In this chapter, you will explore foreign direct investment.

You will also:

•Learn about worldwide patterns of foreign direct investment flows and the theories that attempt to explain them.

•Understand important management issues in the foreign direct investment decision.

•And examine why governments intervene in the flow of foreign direct y g ginvestment and the methods they use.

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In this chapter, you will explore foreign direct investment.

You will also:

•Learn about worldwide patterns of foreign direct investment flows and the theories that attempt to explain them.

•Understand important management issues in the foreign direct investment decision.

•And examine why governments intervene in the flow of foreign direct y g ginvestment and the methods they use.

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•Foreign direct investment is the purchase of physical assets or a significant amount of the ownership of a company in another country to gain some measure of management control.

•It differs from portfolio investment, which is an investment that does not involve obtaining a degree of control in a company.

•Most governments set the FDI threshold at somewhere between 10 and 25 percent of stock ownership in a company abroad.

•The U.S. Commerce Department says that stock ownership above 10 percent constitutes FDI.

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As shown in this graph, yearly FDI inflows grew approximately 30% through the 1990s.

FDI inflows peaked at $1.4 trillion in 2000, slowed for several years, and then rebounded to reach an all-time high of $1.9 trillion in 2007.

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One main driver behind global flows of foreign direct investment is increasing globalization.

•Globalization of the world economy encourages firms to use FDI as a way to create low-cost production bases.

•It also prompts multinationals from advanced and emerging economies alike to buy up businesses in other markets.

Another driver is international mergers and acquisitions.

•Mergers and acquisitions have propelled long-term growth in FDI and will likely do so for the foreseeable future.

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This graph shows that annual worldwide FDI inflows rise and fall from year to year—which tend to follow the health of national economies.

Many cross-border mergers and acquisitions are intended to:

•Get a foothold in a new geographic market.

•Increase a firm’s global competitiveness.

•Fill gaps in companies’ product lines in a global industry.

•And reduce the cost of research and development production or distribution•And reduce the cost of research and development, production, or distribution.

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•More than 82,000 multinational companies with over 810,000 affiliates drive global FDI flows.

•Developed countries account for about 57% of all world FDI—the main recipients being the European Union, the United States, and Japan.

•Developing and emerging markets account for about 37% of global FDI, with the largest portions going to China and India.

•Outflows of FDI from emerging economies are also on the rise.

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Foreign direct investment is the purchase of physical assets or a significant amount of the ownership of a company in another country to gain a measure of management control. A portfolio investment is an investment that does not involve obtaining a degree of control in a company.

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The international product life cycle theory is divided into three stages:

•In stage 1, the new product stage, a good is produced entirely in the home market and virtually no export market exists.

•In stage 2, the maturing product stage, a good is produced in the home market and in markets abroad that are large enough to warrant production facilities.

•In stage 3, the standardized product stage, a company builds production capacity in relatively low-cost nations that will then serve global markets.

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The market imperfections (or internalization) 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 eliminate the imperfection.

•One type of market imperfection is a trade barrier, such as a tariff.

•Another type of imperfection is a company’s unique competitive advantage, such as specialized knowledge, technical expertise, or special abilities embodied in employeesin employees.

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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 abilitymanagement 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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The market power theory states that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment.

•The benefit of market power is increased profits because greater power helps a firm to dictate the cost of its inputs and/or the price of its output and thereby obtain a better ROI (return on Investment

•Companies can gain market power through vertical integration—the extension of activities into production that provide a firm’s inputs or absorb its output.

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The eclectic theory says that firms undertake FDI when location, ownership, and Internalization advantages combine to make a location appealing for investment.

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Many companies invest abroad to increase their control over factors such as selling price in a local market. But a host nation may demand shared ownership in an operation.

• Benefits to companies of shared ownership can include better communication with local government officials.

• Benefits to the host country are worker and industry protection, and more control over worker training and technology transfers.

The purchase-or-build decision entails deciding whether to purchase an existing business or to build a subsidiary from the ground up—called a greenfield investment.

• Benefits of purchasing a firm include the existing company’s goodwill in the marketplace, brand recognition, and potential sources of financing.

• Drawbacks of purchasing existing facilities can include obsolete equipment, poor labor relations and an unsuitable locationpoor labor relations, and an unsuitable location.

• A greenfield investment lets a company start operating with a clean slate, but drawbacks include obtaining permits, arranging financing, and hiring local personnel.

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Production costs that add to local labor costs include worker benefits, training programs, and burdensome regulations.

•Rationalized production, whereby each component is produced where its production cost is lowest, can be problematic if a work stoppage in one country can halt the entire production process.

•Mexico’s Maquiladora zone along the U.S.-Mexico border has become a model for other regions split by wage or technology gaps. Yet, union jobs in the United States are sometimes lost to nonunion jobs in maquiladora firms that operateStates are sometimes lost to nonunion jobs in maquiladora firms that operate under less stringent regulations.

•Lower research and development costs can encourage cross-border alliances and acquisitions, but such costs can be secondary to supply factors such as access to top scientists and technical experts.

Knowledge of customer and buyer behavior can be a key issue in the decision of whether to undertake FDI.

•A local presence can give companies valuable knowledge of customers that is unobtainable in the home market.

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•The practice of following clients into markets abroad typically occurs when suppliers of component parts have close working relationships with their customers. An FDI puts the supplier nearer to their customers where they can better understand and anticipate their needs.

•The practice of following rivals resembles a “follow the leader” scenario and is common in industries with a limited number of large firms. The force behind FDI is a belief that not matching rivals’ moves means the loss of a “first mover” advantage or being shut out of a lucrative market altogether.adva tage o be g s ut out o a uc at ve a et a toget e .

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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 plants and equipment and financial assets such as shares of stock in ain plants and equipment, and financial assets such as shares of stock in a company abroad.

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This table shows the U.S. balance of payments position for one recent year.

•Payments to entities in other nations are reductions in the balance of payments accounts and recorded with a minus (–) sign.

•Receipts from other nations are additions to the balance of payments accounts and recorded with a plus (+) sign.

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Answer:

A country’s 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 system helps a country monitor the flows of goods, services, income, and transfer of assets between itself and other nations. The balance of payments position sends warning signals about trade deficits with other nations.

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•Host countries get a balance-of-payments boost from initial FDI inflows. The balance-of-payments position benefits further if that investment produces goods destined for export.

•When a company repatriates profits back to its home market, it depletes the host nation’s foreign exchange reserves and decreases the balance of payments. This entices some host nations to restrict foreign firms from repatriating profits and to monitor transfer pricing arrangements between the operation and its Head Quarters.Qua te s.

•By contrast, a host country conserves its foreign exchange reserves when foreign companies reinvest earnings locally. This boosts the host nation’s exports and improves its balance-of-payments position.

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Host countries also intervene in foreign direct investments to obtain resources and benefits.

•Encouraging FDI in new technological products and processes increases the competitiveness and productivity of a host country.

•A host country can also obtain management skills and employment benefits if the FDI involves technical training of locals in how to operate facilities. Some of these managers may go on to establish their own homegrown businesses.

•In general, inflows of foreign direct investment tend to increase economic output and enhance standards of living in a host country.

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Home countries may discourage outward FDI for several reasons:

•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 promote outward FDI because:

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

•And FDI outflows can help export jobs in industries that use obsolete technology or employ low-wage, low-skilled workers at home.

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One method host countries can use to promote FDI inflows are financial incentives.

•Tax incentives and/or low-interest loans to attract investment are common incentives.

•But if bidding wars arise between locations competing for the investment, the cost of the FDI for taxpayers may be more than what the actual jobs will pay.

Other methods to promote FDI inflows include infrastructure improvements.

•Lasting benefits for communities in the host nation can arise from local infrastructure improvements—including better seaports for containerized shipping, improved roads, and advanced telecommunications systems.

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One method host countries can use to restrict FDI inflows are ownership restrictions.

•Governments can prohibit foreign companies from investing in certain industries or owning certain types of businesses.

•They may also require foreign investors to hold less than a 50% stake in a local firm.

Other methods to restrict FDI inflows include performance demands.

•Such demands can dictate the portion of a product’s content that originates locally, stipulate that a portion of output must be exported, or demand that certain technologies be transferred to local businesses.

•Australia has a foreign Investment review Board which oversees major and strategic investments on Australian soil

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To promote FDI outflows, home nations can:

•Offer insurance to cover the risks of investing assets abroad.

•Grant loans to firms wishing to increase their investments abroad.

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

•And apply political pressure to get other nations to relax their restrictions on FDI inflows.

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To restrict FDI outflows, home countries can:

•Impose a higher tax rate on income earned abroad than that levied on domestic earnings.

•And impose sanctions that prohibit domestic firms from making investments in certain nations.

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A host government may encourage an initial FDI because the inflow can __________ its balance-of-payments position.

a. Level

b. Lower

c. Boost

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A host government may encourage an initial FDI because the inflow can ____Boost______ its balance-of-payments position.

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In this chapter, you will explore regional economic integration.

You will also:

•Learn about the five different levels of integration.

•Understand the potential benefits and drawbacks of regional integration.

•And examine the progress of various efforts at integration around the world.

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