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Why Do Companies Invest Overseas?
Krishna G IyerDepartment of Applied and International Economics
Massey University, Palmerston North.
Outline of the Presentation Define overseas/foreign investment. Types of foreign investment. Foreign direct investment and Multinational Enterprises. Statistical highlights: Macro-level Data. What drives FDI – Micro factors. Shareholder portfolio diversification. Revenue related objectives. Cost related objectives. Trojan Horse Theory. Incentives and Barriers to FDI. Conclusion.
Types of Investment
Foreign Direct Investment (FDI) – Multinational Enterprise (MNE).
Foreign Portfolio Investment (FPI) Other Foreign Investment (OFI)
Relative Importance (USA)
0
1000
2000
3000
4000
5000
6000
70001980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Bn
$ (
US
)
FDII FPII OFII
Relative Importance (USA)
0.00500.00
1000.001500.002000.00
2500.003000.00
3500.004000.00
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Bn
$ U
S
FDIO FPIO OFIO
Relative Importance (NZ)
0
10000
20000
30000
40000
50000
6000019
89
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Mn
$ U
S
FDII FPII OFII
Relative Importance (NZ)
0
5000
10000
15000
20000
2500019
89
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Mn
$ U
S
FDIO FPIO OFIO
Growth RatesC’try FDII FPII OFII FDIO FPIO OFIO GDP
USA (81-05)
12.70 22.98 8.60 9.71 15.87 7.09 3.17
NZ(90-05)
13.62 9.52 2.69 10.11 49.84 15.00 2.91
FDI as share of GDPFDII and FDIO Flows as Percentage of GDP (1980-
2004)
RegionFDII Flow as % of GDP
FDIO Flow as % of GDP
USA 1.05 0.99
New Zealand 3.41 0.92
OECD 1.25 1.59
World 1.35 1.35
FDI – Who InvestsInvestors/Sources 1980 1990 2000 2004
Developed economies 0.8703 0.9174 0.8551 0.8847
Developing economies 0.1297 0.0825 0.1413 0.1064
Developing America 0.0824 0.0330 0.0343 0.0279
Developing Africa 0.0129 0.0112 0.0074 0.0047
Developing Asia 0.0341 0.0382 0.0996 0.0738
Developing Oceania 0.0003 0.0001 0.0000 0.0000
LDCs 0.0002 0.0004 0.0005 0.0004
Developing excl. China 0.1297 0.0800 0.1368 0.1024
Sub-Saharan Africa 0.0109 0.0101 0.0068 0.0042
FDI – Who Hosts
Hosts 1980 1990 2000 2004
Developed economies 0.7510 0.7941 0.6872 0.7268
Developing economies 0.2490 0.2058 0.3007 0.2508
Developing America 0.0751 0.0668 0.0898 0.0821
Developing Africa 0.0757 0.0336 0.0261 0.0246
Developing Asia 0.0960 0.1040 0.1839 0.1436
Developing Oceania 0.0023 0.0015 0.0008 0.0005
LDCs 0.0087 0.0053 0.0066 0.0081
Developing excl. China 0.2470 0.1941 0.2673 0.2232
Sub-Saharan Africa 0.0533 0.0198 0.0187 0.0174
The China Story
FDI INWARD 1980 1990 2000 2004
China - ML 0.0020 0.0117 0.0334 0.0276
China - ML, HK, Mac
0.0472 0.0388 0.1126 0.0794
FDI OUTWARD 1980 1990 2000 2004
China - ML 0.0000 0.0025 0.0045 0.0040
China - ML, HK, Mac
0.0003 0.0092 0.0677 0.0457
The Micro-Story: Why do firms invest overseas?
Shareholder Diversification Services. Revenue Related Motives. Cost Related Motives. Trojan Horse Theory.
Shareholder diversification services Don’t put all your eggs in one basket.
International Stock Market Correlations are low – thus portfolio risk might converge to the systematic risk.
FDI provides indirect diversification services.
Little empirical evidence favoring this thesis.
In any case, reducing barriers to FPI makes this motive, if it ever existed, less important.
Revenue Related Motives
New markets. Enter markets with superior profits. Exploit intangible assets. Reacting to trade barriers. International business diversification.
New Markets
Establish a subsidiary or acquire a competitor – Greenfield Investments / joint ventures / cross-border mergers and acquisitions.
E.g. Blockbuster Entertainment Corp. – entering the rest of the OECD.
Coca-Cola and Pepsi in China and India. FORD, HP, IBM. YUM Brands – KFC Franchises. Firm Level Surveys indicates access to new markets as the
primary determinant of FDI (PC - Australia).
Markets with superior profits
MNE’s are attracted to markets with superior profits. When profit margins are squeezed in the domestic market
– foreign markets may be worth exploring. Related to the Product Life Cycle theory of Vernon
(1966). Entry may trigger a price war and defeat the purpose of
FDI – E.g. the Mobile Phone Industry in Asia and more recently India. Joint Ventures may then be preferred.
Exploit Intangible Assets
Comparative advantage of MNE’s off-setting the inherent disadvantages vis-à-vis domestic firms.
The intangible assets may take the form of technology, marketing know-how, superior R&D capabilities, brand name and recognition.
Hard to package and sell intangible assets to foreign firms. Further, property rights are difficult to establish and protect in foreign countries – So FDI emerges, often, as the best way to exploit intangible assets.
The Coca-Cola Story in India.
Reacting to Existing/Potential Trade Barriers
Transportation costs. Circumvent trade barriers – E.g. Japanese televisions in
US. Pre-empt trade barriers – E.g. Japanese automobiles in
US. Surge of FDI in Mexico (NAFTA) and Spain and newer
members of EU.
International Business Diversification
Reducing overall risk via international diversification – low correlation once again the key.
The Enron Story.
Cost Related Motives
Exploiting economies of scale. Access to raw materials / inputs. Labor market imperfection. Exchange Rate Movements.
Exploiting Economies of Scale
Lower average cost per unit resulting from increased production.
Also relates to the revenue related objective of exploiting intangible assets.
E.g. Consolidation of US MNEs in Europe since the Single European Act.
Specific examples include: General Motors – Poland, Peugeot – Czech Republic, Toyota – Slovakia, Audi – Hungary, Renault – Romania, Volkswagen – Slovenia.
Access to raw materials / inputs
Transportation costs – bulky raw materials. Ensuring inputs supply stability. E.g. SKF the Swedish ball-bearing manufacturer.
Labor Market Imperfection Labor services in a country can be severely under-priced
relative to its productivity. Labor is not perfectly mobile across countries. Surging FDI in Mexico, China, India, Thailand, Indonesia,
Malaysia often attributed to low cost of labor. Revisiting examples: General Motors – Poland, Peugeot
– Czech Republic, Toyota – Slovakia, Audi – Hungary, Renault – Romania, Volkswagen – Slovenia (Spain – Germany Link).
Surge of FDI in Mexico (NAFTA) and Spain (EU).
How divergent are labor costs?
CountryAvg. Hourly Cost
(USD) CountryAvg. Hourly Cost
(USD)
Germany 31.25 Spain 14.96
Belgium 27.73 Israel 11.73
Sweden 25.18 Korea 10.28
USA 21.97 Taiwan 5.84
France 21.13 Hong Kong 5.54
UK 20.37 Mexico 2.48
Japan 20.09 Philippines 0.66
Australia 20.05 China 0.6
Italy 18.35 Indonesia 0.22
Exchange Rate Movements
Undervalued currency may encourage FDI since initial outlay is likely to be low.
Empirical evidence is not clear.
Trojan Horse Hypothesis
Has been the hot topic over the last few years. Rising Sun – the book by Michael Crichton has several
references to this theory. To revisit the Trojan Horse Story. Trojan Computer Virus – and now Trojan FDI. Van Pottelsberghe and Lichtenberg (1996, 1998 and
2001) say FDI is essentially driven by the desire to acquire technology.
At the aggregate level, almost no evidence is found. But what does the market say?
Average Wealth Gains from Cross-Border Acquisitions: Foreign Acquisitions of US Firms (Eun et al. 1996)
C’try of Acquirer
Cases R&D as a % of Sales
Average Wealth Gain in Mn USD
Acquirer Target Acquirer Target Comb.
Canada 10 0.21 0.65 14.93 85.59 100.53
Japan 15 5.08 4.81 227.83 170.66 398.49
UK 46 1.11 2.18 -122.91 94.55 -28.36
Others 32 1.63 2.80 -47.46 89.48 42.02
All 103 1.66 2.54 -35.01 103.19 68.18
Returning to the macro level - Incentives for FDI
Widely held view that FDI offers substantial benefits for host economies – technology, employment, export revenue, consumer choice, increased competition etc.
Empirical evidence is ambiguous. Incentives include tax breaks, rent-free land and buildings,
low interest loans, subsidized energy, reduced environmental regulations. Classic examples – Finland and Ireland 1990s.
With tax breaks there is always the possibility of round tripping – China and India are examples.
Incentives must be carefully weighed – easy to go overboard.
Barriers to FDI Barriers placed by Government agencies. E.g. France, Australia. Japan has a historically
imposed barriers on acquisitions. Restricted Ownership rules in several developing
countries – can be effectively used to reduce political risk of FDI.
Conditions – Employment related conditions (American Universities in the Middle East), Acquisition of Inputs from local sources e.g. Mexico, Export conditions, E.g. Spain, etc.
Red Tape / Corruption.
Conclusion
Large and Increasing Magnitudes of FDI – a trend certain to continue in the future.
Why do firms undertake FDI? Is it beneficial for host and source economies? What sort of incentives are being offered? What kind of barriers exist? Weighing the Costs and Benefits.