Foreign Direct Investment - Essay Example

Foreign Direct Investment When a multinational firm makes a choice to enter a foreign country, there are several factors that play a role in its decision, but monetary considerations play the pivotal role in influencing such decisions. The kind of infrastructure available in the target country, the facility of less expensive production facilities thereby allowing for a greater margin of profits and gains from exchange rates are all important factors. Foreign Direct Investment influences international trade and lowers the cost of intra-firm trade. The increase in volume of trade is beneficial to the economic status of the home country and also aids the multinational firms by lowering costs of trading while enhancing the volume of business. A multinational firm in a developed country may face higher labor costs, scare production resources and higher production costs when locating its subsidiaries in its own home country, while a shift overseas may involve a larger initial investment but is economically beneficial in the long run because the margin of profits are higher, with the development of new markets. 1.1: Introduction: Foreign Direct Investment refers to the investments that a multinational firm makes when it is initially located in one country but decides to locate to or acquire substantial production facilities in another country. FDI is a significant factor in operation of MNCs. As Bernard, Jensen and Schott [2] point out, its importance to the U.S. economy is demonstrated by the fact that about 90% of all exports from and imports into the U.S. flow through a U.S. MNC while roughly 50% of the trade flows in fact occur between subsidiaries or affiliates of the same MNCs.[2]. Foreign Direct Investment in another country could take place through the financing of new investments within the target country or even through mergers and acquisitions of local firms and production facilities, etc by a multinational entity, with the value of mergers increasing from 52% of the FDI in 1987 to 83% in 1999, as per UNCTAD [13]. 1.2: Benefits of Foreign Direct Investment: Foreign Direct Investment can be beneficial to a multinational firm in several ways and Isobe et al [8] have examined the multinational firm in the context of technology transfer. They have examined the impact of early movers in technology within emerging economic regions as far as performance is concerned by studying 220 Japanese multinational companies that have set up their business in China. The findings in this study suggested that a multinational firm gains from technology transfer especially when the degree of commitment of the firm is high. The study also found that timing an entry early affects performance of the firm in a positive manner and that its market performance is enhanced within the emerging economic region, thereby enabling it to accrue financial advantages. Thus, the most significant advantages accruing to multinational firms from foreign direct investment is that of capturing emerging markets, enabling production at lower costs thereby increasing profit margins and ensuring trading at lower costs. One of the theories behind Foreign Direct Investment is that of internationalization, which is centered on the belief that firms try and develop their own internal markets, in order to ensure that transactions can take place within the firm itself at lower costs.[4]. Moreover, the decision of a multinational firm to locate its operations overseas may be an effective business strategy that is impelled by the notion that by investing overseas, the firm may be able to gain some capabilities in the foreign countries which will not be available to their competitors in their own domestic territory and thereby it is able to gain the competitive advantage. Bradley [3] also explores other theories that drive foreign direct investment by a multinational firm, including the international production theory, which postulates that the question of whether and to what extent a multinational firm may decide to initiate production activity within another country and make significant investments, will depend upon the perceived relative advantages between the facilities available on home turf and the implied advantages and resources involved in locating to another country. Morgan and Katsikeas [9] have closely examined all relevant theories in reference to international involvement and expansion and they have concluded that there is a need to take into account possible anomalies before precise conclusions can be drawn as to what motivates multinational firms to shift their operations overseas and enter into substantial foreign direct investment. They have corroborated the fact that foreign direct investment by multinational firms plays an important role in regulating international trade, which is vital to a nation’s economic welfare and development. 2.1: Factors affecting Foreign Direct Investment: In a recent study conducted by Hsiao and Chen [7], data was collected from 23 different developing countries over a period from 1976 to 1997 in order to make an analysis of the factors that had determined Foreign Direct Investment in each of those nations. They have used statistical analysis of data obtained from these countries in order to arrive at their determination. The authors have stated that the choice on whether or not to go for Foreign Direct Investment is dictated by the profit motive. For purposes of their analysis, the authors have selected quantifiable variables that are the result of location and the competitive advantage that may be gained. These variables were: 2.1.1: Growth rate and corporate tax rate: to determine differences in rates of return after investment in different countries. A strong growth rate increases the risk adjusted return to capital and raises net FDI while the tax rate will be reflected in the cost of doing business in a different country. 2.1.2: Openness to capital flows: this is a measure of the degree of restrictiveness in the market and is a proxy for the clarity of the laws of the country and therefore a determinant in the degree of FDI that is likely to be possible. 2.1.3: Index of absence of corruption: which reflects the conditions of law enforcement and the extent of bureaucracy, therefore an absence of corruption index is likely to generate higher Foreign Direct Investment. 2.1.4: The infrastructure of the country: those with better countries are likely to achieve higher levels of investment from foreign sources. This study therefore examined several factors affecting economic growth in a particular country and how it relates to foreign direct investment, including such aspects as infrastructure, human capital, real wage and inventory accumulation which they have analyzed statistically. These authors conclude that economic growth, lower tax rates, good infrastructure, lack of corruption and trustworthiness of the Government and predictability of behavior and conditions in a particular country are conducive to foreign direct investment in that country. Carr et al [5] have examined the dynamics of investment of multinational companies in the developing countries and they have found that the per capita inward investment that is made by a multinational corporation often depends upon the availability of good labor skills, large markets and the presence of good infrastructure. The econometric analysis they conducted showed that it is not the sweatshop theory that motivates multinational corporations to invest in the developing countries rather it is the quality of the infrastructure that is available in those countries. The importance of availability of good infrastructure to encourage Foreign Direct Investment has been corroborated in several studies.[1, 6, 10, 14]. One notable example of a country that has been able to benefit from FDI within its terrain is the case of Ireland.[12]. Microsoft Corporation pays taxes to Ireland and the resultant funds that pour into the Irish treasury are sufficient to contribute up to $77 for each Irish citizen and therefore, function as a great boost to the Irish economy. Although Microsoft Corporation has also considered other countries to set up operations, Ireland was able to successfully emerge as the preferred location on account of the superior quality of the physical and economic infrastructure that is available in this country, which helped it to beat out other competitors such as the Caymen islands where infrastructure development is poor. Therefore location is another significant factor that plays a role in the decision of a multinational corporation to opt for foreign direct investment. In a study conducted among Japanese MNE’s [11] executives were asked to rank the location advantages of India as compared to China and other South east Asian countries and their results showed that India ranked poorly. Their study also supported the importance of infrastructure developed in less developed countries as a significant factor impacting upon inflows of foreign direct investment. However, the importance of a particular location in determining foreign direct investment was conditioned not only by the infrastructure facilities but also by the controls and administrative complexities existing within a particular location. In particular, the willingness of the target location to implement Japanese management techniques also is a factor in encouraging foreign direct investment. 3.1: Conclusions: Globalization is here to stay and the lowering of trade barriers has opened up the facility of a wide world market to be tapped by firms in enhancing their productivity and profitability. Foreign Direct Investment is important to a firm because it helps to contribute to the flow of trade and can also contribute to a cost advantage through intra-firm trade. Moreover, depending upon the level of infrastructure and local facilities available at the target location, it may be more profitable for a firm to directly invest in production at the target location rather than selective investment. Mergers are also becoming increasingly common, as firms in different territories seek to consolidate their operations in order to render themselves finally capable of competing effectively within a global market. Foreign Direct Investment can provide a greater degree of autonomy to a firm over its own operations through an enhanced degree of control over its subsidiaries, as opposed to mergers, where the goals and objectives of both firms have to be coordinated. Moreover, early timing and technology transfers to an economically emerging region are likely to substantially enhance market performance of a multinational firm, both in terms of financial benefits to be derived from the resources available in the target country as well as the tapping of the market before the entry of competitors. Further financial benefits can be accrued as well, such as benefiting from tax breaks in the target countries or gains from different exchange rates. When there is free capital flow within the target country and tax breaks available for FDI by multinationals, this is likely to further aid and enhance FDI. One of the most important factors that impacts upon the multinational corporation’s decision on FDI appears to be the level and nature of infrastructure that is available in the target country. Contrary to popular belief, cheap labor is not always the salient factor that is taken into consideration by multinational firms considering FDI, since a target country with the facility of cheap labor where infrastructure development is poor is unlikely to be looked upon with favor from the investment point of view. The case of Ireland winning out over the Caymen Islands for Microsoft investment demonstrates that it is infrastructure that largely determines FDI. Moreover, Government regulations and the index of corruption in a target country also play a significant role in the decisions made about FDI. When the corruption index is low, there is a degree of stability and honesty in administration which allows for efficient functioning of multinational entities and is likely to be conducive for FDI. Developed countries may be preferred over developing countries for FDI, since economies that have enjoyed economic growth fairly consistently are likely to provide the kind of backup and stability in environment that are essential for FDI. A multinational firm that operates within a foreign country and decides to make substantial investments in production already faces some difficulties, because there will cultural differences to be overcome, irregularities in exchange rate fluctuations that must be borne and potentially restrictive Government regulations, apart from volatile social and economic scenarios. Therefore, FDI is more likely to be considered in a target country where there is political and economic stability, consistent economic growth or an emerging economic market and solid infrastructure to aid and enhance its operations. The locations where multinational firms choose to set up subsidiary operations and the extent of their investments will therefore be conditioned by all of the factors that have been detailed above. Bibliography [1] Belderbos, Rene, Giovanni Capannelli and Kyoji Fukao, 2001, "Backward vertical linkages of foreign manufacturing affiliates: Evidence from Japanese multinationals," World Development 29(1): 189-208. [2] Bernard, A.B., Jensen, A.B. and Schott, P.K., 2005. “Importers, exporters and Multinationals: A portrait of the firms in the U.S. that trade goods.” National Bureau of Economic research Working Paper No:11404. [online] available at: http://papers.nber.org/papers/w11404.pdf [3] Bradley, M.F, 1991. “International Marketing Strategy” Prentice-Hall International, London. [4] Buckley, P.J, 1982. “Multinational enterprises and Economic Analysis.” London: Cambridge University Press [5] Carr, David L, Markusen, James R and Maskus, Keith E, 2002. “Competition for Multinational Investment in developing countries: Human capital, infrastructure and Market size.” Centre for Business and Economic research. [online] available at: http://www.cebr.dk/upload/dp1402.pdf#search=%22Comparison%20multinational%20vs%20domestic%20firms%20IT%20infrastructure%22 [6] Cheng, Leonard K. and Yum K. Kwan, 2000, "What Are the Determinants of the Location of Foreign Direct Investment? The Chinese Experience," Journal of International Economics 51(2): 379-400. [7] Hsiao, Cheng and Shen Yan, 2003. “Foreign Direct Investment and Investment Growth: The importance of institutions and urbanization.” Economic development and cultural change, 51(4): 883 [8] Isobe, Takehiko, Makino, Shige and Montgomery, David, B, 2000. “Resource Commitment, entry timing and market performance of foreign direct investments in emerging economies: The case of Japanese international joint ventures in China.” Academy of Management Journal, 43(3): 468-485. [9] Morgan, Robert E and Katsikeas, Constantine S, 1997. “Theories of international trade, foreign direct investment and firm internationalization: a critique.” Management Decision, 35(1): 68 [10] Root, Franklin and Ahmed, Ahmed, 1979, "Empirical Determinants of Manufacturing Direct Foreign Investment in Developing Countries," Economic Development and Cultural Change 27(4): 751-761. [11] Siddharthan, N.S. and Lakhera, M.L., 2005. “Foreign Direct Investment: Japanese perceptions of India compared to China and ASEAN.” Journal of International and Area Studies, 12(1): 99-111. [12] Simpson, Glenn R, 2005. “Wearing of the Green: Irish subsidiary lets Microsoft slash taxes in U.S. and Europe; Tech and Drug firms move key intellectual property to Low levy island Haven: Center of Windows licensing.” Wall Street Journal, Nov 7, 2005, pp A1. [14] UNCTAD, 2000. “World Investment Report 2000: Cross border mergers and acquisitions and development.” United Nations, New York and Geneva. [15] Wheeler, David and Ashoka Mody, 1992, "International Investment, Location Decisions: The case of U.S. Finns," Journal of International Economics 33: 57-76. Read More