Global Business Management(MGT380)

Lecture #10: Foreign Direct Investment

Learning Objectives

Understand the costs and benefits of FDI for home country

Understand the costs and benefits of FDI for host country

understand the government policy instruments and FDI

What is the Implication for business

A Quick Recap of last lecture Why do firms in the same industry undertake FDI

at about the same time and the same locations? Knickerbocker : Suggests that firms follow their

domestic competitors overseas. FDI flows are a reflection of strategic rivalry between firms in the global marketplace; More pertinent in Oligopolistic market. For example: Toyota and Nissan responded to investment of Honda; Electrolux did in response of G.E and Whirlpool.

Vernon - firms undertake FDI at particular stages in the life cycle of a product; Xerox; This theory is did well to explain When demand of country support the production and

shift production to low-cost markets when competition is high

It fails to explain that why firm do FDI when export/license is profitable (because of economies of scale)

According to Dunning’s eclectic paradigm- it is important to consider: location-specific advantages - that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets. Electrolux in China, externalities - knowledge spillovers that occur when companies in the same industry locate in the same area. Firms willing to take advantage of low-cost labor/natural resources/ technology they go accordingly. Silicon Valley in CA.

How does a government’s attitude affect FDI? 1. Radical view (traces its roots to Marxist

political and economic theory). This perspective argues that the MNE is an instrument of imperialist domination and a means of exploiting host countries for the benefit of their capitalist-imperialist home countries. Socialists and Nationalists , world is changing

Free market perspective which argues that international production should be distributed among countries according to the theory of comparative advantage. This perspective suggests that countries specialize in the production of the goods they can produce most efficiently and trade for everything else. It then follows, that FDI will actually increase the overall efficiency of the global economy. Not fully embraced.

In the middle of the continuum is pragmatic nationalism which argues that FDI has both benefits and costs. Benefits include things like inflows of capital, technology, skills, and jobs, while costs include the repatriation of profits and negative balance of payments effects. Pragmatic nationalism suggests that FDI should only be allowed if the benefits outweigh the costs.

How Does FDI Benefit The Host Country? Resource transfer effects - we’ve actually already talked a

bit about this. Remember that FDI can benefit a country by bringing in capital, technology, and management skills helping the country to increase its economic growth.

Bring jobs. Well cited example is Many people in Middle Tennessee are employed at

Nissan facilities there, and because the Nissan workers need houses to live in, grocery stores, and schools, a host of other jobs have been created as well. Keep in mind of course, that some of these jobs will be canceled out by the loss of jobs in Detroit that will occur when U.S. consumers buy Nissans instead of Fords!

Balance of payment effect: BOP: record of a country’s payments to an

receipts from other countries. Current Account: Record of a country’s

export and import of goods and services. Government wants to see CA surplus. FDI helps BOP in two ways:

FDI is substitute for imports of goods/services, it increases CA. For instance, Japanese FDI in EU and USA.

When MNCs export product to other countries

FDI affects competition and economic growth

If FDI is in the form of greenfield investment, competition will increase in a market. This should drive down prices and benefit consumers.

More competition also promotes increased productivity, innovation, and then, economic growth.

We’ve seen huge improvements in world telecommunications for example, since the 1997 WTO agreement to liberalize the industry.

What Are The Costs Of FDI To The Host Country? There are three main costs of inward

FDI. 1. Adverse effect on competition:

subsidiaries of foreign MNE’s might end up having greater economic power than indigenous competitors. It gives the negative effects on competition.

So, for example, if an MNE supports its subsidiary while it becomes established in the host market, it might be stronger than an indigenous company, and could drive the local company out of business.

Host governments, particularly those of developing countries, worry. Infant industry.

2. Negative effects on the balance of payments

When it comes to the balance of payments, host countries worry that along with the capital inflows that come will the FDI, will be the capital outflows that occur when the subsidiary repatriates profits to the parent company. Some countries actually limit the amount of profits that can be repatriated to limit the negative effects of this.

Host countries are also concerned that some subsidiaries import a substantial number of their inputs. These imports will show up in the current account of the balance of payments.

Japanese automakers, for example, import from Japan, many of the components they use in their U.S. operations. The companies have responded to criticism about this by pledging to buy more inputs locally.

3. Loss of national sovereignty and autonomy

Sometimes host governments worry that they may lose some economic independence as a result of FDI. They worry that since foreign companies have no particular commitment to the host country, they won’t really worry about the consequences of their decisions on the host country. Loss of economic independence,

However, Robert Reich, a former member of the Clinton cabinet, notes that this is really outdated thinking. In today’s interdependent economy, no company maintains strong loyalty to any country.

How Does FDI Benefit The Home Country?

1. The effect on the capital account of the home country’s balance of payments from the inward flow of foreign earnings.

2. The employment effects that arise from outward FDI when importing parts.

3. The gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country. Reverse resource-transfer. GM-Isuzu & Ford-Mazda in Japan

What Are The Costs Of FDI To The Home Country?1. The home country’s balance of payments can

suffer from the initial capital outflow required to finance the

FDI if the purpose of the FDI is to serve the home market

from a low cost labor location if the FDI is a substitute for direct exports

2. Employment may also be negatively affected if the FDI is a substitute for domestic production

But, international trade theory suggests that home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid. It is actually be freeing up resources that could be used more effectively elsewhere.

How Does Government Influence FDI? Well, there are various ways that home

countries can encourage or discourage FDI by local firms.

We’ll begin with policies to encourage FDI. A key reason that firms may resist FDI is

because of the risk involved. To minimize this concern, many countries have government-backed programs that cover the major forms of risk like the risk of expropriation, war losses, or the inability to repatriate profits. Some countries have also developed special loan programs for companies investing in developing countries, created tax incentives, and encouraged host nations to relax their restrictions on inward FDI.

Toys R Us entered in Japan

To discourage outward FDI, countries regulate the amount of capital that can be taken out of a country, use tax incentives to keep investments at home, and actually forbid investments in certain countries like the U.S. has done for companies trying to invest in Cuba and Iran.

Host countries can also restrict or encourage FDI.

Recall that we’ve moved away from the radical stance that discouraged FDI in general and towards a more free market approach, and pragmatic nationalism.

To encourage inward FDI, host countries usually offer incentives for investment like tax breaks, low interest loans, or subsidies.

Why would countries offer these benefits to foreign firms?

Kentucky for example, offered a $112 million package to Toyota to get it to build its U.S. plants in the state!

When a country wants to restrict FDI, it will usually implement ownership restraints or performance requirements.

In Sweden for example, foreign companies aren’t allowed to invest in the tobacco industry. US airline 25%.

Ownership restraints accomplish two things. First, they keep foreign firms out of certain industries

on the grounds of national security or competition, allowing the local firms to develop.

Second, they help maximize the resource transfer effect and employment benefits that are associated with FDI.

In Japan for example, until the early 1980s, most FDI was prohibited unless the foreign firm had valuable technology.

Then, the foreign firm was allowed to form a joint venture with a Japanese company because the government believed this would speed up the diffusion of the technology throughout the Japanese economy.

How Do International Institutions Influence FDI?Are there any international agreements on FDI that

limit country policies? Well, until recently, there hasn’t been any

consistent involvement by multinational institutions on how FDI should be handled, but in 1995, the WTO got involved through its agreement on services.

Remember, that in order to sell services internationally, FDI is often required.

So, as you might expect, the WTO is pushing for the liberalization of regulations governing FDI. OECD.

Already, agreements on the liberalization of telecommunications and financial services have been reached.

What Does FDI Mean For Managers?We know from Dunning’s eclectic theory that FDI may make sense for location reasons, but the theories can also help firms identify the trade-offs between exporting, licensing, and foreign direct investment.

For example, we know that exporting will be preferable to licensing as long as transportation costs and trade barriers are low. We also know that licensing isn’t attractive when the firm has know-how that can’t be properly protected by a licensing agreement, when the firm need control over a foreign entity in order to maximize profits, and when the firm’s skills and capabilities aren’t amenable to licensing.

In fact, licensing is going to be most likely in fragmented, low-tech industries where globally dispersed manufacturing isn’t an alternative.

So, for companies like McDonald’s, which use the service-industry version of licensing, franchising, licensing or franchising makes sense.

Finally, a government’s policy toward FDI can be an important factor in decisions about where to locate foreign production facilities.

Clearly, firms will prefer to establish operations in countries with permissive attitudes toward FDI, like the U.S.

Firms may be able to negotiate with foreign governments and receive favorable terms for their investments like Toyota did when it invested in Kentucky.

A decision framework

Mini-case: FDI in Russia

After five years of launching reforms, still was experiencing unprecedented capital flight. In 1996, some $22.3 billion left the country and $2.2 billion came in the country. Russian FDI was $5.3 billion, $11.5 billion in Hungary.

Reasons was tax code, weak and untested property and contract safeguards, regulations, privatization laws.

In a attempt to generate capital, they did privatization of many state-run organizations.

In 1997, Yelstin allowed FDI in Oil and gas industry. Shell/Royal Dutch attempted to bid for Rosneft, BP tried for 10% shares in Sidanco. It was estimated to create 550,000 jobs and $450 billion revenue of capital.

Discussion Questions: 1)what are the benefits to the Russian economy from FDI in general and Oil& gas industry in particular. 2) Can firms reduce the risks associated with Russian economy.

Summary of the lecture

Host country benefits: Resource transfer effects - we’ve actually already talked a bit about this. Remember that FDI can benefit a country by bringing in capital, technology, and management skills helping the country to increase its economic growth.

Bring jobs. Well cited example is FDI helps BOP in two ways:

FDI is substitute for imports of goods/services, it increases CA. For instance, Japanese FDI in EU and USA.

When MNCs export product to other countries

FDI affects competition and economic growth: If FDI is in the form of greenfield investment, competition will increase in a market. This should drive down prices and benefit consumers. More competition also promotes increased productivity, innovation, and then, economic growth.

There are three main costs of inward FDI. 1. Adverse effect on competition: subsidiaries of foreign MNE’s might end up having greater economic power than indigenous competitors. It gives the negative effects on competition. 2. Negative effects on the balance of payments. When it comes to the balance of payments, host countries worry that along with the capital inflows that come will the FDI, will be the capital outflows that occur when the subsidiary repatriates profits to the parent company. Some countries actually limit the amount of profits that can be repatriated to limit the negative effects of this. Host countries are also concerned that some subsidiaries import a substantial number of their inputs.

Loss of national sovereignty and autonomy: Sometimes host governments worry that they may lose some economic independence as a result of FDI. They worry that since foreign companies have no particular commitment to the host country, they won’t really worry about the consequences of their decisions on the host country. Loss of economic independence.

The effect on the capital account of the home country’s balance of payments, the employment effects that arise from outward FDI when importing parts, the gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country. Reverse resource-transfer.

The home country’s balance of payments can suffer and employment.

Well, there are various ways that home and host countries can encourage or discourage FDI (ownership and performance restraints)

Decision to export/license/FDI