Lecture 4 FDI.ppt

Foreign Direct Investment (FDI)in
Emerging Markets

COMPANIES COLLABORATE
• Companies collaborate (use alliances that are
often called strategic alliances) abroad for much
of the same reasons they do so domestically.
However, there are some reasons specific to
international operations.
• Both domestically and internationally, companies
collaborate to spread and reduce costs, enable
them to specialize in their competencies, avoid
competition, secure vertical and horizontal links,
and gain knowledge.

FORMS OF AND CHOICE OF COLLABORATIVE
ARRANGEMENTS

•
Collaborative Strategy and Complexity of
Control
• The more equity a firm puts into collaborative
arrangement, coupled with the fewer partners
it takes on, the more control it will have over
the foreign operations conducted under the
arrangement.
• Note that non-equity arrangements typically
entail at least one and often several partners.

1. MANAGEMENT CONTRACTS
• An organization may pay for managerial assistance under a
management contract when it believes another can manage
its operation more efficiently than it can, usually because the
contractor has industry-specific capabilities.
• Such contracts are common when host governments want
foreign expertise, but do not want foreign ownership.
• In turn, the management company receives income without
having to make a capital investment.
• Airport operations, Hotels management contracts are also
popular.
• In essence, host-country real estate owners may have good
hotel locations, but know little about running a hotel.
• At the same time, many hotel chains have been shying away
from property ownership abroad because of the perceived
risk.

2. TURNKEY OPERATIONS
• Companies handling turnkey operations are usually industrial-equipment
manufacturers, construction companies, or consulting firms.
• Manufacturers also sometimes provide turnkey services when they are disallowed
to invest. The customer for a turnkey operation is often a governmental agency.
• Recently, most large projects have been in those developing countries that are
moving rapidly toward infrastructure development and industrialization.
Contracting to Scale
• One characteristic setting turnkey business is the size of contracts, frequently for
billions of dollars..
• Some projects are so large that they are handled by a consortium of turnkey
operators, such as the additional wider channel for the Panama Canal, led by
Spain’s Sacyr Vallehermoso.
• Often, smaller firms serve either as subcontractors for primary turnkey suppliers or
specialize in a particular sector, such as the handling of hazardous waste.
Making Contacts
• The nature of these contracts places importance on hiring executives with top-
level governmental contacts abroad, as well as on ceremony and building goodwill,
such as opening a facility on a country’s national holiday or getting a head of state
to inaugurate a facility. Although public relations is important to gain contracts,
other factors—price, are necessary to sell contracts of such magnitude

Marshaling Resources
• Many turnkey contracts are in remote areas, necessitating massive
housing construction and importation of personnel. Projects may involve
building an entire infrastructure under the most adverse conditions, such
as Bechtel’s complex for Minera Escondida high in the Andes, so turnkey
operators must have expertise in hiring people willing to work in remote
areas for extended periods and in transporting and using supplies under
very difficult conditions.
• If a company has a unique capability, such as the latest refining
technology, it will have little competition. As the production process
becomes known, however, competition increases.
• Companies from developed countries have moved largely toward projects
involving high technology, whereas those from such countries as China,
India, Korea, and Turkey can compete better for conventional projects
requiring low labor costs.
• The Chinese companies, China State Construction Engineering and
Shanghai Construction Group, have worked on subway systems in Iran and
Saudi Arabia, a railway line in Nigeria, a tourist complex in the Bahamas,
an oil pipeline in Sudan, and office buildings in the United States

3. FRANCHISING
• Franchising, a specialized form of licensing, the
parties act almost as a vertically integrated
company because they are interdependent and
each creates part of the product or service that
ultimately reaches the consumer.
• Franchisors once depended on trade shows and
costly visits to foreign countries to promote their
expansion.
• While such trade shows are still important,
especially for young franchising operations that
are not well-known, the Internet has given
companies another channel to exchange
information.

Franchise Organization
• A franchisor may deal directly with individual franchisees
abroad or set up a master franchise that has rights to open
outlets on its own or to develop sub-franchisees in the
country or region.
• Sub-franchisees pay royalties to the master franchisee, which
then remits some predetermined percentage to the
franchisor.
• Companies are most apt to use a master franchise system
when they are not confident about evaluating potential
individual franchisees and when overseeing and controlling
them directly would be too expensive.

Operational Modifications
• Franchising success generally depends as well on product and
service standardization, high identification through promotion, and
effective cost controls.
• The latter two are pretty straightforward, but transferring the home
country’s product and service, especially for food franchising, is
often difficult, first, because of local supplies.
• McDonald’s, for instance, had to build a plant to make hamburger
buns in the United Kingdom, while in Thailand it had to help
farmers develop potato production.
• Second, foreign country taste preferences may differ from those in
the home country—even within regions of large countries.
• In China, for example, Yum! Brands offers regionally different food
in its KFC and Pizza Hut outlets.
• However, the more adjustments made for the host consumers’
different tastes, the less a franchisor has to offer a potential
franchisee.

4. LICENSING
• 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.
• The rights for use of intangible property may be for an exclusive
license (the licensor can give rights to no other company for the
specified geographic area for a specified period of time) or a
nonexclusive one.
• The U.S. Internal Revenue Service classifies intangible property into
five categories:
1. Patents, inventions, formulas, processes, designs, patterns
2. Copyrights for literary, musical, or artistic compositions
3. Trademarks, trade names, brand names
4. Franchises, licenses, contracts
5. Methods, programs, procedures, systems
• Usually, the licensor is obliged to furnish sufficient information and
assistance, and the licensee is obliged to exploit the rights
effectively and pay compensation to the licensor.

why do so many firms apparently prefer FDI
over either exporting or licensing?
Limitations of Exporting
• The viability of exporting physical goods is
often constrained by transportation costs
and trade barriers.
• When transportation costs are added to
production costs, it becomes unprofitable
to ship some products over a large
distance.
• This is particularly true of products that
have a low value-to-weight ratio and that
can be produced in almost any location.
• Transportation costs aside, some firms
undertake foreign direct investment as a
response to actual or threatened trade
barriers such as import tariffs or quotas.
• by protectionist threats from Budget and
by tariffs on the importation
Limitations of Licensing
• internalization theory/market
imperfection approach
• First, licensing may result in a firm’s giving
away valuable technological know-how to
a potential foreign competitor.
• A second problem is that licensing does
not give a firm the tight control over
production, marketing, and strategy in a
foreign country that may be required to
maximize its profitability (tight control is in
FDI).
• A third problem with licensing arises when
the firm’s competitive advantage is based
not as much on its products as on the
management, marketing, and
manufacturing capabilities that produce
those products. ( lean could not be same
lean when used by other than Toyota)

All of this suggests that when one or more of
the following conditions holds, markets fail as
a mechanism for selling know-how and FDI is
more profitable than licensing:
(1) When the firm has valuable know-how that
cannot be adequately protected by a licensing
contract,
(2) When the firm needs tight control over a
foreign entity to maximize its market share
and earnings in that country, and
(3) When a firm’s skills and know-how are not
amenable to licensing.

5. Sales Contract
• A sales contract is a formal agreement
between a seller and a buyer laying out the
terms and conditions for which the sale of
goods is carried out.

JOINT VENTURES (JVs)
• JVs may involve more than two companies and ones in which a
partner owns more than 50 percent.
• For example, Flagship Ventures (U.S.), AstraZeneca (U.K.-Sweden),
Nestlé Health Science (Switzerland), and Bayer CropScience
(Germany) have joined together to develop health-care innovations.
• When more than two organizations participate, the venture is
sometimes called a consortium.
• JVs may also involve a partner owning over 50 percent, such as
ANA’s ownership of 67 percent in AirAsia Japan.
• Two companies from the same country joining together in a foreign
market (e.g., NEC and Mitsubishi [Japan] in the United Kingdom)
• A foreign company joining with a local company (e.g., Barrick
[Canada] and Zijin Mining Group in China)
• Companies from two or more countries establishing a joint venture
in a third country (e.g., Mercedes-Benz [Germany] and Nissan
[Japan] in Mexico)

• A private company and a local government forming a joint venture,
or mixed venture (e.g., Mitsubishi [Japan] with the government-
owned Exportadora de Sal in Mexico)
• A private company joining a government-owned company in a third
country (e.g., BP Amoco [private British-U.S.] and Eni [government-
owned Italian] in Egypt)
• The more companies in the JV or any alliance, the more complex its
management becomes.
• Development of the Boeing 787 (the Dreamliner) and the Airbus
A380 were joint efforts among numerous companies from several
countries.
• The projects were difficult to control, and a delay or performance
hitch by any participating company delayed the others and caused
project problems.

EQUITY ALLIANCES
• An equity alliance is a collaborative arrangement in which at least
one of the companies takes an ownership position (almost always
minority) in the other(s).
• For instance, the Port of Antwerp (Belgium) took a minority
position in Essar Ports (India) when the two signed a long-term
alliance to mutually improve quality and productivity.
• In some cases, each party takes an ownership in the other, such as
occurred with Panama-based Copa and Colombia based
AeroRepublic (airlines).
• The purpose of the equity ownership is to solidify a collaborating
contract, such as a supplier–buyer contract, so that it is more
difficult to break—particularly if the ownership is large enough for
the investing company to secure a board membership

History of Foreign Investment
• In the nineteenth century, foreign investment was
prominent, but it mainly took the form of lending by
Britain to finance economic development in other
countries as well as the ownership of financial assets.
• Prior to l890, British investment were primarily in the
consumer goods sector with concern about enhancing
access to the British market.
• Singer Manufacturing Company made enthusiastic
commitment to FDI, the company emerged as the
world’s first modern MNC and was one of the largest
firms in the world by l900.

• In the interwar period of the twentieth century,
foreign investment declined, but direct
investment rose to about a quarter of the total.
• This period was that Britain lost its status as the
major world creditor, and the USA emerged as
the major economic and financial power.
• In the post-Second World War period, FDI started
to grow, for two reasons.
1. Technology- the improvement in transport and
communications which made it possible to exercise
control from a distance.
2. Reconstruction following the damage inflicted by the
war

The 1980s witnessed two major changes and
saw a surge in FDI.
1. Low saving rate in the US economy, making it
impossible to finance the widening budget
deficit by resorting to the domestic capital
market, and giving rise to the need for
foreign capital, which came primarily from
Japan and Germany.
2. Restrictive trade policy adopted by the USA.

• In the period l990–2, FDI flows fell as growth in
industrial countries slowed, but a strong rebound
subsequently took place.
• This rebound is attributed to three reasons:
– (i) FDI was no longer confined to large firms, as an
increasing number of smaller firms became
multinational;
– (ii) the sectoral diversity of FDI broadened, with the
share of the service sector rising sharply; and
– (iii) the number of countries that were outward
investors or hosts of FDI rose considerably.

The average yearly outflow of FDI
By 2016 the global stock of FDI was about $26 trillion

FDI inflow as region of the country

Cumulative FDI outflows,
1998–2016 ($ billions).

Source country(above slide too)
• In 2005, Chinese firms invested some $12 billion
internationally. Since then, the figure has risen steadily,
reaching a record $134 billion in 2016.
• Firms based in Hong Kong accounted for another $108
billion of outward FDI in 2016
• Much of the outward investment by Chinese firms has
been directed at extractive industries in less developed
nations (e.g., China has been a major investor in
African countries).
• A major motive for these investments has been to gain
access to raw materials, of which China is one of the
world’s largest consumers.

• United States has been an attractive target for FDI
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
• Most recent inflows into developing nations have been
targeted at the emerging economies of Southeast Asia.
• Driving much of the increase has been the growing
importance of China as a recipient of FDI, which
attracted about $60 billion of FDI in 2004 and rose
steadily to hit a record $134 billion in 2016.

What is Foreign Direct Investment
Foreign direct investment (FDI) is the process
whereby residents of one country (the source
country) acquire ownership of assets for the
purpose of controlling the production,
distribution and other activities of a firm in
another country (the host country).

• The International Monetary Fund’s Balance of
Payment Manual defines FDI as
‘an investment that is made to acquire a lasting
interest in an enterprise operating in an economy
other than that of the investor, the investor’s
purpose being to have an effective voice in the
management of the enterprise’.
• The United Nations 1999 World Investment
Report (UNCTAD, 1999) defines FDI as
‘an investment involving a long- term relationship
and reflecting a lasting interest and control of a
resident entity in one economy (foreign direct
investor or parent enterprise) in an enterprise
resident in an economy other than that of the
foreign direct investor (FDI enterprise, affiliate
enterprise or foreign affiliate)’

Foreign Investment
• As per Foreign investment and Technology Transfer Act 2018
(FITTA): "Foreign Investment" means the following investment
made by a foreign investor in any industry"
• a. Equity Investment in a new industry in foreign currency
• b. Investment through purchase of shares of an existing industry
• c. Reinvestment of dividend earned from foreign investment
• d. Investment through capital investment fund
• e. Investment through technology transfer in the form of patent,
design, trademark etc.
• f. Lease investment
• "Foreign Investor" means any foreign individual, firm, company or
corporate body involved in foreign investment or technology
transfer including foreign government or international agency.

TYPES OF FDI
FDI can be classified from the perspective of the
investor (the source country) and from the
perspective of the host country.
From the perspective of the investor,
1. Horizontal FDI,
2. Vertical FDI,
3. Conglomerate

Horizontal FDI
• The affiliate industry (in host country) replicates the production
process that the parent MNC firm undertakes in (its source country
facilities) elsewhere in the world;
• Horizontal FDI is undertaken for the purpose of horizontal
expansion to produce the same or similar kinds of goods abroad (in
the host country) as in the home country.
• Hence, product differentiation is the critical element of market
structure for horizontal FDI.
• horizontal FDI is undertaken to exploit more fully certain
monopolistic or oligopolistic advantages, such as patents or
differentiated products, particularly if expansion at home were to
violate anti-trust laws (competition laws).
• Toyota has replicated the production process for its most popular
car model, the Corolla, in assembly plants in Brazil, Canada, China,
India, Japan, Pakistan, South Africa, Taiwan, Thailand, Turkey, the
United States, the United Kingdom, Vietnam, and Venezuela

The Horizontal FDI Decision
• If a firm wants to reach customers in (host
country) Foreign, it has only one possibility:
export and incur the trade cost t per unit
exported.
• Let’s now introduce the choice of becoming a
multinational via horizontal FDI: A firm could
avoid the trade cost t by building a production
facility in Foreign.
• Of course, building this production facility is
costly and implies incurring the fixed
• cost F again for the foreign affiliate.

• The firm’s export versus FDI choice will then
involve a trade-off between the perunit export
cost t and the fixed cost F of setting up an
additional production facility.
• Any such trade-off between a per-unit and a
fixed cost boils down to scale.
• If the firm sells Q units in the foreign market,
then it incurs a total trade-related cost Q * t to
export; this is weighed against the alternative
of the fixed cost F.
• If Q > F/t, then exporting is more expensive,
and FDI is the profit-maximizing choice.

Vertical FDI
• firm’s decision to break up its production chain and move
parts of that chain to a foreign affiliate will also involve a
trade-off between per-unit and fixed costs—so the scale of
the firm’s activity will again be a crucial element
determining this outcome.
• Vertical FDI is undertaken for the purpose of exploiting raw
materials (backward vertical FDI) or to be nearer to the
consumers through the acquisition of distribution outlets
(forward vertical FDI).
• In vertical FDI, the key cost saving is not related to the
shipment of goods across borders; rather, it involves
production cost differences for the parts of the production
chain that are being moved. This cost differences stem
mostly from comparative advantage forces

• Intel (the world’s largest computer chip manufacturer) has broken
up the production of chips into wafer fabrication, assembly, and
testing.
• Wafer fabrication and the associated research and development are
very skill-intensive, so Intel still performs most of those activities in
the United States as well as in Ireland and Israel (where skilled labor
is still relatively abundant).
• On the other hand, chip assembly and testing are labor intensive,
and Intel has moved those production processes to countries where
labor is relatively abundant, such as Malaysia, the Philippines, Costa
Rica, and China.
• The vertical FDI is one of the fastest-growing types of FDI and is
behind the large increase in FDI inflows to developing countries

Trends in Global Supply Chains and Sourcing

Iphone 7
• Consumer will pay much more than that
for the phone (the unsubsidized price is
$649).
• Apple, this transaction is recorded as a
$225 import from China (where the
iPhone is assembled and tested).
• Of the $225 total cost, only $5 represents
assembly and testing costs (performed in
China).
• The remaining $220 represents the
iPhone’s component costs, which are
overwhelmingly produced outside of
China.
• The manufacturing of these components
is spread throughout Asia (Korea, Japan,
and Taiwan are the largest suppliers),
Europe, and the Americas.

The Vertical FDI Decision
• A firm’s decision to break up its production chain and move parts of that
chain to a foreign affiliate will also involve a trade-off between per-unit
and fixed costs—so the scale of the firm’s activity will again be a crucial
element determining this outcome.
• When it comes to vertical FDI, the key cost saving is not related to the
shipment of goods across borders; rather, it involves production cost
differences for the parts of the production chain that are being moved.
• those cost differences stem mostly from comparative advantage forces.
• We will not discuss those cost differences further here, but rather ask
why—given those cost differences—all firms do not choose to operate
affiliates in low-wage countries to perform the activities that are most
labor-intensive and can be performed in a different location. The reason is
that, as with the case of horizontal FDI, vertical FDI requires a substantial
fixed cost investment in a foreign affiliate in a country with the
appropriate characteristics.
• Again, as with the case of horizontal FDI, there will be a scale cutoff for
vertical FDI that depends on the production cost differentials on one hand,
and the fixed cost of operating a foreign affiliate on the other hand.
• Only those firms operating at a scale above that cutoff will choose to
perform vertical FDI.

Conglomerate FDI
A conglomerate is the combination of two or
more corporations operating in entirely
different industries under one corporate
group, usually involving a parent company and
many subsidiaries.
A conglomerate is a multi-industry company.
It involves both horizontal and vertical FDI.

TYPES OF FDI
• From the perspective of the host country, FDI
can be classified into
1. Import-substituting FDI;
2. Export-increasing FDI;
3. Government-initiated FDI.

Import-substituting FDI
• Import-substituting FDI involves the
production of goods previously imported by
the host country, necessarily implying that
imports by the host country and exports by
the investing country will decline.
• This type of FDI is likely to be determined by
the size of the host country’s market,
transportation costs and trade barriers.

Export-increasing FDI
Export-increasing FDI, on the other hand, is
motivated by the desire to seek new sources of
input, such as raw materials and intermediate
goods.
This kind of FDI is export-increasing in the sense
that the host country will increase its exports of
raw materials and intermediate products to the
investing country and other countries (where the
subsidiaries of the multinational corporation are
located).

Government-initiated FDI
• Government-initiated FDI may be triggered,
for example, when a government offers
incentives to foreign investors in an attempt to
eliminate a balance of payments deficit.
• FDI is either trade-orientated FDI (which
generates an excess demand for imports and
excess supply of exports at the original terms
of trade) or anti-trade-orientated FDI, which
has an adverse effect on trade.

APPROACHES TO INTERNATIONAL BUSINESS
Common sequence that firms use to develop foreign
markets for their products:
1. Export of the goods produced in the source country.
2. Licensing a foreign company to use process or product
technology.
3. Foreign distribution of products through an affiliate
entity.
4. Foreign (international) production, which is the
production of goods and services in a country that is
controlled and managed by firms headquartered in
other countries.

Moving from step l to step 4 requires a larger
commitment of resources, and in some
respects greater exposure to risk.
While this sequence may be a chronological
path for developing foreign sales, it is not
necessary that all four steps are taken
sequentially, as some firms jump immediately
to step 3 or step4.
Steps 3 and 4 involve FDI.

UNCTAD (l999) identifies the following characteristics of inter-
national production:
1. International production arises when a firm exercises control over an
enterprise located abroad, whether through capital investment or
through contractual arrangements.
2. Technology flows play an important role in international production.
3. Innovation and research & development are at the heart of the
ownership advantages that propel firms to engage in international
production.
4. International trade is stimulated by international production because of
the trading activities of MNCs.
5. International production generates employment opportunities that are
particularly welcome in host countries with high rates of unemployment.
6. Financial flows associated with international production consists of
funds for financing the establishment, acquisition or expansion of the
foreign affiliates.
7. The capital base of international production, regardless of how it is
financed, is reflected in the value of assets of foreign affiliates.
• “The choice between exporting and FDI depends on the following factors:
profitability, opportunities for market growth, production cost levels, and
economies of scale.”

FDI may take one of three forms
1. Greenfield investment,
2. Cross- border mergers and acquisitions
(M&As)
3. Joint ventures.

Greenfield investment
• Greenfield investment occurs when the
investing firm establishes new production,
distribution or other facilities in the host
country. This is normally welcomed by the
host country because of the job-creating
potential and value-added output.
• Ex: Pre fab Panel, Britannia Biscuit, Kasai

Merger & Acquisition
• FDI may occur via an acquisition of, or a merger with, an established firm
in the host country (the vast majority of M&As are indeed acquisitions
rather than mergers).
• This mode of FDI has two advantages over greenfield investment:
– (i) it is cheaper, particularly if the acquired project is a loss-making
operation that can be bought cheaply; and
– (ii) it allows the investor to gain a quick access to the market.
• Firms may be motivated to engage in cross-border acquisitions to bolster
their competitive positions in the world market by acquiring special assets
from other firms or by using their own assets on a larger scale.
• The extent of failure depends crucially on the success criteria, which
means that the failure rate may be high or low, depending on these
criteria
• Ex ; one gas, Nepal Distillery

Joint Ventures
• FDI can also take the form of joint ventures,
either with a host country firm or a government
institution, as well as with another company that
is foreign to the host country.
• One side normally provides the technical
expertise and its ability to raise finance, while the
other side provides valuable input through its
local knowledge of the bureaucracy as well as of
local laws and regulations.

Buckley and Casson present a model that
explains the formation of joint ventures in terms
of nine distinct factors:
(i) market size;
(ii) pace of technological change;
(iii) interest rates;
(iv) cultural distance;
(v) protection of independence;
(vi) missing patent rights;
(vii) economies of scope; (varieties of products)
(viii) technological uncertainty; and
(ix) economies of scale.

Country selection criteria for Foreign
investment
1. Foreign Market, where manufacturing and or
service facilities are developed to cater the
local market need as well as optimal facility
in the global distribution network. In this
connection Chinese firm can investment in
Nepal to meet the demand of product in
Nepal or second highest populated country
India via Nepalese facility.

2. Efficiency seeking industry can invest in the
country where cost of production could be
lower due to lower cost locations for
operations, in particular in the lower labour
cost and availability of energy.
3. Resources seeking investor could be invest in
resources sector to acquire or secure the
supply of raw materials and energy sources.

Lecture 4 FDI.ppt

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