Business Explain: Foreign Direct Investment

What are the implications for managers of the theory and government policies associated with FDI?

Looking at the theory of FDI, these mainly explain the direction of foreign direct investment being location-specific advantages. Complementary to this theory are the internalization theories that cover why FDI is in many cases preferable to licensing and export.

FDI over export → mainly to avoid high transportation costs and trade barriers.

FDI over licensing → tends to be three specific types of firms.

First one, high-technology firms that need to protect their expertise and know-how as this is of great importance to the firm's competitive advantage.

Second are firms that function as global oligopolies(=few firms have large majority of market share) need to retain tight control over foreign operations in order to launch coordinated attacks against global competitors.

Lastly there is the type of firm that is under intense cost pressures and therefore needs to maintain tight control over foreign productions in order to locate production in optimal location.
Government policies also have implications on foreign direct investment, since the attitude of the government can be more or less attractive and therefore affect choice of location for production. Negotiations often arise and depending on the government's attitude towards FDI, comparable alternatives are greater or narrower.

What kinds of policy instruments exist for governments to use and influence FDI?

Policies for host country.

Encouraging inward FDI

By using incentives to foreign firms. The motivation is to gain resource transfer effects and employment effects.

Restricting inward FDI

By applying ownership restraints and performance requirements.

Policies for home country.

Encouraging outward FDI

Government-backed insurance programs, special funds and banks and relaxed restrictions.

Restricting outward FDI

By limiting capital to maintain a safe balance of payment. Use of manipulated tax rules and prohibit national firms from FDI due to political reasons.

What are the benefits and costs of FDI to home and host country?

The benefits and costs of FDI to Host country:

Resource transfer effects

Capital, technology and management resources etc are brought into the host country from the home country to be incorporated into production of products.

Employment effects

FDI requires employees on the spot, and creates jobs directly and indirectly.

Balance-of-payments

By creating a surplus, FDI can improve the current account of the host country.

Effect on competition and economic growth

Another enterprise means competition increases → decrease in price and increase in product quality.

Adverse effects on competition

Can also end up driving out domestic producers, which is not beneficial to host country.

Adverse effects on balance-of-payments

Might create a debt on the account instead of surplus.

Possible effects on national sovereignty and autonomy

If the enterprise becomes extremely influential, this might result in the loss of economic independence. Instead a foreign parent company would be making all economic decisions.

The benefits and costs of FDI to Home country:

Balance-of-payments

The inward flow of foreign earnings creates a surplus on the current account.

Employment effects

Foreign subsidiaries creates demand for home-country export, which in return creates job opportunities in the home country.

Reverse resource transfer effects

Valuable skills learned in the host country can be transferred back to the home country.

Reverse effects on balance-of-payments

Due to initial outflow of capital used to finance FDI, if the FDI is intended to serve the home country from a low-cost production location, and if it is a substitute for domestic production.

How does political ideology shape a government's attitudes toward FDI?

The three different political ideologies "The Radical View, The Free Market View & Pragmatic Nationalism" all have different approaches to FDI.

The Radical View

Bad attitude towards FDI. The believe is that FDI should never be allowed, as foreign corporations undertaking production facilities in a country can never be viewed as instruments for economic development in that country.

The Free Market View

Good attitude towards FDI. The believe is that international trade boosts the economic growth and development of all countries involved, according to the theories of Ricardo and Smith.

Pragmatic Nationalism

An ok attitude towards FDI. As long as the benefits outweigh the costs, FDI should be allowed.

What are the different theories of FDI? Why is it a good idea?

Limitations of exporting

→ Constrained by transportation cost and trade barriers
→ Especially unprofitable for low value-to-weight products
→ Fear of future import tariffs and quotas

Limitations of licensing

→ Possibility of giving away valuable technological know-how
→ Lost of tight control manufacturing, marketing and strategy and therefore difficult to enforce radical decisions
→ Decrease in production efficiency due to lacking management by licensee

Advantages of FDI

→ Helps avoid high transportation costs and tariff barriers
→ Ensures valuable technological know-how remains safe within the hands of the firm.
→ Firm retains tight control over manufacturing, marketing and strategy which can help gain greater market shares and maximize profitability
→ Maximized efficiency in all parts of production due to good management

What are the current trends regarding FDI in the world economy?

Investing directly in facilities to produce or market a product or service in a foreign country has become increasingly popular in the last decades, outgrowing both world trade and exporting. The main arguments for the increasingly trendy FDI's are following:

Fear of protectionist pressures

Despite lowering of trade barriers, firms still fear that governments will install new barriers to prevent trade. Therefore, FDI is a great way of avoiding these future uncertainties, as FDI is located inside the country borders.

Political and economic changes

The shift toward free market economies and democracy encourages FDI. Many countries have also taken on multiple programs to increase economic growth, deregulation and privatization to open up to foreign investors.

Globalization of world economy

Has had a positive effect on the volume of FDI → many firms see the world as their market, and undertaking FDI is to ensure their significant presence in as many locations as possible.