Greenfield Investments
8ch ap
ter
opening case
For years the economy of Nigeria, Africa’s most populous nation, was held back by political instability, poor government policies, a lack of infrastructure, and endemic corruption. This started to change in the 2000s. In halting steps, Nigeria has moved toward a more stable democratic form of government. In 2007, for the first time in the history of the country, there was a peaceful transfer of civilian power fol- lowing general elections. Since then, the government has pursued market-orientated reforms, including the removal of subsidies, privatization of some state-run businesses, lowering trade barriers, and deregulation. The government has tried to rid itself of corruption, albeit with mixed success. There has also been some attempt to improve the country’s poor transportation and power infrastructure.
The reforms have had a positive impact. The GDP of Nigerian purchasing power parity almost tripled from $170 billion in 2000 to $451 billion in 2012. When estimates of the “informal” or “black economy” sector are taken into account, GDP may have been as large as $630 billion in 2012. The economy grew at around 7 percent per annum during the 2010–2012 period. Powering this growth have been high oil prices. Nigeria is a significant oil producer, and high oil prices have helped to improve government finances, but the industrial and agricultural sectors of the economy are also growing.
One of the major engines of growth has been foreign direct investment. For years, foreign investors stayed away from Nigeria—scared off by the political instability and high levels of corruption—but that too is starting to change. Encouraged by better economic management and the promise of a large domestic market, inward foreign investment in Nigeria increased from $1.2 billion in 2000 to a peak of almost $9 billion in both 2011 and 2012. Among recent investors has been General Electric, which announced in 2013 that it would put more than $1 billion into Nigeria over the next five years. The investments include building a manufacturing plant to support the power generation and oil extraction industries and a service center for supporting GE equipment. GE believes that its investment will create 2,300 jobs.
While the majority of investments are still targeted at Nigeria’s large energy sector, there are signs that this too is beginning to shift. A case in point is Procter & Gamble, which in 2012 invested $250 million to
Foreign Direct Investment in Nigeria
Foreign Direct Investment
–continued
224 Part Three The Global Trade and Investment Environment
construct a state-of-the-art plant to manufacture disposable diapers in Nigeria. Explaining the investment, a P&G spokesperson noted that “Nigeria has a very strong, dynamic and growing population of now over 167 million people with over 40 percent less than 15 years old. By 2050, Nigeria is projected to have the third largest population in the world. This represents a rapidly growing number of consumers and a wonderful opportunity to serve.” The P&G spokesperson also indicated that P&G would increase its investment if the Nigeria government was successful in further lowering import tariffs and consumption taxes and resolved some of the infrastructure problems that were currently holding the country back. • Sources: K. Aderinokun, “Nigeria: We Want to Make Nigeria the Hub of Procter and Gamble’s West African Operations,” AllAfrica, August 21, 2012; N. Mazen, “General Electric Plans $1 Billion Investment in Nigerian Power,” Bloomberg, January 31, 2013; and CIA, The World Factbook: Nigeria, updated January 7, 2014.
Introduction Foreign direct investment (FDI) occurs when a firm invests directly in facilities to pro- duce or market a product in a foreign country. According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, or affiliated group takes an interest of 10 percent or more in a foreign business entity. Once a firm undertakes FDI, it becomes a multinational enterprise. Two examples of FDI are given in the opening case— the recent investments by General Electric and Procter & Gamble in production facilities in Nigeria.
FDI takes on two main forms. The first is a greenfield investment, which involves the establishment of a new operation in a foreign country. The second involves acquir- ing or merging with an existing firm in the foreign country. Both GE’s and P&G’s investments in Nigeria were greenfield investments. Acquisitions can be a minority (where the foreign firm takes a 10 to 49 percent interest in the firm’s voting stock), majority (foreign interest of 50 to 99 percent), or full outright stake (foreign interest of 100 percent).1
This chapter opens by looking at the importance of foreign direct investment in the world economy. Next, it reviews the theories that have been used to explain foreign direct investment. The chapter then moves on to look at government policy toward foreign direct investment and closes with a section on implications for business.
Foreign Direct Investment in the World Economy When discussing foreign direct investment, it is important to distinguish between the flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI under- taken over a given time period (normally a year). The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. We also talk of outflows of FDI, meaning the flow of FDI out of a country, and inflows of FDI, the flow of FDI into a country.
TRENDS IN FDI The past 35 years have seen a marked increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from $25 billion in 1975 to $1.4 trillion in 2012 (see Figure 8.1).2 Over the past 30 years the flow of FDI has accelerated faster than the growth in world trade and world output. For example, between 1992 and 2012, the total flow of FDI from all countries increased around ninefold while world trade by value grew fourfold and world output by around 55 percent.3 As a
Greenfield Investment The establishment of a new operation in a foreign country.
LO 8-1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.
Flow of FDI The amount of foreign direct investment undertaken over a given time period (normally one year).
Stock of FDI The total accumulated value of foreign- owned assets at a given time.
Outflows of FDI Flow of foreign direct investment out of a country.
Inflows of FDI Flow of foreign direct investment into a country.
Chapter Eight Foreign Direct Investment 225
result of the strong FDI flows, by 2012 the global stock of FDI was about $22.8 trillion. The foreign affiliates of multinationals had more than $27.9 trillion in global sales and accounted for one-third of all cross-border trade in goods and services.4 Clearly by any measure, FDI is a very important phenomenon.
FDI has grown more rapidly than world trade and world output for several reasons. First, despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Second, much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world’s developing nations. The general shift toward democratic political institutions and free market economies that we discussed in Chapter 3 has encouraged FDI. Across much of Asia, eastern Europe, and Latin America, economic growth, economic deregulation, privatization programs that are open to foreign investors, and removal of many restrictions on FDI have made these countries more attractive to foreign multinationals. According to the United Nations, some 90 percent of the 2,700 changes made worldwide between 1992 and 2009 in the laws governing foreign direct investment created a more favorable envi- ronment for FDI.5
The globalization of the world economy is also having a positive effect on the volume of FDI. Many firms see the whole world as their market, and they are undertaking FDI in an attempt to make sure they have a significant presence in many regions of the world. For reasons that we explore later in this book, many firms now believe it is important to have production facilities close to their major customers. This too creates pressure for greater FDI.
THE DIRECTION OF FDI Historically, most FDI has been directed at the devel- oped nations of the world as firms based in advanced countries invested in the others’ mar- kets (see Figure 8.2). During the 1980s and 1990s, the United States was often the favorite target for FDI inflows. The United States has been an attractive target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI. Investors include firms based in Great Britain, Japan, Germany, Holland, and France. Inward investment into the United States remained high during the 2000s and stood at $167 billion in 2012. The developed nations of the European Union have also been recipients of significant FDI inflows, princi- pally from the United States and other member-states of the EU. In 2012, inward invest- ment into the EU was $276 billion. The United Kingdom and France have historically been the largest recipients of inward FDI.6
8.1 FIGURE FDI Outflows, 1980–2012 ($ billions) Source: UNCTAD Statistical Data Set, http:// unctadstat.unctad.org/ReportFolders/ reportFolders.aspx.
19 80
19 84
19 86
19 88
19 90
19 92
19 94
19 96
19 98
20 00
20 02
20 04
20 06
20 08
20 10
20 12
19 82
0
500
1,000
1,500
2,000
2,500
$ B
ill io
ns
226 Part Three The Global Trade and Investment Environment
Even though developed nations still account for the largest share of FDI inflows, FDI into developing nations and the transition economies of eastern Europe and the old Soviet Union have increased markedly (see Figure 8.2). Most recent inflows into devel- oping nations have been targeted at the emerging economies of Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient of FDI, which attracted about $60 billion of FDI in 2004 and rose steadily to hit a record $124 billion in 2011 followed by $121 billion in 2012.7 The reasons for the strong flow of investment into China are discussed in the accompanying Country Focus. Latin America is the next most important region in the developing world for FDI inflows. In 2012, total inward investments into this region reached $244 billion. Brazil has histori- cally been the top recipient of inward FDI in Latin America. At the other end of the scale, Africa has long received the smallest amount of inward investment, $50 billion in 2012. In recent years, Chinese enterprises have emerged as major investors in Africa, particularly in extraction industries where they seem to be trying to ensure future sup- plies of valuable raw materials. The inability of Africa to attract greater investment is in part a reflection of the political unrest, armed conflict, and frequent changes in economic policy in the region.8
THE SOURCE OF FDI Since World War II, the United States has consistently been the largest source country for FDI. Other important source countries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countries accounted for 60 percent of all FDI outflows for 1998–2012 (see Figure 8.3). As might be expected, these countries also predominate in rankings of the world’s largest mul- tinationals.9 These nations dominate primarily because they were the most developed na- tions with the largest economies during much of the postwar period and therefore home to many of the largest and best capitalized enterprises. Many of these countries also had a long history as trading nations and naturally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enterprises based there have been at the forefront of foreign investment trends.
That being said, it is noteworthy that Chinese firms have started to emerge as major for- eign investors. In 2005, Chinese firms invested some $12 billion internationally. Since then, the figure has risen steadily, reaching $84 billion in 2012. Firms based in Hong Kong accounted for another $84 billion of outward FDI in 2012. Much of the outward investment by Chinese firms has been directed at extractive industries in less developed nations (e.g., China has been a major investor in African countries). A major motive for these investments has been to gain access to raw materials, of which China is one of the world’s largest
8.2 FIGURE FDI Inflows by Region, 1995–2012 ($ billions) Source: Calculated by the author from United Nations World Investment Report, various editions.
19 95
19 97
19 98
19 99
20 00
20 01
20 02
20 03
20 04
20 05
20 06
20 07
20 08
20 09
20 10
20 11
20 12
19 96
0
500
1,000
1,500
2,000
2,500
$ B
ill io
ns
Developed Nations Developing Nations Transition Economies
Chapter Eight Foreign Direct Investment 227
Foreign Direct Investment in China
Beginning in late 1978, China’s leadership decided to move the econ- omy away from a centrally planned socialist system to one that was more market driven. The result has been 35 years of sustained high economic growth rates of around 8–10 percent, compounded annu- ally. This growth attracted substantial foreign investment. Starting from a tiny base, foreign investment increased to an annual average rate of $2.7 billion between 1985 and 1990 and then surged to $40 billion annually in the late 1990s, making China the second- biggest recipient of FDI inflows in the world after the United States. The growth has continued, with inward investments into China hitting a record $124 billion in 2011 (with another $83 billion going into Hong Kong). Over the past 20 years, this inflow has resulted in the estab- lishment of more than 300,000 foreign-funded enterprises in China. The total stock of FDI in mainland China grew from almost nothing in 1978 to $832 billion in 2012 (another $1.4 trillion of FDI stock was in Hong Kong).
The reasons for this investment are fairly obvious. With a popula- tion of more than 1.3 billion people, China represents the world’s largest market. Historically, import tariffs made it difficult to serve this market via exports, so FDI was required if a company wanted to tap into the country’s huge potential. China joined the World Trade Organization in 2001. As a result, average tariff rates on imports have fallen from 15.4 percent to about 8 percent today, and reducing the tariff became a motive for investing in China (although at 8 percent, tariffs are still above the average of 3.5 percent found in many devel- oped nations). Notwithstanding tariff rates, many foreign firms be- lieve that doing business in China requires a substantial presence in the country to build guanxi, the crucial relationship networks (see Chapter 4 for details). Furthermore, a combination of relatively inex- pensive labor and tax incentives, particularly for enterprises that establish themselves in special economic zones, makes China an
attractive base from which to serve Asian or world markets with exports (although rising labor costs in China are now making this less important).
Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China. China may have a huge popu- lation, but despite decades of rapid growth, it is still relatively poor. The lack of purchasing power translates into a relatively immature market for many Western consumer goods outside of affluent urban areas such as Shanghai. Other problems include a highly regulated environ- ment, which can make it problematic to conduct business transactions, and shifting tax and regulatory regimes. Then there are problems with local joint-venture partners that are inexperienced, opportunistic, or simply operate according to different goals. One U.S. manager ex- plained that when he laid off 200 people to reduce costs, his Chinese partner hired them all back the next day. When he inquired why they had been hired back, the Chinese partner, which was government- owned, explained that as an agency of the government, it had an “obli- gation” to reduce unemployment.
To continue to attract foreign investment, in late 2000 the Chinese government had committed itself to invest more than $800 billion in infrastructure projects over 10 years. Further commitments were made in the late 2000s. These investments have improved the nation’s poor highway system. They have been pursuing a macroeconomic policy that includes an emphasis on maintaining steady economic growth, low inflation, and a stable currency—all of which are attractive to for- eign investors. Given these developments, it seems likely that the country will continue to be an important magnet for foreign investors well into the future.
Sources: Interviews by the author while in China; United Nations, World Investment Report, 2012; Linda Ng and C. Tuan, “Building a Favorable Investment Environment: Evidence for the Facilitation of FDI in China,” The World Economy, 2002, pp. 1095–114; and S. Chan and G. Qingyang, “Investment in China Migrates Inland,” Far Eastern Economic Review, May 2006, pp. 52–57.
country FOCUS
8.3 FIGURE Cumulative FDI Outflows, 1998–2012 ($ billions) Source: Calculted by the author from United Nations World Investment Report, various editions.
3,500
3,000
2,000
2,500
1,500
1,000
500
0
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es
Un ite
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do m
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s
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n
Fra nc
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$ B
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228 Part Three The Global Trade and Investment Environment
consumers. There are signs, however, that Chinese firms are starting to turn their attention to more advanced na- tions. In 2012, Chinese firms invested $6.5 billion in the United States, up from $146 million in 2003.10
THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTS FDI can take the form of a greenfield investment in a new facility or an acquisition of or a merger with an existing local firm. UN estimates indicate that some 40 to 80 per- cent of all FDI inflows were in the form of mergers and acquisitions between 1998 and 2012.11 However, FDI flows into developed nations differ markedly from those into developing nations. In the case of developing na- tions, only about one-third or less of FDI is in the form of cross-border mergers and acquisitions. The lower per- centage of mergers and acquisitions may simply reflect the fact that there are fewer target firms to acquire in de- veloping nations.
When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake greenfield investments? We consider this question in depth in Chap- ter 13. For now, we will make a few basic observations. First, mergers and acquisitions are quicker to execute than greenfield investments. This is an important consid- eration in the modern business world where markets
evolve very rapidly. Many firms apparently believe that if they do not acquire a desirable target firm, then their global rivals will. Second, foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trade- marks or patents, distribution systems, production systems, and the like. It is easier and perhaps less risky for a firm to acquire those assets than to build them from the ground up through a greenfield investment. Third, firms make acquisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology, or man- agement skills (see the next Management Focus on Cemex for an example). However, as we discuss in Chapter 13, there is evidence that many mergers and acquisitions fail to realize their anticipated gains.12
Theories of Foreign Direct Investment In this section, we review several theories of foreign direct investment. These theories approach the various phenomena of foreign direct investment from three complementary perspectives. One set of theories seeks to explain why a firm will favor direct investment as a means of entering a foreign market when two other alternatives, exporting and licensing, are open to it. Another set of theories seeks to explain why firms in the same industry often undertake foreign direct investment at the same time and why they favor certain locations over others as targets for foreign direct investment. Put differently, these theories attempt to explain the observed pattern of foreign direct investment flows. A third theoretical per- spective, known as the eclectic paradigm, attempts to combine the two other perspectives into a single holistic explanation of foreign direct investment (this theoretical perspective is eclectic because the best aspects of other theories are taken and combined into a single explanation).
WHY FOREIGN DIRECT INVESTMENT? Why do firms go to the trouble of establishing operations abroad through foreign direct investment when two alternatives, exporting and licensing, are available to them for exploiting the profit opportunities in a
LO 8-2 Explain the different theories of FDI.
Eclectic Paradigm Argument that combining location specific assets or resource endowments and the firm’s own unique assets often requires FDI; it requires the firm to establish production facilities where those foreign assets or resource endowments are located.
Which Is Better, an Acquisition or a Greenfield Investment? A greenfield investment is an establishment of a new operation in a foreign country (i.e., a parent company starts a new venture in a foreign country by building new production facilities from the ground up). The acquisition approach refers to buying or merging operations with an existing firm in a foreign country. In the text of Chapters 8 and 13, we discuss reasons for greenfield and acquisition-based investments in a foreign country. While mergers and acquisitions (M&A) are typically quicker to execute than building something from literally the ground up, M&A often fail to gain the advantages expected. The failure rate of M&A is somewhere between 50 and 83 percent. At the same time, the trend shows that both the number of M&A and the sums of money spent on M&A are increasingly consistently every year. If you were making the decision, would you prefer to make a greenfield investment or engage in either a merger or acquisi- tion in a foreign country?
Source: Y. Weber, C. Oberg, and S. Tarba, “The M&A Paradox: Factors of Success and Failure in Mergers and Acquisitions,” Comprehensive Guide to Mergers & Acquisitions, A: Managing the Critical Success Factors Across Every Stage of the M&A Process (Upper Saddle River, NJ: FT Press, 2013).
test PREP Use LearnSmart to help retain what you have learned. Access your instructor’s Connect course to check out LearnSmart or go to learnsmartadvantage.com for help.
Chapter Eight Foreign Direct Investment 229
foreign market? Exporting involves producing goods at home and then shipping them to the receiving country for sale. Licensing involves granting a foreign entity (the licensee) the right to produce and sell the firm’s product in return for a royalty fee on every unit sold. The question is important, given that a cursory examination of the topic suggests that for- eign direct investment may be both expensive and risky compared with exporting and li- censing. FDI is expensive because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise. FDI is risky because of the problems associated with doing business in a different culture where the rules of the game may be very different. Relative to indigenous firms, there is a greater probability that a for- eign firm undertaking FDI in a country for the first time will make costly mistakes due to its ignorance. When a firm exports, it need not bear the costs associated with FDI, and it can reduce the risks associated with selling abroad by using a native sales agent. Similarly, when a firm allows another enterprise to produce its products under license, the licensee bears the
Exporting Sale of products produced in one country to residents of another country.
Licensing Occurs when a firm (the licensor) licenses the right to produce its product, use its production processes, or use its brand name or trademark to another firm (the licensee). In return for giving the licensee these rights, the licensor collects a royalty fee on every unit the licensee sells.
Foreign Direct Investment by Cemex
Since the early 1990s, Mexico’s largest cement manufacturer, Cemex, has transformed itself from a primarily Mexican operation into the third-largest cement company in the world behind Holcim of Switzerland and Lafarge Group of France. Cemex has long been a powerhouse in Mexico and currently controls more than 60 percent of the market for cement in that country. Cemex’s domestic success has been based in large part on an obsession with efficient manufacturing and a focus on customer service that is tops in the industry.
Cemex is a leader in using information technology to match pro- duction with consumer demand. The company sells ready-mixed ce- ment that can survive for only about 90 minutes before solidifying, so precise delivery is important. But Cemex can never predict with total certainty what demand will be on any given day, week, or month. To better manage unpredictable demand patterns, Cemex developed a system of seamless information technology—including truck-mounted global positioning systems, radio transmitters, satellites, and computer hardware—that allows it to control the production and distribution of cement like no other company can, responding quickly to unantici- pated changes in demand and reducing waste. The results are lower costs and superior customer service, both differentiating factors for Cemex.
Cemex’s international expansion strategy was driven by a number of factors. First, the company wished to reduce its reliance on the Mex- ican construction market, which was characterized by very volatile demand. Second, the company realized there was tremendous demand for cement in many developing countries, where significant construc- tion was being undertaken or needed. Third, the company believed that it understood the needs of construction businesses in developing na- tions better than the established multinational cement companies, all of which were from developed nations. Fourth, Cemex believed that it could create significant value by acquiring inefficient cement compa- nies in other markets and transferring its skills in customer service, marketing, information technology, and production management to those units.
The company embarked in earnest on its international expansion strategy in the early 1990s. Initially, Cemex targeted other developing
nations, acquiring established cement makers in Venezuela, Colombia, Indonesia, the Philippines, Egypt, and several other countries. It also purchased two stagnant companies in Spain and turned them around. Bolstered by the success of its Spanish ventures, Cemex began to look for expansion opportunities in developed nations. In 2000, Cemex pur- chased Houston-based Southland, one of the largest cement companies in the United States, for $2.5 billion. Following the Southland acquisition, Cemex had 56 cement plants in 30 countries, most of which were gained through acquisitions. In all cases, Cemex devoted great attention to transferring its technological, management and marketing know-how to acquired units, thereby improving their performance.
In 2004, Cemex made another major foreign investment move, pur- chasing RMC of Great Britain for $5.8 billion. RMC was a huge multina- tional cement firm with sales of $8 billion, only 22 percent of which were in the United Kingdom, and operations in more than 20 other na- tions, including many European nations where Cemex had no pres- ence. Finalized in March 2005, the RMC acquisition had transformed Cemex into a global powerhouse in the cement industry with more than $15 billion in annual sales and operations in 50 countries. Only about 15 percent of the company’s sales was now generated in Mexico. Fol- lowing the acquisition of RMC, Cemex found that the RMC plant in Rugby was running at only 70 percent of capacity, partly because re- peated production problems kept causing a kiln shutdown. Cemex brought in an international team of specialists to fix the problem and quickly increased production to 90 percent of capacity. Going forward, Cemex has made it clear that it will continue to expand and is eyeing opportunities in the fast-growing economies of China and India where currently it lacks a presence and where its global rivals are already expanding.
Sources: C. Piggott, “Cemex’s Stratospheric Rise,” Latin Finance, March 2001, p. 76; J. F. Smith, “Making Cement a Household Word,” Los Angeles Times, January 16, 2000, p. C1; D. Helft, “Cemex Attempts to Cement Its Future,” The Industry Standard, November 6, 2000; Diane Lindquist, “From Cement to Services,” Chief Executive, November 2002, pp. 48–50; “Cementing Global Success,” Strategic Direct Investor, March 2003, p. 1; M. T. Derham, “The Cemex Surprise,” Latin Finance, November 2004, pp. 1–2; “Holcim Seeks to Acquire Aggregate,” The Wall Street Journal, January 13, 2005, p. 1; J. Lyons, “Cemex Prowls for Deals in Both China and India,” The Wall Street Journal, January 27, 2006, p. C4; and S. Donnan, “Cemex Sells 25 Percent Stake in Semen Gresik,” FT.com, May 4, 2006, p. 1.
management FOCUS
230 Part Three The Global Trade and Investment Environment
costs or risks. So why do so many firms apparently prefer FDI over either exporting or li- censing? The answer can be found by examining the limitations of exporting and licensing as means for capitalizing on foreign market opportunities.
Limitations of Exporting The viability of an exporting strategy is often constrained by transportation costs and trade barriers. When transportation costs are added to produc- tion costs, it becomes unprofitable to ship some products over a large distance. This is par- ticularly true of products that have a low value-to-weight ratio and that can be produced in almost any location. For such products, the attractiveness of exporting decreases, relative to either FDI or licensing. This is the case, for example, with cement. Thus, Cemex, the large Mexican cement maker, has expanded internationally by pursuing FDI, rather than export- ing (see the accompanying Management Focus). For products with a high value-to-weight ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic components, personal computers, medical equipment, computer software, etc.) and have little impact on the relative attractiveness of exporting, licensing, and FDI.
Transportation costs aside, some firms undertake foreign direct investment as a response to actual or threatened trade barriers such as import tariffs or quotas. By placing tariffs on imported goods, governments can increase the cost of exporting relative to foreign direct investment and licensing. Similarly, by limiting imports through quotas, governments in- crease the attractiveness of FDI and licensing. For example, the wave of FDI by Japanese auto companies in the United States during the 1980s and 1990s was partly driven by pro- tectionist threats from Congress and by quotas on the importation of Japanese cars. For Japanese auto companies, these factors decreased the profitability of exporting and increased that of foreign direct investment. In this context, it is important to understand that trade barriers do not have to be physically in place for FDI to be favored over exporting. Often, the desire to reduce the threat that trade barriers might be imposed is enough to justify foreign direct investment as an alternative to exporting.
Limitations of Licensing A branch of economic theory known as internalization theory seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering foreign markets (this approach is also known as the market imperfec- tions approach).13 According to internalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities. First, licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor. For example, in the 1960s, RCA licensed its leading-edge color television technology to a number of Japanese companies, including Matsushita and Sony. At the time, RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market without the costs and risks associated with foreign direct investment. However, Matsushita and Sony quickly
Internalization Theory Marketing imperfection approach to foreign direct investment.
Market Imperfections Imperfections in the operation of the market mechanism.
Rankings
Cross-border investments have been ramped up to a relatively large degree in the last decade. Even with the economic downturn that started in 2008, the world continued to see a great deal of foreign direct investment by companies in the last decade. Now, when the economic prosperity is likely to be better, given that we are removed from those downturn days, the expectation is that more foreign direct investment will be considered by companies. On globalEDGE, there are myriad opportunities to gain more knowl- edge about foreign direct investment or, FDI, as it is typically called.
The “Rankings” section is a great starting point (globaledge.msu. edu/global-resources/rankings). In the Rankings section, glo- balEDGE features several reports by A.T. Kearney—with one of them squarely centered on foreign direct investment and a “confi- dence index” for FDI. The companies that participate in the regular study account for more than $2 trillion in annual global revenue! Which countries are in the top three in the investment confidence index, and do you agree that the three countries are the best ones to invest in if you were running a company?
Chapter Eight Foreign Direct Investment 231
assimilated RCA’s technology and used it to enter the U.S. market to compete directly against RCA. As a result, RCA is now a minor player in its home market, while Matsushita and Sony have a much bigger market share.
A second problem is that licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability. With licensing, control over manufacturing, marketing, and strategy are granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. The rationale for wanting control over the strategy of a foreign entity is that a firm might want its foreign subsidiary to price and market very aggressively as a way of keeping a foreign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept such an imposition, be- cause it would likely reduce the licensee’s profit, or it might even cause the licensee to take a loss.
The rationale for wanting control over the operations of a foreign entity is that the firm might wish to take advantage of differences in factor costs across countries, producing only part of its final product in a given country, while importing other parts from elsewhere where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement, since it would limit the licensee’s autonomy. Thus, for these reasons, when tight control over a foreign entity is desirable, foreign direct investment is preferable to licensing.
A third problem with licensing arises when the firm’s competitive advantage is based not as much on its products as on the management, marketing, and manufacturing capabilities that produce those products. The problem here is that such capabilities are often not amenable to licensing. While a foreign licensee may be able to physically reproduce the firm’s product under license, it often may not be able to do so as efficiently as the firm could itself. As a result, the licensee may not be able to fully exploit the profit potential inherent in a foreign market.
For example, consider Toyota, a company whose competitive advantage in the global auto industry is acknowledged to come from its superior ability to manage the overall process of designing, engineering, manufacturing, and selling automobiles—that is, from its management and organizational capabilities. Indeed, Toyota is credited with pioneer- ing the development of a new production process, known as lean production, that enables it to produce higher-quality automobiles at a lower cost than its global rivals.14 Although Toyota could license certain products, its real competitive advantage comes from its man- agement and process capabilities. These kinds of skills are difficult to articulate or codify; they certainly cannot be written down in a simple licensing contract. They are organiza- tionwide and have been developed over the years. They are not embodied in any one individual but instead are widely dispersed throughout the company. Put another way, Toyota’s skills are embedded in its organizational culture, and culture is something that cannot be licensed. Thus, if Toyota were to allow a foreign entity to produce its cars under license, the chances are that the entity could not do so as efficiently as could Toyota. In turn, this would limit the ability of the foreign entity to fully develop the market potential of that product. Such reasoning underlies Toyota’s preference for direct investment in foreign markets, as opposed to allowing foreign automobile companies to produce its cars under license.
All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing: (1) when the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) when a firm’s skills and know-how are not amenable to licensing.
Advantages of Foreign Direct Investment It follows that a firm will favor foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favor foreign direct investment over licensing (or franchising) when it wishes to maintain control over its
232 Part Three The Global Trade and Investment Environment
technological know-how, or over its operations and business strategy, or when the firm’s capabilities are simply not amenable to licensing, as may often be the case.
THE PATTERN OF FOREIGN DIRECT INVESTMENT Observation suggests that firms in the same industry often undertake foreign direct investment at about the same time. Also, firms tend to direct their investment activities toward the same target markets. The two theories we consider in this section attempt to explain the patterns that we observe in FDI flows.
Strategic Behavior One theory is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. An early variant of this argument was expounded by F. T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic industries.15 An oligopoly is an industry composed of a limited num- ber of large firms (e.g., an industry in which four firms control 80 percent of a domestic market would be defined as an oligopoly). A critical competitive feature of such industries is interdependence of the major players: What one firm does can have an immediate impact on the major competitors, forcing a response in kind. By cutting prices, one firm in an oli- gopoly can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share. Thus, the interdependence between firms in an oligopoly leads to imitative behavior; rivals often quickly imitate what a firm does in an oligopoly.
Imitative behavior can take many forms in an oligopoly. One firm raises prices, and the others follow; one expands capacity, and the rivals imitate lest they be left at a disadvantage in the future. Knickerbocker argued that the same kind of imitative behavior characterizes FDI. Consider an oligopoly in the United States in which three firms—A, B, and C—domi- nate the market. Firm A establishes a subsidiary in France. Firms B and C decide that if successful, this new subsidiary may knock out their export business to France and give a first-mover advantage to firm A. Furthermore, firm A might discover some competitive asset in France that it could repatriate to the United States to torment firms B and C on their native soil. Given these possibilities, firms B and C decide to follow firm A and establish operations in France.
Studies that have looked at FDI by U.S. firms show that firms based in oligopolistic industries tended to imitate each other’s FDI.16 The same phenomenon has been ob- served with regard to FDI undertaken by Japanese firms.17 For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by under- taking their own FDI in the United States and Europe. Research has also shown that models of strategic behavior in a global oligopoly can explain the pattern of FDI in the global tire industry.18
Knickerbocker’s theory can be extended to embrace the concept of multipoint competi- tion. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.19 Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other’s moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize competitive attacks in other markets.
Although Knickerbocker’s theory and its extensions can help explain imitative FDI be- havior by firms in oligopolistic industries, it does not explain why the first firm in an oli- gopoly decides to undertake FDI rather than to export or license. Internalization theory addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, internalization theory addresses the efficiency issue. For these reasons, many economists favor internalization theory as an explanation for FDI, although most would agree that the imitative explanation tells an important part of the story.
THE ECLECTIC PARADIGM The eclectic paradigm has been championed by the British economist John Dunning.20 Dunning argues that in addition to the various
Oligopoly An industry composed of a limited number of large firms.
Multipoint Competition Arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.
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factors discussed earlier, location-specific advantages are also of considerable importance in explaining both the rationale for and the direction of foreign direct investment. By location-specific advantages, Dunning means the advantages that arise from utilizing resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm’s technological, mar- keting, or management capabilities). Dunning accepts the argument of internalization the- ory that it is difficult for a firm to license its own unique capabilities and know-how. Therefore, he argues that combining location-specific assets or resource endowments with the firm’s own unique capabilities often requires foreign direct investment. That is, it re- quires the firm to establish production facilities where those foreign assets or resource en- dowments are located.
An obvious example of Dunning’s arguments are natural resources, such as oil and other minerals, which are by their character specific to certain locations. Dunning suggests that to exploit such foreign resources, a firm must undertake FDI. Clearly, this explains the FDI undertaken by many of the world’s oil companies, which have to invest where oil is located in order to combine their technological and managerial capabilities with this valuable location- specific resource. Another obvious example is valuable human resources, such as low-cost, highly skilled labor. The cost and skill of labor varies from country to country. Because labor is not internationally mobile, according to Dunning it makes sense for a firm to locate pro- duction facilities in those countries where the cost and skills of local labor are most suited to its particular production processes.
However, Dunning’s theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semiconductor industry. Many of the world’s major computer and semiconductor companies—such as Apple Computer, Hewlett-Packard, Oracle, Google, and Intel—are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs there. According to Dunning’s arguments, knowledge being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors is avail- able nowhere else in the world. To be sure, that knowledge is commercialized as it diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning’s language, this means that Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semiconductor industries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part it arises from a network of infor- mal contacts that allows firms to benefit from each other’s knowledge generation. Econo- mists refer to such knowledge “spillovers” as externalities, and there is a well-established theory suggesting that firms can benefit from such externalities by locating close to their source.21
Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and, perhaps, production facilities so they too can learn about and utilize valuable new knowledge before those based elsewhere, thereby giving them a competitive advan- tage in the global marketplace.22 Evidence suggests that European, Japanese, South Korean, and Taiwanese com- puter and semiconductor firms are investing in the Silicon Valley region precisely because they wish to benefit from the externalities that arise there.23 Others have argued that direct investment by foreign firms in the U.S. biotechnol- ogy industry has been motivated by desires to gain access to the unique location-specific technological knowledge of U.S. biotechnology firms.24 Dunning’s theory, therefore, seems to be a useful addition to those outlined previously, because it helps explain how location factors affect the direction of FDI.25
Location-Specific Advantages Advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm’s technological, marketing, or management know-how).
Externalities Knowledge spillovers.
Silicon Valley, where Google is based, has long been known as the epicenter of the computer and semiconductor industry.
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234 Part Three The Global Trade and Investment Environment
Political Ideology and Foreign Direct Investment Historically, political ideology toward FDI within a nation has ranged from a dogmatic radical stance that is hostile to all inward FDI at one extreme to an adherence to the nonin- terventionist principle of free market economics at the other. Between these two extremes is an approach that might be called pragmatic nationalism.
THE RADICAL VIEW The radical view traces its roots to Marxist political and economic theory. Radical writers argue that the multinational enterprise (MNE) is an in- strument of imperialist domination. They see the MNE as a tool for exploiting host coun- tries to the exclusive benefit of their capitalist-imperialist home countries. They argue that MNEs extract profits from the host country and take them to their home country, giving nothing of value to the host country in exchange. They note, for example, that key technology is tightly controlled by the MNE and that important jobs in the foreign subsidiaries of MNEs go to home-country nationals rather than to citizens of the host country. Because of this, according to the radical view, FDI by the MNEs of advanced capitalist nations keeps the less developed countries of the world relatively backward and dependent on advanced capitalist nations for investment, jobs, and technology. Thus, according to the extreme version of this view, no country should ever permit foreign cor- porations to undertake FDI, because they can never be instruments of economic develop- ment, only of economic domination. Where MNEs already exist in a country, they should be immediately nationalized.26
From 1945 until the 1980s, the radical view was very influential in the world economy. Until the collapse of communism between 1989 and 1991, the countries of eastern Europe were opposed to FDI. Similarly, communist countries elsewhere—such as China, Cambodia, and Cuba—were all opposed in principle to FDI (although, in practice, the Chinese started to allow FDI in mainland China in the 1970s). Many socialist countries—particularly in Africa, where one of the first actions of many newly independent states was to nationalize
foreign-owned enterprises—also embraced the radical position. Countries whose political ideology was more nationalistic than socialistic further embraced the radical position. This was true in Iran and India, for example, both of which adopted tough policies restricting FDI and nationalized many foreign-owned enterprises. Iran is a particularly interesting case because its Islamic govern- ment, while rejecting Marxist theory, has essentially em- braced the radical view that FDI by MNEs is an instrument of imperialism.
By the early 1990s, the radical position was in retreat almost everywhere. There seem to be three reasons for this: (1) the collapse of communism in eastern Europe; (2) the generally abysmal economic performance of those countries that embraced the radical position, and a grow- ing belief by many of these countries that FDI can be an important source of technology and jobs and can stimu- late economic growth; and (3) the strong economic per- formance of those developing countries that embraced capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan).
THE FREE MARKET VIEW The free mar- ket view traces its roots to classical economics and the international trade theories of Adam Smith and David Ricardo (see Chapter 6). The intellectual case for this view has been strengthened by the internalization
LO 8-3 Understand how political ideology shapes a government’s attitudes toward FDI.
Are They Friends or Not—India and Pakistan? For many years, since the partition of British India in 1947 and the creation of India and Pakistan, these two South Asian coun- tries have been involved in numerous wars, border skirmishes, and military stand-offs. The dispute for Kashmir has been the main reason in most interactions, with a notable exception be- ing the Indo-Pakistani War of 1971, when the conflict started because of turmoil in East Pakistan (now called Bangladesh). However, in trying to improve the economic ties between the two nations, India recently announced that it will allow FDI from Pakistan, paving the way for industries from the neighboring country to set up businesses in the growing Indian market. While this is a prime example of how free markets are promot- ing trade between countries that have not traditionally enjoyed stable political relationships with each other, the question is also on what grounds cross-border interaction is founded. What do you think? Can countries that have been long-standing ene- mies normalize their relationship simply based on foreign direct investment opportunities?
Source: www.hindustantimes.com/business-news/WorldEconomy/India-to-allow- FDI-from-Pakistan-Anand-Sharma/Article1-839942.aspx.
Chapter Eight Foreign Direct Investment 235
explanation of FDI. The free market view argues that international production should be distributed among countries according to the theory of comparative advantage. Countries should specialize in the production of those goods and services that they can produce most efficiently. Within this framework, the MNE is an instrument for dispers- ing the production of goods and services to the most efficient locations around the globe. Viewed this way, FDI by the MNE increases the overall efficiency of the world economy.
Imagine that Dell decided to move assembly operations for many of its personal comput- ers from the United States to Mexico to take advantage of lower labor costs in Mexico. According to the free market view, moves such as this can be seen as increasing the overall efficiency of resource utilization in the world economy. Mexico, due to its lower labor costs, has a comparative advantage in the assembly of PCs. By moving the production of PCs from the United States to Mexico, Dell frees U.S. resources for use in activities in which the United States has a comparative advantage (e.g., the design of computer software, the man- ufacture of high value-added components such as microprocessors, or basic R&D). Also, consumers benefit because the PCs cost less than they would if they were produced domes- tically. In addition, Mexico gains from the technology, skills, and capital that the computer company transfers with its FDI. Contrary to the radical view, the free market view stresses that such resource transfers benefit the host country and stimulate its economic growth. Thus, the free market view argues that FDI is a benefit to both the source country and the host country.
PRAGMATIC NATIONALISM In practice, many countries have adopted nei- ther a radical policy nor a free market policy toward FDI, but instead a policy that can best be described as pragmatic nationalism.27 The pragmatic nationalist view is that FDI has both benefits and costs. FDI can benefit a host country by bringing capital, skills, technol- ogy, and jobs, but those benefits come at a cost. When a foreign company rather than a domestic company produces products, the profits from that investment go abroad. Many countries are also concerned that a foreign-owned manufacturing plant may import many components from its home country, which has negative implications for the host country’s balance-of-payments position.
Recognizing this, countries adopting a pragmatic stance pursue policies designed to maximize the national benefits and minimize the national costs. According to this view, FDI should be allowed so long as the benefits outweigh the costs. Japan offers an example of pragmatic nationalism. Until the 1980s, Japan’s policy was probably one of the most restrictive among countries adopting a pragmatic nationalist stance. This was due to Japan’s perception that direct entry of foreign (especially U.S.) firms with ample managerial resources into the Japanese markets could hamper the development and growth of its own industry and technology.28 This belief led Japan to block the majority of applications to invest in Japan. However, there were always exceptions to this policy. Firms that had important technology were often permitted to undertake FDI if they insisted that they would neither license their technology to a Japanese firm nor enter into a joint venture with a Japanese enterprise. IBM and Texas Instruments were able to set up wholly owned subsidiaries in Japan by adopting this negotiating position. From the perspective of the Japanese government, the benefits of FDI in such cases—the stimulus that these firms might impart to the Japanese economy—outweighed the perceived costs.
Another aspect of pragmatic nationalism is the tendency to aggressively court FDI believed to be in the national interest by, for example, offering subsidies to foreign MNEs in the form of tax breaks or grants. The countries of the European Union often seem to be competing with each other to attract U.S. and Japanese FDI by offering large tax breaks and subsidies. Britain has been the most successful at attracting Japanese invest- ment in the automobile industry. Nissan, Toyota, and Honda now have major assembly plants in Britain and use the country as their base for serving the rest of Europe—with obvious employment and balance-of-payments benefits for Britain.
236 Part Three The Global Trade and Investment Environment
SHIFTING IDEOLOGY Recent years have seen a marked decline in the number of countries that adhere to a radical ideology. Although few countries have adopted a pure free market policy stance, an increasing number of countries are gravitating toward the free mar- ket end of the spectrum and have liberalized their foreign investment regime. This includes many countries that less than two decades ago were firmly in the radical camp (e.g., the former communist countries of eastern Europe, many of the socialist countries of Africa, and India) and several countries that until recently could best be described as pragmatic nationalists with regard to FDI (e.g., Japan, South Korea, Italy, Spain, and most Latin Amer- ican countries). One result has been the surge in the volume of FDI worldwide, which, as we noted earlier, has been growing twice as fast as the growth in world trade. Another result has been an increase in the volume of FDI directed at countries that have recently liberalized their FDI regimes, such as China, India, and Vietnam.
As a counterpoint, there is some evidence of a shift to a more hostile approach to foreign direct investment in some nations. Venezuela and Bolivia have become increasingly hostile to foreign direct investment. In 2005 and 2006, the governments of both nations unilater- ally rewrote contracts for oil and gas exploration, raising the royalty rate that foreign enterprises had to pay the government for oil and gas extracted in their territories. Follow- ing his election victory in 2006, Bolivian President Evo Morales nationalized the nation’s gas fields and stated that he would evict foreign firms unless they agreed to pay about 80 percent of their revenues to the state and relinquish production oversight. In some de- veloped nations, there is increasing evidence of hostile reactions to inward FDI as well. In Europe in 2006, there was a hostile political reaction to the attempted takeover of Europe’s largest steel company, Arcelor, by Mittal Steel, a global company controlled by the Indian entrepreneur Lakshmi Mittal. In mid-2005, China National Offshore Oil Company with- drew a takeover bid for Unocal of the United States after highly negative reaction in Congress about the proposed takeover of a “strategic asset” by a Chinese company. Similarly, as detailed in the accompanying Management Focus, in 2006 a Dubai-owned
DP World and the United States
In February 2006, DP World, a ports operator with global reach owned by the government of Dubai, a member of the United Arab Emirates and a staunch U.S. ally, paid $6.8 billion to acquire P&O, a British firm that runs a global network of marine terminals. With P&O came the man- agement operations of six U.S. ports: Miami, Philadelphia, Baltimore, New Orleans, New Jersey, and New York. The acquisition had already been approved by U.S. regulators when it suddenly became front-page news. Upon hearing about the deal, several prominent U.S. senators raised concerns about the acquisition. Their objections were twofold. First, they raised questions about the security risks associated with management operations in key U.S. ports being owned by a foreign enterprise that was based in the Middle East. The implication was that terrorists could somehow take advantage of the ownership arrange- ment to infiltrate U.S. ports. Second, they were concerned that DP World was a state-owned enterprise and argued that foreign govern- ments should not be in a position of owning key “U.S. strategic assets.”
The Bush administration was quick to defend the takeover, stating it posed no threat to national security. Others noted that DP World was a respected global firm with an American chief operating officer and an American-educated chairman; the head of the global ports
management operation would also be an American. DP World would not own the U.S. ports in question, just manage them, while security issues would remain in the hands of American customs officials and the U.S. Coast Guard. Dubai was also a member of America’s Con- tainer Security Initiative, which allows American customs officials to inspect cargo in foreign ports before it leaves for the United States. Most of the DP World employees at American ports would be U.S. citizens, and any UAE citizen transferred to DP World would be sub- ject to American visa approval.
These arguments fell on deaf ears. With several U.S. senators threatening to pass legislation to prohibit foreign ownership of U.S. port operations, DP World bowed to the inevitable and announced it would sell off the right to manage the six U.S. ports for about $750 million. Looking forward, however, DP World stated it would seek an initial pub- lic offering in 2007, and the then-private firm would in all probability continue to look for ways to enter the United States. In the words of the firm’s CEO, “This is the world’s largest economy. How can you just ignore it?”
Sources: “Trouble at the Waterfront,” The Economist, February 25, 2006, p. 48; “Paranoia about Dubai Ports Deals Is Needless,” Financial Times, February 21, 2006, p. 16; and “DP World: We’ll Be Back,” Traffic World, May 29, 2006, p. 1.
management FOCUS
Chapter Eight Foreign Direct Investment 237
company withdrew its planned takeover of some operations at six U.S. ports after negative political reactions. So far, these countertrends are nothing more than isolated incidents, but if they become more widespread, the 30-year movement toward lower barriers to cross- border investment could be in jeopardy.
Benefits and Costs of FDI To a greater or lesser degree, many governments can be considered pragmatic national- ists when it comes to FDI. Accordingly, their policy is shaped by a consideration of the costs and benefits of FDI. Here, we explore the benefits and costs of FDI, first from the perspective of a host (receiving) country and then from the perspective of the home (source) country. In the next section, we look at the policy instruments governments use to manage FDI.
HOST-COUNTRY BENEFITS The main benefits of inward FDI for a host country arise from resource-transfer effects, employment effects, balance-of-payments ef- fects, and effects on competition and economic growth.
Resource-Transfer Effects Foreign direct investment can make a positive contri- bution to a host economy by supplying capital, technology, and management resources that would otherwise not be available and thus boost that country’s economic growth rate (as described in the opening case, the Indian government has come around to this view and has adopted a more permissive attitude to inward investment).29
With regard to capital, many MNEs, by virtue of their large size and financial strength, have access to financial resources not available to host-country firms. These funds may be available from internal company sources, or, because of their reputation, large MNEs may find it easier to borrow money from capital markets than host-country firms would.
As for technology, you will recall from Chapter 3 that technology can stimulate economic development and industrialization. Technology can take two forms, both of which are valu- able. Technology can be incorporated in a production process (e.g., the technology for dis- covering, extracting, and refining oil), or it can be incorporated in a product (e.g., personal computers). However, many countries lack the research and development resources and skills required to develop their own indigenous product and process technology. This is particularly true in less developed nations. Such countries must rely on advanced industrialized nations for much of the technology required to stimulate economic growth, and FDI can provide it.
Research supports the view that multinational firms often transfer significant technology when they invest in a foreign country.30 For example, a study of FDI in Sweden found that foreign firms increased both the labor and total factor pro- ductivity of Swedish firms that they acquired, suggesting that significant technology transfers had occurred (technol- ogy typically boosts productivity).31 Also, a study of FDI by the Organization for Economic Cooperation and Develop- ment (OECD) found that foreign investors invested signifi- cant amounts of capital in R&D in the countries in which they had invested, suggesting that not only were they trans- ferring technology to those countries but they may also have been upgrading existing technology or creating new tech- nology in those countries.32
Foreign management skills acquired through FDI may also produce important benefits for the host country.
LO 8-4 Describe the benefits and costs of FDI to home and host countries.
Does Foreign Direct Investment Promote Growth? There are multiple reasons for companies to make foreign direct investments. Lowering the cost of production, increasing capac- ity (volume) of production, and strategically locating production facilities to serve world regions are some of the many reasons for FDI by a company. For the host countries that receive the in- vestment by multinational corporations, the logic is that the in- flux of capital and increase in tax revenues will benefit the host country in the form of new infrastructure, increased knowledge, and general economic development. However, the evidence so far is very mixed on the value of FDI to the host, ranging from beneficial to detrimental. What do you think? Does FDI promote growth in the host country?
Source: L. Alfaro, A. Chanda, S. Kalemli-Ozcan, and S. Sayek, “Does Foreign Direct Investment Promote Growth? Exploring the Role of Financial Markets on Linkages,” Cambridge, MA; Harvard Business School, 2009. www.people.hbs.edu/ lalfaro/fdiandlinkages.pdf.
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238 Part Three The Global Trade and Investment Environment
Foreign managers trained in the latest management techniques can often help improve the efficiency of operations in the host country, whether those operations are acquired or greenfield de- velopments. Beneficial spin-off effects may also arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help establish indigenous firms. Similar benefits may arise if the superior management skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own man- agement skills.
Employment Effects Another beneficial employment effect claimed for FDI is that it brings jobs to a host country that would otherwise not be created there. The effects of FDI on employ- ment are both direct and indirect. Direct effects arise when a for- eign MNE employs a number of host-country citizens. Indirect
effects arise when jobs are created in local suppliers as a result of the investment and when jobs are created because of increased local spending by employees of the MNE. The indirect employment effects are often as large as, if not larger than, the direct effects. For example, when Toyota decided to open a new auto plant in France, estimates suggested the plant would create 2,000 direct jobs and perhaps another 2,000 jobs in support industries.33
Cynics argue that not all the “new jobs” created by FDI represent net additions in em- ployment. In the case of FDI by Japanese auto companies in the United States, some argue that the jobs created by this investment have been more than offset by the jobs lost in U.S.- owned auto companies, which have lost market share to their Japanese competitors. As a consequence of such substitution effects, the net number of new jobs created by FDI may not be as great as initially claimed by an MNE. The issue of the likely net gain in employ- ment may be a major negotiating point between an MNE wishing to undertake FDI and the host government.
When FDI takes the form of an acquisition of an established enterprise in the host economy as opposed to a greenfield investment, the immediate effect may be to reduce employment as the multinational tries to restructure the operations of the acquired unit to improve its operating efficiency. However, even in such cases, research suggests that once the initial period of restructuring is over, enterprises acquired by foreign firms tend to increase their employment base at a faster rate than domestic rivals. An OECD study found that foreign firms created new jobs at a faster rate than their domestic counterparts.34
Balance-of-Payments Effects FDI’s effect on a country’s balance-of-payments accounts is an important policy issue for most host governments. A country’s balance-of-payments accounts track both its payments to and its receipts from other countries. Governments normally are concerned when their country is running a deficit on the current account of their balance of payments. The current account tracks the export and import of goods and services. A current account deficit, or trade deficit as it is often called, arises when a country is importing more goods and services than it is exporting. Governments typically prefer to see a current account surplus than a deficit. The only way in which a current account deficit can be supported in the long run is by selling off assets to foreigners (for a detailed explanation of why this is the case, see the appendix to Chapter 6). For example, the persistent U.S. current account deficit since the 1980s has been financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to foreigners. Because national governments invariably dislike seeing the assets of their country fall into foreign hands, they prefer their nation to run a current account surplus. There are two ways in which FDI can help a country achieve this goal.
Balance-of-Payments Accounts National accounts that track both payments to and receipts from foreigners.
Current Account In the balance of payments, records transactions involving the export or import of goods and services.
Job creation is a result of FDI. These French workers assemble cars at Toyota’s Valenciennes manufacturing plant.
Chapter Eight Foreign Direct Investment 239
First, if the FDI is a substitute for imports of goods or services, the effect can be to improve the current account of the host country’s balance of payments. Much of the FDI by Japanese automobile companies in the United States and Europe, for example, can be seen as substituting for imports from Japan. Thus, the current account of the U.S. balance of pay- ments has improved somewhat because many Japanese companies are now supplying the U.S. market from production facilities in the United States, as opposed to facilities in Japan. Insofar as this has reduced the need to finance a current account deficit by asset sales to foreigners, the United States has clearly benefited.
A second potential benefit arises when the MNE uses a foreign subsidiary to export goods and services to other countries. According to a UN report, inward FDI by foreign multinationals has been a major driver of export-led economic growth in a number of devel- oping and developed nations.35 For example, in China exports increased from $26 billion in 1985 to more than $250 billion by 2001 and $1.9 trillion in 2012. Much of this dramatic export growth was due to the presence of foreign multinationals that invested heavily in China during the 1990s.
Effect on Competition and Economic Growth Economic theory tells us that the efficient functioning of markets depends on an adequate level of competition between producers. When FDI takes the form of a greenfield investment, the result is to establish a new enterprise, increasing the number of players in a market and thus con- sumer choice. In turn, this can increase the level of competition in a national market, thereby driving down prices and increasing the economic welfare of consumers. Increased competition tends to stimulate capital investments by firms in plant, equipment, and R&D as they struggle to gain an edge over their rivals. The long-term results may include in- creased productivity growth, product and process innovations, and greater economic growth.36 Such beneficial effects seem to have occurred in the South Korean retail sector following the liberalization of FDI regulations in 1996. FDI by large Western discount stores—including Walmart, Costco, Carrefour, and Tesco—seems to have encouraged in- digenous discounters such as E-Mart to improve the efficiency of their own operations. The results have included more competition and lower prices, which benefit South Korean consumers.
FDI’s impact on competition in domestic markets may be particularly important in the case of services, such as telecommunications, retailing, and many financial services, where exporting is often not an option because the service has to be produced where it is deliv- ered.37 For example, under a 1997 agreement sponsored by the World Trade Organization, 68 countries accounting for more than 90 percent of world telecommunications revenues pledged to start opening their markets to foreign investment and competition and to abide by common rules for fair competition in telecommunications. Before this agreement, most of the world’s telecommunications markets were closed to foreign competitors, and in most countries the market was monopolized by a single carrier, which was often a state-owned enterprise. The agreement has dramatically increased the level of competition in many na- tional telecommunications markets, producing two major benefits. First, inward investment has increased competition and stimulated investment in the modernization of telephone networks around the world, leading to better service. Second, the increased competition has resulted in lower prices.
HOST-COUNTRY COSTS Three costs of FDI concern host countries. They arise from possible adverse effects on competition within the host nation, adverse effects on the balance of payments, and the perceived loss of national sovereignty and autonomy.
Adverse Effects on Competition Host governments sometimes worry that the subsidiaries of foreign MNEs may have greater economic power than indigenous competi- tors. If it is part of a larger international organization, the foreign MNE may be able to draw on funds generated elsewhere to subsidize its costs in the host market, which could drive
240 Part Three The Global Trade and Investment Environment
indigenous companies out of business and allow the firm to monopolize the market. Once the market is monopolized, the foreign MNE could raise prices above those that would prevail in competitive markets, with harmful effects on the economic welfare of the host na- tion. This concern tends to be greater in countries that have few large firms of their own (generally, less developed countries). It tends to be a relatively minor concern in most ad- vanced industrialized nations.
In general, while FDI in the form of greenfield investments should increase competi- tion, it is less clear that this is the case when the FDI takes the form of acquisition of an established enterprise in the host nation, as was the case when Cemex acquired RMC in Britain (see the Management Focus). Because an acquisition does not result in a net in- crease in the number of players in a market, the effect on competition may be neutral. When a foreign investor acquires two or more firms in a host country, and subsequently merges them, the effect may be to reduce the level of competition in that market, create monopoly power for the foreign firm, reduce consumer choice, and raise prices. For ex- ample, in India, Hindustan Lever Ltd., the Indian subsidiary of Unilever, acquired its main local rival, Tata Oil Mills, to assume a dominant position in the bath soap (75 percent) and detergents (30 percent) markets. Hindustan Lever also acquired several local companies in other markets, such as the ice cream makers Dollops, Kwality, and Milkfood. By combining these companies, Hindustan Lever’s share of the Indian ice cream market went from zero in 1992 to 74 percent in 1997.38 However, although such cases are of obvious concern, there is little evidence that such developments are widespread. In many nations, domestic competition authorities have the right to review and block any mergers or acquisitions that they view as having a detrimental impact on competition. If such institutions are operating effectively, this should be sufficient to make sure that foreign entities do not monopolize a country’s markets.
Adverse Effects on the Balance of Payments The possible adverse effects of FDI on a host country’s balance-of-payments position are twofold. First, set against the initial capital inflow that comes with FDI must be the subsequent outflow of earnings from the foreign subsidiary to its parent company. Such outflows show up as capital outflow on balance-of-payments accounts. Some governments have responded to such outflows by restricting the amount of earnings that can be repatriated to a foreign subsid- iary’s home country. A second concern arises when a foreign subsidiary imports a substan- tial number of its inputs from abroad, which results in a debit on the current account of the host country’s balance of payments. One criticism leveled against Japanese-owned auto assembly operations in the United States, for example, is that they tend to import many component parts from Japan. Because of this, the favorable impact of this FDI on the current account of the U.S. balance-of-payments position may not be as great as initially supposed. The Japanese auto companies responded to these criticisms by pledg- ing to purchase 75 percent of their component parts from U.S.-based manufacturers (but not necessarily U.S.-owned manufacturers). When the Japanese auto company Nissan in- vested in the United Kingdom, Nissan responded to concerns about local content by pledging to increase the proportion of local content to 60 percent and subsequently rais- ing it to more than 80 percent.
National Sovereignty and Autonomy Some host governments worry that FDI is accompanied by some loss of economic independence. The concern is that 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. Most economists dismiss such concerns as groundless and irrational. Political scien- tist Robert Reich has noted that such concerns are the product of outmoded thinking be- cause they fail to account for the growing interdependence of the world economy.39 In a world in which firms from all advanced nations are increasingly investing in each other’s markets, it is not possible for one country to hold another to “economic ransom” without hurting itself.
Chapter Eight Foreign Direct Investment 241
HOME-COUNTRY BENEFITS The benefits of FDI to the home (source) country arise from three sources. First, the home country’s balance of payments benefits from the inward flow of foreign earnings. FDI can also benefit the home country’s balance of payments if the foreign sub- sidiary creates demands for home-country exports of capital equipment, intermediate goods, complementary products, and the like.
Second, benefits to the home country from outward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the for- eign subsidiary creates demand for home-country exports. Thus, Toyota’s investment in auto assembly operations in Europe has benefited both the Japanese balance-of-pay- ments position and employment in Japan, because Toyota imports some component parts for its European-based auto assembly operations directly from Japan.
Third, benefits arise when the home-country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home coun- try. This amounts to a reverse resource-transfer effect. Through its exposure to a foreign market, an MNE can learn about superior management techniques and superior product and process technologies. These resources can then be transferred back to the home country, contributing to the home country’s economic growth rate.40
HOME-COUNTRY COSTS Against these benefits must be set the apparent costs of FDI for the home (source) country. The most important concerns center on the balance- of-payments and employment effects of outward FDI. The home country’s balance of pay- ments may suffer in three ways. First, the balance of payments suffers from the initial capital outflow required to finance the FDI. This effect, however, is usually more than offset by the subsequent inflow of foreign earnings. Second, the current account of the balance of pay- ments suffers if the purpose of the foreign investment is to serve the home market from a low-cost production location. Third, the current account of the balance of payments suffers if the FDI is a substitute for direct exports. Thus, insofar as Toyota’s assembly operations in the United States are intended to substitute for direct exports from Japan, the current ac- count position of Japan will deteriorate.
With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for domestic production. This was the case with Toyota’s investments in the United States and Europe. One obvious result of such FDI is reduced home-country employment. If the labor market in the home country is already tight, with little unemployment, this concern may not be that great. However, if the home country is suffering from unemployment, con- cern about the export of jobs may arise. For example, one objection frequently raised by U.S. labor leaders to the free trade pact among the United States, Mexico, and Canada (see the next chapter) is that the United States would lose hundreds of thousands of jobs as U.S. firms in- vest in Mexico to take advantage of cheaper labor and then export back to the United States.41
INTERNATIONAL TRADE THEORY AND FDI When assessing the costs and benefits of FDI to the home country, keep in mind the lessons of international trade theory (see Chapter 6). International trade theory tells us that home-country concerns about the negative economic effects of offshore production may be misplaced. The term offshore production refers to FDI undertaken to serve the home market. Far from reducing home- country employment, such FDI may actually stimulate economic growth (and hence em- ployment) in the home country by freeing home-country resources to concentrate on
Offshore Production FDI undertaken to serve the home market.
Is FDI a Form of Colonialism or Ethical Investing? Some critics of globalization suggest that FDI is an advanced form of colonialism that destroys local cultures in developing countries. What these critics say may have some limited validity, but it isn’t the whole picture. Take Freeport McMoRan, a U.S.- based mining company with operations in West Papua (the for- mer Irian Jaya), Indonesia, where the world’s largest gold, mineral, and copper reserves have been found. Freeport formed a joint venture with the Indonesian government to mine a con- cession, an isolated tract of land the size of Massachusetts on a remote island, half of which is the country of Papua New Guinea. Freeport has brought education, Internet connections, world- class health care, and the modern world to the isolated local tribes in West Papua, nomadic peoples who wear loincloths and hunt in the forest. Their traditional, subsistence way of life is threatened, while at the same time, they gain from their share of the operation’s profits, from their increased health care and edu- cation, and from local employment opportunities with FCX. Is this colonialism or a kind of ethical investing?
Source: www.corpwatch.org
242 Part Three The Global Trade and Investment Environment
activities where the home country has a comparative advantage. In addition, home-country consumers benefit if the price of the particular product falls as a result of the FDI. Also, if a company were prohibited from making such investments on the grounds of negative em- ployment effects while its international competitors reaped the benefits of low-cost produc- tion locations, it would undoubtedly lose market share to its international competitors. Under such a scenario, the adverse long-run economic effects for a country would probably outweigh the relatively minor balance-of-payments and employment effects associated with offshore production.
Government Policy Instruments and FDI We have now reviewed the costs and benefits of FDI from the perspective of both home country and host country. We now turn our attention to the policy instruments that home (source) countries and host countries can use to regulate FDI.
HOME-COUNTRY POLICIES Through their choice of policies, home coun- tries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first. These include foreign risk insurance, capital assistance, tax incentives, and political pressure. Then we will look at policies designed to restrict out- ward FDI.
Encouraging Outward FDI Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. The types of risks insurable through these programs include the risks of expropriation (nationalization), war losses, and the inability to transfer profits back home. Such programs are particularly use- ful in encouraging firms to undertake investments in politically unstable countries.42 In addition, several advanced countries also have special funds or banks that make govern- ment loans to firms wishing to invest in developing countries. As a further incentive to encourage domestic firms to undertake FDI, many countries have eliminated double taxa- tion of foreign income (i.e., taxation of income in both the host country and the home country). Last, and perhaps most significant, a number of investor countries (including the United States) have used their political influence to persuade host countries to relax their restrictions on inbound FDI. For example, in response to direct U.S. pressure, Japan re- laxed many of its formal restrictions on inward FDI in the 1980s. Now, in response to further U.S. pressure, Japan has moved toward relaxing its informal barriers to inward FDI. One beneficiary of this trend has been Toys “R” Us, which, after five years of inten- sive lobbying by company and U.S. government officials, opened its first retail stores in Japan in December 1991. By 2012, Toys “R” Us had more than 170 stores in Japan, and its Japanese operation, in which Toys “R” Us retained a controlling stake, had a listing on the Japanese stock market.
Restricting Outward FDI Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. One policy has been to limit capital outflows out of concern for the country’s balance of payments. From the early 1960s until 1979, for example, Britain had exchange-control regulations that lim- ited the amount of capital a firm could take out of the country. Although the main intent of such policies was to improve the British balance of payments, an important secondary intent was to make it more difficult for British firms to undertake FDI.
In addition, countries have occasionally manipulated tax rules to try to encourage their firms to invest at home. The objective behind such policies is to create jobs at home rather than in other nations. At one time, Britain adopted such policies. The British advanced corporation tax system taxed British companies’ foreign earnings at a higher rate than their domestic earnings. This tax code created an incentive for British companies to invest at home.
LO 8-5 Explain the range of policy instruments that governments use to influence FDI.
test PREP Use LearnSmart to help retain what you have learned. Access your instructor’s Connect course to check out LearnSmart or go to learnsmartadvantage.com for help.
Chapter Eight Foreign Direct Investment 243
Finally, countries sometimes prohibit national firms from investing in certain countries for political reasons. Such restrictions can be formal or informal. For example, formal U.S. rules prohibited U.S. firms from investing in countries such as Cuba and Iran, whose politi- cal ideology and actions are judged to be contrary to U.S. interests. Similarly, during the 1980s, informal pressure was applied to dissuade U.S. firms from investing in South Africa. In this case, the objective was to pressure South Africa to change its apartheid laws, which happened during the early 1990s.
HOST-COUNTRY POLICIES Host countries adopt policies designed both to restrict and to encourage inward FDI. As noted earlier in this chapter, political ideology has determined the type and scope of these policies in the past. In the last decade of the twenti- eth century, many countries moved quickly away from adhering to some version of the radical stance and prohibiting much FDI, and toward a situation where a combination of free market objectives and pragmatic nationalism took hold.
Encouraging Inward FDI It is common for governments to offer incentives to for- eign firms to invest in their countries. Such incentives take many forms, but the most com- mon are tax concessions, low-interest loans, and grants or subsidies. Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI. They are also motivated by a desire to capture FDI away from other potential host countries. For example, in the mid-1990s, the governments of Britain and France competed with each other on the incentives they offered Toyota to invest in their respective countries. In the United States, state governments often compete with each other to attract FDI. For example, Kentucky offered Toyota an incentive package worth $147 million to persuade it to build its U.S. au- tomobile assembly plants there. The package included tax breaks, new state spending on infrastructure, and low-interest loans.43
Restricting Inward FDI Host governments use a wide range of controls to restrict FDI in one way or another. The two most common are ownership restraints and perfor- mance requirements. Ownership restraints can take several forms. In some countries, for- eign companies are excluded from specific fields. They are excluded from tobacco and mining in Sweden and from the development of certain natural resources in Brazil, Finland, and Morocco. In other industries, foreign ownership may be permitted although a signifi- cant proportion of the equity of the subsidiary must be owned by local investors. Foreign ownership is restricted to 25 percent or less of an airline in the United States. In India, for- eign firms were prohibited from owning media businesses until 2001, when the rules were relaxed, allowing foreign firms to purchase up to 26 percent of an Indian newspaper. As de- scribed in the opening case, foreign firms are still restricted from owning retail establish- ments in India.44
The rationale underlying ownership restraints seems to be twofold. First, foreign firms are often excluded from certain sectors on the grounds of national security or competi- tion. Particularly in less developed countries, the feeling seems to be that local firms might not be able to develop unless foreign competition is restricted by a combination of import tariffs and controls on FDI. This is a variant of the infant industry argument dis- cussed in Chapter 7.
Second, ownership restraints seem to be based on a belief that local owners can help maximize the resource-transfer and employment benefits of FDI for the host country. Until the early 1980s, the Japanese government prohibited most FDI but allowed joint ventures between Japanese firms and foreign MNEs if the MNE had a valuable technology. The Japanese government clearly believed such an arrangement would speed up the subsequent diffusion of the MNE’s valuable technology throughout the Japanese economy.
Performance requirements can also take several forms. Performance requirements are controls over the behavior of the MNE’s local subsidiary. The most common perfor- mance requirements are related to local content, exports, technology transfer, and local participation in top management. As with certain ownership restrictions, the logic
underlying performance requirements is that such rules help maximize the benefits and minimize the costs of FDI for the host country. Many countries employ some form of performance requirements when it suits their objectives. However, performance re- quirements tend to be more common in less developed countries than in advanced in- dustrialized nations.45
INTERNATIONAL INSTITUTIONS AND THE LIBERALIZATION OF FDI Until the 1990s, there was no consistent involvement by multinational institu- tions in the governing of FDI. This changed with the formation of the World Trade Orga- nization in 1995. The WTO embraces the promotion of international trade in services. Because many services have to be produced where they are sold, exporting is not an option (e.g., one cannot export McDonald’s hamburgers or consumer banking services). Given this, the WTO has become involved in regulations governing FDI. As might be expected for an institution created to promote free trade, the thrust of the WTO’s efforts has been to push for the liberalization of regulations governing FDI, particularly in services. Under the auspices of the WTO, two extensive multinational agreements were reached in 1997 to liberalize trade in telecommunications and financial services. Both these agreements con- tained detailed clauses that require signatories to liberalize their regulations governing in- ward FDI, essentially opening their markets to foreign telecommunications and financial services companies. The WTO has had less success trying to initiate talks aimed at estab- lishing a universal set of rules designed to promote the liberalization of FDI. Led by Malaysia and India, developing nations have so far rejected efforts by the WTO to start such discussions.
FOCUS ON MANAGERIAL IMPLICATIONS
FDI AND GOVERNMENT POLICY Several implications for business are inherent in the material discussed in this chapter. In this section, we deal first with the implications of the theory and then turn our attention to the implications of government policy.
THE THEORY OF FDI The implications of the theories of FDI for business practice are straightforward. First, the location-specific advantages argument associated with John Dunning does help explain the direction of FDI. However, the location-specific advantages argument does not explain why firms prefer FDI to licensing or to exporting. In this regard, from both an explanatory and a business perspective, perhaps the most useful theories are those that focus on the limitations of exporting and licensing—that is, internalization theories. These theories are useful because they identify with some precision how the relative profitability of foreign direct investment, exporting, and licensing vary with circum- stances. The theories suggest that exporting is preferable to licensing and FDI so long as transportation costs are minor and trade barriers are trivial. As transportation costs or trade barriers increase, exporting becomes unprofitable, and the choice is between FDI and licensing. Because FDI is more costly and more risky than licensing, other things being equal, the theories argue that licensing is preferable to FDI. Other things are seldom equal, however. Although licensing may work, it is not an attractive option when one or more of the following conditions exist: (1) The firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) the firm needs tight control
LO 8-6 Identify the implications for managers of the theory and government policies associated with FDI.
244 Part Three The Global Trade and Investment Environment
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over a foreign entity to maximize its market share and earnings in that country, and (3) a firm’s skills and capabilities are not amenable to licensing. Figure 8.4 presents these considerations as a decision tree.
Firms for which licensing is not a good option tend to be clustered in three types of industries:
1. High-technology industries in which protecting firm-specific expertise is of paramount importance and licensing is hazardous.
2. Global oligopolies, in which competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors.
3. Industries in which intense cost pressures require that multinational firms maintain tight control over foreign operations (so that they can disperse manufacturing to locations around the globe where factor costs are most favorable in order to minimize costs).
Although empirical evidence is limited, the majority seems to support these conjec- tures.46 In addition, licensing is not a good option if the competitive advantage of a firm is based upon managerial or marketing knowledge that is embedded in the routines of the firm or the skills of its managers, and that is difficult to codify in a “book of blueprints.” This would seem to be the case for firms based in a fairly wide range of industries.
8.4 FIGURE A Decision FrameworkExport
FDI
FDI
FDI
Then License
Low
High
Yes
No
Yes
No
Yes
No
Is Tight Control over Foreign Operation Required?
How High Are Transportation Costs and Tariffs?
Is Know-how Amenable to Licensing?
Can Know-how Be Protected by Licensing Contract?
Chapter Eight Foreign Direct Investment 245
Firms for which licensing is a good option tend to be in industries whose conditions are opposite to those just specified. That is, licensing tends to be more common, and more profitable, in fragmented, low-technology industries in which globally dispersed manufac- turing is not an option. A good example is the fast-food industry. McDonald’s has expanded globally by using a franchising strategy. Franchising is essentially the service-industry ver- sion of licensing, although it normally involves much longer-term commitments than licensing. With franchising, the firm licenses its brand name to a foreign firm in return for a percentage of the franchisee’s profits. The franchising contract specifies the conditions that the franchisee must fulfill if it is to use the franchisor’s brand name. Thus, McDonald’s allows foreign firms to use its brand name so long as they agree to run their restaurants on exactly the same lines as McDonald’s restaurants elsewhere in the world. This strategy makes sense for McDonald’s because (1) like many services, fast food cannot be exported; (2) franchising economizes the costs and risks associated with opening up foreign markets; (3) unlike technological know-how, brand names are relatively easy to protect using a con- tract; (4) there is no compelling reason for McDonald’s to have tight control over franchi- sees; and (5) McDonald’s know-how, in terms of how to run a fast-food restaurant, is amenable to being specified in a written contract (e.g., the contract specifies the details of how to run a McDonald’s restaurant).
Finally, it should be noted that the product life-cycle theory and Knickerbocker’s theory of FDI tend to be less useful from a business perspective. The problem with these two theories is that they are descriptive rather than analytical. They do a good job of describing the historical evolution of FDI, but they do a relatively poor job of identi- fying the factors that influence the relative profitability of FDI, licensing, and export- ing. Indeed, the issue of licensing as an alternative to FDI is ignored by both these theories.
GOVERNMENT POLICY A host government’s attitude toward FDI should be an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct investment. Other things being equal, investing in countries that have permissive policies toward FDI is clearly preferable to investing in countries that restrict FDI.
However, often the issue is not this straightforward. Despite the move toward a free market stance in recent years, many countries still have a rather pragmatic stance toward FDI. In such cases, a firm considering FDI must often negotiate the specific terms of the investment with the country’s government. Such negotiations center on two broad issues. If the host government is trying to attract FDI, the central issue is likely to be the kind of incentives the host government is prepared to offer to the MNE and what the firm will commit in exchange. If the host government is uncertain about the benefits of FDI and might choose to restrict access, the central issue is likely to be the concessions that the firm must make to be allowed to go forward with a proposed investment.
To a large degree, the outcome of any negotiated agreement depends on the relative bargaining power of both parties. Each side’s bargaining power depends on three factors:
• The value each side places on what the other has to offer. • The number of comparable alternatives available to each side. • Each party’s time horizon.
From the perspective of a firm negotiating the terms of an investment with a host government, the firm’s bargaining power is high when the host government places a high value on what the firm has to offer, the number of comparable alternatives open to the firm is greater, and the firm has a long time in which to complete the negotia- tions. The converse also holds. The firm’s bargaining power is low when the host govern- ment places a low value on what the firm has to offer, the number of comparable alternatives open to the firm is fewer, and the firm has a short time in which to complete the negotiations.47
246 Part Three The Global Trade and Investment Environment
Chapter Eight Foreign Direct Investment 247
greenfield investment, p. 224 flow of FDI, p. 224 stock of FDI, p. 224 outflows of FDI, p. 224 inflows of FDI, p. 224 eclectic paradigm, p. 228
exporting, p. 229 licensing, p. 229 internalization theory, p. 230 market imperfections, p. 230 oligopoly, p. 232 multipoint competition, p. 232
location-specific advantages, p. 233 externalities, p. 233 balance-of-payments accounts, p. 238 current account, p. 238 offshore production, p. 241
Key Terms
Summary
This chapter reviewed theories that attempt to explain the pattern of FDI between countries and to examine the in- fluence of governments on firms’ decisions to invest in for- eign countries. The chapter made the following points:
1. Any theory seeking to explain FDI must explain why firms go to the trouble of acquiring or establishing operations abroad when the alternatives of exporting and licensing are available to them.
2. High transportation costs or tariffs imposed on imports help explain why many firms prefer FDI or licensing over exporting.
3. Firms often prefer FDI to licensing when (a) a firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) a firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country, and (c) a firm’s skills and capabilities are not amenable to licensing.
4. Knickerbocker’s theory suggests that much FDI is explained by imitative behavior by rival firms in an oligopolistic industry.
5. Dunning has argued that location-specific advantages are of considerable importance in explaining the nature and direction of FDI. According to Dunning, firms undertake FDI to exploit resource endowments or assets that are location specific.
6. Political ideology is an important determinant of government policy toward FDI. Ideology ranges from a radical stance that is hostile to FDI to a
noninterventionist, free market stance. Between the two extremes is an approach best described as pragmatic nationalism.
7. Benefits of FDI to a host country arise from resource- transfer effects, employment effects, and balance-of- payments effects.
8. The costs of FDI to a host country include adverse effects on competition and balance of payments and a perceived loss of national sovereignty.
9. The benefits of FDI to the home (source) country include improvement in the balance of payments as a result of the inward flow of foreign earnings, positive employment effects when the foreign subsidiary creates demand for home-country exports, and benefits from a reverse resource-transfer effect. A reverse resource-transfer effect arises when the foreign subsidiary learns valuable skills abroad that can be transferred back to the home country.
10. The costs of FDI to the home country include adverse balance-of-payments effects that arise from the initial capital outflow and from the export substitution effects of FDI. Costs also arise when FDI exports jobs abroad.
11. Home countries can adopt policies designed to both encourage and restrict FDI. Host countries try to attract FDI by offering incentives, and try to restrict FDI by dictating ownership restraints and requiring that foreign MNEs meet specific performance requirements.
Critical Thinking and Discussion Questions
1. In 2008, inward FDI accounted for some 63.7 percent of gross fixed capital formation in Ireland, but only 4.1 percent in Japan (gross fixed capital formation refers to investments in fixed assets such as factories, warehouses, and retail stores). What do you think explains this difference in FDI inflows into the two countries?
2. Compare and contrast these explanations of FDI: internalization theory and Knickerbocker’s theory of FDI. Which theory do you think offers the best explanation of the historical pattern of FDI? Why?
3. What are the strengths of the eclectic theory of FDI? Can you see any shortcomings? How does the eclectic theory influence management practice?
4. Read the Management Focus on Cemex, and then answer the following questions: a. Which theoretical explanation, or explanations, of
FDI best explains Cemex’s FDI? b. What is the value that Cemex brings to a host
economy? Can you see any potential drawbacks of inward investment by Cemex in an economy?
c. Cemex has a strong preference for acquisitions over greenfield ventures as an entry mode. Why?
5. You are the international manager of a U.S. business that has just developed a revolutionary new personal
computer that can perform the same functions as existing PCs but costs only half as much to manufacture. Several patents protect the unique design of this computer. Your CEO has asked you to formulate a recommendation for how to expand into western Europe. Your options are (a) to export from the United States, (b) to license a European firm to manufacture and market the computer in Europe, or (c) to set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative, and suggest a course of action to your CEO.
For years now, there has been intense debate in India about the wisdom of relaxing the country’s restrictions on foreign direct investment into its retail sector. The Indian retailing sector is highly fragmented and dominated by small enterprises. Estimates suggest that barely 6 percent of India’s al- most $500 billion in retail sales take place in organized retail establish- ments. The rest takes place in small shops, most of which are unincorpo- rated businesses run by individuals or households. In contrast, organized retail establishments account for more than 20 percent of sales in China, 36 percent of sales in Brazil, and 85 percent of all retail sales in the United States. In total, retail establishments in India employ some 34 million peo- ple, accounting for more than 7 percent of the workforce.
Advocates of opening up retailing in India to large foreign enterprises such as Walmart, Carrefour, Ikea, and Tesco, make a number of arguments. They believe that foreign retailers can be a positive force for improving the efficiency of India’s distribution systems. Companies like Walmart and Tesco are experts in supply chain management. Applied to India, such know-how could take significant costs out of the economy. Logistics costs are around 14 percent of GDP in India, much higher than the 8 percent in the United States. While this is partly due to a poor road system, it is also
the case that most distribution is done by small trucking enterprises, often with a single truck, that have few economies of scale or scope. Large for- eign retailers tend to establish their own trucking operations and can reap significant gains from tight control of their distribution system.
Foreign retailers will also probably make major investments in distri- bution infrastructure such as cold storage facilities and warehouses. Currently, there is a chronic lack of cold storage facilities in India. Esti- mates suggest that about 25 to 30 percent of all fruits and vegetables spoil before they reach the market due to inadequate cold storage. Similarly, there is a lack of warehousing capacity. A lot of wheat, for example, is simply stored under tarpaulins, where it is at risk of rotting. Such problems raise foods costs to consumers and impose significant losses on farmers.
Farmers have emerged as significant advocates of reform. This is not surprising because they stand to benefit from working with foreign retail- ers. Similarly, reform-minded politicians argue that foreign retailers will help to keep food processing in check, which benefits all. Ranged against them is a powerful coalition of small shop owners and left-wing politi- cians, who argue that the entry of large, well-capitalized foreign retailers
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248 Part Three The Global Trade and Investment Environment
Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:
1. The World Investment Report published annually by UNCTAD provides a summary of recent trends in FDI as well as quick access to comprehensive investment statistics. Identify the table of largest transnational corporations from developing and transition countries. The ranking is based on the foreign assets each corporation owns. Based only at the top 20 companies, provide a summary of the countries and industries represented. Do you notice any common traits from your analysis? Did any industries or countries in the top 20 surprise you? Why?
2. An integral part of successful foreign direct investment is to understand the target market opportunities as well as the nature of the risk inherent in possible investment projects, particularly in developing countries. You work for a company that builds wastewater and sanitation infrastructure in such countries. The Multilateral Investment Guarantee Agency (MIGA) provides insurance for risky projects in these markets. Identify the sector brief for the water and wastewater sector, and prepare a report to identify the major risks projects in this sector tend to face and how MIGA can assist in such projects.
Research Task http://globalEDGE.msu.edu
Chapter Eight Foreign Direct Investment 249
will result in the significant job losses and force many small retailers out of businesses.
In 1997, it looked as if the reformers had the upper hand when they succeeded in changing the rules to allow foreign enterprises to participate in wholesale trading. Taking advantage of this reform, in 2009 Walmart started to open up wholesale stores in India under the name Best Price. The stores are operated by a joint venture with Bharti, an Indian conglom- erate. These stores are only allowed to sell to other businesses, such as hotels, restaurants, and small retailers. By 2012, the venture had 20 stores in India. Customers of these stores note that unlike many local competi- tors, they always have products in stock, and they are not constantly changing their prices. Farmers, too, like the joint venture because it has worked closely with farmers to secure consistent supplies and has made investments in warehouses and cold storage. The joint venture also pays farmers better prices—something it can afford to do because far less pro- duce goes to waste in its system.
For its part, in 2011 the Indian government indicated that it would soon introduce legislation to allow foreign enterprises like Walmart entry into the retail sector. On the basis on this promise, Walmart and Bharti were plan- ning to expand downstream from wholesale into retail establishments, but their plans were put on hold in late 2011 when the Indian government announced that the legislation had been shelved for the time being. Appar- ently, opposition to such reform had reached such a pitch that implementing it was not worth the political risk. Opponents argued that global experience showed that FDI leads to job losses, although they cited no data to support this claim. Whether India will further relax regulations limiting inward FDI into retail remains to be seen.
Sources: V. Bajaj, “Wal-Mart Debate Rages in India,” The New York Times, December 6, 2011, pp. B1, B2; S. G. Mozumder, “Walmart Is Not Coming to India Just to Sell,” India Abroad, December 16, 2011, pp. A18–A19; and R. Kohli and J. Bhaqwati, “Organized Retailing in India: Issues and Outlook,” Columbia Program on Indian Economic Policies, working paper no. 2011-1, January 22, 2011.
CASE DISCUSSION QUESTIONS 1. Why do you think that the Indian retail sector is so fragmented?
2. What are the potential benefits to India of entry by foreign retail establishments?
3. Who stands to lose as a result of foreign entry into the Indian retail sector?
4. Why do you think reform of FDI regulations in India has been so difficult?
Endnotes
1. United Nations, World Investment Report, 2013 (New York and Geneva: United Nations, 2013).
2. United Nations, World Investment Report, 2013; and United Nations Conference on Trade and Investment, “Global Flows of Foreign Direct Investment Exceeding Pre-Crisis Levels in 2011,” Global Investment Trends Monitor, January 24, 2012.
3. World Trade Organization, International Trade Statistics, 2012 (Geneva: WTO, 2012); and United Nations, World Investment Report, 2012.
4. United Nations, World Investment Report, 2013.
5. United Nations, World Investment Report, 2010 (New York and Geneva: United Nations, 2010).
6. United Nations, World Investment Report, 2013; and UN Con- ference on Trade and Investment, “Global Flows of Foreign Direct Investment.”
7. Ibid.
8. United Nations, World Investment Report, 2013 (New York and Geneva: United Nations, 2013).
9. United Nations, World Investment Report, 2013.
10. M. Caruso-Cabrera, “Chinese Investment in US May Break Record in 2013,” CNBC, January 2, 2013.
11. United Nations, World Investment Report, 2012.
12. See D. J. Ravenscraft and F. M. Scherer, Mergers, Selloffs and Economic Efficiency (Washington, DC: The Brookings
Shoppers at a supermarket in Mumbai, India have an array of fruits and vegetables to choose from.
250 Part Three The Global Trade and Investment Environment
Institution, 1987); and A. Seth, K. P. Song, and R. R. Pettit, “Value Creation and Destruction in Cross-Border Acquisi- tions,” Strategic Management Journal 23 (2002), pp. 921–40.
13. For example, see S. H. Hymer, The International Operations of National Firms: A Study of Direct Foreign Investment (Cambridge, MA: MIT Press, 1976); A. M. Rugman, Inside the Multinationals: The Economics of Internal Markets (New York: Columbia University Press, 1981); D. J. Teece, “Multi- national Enterprise, Internal Governance, and Industrial Organization,” American Economic Review 75 (May 1983), pp. 233–38; C. W. L. Hill and W. C. Kim, “Searching for a Dynamic Theory of the Multinational Enterprise: A Transac- tion Cost Model,” Strategic Management Journal 9 (special issue, 1988), pp. 93–104; A. Verbeke, “The Evolutionary View of the MNE and the Future of Internalization Theory,” Journal of International Business Studies 34 (2003), pp. 498–501; and J. H. Dunning, “Some Antecedents of Internalization Theory,” Journal of International Business Studies 34 (2003), pp. 108–28.
14. J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).
15. The argument is most often associated with F. T. Knicker- bocker, Oligopolistic Reaction and Multinational Enterprise (Boston: Harvard Business School Press, 1973).
16. The studies are summarized in R. E. Caves, Multinational Enterprise and Economic Analysis, 2nd ed. (Cambridge, UK: Cambridge University Press, 1996).
17. See R. E. Caves, “Japanese Investment in the US: Lessons for the Economic Analysis of Foreign Investment,” The World Economy 16 (1993), pp. 279–300; B. Kogut and S. J. Chang, “Technological Capabilities and Japanese Direct Investment in the United States,” Review of Economics and Statistics 73 (1991), pp. 401–43; and J. Anand and B. Kogut, “Technologi- cal Capabilities of Countries, Firm Rivalry, and Foreign Direct Investment,” Journal of International Business Studies, 1997, pp. 445–65.
18. K. Ito and E. L. Rose, “Foreign Direct Investment Location Strategies in the Tire Industry,” Journal of International Busi- ness Studies 33 (2002), pp. 593–602.
19. H. Haveman and L. Nonnemaker, “Competition in Multiple Geographical Markets,” Administrative Science Quarterly 45 (2000), pp. 232–67; and L. Fuentelsaz and J. Gomez, “Multi- point Competition, Strategic Similarity and Entry into Geo- graphic Markets,” Strategic Management Journal 27 (2006), pp. 447–57.
20. J. H. Dunning, Explaining International Production (London: Unwin Hyman, 1988).
21. P. Krugman. “Increasing Returns and Economic Geography,” Journal of Political Economy 99, no. 3 (1991), pp. 483–99.
22. J. M. Shaver and F. Flyer, “Agglomeration Economies, Firm Heterogeneity, and Foreign Direct Investment in the United States,” Strategic Management Journal 21 (2000), pp. 1175–93.
23. J. H. Dunning and R. Narula, “Transpacific Foreign Direct Investment and the Investment Development Path,” South Carolina Essays in International Business, May 1995.
24. W. Shan and J. Song, “Foreign Direct Investment and the Sourcing of Technological Advantage: Evidence from the
Biotechnology Industry,” Journal of International Business Studies, 1997, pp. 267–84.
25. For some additional evidence, see L. E. Brouthers, K. D. Brouthers, and S. Warner, “Is Dunning’s Eclectic Framework Descriptive or Normative?” Journal of International Business Studies 30 (1999), pp. 831–44.
26. For elaboration, see S. Hood and S. Young, The Economics of the Multinational Enterprise (London: Longman, 1979); and P. M. Sweezy and H. Magdoff, “The Dynamics of U.S. Capi- talism,” Monthly Review Press, 1972.
27. For an example of this policy as practiced in China, see L. G. Branstetter and R. C. Freenstra, “Trade and Foreign Direct Investment in China: A Political Economy Approach,” Jour- nal of International Economics 58 (December 2002), pp. 335–58.
28. M. Itoh and K. Kiyono, “Foreign Trade and Direct Invest- ment,” in Industrial Policy of Japan, ed. R. Komiya, M. Okuno, and K. Suzumura (Tokyo: Academic Press, 1988).
29. R. E. Lipsey, “Home and Host Country Effects of FDI,” National Bureau of Economic Research Working Paper Series, paper no. 9293, October 2002; and X. Li and X. Liu, “For- eign Direct Investment and Economic Growth,” World Devel- opment 33 (March 2005), pp. 393–413.
30. X. J. Zhan and T. Ozawa, Business Restructuring in Asia: Cross Border M&As in Crisis Affected Countries (Copenhagen: Co- penhagen Business School, 2000); I. Costa, S. Robles, and R. de Queiroz, “Foreign Direct Investment and Technological Capabilities,” Research Policy 31 (2002), pp. 1431–43; B. Potterie and F. Lichtenberg, “Does Foreign Direct Investment Transfer Technology across Borders?” Review of Economics and Statistics 83 (2001), pp. 490–97; and K. Saggi, “Trade, Foreign Direct Investment and International Technology Transfer,” World Bank Research Observer 17 (2002), pp. 191–235.
31. K. M. Moden, “Foreign Acquisitions of Swedish Companies: Effects on R&D and Productivity,” Research Institute of International Economics, 1998, mimeo.
32. “Foreign Friends,” The Economist, January 8, 2000, pp. 71–72.
33. A. Jack, “French Go into Overdrive to Win Investors,” Finan- cial Times, December 10, 1997, p. 6.
34. “Foreign Friends,” The Economist, January 8, 2000, pp. 71–72.
35. United Nations, World Investment Report, 2014 (New York and Geneva: United Nations, 2002).
36. R. Ram and K. H. Zang, “Foreign Direct Investment and Economic Growth,” Economic Development and Cultural Change 51 (2002), pp. 205–25.
37. United Nations, World Investment Report, 2014 (New York and Geneva: United Nations, 1998).
38. United Nations, World Investment Report, 2000 (New York and Geneva: United Nations, 2000).
39. R. B. Reich, The Work of Nations: Preparing Ourselves for the 21st Century (New York: Alfred A. Knopf, 1991).
40. This idea has been articulated, although not quite in this form, by C. A. Bartlett and S. Ghoshal, Managing across
Chapter Eight Foreign Direct Investment 251
Borders: The Transnational Solution (Boston: Harvard Business School Press, 1989).
41. P. Magnusson, “The Mexico Pact: Worth the Price?” Busi- nessWeek, May 27, 1991, pp. 32–35.
42. C. Johnston, “Political Risk Insurance,” in Assessing Corporate Political Risk, ed. D. M. Raddock (Totowa, NJ: Rowan & Littlefield, 1986).
43. M. Tolchin and S. Tolchin, Buying into America: How Foreign Money Is Changing the Face of Our Nation (New York: Times Books, 1988).
44. S. Rai, “India to Ease Limits on Foreign Ownership of Media and Tea,” The New York Times, June 26, 2002, p. W1.
45. L. D. Qiu and Z. Tao, “Export, Foreign Direct Investment and Local Content Requirements,” Journal of Development Economics 66 (October 2001), pp. 101–25.
46. See R. E. Caves, Multinational Enterprise and Economic Analysis (Cambridge, UK: Cambridge University Press, 1982).
47. For a good general introduction to negotiation strategy, see M. H. Bazerman and M. A. Neale, Negotiating Rationally (New York: Free Press, 1992); A. Dixit and B. Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (New York: W. W. Norton, 1991); and H. Raiffa, The Art and Science of Negotiation (Cambridge, MA: Harvard University Press, 1982).