Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country. Once a firm undertakes FDI it becomes a multinational enterprise. Each year Fortune magazine publishes a list of the 500 largest global corporations in the world. Fortune calls its list the “Global 500.” This list can be accessed at {http://money.cnn.com/magazines/fortune/global500/2011/}. The article contains an excellent discussion of the role of global firms in the world economy.
FDI can take the form of a greenfield investment where a wholly new operation is established in a foreign country, or it can take place via acquisitions or mergers with existing firms in the foreign country. Another web site that provides an excellent discussion of the role of multinational corporations in the world economy is available at {http://www.oecdobserver.org/news/fullstory.php/aid/446/The_trust_business.html}.
The flow of FDI refers to the amount of FDI undertaken over a given time period, while the stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. Outflows of FDI are the flows of FDI out of a country, and inflows of FDI are the flows of FDI into a country. There has been a marked increase in both the flow and stock of FDI in the world economy over the last 30 years. While the United States remains a top destination for FDI flows, South, East, and Southeast Asia, and particularly China, are now seeing an increase of FDI inflows, and Latin America is also emerging as an important region for FDI.
FDI in China continues to be strong, and India is emerging as another hotspot for FDI. To learn more about these markets go to {http://www.businessweek.com/magazine/content/10_49/b4206016219076.htm} and {http://www.businessweek.com/news/2011-02-17/china-s-foreign-investment-rose-23-4-in-january.html}.
In contrast to China and India, Britain and the EU countries in general are seeing inward FDI drop. A similar trend can be found in the United States. To learn more about these trends go to {http://www.businessweek.com/globalbiz/content/feb2010/gb20100224_156946.htm}
Since World War II, the U.S. has been the largest source country for FDI. The United Kingdom, the Netherlands, France, Germany, and Japan are other important source countries.
The Form of FDI: Acquisitions Versus Greenfield Investments. Most cross-border investment is in the form of mergers and acquisitions rather than greenfield investments.
Why do firms choose FDI instead of exporting or licensing? Internalization theory (also known as market imperfections theory) suggests that licensing has three major drawbacks.
The Pattern of Foreign Direct Investment has been explored by many researchers. Knickerbocker looked at the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms) and suggested that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. Vernon argued that firms undertake FDI at particular stages in the life cycle of a product they have pioneered.
According to the eclectic paradigm, in addition to the various factors discussed earlier, it is important to consider:
- location-specific advantages – that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets
and
- externalities – knowledge spillovers that occur when companies in the same industry locate in the same area
Political Ideology and Foreign Direct Investment ranges from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economies. Between these two extremes is an approach that might be called pragmatic nationalism. The radical view argues that the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries. According to the free market view, international production should be distributed among countries according to the theory of comparative advantage. Pragmatic nationalism suggests that FDI has both benefits, such as inflows of capital, technology, skills and jobs, and costs, such as repatriation of profits to the home country and a negative balance of payments effect.
Recently, there has been a strong shift toward the free market stance creating:
- a surge in FDI worldwide
- an increase in the volume of FDI in countries with newly liberalized regimes
Host Country Benefits of FDI
Government policy is often shaped by a consideration of the costs and benefits of FDI. There are four main benefits of inward FDI for host countries: resource transfer effects; employment effects; balance of payments effects, and effects on competition and growth.
Host Country Costs
There are three mains costs from inward FDI for the host country: the possible adverse effects of FDI on competition within the host nation; adverse effects on the balance of payments; and the perceived loss of national sovereignty and autonomy.
Home Country Benefits
The benefits of FDI for the home country include: the effect on the capital account of the home country’s balance of payments from the inward flow of foreign earnings; the employment effects that arise from outward FDI; and the gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country.
Home Country Costs
The home country’s balance of payments can suffer from the initial capital outflow required to finance the FDI; if the purpose of the FDI is to serve the home market from a low cost labor location; and if the FDI is a substitute for direct exports.
International trade theory suggests that home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid.
Government Policy Instruments and FDI
Home countries and host countries use various policies to regulate FDI. The World Bank offers information on the business environment in different countries. To explore the information, go to {http://www.worldbank.org/}, click on “countries”, and select the country in question. Governments can both encourage and restrict FDI. India has recently revised its regulations regarding FDI raising concerns among some analysts. To learn more about India’s new regulations go to {http://www.businessweek.com/globalbiz/content/feb2009/gb20090213_539478.htm}.
To encourage inward FDI, governments offer incentives to foreign firms to invest in their countries, while they restrict inward FDI through ownership restraints and Institutions and the Liberalization of FDI. Many organizations are working to streamline FDI. The World Trade Organization is trying to establish a universal set of rules designed to promote the liberalization of FDI.
Managers need to consider what trade theory implies, and the link between government policy and FDI. The direction of FDI can be explained through the location-specific advantages argument associated with John Dunning. A host government’s attitude toward FDI is an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct investment.