Understanding Global Markets:

Lecture 4: Long-run capital flows:FDI, MNCs

Foreign Direct Investment• FDI = a form of capital mobility. Need to distinguish

between different types of capital mobility– 1) Portfolio investment = investment in bonds / securities /

organisations by residents of another country. This form of investment does not grant any special rights or power

– 2) FDI = purchase / control of a company in a country by residents of another country MNCs. Note refers equally to take-overs as well as to “new investment”.

• In order to think about global markets & FDI:– important to consider the pattern of financial flows (including

FDI), any changes over time, and the drivers of those changes.– important to consider the relationship between trade and capital

mobility• eg. trade and FDI as complements or substitutes

– what are the welfare implications of FDI

Stylised Facts• In considering degree of financial integration need to distinguish

between actual capital flows, and de jure financial integration (ie with the underlying policies).– eg. India has supposedly relatively free access for firms wishing to invest,

yet actual flow of fdi lower than perhaps what would be expected.

FDI inward stocks (millions of dollars)

0

50000

100000

150000

200000

250000

300000

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

Brazil China India

Source: Prasad, et.al. (2003), Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, IMF.

Source: Prasad, et.al. (2003), Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, IMF.

Stylised Facts• FDI has grown considerably faster than world trade and is typically

driven by:– “push factors”: business cycle conditions, macroeconomic policy changes in

industrial countries (changing role of institutional investors, de, liberalisation of tariffs and vertical specialisation

– “pull factors”: changes in policy by (developing) countries: liberlalization of capital accounts and domestic stock markets, privatisation, raising equity caps on foreign investment, providing information re. investment rules and possibilities...

• OECD countries are both the biggest exporters and importers of FDI. Rich nations account for 97% of direct investment outflows, and 75% of inflows ( early 1990s)

• In 1990 developing countries received 17% of FDI inflows, by 1997 they received 37%, but this then dipped heavily around 2000 (18%), and then rose again to 36% in 2005 (World Investment Report, 1998, 2003,2006)

• the largest 500 MNCs control over 50% of world trade, and 1/5th of global GDP (Rugman, 1988)

• 30% of world trade is intra-firm trade (UNCTAD, 1993)• Industries in which there is a lot of intra-industry trade also tend to be

industries with a lot of intra-industry FDI (Rugman, 1985)

• MNC investment seems largely “one-way” horizontal ie affiliates produce abroad and serve the market abroad, and do not significantly export back to the parent. – Eg. US MNCs export only 13% of their production back to the US

(Brainard, 1993)

• Newly acquired or established affiliates tend to be concentrated in countries with large and prosperous markets rather than in countries with low labour costs

• In terms of industry characteristics MNCs tend to more in industries & firms with:– high levels of R&D relative to sales– large share of skilled workers– in products which are new / technically complex– high levels of product differentiation and advertising

• though important to note rising FDI in services - telecommunications, transport, banking, postal/courier services

Source: Prasad, et.al. (2003), Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, IMF.

Source: Prasad, et.al. (2003), Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, IMF.

Source: World Investment Report, 2004 2006, UNCTAD.

In 1990 developing countries received 17% of FDI inflows, by 1997 they received 37%, but this then dipped heavily around 2000 (18%), and then rose again to 36% in 2005

Developing country FDI outflows were only 7% of the total in 1998, and rose to 15% by 2005.

FDI inflows ($s million)

0200000400000600000800000

1000000120000014000001600000

1992

-199

719

9819

9920

0020

0120

0220

0320

0420

05

World

Developed

Developing

FDI outflows ($ million)

0200000400000600000800000

100000012000001400000

1992

-199

719

9819

9920

0020

0120

0220

0320

0420

05

World

Developed

Developing

Source: World Investment Report, 2004 & 2006, UNCTAD.

0

5

10

15

20

25

30

1980 1985 1990 1995 2000 2005

Inward FDI stock as % of GDP

World

Developed

Developing

0

5

10

15

20

25

30

1980 1985 1990 1995 2000 2005

Outward FDI stock as % of GDP

World

Developed

Developing

FDI performance index ranks countries by the amount of FDI received relative to economic size (=ratio of countries’ share of world FDI relative to countries’ share of world GDP). Hence if greater than 1 than the country is getting more FDI in proportion to its’ size; if less than one than the converse.

Source: World Investment Report, 2004, UNCTAD.

Explaining FDI• 2 questions arise:

– 1) If a firm is wishing to expand it could…• increase domestic production and export to foreign markets• expand into a different product at home• engage in portfolio investment• licence another firm to produce abroad

– 2) if a given firm chooses to engage in FDI, that raises the question of why production is not taking place in that market by domestic firms.

• Dunning’s (eclectic) OLI framework: ie FDI can be explained by the interaction of three types of advantages– locational– ownership– internalisation

Dunning’s OLI framework• Ownership advantages: the firm may “own” an

advantage over it’s rivals:– technology (better products, management techniques, marketing

skills)

– industrial organisation & size: may be better equipped for innovation, to fight price wars, cope with legal problems, take advantage of economies of scale…

– access to markets: eg due to historical circumstance, political leverage…

– Finance: ability to raise money more easily (reputation, less variability of profits can be seen as a form of geographical diversification

– note that the presence of ownership advantages suggests some form of market failure imperfect competition

• Locational advantages: reflect importance of comparative advantage (ie anything that makes it relatively cheaper for the firm to produce in a given country– transport costs

– unexploited economies of scale

– factor endowments

– tax concessions, tariff rates, quantitative restrictions

• even given O & L why does the MNC itself carry out the investment ie why is it not possible to sell or lease the ownership advantages to another firm eg. lease the technology (eg. coca-cola, beers..)

• A range of market imperfections suggest why this might not be possible.

• Internalisation advantages: ie reasons why it is more efficient / less costly for the firm to be directly engaged in the production and to make direct own use of its ownership advantages:– costs of negotiation expensive contracting procedures

– issue of “proving” the profitability of the venture

– brand image

– not wishing competitors to “catch up”

– underutilised (managerial) economies of scale

– transfer pricing

Why the rise in FDI in recent years• greater trade integration + regionalism + deep integration

(eg. liberalisation of services) + GATS• Political environment more friendly, developing countries

much keener on FDI, and indeed in certain cases subsidise / promote it

• improved macro environment • the embodied knowledge which is part of the internalisation

story may have risen - more patenting and more enforcement (eg. by US government + by the improved IPR protection in developing countries)

• large change in cross country costs in particular costs of communication (telephony, business travel…)

• the preceding all suggest that the geographic realm of MNC has substantially risen.

GATS• Mode 1: cross border supply:

– services supplied from one country to another (e.g. international telephone calls), officially known as “cross-border supply”

• Mode 2: consumption abroad:– consumers or firms making use of a service in another

country (e.g. tourism), officially “consumption abroad” (“mode 2”)

• Mode 3: commercial presence:– a foreign company setting up subsidiaries or branches

to provide services in another country (e.g. foreign banks setting up operations in a country)

• Mode 4: presence of natural persons– individuals travelling from their own country to supply

services in another e.g. fashion models or consultants, temporary workers

FDI & Welfare• MNCs maximise their profits geographically ie they shift the

location of production such that the return from their factors is highest

• This would suggest that welfare should increase from MNC activity

• However MNC based on imperfect competition therefore although there may be improved resource allocation this may be at the cost of market imperfections

• technology transfer v appropriateness of technology• pro-competitive impact• tax revenue from MNC activity, however, with repatriation of

profits the surplus goes to host country

Source: Prasad, et.al. (2003), Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, IMF.

FDI & Welfare: evidence?• many LDCs with a “high degree of financial

integration” have experienced higher growth rates• however difficult to establish a causal relationship:

the evidence is strongest with respect to FDI over other forms of international capital movements.

• To the extent that there is a causal relationship the quality of domestic institutions appears to be an important factor in this:– robust legal and supervisory frameworks

– low levels of corruption

– high degree of transparency

– good corporate governence