Foreign Direct Investment

1. Foreign Direct Investment

3. Foreign Direct Investment • Why is FDI increasing in the world economy? • Why do firms often prefer FDI to other market entry strategies? • Why do firms imitate competitors with FDI strategies? • Why are certain locations favored for FDI? • How does political ideology affect government FDI policy? • What are key FDI related costs and benefits for receiving and source countries?

4. Foreign Direct Investment • Foreign direct investment (FDI): a firm invests directly in foreign facilities • A firm that engages in FDI becomes a multinational enterprise (MNE) • Multinational = “more than one country” • Factors which influence FDI are related to factors that stimulate trade

5. Foreign Direct Investment • Involves ownership of entity abroad for • production • Marketing/service • R&D • Access of raw materials or other resource • Parent has direct managerial control • Depending on its extent of ownership and • On other contractual terms of the FDI • No managerial involvement = portfolio investment

6. FDI Growth in the World Economy • FDI Outflow: $35 billion in ‘75 to $1.3 trillion in ‘00 to $653 billion in ‘03 • FDI Flow (from all countries): from ‘92 to ‘02 up 292%, compared to trade up 69% and world output up 28% • FDI Stock: $3.5 trillion by ‘97 to > $7 trillion in ‘02 • In ‘02: • 64,000 MNEs had: • 850,000 foreign affiliates • 53 million employees • $17.7 trillion in sales • $8 trillions global exports • Conclusion: FDI flow growing faster than world trade and world output

8. Direction and Source of FDI • Most FDI flow has been to developed countries from developed countries • Much to the US from EU, Japan • FDI increase to developing countries since ‘85 • Much to the emerging Asian and Latin America economies • Africa lagging

10. Forms of FDI • FDI forms • Purchase of assets: why? why not? • Quick entry, local market know-how, local financing may be possible, eliminate competitor, buying problems • New investment: why? why not? • No local entity is available for sale, local financial incentives, no inherited problems, long lead time to generation of sales • International joint-venture • Shared ownership with local and/or other non-local partner • Shared risk

11. Alternative Modes of Market Entry • FDI • FDI - 100% ownership • FDI < 100% ownership, International Joint Venture • Strategic Alliances (non-equity) • Franchising • Licensing • Exports: Direct vs Indirect

12. Why FDI? • FDI over exporting • High transportation costs, trade barriers • FDI over licensing or franchising • Need to retain strategic control • Need to protect technological know-how • Capabilities not suitable for licensing/franchising • Follow few main competitors • Immediate strategic responses

14. Pattern of FDI Explanations • International product life-cycle (Ray Vernon) • Trade theory similarity • Eclectic paradigm of FDI (John Dunning) • Combines ownership specific, location specific, and internalization specific advantages • Explains FDI decision over a decision to enter through licensing or exports

15. Eclectic Paradigm of FDI (Dunning) • Ownership advantage: creates a monopolistic advantage to be used in markets abroad • Unique ownership advantage protected through ownership • e.g., Brand, technology, economies of scale, management know-how • Location advantage: the FDI destination market must offer factors (land, capital, know-how, cost/quality of labor, economies of scale) that are advantageous for the firm to locate its investment there (link to trade theory) • Internalization advantage: transaction costs of an arms-length relationship --licensing, exports-- higher than managing the activity within the MNC’s boundaries

16. Government Policy and FDI • The radical view: inbound FDI harmful; MNEs • Are imperialist dominators • Exploit host to the advantage of home country • Extract profits from host country; give nothing back • Keep LDCs backward and dependent for investment, technology and jobs • The free market view: FDI should be encouraged • Adam Smith, Ricardo, et al: international production should be distributed per national comparative advantage • An MNE increases the world economy efficiency • Brings to bear unique ownership advantages • Adds to local economy’s comparative advantages

17. Host Country Effects of FDI • Benefits • Resource -transfer • Employment • Balance-of-payment (BOP) • Import substitution • Source of export increase • Costs • Adverse effects on the BOP • Capital inflow followed by capital outflow + profits • Production input importation • Threat to national sovereignty and autonomy • Loss of economic independence

18. Government Policy and FDI • Home country • Outward FDI encouragement • Risk reduction policies (financing, insurance, tax incentives) • Outward FDI restrictions • National security, BOP • Host country • Inward FDI encouragement • Investment incentives • Job creation incentives • Inward FDI restrictions • Ownership extent restrictions (national security; local nationals can safeguard host country’s interests

19. Are transportation costs high? Yes Is know-how easy to license? Yes Tight control over foreign ops required? No Is know-how valuable and is protection possible? Decision Framework for FDI Import Barriers? No No Export Yes No FDI Yes FDI Yes FDI No License