Foreign Direct Investment - Assignment Example

FDI is an appropriate mode of entry for certain industries and organisations but not for others. Using 2 different industries or organisations demonstrate how FDI can be (1) successful for one and(2) disastrous for the other. Please allocate about half your essay to address (1) and the other half to address (2). As part of (2), for your chosen industry or organisation that should not consider FDI, suggest another mode of entry that it should utilise. Also explain why this is a better strategic choice Abstract The amount of FDI (Foreign Direct Investment) in a country has largely been attributed to the effectiveness of the host states and their legal apparatus and machinery in the attraction and accommodation of these investors. However the FDI strategy is not always a beneficial means of investment and in this vein this essay will look at the effectiveness of the conditions in the Host countries which possibly attract FDI growth in relation to western and under developed countries and whether the data from large organisations like the World Bank is to be trusted in making competitive decisions about the FDI success and strategy.In this vein the question will discuss alternatively with examples whether the success factors for FDI hold true for some industries and may be disadvantageous to some industries. Introduction Foreign direct investment or FDI can be defined as an investment made to obtain long lasting shares or interest in out of country enterprises. There will always be a parent enterprise with some sort of a foreign affiliation the co-operation of whom would be known as a translational corporation (TNC) and the parent enterprise will have a 10% or more share control of its foreign affiliate. The Post World War II the position was that the US was dominating the world share of FDI by three quarters of the entire market share. The US at this point had around three-quarters of the Global FDI (1945 and 1960).However today in the age of globalisation the FDI is no longer a phenomena restricted to OECD countries. FDI growth is very important for the modern global economy with the FDI stocks now constituting over 20 percent of global GDP. Inward FDI happens when there is an investment of foreign capital within a country’s own local resources and can be attracted by tax holidays and tax subsidies, low rates of interest, and more investor friendly laws. However ownership restraints or differential performance requirements are likely to discourage FDI. Outward FDI is local investment in foreign resources and is encouraged by a positive role of the host governments in providing insurance and tax breaks for these people who want to trade abroad. Therefore “Foreign Direct Investment” can be both inwards and outwards for the economy. Can the FDI benefit the economy? Academics have expressed a lot of scepticism over the fact whether FDI has been meaningful to the contribution to domestic growth .According to Froot (1993), FDI outwards does not actually require neither capital flows nor investment in capacity but is a mere extension of corporate control over international boundaries: Therefore the recent ability of the FDI to benefit or profit an economy has also suffered from criticism as to its negative effects. In the case of Developing Countries a comprehensive study by Bosworth and Collins (1999) investigated evidence concerning the effect of capital inflows and found that multinationals find it cheaper to expand directly in a foreign country rather than through trade “ in cases where the advantages associated with cost or product are based on internal, indivisible assets based on knowledge and technology.” The assertion whether large inflows of foreign capital present developing countries with a good opportunity in accelerating their economic development or not is a big question mark for economists in the light of the recent developments that have taken place in the Asian markets. With the governments of developing countries actively seeking our FDI’s for their countries there is a large disagreement amongst economists and development agencies whether FDI flows are to some extent determined by the effectiveness of host state legal systems .The main players in the risks associated with FDI’s are the host states, foreign investors and those engaged in development assistance and theorising(like the World bank.). So why has East Asia become a phenomenal success in this regard? This is mainly because of the factors affecting the location of FDI, in terms of , natural resource-securing type, market-securing type, and cost-saving type. The factors determining the location of FDI are different for these three types of FDI and a major determinant of market-securing type FDI is the presence of a large consumer population which is very characteristic of Asian countries. In Asia the cost saving FDI is done by export-oriented foreign firms. The aim is to set up low cost production bases. Interesting because of the low wages and the exchange rate gap much of the FDI in Asia since the mid-1980s has been the cost-saving type particularly prominent in the electric and electronics industry. Example of FDI success in East Asian Countries The Pepsi Vs Coke Saga in China This case study shows as it will be discussed later that FDI is not just based upon strategic factors but also in the case of consumer goods upon the marketing strategies and advertising budgets of the Multinationals who invest in foreign countries.Take the example of the two Cola Giants.In a bid to defeat its arch enemy Pepsi, Coke has made an excellent use of its marketing strategies to capture some of the most lucrative markets around the world. (Jian Wang 1996) The purpose of mentioning this market share war is to show how the two Cola Giants, Coke and Pepsi have used the broad purpose of marketing instead of following the narrow, functionalist approach to actually carry out strategic marketing planning to tilt the profits in their favour. Coca Cola’s strategic planning involved heavy marketing in the form beverage festivals and the like to advertise and research through many drinks to suit the Chinese tastes. At these festivals the Chinese folk artists were invited to make paper-cuts and mold clay dolls, in order to better combine traditional Chinese art with a foreign brand. In this way the Coca-Cola Company knew exactly how to further make and implement their strategic plans.To counter this in China, Pepsi also spent huge amounts of money to invite famous singers, stars and soccer players to promote its products. This was known as the “soccer & music” promotional strategy and very obviously based on a heavy amount of marketing! (Jian Wang 1996) As an FDI investment success all the marketing and strategic planning therefore required an understanding of the unique problems of the Chinese market. The majority of the soft-drink bottlers are state-owned and they formed an oligopoly. Therefore keeping the costs in mind and the prices very low, a strategy of marketing through the local bottlers was adopted by both the Cola giants for an easier and politically safer bet.Apart from pricing and strategic planning, marketing was the main tool through which these Cola Giants have achieved the status they wanted in China. (Jian Wang 1996) . Factors pertaining to FDI failure in East Asia Case study of Japanese FDI in East Asia(Electronic Goods) There has to be an effective use of legal and economic reforms which balance domestic commercial and non-commercial interests. The following diagram shows the rise and fall of FDI in a China .Notice how the trends are very irregular thus putting the whole benefit of the FDI in doubt.1 The last two decades have seen an increase in the FDI within Asia and FDI rates have peaked in the mid nineties. FDI has had a large role in promoting the growth of the “Asian Tigers” and has played a large role in Asia’s more globalised trade structure. Asia, especially East Asia, has been very focal in attracting FDI.According to UN statistics the growth in the FDI destined to Asia has increased ten times in past two decades. During the period of 1985 to 1995 alone FDI inflow increased from 39 percent to 57 percent over the 1985-94 period.The Japanese FDI outflow has been phenomenal with a total of ten percent of an increase during 1985-1994 alone. The electric and electronics FDI industry has been dominated by Japan in the past two decades.2 Feenstra (1998) has discussed the case of the Japanese electronics firms who when faced with losing price competitiveness of their products (due to the drastic yen appreciation in the mid-1980s) so they decided to set up their production bases in low cost locations like Korea and Taiwan, to maintain their price competitiveness. Later on as all the FDI increased the exchange rates of Korea and Taiwan as well they too stopped being FDI favourites in the early nineties.The Japanese firms were now faced with the dilemma of shifting their FDI’s back into ASEAN countries to avail the advantages of low cost labour. The same happened to the ASEAN countries eventually and their exchange rates increased as well. Now Japan chose China for its large consumer market and low wages. China’s recent measures have no been very pro-FDI either and therefore it seems that China is no longer a low cost favourite of the FDI’s. China seems to have lost its low cost attractiveness to foreign firms therefore. Towards some conclusions: Evaluation of the case studies and alternative forms of investment Early economists like Caves(1971) explained FDI in microeconomic terms where the focus was on market imperfections along with the desire of the multinational enterprises to gain monopolistic control. Subsequently it is possible to see an approach which is more focused on firm-specific advantages owing to product superiority or cost advantages, and the benefits of technology (Helpman(1984).The modern view suggests that FDI happens because Multinationals find it cheaper to expand directly into foreign low cost countries like those in Asia. Other theories have shown that FDI emerges by the positive role of regulatory restrictions, including tariffs, quotas, that either encourage or discourage cross-border acquisitions.Macroeconomic factors like low exchange rate in the host country and therefore cheaper raw materials are another reason given for a profitable FDI.The theory of wealth effect is another way through which a depreciation of the real exchange rate could raise FDI. This has been argued by( Froot 1991 )that the interaction of the relative wealth of foreign firms, with the depreciated exchange rate causes profits.FDI brings with it many advantages like technology and modern capital.(Blomstrom, Kokko and Globerman (2001)). The theories of FDI often emphasise on the developed/developing country dichotomy and an example would be the “product cycle” model of Vernon who has described how models are created with in developed countries, where production first occurs, and then as the production process is standardized they will shift its production to lower wage developing countries. Vernon emphasises that this shift will occur in most firms but Feenstra (1998) disagrees to the extent that it ignores the fact the majority of foreign investment flows have been between developed countries. Almost 75 % of the worlds stock of direct investment is currently located in developed countries, with only 25% in developing countries. .The conditions of law and government in the host country will inevitable affect the choice of a country as an FDI location. More importantly the notion of the FDI involves the decisions of which activities to keep internal to a firm and what to outsource. It can be said that activities only internal to the firm will be included in the FDI,otherwise outsourcing is a good solution for FDI’s. For example a firm that invests in a country might want to bring with it the new technology and lead to a transfer of intangible assets from the parent to host country. This can also be reversed when the parent firm will end up benefiting and taking its newly learnt knowledge home. Feenstra (1998) has pointed out some interesting myths and fallacies which have rooted themselves deep in economic theory and can potential distort an FDI’s vision. She argues that depreciation of the dollar has played a significant role in increasing the flow of FDI. The diagram below shows the FDI trends in countries operating on a Foreign Currency surplus or Deficit and the resultant effect on the economies. FDI is not exactly a positive sign for an economy sometimes. For one thing it increases local prices and other costs of production. Take the example of South Asia. The advent of multinational firms means there is a lot of money coming in and people are getting jobs. But the expectations of the labour force rise unnaturally because of the superior exchange rates of the FDI investor and as a result local growth gets painfully stunted. This is not the end of the story however .If you see the example of Japan above, FDI’s are unreliable. They opportunistically enter a low cost location, exploit their resources for their own business and take the profits outside the host country. As soon as the exchange rates will rise they will tend to take flight in search of greener pastures so reliance of an economy on FDI should be temporary only. An alternative to putting its hopes in the FDI would be for the country to invest in producing goods at home shipping them abroad to avoid inflation in the country due to the increased FDI coming in. This will avoid the costs of FDI in the environmental and cultural context as Multinationals cause pollution and disorganise the local work force. Because of the forex advantage they are able to pay higher wages and this means that the local industries also have to increase their costs which ultimately results in the local products becoming too expensive and a paralysis within the local industry. All this will be avoided if a country would focus more on exporting its materials. References 1. Rui Albuquerque, 2000, "The Composition of International Capital Flows: Risk Sharing through Foreign Direct Investment," Bradley Policy Research Center Working Paper No. FR 00-08 (Rochester, New York: University of Rochester). 2. Blomstrom, M., Kokko, A. and Globerman, S. (2001), “The Determinants of Host Country Spillovers from Foreign Direct Investment: A Review and Synthesis of the Literature," in: Pain, N. (ed.) Inward Investment, Technological Change and Growth: The Impact of Multinational Corporations on the U.K. Economy, Palgrave Press. 3. Eduardo Borensztein, Jose De Gregorio, and Jong-Wha Lee, 1998, "How Does Foreign Direct Investment Affect Growth?" Journal of International Economics, Vol. 45, pp. 115-35. 4. Barry P. Bosworth and Susan M. Collins, 1999, "Capital Flows to Developing Economies: Implications for Saving and Investment," Brookings Papers on Economic Activity:1, Brookings Institution, pp. 143-69. 5. Caves, Richard E., 1971, "International Corporations: The Industrial Economics of Foreign Investment," Economica, Vol. 38(February), pp. 1-27. 6. Kenneth A. Froot, 1991, "Japanese Foreign Direct Investment," Working Paper No.3737, issued in June 1991, Published in US-Japan Economic Forum, edited by Martin Feldstein and Kosai. 7. Hart, Oliver (2000), “Financial Contracting,” Nancy L. Schwartz Lecture, Kellog Graduate School of Management, Northwestern University. 8. Joel Hecht, Assaf Razin, and Nitsan Shinar, 2002, “Capital Inflows and Domestic Investment: New Econometric Look,” mimeo, Bank of Israel. 9. Elhanan Helpman,1984, A Simple Theory of International Trade with Multinational Corporations, June, Vol 92, pp. 451-471 10. Prakash Loungani, Assaf Razin, ”How Beneficial Is Foreign Direct Investment For Developing Countries?” Finance and Development, June 2001,Volume 38, Number 2, pp: 6-10. 11 11. Prakash Loungani, Ashoka Mody, Assaf Razin, and Efraim Sadka, 2003, The Role of Information in Driving FDI: Theory and Evidence, Paper presented in the North American Winter Meeting of the Econometric Society on January 3 - 5, 2003. 12. Assaf Razin and Efraim Sadka, 2002, Labor, Capital and Finance: International Flows (New York and Cambridge, England: Cambridge University Press). 13. Assaf Razin and Efraim Sadka (forthcoming) , “Gains from FDI Inflows with Incomplete Information”, Economics Letters. 12 14. Barrell, R. and N.Pain (1997). 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Foreign Direct Investment and the Labour Market: A Review of Evidence and Policy Implications, Oxford Review of Economic Policy. 16(3): 90–103.10.1093/oxrep/16.3.90 21. Economic Report of the President (Transmitted to Congress, February 1999), Washington, DC: USGPO, 1999. 22. Figlio, D.N. and B.A.Blonigen (2000). The Effects of Foreign Direct Investment on Local Communities, Journal of Urban Economics. 48(2): 338–363.10.1006/juec.2000.2170 23. Friedman, J., D.A.Gerlowski and J.Silberman (1992). What Attracts Foreign Multinational Corporations? Evidence from Branch Plant Location in the U.S., Journal of Regional Science. 32: 403–418. 24. Feenstra.R,(1998),Facts and Fallacies about FDI.,University of California. 25. Jian Wang 1996, Foreign Advertising in China: Becoming Global, Becoming Local Read More