Download Foreign Direct Investment

International Business: Competing in the Global Marketplace Fifth Edition
Foreign Direct Investment
Learning objectives
 Discuss the importance of foreign
direct investment (FDI) in the
world economy, and the changing
patterns of FDI over time
 Present different theories that
explain why a company would
undertake an acquisition rather
than a Greenfield investment
 Explain horizontal FDI, and
suggest the conditions under
which each may be most
applicable.
 Explain vertical FDI, and suggest
the conditions under which each
may be most applicable.
 Implications of these theories of
FDI. Comparison of licensing to
FDI
Chapter 6
6
The focus of this chapter is foreign direct
investment (FDI). The growth of foreign direct
investment in the last 25 years has been
phenomenal. FDI can take the form of a foreign
firm buying a firm in a different country, or
deciding to invest in a different country by
building operations there.
With FDI, a firm has a significant ownership in a
foreign operation and the potential to affect
managerial decisions of the operation. The goal of
our coverage of FDI is to understand the pattern of
FDI that occurs between countries, and why firms
undertake FDI and become multinational in their
operations as well as why firms undertake FDI
rather than simply exporting products or licensing
their know-how.
The opening case describes Starbuck’s investments
outside the US. Although concentrating originally
on the franchising method of expansion and
licensing of its products, Starbucks later pursued
other options such as joint ventures, wholly owned
subsidiaries, and acquisitions to retain tighter
control over operations.
97
International Business: Competing in the Global Marketplace Fifth Edition
e
Web Source
Chapter 6
http://www.globalpolicy.org/globaliz/cultural/2003/0710starbucks.htm
http://msnbc.msn.com/id/4192116/
http://economictimes.indiatimes.com/articleshow/370334.cms
http://economictimes.indiatimes.com/articleshow/450656.cms
http://www.fdimagazine.com/
OUTLINE OF CHAPTER 6: FOREIGN DIRECT INVESTMENT
Opening Case: Starbuck’s Foreign Direct Investment
Foreign Direct Investment in the World Economy
The Growth of FDI
The Direction of FDI
Country Focus: FDI in China
The Source of FDI
The Form of FDI: Acquisitions vs. Greenfield Investments
Management Focus: Cemex’s Foreign Acquisitions
Horizontal Foreign Direct Investment
Transportation Costs
Market Imperfections (Internalization Theory)
Strategic Behavior
The Product Life Cycle
Location-Specific Advantages
Vertical Foreign Direct Investment
Strategic Behavior
Market Imperfections
Implications for Business
Chapter Summary
Discussion Questions
Closing Case: Ford and General Motors in Russia.
98
International Business: Competing in the Global Marketplace Fifth Edition
Chapter 6
TEACHING SUGGESTIONS
I like to ask students to give me an example of a firm that they know has invested in the
US. From the list that students present push them to figure out which of these may be
licensees and which of these firms have actually undertaken FDI. Then ask the question
what are some of the reasons these firms invest in the US. You may also point out, just
as outsourcing takes jobs out of the country, FDI creates jobs in the country where such
investment takes place.
LECTURE OUTLINE FOR CHAPTER
This teaching outline follows the Power Point presentation provided along with this
instructor’s manual.
Introduction
This chapter focuses on foreign direct investment (FDI). FDI can take the form of a
foreign firm buying a firm in a different country, or deciding to invest in a different
country by building operations there
Slide 6-2 Opening case: Starbucks
In the opening case, Starbuck’s venture to go global is described. Although concentrating
originally on the franchising method of expansion and licensing of its products, Starbucks
later pursued other options such as joint ventures, wholly owned subsidiaries, and
acquisitions to retain tighter control over operations. By October 2000, Starbucks had
invested some 52 million in foreign joint ventures. By the end of 2002 Starbucks had
more than 1200 stores in 27 countries outside of North America. Check the websites
provided for you for further readings. In addition there are a few questions and answers
on the case provided for you at the end of this chapter in the instruction manual.
Why did Starbucks originally pursue a strategy of licensing for international expansion in
Japan and further why did Starbucks retreat from that strategy of licensing and revert to
joint ventures and subsidiaries? Starbucks believed that this technique would allow it to
achieve the quickest path the international expansion. Although much more would be put
into finding the proper licensee, there would be little need to invest considerable capital.
Starbucks believed that the individualistic nature of a Starbucks store had to be managed
carefully. A licensing strategy, although giving it the opportunity to expand
internationally, did not allow the strong control Starbucks felt was necessary for success.
A strategy of joint ventures and subsidiaries, where hands-on control is expected and
required, was clearly more fitting to the operational philosophy.
The success of Starbucks relied on strong control at the retail level, including store layout
and the training of personnel. The case shows that more than one strategy for
international expansion may be required depending on the mechanics of the company and
the nature of the country entered.
Slide 6-3 What is foreign direct investment
Foreign direct investment is undertaken by firms so that they can take advantage of
resources that are either unavailable in the home country or because these resources are
available at costs lower than those in their home country.
99
International Business: Competing in the Global Marketplace Fifth Edition
Chapter 6
When we talk about firms seeking resources, these firms could be seeking physical
resources (example oil) Companies such as Dutch Shell set up Greenfield operations in
Kuwait. Firms may pursue resources such as cheap/skilled labor (Mexico, China) or
technological and managerial skills (India). Firms could be seeking Markets to increase
their sales or be the first movers so as to capture market share in which case they will set
up subsidiaries. GE or firms could be locating themselves close to suppliers or raw
materials. Often firms find the need to follow the lead of supplier firms and set up
facilities close to them.
It is important to note that firms seek to pursue their strategic objectives through FDI
either by acquiring strategic firms or merging with firms in order to remain competitive
and sustainable over time.
Slide 6-4 FDI - Flow versus stock
When discussing foreign direct investment, it is important to distinguish between the
flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI
undertaken over a given time period (normally one year). The stock of FDI refers to the
total accumulated value of foreign owned assets at a given point in time.
Slide 6-5 Why is FDI important ?
Firms undertake FDI only if it is the strategic interest of the firm for all of the above
reasons stated in the slide
Firms want a presence in foreign markets
Firms want control over growth of these foreign markets
To gain first mover advantages
To ward off competitors
To determine locations, advertising and other related strategic decisions in the firm’s
interest
Slide 6-6 Trends in FDI
The significant growth in FDI has both to do with the political economy of trade as
outlined in the previous chapter and the political and economic changes that have been
taking place in developing countries. Globalization of the world economy has raised the
vision of firms who now see the entire world as their market
Slide 6-7 FDI outflows, 1982-2002
Fig 6.2
Slide 6-8 Growth in world exports
Fig 6.2
Slide 6-9 FDI flows by region
Fig 6.3
100
International Business: Competing in the Global Marketplace Fifth Edition
Chapter 6
Slide 6-10 Inward FDI flows Fig 6.4
Another important trend is has been the rise of inflows into the US. The stock of foreign
FDI in the US increased more rapidly than US FDI abroad.
The rapid increase in FDI growth into the US may be due to the attractiveness of the US
market and the falling value of the dollar.
It is difficult to say whether the increase in the FDI into the US is good for the country or
not. To the extent that foreigners are making more productive use of US assets and
workers, it is probably good for the country.
Slide 6-11 FDI outflows by select country 1998-2001 Fig 6.5
Figures 6.3, 6.4 and 6.5 provide some insight into the countries that have been the major
recipients and sources of foreign direct investment in recent years.
Slide 6-12 FDI trends: 2001-2002
A downward trend in FDI was recorded in 2001-2002 that reflected in part the state of the
economy and geopolitical uncertainty of the times.
Slide 6-13 Form Of FDI: Greenfield versus acquisitions
Once a firm decides to enter a foreign market using FDI they have to determine the
specific approach they will use to realize their entry mode.
Generally setting up Greenfield operations (i.e. building brand new facilities) are more
prevalent in developing countries. Often this was because there are few or no existing
firms to acquire.
Cross border mergers and acquisitions are favored by firms because while they are
quicker to execute they also bring in valuable strategic assets such as technology, human
resources or market share
Slide 6-14 Two forms of FDI
There are two kinds of foreign direct investment:
Horizontal FDI is FDI in the same industry abroad as a firm operates in at home.
Example: A Japanese automobile manufacturer in Japan seeks to produce the same
product in the US. Vertical Foreign Direct Investment
Vertical FDI is of two types.
(1)Backward vertical FDI involves investment into an industry that provides inputs for a
firm's domestic production processes.
(2) Forward vertical FDI involves investment in an industry that utilizes the outputs of a
firm's domestic production processes.
101
International Business: Competing in the Global Marketplace Fifth Edition
Chapter 6
Slide 6-15, 6-16 Horizontal FDI when and why?
Impediments to the sale of know-how
FDI would seem to be more expensive and risky than exporting or licensing, so there
must be some other good reasons for firms to undertake horizontal FDI.
Transportation costs can make export infeasible, especially for products that have a low
value/weight ratio (i.e. cement, soft drinks), or would require refrigeration or similar
controlled environments. For items like electronics, software, and medical equipment,
transportation costs may not be an impediment to exporting.
The most accepted reason for horizontal FDI relates to market imperfections. By
imposing quotas, tariffs, or impediments, governments can make FDI and licensing more
attractive than exporting.
Technological or managerial know-how can be difficult and dangerous to license,
however, making it an infeasible alternative. A firm can lose control of critical
competitive know-how, may not be able to optimize the flow and configuration of
operations between countries, or simply may be unable to codify its knowledge in a way
that would make licensing a practical option.
Firms may choose to undertake FDI simply to follow the lead of a competitor so as not be
left behind or locked out of an opportunity.
FDI may be most likely to occur in certain stages of a product’s lifecycle - when other
countries have a large enough market to justify local production or when there is a need
to locate production in a low cost location.
A firm may choose to undertake FDI in a particular country or region due to location
specific advantages. An obvious example occurs with respect to natural resources, but it
also applies to the ability to tap into a particular expertise (e.g. Silicon valley) or be
located near customers or suppliers with unique characteristics. Porter’s diamond, as
discussed in chapter 4, provides a partial explanation why firms in certain industries may
find it attractive to invest in a particular country.
Slide 6-17 Vertical Foreign Direct Investment when and why?
Backward vertical FDI involves investment into an industry that provides inputs for a
firm's domestic production processes. Forward vertical FDI involves investment in an
industry that utilizes the outputs of a firm's domestic production processes.
The strategic behavior explanation for vertical FDI suggests that firms try to either
create new entry barriers or erode competitors’ entry barriers. While there certainly are
some examples where the strategic behavior explanation seems to apply, the market
imperfections explanation seems to present a more complete explanation.
102
International Business: Competing in the Global Marketplace Fifth Edition
Chapter 6
Market imperfections can result from impediments to the sale of know-how and the
need to invest in specialized assets.
Because specialized know-how can be difficult to sell or license, a firm may have to
integrate vertically to be successful. The establishment of sales and services centers in
high technology industries, or the investment in knowledge intensive extractive processes
are two examples.
When specialized assets must be invested in (i.e. the aluminum smelter), companies may
need to secure a supply of the needed inputs to assure that those assets can be used
efficiently.
Slide 6-18 Decision framework
Slide 6-18 provides a decision framework that points out the conditions under which a
firm may choose to license, export or commit to FDI
Implications for Business- Discussion
The market imperfections theory suggests that exporting should be preferred to licensing
and horizontal FDI as long as transport costs are minor and tariff barriers are trivial. If
that is not the case, then firms should consider licensing and FDI.
FDI is more costly than licensing, but may be the most reasonable option. Figure 6.6
presents a decision tree suggesting when licensing, FDI, and exporting are most
appropriate.
Licensing tends not to be a good option in high technology industries where protecting
firm specific know-how is critical, in industries where a firm must carefully coordinate
and orchestrate its worldwide activities, or where there are intense cost pressures.
ANSWERS TO CRITICAL DISCUSSION QUESTIONS FOR CHAPTER 6
QUESTION 1: In 2000 inward FDI accounted for some 45% of the gross fixed capital
formation in Ireland, but only .03% in Japan. What do you think explains the difference
in FDI inflows into the two countries?
ANSWER 1: There are several approaches to answer this question. One consideration is
the historical attitude of the Japanese government to FDI. Traditionally, the Japan has
discouraged and even prohibited inward FDI, unless there was some specific, tangible
benefit to a particular Japanese industry. Ireland, on the other hand, is a member of the
EU and has a trade dependent economy without many resources to develop fixed capital.
It would be natural for such an economy to rely on FDI to develop an economic
infrastructure.
Another approach would involve comparison of the economies of Japan and Ireland. In
2000, Japan’s purchasing power parity was estimated a $3.15 trillion, while Ireland
103
International Business: Competing in the Global Marketplace Fifth Edition
Chapter 6
purchasing power parity was just under $82 billion—approximately 26% of that of Japan.
The population of Ireland at 3+million is slightly over 2% of Japan’s population of 126
million. Clearly, the ability to achieve significant increases (in almost anything), at least
as a percent of increase, is greater in Ireland than in Japan.
The attraction of Ireland as a European base of operations can be deduced from the fact
that one-third of all manufacturing employment is accounted for by foreign subsidiaries
in Ireland. The establishment of a business enterprise in Ireland does not require specific
government authorization; a foreign investor has the same rights and obligations as an
Irish firm. The crowding of habitable land area and the aging of the population are two
major long-run problems for continued growth in Japan. However, the Japanese economy
is much more technologically oriented than that of Ireland. (As an example, Japan has
possessed 410,000 of the world's 720,000 "working robots".)
QUESTION 2: Compare and contrast these explanations of horizontal FDI; the market
imperfections approach, Vernon's product life cycle theory, and Knickerbocker's theory
of FDI? Which theory do you think offers the best explanation of the historical pattern of
horizontal FDI? Why?
ANSWER 2: Knickerbocker's theory suggests that firms imitate other firms in
oligopolistic industries, and will "follow the leader" in undertaking FDI in certain
countries. This theory does not explain why the first firm undertakes FDI, and why it
chooses to do this rather than export or license. The product life cycle theory suggests
that firms invest in foreign countries when demand in that country will support local
production or when cost pressures make it necessary to locate production in low cost
locations. While this theory does explain why some FDI takes place, it also does not
explain why FDI is preferred over licensing or exporting. The market imperfections
approach more directly confronts these issues, and explains why FDI may be preferable
to other alternatives for expanding business activities. It identifies the importance and
difficulty of transferring know-how and describes some of the impediments to exporting.
By explaining better exactly why a firm may undertake FDI, the market imperfections
model is probably the best explanation of the historical pattern of horizontal FDI.
QUESTION 3: Read the opening case on Starbucks. Using the market imperfections
approach to FDI, explain Starbucks’ approach to expanding its presence in Thailand,
Britain, and Japan.
ANSWER 3: Starbucks’ management believed that its success came from its unique
ability to brand its merchandise, to layout and operate its stores in a manner unable to be
duplicated by the competition, and to the intense training undergone by its employees.
The market imperfections approach impacted Starbucks expansion because it found it
difficult to sell its know-how, the very characteristic that made its stores so successful.
Undoubtedly, the reason that Starbucks became disenchanted with a straight licensing
agreement with some of its Asian partners was because it was not able to obtain the
degree of control it felt it required to operate a “real” Starbucks store. Given the need to
expand internationally, the obvious alternative strategy was to move to joint ventures.
104
International Business: Competing in the Global Marketplace Fifth Edition
Chapter 6
QUESTION 4: Compare and contrast these explanations of vertical FDI: the strategic
behavior approach and the market imperfections approach? Which theory do you think
offers the best explanation of the historical pattern of vertical FDI? Why?
ANSWER 4: The market power explanation suggests that a firm undertakes FDI to
either create barriers to entry or to overcome the entry barriers protecting other firms.
Hence it focuses on concerns that are external to the firm, and that the firm wants to take
into its control. The market imperfections approach looks more at factors internal to a
firm - know-how and specialized assets - and the difficulties firms have in utilizing their
capabilities most efficiently. Although there certainly are some cases where the strategic
behavior explanation makes sense, a great deal of the modern day FDI appears to involve
industries where there is a great deal of know-how and investment in specialized assets.
Even firms that have had a great deal of market power (i.e. IBM and Xerox) have also
had a significant level of know-how that would be difficult to fully profit from without
FDI.
QUESTION 5: You are the international manager of a US business that has just invented
a revolutionary new personal computer that can perform the same functions as existing
PCs but costs only half as much to manufacture. Several patents protect the unique
design of this computer. Your CEO has asked formulate a recommendation for how to
expand into Western Europe. Your options are (a) to export from the US, (b) to license a
European firm to manufacture and market the computer in Europe, and (c) to set up a
wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative and
suggest a course of action to your CEO.
ANSWER 5: In considering expansion into Western Europe, an international manager
should consider three options: FDI, licensing, and export. With export, assuming there
are no trade barriers, the key considerations would likely be transport costs and
localization. While transport costs may be quite low for a relatively light and high value
product like a computer, localization can present some difficulties. Power requirements,
keyboards, and preferences in models all vary from country to country. It may be
difficult to fully address these localization issues from the US, but not entirely infeasible.
Since there are many computer manufacturers and distributors in Europe, there are likely
to be a number of potential licensees. But by signing up licensees, valuable technological
information may have to be disclosed, and the competitive advantage will be lost if the
licensees use or disseminate this information. FDI (setting up a wholly owned
subsidiary) is clearly the most costly and time consuming approach, but the one that best
guarantees that critical knowledge will not be disseminated and that localization can be
done effectively. Given the fast pace of change in the personal computer industry, it is
difficult to say how long this revolutionary new computer will retain its competitive
advantage. If the firm can protect its advantage for a period of time, FDI may pay off and
help assure that no technological know-how is lost. If, however, other firms can copy or
develop superior products relatively easily, than licensing, while speeding up knowledge
dissemination, may also allow the firm to get the quickest large scale entry into Europe
and make as much as it can before the advantage is lost.
105
International Business: Competing in the Global Marketplace Fifth Edition
Chapter 6
TEACHING SUGGESTIONS FOR THE CLOSING CASE OF CHAPTER 6
Ford and General Motors in Russia. The case describes the entry of auto giants Ford and
GM into the Russian market. A discussion of the case can revolve around the following
questions:
QUESTION 1 Why are Ford and GM entering the Russian car market now? Why did
they not invest earlier, and why do they not postpone investment until the market is
bigger?
ANSWER 1: Both companies are motivated by a desire to get a foothold and establish a
presence in the Russian car market. The stabilizing of the political climate was also a
major factor, in addition, the Russian government was increasing import tax on finished
cars to 35percent. This would make imported cars much more expensive and cause these
companies to loose market share.
QUESTION 2: Why do you think Ford chose to establish a wholly owned subsidiary in
Russia, rather than license its production and product technology to a Russian carmaker
like Auto VAZ?
ANSWER 2: Ford was responding to the growth in the Russian car market. Its initial
$150 million wholly owned facility gave Ford an opportunity to test its capability to build
a Ford Focus at a premium of $2-5000 more than the average price of Russian cars.
100% ownership gave Ford complete control over the manufacturing facility.
QUESTION 3:Why do you think GM chose to establish a joint venture with Auto VAZ
rather than a wholly owned subsidiary? What are the risks associated with GM’S joint
venture strategy?
ANSWER 3: GM’s 41.5% ownership stake gave it instant access to an established car
manufacturer in Russia. By 2005, in slightly less than 3 years after the deal was
finalized, GM would have the capability to sell 75,000 cars made by the joint venture.
The risks associated with GM’s move are linked to the lack of total control. GM has no
way to assure itself that the quality of the car or the speed of completion of the facility
will be in line with GM’s strategy. For example, if AutoVAZ finds a partner to launch a
new mass-market version of the Lada, that venture may divert capital as well as
management attention away from GM’s joint venture.
QUESTION 4: Which theory of FDI best explains the sudden increase in interest by
foreign auto companies to Russian investment ?
ANSWER 4: The best theories to explain the actions of Foreign auto companies are the
market imperfections theory and the strategic behavior theory. There were impediments
to the free flow of imported automobiles namely higher import duties.
106
International Business: Competing in the Global Marketplace Fifth Edition
Chapter 6
Knickerbocker’s theory suggests that in oligopolistic industries FDI is best explained by
the imitative strategic behavior by rival firms. Firms wanted to establish a presence in
Russia’s growing market.
STUDENT EXERCISES FOR CHAPTER 6
globalEDGE™ Exercise Questions http://globalEDGE.msu.edu/
Chapter 6 – Exercise 1
The data source can be accessed by searching the term “World Investment Directory” at
http://globaledge.msu.edu/ibrd/ibrd.asp. The link to the World Investment Directory is
found under the globalEDGE category “Research: Statistical Data Sources”. On this
website, the list of members top transnational corporations can be found under the “Top
100 TNCs” link, located on the right side of the page.
Search Phrase: “World Investment Directory”
Resource Name: UNCTAD World Investment Directory
Website: http://r0.unctad.org/en/subsites/dite/fdistats_files/WID.htm
globalEDGE™ Category: “Research: Statistical Data Sources”
Chapter 6 – Exercise 2
The foreign direct investment statistics are provided by a variety of sources. One of the
most comprehensive sources is the UNCTAD’s World Investment Report and can be
accessed by searching the term “FDI” at http://globaledge.msu.edu/ibrd/ibrd.asp. The
link to the World Investment Report (www.unctad.org) is found under the globalEDGE
category “News & Periodicals: Publications”. On this website, country specific
information can be found by following the “Country fact sheets” link, located on the right
side of the page.
Search Phrase: “FDI”
Resource Name: UNCTAD World Investment Report - Country Fact Sheets
Website: http://r0.unctad.org/wir/fs/fs02.htm
globalEDGE™ Category: “News & Periodicals: Publications”
Alternatively, a lot of the same statistics, as well as detailed write-ups of the FDI
environment can also be reached through the Country Commercial Guides. See Chapter 5
– Exercise 1 for instructions on how to reach the Country Commercial Guides through
globalEDGE™.
SUGGESTED READINGS FOR CHAPTER 6
J. F. Hennart, “Upstream Vertical Integration in the Aluminum and Tin Industries,”
Journal of Economic Behavior and Organization 9 (1988), pp. 281–99; and O. E.
Womack, J. P., D. T. Jones and D. Roos. The Machine that changed the world. New
York: Rawson Associates.
107
International Business: Competing in the Global Marketplace Fifth Edition
Chapter 6
Williamson, The Economic Institutions of Capitalism (New York: Free Press, 1985). See
also G.M. Grossman and E. Helpman. “Outsourcing versus FDI in Industry
Equilibrium,” NBER Working Paper 9300, October 2002.
Caves, Multinational Enterprise and Economic Analysis.
B. Aris, “Ford drives under the barrier,” Euromoney, August 2002, page 20-22.
J. Daniszewski, “GM rolls out joint venture with Russia”, Los Angeles Times, September
24th, 2002, page A3.
G. Chazan, “Russians want foreign wheels,” Wall Street Journal, December 24th, 2002,
page A8.
108