The Rise in Importance of FDI for Multinational Enterprises - Essay Example

Discuss the rise in importance of FDI for Multinational Enterprises and Identify circumstances under which FDI may or may not be an appropriate strategy for International Business to adopt I. Introduction The technological innovation and the peace initiatives taken by the world leaders in the post world war period augmented the process of economic and political integration at the international level. The spurt in productivity both in goods and services and the growth in consumerism across the globe prompted the countries to liberalize their trade barriers thus inviting grater access to inputs as well as access to external potential markets. So the focus shifted from national economies to an integrated world economy through globalization of the business processes. The rise in interest of the business houses to expand their activities surpassing the geographical barriers boosted the pace of this economic globalization. This deepening and widening economic integration is achieved through three main channels such as trade, foreign direct investment and the international transfer of knowledge and technology. The enterprises, which have dispersed their business processes across the globe through the channel of FDI, are termed as Multinational Enterprises (MNEs). These MNEs are the main pillars in the globalized economies which involved in the world economic activities. Though trade which principally means export-import of goods and services across the geographical regions are there since many years but the concept of foreign direct investment (FDI) is rather of recent origin. Being different from portfolio investment this type of investment entails a firm to open its subsidiary in a foreign land to expand its business activities there. In today's fast moving global economy the scale of FDI made by a multinational enterprise plays a vital role for the growth of developed as well as developing countries across the world. In this essay the rise in FDI as well as its importance for the MNEs has been vividly described in the Section-II and also an analysis of the circumstances under which FDI may or may not be an appropriate strategy for an international business has been made in the Section-III. The conclusion to the discussion has been given in Section-IV. The analysis of the rising trend in the various regions of the world and the possible impact of FDI in the host and home economies has been made in this paper. II. FDI: The Increasing Trend in Global Economy "FDI is defined as a firm based in one country (the 'home country') owning 10 percent or more of the stock of a company located in a foreign country (the 'host country') -- this amount of stock is generally enough to give the home country firm significant control rights over the host country firm. Most FDI is in wholly-owned or nearly wholly-owned subsidiaries." (http://www.populareconomics.org/globalization/html%20/Glossary.html). Thus FDI is different from the portfolio investment which may cross borders but lacks such controls over it. This FDI may be 'Green-field'1 or 'Acquisition/Mergers'2 and also it may be 'horizontal'3 or 'vertical'4. "Thus to create, acquire or expand a foreign subsidiary, MNEs undertake FDI. The total direct capital owned by non-residents in a given country each year constitutes the stock of FDI" (Navaretti & Venables, 3). If one makes a comparison between export and FDI during the last twentieth century one can see that the exports grew much stronger than FDI in the pre 1980 period while the FDI sown an unprecedented rise after 1985. "The worldwide real GDP increased at a rate of 2.5% per year between 1985 and 1999 and worldwide exports by 5.6%, worldwide real inflows of FDI increased by 17.7%." (Navaretti & Venables 3). Also it is seen that the worldwide FDI stocks increased from $794 billion to $1, 768 billion in the second half of the eighties (Table-1). That means they more than doubled in just six years. The inflow of FDI peaked in the year 2000 but suddenly declined from the year 2001 due to slowing down of economy. But then onwards it is maintained at that level and even shown an increase in the year 2004 (Fig.-1). It is obvious from the data given in the table that the developed countries have the major chunk of the FDI than the developing countries. Among the individual countries, U.S. was the world's largest foreign investor. The European Union as a whole accounted for 71.2% of all outward stocks, a share that has risen sharply partly because of the rise in intra-EU investments associated with the deepening integration in the EU and following the creation of the Single Market in 1992 (Navaretti & Venables 5). Among the Asian countries the higher share is being taken by China. It again received 12% of all FDI inflows worldwide or one third of all inflows in the developing countries in 1996 (Kleinert 4). In nominal dollar terms, inward direct investment to China increased from $57 million in 1980 to $40.3 billion in 1999 (Stewart & Venables) (http://www.publications.parliament.uk/pa/ld200203/ldselect/ldeconaf/5/514.htm) Table-1: Inward* and Outward** FDI stocks for different economies from 1980-2004 UNIT Millions of dollars YEAR 1980 1985 1990 1995 2000 2004 ECONOMY CATEGORY World FDI inward stock 530244 794628 1768589 2763117 5786029 8902153 FDI outward stock 570125 752841 1785264 2942248 6148284 9732233 Developed economies FDI inward stock 398200 576045 1404411 2055763 3976356 6469832 FDI outward stock 496197 663312 1637760 2605892 5257261 8610146 Developing economies FDI inward stock 132044 218583 364057 697534 1739726 2232868 FDI outward stock 73927 89529 147313 334720 868920 1035676 United States FDI inward stock 83046 184615 394911 535553 1256867 1473860 FDI outward stock 215375 238369 430521 699016 1316247 2018205 Source: UNCATD (www.uncatd.org/fdistatistics) *Total stock of FDI from around the world to a particular country constitutes inward stock. **Total stock of FDI from a particular country around the world constitute outward stock. Figure-1: The FDI inward5 and Outward6 Flow from the year 1980-2004 (in million dollars) Source: UNCATD (www.uncatd.org/fdistatistics ) The increase in FDI is not only seen in large MNEs but also in medium and small enterprises including the public sector undertakings e.g ONGC Videsh of India. "Countries in South, East and South-East Asia continue to open up their economies to inward FDI. Significant steps in this direction were taken in 2005, particularly in services. For example, India is now allowing singlebrand retail FDI as well as investment in construction, and China has lifted geographic restrictions on operations of foreign banks and travel agencies. A few measures were also introduced to address concerns over cross-border M&As in countries such as the Republic of Korea" (WIR 2006). China and India are the two emerging giants in attracting the FDI. Temasek's (Singapore) purchase of an 11.5% stake in Standard Chartered (United Kingdom) in 2006, and CNPC's (China) takeover of Petrokazakhstan in 2005 are recent examples of FDI deals in this region. Like wise the West Asia also witnessed high level of inflows especially in services sector such as power and water in Bahrain, transport in Jordan and Telecommunication in Jordan and Turkey. "The United Arab Emirates collectively received inflows of $12 billion to become the largest recipient of FDI in West Asia in 2005" (WIR 2006). Earlier much of the earnings of these countries were used to be channeled through portfolio investment in United States and other developed countries but the present scenario is gradually changing. These countries are also leading in outward flow of FDI in many developed as well as developing countries. The acquisition of P & O by DP world of UAE and the purchase of Celtel International (The Netherlands) by Kuwait's Mobile Telecommunications illustrate this trend (WIR 2006). The other regions of the world like Africa, Latin America among the developing countries are also attracting FDIs from around the world in various sectors. In making a sector wise analysis one can found that the services sector attracts more FDI than the manufacturing sector. Again it is often noticed that the higher growth in FDI is mainly contributed by the Merger/Acquisition type of investment than in Green-field investments. This may be due to the fact that acquiring an existing firm is quicker and less risky than establishing a completely new firm. Also the existing firm provides the infrastructure and the brand which can be improved by the acquiring company. III. FDI: When & When Not Conducting business in foreign countries is more risky which demands the knowledge of local rules and regulations, local culture, frequent travel of the management etc. and the list of the problems may be many. Also other than FDI there are various alternate modes for an international business firm to enter into a foreign market such as franchising, licensing, exports etc. But then FDI is preferred over others for many reasons some of which are: 1. Transportation Costs 2. Locational advantages 3. Market Imperfections 4. Strategic behaviours The amount of cost incurred for transportation for the goods and services is determining factor for the MNEs to go for the FDI. Usually Low value to weight products is not suitable for exporting and hence FDI is a better strategy for the same e.g. bottled drinks. (Horizontal FDI) The cost of factors of production like land, labour and capital etc. depends upon the locations and accordingly the MNEs diversify their business processes to make them cost effective i.e. different stages of production of goods takes place in different countries (Vertical FDI). e.g. 'American Car' for which 30% of car's value goes to Korea for assembly, 17.5% to Japan for components and advanced technology, 7.5% to Germany for design, 4% to Taiwan and Singapore for minor parts, 2.5% to the U.K. for advertising and marketing services and 1.5% to Ireland and Barbados for data processing. Only 37% of the production value is generated in the United States. (WTO 1998 cited by Navaretti and Venables 14) To avoid restrictions on free flow of goods and that on free flow of information companies generally resort to FDI. Thus "the FDI may also be driven by trade barriers, either existing measures - "tariff-jumping" FDI - or with the intention of reducing the probability of future protectionist measures, the so-called "quid pro quo" FDI. For example Japanese automobile manufacturers began producing in the European Union and the United States following the imposition of so-called "voluntary export restraint" agreements (VERs) limiting the number of automobiles that could be shipped from Japan" (WTO News 1996 http://www.wto.org/English/news_e/pres96_e/pr057_e.htm ) Due to competition the oligopolistic firms sometimes adopt the FDI strategy looking to their rivals. Multipoint7 competition encourages copycat behaviour so that rivals do not steal a march on their competitors.(Williams, lecture handnotes) When transportation cost is low i.e. in high vale to weight ratio export is preferred over FDI. Also when there was no trade barrier the mode of export should be the best strategy for the MNEs to adopt. Another mode to go multinational is by global licensing and franchising. This can be done when the value of the technology is less or its protection is not possible. Internalisation of the technology is the first priority given by a company as it often happens that the technology are not being utilized to its optimum level by the firm which has not developed the same. It may so happen that to utilize the same the necessary skill and ancillary needs may not be there with the company to whom it is licensed. Thus it is important to determine the mode of entry to foreign market. Various models have been devised by which this decision making can be determined. "Dunning's (1988) "eclectic paradigm" denoted that the choice of entry mode decision is influenced by three types of factors: ownership-specific factors of a firm, location-specific factors of a market and internalization advantages of integrating transactions within the firm" (Cited by Jiang in http://findarticles.com/p/articles/mi_m0OGT/is_1_3/ai_n8690377 ). One such decision making frame work has been given below which clearly describes the apt decision to be taken whether to go for FDI or other mode (www.utdallas.edu/sxl029100/IMS-5200/Chap06&07.ppt-). IV. Conclusion Though FDI has mixed impact on the host and home countries still it has gained importance in this modern economy. Merger/Acquistion has become the buzzword for the MNEs. This is seen across the sectors i.e. both in service and manufacturing goods. There is much opposition to the concept of FDI owing to the reason of security threats, imperialist domination and the balance of payment crisis but the job opportunity and the wealth creation which are the major advantages of the FDI surpasses all the hindrances. This makes the market more competitive and erodes monopoly powers of local firms. Also by facing stiff competition from the foreign counterparts the local firms are compelled to equip themselves with the new technologies, management methods and market opportunities. The rise in FDI also forces the host countries to provide a better tax policy and labour market regulations. Thus world economic integration is taking place with the MNEs being the change agents. The wealth they create boost the development as a whole. WORKS CITED CPE Globalisation Briefs. Glossary. 28th October 2006. Jiang F., "Sequence of FDI entry mode decision making process: New evidences from the multinational parmaceutical firms' FDI into China". January 2004. Find Articles. 29th October 2006. Kleinert, J. The role of Multinational Enterprises in Globalisation: An Empirical Overview, Kiel Working Papers No. 1069, Kiel Institute of World Economics:2001 Navaretti, G.B & Venables A.J. Multinational Firms in the World Economy. New Jersey: Princeton University Press, 2004 Stewart Martin, Notes on Globalisation prepared for the select committee on Economic Affairs, 28th October 2006. The WTO, Trade and Foreign Direct Investment. 9th October1996. WTO News: 1996 Press releases. 28th October 2006. UNCATD (2006), World Investment Report 2006, New York Williams Tim, Lecture Hnadnotes Read More