Foreign Direct Investment

GEETA SHIROMANI
ASSOCIATE PROFESSOR

Foreign Direct Investment

Why is FDI increasing in the world
economy?
Why do firms often prefer FDI to other
market entry strategies?
Why are certain locations favored for FDI?
How does political ideology affect
government FDI policy?
What are key FDI related costs and
benefits for receiving and source
countries?

Foreign Direct Investment

Involves ownership of entity abroad for
production
Marketing/service
R&D
Access of raw materials or other resource

Parent has direct managerial control

Depending on its extent of ownership and
On other contractual terms of the FDI

No managerial involvement = portfolio investment

FDI - Flow versus stock

FDI occurs when a firm invests directly in
facilities to produce and/or market a product in a
foreign country
Flow: Amount of FDI over a period of time (one year)
Stock: Total accumulated value of foreign owned assets
at a given point of time

FDI is not the investment by individuals, firms or

public bodies in foreign financial instruments

Why is FDI important ?

Firms want a presence in foreign markets
Firms want control over growth of these foreign
markets
To gain first mover advantages
To ward off competitors
To determine locations, advertising and other related
strategic decisions in the firms interest

Trends in FDI
Flow and stock increased in the last 30 years
In spite of decline of trade barriers, FDI has grown
more rapidly than world trade because:
Businesses fear protectionist pressures
FDI is seen as a way of circumventing trade barriers
Dramatic political and economic changes in many parts of
the world
Globalization of the world economy has raised the vision
of firms who now see the entire world as their market

FDI Growth in the World Economy

FDI Outflow: $35 billion in 75 to $1.3 trillion in 00 to $620
billion in 04

FDI Flow (from all countries): from 92 to 04 up 260%,

compared to trade up 100% and world output up 32%

FDI Stock: $3.5 trillion by 97 to more than $ 8.1 trillion in 03

In 03:

61,000 MNEs had:

9,00,000 foreign affiliates
54 million employees
$17.6 trillion in global sales

$9.2 trillions global exports

Conclusion:

FDI flow growing faster than world trade and world output

FDI- inflows & outflows

Direction and Source of FDI

Most FDI flow has been to developed countries from
developed countries

Much to the US from EU, Japan

FDI increase to developing countries since 85

Much to the emerging Asian and Latin

America economies
Africa lagging

Inflows in developed vs. developing countries

Outflows in developed vs. developing countries

FDI trends: 2001-2002

The value of FDI
slumped almost 60
percent in 2001-2002
Slowdown in world
economy
Heightened geopolitical
uncertainty since
September 11, 2001
Bursting of the stock
market bubble in the US

Developed countries- FDI outflows

Top 10 sources of FDI outflows, 2005-06

Types of FDI

Types of FDI

Types of FDI

Types of FDI
Horizontal FDI:
Investment in the same industry abroad as a firm
operates in at home

Vertical FDI:
Backward Vertical FDI: investment in an industry
abroad that provides inputs for the firms domestic
production processes eg: oil refining, Royal
Dutch/shell, British petroleum etc.)
Forward Vertical FDI: investment in which an industry
abroad sells the outputs of the firms domestic
production processes eg: Volkswagon in U.S.

Types of FDI

Types of FDI: By Motive

Resources seeking - looking for resources at a
lower real cost.
Market seeking - secure market share and sales
growth in target foreign market.
Efficiency seeking - seeks to establish efficient
structure through useful factors, cultures,
policies, or markets.
Strategic asset seeking - seeks to acquire assets
in foreign firms that promote corporate long
term objectives.

Types of FDI

Green-field Ventures

A Greenfield Investment is the

investment in a manufacturing, office,
or other physical company-related
structure or group of structures in an
area where no previous facilities exist.
The name comes from the idea of
building a facility literally on a
"green" field, such as farmland or a
forest.
Green field operation:
Mostly in developing nations

Mergers & Acquisitions

Mergers and
acquisitions:
Quicker to execute.
Foreign firms have
valuable strategic
assets
Believe they can
increase the
efficiency of the
acquired firm

More prevalent in
developed nations

FDI when and why?

Transportation costs are high
Market Imperfections (Internalization Theory)
Impediments to the free flow of products between
nations
Impediments to the sale of know-how

Follow the lead of a competitor - strategic rivalry

Product Life Cycle - however, does not explain
when it is profitable to invest abroad
Location specific advantages (natural
resources)

Pattern of FDI Explanations

Eclectic paradigm of FDI (John Dunning)
Combines ownership specific, location specific, and
internalization specific advantages
Explains FDI decision over a decision to enter through
licensing or exports

Pattern of FDI Explanations

Eclectic Paradigm of FDI (Dunning)
Ownership advantage: creates a
monopolistic advantage to be used in
markets abroad
Unique ownership advantage protected
through ownership
e.g., Brand, technology, economies of scale,
management know-how

Pattern of FDI Explanations

Eclectic Paradigm of
FDI (Dunning)
Location advantage: the
FDI destination market
must offer factors (land,
capital, know-how,
cost/quality of labor,
economies of scale) that
are advantageous for the
firm to locate its
investment there (link to
trade theory)

Pattern of FDI Explanations

Eclectic Paradigm of FDI (Dunning)
Internalization advantage: transaction costs of
an arms-length relationship --licensing, exports-higher than managing the activity within the
MNCs boundaries

Why FDI?
FDI over exporting

High transportation costs, trade barriers

FDI over licensing or franchising

Need to retain strategic control

Need to protect technological know-how
Capabilities not suitable for
licensing/franchising
Follow few main competitors

Immediate strategic responses

Decision framework
How high are transportation
costs and tariffs?

Low

Export

High
Is know-how amenable to
licensing?

No

FDI

Yes
Is tight control over foreign
operation required?

Yes

FDI

No

FDI

No
Can know-how be protected
by licensing contract?

Yes
Then license

Factors affecting investment decisions

Costs
Barriers
Control
Incentives like tax concessions, subsidies etc

Location advantages
Essential Criteria

Access to skilled and educated workforce

Proximity to world class research institutions
Quality of life
Access to venture capital

Factors affecting investment decisions

Important Criteria

Reasonable costs of doing business

Established technology presence
Available bandwidth and adequate infrastructure
Favorable business climate and regulatory
environment

Desirable Criteria
Presence of suppliers and partners
Availability of community incentives

Political Ideology and FDI

Radical
View

Pragmatic
Nationalism

Free
Market

The Radical View

Marxist view: MNEs exploit lessdeveloped host countries

Extract profits
Give nothing of value in exchange
Instrument of domination, not development
Keep less-developed countries relatively
backward and dependent on capitalist nations
for investment, jobs, and technology

The Radical View

By the end of the 1980s radical view was
in retreat
Collapse of communism
Bad economic performance of countries that embraced
the radical view
Strong economic performance of some countries that
embraced capitalism rather than the radical view

The Free Market View

Adam Smith, Ricardo: international production
should be distributed per national comparative
advantage
Nations specialize in goods and services that they
can produce most efficiently
Resource transfers benefit and strengthen the host
country
Pro-investment changes in laws and growth of
bilateral agreements attest to strength of free
market view
But all countries impose some restrictions on FDI

Pragmatic Nationalism
FDI has benefits and costs
Allow FDI if benefits outweigh costs
Block FDI that harms indigenous industry
Encourage FDI that is in national interest
Tax breaks
Subsidies

But who can predict which FDI is in

national interest?
Regulations open opportunity for favoritism

Pragmatic Nationalism
Many of the most successful developing
countries past and present followed a
pragmatic nationalistic stance
Japan
South Korea
China

Economists note that Hong Kong, which

followed the
free market approach, was even more
successful

The Benefits of FDI to Host countries

Resource transfer effects
Capital
Technology
Management

Employment effects
Effect on competition &
economic growth

The Benefits of FDI to Host countries

Balance of payment effects
Initial capital inflows
Import substitution
Export of goods & services to other countries

In a free market view

Many economists argue that the benefits of FDI so
outweigh the costs associated with pragmatic
nationalism that it is misguided
The best policy would be for countries to forgo all
intervention in an MNEs investment decisions

Costs of FDI to the Host Country

Adverse effects on competition
Adverse effects on balance of payment
Outflow of earnings from foreign subsidiary to its
parent company
Imports of raw material results into adverse effect on
current account

Adverse effect on national sovereignty and

Autonomy

Benefits of FDI to Home country

Positive effect on Balance of payment due to
inward flow of foreign earnings & demand of
home-country exports of capital-equipments
Employment effects due to demand of home
country products
MNEs learn valuable skills from foreign markets
that can be transferred back to the home
country

Costs of FDI to Home countries

Adverse effect on BOP account:
Adverse effect on capital account due to outflow of
capital
Adverse effect on current account due to imports from
low production locations in foreign countries
Adverse effect on current account due to export
substitution

Reduced home country employment

Government Policy and FDI

Home country
Outward FDI encouragement
Risk reduction policies (financing, insurance, tax
incentives)

Outward FDI restrictions

National security, BOP

Government Policy and FDI

Host country
Inward FDI encouragement
Investment incentives
Job creation incentives

Inward FDI restrictions

Ownership extent restrictions (national security);
local nationals can safeguard host countrys
interests

International institutions & the liberalization

of FDI
WTO (world trade
organization)

OECD (Organization
for economic
cooperation &
development)