Mergers and acquisitions are quicker to execute than greenfield investments

Greenfield Investments

opening case

For years the economy of Nigeria, Africa’s most populous nation, was held back by political instability, poor government policies, a lack of infrastructure, and endemic corruption. This started to change in the 2000s. In halting steps, Nigeria has moved toward a more stable democratic form of government. In 2007, for the first time in the history of the country, there was a peaceful transfer of civilian power fol- lowing general elections. Since then, the government has pursued market-orientated reforms, including the removal of subsidies, privatization of some state-run businesses, lowering trade barriers, and deregulation. The government has tried to rid itself of corruption, albeit with mixed success. There has also been some attempt to improve the country’s poor transportation and power infrastructure.

The reforms have had a positive impact. The GDP of Nigerian purchasing power parity almost tripled from $170 billion in 2000 to $451 billion in 2012. When estimates of the “informal” or “black economy” sector are taken into account, GDP may have been as large as $630 billion in 2012. The economy grew at around 7 percent per annum during the 2010–2012 period. Powering this growth have been high oil prices. Nigeria is a significant oil producer, and high oil prices have helped to improve government finances, but the industrial and agricultural sectors of the economy are also growing.

One of the major engines of growth has been foreign direct investment. For years, foreign investors stayed away from Nigeria—scared off by the political instability and high levels of corruption—but that too is starting to change. Encouraged by better economic management and the promise of a large domestic market, inward foreign investment in Nigeria increased from $1.2 billion in 2000 to a peak of almost $9 billion in both 2011 and 2012. Among recent investors has been General Electric, which announced in 2013 that it would put more than $1 billion into Nigeria over the next five years. The investments include building a manufacturing plant to support the power generation and oil extraction industries and a service center for supporting GE equipment. GE believes that its investment will create 2,300 jobs.

While the majority of investments are still targeted at Nigeria’s large energy sector, there are signs that this too is beginning to shift. A case in point is Procter & Gamble, which in 2012 invested $250 million to

Foreign Direct Investment in Nigeria

Foreign Direct Investment

–continued

224 Part Three The Global Trade and Investment Environment

construct a state-of-the-art plant to manufacture disposable diapers in Nigeria. Explaining the investment, a P&G spokesperson noted that “Nigeria has a very strong, dynamic and growing population of now over 167 million people with over 40 percent less than 15 years old. By 2050, Nigeria is projected to have the third largest population in the world. This represents a rapidly growing number of consumers and a wonderful opportunity to serve.” The P&G spokesperson also indicated that P&G would increase its investment if the Nigeria government was successful in further lowering import tariffs and consumption taxes and resolved some of the infrastructure problems that were currently holding the country back. • Sources: K. Aderinokun, “Nigeria: We Want to Make Nigeria the Hub of Procter and Gamble’s West African Operations,” AllAfrica, August 21, 2012; N. Mazen, “General Electric Plans $1 Billion Investment in Nigerian Power,” Bloomberg, January 31, 2013; and CIA, The World Factbook: Nigeria, updated January 7, 2014.

Introduction Foreign direct investment (FDI) occurs when a firm invests directly in facilities to pro- duce or market a product in a foreign country. According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, or affiliated group takes an interest of 10 percent or more in a foreign business entity. Once a firm undertakes FDI, it becomes a multinational enterprise. Two examples of FDI are given in the opening case— the recent investments by General Electric and Procter & Gamble in production facilities in Nigeria.

FDI takes on two main forms. The first is a greenfield investment, which involves the establishment of a new operation in a foreign country. The second involves acquir- ing or merging with an existing firm in the foreign country. Both GE’s and P&G’s investments in Nigeria were greenfield investments. Acquisitions can be a minority (where the foreign firm takes a 10 to 49 percent interest in the firm’s voting stock), majority (foreign interest of 50 to 99 percent), or full outright stake (foreign interest of 100 percent).1

This chapter opens by looking at the importance of foreign direct investment in the world economy. Next, it reviews the theories that have been used to explain foreign direct investment. The chapter then moves on to look at government policy toward foreign direct investment and closes with a section on implications for business.

Foreign Direct Investment in the World Economy When discussing foreign direct investment, it is important to distinguish between the flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI under- taken over a given time period (normally a year). The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. We also talk of outflows of FDI, meaning the flow of FDI out of a country, and inflows of FDI, the flow of FDI into a country.

TRENDS IN FDI The past 35 years have seen a marked increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from $25 billion in 1975 to $1.4 trillion in 2012 (see Figure 8.1).2 Over the past 30 years the flow of FDI has accelerated faster than the growth in world trade and world output. For example, between 1992 and 2012, the total flow of FDI from all countries increased around ninefold while world trade by value grew fourfold and world output by around 55 percent.3 As a

Greenfield Investment The establishment of a new operation in a foreign country.

LO 8-1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.

Flow of FDI The amount of foreign direct investment undertaken over a given time period (normally one year).

Stock of FDI The total accumulated value of foreign- owned assets at a given time.

Outflows of FDI Flow of foreign direct investment out of a country.

Inflows of FDI Flow of foreign direct investment into a country.

Chapter Eight Foreign Direct Investment 225

result of the strong FDI flows, by 2012 the global stock of FDI was about $22.8 trillion. The foreign affiliates of multinationals had more than $27.9 trillion in global sales and accounted for one-third of all cross-border trade in goods and services.4 Clearly by any measure, FDI is a very important phenomenon.

FDI has grown more rapidly than world trade and world output for several reasons. First, despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Second, much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world’s developing nations. The general shift toward democratic political institutions and free market economies that we discussed in Chapter 3 has encouraged FDI. Across much of Asia, eastern Europe, and Latin America, economic growth, economic deregulation, privatization programs that are open to foreign investors, and removal of many restrictions on FDI have made these countries more attractive to foreign multinationals. According to the United Nations, some 90 percent of the 2,700 changes made worldwide between 1992 and 2009 in the laws governing foreign direct investment created a more favorable envi- ronment for FDI.5

The globalization of the world economy is also having a positive effect on the volume of FDI. Many firms see the whole world as their market, and they are undertaking FDI in an attempt to make sure they have a significant presence in many regions of the world. For reasons that we explore later in this book, many firms now believe it is important to have production facilities close to their major customers. This too creates pressure for greater FDI.

THE DIRECTION OF FDI Historically, most FDI has been directed at the devel- oped nations of the world as firms based in advanced countries invested in the others’ mar- kets (see Figure 8.2). During the 1980s and 1990s, the United States was often the favorite target for FDI inflows. The United States has been an attractive target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI. Investors include firms based in Great Britain, Japan, Germany, Holland, and France. Inward investment into the United States remained high during the 2000s and stood at $167 billion in 2012. The developed nations of the European Union have also been recipients of significant FDI inflows, princi- pally from the United States and other member-states of the EU. In 2012, inward invest- ment into the EU was $276 billion. The United Kingdom and France have historically been the largest recipients of inward FDI.6

8.1 FIGURE FDI Outflows, 1980–2012 ($ billions) Source: UNCTAD Statistical Data Set, http:// unctadstat.unctad.org/ReportFolders/ reportFolders.aspx.

19 80

19 84

19 86

19 88

19 90

19 92

19 94

19 96

19 98

20 00

20 02

20 04

20 06

20 08

20 10

20 12

19 82

0

500

1,000

1,500

2,000

2,500

$ B

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226 Part Three The Global Trade and Investment Environment

Even though developed nations still account for the largest share of FDI inflows, FDI into developing nations and the transition economies of eastern Europe and the old Soviet Union have increased markedly (see Figure 8.2). Most recent inflows into devel- oping nations have been targeted at the emerging economies of Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient of FDI, which attracted about $60 billion of FDI in 2004 and rose steadily to hit a record $124 billion in 2011 followed by $121 billion in 2012.7 The reasons for the strong flow of investment into China are discussed in the accompanying Country Focus. Latin America is the next most important region in the developing world for FDI inflows. In 2012, total inward investments into this region reached $244 billion. Brazil has histori- cally been the top recipient of inward FDI in Latin America. At the other end of the scale, Africa has long received the smallest amount of inward investment, $50 billion in 2012. In recent years, Chinese enterprises have emerged as major investors in Africa, particularly in extraction industries where they seem to be trying to ensure future sup- plies of valuable raw materials. The inability of Africa to attract greater investment is in part a reflection of the political unrest, armed conflict, and frequent changes in economic policy in the region.8

THE SOURCE OF FDI Since World War II, the United States has consistently been the largest source country for FDI. Other important source countries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countries accounted for 60 percent of all FDI outflows for 1998–2012 (see Figure 8.3). As might be expected, these countries also predominate in rankings of the world’s largest mul- tinationals.9 These nations dominate primarily because they were the most developed na- tions with the largest economies during much of the postwar period and therefore home to many of the largest and best capitalized enterprises. Many of these countries also had a long history as trading nations and naturally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enterprises based there have been at the forefront of foreign investment trends.

That being said, it is noteworthy that Chinese firms have started to emerge as major for- eign investors. In 2005, Chinese firms invested some $12 billion internationally. Since then, the figure has risen steadily, reaching $84 billion in 2012. Firms based in Hong Kong accounted for another $84 billion of outward FDI in 2012. Much of the outward investment by Chinese firms has been directed at extractive industries in less developed nations (e.g., China has been a major investor in African countries). A major motive for these investments has been to gain access to raw materials, of which China is one of the world’s largest

8.2 FIGURE FDI Inflows by Region, 1995–2012 ($ billions) Source: Calculated by the author from United Nations World Investment Report, various editions.

19 95

19 97

19 98

19 99

20 00

20 01

20 02

20 03

20 04

20 05

20 06

20 07

20 08

20 09

20 10

20 11

20 12

19 96

0

500

1,000

1,500

2,000

2,500

$ B

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ns

Developed Nations Developing Nations Transition Economies

Chapter Eight Foreign Direct Investment 227

Foreign Direct Investment in China

Beginning in late 1978, China’s leadership decided to move the econ- omy away from a centrally planned socialist system to one that was more market driven. The result has been 35 years of sustained high economic growth rates of around 8–10 percent, compounded annu- ally. This growth attracted substantial foreign investment. Starting from a tiny base, foreign investment increased to an annual average rate of $2.7 billion between 1985 and 1990 and then surged to $40 billion annually in the late 1990s, making China the second- biggest recipient of FDI inflows in the world after the United States. The growth has continued, with inward investments into China hitting a record $124 billion in 2011 (with another $83 billion going into Hong Kong). Over the past 20 years, this inflow has resulted in the estab- lishment of more than 300,000 foreign-funded enterprises in China. The total stock of FDI in mainland China grew from almost nothing in 1978 to $832 billion in 2012 (another $1.4 trillion of FDI stock was in Hong Kong).

The reasons for this investment are fairly obvious. With a popula- tion of more than 1.3 billion people, China represents the world’s largest market. Historically, import tariffs made it difficult to serve this market via exports, so FDI was required if a company wanted to tap into the country’s huge potential. China joined the World Trade Organization in 2001. As a result, average tariff rates on imports have fallen from 15.4 percent to about 8 percent today, and reducing the tariff became a motive for investing in China (although at 8 percent, tariffs are still above the average of 3.5 percent found in many devel- oped nations). Notwithstanding tariff rates, many foreign firms be- lieve that doing business in China requires a substantial presence in the country to build guanxi, the crucial relationship networks (see Chapter 4 for details). Furthermore, a combination of relatively inex- pensive labor and tax incentives, particularly for enterprises that establish themselves in special economic zones, makes China an

attractive base from which to serve Asian or world markets with exports (although rising labor costs in China are now making this less important).

Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China. China may have a huge popu- lation, but despite decades of rapid growth, it is still relatively poor. The lack of purchasing power translates into a relatively immature market for many Western consumer goods outside of affluent urban areas such as Shanghai. Other problems include a highly regulated environ- ment, which can make it problematic to conduct business transactions, and shifting tax and regulatory regimes. Then there are problems with local joint-venture partners that are inexperienced, opportunistic, or simply operate according to different goals. One U.S. manager ex- plained that when he laid off 200 people to reduce costs, his Chinese partner hired them all back the next day. When he inquired why they had been hired back, the Chinese partner, which was government- owned, explained that as an agency of the government, it had an “obli- gation” to reduce unemployment.

To continue to attract foreign investment, in late 2000 the Chinese government had committed itself to invest more than $800 billion in infrastructure projects over 10 years. Further commitments were made in the late 2000s. These investments have improved the nation’s poor highway system. They have been pursuing a macroeconomic policy that includes an emphasis on maintaining steady economic growth, low inflation, and a stable currency—all of which are attractive to for- eign investors. Given these developments, it seems likely that the country will continue to be an important magnet for foreign investors well into the future.

Sources: Interviews by the author while in China; United Nations, World Investment Report, 2012; Linda Ng and C. Tuan, “Building a Favorable Investment Environment: Evidence for the Facilitation of FDI in China,” The World Economy, 2002, pp. 1095–114; and S. Chan and G. Qingyang, “Investment in China Migrates Inland,” Far Eastern Economic Review, May 2006, pp. 52–57.

country FOCUS

8.3 FIGURE Cumulative FDI Outflows, 1998–2012 ($ billions) Source: Calculted by the author from United Nations World Investment Report, various editions.

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3,000

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228 Part Three The Global Trade and Investment Environment

consumers. There are signs, however, that Chinese firms are starting to turn their attention to more advanced na- tions. In 2012, Chinese firms invested $6.5 billion in the United States, up from $146 million in 2003.10

THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTS FDI can take the form of a greenfield investment in a new facility or an acquisition of or a merger with an existing local firm. UN estimates indicate that some 40 to 80 per- cent of all FDI inflows were in the form of mergers and acquisitions between 1998 and 2012.11 However, FDI flows into developed nations differ markedly from those into developing nations. In the case of developing na- tions, only about one-third or less of FDI is in the form of cross-border mergers and acquisitions. The lower per- centage of mergers and acquisitions may simply reflect the fact that there are fewer target firms to acquire in de- veloping nations.

When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake greenfield investments? We consider this question in depth in Chap- ter 13. For now, we will make a few basic observations. First, mergers and acquisitions are quicker to execute than greenfield investments. This is an important consid- eration in the modern business world where markets

evolve very rapidly. Many firms apparently believe that if they do not acquire a desirable target firm, then their global rivals will. Second, foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trade- marks or patents, distribution systems, production systems, and the like. It is easier and perhaps less risky for a firm to acquire those assets than to build them from the ground up through a greenfield investment. Third, firms make acquisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology, or man- agement skills (see the next Management Focus on Cemex for an example). However, as we discuss in Chapter 13, there is evidence that many mergers and acquisitions fail to realize their anticipated gains.12

Theories of Foreign Direct Investment In this section, we review several theories of foreign direct investment. These theories approach the various phenomena of foreign direct investment from three complementary perspectives. One set of theories seeks to explain why a firm will favor direct investment as a means of entering a foreign market when two other alternatives, exporting and licensing, are open to it. Another set of theories seeks to explain why firms in the same industry often undertake foreign direct investment at the same time and why they favor certain locations over others as targets for foreign direct investment. Put differently, these theories attempt to explain the observed pattern of foreign direct investment flows. A third theoretical per- spective, known as the eclectic paradigm, attempts to combine the two other perspectives into a single holistic explanation of foreign direct investment (this theoretical perspective is eclectic because the best aspects of other theories are taken and combined into a single explanation).

WHY FOREIGN DIRECT INVESTMENT? Why do firms go to the trouble of establishing operations abroad through foreign direct investment when two alternatives, exporting and licensing, are available to them for exploiting the profit opportunities in a

LO 8-2 Explain the different theories of FDI.

Eclectic Paradigm Argument that combining location specific assets or resource endowments and the firm’s own unique assets often requires FDI; it requires the firm to establish production facilities where those foreign assets or resource endowments are located.

Which Is Better, an Acquisition or a Greenfield Investment? A greenfield investment is an establishment of a new operation in a foreign country (i.e., a parent company starts a new venture in a foreign country by building new production facilities from the ground up). The acquisition approach refers to buying or merging operations with an existing firm in a foreign country. In the text of Chapters 8 and 13, we discuss reasons for greenfield and acquisition-based investments in a foreign country. While mergers and acquisitions (M&A) are typically quicker to execute than building something from literally the ground up, M&A often fail to gain the advantages expected. The failure rate of M&A is somewhere between 50 and 83 percent. At the same time, the trend shows that both the number of M&A and the sums of money spent on M&A are increasingly consistently every year. If you were making the decision, would you prefer to make a greenfield investment or engage in either a merger or acquisi- tion in a foreign country?

Source: Y. Weber, C. Oberg, and S. Tarba, “The M&A Paradox: Factors of Success and Failure in Mergers and Acquisitions,” Comprehensive Guide to Mergers & Acquisitions, A: Managing the Critical Success Factors Across Every Stage of the M&A Process (Upper Saddle River, NJ: FT Press, 2013).

test PREP Use LearnSmart to help retain what you have learned. Access your instructor’s Connect course to check out LearnSmart or go to learnsmartadvantage.com for help.

Chapter Eight Foreign Direct Investment 229

foreign market? Exporting involves producing goods at home and then shipping them to the receiving country for sale. Licensing involves granting a foreign entity (the licensee) the right to produce and sell the firm’s product in return for a royalty fee on every unit sold. The question is important, given that a cursory examination of the topic suggests that for- eign direct investment may be both expensive and risky compared with exporting and li- censing. FDI is expensive because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise. FDI is risky because of the problems associated with doing business in a different culture where the rules of the game may be very different. Relative to indigenous firms, there is a greater probability that a for- eign firm undertaking FDI in a country for the first time will make costly mistakes due to its ignorance. When a firm exports, it need not bear the costs associated with FDI, and it can reduce the risks associated with selling abroad by using a native sales agent. Similarly, when a firm allows another enterprise to produce its products under license, the licensee bears the

Exporting Sale of products produced in one country to residents of another country.

Licensing Occurs when a firm (the licensor) licenses the right to produce its product, use its production processes, or use its brand name or trademark to another firm (the licensee). In return for giving the licensee these rights, the licensor collects a royalty fee on every unit the licensee sells.

Foreign Direct Investment by Cemex

Since the early 1990s, Mexico’s largest cement manufacturer, Cemex, has transformed itself from a primarily Mexican operation into the third-largest cement company in the world behind Holcim of Switzerland and Lafarge Group of France. Cemex has long been a powerhouse in Mexico and currently controls more than 60 percent of the market for cement in that country. Cemex’s domestic success has been based in large part on an obsession with efficient manufacturing and a focus on customer service that is tops in the industry.

Cemex is a leader in using information technology to match pro- duction with consumer demand. The company sells ready-mixed ce- ment that can survive for only about 90 minutes before solidifying, so precise delivery is important. But Cemex can never predict with total certainty what demand will be on any given day, week, or month. To better manage unpredictable demand patterns, Cemex developed a system of seamless information technology—including truck-mounted global positioning systems, radio transmitters, satellites, and computer hardware—that allows it to control the production and distribution of cement like no other company can, responding quickly to unantici- pated changes in demand and reducing waste. The results are lower costs and superior customer service, both differentiating factors for Cemex.

Cemex’s international expansion strategy was driven by a number of factors. First, the company wished to reduce its reliance on the Mex- ican construction market, which was characterized by very volatile demand. Second, the company realized there was tremendous demand for cement in many developing countries, where significant construc- tion was being undertaken or needed. Third, the company believed that it understood the needs of construction businesses in developing na- tions better than the established multinational cement companies, all of which were from developed nations. Fourth, Cemex believed that it could create significant value by acquiring inefficient cement compa- nies in other markets and transferring its skills in customer service, marketing, information technology, and production management to those units.

The company embarked in earnest on its international expansion strategy in the early 1990s. Initially, Cemex targeted other developing

nations, acquiring established cement makers in Venezuela, Colombia, Indonesia, the Philippines, Egypt, and several other countries. It also purchased two stagnant companies in Spain and turned them around. Bolstered by the success of its Spanish ventures, Cemex began to look for expansion opportunities in developed nations. In 2000, Cemex pur- chased Houston-based Southland, one of the largest cement companies in the United States, for $2.5 billion. Following the Southland acquisition, Cemex had 56 cement plants in 30 countries, most of which were gained through acquisitions. In all cases, Cemex devoted great attention to transferring its technological, management and marketing know-how to acquired units, thereby improving their performance.

In 2004, Cemex made another major foreign investment move, pur- chasing RMC of Great Britain for $5.8 billion. RMC was a huge multina- tional cement firm with sales of $8 billion, only 22 percent of which were in the United Kingdom, and operations in more than 20 other na- tions, including many European nations where Cemex had no pres- ence. Finalized in March 2005, the RMC acquisition had transformed Cemex into a global powerhouse in the cement industry with more than $15 billion in annual sales and operations in 50 countries. Only about 15 percent of the company’s sales was now generated in Mexico. Fol- lowing the acquisition of RMC, Cemex found that the RMC plant in Rugby was running at only 70 percent of capacity, partly because re- peated production problems kept causing a kiln shutdown. Cemex brought in an international team of specialists to fix the problem and quickly increased production to 90 percent of capacity. Going forward, Cemex has made it clear that it will continue to expand and is eyeing opportunities in the fast-growing economies of China and India where currently it lacks a presence and where its global rivals are already expanding.

Sources: C. Piggott, “Cemex’s Stratospheric Rise,” Latin Finance, March 2001, p. 76; J. F. Smith, “Making Cement a Household Word,” Los Angeles Times, January 16, 2000, p. C1; D. Helft, “Cemex Attempts to Cement Its Future,” The Industry Standard, November 6, 2000; Diane Lindquist, “From Cement to Services,” Chief Executive, November 2002, pp. 48–50; “Cementing Global Success,” Strategic Direct Investor, March 2003, p. 1; M. T. Derham, “The Cemex Surprise,” Latin Finance, November 2004, pp. 1–2; “Holcim Seeks to Acquire Aggregate,” The Wall Street Journal, January 13, 2005, p. 1; J. Lyons, “Cemex Prowls for Deals in Both China and India,” The Wall Street Journal, January 27, 2006, p. C4; and S. Donnan, “Cemex Sells 25 Percent Stake in Semen Gresik,” FT.com, May 4, 2006, p. 1.

management FOCUS

230 Part Three The Global Trade and Investment Environment

costs or risks. So why do so many firms apparently prefer FDI over either exporting or li- censing? The answer can be found by examining the limitations of exporting and licensing as means for capitalizing on foreign market opportunities.

Limitations of Exporting The viability of an exporting strategy is often constrained by transportation costs and trade barriers. When transportation costs are added to produc- tion costs, it becomes unprofitable to ship some products over a large distance. This is par- ticularly true of products that have a low value-to-weight ratio and that can be produced in almost any location. For such products, the attractiveness of exporting decreases, relative to either FDI or licensing. This is the case, for example, with cement. Thus, Cemex, the large Mexican cement maker, has expanded internationally by pursuing FDI, rather than export- ing (see the accompanying Management Focus). For products with a high value-to-weight ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic components, personal computers, medical equipment, computer software, etc.) and have little impact on the relative attractiveness of exporting, licensing, and FDI.

Transportation costs aside, some firms undertake foreign direct investment as a response to actual or threatened trade barriers such as import tariffs or quotas. By placing tariffs on imported goods, governments can increase the cost of exporting relative to foreign direct investment and licensing. Similarly, by limiting imports through quotas, governments in- crease the attractiveness of FDI and licensing. For example, the wave of FDI by Japanese auto companies in the United States during the 1980s and 1990s was partly driven by pro- tectionist threats from Congress and by quotas on the importation of Japanese cars. For Japanese auto companies, these factors decreased the profitability of exporting and increased that of foreign direct investment. In this context, it is important to understand that trade barriers do not have to be physically in place for FDI to be favored over exporting. Often, the desire to reduce the threat that trade barriers might be imposed is enough to justify foreign direct investment as an alternative to exporting.

Limitations of Licensing A branch of economic theory known as internalization theory seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering foreign markets (this approach is also known as the market imperfec- tions approach).13 According to internalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities. First, licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor. For example, in the 1960s, RCA licensed its leading-edge color television technology to a number of Japanese companies, including Matsushita and Sony. At the time, RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market without the costs and risks associated with foreign direct investment. However, Matsushita and Sony quickly

Internalization Theory Marketing imperfection approach to foreign direct investment.

Market Imperfections Imperfections in the operation of the market mechanism.

Rankings

Cross-border investments have been ramped up to a relatively large degree in the last decade. Even with the economic downturn that started in 2008, the world continued to see a great deal of foreign direct investment by companies in the last decade. Now, when the economic prosperity is likely to be better, given that we are removed from those downturn days, the expectation is that more foreign direct investment will be considered by companies. On globalEDGE, there are myriad opportunities to gain more knowl- edge about foreign direct investment or, FDI, as it is typically called.

The “Rankings” section is a great starting point (globaledge.msu. edu/global-resources/rankings). In the Rankings section, glo- balEDGE features several reports by A.T. Kearney—with one of them squarely centered on foreign direct investment and a “confi- dence index” for FDI. The companies that participate in the regular study account for more than $2 trillion in annual global revenue! Which countries are in the top three in the investment confidence index, and do you agree that the three countries are the best ones to invest in if you were running a company?

Chapter Eight Foreign Direct Investment 231

assimilated RCA’s technology and used it to enter the U.S. market to compete directly against RCA. As a result, RCA is now a minor player in its home market, while Matsushita and Sony have a much bigger market share.

A second problem is that licensing 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. With licensing, control over manufacturing, marketing, and strategy are granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. The rationale for wanting control over the strategy of a foreign entity is that a firm might want its foreign subsidiary to price and market very aggressively as a way of keeping a foreign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept such an imposition, be- cause it would likely reduce the licensee’s profit, or it might even cause the licensee to take a loss.

The rationale for wanting control over the operations of a foreign entity is that the firm might wish to take advantage of differences in factor costs across countries, producing only part of its final product in a given country, while importing other parts from elsewhere where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement, since it would limit the licensee’s autonomy. Thus, for these reasons, when tight control over a foreign entity is desirable, foreign direct investment is preferable to licensing.

A third problem with licensing arises when the firm’s competitive advantage is based not as much on its products as on the management, marketing, and manufacturing capabilities that produce those products. The problem here is that such capabilities are often not amenable to licensing. While a foreign licensee may be able to physically reproduce the firm’s product under license, it often may not be able to do so as efficiently as the firm could itself. As a result, the licensee may not be able to fully exploit the profit potential inherent in a foreign market.

For example, consider Toyota, a company whose competitive advantage in the global auto industry is acknowledged to come from its superior ability to manage the overall process of designing, engineering, manufacturing, and selling automobiles—that is, from its management and organizational capabilities. Indeed, Toyota is credited with pioneer- ing the development of a new production process, known as lean production, that enables it to produce higher-quality automobiles at a lower cost than its global rivals.14 Although Toyota could license certain products, its real competitive advantage comes from its man- agement and process capabilities. These kinds of skills are difficult to articulate or codify; they certainly cannot be written down in a simple licensing contract. They are organiza- tionwide and have been developed over the years. They are not embodied in any one individual but instead are widely dispersed throughout the company. Put another way, Toyota’s skills are embedded in its organizational culture, and culture is something that cannot be licensed. Thus, if Toyota were to allow a foreign entity to produce its cars under license, the chances are that the entity could not do so as efficiently as could Toyota. In turn, this would limit the ability of the foreign entity to fully develop the market potential of that product. Such reasoning underlies Toyota’s preference for direct investment in foreign markets, as opposed to allowing foreign automobile companies to produce its cars under license.

All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing: (1) when the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) when a firm’s skills and know-how are not amenable to licensing.

Advantages of Foreign Direct Investment It follows that a firm will favor foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favor foreign direct investment over licensing (or franchising) when it wishes to maintain control over its

232 Part Three The Global Trade and Investment Environment

technological know-how, or over its operations and business strategy, or when the firm’s capabilities are simply not amenable to licensing, as may often be the case.

THE PATTERN OF FOREIGN DIRECT INVESTMENT Observation suggests that firms in the same industry often undertake foreign direct investment at about the same time. Also, firms tend to direct their investment activities toward the same target markets. The two theories we consider in this section attempt to explain the patterns that we observe in FDI flows.

Strategic Behavior One theory is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. An early variant of this argument was expounded by F. T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic industries.15 An oligopoly is an industry composed of a limited num- ber of large firms (e.g., an industry in which four firms control 80 percent of a domestic market would be defined as an oligopoly). A critical competitive feature of such industries is interdependence of the major players: What one firm does can have an immediate impact on the major competitors, forcing a response in kind. By cutting prices, one firm in an oli- gopoly can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share. Thus, the interdependence between firms in an oligopoly leads to imitative behavior; rivals often quickly imitate what a firm does in an oligopoly.

Imitative behavior can take many forms in an oligopoly. One firm raises prices, and the others follow; one expands capacity, and the rivals imitate lest they be left at a disadvantage in the future. Knickerbocker argued that the same kind of imitative behavior characterizes FDI. Consider an oligopoly in the United States in which three firms—A, B, and C—domi- nate the market. Firm A establishes a subsidiary in France. Firms B and C decide that if successful, this new subsidiary may knock out their export business to France and give a first-mover advantage to firm A. Furthermore, firm A might discover some competitive asset in France that it could repatriate to the United States to torment firms B and C on their native soil. Given these possibilities, firms B and C decide to follow firm A and establish operations in France.

Studies that have looked at FDI by U.S. firms show that firms based in oligopolistic industries tended to imitate each other’s FDI.16 The same phenomenon has been ob- served with regard to FDI undertaken by Japanese firms.17 For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by under- taking their own FDI in the United States and Europe. Research has also shown that models of strategic behavior in a global oligopoly can explain the pattern of FDI in the global tire industry.18

Knickerbocker’s theory can be extended to embrace the concept of multipoint competi- tion. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.19 Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other’s moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize competitive attacks in other markets.

Although Knickerbocker’s theory and its extensions can help explain imitative FDI be- havior by firms in oligopolistic industries, it does not explain why the first firm in an oli- gopoly decides to undertake FDI rather than to export or license. Internalization theory addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, internalization theory addresses the efficiency issue. For these reasons, many economists favor internalization theory as an explanation for FDI, although most would agree that the imitative explanation tells an important part of the story.

THE ECLECTIC PARADIGM The eclectic paradigm has been championed by the British economist John Dunning.20 Dunning argues that in addition to the various

Oligopoly An industry composed of a limited number of large firms.

Multipoint Competition Arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.

Chapter Eight Foreign Direct Investment 233

factors discussed earlier, location-specific advantages are also of considerable importance in explaining both the rationale for and the direction of foreign direct investment. By location-specific advantages, Dunning means 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 (such as the firm’s technological, mar- keting, or management capabilities). Dunning accepts the argument of internalization the- ory that it is difficult for a firm to license its own unique capabilities and know-how. Therefore, he argues that combining location-specific assets or resource endowments with the firm’s own unique capabilities often requires foreign direct investment. That is, it re- quires the firm to establish production facilities where those foreign assets or resource en- dowments are located.

An obvious example of Dunning’s arguments are natural resources, such as oil and other minerals, which are by their character specific to certain locations. Dunning suggests that to exploit such foreign resources, a firm must undertake FDI. Clearly, this explains the FDI undertaken by many of the world’s oil companies, which have to invest where oil is located in order to combine their technological and managerial capabilities with this valuable location- specific resource. Another obvious example is valuable human resources, such as low-cost, highly skilled labor. The cost and skill of labor varies from country to country. Because labor is not internationally mobile, according to Dunning it makes sense for a firm to locate pro- duction facilities in those countries where the cost and skills of local labor are most suited to its particular production processes.

However, Dunning’s theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semiconductor industry. Many of the world’s major computer and semiconductor companies—such as Apple Computer, Hewlett-Packard, Oracle, Google, and Intel—are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs there. According to Dunning’s arguments, knowledge being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors is avail- able nowhere else in the world. To be sure, that knowledge is commercialized as it diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning’s language, this means that Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semiconductor industries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part it arises from a network of infor- mal contacts that allows firms to benefit from each other’s knowledge generation. Econo- mists refer to such knowledge “spillovers” as externalities, and there is a well-established theory suggesting that firms can benefit from such externalities by locating close to their source.21

Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and, perhaps, production facilities so they too can learn about and utilize valuable new knowledge before those based elsewhere, thereby giving them a competitive advan- tage in the global marketplace.22 Evidence suggests that European, Japanese, South Korean, and Taiwanese com- puter and semiconductor firms are investing in the Silicon Valley region precisely because they wish to benefit from the externalities that arise there.23 Others have argued that direct investment by foreign firms in the U.S. biotechnol- ogy industry has been motivated by desires to gain access to the unique location-specific technological knowledge of U.S. biotechnology firms.24 Dunning’s theory, therefore, seems to be a useful addition to those outlined previously, because it helps explain how location factors affect the direction of FDI.25

Location-Specific Advantages Advantages that arise from using 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 (such as the firm’s technological, marketing, or management know-how).

Externalities Knowledge spillovers.

Silicon Valley, where Google is based, has long been known as the epicenter of the computer and semiconductor industry.

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234 Part Three The Global Trade and Investment Environment

Political Ideology and Foreign Direct Investment Historically, political ideology toward FDI within a nation has ranged from a dogmatic radical stance that is hostile to all inward FDI at one extreme to an adherence to the nonin- terventionist principle of free market economics at the other. Between these two extremes is an approach that might be called pragmatic nationalism.

THE RADICAL VIEW The radical view traces its roots to Marxist political and economic theory. Radical writers argue that the multinational enterprise (MNE) is an in- strument of imperialist domination. They see the MNE as a tool for exploiting host coun- tries to the exclusive benefit of their capitalist-imperialist home countries. They argue that MNEs extract profits from the host country and take them to their home country, giving nothing of value to the host country in exchange. They note, for example, that key technology is tightly controlled by the MNE and that important jobs in the foreign subsidiaries of MNEs go to home-country nationals rather than to citizens of the host country. Because of this, according to the radical view, FDI by the MNEs of advanced capitalist nations keeps the less developed countries of the world relatively backward and dependent on advanced capitalist nations for investment, jobs, and technology. Thus, according to the extreme version of this view, no country should ever permit foreign cor- porations to undertake FDI, because they can never be instruments of economic develop- ment, only of economic domination. Where MNEs already exist in a country, they should be immediately nationalized.26

From 1945 until the 1980s, the radical view was very influential in the world economy. Until the collapse of communism between 1989 and 1991, the countries of eastern Europe were opposed to FDI. Similarly, communist countries elsewhere—such as China, Cambodia, and Cuba—were all opposed in principle to FDI (although, in practice, the Chinese started to allow FDI in mainland China in the 1970s). Many socialist countries—particularly in Africa, where one of the first actions of many newly independent states was to nationalize

foreign-owned enterprises—also embraced the radical position. Countries whose political ideology was more nationalistic than socialistic further embraced the radical position. This was true in Iran and India, for example, both of which adopted tough policies restricting FDI and nationalized many foreign-owned enterprises. Iran is a particularly interesting case because its Islamic govern- ment, while rejecting Marxist theory, has essentially em- braced the radical view that FDI by MNEs is an instrument of imperialism.

By the early 1990s, the radical position was in retreat almost everywhere. There seem to be three reasons for this: (1) the collapse of communism in eastern Europe; (2) the generally abysmal economic performance of those countries that embraced the radical position, and a grow- ing belief by many of these countries that FDI can be an important source of technology and jobs and can stimu- late economic growth; and (3) the strong economic per- formance of those developing countries that embraced capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan).

THE FREE MARKET VIEW The free mar- ket view traces its roots to classical economics and the international trade theories of Adam Smith and David Ricardo (see Chapter 6). The intellectual case for this view has been strengthened by the internalization

LO 8-3 Understand how political ideology shapes a government’s attitudes toward FDI.

Are They Friends or Not—India and Pakistan? For many years, since the partition of British India in 1947 and the creation of India and Pakistan, these two South Asian coun- tries have been involved in numerous wars, border skirmishes, and military stand-offs. The dispute for Kashmir has been the main reason in most interactions, with a notable exception be- ing the Indo-Pakistani War of 1971, when the conflict started because of turmoil in East Pakistan (now called Bangladesh). However, in trying to improve the economic ties between the two nations, India recently announced that it will allow FDI from Pakistan, paving the way for industries from the neighboring country to set up businesses in the growing Indian market. While this is a prime example of how free markets are promot- ing trade between countries that have not traditionally enjoyed stable political relationships with each other, the question is also on what grounds cross-border interaction is founded. What do you think? Can countries that have been long-standing ene- mies normalize their relationship simply based on foreign direct investment opportunities?

Source: www.hindustantimes.com/business-news/WorldEconomy/India-to-allow- FDI-from-Pakistan-Anand-Sharma/Article1-839942.aspx.

Chapter Eight Foreign Direct Investment 235

explanation of FDI. The free market view argues that international production should be distributed among countries according to the theory of comparative advantage. Countries should specialize in the production of those goods and services that they can produce most efficiently. Within this framework, the MNE is an instrument for dispers- ing the production of goods and services to the most efficient locations around the globe. Viewed this way, FDI by the MNE increases the overall efficiency of the world economy.

Imagine that Dell decided to move assembly operations for many of its personal comput- ers from the United States to Mexico to take advantage of lower labor costs in Mexico. According to the free market view, moves such as this can be seen as increasing the overall efficiency of resource utilization in the world economy. Mexico, due to its lower labor costs, has a comparative advantage in the assembly of PCs. By moving the production of PCs from the United States to Mexico, Dell frees U.S. resources for use in activities in which the United States has a comparative advantage (e.g., the design of computer software, the man- ufacture of high value-added components such as microprocessors, or basic R&D). Also, consumers benefit because the PCs cost less than they would if they were produced domes- tically. In addition, Mexico gains from the technology, skills, and capital that the computer company transfers with its FDI. Contrary to the radical view, the free market view stresses that such resource transfers benefit the host country and stimulate its economic growth. Thus, the free market view argues that FDI is a benefit to both the source country and the host country.

PRAGMATIC NATIONALISM In practice, many countries have adopted nei- ther a radical policy nor a free market policy toward FDI, but instead a policy that can best be described as pragmatic nationalism.27 The pragmatic nationalist view is that FDI has both benefits and costs. FDI can benefit a host country by bringing capital, skills, technol- ogy, and jobs, but those benefits come at a cost. When a foreign company rather than a domestic company produces products, the profits from that investment go abroad. Many countries are also concerned that a foreign-owned manufacturing plant may import many components from its home country, which has negative implications for the host country’s balance-of-payments position.

Recognizing this, countries adopting a pragmatic stance pursue policies designed to maximize the national benefits and minimize the national costs. According to this view, FDI should be allowed so long as the benefits outweigh the costs. Japan offers an example of pragmatic nationalism. Until the 1980s, Japan’s policy was probably one of the most restrictive among countries adopting a pragmatic nationalist stance. This was due to Japan’s perception that direct entry of foreign (especially U.S.) firms with ample managerial resources into the Japanese markets could hamper the development and growth of its own industry and technology.28 This belief led Japan to block the majority of applications to invest in Japan. However, there were always exceptions to this policy. Firms that had important technology were often permitted to undertake FDI if they insisted that they would neither license their technology to a Japanese firm nor enter into a joint venture with a Japanese enterprise. IBM and Texas Instruments were able to set up wholly owned subsidiaries in Japan by adopting this negotiating position. From the perspective of the Japanese government, the benefits of FDI in such cases—the stimulus that these firms might impart to the Japanese economy—outweighed the perceived costs.

Another aspect of pragmatic nationalism is the tendency to aggressively court FDI believed to be in the national interest by, for example, offering subsidies to foreign MNEs in the form of tax breaks or grants. The countries of the European Union often seem to be competing with each other to attract U.S. and Japanese FDI by offering large tax breaks and subsidies. Britain has been the most successful at attracting Japanese invest- ment in the automobile industry. Nissan, Toyota, and Honda now have major assembly plants in Britain and use the country as their base for serving the rest of Europe—with obvious employment and balance-of-payments benefits for Britain.

236 Part Three The Global Trade and Investment Environment

SHIFTING IDEOLOGY Recent years have seen a marked decline in the number of countries that adhere to a radical ideology. Although few countries have adopted a pure free market policy stance, an increasing number of countries are gravitating toward the free mar- ket end of the spectrum and have liberalized their foreign investment regime. This includes many countries that less than two decades ago were firmly in the radical camp (e.g., the former communist countries of eastern Europe, many of the socialist countries of Africa, and India) and several countries that until recently could best be described as pragmatic nationalists with regard to FDI (e.g., Japan, South Korea, Italy, Spain, and most Latin Amer- ican countries). One result has been the surge in the volume of FDI worldwide, which, as we noted earlier, has been growing twice as fast as the growth in world trade. Another result has been an increase in the volume of FDI directed at countries that have recently liberalized their FDI regimes, such as China, India, and Vietnam.

As a counterpoint, there is some evidence of a shift to a more hostile approach to foreign direct investment in some nations. Venezuela and Bolivia have become increasingly hostile to foreign direct investment. In 2005 and 2006, the governments of both nations unilater- ally rewrote contracts for oil and gas exploration, raising the royalty rate that foreign enterprises had to pay the government for oil and gas extracted in their territories. Follow- ing his election victory in 2006, Bolivian President Evo Morales nationalized the nation’s gas fields and stated that he would evict foreign firms unless they agreed to pay about 80 percent of their revenues to the state and relinquish production oversight. In some de- veloped nations, there is increasing evidence of hostile reactions to inward FDI as well. In Europe in 2006, there was a hostile political reaction to the attempted takeover of Europe’s largest steel company, Arcelor, by Mittal Steel, a global company controlled by the Indian entrepreneur Lakshmi Mittal. In mid-2005, China National Offshore Oil Company with- drew a takeover bid for Unocal of the United States after highly negative reaction in Congress about the proposed takeover of a “strategic asset” by a Chinese company. Similarly, as detailed in the accompanying Management Focus, in 2006 a Dubai-owned

DP World and the United States

In February 2006, DP World, a ports operator with global reach owned by the government of Dubai, a member of the United Arab Emirates and a staunch U.S. ally, paid $6.8 billion to acquire P&O, a British firm that runs a global network of marine terminals. With P&O came the man- agement operations of six U.S. ports: Miami, Philadelphia, Baltimore, New Orleans, New Jersey, and New York. The acquisition had already been approved by U.S. regulators when it suddenly became front-page news. Upon hearing about the deal, several prominent U.S. senators raised concerns about the acquisition. Their objections were twofold. First, they raised questions about the security risks associated with management operations in key U.S. ports being owned by a foreign enterprise that was based in the Middle East. The implication was that terrorists could somehow take advantage of the ownership arrange- ment to infiltrate U.S. ports. Second, they were concerned that DP World was a state-owned enterprise and argued that foreign govern- ments should not be in a position of owning key “U.S. strategic assets.”

The Bush administration was quick to defend the takeover, stating it posed no threat to national security. Others noted that DP World was a respected global firm with an American chief operating officer and an American-educated chairman; the head of the global ports

management operation would also be an American. DP World would not own the U.S. ports in question, just manage them, while security issues would remain in the hands of American customs officials and the U.S. Coast Guard. Dubai was also a member of America’s Con- tainer Security Initiative, which allows American customs officials to inspect cargo in foreign ports before it leaves for the United States. Most of the DP World employees at American ports would be U.S. citizens, and any UAE citizen transferred to DP World would be sub- ject to American visa approval.

These arguments fell on deaf ears. With several U.S. senators threatening to pass legislation to prohibit foreign ownership of U.S. port operations, DP World bowed to the inevitable and announced it would sell off the right to manage the six U.S. ports for about $750 million. Looking forward, however, DP World stated it would seek an initial pub- lic offering in 2007, and the then-private firm would in all probability continue to look for ways to enter the United States. In the words of the firm’s CEO, “This is the world’s largest economy. How can you just ignore it?”

Sources: “Trouble at the Waterfront,” The Economist, February 25, 2006, p. 48; “Paranoia about Dubai Ports Deals Is Needless,” Financial Times, February 21, 2006, p. 16; and “DP World: We’ll Be Back,” Traffic World, May 29, 2006, p. 1.

management FOCUS

Chapter Eight Foreign Direct Investment 237

company withdrew its planned takeover of some operations at six U.S. ports after negative political reactions. So far, these countertrends are nothing more than isolated incidents, but if they become more widespread, the 30-year movement toward lower barriers to cross- border investment could be in jeopardy.

Benefits and Costs of FDI To a greater or lesser degree, many governments can be considered pragmatic national- ists when it comes to FDI. Accordingly, their policy is shaped by a consideration of the costs and benefits of FDI. Here, we explore the benefits and costs of FDI, first from the perspective of a host (receiving) country and then from the perspective of the home (source) country. In the next section, we look at the policy instruments governments use to manage FDI.

HOST-COUNTRY BENEFITS The main benefits of inward FDI for a host country arise from resource-transfer effects, employment effects, balance-of-payments ef- fects, and effects on competition and economic growth.

Resource-Transfer Effects Foreign direct investment can make a positive contri- bution to a host economy by supplying capital, technology, and management resources that would otherwise not be available and thus boost that country’s economic growth rate (as described in the opening case, the Indian government has come around to this view and has adopted a more permissive attitude to inward investment).29

With regard to capital, many MNEs, by virtue of their large size and financial strength, have access to financial resources not available to host-country firms. These funds may be available from internal company sources, or, because of their reputation, large MNEs may find it easier to borrow money from capital markets than host-country firms would.

As for technology, you will recall from Chapter 3 that technology can stimulate economic development and industrialization. Technology can take two forms, both of which are valu- able. Technology can be incorporated in a production process (e.g., the technology for dis- covering, extracting, and refining oil), or it can be incorporated in a product (e.g., personal computers). However, many countries lack the research and development resources and skills required to develop their own indigenous product and process technology. This is particularly true in less developed nations. Such countries must rely on advanced industrialized nations for much of the technology required to stimulate economic growth, and FDI can provide it.

Research supports the view that multinational firms often transfer significant technology when they invest in a foreign country.30 For example, a study of FDI in Sweden found that foreign firms increased both the labor and total factor pro- ductivity of Swedish firms that they acquired, suggesting that significant technology transfers had occurred (technol- ogy typically boosts productivity).31 Also, a study of FDI by the Organization for Economic Cooperation and Develop- ment (OECD) found that foreign investors invested signifi- cant amounts of capital in R&D in the countries in which they had invested, suggesting that not only were they trans- ferring technology to those countries but they may also have been upgrading existing technology or creating new tech- nology in those countries.32

Foreign management skills acquired through FDI may also produce important benefits for the host country.

LO 8-4 Describe the benefits and costs of FDI to home and host countries.

Does Foreign Direct Investment Promote Growth? There are multiple reasons for companies to make foreign direct investments. Lowering the cost of production, increasing capac- ity (volume) of production, and strategically locating production facilities to serve world regions are some of the many reasons for FDI by a company. For the host countries that receive the in- vestment by multinational corporations, the logic is that the in- flux of capital and increase in tax revenues will benefit the host country in the form of new infrastructure, increased knowledge, and general economic development. However, the evidence so far is very mixed on the value of FDI to the host, ranging from beneficial to detrimental. What do you think? Does FDI promote growth in the host country?

Source: L. Alfaro, A. Chanda, S. Kalemli-Ozcan, and S. Sayek, “Does Foreign Direct Investment Promote Growth? Exploring the Role of Financial Markets on Linkages,” Cambridge, MA; Harvard Business School, 2009. www.people.hbs.edu/ lalfaro/fdiandlinkages.pdf.

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238 Part Three The Global Trade and Investment Environment

Foreign managers trained in the latest management techniques can often help improve the efficiency of operations in the host country, whether those operations are acquired or greenfield de- velopments. Beneficial spin-off effects may also arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help establish indigenous firms. Similar benefits may arise if the superior management skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own man- agement skills.

Employment Effects Another beneficial employment effect claimed for FDI is that it brings jobs to a host country that would otherwise not be created there. The effects of FDI on employ- ment are both direct and indirect. Direct effects arise when a for- eign MNE employs a number of host-country citizens. Indirect

effects arise when jobs are created in local suppliers as a result of the investment and when jobs are created because of increased local spending by employees of the MNE. The indirect employment effects are often as large as, if not larger than, the direct effects. For example, when Toyota decided to open a new auto plant in France, estimates suggested the plant would create 2,000 direct jobs and perhaps another 2,000 jobs in support industries.33

Cynics argue that not all the “new jobs” created by FDI represent net additions in em- ployment. In the case of FDI by Japanese auto companies in the United States, some argue that the jobs created by this investment have been more than offset by the jobs lost in U.S.- owned auto companies, which have lost market share to their Japanese competitors. As a consequence of such substitution effects, the net number of new jobs created by FDI may not be as great as initially claimed by an MNE. The issue of the likely net gain in employ- ment may be a major negotiating point between an MNE wishing to undertake FDI and the host government.

When FDI takes the form of an acquisition of an established enterprise in the host economy as opposed to a greenfield investment, the immediate effect may be to reduce employment as the multinational tries to restructure the operations of the acquired unit to improve its operating efficiency. However, even in such cases, research suggests that once the initial period of restructuring is over, enterprises acquired by foreign firms tend to increase their employment base at a faster rate than domestic rivals. An OECD study found that foreign firms created new jobs at a faster rate than their domestic counterparts.34

Balance-of-Payments Effects FDI’s effect on a country’s balance-of-payments accounts is an important policy issue for most host governments. A country’s balance-of-payments accounts track both its payments to and its receipts from other countries. Governments normally are concerned when their country is running a deficit on the current account of their balance of payments. The current account tracks the export and import of goods and services. A current account deficit, or trade deficit as it is often called, arises when a country is importing more goods and services than it is exporting. Governments typically prefer to see a current account surplus than a deficit. The only way in which a current account deficit can be supported in the long run is by selling off assets to foreigners (for a detailed explanation of why this is the case, see the appendix to Chapter 6). For example, the persistent U.S. current account deficit since the 1980s has been financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to foreigners. Because national governments invariably dislike seeing the assets of their country fall into foreign hands, they prefer their nation to run a current account surplus. There are two ways in which FDI can help a country achieve this goal.

Balance-of-Payments Accounts National accounts that track both payments to and receipts from foreigners.

Current Account In the balance of payments, records transactions involving the export or import of goods and services.

Job creation is a result of FDI. These French workers assemble cars at Toyota’s Valenciennes manufacturing plant.

Chapter Eight Foreign Direct Investment 239

First, if the FDI is a substitute for imports of goods or services, the effect can be to improve the current account of the host country’s balance of payments. Much of the FDI by Japanese automobile companies in the United States and Europe, for example, can be seen as substituting for imports from Japan. Thus, the current account of the U.S. balance of pay- ments has improved somewhat because many Japanese companies are now supplying the U.S. market from production facilities in the United States, as opposed to facilities in Japan. Insofar as this has reduced the need to finance a current account deficit by asset sales to foreigners, the United States has clearly benefited.