Charles W. L. Hill PhD ISE International Business Competing in the Global Marketplace PDF

part three The Global Trade and Investment Environment Foreign Direct Investment 8 LEARNING OBJECTIVES After reading this chapter, you will be able to: LO8-1 Recognize current...

part three The Global Trade and Investment Environment Foreign Direct Investment 8 LEARNING OBJECTIVES After reading this chapter, you will be able to: LO8-1 Recognize current trends regarding foreign direct investment (FDI) in the world economy. LO8-2 Explain the different theories of FDI. LO8-3 Understand how political ideology shapes a government’s attitudes toward FDI. LO8-4 Describe the benefits and costs of FDI to home and host countries. LO8-5 Explain the range of policy instruments that governments use to influence FDI. LO8-6 Identify the implications for managers of the theory and government policies associated with FDI. Chine Nouvelle/SIPA/Shutterstock Tesla’s Investment in China OPENING CASE 50 percent share in ownership of the factory to a local partner. For a company whose competitive advantage is In July of 2018, Tesla announced that it would be building based upon technology, this was a risky proposition. In a new auto plant in Shanghai, China, its first factory outside 2018, however, China announced it was relaxing the of the United States. When operating at full production, the 50/50 joint venture requirement for foreign investment in a Chinese plant will be capable of producing 500,000 of number of areas, including the automobile industry. Tesla’s electric cars a year, doubling the company’s output. Under the Trump administration the United States had Tesla has been selling its vehicles in China for several launched a trade war with China. The United States had years, exporting finished cars from its Fremont, California, placed 25 percent import tariffs on a wide range of Chinese plant. The investment had been approved by Chinese goods, and China had responded by placing tariffs of its authorities in record time, who indicated they would allow own on some American imports. This created a risk for any Tesla to establish a wholly owned subsidiary in China. The company exporting products from the United States to Chinese also helped with $1.6 billion in funding from state- China. China had only recently eliminated a 25 percent tar- owned banks. The decision to invest directly in the country iff on imports of foreign cars, and now there was a risk this was precipitated by a number of factors. might be reimposed. In addition to trade policy reversals, By 2018, China was already the world’s largest auto Tesla faced risks from currency fluctuations. Investing market and the largest market for electric vehicles (EV) directly in China sidestepped these risks. with sales of 1.2 million in 2018 (including trucks and Tesla’s Shanghai factory started up production in buses). Forecasts suggested that China could reach EV December 2020, producing Tesla’s Model 3 car, which sales of 1.8 million by 2021 and 6 million by 2025. Driving was priced at around $50,000. China exempted the the growth projections is a bold commitment by the Model 3s from a 10 percent sales tax and was providing a Chinese government that 100 percent of vehicles sold in $3,560 subsidy on each car. In the company’s first year of China by 2030 will be EVs. The Chinese government is local production, sales surged to 120,000 units, up from pursuing this goal in order to limit CO2 emissions and 40,000 in 2019. This made China Tesla’s largest market reach its climate change objectives under the Paris after the United States. Forecasts suggest that China will Agreement on climate change, to reduce urban pollution, make up 40 percent of Tesla’s sales by early 2022, up and to reduce its dependence on imports of foreign oil from 20 percent in 2020. However, Tesla does not have (China produces very little oil). The goal has been sup- the premium electric car market to itself in China. A trio of ported by favorable regulations and producer subsidies local producers—Nio, Xpeng, and Li—are also in the from the Chinese government, along with tax credits for premium EV segment, and although Tesla leads, they are buyers of EVs. The government sees electric vehicle pro- catching up. duction as a way to transform China into a major player in the global auto industry. Sources: B. Goh, “Tesla Goes Big in China with Shanghai Plant,” For Tesla, participating directly in this booming market Reuters, July 10, 2018; L. Tang, “China’s Electric Vehicle Sales to Reach More that 1.3 Million in 2020,” S&P Global, December 17, with local production had long been considered an option. 2020; C. Zhu et al., “Tesla’s Dominant Position in China Could Be Tesla had been held back by China’s tough rules for for- Threatened Next Year,” Bloomberg, December 28, 2020; D. Gessner, eign businesses, which would have required it to cede a “Why China Loves Tesla,” Business Insider, June 4, 2020. 231 232 Part 3 The Global Trade and Investment Environment Introduction Foreign direct investment (FDI) is when a firm invests directly in facilities to produce or market a good or service in a foreign country. According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, or affiliated group takes an interest of 10 percent or more in a foreign business entity. Other nations use similar clas- sifications. Once a firm undertakes FDI, it becomes a multinational enterprise. The invest- ments made by Tesla in Chinese production facilities is an example of FDI (see the Opening Case). Due to these investments, Tesla is now considered to be a multinational enterprise. While much FDI takes the form of greenfield ventures—building up subsidiar- ies from scratch—acquisitions and joint ventures with well-established foreign entities are also important vehicles for foreign direct investment. This chapter begins by looking at the importance of FDI in the world economy. Next, we review theories explaining why enterprises undertake foreign direct investment, and what form that investment takes, ranging from licensing and franchising to joint ventures and wholly owned subsidiaries. These theories help to explain why Tesla held off from investing directly in Chinese production until local regulations permitted it to establish a wholly owned subsidiary. If Tesla had entered earlier via a joint venture, Tesla would have risked giving away valuable technology to its Chinese partner. That was something Tesla’s CEO, Elon Musk, frowned upon. After discussing theories of FDI, this chapter looks at government policy toward foreign direct investment. As can be seen from the Opening Case, government policy is important. The Chinese government has clearly welcomed Tesla, allowing it to establish a wholly owned subsidiary and providing the company with significant financial help. We will look at why governments sometimes do this, as well as why they sometimes do the opposite and prohibit foreign direct investment, or place limits on it. The chapter closes with a section on the implications of the material discussed here, as they relate to management practice. Foreign Direct Investment in the World Economy 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 LO8-1 a given time period (normally a year). The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. We also talk of outflows of FDI, meaning the Recognize current trends flow of FDI out of a country, and inflows of FDI, the flow of FDI into a country. regarding foreign direct investment (FDI) in the world economy. TRENDS IN FDI The past 30 years have seen an increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from $250 billion in 1990 to a peak of $2.2 trillion in 2007, before slipping back to around $1.4 trillion by 2019 and then slumping to $740 billion during 2020 due to the COVID 19 pandemic (see Figure 8.1).1 Despite the pullback since 2007, from 1990 the flow of FDI has accelerated faster than the growth in world trade and world output. For example, between 1990 and 2020, the total flow of FDI from all countries increased around sixfold, while world trade by value grew fourfold and world output by around 60 percent.2 As a result of the strong FDI flows, by 2020 the global stock of FDI was about $39 trillion. As a result of sustained cross-border investment, the sales of foreign affiliates of multinational corporations reached $33 trillion in 2020, over $10 trillion more than the value of international trade, and these affiliates employed some 86 million people.3 Clearly, by any measure, FDI is a very important phenomenon in the global economy. FDI has grown rapidly for several reasons. First, despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Given the rising pressures for protectionism  Foreign Direct Investment Chapter 8 233 F IG URE 8.1 2,500 FDI outflows, 1990–2020 ($ billions). 2,000 Source: UNCTAD statistical data set, http://unctadstat.unctad.org. 1,500 $ Billions 1,000 500 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 associated with the election of Donald Trump as President in the United States and the decision by the British to leave the European Union, this seems likely to continue for some time. Second, much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world’s developing nations. The general shift toward democratic political institutions and free market economies that we discussed in Chapter 3 has encouraged FDI. Across much of Asia, eastern Europe, and Latin America, economic growth, economic deregulation, privatization programs that are open to foreign investors, and removal of many restrictions on FDI have made these countries more attractive to foreign multinationals. According to United Nations data, almost 80 percent of the more than 1,500 changes made to national laws governing foreign direct investment since 2000 have created a more favorable environment.4 The globalization of the world economy has also had an impact on the volume of FDI. Many firms see the whole world as their market, and they are undertaking FDI in an attempt to make sure they have a significant presence in many regions of the world. For example, around 43 percent of the sales of American firms in the S&P 500 index are generated abroad.5 For reasons that we explore later in this book, many firms now believe it is important to have production facilities close to their major customers. This too creates pressure for greater FDI. THE DIRECTION OF FDI Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the others’ markets (see Figure 8.2). During the 1980s and 1990s, the United States was often the favorite target for FDI inflows. The United States has been an attractive target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI. Investors include firms based in Great Britain, Japan, Germany, Holland, and France. Inward investment into the United States remained high during the 2000s and stood at $261 billion in 2019, before falling to $156 billion in 2020. The 2020 decline was primarily as a result of the COVID-19 pandemic. The developed nations of Europe have also been recipients of significant FDI inflows, principally from the United States and other European nations. In 2019, inward investment into Europe was $363 billion (it fell to only $73 billion in 2020, again due to the COVID-19 pandemic). The United Kingdom and France have historically been the largest recipients of inward FDI.6 234 Part 3 The Global Trade and Investment Environment FI GU R E 8.2 2,500 FDI inflows by region, 1995–2020 ($ billions). Source: UNCTAD statistical data 2,000 set, http://unctadstat.unctad.org. 1,500 $ Billions 1,000 500 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Developed Nations Developing Nations Transition Economies However, over the last decade, FDI inflows directed at developing nations and the tran- sition economies of eastern Europe and the old Soviet Union have increased markedly (see Figure 8.2) and in 2018 they matched inflows into developed nations for the first time. Most recent inflows into developing nations have been targeted at the emerging economies of Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient of FDI, which attracted about $60 billion of FDI in 2004 and rose steadily to hit a record $149 billion in 2020.7 The reasons for the strong flow of investment into China are discussed in the accompanying Country Focus. Latin America is the next most important region in the developing world for FDI inflows. In 2019, total inward investments into this region reached $160 billion, although it fell to $88 billion in 2020, again primarily due to the impact of the COVID-19 pandemic. Brazil has historically been the top recipient of inward FDI in Latin America. In Central America, Mexico has been a big recipient of inward investment thanks to NAFTA and the country’s proximity to the United States. In 2019, some $34 billion of investments were made by foreigners in Mexico and another $29 billion was invested in 2020. At the other end of the scale, Africa has long received the smallest amount of inward investment, $47 billion in 2019 and $40 billion in 2020. In recent years, Chinese enterprises have emerged as major investors in Africa, particularly in extraction industries, where they seem to be trying to ensure future supplies of valuable raw materials. The inability of Africa to attract greater investment is in part a reflection of the political unrest, armed conflict, and frequent changes in economic policy in the region.8 THE SOURCE OF FDI Since World War II, the United States has consistently been the largest source country for FDI. Other important source countries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countries accounted for 60 percent of all FDI outflows for 2000–2020 (see Figure 8.3). As might be expected, these countries have long predominated in rankings of the world’s largest multinationals, although as noted in Chapter 1, mainland China is now rising fast in the rankings.9 Excluding China, these nations dominate primarily because they were the most developed nations with the largest economies during much of the postwar period and therefore home to many of the largest and best-capitalized  C OUNTRY FOC US Foreign Direct Investment in China Beginning in late 1978, China’s leadership decided to Less obvious, at least to begin with, was how difficult it move the economy away from a centrally planned socialist would be for foreign firms to do business in China. For one system to one that was more market driven. The result has thing, despite decades of growth, China still lags behind been 40 years of sustained high economic growth rates of developed nations in the wealth and sophistication of its between 6 and 10 percent, compounded annually. This consumer market. This limits opportunities for Western growth attracted substantial foreign investment. Starting firms. For example, real GDP per capita in China on a pur- from a tiny base, foreign investment increased to an annual chasing power parity was $18,237 in 2018, compared to average rate of $2.7 billion between 1985 and 1990 and $62,794 in the United States. Moreover, income and wealth then surged to $40 billion annually in the late 1990s, mak- in China is skewed toward a few areas such as Beijing and ing China the second-biggest recipient of FDI inflows in the Shanghai, where real household income per capita is about world after the United States. The growth has continued, four times the level in the country’s poorest provinces. with inward investments into China hitting $140 billion in Other problems include a highly regulated environ- 2019 (with another $55 billion going into Hong Kong). ment, which can make it problematic to conduct business Over the past 20 years, this inflow has resulted in the transactions, and shifting tax and regulatory regimes. Then establishment of more than 300,000 foreign-funded enter- there are problems with local joint-venture partners that prises in China. The total stock of FDI in mainland China are inexperienced, opportunistic, or simply operate grew from almost nothing in 1978 to $1.6 trillion in 2018 according to different goals. One U.S. manager explained (another $1.99 trillion of FDI stock was in Hong Kong). that when he laid off 200 people to reduce costs, his The reasons for this investment are fairly obvious. With a Chinese partner hired them all back the next day. When he population of more than 1.3 billion people, China represents inquired why they had been hired back, the Chinese part- the world’s largest market. Historically, import tariffs made it dif- ner, which was government owned, explained that as an ficult to serve this market via exports, so FDI was required if a agency of the government, it had an “obligation” to reduce company wanted to tap into the country’s huge potential. unemployment. Western firms also need to be concerned China joined the World Trade Organization in 2001. As a result, about protecting their intellectual property because there average tariff rates on imports have fallen from 15.4 percent to is a history of intellectual property not being respected in about 8 percent today. Even so, avoiding the tariff on imports is China, although this may now be starting to change. still a motive for investing in China (at 8 percent, tariffs are still significantly above the average of 1.9 percent found in many Sources: Interviews by the author while in China; United Nations, World Investment Report, 2017; L. Ng and C. Tuan, “Building a developed nations). Notwithstanding tariff rates, many foreign Favorable Investment Environment: Evidence for the Facilitation of firms believe that doing business in China requires a substan- FDI in China,” The World Economy, 2002, pp. 1095–114; S. Chan and tial presence in the country to build guanxi, the crucial relation- G. Qingyang, “Investment in China Migrates Inland,” Far Eastern Economic Review, May 2006, pp. 52–57; R. Chang, “Here’s What ship networks (see Chapter 4 for details). Furthermore, a China’s Middle Classes Really Earn—and Spend,” Bloomberg, March combination of relatively inexpensive labor and tax incentives, 9, 2016; Yi Wen, “Income and Living Standards Across China,” On the particularly for enterprises that establish themselves in special Economy Blog, Federal Reserve Bank of St Louis, January 8, 2018; G. economic zones, makes China an attractive base from which Orr, “A Pocket Guide to Doing Business in China,” McKinsey, October 2014, archived at www.mckinsey.com/business-functions/strategy- to serve Asian or world markets with exports (although rising and-corporate-finance/our-insights/a-pocket-guide-to-doing- labor costs in China are now making this less important). business-in-china. enterprises. Many of these countries also had a long history as trading nations and naturally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enter- prises based there have been at the forefront of foreign investment trends. The dramatic rise of China, particularly since 2010 when outward investment by Chinese multinationals started to surge, may soon upset this long established narrative. In 2005, Chinese firms invested some $12 billion internationally. Since then, the figure has risen steadily, reaching a record $158 billion in 2016 before slipping back to $138 billion in 235 236 Part 3 The Global Trade and Investment Environment FI G U R E 8.3 Cumulative FDI outflows, 5,000 2000–2020 ($ billions). 4,500 Source: UNCTAD statistical data 4,000 set, http://unctadstat.unctad.org. 3,500 3,000 $ Billions 2,500 2,000 1,500 1,000 500 0 s m s y n e na te nd an pa nc do hi a m rla a Ja C St ng Fr er he d Ki G te et d ni N te U ni U Did You Know? 2019 and $133 billion in 2020. Firms based in Hong Kong accounted for another $53 billion Did you know that the value of outward FDI in 2019 and $102 billion in 2020. Much of the outward investment by of Foreign Direct Chinese firms has been directed at extractive industries in less developed nations (e.g., Investment has been China has been a major investor in African countries). A major motive for these invest- growing faster than world ments has been to gain access to raw materials, of which China is one of the world’s largest trade and world output? consumers. There are signs, however, that Chinese firms are starting to turn their attention to more advanced nations. Chinese firms invested around $46 billion in the United States Visit your instructor’s in 2016, and another $30 billion in 2017, up very little prior to 2010. In 2018 and 2019, Connect® course and click however, Chinese investment in the United States slumped to around $5 billion as the on your eBook or ongoing trade conflict between the two nations soured relations.10 Smartbook ® to view a short video explanation from the THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTS author. FDI takes two main forms. The first is a greenfield investment, which involves the establish- ment of a new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country. UN estimates indicate that some 40 to 80 percent of all FDI inflows were in the form of mergers and acquisitions between 1998 and 2020.11 However, FDI flows into developed nations differ markedly from those into developing nations. In the case of developing nations, only about one-third or less of FDI is in the form of cross-border mergers and acquisitions. The lower percentage of mergers and acquisitions may simply reflect the fact that there are fewer target firms to acquire in developing nations. When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake greenfield investments? We consider this question in depth in Chapter 15. For now, we can make a few basic observations. First, mergers and acquisitions are quicker to execute than greenfield investments. This is an important consideration in the modern business world where markets evolve very rapidly. Many firms apparently believe that if TEST PREP they do not acquire a desirable target firm, then their global rivals will. Second, foreign Use SmartBook to help retain firms are acquired because those firms have valuable strategic assets, such as brand loyalty, what you have learned. customer relationships, trademarks or patents, distribution systems, production systems, Access your instructor’s and the like. It is easier and perhaps less risky for a firm to acquire those assets than to Connect course to check out build them from the ground up through a greenfield investment. Third, firms make acquisi- SmartBook or go to tions because they believe they can increase the efficiency of the acquired unit by transfer- learnsmartadvantage.com ring capital, technology, or management skills. However, as we discuss in Chapter 15, there for help. is evidence that many mergers and acquisitions fail to realize their anticipated gains.12  Foreign Direct Investment Chapter 8 237 Theories of Foreign Direct Investment In this section, we review several theories of foreign direct investment. These theories LO8-2 approach the various phenomena of foreign direct investment from three complementary Explain the different perspectives. One set of theories seeks to explain why a firm will favor direct investment as theories of FDI. a means of entering a foreign market when two other alternatives, exporting and licensing, are open to it. Another set of theories seeks to explain why firms in the same industry often undertake foreign direct investment at the same time and why they favor certain loca- tions over others as targets for foreign direct investment. Put differently, these theories attempt to explain the observed pattern of foreign direct investment flows. A third theoreti- cal perspective, known as the eclectic paradigm, attempts to combine the two other per- spectives into a single holistic explanation of foreign direct investment (this theoretical perspective is eclectic because the best aspects of other theories are taken and combined into a single explanation). WHY FOREIGN DIRECT INVESTMENT? Why do firms go to the trouble of establishing operations abroad through foreign direct investment when two alternatives, exporting and licensing, are available to them for exploit- ing the profit opportunities in a foreign market? Exporting involves producing goods at home and then shipping them to the receiving country for sale. Licensing involves grant- ing a foreign entity (the licensee) the right to produce and sell the firm’s product in return for a royalty fee on every unit sold. The question is important, given that a cursory exami- nation of the topic suggests that foreign direct investment may be both expensive and risky compared with exporting and licensing. FDI is expensive because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise. FDI is risky because of the problems associated with doing business in a differ- ent culture where the rules of the game may be very different. Relative to indigenous firms, there is a greater probability that a foreign firm undertaking FDI in a country for the first time will make costly mistakes due to its ignorance. When a firm exports, it need not bear the costs associated with FDI, and it can reduce the risks associated with selling abroad by using a native sales agent. Similarly, when a firm allows another enterprise to produce its products under license, the licensee bears the costs or risks (e.g., fashion retailer Burberry originally entered Japan via a licensing contract with a Japanese retailer—see the accompa- nying Management Focus). So why do so many firms apparently prefer FDI over either exporting or licensing? The answer can be found by examining the limitations of exporting and licensing as means for capitalizing on foreign market opportunities. Limitations of Exporting The viability of exporting physical goods is often constrained by transportation costs and trade barriers. When transportation costs are added to production costs, it becomes unprof- itable to ship some products over a large distance. This is particularly true of products that have a low value-to-weight ratio and that can be produced in almost any location. For such products, the attractiveness of exporting decreases, relative to either FDI or licensing. This is the case, for example, with cement. Thus, Cemex, the large Mexican cement maker, has expanded internationally by pursuing FDI, rather than exporting. For products with a high value-to-weight ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic components, personal computers, medical equipment, computer software.) and have little impact on the relative attractiveness of exporting, licensing, and FDI. Transportation costs aside, some firms undertake foreign direct investment as a response to actual or threatened trade barriers such as import tariffs or quotas. By placing tariffs on imported goods, governments can increase the cost of exporting relative to foreign direct investment and licensing. Similarly, by limiting imports through quotas, governments increase the attractiveness of FDI and licensing. For example, the wave of FDI by Japanese auto  M AN AGE M E N T F OC U S Burberry Shifts Its Entry Strategy in Japan Burberry, the iconic British luxury apparel company best Ahrendts was determined to rein in licensees and regain known for its high-fashion outerwear, has been operating control of Burberry’s sales in foreign markets, even if it in Japan for nearly half a century. Until recently, its branded meant taking a short-term hit to sales. She started off the products were sold under a licensing agreement with process of terminating licensees before leaving Burberry to Sanyo Shokai. The Japanese company had considerable run Apple’s retail division in 2014. Her hand-picked succes- discretion as to how it utilized the Burberry brand. It sold sor as CEO, Christopher Bailey, who rose through the design everything from golf bags to miniskirts to Burberry-clad function at Burberry, has continued to pursue this strategy. Barbie dolls in its 400 stores around the country, typically In Japan, the license was terminated in 2015. Sanyo at prices significantly below those Burberry charged for its Shokai was required to close nearly 400 licensed Burberry high-end products in the United Kingdom. stores. Burberry is not giving up on Japan, however. After all, For a long time, it looked like a good deal for Burberry. Japan is the world’s second-largest market for luxury goods. Sanyo Shokai did all of the market development in Japan, Instead, the company will now sell products through a lim- generating revenues of around $800 million a year and ited number of wholly owned stores. The goal is to have 35 paying Burberry $80 million in annual royalty payments. to 50 stores in the most exclusive locations in Japan by However, by 2007, Burberry’s CEO, Angela Ahrendts, was 2018. They will offer only high-end products, such as becoming increasingly dissatisfied with the Japanese Burberry’s classic $1,800 trench coat. In general, the price licensing deal and 22 others like it in countries around the point will be 10 times higher than was common for most world. In Ahrendts’ view, the licensing deals were diluting Burberry products in Japan. The company realizes the move Burberry’s core brand image. Licensees such as Sanyo is risky and fully expects sales to initially fall before rising Shokai were selling a wide range of products at a much again as it rebuilds its brand, but CEO Bailey argues that the lower price point than Burberry charged for products in its move is absolutely necessary if Burberry is to have a coher- own stores. “In luxury,” Ahrendts once remarked, “ubiquity ent global brand image for its luxury products. will kill you—it means that you’re not really luxury any- Sources: K. Chu and M. Fujikawa, “Burberry Gets a Grip on Brand in more.” Moreover, with an increasing number of customers Japan,” The Wall Street Journal, August 15–16, 2015; A. Ahrendts, buying Burberry products online and on trips to Britain, “Burberry’s CEO on Turning an Aging British Icon into a Global Luxury Brand,” Harvard Business Review, January–February 2013; T. Blanks, where the brand was considered very upmarket, Ahrendts “The Designer Who Would be CEO,” The Wall Street Journal felt that it was crucial for Burberry to tightly control its Magazine, June 18, 2015; G. Fasol, “Burberry Solves Its ‘Japan global brand image. Problem,’ at Least for Now,” Japan Strategy, August 19, 2015. companies in the United States that started in the mid-1980s and continues to this day has been partly driven by protectionist threats from Congress and by tariffs on the importation of Japanese vehicles, particularly light trucks (SUVs), which still face a 25 percent import tariff into the United States. For Japanese auto companies, these factors decreased the prof- itability of exporting and increased that of foreign direct investment. In this context, it is important to understand that trade barriers do not have to be physically in place for FDI to be favored over exporting. Often, the desire to reduce the threat that trade barriers might be imposed is enough to justify foreign direct investment as an alternative to exporting. Limitations of Licensing A branch of economic theory known as internalization theory seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering foreign mar- kets (this approach is also known as the market imperfections approach).13 According to internalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities. First, licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor. In a classic example, in the 1960s, 238  Foreign Direct Investment Chapter 8 239 RANKINGS Cross-border investments have been ramped up to a relatively large degree in the last decade. Even with the economic downturn that started in 2008, the world continued to see a great deal of foreign direct investment by companies in the last decade. Now, when the economic prosperity is likely to be better, given that we are removed from those downturn days, the expectation is that more foreign direct investment will be considered by compa- nies. On globalEDGE™, there are myriad opportunities to gain more knowledge about for- eign direct investment (FDI). The “Rankings” section is a great starting point (globaledge. msu.edu/global-resources/rankings). In this section, globalEDGE™ features several reports by A. T. Kearney—with one of them squarely centered on foreign direct investment and a “confidence index” for FDI. The companies that participate in the regular study account for more than $2 trillion in annual global revenue! Which countries are in the top three in the investment confidence index, and do you agree that the three countries are the best ones to invest in if you were running a company? RCA licensed its leading-edge color television technology to a number of Japanese compa- nies, including Matsushita and Sony. At the time, RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market without the costs and risks associated with foreign direct investment. However, Matsushita and Sony quickly assimilated RCA’s technology and used it to enter the U.S. market to compete directly against RCA. As a result, RCA was relegated to being a minor player in its home market, while Matsushita and Sony went on to have a much bigger market share. A second problem is that licensing does not give a firm the tight control over production, marketing, and strategy in a foreign country that may be required to maximize its profitability. With licensing, control over production (of a good or a service), marketing, and strategy are granted to a licensee in return for a royalty fee. However, for both strategic and opera- tional reasons, a firm may want to retain control over these functions. One reason for wanting control over the strategy of a foreign entity is that a firm might want its foreign subsidiary to price and market very aggressively as a way of keeping a foreign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept such an imposition because it would likely reduce the licensee’s profit, or it might even cause the licensee to take a loss. Another reason for wanting control over the strategy of a foreign entity is to make sure that the entity does not damage the firm’s brand. This was the pri- mary reason fashion retailer Burberry recently terminated its licensing agreement in Japan and switched to a strategy of direct ownership of its own retail stores in the Japanese mar- ket (see the Management Focus about Burberry for details). One reason for wanting control over the operations of a foreign entity is that the firm might wish to take advantage of differences in factor costs across countries, producing only part of its final product in a given country, while importing other parts from where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement because it would limit the licensee’s autonomy. For reasons such as these, when tight control over a foreign entity is desirable, foreign direct investment is preferable to licensing. A third problem with licensing arises when the firm’s competitive advantage is based not as much on its products as on the management, marketing, and manufacturing capabilities that produce those products. The problem here is that such capabilities are often not amenable to licensing. While a foreign licensee may be able to physically reproduce the firm’s product under license, it often may not be able to do so as efficiently as the firm could itself. As a result, the licensee may not be able to fully exploit the profit potential inherent in a foreign market. 240 Part 3 The Global Trade and Investment Environment For example, consider Toyota, a company whose competitive advantage in the global auto industry is acknowledged to come from its superior ability to manage the overall process of designing, engineering, manufacturing, and selling automobiles—that is, from its management and organizational capabilities. Indeed, Toyota is credited with pioneer- ing the development of a new production process, known as lean production, that enables it to produce higher-quality automobiles at a lower cost than its global rivals.14 Although Toyota could license certain products, its real competitive advantage comes from its man- agement and process capabilities. These kinds of skills are difficult to articulate or codify; they certainly cannot be written down in a simple licensing contract. They are organiza- tion-wide and have been developed over the years. They are not embodied in any one individual but instead are widely dispersed throughout the company. Put another way, Toyota’s skills are embedded in its organizational culture, and culture is something that cannot be licensed. Thus, if Toyota were to allow a foreign entity to produce its cars under license, the chances are that the entity could not do so as efficiently as could Toyota. In turn, this would limit the ability of the foreign entity to fully develop the market potential of that product. Such reasoning underlies Toyota’s preference for direct investment in foreign markets, as opposed to allowing foreign automobile companies to produce its cars under license. All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing: (1) when the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) when a firm’s skills and know-how are not amenable to licensing. Advantages of Foreign Direct Investment It follows that a firm will favor foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favor foreign direct investment over licensing (or franchising) when it wishes to maintain control over its technological know-how, or over its operations and business strat- egy, or when the firm’s capabilities are simply not amenable to licensing, as may often be the case. Moreover, gaining technology, productive assets, market share, brand equity, dis- tribution systems, and the like through FDI by purchasing the assets of an established company can all speed up market entry, improve production in the firm’s home base, and facilitate the transfer of technology from the acquired company to the acquiring company. We return to this topic in Chapter 13 when we discuss different entry strategies. THE PATTERN OF FOREIGN DIRECT INVESTMENT Observation suggests that firms in the same industry often undertake foreign direct invest- ment at about the same time. Also, firms tend to direct their investment activities toward the same target markets. The two theories we consider in this section attempt to explain the patterns that we observe in FDI flows. Strategic Behavior One theory is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. An early variant of this argument was expounded by F. T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic industries.15 An oligopoly is an industry composed of a limited number of large firms (e.g., an industry in which four firms control 80 percent of a domestic market would be defined as an oligopoly). A critical competitive feature of such industries is interdependence of the major players: What one firm does can have an immediate impact on the major competi- tors, forcing a response in kind. By cutting prices, one firm in an oligopoly can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share. Thus, the interdependence between firms in an oligopoly leads to imita- tive behavior; rivals often quickly imitate what a firm does in an oligopoly.  Foreign Direct Investment Chapter 8 241 Imitative behavior can take many forms in an oligopoly. One firm raises prices, and the others follow; one expands capacity, and the rivals imitate lest they be left at a disadvan- tage in the future. Knickerbocker argued that the same kind of imitative behavior charac- terizes FDI. Consider an oligopoly in the United States in which three firms—A, B, and C—dominate the market. Firm A establishes a subsidiary in France. Firms B and C decide that if successful, this new subsidiary may knock out their export business to France and give a first-mover advantage to firm A. Furthermore, firm A might discover some competi- tive asset in France that it could repatriate to the United States to torment firms B and C on their native soil. Given these possibilities, firms B and C decide to follow firm A and establish operations in France. Studies that have looked at FDI by U.S. firms show that firms based in oligopolistic industries tended to imitate each other’s FDI.16 The same phenomenon has been observed with regard to FDI undertaken by Japanese firms.17 For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by undertaking their own FDI in the United States and Europe. Research has also shown that models of strate- gic behavior in a global oligopoly can explain the pattern of FDI in the global tire industry.18 Knickerbocker’s theory can be extended to embrace the concept of multipoint competi- tion. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.19 Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other’s moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits gener- ated there to subsidize competitive attacks in other markets. Although Knickerbocker’s theory and its extensions can help explain imitative FDI behavior by firms in oligopolistic industries, it does not explain why the first firm in an oligopoly decides to undertake FDI rather than to export or license. Internalization theory addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, internalization theory addresses the efficiency issue. For these reasons, many economists favor internalization theory as an explanation for FDI, although most would agree that the imitative explanation tells an important part of the story. THE ECLECTIC PARADIGM The eclectic paradigm has been championed by the late British economist John Dunning.20 Dunning argues that in addition to the various factors discussed earlier, location-specific advantages are also of considerable importance in explaining both the rationale for and the direction of foreign direct investment. By location-specific advantages, Dunning means the advantages that arise from utilizing resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm’s technological, marketing, or management capabilities). Dunning accepts the argument of internalization theory that it is difficult for a firm to license its own unique capabilities and know-how. Therefore, he argues that combining location-specific assets or resource endowments with the firm’s own unique capabilities often requires foreign direct investment. That is, it requires the firm to establish produc- tion facilities where those foreign assets or resource endowments are located. An obvious example of Dunning’s arguments are natural resources, such as oil and other minerals, which are—by their character—specific to certain locations. Dunning sug- gests that to exploit such foreign resources, a firm must undertake FDI. Clearly, this explains the FDI undertaken by many of the world’s oil companies, which have to invest where oil is located in order to combine their technological and managerial capabilities with this valuable location-specific resource. Another obvious example is valuable human resources, such as low-cost, highly skilled labor. The cost and skill of labor varies from country to country. Because labor is not internationally mobile, according to Dunning it 242 Part 3 The Global Trade and Investment Environment makes sense for a firm to locate production facilities in those coun- tries where the cost and skills of local labor are most suited to its particular production processes. However, Dunning’s theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semiconductor industry. Many of the world’s major computer and semiconductor companies— such as Apple Computer, Hewlett-Packard, Oracle, Google, and Intel—are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs there. According to Dunning’s arguments, knowledge being generated in Google Headquarters in Mountain View, California, USA. Silicon Valley with regard to the design and manufacture of comput- Phillip Bond/Alamy Stock Photo ers and semiconductors is available nowhere else in the world. To be sure, that knowledge is commercialized as it diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning’s language, this means that Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semiconductor industries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part, it arises from a network of informal contacts that allows firms to benefit from each other’s knowledge generation. Economists refer to such knowledge “spillovers” as externalities, and there is a well-established theory suggesting that firms can benefit from such externalities by locating close to their source.21 Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and, perhaps, production facilities so they too can learn about and TEST PREP utilize valuable new knowledge before those based elsewhere, thereby giving them a com- Use SmartBook to help retain petitive advantage in the global marketplace.22 Evidence suggests that European, Japanese, what you have learned. South Korean, and Taiwanese computer and semiconductor firms are investing in the Access your instructor’s Silicon Valley region precisely because they wish to benefit from the externalities that arise Connect course to check out there.23 Others have argued that direct investment by foreign firms in the U.S. biotechnol- SmartBook or go to ogy industry has been motivated by desire to gain access to the unique location-specific learnsmartadvantage.com technological knowledge of U.S. biotechnology firms.24 Dunning’s theory, therefore, seems for help. to be a useful addition to those outlined previously because it helps explain how location factors affect the direction of FDI.25 Political Ideology and Foreign Direct Investment LO8-3 Understand how political Historically, political ideology toward FDI within a nation has ranged from a dogmatic ideology shapes a radical stance that is hostile to all inward FDI at one extreme to an adherence to the non- government’s attitudes interventionist principle of free market economics at the other. Between these two toward FDI. extremes is an approach that might be called pragmatic nationalism. THE RADICAL VIEW The radical view traces its roots to Marxist political and economic theory. Radical writers argue that the multinational enterprise (MNE) is an instrument of imperialist domination. They see the MNE as a tool for exploiting host countries to the exclusive benefit of their capitalist–imperialist home countries. They argue that MNEs extract profits from the host country and take them to their home country, giving nothing of value to the host country in exchange. They note, for example, that key technology is tightly controlled by the MNE and that important jobs in the foreign subsidiaries of MNEs go to home-country nationals rather than to citizens of the host country. Because of this, according to the radical view, FDI by the MNEs of advanced capitalist nations keeps the less developed countries of the world relatively backward and dependent on advanced capitalist nations for investment,  Foreign Direct Investment Chapter 8 243 jobs, and technology. Thus, according to the extreme version of this view, no country should ever permit foreign corporations to undertake FDI because they can never be instruments of economic development, only of economic domination. Where MNEs already exist in a country, they should be immediately nationalized.26 From 1945 until the 1980s, the radical view was very influential in the world economy. Until the collapse of communism between 1989 and 1991, the countries of eastern Europe were opposed to FDI. Similarly, communist countries elsewhere—such as China, Cambodia, and Cuba—were all opposed in principle to FDI (although, in practice, the Chinese started to allow FDI in mainland China in the 1970s). Many socialist countries— particularly in Africa, where one of the first actions of many newly independent states was to nationalize foreign-owned enterprises—also embraced the radical position. Countries whose political ideology was more nationalistic than socialistic further embraced the radi- cal position. This was true in Iran and India, for example, both of which adopted tough policies restricting FDI and nationalized many foreign-owned enterprises. Iran is a particu- larly interesting case because its Islamic government, while rejecting Marxist theory, essen- tially embraced the radical view that FDI by MNEs is an instrument of imperialism. By the early 1990s, the radical position was in retreat. There seem to be three reasons for this: (1) the collapse of communism in eastern Europe; (2) the generally abysmal economic performance of those countries that embraced the radical position, in addition to a growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth; and (3) the strong economic performance of those developing countries that embraced capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan). Despite this, the radical view lingers on in some countries, such as Venezuela, where the government of Hugo Chavez, and that of his successor Nicolas Maduro, have both viewed foreign multinationals as an instrument of domination. THE FREE MARKET VIEW The free market view traces its roots to classical economics and the international trade theories of Adam Smith and David Ricardo (see Chapter 6). The intellectual case for this view has been strengthened by the internalization explanation of FDI. The free market view argues that international production should be distributed among countries accord- ing to the theory of comparative advantage. Countries should specialize in the production of those goods and services that they can produce most efficiently. Within this framework, the MNE is an instrument for dispersing the production of goods and services to the most efficient locations around the globe. Viewed this way, FDI by the MNE increases the over- all efficiency of the world economy. Imagine that Dell decided to move assembly operations for many of its personal comput- ers from the United States to Mexico to take advantage of lower labor costs in Mexico. According to the free market view, moves such as this can be seen as increasing the overall efficiency of resource utilization in the world economy. Mexico, due to its lower labor costs, has a comparative advantage in the assembly of PCs. By moving the production of PCs from the United States to Mexico, Dell frees U.S. resources for use in activities in which the United States has a comparative advantage (e.g., the design of computer software, the manufacture of high value-added components such as microprocessors, or basic R&D). Also, consumers ben- efit because the PCs cost less than they would if they were produced domestically. In addition, Mexico gains from the technology, skills, and capital that the computer company transfers with its FDI. Contrary to the radical view, the free market view stresses that such resource transfers benefit the host country and stimulate its economic growth. Thus, the free market view argues that FDI is a benefit to both the source country and the host country. PRAGMATIC NATIONALISM In practice, many countries have adopted neither a radical policy nor a free market policy toward FDI but, instead, a policy that can best be described as pragmatic nationalism.27 The pragmatic nationalist view is that FDI has both benefits and costs. FDI can benefit a 244 Part 3 The Global Trade and Investment Environment host country by bringing capital, skills, technology, and jobs, but those benefits come at a cost. When a foreign company rather than a domestic company produces products, the profits from that investment go abroad. Many countries are also concerned that a foreign- owned manufacturing plant may import many components from its home country, which has negative implications for the host country’s balance-of-payments position. Recognizing this, countries adopting a pragmatic stance pursue policies designed to maximize the national benefits and minimize the national costs. According to this view, FDI should be allowed so long as the benefits outweigh the costs. Japan offers an example of pragmatic nationalism. Until the 1980s, Japan’s policy was probably one of the most restrictive among countries adopting a pragmatic nationalist stance. This was due to Japan’s perception that direct entry of foreign (especially U.S.) firms with ample manage- rial resources into the Japanese markets could hamper the development and growth of its own industry and technology.28 This belief led Japan to block the majority of applications to invest in Japan. However, there were always exceptions to this policy. Firms that had important technology were often permitted to undertake FDI if they insisted that they would neither license their technology to a Japanese firm nor enter into a joint venture with a Japanese enterprise. IBM and Texas Instruments were able to set up wholly owned subsidiaries in Japan by adopting this negotiating position. From the perspective of the Japanese government, the benefits of FDI in such cases—the stimulus that these firms might impart to the Japanese economy—outweighed the perceived costs. Another aspect of pragmatic nationalism is the tendency to aggressively court FDI believed to be in the national interest by, for example, offering subsidies to foreign MNEs in the form of tax breaks or grants. The countries of the European Union often seem to be competing with each other to attract U.S. and Japanese FDI by offering large tax breaks and subsidies. Historically, Britain has been the most successful at attracting Japanese invest- ment in the automobile industry. Nissan, Toyota, and Honda all have major assembly plants in Britain and have used the country as their base for serving the rest of Europe—with obvi- ous employment and balance-of-payments benefits for Britain. However, given Britain’s exit from the EU in early 2020, it seems likely that these companies will reduce their investments in the country going forward. Similarly, within the United States, individual states often compete with each other to attract FDI, offering generous financial incentives in the form of tax breaks to foreign companies looking to set up operations in the country. SHIFTING IDEOLOGY Recent years have seen a marked decline in the number of countries that adhere to a radi- cal ideology. Although few countries have adopted a pure free market policy stance, an increasing number of countries are gravitating toward the free market end of the spectrum and have liberalized their foreign investment regime. This includes many countries that 30 years ago were firmly in the radical camp (e.g., the former communist countries of eastern Europe, many of the socialist countries of Africa, and India) and several countries that until recently could best be described as pragmatic nationalists with regard to FDI (e.g., Japan, South Korea, Italy, Spain, and most Latin American countries). One result has been the surge in the volume of FDI worldwide, which, as we noted earlier, has been grow- ing faster than world trade. Another result has been an increase in the volume of FDI directed at countries that have liberalized their FDI regimes in the last 20 years, such as China, India, and Vietnam. As a counterpoint, there is some evidence of a shift to a more hostile approach to foreign direct investment in some nations. Venezuela and Bolivia have become increasingly hostile to foreign direct investment. In 2005 and 2006, the governments of both nations unilaterally rewrote contracts for oil and gas exploration, raising the royalty rate that foreign enterprises had to pay the government for oil and gas extracted in their territories. Following his election victory in 2006, Bolivian president Evo Morales nationalized the nation’s gas fields and stated that he would evict foreign firms unless they agreed to pay about 80 percent of their revenues to the state and relinquish production oversight. In some developed nations, there  Foreign Direct Investment Chapter 8 245 is increasing evidence of hostile reactions to inward FDI as well. In Europe in 2006, there TEST PREP was a hostile political reaction to the attempted takeover of Europe’s largest steel company, Use SmartBook to help retain Arcelor, by Mittal Steel, a global company controlled by the Indian entrepreneur Lakshmi what you have learned. Mittal. In mid-2005, China National Offshore Oil Company withdrew a takeover bid for Access your instructor’s Unocal of the United States after highly negative reaction in Congress about the proposed Connect course to check out takeover of a “strategic asset” by a Chinese company. SmartBook or go to learnsmartadvantage.com for help. Benefits and Costs of FDI To a greater or lesser degree, many governments can be considered pragmatic nationalists LO8-4 when it comes to FDI. Accordingly, their policy is shaped by a consideration of the costs Describe the benefits and and benefits of FDI. Here, we explore the benefits and costs of FDI, first from the perspec- costs of FDI to home and tive of a host (receiving) country and then from the perspective of the home (source) coun- host countries. try. In the next section, we look at the policy instruments governments use to manage FDI. HOST-COUNTRY BENEFITS The main benefits of inward FDI for a host country arise from resource-transfer effects, employment effects, balance-of-payments effects, and effects on competition and eco- nomic growth. Resource-Transfer Effects Foreign direct investment can make a positive contribution to a host economy by supply- ing capital, technology, and management resources that would otherwise not be available and thus boost that country’s economic growth rate. With regard to capital, many MNEs, by virtue of their large size and financial strength, have access to financial resources not available to host-country firms. These funds may be available from internal company sources, or, because of their reputation, large MNEs may find it easier to borrow money from capital markets than host-country firms would. As for technology, you will recall from Chapter 3 that technology can stimulate economic development and industrialization. Technology can take two forms, both of which are valu- able. Technology can be incorporated in a production process (e.g., the technology for discov- ering, extracting, and refining oil), or it can be incorporated in a product (e.g., personal computers). However, many countries lack the research and development resources and skills required to develop their own indigenous product and process technology. This is particularly true in less developed nations. Such countries must rely on advanced industrialized nations for much of the technology required to stimulate economic growth, and FDI can provide it. Research supports the view that multinational firms often transfer significant technology when they invest in a foreign country.29 For example, a study of FDI in Sweden found that foreign firms increased both the labor and total factor productivity of Swedish firms that they acquired, suggesting that significant technology transfers had occurred (technology typically boosts productivity).30 Also, a study of FDI by the Organisation for Economic Co-operation and Development (OECD) found that foreign investors invested signifi- cant amounts of capital in R&D in the countries in which they had invested, suggesting that not only were they transferring technology to those countries but they may also have been upgrading existing technology or creating new technology in those countries.31 An employee uses a robotic arm to fit a wheel onto a Foreign management skills acquired through FDI may also pro- Volkswagen AG Vento automobile on the production duce important benefits for the host country. Foreign managers line at the Volkswagen India Pvt. plant in Chakan, trained in the latest management techniques can often help improve Maharashtra, India. the efficiency of operations in the host country, whether those Udit Kulshrestha/Bloomberg/Getty Images 246 Part 3 The Global Trade and Investment Environment operations are acquired or greenfield developments. Beneficial spin-off effects may also arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help establish indigenous firms. Similar benefits may arise if the superior management skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own management skills. Employment Effects Another beneficial employment effect claimed for FDI is that it brings jobs to a host coun- try that would otherwise not be created there. The effects of FDI on employment are both direct and indirect. Direct effects arise when a foreign MNE employs a number of host- country citizens. Indirect effects arise when jobs are created in local suppliers as a result of the investment and when jobs are created because of increased local spending by employees of the MNE. The indirect employment effects are often as large as, if not larger than, the direct effects. For example, when Toyota decided to open a new auto plant in France, estimates suggested the plant would create 2,000 direct jobs and perhaps another 2,000 jobs in support industries.32 Cynics argue that not all the “new jobs” created by FDI represent net additions in employment. In the case of FDI by Japanese auto companies in the United States, some argue that the jobs created by this investment have been more than offset by the jobs lost in U.S.-owned auto companies, which have lost market share to their Japanese competi- tors. As a consequence of such substitution effects, the net number of new jobs created by FDI may not be as great as initially claimed by an MNE. The issue of the likely net gain in employment may be a major negotiating point between an MNE wishing to undertake FDI and the host government. When FDI takes the form of an acquisition of an established enterprise in the host economy as opposed to a greenfield investment, the immediate effect may be to reduce employment as the multinational tries to restructure the operations of the acquired unit to improve its operating efficiency. However, even in such cases, research suggests that once the initial period of restructuring is over, enterprises acquired by foreign firms tend to increase their employment base at a faster rate than domestic rivals. An OECD study found that foreign firms created new jobs at a faster rate than their domestic counterparts.33 Balance-of-Payments Effects FDI’s effect on a country’s balance-of-payments accounts is an important policy issue for most host governments. A country’s balance-of-payments accounts track both its pay- ments to and its receipts from other countries. Governments normally are concerned when their country is running a deficit on the current account of their balance of pay- ments. The current account tracks the export and import of goods and services. A cur- rent account deficit, or trade deficit as it is often called, arises when a country is importing more goods and services than it is exporting. Governments typically prefer to see a current account surplus rather than a deficit. The only way in which a current account deficit can be supported in the long run is by selling off assets to foreigners (for a detailed explanation of why this is the case, see the appendix to Chapter 6). For example, the persistent U.S. current account deficit since the 1980s has been financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to foreigners. Because national gov- ernments invariably dislike seeing the assets of their country fall into foreign hands, they prefer their nation to run a current account surplus. There are two ways in which FDI can help a country achieve this goal. First, if the FDI is a substitute for imports of goods or services, the effect can be to improve the current account of the host country’s balance of payments. Much of the FDI by Japanese automobile companies in the United States and Europe, for example, can be seen as substituting for imports from Japan. Thus, the current account of the U.S. balance of payments has improved somewhat because many Japanese companies are now  Foreign Direct Investment Chapter 8 247 supplying the U.S. market from production facilities in the United States, as opposed to facilities in Japan. Insofar as this has reduced the need to finance a current account deficit by asset sales to foreigners, the United States has clearly benefited. A second potential benefit arises when the MNE uses a foreign subsidiary to export goods and services to other countries. According to a UN report, inward FDI by foreign multinationals has been a major driver of export-led economic growth in a number of developing and developed nations.34 For example, in China, exports increased from $26 billion in 1985 to over $2 trillion in 2018. Much of this dramatic export growth was due to the presence of foreign multinationals that invested heavily in China. Effect on Competition and Economic Growth Economic theory tells us that the efficient functioning of markets depends on an adequate level of competition between producers. When FDI takes the form of a greenfield invest- ment, the result is to establish a new enterprise, increasing the number of players in a market and thus consumer choice. In turn, this can increase the level of competition in a national market, thereby driving down prices and increasing the economic welfare of consumers. Increased competition tends to stimulate capital investments by firms in plant, equipment, and R&D as they struggle to gain an edge over their rivals. The long-term results may include increased productivity growth, product and process innovations, and greater economic growth.35 Such beneficial effects seem to have occurred in the South Korean retail sector following the liberalization of FDI regulations in 1996. FDI by large Western discount stores—including Walmart, Costco, Carrefour, and Tesco—seems to have encouraged indige- nous discounters such as E-Mart to improve the efficiency of their own operations. The results have included more competition and lower prices, which benefit South Korean con- sumers. In a similar vein, the Indian government has been opening up that country’s retail sector to FDI, partly because it believes that inward investment by efficient global retailers such as Walmart, Carrefour, and IKEA will provide the competitive stimulus that is neces- sary to improve the efficiency of India’s fragmented retail system. FDI’s impact on competition in domestic markets may be particularly important in the case of services, such as telecommunications, retailing, and many financial services, where exporting is often not an option because the service has to be produced where it is deliv- ered.36 For example, under a 1997 agreement sponsored by the World Trade Organization, 68 countries accounting for more than 90 percent of world telecommunications revenues pledged to start opening their markets to foreign investment and competition and to abide by common rules for fair competition in telecommunications. Before this agreement, most of the world’s telecommunications markets were closed to foreign competitors, and in most countries, the market was monopolized by a single carrier, which was often a state- owned enterprise. The agreement has dramatically increased the level of competition in many national telecommunications markets, producing two major benefits. First, inward investment has increased competition and stimulated investment in the modernization of telephone networks around the world, leading to better service. Second, the increased competition has resulted in lower prices. HOST-COUNTRY COSTS Three costs of FDI concern host countries. They arise from possible adverse effects on competition within the host nation, adverse effects on the balance of payments, and the perceived loss of national sovereignty and autonomy. Adverse Effects on Competition Host governments sometimes worry that the subsidiaries of foreign MNEs may have greater economic power than indigenous competitors. If it is part of a larger international organization, the foreign MNE may be able to draw on funds generated elsewhere to sub- sidize its costs in the host market, which could drive indigenous companies out of business and allow the firm to monopolize the market. Once the market is monopolized, the foreign 248 Part 3 The Global Trade and Investment Environment MNE could raise prices above those that would prevail in competitive markets, with harm- ful effects on the economic welfare of the host nation. This concern tends to be greater in countries that have few large firms of their own (generally, less developed countries). It tends to be a relatively minor concern in most advanced industrialized nations. In general, while FDI in the form of greenfield investments should increase competition, it is less clear that this is the case when the FDI takes the form of acquisition of an estab- lished enterprise in the host nation. Because an acquisition does not result in a net increase in the number of players in a market, the effect on competition may be neutral. When a for- eign investor acquires two or more firms in a host country and subsequently merges them, the effect may be to reduce the level of competition in that market, create monopoly power for the foreign firm, reduce consumer choice, and raise prices. For example, in India, Hindustan Lever Ltd., the Indian subsidiary of Unilever, acquired its main local rival, Tata Oil Mills, to assume a dominant position in the bath soap (75 percent) and detergents (30 percent) markets. Hindustan Lever also acquired several local companies in other markets, such as the ice cream makers Dollops, Kwality, and Milkfood. By combining these compa- nies, Hindustan Lever’s share of the Indian ice cream market went from zero to 74 per- cent.37 However, although such cases are of obvious concern, there is little evidence that such developments are widespread. In many nations, domestic competition authorities have the right to review and block any mergers or acquisitions that they view as having a detri- mental impact on competition. If such institutions are operating effectively, this should be sufficient to make sure that foreign entities do not monopolize a country’s markets. Adverse Effects on the Balance of Payments The possible adverse effects of FDI on a host country’s balance-of-payments position are twofold. First, set against the initial capital inflow that comes with FDI must be the subse- quent outflow of earnings from the foreign subsidiary to its parent company. Such outflows show up as capital outflow on balance-of-payments accounts. Some governments have responded to such outflows by restricting earnings that can be repatriated to a foreign subsid- iary’s home country. A second concern arises when a foreign subsidiary imports a substantial number of its inputs from abroad, which results in a debit on the current account of the host country’s balance of payments. One criticism leveled against Japanese-owned auto assembly operations in the United States, for example, is that they tend to import many component parts from Japan. Because of this, the favorable impact of this FDI on the current account of the U.S. balance-of-payments position may not be as great as initially supposed. The Japanese auto companies responded to these criticisms by pledging to purchase 75 percent of their component parts from U.S.-based manufacturers (but not necessarily U.S.-owned manufac- turers). When the Japanese auto company Nissan invested in the United Kingdom, Nissan responded to concerns about local content by pledging to increase the proportion of local content to 60 percent and subsequently raising it to more than 80 percent. Possible Effects on National Sovereignty and Autonomy Some host governments worry that FDI is accompanied by some loss of economic inde- pendence. The concern is that key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country and over which the host country’s government has no real control. Most economists dismiss such concerns as groundless and irrational. Political scientist Robert Reich has noted that such concerns are the product of outmoded thinking because they fail to account for the grow- ing interdependence of the world economy.38 In a world in which firms from all advanced nations are increasingly investing in each other’s markets, it is not possible for one country to hold another to “economic ransom” without hurting itself. HOME-COUNTRY BENEFITS The benefits of FDI to the home (source) country arise from three sources. First, the home country’s balance of payments benefits from the inward flow of foreign earnings.  Foreign Direct Investment Chapter 8 249 FDI can also benefit the home country’s balance of payments if the foreign subsidiary cre- ates demands for home-country exports of capital equipment, intermediate goods, comple- mentary products, and the like. Second, benefits to the home country from outward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the for- eign subsidiary creates demand for home-country exports. Thus, Toyota’s investment in auto assembly operations in Europe has benefited both the Japanese balance-of-payments position and employment in Japan, because Toyota imports some component parts for its European-based auto assembly operations directly from Japan. Third, benefits arise when the home-country MNE learns valuable skills from its expo- sure to foreign markets that can subsequently be transferred back to the home country. This amounts to a reverse resource-transfer effect. Through its exposure to a foreign mar- ket, an MNE can learn about superior management techniques and superior product and process technologies. These resources can then be transferred back to the home country, contributing to the home country’s economic growth rate.39 HOME-COUNTRY COSTS Against these benefits must be set the apparent costs of FDI for the home (source) country. The most important concerns center on the balance-of-payments and employment effects of outward FDI. The home country’s balance of payments may suffer in three ways. First, the balance of payments suffers from the initial capital outflow required to finance the FDI. This effect, however, is usually more than offset by the subsequent inflow of foreign earnings. Second, the current account of the balance of payments suffers if the purpose of foreign investment is to serve the home market from a low-cost production location. Third, the cur- rent account of the balance of payments suffers if the FDI is a substitute for direct exports. Thus, insofar as Toyota’s assembly operations in the United States are intended to substitute for direct exports from Japan, the current account position of Japan will deteriorate. With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for domestic production. This was the case with Toyota’s investments in the United States and Europe. One obvious result of such FDI is reduced home-country employment. If the labor market in the home country is already tight, with little unemploy- ment, this concern may not be that great. However, if the home country is suffering from unemployment, concern about the export of jobs may arise. For example, one objection frequently raised by U.S. labor leaders to the free trade pact among the United States, Mexico, and Canada (see Chapter 9) is that the United States would lose hundreds of thousands of jobs as U.S. firms invest in Mexico to take advantage of cheaper labor and then export back to the United States.40 INTERNATIONAL TRADE THEORY AND FDI When assessing the costs and benefits of FDI to the home country, keep in mind the les- sons of international trade theory (see Chapter 6). International trade theory tells us that home-country concerns about the negative economic effects of offshore production may be misplaced. The term offshore production refers to FDI undertaken to serve the home market. An example would be U.S. automobile companies investing in auto parts produc- tion facilities in Mexico. Far from reducing home-country employment, such FDI may actually stimulate economic growth (and hence employment) in the home country by free- ing home-country resources to concentrate on activities where the home country has a TEST PREP comparative advantage. In addition, home-country consumers benefit if the price of the Use SmartBook to help retain particular product falls as a result of the FDI. Also, if a company were prohibited from what you have learned. making such investments on the grounds of negative employment effects while its interna- Access your instructor’s tional competitors reaped the benefits of low-cost production locations, it would undoubt- Connect course to check out edly lose market share to its international competitors. Under such a scenario, the adverse SmartBook or go to long-run economic effects for a country would probably outweigh the relatively minor learnsmartadvantage.com balance-of-payments and employment effects associated with offshore production. for help. 250 Part 3 The Global Trade and Investment Environment Government Policy Instruments and FDI LO8-5 We have reviewed the costs and benefits of FDI from the perspective of both home coun- try and host country. We now turn our attention to the policy instruments that home Explain the range of policy (source) countries and host countries can use to regulate FDI. instruments that governments use to influence FDI. HOME-COUNTRY POLICIES Through their choice of policies, home countries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first. These include foreign risk insurance, capital assistance, tax