra-industry production specialization (following IIT shares) • Prediction: high-surplus of ADI, both flows increasing • Stage 5: Firms become globalized and nationalities blurred (Dunning-Narula, p8) • But there can be instable positions (fluctuations, vicious and virtuous circles) • Prediction: Net positions equalize again

8. Empirics of FDI Stylized fact 1: FDI growth higher than trade and GNP growth Hierarchy of dynamics 1985 - 97: (UNCTAD FDI/TNC Database Nominal GDP 7% Trade by 9% FDI inflow 18% Stylized fact 2: Significant share of trade is intra-firm trade 1998 - 30% of world trade is trade in commodities within firms (Yeats p.16) Stylized fact 3: FDI is investment of developed countries in developed countries High share from neighbors Much intra EU A lot from US 18% of employees in EU work in MNE 8.6% owned by non-EU parents 7% in US parents Stylized fact 4: There are industry differences High FDI sectors are R&D intensive Skill intensive Technically sophisticated, differentiated Peak of US firm shares in Europe Optical and medical instruments 17% Transportation 14% Chemicals 12% Telecom 10% Peak of EU in US are Chemicals 36% Glass, stone 18% Electronics 14%

9. Stylized fact 5: In bilateral investment EU has a substantial surplus, high overlap US firms in EU are responsible for 22% of EU imports from US and 19% of EU exports to US EU firms in US are responsible for 28% of US imports from EU and 12% of US exports to EU Interpretations: EU “needs more home input” 35% of EU and 47% of US imports (share of bilateral flows) Stylized fact 6: Developing countries are recipient: IDI: ADI=4:1 Stylized fact 7: Developing countries receive minority of FDI (30%) However, relative to GDP now more (2.4%) than developed 1.3% (p13) Stylized fact 8: EU is net investor in FDI, as well as a net export in trade Stylized fact 9: US are marginally a net investor in FDI, net importer in trade Stylized fact 10: Japan is a net investor, though with low flows and less surplus than in trade

10. Does actual pattern of FDI follow Five Stage Theory? • Deficit in stage 2 is empirically shown • FDI deficit in developing countries • And in GR, P, SP • Increasing outward investment in stage 3 also • But to different extent • Deficit depends on natural resources vs. firm specific advantages • Country specific persistency in phase 4 • See European countries: • UK and Switzerland have persistent investment surplus • Austria a persistent deficit (never a surplus in between)… • Equalization in phase 5 is open question • US has still a surplus (decreasing) • Japan has a large non-decreasing surplus • What is behind? • High wage in Switzerland • Financial center, research and other attractions for headquarters • Headquarters move only for significant cost-service differences

11. Inward and outward investment across countries Conclusions:FDI activists in Europe: UK, Netherlands, Sweden, D,F,SF,S,I These are all big 4 plus the Nordic FDI receivers all south (exception Italy) plus Austria (A-D); Belgium (B:NI) Sp less than expected see SP-P

12. The impact of FDI on economic development • Positive: • Quickest import of technology and management • High productivity, cheap products • Learning to catch up in skills • Negative: • Host country may get second best technology • Development trap (MNE invest in industry with low future potential) • Plants not fitting into endogenous development • Footloose industries stay only as long as costs are low • Outside steering of development, dictated by headquarter • Important for a positive contribution to host country: • Linkages, Learning, Upgrading as shown in the Irish example • Open for inward FDI plus upgrading infrastructure • And inviting firms to upgrade plant • Focus on linkages • On learning • On small local firms interrelating with MNE

13. Empirical facts about behavior of MNE Labor-intensive sectors dominate Capital-intensive sectors Human capital-intensive industries underrepresented Many IDI have few linkages (insolated firms) MNE plants have high productivity Fast growing Technology transfer, however, not own research Countries pursuing export lead perform better Than countries relying on import substitution strategies

14. The impact of FDI on economic development • The rationale for FDI • Lowering costs (road to cost leadership) • Increasing market share (size, barriers to entry, strategic advantage • Diversification (new market, distributing fixed costs of firm specific asset or capability) • Acquiring strategic assets (innovative capacity of foreign firm, country) • Long-run profitability • Chances • To evade the eternal threat of profit dissipation (the need for markets) • To reduce costs (the need of evading high costs) • To increase world market share (the need of top 3 position) • To shift into fast growing countries • To acquire strategic assets and capabilities (IT, knowledge) • Risks • Specific country risk (political, legal) • Difference in culture and corporate governance • Different scheme of wages, social contributions, taxes • Danger that competitive advantage can not be transferred, sustained • Danger that resources will be diverted from investing into sustaining competitive advantage • Specific problem of control (size, distance) • And organization (decentralization, centralization, divisional, functional)

15. The implementation in formal mode (A1) FDI: fixed cost at headquarter (once): F lower variable costs (relative to domestic firms): c.q, c<c* set up costs at each location: n.f