MGT 372

International Business Management Course Instructor: Mehree Iqbal (MeI)

Lecture 9 & 10 Chapter- 7

Foreign Direct Investment

Learning Objectives: -Foreign Direct Investment in the World Economy -Horizontal FDI and the factors stimulating horizontal FDI -Vertical FDI and the factors stimulating vertical FDI -Managerial implication

Foreign Direct Investment in the World Economy

Flow

of FDI: This refers to the amount of FDI undertaken over a given time period. Stock of FDI: This refers to the total accumulated value of foreign-owned assets at a given time. Outflow of FDI: This means the flow of FDI out of a country. Inflows of FDI: This means the flow of FDI into a country.

Trends in FDI:
During 1975 to 2000 FDI has increased from $25 billion to a record $1.4 trillion. During 2000 to 2002 FDI observed a slow growth. However, by 2007 FDI flows to $1.8 trillion. The growth of FDI has been more than world trade and world output. Because, 1.Despite there has been general decline in trade barrier, companies still fear protectionist. FDI is a way to avoid future trade barrier. E.g. Japanese companies started investing in USA to combat US trade barriers. (Cars) 2.Dramatic economic and political changes in developing countries and increase of free market economies in developing nations

3. According to UN, laws governing FDI created more favourable environment for FDI. (India changed ownership policy) 4. Globalization of the world economy has encouraged companies to think world as their markets.

The Direction of FDI:

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Historically, most FDI has been directed at the developed nations of the world. USA has always been the favorite location because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment and openness of the country to FDI. During 1985 to 2002 the FDI inflow in developing countries has increased from 17.4% to 35% From 2004 to 2008 again it increased to 31% to 40%

In 2001, China was the largest recipient of FDI among developing nations. Chinas cheap labor, tax incentive and entry into the WTO have stimulated its FDI inflow. After South, East and South East Asia, the next most important region in the developing world is Latin America. Africa attracts lowest inflow due to political unrest, armed conflict and frequent changes.

The form of FDI: Acquisition Vs. Green-Field Investments

FDI

can take the form of a green-field investment in a new facility or an acquisition of or a merger with an existing local firm. 40% to 90% of FDI inflows are in the form of mergers and acquisition between 1998 to 2007. In developing countries, only one third of FDI is in the form of mergers and acquisitions as there are fewer firms to acquire in developing nations.

Horizontal FDI:
Horizontal FDI refers to investment in the same industry abroad as a firm operates in at home. - Other alternatives: exporting or licensing. FDI is problematic than these alternatives because, 1. It is expensive as setup cost of the production process is involved. 2. It is risky as problems associated with doing business in another culture are also involved.
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Still companies prefer FDI because of following factors, Transportation cost Market imperfection Strategic behavior The product life cycle Location-specific advantages

Transportation cost:
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When transportation costs are added to productions, it sometimes become unprofitable to ship some products abroad Products that have low value-to-weight ratio and can be produced in almost any location should not be considered for export. E.g. cement, soft drinks However, products that have high value-toweight ratio and can only be produced in some key strategic locations can be considered for exporting. In this case, transportation cost will be a little percentage of production cost. E.g. electronics, PC, medical equipment, computer

Market imperfection (Internationalization theory)

Why firms do FDI over Exporting and Licensing?

Market

imperfections are factors that inhibit markets from working perfectly. In international business market imperfections are referred to as internationalization theory. Two types of impediments exist in the market. These reduce the attractiveness of export and licensing and increase the attractiveness of FDI. 1. Free flow of products between nations: By placing tariffs on imported goods government increase the cost of exporting relative to licensing and FDI. So to combat

2. Impediment to sale of know-how: If know-how is the key to competitive advantage of a company, then they can earn greater return by selling know-how. But some companies try to avoid licensing for certain reasons. For example, Nokia, instead of licensing its technological know-how, is more attracted towards FDI. Because,
-First,

licensing may result in firms giving away its know-how to a potential competitor. E.g. RCA color Television example (pg 240)

Second, licensing does not give a firm the tight control over manufacturing, marketing and strategy in a foreign country that may be required to profitably exploit its advantage in know-how. With licensing company can achieve royalty fee but sometimes for strategic and operational reason control is necessary for which FDI is needed. Company may want to price and market aggressively which licensee may disagree as that will cut down his profit. E.g. Pizza-hut in India. Company may want to take cost advantage of a location and produce a part of final product in that location. This may affect licensees autonomy.

Third, a firms know-how may not be amenable to licensing. E.g. Toyotas competitive advantage is in its innovative production process and management know-how which is embedded in the whole organization. So this know-how cannot be transferred.

Strategic Behaviour:
his theory suggests that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. Knickerbocker looked at the relationship between FDI and rivalry in oligopolistic industry. ligopoly means when a limited number of large firms exist in a market. Interdependency of these firms lead to imitative behavior.

ultipoint competition: This arises when two or more enterprises encounter each other in different regional markets, national markets or industries. .g. Indian industry. and Bangladeshi mobile

.g. Kodak follows Fuji in any market

Product life cycle

Companies invest in different locations at different phases to comply with cost pressure

Example- Garment industry Explained in chapter 5

Location-specific advantage: economist John Dunning Proponent: British

By

location-specific advantage, Dunning means advantages that arise from using resource endowments or assets that are tied to particular foreign location and that a firm find valuable to combine with own assets. advantage comes from companys own asset like technological, managerial or marketing know-how.

Ownership-specific

 Exporting

helps to exploit the market and licensing ensures earning profit from selling know-how but FDI allows internalization of location specific assets and thus overcome the market impediments (argued in internalization theory). Exploiting natural resources of international locations is not possible in licensing and export.

E.g. Many Taiwanese, South Korean firms invest in Silicon Valley to internalize the locationspecific advantage of talented work pool.
Eclectic

behavior = location-specific advantage + ownership-specific advantage + internalization of assets

Vertical FDI
Backward

vertical FDI: This means investment into an industry abroad that provides inputs for a firms domestic production process. This is more common in oil extraction and mining industry. Forward vertical FDI: here an industry abroad sells the output of firms domestic production process. E.g. Volkswagen in USA. Strategic behavior: By vertically integrating backward to control over the source of raw material, a firm can raise entry barriers and shut new competitors out. E.g. Alcoa in USA. It will not be possible to attempt to

Market imperfection:
Following market imperfections explain the reason for vertical FDI Impediment to sale of know-how Shell, BP all these companies do not sell the know-how to oil suppliers of Saudi Arabia and Kuwait rather they purchase the oil fields. If the suppliers learn the technology of oil extraction then in future they might become the competitor of BP and Shell.

Investment in specialized assets Vertical FDI will occur when a firm must invest in specialized assets whose value depends on inputs provided by foreign supplier.