Chapter 8 - FDI Flashcards
FDI
Occurs when a firm invests directly in new facilities to produce or market a good or service in a foreign country.
-> it becomes a multinational enterprise
Flow of FDI
Refers to the amount of FDI undertaken over a given period of time (normally a year).
stock of FDI
Total accumulated value of foreign-owned assets at a given time.
Rapid FDI growth can be explained with
- circumventing future trade barriers
- political and economic changes that have been occurring in many of the world’s developing nations
- democracy and free market
Direction of FDI
before: developed countries
now: developing countries thanks to technology (given the country is safe, democratic)
Source of FDI
US, Japan, Uk, France, Germany and Netherlands account for 60% since home to largest capitalized enterprises,
slowly China also in Africa.
Two forms of FDI
Greenfield investments and acquisitions
Greenfield investments
Involves the establishment of a new operation in a foreign country.
Mergers/acquisitions
Merging/acquiring with existing firm in the country 80%, but only 1/3 in developing nations since there are less target firms
Why acquisitions
quicker than greenfield
foreign firms have valuable strategic assets (brand loyalty, customer, trademarks or patents)
less risky to acquire then rebuild
increase efficiency by adding capital, technology and management skills
exporting
Involves producing goods at home and then shipping them to the receiving country for sale.
licensing
Involves granting a foreign entity (the licensee) the right to produce and sell the firm’s product in return for a royalty fee on every unit sold.
Cons of FDIs
- expensive: cost acquisition or establishment
- risk because different culture and environment
- costly mistakes due to ignorance
limitations of exporting
restrained by transportation costs and trade barriers
i.e. products that can be produced in any location (low value-weight), but if high value-weight ratio, transportation is a small proportion and no impact on attractiveness of exporting over others
High value-weight ratio
transportation costs are normally a minor component of total landed cost (electronic components, personal computers, medical equipment, computer software etc.)
Internalization theory
Seeks to explain why firms often prefer FDI over licensing as a strategy for entering foreign markets aka market imperfection approach
Drawbacks of licensing
- giving away valuable technological know-how to a potential foreign competitor
- no tight control over production, marketing and strategy in a foreign country
- competitive advantage is based on the management, marketing and manufacturing capabilities which is not amenable to licensing
Reasons to have control over the strategy
- control foreign location to be aggressive and undermine the local competition, but reduce license’s profit
- make sure that the entity does not damage the firm’s brand.
Reasons to have control over operations
Take advantage of differences in factor costs across countries, deciding where to produce what for lower costs
Advantages of FDI
- when transportation costs are high
2. maintain control over technological know-how, operations and business strategy
Patterns of FDI
Knickerbocker: relationship between FDI and rivalry in oligopolistic industries (Interdependence between firms in an oligopoly leads to imitative behaviour; rivals often quickly imitate what a firm does in an oligopoly)
oligopoly
an industry composed of a limited number of large firms
Multipoint competition
two or more enterprises encounter each other in different regional markets, national markets or industries
- Firms will try to match other’s moves in different markets to try to hold each other in check.
- Idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize competitive attacks in other markets
The eclectic paradigm- John Dunning
using location specific advantages to explain the direction and rationale of FDI
Location specific advantages
- using resource endowments
- assets tied to a foreign specific location valuable to tie with own assets
- requires firm to establish production facilities where the production endowments are
knowledge spillovers
concentration of intellectual talent which arises from a network of informal contacts that allows firms to benefit from each other’s knowledge generation
Political ideology and FDIs
Radical view by Marxist political and economic theory + the multinational enterprise is an instrument of imperialist domination
MNEs
- exploit host country for the exclusive benefit of home country
- gets profit but gives nothing in exchange
- key technology controlled, if good positions they go to home country instead of host
- keeps the developing countries backwards and dependent for investment, jobs and technology
by early 90’s, radical view extinct
- collapse of communism in Eastern Europe
- A growing belief FDI can be an important source of technology and jobs
- strong performance by those who embraced capitalism
Free market view
- trade theories of Adam Smith and David Ricardo
- Distribution among countries according to the theory of comparative advantage
- MNE is an instrument for dispersing the production of goods and services to the most efficient locations around the globe
- Resource transfers benefit the host country and stimulate its economic growth
success example FDI
If Dell were to move the assembly production from the U.S to Mexico. Due to Mexico’s low labour cost, they have a comparative advantage. Dell frees U.S resources for use in activities in which they have a comparative advantage (computer software, R&D etc). Additionally, the consumers benefit from the lower prices.
FDI is a benefit to both the source country and the host country (win-win).
Pragmatic Nationalism
- FDI has both benefits and costs
- FDI can benefit a host country by bringing capital, skills, technology and jobs. However, the profits from that investment go abroad.
- foreign owned manufacturing plant may import many components from its home country = bad for balance of payments
- maximize the national benefits and minimize the national costs
FDI today
decline in radical ideology –> increase in free market
leads to: volume of FDI worldwide (china, viet nam and india)
Host country benefits
- resource transfer effect
- employment effects
- balance of payments effects
- competition and economic growth effect
Resource transfer effect
- FDI can make a positive contribution to host economy by supplying capital, technology, and management resources that would otherwise not be available
- MNEs have financial means available
- technology can stimulate economic development
Forms of technology
1) in the production process
2) in the product itself
ex. personal computers help with management activities
Employment effects
- bring jobs to host country
a. direct effect: foreign MNE employs a # of citizens
b. Indirect effect: jobs created by investment, jobs created because of increased spending
but not all jobs are worth and good
Balance of payments effect
FDI helps with current account surplus: by substituting for imports + When the MNE uses a foreign subsidiary to export goods and services to other countries
Effect on competition and economic growth
Greenfield investment = new enterprise = increasing consumer demand with more options
Increase the level of competition in a national market, driving down prices and increasing the economic welfare of consumers.
Services where exporting is not an option: stimulates investment, lower prices
Host country costs
- Adverse effects on competition
- adverse effect on payments and balances
- Possible effects on national sovereignty and autonomy (loss of economic independence)
Adverse effects on competition
Subsidiaries of foreign MNEs may have greater power than indigenous competitors
MNEs may be able to draw on funds generated elsewhere to subsidize its cost in the host market –> monopoly if it drives other companies out of it
Adverse effect on balance of payment
- capital outflow from the foreign subsidy to its home country (
- Government have put limits on the amount of capital companies can bring back to their home country
- large inputs from abroad which results in a debit on current account of host country balance of payment which mitigates the effect of the FDI in host country
- government responded to this with laws that a certain % of product must be purchased from host-country based companies
Home country benefits
- inward flow of capital from foreign earnings (or demand for home country exports of raw materials)
- Employment effects (for the manufacturers of parts where export demand is increased)
- Reverse resource transfer effect (valuable skills that can subsequently be transferred back to the home country)
Home country costs
- Balance of payment of outward FDI
2. employment effect (when fdi is substitue for domestic production)
Balance of payment consequence from FDI for home country
- initial capital outflow required to finance start up FDI
- current account suffers if the purpose of the FDI is to serve a low cost production
- the current account suffers if fDI is substitute for direct exports
International trade theory and FDI
Offshore production: when FDI is undertaken to serve the home market:
- > stimulate economic growth in home country
- > result in lower prices
- > makes a company more competitive
Home country policies and FDI
- Encouraging outward FDI
2. Restricting outward FDI
Encouraging outward FDI
- Government backed insurance programs
- Government loans
- Elimination of double taxation of foreign income
- Relaxation of restrictions on FDI by host countries
Restricting outward FDI
- Limit capital outflows
- Manipulate tax rules (i.e. were going to give you a tax break if you bring it here, but if you send it abroad we will tax more)
- Prohibit investment for political reasons
Host country policies and FDI
- Encouraging inward FDI
2. Restricting inward FDI
Encouraging inward FDI
tax concessions, low interest loans, grants or subsidies
Restricting inward FDI
ownership restraints, performance requirements
International institutions and liberalization of FDI
WTO: Push for liberalization of regulations that govern FDI
i.e. two multinational agreements reached in 1997
If low transportation costs
Export
If cannot license the know-how
FDI
If need tight control over foreign operations
FDI
If the know-how can be protected with licensing contract
license
if the know-how cannot be protecting by licensing contract
FDI
