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Transcript of FDI
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CH 7 Foreign Direct Investment
Importance of FDI in world economy Theories used to explain FDI Government policy towards FDI
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FDI Terms FDI = firm invests directly in facilities to
produce and/or market a product in a foreign country Green-field investment = establishment of a
new operation Acquiring or merging with an existing firm
Multinational Enterprise = firm that owns business operations in more than one country
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FDI Terms
Flow of FDI = amount of foreign direct investment undertake over given period FDI outflows = FDI flow out of a country FDI inflows = FDI flow into a country
Stock of FDI = total accumulated value of foreign owned assets at a given time
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Growth of FDI Firms fear protectionist pressures
Way of circumventing future trade barriers
Political and economic changes – shift toward democratic political institutions and free market economies
Globalization of the world economy
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Drivers of FDI To get access to national markets
Establish low cost manufacturing locations from which to serve regional or global markets
Important to have production facilities based close to their major customers
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Direction of FDI
Historically directed at the developed nations
US was largest recipient because Large and wealthy domestic market Stable economy Favorable political environment Openness to FDI
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Direction of FDI Recent inflow targeted into
developing nations – emerging economies Asia, especially China Latin America
Inability of Africa to attract FDI Political unrest, armed conflict Frequent changes in economic policy
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Source of FDI 60% of all FDI outflows 1997-2002
US has been the largest source country UK, Netherlands, France, Germany, Japan
2002 – 100 largest multinationals 26% US 17% Japanese 12% French 12% German 10% British
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Form of FDI Majority of cross-border investments in the form
of mergers & acquisitions rather than green-field Developed nations 2/3 M&A Developing nations 1/3 M&A
Why M&A Quicker and easier to execute than Green-field Acquire valuable strategic assets – brand loyalty,
customer relations, trademarks & patents, distribution systems, production systems, etc.
Increase efficiency of acquired unit by transferring capital, technology or management skills
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Theories of FDI
Why FDI when could export or license
Why firms in same industry undertake FDI at same time & why certain locations are favored as targets
Eclectic paradigm – combine the two
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Alternative to FDI Exporting
Producing good at home and shipping to receiving country for sale
Limitations- viability is often constrained by transportation costs – unprofitable to ship
some products over large distances trade barriers – import tariffs or quotas
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Alternative to FDI Licensing
Granting a foreign licensee the right to produce & sell the firm’s products in return for a royalty fee on every unit
Limitations – Internalization theory Give away valuable technological know-how to
potential foreign competitor Lack of control over manufacturing, marketing &
strategy required to maximize profitability Firm’s competitive advantage may be based not on
product, but on marketing, management or manufacturing process capabilities
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FDI best entry strategy when Firm has valuable know-how that cannot
be adequately protected by a licensing contract
Firm needs tight control over a foreign entity to maximize its market share and earnings in that country
Firm’s skills and know-how are not amenable to licensing
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Pattern of FDI Knickerbocker - Mulitpoint competition Firms in the same industry often undertake FDI
at same time Clear tendency to direct FDI toward certain
locations
Reflection of strategic rivalry of competitors Oligopoly – interdependence of major players Firms tend to imitate each other’s FDI Match each other’s moves to hold each other in
check
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Pattern of FDI Raymond Vernon - Product Life cycle
Firms undertake FDI at particular stages in the life cycle of a product that they have pioneered in their home market
Invest in other countries when local demand is large enough to support local production
Shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressure.
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Eclectic Paradigm British economist John Dunning
In addition to theories of patterns of trade -Location specific advantages important in explaining rationale for and direction of FDI
Combining location specific assets or resource endowments & the firm’s own unique technological or management capabilities often requires FDI
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Political Ideology & FDI Radical view - MNE is instrument of
imperialist domination Exploit host country for benefit of home
country Keeps developing countries backward &
dependent on capitalist nations for investment, jobs & technology
Extract profits & give nothing of value to host country
Important jobs go to home country nationals
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Political Ideology & FDI Free Market View – Adam Smith &
David Ricardo
Theory of comparative advantage Countries should specialize in the
production of those goods & services they can produce most efficiently
MNE is instrument for dispersing production to the most efficient locations around the globe
FDI resource transfers benefit the host country & stimulate its economic growth
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Political Ideology & FDI Pragmatic Nationalism – FDI has
both benefits & costs
Benefit a host country with capital, skills, technology, & jobs
Costs to host country in terms of repatriation of profits and importing of components
FDI should be allowed if the benefits outweigh the costs
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FDI Benefits Host Country Resource transfer effects
Supplying capital, technology & management resources
Employment effects Brings jobs directly by MNE employing & indirectly by suppliers
employing MNE tend to pay higher wages
Balance of payment effects Tracks payments to & receipts from other countries FDI can substitute for imports, & can export to other countries
Effects on competition & economic growth Green-field increases the number of players, increase competition Competition drive down prices & benefit consumers Increased productivity, innovation & economic growth
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FDI CostsHost Country Adverse effects on competition
MNE subsidiaries may have greater economic power than indigenous firms
Adverse effects on balance of payments Too much outflow so restrict the amount that can be
repatriated Too much importing of components vs local sourcing
Perceived loss of national sovereignty Key decisions that effect host economy will be made
by foreign parent with no commitment to & no control by host country
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FDI Benefits Home Country Inward flow of foreign earnings
May also create demand for home country exports of equipment & goods
Employment effects Jobs created by demand for exports
MNE learns valuable skills that can be transferred back reverse resource-transfer contributing to
home country economic growth rate
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FDI CostsHome Country Balance of payments
Suffers from initial capital outflow to finance FDI Suffers if purpose to supply home market from
low-cost production location Suffers if the FDI is substitute for direct exports
Employment effects Suffers when FDI is substitute for domestic
production – reduced home country employment
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FDI & Government PolicyHome CountryPolicies for encouraging outward FDI
Foreign risk insurance Risks of expropriation (nationalization) War losses Inability to transfer profits back home
Capital assistance Special funds or banks to make government loans to encourage domestic
firms to undertake FDI
Tax incentives Eliminate double taxation of foreign income (host & home governments)
Political pressure Use political influence to encourage host countries to reduce FDI
restrictions
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FDI & Government PolicyHome CountryRestricting Outward FDI
Limit capital outflows out of concern for the balance of payments
Manipulated tax rules to encourage their firms to invest at home – create jobs at home
Countries sometimes prohibit national firms from investing in certain countries for political reasons. (Cuba, South Africa)
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FDI & Government PolicyHost CountryEncouraging inward FDI
Offer incentives for foreign firms to invest in their countries
Tax concessions Low-interest loans New state spending on infrastructure Grants or subsidies
Desire to gain from the resource transfer and employment effects
Desire to capture FDI away from other potential host countries
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FDI & Government PolicyHost CountryRestricting inward FDI Ownership restraints
Foreign companies excluded from specific fields – national security or competition (infant industry)
Significant proportion of the equity of the subsidiary must be owned by local investors – maximize resource-transfer & employment benefits
Performance requirements Maximize the benefits and minimize the costs Related to local content, exports, technology
transfer & local participation by top management
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International Institutions & FDI
WTO Embraces the promotion of trade in
services Many services need to be produced
where they are sold Push for the liberalization of FDI
particularly in services Less successful in establishing universal
rules with regards to FDI
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Managerial Implications Relative profitability of FDI, exporting &
licensing vary with circumstances
As transport costs & trade barriers increase, FDI or licensing are better
Licensing not best when have valuable know-how or need tight control
Host governments attitude toward FDI important variable in where to locate production