Foreign Direct Investment(FDI)

A foreign investment (FDI) is a company controlled through ownership by a foreign company of foreign individuals.

Control must accompany the investment; otherwise it is a portfolio investment.

Companies want to control their foreign operations so that these operations will help achieve their global objectives. Investors who control an organization are more willing to transfer technology and other competitive assets. The idea of denying rivals access to resources is called the appropriability theory.

Governmental authorities worry that this control will lead to decisions contrary to their countries’ best interests.

Direct investments usually, but not always, involve some capital movement.

There are two ways companies can invest in a foreign country. They can either acquire an interest in an existing operation or construct new facilities.

Buy: Depends on which companies are available for purchase; difficulty to transfer resources or acquire resources for a new facility; the goodwill and brand identification; easier access to local capital; market does not justify added capacity; immediate cash flow.

Build: Depends on difficulty to find a company to buy; little or no competition; local governments prevent acquisition; acquisition less likely to succeed (inefficient); local financing easier to obtain for building.

Whether a company first transfers capital or some other asset to acquire a foreign direct investment, the asset is a type of production factor. Production factors: capital, technology, trademarks, managers, raw material, ….

If trade could not occur and production factors could not move internationally, a country would have to either forgo consuming certain goods or produce them differently, which in either case would usually result in decreased worldwide output and higher prices. In some cases, the inability to use foreign production factors may stimulate efficient methods of substitution.

If finished goods and production factors were both free to move internationally, the comparative costs of transferring goods and factors would determine the location of production. However, as is true of trade, there are restrictions on factor movements that make them only partially mobile internationally.

Factor movements may substitute for or stimulate trade. World trade (exports) are stimulated by FDI because of the need for components, complementary products and equipment for subsidiaries.

The least-cost production location changes because of inflation, regulations, transportation costs, and productivity.

Businesses and governments are motivated to engage in FDI in order to expand sales, acquire resources and minimize competitive risk. Governments may additionally be motivated by some desired political advantage.

Sales expansion objectives :

– Overcome high transportation costs

– Lack of domestic capacity

– Low gains from scale economies

– Trade restrictions

– Barriers because of country-origin effects (nationalism, product image, delivery risk)

– Lower production costs abroad

Resource acquisition objectives :

– Savings through vertical integration

– Savings through rationalized production

– Gain access to cheaper or different resources and knowledge

– Need for lower costs as product mature

– Gain governmental investment incentives

Risk minimization objectives :

– Diversification of customer base (same motivations as for sales expansion objectives)

– Diversification of supplier base (same motivations as for resource acquisition objectives)

– Following customers

– Preventing competitors’ advantage

Political objectives :

Influence companies usually through factors under resource acquisition objectives.

Companies invest directly only if they think they hold some supremacy over similar companies in countries of interest. The advantage results from a foreign company’s ownership of some resource – patents, product differentiation, management skills, access to market – unavailable at the same price or terms to the local company.

To support the high costs necessary to maintain domestic competitiveness, companies frequently must sell on a global basis.

Almost all ownership is by companies from developed countries, but the emerging economy ownership is increasing. Most FDI occurs in developed countries because they have the biggest markets, lowest perceived risk and are the least discrimination toward foreign companies.

Over time, the portion of FDI accounted for in the raw materials sector that includes mining, smelting, and petroleum has declined. The portion in manufacturing, especially resource-based production, grew steadily. The highest recent growth in FDI has been in service (especially banking and finance) and technology-intensice manufacturing.

1. Define the following terms:

a. Appropriability theory.- Companies are reluctant to transfer vital resources, capital, patents, trademarks and management know how to another organization that can make all its decisions independently, because the company receiving these resources can use them to undermine the competitive position of the foreign company transferring them.

b. Internalization.- The control inherent in FDI may decrease a company’s operating costs and increase its rate of technological transfer because:

– The parent and subsidiary usually share a common corporate culture.

– The company can use its own managers, who understand its objectives.

– The company can avoid protracted negotiations with another company.

– The company can avoid problems of enforcing an agreement.

c. Horizontal expansion.– It’s when companies move abroad to produce basically the same products they produce at home.

d. Just-in-time (JIT) manufacturing systems.- It’s the decrease of inventory costs by having components and parts delivered as needed, these systems favor nearby suppliers who can deliver quickly.

e. Vertical integration.– It’s a company’s control of the different stages (sometimes collectively called a value chain) of making its product, from raw material through production to its final distribution.

f. Rationalized production.– It’s when some companies produce different components or different portions of their product line in different parts of the world to take advantage of low labor costs, capital and raw materials.

g. Monopoly advantage.- It’s when companies invest only if they think they hold some supremacy over similar companies in countries of interest. The advantage results from a foreign company’s ownership of some resource, patents, products differentiation, management skills, access to markets, unavailable at the same price or terms to the local company.

2. What is the major difference between a direct investment and a portfolio investment?

In a direct investment, control must accompany the investment, otherwise it’s a portfolio investment.

3. Why are some governments and citizens concerned when investments are controlled abroad?

Many critics of Foreign Direct Investment (FDI), worry that the host country’s national interests will suffer somewhat if a multinational company makes decision from afar on the basis of its own global or national objectives.

4. Why do companies want to control their investments abroad?

Because with that, foreign companies are less reluctant to transfer vital resources such as capital, patents, trademarks and management know-how, that eventually could be used to undermine the competitive position of the foreign company transferring these resources.

5. Why might control over one’s own foreign production result in a lower operating cost than if control is vested in another company?

Because investors who control an organization are more willing to transfer technology and other competitive assets, also, they usually use cheaper and faster means of transferring assets.

6. What types of assets could be used to acquire a direct investment?

There are two other means of acquiring foreign investments that are not capital movements per se.

First, a company may use funds it earns in a foreign country to establish an investment, for example, a company that exports merchandise but holds payments for those goods abroad can use settlement to acquire an investment, in this case, it has merely exchanged goods for equity.

Second, a company may transfer assets abroad to establish a sales or production facility, if the earnings from the facility can increase the value of the foreign holdings, FDI has increased without a new international capital movement.

7. Explain how factor proportions and mobility affect patterns of international direct investment.

Factor movement is an alternative to trade that may or may not be a more efficient allocation of resources.

8. Explain why FDI and trade may or may not be a substitute for each other.

No, they may not be a substitute for each other, since FDI is a major cause and means of factor movements. If trade could not occur and production factors could not move internationally, a country would have to either forgo consuming certain goods or produce them differently, which in either case would usually result in decreased worldwide output and higher prices.

9. How might FDI stimulate trade?

Factor mobility via direct investment often stimulates trade because of the need for:
Components
Complementary products
Equipment for subsidiaries

10. What are the general motivations for firms to engage in direct investment?

Expand sales
Acquire resources
Minimize competitive risk
Governments may additionally be motivated by some desired political advantage.

11. What is the role of transportation costs in influencing FDI decisions?

Transportation raises costs so much that it becomes impractical to export some products.

12. How does capacity use influence the decision to serve foreign markets through exports versus direct investment?

As long as a company has excess capacity at its plant(s), it may compete effectively in limited export markets despite high transport costs. This ability might occur if domestic sales cover fixed operating expenses. The cost per unit decreases until it reaches full capacity. When demand pushes the plant toward capacity, production should be increased by use of FDI.

13. How do economies of scale impact the FDI decision?

Standardized products : Cost per unit drops significantly as output increases. Companies can export large amounts of such products because they can spread the fixed costs over more units in output.

14. How does the need to alter products to sell them in foreign country affect the decisions to export to, versus produce within, that foreign country?

Companies that need to alter their products substantionally for different foreign markets benefit less by scale economies. For these types of products smaller plants to serve national rather than international markets will save transport costs. In this case companies’ country-by-country production reduces costs by minimizing transportation expenses.

15. What is the relationship between trade restrictions and FDI?

If imports are highly restricted, companies often produce locally to server the local market if the market potential is high relative to scale economies.

Removing trade restrictions among a regional group of countries may attract FDI, because the expanded market may justify scale economies. Or the removal of trade restrictions may result in trade diversion.

16. How do country-of origin effects influence a firm’s decision to produce abroad rather than export.

Consumers sometimes prefer domestically produced goods because of

– Nationalism: Promotional campaigns to buy locally
– A belief these products are better
– A fear that foreign-made goods may not be delivered on time.

Consumers often view their quality different on basis of the country of origin.

17. How may companies use FDI as a means to reduce competitive risk?

FDI enables companies to reduce competitive risk by

– Diversifying of customer & supplier base
– Providing low-end pricing through Production rationalization & vertical integration = stay competitive.
– Taking advantage of scale economies
– Increasing market share

18. What factors affect the least-cost production location and why might this location change?

Factors affection the least-cost production location: capital, raw material, productivity, labor costs, technology, assets.

The least-cost production location changes because of inflation, regulations, transportation costs, and productivity.

19. What are some of the advantages of international vertical integration?

The foreign direct investor will have control over the value chain; raw material, production & distribution.

The supply and/or markets are more assured, the foreign direct investor may be able to carry smaller inventories and spend less on promotion.

By buying and selling within the family of companies, the foreign direct investor also has considerably grater flexibility in shifting funds, taxes, and profits among countries.

20. What are the managerial implications of vertical integration?

There is a great interdependence among the different stages. A tight relationship is needed to ensure that production and marketing continue to flow.

21. What are the advantages of rationalized productions?

Rationalized production is taking advantage of low labor costs, capital and raw materials.

Advantages :

– Lower total production cost

– Rationalized production of complete product: increase market share, gain advantage of locally produced finished goods.
– Smoother earnings when exchange rates fluctuate

22. What are the problems of rationalized productions?

Disadvantages :

– Rationalized production of parts: risk of work stoppages in one country will have an impact on the whole production.
– Difficult to determine the origin of the product

23. Discuss possible political motivations for foreign direct investment.

Reduce security risk by controlling resources. A government-owned company invests abroad in order to be less dependent on foreign companies for resources, and to hold down the prices on production it receives.

Increase profitability of investments in countries that are unfriendly to certain regimes: governments institute various incentives for those who support the embargos.

24. What are the major advantages of making an FDI via acquisition rather than via start-up operations?

• Immediate cash flow
• Easy access to resources (labor, capital)
• Market position in foreign country (goodwill, brand)

25. What are the major advantages of making an FDI via start-up operations rather than via acquisition?

• Full control at start.
• Possibility to gain market-share before the competition does.

26. Why do critics claim that worker displacement due to FDI is different from worker displacement due to technological change?

The workers cannot move abroad to take advantage of the new opportunities there.

The employers are responsible for the job losses. The company has an ethical obligation to give employees advance notice of the move and to provide training and help with job searches.

Critics’ conclusion: FDI is unethical because the process creates economic distinctions between the ‘have’ and ‘have-not’ countries.

27. How do currency values impact flows of direct investment?

When a currency is very strong, converting it to other currencies the buying power increases in those foreign currency countries. This advantage is an incentive to make foreign investments.

Reviewing the history, the currency-strength scenario only partially explains direct investment flow. FDI linked to strength of economy (ROI).

28. What advantages do companies gain from FDI?

Monopoly advantages before DI

A company will go for FDI when it has the ownership of some resource ( patents, product differentiation, management skills, access to markets) unavailable at the same price or terms to the local company

A company may benefit because its currency has high buying power to go for a “cheap” FDI

Advantages after DI

Spreading out costs (product differentiation, R&D, advertising) results in maintaining the domestic competitiveness.

29. What factors have contributed to the dramatic increase in the amount of foreign direct investment?

The growth resulted from several factors :

– the more receptive attitude of governments to investment inflows
– the process of privatisation
– growing interdependence of the world economy

30. Which countries are the largest foreign direct investors?

The industrial countries account for over 90 percent of all direct investment outflows. Those countries do have the capital, technology and the managerial skills to invest abroad.

31. Explain why most FDI flows to developed countries rather than to LDCs.

The developed countries have the biggest markets, lowest perceived risk and are the least discrimination toward foreign companies.

32. What have been the major FDI trends in the raw materials, manufacturing, and service sectors?

The portion of FDI accounted for in the raw materials sector that includes mining, smelting, and petroleum has declined.

The portion of manufacturing, especially resource-based production, grew steadily from the 1920s to the early 1970s but has stabilized.

In the 1980s and 1990s, FDI in the service sector ( banking, finance ) grew rapidly, as did FDI in technology intensive manufacturing.

33. How do direct investments serve to enhance global economic efficiency?

FDI transfers resources to where they can be used more effectively and will enable a better use of the local resources. Eventually FDI may lead to better global use of resources.

FDI will employ laborers from emerging economies who otherwise may not find work and at the same time it will create a need for more highly paid managerial personnel at the company’s home country headquarters.

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