International Business
Oded Shenkar and Yadong Luo
Chapter 3
Foreign Direct Investment Theory
and Application
Chapter 3: Foreign Direct Investment Theory and Application
Do You Know?
• What are the types of foreign direct
investment (FDI)?
• What strategies encourage an MNE to
engage in such investment?
• Do companies share strategic goals in
pursuing FDI?
• What benefits would you cite to MNE
executives to attract them to establish a
subsidiary?
• What drives FDI distribution and patterns?
• Why is Africa left out of the FDI mix?
Chapter 3: Foreign Direct Investment Theory and Application
Definition and Types of FDI
• Foreign Direct Investment – when a
firm invests directly in production or
other facilities, over which it has
effective control, in a foreign country.
• Manufacturing FDI requires the
establishment of production facilities.
• Service FDI requires building service
facilities or an investment foothold via
capital contributions or building office
facilities.
Chapter 3: Foreign Direct Investment Theory and Application
Definition and Types of FDI
• Foreign subsidiaries – overseas units
or entities.
• Host country – the country in which a
foreign subsidiary operates.
• Flow of FDI – the amount of FDI
undertaken over a given time.
• Stock of FDI – total accumulated value
of foreign-owned assets.
• Outflows/Inflows of FDI – the flow of
FDI out of or into a country.
Chapter 3: Foreign Direct Investment Theory and Application
FDI versus Foreign Portfolio Investment
• Foreign Portfolio Investment – the
investment by individuals, firms, or
public bodies in foreign financial
instruments.
– Stocks, bonds, other forms of debt.
• Differs from FDI, which is the
investment in physical assets.
• Portfolio theory – the behavior of
individuals or firms administering large
amounts of financial assets.
Chapter 3: Foreign Direct Investment Theory and Application
Types of FDI
• Horizontal FDI – the MNE enters a foreign
country to produce the same products
product at home.
• Conglomerate FDI – the MNE produces
products not manufactured at home.
• Vertical FDI – the MNE produces
intermediate goods either forward or
backward in the supply stream.
• Liability of foreignness – the costs of doing
business abroad resulting in a competitive
disadvantage.
Chapter 3: Foreign Direct Investment Theory and Application
Entry Mode
• The manner in which a firm chooses to enter
a foreign market through FDI.
–
–
–
–
–
International franchising
Branches
Contractual alliances
Equity joint ventures
Wholly foreign-owned subsidiaries
• Investment approaches:
–
–
–
–
Greenfield investment (building a new facility)
Cross-border mergers
Cross-border acquisitions
Sharing existing facilities
Chapter 3: Foreign Direct Investment Theory and Application
The Strategic Logic Behind FDI
• Resources seeking - looking for resources
at a lower real cost.
• Market seeking - secure market share and
sales growth in target foreign market.
• Efficiency seeking - seeks to establish
efficient structure through useful factors,
cultures, policies, or markets.
• Strategic asset seeking - seeks to acquire
assets in foreign firms that promote corporate
long term objectives.
Chapter 3: Foreign Direct Investment Theory and Application
Enhancing Efficiency from Location
Advantages
• Location advantages are defined as
the benefits arising from a host
country’s comparative advantages.
– Better access to resources
– Lower real cost from operating in a host
country
– Labor cost differentials
– Transportation costs, tariff and non-tariff
barriers
– Governmental policies
Chapter 3: Foreign Direct Investment Theory and Application
Improving Performance from Structural
Discrepancies
• Structural discrepancies are the
differences in industry structure
attributes between home and host
countries.
• Examples include areas where:
– Competition is less intense
– Products are in different stages of their life
cycle
– Market demand is unsaturated
– There are differences in market
sophistication
Chapter 3: Foreign Direct Investment Theory and Application
Increasing Return from Ownership
Advantages
• Ownership Advantages come from the
application of proprietary tangible and
intangible assets in the host country.
– Reputation, brand image, distribution
channels
– Technological expertise, organizational
skills, experience
• Core competence – skills within the
firm that competitors cannot easily
imitate or match.
Chapter 3: Foreign Direct Investment Theory and Application
Ensuring Growth from Organizational
Learning
• MNEs exposed to multiple stimuli,
developing:
– Diversity capabilities
– Broader learning opportunities
• Exposed to:
– New markets
– New practices
– New ideas
– New cultures
– New competition
Chapter 3: Foreign Direct Investment Theory and Application
The Impact of FDI on the Host Country
• Employment
– Firms attempt to capitalize on abundant
and inexpensive labor.
– Host countries seek to have firms develop
labor skills and sophistication.
– Host countries often feel like “least
desirable” jobs are transplanted from home
countries.
– Home countries often face the loss of
employment as jobs move.
Chapter 3: Foreign Direct Investment Theory and Application
The Impact of FDI on the Host Country
• FDI Impact on Domestic Enterprises
– Foreign invested companies are likely
more productive than local competitors.
– The result is uneven competition in the
short run, and competency building efforts
in the longer term.
– It is likely that FDI developed enterprises
will gradually develop local supporting
industries, supplier relationships in the host
country.
Chapter 3: Foreign Direct Investment Theory and Application
Product Life-Cycle Theory
• Ray Vernon asserted that product
moves to lower income countries as
products move through their product life
cycle.
• The FDI impact is similar: FDI flows to
developed countries for innovation, and
from developed countries as products
evolve from being innovative to being
mass-produced.
Chapter 3: Foreign Direct Investment Theory and Application
Monopolistic Advantage Theory
• An MNE has and/or creates
monopolistic advantages that enable it
to operate subsidiaries abroad more
profitably than local competitors.
• Monopolistic Advantage comes from:
– Superior knowledge – production
technologies, managerial skills, industrial
organization, knowledge of product.
– Economies of scale – through horizontal or
vertical FDI
Chapter 3: Foreign Direct Investment Theory and Application
Internationalization Theory
• When external markets for supplies, production, or
distribution fails to provide efficiency, companies can
invest FDI to create their own supply, production, or
distribution streams.
• Advantages
– Avoid search and negotiating costs
– Avoid costs of moral hazard (hidden detrimental action by
external partners)
– Avoid cost of violated contracts and litigation
– Capture economies of interdependent activities
– Avoid government intervention
– Control supplies
– Control market outlets
– Better apply cross-subsidization, predatory pricing and
transfer pricing
Chapter 3: Foreign Direct Investment Theory and Application
The Eclectic Paradigm
• OLI Framework
– O – Ownership-specific
• Tangible assets, such natural endowments, manpower,
and capital.
• Intangible assets, such as technology and information,
managerial, marketing and entrepreneurial skills.
– L – Location-specific
• Market structure, government policies, and political,
legal, and cultural environment.
– I – Internationalization
• Firm’s inherent flexibility and capacity to produce and
market through its internal subsidiaries.
• All three factors important in determining the
extent and pattern of FDI.
Chapter 3: Foreign Direct Investment Theory and Application
The Eclectic Paradigm
• Distinguishes between:
– Structural market failure – external
condition that gives rise to monopoly
advantages as a result of entry barriers
– Transactional market failure – failure of
intermediate product markets to transact
goods and services at a lower cost than
internationalization
Chapter 3: Foreign Direct Investment Theory and Application
The Dynamic Capability Perspective
• A firm’s ability to diffuse, deploy, utilize and rebuild
firm-specific resources for a competitive advantage.
• Ownership specific resources or knowledge are
necessary but not sufficient for international
investment or production success.
• It is necessary to effectively use and build dynamic
capabilities for quantity and/or quality based
deployment that is transferable to the multinational
environment.
• Firms develop centers of excellence to concentrate
core competencies to the host environment.
Chapter 3: Foreign Direct Investment Theory and Application
The Evolutionary Perspective
• International investment is an ongoing,
evolutionary process shaped by an MNE’s:
–
–
–
–
International experience
Organizational capabilities
Strategic objectives
Environmental dynamics
• Also known as the Uppsala model.
• Distinguishes two kinds of knowledge:
– Objective – can be taught
– Experiential – can be acquired through personal
experience
Chapter 3: Foreign Direct Investment Theory and Application
The Evolutionary Perspective
• Firms progressively engage in a target
market:
– Export takes place via independent
representatives
– Sales subsidiaries are set up, specializing in
marketing and promotion
– Manufacturing facilities are established
– Insideration – MNEs shift major functions to local
subsidiaries
– Complete globalization – MNEs coordinate
common functions; foreign subsidiaries share
common purposes and corporate mission
Chapter 3: Foreign Direct Investment Theory and Application
The Evolutionary Perspective
• Another pattern is that firms entering
new markets involve greater psychic
distance:
– Differences in language, culture, political
systems that disturb the flow of information
between firm and market
• Familiarity theory – firms would rather
invest in host countries that are
relatively close to it culturally
Chapter 3: Foreign Direct Investment Theory and Application
The Integration-Responsiveness
Perspective
• FDI is a complex process requiring
coordinating subsidiary activities across
national boundaries.
• Global integration – the coordination
of activities across countries to build
efficient operations networks
• Local responsiveness – response to
specific host country needs.
Chapter 3: Foreign Direct Investment Theory and Application
The Integration-Responsiveness
Perspective
• Advantages of Strategic Flexibility:
– Production movement
– Tax avoidance
– Financial arbitrage
– Information transfer
– Competitive power
Chapter 3: Foreign Direct Investment Theory and Application
Patterns of FDI
• FDI continues to register dramatic
growth:
– 1980 – global FDI stock was 10% of global
GDP
– 1999 – global FDI stock was 31% of global
GDP
• Composition of FDI continues to
change:
– Increase in financial services, tourism,
retail operations, healthcare
Chapter 3: Foreign Direct Investment Theory and Application
Patterns of FDI
Exhibit 3-2: Growth of sales and gross product associated
with international production, GDP and exports, 1982 -1999
Chapter 3: Foreign Direct Investment Theory and Application
Patterns of FDI
Exhibit 3-3: Selected indicators of FDI and
international production, 1982-2000
Chapter 3: Foreign Direct Investment Theory and Application
FDI Outflows
• Developing countries account for most
of the FDI outflow.
• Developed countries are more likely to:
– Possess ownership or monopolistic
advantages
– Be innovators
– Extract advantages from internalization
– Have the dynamic capabilities for
successful ventures abroad
Chapter 3: Foreign Direct Investment Theory and Application
FDI Outflows
Exhibit 3-4: Outward FDI Stock, 1985
Chapter 3: Foreign Direct Investment Theory and Application
FDI Outflows
Exhibit 3-4: Outward FDI Stock, 2000
Chapter 3: Foreign Direct Investment Theory and Application
FDI Outflows
Exhibit 3-5: Developed
countries: FDI outflows,
1999 and 2000
• Note that the U.S.
places third behind
the UK and France
• U.S. remains first in
terms of FDI outward
stock
Chapter 3: Foreign Direct Investment Theory and Application
FDI Inflows
• Significant growth in overall FDI Inflows
• In the 1998 – 2000 period:
– 59% of incoming stock went to developed
economies
– 75% of inflow went to developed countries
• Significant increases in:
– Latin America
– South, East, and Southeast Asia
Chapter 3: Foreign Direct Investment Theory and Application
FDI Inflows
Exhibit 3-6: Inward FDI Stock, 1985
Chapter 3: Foreign Direct Investment Theory and Application
FDI Inflows
Exhibit 3-6: Inward FDI Stock, 2000
Chapter 3: Foreign Direct Investment Theory and Application
FDI Inflows
Exhibit 3-7: Share of developing countries in world
FDI, 1980-2000
Note that the curves for inflows and outflows track each
other.
Chapter 3: Foreign Direct Investment Theory and Application
Inflows into Developing Countries
• What explains the declining share of FDI
inflows in developing economies:
– Growing share of services in developed
economies makes them ripe for investment
services.
– Decline in value of labor and commodities in
overall product prices erodes competitive
advantage.
– Developed countries offer:
•
•
•
•
A stable environment
Low corruption
A large market
A skilled workforce
Chapter 3: Foreign Direct Investment Theory and Application
Inflows into Developing Countries
Exhibit 3-9: Share of the largest recipients of FDI flows
among developing economies, 1985-2000
Chapter 3: Foreign Direct Investment Theory and Application
FDI via Mergers and Acquisitions
• Proportion of M&As growing at the
expense of greenfield investments.
– From 52% in 1987 to 83% in 1999
• Brings new technologies and better
management that allow the acquired
firm to survive.
• Most M&As originate in and target
developed country firms.
Chapter 3: Foreign Direct Investment Theory and Application
Intra-Regional Patterns
• In most host countries, the distribution of FDI
is uneven
– Four states in the U.S. had only ¼ of
manufacturing employment of Japanese affiliates
– These same four states had 2/3 of their R&D
facilities
• Regional distribution of FDI is often correlated
with the investor country of origin
– May be predicted by the theory of familiarity
Chapter 3: Foreign Direct Investment Theory and Application
Intra-Regional Patterns
Exhibit 3-11:
Distribution of
production of
foreign
affiliates in the
U.S., by state
(1992)
Chapter 3: Foreign Direct Investment Theory and Application
The Investment Environment
• Liberalization of markets and openness to
FDI on the increase.
• In 1991-2000, 1,185 regulatory changes
– 1,121 favored investors
• In 1999, 150 regulatory changes in 69 nations
– 147 positive to FDI
• Many countries offer incentives, such as:
–
–
–
–
–
–
Tax holidays
Tariff concessions
Direct and indirect financial subsidies
Training support
Infrastructure improvement
Capital repatriation rights
Chapter 3: Foreign Direct Investment Theory and Application
FDI Decision Criteria
• Natural and creative endowments vary
by region and industry, and tend to shift
over time.
• U.S. manufacturers are more likely to
choose a high- rather than a low-wage
country for investment.
• National boundaries not always a good
indication of key criteria for location
decision.
Chapter 3: Foreign Direct Investment Theory and Application
Foreign Investment Location Criteria
• Essential Criteria
–
–
–
–
Access to skilled and educated workforce
Proximity to world class research institutions
Quality of life
Access to venture capital
• Important Criteria
–
–
–
–
Reasonable costs of doing business
Established technology presence
Available bandwidth and adequate infrastructure
Favorable business climate and regulatory environment
• Desirable Criteria
– Presence of suppliers and partners
– Availability of community incentives
Chapter 3: Foreign Direct Investment Theory and Application
The Lost Continent: FDI in Africa
• Africa draws only 1.2 percent of the
share of global FDI.
• UNCTAD report observes:
– FDI in Africa has been on the increase
– Per-capita income in Africa has been on
the increase
– Significant variations from country to
country
– New investors merging (Canada, Italy, the
Netherlands, Norway, and others)
Chapter 3: Foreign Direct Investment Theory and Application
The Lost Continent: FDI in Africa
• UNCTAD report observes:
– Inward FDI originating in other African
countries is taking place
– FDI in Africa has expanded from mining
and energy into manufacturing and
services
– FDI in Africa has proven profitable; more
profitable than in other developing
economies
Chapter 3: Foreign Direct Investment Theory and Application