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Foreign Direct Investment: a tool for sustained competitive advantageand/or for technology diffusion

Foreign Direct Investment: a tool for sustained competitive advantageand/or for technology diffusion

MGTECON 580: Class 4

Definition: acquisition of controlling assets of a Definition: acquisition of controlling assets of a firm in another countryfirm in another country

FDI in perspective is one alternative strategy to FDI in perspective is one alternative strategy to internationalize:internationalize:

- exports- exports - licensing - licensing - sourcing abroad - sourcing abroad - distribution subsidiary - distribution subsidiary - production subsidiary - production subsidiary

Relation to location theory:Relation to location theory:

One step more complicatedOne step more complicated

Different functions at different locationDifferent functions at different location

Centrifugal versus centripetal forces; transport costsCentrifugal versus centripetal forces; transport costs

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The firm perspective and the country view

The firm perspective and the country view

Strategic importance for firmsLowering costsIncreasing market shareDiversificationAcquiring strategic assetsSecuring long-run profitability

The policy issue (country perspective)

There are usually arguments against both types: - Inward investment (IDI) implies “Foreign dominance”

specifically in sophisticated, strategic industries- Inward investment implies “development trap”

if only low-skill industries come in- “Investing abroad” implies employment loss

Old style firm vs. newOld: one region, one country

production and demand overlap

New: optimizing jointly production, transport, marketing, sourcing

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Technicalities and indicatorsTechnicalities and indicators

Investment vs. stocksFlows in a year, stocks accumulated

Investment is recorded (via National Bank)Divestment often not, if bankruptcy

Acquisition value vs. net addition to stockBuying price (investment) in % of national (physical) investmentAlternative indicator: capital stock in % to GNP

Sales of a firm can comprise: Sales = SHD + SHF + SAF + SAH

Sales at home for domestic marketSales at home for foreign marketSales abroad for foreign marketSales abroad for home market

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The many faces (types) of FDIThe many faces (types) of FDIAccording to activityAccording to activity• ProductionProduction

• Upward activities (sourcing)Upward activities (sourcing)

• Distribution, logisticDistribution, logistic

• ResearchResearch

• HeadquartersHeadquarters

According to activityAccording to activity• ProductionProduction

• Upward activities (sourcing)Upward activities (sourcing)

• Distribution, logisticDistribution, logistic

• ResearchResearch

• HeadquartersHeadquarters

According to investment modeAccording to investment mode• Greenfield investmentGreenfield investment

• Merger/acquisitionMerger/acquisition

• Joint ventureJoint venture

Note: portfolio investment (small shares) is not FDINote: portfolio investment (small shares) is not FDI

According to investment modeAccording to investment mode• Greenfield investmentGreenfield investment

• Merger/acquisitionMerger/acquisition

• Joint ventureJoint venture

Note: portfolio investment (small shares) is not FDINote: portfolio investment (small shares) is not FDI

According to motivesAccording to motives• Cost-drivenCost-driven

• Market-driven (serve better the market)Market-driven (serve better the market)

• Infrastructure-driven (business environment)Infrastructure-driven (business environment)

According to motivesAccording to motives• Cost-drivenCost-driven

• Market-driven (serve better the market)Market-driven (serve better the market)

• Infrastructure-driven (business environment)Infrastructure-driven (business environment)

According to trade effectAccording to trade effect• Import substitutingImport substituting

• Export increasingExport increasing

According to trade effectAccording to trade effect• Import substitutingImport substituting

• Export increasingExport increasing

According to financial transactionAccording to financial transaction• Equity capital (share)Equity capital (share)

• Reinvested earningsReinvested earnings

• Intra-company loansIntra-company loans

According to financial transactionAccording to financial transaction• Equity capital (share)Equity capital (share)

• Reinvested earningsReinvested earnings

• Intra-company loansIntra-company loans

According to firm’s internal structureAccording to firm’s internal structure• Horizontal FDIHorizontal FDI

•Duplicating plans to get rid of tariffs and trade costsDuplicating plans to get rid of tariffs and trade costs

•In principle substitute to exportsIn principle substitute to exports

• Vertical FDIVertical FDI

•Part of the supply chain is “outsourced”Part of the supply chain is “outsourced”

•In principle complement to exportsIn principle complement to exports

• Horizontal FDIHorizontal FDI

•Duplicating plans to get rid of tariffs and trade costsDuplicating plans to get rid of tariffs and trade costs

•In principle substitute to exportsIn principle substitute to exports

• ConglomerateConglomerate

According to firm’s internal structureAccording to firm’s internal structure• Horizontal FDIHorizontal FDI

•Duplicating plans to get rid of tariffs and trade costsDuplicating plans to get rid of tariffs and trade costs

•In principle substitute to exportsIn principle substitute to exports

• Vertical FDIVertical FDI

•Part of the supply chain is “outsourced”Part of the supply chain is “outsourced”

•In principle complement to exportsIn principle complement to exports

• Horizontal FDIHorizontal FDI

•Duplicating plans to get rid of tariffs and trade costsDuplicating plans to get rid of tariffs and trade costs

•In principle substitute to exportsIn principle substitute to exports

• ConglomerateConglomerate

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The eclectic OLI Model by John Dunning

The eclectic OLI Model by John Dunning

The basic theoretical challengeThe basic theoretical challenge• Indigenous, domestic firms should have a priori advantageIndigenous, domestic firms should have a priori advantage

• Knowledge of environmentKnowledge of environment

• Distance HQ -- production siteDistance HQ -- production site

The basic theoretical challengeThe basic theoretical challenge• Indigenous, domestic firms should have a priori advantageIndigenous, domestic firms should have a priori advantage

• Knowledge of environmentKnowledge of environment

• Distance HQ -- production siteDistance HQ -- production site

What compensates this advantageWhat compensates this advantage• Ownership advantages: firm-specific knowledgeOwnership advantages: firm-specific knowledge

• Patents, expertise of organization and learningPatents, expertise of organization and learning

• Location advantages: cheaper/better inputsLocation advantages: cheaper/better inputs

• Internalization advantagesInternalization advantages

• Better use inside the firm than through the market (licensing and Better use inside the firm than through the market (licensing and pricing)pricing)

OLI paradigm: you need all threeOLI paradigm: you need all three

What compensates this advantageWhat compensates this advantage• Ownership advantages: firm-specific knowledgeOwnership advantages: firm-specific knowledge

• Patents, expertise of organization and learningPatents, expertise of organization and learning

• Location advantages: cheaper/better inputsLocation advantages: cheaper/better inputs

• Internalization advantagesInternalization advantages

• Better use inside the firm than through the market (licensing and Better use inside the firm than through the market (licensing and pricing)pricing)

OLI paradigm: you need all threeOLI paradigm: you need all three

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1st phase: invention in developed country

2nd phase: growth period exports

3rd phase: maturity FDI

Other determinants of FDIOther determinants of FDI

Rate of return differenceFDI goes in countries with higher expected

return

Portfolio diversification: investments to diversify risks

Market size attracts investment

Product cycle explanationEach product passes three phases:

Oligopolistic interaction• Investment is a commitment

Which puts other firms in worse position• Other strategic factors

Defend markets, get foothold, complementing, committing

Internal financing: free cash flow looks for opportunities

Policy related determinants: better business conditions

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Stage 1: No location bound assetStage 1: No location bound asset• At least no created ones, ev. Natural resourcesAt least no created ones, ev. Natural resources

• Prediction: Neither IDI nor ADIPrediction: Neither IDI nor ADI

Stage 1: No location bound assetStage 1: No location bound asset• At least no created ones, ev. Natural resourcesAt least no created ones, ev. Natural resources

• Prediction: Neither IDI nor ADIPrediction: Neither IDI nor ADI

Five Stage Theory: Net FDI depends on stages of

development, by John Dunning

Stage 2: Inward FDI attracted by cheap inputs or Stage 2: Inward FDI attracted by cheap inputs or resourcesresources• Possibly government helps (involuntarily) with import taxesPossibly government helps (involuntarily) with import taxes

• Outward investment starts, but well behind inwardOutward investment starts, but well behind inward

• Prediction: FID-deficitPrediction: FID-deficit

Stage 2: Inward FDI attracted by cheap inputs or Stage 2: Inward FDI attracted by cheap inputs or resourcesresources• Possibly government helps (involuntarily) with import taxesPossibly government helps (involuntarily) with import taxes

• Outward investment starts, but well behind inwardOutward investment starts, but well behind inward

• Prediction: FID-deficitPrediction: FID-deficit

Stage 3: Upcoming ownership advantages: ADI rises Stage 3: Upcoming ownership advantages: ADI rises faster than IDIfaster than IDI• Surpluses with poor countries, deficits with rich onesSurpluses with poor countries, deficits with rich ones

• Prediction: FDI stock becomes balancedPrediction: FDI stock becomes balanced

Stage 3: Upcoming ownership advantages: ADI rises Stage 3: Upcoming ownership advantages: ADI rises faster than IDIfaster than IDI• Surpluses with poor countries, deficits with rich onesSurpluses with poor countries, deficits with rich ones

• Prediction: FDI stock becomes balancedPrediction: FDI stock becomes balanced

Stage 4: Ownership advantages and search for low Stage 4: Ownership advantages and search for low cost production sitescost production sites• Further push outward investment up to maximum surplusFurther push outward investment up to maximum surplus

• Intra-industry production specialization (following IIT shares)Intra-industry production specialization (following IIT shares)

• Prediction: high-surplus of ADI, both flows increasingPrediction: high-surplus of ADI, both flows increasing

Stage 4: Ownership advantages and search for low Stage 4: Ownership advantages and search for low cost production sitescost production sites• Further push outward investment up to maximum surplusFurther push outward investment up to maximum surplus

• Intra-industry production specialization (following IIT shares)Intra-industry production specialization (following IIT shares)

• Prediction: high-surplus of ADI, both flows increasingPrediction: high-surplus of ADI, both flows increasing

Stage 5: Firms become globalized and nationalities Stage 5: Firms become globalized and nationalities blurred blurred (Dunning-Narula, p8)(Dunning-Narula, p8)

• But there can be instable positions (fluctuations, vicious and virtuous circles)But there can be instable positions (fluctuations, vicious and virtuous circles)

• Prediction: Net positions equalize againPrediction: Net positions equalize again

Stage 5: Firms become globalized and nationalities Stage 5: Firms become globalized and nationalities blurred blurred (Dunning-Narula, p8)(Dunning-Narula, p8)

• But there can be instable positions (fluctuations, vicious and virtuous circles)But there can be instable positions (fluctuations, vicious and virtuous circles)

• Prediction: Net positions equalize againPrediction: Net positions equalize again

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Empirics of FDIEmpirics of FDI

Stylized fact 1: FDI growth higher than trade and GNP growth

Stylized fact 2: Significant share of trade is intra-firm trade

Stylized fact 3: FDI is investment of developed countries in developed countries

Stylized fact 4: There are industry differences

Hierarchy of dynamics 1985 - 97: (UNCTAD FDI/TNC DatabaseNominal GDP 7%Trade by 9%FDI inflow 18%

1998 - 30% of world trade is trade in commodities within firms (Yeats p.16)

High share from neighborsMuch intra EUA lot from US

18% of employees in EU work in MNE8.6% owned by non-EU parents7% in US parents

High FDI sectors areR&D intensiveSkill intensiveTechnically sophisticated, differentiated

Peak of US firm shares in EuropeOptical and medical instruments 17%Transportation 14%Chemicals 12%Telecom 10%

Peak of EU in US areChemicals 36%Glass, stone 18%Electronics 14%

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Stylized fact 5: In bilateral investment EU has a substantial surplus, high overlap

Stylized fact 6: Developing countries are recipient: IDI: ADI=4:1

Stylized fact 7: Developing countries receive minority of FDI (30%)

Stylized fact 8: EU is net investor in FDI, as well as a net export in trade

US firms in EU are responsible for 22% of EU imports from US and 19% of EU exports to US

EU firms in US are responsible for 28% of US imports from EU and 12% of US exports to EU

Interpretations: EU “needs more home input”35% of EU and 47% of US imports (share of bilateral flows)

However, relative to GDP now more (2.4%) than developed 1.3% (p13)

Stylized fact 9: US are marginally a net investor in FDI, net importer in trade

Stylized fact 10: Japan is a net investor, though with low flows and less surplus than in trade

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Does actual pattern of FDI follow Five Stage Theory?

Does actual pattern of FDI follow Five Stage Theory?

Deficit in stage 2 is empirically shownDeficit in stage 2 is empirically shown• FDI deficit in developing countriesFDI deficit in developing countries

• And in GR, P, SPAnd in GR, P, SP

Deficit in stage 2 is empirically shownDeficit in stage 2 is empirically shown• FDI deficit in developing countriesFDI deficit in developing countries

• And in GR, P, SPAnd in GR, P, SP

Increasing outward investment in stage 3 alsoIncreasing outward investment in stage 3 also• But to different extentBut to different extent

• Deficit depends on natural resources vs. firm specific advantagesDeficit depends on natural resources vs. firm specific advantages

Increasing outward investment in stage 3 alsoIncreasing outward investment in stage 3 also• But to different extentBut to different extent

• Deficit depends on natural resources vs. firm specific advantagesDeficit depends on natural resources vs. firm specific advantages

Country specific persistency in phase 4Country specific persistency in phase 4• See European countries:See European countries:

• UK and Switzerland have persistent investment surplusUK and Switzerland have persistent investment surplus

• Austria a persistent deficit (never a surplus in between)…Austria a persistent deficit (never a surplus in between)…

Country specific persistency in phase 4Country specific persistency in phase 4• See European countries:See European countries:

• UK and Switzerland have persistent investment surplusUK and Switzerland have persistent investment surplus

• Austria a persistent deficit (never a surplus in between)…Austria a persistent deficit (never a surplus in between)…

Equalization in phase 5 is open questionEqualization in phase 5 is open question• US has still a surplus (decreasing)US has still a surplus (decreasing)

• Japan has a large non-decreasing surplusJapan has a large non-decreasing surplus

Equalization in phase 5 is open questionEqualization in phase 5 is open question• US has still a surplus (decreasing)US has still a surplus (decreasing)

• Japan has a large non-decreasing surplusJapan has a large non-decreasing surplus

What is behind?What is behind?• High wage in SwitzerlandHigh wage in Switzerland

• Financial center, research and other attractions for headquartersFinancial center, research and other attractions for headquarters

• Headquarters move only for significant cost-service differencesHeadquarters move only for significant cost-service differences

What is behind?What is behind?• High wage in SwitzerlandHigh wage in Switzerland

• Financial center, research and other attractions for headquartersFinancial center, research and other attractions for headquarters

• Headquarters move only for significant cost-service differencesHeadquarters move only for significant cost-service differences

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Conclusions:Conclusions:FDI activists in Europe: UK, Netherlands, FDI activists in Europe: UK, Netherlands, Sweden, D,F,SF,S,ISweden, D,F,SF,S,I

These are all big 4 plus the NordicThese are all big 4 plus the Nordic

FDI receivers all south (exception Italy)FDI receivers all south (exception Italy)

plus Austria (A-D); Belgium (B:NI) plus Austria (A-D); Belgium (B:NI) Sp less than expected see SP-PSp less than expected see SP-P

Inward and outward investment across countries

Inward and outward investment across countries

Inward and Outward investment across countries

11.2

108.3

20.914.5 17.1

13.717.7

50.7

9.4

50.1

21.2 20.5

32.729.9

26.8

11.19.2

97.5

21.526.8 24.7

18.9

0.4

16.4 15.8

65.7

10.6

19.0

47.4

73.9

49.8

13.0

0.0

50.0

100.0

150.0

AB&L

Den SF FrGe Gr

Ire Ita Ned Por SpSwe

SwiUK

USA

Country 1999 FDI stocks as percentage of GDP

Inw

ard

/Ou

twa

rd

InwardOutward

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The impact of FDI on economic development

The impact of FDI on economic development

Positive:Positive:• Quickest import of technology and managementQuickest import of technology and management

• High productivity, cheap productsHigh productivity, cheap products

• Learning to catch up in skillsLearning to catch up in skills

Positive:Positive:• Quickest import of technology and managementQuickest import of technology and management

• High productivity, cheap productsHigh productivity, cheap products

• Learning to catch up in skillsLearning to catch up in skills

Negative:Negative:• Host country may get second best technologyHost country may get second best technology

• Development trap (MNE invest in industry with low future potential)Development trap (MNE invest in industry with low future potential)

• Plants not fitting into endogenous developmentPlants not fitting into endogenous development

• Footloose industries stay only as long as costs are lowFootloose industries stay only as long as costs are low

• Outside steering of development, dictated by headquarterOutside steering of development, dictated by headquarter

Negative:Negative:• Host country may get second best technologyHost country may get second best technology

• Development trap (MNE invest in industry with low future potential)Development trap (MNE invest in industry with low future potential)

• Plants not fitting into endogenous developmentPlants not fitting into endogenous development

• Footloose industries stay only as long as costs are lowFootloose industries stay only as long as costs are low

• Outside steering of development, dictated by headquarterOutside steering of development, dictated by headquarter

Important for a positive contribution to host country:Important for a positive contribution to host country:• Linkages, Learning, Upgrading as shown in the Irish exampleLinkages, Learning, Upgrading as shown in the Irish example

• Open for inward FDI plus upgrading infrastructureOpen for inward FDI plus upgrading infrastructure

And inviting firms to upgrade plantAnd inviting firms to upgrade plant

• Focus on linkagesFocus on linkages

•On learningOn learning

•On small local firms interrelating with MNEOn small local firms interrelating with MNE

Important for a positive contribution to host country:Important for a positive contribution to host country:• Linkages, Learning, Upgrading as shown in the Irish exampleLinkages, Learning, Upgrading as shown in the Irish example

• Open for inward FDI plus upgrading infrastructureOpen for inward FDI plus upgrading infrastructure

And inviting firms to upgrade plantAnd inviting firms to upgrade plant

• Focus on linkagesFocus on linkages

•On learningOn learning

•On small local firms interrelating with MNEOn small local firms interrelating with MNE

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Empirical facts about behavior of MNE

Empirical facts about behavior of MNE

Labor-intensive sectors dominateLabor-intensive sectors dominate

Capital-intensive sectorsCapital-intensive sectors

Human capital-intensive industries underrepresentedHuman capital-intensive industries underrepresented

Many IDI have few linkages (insolated firms)Many IDI have few linkages (insolated firms)

Labor-intensive sectors dominateLabor-intensive sectors dominate

Capital-intensive sectorsCapital-intensive sectors

Human capital-intensive industries underrepresentedHuman capital-intensive industries underrepresented

Many IDI have few linkages (insolated firms)Many IDI have few linkages (insolated firms)

MNE plants have high productivityMNE plants have high productivity

Fast growingFast growing

Technology transfer, however, not own researchTechnology transfer, however, not own research

MNE plants have high productivityMNE plants have high productivity

Fast growingFast growing

Technology transfer, however, not own researchTechnology transfer, however, not own research

Countries pursuing export lead perform betterCountries pursuing export lead perform better

Than countries relying on import substitution strategiesThan countries relying on import substitution strategies

Countries pursuing export lead perform betterCountries pursuing export lead perform better

Than countries relying on import substitution strategiesThan countries relying on import substitution strategies

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The impact of FDI on economic development

The impact of FDI on economic development

The rationale for FDIThe rationale for FDI• Lowering costs (road to cost leadership)Lowering costs (road to cost leadership)

• Increasing market share (size, barriers to entry, strategic advantageIncreasing market share (size, barriers to entry, strategic advantage

• Diversification (new market, distributing fixed costs of firm specific asset or Diversification (new market, distributing fixed costs of firm specific asset or capability)capability)

• Acquiring strategic assets (innovative capacity of foreign firm, country)Acquiring strategic assets (innovative capacity of foreign firm, country)

• Long-run profitabilityLong-run profitability

The rationale for FDIThe rationale for FDI• Lowering costs (road to cost leadership)Lowering costs (road to cost leadership)

• Increasing market share (size, barriers to entry, strategic advantageIncreasing market share (size, barriers to entry, strategic advantage

• Diversification (new market, distributing fixed costs of firm specific asset or Diversification (new market, distributing fixed costs of firm specific asset or capability)capability)

• Acquiring strategic assets (innovative capacity of foreign firm, country)Acquiring strategic assets (innovative capacity of foreign firm, country)

• Long-run profitabilityLong-run profitability

ChancesChances• To evade the eternal threat of profit dissipation (the need for markets)To evade the eternal threat of profit dissipation (the need for markets)

• To reduce costs (the need of evading high costs)To reduce costs (the need of evading high costs)

• To increase world market share (the need of top 3 position)To increase world market share (the need of top 3 position)

• To shift into fast growing countriesTo shift into fast growing countries

• To acquire strategic assets and capabilities (IT, knowledge)To acquire strategic assets and capabilities (IT, knowledge)

ChancesChances• To evade the eternal threat of profit dissipation (the need for markets)To evade the eternal threat of profit dissipation (the need for markets)

• To reduce costs (the need of evading high costs)To reduce costs (the need of evading high costs)

• To increase world market share (the need of top 3 position)To increase world market share (the need of top 3 position)

• To shift into fast growing countriesTo shift into fast growing countries

• To acquire strategic assets and capabilities (IT, knowledge)To acquire strategic assets and capabilities (IT, knowledge)

RisksRisks• Specific country risk (political, legal)Specific country risk (political, legal)

• Difference in culture and corporate governanceDifference in culture and corporate governance

• Different scheme of wages, social contributions, taxesDifferent scheme of wages, social contributions, taxes

• Danger that competitive advantage can not be transferred, sustainedDanger that competitive advantage can not be transferred, sustained

• Danger that resources will be diverted from investing into sustaining Danger that resources will be diverted from investing into sustaining competitive advantagecompetitive advantage

• Specific problem of control (size, distance)Specific problem of control (size, distance)

And organization (decentralization, centralization, divisional, And organization (decentralization, centralization, divisional, functional)functional)

RisksRisks• Specific country risk (political, legal)Specific country risk (political, legal)

• Difference in culture and corporate governanceDifference in culture and corporate governance

• Different scheme of wages, social contributions, taxesDifferent scheme of wages, social contributions, taxes

• Danger that competitive advantage can not be transferred, sustainedDanger that competitive advantage can not be transferred, sustained

• Danger that resources will be diverted from investing into sustaining Danger that resources will be diverted from investing into sustaining competitive advantagecompetitive advantage

• Specific problem of control (size, distance)Specific problem of control (size, distance)

And organization (decentralization, centralization, divisional, And organization (decentralization, centralization, divisional, functional)functional)

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The implementation in formal mode (A1)

The implementation in formal mode (A1)

FDI:FDI: fixed cost at headquarter (once): Ffixed cost at headquarter (once): F

lower variable costs (relative to domestic lower variable costs (relative to domestic firms): c.q, c<c*firms): c.q, c<c*

set up costs at each location: n.fset up costs at each location: n.f

FDI:FDI: fixed cost at headquarter (once): Ffixed cost at headquarter (once): F

lower variable costs (relative to domestic lower variable costs (relative to domestic firms): c.q, c<c*firms): c.q, c<c*

set up costs at each location: n.fset up costs at each location: n.f