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Foreign Direct Investment

Foreign Direct Investment

Foreign Direct Investment

Learning Objectives

After studying this chapter, you should be able to

1 Describe worldwide patterns of foreign direct investment (FDI) and reasons for these patterns.

2 Describe each of the theories that attempt to explain why foreign direct investment occurs.

3 Discuss the important management issues in the foreign direct investment decision.

4 Explain why governments intervene in the free flow of foreign direct investment.

5 Discuss the policy instruments that governments use to promote and restrict foreign direct investment.

A LOOK BACK

Chapter 6 explained business–government relations in the context of world trade in goods and services. We explored the motives and methods of government intervention. We also examined the global trading system and how it promotes free trade.

A LOOK AT THIS CHAPTER

This chapter examines another significant form of international business: foreign direct investment (FDI). Again, we are concerned with the patterns of FDI and the theories on which it is based. We also explore why and how governments intervene in FDI activity.

A LOOK AHEAD

Chapter 8 explores the trend toward greater regional integration of national economies. We explore the benefits of closer economic cooperation and examine prominent regional trading blocs that exist around the world.

Auf Wiedersein to VW Law

Frankfurt, Germany — The Volkswagen Group (www.vw.com) owns eight of the most prestigious and best-known automotive brands in the world, including Audi, Bentley, Bugatti, Lamborghini, Seat, Skoda, and Volkswagen. From its 48 production facilities worldwide, the company produces and sells around 6 million cars annually. The VW Group sells cars in more than 150 countries and holds a 10 percent share of the world car market. Pictured at right, workers train at the Volkswagen plant in Puebla, Mexico.

Volkswagen, like companies everywhere, received plenty of help in getting where it is today. Since the 1960s, Volkswagen received special protection from its own legislation known as the “VW Law.” The law gave the German state of Lower Saxony, which owns 20.1 percent of Volkswagen, the power to block any takeover attempt that threatened local jobs and the economy. Germany’s former Chancellor Gerhard Schröder once told a cheering crowd of autoworkers in Germany, “Any efforts by the [European Union] commission in Brussels to smash the VW culture will meet the resistance of the federal government as long as we are in power.”

Source: Keith Dannemiller/CORBIS-NY.

The European Court finally struck down the VW Law in late 2007, although Lower Saxony’s government did not give up the fight. Legislators introduced multiple reincarnations of the VW Law to help it avoid the wrath of European regulators, but it is unlikely to be resurrected.

Volkswagen’s special treatment lies in its importance to the German economy and close ties between government and management in Germany. Volkswagen employs tens of thousands of people at home and symbolizes the resurgence of the German economy over the past 60 years. As you read this chapter, consider all the issues that can arise between companies and governments in global business.1

Many early trade theories were created at a time when most production factors (such as labor, financial capital, capital equipment, and land or natural resources) either could not be moved or could not be moved easily across national borders. But today, all of the above except land are internationally mobile and flow across borders to wherever they are needed. Financial capital is readily available from international financial institutions to finance corporate expansion, and whole factories can be picked up and moved to another country. Even labor is more mobile than in years past, although many barriers restrict the complete mobility of labor.

International flows of capital are at the core of foreign direct investment (FDI)—the purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control. But there is wide disagreement on what exactly constitutes foreign direct investment. Nations set different thresholds at which they classify an international capital flow as FDI. The U.S. Commerce Department sets the threshold at 10 percent of stock ownership in a company abroad, but most other governments set it at anywhere from 10 to 25 percent. By contrast, an investment that does not involve obtaining a degree of control in a company is called a portfolio investment.

foreign direct investment

Purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control.

portfolio investment

Investment that does not involve obtaining a degree of control in a company.

In this chapter, we examine the importance of foreign direct investment to the operations of international companies. We begin by exploring the growth of FDI in recent years and investigating its sources and destinations. We then take a look at several theories that attempt to explain foreign direct investment flows. Next, we turn our attention to several important management issues that arise in most decisions about whether a company should undertake FDI. This chapter closes by discussing the reasons why governments encourage or restrict foreign direct investment and the methods they use to accomplish these goals.

Patterns of Foreign Direct Investment

Just as international trade displays distinct patterns (see Chapter 5), so too does foreign direct investment. In this section, we first take a look at the factors that have propelled growth in FDI over the past decade. We then turn our attention to the destinations and sources of foreign direct investment.

Ups and Downs of Foreign Direct Investment

After growing around 20 percent per year in the first half of the 1990s, FDI inflows grew by about 40 percent per year in the second half of the decade. In 2000, FDI inflows peaked at around $1.4 trillion. Slower FDI for 2001, 2002, and 2003 reduced FDI inflows to nearly half its earlier peak. Strong economic performance and high corporate profits in many countries lifted FDI inflows to around $648 billion in 2004, $946 billion in 2005, and $1.3 trillion in 2006. Figure 7.1 illustrates this pattern and shows that changes in FDI flows are far more erratic than changes in global GDP.2

The main causes of decreased FDI around the year 2000 were slower global economic growth, tumbling stock market valuations, and relatively fewer privatizations of state-owned firms. Yet FDI inflows show a recovery since then. Despite the ebb and flow of FDI that we see in Figure 7.1, the long-term trend points toward greater FDI inflows worldwide. Among the driving forces behind renewed activity in FDI is an emphasis on the “offshoring” of business activities. The two main drivers of FDI flows are globalization and international mergers and acquisitions.

Globalization

Recall from Chapter 6 that years ago barriers to trade were not being reduced, and new, creative barriers seemed to be popping up in many nations. This presented a problem for companies that were trying to export their products to markets around the world. This resulted in a wave of FDI as many companies entered promising markets to get around growing trade barriers. But then the Uruguay Round of GATT negotiations created renewed determination to further reduce barriers to trade. As countries lowered their trade barriers, companies realized that they could now produce in the most efficient and productive locations and simply export to their markets worldwide. This set off another wave of FDI flows into low-cost, newly industrialized nations and emerging markets. Forces causing globalization to occur are, therefore, part of the reason for long-term growth in foreign direct investment.

FIGURE 7.1 Growth Rate of FDI versus GDP

Source: World Investment Report 2007 (Geneva, Switzerland: UNCTAD, September 2007), Chapter 1, Table I.4, p. 9; World Economic Outlook Database, April 2008.

Increasing globalization is also causing a growing number of international companies from emerging markets to undertake FDI. For example, companies from Taiwan began investing heavily in other nations two decades ago. Acer (www.acer.com), headquartered in Singapore but founded in Taiwan, manufactures personal computers and computer components. Just 20 years after it opened for business, Acer had spawned 10 subsidiaries worldwide and became the dominant industry player in many emerging markets.

Mergers and Acquisitions

The number of mergers and acquisitions (M&As) and their exploding values also underlie long-term growth in foreign direct investment. In fact, cross-border M&As are the main vehicle through which companies undertake foreign direct investment. Throughout the past two decades the value of all M&A activity as a share of GDP rose from 0.3 percent to 8 percent. The value of cross-border M&As peaked in 2000 at around $1.15 trillion. This figure accounted for about 3.7 percent of the market capitalization of all stock exchanges worldwide. Reasons previously mentioned for the dip and later rise in FDI inflows also caused the pattern we see in cross-border M&A deals (see Figure 7.2). By 2006, the value of cross-border M&As had climbed back to around $880 billion.3

Many cross-border M&A deals are driven by the desire of companies to:

■ Get a foothold in a new geographic market

■ Increase a firm’s global competitiveness

■ Fill gaps in companies’ product lines in a global industry

■ Reduce costs of R&D, production, distribution, and so forth

FIGURE 7.2 Value of Cross-Border M&As

Source: Based on World Investment Report 2007 (Geneva, Switzerland: UNCTAD, 2007), Chapter 1, Figure I.3, p. 6.

Entrepreneurs and small businesses also play a role in the expansion of FDI inflows. There is no data on the portion of FDI contributed by small businesses, but we know from anecdotal evidence that these companies are engaged in FDI. Unhindered by many of the constraints of a large company, entrepreneurs investing in other markets often demonstrate an inspiring can-do spirit mixed with ingenuity and bravado. For a day-in-the-life look at a young entrepreneur who is realizing his dreams in China, see the Entrepreneur’s Toolkit titled, “The Cowboy of Manchuria.”

Worldwide Flows of FDI

Driving FDI growth are more than 70,000 multinational companies with over 690,000 affiliates abroad, nearly half of which are now in developing countries.4 Developed countries remain the prime destination for FDI because cross-border M&As are concentrated in developed nations. Developed countries account for around 65 percent ($857 billion) of global FDI inflows, which were a little over $1.3 trillion in 2006. By comparison, FDI inflows to developing countries were valued at $379 billion—about 29 percent of world FDI inflows and down from a peak of a little more than 40 percent a decade earlier.

Among developed countries, European Union (EU) nations, the United States, and Japan account for the vast majority of world inflows. The EU remains the world’s largest FDI recipient, garnering $531 billion in 2006 (over 40 percent of the world’s total). Behind the large FDI figure for the EU is increased consolidation in Europe among large national competitors and further efforts at EU regional integration.

Developing nations had varying experiences in 2006. FDI inflows to developing nations in Asia were nearly $259 billion in 2006, with China attracting over $69 billion of that total. India, the largest recipient on the Asian subcontinent, had inflows of nearly $17 billion. FDI flowing from developing nations in Asia is also on the rise, coinciding with the rise of these nations’ own global competitors.

ENTREPRENEUR’S TOOLKIT: The Cowboy of Manchuria

Tom Kirkwood, at just 28 years of age, turned his dream of introducing his grandfather’s taffy to China into a fast growing business. Kirkwood’s story—his hassles and hustling—provides some lessons on the purest form of global investing. The basics that small investors in China can follow are as basic as they get. Find a product that’s easy to make, widely popular, and cheap to sell and then choose the least expensive, investor-friendliest place to make it.

Kirkwood, whose family runs the Shawnee Inn, a ski and golf resort in Shawnee-on-Delaware, Pennsylvania, decided to make candy in Manchuria—China’s gritty, heavily populated, industrial northeast. Chinese people often give individually wrapped candies as a gift, and Kirkwood reckoned that China’s rising, increasingly prosperous urbanites would have a lucrative sweet tooth. “You can’t be M&Ms, but you don’t have to be penny candy, either,” Kirkwood says. “You find your niche because a niche in China is an awful lot of people.”

Kirkwood decided early on that he wanted to do business in China. In the mid-1980s after prep school, he spent a year in Taiwan and China learning Chinese and working in a Shanghai engineering company. The experience gave him a taste for adventure capitalism on the frontier of China’s economic development. Using $400,000 of Kirkwood’s family money, Kirkwood and his friend Peter Moustakerski bought equipment and rented a factory in Shenyang, a city of six million people in the heart of Manchuria. Roads and rail transport were convenient, and wages were low. The local government seemed amenable to a 100 percent foreign-owned factory, and the Shenyang Shawnee Cowboy Food Company was born.

Although it’s a small operation, it now has 89 employees and is growing. Kirkwood is determined to succeed selling his candies with names such as Longhorn Bars. As he boarded a flight to Beijing for a meeting with a distributor recently, Kirkwood realized he had a bag full of candy. He offered one to a flight attendant. When lunch is over, he vowed, “Everybody on this plane will know Cowboy Candy.”

Source: Adapted from Roy Rowan “Mao to Now,” Fortune (www.fortune.com), October 11, 1999; Marcus W. Brauchli, “Sweet Dreams,” Wall Street Journal, June 27, 1996, R, 10:1.

Elsewhere, all of Africa drew in slightly more than $35 billion of FDI in 2006, or about 2.7 percent of the world’s total. FDI flows into Latin America and the Caribbean declined rapidly in the early 2000s but then surged to $84 billion in 2006. Finally, FDI inflows to southeast Europe and the Commonwealth of Independent States reached an all-time high of $69 billion in 2006.

Quick Study

1. What is the difference between foreign direct investment and portfolio investment?

2. What factors influence global flows of foreign direct investment?

3. Identify the main destinations of foreign direct investment. Is the pattern shifting?

Explanations for Foreign Direct Investment

So far we have examined the flows of foreign direct investment, but we have not investigated explanations for why FDI occurs. Let’s now investigate the four main theories that attempt to explain why companies engage in foreign direct investment.

International Product Life Cycle

Although we introduced the international product life cycle in Chapter 5 in the context of international trade, it is also used to explain foreign direct investment.5 The international product life cycle theory states that a company will begin by exporting its product and later undertake foreign direct investment as a product moves through its life cycle. In the new product stage, a good is produced in the home country because of uncertain domestic demand and to keep production close to the research department that developed the product. In the maturing product stage, the company directly invests in production facilities in countries where demand is great enough to warrant its own production facilities. In the final standardized product stage, increased competition creates pressures to reduce production costs. In response, a company builds production capacity in low-cost developing nations to serve its markets around the world.

international product life cycle

Theory stating that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its life cycle.

Despite its conceptual appeal, the international product life cycle theory is limited in its power to explain why companies choose FDI over other forms of market entry. A local firm in the target market could pay for (license) the right to use the special assets needed to manufacture a particular product. In this way, a company could avoid the additional risks associated with direct investments in the market. The theory also fails to explain why firms choose FDI over exporting activities. It might be less expensive to serve a market abroad by increasing output at the home country factory rather than by building additional capacity within the target market.

The theory explains why the FDI of some firms follows the international product life cycle of their products. But it does not explain why other market entry modes are inferior or less advantageous options.

Market Imperfections (Internalization)

A market that is said to operate at peak efficiency (prices are as low as they can possibly be) and where goods are readily and easily available is said to be a perfect market. But perfect markets are rarely, if ever, seen in business because of factors that cause a breakdown in the efficient operation of an industry—called market imperfections. Market imperfections theory states that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake foreign direct investment to internalize the transaction and thereby remove the imperfection. There are two market imperfections that are relevant to this discussion—trade barriers and specialized knowledge.

market imperfections

Theory stating that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake foreign direct investment to internalize the transaction and thereby remove the imperfection.

Employees from quality control check plasma screens on the production line at a newly opened television assembly plant in Nymburk near Prague, Czech Republic. The plant is a foreign direct investment by a company called Chinese Changhong Europe Electric TV. The plant is Changhong’s biggest foreign direct investment in recent times and produces LCD, plasma, and classic televisions. What advantages do you think the Chinese company gained by investing in the Czech Republic?

Source: Radim Beznoska/CORBIS-NY.

Trade Barriers

One common market imperfection in international business is trade barriers, such as tariffs. For example, the North American Free Trade Agreement stipulates that a sufficient portion of a product’s content must originate within Canada, Mexico, or the United States for the product to avoid tariff charges when it is imported to any of these three markets. That is why a large number of Korean manufacturers invested in production facilities in Tijuana, Mexico, just south of Mexico’s border with California. By investing in production facilities in Mexico, the Korean companies were able to skirt the North American tariffs that would have been levied if they were to export goods from Korean factories. The presence of a market imperfection (tariffs) caused those companies to undertake foreign direct investment.

Specialized Knowledge

The unique competitive advantage of a company sometimes consists of specialized knowledge. This knowledge could be the technical expertise of engineers or the special marketing abilities of managers. When the knowledge is technical expertise, companies can charge a fee to companies in other countries for use of the knowledge in producing the same or a similar product. But when a company’s specialized knowledge is embodied in its employees, the only way to exploit a market opportunity in another nation may be to undertake FDI.

The possibility that a company will create a future competitor by charging another company for access to its knowledge is another market imperfection that can encourage FDI. Rather than trade a short-term gain (the fee charged another company) for a long-term loss (lost competitiveness), a company will prefer to undertake investment. For example, as Japan rebuilt its industries following the Second World War, many Japanese companies paid Western firms for access to the special technical knowledge embodied in their products. Those Japanese companies became adept at revising and improving many of these technologies and became leaders in their industries, including electronics and automobiles.

Eclectic Theory

The eclectic theory states that firms undertake foreign direct investment when the features of a particular location combine with ownership and internalization advantages to make a location appealing for investment.6 A location advantage is the advantage of locating a particular economic activity in a specific location because of the characteristics (natural or acquired) of that location.7 These advantages have historically been natural resources such as oil in the Middle East, timber in Canada, or copper in Chile. But the advantage can also be an acquired one such as a productive workforce. An ownership advantage refers to company ownership of some special asset, such as brand recognition, technical knowledge, or management ability. An internalization advantage is one that arises from internalizing a business activity rather than leaving it to a relatively inefficient market. The eclectic theory states that when all of these advantages are present, a company will undertake FDI.

eclectic theory

Theory stating that firms undertake foreign direct investment when the features of a particular location combine with ownership and internalization advantages to make a location appealing for investment.

Market Power

Firms often seek the greatest amount of power possible in their industries relative to rivals. The market power theory states that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment. The benefit of market power is greater profit because the firm is far better able to dictate the cost of its inputs and/or the price of its output.

market power

Theory stating that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment.

One way a company can achieve market power (or dominance) is through vertical integration—the extension of company activities into stages of production that provide a firm’s inputs (backward integration) or absorb its output (forward integration). Sometimes a company can effectively control the world supply of an input needed by its industry if it has the resources or ability to integrate backward into supplying that input. Companies may also be able to achieve a great deal of market power if they can integrate forward to increase control over output. For example, they could perhaps make investments in distribution to leapfrog channels of distribution that are tightly controlled by competitors.

vertical integration

Extension of company activities into stages of production that provide a firm’s inputs (backward integration) or absorb its output (forward integration).

Quick Study

1. Explain the international product life cycle theory of foreign direct investment (FDI).

2. How does the theory of market imperfections (internalization) explain FDI?

3. Explain the eclectic theory, and identify the three advantages necessary for FDI to occur.

4. How does the theory of market power explain the occurrence of FDI?

Management Issues in the FDI Decision

Decisions about whether to engage in foreign direct investment involve several important issues regarding management of the company and its market. Some of these issues are grounded in the inner workings of firms that undertake FDI, such as the control desired over operations abroad or the firm’s cost of production. Others are related to the market and industry in which a firm competes, such as the preferences of customers or the actions of rivals. Let’s examine each of these important issues.

Control

Many companies investing abroad are greatly concerned with controlling the activities that occur in the local market. Perhaps the company wants to be certain that its product is being marketed in the same way in the local market as it is at home. Or maybe it wants to ensure that the selling price remains the same in both markets. Some companies try to maintain ownership of a large portion of the local operation, say, even up to 100 percent, in the belief that greater ownership gives them greater control.

Yet for a variety of reasons, even complete ownership does not guarantee control. For example, the local government might intervene and require a company to hire some local managers rather than bring them all in from the home office. Companies may need to prove a scarcity of skilled local managerial talent before the government will let them bring managers in from the home country. Governments might also require that all goods produced in the local facility be exported so they do not compete with products of the country’s domestic firms.

Partnership Requirements

Many companies have strict policies regarding how much ownership they take in firms abroad because of the importance of maintaining control. In the past, IBM (www.ibm.com) strictly required that the home office own 100 percent of all international subsidiaries. But companies must sometimes abandon such policies if a country demands shared ownership in return for market access.

Some governments saw shared ownership requirements as a way to shield their workers from exploitation and their industries from domination by large international firms. Companies would sometimes sacrifice control to pursue a market opportunity, but frequently they did not. Most countries today do not take such a hard-line stance and have opened their doors to investment by multinational companies. Mexico used to make decisions on investment by multinationals on a case-by-case basis. IBM was negotiating with the Mexican government for 100 percent ownership of a facility in Guadalajara and got the go-ahead only after the company made numerous concessions in other areas.

Benefits of Cooperation

Many nations have grown more cooperative toward international companies in recent years. Governments of developing and emerging markets realize the benefits of investment by multinationals, including decreased unemployment, increased tax revenues, training to create a more highly skilled workforce, and the transfer of technology. A country known for overly restricting the operations of multinational enterprises can see its inward investment flow dry up. Indeed, restrictive policies of India’s government hampered foreign direct investment inflows for many years.

Cooperation also frequently opens important communication channels that help firms to maintain positive relationships in the host country. Both parties tend to walk a fine line—cooperating most of the time, but holding fast on occasions when the stakes are especially high.

Cooperation with a local partner and respect for national pride in Central Europe contributed to the successful acquisition of Hungary’s Borsodi brewery (formerly a state-owned enterprise) by Belgium’s Interbrew (www.interbrew.com). From the start, Interbrew wisely insisted it would move ahead with its purchase only if local management would be in charge. Interbrew then assisted local management with technical, marketing, sales, distribution, and general management training. Borsodi eventually became one of Interbrew’s key subsidiaries and is now run entirely by Hungarian managers.

At one time, Boeing aircraft were made entirely in the United States. But today Boeing can source its landing gear doors from Northern Ireland, outboard wing flaps from Italy, wing tip assemblies from Korea, rudders from Australia, and fuselages from Japan. Boeing sometimes undertakes foreign direct investment by buying a large portion of its suppliers’ assets or traded stock in another country. Why do you think a company may want to control its suppliers through taking an ownership stake?

Source: Larry W. Smith/Getty Images.

Purchase-or-Build Decision

Another important matter for managers is whether to purchase an existing business or to build a subsidiary abroad from the ground up—called a greenfield investment. An acquisition generally provides the investor with an existing plant, equipment, and personnel. The acquiring firm may also benefit from the goodwill the existing company has built up over the years and, perhaps, brand recognition of the existing firm. The purchase of an existing business may also allow for alternative methods of financing the purchase, such as an exchange of stock ownership between the companies. Factors that can reduce the appeal of purchasing existing facilities include obsolete equipment, poor relations with workers, and an unsuitable location.

Mexico’s Cemex, S.A. (www.cemex.com), is a multinational company that made a fortune by buying struggling, inefficient plants around the world and reengineering them. Chairman Lorenzo Zambrano has long figured the overriding principle was “Buy big globally, or be bought.” The success of Cemex in using FDI has confounded, even rankled, its competitors in developed nations. For example, Cemex shocked global markets when it carried out a $1.8 billion purchase of Spain’s two largest cement companies, Valenciana and Sanson.

But adequate facilities in the local market are sometimes unavailable and a company must go ahead with a greenfield investment. Because Poland is a source of skilled and inexpensive labor, it is an appealing location for car manufacturers. But the country had little in the way of advanced car-production facilities when General Motors (www.gm.com) considered investing there. So GM built a $320 million facility in Poland’s Silesian region. The factory has the potential to produce 200,000 units annually—some of which are destined for export to profitable markets in Western Europe. However, greenfield investments can have their share of headaches. Obtaining the necessary permits, financing, and hiring local personnel can be a real problem in some markets.

Production Costs

Many factors contribute to production costs in every national market. Labor regulations can add significantly to the overall cost of production. Companies may be required to provide benefits packages for their employees that are over and above hourly wages. More time than was planned for might be required to train workers adequately to bring productivity up to an acceptable standard. Although the cost of land and the tax rate on profits can be lower in the local market (or purposely lowered to attract multinationals), it cannot be assumed that they will remain constant. Companies from around the world using China as a production base have witnessed rising wages erode their profits as the economy continues to industrialize. Some companies are therefore finding that Vietnam is their low-cost location of choice.

Rationalized Production

One approach companies use to contain production costs is called rationalized production—a system of production in which each of a product’s components is produced where the cost of producing that component is lowest. All the components are then brought together at one central location for assembly into the final product. Consider the typical stuffed animal made in China whose components are all imported to China (with the exception of the polycore thread with which it’s sewn). The stuffed animal’s eyes are molded in Japan. Its outfit is imported from France. The polyester-fiber stuffing comes from either Germany or the United States, and the pile-fabric fur is produced in Korea. Only final assembly of these components occurs in China.

rationalized production

System of production in which each of a product’s components is produced where the cost of producing that component is lowest.

Although this production model is highly efficient, a potential problem is that a work stoppage in one country can bring the entire production process to a standstill. For example, the production of automobiles is highly rationalized, with parts coming in from a multitude of countries for assembly. When the United Auto Workers (www.uaw.com) union held a strike for weeks against General Motors (www.gm.com), many of GM’s international assembly plants were threatened. The UAW strategically launched their strike at GM’s plant that supplied brake pads to virtually all of its assembly plants throughout North America.

Mexico’s Maquiladora

Stretching 2,000 miles from the Pacific Ocean to the Gulf of Mexico, the 130-mile-wide strip along the U.S.–Mexican border may well be North America’s fastest-growing region. With 11 million people and $150 billion in output, the region’s economy is larger than that of Israel’s. The combination of a low-wage economy nestled next to a prosperous giant is now becoming a model for other regions that are split by wage or technology gaps. Some analysts compare the U.S.–Mexican border region to that between Hong Kong and its manufacturing realm, China’s Guangdong province. Officials from cities along the border between Germany and Poland studied the U.S.–Mexican experience to see what lessons could be applied to their unique situation.

Cost of Research and Development

As technology becomes an increasingly powerful competitive factor, the soaring cost of developing subsequent stages of technology has led multinationals to engage in cross-border alliances and acquisitions. For instance, huge multinational pharmaceutical companies are intensely interested in the pioneering biotechnology work done by smaller, entrepreneurial startups. Cadus Pharmaceutical Corporation of New York determined the function of 400 genes related to so-called receptor molecules. Many disorders are associated with the improper functioning of these receptors—making them good targets for drug development. Britain’s SmithKline Beecham (www.gsk.com) then invested around $68 million with Cadus in order to access Cadus’s research knowledge.

One indicator of technology’s significance in foreign direct investment is the amount of R&D conducted by companies’ affiliates in other countries. The globalization of innovation and the phenomenon of foreign direct investment in R&D are not necessarily motivated by demand factors such as the size of local markets. They instead appear to be encouraged by supply factors, including gaining access to high-quality scientific and technical human capital.

Customer Knowledge

The behavior of buyers is frequently an important issue in the decision of whether to undertake foreign direct investment. A local presence can help companies gain valuable knowledge about customers that could not be obtained from the home market. For example, when customer preferences for a product differ a great deal from country to country, a local presence might help companies to better understand such preferences and tailor their products accordingly.

Some countries have quality reputations in certain product categories. German automotive engineering, Italian shoes, French perfume, and Swiss watches impress customers as being of superior quality. Because of these perceptions, it can be profitable for a firm to produce its product in the country with the quality reputation, even if the company is based in another country. For example, a cologne or perfume producer might want to bottle its fragrance in France and give it a French name. This type of image appeal can be strong enough to encourage foreign direct investment.

Following Clients

Firms commonly engage in foreign direct investment when the firms they supply have already invested abroad. This practice of “following clients” is common in industries in which producers source component parts from suppliers with whom they have close working relationships. The practice tends to result in companies clustering within close geographic proximity to each other because they supply each other’s inputs (see Chapter 5). When Mercedes (www.mercedes.com) opened its first international car plant in Tuscaloosa County, Alabama, auto-parts suppliers also moved to the area from Germany—bringing with them additional investment in the millions of dollars.

Following Rivals

FDI decisions frequently resemble a “follow the leader” scenario in industries having a limited number of large firms. In other words, many of these firms believe that choosing not to make a move parallel to that of the “first mover” might result in being shut out of a potentially lucrative market. When firms based in industrial countries moved back into South Africa after the end of apartheid, their competitors followed. Of course, each market can sustain only a certain number of rivals. Firms that cannot compete choose the “least damaging option.” This seems to have been the case for Pepsi (www.pepsi.com), which went back into South Africa in 1994, but withdrew in 1997 after being crushed there by Coke (www.cocacola.com).

GLOBAL MANAGER’S BRIEFCASE: Surprises of Investing Abroad

The decision of whether to build facilities in a market abroad or to purchase existing operations in the local market can be a difficult one. Managers can minimize risk by preparing their companies for a number of surprises they might face.

■ Human Resource Policies. Home country policies cannot be simply imported and they seldom address local laws and customs. Countries have differing requirements for plant operations and their own regulations regarding business operations.

■ Labor Costs. France has a minimum wage of about $12 an hour, whereas Mexico has a minimum wage of nearly $5 a day. But Mexico’s real minimum wage is nearly double that due to government-mandated benefits and employment practices.

■ Mandated Benefits. These include company-supplied clothing and meals, required profit sharing, guaranteed employment contracts, and generous dismissal policies. These costs can exceed an employee’s wages and are typically nonnegotiable.

■ Labor Unions. In some countries organized labor is found at almost every company. Rather than dealing with a single union at plants in Scandinavin countries, managers may need to negotiate with five or six different unions, each of which represents a distinct skill or profession.

■ Economic-Development Incentives. These incentives can be substantial and change constantly. The European Union is trying to standardize incentives based on unemployment levels, but some nations continually stretch the rules and exceed guidelines.

■ Information. Sometimes there simply is no reliable data on factors such as labor availability, cost of energy, and national inflation rates. These data are generally high quality in developed countries and suspect in developing ones.

■ Personal and Political Contacts. These contacts can be extremely important in developing and emerging markets and the only way to establish operations. But complying with locally accepted practices can cause ethical dilemmas for managers.

Source: Conrad de Aenlle, “China’s Cloudy Investment Picture,” International Herald Tribune (www.iht.com), June 13, 2008; “Mexico Raises Minimum Wages by 4 Percent, to around $4.85 a Day,” International Herald Tribune (www.iht.com), December 22, 2007; U.S. Department of Labor Web site (www.dol.gov), select reports.

In this section we have presented several key issues managers consider when investing abroad. We will have more to say on this topic in Chapter 15, when we learn how companies take on such an ambitious goal. Meanwhile, you can read more about what managers should consider when going global in the Global Manager’s Briefcase titled, “Surprises of Investing Abroad.”

Quick Study

1. Why is control important to companies considering the FDI decision?

2. What is the role of production costs in the FDI decision? Define rationalized production.

3. Explain the need for customer knowledge, following clients, and following rivals in the FDI decision.

Government Intervention in Foreign Direct Investment

Nations often intervene in the flow of FDI to protect their cultural heritages, domestic companies, and jobs. They can enact laws, create regulations, or construct administrative hurdles that companies from other nations must overcome if they want to invest in the nation. Yet rising competitive pressure is forcing nations to compete against each other to attract multinational companies. The increased national competition for investment is causing governments to enact regulatory changes that encourage investment. As Table 7.1 demonstrates, the number of regulatory changes that governments introduced in recent years has climbed, the vast majority of which are more favorable to FDI.

In a general sense, a bias toward protectionism or openness is rooted in a nation’s culture, history, and politics. Values, attitudes, and beliefs form the basis for much of a government’s position regarding foreign direct investment. For example, South American nations with strong cultural ties to a European heritage (such as Argentina) are generally enthusiastic about investment received from European nations. South American nations with stronger indigenous influences (such as Ecuador) are generally less enthusiastic.

Opinions vary widely on the appropriate amount of foreign direct investment a country should encourage. At one extreme are those who favor complete economic self-sufficiency and oppose any form of FDI. At the other extreme are those who favor no governmental intervention and booming FDI inflows. Between these two extremes lie most countries, which believe a certain amount of FDI is desirable to raise national output and enhance the standard of living for their people.

Besides philosophical ideals, countries intervene in FDI for a host of very practical reasons. But to fully appreciate those reasons, we must first understand what is meant by a country’s balance of payments.

Balance of Payments

A country’s balance of payments is a national accounting system that records all payments to entities in other countries and all receipts coming into the nation. International transactions that result in payments (outflows) to entities in other nations are reductions in the balance of payments accounts, and are therefore recorded with a minus sign. International transactions that result in receipts (inflows) from other nations are additions to the balance of payments accounts, and thus are recorded with a plus sign.

balance of payments

National accounting system that records all payments to entities in other countries and all receipts coming into the nation.

For example, when a U.S. company buys 40 percent of the publicly traded stock of a Mexican company on Mexico’s stock market, the U.S. balance of payments records the transaction as an outflow of capital and it is recorded with a minus sign. Table 7.2 shows the recent balance of payments accounts for the United States. As shown in the table, any nation’s balance of payments consists of two major components—the current account and capital account. Let’s describe each of these accounts and discuss how to read Table 7.2.

TABLE 7.1 National Regulations and FDI

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Number of countries that introduced changes

76

60

65

70

71

72

82

103

93

93

Number of changes

150

145

139

150

207

246

242

270

205

184

More favorable to FDI

134

136

130

147

193

234

218

234

164

147

Less favorable to FDI

16

9

9

3

14

12

24

36

41

37

Source: Based on World Investment Report 2007 (Geneva, Switzerland: UNCTAD, September 2007), Overview, Table I.8, p. 14.

TABLE 7.2 U.S. Balance of Payments Accounts (U.S. $ millions)

Current Account

Exports of goods and services and income receipts

1,418,568

Merchandise

772,210

Services

293,492

Income receipts on U.S. assets abroad

352,866

Imports of goods and services and income payments

–1,809,099

Merchandise

–1,224,417

Services

–217,024

Income payments on foreign assets in United States

–367,658

Unilateral transfers

–54,136

Current account balance

–444,667

Capital Account

Increase in U.S. assets abroad (capital outflow)

–580,952

U.S. official reserve assets

–290

Other U.S. government assets

–944

U.S. private assets

–579,718

Foreign assets in the United States (capital inflow)

1,024,218

Foreign official assets

37,619

Other foreign assets

986,599

Capital account balance

443,266

Statistical discrepancy

55,537

Source: Survey of Current Business, July 2001, (Washington, D.C.: U.S. Department of Commerce, 2001), p. 47.

Current Account

The current account is a national account that records transactions involving the import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country. The merchandise account in Table 7.2 includes exports and imports of tangible goods such as computer software, electronic components, and apparel. The services account includes exports and imports of services such as tourism, business consulting, and banking services. Suppose a company in the United States receives payment for consulting services provided to a company in another country. The receipt is recorded as an “export of services” and assigned a plus sign in the services account in the balance of payments.

current account

National account that records transactions involving the import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country.

The income receipts account includes income earned on U.S. assets held abroad. When a U.S. company’s subsidiary in another country remits profits back to the parent in the United States, the receipt is recorded in the income receipts account and given a plus sign. The income payments account includes income paid to entities in other nations that is earned on assets they hold in the United States. For example, when a French company’s U.S. subsidiary sends profits earned in the United States back to the parent company in France, the transaction is recorded in the income payments account as an outflow, and it is given a minus sign.

A current account surplus occurs when a country exports more goods and services and receives more income from abroad than it imports and pays abroad. Conversely, a current account deficit occurs when a country imports more goods and services and pays more abroad than it exports and receives from abroad. Table 7.2 shows that the United States had a current account deficit in the year shown.

current account surplus

When a country exports more goods and services and receives more income from abroad than it imports and pays abroad.

current account deficit

When a country imports more goods and services and pays more abroad than it exports and receives from abroad.

Capital Account

The capital account is a national account that records transactions involving the purchase or sale of assets. Suppose a U.S. citizen buys shares of stock in a Mexican company on Mexico’s stock market. The transaction would show up on the capital accounts of both the United States and Mexico—as an outflow of assets from the United States and an inflow of assets to Mexico. Conversely, suppose a Mexican investor buys real estate in the United States. That transaction also shows up on the capital accounts of both nations—as an inflow of assets to the United States and as an outflow of assets from Mexico. Although the balances of the current and capital accounts should be the same, there commonly is error caused by recording methods. This figure is recorded in Table 7.2 as a statistical discrepancy.

capital account

National account that records transactions involving the purchase or sale of assets.

Reasons for Intervention by the Host Country

A number of reasons underlie a government’s decisions regarding foreign direct investment by international companies. Let’s now look at the two main reasons countries intervene in FDI flows—to control the balance of payments and to obtain resources and benefits.

Control Balance of Payments

Many governments see intervention as the only way to keep their balance of payments under control. First, because foreign direct investment inflows are recorded as additions to the balance of payments, a nation gets a balance-of-payments boost from an initial FDI inflow. Second, countries can impose local content requirements on investors from other nations coming in for the purpose of local production. This gives local companies the chance to become suppliers to the production operation, which can help reduce the nation’s imports and thereby improve its balance of payments. Third, exports (if any) generated by the new production operation can have a favorable impact on the host country’s balance of payments.

But when companies repatriate profits back to their home countries, they deplete the foreign exchange reserves of their host countries. These capital outflows decrease the balance of payments of the host country. To shore up its balance of payments, the host nation may prohibit or restrict the nondomestic company from removing profits to its home country.

Alternatively, host countries conserve their foreign exchange reserves when international companies reinvest their earnings. Reinvesting in local manufacturing facilities can also improve the competitiveness of local producers and boost a host nation’s exports—thus improving its balance-of-payments position.

Obtain Resources and Benefits

Beyond balance-of-payments reasons, governments might intervene in FDI flows to acquire resources and benefits such as technology and management skills and employment.

A worker is shown looking up at a skyscraper being built in Beijing, China. The country’s liberal economic policies have caused foreign direct investment in China to surge. The investments of multinationals brings badly needed jobs to China’s 130 million migrant workers, who travel from one city and job site to another doing day labor on construction sites. How might such investments affect China’s balance of payments?

Source: Michael Reynolds/CORBIS-NY.

ACCESS TO TECHNOLOGY

Investment in technology, whether in products or processes, tends to increase the productivity and the competitiveness of a nation. That is why host nations have a strong incentive to encourage the importation of technology. For years, developing countries in Asia were introduced to expertise in industrial processes as multinationals set up factories within their borders. But today some of them are trying to acquire and develop their own technological expertise. When German industrial giant Siemens (www.siemens.com) chose Singapore as the site for an Asia-Pacific microelectronics design center, Singapore gained access to valuable technology. Singapore also accessed valuable semiconductor technology by joining with U.S.-based Texas Instruments (www.ti.com) and others to set up the country’s first semiconductor production facility.

MANAGEMENT SKILLS AND EMPLOYMENT

As we saw in Chapter 4, many formerly communist nations suffer from a lack of management skills needed to succeed in the global economy. By encouraging FDI, these nations can attract talented managers to come in and train locals and thereby improve the international competitiveness of their domestic companies. Furthermore, locals who are trained in modern management techniques may eventually start their own local businesses—further expanding employment opportunities. Yet detractors argue that, although FDI may create jobs, it may also destroy jobs because less competitive local firms may be forced out of business.

Reasons for Intervention by the Home Country

Home nations (those from which international companies launch their investments) may also seek to encourage or discourage outflows of FDI for a variety of reasons. But home nations tend to have fewer concerns because they are often prosperous, industrialized nations. For these countries, an outward investment seldom has a national impact—unlike the impact on developing or emerging nations that receive the FDI. Nevertheless, among the most common reasons for discouraging outward FDI are the following:

■ Investing in other nations sends resources out of the home country. As a result, fewer resources are used for development and economic growth at home. On the other hand, profits on assets abroad that are returned home increase both a home country’s balance of payments and its available resources.

■ Outgoing FDI may ultimately damage a nation’s balance of payments by taking the place of its exports. This can occur when a company creates a production facility in a market abroad, the output of which replaces exports that used to be sent there from the home country. For example, if a Volkswagen (www.vw.com) plant in the United States fills a demand that U.S. buyers would otherwise satisfy with purchases of German-made autos, Germany’s balance of payments is correspondingly decreased. Still, Germany’s balance of payments would be positively affected when companies repatriate U.S. profits, which helps negate the investment’s initial negative balance-of-payments effect. Thus an international investment might make a positive contribution to the balance-of-payments position of the country in the long term and offset an initial negative impact.

■ Jobs resulting from outgoing investments may replace jobs at home. This is often the most contentious issue for home countries. The relocation of production to a low-wage nation can have a strong impact on a locale or region. However, the impact is rarely national, and its effects are often muted by other job opportunities in the economy. In addition, there may be an offsetting improvement in home country employment if additional exports are needed to support the activity represented by the outgoing FDI. For example, if Hyundai (www.hyundai-motor.com) of South Korea builds an automobile manufacturing plant in Brazil, Korean employment may increase in order to supply the Brazilian plant with parts.

But foreign direct investment is not always a negative influence on home nations. In fact, under certain circumstances governments might encourage it. Countries promote outgoing FDI for the following reasons:

■ Outward FDI can increase long-term competitiveness. Businesses today frequently compete on a global scale. The most competitive firms tend to be those that conduct business in the most favorable location anywhere in the world, continuously improve their performance relative to competitors, and derive technological advantages from alliances formed with other companies. Japanese companies have become masterful at benefiting from FDI and cooperative arrangements with companies from other nations. The key to their success is that Japanese companies see every cooperative venture as a learning opportunity.

■ Nations may encourage FDI in industries identified as “sunset” industries. Sunset industries are those that use outdated and obsolete technologies or employ low-wage workers with few skills. These jobs are not greatly appealing to countries having industries that pay skilled workers high wages. By allowing some of these jobs to go abroad and retraining workers in higher-paying skilled work, they can upgrade their economies toward “sunrise” industries. This represents a trade-off for governments between a short-term loss of jobs and the long-term benefit of developing workers’ skills.

Quick Study

1. What is a country’s balance of payments? Briefly explain its usefulness.

2. Explain the difference between the current account and the capital account.

3. For what reasons do host countries intervene in FDI?

4. For what reasons do home countries intervene in FDI?

Government Policy Instruments and FDI

Over time, both host and home nations have developed a range of methods to either promote or restrict FDI (see Table 7.3). Governments use these tools for many reasons, including improving balance-of-payments positions; acquiring resources; and, in the case of outward investment, keeping jobs at home. Let’s take a look at these methods.

Host Countries: Promotion

Host countries offer a variety of incentives to encourage FDI inflows. These take two general forms—financial incentives and infrastructure improvements.

Financial Incentives

Host governments of all nations grant companies financial incentives if they will invest within their borders. One method includes tax incentives, such as lower tax rates or offers to waive taxes on local profits for a period of time—extending as far out as five years or more. A country may also offer low interest loans to investors.

The downside of these types of incentives is they can allow multinationals to create bidding wars between locations that are vying for the investment. In such cases, the company typically invests in the most appealing region after the locations endure rounds of escalating incentives. Companies have even been accused of engaging other governments in negotiations to force concessions from locations already selected for investment. The cost to taxpayers of attracting FDI can be several times what the actual jobs themselves pay—especially when nations try to one-up each other to win investment.

TABLE 7.3 Methods of Promoting and Restricting FDI

FDI Promotion

FDI Restriction

Host Countries

Tax incentives

Ownership restrictions

Low-interest loans

Performance demands

Infrastructure improvements

Home Countries

Insurance

Differential tax rates

Loans

Sanctions

Tax breaks

Political pressure

Infrastructure Improvements

Because of the problems associated with financial incentives, some governments are taking an alternative route to luring investment. Lasting benefits for communities surrounding the investment location can result from making local infrastructure improvements—better seaports suitable for containerized shipping, improved roads, and increased telecommunications systems. For instance, Malaysia is carving an enormous Multimedia Super Corridor (MSC) into a region’s forested surroundings. The MSC promises a paperless government, an intelligent city called Cyberjaya, two telesuburbs, a technology park, a multimedia university, and an intellectual-property-protection park. The MSC is dedicated to creating the most advanced technologies in telecommunications, medicine, distance learning, and remote manufacturing.

Host Countries: Restriction

Host countries also have a variety of methods to restrict incoming FDI. Again, these take two general forms—ownership restrictions and performance demands.

Ownership Restrictions

Governments can impose ownership restrictions that prohibit nondomestic companies from investing in certain industries or from owning certain types of businesses. Such prohibitions typically apply to businesses in cultural industries and companies vital to national security. For example, as some Islamic countries in the Middle East try to protect traditional values, accepting investment by Western companies is a controversial issue between purists and moderates. Also, most nations do not allow FDI in their domestic weapons or national defense firms. Another ownership restriction is a requirement that nondomestic investors hold less than a 50 percent stake in local firms when they undertake foreign direct investment.

But nations are eliminating such restrictions because companies today often can choose another location that has no such restriction in place. When General Motors was deciding whether to invest in an aging automobile plant in Jakarta, Indonesia, the Indonesian government scrapped its ownership restriction of an eventual forced sale to Indonesians because China and Vietnam were also courting GM for the same financial investment.

Performance Demands

More common than ownership requirements are performance demands that influence how international companies operate in the host nation. Although typically viewed as intrusive, most international companies allow for them in the same way they allow for home country regulations. Performance demands include ensuring that a portion of the product’s content originates locally, stipulating the portion of output that must be exported, or requiring that certain technologies be transferred to local businesses.

Home Countries: Promotion

To encourage outbound FDI, home country governments can do any of the following:

■ Offer insurance to cover the risks of investments abroad, including, among others, insurance against expropriation of assets and losses from armed conflict, kidnappings, and terrorist attacks.

■ Grant loans to firms wishing to increase their investments abroad. A home country government may also guarantee the loans that a company takes from financial institutions.

■ Offer tax breaks on profits earned abroad or negotiate special tax treaties. For example, several multinational agreements reduce or eliminate the practice of double taxation—profits earned abroad being taxed both in the home and host countries.

■ Apply political pressure on other nations to get them to relax their restrictions on inbound investments. Non-Japanese companies often find it very difficult to invest inside Japan. The United States, for one, repeatedly pressures the Japanese government to open its market further to FDI. But because such pressure has achieved little success, many U.S. companies cooperate with local Japanese businesses.

Home Countries: Restriction

On the other hand, to limit the effects of outbound FDI on the national economy, home governments may exercise either of the following two options:

■ Impose differential tax rates that charge income from earnings abroad at a higher rate than domestic earnings.

■ Impose outright sanctions that prohibit domestic firms from making investments in certain nations.

Quick Study

1. Identify the main methods host countries use to promote and restrict FDI.

2. What methods do home countries use to promote and restrict FDI?

Bottom Line FOR BUSINESS

Companies ranging from massive global corporations to adventurous entrepreneurs all contribute to FDI flows, and the long-term trend in FDI is upward. Here we briefly discuss the influence of national governments on FDI flows and flows of FDI in Asia and Europe.

National Governments and FDI

The actions of national governments have important implications for business. Companies can either be thwarted in their efforts or be encouraged to invest in a nation, depending on the philosophies of home and host governments. The balance-of-payments positions of both home and host countries are also important because FDI flows affect the economic health of nations. To attract investment, a nation must provide a climate conducive to business operations, including pro-growth economic policies, a stable regulatory environment, and a sound infrastructure, to name just a few.

Increased competition for investment by multinationals has caused nations to make regulatory changes more favorable to FDI. Moreover, just as nations around the world are creating free trade agreements (covered in Chapter 8), they are also embracing bilateral investment treaties. These bilateral investment treaties are becoming prominent tools used to attract investment. Investment provisions within free trade agreements are also receiving greater attention than in the past. These efforts to attract investment have direct implications for the strategies of multinational companies, particularly when it comes to deciding where to locate production, logistics, and backoffice service activities.

Foreign Direct Investment in Europe

Developing nations in Africa, Latin America, and much of Southeast Asia were hit especially hard by the lower FDI flows in the early 2000s, but are rebounding. FDI inflows into the developing (transition) nations of Southeast Europe and the Commonwealth of Independent States hit an all-time high in 2006. Countries that recently entered the European Union did particularly well. They saw less investment in areas supporting low-wage, unskilled occupations, and greater investment in higher value-added activities that take advantage of a well-educated workforce.

Yet the main reason for the fast pace at which foreign direct investment is occurring in Western Europe is regional economic integration (see Chapter 8). Some of the foreign investment reported by the European Union certainly went to the relatively less developed markets of the new central and eastern European members. But much of the activity occurring among western European companies is industry consolidation brought on by the opening of markets and the tearing down of barriers to free trade and investment. Change in the economic landscape across Europe is creating a more competitive business climate there.

Foreign Direct Investment in Asia

China attracts the majority of Asia’s FDI, luring companies with a low-wage workforce and access to an enormous domestic market. Many companies already active in China are upping their investment further, and companies not yet there are developing strategies for how to include China in their future plans. The “off-shoring” of services will likely propel continued FDI in the coming years, of which India is the primary destination. India’s attraction is its well-educated, low-cost, and English-speaking workforce.

An aspect of national business environments that has implications for future business activity is the natural environment. By their actions, businesses lay the foundation for people’s attitudes in developing nations toward FDI by multinationals. For example, greater decentralization in China’s politics has placed local Communist Party bosses and bureaucrats at the center of many FDI deals there. These individuals are often more motivated by their personal financial gain than they are worried about pollution. But China’s government is increasing spending on the environment, and multinationals are helping in cleaning up the environment.

Chapter Summary

1. Describe worldwide patterns of foreign direct investment (FDI) and reasons for these patterns.

■ FDI inflows peaked in 2000 at $1.4 trillion, but then contracted through 2003. They then rebounded to around $648 billion in 2004, $946 billion in 2005, and $1.3 trillion in 2006.

■ Developed countries account for around 65 percent of global FDI inflows, and developing countries account for about 29 percent.

■ Among developed countries, the European Union (EU), the United States, and Japan account for the majority of FDI inflows. The EU garnered $531 billion of FDI in 2006 (40 percent of the world total).

■ FDI inflows to developing Asian nations were just over $259 billion in 2006, with China attracting over $69 billion and India attracting nearly $17 billion.

■ FDI inflows to all of Africa accounted for about 2.7 percent of total world FDI inflows in 2006.

■ Globalization and a growing number of mergers and acquisitions account for the rising tide of FDI flows.

2. Describe each of the theories that attempt to explain why foreign direct investment occurs.

■ The international product life cycle theory says that a company begins by exporting its product and later undertakes foreign direct investment as the product moves through its life cycle of three stages: new product, maturing product, and standardized product.

■ Market imperfections theory says that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake foreign direct investment to internalize the transaction and thereby remove the imperfection.

■ The eclectic theory says that firms undertake foreign direct investment when the features of a particular location combine with ownership and internalization advantages to make a location appealing for investment.

■ The market power theory states that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment.

3. Discuss the important management issues in the foreign direct investment decision.

■ Although companies investing abroad often wish to control activities in the local market, they may be forced to hire local managers or to export all goods produced locally.

■ Acquisition of an existing business is preferred when the existing business entails updated equipment, good relations with workers, and a suitable location.

■ When adequate facilities are unavailable, a company might need to pursue a greenfield investment.

■ A local market presence can give a company valuable knowledge of local buyer behavior.

■ Firms commonly engage in FDI when it locates them close to client firms and rival firms.

4. Explain why governments intervene in the free flow of foreign direct investment.

■ Host nations receive a balance-of-payments boost from initial FDI and from any exports the FDI generates, but they see a decrease in balance of payments when a company sends profits to the home country.

■ FDI in technology brings in people with management skills who can train locals and increase a nation’s productivity and competitiveness.

■ Home countries intervene in FDI outflows because they can lower the balance of payments, but profits sent home that are earned on assets abroad increase the balance of payments.

■ FDI outflows may replace jobs at home that were based on exports to the host country and may damage the home nation’s balance of payments if they reduce prior exports.

5. Discuss the policy instruments that governments use to promote and restrict foreign direct investment.

■ Host countries can promote FDI inflows by offering companies tax incentives (such as lower tax rates or waived taxes), extending low interest loans, and making local infrastructure improvements.

■ Host countries can restrict FDI inflows by imposing ownership restrictions (prohibitions from certain industries) and by creating performance demands that influence how a company can operate.

■ Home countries can promote FDI outflows by offering insurance to cover investment risks abroad, granting loans to firms investing abroad, guaranteeing company loans from financial institutions, offering tax breaks on profits earned abroad, negotiating special tax treaties, and applying political pressure to get other nations to accept FDI.

■ Home countries can restrict FDI outflows by imposing differential tax rates that charge income from earnings abroad at a higher rate than domestic earnings and by imposing sanctions that prohibit domestic firms from making investments in certain nations.

Talk It Over

1. You overhear your superior tell another manager in the company: “I’m fed up with our nation’s companies sending manufacturing jobs abroad and offshoring service work to lower-wage nations. Don’t any of them have any national pride?” The other manager responds, “I disagree. It is every company’s duty to make as much profit as possible for its owners. If that means going abroad to reduce costs, so be it.” Do you agree with either of these managers? Why or why not? Now step into the conversation and explain where you stand on this issue.

2. The global carmaker you work for is investing in an automobile assembly facility in Costa Rica with a local partner. Explain the potential reasons for this investment. Will your company want to exercise a great deal of control over this operation? Why or why not? In what areas might your company want to exercise control and in what areas might it cede control to the partner?

3. This chapter presented several theories that attempt to explain why firms undertake foreign direct investment. Which of these theories seems most appealing to you? Why is it appealing? Can you think of one or more companies that seem to fit the pattern described by the theory? In your opinion, what faults do the alternative theories have?

Teaming Up

1. Research Project. In a small group, locate an article in the business press that discusses a cross-border merger or acquisition within the past year. Gather additional information on the deal from any sources available. What reasons did each company give for the merger or acquisition? Was it a marriage of equals or did a larger partner absorb a far smaller one? Do the articles identify any internal issues managers had to deal with following the merger or acquisition? What is the current performance of the new company? Write a two- to three-page report of your group’s findings.

2. Market Entry Strategy Project. This exercise corresponds to the MESP online simulation. For the country your team is researching, does it attract large amounts of FDI? Is it a major source of FDI for other nations? What is the nation’s balance-of-payments position? What is its current account balance? List some possible causes for its surplus or deficit. How is this surplus or deficit affecting the nation’s economic performance? What is its capital account balance? How does the government encourage or restrict trade with other nations? Integrate your findings into your completed MESP report.

Key Terms

balance of payments (p. 204)

capital account (p. 205)

current account (p. 205)

current account deficit (p. 205)

current account surplus (p. 205)

eclectic theory (p. 198)

foreign direct investment (FDI) (p. 194)

international product life cycle (p. 197)

market imperfections (p. 197)

market power (p. 199)

portfolio investment (p. 194)

rationalized production (p. 201)

vertical integration (p. 199)

Take It to the Web

1. Video Report. Visit this book’s channel on YouTube (YouTube.com/MyIBvideos). Click on “Playlists” near the top of the page and click on the set of videos labeled “Ch 07: Foreign Direct Investment.” Watch one video from the list and summarize it in a half-page report. Reflecting on the contents of this chapter, which aspects of foreign direct investment can you identify in the video? How might a company engaged in international business act on the information contained in the video?

2. Web Site Report. This chapter presented many reasons why companies directly invest in other nations and factors in the decision of whether and where to invest abroad.

Research the economy of the Philippines and its neighbors. In what economic sectors is each country strong? Do the strengths of each country really complement one another, or do they compete directly with one another? If you were considering investing in the Philippines, what management issues would concern you? Be specific in your answer. (Hint: A good place to begin your research is the CIA’s World Factbook (www.odci.gov/cia/publications/factbook).

In this era of intense national competition to attract jobs, Southeast Asian governments fear losing ground to China in the race for investment. What do you think those governments could do to increase the attractiveness of their homelands for multinationals?

Find an article on the Internet that describes a company’s decision to relocate some or all of its business operations (goods or services). What reasons are stated for the relocation? Was any consideration given to the plight of employees being put out of work?

Ethical Challenges

1. You are a sales manager working in international sales for a major U.S. beef distributor. Your firm is attempting to sell a large quantity of beef to a developing market in northern Africa where U.S. beef is a rarity. The vice president for new business development has instructed you to sell the beef well below market price quickly. Standing at the coffee machine, you overhear two quality assurance managers discussing “the potentially tainted beef heading for Africa.” You are aware that in the past your firm has come across small traces of typhoid in some of its products. What do you do? Do you go through with the northern Africa deal? Do you first contact someone inside or outside the company? If additional information would be helpful to you, what would it be?

2. You are the U.S. senator deciding whether to vote up or down on a new piece of legislation. The potential new law places restrictions on the practice of outsourcing work to low-wage countries and is designed to protect U.S. workers’ jobs. These days it is increasingly common for companies to promise manufacturing contracts to overseas suppliers in exchange for entry into that country’s market. Labor union representatives argue that these kinds of deals are made at the expense of jobs at home. After all, if a company can have parts made in China at lower wages, why keep factories going at home? They also are concerned that the transfer of technology will breed strong competitors in other nations and thereby threaten even more domestic jobs in the future. But others argue that increased sales abroad actually helps create more jobs at home. Discuss the ethics of companies contracting out production to factories abroad in exchange for sales contracts. How would you vote on the pending legislation? What other issues must you consider?

3. You are the U.S. ambassador to Malaysia. In order to become a major export platform for the semiconductor industry, Malaysia’s government not only offered tax breaks but also guaranteed that electronics workers would be prohibited from organizing independent labor unions. The government decreed that the goal of national development required a “union-free” environment for the “pioneers” of semiconductors. Under pressure from U.S. labor unions, the Malaysian government offered a weak alternative to industry unions—company-by-company “in-house” unions. Yet as soon as workers organized one at a Harris Electronics plant, the 21 union leaders were fired, and the new union was disbanded. In another instance, when French-owned Thomson Electronics inherited a Malaysian factory with a union of 3,000, it closed the plant and moved the work to Vietnam. Newly industrialized nations such as Malaysia feel that their futures depend on investment by multinationals. Yet their governments are acutely aware that in the absence of incentives such as a “union-free” workforce, international companies can easily take their investment money elsewhere. Discuss the problems that these governments face in balancing the needs of their citizens with the long-term quest for economic development. As the ambassador, what advice do you give Malaysian business and government leaders? Can you think of examples from other nations that can help you make the case for local unions?

PRACTICING INTERNATIONAL MANAGEMENT CASE: World Class in Dixieland

“A loof.” “Serious.” “Not youthful.” Definitely “not fun.” These were the unfortunate epithets applied to Mercedes-Benz by a market research firm that assesses product personalities. Research among dealers in the United States also revealed that consumers felt so intimidated by Mercedes that they wouldn’t sit in the cars at the showroom.

To boost sales and broaden the market to a more youthful and value-conscious consumer, Mercedes-Benz U.S. International (www.mbusi.com) came up with a series of inventive, free-spirited ads featuring stampeding rhinos and bobbing aliens. Although the new ads boosted sales, the company needed more than a new marketing message to ensure its future growth. What it needed was an all-new Mercedes. Enter the Mercedes M-Class, a sports utility vehicle (SUV). With a base price of $35,000 and a luxury lineage, Mercedes placed its M-Class to compete squarely against the Ford Explorer and Jeep Grand Cherokee.

Not only was the M-Class Mercedes’ first SUV, it was also the first car that Mercedes had manufactured outside Germany—in the heart of Dixie, no less. The rough-hewn town of Vance, Alabama (population 400), in Tuscaloosa County is where people hang out at the local barbecue joint. And it is the last place you’d expect to find button-down engineers from Stuttgart, Germany. But this small town appealed to Mercedes for several reasons. Labor costs in the U.S. Deep South are 50 percent lower than in Germany. Also, Alabama offered an attractive $250 million in tax refunds and other incentives to win the much-needed Mercedes jobs. Mercedes also wanted to be closer to the crucial U.S. market and to create a plant from the ground up, one that would be a model for its future international operations.

When Japanese carmakers entered the U.S. market, they reproduced their car-building philosophies, cultures, production practices, and management styles. By contrast, Mercedes started with the proverbial blank sheet of paper at Tuscaloosa. To appeal to U.S. workers, Mercedes knew it had to abandon the rigid hierarchy of its typical production line and create a more egalitarian shop floor. Administrative offices in the gleaming, E-shaped Mercedes plant run through the middle of the manufacturing area, and administrators are accessible to team members on the shop floor. Also, the plant’s design lets workers unilaterally stop the assembly line to correct manufacturing problems.

So far, the system has been a catalyst to communication among the Tuscaloosa plant’s U.S. workers, German trainers, and a diverse management team that includes executives from Detroit and Japan. Even so, an enormous amount of time and effort was invested in training the U.S. workforce. Explains Sven Schoolman, a 31-year-old trainer from Sindelfingen, “In Germany, we don’t say we build a car. We say we build a Mercedes. We had to teach that.” The innovative production system is a combination of German, Japanese, and U.S. automotive best practices within a young corporate culture. The Tuscaloosa plant uses a “just-in-time” manufacturing method that requires only about two hours of inventory on line and about three hours of inventory in the body shop. As of 2008, Mercedes’ experience is so successful that Honda, Toyota, and Hyundai followed it to Alabama, and Volkswagen may soon as well.

Mercedes later expanded its Tuscaloosa operations to nearly triple the size of its original factory. The plant now uses flexible manufacturing technology to accommodate the M-Class, R-Class, and GL-Class. Production volume in 2006 was 173,600 vehicles for all three classes. Around 65 percent of vehicle content comes from Canada, Mexico, and the United States, whereas engines and transmissions are imported from Germany. Every vehicle built at the Tuscaloosa plant is for an order from one of Mercedes’ 135 markets worldwide.

The company is gaining valuable experience in how to set up and operate a plant in another country. “It was once sacrosanct to talk about our cars being ‘Made in Germany’,” said Jurgen E. Schrempp, then CEO of Mercedes’ parent company. “We have to change that to ‘Made by Mercedes’, and never mind where they are assembled.”

Thinking Globally

1. What do you think were the chief factors involved in Mercedes’ decision to undertake FDI in the United States rather than build the M-Class in Germany?

2. Why do you think Mercedes decided to build the plant from the ground up in Alabama rather than buy an existing plant in, say, Detroit? List as many reasons as you can, and explain your answer.

3. Do you think Mercedes risks diluting its “Made in Germany” reputation for engineering quality by building its M-class outside Germany? Why or why not?

4. What do you see as the pros and cons of Mercedes’ approach to managing FDI—abandoning the culture and some of its home country practices?

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