International Business: The Challenges of Globalization

International Business: The Challenges of Globalization

Eighth Edition

Chapter 7

Foreign Direct Investment

Copyright © 2016, 2014, 2012 Pearson Education, Inc. All Rights Reserved.

Copyright © 2016, 2014, 2012 Pearson Education, Inc. All Rights Reserved.

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This chapter defines the scope of international business and introduces us to some of its most important topics.

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Learning Objectives

7.1 Describe the worldwide pattern of foreign direct investment (FDI).

7.2 Summarize each theory that attempts to explain why FDI occurs.

7.3 Outline the important management issues in the FDI decision.

7.4 Explain why governments intervene in FDI.

7.5 Describe the policy instruments governments use to promote and restrict FDI.

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In this chapter, we examine the importance of FDI to the operations of international companies. We begin by exploring the growth of FDI in recent years and investigating its sources and destinations. We then look at several theories that attempt to explain FDI flows. Next, we turn our attention to several important management issues that arise in most decisions about whether a company should undertake FDI. This chapter closes by discussing the reasons why governments encourage or restrict FDI and the methods they use to accomplish these goals.

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Das Auto

Volkswagen Group (www.vw.com)

48 production facilities worldwide

Sells to more than 150 countries

Top-selling manufacturer in South America and China

China accounts for around 30% of VW’s total sales

VW’s U.S. expansion

Modular strategy

Special protection in Germany

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Volkswagen Group (www.vw.com) owns 10 of the most prestigious and best-known automotive brands in the world.

From its 48 production facilities worldwide, the company produces and sells around 8 million cars annually to more than 150 countries.

Volkswagen is the top-selling manufacturer in South America and China.

China accounts for around 30 percent of VW’s total sales.

Volkswagen also has ambitious goals for its U.S. expansion. It is adapting designs to domestic tastes, cutting prices, and adding inexpensive production capacity.

The company uses a modular strategy in production that lets it use the same key components in 16 different vehicles and 7 million units across its brands.

Volkswagen, like companies everywhere, received plenty of help in getting where it is today. Until recently, Volkswagen received special protection from its own legislation known as the VW Law. The law gave the German state of Lower Saxony, which owns 20.1 percent of Volkswagen, the power to block any takeover attempt that threatened local jobs and the economy. Volkswagen’s special treatment lies in the close ties between government and management in Germany and its importance to the nation’s economy, where it employs tens of thousands of people.

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Foreign Direct Investment

Foreign Direct Investment

Purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control

Portfolio Investment

Investment that does not involve obtaining a degree of control in a company

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International flows of capital are at the core of foreign direct investment (FDI)—the purchase of physical assets or a significant amount of the ownership (stock) of a company in another country in order to gain a measure of management control.

But there is wide disagreement on what exactly constitutes FDI. Nations set different thresholds at which they classify an international capital flow as FDI.

The U.S. Commerce Department sets the threshold at 10 percent of stock ownership in a company abroad, but most other governments set it at anywhere from 10 to 25 percent. By contrast, an investment that does not involve obtaining a degree of control in a company is called a portfolio investment.

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Pattern of Foreign Direct Investment

Figure 7.1 Yearly Foreign Direct Investment Inflows

Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years.

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As shown in Figure 7.1, global FDI inflows averaged $548 billion annually between 1994 and 1999. FDI inflows peaked at around $1.4 trillion in 2000 and then slowed. Strong economic performance and high corporate profits in many countries lifted FDI inflows in 2004, 2005, 2006, and reached an all-time record of more than $1.9 trillion in 2007. Global financial crises and slower global economic growth meant declining FDI inflows in 2008 and 2009. FDI inflows climbed again in 2010 and 2011 but then fell back to $1.35 trillion in 2012 due to a fragile global economy and uncertain government policies. FDI inflows are expected to rise to $1.6 trillion in 2014 and $1.8 trillion in 2015 as the world emerges from recession.

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Drivers of FDI Flows

Drivers of FDI Flows

Globalization

Mergers and Acquisitions

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The two main drivers of FDI flows are

Globalization: As countries lowered their trade barriers, companies realized that they could now produce in the most efficient and productive locations and simply export to their markets worldwide. This set off another wave of FDI flows into low-cost emerging markets. The forces behind globalization are, therefore, part of the reason for long-term growth in FDI.

International Mergers and Acquisitions: The number of mergers and acquisitions (M&As) and their rising values over time also underlie long-term growth in FDI. In fact, cross-border M&As are the main vehicle through which companies undertake FDI.

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Value of Cross-Border Mergers and Acquisitions

Figure 7.2 Value of Cross-Border Mergers and Acquisitions

Source: Based on World Investment Report (Geneva, Switzerland: UNCTAD), various years.

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By 2007, the value of cross-border M&As rose to around $1 trillion. But M&A activity was significantly lower in 2008, 2009, and 2010 due to effects of the global financial crisis and global economic slowdown. By 2011, the value of cross-border M&A activity had climbed back to $526 billion but then fell back to around $300 billion in 2012.

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Worldwide Flows of FDI

Driving FDI growth are more than 100,000 multinational companies with more than 900,000 affiliates abroad.

In 2012, developing countries attracted greater FDI inflows than did developed countries.

Developed countries account for 42 percent ($561 billion) of total global FDI inflows.

FDI inflows to developing countries accounted for around 52 percent of world FDI inflows ($703 billion).

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Driving FDI growth are more than 100,000 multinational companies with more than 900,000 affiliates abroad, roughly half of which are in developing countries. In 2012, for the first time ever, developing countries attracted greater FDI inflows than did developed countries.

Developed countries account for 42 percent ($561 billion) of total global FDI inflows (more than $1.35 trillion in 2012). By comparison, FDI inflows to developing countries accounted for around 52 percent of world FDI inflows ($703 billion). The remaining roughly six percent of global FDI inflows went to countries across Southeast Europe in various stages of transition from communism to capitalism.

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Quick Study 1

The purchase of physical assets or significant ownership of a company abroad to gain a measure of management control is called a what?

What are the main drivers of foreign direct investment flows?

Why might a company engage in a cross-border merger or acquisition?

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Theories of Foreign Direct Investment (1 of 4)

International Product Life Cycle

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The international product life cycle theory states that a company begins by exporting its product and then later undertakes FDI as a product moves through its life cycle.

In the new product stage, a good is produced in the home country because of uncertain domestic demand and to keep production close to the research department that developed the product.

In the maturing product stage, the company directly invests in production facilities in countries where demand is great enough to warrant its own production facilities.

In the final standardized product stage, increased competition creates pressures to reduce production costs. In response, a company builds production capacity in low-cost developing nations to serve its markets around the world.

Despite its conceptual appeal, the international product life cycle theory is limited in its power to explain why companies choose FDI over other forms of market entry.

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Theories of Foreign Direct Investment (2 of 4)

Market Imperfections (Internalization)

Market Imperfections

Trade Barriers

Specialized Knowledge

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Market imperfections theory states that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake FDI to internalize the transaction and thereby remove the imperfection.

There are two market imperfections that are relevant to this discussion—trade barriers and specialized knowledge.

Trade Barriers: Tariffs are a common form of market imperfection in international business. The presence of a market imperfection (tariffs) might cause companies to undertake FDI.

Specialized Knowledge: This knowledge could be the technical expertise of engineers or the special marketing abilities of managers. When a company’s specialized knowledge is embodied in its employees, the only way to exploit a market opportunity in another nation may be to undertake FDI. The possibility that a company will create a future competitor by charging others a fee for access to its knowledge is another market imperfection that encourages FDI.

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Theories of Foreign Direct Investment (3 of 4)

Eclectic Theory

Location Advantage

Ownership Advantage

Internalization Advantage

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The eclectic theory states that firms undertake foreign direct investment when the features of a location combine with ownership and internalization advantages to make a location appealing for investment.

A location advantage is the advantage of locating a particular economic activity in a specific location because of its natural or acquired characteristics.

An ownership advantage is a company advantage that arises from ownership of some special asset, such as a powerful brand, technical knowledge, or management ability.

And an internalization advantage is the advantage that arises from internalizing a business activity rather than leaving it to a relatively inefficient market.

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Theories of Foreign Direct Investment (4 of 4)

Market Power

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The market power theory states that a firm tries to establish a dominant market presence in an industry by undertaking FDI.

The benefit of market power is greater profit because the firm is far better able to dictate the cost of its inputs and/or the price of its output.

One way a company can achieve market power (or dominance) is through vertical integration—the extension of company activities into stages of production that provide a firm’s inputs (backward integration) or that absorb its output (forward integration).

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Quick Study 2

What imperfections are relevant to the discussion of market imperfections theory?

Location, ownership, and internalization advantages combine in which FDI theory?

Which FDI theory depicts a firm establishing a dominant market presence in an industry?

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Management Issues and Foreign Direct Investment

Control

Purchase-or-Build Decision

Greenfield investment

Production Costs

Rationalized production

Mexico’s Maquiladora

Cost of research and development

Customer Knowledge

Following Clients

Following Rivals

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Control: Many companies investing abroad are greatly concerned with controlling the activities that occur in the local market.

Purchase-or-Build Decision: Another important matter for managers is whether to purchase an existing business or to build a subsidiary abroad from the ground up—called a greenfield investment.

Production costs are important inputs to the FDI decision.

One approach companies use to contain production costs is called rationalized production—a system of production in which each of a product’s components is produced where the cost of producing that component is lowest.

Mexico’s Maquiladora: The combination of a low-wage economy nestled next to a prosperous giant is now becoming a model for other regions that are split by wage or technology gaps.

Cost of Research and Development : As technology becomes an increasingly powerful competitive factor, the soaring cost of developing subsequent stages of technology has led multinational corporations to engage in cross-border alliances and acquisitions.

Customer Knowledge: The behavior of buyers is frequently an important issue in the decision of whether to undertake FDI.

Following Clients: Firms commonly engage in FDI when the firms they supply have already invested abroad.

Following Rivals: FDI decisions frequently resemble a “follow the leader” scenario in industries that have a limited number of large firms. In other words, many of these firms believe that choosing not to make a move parallel to that of the “first mover” might result in being shut out of a potentially lucrative market.

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Quick Study 3

When adequate facilities are not present in a market, a firm may decide to undertake a what?

A system in which a product’s components are made where the cost of producing a component is lowest is called what?

What do we call the situation in which a company engages in FDI because the firms it supplies have already invested abroad?

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Why Governments Intervene in FDI (1 of 4)

Balance of Payments

Current Account

National account that records transactions involving the export and import of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country

Capital Account

National account that records transactions involving the purchase and sale of assets

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A balance of payments is a national accounting system that records all payments to entities in other countries and all receipts coming into the nation.

The current account records transactions involving the import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country.

The capital account records transactions involving the purchase or sale of assets. These assets include physical assets such as foreign direct investments in factories and equipment, and financial assets such as shares of stock in a company abroad.

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Table 7.1 U.S. Balance of Payments Accounts

CURRENT ACCOUNT Blank Blank Blank
Exports of goods and services and income receipts + Blank Blank
Merchandise + Blank Blank
Services + Blank Blank
Income receipts on U.S. assets abroad + Blank Blank
Imports of goods and services and income payments Blank Blank
Merchandise Blank Blank
Services Blank Blank
Income payments on foreign assets in United States Blank Blank
Unilateral transfers Blank Blank
Current account balance Blank +/- Blank

U.S. Balance of Payments Accounts (1 of 2)

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Table 7.1 shows the balance of payments accounts for the United States, which has two major components—the current account and the capital account. The balances of the current and capital accounts should be equal.

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U.S. Balance of Payments Accounts (2 of 2)

Table 7.1 [continued]

CAPITAL ACCOUNT Blank Blank Blank
Increase in U.S. assets abroad (capital outflow) Blank Blank
U.S. official reserve assets Blank Blank
Other U.S. government assets Blank Blank
U.S. private assets Blank Blank
Foreign assets in the United States (capital inflow) + Blank Blank
Foreign official assets + Blank Blank
Other foreign assets + Blank Blank
Capital account balance Blank +/- Blank

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Why Governments Intervene in FDI (2 of 4)

Reasons for Intervention by the Host Country

Control the Balance of Payments

Obtain Resources and Benefits

Access to Technology

Management Skills and Employment

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There are a number of reasons why governments intervene in FDI. Let’s look at the two main reasons—to control the balance of payments and to obtain resources and benefits.

Control Balance of Payments: Many governments see intervention as the only way to keep their balance of payments under control.

Obtain Resources and Benefits: Beyond balance-of-payments reasons, governments might intervene in FDI flows to acquire resources and benefits such as technology, management skills, and employment.

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Why Governments Intervene in FDI (3 of 4)

Home Country: Discouraging Outward FDI

Investing in other nations sends resources out of the home country and lowers investment at home.

FDI outflow can damage a nation’s balance of payments if the investment abroad eliminates an export market.

Jobs created abroad by an FDI outflow may replace jobs in the home country.

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The following are among the most common reasons for discouraging outward FDI:

Investing in other nations sends resources out of the home country and lowers investment at home.

An FDI outflow can damage a nation’s balance of payments if the investment abroad eliminates an export market.

And jobs created abroad by an FDI outflow may replace jobs in the home country.

Home countries may also promote outward FDI.

FDI outflows can improve long-run competitiveness if partnering abroad provides a learning opportunity.

FDI outflows can eliminate low-wage jobs in industries that use obsolete technology or employ low-skilled workers at home.

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Why Governments Intervene in FDI (4 of 4)

Home Country: Promoting outgoing FDI

Increase Long-Term Competitiveness

“Sunset” Industries

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FDI is not always a negative influence on home nations. In fact, countries promote outgoing FDI for the following reasons:

Outward FDI can increase long-term competitiveness.

Nations may encourage FDI in industries identified as “sunset” industries. Sunset industries are those that use outdated and obsolete technologies or those that employ low-wage workers with few skills.

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Government Policy Instruments and FDI (1 of 3)

Table 7.2 Instruments of FDI Policy

Blank FDI Promotion FDI Restriction
Host Countries Tax incentives Ownership restrictions
Blank Low-interest loans Performance demands
Blank Infrastructure improvements Blank
Home Countries Insurance Differential tax rates
Blank Loans Sanctions
Blank Tax breaks Blank
Blank Political pressure Blank

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Over time, both host and home nations have developed a range of methods either to promote or to restrict FDI (see Table 7.2). Governments use these tools for many reasons, including improving balance-of-payments positions, acquiring resources, and, in the case of outward investment, keeping jobs at home.

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Quick Study 4

The national accounting system that records all receipts coming into a nation and all payments to entities in other countries is called what?

Why might a host country intervene in foreign direct investment?

Why might a home country intervene in foreign direct investment?

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Government Policy Instruments and FDI (2 of 3)

Host Countries

Promotion

Financial incentives

Low or waived taxes

Low-interest loans

Infrastructure improvements

Better seaports, roads, and telecom networks

Restriction

Ownership restrictions

Prohibit investment

Performance demands

Local content requirements

Export targets

Technology transfer

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Host countries offer a variety of incentives to encourage FDI inflows. These take two general forms—financial incentives and infrastructure improvements.

Financial Incentives: Host governments of all nations grant companies financial incentives to invest within their borders. One method includes tax incentives, such as lower tax rates or offers to waive taxes on local profits for a period of time—extending as far out as five years or more. A country may also offer low-interest loans to investors.

Infrastructure Improvements: Because of the problems associated with financial incentives, some governments are taking an alternative route to luring investment. Lasting benefits for communities surrounding the investment location can result from making local infrastructure improvements—better seaports suitable for containerized shipping, improved roads, and advanced telecommunications systems.

Host countries also have a variety of methods to restrict incoming FDI. Again, these take two general forms—ownership restrictions and performance demands.

Ownership Restrictions: Governments can impose ownership restrictions that prohibit nondomestic companies from investing in certain industries or from owning certain types of businesses.

Performance Demands: More common than ownership requirements are performance demands that influence how international companies operate in the host nation.

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Government Policy Instruments and FDI (3 of 3)

Home Countries

Promotion

Insurance on assets abroad

Loans and loan guarantees

Special tax treaties

Tax breaks on profits earned abroad

Persuade other nations to accept FDI

Restriction

Higher taxes on foreign income

Sanctions that prohibit investing in certain nations

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To encourage outbound FDI, home-country governments can do any of the following:

Offer insurance to cover the risks of investments abroad, including, among others, insurance against expropriation of assets and losses from armed conflict, kidnappings, and terrorist attacks.

Grant loans to firms wishing to increase their investments abroad.

Offer tax breaks on profits earned abroad or negotiate special tax treaties.

Apply political pressure on other nations to get them to relax their restrictions on inbound investments.

On the other hand, to limit the effects of outbound FDI on the national economy, home governments may exercise either of the following two options:

Impose differential tax rates that charge income from earnings abroad at a higher rate than domestic earnings.

Impose outright sanctions that prohibit domestic firms from making investments in certain nations.

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Quick Study 5

What policy instruments can host countries use to promote FDI?

What policy instruments can home countries use to promote FDI?

Ownership restrictions and performance demands are policy instruments used by whom to do what?

Differential tax rates and sanctions are policy instruments used by whom to do what?

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Copyright

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