CHAPTER 7
FOREIGN DIRECT INVESTMENT
LEARNING OBJECTIVES:
7.1 Describe the worldwide pattern of foreign direct investment (FDI).
7.2 Summarize each theory that attempts to explain why FDI occurs.
7.3 Outline the important management issues in the FDI decision.
7.4 Explain why governments intervene in FDI.
7.5 Describe the policy instruments that governments use to promote and restrict FDI.
CHAPTER OUTLINE:
Introduction
Pattern of Foreign Direct Investment
Ups and Downs of FDI
Globalization
Mergers and Acquisitions
Worldwide Flows of FDI
Theories for Foreign Direct Investment
International Product Life Cycle
Market Imperfections (Internalization)
Trade Barriers
Specialized Knowledge
Eclectic Theory
Market Power
Management Issues and Foreign Direct Investment
Control
Partnership Requirements
Benefits of Cooperation
Purchase-or-Build Decision
Production Costs
Rationalized Production
Mexico’s Maquiladora
Cost of Research and Development
Customer Knowledge
Following Clients
Following Rivals
Why Governments Intervene in FDI
Balance of Payments
Current Account
Capital Account
Reasons for Intervention by the Host Country
Control Balance of Payments
Obtain Resources and Benefits
Copyright © 2019 Pearson Education, Inc.
Access to Technology
Management Skills and Employment
Reasons for Intervention by the Home Country
Government Policy Instruments and FDI
Host Countries: Promotion
Financial Incentives
Infrastructure Improvements
Host Countries: Restriction
Ownership Restrictions
Performance Demands
Home Countries: Promotion
Home Countries: Restriction
Bottom Line for Business
Foreign Direct Investment in Europe
Foreign Direct Investment in Asia
A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 7.
These slides and the lecture outline below form a completely integrated package that simplifies the
teaching of this chapter’s material.
Lecture Outline
I. INTRODUCTION
Foreign direct investment (FDI) is the purchase of physical assets or a significant amount of the
ownership (stock) of a company in another country to gain a measure of management control. It
differs from portfolio investment—an investment that does not involve obtaining a degree of
control in a company. Most governments set the threshold for an investment to be called FDI at
anywhere from 10 to 25 percent of stock ownership in a company abroad—the U.S. Commerce
Department sets it at 10 percent.
II. PATTERN OF FOREIGN DIRECT INVESTMENT
A. Ups and Downs of FDI
FDI inflows grew around 20 percent per year in the first half of the 1990’s and expanded
about 40 percent per year in the second half of the decade. Global FDI inflows averaged
$548 billion annually between 1994 and 1999. FDI inflows peaked at around $1.4
trillion in 2000 and then slowed. FDI inflows benefitted from strong economic
performance and high corporate profits in many countries between 2004 and 2007, at
which point it reached an all-time record of more than $1.9 trillion. Global recession
meant declining FDI inflows in 2008 and 2009. FDI inflows climbed greater in 2010,
2011, and 2012, then dipped to $1.3 trillion in 2014, and then rose to nearly $1.8 trillion
in 2015 as the world emerged from recession. (see Figure 7.1).
1. Globalization
a. Companies got around trade barriers in the 1980s through FDI.
Increasing globalization is also causing a growing number of
international companies from emerging markets to undertake FDI.
b. Uruguay Round of GATT further cut trade barriers, letting firms produce
in the most efficient locations and export to markets. Set off further FDI
into newly industrialized and emerging markets.
c. Globalization also lets emerging-market companies use FDI.
2. Mergers and acquisitions
a. M&As and their rising values propelled long-term growth in FDI, but are
falling off lately due to global credit crisis.
b. Power of largest multinationals seems to multiply each year.
c. The value of cross-border M&As peaked in 2000 at around $1.2 trillion
(see Figure 7.2), accounting for about 3.7 percent of the market
capitalization of all stock exchanges worldwide. After three years of
falling FDI, the value of cross-border M&As rose to around $1 trillion by
2007. M&A activity then cooled in 2008 and then fell significantly in
2009 due to the global recession. The value of cross-border M&A
activity then fluctuated for several years before climbing back to $721
billion by 2015. Many cross-border M&A deals are done to:
i. Get a foothold in a new geographic market
ii. Increase a firm’s global competitiveness
iii. Fill gaps in companies’ product lines in a global industry
iv. Reduce costs in R&D, production, or distribution
d. Entrepreneurs and small businesses also engage in FDI and account for
more of its growth.
B. Worldwide Flows of FDI
1. More than 100,000 MNCs with more than 900,000 affiliates drive FDI flows.
2. In terms of share of global FDI inflows, in 2014, for the first time developing
countries attracted greater FDI inflows than developed countries. FDI inflows to
developing countries were around 55 percent ($699 billion) of total world FDI
inflows ($1.28 trillion). By comparison, developed countries accounted for 41
percent ($522 billion) of total global FDI inflows. The remaining roughly four
percent of global FDI went into countries across Southeast Europe in various
stages of transition from communism to capitalism. FDI inflows reverted back to
their traditional pattern in 2015 whereby developing economies attracted less
FDI (44 percent of the world total) than developed nations did (55 percent).
3. FDI inflows to developing nations were mixed, with China attracting most in
Asia and India attracting a fair amount.
4. Outflows of FDI from developing Asian nations is also rising, coinciding with
the rise of these nations’ own global competitors. Elsewhere, all of Africa drew
in $54 billion of FDI in 2015, or about 2 percent of the world’s total. FDI flows
into Latin America and the Caribbean $168 billion, or nearly 10 percent of the
total world FDI.
III. THEORIES OF FOREIGN DIRECT INVESTMENT
A. International Product Life Cycle
1. States a company will begin by exporting its product and later undertake foreign
direct investment as a product moves through its life cycle.
2. In the new product stage, a good is produced entirely in the home market. In the
maturing product stage, a good is produced in the home market and in markets
abroad that are large enough to warrant production facilities. In the standardized
product stage, a company builds production capacity in low-cost developing
nations to serve its markets around the world.
3. Yet the international product life cycle theory does not explain why companies
choose FDI over other forms of market entry.
B. Market Imperfections (Internalization)
When an imperfection in the market makes a transaction less efficient, a company will
undertake FDI to internalize the transaction and remove the imperfection. In a perfect
market, prices are as low as possible and goods are easily available. Flaws in the
efficient operation of an industry are market imperfections.
1. Trade barriers
a. A trade barrier such as a tariff is a common market imperfection.
b. Firms undertake FDI when market imperfections are present.
2. Specialized knowledge
a. A unique competitive advantage may consist of specialized knowledge,
technical expertise, or special marketing abilities.
b. Companies charge fees for product knowledge, but when a company’s
specialized knowledge is embodied in its employees, the only way to
exploit an opportunity may be FDI.
c. A company may undertake FDI if charging another company for access
to its knowledge might create a future competitor.
C. Eclectic Theory
1. States that firms undertake foreign direct investment when the features of a
location combine with ownership and internalization advantages to make a
location appealing for investment. When each advantage is present, a company
will undertake FDI.
2. A location advantage is the advantage of locating a particular economic activity
in a specific location because of the characteristics (natural or acquired) of the
location.
3. An ownership advantage is the advantage that a company has due to its
ownership of some special asset, such as a powerful brand, technical knowledge,
or management ability.
4. An internalization advantage is the advantage that arises from internalizing a
business activity rather than leaving it to a relatively inefficient market.
D. Market Power
1. The market power theory states that a firm tries to establish a dominant market
presence in an industry by undertaking foreign direct investment.
2. The benefit of market power is greater profit because the firm is better able to
dictate the cost of its inputs or the price of its output.
3. Companies can gain market power through vertical integration—the extension
of activities into production that provide a firm’s inputs (backward integration)
or absorb its output (forward integration).
IV. MANAGEMENT ISSUES AND FOREIGN DIRECT INVESTMENT
A. Control
Many companies invest abroad because they wish to control activities in the local
market (e.g., to ensure the selling price remains the same across markets). Yet complete
ownership does not guarantee control.
1. Partnership requirements
a. Many companies have strict policies regarding how much ownership they
take in firms in other nations.
b. Yet a nation may demand shared ownership in return for market access.
Governments may use such requirements to shield workers and industries
from exploitation or domination by large multinationals.
2. Benefits of cooperation
a. Greater harmony exists today between governments and international
companies. Developing nations and emerging markets need investment,
employment, tax revenues, training, and technology transfers.
b. A country with a reputation for overly restricting the operations of
multinationals can see its inward investment dry up.
c. Cooperation can open communication channels to maintain positive
relationships in the host country.
B. Purchase-or-Build Decision
1. The purchase-or-build decision of managers entails deciding whether to purchase
an existing business or build a subsidiary abroad from the ground up—called a
greenfield investment.
2. An acquiring firm may benefit from the goodwill the existing company has built
over the years and, perhaps, brand recognition of the existing firm. The purchase
of an existing business also may allow for alternative methods of financing, such
as an exchange of stock ownership.
3. Factors that reduce the appeal of purchasing existing facilities are obsolete
equipment, poor labor relations, and an unsuitable location.
4. Adequate facilities are sometimes unavailable and a company must go ahead
with a Greenfield investment. Greenfield investments have their own drawbacks
—obtaining the necessary permits and financing and hiring local personnel can
be difficult in some markets.
C. Production Costs
Labor regulations increase the hourly cost of production, and benefits packages and
training programs add to wage costs. Although the cost of land and tax rate on profits
can be lower locally, they may not remain constant.
1. Rationalized production
a. Production in which components are produced where the cost of
production is lowest.
b. The components are brought together at one central location for assembly
into the final product.
c. Potential problem is that a work stoppage in one country can halt the
entire production process.
2. Mexico’s maquiladora
a. The 130-mile-wide strip along the U.S.–Mexican border.
b. Low-wage regional economy next to a prosperous giant is a model for
other regions split by wage or technology gaps.
c. Ethical dilemmas arise over the wage gap between Mexico and the
United States and lost U.S. union jobs to maquiladora nonunion jobs.
Maquiladoras do not operate under the stringent regulations that firms in
the United States do.
3. Cost of research and development
a. Cost of developing subsequent stages of technology has led to cross-
border alliances and acquisitions.
b. One indicator of the significance of technology in foreign direct
investment is the amount of R&D conducted by affiliates of parent
companies in other countries. FDI in R&D appears to be spurred by
supply factors such as access to high-quality scientific and technical
human capital.
D. Customer Knowledge
1. The behavior of buyers is an important issue in the decision of whether to
undertake FDI. A local presence can give companies valuable knowledge of
customers that is unobtainable in the home market.
2. Some countries have quality reputations in certain product categories that make
it profitable to produce there.
E. Following Clients
1. FDI puts companies near those firms they supply. “Following clients” occurs in
industries in which component parts are obtained from suppliers with whom a
manufacturer has a close working relationship.
F. Following Rivals
1. FDI decisions resemble a “follow the leader” scenario in industries with a
limited number of large firms.
2. Many firms believe that not making a move parallel to that of the “first mover”
might result in being shut out of a lucrative market.
V. GOVERNMENT INTERVENTION IN FOREIGN DIRECT INVESTMENT
Nations enact laws, create regulations, or construct administrative hurdles for foreign
companies. A bias toward protectionism or openness is rooted in a nation’s culture, history, and
politics. But FDI tends to raise output and enhance standards of living. Besides philosophical
ideals, countries intervene in FDI for practical reasons.
A. Balance of Payments
1. National accounting system that records all payments to entities in other
countries and all receipts coming into the nation.
2. International transactions that result in payments (outflows) to entities in other
nations are reductions in the balance of payments accounts and recorded with a
minus (–) sign (see Table 7.1).
3. International transactions that result in receipts (inflows) from other nations are
additions to the balance of payments accounts and recorded with a plus (+) sign.
4. Current account
a. National account that records transactions involving the import and export of
goods and services, income receipts on assets abroad, and income
payments on foreign assets inside the country.
b. A current account surplus occurs when a country exports more goods and
services and receives more income from abroad than it imports and pays
abroad.
c. A current account deficit occurs when a country imports more goods and
services and pays more abroad than it exports and receives from abroad.
5. Capital account
a. National account that records transactions involving the purchase or sale of
assets.
b. Financial assets such as stocks and bonds and physical assets such as
investments in plants and equipment.
B. Reasons for Intervention by the Host Country
1. Control balance of payments
a. Many governments see intervention as the only way to keep their balance
of payments under control.
b. Host countries get a balance-of-payments boost from initial FDI flows.
Local content requirements can lower imports, providing an added
balance-of-payments boost. Exports from the FDI can further help the
balance-of-payments position.
c. When companies repatriate profits, they deplete the foreign exchange
reserves of their host countries; these capital outflows decrease the
balance of payments. Thus, a host nation may prohibit or restrict
nondomestic firms from removing profits.
d. But host countries conserve their foreign exchange reserves when
international companies reinvest their earnings in local manufacturing
facilities. This improves the competitiveness of local producers and
boosts a host nation’s exports—improving its balance-of-payments
position.
2. Obtain resources and benefits
a. Access to technology
Nations encourage FDI in technology because it increases productivity
and competitiveness.
b. Management skills and employment
FDI allows talented foreign managers to train local managers in how to
operate the local facilities. Some of these managers will also go on to
establish their own businesses.
3. Reasons for Intervention by the Home Country
There are fewer concerns regarding the outflow of FDI among home nations because
they tend to be prosperous, industrialized nations.
1. Reasons for discouraging outward FDI
a. Investing in other nations sends resources out of the home country and
can lessen investment at home.
b. Outgoing FDI may damage a nation’s balance of payments by reducing
exports otherwise sent to international markets.
c. Jobs resulting from FDI outflows may replace jobs at home.
2. Reasons for promoting outgoing FDI
a. Outward FDI can increase long-run competitiveness (e.g., partnering as a
learning opportunity).
b. Nations may encourage FDI in industries that use obsolete technology or
employ low-wage workers with few skills.
VI. GOVERNMENT POLICY INSTRUMENTS AND FOREIGN DIRECT INVESTMENT
A. Host Countries: Promotion (See Table 7.2)
1. Financial incentives
a. Host governments commonly offer tax incentives or low-interest loans to
attract investment.
b. But incentives can create bidding wars between locations vying for
investment; the cost to taxpayers of snaring FDI can be more than what
the actual jobs pay.
2. Infrastructure improvements
a. Lasting benefits for communities surrounding the investment location can
result from local infrastructure improvements—better seaports for
containerized shipping, improved roads, and increased
telecommunications systems.
B. Host Countries: Restriction (See Table 7.2)
1. Ownership restrictions
a. Governments impose ownership restrictions that prohibit nondomestic
companies from investing in certain industries or owning certain types of
business.
b. Another restriction is a requirement that nondomestic investors hold less
than a 50 percent stake in local firms. Nations are eliminating such
restrictions because companies can choose another location.
2. Performance demands
a. Some performance demands dictate the portion of a product’s content
that originates locally, stipulates the portion of output that must be
exported, or requires that certain technologies be transferred to local
businesses.
C. Home Countries: Promotion (See Table 7.2)
1. Offer insurance to cover the risks of investments abroad.
2. Grant loans to firms wishing to increase their investments abroad.
3. Offer tax breaks on profits earned abroad or negotiate special tax treaties.
4. Apply political pressure on other nations to get them to relax their restrictions on
inbound investments.
D. Home Countries: Restriction (See Table 7.2)
1. Impose differential tax rates that charge income from earnings abroad at a higher
rate than domestic earnings.
2. Impose sanctions that prohibit domestic firms from making investments in
certain nations.
VII. BOTTOM LINE FOR BUSINESS
This chapter presents foreign direct investment (FDI). Like trade decisions, many factors
influence a company’s decision about whether to invest in markets abroad. Depending on the
philosophy of home or host nations and the impact of FDI on their economic health, a firm can
be encouraged or dissuaded to invest in a nation.
A. Foreign Direct Investment in Europe – FDI inflows into the developing (transition)
nations of Southeast Europe and the Commonwealth of Independent States hit an all-
time high in 2008. The main reason for the fast pace at which FDI is occurring in
Western Europe is regional economic integration (See Chapter 8).
B. Foreign Direct Investment in Asia – China attracts the majority of Asia’s FDI, luring
companies with a lower-wage workforce and access to an enormous domestic market.
Many companies already active in China are upping their investment further, and
companies not yet there are developing strategies for how to include China in their
future plans.