Foreign Direct Investment

Foreign Direct Investment

Learning objectives
Be familiar with current trends regarding FDI in the world economy. Understand the different theories of foreign direct investment. Appreciate how political ideology shapes a governments attitudes towards FDI. Understand the benefits and costs of FDI to home and host countries. Be able to discuss the range of policy instruments that governments use to influence FDI. Articulate the implications for management practice of theory and government policies associated with FDI.

investment in the last 25 years has been phenomenal. FDI can take the form of a foreign firm buying a firm in a different country, or deciding to invest in a different country by building operations there. With FDI, a firm has a significant ownership in a foreign operation and the potential to affect managerial decisions of the operation. The goal of our coverage of FDI is to understand the pattern of FDI that occurs between countries, and why firms undertake FDI and become multinational in their operations as well as why firms undertake FDI rather than simply exporting products or licensing their knowhow.

The focus of this section is foreign direct investment (FDI). The growth of foreign direct
7-1

Introduction Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country. Once a firm undertakes FDI it becomes a multinational enterprise. Another Perspective: Each year Fortune magazine publishes a list of the 500 largest global corporations in the world. Fortune calls its list the "Global 500." This list can be accessed at {http://money.cnn.com/magazines/fortune/global500/2006/}. The article contains an excellent discussion of the role of global firms in the world economy. FDI can take the form of a greenfield investment where a wholly new operation is established in a foreign country, or it can take place via acquisitions or mergers with existing firms in the foreign country. Another Perspective: Another web site that provides an excellent discussion of the role of multinational corporations in the world economy is available at {http://www.oecdobserver.org/news/fullstory.php/aid/446/The_trust_business.html}. Foreign Direct Investment in the World Economy The flow of FDI refers to the amount of FDI undertaken over a given time period, while 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 country, and inflows of FDI are the flows of FDI into a country. Trends in FDI There has been a marked increase in both the flow and stock of FDI in the world economy over the last 30 years. The Direction of FDI While the United States remains a top destination for FDI flows, South, East, and Southeast Asia, and particularly China, are now seeing an increase of FDI inflows, and Latin America is also emerging as an important region for FDI. 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. The Form of FDI: Acquisitions Versus Greenfield Investments Most cross-border investment is in the form of mergers and acquisitions rather than greenfield investments. The Shift to Services FDI is shifting away from extractive industries and manufacturing, and towards services. Theories of Foreign Direct Investment Questions that need to be answered include: Why do firms invest rather than use exporting or licensing to enter foreign markets? Why do firms from the same industry undertake FDI at the same time? How can the pattern of foreign direct investment flows be explained? Why Foreign Direct Investment? Why do firms choose FDI instead of :exporting or licensing? Internalization theory (also known as market imperfections theory) suggests that licensing has three major drawbacks.

The Pattern of Foreign Direct Investment Knickerbocker looked at the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms) and suggested that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. Vernon argued that firms undertake FDI at particular stages in the life cycle of a product they have pioneered. According to the eclectic paradigm, in addition to the various factors discussed earlier, it is important to consider: location-specific advantages - that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets and externalities - knowledge spillovers that occur when companies in the same industry locate in the same area Political Ideology and Foreign Direct Investment Ideology toward FDI ranges from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economies. Between these two extremes is an approach that might be called pragmatic nationalism. The Radical View The radical view argues that the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries. The Free Market View According to the free market view, international production should be distributed among countries according to the theory of comparative advantage.

Pragmatic Nationalism Pragmatic nationalism suggests that FDI has both benefits, such as inflows of capital, technology, skills and jobs, and costs, such as repatriation of profits to the home country and a negative balance of payments effect. Shifting Ideology Recently, there has been a strong shift toward the free market stance creating: a surge in FDI worldwide an increase in the volume of FDI in countries with newly liberalized regimes Benefits and Costs of FDI Government policy is often shaped by a consideration of the costs and benefits of FDI. Host Country Benefits There are four main benefits of inward FDI for host countries: resource transfer effects; employment effects; balance of payments effects, and effects on competition and growth. Host Country Costs

There are three mains costs from inward FDI for the host country: the possible adverse effects of FDI on competition within the host nation; adverse effects on the balance of payments; and the perceived loss of national sovereignty and autonomy. Home Country Benefits The benefits of FDI for the home country include: the effect on the capital account of the home countrys balance of payments from the inward flow of foreign earnings; the employment effects that arise from outward FDI; and the gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country. Home Country Costs The home countrys 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; and if the FDI is a substitute for direct exports. International Trade Theory and FDI 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. Government Policy Instruments and FDI Home countries and host countries use various policies to regulate FDI. Another Perspective: The World Bank has a wonderful site devoted to foreign direct investment. Students can start exploring the site by going to {http://rru.worldbank.org/Themes/ForeignDirectInvestment/}. Then click on Doing Business to see an option to download summaries on 175 countries, or to generate instant reports comparing countries on various factors. The site is easy to navigate and contains a wealth of information. Home Country Policies Governments can both encourage and restrict FDI Host Country Policies
To encourage inward FDI, governments offer incentives to foreign firms to invest in their countries, while they restrict inward FDI through ownership restraints and performance requirements.

International Institutions and the Liberalization of FDI

Implications for Managers Managers need to consider what trade theory implies, and the link between government policy and FDI. The Theory of FDI The direction of FDI can be explained through the location-specific advantages argument associated with John Dunning. Government Policy A host governments attitude toward FDI is an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct investment.