Analysis of German FDI in China within the OLI Framework - Case Study Example

Analysis of German FDI in China within the OLI Framework Introduction This report presents an analysis of foreign direct investment (FDI) in China by German companies, primarily using the examples of the two largest German investors in China, auto manufacturer Volkswagen AG and the engineering group Siemens AG. While there are a large number of German companies with investments in China, Volkswagen and Siemens are good examples because they represent two different kinds of firms; Volkswagen is in a specific industry (automobiles), while Siemens is a diversified firm with business interests in many sectors. An examination of the auto industry is also useful because it represents the largest amount of German investment in China (Frey, 2005). German investment in China is largely driven by the OLI framework (Ownership, Location, Internalisation), to maximise the advantages presented by the Chinese environment. In this report, the basic concepts of the OLI framework are first briefly summarised, followed by an analysis of the different ways German companies enter and maintain a presence in China in the context of the OLI framework. Basics of the OLI Framework The OLI framework, also known as the ‘eclectic paradigm’, states that three independent variables determine the investment choices of multinational enterprises: Ownership (O), which is the competitive advantage the firm has in comparison to other firms, including those in prospective investment locations; Location (L), which describes the attributes of possible investment destinations in terms of available resources (human and material), favourable regulatory environments, physical distance to market, and other things; and Internalisation (I), which is a comparison of whether it is more advantageous for the firm to retain control over the investment, or put a different way, ‘internalise transaction costs’ (Stevanović, 2008, 243), or whether it is better to simply export its products, or license their manufacture to a foreign company (Hill, Hwang & Kim, 1990; Dunning, 2000, 163-164; Griffith & Pustay, 2005; Stevanović, 2008, 241-243). Ownership advantage means that the firm controls or ‘owns’ one or more unique – meaning, not readily available to competitors, and cannot easily be copied or substituted – assets that give it a competitive advantage. Examples of these kinds of assets could be a well-known brand name, which is the intangible asset of reputation, or exclusive access to some kind of technology such as patented designs and formulas, or special production processes. One way or another, the ownership advantage leads to higher profits; the firm can either use its advantages to produce at lower costs, or if the assets are more intangible, charge higher prices than its competitors without reducing its market share (Hill, et al., 1990; Griffith & Pustay, 2005). The location advantage is assessed by comparing the potential profit to be gained by producing in the firm’s home country versus producing in a foreign location, after all the potential costs are considered. Dunning (2000) describes location as an important sub-paradigm of the OLI framework, and it has three basic parts: Resources, labour inputs, and transportation costs. Natural resources may be needed for production, and the cost of locating production near where the resources are produced may be lower than transporting the resources. Labour inputs are more important for labour-intensive industries; if labour costs are lower in a foreign location, there may be a cost advantage to having production done there and shipping finished products (such as what many clothing brands do). Transportation costs refer not just to the costs of shipping finished products or materials, but also to things like taxes and tariffs; government burdens may be less if production is done in the foreign location. And of course, if the foreign location also represents a large consumer market, as China does, the cost of transporting products to that market is greatly reduced if they are produced locally (Dicken, 2003; Wang, 2003). Finally, Internalisation is the degree to which control over the unique assets of the firm are exercised. The level of control can be found along a spectrum ranging from very low control (for example, licensing production of the firm’s products to a local company) to full control (for example, building and fully owning a factory in a foreign location). In practise, internalisation most often occurs somewhere in between these two extremes, such as various kinds of partnerships with local firms or other joint ventures, due to limitations on foreign ownership in other countries, tax advantages, or capital investment requirements like building a factory (Dicken, 2003). Characteristics of the Chinese Environment and Advantages for FDI In general, the advantages of investing in China in terms of the OLI framework are mostly related to location, because it has a large amount of material and human resources, a large consumer market, and low labour costs. China began the process of opening up its economy beginning in about 1979, when it began to shift away from strictly Communist principles of control of its economy (Tang, 2009). The objective of Chinese economic planners is to encourage foreign investment in a controlled way to support and expand its own industries, focusing on cooperative relationships and technology transfer rather than simply providing a base for Western firms to expand (Yang, 1994). China is one of the biggest economies in the world, and in 2010 passed Japan to become the world’s second-largest economy in terms of gross national product, trailing only the United States (International Monetary Fund, 2012). The economy, which has grown at close to 10% for several years, has experienced some ‘growing pains’ like extremely rapid urbanisation (a shift in population from rural areas to cities) and income inequality, which tends to reduce growth of the consumer market. Because China’s population is so large, however, the consumer market relative to that available in Germany or even in Europe as a whole is still growing faster than firms’ ability to saturate it, in most sectors; therefore, China’s economy and market potential is still predicted to grow at a very positive pace for many years to come (World Bank, 2013). Investors in China also have to consider the country’s social and cultural characteristics. Even though economic and market control is continually shifting towards more integration with the rest of the world, Chinese culture is still strongly nationalist and self-reliant; thus, the Chinese typically approach business relationships in a cautious fashion, seeking advantages for native companies and investors (Fung, Iizaka & Tong, 2004; Griffin & Pustay, 2005). By contrast, the healthy Chinese economy has changed traditional attitudes towards thrift among consumers, who show preferences for foreign brands as a matter of social status, particularly in big-ticket purchases like automobiles, electronics, and appliances (Yang, 1994; Tang, 2009). Brief History of Siemens in China The history of Siemens AG in China dates all the way back to 1872, just 25 years after the company was founded, with an order for telegraph equipment that introduced modern communications to China (Siemens China, 2013). By 1879, Siemens had provided China’s first electric power generator to light the port area of Shanghai, and by 1899, China’s first electric trolley line in Beijing. Siemens established a permanent office in Shanghai in 1904, and in 1910 formed the Siemens China Electrical Engineering Company GmbH, with its headquarters in Berlin and a branch office in Shanghai; in 1914, the company was renamed the Siemens China Company (Mutz, 2011). Between the outbreak of the Sino-Japanese War in 1937 and the re-establishment of diplomatic relations between West Germany and Communist China in 1972 there was very little activity for the company in China. The ‘modern’ history of Siemens proceeded somewhat slowly; it was not until 1982 that the company established a representative office in Beijing, with other offices being opened in Shanghai, Guangzhou, and Dalian in the following three years. In 1985, the Chinese government signed a “Memorandum of Comprehensive Co-operation between the Machinery, the Electric and Electronics Industries of the People's Republic of China and Siemens AG”, making Siemens the first foreign enterprise to benefit from such an agreement. This eventually led to the formation of Siemens Ltd., China, a holding company set up to manage Siemens’ various joint ventures in China, which now number more than 20 in the industry, energy, infrastructure, healthcare systems, home appliances, information technology, and financial management sectors (Siemens China, 2013). Brief History of Volkswagen in China Volkswagen began its investment in China with the first of two joint ventures in 1984, starting with an agreement with the Shanghai Automotive Industrial Corp. (SAIC) to distribute Volkswagen cars in China, which was elevated to a formal joint venture in 1985 and named Shanghai Volkswagen (SVW). The joint venture was originally set for 25 years, and was extended upon approval by SVW’s shareholders in 2002 for an additional 20 years, or until 2030 (IHS Global Insights, 2012). SVW produces Volkswagen and ŠKODA (a Czech Republic-based brand owned by VW) models in its facility in Anting, just northwest of Shanghai (IHS Global Insights, 2012; China AutoWeb2, 2013). The second joint venture was with First Auto Works (FAW), which has manufacturing facilities in the cities of Changchun and Jilin, and began in 1991. This joint venture differed from the first in that it was started with a production license agreement rather than just an arrangement to distribute VW cars built elsewhere. In 1995, Audi AG (part of the VW Group) was added, and the joint venture was formalised amongst the three brands, who planned to build a new manufacturing facility as well as extend full-scale production of VW and Audi cars in the two existing FAW factories (FAW, 2011; China AutoWeb1, 2013). OLI Framework Advantages for Siemens and Volkswagen From Siemens’ long history in China it can be fairly concluded that the primary factor in the OLI framework that works to Siemens’ advantage is ownership. Siemens possesses assets in the form of technologies that were not available to China before Siemens’ entry; Siemens provided a number of “firsts” for China – first telegraph system, first large-scale electrical generating systems, first electric trains, first electrical systems for mines – and that gave it a tremendous competitive advantage over foreign firms wanting to enter China later, and of course over native Chinese firms (Mutz, 2011; Siemens China, 2013). The unique assets also largely determined location in Siemens’ case, at least in the early part of its history in China. The story of the company being exposed to the Chinese market through the order of Siemens’ patented telegraph machines suggests that the location was a coincidence; the choice of China just happened because that was where the order was made. 100 years after its first entry into China, Siemens returned, but the circumstances were almost the same in 1972 as they were in 1872; Siemens still had a competitive edge due to ownership of unique assets that no competitor could offer China at that time. Being an early entrant also helped because at the time, China had not yet begun its liberalisation process, so the investor relationship Siemens was establishing was with the government, through government-owned enterprises; that was also a form of location advantage. Internalisation for Siemens was a result of both the ownership advantage and the location advantage. Because the company had a strong relationship with the government beginning when most enterprises were government-controlled, its joint ventures were with enterprises that were not necessarily competitors. And because China needed what Siemens had to offer, the company was able to maintain control over its assets and investment more easily. Volkswagen had a different experience because compared to Siemens, it had fewer unique tangible assets. There was already a fairly competitive automotive industry in China when VW arrived, so the importance of the “O” – ownership – in OLI was much less important for VW than the location factor. What VW did have in terms of unique assets, however, was its brand, which would offset any cost risks to entry into China because of the premium appeal to brand-conscious consumers (Tang, 2009). Volkswagen also had to consider its Chinese ventures in terms of its much larger internationalisation program, where location is much more important because of cost considerations; VW has expanded based on an overall plan to move production as close as possible to markets, which is how the auto manufacturer moved into countries like Canada, the US, Mexico, and Brazil (Keller, 1993; Pries, 2003). So the availability of resources – in VW’s case, not just raw materials and human resources, but actual manufacturing resources – along with the proximity of those resources to a large consumer market meant that China presented a location advantage. The potential of the market likely outweighed some other costs of FDI, as China is the fastest-growing automobile market in the world: Fig. 1: Auto Sales in China 2000-2010 (Source: Seeking Alpha) In terms of internalisation, the differences between VW’s two major joint ventures illustrate a cautious, step-by-step approach. The SVW joint venture is arranged under a kind of concession agreement; ownership is divided equally between SAIC and the VW Group, with a fixed term on the length of the joint venture, which requires government approval for further extensions (IHS Global Insights, 2012). FAW-VW on the other hand is a straight investment. The VW Group owns a total of 40% of the shares, divided as 20% for Volkswagen AG, 10% for Audi AG, and 10% for the VW Group’s Chinese holding company, Volkswagen Automobile (China) Investment Co., Ltd (FAW, 2011). SAIC and its various subsidiaries own a 60% majority share of the joint venture. In its earlier joint venture with SAIC, VW started first with a distribution agreement, and then when that appeared to be favourable, increased its investment and shared more control over its assets with its joint venture partner; even so, the arrangement has a fixed time limit (which can be renewed), meaning that VW minimises some risk by having a predetermined point at which it can exit the partnership (Hill, et al., 1990). With the second investment in FAW-VW, VW had confidence in continuing its presence in the market under the conditions of less internal control, and so entered into a longer-term, open-ended investment relationship. Challenges Faced by German Investors in China Challenges that might be encountered by German investors in China include economic factors that alter the circumstances of the location by either making costs higher or reducing the attractiveness of the market, and the threat of competition that comes from unique assets being lost. Because China actively pursues technology transfer to build its own industries (Yang, 1994), what was once a proprietary technology of a German firm could very well be duplicated by Chinese firms, who are then able to offer the same products of similar quality at much lower prices (Barton, 2007). Sometimes technology transfer happens through illegal means as well; in 2012, for example, Chinese automaker BAIC was caught producing copies of the Volkswagen Tiguan sport utility vehicle, using stolen designs for some key components like the transmission and drivetrain (China AutoWeb3, 2012). Even under normal circumstances, technology transfer can impact the investor’s market share in China, particularly when there is a slight slowing of the Chinese economy. Siemens encountered this situation in 2011-2013, when a decline in manufacturing in China led to zero sales growth for the Siemens China group; where Chinese industrial customers were buying, they were opting for cheaper alternatives of Chinese-produced versions of equipment Siemens had originally introduced to the country (Reuters, 2013). Because many industries are still state-controlled, declines in government capital investment also has a strong impact on multinational companies’ revenues: Fig.2: Declining Capital Investment in China (Source: Frontier Strategy Group) Conclusion From the experiences of Siemens and Volkswagen and the general characteristics of the Chinese market and business environment, it is obvious the OLI framework is an important guide for German investors in China, under some specific conditions. First, there must be some clear ownership advantage, either a unique product, service, or technology, or a strong brand that will appeal to the Chinese market. 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