Week Seven Class Notes

Often, international trade for firms begins as import/export activities but if trade barriers are high, the cost of goods shipped into another country increases. Those goods become less competitive in the focal market (which is what the host government intended - recall the discussion from last week). This same outcome obtains if the costs of transportation are relatively high - that is, the value to weight ratio is too low. For example, think about soft drinks:  why would firms prefer to avoid export of finished goods?

Firms have alternatives to exporting. In general, these are described as internalizing activities (i.e., performing them within the firm) through Foreign Direct Investment (FDI) as a way of capturing location advantages or overcoming market imperfections. FDI is the acquisition or control of factors of production in another country. In this, firms take a much more active role in the governance of transactions abroad. In practice, direct participation entry can range from alliances to full ownership - though not all count as FDI (such as licensing or franchising).

It is useful to distinguish between FDI and Foreign Portfolio Investment (FPI).  FPI is purchase of equity or other ownership instruments in a foreign firm or government where the level of ownership is below 10% (although this is a US standard - other countries (may have different levels of investment as a standard). Examples include the sale of US Treasury bonds to foreign entities or ownership of equity stakes in suppliers or vendors across national boundaries. Put differently, the difference between FPI and FDI is like the difference between investing in stocks and buying the company that issues the stocks (which you can do by buying a sufficient number of shares).

The main ways of conducting FDI are through joint venture, merger and acquisition or through greenfield development. JV's are alliances that create a subsidiary organization distinct from the parents but are owned completely by them. For example, Volkswagen has JVs with First Automotive Works and with Shanghai Automotive Industry in China. When Coca-Cola enters a new country, it has usually done so through a joint venture with a local partner. In some countries, until recently, joint ventures (which amounted to creating equity in-country for partner) were the only way to enter.

Mergers and acquisitions (M&A) are the purchase of a controlling interest in an existing firm. This is often a very fast entry method - faster than Greenfield investments - as the buyer can begin productive activities as soon as the deal is done. Relatedly, the target may already have production, distribution, and market assets which would otherwise have to be built. Finally (and perhaps most importantly) M&A's are often made under the assumption that the buyer can make the target better - more efficient or more powerful. This comes through the transfer of managerial know-how, through improved production processes, and/or greater market power. Also, buyers may be able to tap superior sources of capital.

Greenfield investments entail building a new facility from the ground up (or, making a "green field" into a factory). This makes sense when organizational culture is key to performance (an issue we'll discus in a couple of weeks) or when there are no good candidates available for acquisition AND the market is worth entering. Alternatively, greenfield development may be indicated because host country rules prohibit acquisition.

How do patterns in FDI vary with host country? See Exhibit 1 in the Background paper as a beginning. Note that FDI is usually from developed country to developed country.  This was because markets, infrastructure, and even customers were reasonably similar or compatible. Moving into stable, well developed states made the investments less risky (and risk has been shown to be a key component in the investment decision).

Another way of looking at this is through a trade theory lens.  Historically, the motive for FDI was accessing new markets with existing products which is Vernon's product life cycle theory.  Once the domestic market is established and production has moved down the cost curve, firms go out with same products for new markets. Increasingly, though, the investment pursues globalization of the supply chain (what Peng calls vertical FDI). This has changed the pattern toward investment in newly developed countries (NDCs) or less developed countries (LDCs). Thus, China is the most popular recipient of FDI among this group, and Latin America is also very strong.

The developed versus developing nation contrast is also important in the type of FDI that is undertaken. Entry into Developed Countries is usually through M&A (about 80% of the time) while entry into Developing Countries is usually through greenfield or JV actions (about 70% of the time). Why do you think this is?



1)      Inflows of capital, technology, management skills
2)      Employment increases
3)      Better current account
1)      Improved current account from inflows of repatriated earnings
2)      Demand from foreign subsidiaries for equipment, capital goods, etc.
3)      Knowledge asset transfer from host to home country

1)      Adverse competitive effect on host nation firms
2)      Repatriated earnings negatively affect current account
3)      Possible high use of imported inputs also affects CA
4)      Erosion of national autonomy - we see it in US but more true in small countries
1)      current account suffers if purpose of FDI is to supply home market from offshore
2)      loss of employment

What are the benefits/costs of FDI for host and home nations?

Host Benefit 1: Inflows of capital, technology, management skills. Large foreign firms might have better credit ratings or sufficient internal capital resources to undertake investment the host country cannot. There might also be technical and managerial knowledge transfer to host country if local workers are placed in the right positions. In other words, (and this is often a key issue), the key positions cannot all be filled by ex-patriates. Relatedly, the OECD agreement on technology - this is a specific request to stimulate the diffusion of technologies to the host country - why should this happen?

Host Benefit 2: Local employment increases - but this can be overstated for several reasons. First, if entry is through M&A, we often see reductions in workforces as the buyer tries to make the target more efficient. Second, this may be a transfer of business from one firm to another in the industry with no net gain. However, statistics show that the net effect is generally more employment.

Host Benefit 3: Better current account. This works if the FDI is a replacement for goods/services otherwise imported. In this case, the import side of the ledger decreases. If the goods or services are also exported, this positively affects the export side.

Host Cost 1: Adverse competitive effect on host nation firms. Note that this is often the case when domestic firms weren't very competitive in the first place but this still causes political problems which can inhibit FDI flexibility.

Host costs 2 & 3: Repatriated earnings negatively affect current account (i..e, returned to the home country of the entering firm) and high use of imported inputs also affects the Current Account. This should be self-explanatory.

Host cost 4: Erosion of national autonomy. Especially to the extent that FDI targets formerly protected or sensitive industries (e.g., telecom) or to the extent that a MNC is often larger (budget wise) than some target countries,  real and perceived problems with the power of local governments vis a vis the entrant can occur.

Home benefit 1: Improved current account from inflows of repatriated earnings  will be true to extent that the firm was not exporting already. If so, these can offset each other.

Home benefit 2: Demand from foreign subsidiaries for equipment, capital goods, etc. Often, though, demands for local sourcing prevail so these don't necessarily come about. Moreover, the globalization of  the SC means that even if this demand materializes, it may not be from the home country.

Home benefit 3:  Knowledge asset transfer from host to home country - but this is unlikely when the pursuit is of low cost labor and thus from DC to N/LDC. Put differently, knowledge transfer is more likely from DC to emerging economies or between DCs.

Home cost 1 - current account suffers if  the purpose of FDI is to supply the home market from new offshore facilities (e.g., offshoring or production for domestic markets).

Home country cost 2 - loss of employment due to relocated production. This does not occur if there was little exporting previously.

The patterns of FDI have changed over the past several decades and the absolute level of investment has increased dramatically.  Still, given the potential drawbacks discussed above, governments do seek to manage and control investment. In a general sense, investors typically have to overcome some screening and proof of benefit issues. That is, investors need to demonstrate that their entry will be beneficial to the host country. Research shows that there is a general improvement in the economic conditions of a host country (more exports, better current account, more economic growth) but developing specific benefits analysis can be costly and time consuming.  The OECD publishes data on the governmentally imposed limits on the extent of foreign ownership in select industries from a wide range of countries. The 2010 report can be found here.  The OECD paper shows that transport, telecom, and electricity are typically among the industries most protected - why do you think this is?

There are risks and limitations to FDI.  First and foremost, host governments may decide to expropriate (i.e., claim) the investments. The most prominent recent examples are from Venezuela where Hugo Chavez has taken over foreign firms in petroleum and steel in recent years. In May, 2010, Chavez moved to takeover firms in the production of iron and aluminum. This nationalization or expropriation usually means at least a significant loss for owners as governments rarely reimburse for the market value of the claimed assets. For this reason, licensing is often preferred to direct ownership in high risk countries.         Other problems include onerous taxation - i.e., taxes which are not consistent with domestic tax rates or  where the investing firm is subject to full dual taxation. Further, host government may require that investing firms divulge important information. Sometimes, those transparency requirements may be too demanding. For example, when Coca-Cola was considering entering India, they faced the problem of an official requirement that they divulge the formula for Coke. For obvious reasons, Coca-Cola declined and entry was put off for years (when requirements changed). Finally, there may be important limits on how profits can be repatriated. In some countries, fund outflows are prohibited which makes getting the profits home virtually impossible.

FDI is, as Peng comments, what turns firms into Multinational Enterprises (MNEs) and is an important way to manage competition domestically and abroad. Historically, FDI has been in pursuit of new markets but more and more, the flows are to developing countries in pursuit of labor cost advantages. However, the data indicate that the economic contraction beginning in 2008 has not only slowed down rates of investment abroad but that DC firms may actually be drawing back in and eliminating some off-shore facilities. The effect this will have on developing countries should make an interesting discussion point.

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