Supply Chains, FDI and MNCs

Question 1

Supply chains and economic interests

Answer 1

• Not all import-competing sectors benefit from protectionism
• Some firms and workers in import-competing sectors are part of Global Supply Chains
  – These firms also depend on imports as inputs for production
  – May receive Foreign Direct Investment that depends on trade openness
• eg. Milner and Jamal’s 2019 Survey in Tunisia founds that workers in import-competing sectors that are embedded in Global Supply Chains are more supportive of free trade than those not embedded in Global Supply Chains

Question 2

Trump’s Steel Tariff

Answer 2

• In February 2018 Trump imposed a 25% tariff on steel imports from EU and elsewhere (import-competing sector)
• this should have led to record profits in the US steel industry
• They should have performed better than traditional stocks
• Did they help the industry?
  – They did for a bit, however, when trump imposed tariffs on other Chinese inputs, things changed
• Chinese imports are key intermediate goods in the production of many products that also use steel
• This made other parts in goods using steel, but made in the US, more expensive to make and thus demand fell
• Less steel was demanded because the products making steel (like cars) became too expensive

Question 3

What does Trumps steel tariff teach us?

Answer 3

• The modern supply chain is complex, simple tariffs can have complex results
• Maybe our models are too simple for the complex global economy

Question 4

Two categories of foreign investment

Answer 4

• Portfolio investment
• Direct investment

Question 5

Portfolio investment (categories of foreign investment)

Answer 5

• Investors have claim on some income, but do not manage the investment (less than a controlling percentage)
• Investors only interested in the rate of return
• eg. Stocks, Bonds
  – Highly mobile, can be sold instantaneously
• Includes sovereign lending
  – Lending directly to a country’s government

Question 6

Direct investment (categories of foreign investment)

Answer 6

• Investment by a company that owns and controls facilities that are located in another country
  – eg. Shell Oil refinery in Nigeria
  – eg. BMW factory in US
  – eg. Foxconn factory in Brazil
• Highly immobile, requires a fixed-investment

Question 7

What is an MNC?

Answer 7

• Multinational Corporation:
  – A single corporate structure that controls and manages production establishments in at least 2 countries
• Emerged during the late 19th century
  – Maybe before (Dutch and British East India Companies)
• Initially UK companies dominated
  – 1st US MNC in 1867
  – US overtook UK in 1920s as largest source of FDI
  – Since 1960s US dominance has diminished
  —> Europe, Japan, and other countries/regions, have gathered steam
• MNCs are not new but the growth of MNCs is

Question 8

Why invest abroad?

Answer 8

• Why not just hire a foreign company?
  – Like Apple does to build its products (Foxconn)
• Locational advantages
• Market imperfections

Question 9

Locational advantages (reasons to invest abroad)

Answer 9

• Large reserve of natural resources
• Access a large local market
  – Market-oriented investments
  – “Jump over” trade barriers
• Enhance efficiency:
  – Lower cost of the factors of production
  – Match the factor intensity of a production stage to the factor abundance of particular countries:
  —> Go where you get the most for your money
  —> Design the Honda Accord in capital-abundant Japan, Assemble the car in labor-abundant Mexico

Question 10

Market imperfections, horizontal integration (reasons to invest abroad)

Answer 10

• Intangible asset:
  – eg. How much is the Coca-Cola formula worth?
  —> The value is derived from knowledge or from a set of skills/routines possessed by a firm’s workforce
  – “know-how”
• It is difficult to sell or license intangible assets
• Paradox of information
  – The value of the information for the purchaser is not known until she has the information but then she has acquired it without cost
• The owner of the information is unwilling to share info, the purchaser is unwilling to buy
• Rather than sell the information, the firm can simply set up shop in a new location

Question 11

Market imperfections, vertical integration (reasons to invest abroad)

Answer 11

• Specific assets, dedicated to a particular long-term economic relationship
• Difficult to enforce long-term contracts
• One party in the long-term relationship can take advantage of the specific nature of the asset to extract a larger share of the value from the transaction
  – One party has leverage to make concessions of the other in the future and engage in opportunistic behavior
• Vertical integration eliminates this problem arising from specific assets

Question 12

Time inconsistency in long-term contracts

Answer 12

• What you want today is not what you’ll want tomorrows (and others know it!)
• You need to find a way to lock in your current preferences to solve the problem
  – Easier said than done
• Firms face a similar problem of having different preferences across time
  – They can eliminate the middle man with vertical integration
• Firms that rely heavily on specific assets are more likely to integrate vartically

Question 13

Where and when MNCs?

Answer 13

• MNCs are a “predictable” response to the economic environment in which firms operate
• Locational advantages tell us if MNCs are profitable
• Imperfections tell us whether a firm will internalize the production

Question 14

FDI’s potential economic benefits

Answer 14

• Transfers savings (capital) between states
  – Aids economic growth
• Technological and managerial experience
  – Spillover effects: advanced technology that can be learned from
• Integration into global markets
  – Opportunity to show “worth” to other firms

Question 15

FDI’s potential economic costs

Answer 15

• Can potentially reduce domestic capital
  – Sometimes they borrow domestic capital and “crowd out” investment to other firms
  – (Over)charge affiliates with licensing fees and royalties for technology, “transfer pricing”
  – Require affiliates to purchase inputs abroad from MNC
• Can drive local firms out of business
  – More competitive (better tech and management) than local firms
  – Like the Walmart effects
• Technology is often tightly controlled, limiting transfers and integration into global markets
• MNC objectives might clash with domestic economic objectives
  – Can undermine policy or other social policy goals

Question 16

MNCs in the developing world history and development

Answer 16

• After independence from colonialism, many states wanted to establish political and economic autonomy from former powers
  – Through nationalization or expropriation
• They took control of existing foreign investments and managed the terms of new investments
• Now, many developing countries are again open to foreign direct investment and actively try to attract it
• Why give control back to foreign interests?

Question 17

MNCs in the developing world effects

Answer 17

• The economic benefits are attractive
• States try to manage FDI and MNCs to their advantage
  – Prohibited ownership of: utilities, extractive industries and other important industries
  – Required some local ownership
  – Imposed performance requirements
• Countries varied in how they regulated FDI
  – Thus, competition to attract FDI was born

Question 18

Where does FDI go?

Answer 18

• Advanced industrial countries
  – Both the largest providers and recipients of FDI
• FDI to developing world is concentrated
  – Largely, in most populous and wealthy countries (BRICS)
• FDI has increased to developing world in past 30 years
  – Still not as big as theory would predict

Question 19

Bargaining for FDI

Answer 19

• The state wants the economic benefits
• The MNC wants a profit maximizing environment and limited risk
• State fears: Loss of economic policy control, other negative externalities
• MNCs fear:
  – Burdensome regulation
  – Expropriation of investments
  —> Investments are fixed and difficult to remove (ie. immobile)
  —> The fixed investment can become a hostage
• Obsolescing bargain:
  – Over time, bargaining power shifts towards the governments (because fixed investments grow)
• These fears (the time inconsistency problem) make attracting FDI difficult for states

Question 20

Democracy and FDI

Answer 20

• Some states are better at tying their hands
• Generally, democracies attract more FDI because the costs of expropriation are greater
• Expropriation buys them little in terms of money to provide to a larger group of supporters
  – That money buys a lot more support where the individuals needed to remain in power is smaller
• Plus, FDI has widespread benefits
  – Leaders will be punished (with poor economic growth) if they deter investment with expropriation
• Democracies have more “veto players” that can constrain policy choices

Question 21

Other risks of FDI

Answer 21

Beyond expropriation, firms fear that other policies might eat their profits
- Policy volatility
– Regulation changes that make conducting business difficult
– Environment, labor laws, tax policy
- Transfer risk
– Restriction on ability to convert currency to move profits out of the country
- Exchange rate risk
– Unstable exchange rates (led by monetary policy) can also eat into profits
- Violence risk
– Civil conflict, terrorism, etc.
– Can make doing business more costly or damage fixed assets

Question 22

The “Race to the Bottom” (FDI)

Answer 22

• States want to attract FDI and thus offer incentives to firms
• Firms go wherever taxes are lowest, risk is lowest, and regulation is least burdensome
  – Environmental standards, labor practices, kickbacks from governments
• Developing states are at a disadvantage because of their need for FDI and lack of economic diversity
• Countries that want to attract FDI might lower regulations and taxes

Question 23

The “Climb to the Top” (FDI)

Answer 23

• Firms don’t only want lower taxes and regulation they also want public goods
  – Infrastructure, educated workforce
  – These are usually paid for with taxes
• Democracy and public goo investment may attract FDI
• Also, multinational firms can be subject to pressure to improve “Corporate Social Responsibility”
• FDI then (maybe) pressures governments to grow and incentivizes “better” political regimes and public goods investment

Question 24

International regulation of MNCs

Answer 24

• No multilateral rules or institutions like those that govern trade
• Some “legal” norms of behavior but no enforcement mechanism
• Attempts thus far have been unsuccessful, countries’ interests clash:
  – Advanced industrialized countries want protections for investors
  – Developing countries want rights for host countries

Question 25

Bilateral Investment Treaties (BITs)

Answer 25

• In the absence of global rules, states have turned to bilateral treaties to govern international investment
• BITs govern:
  – Treatment of foreign investors under the law
  – Protection of assets and flows of assets
  – Basically, they make sure foreign firms aren’t exploited by host government
• BITs tend to be highly skewed towards the rights of foreign investors (as opposed to host countries)

Question 26

Investor-State Dispute Settlement (ISDS)

Answer 26

• Provision included in many trade agreements (such as TPP) and BITS
• Allows investors to sue countries for “expropriation” and rulings may take precedence over country’s laws
  – Traditionally expropriation meant the literal seizing of assets
  – But now often much broader, eg. expropriation of expected profits through new regulations
• Suit is head in private court adjudicated by a panel of arbitrators
• Cost of lawsuits might be crippling for poor countries
• Many suggest the system is being abused and infringes on norms of sovereignty, countries have started pulling out/not renewing BITs over it