foreign direct investment chapter 7. 7 - 2 mcgraw-hill/irwin international business, 6/e, 7e...

Foreign Direct Investment

Chapter 7

7 - 2

McGraw-Hill/IrwinInternational Business, 6/e, 7e

Portions © 2007-2009 The McGraw-Hill Companies, Inc., All Rights Reserved.

Extra credit opportunity

• Presentations on - a country or - a region (even a town/city in U.S.)- some other subject in global business

• An especially good chance to discuss your home or your ancestors’ home

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• Length – - 6 to 10 minutes (individual)- Up to 18 minutes (group)

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• A country presentation can describe- The economic environment

• How do people live? • What is GNI per capita include both

- unadjusted and - PPP-adjusted GNI, - compare to US

• How does GNI per capita level affect life?

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- The political environment• How is the country/region governed?

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- Something of the cultural environment• You can’t summarize the culture;

just say one or two things that strike you as important

- The country or region’s role in global business• What does the country or region produce?• How important is it to people elsewhere?• Can you tell what is likely to happen in the

future?

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What is foreign direct investment?

• An indirect investment is one where the investor does not gain control of the entity he or she invests in

- I can buy stock in Toyota, but Toyota’s management won’t pay much attention to my opinions

• A direct investment is one where the investing company creates a new business or gains control

- When BP bought the whole of Amoco (a U.S. oil

company), it took control of the firm

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• Taking control of the business your firm will work with may:

- decrease operating costs • because it results in better coordination

- increase rate of technology transfer• because businesses are willing to transfer tech

to units they control

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You can enter foreign markets without control by…

• Exporting – selling your goods overseas without setting up a unit abroad that you control

• Licensing – selling others the permission to use your knowhow- Franchising – where you provide a complete package to allow

others to set up a business like yours – is a kind of licensing

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How companies make foreign direct investments

• Acquisition: buying an existing company- Easy to execute- Gain brand identification and goodwill- Best if your company is attempting to acquire knowledge

• Building a new unit from scratch (‘Greenfield’ investment): - hire or buy local resources- construct or buy buildings- build own labor force

• Foreign personnel may be difficult to hire• You control the results

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• Foreign direct investment is correlated with profitability.- Companies that do more foreign direct investment are,

on average, more profitable • Why?

- Create supremacy over other companies in countries of interest (monopoly)

- Sell more efficiently- Get to know markets, resource sources better- Foreign currency may have a high buying power- May be able to borrow capital at a lower interest rate than

companies from other countries

The Investor’s Advantage

8-12

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Economists generally favor free flows of foreign direct investment

• They believe freedom for FDI allows business know-how to go where it will be most useful

- Just as free trade allows people to use skills and resources most efficiently

• We haven’t seen the dramatic problems from FDI that we’ve seen from the global capital market

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Trends in FDI

• Foreign direct investment increased in the last 20 years• In spite of decline of trade barriers, FDI grew even more

rapidly than world trade because- Businesses feared protectionist pressures- FDI is seen a a way of circumventing trade barriers- Dramatic political and economic changes in many parts of

the world encouraged investment- Globalization of the world economy created firms who see

the entire world as their market

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BUT – The FDI Slump

• Between 2000 and 2004 the value of FDI declined almost 50% from $1.2 trillion to about $620 billion

• The slowdown in FDI flows was most pronounced in developed nations

• Then FDI increased dramatically 2005-2007- And slowed radically in 2008-10

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Trends In FDI

Figure 7.1: FDI Outflows 1982-2006 ($ billions)

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The Direction of FDI

• Historically, most FDI was directed at the developed nations

- advanced countries invested in other markets- The US has been the favorite target for FDI inflows

• While developed nations still account for the largest share of FDI inflows, FDI into developing nations has increased

- Most recent inflows into developing nations have been targeted at the emerging economies of South, East, and Southeast Asia

- Flows to Africa are growing, especially from China

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Foreign Direct Investment in the World Economy

• The flow of FDI refers to the amount of FDI undertaken over a given time period

• The stock of FDI refers to the total accumulated value of foreign owned assts at a given time

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The Direction Of FDI

Figure 7.3: FDI Inflows by Region ($ billion), 1995-2006

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The Direction Of FDIFigure 7.4: Inward FDI as a % of

Gross Fixed Capital Formation 1992-2005

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• ‘Gross fixed capital formation’ is the total amount of investment in factories, stores, office buildings, and the like

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The Source of FDI

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The Shift to Services

• A shift to services is being driven by four factors- In many developed economies, services make up growing

portions of GNI- Many services cannot be traded internationally- Many countries have liberalized their regimes governing

FDI in services- The rise of Internet-based global telecommunications

networks has allowed some service enterprises to relocate some of their value creation activities to different nations to take advantage of favorable factor costs

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Should a nation always accept foreign investment?

• 19th Century political economists showed countries gain hugely from trade, but the case for allowing free foreign direct investment is not as strong

• Foreign firms bring technology and knowhow to a country• But they can also take over positions in the local economy

where local firms could - learn new technology, - earn profits they would keep at home, and - create more jobs than a foreign firm

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The Free Market View

• Nations specialize in goods and services that they can produce most efficiently

• Resource transfers benefit and strengthen the host country. It

- gains investments- gets new jobs- substitutes for imports- gets smart new competition in the domestic economy

• Recent changes in laws and growth of bilateral agreements attest to strength of free market view

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Pragmatic Nationalism

• FDI has benefits and costs• Allow FDI if benefits outweigh costs

- Block FDI that ‘harms indigenous industry’- Court FDI that ‘is in national interest’

• Tax breaks• Subsidies

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• Many of the most successful developing countries – past and present – followed a pragmatic nationalistic stance

- Japan- South Korea- China

• Economists note that Hong Kong, which followed the free market approach, was even more successful

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The richest countries all practice a basically free market approach

• They have an association, the Organization for Economic Cooperation and Development that requires members to open their markets to foreign direct investment

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Business Decision Making Grid for foreign direct investment

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• Slides below here were not presented in class and are not required

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Political Ideology and FDI

RadicalView

PragmaticNationalism

FreeMarket

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The Radical View

• Marxist view: MNE’s exploit less-developed host countries

- Extract profits- Give nothing of value in exchange- Instrument of domination, not development- Keep less-developed countries relatively backward

and dependent on capitalist nations for investment, jobs, and technology

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The Radical View

• By the end of the 1980s radical view was in retreat- Collapse of communism - Bad economic performance of countries that embraced the

radical view- Strong economic performance of some countries who

embraced capitalism rather than the radical view

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Costs of FDI to the Home Country

• Can drive out local competitors or prevent their development

• Profits brought home ‘hurt’ (debit) a host’s capital account

• Parts imported for assembly hurt trade balance• Can affect sovereignty and national defense

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The Benefits of FDI to Host Countries

• Four main benefits of FDI for a host country- Resource-transfer effect- Employment effect- Balance-of-Payments effect- Effect on competition and economic growth

• In a free market view- Many economists argue that the benefits of FDI so outweigh the

costs associated with pragmatic nationalism that it is misguided- The best policy would be for countries to forgo all intervention in

an MNE’s investment decisions

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“Horizontal” FDI

• Horizontal Direct Investment- FDI in the same industry abroad as company operates at

home

• FDI is expensive because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise

• FDI is risky because of the problems associated with doing business in another culture where the rules of the game may be different

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“Horizontal” FDI – When

• Transportation costs for a product are high• Market Imperfections (Internalization Theory)

- Impediments to the free flow of products between nations- Impediments to the sale of know-how

• Follow the lead of a competitor - strategic rivalry• Product Life Cycle - however, does not explain when

it is profitable to invest abroad• Location specific advantages (natural resources)

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• Info on slides below here is not required

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Vertical FDI

• Vertical FDI takes two forms- Backward vertical FDI is an investment in an industry

abroad that provides inputs for a firm’s domestic production processes

- Forward vertical FDI occurs when an industry abroad sells the outputs of a firm’s domestic production processes, this is less common than backward vertical FDI

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Strategic Behavior

• One explanation for firm’s choice of vertical FDI is that by using vertical backward integration, a firm can gain control over the source of raw materials

- This would allow the firm to raise entry barriers and shut new competitors out of an industry

• Another explanation of vertical FDI is that firms use this strategy to circumvent the barriers established by firms already doing business in a country

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Market Imperfections

• The market imperfections approach offers two explanations for vertical FDI

- There are impediments to the sale of know-how through the market mechanism

- Investments in specialized assets expose the investing firm to hazards that can be reduced only through vertical FDI

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Gross Capital Fixed Formation

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Market Imperfections

• Market imperfections are factors that inhibit markets from working perfectly

- In the international business literature, the marketing imperfection approach to FDI is typically referred to as internalization theory

• With regard to horizontal FDI, market imperfections arise in two circumstances:

- When there are impediments to the free flow of products between nations which decrease the profitability of exporting relative to FDI and licensing

- When there are impediments to the sale of know-how which increase the profitability of FDI relative to licensing

foreign direct investment chapter 7. 7 - 2 mcgraw-hill/irwin international business, 6/e, 7e...

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