Topic 7

Foreign Direct Investment

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Learning Objectives

LO 7-1 Recognize current trends regarding foreign

direct investment (FDI) in the world economy.
LO 7-2 Describe the various forms of FDI based on
the nature and purpose of investment
LO 7-3 Explain the different rationales for FDI.
LO 7-4 Discuss the benefits and costs of FDI to home
and host countries.
LO 7-5 Identify the range of policy instruments that
governments use to influence FDI.
Outline
 Introduction
 FDI Historical Trends
 Forms of FDI
 M&A and Greenfield Investment
 Horizontal and Vertical Direct Invesment
 Rationale for FDI
 Why FDI?
 Benefits and Costs of FDI
 Host country
 Home country
 Government Incentives and Disincentives for FDI
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Introduction
 Foreign Direct Investment (FDI) occurs when:
 a firm invests directly in facilities to produce
and/or market a product in a foreign country.
 undertaking FDI transforms a firm to a MNC
 the parent company holds at least 10% share of a
foreign subsidiary, i.e., management and voting
rights (IMF)
 FDI Terminology
 Home country: source of FDI
 Host country: destination of FDI

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FDI in the World Economy
 FDI has grown more rapidly than world trade.
 Potential reasons:
 Firms still fear protectionist policies.
 The shift towards transparent political institutions and
free market economies makes FDI more attractive.
 The necessity of globalizing production to gain/maintain
competitive edge prompts firms to invest globally.
 Direction of FDI
 Historically, FDI has been directed towards the developed
nations – US and EU being favorite destinations
 But recently, developing and transition economies have also
been major recipients of FDI.
 East, S.E. and S. Asia, and in particular China are significant hosts.
 S. America is also emerging as an important host for FDI.

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FDI Inflows: Global and Economic Groups
2005-2016 (billion$)

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FDI Inflows by Region 2014-2016
(billions of $)

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 FDI Inflows 2015-16 ($bn) FDI Outflows 2015-16 ($bn)

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 Rise of China as a source of FDI
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Forms of FDI: Nature
 Two forms of FDI depending on the nature
of the investment:
 Greenfield Investment
 the establishment of a wholly new operation in a foreign
country
 Volkswagen Group’s establishment of automobile plants in
China, through it’s joint venture subsidiaries, in Anting,
Changchun etc.
 Mergers and Acquisitions (M&A)
 acquiring or merging with an existing firm in the foreign
country
 E.g. Geely
automotive company from China acquiring Volvo (a
Swedish automotive company) from Ford Motors
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Why Greenfield Investment?
 Greenfield investments mostly occur when
 Mergers & Acquisitions (M&A) is ruled out
 no target company exists or provide the desired
products,
 potential target companies are not amenable
towards M&A
 Local government offers incentives encouraging
greenfield investment.
 Greenfield investment is more common in
developing countries, while M&A are more
prevalent in developed countries (Why?)
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Advantages of M&A over Greenfield
Investment
 Ideally, firms prefer M&A over Greenfield
investment:
 Quicker Entry - M&A are quicker to execute than greenfield
investment.
 Less Risky – Less risky for a firm to acquire desired assets
than build them from scratch.
 More Efficient - Increase in efficiency of M&A target firms
can be achieved simply by transferring capital, technology, or
management skills. (e.g. Cemex, Mittal Steel).
 Reduces Competition - M&A automatically helps in
eliminating competitors.
 Strategically Valuable - M&A target firms might have
strategic assets (tangible or intangible) that can be valuable
to acquire.
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Forms of Investment: Purpose
 Two forms of FDI depending upon the purpose for
investment:
 Horizontal Direct Investment - FDI towards the production
of the same good or service in the foreign location as the
one being produced domestically (e.g. automobile companies
setting up plants to produce cars in foreign locations).
 Purpose: either to enter protected foreign markets or utilize
local advantages in cost and quality of production.
 Vertical Direct Investment
 Backward Direct Investment: Investment into an industry that
provides inputs/components for the parent company’s existing
production. (e.g., VW acquiring component manufacturers in China)
 Forward Direct Investment : Investment in an industry that utilizes the
production/facilitates the sales of the parent company’s existing
products (e.g.,VW acquiring a large number of car dealers in US)
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Why FDI?
 Theories explaining the rationale for FDI can be
categorized into:
 Reactive Theories – Firms are FORCED into FDI
 Proactive Theories – Firms WANT to undertake FDI
 Reactive Theories – Why FDI instead of exporting or
licensing?
 Need to consider limitations of exporting & licensing
 Exporting - selling abroad goods produced at existing
production plants
 Licensing – a firm (licensor) grants a foreign entity (licensee) the
right to produce/market the firm’s product
 Proactive Theories – Need to consider the
advantages of FDI
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Theories of FDI: Limitations of Exporting
 Limitations of Exporting
 A firm will favor FDI over exporting as an
entry strategy when
 transportation costs are high, since
exporting can be unprofitable in such
circumstances
 E.g. commodities with low value-to-weight ratio like
cement
 there are actual or threatened trade
barriers such as import tariffs or quotas
 E.g. FDI
by Japanese auto companies in the US in 1980s
due to quotas

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Theories of FDI: Limitations of Licensing
 Limitations of Licensing – “Internalization Theory”
suggests that licensing has three major drawbacks:
 Licensing results in a firm giving away valuable
proprietary technology thus creating a potential
foreign competitor.
 Licensing does not give tight control over licensee in
the context of:
 Pricing strategy (short term profit vs long term growth).
 Operation strategy (local input vs imported input).
 Expansion Strategy (speed of market expansion)
 Licensing is inappropriate if the firm’s competitive
advantage is embedded in its organization and
management and hence is not easily transferred.
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Theories of FDI: Strategic Behavior
 Strategic Behavior or Knickerbrokers Theory - FDI
flows reflect strategic rivalry between firms
 In oligopolistic industries, i.e. industries composed of a
limited number of large firms, firms’ decisions are
strategically interdependent.
 Such strategic interdependence tends to make firms
imitate each others investment decisions to avoid
competitive disadvantage.
 e.g. Toyota and Nissan imitated Honda by undertaking
their own FDI in the US and Europe
 Reflects Multipoint Competition
 firms competing against each other in multiple
markets to avoid cross-market subsidization
 e.g. Canon, Olympus and Nikon competing against each
other around the world

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 Theories of FDI: Product Life Cycle Theory
 Product Life Cycle Theory
 The life-cycle of a product goes through three
stages:
 New product
 Mature product
 Standard product
 Argues that firms undertake FDI at particular stages in the
life cycle of a product they have pioneered
 Firms invest in other countries when local demand in those
countries grows large enough to support local production
(mature product).
 Firms shift production to low-cost developing countries when
product standardization and market saturation create price
competition and cost pressures (standard product).

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Theories of FDI: Location Specific
Advantages
 Location-Specific Advantages
 Advantages that arise from using
resource endowments or assets that are:
 tied to a particular foreign location
(geographically immobile)
or/and are
 valuable to the firm when combined with its
own unique assets.
 Example: Combining semi-skilled low-cost
labor (for manufacturing) in developing
countries with highly-skilled labor (for R&D)
in developed countries.
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Theories of FDI: Eclectic Paradigm
 Eclectic Paradigm
 Argues that in addition to Location-specific
Advantage and Internalization Theory the
additional factor of externalities must be
considered as an important rationale for
FDI by firms.
 Externalities: Knowledge spillovers that
occur when companies in the same
industry locate in the same area.
Example: Silicon-Valley

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Benefits of FDI to Host Country
 Main benefits of FDI for a host country:
1. Resource transfer effect
o FDI can make a positive contribution to a host economy by
supplying capital, technology, and management resources that
would otherwise not be available
2. Employment effect
o FDI can bring jobs to a host country that would
otherwise not be created there
o Direct employment:
o MNCs directly employ citizens of the host country.
o Indirect employment:
o MNCs’ suppliers create jobs in the host country.
o MNCs’ and their suppliers employees increase spending
and create jobs in the host country (expenditure
multiplier effect).

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Benefits of FDI to Host Country
3. Effect on BOP

• Initial capital inflow when MNE establishes

Capital A/C business increases capital a/c balance
surplus

• FDI is a substitute for imports of goods and

Current
A/C
services, therefore it increases current a/c surplus
surplus

• If the MNE uses a foreign subsidiary to export

Current goods and services to other countries, it
A/C increases the current a/c surplus
surplus

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Benefits of FDI to Host Country
4. Competition and Economic Growth Effect
o Greenfield investment increases the level of competition in a
market, where increased competition can lead to:

product and greater

increased
process economic
productivity
innovation growth

decrease
higher greater
in
purchasing economic
consumer
power growth
prices

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(Perceived) Costs of FDI to Host Country
 Costs of inward FDI are perceived due to:
1. Adverse Effects on Competition
 MNC’s or their subsidiaries through M&A or Greenfield
investment in a host country may reduce the level of competition
in that market thereby (which prior rationale?)
 creating monopoly power which will reduce competition, increase
consumer prices and reduce consumer choices.
2. Effect on BOP
 Earnings brought home (repatriation profits) by MNEs leads to
outflow of capital from host country.
 Intermediate goods (inputs) imported for further processing
decreases BOT in the host country’s current account.
3. Loss of National Sovereignty and Autonomy
 host governments worry that FDI is accompanied by some shift
of economic power from host country to home country
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Benefits of FDI to Home Country
1. Structural evolution of the economy by
freeing up resources for higher value
activities in the home country.
2. Lower cost of production in host country
leading to lower prices in the home country.
3. Reverse “resource transfer effect”- gains in
knowledge and skills from operating in a
foreign environment.
4. Improve home country’s BOP from inward
flow of foreign earnings.

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Costs of FDI to Home Country
1. Adverse Employment Effects
 Loss of jobs leading to structural unemployment
2. Effect on BOP
 Initial capital outflow required to finance the FDI
 however, this effect is usually more than offset by the subsequent
inflow of foreign earnings
 If purpose of FDI is for the MNE to use low-cost foreign
subsidiary to serve home market, the current account is
affected by the increase in imports.
 If the MNE uses foreign subsidiary as a substitute for
direct exports from home country then the current
account is again affected by the reduction in exports.

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Government Incentives for FDI
 Incentives used by the government to encourage
outward FDI from home country:
 Government-backed insurance program covering foreign
investment risks due to expropriation, war losses, inability to
transfer profits back home, etc.
 Special funds or banks to make government loans to firms
wishing to invest in developing countries.
 Elimination of double taxation of foreign income.
 Incentives used by the government to encourage inward
FDI in host country:
 Tax concessions
 Low interest loans, grants or subsidies.
 Increase in government spending on infrastructure

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Government Disincentives for FDI
 Disincentives used by the government to discourage
outward FDI from home country:
 Limiting capital outflows
 Example: Exchange control regulations in many countries.
 Manipulate tax rules to encourage domestic investment
 Example: a corporation tax system that taxes companies’ foreign
earnings at a higher rate than their domestic earnings.
 Restrictions on investing in certain countries for political
reasons
 Example: Formal U.S. rules prohibits U.S. firms from investing in
countries such as Cuba and Iran, whose political ideology and actions
are judged to be contrary to U.S. interest.

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Government Disincentives for FDI
 Disincentives used by the government to restrict
inward FDI in host country:

Ownership Totally excluding Performance

Restraints foreign Requirement Controls over the
companies from behavior of the MNE’s
certain industries local subsidiary
(e.g., national
defense)
local content requirement
Imposing a technology transfer
ceiling on foreign requirement.
ownership export requirement
(frequently < 50%) local participation in top
management

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Implications for Managers
 Implications of FDI theories on decision framework of
managers

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Summary
In this topic we have
 Understood how political ideology shapes a
government’s attitudes toward FDI.
 Recognized current trends regarding foreign direct
investment (FDI) in the world economy.
 Explained the different theories of FDI.
 Described the benefits and costs of FDI to home and
host countries.
 Explained the range of policy instruments that
governments use to influence FDI.
 Identified the implications for managers of the theory
and government policies associated with FDI.
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