Firms prefer fdi to licensing because

Global Business Today 6e

by Charles W.L. Hill

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7

Foreign Direct Investment

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Introduction

Question: What is foreign direct investment?

Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country
Once a firm undertakes FDI it becomes a multinational enterprise
There are two forms of FDI
A greenfield investment (the establishment of a wholly new operation in a foreign country)
Acquisition or merging with an existing firm in the foreign country
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Foreign Direct Investment
in the World Economy

There are two ways to look at FDI
The flow of FDI refers to the amount of FDI undertaken over a given time period
The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time
Outflows of FDI are the flows of FDI out of a country
Inflows of FDI are the flows of FDI into a country
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Internet Extra: Each year, Fortune magazine publishes a list of the 500 largest global corporations in the world. Go to the magazine’s web site {http://money.cnn.com/magazines/fortune/global500/2008/index.html} and explore the list. Which country has the most companies on the list? Which region of the world is most represented? Are there any new entrants? Are certain industries better represented than others? What conclusions can you draw from your findings? Are there other meaningful trends to consider?

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Classroom Performance System

A company that establishes a new operation in a foreign country has made

An acquisition

A merger

A greenfield investment

A joint venture

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Classroom Performance System Answer: c

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Trends in FDI

Both the flow and stock of FDI in the world economy has increased over the last 20 years
FDI has grown more rapidly than world trade and world output because
firms still fear the threat of protectionism
the general shift toward democratic political institutions and free market economies has encouraged FDI
the globalization of the world economy is prompting firms to undertake FDI to ensure they have a significant presence in many regions of the world
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Trends in FDI

FDI Outflows 1982-2007

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The Direction of FDI

Historically, most FDI has been directed at the developed nations of the world, with the United States being a favorite target
FDI inflows have remained high during the early 2000s for the United States, and also for the European Union
South, East, and Southeast Asia, and particularly China, are now seeing an increase of FDI inflows
Latin America is also emerging as an important region for FDI
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Country Focus: Foreign Direct Investment in China

Summary

This feature explores investment opportunities in China. In the late 1970s, China opened its doors to foreign investors. By the mid 2000s, China attracted $65-70 billion of FDI annually. China’s large population is a magnet for many companies and because high tariffs make it difficult to export to the Chinese market, firms frequently turn to foreign direct investment. However, many companies have found it difficult to conduct business in China, and in recent years investment rates have slowed. In response, the Chinese government, hoping to continue to attract foreign companies has established a number of incentives for would-be investors. The following questions can be used in a discussion.

1. Consider the challenges involved with investing in China. How does China’s political position and economic situation affect its ability to attract foreign direct investment?

Discussion Points: Students will probably recognize that while on the surface, China has tremendous market potential, it is still a poor country. Anticipated demand does not always translate into actual demand. In addition, thanks to the country’s lack of a well-developed transportation system, distribution problems continue to exist, particularly outside major urban areas. In addition, the country’s highly regulated environment makes it difficult for companies to conduct business.

2. Discuss China’s efforts to encourage investment in its underdeveloped areas. What effect will investment have on these areas? How can firms prepare for the unique challenges of operating in these areas?

Discussion Points: China is making a concerted effort to continue to attract investment, especially in the country’s less developed areas. Recognizing the problems associated with its infrastructure, the country has committed $800 billion to improvements over the next decade. In addition, China is offering preferential tax breaks to countries that invest in more remote areas.

Lecture Note: Some experts believe that a certain amount of interdependency has been established between the United States and China that will influence the policy decisions of the two countries. For more information, go to {http://www.businessweek.com/globalbiz/content/jul2007/gb20070718_614386.htm?chan=search}.

Lecture Note: Some foreign companies with investments in China have recently become targets of intense criticism. For more details, go to {http://www.businessweek.com/globalbiz/content/may2008/gb20080530_213248.htm?chan=search}.

Video Note: The iGlobe China Rising Part 1: The Boom - China’s Rising Economy fits in well with this feature.

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The Direction of FDI

FDI Inflows by Region 1995 -2007

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The Direction of FDI

FDI can also be expressed as a percentage of gross fixed capital formation summarizes (the total amount of capital invested in factories, stores, office buildings, and the like)
All else being equal, the greater the capital investment in an economy, the more favorable its future prospects are likely to be
So, FDI can be seen as an important source of capital investment and a determinant of the future growth rate of an economy
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The Source of FDI

Since World War II, the U.S. has been the largest source country for FDI
Other important source countries include the United Kingdom, the Netherlands, France, Germany, and Japan
These countries also predominate in rankings of the world’s largest multinationals
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The Source of FDI

Cumulative FDI Outflows 1998 - 2006

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The Form of FDI: Acquisitions versus Greenfield Investments

The majority of cross-border investment involves mergers and acquisitions rather than greenfield investments
Firms prefer to acquire existing assets because
mergers and acquisitions are quicker to execute than greenfield investments
it is easier and perhaps less risky for a firm to acquire desired assets than build them from the ground up
firms believe they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills
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The Shift to Services

In the last two decades, there has been a shift towards FDI in services
The shift to services is being driven by
the general move in many developed countries toward services
the fact that many services cannot be exported
a liberalization of policies governing FDI in services
the rise of Internet-based global telecommunications networks that have allowed some service enterprises to relocate some of their value creation activities to different nations to take advantage of favorable factor costs
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Classroom Performance System

Which of the following statements is true?

Over the years, there has been a marked decrease in the stock and flow of FDI

Over the years, there has been a marked increase in the stock and flow of FDI

Over the years, there has been a marked decrease in the stock and an increase in the flow of FDI

Over the years, there has been a marked increase in the stock and an decrease in the flow of FDI

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Classroom Performance System Answer: b

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Theories of
Foreign Direct Investment

Question: Why do firms prefer FDI to either exporting (producing goods at home and then shipping them to the receiving country for sale) or licensing (granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee on every unit that the foreign entity sells)?

To answer this question, we need to look at the limitations of exporting and licensing, and the advantages of FDI
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Management Focus: Foreign Direct Investment by Cemex

Summary

This feature examines Cemex’s rise to global status. Cemex is the world’s third largest cement company and Mexico’s largest multinational company. In Mexico, Cemex is known for its efficient manufacturing and excellent customer service. Cemex began its international expansion in an effort to reduce its reliance on the Mexican market, to capitalize on demand in developing countries and its knowledge of the needs of developing companies, and finally, to increase its value by acquiring inefficient companies and transferring its skills to those companies. Cemex plans to continue its foreign expansion, and believes that China and India will be important markets in the future. The following questions can be used in a discussion.

1. Reflect on the decision made by Cemex with regard to international expansion. Why do you think the company chose to invest directly in other countries rather than export? Why was it more attractive for Cemex to acquire companies in foreign markets rather than establish its own operations?

Discussion Points: Most students will quickly recognize the difficulties inherent in shipping cement. In the case of Cemex, transportation is made even more critical because of the short “set” time involved with its product. Cemex sells ready-mixed cement that has a life of just 90 minutes. Therefore, it is essential for Cemex to be close to its customers, which implies that exporting is not an option for the company. In addition, one of Cemex’s competitive advantages lies in its superior customer service and relationship with distributors – advantages that could be difficult to transfer through licensing agreements. Most students will probably suggest that Cemex’s apparent preference for acquisitions over greenfield investments probably reflects the company’s desire to quickly establish a presence in the foreign market.

2. What benefits does Cemex bring to host countries? Why do you think the Indonesian government was suspicious of the company’s intentions there? Do you agree with the company’s decision to pull out of the market?

Discussion Points: Most students will probably agree that in addition to providing jobs in host countries, Cemex also brings benefits like new technology, management know-how, and marketing know-how. Students may also note that because Cemex often acquires existing companies, it helps bring these companies to full production. Many students may suggest that Cemex did not fare as well in the Indonesian market because of its dispute with the Indonesian government. Cemex had been promised a majority position in the government-owned cement company, Semen Gresik, a promise that never materialized. Students may suggest that trust is essential in business, and the fact that the Indonesian government did not follow through with its promises justified Cemex’s actions in the country.

Teaching Tip: To learn more about Cemex’s foreign operations, go to {http://www.cemex.com/}.

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Theories of
Foreign Direct Investment

1. Limitations of Exporting

The viability of an exporting strategy can be constrained by transportation costs and trade barriers
When transportation costs are high, exporting can be unprofitable
Foreign direct investment may be a response to actual or threatened trade barriers such as import tariffs or quotas
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Theories of
Foreign Direct Investment

2. Limitations of Licensing

Internalization theory (also known as market imperfections) suggests that licensing has three major drawbacks
it may result in a firm’s giving away valuable technological know-how to a potential foreign competitor

it does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability

It may be difficult if the firm’s competitive advantage is not amendable to licensing

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The Pattern of
Foreign Direct Investment

3. Advantages of Foreign Direct Investment

A firm will favor FDI over exporting as an entry strategy when
transportation costs are high
trade barriers are high
A firm will favor FDI over licensing when
it wants control over its technological know-how
it wants over its operations and business strategy
the firm’s capabilities are not amenable to licensing
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The Pattern of
Foreign Direct Investment

It is common for firms in the same industry to
have similar strategic behavior and undertake foreign direct investment around the same time

direct their investment activities towards certain locations at certain stages in the product life cycle

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The Pattern of
Foreign Direct Investment

1. Strategic Behavior

Knickerbocker explored the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms)
Knickerbocker suggested that FDI flows are a reflection of strategic rivalry between firms in the global marketplace
This theory can be extended to embrace the concept of multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries)
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The Pattern of
Foreign Direct Investment

2. The Product Life Cycle

Vernon argues that firms undertake FDI at particular stages in the life cycle of a product they have pioneered
Firms invest in other advanced countries when local demand in those countries grows large enough to support local production
Firms then shift production to low-cost developing countries when product standardization and market saturation give rise to price competition and cost pressures
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The Eclectic Paradigm

John Dunning’s eclectic paradigm argues that in addition to the various factors discussed earlier, two additional factors must be considered when explaining both the rationale for and the direction of foreign direct investment
location-specific advantages (that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets)
externalities (knowledge spillovers that occur when companies in the same industry locate in the same area)
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Classroom Performance System

Advantages that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets are

First mover advantages

Location advantages

Externalities

Proprietary advantages

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Classroom Performance System Answer: b

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Political Ideology and
Foreign Direct Investment

Ideology toward FDI has ranged from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economies
Between these two extremes is an approach that might be called pragmatic nationalism
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The Radical View

The radical view argues that the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries
The radical view has been in retreat because of
the collapse of communism in Eastern Europe
the poor economic performance of those countries that had embraced the policy
the strong economic performance of developing countries that had embraced capitalism
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The Free Market View

The free market view argues that international production should be distributed among countries according to the theory of comparative advantage
So, the MNE increases the overall efficiency of the world economy
The free market view has been embraced by advanced and developing nations, including the United States, Britain, Chile, and Hong Kong
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Pragmatic Nationalism

The pragmatic nationalist view is that FDI has both benefits, such as inflows of capital, technology, skills and jobs, and costs, such as repatriation of profits to the home country and a negative balance of payments effect
According to this view, FDI should be allowed only if the benefits outweigh the costs
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Shifting Ideology

In recent years, there has been a strong shift toward the free market stance creating
a surge in the volume of FDI worldwide
an increase in the volume of FDI directed at countries that have recently liberalized their regimes
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Management Focus: DP World and the United States

Summary

This feature explores the reaction to the bid by DP World, a Dubai-based ports operator, to acquire P&O, a British firm that runs a network of global marine terminals. An acquisition of P&O would give DP World management of six U.S. ports. While the Bush administration claimed the acquisition posed no threat to national security, several prominent U.S. Senators raised concerns about the acquisition. Ultimately, DP World pulled out of the deal, but stated that it would look for alternative ways to enter the U.S. market, beginning with an initial public offering in 2007. The following questions can be used in a discussion.

Suggested Discussion Questions

1. Do you agree with the senators who raised concerns about the DP World deal? Why or why not? Would your response be different if DP World were a British firm?

Discussion Points: This issue will probably generate significant debate among students. At the heart of the issue is whether a company, because of its country of origin, should be denied ownership of something that could be important to a nation’s national security. Some students will probably argue that the United States was unjustified in its reaction to the deal, that DP World has a long history of American associations. Students taking this perspective will probably suggest that the United States is being prejudiced against the company simply because of its nationality. Other students however, will probably claim that DP World’s role in with American companies to date, has not involved ownership of ports that could be important to the country’s national security. Students in this camp will probably argue that the ports should be owned by American companies, or at least companies from countries that are allies of the United States in order to preserve national security, but definitely not a state-owned company from the Middle East. The implication here is that ownership of the ports would effectively transfer to a foreign government.

2. DP World has vowed to enter the United States market in some other way. Why is the U.S. market so important to DP World? What do you think the response of the government might be to another attempt by DP World?

Discussion Points: The U.S. market is important to DP World because it is an epicenter of capitalism. Goods from all over the world flow to the United States, and DP World wants to be in a position to capitalize on this. Students will probably agree that should the company make another attempt to gain a foothold in the market, the United States will be reluctant to allow DP World a significant role in the country, especially in major ports.

Teaching Tip: For more information on the company and its recent developments, go to {http://portal.pohub.com/portal/page?_pageid=761,1&_dad=pogprtl&_schema=POGPRTL } and click on “Marine Terminals.”

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Benefits and Costs of FDI

Question: What are the benefits and costs of FDI?

The benefits and costs of FDI must be explored from the perspective of both the host (receiving) country and the home (source) country
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Host Country Benefits

The main benefits of inward FDI for a host country are
the resource transfer effect

the employment effect

the balance of payments effect

effects on competition and economic growth

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Host Country Benefits

1. Resource Transfer Effects

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 Effects

FDI can bring jobs to a host country that would otherwise not be created there
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Host Country Benefits

3. Balance-of-Payments Effects

A country’s balance-of-payments account is a record of a country’s payments to and receipts from other countries
The current account is a record of a country’s export and import of goods and services
A current account surplus is usually favored over a deficit
FDI can help achieve a current account surplus
if the FDI is a substitute for imports of goods and services
if the MNE uses a foreign subsidiary to export goods and services to other countries
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Host Country Benefits

4. Effect on Competition and Economic Growth

FDI in the form of greenfield investment
increases the level of competition in a market
drives down prices
improves the welfare of consumers
Increased competition can lead to
increased productivity growth
product and process innovation
greater economic growth
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Classroom Performance System

Benefits of FDI include all of the following except

The resource transfer effect

The employment effect

The balance of payments effect

National sovereignty and autonomy

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Classroom Performance System Answer: d

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Host Country Costs

There are three main costs of inward FDI
the possible adverse effects of FDI on competition within the host nation

adverse effects on the balance of payments

the perceived loss of national sovereignty and autonomy

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Host Country Costs

1. Adverse Effects on Competition

Host governments worry that the subsidiaries of foreign MNEs operating in their country may have greater economic power than indigenous competitors because they may be part of a larger international organization
As part of larger organization, the MNE could draw on funds generated elsewhere to subsidize costs in the local market
Doing so could allow the MNE to drive indigenous competitors out of the market and create a monopoly position
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Host Country Costs

2. Adverse Effects on the Balance of Payments

There are two possible adverse effects of FDI on a host country’s balance-of-payments
with the initial capital inflows that come with FDI must be the subsequent outflow of capital as the foreign subsidiary repatriates earnings to its parent country
when a foreign subsidiary imports a substantial number of its inputs from abroad, there is a debit on the current account of the host country’s balance of payments
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Host Country Costs

3. National Sovereignty and Autonomy

Many host governments worry that FDI is accompanied by some loss of economic independence
Key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control
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Home Country Benefits

The benefits of FDI to the home country include
the effect on the capital account of the home country’s balance of payments from the inward flow of foreign earnings

the employment effects that arise from outward FDI

the gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country

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Home Country Costs

The most important concerns for the home country center around
The balance-of-payments

The balance of payments suffers from the initial capital outflow required to finance the FDI
The current account is negatively affected if the purpose of the FDI is to serve the home market from a low-cost production location
The current account suffers if the FDI is a substitute for direct exports
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Home Country Costs

2. Employment effects of outward FDI

If the home country is suffering from unemployment, there may be concern about the export of jobs
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International Trade Theory and FDI

International trade theory suggests that home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid
FDI may actually stimulate economic growth by freeing home country resources to concentrate on activities where the home country has a comparative advantage
Consumers may also benefit in the form of lower prices
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Government Policy Instruments
and FDI

FDI can be regulated by both home and host countries
Governments can implement policies to
encourage FDI

discourage FDI

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Home Country Policies

1. Encouraging Outward FDI

Many nations now have government-backed insurance programs to cover major types of foreign investment risk
This type of policy can encourage firms to undertake FDI in politically unstable nations
Many countries have eliminated also double taxation of foreign income
Many host nations have relaxed restrictions on inbound FDI
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Home Country Policies

2. Restricting Outward FDI

Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time
Some countries manipulate tax rules to make it more favorable for firms to invest at home
Countries may restrict firms from investing in certain nations for political reasons
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Host Country Policies

1. Encouraging Inward FDI

Governments offer incentives to foreign firms to invest in their countries
Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI, and to capture FDI away from other potential host countries
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Host Country Policies

2. Restricting Inward FDI

Ownership restraints and performance requirements (controls over the behavior of the MNE’s local subsidiary) are used to restrict FDI
Ownership restraints
exclude foreign firms from certain sectors on the grounds of national security or competition
are often based on a belief that local owners can help to maximize the resource transfer and employment benefits of FDI
Performance requirements are used to maximize the benefits and minimize the costs of FDI for the host country
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International Institutions
and the Liberalization of FDI

Until recently there has been no consistent involvement by multinational institutions in the governing of FDI
The formation of the World Trade Organization in 1995 is changing this
The WTO has had some success in establishing a universal set of rules to promote the liberalization of FDI
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Implications for Managers

Question: What does FDI mean for international businesses?

The theory of FDI has implications for strategic behavior of firms
Government policy on FDI can also be important for international businesses
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Internet Extra: The World Bank is a great place to start researching a country as a potential destination for FDI. Go to the World Bank site {http://www.worldbank.org/} and click on Data and Research, then on Foreign Direct Investment. Compare and contrast several countries on various factors to determine the relative merits of countries as host nations for investment.

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The Theory of FDI

The location-specific advantages argument associated with John Dunning help explain the direction of FDI
However, internalization theory is needed to explain why firms prefer FDI to licensing or exporting
Exporting is preferable to licensing and FDI as long as transportation costs and trade barriers are low
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The Theory of FDI

Licensing is unattractive when
the firm’s proprietary property cannot be properly protected by a licensing agreement
the firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country
the firm’s skills and capabilities are not amenable to licensing
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The Theory of FDI

A Decision Framework

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Government Policy

A host government’s attitude toward FDI is an important in decisions about where to locate foreign production facilities and where to make a foreign direct investment
A firm’s bargaining power with the host government is highest when
the host government places a high value on what the firm has to offer
when there are few comparable alternatives available
when the firm has a long time to negotiate
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Critical Discussion Question

1. In 2004, inward FDI accounted for some 24 percent of gross capital formation in Ireland, but only 0.6 percent in Japan. What do you think explains this difference in FDI inflows into the two countries?

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Answer: Gross capital formation summarizes the total amount of capital invested in factories, stores, office buildings, and so on. When capital investment is high, a country has more favorable growth prospects. The difference between the rates of gross capital formation in Ireland and Japan would indicate that FDI is an important source of investment capital and economic growth in Ireland, but not in Japan. There are several reasons for this. Companies may perceive that Ireland is more attractive as a destination for their investments, or that it is easier to establish operation in Ireland than in Japan. Investors may be cautious about Japan because of its reputation for burdensome regulations.