Global Dimensions of Business Mark McKenna BUS 1875, Fall 2008 Charles H. Hill, International Business: Competing in

1. Global Dimensions of Business Mark McKenna BUS 187(5), Fall 2008 Charles H. Hill, International Business: Competing in the Global Marketplace, 7th ed. (New York: McGraw-Hill/Irwin, 2009) Adapted from PowerPoint slides prepared for the text by Veronica Horton

2. WEEK 6 (Oct. 1) Foreign Direct Investment Hill, Chapter 7

3. Trends in FDI Flow and stock increased in the last 30 years (from $25 billion p/a in 1975 to $1,200 billion in 2006) Flow (inflow/outflow) � movement of capital across borders Stock � accumulated value of foreign-owned assets FDI has grown more rapidly than world trade and output Businesses fear protectionist pressures; FDI is a way to circumvent trade barriers New opportunities for FDI with the end of the Cold War Firms with a global vision see the world as their market Firms recognize the value of locating production facilities near major customers

4. Trends In FDI Figure 7.1: FDI Outflows 1982-2006 ($ billions)

5. The Direction of FDI Most FDI has been directed at developed nations as MNCs invested in each others� markets The US has been the favorite target for FDI inflows Developed nations still account for largest share, but inflows into developing nations has increased FDI has targeted, in particular, emerging economies of South, East, and Southeast Asia, and Latin America Gross figures hide important country differences FDI as share of gross fixed capital formation (total amount invested in factories, stores, office buildings, etc): Ireland, 75%; Chile, 20%; India, 4%; Japan, 0.6%

6. The Direction Of FDI Figure 7.3: FDI Inflows by Region ($ billion), 1995-2006

7. The Source Of FDI Figure 7.5: Cumulative FDI Outflows ($ billions), 1998-2005

8. The Shift to Services Over past 20 years FDI as shifted away from extractive industries and manufacturing to services Four factors have driven this shift General move in many developed economies away toward service industries Difficulty of trading services internationally; need to be produced where consumed Liberalization of FDI regimes governing services Rise of internet-based global telecommunications networks enabling the outsources or off-shoring of service functions (e.g. back-office operations, customer service) In the past two decades, the sector composition of FDI has shifted sharply away from extractive industries and manufacturing and toward services. In 1990, some 47 percent of outward FDI stock was in service industries; by 2003 this figure had increased to 67 percent. Similar trends can be seen in the composition of cross-border mergers and acquisitions, in which services are playing a much larger role. In the past two decades, the sector composition of FDI has shifted sharply away from extractive industries and manufacturing and toward services. In 1990, some 47 percent of outward FDI stock was in service industries; by 2003 this figure had increased to 67 percent. Similar trends can be seen in the composition of cross-border mergers and acquisitions, in which services are playing a much larger role.

9. Mergers and acquisitions: Most prevalent for FDI in developed nations Builds on existing infrastructure and capacities Allows acquisition of valuable strategic assets Assumes efficiency of the acquired firm can be increased by transferring capital, technology and management skills Forms of FDI Greenfield operation: Mostly in developing nations (66%) Main reason, lack of suitable target firms Requires a longer time horizon for return on investment (ROI)

10. Horizontal and Vertical FDI Horizontal FDI occurs when a firm invest abroad in the same industry it operates at home Vertical FDI takes two forms Backward vertical FDI � investment in an industry that provides inputs for a firm�s domestic production processes Forward vertical FDI � investment in an industry that sells the outputs of a firm�s domestic production processes, this is less common than backward vertical FDI Relative to firms native to a culture, a firm in a foreign culture has a greater probability of making costly mistakes due to ignorance. When a firm exports, it need not bear the costs of FDI, and the risks associated with selling abroad can be reduced by using a native sales agent. Similarly, when a firm licenses its know-how, it need not bear the costs or risks of FDI. So why do so many firms apparently prefer FDI over either exporting or licensing? Relative to firms native to a culture, a firm in a foreign culture has a greater probability of making costly mistakes due to ignorance. When a firm exports, it need not bear the costs of FDI, and the risks associated with selling abroad can be reduced by using a native sales agent. Similarly, when a firm licenses its know-how, it need not bear the costs or risks of FDI. So why do so many firms apparently prefer FDI over either exporting or licensing?

11. Theories Of Foreign Direct Investment Why do firms invest rather than use exporting or licensing to enter foreign markets? Why do firms from the same industry undertake FDI at the same time? How can the pattern of foreign direct investment flows be explained?

12. Reasons for Engaging in Horizontal FDI Reasons not to engage in FDI at all FDI is expensive FDI is risky Reasons for engaging in horizontal FDI Transportation costs are high Trade barriers (actual or threatened) impede the free flow of goods and services In response to actions of a competitor/strategic rival In response to shifts in the product�s life cycle Because of location specific advantages (e.g. natural resources) Relative to firms native to a culture, a firm in a foreign culture has a greater probability of making costly mistakes due to ignorance. When a firm exports, it need not bear the costs of FDI, and the risks associated with selling abroad can be reduced by using a native sales agent. Similarly, when a firm licenses its know-how, it need not bear the costs or risks of FDI. So why do so many firms apparently prefer FDI over either exporting or licensing? Relative to firms native to a culture, a firm in a foreign culture has a greater probability of making costly mistakes due to ignorance. When a firm exports, it need not bear the costs of FDI, and the risks associated with selling abroad can be reduced by using a native sales agent. Similarly, when a firm licenses its know-how, it need not bear the costs or risks of FDI. So why do so many firms apparently prefer FDI over either exporting or licensing?

13. What are Market Imperfections Factors that inhibit markets from working perfectly In the international business literature, the marketing imperfection approach to FDI is typically referred to as internalization theory With regard to horizontal FDI, market imperfections arise in two circumstances: When there are impediments to the free flow of products between nations which decrease the profitability of exporting relative to FDI and licensing When there are impediments to the sale of know-how which increase the profitability of FDI relative to licensing

14. Reasons for Engaging in Vertical FDI By using vertical backward integration, a firm can gain control over the source of raw materials raising barriers to entry and shutting new competitors out of an industry circumvent the barriers established by firms already doing business in a country Market imperfections impediments to the sale of know-how through market mechanisms investments in specialized assets expose the investing firm to hazards that can be reduced only through vertical FDI

15. Political Ideology and FDI The radical view (dependency theory) sees MNEs and FDIs as instruments of economic domination exploiting host countries for the benefit of home countries The free market view argues that it is in everyone�s best interests for international production to be distributed according to the theory of comparative advantage Pragmatic nationalism suggests that FDI has both benefits (inflows of capital, technology, skills and jobs), and costs (repatriation of profits to the home country and a negative balance of payments effect), and should be allowed only if the benefits outweigh the costs This position lacked support by the end of the 1980s because of: the collapse of communism in Eastern Europe the poor economic performance of those countries that followed the policy a growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth the strong economic performance of developing countries that embraced capitalism rather than ideology This position lacked support by the end of the 1980s because of: the collapse of communism in Eastern Europe the poor economic performance of those countries that followed the policy a growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth the strong economic performance of developing countries that embraced capitalism rather than ideology

16. Host-Country Benefits 1. resource transfer effects � FDI supplies capital, technology, and management resources 2. employment effects � FDI creates jobs 3. balance of payments effects � FDI contributes to the current account if FDI is a substitute for imports of goods and services, and the MNE uses its foreign subsidiary to export goods and services to other countries 4. effects on competition and economic growth - Greenfield investments increase the level of competition in a market, driving down prices and improving the welfare of consumers

17. Host-Country Costs 1. possible adverse effects on competition subsidiaries of foreign MNEs may have greater economic power than indigenous competitors 2. adverse effects on the balance of payments capital outflow due to repatriation of earnings imported inputs hurt a country�s current account balance 3. perceived loss of national sovereignty and autonomy key decisions made by a foreign MNE with no real commitment to the host country and over which host-country government has no real control

18. Home-Country Benefits and Costs The benefits of FDI for the home country include: the effect on the capital account of the home country�s balance of payments from the inward flow of foreign earnings the employment effects that arise from outward FDI the gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country The home country�s balance of payments can suffer: from the initial capital outflow required to finance the FDI if the purpose of the FDI is to serve the home market from a low cost labor location if the FDI is a substitute for direct exports Employment may also be negatively affected if the FDI is a substitute for domestic production

19. Home-Country Policies Governments can encourage and restrict FDI: To encourage outward FDI, many nations now have government-backed insurance programs to cover major types of foreign investment risk To restrict outward FDI, most countries, including the United States, limit capital outflows, manipulate tax rules, or outright prohibit FDI

20. Host-Country Policies Governments can encourage or restrict inward FDI To encourage inward FDI, governments offer incentives to foreign firms to invest in their countries Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI, and to capture FDI away from other potential host countries To restrict inward FDI, governments use ownership restraints and performance requirements The rationale underlying ownership restraints is twofold: first, foreign firms are often excluded from certain sectors on the grounds of national security or competition second, ownership restraints seem to be based on a belief that local owners can help to maximize the resource transfer and employment benefits of FDI for the host country The rationale underlying ownership restraints is twofold: first, foreign firms are often excluded from certain sectors on the grounds of national security or competition second, ownership restraints seem to be based on a belief that local owners can help to maximize the resource transfer and employment benefits of FDI for the host country