Multinational business

Week 4

Economic Impact of FDI

Agenda

• Foreign direct investment

• Motives of FDI

• Types of FDI

• Advantages of FDI to home and host country

The Economic Impact of Foreign Direct Investment(FDI)

• FDI is an internationalisation strategy in which firm establishes a physical presence abroad through ownership of productive assets such as • Capital

• Technology

• Labour

• Plant

• Equipment

FDI V FPI

• FPI (Foreign Portfolio Investment)

• Passive ownership of foreign securities such as stocks or bonds for the purpose of generating financial returns

• Form of international investment but not direct investment which seeks control of business abroad and represents a long term commitment

• Not more than 10% of ownership in the enterprise according to UN

Trends in FDI

• FDI active in both advanced and emerging markets

• Destination or recipient countries for such investments include both advanced economies and emerging markets

• Company employ multiple strategies to enter foreign markets as investors, including acquisitions and collaborative ventures

• Companies from all type of industries including services are active in FDI

• Direct investment from foreign companies occasionally raises patriotic sentiments among citizens

Factors to be considered when undertaking foreign market entry

• Degree of control

• Degree of risk

• Commitment of organisational and financial resources

• Flexibility

Key features of FDI

• Greater resource commitment

• Local presence and operations

• Global scale efficiency

• Substantial risk and uncertainty

• MNE increasingly strive to behave in socially responsible ways in host countries.

Leading destination for FDI

• Advanced economies: high GDP per capita, GDP growth rate, density of knowledgeable workers, and superior business structure

• In recent years however emerging markets and developing countries such as China and India a popular destination• Size

• Rapid growth rate

• Low labour costs

• Act as a platform where MNEs manufacture products for export to key markets in Asia and elsewhere

• Strategically, these countries hold long term potential as target markets and new sources of competitive advantage

Factors to be considered in selecting FDI location

• Market factors: size and growth of national and regional markets; proximity to key export markets

• Human resource factors: cost, availability and productivity of skilled labour, labour unions, employment regulations

• Infrastructural factors: efficiency of physical distribution, cost availability and qualities of utilities and finance, quality of marketing and distribution

• Political and environmental factor: stability, openness to foreign investment, transparency and corruption

• Economic factors: cost of land and facilities, state of the local economy, stability of currency, extent of regional integration and free trade

• Legal and regulatory factor: regulations on FDI, nature of legal system and laws, intellectual property protection, extent of tariff and other trade barriers

• Profit retention factors: level of taxes, tax rate for profit repatriation, complexity of tax system, rate of inflation

Motives of FDI

• Market seeking

• Resource or asset seeking

• Efficiency seeking

Market seeking FDI

• Pushed into international markets

• Pulled into international markets

• Three primary market seeking motivation• Gain access to new markets or opportunities

• Follow key customers: e.g. Tradegar following P&G in China

• Compete with key rival in their own markets: e.g. Caterpillar entering into Japanese market to compete with Komatsu

Asset or resource seeking FDI

• Access to raw materials

• Gain access to knowledge or other assets

• Access technological and managerial know how available in a key market: robotics in Japan, chemicals in Germany, fashion in Italy, or software in US.

Efficiency seeking FDI

• Objectives to create economies of scale

• Efficiency seeking motives include• Reduce sourcing and production costs

• Locate production near customers

• Take advantage of government incentives

• Avoid trade barriers

Types of FDI

FDI can be classified

• By the form of FDI• Greenfield versus mergers and acquisitions

• Nature of ownership• Wholly owned versus Joint ventures

• Level of integration• Horizontal Versus vertical

Greenfield investment vs. Merger and Acquisition

• Greenfield investment:• Direct investment to build a new manufacturing, marketing or administrative

facility as opposed to acquiring existing facilities

• ACQUSITION • refers to a direct investment or purchase of an existing company or facility.

• A MERGER • is a special type of acquisition in which two firms join to form a new, larger

firm

• Mergers are more common between companies of similar size

Greenfield investment vs. Merger and Acquisition

• MNE may favour acquisition over Greenfield investment• MNE will gain access to acquired firm experienced staff

• Obtain ownership of existing asset

• Access to existing suppliers and customers

• Provides immediate stream of revenues and accelerate MNEs return on investment

• By contrast, host country governments usually prefer MNE to undertake greenfield investment and provides incentives to encourage them.• Create new jobs and production capacity

• Facilitates technology and know how transfer to locals

• Improve linkages to global market place

Wholly owned vs Joint ventures

• Equity participation:• Acquisition of partial ownership in an existing firm

• Wholly owned direct investment• Investor fully owns the foreign assets

• Equity joint ventures• Types of partnerships in which a separate firm is created through the

investment or pooling of assets by two or more parents firms that gain joint ownership of the legal entity.

• Partner may hold majority, 50-50, or minority ownership

Vertical Vs horizontal FDI

• Vertical integration:• An arrangement whereby the firm owns, or seeks to own multiple stages

of a value chain for producing, selling and delivering a product or service

• Two forms:

• Forward vertical integration

• Backward vertical integration

• Horizontal integration:• An arrangement whereby the firm owns, or seeks to own, the activities

involved in a single stage of its value chain

Impact or Advantages of FDI

Ownership Advantages

• These are advantages specific to the firm.• For example; patents, trademarks, managerial capabilities,

organisational or marketing skills, technological sophistication.

• Other examples; size and diversification, access to or control over raw materials, ability to call on the political support of host government, access to finance on favourable terms.

• These advantages give foreign direct investors a competitive edge over rival firms in the host country.

Locational Advantages

• These are advantages which will help determine the locational dimension of the FDI decision, i.e. the ‘where’ of international production.• Key location factors

• Comparative advantage: Effects of resource availability on costs of producing in different countries.

• Economies of scale: Better to concentrate production in a few locations.

• Tariffs and NTBs: Circumvent barriers to trade.

• Trade blocs: Setup favours FDI when host country is member of a FTA which home country is not.

• Other factors: quality of transport and communication facilities, more conducive climates for some agricultural goods, favourable host government policies, better understanding of local tastes.

Internalisation Advantages

• Internalisation advantages means that it is more profitable to carry out production within the host economy rather than to rely on external markets (exporting, licensing).

• The transaction costs of arms-length relationship is higher than managing the activities and relocating production of the MNC.

• Therefore it is more advantageous for the firm to retain its specific advantages under its control.

• The importance of internalisation can explain why FDI occurs in high-technology industries(pharmaceuticals) and marketing-intensive products(food / automobiles).

Benefits and Disadvantages –Host Countries

Resource transfer effect

• New firms can bring in

• Capital• By virtue of their size and reputation, FDI firms have easier access to international capital markets.

• Technology• FDI firms have a higher R&D capacity.

• Technology transfer(royalty fee) and technology diffusion(demonstration effects and reverse engineering). May need a certain amount of human capital to absorb new technology, Borensztein et al (1998).

• Overall studies show that the introduction of technologies by foreign affiliates have increased labour productivity in several cases (UNCTAD, 2008).

• Managerial and organisational skills• Training of indigenous human capital will lead to knowledge spill over effects

Employment effect

• Direct: • FDI firms can directly recruit domestic nationals.

• Usually, they receive a higher wage rate as opposed to what domestic firms pay (Lim 2001 for LDCs).

• FDI often targets cheap labour, especially in LDCs, but uses a higher proportion of skilled labour than domestic firms.

• Indirect:• An indirect increase in employment occurs through backward linkages .

• The inflows of FDI firms attract workers in the production of intermediate goods that are used in the latter’s production processes.

• The overall impact of FDI on employment depends on the choice of production techniques and the degree of complementarity and substitutability between FDI and domestic firms.

Balance of Payments Effect

• FDI might affect both imports and exports in host economies, depending on their production and marketing strategies.

• Exports may increase if FDI is export-oriented and uses the host economy as an export platform (ownership advantage).

• Imports may reduce if FDI firms are asset seeking. However if FDI firms are heavily reliant on imported raw material, we can anticipate imports to rise.

FDI and Domestic Investment

• Inflows of FDI firms can have 3 possible impacts on domestic firms:

(1)Crowding-in effect

• FDI acts as a catalyst to the development of domestic firms. How?i. Knowledge spill over effects

ii. Technological spill over effects

iii. Forward linkage effects: MNCs may help domestic firms by opening up marketing facilities.

iv. Backward linkage effects: MNCs may contribute to raise productivity and efficiency of local supplier firms (Javorcik2004 found positive spillovers for Lithuania and Venuzuela).

FDI and Domestic Investment

(2) Crowding-out effect

• The inflows of FDI forces domestic firms out of the market.

• Why?• i. Competitive advantages

• Product market

• Factor market

• ii. Lack of absorptive capacities (linked to human capital and financial development).

(3) Neutral effect •The inflow of FDI does not affect domestic investment.

•FDI goes into a market that means it is not in competition with local producers. (Novel products for that country).

Disadvantages of FDI for host state.

• Multinational investment may not always be beneficial to the host states because of the following reasons:

• MNCs use their power to drive existing domestic firms out of business and suppress new indigenous ones

• Control• In many developing countries, MNCs are the principal wealth-creators and

may oppose safety or pollution controls if against their interests

• Transfer pricing• MNCs manipulate their internal pricing structure to reduce their tax liabilities.

Disadvantages of FDI for host state.

• Environment• MNCs are often accused of investing in Least Developed Countries to extract resources at

least cost regardless of the local environmental damage.

• Bulk of MNCs profits repatriated• Little of the MNCs profits may be invested in the host country (in case of developing

countries, the concessions given to the MNCs may not be worthwhile)

• Technology and skills brought by MNCs may be fiercely guarded• Little chance of technology transfer to domestic firms

• Dominance of MNCs may lead to demise of domestic firm and indigenous technology

• Worsening the inequality gap(for developing countries)• Capital-intensive MNCs may create too few job opportunities

Benefits and Disadvantages –Home Countries

Benefits

• The main benefit from FDI is that the MNE earns a higher rate of return than it can make on alternative domestic investment.

• Taxes levied on the foreign income of MNEs can, in principle, capture some of the benefits of the higher income for the entire society.

Disadvantages

• Workers in home countries lose out on job opportunities.

• Government receive fewer or no taxes from MNCs.

• Export of advanced technology may undermine technological superiority of home country.

• Outward FDI may take away the external technological benefits to other countries.

• Note: Industrialised nations impose few restrictions on outward FDI.