Hand Out Chap 7

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Lecture 3Foreign Direct Investment[ Ref. Chapter- 7, Global Business Today ]

Introduction

What is foreign direct investment?

firm invests directly in new facilities to produceand/or market in a foreign country

Once a firm undertakes FDI it becomes amultinational enterprise

There are two forms of FDI

. green e nves men e es a s menof a wholly new operation in a foreigncountry)

2. Acquisition or merging with an existing firmin the foreign country


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Foreign Direct Investmentin the World Economy

{There are two ways to look at FDI

1. The flow of FDI refers to the amount ofFDI undertaken over a given time period

2. The stock of FDI refers to the totalaccumulated value of foreign-ownedassets at a given time

Outflows of FDI are the flows of FDI out of acountry

Inflows of FDI are the flows of FDI into acountry

Trends in FDI

Both the flow and stockof FDI in the worldeconomy has increased over the last 20 years

FDI has rown more ra idl than world t radeand world output because:

firms still fear the threatof protectionism

the general shift toward democratic politicalinstitutions and free market economies hasencouraged FDI

t e go a zaton s promptng rms toundertake FDI to ensure they have asignificant presence in many regions of theworld


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Trends in FDI

FDI Outflows 1982-2007

The Direction of FDI

Historically, most FDI has been directedat the developed nations of theworld with the United States bein afavorite target

FDI inflows have remained high duringthe early 2000s for the UnitedStates, and also for the European Union

, , ,particularlyChina, are now seeing anincrease of FDI inflows

Latin America is also emerging as animportant region for FDI


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Trends in Inward FDI : 1970 -2011 (US $ Mill ions)

2000000

2500000

500000

1000000

1500000

Source: http://unctadstat.unctad.org

0

19

70

19

80

19

90

20

00

20

10

World Developing economies


FDI Inflows by Region 1995 -2007


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FDI can be expressed as a percentage ofgross fixed capital formation(the total amounto ca ital invested in factories stores officebuildings etc.)

All else being equal, the greater the capitalinvestment in an economy, the morefavorable its future prospects are likely to be

So, FDI can be seen as an important source

ofcapital investment and a determinant ofthe future growth rate ofaneconomy

The Source of FDI

{ Since World War II, the U.S. has been the

{ Other important source countries include theU.K., Netherlands, France, Germany, J apan

of the worlds largest multinationals


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The Source of FDI

Cumulative FDI Outflows 1998 - 2006

The Form of FDI: Acquisitionsversus Greenfield Investments

{Major ity of cross-border investment involvesmer ers and ac uisitions rather than reenfieldinvestments

{Firms prefer to acquire existing assets because

mergers and acquisitions are quicker to executethan greenfield investments

it is easier and perhaps less risky for a firm to

acqure es re assets t an u t em rom t eground up

firms believe they can increase the efficiency ofan acquired unit by transferringcapital, technology, or management skills


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The Shift to Services{ In the last two decades, there has been a shift of FDI

towards services

{The shift to services is being driven by

the general move in many developed countriestoward services

Many services cannot be stored/exported-->produce them then and there --> hence need forFDI

Liberalization of policies governing FDI in

Rise of Internet-based global telecom networksthat have allowed some service enterprises torelocate some of their value creation activities todifferent nations to take advantage of favorablefactor costs

Theories ofForeign Direct Investment

Question: Why do firms prefer FDI toe e expor ng o cens ng gran ng aforeign entity the right to produce and sellthe firms product in return for a royalty feeonevery unit that the foreign entity sells)?

To answer this question, we need to lookat the limitations of exporting andlicensing, and the advantages of FDI


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1. Limitations of Exporting{The viabilit of an ex ortin strate can be

constrained by transportation costs andtrade barriers

When transportation costs arehigh, exporting canbe unprofitable

response to actual or threatened trade

barriers such as import tariffs or quotas

Theories of

Foreign Direct Investment2. Limitations of Licensing

Internalization theory (also known as market

major drawbacks1. it may result in a firms giving away valuable

technological know-how to a potential foreigncompetitor

2. it does not give a firm the tight control overmanufacturin marketin and strate in aforeign country that may be required tomaximize its profitability

3. It may be difficult if the firms competitiveadvantage is not amendable to licensing


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Starbucks in IndiaStarbucks in India

Starbucks, the world's largest coffee-shop chain, opened its firstbranch in India on 19 October, 2012. Two more branches

including one in Mumbai's famous Taj Mahal Palace hotel, which haslikewiseseen dozens of people queuing for a frappuccino opened inthesubsequentweek (All the 3 outlets inMumbai)

With more than 17,600 branches in 61 countries, it is perhapssurprising that the Seattle-based company has only just arrived inIndia. It entered China in 1999 and has around 600 out lets there.

Indiangovernment in September, 2012relaxedrules on local sourcingfor foreign "single-brand retailers" shops thatsell items belongingto one brand. Last November, it scrapped rules stating that suchretailers needed to partner with a local company. Following thesereforms, IKEA this month appliedto open around25outlets.

Starbucks has entered India through an $80mjoint venture wi thTata, one of the country's biggest conglomerates, having worked onthis deal before the rules changed (guardian.co.uk, Monday 29October 2012 ).

The Pattern ofForeign Direct Investment

3.Advantages of Foreign Direct Investment A firm will favor FDI over ex ortin as an entr

strategy when:1. transportation costs are high2. trade barriers are high

A firm will favor FDI over licensing when1. it wants control over its technological know-

2. it wants control over its operations andbusiness strategy

3. the firms capabilities are not amenable tolicensing


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{ It is common for firms in the same industryto:

1. have similar strategic behaviorandundertake foreign direct investmentaround the same time

2. direct their investment activities towardscertain locations at certain stages in the

product life cycle

Theories of

Foreign Direct Investment1. Strategic Behavior Knickerbockerexplored the relationship

between FDI and rivalry in oligopolistic industries

large firms)

Knickerbockersuggested that FDI flows are areflection of strategic rivalry between firms in theglobal marketplace

This theory can be extended to embrace the

concept ofmultipoint competition (when two ormore enterprises encounter each other indifferent regional markets, national markets, orindustries)


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2. The Product Life Cycle

{ Vernon argues that firms undertake FDI atparticular stages in the life cycle of a producttheyhave pioneered

{ Firms invest in other advanced countries whenlocal demand in those countries grows largeenough to support local production

{ Firms then shift production to low-cost

developing countries when productstandardization and market saturation give riseto price competition and costpressures

The Eclectic Paradigm(Dunning)

J ohn Dunnings eclectic paradigm argues that inaddition to the various factors discussed

,must be considered when explaining both therationale for and the direction of foreign directinvestment:

1. location-specific advantages (arise from usingresources or assets that are tied to a

par cu ar oca on an a a rm n s vaua eto combine with its own unique assets)

2. externalities (knowledge spillovers that occurwhen companies in the same industry locate inthe same area)


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The Eclectic Paradigm(OLI)Ownership (or Firm Spec ifi c) Advantages. This helps explain the

"why," or mot ivat ion, of multinat ional enterprise activities. Ownershipadvantages are defined as the degree to which a firm possessessustainable ownership-specific advantages over other firms in the market.

,financial resources, andorganizational andmarketingsystems.

Location Advantages. This helps explain the "where," or locat ion, of

multinational enterprise activities. These advantages are specific to thecountry. Some examples are natural resources, labor force (availability andquality), andsocietal structure (legal systems, political structure).

Internalization Advantages. This helps explain the "how," or themanner, of multinational enterprise activities. Internalization is the degree

of ownership and control. At one end of the spectrum is no control orownership. Transactions are made at arm's length or through the market.At the other end of the spectrum is full control. The firm "internalizes" themarket transactions by owning or controlling the other firm. Thetransactions arenotarm's-length.

Different Types of FDIThe typology of FDI was developed by

objectives of FDI:

1. Resource seeking FDI

2. Market seeking FDI

. 4. Strategic asset/capabilities seeking FDI


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Resource seeking FDI

To seek and secure natural resourcese.g. mneras, raw ma eras, o owelaborcosts for the investing company

For example, a German companyopening a plant in Slovakia to produce

- x y

Market seeking FDI To identify and exploit new markets for the

finished products of the firm

Some type of services for which productionand distribution have to becontemporaneous (telecom, water supply,energy supply)

Automotive TNCs have invested heavily inChina


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Efficiency seeking FDI

To restructure its existing investments so as toachieve an efficient allocation of internationaleconomic activity o the irms

International specialization whereby firmsseek to benefit fromdifferences in product andfactor prices and to diversify risk

Global sourcing resource saving andimproved efficiency by rationalizing the

structure of their global activities. Undertakenprimarily by network based MNCs with globalsourcing operations.

Strategic asset/capabilit ies

seeking FDIMNCs pursue strategic operations through

the purchase of existing firms and/o assetsin order to protect specific advantages inorder to sustain or advance its globalcompetitive position Acquisition of key established local firms

Ac uisition of local ca abilities includin R&Dknowledge and human capital

Acquisition of market knowledge

Pre empting market entrance by competitors

Pre empting the acquisition of local firms by competitors


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Political Ideology andForeign Direct Investment

Ideology toward FDI has ranged from

FDI to the non-interventionistprinciple of free market economies

Between these two extremes is an

pragmatic nationalism

The Radical View

{The radical view argues that the MNE is an

exploiting host countries to the exclusive benefit oftheir capitalist-imperialist home countries

{The radical view has been in retreat because of:

the collapse of communismin Eastern Europe

the poor economic performance of those

countries that had embraced the policy the strong economic performance of

developing countries that had embracedcapitalism


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The Free Market View

The free market view argues that

distributed among countries according tothe theory of comparative advantage

Thus, MNCs increase the overallThus, MNCs increase the overallefficiency of the world economyefficiency of the world economy

by advanced and developingnations, including the UnitedStates, Britain, Chile, and Hong Kong

Pragmatic Nationalism

The pragmatic nationalist view - FDIhas both benefits, such as inflows ofcap a , ec no ogy, s s anjobs, and costs, such as repatriationof profits to the home country and anegative balance of payments effect

According to this view, FDI should beallowed only if the benefits outweighthe costs


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Shifting Ideology

Recent years have seen a strong shift

worldwide, creating:

a surge in the volume of FDIworldwide

countries that have recentlyliberalized their regimes

Benefits and Costs of FDI

QuestionQuestion: What are the benefits and costsof FDI?

The benefits and costs of FDI must beexamined from the perspective of both thehost (receiving) country and the

home source countr .


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Host Country Benefits

The main benefits of inward FDI for a host

1. the resource transfer effect

2. the employment effect

3. the balance of payments effect

. growth


1. Resource Transfer Effects

FDI can make a positive contribution to ahost economy by supplyingcapital, technology, and managementresources that would otherwise not beavailable

2. Employment Effects FDI can bring jobs to a host country that

would otherwise not be created there


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3. Balance-of-Payments Effects A countrys balance-of-payments account is a

record of a countrys payments to and receiptsrom o er coun res

The current account is a record of a countrysexport and import of goods and services

FDI can help achieve a current accountsurplus: e s a su s u e or mpor s o

goods and services if the MNE uses a foreign subsidiary to

export goods and services to othercountries

Host Country Benefits4. Effect on Competition and Economic Growth

FDI in the form of greenfield investment

increases the level of competition in a market

drives down prices

improves the welfare of consumers

Increased competition can lead to

ncrease pro uc v y grow product and process innovation

greater economic growth


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Host Country CostsCosts

There are three main costs of inward FDI:

1. the possible adverse effects of FDI oncompetitionwithin the host nation

2. adverse effects on the balance ofpayments

3. the perceived loss of national

sovereignty andautonomy


1. Adverse Effects on Competition

Subsidiaries of foreign MNEs operating in acountr ma have reater economic ower than domestic competitors because they maybe part of a larger international organization

As part of larger organization, the MNE coulddraw on funds generated elsewhere tosubsidize costs in the local market

Doing so could allow the MNE to drivedomestic competitors out of the market andcreate a monopolyposition


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2. Adverse Effects on the Balance of Payments

There are two possible adverse effects of FDI on ahost countr s balance-of- a ments:

1. Initial inflows of FDI would involvesubsequent outflow of capital as the foreignsubsidiary repatriates dividend/earnings to itsparentcountry

2. When a forei n subsidiar im orts its in utsfrom abroad, there is a debit on the current

account of the host countrys balance ofpayments


3. National Sovereignty and Autonomy

Many host governments worry that FDI

economic independence

Key decisions that can affect the hostcountrys economy will be made by aforeign parent that has no real

,over which the host countrysgovernmenthas no real control


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Home Country BenefitsBenefitsThe benefits of FDI to the home country include:

1. the effect on the capital account of the home

inward flowof foreign earnings

2. the employment effects that arise fromoutward FDI

3. the ains from learnin valuable skills fromforeign markets that can subsequently be

transferred back to the home country

Home Country CostsCosts

The most important concerns for the home countrycenter around

1. The balance-of-payments

{ The balance of payments suffers from the initialcapital outflow required to finance the FDI

{ The current account is negatively affected if thepurpose of the FDI is to serve the home marketfrom a low-cost production location

{ The current account suffers if the FDI is asubstitute for direct exports

2. Employment effects of outward FDI

{ If the home country is suffering fromunemployment, there may be concern aboutthe export of jobs


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Government Policy regarding FDI

FDI can be regulated by both home and

Governments can implement policies to:

1. encourage FDI

. scourage

Home Country Policies1. Encouraging Outward FDI

Many nations now have government-backedinsurance programs to cover major types offoreign investment risk

This type of policy can encourage firms toundertake FDI in politically unstable

Eliminate double taxation of foreign income

Lobby with host country govts. to relaxrestrictions on FDI


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Home Country Policies

2. Restr ict ing Outward FDI All countries, including the United

a es, ave exerc se some con ro oveoutward FDI fromtime to time

Some countries manipulate tax rules tomake it more favorable for firms to invest athome

Countries may restrict firms from investing

in certain nations for political reasons

Host Country Policies1. Encouraging Inward FDI

Host countr Governments offevarious incentives to foreign firms toinvest in their countries

Incentives are motivated by:a desire to gain from the resource-

rans er an empoymen e ec s oFDI, and to

capture FDI away from other potentialhost countries


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Host Country Policies

2. Restr ict ing Inward FDI{ Ownership restrictions and performance requirements

are used to restrict FDI

{ Ownership restraints

exclude foreign firms from certain sectors on thegrounds of national security or competition

are often based on a belief that local owners can helpto maximize the resource transferand em lo mentbenefits of FDI

{Performance requirements are used to maximize thebenefits and minimize the costs of FDI for the hostcountry

International Institutionsand the Liberalization of FDI

Until recently there has been noconsistent involvement b multinationalinstitutions in the governing of FDI.

The formation of the World TradeOrganization in1995 is changing this.

The WTO has framed some universalset of rules to promote the liberalizationofFDI


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Implications for Managers

Question: What does the theory FDImean fo international businesses?

The theory of FDI has implications forstrategic behaviorof firms

Government olic on FDI can also beimportantfor international businesses

The Theory of FDI

{The location-specific advantages argumentassociated with J ohn Dunnin hel ex lain thedirection of FDI

{However, internalization theory is needed toexplain why firms prefer FDI to licensing orexporting

{Ex ortin is referable to licensin and FDIas long as transportation costs and tradebarriers are low


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The Theory of FDI

{Licensing is unattractive when:

properly protected by a licensing agreement

the firm needs tight control over a foreignentity in order to maximize its market shareand earnings in that country

the firms skills and capabilities are not

amenable to licensing

The Theory of FDI

ork

cisionFrame

AD


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Government Policy

A host governments attitude toward FDI is animportant in decisions about where to locate

a foreign direct investment

A firms bargaining power with the hostgovernment is highest when:

1. the host government places a high value on

2. when there are few comparable alternatives

available3. when the firm has a long time to negotiate

Inward FDI- India & China,

1979 2011 (USD Mill ions)

120000

140000 124Billion

20000

40000

60000

80000

32Billion

0

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

India China

Source: http://unctadstat.unctad.org


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Inward FDI: India and China and Total World,

1979 2011 (USD Millions)

2007 2008 2009 2010 2011

India(1.3) (2.4) (3.0) (1.8) (2.1)

China83521

(4.2)108312

(6.0)95000

(7.9)114734

(8.8)123985

(8.1)

Developing

world 574311(29.1) 650017(36.3) 519225(43.3) 616661(47.1) 684399(44.9)World 1975537 1790706 1197824 1309001 1524422

Figures in Brackets show percentage to total World FDISource: http://unctadstat.unctad.org


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Critical Discussion Question - 1

In 2004, inward FDI accounted forsome 24 percent of gross capitalformation in Ireland, but only 0.6percent in J apan.

Q. What do you think can explain this

difference in FDI inflows into the two

countries?

Critical Discussion Question - 2

Compare and contrast the following

internalization theory, Vernons product life cycle theory,

and Knickerbockers theor of FDI.

Which theory do you think offers thebest explanation of the historical patternof horizontal FDI? Why?


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3. Cemex Case

Reread the Management Focus on Cemex and answerthe following questions:

a)Which theoretical explanation, or explanations, of FDI best

b) What is the value that Cemex brings to the host economy?Can you see any potential drawbacks of inward investmentby Cemexinaneconomy?

c) Cemex has a strong preference for acquisitions overgreenfieldventures as an entrymode. Why?

failing to gain majority control of Semen Gresik? Why ismajority control so importantto Cemex?

e) Why do you think politicians in Indonesia tried to blockCemexs attempt to gain majority control over SemenGresik? Do you think Indonesias best interests were servedbylimiting Cemexs FDI in thecountry?

3. Mittal Steel Case

1. How did Mittal Steel grow from almost nothing tobe the worlds largest steel company in such ashort time? How important were the companys

2. Why was Mittal Steels acquisition of Arcelor socontroversial? Do you agree with those whoopposedthe acquisition? Why or why not?

. world, Mittal Steel doesnt operate in India.ExplainWhy?


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Assignment

4. You are the international manager of a US business that

has just invented a revolutionary new personal computerthat can perform the same functions as PCs, but costsonly half as much to manufacture. Your CEO has askedyou to decide how to expand into the European Unionmarket. Your options are:

(i) export fromthe United States,

(ii) license a European firm to manufacture and marketthecomputer inEurope, and

(iii) set up a wholly owned subsidiary in Europe.

Evaluate the pros and cons of each alternative andsuggest a course of action to your CEO.

Quiz

1. A company that establishes a new operationin a foreign country has made

a)An acquisition

merge

c) A greenfield investment

d) A joint venture

2. Benefits of FDI include all of the followingexcept

a)The resource transfer effect

b)The employment effect

c)The balance of payments effect

d) National sovereignty and autonomy


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Quiz

3. Which of the following statements is true?a) Over the years, there has been a marked

b) Over the years, there has been a marked increasein the stock and flow of FDI

c) Over the years, there has been a markeddecrease in the stock and an increase in the flow of

d) Over the years, there has been a marked increasein the stock and an decrease in the flow of FDI

Quiz

4. Advantages that arise from using resourceendowments or assets that are tied to a particularlocation and that a firm finds valuable to combine

a) First mover advantages

b) Location advantages

c) Externalities

d) Proprietary advantages


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StarbucksStarbucksQUESTION 1: Initially Starbucks expanded internationally by licensing its format to foreign operators. It soon became disenchanted

with this strategy. Why?

Starbucks began its international expansion in Japan where it licensed its formula to a joint venture formed with a local company.

Starbucks feared that a pure licensing agreement would not provide it with the control it felt was necessary to successfully replicate

the look, feel, and experience of an American Starbucks. To help ensure continuity between its American stores, and its Japanese

locations, Starbucks transferred American employees to the Japanese stores to help train workers in the Starbucks way. Starbucks

shifted many of it arrangements to joint ventures and wholly owned subsidiaries in an effort to gain greater control over the

operations.

QUESTION 2: Why do you think Starbucks has now elected to expand internationally primarily through local joint ventures, to

whom it licenses its format, as opposed to a pure licensing strategy?

Probably because of the greater control that joint ventures provide over licensing arrangements. By using joint ventures to expand

internationally, Starbucks can link up with local firms that know the market, but still maintain a greater degree of control.

QUESTION 3: What are the advantages of a joint venture entry mode for Starbucks over entering through wholly owned

subsidiaries? On occasion, Starbucks has chosen a wholly owned subsidiary to control its foreign expansion (e.g. in Britain and

Thailand). Why?

Using joint ventures has allowed Starbucks to share the cost and risk of developing its foreign markets. While a wholly owned

subsidiary would give Starbucks complete control, it also implies that Starbucks would incur all of the cost and risk involved. In

Britain, Starbucks did acquire an existing coffee chain that was modeled after Starbucks. Because the chain was already successful,

some of the risk that would normally be associated with introducing a new concept to a foreign market was eliminated. Starbucks

also shifted to a wholly owned operation in Thailand after its joint venture there experienced difficulty raising capital for furtherexpansion. By acquiring the joint venture, Starbucks was able to gain control over the process

QUESTION4: Which theory of FDI best explains the international expansion strategy adopted by Starbucks?

Internalization theory suggests that when licensing is difficult, foreign direct investment is appropriate. Starbucks seems to have

followed this philosophy.

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