IBM Lecture Foreign Direct Investment and Political Economy of FD

Lecture: Foreign Direct Investment

Read CEMEX case

• In less than 10 yearx CEMEX transformed itself from a primarily Mexican company to the third largest cement company in the world

• Sales of > 7.1 billion dollars and over 2 billion dollars of cash flow. • Used technology effectively (GPS in trucks etc) to deliver product on

time• Company’s vision:1. Wanted to reduce reliance on volatile Mexican market• Saw tremendous opportunity in developing countries• Understood needs of developing nations better than multi-nationals

from developed countries• Acquired inefficient cement companies in other markets transferring

its skills in customer services, marketing, information technology and production management

• CEMEX acquired British cement manufacturer RMC – RMC had operations in 22 European nations.

FDI

• Foreign Direct Investment: occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country. o Once a firm undertakes FDI, it becomes a multinational

enterprise

2 forms of FDI

1.Greenfield Investment: involves establishment of a new operation in a foreign country

2.Acquiring or merging with a n existing firm in a foreign country (most of CEMEX’s expansion has been in the form of acquisitions).

Objective of Chapter

• Identify the economic rationale that underlies foreign direct investment

Licensing

• Licensing: occurs when a domestic firm, the licensor, licenses to a foreign firm, the licensee, the right to produce its product, to use its production processes, or to use its brand name or trademark. In return licensor collects royalty or fee.

• Advantage is that the licensor doesn’t have to pay for opening a foreign market (licensee does that).

Horizontal vs. Vertical FDI

• Horizontal FDI: is FDI in the dame industry in which a firm operates at home (CEMEX acquiring RMC is an example of HFDI).

• Vertical FDI is in an industry that provides inputs for a firm’s domestic operations or it may be FDI in an industry abroad that sells the outputs of a firm’s domestic operations.

Aspects of FDI

• Flow of FDI: refers to the amount of FDI undertakne over a given time period

• Stock of FDI: refers to the total accumulated value of foreign-owned assets at a given time

• Outflows of FDI: flow of FDI out of the country• Inflows of FDI: flow of FDI into a country

Growth and trends of FDI

• FDI increase from $25 billion in 1975 to a record $1.2 trillion in 2000

• Growth in FDI has been more rapdi than growth in world trade and world output. o Executives see FDI as a way of circumventing future trade

barrierso Shift in free-market economies and democratic governments

have helped increase trade and engagement with the worldo Globalization of world economy – more markets have positive

impact

Gross fixed capital formation

• Gross fixed capital formation: summarizes the total amount of capital invested in factories, stores, office buildings, and the like.

• Other things being equal, the greater the capital investment in an economy, the more favorable its future growth prospects are likely to be.

Source of FDI

• Since WWII, USA has been single largest source of FDI.

• As of 2003, 27 of world’s 100 MNC’s were from USA.

Form of FDI

• Acquisitions versus Greenfield: UN estimates that 40-80% of all FDI inflows were in the form of mergers and acquisitions between 1998-2003

• Difference in form of FDI going to developed and developing nationso Developing nations only 33% is in form of mergers and

acquisitions May reflect that there are fewer firms to acquire in developing

nations

Shift to Services

• 1990 47% of outward FDI stock was in service industries• 2003 it went up to 67%• Until recently services composed of financial services• Now it includes:

o Telecommunications (PTCL, wireless licenses)o Electricity (Pakistan offering IPP projects)

• Shift based on four factor:1. General move away from manufacturing to services• Many services cannot be traded internationally• Many nations have liberalized their regimes governing FDI in services

(courtesy WTO etc.)• Rise of internet-based global telecommunications networks has allowed

some service enterprises to relocated some of their value creation activities to different nations to take advantage of favorable costs.

Why HFDI?

• Why opt for horizontal foreign direct investment?• Several reasons for undertaking direct investment?

1.Transportation costs: When such costs are added to production costs, it becomes difficult to compete

• Market imperfections (Internalization theory): factors that inhibit markets from working perfectly

• When there are impediments to the free flow of products between nations

• When there are impediments to the sale of know-how• Competitions• Strategic behavior• Location advantages

Why licensing doesn’t always work

1. Licensing may result in a firm’s giving away it’s know-how to a potential foreign competitor. 1. Example: RCA licensed it’s color TV technology to Matsushita and Sony who then easily

assimilated it2. Licensing doesn’t give a firm the tight control over manufacturing,

marketing and strategy in a foreign country 1. Whereas a licensor may want its foreign subsidiary to price and market very

aggressively to keep a global competitor in check but the licensee wants to make a profit.

A firm may want control over the operations of a foreign entity to take advantage of differences in factor costs among countries, producing only part of its final product in a given country, while importing other parts from where they can be produced at lower cost. • The licensee would unlikely accept an arrangement like this with such tight controls.

3. A firm’s know-how may not be amenable to licensing. • particularly true of management and marketing know-how [CEMEX and

Toyota, whose management and lean productions skills are embedded in its culture, prefer to do direct FDI rather than license]

Strategic Behavior / Imitative theory

• Oligopoly is an industry composed of a limited number of large firms. [an industry in which four firms control about 80% of the business would be considered an oligopoly]

• Knickerbocker reasoned that FDI flows are a reflection of strategic rivalry between firms in the global marketplace.

• Multipoint competition: arises when two or more enterprises encounter each other in different regional markets, national markets or industries.

Location Specific Advantage

• Location specific advantage: 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 (such as technological, marketing or management know-how) – an argument by British economist John Dunning

• Firms in one concentrated area can gain from each other via ‘spillover’ knowledge or ‘externalities’

Vertical FDI

• Backward Vertical FDI: investment in an industry abroad that provides inputs for a firm’s domestiv production processes. o Historically most backward VFDI has been in extractive

industries (oil extraction, bauxite mining, tin mining and copper mining) – Royal Dutch/Shell, BP, ALCOA

• Forward Vertical FDI: in which an industry abroad sells outputs of a firm’s domestic production processes. Less common then backward VFDI. o Volkeswagen entered the US and acquired a large number of

dealers rather than distribute its cars through independent US dealers

Lecture VII: Political Economy of Foreign Direct Investment

Political Ideology and Foreign Direct Investment: Radical View and Free market View

1.Radical view: 1. Has Marxist roots; views MNE as an instrument of imperialist domination2. Prohibits FDI; nationalize subsidiaries of foreign-owned MNE’s

2.Free market view:1. Classical economic roots (Smith); views the MNE as an instrument for allocating production to

most efficient locations2. No restrictions on FDI

3.Pragmatic nationalism1. Views FDI as having both benefits and costs2. Restricts FDI where costs outweigh benefits; Bargain for greater benefits and fewer costs;

aggressively court beneficial FDI by offering incentives

Benefits of FDI to host country

1.Resource-transfer effect2.Employment effect3.Balance-of-payment effect4.Competition and economic growth

Resource transfer effect

• FDI makes contribution to host economy by supplying:

1.Capital• Technology• Management

Balance-of-Payment effect

• Balance-of-payment account: keep track of both its payments to and its receipts from other countries.o Divided into two portions:

Current account Capital account

• Current Account records (exports):o Merchandiseo Serviceso Income receipts on investments

• Capital Account records: records transactions that involve the purchase or sale of assets

Surplus and deficit

• Current account deficit: occurs when country imports more goods, services and income than it exports.

• Current account surplus: occurs when a country exports more goods, services and income than it imports

FDI and Balance of Payments

• Three Balance of Payment consequences of FDI:1.MNE investment causes a one time inflow of capital

in the capital account• If FDI is a substitute for imports of goods or services,

it can improve the current account of the host country’s balance of payments.

• When MNE uses a foreign subsidiary to export goods and services to another country,.

Effects on Competition and Growth

• Economic theory: markets function efficiently when there is competition between different producers.

• If FDI via greenfield investment – you have another producer in the marketo Increases level of competitiono Increases level of R&D etc. by competitors

Cost of FDI to Host Countries

1.Adverse effects on competition2.Adverse effects on the Balance of

Payments3.National Sovereignty