TEMA 1.

FOREIGN DIRECT INVESTMENT

1. DEFINITIONS

There exist two kinds of international investment:

 Foreign Portfolio Investment (FPI). FPI refers to investments in a collection of foreign

securities, including stocks and bonds, without the direct management of foreign assets.

It is often known as foreign indirect investment.

 Foreign Direct Investment (FDI). FDI, as defined by the United Nations, entails

acquiring and equity stake of 10% or more in a foreign enterprise.

1.1. WHAT IS FDI?

I. A category of international investment denoting an intent to acquire a lasting interest in

an enterprise operating within a different economy. This encompasses all financial

transactions between the investing enterprise and its overseas subsidiaries.

II. Involves an investment characterized by a long-term relationship, reflecting lasting

interest and control of a domestic entity in one economy over an enterprise domiciled in a

different economy.

III. In practical terms, it typically entails ownership of at least 10% of the ordinary shares of a

foreign establishment.

IV. A multinational enterprise is identified as one that owns, controls, and oversees

production facilities situated in a minimum of two countries.

1.2. WHAT IS NOT FDI?

Foreign Direct Investment (FDI) does not encompass the following:

i. Non-equity investments, such as debt instruments.

ii. Portfolio investment, where the investment is made with the primary goal of

generating returns on the invested capital, without seeking any form of control or

significant influence over the invested entity.

iii. Licensing production or technology rights to another company abroad.

iv. Strategi alliances.

2. TYPES OF FOREIGN DIRECT INVESTMENT

2.1. BY ACTIVITY

 Horizontal FDI. Involves establishing similar plants, operating at the same stage of

production process, but located in different national markets. Often referred to as

“market-seeking investment”, as the primary motive is to access new markets and

customer bases.

 Vertical FDI. Involves setting up plants that produce at adjacent stages within a vertically

related set of production processes. Also known as “natural resource-seeking

investment”, as it often aims to secure access to crucial resources or inputs necessary

for the production process.

 Diversified FDI. Involves establishing plants whose outputs are not directly related to

each other. The primary aim here is risk diversification, as the investment spans across

different sectors or industries, reducing exposure to risks associated with a single

industry or market segment.

2.2. BY INVESTMENT STRATEGY

 Greenfield investment. This strategy involves entering a market by establishing a

completely new plant or facility.

 Mergers and acquisition (M&A). In this approach, market entry is achieved by acquiring

an existing plant or business entity within the target market.

 Joint venture. Market entry though joint ventures entails forming a new enterprise in

collaboration with a foreign partner.

2.3. MNE VS. NON-MNE

An MNE, by definition, is a company involved in FDI. Conversely, non-MNE firms can conduct

international business through various other means such as exporting, importing, licensing,

franchising, outsourcing, or participating in FPI among others.

The key factor that sets MNEs apart from non-MNEs is their involvement in FDI. However, it’s

important to note that FDI comes with its own set of challenges and expenses compared to

alternative international business strategies like exporting or licensing.

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  FDI is often perceived as expensive due to the costs associated with establishing

production facilities in foreign countries or acquiring a foreign enterprise.

 Additionally, it is considered risky because of the inherent complexities and uncertainties

of operating in culturally diverse environments where business practices and regulations

may differ significantly.

Despite these challenges, several factors can influence the comparative attractiveness of

exporting, licensing, and FDI: transport costs, market imperfections and location advantages.

2.3.1. TRANSPORT COSTS

When factoring in transportation costs alongside production costs, if often becomes economically

unfeasible to transport certain products over long distances. This is particularly evident for goods

with a low value-to-weight ratio than can be manufactured in virtually any location (such as

cement or soft drinks). In such cases, the relative attractiveness of exporting diminishes

compared to options like FDI or licensing agreements.

On the other hand, products with a high value-to-weight radio typically incur minimal

transportation costs as a proportion of the total landed cost (electronic components, personal

computers, medial equipment, computer software, etc.). In these instances, transportation costs

exert little influence on the comparative appeal of exporting, licensing, and FDI as viable

international business strategies.

2.3.2. MARKET IMPERFECTIONS

Market imperfections in the context of FDI arise under two main circumstances:

i. Impediments to the free flow of products between nations decrease the

profitability of exporting, relative to FDI and licensing.

ii. Impediments to the sale of know-how increase the profitability of FDI relative to

licensing. Licensing, while a mechanism for selling know-how, may not be feasible or

profitable on some occasions.

Thus, market imperfections explanation predicts that FDI will be preferred whenever there are

impediments that make both exporting and the sale of know-how difficult and/or expensive.

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Impediments to Exporting. Governments serve as the primary obstacle to the free flow of

products across borders. Through the imposition of tariffs on imported goods, governments raise

the cost of exporting, making FDI and licensing comparatively more attractive. Similarly, by

enforcing import quotas, governments enhance the appeal of FDI and licensing by limiting

alternative avenues for market entry.

Impediments to the Sale of Know-How. Many firms derive their competitive edge from

proprietary technological, marketing, or management expertise. However, the market doesn’t

facilitate the sale of this know-how effectively, and licensing might not be as attractive as it

seems initially, as it could potentially expose the firm’s valuable know-how to foreign competitors.

Certain aspects of a firm’s know-how may not lend themselves well to licensing agreements.

This holds particularly true for management and marketing know-how. While licensing the

manufacturing of a specific product is feasible, granting access to a firm’s business methods

presents a different challenge altogether.

2.3.3. LOCATION-SPECIFIC ADVANTAGES

Location-specific advantages refer to the advantages that arise from using resource endowments

or assets that are tied to a particular foreign location and that a firm finds valuable to combine

with its own unique assets (such as the firm’s technological, marketing or management know-

how).

3. MEASUREMENT OF FOREIGN DIRECT INVESTMENT

The measurement of FDI via the balance of payments’ capital account involves tracking capital

transfers between parent companies and their foreign affiliates.

FDI flow denotes the amount of investment conducted within a specific timeframe. Outflows

signify investments moving out of a country, while inflows indicate investments coming into a

country. The sock of FDI represents the total accumulated value of foreign-owned assets at a

given point in time.

The recent surge in FDI has been primarily fueled by significant political and economic

transformations in many developing nations worldwide. The transition towards democratic

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governance and free-market economies has attracted new Multinational Corporations (MNCs) to

these regions. Economic growth, deregulation, privatization initiatives, and relaxed restrictions on

FDI have notably enhanced the appeal of these countries to foreign investors. Additionally,

there’s been a noticeable shift in the destination of FDI, with emerging economies witnessing a

substantial influx of investment, diverging from the historical dominance of developed nations,

especially the United States.

4. THEORETICAL FRAMEWORKD OF FOREIGN DIRECT INVESTMENT

Early Foreign Direct Investment (FDI) theory emerged as the prevailing explanation for

international capital movements by the late 1950s. At its core was the theory of portfolio

investment, which centered on the role of interest rates. According to this theory, investors seek

to maximize profits by allocating their investments to areas with the highest returns. It operated

under the assumption of a frictionless environment with no transaction costs, where capital

shifted in response to changes in interest rate differentials.

However, this interest rate-centric perspective faced several challenges. Firstly, capital flows

were observed in both directions, indicating that interest rates alone couldn’t entirely explain

investment movements. Additionally, questions arose regarding the organization of international

trade within firms rather than through markets.

4.1. HYMER

Hymer’s work marked a significant shift in focus towards MNCs, emphasizing their role in

international production rather than mere exchange. He posed a crucial question: How could a

foreign company effectively compete in an unfamiliar market, where it inherently faced

disadvantages compared to local firms?

To address this question, Hymer proposed that for firms to engage in foreign ownership and

control of value-adding activities, they must possess specific advantages that outweigh the

challenges of competing with local firms. These advantages include: access to raw materials,

economies of scale, intangible assets and reduced transaction costs.

4.2. VERNON

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Vernon (1996) developed the Product Life Cycle Model (PLC). He observed that traditional

theories failed to adequately address the role of innovation and economies of scale in shaping

trade patterns. Additionally, Vernon sought to introduce the concept of Dynamic Comparative

Advantage to better evolving international trade dynamics.

The PLC model operates in three main stages:

i. STAGE 1. Initially, production is situated in the domestic country, primarily serving

the local market. As the product gains acceptance and demand increases, production

may expand to serve export markets.

ii. STAGE 2. As production matures, companies may face pressure to reduce costs.

Outsourcing to countries with lower labor costs become a viable option, leading to the

relocation of production abroad.

iii. STAGE 3. Eventually, the domestic country may transform from being a net exporter

of the product to becoming an importer.

4.3. INTERNALIZATION

Internalization theory seeks to explain why certain business transactions occur within a firm

(hierarchy) rather than between independent firms in a market, a question particularly relevant for

multinational firms.

I. Firm-specific advantages. While possessing firm-specific advantages is necessary

for FDI, it alone does not explain why a firm chooses internalization over other

options such as exporting or licensing. Understanding why the firm prefers to utilize

its advantages internally requires consideration of factors like control, quality

assurance, and strategic objectives.

II. Market imperfections. Market imperfections provide incentives for firms to

internalize transactions rather than rely on external markets. Buckely and Casson,

influenced by Coase’s work, argued that firms create internal markets to overcome

these imperfections and achieve greater control over their operations, avoiding

uncertainties, instability, and tax pressures associated with external markets.

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 III. Internalization. Firms are likely to replace open market transactions with internal

under certain circumstances: ensuring product quality (forward integration), ensuring

a stable supply of raw materials (backward integration) and market for knowledge.

4.4. DUNNING

John Dunning’s Electric Paradigm. Is a comprehensive approach that seeks to integrate

various theories and perspectives to explain the determinants of FDI. Drawing from

macroeconomic theory, trade theories, microeconomic theory, and industrial economics, Dunning

developed a framework that identifies three key factors influencing the decision to engage in FDI.

When a company aims to serve a local or foreign market from a foreign location, it requires

access to firm-specific advantages or the ability to acquire them at a lower cost. These

advantages are referred to as ownership-specific advantages, or O-advantages. Some firms

possess a specific type of capital known as knowledge capital, which includes human capital

(managers), patents, technologies, brand, reputation, and other intangible assets. Importantly,

this knowledge capital can be replicated in different countries without losing its value and can be

easily transferred within the firm without incurring high transaction costs.

Given the presence of ownership-specific advantages, it is typically in the firm’s best interest to

utilize these advantages internally rather than selling or licensing them to other firms. These

advantages, known as internalization or I-advantages, arise because a hierarchical

organizational structure is often more efficient for organizing transactions than relying solely on

external market.

Internalization advantages explain why firms may choose not to contract with external agents in

foreign countries. The primary reasons for this choice are the risks associated with contracting

out: it involves transferring specific capital outside the firm, which may include proprietary

information such as technology, patents, or trade secrets.

If the subcontractor gains access to proprietary technology or knowledge, there is a risk that they

could use it to compete with the mother company. In the case of brands or reputation,

subcontractors could damage the brand reputation though subpar performance, poor customer

service or unethical practices.

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Localization advantages, or L-advantages, complement ownership-specific and internalization

advantages in driving a firm’s decision to utilize foreign factor inputs and establish operations

abroad. These advantages underscore the benefits of combining firm-specific with access to

certain factors located abroad: proximity to final customers, lower cost saving on inputs,

overcoming trade barriers and service provision.

4.4.1. OLI PARADIGM

The OLI paradigm, which integrates Ownership (O), Internalization (I), and Localization (L)

advantages, provides a comprehensive framework for understanding the motivations behind FDI.

According to this paradigm:

 The greater the O and I advantages possessed by a firm, the more L advantages of

creating, acquiring (or augmenting) and exploiting these advantages form 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 supplied by exports.

 When firms possess O advantages, then FDI will be replaced by a transfer of at least

some assets normally associated with FDI and transfer of these assets or the right to

their use.

4.5. TYPES OF FDI IN THE OLI

Jere Behrman developed a theory of FDI to elucidate the various objectives that drive

multinational corporations (MNCs) to invest abroad:

i. Resource Seeking FDI. This type of FDI involves seeking and securing natural

resources or lower labor costs to benefit the investing company. MNCs engage in

resource-seeking FDI to access minerals, raw materials, or inexpensive labor in

foreign countries.

ii. Market Seeking FDI. MNCs pursue market-seeking FDI to identify and exploit new

markets for their finished products. This is particularly relevant for industries where

production and distribution must occur simultaneously, such as telecom, water supply

or energy supply.

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 iii. Efficiency Seeking FDI. This involves restructuring exiting investments to achieve a

more efficient allocation of international economic activities for the firm. MNCs

engage in global sourcing to benefit from differences in product and factor prices, as

well as to diversify risks. Thy type of FDI is often undertaken by network-based

MNCs with global sourcing operations, aiming to save resources and improve

efficiency by rationalizing their global activities.

iv. Strategic Asset / Capabilities Seeking FDI. MNCs pursue strategic asset or

capabilities-seeking FDI to protect or enhance their ownership-specific advantages

and competitive position globally. This may involve acquiring key established local

firms, acquiring local capabilities such as research and development, knowledge, and

human capital. Additionally, firms may engage in FDI to preempt acquisition by local

competitors, safeguarding their market position and strategic assets.