Why Do Companies Invest
Overseas?
Krishna G Iyer
Department of Applied and International Economics
Massey University, Palmerston North.
Outline of the Presentation
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Define overseas/foreign investment.
Types of foreign investment.
Foreign direct investment and Multinational Enterprises.
Statistical highlights: Macro-level Data.
What drives FDI – Micro factors.
Shareholder portfolio diversification.
Revenue related objectives.
Cost related objectives.
Trojan Horse Theory.
Incentives and Barriers to FDI.
Conclusion.
Types of Investment
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Foreign Direct Investment (FDI) – Multinational Enterprise
(MNE).
Foreign Portfolio Investment (FPI)
Other Foreign Investment (OFI)
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Bn $ (US)
Relative Importance (USA)
7000
6000
5000
4000
3000
2000
1000
0
FDII
FPII
OFII
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Bn $ US
Relative Importance (USA)
4000.00
3500.00
3000.00
2500.00
2000.00
1500.00
1000.00
500.00
0.00
FDIO
FPIO
OFIO
FDII
FPII
OFII
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
Mn $ US
Relative Importance (NZ)
60000
50000
40000
30000
20000
10000
0
FDIO
FPIO
OFIO
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
Mn $ US
Relative Importance (NZ)
25000
20000
15000
10000
5000
0
Growth Rates
C’try
FDII
FPII
OFII
FDIO
FPIO
OFIO
GDP
USA
(81-05)
12.70
22.98
8.60
9.71
15.87
7.09
3.17
NZ
(90-05)
13.62
9.52
2.69
10.11
49.84
15.00
2.91
FDI as share of GDP
FDII and FDIO Flows as Percentage of GDP (1980-2004)
Region
FDII Flow as % of
GDP
FDIO Flow as % of
GDP
USA
1.05
0.99
New Zealand
3.41
0.92
OECD
1.25
1.59
World
1.35
1.35
FDI – Who Invests
Investors/Sources
1980
1990
2000
2004
Developed economies
0.8703
0.9174
0.8551
0.8847
Developing economies
0.1297
0.0825
0.1413
0.1064
Developing America
0.0824
0.0330
0.0343
0.0279
Developing Africa
0.0129
0.0112
0.0074
0.0047
Developing Asia
0.0341
0.0382
0.0996
0.0738
Developing Oceania
0.0003
0.0001
0.0000
0.0000
LDCs
0.0002
0.0004
0.0005
0.0004
Developing excl. China
0.1297
0.0800
0.1368
0.1024
Sub-Saharan Africa
0.0109
0.0101
0.0068
0.0042
FDI – Who Hosts
Hosts
1980
1990
2000
2004
Developed economies
0.7510
0.7941
0.6872
0.7268
Developing economies
0.2490
0.2058
0.3007
0.2508
Developing America
0.0751
0.0668
0.0898
0.0821
Developing Africa
0.0757
0.0336
0.0261
0.0246
Developing Asia
0.0960
0.1040
0.1839
0.1436
Developing Oceania
0.0023
0.0015
0.0008
0.0005
LDCs
0.0087
0.0053
0.0066
0.0081
Developing excl. China
0.2470
0.1941
0.2673
0.2232
Sub-Saharan Africa
0.0533
0.0198
0.0187
0.0174
The China Story
FDI INWARD
1980
1990
2000
2004
China - ML
0.0020
0.0117
0.0334
0.0276
China - ML, HK,
Mac
0.0472
0.0388
0.1126
0.0794
1980
1990
2000
2004
China - ML
0.0000
0.0025
0.0045
0.0040
China - ML, HK,
Mac
0.0003
0.0092
0.0677
0.0457
FDI OUTWARD
The Micro-Story: Why do firms invest
overseas?
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Shareholder Diversification Services.
Revenue Related Motives.
Cost Related Motives.
Trojan Horse Theory.
Shareholder diversification
services
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Don’t put all your eggs in one basket.
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International Stock Market Correlations are low – thus
portfolio risk might converge to the systematic risk.
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FDI provides indirect diversification services.
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Little empirical evidence favoring this thesis.
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In any case, reducing barriers to FPI makes this motive, if it
ever existed, less important.
Revenue Related Motives
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New markets.
Enter markets with superior profits.
Exploit intangible assets.
Reacting to trade barriers.
International business diversification.
New Markets
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Establish a subsidiary or acquire a competitor – Greenfield
Investments / joint ventures / cross-border mergers and
acquisitions.
E.g. Blockbuster Entertainment Corp. – entering the rest of
the OECD.
Coca-Cola and Pepsi in China and India.
FORD, HP, IBM.
YUM Brands – KFC Franchises.
Firm Level Surveys indicates access to new markets as the
primary determinant of FDI (PC - Australia).
Markets with superior profits
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MNE’s are attracted to markets with superior profits.
When profit margins are squeezed in the domestic market
– foreign markets may be worth exploring.
Related to the Product Life Cycle theory of Vernon
(1966).
Entry may trigger a price war and defeat the purpose of
FDI – E.g. the Mobile Phone Industry in Asia and more
recently India. Joint Ventures may then be preferred.
Exploit Intangible Assets
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Comparative advantage of MNE’s off-setting the inherent
disadvantages vis-à-vis domestic firms.
The intangible assets may take the form of technology,
marketing know-how, superior R&D capabilities, brand
name and recognition.
Hard to package and sell intangible assets to foreign
firms. Further, property rights are difficult to establish and
protect in foreign countries – So FDI emerges, often, as
the best way to exploit intangible assets.
The Coca-Cola Story in India.
Reacting to Existing/Potential Trade
Barriers
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Transportation costs.
Circumvent trade barriers – E.g. Japanese televisions in
US.
Pre-empt trade barriers – E.g. Japanese automobiles in
US.
Surge of FDI in Mexico (NAFTA) and Spain and newer
members of EU.
International Business
Diversification
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Reducing overall risk via international diversification – low
correlation once again the key.
The Enron Story.
Cost Related Motives
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Exploiting economies of scale.
Access to raw materials / inputs.
Labor market imperfection.
Exchange Rate Movements.
Exploiting Economies of Scale
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Lower average cost per unit resulting from increased
production.
Also relates to the revenue related objective of exploiting
intangible assets.
E.g. Consolidation of US MNEs in Europe since the
Single European Act.
Specific examples include: General Motors – Poland,
Peugeot – Czech Republic, Toyota – Slovakia, Audi –
Hungary, Renault – Romania, Volkswagen – Slovenia.
Access to raw materials / inputs
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Transportation costs – bulky raw materials.
Ensuring inputs supply stability.
E.g. SKF the Swedish ball-bearing manufacturer.
Labor Market Imperfection
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Labor services in a country can be severely under-priced
relative to its productivity.
Labor is not perfectly mobile across countries.
Surging FDI in Mexico, China, India, Thailand, Indonesia,
Malaysia often attributed to low cost of labor.
Revisiting examples: General Motors – Poland, Peugeot
– Czech Republic, Toyota – Slovakia, Audi – Hungary,
Renault – Romania, Volkswagen – Slovenia (Spain –
Germany Link).
Surge of FDI in Mexico (NAFTA) and Spain (EU).
How divergent are labor costs?
Country
Avg. Hourly Cost
(USD) Country
Avg. Hourly Cost
(USD)
Germany
31.25 Spain
14.96
Belgium
27.73 Israel
11.73
Sweden
25.18 Korea
10.28
USA
21.97 Taiwan
5.84
France
21.13 Hong Kong
5.54
UK
20.37 Mexico
2.48
Japan
20.09 Philippines
0.66
Australia
20.05 China
Italy
18.35 Indonesia
0.6
0.22
Exchange Rate Movements
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Undervalued currency may encourage FDI since initial
outlay is likely to be low.
Empirical evidence is not clear.
Trojan Horse Hypothesis
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Has been the hot topic over the last few years.
Rising Sun – the book by Michael Crichton has several
references to this theory.
To revisit the Trojan Horse Story.
Trojan Computer Virus – and now Trojan FDI.
Van Pottelsberghe and Lichtenberg (1996, 1998 and
2001) say FDI is essentially driven by the desire to
acquire technology.
At the aggregate level, almost no evidence is found. But
what does the market say?
Average Wealth Gains from Cross-Border Acquisitions: Foreign
Acquisitions of US Firms (Eun et al. 1996)
C’try of Cases
Acquirer
R&D as a % of
Sales
Average Wealth Gain in Mn
USD
Acquirer Target Acquirer Target
Comb.
Canada
10
0.21
0.65
14.93
85.59
100.53
Japan
15
5.08
4.81
227.83
170.66 398.49
UK
46
1.11
2.18
-122.91
94.55
-28.36
Others
32
1.63
2.80
-47.46
89.48
42.02
All
103
1.66
2.54
-35.01
103.19 68.18
Returning to the macro level Incentives for FDI
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Widely held view that FDI offers substantial benefits for host
economies – technology, employment, export revenue,
consumer choice, increased competition etc.
Empirical evidence is ambiguous.
Incentives include tax breaks, rent-free land and buildings,
low interest loans, subsidized energy, reduced environmental
regulations. Classic examples – Finland and Ireland 1990s.
With tax breaks there is always the possibility of round
tripping – China and India are examples.
Incentives must be carefully weighed – easy to go overboard.
Barriers to FDI
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Barriers placed by Government agencies.
E.g. France, Australia. Japan has a historically
imposed barriers on acquisitions.
Restricted Ownership rules in several developing
countries – can be effectively used to reduce political
risk of FDI.
Conditions – Employment related conditions
(American Universities in the Middle East),
Acquisition of Inputs from local sources e.g. Mexico,
Export conditions, E.g. Spain, etc.
Red Tape / Corruption.
Conclusion
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Large and Increasing Magnitudes of FDI – a trend certain
to continue in the future.
Why do firms undertake FDI?
Is it beneficial for host and source economies?
What sort of incentives are being offered?
What kind of barriers exist?
Weighing the Costs and Benefits.