Lecture 10 Foreign Direct Investment

8/6/2019 Lecture 10 Foreign Direct Investment

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LECTURE 10LECTURE 10

FOREIGN DIRECTFOREIGN DIRECT

INVESTMENTINVESTMENT


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Foreign Direct InvestmentForeign Direct Investment

Why do firms often prefer FDI to other marketWhy do firms often prefer FDI to other marketentry strategies?entry strategies?

Why do firms imitate competitors with FDIWhy do firms imitate competitors with FDIstrategies?strategies?

Why are certain locations favored for FDI?Why are certain locations favored for FDI?

What are key FDI related costs and benefitsWhat are key FDI related costs and benefitsfor receiving and source countries?for receiving and source countries?


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INTERNATIONAL CAPITAL FLOWSINTERNATIONAL CAPITAL FLOWSFORMSFORMS

FDI AND FIIsFDI AND FIIs GOVERNMENT, INSTITUTIONAL ANDGOVERNMENT, INSTITUTIONAL AND

PRIVATE CAPITALPRIVATE CAPITAL HOME AND FOREIGN CAPITALHOME AND FOREIGN CAPITAL FOREIGN AIDFOREIGN AID


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FDI is investment in real assets such asFDI is investment in real assets such asfactories, offices ,lands ,buildings,factories, offices ,lands ,buildings,

capital goods etc.capital goods etc.

FII is investment in financial assetsFII is investment in financial assetssuch as in bonds and stocks,such as in bonds and stocks,

denominated in national currency.denominated in national currency.


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Foreign investment

Direct investmentPortfolio investment

Wholly ownedsubsidiary

Jointventure

Acquisition

INVESTMENT by FIIGDR,ADR FCCB

GDR-A bank certificate issued in more than one country for shares in a foreign company. Theshares are held by a foreign branch of an international bank. The shares trade as domestic shares,but are offered for sale globally through the various bank branches.

FCCB- A type of convertible bond issued in a currency different than the issuer'sdomestic currency. In other words, the money being raised by the issuing company isin the form of a foreign currency.


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FORMS OF FOREIGN DIRECT INVESTMENTFORMS OF FOREIGN DIRECT INVESTMENT

BYTARGETBYTARGET

GREEN FIELD INVESTMENTGREEN FIELD INVESTMENT-- DirectDirect investment ininvestment in newnewfacilities.facilities.

TOYOTA IN UK AND TOYOTA IN NORTH AMERICATOYOTA IN UK AND TOYOTA IN NORTH AMERICA

MERGERSAND ACQUISITIONSMERGERSANDACQUISITIONS--Transfers of existingTransfers of existingassets from local firms to foreign firms takes place; theassets from local firms to foreign firms takes place; the

primary type of FDI.primary type of FDI. CrossCross--border mergers occur when the assets andborder mergers occur when the assets and

operation of firms from different countries are combinedoperation of firms from different countries are combinedto establish a new legal entity.to establish a new legal entity.

CrossCross--border acquisitions occur when the control ofborder acquisitions occur when the control ofassets and operations is transferred from a local to aassets and operations is transferred from a local to aforeign company, with the local company becoming anforeign company, with the local company becoming anaffiliate of the foreign company.affiliate of the foreign company.


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FORMS OF FOREIGN DIRECT INVESTMENTFORMS OF FOREIGN DIRECT INVESTMENT

By directionBy direction Inward foreign direct investment is when foreign capitalInward foreign direct investment is when foreign capital

is invested in local resources.is invested in local resources.

Outward foreign direct investment, sometimes calledOutward foreign direct investment, sometimes called"direct investment abroad", is when local capital is"direct investment abroad", is when local capital isinvested in foreign resources.invested in foreign resources.


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Horizontal FDIHorizontal FDI

Investment in the same industry abroad as a firm operates in at home.Investment in the same industry abroad as a firm operates in at home.

e.g.e.g.Star bucks acquisition of

Seattle coffee in Britain

Star bucks acquisition of

Seattle coffee in BritainFord builds up automobile plant in Mexico.Ford builds up automobile plant in Mexico.

VERTICAL FDIVERTICAL FDI

BACKWARD VERTICAL FDIBACKWARD VERTICAL FDI----Where an industry abroad provides inputsWhere an industry abroad provides inputsfor a firm's domestic production process.for a firm's domestic production process.

oil refining, tin smelting, Royal Dutch, Alcoaoil refining, tin smelting, Royal Dutch, Alcoa Fords builds up engine in Mexico which ships engine to itsFords builds up engine in Mexico which ships engine to its

manufacturing site in Texas.manufacturing site in Texas.

FORWARD VERTICAL FDIFORWARD VERTICAL FDI----Where an industry abroad sells the outputs ofWhere an industry abroad sells the outputs of

a firm's domestic production.a firm's domestic production. Ford buys Seven dealerships in Mexico city which it uses to distributeFord buys Seven dealerships in Mexico city which it uses to distribute

its cars made in Texas.its cars made in Texas.


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FORMS OF FOREIGN DIRECT INVESTMENTFORMS OF FOREIGN DIRECT INVESTMENTBYMOTIVEBYMOTIVE

ResourceResource--SeekingSeeking--

Investments which seek to acquire factors ofInvestments which seek to acquire factors ofproduction that are more efficient than thoseproduction that are more efficient than thoseobtainable in the home economy of the firm. Inobtainable in the home economy of the firm. In

some cases, these resources may not besome cases, these resources may not beavailable in the home economy at all (e.g. cheapavailable in the home economy at all (e.g. cheaplabor and natural resources).labor and natural resources).

This typifies FDI into developing countries, forThis typifies FDI into developing countries, forexample seeking natural resources in the Middleexample seeking natural resources in the MiddleEast and Africa, or cheap labor in Southeast AsiaEast and Africa, or cheap labor in Southeast Asiaand Eastern Europe.and Eastern Europe.


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MarketMarket--SeekingSeeking

Investments which aim at either penetrating new marketInvestments which aim at either penetrating new market

or maintaining existing ones.or maintaining existing ones.

EfficiencyEfficiency--SeekingSeeking

Investments which firms hope will increase their efficiency byInvestments which firms hope will increase their efficiency by

exploiting the benefits of economies of scale and scope.exploiting the benefits of economies of scale and scope.

StrategicStrategic--AssetAsset--SeekingSeeking--A tactical investment toA tactical investment to

prevent the loss of resource to a competitorprevent the loss of resource to a competitor..


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Direction and Source of FDIDirection and Source of FDI

Most FDI flow has been to developedMost FDI flow has been to developed

countries from developed countriescountries from developed countries

Much to the US from EU, JapanMuch to the US from EU, Japan

FDI increase to developing countriesFDI increase to developing countries

since 85since 85

Much to the emerging Asian and LatinMuch to the emerging Asian and Latin

America economiesAmerica economies

FDIFDI moving towards Africamoving towards Africa


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Majority of cross border investments is in theMajority of cross border investments is in theform of mergers and acquisitions rather than

green field investments.

U.N Estimates that 70-80% of all FDI are inform of mergers and acquisitions.

In case of developing nations, only about onethird of FDI is in the form of cross bordermergers and acquisitions because there are few

target firms to acquire.


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The Form of FDI: Acquisitions versusThe Form of FDI: Acquisitions versusGreenGreen--FieldsFields

Why the preference for mergers & acquisitions?Why the preference for mergers & acquisitions? Quicker to executeQuicker to execute

When German automobile company Daimler Benz decided it needed aWhen German automobile company Daimler Benz decided it needed a

bigger presence in the U.S, it acquired Chrysler to form Daimler Chryslerbigger presence in the U.S, it acquired Chrysler to form Daimler Chrysler..

Foreign firms have valuable strategic assets.Foreign firms have valuable strategic assets.

MittalMittal ArcelorArcelor

NESTLE AND ROWNTREESNESTLE AND ROWNTREES

Believe they can increase the efficiency of the acquiredBelieve they can increase the efficiency of the acquiredfirm by transferring capital, technology, managerial skills.firm by transferring capital, technology, managerial skills.

CemexCemex global status is largely due to acquisitions.global status is largely due to acquisitions.


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Case 1:CemexCase 1:Cemex


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CEMEXCEMEX:: Third largest Mexican cementThird largest Mexican cementcompany in the worldcompany in the world

TurnoverTurnover of $16 billion with a work force of 25000of $16 billion with a work force of 25000

A truly global organization with plants in 15 countries ,owned productionA truly global organization with plants in 15 countries ,owned productionand distribution in 30 and traded in more than 60and distribution in 30 and traded in more than 60 companies.companies.

CEMEX is a leader in using information technology to match production withCEMEX is a leader in using information technology to match production withconsumers demand.consumers demand.

Sells readySells ready--mixed cement that can survive for only 90 minutes beforemixed cement that can survive for only 90 minutes beforesolidifysolidify

To better manage unpredictable demand CEMEX developed a system ofTo better manage unpredictable demand CEMEX developed a system ofseamless information technology including truck mounting globalseamless information technology including truck mounting globalpositioning systems ,radio transmitters ,satellites and computer hardwarepositioning systems ,radio transmitters ,satellites and computer hardwarethat allows CEMEX to control the production and distribution of cementthat allows CEMEX to control the production and distribution of cement


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Holderbank(Switzerland)

Lafarge(France)

Heidelberger(Germany )

Italcementi(Italy)

Blue Circle(UK,Bought by Lafarge)

CemexsCemexs CompetitorsCompetitors


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CEMEXs major International moves are as below:

International Expansion

Contd


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DEMERITS OF FDIDEMERITS OF FDI

EXPENSIVEEXPENSIVE BUSINESS IS RISKYBUSINESS IS RISKY--e.ge.g SCHINDLERSCHINDLER

faced a lot of cross culture differencesfaced a lot of cross culture differenceswhen it came to India .when it came to India .


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FDI over exportingFDI over exporting

High transportation costs, tradeHigh transportation costs, tradebarriers.barriers.

When the cost of transportation is added to productionWhen the cost of transportation is added to productioncosts, some products become impractical to ship overcosts, some products become impractical to ship over

greater distances.greater distances.

Products that have a low value to weightProducts that have a low value to weightratio. e.g. cement, soft drinks,ratio. e.g. cement, soft drinks, TyresTyres

e.g.e.g. CemexCemex


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Why firms prefer FDI than exporting, licensing..?

1)Impediments To The Free Flow Of Products Between

Nations.a)a) TradeTrade RestrictionsRestrictions:: TariffsTariffs andand nonnon--tarifftariff barriersbarriers actact asas anan enticemententicement

forfor makingmaking foreignforeign directdirect investmentinvestment..

b)b) RemovingRemoving tradetrade restrictionsrestrictions amongamong aa regionalregional groupgroup ofof countriescountries alsoalso

maymay attractattract directdirect investmentinvestment..

ExportingTariff and quota, govt increase the attractiveness of FDI

FDI by Japan in 1980s in U.S was due to heavy tariff placed by U.S

govt.

MARKET IMPERFECTIONSMARKET IMPERFECTIONS


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2)IMPEDIMENTS TO THE SALE OF KNOWHOW

Licensing is not attractive as it initially appears.

Licensing may result in a firms giving away itsknow-how to a potential foreign competitor.

Licensing does not gives a firm a tight control

over manufacturing, marketing etc. In Thailand star bucks initially entered into a licensing agreement with

coffee partners, but when coffee partners found it difficult to raise fromThai banks star bucks acquired coffee partners for tighter control.

A firms know-how may not be amenable to

licensing in case of management and marketingknow-how. e.g. cemex


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STRATEGIC BEHAVIOURSTRATEGIC BEHAVIOUR

F.T KNICKERBOCKORF.T KNICKERBOCKOR RELATIONSHIP BETWEEN FDI and rivalry in oligopolisticRELATIONSHIP BETWEEN FDI and rivalry in oligopolistic INTERDEPENDENCEINTERDEPENDENCE

FDI follows same pattern as price rivalry.FDI follows same pattern as price rivalry.

FIRM A establishes its subsidiary in FranceFIRM A establishes its subsidiary in France Firm B and C decide if investment is successful they willFirm B and C decide if investment is successful they will

also follow.also follow. A discovers that there is some competitive asset inA discovers that there is some competitive asset inFrance that it can repatriate to torment B and CFrance that it can repatriate to torment B and C

B and C decides to follow AB and C decides to follow A E.gE.g Kodak and FujiKodak and Fuji


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The product Life cycle (pattern ofThe product Life cycle (pattern of

FDI)FDI)Vernon theory explain about FDIVernon theory explain about FDI Firms that pioneer a production theirFirms that pioneer a production their

home market undertake FDI to produce ahome market undertake FDI to produce aproduct for consumption in foreignproduct for consumption in foreignmarket.market.


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Location specific advantagesLocation specific advantages

John DunningJohn Dunning Explains nature and direction of FDIExplains nature and direction of FDI Firms have to establish production facilities at whereFirms have to establish production facilities at where

foreign resources are located known as electricforeign resources are located known as electricparadigm.paradigm.

E.g. oil and mineral gas, cheap laborE.g. oil and mineral gas, cheap labor ExternalitiesExternalities--They are defined asThey are defined as third partythird party (or spill(or spill--

over)over) effectseffects arising from thearising from the productionproduction and/orand/orconsumptionconsumption of goods and services for which noof goods and services for which noappropriate compensation is paid.appropriate compensation is paid.


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A Decision FrameworkA Decision Framework

Figure 6.6

Yes

How high aretransportation costs

and tariffs?

Is know-how amenableto licensing?

Is tight control overforeign operation

required?

Can know-how be protectedby licensing contract?

Then license

ExportExport




High

Yes

No

LOW

No

Yes

No


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The benefits of FDI to host countriesThe benefits of FDI to host countries

Resource transfer effectResource transfer effectCapitalCapital

TechnologyTechnology

ManagementManagement Employment effectsEmployment effects Balance of payment effectsBalance of payment effects

Effect on competition and economicEffect on competition and economicgrowthgrowth


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The benefits of FDI to home countriesThe benefits of FDI to home countries

Capital account of the home country, s BOP benefitsCapital account of the home country, s BOP benefitsfrom inward flow of foreign earnings.from inward flow of foreign earnings.

Outward flow of FDI arise from employment effects.Outward flow of FDI arise from employment effects.positive employment effects arisepositive employment effects arise when the foreignwhen the foreignsubsidiary creates demand for home country exports ofsubsidiary creates demand for home country exports of

capital equipment, intermediate goods ,complementarycapital equipment, intermediate goods ,complementaryproducts.products.

Home country MNE learnsHome country MNE learns valuable skillsvaluable skills from itsfrom itsexposure to foreign markets that can transferred back toexposure to foreign markets that can transferred back to

the home country.the home country.


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FOREIGN DIRECT INVESTMENTFOREIGN DIRECT INVESTMENTCONFIDENCE INDEX,2010CONFIDENCE INDEX,2010 TheThe ForeignForeign DirectDirect InvestmentInvestment ConfidenceConfidence IndexIndex isis aa

regularregular surveysurvey ofof globalglobal executivesexecutives conductedconducted byby AA..TT..KearneyKearney.. TheThe IndexIndex providesprovides aa uniqueunique looklook at at thethepresentpresent andand futurefuture prospectsprospects forfor internationalinternational investmentinvestmentflowsflows.. CompaniesCompanies participatingparticipating inin thethe surveysurvey accountaccount forfor

moremore thanthan $$22 trilliontrillion inin annualannual globalglobal revenuerevenue.. ChinaChina remainsremains thethe toptop--rankedranked destinationdestination byby foreignforeign

investors,investors, aa titletitle itit hashas heldheld sincesince 20022002..

TheThe UnitedUnited StatesStates retakesretakes secondsecond placeplace fromfrom India,India,

whichwhich hadhad surpassedsurpassed itit inin 20052005.. India,India, BrazilBrazil andand GermanyGermany completecomplete thethe toptop fivefive favoredfavoredinvestmentinvestment destinationsdestinations


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China, India and BrazilChina, India and Brazildominate the indexdominate the index For the first time, the three major emerging marketsFor the first time, the three major emerging markets

China, India and BrazilChina, India and Brazilall ranked among the top fourall ranked among the top fourinvestment destinations as investors expect theseinvestment destinations as investors expect thesecountries to continue to deliver growth despite thecountries to continue to deliver growth despite the

economic crisis.economic crisis. Investors also reported the highest degree of optimismInvestors also reported the highest degree of optimism

in the outlook for three countries, with nearly onein the outlook for three countries, with nearly one--thirdthirdseeing a more positive outlook for China (32 percent)seeing a more positive outlook for China (32 percent)and India (31 percent) compared to one year ago, andand India (31 percent) compared to one year ago, and22 percent saying Brazils outlook had improved.22 percent saying Brazils outlook had improved.


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Brown field investmentBrown field investment

FDI that involves the purchase of anFDI that involves the purchase of anexisting plant or firm, rather thenexisting plant or firm, rather then

construction of a new plant. Contrastsconstruction of a new plant. Contrastswith green field investmentwith green field investment

When a company or government entityWhen a company or government entity

purchases or leases existing productionpurchases or leases existing productionfacilities to launch a new productionfacilities to launch a new productionactivity. This is one strategy used inactivity. This is one strategy used inforeignforeign--direct investmentdirect investment


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Green field investmentGreen field investment

New plantNew plant is constructed.is constructed.

Documents

Lecture 10 Foreign Direct Investment