06 - Investing Abroad Directly

Question 1

Foreign Portfolio Investment (FPI)

Answer 1

• An investment in a portfolio of foreign securities such as stocks and bonds that do not entail the active management of foreign assets
• “foreign indirect investment”

Question 2

Foreign Direct Investment

Answer 2

• Investment in controlling and managing value-added activities in other countries
• Defined by the United Nations as involving an equity stake of 10% or more in a foreign-based enterprise
• Requires resource commitment

Question 3

Horizontal FDI

Answer 3

Horizontal FDI duplicates its home country-based activities at the same value chain stage in a host country through FDI

Question 4

Vertical FDI

Answer 4

If a firm through FDI moves upstream or downstream in different value chain stages in a host country

Question 5

Upstream vertical FDI

Answer 5

• A type of vertical FDI in which a firm engages in an upstream stage of the value

Question 6

Downstream vertical FDI

Answer 6

• A type of vertical FDI in which a firm engages in a downstream stage of the value chain in two different countries

Question 7

FDI flow

Answer 7

The amount of FDI moving in a given period (usually a year) in a certain direction

Question 8

FDI inflow

Answer 8

inbound FDI moving in a country

Question 9

FDI outflow

Answer 9

Outbound FDI moving out of the country

Question 10

FDI stock

Answer 10

the total accumulation of inbound FDI in a country or outbound FDI from a country across a given period of time (usually several years)

Question 11

OLI paradigm

Answer 11

proposes that FDI is the most appropriate form of international business if three conditions are met

1. Ownership advantages (O-advantages)
   * Resources of the firm that are transferable across borders and enable the firm to attain competitive advantages abroad
2. Locational advantages (L-advantages)
   * Advantages enjoyed by firms operating in certain locations
3. Internalization advantages (I-advantages)
   * Advantages of organizing activities within a multinational firm rather than using a market transaction

Question 12

Types of O-advantages

Answer 12

• Resources created in one country that can be exploited in other countries
• Capabilities arising from combining business units in multiple countries
• Capabilities arising from organizational structures and culture

Question 13

Types of L-advantages

Answer 13

• markets
• location-bound Human Resources
• natural resources
• agglomeration
• institutions

Question 14

I-advantages: Types of market failure

Answer 14

• asset specificity
• information assymetry
• dissemination risk
• tacit knowledge transers

Question 15

L-advantages: MARKETS

Five reasons firms set up close to their markets

Answer 15

1. Protectionism in the form of tariffs or non-tariffs barriers, may inhibit exports. However MNEs can overcome such barriers by setting up local production.
2. Transportation Costs especially over long distances for e.g. persihable, breakable, heavy or bulky products can be a major barrier. Local production allows serving a market at lower costs.
3. Direct interaction with the customer e.g. suppliers to the automotive industry need to produce near manufacturers to integrate in their supply chain.
4. Production and sales of some services cannot be physically separated e.g. hotels, banking or consultancy
5. Marketing assets may be more important for a fast-entry strategy. FDI enables MNEs to acquire local firms which control sought-after assets, e.g. distribution networks and brand names.

Question 16

L-advantages: RESOURCES

Answer 16

natural resources and created assets like human capital and infratstructure

Question 17

L-advantages: INSTITUTIONS

Answer 17

• e.g. clear and simple rules, low level of corruption and an efficient bureaucracy

Question 18

L-advantages: AGGLOMERATION

Answer 18

• the location advantages that arise from clustering of economic activities in certain locations
• Advantages of locating in a cluster stem from
  
  • Knowledge spillovers among closely-located firms that attempt to hire individuals from competitors
  • Industry demand that creates a skilled labour force whose members may work for different firms without having to move out of the region

Question 19

Internalization Advantages

Answer 19

• A key advantage of FDI over other modes is the ability to replace (“internalize”) external market relationships
• With one firm (the MNE) owning, controlling and managing activities in two or more countries
• Transaction costs are the costs of organizing a transaction
  
  • searching for partners, monitoring product quality and enforcing contracts
  • sub-optimal allocation of resources due to unrealized transactions (aka. opportunity costs)
• High transaction costs can result in market failure
  
  • Imperfection of the market mechanism that make some transactions prohibitively costly

Question 20

I-advantage: FDI VERSUS EXPORTING

Answer 20

Asset specificity: an investment that is specific to a business relationship (e.g. adapting production process to requirements of customer)

• can lead to opportunistic behavior

Creating an I-Advantage through FDI: Advantages of the MNE:

• reduce cross border transaction costs
• increases efficiencies

Question 21

I-advantage: FDI VERUS LICENSING

Three reasons to prefer FDI to licensing

Answer 21

1. Dissemination risk: risk is associated with the unauthorized diffusion of firm-specific know-how

• if a foreign company grants a license to a local firm to manufacture or market a product, it runs the risk of the licensee, or an employee of the licensee, disseminating the know-how or using it for purposes other than those origingally intended

2. Certain types of knowledge may be too difficult to transfer to lincensees without FDI

• Tacit knowledge is non-codifiable, and acquistion and transfer require hands-on practice

3. FDI provides more direct and tighter control over foreign operations

Question 22

I-advantage: FDI VERSUS OFFSHORE OUTSOURCING

Problems arising with Offshore Outsourcing

Answer 22

1. Asset specificity can arise if the activity would require substantial specific investment by the service provider
2. The outsourcing partner may use knowledge of the firms technology for other purposes, for instance helping competitors entering the industry
3. For some activities companies may find it necessary to monitor the actual manufacturing process, rather than simply buying finished products

Question 23

Licensing

Answer 23

Firm A’s agreement to give Firm B the rights to use A’s proprietary technology or trademark for royalty fee paid to A by B

Question 24

National Institutions and FDI

Answer 24

• Consensus is that FDI leads to a win-win stituation for both home and host countries
• Most countries retain some institution that either (1) restrict the presence of FDI or (2) regulate the operations of FDI
• Host country institutions
  
  • Outright bans on FDI
  • Case by Case approvals of FDI
  • Ownership requirements
  • General regulatory institutions of business
  • FDI specific regulation
  • Corporate taxation

Question 25

Debates regarding FDI

Answer 25

• MNEs and host governments are shaped by their relative bargaining power - their ability to extraxt a favorable outcome from negationts due to one party’s strength
• Emerging economy multinationals - those MNEs originating from an emerging economy and headquarter there
• Sovereign wealth funds (SWF) are a state-owned investment fund of financial assets such as stocks, bonds, real estate or other financial instruments funded by foreign exchange assets. SWFs undertake FDI, yet they oeprate differently than conventional MNEs
  
  • they are state-owned or controlled
  • they typically acquire equity stakes suffcient to influence target forms, yet they do not fet involved in day-to-day management or integrate operations