Peng Cap 06

Investing Abroad Directly

Understanding FDI Vocabulary
Foreign direct investments: Investment in portfolio of foreign securities such as bonds and
stocks
Management Control Rights: The rights to appoint key managers and establish control
mechanisms
Horizontal FDI: A type of FDI in which a firm duplicates its home country based activities at
the same value chain stage in a host country
Vertical FDI: A type of FDI in which a firm moves upstream or downstream at different
value chain stages in a host country
Upstream vertical FDI: A type of vertical FDI in which a firm engages in an upstream stage
of the value chain in a host country
Downstream vertical FDI: A type of vertical FDI in which a firm engages in a downstream
stage of the value chain in a host country
FDI flow: The amount of FDI moving in a given period in a certain direction
FDI inflow: Inbound FDI moving into a country in a year
FDI outflow: Outbound FDI moving out of a country in a year
Why do firms become MNEs by engaging in FDI?
The answer boils down to firms quest for ownership (O) advantages, localisation (L)
advantages and internationalization (I) advantages – OLI advantages
Ownership Advantages
 An MNEs possession and leveraging of certain valuable, rare, hard-to-imitate and
organizationally embedded assets
 The benefits of direct ownership lie in the combination of equity ownership rights and
management control rights
 FDI vs. Licencing
o FDI reduces dissemination risk (risk associated with unauthorized diffusion of
firm specific knowledge)
o FDI provides tight control over foreign operations
o FDI facilitates the transfer of tacit knowledge through “learning by doing”
Location Advantages
 Beyond natural geographic advantages, location advantages also arise from the
clustering of economic activities in certain locations, referred to agglomeration
  Agglomeration: Clustering of economic activities in certain locations
 Agglomeration advantages stem from
o Knowledge spillover: the diffusion of knowledge from one firm to others
among closely located firms that attempt to hire employees from competitiors
o Industry demand that creates skilled labour force whose members may work
for different firms without moving out of the region
o Industry demand that facilitates a pool of specialized suppliers and buyers also
located in the region
Internalization Advantages
 Market failure
o Difficult to enforce contracts between firms located in different countries
o Higher transaction costs in dealings with foreign countries
o FDI as a way of overcoming these market failures
Overcoming market failure through FDI
 FDI combats market failure through internalization i.e. replacement of external
markets by in-house activities
The Realities of FDI
Political Views on FDI
 Radical View on FDI: treats FDI as an instrument of imperialism and a vehicle for
exploiting domestic resources and people by foreign capitalists and firms.
Government holding this view are hostile to FDI.
 Free market view on FDI: FDI, unrestricted by government intervention will enable
countries to tap into their absolute or comparative advantages by specializing in the
production of certain goods and services
 Pragmatic Nationalism: considering pros and cons of FDI and approve only on the
case of FDI benefiting
Benefits and Costs of FDI to Host countries
Benefits Host: Capital inflow, technology, management, job creation
Benefit source: Earnings, exports, learning from abroad
Costs Host: Loss of sovereignty, competition, capital outflow
Costs Home: Capital outflow, job loss
Technology spillover: Technology diffused from foreign to domestic firms
Demonstration effect: The reaction of local firms to rise to the challenge demonstrated by
MNEs through learning an imitation
Benefits and Cost of FDI to Home Countries
 Repatriated earnings from profits from FDI
 Increased exports of components and services to host countries
 Learning via FDI from operations abroad
How MNEs and Host Governments Bargain
 Bargaining Powers: Ability to extract favourable outcome from negotiations due to
one’s party`s strength
 FDI is not a zero sum game. Negotiations are characterized by Common Interest,
Conflicting Interests and Compromises
 Despite a variety of conflicts, conditions exist, where the interests of both sides sides
may converge on an outcome that benefits both sides
 Obsolescing bargain: The deal struck by MNEs and host governments, which change
their requirements after the Initial FDI entry
 Expropriation: Governments confiscation of foreign assets
 Sunk costs: Cost that a firm has to endure even when its investment turns out to be
satisfactory
Debates and Extensions
FDI versus Outsourcing
 How critical?
 How common?
 How readily available?
 If marginal- outsource
Facilitating versus Confronting Inbound FDI
 For political and cultural reasons FDI from certain source countries in certain host
countries can be controversial
Welcoming versus Restricting Sovereign Wealth Fund Investments
 Sovereign Wealth Fund: A state-owed investment fund composed of financial assets
such as stocks, bonds, real estate, or financial instruments funded by foreign by
foreign exchange assets
 SWFs bring in cash however concerns exist with regard to national security and the
undue influence, that could be taken by SWFs for political reasons, also: lack of
transparency