FDI

If you’ve traveled to London or Beijing, you may have seen some familiar companies like Starbucks or
McDonald’s as you walked through the streets. These companies have investments in many countries
around the world. In fact, as you’ll recall from the Opening Case, Wal-Mart recently continued its
international expansion by acquiring a stake in Japan’s Seiyu. Even if you haven’t traveled to other
countries you can see examples of foreign direct investment in your own country. For example, Nissan
and Toyota have both made investments in the U.S., and Ford has factories in Mexico.

Foreign direct investment, or FDI, occurs when a firm invests directly in new facilities to produce and/or
market in a foreign country. Once a firm undertakes FDI it becomes a multinational enterprise or MNE.

There are two main forms of FDI. A greenfield investment involves establishing a wholly owned new
operation in a foreign country. This is what Starbucks has done for most of its foreign expansion. The
second type of FDI is an acquisition or merger with an existing firm in the foreign country. Wal-Mart
chose this path with its acquisition of Seiyu.

You probably already know that companies are expanding in foreign countries more than ever. But, let’s
look at the patterns of FDI in the world economy a little more closely. Before we do that though, we
need to go over a few definitions.

The flow of FDI refers to the amount of FDI undertaken over a given period of time.

The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time.

Outflows of FDI are the flows of FDI out of a country, while inflows of FDI are the flows of FDI into a
country.

3. What trends in FDI can we see over the last twenty years or so? Well, there has been a marked
increase in both the flow and stock of FDI in the world economy. In 1975, the outflow of FDI was about
$25 billion, by 2000, it was $1.2 trillion. It dropped back a bit in 2005 to $897 billion, but as you can see,
there is a clear upward pattern.

4. Why has there been such a significant increase in FDI outflows? There are several reasons for this
pattern. Firms are worried about protectionist measures, and see FDI as a way of getting around trade
barriers. Second, changes in the economic and political policies of many countries have opened new
markets to investment. Think, for example of the changes in Eastern Europe that have made it possible
for foreign firms to expand there. Third, many firms see the world as their market now, and so are
expanding wherever they feel it makes sense. Wal-Mart for example, sees growth opportunities in
foreign markets that may not be available in the U.S. Many manufacturers are expanding into foreign
countries to take advantage of lower cost labor, or to be closer to customers, and so on.

5. We can also look at FDI flows in terms of percentages of gross fixed capital formation, or the total
amount of capital invested in factories, stores, office buildings, and so on.

All else being equal, the greater the capital investment in an economy, the more favorable its future
prospects are likely to be. In other words, FDI can be an important source of capital investment which
can be factor in the future growth rate of an economy.
6. You may be wondering how most firms make their investments. Do they establish greenfield
operations, or do they merge or acquire existing firms?

Most firms make their investments either through mergers with existing firms, or acquisitions. Firms
prefer this route because mergers and acquisitions tend to be quicker to execute than greenfield
investments, it’s usually easier to acquire assets than build them from the ground up, and because firms
believe they can increase the efficiency of acquired assets by transferring capital, technology, or
management skills.

Keep in mind that when a developing country is the target for FDI flows, mergers and acquisitions are
much less common, probably because there are fewer firms to acquire or merge with in developing
countries.

7. Remember that exporting involves producing goods at home and then shipping to the receiving
country for sale. While this may seem to be an obvious way to expand into foreign markets, it’s not
always possible. Imagine trying to export cement for example! Even smaller things like soft drinks can
be expensive to ship over long distances. Even if products are easy to ship like computer software, firms
may run into trade barriers that make this strategy less attractive.

Japanese auto producers for example, found that it was easier to set up shop in the U.S. than to deal
with the protectionist threats made by the U.S. government in the 1980s and 1990s.

8. Now, let’s look at why licensing isn’t always a viable option for foreign expansion. Recall that licensing
involves granting a foreign entity the right to produce and sell the firm’s product in return for a royalty
fee on every unit the foreign entity sells, and while it may seem like a good way to get into a foreign
market without the costs and risks of FDI, like exporting, licensing isn’t always attractive to companies.

Internalization theory suggests that licensing isn’t appropriate for three main reasons. First, licensing
may result in a firm’s giving away valuable technological know-how to a potential foreign competitor.
RCA found this out the hard way. RCA licensed its cutting edge color TV technology to Sony and
Matsushita in the 1960s only to find that they copied the technology and used it to compete against RCA
in the U.S. market. So, instead of expanding successfully into Japan, RCA became a minor player in its
own market!

A second problem with licensing is that it doesn’t give a firm the tight control over manufacturing,
marketing, and strategy that may be required to be successful in a foreign market. So, the firm doesn’t
have the ability to set prices, or market aggressively, and so on. Instead, it’s at the mercy of the
licensee.

Finally, if a firm’s competitive advantage is based on management, marketing, or manufacturing

capabilities rather than its product, licensing is probably not attractive. Much of Toyota’s competitive
advantage for example, lies in its superior process of designing, engineering, manufacturing, and selling
cars. Toyota can’t just license that know-how out to another firm because the skills are embedded in its
organizational culture! This efficiency is critical to Toyota’s success. In 2005, for example, the company
was able to earn about $2,400 more per car than the Big Three American automakers.