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 undertaken over a given 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.

HAS FDI BEEN GROWING OR DECLINING? WHY?

During the past 20 years there has been a marked increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from about $25 billion in 1975 to a record $644 billion in 1998. Not only did the flow of FDI accelerate during the 1980s and 1990s, but it also accelerated faster than the growth in world trade.

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There are several reasons why FDI is growing more then the world trade and world output. Despite the general decline in trade barriers that we have witnessed for the past 30 years, there is still some fear among businesses of protectionist pressures. Some executives see FDI as a way of circumventing future trade barriers. Secondly, much of the recent increase in FDI is being driven by the dramatic political and economic policy changes that have been occurring in many of the world’s developing countries such as the aggressive promotion of industrial investment using fiscal and other incentives.

The globalization of the world economy is also having a positive impact on the volume of FDI. Firms such as Electrolux now see the whole world as their market, and they are undertaking FDI in an attempt to make sure they have a significant presence in every region of the world. It is important to note that many firms now want to have production facilities close to their customers.

What are the Advantages of Foreign Direct Investment?

A firm will prefer FDI over exporting as a strategy to break into foreign markets when transportation costs or trade barriers make exporting unattractive, the firm will also favour FDI over licensing (or franchising) when it wishes to maintain control over its technological know how, or over its operations and business strategy, or when firm’s capabilities are simply not amenable to licensing, as may often be the case.

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 the foreign entity sells.

Limitations of Exporting. The viability of an exporting strategy is often constrained by transportation costs and trade barriers. When transportation cost is added to production cost, it becomes unprofitable to ship some products over a long distance. This is particularly true for products that have a low value-to-weight ratio and that can be produced in almost any location (eg cement, soft drinks etc).

Limitations of Licensing. A branch of economic theory known as internationalization theory seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering foreign direct investment. According to this theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities.

licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor

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.

this happens particularly if the firm’s competitive advantage is based not so much on its product, but rather on the management, marketing, or manufacturing facilities that produce those products. Such capabilities are not usually amenable to licensing.

WHAT recent pattern of FDI HAVE BEEN OBSERVED?

Firms in the same industry often undertake FDI at about the same time. There also is a clear tendency for firms to direct their investment activities toward certain locations. We consider two explanations why firms in the same industry often undertake foreign direct investment simultaneously, and why some locations are favoured over others as targets for foreign direct investment:

Following the marketleading competitors – One theory to explain why firms follow their domestic competitors overseas is that oligopolistic industries (industries composed of a small number of large firms) tend to follow the other players in the group especially the strong ones. This is a critical competitive feature of such industries. What one firm does can have an immediate impact on the major competitors, forcing a response. Thus if one firm in an oligopoly cuts prices, this can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share. A move to produce overseas will prompt a follow-pattern reaction from others in a tight struggle for supremacy.

The Product Life Cycle – The PLC explains the pattern of FDI over time. Vernon argued that in many cases the establishment of facilities abroad, to produce a product for consumption in that market or for export to other markets, is often undertaken by the same firm or firms that pioneered the product in their home market endeavouring to extend the PLC by opening new markets.

The Eclectic Paradigm – A third theoretical perspective, known as the eclectic paradigm attempts to combine the two perspectives mentioned above into a single holistic explanation of foreign direct investment. It proposes that companies look to achieve three main objectives when pursuing direct foreign investment:

Product or company specific advantages, such as a comparative advantage.

Location specific advantages – where the company derives greater benefit through a foreign establishment.

Market internalization – meaning it is better for the company to exploit a foreign opportunity itself, rather than through an agreement with a foreign firm.

WHAT IDEOLOGICAL QUESTIONS SURROUND FDI?

Government policy is driven by political ideology. Historically, ideology towards FDI has ranged from a radical stance that is hostile to all FDI . . . to the non-interventionist principle of free-market economics. In 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 instrument of imperialistic domination. They see the MNE as a tool for exploiting host countries to the exclusive benefit of the MNE’s capitalist-imperialistic home country. They argue that the MNE extracts profits from the host country and takes them to the 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 the important jobs in the foreign subsidiaries of the MNEs go to the home country nationals rather than citizens of the host country. Due to this reason, according to the radical view, FDI by 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 corporations to undertake FDI because they can never be instruments of economic development, only of economic domination. Where MNEs already exists in a country, they should be immediately nationalized.

The Free Market View

The free market view traces its roots to classical economics and the international trade theories of Adam Smith and David Ricardo. The free market view argues that international production should be distributed among countries according to the theory of comparative advantage. That is countries should specialize in the production of goods and services that they can produce most efficiently. Within this framework, the MNE is seen as an instrument for dispersing the production of goods and services to those locations around the globe where they can be produced most efficiently. Viewed this way, FDI by the MNE is a way to increase the overall efficiency of the world economy.

Pragmatic Nationalism

In practice, many countries have adopted neither the radical policy nor a free market policy towards the FDI, but instead a policy that can best be described as pragmatic nationalism. The pragmatic nationalistic view postulates that FDI has both benefits and costs. FDI can benefit a host country by bringing capital, skills, technology and jobs but those benefits come at a cost. When products resulting from an investment are produced by a foreign company rather than a domestic company, the profits from the investment go abroad. Many countries are also concerned that a foreign-owned manufacturing plant may import many components from its home country, which has a negative implication for the host country’s balance of payment position.

Shifting Ideology

Recent years have seen a marked decline in the number of countries that adhere to a radical ideology. Although no countries have adopted pure free market policy stance, an increasing number of countries are gravitating toward the free market end of the spectrum and have liberalized their foreign investment regime.

What are the Cost and BenefitS of FDI to a country?

Many governments can be considered pragmatic nationalists 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 country and then from a perspective of the home country.

Host Country Effects: Benefits

There are three main benefits of inward FDI for a host country: the resource-transfer effect, the employment effect, and the balance of payments effect.

Resource transfer effects: Foreign direct investment can make a positive contribution to the host country’s economy by supplying capital, technology, and management resources that would otherwise not be available. If such factors are scarce in a country, the FDI may boost that country’s economic growth rate. Many of the MNEs by virtue of their size and financial strength, have access to financial resources not available in the host country firms. These funds may be available from internal company resources, or, because of their reputation, large MNEs may find it easier to borrow money from the capital markets than host country firm would.

Employment Effects: The beneficial employment effect claimed for FDI is that it brings jobs to the host countries that would otherwise not be created there. Direct effects arise when a foreign MNE directly employs host country’s citizen

Balance of Payment: The effect FDI has on a country’s balance of payment accounts is an important policy issue for most host countries. A country’s balance of payment accounts keeps track of both its payment to and its receipt 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 imports 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 assets to foreigners. For instance, the persistent US current account deficit of the 1980s and 1990s was financed by a steady sale of US assets (stocks, bonds, real estate, and the whole corporations) to foreigners. Because national governments dislike seeing the assets of their country fall into foreign hands, they prefer a current account surplus. FDI can help a country achieve this goal in two ways.

(1) FDI is a substitute for imports of goods and services, it improves the current account of the host’s countries/balance of payments. Much of the FDI by Japanese automobile companies in the US and UK, for instance, substitutes fore imports from Japan. Thus, the current account of the US balance of payments has improved somewhat because many Japanese companies are now supplying the US market from production facilites in the US, as opposed deficit in Japan. For insomuch as this has reduced the need to finance a current account deficit by asset sales to foreigners, the US has benefited.

(2) potential benefit arises when the MNE uses a foreign subsidiary to export goods and services to other countries.

Host Country Effects: Costs

Three main costs of inward FDI that give rise to concern in host countries are: the possible adverse effects of FDI on competition within the host nation, adverse effects on the balance of payments and the perceived loss of national sovereignty and autonomy.

Adverse effect on competition – Host governments sometimes worry that the subsidiaries of foreign MNEs operating in their country may have greater economic power than indigenous competitors because they may be part of a larger international organizations. As such, the foreign MNE may be able to draw on funds generated elsewhere to subsidize its costs in the host market, which could drive indigenous out of business and allow the firm to monopolize the market. Once the market was monopolized, the foreign MNE could raise prices above those that would prevail in competitive markets, with harmful effects on the economic welfare of the host nation. This concern tends to be greater in countries that have few large firms of their own that can compete with the subsidiaries of foreign MNEs.

Adverse Effect on the Balance of Payment – The possible adverse effects of FDI on a host country’s balance of payment position are twofold.

(1) To offset the initial capital inflow that comes with FDI must be the subsequent outflow of income as the foreign subsidiary repatriates earnings to its parent company. Such outflows show up as a debeit on the current account of the balance of payments.

(2) When a foreign subsidiary imports a substantial number of its inputs from abroad, which also results in a debit on the current account of the host’s country’s balance of payments. One of the criticisms leveled against Japanese-owned auto assembly operations in the US, for instance, was that they imported many components parts from Japan, reducing the favourable impact of this FDI on the current account of the US balance of payment position. The Japanese auto companies responded by pledging to purchase 75% of their component parts from US-based manufacturers (but not necessarily US-owned manufacturers).

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3. National Sovereignty and Autonomy- many host countries worry that FDI is accompanied by loss of economic independence. Key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control. Over thirty years ago this concern was expressed by several European countries, who feared that FDI by US MNEs was threatening their national sovereignty. The same concerns are now surfacing in the US with regard to European and Japanese FDI.

Home Country Effects: Benefits

There are also costs and benefits to the home (or source) country. Does the US economy benefit or lose from investments by having its firms invest in foreign markets? Does the Swedish economy lose or gain from Electrolux’s investment in other nations? Some even go a step further to argue that FDI is not in the interest of the home country and therefore should be restricted. Others also argue that the benefits far outweigh the costs and that any restrictions would be contrary to national interests. For us to understand why people take these positions, it becomes imperative for us to look at the benefits and costs of FDI to the home (source) country.

The benefits of FDI to the home country arise from three sources.

(1) The current account of the home country’s balance of payments benefits from the inward flow of foreign earnings. Thus, one benefit to Sweden from Electrolux’s investment in other nations which are the earnings that are repatriated to Sweden from those countries. FDI can also improve the current account of the home country’s balance of payments if the foreign subsidiary creates demands for the home country exports of capital equipment; intermidate goods, complementary products, and the like.

(2) benefits to the home country from outward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the foreign subsidiary creates demand for home country exports of capital equipment, intermediate goods, complementary products, and so on. Thus Electrolux’s investment in foreign manufacturing plants can benefit both the Swedish balance of payments position and employment in Sweden, if Electrolux imported some component parts for its foreign plants directly from Sweden. The third point is that benefits arise when the home country MNE learns valuable skills from its exposure to foreign markets that can be transferred back to the home country. Through its exposure to a foreign market, an MNE can learn about superior management techniques and superior product and process technologies. These resources can then be transferred back to the home country’s economic growth rate. For instance, one reason General Motors and Ford invested in Japanese automobile companies (GM owns part of Isuzu, and Ford owns part of Mazda) was to learn about those Japanese companies apparent superior management techniques and production processes. If GM and Ford can transfer this know-how back to US operations, the result may be a net gain for US economy.

Home Country Effects: Costs

Against these benefits must be set the apparent costs of FDI for the home (source) country. The most important concerns center around the balance of payments and employment effects of outward FDI. The home country’s trade position (its current account) may deteriorate if the purpose of the foreign investment is to serve the home market from low cost production location. For instance, when a US textile company shuts its plants in South Carolina and moves production to Central America, imports into the US rose and trade position deteriorated. The current account of the balance of payments also suffers if the FDI is a substitute for direct exports. Thus, insofar as Toyota’s assembly operations in the US are intended to substitute for direct exports from Japan, the current account position of Japan will deteriorate.

WHAT Government Policy Instruments ARE USED TO MANAGE FDI?

By their choice of policies, home countries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first. These include foreign risk insurance, tax incentives, and political pressure. Then we will look at policies designed to restrict outward FDI.

Home Country Policies to Encourage Outward FDI

Many investor nations now have government backed insurance programs to cover major types of foreign investment risks. The types of risks insurable through these programs include risks of expropriation (nationalization), war losses and the inability to transfer profit back home. Such programs are particularly useful in encouraging firms to undertake investments in politically unstable countries.

Home Country Policies to Restrict Outward FDI

Virtually all investor countries, including the US, have tried to exercise some control over outward FDI from time to time. One common policy has been to limit capital outflows out of certain concern for the country’s balance of payment. From the early 1960s until 1979, for example, Britain had exchange control regulations that limited the amount of capital a firm could take out of the country. Although the main intent was to improve the British balance of payments, an important secondary intent was to make it more difficult for British firms to undertake FDI.

In addition countries have manipulated tax rules to encourage their firms to invest at home. The objective behind such policies is to create jobs at home rather than in other nations. At one time the British taxed companies’ foreign earnings at a higher rate than their domestic earnings, creating an incentive for British companies to invest at home.

Finally, countries sometimes prohibit national firms from investing in certain countries for political reasons. Such restrictions can be formal or informal. For instance, formal rules have prohibited US firms from investing in countries such as Cuba, Libya and Iran, whose political ideology and actions are judged to be contrary to US interests.

Host Country Policies to Encourage Inward FDI

it is increasingly common for governments to offer incentives to foreign firms to invest in their countries. Such incentives take many forms, but the most common are tax concessions, low interest loans, grants or subsidies. Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI. They are also motivated by desire to capture FDI away from other potential host countries. Not only do countries compete with each other to attract FDI, but so do regions of countries.

Host Country Policies to Restrict Inward FDI

Host governments use a range of controls to restrict FDI. The two most common are ownership limitations and performance requirements. Ownership restraints can take several forms. In some countries foreign companies are excluded from certain businesses. For example, they are excluded from tobacco and mining in Sweden and from the development of certain natural resources in Brazil, Finland and Morocco. In other countries, foreign firms may only own up to a certain percentage of the shares in the local company.

RISK

For most decisions, risk is a function of random events that are inherently unpredictable. In the context of investment decisions (specifically capital budgeting decisions and other investment isues) risk relates to the variability of net cash flows associated with a given asset or project. The higher the variability of net present value, the riskier the project.

Risk/return concepts are fundamental to the subject of finance. Investors are unwilling to undertake risky decisions especially in international business unless they are compensated accordingly.

DIVERSIFICATION

The critical concept of risk in underlying investments is diversification. The theory is that, since the risk of a portfolio can be averaged across a large number of individual assets, a decrease in the value of some should be compensated by a gain in the value of others. This theory is particularly relevant in international business since all the locations may not be performing very well; the issue of diversification becomes an effective means of decreasing the effect of non performance.

Benefits from diversification can be achieved by combining investments which have negatively correlated cash flows, so that overall portfolio returns have less variability than individual asset returns.

In constructing a portfolio of assets in varying proportions (for example, a portfolio consisting of shares), an unlimited number of different risk/return combinations can be obtained where higher risks shares usually offer greater return potential. In the early 1950’s, Harry Markowitz presented a portfolio model featured a rational and structured approach to diversification. The three essential features are:

1. Investment decisions are considered within a portfolio context using an expected return-variance framework, where stocks can be combined into security portfolios.

2. To compute the expected portfolio return, simply take the weighted average of the expected return on individual stocks.

3. To compute the expected portfolio variance, you need to know the proportion of funds invested in each stock with all other stocks in the portfolio.

Proper diversification eliminates the unique or firm-specific risk of securities. However, it does not eliminate market or ‘systematic’ risk. It can be shown that by the time twenty to thirty securities are in a portfolio, most of the diversifiable risk is eliminated, leaving only non-diversifiable or market-related risk. So investors in international business will more than likely prefer more wealth to less for any given level of risk, an investor will prefer the portfolio that offers the highest level of return.

PROTECTIONISM AND THE MARCH TOWARD FREE TRADE

A large part of the world has eliminated all barriers to trade or is in the process of doing so. The fifteen members of the European Union have created a “single internal market”. Australia and New Zealand have completed their free trade area. Several large groupings are en route to a similar outcome: the North American Free Trade Agreement (Canada, Mexico, United States), Mercusor (Argentina, Brazil, Paraguay, Uruguay), and the ASEAN Free Trade Agreement (Brunei, Indonesia, Malaysia, Philippines, Singapore,