Global Business homework
bakliy
chapter7.pdf
L E
A R
N IN
G O
B J E
C T
IV E
S
After you have read this chapter you should be able to:
1 Recognize current trends regarding foreign direct investment in
the world economy.
2 Explain the different theories of foreign direct
investment.
3 Understand how political ideology shapes a government’s
attitudes toward FDI.
4 Describe the benefits and costs of FDI to home and
host countries.
5 Explain the range of policy instruments that governments use
to influence FDI.
6 Identify the implications for management practice of the theory and
government policies associated with FDI.
part 3 Cross-Border Trade and Investment
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opening case
Japan has been a tough market for foreign firms to enter. The level of foreign direct invest-ment (FDI) in Japan is a fraction of that found in many other developed nations. In 2008, for example, the stock of foreign direct investment as a percentage of GDP was 4.1 percent in Japan. In the United States, the comparable figure was 16 percent; in Germany, 19.2 percent; in France, 34.7 percent; and in the United Kingdom, 36.9 percent. Various reasons account for the lack of FDI into Japan. Until the 1990s, government regulations made it difficult for companies to establish a direct presence in the nation. In the retail sector, for example, the Large Scale Retail Store Law, which was designed to protect politically powerful small retailers, made it all but impossible for foreign retailers to open large-volume stores in the country (the law was repealed in 1994). Despite deregulation during the 1990s, FDI into Japan remained at low levels. Some cite cultural factors in explaining this. Many Japanese companies have resisted acquisitions by foreign enterprises (acquisitions are a major vehicle for FDI). They did so because of fears that new owners would restructure too harshly, cutting jobs and break- ing long-standing commitments with suppliers. Foreign investors also state that they find it difficult to find managerial talent in Japan, since most managers tend to stay with a single employer for their entire career, leaving very few managers in the labor market for foreign firms to hire. Furthermore, a combination of slow economic growth, sluggish consumer spending, and an aging population makes the Japanese economy less attractive than it once was, particularly when compared to the dynamic and rapidly growing economies of India and China, or even the United States and the United Kingdom. The Japanese government, however, has come around to the view that the country needs more foreign investment. Foreign firms can bring competition to Japan where local ones may not, because they do not feel bound by existing business practices or relationships. They can be a source of new management ideas, business poli- cies, and technology, all of which boost productivity. Indeed, a study by the Organization for Economic Cooperation and Development (OECD) sug- gests that labor productivity at the Japanese affiliates of foreign firms is as much as 60 percent higher than at domestic firms, and in services
Walmart in Japan
Foreign Direct Investment
7c h a p t e r
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242 Part Three Cross-Border Trade and Investment
firms it is as much as 80 percent higher. (The OECD is a Paris-based inter- governmental organization of “wealthy” nations whose purpose is to provide its 29 member states with a forum in which governments can compare their experiences, discuss the problems they share, and seek solutions that can then be applied within their own national contexts. The members include most Euro- pean Union countries, the United States, Canada, Japan, and South Korea). It was the opportunity to help restructure Japanʼs retail sector, boosting productivity, gaining market share, and profiting in the process, that attracted Walmart to Japan. The worldʼs largest retailer, Walmart entered Japan in 2002 by acquiring a stake in Seiyu, which was then the fifth-largest retailer in Japan. Under the terms of the deal, Walmart increased its ownership stake over the next five years, becoming a majority owner by 2006. Seiyu was con- sidered an inefficient retailer. According to one top officer, “Seiyu is bogged down in old customs that are wasteful. Walmart brings proven skills in man- aging big supermarkets, which is what we would like to learn to do. ” Walmartʼs goal was to transfer best practice from its U.S. stores and use them to improve the performance of Seiyu. This meant implementing Walmartʼs cutting-edge information systems, adopting tight inventory control, leveraging its global supply chain to bring low-cost goods into Japan, intro- ducing everyday low prices, retraining employees to improve customer ser- vice, extending opening hours, renovating stores, and investing in new ones. Itʼs proven to be more difficult than Walmart hoped. Walmartʼs entry prompted local rivals to change their strategies. They began to make acquisi- tions to grow and started to cut their prices to match Walmartʼs discounting strategy. Walmart also found that it had to alter its merchandising approach, offering more high-value items to match Japanese shopping habits, which were proving to be difficult to change. Also, many Japanese suppliers were reluctant to work closely with Walmart. Despite this, after years of losses, it looked as if Seiyu would become profitable in 2010, indicating that Walmart might ultimately reap a return on its investment. • Sources: D. R. John, “Wal-Mart in Japan: Survival and Future of Its Japanese Business,” Icfai University Journal of International Business 3 (2008), pp. 45–67; United Nations, World Investment Report, 2009 (New York and Geneva: United Nations, 2009); “Challenges Persist in Japan,” MMR , December 14, 2009, p. 45; and J. Matusitz and M. Forrester, “Successful Globalization Practices: The Case of Seiyu in Japan,” Journal of Transnational Management 14, no. 2 (April 2009), pp. 155–76.
Introduction Foreign direct investment (FDI) occurs when a firm invests directly in facilities to produce or market a product in a foreign country. According to the U.S. Department of Commerce, in the United States 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 . An example of FDI
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Chapter Seven Foreign Direct Investment 243
is given in the opening case: Walmart’s investment in Japan. Walmart first became a multinational in the early 1990s when it invested in Mexico. 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 acquiring or merging with an existing firm in the foreign country (Walmart’s entry into Japan was in the form of an acquisition). Acquisitions can be a minority (where the foreign firm takes a 10 percent to 49 percent interest in the firm’s voting stock), majority (foreign in- terest of 50 percent to 99 percent), or full outright stake (foreign interest of 100 percent). 1 We begin this chapter by looking at the importance of foreign direct investment in the world economy. Next, we review 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 undertaken 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 30 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 a record $1.8 trillion in 2007 (see Figure 7.1). However, FDI outflows did contract to $1.2 trillion in 2009 in the wake of the global financial crisis, although they are forecasted to recover in 2011. 2 In general, however, over the past three decades the flow of FDI has accelerated faster than the growth in world trade and world output. For example, between 1992 and 2008, the total flow of FDI from all countries increased more than eightfold while world trade by value grew by some 150 percent and world output by around 45 percent. 3 As a result of the strong FDI flow, by 2009 the global stock of FDI was about $15 trillion. At least 82,000 parent companies had 810,000 affiliates in foreign markets that collectively employed more than 77 million people abroad and generated value accounting for about 11 percent of global GDP. The foreign affiliates of multinationals had over $30 trillion in global sales, higher than the value of global exports of goods and services, which stood at close to $19.9 trillion. 4 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, business 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 2 has encouraged FDI. Across much of Asia, Eastern Eu- rope, and Latin America, economic growth, economic deregulation, privatization pro- grams 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 2,600 changes made worldwide between 1992 and 2008 in the laws governing foreign direct investment created a more favorable environment for FDI (see Figure 7.2). 5 However, since 2002, the number of regulations that are less favorable toward FDI has increased, suggesting the pendulum may be starting to swing
Greenfield Investment Establishing a new operation in a foreign country.
LEARNING OBJECTIVE 1 Recognize current trends
regarding foreign direct investment in the world
economy.
Flow of FDI The amount of FDI undertaken over a given time period (normally a year).
Stock of FDI The total accumulated value of foreign-owned assets at a given time.
Outflows of FDI The flow of FDI out of a country.
Inflows of FDI The flow of FDI into a country.
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244 Part Three Cross-Border Trade and Investment
the other way. Latin America, in particular, has seen an increase in regulations that are less favorable to FDI; two-thirds of the reported changes in 2005 and 2008 made the environment for direct investment less welcome there. Most of these unfavorable changes were focused on extractive industries, such as oil and gas, where governments seem focused on limiting FDI and capturing more of the economic value from FDI through, for example, higher taxes and royalty rates applied to foreign enterprises.
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figure 7.1
FDI Outflows, 1982–2009 ($ billion)
Source: Constructed by the author
from data in United Nations, World
Investment Report, 2009 (New York
and Geneva: United Nations, 2009).
figure 7.2
National Regulatory Changes Governing FDI,
1992–2008
Source: Constructed by the author
from data in United Nations, World
Investment Report, 2009 (New York
and Geneva: United Nations, 2009).
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Chapter Seven Foreign Direct Investment 245
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Notwithstanding recent adverse developments in some nations, the general desire of governments to facilitate FDI also has been reflected in a sharp increase in the number of bilateral investment treaties designed to protect and promote investment between two countries. As of 2009, 2,676 such treaties involved more than 180 coun- tries, a 12-fold increase from the 181 treaties that existed in 1980. 6 The globalization of the world economy is also having a positive impact on the vol- ume of FDI. Many firms (such as Walmart profiled in the opening case) now 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. For reasons that we shall explore later in this book, many firms now believe it is important to have production facilities based close to their major customers. This, too, creates pressure for greater FDI.
THE DIRECTION OF FDI Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the oth- ers’ markets (see Figure 7.3). 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 in- vestment into the United States remained high during the 2000s, totaling $271 billion in 2007 and $316 billion in 2008. The developed nations of the European Union have also been recipients of significant FDI inflows, principally from U.S. and Japanese enter- prises and from other member states of the EU. In 2007, inward investment into the EU reached a record $842 billion, although it fell to $503 billion in 2008. The United Kingdom and France were the largest national recipients. Some $280 billion was in- vested in the United Kingdom in 2007 and 2008 combined, and $275 billion in France. 7 Even though developed nations still account for the largest share of FDI inflows, FDI into developing nations has increased (see Figure 7.3). From 1985 to 1990, the annual
7.3 figure
FDI Inflows by Region, 1995–2008 ($ billion)
Source: Constructed by the author
from data in United Nations, World
Investment Report, 2009 (New York
and Geneva: United Nations, 2009).
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246 Part Three Cross-Border Trade and Investment
inflow of FDI into developing nations averaged $27.4 billion, or 17.4 percent of the total global flow. In the mid- to late 1990s, the inflow into developing nations was generally between 35 and 40 percent of the total, before falling back to account for about 25 per- cent of the total in the 2000–2002 period and then rising to 31 to 40 percent between 2004 and 2008. Most recent inflows into developing nations have been targeted at the emerg- ing economies of South, East, and Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient of FDI, which attracted around $60 bil- lion of FDI in 2004 and rose steadily to hit $108 billion in 2008. 8 The reasons for the strong flow of investment into China are discussed in the accompanying Country Focus. Latin America emerged as the next most important region in the developing world for FDI inflows. In 2008, total inward investments into this region reached about $144 billion. Mexico and Brazil have historically been the two top recipients of inward FDI in Latin America, a trend that continued in 2008. At the other end of the scale, Africa has long received the smallest amount of inward investment, although the continent did receive a record $87 billion in 2008. In recent years, Chinese enterprises have emerged as major investors in Africa, particularly in extraction industries where they seem to be trying to assure future supplies 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. 9 Another way of looking at the importance of FDI inflows is to express them as a per- centage of gross fixed capital formation. Gross fixed capital formation summarizes the total amount of capital invested in factories, stores, office buildings, and the like. Other things being equal, the greater the capital investment in an economy, the more favorable its future growth prospects are likely to be. Viewed this way, FDI can be seen as an im- portant source of capital investment and a determinant of the future growth rate of an economy. Figure 7.4 summarizes inward flows of FDI as a percentage of gross fixed
Gross Fixed Capital Formation
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invested in factories, stores, office buildings,
and the like.
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Inward FDI as a Percentage of Gross
Fixed Capital Formation, 1992–2008
Source: Constructed by the author
from data in United Nations, World
Investment Report, 2009 (New York
and Geneva: United Nations, 2009).
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Chapter Seven Foreign Direct Investment 247
Foreign Direct Investment in China
Beginning in late 1978, China’s leadership decided to move the economy away from a centrally planned socialist sys- tem to one that was more market driven. The result has been close to three decades of sustained high economic growth rates of about 10 percent annually compounded. This rapid growth has attracted substantial foreign invest- ment. Starting from a tiny base, foreign investment in- creased 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. By the late 2000s, China was attracting between $80 billion and $100 billion of FDI annually, with another $60 billion a year going into Hong Kong. Over the past 20 years, this inflow has resulted in estab- lishment of over 300,000 foreign-funded enterprises in China. The total stock of FDI in mainland China grew from effectively zero in 1978 to $378 billion in 2008 (another $835 billion of FDI stock was in Hong Kong). FDI amounted to about 8 percent of annualized gross fixed capital for- mation in China between 1998 and 2008, suggesting that FDI is an important source of economic growth in China. The reasons for the investment are fairly obvious. With a population of more than 1 billion people, China repre- sents one of the world’s largest markets. Historically, im- port 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. Although China joined the World Trade Organization in 2001, which will ulti- mately mean a reduction in import tariffs, this will occur slowly, so this motive for investing in China will persist. Also, many foreign firms believe that doing business in China requires a substantial presence in the country to build guanxi, the crucial relationship networks (see Chap- ter 3 for details). Furthermore, a combination of cheap 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. Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China. Blinded by the size and potential of China’s market, many firms have paid less attention than perhaps they should have to the complexities of operating a business in this country un- til after the investment has been made. China may have a huge population, but despite two decades of rapid growth, it is still relatively poor. The lack of purchasing power
translates into relative weak markets for many Western consumer goods. Another problem is the lack of a well- developed transportation infrastructure or distribution sys- tem outside of major urban areas. PepsiCo discovered this problem at its subsidiary in Chongqing. Perched above the Yangtze River in southwest Sichuan province, Chongqing lies at the heart of China’s massive hinterland. The Chong- qing municipality, which includes the city and its surround- ing regions, contains more than 30 million people, but according to Steve Chen, the manager of the PepsiCo sub- sidiary, the lack of well-developed road and distribution systems means he can reach only about half of this popu- lation with his product. Other problems include a highly regulated environment, which can make it problematic to conduct business trans- actions, and shifting tax and regulatory regimes. For ex- ample, a few years ago, the Chinese government suddenly scrapped a tax credit scheme that had made it attractive to import capital equipment into China. This immediately made it more expensive to set up operations in the country. Then there are problems with local joint-venture partners that are inexperienced, opportunistic, or simply operate according to different goals. One U.S. manager explained that when he laid off 200 people to reduce costs, his Chi- nese partner hired them all back the next day. When he inquired why they had been hired back, the executive of the Chinese partner, which was government owned, ex- plained that as an agency of the government, it had an “ob- ligation” to reduce unemployment. To continue to attract foreign investment, the Chinese government has committed itself to invest more than $800 billion in infrastructure projects over the next 10 years. This should improve the nation’s poor highway system. By giving preferential tax breaks to companies that invest in special regions, such as that around Chongqing, the Chinese have created incentives for foreign companies to invest in China’s vast interior where markets are underserved. 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 foreign investors. Given these developments, it seems likely that the country will continue to be an important mag- net for foreign investors well into the future.
Sources: Interviews by the author while in China; United Nations, World Investment Report, 2009 (New York and Geneva: United Nations, 2009); 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.
3 C o u n t r y F O C U S
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248 Part Three Cross-Border Trade and Investment
capital formation for developed and developing economies for 1992–2008. During 1992–1997, FDI flows accounted for about 4 percent of gross fixed capital formation in developed nations and 8 percent in developing nations. By 2006–2008, the figure was 14 percent worldwide, suggesting that FDI had become an increasingly important source of invest- ment in the world’s economies.
These gross figures hide important individual country differences. For example, in 2008, inward FDI accounted for some 47 percent of gross fixed capital formation in Sweden and 21 percent in the United Kingdom, but 2.3 percent in Venezuela and 2.2 percent in Japan—suggesting that FDI is an im- portant source of investment capital, and thus eco- nomic growth, in the first two countries but not the latter two. These differences can be explained by several factors, including the perceived ease and at- tractiveness of investing in a nation. To the extent
that burdensome regulations limit the opportunities for foreign investment in countries such as Japan and Venezuela, these nations may be hurting themselves by limiting their access to needed capital investments (see the opening case for more details on Japan).
THE SOURCE OF FDI Since World War II, the United States has been the largest source country for FDI, a position it retained during the late 1990s and early 2000s. Other important source countries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countries ac- counted for 56 percent of all FDI outflows for the 1998–2008 period and 61 per- cent of the total global stock of FDI in 2008 (see Figure 7.5). As might be expected, these countries also predominate in rankings of the world’s largest multinationals. 10 These nations dominate primarily because they were the most developed nations with the largest economies during much of the postwar period and therefore home
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Cumulative FDI Outflows, 1998–2008
($ billions)
Note: Share accounted for by the
United States would have been
larger were it not for significant
one-time investment inflows in 2005
due to changes in U.S. tax laws.
Source: Constructed by the author
from data in United Nations, World
Investment Report, 2009 (New York
and Geneva: United Nations, 2009).
A n o t h e r P e r s p e c t i v e Diageo Makes “Spirited” Entry into China London-based Diageo, the world’s largest seller of pre- mium spirits, beer, and wine, operates in 180 markets worldwide. Its family includes such well-known brands as Baileys, Captain Morgan, Guinness, Johnny Walker, Jose Cuervo, Smirnoff, and Tanqueray. The company tradition- ally has generated about three-fourths of its revenues in Europe and North America. However, when sales were down in those regions, the company decided to introduce its premium Johnny Walker brand in China shortly before the Chinese New Year. The product, which retails for an eye-popping $300 per bottle, sold out quickly. Diageo plans to deepen its reach into China as well as the rest of Asia. (“Diageo Makes Play for Asia,” Foreign Direct Invest- ments, April 15, 2010, http://fdimagazine.com)
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Chapter Seven Foreign Direct Investment 249
to many of the largest and best-capitalized enter- prises. Many of these countries also had a long his- tory 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.
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. The data suggest the majority of cross-border investment is in the form of mergers and acquisitions rather than greenfield investments. UN estimates indicate that some 40 to 80 percent of all FDI inflows per annum were in the form of merg- ers and acquisitions between 1998 and 2008. In 2001, for example, mergers and acquisitions accounted for some 78 percent of all FDI inflows. In 2004, the fig- ure was 59 percent, while in 2008 it was 40 percent. 11 However, FDI flows into developed nations differ markedly from those into develop- ing nations. In the case of developing nations, only about one-third of FDI is in the form of cross-border mergers and acquisitions. The lower percentage of mergers and acquisitions may simply reflect the fact that there are fewer target firms to acquire in developing nations. When contemplating FDI, why do firms apparently prefer to acquire existing assets rather than undertake greenfield investments? We shall consider it in greater depth in Chapter 12; for now we will make only a few basic observations. First, mergers and acquisitions are quicker to execute than greenfield investments. This is an important consideration 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, trademarks 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. However, 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 complemen- tary perspectives. One set of theories seeks to explain why a firm will favor direct in- vestment 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
When you see a BP gas station as you are driving down the road, do you realize that the company is British owned? BP = British Petroleum.
LEARNING OBJECTIVE 2 Explain the different
theories of foreign direct investment.
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250 Part Three Cross-Border Trade and Investment
investment flows. A third theoretical perspective, 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 all of the trouble of establishing operations abroad through foreign direct investment when two alternatives, exporting and licensing, are available for exploiting the profit opportunities in a 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 foreign direct investment may be both expen- sive and risky compared with exporting and licensing. 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 differ- ent. Relative to indigenous firms, there is a greater probability that a foreign 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 costs or risks. So why do so many firms apparently prefer FDI over either exporting or licensing? 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 con- strained by transportation costs and trade barriers. When transportation costs are added to production costs, it becomes unprofitable to ship some products over a large distance. This is particularly 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 interna- tionally by pursuing FDI, rather than exporting (see the Management Focus feature on Cemex). For products with a high value-to-weight ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic compo- nents, 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 increase 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 protectionist 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.
Licensing Occurs when a firm (the
licensor) licenses the right to produce its
product, its production processes, or 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.
Exporting Sale of products
produced in one country to residents of another
country.
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.
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Chapter Seven Foreign Direct Investment 251
M a n a g e m e n t F O C U S
Foreign Direct Investment by Cemex
In little more than a decade, Mexico’s largest cement man- ufacturer, 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 suc- cess 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 production with consumer demand. The company sells ready-mixed cement that can survive for only about 90 minutes before solidifying, so precise delivery is impor- tant. 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 transmit- ters, satellites, and computer hardware, that allows it to control the production and distribution of cement like no other company can, responding quickly to unanticipated changes in demand and reducing waste. The results are lower costs and superior customer service, both differenti- ating factors for Cemex. The company also pays lavish attention to its distributors— some 5,000 in Mexico alone—who can earn points toward rewards for hitting sales targets. The distributors can then convert those points into Cemex stock. High-volume distributors can purchase trucks and other supplies through Cemex at significant discounts. Cemex also is known for its marketing drives that focus on end users, the builders themselves. For example, Cemex trucks drive around Mexican building sites, and if Cemex cement is being used, the construction crews win soccer balls, caps, and T-shirts. Cemex’s international expansion strategy was driven by a number of factors. First, the company wished to reduce its reliance on the Mexican construction market, which was characterized by very volatile demand. Second, the com- pany realized there was tremendous demand for cement in many developing countries, where significant construction was being undertaken or needed. Third, the company be- lieved that it understood the needs of construction busi- nesses in developing nations 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 companies 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 tar- geted other developing nations, acquiring established cement makers in Venezuela, Colombia, Indonesia, the Philippines, Egypt, and several other countries. It also pur- chased 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 devel- oped nations. In 2000, Cemex purchased Houston-based Southland, one of the largest cement companies in the United States, for $2.5 billion. Following the Southland ac- quisition, 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, purchasing RMC of Great Britain for $5.8 billion. RMC was a huge multinational cement firm with sales of $8.0 billion, only 22 percent of which were in the United Kingdom, and operations in more than 20 other nations, including many European nations where Cemex had no presence. Finalized in March 2005, the RMC acquisition has 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 per- cent of the company’s sales are now generated in Mex- ico. Following the acquisition of RMC, Cemex found that the RMC plant in Rugby was running at only 70 percent of capacity, partly because repeated production problems kept causing a kiln shutdown. Cemex brought in an inter- national 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.
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252 Part Three Cross-Border Trade and Investment
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 imperfections 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 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 manufac- turing, marketing, and strategy in a foreign country that may be required to maximize its profitability. With licensing, control over manufacturing, marketing, and strategy is granted to a licensee in return for a royalty fee. However, for both strategic and op- erational reasons, a firm may want to retain control over these functions. The ratio- nale 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 for- eign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept such an imposition, because 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, pro- ducing 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 manufactur- ing 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 effi- ciently 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 cred- ited with pioneering 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 management 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 organizationwide 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 organi- zational 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 anywhere near as efficiently as could Toyota. In turn, this
Internalization Theory
The argument that firms prefer FDI over licensing
to retain control over know-how, manufacturing,
marketing, and strategy or because some firm
capabilities are not amenable to licensing;
also known as the market imperfections approach.
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Chapter Seven Foreign Direct Investment 253
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, mar- kets fail as a mechanism for selling know-how and FDI is more profitable than licens- ing: (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 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 undertaken foreign direct investment about the same time. There also is a clear tendency for firms to direct their investment activities toward certain locations. The two theories we consider in this section at- tempt to explain the patterns that we observe in FDI flows.
Strategic Behavior One theory is based on the idea that FDI flows are a reflec- tion 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 number 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 re- sponse in kind. By cutting prices, one firm in an oligopoly 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 imita- tive 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, the others follow; one expands capacity, and the rivals imitate lest they be left at a disad- vantage 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—dominate 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 busi- ness to France and give firm A a first-mover advantage. 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 looked at FDI by U.S. firms during the 1950s and 60s show that firms based in oligopolistic industries tended to imitate each other’s FDI. 16 The same phe- nomenon has been observed with regard to FDI undertaken by Japanese firms during the 1980s. 17 For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by undertaking their own FDI in the United States and Europe. More recently, research has shown that models of strategic behavior in a global oligopoly can explain the pattern of FDI in the global tire industry. 18
Oligopoly An industry composed of a limited number of large firms.
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254 Part Three Cross-Border Trade and Investment
Knickerbocker’s theory can be extended to embrace the concept of multipoint com- petition. 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. Kodak and Fuji Photo Film Co., for example, compete against each other around the world. If Kodak enters a particular foreign market, Fuji will not be far behind. Fuji feels compelled to follow Kodak to ensure that Kodak does not gain a dominant posi- tion in the foreign market that it could then leverage to gain a competitive advantage elsewhere. The converse also holds, with Kodak following Fuji when the Japanese firm is the first to enter a foreign market. Although Knickerbocker’s theory and its extensions can help to explain imitative FDI behavior by firms in oligopolistic industries, it does not explain why the first firm in an oligopoly decides to undertake FDI rather than to export or license. Internaliza- tion 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 Product Life Cycle Raymond Vernon’s product life-cycle theory, described in Chapter 5, also is used to explain FDI. Vernon argued that often the same firms that pioneer a product in their home markets undertake FDI to produce a product for consumption in foreign markets. Thus, Xerox introduced the photocopier in the United States, and it was Xerox that set up production facilities in Japan (Fuji Xerox) and Great Britain (Rank Xerox) to serve those markets. Vernon’s view is that firms undertake FDI at particular stages in the life cycle of a product they have pioneered. They invest in other advanced countries when local demand in those countries grows large enough to support local production (as Xerox did). They subsequently shift pro- duction to developing countries when product standardization and market saturation give rise to price competition and cost pressures. Investment in developing countries, where labor costs are lower, is seen as the best way to reduce costs. Vernon’s theory has merit. Firms do invest in a foreign country when demand in that country will support local production, and they do invest in low-cost locations (e.g., de- veloping countries) when cost pressures become intense. 20 However, Vernon’s theory fails to explain why it is profitable for a firm to undertake FDI at such times, rather than continuing to export from its home base or licensing a foreign firm to produce its prod- uct. Just because demand in a foreign country is large enough to support local produc- tion, it does not necessarily follow that local production is the most profitable option. It may still be more profitable to produce at home and export to that country (to realize the economies of scale that arise from serving the global market from one location). Al- ternatively, it may be more profitable for the firm to license a foreign company to pro- duce its product for sale in that country. The product life-cycle theory ignores these options and, instead, simply argues that once a foreign market is large enough to support local production, FDI will occur. This limits its explanatory power and its usefulness to business in that it fails to identify when it is profitable to invest abroad.
THE ECLECTIC PARADIGM The eclectic paradigm has been championed by the British economist John Dunning. 21 Dunning argues that in addition to the various factors discussed above, location-specific advantages are also of considerable importance
Multipoint Competition
Arises when two or more enterprises encounter each other in different
regional markets, national markets,
or industries.
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Chapter Seven Foreign Direct Investment 255
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 technologi- cal, marketing, or management capabilities). Dunning accepts the argument of internal- ization theory 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 en- dowments with the firm’s own unique capabilities often requires foreign direct invest- ment. That is, it requires the firm to establish production facilities where those foreign assets or resource endowments 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 sug- gests 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 in- vest where oil is located to combine their technological and managerial capabilities with this valuable location-specific resource. Another obvious example are valuable hu- man resources, such as low-cost, highly skilled labor. The cost and skill of labor varies from country to country. Since labor is not internationally mobile, according to Dunning it makes sense for a firm to locate production facilities in those countries where the cost and skills of local labor is 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, 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, there is knowledge being generated in Sili- con Valley with regard to the design and manufacture of computers and semiconduc- tors that is available nowhere else in the world. To be sure, as it is commercialized that knowledge diffuses throughout the world, but the leading edge of knowl- edge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dun- ning’s language, this means that Silicon Valley has a location-specific advantage in the generation of knowl- edge related to the computer and semiconductor in- dustries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part it arises from a network of informal contacts that allows firms to benefit from each others’ knowledge generation. Economists refer to such knowledge “spillovers” as externalities , and a well-established theory suggests that firms can benefit from such ex- ternalities by locating close to their source. 22 In so far 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 advantage in the global marketplace. 23 Evidence suggests that European, Japanese, South Korean, and Taiwanese computer
Location-Specific Advantages 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, marketing, or management capabilities).
Externalities Knowledge spillovers.
Silicon Valley has long been known as the epicenter of the computer and semiconductor industry.
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256 Part Three Cross-Border Trade and Investment
and semiconductor firms are investing in the Silicon Valley region, precisely because they wish to benefit from the externalities that arise there. 24 Others have argued that direct investment by foreign firms in the U.S. biotechnology industry has been mo- tivated by desires to gain access to the unique location-specific technological knowl- edge of U.S. biotechnology firms. 25 Dunning’s theory, therefore, seems to be a useful addition to those outlined above, for it helps explain how location factors affect the direction of FDI. 26
Political Ideology and Foreign
Direct Investment Historically, political ideology toward FDI within a nation has ranged from a dog- matic radical stance that is hostile to all inward FDI at one extreme to an adherence to the noninterventionist 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 instrument of imperialist domination. They see the MNE as a tool for exploiting host countries 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 ex- ample, 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 citi- zens 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 corporations to undertake FDI, since they can never be instru- ments of economic development, only of economic domination. Where MNEs al- ready exist in a country, they should be immediately nationalized. 27 From 1945 until the 1980s, the radical view was very influential in the world econ- omy. Until the collapse of communism between 1989 and 1991, the countries of East- ern Europe were opposed to FDI. Similarly, communist countries elsewhere, such as China, Cambodia, and Cuba, were all opposed in principle to FDI (although in prac- tice 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 indepen- dent 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 embraced the radical view that FDI by MNEs is an instrument of imperialism. By the end of the 1980s, 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 growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth; and (3) the strong economic performance of those developing countries that embraced capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan).
LEARNING OBJECTIVE 3 Understand how political ideology shapes a government’s attitudes toward FDI.
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Chapter Seven Foreign Direct Investment 257
THE FREE MARKET VIEW The free market view traces its roots to classical economics and the international trade theories of Adam Smith and David Ricardo (see Chapter 5). The intellectual case for this view has been strengthened by the internaliza- tion 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 computers 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 increas- ing 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 de- sign of computer software, the manufacture 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 domestically. In addition, Mexico gains from the technology, skills, and capital that the PC company transfers with its FDI. Con- trary 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. For reasons explored earlier in this book (see Chapter 2), the free market view has been ascendant worldwide in recent years, spurring a global move toward the removal of restrictions on inward and outward foreign direct investment. However, in practice no country has adopted the free market view in its pure form (just as no country has adopted the radical view in its pure form). Countries such as Great Britain and the United States are among the most open to FDI, but the governments of these countries both have still reserved the right to intervene. Britain does so by reserving the right to block foreign takeovers of domestic firms if the takeovers are seen as “contrary to national security in- terests” or if they have the potential for “reducing competition.” (In practice, the British government has rarely exercised this right.) U.S. controls on FDI are more limited and largely informal. For political reasons, the United States will occasionally restrict U.S. firms from undertaking FDI in certain countries (e.g., Cuba and Iran). In addition, in- ward FDI meets some limited restrictions. For example, foreigners are prohibited from purchasing more than 25 percent of any U.S. airline or from acquiring a controlling in- terest in a U.S. television broadcast network. Since 1988, the government has had the right to review the acquisition of a U.S. enterprise by a foreign firm on the grounds of national security. However, of the 1,500 bids reviewed by the Committee on Foreign In- vestment in the United States under this law by 2008, only one has been nullified: the sale of a Seattle-based aircraft parts manufacturer to a Chinese enterprise in the early 1990s. 28
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. 29 The pragmatic nationalist view is that FDI has both benefits and costs. FDI can benefit a host country by bringing capital, skills, technology, 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.
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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 manage- rial resources into the Japanese markets could hamper the development and growth of their own industry and technology. 30 This belief led Japan to block the majority of appli- cations 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 Japa- nese investment 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.
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 market 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 and many of the socialist countries of Africa) 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 American countries). One result has been the surge in the volume of FDI world- wide, 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 recent evidence of the beginnings of what might be- come a shift to a more hostile approach to foreign direct investment. Venezuela and Bolivia have become increasingly hostile to foreign direct investment. In 2005 and 2006, the governments of both nations unilaterally rewrote contracts for oil and gas exploration, raising the royalty rate that foreign enterprises had to pay the govern- ment for oil and gas extracted in their territories. Bolivian President Evo Morales in 2006 nationalized the nation’s gas fields and stated he would evict foreign firms un- less they agreed to pay about 80 percent of their revenues to the state and relinquish production oversight. In some developed nations, too, there is increasing evidence of hostile reactions to inward FDI. In Europe in 2006, there was a hostile political reac- tion 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 withdrew 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 company withdrew
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its planned takeover of some operations at six U.S. ports after negative political reac- tions. 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 nation- alists 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 gov- ernments 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 effects, 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 the opening case makes clear, the Japanese government has recently come around to this view and has adopted a more permissive attitude to inward investment). 31
M a n a g e m e n t F O C U S
DP World and the United States
In February 2006, DP World, a ports operator owned by the government of Dubai, a member of the United Arab Emir- ates 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 management operations of six U.S. ports: Miami, Philadelphia, Baltimore, New Orleans, New Jersey, and New York. The acquisition had al- ready 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 arrangement 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. stra- tegic assets.” The Bush administration was quick to defend the takeover, stating that 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 opera- tion would also be an American. DP World would not own the U.S. ports in question, just manage them, while security is- sues would remain in the hands of U.S. customs officials and the U.S. Coast Guard. Dubai was also a member of America’s Container Security Initiative, which allows U.S. customs offi- cials 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 subject 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 the right to manage the six U.S. ports for about $750 million. Looking forward, however, DP World stated it would seek an initial public offering in 2007, and that 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.
LEARNING OBJECTIVE 4 Describe the benefits and costs of FDI to home and
host countries.
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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 2 that technology can stimulate economic development and industrialization. Technology can take two forms, both of which are valuable. Technology can be incorporated in a production process (e.g., the technology for discovering, 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 coun- tries 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 tech- nology when they invest in a foreign country. 32 For example, a study of FDI in Sweden found that foreign firms increased both the labor and total factor productivity of Swedish firms that they acquired, suggesting that significant technology transfers had occurred (technology typically boosts productivity). 33 Also, a study of FDI by the Or- ganization for Economic Cooperation and Development (OECD) found that foreign investors invested significant amounts of capital in R&D in the countries in which they had invested, suggesting that not only were they transferring technology to those countries, but they may also have been upgrading existing technology or creating new technology in those countries. 34 Foreign management skills acquired through FDI may also produce important benefits for the host country. Foreign managers trained in the latest management techniques can often help to improve the efficiency of operations in the host coun- try, whether those operations are acquired or greenfield developments. Beneficial spin-off effects may also arise when local personnel who are trained to occupy man- agerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help to 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 management skills.
Employment Effects Another beneficial em- ployment 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 employment are both direct and indirect. Direct effects arise when a foreign MNE employs a number of host- country citizens. Indirect effects arise when jobs are created in local suppliers as a result of the in- vestment and when jobs are created because of in- creased local spending by employees of the MNE. The indirect employment effects are often as large as, if not larger than, the direct effects. For exam- ple, 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. 35
Cynics argue that not all the “new jobs” created by FDI represent net additions in employment.
A n o t h e r P e r s p e c t i v e Uganda Reaches Out to Foreign Investors Unlikely though it may seem, the East African nation of Uganda is making strides in attracting foreign direct in- vestment. Once the scene of bloody unrest and tribal war, today this landlocked country (bordered by Congo, Kenya, Rwanda, and Tanzania) works to maintain stable economic policies and provide the kind of predictable environment that makes foreign investment more appealing. Aided by its Investment Authority, a government body established to promote foreign investment, Uganda has attracted busi- nesses in the agriculture, banking, energy, insurance, min- ing, and telecommunications sectors. Foreign direct investment has brought jobs, improved Uganda’s communi- cations and financial services sectors, and generally en- hanced its infrastructure. (Keith Kallyegira, “Uganda Tops Region in FDIs,” New Vision Online, February 18, 2010, www.newvision.co.ug)
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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 employment may be a major negotiating point between an MNE wishing to under- take 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 re- duce employment as the multinational tries to restructure the operations of the ac- quired 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 grow their employment base at a faster rate than domestic rivals. For example, an OECD study found that foreign firms created new jobs at a faster rate than their domestic counterparts. 36 In America, the workforce of foreign firms grew by 1.4 percent per year, compared with 0.8 percent per year for domestic firms. In Britain and France, the workforce of foreign firms grew at 1.7 percent per year, while employ- ment at domestic firms fell by 2.7 percent. The same study found that foreign firms tended to pay higher wage rates than domestic firms, suggesting that the quality of employment was better. Another study looking at FDI in Eastern European transition economies found that although employment fell following the acquisition of an enter- prise by a foreign firm, often those enterprises were in competitive difficulties and would not have survived if they had not been acquired. Also, after an initial period of adjustment and retrenchment, employment downsizing was often followed by new investments, and employment either remained stable or increased. 37
Balance-of-Payments Effects FDI’s effect on a country’s balance-of-payments ac- counts 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 cur- rent 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. Govern- ments typically prefer to see a current account surplus rather than a deficit. The only way in which a current account deficit can be supported in the long run is by selling assets to foreigners (for a detailed explanation of why this is the case, see the appendix to Chapter 5). For example, the persistent U.S. current account deficit since the 1980s has been fi- nanced by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to foreigners. Since 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 to achieve this goal. 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 payments 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
Balance-of- Payments Accounts National accounts that track both payments to and receipts from other countries.
Current Account In the balance of payments, records transactions involving the export and import of goods and services.
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262 Part Three Cross-Border Trade and Investment
developing and developed nations over the last decade. 38 For example, in China exports increased from $26 billion in 1985 to more than $250 billion by 2001 and to $969 billion in 2006. Much of this dramatic export growth was due to the presence of foreign multi- nationals that invested heavily in China during the 1990s. The subsidiaries of foreign multinationals accounted for 50 percent of all exports from that country in 2001, up from 17 percent in 1991. In mobile phones, for example, the Chinese subsidiaries of foreign multinationals—primarily Nokia, Motorola, Ericsson, and Siemens—accounted for 95 percent of China’s exports.
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 consumer 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 increased productivity growth, product and process innovations, and greater economic growth. 39 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 indigenous 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 delivered. 40 For example, under a 1997 agreement sponsored by the World Trade Organization, 68 countries accounting for more than 90 percent of world telecommu- nications 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 in- creased the level of competition in many national telecommunications markets produc- ing 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 competitors. 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 indigenous companies out of business and allow the firm to mo- nopolize 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 nation. 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 advanced industrialized nations.
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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 is Britain (see the Management Focus, “Foreign Direct Investment by Cemex”). Because an acquisition does not result in a net increase in the number of players in a market, the ef- fect 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 con- sumer choice, and raise prices. For example, 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 mak- ers 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. 41 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 det- rimental 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 earn- ings 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 subsidiary’s home country. A second concern arises when a foreign subsidiary imports a substantial 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 favor- able impact of this FDI on the current account of the U.S. balance-of-payments posi- tion may not be as great as initially supposed. The Japanese auto companies responded to these criticisms by pledging 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 invested 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 raising 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 deci- sions 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 gov- ernment has no real control. Most economists dismiss such concerns as groundless and irrational. Political scientist Robert Reich has noted that such concerns are the product of outmoded thinking because they fail to account for the growing interde- pendence of the world economy. 42 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.
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
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264 Part Three Cross-Border Trade and Investment
from the inward flow of foreign earnings. FDI can also benefit the home country’s balance of payments if the foreign subsidiary creates demands for home- country exports of capital equipment, intermediate goods, complementary products, and the like.
Second, benefits to the home country from out- ward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the foreign subsidiary creates demand for home-country exports. Thus, Toyota’s investment in auto assembly operations in Europe has benefited both the Japanese balance-of-payments position and employment in Japan, because Toyota imports some component parts for its European-based auto assem- bly operations directly from Japan.
Third, benefits arise when the home-country MNE learns valuable skills from its exposure to for- eign markets that can subsequently be transferred back to the home country. This amounts to a re- verse resource-transfer effect. Through its exposure to a foreign market, an MNE can learn about supe- rior management techniques and superior product and process technologies. These resources can then be transferred back to the home country, contribut- ing to the home country’s economic growth rate. 43
For example, one reason General Motors and Ford invested in Japanese automobile companies (GM owned part of Isuzu, and Ford owns part of Mazda) was to learn about their production processes. If GM and Ford are successful in transferring this know- how back to their U.S. operations, the result may be a net gain for the U.S. economy.
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 bal- ance of payments 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 ac- count of the balance of payments 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, in- sofar as Toyota’s assembly operations in the United States are intended to substitute for direct exports from Japan, the current account 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 invest- ments 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, concern about the export of jobs may arise. For example, one objection frequently raised by U.S. labor leaders to the free trade pact between the United States, Mexico, and Canada (see the next chap- ter) is that the United States will lose hundreds of thousands of jobs as U.S. firms invest in Mexico to take advantage of cheaper labor and then export back to the United States. 44
A n o t h e r P e r s p e c t i v e FDI Effects: Look at the Whole Picture Some critics of globalization suggest that FDI is an ad- vanced 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 op- erations in West Papua, the former Irian Jaya, Indonesia, where the world’s largest gold, mineral, and copper re- serves have been found. Freeport formed a joint venture with the Indonesian government to mine a concession, 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 iso- lated 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 education, and from local employment opportunities with FCX. Is this colonial- ism or a kind of ethical investing? See more on this issue at www.FCX.com and www.corpwatch.org.
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Chapter Seven Foreign Direct Investment 265
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 5). 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 eco- nomic growth (and hence employment) in the home country by freeing home-country resources to concentrate on activities where the home country has a comparative ad- vantage. 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 employment effects while its international competitors reaped the benefits of low-cost production 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 assis- tance, tax incentives, and political pressure. Then we will look at policies designed to restrict outward 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 (national- ization), war losses, and the inability to transfer profits back home. Such programs are particularly useful in encouraging firms to undertake investments in politically unsta- ble countries. 45 In addition, several advanced countries also have special funds or banks that make government 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 taxation 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 inves- tor countries (including the United States) have used their political influence to per- suade host countries to relax their restrictions on inbound FDI. For example, in response to direct U.S. pressure, Japan relaxed many of its formal restrictions on in- ward FDI in the 1980s. Now, in response to further U.S. pressure, Japan moved to- ward relaxing its informal barriers to inward FDI. One beneficiary of this trend has been Toys “R” Us, which, after five years of intensive lobbying by company and U.S. government officials, opened its first retail stores in Japan in December 1991. By 2009, Toys “R” Us had more 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
Offshore Production FDI undertaken to serve the home market.
LEARNING OBJECTIVE 5 Explain the range of
policy instruments that governments
use to influence FDI.
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266 Part Three Cross-Border Trade and Investment
that limited 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 impor- tant 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 advance 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. Finally, countries sometimes prohibit national firms from investing in certain coun- tries 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 political 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 twentieth century, many countries moved quickly away from a situation where they ad- hered to some version of the radical stance and prohibited much FDI and toward a situa- tion 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 common 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 coun- tries. 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 coun- tries. In the United States, state governments often compete with each other to attract FDI. For example, Kentucky offered Toyota an incentive package worth $112 million to
persuade it to build its U.S. automobile assembly plants there. The package included tax breaks, new state spending on infrastructure, and low-interest loans. 46
Restricting Inward FDI Host governments use a wide range of controls to restrict FDI in one way or another. The two most common are owner- ship restraints and performance requirements. Ownership restraints can take several forms. In some countries, foreign companies are excluded from specific fields. They are excluded from to- bacco and mining in Sweden and from the develop- ment of certain natural resources in Brazil, Finland, and Morocco. In other industries, foreign owner- ship may be permitted although a significant pro- portion of the equity of the subsidiary must be owned by local investors. Foreign ownership is re- stricted to 25 percent or less of an airline in the United States. In India, foreign firms were prohibited from
Often governments provide incentives to attract foreign firms. For example, Kentucky offered Toyota an incentive package worth $112 million to build its assembly plant there.
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Chapter Seven Foreign Direct Investment 267
owning media businesses until 2001, when the rules were relaxed, allowing foreign firms to purchase up to 26 percent of a newspaper. 47 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 competition. 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 com- bination of import tariffs and controls on FDI. This is a variant of the infant industry argument discussed in Chapter 6. Second, ownership restraints seem to be based on a belief that local owners can help to maximize the resource-transfer and employment benefits of FDI for the host country. Until the early 1980s, the Japanese government prohibited most FDI but al- lowed 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 through- out 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 per- formance 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 to 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, per- formance requirements tend to be more common in less developed countries than in advanced industrialized nations. 48
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 Organization in 1995. The WTO embraces the promotion of international trade in services. Since many services have to be produced where they are sold, exporting is not an option (for example, 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 multina- tional agreements were reached in 1997 to liberalize trade in telecommunications and financial services. Both these agreements contained detailed clauses that require signa- tories to liberalize their regulations governing inward FDI, essentially opening their markets to foreign telecommunications and financial services companies. The WTO has had less success trying to initiate talks aimed at establishing a univer- sal 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. In an attempt to make some progress on this issue, the OECD in 1995 initiated talks between its members. The aim of the talks was to draft a multilateral agreement on investment (MAI) that would make it illegal for signatory states to discriminate against foreign investors. This would liberalize rules governing FDI between OECD states. These talks broke down in early 1998, primarily because the United States refused to sign the agreement. According to the United States, the proposed agreement con- tained too many exceptions that would weaken its powers. For example, the proposed agreement would not have barred discriminatory taxation of foreign-owned companies, and it would have allowed countries to restrict foreign television programs and music in the name of preserving culture. Environmental and labor groups also campaigned
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268 Part Three Cross-Border Trade and Investment
against the MAI, criticizing the proposed agreement because it contained no binding environmental or labor agreements. Despite such setbacks, negotiations on a revised MAI treaty might restart in the future. As noted earlier, many individual nations have continued to liberalize their policies governing FDI to encourage foreign firms to in- vest in their economies. 49
Focus on Managerial Implications
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 at- tention to the implications of government policy.
The Theory of FDI The implications of the theories of FDI for business practice are straightforward. First, it is worth noting that 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 export- ing. 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 circumstances. The theories suggest that exporting is prefera- ble 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 un- profitable, and the choice is between FDI and licensing. Since 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: ( a ) the firm has valuable know-how that cannot be adequately protected by a licensing contract, ( b ) the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and ( c ) a firm’s skills and capabilities are not ame- nable to licensing. Figure 7.6 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 of the evidence seems to support these conjectures. 50 In addition, licensing is not a good option if the competitive ad- vantage of a firm is based upon managerial or marketing knowledge that is embedded
LEARNING OBJECTIVE 6 Identify the implications for management practice of the theory and government policies associated with FDI.
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Chapter Seven Foreign Direct Investment 269
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. Firms for which licensing is a good option tend to be in industries whose conditions are opposite to those specified above. That is, licensing tends to be more common, and more profitable, in fragmented, low-technology industries in which globally dispersed manufacturing 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 ser- vice-industry version of licensing, although it normally involves much longer-term com- mitments 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 spec- ifies 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 ( a ) like many services, fast food cannot be exported; ( b ) franchising economizes the costs and risks associated with opening up foreign markets; ( c ) unlike technological know-how, brand names are rela- tively easy to protect using a contract; ( d ) there is no compelling reason for McDonald’s
Export
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?
7.6 figure
A Decision Framework
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270 Part Three Cross-Border Trade and Investment
to have tight control over franchisees; and ( e ) 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 the- ory 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 describ- ing the historical evolution of FDI, but they do a relatively poor job of identifying the factors that influence the relative profitability of FDI, licensing, and exporting. Indeed, the issue of licensing as an alternative to FDI is ignored by both of 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 pol- icies 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 to- ward 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 pro- posed 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 negotiations. The converse also holds. The firm’s bargaining power is low when the host government 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. 51
greenfield investment, p. 243 flow of FDI, p. 243 stock of FDI, p. 243 outflows of FDI, p. 243 inflows of FDI, p. 243 gross fixed capital formation, p. 246
eclectic paradigm, p. 250 exporting, p. 250 licensing, p. 250 internalization theory, p. 252 oligopoly, p. 253
multipoint competition, p. 254 location-specific advantages, p. 255 balance-of-payments accounts, p. 261 current account, p. 261 offshore production, p. 265
Key Terms
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Chapter Seven Foreign Direct Investment 271
Summary
The objectives of this chapter were to review theo- ries that attempt to explain the pattern of FDI between countries and to examine the influence of governments on firms’ decisions to invest in foreign countries. The following points were made:
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. Vernon’s product life-cycle theory suggests that firms undertake FDI at particular stages in the life cycle of products they have pioneered. However, Vernon’s theory does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad.
6. Dunning has argued that location-specific advantages are of considerable importance in explaining the nature and direction of FDI. According the Dunning, firms undertake FDI to exploit resource endowments or assets that are location specific.
7. 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.
8. Benefits of FDI to a host country arise from resource transfer effects, employment effects, and balance-of-payments effects.
9. The costs of FDI to a host country include adverse effects on competition and balance of payments and a perceived loss of national sovereignty.
10. 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.
11. 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.
12. 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 2004, inward FDI accounted for some 24 percent of gross fixed capital formation in Ireland, but only 0.6 percent in Japan. What do you think explains this difference in FDI inflows into the two countries?
2. Compare and contrast these explanations of FDI: internalization theory, Vernon’s product life-cycle theory, and Knickerbocker’s theory of FDI. Which theory do you think offers the best explanation of the historical pattern of FDI? Why?
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272 Part Three Cross-Border Trade and Investment
3. 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 the 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?
d. Why is majority control so important to Cemex?
4. 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.
Use the globalEDGE Resource Desk (http:// globalEDGE.msu.edu/resourcedesk/) to complete the following exercises:
1. You are working for a company that is considering investing in a foreign country. Management has requested a report regarding the attractiveness of alternative countries based on the potential return of FDI. Accordingly, the ranking of the top 10 countries in terms of FDI attractiveness is a crucial ingredient for your report. A colleague mentioned a potentially useful tool called the FDI Confidence Index, which is updated periodically. Find this index and
provide additional information regarding how the index is constructed.
2. Your company is considering opening a new factory in Latin America, and management is evaluating the specific country locations for this direct investment. The pool of candidate countries has been narrowed to Argentina, Brazil, and Mexico. Prepare a short report comparing the foreign direct investment climate and regulations of these three countries, using the Country Commercial Guides prepared by the U.S. Department of Commerce.
Research Task http://globalEDGE.msu.edu
Spain’s Telefonica
Established in the 1920s, Spain’s Telefonica was a typical state-owned national telecommunications monopoly until the 1990s. Then the Spanish government privatized the company and deregulated the Spanish telecommunications market. What followed was a sharp reduction in the workforce, rapid adoption of new technology, and focus on driving up profits and shareholder value. In this new era, Telefonica was looking for growth. Its search first took it to Latin America. There, too, a wave of de- regulation and privatization was sweeping across the region.
For Telefonica, Latin America seemed to be the perfect fit. Much of the region shared a common language and had deep cultural and historical ties to Spain. After decades of slow growth, Latin American markets were now growing rapidly, increasing the adoption rate and usage not just of traditional fixed-line telecommunications services, but also of mobile phones and Internet connections. Having already transformed itself from a state-owned en- terprise into an efficient and effective competitor, Telefonica now believed it could do the same for companies it acquired
closing case
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Chapter Seven Foreign Direct Investment 273
in Latin America, many of which were once part of state- owned telecommunications monopolies. In the late 1990s, Telefonica invested some $11 billion in Latin America, acquir- ing companies throughout the region. Its largest investments were reserved for Brazil, the biggest market in the region, where it spent some $6 billion to purchase several compa- nies, including the largest fixed-line operator in San Paulo, the leading mobile phone operator in Rio de Janeiro, and the principal carrier in the state of Rio Grande do Sul. In Argen- tina, it acquired 51 percent of the southern region’s monopoly provider, a franchise that included the lucrative financial dis- trict of Buenos Aires. In Chile, it became the leading share- holder in the former state-owned monopoly, and so on. Indeed, by the early 2000s Telefonica was the No. 1 or 2 player in almost every Latin American country, had a conti- nent-wide market share of around 40 percent, and was gen- erating 18 percent of its revenues from the region. Still, for all of its investment, Telefonica has not had it all its own way in Latin America. Other companies could also see the growth opportunities, and several foreign telecom- munications enterprises entered Latin America’s newly opened markets. In the fast-growing mobile segment, America Movil, controlled by the Mexican billionaire Carlos Slim, emerged as a strong challenger. By 2008, the Mexican company had 182 million wireless subscribers across Latin America, compared to Telefonica’s 123 million, and intense price competi- tion between the two companies was emerging. With the die already cast in Latin America by the mid-2000s, Telefonica turned its attention to neighboring countries in Europe. For years, there had been a tacit agreement between
national telecommunications companies that they would not invade each other’s markets. In 2005 this started to break down when France Telecom entered Spain, purchasing Amena, the country’s second-largest mobile carrier behind Telefonica. Telefonica moved quickly to make its own European acquisition, acquiring Britain’s major mobile phone operator, O2, for $31.4 billion. O2 already had significant operations in Germany as well as the United Kingdom. The acquisition transformed Telefonica into the second-largest mobile phone operator in the world measured by customers, behind only China Mobile.
Sources: R. Tomlinson, “Dialing in on Latin America,” Fortune , October 25, 1999, pp. 259–62; T. Serafin, “Spanish Armada,” Forbes , January 9, 2006, p. 132; and G. Smith, “The Race for Numero Uno in Latin Wireless,” BusinessWeek Online , November 27, 2006.
Case Discussion Questions 1. What changes in the political and economic environment
allowed Telefonica to start expanding globally?
2. Why did Telefonica initially focus on Latin America? Why was it slower to expand in Europe, even though Spain is a member of the European Union?
3. Telefonica has used acquisitions, rather than greenfield ventures, as its entry strategy. Why do you think this has been the case? What are the potential risks associated with this entry strategy?
4. What is the value that Telefonica brings to the companies it acquires?
5. In your judgment, does inward investment by Telefonica benefit a host nation? Explain your reasoning?
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