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Foreign Direct Investment

(FDI) and Globalization


Barry Naughton
IR/PS October 17, 2006
I. Foreign Direct Investment (FDI) Macro: The
Global Picture.
A. Definition
B. Trends
C. Worldwide Driving Forces
D. Country Patterns
II. FDI Micro: the Firm’s Eye View.
A. Firm-specific advantage and country locational
advantage.
B. The Value Chain and Global Production Networks.
C. Eclectic Theory of the Firm: O,I,L
Foreign Direct Investment (FDI):
The Big Picture:
• Investment and trade are the two crucial dimensions of “open-ness,”
determining the extent to which a national economy is open to global
economic forces.

• Investment and services are, along with trade, the main issues in
international economic negotiations. More than trade, FDI leads to a blurring
of the boundary between domestic and foreign, raising issues of regulation,
legal system and intellectual property rights.

• Distinctive feature of the 4th Period of Globalization (1975-present): Two


turning points: after 1975, global capital flows became much more important;
since 1990, FDI has been consistently the most important source of long-
term capital.

• Investment is another way that economies and firms interact in an attempt to


exploit the economic differences between them. Their should be “gains from
investment” just as there are “gains from trade,” but issues of control,
sovereignty, and distribution of gains are not easy to resolve.
IA. Foreign Direct Investment:
Definition
• Involves managerial control of a
productive asset.
• At least 10% of ownership, but can have
a variety of ownership structures (joint-
ventures; wholly-owned subsidiaries).
• Can involve either creation of new assets
(import of machinery and other capital), or
purchase of existing assets.
Context: FDI is One Component of
Private Capital Flows
Private Capital Flows consist of:
A. FDI
B. Portfolio Investment
1. Stocks
2. Bonds
C. Bank Lending
1. Short-term
2. Long-term
D. Other
Foreign Direct Investment
• Because the multi-national firm retains
some control, FDI is investment that is
“outside the country, but inside the firm.”

• FDI comes in a “package”: not just money,


also capital goods, technology,
management skills, access to markets,
etc. [Unlike “indirect,” or portfolio
investment.]
Let’s Look at Some Numbers….
Billion US Dollars IB

200
400
600
800
1,000
1,200

0
1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994
Countries
Developed

1995

1996

1997
World FDI Inflows

1998

1999

2000
Countries
Developing

2001

2002

2003

2004

2005
Developed Country FDI and Mergers and
Acquisitions (M&A)
1,200

1,000
FDI

800
Billion US Dollars

600

400

200 efinition
Data D 2002
M&A Change
s

0
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Developed Country FDI
• Both developed and developing country FDI are
of interest, but they show different things.
• Developed country FDI: countries tend to have
similar “inward” and “outward” stocks. Balanced,
diversified, not big net creditors or debtors (in
FDI only).
• Multinational corporations invest first in the
“Triad regions” (EU, NA, Japan), and
subsequently go global.
Developing Countries FDI and M&A
!
ent
400 r
iffe
D
350 is
c ale FDI
a lS
tic
300
e r
V
250
Billion US Dollars

200

150

M&A
100

50

0
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Developing Country FDI
• Associated with net flow from developed
to developing countries.

• Usually involves new construction—so-


called “greenfield” investment—including
import of capital equipment.

• Now an important part of developing


country capital formation (investment), but
not the main part.
FDI in the US and China
350

300 US

250
Billion US Dollars

200

150

100
China

50

0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Policy toward Foreign Direct
Investment (FDI)
• After the debt crisis of the 1980s,
developing countries became much more
favorable to FDI. It seemed to promise:
– Capital
– Transfer of technology, management skills.
– Marketing channels
– Less volatility: long-term commitment
reinforced by less mobile assets.
» Let’s pick up on the volatility issue…..
Overall, Private
Capital Flows
Have Been
Extremely
Volatile:
Particularly
those to
Developing
Countries
Total Resource Flows to
Developing Countries have
Recovered Since 2002
IC: Global Driving Forces
• Advances in information technology and supply chain
management.
• Liberalization of trade and investment regime; WTO
rules move toward investment
– TRIMS (Trade-related Investment Measures),
– TRIPS (Agreement on Trade-related Intellectual
Property Rights)
– GATS (General Agreement on Trade in Services)
• Privatization.
• Collapse of Communism and opening of Eastern
Europe, USSR and China.
One Result of Systemic Change:
• An increasing share of FDI is in service sectors.
– Services have accounted for two-thirds of total FDI
inflows recently. Of the accumulated stock of FDI,
60% is in services ($4 trillion).
– Finance and trade the largest components, but
electricity, telecom, and business services are
growing rapidly. (Natural resources have rebounded
since 2005.)
• The US is the biggest source and the biggest
destination. What other countries are large
hosts of FDI?
Largest FDI Host Countries ($ Billion, end-2005)
EU (includes intra-EU) 4,499 UK 817
US 1,626 France 601
Hong Kong 533 Germany 502
Canada 357 Netherlands 463
China 318
Australia 211
Mexico 210
Brazil 201
Singapore 187
Switzerland 172
Russia 132
Bermuda 102
Japan 101
Chile 74
South Africa 69
British Virgin Islands 67
Korea 63 Source: UNCTAD, WIR 2006
Thailand 56
Argentina 55
Malaysia 48
India 45
To Summarize: FDI Country
Patterns
• Rapid sustained increase in FDI flows, peaking
in 2000 at over $1.4 trillion, dropping to half that
in 2003, before recovering strongly.
• US the largest source of FDI ($2.1 trillion
outward stock 2005 and the largest recipient ($1.6
trillion inward stock 2005).
• Developed countries used to account for over
90% of outflows, now it is over 80%, since more
LDC investment is emerging.
• Developed countries also account for about 60%
of inflows in recent years.
Summarizing Country Patterns
(cont.): Japan is the Outlier
• In late 1980s, Japan was largest source of
outgoing FDI, but its share has fallen since
1991. Back in 1990, when Japan was already
the world’s largest source country, its stock of
inward FDI was still less than $10 billion in 1990,
when it was the world’s large source country.
• Japan’s stock of inward FDI was still only $50
billion in 2000. Liberalization since the late
1990s has been significant, but still lags other
developed countries.
• UK $817 billion inward stock ($1.24 trillion
outward stock), rapid growth of intra-European
investment.
II. FDI: The Microeconomic
Perspective
• A New Actor: The trans-national firm. The
investment decision is made by a firm,
based on its own interest.
• Firms have choices:
– Which activities they perform.
– Where they locate those activities.
– How the activities should be linked together.
• Why do firms incur the extra cost of
operating at a distance across borders in
unfamiliar markets?
Firms invest across borders
because they see an opportunity to
increase profit.
At a minimum, that means bringing together
two considerations:
1. A firm-specific competitive advantage
(sometimes called an “ownership”
advantage);
2. A location-specific advantage for the host
country.
Firm-specific competitive
advantage:
Sustainable competitive advantage, or “core
competence.” Not readily copied.
• Tangible or intangible firm-specific assets.
• Examples:
– Technology.
• Proprietary technologies
• Sustained R&D spending, maintaining a lead.
– Brand: Consumer recognition, defended with
advertising, packaging, and incremental product
innovation as well as quality control.
– Logistics and inventory management.
– Etc.
(Also called “ownership advantages”)
Location-specific advantage
• Market access.
– Size: High per capita income and large population.
– Being close to customers and circumventing trade barriers: investing “under”
tariff walls. ?
• Policy reform
– Liberalizing entry (sectoral, ownership, local-content and indigenization
restrictions)
– Privatization
– Incentives; taxes.
– Dependable and transparent legal system (but how well does China fit?)
• Access to Resources
• Low factor costs (abundant factor endowments):
– Low labor costs.…
• …but productivity matters (unit labor costs).
– Countries with natural resources
• Oil, mining, and plantation agriculture.
– Specific resources, such as research and development (R&D) capability.
How do companies decide which
locations are most advantageous,
given their firm-specific competitive
advantages?
• To get a sense of the range of firm
strategies, let’s use the concept of the
value chain.
Research Value Chain
Product Design (Generic Version)
Core Components

Sourcing

Assembly A sequence of
Distribution related activities, or
Marketing functions, all of
Retailing which add value to
Service the final product or
Final service
Market
A Corporate Strategy Perspective
• Identify specifically the areas in which the
corporation has firm-specific assets, where it has
unique capabilities that create competitive
advantage.
• Focus on those “core businesses”.
• Leverage those capabilities by expanding
geographically.
• Spin-off non-core businesses.
• Maintain control as architects of the value chain:
cross-border networks of FDI, long-term
cooperation, and contracting dominated by lead
firms, the major multinationals.
Value Chain
(Specific Version)
Research

Product Design

Core Components

Sourcing

Assembly

Distribution
Marketing Concentrate on those
links where you have
Retailing
sustainable competitive
Service advantage and global
Final competitiveness;
Market outsource everything
else.
Multi-national Firms create Global
Production Networks (GPNs)
• They seek to structure these networks to their
advantage—they serve as architects of the
networks.
• There is a complex interaction between the
activities in which the firm specializes, and the
related locational decisions.
• Locate activities in areas where they can be
performed at lowest cost.
• Access specific resources and capabilities
world-wide.
Services as well as Manufacturing:
Outsourcing to India
• Technical support
• Financial Services
• Catalog order-taking.
• Legal services (patent applications, divorce
papers, legal research). 200,000 Indians graduate from
law school annually (about 5X US); outsourcing has created about
12,000 law jobs worldwide, most of them in India.
• Accounting
• Research.
• All back-office business services.
New Technology Infrastructure
• Broadband connections (undersea cable, etc.)
• Cheap and ubiquitous computers
• Software to communicate, search, and
disaggregate business processes.

“When these things suddenly came together around 2000,


they created a platform where intellectual work,
intellectual capital, could be delivered from anywhere. It
could be disaggregated, delivered, distributed, produced,
and put back together again—and this gave a whole new
degree of freedom to the way we do work, especially
work of an intellectual nature.”
--Nandan Nilekani, CEO of Infosys Technologies Ltd.,
Bangalore, India, quoted in Tom Friedman, The World is Flat, p. 7.
FDI associated with the Successive
Stages of a Value Chain can be
called “Vertically Motivated”
• In this case, the resulting output is streamed into
that corporation’s GPN.

• Final markets can be anywhere, but markets in


developed countries, and especially the
corporation’s home country, are most important.
Conversely, FDI is sometimes
“Horizontally Motivated.”
• When a company seeks to reproduce, in another
company, the specific activity in which it already
has a competitive advantage.
• The company seeks to leverage the specific
capabilities and core competence it has already
developed.
• Most often this is market-seeking investment in
which goods or services are sold in the “host
country.”
In fact, for FDI to be chosen, a third
consideration must also be present:
• Firms have the choice of simply engaging in
arm’s length trade, or other forms of
cooperation.

• For a firm to decide to engage in foreign direct


investment, it must see some advantage to
maintaining the control implied by FDI.

• Some benefit to keeping the transactions “in


house” must be seen to compensate for the
extra cost of operating across borders.
I: Internalization Advantages
• Compensate for market failures and imperfections: moral
hazard and adverse selection.
• Inadequate property rights protection, or technology
inherently not able to protect.
– Market failures can preclude licensing.
– Control is important…
– …and defense of intellectual property rights.

• Wish to price discriminate (set different prices in different


markets).
• Capture economies of scale, or economies of inter-
dependent activities.
In fact, multi-national firms seek out
multiple organizational forms…
…to maximize the benefits and minimize the
cost of cross-border operations.
II. With control ( = FDI), and internalization
of management.
A. Wholly-owned subsidiaries
B. Joint Ventures
C. Minority stakes in foreign operations.
I. Without direct control, and with
transactions through the market.
A. Subcontracting.
B. Licensing.
C. Franchising.
D. Management contracts.
E. Non-equity (contractual) joint
ventures.
F. Turnkey projects.
G. Strategic partnerships.
Even though these last types do
not constitute FDI, they can be
central to the operation of GPNs
• Complex Value Chain Architecture
• Ownership (FDI) is mixed with a variety of other
relationships:
– Long-term contracting
– Brokers
– Partnerships and alliances
– “Networks”
• Nike as architect of its own value chain; Walmart
architect of its supply chain.
Dunning’s “Eclectic Theory of FDI”
FDI will occur when the firm perceives that all
three of the following factors are present (LOI):

3. Locational advantages (as discussed earlier--


low labor costs, natural resources, markets,
favorable regulatory regime). “L”

4. Ownership advantages (specific assets and/or


competitive advantages that can be exploited
internationally).“O”

5. Benefits to internalization (rather than selling at


arm’s length). “I”
The Effects on Trade
• Global production networks contribute
strongly to the growth of trade. Products
may move across borders several times in
the production process.
• Statistics are scarce, but it appears that in
2002, about 50% of all trade in
manufactures was associated with global
production networks.
• More than 35 percent of US trade is intra-
firm trade.
– Home companies export/import from their
subsidiaries.
– Foreign firms in US export/import from their
home companies and subsidiaries.
• Trade is still in line with comparative
advantage. Firms tend to locate
production stages in those economies that
abundantly (cheaply) possess the factor
that is intensively used. But it may not
look that way at first glance (example of
hard-disk drives next time).