Lecture 4
Foreign Direct Investment
© Ram Mudambi, Temple University, 2007
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1. Foreign Direct Investment
2. The Political Economy of
Foreign Direct Investment
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DaimlerChrysler – Group Sales by
Region - 2004
Units in ‘000s
NAFTA
US
62.3%
71.1%
West
Europe
20.5%
Germany
9.9%
Japan
1.1%
WORLD Total = 3,903
Is this an accurate picture of the firm’s global footprint?
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Mercedes – Group Sales by Region 2004
Units in ‘000s
NAFTA
US
18.5%
19.9%
West
Europe
66.6%
Germany
32.2%
Japan
3.5%
WORLD Total = 3,903
What is the unit value of Mercedes relative to Chrysler?
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What is Foreign Direct
Investment (FDI)?
FDI occurs when a firm invests directly in
facilities to produce and/or market a product or
service in a foreign country.
FDI is not the investment by individuals, firms
or public bodies in foreign financial
instruments (PORTFOLIO INVESTMENT)
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A firm buying
a firm in
another country
FDI Taxonomy
A firm setting
up a de novo
operation in
another country
Controlling
interest
Minority
interest
MODE
Greenfield
Acquisition
Whollyowned
1
3
Partially
owned
2
4
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Targets
necessary
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Flow vs Stock of FDI
Flow: Amount of FDI over a period of time
(one year).
Stock: Total accumulated value of foreign
owned assets at a given point in time.
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FDI outflows, 1982-2002
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FDI flows by region
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FDI outflows by select country
1998-2001
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World GDP, exports and FDI
World GDP and FDI 1990-2001 (index = 100 in 1990)
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Secular pattern
FDI Growth > Trade growth > Output growth
Gross Fixed Capital Formation
A summary of the total amount of capital
invested in factories, stores office buildings,
and the like.
All things being equal, the greater the
capital investment in an economy, the more
favorable its future growth prospects are
likely to be.
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Inward FDI flows
As a percentage of gross fixed capital formation, 2000
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FDI Inflow for Selected Countries
% of total capital investment, 2005
45
40
35
UK
Sweden
Chile
Argentina
China
India
Japan
30
25
20
15
10
5
0
2005
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MACRO
Why is FDI growing more rapidly
than world trade or output?
World political and
economic change
Wider acceptance
of MNC operations
Movement of operations to the
most efficient location
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MICRO
Why is FDI growing more rapidly
than world trade or output?
Growing power of regional
economic blocs
Improved logistics
EU, NAFTA, Mercosur, etc.
Strategy of extra-bloc
firms to become ‘domestic’
– ‘tariff-jumping’
Most international
trade is intra-firm
Movement of operations to the
most efficient location
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Two Forms of FDI
HOME
Backward
Vertical FDI
Location 1
Stage 1
Horizontal FDI
Forward
Vertical FDI
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HOST
Location 2
Stage 0
Location 2
Stage 1
Location 2
Stage 2
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FDI – composition changes
FDI been growing in terms of volume, but
it has also been changing in its composition
 Increasingly FDI represents a considerable
amount of transfer of knowledge
Know-how and skills
Scientific knowledge
Organizational knowledge
Multinational firms do not like to give up
control of this knowledge
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Impediments to the Sale of Knowhow
Risk giving away
know-how to
competitors
Impediments to
the sale of knowhow
Licensing implies
low control over
foreign entity
Know-how not
amenable to
licensing
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HFDI, When and Why?
Transportation too costly?
Most cited: Market Imperfections (Internalization
Theory).
Impediments to the free flow of products between nations.
Impediments to the sale of know-how.
Follow the lead of a competitor - strategic rivalry.
Product Life Cycle - however, does not explain when it’s
profitable to invest abroad.
Location specific advantages (natural resources).
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HFDI, Where?
The Stage Theory of FDI
Firms first expand into host countries that
are culturally close to the home country
US, Australia, New Zealand
British firms
Canada, Mexico
US firms
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The Stage Theory:
Wal-Mart International
INTERNATIONAL DISCOUNT STORES
Argentina
0
Brazil
0
Canada
144
Mexico
347
Puerto Rico
9
China
0
Germany
0
SUPERCENTERS
6
5
0
27
0
2
21
SAM'S CLUB
3
3
0
28
5
1
0
International Totals:
61
40
500
Wal-mart has since withdrawn
from Germany
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HFDI – A Decision Framework
How high are
transportation costs and
tariffs?
Low
Export
High
Is know-how amenable to
licensing?
No
Horizontal FDI
Yes
Horizontal FDI
No
Horizontal FDI
Yes
Is tight control over foreign
operation required?
No
Can know-how be protected
by licensing contract?
Yes
License
Case: FDI and the Irish miracle
FDI in Ireland grew from $164m (1985) to
$24b (2000) (roughly 150 fold!)
By 2000 two-thirds of Irelands top exporters
were MNEs
Reasons for Ireland’s success
Member of EU (access to EU markets)
Highly educated workforce; Good infrastructure
In 1985, Ireland was the 2nd poorest
W.European country. Today it is the 2nd
richest.
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FDI into China – Success story?
Second Largest Recipient of FDI After US
US
Japan Taiwan
Hong Kong
Other
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Hong Kong
Other
US
Japan
Taiwan
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Changing Face of China’s
Foreign Investment
1992
2002
Joint Ventures
70%
48%
Wholly owned foreign
subsidiaries
30%
52%
Source: McKinsey & Co
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FDI – China vs. the US
China
The US
• High percentage from
other developing
countries
• Largely greenfield
• Largely asset seeking
• Large amount of
‘round-tripping’
• High percentage from
other developed
countries
• Largely by acquisition
• Largely market seeking
However, recently:
• More market seeking FDI
• More FDI from developed countries
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The Political Economy of
Foreign Direct Investment
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The Spectrum of Political
Ideology Toward FDI
Radical
View
Pragmatic
Nationalism
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Free
Market
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Radical View
Marxist view is that MNE’s enslave less
developed countries.
Instrument of domination
not development.
Popular from WWII to the 1980s.
Practiced by Eastern Europe, India, China, 3rd
World Countries.
Ended with the collapse of Communism.
Bad performance by those countries vs. those
with freer market approach
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Free Market View
Sees FDI as way to disperse production and
flow of goods and services in the most
efficient manner.
Supported by Smith and Ricardo and ‘market
imperfection’ explanations of FDI.
However, all countries impose some
restrictions on FDI.
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Pragmatic View
Lies somewhere between
radical and free market
views.
Governments should
maximize national benefits
and minimize costs of FDI.
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Ideology and FDI
Ideology
Characteristics
Marxist roots
Radical
Views FDI as an
imperialist tool
Classical economic
roots
Free Market
FDI as a tool for
efficient location of
operations
Pragmatic
Nationalism
FDI has both
benefits and costs
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Host-Government
Policy Implications
Prohibit FDI
Nationalize MNC
subsidiaries
No restrictions on
FDI
Court targeted
MNCs
Tailor incentives
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What do the data tell us? – 1
MNC economic interests are
overwhelmingly concentrated in the triad –
North America, Europe and Japan/East Asia
There is no evidence that triad governments
are subject to ‘control’ by MNCs
Competitive pressures cause MNCs to cancel each
other out
Activities outside the triad are too
insignificant to justify expense of political
activities
E.g., a recent CIMA study found that most MNCs
followed ‘whiter than white’ accounting practices
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What do the data tell us? – 2
Globalization refers to FDI, not financial flows
FDI flows are extremely stable
MNC strategies tend to be regional, rather than
global, reflecting regional trading blocs
Fears of global homogenization are over-rated
EU, NAFTA, Mercosur, APEC
MNCs tend to be “flagship firms” – serve as
hubs of extensive business networks/clusters
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Benefits of FDI to Host Countries
Resource-transfer effects
Capital, technology, management
Employment effects
Balance-of-payments effects
Economic growth
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FDI and resource-transfer effects
HOST
Inflow of capital
Subsidiary
HOME
Parent
Spillover
of
technology
and
management
practices
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FDI and employment effects
HOST
Subsidiary
Direct
local
jobs
created
Jobs created
in local
supplier &
ancillary
network
Jobs lost in local
firms that are
driven out of
business
Jobs created due to increased
income generation
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FDI and balance of payments
Taxes, tariffs
and other
HOST
payments
to the govt. Subsidiary
(+)
Local
output
replaces
imports
Subsidiary
(+)
exports
(+)
Inflow of capital
(+)
HOME
Parent
Repatriated
profits (-)
3rd Country
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Economic Growth
Increased:
 productivity growth,
product and process innovation,
and greater economic growth,
Stemming from increased competition of
MNE’s investments.
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How Do Countries Encourage
FDI?*
Risk insurance.(Home)
Elimination of double taxation. (Home)
Tax incentives.(Host)
Low interest rates. (Host)
Grants for land and training of workforce
(Host)
Stable government and stable policies (Host)
*See http://sbm.temple.edu/~rmudambi/Publications/Mudambi%20IJEB.pdf
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How Do Countries Discourage
FDI?
Limit capital outflows. (Home)
Manipulate tax code to encourage domestic
investment. (Home)
Political restrictions on investing in certain
countries. (Home)
Ownership restraints. (Host)
Performance requirements. (Host)
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Vernon’s Obsolescing Bargain:
Determinants of Bargaining Power
Bargaining Power of Firm
High
Low
Firms time horizon
Long
Short
Comparable alternatives open to
firm
Many
Few
Value placed by host
government on investment
High
Low
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Takeaways
FDI has been rising faster than GDP or trade
Rising power of regional blocs; better logistics
HFDI – customization
VFDI – value chain disaggregation
FDI as a powerful economic stimulant
Examples – Ireland, China
Pragmatic view of MNEs – use with care
Potential benefits of FDI
Resource transfer, employment, BOP, growth
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