International Business

Sessions 6-7

Foreign Direct Investment

Recap - Session 4-5
• Trade theories
• Mercantilism, Absolute advantage (Smith), Comparative advantage (Ricardo)
• Heckscher-Ohlin theory, Product lifecycle theory (Vernon), New trade theory (Krugman), National
competitive advantage (Porter)
• Benefits of free trade
• Opening a country to trade could increase a country's stock of resources as increased supplies
become available from abroad, the efficiency of resource utilization and so free up resources for
other uses, leading to economic growth
• Government interventions in trade
• Tariffs, subsidies, import quotas, VERs, local content requirements, anti-dumping duties,
administrative policies
• Political and economic arguments for intervention
• Evolution of WTO
• 1846: Corn laws; 1930: Smoot-Hawley act; 1947-1993: GATT; 1993: WTO: GATT+2 sister bodies
• Managerial implication
• Choosing location, taking the first mover advantage, lobbying the government; impact of trade
barriers
Sessions 6-7 Learning Objectives
• Recognize the current trends in FDI

• Explain the different theories of FDI

• Understand the role of political ideology and the instruments

governments have in shaping the FDI policies

• Describe the benefits and costs of FDI to all stakeholders

• Understand managerial implications of FDI theories, and government

interventions
6.1 FDI Trends
What Is FDI?

• Foreign direct investment (FDI) occurs when a firm invests directly in

new facilities to produce and/or market in a foreign country

• The firm becomes a multinational enterprise

• FDI can be in the form of

• Greenfield investments - the establishment of a wholly new operation in a

foreign country

• Acquisitions or mergers with existing firms in the foreign country

What Is FDI?

• The flow of FDI - the amount of FDI undertaken over a given time
period

• Outflows of FDI are the flows of FDI out of a country

• Inflows of FDI are the flows of FDI into a country

• The stock of FDI - the total accumulated value of foreign-owned

assets at a given time
What are the Patterns Of FDI?

• Both the flow and stock of FDI have increased over the last 40 years

• Most FDI is still targeted towards developed nations

• United States, Japan, and the EU

• But, other destinations are emerging

• South, East, and South East Asia especially China
• Latin America

• Trends
• https://unctadstat.unctad.org/wds/ReportFolders/reportFolders.aspx
 What are the Patterns of FDI?
World FDI Flow in Million USD
2000000

1500000

1000000

500000

World

Source: https://unctadstat.unctad.org/EN
 What are the Patterns of FDI?
Inbound FDI Flow in Million USD
500000

450000

400000

350000

300000

250000

200000

150000

100000

50000

China India United States of America

Source: https://unctadstat.unctad.org/EN
 What are the Patterns of FDI?
Outbound FDI Flow in Million USD
500000

400000

300000

200000

100000

-100000

-200000

China India United States of America

Source: https://unctadstat.unctad.org/EN
What are the Patterns of FDI?

Source: https://unctadstat.unctad.org/EN
What are the Patterns of FDI?

Source: https://unctadstat.unctad.org/EN
The Growth and Slowdown of International Production

Source: https://unctadstat.unctad.org/EN
What are the Patterns Of FDI?

Source: https://unctadstat.unctad.org/EN
What are the Patterns of FDI?

Source: https://unctadstat.unctad.org/EN
What are the Patterns of FDI?

• The growth of FDI is a result of

1. A fear of protectionism
• Want to circumvent trade barriers

2. Political and economic changes

• Deregulation, privatization, fewer restrictions on FDI

3. New bilateral investment treaties

• Designed to facilitate investment

4. The globalization of the world economy

• Many companies now view the world as their market
• Need to be closer to their customers
What are the Patterns of FDI?

• Gross fixed capital formation - the total amount of capital invested in

factories, stores, office buildings, and the like

• The greater the capital investment in an economy, the more favorable its
future prospects are likely to be

• FDI is an important source of capital investment and a determinant of

the future growth rate of an economy
What is The Source of FDI?

• Since World War II, the U.S. has been the largest source country for
FDI

• The United Kingdom, the Netherlands, France, Germany, and Japan are other
important source countries

• Together, these countries account for 60% of all FDI outflows from 1998-2018
What is the Source of FDI?

Source: https://unctadstat.unctad.org/EN
Outbound FDI from USA in US$ Million

2017 US Tax Cut and Jobs

Acts (TCJA)

Source: https://unctadstat.unctad.org/EN
What are the Patterns Of FDI – Greenfield vs. M&A?

Source: https://unctadstat.unctad.org/EN
What are the Patterns Of FDI – Greenfield vs. M&A?

Source: https://unctadstat.unctad.org/EN
How Do Firms Choose Acquisitions Over Greenfield
Investments?

• A large part of cross-border investment is in the form of mergers and

acquisitions rather than greenfield investments

• Between 40-80% of all FDI inflows per annum from 1998 to 2018 were
in the form of mergers and acquisitions

• But, why in developing countries two-thirds of FDI is greenfield

investment?
• Fewer target companies
How Do Firms Choose Acquisitions Over Greenfield
Investments?

• Firms prefer to acquire existing assets because

• Mergers and acquisitions are quicker to execute than greenfield investments

• It is easier and perhaps less risky for a firm to acquire desired assets than
build them from the ground up

• Firms believe that they can increase the efficiency of an acquired unit by
transferring capital, technology, or management skills
 How Do Firms Choose Acquisitions Over Greenfield
Investments?
Greenfield Investment
• Will achieve economies of scale and scope in
production, marketing, finance, R&D, logistics
and purchasing
• Greater control of all aspects of the business
• Will be able to implement the best long-term
strategy with solid commitment to the market
• Control over the brand
• Better control over staff
• Likely to cost more and delay in ROI
• Local competition will be difficult to overcome
• The entry process may take long
• Governmental regulations may put the
company at a disadvantage
Cross-border Acquisition
• Gain access to an established market
• Have skilled workers at your disposal
• Instantly acquire the target company’s
technology, clients and vendors
• Get instant branding advantage, if present
• One less competitor to deal with
• Knowledge pool increases
• Hidden surprises? Legal/tax issues?
• Target’s technology may well be outmoded
• Target’s branding and culture is often not in
alignment with acquirer
• Valuation is tricky
• Potential integration issues
Harley-Davidson’s Business in India
• Started selling super-bikes (750cc+) in India in 2010

• Started own assembly unit in India in 2014

• Discontinued sales and manufacturing operations in Sep-2020

• Sold just about 25000 bikes in 10 years, against annual target of
10000 bikes

• Decided to form an agreement with Hero Motocorp to sell, service and

distribute H-D bikes in India
Looking Ahead – Projections on FDI

Source: https://unctadstat.unctad.org/EN
6.2 FDI Theories
Why Choose FDI?
• Question: Why is it profitable for firms to undertake FDI rather than
making a portfolio investment in a country?

• Portfolio Theory
• Capital movements across borders reflect interest rate differential among countries

• In a perfect international capital markets the interest rates would align across
countries

• But risk of default varies, leading to a risk premium, and hence capital moves across
countries by taking opportunities for higher returns

• Portfolio investment does not offer control over firm to ensure returns on
investments
Why Choose FDI?

• Question: Why does FDI occur instead of exporting or licensing?

• Exporting - producing goods at home and then shipping them to

the receiving country for sale

• Exports can be limited by transportation costs and trade barriers

• FDI may be a response to actual or threatened trade barriers such as

import tariffs or quotas
Why Choose FDI?

• Licensing - granting a foreign entity the right to produce and sell the firm’s
product in return for a royalty fee on every unit that the foreign entity
sells

• Compared to FDI, why licensing is less attractive?

• Firm could give away valuable technological know-how to a potential foreign

competitor

• Does not give a firm the control over manufacturing, marketing, and strategy
in the foreign country

• The firm’s competitive advantage may be based on its management and

process “capabilities” – not amenable for licensing
Foreign direct investment (FDI) in a developing economy, such as
Russia or the countries of sub-Saharan Africa, can be extremely
profitable for multinational enterprises. It can also result in
substantial losses if economic conditions in the host country
deteriorate.

If you were the head of a major manufacturer of household goods

seeking entry into the market of a country experiencing strong
economic growth due to its oil and gas exports, which entry
strategy would you pursue: exporting, licensing, or foreign direct
investment? If FDI, would you seek to acquire an existing firm, or
build entirely new facilities (a greenfield investment)?
Why Choose FDI?
• Question: Why do firms in the same industry undertake FDI at about
the same time and the same locations?

• Knickerbocker - FDI flows are a reflection of strategic rivalry between

firms in the global marketplace

• In an oligopoly there is strong interdependence among players

• Action by one is responded with similar action by others

• Hero – Honda  Yamaha – Escorts
• Honda SIEL Toyota - Kirloskar

• Multipoint competition - when two or more enterprises encounter each other

in different regional markets, national markets, or industries
Why Choose FDI?
• Question: Why is it profitable for firms to undertake FDI rather than
continuing to export from a home base, or licensing a foreign firm?

• Dunning’s OLI paradigm - it is important to consider

• Ownership advantages - that arise from the firm owning specific assets and
resources, including human resources

• Location-specific advantages - that arise from using resource endowments that are
tied to a particular location and that a firm finds valuable to combine with its own
unique assets

• Internalization advantages – that arise from internalizing business processes in

foreign country in order to have a control over its overseas operations – better
synergy between HQ and subsidiary through control and coordination
• Imperfect markets in host countries leads to higher transaction costs in the market
6.3 Political Ideologies and FDI
Political Ideologies on FDI?

• The radical view - the multinational enterprise (MNE) is an instrument of

imperialist domination and a tool for exploiting host countries to the
exclusive benefit of their capitalist-imperialist home countries

• In retreat almost everywhere

• The free market view - international production should be distributed

among countries according to the theory of comparative advantage

• Embraced by advanced and developing nations including the United States and
Britain, but no country has adopted it in its purest form
Political Ideologies on FDI?

• Pragmatic nationalism - FDI has both benefits (inflows of capital,

technology, skills, and jobs) and costs (repatriation of profits to the home
country and a negative balance of payments effect)

• FDI should be allowed only if the benefits outweigh the costs

• Recently, there has been a strong shift toward the free market stance
creating

• A surge in FDI worldwide

• An increase in the volume of FDI in countries with newly liberalized regimes

Exercise: Why India Ranks Low in FDI Confidence Index?

• https://www.atkearney.com/foreign-direct-investment-confidence-index

• India in 16th rank in 2019, dropped from 11th rank in 2018

• 2020 list has dropped India!

From Business Standard, Dec 17, 2020

• https://www.business-standard.com/article/current-affairs/karnataka-cm-
assures-support-to-restart-wistron-s-iphone-making-plant-
120121701266_1.html

• https://www.wsj.com/market-data/quotes/TW/3231/company-people
6.4 Benefits and Costs of FDI
How Does FDI Benefit the Host Country?

• Four main benefits of inward FDI for a host country

• Resource transfer effects - FDI brings capital, technology, and

management resources

• Employment effects - FDI can bring jobs

How Does FDI Benefit the Host Country?

3. Balance of payments effects - FDI can help a country to achieve a

current account surplus
• FDI, leading to domestic consumption, can reduce imports
• FDI can also lead to additional exports

4. Effects on competition and economic growth - greenfield

investments increase the level of competition in a market, driving
down prices and improving the welfare of consumers

• Can lead to increased productivity growth, product and process innovation,

and greater economic growth
What are the Costs of FDI to the Host Country?

• Three main costs:

1. Adverse effects of FDI on competition within the host nation

• Subsidiaries of foreign MNEs may have greater economic power than

indigenous competitors because they may be part of a larger
international organization

• MNEs may also consolidate market share by acquiring several players

What are the Costs of FDI to the Host Country?

2. Adverse effects on the balance of payments

• When a foreign subsidiary imports a substantial number of its input

content from abroad, there is a debit on the current account of the host
country’s balance of payments
• Outflow of earnings of the subsidiary in the host country

3. Perceived loss of national sovereignty and autonomy

• Decisions that affect the host country will be made by a foreign parent that
has no real commitment to the host country, and over which the host
country’s government has no real control
How Does FDI Benefit the Home Country?

• Three benefits of FDI for the home country

• The effect on the capital account / financial account of the home

country’s balance of payments from the inward flow of foreign
earnings

• The employment effects that arise from outward FDI

• The gains from learning valuable skills from foreign markets that
can subsequently be transferred back to the home country
What are the Costs of FDI to the Home Country?

1. The home-country’s balance of payments can suffer

• From the initial capital outflow required to finance the FDI

• May be offset by inflow of earnings in current account

• If the purpose of the FDI is to serve the home market from a low cost labor
location
• Import goes up for the home country

• If the FDI is a substitute for direct exports

• Export comes down for the home country
What are the Costs of FDI to the Home Country?

• Employment may also be negatively affected if the FDI is a substitute for

domestic production

• Significant if there are employment issues in home country

• However, outbound FDI may stimulate economic growth and employment in the
home country if home country resources can be deployed in more specialized
activities
6.5 Government’s Policy Instruments
How Does the Government Influence Outbound FDI?

• Governments can encourage outward FDI

• Government-backed insurance programs to cover major types of foreign

investment risk

• Governments can restrict outward FDI

• Limit capital outflows, manipulate tax rules, or outright prohibit FDI

How Does the Government Influence Inbound FDI?

• Governments can encourage inward FDI

• Offer incentives to foreign firms to invest in their countries

• Gain from the resource-transfer and employment effects of FDI, and capture FDI away
from other potential host countries

• Governments can restrict inward FDI

• Use ownership restraints and performance requirements

How Do the International Institutions Influence
FDI?

• Until the 1990s, there was no consistent involvement by multinational

institutions in the governing of FDI

• The World Trade Organization is changing this by trying to establish a

universal set of rules designed to promote the liberalization of FDI
6.6 Impact of Trade and Investment on
Balance of Payments Accounts
Balance of Payments Accounts

• Keeps track of payments to foreign entities and receipt from foreign

entities
• Current account == Capital account + Financial account

• Current account
• Records transactions that pertain to
• Export and import of physical goods and services
• Primary income receipts or payments – Income from foreign investments or payments to
foreigners (e.g., dividend / interest receipts or payments)
• Secondary income receipts or payments – Transfer of goods, services or assets to the govt. (or
private entities) or to the foreign govt. (or foreign private entities) (e.g., tax payments)
• Does not create future liabilities
Balance of Payments Accounts
• Capital account
• Records flow of international assets
• Acquisition or disposal of non-financial and non-produced assets (goodwill, patents etc.)
• Small, compared to other accounts (earlier was part of current account)

• Financial account
• Records changes in asset ownership that involve direct investments, portfolio
investments and reserve assets (currency held by central bank)
• Change in foreign assets owned by the govt. or private entities of the country
• Change in assets owned by foreign entities
• Earlier known as capital account

IMF’s Differentiation:
Financial account measures increases or decreases in international ownership of assets, whether they be
individuals, businesses, governments, or central banks.
Capital account measures capital transactions that do not directly affect income, production, or savings.
Balance of Payments Accounts (India Q1 FY20)

Goods imports
higher than exports

Services exports and

private transfers partly
compensate for
imbalance in goods

Inbound FDI helps in

maintaining positive
financial accounts
balance

Source: rbi.gov.in
Does the Current Account Deficit Matter?
• As long as current account deficit is balanced with a surplus in financial
accounts, foreign exchange reserve is not impacted

• Money that flows to other countries as their export income can be used by
those countries to purchase assets in the deficit country
• Chinese use the gains from exports to purchase US assets such as stocks, bonds etc.,
as capital flows in where there is maximum productive use
• Increases liability in financial account

• However, reinvesting in the country spur economic activities within the

country

• If foreigners decide to withdraw investments and pull out their capital, the
currency rate may fall (unless controlled by central bank), leading to
• Higher cost of imports and reduced the value of exports ➔ making country’s export
more competitive ➔increasing exports ➔correcting current account deficit
6.7 Country Perspectives
FDI in China
• 1978: Chinese leadership decided to move from centrally planned socialist
economy to a more market-driven economy
• Result: High economic growth of 40 years ~ @8% CAGR
• FDI in 1980s: ~ US$2.5 billion / annum
• FDI in late 2018: US$139 billion (US$261 billion including Hong Kong and
Taiwan)
• Reason
• Population 1.4 billion ➔ Largest market
• Historically import tariffs have been high (@ ~8% even today)
• Inexpensive labor force, availability of infrastructure and tax incentives in SEZ
• Challenges
• Guanxi – the relationship network / connection that one must have
• Relatively low purchasing power of the citizens
• Highly regulated environment – local JV partners are inexperienced but opportunistic
FDI in China
• Inbound FDI flow in US$ million

Source: https://unctadstat.unctad.org/EN
FDI in India
• Inbound FDI flow in US$ million

Source: https://unctadstat.unctad.org/EN
FDI in India

Source: dipp.gov.in
FDI in India

Source: dipp.gov.in
FDI in India

Source: dipp.gov.in
FDI in India: Sectors Where No Approval Required But Cap
Exists

• Petroleum refining by PSUs 49%

• Infrastructure Company in the Securities Market 49%
• Insurance 49%
• Pension 49%
• Power Exchanges 49%

Source: dipp.gov.in
FDI in India: Sectors Where Govt. Approval is Necessary

Sector / Activity Cap Govt. Approval

1. Mining and mineral separation of titanium bearing minerals and ores 100% Upto 100%
2. Food Product Retail Trading 100% Upto 100%
3. Defence 100% Beyond 49%
4. Publishing/printing of scientific and technical magazines/specialty journals/ periodicals 100% Upto 100%
5. Publication of facsimile edition of foreign newspapers 100% Upto 100%
6. Print Media - Publishing of newspaper and periodicals dealing with news and current affairs 26% Upto 26%
7. Print Media - Publication of Indian editions of foreign magazines dealing with news and current affairs 26% Upto 26%
8. Air Transport Service – Scheduled 100% Beyond 49%
9. Investment by Foreign Airlines 100% Upto 49%
10. Satellites- establishment and operation 100% Upto 100%
11. Telecom Services 100% Beyond 49%
12. Pharmaceutical – Brownfield 100% Beyond 74%
13. Banking- Private Sector 74% Beyond 49%
14. Banking- Public Sector 20% Upto 20%
15. Private Security Agencies 74% Beyond 49%
16. Broadcasting Content Service a) FM Radio b) Up linking of ‘News & Current Affairs’ TV Channels 49% Upto 49%
17. Trading 51% Upto 51%

Source: dipp.gov.in
FDI in India: Prohibited Sectors
• Lottery Business including Government/private lottery, online lotteries,
etc.
• Gambling and Betting including casinos etc.
• Chit funds
• Nidhi company
• Trading in Transferable Development Rights (TDRs)
• Real Estate Business or Construction of Farm Houses
• Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or
of tobacco substitutes
• Activities/sectors not open to private sector investment e.g. Atomic
Energy

Source: dipp.gov.in
FDI – To and From India
• https://www.bloombergquint.com/opinion/where-is-all-the-fdi-into-india-really-
coming-from-and-going-to
Case: Facebook’s Investment in Reliance Jio
• https://www.ibef.org/blogs/india-s-largest-tech-fdi-decoding-the-facebook-
reliance-jio-deal
6.8 Managerial Implications
Case: Cemex
• World’s third largest cement manufacturer and controls 60% of the domestic
market
• Global expansion strategy
• Reduce dependence on volatile domestic construction market
• Tremendous demand for cement in many developing countries
• Understood the construction activities in developing countries better than Holcim or
Lafarge etc.
• Approach: acquire inefficient cement companies in other markets, transfer its
superior skills in production, customer service, IT, and marketing
• From early 1990s – 2000
• 56 cement plants in 30 countries, including acquisition of Southland in USA
• 2005: Acquisition of RMC in the UK
• US $15 billion sales, with just 15% of sales in Mexico
• Questions
• What theoretical explanation is suitable in Cemex’s expansion?
• What is the value Cemex brings to a country? Is there any flipside?
• Cemex prefers acquisition over greenfield investments; any explanation?
Case: Cemex
• Question 1
• What theoretical explanation is suitable in Cemex’s expansion?

• Why not exports from Mexico / licensing a local player?

• Knickerbocker’s theory – Dunning’s OLI paradigm

Case: Cemex
• Question 2
• What is the value Cemex brings to a country? Is there any flipside?

• Competitive advantages of Cemex?

• Contribution to host economies?

• Expatriation of profits?
Case: Cemex
• Question 3
• Cemex prefers acquisition over greenfield investments; any explanation?

• Greenfield vs. Acquisition

• Time to market
• Risk in host countries, assumption of liabilities of the target companies
• Possible lack of recognition in host countries
• Cultural integration with acquired company’s staff
• Dealing with poor quality assets of the acquired company
Case: Royal Enfield (Eicher Motors)

• Sales in India dropped by 24%, exports soared by 205% in August

2019 (source: auto.ndtv.com)
• About 10% of RE’s production are exported
• All RE manufacturing facilities are in India
• Top 3 export markets by value for RE are USA, Colombia and Italy

• Questions
• Should RE continue only with exports?
• Or, license production activities to a local player in these countries?
• Or, invest in setting up manufacturing base outside India?
What Does FDI Mean for Managers?

• Managers need to consider what trade theory implies about FDI, and
the link between government policy and FDI

• The direction of FDI can be explained through the location-specific

advantages argument associated with John Dunning

• However, it does not explain why FDI is preferable to exporting or licensing,

must consider internalization perspective
What Does FDI Mean for Managers?
• Decision Workflow

Are transportation costs and tariffs high? Export!

No
Yes

Is know-how amenable to licensing? FDI!

No
Yes
Can foreign operations be monitored
loosely? FDI!
No
Yes
Can know-how be protected by licensing
contract? FDI!
No
Yes

License!
What Does FDI Mean for Managers?

• A host government’s attitude toward FDI is important in decisions

about where to locate foreign production facilities and where to make
a foreign direct investment

• Firms have the most bargaining power when the host government values
what the firm has to offer, when the firm has multiple comparable
alternatives, and when the firm has a long time to complete negotiations
In Summary…
• Firms pursue FDI over exporting and licensing when there are
• Trade barriers or threat of trade barriers
• Threats of misappropriation of intellectual property / trade secrets, or skills are not amenable for licensing
• Needs to have a tighter control over foreign entity to maximize market share and earnings
• Knickerbocker’s theory: FDI flows are a reflection of strategic rivalry between firms in a global
marketplace
• Dunning’s eclectic paradigm: Ownership factors, Locational factors, Internalization factors
• Political ideologies
• Radical view: MNEs pursue FDI for exploitation
• Free market view: value chain activities are distributed across the world according to the theory of comparative
advantage
• Pragmatic nationalism: FDI offers benefits but also may add to costs to the nation’s economy
• Host country benefits: resource transfer effects, employment effects, balance of payments effects,
effects on competition and economic growth
• Host country costs: adverse effect on competition, BoP, national sovereignty
• Home country benefits: effect on BoP, effect on employment, reverse resource transfer effect
• Home country costs: negative effect on BoP and employment
Thank You