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Management 160

Foreign Direct Investment

This is what happens when a firm invests directly in a foreign company. All that it takes is for a firm
to acquire 10% or more of a foreign company and that firm is technically a multinational.

Most FDI is in the form of mergers and acquisitions (M&A) rather than building a new operation
(green-field investment) but this depends on the country. Only about a third of FDI in low income
countries is in M&A.

M&As

 M&As are quicker than building a new company. We know how quickly markets are
changing (comparative advantage for example) so it is important to get into a market as soon
as possible when the conditions are favourable.
 M&As mean that you are taking over a firm with:
brand loyalty, reputation
patents
capital (production lines, equipment, buildings etc)
distribution systems (suppliers of inputs, delivery infrastructure)
trained staff
A known record (profitability, debt, customer base)

More information (fewer unknowns) always means less risk

The investing firm has to believe that it will be profitable to buy or merge with another company, and
this often comes about because it can introduce efficiencies by using better technology, capital or
management skills (such as introducing more efficient working practices). These are the things that
came under the heading of ‘leveraging core competencies’ that we looked at before.

Why FDI?
This comes down to a cost benefit analysis.

We know what exporting is but we should explain licensing. Licensing happens when a firm owns a
brand and then allows another firm to make that brand name under license (with the permission of the
brand owner). The owner of the brand receives royalties or a share of the profits that the licensee firm
makes from selling the product. Exporting or licensing are both less risky and cheaper than FDI as
they don’t involve the firm having to buy or build anything in other countries (assuming that they are
already in business in the domestic market).

The risks of FDI are political, legal, cultural and ethical and a local firm, because that is their home
country, will know exactly what the issues are and how to deal with them.

So what problems might there be with exporting? It involves transport costs and is subject to
barriers to trade (such as tariffs).
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Transport costs are problematic with a low value to weight ratio goods (like soft drinks or cement).
Such goods would be much more efficiently made under licence or by FDI (the opposite is true of cell
phones or software).

FDI can avoid barriers to trade (but not necessarily local content requirement) or the perceived threat
of barriers being put in place in future.

FDI can also be a way to avoid exchange rate problems. Countries that have a very high value
currency will find exporting difficult (it makes their goods more expensive for others to buy) – so
setting up to produce abroad rather than export can avoid that problem.

So what are the problems of licensing?

 it could give away technological information to a potential competitor

 it doesn’t give a firm control over marketing or management structure. If for example a firm
wanted the licensee to charge a minimum price (to outcompete a global rival), the licensee
may not see that as a profit maximising strategy.
 The licensing firm may have comparative advantage in management or marketing which may
not be easily transferred to the licensee.

So FDI would be beneficial when:

1. Know how cannot be protected by licensing

2. Control of strategy is needed to maximise earnings and market share
3. Core competencies are not easily transferred

FDI Strategies
Multipoint competition is relevant to industries which are made up of a few large firms (oligopoly).
In this case firms often copy the actions of the competitors in order to protect market share and future
competitiveness. If one of the firms invests abroad the others may have to follow suit to prevent the
first firm gaining some advantage that it could then use in existing markets (for example, the firm
makes large profits in an uncontested market and uses them to subsidise its branches in more
competitive markets. This lowers is costs in those markets and may allow it to cut prices and gain
market share).

The Eclectic Paradigm as the name suggests is a mix of ideas. A firm will identify a comparative
advantage in particular country or region of a country (such as low cost labour or a natural resource
like oil). It combines these with its own advantages (such as its management skills). If licensing or
exporting aren’t advantageous, then FDI will be the best option.

It also includes other factors such as externalities1. If there are many similar firms in an area (like
Silicon Valley), the area will have a well trained and experienced work force in computer technology

1
An externality is an economics term for an effect that goes beyond the individual firm.
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and higher education institutions that feed into this in terms of training and research. This will be a
benefit to a firm wanting to set up in that industry as a highly skilled workforce is so important.

Costs and Benefits

Benefits:

 Large MNCs may have better credit ratings than the county in which they are investing. As a
result the MNC can get financial resources at lower cost (interest rates) making investment
more likely.
 FDI can provide technology to countries that may not otherwise have it or be able to afford its
development.
 Management skills may also come with FDI – particularly if local people get access to
management jobs (this is often one of the negotiating points of FDI – local content
requirement).
 Direct employment (hiring workers) and indirect effects (increased demand from supporting
industries – anything from providing lunches to natural resources). However we have to
count the net effect as jobs may be lost in an existing domestic industry. When FDI takes the
form of M&A it can lead to downsizing the labour force, although in the long term these
firms usually grow faster after restructuring and employment will remain stable or increase.
 FDI can have positive effects on the balance of payments. It can reduce imports (as the goods
are now made in the host country) and it can increase exports (if the goods are exported from
the host country). The latter has been important to economic growth in many low income
countries in the last 10 years.

Costs

 All the things that make a MNC economically efficient may result in it out-competing the
domestic industries and monopolising the market. The MNC can then use its market power to
increase prices. Even if there is no domestic industry, the MNC could prevent one from
developing. This is more of a concern in smaller economies.
 There can be negative effects on the balance of payments. The repatriation of profits is one
such effect; also if the MNC imports materials from abroad it would have a negative effect.
 Loss of autonomy by the host country (usually in the case of smaller economies) is often
raised as a concern (it was one of the issues about Canada allowing FDI by China in the oil
sands). Although the text dismisses this issue there are potential problems. Many countries
often compete to bring in FDI by offering huge tax breaks or generous relocation grants. The
government may also spend on infrastructure etc. As we saw in the Silicon Glen example, if
the FDI does not last, the long term benefits may not accrue and the cost of attracting the
MNC will have exceeded the benefit.

Politics and FDI

Since the collapse of hard line communism and the realisation that it led to very poor economic
performances, FDI has increased with more countries moving towards freer markets. FDI has grown
faster than world trade in recent years, in part the result of the collapse of the Soviet Bloc, freer
markets in socialist African countries and liberalisation in China, India and Vietnam.
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However there are exceptions to this trend. Bolivia and Venezuela have become increasing hostile to
FDI (for example Bolivia nationalised gas fields).

Encouraging Outward FDI (how a government helps its own firms invest in other countries).
Investor nations often have government backed insurance to cover against losses from war,
nationalisation etc. Financially, governments in higher income countries make loans to firms for FDI
and have eliminated double taxing (getting taxed at home and abroad). Governments use their
political influence to persuade countries to relax restrictions on inward FDI.

Restricting Outward FDI (why governments would prevent its own firms investing abroad). A
country may want its firms to invest at home – it creates employment and improves the balance of
payments (if the firm exports its goods rather than making them abroad). It can be done through taxes
for example (taxing foreign earnings at a higher rate). It is also done as an economic sanction on a
country which is acting against the interests of a country (Canada for example has trade restrictions on
Syria and Iran)2.

Encouraging Inward FDI given that a country can often gain employment, technology and
management know-how, governments can be keen to encourage them to come to their country. This
usually takes the form of tax concessions, subsidies or low interest loans. They may have to offer a
better deal than a competing country. Canada has offered Toyota $34m. The text talks about the US
complaining that Canada has taken jobs from the Hollywood film industry by offering subsidies to
film makers to come to Toronto and Vancouver. In an update on this, there is a struggle within
Canada between BC, Quebec and Ontario to attract film companies. BC offers subsidies that cover
labour costs and Quebec and Toronto offer wider ranging subsidies (the BC tax credits are worth
$285m).3 See the Moodle link on what cities offered to Amazon in order to attract it.

Restricting Inward FDI the main reasons for this are national security and competition (the local
industry might not get a chance to develop). Local content requirements may be put in place if it is
believed that having local employees in a foreign firm will speed up the transfer of knowledge (i.e. we
can find out how to do something quicker than if all the employees were from the other country). It
applies to technology transfer as well as management.

What it all means

The decisions that you face with regard to whether you should export/import, licence or invest in FDI
are based costs and benefits of each case. These are not always easy to calculate; particularly when
you are trying to assess risks but the following can give you a start:

2
http://www.international.gc.ca/sanctions/index.aspx?view=d
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http://www.vancouverobserver.com/culture/support-bcs-film-industry-not-just-natural-resources-save-bc-film-organizer
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Transport costs/tariffs low Export

high

Can know-how be licenced? no FDI

yes

Tight Control of foreign yes FDI

operation needed?

no

Protection of property no FDI

in licensing is strong

yes

licence