International Finance
Chapter 15
Foreign Direct Investment
Preliminary Concepts
• Trade and investment are the two fundamental
ways in which global firms engage in overseas
markets.
• Investment can take one of two forms:
– Portfolio: Relatively short term; investors passive with
regard to control of invested assets.
– Direct: relatively long term; involves an equity position
large enough to confer some degree of control.
• Percentage for classifying DFI varies from country to country
• U.S., Japan, and the OECD use 10%
Foreign Direct Investment (FDI)
• FDI Defined”
– FDI is the movement or accumulation of long term
capital across political boundaries.
• It may take the form of:
– Cash, securities, plant, equipment, and other factors
of production, such as managerial skills, technology,
or know how.
– FDI usually involves some combination of the above.
– The transfer of this “package” of capital assets as well
as the retention of control is what distinguishes FDI
from portfolio investment.
Measuring FDI
• More broadly defined, FDI includes not
only the movement, but also the
accumulation of long term capital abroad.
– For example, the United States includes
retained earnings and locally financed direct
investments by American affiliates in its
measure of FDI.
– Other countries, however, such as Japan,
recognize only the movement of long term
capital abroad as FDI.
Observations on FDI
• From 1997-2001, global FDI averaged about $830 billion
annually.
• Developed countries account for about 85% of this
amount.
• United States is the largest source and largest target,
followed by the United Kingdom.
– Large market, little political risk, developed business
environment.
• Japan a relatively small target
– Reflects legal, economic and cultural barriers.
• Growing importance of China as a target!
– Fourth most important target country.
• FDI has grown faster than world exports!
25.3
9.3
Switzerland
71.7
21
25.5
Sweden
150
202.3
250
139.2
134.5
200
United
Kingdom
United
States
31.1
18.6
46.6
37.1
Spain
Netherlands
1.7
15
Mexico
12.6
8.3
91
65.8
62.2
38.8
43.5
28.5
6.7
0
Japan
Italy
Germany
France
1.7
29.4
29.3
100
China
Canada
5.5
7.4
50
Australia
Average Annual FDI (in Billions $)
1997-2001
(Outflows: Blue; Inflows: Red)
FDI Compared to World Exports
600
400
Value Exports
300
World GDP
200
World FDI
100
20
00
98
96
94
92
0
90
Index
500
Note: The
dramatic
growth in
FDI since
1997
FDI Theories
• Theory: The purpose of theory is to “explain” or “predict”
the behavior of a particular phenomena.
– For example, why do firms engage in FDI?
• The theoretical development of FDI did not begin until
1960.
– Prior to this, economists and, thus, theoretical modeling was
concerned with explaining international trade and portfolio
investment.
• To this day FDI theories are still not as well developed as
other theories of international economics (especially
trade theories and portfolio diversification theories).
FDI Theory: 1960s
• Stephen Hymer (1960, Ph.D. thesis, MIT).
– Monopolistic Advantage Theory of FDI
• Hymer, borrowing from market structure theory,
suggested that monopolistic advantages (which
allowed firms to generate above average profits)
provided firms with the incentive to expand
abroad.
– Monopolistic advantages resulted in barriers to
competition and resulted from:
• Brand loyalty, patents, managerial skills, etc.
FDI Theories: 1960s
• Raymond Vernon (1966, Quarterly Journal of
Economics):
– International Product Life Cycle of FDI
• Vernon’s theory attempts to explain the “timing and
location” of FDI
– Initially firms will undertake production in their home markets
(control and risk avoidance); generally highest income countries.
– During the next stage, the firm will begin to export, but to
markets most similar to the home market (in demand patterns).
– As the product matures and becomes standardized, the
competitive advantage shifts from product advantage to cost
advantage.
– Initial producer is forced to seek lower cost production to remain
competitive, and eventually establishes a manufacturing facility
overseas (overseas production replaces exports and is also
used to service the home market).
International Product Life Cycle Model
Highest Income Countries
Importing
production
consumption
Q
u
a
n
t
i
t
y
Exporting
11
2
3
4
5
6
7
8
9
10
11
High Income Countries
12
2
3
4
5
6
7
8
9
10
2
3
4
New Product
15
5
6
7
8
9
11
12
13
14
15
FDI:
Exporting
Low Cost Location
Countries
1
14
Importing
Importing
1
13
10
11
12
13
14
15
Maturing Product Standardized Product
Stages of Production Development
Time
Eclectic Explanation of FDI
• Rather than focusing on any one theory, the
eclectic approach attempts to identify possible
motivating factors in affecting a firm’s decision to
engage in FDI.
• Many of these factors tend to focus on various
market imperfection and include:
–
–
–
–
Trade barriers
Imperfect labor markets
Intangible assets (internalization theory of FDI)
Vertical integration
Trade Barriers
• Trade barriers are those factors which
discourage the movement of goods and
services across national borders.
– Impact on exports and imports
• Trade barriers arise from:
– Government policies
• Tariffs, quotas, anti-dumping actions.
– Natural forces (e.g., transportation costs)
Trade Barriers and FDI
• FDI is seen as a strategy for circumventing trade
barriers.
– Japanese TV manufacturers moving production
facilities to the U.S. in 1977 in response to U.S. import
quotas on Japanese tvs.
– Japanese automobile manufacturers establishing
production facilities in the U.S. in the 1980s in
response to the 1981 voluntary restraint agreement
between the U.S. and Japan.
• Honda’s 1982 FDI investment in Marysville, Ohio
– Haier Corporation (China) establishing a $40 million
refrigerator manufacturing facility in South Carolina in
2000 to overcome transportation costs.
Imperfect Labor Markets
• Firms may locate overseas production
facilities on the basis of under-priced labor
costs (relative to its productivity).
– Why might labor be under-priced?
– Because labor cannot move freely across
national borders to take advantage of higher
wages elsewhere.
• Explains FDI investment in:
– China, Mexico, India, etc.
Labor Market Costs Around the
World (2001)
Persistent wage
differentials across
countries exist.
This is one on the
main reasons
MNCs are making
substantial FDIs in
less developed
nations.
Country
Germany
U.S.
Japan
Korea
Taiwan
Mexico
China
Indonesia
Hourly Cost
$23.04
$20.67
$19.52
$7.53
$5.44
$1.70
$0.60
$0.22
Intangible Assets
• Firms may engage in FDI if they possess
intangible assets.
– Technology, managerial talent, brand loyalty.
– Firms owning these intangible assets find it
more beneficial to establish their own foreign
subsidiaries then to license their intangible
assets to a foreign partner.
• Assets may be difficult to transfer to partners.
• Firm may wish to “protect” its assets; and not
share (Coca-Cola). Thus, Coke invests in bottling
plants overseas!
Internalization Theory of FDI
• Suggests that those firms possessing
intangible assets will use their own
subsidiaries, rather than “local” host
country firms to capture returns.
– Avoids misappropriation of assets.
– Avoids sharing technology.
– Insures full control.
• Firms “internalize” their activities!
Vertical Integration
• Firms may engage in integrating FDI to stabilize
a critical supply (of inputs) chain.
– A gasoline company owning oil fields.
– Referred to as backward integration!
• Firms may engage in integrating FDI to promote
product sales.
– Automobile manufacturing companies buying car
dealerships.
• American car companies buying dealerships in Japan!
– Referred to as forward integration!
Viewing the FDI Sequence
Domestic Firm Analyzes its
Competitive Advantage
None: How to Develop its
Competitive Advantage?
Greater Foreign Presence
Exploit Existing Competitive
Advantage Overseas
Produce at Home:
Exporting
Produce Overseas
Licensing Firm’s
Competitive Advantage
Greater
Foreign
Investment
Joint Venture with
Foreign Partners
Greenfield
Investment
Firm Controlled Assets
Abroad (FDI)
Wholly-Owned
Subsidiary
Acquisition of a
Foreign Enterprise
Joint Ventures
• Definition: A combination of two or more
entities (companies, state enterprises) into
a single business organization.
– Each party contributes to the organization
(money, technology, plant, labor)
– Each party owns a portion of the organization
(equal stakes or majority/minority stakes)
• Most are 50/50
– Each party shares risk of failure.
Reasons for Joint Ventures
• Possible Reasons for Joint Venturing:
– Host government require it
• China, India and Malaysia
– Partners realize needs for each others’ skills
• Managerial, production, distribution, understanding of the
country
• Especially important when national cultures differ.
– Partners realize needs for each others’
complementary assets
• Technology, products, capital, plant, labor
– Large capital outlay requirements may render wholly
owned subsidiary unfeasible.
Joint Venture Example: Nike Japan
• Nike Corporation: Headquartered in
Oregon; designer and marketer of athletic
footwear.
– Founded in 1962 (as Blue Ribbon Sports)
– 1963 Imported 200 pairs of athletic shoes
from Onitsuka Tiger Company in Japan
(Importer stage)
– 1981: Nike Japan is created through a joint
venture between Nike and Japanese trading
company, Nissho Iwai (DFI stage)
Advantages of Joint Ventures
• Advantages include:
– Combining with another firm and building on
both firm’s comparative advantages.
– Limits capital outlay.
– Permits potentially better relations with local
government, banks, labor unions, community!
– Minimizes cultural risk.
– Minimizes expropriation risk.
Disadvantages of Joint Ventures
• Disadvantages include:
– Corporate disagreements
• Corporate culture clashes (Anglo-American versus
non-Anglo-American views regarding corporate
objectives)
– Sharing of profits
– Usually one partner will dominate the
enterprise.
Wholly Owned Subsidiary
• Definition: A firm (parent company) with 100%
ownership of an overseas enterprise.
• Features:
– Firm does not share the organization with another
firm.
• Firm contributes all the assets.
• Firm does not share profits.
• No control issues (no sharing of decision making).
– However, there is:
• High cost
• Full risk exposure
Greenfield Versus Acquisition
• Greenfield Investment
– A greenfield investment is the
construction of a new facility; “starting
from the ground up.”
• Usually requires extended periods of
physical construction and organizational
development.
– Honda building an automobile assemble
plant in Marysville Ohio in 1982!
Greenfield Versus Acquisition
• A cross-border acquisition refers to the
purchase of an existing enterprise.
– Shorter time frame and less financing
exposure.
– Issues:
• Do appropriate foreign assets exist?
• How much to pay for existing assets?
– Generally too much!
– Potential problems with post acquisition
integration of firms
– Ford buying Jaguar for $2.8 billion in 1990!
Top 10 Cross-Border M&A Deals: 1996-01
Year
2000
($ b)
Acquirer
202.8 Vodafone Airtouch
PLC
Home
Target
Host
U.K.
Mannesmann AG
Germany
1999
60.3 Vodafone Group PLC
U.K.
Airtouch
U.S.
1998
48.2 British Petroleum Co.
U.K.
Amoco
U.S.
2000
46 France Telecom SA
France
Orange PLC
U.K.
1998
40.5 Daimer-Benz AG
Germany
Chrysler Corp.
U.S.
2000
40.4 Vivendi SA
France
Seagram Co. LTD
Canada
1999
34.6 Zeneca Group PLC
U.K.
Astra AB
Sweden
1999
32.6 Mannesmann AG
Germany
Orange PLC
U.K.
2001
29.4 VoiceStream Wireless
Corp
U.S.
Deutsche Telekom
AG
Germany
2000
27.2 BP Amoco PLC
U.K.
ARCO
U.S.
Political Risk
• Relates to the actions that a host government might take
that could adversely affect the interests of a global firm.
• Range from changes in tax laws to ownership issues.
• One of the biggest risk when investing abroad.
• Individual country’s legal system and the enforcement of
its laws (relating to business) is also critical here!
– Contract law, private property laws, intellectually property!
Political Risk Components
• Transfer Risk
– Uncertainty regarding cross-border flows of capital (repatriation of
profits).
• Imposition of capital controls, changes in withholding taxes on
dividends.
• Operational Risk
– Uncertainty regarding host countries policies on firm’s operations.
• Changes in environmental regulations, local content requirements,
minimum wage laws.
• Control Risk
– Uncertainty regarding control or ownership of assets
(expropriation).
• Changes in restrictions on maximum ownership by non-resident
firms, nationalization of foreign assets.
Assessing Political Risk
• Corruption Indexes
– http://www.transparency.org/ (no fee)
• Country Analysis
– http://www.state.gov/countries/
– http://library.uncc.edu/display/?dept=reference&format=open&pa
ge=68
• Political Risk Indexes
– http://www.duke.edu/~charvey/index.html (no fee)
– http://www.countrydata.com/ (fee based)
• Insurance (OPIC)
– http://www.opic.gov/
Case Study: Coca-Cola and
Political Risk
• From the 1950s into the
early 1970s, Coca-Cola had
operated successfully in
India as the country’s
leading soft drink company.
• However, by the mid-1970s,
the political environment in
India towards non-resident
firms changed dramatically.
Coca-Cola in India
• From 1974 to 1977, India’s socialist government
had engaged in a four-year campaign against
multinational firms in general and Coca-Cola in
particular.
• In the case of Coca-Cola, the Indian government
claimed that the company was taking more
money out of the country then putting in and was
adversely affecting its domestic soft-drink
industry.
Coca-Cola and India
• In 1977 the government demanded that CocaCola turn over its secret drink formula and sell
60% of its operations to Indian investors or face
expulsion.
• A year later, in 1978, Coca-Cola left India.
• Coca-Cola has since returned to India!