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International Business 7.10.2014 Class 4 FDI ENTRY STRATEGIES Course materials could be found at • http://pub.econom.nsu.ru/econom/ • Юсупова А.Т. • International business Previous class question • Free trade…. A.Refers to a situation in which a government does not attempt to restrict what its citizens can buy from or sell to another country. B.Reduces the overall efficiency of the world economy. C.Describes the range of policy instruments that governments use to intervene in international trade. D.Is a government payment to a domestic producer. Previous class question Which of the following is not one of the main instruments of trade policy? A.Tariffs B.Credit portfolios C.Local content requirements D.Administrative policies Previous class question Specific tariffs are: A.Levied as a proportion of the value of the imported good. B.Levied as a fixed charge for each unit of a good imported. C.In the form of manufacturing or production requirements of goods. D.Government payment to domestic producers. Previous class question Identify the incorrect statement pertaining to trade barriers: A.They raise the costs of exporting products to a country. B.They may put a firm at a competitive advantage to indigenous competitors C.They may limit a firm’s ability to serve a country from locations outside of that country. D.To conform to local content regulations, a firm may have to locate more production activities in a given market than it would otherwise. Previous class question ___________ suggests that a government should use subsidies to support promising firms that are active in newly emerging industries. A.The infant industry argument B.Strategic trade policy C.Retaliation policy D.The national security argument Tariffs Subsidies Instruments of Trade Policy Import Quotas & Voluntary Export Restraints Local Content Requirements Administrative Policies Foreign Direct Investment FDI FDI • Direct investment in real or physical assets such as factories and facilities in a foreign country • Direction - production, R&D,marketing, sales • Occurs when a firm invests directly in facilities to produce or market a product in a foreign country” and requires “an interest of 10 percent or more in a foreign business entity (active participation in management) • Recent years (30 years) – significant increase, rates higher that those for output and sales; FDI • 10% - defined by US Trade Department • Firm with FDI – multinational enterprise . • Portfolio investments in foreign countries – less than 10%; Forms of FDI • Greenfield Investment: involves the establishment of a new operation in a foreign country; • Acquisitions and Mergers: involve the acquiring, or merging with, an existing organisation within a foreign country Types of FDI • Horizontal FDI: refers to investment which is in the same industry as that in which the firm operates in its home country • Vertical FDI: refers to investment in an industry which provides inputs into a firm’s domestic operations. Alternatively it could involve FDI in an industry which markets and sells the outputs of the firm’s domestic operations • Conglomerate FDI: refers to investment with the focus of manufacturing products which are not manufactured by the firm’s domestic operations. Such products are often unrelated to the parent company’s core business Indicators of FDI • Flow of FDI: refers to the amount of FDI undertaken over a given time period (e.g. a year) : – Inflow of FDI: refers to the flow of FDI into a country (i.e. foreign firms directly investing in the country). – Outflow of FDI: refers to the flow of FDI out of a country (i.e. firms undertaking FDI outside of the country). • Stock of FDI: refers to the total accumulated value of foreign owned assets at a given time Growth of FDI • The reasons for FDI’s rapid growth, in comparison to the growth of world trade and world output: • FDI is seen as a means of avoiding potential future trade barriers. • Political and economic changes, particularly within developing nations where there has been a move to a more democratic government and free market economies has resulted in a growth of FDI. • The globalisation of the world economy has contributed significantly to the growth in FDI Forms of FDI • Most FDI takes the form of mergers and acquisitions rather than greenfield investments • The reasons are: • M&A are more quickly executed than greenfield investments. • M&A provide for the acquisition of existing strategic assets, such as brand loyalty and production systems. • M&A provide an opportunity to increase efficiency of the acquired firm due to transferring technology, capital and management skills General situation with FDI • Global FDI inflows totaled US$1.3 trillion in 2012, down 18% on 2011. • 2010 and 2011 - increase, • Developed economies - 90% decline in global FDI. • Developing economies - also loses; FDI inflows by region (2012 compared with 2011) Region Latin America and the Caribbean Africa Asia European Union United States Europe % 7.2 5.5 - 9.5 - 34.8 - 35.3 - 36.1 FDI in Russia • FDI to Russia in 2012 US$ 11.090 billion (without off shore investments) Number of FDI projects and FDI jobs in Russia Year 2007 2008 2009 2010 2011 2012 Number of projects 139 143 170 201 128 128 Number of jobs 14934 12900 11834 8058 8362 13356 FDI in Russia by activities 2012 Activity Number of jobs, share Manufacturing Number of projects, share 46.9 Sales and Marketing Logistics 38.3 4.7 0.5 0 Testing and servicing R&D Education and training 4.7 3.1 1.6 0.4 0.9 0 Other… 98.2 FDI in Russia by country of origin, 2012 Country Number of jobs, share US Number of projects, share 22.7 Germany France 21.9 10.9 33.4 5 Japan Finland Italy 7 3.9 3.9 12 4.5 18 Other….. 8 FDI in Russia by region – recipient , 2012 Region Moscow St. Petersburg Nizhniy Novgorod Kaluga Other… Number of projects, share 31.3 8.6 7.0 5.5 Number of jobs, share 0.5 4.5 13.3 16.2 Assignment • Discuss positive and negative consequences of FDI (you can choose an example of any country) Foreign Direct Investment Theories Cluster 1: Why FDI? Limitatio ns of Exporting Limitations of Licensing Cluster 2: Patterns of FDI Strategic Behaviour Product Life Cycle Cluster 3: Eclectic Paradigm Theory Cluster 1: Why Foreign Direct Investment • Limitations of Exporting: The possibility of a firm exporting its goods to a foreign country is often constrained due to transportation costs and trade barriers • Limitations of Licensing – Internalisation Theory: Internalisation theory, also known as Market Imperfections theory, highlights why firms may favour a FDI strategy rather than a licensing strategy as a means of entering a foreign market. Internalisation theory advocates that the available external market fails to produce an efficient environment in which the firm can profit by using its technology or production of resources....therefore the firm tends to produce an internal market via investment in multiple countries, and thus creates the needed market to achieve its objective Circumstances under which FDI would be more profitable than licensing: In instances where the firm has valuable intellectual capital which the licensing contract would not be able to adequately protect; In situations where the firm requires tight control over the foreign licensee (e.g. to maximise profitability and market share); In instances where the firm’s competitive advantage lies in its skills and intellectual capital, which could not be licensed Cluster 2: Patterns of Foreign Direct Investment • Strategic Behaviour – Knickerbockers’ Theory: This theory argues that FDI flows reflect strategic rivalry between firms in the global marketplace. Knickerbocker conducted research into oligopolistic industries and found that a critical competitive feature was their imitative behaviour. • Product Life Cycle Theory (Vernon)- a trade cycle emerges where a product is produced by a parent firm, then by its foreign subsidiaries and then anywhere in the world where costs are at their lowest possible Cluster 3: Eclectic Paradigm • Identifies all of the following three factors in being important determinants of FDI: • Ownership specific factors (e.g. natural endowments, capital, intellectual capital, technology, management and marketing skills) • Location specific factors (e.g. factor endowments, market structure, government legislation, political environment, legal environment, cultural environment) • Internalisation specific factors (inherent capacity and flexibility to produce and market through its internal subsidiaries) • Foreign Market Entry Modes Exporting Wholly Owned Subsidiaries Turnkey FOREIGN MARKET Projects ENTRY MODES Joint Licensing Ventures Franchising Exporting • Occurs when a firm maintains its production facilities in its home country and sells its products. • A firm can export goods directly to foreign customers or through export intermediaries • + Avoids considerable costs of setting up manufacturing operations in a foreign country • +May assist a firm to realise experience curve economies as well as location economies • - may not be the most profitable option if there are lower cost locations for manufacturing the goods abroad. • -may not be economical due to high transportation costs and tariff barriers. • -Export intermediaries, contracted by the firm to market and sell their goods abroad, may have divided loyalties (e.g. through selling a competitor’s product as well) Turnkey Projects • “contractor agrees to handle every detail of the project for a foreign client, including the training of operation personnel” • Common in chemical, pharmaceutical, petroleum refining and metal refining industries + • Helps to earn significant economic gains from process technology skills in foreign markets where FDI is restricted • Potentially not as risky as conventional FDI. • Firm entering in turnkey project has no long-term interest in the foreign country, which is a weakness if the country proves to be a major market for the product/service. • The foreign entity may become a competitor. • Firm’s process technology is a source of competitive advantage Licensing • • • • • • • A licensing agreement is where a firm (licensor) “grants specified intangible property rights to the local licensee for a specified period of time in exchange for a royalty fee”. Intangible property includes patents, formulas, processes, designs, copyrights, trademarks and inventions. These allow the licensee to manufacture and sell a product similar to the one which the licensor has been producing in its home country + The firm (licensor) does not have to carry the risks and costs associated with setting up a foreign operation The firm does not have tight control over manufacturing, marketing and strategy necessary for achieving experience curve economies and location economies. Limits a firm’s ability to implement a coordinated strategy to facilitate entry into multiple foreign markets. Firms potentially could lose control of their technological know-how Franchising • Franchising involves a foreign franchisor in granting “specified intangible property rights to the local franchisee, which must abide by strict and detailed rules as to how it does business” • Franchising involves longer commitments than licensing and provides greater control. • + • Little political risk and low cost involved. • Fast and easy avenue for leveraging assets such as a brand name • • Franchisor’s image may be tarnished due to franchisee not upholding standards. • Limits a firm’s ability to implement a coordinated strategy to facilitate entry into multiple foreign markets Joint Ventures • Involves “establishing a firm that is jointly owned by two or more otherwise independent firms.” • Joint ventures are usually 50 / 50 arrangements where the two parties (firms) share ownership and management control. • + • Firm benefits from partner’s knowledge of host country’s market. • When costs and risks of entering a foreign market are high, it is beneficial to share these costs with a partner firm. • In certain countries, joint ventures are the only feasible entry mode • • Risk of giving control of firm’s technology to partner. • Firm does not have tight control over subsidiaries necessary to attain experience curve economies and location economies. • Inability to engage in global strategic coordination. • Shared ownership arrangement could result in conflicts and battles for control Wholly Owned Subsidiaries • Involves the investing firm in owning 100% of the new entity in the host country. • The subsidiary may be an acquired local business in the host country, or may be a greenfield investment + • Maintain control over technological know-how and therefore the firm’s competitive advantage • Able to engage in strategic global coordination. • Able to realise experience curve economies and location economies • Most costly method of entering into and serving a foreign market. • High risk involved where firm needs to learn how to do business in a new culture Assignment (5 points) • Choose an example of any company which operates at foreign markets and analyze it’s entry mode. • Presentation during the class • Could be done in pairs • General score – 25 points 5 this assignment 5 questions at final exam 10 general analysis at final exam 5 class participation Fundamental Entry Decisions Timing Which Foreign Markets? of Entry Scale of Entry & Strategic Commitments Which Foreign Markets? • • • • • Cost / Tax Factors: transportation costs, the wage rate, availability and cost of land, as well as construction costs. Tax rates Investment incentives Demand Factors: market size and growth, presence of customers, as well as local competition Strategic Factors: investment infrastructure (e.g. transportation, telecommunications) as well as the manufacturing The presence of complementary industries and special services such as auditing, banking, insurance are also important to a foreign operation. Levels of workforce productivity and the effectiveness of inbound/outbound logistics Regulatory / Economic Factors potential host country’s industrial policies, which may control new entrants and the degree of competition.. The availability of “special economic zones” (e.g. free trade zones), Socio-Political Factors: the degree of political stability, cultural barriers, local business practices, government efficiency and corruption, attitudes towards foreign businesses, community characteristics as well as pollution control measures Timing of Entry The advantages of early entry into a foreign market - “first-mover advantages” : • Pre-empting rivals and securing demand through establishing a strong brand name; • Building sales volumes prior to rivals and gaining experience in servicing the customer over time • Tying customers into their products and services Timing of Entry The disadvantages of early entry into a foreign market (“first-mover disadvantages” ): • primarily pioneering costs. - costs which a later entrant would be able to avoid (such costs include costs associated with ‘learning the rules of the game’ in the foreign market, educating foreign consumers about the product, etc.) Scale of Entry and Strategic Commitments • large scale, - rapid, involves the commitment of significant resources - is a considerable strategic commitment and can impact the nature of competition within the market, making it easier for the firm to attract customers and distributors, could also deter other foreign entities from entering the market. • potential disadvantage of the strategic commitment of a large scale entry - it may leave the firm with insufficient resources to enter into other attractive foreign markets, thereby limiting the firm’s strategic flexibility • the small scale entry - less risky as it provides the firm with an opportunity to learn and adjust to the foreign market.