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Chapter One – Theoretical Background.
1.1 - What is Foreign Direct Investment?
Foreign direct investment (FDI) can be defined as the international capital flows in
which a firm in one country creates or expends a subsidiary in another1. There are four widely
accepted main motives behind a firm investing in the acquisition of a foreign subsidiary – to
seek natural resources, to seek new markets, to restructure existing foreign production through
rationalisation and to seek strategically related created assets.
The location of production is often determined by the location of the resources needed.
Aluminium mining must be located where the bauxite is, aluminium smelting near cheap
electricity2. Resource-seeking FDI is one of the most significant kinds of FDI for developing
countries, but is dependent on the resource’s scarcity and availability in other locations.
However, since resource seeking investment generally (but not always) implies low value
adding activity and low capital expenditure on plant and equipment (extractive industries
being the exception), FDI is less “sticky”, i.e. more footloose. In general, a purely resourceseeking investment is not tightly integrated into the investing firm’s global strategy3.
A firm exhibits market-seeking behaviour when a foreign market offers the
opportunity to achieve production economies of scale, or where there are considerable barriers
to exporting from the home country. This requires not only a sizeable population, but also the
ability of the market to support (within a reasonable timeframe) the expected demand on
which the investment is based4. There is also a certain “follow the leader” aspect to marketseeking FDI. We may say that firms are prompted to go overseas if they feel that their
1
Krugman, P. & Obstfeld, M., 2000, page 169.
Ibid, page 172.
3
Narula, R. & Dunning J., 2000, page 146.
4
Ibid, page 146.
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productivity advantages are (or could become) threatened, if they do not follow their
competitor’s lead5.
Globalisation can be defined as “the process whereby the countries, regions and
localities of the world are homogenised by changing economic, social, political and
technological forces”6. It is this process that prompts the creation of assets within the host
country over time, which will attract both efficiency-seeking and strategic asset-seeking FDI.
The agglomeration of related activities within the host country plays a central part in
attracting these forms of FDI. Unfortunately, the process of globalisation is not
geographically uniform and countries (or regions) that have (the basis for) agglomerative
economies are the ones likely to be in a strong bargaining position7. Firms that pursue
efficiency-seeking or asset-seeking FDI are more likely to become “stuck” in the host country
and remain there, even when the original benefits of the investment are spent, and these are
the types of firms that governments wish to attract when devising their target strategies.
1.2 – What are the affects of FDI on the host country?
FDI is thought to bring several benefits to the economy of the host country. It can
contribute to Gross Domestic Product (GDP), Gross Fixed Capital Investment (total
investment in the host country) and balance of payments. It can also contribute to debt
servicing repayments and stimulate export markets. More importantly (in the long run) it can
result in social change, improvements in infrastructure and technology transfers.
FDI, where it generates and expands businesses, can help stimulate employment, raise
wages and replace declining market sectors. The benefits, however, may only be felt by small
portion of the population, e.g. where employment and training is given to more educated,
typically wealthy elites or there is an urban emphasis, wage differentials between income
5
Dunning, J., 2001, page 180.
Jacobson, D & Andreosso-O’Callahan, B, 1996, page 114.
7
Narula, R. & Dunning J., 2000, page 147.
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groups will be exacerbated8. Social and cultural impacts may occur with investment directed
at non-traditional goods. For example, if financial resources are diverted away from food and
subsistence production towards more sophisticated products. Encouraging a culture of
consumerism can also have negative environmental impacts.
Before setting up a subsidiary, the parent company must ensure that the host country
meets the relevant infrastructure and HR requirements. These investments in industries can
stimulate new infrastructure development and technologies to host countries. Investment in
research and development (R&D) from parent companies can stimulate innovation in
production and processing techniques in the host country. Foreign technology/organizational
techniques may, however, be inappropriate to local needs, capital intensive and have a
negative affect on local competitors, especially smaller business that are less able to make
equivalent adoptions. This can lead to the “familiar harmful consequence known as the ‘crowding
out’ effect”9.
1.3 – FDI Theory.
In the 1950’s (and 1960’s), a number of theories of international trade and investment,
enriched by the introduction of technical change as a crucial and new explanatory variable,
followed a more dynamic approach than the traditional theories. Among these were theories
that also provided frameworks for analysing the existence and behaviour of MNEs10.
1.3.1 Product Life Cycle Model (PLCM)
The product life cycle model was developed by Vernon (1966), and is the most
famous of the “new technology” theories of international trade. Vernon’s theory begins with
the axiom that the USA is a high-income country characterised by high wages and plenty of
8
OECD 1999, page 3.
Jacobson, D & Andreosso-O’Callahan, B, 1996, page 314.
10
Ibid, page 253.
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available capital. The high-income elasticity and the high skill level facilitate the demand and
the production of new innovations.
In phase one (see figure 111), the total production takes place in the country of origin
Figure 1 - The Product Life Cycle.
(USA) because any adjustments that need to be made at the – the prototype product, and not
yet standardised process – stage will need to be made quickly, in response to the home
market12. This stage is characterised by high unit production costs, but these costs are less
significant because, as mentioned above, the demand for innovations is price inelastic.
In phase two, the market for the product widens as demand develops in other highincome countries. The production of the product becomes standardised and combines with the
widening of the market to give rise to economies of scale, and therefore a decrease in price.
This causes the market for the product to widen further, and the USA will begin to export to
Less Developed Countries (LDC’s) (see phase three). Eventually, the increasing international
11
12
Source: Callinan, P.
Jacobson, D & Andreosso-O’Callahan, B, 1996, page 254.
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distribution of the product, and the relatively lower costs of production, will result in phase
four and eventually phase five i.e. the relocation of production where the factor costs involved
in production are lowest.
The PLCM proved most useful in explaining the flows of US FDI, post World War
Two, in Europe and South-East Asia. It also helped explain international trade, in the 1950s
and 1960s, in that more sophisticated, innovative products and products of innovative
processes tended to be exported from advanced countries, but some manufactured goods were
produced by and exported from less well developed countries13.
While the PLCM does go some way towards explaining the theory behind MNE
activity, there are some criticisms of the model that are commonly made. Firstly, while the
PLCM may have explained MNE behaviour for the 1950s to the 1970s, the applicability of
the model is called more and more into question given the huge technological advances in
technology, and the development of new locations (such as Japan and Europe) from which
competitive firms have originated. Secondly, it mainly focuses on the discontinuity created by
the emergence of an entirely new innovation or product and does not acknowledge
technological innovation as a continual process. Thirdly, the PLCM does not answer the
question of why MNEs find relocation of production through FDI preferable to licensing, for
example. Lastly, it does not take into account oligopolistic market structures in the location
decisions of MNEs.
In response to these criticisms, Vernon presented an alternative model, based on the
oligopolistic behaviour of MNEs. Here, he proposed that there were three phases in the
development of MNEs: innovation-based oligopolies, when production will tend to be in the
home market; mature oligopolies, when pricing, investment and location decisions are made
in response to expectations about the behaviour of competitors, and senescent oligopolies,
13
Ibid, page 254.
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when differences in costs determine the location of production14. As you can see, large
elements of his original hypothesis influence the new model.
1.3.2 – The Eclectic (OLI) Model.
Dunning developed the eclectic (OLI) model in 1958 to explain why production is
sometimes organised internationally. He examined the internationalisation of firms based on
ownership-specific (O), location-specific (L) and internalisation-specific (I) advantages (see
figure 2). A firm considering producing abroad will analyse each of these factors in turn, to
determine their FDI strategy.
“O” explains why the firm in question produces the good, rather than any other firm. It
also explains why that firm is better at fulfilling the needs of the market for that product –
both domestic and foreign – than its competitors. There are two types of ownership specific
Figure 2 - The Eclectic (OLI) Model.
14
Ibid, page 254.
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advantages; those which arise from “the privileged possession of income generating assets”
(patents, the capacity to innovate, superior production techniques etc.) and those which arise
from the firm’s superior ability to “take advantage of the economies of common governance
of separate but related activities which might otherwise have been coordinated through
external market”15.
“L” explains why a firm chooses to produce in the host country. The L advantages of
the chosen host country are non-transferable and immobile. These are differences that arise
from the endowment of natural resources, infrastructure, culture, production and transport
costs. L advantages can also be created artificially through government policies on trade
barriers, taxation etc.
“I” refers to the way firms organised the generation and use of the resources and
capabilities within their jurisdiction and those they could access in different location.
Dunning acknowledged that only way to fully explain the extent and pattern of the foreign
value added activities of firms, one also had to explain why firms opted to generate and/or
exploit their O specific advantages internally, rather than to acquire and/or sell these, or their
rights, through the open market. Of the variables that are likely to cause firms to internalise
markets, the likelihood and costs of a contractual default and the inability of a contractor to
capture the external economies of any transaction are perhaps the two most important16.
The first criticism of this model is that the explanatory variables identified by the
paradigm are so numerous that its predictive value is almost zero. Dunning, however, states
that the eclectic paradigm is best regarded as a framework for analysing the determinants of
international production rather than a predictive theory of the MNE17.
The second criticism implies that it is misleading to suggest that the triumvirate of
variables that make up the eclectic paradigm are independent of one another18. While
15
Ibid, page 114.
Dunning, J., 1993, page 136.
17
Dunning, J., 2001, page 176.
18
Ibid, page 176.
16
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Dunning admits that, over time, keeping the “separateness” of these variables distinct, he
believes that it is important to separate the reasons for MNE activity which are primarily due
to the unique resources and capabilities possessed or accessed by firms of a particular
ownership (including their ability to choose the right location and mode of organisation to
exploit or augment these assets) from those to do with location-bound resources and markets
of the countries in which they operate19. For example, FDI based upon the O advantages of
the investing firms at a specific point in time will affect the L advantages of the host country
in the future.
1.3.3 – The Investment Development Path (IDP) Model.
Dunning first put the concept of the investment development path forward in 1975, as
an application of the eclectic paradigm. It seeks to explain the international direct investment
position of a country in terms of the juxtaposition between the locational attractions of its
endogenous resources, capabilities and markets, vis-à-vis those of other countries, and the
ownership or competitive advantages of its firms vis-à-vis those of other nationalities20. It
suggests that as countries increase their GNP per capita in parallel with the created asset
component of their resources and capabilities, the level, significance and pattern of their
inward direct investment (IDI) and outward direct investment (ODI) and the relationship
between them displays a systematic change (see figure 3).
By incorporating the trade development path (TDP), i.e. the relationship between
trade and economic development, into the IDP model, it provides a more comprehensive
description of the combined interaction between the cross-border transactions and the pattern
and rate of economic development. Dunning et al (2001, page 148) propose that, at relatively
low levels of GNP per capita, an industrialising country will engage primarily in imports and
19
20
Ibid, page 177
Dunning , J., Kim, C-S. & Lin, J-D, 2001, page 148.
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exports with a low created asset content. As development proceeds, the created asset intensity
of both imports and exports increases, with that of exports lagging that of imports.
Stage 1
Low Resource & Capability Base – Small Domestic Markets
Exports (X) mainly in less FDI intensive sector (B)
Imports (M) mainly in medium FDI intensive sector (O)
Intra-industry trade relatively low
Modest IDI, & mainly in less/medium (B & O) FDI intensive sector
Virtually no ODI
Intra industry FDI low.
Stage 2
Improving Resource & Capability Base – Rising Domestic Markets
Exports (X) still mainly in B sectors but increasing in O sectors
Imports (M) as in stage 1, but some also in A sectors
Intra-industry trade still low but increasing
More IDI, mainly in B & O sectors
ODI beginning mainly in B & O sectors
Intra industry FDI low
Stage 3
Created Asset Intensity & Indigenous Base New Becoming Significant –
Rising Domestic Markets
Exports (X) now largely O but some A, B type exports becoming relatively less
important
Imports (M) increasing % of O & A products
Intra-industry trade now becoming significant
IDI now being concentrated in O & A sectors
ODI increasing in O type products and some asset-seeking ODI in A sectors
Intra industry FDI beginning to increase
Stage 4
Approaching Mature Industrialization: Relatively Rich and Sophisticated
Markets
Exports (X) now mainly of FDI intensive products (O & A)
Imports (M) are mixed as some B & O products cheaper to import than produce
domestically. But imports of A type products rising.
Intra-industry trade has a high % of total trade.
IDI increasingly concentrated in O & A sectors
ODI rising faster, and sometimes exceeding IDI; concentrated in O & A sector
Intra industry FDI is an important component of all cross border FDI flows.
Figure 3 – Four stages in the IDP and TDP of industrialising developing countries
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Accordingly, the proportion of intra-industry trade to total trade increases, particularly so with
the created asset-intensive products.
In stage one, the imports and exports of the country in question are in the low to
medium created asset-intensive sector. As the country becomes more industrialised, the
quality of their indigenous and immobile resources and capabilities improves as does their
domestic spending power. In stage two, countries start to attract IDI, but ODI is minimal (if
any). In stage three, as indigenous firms start to generate their own O advantages, they tend to
exploit these first by exports and then, as their foreign markets expand (of the costs of home
production increase), by ODI. In order to become competitive in the global market, the firm
must seek out new management skills, production techniques and organizational expertise by
means of mergers and acquisitions or strategic alliances – preferably with firms from more
industrialised countries.
As this model is derived from the eclectic paradigm, it is also criticised for having too
many variables and that the vast majority of these variables become interdependent over time.
The IDP model, however, provides a robust framework for testing the patterns of trade in
relation to development , and introduces a dynamic element into the eclectic paradigm on a
macroeconomic level21.
21
Dunning, J., 2001, page 183
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