chapter 3: foreign direct investment theory and application chapter 3 foreign direct investment...

Chapter 3: Foreign Direct Investment Theory and Application

Chapter 3

Foreign Direct Investment Theory and Application

International Business

Oded Shenkar and Yadong Luo


Do You Know?

• What are the types of foreign direct investment (FDI)?

• What strategies encourage an MNE to engage in such investment?

• Do companies share strategic goals in pursuing FDI?

• What benefits would you cite to MNE executives to attract them to establish a subsidiary?

• What drives FDI distribution and patterns?• Why is Africa left out of the FDI mix?


Definition and Types of FDI

• Foreign Direct Investment – when a firm invests directly in production or other facilities, over which it has effective control, in a foreign country.

• Manufacturing FDI requires the establishment of production facilities.

• Service FDI requires building service facilities or an investment foothold via capital contributions or building office facilities.


Definition and Types of FDI

• Foreign subsidiaries – overseas units or entities.

• Host country – the country in which a foreign subsidiary operates.

• Flow of FDI – the amount of FDI undertaken over a given time.

• Stock of FDI – total accumulated value of foreign-owned assets.

• Outflows/Inflows of FDI – the flow of FDI out of or into a country.


FDI versus Foreign Portfolio Investment

• Foreign Portfolio Investment – the investment by individuals, firms, or public bodies in foreign financial instruments.– Stocks, bonds, other forms of debt.

• Differs from FDI, which is the investment in physical assets.

• Portfolio theory – the behavior of individuals or firms administering large amounts of financial assets.


Types of FDI

• Horizontal FDI – the MNE enters a foreign country to produce the same products product at home.

• Conglomerate FDI – the MNE produces products not manufactured at home.

• Vertical FDI – the MNE produces intermediate goods either forward or backward in the supply stream.

• Liability of foreignness – the costs of doing business abroad resulting in a competitive disadvantage.


Entry Mode

• The manner in which a firm chooses to enter a foreign market through FDI.– International franchising– Branches– Contractual alliances– Equity joint ventures– Wholly foreign-owned subsidiaries

• Investment approaches:– Greenfield investment (building a new facility)– Cross-border mergers– Cross-border acquisitions– Sharing existing facilities


The Strategic Logic Behind FDI

• Resources seeking - looking for resources at a lower real cost.

• Market seeking - secure market share and sales growth in target foreign market.

• Efficiency seeking - seeks to establish efficient structure through useful factors, cultures, policies, or markets.

• Strategic asset seeking - seeks to acquire assets in foreign firms that promote corporate long term objectives.


Enhancing Efficiency from Location Advantages

• Location advantages are defined as the benefits arising from a host country’s comparative advantages.– Better access to resources– Lower real cost from operating in a host

country– Labor cost differentials– Transportation costs, tariff and non-tariff

barriers– Governmental policies


Improving Performance from Structural Discrepancies

• Structural discrepancies are the differences in industry structure attributes between home and host countries.

• Examples include areas where:– Competition is less intense– Products are in different stages of their life

cycle– Market demand is unsaturated– There are differences in market

sophistication


Increasing Return from Ownership Advantages

• Ownership Advantages come from the application of proprietary tangible and intangible assets in the host country.– Reputation, brand image, distribution

channels– Technological expertise, organizational

skills, experience

• Core competence – skills within the firm that competitors cannot easily imitate or match.


Ensuring Growth from Organizational Learning

• MNEs exposed to multiple stimuli, developing:– Diversity capabilities– Broader learning opportunities

• Exposed to:– New markets– New practices– New ideas– New cultures– New competition


The Impact of FDI on the Host Country

• Employment– Firms attempt to capitalize on abundant

and inexpensive labor.– Host countries seek to have firms develop

labor skills and sophistication.– Host countries often feel like “least

desirable” jobs are transplanted from home countries.

– Home countries often face the loss of employment as jobs move.


The Impact of FDI on the Host Country

• FDI Impact on Domestic Enterprises– Foreign invested companies are likely

more productive than local competitors.– The result is uneven competition in the

short run, and competency building efforts in the longer term.

– It is likely that FDI developed enterprises will gradually develop local supporting industries, supplier relationships in the host country.


Product Life-Cycle Theory

• Ray Vernon asserted that product moves to lower income countries as products move through their product life cycle.

• The FDI impact is similar: FDI flows to developed countries for innovation, and from developed countries as products evolve from being innovative to being mass-produced.


Monopolistic Advantage Theory

• An MNE has and/or creates monopolistic advantages that enable it to operate subsidiaries abroad more profitably than local competitors.

• Monopolistic Advantage comes from:– Superior knowledge – production

technologies, managerial skills, industrial organization, knowledge of product.

– Economies of scale – through horizontal or vertical FDI


Internationalization Theory

• When external markets for supplies, production, or distribution fails to provide efficiency, companies can invest FDI to create their own supply, production, or distribution streams.

• Advantages– Avoid search and negotiating costs– Avoid costs of moral hazard (hidden detrimental action by

external partners)– Avoid cost of violated contracts and litigation– Capture economies of interdependent activities– Avoid government intervention– Control supplies– Control market outlets– Better apply cross-subsidization, predatory pricing and

transfer pricing


The Eclectic Paradigm

• OLI Framework– O – Ownership-specific

• Tangible assets, such natural endowments, manpower, and capital.

• Intangible assets, such as technology and information, managerial, marketing and entrepreneurial skills.

– L – Location-specific• Market structure, government policies, and political,

legal, and cultural environment.

– I – Internationalization• Firm’s inherent flexibility and capacity to produce and

market through its internal subsidiaries.

• All three factors important in determining the extent and pattern of FDI.


The Eclectic Paradigm

• Distinguishes between:– Structural market failure – external

condition that gives rise to monopoly advantages as a result of entry barriers

– Transactional market failure – failure of intermediate product markets to transact goods and services at a lower cost than internationalization


The Dynamic Capability Perspective

• A firm’s ability to diffuse, deploy, utilize and rebuild firm-specific resources for a competitive advantage.

• Ownership specific resources or knowledge are necessary but not sufficient for international investment or production success.

• It is necessary to effectively use and build dynamic capabilities for quantity and/or quality based deployment that is transferable to the multinational environment.

• Firms develop centers of excellence to concentrate core competencies to the host environment.


The Evolutionary Perspective

• International investment is an ongoing, evolutionary process shaped by an MNE’s:– International experience– Organizational capabilities– Strategic objectives– Environmental dynamics

• Also known as the Uppsala model.• Distinguishes two kinds of knowledge:

– Objective – can be taught– Experiential – can be acquired through personal

experience



• Firms progressively engage in a target market:– Export takes place via independent

representatives– Sales subsidiaries are set up, specializing in

marketing and promotion– Manufacturing facilities are established– Insideration – MNEs shift major functions to local

subsidiaries– Complete globalization – MNEs coordinate

common functions; foreign subsidiaries share common purposes and corporate mission



• Another pattern is that firms entering new markets involve greater psychic distance:– Differences in language, culture, political

systems that disturb the flow of information between firm and market

• Familiarity theory – firms would rather invest in host countries that are relatively close to it culturally


The Integration-Responsiveness Perspective

• FDI is a complex process requiring coordinating subsidiary activities across national boundaries.

• Global integration – the coordination of activities across countries to build efficient operations networks

• Local responsiveness – response to specific host country needs.


The Integration-Responsiveness Perspective

• Advantages of Strategic Flexibility:– Production movement– Tax avoidance– Financial arbitrage– Information transfer– Competitive power


Patterns of FDI

• FDI continues to register dramatic growth:– 1980 – global FDI stock was 10% of global

GDP– 1999 – global FDI stock was 31% of global

GDP

• Composition of FDI continues to change:– Increase in financial services, tourism,

retail operations, healthcare


Patterns of FDI

Exhibit 3-2: Growth of sales and gross product associated with international production, GDP and exports, 1982 -1999


Patterns of FDI

Exhibit 3-3: Selected indicators of FDI and international production, 1982-2000


FDI Outflows

• Developing countries account for most of the FDI outflow.

• Developed countries are more likely to:– Possess ownership or monopolistic

advantages– Be innovators– Extract advantages from internalization– Have the dynamic capabilities for

successful ventures abroad


FDI Outflows

Exhibit 3-4: Outward FDI Stock, 1985


FDI Outflows

Exhibit 3-4: Outward FDI Stock, 2000


FDI Outflows

• Note that the U.S. places third behind the UK and France

• U.S. remains first in terms of FDI outward stock

Exhibit 3-5: Developed countries: FDI outflows, 1999 and 2000


FDI Inflows

• Significant growth in overall FDI Inflows

• In the 1998 – 2000 period:– 59% of incoming stock went to developed

economies– 75% of inflow went to developed countries

• Significant increases in:– Latin America– South, East, and Southeast Asia


FDI Inflows

Exhibit 3-6: Inward FDI Stock, 1985


FDI Inflows

Exhibit 3-6: Inward FDI Stock, 2000


FDI Inflows

Exhibit 3-7: Share of developing countries in world FDI, 1980-2000

Note that the curves for inflows and outflows track each other.


Inflows into Developing Countries

• What explains the declining share of FDI inflows in developing economies:– Growing share of services in developed

economies makes them ripe for investment services.

– Decline in value of labor and commodities in overall product prices erodes competitive advantage.

– Developed countries offer:• A stable environment• Low corruption• A large market• A skilled workforce


Inflows into Developing Countries

Exhibit 3-9: Share of the largest recipients of FDI flows among developing economies, 1985-2000


FDI via Mergers and Acquisitions

• Proportion of M&As growing at the expense of greenfield investments.– From 52% in 1987 to 83% in 1999

• Brings new technologies and better management that allow the acquired firm to survive.

• Most M&As originate in and target developed country firms.


Intra-Regional Patterns

• In most host countries, the distribution of FDI is uneven– Four states in the U.S. had only ¼ of

manufacturing employment of Japanese affiliates– These same four states had 2/3 of their R&D

facilities

• Regional distribution of FDI is often correlated with the investor country of origin– May be predicted by the theory of familiarity


Intra-Regional Patterns

Exhibit 3-11: Distribution of production of foreign affiliates in the U.S., by state (1992)


The Investment Environment

• Liberalization of markets and openness to FDI on the increase.

• In 1991-2000, 1,185 regulatory changes– 1,121 favored investors

• In 1999, 150 regulatory changes in 69 nations– 147 positive to FDI

• Many countries offer incentives, such as:– Tax holidays– Tariff concessions– Direct and indirect financial subsidies– Training support– Infrastructure improvement– Capital repatriation rights


FDI Decision Criteria

• Natural and creative endowments vary by region and industry, and tend to shift over time.

• U.S. manufacturers are more likely to choose a high- rather than a low-wage country for investment.

• National boundaries not always a good indication of key criteria for location decision.


Foreign Investment Location Criteria

• Essential Criteria– Access to skilled and educated workforce– Proximity to world class research institutions– Quality of life– Access to venture capital

• Important Criteria– Reasonable costs of doing business– Established technology presence– Available bandwidth and adequate infrastructure– Favorable business climate and regulatory environment

• Desirable Criteria– Presence of suppliers and partners– Availability of community incentives


The Lost Continent: FDI in Africa

• Africa draws only 1.2 percent of the share of global FDI.

• UNCTAD report observes:– FDI in Africa has been on the increase– Per-capita income in Africa has been on

the increase– Significant variations from country to

country– New investors merging (Canada, Italy, the

Netherlands, Norway, and others)


The Lost Continent: FDI in Africa

• UNCTAD report observes:– Inward FDI originating in other African

countries is taking place– FDI in Africa has expanded from mining

and energy into manufacturing and services

– FDI in Africa has proven profitable; more profitable than in other developing economies

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