CHAPTER 7

Foreign Direct Investment

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Learning Objectives

What are the global trends in FDI?

Why China receives a lion’s share of total foreign investment?

What are the consequences of MNC’s increasing presence in developing countries?

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Chapter Focus

This chapter seeks to identify the economic rationale that underlies Foreign Direct Investment. For example, why do some firms prefer FDI to exporting or licensing. Is the need for control, part of the answer?

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Foreign Direct Investment FDI occurs when a firm invests directly in facilities

to produce and/or market a product in a foreign country.

Once a firm undertakes FDI, it becomes a multinational enterprise (multinational = more than one country).

FDI takes two forms: Greed-field investment: establishing a wholly

new operation in a foreign country. Acquiring or merging with an existing firm in the

foreign country. Investing in foreign financial instruments (Portfolio

Investment) IS NOT FDI.

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FDI Outflows1982-2000

0

200

400

600

800

1000

1200

1400

82-86

92 94 96 98 2000

$ Billions

Figure 6.1

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FDI Flows by Region

0

100

200

300

400

500

600

Value Exports

World GDP

World FDI

Figure 6.2

Ind

ex

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Reasons for FDI Growth

FDI circumvents potential future trade barriers.

Dramatic political and economic changes occurring in developing countries.

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FDI into Developed and Developing Nations: 1990-2000

0

200

400

600

800

1000

1200

94 95 96 97 98 99 2000

Dev Nations

Devg. Nations

W. Europe

N. Amer.

Asia

L. Amer.

$B

illio

n

Figure 6.3

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Inward FDI Flows as a Percentage of Gross Fixed Capital Formation, 1998

0 10 20 30

World

Devg. Nations

N. Amer.

Asia

L. Amer.

W. Europe

Dev. Nations

Figure 6.4

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FDI Outflows by Selected Countries, 1994-1999

0

50

100

150

200

250

300

1994 1995 1996 1997 1998 1999 2000

U.S.

U.K.

Netherlands

Germany

J apan

Spain

France

Figure 6.5

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The Form of FDI: Acquisitions versus Greed-Fields

The majority of investments is in the form of mergers & acquisitions: Represents about 77% of all flows in

developed countries. Represent about 33% of all flows in

developing countries. Fewer target firms.

Why the preference for mergers & acquisitions? Quicker to execute. Foreign firms have valuable strategic

assets. Believe they can increase the

efficiency of the acquired firm.

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FDI and Risk

FDI is expensive and risky compared to exporting orlicensing:

Costs of establishing facilities. Problems with doing business in a different Culture.

Horizontal Direct Investment: FDI in the same industry as the firm operates at home.

Factors to consider: Transportation Costs. Market Imperfections. Following Competitors. Strategic Competitors Location Advantages.

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Horizontal FDI and Factor Considerations

Transportation Costs: High/low value to weight impacts costs.

Market Imperfections (Internalization Theory): Factors that inhibit markets from working perfectly. This includes (1) governments impeding the free flow ofproducts between nations, and (2) impediments to the sale of know-how.

Strategic Behavior: Concentrated industries (oligopoly) tendto mimic each other’s moves. Where there is multipoint competition, competing firms match eachother’s moves to keep the competitor in check.

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Horizontal FDI and Factor Considerations

The Product Life Cycle: Suggests that foreign market demand leads to FDI, probably not true and therefore is not a good predictor of FDI.

Location-Specific Advantages: Advantages that arise from using resource endowments or assets tied to a particular location (Dunning - eclectic

paradigm)

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Vertical FDI

Two forms: Backward: Providing inputs (raw

materials, parts) for a firm’s domestic production processes.

Forward: An industry abroad sells the outputs of the firm’s domestic production processes.

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Why Do Companies Engage in FDI?

Strategic Behavior: Can raise entry barriers or shut out new competitors, or circumvent barriers established by companies already doing business in the foreign country.

Market Imperfections: Need to overcome lack of know-how or the firm must invest in specialized assets whose value depends on inputs provided by a foreign supplier.

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Impediments to the Sale of Know-how

Impediments to the sale of know

how

Risk giving away know-

how to competitors

Licensing implies low control over

foreign entityKnow-how not amenable to

licensing

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A Decision Framework

Figure 6.6

Yes

How high are transportation costs

and tariffs?

Is know-how amenable to

licensing?Is tight control over foreign operation

required?

Can know-how be protected by licensing

contract?

Then license

Export

Horizontal FDI

Horizontal FDI

Horizontal FDI

High

Yes

No

Low

No

Yes

No