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CHAPTER
6
Foreign Direct Investment
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Key Issues
• Why is FDI increasing?
• Why do firms choose FDI over exporting or
licensing to enter a foreign market?
• Why are certain locations attractive for FDI?
• How does political ideology influence government
policy over FDI?
• From a host or source country perspective, what
are FDI’s costs and benefits?
• How can governments restrict/encourage FDI?
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Foreign Direct Investment
• Foreign direct investment (FDI) happens when
a firm invests directly in facilities in a foreign
country
• A firm that engages in FDI becomes a
multinational enterprise (MNE)
– Multinational = “more than one country”
• Factors which influence FDI are related to
factors that stimulate trade across national
borders
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Foreign Direct Investment
• Involves ownership of entity abroad for
–
–
–
–
production
Marketing/service
R&D
Raw materials or other resource access
• Parent has direct managerial control
– The degree of direct managerial control depends
on the extent of ownership of the foreign entity
and on other contractual terms of the FDI
– No managerial involvement = portfolio
investment
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FDI Growth in the World Economy
• FDI Outflow of $25 billion in 1975 increased to $1.3
trillion in 2000
• FDI flow accelerated more than world trade (x 5 and x
1.8 respectively)
• FDI Flow from all countries increased 1000%, trade
91%, world output 27% from 1984 to 1998
• FDI Stock increased to $3.5 trillion by 1997
• 63,000 parent firms with 690,000 foreign affiliates
produced $14 trillion sales, almost twice global exports
• FDI growing faster than world trade
– Political risk issues
– Economic reason issues
– Globalization
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Direction and Source of FDI
• Historically, FDI flow was to developed countries from
other developed countries
– Much of this to the US
• Since 1985 there has been an increase of FDI towards
developing countries
– Much to the emerging Asian and Latin America economies
– Africa lagging
• Through 1970s US led in FDI outflows
– 1985-1990 Japan 1st, UK 2nd, US 3rd
– Effect of ¥ increase in value
• In 2000 the USA received 21.6% of world FDI; the EU
received 48.7%
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Forms of FDI
• FDI forms
– Purchase of existing assets
• Quick entry, local market know-how, local financing may be
possible, eliminate competitor, buying problems
– New investment
• No local entity exists or is available for sale, local financial
incentives may encourage, no inherited problems, long lead
time to generation of sales or other desired outcome
– Participation in an international joint-venture
• Shared ownership with local and/or other non-local partner
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Alternative Modes of Market Entry
• FDI
– FDI - 100% ownership
– FDI < 100% ownership, International Joint Venture
• Majority, Equal Share, Minority Participation
•
•
•
•
Strategic Alliances (non-equity)
Franchising
Licensing
Exports
– Direct vs Indirect
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Why FDI?
• FDI over exporting
– High transportation costs, trade barriers
• FDI over licensing or franchising
– Need to retain strategic control
– Need to protect technological know-how
– Capabilities not suitable for
licensing/franchising
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Pattern of FDI
• Follow main competitors
– Oligopolistic industries
– Interdependence of the few major competitors forces
immediate strategic responses
• International product life-cycle (Vernon, see Ch. 4)
• Eclectic paradigm of FDI (John Dunning)
– Combines ownership specific, location specific, and
internalization specific advantages that drive FDI choice
over a decision to enter through licensing or exports
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Eclectic Paradigm of FDI (Dunning)
• Ownership advantage: creates a monopolistic advantage
which can be used to prevail in markets abroad
– Unique ownership advantage protected through ownership
– e.g., Brand, technology, economies of scale, management know-how
• Location advantage: the FDI destination local market must
offer factors (land, capital, know-how, cost/quality of labor,
economies of scale) such that it is advantageous for the firm
to locate its investment there (link to trade theory)
• Internalization advantage: transaction costs of an armslength relationship --licensing, exports-- higher than
managing the activity within the MNE’s boundaries
Dunning, John H. (1980). “Towards an eclectic theory of international production:
Some empirical tests.” Journal of International Business Studies 11(2): 931
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Government Policy and FDI
• The radical view: inbound FDI harmful; MNEs
–
–
–
–
Are an instrument of imperialist domination
Exploit host to the advantage of home country
Extract profits from host country; give nothing back
Keep LDCs backward/dependent for investment, technology
and jobs
• The free market view: FDI should be encouraged
– Adam Smith, Ricardo, et al: international production should be
distributed according to comparative advantage
– The MNE increases the world economy efficiency because it
brings to bear unique ownership advantages on the local
economy’s comparative advantages
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Host Country Effects of FDI
• Benefits
– Resource -transfer
– Employment
– Balance-of-payment (BOP)
• Import substitution
• Source of export increase
• Costs
– Adverse effects on the BOP
• Capital inflow followed by capital outflow + profits
• Production input importation
– Threat to national sovereignty and autonomy
• Loss of economic independence
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Home Country Effects of FDI
• Benefits
– BOP current account adversely affected by inward flow
of foreign earnings
– Positive employment effect from increased exports of
raw materials / assemblies to the overseas subsidiary
– Repatriation of skills and know-how
• Costs
– BOP trade position is negatively affected (lower
finished goods exports)
– Loss of employment to overseas market
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Government Policy and FDI
• Home country
– Outward FDI encouragement
• Risk reduction policies (financing, insurance, tax incentives)
– Outward FDI restrictions
• National security, BOP
• Host country
– Inward FDI encouragement
• Investment incentives
• Job creation incentives
– Inward FDI restrictions
• Ownership extent restrictions (national security; local nationals
can safeguard host country’s interests
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Decision Framework for FDI
No
Are transportation costs
high?
Yes
No
Is knowhow easy to
license?
Yes
Tight control over
foreign ops required?
No
Is knowhow valuable and
is protection possible?
No
Export
Yes
FDI
Yes
FDI
Yes
FDI
No
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Barriers?
License
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