Foreign Direct Investment Prof. G. R. Agrawal

1. Foreign Direct Investment Prof. G. R. Agrawal

2. Slide 6-1 Foreign Direct Investment • Foreign direct investment (FDI) happens when a firm invests directly in facilities in a foreign country • 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 across national borders

3. Slide 6-2 Foreign Direct Investment • Involves ownership of entity abroad for • production • Marketing/service • R&D • Raw materials or other resource access • Parent has direct managerial control • The degree of direct managerial control depends on the extent of ownership of the foreign entity and on other contractual terms of the FDI • No managerial involvement = portfolio investment

4. Slide 6-3 FDI Growth in the World Economy • FDI Outflow of $25 billion in 1975 increased to $1.3 trillion in 2000 • FDI flow accelerated more than world trade (x 5 and x 1.8 respectively) • FDI Flow from all countries increased 1000%, trade 91%, world output 27% from 1984 to 1998 • FDI Stock increased to $3.5 trillion by 1997 • 63,000 parent firms with 690,000 foreign affiliates produced $14 trillion sales, almost twice global exports • FDI growing faster than world trade • Political risk issues • Economic reason issues • Globalization

5. Slide 6-4 Direction and Source of FDI • Historically, FDI flow was to developed countries from other developed countries • Much of this to the US • Since 1985 there has been an increase of FDI towards developing countries • Much to the emerging Asian and Latin America economies • Africa lagging • Through 1970s US led in FDI outflows • 1985-1990 Japan 1st, UK 2nd, US 3rd • Effect of ¥ increase in value • In 2000 the USA received 21.6% of world FDI; the EU received 48.7%

6. Slide 6-5 Forms of FDI • FDI forms • Purchase of existing assets • Quick entry, local market know-how, local financing may be possible, eliminate competitor, buying problems • New investment • No local entity exists or is available for sale, local financial incentives may encourage, no inherited problems, long lead time to generation of sales or other desired outcome • Participation in an international joint-venture • Shared ownership with local and/or other non-local partner

7. Slide 6-6 Alternative Modes of Market Entry • FDI • FDI - 100% ownership • FDI < 100% ownership, International Joint Venture • Majority, Equal Share, Minority Participation • Strategic Alliances (non-equity) • Franchising • Licensing • Exports • Direct vs Indirect

8. Slide 6-7 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

9. Slide 6-8 Pattern of FDI • Follow main competitors • Oligopolistic industries • Interdependence of the few major competitors forces immediate strategic responses • International product life-cycle (Vernon, see Ch. 4) • Eclectic paradigm of FDI (John Dunning) • Combines ownership specific, location specific, and internalization specific advantages that drive FDI choice over a decision to enter through licensing or exports

10. Slide 6-9 Eclectic Paradigm of FDI (Dunning) • Ownership advantage: creates a monopolistic advantage which can be used to prevail in markets abroad • Unique ownership advantage protected through ownership • e.g., Brand, technology, economies of scale, management know-how • Location advantage: the FDI destination local market must offer factors (land, capital, know-how, cost/quality of labor, economies of scale) such that it is 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 MNE’s boundaries Dunning, John H. (1980). “Towards an eclectic theory of international production: Some empirical tests.” Journal of International Business Studies11(2): 9-31

11. Slide 6-10 Government Policy and FDI • The radical view: inbound FDI harmful; MNEs • Are an instrument of imperialist domination • Exploit host to the advantage of home country • Extract profits from host country; give nothing back • Keep LDCs backward/dependent for investment, technology and jobs • The free market view: FDI should be encouraged • Adam Smith, Ricardo, et al: international production should be distributed according to comparative advantage • The MNE increases the world economy efficiency because it brings to bear unique ownership advantages on the local economy’s comparative advantages

12. Slide 6-11 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

13. Slide 6-12 Home Country Effects of FDI • Benefits • BOP current account adversely affected by inward flow of foreign earnings • Positive employment effect from increased exports of raw materials / assemblies to the overseas subsidiary • Repatriation of skills and know-how • Costs • BOP trade position is negatively affected (lower finished goods exports) • Loss of employment to overseas market

14. Slide 6-13 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

15. Slide 6-14 Decision Framework for FDI No No Are transportation costs high? Import Barriers? Export Yes Yes No Is know-how easy to license? FDI Yes Yes Tight control over foreign ops required? FDI No Yes Is know-how valuable and is protection possible? FDI No License