Why Do Companies Invest Overseas?

Krishna G IyerDepartment of Applied and International Economics

Massey University, Palmerston North.

Outline of the Presentation Define overseas/foreign investment. Types of foreign investment. Foreign direct investment and Multinational Enterprises. Statistical highlights: Macro-level Data. What drives FDI – Micro factors. Shareholder portfolio diversification. Revenue related objectives. Cost related objectives. Trojan Horse Theory. Incentives and Barriers to FDI. Conclusion.

Types of Investment

Foreign Direct Investment (FDI) – Multinational Enterprise (MNE).

Foreign Portfolio Investment (FPI) Other Foreign Investment (OFI)

Relative Importance (USA)

0

1000

2000

3000

4000

5000

6000

70001980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Bn

$ (

US

)

FDII FPII OFII

Relative Importance (USA)

0.00500.00

1000.001500.002000.00

2500.003000.00

3500.004000.00

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Bn

$ U

S

FDIO FPIO OFIO

Relative Importance (NZ)

0

10000

20000

30000

40000

50000

6000019

89

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Mn

$ U

S

FDII FPII OFII

Relative Importance (NZ)

0

5000

10000

15000

20000

2500019

89

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Mn

$ U

S

FDIO FPIO OFIO

Growth RatesC’try FDII FPII OFII FDIO FPIO OFIO GDP

USA (81-05)

12.70 22.98 8.60 9.71 15.87 7.09 3.17

NZ(90-05)

13.62 9.52 2.69 10.11 49.84 15.00 2.91

FDI as share of GDPFDII and FDIO Flows as Percentage of GDP (1980-

2004)

RegionFDII Flow as % of GDP

FDIO Flow as % of GDP

USA 1.05 0.99

New Zealand 3.41 0.92

OECD 1.25 1.59

World 1.35 1.35

FDI – Who InvestsInvestors/Sources 1980 1990 2000 2004

Developed economies 0.8703 0.9174 0.8551 0.8847

Developing economies 0.1297 0.0825 0.1413 0.1064

Developing America 0.0824 0.0330 0.0343 0.0279

Developing Africa 0.0129 0.0112 0.0074 0.0047

Developing Asia 0.0341 0.0382 0.0996 0.0738

Developing Oceania 0.0003 0.0001 0.0000 0.0000

LDCs 0.0002 0.0004 0.0005 0.0004

Developing excl. China 0.1297 0.0800 0.1368 0.1024

Sub-Saharan Africa 0.0109 0.0101 0.0068 0.0042

FDI – Who Hosts

Hosts 1980 1990 2000 2004

Developed economies 0.7510 0.7941 0.6872 0.7268

Developing economies 0.2490 0.2058 0.3007 0.2508

Developing America 0.0751 0.0668 0.0898 0.0821

Developing Africa 0.0757 0.0336 0.0261 0.0246

Developing Asia 0.0960 0.1040 0.1839 0.1436

Developing Oceania 0.0023 0.0015 0.0008 0.0005

LDCs 0.0087 0.0053 0.0066 0.0081

Developing excl. China 0.2470 0.1941 0.2673 0.2232

Sub-Saharan Africa 0.0533 0.0198 0.0187 0.0174

The China Story

FDI INWARD 1980 1990 2000 2004

China - ML 0.0020 0.0117 0.0334 0.0276

China - ML, HK, Mac

0.0472 0.0388 0.1126 0.0794

FDI OUTWARD 1980 1990 2000 2004

China - ML 0.0000 0.0025 0.0045 0.0040

China - ML, HK, Mac

0.0003 0.0092 0.0677 0.0457

The Micro-Story: Why do firms invest overseas?

Shareholder Diversification Services. Revenue Related Motives. Cost Related Motives. Trojan Horse Theory.

Shareholder diversification services Don’t put all your eggs in one basket.

International Stock Market Correlations are low – thus portfolio risk might converge to the systematic risk.

FDI provides indirect diversification services.

Little empirical evidence favoring this thesis.

In any case, reducing barriers to FPI makes this motive, if it ever existed, less important.

Revenue Related Motives

New markets. Enter markets with superior profits. Exploit intangible assets. Reacting to trade barriers. International business diversification.

New Markets

Establish a subsidiary or acquire a competitor – Greenfield Investments / joint ventures / cross-border mergers and acquisitions.

E.g. Blockbuster Entertainment Corp. – entering the rest of the OECD.

Coca-Cola and Pepsi in China and India. FORD, HP, IBM. YUM Brands – KFC Franchises. Firm Level Surveys indicates access to new markets as the

primary determinant of FDI (PC - Australia).

Markets with superior profits

MNE’s are attracted to markets with superior profits. When profit margins are squeezed in the domestic market

– foreign markets may be worth exploring. Related to the Product Life Cycle theory of Vernon

(1966). Entry may trigger a price war and defeat the purpose of

FDI – E.g. the Mobile Phone Industry in Asia and more recently India. Joint Ventures may then be preferred.

Exploit Intangible Assets

Comparative advantage of MNE’s off-setting the inherent disadvantages vis-à-vis domestic firms.

The intangible assets may take the form of technology, marketing know-how, superior R&D capabilities, brand name and recognition.

Hard to package and sell intangible assets to foreign firms. Further, property rights are difficult to establish and protect in foreign countries – So FDI emerges, often, as the best way to exploit intangible assets.

The Coca-Cola Story in India.

Reacting to Existing/Potential Trade Barriers

Transportation costs. Circumvent trade barriers – E.g. Japanese televisions in

US. Pre-empt trade barriers – E.g. Japanese automobiles in

US. Surge of FDI in Mexico (NAFTA) and Spain and newer

members of EU.

International Business Diversification

Reducing overall risk via international diversification – low correlation once again the key.

The Enron Story.

Cost Related Motives

Exploiting economies of scale. Access to raw materials / inputs. Labor market imperfection. Exchange Rate Movements.

Exploiting Economies of Scale

Lower average cost per unit resulting from increased production.

Also relates to the revenue related objective of exploiting intangible assets.

E.g. Consolidation of US MNEs in Europe since the Single European Act.

Specific examples include: General Motors – Poland, Peugeot – Czech Republic, Toyota – Slovakia, Audi – Hungary, Renault – Romania, Volkswagen – Slovenia.

Access to raw materials / inputs

Transportation costs – bulky raw materials. Ensuring inputs supply stability. E.g. SKF the Swedish ball-bearing manufacturer.

Labor Market Imperfection Labor services in a country can be severely under-priced

relative to its productivity. Labor is not perfectly mobile across countries. Surging FDI in Mexico, China, India, Thailand, Indonesia,

Malaysia often attributed to low cost of labor. Revisiting examples: General Motors – Poland, Peugeot

– Czech Republic, Toyota – Slovakia, Audi – Hungary, Renault – Romania, Volkswagen – Slovenia (Spain – Germany Link).

Surge of FDI in Mexico (NAFTA) and Spain (EU).

How divergent are labor costs?

CountryAvg. Hourly Cost

(USD) CountryAvg. Hourly Cost

(USD)

Germany 31.25 Spain 14.96

Belgium 27.73 Israel 11.73

Sweden 25.18 Korea 10.28

USA 21.97 Taiwan 5.84

France 21.13 Hong Kong 5.54

UK 20.37 Mexico 2.48

Japan 20.09 Philippines 0.66

Australia 20.05 China 0.6

Italy 18.35 Indonesia 0.22

Exchange Rate Movements

Undervalued currency may encourage FDI since initial outlay is likely to be low.

Empirical evidence is not clear.

Trojan Horse Hypothesis

Has been the hot topic over the last few years. Rising Sun – the book by Michael Crichton has several

references to this theory. To revisit the Trojan Horse Story. Trojan Computer Virus – and now Trojan FDI. Van Pottelsberghe and Lichtenberg (1996, 1998 and

2001) say FDI is essentially driven by the desire to acquire technology.

At the aggregate level, almost no evidence is found. But what does the market say?

Average Wealth Gains from Cross-Border Acquisitions: Foreign Acquisitions of US Firms (Eun et al. 1996)

C’try of Acquirer

Cases R&D as a % of Sales

Average Wealth Gain in Mn USD

Acquirer Target Acquirer Target Comb.

Canada 10 0.21 0.65 14.93 85.59 100.53

Japan 15 5.08 4.81 227.83 170.66 398.49

UK 46 1.11 2.18 -122.91 94.55 -28.36

Others 32 1.63 2.80 -47.46 89.48 42.02

All 103 1.66 2.54 -35.01 103.19 68.18

Returning to the macro level - Incentives for FDI

Widely held view that FDI offers substantial benefits for host economies – technology, employment, export revenue, consumer choice, increased competition etc.

Empirical evidence is ambiguous. Incentives include tax breaks, rent-free land and buildings,

low interest loans, subsidized energy, reduced environmental regulations. Classic examples – Finland and Ireland 1990s.

With tax breaks there is always the possibility of round tripping – China and India are examples.

Incentives must be carefully weighed – easy to go overboard.

Barriers to FDI Barriers placed by Government agencies. E.g. France, Australia. Japan has a historically

imposed barriers on acquisitions. Restricted Ownership rules in several developing

countries – can be effectively used to reduce political risk of FDI.

Conditions – Employment related conditions (American Universities in the Middle East), Acquisition of Inputs from local sources e.g. Mexico, Export conditions, E.g. Spain, etc.

Red Tape / Corruption.

Conclusion

Large and Increasing Magnitudes of FDI – a trend certain to continue in the future.

Why do firms undertake FDI? Is it beneficial for host and source economies? What sort of incentives are being offered? What kind of barriers exist? Weighing the Costs and Benefits.