Advantages and Disadvantages of Foreign Direct Investment for Germany - Essay Example

ADVANTAGES AND DISADVANTAGES OF FOREIGN DIRECT INVESTMENT (FDI) FOR GERMANY Lecturer: Contents Introduction 3 Background and Problem Statement 3 Aim and Objectives 4 Outline 4 Literature Review 6 Factors that influence the need for outward direct investment 6 Types of Outward Direct Investment and its associated advantages and disadvantages 8 Green field investment 8 Merger and acquisition 9 Expansion of an existing foreign facility 10 Findings and Discussion 12 Pattern of Outward FDI flow for Germany by partner country 12 Pattern of Outward FDI for Germany by industry 15 Conclusion 17 References 19 List of Figures Figure 1: Germanys FDI outward flow by partner country 13 Figure 2: Outward FDI flow for Germany by industry 15 Introduction Background and Problem Statement Globalization has several impacts on businesses and investors, including the ease with which businesses and investors can move from their own countries into other countries to do business. Such ease that has come with the movement of businesses and investors across borders have come about as nations of the world have come to appreciate the need of making the world a global village where trade and economic engagements can take place in a more liberal manner (Aliber, 2010). An outstanding phenomenon that this situation has brought about is the increase in the number of foreign direct investments (FDI) that have taken place across the globe in the past two decades (Freeman and Kagarlitsky, 2014). For example the Organization for Economic Co-operation and Development OECD (2014) noted that global FDI flows increased by 4.5% in 2013. According to Radice (2012), even though the value does not represent a very highly anticipated growth, it still gives an indication that FDIs have been growing. IMF (2013) observed that even though FDIs are largely initiated by businesses and investors, the countries involved in these FDIs, whether they are home countries or host countries have ways in which the international investments through FDIs affect them. To get a better understanding of how FDI affects a country however, Frankel (2012) advised on the need to separate outward direct investment from inward investment. A preliminary search through literature has revealed that most researchers have focused their attention about FDI on how individual companies and investors benefit or loss out from FDI (Alguacil, 2002 and Imani, 2003). This leaves very little room for discussion about how countries as entities and stakeholders in international investments are impacted by FDIs. For the few available researches that put countries on the focus, they tend to concentrate on what the countries earn by way of acting as host countries to foreign companies that invest in those countries (Meier and Stiglitz, 2012). This makes knowledge very limited on how countries are impacted by FDI when these international investments take place with the countries acting as home countries. That is, when companies or investors from one country go to other countries to invest, there are both advantages and disadvantages to their countries of origin that needs to be researched into. As Germany is considered an important global player in the FDI engagements, it is important that research is performed on not just how Germany is benefits from the international investments that country hosts. Rather, it is important that the discussion is further expanded to capture the impacts Germany gets as companies and investors from that country move from Germany to be engaged in either outward direct investment or inward investment in other countries. Aim and Objectives To address the background given and the problem identified, this presented was prepared with the aim of finding the advantages and disadvantages of FDI to Germany as a home country. This aim will be pursued with the following specific objectives in mind. 1. What factors influence the need for FDI by German businesses and investors? 2. What types of FDI are used by German businesses and investors? 3. What advantages does Germany get as a home country to FDI of its businesses and investors? 4. What disadvantages does Germany deal with as a home country to FDI of its businesses and investors? Outline The presentation is divided into four major sections. The first section is the introduction, which gives a generalized background to the study. The introduction also identifies the research problem and lists the aim and objectives that will be pursued in the study. It is also under the introduction that the outline of the paper is given. The introduction is followed by two major forms of data collection, where the researcher makes use of secondary data and primary data respectively. The use of secondary data forms the basis of the literature where existing works of research are analyzed and related to the specific objectives that are set. The focus for literature review is placed on academic articles and textbooks that address FDI as a conceptual model rather than the practical application of the model. In the analysis and discussion section, primary data on FDI outward flows for Germany are taken from credible agencies and sources that have empirical data on these issues. Some of the sources include the World Bank, International Monetary Fund, Deutsche Bundesbank, European Central Bank, and Yahoo Finance. The last section of the presentation is conclusion, where the researcher finalizes the paper by taking a stand on the overall impact of FDI to Germany as a home country. Literature Review The literature review is performed as a secondary data collection exercise which seeks to examine what others have already written about the subject of FDI and how these relate to the objectives of this study. This means that the literature review focuses specifically on the theory of outward direct investment. This theory is however reviewed in its generalised term without necessarily focusing on German background and history even though reference is made to Germany in some cases. The review is performed from two major perspectives. The first is with the factors that influence the need for outward direct investment by German businesses. The second looks at the different types of outward direct investment and the advantages and disadvantages associated with these. Factors that influence the need for outward direct investment Basing on the PEST analysis, which serves as a theory of finding how competitive countries are in promoting businesses, Rao (2012) stressed that factors that influence the need for outward direct investment from a country can be informed by political, economic, social, and technological factors. From this understanding, Iversen (2006) posited that the major reason investors have preferred to do business outside their home countries is because their home countries score or have more weaknesses and threats with their PEST analysis. Rafiei (2013) however disagreed with this position, stressing that prudent local market development can actually lead to a situation where local investors find their markets as choked and thus seek new markets outside. Using the German market as an example, International Marketing Data and Statistics Euromonitor Publications (2007) emphasised that there are several industries that faced higher intensity of competitive rivalry because of the extent to which the overall market has been choked with products or services from these industries. Typical examples of these are the automobile and computer hardware industries. Because most Germans own automobiles and computers, finding new sustainable market segment remains problematic for industry players. In situations like this, companies in these industries are forced to go foreign when they can be guaranteed of existing markets. Also adding to the impact of a well managed local market on the need for outward direct investment, Meier and Stiglitz (2013) indicated that in Germany, most home grown businesses have grown bigger than the local market can act as its sole consumers. This means that the industries supply far more than the local market demands. Meanwhile, such situations do not mean the companies have to cut down on production if they are concerned about global competition (Prasad et al., 2007). In a situation like that, these companies look for new markets where there will be adequate demand for their supply. As noted by Mathieson, Donald and Rojas-Suarez (2013), the purchasing behaviour of consumers for these products with higher supply is often shifted to cost leadership strategies where they expect products to be sold at cheaper prices. This means that the changes in purchasing behaviour of consumers can also be a factor influencing investors to seek new markets outside their home countries. This position has been supported by Foley (2006) who emphasised that based on the strategic positioning of a company, that company may find its local market as not having the sought of market or buyers it requires to sell its products or services. In a situation like this, the country of origin may not be blamed for not doing much to protect its investors. Types of Outward Direct Investment and its associated advantages and disadvantages Green field investment Green field investment has been noted to be one of the most preferred types of FDI used by multinational companies and new local companies seeking to invest internationally. In this form of international investment, new factories, stores or production plants are started from scratch in new markets (Eichengreen, 2014). Ironmonger et al. (2008) noted that his form of FDI is very common within developing markets due to the availability of foreign business growth incentives that the governments put in place to attract foreign companies (Andersson, 2002). For home countries such as Germany, there are ways in which they benefit or get advantage from green field investments involving their local businesses or investors. First, Poniachek (2006) emphasised that investors often invest their earnings and profits back to their home countries. In most cases, the businesses have their head offices in the home countries, where they direct all their banking and financial transactions. As a result, the home country gets the advantage of earning foreign exchange. Meanwhile, the flow of foreign exchange into a country’s economy is very important in making the local currency robust against depreciation. The acquisition of foreign exchange is therefore a major advantage that countries such as Germany get as home country of FDI. Also writing on the advantages with green field for home countries, Sundrum (2011) noted that green field investment helps in offsetting the volatility created by hot money. Such hot money has been explained to be the outcome of short term investments into the economy when there is so much money in the hands of businesses (Fontaine, 2012). Such investments are normally directed at short term lending and currency trading, causing the economy to suffer from asset bubble (Azizy, 2004). Green field investment ensures that this phenomenon is avoided because it is a long term investment that brings into the economy of the home country, long term and robust yields. Having noted all these, Sugden and Wilson (2005) held a different view, stating that the disadvantages with green field investment are more serious for home countries. Specifically, it was argued that even though foreign exchange may be earned, this happened in a long term basis and that at the set up stage, the companies require much forex exchange to start the new foreign businesses from scratch. This form of forex demand has been noted to have pressure on the local currency, which in the case of Germany would be the Euro. Merger and acquisition One other common type of FDI that has been used is merger and acquisition. This is a situation where a company buys or merges with another foreign company (Caves, 2011). Unlike green field investment, merger and acquisition, particularly merger has been noted to come with much correspondence between the home country and the host country (Meier, 2005). This means that when German companies merge with foreign companies, the corporate culture and business philosophies of Germany will be promoted in the foreign country. Meen (2012) likened this to a situation the home country gains a comparative advantage due to the presence of the merger and acquisition. It would be noted that theorists of comparative advantage argue that when a country cannot seem to buy what it needs at lower prices within its own territory, it would fall on another country for these by exchanging resources that helps them maintain an advantage (Yaqoti, 2013). By implication, merger and acquisition will result in a long term advantage for the home country because it will be gaining resources from the host countries which will be needed for the economic development of the home country. Tallman (2008) also looked at the issue of comparative advantage that merger and acquisition creates from a perspective of global branding and competitiveness for countries. There are theorists of comparative advantage who argue that when countries have comparative advantage, it develops into a competitive advantage, through which home countries earn global brands for their local industries (Cantwell, 2009). For example as companies from Germany go into other countries through merger and acquisition and performs well, it is the collective brand of Germany that is promoted at the foreign country. Such promoted country brand helps in attracting reciprocal investors who may also want to be hosted by Germany for their business. There are however some disadvantages with acquisition and merger for the home country. Suzuki (2009) stressed on the problem of revenue loss through taxations which are paid to foreign nations. Taxes happen to be a very important source of government revenue (Wright, 2013). This means that where companies decide to do business outside their home countries through merger and acquisition, most amounts of monies that could be generated from the companies go to the foreign companies instead of the home countries (Casson, 2005). Expansion of an existing foreign facility In some other cases, companies may have subsidiaries or foreign facilities that are not operating autonomously. One form of FDI is for the owners of the foreign facilities to decide to expand those facilities to make them independent, autonomous and operational as separate companies (Mehregan, 2004). Cable and Henderson, (2004) mentioned that in most cases, this form of expansion of an existing foreign facility require that skilled labour from the home country who can work in a way and within a culture that maintains the business model of the home company be used (Yean, 2008). To fill such vacuum, the most preferred decision by most companies has been to export local labour from the home country into the host country. As this is done, the home country becomes relieved of its employment responsibility (Szporluk, 2013). In effect, expansion of existing foreign facility helps home countries to solve part of their unemployment problems. But as companies try to expand their foreign facility, Buckley et al. (2012) saw a trend where most host countries fall to support them financially. In such situations, they fall back on the banks of their home countries for capital support. By so doing, they create an undue competition for local and indigenous companies for the search of credit. Situations like this have been said to have the potential of creating credit risk for local banks. Findings and Discussion This section of the paper uses the most up-to-date empirical data on German’s FDI to focus very directly on the advantages and disadvantages of FDI to that country. This is done by looking at two major components of FDI which are directly linked with the theory of outward direct investment as discussed in literature review. The components of the outward direct investment are FDI by partner country and those by industry. Under each of these two, the trends of FDI are related to literature to know how the trend comes as an advantage or disadvantage to Germany. Pattern of Outward FDI flow for Germany by partner country There are major partner countries under the Organisation for Economic Co-operation and Development (OECD) that outward FDI from Germany are focused on. In the chart below, data gathered from the OECD looks at the trend of outward FDI from Germany to those countries in the last past years. Four countries are selected together with the overall values for OECD member countries. The selection of the four countries namely France, Japan, UK, and US are based on specific rationale. France is selected as a member of EU. Japan is selected as an Asian partner, UK is selected for the strength of its currency, whiles US is selected as the world’s largest economy in terms of FDI recipient and GDP (Germany Trade and Investment, 2014). Figure 1: Germanys FDI outward flow by partner country Source: OCED (2014) Figure 1 shows major patterns in how German businesses and investors direct their FDI. First, it is seen that the most dominant sources of outward FDI flow is the UK. Japan comes as the least source of outward FDI flow, with the US being the second highest source. In line with the literature review, there are two clear advantages of FDI outward flow that can be noted for Germany. First, the fact that the country’s FDI outward flow comes mainly from the UK and US means that the company is well braced for foreign exchange returns which can be helpful for stabilising the Euro and the country’s economy as a whole (Index Mundi, 2014). This is because of the market strength of the British pound and the US dollar. Secondly, the attention given to US market comes with the advantage of taking the global brand of Germany right into the heart of world economy. This is because as the world’s largest trade destination, it is important that Germany has a good representation in the US business environment to consolidate the global comparative advantage of Germany as a country (Trading Economics, 2014). On the other hand, the same trend of partner country outward flow shows a disadvantage with the extent to which little business is done with France. As a member of the EU, trading in same currency will help Germany avoid currency volatility when it focuses on EU countries (Germany Trade and Investment, 2014). For now, the direction of FDI which is outside Germany threatens the credit situation of German banks when money has to be taken outside of the EU. The figure also shows that there is no specific trend in the outward flow of FDI. This is because in the last 5 years, there is no country that shows any sign of constant trend of flow of outward FDI. In some cases as seen with France, Japan and UK, deficits are actually recorded. This is a situation that can be said to come with major disadvantage for Germany as far as global economic competitiveness is concerned. As stressed by The World Factbook (2013), FDI outward flows contributes significantly to the gross domestic product (GDP) of Germany. With this known, it is only fair that Germany will continue to experience higher growth of its outward FDI flow as a way of amalgamating the sustained growth of the country’s GDP. As it is now, Germany cannot confidently point to specific budgetary or forecasted revenues from its outward FDI flow because of the trend identified (International Monetary Fund, 2014). In terms of the deficits in FDI outward flows, this is an indication that in some cases, Germany makes losses rather than gains in its outward FDI. This is another important disadvantage associated with overly emphasising on outward FDI flow. As posited by Rogers, Sedghi & Burn-Murdoch (2013), the only guarantee under which Germany can be assured of making gains from FDI as home country is when the country’s foreign companies succeed and return home with profits. Meanwhile, such success can hardly be controlled by the home country. Pattern of Outward FDI for Germany by industry In the literature review, it was noted that the structure of particular industries can influence outward flow of FDI. This means that the compact a particular industry is in Germany, they more likely it is that players in those industries will look outside for direct investment. Also, industries with fewer raw materials or resources to implement in a given country can also find new international markets to ply their trade. In the light of this, four major industries are focused on with an analysis of the outward FDI flow they earn Germany. The results are discussed to establish how their trend constitute advantage and disadvantage for Germany. Figure 2: Outward FDI flow for Germany by industry From the figure above, a number of trends and implications can be drawn. First, it is seen that the service sector far outweighs all the other sectors in terms of how much comes to the country as outward FDI flow. Writing on this, Library of Congress (2008) noted this to be a major advantage for the country, since Germany can be said to have a service sector that has paid its dues to the country’s economy for years. As the major contributor to GDP, it is only fair that instead of keeping human resource and other forms of resources in the service sector underutilised, these will be made to go into outward FDI where they can get the country the needed foreign exchange and international human capital exposure. A second trend that is seen from the graph is that the manufacturing sector continues to record deficits for Germany in most of the years in the past five years. This is certainly a worrying situation, which reflects the disadvantage discussed about the impact of credit outflow associated with outward FDI (Hans-Werner, 2011). Most German companies in the manufacturing sector have used the green field investment type of outward FDI. Meanwhile, in this type, there is much capital injection, most of which are funded by German banks (Mittwoch, 2014). As a result, even if profits will be recorded, these come in as long term returns after the credit vacuum has already been created for the local industries. Lastly, the graph also shows a very minimal level of outward FDI flow for the agriculture and mining sectors. Regardless of how little the flow is from these two sectors, German Travel (2014) sees that to represent a gain for German given the fact that these two sectors have unfavourable markets in Germany. In relations to the literature review, it can be said that it is an advantage that those two industries which would otherwise have been dormant industries in Germany are being utilised elsewhere in the world and are fetching the country positive outward FDI flows instead of deficit. Conclusion This presentation has been very helpful in exposing the advantages and disadvantages that Germany face as hoe country to FDI when its businesses and investors engage in international investment. On the whole, it has been realized that there are a number of factors that would cause German businesses and investors to look beyond the German borders for investment. Largely, the need for outward FDI becomes necessitated when specific lines of products and services are seen by investors to be choked on the market, making local penetration or expansion very difficult. In situations like this, investors look outside their means to find international markets that may be considered virgin markets for the products or services that the company is engaged in. Another factor that has been noted to influence FDI is when there is the need to expand a business beyond the scope of the German market. Based on these factors, it can be concluded that as long as Germany as a country makes its local economy attractive for local investors, the means for local businesses to expand will arise and when the German market seems choked, the best option for the businesses will be to look beyond the German borders. As far as the advantages and disadvantages are concerned, it has been noted from the presentation that there are different forms of merits and demerits that German harbours as a home nation in FDI. However, these advantages and disadvantages are influenced by the type of FDI that businesses engage in when they invest internationally. As far as advantages are concerned, green field investment is concerned, it ensures that there is an offsetting of the volatility created by hot money. This is because investors are motivated to engage in FDI when there is no market opportunity instead of engaging in short term lending and currency trading which creates asset bubble. When it comes to merger and acquisition, FDI comes with the advantage of expanding the comparative advantage and international brand of Germany. Expanding an existing foreign facility has also been coupled with exportation of German skilled labour, which eases employment burden on German government. There are also disadvantages with FDI when it comes to green field investment. Starting new businesses outside of Germany have often required the investors to have more foreign currency, which leads to the exchange of the Euro for these foreign currencies when the investment is outside the EU. This is a situation that has the potential of creating currency risk for Germany, leading to depreciation. Germany also loses out on huge government revenue which could have come to the country as direct tax when there is acquisition and merger outside of the country. When there is expansion of existing foreign facility, Germany loses out on with capital support to the parent companies. 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