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Summary FDI, trade and geography
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Lecture week 1Foreign investment = Flow of financial capital from one country to another.
1. Foreign direct investment (FDI) = Investor has a significant degree of control of and
influence on the foreign management.
2. Foreign portfolio investment (FPI) = Foreign portfolio investment without controlling
stake.
→ 10 percent ownership rule: Has ownership of 10 percent or more of the foreign firm is
considered FDI.
FDI flows vs. FDI stocks
FDI flow = the amount of FDI moving in a certain direction during a given time interval. (period)
1. Inflow: The volume of FDI moving into a country.
2. Outflow: The volume of FDi originating from a country.
FDI stock = Total cumulative value of all FDI flows (snapshot)
1. Inward: Total cumulative value of all foreign direct investments in a economy at a given
point of time
2. Outward: Total cumulative value of all foreign direct investments held abroad by resident
firms from a given country at a given point in time.
Multinational enterprise (MNE)
MNE = A firm that own and controls operations in more than one country = a firms that
undertakes FDI
→ One parent firm, one or more foreign affiliates.
MNE vs. FDI
MNE is more than just the flow of FDI
- Parent firms transfer more than just financial capital.
- Not all funds used for multinational financing are included in FDI data.
Multinationals finance an amount of their activities by borrowing in the host country → Why?
Exchange rate risk: Take on liabilities and assets denominated in foreign currency to reduce
fluctuations in the value of the net assets
Risk of expropriation: Possibility to default on foreign liabilities if foreign government
expropriates firm assets
,Types of FDI
Horizontal (market seeking): Serving foreign markets directly, replication of home
activities in host country.
Vertical (efficiency seeking): Sourcing from abroad; locating activities from a different
stage of the value chain to the host country (get access to different materials,
outsourcing)
,FDI and trade
Horizontal leads to reduction of trade, so FDI substitutes for trade if the firm is market-seeking.
→ Producing locally avoids cost of importing
Vertical leads to more trade, so FDI complements trade in situations where FDI is efficiency
seeking.
→ Overseas production generates exports back to the home country.
Summary:
Foreign investment that leads to control over foreign operations is considered FDI.
FDI is the main indicator of multinational activity.
FDI can be a substitute or a complement to trade.
Most FDI flows between rich countries.
Why do MNEs exist?
Multinational activity is more than just shifting financial capital across borders
- If this was the case firms could just engage in FPI, without establishing managerial
control.
Implies that there must be additional advantages of owning foreign operations.
- Firms have valuable assets and capabilities (FSA’s) they want to exploit in foreign
markets
Firm-specific advantages
Firm-specific advantage = valuable firm-specific tangible and intangible resources and
capabilities.
Resources and capabilities generate a firm's specific advantage if they are:
- Valuable
- Rare
- Inimitable
- Non-substitutable
→ allow the firms to overcome inherent disadvantages of being foreign. (liability of
foreignness)
- Overcoming institutional, cultural and language barriers.
- Travel and communications costs
- Not native costs
FDI vs. alternative strategies
1. Exporting to foreign markets
2. Licensing to foreign firms.
FDI vs. exporting
Exporting directly to foreign markets is a substitute for a horizontal FDI
Advantages of FDI over exporting:
- Utilize local resources
, - Circumvent import restrictions in foreign country and avoid transportation costs
- Get access to trade blocs
- Proximity to foreign customers
Disadvantages of FDI over exporting
- Production takes place in multiple locations
- Loss of size advantaged (economies of scale)
FDI vs. licensing
Licensing = Giving permission to use a firm’s assets
Advantages of FDI over licensing (internalization advantages(=organizing a foreign activity
within the boundaries of the firm rather than through the market):
- Avoid transaction costs relate to licensing
- Control over how firm’s assets are used
- Reduce dissemination risk (verspreidingsrisico)
Disadvantage of FDI over licensing:
- Local firms are more familiar with the foreign business environment
- High costs of establishing and managing foreign operations
Dunning’s OLI model:
Ownership advantages: Firm-level source that helps to overcome ‘liability of foreignness
- Scarce, tacit FSA (great brand or new technology)
- Ability of managers to identify and exploit resources and coordinate
- Monopoly power
Location advantages: Attractive, country specific resources that are ‘location-bound’.
- Resources
- Innovations: knowledge, technology, skills etc.
- Efficiency: wages, costs etc.
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