FOREIGN DIRECT

INVESTMENT
Reference: Chapter 8,
Charles Hill, Tomas Hult and Rohit Mehtani

Dr. Mini Thomas

Dept. of Economics & Finance,
BITS Pilani Hyderabad campus
Learning Objectives
• Foreign direct investment (FDI) occurs when a firm invests directly in
facilities to produce or market a product in a foreign country.
• Once a firm undertakes FDI, it becomes a multinational enterprise.
• FORMS OF FDI:
• Greenfield investment – involves the establishment of a new operation
in a foreign country.
• Acquisition investment - involves acquiring or merging with an existing
firm in the foreign country.
• Acquisitions can be a:
• minority stake(where the foreign firm takes a 10 percent to 49
percent interest in the firm's voting stock),
• majority stake (foreign interest of 50 percent to 99 percent), or
• full outright stake (foreign interest of 100 percent).
• The flow of FDI refers to the amount of FDI undertaken over a given time period
(normally a year).

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

• FDI outflows - the flow of FDI out of a country.

• FDI inflows - the flow of FDI into a country.

• For developing countries, only one third or less of FDI is in the form of cross border
M&As. Less risky than Greenfield FDI.
• Case study: Volkswagen FDI in Russia – in mid 2000s
 Recent Trends in FDI
• Global flows of FDI have been severely hit by the COVID-19 pandemic.

• In 2020, FDI fell by 35 percent to $1 trillion, well below the low point reached
after the global financial crisis a decade ago.

• The decline was heavily skewed towards developed economies, where FDI fell
by 58 per cent. FDI in developing economies decreased by a more moderate 8
per cent, mainly because of resilient flows in Asia.

• Greenfield investments in industry and new infrastructure investment

projects in developing countries were hit especially hard – 2020 and 2021 Q1
• Cross border M&As recovered in the second half of 2020.
Direction of FDI
• Historically, most FDI has been directed at the developed nations of the world
as firms based in advanced countries invested in the others' markets
• The United States has been an attractive target for FDI since 1980s because of
its large and wealthy domestic markets, its dynamic and stable economy, a
favorable political environment, and the openness of the country to FDI.
• Investors include firms based in UK, Japan, Germany, Netherlands, and
France.
• Developed countries of EU – major destination for US firms
• China emerged as a major recipient of FDI in last decade.
• Brazil, South, East, South East Asia, India
• Chinese FDI in Africa, especially in extractive industries. Hong Kong.
THEORIES OF FDI
• Why will a firm favor FDI as a means of entering a foreign market when it has
two other alternatives, exporting and licensing?

• Why firms in the same industry often undertake FDI at the same time, and
why do they favor certain locations over others as targets?

• A third theoretical perspective, known as the eclectic paradigm, attempts to

combine the above two perspectives into a single holistic explanation
• Exporting involves producing goods at home and then shipping them to the
receiving country for sale.

• Licensing involves granting a foreign entity (the licensee) the right to produce
and sell the firm’s product in return for a royalty fee on every unit sold.

• FDI is expensive because a firm must bear the costs of establishing

production facilities in a foreign country or of acquiring a foreign enterprise.

• FDI is risky - problems associated with doing business in a different culture

where the rules of the game may be very different.
Limitations of exporting
• The viability of an exporting strategy is often constrained by transportation
costs and trade barriers.
• Mainly applicable for products that have a low value-to-weight ratio and
that can be produced in almost any location. Eg: cement
• electronic components, personal computers, medical equipment – high
value to weight ratio – transportation minor component of total cost
• Response to actual or threatened trade barriers such as import tariffs/quota
• Japanese FDI in US automobile sector during 1980s and 1990s
 Limitations of Licensing
Market imperfections approach/internalization theory - 3 major drawbacks

• Licensing may result in a firm giving away valuable technological know-how to

a potential foreign competitor.

• Licensing does not give a firm tight control over manufacturing, marketing, and
strategy in a foreign country - required to maximize its profitability.

• Capabilities are often not amenable to licensing

STRATEGIC BEHAVIOUR OF FDI
• One theory is based on the idea that FOi flows are a reflection of strategic
rivalry between firms in the global marketplace.
• Knickerbocker - the relationship between FDI and rivalry in oligopolistic
industries
• interdependence of the major players – price cut by one firm – quickly
imitated by rivals. same kind of imitative behavior characterizes FDI.
• Toyota and Nissan followed Honda to Europe and US.
• MULTIPOINT COMPETITION
• Arises when two or more enterprises encounter each other in different
regional markets, national markets, or industries.
• Economic theory suggests that rather like chess players playing for
advantage, firms will try to match each other's moves in different markets
to try to hold each other in check.
• The idea is to ensure that a rival does not gain a commanding position in
one market and then use the profits generated there to subsidize
competitive attacks in other markets.
• Kodak and Fuji Photo Film Co.

• However, Imitative theory does not explain why the first firm in an oligopoly
decides to undertake FDI rather than to export or license.
THE ECLECTIC PARAGIDM – John Dunning
• Location-specific advantages - The advantages that arise from utilizing
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 capabilities).

• Eg: FDI undertaken by oil companies; locations abundant in low cost and high
skilled labour.
• Silicon Valley:epicenter of computer software,tech & semiconductor Industry
• Concentration of intellectual talent, knowledge spillovers – externalities
• European, Japanese, Korean companies investing in SV. FDI in US Biotech.
 Political Ideology and FDI
• Radical View – Marxist view – dominant from 1945 to 1980s
• MNE is seen as a tool for exploiting host countries to the exclusive benefit of their capitalist-
imperialist home countries.
• MNEs extract profits from the host country and take them to their home country, giving
nothing of value to the host country in exchange.
• Key technology is tightly controlled by the MNE
• Important jobs in the foreign subsidiaries of MNEs go to home-country nationals
• FDI can never be instruments of economic development, only of economic domination.
• Where MNEs already exist in a country, they should be immediately nationalized - Africa
• Eastern Europe, China, Cambodia, Cuba – opposed to FDI
• Nationalistic countries such as Iran, India also embraced this view.
• By end of 1980s, radical view was in retreat.
Reasons for decline of radical view
• ( 1) the collapse of communism in Eastern Europe;

• (2) the generally abysmal economic performance of those countries that

embraced the radical position, and

• (3) the strong economic performance of those developing countries that

embraced capitalism rather than radical ideology (e.g., Singapore, Hong
Kong, and Taiwan).
FREE MARKET VIEW – based on theories of
Smith and Ricardo
• International production should be distributed among countries according to
the theory of comparative advantage.
• Countries should specialize in the production of those goods and services that
they can produce most efficiently.
• MNE is an instrument for dispersing the production of goods and services to
the most efficient locations around the globe.
• Resource transfers benefit host country and stimulate its economic growth.
• The free market view argues that FDI is a benefit to both the source country
and the host country.
• This view gaining more popularity in recent years. Remove restrictions on
inward and outward FDI.
PRAGMATIC NATIONALISM – adopted by
many countries
• FDI can benefit a host country by bringing capital, skills, technology, and jobs, but those
benefits come at a cost.
• When a foreign company rather than a domestic company produces products, the profits
from that investment go abroad.
• A foreign owned manufacturing plant may import many components from its home
country - negative implications for the host country ‘s BOP
• FDI should be allowed so long as the national benefits outweigh the costs.
• Perception that direct entry of foreign (U.S.) firms with ample managerial resources into
the Japanese markets could hamper the development and growth of their own industry
and technology.
• Exception – foreign firms should neither license their technology to a Japanese firm nor
enter into a joint venture with a Japanese enterprise.
• IBM and Texas Instruments set up wholly owned subsidiaries in Japan.
INTERNATIONAL TRADE THEORY AND
FDI
• Home-country concerns about the negative economic effects of offshore
production may be misplaced.
• Offshore production refers to FDI undertaken to serve the home market.
• Stimulate economic growth (and hence employment) in the home country,
by freeing up resources for activities in which home country has comparative
advantage.
• Home-country consumers benefit from lower prices.
• If a company was prohibited from FDI on the grounds of negative
employment effects while its international competitors reaped the benefits
of low-cost production locations, that company would undoubtedly lose
market share to its international competitors.
Host Country Benefits

• Resource-Transfer Effects

• Employment Effects Acquisition FDI

• Balance of Payments Effects

• Effect on Competition and Economic Growth

Host Country Costs
• Adverse Effects on Competition

• Adverse Effects on the Balance of Payments

• National Sovereignty and Autonomy

 Home country Benefits
• Home country's balance of payments benefits from the inward flow of
foreign earnings.
• Foreign subsidiary creates demands for home-country exports of capital
equipment, intermediate goods, complementary products
• Positive employment effects arise when the foreign subsidiary creates
demand for home-country exports
• Home-country MNE learns valuable skills from its exposure to foreign
markets that can subsequently be transferred back to the home country –
Reverse resource transfer effect – management, product & process tech
Home country Costs
• The BOP suffers from the initial capital outflow required to finance the FDI.
Offset by subsequent inflow.
• Adverse current account balance if the purpose of the foreign investment is
to serve the home market from a low-cost production location.
• FDI as a substitute for direct exports. Japan current account deterioration.

• Reduced home-country employment. Not a major concern if the labour

market in the home country is already tight, with little unemployment.
• Objection to NAFTA – US FDI in Mexico
Government Policy Instruments for
regulating FDI
• HOME COUNTRY POLICIES
• Encouraging Outward FDI
• Government-backed insurance programs to cover major types of foreign
investment risk
• Risks of expropriation (nationalization), war losses, and the inability to transfer
profits back home
• Special funds or banks that make government loans to firms wishing to invest in
developing countries
• Eliminated double taxation of foreign income
• Political influence to persuade host countries to relax their restrictions on inbound
FDI.
• Toys R Us in Japan
• Restrictions on Outward FDI

• From the early 1960s until 1979, Britain had exchange-control regulations
that limited the amount of capital a firm could take out of the country.

• The British advanced corporation tax system taxed British companies' foreign
earnings at a higher rate than their domestic earnings.

• Formal or informal political restrictions – Cuba, Iran

South Africa in 1980s to change their stance on Apartheid
• Encouraging FDI inflows
• Tax concessions, low interest loans, grants or subsidies, infrastructure
upgradation. Incentives are motivated by a desire to gain from the resource-
transfer and employment effects of FDI.
• capture FDI away from other potential host countries. Britian vs. France.

• Restricting FDI inflows

• Ownership restraints and performance requirements
• Foreign companies excluded from tobacco and mining in Sweden and from
the development of certain natural resources in Brazil, Finland, Morocco
• Foreign ownership permitted although a significant proportion of the equity
of the subsidiary must be owned by local investors.
• Ownership restraints on the grounds of national security or competition.
• Variant of infant industry argument
• Based on belief that local owners can help to maximize the resource-transfer
and employment benefits of FDI for the host country.

• Performance requirements are controls over the behavior of the MNE's local
subsidiary.
• The most common performance requirements are related to local content,
exports, technology transfer, and local participation in top management.

• Performance requirements tend to be more common in less developed

countries than in advanced industrialized nations
INTERNATIONAL INSTITUTIONS AND
FDI
• Until the 1990s, there was no consistent involvement by multinational
institutions in the governing of FDI.

• WTO set up in 1995, embraced promotion of international trade in services.

• Many services have to be produced where they are sold, so exporting is not an
option. Hence WTO got involved in FDI.

• Push for the liberalization of regulations governing FDI, particularly in services.

IMPLICATIONS OF FDI THEORIES
FOR MANAGERS
• The Internalisation theories are useful for IB managers because they identify
with some precision how the relative profitability of foreign direct
investment, exporting, and licensing, vary with circumstances.

• Although less risky and less costly, Licensing is not an attractive option when
• (a) the firm has valuable know-how that cannot be adequately protected
by a licensing contract,
• (b) the firm needs tight control over a foreign entity to maximize its market
share and earnings in that country, and
• (c) a firm's skills and capabilities are not amenable to licensing.
Govt Policy influence on managerial
decisions
• If the host government is trying to attract FDI - the kind of incentives the host
government is prepared to offer to MNE and what it will commit in exchange.
• If the host government is uncertain about the benefits of FDI and might
choose to restrict access - the concessions that the MNE must make to be
allowed to go forward with a proposed investment.

• Outcome of negotiated agreement between MNE and host govt depends on

the relative bargaining power of both parties
(1) The value each side places on what the other has to offer.
(2) The number of comparable alternatives available to each side.(many)
(3) Each party's time horizon.(long time)
Global Minimum Tax – G20 - October
2021
• A global agreement between 136 countries to ensure big companies and MNCs
pay a minimum tax rate of 15% and make it harder for them to avoid taxation.

• With budgets strained after the COVID-19 crisis, many governments want more
than ever to discourage multinationals from shifting profits - and tax revenues -
to low-tax countries regardless of where their sales are made.

• Rising trend of income from intangible sources such as drug patents, software
and royalties on intellectual property having migrated to these jurisdictions

• Aim to put an end to decades of tax competition between governments to

attract foreign investment.
• The 136 countries behind THE GLOBAL MINIMUM TAX rate, together account for over 90%
of the global economy. Kenya, Nigeria, Pakistan and Sri Lanka yet to join.

• The OECD, which has steered the negotiations, estimates the minimum tax will generate
$150 billion in additional global tax revenues annually.

• The global minimum tax rate would apply to overseas profits of MNEs with 750 million
euros ($868 million) in sales globally.

• Governments could still set whatever local corporate tax rate they want, but if companies
pay lower rates in a particular country, their home governments could "top up" their taxes
to the 15% minimum, eliminating the advantage of shifting profits.

• It also allows countries where revenues are earned to tax 25% of the largest
multinationals' so-called excess profit (defined as profit in excess of 10% of revenue).