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Foreign Direct Investment

• General Definition
– Direct investments in productive assets in a
foreign country.
• Practical Definition
– Many countries differentiate between portfolio
investment and FDI using the 10% rule.
– Often, requires investment ≥ 10% of total
capital of company to be considered FDI.
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What is FDI?
• 3 components:
1. Equity capital
2. Reinvested earnings
3. Intra-company loans

• Will all of this data actually be available


for analysis?

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Defining Characteristics of MNEs
• Larger
• More productive
• Stronger
• Usually already export/import

 What are the implications for firm’s ability


to raise capital?
3
Why do FDI?
• Arbitrage market imperfections.

• Leverage firm strengths.

4
Trade Barriers
• Why would these lead to FDI?

• More generally, this shows that government


policies towards specific industries can
have a profound impact on domestic &
foreign investment in those industries.

• De facto barriers also exist.


5
Imperfect Labor Market
• Output = function (capital, labor).
• Capital is largely location-invariant.
• Salaries vary widely by location.
• Non-salary costs associated with labor.

6
Intangible Assets
• Internalization theory of FDI: MNEs
conduct FDI in order to retain control of
intangibles while enjoying benefits of larger
markets.

7
Vertical Integration
• What is it?
• How does it change competitive landscape?
• Backward vs. forward
• Interesting twist: double marginalization if
and only if also have monopoly power.

8
Product Life Cycle
• Not same in all countries
– Example: land-lines vs. cell phones.
– Example: cell phones in Japan vs. US.
• Reflects high initial importance of R&D.
Later, total costs are more important.
• This leads to FDI in lower cost countries.

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Product Life Cycle
The U.S.
Quantity

production exports
imports

m p ti on
co nsu

New product Maturing product Standardized product


Less advanced
countries
exports
Quantity

n
p tio
su m
con
imports
production

New product Maturing product Standardized product10


Source: McGraw Hill
World FDI Inflows & Outflows
1,600

1,400

1,200

1,000
US$bn

800

600

400

200

0
1970 1980 1990 1995 1999 2000 2001

Inflows Outflows

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Global Inflows of FDI 1993-2001
1,600

1,400

1,200

1,000
US$bn

800

600

400

200

0
1970 1980 1990 1995 1999 2000 2001

World Developed Countries Developing Countries Central & Eastern Europe

12
Global Outflows of FDI 1993-2001
1,600

1,400

1,200

1,000
US$bn

800

600

400

200

0
1970 1980 1990 1995 1999 2000 2001

World Developed Countries Developing Countries Central & Eastern Europe

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Net Global Inflows of FDI 1993-2001
200

150

100

50
US$bn

0
1970 1980 1990 1995 1999 2000 2001
-50

-100

-150

World Developed Countries Developing Countries Central & Eastern Europe

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Sectoral Allocation of FDI
• General rules – averaged over time &
countries so take cautiously:
– 35.6% to manufacturing
– 47.4% to services
– 17.0% to primary products

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Forms of FDI
• Greenfield investment
– Build new production facilities in foreign
country.
• M&A
– Buy existing businesses in foreign countries

• WFOE vs. JV
– Some countries specify 2+ types of JVs.
16
Interpreting FDI
• Transfer ownership of productive assets to
more efficient owners.
or
• Leverage comparative advantage by
moving to more suitable locations.

17
Markets’ View of FDI
• Are there synergistic gains? (i.e. 1+1 > 2?)
• Multinationality is positively correlated
with firm’s market value because of
intangibles.
• Consistent with internalization theory of
FDI.
• Morck & Yeung (“Why Investors Value
Multinationality”, Journal of Business, 1991)

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FDI & Exchange Rates
Empirical data indicate that exchange rates:
• may influence M&A FDI.
• have little/no influence on greenfield
investments.

• Why?

19
Consequences for Host Countries
• Positive
– Direct: Technology transfer; increased
employment; higher salaries (~20% common).
– Indirect: Enhances market competitiveness;
may lower domestic prices; improve quality of
labor force.
• Negative
– Direct: reduce market power of domestic firms;
profits shipped to MNE’s home country;
foreign firms gain domestic influence.
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Consequences for Home Countries
• Technological innovation.
• Foreign trade expansion positively
correlated to outward FDI  mixed net
impact on labor market.
• Profit remittance from overseas
investments.
– Not always a positive. Why?

21
Policy Changes that Promote FDI
• World Trade Organization (WTO)
• Bilateral Investment Treaties (BITs)

 Illustrates political sensitivity of certain


industries/countries.

22
Political Risk
• Difficult to measure but fundamental to a
full understanding of a market’s projected
development.
• Macro risk – affects all FDI in host country.
• Micro risk – affects only certain industries
or types of firms.

23
Hedging Political Risk
• Geographic diversification
• Minimize exposure
– Form JVs with local companies.
– Form/join international consortium to make
investments.
– Use local financing.
– Insurance against political risk.

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