Because learning changes everything.

Chapter Sixteen
Foreign Direct Investment
and Cross-Border
Acquisitions

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 Chapter Outline
Global Trends in FDI.
Why Do Firms Invest Overseas?
• Trade Barriers.
• Imperfect Labor Market.
• Intangible Assets.
• Vertical Integration.
• Product Life Cycle.
• Shareholder Diversification Services.
Cross-Border Mergers and Acquisitions.
Political Risk and FDI.

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 Introduction
Firms become multinational when they undertake foreign
direct investments (FDI) via.
• Greenfield investment (that is, building brand-new
production facilities) or
• Cross-border mergers and acquisitions of existing
businesses.
FDI affords the multinational corporation (MNC) a measure
of control.

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 Global Trends in FDI 1

FDI flows represent new additions to the existing stocks of F

DI.
• Between 1982 and 2020, the world FDI outward stock
grew by 11.8% per year on average.
• FDI outflows from developing economies started growing
significantly from the mid-2000s and surpassed FDI
outflows from developed economies for the first time in
2020.

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 Global Trends in FDI 2

As for FDI outflows during 2015-2020,

• Japan, China, and the United States were the dominant
sources.
• The top ten countries account for about 64 percent of the
total worldwide FDI outflows.

As for FDI inflows during 2015-2020,

• The United States, China, and the United Kingdom
received the largest amount of FDI inflows.
• The top ten countries account for about 51 percent of the
total worldwide FDI inflows.

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 Exhibit 16.1 Foreign Direct Investment
Outflows in Billions of Dollars
Exhibit 16.1 Foreign Direct Investment Outflows in Billions of Dollars

Access the text alternative for slide images.

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 Exhibit 16.3 Average Foreign Direct Investment
per Year during 2015-2020 ($ billions)
Exhibit 16.3 Exhibit 16.3 Average Foreign Direct Investment per Year during
2015-2020 ($ billions)

Source: UNCTAD.

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 Global Trends in FDI 3

FDI stocks are the accumulation of previous FDI flows

Overall cross-border production activities of M N Cs are best
captured by FDI stocks
Total worldwide FDI stock, which was about $514 billion in 1980
rose to about $7,400 billion in 2000 and $39,000 billion in 2020.
As of 2020,
• The United States, the Netherlands, China, the United Kingdom,
Japan, Germany, Canada, France, and Switzerland held the
most outward FDI stocks.
• The United States, the Netherlands, the United Kingdom, China,
Switzerland, Canada, and Germany are the most important
hosts for FDI inward stock.

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 Exhibit 16.4 Foreign Direct Investment‒Outward
(Inward) Stocks in Billions of Dollars 1

Exhibit 16.4 Foreign Direct Investment‒Outward (Inward) Stocks in Billions of

Dollars.
1995 2000 2005 2010 2015 2020
Australia 60.5 92.5 205.4 449.7 416.6 627.3
(1113.)
Brazil 44.5 NA 75.8 149.3 184.9 277.5
(47.9) NA (177.9) (640.3) (429.3) (608.1)
Canada 118.1 442.6 692.3 983.9 1,156.0 1,964.4
(123.2) (325.0) (638.7) (913.9) (806.3) (1,099.9)
China 17.8 27.8 57.2 317.2 (1,097.0) 2,351.8
(101.1) (193.3) (272.1) 586.9 (1,219.9) 1,918.8
France 373.1 365.9 633.5 1,173.0 1,268.2 1,721.8
(233.1) (184.2) (379.4) (630.7) (687.4) (1,977.2)
Germany 505.7 483.9 794.2 1,364.4 1,369.2 1,977.2
(312.6) (470.9) (640.1) ( 955.9) (781.7) (1,059.3)
India 0.5 1.7 9.7 96.9 139.0 191.3
(5.6) (16.3) (43.2) (205.6) (781.7) (480.3)
Italy 106.3 170.0 244.6 491.2 456.6 596.2
(65.3) (122.5) (237.5) (328.1) (340.5) (485.8)

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 Exhibit 16.4 Foreign Direct Investment‒Outward
(Inward) Stocks in Billions of Dollars 2

1995 2000 2005 2010 2015 2020

Japan 238.5 278.4 386.6 831.1 1,228.8 1,928.1
(33.5) (50.3) (100.9) (214.9) (174.1) (243.0)
Korea 13.3 21.5 38.7 144.0 285.9 500.9
(18.2) (43.7) (104.9) (135.5) (179.5) (264.9)
Mexico 4.2 8.3 58.3 120.0 143.7 178.9
(41.1) (121.7) (248.2) (355.5) (430.6) (596.8)
Netherlands 164.9 305.5 637.1 968.1 1,666.0 3,797.6
(110.8) (243.7) 479.4 (588.1) (1,269.6) (2,890.6)
Russia 3.3 19.2 139.2 336.4 290.1 379.6
(5.6) (29.7) (178.6) (464.2) (262.7) (446.7)
Spain 35.0 129.2 305.4 653.2 513.0 624.8
(105.7) (156.3) (384.5) (628.3) (561.6) (853.3)
Switzerland 142.5 232.2 432.5 1043.2 1,137.3 1,628.9
(57.1) (101.6) (192.3) (648.1) (982.4) (1,536.3)
United Kingdom 304.9 940.2 1,239.3 1,6863 1,605.4 2,055.4
(199.8) (439.5) (788.1) (1,068.2) (1,530.6) (2,206.2)
United States 1,363.8 2,694.0 3,638.0 4,809.6 6,059.3 8,128.5
(1.005.7) (2,783.2) (2,818.0) (3,422.3) (5,731.4) (10,802.6)
World 3,993.3 7,408.9 12,000.5 20,468.1 26,209.5 39,246.2
(3,564.4) (7,377.4) (11,525.3) (19,898.9) (26,523.7) 41,354.2

Source: UNCTAD.

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 Why Do Firms Invest Overseas?
We do not have a well-developed, comprehensive theory of
FDI, but several theories can shed light on certain aspects of
the FDI phenomenon.
Key factors that are important in firms’ decisions to invest
overseas:
• Trade barriers.
• Imperfect labor market.
• Intangible assets.
• Vertical integration.
• Product life cycle.
• Shareholder diversification services.

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 Trade Barriers
Governments may impose tariffs, quotas, and other
restrictions on exports and imports of goods and services.
Facing barriers to exporting its products to foreign markets, a
firm may decide to move production to foreign countries to
circumvent the trade barriers.
Trade barriers can also arise naturally from transportation
costs (example, mineral ore and cement are bulky, which
means high transportation costs relative to their economic
values)

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 Imperfect Labour Market
• Among all factor markets, the labour market is the most
imperfect because workers are not allowed to freely move
across borders.
• Severe imperfections in the labour market lead to
persistent wage differentials among countries.
• When workers are not mobile because of immigration
barriers, firms themselves should move to the workers in
order to benefit from the underpriced labor services.

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 Exhibit 16.5 Labor Costs in Manufacturing
around the Globe (2020) 1

Exhibit 16.5 Labor Costs in Manufacturing around the Globe (2020)

Country Average Hourly Cost ($)
Denmark 54.46
Belgium 50.49
Germany 47.52
Sweden 46.91
France 45.23
Finland 42.15
Ireland 37.46
Island 36.44
Italy 33.47
Canada 33.22
United States 29.08
Spain 27.76
South Korea 22.14
New Zealand 20.87
Japan 18.57
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 Exhibit 16.5 Labor Costs in Manufacturing
around the Globe (2020) 2

Country Average Hourly Cost ($)

Portugal 14.16
Poland 11.28
Bulgaria 6.18
China 5.77
Kazakhstan 4.71
Mexico 3.70
Brazil 3.25
Moldova 3.22
Vietnam 1.82
Indonesia 1.10
India 0.80

Source: Compiled and estimated using data from the International Labor Organization, Bureau of Labor
Statistics, and www.tradingeconomics.com.

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 Intangible Assets
MNCs often enjoy comparative advantages due to special
intangible assets they possess.
To protect that proprietary information, firms may choose FDI
over licensing (example, Coca-Cola protecting its closely
guarded “secret formula”).
According to the internalization theory of FDI, firms that
have intangible assets with a public good property tend to
invest directly in foreign countries in order to use these
assets on a larger scale and, at the same time, avoid the
misappropriations of intangible assets that may occur while
transacting in foreign markets through a market mechanism.

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 Vertical Integration
MNCs may undertake FDI in countries where inputs are
available in order to secure the supply of inputs at a stable
price.
• If MNCs have monopolistic or oligopolistic control over the
input market, this can serve as a barrier to entry to the
industry.
Vertical FDIs may be backward or forward:
• Backward vertical FDI involves an industry abroad that
produces inputs for MNCs.
• Forward vertical FDI involves an industry abroad that
sells an MNC’s outputs.

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 Product Life Cycle
Product life cycle theory, proposed by Vernon (1966),
suggests the following:
• When U.S. firms first introduce new products, they choose
to keep production facilities at home, close to customers.
• As demand for the new product develops in foreign
countries, the pioneering U.S. firm begins to export to
those countries.
• As the product becomes standardized and mature, it
becomes important to cut the cost of production to stay
competitive.
• FDI takes place when the product reaches maturity and
cost becomes an important consideration.

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 Exhibit 16.6 The Product Life Cycle

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 Shareholder Diversification
Firms may be able to provide indirect diversification to their
shareholders if barriers to the cross-border capital flows exist
• When a firm holds assets in many countries, the firm’s
cash flows are internationally diversified, and shareholders
can indirectly benefit from international diversification even
if they are not directly holding foreign shares.
• Capital market imperfections as a motivating factor for FDI
are likely to have become less relevant given that many
barriers to international portfolio investments have been
dismantled in recent years.

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 Cross-Border Mergers and Acquisitions
In recent years, cross-border mergers and acquisitions
account for more than 50% of FDI flows in terms of dollar
amount.
Cross-border M&As offer two key advantages over greenfield
investments:
• Speed.
• Access to proprietary assets.

Synergistic gains are obtained when the value of the

combined firm is greater than the stand-alone valuations of
the individual (acquiring and target) firms.

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 Political Risk and FDI 1

Political risk refers to the potential losses to the parent firm

resulting from adverse political developments in the host
country (example, outright expropriation of foreign assets,
unexpected changes in tax laws that hurt the profitability).
Depending on the incidence, political risk can be classified
into two types:
1. Macro risk, where all foreign operations are affected by
adverse political developments in the host country.
2. Micro risk, where only selected areas of foreign business
operations or particular foreign firms are affected.
MNCs are increasingly facing global risks (example,
terrorism, environmental concerns, cyber attacks).
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 Exhibit 16.9 Expropriations Acts by
Sector, 1990 to 2014
Exhibit 16.9 Expropriations Acts by Sector, 1990-2014

Source: Hajzler, Christopher, and Jonathan Rosborough. “Government Corruption and Foreign Direct
Investment Under the Threat of Expropriation.” Bank of Canada Staff Working Paper 2016-13, 2016.
Access the text alternative for slide images.

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 Political Risk and FDI 2

Depending on the manner in which firms are affected,

political risk can be classified as follows:
1. Transfer risk, which arises from uncertainty about cross-
border flows of capital, payments, know-how, etc .
etera

2. Operational risk, which is associated with uncertainty

about the host country’s policies affecting the local
operations of MNCs.
3. Control risk, which arises from uncertainty about the host
country’s policy regarding ownership and control of local
operations.

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 Measuring Political Risk
Political risk is not easy to measure, but experts evaluate a
set of key factors, such as:
• The host country’s political and government system.
• Track records of political parties and their relative strength.
• Integration into the world system.
• The host country’s ethnic and religious stability.
• Regional security.
• Key economic indicators.
Corruption Perceptions Index (CPI) provides a composite
measure of perceived corruption in the public sector.

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 Exhibit 16.10 Political Risk Analysis:
Vietnam
Sovereign Rating: Moody's:B1, Outlook: Stable; S and P: BB−, Outlook: Stable

Political Strengths Economic Strengths

• Political stability with Communist Party in government • Transformation to market-oriented economy since late 19
since end of the country’s civil war in 1975. 80s.
• Widespread support for the CPV (Vietnam Communist • High GDP growth facilitated by foreign investment.
Party) reflects its success in raising living standards • Well-educated and cheap labor force.
and creating and maintaining security. • Sizable natural resources and advantageous location.
• Membership in TPP trade agreement.
Political Weaknesses Economic Weaknesses
• Inconsistent and evolving regulations. • Large fiscal deficits and weak banking system.
• Unreliable legal system and corruption. • Plethora of state-owned enterprises and less
• A lack of financial transparency, insufficient protection diversification.
for minority owners, and poor corporate governance. • Industry and credit policies favor state-owned enterprises.
• Lack of infrastructure.
Political & Governance Indicators Economic Indicators
• World Bank Ranking—Ease of doing business • GDP ($US bn) 241
68th/190 • GDP per capita ($U S) 2.482
• Freedom House—Political rights and civil liberties • Real GDP growth (15-year average, %) 6.8
Not Free • Fiscal balance (% of GDP) −4.7
• Transparency International Ranking—Corruption • Public debt (% of GDP) 57.8
Perception Index 117th/180 • Foreign direct investment (% of GDP) 7.3
• OECD country risk rating (Scale: 0‒7, 0 is least risk, 7 • Current account (% of GDP) 22
is highest risk) 5 • External debt (% of GDP) 49.7
• Foreign reserves (% of GDP) 26.3

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 Exhibit 16.11 Political Risk Analysis:
Turkey
Sovereign Rating: Moody’s: Ba3, Outlook: Negative; S and P: B+, Outlook:
Negative
Political Strengths Economic Strengths
• Transition to democracy at the end of 1970s. • Key dimensions of economic performance on par with
• Significant liberalization and stabilization by a drive to central and eastern European countries.
join European Union. • Was able to weather the recent global economic crisis.
• Rapid decline in poverty incidence. • Debt is highly sought after by foreign investors.
• Healthy growth forecast..

Political Weaknesses Economic Weaknesses

• Instability fueled by conflict between the army and the • Mounting macroeconomic imbalances and major reliance
civilian government. on foreign financing.
• Strained relations between religious conservatives and • Widening current account deficit, surging credit growth
secular modernists. and building inflation pressures.
• Proximity to war-torn Syria. • High business cycle and currency risk.
• Lira is a volatile emerging market currency.
Political & Governance Indicators Economic Indicators
• World Bank Ranking—Ease of doing business • GDP ($US bn) 769
43rd/190 • GDP per capita ($U S) 9,445
• Freedom House—Political rights and civil liberties • Real GDP growth (15-year average, %) 2.6
Partly Free • Fiscal balance (% of GDP) −1.9
• Transparency International Ranking—Corruption • Public debt (% of GDP) 30.4
Perception Index 78th/180 • Foreign direct investment (% of GDP) 1.7
• OECD country risk rating 5 (Scale: 0‒7, 0 is least • Current account (% of GDP) −5.7
risk, 7 is highest risk). • External debt (% of GDP) 56.7
• Foreign reserves (% of GDP) 12.0

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 Investment Insurance and Guarantees
Overseas Private Investment Corporation (OPIC)—the
U.S. investment insurance and guarantee program—
designed to facilitate private capital investment in lesser
developed countries. Offers insurance for four types of
political risk:
• Inconvertibility: the risk that the investor will not be able to
convert the profits into dollars.
• Expropriation: the risk that the host government will take
the assets.
• War.
• Business income due to losses from political strife.

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