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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