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International Business

https://saylordotorg.github.io/text_international-business/s06-international-trade-and-foreig.html

Chapter 2. Cont.

International Trade and FDI

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This chapter defines the scope of international business and introduces us to some of its most important topics.

Learning Objectives

7.1 Describe the worldwide pattern of foreign direct investment (F D I).

7.2 Summarize each theory that attempts to explain why F D I occurs.

7.3 Outline the important management issues in the F D I decision.

7.4 Explain why governments intervene in F D I.

7.5 Describe the policy instruments governments use to promote and restrict F D I.

In this chapter, we examine the importance of FDI to the operations of international companies. We begin by exploring the growth of FDI in recent years and investigating its sources and destinations. We then look at several theories that attempt to explain FDI flows. Next, we turn our attention to several important management issues that arise in most decisions about whether a company should undertake FDI. This chapter closes by discussing the reasons why governments encourage or restrict FDI and the methods they use to accomplish these goals.

Das Auto

Volkswagen Group (www.vw.com)

48 production facilities worldwide

Sells to more than 150 countries

Top-selling manufacturer in South America and China

China accounts for around 30% of VW’s total sales

VW’s U.S. expansion

Modular strategy

Special protection in Germany

Volkswagen Group (www.vw.com) owns 10 of the most prestigious and best-known automotive brands in the world.

From its 48 production facilities worldwide, the company produces and sells around 8 million cars annually to more than 150 countries.

Volkswagen is the top-selling manufacturer in South America and China.

China accounts for around 30 percent of VW’s total sales.

Volkswagen also has ambitious goals for its U.S. expansion. It is adapting designs to domestic tastes, cutting prices, and adding inexpensive production capacity.

The company uses a modular strategy in production that lets it use the same key components in 16 different vehicles and 7 million units across its brands.

Volkswagen, like companies everywhere, received plenty of help in getting where it is today. Until recently, Volkswagen received special protection from its own legislation known as the VW Law. The law gave the German state of Lower Saxony, which owns 20.1 percent of Volkswagen, the power to block any takeover attempt that threatened local jobs and the economy. Volkswagen’s special treatment lies in the close ties between government and management in Germany and its importance to the nation’s economy, where it employs tens of thousands of people.

Foreign Direct Investment

Purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control

Nations set different thresholds at which they classify an international capital flow as FDI. The US Commerce Department sets the threshold at 10 percent of stock ownership in a company abroad, but most other governments set it at anywhere from 10 to 25 percent.

Portfolio Investment

Investment that does not involve obtaining a degree of control in a company

International flows of capital are at the core of foreign direct investment (FDI)—the purchase of physical assets or a significant amount of the ownership (stock) of a company in another country in order to gain a measure of management control.

But there is wide disagreement on what exactly constitutes FDI. Nations set different thresholds at which they classify an international capital flow as FDI.

The U.S. Commerce Department sets the threshold at 10 percent of stock ownership in a company abroad, but most other governments set it at anywhere from 10 to 25 percent. By contrast, an investment that does not involve obtaining a degree of control in a company is called a portfolio investment.

Pattern of Foreign Direct Investment

Figure 7.1 Yearly Foreign Direct Investment Inflows

Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years.

As shown in Figure 7.1, global FDI inflows averaged $548 billion annually between 1994 and 1999. FDI inflows peaked at around $1.4 trillion in 2000 and then slowed. FDI inflows benefitted from strong economic performance and high corporate profits in many countries between 2004 and 2007, at which point it reached an all-time record of more than $1.9 trillion. Global recession meant declining FDI inflows in 2008 and 2009. FDI inflows climbed again in 2010 and 2011; then dipped in 2012, 2013, and 2014; and then rose to nearly $1.8 trillion in 2015 as the world emerged form recession.

Drivers of F D I Flows

Globalization.

As countries lowered their trade barriers, companies realized that they could now produce in the most efficient and productive locations and simply export to their markets worldwide. This set off another wave of FDI flows into low-cost emerging markets.

Mergers and Acquisitions

The terms merger and acquisition mean slightly different things, though they are often used interchangeably.

The two main drivers of FDI flows are

Globalization: As countries lowered their trade barriers, companies realized that they could now produce in the most efficient and productive locations and simply export to their markets worldwide. This set off another wave of FDI flows into low-cost emerging markets. The forces behind globalization are, therefore, part of the reason for long-term growth in FDI.

International Mergers and Acquisitions: The number of mergers and acquisitions (M&As) and their rising values over time also underlie long-term growth in FDI. In fact, cross-border M&As are the main vehicle through which companies undertake FDI.

Mergers and Acquisitions

When one company takes over another and clearly establishes itself as the new owner, the purchase is called an acquisition.

From a legal point of view, the target company ceases to exist, the buyer absorbs the business and the buyer's stock continues to be traded while the target company’s stock does not.

Mergers and Acquisitions

In the pure sense of the term, a merger happens when two firms, often of about the same size, agree to go forward as a single new company rather than remain separately owned and operated.

This kind of action is more precisely referred to as a "merger of equals." Both companies' stocks are surrendered and new company stock is issued in its place. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, Daimler Chrysler, was created.

Figure 7.2 Value of Cross-Border Mergers and Acquisitions

Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years.

The value of cross-border M&As peaked in 2000 at around $1.2 trillion. After three years of falling FDI, the value of cross-border M&As rose to around $1 trillion by 2007. M&A activity then cooled in 2008 and then fell significantly in 2009 due to the global recession. The value of cross-border M&A activity then fluctuated for several years before climbing back to $721 billion by 2015.

Worldwide Flows of F D I

Driving F D I growth are more than 100,000 multinational companies with more than 900,000 affiliates abroad.

In 2012, developing countries attracted greater F D I inflows than did developed countries.

Developed countries account for 42 percent ($561 billion) of total global F D I inflows.

F D I inflows to developing countries accounted for around 52 percent of world F D I inflows ($703 billion).

Driving FDI growth are more than 100,000 multinational companies with more than 900,000 affiliates abroad, roughly half of which are in developing countries. In 2014, for the first time ever, developing countries attracted greater FDI inflows than did developed countries.

Developed countries account for 41 percent ($522 billion) of total global FDI inflows (more than $1.28 trillion in 2014). By comparison, FDI inflows to developing countries accounted for around 55 percent of world FDI inflows ($699 billion). The remaining roughly four percent of global FDI inflows went to countries across Southeast Europe in various stages of transition from communism to capitalism.

Quick Study 1

The purchase of physical assets or significant ownership of a company abroad to gain a measure of management control is called a what?

What are the main drivers of foreign direct investment flows?

Why might a company engage in a cross-border merger or acquisition?

Management Issues and Foreign Direct Investment

Control

Purchase-or-Build Decision

Production Costs

Customer Knowledge

Following Clients

Following Rivals

Control: Many companies investing abroad are greatly concerned with controlling the activities that occur in the local market. Many companies have strict policies regarding how much ownership they take in firms abroad because of the importance of maintaining control. Governments of developing and emerging markets realize the benefits of investment by multinational corporations, including decreased unemployment, increased tax revenues, training to create a more highly skilled workforce, and the transfer of technology

Purchase-or-Build Decision: Another important matter for managers is whether to purchase an existing business or to build a subsidiary abroad from the ground up—called a greenfield investment.

Production costs are important inputs to the FDI decision.

One approach companies use to contain production costs is called rationalized production—a system of production in which each of a product’s components is produced where the cost of producing that component is lowest.

Mexico’s Maquiladora: The combination of a low-wage economy nestled next to a prosperous giant is now becoming a model for other regions that are split by wage or technology gaps.

Cost of Research and Development : As technology becomes an increasingly powerful competitive factor, the soaring cost of developing subsequent stages of technology has led multinational corporations to engage in cross-border alliances and acquisitions.

Customer Knowledge: The behavior of buyers is frequently an important issue in the decision of whether to undertake FDI.

Following Clients: Firms commonly engage in FDI when the firms they supply have already invested abroad.

Following Rivals: FDI decisions frequently resemble a “follow the leader” scenario in industries that have a limited number of large firms. In other words, many of these firms believe that choosing not to make a move parallel to that of the “first mover” might result in being shut out of a potentially lucrative market.

Quick Study 3

When adequate facilities are not present in a market, a firm may decide to undertake a what?

A system in which a product’s components are made where the cost of producing a component is lowest is called what?

What do we call the situation in which a company engages in F D I because the firms it supplies have already invested abroad?

Explain the drivers of FDI in details.

Why Governments Intervene in F D I

Nations often intervene in the flow of FDI in order to protect their cultural heritages, domestic companies, and jobs. They can enact laws, create regulations, or construct administrative hurdles that companies from other nations must overcome if they want to invest in the nation. Yet, rising competitive pressure is forcing nations to compete against each other to attract multinational companies. The increased national competition for investment is causing governments to enact regulatory changes that encourage investment.

Why Governments Intervene in F D I

A country’s balance of payments is a national accounting system that records all receipts coming into the nation and all payments to entities in other countries.

International transactions that result in inflows from other nations add to the balance of payments accounts.

International transactions that result in outflows to other nations reduce the balance of payments accounts.

Balance of payments has two major components—the current account and the capital account. The balances of the current and capital accounts should be equal.

Why Governments Intervene in F D I (1 of 4)

Balance of Payments

Current Account

National account that records transactions involving the export and import of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country

Capital Account

National account that records transactions involving the purchase and sale of assets

A country’s balance of payments is a national accounting system that records all receipts coming into the nation and all payments to entities in other countries.

The current account records transactions involving the import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country.

The capital account records transactions involving the purchase or sale of assets. These assets include physical assets such as foreign direct investments in factories and equipment, and financial assets such as shares of stock in a company abroad.

Table 7.1 U.S. Balance of Payments Accounts (1 of 2)

CURRENT ACCOUNT	Blank	Blank	Blank
Exports of goods and services and income receipts	+	Blank	Blank
Merchandise	+	Blank	Blank
Services	+	Blank	Blank
Income receipts on U.S. assets abroad	+	Blank	Blank
Imports of goods and services and income payments	Blank	Blank	−
Merchandise	Blank	Blank	−
Services	Blank	Blank	−
Income payments on foreign assets in United States	Blank	Blank	−
Unilateral transfers	Blank	Blank	−
Current account balance	Blank	+/−	Blank

Table 7.1 shows the balance of payments accounts for the United States, which has two major components—the current account and the capital account. The balances of the current and capital accounts should be equal.

Table 7.1 U.S. Balance of Payments Accounts (2 of 2)

CAPITAL ACCOUNT	Blank	Blank	Blank
Increase in U.S. assets abroad (capital outflow)	Blank	Blank	−
U.S. official reserve assets	Blank	Blank	−
Other U.S. government assets	Blank	Blank	−
U.S. private assets	Blank	Blank	−
Foreign assets in the United States (capital inflow)	+	Blank	Blank
Foreign official assets	+	Blank	Blank
Other foreign assets	+	Blank	Blank
Capital account balance	Blank	+/−	Blank

Why Governments Intervene in F D I (2 of 4)

Reasons for Intervention by the Host Country

Control the Balance of Payments

Obtain Resources and Benefits

Access to Technology

Management Skills and Employment

There are a number of reasons why governments intervene in FDI. Let’s look at the two main reasons—to control the balance of payments and to obtain resources and benefits.

Control Balance of Payments: Many governments see intervention as the only way to keep their balance of payments under control.

Obtain Resources and Benefits: Beyond balance-of-payments reasons, governments might intervene in FDI flows to acquire resources and benefits such as technology, management skills, and employment.

Access to Technology: Investment in technology, whether in products or processes, tends to increase productivity and the competitiveness of a nation.

Management Skills and Employment: Former communist nations lack some of the management skills needed to succeed in the global economy. By encouraging FDI, these nations can attract talented managers to come in and train locals and thereby improve the international competitiveness of their domestic companies.

Why Governments Intervene in F D I (3 of 4)

Home Country: Discouraging Outward F D I

Investing in other nations sends resources out of the home country and lowers investment at home.

Outgoing F D I may ultimately damage a nation’s balance of payments by taking the place of its exports.

Jobs resulting from outgoing investments may replace jobs at home.

The following are among the most common reasons for discouraging outward FDI:

Investing in other nations sends resources out of the home country and lowers investment at home.

An FDI outflow can damage a nation’s balance of payments if the investment abroad eliminates an export market.

And jobs created abroad by an FDI outflow may replace jobs in the home country.

Home countries may also promote outward FDI.

FDI outflows can increase long-term competitiveness if partnering abroad provides a learning opportunity.

FDI outflows can eliminate low-wage jobs in industries that use obsolete technology or employ low-skilled workers at home.

Why Governments Intervene in F D I (4 of 4)

Home Country: Promoting Outgoing F D I

Increase Long-Term Competitiveness

“Sunset” Industries

FDI is not always a negative influence on home nations. In fact, countries promote outgoing FDI for the following reasons:

Outward FDI can increase long-term competitiveness.

Nations may encourage FDI in industries identified as “sunset” industries. Sunset industries are those that use outdated and obsolete technologies or those that employ low-wage workers with few skills.

Quick Study 4

The national accounting system that records all receipts coming into a nation and all payments to entities in other countries is called what?

Why might a host country intervene in foreign direct investment?

Why might a home country intervene in foreign direct investment?

Government Policy Instruments and F D I (1 of 3)

Host Countries

Promotion

Financial incentives

Low or waived taxes

Low-interest loans

Infrastructure improvements

Better seaports, roads, and telecom networks

Restriction

Ownership restrictions

Prohibit investment

Performance demands

Local content requirements

Export targets

Technology transfer

Host countries offer a variety of incentives to encourage FDI inflows. These take two general forms—financial incentives and infrastructure improvements.

Financial Incentives: Host governments of all nations grant companies financial incentives to invest within their borders. One method includes tax incentives, such as lower tax rates or offers to waive taxes on local profits for a period of time—extending as far out as five years or more. A country may also offer low-interest loans to investors.

Infrastructure Improvements: Because of the problems associated with financial incentives, some governments are taking an alternative route to luring investment. Lasting benefits for communities surrounding the investment location can result from making local infrastructure improvements—better seaports suitable for containerized shipping, improved roads, and advanced telecommunications systems.

Host countries also have a variety of methods to restrict incoming FDI. Again, these take two general forms—ownership restrictions and performance demands.

Ownership Restrictions: Governments can impose ownership restrictions that prohibit nondomestic companies from investing in certain industries or from owning certain types of businesses.

Performance Demands: More common than ownership requirements are performance demands that influence how international companies operate in the host nation.

Government Policy Instruments and F D I (2 of 3)

Home Countries

Promotion

Insurance on assets abroad

Loans and loan guarantees

Special tax treaties

Persuade other nations to accept F D I

Restriction

Higher taxes on foreign income

Sanctions that prohibit investing in certain nations

To encourage outbound FDI, home-country governments can do any of the following:

Offer insurance to cover the risks of investments abroad, including, among others, insurance against expropriation of assets and losses from armed conflict, kidnappings, and terrorist attacks.

Grant loans to firms wishing to increase their investments abroad.

Offer tax breaks on profits earned abroad or negotiate special tax treaties.

Apply political pressure on other nations to get them to relax their restrictions on inbound investments.

On the other hand, to limit the effects of outbound FDI on the national economy, home governments may exercise either of the following two options:

Impose differential tax rates that charge income from earnings abroad at a higher rate than domestic earnings.

Impose outright sanctions that prohibit domestic firms from making investments in certain nations.

Government Policy Instruments and F D I (3 of 3)

Table 7.2 Instruments of FDI Policy

Blank	FDI Promotion	FDI Restriction
Host Countries	Tax incentives	Ownership restrictions
Blank	Low-interest loans	Performance demands
Blank	Infrastructure improvements	Blank
Home Countries	Insurance	Differential tax rates
Blank	Loans	Sanctions
Blank	Tax breaks	Blank
Blank	Political pressure	Blank

Over time, both host and home nations have developed a range of methods either to promote or to restrict FDI (see Table 7.2). Governments use these tools for many reasons, including improving balance-of-payments positions, acquiring resources, and, in the case of outward investment, keeping jobs at home.

Quick Study 5

What policy instruments can host countries use to promote F D I?

What policy instruments can home countries use to promote F D I?

Ownership restrictions and performance demands are policy instruments used by whom to do what?

Differential tax rates and sanctions are policy instruments used by whom to do what?

Theories of Foreign Direct Investment (1 of 4)

International Product Life Cycle

The international product life cycle theory states that a company begins by exporting its product and then later undertakes FDI as a product moves through its life cycle.

In the new product stage, a good is produced in the home country because of uncertain domestic demand and to keep production close to the research department that developed the product.

In the maturing product stage, the company directly invests in production facilities in countries where demand is great enough to warrant its own production facilities.

In the final standardized product stage, increased competition creates pressures to reduce production costs. In response, a company builds production capacity in low-cost developing nations to serve its markets around the world.

Despite its conceptual appeal, the international product life cycle theory is limited in its power to explain why companies choose FDI over other forms of market entry.

international product life cycle theory states that a company begins by exporting its product and then later undertakes FDI as a product moves through its life cycle.

In the new product stage, a good is produced in the home country because of uncertain domestic demand and to keep production close to the research department that developed the product. In the maturing product stage, the company directly invests in production facilities in countries where demand is great enough to warrant its own production facilities. In the final standardized product stage, increased competition creates pressures to reduce production costs. In response, a company builds production capacity in low-cost developing nations to serve its markets around the world.

Theories of Foreign Direct Investment (2 of 4)

Market Imperfections (Internalization)

Types of Market Imperfections

Trade Barriers

Specialized Knowledge

Market imperfections theory states that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake FDI to internalize the transaction and thereby remove the imperfection.

There are two market imperfections that are relevant to this discussion—trade barriers and specialized knowledge.

Trade Barriers: Tariffs are a common form of market imperfection in international business. The presence of a market imperfection (tariffs) might cause companies to undertake FDI.

Specialized Knowledge: This knowledge could be the technical expertise of engineers or the special marketing abilities of managers. When a company’s specialized knowledge is embodied in its employees, the only way to exploit a market opportunity in another nation may be to undertake FDI. The possibility that a company will create a future competitor by charging others a fee for access to its knowledge is another market imperfection that encourages FDI.

Internalization has different definitions depending on the field that the term is used in. Internalization is the opposite of externalization.

Internalization can refer to any process that is handled within a particular entity instead of directing it to an outside source for completion.

In business,internalization is a transaction conducted within the confines of a corporation rather than in the open market.

Perfect market

Imperfect market / Imperfect completion

A market that is said to operate at peak efficiency (prices are as low as they can possibly be) and where goods are readily and easily available is said to be a perfect market.

Perfect competition states that the buyers and sellers have the same information, all firms sell an identical product, the price of the product is determined by the market.

The assumptions for a perfect market are:

Buyers and sellers are both price takers

Companies sell virtually identical products

Buyers and sellers have perfect information

Multiple companies owns a small market share

There is no barrier of entry or exit

But perfect markets are rarely, if ever, seen in business because of factors that cause a breakdown in the efficient operation of an industry—called market imperfections.

In economic theory, imperfect competition is a type of market structure showing some but not all features of competitive markets.

Forms of imperfect competition include: Monopolistic and Oligopolistic competition.

Market imperfection theory is based on facts that everyone does not have the same homogenous expectations , there are no unlimited buyers and sellers , nor does everyone have the same information. It assumes there is no perfect competition.

There are two market imperfections that are relevant to this discussion—

trade barriers and

specialized knowledge.

Theories of Foreign Direct Investment (3 of 4)

Eclectic Theory

The eclectic theory states that firms undertake FDI when the features of a particular location combine with ownership and internalization advantages to make a location appealing for investment.

Location Advantage (natural resources, workforce)

Ownership Advantage (brand recognition, special knowledge, management ability)

Internalization Advantage (business activity)

The eclectic theory states that firms undertake foreign direct investment when the features of a location combine with ownership and internalization advantages to make a location appealing for investment.

A location advantage is the advantage of locating a particular economic activity in a specific location because of its natural or acquired characteristics.

An ownership advantage is a company advantage that arises from ownership of some special asset, such as a powerful brand, technical knowledge, or management ability.

And an internalization advantage is the advantage that arises from internalizing a business activity rather than leaving it to a relatively inefficient market.

A location advantage is the advantage of locating a particular economic activity in a specific location because of the characteristics (natural or acquired) of that location. These advantages have historically been natural resources such as oil in the Middle East, timber in Canada, or copper in Chile. But the advantage can also be an acquired one, such as a productive workforce. An ownership advantage refers to company ownership of some special asset, such as brand recognition, technical knowledge, or management ability. An internalization advantage is one that arises from internalizing a business activity rather than leaving it to a relatively inefficient market.

The eclectic theory states that when all of these advantages are present, a company will undertake FDI.

Theories of Foreign Direct Investment (4 of 4)

Market Power

The market power theory states that a firm tries to establish a dominant market presence in an industry by undertaking FDI.

The benefit of market power is greater profit because the firm is far better able to dictate the cost of its inputs and/or the price of its output.

One way a company can achieve market power (or dominance) is through vertical integration—the extension of company activities into stages of production that provide a firm’s inputs (backward integration) or that absorb its output (forward integration).

Firms often seek the greatest amount of power possible relative to rivals in their industries.

The market power theory states that a firm tries to establish a dominant market presence in an industry by undertaking FDI. The benefit of market power is greater profit because the firm is far better able to dictate the cost of its inputs and/or the price of its output.

Vertical integration the combination in one company of two or more stages of production normally operated by separate companies.

Quick Study 2

What imperfections are relevant to the discussion of market imperfections theory?

Location, ownership, and internalization advantages combine in which F D I theory?

Which F D I theory depicts a firm establishing a dominant market presence in an industry?