Global Business Today 10e

by Charles W.L. Hill

and G. Tomas M. Hult
The Global Trade and Investment Environment

Source: © Silviu Doroftei/ZUMA Press/London/Newscom

Chapter 8: Foreign Direct Investment

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Learning Objectives
LO 8-1Recognize current trends regarding foreign direct
investment (FDI) in the world economy.
LO 8-2Explain the different theories of FDI.
LO 8-3Understand how political ideology shapes a government’s
attitudes toward FDI.
LO 8-4Describe the benefits and costs of FDI to home and host
countries.
LO 8-5Explain the range of policy instruments that governments
use to influence FDI.
LO 8-6Identify the implications for managers of the theory and
government policies associated with FDI

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Opening Case:
Burberry Shifts Its Strategy in Japan
 Until recently, Burberry branded products sold in Japan under
a licensing agreement with Sanyo Shokai
 Typically sold at prices significantly lower than prices Burberry
charged for its high-end products
 In 2007, Burberry’s CEO didn’t like the way the company’s
core brand image was being diluted
 Began to terminate license agreements
 Sanyo Shokai required to close nearly 400 licensed stores
 Burberry now sells its products through wholly-owned stores
 Burberry expects sales to initially fall as it rebuilds the brand

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Introduction
Foreign direct investment (FDI): a firm invests directly in
new facilities to produce or market in a foreign country
 A firm engaged in FDI is a multinational enterprise

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Foreign Direct Investment in the World Economy 1 of 5
The flow of FDI - the amount of FDI undertaken over a
given time period
 Outflows of FDI are the flows of FDI out of a country
 Inflows of FDI are the flows of FDI into a country
The stock of FDI - the total accumulated value of
foreign-owned assets at a given time

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Foreign Direct Investment in the World Economy 2 of 5
Trends in FDI
 Both the flow and stock of FDI in the world economy have
increased over the last 35 years
 FDI has grown more rapidly than world trade and world
output
 Firms still fear protectionist policies
 The shift toward democratic political institutions and free market
economies encourages FDI
 Globalization is prompting firms to ensure they have a significant
presence in many regions of the world

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Figure 8.1 FDI Outflows 1980-2014 ($billions)

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

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Foreign Direct Investment in the World Economy 3 of 5
The Direction of FDI
 Historically, most FDI has been directed at the developed
nations of the world
 The United States is a favorite target as is the European Union
 More recently, developing nations have been the
recipients of FDI
 South, East, and Southeast Asia, and particularly China have
received significant inflows
 Latin America is also emerging as an important region for FDI

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Figure 8.2 FDI Inflows by Region 1995-2014 ($billions)

Source: United Nations World Investment Report, various editions.

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Foreign Direct Investment in the World Economy 4 of 5
The Source of FDI
 Since World War II, the U.S. has been the largest source
country for FDI
 Other important source countries: the United Kingdom,
the Netherlands, France, Germany, and Japan
 Chinese firms have recently emerged as major foreign
investors

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Figure 8.3 Cumulative FDI Outflows 1998-2014 ($billions)

Source: United Nations World Investment Report, various editions

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Did You Know?

Did you know that

America is the world's
largest foreign investor
and the largest
recipient of foreign
investment?

Click to play video

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Foreign Direct Investment in the World Economy 5 of 5
The Form of FDI: Acquisitions versus Greenfield
Investments
 Greenfield investments involve establishing new operation
in a foreign country
 Acquisitions are attractive because:
 They are quicker to execute than greenfield investments
 It is easier and less risky for a firm to acquire desired assets than
build them from the ground up
 Firms believe they can increase the efficiency of an acquired unit
by transferring capital, technology, or management skills

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Theories of Foreign Direct Investment 1 of 7
Three complementary perspectives
 Why does a firm favor direct investment over exporting
and licensing?
 Why do firms in same industry undertake foreign direct
investment at the same time and favor certain locations as
targets for FDI?
 Eclectic paradigm combines these two perspectives

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Theories of Foreign Direct Investment 2 of 7
Why Foreign Direct Investment?
 Exporting: producing goods at home and then shipping
them to the receiving country for sale
 Licensing: granting a foreign entity the right to produce
and sell the firm’s product in return for a royalty fee on
every unit that the foreign entity sells

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Theories of Foreign Direct Investment 3 of 7
Why Foreign Direct Investment? continued
 Limitations of Exporting
 An exporting strategy can be limited by transportation costs and
trade barriers
 When transportation costs are high, exporting can be unprofitable
 Low value-to-weight ratio
 Foreign direct investment may be a response to actual or
threatened trade barriers such as import tariffs or quotas

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Theories of Foreign Direct Investment 4 of 7
Why Foreign Direct Investment? continued
 Limitations of Licensing
 Internalization theory (aka market imperfections)
 Licensing could 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
manufacturing, marketing, and strategy in a foreign country that
may be required to maximize its profitability
 Licensing may be difficult if the firm’s competitive advantage is
not amenable to it

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Theories of Foreign Direct Investment 5 of 7
Why Foreign Direct Investment? continued
 Advantages of Foreign Direct Investment
 FDI will be favored over exporting when
 Transportation costs are high
 Trade barriers are high
 FDI will be favored over licensing when
 The firm wants control over its technological know-how
 The firm wants control over its operations and business
strategy
 The firm’s capabilities are not amenable to licensing

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Theories of Foreign Direct Investment 6 of 7
The Pattern of Foreign Direct Investment
 Strategic Behavior
 Knickerbocker explored the relationship between FDI and rivalry in
oligopolistic industries (industries composed of a limited number
of large firms)
 FDI flows reflect strategic rivalry between firms
 This theory can be extended to multipoint competition (when two
or more enterprises encounter each other in different regional
markets, national markets, or industries)

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Theories of Foreign Direct Investment 7 of 7
The Eclectic Paradigm
 Dunning’s eclectic paradigm - in addition to the various
factors discussed earlier, two additional factors must be
considered when explaining both the rationale for and the
direction of foreign direct investment
 Location-specific advantages - arise from using resource
endowments or assets that are tied to a particular location and
that a firm finds valuable to combine with its own unique assets
 Externalities - knowledge spillovers that occur when companies in
the same industry locate in the same area

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Location Factors and FDI

Source: © Phillip Bond/Alamy Stock Photo

Silicon Valley, where Google is based, has long been known as
the epicenter of the computer and semiconductor industry.

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Political Ideology and Foreign Direct Investment 1 of 5
Ideology toward FDI has ranged from a radical stance
that is hostile to all FDI to the non-interventionist
principle of free market economies
 Between these two extremes is an approach that might be
called pragmatic nationalism

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Political Ideology and Foreign Direct Investment 2 of 5
The Radical View
 MNE is an instrument of imperialist domination and a tool
for exploiting host countries to the exclusive benefit of
their capitalist-imperialist home countries
 The radical view has been in retreat
 The collapse of communism in Eastern Europe
 The poor economic performance of those countries that had
embraced the policy
 The strong economic performance of developing countries that
had embraced capitalism

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Political Ideology and Foreign Direct Investment 3 of 5
The Free Market View
 International production should be distributed among
countries according to the theory of comparative
advantage
 Countries should specialize in the production of goods and
services they can produce most efficiently
 The MNE increases the overall efficiency of the world economy

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Political Ideology and Foreign Direct Investment 4 of 5
Pragmatic Nationalism
 FDI has benefits and costs
 Benefits: inflows of capital, technology, skills and jobs
 Costs: repatriation of profits to the home country and a negative
balance of payments effect

 FDI should be allowed only if the benefits outweigh the

costs

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Political Ideology and Foreign Direct Investment 5 of 5
Shifting Ideology
 In recent years, there has been a strong shift toward the
free market stance
 A surge in the volume of FDI worldwide
 An increase in the volume of FDI directed at countries that have
recently liberalized their regimes
 China, India, Vietnam
 But, some countries are becoming more hostile to FDI
 Venezuela, Bolivia

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Benefits and Costs of FDI 1 of 9
Host-Country Benefits
 Resource Transfer Effects
 FDI can bring capital, technology, and management resources that
would otherwise not be available
 Employment Effects
 FDI can bring jobs that would otherwise not be created there
 Opponents say not all “new jobs” represent net additions in
employment

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Benefits and Costs of FDI 2 of 9
Host-Country Benefits continued
 Balance-of-Payments Effects
 The balance-of-payments account records a country’s payments
to and receipts from other countries
 The current account records a country’s export and import of
goods and services
 A surplus is usually favored over a deficit
 FDI can help achieve a current account surplus
 If it is a substitute for imports of goods and services
 If the MNE uses a foreign subsidiary to export goods and
services to other countries

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Benefits and Costs of FDI 3 of 9
Host-Country Benefits continued
 Effect on Competition and Economic Growth
 FDI in the form of greenfield investment
 Increases the level of competition in a market
 Drives down prices
 Improves the welfare of consumers
 Increased competition leads to
 Increased productivity growth
 Product and process innovation
 Greater economic growth

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Does Foreign Direct Investment Promote Growth?
There are multiple reasons for companies to make foreign direct
investments. Lowering the cost of production, increasing
capacity (volume) of production, and strategically locating
production facilities to serve world regions are some of the many
reasons for FDI by a company. For the host countries that receive
the investment by multinational corporations, the logic is that
the influx of capital and increase in tax revenues will benefit the
host country in the form of new infrastructure, increased
knowledge, and general economic development. However, the
evidence so far is very mixed on the value of FDI to the host,
ranging from beneficial to detrimental. What do you think? Does
FDI promote growth in the host country?
Source: L. Alfaro, A. Chanda, S. Kalemli-Ozcan, and S. Sayek, Does Foreign Direct Investment Promote Growth?
Exploring the Role of Financial Markets on Linkages (Cambridge, MA: Harvard Business School,
2009), www.people.hbs.edu/lalfaro/fdiandlinkages.pdf

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FDI and Job Creation

Job creation is a
result of FDI.
These French
workers
assemble cars at
Toyota’s
Valenciennes
manufacturing
plant.
Source: © Philippe Huguen/AFP/Getty Images

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Benefits and Costs of FDI 4 of 9
Host Country Costs
 Adverse Effects on Competition
 The subsidiaries of foreign MNEs may have greater economic
power than indigenous competitors because they may be part of a
larger international organization
 The MNE could draw on funds generated elsewhere to
subsidize costs in the local market
 Doing so could allow the MNE to drive indigenous competitors
out of the market and create a monopoly position

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Benefits and Costs of FDI 5 of 9
Host Country Costs continued
 Adverse Effects on the Balance of Payments
 There are two possible adverse effects of FDI on a host country’s
balance-of-payments
1. The capital outflows as foreign subsidiaries repatriate earnings to
the parent country
2. There is a debit on the current account of the host country’s
balance of payments associated with imports of input products by
the foreign subsidiary

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Benefits and Costs of FDI 6 of 9
Host Country Costs continued
 Possible Effects on National Sovereignty and Autonomy
 FDI can mean some loss of economic independence
 Key decisions that can affect the host country’s economy will be
made by a foreign parent that has no real commitment to the host
country, and over which the host country’s government has no real
control

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Benefits and Costs of FDI 7 of 9
Home Country Benefits
1. The effect on the capital account of the home country’s
balance of payments from the inward flow of foreign
earnings
2. The employment effects that arise from outward FDI
3. The gains from learning valuable skills from foreign
markets that can subsequently be transferred back to the
home country

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Benefits and Costs of FDI 8 of 9
Home Country Costs
 The balance-of-payments
 The balance of payments suffers from the initial capital outflow
required to finance the FDI
 The current account is negatively affected if the purpose of the
FDI is to serve the home market from a low-cost production
location
 The current account suffers if the FDI is a substitute for direct
exports
 Employment effects of outward FDI
 If the home country is suffering from unemployment, there may
be concern about the export of jobs

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Benefits and Costs of FDI 9 of 9
International Trade Theory and FDI
 Home country concerns about the negative economic
effects of offshore production (FDI undertaken to serve
the home market) may not be valid
 FDI may actually stimulate economic growth by freeing home
country resources to concentrate on activities where the home
country has a comparative advantage
 Consumers may also benefit in the form of lower prices

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Government Policy Instruments and FDI 1 of 5
Home-Country Policies
 Encouraging Outward FDI
 Have government-backed insurance programs to cover major
types of foreign investment risk
 Have special funds or banks that make governmental loans to
firms investing in developing countries
 Have eliminated double taxation of foreign income
 Many host nations have relaxed restrictions on inbound FDI

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Government Policy Instruments and FDI 2 of 5
Home-Country Policies continued
 Restricting Outward FDI
 Virtually all investor countries, including the United States, have
exercised some control over outward FDI from time to time
 Countries manipulate tax rules to make it more favorable for firms
to invest at home
 Countries may restrict firms from investing in certain nations for
political reasons

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Government Policy Instruments and FDI 3 of 5
Host-Country Policies
 Encouraging Inward FDI
 Governments offer incentives to foreign firms to invest in their
countries
 Gain from the resource-transfer and employment effects of FDI
 Capture FDI away from other potential host countries

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Government Policy Instruments and FDI 4 of 5
Host-Country Policies continued
 Restricting Inward FDI
 Ownership restraints: exclude foreign firms from certain sectors on
the grounds of national security or competition
 Local owners can help to maximize the resource transfer and
employment benefits of FDI
 Performance requirements: used to maximize the benefits and
minimize the costs of FDI for the host country

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Government Policy Instruments and FDI 5 of 5
International Institutions and the Liberalization of FDI
 Until recently there has been no consistent involvement by
multinational institutions in the governing of FDI
 The formation of the World Trade Organization in 1995
changed this
 The WTO has had some success in establishing a universal set of
rules to promote the liberalization of FDI

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Focus on Managerial Implications 1 of 3
FDI AND GOVERNMENT POLICY
The location-specific advantages argument associated
with Dunning help explain the direction of FDI
However, internalization theory is needed to explain
why firms prefer FDI to licensing or exporting
 Exporting is preferable to licensing and FDI as long as
transportation costs and trade barriers are low

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Focus on Managerial Implications 2 of 3
Licensing is unattractive when
 The firm’s proprietary property cannot be properly
protected by a licensing agreement
 The firm needs tight control over a foreign entity in order
to maximize its market share and earnings in that country
 The firm’s skills and capabilities are not amenable to
licensing

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Focus on Managerial Implications 3 of 3
Government Policy
A firm’s bargaining power with the host government is
highest when
 The host government places a high value on what the firm has to
offer
 When there are few comparable alternatives available
 When the firm has a long time to negotiate

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Figure 8.4
A Decision
Framework

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Summary
In this chapter we have
 Recognized current trends regarding foreign direct
investment (FDI) in the world economy.
 Explained the different theories of FDI.
 Understood how political ideology shapes a
government’s attitudes toward FDI.
 Described the benefits and costs of FDI to home and
host countries.
 Explained the range of policy instruments that
governments use to influence FDI.
 Identified the implications for managers of the theory
and government policies associated with FDI.
©McGraw-Hill Education.