Chapter 07 - Foreign Direct Investment

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International Business: The Challenges of

Globalization
Ninth Edition, Global Edition

Chapter 7
Foreign Direct Investment

Copyright © 2019 Pearson Education Ltd.


Learning Objectives
7.1 Describe the worldwide pattern of foreign direct
investment (FDI).
7.2 Summarize each theory that attempts to explain why FDI
occurs.
7.3 Outline the important management issues in the FDI
decision.
7.4 Explain why governments intervene in FDI.
7.5 Describe the policy instruments governments use to
promote and restrict FDI.

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Das Auto
• Volkswagen Group (www.vw.com)
– 48 production facilities
worldwide
– Sells to more than 150
countries
– Top-selling manufacturer in
South America and China
– China accounts for around
30% of VW’s total sales
• VW’s U.S. expansion
• Modular strategy
• Special protection in Germany

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Das Auto
• Volkswagen Group (www.vw.com) owns 10 of the most prestigious and best-known
automotive brands in the world.

• From its 48 production facilities worldwide, the company produces and sells around 8
million cars annually to more than 150 countries.

• Volkswagen is the top-selling manufacturer in South America and China.

• China accounts for around 30 percent of VW’s total sales.

• Volkswagen also has ambitious goals for its U.S. expansion. It is adapting designs to
domestic tastes, cutting prices, and adding inexpensive production capacity.

• The company uses a modular strategy in production that lets it use the same key
components in 16 different vehicles and 7 million units across its brands.

• Volkswagen, like companies everywhere, received plenty of help in getting where it is


today. Until recently, Volkswagen received special protection from its own legislation
known as the VW Law. The law gave the German state of Lower Saxony, which owns
20.1 percent of Volkswagen, the power to block any takeover attempt that threatened
local jobs and the economy. Volkswagen’s special treatment lies in the close ties between
government and management in Germany and its importance to the nation’s economy,
where it employs tens of thousands of people.
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Foreign Direct Investment
Foreign Direct Investment
• Purchase of physical assets or a significant amount of the
ownership (stock) of a company in another country to gain
a measure of management control
Portfolio Investment
• Investment that does not involve obtaining a degree of
control in a company

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Foreign Direct Investment
• International flows of capital are at the core of foreign direct
investment (FDI)—the purchase of physical assets or a significant
amount of the ownership (stock) of a company in another country in
order to gain a measure of management control.
• But there is wide disagreement on what exactly constitutes FDI.
Nations set different thresholds at which they classify an international
capital flow as FDI.
• The U.S. Commerce Department sets the threshold at 10 percent of
stock ownership in a company abroad, but most other governments set
it at anywhere from 10 to 25 percent. By contrast, an investment that
does not involve obtaining a degree of control in a company is called a
portfolio investment.

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Pattern of Foreign Direct Investment
Figure 7.1 Yearly Foreign Direct Investment Inflows

Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years.

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Pattern of Foreign Direct Investment
• As shown in Figure 7.1, global FDI inflows averaged $548 billion
annually between 1994 and 1999.
• FDI inflows peaked at around $1.4 trillion in 2000 and then slowed.
• FDI inflows benefitted from strong economic performance and high
corporate profits in many countries between 2004 and 2007, at which
point it reached an all-time record of more than $1.9 trillion.
• Global recession meant declining FDI inflows in 2008 and 2009.
• FDI inflows climbed again in 2010 and 2011; then dipped in 2012,
2013, and 2014; and then rose to nearly $1.8 trillion in 2015 as the
world emerged form recession.

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Drivers of FDI Flows
• Globalization
• Mergers and Acquisitions
• FDI in UAE

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1. Globalization: As countries lowered their trade barriers, companies realized that
they could now produce in the most efficient and productive locations and simply
export to their markets worldwide. This set off another wave of FDI flows into low-
cost emerging markets. The forces behind globalization are, therefore, part of the
reason for long-term growth in FDI.
2. International Mergers and Acquisitions: The number of mergers and acquisitions
(M&As) and their rising values over time also underlie long-term growth in FDI. In
fact, cross-border M&As are the main vehicle through which companies undertake
FDI.

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Figure 7.2 Value of Cross-Border Mergers
and Acquisitions

Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years.

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• The value of cross-border M&As peaked in 2000 at around $1.2
trillion.
• After three years of falling FDI, the value of cross-border M&As rose to
around $1 trillion by 2007.
• M&A activity then cooled in 2008 and then fell significantly in 2009 due
to the global recession.
• The value of cross-border M&A activity then fluctuated for several
years before climbing back to $721 billion by 2015.

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Worldwide Flows of FDI
• Driving FDI growth are more than 100,000 multinational
companies with more than 900,000 affiliates abroad.
• In 2012, developing countries attracted greater FDI inflows
than did developed countries.
• Developed countries account for 42 percent ($561 billion)
of total global FDI inflows.
• FDI inflows to developing countries accounted for around
52 percent of world FDI inflows ($703 billion).

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Worldwide Flows of FDI
• Driving FDI growth are more than 100,000 multinational companies
with more than 900,000 affiliates abroad, roughly half of which are in
developing countries.
• In 2014, for the first time ever, developing countries attracted greater
FDI inflows than did developed countries.
• Developed countries account for 41 percent ($522 billion) of total global
FDI inflows (more than $1.28 trillion in 2014).
• By comparison, FDI inflows to developing countries accounted for
around 55 percent of world FDI inflows ($699 billion).
• The remaining roughly four percent of global FDI inflows went to
countries across Southeast Europe in various stages of transition from
communism to capitalism.

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Quick Study 1
1. The purchase of physical assets or significant ownership
of a company abroad to gain a measure of management
control is called a what?
2. What are the main drivers of foreign direct investment
flows?
3. Why might a company engage in a cross-border merger
or acquisition?

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Theories of Foreign Direct Investment (1 of 8)
International Product Life Cycle

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Theories of Foreign Direct Investment (2 of 8)
• The international product life cycle theory states that a company begins by exporting
its product and then later undertakes FDI as a product moves through its life cycle.

• In the new product stage, a good is produced in the home country because of uncertain
domestic demand and to keep production close to the research department that
developed the product.

• In the maturing product stage, the company directly invests in production facilities in
countries where demand is great enough to warrant its own production facilities.

• In the final standardized product stage, increased competition creates pressures to


reduce production costs. In response, a company builds production capacity in low-cost
developing nations to serve its markets around the world.

• Despite its conceptual appeal, the international product life cycle theory is limited in its
power to explain why companies choose FDI over other forms of market entry.

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Theories of Foreign Direct Investment (3 of 8)
Market Imperfections (Internalization)
Types of Market Imperfections
• Trade Barriers
• Specialized Knowledge

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Theories of Foreign Direct Investment (4 of 8)
• Market imperfections theory states that when an imperfection in the market makes a
transaction less efficient than it could be, a company will undertake FDI to internalize the
transaction and thereby remove the imperfection.

• There are two market imperfections that are relevant to this discussion—trade barriers
and specialized knowledge.

• Trade Barriers: Tariffs are a common form of market imperfection in international


business. The presence of a market imperfection (tariffs) might cause companies to
undertake FDI.

• Specialized Knowledge: This knowledge could be the technical expertise of engineers


or the special marketing abilities of managers. When a company’s specialized knowledge
is embodied in its employees, the only way to exploit a market opportunity in another
nation may be to undertake FDI. The possibility that a company will create a future
competitor by charging others a fee for access to its knowledge is another market
imperfection that encourages FDI.

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Theories of Foreign Direct Investment (5 of 8)
Eclectic Theory
• Location Advantage
• Ownership Advantage
• Internalization Advantage

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Theories of Foreign Direct Investment (6 of 8)
• The eclectic theory states that firms undertake foreign direct investment when the
features of a location combine with ownership and internalization advantages to make a
location appealing for investment.

• A location advantage is the advantage of locating a particular economic activity in a


specific location because of its natural or acquired characteristics.

• An ownership advantage is a company advantage that arises from ownership of some


special asset, such as a powerful brand, technical knowledge, or management ability.

• And an internalization advantage is the advantage that arises from internalizing a


business activity rather than leaving it to a relatively inefficient market.

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Theories of Foreign Direct Investment (7 of 8)
Market Power

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Theories of Foreign Direct Investment (8 of 8)
• The market power theory states that a firm tries to establish a dominant market
presence in an industry by undertaking FDI.

• The benefit of market power is greater profit because the firm is far better able to dictate
the cost of its inputs and/or the price of its output.

• One way a company can achieve market power (or dominance) is through vertical
integration—the extension of company activities into stages of production that provide a
firm’s inputs (backward integration) or that absorb its output (forward integration).

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Quick Study 2
1. What imperfections are relevant to the discussion of
market imperfections theory?
2. Location, ownership, and internalization advantages
combine in which FDI theory?
3. Which FDI theory depicts a firm establishing a dominant
market presence in an industry?

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Management Issues and Foreign Direct
Investment
• Control
– Partnership requirements
– Benefits of cooperation

• Purchase-or-Build Decision
– Greenfield investment

• Production Costs
– Rationalized production
– Mexico’s Maquiladora
– Cost of research and development

• Customer Knowledge

• Following Clients

• Following Rivals
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Management Issues and Foreign Direct
Investment
• Control: Many companies investing abroad are greatly concerned with
controlling the activities that occur in the local market. Many companies
have strict policies regarding how much ownership they take in firms
abroad because of the importance of maintaining control.
Governments of developing and emerging markets realize the benefits
of investment by multinational corporations, including decreased
unemployment, increased tax revenues, training to create a more
highly skilled workforce, and the transfer of technology
• Purchase-or-Build Decision: Another important matter for managers
is whether to purchase an existing business or to build a subsidiary
abroad from the ground up—called a greenfield investment.

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Management Issues and Foreign Direct
Investment
• Production costs are important inputs to the FDI decision.
• One approach companies use to contain production costs is called rationalized
production—a system of production in which each of a product’s components is
produced where the cost of producing that component is lowest.
• Mexico’s Maquiladora: The combination of a low-wage economy nestled next to a
prosperous giant is now becoming a model for other regions that are split by wage
or technology gaps.
• Cost of Research and Development : As technology becomes an increasingly
powerful competitive factor, the soaring cost of developing subsequent stages of
technology has led multinational corporations to engage in cross-border alliances
and acquisitions.

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Management Issues and Foreign Direct
Investment
• Customer Knowledge: The behavior of buyers is frequently an
important issue in the decision of whether to undertake FDI.
• Following Clients: Firms commonly engage in FDI when the firms
they supply have already invested abroad.
• Following Rivals: FDI decisions frequently resemble a “follow the
leader” scenario in industries that have a limited number of large firms.
In other words, many of these firms believe that choosing not to make a
move parallel to that of the “first mover” might result in being shut out of
a potentially lucrative market.

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Quick Study 3
1. When adequate facilities are not present in a market, a
firm may decide to undertake a what?
2. A system in which a product’s components are made
where the cost of producing a component is lowest is
called what?
3. What do we call the situation in which a company
engages in FDI because the firms it supplies have
already invested abroad?

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Why Governments Intervene in F DI (1 of 4)
Balance of Payments
• Current Account
– National account that records transactions involving the
export and import of goods and services, income
receipts on assets abroad, and income payments on
foreign assets inside the country
• Capital Account
– National account that records transactions involving the
purchase and sale of assets

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• A country’s balance of payments is a national accounting system that records all
receipts coming into the nation and all payments to entities in other countries.

• The current account records transactions involving the import and export of goods and
services, income receipts on assets abroad, and income payments on foreign assets
inside the country.

• The capital account records transactions involving the purchase or sale of assets. These
assets include physical assets such as foreign direct investments in factories and
equipment, and financial assets such as shares of stock in a company abroad.

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Table 7.1 U.S. Balance of Payments Accounts (1 of 2)

CURRENT ACCOUNT Blank Blank Blank

Exports of goods and services and income receipts + Blank Blank

Merchandise + Blank Blank

Services + Blank Blank

Income receipts on U.S. assets abroad + Blank Blank

Imports of goods and services and income payments Blank Blank


Merchandise Blank Blank



Services Blank Blank

Income payments on foreign assets in United States Blank Blank

Unilateral transfers Blank Blank



Current account balance Blank
+/− Blank

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Table 7.1 U.S. Balance of Payments Accounts (2 of 2)
CAPITAL ACCOUNT Blank Blank Blank

Increase in U.S. assets abroad (capital outflow) Blank Blank



U.S. official reserve assets Blank Blank

Other U.S. government assets Blank Blank

U.S. private assets Blank Blank

Foreign assets in the United States (capital inflow) + Blank Blank

Foreign official assets + Blank Blank

Other foreign assets + Blank Blank

Capital account balance Blank


+/− Blank

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Why Governments Intervene in F DI (2 of 4)
Reasons for Intervention by the Host Country
• Control the Balance of Payments
• Obtain Resources and Benefits
– Access to Technology
– Management Skills and Employment

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• There are a number of reasons why governments intervene in FDI. Let’s look at the two
main reasons—to control the balance of payments and to obtain resources and benefits.
• Control Balance of Payments: Many governments see intervention as the only
way to keep their balance of payments under control.
• Obtain Resources and Benefits: Beyond balance-of-payments reasons,
governments might intervene in FDI flows to acquire resources and benefits such as
technology, management skills, and employment.
• Access to Technology: Investment in technology, whether in products or
processes, tends to increase productivity and the competitiveness of a nation.
• Management Skills and Employment: Former communist nations lack some of the
management skills needed to succeed in the global economy. By encouraging FDI,
these nations can attract talented managers to come in and train locals and thereby
improve the international competitiveness of their domestic companies.

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Why Governments Intervene in F DI (3 of 4)
Home Country: Discouraging Outward FDI
• Investing in other nations sends resources out of the home
country and lowers investment at home.
• Outgoing FDI may ultimately damage a nation’s balance of
payments by taking the place of its exports.
• Jobs resulting from outgoing investments may replace jobs
at home.

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• The following are among the most common reasons for discouraging outward FDI:
• Investing in other nations sends resources out of the home country and lowers
investment at home.
• An FDI outflow can damage a nation’s balance of payments if the investment abroad
eliminates an export market.
• And jobs created abroad by an FDI outflow may replace jobs in the home country.
• Home countries may also promote outward FDI.
• FDI outflows can increase long-term competitiveness if partnering abroad provides a
learning opportunity.
• FDI outflows can eliminate low-wage jobs in industries that use obsolete technology
or employ low-skilled workers at home.

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Why Governments Intervene in F DI (4 of 4)
Home Country: Promoting Outgoing FDI
• Increase Long-Term Competitiveness
• “Sunset” Industries

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• FDI is not always a negative influence on home nations. In fact, countries promote
outgoing FDI for the following reasons:
• Outward FDI can increase long-term competitiveness.
• Nations may encourage FDI in industries identified as “sunset” industries. Sunset
industries are those that use outdated and obsolete technologies or those that
employ low-wage workers with few skills.

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Quick Study 4
1. The national accounting system that records all receipts
coming into a nation and all payments to entities in other
countries is called what?
2. Why might a host country intervene in foreign direct
investment?
3. Why might a home country intervene in foreign direct
investment?

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Government Policy Instruments and F DI (1 of 3)

Host Countries
Promotion Restriction
• Financial incentives • Ownership restrictions
– Low or waived taxes – Prohibit investment
– Low-interest loans • Performance demands
• Infrastructure improvements – Local content
– Better seaports, roads, and requirements
telecom networks – Export targets
– Technology transfer

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Government Policy Instruments and FDI
(1 of 3)
• Host countries offer a variety of incentives to encourage FDI inflows. These take two
general forms—financial incentives and infrastructure improvements.
• Financial Incentives: Host governments of all nations grant companies financial
incentives to invest within their borders. One method includes tax incentives, such
as lower tax rates or offers to waive taxes on local profits for a period of time—
extending as far out as five years or more. A country may also offer low-interest
loans to investors.
• Infrastructure Improvements: Because of the problems associated with financial
incentives, some governments are taking an alternative route to luring investment.
Lasting benefits for communities surrounding the investment location can result from
making local infrastructure improvements—better seaports suitable for containerized
shipping, improved roads, and advanced telecommunications systems.

• Host countries also have a variety of methods to restrict incoming FDI. Again, these take
two general forms—ownership restrictions and performance demands.
• Ownership Restrictions: Governments can impose ownership restrictions that
prohibit nondomestic companies from investing in certain industries or from owning
certain types of businesses.
• Performance Demands: More common than ownership requirements are
performance demands that influence how international companies operate in the
host nation.
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Government Policy Instruments and F DI (2 of 3)
Home Countries
Promotion Restriction
• Insurance on assets abroad • Higher taxes on
• Loans and loan guarantees foreign income

• Special tax treaties • Sanctions that


prohibit investing in
• Tax breaks on profits earned certain nations
abroad
• Persuade other nations to
accept FDI

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Government Policy Instruments and FDI
(2 of 3)
• To encourage outbound FDI, home-country governments can do any of the following:
• Offer insurance to cover the risks of investments abroad, including, among others,
insurance against expropriation of assets and losses from armed conflict,
kidnappings, and terrorist attacks.
• Grant loans to firms wishing to increase their investments abroad.
• Offer tax breaks on profits earned abroad or negotiate special tax treaties.
• Apply political pressure on other nations to get them to relax their restrictions on
inbound investments.

• On the other hand, to limit the effects of outbound FDI on the national economy, home
governments may exercise either of the following two options:
• Impose differential tax rates that charge income from earnings abroad at a higher
rate than domestic earnings.
• Impose outright sanctions that prohibit domestic firms from making investments in
certain nations.

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Government Policy Instruments and F DI (3 of 3)
Table 7.2 Instruments of FDI Policy

Blank FDI Promotion FDI Restriction


Host Countries Tax incentives Ownership restrictions
Blank Low-interest loans Performance demands
Blank Infrastructure improvements Blank
Home Countries Insurance Differential tax rates
Blank Loans Sanctions
Blank Tax breaks Blank
Blank Political pressure Blank

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Quick Study 5
1. What policy instruments can host countries use to
promote FDI?
2. What policy instruments can home countries use to
promote FDI?
3. Ownership restrictions and performance demands are
policy instruments used by whom to do what?
4. Differential tax rates and sanctions are policy instruments
used by whom to do what?

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Copyright

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