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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 managers of the theory and government policies associated with FDI.

opening case Foreign Retailers in India

For years now, there has been intense debate in India about the wisdom of relaxing the country's restrictions on foreign direct investment into its retail sector. The Indian retailing sector is highly fragmented and dominated by small enterprises. Estimates suggest that barely 6 percent of India's almost $500 billion in retail sales take place in organized retail establishments. The rest takes place in small shops, most of which are unincorporated businesses run by individuals or households. In contrast, organized retail establishments account for more than 20 percent of sales in China, 36 percent of sales in Brazil, and 85 percent of all retail sales in the United States. In total, retail establishments in India employ some 34 million people, accounting for more than 7 percent of the workforce.

Advocates of opening up retailing in India to large foreign enterprises such as Walmart, Carrefour, and Tesco, make a number of arguments. They believe that foreign retailers can be a positive force for improving the efficiency of India's distribution systems. Companies like Walmart and Tesco are experts in supply chain management. Applied to India, such know-how could take significant costs out of the economy. Logistics costs are around 14 percent of GDP in India, much higher than the 8 percent in the United States. While this is partly due to a poor road system, it is also the case that most distribution is done by small trucking enterprises, often with a single truck, that have few economies of scale or scope. Large foreign retailers tend to establish their own trucking operations and can reap significant gains from tight control of their distribution system.

Foreign retailers will also probably make major investments in distribution infrastructure such as cold storage facilities and warehouses. Currently, there is a chronic lack of cold storage facilities in India. Estimates suggest that about 25 to 30 percent of all fruits and vegetables spoil before they reach the market due to inadequate cold storage. Similarly, there is a lack of warehousing capacity. A lot of wheat, for example, is simply stored under tarpaulins, where it is at risk of rotting. Such problems raise foods costs to consumers and impose significant losses on farmers.

Farmers have emerged as significant advocates of reform. This is not surprising, because they stand to benefit from working with foreign retailers. Similarly, reform-minded politicians argue that foreign retailers will help to keep food processing in check, which benefits all. Ranged against them is a powerful coalition of small shop owners and left-wing politicians, who argue that the entry of large, well-capitalized foreign retailers will result in the significant job losses and force many small retailers out of businesses.

In 1997, it looked as if the reformers had the upper hand when they succeeded in changing the rules to allow foreign enterprises to participate in wholesale trading. Taking advantage of this reform, in 2009 Walmart started to open up wholesale stores in India under the name Best Price. The stores are operated by a joint venture with Bharti, an Indian conglomerate. These stores are only allowed to sell to other businesses, such as hotels, restaurants, and small retailers. By 2011, the venture had 19 stores in India. Customers of these stores note that unlike many local competitors, they always have produce in stock, and they are not constantly changing their prices. Farmers, too, like the joint venture because it has worked closely with farmers to secure consistent supplies and has made investments in warehouses and cold storage. The joint venture also pays farmers better prices—something it can afford to do because far less produce goes to waste in its system.

For its part, in 2011 the Indian government indicated that it would soon introduce legislation to allow foreign enterprises like Walmart entry into the retail sector. On the basis on this promise, Walmart and Bharti were planning to expand downstream from wholesale into retail establishments, but their plans were put on hold in late 2011 when the Indian government announced that the legislation had been shelved for the time being. Apparently, opposition to such reform had reached such a pitch that implementing it was not worth the political risk. Whether and when this will change remains to be seen.•

  Sources: V. Bajaj, “Wal-Mart Debate Rages in India,” The New York Times, December 6, 2011, pp. B1, B2; S.G. Mozumder, “Walmart Is Not Coming to India Just to Sell,” India Abroad, December 16, 2011, pp. A18–A19; and R. Kohli and J. Bhaqwati, “Organized Retailing in India: Issues and Outlook,” Columbia Program on Indian Economic Policies, working paper no. 2011-1, January 22, 2011.

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, 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 is given in the opening case, which describes Walmart's recent investments in India. 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. 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 interest of 50 percent to 99 percent), or full outright stake (foreign interest of 100 percent). 1

Greenfield Investment

Establishing a new operation in a foreign country.

This chapter opens by looking at the importance of foreign direct investment in the world economy. Next, it reviews the theories that have been used to explain foreign direct investment. The chapter then moves on to look at government policy toward foreign direct investment and closes with a section on implications for business.

Foreign Direct Investment in the World Economy

LEARNING OBJECTIVE 1

Recognize current trends regarding foreign direct investment (FDI) 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.

Flow of FDI

The amount of direct investment into a country in a defined time period undertaken by foreign entities (FDI inflow), or the amount of direct investment into foreign countries made by entities resident in a country in a defined period of time (FDI outflow).

Stock of FDI

The cumulative value of direct investments that have been made by foreign entities in a country at a given point in time.

Outflows of FDI

Flow of foreign direct investment out of a country.

Inflows of FDI

Flow of foreign direct investment into a country.

TRENDS IN FDI

The past 35 years have seen a marked increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from $25 billion in 1975 to $1.5 trillion in 2011 (see Figure 8.1). FDI outflows did contract to around $1.1 trillion in 2009 in the wake of the global financial crisis after hitting a record $2 trillion in 2007, but they have since recovered. 2 In general, however, over the past 30 years the flow of FDI has accelerated faster than the growth in world trade and world output. For example, between 1992 and 2010, the total flow of FDI from all countries increased around ninefold while world trade by value grew fourfold and world output by around 55 percent. 3 As a result of the strong FDI flows, by 2010 the global stock of FDI was about $20 trillion. Multinationals accounted for one-quarter of global GDP in 2010. The foreign affiliates of multinationals had more than $32 trillion in global sales and accounted for one-tenth of global GDP and one-third of global exports. 4

FIGURE 8.1 FDI Outflows, 1982–2011 ($ billions)

FDI has grown more rapidly than world trade and world output for several reasons. First, despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Second, much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world's developing nations. The general shift toward democratic political institutions and free market economies that we discussed in Chapter 3 has encouraged FDI. Across much of Asia, eastern Europe, and Latin America, economic growth, economic deregulation, privatization programs that are open to foreign investors, and removal of many restrictions on FDI have made these countries more attractive to foreign multinationals. According to the United Nations, some 90 percent of the 2,700 changes made worldwide between 1992 and 2009 in the laws governing foreign direct investment created a more favorable environment for FDI. 5

The globalization of the world economy is also having a positive effect on the volume of FDI. Many firms 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 of the world. 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.

ANOTHER PERSPECTIVE Zambia experiences large FDI increase for 2011

Inward foreign investment into Zambia increased significantly in 2011, arresting a downward trend that followed the 2008 financial crisis. In 2011 there were record levels of FDI into the country, with 26 investments made and more than $2.3bn [billion] invested. This led to the creation of more than 10,000 jobs. When compared with 2010 data, the number of investments increased by 86 percent, the level of capital investment increased by 74 percent, and the number of jobs created increased by 273 percent. This assertion is attributed to the efforts made by the Zambian government to make the country more attractive to potential investors. Much of this increase in 2011 can be explained by large-scale investments in the metals sector, with eight investments in this sector creating more than 6500 jobs and garnering $1.8bn in investments.

  Source: http://www.fdiintelligence.com/Trend-Tracker/Zambia-experiences-large-FDI-increase-for-2011

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 others' markets (see Figure 8.2). During the 1980s and 1990s, the United States was often the favorite target for FDI inflows. The United States has been an attractive target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI. Investors include firms based in Great Britain, Japan, Germany, Holland, and France. Inward investment into the United States remained high during the 2000s and stood at $210 billion in 2011. The developed nations of the European Union have also been recipients of significant FDI inflows, principally from the United States and other member-states of the EU. In 2011, inward investment into the EU was $414 billion. The United Kingdom and France have historically been the largest recipients of inward FDI. 6

FIGURE 8.2 FDI Inflows by Region, 1995–2010 ($ billions)

Even though developed nations still account for the largest share of FDI inflows, FDI into developing nations has increased markedly (see Figure 8.2). Most recent inflows into developing nations have been targeted at the emerging 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 about $60 billion of FDI in 2004 and rose steadily to hit a record $124 billion in 2011. 7 The reasons for the strong flow of investment into China are discussed in the accompanying Country Focus. Latin America is the next most important region in the developing world for FDI inflows. In 2011, total inward investments into this region reached $216 billion. Brazil has historically been the top recipient of inward FDI in Latin America. At the other end of the scale, Africa has long received the smallest amount of inward investment; $54 billion in 2011. 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. 8

COUNTRY FOCUS Foreign Direct Investment in China

Beginning in late 1978, China's leadership decided to move the economy away from a centrally planned socialist system to one that was more market driven. The result has been nearly three decades of sustained high economic growth rates of around 10 percent annually compounded. This growth attracted substantial foreign investment. Starting from a tiny base, foreign investment increased to an annual average rate of $2.7 billion between 1985 and 1990 and then surged to $40 billion annually in the late 1990s, making China the second biggest recipient of FDI inflows in the world after the United States. By late 2000, China was attracting between $80 billion and $100 billion of FDI annually, with another $60 billion a year going into Hong Kong. In 2011, a record $124 billion was invested in China and another $78.4 billion in Hong Kong. Over the past 20 years, this inflow has resulted in the establishment of more than 300,000 foreign-funded enterprises in China. The total stock of FDI in mainland China grew from almost nothing in 1978 to $578 billion in 2011 (another $1.1 trillion of FDI stock was in Hong Kong).

The reasons for this investment are fairly obvious. With a population of more than 1.3 billion people, China represents the world's largest market. Historically, import tariffs made it difficult to serve this market via exports, so FDI was required if a company wanted to tap into the country's huge potential. China joined the World Trade Organization in 2001. As a result, average tariff rates on imports have fallen from 15.4 percent to about 8 percent today, reducing this motive for investing in China (although at 8 percent, tariffs are still above the average of 3.5 percent found in many developed nations). Notwithstanding tariff rates, many foreign firms believe that doing business in China requires a substantial presence in the country to build guanxi, the crucial relationship networks (see Chapter 4 for details). Furthermore, a combination of relatively inexpensive labor and tax incentives, particularly for enterprises that establish themselves in special economic zones, makes China an attractive base from which to serve Asian or world markets with exports (although rising labor costs in China are now making this less important).

Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China. 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 until after the investment has been made. China may have a huge population, but despite decades of rapid growth, it is still relatively poor. The lack of purchasing power translates into relatively immature market for many Western consumer goods outside of relatively affluent urban areas such as Shanghai. Other problems include a highly regulated environment, which can make it problematic to conduct business transactions, and shifting tax and regulatory regimes. For example, 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 Chinese 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, explained that as an agency of the government, it had an “obligation” to reduce unemployment.

To continue to attract foreign investment, in late 2000 the Chinese government has committed itself to invest more than $800 billion in infrastructure projects over 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 magnet 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: The 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.

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 accounted for 60 percent of all FDI outflows for 1998–2010 (see Figure 8.3). As might be expected, these countries also predominate in rankings of the world's largest multinationals. 9 These nations dominate primarily because they were the most developed nations with the largest economies during much of the postwar period and therefore home to many of the largest and best capitalized enterprises. Many of these countries also had a long history as trading nations and naturally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enterprises based there have been at the forefront of foreign investment trends.

FIGURE 8.3 Cumulative FDI Outflows, 1998–2010 ($ billions)

This being said, it is noteworthy that Chinese firms have started to emerge as major foreign investors. In 2005, Chinese firms invested some $15 billion internationally. Since then, the figure has risen every year, hitting $68 billion in 2010. Firms based in Hong Kong accounted for another $76 billion of outward FDI in 2010. Much of the outward investment by Chinese firms has been directed at extractive industries in less developed nations (e.g., China has been a major investor in African countries). A major motive for these investments has been to gain access to raw materials, of which China is one of the world's largest consumers. There are signs, however, that Chinese firms are starting to turn their attention to more advanced nations. In 2010, Chinese firms invested $5 billion in the United States, up from $146 million in 2003. 10

THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTS

FDI can take the form of a greenfield investment in a new facility or an acquisition of or a merger with an existing local firm. UN estimates indicate that some 40 to 80 percent of all FDI inflows were in the form of mergers and acquisitions between 1998 and 2010. In 2001, for example, mergers and acquisitions accounted for 78 percent of all FDI inflows. In 2004, the figure was 59 percent. The figure slumped to 22 percent in 2009, reflecting the impact of the global financial crisis and the difficulties of financing acquisitions through the public capital markets before rising again to around 40 percent in 2010 11 However, FDI flows into developed nations differ markedly from those into developing nations. In the case of developing nations, only about one-third or less 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, when do firms prefer to acquire existing assets rather than undertake greenfield investments? We shall consider this question in depth in Chapter 12. For now, we will make 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 management skills (see the next Management Focus on Cemex for an example). However, as we shall discuss in Chapter 12, there is evidence that many mergers and acquisitions fail to realize their anticipated gains. 12

• QUICK STUDY

1. How important has FDI been in the world economy during the last three decades? What explains the growth in FDI?

2. Why has the United States been a favored target for inward FDI? Why has China?

3. Why have developed nations been the source of most outward FDI?

4. What do you think explains the recent rise of China as a source of outward FDI?

Theories of Foreign Direct Investment

LEARNING OBJECTIVE 2

Explain the different theories of FDI.

In this section, we review several theories of foreign direct investment. These theories approach the various phenomena of foreign direct investment from three complementary perspectives. One set of theories seeks to explain why a firm will favor direct investment as a means of entering a foreign market when two other alternatives, exporting and licensing, are open to it. Another set of theories seeks to explain why firms in the same industry often undertake foreign direct investment at the same time and why they favor certain locations over others as targets for foreign direct investment. Put differently, these theories attempt to explain the observed pattern of foreign direct investment flows. A third theoretical 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).

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.

WHY FOREIGN DIRECT INVESTMENT?

Why do firms go to the trouble of establishing operations abroad through foreign direct investment when two alternatives, exporting and licensing, are available to them for exploiting the profit opportunities in a 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 expensive 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 different. 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.

Exporting

Sale of products produced in one country to residents of another country.

Licensing

Occurs when a firm (the licensor) licenses the right to produce its product, 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.

Limitations of Exporting

The viability of an exporting strategy is often constrained 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 internationally by pursuing FDI, rather than exporting (see the accompanying Management Focus). For products with a high value-to-weight ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic components, personal computers, medical equipment, computer software, etc.) and have little impact on the relative attractiveness of exporting, licensing, and FDI.

Transportation costs aside, some firms undertake foreign direct investment as a response to actual or threatened trade barriers such as import tariffs or quotas. By placing tariffs on imported goods, governments can increase the cost of exporting relative to foreign direct investment and licensing. Similarly, by limiting imports through quotas, governments 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.

MANAGEMENT FOCUS Foreign Direct Investment by Cemex

Since the early 1990s, Mexico's largest cement manufacturer, Cemex, has transformed itself from a primarily Mexican operation into the third largest cement company in the world behind Holcim of Switzerland and Lafarge Group of France. Cemex has long been a powerhouse in Mexico and currently controls more than 60 percent of the market for cement in that country. Cemex's domestic success has been based in large part on an obsession with efficient manufacturing and a focus on customer service that is tops in the industry.

Cemex is a leader in using information technology to match production with consumer demand. The company sells ready-mixed cement that can survive for only about 90 minutes before solidifying, so precise delivery is important. But Cemex can never predict with total certainty what demand will be on any given day, week, or month. To better manage unpredictable demand patterns, Cemex developed a system of seamless information technology—including truck-mounted global positioning systems, radio transmitters, satellites, and computer hardware—that allows it to control the production and distribution of cement like no other company can, responding quickly to unanticipated changes in demand and reducing waste. The results are lower costs and superior customer service, both differentiating 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 is also 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 company realized there was tremendous demand for cement in many developing countries, where significant construction was being undertaken or needed. Third, the company believed that it understood the needs of construction businesses 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 targeted other developing nations, acquiring established cement makers in Venezuela, Colombia, Indonesia, the Philippines, Egypt, and several other countries. It also purchased two stagnant companies in Spain and turned them around. Bolstered by the success of its Spanish ventures, Cemex began to look for expansion opportunities in developed nations. In 2000, Cemex purchased Houston-based Southland, one of the largest cement companies in the United States, for $2.5 billion. Following the Southland acquisition, Cemex had 56 cement plants in 30 countries, most of which were gained through acquisitions. In all cases, Cemex devoted great attention to transferring its technological, management, and marketing know-how to acquired units, thereby improving their performance.

In 2004, Cemex made another major foreign investment move, purchasing RMC of Great Britain for $5.8 billion. RMC was a huge multinational cement firm with sales of $8 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 percent of the company's sales are now generated in Mexico. 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 international team of specialists to fix the problem and quickly increased production to 90 percent of capacity. Going forward, Cemex has made it clear that it will continue to expand and is eyeing opportunities in the fast-growing economies of China and India where currently it lacks a presence and where its global rivals are already expanding.

  Sources: C. Piggott, “Cemex's Stratospheric Rise,” Latin Finance, March 2001, p. 76; J. F. Smith, “Making Cement a Household Word,” Los Angeles Times, January 16, 2000, p. C1; D. Helft, “Cemex Attempts to Cement Its Future,” The Industry Standard, November 6, 2000; Diane Lindquist, “From Cement to Services,” Chief Executive, November 2002, pp. 48–50; “Cementing Global Success,” Strategic Direct Investor, March 2003, p. 1; M. T. Derham, “The Cemex Surprise,” Latin Finance, November 2004, pp. 1–2; “Holcim Seeks to Acquire Aggregate,” The Wall Street Journal, January 13, 2005, p. 1; J. Lyons, “Cemex Prowls for Deals in Both China and India,” The Wall Street Journal, January 27, 2006, p. C4; and S. Donnan, “Cemex Sells 25 Percent Stake in Semen Gresik,” FT.com, May 4, 2006, p. 1.

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.

Internalization Theory

The argument that firms prefer FDI over licensing in order to retain control over know-how, manufacturing, marketing, and strategy or because some firm's capabilities are not amenable to licensing.

Market Imperfections

Imperfections in the operation of the market mechanism.

A second problem is that licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability. With licensing, control over manufacturing, marketing, and strategy are granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. The rationale for wanting control over the strategy of a foreign entity is that a firm might want its foreign subsidiary to price and market very aggressively as a way of keeping a foreign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept such an imposition, 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, producing only part of its final product in a given country, while importing other parts from elsewhere where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement, since it would limit the licensee's autonomy. Thus, for these reasons, when tight control over a foreign entity is desirable, foreign direct investment is preferable to licensing.

A third problem with licensing arises when the firm's competitive advantage is based not as much on its products as on the management, marketing, and manufacturing capabilities that produce those products. The problem here is that such capabilities are often not amenable to licensing. While a foreign licensee may be able to physically reproduce the firm's product under license, it often may not be able to do so as efficiently as the firm could itself. As a result, the licensee may not be able to fully exploit the profit potential inherent in a foreign market.

For example, consider Toyota, a company whose competitive advantage in the global auto industry is acknowledged to come from its superior ability to manage the overall process of designing, engineering, manufacturing, and selling automobiles—that is, from its management and organizational capabilities. Indeed, Toyota is credited with 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 organizational culture, and culture is something that cannot be licensed. Thus, if Toyota were to allow a foreign entity to produce its cars under license, the chances are that the entity could not do so as efficiently as could Toyota. In turn, this would limit the ability of the foreign entity to fully develop the market potential of that product. Such reasoning underlies Toyota's preference for direct investment in foreign markets, as opposed to allowing foreign automobile companies to produce its cars under license.

All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing: (1) when the firm has valuable know-how that cannot be adequately protected by a licensing contract; (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country; and (3) when a firm's skills and know-how are not amenable to licensing.

Advantages of Foreign Direct Investment

It follows that a firm will favor foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favor foreign direct investment over licensing (or franchising) when it wishes to maintain control over its technological know-how, or over its operations and business strategy, or when the firm's capabilities are simply not amenable to licensing, as may often be the case.

THE PATTERN OF FOREIGN DIRECT INVESTMENT

Observation suggests that firms in the same industry often undertake foreign direct investment at about the same time. Also, firms tend to direct their investment activities toward the same target markets. The two theories we consider in this section attempt to explain the patterns that we observe in FDI flows.

Strategic Behavior

One theory is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. An early variant of this argument was expounded by F. T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic industries. 15 An oligopoly is an industry composed of a limited 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 response 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 imitative behavior; rivals often quickly imitate what a firm does in an oligopoly.

Oligopoly

An industry composed of a limited number of large firms.

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 disadvantage in the future. Knickerbocker argued that the same kind of imitative behavior characterizes FDI. Consider an oligopoly in the United States in which three firms—A, B, and C—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 business 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 have looked at FDI by U.S. firms show that firms based in oligopolistic industries tended to imitate each other's FDI. 16 The same phenomenon has been observed with regard to FDI undertaken by Japanese firms. 17 For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by undertaking their own FDI in the United States and Europe. Research has also shown that models of strategic behavior in a global oligopoly can explain the pattern of FDI in the global tire industry. 18

Knickerbocker's theory can be extended to embrace the concept of multipoint competition. 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.

Multipoint Competition

Arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.

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. Internalization theory addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, internalization theory addresses the efficiency issue. For these reasons, many economists favor internalization theory as an explanation for FDI, although most would agree that the imitative explanation tells an important part of the story.

THE ECLECTIC PARADIGM

The eclectic paradigm has been championed by the British economist John Dunning. 20 Dunning argues that in addition to the various factors discussed earlier, location-specific advantages are also of considerable importance in explaining both the rationale for and the direction of foreign direct investment. By location-specific advantages , Dunning means the advantages that arise from utilizing resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm's technological, marketing, or management capabilities). Dunning accepts the argument of internalization 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 endowments with the firm's own unique capabilities often requires foreign direct investment. That is, it requires the firm to establish production facilities where those foreign assets or resource endowments are located.

Location-Specific Advantages

Advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm's technological, marketing, or management know-how).

An obvious example of Dunning's arguments are natural resources, such as oil and other minerals, which are by their character specific to certain locations. Dunning suggests that to exploit such foreign resources, a firm must undertake FDI. Clearly, this explains the FDI undertaken by many of the world's oil companies, which have to invest where oil is located in order to combine their technological and managerial capabilities with this valuable location-specific resource. Another obvious example is valuable human resources, such as low-cost, highly skilled labor. The cost and skill of labor varies from country to country. Because labor is not internationally mobile, according to Dunning it makes sense for a firm to locate production facilities in those countries where the cost and skills of local labor are most suited to its particular production processes.

However, Dunning's theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semiconductor industry. Many of the world's major computer and semiconductor companies—such as Apple Computer, Hewlett-Packard, Oracle, Google, and Intel—are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs there. According to Dunning's arguments, knowledge being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors is available nowhere else in the world. To be sure, that knowledge is commercialized as it diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning's language, this means that Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semiconductor industries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part it arises from a network of informal contacts that allows firms to benefit from each others' knowledge generation. Economists refer to such knowledge “spillovers” as externalities , and there is a well-established theory suggesting that firms can benefit from such externalities by locating close to their source. 21

Externalities

Knowledge spillovers.

Silicon Valley has long been known as the epicenter of the computer and semiconductor industry.

Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and, perhaps, production facilities so they too can learn about and utilize valuable new knowledge before those based elsewhere, thereby giving them a competitive advantage in the global marketplace. 22 Evidence suggests that European, Japanese, South Korean, and Taiwanese computer and semiconductor firms are investing in the Silicon Valley region, precisely because they wish to benefit from the externalities that arise there. 23 Others have argued that direct investment by foreign firms in the U.S. biotechnology industry has been motivated by desires to gain access to the unique location-specific technological knowledge of U.S. biotechnology firms. 24 Dunning's theory, therefore, seems to be a useful addition to those outlined previously, because it helps explain how location factors affect the direction of FDI. 25

• QUICK STUDY

1. Why do firms often prefer FDI to exporting and licensing as a strategy for expanding into foreign markets?

2. What theories explain the timing and direction of FDI by firms in the same industries?

3. What is the role of location-specific advantages in explaining FDI?

Political Ideology and Foreign Direct Investment

LEARNING OBJECTIVE 3

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

Historically, political ideology toward FDI within a nation has ranged from a dogmatic radical stance that is hostile to all inward FDI at one extreme to an adherence to the 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 example, that key technology is tightly controlled by the MNE and that important jobs in the foreign subsidiaries of MNEs go to home-country nationals rather than to citizens of the host country. Because of this, according to the radical view, FDI by the MNEs of advanced capitalist nations keeps the less developed countries of the world relatively backward and dependent on advanced capitalist nations for investment, jobs, and technology. Thus, according to the extreme version of this view, no country should ever permit foreign corporations to undertake FDI, because they can never be instruments of economic development, only of economic domination. Where MNEs already exist in a country, they should be immediately nationalized. 26

From 1945 until the 1980s, the radical view was very influential in the world economy. Until the collapse of communism between 1989 and 1991, the countries of eastern Europe were opposed to FDI. Similarly, communist countries elsewhere—such as China, Cambodia, and Cuba—were all opposed in principle to FDI (although, in practice, the Chinese started to allow FDI in mainland China in the 1970s). Many socialist countries—particularly in Africa, where one of the first actions of many newly independent states was to nationalize foreign-owned enterprises—also embraced the radical position. Countries whose political ideology was more nationalistic than socialistic further embraced the radical position. This was true in Iran and India, for example, both of which adopted tough policies restricting FDI and nationalized many foreign-owned enterprises. Iran is a particularly interesting case because its Islamic government, while rejecting Marxist theory, has essentially embraced the radical view that FDI by MNEs is an instrument of imperialism.

ANOTHER PERSPECTIVE India to Allow FDI from Pakistan

Improving the economic ties between the two nations, India recently announced that it will allow FDI from Pakistan paving the way for industries from the neighboring country to set up businesses in the growing Indian market. This is a prime example of how free markets are promoting trade between countries that have not traditionally enjoyed stable political relationships with each other. However, free markets are promoting trade normalization process to allow foreign direct investment from Pakistan into India. Leading to further economic activity, talks are also underway to allow banks from both the countries to open branches in each other's territory. At present, India and Pakistan are engaged only in trade of goods, which has recently been liberalized. Several Pakistani industries and banks are keen on setting up business in India, which is possible only when a policy decision on allowing cross-border FDI is taken.

  Source: www.hindustantimes.com/business-news/WorldEconomy/India-to-allow-FDI-from-Pakistan-Anand-Sharma/Article1-839942.aspx.

By the early 1990s, the radical position was in retreat almost everywhere. There seem to be three reasons for this: (1) the collapse of communism in eastern Europe; (2) the generally abysmal economic performance of those countries that embraced the radical position, and a 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).

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 6). The intellectual case for this view has been strengthened by the internalization 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 dispersing 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 increasing the overall efficiency of resource utilization in the world economy. Mexico, due to its lower labor costs, has a comparative advantage in the assembly of PCs. By moving the production of PCs from the United States to Mexico, Dell frees U.S. resources for use in activities in which the United States has a comparative advantage (e.g., the design of computer software, the 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 computer company transfers with its FDI. Contrary to the radical view, the free market view stresses that such resource transfers benefit the host country and stimulate its economic growth. Thus, the free market view argues that FDI is a benefit to both the source country and the host country.

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 interests” or if they have the potential for “reducing competition.” (In practice, the UK 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, inward 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 interest 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 Investment 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. 27

PRAGMATIC NATIONALISM

In practice, many countries have adopted neither a radical policy nor a free market policy toward FDI, but instead a policy that can best be described as pragmatic nationalism. 28 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.

Recognizing this, countries adopting a pragmatic stance pursue policies designed to maximize the national benefits and minimize the national costs. According to this view, FDI should be allowed so long as the benefits outweigh the costs. Japan offers an example of pragmatic nationalism. Until the 1980s, Japan's policy was probably one of the most restrictive among countries adopting a pragmatic nationalist stance. This was due to Japan's perception that direct entry of foreign (especially U.S.) firms with ample managerial resources into the Japanese markets could hamper the development and growth of their own industry and technology. 29 This belief led Japan to block the majority of applications to invest in Japan. However, there were always exceptions to this policy. Firms that had important technology were often permitted to undertake FDI if they insisted that they would neither license their technology to a Japanese firm nor enter into a joint venture with a Japanese enterprise. IBM and Texas Instruments were able to set up wholly owned subsidiaries in Japan by adopting this negotiating position. From the perspective of the Japanese government, the benefits of FDI in such cases—the stimulus that these firms might impart to the Japanese economy—outweighed the perceived costs.

Another aspect of pragmatic nationalism is the tendency to aggressively court FDI believed to be in the national interest by, for example, offering subsidies to foreign MNEs in the form of tax breaks or grants. The countries of the European Union often seem to be competing with each other to attract U.S. and Japanese FDI by offering large tax breaks and subsidies. Britain has been the most successful at attracting Japanese 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, many of the socialist countries of Africa, and India) and several countries that until recently could best be described as pragmatic nationalists with regard to FDI (e.g., Japan, South Korea, Italy, Spain, and most Latin American countries). One result has been the surge in the volume of FDI worldwide, which, as we noted earlier, has been growing twice as fast as the growth in world trade. Another result has been an increase in the volume of FDI directed at countries that have recently liberalized their FDI regimes, such as China, India, and Vietnam.

MANAGEMENT FOCUS DP World and the United States

In February 2006, DP World, a ports operator with global reach owned by the government of Dubai, a member of the United Arab Emirates and a staunch U.S. ally, paid $6.8 billion to acquire P&O, a British firm that runs a global network of marine terminals. With P&O came the management operations of six U.S. ports: Miami, Philadelphia, Baltimore, New Orleans, New Jersey, and New York. The acquisition had already been approved by U.S. regulators when it suddenly became front-page news. Upon hearing about the deal, several prominent U.S. senators raised concerns about the acquisition. Their objections were twofold. First, they raised questions about the security risks associated with management operations in key U.S. ports being owned by a foreign enterprise that was based in the Middle East. The implication was that terrorists could somehow take advantage of the ownership arrangement to infiltrate U.S. ports. Second, they were concerned that DP World was a state-owned enterprise and argued that foreign governments should not be in a position of owning key “U.S. strategic assets.”

The Bush administration was quick to defend the takeover, stating it posed no threat to national security. Others noted that DP World was a respected global firm with an American chief operating officer and an American-educated chairman; the head of the global ports management operation would also be an American. DP World would not own the U.S. ports in question, just manage them, while security issues would remain in the hands of American customs officials and the U.S. Coast Guard. Dubai was also a member of America's Container Security Initiative, which allows American customs officials to inspect cargo in foreign ports before it leaves for the United States. Most of the DP World employees at American ports would be U.S. citizens, and any UAE citizen transferred to DP World would be 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 off the right to manage the six U.S. ports for about $750 million. Looking forward, however, DP World stated it would seek an initial public offering in 2007, and the then-private firm would in all probability continue to look for ways to enter the United States. In the words of the firm's CEO, “This is the world's largest economy. How can you just ignore it?”

  Sources: “Trouble at the Waterfront,” The Economist, February 25, 2006, p. 48; “Paranoia about Dubai Ports Deals Is Needless,” Financial Times, February 21, 2006, p. 16; and “DP World: We'll Be Back,” Traffic World, May 29, 2006, p. 1.

As a counterpoint, there is some evidence of a shift to a more hostile approach to foreign direct investment in some nations. Venezuela and Bolivia have become increasingly hostile to foreign direct investment. In 2005 and 2006, the governments of both nations unilaterally rewrote contracts for oil and gas exploration, raising the royalty rate that foreign enterprises had to pay the government for oil and gas extracted in their territories. Following his election victory in 2006, Bolivian President Evo Morales nationalized the nation's gas fields and stated that he would evict foreign firms unless they agreed to pay about 80 percent of their revenues to the state and relinquish production oversight. In some developed nations, there is increasing evidence of hostile reactions to inward FDI as well. In Europe in 2006, there was a hostile political reaction to the attempted takeover of Europe's largest steel company, Arcelor, by Mittal Steel, a global company controlled by the Indian entrepreneur Lakshmi Mittal. In mid-2005, China National Offshore Oil Company 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 its planned takeover of some operations at six U.S. ports after negative political reactions. So far, these countertrends are nothing more than isolated incidents, but if they become more widespread, the 30-year movement toward lower barriers to cross-border investment could be in jeopardy.

• QUICK STUDY

1. What is the main thesis of the radical view on FDI?

2. What is the main thesis of the free market view on FDI?

3. What is meant by a policy of pragmatic nationalism with regard to FDI?

Benefits and Costs of FDI

LEARNING OBJECTIVE 4

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

To a greater or lesser degree, many governments can be considered pragmatic nationalists when it comes to FDI. Accordingly, their policy is shaped by a consideration of the costs and benefits of FDI. Here, we explore the benefits and costs of FDI, first from the perspective of a host (receiving) country and then from the perspective of the home (source) country. In the next section, we look at the policy instruments governments use to manage FDI.

Host-Country Benefits

The main benefits of inward FDI for a host country arise from resource-transfer effects, employment effects, balance-of-payments effects, and effects on competition and economic growth.

Resource-Transfer Effects

Foreign direct investment can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available and thus boost that country's economic growth rate (as described in the opening case, the Indian government has come around to this view and has adopted a more permissive attitude to inward investment). 30

With regard to capital, many MNEs, by virtue of their large size and financial strength, have access to financial resources not available to host-country firms. These funds may be available from internal company sources, or, because of their reputation, large MNEs may find it easier to borrow money from capital markets than host-country firms would.

As for technology, you will recall from Chapter 3 that technology can stimulate economic development and industrialization. Technology can take two forms, both of which are 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 countries must rely on advanced industrialized nations for much of the technology required to stimulate economic growth, and FDI can provide it.

Research supports the view that multinational firms often transfer significant technology when they invest in a foreign country. 31 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). 32 Also, a study of FDI by the Organization 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. 33

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 country, whether those operations are acquired or greenfield developments. This is one reason the Indian government would like to open up the Indian retail sector to inward investment by foreign firms such as Walmart and Carrefour (see the opening case). Beneficial spin-off effects may also arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help 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.

ANOTHER PERSPECTIVE FDI Creates 8,351 Jobs in Ghana

A total of 8,351 jobs are expected to be created out of 117 new projects registered in the fourth quarter of 2011, representing 134.32 percent over 3,564 expected jobs to be created in the corresponding quarter of 2010. According to the Ghana Investment Promotion Center (GIPC), 7,629 of the jobs representing 91.35 percent were for Ghanaians, while 722 representing 8.65 percent would go to expatriates. In terms of the sectors, agriculture recorded the highest with 3,277 jobs followed by manufacturing, building and construction and services with 1,357, 930, and 918 jobs respectively. General trading and liaison were also expected to create 844 and 263 jobs respectively.

  Source: www.dailyguideghana.com/?p=37703

Employment Effects

Another beneficial employment effect claimed for FDI is that it brings jobs to a host country that would otherwise not be created there. The effects of FDI on 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 investment and when jobs are created because of increased local spending by employees of the MNE. The indirect employment effects are often as large as, if not larger than, the direct effects. For example, when Toyota decided to open a new auto plant in France, estimates suggested the plant would create 2,000 direct jobs and perhaps another 2,000 jobs in support industries. 34

Job creation is a result of FDI. These French workers assemble cars at Toyota's Valenciennes manufacturing plant.

Cynics argue that not all the “new jobs” created by FDI represent net additions in employment. 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 undertake FDI and the host government.

When FDI takes the form of an acquisition of an established enterprise in the host economy as opposed to a greenfield investment, the immediate effect may be to reduce employment as the multinational tries to restructure the operations of the acquired unit to improve its operating efficiency. However, even in such cases, research suggests that once the initial period of restructuring is over, enterprises acquired by foreign firms tend to grow their employment base at a faster rate than domestic rivals. An OECD study found that foreign firms created new jobs at a faster rate than their domestic counterparts. 35 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 employment 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 enterprise by a foreign firm, often those enterprises were in competitive difficulties and would not have survived had they 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. 36

Balance-of-Payments Effects

FDI's effect on a country's balance-of-payments accounts is an important policy issue for most host governments. A country's balance-of-payments accounts track both its payments to and its receipts from other countries. Governments normally are concerned when their country is running a deficit on the current account of their balance of payments. The current account tracks the export and import of goods and services. A current account deficit, or trade deficit as it is often called, arises when a country is importing more goods and services than it is exporting. Governments typically prefer to see a current account surplus than a deficit. The only way in which a current account deficit can be supported in the long run is by selling off assets to foreigners (for a detailed explanation of why this is the case, see the Appendix to Chapter 6). For example, the persistent U.S. current account deficit since the 1980s has been financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to foreigners. Because national governments invariably dislike seeing the assets of their country fall into foreign hands, they prefer their nation to run a current account surplus. There are two ways in which FDI can help a country to achieve this goal.

Balance-of-Payments Accounts

National accounts that track both payments to and receipts from foreigners.

Current Account

In the balance of payments, records transactions involving the export or import of goods and services.

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 developing and developed nations. 37 For example, in China exports increased from $26 billion in 1985 to more than $250 billion by 2001 and $1.6 trillion in 2010. Much of this dramatic export growth was due to the presence of foreign multinationals that invested heavily in China during the 1990s.

Effect on Competition and Economic Growth

Economic theory tells us that the efficient functioning of markets depends on an adequate level of competition between producers. When FDI takes the form of a greenfield investment, the result is to establish a new enterprise, increasing the number of players in a market and thus 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. 38 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. 39 For example, under a 1997 agreement sponsored by the World Trade Organization, 68 countries accounting for more than 90 percent of world telecommunications revenues pledged to start opening their markets to foreign investment and competition and to abide by common rules for fair competition in telecommunications. Before this agreement, most of the world's telecommunications markets were closed to foreign competitors, and in most countries the market was monopolized by a single carrier, which was often a state-owned enterprise. The agreement has dramatically increased the level of competition in many national telecommunications markets, producing two major benefits. First, inward investment has increased competition and stimulated investment in the modernization of telephone networks around the world, leading to better service. Second, the increased competition has resulted in lower prices.

HOST-COUNTRY COSTS

Three costs of FDI concern host countries. They arise from possible adverse effects on competition within the host nation, adverse effects on the balance of payments, and the perceived loss of national sovereignty and autonomy.

Adverse Effects on Competition

Host governments sometimes worry that the subsidiaries of foreign MNEs may have greater economic power than indigenous 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 monopolize the market. Once the market is monopolized, the foreign MNE could raise prices above those that would prevail in competitive markets, with harmful effects on the economic welfare of the host 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.

In general, while FDI in the form of greenfield investments should increase competition, it is less clear that this is the case when the FDI takes the form of acquisition of an established enterprise in the host nation, as was the case when Cemex acquired RMC in Britain (see the Management Focus). Because an acquisition does not result in a net increase in the number of players in a market, the effect on competition may be neutral. When a foreign investor acquires two or more firms in a host country, and subsequently merges them, the effect may be to reduce the level of competition in that market, create monopoly power for the foreign firm, reduce consumer choice, and raise prices. For 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 makers Dollops, Kwality, and Milkfood. By combining these companies, Hindustan Lever's share of the Indian ice cream market went from zero in 1992 to 74 percent in 1997. 40 However, although such cases are of obvious concern, there is little evidence that such developments are widespread. In many nations, domestic competition authorities have the right to review and block any mergers or acquisitions that they view as having a detrimental impact on competition. If such institutions are operating effectively, this should be sufficient to make sure that foreign entities do not monopolize a country's markets.

Adverse Effects on the Balance of Payments

The possible adverse effects of FDI on a host country's balance-of-payments position are twofold. First, set against the initial capital inflow that comes with FDI must be the subsequent outflow of earnings from the foreign subsidiary to its parent company. Such outflows show up as capital outflow on balance-of-payments accounts. Some governments have responded to such outflows by restricting the amount of earnings that can be repatriated to a foreign 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 favorable impact of this FDI on the current account of the U.S. balance-of-payments position may not be as great as initially supposed. The Japanese auto companies responded to these criticisms by 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 decisions that can affect the host country's economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country's government has no real control. Most economists dismiss such concerns as groundless and irrational. Political scientist Robert Reich has noted that such concerns are the product of outmoded thinking because they fail to account for the growing interdependence of the world economy. 41 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 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 outward 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 assembly operations directly from Japan.

ANOTHER PERSPECTIVE FDI Effects: Look at the Whole Picture

Some critics of globalization suggest that FDI is an advanced form of colonialism that destroys local cultures in developing countries. What these critics say may have some limited validity, but it isn't the whole picture. Take Freeport McMoRan, a U.S.-based mining company with operations in West Papua, the former Irian Jaya, Indonesia, where the world's largest gold, mineral, and copper reserves have been found. Freeport formed a joint venture with the Indonesian government to mine a 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 isolated local tribes in West Papua, nomadic peoples who wear loincloths and hunt in the forest. Their traditional, subsistence way of life is threatened, while at the same time, they gain from their share of the operation's profits, from their increased health care and education, and from local employment opportunities with FCX. Is this colonialism or a kind of ethical investing? See more on this issue at www.FCX.com and www.corpwatch.org.

Third, benefits arise when the home-country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country. This amounts to a reverse resource-transfer effect. Through its exposure to a foreign market, an MNE can learn about superior management techniques and superior product and process technologies. These resources can then be transferred back to the home country, contributing to the home country's economic growth rate. 42 For example, one reason General Motors and Ford invested in Japanese automobile companies (GM owns 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 balance 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 account 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, insofar 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 investments in the United States and Europe. One obvious result of such FDI is reduced home-country employment. If the labor market in the home country is already tight, with little unemployment, this concern may not be that great. However, if the home country is suffering from unemployment, concern about the export of jobs may arise. For example, one objection frequently raised by U.S. labor leaders to the free trade pact among the United States, Mexico, and Canada (see the next chapter) is that the United States 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. 43

INTERNATIONAL TRADE THEORY AND FDI

When assessing the costs and benefits of FDI to the home country, keep in mind the lessons of international trade theory (see Chapter 6). International trade theory tells us that home-country concerns about the negative economic effects of offshore production may be misplaced. The term offshore production refers to FDI undertaken to serve the home market. Far from reducing home-country employment, such FDI may actually stimulate economic growth (and hence employment) in the home country by freeing home-country resources to concentrate on activities where the home country has a comparative advantage. In addition, home-country consumers benefit if the price of the particular product falls as a result of the FDI. Also, if a company were prohibited from making such investments on the grounds of negative 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.

Offshore Production

FDI undertaken to serve the home market.

• QUICK STUDY

1. What are the benefits to a host country of inward FDI? What are the costs?

2. What are the benefits to a home (source) country of outward FDI by firms based in that nation? What are the costs?

3. What does international trade theory teach us about the benefits and costs of FDI?

Government Policy Instruments and FDI

LEARNING OBJECTIVE 5

Explain the range of policy instruments that governments use to influence 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 countries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first. These include foreign risk insurance, capital assistance, tax incentives, and political pressure. Then we will look at policies designed to restrict 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 (nationalization), war losses, and the inability to transfer profits back home. Such programs are particularly useful in encouraging firms to undertake investments in politically unstable countries. 44 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 investor countries (including the United States) have used their political influence to persuade host countries to relax their restrictions on inbound FDI. For example, in response to direct U.S. pressure, Japan relaxed many of its formal restrictions on inward FDI in the 1980s. Now, in response to further U.S. pressure, Japan has moved toward relaxing its informal barriers to inward FDI. One beneficiary of this trend has been Toys “R” Us, which, after five years of intensive lobbying by company and U.S. government officials, opened its first retail stores in Japan in December 1991. By 2011, 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 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 important secondary intent was to make it more difficult for British firms to undertake FDI.

Because Japan was willing to relax some obstacles to FDI, Toys “R” Us was able to open stores there.

In addition, countries have occasionally manipulated tax rules to try to encourage their firms to invest at home. The objective behind such policies is to create jobs at home rather than in other nations. At one time, Britain adopted such policies. The British advanced corporation tax system taxed British companies' foreign earnings at a higher rate than their domestic earnings. This tax code created an incentive for British companies to invest at home.

Finally, countries sometimes prohibit national firms from investing in certain countries for political reasons. Such restrictions can be formal or informal. For example, formal U.S. rules prohibited U.S. firms from investing in countries such as Cuba and Iran, whose 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 adhering to some version of the radical stance and prohibiting much FDI, and toward a situation where a combination of free market objectives and pragmatic nationalism took hold.

Encouraging Inward FDI

It is common for governments to offer incentives to foreign 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 countries. For example, in the mid-1990s, the governments of Britain and France competed with each other on the incentives they offered Toyota to invest in their respective countries. In the United States, state governments often compete with each other to attract FDI. For example, Kentucky offered Toyota an incentive package worth $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. 45

Restricting Inward FDI

Host governments use a wide range of controls to restrict FDI in one way or another. The two most common are ownership restraints and performance requirements. Ownership restraints can take several forms. In some countries, foreign companies are excluded from specific fields. They are excluded from tobacco and mining in Sweden and from the development of certain natural resources in Brazil, Finland, and Morocco. In other industries, foreign ownership may be permitted although a significant proportion of the equity of the subsidiary must be owned by local investors. Foreign ownership is restricted to 25 percent or less of an airline in the United States. In India, foreign firms were prohibited from owning media businesses until 2001, when the rules were relaxed, allowing foreign firms to purchase up to 26 percent of a foreign newspaper. As described in the opening case, foreign firms are still restricted from owning retail establishments in India. 46

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 combination of import tariffs and controls on FDI. This is a variant of the infant industry argument discussed in Chapter 7.

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 allowed joint ventures between Japanese firms and foreign MNEs if the MNE had a valuable technology. The Japanese government clearly believed such an arrangement would speed up the subsequent diffusion of the MNE's valuable technology throughout the Japanese economy.

Performance requirements can also take several forms. Performance requirements are controls over the behavior of the MNE's local subsidiary. The most common performance 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, performance requirements tend to be more common in less developed countries than in advanced industrialized nations. 47

INTERNATIONAL INSTITUTIONS AND THE LIBERALIZATION OF FDI

Until the 1990s, there was no consistent involvement by multinational institutions 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. Because many services have to be produced where they are sold, exporting is not an option (e.g., one cannot export McDonald's hamburgers or consumer banking services). Given this, the WTO has become involved in regulations governing FDI. As might be expected for an institution created to promote free trade, the thrust of the WTO's efforts has been to push for the liberalization of regulations governing FDI, particularly in services. Under the auspices of the WTO, two extensive multinational agreements were reached in 1997 to liberalize trade in telecommunications and financial services. Both these agreements contained detailed clauses that require signatories 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 universal set of rules designed to promote the liberalization of FDI. Led by Malaysia and India, developing nations have so far rejected efforts by the WTO to start such discussions.

• QUICK STUDY

1. What policies do home (source) countries use to encourage outward FDI? How do they restrict it?

2. What policies do host countries use to restrict inward FDI? How do they encourage it?

3. Why is the WTO interested in promoting greater liberalization of FDI rules?

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 attention to the implications of government policy.

LEARNING OBJECTIVE 6

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

THE THEORY OF FDI

The implications of the theories of FDI for business practice are straightforward. First, the location-specific advantages argument associated with John Dunning does help explain the direction of FDI. However, the location-specific advantages argument does not explain why firms prefer FDI to licensing or to exporting. In this regard, from both an explanatory and a business perspective, perhaps the most useful theories are those that focus on the limitations of exporting and licensing—that is, internalization theories. These theories are useful because they identify with some precision how the relative profitability of foreign direct investment, exporting, and licensing vary with circumstances. The theories suggest that exporting is preferable to licensing and FDI so long as transportation costs are minor and trade barriers are trivial. As transportation costs or trade barriers increase, exporting becomes unprofitable, and the choice is between FDI and licensing. Because FDI is more costly and more risky than licensing, other things being equal, the theories argue that licensing is preferable to FDI. Other things are seldom equal, however. Although licensing may work, it is not an attractive option when one or more of the following conditions exist: (1) the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) a firm's skills and capabilities are not amenable to licensing. Figure 8.4 presents these considerations as a decision tree.

FIGURE 8.4 A Decision Framework

Firms for which licensing is not a good option tend to be clustered in three types of industries:

1. High-technology industries in which protecting firm-specific expertise is of paramount importance and licensing is hazardous.

2. Global oligopolies, in which competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors.

3. Industries in which intense cost pressures require that multinational firms maintain tight control over foreign operations (so that they can disperse manufacturing to locations around the globe where factor costs are most favorable in order to minimize costs).

Although empirical evidence is limited, the majority seems to support these conjectures. 48 In addition, licensing is not a good option if the competitive advantage of a firm is based upon managerial or marketing knowledge that is embedded in the routines of the firm or the skills of its managers, and that is difficult to codify in a “book of blueprints.” This would seem to be the case for firms based in a fairly wide range of industries.

Firms for which licensing is a good option tend to be in industries whose conditions are opposite to those just specified. That is, licensing tends to be more common, and more profitable, in fragmented, low-technology industries in which globally dispersed 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 service-industry version of licensing, although it normally involves much longer-term commitments than licensing. With franchising, the firm licenses its brand name to a foreign firm in return for a percentage of the franchisee's profits. The franchising contract specifies the conditions that the franchisee must fulfill if it is to use the franchisor's brand name. Thus, McDonald's allows foreign firms to use its brand name so long as they agree to run their restaurants on exactly the same lines as McDonald's restaurants elsewhere in the world. This strategy makes sense for McDonald's because (1) like many services, fast food cannot be exported; (2) franchising economizes the costs and risks associated with opening up foreign markets; (3) unlike technological know-how, brand names are relatively easy to protect using a contract; (4) there is no compelling reason for McDonald's to have tight control over franchisees; and (5) McDonald's know-how, in terms of how to run a fast-food restaurant, is amenable to being specified in a written contract (e.g., the contract specifies the details of how to run a McDonald's restaurant).

Finally, it should be noted that the product life-cycle theory and Knickerbocker's theory of FDI tend to be less useful from a business perspective. The problem with these two theories is that they are descriptive rather than analytical. They do a good job of describing the historical evolution of FDI, but they do a relatively poor job of 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 policies toward FDI is clearly preferable to investing in countries that restrict FDI.

However, often the issue is not this straightforward. Despite the move toward a free market stance in recent years, many countries still have a rather pragmatic stance toward FDI. In such cases, a firm considering FDI must often negotiate the specific terms of the investment with the country's government. Such negotiations center on two broad issues. If the host government is trying to attract FDI, the central issue is likely to be the kind of incentives the host government is prepared to offer to the MNE and what the firm will commit in exchange. If the host government is uncertain about the benefits of FDI and might choose to restrict access, the central issue is likely to be the concessions that the firm must make to be allowed to go forward with a proposed investment.

To a large degree, the outcome of any negotiated agreement depends on the relative bargaining power of both parties. Each side's bargaining power depends on three factors:

• The value each side places on what the other has to offer.

• The number of comparable alternatives available to each side.

• Each party's time horizon.

From the perspective of a firm negotiating the terms of an investment with a host government, the firm's bargaining power is high when the host government places a high value on what the firm has to offer, the number of comparable alternatives open to the firm is greater, and the firm has a long time in which to complete the 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. 49

• QUICK STUDY

1. When is FDI preferable to licensing as a strategy for expanding internationally?

2. When is licensing preferable to FDI as a strategy for expanding internationally?

3. When is exporting the best choice for growing international revenues?

4. How does government policy influence decisions about FDI?

Key Terms

greenfield investment, p. 220

flow of FDI, p. 221

stock of FDI, p. 221

outflows of FDI, p. 221

inflows of FDI, p. 221

eclectic paradigm, p. 225

exporting, p. 225

licensing, p. 225

internalization theory, p. 227

market imperfections, p. 227

oligopoly, p. 228

multipoint competition, p. 228

location-specific advantages, p. 228

externalities, p. 230

balance-of-payments accounts, p. 235

current account, p. 235

offshore production, p. 238

Chapter Summary

This chapter reviewed theories 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 chapter made the following points:

1. Any theory seeking to explain FDI must explain why firms go to the trouble of acquiring or establishing operations abroad when the alternatives of exporting and licensing are available to them.

2. High transportation costs or tariffs imposed on imports help explain why many firms prefer FDI or licensing over exporting.

3. Firms often prefer FDI to licensing when: ( a) a firm has valuable know-how that cannot be adequately protected by a licensing contract, ( b) a firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country, and ( c) a firm's skills and capabilities are not amenable to licensing.

4. Knickerbocker's theory suggests that much FDI is explained by imitative behavior by rival firms in an oligopolistic industry.

5. Dunning has argued that location-specific advantages are of considerable importance in explaining the nature and direction of FDI. According to Dunning, firms undertake FDI to exploit resource endowments or assets that are location specific.

6. Political ideology is an important determinant of government policy toward FDI. Ideology ranges from a radical stance that is hostile to FDI to a noninterventionist, free market stance. Between the two extremes is an approach best described as pragmatic nationalism.

7. Benefits of FDI to a host country arise from resource transfer effects, employment effects, and balance-of-payments effects.

8. The costs of FDI to a host country include adverse effects on competition and balance of payments and a perceived loss of national sovereignty.

9. The benefits of FDI to the home (source) country include improvement in the balance of payments as a result of the inward flow of foreign earnings, positive employment effects when the foreign subsidiary creates demand for home-country exports, and benefits from a reverse resource-transfer effect. A reverse resource-transfer effect arises when the foreign subsidiary learns valuable skills abroad that can be transferred back to the home country.

10. The costs of FDI to the home country include adverse balance-of-payments effects that arise from the initial capital outflow and from the export substitution effects of FDI. Costs also arise when FDI exports jobs abroad.

11. Home countries can adopt policies designed to both encourage and restrict FDI. Host countries try to attract FDI by offering incentives and try to restrict FDI by dictating ownership restraints and requiring that foreign MNEs meet specific performance requirements.

Critical Thinking and Discussion Questions

1. In 2008, inward FDI accounted for some 63.7 percent of gross fixed capital formation in Ireland, but only 4.1 percent in Japan (gross fixed capital formation refers to investments in fixed assets such as factories, warehouses, and retail stores). What do you think explains this difference in FDI inflows into the two countries?

2. Compare and contrast these explanations of FDI: internalization theory and Knickerbocker's theory of FDI. Which theory do you think offers the best explanation of the historical pattern of FDI? Why?

3. What are the strengths of the eclectic theory of FDI? Can you see any shortcomings? How does the eclectic theory inform management practice?

4. Read the Management Focus on Cemex and then answer the following questions:

a. Which theoretical explanation, or explanations, of FDI best explains Cemex's FDI?

b. What is the value that Cemex brings to a host economy? Can you see any potential drawbacks of inward investment by Cemex in an economy?

c. Cemex has a strong preference for acquisitions over greenfield ventures as an entry mode. Why?

5. You are the international manager of a U.S. business that has just developed a revolutionary new personal computer that can perform the same functions as existing PCs but costs only half as much to manufacture. Several patents protect the unique design of this computer. Your CEO has asked you to formulate a recommendation for how to expand into western Europe. Your options are ( a) to export from the United States, ( b) to license a European firm to manufacture and market the computer in Europe, or ( c) to set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative and suggest a course of action to your CEO.

http://globalEDGE.msu.edu Research Task

Foreign Direct Investment

Use the globalEDGE Resource Desk ( http://globaledge.msu.edu/Resource-Desk/) 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. As a part of the recommendations in your report, be sure to evaluate the variation in confidence of the top countries. This provides an additional level of stability in your analysis.

2. Your company is considering opening a new factory in Africa, and management is evaluating the specific country locations for this direct investment. The pool of candidate countries has been narrowed to Kenya, Liberia, and South Africa. Prepare a short report comparing the foreign direct investment (FDI) climate and regulations of these three countries, using the Country Commercial Guides for US Investors prepared by the U.S. Department of Commerce.

closing case Walmart in Japan

Japan has been a tough market for foreign firms to enter. The level of foreign direct investment (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 breaking long-standing commitments with suppliers. Foreign investors also state that it is difficult to find managerial talent in Japan. 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 the foreign firms do not feel bound by existing business practices or relationships. They can be a source of new management ideas, business policies, and technology—all of which boost productivity. Indeed, a study by the Organization for Economic Cooperation and Development (OECD) suggests that labor productivity at the Japanese affiliates of foreign firms is as much as 60 percent higher than at domestic firms, and in services firms it is as much as 80 percent higher.

It was the opportunity to help restructure Japan's retail sector—boosting productivity, gaining market share, and profiting in the process—that attracted Walmart to Japan. The world's 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, by all accounts, an inefficient retailer. According to one top officer, “Seiyu is bogged down in old customs that are wasteful. Walmart brings proven skills in managing big supermarkets, which is what we would like to learn to do.”

Walmart's goal was to transfer best practices from its U.S. stores and use them to improve the performance of Seiyu. This meant implementing Walmart's cutting-edge information systems, adopting tight inventory control, leveraging its global supply chain to bring low-cost goods into Japan, introducing everyday low prices, retraining employees to improve customer service, extending opening hours, renovating stores, and investing in new ones.

It proved to be more difficult than Walmart had hoped. When Walmart acquired a majority stake in Seiyu, it promptly laid off 1,500 employees at the retailer's headquarters. While this reduced costs, it also created resistance from former and remaining employees, who complained vocally to the press about how Walmart was trying to impose American management practices on a Japanese corporation. This was a public relations setback for Walmart. Walmart also stumbled when it began to stock low-priced (and low-perceived-quality) Chinese goods in its Japanese stores. Japanese consumers did not respond favorably, and Walmart 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. Walmart's entry also prompted local rivals to change their strategies. They began to make acquisitions and started to cut their prices to match Walmart's discounting strategy. Also, many Japanese suppliers were reluctant to work closely with Walmart due to their belief that Walmart would force them to cut prices to the bone. Despite this, after years of losses, it looked as if Seiyu would become profitable in 2010, indicating that Walmart might be able to 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. Foster, “Successful Globalization Practices: The Case of Seiyu in Japan,” Journal of Transnational Management, 2009, pp. 155–76.

Case Discussion Questions

1. Why, historically, has the level of FDI in Japan been so low?

2. What are the potential benefits to the Japanese economy of greater FDI?

3. How did the entry of Walmart into the Japanese retail sector benefit that sector? Who lost as a result of Walmart's entry?

4. Why has it been so hard for Walmart to make a profit in Japan? What might the company have done differently?

(Hill 219)

Hill, Charles W. Global Business Today, 8th Edition. McGraw-Hill Learning Solutions, 09/2013. VitalBook file.