Foreign Direct Investment

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Chapter ObjectivesChapter Objectives

• Describe worldwide patterns of foreign direct investment (FDI) and reasons for those patterns

• Describe each of the theories that attempt to explain why FDI occurs

• Discuss the important management issues in the FDI decision

• Explain why governments intervene in the free flow of FDI

• Discuss the policy instruments that governments use to promote and restrict FDI

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VolkswagenVolkswagen

• Produces 8 million cars a year• Modular production strategy• Special protection in Germany

• Produces 8 million cars a year• Modular production strategy• Special protection in Germany

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Foreign Direct Investment Foreign Direct Investment (FDI)(FDI)

Purchase of physical assets or significant amount of ownership of a company in another country in order to gain some measure of management control

By contrast, portfolio investment does not involve obtaining a degree of control in a company

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Yearly FDI InflowsYearly FDI Inflows

Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years.

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Reasons for FDI GrowthReasons for FDI Growth

Increasingglobalization

International mergersand acquisitions

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Value of Cross-Border M&AsValue of Cross-Border M&As

Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years.

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Worldwide FDI FlowsWorldwide FDI Flows

World FDI inflows

Developed (49%), developing (45%)

European Union: 28% of world FDI

Developing nations

China and India attract most FDI

All of Africa: 2.8% of world FDI

82,000 multinationals

with810,000 affiliates

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Discussion QuestionDiscussion Question

What is the difference between foreign direct investment and portfolio investment?

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Answer to Discussion Answer to Discussion QuestionQuestion

Foreign direct investment is the purchase of physical assets or a significant amount of the ownership of a company in another country to gain a measure of management control.

Portfolio investment does not involve obtaining a degree of control in a company.

International Product Life International Product Life CycleCycle

A company begins by exporting its product and later undertakes foreign direct investment as a product moves through its life cycle

Source: Raymond Vernon and Louis T. Wells, Jr., The Economic Environment of International Business , 5th ed. (Upper Saddle River, N.J.: Prentice Hall, 1991), p. 85.

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Market Imperfections Market Imperfections (Internalization)(Internalization)

Trade barriers(e.g., tariffs)

Unique advantage(e.g., special

knowledge)

A company undertakes FDI to internalize a transaction that is made inefficient because of a market imperfection

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Eclectic TheoryEclectic Theory

FDI when location, ownership, and internalization advantages combine to make a location appealing

Locationadvantage

(optimal location)

Ownershipadvantage(special asset)

Internalizationadvantage

(efficiency)

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Market PowerMarket Power

FDI used to establish a dominant presence in an industry

Vertical integrationExtends company’s activitiesinto stages of production that provide its inputs (backward integration) or absorb its out-puts (forward integration)

Market power= Greater profits

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Discussion QuestionDiscussion Question

The eclectic theory says that firms undertake FDI when location, ownership, and __________ advantages combine to make a location appealing for investment.

a. Internalization

b. First-mover

c. Life-cycle

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Answer to Discussion Answer to Discussion QuestionQuestion

The eclectic theory says that firms undertake FDI when location, ownership, and __________ advantages combine to make a location appealing for investment.

a. Internalization

b. First-mover

c. Life-cycle

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Management Issues IManagement Issues I

Control Purchase-or-build

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Management Issues IIManagement Issues II

Productioncosts

Customerknowledge

Source: LIU JIN/Newscom

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Management Issues IIIManagement Issues III

Following rivalsFollowing clients

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Balance of PaymentsBalance of Payments

Capital accountCapital accountCurrent accountCurrent account

National accounting system that records all payments to entities in other countries and all receipts coming into the nation

The import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country

The purchase or sale of assets (including assets such as property and shares of common stock in a company)

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U.S. Balance of PaymentsU.S. Balance of Payments

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Discussion QuestionDiscussion Question

What do we mean by a country’s balance of payments and what is its usefulness?

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Answer to Discussion Answer to Discussion QuestionQuestion

A country’s balance of payments is a national accounting system that records all payments to entities in other countries and all receipts coming into the nation.

The system helps monitor a country’s flows of goods, services, income, and asset transfers between itself and other nations. The balance of payments position sends warning signals about trade deficits with other nations.

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Host Intervention IHost Intervention I

Balance of Payments+

Balance of Payments+

FDI may generate exportsFDI may generate exports

Initial FDI boosts economyInitial FDI boosts economy

FDI may decrease importsFDI may decrease imports

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Host Intervention IIHost Intervention II

Obtain resourcesand benefits

+

Obtain resourcesand benefits

+

Access technologyAccess technology

Access management skillsAccess management skills

Create employmentCreate employment

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Home InterventionHome Intervention

+ Improve competitiveness+ Eliminate low-wage jobs

– Remove national resources– Eliminate export markets– Eliminate domestic jobs

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Host Promotion MethodsHost Promotion Methods

Financial incentives■ Low or waived taxes■ Low-interest loans

Infrastructure benefits■ Better seaports, roads,

and telecom networks

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Host Restriction MethodsHost Restriction Methods

Ownership restrictions■ Prohibit investment in industries or businesses

Performance demands■ Local content requirements■ Export targets■ Technology transfers

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Home Promotion MethodsHome Promotion Methods

Insurance on assets abroad

Loans and loan guarantees

Tax breaks on profits earned abroad

Special tax treaties

Persuade other nations to accept FDI

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Home Restriction MethodsHome Restriction Methods

Higher taxes onforeign income

Sanctions that prohibit investing

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Discussion QuestionDiscussion Question

A host government may encourage an initial FDI because the inflow can __________ its balance-of-payments position.

a. Level

b. Lower

c. Boost

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Answer to Discussion Answer to Discussion QuestionQuestion

A host government may encourage an initial FDI because the inflow can __________ its balance-of-payments position.

a. Level

b. Lower

c. Boost