© Ram Mudambi, Temple University, 2007 1 Lecture 4 Foreign Direct Investment.

© Ram Mudambi, Temple University, 2007 1

Lecture 4 Foreign Direct Investment

http://www.temple.edu/


1. Foreign Direct Investment

2. The Political Economy of Foreign Direct Investment



DaimlerChrysler – Group Sales by Region - 2004

Units in ‘000s

Is this an accurate picture of the firm’s global footprint?

71.1%

West Europe20.5%

Japan1.1%

9.9%

WORLD Total = 3,903

GermanyNAFTA

US62.3%



Mercedes – Group Sales by Region - 2004

Units in ‘000s

What is the unit value of Mercedes relative to Chrysler?

WORLD Total = 3,903

19.9%

West Europe66.6%

Japan3.5%

32.2%

GermanyNAFTA

US18.5%



What is Foreign Direct Investment (FDI)?

FDI occurs when a firm invests directly in facilities to produce and/or market a product or service in a foreign country.

FDI is not the investment by individuals, firms or public bodies in foreign financial instruments (PORTFOLIO INVESTMENT)



FDI Taxonomy

MODE

Greenfield Acquisition

Wholly-owned 1 3

Partially owned 2 4

Controllinginterest

Minorityinterest

A firm settingup a de novooperation in

another country

A firm buying a firm in

another country

Targets necessary



Flow vs Stock of FDI

Flow: Amount of FDI over a period of time (one year).

Stock: Total accumulated value of foreign owned assets at a given point in time.



FDI outflows, 1982-2002



FDI flows by region



FDI outflows by select country1998-2001



World GDP, exports and FDI

World GDP and FDI 1990-2001 (index = 100 in 1990)


Secular pattern

FDI Growth > Trade growth > Output growth



Gross Fixed Capital Formation

A summary of the total amount of capital invested in factories, stores office buildings, and the like.

All things being equal, the greater the capital investment in an economy, the more favorable its future growth prospects are likely to be.



Inward FDI flows As a percentage of gross fixed capital formation, 2000



FDI Inflow for Selected Countries% of total capital investment, 2005

0

5

1 0

1 5

2 0

2 5

3 0

3 5

4 0

4 5

2 0 0 5

U KS w e d e nC h i l eA r g e n t i n aC h i n aI n d i aJ a p a n



Why is FDI growing more rapidly than world trade or output?

World political and economic change

Wider acceptanceof MNC operations

Movement of operations to the most efficient location

MACRO



Why is FDI growing more rapidly than world trade or output?

Growing power of regionaleconomic blocs

EU, NAFTA, Mercosur, etc.

Strategy of extra-bloc firms to become ‘domestic’

– ‘tariff-jumping’

MICRO

Improved logistics

Movement of operations to the most efficient location

Most internationaltrade is intra-firm



Two Forms of FDIV

alue

cha

in Location 1Stage 1

Location 2Stage 1Horizontal FDI

Location 2Stage 0

BackwardVertical FDI

Location 2Stage 2

ForwardVertical FDI

HOME

HOST



FDI – composition changes FDI been growing in terms of volume, but

it has also been changing in its composition Increasingly FDI represents a considerable

amount of transfer of knowledge Know-how and skills Scientific knowledge Organizational knowledge

Multinational firms do not like to give up control of this knowledge


Impediments to the Sale of Know-how

Impediments to the sale of know- how

Risk giving away know-

how to competitors

Licensing implies low control over

foreign entityKnow-how not amenable to

licensing

© Ram Mudambi, Temple University, 2001


HFDI, When and Why?

Transportation too costly? Most cited: Market Imperfections (Internalization

Theory). Impediments to the free flow of products between nations. Impediments to the sale of know-how.

Follow the lead of a competitor - strategic rivalry. Product Life Cycle - however, does not explain when it’s

profitable to invest abroad.

Location specific advantages (natural resources).



HFDI, Where?

Firms first expand into host countries that are culturally close to the home country

British firms US firms

The Stage Theory of FDI

US, Australia, New Zealand

Canada, Mexico



The Stage Theory: Wal-Mart International

INTERNATIONAL DISCOUNT STORES SUPERCENTERS SAM'S CLUBArgentina 0 6 3Brazil 0 5 3Canada 144 0 0Mexico 347 27 28Puerto Rico 9 0 5China 0 2 1Germany 0 21 0

International Totals: 500 61 40

Wal-mart has since withdrawnfrom Germany


HFDI – A Decision FrameworkHow high are How high are

transportation costs transportation costs and tariffs?and tariffs?

Is know-how amenable Is know-how amenable to licensing?to licensing?

Is tight control over foreign Is tight control over foreign operation required?operation required?

Can know-how be protected Can know-how be protected by licensing contractby licensing contract??

LicenseLicense

ExportExport

Horizontal FDIHorizontal FDI



No

High

Yes

Yes

Low

No

Yes

No


Case: FDI and the Irish miracle FDI in Ireland grew from $164m (1985) to

$24b (2000) (roughly 150 fold!) By 2000 two-thirds of Irelands top exporters

were MNEs Reasons for Ireland’s success

Member of EU (access to EU markets) Highly educated workforce; Good infrastructure

In 1985, Ireland was the 2nd poorest W.European country. Today it is the 2nd richest.



FDI into China – Success story?

Japan TaiwanUS

Other

Hong KongHong KongOtherUSJapanTaiwan

Second Largest Recipient of FDI After US



Changing Face of China’s Foreign Investment

Source: McKinsey & Co

1992 2002

Joint Ventures 70% 48%

Wholly owned foreign subsidiaries

30% 52%



FDI – China vs. the US

• High percentage fromother developedcountries • Largely by acquisition• Largely market seeking

The US

• High percentage fromother developingcountries • Largely greenfield• Largely asset seeking• Large amount of‘round-tripping’

China

However, recently:• More market seeking FDI• More FDI from developed countries



The Political Economy of Foreign Direct Investment



The Spectrum of Political Ideology Toward FDI

RadicalView

PragmaticNationalism

FreeMarket



Radical View Marxist view is that MNE’s enslave less

developed countries. Instrument of domination not

development. Popular from WWII to the 1980s.

Practiced by Eastern Europe, India, China, 3rd World Countries.

Ended with the collapse of Communism. Bad performance by those countries vs. those

with freer market approach



Free Market View

Sees FDI as way to disperse production and flow of goods and services in the most efficient manner. Supported by Smith and Ricardo and ‘market

imperfection’ explanations of FDI.

However, all countries impose some restrictions on FDI.



Pragmatic View

Lies somewhere between radical and free market views.

Governments should maximize national benefits and minimize costs of FDI.



Ideology and FDIIdeology Characteristics

Host-Government Policy Implications

Radical

Marxist rootsViews FDI as an imperialist tool

Prohibit FDINationalize MNC

subsidiaries

Free Market

Classical economic roots

FDI as a tool for efficient location of

operations

No restrictions on FDI

Pragmatic Nationalis

m

FDI has both benefits and costs

Court targeted MNCsTailor incentives



What do the data tell us? – 1 MNC economic interests are

overwhelmingly concentrated in the triad – North America, Europe and Japan/East Asia

There is no evidence that triad governments are subject to ‘control’ by MNCs Competitive pressures cause MNCs to cancel each

other out

Activities outside the triad are too insignificant to justify expense of political activities E.g., a recent CIMA study found that most MNCs

followed ‘whiter than white’ accounting practices



What do the data tell us? – 2 Globalization refers to FDI, not financial flows FDI flows are extremely stable MNC strategies tend to be regional, rather than

global, reflecting regional trading blocs Fears of global homogenization are over-rated EU, NAFTA, Mercosur, APEC

MNCs tend to be “flagship firms” – serve as hubs of extensive business networks/clusters



Benefits of FDI to Host Countries

Resource-transfer effects Capital, technology, management

Employment effects Balance-of-payments effects Economic growth



FDI and resource-transfer effects

HOME

Parent

HOST

Subsidiary

Spilloverof

technologyand

managementpractices

Inflow of capital



FDI and employment effects

HOST

Subsidiary

Directlocaljobs

created

Jobs createdin local

supplier &ancillary network

Jobs created due to increasedincome generation

Jobs lost in localfirms that are driven out ofbusiness



FDI and balance of payments

HOME

Parent

HOST

Subsidiary

Localoutput

replacesimports

(+)

Inflow of capital(+)

Repatriated profits (-)

3rd CountrySubsidiary

exports(+)

Taxes, tariffsand otherpaymentsto the govt.(+)



Economic Growth

Increased: productivity growth, product and process innovation, and greater economic growth,

Stemming from increased competition of MNE’s investments.



How Do Countries Encourage FDI?*

Risk insurance.(Home) Elimination of double taxation. (Home) Tax incentives.(Host) Low interest rates. (Host) Grants for land and training of workforce

(Host) Stable government and stable policies (Host)

*See http://sbm.temple.edu/~rmudambi/Publications/Mudambi%20IJEB.pdf

http://sbm.temple.edu/~rmudambi/Publications/Mudambi%20IJEB.pdf



How Do Countries Discourage FDI?

Limit capital outflows. (Home) Manipulate tax code to encourage domestic

investment. (Home) Political restrictions on investing in certain

countries. (Home) Ownership restraints. (Host) Performance requirements. (Host)



Vernon’s Obsolescing Bargain: Determinants of Bargaining Power

Bargaining Power of FirmHigh Low

Firms time horizon Long Short

Comparable alternatives open to firm

Many Few

Value placed by host government on investment

LowHigh



Takeaways

FDI has been rising faster than GDP or trade Rising power of regional blocs; better logistics

HFDI – customization VFDI – value chain disaggregation FDI as a powerful economic stimulant

Examples – Ireland, China

Pragmatic view of MNEs – use with care Potential benefits of FDI

Resource transfer, employment, BOP, growth


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© Ram Mudambi, Temple University, 2007 1 Lecture 4 Foreign Direct Investment.

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