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Foreign Direct Investment

CHAPTER SEVEN

INTERNATIONAL

BUSINESS

The Challenges of Globalization

Canadian Edition

Wild • Wild • Valladares Montemayor

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Chapter Objectives

Describe worldwide patterns of foreign direct investment (FDI) and reasons for these patterns

Describe each of the theories that attempt to explain why foreign direct investment occurs

Discuss the important management issues in the foreign direct investment decision

Explain why governments intervene in the free flow of foreign direct investment

Discuss the policy instruments that governments use to promote and restrict foreign direct investment

In this chapter, you will explore foreign direct investment.

You will also:

Learn about worldwide patterns of foreign direct investment flows and the theories that attempt to explain them.
Understand important management issues in the foreign direct investment decision.
And examine why governments intervene in the flow of foreign direct investment and the methods they use.

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Foreign Direct Investment (FDI)

Purchase of physical assets or significant amount of ownership of a company in another country to gain some measure of management control

By contrast, portfolio investment does not involve obtaining a

degree of control in a company.

Photo: Gerry Taft Mount Royal University

As a Canadian investor, would you rather buy this Berlin Tour company, or be a “silent partner”?

Foreign direct investment is the purchase of physical assets or a significant amount of the ownership of a company in another country to gain some measure of management control.
It differs from portfolio investment, which is an investment that does not involve obtaining a degree of control in a company.
Most governments set the FDI threshold at somewhere between 10 and 25 percent of stock ownership in a company abroad.
The U.S. Commerce Department says that stock ownership above 10 percent constitutes FDI.

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Ups and Downs of Foreign Direct Investment

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

FDI inflows grew around 20 percent per year in the first half of the 1990s and expanded about 40 percent per year in the second half of the decade. As shown in Figure 7.1 , global FDI inflows averaged roughly $580 billion annually between 1995 and 1999. The figure also shows that FDI inflows peaked at around $1.4 trillion in 2000, but then slowed in 2001, 2002, and 2003. Strong economic performance and high corporate profits in many countries lifted FDI inflows in 2004,

2005, 2006, and reached an all-time record of more than $1.9 trillion in 2007. Global FDI inflows slowed considerably during the global credit crisis of 2008–2009 amid shrinking corporate profits and plummeting stock prices. However, FDI inflows started to recover during 2010 and 2011, and are expected to keep rising as the global economy emerges from recession.

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Reasons for FDI Growth

Increasing

Globalization

International mergers

and acquisitions

How is this crosswalk in London, England designed to help people from other countries?

Photo: Gerry Taft, Mount Royal University

One main driver behind global flows of foreign direct investment is increasing globalization.

Globalization of the world economy encourages firms to use FDI as a way to create low-cost production bases.
It also prompts multinationals from advanced and emerging economies alike to buy up businesses in other markets.

Another driver is international mergers and acquisitions.

Mergers and acquisitions have propelled long-term growth in FDI and will likely do so for the foreseeable future.

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Mergers And Acquisitions

In 2011 the total value of cross-border M&As was $526 billion, an increase from 44 megadeals in 2010 to 62 in 2011. Figure 7.2 also shows the values for greenfield FDI projects, which, in contrast to M&As, remained flat in value terms.

Many cross-border M&A deals are driven by the desire of companies to:

● Get a foothold in a new geographic market.

● Increase a firm’s global competitiveness.

● Fill gaps in companies’ product lines in a global industry.

● Reduce costs of research and development (R&D), production, distribution, and so forth.

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Worldwide FDI Flows

World FDI inflows

Developed (57%), developing (37%)

European Union: 30% of world FDI

Developing nations

China: 6.4% of world FDI

All of Africa: 5.2% of world FDI

82,000 multinationals

with

810,000 affiliates

More than 82,000 multinational companies with over 810,000 affiliates drive global FDI flows.
Developed countries account for about 57% of all world FDI—the main recipients being the European Union, the United States, and Japan.
Developing and emerging markets account for about 37% of global FDI, with the largest portions going to China and India.
Outflows of FDI from emerging economies are also on the rise.

Canada’s Flows of FDI

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It is evident (see Table 7.1 ) that the United States is still the main source of both inward and outward FDI. Economists generally agree that the FDI flows with emerging markets, particularly countries with which Canada has signed free trade agreements, need to grow in order for Canada to sustain its economic position.

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Discussion Question

What is the difference between foreign direct investment and portfolio investment?

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Answer to Discussion Question

Foreign direct investment is the purchase of physical assets or a significant amount of the ownership of a company in another country to gain a measure of management control. A portfolio investment is an investment that does not involve obtaining a degree of control in a company.

Answer:

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International Product Life Cycle

A company begins by exporting its product and later undertakes foreign direct investment as a product moves through its life cycle

Source: Raymond Vernon and Louis T. Wells, Jr., The Economic Environment of International Business, 5th ed. (Upper Saddle River, N.J.: Prentice Hall, 1991), p. 85.

The international product life cycle theory is divided into three stages:

In stage 1, the new product stage, a good is produced entirely in the home market and virtually no export market exists.
In stage 2, the maturing product stage, a good is produced in the home market and in markets abroad that are large enough to warrant production facilities.
In stage 3, the standardized product stage, a company builds production capacity in relatively low-cost nations that will then serve global markets.

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Market Imperfections (Internalization)

A company undertakes FDI to internalize a transaction that is made inefficient because of a market imperfection

Trade barriers

(e.g., tariffs)

Unique advantage

(e.g., special knowledge)

Photo: Gerry Taft, Mount Royal University

China requires local participation in all FDI ventures

The market imperfections (or internalization) 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 eliminate the imperfection.

One type of market imperfection is a trade barrier, such as a tariff.
Another type of imperfection is a company’s unique competitive advantage, such as specialized knowledge, technical expertise, or special abilities embodied in employees.

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Eclectic Theory

A firm undertakes FDI when location, ownership, and internalization advantages combine to make a location appealing

Photo: Gerry Taft, Mount Royal University

Location advantage

(optimal location)

Ownership advantage

(special asset)

Internalization advantage

(efficiency)

Do you think this restaurant in Zihuatanejo, Mexico has a location advantage for a Canadian Investor?

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.

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Market Power

A firm undertakes FDI to establish a dominant presence in an industry

Vertical integration

Extends company’s activities

into stages of production that provide its inputs (backward integration) or absorb its out-puts (forward integration)

Market power

= Greater profits

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

The benefit of market power is increased profits because greater power helps a firm to dictate the cost of its inputs and/or the price of its output.
Companies can gain market power through vertical integration—the extension of activities into production that provide a firm’s inputs or absorb its output.

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Discussion Question

The eclectic theory says that firms undertake FDI when location, ownership, and __________ advantages combine to make a location appealing for investment.

a. Internalization

b. First-mover

c. Life-cycle

The eclectic theory says that firms undertake FDI when location, ownership, and __________ advantages combine to make a location appealing for investment.

a. Internalization

b. First-mover

c. Life-cycle

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Answer to Discussion Question

The eclectic theory says that firms undertake FDI when location, ownership, and __________ advantages combine to make a location appealing for investment.

a. Internalization

b. First-mover

c. Life-cycle

The correct answer is a. Internalization

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Management Issues I

Control

over factors such as selling price in a local market

Purchase-or-build

to build a subsidiary from the ground up is called a greenfield investment.

Photo: Gerry Taft, Mount Royal University

Some office space for rent in downtown Ulaan Bator, Mongolia

Many companies invest abroad to increase their control over factors such as selling price in a local market. But a host nation may demand shared ownership in an operation.

Benefits to companies of shared ownership can include better communication with local government officials.
Benefits to the host country are worker and industry protection, and more control over worker training and technology transfers.

The purchase-or-build decision entails deciding whether to purchase an existing business or to build a subsidiary from the ground up—called a greenfield investment.

Benefits of purchasing a firm include the existing company’s goodwill in the marketplace, brand recognition, and potential sources of financing.
Drawbacks of purchasing existing facilities can include obsolete equipment, poor labor relations, and an unsuitable location.
A greenfield investment lets a company start operating with a clean slate, but drawbacks include obtaining permits, arranging financing, and hiring local personnel.

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Management Issues II

Production

Costs

that add to local labor costs include worker benefits, training programs, and burdensome regulations.

Customer

Knowledge

A local presence can give companies valuable knowledge of customers that is unobtainable in the home market.

Photo: Gerry Taft, Mount Royal University

Where is the best location to build “mini” cars or folding bicycles? Where is the best location to sell them?

Production costs that add to local labor costs include worker benefits, training programs, and burdensome regulations.

Rationalized production, whereby each component is produced where its production cost is lowest, can be problematic if a work stoppage in one country can halt the entire production process.
Mexico’s Maquiladora zone along the U.S.-Mexico border has become a model for other regions split by wage or technology gaps. Yet, union jobs in the United States are sometimes lost to nonunion jobs in maquiladora firms that operate under less stringent regulations.
Lower research and development costs can encourage cross-border alliances and acquisitions, but such costs can be secondary to supply factors such as access to top scientists and technical experts.

Knowledge of customer and buyer behavior can be a key issue in the decision of whether to undertake FDI.

A local presence can give companies valuable knowledge of customers that is unobtainable in the home market.

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Management Issues III

Following clients

FDI puts the supplier nearer to their customers where they can better understand and anticipate their needs

Following rivals

not matching rivals’ moves means the loss of a “first mover” advantage or being shut out of a lucrative market altogether.

From Mexico City - above, to Moscow - below,

cities around the world are providing space for companies to offer urban bicycle rentals.

How important is a “first mover” advantage in this market?

Photos: Gerry Taft, Mount Royal University

The practice of following clients into markets abroad typically occurs when suppliers of component parts have close working relationships with their customers. An FDI puts the supplier nearer to their customers where they can better understand and anticipate their needs.
The practice of following rivals resembles a “follow the leader” scenario and is common in industries with a limited number of large firms. The force behind FDI is a belief that not matching rivals’ moves means the loss of a “first mover” advantage or being shut out of a lucrative market altogether.

Think – Pair - Share

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Mexico City uses rubber tires instead of steel wheels for their metro system.

How do you think following Management Issues impact Bombardier when they bid on transportation systems?

Control

Purchase-or-build

Production Costs

Customer Knowledge

Following clients

Following rivals

Photo: Gerry Taft, Mount Royal University

Slide 20 is the first “Think-Pair-Share” in this chapter. These slides are intended to stimulate discussion between students. The activity requires students to consider the question individually, and then share their thoughts with one classmate or a small group. The goals of these slides are to 1) improve students’ conceptual understanding of the material, 2) hone critical thinking skills, and 3) improve problem solving.

Mexico City uses rubber tires instead of steel wheels for their metro system. How do you think following Management Issues impact Bombardier when they bid on transportation systems?

Many companies invest abroad to increase their control over factors such as selling price in a local market. But a host nation may demand shared ownership in an operation.

Benefits to companies of shared ownership can include better communication with local government officials.
Benefits to the host country are worker and industry protection, and more control over worker training and technology transfers.

The purchase-or-build decision entails deciding whether to purchase an existing business or to build a subsidiary from the ground up—called a greenfield investment.

Production costs that add to local labor costs include worker benefits, training programs, and burdensome regulations.

Rationalized production, whereby each component is produced where its production cost is lowest, can be problematic if a work stoppage in one country can halt the entire production process.
Mexico’s Maquiladora zone along the U.S.-Mexico border has become a model for other regions split by wage or technology gaps. Yet, union jobs in the United States are sometimes lost to nonunion jobs in maquiladora firms that operate under less stringent regulations.
Lower research and development costs can encourage cross-border alliances and acquisitions, but such costs can be secondary to supply factors such as access to top scientists and technical experts.

Knowledge of customer and buyer behavior can be a key issue in the decision of whether to undertake FDI.

A local presence can give companies valuable knowledge of customers that is unobtainable in the home market.
Benefits of purchasing a firm include the existing company’s goodwill in the marketplace, brand recognition, and potential sources of financing.
Drawbacks of purchasing existing facilities can include obsolete equipment, poor labor relations, and an unsuitable location.
A greenfield investment lets a company start operating with a clean slate, but drawbacks include obtaining permits, arranging financing, and hiring local personnel.
The practice of following clients into markets abroad typically occurs when suppliers of component parts have close working relationships with their customers. An FDI puts the supplier nearer to their customers where they can better understand and anticipate their needs.
The practice of following rivals resembles a “follow the leader” scenario and is common in industries with a limited number of large firms. The force behind FDI is a belief that not matching rivals’ moves means the loss of a “first mover” advantage or being shut out of a lucrative market altogether.

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Balance of Payments

Capital account

Current account

National accounting system that records all payments to entities in other countries and all receipts coming into the nation

The import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country

The purchase or sale of assets (including assets such as property and shares of common stock in a company)

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

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 plants and equipment, and financial assets such as shares of stock in a company abroad.

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Canada’s Balance of Payments

Table 7.3 shows that Canada had a current account deficit (see the line that reads Total current account under the Balances section) in the year shown.

Payments to entities in other nations are reductions in the balance of payments accounts and recorded with a minus (–) sign.

Receipts from other nations are additions to the balance of payments accounts and recorded with a plus (+) sign.

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Discussion Question

What do we mean by a country’s balance of payments and what is its usefulness?

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Answer to Discussion Question

A country’s balance of payments is a national accounting system that records all payments to entities in other countries and all receipts coming into the nation. The system helps a country monitor the flows of goods, services, income, and transfer of assets between itself and other nations. The balance of payments position sends warning signals about trade deficits with other nations.

Answer:

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Host Intervention in FDI

Balance of Payments

FDI may generate exports

Initial FDI boosts economy

FDI may decrease imports

Host countries get a balance-of-payments boost from initial FDI inflows. The balance-of-payments position benefits further if that investment produces goods destined for export.
When a company repatriates profits back to its home market, it depletes the host nation’s foreign exchange reserves and decreases the balance of payments. This entices some host nations to restrict foreign firms from repatriating profits.
By contrast, a host country conserves its foreign exchange reserves when foreign companies reinvest earnings locally. This boosts the host nation’s exports and improves its balance-of-payments position.

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Host Intervention in FDI

Obtain resources

and benefits

Access technology

Access management skills

Create employment

Host countries also intervene in foreign direct investments to obtain resources and benefits.

Encouraging FDI in new technological products and processes increases the competitiveness and productivity of a host country.
A host country can also obtain management skills and employment benefits if the FDI involves technical training of locals in how to operate facilities. Some of these managers may go on to establish their own homegrown businesses.
In general, inflows of foreign direct investment tend to increase economic output and enhance standards of living in a host country.

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Home Intervention in FDI

Improves competitiveness

Offshore ‘sunset’ industries

Remove national resources
Eliminate export markets
Eliminate domestic jobs

Home countries may discourage outward FDI for several reasons:

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 promote outward FDI because:

FDI outflows can improve long-run competitiveness if partnering abroad provides a learning opportunity.
And FDI outflows can help export jobs in industries that use obsolete technology or employ low-wage, low-skilled workers at home.

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Host Promotion Methods

Financial incentives

Low or waived taxes
Low-interest loans

Infrastructure benefits

Better seaports, roads, and telecom networks

Photo: Gerry Taft, Mount Royal University

St Pancras railway station in London, England is where the Eurostar High Speed Train will take you under the English Channel to Paris and Brussels at up to 300 km/hr!

One method host countries can use to promote FDI inflows are financial incentives.

Tax incentives and/or low-interest loans to attract investment are common incentives.
But if bidding wars arise between locations competing for the investment, the cost of the FDI for taxpayers may be more than what the actual jobs will pay.

Other methods to promote FDI inflows include infrastructure improvements.

Lasting benefits for communities in the host nation can arise from local infrastructure improvements—including better seaports for containerized shipping, improved roads, and advanced telecommunications systems.

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Host Restriction Methods

Ownership restrictions

Prohibit investment in

industries or businesses

Performance demands

Local content requirements
Export targets
Technology transfers

Photo: Gerry Taft, Mount Royal University

Ocean Ports around the world, like this one in Grundarfjordur, Iceland, are typically subject to Ownership Restrictions

One method host countries can use to restrict FDI inflows are ownership restrictions.

Governments can prohibit foreign companies from investing in certain industries or owning certain types of businesses.
They may also require foreign investors to hold less than a 50% stake in a local firm.

Other methods to restrict FDI inflows include performance demands.

Such demands can dictate the portion of a product’s content that originates locally, stipulate that a portion of output must be exported, or demand that certain technologies be transferred to local businesses.

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Home Promotion Methods

Insurance on assets abroad

Loans and loan guarantees

Tax breaks on profits earned abroad

Special tax treaties

Persuade other nations to accept FDI

To promote FDI outflows, home nations can:

Offer insurance to cover the risks of investing assets abroad.
Grant loans to firms wishing to increase their investments abroad.
Offer tax breaks on profits earned abroad or negotiate special tax treaties.
And apply political pressure to get other nations to relax their restrictions on FDI inflows.

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Home Restriction Methods

Higher taxes on

foreign income

Sanctions that prohibit investing

To restrict FDI outflows, home countries can:

Impose a higher tax rate on income earned abroad than that levied on domestic earnings.
And impose sanctions that prohibit domestic firms from making investments in certain nations.

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Discussion Question

A host government may encourage an initial FDI because the inflow can __________ its balance-of-payments position.

a. Level

b. Lower

c. Boost

A host government may encourage an initial FDI because the inflow can __________ its balance-of-payments position.

a. Level

b. Lower

c. Boost

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Answer to Discussion Question

A host government may encourage an initial FDI because the inflow can __________ its balance-of-payments position.

a. Level

b. Lower

c. Boost

The correct answer is c. Boost

Think - Pair - Share

“It is every company’s duty to make as much profit as possible for its owners.

If that means going abroad to reduce costs, so be it.”

Do you agree?

Why or why not?

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Photo: Gerry Taft, Mount Royal University

Raw sewage flows from these homes into the Chao Phraya river in Bangkok. Thailand has a high growth rate and is a major recipient of foreign investment .

Slide 34 is the second “Think-Pair-Share” in this chapter. These slides are intended to stimulate discussion between students. The activity requires students to consider the question individually, and then share their thoughts with one classmate or a small group. The goals of these slides are to 1) improve students’ conceptual understanding of the material, 2) hone critical thinking skills, and 3) improve problem solving.

“It is every company’s duty to make as much profit as possible for its owners.

If that means going abroad to reduce costs, so be it.”

Do you agree? Why or why not?

By this point in the course, students should be able to give a detailed response to why they agree or disagree with either of these managers. They should understand the role of culture, politics, and law in international business and have examined how different economic systems function. They also should have a grasp of the theories of international trade and foreign direct investment and why governments intervene in their free flow. Thus, students should include in their response a rational discussion of how culture, politics, law, and economics influence their own opinion. The opinions of most students will likely lie somewhere in-between those of the two managers quoted.