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CHAPTER
6
Foreign Direct Investment
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© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Key Issues
• Why is FDI increasing?
• Why do firms choose FDI over exporting or
licensing to enter a foreign market?
• Why are certain locations attractive for FDI?
• How does political ideology influence government
policy over FDI?
• From a host or source country perspective, what
are FDI’s costs and benefits?
• How can governments restrict/encourage FDI?
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Slide
6-1
Foreign Direct Investment
• Foreign direct investment (FDI) happens
when a firm invests directly in facilities in a
foreign country
• A firm that engages in FDI becomes a
multinational enterprise (MNE)
– Multinational = “more than one country”
• Factors which influence FDI are related to
factors that stimulate trade across national
borders
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Slide
6-2
Foreign Direct Investment
• Involves ownership of entity abroad for
–
–
–
–
production
Marketing/service
R&D
Raw materials or other resource access
• Parent has direct managerial control
– The degree of direct managerial control depends
on the extent of ownership of the foreign entity
and on other contractual terms of the FDI
– No managerial involvement = portfolio
investment
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Slide
6-3
FDI Growth in the World Economy
• FDI Outflow of $25 billion in 1975 increased to $1.3
trillion in 2000
• FDI flow accelerated more than world trade (x 5 and x
1.8 respectively)
• FDI Flow from all countries increased 1000%, trade
91%, world output 27% from 1984 to 1998
• FDI Stock increased to $3.5 trillion by 1997
• 63,000 parent firms with 690,000 foreign affiliates
produced $14 trillion sales, almost twice global exports
• FDI growing faster than world trade
– Political risk issues
– Economic reason issues
– Globalization
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Direction and Source of FDI
• Historically, FDI flow was to developed countries from
other developed countries
– Much of this to the US
• Since 1985 there has been an increase of FDI towards
developing countries
– Much to the emerging Asian and Latin America economies
– Africa lagging
• Through 1970s US led in FDI outflows
– 1985-1990 Japan 1st, UK 2nd, US 3rd
– Effect of ¥ increase in value
• In 2000 the USA received 21.6% of world FDI; the EU
received 48.7%
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6-5
Forms of FDI
• FDI forms
– Purchase of existing assets
• Quick entry, local market know-how, local financing may be
possible, eliminate competitor, buying problems
– New investment
• No local entity exists or is available for sale, local financial
incentives may encourage, no inherited problems, long lead
time to generation of sales or other desired outcome
– Participation in an international joint-venture
• Shared ownership with local and/or other non-local partner
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Alternative Modes of Market Entry
• FDI
– FDI - 100% ownership
– FDI < 100% ownership, International Joint Venture
• Majority, Equal Share, Minority Participation
•
•
•
•
Strategic Alliances (non-equity)
Franchising
Licensing
Exports
– Direct vs Indirect
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6-7
Why FDI?
• FDI over exporting
– High transportation costs, trade barriers
• FDI over licensing or franchising
– Need to retain strategic control
– Need to protect technological know-how
– Capabilities not suitable for
licensing/franchising
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Pattern of FDI
• Follow main competitors
– Oligopolistic industries
– Interdependence of the few major competitors forces
immediate strategic responses
• International product life-cycle (Vernon, see Ch. 4)
• Eclectic paradigm of FDI (John Dunning)
– Combines ownership specific, location specific, and
internalization specific advantages that drive FDI choice
over a decision to enter through licensing or exports
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Eclectic Paradigm of FDI (Dunning)
• Ownership advantage: creates a monopolistic advantage
which can be used to prevail in markets abroad
– Unique ownership advantage protected through ownership
– e.g., Brand, technology, economies of scale, management know-how
• Location advantage: the FDI destination local market must
offer factors (land, capital, know-how, cost/quality of labor,
economies of scale) such that it is advantageous for the firm
to locate its investment there (link to trade theory)
• Internalization advantage: transaction costs of an armslength relationship --licensing, exports-- higher than
managing the activity within the MNE’s boundaries
Dunning, John H. (1980). “Towards an eclectic theory of international production:
Some empirical tests.” Journal of International Business Studies 11(2): 9-31
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Government Policy and FDI
• The radical view: inbound FDI harmful; MNEs
–
–
–
–
Are an instrument of imperialist domination
Exploit host to the advantage of home country
Extract profits from host country; give nothing back
Keep LDCs backward/dependent for investment, technology
and jobs
• The free market view: FDI should be encouraged
– Adam Smith, Ricardo, et al: international production should be
distributed according to comparative advantage
– The MNE increases the world economy efficiency because it
brings to bear unique ownership advantages on the local
economy’s comparative advantages
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Host Country Effects of FDI
• Benefits
– Resource -transfer
– Employment
– Balance-of-payment (BOP)
• Import substitution
• Source of export increase
• Costs
– Adverse effects on the BOP
• Capital inflow followed by capital outflow + profits
• Production input importation
– Threat to national sovereignty and autonomy
• Loss of economic independence
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Home Country Effects of FDI
• Benefits
– BOP current account adversely affected by inward flow
of foreign earnings
– Positive employment effect from increased exports of
raw materials / assemblies to the overseas subsidiary
– Repatriation of skills and know-how
• Costs
– BOP trade position is negatively affected (lower
finished goods exports)
– Loss of employment to overseas market
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Government Policy and FDI
• Home country
– Outward FDI encouragement
• Risk reduction policies (financing, insurance, tax incentives)
– Outward FDI restrictions
• National security, BOP
• Host country
– Inward FDI encouragement
• Investment incentives
• Job creation incentives
– Inward FDI restrictions
• Ownership extent restrictions (national security; local nationals
can safeguard host country’s interests
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6-14
Decision Framework for FDI
No
Are transportation costs
high?
Yes
No
Is know-how easy to
license?
Yes
Export
Yes
Yes
FDI
Yes
Is know-how valuable and
is protection possible?
FDI
No
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No
FDI
Tight control over foreign
ops required?
No
Import
Barriers?
License
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