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FDI, Trade and Geography summary

Name: FDI, Trade and Geography summary
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Rijksuniversiteit Groningen (RuG)

Summary of the course of FDI, Trade and Geography taught in the BSC of International Business. A detailed summary the whole course including figures, definitions, and examples. The summary incldues the answers to all tutorials.

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geography
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summary
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LECTURE 1: MULTINATIONALS AND FDI - Ch. 15 p. 334-354, Markusen (2008)

FDI vs multinational activity (MNE)
Foreign investment: flow of financial capital from one country to another
1. Foreign direct investment (FDI): investor has a significant degree of control and influence on the
foreign management
2. Foreign portfolio investment (FPI): foreing investment without controlling stake
10% ownership rule is used to distinguish between the two: any flow of capital to a foreign firm in which
the investor has or gains ownership of 10% or more of the foreign firms is considered FDI
- Less than 10% means investor has limited influence on foreign manager so no controlling stakes

FDI flow: the amount of FDI moving in a certain direction during a given time interval (one year)
- FDI inflow: the volume of FDI moving into a country
- FDI outflow: the volume of FDI originating from a country

FDI stock: the total cumulative value of all FDI flows, measured at a specific time not interval
- Inward FDI stock: a snapshot of the total cumulative value of all FDI in an economy (=cumulative
value of all FDI inflows) at a given point in time
- Outward FDI: a snapshot of the total cumulative value of all FDI held abroad by resident firms
from a given country (=cumulative value of all FDI outflows) at a given point in time

Multinational enterprise (MNE): a firm that owns and controls operations in more than one country,
hence a firm that undertakes FDI
- It consists of one parent firm and one or more foreign affiliates (subsidiaries, branches)
- FDI is the most commonly used indicator of multinational activity

MNE vs FDI
An MNE is more than just the flow of FDI
- Parent firms transfer more than just financial capital (e.g. intangible assets such as know-how,
brand)
- Not all funds used for multinational financing are included in FDI data (e.g. funds borrowed in
the host country)
Not all FDI is used to finance real economic activity (e.g. “mailbox firms” in Bermuda Islands)

But the correlation between FDI and other measures of MNE activity (e.g. foreign sales, employment)
are generally high.

Multinationals finance a substantial 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 net assets
- Risk of expropriation: possibility to default on foreign liabilities if foreign government
expropriates firm assets, match value of physical assets in host with borrowings in that country

,Two types of multinational activity or FDI:
1. Horizontal (market-seeking): serving foreign markets directly (producing and selling to
customers abroad); replication of home activities in host country; Volkswagen production plants
in China, production of cars directly for Chinese market
a. Occurs between industrial companies, a firm from one industrial country owns a
company in another industrial country
b. When the foreign affiliates undertake the same kind of production as the parent firm,
the affiliate displaces some trade in that product and it expands trade through better
local marketing of other products produced by the MNE in other countries

2. Vertical (efficiency-seeking): sourcing from abroad; locating activities from a different stage of
the value chain to the host country - US oil company engaging in oil drilling in Russia
a. Firm from an industrial country owns a plant in a developing country
b. A dilemma for developing countries in their dealings with MNEs is that they fear
exploitation by powerful MNEs as well as the inability to access the benefits that MNEs
have to offer them
c. As long as transportation costs and trade barriers are low enough, FDI can reduce total
costs by locating different stages of overall production in different countries
Most real-world MNE’s do both; hybrid between the two

FDI and trade - Does FDI lead to more trade or less trade?
● FDI substitutes for trade if the firm is market-seeking and trying to get around tariffs or
transportation costs
○ Producing locally means there are no costs of importing
● FDI complements trade in when FDI is efficiency or strategic-asset (innovation) seeking
○ Overseas production generates exports back to the home country
History and key patterns:
● 1970s: FDI dominated by investments of US firms in developing countries
● 1980s: rise of FDI by European and South- and East Asian firms however it was orientated
toward developed countries (US as main receiver of FDI)
● 1990s: rising FDI into developing countries driven by low labor costs and economic reforms
● Nowadays: most FDI flows between industrialized/rich countries
● Rising role of FDI in services sector, declining role of manufacturing and primary sector

,Why do MNEs exist:
1. Inherent disadvantages of being foreign
2. Firm-specific advantages (to overcome inherent disadvantages)
3. Location factors (that favor foreign production over exporting)
4. Internalization advantages (favor direct investment over contracting with independent firms)
5. Oligopolistic rivalry (among MNEs)

Multinational activity is more than just shifting financial capital across borders because if differential
returns to capital were the only reason, firms could just engage in FPI without establishing managerial
control. This implies that there must be additional advantages of owning/controlling foreign operations:
- Firms have valuable assets and capabilities (firm-specific advantages) they want to exploit in
foreign markets (resource-based view of the firm)

Firm-specific advantages: valuable firm-specific tangible and intangible resources and capabilities, these
generate a firm-specific advantage if they are:
- Valuable: generates value for firm
- Rare: competitors do not possess it
- Inimitable: competitors cannot copy it and create it
- Non-subsitable: vital for firm success and cannot be replaced

These allow firms to overcome the inherent disadvantages of being foreign (liability of foreignness):
- Overcoming institutional, cultural, and language barriers in the foreign country
- Travel and communications costs between HQ and subsidiary
- Other costs of doing business that native firms are not facing
Firms engage in FDI to enhance these firm-specific advantages.

FDI vs alternative strategies
- FDI is not the only mean to exploit firm-specific advantages
- Alternative ways to leverage the firm-specific assets:
- Exporting to foreign markets
- Licensing to foreign firms
- Why do then firms engage in FDI if there are alternative strategies which are easier and cheaper?

FDI vs exporting - exporting directly to foreign markets is a substitute for horizontal FDI
Advantages of FDI over exporting:
● Utilize local resources (cheap labor)
● 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
● Hence loss of size advantages; economies of scale

, FDI vs licensing - licensing involves giving permission to use a firm’s assets (manufacture and sell the
firm’s product, use the firm’s proprietary technology or trademark/brand) to independent foreign firms
Advantages of FDI over licensing (internalization advantages):
● Avoid transaction costs related to licensing
● Control over how firm’s assets are used
● Reduce dissemination risk; the risk that partner turns into a competitor
Disadvantages of FDI over licensing:
● Local firms are more familiar with the foreign business environment
● High costs of establishing and managing foreign operations

Eclectic paradigm (Dunning’s OLI model)
So when do we see FDI? When a firm has the following three advantages →

1. Ownership advantages: firm-level sources of competitive advantage that help to overcome the
“liability of foreignness”:
a. Scarce, tacit firm-specific assets or resources like a great brand or proprietary technology
b. Monopoly power due to size
c. Ability of managers to identify and exploit resources and coordinate
d. Explain why firms want to enter foreign markets to begin with
2. Location advantages: presence of attractive, country-specific resources - “location-bound” :
a. Resources: natural resources that you need for your business
b. Innovations: knowledge, technology, skills, best practices, new approaches to tap into
c. Efficiency: since wages and other costs are NOT equal around the globe, companies can
exploit these differences to reduce costs
d. Comparative advantage, scale economies, governmental barriers to trade, trade bloc
e. Explain the direction of FDI
3. Internalization advantages: benefits of organizing cross-border activities “in house” instead of
through the market (the pipeline effect):
a. Incomplete contracting: where contracts fail, internal markets arise
b. Asset specificity: market parties cannot use your technology, or you do not want them to
c. Internal market for transferring tacit knowledge (knowledge intensity becomes
important)
d. When a firm resists pressures to allow outsiders to use the firm’s firm-specific
advantages and retains and uses those advantages (keep internally)
e. Explain why firms prefer FDI to licensing
i. MNEs compensate for market failure
FDI will be favored over exporting when:
➔ Transportation costs are high
➔ Trade barriers are high
FDI will be favored over licensing when:
➔ The firm wants control over its technology
➔ The firm wants strategic control over operations
➔ Firm’s capabilities are not amenable to licensing

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