Foreign Direct Investment

Learning Objectives
LO 8-1 Recognize current trends regarding foreign direct
investment (FDI) in the world economy.
LO 8-2 Explain the different theories of FDI.
LO 8-3 Understand how political ideology shapes a
government’s attitudes toward FDI.
LO 8-4 Describe the benefits and costs of FDI to home
and host countries.
LO 8-5 Explain the range of policy instruments that
governments use to influence FDI.
LO 8-6 Identify the implications for managers of the theory
and government policies associated with FDI.
 Introduction
Foreign direct investment (FDI)
• Occurs when a firm invests directly in new facilities
to produce and/or market in a foreign country (10
percent or more)
• The firm becomes a multinational enterprise
Foreign Direct Investment in the World
Economy 1 of 5

Flow of FDI - the amount of FDI undertaken over

a given time period
• Outflows―flows of FDI out of a country
• Inflows―flows of FDI into a country
Stock of FDI - the total accumulated value of
foreign-owned assets at a given time
Foreign Direct Investment in the World
Economy 2 of 5
Trends in FDI
• Increase in both flow and stock of FDI over past 25
years
• Growing more rapidly than world trade and world
output
• Way to circumvent trade barriers
• Political and economic changes
• Shift toward democratic political institutions and free
market economies
• Globalization
Figure 8.1 FDI outflows, 1990–2016 ($ billions)

Source: UNCTAD statistical data set, http://unctadstat.unctad.org

Foreign Direct Investment in the World
Economy 3 of 5
The Direction of FDI
• Historically, mostly directed at developed nations
• U.S. is a target for FDI inflows
• Large and wealthy domestic market
• Dynamic and stable economy
• Favorable political environment and openness to FDI

• European inflows mainly from the U.S. and other

European nations
• China has also been a recipient of FDI recently
Figure 8.2 FDI inflows by region, 1995–2016
($ billions)

Source: UNCTAD statistical data set, http://unctadstat.unctad.org

Foreign Direct Investment in the World
Economy 4 of 5
The Source of FDI
• U.S. is the largest source since WWII
• Six countries (U.S., UK, France, Germany, Japan,
and the Netherlands) account for 60 percent of all FDI
outflows
• China became a major foreign investor around 2005,
especially in less developed nations
Figure 8.3 Cumulative FDI outflows, 1998–2016
($ billions)

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Source: UNCTAD statistical data set, http://unctadstat.unctad.org
Foreign Direct Investment in the World
Economy 5 of 5
The Form of FDI: Acquisitions versus Greenfield
Investments
• Greenfield investment
• Acquisitions and mergers
• Quicker to execute
• Can acquire valuable strategic assets
• Can increase the efficiency of the acquired unit by
transferring capital, technology, or management skills
Theories of Foreign Direct Investment 1 of 7
Three complementary perspectives
1st set of theories –
Seeks to explain why a firm will favor direct investment
as a means of entering a foreign market when two other
alternatives, exporting and licensing, are open to it
2nd set of theories –
Attempts to explain the observed pattern of foreign direct
investment flows
3rd set of theories - The eclectic paradigm
Attempts to combine the two other perspectives into a
single holistic explanation of foreign direct investment
Theories of Foreign Direct Investment 2 of 7
Why Foreign Direct Investment?
• Why do firms make investments in other countries?
• Exporting- Sale of products produced in one country to
residents of another country
• Licensing- Occurs when a firm (the licensor) licenses the right
to produce its product, use its production processes, or use its
brand name or trademark to another firm (the licensee). In return
for giving the licensee these rights, the licensor collects a royalty
fee on every unit the licensee sells.

• FDI is expensive and risky compared with exporting and

licensing.
• However, many firms apparently prefer FDI over either exporting or
licensing. Why?
Theories of Foreign Direct Investment 3 of 7
Why Foreign Direct Investment? continued
• Limitations of exporting
• Constrained by
– Transportation costs – Products having a low
value-to-weight ratio (ex. cement)
– Trade barriers – increasing the cost of exporting
(time and financial)
» By limiting imports through quotas and tariffs,
governments increase the attractiveness of FDI
and licensing
Theories of Foreign Direct Investment 4 of 7
Why Foreign Direct Investment? continued
• Limitations of licensing explaining
• Licensing may result in a firm’s giving away valuable
technological know-how to a potential foreign competitor.
• Licensing does not give a firm the tight control over
production, marketing, and strategy in a foreign country
that may be required to maximize its profitability.
• The firm’s competitive advantage is based on the
management, marketing, and manufacturing capabilities,
which is not amenable to licensing.
Theories of Foreign Direct Investment 5 of 7
Why Foreign Direct Investment? continued
• Advantages of Foreign Direct Investment
• MNE choose FDI
– When transportation costs or trade barriers make
exporting unattractive.
– When a firm wishes to maintain control over
» its technological know-how, or over
» its operations and business strategy
– When the firm’s capabilities are simply not amenable
to licensing.
Theories of Foreign Direct Investment 6 of 7
The Pattern of Foreign Direct Investment
• Strategic Behavior
• Knickerbocker - relationship between FDI and rivalry
in oligopolistic industries
• Oligopoly – composition of a limited number of large
firms
• Interdependence between firms in an oligopoly leads to
imitative behavior
• Imitative behavior also occurs in FDI
• Multipoint competition
• It didn’t explain ‘why the first firm in an oligopoly decided
to invest rather than export’.
Theories of Foreign Direct Investment 7 of 7
The Eclectic Paradigm - John Dunning
• Location-specific advantages
• Advantages that arise from using resource
endowments or assets that are tied to a
particular foreign location and that a firm finds
valuable to combine with its own unique assets.
• Combining location-specific assets or resource
endowments with the firm’s own unique capabilities
often requires foreign direct investment.
• Externalities
– knowledge spillovers
 Political Ideology and Foreign Direct
Investment 1 of 4
Pragmatic Free market
Radical View
Nationalism Perspective

- The Radical View

• Roots in Marxist political and economic theory
• The multinational enterprise (MNE) is an instrument of
imperialist domination
• Influential view from 1945-1980s
• No longer widely accepted
 Political Ideology and Foreign Direct
Investment 2 of 4
The Free Market Perspective
• Roots in classical economic theory and trade theories
of Adam Smith and David Ricardo
• International production should be distributed among
countries for achieving production efficiency
according to the theory of comparative advantage.
• FDI is a benefit to both the source country and the
host country.
 Political Ideology and Foreign Direct
Investment 3 of 4
Pragmatic Nationalism
• FDI has both benefits and costs
• Benefit – inflows of capital, technology, skills, and jobs
• Cost - repatriation of profits and negative balance of
payments effects

• Pursue policies designed to maximize the national

benefits and minimize the national costs
• Aggressively court? FDI believed to be in the
national interest
 Political Ideology and Foreign Direct
Investment 4 of 4
Shifting Ideology
• Decline in radical ideology
• Increase in free market ideology, more liberal foreign
investment regime
• Surge in FDI worldwide
• China, Vietnam, India

• Some nations more hostile to FDI

• Venezuela and Bolivia
 Benefits and Costs of FDI 1 of 8

Host-Country Benefits
• Resource-transfer effects
• Inflow of capital, technology, management resources
from foreign firms.
• Employment effects (Job Creation)
• Brings jobs to a host country that would otherwise not be
created there
• Direct or Indirect effects
• May be offset by loss of jobs in home country
 Benefits and Costs of FDI 2 of 8
Host-Country Benefits continued
• Balance-of-Payments Effects
• Balance of payments - National accounts that track
both payments to and receipts from foreigners.
• Current account
– In the balance of payments, record transactions involving
the export or import of goods and services.
– A current account deficit, or trade deficit, arises when a
country is importing more goods and services than it is
exporting.
 Benefits and Costs of FDI 3 of 8
Host-Country Benefits continued
• Balance-of-Payments Effects continued
• FDI helps with a current account surplus
• By substituting for imports
• When the MNE uses a foreign subsidiary to export
goods and services to other countries
 Benefits and Costs of FDI 4 of 8
Host-Country Benefits continued
• Effect on competition and economic growth
• Greenfield investment mainly creates new enterprise in local
market.
• Increased competition
– Driving down prices and increasing welfare of
consumers
– stimulating investment
– lowering prices
 Benefits and Costs of FDI 5 of 8
Host-Country Costs
• Adverse effects on competition
• Subsidiaries of foreign MNEs may have greater economic
power than domestic competitors
• Adverse effects on the balance of payments
• Subsequent capital outflow
• Imports of inputs from abroad
• Possible effects on national sovereignty and autonomy
• A loss of economic independence
 Benefits and Costs of FDI 6 of 8
Home-Country Benefits
• The home country’s balance of payments benefits
from the inward flow of foreign earnings
• Employment effects by subsidiary’s components and
parts importing from home-country
• Reverse resource-transfer effect
• MNE learns valuable skills from its exposure to foreign
markets that can subsequently be transferred back to the
home country.
 Benefits and Costs of FDI 7 of 8
Home-Country Costs
• Balance-of-payments effects of outward FDI
• Initial capital outflow
• The current account of the balance of payments suffers if the
purpose of the foreign investment is to serve the home
market from a low-cost production location.
• The current account of the balance of payments suffers if the
FDI is a substitute for direct exports.
• Employment effects
• When FDI is a substitute for domestic production
Government Policy Instruments and FDI 1 of 4

Home-Country Policies
• Encouraging outward FDI
• Government-backed insurance programs
• Government loans
• Elimination of double taxation of foreign income
• Relaxation of restrictions on FDI by host countries
Government Policy Instruments and FDI 2 of 4

Home-Country Policies continued

• Restricting outward FDI
• Limit capital outflows
• Manipulate tax rules
– tax incentives to keep investments at home
• Prohibit investment for political reasons
– Ex. North Korea
Government Policy Instruments and FDI 3 of 4
Host-Country Policies
• Encouraging inward FDI
• Incentives such as tax concessions, low-interest loans,
grants or subsidies to MNCs’ subsidiaries

• Restricting inward FDI

• Ownership restraints
• Performance requirements
 Managerial Implications

FDI, Government Policy

• The Theory of FDI
• Dunning’s locations specific advantages argument
explains the direction of FDI, but not why firms prefer FDI
to exporting or licensing

• Government policy
• Attitude toward FDI affecting on the decision about the
country for efficient production.
• Need the better skills for negotiation with foreign
government.
Figure 8.4 A decision framework

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