china and mexico
Debate Merits of Doing Business with either China or Mexico
Discuss the pros and cons of doing business in Mexico and China respectively.
Britain has been a favored destination of foreign direct investment (FDI) from India since economic reforms were launched in the early 1990s. According to a UK Trade and Investment (UKTI) report, Indian FDI helped create as many as 7,255 jobs in Britain in 2012 alone. From a recent Ernst and Young report, 49% of India’s outward FDI goes to Britain, and India has been among the top five countries undertaking FDI in Britain. Among the Brazil, Russia, India, China and South Africa (BRICS) countries, India ranks first in terms of FDI in Britain. The Tata Group alone employs more than 50,000 employees in 19 companies operating in the UK. It is now the largest private-sector employer in the UK. In total, more than 100,000 jobs are created by Indian FDI in Britain. The 2008 acquisition of Land Rover and Jaguar from Ford by Tata for more than US$2.3 billion was a signifi- cant milestone of Indian FDI in Britain. Turning around the initial losses and tripling revenues have become a new success story of profitable acquisitions by multinationals from a developing country. In a Grant Thornton report, the top 41 fastest-growing Indian companies in Britain contribute more than US$30 billion in revenue. Automotive, service, technology, and telecommunication sectors dominate the largest contributors. The Indian government’s continued reforms in FDI policies and the booming entrepreneurial culture in India further aid the overall outward FDI from India. The inflows of dividends from overseas investments in joint ventures and wholly owned subsidiaries enjoy a 50% reduction in the tax rate. There are also some tax benefits and incentives for businesses created with FDI outflow. With the election of Narendra Modi as the prime minister in the elections of May 2014, there is increased optimism in economic growth, which may further aid FDI initiatives. In 2011, India overtook Ireland in the number of non-UK-born residents in Britain, although Ireland is so much closer geographically. Hundreds of years of cultural links, an increasing Indian diaspora in Britain, and the growing stature of India are significant con- tributors behind the increase of Indian FDI in Britain. While the manufacturing export segment in the UK is weak, increase of FDI from emerging economies, such as India, would help boost the manufactur- ing segment and propel exports from Britain (such as Made-in-UK Jaguar and Land Rover) to emerging economies. However, not all is rosy. While not specific to Britain, Indian outward FDI growth has potential risks. A key risk is foreign currency exchange fluctua- tions. Purchase of foreign exchange in India is one of the common methods of funding overseas invest- ments, while swapping of shares of an Indian entity with those of an overseas entity and capitalization of foreign currency proceeds received for trade is also often used. With India’s heavy exposure to oil imports and current account deficit, Indian investors must be extremely careful about foreign exchange fluctuations. In a span of two months between July and August 2013, the Indian rupee (INR) deva- lued by more than 15%. Indian overseas investors could be heavily exposed to such currency fluctua- tions. Such steep fluctuations prompted the Reserve Bank of India to institute several measures, including limiting the amount of FDI outflows—thus putting projects on hold. Although these restrictive mea- sures have been subsequently relaxed, they show a critical weakness associated with Indian outward FDI in general. Although India and Britain share a special and long relationship hailed as a “relationship of choice,” shifting dynamics in the global economy, according to the Economist, makes India and Britain an “odd couple.” Simply put, they do not trade a lot. Global trade statistics show that India is ranked 18th on the list of Britain’s export destinations and 17th as a supplier of imports. China’s trade volume with India is four times that of Britain. In September 2014, China and India signed deals worth more than US$20 billion and trade winds are blowing differently than before. In addition, although the September 2014 referendum for Scotland independence was rejected by a 55-45 vote, the underlying currents create uncertainty in the minds of Indian executives entertaining FDI in Britain, when many other opportunities exist elsewhere in the world. India’s political winds are also uncertain and can change for populist schemes for electoral gains. Given these risks and uncertainties in the global economy, multinationals from India and their partners in Britain would have to be persistent in order to sustain the momentum and realize the growth potential. Why are many Indian firms increasingly interested in outward foreign direct invest- ment (FDI)? Why are they interested in Britain in particular? Why do some of them succeed and others struggle? Recall from Chapter 1 that FDI is defined as directly investing in activities that control and manage value creation in other countries.1 Also recall from Chapter 1 that firms that engage in FDI are known as multinational enter- prises (MNEs). In 2014, while most developed economies slowly recovered from the Great Recession of 2008–2009, emerging economies as a group attracted approxi- mately 60% of the FDI inflows. Firms from emerging economies, such as those from India discussed in the Opening Case, generated approximately 40% of FDI outflows worldwide.2 This chapter starts by first clarifying the FDI terms. Then we address a crucial question: Why do firms engage in FDI? We outline how the two core perspectives introduced earlier—namely, resource-based and institution-based views—can help answer this question.3 Debates and implications for action follow. 6-1 Understanding the FDI Vocabulary Part of FDI’s complexity is associated with the vocabulary. We will try to reduce this complexity by setting the terms straight in this section. 6-1a The Key Word Is D International investment can be made primarily in two ways: FDI and foreign portfolio investment (FPI). FPI refers to investment in a portfolio of foreign securi- ties, such as stocks and bonds, that do not entail the active management of foreign assets. Essentially, FPI is “foreign indirect investment.” In contrast, the key word in FDI is D (direct)—the direct hands-on management of foreign assets. While reading this book, some of you may have some FPI at the same time—that is, you own some foreign stocks and bonds. However, as a student taking this course, it is by definition impossible that you are also engaging in FDI at the same time, which requires you to be a manager getting your feet “wet” by actively managing foreign operations. For statistical purposes, the United Nations defines FDI as an equity stake of 10% or more in a foreign-based enterprise.4 Without a sufficiently large equity, it is difficult to exercise management control rights—namely, the rights to appoint key managers and establish control mechanisms. Many firms invest abroad for the explicit purpose of managing foreign operations, and they need a large equity (sometimes up to 100%) to be able to do that. 6-1b Horizontal and Vertical FDI FDI can be horizontal or vertical. Recall the value chain from Chapter 4, whereby firms perform value-adding activities stage-by-stage in a vertical fashion, from upstream to downstream. When a firm duplicates its home country-based activities at the same value- chain stage in a host country through FDI, we call this horizontal FDI (see Figure 6.1). For example, BMW makes cars in Germany. Through horizontal FDI, it does the same thing in the United States. Overall, horizontal FDI refers to producing the same prod- ucts or offering the same services in a host country as firms do at home. If a firm through FDI moves upstream or downstream in different value-chain stages in a host country, we label this vertical FDI (Figure 6.2). For instance, if BMW (hypothetically) only assembles cars and does not manufacture components in Germany, but in Indonesia it enters into components manufacturing through FDI (an upstream activity), this would be upstream vertical FDI. Likewise, if BMW does not engage in car distribution in Germany but invests in car dealerships in Egypt (a downstream activity), it would be downstream vertical FDI
6-1c FDI Flow and Stock Another pair of words often used is flow and stock. FDI flow is the amount of FDI moving in a given period (usually a year) in a certain direction. FDI inflow usually refers to inbound FDI moving into a country in a year, and FDI outflow typically refers to outbound FDI moving out of a country in a year. Figures 6.3 and 6.4 illus- trate the top ten economies receiving inflows and generating outflows. FDI stock is the total accumulation of inbound FDI in a country or outbound FDI from a country. Hypothetically, between two countries A and B, if firms from A undertake US$10 billion of FDI in B in Year 1 and another US$10 billion in Year 2, then we can say that in each of these two years, B receives annual FDI inflows of US$10 bil- lion and, correspondingly, A generates annual FDI outflows of US$10 billion. If we assume that firms from no other countries undertake FDI in country B and prior to Year 1 no FDI was possible, then the total stock of FDI in B, by the end of Year 2, is US$20 billion. Essentially, flow is a snapshot of a given point in time, and stock represents cumulating volume. 6-1d MNE versus non-MNE An MNE, by definition, is a firm that engages in FDI when doing business abroad.5 An MNE is sometimes called a multinational corporation (MNC) or a transnational corporation (TNC). To avoid confusion, we will stick with the term “MNE” through- out the book. Note that non-MNE firms can also do business abroad, by (1) export- ing and importing, (2) licensing and franchising, (3) outsourcing, (4) engaging in FPI, or other means. What sets MNEs apart from non-MNEs is FDI. An exporter has to undertake FDI in order to become an MNE. In other words, BMW would not be an MNE if it made all its cars in Germany and exported them around the world. BMW became an MNE only when it started to directly invest abroad. Although a lot of people believe that MNEs are a new organizational form that emerged recently, that is not true. MNEs have existed for at least 2,000 years, with some of the earliest traces discovered in the Assyrian, Phoenician, and Roman times.6 In 1903 when Ford Motor Company was founded, it exported its sixth car. Ford almost immediately engaged in FDI by having a factory in Canada that pro- duced its first output in 1904.7 It is true that MNEs have experienced significant growth since World War II. In 1970, there were approximately 7,000 MNEs world- wide. By 2010, more than 82,000 MNEs managed approximately 810,000 foreign affiliates.8 Clearly, there is a proliferation of MNEs lately. 6-2 Why Do Firms Become MNEs by Engaging in FDI? Having set the terms straight, we need to address a fundamental question: Why do so many firms—ranging from those in the ancient world to today’s GE and Tata— become MNEs by engaging in FDI? Without getting into details, we can safely say that there must be economic gains from FDI. More importantly, given the tremendous complexities, such gains must significantly outweigh the costs. What are the sources of such gains? The answer, as suggested by British scholar John Dunning and illustrated in Figure 6.5, boils down to firms’ quest for ownership (O) advantages, location (L) advantages, and internalization (I) advantages— collectively known as the OLI advantages.9 The two core perspectives introduced earlier, resource-based and institution-based views, enable us to probe into the heart of this question. In the context of FDI, ownership refers to MNEs’ possession and leveraging of certain valuable, rare, hard-to-imitate, and organizationally embedded (VRIO) assets overseas. Owning proprietary technology and management know-how that goes into making a BMW helps ensure that the MNE can beat rivals abroad. Location advantages are those enjoyed by firms because they do business in a certain place. Features unique to a place, such as its natural or labor resources or its location near particular markets, provide certain advantages to firms doing business there. For example, Vietnam has emerged as a convenient location for MNEs that want to diversify away from coastal China due to rising labor costs. From a resource-based view, an MNE’s pursuit of ownership and location advantages can be regarded as flexing its muscles—its resources and capabilities—in global competition. Internalization refers to the replacement of cross-border markets (such as exporting and importing) with one firm (the MNE) locating in two or more coun- tries. For example, instead of selling its technology to a Indonesian firm for a fee (which is a non-FDI-based market entry mode technically called licensing), BMW assembles cars in Indonesia via FDI. In other words, external market transactions (in this case, buying and selling of technology through licensing) are replaced by internalization. From an institution-based view, internalization is a response to the imperfect rules governing international transactions—known as market imperfections (or market failure). Evidently, Indonesian regulations governing the protection of intellectual property such as BMW’s proprietary technology do not give BMW sufficient confidence that its rights will be protected. Therefore, inter- nalization is a must. Overall, firms become MNEs because FDI provides the three-pronged OLI advantages that they otherwise would not obtain. The next three sections outline why this is the case. In addition, MNEs also enjoy some other advantages, such as being able to reduce tax payments by tapping into favorable rules of the game around the world (In Focus 6.1 We often treat each multinational enterprise (MNE) as one firm, regardless of how many countries it operates in. However, from an institution-based standpoint, one can argue that a “multinational” enterprise may be a total fiction that does not exist. This is because, legally, incorporation is only possible under national law, every so-called MNE is essentially a bunch of national companies (subsidiaries) regis- tered in various countries. A generation ago, such firms were often labeled “multi-national companies” with a hyphen. Although some pundits argue that globalization is undermining the power of national governments, there is little evidence that the mod- ern nation-state system, in existence since the 1648 Treaty of Westphalia, is retreating. This debate is not just academic hair-splitting fight- ing over a hyphen. It is very relevant and stakes are high. In 2010, Zhejiang Geely Holding Group (in short, “Geely”) of China acquired Volvo Car Corporation (Volvo Personvagnar AB in Swedish—in short, “Volvo Cars” in English) from Ford Motor Company of the United States for US$1.8 billion. Volvo Cars thus became a wholly owned subsidiary of Geely. Everybody in the world, including Geely’s owner Li Shufu, thought Volvo Cars was “Chinese”—except the Chinese govern-
ment. Refusing to acknowledge the existence of any “multinational,” the Chinese government maintained that Volvo Cars, registered in Sweden and headquar- tered in Gothenburg, Sweden, was Swedish. When Li sought to produce Volvo vehicles in Chengdu, Daqing, and Zhangjiakou in China, the government advised that he set up a new joint venture (JV) between Volvo Cars (a Swedish firm) and Geely (a Chinese firm). Since Li was chairman of the board for Volvo Cars and chairman of the board for Geely, he ended up signing both sides of the JV contract. In other words, one individual repre- sented both the Swedish firm and the Chinese firm (!). In 2013, the Chinese government approved this new international JV, in which the Swedish side (Volvo Cars) owned 30% equity. If Li signing his name twice on a JV contract is funny, a more serious case in point concerns tax avoi- dance. Legally, Google Ireland is not a branch of the US-based Google Corporation. Although 100% owned by Google Corporation, Google Ireland is a separate, legally independent corporation registered in Ireland. While Google Corporation intentionally lets Google Ireland earn a lot of profits, the US Internal Revenue Service (IRS) cannot tax a dime Google Ireland makes, unless it sends back (repatriates) the profits to Google Corporation. Google Corporation does not have just one subsidiary. It has many around the world. Overall, 54% of Google’s profits are parked overseas and are not taxable by the IRS. Google is not alone. The list of leading US firms that have left a majority of their profits overseas includes Chevron, Cisco, Citigroup, ExxonMobil, GE, HP, IBM, Johnson & Johnson, Microsoft, P&G, PepsiCo, and Pfizer. Running huge budget deficits, Congress is understandably furious. 6-3 Ownership Advantages All investments, including both FDI and FPI, entail ownership of assets. So, what is unique about FDI? This section (1) highlights the benefits of direct ownership, and (2) compares FDI to licensing when entertaining market entries abroad. 6-3a The Benefits of Direct Ownership Remember the key word of FDI is D (direct) and it requires a significant equity ownership position. The benefits of ownership lie in the combination of equity own- ership rights and management control rights. Specifically, it is significant owner- ship rights that provide much needed management control rights. In contrast, FPI represents essentially insignificant ownership rights but no management control rights. To compete successfully, firms must deploy overwhelming resources and capabilities to overcome their liabilities of foreignness (see Chapters 1 and 4). FDI provides one of the best ways to facilitate such extension of firm-specific resources and capabilities abroad. 6-3b FDI versus Licensing When entering foreign markets, basic entry choices include (1) exporting, (2) licens- ing, and (3) FDI. Successful exporting may provoke protectionist responses from host countries, thus forcing firms to choose between licensing and FDI (see Chapters 5 and 10). Between licensing and FDI, which is better? Three reasons may compel firms to prefer FDI to licensing (Table 6.1). First, FDI affords a high degree of direct management control that reduces the risk of firm-specific resources and capabilities being opportunistically taken advan- tage of. One of the leading risks abroad is dissemination risks, defined as the pos- sibility of unauthorized diffusion of firm-specific know-how. If a foreign company grants a license to a local firm to manufacture or market a product, the licensee (or an employee of the licensee) may disseminate the know-how by using it against the wishes of the foreign company. For instance, Pizza Hut found out that its long- time licensee in Thailand disseminated its know-how and established a direct com- petitor, simply called The Pizza Company, which controlled 70% of the market in Thailand.10 While owning and managing proprietary assets through FDI does not completely shield firms from dissemination risks (after all, their employees can quit and join competitors), FDI is better than licensing that provides no manage- ment control at all. Understandably, FDI is extensively used in knowledge-intensive, high-tech industries, such as automobiles, electronics, chemicals, and IT. Second, FDI provides more direct and tighter control over foreign operations. Even when licensees (and their employees) harbor no opportunistic intention to take away “secrets,” they may not follow the wishes of the foreign firm that provides the know-how. Without FDI, the foreign firm cannot order or control its licensee to move ahead. For example, Starbucks entered South Korea by licensing its format to ESCO. Although ESCO soon opened ten stores, Starbucks felt that ESCO was not aggressive enough. But there was very little Starbucks could do. Eventually, Starbucks switched from licensing to FDI, which allowed Starbucks to directly call “the shots” and promote the aggressive growth of the chain in South Korea. Finally, certain knowledge (or know-how) calls for FDI, as opposed to licens- ing. Even if there is no opportunism on the part of licensees and if they are will- ing to follow the wishes of the foreign firm, certain know-how may be simply too difficult to transfer to licensees without FDI. Knowledge has two basic categories: (1) explicit and (2) tacit. Explicit knowledge is codifiable (i.e., it can be written down and transferred without losing much of its richness). Tacit knowledge, on the other hand, is non-codifiable and its acquisition and transfer requires hands-on practice. For instance, a driving manual represents a body of explicit knowledge. However, mastering this manual without any road practice does not make you a good driver. Tacit knowledge is evidently more important and harder to transfer and learn—it can only be acquired through learning by doing (in this case, driv- ing practice supervised by an experienced driver). Likewise, operating a Wal-Mart store entails a great deal of knowledge, some explicit (often captured in an opera- tional manual) and some tacit. However, simply giving foreign licensees a copy of the Wal-Mart operational manual will not be enough. Foreign employees will need to learn from experienced Wal-Mart personnel side-by-side (learning by doing). From a resource-based standpoint, it is Wal-Mart’s tacit knowledge that gives it competitive advantage (see Chapter 4). Wal-Mart owns such crucial tacit knowledge, and has no incentive to give it away to licensees without having some management control over how such tacit knowledge is used. Therefore, properly transferring and controlling tacit knowledge calls for FDI. Overall, ownership advantages enable the firm, now becoming an MNE, to more effectively extend, transfer, and leverage firm-specific capabilities abroad.11 Next, we discuss location advantages. 6-4 Location Advantages The second key word in FDI is F, referring to a foreign location. Given the well-known liability of foreignness, foreign locations must offer compelling advantages.12 This section (1) highlights the sources of location advantages and (2) outlines ways to acquire and neutralize location advantages. 6-4a Location, Location, Location Certain locations possess geographical features that are difficult to match by oth- ers. We may regard the continuous expansion of international business (IB), such as FDI, as an unending saga in search of location advantages.13 For example, although Austria politically and culturally belongs to the West, the country is geographically located in the heart of Central and Eastern Europe (CEE). In fact, Austria’s capital Vienna is actually east of Prague, the Czech Republic, and Ljubljana, Slovenia. Not surprisingly, Vienna attracts significant FDI from MNEs to set up regional head- quarters for CEE. Due to its proximity to the United States, Mexico attracts numer- ous automakers to set up production there. Thanks to such FDI, 64% of Mexico’s vehicle production is exported to the United States (see the Closing Case). Beyond natural geographical advantages, location advantages also arise from the clustering of economic activities in certain locations—referred to as agglomeration. For instance, the Netherlands grows and exports two-thirds of the world’s exported cut flowers. Dallas attracts all of the world’s major telecom equip- ment makers and many telecom service providers, making it the Telecom Corridor. Denmark enjoys the clustering of the world’s leading wind turbine makers and sup- pliers (In Focus 6.2). Overall, agglomeration advantages stem from: ●● Knowledge spillovers (knowledge being diffused from one firm to oth- ers) among closely located firms that attempt to hire individuals from competitors.14 ●● Industry demand that creates a skilled labor force whose members may work for different firms without having to move out of the region. ●● Industry demand that facilitates a pool of specialized suppliers and buyers also located in the region.15 6-4b Acquiring and Neutralizing Location Advantages Note that from a resource-based view, location advantages do not entirely overlap with country-level advantages such as factor endowments discussed in Chapter 5. Location advantages refer to the advantages one firm obtains when operating in one location due to its firm-specific capabili- ties. In 1982, General Motors (GM) ran its Fremont, California, plant to the ground and had to close it. Reopening the same plant, Toyota in 1984 initiated its first FDI proj- ect in the United States (in a joint venture [JV] with GM). Since then, Toyota (together with GM) has leveraged this plant’s location advantages by producing award-winning cars that American customers particularly like, the Toyota Corolla and Tacoma. The point is: it is Toyota’s unique capabilities, applied to the California location, that literally saved this plant from its demise. The California location in itself does not provide location advantages per se, as shown by GM’s inability to make it work prior to 1982. Firms do not operate in a vacuum. When one firm enters a foreign country through FDI, its rivals are likely to follow by undertaking additional FDI in a host country to either (1) acquire location advantages themselves or (2) at least neutral- ize the first mover’s location advantages. These actions to follow competitors are especially likely in industries characterized by oligopoly—industries populated by a small number of players (such as aerospace and semiconductors).16 The automo- bile industry is a typical oligopolistic industry. In China, Volkswagen was the first foreign entrant, starting production in 1985 and enjoying a market share of 60% in the 1990s. Now, every self-respecting global automaker has entered China try- ing to eat some of Volkswagen’s lunch. Overall, competitive rivalry and imitation, especially in oligopolistic industries, underscores the importance to acquire and neutralize location advantages around the world. On a clear day, passengers with window seats on planes taking off and landing at Copenhagen airport can clearly see dozens of huge wind turbines offshore in Oresund (the straight that separates Denmark and Sweden). Chances are that these wind turbines are also developed and made in Denmark. Thanks to vision- ary government policies that offer generous subsidies, Denmark is a first mover, and now a world leader, in the wind turbine industry. At present, one-third of Dan- ish energy consumption comes from wind. No other country comes close. Denmark’s goal is to become the first country in the world to meet 50% of energy needs with wind power by 2020 and 100% by 2050. Underpinning these achievements and ambitions is a cluster of wind turbine manufacturers and suppli- ers in one part of Denmark—Jutland, the peninsula in western Denmark that is attached to the European mainland (Copenhagen is located in the easternmost part of the country on the island of Zealand). Based in Aarhus (Denmark’s second largest city), Vestas is the world leader in terms of installed tur- bines (60 GW), accounting for nearly one-fifth of the total capacity of all the installed turbines in the world. Founded in 1979, Vestas employs 15,000 people, including 4,000 in Denmark. About 80 kilometers west of Aarhus, in the small town of Brande, Siemens Wind Power is headquar- tered. Founded in 2004 following the acquisi- tion of Bonus Energy, which was established in 1979, Siemens Wind Power (a division of Siemens) is another giant in this industry. It has 23 GW installed turbines and 11,000 employees worldwide (of which 5,500 are in Denmark). In addition, major Danish-owned suppliers LM Wind Power and AH Industries are also nearby. Attracted by the greatest agglomeration of know-how in this specialized but rapidly expand- ing industry, a number of international wind tur- bine manufacturers, such as India’s Suzlon and China’s Envision Energy, have also undertaken foreign direct investment (FDI) in this region of Denmark. With an investment of US$400 mil- lion, recently established a 50-50 joint venture with Vestas named MHI Vestas Offshore Wind that focuses on the huge 8.0 MW turbines. Anders Rebsdorf, director of Envision Energy (Denmark) located in Silkeborg, a town almost equidistance between the global head- quarters of the two giants Vestas and Siemens Wind Power, articulated the firm’s location choice: Our choice of Denmark is directly related to the country’s strong cluster of know-how in the area of turbine design. It is also important that there are manufacturers of turbine components and experts in turbine service.The entire value chain is represented to a degree that is not found any- whereelse...Ifwearetoearntherighttojoin the battle for international orders, then we must be visible where the competition is fierce. 6-5 Internalization Advantages Known as internalization, another great advantage associated with FDI is the abil- ity to replace the external market relationship with one firm (the MNE) owning, controlling, and managing activities in two or more countries.17 This is important because of significant imperfections in international market transactions. The institution-based view suggests that markets are governed by rules, regulations, and norms that are designed to reduce uncertainties.18 Uncertainties introduce trans- action costs—costs associated with doing business (see Chapter 2). This section (1) outlines the necessity to combat market failure, and (2) describes the benefits brought by internalization. 6-5a Market Failure International transaction costs tend to be higher than domestic transaction costs. Because laws and regulations are typically enforced on a nation-state basis, if one party from country A behaves opportunistically, the other party from country B will have a hard time enforcing the contract. Suing the other party in a foreign country is not only costly, but also uncertain. In the worst case, such imperfections are so grave that markets fail to function, and many firms choose not to do busi- ness abroad to avoid being “burned.” Thus, high transaction costs can result in market failure—the imperfections of the market mechanisms that make transac- tions prohibitively costly and sometimes make transactions unable to take place. However, recall from Chapter 5 that there are gains from trade. In response, MNEs emerge to overcome and combat such market failure through FDI How do MNEs combat market failure through internalization? Let us use a simple example: An oil importer, BP in Britain, and an oil exporter, Nigerian National Petroleum Corporation (NNPC) in Nigeria. For the sake of our discussion, assume that BP does all its business in Britain and NNPC does all its business in Nigeria— in other words, none of them is an MNE for the time being. BP and NNPC negoti- ate a contract that specifies that NNPC will export from Nigeria a certain amount of crude oil to BP’s oil refinery facilities in Britain for a certain amount of money. Shown in Figure 6.6, this is both an export contract (from NNPC’s perspective) and an import contract (from BP’s standpoint) between two firms. However, this international market transaction between an importer and an exporter may suffer from high transaction costs. What is especially costly is the potential opportunism on both sides. For example, NNPC may demand a higher- than-agreed-upon price, citing a variety of reasons, such as inflation, natural disas- ters, or simply rising oil price, after the deal is signed. BP thus has to either (1) pay more than the agreed-upon price or (2) refuse to pay and suffer from the huge costs of keeping expensive refinery facilities idle. In other words, NNPC’s opportu- nistic behavior can cause a lot of BP’s losses. Opportunistic behavior can go both ways in a market transaction. In this partic- ular example, BP can also be opportunistic. For instance, BP may refuse to accept a shipment after its arrival from Nigeria, citing unsatisfactory quality, but the real reason could be BP’s inability to sell refined oil downstream because gasoline demand is going down (in a recession, the jobless do not need to commute to work). NNPC is thus forced to find a new buyer for a huge tanker load of crude oil on a last-minute, “fire sale” basis with a deep discount, losing a lot of money. Overall, in a market (export/import) transaction, once one side behaves oppor- tunistically, the other side will not be happy and will threaten or initiate lawsuits. Because the legal and regulatory frameworks governing such international trans- actions are generally not as effective as those governing domestic transactions, the injured party will generally be frustrated, whereas the opportunistic party can often get away. All these are examples of transaction costs that increase international market inefficiencies and imperfections, ultimately resulting in market failure. In response, FDI combats such market failure through internalization. The MNE reduces cross-border transaction costs and increases efficiencies by replacing an external market relationship with a single organization spanning both countries— in a process called internalization (transforming the external market with in-house links).19 In theory, there can be two possibilities: (1) BP undertakes upstream vertical FDI by owning oil production assets in Nigeria, or (2) NNPC undertakes downstream vertical FDI by owning oil refinery assets in Britain (Figure 6.7). FDI essentially transforms the international trade between two independent firms in two countries to intrafirm trade between two subsidiaries in two countries controlled by the same MNE. 20 The MNE is thus able to coordinate cross-border activities better. Such advantage is called internalization advantage. Overall, the motivations for FDI are complex. Based on resource-based and institution-based views, we can see FDI as a reflection of both (1) firms’ motivation to extend firm-specific capabilities abroad and (2) their responses to overcome market imperfections and failures. 6-6 Realities of FDI The realities of FDI are intertwined with politics. This section starts with three political views on FDI, followed by a discussion of pros and cons of FDI for home and host countries.
6-6a Political Views on FDI There are three primary political views on FDI. First, the radical view is hostile to FDI. Tracing its roots to Marxism, the radical view treats FDI as an instrument of imperialism and as a vehicle for exploitation of domes- tic resources by foreign capitalists and firms. Govern- ments embracing the radical view often nationalize MNE assets, or simply ban (or discourage) inbound MNEs. Between the 1950s and the early 1980s, the radi- cal view was influential throughout Africa, Asia, Eastern Europe, and Latin America.21 However, the popularity of this view is in decline worldwide, because (1) eco- nomic development in these countries was poor in the absence of FDI, and (2) the few developing countries (such as Singapore) that embraced FDI attained envi- able growth (see Chapter 1) On the other hand, the free market view suggests that FDI, unrestricted by gov- ernment intervention, will enable countries to tap into their absolute or compara- tive advantages by specializing in the production of certain goods and services. Similar to the win-win logic for international trade as articulated by Adam Smith and David Ricardo (see Chapter 5), free market-based FDI will lead to a win-win situation for both home and host countries. Since the 1980s, a series of countries, such as Brazil, China, Hungary, India, Ireland, and Russia, have adopted more FDI-friendly policies. However, in practice, a totally free market view on FDI does not really exist. Most countries practice pragmatic nationalism—viewing FDI as having both pros and cons and only approving FDI when its benefits outweigh costs. The French government, invoking “economic patriotism,” has torpedoed several foreign takeover attempts of French firms. The Chinese government insists that automo- bile FDI has to take the form of JVs with MNEs so that Chinese automakers can learn from their foreign counterparts. The US government has expressed alleged “national security concerns” over the FDI made by Chinese telecom equipment makers Huawei and ZTE.22 More countries in recent years have changed their policies to be more favorable to FDI. Even hardcore countries that practiced the radical view on FDI, such as Cuba and North Korea, are now experimenting with some opening to FDI, which is indicative of the emerging pragmatic nationalism in their new thinking. How- ever, there is some creeping increase of restrictions in the form of policies dis- couraging inbound FDI in some countries. For example, France and Russia have recently issued decrees reinforcing control for FDI in the interest of public security or national defense. 6-6b Benefits and Costs of FDI to Host Countries Underpinning pragmatic nationalism is the need to assess the various benefits and costs of FDI to host (recipient) countries and home (source) countries (see the Closing Case). In a nutshell, Figure 6.8 outlines these considerations. This section focuses on host countries, and the next section deals with home countries. Cell 1 in Figure 6.8 shows four primary benefits to host countries:23 ●● Capital inflow can help improve a host country’s balance of payments. (See Chapter 7 for more coverage on balance of payments.) ●● Technology, especially more advanced technology from abroad, can create technology spillovers that benefit domestic firms and industries.24 Local rivals, after observing such technology, may recognize its feasibility and strive to imi- tate it. This is known as the demonstration effect—sometimes also called the contagion (or imitation) effect.25 It underscores the important role that MNEs play in stimulating competition in host countries.26 ●● Advanced management know-how may be highly valued. It is often difficult for indigenous development of management know-how to reach a world-class level in the absence of FDI (see the Closing Case). ●● FDI creates a total of 80 million jobs, which represent approximately 4% of the global workforce.27 FDI creates jobs both directly and indirectly. Direct benefits arise when MNEs employ individuals locally. In Ireland, more than 50% of the manufacturing employees work for MNEs.28 In the UK, the largest private sector employer is an MNE: India’s Tata has 50,000 employees in the UK (see the Open- ing Case).29 Indirect benefits include jobs created when local suppliers increase hiring and when MNE employees spend money locally resulting in more jobs. Cell 2 in Figure 6.8 outlines three primary costs of FDI to host countries: (1) loss of sovereignty, (2) adverse effects on competition, and (3) capital outflow. The first concern is the loss of some (but not all) economic sovereignty associated with FDI. Because of FDI, decisions to invest, produce, and market products and/or to close plants and lay off workers in a host country are being made by foreigners—or if locals serve as heads of MNE subsidiaries, they represent the interest of foreign firms. Will foreigners and foreign firms make decisions in the best interest of host countries? This is truly a “million dollar” question. According to the radical view, the answer is “No!” because foreigners and foreign firms are likely to maximize their own profits by exploiting people and resources in host countries. Such deep suspicion of MNEs leads to policies that discourage or even ban FDI. On the other hand, countries embracing free market and pragmatic nationalism views agree that despite some acknowledged differences between foreign and host country interests, there is a sufficient overlap of interests between MNEs and host countries. Thus, host countries are willing to live with some loss of sovereignty. A second concern is associated with the negative effects on local competition. While we have just discussed the positive effects of MNEs on local competition, it is possible that MNEs may drive some domestic firms out of business. Having driven domestic firms out of business, MNEs, in theory, may be able to monopo- lize local markets. While this is a relatively minor concern in developed econo- mies, this is a legitimate concern for less-developed economies, where MNEs are of such a magnitude in size and strength and local firms tend to be signifi- cantly weaker. For example, as Coca-Cola and PepsiCo extend their “cola wars” from the United States around the world, they have almost “accidentally” wiped out much of the world’s indigenous beverages companies, which are—or were— much smaller. A third concern is associated with capital outflow. When MNEs make profits in host countries and repatriate (send back) such earnings to headquarters in home countries, host countries experience a net outflow in the capital account in their balance of payments. As a result, some countries have restricted the ability of MNEs to repatriate funds. Another issue arises when MNE subsidiaries spend a lot of money to import components and services abroad, which also results in outflows of capital and reduction of tax revenue (see In Focus 6.1). 6-6c Benefits and Costs of FDI to Home Countries As exporters of capital, technology, management, and (in some cases) jobs, home (source) countries often reap benefits and endure costs associated with FDI that are opposite to those experienced by host countries. In Cell 3 of Figure 6.8, three benefits to home countries are: ●● ●● ●● Repatriated earnings from profits from FDI. Increased exports of components and services to host countries. Learning via FDI from operations abroad. Shown in Cell 4 in Figure 6.8, costs of FDI to home countries primarily center on (1) capital outflow and (2) job loss. First, since host countries enjoy capital inflow because of FDI, home countries naturally suffer from some capital out- flow. Less-confident home country governments often impose capital controls to prevent or reduce FDI from flowing abroad. However, this concern is now less significant, as many governments realize the benefits eventually brought by FDI outflows. Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. The second concern is now more prominent: job loss. Many MNEs simultane- ously invest abroad by adding employment overseas and curtail domestic produc- tion by laying off employees. It is not surprising that restrictions on FDI outflows have been increasingly vocal, called for by politicians, union members, journalists, and activists in many developed economies. 6-7 How MNES and Host Governments Bargain MNEs react to various policies by bargaining with host governments. The outcome of MNE-host government relationship, namely, the scale and scope of FDI in a host country, is a function of the relative bargaining power of both sides—the ability to extract favorable outcome from negotiations due to one party’s strengths. MNEs typically prefer to minimize the intervention from host governments and maximize the incentives provided by host governments. Host governments usually want to ensure a certain degree of control and minimize the incentives provided to MNEs. Sometimes, host governments “must coerce or cajole the multinationals into under- taking roles that they would otherwise abdicate.”30 However, host governments have to “induce, rather than command,” because MNEs have options elsewhere.31 Dif- ferent countries, in effect, are competing with each other for precious FDI dollars. Shown in Figure 6.9, FDI is not a zero-sum game. The negotiations are charac- terized by the “three Cs”: common interests, conflicting interests, and compro- mises.32 The upshot is that despite conflicts, the interests of both sides may converge on an outcome that makes each side better off.3 Typically, FDI bargaining is not one round only. After the initial FDI entry, both sides may continue to exercise bargaining power. A well-known phenomenon is the obsolescing bargain, referring to the deal struck by MNEs and host governments, which change their requirements after the initial FDI entry. It typically unfolds in three rounds: ●● In Round One, the MNE and the government negotiate a deal. The MNE usually is not willing to enter in the absence of some government assurance of property rights and incentives (such as tax holidays). ●● In Round Two, the MNE enters and, if all goes well, earns profits that may become visible. ●● In Round Three, the government, often pressured by domestic political groups, may demand renegotiations of the deal that seems to yield “excessive” profits to the foreign firm (which, of course, regards these as “fair” and “nor- mal” profits). The previous deal, thus, becomes obsolete. The government’s tactics include removing incentives, demanding more profits and taxes, and even expropriation (confiscating foreign assets). At this time, the MNE has already invested substantial sums of resources (called sunk costs) and often has to accommodate some new demands. Otherwise, it may face expropriation or exit at a huge loss. Not surprisingly, MNEs do not appreciate the risk associated with such obsolescing bargains. Unfortunately, recent actions in Argentina, Bolivia, Ecuador, and Venezuela suggest that obsolescing bargains have not necessarily become obsolete (see the next section for some details). 6-8 Debates and Extensions As an embodiment of globalization, FDI has stimulated many debates. This section highlights two: (1) FDI versus outsourcing and (2) facilitating versus confronting inbound FDI. 6-8a FDI versus Outsourcing While this chapter has focused on FDI, we need to be aware that FDI is not the only mode of foreign market entry (see Chapter 10). Especially when undertaking a value chain analysis regarding specific activities (see Chapter 4), a decision to undertake FDI will have to be assessed relative to the benefits and costs of out- sourcing. Recall from Chapter 4 that in a foreign location, overseas outsourcing becomes “offshoring,” whereas FDI—that is, performing an activity in-house at an