Importance of Foreign Direct Investment - Research Paper Example

Advantages and Disadvantages of Foreign Direct Investment (FDI) for Germany Table of Contents Introduction 3 1. Global FDI trend 3 2. FDI outflow trend in Germany 3 1.3. Objective 4 1.4. Layout 4 2. Literature review 5 2.1. Importance of FDI 5 2.2. Advantages of FDI 5 2.3. Risks of FDI 6 2.4. German FDI activity 6 3. Findings and discussion 9 3.1. Advantages of FDI for Germany 9 3.2. Disadvantages of FDI for Germany 12 4. Conclusion and recommendation 13 Reference List 14 1. Introduction Foreign direct investment (FDI) refers to form of investment that is made by an entity that is headquartered in a particular country into another entity that is headquartered in a different country. This form of investment has grown into prominence due to the advent of globalization. Companies have been witnessed to increasingly invest in foreign entities particularly the ones based in the emerging economies with the hope of expanding their customer base and augment the market share. As such the level of FDI net inflows have increased considerably over the last decade or so. This fact can be justified by the data provided within the World Bank database (refer to figure 1). 1.1. Global FDI trend Figure 1: Net inflow (all countries) (Source: The World Bank Group, 2014a) The level of FDI has a direct association with various economic factors related to a country. The extent to which a country’s economic factors are favourable determines the level of foreign investment inflows to be received by that country. However, off late FDI has become exposed to various types of risk out of which the common ones are foreign exchange risk, country risk and sovereign risk. It is undeniably true that FDI has lots of advantages but it has to be kept in mind that such investments are associated with fair share of disadvantages as well. With regards to these facts, what follows is a detailed review of literatures that emphasizes on the advantages and disadvantages of FDI with particular focus on German companies. 1.2. FDI outflow trend in Germany Figure 2: Net FDI outflow as a percent of GDP (Germany) (Source: The World Bank Group, 2014b) As is evident from figure 2 given above, FDI outflow from Germany has been decreasing since 2006 when the country reached the maximum level in terms of FDI outflow as a percent of GDP. The investment has since then decreased abruptly and hit a record low of 2.34% and 1.26% in the year 2008 and 2011 respectively (The World Bank Group, 2014b). Such abrupt decrease in FDI outflow can be largely attributed to the global financial crisis during 2007-08 as well as the euro zone crisis in 2010. Majority of the German companies have accrued the benefits of FDI during the course of their international operations. Regardless of such benefits, FDI is still associated with a quite a number of disadvantages. Therein lies the relevance of this research as the researcher endeavours to identify the advantages and disadvantages of FDI for Germany. 1.3. Objective To understand the key determinants of FDI. To explain the advantages of FDI for Germany. To explain the disadvantages of FDI for Germany. 1.4. Layout The research will be entirely qualitative in nature where the researcher will be attempting to identify the key advantages and disadvantages of FDI for Germany through an extensive review of empirical literature. The factors that will be identified will then be documented in the findings and discussion section. These findings will then be translated into evidential conclusions. 2. Literature review 2.1. Importance of FDI FDI has a significant contribution towards the economic development and growth of a nation (Li and Liu, 2005). According to Choe (2003), such forms of investment are heavily reliant on several macro and micro economical factors associated with a country. Academic scholars have conducted a significant amount of research on FDI and have concluded that some of the major determinants of FDI include productivity and cost of labour, availability of natural resource, level of private, public and government debt, inflation, political scenario, interest and exchange rates. Alam and Shah (2013) have argued that the factors which have a significant impact on FDI vary from country to country. This is precisely because of the dissimilar macro and micro economic situation that prevail in those countries. The authors have put forward the perspectives of investors who believe that FDI is an instrument of investment diversification which is done to reduce a company’s exposure to home country risk factors. The rationale behind making investment in a foreign country is to exploit cheaper resources available in those countries and increase the rate of return (Globerman and Shapiro, 2002). This provides investor companies with the option to spread their risk as the adverse impact of country risk is balanced by the encouraging opportunities available in the foreign country (Estrin and Meyer, 2004; Estrin and Bevan, 2004). 2.2. Advantages of FDI It is undeniably true that FDI has a profound significance towards the development of the home country. It plays a crucial role in improving the economic scenario of the home country by allowing investors to attain higher rates of return, enhances the working environment considerably, creates new employment opportunities, fosters innovation and facilities development of technology (Markusen and Venables, 1999). Empirical theories have suggested that multinational corporations mainly engage in FDI activities with the underlying aim of attaining first mover’s advantage (if it is a relatively unexplored market) or to explore a market with prospective growth opportunities (Calhoun, 2005). In that way investors are able to create firm specific benefits. According to Shatz and Venables (2000), the major reasons behind foreign investment it to capture the local market and serve the customers’ needs as well as to obtain inputs from cheaper sources. Capturing the local market provides firms with a wider customer base whereas obtaining a cheaper source of input enables investors to increase their margin of profit (Chakrabarti, 2001). Germany has been making considerable amount of investments over the last two decades in foreign countries. The major recipients of Germany’s foreign investments include the US, China, India and Brazil. While the venture of German companies in the US is largely driven by the prospective market in the country and a large base of customers, the venture of the same companies in the emerging market is largely stimulated by the availability of cheaper source of labour (Apergis, Katrakilidis and Tabakis, 2006; llis and Zhan, 2011). This is one of the fundamental reasons why Artige and Nicolini (2005) identified different factors as stimulant of FDI outflows for different countries in Europe. 2.3. Risks of FDI There is no doubt regarding the fact that FDI facilitates economic development drastically. However, inappropriate strategies related to foreign investments may often lead to severe consequences. FDI has a lot of disadvantages that may disrupt the operations of a home country investor on the foreign soil. The impact may not always be visible in financial figures as a lot of impacts tend to be intangible (Borensztein, Gregorio and Lee, 1998). One of the major disadvantages associated with FDI for the home country is exchange rate fluctuations. Usually, a home country investor either adopts a joint venture strategy or a direct investment strategy in order to enter a foreign market (Musila and Sigué, 2006). Adoption of both the aforementioned strategies requires the investor company to make a hefty investment upfront in order to initiate its operations in the foreign market. Some investors choose to finance it through their home country currency while some choose to avail funds from sources available in the host country (Chan, 2013). Such exposure to different currencies renders the investor vulnerable to exchange rate risk, should the rate exchange rate vary abruptly (Chen, F., Zhong and Chen, Y., 2014; Galan, Gonzalez-Benito and Zuniga-Vincente, 2007). The instability in political infrastructure of the host country may also pose significant threat to the investments made by foreign investors (Aharoni, 2011). It is widely known that political actions and legislations have a huge impact on several economic aspects of a country (Hatzius, 2000; Busse and Hefeker, 2007). The extent of variability of a country’s political scenario serves as a fundamental determinant of factors such as income tax rate, corporate tax rate, commodity prices, interest rate, transport prices and many more. Such invariabilities many often prove to be costly for a foreign investor (Ambos, 2005). The foreign company may incur huge expense that may decrease the profit margin significantly (Chen and Reger, 2006). Inflation is another factor that has plagued foreign investors over the last decade or so. Inflation leads to price rise which in turn increases the cost of purchasing raw materials for companies. This in turn also increases the inventory holding cost for foreign investors (Agosin and Machado, 2005). 2.4. German FDI activity The involvement of German investors in FDI dates back to the 1990s. Since then the country’s global capital network has strengthened considerably. The FDI outflow from Germany has increased sharply since 1990 and it has been equally complimented by a sharp growth in the FDI inflows. The extensive presence of investors from Germany in the international market has made the country even more competitive now more than ever before. Companies headquartered in Germany have invested close to €134.5 billion during the time period between 2001 and 2006 (Deutsche Bundesbank, 2006). A majority of the trans-border FDI outflows from Germany were in the form of equity capital which were used in order to merger and acquisition with foreign companies based anywhere outside Germany. The statistics for FDI stocks outflow is a more genuine representation of a country’s outward flow as it not includes the direct participating interests of an investor but also the indirect participating interests of the investor. The indirect participating interest is more often than not recognised through holding companies. As of 2006, Germany’s FDI assets were valued at €677 billion, out of which €345 billion were invested in international companies operating in Germany (Deutsche Bundesbank, 2006). In the year 1990, the FDI assets were valued at €116 billion, out of which €85 billion was invested in international companies which had subsidiaries in Germany (Deutsche Bundesbank, 2006). This figures show the growth in Germany FDI during the time period between 1990 and 2006. Thereafter, companies in Germany have increasingly followed a global orientation strategy in order to enhance their presence aboard and gain from the economies of scale and scope that were on offer in the foreign markets. Figure 3: FDI stocks (Source: Deutsche Bundesbank, 2006) Figure 4: FDI outflow since 2004 (Source: Knoema, 2014) A major proportion of Germany’s investment has been towards the financial services industry throughout the world which is followed by their investment in holding companies and then in the banking sector. Figure 5 given below provides a good explanation of the extensive presence of German companies in each of the industries all over the world. This has been the major benefits of FDI for German investors whereby they were able to reach out to a wider population and increase their source of revenue. Figure 5: German FD outflow according to industry (Source: Deutsche Bundesbank, 2006) 3. Findings and discussion 3.1. Advantages of FDI for Germany As mentioned above FDI has a significant contribution towards the development of a country and its economy. The major source behind such developments is the investors and the companies who invest in foreign companies. Therefore in order to understand the advantages of FDI for the German economy, the advantages achieved by the investors needs to be comprehended first. To start with the advantages first, investors based in Germany have been able to reap several benefits out of making investment in foreign countries. The first and foremost advantage can be explained through the application of the OLI model. The OLI is also sometimes referred to as the eclectic paradigm which provides an explanation of the theory of internalization. The theory outlines a FDI entry mode and advantage matrix that theorizes the advantages to be gained through a particular mode of entry. The following figures depict the eclectic paradigm introduced by Dunning. This model was also incorporated in a study by L. E. Brouthers, K. D. Brouthers and Werner (1999). Figure 6: Eclectic paradigm (Source: L. E. Brouthers, K. D. Brouthers and Werner, 1999) As is evident from the figure 5, German companies clearly have the ownership advantages. This advantage is very well evident in case of Germany based automobile company, BMW and Mercedes Benz. Both these companies have enjoyed tremendous success by setting up their own operations countries like the US, the UK, India and Russia. The underlying reason behind such expansion has been to provide world class travelling and driving experience to an ever growing and rapidly developing upper middle class population in these countries. Moreover, these companies have proven to be highly competitive when compared to the likes of automobile manufacturers such as Toyota and General Motors. The Germany based automobile manufacturers have emphasized a lot on bringing upon technological developments in their cars on a frequent basis in order to make sure that their products satisfy the needs and demands of their customers. Attaining such ownership advantages enabled companies to increase their profit margin which in turn added a lot to the development of the home country’s economy. Moreover, such ownership advantages also provided the companies with the option of choosing their own source of raw materials. In that way they were able to import products and other raw materials from their home country (Germany). Consequently, the export competitiveness in Germany increased greatly (Lim and Moon, 2001). Companies in Germany were able to export more goods which in turn resulted in a drastic increase in the flow of money within the German economy. Moreover, given the fact that the government was able to export more products when compared to the amount of imports within the economy, the balance of payments increased considerably over the years (Chen, Hsu and Wang, 2012). As a result, the government realized significant current account surplus which had a significant contribution towards the economic development of Germany (Be´nassy-Que´re´, Coupet and Mayer, 2007). Moreover, the current account surpluses helped the German government to invest in foreign country and build up a reserve of foreign currency. By doing so, the country was able to hedge foreign exchange risk and was also able to reap the benefits of home country currency appreciation (Dunning and Lundan, 2008). These benefits also contributed a lot towards the development of the German economy. The second advantage came in the form of internalization. As far as the internalization is concerned, companies adopting this strategy tend to have their own manufacturing and production facility instead of having such facilities on a joint venture basis (Ghauri and Firth, 2011). A considerable number of German companies have their own production facilities based in foreign countries. One such company from Germany is Systems, Applications & Products in Data Processing (SAP SE) who has its production facilities based in some of the major economies all over the world. The company has attained a highly advantages position by internalizing its business in countries such as the US, France, Switzerland and Norway. Entry into such countries enabled the company to serve its clients in a more effective and efficient way. Attainment of internalization advantage helped the German companies to channelize a lot of benefits accrued from such venture to the home country economy. Some of the major benefits of such venture include introduction of technology, channelization of cheaper source of labour as well as transfer of knowledge from the host country economy to the home country economy (Germany). This could then be used by the German leaders in order to strengthen the country’s economy. In fact, such channelization of benefits played a crucial role in stabilizing the German economy and kept it shielded from the effects of the Euro zone crisis which happened in the year 2010 (Nourbakhshian, et al, 2012). Moreover, internalization advantage also allowed the German companies to diversify their operations and share the risk (Ambos, 2005). The same benefit was also accrued by the economy itself it is the major benefactor of the advantages reaped by the German investors. Not only was the German economy shielded from foreign exchange risk due to FDI activities in multiple countries, but it also helped the economy to reduce its exposure from other economic fluctuations such as rise in interest rates, rise in import tax and inflation and so on and so forth (Hatzius, 2000). In addition, given the fact that in this increasingly globalized world the political actions of one country of one country have a severe impact on another country because of economic ties, Germany was able to keep its economy stable and protected from such abrupt political taken by other countries by encouraging the German companies to indulge in FDI with multiple countries (Busse and Hefeker, 2007). Location advantages include factors such low cost of labour, cheaper source of raw materials, large target market, lower tax rate and many more (Buckley and Ghauri, 2004). One of the many advantages attained by German companies has been stimulated by their choice of location. For example, by entering into the US market through FDI, companies in Germany were able to benefit from a free market and a rapidly developing economy. The US market provides these with a huge customer base from various segments which in turn enabled the companies to enhance their productivity and increase their market share. The revenues of these companies soared gradually over the course of the last decade which in turn allowed them to attain huge profits from their FDI activities. Moreover, the companies were also able to conduct transaction in US dollar which in turn allowed them to hedge the risk posed by their home country risk. Given the fact that inflation rate was considerably low in the US, the German companies were able to minimize their expenses by getting access to cheaper source of raw materials and procurement. The rationale behind investing in the emerging economies was justified by the German companies’ access to cheaper source of labour. The German investors were able achieve economies of scale and scope by outsourcing their production to smaller companies based in the emerging economies which in turn increases the former’s productivity by a drastic level. Given the fact that attainment of location advantages through FDI allowed German companies to get access to cheaper source of labour from the host country, they were in a position to mix the knowledge shared by the cheaper labours with the experience of the expatriate managers. They were able to hire more number of expatriate managers from the home country but spending a bit more on their salary and compensating the same with the cheaper labour available from the host country (Buch, et al, 2005). This opened considerable number of employment opportunities for people in Germany. A lot of people were recruited as expatriate managers and junior officials and as a result there was a significant increased in the employment rate in Germany. The disposable income of households increased by a considerable level in Germany which in turn increase the purchasing power of people in Germany. Therefore, people could afford to spend more in order to enhance their lifestyle and this enhancement was considered as one of the major yet indirect advantages of FDI for the German economy. 3.2. Disadvantages of FDI for Germany Although FDI is associated with several advantages, but the fact that it poses a number of risks to the investors cannot be denied. The research into the German FDI activities pointed out that the German companies conduct a major proportion of their transaction in the US dollar currency. This is precisely because of the fact that large proportion of German FDI outflows is received by the US. Germany companies have a lot of investment in the financial services industry (excluding banks and insurance companies) in the US. Such level of transaction in foreign exchange exposes the companies to foreign exchange risk if those currencies tend to depreciate with respect to other currencies in the world (Yin, 1999). Such exposure also possess a severe risk to the German economy as drastic appreciation of a foreign currency with respect to the home country currency could soon set forth the requirement for the German government to opt for debt from other countries in order to compensate for the loss due to appreciation of foreign currency. This may deteriorate the German economy by a considerable margin. Unstable macro and micro economic situations in the host country may also pose a severe threat to foreign investors. It is widely observed that the actions taken by the government of a particular company has a significant impact on various economical factors such as interest rates, inflation rate, and tax rate (Buckley and Ghauri, 2004). Interest rates and inflation rates have the propensity to increase upon the enactment of certain government legislations. This in turn my have a considerable effect on the financial performance of the German companies. For example, rise in the rate of interest in a host country will increase the cost of capital for the German investor which in turn will minimize the profit margin. Besides that an increase in the rate of interest may also expose the German company to interest rate risk if the company’s investment is levered significantly. Inflation may also increase the cost of purchasing raw materials as well as augment the cost of procurement (Javorcik, 2004). This will also have a deep impact on the financial performance of the German company. If the financial performance of the German companies deteriorates considerably and on a consistent basis, this may put the companies towards the brink of being insolvent. Thereafter they may have to seek the help of the German government following which the government have to either accept or refuse to bail the companies depending on the company’s importance to economy. There will be severe consequences regardless of whichever decision is made. If the company is not bailed out, then its failure will have a negative impact on the German economy thereby hindering its growth in the future. However, if the government decides to bail out the company, then they have to use a considerable amount of funds which will also affect the economy severely. 4. Conclusion and recommendation FDI strategies have proven to be extremely beneficial for companies which endeavoured to establish their presence in the international arena. This type of investment enabled companies to expand their operations beyond home country borders. FDI has long been considered as a means to attain competitive advantage where companies have rigorously manoeuvred their strategies in order to expand their global customer base with the primary aim to increase their market share and margin of profit. German companies have been making substantial foreign direct investments over the past twenty years in various industries so as to diversify their business operations and share the risk. Expansion of business in foreign countries enabled the German investors to reap the benefits of favourable market conditions, prospective target market and cheaper labour. FDI activities placed the German investors in an advantageous position which helped them to extend their physical presence and provided them ample opportunities to serve the global population. This led to a significant enhancement of the financial performances of these companies. Such an extensive indulgence in FDI activities by the German economies and the corresponding improvement in the financial performance contributed a lot towards the development of the country’s economy. FDI helped stabilize the German economy during the time of crisis as well as strengthened the economy in order to endure any such adverse scenarios in the future. There was a considerable increase in the amount of export generated by the country which in turn helped the government to accrue current account surplus which could further be used for bringing upon economic development. FDI also led to a sharp increase in the employment rate in the country thereby increasing the disposable income of a large proportion of German households. Such increase in disposable income augmented the purchasing power parity of German households which in turn also contributed a lot towards the country’s economic development. On the flip side, extensive engage in FDI activities can also prove to be disadvantageous for the German companies. Exposes to foreign currency poses severe threats associated with exchange rate fluctuations and currency depreciation. Abrupt fluctuations in macro and micro economical factors such as interest rates and inflation can also deteriorate the financial performance of the German companies. Moreover, failure of entry strategies is another disadvantage associated with FDI which will not only severely hamper the operations of German companies in the host country but also in their home country. The government also has to keep a check over the FDI activities being conducted by the companies. They will make sure that the companies are not exposed hugely to one particular country or currency. It is the duty of the German government to convey the importance of FDI to the German investors and at the same time make them aware about the flip side effects if the deals go wrong. 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