Main Theories of FDI

Ing. Tomáš Dudáš, PhD.

Structure of the presentationFDI theories – introduciton and main questions

FDI theories on macro level

Development theories of FDI

FDI theories on micro level

Eclectic FDI theory (OLI theory)

The basic questions of FDI theories (6W+H)Who? (is the investor)

What? (kind of FDI)

Why? (are we investing)

Where? (is the FDI going)

When? (do we invest)

How? (the mode of entry)

FDI theories on macro levelCapital market theory

One of the oldest theories of FDI (60s)FDI is determined by interest rates

Dynamic macroeconomic FDI theoryFDI are a long term function of TNC strategiesThe timing of the investment depends on the

changes in the macroeconomic environment„hysteresis effect“

FDI theories on macro levelFDI theory based on exchange rates

Analyses the relationship of FDI flows and exchange rate changes

FDI as a tool of exchange rate risk reduction

FDI theory based on economic geographyExplores the factors influencing the creation of

international production clustersInnovation as a determinant of FDI – „Greta

Garbo effect“

FDI theories on macro levelGravity approach to FDI

The closer two countries are (geographically, economically, culturally ...) the higher will be the FDI flows between these countries

FDI theories based on istitutional analysisExplores the importance of the institutional

framework on the FDI flowsPolitical stability – key factor

Life cycle theoryRaymond Vernon – 1966

It can be used to analyse the relationship of product life cycle and possible FDI flowsFDI can be seen mostly in the phases of

maturity and decline

The conclusions of this theory are questionable nowadays

Japanese FDI theoriesWere initially developed in the 70s of the last

century

Main representant – Terumoto Ozawa

He analysed the relationship of FDI, competitiveness and economic development based on the ideas of Michael Porter

He identified three main phases of development when he analysed the waves of FDI inflow and outflow from a country

Japanese FDI theoriesI. phase of economic growth

The country is underdeveloped and is targeted by foreign companies wanting to use its potential advantages (especially low labour costs)

Almost no outgoing FDI

II. Phase of economic growthNew FDI is drawn by the growing internal

markets and by the growing standards of livingOutgoing FDI are motivated by the raising labour

costs

Japanese FDI theoriesIII. Phase of economic growth

The competitivness of the country is based on innovation

The incoming and outgoing FDI are motivated by market factors and technological factors

Five Stage Theory - John Dunning

Stage 1Low incoming FDI, but foreign companies are

beginning to discover the advantages of the countryNo outgoing FDI – no specific advantages owned by

the domestic firms

Stage 2Growing incoming FDI do the advantages of the

country - especially the low labour costsThe standards of living are rising which is drawing

more foreign companies to the countryStill low outgoing FDI

Five Stage Theory - John DunningStage 3

Still strong incoming FDI, but their nature is changing due to the rising wages

The outgoing FDI are taking off as domestic companies are getting stronger and develop their competitive advantages

Stage 4Strong outgoing FDI seeking advantages

abroad (low labour costs)

Five Stage Theory - John Dunning

Stage 5Investment decisions are based on the

strategies of TNCsThe flows of outgoing and incoming FDI come

into equilibrium

Incoming and outgoing FDI in China Incoming and outgoing FDI in China between 2001-2004between 2001-2004

-10000

0

10000

20000

30000

40000

50000

60000

70000

2001 2002 2003 2004

FDI inflowFDI outflow

Incoming and outgoing FDI in South Korea between 2001-2004Incoming and outgoing FDI in South Korea between 2001-2004

0

1000

2000

3000

4000

5000

6000

7000

8000

2001 2002 2003 2004

FDI inflowFDI outflow

Incoming and outgoing FDI in Japan Incoming and outgoing FDI in Japan between 2001-2004between 2001-2004

0

5000

10000

15000

20000

25000

30000

35000

40000

2001 2002 2003 2004

FDI inflowFDI outflow

FDI theories on micro levelExistence of firm specific advantages (Hymer)

Access to raw materialsEconomies of scaleIntangible assets such as trade names, patents,

superior management etcReduced transaction costs when replacing an arm's

length transaction in the market by an internal firm transaction

FDI and oligopolistic marketsIn oligopolistic markets the companies follow the

actions of the market leaderMutual threats – game theory

FDI theories on micro levelTheory of internalisation

Due to market imperfections, there may be several reasons why a firm wants to make use of its monopolistic advantage itself (or organise an activity itself)

Buckley and Casson (influenced by Coase), suggested that a firm overcomes market imperfections by creating its own market - internalisation

he theory of internalisation was long regarded as a theory of why FDI occurs

By internalising across national boundaries, a firm becomes multinational

Eclectic FDI theory – John DunningJohn Dunning attempts to integrate a variety

of strands of thinking

He draws partly on macroeconomic theory and trade, as well as microeconomic theory and firm behavior (industrial economics)

O = Ownership advantages

Some firms have a firm specific capital known as knowledge capital: Human capital (managers), patents, technologies, brand, reputation…

This capital can be replicated in different countries without losing its value, and easily transferred within the firm without high transaction costs

L – Localization advantagesProducing close to final consumers or

downstream customers

Saving transport costs

Obtaining cheap inputs

Jumping trade barriers

Provide services (for most services production and delivery have to be contemporaneous)

OLI approach - conclusionsThe eclectic, or OLI paradigm, suggests that

the greater the O and I advantages possessed by firms and the more the L advantages of creating, acquiring (or augmenting) and exploiting these advantages from a location outside its home country, the more FDI will be undertaken

Where firms possess substantial O and I advantages but the L advantages favor the home country, then domestic investment will be preferred to FDI and foreign markets will be supplies by exports

I – internalization advantagesWhy don't a firm just sign a contract with a

subcontractor (external agent) in a foreign country?

Because contracting out is risky: it implies transferring the specific capital outside the firm and revealing the proprietary information (e.g. how to use the technology or the patent).

Problem:If the agent interrupts the contract it can use the

technology to compete with the mother companyIn the case of brands/reputation: if the agent

damages the brand reputation

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4 types of FDI derived from OLI theory

The typology of FDI was developed by Jere Behrman to explain the different objectives of FDI:Resource seeking FDIMarket seeking FDIEfficiency seeking (global sourcing FDI)Strategic asset/capabilities seeking FDI

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Resource seeking FDITo seek and secure natural resources

e.g. minerals, raw materials, or lower labor costs for the investing company

For example, a German company opening a plant in Slovakia to produce and re-export to Germany

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Market seeking FDITo identify and exploit new markets for

the firms` finished productsUnique possibility for some type of

services for which production and distribution have to be contemporaneous (telecom, water supply, energy supply)

Automotive TNCs have invested heavily in China

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Efficiency seeking FDITo restructure its existing investments so as

to achieve an efficient allocation of international economic activity of the firmsInternational specialization whereby firms seek to

benefit from differences in product and factor prices and to diversify risk

Global sourcing – resource saving and improved efficiency by rationalizing the structure of their global activities. Undertaken primarily by network based MNCs with global sourcing operations.

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Strategic asset/capabilities seeking FDIMNCs pursue strategic operations through the

purchase of existing firms and/or assets in order to protect O specific advantages in order to sustain or advance its global competitive positionAcquisition of key established local firmsAcquisition of local capabilities including R&D,

knowledge and human capitalAcquisition of market knowledgePre empting market entrance by competitorsPre empting the acquisition by local firms by

competitors