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Chapter 7

Chapter 7. 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?

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Chapter 7

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  1. Chapter 7 Foreign Direct Investment

  2. 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? Foreign Direct Investment

  3. 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 Foreign Direct Investment

  4. 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 Foreign Direct Investment

  5. 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 FDI Growth in the World Economy

  6. 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 Direction and Source of FDI

  7. 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 Forms of FDI

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

  9. 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 Why FDI?

  10. 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 Pattern of FDI Explanations

  11. 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 Eclectic Paradigm of FDI (Dunning) Dunning, John H. (1980). “Towards an eclectic theory of international production: Some empirical tests.” Journal of International Business Studies11(2): 9-31

  12. 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 Government Policy and FDI

  13. 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 Host Country Effects of FDI

  14. 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 Government Policy and FDI

  15. 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

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