Chapter 7

Foreign Direct Investment

International Business
 Foreign Direct Investment (FDI)
 Foreign direct investment (FDI) occurs when a firm invests directly
in
new facilities to produce and/or market in a foreign country
 Once a firm undertakes FDI it becomes a multinational enterprise
FDI is undertaken by firms so that they can take advantage of
resources that are either unavailable in the home country or because
these resources are available at costs lower than those in their home
country. As a result, the firm has significant control of its foreign
operation and can affect managerial decisions of the foreign operation
 FDI can be:
Acquisitions or mergers with existing firms in the foreign country
Greenfield investments - the establishment of a wholly new operation in a
foreign country
FDI In The World Economy

The flow of FDI refers to the amount of

FDI undertaken over a given time
period
The stock of FDI refers to the total
accumulated value of foreign-owned
assets at a given time
 Outflows of FDI are the flows of FDI
out
of a country
 Inflows of FDI are the flows of FDI
into a
 Trends In FDI
There has been a marked increase in both the flow and
stock of
FDI in the world economy over the last 30 years
 FDI has grown more rapidly than world trade and world
output
because:
firms still fear the threat of protectionism
the general shift toward democratic political institutions
and free
market economies has encouraged FDI
the globalization of the world economy is having a
positive
impact on the volume of FDI as firms undertake FDI to
 The Direction Of FDI
Most FDI has historically been directed at the developed nations
of the world, with the United States being a favorite target
FDI inflows have remained high during the early 2000s for the
United States, and also for the European Union
South, East, and Southeast Asia, and particularly China, are now
seeing an increase of FDI inflows
Latin America is also emerging as an important region for FDI

FDI Inflows by
Region ($ billion),
1995-2006
 The Direction Of FDI- Gross Fixed Capital
Gross fixed capital formation summarizes the total amount
of capital invested in factories, stores, office buildings, and the
like
All else being equal, the greater the capital investment in an
economy, the more favorable its future prospects are likely to
be
So, FDI can be seen as an important source of capital
investment and a determinant of the future growth rate ofFDI
Inward anas a %
economy of Gross Fixed
Capital Formation
1992-2005
 The Source Of FDI
Since World War II, the U.S. has been the largest source
country for
FDI
The United Kingdom, the Netherlands, France, Germany,
and
Japan are other important source countries

Cumulative FDI
Outflows ($ billions),
1998-2005
 Two General Ways to Initiate FDI
1) Mergers and acquisitions:
 Most cross-border investment is in the form of mergers and
acquisitions
 More prevalent in developed nations
 Firms prefer to acquire existing assets because:
 Mergers and acquisitions are quicker to execute than Greenfield
investments
 It is easier and perhaps less risky for a firm to acquire desired
assets than build them from the ground up
 firms believe that they can increase the efficiency of an acquired
unit by transferring capital, technology

2)Greenfield operation: Mostly in developing nations

 The Shift To Services
FDI is shifting away from extractive industries and
manufacturing, and towards services

The shift to services is being driven by:

 the general move in many developed countries toward
services
the fact that many services need to be produced where
they are consumed
a liberalization of policies governing FDI in services
the rise of Internet-based global telecommunications
networks
 Two forms of FDI
1) Horizontal Direct Investment
FDI in the same industry abroad as company operates at
home.

2) Vertical Direct Investment

Backward - investments into industry that provides inputs
into a firm’s domestic production (typically extractive
industries)
Forward - investment in an industry that utilizes the
outputs from a firm’s domestic production (typically sales
and distribution)
Decision Making Grid For FDI
and Implications for Business
FDI versus Exporting versus
Licensing
The market imperfections theory suggests
that exporting should be preferred to
licensing and horizontal FDI as long as
transport costs are minor and tariff barriers
are trivial. If that is not the case, then firms
should consider licensing and FDI.
Licensing tends not to be a good option in
high technology industries where protecting
firm specific know-how is critical, and in
industries where a firm must carefully
coordinate and orchestrate its worldwide
activities, or where there are intense cost
pressures.
FDI is more costly than licensing, but may be
the most reasonable option.
 The Pattern Of Foreign Direct Investment
Firms in the same industry often undertake foreign direct investment
around the same time and tend to direct their investment activities
towards certain locations
Knicker bocker suggested that FDI flows are a reflection of strategic rivalry
between firms in the global marketplace
The theory can be extended to embrace the concept of multipoint
competition (when two or more enterprises encounter each other in different
regional markets, national markets, or industries)
According to the 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
 externalities - knowledge spillovers that occur when companies in the same
industry locate in the same area
 Host-Country Benefits
There are four main benefits of inward FDI for a host country:

1. Resource transfer effects - FDI can make a positive

contribution to a host economy by supplying capital,
technology, and management resources that would otherwise
not be available
2. Employment effects - FDI can bring jobs to a host country
that would otherwise not be created there
 Direct: Hiring host-country citizens
 Indirect:
 Jobs created by local suppliers
 Jobs created by increased spending by employees of the multi-national
enterprise
 Host-Country Benefits
3. Balance of payments effects - a country’s balance of payment account
is a record of a country’s payments to and receipts from other countries.
The current account is a record of a country’s export and import of
goods and services
Governments typically prefer to see a current account surplus than a
deficit
FDI can help a country to achieve a current account surplus if the FDI
is a substitute for imports of goods and services, and if the MNE uses a
foreign subsidiary to export goods and services to other countries

4. Effects on competition and economic growth - FDI in the form of

Greenfield investment increases the level of competition in a market,
driving down prices and improving the welfare of consumers
Increased competition can lead to increased productivity growth,
product and process innovation, and greater economic growth
 Host-Country Costs
Inward FDI has three main costs:
1. The possible adverse effects of FDI on competition within the host nation-
subsidiaries of foreign MNEs may have greater economic power than indigenous
competitors because they may be part of a larger international organization
2. Adverse effects on the balance of payments
with the initial capital inflows that come with FDI must be the subsequent
outflow of capital as the foreign subsidiary repatriates earnings to its parent
country
when a foreign subsidiary imports a substantial number of its inputs from
abroad, there is a debit on the current account of the host country’s balance of
payments
3. The perceived loss of national sovereignty and autonomy
key decisions that can affect the host country’s economy will be made by a
foreign parent that has no real commitment to the host country, and over which
the host country’s government has no real control
 Benefits of FDI to the Home Country
 Improves balance of payments for inward flow of foreign earnings

 Creates a demand for exports.

 Export demand can create jobs

 Increased knowledge from operating in a foreign environment

 Benefits the consumer through lower prices

 Frees up employees and resources for higher value activities

 Costs of FDI to the
Home Country
Negative effect on Balance of Payments
Initial capital outflow
MNC uses foreign subsidiary to sell back to
home market
MNC uses foreign subsidiary as a substitute
for direct exports
Potential loss of jobs
Home Country Policies and FDI
To encourage outward Restricting Outward
FDI FDI
 Government backed  Limit capital outflows
insurance programs to out of concern for the
cover foreign country’s balance of
investment risk payments
 Capital assistance  Tax incentives to invest
 Tax incentives at home
 Political pressure  Prohibit national firms
from investing in certain
countries for political
reasons
Host Country Policies and FDI
Encouraging Restricting Inward FDI
Ownership restraints
Inward FDI Foreign firms are
Offer government prohibited to operate in
incentives to foreign certain fields
Foreign ownership is
firms to invest
Tax concessions allowed but a significant
proportion of the equity
Low interest loans must be owned by local
Grants/subsidies investors
Performance requirements
that control the behavior of
the MNE’s local subsidiary
 International Institutions And
The Liberalization Of FDI

Until the 1990s, there was no consistent involvement by

multinational institutions in the governing of FDI

Today, the World Trade Organization is changing this by

trying to establish a universal set of rules designed to
promote the liberalization of FDI
 Implications For Managers

•Managers need to consider what trade theory implies, and

the link between government policy and FDI

• A host government’s attitude toward FDI is an important

variable in decisions about where to locate foreign
production facilities and where to make a foreign direct
investment
Questions…