Part Three Chapter Foreign Direct Investment CrossBorder Trade

Part Three Chapter Foreign Direct Investment Cross-Border Trade and Investment Six

Slide 6 -1 Foreign Direct Investment l Foreign direct investment (FDI) happens when a firm invests directly in facilities in a foreign country l A firm that engages in FDI becomes a multinational enterprise (MNE) u Multinational = “more than one country” l Factors which influence FDI are related to factors that stimulate trade across national borders Irwin/Mc. Graw-Hill Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -2 Foreign Direct Investment l Involves ownership of entity abroad for Production u Marketing/service u R&D u Raw materials or other resource access u l Parent has direct managerial control The degree of direct managerial control depends on the extent of ownership of the foreign entity and on other contractual terms of the FDI u No managerial involvement = portfolio investment u Irwin/Mc. Graw-Hill Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -3 FDI Growth in the World Economy FDI Outflow of $35 billion in 1975 increased to $644 billion in 1998 l FDI Flow from all countries increased 1000%, trade 91%, world output 27% from 1984 to 1998 l FDI Stock increased to $3. 5 trillion by 1997 l 60, 000 parent MNEs with 500, 000 foreign affiliates produced $11 trillion sales, 25% of global output l FDI growing faster than world trade l Political risk issues u Economic reason issues u Globalization u Irwin/Mc. Graw-Hill Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -4 Direction and Source of FDI l Historically, FDI flow was to developed countries from other developed countries u Much of this to the US l Since 1985 there has been an increase of FDI towards developing countries Much to the emerging Asian and Latin America economies u Africa lagging u l Through 1970 s US led in FDI outflows 1985 -1990 Japan 1 st, UK 2 nd, US 3 rd u Effect of ¥ increase in value u Irwin/Mc. Graw-Hill Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -5 Forms of FDI l FDI u forms Purchase of existing assets n Quick entry, local market know-how, local financing may be possible, eliminate competitor, buying problems u New investment n No local entity exists or is available for sale, local financial incentives may encourage, no inherited problems, long lead time to generation of sales or other desired outcome u Participation in an international joint-venture n Shared Irwin/Mc. Graw-Hill ownership with local and/or other non-local partner Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -6 Alternative Modes of Market Entry l FDI - 100% ownership u FDI < 100% ownership, International Joint Venture u n Majority, Equal Share, Minority Participation l Strategic Alliances (non-equity) l Franchising l Licensing l Exports u Direct vs Indirect Irwin/Mc. Graw-Hill Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -7 Why FDI? l FDI u over exporting High transportation costs, trade barriers l FDI over licensing or franchising Need to retain strategic control u Need to protect technological knowhow u Capabilities not suitable for licensing/franchising u Irwin/Mc. Graw-Hill Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -8 Pattern of FDI l Follow main competitors Oligopolistic industries u Interdependence of the few major competitors forces immediate strategic responses u l International u As explained in Chapter 4 l Eclectic u product life-cycle (Ray Vernon) paradigm of FDI (John Dunning) Combines ownership specific, location specific, and internalization specific advantages that drive FDI decisions over a decision to enter through licensing or exports Irwin/Mc. Graw-Hill Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -9 l Eclectic Paradigm of FDI (Dunning) Ownership advantage: creates a monopolistic advantage which can be used to prevail in markets abroad u u Unique ownership advantage protected through ownership e. g. , Brand, technology, economies of scale, management know-how Location advantage: the FDI destination local market must offer factors (land, capital, know-how, cost/quality of labor, economies of scale) such that it is advantageous for the firm to locate its investment there (link to trade theory) l Internalization advantage: transaction costs of an armslength relationship --licensing, exports-- higher than managing the activity within the MNE’s boundaries l Source: Dunning, John H. (1980). “Towards an eclectic theory of international production: Some empirical tests. ” Journal of International Business Studies 11(2): 9 -31

Slide 6 -10 Government Policy and FDI l The radical view: inbound FDI harmful; MNEs Are an instrument of imperialist domination u Exploit host to the advantage of home country u Extract profits from host country; give nothing back u Keep LDCs backward/dependent for investment, technology and jobs u l The free market view: FDI should be encouraged Adam Smith, Ricardo, et al: international production should be distributed according to comparative advantage u The MNE increases the world economy efficiency because it brings to bear unique ownership advantages on the local economy’s comparative advantages u Irwin/Mc. Graw-Hill Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -11 Host Country Effects of FDI l Benefits Resource -transfer u Employment u Balance-of-payment (BOP) u n Import substitution n Source of export increase l Costs u Adverse effects on the BOP n Capital inflow followed by capital outflow + profits n Production input importation u Threat to national sovereignty and autonomy n Loss Irwin/Mc. Graw-Hill of economic independence Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -12 Home Country Effects of FDI l Benefits BOP current account adversely affected by inward flow of foreign earnings u Positive employment effect from increased exports of raw materials / assemblies to the overseas subsidiary u Repatriation of skills and knowhow u l Costs BOP trade position is negatively affected (lower finished goods exports) u Loss of employment to overseas market u Irwin/Mc. Graw-Hill Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -13 Government Policy and FDI l Home u country Outward FDI encouragement n Risk u reduction policies (financing, insurance, tax incentives) Outward FDI restrictions n National l Host u security, BOP country Inward FDI encouragement n Investment incentives n Job creation incentives u Inward FDI restrictions n Ownership extent restrictions (national security; local nationals can safeguard host country’s interests Irwin/Mc. Graw-Hill Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights

Slide 6 -14 Decision Framework for FDI Are transportation costs high? Yes No No Is know-how easy to license? No Export Yes FDI Yes Tight control over foreign ops required? No Is know-how valuable and is protection possible? Yes FDI No Irwin/Mc. Graw-Hill Import Barriers? License Copyright 2001 The Mc. Graw-Hill Companies, Inc. All rights