Foreign Direct Investment - Dissertation Example

 Foreign Direct Investment Assignment Question Compare and contrast these explanations for horizontal Foreign Direct Investment (FDI): the market imperfections approach, Vernon’s product lifecycle theory, Knickerbockers’ theory of FDI. Which theory do you think offers the best explanation of the horizontal pattern of FDI? Why? Introduction Foreign direct investment (FDI) flows has seen a steady rise amongst world economies for the past three decades. Between 1990 and 2005, the total worldwide FDI flows increased from $203 billion to $974 billion (Sayek, 2009, pp. 419). Developing countries and transition economies are intensely competing to attract FDI inflows, and requisite regulatory frameworks have been put into place. The motivation for firms to prefer FDI over exports, or licensing, continues to be an area of focused research. Are their theories that explain why firms choose FDI? This essay explores the reasons for growth of FDI, and different venture options available to a firm. The paper differentiates horizontal FDI versus vertical FDI, and goes on to elaborate specific features of three theories viz.: (a) market imperfections approach (b) product lifecycle theory, and (c) oligopolistic reactions. The paper analyses these approaches, and concludes by selecting the theory that best explains the growth of horizontal FDI. Reasons for growth of FDI Succinctly put, foreign direct investment provides a viable route for companies to take advantage of resources that are cheaper and abundant in a foreign country; or perhaps, scarcely or unavailable, in the country of origin. The resources sought by the firms could be physical, skilled labour, or techno-managerial skills (Dunning & Narula, 1996). Firms seek to do business on a foreign soil using its internal organization, techno-management know-how thereby acquiring, training and coordinating resources towards development of processes, technologies and products, and thus meet market demands. Mere location-specific advantages and ownership of assets in a foreign country does not make FDI successful. Firms need to internalise operations to control structural and transaction costs that result from the imperfect nature of product and technology market (Vernon, 1966), as well as, imperfections in financial market (Rugman, 1982). These include tariffs, restrictions on capital flows, taxation regimes and legal framework. Political governance and stability in the host country plays a crucial role in attracting foreign investment (World Bank report, 2001).Corporate governance reflects through political stability and transparency of financial markets, attracting higher FDI flows in less developed countries (OECD, 2001). Types of FDI Ventures Multinational firms seek foreign markets to increase their sales, or be the first movers to capture market share, in which case, they may set up subsidiaries. It is important to reckon that firms pursue strategic objectives through FDI either by acquiring companies, or by merging with other firms to remain competitive, and sustainable over time. Greenfield investments or joint-ventures are other forms of FDI that multinational firms often resort to. Horizontal and Vertical FDI Multinational firms can route their investments through horizontal FDI or vertical FDI. Horizontal FDI refers to investments made in setting up plants or services in a foreign country that have similar lines of business in the home country. Vertical FDI refers to investments made in setting up different production or supply stages of a single plant, in different countries. In backward vertical FDI, the production stage set abroad provides inputs to the domestic plant in home country; whereas, in forward FDI, the production stage abroad uses the output of the domestic plant in home country. The majority of investments are made as horizontal FDI which essentially revolves around the trade-off between plant level fixed costs, and trade costs. Horizontal FDI is seen as a viable option when the transportation costs for a product are high. Specific Features of Theories to Explain Growth of Horizontal FDI Market Imperfections Approach – Internalisation Internalisation theory acknowledges imperfections within the market. These imperfections, as Casson (1983) states, prevent efficient operation of international market and trade investment. The exogenous imperfection variables include government induced regulations and controls. To overcome the exogenous barriers multinational companies attempt to internalize their operations. The primary thrust of internalisation theory is to identify situations, in which there is scope to internalize markets for intermediate products. The firms then can control value-adding services outside their country boundaries. The MNCs can choose to exercise production control to correct market imperfections (Dunning & Rugman, 1985). Hymer (1976) posited that multinational firms came into existence owing to market imperfections. These imperfections can offer advantages of ownership, provide access to distribution channels, promote product differentiation, and yield advantages on proprietary processes. The MNCs would seek to consolidate and internalize their relationships with licensors, and organizes economic activity to further advance its monopoly power. Distinct to structural imperfections are transaction cost economies that in fact underpin internalisation theory and helps in understanding the establishment and development of MNCs (Casson, 1987). Companies compulsively explore business opportunity through internal operations, rather than licensing or franchisees. This in fact provides a clue as to why MNCs undertake horizontal FDI in particular. More than the mere existence of MNCs, internalisation theory explains multi-plant operation over geographic boundaries, and achieving improved economies and efficiencies. These can result from long term contracts, efficient governance mechanism, R&D, foreign exchange controls, and tax differentials. In the context of horizontal FDI, market imperfections arise from two conditions:- When there are impediments to free flow of products between nations which decrease the profitability of exporting relative to FDI and licensing. When there are impediments to the sale of knowhow which increase profitability of FDI relative to licensing. Five types of market imperfections have been identified by Buckley and Casson (1976, pp. 37-38), that calls for internalization:- When coordination of resources over long period is needed When the efficient exploitation of market power requires discriminatory pricing When bilateral monopoly produces unstable bargaining situations When the buyer cannot price correctly the goods on sale (intangible aspects) When government interventions in international markets create incentives for transfer pricing Oligopolistic Reactions Whilst studying the location preferences by MNCs, Knickerbocker (1973), noticed an unusual grouping of FDI in certain countries. This “follow the leader” syndrome is often referred to in literature, as the herd-effect where the rival firms subscribe to an oligopolistic structure. Cowling and Sugden (1987) studied such rivalry between competing firms, and their larger effects on countries and societies. The central theme of oligopolistic reaction, hinges on two factors: (a) cost associated with uncertainty in the foreign market, and (b) aversion to risk (Head, Meyer and Ries 2002). Multinational firms begin to fear under pricing by rivals, who seek to gain a possible advantage by shifting their production, or service facilities in a foreign land. The advantage seems to accrue from cost reduction, and economies of scale. Knickerbocker (1973, pp. 23) observes, “Oligopolistic reaction is driven by the fear that if the foreign investment of one of the firms in the oligopoly is not matched by others, a permanent loss in competitive advantage might occur.” Therefore to thwart any such possibility, firms emulate the rival’s FDI strategy. Several empirical studies have been conducted to find the evidence of oligopolistic reactions in industry. Pisani (2007) analysed the business process off-shoring practices by U.S. firms and confirmed their oligopolistic tendencies. Information-intensive industries in fact, have been found to be more amenable to oligopolistic considerations (Nachum & Zaheer, 2005). These competitive pressures indeed act as prime mover of business off-shoring industries. In particular, high industrial concentration is seen to attract increased FDI as a consequence of oligopolistic reaction. This is evident from the fact that the bulk of FDI movement has been localized in the developed countries, amounting to 75% of world inward FDI stock (UNCTAD Report, 2008). Domestic market saturation gradually occurs in the oligopolistic structure and local competition increases. At such a stage, MNCs find such regions unattractive and look for strategic relocation or position strategic products or services. Pisani cites the case of General Electric and British Airways who located their off-shoring businesses to optimal foreign locations. However, as competition rose, these firms were forced to seek alternate attractive locations to keep the competitive edge. In recent times, shifts have occurred in off-shore locations between India, China, South Africa, and Brazil etc. Shifts in FDI destinations over time have been analyzed at country level since the associated determinants affect all MNCs uniformly (Freeman, 1978). The oligopolistic reaction model however fails to explain:- Why would the first firm among the investors, seek the route of FDI to expand their business? Why would firms prefer FDI over exports or licensing? Vernon’s Product Lifecycle Theory The product lifecycle theory is a generalization of the technological gap model which suggests that the trade proliferates when new products, services, or production methods are introduced in the market. The innovating firm which creates new products or processes seeks to obtain a temporary monopoly in the world market by exercising patents and copyrights. Vernon (1966) postulates a three stage product lifecycle:- Innovation or new product stage: In this innovation or explorative stage, production of new products is often restricted to the country of origin. Developing product stage: The mass production of the product begins, leveraging on the economies of scale. In this stage, typically, exports of products are emphasized. The key consideration here is that as long as production and transportation costs are lower than the cost of production abroad, export continues to get the stimulus. When the cost of production abroad becomes cheaper and competitive, changeover eventually happens. Maturing or standardized product stage: This stage is reflected through technology export and product import. Competitors’ seek to retain their dominant position through pricing taking advantages of cheap labour and lower production costs. The European clothier “ETAM” for example, deploys Chinese, Romanian and Ukrainian labour to tailor their item (ETAM Annual Report, 2008). When a new product or production processes is introduced in a new country, it eventually gets absorbed over time, and can even become competitive in the world market owing to lower labour costs, and cheaper resources. Therefore, to maintain a competitive edge, the innovating company continues to refine its product-lines with newer technologies and features, thus seeking to maintain a competitive technological gap. Wells (1969) studied the income elasticity of demand of fast growing U.S. exports. The evidence supports the postulates of product lifecycle theory. The study analyses the demand structure, production, and industry structure with the three stages of product lifecycle: early, growth and mature. Vernon (1979, pp. 266) proposed a modification to his theory keeping in view the role of multinational companies in a globalizing economy. He conceded that his theory may not have a wide general applicability as he posited earlier. Whilst R&D work may still be carried out by the innovating company at its headquarters, the initial production of the product could take place in a different country (http://www.wright.edu/~tdung/product_cycle.htm), perhaps, at the MNCs subsidiaries. However, the relevance of Vernon’s theory has still profound impact on industrializing countries such as, Mexico, Brazil, and Korea, whose innovations tailored to local markets might find promising businesses in international markets, especially those countries which are lagging behind them in the industrialized pecking order. Studies have also been conducted to embed technology related variables as determinants to pattern of trade (Deardorff, 1982). The newness of products and the process know-how’s govern trade from technology standpoint. Although, it is difficult to conclude, whether, supporting technology, or supporting human capital and skills, become the primary determinants of trade. As with oligopolistic reaction, the product life cycle theory fails to explain the preference by firms on FDI than exports. Critical Analysis of Horizontal FDI Approaches Market Imperfection Theory Market imperfection theory recognizes that high tariffs and protectionist policies of government impede export options. When regulatory restrictions on exports become severe, market imperfection theory suggests that horizontal FDI would become a preferred option. This is so because companies would overcome the regulatory barriers by internalizing their operations (Casson, 1983). Market imperfection theory also provides an explanation for the mix of preferences between FDI and exports by firms. Helpman, Melitz and Yeaple (2003), show that firms with high productivity prefer horizontal FDI as the investment of choice. Such firms would have perfected their production methodologies and processes, for economies of scale and leverage this advantage in proliferating new production facilities in foreign lands. Firms with medium productivity levels may find competitive advantage in serving domestic markets and use exports as a medium to reach global markets. Firms at low productivity levels may eventually phase out of competition. Market imperfection theory also explains when a firm would prefer FDI over licensing. This would happen when:- Licensing agreement may not adequately protect the product or process know-how Firm may want to keep tight control of its operations The firm’s expertise or know-how may not be amenable to licensing. Oligopolistic Reaction Oligopolistic structured firms (e.g. tire or oil industry) are highly driven by market share. If a member of oligopoly decreases price or expands capacity, all others in the membership would be constrained to do the same. If a member of oligopoly chooses horizontal FDI, other members would follow suit. However, this still does not explain the behaviour of the imitating member on their options towards exports or licensing. The clustering of FDI flows to a limited band of developed countries is an evidence of oligopolistic structure in action. The competitive forces still does not explain the rationale of why a particular kind of investment is chosen as business growth option. Vernon’s Product Lifecycle (PLC) Theory One of the prime drivers for an innovating firm to set up production facility in a foreign land is the existence of a significant demand. Alternatively, innovating firms may find merit in establishing a facility in foreign land, if resources are cheaper, and abundant, in comparison to the home country. Thus the product lifecycle theory does have a strong rationale for establishing FDI. But PLC fails to explain why does FDI become preferable over exports or licensing? The PLC is seen by practitioners as anachronistic. Since technological gap was the prime mover for innovations, the gap in modern times is fast narrowing in developed countries. In modern age where technological-lives have become shorter, especially, in software based industries, the product life extension at the maturity stage may be counterproductive. Instead, it may be preferred to rain a host of new products with distinctive features. Conclusion In view of the foregoing analyses, it is evident that the market imperfection theory provides a holistic view of growth for horizontal pattern of FDI. The theory explains why FDI is preferable over exports, or licensing (Casson 1983, 1987). It also recognizes the restraints to proliferate know-how element and business process proprietary (Hymer, 1976). Above all, the most convincing reason to horizontal FDI emanates from market imperfections. Imposition of quotas, tariffs and other trade barriers by government can actually make FDI viable, and more attractive (Dunning & Rugman, 1985). Therefore, in my opinion, market imperfections model is perhaps the best explanation to horizontal FDI. References Buckley, P.J., Casson, M., 1976. The Future of Multinational Enterprise. London: Macmillan. Casson, M., 1983. The Growth of Internal Business. London: Allen and Unwin. Casson, M. 1987. The Firm and the Market. Oxford: Basil Blackwell. Cowling, K., Sugden, R., 1987. Transnational Monopoly Capitalism. Brighton: Wheatsheaf. Deardorff, A. V., 1984. An Exposition and Exploration of Krueger’s Trade Model. Canadian Journal of Economics, 36, pp. 167-175. Dunning, J.H. & Narula, R. 1996. The investment development path revisited: Some emerging issues, In Dunning, J.H., & Narula, R. (Eds.), Foreign Direct Investment and Governments: Catalysts for Economic Restructuring. Routledge, London and New York, pp.1-41. 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