Lecture 3 Foreign Direct Investment

[ Ref. Chapter- 7, Global Business Today ]

Introduction
What is foreign direct investment? Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country Once a firm undertakes FDI it becomes a multinational enterprise There are two forms of FDI 1 A greenfield in 1. investment estment (the establishment of a wholly new operation in a foreign country) 2. Acquisition or merging with an existing firm in the foreign country

Foreign Direct Investment in the World Economy

{ There are two ways to look at FDI 1. The flow of FDI refers to the amount of FDI undertaken over a given time period 2. The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time Outflows of FDI are the flows of FDI out of a country Inflows of FDI are the flows of FDI into a country

Trends in FDI
Both the flow and stock of FDI in the world economy has increased over the last 20 years FDI has g grown more rapidly p y than world trade and world output because: firms still fear the threat of protectionism the general shift toward democratic political institutions and free market economies has encouraged FDI the th globalization l b li ti i is prompting ti fi firms t to undertake FDI to ensure they have a significant presence in many regions of the world

Trends in FDI
FDI Outflows 1982-2007

The Direction of FDI Historically, most FDI has been directed at the developed nations of the , with the United States being ga world, favorite target FDI inflows have remained high during the early 2000s for the United States, and also for the European Union South, South East, East and Southeast Asia Asia, and particularly China, are now seeing an increase of FDI inflows Latin America is also emerging as an important region for FDI

Trends in Inward FDI : 1970 -2011 (US $ Millions)

2500000 2000000 1500000 1000000 500000 0
1970 1980 1990 2000 2010

World

Developing economies
Source: http://unctadstat.unctad.org

The Direction of FDI

FDI Inflows by Region 1995 -2007

The Direction of FDI

FDI can be expressed as a percentage of gross fixed capital formation (the total amount of capital invested in factories, stores, office buildings etc.) All else being equal, the greater the capital investment in an economy, the more favorable its future prospects are likely to be So, FDI can be seen as an important source of capital investment and a determinant of the future growth rate of an economy

The Source of FDI

{ Since World War II, the U.S. has been the largest source country for FDI { Other important source countries include the U.K., Netherlands, France, Germany, Japan { These countries also predominate in rankings of the worlds largest multinationals

The Source of FDI

Cumulative FDI Outflows 1998 - 2006

The Form of FDI: Acquisitions versus Greenfield Investments

{ Majority of cross-border investment involves mergers g and acquisitions q rather than g greenfield investments { Firms prefer to acquire existing assets because mergers and acquisitions are quicker to execute than greenfield investments it is easier and perhaps less risky for a firm to acquire i d desired i d assets t th than b build ild th them f from th the ground up firms believe they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills

The Shift to Services

{ In the last two decades, there has been a shift of FDI towards services

{ The shift to services is being driven by general move in many y developed countries the g toward services Many services cannot be stored/exported--> produce them then and there --> hence need for FDI Liberalization of policies governing FDI in services Rise of Internet-based global telecom networks that have allowed some service enterprises to relocate some of their value creation activities to different nations to take advantage of favorable factor costs

Theories of Foreign Direct Investment Question: Why do firms prefer FDI to either ith exporting ti or licensing li i ( (granting ti a foreign entity the right to produce and sell the firms product in return for a royalty fee on every unit that the foreign entity sells)? To answer this question, we need to look at the limitations of exporting and licensing, and the advantages of FDI

Theories of Foreign Direct Investment

1. Limitations of Exporting

y of an exporting p g strategy gy can be {The viability constrained by transportation costs and trade barriers When transportation costs are high, exporting can be unprofitable Foreign direct investment may be a response to actual or threatened trade barriers such as import tariffs or quotas

Theories of Foreign Direct Investment

2. Limitations of Licensing

Internalization theory (also known as market imperfections) suggests that licensing has three major drawbacks 1. it may result in a firms giving away valuable technological know-how to a potential foreign competitor 2. it does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability 3. It may be difficult if the firms competitive advantage is not amendable to licensing

Starbucks in India

Starbucks, the world's largest coffee-shop chain, opened its first branch in India on 19 October, 2012. Two more branches including one in Mumbai's famous Taj Mahal Palace hotel, which has likewise seen dozens of people queuing for a frappuccino opened in the subsequent week (All the 3 outlets in Mumbai) With more than 17,600 branches in 61 countries, it is perhaps surprising that the Seattle-based company has only just arrived in India. It entered China in 1999 and has around 600 outlets there. Indian government in September, 2012 relaxed rules on local sourcing for foreign "single-brand retailers" shops that sell items belonging to one brand. Last November, it scrapped rules stating that such retailers needed to partner with a local company. Following these reforms, IKEA this month applied to open around 25 outlets. Starbucks has entered India through an $80m joint venture with Tata, one of the country's biggest conglomerates, having worked on this deal before the rules changed (guardian.co.uk, Monday 29 October 2012 ).

The Pattern of Foreign Direct Investment

3. Advantages of Foreign Direct Investment

A firm will favor FDI over exporting p g as an entry y strategy when: 1. transportation costs are high 2. trade barriers are high A firm will favor FDI over licensing when 1. it wants control over its technological knowhow 2. it wants control over its operations and business strategy 3. the firms capabilities are not amenable to licensing

Theories of Foreign Direct Investment { It is common for firms in the same industry to: 1. have similar strategic behavior and undertake foreign direct investment around the same time 2. direct their investment activities towards certain locations at certain stages in the product life cycle

Theories of Foreign Direct Investment

1. Strategic Behavior

Knickerbocker explored the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms) Knickerbocker suggested that FDI flows are a reflection of strategic rivalry between firms in the global marketplace y can be extended to embrace the This theory concept of multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries)

Theories of Foreign Direct Investment

2. The Product Life Cycle { Vernon argues that firms undertake FDI at particular stages in the life cycle of a product they have pioneered { Firms invest in other advanced countries when local demand in those countries grows large enough to support local production { Firms then shift production to low-cost developing countries when product standardization and market saturation give rise to price competition and cost pressures

The Eclectic Paradigm(Dunning)

John Dunnings eclectic paradigm argues that in addition to the various factors discussed earlier two additional location related factors earlier, must be considered when explaining both the rationale for and the direction of foreign direct investment: 1. location-specific advantages (arise from using resources or assets that are tied to a particular ti l location l ti and d that th t a firm fi finds fi d valuable l bl to combine with its own unique assets) 2. externalities (knowledge spillovers that occur when companies in the same industry locate in the same area)

The Eclectic Paradigm(OLI)

Ownership (or Firm Specific) Advantages. This helps explain the "why," or motivation, of multinational enterprise activities. Ownership advantages are defined as the degree to which a firm possesses sustainable ownership-specific advantages over other firms in the market. Some examples of these advantages are innovative capacity, capacity access to financial resources, and organizational and marketing systems. Location Advantages. This helps explain the "where," or location, of multinational enterprise activities. These advantages are specific to the country. Some examples are natural resources, labor force (availability and quality), and societal structure (legal systems, political structure). Internalization Advantages. This helps explain the "how," or the manner, of multinational enterprise activities. Internalization is the degree of ownership and control. At one end of the spectrum is no control or ownership. Transactions are made at arm's length or through the market. At the other end of the spectrum is full control. The firm "internalizes" the market transactions by owning or controlling the other firm. The transactions are not arm's-length.

Different Types of FDI

The typology of FDI was developed by Jere Behrman to explain the different objectives of FDI:
1. 2. 3 3. 4. Resource seeking FDI Market seeking FDI Efficiency seeking (global sourcing FDI) Strategic asset/capabilities seeking FDI

Resource seeking FDI

To seek and secure natural resources e.g. minerals, i l raw materials, t i l or lower l labor costs for the investing company For example, a German company opening a plant in Slovakia to produce and re-export re e port to Germany German

Market seeking FDI

To identify and exploit new markets for the finished p products of the firm Some type of services for which production and distribution have to be contemporaneous (telecom, water supply, energy supply) Automotive TNCs have invested heavily in China

Efficiency seeking FDI

To restructure its existing investments so as to achieve an efficient allocation of international economic activity of f the firms f International specialization whereby firms seek to benefit from differences in product and factor prices and to diversify risk Global sourcing resource saving and improved efficiency by rationalizing the structure of their global activities. Undertaken primarily by network based MNCs with global sourcing operations.

Strategic asset/capabilities seeking FDI

MNCs pursue strategic operations through the p purchase of existing g firms and/or assets in order to protect specific advantages in order to sustain or advance its global competitive position
Acquisition of key established local firms Acquisition of local capabilities including R&D, knowledge and human capital Acquisition of market knowledge Pre empting market entrance by competitors Pre empting the acquisition of local firms by competitors

Political Ideology and Foreign Direct Investment

Ideology toward FDI has ranged from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economies Between these two extremes is an approach that might be called pragmatic nationalism

The Radical View

{ The radical view argues that the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries { The radical view has been in retreat because of: the collapse of communism in Eastern Europe the p poor economic p performance of those countries that had embraced the policy the strong economic performance of developing countries that had embraced capitalism

The Free Market View

The free market view argues that international production should be distributed among countries according to the theory of comparative advantage Thus, MNCs increase the overall efficiency of the world economy The free market view has been embraced by advanced and developing nations, including the United States, Britain, Chile, and Hong Kong

Pragmatic Nationalism The pragmatic nationalist view - FDI has both benefits, such as inflows of capital, it l t h l technology, skills kill and d jobs, and costs, such as repatriation of profits to the home country and a negative balance of payments effect According to this view, FDI should be allowed only if the benefits outweigh the costs

Shifting Ideology Recent years have seen a strong shift toward the free market economy worldwide, creating: a surge in the volume of FDI worldwide an increase of FDI directed at countries that have recently liberalized their regimes

Benefits and Costs of FDI

Question: What are the benefits and costs of FDI? The benefits and costs of FDI must be examined from the perspective of both the host (receiving) country and the home ( (source) ) country y.

Host Country Benefits

The main benefits of inward FDI for a host country are:

1. 2. 3. 4 4.

the resource transfer effect the employment effect the balance of payments effect effects on competition and economic growth

Host Country Benefits 1. Resource Transfer Effects FDI can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available 2. Employment Effects FDI can bring jobs to a host country that would otherwise not be created there

Host Country Benefits

Effects A countrys balance-of-payments account is a record of a countrys payments to and receipts f from other th countries ti The current account is a record of a countrys export and import of goods and services FDI can help achieve a current account surplus: if the th FDI i is a substitute b tit t for f imports i t of f goods and services if the MNE uses a foreign subsidiary to export goods and services to other countries
3. Balance-of-Payments

Host Country Benefits

4. Effect on Competition and Economic Growth

FDI in the form of greenfield investment increases the level of competition in a market drives down prices improves the welfare of consumers Increased competition can lead to increased prod productivity cti it gro growth th product and process innovation greater economic growth

Host Country Costs

There are three main costs of inward FDI: 1. the possible adverse effects of FDI on competition within the host nation 2. adverse effects on the balance of payments 3. the perceived loss of sovereignty and autonomy national

Host Country Costs

1. Adverse Effects on Competition Subsidiaries of foreign MNEs operating in a country y may y have g greater economic p power than domestic competitors because they may be part of a larger international organization As part of larger organization, the MNE could draw on funds generated elsewhere to subsidize costs in the local market Doing so could allow the MNE to drive domestic competitors out of the market and create a monopoly position

Host Country Costs

2. Adverse Effects on the Balance of Payments There are two possible adverse effects of FDI on a os countrys cou y s ba balance-of-payments: a ce o pay e s host 1. Initial inflows of FDI would involve subsequent outflow of capital as the foreign subsidiary repatriates dividend/earnings to its parent country 2. When a foreign subsidiary imports its inputs from abroad, there is a debit on the current account of the host countrys balance of payments

Host Country Costs

3. National Sovereignty and Autonomy Many host governments worry that FDI is accompanied by some loss of economic independence Key decisions that can affect the host countrys economy will be made by a foreign parent that has no real commitment to the host country, country and over which the host countrys government has no real control

Home Country Benefits

The benefits of FDI to the home country include: 1. the effect on the capital account of the home countrys country s balance of payments from the inward flow of foreign earnings 2. the employment effects that arise from outward FDI 3. the g gains from learning g valuable skills from foreign markets that can subsequently be transferred back to the home country

Home Country Costs

The most important concerns for the home country center around 1. The balance-of-payments { The balance of payments suffers from the initial capital i l outflow fl required i d to finance fi the h FDI { The current account is negatively affected if the purpose of the FDI is to serve the home market from a low-cost production location { The current account suffers if the FDI is a substitute for direct exports 2. Employment effects of outward FDI { If the home country is suffering from unemployment, there may be concern about the export of jobs

Government Policy regarding FDI FDI can be regulated by both home and host countries Governments can implement policies to: 1. encourage FDI 2 discourage 2. di FDI

Home Country Policies

1. Encouraging

Outward FDI y nations now have government-backed g Many insurance programs to cover major types of foreign investment risk This type of policy can encourage firms to undertake FDI in politically unstable nations Eliminate double taxation of foreign income Lobby with host country govts. to relax restrictions on FDI

Home Country Policies

2. Restricting Outward FDI

All countries, including the United St t States, h have exercised i d some control t l over outward FDI from time to time Some countries manipulate tax rules to make it more favorable for firms to invest at home Countries may restrict firms from investing in certain nations for political reasons

Host Country Policies

1. Encouraging Inward FDI

Host country y Governments offer various incentives to foreign firms to invest in their countries Incentives are motivated by:
a desire to gain from the resourcet transfer f and d employment l t effects ff t of f FDI, and to capture FDI away from other potential host countries

Host Country Policies

2. Restricting Inward FDI
{ Ownership restrictions and performance requirements (controls over the behavior of the MNE MNEs s local subsidiary) are used to restrict FDI { Ownership restraints exclude foreign firms from certain sectors on the grounds of national security or competition are often based on a belief that local owners can help to maximize the resource transfer and employment benefits of FDI { Performance requirements are used to maximize the benefits and minimize the costs of FDI for the host country

International Institutions and the Liberalization of FDI Until recently there has been no consistent involvement by y multinational institutions in the governing of FDI. The formation of the World Trade Organization in 1995 is changing this. The WTO has framed some universal set of rules to promote the liberalization of FDI

Implications for Managers

Question: What does the theory FDI mean ea for o international te at o a bus businesses? esses The theory of FDI has implications for strategic behavior of firms Government p policy y on FDI can also be important for international businesses

The Theory of FDI

{ The location-specific advantages argument associated with John Dunning g help p explain p the direction of FDI { However, internalization theory is needed to explain why firms prefer FDI to licensing or exporting po t g is sp preferable e e ab e to licensing ce s g a and d FDI {Exporting as long as transportation costs and trade barriers are low

The Theory of FDI

{ Licensing is unattractive when: the firms firm s proprietary property cannot be properly protected by a licensing agreement the firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country the firms skills and capabilities are not amenable to licensing

The Theory of FDI

A De ecision Framew work

Government Policy
A host governments attitude toward FDI is an important in decisions about where to locate foreign production facilities and where to make a foreign direct investment A firms bargaining power with the host government is highest when: 1. the host government places a high value on what the firm has to offer 2. when there are few comparable alternatives available 3. when the firm has a long time to negotiate

Inward FDI- India & China, 1979 2011 (USD Millions)

140000 120000 100000 80000 60000 40000 20000 0 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
32 Billion 124 Billion

India

China

Source: http://unctadstat.unctad.org

Inward FDI: India and China and Total World, 1979 2011 (USD Millions)
2007 2008 2009 35596 (3.0) 95000 (7.9) 519225 (43.3) 2010 2011

25506 43406 (1.3) (2.4) 83521 108312 China (4.2) (6.0) Developing 574311 650017 world (29.1) (36.3)

India

24159 31554 (1.8) (2.1) 114734 123985 (8.8) (8.1) 616661 684399 (47.1) (44.9)

World 1975537 1790706 1197824 1309001 1524422

Figures in Brackets show percentage to total World FDI Source: http://unctadstat.unctad.org

Critical Discussion Question - 1 In 2004, inward FDI accounted for some 24 percent of gross capital formation in Ireland, but only 0.6 percent in Japan. Q. What do you think can explain this difference in FDI inflows into the two countries?

Critical Discussion Question - 2 Compare and contrast the following explanations of FDI: internalization theory, Vernons product life cycle theory, and Knickerbockers theory y of FDI. Which theory do you think offers the best explanation of the historical pattern of horizontal FDI? Why?

3. Cemex Case
Reread the Management Focus on Cemex and answer the following questions: a) Which theoretical explanation, or explanations, of FDI best
explains Cemex Cemexs s FDI? b) What is the value that Cemex brings to the host economy? Can you see any potential drawbacks of inward investment by Cemex in an economy? c) Cemex has a strong preference for acquisitions over greenfield ventures as an entry mode. Why? d) Why do you think Cemex decided to exit Indonesia after failing to gain majority control of Semen Gresik? Why is majority control so important to Cemex? e) Why do you think politicians in Indonesia tried to block Cemexs attempt to gain majority control over Semen Gresik? Do you think Indonesias best interests were served by limiting Cemexs FDI in the country?

3. Mittal Steel Case

1. How did Mittal Steel grow from almost nothing to

be the worlds largest steel company in such a short time? How important were the companys foreign acquisitions to its success? 2. Why was Mittal Steels acquisition of Arcelor so controversial? Do you agree with those who opposed the acquisition? Why or why not? 3 In spite of being the largest steel producer in the 3. world, Mittal Steel doesnt operate in India. Explain Why?

Assignment
4. You are the international manager of a US business that has just invented a revolutionary new personal computer that can perform the same functions as PCs, but costs only half as much to manufacture. Your CEO has asked you to decide how to expand into the European Union market. Your options are: (i) export from the United States, (ii) license a European firm to manufacture and market the computer in Europe, and (iii) set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative and suggest a course of action to your CEO.

Quiz
1. A company that establishes a new operation in a foreign country has made a) An acquisition b) A merger c) A greenfield investment d) A joint venture 2. Benefits of FDI include all of the following except a) The resource transfer effect b) The employment effect c) The balance of payments effect d) National sovereignty and autonomy

Quiz
3. Which of the following statements is true? a) Over the years, there has been a marked
decrease in the stock and flow of FDI b) Over the years, there has been a marked increase in the stock and flow of FDI c) Over the years, there has been a marked decrease in the stock and an increase in the flow of FDI d) Over the years, there has been a marked increase in the stock and an decrease in the flow of FDI

Quiz
4. Advantages that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets are: a) First mover advantages

b) Location advantages c) Externalities d) Proprietary advantages

Starbucks
QUESTION 1: Initially Starbucks expanded internationally by licensing its format to foreign operators. It soon became disenchanted with this strategy. Why? Starbucks began its international expansion in Japan where it licensed its formula to a joint venture formed with a local company. Starbucks feared that a pure licensing agreement would not provide it with the control it felt was necessary to successfully replicate the look, feel, and experience of an American Starbucks. To help ensure continuity between its American stores, and its Japanese locations, Starbucks transferred American employees to the Japanese stores to help train workers in the Starbucks way. Starbucks shifted many of it arrangements to joint ventures and wholly owned subsidiaries in an effort to gain greater control over the operations. QUESTION 2: Why do you think Starbucks has now elected to expand internationally primarily through local joint ventures, to whom it licenses its format, as opposed to a pure licensing strategy? Probably because of the greater control that joint ventures provide over licensing arrangements. By using joint ventures to expand internationally, Starbucks can link up with local firms that know the market, but still maintain a greater degree of control. QUESTION 3: What are the advantages of a joint venture entry mode for Starbucks over entering through wholly owned subsidiaries? On occasion, Starbucks has chosen a wholly owned subsidiary to control its foreign expansion (e.g. in Britain and Thailand). Why? Using gj joint ventures has allowed Starbucks to share the cost and risk of developing p g its foreign g markets. While a wholly y owned subsidiary would give Starbucks complete control, it also implies that Starbucks would incur all of the cost and risk involved. In Britain, Starbucks did acquire an existing coffee chain that was modeled after Starbucks. Because the chain was already successful, some of the risk that would normally be associated with introducing a new concept to a foreign market was eliminated. Starbucks also shifted to a wholly owned operation in Thailand after its joint venture there experienced difficulty raising capital for further expansion. By acquiring the joint venture, Starbucks was able to gain control over the process QUESTION 4: Which theory of FDI best explains the international expansion strategy adopted by Starbucks? Internalization theory suggests that when licensing is difficult, foreign direct investment is appropriate. Starbucks seems to have followed this philosophy.