Describe worldwide patterns of foreign direct investment

Foreign Direct Investment

Learning Objectives

After studying this chapter, you should be able to

1 Describe worldwide patterns of foreign direct investment (FDI) and reasons for these patterns.

2 Describe each of the theories that attempt to explain why foreign direct investment occurs.

3 Discuss the important management issues in the foreign direct investment decision.

4 Explain why governments intervene in the free flow of foreign direct investment.

5 Discuss the policy instruments that governments use to promote and restrict foreign direct investment.

 A LOOK BACK

Chapter 6 explained business–government relations in the context of world trade in goods and services. We explored the motives and methods of government intervention. We also examined the global trading system and how it promotes free trade.

 A LOOK AT THIS CHAPTER

This chapter examines another significant form of international business: foreign direct investment (FDI). Again, we are concerned with the patterns of FDI and the theories on which it is based. We also explore why and how governments intervene in FDI activity.

 A LOOK AHEAD

Chapter 8 explores the trend toward greater regional integration of national economies. We explore the benefits of closer economic cooperation and examine prominent regional trading blocs that exist around the world.

Auf Wiedersein to VW Law

Frankfurt, Germany — The Volkswagen Group (www.vw.com) owns eight of the most prestigious and best-known automotive brands in the world, including Audi, Bentley, Bugatti, Lamborghini, Seat, Skoda, and Volkswagen. From its 48 production facilities worldwide, the company produces and sells around 6 million cars annually. The VW Group sells cars in more than 150 countries and holds a 10 percent share of the world car market. Pictured at right, workers train at the Volkswagen plant in Puebla, Mexico.

Volkswagen, like companies everywhere, received plenty of help in getting where it is today. Since the 1960s, Volkswagen received special protection from its own legislation known as the “VW Law.” The law gave the German state of Lower Saxony, which owns 20.1 percent of Volkswagen, the power to block any takeover attempt that threatened local jobs and the economy. Germany’s former Chancellor Gerhard Schröder once told a cheering crowd of autoworkers in Germany, “Any efforts by the [European Union] commission in Brussels to smash the VW culture will meet the resistance of the federal government as long as we are in power.”

Source: Keith Dannemiller/CORBIS-NY.

The European Court finally struck down the VW Law in late 2007, although Lower Saxony’s government did not give up the fight. Legislators introduced multiple reincarnations of the VW Law to help it avoid the wrath of European regulators, but it is unlikely to be resurrected.

Volkswagen’s special treatment lies in its importance to the German economy and close ties between government and management in Germany. Volkswagen employs tens of thousands of people at home and symbolizes the resurgence of the German economy over the past 60 years. As you read this chapter, consider all the issues that can arise between companies and governments in global business.1

Many early trade theories were created at a time when most production factors (such as labor, financial capital, capital equipment, and land or natural resources) either could not be moved or could not be moved easily across national borders. But today, all of the above except land are internationally mobile and flow across borders to wherever they are needed. Financial capital is readily available from international financial institutions to finance corporate expansion, and whole factories can be picked up and moved to another country. Even labor is more mobile than in years past, although many barriers restrict the complete mobility of labor.

International flows of capital are at the core of foreign direct investment (FDI)—the purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control. But there is wide disagreement on what exactly constitutes foreign direct investment. Nations set different thresholds at which they classify an international capital flow as FDI. The U.S. Commerce Department sets the threshold at 10 percent of stock ownership in a company abroad, but most other governments set it at anywhere from 10 to 25 percent. By contrast, an investment that does not involve obtaining a degree of control in a company is called a portfolio investment.

foreign direct investment

Purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control.

portfolio investment

Investment that does not involve obtaining a degree of control in a company.

In this chapter, we examine the importance of foreign direct investment to the operations of international companies. We begin by exploring the growth of FDI in recent years and investigating its sources and destinations. We then take a look at several theories that attempt to explain foreign direct investment flows. Next, we turn our attention to several important management issues that arise in most decisions about whether a company should undertake FDI. This chapter closes by discussing the reasons why governments encourage or restrict foreign direct investment and the methods they use to accomplish these goals.

Patterns of Foreign Direct Investment

Just as international trade displays distinct patterns (see Chapter 5), so too does foreign direct investment. In this section, we first take a look at the factors that have propelled growth in FDI over the past decade. We then turn our attention to the destinations and sources of foreign direct investment.

Ups and Downs of Foreign Direct Investment

After growing around 20 percent per year in the first half of the 1990s, FDI inflows grew by about 40 percent per year in the second half of the decade. In 2000, FDI inflows peaked at around $1.4 trillion. Slower FDI for 2001, 2002, and 2003 reduced FDI inflows to nearly half its earlier peak. Strong economic performance and high corporate profits in many countries lifted FDI inflows to around $648 billion in 2004, $946 billion in 2005, and $1.3 trillion in 2006. Figure 7.1 illustrates this pattern and shows that changes in FDI flows are far more erratic than changes in global GDP.2

The main causes of decreased FDI around the year 2000 were slower global economic growth, tumbling stock market valuations, and relatively fewer privatizations of state-owned firms. Yet FDI inflows show a recovery since then. Despite the ebb and flow of FDI that we see in Figure 7.1, the long-term trend points toward greater FDI inflows worldwide. Among the driving forces behind renewed activity in FDI is an emphasis on the “offshoring” of business activities. The two main drivers of FDI flows are globalization and international mergers and acquisitions.

Globalization

Recall from Chapter 6 that years ago barriers to trade were not being reduced, and new, creative barriers seemed to be popping up in many nations. This presented a problem for companies that were trying to export their products to markets around the world. This resulted in a wave of FDI as many companies entered promising markets to get around growing trade barriers. But then the Uruguay Round of GATT negotiations created renewed determination to further reduce barriers to trade. As countries lowered their trade barriers, companies realized that they could now produce in the most efficient and productive locations and simply export to their markets worldwide. This set off another wave of FDI flows into low-cost, newly industrialized nations and emerging markets. Forces causing globalization to occur are, therefore, part of the reason for long-term growth in foreign direct investment.

FIGURE 7.1 Growth Rate of FDI versus GDP

Source: World Investment Report 2007 (Geneva, Switzerland: UNCTAD, September 2007), Chapter 1, Table I.4, p. 9; World Economic Outlook Database, April 2008.

Increasing globalization is also causing a growing number of international companies from emerging markets to undertake FDI. For example, companies from Taiwan began investing heavily in other nations two decades ago. Acer (www.acer.com), headquartered in Singapore but founded in Taiwan, manufactures personal computers and computer components. Just 20 years after it opened for business, Acer had spawned 10 subsidiaries worldwide and became the dominant industry player in many emerging markets.

Mergers and Acquisitions

The number of mergers and acquisitions (M&As) and their exploding values also underlie long-term growth in foreign direct investment. In fact, cross-border M&As are the main vehicle through which companies undertake foreign direct investment. Throughout the past two decades the value of all M&A activity as a share of GDP rose from 0.3 percent to 8 percent. The value of cross-border M&As peaked in 2000 at around $1.15 trillion. This figure accounted for about 3.7 percent of the market capitalization of all stock exchanges worldwide. Reasons previously mentioned for the dip and later rise in FDI inflows also caused the pattern we see in cross-border M&A deals (see Figure 7.2). By 2006, the value of cross-border M&As had climbed back to around $880 billion.3

Many cross-border M&A deals are driven by the desire of companies to:

■ Get a foothold in a new geographic market

■ Increase a firm’s global competitiveness

■ Fill gaps in companies’ product lines in a global industry

■ Reduce costs of R&D, production, distribution, and so forth

FIGURE 7.2 Value of Cross-Border M&As

Source: Based on World Investment Report 2007 (Geneva, Switzerland: UNCTAD, 2007), Chapter 1, Figure I.3, p. 6.

Entrepreneurs and small businesses also play a role in the expansion of FDI inflows. There is no data on the portion of FDI contributed by small businesses, but we know from anecdotal evidence that these companies are engaged in FDI. Unhindered by many of the constraints of a large company, entrepreneurs investing in other markets often demonstrate an inspiring can-do spirit mixed with ingenuity and bravado. For a day-in-the-life look at a young entrepreneur who is realizing his dreams in China, see the Entrepreneur’s Toolkit titled, “The Cowboy of Manchuria.”

Worldwide Flows of FDI

Driving FDI growth are more than 70,000 multinational companies with over 690,000 affiliates abroad, nearly half of which are now in developing countries.4 Developed countries remain the prime destination for FDI because cross-border M&As are concentrated in developed nations. Developed countries account for around 65 percent ($857 billion) of global FDI inflows, which were a little over $1.3 trillion in 2006. By comparison, FDI inflows to developing countries were valued at $379 billion—about 29 percent of world FDI inflows and down from a peak of a little more than 40 percent a decade earlier.

Among developed countries, European Union (EU) nations, the United States, and Japan account for the vast majority of world inflows. The EU remains the world’s largest FDI recipient, garnering $531 billion in 2006 (over 40 percent of the world’s total). Behind the large FDI figure for the EU is increased consolidation in Europe among large national competitors and further efforts at EU regional integration.

Developing nations had varying experiences in 2006. FDI inflows to developing nations in Asia were nearly $259 billion in 2006, with China attracting over $69 billion of that total. India, the largest recipient on the Asian subcontinent, had inflows of nearly $17 billion. FDI flowing from developing nations in Asia is also on the rise, coinciding with the rise of these nations’ own global competitors.

ENTREPRENEUR’S TOOLKIT: The Cowboy of Manchuria

Tom Kirkwood, at just 28 years of age, turned his dream of introducing his grandfather’s taffy to China into a fast growing business. Kirkwood’s story—his hassles and hustling—provides some lessons on the purest form of global investing. The basics that small investors in China can follow are as basic as they get. Find a product that’s easy to make, widely popular, and cheap to sell and then choose the least expensive, investor-friendliest place to make it.

Kirkwood, whose family runs the Shawnee Inn, a ski and golf resort in Shawnee-on-Delaware, Pennsylvania, decided to make candy in Manchuria—China’s gritty, heavily populated, industrial northeast. Chinese people often give individually wrapped candies as a gift, and Kirkwood reckoned that China’s rising, increasingly prosperous urbanites would have a lucrative sweet tooth. “You can’t be M&Ms, but you don’t have to be penny candy, either,” Kirkwood says. “You find your niche because a niche in China is an awful lot of people.”

Kirkwood decided early on that he wanted to do business in China. In the mid-1980s after prep school, he spent a year in Taiwan and China learning Chinese and working in a Shanghai engineering company. The experience gave him a taste for adventure capitalism on the frontier of China’s economic development. Using $400,000 of Kirkwood’s family money, Kirkwood and his friend Peter Moustakerski bought equipment and rented a factory in Shenyang, a city of six million people in the heart of Manchuria. Roads and rail transport were convenient, and wages were low. The local government seemed amenable to a 100 percent foreign-owned factory, and the Shenyang Shawnee Cowboy Food Company was born.

Although it’s a small operation, it now has 89 employees and is growing. Kirkwood is determined to succeed selling his candies with names such as Longhorn Bars. As he boarded a flight to Beijing for a meeting with a distributor recently, Kirkwood realized he had a bag full of candy. He offered one to a flight attendant. When lunch is over, he vowed, “Everybody on this plane will know Cowboy Candy.”

Source: Adapted from Roy Rowan “Mao to Now,” Fortune (www.fortune.com), October 11, 1999; Marcus W. Brauchli, “Sweet Dreams,” Wall Street Journal, June 27, 1996, R, 10:1.

Elsewhere, all of Africa drew in slightly more than $35 billion of FDI in 2006, or about 2.7 percent of the world’s total. FDI flows into Latin America and the Caribbean declined rapidly in the early 2000s but then surged to $84 billion in 2006. Finally, FDI inflows to southeast Europe and the Commonwealth of Independent States reached an all-time high of $69 billion in 2006.

Quick Study

1. What is the difference between foreign direct investment and portfolio investment?

2. What factors influence global flows of foreign direct investment?

3. Identify the main destinations of foreign direct investment. Is the pattern shifting?

Explanations for Foreign Direct Investment

So far we have examined the flows of foreign direct investment, but we have not investigated explanations for why FDI occurs. Let’s now investigate the four main theories that attempt to explain why companies engage in foreign direct investment.

International Product Life Cycle

Although we introduced the international product life cycle in Chapter 5 in the context of international trade, it is also used to explain foreign direct investment.5 The international product life cycle theory states that a company will begin by exporting its product and later undertake foreign direct investment as a product moves through its life cycle. In the new product stage, a good is produced in the home country because of uncertain domestic demand and to keep production close to the research department that developed the product. In the maturing product stage, the company directly invests in production facilities in countries where demand is great enough to warrant its own production facilities. In the final standardized product stage, increased competition creates pressures to reduce production costs. In response, a company builds production capacity in low-cost developing nations to serve its markets around the world.

international product life cycle

Theory stating that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its life cycle.

Despite its conceptual appeal, the international product life cycle theory is limited in its power to explain why companies choose FDI over other forms of market entry. A local firm in the target market could pay for (license) the right to use the special assets needed to manufacture a particular product. In this way, a company could avoid the additional risks associated with direct investments in the market. The theory also fails to explain why firms choose FDI over exporting activities. It might be less expensive to serve a market abroad by increasing output at the home country factory rather than by building additional capacity within the target market.

The theory explains why the FDI of some firms follows the international product life cycle of their products. But it does not explain why other market entry modes are inferior or less advantageous options.

Market Imperfections (Internalization)

A market that is said to operate at peak efficiency (prices are as low as they can possibly be) and where goods are readily and easily available is said to be a perfect market. But perfect markets are rarely, if ever, seen in business because of factors that cause a breakdown in the efficient operation of an industry—called market imperfectionsMarket imperfections theory states that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake foreign direct investment to internalize the transaction and thereby remove the imperfection. There are two market imperfections that are relevant to this discussion—trade barriers and specialized knowledge.

market imperfections

Theory stating that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake foreign direct investment to internalize the transaction and thereby remove the imperfection.

Employees from quality control check plasma screens on the production line at a newly opened television assembly plant in Nymburk near Prague, Czech Republic. The plant is a foreign direct investment by a company called Chinese Changhong Europe Electric TV. The plant is Changhong’s biggest foreign direct investment in recent times and produces LCD, plasma, and classic televisions. What advantages do you think the Chinese company gained by investing in the Czech Republic?

Source: Radim Beznoska/CORBIS-NY.

Trade Barriers

One common market imperfection in international business is trade barriers, such as tariffs. For example, the North American Free Trade Agreement stipulates that a sufficient portion of a product’s content must originate within Canada, Mexico, or the United States for the product to avoid tariff charges when it is imported to any of these three markets. That is why a large number of Korean manufacturers invested in production facilities in Tijuana, Mexico, just south of Mexico’s border with California. By investing in production facilities in Mexico, the Korean companies were able to skirt the North American tariffs that would have been levied if they were to export goods from Korean factories. The presence of a market imperfection (tariffs) caused those companies to undertake foreign direct investment.

Specialized Knowledge

The unique competitive advantage of a company sometimes consists of specialized knowledge. This knowledge could be the technical expertise of engineers or the special marketing abilities of managers. When the knowledge is technical expertise, companies can charge a fee to companies in other countries for use of the knowledge in producing the same or a similar product. But when a company’s specialized knowledge is embodied in its employees, the only way to exploit a market opportunity in another nation may be to undertake FDI.

The possibility that a company will create a future competitor by charging another company for access to its knowledge is another market imperfection that can encourage FDI. Rather than trade a short-term gain (the fee charged another company) for a long-term loss (lost competitiveness), a company will prefer to undertake investment. For example, as Japan rebuilt its industries following the Second World War, many Japanese companies paid Western firms for access to the special technical knowledge embodied in their products. Those Japanese companies became adept at revising and improving many of these technologies and became leaders in their industries, including electronics and automobiles.

Eclectic Theory

The eclectic theory states that firms undertake foreign direct investment when the features of a particular location combine with ownership and internalization advantages to make a location appealing for investment.6 A location advantage is the advantage of locating a particular economic activity in a specific location because of the characteristics (natural or acquired) of that location.7 These advantages have historically been natural resources such as oil in the Middle East, timber in Canada, or copper in Chile. But the advantage can also be an acquired one such as a productive workforce. An ownership advantage refers to company ownership of some special asset, such as brand recognition, technical knowledge, or management ability. An internalization advantage is one that arises from internalizing a business activity rather than leaving it to a relatively inefficient market. The eclectic theory states that when all of these advantages are present, a company will undertake FDI.

eclectic theory

Theory stating that firms undertake foreign direct investment when the features of a particular location combine with ownership and internalization advantages to make a location appealing for investment.

Market Power

Firms often seek the greatest amount of power possible in their industries relative to rivals. The market power theory states that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment. The benefit of market power is greater profit because the firm is far better able to dictate the cost of its inputs and/or the price of its output.

market power

Theory stating that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment.

One way a company can achieve market power (or dominance) is through vertical integration—the extension of company activities into stages of production that provide a firm’s inputs (backward integration) or absorb its output (forward integration). Sometimes a company can effectively control the world supply of an input needed by its industry if it has the resources or ability to integrate backward into supplying that input. Companies may also be able to achieve a great deal of market power if they can integrate forward to increase control over output. For example, they could perhaps make investments in distribution to leapfrog channels of distribution that are tightly controlled by competitors.

vertical integration

Extension of company activities into stages of production that provide a firm’s inputs (backward integration) or absorb its output (forward integration).

Quick Study

1. Explain the international product life cycle theory of foreign direct investment (FDI).

2. How does the theory of market imperfections (internalization) explain FDI?

3. Explain the eclectic theory, and identify the three advantages necessary for FDI to occur.

4. How does the theory of market power explain the occurrence of FDI?

Management Issues in the FDI Decision

Decisions about whether to engage in foreign direct investment involve several important issues regarding management of the company and its market. Some of these issues are grounded in the inner workings of firms that undertake FDI, such as the control desired over operations abroad or the firm’s cost of production. Others are related to the market and industry in which a firm competes, such as the preferences of customers or the actions of rivals. Let’s examine each of these important issues.

Control

Many companies investing abroad are greatly concerned with controlling the activities that occur in the local market. Perhaps the company wants to be certain that its product is being marketed in the same way in the local market as it is at home. Or maybe it wants to ensure that the selling price remains the same in both markets. Some companies try to maintain ownership of a large portion of the local operation, say, even up to 100 percent, in the belief that greater ownership gives them greater control.

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