Foreign Direct Investment (FDI)
A foreign investment (FDI) is a company controlled through ownership by a foreign company of foreign individuals.
Control must accompany the investment; otherwise it is a portfolio investment.
Companies want to control their foreign operations so that these
operations will help achieve their global objectives. Investors who
control an organization are more willing to transfer technology and
other competitive assets. The idea of denying rivals access to
resources is called the appropriability theory.
Governmental authorities worry that this control will lead to decisions contrary to their countries' best interests.
Direct investments usually, but not always, involve some capital movement.
There are two ways companies can invest in a foreign country. They
can either acquire an interest in an existing operation or construct
new facilities.
Buy: Depends on which companies are available for purchase;
difficulty to transfer resources or acquire resources for a new
facility; the goodwill and brand identification; easier access to local
capital; market does not justify added capacity; immediate cash flow.
Build: Depends on difficulty to find a company to buy; little or no
competition; local governments prevent acquisition; acquisition less
likely to succeed (inefficient); local financing easier to obtain for
building.
Whether a company first transfers capital or some other asset to
acquire a foreign direct investment, the asset is a type of production
factor. Production factors: capital, technology, trademarks, managers,
raw material, ....
If trade could not occur and production factors could not move
internationally, a country would have to either forgo consuming certain
goods or produce them differently, which in either case would usually
result in decreased worldwide output and higher prices. In some cases,
the inability to use foreign production factors may stimulate efficient
methods of substitution.
If finished goods and production factors were both free to move
internationally, the comparative costs of transferring goods and
factors would determine the location of production. However, as is true
of trade, there are restrictions on factor movements that make them
only partially mobile internationally.
Factor movements may substitute for or stimulate trade. World trade
(exports) are stimulated by FDI because of the need for components,
complementary products and equipment for subsidiaries.
The least-cost production location changes because of inflation, regulations, transportation costs, and productivity.
Businesses and governments are motivated to engage in FDI in order
to expand sales, acquire resources and minimize competitive risk.
Governments may additionally be motivated by some desired political
advantage.
Sales expansion objectives :
- Overcome high transportation costs
- Lack of domestic capacity
- Low gains from scale economies
- Trade restrictions
- Barriers because of country-origin effects (nationalism, product image, delivery risk)
- Lower production costs abroad
Resource acquisition objectives :
- Savings through vertical integration
- Savings through rationalized production
- Gain access to cheaper or different resources and knowledge
- Need for lower costs as product mature
- Gain governmental investment incentives
Risk minimization objectives :
- Diversification of customer base (same motivations as for sales expansion objectives)
- Diversification of supplier base (same motivations as for resource acquisition objectives)
- Following customers
- Preventing competitors' advantage
Political objectives :
Influence companies usually through factors under resource acquisition objectives.
Companies invest directly only if they think they hold some
supremacy over similar companies in countries of interest. The
advantage results from a foreign company's ownership of some resource -
patents, product differentiation, management skills, access to market -
unavailable at the same price or terms to the local company.
To support the high costs necessary to maintain domestic competitiveness, companies frequently must sell on a global basis.
Almost all ownership is by companies from developed countries, but
the emerging economy ownership is increasing. Most FDI occurs in
developed countries because they have the biggest markets, lowest
perceived risk and are the least discrimination toward foreign
companies.
Over time, the portion of FDI accounted for in the raw materials
sector that includes mining, smelting, and petroleum has declined. The
portion in manufacturing, especially resource-based production, grew
steadily. The highest recent growth in FDI has been in service
(especially banking and finance) and technology-intensice
manufacturing.
1. Define the following terms:
a. Appropriability theory.- Companies are reluctant to transfer
vital resources, capital, patents, trademarks and management know how
to another organization that can make all its decisions independently,
because the company receiving these resources can use them to undermine
the competitive position of the foreign company transferring them.
b. Internalization.- The control inherent in FDI may decrease a
company's operating costs and increase its rate of technological
transfer because:
- The parent and subsidiary usually share a common corporate culture.
- The company can use its own managers, who understand its objectives.
- The company can avoid protracted negotiations with another company.
- The company can avoid problems of enforcing an agreement.
c. Horizontal expansion.- It's when companies move abroad to produce basically the same products they produce at home.
d. Just-in-time (JIT) manufacturing systems.- It's the decrease of
inventory costs by having components and parts delivered as needed,
these systems favor nearby suppliers who can deliver quickly.
e. Vertical integration.- It's a company's control of the different
stages (sometimes collectively called a value chain) of making its
product, from raw material through production to its final
distribution.
f. Rationalized production.- It's when some companies produce
different components or different portions of their product line in
different parts of the world to take advantage of low labor costs,
capital and raw materials.
g. Monopoly advantage.- It's when companies invest only if they
think they hold some supremacy over similar companies in countries of
interest. The advantage results from a foreign company's ownership of
some resource, patents, products differentiation, management skills,
access to markets, unavailable at the same price or terms to the local
company.
2. What is the major difference between a direct investment and a portfolio investment?
In a direct investment, control must accompany the investment, otherwise it's a portfolio investment.
3. Why are some governments and citizens concerned when investments are controlled abroad?
Many critics of Foreign Direct Investment (FDI), worry that the
host country's national interests will suffer somewhat if a
multinational company makes decision from afar on the basis of its own
global or national objectives.
4. Why do companies want to control their investments abroad?
Because with that, foreign companies are less reluctant to transfer
vital resources such as capital, patents, trademarks and management
know-how, that eventually could be used to undermine the competitive
position of the foreign company transferring these resources.
5. Why might control over one's own foreign production result in a
lower operating cost than if control is vested in another company?
Because investors who control an organization are more willing to
transfer technology and other competitive assets, also, they usually
use cheaper and faster means of transferring assets.
6. What types of assets could be used to acquire a direct investment?
There are two other means of acquiring foreign investments that are not capital movements per se.
First, a company may use funds it earns in a foreign country to
establish an investment, for example, a company that exports
merchandise but holds payments for those goods abroad can use
settlement to acquire an investment, in this case, it has merely
exchanged goods for equity.
Second, a company may transfer assets abroad to establish a sales
or production facility, if the earnings from the facility can increase
the value of the foreign holdings, FDI has increased without a new
international capital movement.
7. Explain how factor proportions and mobility affect patterns of international direct investment.
Factor movement is an alternative to trade that may or may not be a more efficient allocation of resources.
8. Explain why FDI and trade may or may not be a substitute for each other.
No, they may not be a substitute for each other, since FDI is a
major cause and means of factor movements. If trade could not occur and
production factors could not move internationally, a country would have
to either forgo consuming certain goods or produce them differently,
which in either case would usually result in decreased worldwide output
and higher prices.
9. How might FDI stimulate trade?
Factor mobility via direct investment often stimulates trade because of the need for:
Components
Complementary products
Equipment for subsidiaries
10. What are the general motivations for firms to engage in direct investment?
Expand sales
Acquire resources
Minimize competitive risk
Governments may additionally be motivated by some desired political advantage.
11. What is the role of transportation costs in influencing FDI decisions?
Transportation raises costs so much that it becomes impractical to export some products.
12. How does capacity use influence the decision to serve foreign markets through exports versus direct investment?
As long as a company has excess capacity at its plant(s), it may
compete effectively in limited export markets despite high transport
costs. This ability might occur if domestic sales cover fixed operating
expenses. The cost per unit decreases until it reaches full capacity.
When demand pushes the plant toward capacity, production should be
increased by use of FDI.
13. How do economies of scale impact the FDI decision?
Standardized products : Cost per unit drops significantly as output
increases. Companies can export large amounts of such products because
they can spread the fixed costs over more units in output.
14. How does the need to alter products to sell them in foreign
country affect the decisions to export to, versus produce within, that
foreign country?
Companies that need to alter their products substantionally for
different foreign markets benefit less by scale economies. For these
types of products smaller plants to serve national rather than
international markets will save transport costs. In this case
companies' country-by-country production reduces costs by minimizing
transportation expenses.
15. What is the relationship between trade restrictions and FDI?
If imports are highly restricted, companies often produce locally
to server the local market if the market potential is high relative to
scale economies.
Removing trade restrictions among a regional group of countries may
attract FDI, because the expanded market may justify scale economies.
Or the removal of trade restrictions may result in trade diversion.
16. How do country-of origin effects influence a firm's decision to produce abroad rather than export.
Consumers sometimes prefer domestically produced goods because of
- Nationalism: Promotional campaigns to buy locally
- A belief these products are better
- A fear that foreign-made goods may not be delivered on time.
Consumers often view their quality different on basis of the country of origin.
17. How may companies use FDI as a means to reduce competitive risk?
FDI enables companies to reduce competitive risk by
- Diversifying of customer & supplier base
- Providing low-end pricing through Production rationalization & vertical integration = stay competitive.
- Taking advantage of scale economies
- Increasing market share
18. What factors affect the least-cost production location and why might this location change?
Factors affection the least-cost production location: capital, raw material, productivity, labor costs, technology, assets.
The least-cost production location changes because of inflation, regulations, transportation costs, and productivity.
19. What are some of the advantages of international vertical integration?
The foreign direct investor will have control over the value chain; raw material, production & distribution.
The supply and/or markets are more assured, the foreign direct
investor may be able to carry smaller inventories and spend less on
promotion.
By buying and selling within the family of companies, the foreign
direct investor also has considerably grater flexibility in shifting
funds, taxes, and profits among countries.
