2.0 Foreign Direct Investment: (I) Availability of Raw Materials

~ 2.
0 FOREIGN DIRECT INVESTMENT

Regardless of where one lives (in any country) chances are that the person must have come
across the names of various MULTINATIONALS SUCH AS IBM - MITSUBISHI - TOYOTA-
DAIMLER - BENZ - SIEMENS - SONY - NESTLE - UNILEVER - XEROX etc.
These multinationals belong to countries like USA - Japan - Germany - Switzerland - U.K.
These mammoth organisations, which measure sales by the tens of billions of U.S. Dollars and
employment by the tens or even hundreds of thousands, have evaluated expected cash flows and
risks and decided that FDI is worthwhile. But what makes expected cash flows and risks and what
they are? Further more can anything be done to influence them? For example, can transfer prices
of goods and services moving within a multinational corporation be used to reduce taxes Of other-
wise increase net cash flows? The growth of the multinational corporation has been a result of
Copyright © 2009. Himalaya Publishing House. All rights reserved.
foreign direct investments which have taken place in the past. Strategic overseas investment is
especially important in dynamic and changing markets, such as publishing and fashion clofuing,
where subsidiaries must keep in line with local needs and where shipping time is vital. In addition
to strategic reasons for direct investment, numerous other reasons have been put forward and while
these are not strictly financial, they are also to be discussed.
~ 2.1 RATIONAL OR REASONS OF GROWTH

(i) Availability of Raw Materials: If there are mills producing denim cloth in other countries
and the quality is good and the price is attractive, why should a firm like AVIV A CORPORATION
buy the material abroad, ship it to the United States, manufacture the jeans, and then ship the finished
garments? Cleanly, if the ability exists to manufacture the jeans in the foreign market, the firm can
eliminate two way shipping costs - for denims in one direction and jeans in the order - by directly
investing in a manufacturing plant abroad. Many industrial firms, most particularly mining
companies, have little choice but to locate at the site of their raw materials. If copper or iron are is
being smelted, it often does not make sense to ship the ore when a smelter can be built near the mine
(22)
Agarwal, O. P.. International Financial Management, Himalaya Publishing House, 2009. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/inflibnet-ebooks/detail.action?docID=618187.
Created from inflibnet-ebooks on 2019-01-07 03:21:25.
site. The product of the smelter - the copper or iron bars, which weigh much less than the original
ore - can be shipped out to the market. But we still have to ask why it would be a foreign firm rather
than an indigenous firm that would carry out the enterprise. With an indigenous firm there would
be no foreign direct investment. Thus, to explain FDI, we must explain why a multinational
corp0rate organisation can do things better or cheaper than local firms .
(ii) Integrating operations: When there are advantages to vertical integration in terms of
assured delivery between various stages of production and the different stages can be performed
better in different locations (as with the smelting of ores) there is good reason to invest abroad.
(iii) Non-Transferable Knowledge: It is often possible for firms (corporations) to sell their
knowledge in the form of patent rights, and to license a foreign producer. This relieves a firm that
has a production process or product patent can make a larger profit by doing the foreign
production itself. This is because there are some kinds of knowledge which cannot be sold and
which are the results of years of experience. A viva, for example, might be able to sell patterns and
designs, and it can license the use of its name, but it can not sell a foreign firm its experience in
producing and marketing the product. This points to another reason why a firm might wish to do
its own foreign production .
(iv) Protecting Reputations: Products develop good or bad names, and these are carried
across international boundaries. Even people in Russia, for example, know the names of certain
brands of jeans. It would not serve the good name of A viva Corporation to have a foreign licensee
to do a shoddy job in producing jeans with the Aviva Label. Similarly, it is important for
multinational restaurant and hotel chains to maintain homogeneous quality to protect their
reputations, (as in case of Pizza Hut or McDonald). We find that there can be valid reasons for
direct investment rather than licensing in terms of transferring expertise and ensuring the
maintenance of a good name.
(v) Exploiting Reputations: FDI may occur to exploit rather than protect a reputation. This
motivation is probably of particular importance in foreign direct investment by banks and it takes
the form of opening branches and establishing or buying subsidiaries. One of the reasons why
banking has become an industry with mammoth multinationals is that an international reputation
can attract deposits, many associate the size of a bank with its safety. For example, a name like
Chase, or Citibank in a small, less developed nations is likely to attract deposits away from local
banks. Reputation is also important in accounting such as accountancy firms like Arthur Andersen
or Price Waterhouse. This is why many large industrial nations such as U.S.A./U.K./Japan/South
Korea and India have pushed in global trade negotiations for a liberalisation of restrictions on
services, including accounting and banking.
(vi) Protecting Secrecy: Direct investment may be preferred to the granting of a license for a
I foreign company to produce a product if secrecy is important. This point has been raised by IMF
which argues that a firm can be motivated to choose direct investment over licensing by a feeling
that, while a licenses will take precautions to protect patent rights, it maybe less conscientious
than the original owner of the patent.
(vii) Product's life cycle continUity: It is argued - Raymond Vern an - International Investment
and International Trade in the Product Life Cycle - 1966 - that opportunities for further gains at
home eventually dry up. To maintain the growth of profits, the corporation must venture abroad to.
where markets are not as well penetrated and where there is perhaps less competition. This makes
direct investment the natural consequence of being in business for a long enough time and doing
well at home. There is an inevitability in this view that has concerned those who believe that
American firms are further along in their life-cycle development than the firms of other nations
and are, therefore, dominant in foreign expansion However, even when U.S. firms do expand into
foreign markets, their activities are often scrutinised by the host governments. Moreover, the
spread of U.S. multinationals has been matched by the inroads of foreign firms into the U.S.A.,
particularly noticeable have been auto and auto-parts producers such as ToyotaIHondalNissan and
Michelin tyres.
(viii) Capital availability: Access to capital markets is one of the reasons as to why firms
themselves move abroad. The smaller one-country licensee does not have the same access to
cheaper funds as the larger firms, so the larger firms are able to operate within foreign markets
with a lower discount rate.
(ix) Strategic motivation for FDI: Companies enter foreign markets to preserve market share
when this is being threatened by the potential entry of indigenous firms (corporations) or
multinationals from other countries. The strategic motivation for FOI has always existed, but it
may have contributed to the multi-nationalisation of business as a result of improved access to
capital markets. This is different from the argument concerning the differential cost of capital,
given previously. In the case of increased strategic FOI, it is globalisation of financial markets that
has reduced entry barriers due to large fixed costs. Access to the necessary capital means a wider
set of companies with an ability to expand into any given market. This increases the incentive to
move and enjoy any potential fir~ t mover advantage.
(x) Operation in many markets for bigger sales: The organisation theory - The Behavioural
Theory of the Firm and Top Level Corporation Decisions - E. Eugene Carter - 1971 - view of
direct investment emphasises broad management objectives in terms of the way management
attempts to shift risk by operating in many markets, achieve growth in sales, and so on as opposed
to concentrating on the traditional economic growth of profit maximisation.
(xi) Avoiding Tariffs and Quotas: Another reason for producing abroad instead of producing
at HOME COUNTRY and shipping the product concerns the import tariffs that might have to be
paid. If import duties are in place, a firm might produce inside the foreign market in order to avoid
them. Tariffs protect the corporation engaged in production in the foreign market, whether it be a
foreign corporation or an indigenous company. Tariffs cannot, therefore explain why foreign
corporation move abroad, and yet the movement of companies is the essence of direct investment.
Nor, along similar lines, can tax write offs, subsidised or even free land offerings, and so on
explain direct investment, since foreign companies usually are not helped more than domestic
ones. There have been cases where the threat of tariffs or quantitative restrictions on imports in the
form of quotas have prompted direct investment overseas.
In multinationals, reputation has value when a supplier's reputation is a SIGNAL OF GOOD QUALITY.
Reputation is important when quality is difficult to observe directly and thus this issue is particularly relevant
with services.
(xii) Escaping Regulations: In multi-nationalisation of banking direct investment has been
made by banks to avoid regulations. This has al so been a motivation for foreign investment by
manufacturing companies for example a case might be made that some companies have moved to
escape standards set by the U.S. Environmental Protection Agency, the Occupational Safety and
Health Administration and the other agencies. Some foreign countries, live India Pakistan,
Tanzania with lower environmental and safety standards offer a haven to corporations using
DIRTY OR DANGEROUS PROCESSES. The items produced such as chemicals, drugs and
fertilisers may be even be offered for sale back in the U.S .A.
(xiii) Production flexibility: When the production costs in one country is particularly LOW
because of a rCilI depreciation of its currency. Multinational corporations maybe able to relocate
production to exploit the opportunities that real depreciations offer. This requires, of course, that
necessary technology can be transferred easily between countries and that trade unions or
governments do not make the shifting of production too difficult. Small manufactured goods such
as computer components, television, mobiles etc lend themselves to such shuffling of production,
whereas automobile production, with its international unions and expensive set up costs, does not.
(xiv) Symbiotic Relationship: Some corporations follow clients who make FDI. For example,
large U.S . accounting companies which have knowledge of parent companies' special needs and
practices have opened offices in countries where their clients have opened subsidiaries. These U.S.
accounting companies have an advantage over local companies because of their knowledge of the
parent and because the client may prefer to engage only one company in order to reduce the
number of people with access to sensitive information. The same factor may apply to consulting/
legal and securities companies which often follow their home country clients' direct investment by
opening offices in the same foreign locations.
(xv) Portfolio Diversification: This service is valued only if shareholders are unable to diversify
themselves. This requires the existence of segmentation capital markets that only the MNC can overcome.
This argument also causes the growth of MNCs depend on market imperfections.
(xvi) Empirical evidence of growth of MNCs: The growth of MNCs depends on the nature of
the MNCs business, partly as a result or this, the empirical evidence we have on MNCs tends to be
limited to some stylised facts about the nature of the industries in which most direct investment
occurs. More investment occurs in those industries that have offered investors HIGHER RETURNS.
There also appears to be a connection betweens domestic economic activity and foreign investment
with good conditions at HOME discouraging investment abroad.
Multinationals are not exploiters of purity but rather creatures of market imperfections or failures. The
best way to understand their behaviour is to understand those imperfections and how they are developing.
Broadly, two sorts of imperfections are relevant. One is structural imperfection , which maybe natural like
transport costs or MANMADE Examples of the latter include government restrictions on investment or
imports, taxes and subsidies, inadequate capital markets and monopolistic or oligopolistic markets. Many of
ii there sorts of imperfect;ons have indeed been disappearing in the industrial countries and are beginning in '"
;; developing ones. ;
n ;
'; b I The othedr. sort of. impeErfectioln is inhherent in tr~nsachtions and mi' arke~sll tdhell~selves ha~d has ~ot, °h n .'•.:'•,.',.:',.:'
t a ance, been Isappeanng. xamp es are t e uncertalllty t at a supp ler WI elver on IS promIse, t e '.
~;;.;,
volatility of exchange rates, the difficulty that customers face in evaluating unfamiliar products, the costs of
negotiating deals, economies of scale in production. purchasing, research and development, distribution or
marketing, which give advantages to existing corporations and impose barriers against newcomers, concerns
about infringement of intellectual property rights, uncertainty about competitors actions, the opportunity to
spread risks though diversification .
... 2.2 RISKS AND CONSTRAINTS

There are various risks or constraints which are faced by multinationals The risks are.
(a) Country Risk (or political or sovereign risk): Country risk involves the possibility of
losses due to country specific economic, political and social events and therefore, all political risk
is country risk, but not all country risk is political risk. Sovereign risk exists on bank loans and
bonds and is therefore not of special concern to MNCs - unless they are banks. Among the country
r~sks that are faced on an overseas direct investment are those related to the local economy, those
due to the possibility of confiscation and those due to the possibility of expropriation (which refers
to a government takeover with compensation, which at times can be generous). While these are not
the result of action by foreign governments specifically directed at the corporation, they can
damage or destroy an investment. In addition, there are risks of currency inconvertibility and
restrictions on the repatriation of income.
One of the technique for reducing the expropriation is for the owner of a FOI to promise to
turnover ownership and control to local people in the future.

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~ 2.

0 FOREIGN DIRECT INVESTMENT

~ 2.1 RATIONAL OR REASONS OF GROWTH

... 2.2 RISKS AND CONSTRAINTS

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