Fourth Edition

InternationalBusiness

CHAPTER 7

The Political Economy of Foreign Direct Investment

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Chapter Focus

This chapter examines the role of government in FDI.Through its actions, governments can encourage or discourage FDI by providing investment incentives or passing laws/implementing policies that restrict foreign investment.Political ideology influences government policy.

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Political Ideology and FDI

Radical View

FreeMarket

PragmaticNationalism

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Radical View

Marxist roots.An instrument of imperialist domination.Exploit host country for the benefit of the MNE.Keeps less developed countries relatively backward and dependent on capitalist nations for investment, jobs, and technology.

Influential from 1945 to the 80s.Eastern Europe, China, Cuba, some African countries, Iran, and India.

Failure.Collapse of Communism.Poor economic performance.Strong economic performance of countries embracing capitalism.

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Free Market ViewRoots in Smith and Ricardo.International production should be distributed among countries according to the theory of competitive advantage.Positive changes in laws and growth of bilateral agreements attest to strength of free market view.However, all governments, to some degree, intervene in the free market.

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Pragmatic Nationalism

View FDI as having both benefits and costs.Governments tend toward FDI when benefits versus costs are high.

Aggressively court FDI that has national interest ramifications, typically through tax breaks or grants.

Technology.Employment.Balance of payment benefits.

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Political Ideology Toward FDIIdeology Characteristics Host-Government Policy

ImplicationsRadical

FreeMarket

PragmaticNationalism

Marxist rootsViews the MNE as aninstrument of imperialistdomination

Prohibit FDINationalize subsidiaries of

foreign-owned MNEs

Classical economic roots (Smith)Views the MNE as aninstrument for allocatingproduction to most efficient

locations

No restrictions on FDI

Views FDI as having bothbenefits and costs

Restrict FDI where costsoutweigh benefits

Bargain for greater benefitsand fewer costs

Aggressively court beneficialFDI by offering incentives

Table 7.1

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Benefits of FDI to Host Countries

Resource-TransferEffects

Management

CapitalTechnology

EmploymentEffects

Direct

Indirect

Balance-of-PaymentsEffects

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Current Account Credits DebitsExport of goods, servicesand income

$1,069,531

Merchandise 773,304Services 296,227Income receipts oninvestments

345,394

Imports of goods, servicesand income

$-1,797,061

Merchandise -1,222,772Services -215,239Income payments oninvestments

-359,050

Unilateral transfers -53,241Balance of current account -435,377

Capital AccountUS assets abroad (net) -553,349Foreign assets in the US 952,430

Balance on capital account 399,081

Statistical discrepancy 35,616

US Balance-of-Payments Accounts 2000

$Millions

Table 7.2

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FDI and Balance-of-Payments

Current Account Deficit occurs when imports are greater than exports.Current Account Surplus occurs when exports are greater than imports.Capital Account records transactions that involve the purchase or sale of assets.

3 B-of-P Consequences:When MNE establishes its foreign subsidiary, the host country benefits from initial capital inflow.If the FDI is a substitute for imports, it improves the host country’s balance of payments.Subsidiary is used for exports.

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Effect on Competition and Economic Growth

FDI can:Increase market competition.

Lower prices.Greater consumer choice.

Stimulate capital investments.Increase:

Productivity.Product/process innovation.Economic growth.

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Costs of FDI to Host Countries

Adverse Effectson

Competition

Adverse Effectson the

Balance ofPayments

Adverse Effectson

Sovereigntyand

Autonomy

Drive outlocal

competitors Earnings &imports hurt

capital account

Key economicdecisions madeby ‘foreigners’

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Benefits and Costs of FDI to Home Countries

Inward flow of

earnings Creates export

demand

Increasedknowledge

Balanceof

Payments hurt

Potentialreductionin home country

employment

Initial capitaloutflow

Sellsback tohome market

Substitutefor

exports

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International Trade Theory and FDI

Home-country concerns about offshore production may be misplaced.

Offshore production refers to FDI undertaken to serve the home market.May increase employment by freeing home country resources to concentrate on activities where the home country has a competitive advantage.May lead to lower prices for consumers.

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Government Policy Instruments and FDI

Encourage Outward FDIGovernment backed risk insurance.Government loans.Eliminate double taxation.Political persuasion to relax restrictions on inbound FDI.

Restricting Outward FDILimit capital outflows.Use tax code to encourage companies to stay home.Prohibitions against investing in certain countries (Cuba, Libya, Iran).

Home Country Policies

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Government Policy Instruments and FDI

Encourage Inward FDIOffer investment incentives.

Tax concessions.Low-interest loans.Grant/subsidies.

Attempt to attract investment away from other countries.

Restricting Inward FDIOwnership restraints.

Excluded from specific fields.

National security.

Competition.Restrictions on amount of ownership.

Performance requirements.

Local content.Technology transfer.Local participation in management

Host Country Policies

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Developed nationshave had problemsagreeing on rules.

Developing nationshave been reluctant

to agree to liberalization.

International Institutions and the Liberalization of FDI

WTO OECD

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The Context of NegotiationThe four Cs

Compromise Figure 7.1

Common

Interests

Negotiation

Process

Conflicting Interests

CriteriaCompromise

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Determinants of Bargaining Power

Bargaining Power of FirmHigh Low

Firms time horizon

Comparable alternatives open to firm

Value placed by host government on investment

Long Short

Low

Many Few

High

Table 7.3