Undertaking Foreign Direct Investment by the Multinational Enterprise - Essay Example

?Running head: REASONS FOR FDIs BY MNEs Reasons for undertaking Foreign Direct Investment by the Multinational Enterprises Insert Insert Grade Course Insert Tutor’s Name 26 February 2012 Reasons for undertaking Foreign Direct Investment by the Multinational Enterprises Introduction A multinational corporation or enterprise is a large firm that has the productive capacity, and performs its function and operations across national borders (Bized, 2001; Multinational Enterprise, n.d). Nonetheless, the MNEs need not be large firms, and neither must they be operating in the technologically intensive industries (Huang, 2003, p.73). The main conventional objective of an MNE is to maximize the wealth of the shareholders. The decisions of the MNE will be made towards the achievement of this objective (Multinational Enterprise, n.d). Unlike the small and medium sized enterprises that only seek to access foreign markets, the major concern of the multinational enterprises is to develop a global manufacturing capacity and improve their proximity to the major world markets (Graham & Spaulding, 2005). The foreign direct investments provide a measure of ownership of domestic productive assets in a given economy by foreign organizations (Economy Watch, 2010a). Classically, foreign direct investment is a situation where ‘a company from one country makes a foreign physical investment by building a factory in another country’ (Graham and Spaulding, 2005). It is an investment in the form of buildings, machinery, and equipment and it is opposed to portfolio investments that are considered indirect investments. Several factors drive firms to expand their operations to cut across different national and regional boundaries. MNEs establish foreign direct investments in response to the changing global and regional competition (Bartels & Crombrugghe, 2009, p.1). Foreign direct investments can be a means of accessing new markets and marketing channels, reduction in costs of production, providing the organization with access to new skills, technologies and other resources, and sources of financing (Graham & Spaulding, 2005). To go global, the firms can decide to make foreign direct investment, and this decision is in turn guided by a number of factors that are considered the potential benefits of the approach. This paper provides a critical evaluation and discussion of some of the major factors that can drive a multinational enterprise to decide to undertake foreign direct investment in efforts to expand its operations and go global. The paper highlights on the benefits of foreign direct investments to the multinational enterprises. Reasons for establishing FDIs to MNEs Foreign Direct Investment has been associated greatly with the current trend that is observed towards globalization and internationalization of business operations. High growths of the economy and better economic performances in different parts of the world in the recent past can be attributed to the foreign direct investments by the multinational enterprises (Vardar, 2012). Significant growth has been seen in the flows of foreign direct investment especially into the developing countries in the last few decades (Graham & Spaulding, 2005). It becomes one of the drivers of globalization. With the developments that have been seen in the global business operations and global investment patterns, the concept of foreign direct investment has been expanded to include alliances with local companies, foreign mergers and acquisition, or establishment of joint ventures in the foreign markets (a Watch, 2010). The foreign direct investor will seek to have a controlling stake in these investments (ILIKEINVESTING, 2011). Cross-border investments have been in existence as early as the 1950s and different theories have been advanced to explain why the firms decided, and continue to make decisions, to internationalize their operations. In the recent pasts, countries have entered a habit of competition to attract more foreign direct investment due to its potential benefits to the host country whereas the multinational corporations are struggling to identify the appropriate regions and countries to establish their foreign investment (Vardar, 2012). Nonetheless, it has to be stressed that establishment of foreign direct investments by the MNCs follow a number of factors some of which will be specific to the organization and the industry involved (Quncy.com, 2012). No single theory holds on its own towards explaining this behavior of organizations. An eclectic approach that incorporates different theories has been considered appropriate here (Quncy.com, 2012). Foreign direct investment, just like any other business investment, involves a cost-benefit analysis in which the resources that are to be spent today in a given investment should provide profits in the future to the investors that are worth the risk of investment (Multinational Corporations & Foreign Direct Investment, 1989). It is necessary that the present value of the expected (future) returns of an investment be greater than the present discounted value of the costs of these investment, otherwise the investment is not worthwhile. Multinational firms have two options from which to weigh and make decisions. The firms need to analyze and understand whether it would be more profitable to increase domestic production and export the products to foreign markets or establish a foreign subsidiary to produce in the foreign markets (Multinational Corporations & Foreign Direct Investment, 1989). The analysis should involve an assessment of the internal and external factors affecting the operations of the MNE. Essentially, the major factors are cost reduction, demand related factors, risk management, management of competition, and circumventing of trade barriers. The cost reduction impetus One consideration that an MNC takes into account is cost reduction in its production and other operations. The motive to establish foreign subsidiaries will follow a need to reduce production costs that takes different dimensions. The availability of resources and the costs of labor will influence the decision to invest in an area. These cost cutting needs prompt the organizations to look for new locations that have lower production costs and establish their investments there (Vardar, 2012). A realization of the scale economies enables MNEs to enjoy benefits of cost reduction from the foreign direct investments (Economy Watch, 2010b). Cross-country differences are observed in the cost of labor and other inputs. The MNEs will find it beneficial to use the cheap domestic labor than to import workforce from the home country. An MNE will be attracted to have a foreign direct investment in a region or country that has better human capital (Hanson, 2001, p.12). This has been the trend observed in the expansion of MNEs from the developed countries to take advantage of the cheap labor in the developing nations. However, the benefit may not be obvious. In as much as the organization needs cheap labor, the reduction in the overall cost of production will be realized if the quality of this labor is the same as the expensive labor in the home country. The FDI will not benefit the MNE if the labor productivity is too low with negative effects on returns from these wages (Multinational Corporations & Foreign Direct Investment, 1989). Similarly, the availability of capital in a country will attract FDIs. Earlier theories suggested that there are differences in capital returns across different countries following different capital flows. There are a plenty of capital in the developed nations like the United States and the investors seemed to have exhausted the best investment opportunities that were available in the country (Kokko, 2006). This could lead to low returns in further investment. On the other hand, the underdeveloped nations had investment opportunities that had not been exploited with expected high rates of returns on the investments. Thus, the multinational enterprises from the developed nations are moved to establish in the developed countries to exploit the existing investment opportunities (Kokko, 2006). This enables them to exploit the cross-country differences in return and maximize their returns. Circumventing trade barriers Another factor related to cost reduction is managing the trade barriers. Different countries are aware of the factors that the MNCs consider before establishing foreign direct investments and the countries struggle to develop strategies to attract these firms by offering certain incentives (Siddaiah, 2009, p.361; Vardar, 2012). An important factor influencing FDIs is the fiscal incentives that are provided in a given economy. MNCs will be attracted to establish FDIs in regions with fiscal incentives like tax break, reduced custom duties, relieved foreign exchange restrictions, or streamlined administrative procedures among many other favorable conditions (Vardar, 2012). Establishing foreign direct investments helps in minimizing the pressure by the foreign governments on the local production by the MNE. It enables business organizations to ‘avoid governmental pressures on local production and cope with protectionist measures by circumnavigating trade barriers’ (Economy Watch, 2010a). Some countries impose strict and costly environmental laws for local production. Am MNC may establish an FDI to escape the “wrath” of these laws (Hotter, 2012, p.11). A firm can either produce in its home country and export the products or produce in the foreign country. In the event that there are strong barriers to export to the foreign market, then the firms are likely, and justifiable, to set subsidiaries and produce in the foreign countries (Multinational Corporations & Foreign Direct Investment, 1989). On the other hand, low barriers to trade may favor export depending on the other prevailing factors (Hanson, 2001, p.11). Considering the fiscal and monetary policies as well as the transportation costs (Hotter, 2012), it may be cheaper to produce locally in these countries than to produce in the home countries then make exports to the foreign markets. Response to market demand Through establishment of a subsidiary, the multinational enterprise is capable of providing close monitoring on the foreign market (Multinational Corporations & Foreign Direct Investment, 1989). Foreign direct investment provides a method of internationalization of the operations of a business organization. The move enables the firm to study the market trends and respond to the changing patterns in good time. By moving into the local markets, the foreign companies get closer to their clients and they are able to develop better relationship and customer loyalty. However, this will be valid to the extent that the foreign market is large and undergoing rapid development. Management of competition in the domestic market Another important factor that an MNC will consider before establishing a foreign direct investment is the competitive intensity in the domestic market (Vardar, 2012). An organization will decide to establish a foreign direct investment if there is high level of competition in the home country in order to manage the competition. Similarly, FDIs can take the form of mergers and acquisitions of other firms that could be initially the competitors of the MNC on the global market. An MNE can maintain its market power by acquiring a foreign competing firm or forming a merger with the firm (Multinational Corporations & Foreign Direct Investment, 1989). In certain instances, an MNC may move to establish foreign direct investment as a pressure following the move of the other competitors to go global (Vardar, 2012). Some corporations establish the FDIs as response to overcome the competitive advantage that the competitors that have foreign direct investments could have on them. However, this objective may only be realized if the corporation first performs internal assessment of its capability towards foreign establishment and not a mere imitation of the operational strategies of the other organizations. The potential capabilities of each of the organizations to go global are varied due to diversity in resource availability and the management abilities of the organization. Risk diversification Foreign Direct Investment can also be performed as mechanism for diversification of the risks of the corporation. This applies to products with a high-income elasticity since the growth rates of different world economies are different (Multinational Corporations & Foreign Direct Investment, 1989). While a growth in economy could be recorded in one region, another region may record significant recession. By geographical differentiation, the corporations expect to gain competitive advantage through distribution of risks. In the event that a region is hit by some crisis (financial or economic), the corporation can still rely on the investments in other regions that are not affected. The implications Establishing a foreign direct investment will be a viable option of companies depending on the type of the business and the business industry sector. The current high rate of globalization across many industries and the rapid vertical integration in the industries observed globally would necessitate that a firm also go global in its operations (Graham & Spaulding, 2005). Besides, there is barely competition in every business industry in the contemporary market. In order to make a meaningful foreign direct investment, an organization should access the behaviors of the competitors towards foreign establishments. The organization has to consider whether the competitors are also expanding their operations into the foreign markets and the methods that they are applying to go global (Graham & Spaulding, 2005). The organization also needs to consider the effects that foreign investments will have on its relations with the local clients. It would be inappropriate if the move will not maintain the previous client relationship to the organization. Thus, company should decide to go global in order ‘to reduce costs of purchasing materials, get suppliers to compete for your business, enlarge the market, increase profits, the product require new skill or technology, and [if] the company wants to stay ahead of the competition’ (Multinational Enterprise, n.d). Conclusion Multinational enterprises have been in existence in the past with significant developments in the last few decades. The firms operate in different countries and they will adjust their products and operations to meet the requirements of the domestic clients. The organizations struggle to increase their closeness to the major markets in the world as well as their production capacities in these markets. This is achieved through foreign direct investment. The firms opt to use FDIs due to the potential benefits they expect from the investments. These include reduction in the costs of production and meeting the demands of the clients to increase their sales and gain competitive advantage. Reduced transportation costs, cheap labor, and availability of resources contribute to reduced production costs. The firms also establish FDIs to manage competition in different ways and manage the trade barriers in the foreign or in the domestic market. However, these potential benefits may not be realized automatically. An analysis of the firm’s internal and external factors needs to be done to examine if the move will be beneficiary to the organization. Reference List Bartels, F., & Crombrugghe, S., 2009. FDI Policy Instruments: Advantages and Disadvantages. (Online). Available at: http://www.unido.org/fileadmin/user_media/Publications/RSF_DPR/WP012009_Ebook.pdf [Accessed February 28, 2012]. Bized. 2001. The Impact of Multinational Enterprises. (Online). 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