Chapter 8

Foreign Direct Investment

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 Foreign Direct Investment (FDI)
• What is it? Occurs when a firm invests directly in facilities to produce
or market a good or service in a foreign country.
• According to US Law: FDI = adopting a share of at least 10% of a
foreign business entity.
• Examples: Apple; Migros; Volkswagon, etc.
• Overview:
1. Importance of FDI to the world economy
2. Theories of FDI
3. Government Policies regarding FDI
4. Benefits and Harms
 Terminology of FDI
• Stock of FDI: The total accumulated value of foreign-owned assets
over a period of time.
• Flow of FDI: Amount of FDI undertaken over a period of time.
• Outflows of FDI: Flow of FDI out of a given country
• Inflows of FDI: Flow of FDI into a given country.
• Home and Host Country
• Form of FDI
 Terminology of FDI
• Foreign Entry Modes
• Exporting
• Licensing
• Franchising
• Turnkey Contracts
• Partnerships
• FDI
• Acquisition
• Greenfield Investment
• Form of FDI:
1. Acquisition: Acquiring or merging with an existing firm in a foreign country.
2. Greenfield Investment: Establishment of a new operation in a foreign country (start from the
scratch).
- Which one is easier / less risky?
 FDI Trends (1990 – 2016)
• FDI Increased by six fold
• World Trade Increased by Fourfold
• World Output Increased by 60%

FDI has been more rapid:

1. FDI a way of Circumventing Trade
barriers,
2. Shift towards more democratic
and free market economies in the
world creates more favorable
conditions for FDI.
Theories of FDI (The Three Perspectives):
1. Why FDI Is Preferred?
• FDI is riskier and more expensive than other international entry
strategies.
• Why should firms bother establishing operations abroad or risk
buying them abroad while there are easier strategies (e.g.,
exporting, licensing).
Theories of FDI (The Three Perspectives):
1. Why FDI Is Preferred?
• Exporting: Producing home and selling them abroad
• Disadvantages of Exporting
1. High Transportation Costs: especially true for products with low value-to-
weight ratio (e.g., cement). It is more profitable for Cemex (Mexican
Cement Producer) to expand through FDI than exporting.
2. Inefficient when there are trade barriers (e.g., tariffs): FDI preferred.
• FDI will be a better choice when the transportation costs are high
and there are tough trade barriers.
 Theories of FDI (The Three Perspectives):
1. Why FDI Is Preferred?
• Licensing: Granting a foreign entity the permission and right (or license) to
produce and sell the firm’s product in return for a royalty (fee).
Why FDI preferred over Licensing: Internalization Theory
• Licensing has three main drawbacks
1. Giving away valuable technological know-how to a potential foreign competitor.
(e.g., RCA giving away to Sony).
2. No tight control over production, marketing, distribution, and the overall strategy
of the target country Some capabilities are not amenable to licensing (e.g., Toyota)
3. Transfer of knowledge is difficult or impossible (Toyota).
• THUS: FDI may be preferred due to: Transportation Costs; trade barriers;
control; and difficulty in transferring processes and capabilities.
 Burberry in Japan
• What does Burberry sell?
• What is the entry mode of Burberry
in Japan?
• What problems did they face?
• What did they do finally?
• What is the risk?
Theories of FDI (The Three Perspectives):
2: Patterns of FDI
Key Argument: FDI flows are reflections of rivalry. Firms often undertake
FDI at the same time and target the same markets.
• Strategic Behavior:
• KnickerBocker’s Theory: Firms imitate one another in oligopolistic Industries.
• Oligopoly: few firms control more than 80% of the market. So they are
interdependent. One move by one affects the others.
• Imitative Behavior: Reducing prices, increasing capacity, innovating, etc.
• How about FDI?
• Make sure that a competitor does not gain a commanding position in a market
and then use the profits generated there to subsidize the competitive attacks
in other markets.
• Toyota and Nissan follow Honda investing in the USA; Kodak & Fuji
Theories of FDI (The Three Perspectives):
3: Eclectic Paradigm
• This theory agrees with Internalization theory: The combination
occurs best through FDI.
• The Eclectic Paradigm (John Dunning): Location-specific advantages
are also important in explaining both the rationale for and direction of
FDI.
• Mostly refers to natural resources (e.g., oil companies; cheap labor).
• The advantages that arise from utilizing resource endowments or
assets that are tied to a particular foreign location and that a firm
finds valuable to combine with its own unique assets.
Geely Goes Global
1. Why did Geely acquire Volvo? What are the benefits
of acquisition? What are the potential costs and
risks?
2. Why Acquisition, but not licensing from Volvo?
3. Following the Volvo acquisition, Geely built a new,
wholly owned factory to produce Volvo cars in the
United States. Why not licensing or exporting?
• Better understand customers; avoid transportation and
tarrifs; “Made in America” Image; …
4. What are the benefits and costs to the US Economy?
 Political Ideology and FDI

Dogmatic Radical Stance Pragmatic Noninterventionist

Nationalism Stance
 Political Ideology and FDI
The Dogmatic Radical Stance
• Multinational firm is the instrument for imperialist domination.
• Gains are sent back to the home country
• All the key technology and knowledge is controlled by the MNE, keeping the
host country backward and dependent.
• Thus, Inward FDI should not be allowed (Extreme View).
• Most common between 1945 & 1980s.
• Ex-Soviet countries; Cuba, North Korea, Cuba, Iran.
 Political Ideology and FDI
The Free Market View
• International production should be distributed among the countries according to the
theory of comparative advantage.
• MNE and FDI is a means to distribute efficient production and increase world
production efficiency.
• What do countries adopt in reality?
Pragmatic Nationalism
• Both Approaches have their pros and cons.
• FDI should be allowed as long as the benefits outweigh costs.
• Japan Example: FDI was not allowed unless it worked as a significant stimulus for the
economy (i.e., benefits > costs).
• Pragmatic Nationalists often compete to attract FDI through incentives such as tax
breaks or grants.
 Costs & Benefits: Host Country Benefits
• Resource Transfer Effects
• Capital;
• production skills;
• technology and productivity;
• management skills.
• Employment Effects (Direct and Indirect)
Costs & Benefits: Host Country Benefits
Balance of Payments Effects: a country’s net payments and
receipts from other countries.
• Deficit in current account (Exports < Imports) can be worrying
for any country.
• One way to support current account deficit is to sell assets to
foreigners that is not interesting.
• How to run a current account surplus through FDI?
1. FDI is a substitute for imports
2. FDI increases the exports: China exports ($26 billion in 1985; $250
billion by 2001; and $969 billion in 2006).
 Costs & Benefits: Host Country Benefits
• Effects on Competition and Economic Growth

Lower Prices; Increased productivity,

More Competition &
FDI consumer welfare; innovation, and
Production
more R&D Economic Growth
 Costs & Benefits: Host Country Costs
• Adverse effects on competition
• More relative power of MNEs
• Adverse Effects on Balance of Payments
• Inflows are set off by outflows of capital to the
parent company.
• MNE imports a substantial amount/number
of inputs (e.g., Japanese owned auto
operations in the USA).
• Effects on National Sovereignty
 Costs & Benefits: Home Country Benefits
& Costs
Balance of payments from foreign operations
- Capital required to finance foreign operations; if FDI is a substitute for
exports
 Employment effects
- Employment Effects
 Learning skills that can be transferred to the home country
 Government Policies & Regulation
• In the broad sense, policies could be divided into two sets of policies including home-country policies
and host-country policies.
Home Country
• Encouraging Inward / Outward FDI
• Risk Insurance
• Capital Assistance
• Tax Incentives
• Political Pressures
• Tax Concessions
• Low Interest Loans
• Grants or Subsidies
• Example: France and Britain competition to gain more FDI from Toyota. Interstate Competition among
USA states.
• Restricting Outward FDI: Tax rules, forcing, limiting outward flows of capital (Britain between 1960s and
1979).
 Government Policies & Regulation
Host Country
Restricting Inward FDI
Instruments:
• Ownership Restraints:
• Total Exclusion: Exclusion from tobacco and mining in Sweden and from the
development of certain natural resources in Brazil, Finland, and Morocco.
• Partial Exclusion: Restrictions on the specific proportion of the equity of the subsidiary
Example: Foreign ownership is restricted to 25 percent or less of an airline in the United
States.
Motivation
1. National Security or Competition
2. Local owners can help maximize the resource transfer
Geely Goes Global
1. Why did Geely acquire Volvo? What are the benefits
of acquisition? What are the potential costs and
risks?
2. Why Acquisition, but not licensing from Volvo?
3. Following the Volvo acquisition, Geely built a new,
wholly owned factory to produce Volvo cars in the
United States. Why not licensing or exporting?
• Better understand customers; avoid transportation and
tarrifs; “Made in America” Image; …
4. What are the benefits and costs to the US Economy?
 The Country Rankings on FDI and Other
Factors

• https://globaledge.msu.edu/global-resources/rankings
• https://
unctadstat.unctad.org/wds/ReportFolders/reportFolders.aspx
 Group Project: Module 1
• Assessment of the general market potential of the country:
• Market Potential Index (MPI)
• Industry-focused MPI
Steps to follow:
1. Identification of the overall capacity and market potential of the
country
2. Identification of the degree to which the focus industry has high
potential
3. Identification of the other specific factors that make the country /
industry potentially profitable for your product.
 Group Project: Module 2
Questions To Be Addressed
1. Who are the main competitors in the target country?
2. How are they performing (i.e., their market share, revenues, sales, etc.)
3. What are their weaknesses and strengths?
• Strengths: Strong network, market share, consumer loyalty, government support, etc.
• Weaknesses: inability to meet a specific demand, etc.
4. What are the main threats of these competitors?
5. What are our weaknesses and strengths?
6. How shall we use our strengths to defend against them? How will our strengths
help us meet a demand that they cannot?
7. Other elevant questions