International Business Homework : Country Analysis Report

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Global Business Today 9e

by Charles W.L. Hill

and Tomas Hult

© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 8

Foreign Direct Investment

Learning Objectives

The learning objectives for this chapter are to:

Recognize current trends regarding foreign direct investment (FDI) in the world economy.

Explain the different theories of FDI.

Understand how political ideology shapes a government’s attitudes toward FDI.

Describe the benefits and costs of FDI to home and host countries.

Explain the range of policy instruments that governments use to influence FDI.

Identify the implications for managers of the theory and government policies associated with FDI.

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Introduction

Question: What is foreign direct investment?

Foreign direct investment (FDI): a firm invests directly in new facilities to produce or market in a foreign country

A firm engaged in FDI is a multinational enterprise

Two forms of FDI:

A greenfield investment - the establishment of a wholly new operation in a foreign country

Acquisition or merging with an existing firm in the foreign country

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FDI in the World Economy

The flow of FDI - the amount of FDI undertaken over a given time period

Outflows of FDI are the flows of FDI out of a country

Inflows of FDI are the flows of FDI into a country

The stock of FDI - the total accumulated value of foreign-owned assets at a given time

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Internet Extra: Each year, Fortune magazine publishes a list of the 500 largest global corporations in the world. Go to the magazine’s web site {http://fortune.com/rankings} and explore the list. Which country has the most companies on the list? Which region of the world is most represented? Are there any new entrants? Are certain industries better represented than others? What conclusions can you draw from your findings? Are there other meaningful trends to consider?

Trends in FDI

Both the flow and stock of FDI in the world economy have increased over the last 35 years

FDI has grown more rapidly than world trade and world output because:

Firms still fear protectionist policies

The shift toward democratic political institutions and free market economies encourages FDI

Globalization is prompting firms to ensure they have a significant presence in many regions of the world

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Trends in FDI (continued from Slide 8-6)

FDI Outflows 1980-2012 ($ billions)

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The Direction of FDI

Historically, most FDI has been directed at the developed nations of the world

The United States is a favorite target as is the European Union

More recently, developing nations have been the recipients of FDI

South, East, and Southeast Asia, and particularly China have received significant inflows

Latin America is also emerging as an important region for FDI

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Country Focus: Foreign Direct Investment in China

Summary

This feature explores investment opportunities in China. In the late 1970s, China opened its doors to foreign investors. By 2011, China attracted a record $124 billion of FDI, and now claims the position of being second only to the United States in terms of attracting FDI. China’s large population is a magnet for many companies and because high tariffs make it difficult to export to the Chinese market, firms frequently turn to foreign direct investment. However, many companies have found it difficult to conduct business in China, and in recent years investment rates have slowed. In response, the Chinese government, hoping to continue to attract foreign companies has established a number of incentives for would-be investors. The following questions can be used in a discussion.

1. Consider the challenges involved with investing in China. How does China’s political position and economic situation affect its ability to attract foreign direct investment?

Discussion Points: Students will probably recognize that while on the surface, China has tremendous market potential it is still a poor country. Anticipated demand does not always translate into actual demand. In addition, opportunistic and inexperienced local joint venture partners can make it challenging for companies to successfully establish their presence in China. Furthermore, the country’s highly regulated environment and lack of protection for proprietary assets can make it difficult for companies to conduct business.

2. Discuss China’s efforts to encourage investment in its underdeveloped areas. What effect will investment have on these areas? How can firms prepare for the unique challenges of operating in these areas?

Discussion Points: China is making a concerted effort to continue to attract investment, especially in the country’s less developed areas. Recognizing the problems associated with its infrastructure, the country has committed $800 billion to improvements over the next decade. In addition, China is offering preferential tax breaks to countries that invest in more remote areas.

Lecture Note: Despite the strong interest in China as an investment destination, some believe that China is still unstable, and not yet ready to handle the responsibilities of being a global superpower. For more information, go to {http://www.businessweek.com/articles/2012-09-27/china-what-kind-of-superpower} and {http://www.businessweek.com/ap/2014-10-28/china-wants-better-legal-system-under-party-rule}.

Lecture Note: While China remains a popular location for foreign investment {http://www.bbc.com/news/business-23339706}, questions about the country’s infrastructure have risen recently. For more details, go to {http://www.businessweek.com/articles/2012-09-27/the-cracks-in-chinas-shiny-buildings}.

The Direction of FDI (continued from Slide 8-8)

FDI Inflows by Region ($ billion), 1995 -2012

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The Direction of FDI (continued from Slide 8-9)

Since World War II, the U.S. has been the largest source country for FDI

Other important source countries: the United Kingdom, the Netherlands, France, Germany, and Japan

Chinese firms have recently emerged as major foreign investors

The largest source countries – the United States, United Kingdom, Japan, France, Germany, and the Netherlands - also predominate in rankings of the world’s largest multinationals.

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The Direction of FDI (continued from Slide 8-10)

Cumulative FDI Outflows ($ billions), 1998 - 2012

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The Form of FDI

Most cross-border investment involves mergers and acquisitions rather than greenfield investments

Acquisitions are attractive because:

They are quicker to execute than greenfield investments

It is easier and less risky for a firm to acquire desired assets than build them from the ground up

Firms believe they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills

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Theories of FDI

Question: Why do firms prefer FDI to either:

1. Exporting: producing goods at home and then shipping them to the receiving country for sale

2. Licensing: granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee on every unit that the foreign entity sells

Answer: To answer this question, we need to look at the limitations of exporting and licensing, and the advantages of FDI

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Management Focus: Foreign Direct Investment by Cemex

Summary

This feature examines Cemex’s rise to global status. Cemex is the world’s third largest cement company and Mexico’s largest multinational company. In Mexico, Cemex is known for its efficient manufacturing and excellent customer service. Cemex began its international expansion in an effort to reduce its reliance on the Mexican market, to capitalize on demand in developing countries and its knowledge of the needs of developing companies, and finally, to increase its value by acquiring inefficient companies and transferring its skills to those companies. Cemex plans to continue its foreign expansion, and believes that China and India will be important markets in the future. The following questions can be used in a discussion.

1. Reflect on the decision made by Cemex with regard to international expansion. Why do you think the company chose to invest directly in other countries rather than export? Why was it more attractive for Cemex to acquire companies in foreign markets rather than establish its own operations?

Discussion Points: Most students will quickly recognize the difficulties inherent in shipping cement. In the case of Cemex, transportation is made even more critical because of the short “set” time involved with its product. Cemex sells ready-mixed cement that has a life of just 90 minutes. Therefore, it is essential for Cemex to be close to its customers, which implies that exporting is not an option for the company. In addition, one of Cemex’s competitive advantages lies in its superior customer service and relationship with distributors – advantages that could be difficult to transfer through licensing agreements. Most students will probably suggest that Cemex’s apparent preference for acquisitions over greenfield investments probably reflects the company’s desire to quickly establish a presence in the foreign market.

2. What benefits does Cemex bring to host countries? Why do you think the Indonesian government was suspicious of the company’s intentions there? Do you agree with the company’s decision to pull out of the market?

Discussion Points: Most students will probably agree that in addition to providing jobs in host countries, Cemex also brings benefits like new technology, management know-how, and marketing know-how. Students may also note that because Cemex often acquires existing companies, it helps bring these companies to full production. Many students may suggest that Cemex did not fare as well in the Indonesian market because of its dispute with the Indonesian government. Cemex had been promised a majority position in the government-owned cement company, Semen Gresik, a promise that never materialized. Students may suggest that trust is essential in business, and the fact that the Indonesian government did not follow through with its promises justified Cemex’s actions in the country.

Teaching Tip: To learn more about Cemex’s foreign operations, go to {http://www.cemex.com/}.

Lecture Note: To extend this discussion, consider {http://www.businessweek.com/news/2014-04-30/cemex-loss-widens-as-mexico-construction-industry-slump-lingers}

Theories of FDI (continued from Slide 8-13)

1. Limitations of Exporting: an exporting strategy can be limited by transportation costs and trade barriers

When transportation costs are high, exporting can be unprofitable

Foreign direct investment may be a response to actual or threatened trade barriers such as import tariffs or quotas

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Theories of FDI (continued from Slide 8-14)

2. Limitations of Licensing: internalization theory (aka market imperfections) suggests:

Licensing could result in a firm’s giving away valuable technological know-how to a potential foreign competitor

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

Licensing may be difficult if the firm’s competitive advantage is not amendable to it

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Theories of FDI (continued from Slide 8-15)

3. Advantages of Foreign Direct Investment:

FDI will be favored over exporting when:

Transportation costs are high

Trade barriers are high

FDI will be favored over licensing when:

The firm wants control over its technological know-how

The firm wants control over its operations and business strategy

The firm’s capabilities are not amenable to licensing

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The Pattern of FDI (continued from Slide 8-16)

It is common for firms in the same industry to:

Have similar strategic behavior and undertake foreign direct investment around the same time

Direct their investment activities towards certain locations at certain stages in the product life cycle

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The Pattern of FDI (continued from Slide 8-17)

1. Strategic Behavior

Knickerbocker explored the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms)

FDI flows reflect strategic rivalry between firms

This theory can be extended to multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries)

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The Eclectic Paradigm

Dunning’s eclectic paradigm - in addition to the various factors discussed earlier, two additional factors must be considered when explaining both the rationale for and the direction of foreign direct investment

Location-specific advantages - arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets

Externalities - knowledge spillovers that occur when companies in the same industry locate in the same area

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Political Ideology and FDI

Ideology toward FDI has ranged from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economies

Between these two extremes is an approach that might be called pragmatic nationalism

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The Radical View

The radical view: the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries

The radical view has been in retreat because of:

The collapse of communism in Eastern Europe

The poor economic performance of those countries that had embraced the policy

The strong economic performance of developing countries that had embraced capitalism

The radical view traces its roots to Marxist political and economic theory.

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The Free Market View

The free market view: international production should be distributed among countries according to the theory of comparative advantage

Countries should specialize in the production of goods and services they can produce most efficiently

The MNE increases the overall efficiency of the world economy

The free market view traces its roots to classical economics and the trade theories of Adam Smith and David Ricardo.

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Pragmatic Nationalism

The pragmatic nationalist view: FDI has benefits and costs

Benefits: inflows of capital, technology, skills and jobs

Costs: repatriation of profits to the home country and a negative balance of payments effect

FDI should be allowed only if the benefits outweigh the costs

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Shifting Ideology

In recent years, there has been a strong shift toward the free market stance creating:

A surge in the volume of FDI worldwide

An increase in the volume of FDI directed at countries that have recently liberalized their regimes

China, India, Vietnam

But, some countries are becoming more hostile to FDI

Venezuela, Bolivia

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Management Focus: DP World and the United States

Summary

This feature explores the reaction to the bid by DP World, a Dubai-based ports operator, to acquire P&O, a British firm that runs a network of global marine terminals. An acquisition of P&O would give DP World management of six U.S. ports. While the Bush administration claimed the acquisition posed no threat to national security, several prominent U.S. Senators raised concerns about the acquisition. Ultimately, DP World pulled out of the deal, but stated that it would look for alternative ways to enter the U.S. market, beginning with an initial public offering in 2007. The following questions can be used in a discussion.

Suggested Discussion Questions

1. Do you agree with the senators who raised concerns about the DP World deal? Why or why not? Would your response be different if DP World were a British firm?

Discussion Points: This issue will probably generate significant debate among students. At the heart of the issue is whether a company, because of its country of origin, should be denied ownership of something that could be important to a nation’s national security. Some students will probably argue that the United States was unjustified in its reaction to the deal, that DP World has a long history of American associations. Students taking this perspective will probably suggest that the United States is being prejudiced against the company simply because of its nationality. Other students however, will probably claim that DP World’s role in with American companies to date, has not involved ownership of ports that could be important to the country’s national security. Students in this camp will probably argue that the ports should be owned by American companies, or at least companies from countries that are allies of the United States in order to preserve national security, but definitely not a state-owned company from the Middle East. The implication here is that ownership of the ports would effectively transfer to a foreign government.

2. DP World has vowed to enter the United States market in some other way. Why is the U.S. market so important to DP World? What do you think the response of the government might be to another attempt by DP World?

Discussion Points: The U.S. market is important to DP World because it is an epicenter of capitalism. Goods from all over the world flow to the United States, and DP World wants to be in a position to capitalize on this. Students will probably agree that should the company make another attempt to gain a foothold in the market, the United States will be reluctant to allow DP World a significant role in the country, especially in major ports.

Teaching Tip: For more information on the company and its recent developments, go to {http://www.dpworld.ae/}.

Lecture Note: To extend this discussion, consider {http://www.businessweek.com/videos/2014-03-28/dp-world-chairman-sees-latin-america-africa-growth}.

Benefits and Costs of FDI

Question: What are the benefits and costs of FDI?

Answer:

The benefits and costs of FDI must be explored from the perspective of both the host (receiving) country and the home (source) country

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Host Country Benefits

1. Resource Transfer Effects

FDI can bring capital, technology, and management resources that would otherwise not be available

2. Employment Effects

FDI can bring jobs that would otherwise not be created there

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Host Country Benefits (continued from Slide 8-26)

3. Balance-of-Payments Effects

The balance-of-payments account records a country’s payments to and receipts from other countries

The current account records a country’s export and import of goods and services

A surplus is usually favored over a deficit

FDI can help achieve a current account surplus:

If it is a substitute for imports of goods and services

If the MNE uses a foreign subsidiary to export goods and services to other countries

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Host Country Benefits (continued from Slide 8-27)

4. Effect on Competition and Economic Growth

FDI in the form of greenfield investment:

Increases the level of competition in a market

Drives down prices

Improves the welfare of consumers

Increased competition can lead to:

Increased productivity growth

Product and process innovation

Greater economic growth

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Host Country Costs

1. Adverse Effects on Competition

The subsidiaries of foreign MNEs may have greater economic power than indigenous competitors because they may be part of a larger international organization

The MNE could draw on funds generated elsewhere to subsidize costs in the local market

Doing so could allow the MNE to drive indigenous competitors out of the market and create a monopoly position

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Host Country Costs (continued from Slide 8-29)

2. Adverse Effects on the Balance of Payments

There are two possible adverse effects of FDI on a host country’s balance-of-payments:

The capital outflows as foreign subsidiaries repatriate earnings to the parent country

There is a debit on the current account of the host country’s balance of payments associated with imports of input products by the foreign subsidiary

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Host Country Costs (continued from Slide 8-30)

3. National Sovereignty and Autonomy

FDI can mean some loss of economic independence

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

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Home Country Benefits

The benefits of FDI to the home country include:

The effect on the capital account of the home country’s balance of payments from the inward flow of foreign earnings

The employment effects that arise from outward FDI

The gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country

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Home Country Costs

The balance-of-payments

The balance of payments suffers from the initial capital outflow required to finance the FDI

The current account is negatively affected if the purpose of the FDI is to serve the home market from a low-cost production location

The current account suffers if the FDI is a substitute for direct exports

Employment effects of outward FDI

If the home country is suffering from unemployment, there may be concern about the export of jobs

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International Trade Theory and FDI

International trade theory: home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid

FDI may actually stimulate economic growth by freeing home country resources to concentrate on activities where the home country has a comparative advantage

Consumers may also benefit in the form of lower prices

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Government Policy and FDI

FDI can be regulated by both home and host countries

Governments can implement policies to:

Encourage FDI

Discourage FDI

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Home Country Policies

Encouraging Outward FDI

Many nations :

Have government-backed insurance programs to cover major types of foreign investment risk

Have special funds or banks that make governmental loans to firms investing in developing countries

Have eliminated double taxation of foreign income

Many host nations have relaxed restrictions on inbound FDI

Government backed insurance programs can encourage firms to undertake FDI in politically unstable nations.

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Home Country Policies (continued from Slide 8-36)

2. Restricting Outward FDI

Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time

Countries manipulate tax rules to make it more favorable for firms to invest at home

Countries may restrict firms from investing in certain nations for political reasons

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Host Country Policies

1. Encouraging Inward FDI

Governments offer incentives to foreign firms to invest in their countries

Motivated by a desire to:

Gain from the resource-transfer and employment effects of FDI

Capture FDI away from other potential host countries

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Host Country Policies (continued from Slide 8-38)

Restricting Inward FDI

Ownership restraints: exclude foreign firms from certain sectors on the grounds of national security or competition

Local owners can help to maximize the resource transfer and employment benefits of FDI

Performance requirements: used to maximize the benefits and minimize the costs of FDI for the host country

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International Institutions and FDI

Until recently there has been no consistent involvement by multinational institutions in the governing of FDI

The formation of the World Trade Organization in 1995 changed this

The WTO has had some success in establishing a universal set of rules to promote the liberalization of FDI

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Implications for Managers

Question: What does FDI mean for international businesses?

Answer:

The theory of FDI has implications for strategic behavior of firms

Government policy on FDI can also be important for international businesses

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Internet Extra: The World Bank is a great place to start researching a country as a potential destination for FDI. Go to the World Bank site {http://www.worldbank.org/} and click on Data and Research, then on Foreign Direct Investment. Compare and contrast several countries on various factors to determine the relative merits of countries as host nations for investment.

The Theory of FDI

The location-specific advantages argument associated with Dunning help explain the direction of FDI

However, internalization theory is needed to explain why firms prefer FDI to licensing or exporting

Exporting is preferable to licensing and FDI as long as transportation costs and trade barriers are low

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The Theory of FDI (continued from Slide 8-42)

Licensing is unattractive when:

The firm’s proprietary property cannot be properly protected by a licensing agreement

The firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country

The firm’s skills and capabilities are not amenable to licensing

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The Theory of FDI (continued from Slide 8-43)

A Decision Framework

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Government Policy

A firm’s bargaining power with the host government is highest when:

The host government places a high value on what the firm has to offer

When there are few comparable alternatives available

When the firm has a long time to negotiate

A host government’s attitude toward FDI is important in decisions about where to locate foreign production facilities and where to make a foreign direct investment.

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Summary

In this chapter we have:

Recognized current trends regarding foreign direct investment (FDI) in the world economy.

Explained the different theories of FDI.

Understood how political ideology shapes a government’s attitudes toward FDI.

Described the benefits and costs of FDI to home and host countries.

Explained the range of policy instruments that governments use to influence FDI.

Identified the implications for managers of the theory and government policies associated with FDI.

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