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Foreign Direct Investment- What the heck does it mean?

By Edited Nov 13, 2013 0 0

Over the past thirty years we have seen a shift in the pattern of foreign direct investment; while it was once seen as a way for rich countries to exploit poor ones, today it is mostly seen as a win-win situation for the enterprise that expands into a new market, and for the host country that allows these enterprises into their markets. At the most basic level FDI boosts the world economy. First we will discuss what exactly FDI is, and then move on to three supporting theories of FDI. Next we will discuss how the views of FDI have shifted over time, and what economists today conclude to be the most favorable objective of FDI recently dubbed, pragmatic nationalism. Lastly, we will look at the costs and benefits of both the host country, the enterprise’s home country and what they mean for managers of multinational corporations.  

Federal direct investment has become a popular way in which firms can gain access to new markets, cheaper production facilities, cheaper labor and the like. The host nation benefits through higher employment rates, access to better technology, improved facilities and higher economic growth. For this reason many governments attempt to battle for business in specific locations by offering enticing economic incentives such as tax breaks or grants. Federal direct investment happens when a firm invests directly in facilities to produce or market a product in a foreign nation. The flow of FDI can either be inward, which a country receives an investment from a foreign enterprise; or outward in which a country’s firm invests in another country. The stock of FDI is the total accumulated value of foreign owned assets over a specific time period (how much does the country own abroad), while the flow of FDI refers to the amount of FDI undertaken over a given time period by a nation’s businesses(how much funding do multinationals provide in a given country). So it would make sense to conclude that when a country experiences a high level of both inward investments and outward investments that the particular country’s economy will grow. Once a business decides to make an outward flow of FDI into another nation they become a multinational company because they occupy more than one country. FDI can be undertaken through greenfield investments which are wholly owned-new enterprises in a host nation; and this is generally the case in developing countries because due to low economic growth there are little or no businesses to acquire. A more common and convenient way is to acquire or merge with an existing firm in a nation. The reason this is more common is because it is much easier to restructure a business rather than completely start a business from scratch. It is quicker, less risky and by transferring knowledge, technology and great management to the existing business can be a more cost-efficient way than building a business.

There are three supporting theories of FDI, and some are stronger than others, however each are important in understanding the pattern of FDI and why firms choose to use this in their business strategies. It is important to note that FDI is costly because a firm has to invest heavily in the beginning to set up facilities, hire employees, purchase equipment and so on, furthermore it is risky simply because you are in a foreign culture and you may abide by different business codes. Beyond this, however, FDI has considerable benefits to not only one, but two economies. But why does a firm choose FDI as opposed to exporting its products?  When one thinks about this there are certain products that cannot be shipped at a cost-efficient rate due to transportation costs, a product with a low value-to-weight ratio usually cannot ship goods at a profitable price. This would leave them with two options, either license the product to an overseas licensee or use FDI. Another issue with exporting is a country’s government (discussed in chapter 7) may impose trade barriers such as a quota restriction, a high tariff rate, or some other protectionist measure for their domestic businesses. If this is the case, it may help to ease tensions by investing directly into the country. I think this is a fantastic way to gain the trust of many Asian governments whom are skeptical of Westerner’s “short-term” profit agenda. By making a hefty investment it shows that the Western firm is in for the long haul. Another way a firm could expand is through licensing their product to a foreign licensee. For companies that do not need tight control over their products, such as fast-food chains (franchising), this is a completely viable and cost-effective option to expand. However, the internalization theory provides three reasons why some firms such as high tech companies, oligopolies and firms with intense cost pressures should not use licensing as a way to expand. First, since one benefit of FDI to the host country is that they receive advanced technology, it is important to evaluate just how valuable that technology is, and if it can be pirated by a person in that nation and sold abroad you should not use licensing. Second, licensing doesn’t give a firm control over its marketing, manufacturing or business strategy that is generally imperative to maximizing profits. Lastly, if the firm’s organizational cannot be replicated and its competitive advantage can be put at risk because their capabilities are no amenable to licensing, then FDI is a better option.

Another interesting question to look at when observing the patterns of FDI is why companies tend to follow each other and conduct FDI at the same times. Two sets of theories, one the strategic behavior theory and next the product life-cycle give a good insight into the historical reasons FDI has been undertaken by firms.

FT Knickerbocker explored the patterns of FDI in oligopolistic industries, where only a few firms dominate the market. Probably the most innovative conclusion he came up with was that these firms were extremely interdependent and competitive with one another (their survival depended on it) therefore what one firm did, the next firm would follow in order to deter the next firm form getting a competitive advantage. Beyond this, if we look at a real world example, we can consider how when you see a store with Pepsi, a Coca-Cola provider isn’t far behind. They battle with each other in almost every respect, trying to have stores, restaurants, malls, vending machines, even whole countries (India) to sell their product instead of their rivals. Furthermore, Knickerbocker’s theory can be further extended to the theory of multi-point competition which happens when two or more enterprises encounter each other in different regional markets, national markets or industries. It is no surprise with the rapid globalization and integrated production this is going to happen more frequently in the future, as firms attempt to get first-mover advantages and establish them in culturally different nations. Some drawbacks of this theory are that it doesn’t explain why firms decide to use FDI relative to exporting or licensing, nor does it explain why this method is more efficient. In this respect, it is more credible to combine this theory with the theory of internalization. Another theory, discussed earlier in the book, is Raymond Vernon’s Product Life-Cycle Theory, while it a very ethnocentric theory and is relatively outdated, there are some points to consider when expanding into a new market. Vernon’s perspective was that when local demand was high enough in foreign nations that firm’s that pioneered and first produced a product would use FDI to expand. First they will invest in other advanced countries, then as the product becomes widely distributed and accepted by the market, new competitor’s enter, as these competitor’s enter they drive down the price of the product. If the price is driven down, then the firm must find another way to produce their product, shifting production out of their home country and other advanced countries to developing countries where labor costs are cheaper. However, Vernon too, failed to explain why FDI and location based production is a more profitable option relative to exporting and licensing. Still both these theories help explain the patterns of FDI.

A more widely accepted theory has been the eclectic paradigm, in which John Dunning explains that location-specific advantages can work in a firms favor if the resource endowments or assets that are tied to a foreign location can be combined with the firm’s own assets to maximize profits. At a basic level we could use the example of champagne that comes from champagne, France; or the wines that come out of Napa. The grapes in these locations are specific to the region, and without being located in those regions, it is impossible to create the same quality, and in the case of champagne, if it was produced elsewhere it would be considered sparkling wine.  Champagne is widely accepted as a territorial brand that cannot be produced anywhere in the world but Champagne France. These indigenous raw materials, combined with the experience local producers have (Champagne has been produced in France since the medieval times) a firm wishing to produce champagne would be best off locating in France. At another level a firm wishing to produce wine in the United States might turn to the lush fields and experience of Napa Valley. By locating where the industries are in clusters, firms can benefit from what is called a knowledge spill-over, or a more formal term, externalities. Thus these externalities don’t only provide the firms with steady competition to be a key player in the global marketplace, but to also allow these firms to be more productive because knowledge about that industry surrounds them.

The political ideology of a nation directly affects foreign policy, and thus policy on FDI. Today many countries have adopted a stance that stands as long as a foreign company is maximizing the national benefits and minimizing national costs. So what exactly are the benefits and costs to the host country and home country of the multinational that invests in the host country?

There are several benefits and costs to a host country when they receive inward FDI. The first benefit that constitutes FDI is resource transfer-effects, in simple terms when a firm moves to a country they bring along capital, technology and management resources that in turn boost the efficiency of business practices. The corporation itself can teach the country’s citizens valuable skills, and depending on if the country wants to gain access to these skills; they might offer enticing economic incentives with tax breaks and the like to try and “bribe” the company to locate there. In contrast, if they feel that the corporation will be so efficient that it will drive out domestic producers, they might put up certain barriers to try to deter that firm from entering the location. This is very prominent in certain sections of China, where foreign firms are not allowed to partake in business. Another positive affect of inward FDI is employment, to this degree, when a MNE decides to open a production facility, it must hire workers. When they decide to higher local citizens of that nation, they are increasing their employment rates, which boost economic growth. Again, if the government feels the MNE will threaten their own economy, they may create barriers to entry to protect their domestic markets. MNE’s can also help countries to develop an account surplus in its balance of payments accounts (tracks payments to and receipts from other countries; current account- tracks export and import of goods and services.) When a country has a trade deficit it is importing more than it is exporting, and to reduce this they must sell off their foreign assets. However FDI can help a country experience a trade surplus and get back on track by setting up production facilities in a host country. When an MNE does this it is substituting exporting for local facility production; increasing the account balance of the host country. Another way it can help create an account surplus is if the host nation’s foreign subsidiary is used to export goods and services to other countries. Foreign subsidiary and FDI have been a main link to China’s rapid export-market growth. Some countries are afraid, however that there can be an adverse effect on the balance of payments. First the company must be making money for both themselves and the host nation; the initial capital inflow the subsequent to outflow of earnings from the foreign subsidiary to its parent company.  These outflows would be seen as money leaving the country, and the whole point of a host-nation allowing a foreign enterprise access is to boost their economy, not exploit it. Another concern is when the inputs are produced at other locations, such as the home nation of the enterprise, and shipped to the host-country for production. Many countries have attempted to combat this with local content requirements which are an agreement that the MNE will purchase a percentage of inputs from the host-country so that their suppliers and economy grow.

In contrast we will discuss how the home country of the MNE benefits and loses. The first and most obvious benefit comes in the form of profits from the foreign enterprise flowing into the country and this boosts the country’s balance of payments. In addition, if local content requirements are low, factors of production and inputs can be produced in the home country further boosting demand for supporting industries that can export these inputs to the host nation for further production. However, if there is a high local content requirement for instance, the home country’s employment rate may suffer. Also, initially the balance of payments might be low due to initial costs of FDI, if FDI is a substitute for exports (which could have created jobs in the home country) or if the firm is trying to benefit the home country through low cost production (which can’t be replicated in the form of wages). Beyond this however, if another benefit which is a reverse-transfer of resources which means the knowledge and MNE can gain through exposure to an international market. Sometimes firms will locate in an area just to learn, as we observed in John Dunning’s location-specific advantage argument.

FDI is a give and take, and this being equal, both sides must benefit from the transaction. In addition to this FDI can be a good way to expand into a multinational so long that exporting and licensing aren’t more profitable options. Exporting isn’t profitable if there are high transportation costs involved or if there are trade barriers that are set up to prevent a firm from entering the market. If this is the case, then a firm that wants to relieve tensions should consider FDI, licensing or relocation. Licensing too can have its limitations though, and there are particular industries that should steer clear from this as they cannot maintain tight control over their business strategies, knowledge or when skills and capabilities are not amenable, and only the firm themselves can create the desired experience for consumers. This is generally the case as mentioned above with high tech industries, oligopolies and industries where there are intense costs pressures; where control is needed to conduct effective, efficient and profitable business transactions. Another determinant in where to locate production is how favorable government policy is relative to FDI. If a country needs the FDI because to boost knowledge, for instance, then the firm has grounds to negotiate a nice incentive package in the form of tax breaks, grants and the like. In the government is hostile however, the firm must get host-country to understand what is being brought to the table by allowing access to their market. The extent to which each party can bargain however is based on the value each side places on the investment, the number of comparable alternatives each side has and lastly, the predicted time horizon. Once these are established, the company can decide which country or countries to invest in and where to locate.








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