Fourth Edition

InternationalBusiness

CHAPTER 6

Foreign Direct Investment

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6-3

Chapter Focus

This chapter seeks to identify the economic rationale that underlies Foreign Direct Investment. For example, why do some firms prefer FDI to exporting or licensing. Is the need for control, part of the answer?

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Foreign Direct Investment

FDI occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country.Starbucks invested $10m in Japan in 1996.

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Foreign Direct Investment

FDI occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country.

Once a firm undertakes FDI, it becomes a multinational enterprise (multinational = more than one country).

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Foreign Direct Investment

FDI takes two forms:Green-field investment: establishing a wholly new operation in a foreign country.Example ; starbucks

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Foreign Direct Investment

FDI takes two forms:Green-field investment: establishing a wholly new operation in a foreign country.Acquiring or merging with an existing firm in the foreign country.Example: Rank-Xerox, Grameen-Danone

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Foreign Direct Investment

NOTE:

Investing in foreign financial instruments (Portfolio Investment like govt. bond, foreign stocks) IS NOT FDI.

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Flow and Stock of FDI

Flow:The amount of FDI undertaken over a given period of time (usually one year).

Stock:Total accumulated value of foreign-owned assets at a given time.

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FDI Outflows1982-2000

0

200

400

600

800

1000

1200

1400

82-86

92 94 96 98 2000

$ Billions

Figure 6.1

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FDI Flows by Region

0

100

200

300

400

500

600

Value Exports

World GDP

World FDI

Figure 6.2

Ind

ex

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Reasons for FDI Growth

FDI circumvents potential future trade barriers.Many firms preferred the US for FDI because of the hostile trade attitude shown by the US

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Reasons for FDI Growth

FDI circumvents potential future trade barriers.Dramatic political and economic changes occurring in developing countries.(Opening up the economy in India , China, Singapore,etc )

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FDI into Developed and Developing Nations: 1990-2000

0

200

400

600

800

1000

1200

94 95 96 97 98 99 2000

Dev Nations

Devg. Nations

W. Europe

N. Amer.

Asia

L. Amer.

$B

illio

n

Figure 6.3

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FDI Outflows by Selected Countries, 1994-1999

0

50

100

150

200

250

300

1994 1995 1996 1997 1998 1999 2000

U.S.

U.K.

Netherlands

Germany

J apan

Spain

France

Figure 6.5

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The Form of FDI: Acquisitions versus Greed-Fields

The majority of investments is in the form of mergers & acquisitions:

Represents about 77% of all flows in developed countries.Represent about 33% of all flows in developing countries.

Fewer target firms to acquire.

Why the preference for mergers & acquisitions?

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

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FDI and Risk

FDI is expensive and risky compared to exporting or

licensing: Costs of establishing facilities. Problems with doing business in a different

Culture.

But still FDI occurs . Why???

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Horizontal FDI and Factor Considerations

Horizontal FDI: when a firm invests in the same industry as in the home countryTransportation Costs: High/low value to weight impacts

costs. If the product is low in value-to-weight ration like soft drinksOr cement , then transportation costs add to the costs.

Here , FDI is a better option.

If the product has a high value-to-weight ration then exporting Is a better option unless there are other factors to consider.

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Horizontal FDI and Factor Considerations

Market Imperfections (Internalization Theory): Factors that inhibit markets from working perfectly. This includes (1) governments impeding the free flow

ofproducts between nations(Toyota), and (2)

impediments to the sale of know-how.(RCA, Matsushita & Sony)Strategic Behavior: Concentrated industries (oligopoly) tend

to mimic each other’s moves. Where there is multipoint competition, competing firms match

eachother’s moves to keep the competitor in check.Example: Orascom Vs Telenor

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Horizontal FDI and Factor Considerations

The Product Life Cycle: Suggests that foreign market demand leads to FDI, probably not true and therefore is not a good predictor of FDI.

Location-Specific Advantages: Advantages that arise from using resource endowments or assets tied to a particular location (Dunning - eclectic paradigm)Example: Silicon Valley.

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Vertical FDI

Two forms:Backward: Providing inputs (raw materials, parts) for a firm’s domestic production processes.Forward: An industry abroad sells the outputs of the firm’s domestic production processes.

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Why Do Companies Engage in FDI?

Strategic Behavior: Can raise entry barriers or shut out new competitors, or circumvent barriers established by companies already doing business in the foreign country.

Alcoa and Alcan went to T&T to gain control over bauxite.

Market Imperfections: Need to overcome lack of know-how or the firm must invest in specialized assets whose value depends on inputs provided by a foreign supplier.

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Impediments to the Sale of Know-how

Impediments to the sale of know

how

Risk giving away know-

how to competitors (BP

& Shell)Licensing

implies low control over

foreign entity(Kodak Vs

Fuji)Know-how not amenable to

licensing(Starbucks, P& G)

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A Decision Framework

Figure 6.6

Yes

How high are transportation costs

and tariffs?

Is know-how amenable to

licensing?Is tight control over foreign operation

required?

Can know-how be protected by licensing

contract?

Then license

ExportExport

Horizontal FDIHorizontal FDI

Horizontal FDIHorizontal FDI

Horizontal FDIHorizontal FDI

High

Yes

No

Low

No

Yes

No