chapter 8 Foreign Direct Investment
LEARNING OBJECTIVES
1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.
2 Explain the different theories of FDI.
3 Understand how political ideology shapes a government’s attitudes toward FDI.
4 Describe the benefits and costs of FDI to home and host countries.
5 Explain the range of policy instruments that governments use to influence FDI.
6 Identify the implications for managers of the theory and government policies associated with FDI.
opening case Foreign Retailers in India
For years now, there has been intense debate in India about the wisdom of relaxing the country’s restrictions on foreign direct investment into its retail sector. The Indian retailing sector is highly fragmented and dominated by small enterprises. Estimates suggest that barely 6 percent of India’s almost $500 billion in retail sales take place in organized retail establishments. The rest takes place in small shops, most of which are unincorporated businesses run by individuals or households. In contrast, organized retail establishments account for more than 20 percent of sales in China, 36 percent of sales in Brazil, and 85 percent of all retail sales in the United States. In total, retail establishments in India employ some 34 million people, accounting for more than 7 percent of the workforce.
Advocates of opening up retailing in India to large foreign enterprises such as Walmart, Carrefour, and Tesco, make a number of arguments. They believe that foreign retailers can be a positive force for improving the efficiency of India’s distribution systems. Companies like Walmart and Tesco are experts in supply chain management. Applied to India, such know-how could take significant costs out of the economy. Logistics costs are around 14 percent of GDP in India, much higher than the 8 percent in the United States. While this is partly due to a poor road system, it is also the case that most distribution is done by small trucking enterprises, often with a single truck, that have few economies of scale or scope. Large foreign retailers tend to establish their own trucking operations and can reap significant gains from tight control of their distribution system.
Foreign retailers will also probably make major investments in distribution infrastructure such as cold storage facilities and warehouses. Currently, there is a chronic lack of cold storage facilities in India. Estimates suggest that about 25 to 30 percent of all fruits and vegetables spoil before they reach the market due to inadequate cold storage. Similarly, there is a lack of warehousing capacity. A lot of wheat, for example, is simply stored under tarpaulins, where it is at risk of rotting. Such problems raise foods costs to consumers and impose significant losses on farmers.
Farmers have emerged as significant advocates of reform. This is not surprising, because they stand to benefit from working with foreign retailers. Similarly, reform-minded politicians argue that foreign retailers will help to keep food processing in check, which benefits all. Ranged against them is a powerful coalition of small shop owners and left-wing politicians, who argue that the entry of large, well-capitalized foreign retailers will result in the significant job losses and force many small retailers out of businesses.
In 1997, it looked as if the reformers had the upper hand when they succeeded in changing the rules to allow foreign enterprises to participate in wholesale trading. Taking advantage of this reform, in 2009 Walmart started to open up wholesale stores in India under the name Best Price. The stores are operated by a joint venture with Bharti, an Indian conglomerate. These stores are only allowed to sell to other businesses, such as hotels, restaurants, and small retailers. By 2011, the venture had 19 stores in India. Customers of these stores note that unlike many local competitors, they always have produce in stock, and they are not constantly changing their prices. Farmers, too, like the joint venture because it has worked closely with farmers to secure consistent supplies and has made investments in warehouses and cold storage. The joint venture also pays farmers better pricessomething it can afford to do because far less produce goes to waste in its system.
For its part, in 2011 the Indian government indicated that it would soon introduce legislation to allow foreign enterprises like Walmart entry into the retail sector. On the basis on this promise, Walmart and Bharti were planning to expand downstream from wholesale into retail establishments, but their plans were put on hold in late 2011 when the Indian government announced that the legislation had been shelved for the time being. Apparently, opposition to such reform had reached such a pitch that implementing it was not worth the political risk. Whether and when this will change remains to be seen.
Sources: V. Bajaj, Wal-Mart Debate Rages in India, The New York Times, December 6, 2011, pp. B1, B2; S.G. Mozumder, Walmart Is Not Coming to India Just to Sell, India Abroad, December 16, 2011, pp. A18A19; and R. Kohli and J. Bhaqwati, Organized Retailing in India: Issues and Outlook, Columbia Program on Indian Economic Policies, working paper no. 2011-1, January 22, 2011.
Introduction
Foreign direct investment (FDI) occurs when a firm invests directly in facilities to produce or market a product in a foreign country. According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, or affiliated group takes an interest of 10 percent or more in a foreign business entity. Once a firm undertakes FDI, it becomes a multinational enterprise. An example of FDI is given in the opening case, which describes Walmart’s recent investments in India. Walmart first became a multinational in the early 1990s when it invested in Mexico.
FDI takes on two main forms. The first is a greenfield investment , which involves the establishment of a new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country. Acquisitions can be a minority (where the foreign firm takes a 10 percent to 49 percent interest in the firm’s voting stock), majority (foreign interest of 50 percent to 99 percent), or full outright stake (foreign interest of 100 percent).1
Greenfield Investment
Establishing a new operation in a foreign country.
This chapter opens by looking at the importance of foreign direct investment in the world economy. Next, it reviews the theories that have been used to explain foreign direct investment. The chapter then moves on to look at government policy toward foreign direct investment and closes with a section on implications for business.
Foreign Direct Investment in the World Economy
LEARNING OBJECTIVE 1
Recognize current trends regarding foreign direct investment (FDI) in the world economy.
When discussing foreign direct investment, it is important to distinguish between the flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI undertaken over a given time period (normally a year). The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. We also talk of outflows of FDI , meaning the flow of FDI out of a country, and inflows of FDI , the flow of FDI into a country.
Flow of FDI
The amount of direct investment into a country in a defined time period undertaken by foreign entities (FDI inflow), or the amount of direct investment into foreign countries made by entities resident in a country in a defined period of time (FDI outflow).
Stock of FDI
The cumulative value of direct investments that have been made by foreign entities in a country at a given point in time.
Outflows of FDI
Flow of foreign direct investment out of a country.
Inflows of FDI
Flow of foreign direct investment into a country.
TRENDS IN FDI
The past 35 years have seen a marked increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from $25 billion in 1975 to $1.5 trillion in 2011 (see Figure 8.1). FDI outflows did contract to around $1.1 trillion in 2009 in the wake of the global financial crisis after hitting a record $2 trillion in 2007, but they have since recovered.2 In general, however, over the past 30 years the flow of FDI has accelerated faster than the growth in world trade and world output. For example, between 1992 and 2010, the total flow of FDI from all countries increased around ninefold while world trade by value grew fourfold and world output by around 55 percent.3 As a result of the strong FDI flows, by 2010 the global stock of FDI was about $20 trillion. Multinationals accounted for one-quarter of global GDP in 2010. The foreign affiliates of multinationals had more than $32 trillion in global sales and accounted for one-tenth of global GDP and one-third of global exports.4
FIGURE 8.1 FDI Outflows, 19822011 ($ billions)
FDI has grown more rapidly than world trade and world output for several reasons. First, despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Second, much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world’s developing nations. The general shift toward democratic political institutions and free market economies that we discussed in Chapter 3 has encouraged FDI. Across much of Asia, eastern Europe, and Latin America, economic growth, economic deregulation, privatization programs that are open to foreign investors, and removal of many restrictions on FDI have made these countries more attractive to foreign multinationals. According to the United Nations, some 90 percent of the 2,700 changes made worldwide between 1992 and 2009 in the laws governing foreign direct investment created a more favorable environment for FDI.5
The globalization of the world economy is also having a positive effect on the volume of FDI. Many firms now see the whole world as their market, and they are undertaking FDI in an attempt to make sure they have a significant presence in many regions of the world. For reasons that we shall explore later in this book, many firms now believe it is important to have production facilities based close to their major customers. This, too, creates pressure for greater FDI.
ANOTHER PERSPECTIVE Zambia experiences large FDI increase for 2011
Inward foreign investment into Zambia increased significantly in 2011, arresting a downward trend that followed the 2008 financial crisis. In 2011 there were record levels of FDI into the country, with 26 investments made and more than $2.3bn [billion] invested. This led to the creation of more than 10,000 jobs. When compared with 2010 data, the number of investments increased by 86 percent, the level of capital investment increased by 74 percent, and the number of jobs created increased by 273 percent. This assertion is attributed to the efforts made by the Zambian government to make the country more attractive to potential investors. Much of this increase in 2011 can be explained by large-scale investments in the metals sector, with eight investments in this sector creating more than 6500 jobs and garnering $1.8bn in investments.
Source: http://www.fdiintelligence.com/Trend-Tracker/Zambia-experiences-large-FDI-increase-for-2011
THE DIRECTION OF FDI
Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the others’ markets (see Figure 8.2). During the 1980s and 1990s, the United States was often the favorite target for FDI inflows. The United States has been an attractive target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI. Investors include firms based in Great Britain, Japan, Germany, Holland, and France. Inward investment into the United States remained high during the 2000s and stood at $210 billion in 2011. The developed nations of the European Union have also been recipients of significant FDI inflows, principally from the United States and other member-states of the EU. In 2011, inward investment into the EU was $414 billion. The United Kingdom and France have historically been the largest recipients of inward FDI.6
FIGURE 8.2 FDI Inflows by Region, 19952010 ($ billions)
Even though developed nations still account for the largest share of FDI inflows, FDI into developing nations has increased markedly (see Figure 8.2). Most recent inflows into developing nations have been targeted at the emerging economies of South, East, and Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient of FDI, which attracted about $60 billion of FDI in 2004 and rose steadily to hit a record $124 billion in 2011.7 The reasons for the strong flow of investment into China are discussed in the accompanying Country Focus. Latin America is the next most important region in the developing world for FDI inflows. In 2011, total inward investments into this region reached $216 billion. Brazil has historically been the top recipient of inward FDI in Latin America. At the other end of the scale, Africa has long received the smallest amount of inward investment; $54 billion in 2011. In recent years, Chinese enterprises have emerged as major investors in Africa, particularly in extraction industries where they seem to be trying to assure future supplies of valuable raw materials. The inability of Africa to attract greater investment is in part a reflection of the political unrest, armed conflict, and frequent changes in economic policy in the region.8
COUNTRY FOCUS Foreign Direct Investment in China
Beginning in late 1978, China’s leadership decided to move the economy away from a centrally planned socialist system to one that was more market driven. The result has been nearly three decades of sustained high economic growth rates of around 10 percent annually compounded. This growth attracted substantial foreign investment. Starting from a tiny base, foreign investment increased to an annual average rate of $2.7 billion between 1985 and 1990 and then surged to $40 billion annually in the late 1990s, making China the second biggest recipient of FDI inflows in the world after the United States. By late 2000, China was attracting between $80 billion and $100 billion of FDI annually, with another $60 billion a year going into Hong Kong. In 2011, a record $124 billion was invested in China and another $78.4 billion in Hong Kong. Over the past 20 years, this inflow has resulted in the establishment of more than 300,000 foreign-funded enterprises in China. The total stock of FDI in mainland China grew from almost nothing in 1978 to $578 billion in 2011 (another $1.1 trillion of FDI stock was in Hong Kong).
The reasons for this investment are fairly obvious. With a population of more than 1.3 billion people, China represents the world’s largest market. Historically, import tariffs made it difficult to serve this market via exports, so FDI was required if a company wanted to tap into the country’s huge potential. China joined the World Trade Organization in 2001. As a result, average tariff rates on imports have fallen from 15.4 percent to about 8 percent today, reducing this motive for investing in China (although at 8 percent, tariffs are still above the average of 3.5 percent found in many developed nations). Notwithstanding tariff rates, many foreign firms believe that doing business in China requires a substantial presence in the country to build guanxi, the crucial relationship networks (see Chapter 4 for details). Furthermore, a combination of relatively inexpensive labor and tax incentives, particularly for enterprises that establish themselves in special economic zones, makes China an attractive base from which to serve Asian or world markets with exports (although rising labor costs in China are now making this less important).
Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China. Blinded by the size and potential of China’s market, many firms have paid less attention than perhaps they should have to the complexities of operating a business in this country until after the investment has been made. China may have a huge population, but despite decades of rapid growth, it is still relatively poor. The lack of purchasing power translates into relatively immature market for many Western consumer goods outside of relatively affluent urban areas such as Shanghai. Other problems include a highly regulated environment, which can make it problematic to conduct business transactions, and shifting tax and regulatory regimes. For example, a few years ago, the Chinese government suddenly scrapped a tax credit scheme that had made it attractive to import capital equipment into China. This immediately made it more expensive to set up operations in the country. Then there are problems with local joint-venture partners that are inexperienced, opportunistic, or simply operate according to different goals. One U.S. manager explained that when he laid off 200 people to reduce costs, his Chinese partner hired them all back the next day. When he inquired why they had been hired back, the executive of the Chinese partner, which was government owned, explained that as an agency of the government, it had an obligation to reduce unemployment.
To continue to attract foreign investment, in late 2000 the Chinese government has committed itself to invest more than $800 billion in infrastructure projects over 10 years. This should improve the nation’s poor highway system. By giving preferential tax breaks to companies that invest in special regions, such as that around Chongqing, the Chinese have created incentives for foreign companies to invest in China’s vast interior where markets are underserved. They have been pursuing a macroeconomic policy that includes an emphasis on maintaining steady economic growth, low inflation, and a stable currencyall of which are attractive to foreign investors. Given these developments, it seems likely that the country will continue to be an important magnet for foreign investors well into the future.
Sources: Interviews by the author while in China; United Nations, World Investment Report, 2009 (New York and Geneva: The United Nations, 2009); Linda Ng and C. Tuan, Building a Favorable Investment Environment: Evidence for the Facilitation of FDI in China, The World Economy, 2002, pp. 1095114; and S. Chan and G. Qingyang, Investment in China Migrates Inland, Far Eastern Economic Review, May 2006, pp. 5257.
THE SOURCE OF FDI
Since World War II, the United States has been the largest source country for FDI, a position it retained during the late 1990s and early 2000s. Other important source countries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countries accounted for 60 percent of all FDI outflows for 19982010 (see Figure 8.3). As might be expected, these countries also predominate in rankings of the world’s largest multinationals.9 These nations dominate primarily because they were the most developed nations with the largest economies during much of the postwar period and therefore home to many of the largest and best capitalized enterprises. Many of these countries also had a long history as trading nations and naturally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enterprises based there have been at the forefront of foreign investment trends.
FIGURE 8.3 Cumulative FDI Outflows, 19982010 ($ billions)
This being said, it is noteworthy that Chinese firms have started to emerge as major foreign investors. In 2005, Chinese firms invested some $15 billion internationally. Since then, the figure has risen every year, hitting $68 billion in 2010. Firms based in Hong Kong accounted for another $76 billion of outward FDI in 2010. Much of the outward investment by Chinese firms has been directed at extractive industries in less developed nations (e.g., China has been a major investor in African countries). A major motive for these investments has been to gain access to raw materials, of which China is one of the world’s largest consumers. There are signs, however, that Chinese firms are starting to turn their attention to more advanced nations. In 2010, Chinese firms invested $5 billion in the United States, up from $146 million in 2003.10
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