Foreign Direct Investment

An investment made by a company or entity based in

one country, into a company or entity based in
another country is known as foreign direct
investment
FDI differs from indirect investments such as
portfolio investment where investor invests in stock
exchange and do not have controlling power.
Entities making direct investments typically have a
significant degree of influence and control over the
company into which the investment is made.
 Foreign Direct Investment

The investing company may make its overseas

investment in a number of ways - either by setting up
a subsidiary or associate company in the foreign
country, by acquiring shares of an overseas company,
or through a merger or joint venture.
The accepted threshold for a foreign direct
investment relationship, as defined by the OECD, is
10%. That is, the foreign investor must own at least
10% or more of the voting stock or ordinary shares of
the investee company.
 Types of FDI

Horizontal FDI: arises when a firm duplicates its home

country-based activities at the same value chain stage in
a host country through FDI. Example: KFC in Nepal.
Platform FDI: Foreign directs investment from a
source country into a destination country for the purpose
of exporting to a third country. Example: Pearson
publication.
Vertical FDI: takes place when a firm through FDI
moves upstream or downstream in different value chains
i.e., when firms perform value-adding activities stage by
stage in a vertical fashion in a host country.
 Why exporting may not be feasible?
(Cost and benefits of FDI)
When it’s cheaper to produce abroad:
When it is cheaper to produce goods or services to
consumers abroad then home country, the FDI is
important
Example: visa electronic transactions, American and
Japanese automobile industry in India and china
 Why exporting may not be feasible?

When transportation costs too much:

 The further the market from an existing production
unit, the higher the transportation costs to that
market.
When transportation cost is added to production
costs then it is impractical to export.
Examples( coke in Naryanghat and Kathmandu,
coke in turkey and Kyrgyzstan, services like MC
Donald)
 Why exporting may not be feasible?

When domestic capacity is not enough:

When company has excess capacity, it may compete
effectively in exports markets despite high transport
costs.
As long as there is unused capacity foreign sales
push down the production cost. Domestic sales push
down the production cost.
 Why exporting may not be feasible?

When products and services need altering:

Companies often need to alter products to gain
sufficient sales in a foreign market.
Automobile company adding an assembly line to put
driving wheels on the right as well as on the left.
When trade restrictions hinder imports:
Government of every country imposes trade restrictions
for foreign products due to various reasons.
Volkswagen decided to build Skoda models in India
because of India’s 121 percent duty on the imports.
 Why exporting may not be feasible?

When country of origin becomes an issue:

Some countries may prefer to buy goods produced in
their own country rather than another.
Consumers believe that goods produced in some
country are superior to another.
Examples German cars, French perfumes, Russian
vodka.
 The balance of payments: BOP
(statement of international transactions)

Is the statement of balance of country’s trade and

financial transactions as conducted by individuals,
business and government agencies located in that
country with the rest of the world over a specific
period. ( usually one year)
The BOP has two main accounts:
 The current account which tracks all trade and
activity in merchandise.
 The capital account, which tracks loans given to
foreigners and loans received by citizens.
 The balance of payments

Positive net sales account surplus, negative net sales account deficit.
Companies monitor the balance of payments to watch factors that could
lead to currency instability or change in government policy.
Calculating balance of payment
B=(m-m1) + (x-x1)+(c-c1)
Where
B=balance of payment
M=import of displacement
M1=import stimulus
X=export stimulus
X1=export reduction
C= capital inflow
C1=capital outflow
 The balance of payments

Is FDI always good?

 FDI Theories

Product Life-Cycle Theory

This theory developed by Raymond Vernon explains
why U.S. manufacturers shift from exporting to FDI.
The manufacturers initially gain a monopolistic
export advantage from product innovations
developed for the host country market.
In the new product stage, production continues to be
concentrated in the host country even though
production costs in some foreign countries may be
lower.
 Product Life-Cycle Theory

When the product becomes standardized in its growth

product stage, the manufacturer goes abroad to exploit
lower manufacturing costs and to prevent the loss of the
export market to local producers.
The manufacturer’s first investment will be made in another
industrial country where export sales are large enough to
support economies of scale in local production.
In the mature product stage, cost competition among all
producers, including imitating foreign firms, intensifies. At
this stage, the manufacturer may also shift production from
the country of the initial FDI to a lower-cost country,
sustaining the old subsidiary with new products.
 Product Life-Cycle Theory

Procter & Gamble employed more than 8,000 scientists and

researchers in 2000 in 18 technical centers in nine countries.
Many new products in the health care and beauty care segments
were developed in these offshore research centers and
subsequently marketed in the United States and other foreign
countries.

Otis Elevator, a wholly owned subsidiary of United Technologies

Corp., offers its products in more than 200 countries and
maintains major manufacturing facilities in Europe, Asia, and
the Americas. Despite being headquartered in the United States,
MOST of Otis’s revenues are generated abroad.
 Monopolistic Advantage Theory

The monopolistic advantage theory suggests that the

MNE possesses monopolistic advantages, enabling it to
operate subsidiaries abroad more profitably than local
competing firms can.
Monopolistic advantage is the benefit accrued to a firm
that maintains a monopolistic power in the market.
Such advantages are specific to the investing firm
rather than to the location of its production.
According to this theory, monopolistic advantages
come from two sources: superior knowledge and
economies of scale.
 Monopolistic Advantage Theory

Economies of scale occur through either horizontal

or vertical FDI.
An increase in production through horizontal
investment permits a reduction in unit cost of
services such as financing, marketing, and
technological research.
 Internalization Theory

Internalization theory holds that the available external market

fails to provide an efficient environment in which the firm can
profit by using its technology or production resources.
Therefore, the firm tends to produce an internal market via
investment in multiple countries and thus creates the needed
market to achieve its objective.
 A typical MNE consists of a group of geographically dispersed
and goal-disparate organizations that include its headquarters
and different national subsidiaries. These MNEs achieve their
objectives not only through exploiting their proprietary
knowledge but also through internalizing operations and
management.
 Internalization Theory

Internalization is the activity in which an MNE

internalizes its globally dispersed foreign operations
through a unified governance structure and common
ownership.
Internalization theorists argue that internalization creates
“contracting” through a unified, integrated intra firm
governance structure. It takes place either because there is
no market for the intermediate products needed by MNEs.
(e.g. IBM’s speech-recognition technology is “transacted”
internally among different units because the external
markets has not been developed enough to properly value
and protect such expertise).
The Eclectic Paradigm (OLI framework)

The eclectic paradigm offers a general framework for

explaining international production. This paradigm
includes three variables: ownership-specific (O),
location-specific (L), and internalization (I).
Ownership-specific variables include tangible assets
such as natural endowments, manpower, and capital
but also intangible assets such as technology and
information, managerial, marketing, and
entrepreneurial skills, and organizational systems.
 The Eclectic Paradigm (OLI framework)

The owner-specific paradigm relates to ownership and

managerial variables:
managerial effectiveness
structure
process
Technology advantages.
 The Eclectic Paradigm (OLI framework)

The country-specific, i.e., location variables refer to:

the geographical environment
the political environment
the government's regulatory framework
taxation and fiscal policy
production and transportation costs
cultural environment
research and development advantages
 The Eclectic Paradigm (OLI framework)

Internalization refers to the firm’s inherent flexibility

and capacity to produce and market through its own
internal subsidiaries. When market is unable to
produce products according to need of market then
internalization takes place.
 It combines and integrates country specific,
ownership-specific, and internalization factors in
articulating the logic and benefits of international
production
 Exporting

Exporting refers to the sales of goods or services produced by

a company based in one country to customers that reside in a
different country.
Not only physical goods but also services are exported.
Engineering contractors, consultants, hotel chain, franchise
store are some examples of service export.
Exporting requires significantly lower level of investment than
other modes of international expansion, such as FDI.
In exporting, managers have less control on marketing
because an exporter resides very far from the end consumer
and often enlists various intermediaries to manage marketing
and service activities.
 Exporting

Ownership advantages: company’s assets, international experience,

and the ability to develop either low-cost or differentiated products.
location advantages: combination of market potential and investment
risk.
Diversification: economic growth is not same in every country.
Export diversification allows a company to use strong growth in one
market to offset weak growth in another.
The role of serendipity: Accidental export can give international
exposure to manufacturer’s products or service and can act as a catalyst
for companies to being exporting.
Profit potential: A mature product at home may have price
competition and substitute products too. In new market, product may
enjoy greater profitability because of less competition and no substitute
products.
 Designing an export strategy

Access the company’s export potential by examining its

opportunities and resources: first step in exporting is to find
possible new markets for its products and services. Then it need
to make sure that, it can produce enough goods or services for
new market with available resources in given time.
Obtain expert counseling on exporting: most governments
provide assistance for their domestic companies for their
extension of market. In case of USA there is commerce
department and the small business administration to provide
information about new market to manufacturers.
Specialized financial assistance when export increases, secure
payment guarantees, and in hiring agent government provide
assistance to manufacturer
 Designing an export strategy

Select a market or markets: it’s always better to look

at a few markets that have similar products like in home
country rather than targeting big market available.
Experience gained from this small market can be used to
target other markets later on.
Formulate and implement an export strategy:
company needs to set its long term and short term
objectives and need to make strategy according to that. In
some organization there is separate export department
who set goals, make strategy, assign resources and keep
close eyes on its and competitors activities.
 Importing:

The purchase of goods or services by a company

based in one country from sellers that reside in
another country.
When goods and services are available in lower
prices form outside, have higher quality and are
unavailable in local markets then importing takes
place.
Diversified importing also helps to diversify
operating risks of any company. US automobiles
industry import steel from china, Asia, and Europe.
 Counter trade

In ancient time nations traded silk, spices, cloth and animals
of all kinds. Today nation trade food items, defense
equipment, metals, electronics etc.
. Counter trade is an import / export relationship between
nations or large companies in which good and/or services are
exchanged for goods and services instead of money. In some
cases monetary evaluations are made for accounting purposes.
Counter trade takes place when their home country’s currency
is nonconvertible, when the country does not have enough
cash or sufficient lines of credit, or when it is impossible to
generate enough foreign exchange to pay for imports
 Counter trade

Indonesia traded 40,000 tons of palm oil, worth about $15

million, with Russian in exchange for Russian Sukhoi fighter
aircraft. Thailand and Indonesia signed a $40 million deal in
which Indonesia would supply Thailand with an agricultural
aircraft, train carriages, and fertilizer in exchange for Thai rice.
Inefficiencies: cash is king. Countertrade is an inefficient
way of doing business. It is tedious to get into negotiations to
reach a fair value on the exchange, sometime goods send as
payments are of low quality and difficult to sell.
Benefits: many emerging markets prefer counter trade to
preserve their limited monetary assets, generate foreign
exchange, and improve the balance of trade.
 Types of counter trade

Barter:
It is the exchange of goods and services for goods and services
without any use of money. Like the trade relationship between
China and Thailand where fruit has been traded by Thailand for
buses made by China.
Switch Trading:
In this method one company trades products and services or, in
some cases, builds infrastructure like roads, railway lines, hospitals
with another nation and, in turn, are obligated to make a purchase
from that nation.
 One such example is a deal proposed by the Philippine
Government where they offer to trade Philippine coffee for
essential products.
 Types of counter trade

Counter Purchase:
In this, a foreign company, or country, trades with a nation with the
promise that in the future they will make purchase of a specific product
from the nation.
 A recent example of this is the ongoing trade between Congo and China
where infrastructure is being traded for a supply of metals.
Buyback:
In this type of counter trade, a company builds a plant, supplies
technology, training, etc. In exchange they take a part of output of the
plant.
 For example, a company based in the USA sets up a let’s say an
automobile factory in X country. They take a part of the total production
as their own but they have to provide the technology and the training to X
country.
 Types of counter trade

Offset:
This is an agreement by one nation to buy a product
from a company in another.
The terms of contract are subject to the purchase of
some or all of the components and raw materials
from the buyer of the finished product, or the
assembly of such product in the buyer nation.
 Assignment 3

Why do nations need countertrade? Do you

think strategy of countertrade would be
beneficial for Nepal? Explain with and
example.
Compare and contrast the benefits and
disadvantages of FDI and Exporting.
List out all FDI theories and define them with
examples.