Lecture 5Lecture 5

International FinanceInternational Finance

ECON 243 – Summer I, 2005ECON 243 – Summer I, 2005

Prof. Steve CunninghamProf. Steve Cunningham

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International LendingInternational Lending

International capital movementInternational capital movement: the flow of : the flow of capital claims between lenders and capital claims between lenders and borrowers across international boundaries.borrowers across international boundaries.

These are usually broken down by:These are usually broken down by: Private vs. GovernmentPrivate vs. Government (official) (official) Long term vs. Short termLong term vs. Short term

Note that we do not differentiate between Note that we do not differentiate between equity and debt, other than equity positions equity and debt, other than equity positions are always considered long term.are always considered long term.

What is “What is “equityequity”? “”? “Debt equityDebt equity”?”?

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Breakdown of CapitalBreakdown of Capital Private lending and investingPrivate lending and investing

Long TermLong Term Direct InvestmentDirect Investment (lending to or purchasing shares in, a (lending to or purchasing shares in, a

foreign enterprise largely owned and controlled by the foreign enterprise largely owned and controlled by the investor)investor)

LoansLoans (to a foreign borrower) with maturity of more (to a foreign borrower) with maturity of more than one year, mostly by banksthan one year, mostly by banks

Portfolio InvestmentPortfolio Investment (purchasing stock or bonds with a (purchasing stock or bonds with a maturity of more than one year, issued by a gov’t or maturity of more than one year, issued by a gov’t or foreign enterprise foreign enterprise notnot controlled by the investor) controlled by the investor)

Short TermShort Term (lending to a foreign borrower, or (lending to a foreign borrower, or purchasing bonds issued by the gov’t or a foreign purchasing bonds issued by the gov’t or a foreign enterprise not controlled by the investor, maturing in enterprise not controlled by the investor, maturing in a year or less)a year or less)

Official lending and investmentOfficial lending and investment (by a gov’t or (by a gov’t or institution like the IMF or World Bank. Mostly institution like the IMF or World Bank. Mostly lending, both long term and short term.lending, both long term and short term.

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Who is doing the lending?Who is doing the lending?

From WWII until the early 1980s, the U.S. From WWII until the early 1980s, the U.S. was the single largest lender, joined in was the single largest lender, joined in the 1970s by the newly rich oil exporters.the 1970s by the newly rich oil exporters. The major type of lending was official loans The major type of lending was official loans

from governments and direct foreign from governments and direct foreign investments (DFI)investments (DFI)

Since the early 1980s, the dominant Since the early 1980s, the dominant lender has been Japan.lender has been Japan. The major type of lending has been private The major type of lending has been private

loans and portfolio investment.loans and portfolio investment.

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Benefits of Int’l LendingBenefits of Int’l Lending It amounts to It amounts to intertemporal tradeintertemporal trade

The lender gives up resources today in order The lender gives up resources today in order to receive more in return in the future.to receive more in return in the future.

The borrower gets resources today, but will The borrower gets resources today, but will be able to generate more product in the be able to generate more product in the future, which he must share with the lender.future, which he must share with the lender.

It allows lenders and investors to enjoy It allows lenders and investors to enjoy broader broader diversificationdiversification, lowering the , lowering the overall risk of their portfolios.overall risk of their portfolios. What is diversification?What is diversification? There may be no equivalent domestic There may be no equivalent domestic

investment/lending opportunity.investment/lending opportunity.

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Gains to Lending and BorrowingGains to Lending and Borrowing

Optimality depends upon:Optimality depends upon: The world being stable and predictable,The world being stable and predictable, Borrowers fully honoring their Borrowers fully honoring their

commitments to repaycommitments to repay In such a world, lending is Pareto In such a world, lending is Pareto

optimal.optimal. The welfare effects of international The welfare effects of international

lending exactly parallel the welfare lending exactly parallel the welfare effects of free trade.effects of free trade.

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Gains from Int’l LendingGains from Int’l Lending

Free international lending raises world Free international lending raises world product and national incomes—world product and national incomes—world product is maximized.product is maximized.

If a country is dominant enough to have If a country is dominant enough to have power over the world market rate of power over the world market rate of return, it can exploit this market power return, it can exploit this market power to its own advantage, at the expense of to its own advantage, at the expense of other countries, and the world as a other countries, and the world as a whole.whole. Just as oil producers are able to raise world oil prices Just as oil producers are able to raise world oil prices

by controlling supply, a world lender (like Japan) by controlling supply, a world lender (like Japan) could raise world interest rates.could raise world interest rates.

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Lending Among Industrialized Lending Among Industrialized CountriesCountries

Int’l lending and borrowing between Int’l lending and borrowing between industrialized countries is generally well-industrialized countries is generally well-behaved and nonpredatory.behaved and nonpredatory. This may be because even though one country may This may be because even though one country may

dominate lending, other countries have other areas dominate lending, other countries have other areas that they dominate, and each is afraid of retaliation that they dominate, and each is afraid of retaliation in another market.in another market.

Also, these countries present little default risk.Also, these countries present little default risk. The record of int’l lending by industrialized The record of int’l lending by industrialized

countries to developing countries has been countries to developing countries has been quite different.quite different. It has been risky, highly political, and, at times It has been risky, highly political, and, at times

predatory.predatory.

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Lending to Developing CountriesLending to Developing Countries

A developing country sometimes A developing country sometimes runs into problems, and is unable to runs into problems, and is unable to service its debts.service its debts. Such countries sometimes must defaultSuch countries sometimes must default

—fail to make their loan payments as —fail to make their loan payments as required under the loan agreements.required under the loan agreements.

Lenders then cut back or stop new Lenders then cut back or stop new lending, worsening the problems within lending, worsening the problems within the developing country. the developing country.

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1974 - 19821974 - 1982 Oil shocks of the 1970s led to a surge in private int’l lending to Oil shocks of the 1970s led to a surge in private int’l lending to

developing countries.developing countries. Between 1970 and 1980, developing country debt increased by 7 Between 1970 and 1980, developing country debt increased by 7

times.times. Oil shocks caused the price of oil to skyrocket, causing high Oil shocks caused the price of oil to skyrocket, causing high

inflation and recession in the industrialized countries.inflation and recession in the industrialized countries. The windfall profits to the oil producers went primarily to saving The windfall profits to the oil producers went primarily to saving

(and lending), reaching investments in the U.S. and world money (and lending), reaching investments in the U.S. and world money centers.centers.

Productivity was not growing in the large, industrialized nations, Productivity was not growing in the large, industrialized nations, so people were becoming pessimistic about the profitability of so people were becoming pessimistic about the profitability of capital formation in these countries. Therefore, the lenders capital formation in these countries. Therefore, the lenders targeted developing nations.targeted developing nations.

Developing countries had also come to dislike FDI because it Developing countries had also come to dislike FDI because it meant giving up domestic control of its businesses. This made meant giving up domestic control of its businesses. This made more attractive.more attractive.

Banks too aggressively sought to lend, taking on too risky loans.Banks too aggressively sought to lend, taking on too risky loans.

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Debt Crisis of 1982Debt Crisis of 1982 August 1982, Mexico defaults on its large August 1982, Mexico defaults on its large

foreign debt. Other countries quickly followed foreign debt. Other countries quickly followed with defaults.with defaults.

In 1982, driven by fed actions attempting to In 1982, driven by fed actions attempting to end the high inflation of the 1970s, interest end the high inflation of the 1970s, interest rates in the U.S. increased sharply.rates in the U.S. increased sharply.

The U.S. and other industrialized countries fell The U.S. and other industrialized countries fell into deep recession.into deep recession.

Developing countries’ exports and export prices Developing countries’ exports and export prices fell dramatically. fell dramatically. Their interest payments were rising, but their Their interest payments were rising, but their

revenues were falling!revenues were falling!

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Debt Crisis of 1982 Debt Crisis of 1982 (Continued)(Continued)

With such large loans defaulting, some With such large loans defaulting, some banks were in financial danger. banks were in financial danger.

Larger banks couldn’t get rid of the bad Larger banks couldn’t get rid of the bad loans, and wound up rescheduling the loans, and wound up rescheduling the payments and making more smaller payments and making more smaller loans to allow the gov’ts to attempt to loans to allow the gov’ts to attempt to work through their short-term problems. work through their short-term problems. (“Too large to fail” problem.)(“Too large to fail” problem.)

While this prevented immediate While this prevented immediate problems, it greatly reduced the flow of problems, it greatly reduced the flow of lending to these countries.lending to these countries.

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Debt Crisis of 1982 Debt Crisis of 1982 (Continued)(Continued)

Brady BillBrady Bill U.S. Treasury plan to help the debtor U.S. Treasury plan to help the debtor

countries restore growth and financial countries restore growth and financial viability.viability.

The debts were reduced and most of the The debts were reduced and most of the remaining debt was refinanced at much remaining debt was refinanced at much better terms via “Brady bonds.”better terms via “Brady bonds.”

By 1994 most of the bank debt had been By 1994 most of the bank debt had been converted and repackaged as bonds. converted and repackaged as bonds.

The debt crisis was over.The debt crisis was over.

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1980-20011980-2001

Long-term financial flowsLong-term financial flows

-50

0

50

100

150

200

1980 1985 1990 1995 2000

Bank Loans

FDI

Official

Billions of U.S. dollarsBillions of U.S. dollars

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The 1990sThe 1990s

Around 1990, lending to developing Around 1990, lending to developing countries began to recover.countries began to recover. The Brady Plan restored confidence.The Brady Plan restored confidence. As each country agreed to a Brady deal, it was As each country agreed to a Brady deal, it was

usually able to achieve private loans usually able to achieve private loans immediately.immediately.

U.S. interest rates were very low.U.S. interest rates were very low. The gov’ts of developing countries, eager to The gov’ts of developing countries, eager to

attract capital, made changes that made them attract capital, made changes that made them much more attractive to lenders.much more attractive to lenders.

DeregulationDeregulation Privatization of gov’t-owned enterprisesPrivatization of gov’t-owned enterprises Trade policy liberalizationTrade policy liberalization

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Mexican Crisis, 1994-1995Mexican Crisis, 1994-1995

Investors began to move heavily into Mexico in the Investors began to move heavily into Mexico in the early 1990s when that country made significant early 1990s when that country made significant economic reforms and entered NAFTA.economic reforms and entered NAFTA.

The exchange rate of the peso rose.The exchange rate of the peso rose. Mexican inflation was higher than the U.S.Mexican inflation was higher than the U.S. Mexico’s CA deficit rose to 8% of its GDP in 1994.Mexico’s CA deficit rose to 8% of its GDP in 1994. Mexican bank supervision and regulation was poor by Mexican bank supervision and regulation was poor by

int’l standards.int’l standards. Bank lending grew rapidly, as did defaults.Bank lending grew rapidly, as did defaults. 1994 was an election year, there were two political 1994 was an election year, there were two political

assassinations, and an a political uprising, leading to assassinations, and an a political uprising, leading to concerns about the stability of the government.concerns about the stability of the government.

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More on theMore on the

Mexican Crisis, 1994-1995Mexican Crisis, 1994-1995 These events put increasing downward pressure on the peso. These events put increasing downward pressure on the peso.

The gov’t used sterilized intervention to defend the exchange The gov’t used sterilized intervention to defend the exchange rate, causing a drain on int’l reserves.rate, causing a drain on int’l reserves.

The gov’t replaced the peso-denominated debt with short-term The gov’t replaced the peso-denominated debt with short-term dollar-indexed gov’t debt (dollar-indexed gov’t debt (tesobonostesobonos).).

The citizens began to fear currency devaluation, and capital The citizens began to fear currency devaluation, and capital flight ensued. This created a huge supply of pesos on the int’l flight ensued. This created a huge supply of pesos on the int’l market. market.

The Mexican gov’t was forced to allow the peso to depreciate The Mexican gov’t was forced to allow the peso to depreciate against major currencies, and attempted to “roll over” the against major currencies, and attempted to “roll over” the dollar-indexed debt.dollar-indexed debt.

Investors refused to roll-over in Investors refused to roll-over in tesobonostesobonos, and wanted to , and wanted to receive repayment of principal in dollars. Mexico could probably receive repayment of principal in dollars. Mexico could probably not repay them all at once…not repay them all at once…

Investors pulled out of Mexico, but also many other developing Investors pulled out of Mexico, but also many other developing (esp. Latin American) countries—the “tequilla effect”.(esp. Latin American) countries—the “tequilla effect”.

The U.S. arranged a bail-out package, allowing Mexico to borrow The U.S. arranged a bail-out package, allowing Mexico to borrow up $50 billion from the U.S. and the IMF.up $50 billion from the U.S. and the IMF.

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The Asian Crisis, 1997The Asian Crisis, 1997 Impressed with their rapid growth rates, budget Impressed with their rapid growth rates, budget

surpluses, liberal trade policies, and low inflation, surpluses, liberal trade policies, and low inflation, investors were attracted to Southeast and East Asian investors were attracted to Southeast and East Asian countries in the 1990-1996 period.countries in the 1990-1996 period.

Gov’t bank regulation and supervision was poor. Banks Gov’t bank regulation and supervision was poor. Banks took on excessive risks by engaging in foreign exchange took on excessive risks by engaging in foreign exchange speculation, and risky local lending practices.speculation, and risky local lending practices.

Probably as a result of high real exchange rates, the Probably as a result of high real exchange rates, the countries began to suffer worsening trade balances.countries began to suffer worsening trade balances.

In 1996, the prospect of worsening export sales caused a In 1996, the prospect of worsening export sales caused a collapse in Thailand’s stock market. The Thai real estate collapse in Thailand’s stock market. The Thai real estate market began to dive. Finally the exchange rate of the market began to dive. Finally the exchange rate of the Thai baht took a nosedive, and the gov’t had to let it Thai baht took a nosedive, and the gov’t had to let it depreciate in 1997.depreciate in 1997.

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More on More on

The Asian Crisis, 1997The Asian Crisis, 1997 Those Thai citizens with uncovered positions Those Thai citizens with uncovered positions

began to sell off baht to move into foreign began to sell off baht to move into foreign currency assets.currency assets.

Banks that had speculated and made risky Banks that had speculated and made risky loans came under pressure.loans came under pressure.

The fear spread to other Asian countries, The fear spread to other Asian countries, especially Indonesia, Korea, Malaysia, and the especially Indonesia, Korea, Malaysia, and the Phillipines.Phillipines.

The IMF put together a large array of loan The IMF put together a large array of loan packages to the countries involved.packages to the countries involved.

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The Russian Crisis, 1998The Russian Crisis, 1998 Russia still hasn’t solidified its economic position Russia still hasn’t solidified its economic position

since the break-up of the USSR.since the break-up of the USSR. In 1998 it had large fiscal budget deficits and In 1998 it had large fiscal budget deficits and

heavy government borrowing.heavy government borrowing. Ultimate, lenders said “no more”.Ultimate, lenders said “no more”. The IMF organized a bail-out including a credit The IMF organized a bail-out including a credit

line of $23 billion, with the IMF contributing $5 line of $23 billion, with the IMF contributing $5 billion.billion.

Russia failed to enact policy changes required as Russia failed to enact policy changes required as conditions for the loan package.conditions for the loan package.

Capital flight ensued, and the ruble crashed. This Capital flight ensued, and the ruble crashed. This was followed by a collapse in Russian stock and was followed by a collapse in Russian stock and bond prices.bond prices.

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More onMore on

The Russian Crisis, 1998The Russian Crisis, 1998 In August 1998, Russia unilaterally defaulted on In August 1998, Russia unilaterally defaulted on

ruble-denominated debt, wiping out most of the ruble-denominated debt, wiping out most of the value due the lenders. This nearly brought down value due the lenders. This nearly brought down Brazil, who required an IMF loan to survive. Brazil Brazil, who required an IMF loan to survive. Brazil floated its currency, the floated its currency, the realreal..

It placed a 90-day freeze on payments of foreign It placed a 90-day freeze on payments of foreign currency obligations to protect Russian banks.currency obligations to protect Russian banks.

It allowed the ruble to float and depreciate.It allowed the ruble to float and depreciate. Russia asked for the next installment of loans from Russia asked for the next installment of loans from

the IMF, but given these actions, the IMF refused.the IMF, but given these actions, the IMF refused. Foreign investors were in shock, and pulled out of Foreign investors were in shock, and pulled out of

any and all Russian investments they could.any and all Russian investments they could. The stock market crashed.The stock market crashed.

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The Brazilian Crisis, 1999The Brazilian Crisis, 1999 Brazil was hard hit by the Russian crisis.Brazil was hard hit by the Russian crisis. In November 1998, the IMF arranged for Brazil In November 1998, the IMF arranged for Brazil

to be able to borrow up to $41 billion, but to be able to borrow up to $41 billion, but demanded fiscal reforms.demanded fiscal reforms.

Brazil had a large current account deficit.Brazil had a large current account deficit. Brazil was defending a crawling exch rate with Brazil was defending a crawling exch rate with

intervention and high interest rates.intervention and high interest rates. January 1999, Brazil allowed its currency to January 1999, Brazil allowed its currency to

float, and the float, and the realreal depreciated. depreciated. Brazil’s banking system remained sound, and Brazil’s banking system remained sound, and

ultimately Brazil was able to sell new bonds to ultimately Brazil was able to sell new bonds to foreign investors.foreign investors.

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The Turkish Crisis, 2001The Turkish Crisis, 2001 Turkey had borrowed continually from the Turkey had borrowed continually from the

IMF since 1958.IMF since 1958. In January 2000, Turkey borrowed $8 In January 2000, Turkey borrowed $8

billion more from the IMF and World Bank. billion more from the IMF and World Bank. As part of the deal, Turkey pledged to:As part of the deal, Turkey pledged to: Reduce its inflation rate (100%)Reduce its inflation rate (100%) Improve bank regulationImprove bank regulation Privatize state-owned businessesPrivatize state-owned businesses End subsidiesEnd subsidies Reduce its fiscal deficitReduce its fiscal deficit Adopt a crawling exchange rate, pegged to the Adopt a crawling exchange rate, pegged to the

euro and dollareuro and dollar

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More onMore on

The Turkish Crisis, 2001The Turkish Crisis, 2001 Turkey made progress on inflation, but:Turkey made progress on inflation, but:

Continued to run large budget and current account Continued to run large budget and current account deficitsdeficits

Suffered more bank corruptionSuffered more bank corruption Foreign lenders pulled backForeign lenders pulled back Overnight interest rates rose to 2000%Overnight interest rates rose to 2000%

The IMF promised $7.5 billion more in loansThe IMF promised $7.5 billion more in loans February 2001, the gov’t was in gridlock over February 2001, the gov’t was in gridlock over

passing reforms, interest rates skyrocketed, and passing reforms, interest rates skyrocketed, and the gov’t was expending enormous resources the gov’t was expending enormous resources trying to defend its fixed exchange rate.trying to defend its fixed exchange rate.

The gov’t finally gave up and let the The gov’t finally gave up and let the lira lira float. It float. It lost a third of its value in two days. Banks too huge lost a third of its value in two days. Banks too huge losses. losses.

More IMF loans…More IMF loans…

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Financial Crises: What goes wrong?Financial Crises: What goes wrong?

It seems that five major forces can and do It seems that five major forces can and do lead to financial crises:lead to financial crises: Waves of over-lending and over-borrowingWaves of over-lending and over-borrowing

Explain in next slideExplain in next slide Exogenous international shocksExogenous international shocks

Can make repayment difficultCan make repayment difficult Exchange rate riskExchange rate risk

Can make repayment difficultCan make repayment difficult Fickle international short-term lendingFickle international short-term lending

Countries structure their debt badly, relying too much Countries structure their debt badly, relying too much on short-term loanson short-term loans

Global contagion (social psychology, herding Global contagion (social psychology, herding behavior, generalizing notions, reacting on too behavior, generalizing notions, reacting on too little information)little information)

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Over-borrowing/Over-lendingOver-borrowing/Over-lending Is this a coordination failure? Herding Is this a coordination failure? Herding

behavior?behavior? Investors all move toward what appears to be a Investors all move toward what appears to be a

region with high expected returns.region with high expected returns. Too much is lent and borrowed.Too much is lent and borrowed.

This leads to This leads to debt-overhangdebt-overhang: the amount by : the amount by which the debt obligations exceed the which the debt obligations exceed the present value of the resource transfer that present value of the resource transfer that will be made to service the debt. (Trans.: will be made to service the debt. (Trans.: They can’t possible make a high enough They can’t possible make a high enough return to pay their loan payments!)return to pay their loan payments!)

For the borrower, the benefits of default For the borrower, the benefits of default exceed the costs!exceed the costs!

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Rescue PackagesRescue Packages Structure and Purposes:Structure and Purposes:

Loans in the package compensate for lack of Loans in the package compensate for lack of availability of private lending during the crisis.availability of private lending during the crisis.

Restore investor confidence by supporting the Restore investor confidence by supporting the currency and government. Hopefully, this will currency and government. Hopefully, this will help reduce the capital flight.help reduce the capital flight.

Reduce contagion effects that could spread the Reduce contagion effects that could spread the crisis to other countries.crisis to other countries.

IMF imposes conditions requiring policy IMF imposes conditions requiring policy changes to change the fundamentals. This changes to change the fundamentals. This usually includes tighter money (anti-inflation usually includes tighter money (anti-inflation policy) and tighter fiscal policy (reduced policy) and tighter fiscal policy (reduced deficits and gov’t debt). May include tightening deficits and gov’t debt). May include tightening regulation of banks and trade liberalization.regulation of banks and trade liberalization.

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Can this lead to a moral hazard?Can this lead to a moral hazard?

Moral hazardMoral hazard: insurance leads the : insurance leads the insured to to be more less careful insured to to be more less careful and more likely to incur the very and more likely to incur the very thing that the insured is trying to thing that the insured is trying to protect against. The insurance protect against. The insurance makes the event less costly.makes the event less costly.

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Handling the DebtHandling the Debt Debt restructuringDebt restructuring is simply changing when the is simply changing when the

payments are due, allowing the borrower more payments are due, allowing the borrower more time to make the payments.time to make the payments.

Debt reductionDebt reduction lowers the amount of debt. Banks lowers the amount of debt. Banks or gov’ts either “forgive” part of the debt in an or gov’ts either “forgive” part of the debt in an effort to get some of their principal back (instead effort to get some of their principal back (instead of none). This leads to “too big to fail.” of none). This leads to “too big to fail.” Governments or IMF may used its funds or issue Governments or IMF may used its funds or issue bonds to pay off some of the private debt.bonds to pay off some of the private debt.

There is a coordination problem with either as There is a coordination problem with either as individual lenders try to hold out. Each wants the individual lenders try to hold out. Each wants the others to make the adjustments so that they can others to make the adjustments so that they can get all of their principal back now. This is a form of get all of their principal back now. This is a form of the the free-rider problemfree-rider problem..

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DFI: The FearDFI: The Fear Developing countries are afraid that Developing countries are afraid that

foreigners will end up owning all the foreigners will end up owning all the industry, and therefore re-patriot all industry, and therefore re-patriot all the profits. Morever, they fear that the profits. Morever, they fear that this will reduce the long-term this will reduce the long-term prospects for raising their standard prospects for raising their standard of living.of living.

Perhaps this is a fear of colonization? Perhaps this is a fear of colonization? What about national security issues? What about national security issues?

Do you want foreigners controlling Do you want foreigners controlling critical industries?critical industries?

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DFI: The Fear DFI: The Fear (Continued)(Continued)

For this reason, developing For this reason, developing countries often require:countries often require: A significant degree of local ownership A significant degree of local ownership

and management, and management, Local R&D,Local R&D, Local training programs,Local training programs, Locally purchased raw materials,Locally purchased raw materials, Profits to stay in the country (perhaps Profits to stay in the country (perhaps

through tax laws)through tax laws)

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DFI: The IncentivesDFI: The Incentives

To attract DFI, countries offer:To attract DFI, countries offer: SubsidiesSubsidies Tax incentivesTax incentives Free real estateFree real estate Special privilegesSpecial privileges

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DFIDFI

Direct foreign investmentDirect foreign investment is defined as is defined as any flow of lending to, or purchases of any flow of lending to, or purchases of ownership in, a foreign enterprise that ownership in, a foreign enterprise that is largely owned by residents (usually is largely owned by residents (usually firms) of the investing country.firms) of the investing country.

A A multinational firmmultinational firm is a firm that is a firm that controls enterprises in more than one controls enterprises in more than one country. Often this involves a parent country. Often this involves a parent corporation and foreign subsidiaries.corporation and foreign subsidiaries.

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DFI DFI (Continued)(Continued)

Often little financial capital is Often little financial capital is moved initially. By borrowing in moved initially. By borrowing in the country in which they are the country in which they are investing, the firm can minimize:investing, the firm can minimize: Exchange rate risk, andExchange rate risk, and Political risk.Political risk.

What is more important is the What is more important is the firm’s intangible assets—its name, firm’s intangible assets—its name, its reputation, its management its reputation, its management skill, its technology, its marketing skill, its technology, its marketing skills and access to markets.skills and access to markets.

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Why DFI?Why DFI?

It is a form of financial capital flow, It is a form of financial capital flow, seeking the highest risk-adjusted return.seeking the highest risk-adjusted return. Does not explain why firms would choose to Does not explain why firms would choose to

establish managerial control over the firm.establish managerial control over the firm. Perfect competition? Probably not.Perfect competition? Probably not.

DFI is not easy to accomplish. It is hard to DFI is not easy to accomplish. It is hard to run companies at a distance, and the run companies at a distance, and the investing firm does not know the local investing firm does not know the local market, laws, customs, etc.market, laws, customs, etc.

DFI does not happen randomly.DFI does not happen randomly.

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DFI as Imperfect CompetitionDFI as Imperfect Competition

The The Hymer ViewHymer View In essence, the DFI investor is seeking a In essence, the DFI investor is seeking a

monopoly or oligopoly position in a monopoly or oligopoly position in a market. market.

The investor seeks to fight off The investor seeks to fight off competition and protect its market competition and protect its market power.power.

The investor seeks to preserve market The investor seeks to preserve market share or preemptively establish market share or preemptively establish market share.share.

This is This is defensive investmentdefensive investment..

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DFI as Imperfect CompetitionDFI as Imperfect Competition

The The Appropriability Theory Appropriability Theory (Magee)(Magee) The firm wishes to appropriate all The firm wishes to appropriate all

available potential gains, and often available potential gains, and often finds that it is better to keep control finds that it is better to keep control and ownership to do this.and ownership to do this.

If it did not keep such control, its firm-If it did not keep such control, its firm-specific advantages might be lost.specific advantages might be lost.

The firm also would not want to share The firm also would not want to share its secrets with a foreign partner who its secrets with a foreign partner who might eventually become a might eventually become a competitor. competitor.

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Tax IssuesTax Issues

Firms seek out the best tax environment Firms seek out the best tax environment for their operations as they attempt to for their operations as they attempt to minimize their tax liability. They shop minimize their tax liability. They shop taxes.taxes.

Multinational firms engage in Multinational firms engage in international transfer pricinginternational transfer pricing to move to move profits to the lowest tax countries.profits to the lowest tax countries. Much of international trade occurs as Much of international trade occurs as intra-intra-

firm tradefirm trade, between units of the , between units of the multinational firm located in different multinational firm located in different countries.countries.