Foreign Direct Investment in Market Competition - Essay Example

Introduction The amount of FDI(Foreign Direct Investment)in a country has largely been attributed to the effectiveness of the host s and their legal apparatus and machinery in the attraction and accommodation of these investors..This essay will look at the effectiveness of the conditions in the Host countries which possibly attract FDI growth in relation to western and under developed countries and whether the data from large organisations like the World Bank is to be trusted in making competitive decisions about the FDI. Introduction Foreign direct investment or FDI can be defined as an investment made to obtain long lasting shares or interest in out of country enterprises. There will always be a parent enterprise with some sort of a foreign affiliation the co-operation of whom would be known as a translational corporation (TNC) and the parent enterprise will have a 10% or more share control of its foreign affiliate. The Post World War II the position was that the US was dominating the world share of FDI by three quarters of the entire market share. The US at this point had around three-quarters of the Global FDI (1945 and 1960).However today in the age of globalisation the FDI is no longer a phenomena restricted to OECD countries. FDI growth is very important for the modern global economy with the FDI stocks now constituting over 20 percent of global GDP. Inward FDI happens when there is an investment of foreign capital within a country's own local resources and can be attracted by tax holidays and tax subsidies, low rates of interest, and more investor friendly laws. However ownership restraints or differential performance requirements are likely to discourage FDI. Outward FDI is local investment in foreign resources and is encouraged by a positive role of the host governments in providing insurance and tax breaks for these people who want to trade abroad. Therefore "Foreign Direct Investment" can be both inwards and outwards for the economy. Academics have expressed a lot of scepticism over the fact whether FDI has been meaningful to the contribution to domestic growth .According to Froot (1993), FDI outwards does not actually require neither capital flows nor investment in capacity but is a mere extension of corporate control over international boundaries: Therefore the recent ability of the FDI to benefit or profit an economy has also suffered from criticism is to its negative effects. In the case of Developing Countries a comprehensive study by Bosworth and Collins (1999) investigated evidence concerning the effect of capital inflows and found that multinationals find it cheaper to expand directly in a foreign country rather than through trade " in cases where the advantages associated with cost or product are based on internal, indivisible assets based on knowledge and technology." The assertion whether large inflows of foreign capital present developing countries with a good opportunity in accelerating their economic development or not is a big question mark for economists in the light of the recent developments that have taken place in the Asian markets. With the governments of developing countries actively seeking our FDI's for their countries there is a large disagreement amongst economists and development agencies whether FDI flows are to some extent determined by the effectiveness of host state legal systems .The main players in the risks associated with FDI's are the host states, foreign investors and those engaged in development assistance and theorising(like the World bank.) There has to be an effective use of legal and economic reforms which balance domestic commercial and non-commercial interests. The following diagram shows the rise and fall of FDI in developing country, Vietnam .Notice how the trends are very irregular thus putting the whole benefit of the FDI in doubt.1 The many theories of FDI Foreign investors will need to be shown whether the local taxation and legal system will not unduly restrict their profits and activities .In this regard it is important to examine a few theories which can essentially be divided into Micro (industrial organization) theories Macro (cost of capital) theories. Early economists like Caves(1971) explained FDI in microeconomic terms where the focus was on market imperfections along with the desire of the multinational enterprises to gain monopolistic control. Subsequently it is possible to see an approach which is more focused on firm-specific advantages owing to product superiority or cost advantages, and the benefits of technology (Helpman(1984)). The modern view suggests that FDI happens because Multinationals find it cheaper to expand directly into foreign low cost countries like those in Asia. Other theories have shown that FDI emerges by the positive role of regulatory restrictions, including tariffs, quotas, that either encourage or discourage cross-border acquisitions, Macroeconomic factors like low exchange rate in the host country and therefore cheaper raw materials are another reason given for a profitable FDI. The theory of wealth effect is another way through which a depreciation of the real exchange rate could raise FDI. This has been argued by( Froot 1991 )that the interaction of the relative wealth of foreign firms, with the depreciated exchange rate causes profits.FDI brings with it many advantages like technology and modern capital.(Blomstrom, Kokko and Globerman (2001)). Renowned economist John Dunning has noted that 'it is not possible to formulate a single operationally testable theory that can explain all forms of foreign-owned production'. Instead he speaks of the 'eclectic paradigm', which draws together all the existing knowledge over the likeliness of FDI happening and being successful. Dunning's Model would seem something like this: Firms with Ownership Advantages Over Firms Of Other Nationalities -like Useful Intellectual Property Rights - Are Likely To Engage In International Activity; Firms With Such Ownership Advantages Can Sell Or Lease Out Those Advantageslike Trade Or Licensing -Or They Can Exercise Them Fully Abroad Through Foreign Investment (Internalisation); Firmswith Internalisation Advantages will find those Locations Offering a Comparatively Attractive Investment Environment The theories of FDI often emphasise on the developed/developing country dichotomy and an example would be the "product cycle" model of Vernon who has described how models are created with in developed countries, where production first occurs, and then as the production process is standardized they will shift its production to lower wage developing countries. Vernon emphasises that this shift will occur in most firms but Feenstra (1998) disagrees to the extent that t ignores the fact the majority of foreign investment flows have been between developed countries. Almost 75 % of the worlds stock of direct investment is currently located in developed countries, with only 25% in developing countries. The role of transaction costs It has to be seen that economic systems may become counter-productive if they tend to impose transaction costs like inefficient creation and implementation of laws -for example, if court procedures are subject to delays, or bureaucratic red tape. There has to be certainty in the law and legislation should not be passed in an unpredictable fashion. It has to be recognised that some of the major stakeholders in the country's political and legal decisions are the FDI's .The conditions of law and government in the host country will inevitable affect the choice of a country as an FDI location. More importantly the notion of the FDI involves the decisions of which activities to keep internal to a firm and what to outsource. It can be said that activities only internal to the firm will be included in the FDI,otherwise outsourcing is a good solution for FDI's. For example a firm that invests in a country might want to bring with it the new technology and lead to a transfer of intangible assets from the parent to host country. This can also be reversed when the parent firm will end up benefiting and taking its newly learnt knowledge home. The OLI framework consists of the ownership, location, and internalization in the understanding of FDI.The model suggests a kaleidoscopic framework for making decisions in the acquiring of assets abroad.The model might seem too simplistic keeping in mind the political and economic complexities involved yet it helps immensely in understanding how transaction costs can be avoided or repelled. Feenstra (1998) has pointed out some interesting myths and fallacies which have rooted themselves deep in economic theory and can potential distort an FDI's vision. She argues that depreciation of the dollar has played a significant role in increasing the flow of FDI. "(exchange rates are important because) foreign companies purchasing a U.S. firm will be able to use the knowledge from this firm in their own home market, so that they purchase the firms in dollars but earn a return in their own currencies. It is then certainly the case that the exchange rate will enter into the calculation of whether to purchase a U.S. firm or not (but not in the decision of whether to establish a new firm). I believe this argument is especially important in such industries with high R&D expenditures, and can explain the influx of foreign firms into Silicon Valley."(Feenstra 1998) The diagram below shows the FDI trends in countries operating on a Foreign Currency surplus or Deficit and the resultant effect on the economies. The FDI in Asia The last two decades have seen an increase in the FDI within Asia and FDI rates have peaked in the mid nineties.FDI has had a large role in promoting the growth of the "Asian Tigers" and has played a large role in Asia's more globalised trade structure.Asia, especially East Asia, has been very focal in attracting Disaccording to UN statistics the growth in the FDI destined to Asia has increased ten times in past two decades. During the period of 1985 to 1995 alone FDI inflow increased from 39 percent to 57 percent over the 1985-94 period.The Japanese FDI outflow has been phenomenal with a total of ten percent of an increase during 1985-1994 alone. The electric and electronics FDI industry has been dominated by Japan in the past two decades.2 So why has East Asia become a phenomenal success in this regard This is mainly because of the factors affecting the location of FDI, in terms of , natural resource-securing type, market-securing type, and cost-saving type. The factors determining the location of FDI are different for these three types of FDI and a major determinant of market-securing type FDI is the presence of a large consumer population which is very characteristic of Asian countries. In Asia the cost saving FDI is done by export-oriented foreign firms. The aim is to set up low cost production bases.Interesting because of the low wages and the exchange rate gap much of the FDI in Asia since the mid-1980s has been the cost-saving type particularly prominent in the electric and electronics industry. Feenstra (1998) has discussed the case of the Japanese electronics firms who when faced with losing price competitiveness of their products (due to the drastic yen appreciation in the mid-1980s) so they decided to set up their production bases in low cost locations like Korea and Taiwan, to maintain their price competitiveness. Later on as all the FDI increased the exchange rates of Korea and Taiwan as well they too stopped being FDI favourites in the early nineties. The Japanese firms were now faced with the dilemma of shifting their FDI's back into ASEAN countries to avail the advantages of low cost labour. The same happened to the ASEAN countries eventually and their exchange rates increased as well. Now Japan chose China for its large consumer market and low wages. China's recent measures have no been very pro-FDI either and therefore it seems that China is no longer a low cost favourite of the FDI's. China seems to have lost its low cost attractiveness to foreign firms therefore. FDI: a reflection on the good, the bad and the ugly FDI is not exactly a positive sign for an economy sometimes. For one thing it increases local prices and other costs of production. Take the example of South Asia. The advent of multinational firms means there is a lot of money coming in and people are getting jobs. But the expectations of the labour force rise unnaturally because of the superior exchange rates of the FDI investor and as a result local growth gets painfully stunted. This is not the end of the story however .If you see the example of Japan above, FDI's are unreliable. They opportunistically enter a low cost location, exploit their resources for their own business and take the profits outside the host country. As soon as the exchange rates will rise they will tend to take flight in search of greener pastures so reliance of an economy on FDI should be temporary only. Another associated cost of the FDI is the environmental and cultural concern. Multinationals cause pollution and disorganise the local work force. Because of the forex advantage they are able to pay higher wages and this means that the local industries also have to increase their costs which ultimately results in the local products becoming too expensive and a paralysis within the local industry. However as mentioned before the FDI has numerous advantages for the local industry as well because it provides necessary information to the local developers for adopting new technologies ,and this information would otherwise be too costly to obtain. The domestic market should intensify competition in the local markets thus , encouraging domestic firms to become more efficient and technologically aware. The labour force benefits as well by learning new skills and new techniques of production and this upgrading of human capital ultimately benefits the Host country itself. Conclusion The positive spillovers of the FDI's cannot be denied but the negative externalities cannot be ignored either. Therefore the host country has to be well equipped with a legal and governmental system which is not only FDI friendly but also makes Multinationals accountable for any environmental damage that they do. A sound financial and legal system will always encourage the growth of the positive effects of the FDI and ensure a mutually beneficial relationship for the parent and host country. References 1. Rui Albuquerque, 2000, "The Composition of International Capital Flows: Risk Sharing through Foreign Direct Investment," Bradley Policy Research Center Working Paper No. FR 00-08 (Rochester, New York: University of Rochester). 2. Blomstrom, M., Kokko, A. and Globerman, S. (2001), "The Determinants of Host Country Spillovers from Foreign Direct Investment: A Review and Synthesis of the Literature," in: Pain, N. (ed.) 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