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CHAPTER 7FOREIGN DIRECT INVESTMENT

By: Ms Adina Malik (ALK)

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LEARNING OBJECTIVES What is FDI? What is the source of FDI? Trends and Direction of FDI The form of FDI Logics supporting FDI over Exporting and Licensing The Pattern of FDI How FDI Benefits the Host Country and Home Country? How is FDI Costly for the Host Country and Home Country?

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WHAT IS FDI?Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign countryOnce a firm undertakes FDI it becomes a multinational enterprise

FDI can be:Greenfield investments - the establishment of a wholly new operation in a foreign country

Acquisitions or Mergers with existing firms in the foreign country

Acquisitions can involve:A minority stake (10%-49%)A majority stake (50%-99%)A full outright stake (100%)

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FDI IN THE WORLD ECONOMYThe flow of FDI refers to the amount of FDI undertaken over a given time period The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time Outflows of FDI are the flows of FDI out of a countryInflows of FDI are the flows of FDI into a country

Gross Fixed Capital Formation-the total amount of capital invested in factories, stores, office buildings and the like.

FDI can be seen as an important source of capital investment and a determinant of the future growth rate of an economy.

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WHAT IS THE SOURCE OF FDI? Since World War II, the U.S. has been the largest source country

for FDI The United Kingdom, the Netherlands, France, Germany, and

Japan are other important source countries Together, these countries account for 56% of all FDI outflows

from 1998-2006, and 61% of the total global stock of FDI in 2007

Cumulative FDI Outflows 1998-2007 ($ billions)

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TRENDS IN FDIThe growth of FDI has been more than world

trade and world output. What are the Reasons?

Despite there has been general decline in trade barrier, companies still fear protectionist. FDI is a way to avoid future trade barrier.

E.g. Japanese companies started investing in USA to combat US trade barriers. (Cars)

Dramatic economic and political changes in developing countries and increase of free market economies in developing nations encourages FDI.

According to UN, laws governing FDI created more favourable environment for FDI.

Globalization of the world economy has encouraged companies to think world as their markets.

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THE DIRECTION OF FDI Historically, most FDI has been directed at the developed

nations of the world. E.g. USA In 2001, China was the largest recipient of FDI among

developing nations. E.g. cheap labor, tax incentive, entry into the WTO. (FDI in 2004-$60 billion; 2010-$101 billion)

After South, East and South East Asia, the next most important region in the developing world is Latin America. (FDI inflow in Latin American region in 2008-$141 billion. Historically, Mexico and Brazil were the top two recipients of inward FDI, a trend that continued in the late 2000s)

Africa attracts lowest inflow due to political unrest, armed conflict and frequent changes. ($72 billion in 2004, which slumped to $50 billion in 2010)

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FDI TREND OF BANGLADESH

FDI FLOWS

1995-2004 (Annual Avg)

2005-2007(Annual Avg)

2008 2009 2010

Inward 386 768 1,086 700 913

Outward 6 9 9 29 15

Figures are presented in millions of dollars (USD). Source is www.unctad.org

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FDI TREND OF BANGLADESH Bharti Airtel acquired Abu Dhabi Group’s Warid Telecom in

Bangladesh for $300 million In September 2004, Orascom Telecom Holdings purchased 100% of

the shares of Sheba Telecom (Pvt.) Ltd. for US$ 60 million (‘Sheba’, which was a Bangladesh and Malaysia joint venture). Orascom is now known as Global Telecom Ltd.

Sanofi , GSK in Bangladesh (MNCs in Pharmaceutical sector) HSBC, SCB, Unilever BD, BATB (MNCs in Bangladesh) Launched in 1997, Grameenphone was the first Telenor venture in the

Asian Telecom market. It is a joint venture between Telenor and Grameen Telecom Corporation, a non-profit sister concern of the internationally acclaimed microfinance organization and community development bank , Grameen Bank.

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FDI TREND OF BANGLADESH Bangladesh does not have an extensive outward FDI industry.

According to UNCTAD data, FDI outflows from Bangladesh are below $0.1 billion.

Bangladesh has opened an NGO named BRAC in Afghanistan. In Middle East, Bangladesh is seeking to increase economic ties with

Saudi Arabia by investing in ceramics, pharmaceuticals and leather products.

Indonesia has recently signed a deal with Eskayef Bangladesh Ltd. Bangladesh has invested in Sudan in the pharmaceutical industry;

while in agro-processing, pharmaceuticals, science, technology and tourism sector in Egypt. In Sudan & Egypt, Bangladesh has also invested in the form of higher education.

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SECTOR WISE FDI INFLOW: BANGLADESH

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THE FORM OF FDILarge FDI shift towards Service Industry Reasons:

The general move of developed nations away from manufacturing toward service industry

Many service cannot be traded internationally and requires to be produced in the foreign land.

E.g. Starbucks cannot sell hot latte coffee to a consumer in Japan from Seattle store.

Many country liberalized their regimes for the service Industry. E.g. WTO engineered to remove cross-border trade and investment in

telecommunications and financial services in the late 1990s. E.g. Brazilian telecommunication sector

Rise of Internet based global communication network. E.g. Procter and Gamble (back-office accounting functions shifted to

the Philippines) E.g. Dell (call answering center in India) E.g. IBM & Microsoft (software development and testing facilities in

India)

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ARGUMENTS AGAINST FDI OVER EXPORTING OR LICENSING Exporting involves producing goods at home and then

shipping them to the receiving country for sale. Usually done by native sales agent.

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.

Cons of FDI over exporting or licensing: FDI is expensive- cost of establishment or acquisition FDI is risky- cultural, political and economical situation

of the host country (firm might not know the rules of the game in the host country)

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LOGICS SUPPORTING FDI OVER EXPORTING

Limitations of ExportsTransportation Cost: Transportation costs increases the

cost of products that have low value-to-weight ratio - FDI is preferable

E.g. Cemex (cement), soft drinks, etc. Transportation cost will be a little

percentage of production cost for products that have high value-to-weight ratio. –Export is preferable

E.g. electronic components, personal computers, medical equipment, computer software, etc.

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LOGICS SUPPORTING FDI OVER EXPORTING

Limitations of ExportsTrade Barriers: FDI can also increase due to

increased threats of trade barriers such as import tariffs and import quotas.

Exporting will decrease profitability. E.g. during the 1980s and

1990s, protectionist threat by the US Congress via import quotas on Japanese cars increased FDI flow to USA by Japanese auto companies

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LOGICS SUPPORTING FDI OVER LICENSING Limitations of Licensing

Internationalization Theory (also known as Market Imperfection Approach)

Licensing has three major drawbacks: Licensing may result in firms giving away valuable

technological know-how to potential foreign competitor. E.g. RCA color television (USA)-Matsushita and Sony (Japan) The firm’s lack of tight control over manufacturing,

marketing and strategy in a foreign country that are required to maximize their market share and profitability.

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LOGICS SUPPORTING FDI OVER LICENSING A firm’s competitive advantage is based on its

management, marketing and manufacturing capabilities, rather than its products. The problem here is that such capabilities may not be amenable to licensing.

E.g. Toyota’s competitive advantage is in its innovative production process, management know-how and organizational capabilities which are embedded in the whole organizational culture. So this culture cannot be transferred via licensing.

Toyota and Lean Production.

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THE PATTERN OF FDI Observation suggests that firms in the same industry often

undertake FDI around the same time and direct their investment activities toward certain locations.

2 theories are used to explain this pattern Strategic Behavior (specially in oligopolistic industries) Product Life Cycle Theory

However, these theories lack in their rationale as they fail to explain why wouldn’t a firm choose exporting or licensing over FDI.

Note: Oligopoly means when a limited number of large firms exist in a market. (e.g. an industry in which four firms control 80% of a domestic market). There is interdepence of the major players, that leads to imitative behavior.

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THE PATTERN OF FDIStrategic Behavior This theory suggests that FDI flows are a reflection of strategic

rivalry between firms in the global marketplace. Knickerbocker looked at the relationship between FDI and rivalry in oligopolistic industry (imitative behavior). E.g. Honda invested in the US and Europe. Toyota and Nissan

also follow suit. Multipoint competition: This arises when two or more enterprises

encounter each other in different regional markets, national markets or industries. E.g. Kodak & Fuji Photo Film Co.; Coke & Pepsi Co.

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THE PATTERN OF FDIProduct Life Cycle Theory Vernon’s theory suggest that firm undertake FDI at a particular

stage in the life cycle of a product they have pioneered. Firms do invest in a foreign country when demand in that country

will support local production and they do invest in low cost locations when cost pressure become intense.

E.g. Xerox introduced photocopier in the US, then set up production facilities in Japan (Fuji-Xerox) and UK (Rank-Xerox)

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The Eclectic ParadigmProponent: British economist John Dunning

Location factor affects the direction or pattern of FDI. By location-specific advantage, Dunning means advantages

that arise from using resource endowments or assets that are tied to particular foreign location and that firms find valuable to combine with their own assets (technological, managerial or marketing know-how capabilities).

Examples: Oil companies investment middle eastern countries; US investment in labor intensive RMG industries based in India, China & Bangladesh; European & Japanese firms invest in the Silicon Valley region of California.

THE PATTERN OF FDI

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HOW DOES FDI BENEFIT THE HOST COUNTRY? There are four main benefits of inward FDI for a host

country

1. Resource transfer effects - FDI brings capital, technology, and management resources

2. Employment effects - FDI can bring jobs3. Balance of payments effects - FDI can help a country to

achieve a current account surplus4. Effects on competition and economic growth -

greenfield investments increase the level of competition in a market, driving down prices and improving the welfare of consumers

can lead to increased productivity growth, product and process innovation, and greater economic growth

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WHAT ARE THE COSTS OF FDI TO THE HOST COUNTRY? Inward FDI has three main costs:

1. Adverse effects of FDI on competition within the host nation

subsidiaries of foreign MNEs may have greater economic power than indigenous competitors because they may be part of a larger international organization

2. Adverse effects on the balance of payments when a foreign subsidiary imports a substantial number

of its inputs from abroad, there is a debit on the current account of the host country’s balance of payments

3. Perceived loss of national sovereignty and autonomy decisions that affect the host country 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

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HOW DOES FDI BENEFIT THE HOME COUNTRY?

The benefits of FDI for the home country include

1. The effect on the capital account of the home country’s balance of payments from the inward flow of foreign earnings

2. The employment effects that arise from outward FDI

3. The gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country

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WHAT ARE THE COSTS OF FDI TO THE HOME COUNTRY?

1. The home country’s balance of payments can suffer from the initial capital outflow required to finance the FDI if the purpose of the FDI is to serve the home market from

a low cost labor location if the FDI is a substitute for direct exports

2. Employment may also be negatively affected if the FDI is a substitute for domestic production

But, international trade theory suggests that home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid