Chapter 07 - Foreign Direct Investment

Foreign Direct Investment

Chapter Outline
OPENING CASE: Lakshmi Mittal and the Growth of Mittal Steel INTRODUCTION FOREIGN DIRECT INVESTMENT IN THE WORLD ECONOMY Trends in FDI The Direction of FDI Country Focus: Foreign Direct Investment in China The Source of FDI The Form of FDI: Acquisitions versus Greenfield Investments The Shift to Services THEORIES OF FOREIGN DIRECT INVESTMENT Why Foreign Direct Investment Management Focus: Foreign Direct Investment by Cemex The Pattern of Foreign Direct Investment The Eclectic Paradigm POLITICAL IDEOLOGY AND FOREIGN DIRECT INVESTMENT The Radical View The Free Market View Pragmatic Nationalism Shifting Ideology Management Focus: DP World and the United States BENEFITS AND COSTS OF FDI Host Country Benefits Host Country Costs Home Country Benefits Home Country Costs International Trade Theory and FDI

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GOVERNMENT POLICY INSTRUMENTS AND FDI Home Country Policies Host Country Policies International Institutions and the Liberalization of FDI FOCUS ON MANAGERIAL IMPLICATIONS The Theory of FDI Government Policy SUMMARY CRITICAL THINKING AND DISCUSSION QUESTIONS CLOSING CASE: Starbucks Foreign Direct Investment

Learning Objectives
1. Be familiar with current trends regarding FDI in the world economy. 2. Understand the different theories of foreign direct investment. 3. Appreciate how political ideology shapes a governments attitudes towards FDI. 4. Understand the benefits and costs of FDI to home and host countries. 5. Be able to discuss the range of policy instruments that governments use to influence FDI. 6. Articulate the implications for management practice of the theory and government policies associated with FDI.

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Chapter Summary
This chapter focuses on the topic of foreign direct investment (FDI). FDI occurs when a firm invests directly in new facilities to produce and/or market a product in a foreign country. At the outset, the chapter discusses the growth in FDI, particularly by medium-sized and small firms. The theoretical underpinnings of FDI are discussed, which describe under what circumstances it is advantageous for a firm to invest in production facilities in a foreign country. The chapter also addresses the different policies that governments have toward foreign direct investment. Some governments are opposed to FDI and some governments encourage it. Three specific ideologies of FDI are discussed, including the radical view, the free market view, and pragmatic nationalism. The chapter also provides a discussion of the costs and benefits of FDI from the perspective of both the home country and the host country involved. The chapter concludes with a review of the policy instruments that governments use to regulate FDI activity by international firms.

Opening Case: Lakshmi Mittal and the Growth of Mittal Steel

Summary The opening case explores the growth of Mittal Steel. Mittal Steel began as a family-run company in India 1975. By 2007, Mittal Steel was the largest steel company in the world with sales of $110 billion, and a net income of $10.2 billion. Mittal Steels growth strategy involved acquiring distressed companies on the cheap, modernizing them, and taking advantage of an anticipated boom in global steel demand. The following questions can be used to generate discussion of the case: Suggested Discussion Questions QUESTION 1: How did Mittal Steel grow from almost nothing to be the worlds largest steel company in such a short time? How important were the companys foreign acquisitions to its success? ANSWER 1: Mittal Steel began as a small family-run firm in India in 1975. The company acquired a Trinidadian plant in 1989 after helping, under contract, to turn the firm around. Mittal Steel continued making acquisitions throughout the next decade, focusing primarily on companies that were in distress that could be acquired cheaply, modernized, and made more efficient. Most students will probably agree that Mittal Steels strategy was essential to its success because it helped to position the company well when global demand for steel exploded in the 2000s.

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QUESTION 2: Why was Mittal Steels acquisition of Arcelor so controversial? Do you agree with those who opposed the acquisition? Why or why not? ANSWER 2: Arcelor was a European firm that was formed as a result of a merger between steel makers from Luxembourg, France, and Spain. Mittal Steel began its hostile takeover of Arcelor in 2006. Arcelors management strongly resisted the takeover attempt, as did a number of European politicians who felt that it was wrong for an Indian company to acquire the European firm. Many students will agree with the European politicians and management of Arcelor suggesting that the acquisition made Mittal Steel the worlds largest steel company, and therefore, gave the company a certain amount of monopoly power. Some students may also suggest that the acquisition left Europe without a significant player in the industry. Other students however will side with Mittal Steel and point out that the deal was appealing to Arcelors shareholders, who ultimately approved the deal. Teaching Tip: For more information on Mittal Steel go to {http://www.mittalsteel.com/index.htm}.

Chapter Outline with Lecture Notes, Video Notes, and Teaching Tips
INTRODUCTION A) This chapter is concerned with the phenomenon of foreign direct investment (FDI). Foreign direct investment occurs when a firm invests directly in new facilities to produce and/or market in a foreign country. Once a firm undertakes FDI it becomes a multinational enterprise. Teaching Tip: Fortune magazine publishes a list of the 500 largest global corporations in the world. For more information, go to {http://money.cnn.com/magazines/fortune/global500/2007/. The article also breaks down the list by country, and is an excellent resource for discussing the role of large multinationals in the world economy. B) FDI takes on two main forms; the first is a greenfield investment, which involves the establishment of a wholly new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country. There are three types of acquisitions: minority (10 percent to 49 percent stake), majority 50 percent to 99 percent), or full (100 percent). FOREIGN DIRECT INVESTMENT IN THE WORLD ECONOMY A) When discussing foreign direct investment, it is important to distinguish between the flow and the stock of foreign direct investment. The flow of FDI refers to the amount of FDI undertaken over a given time period (normally a year). The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. Outflows of FDI, meaning the flow of FDI out of a country, and inflows of FDI, meaning the flow of FDI into a country are also discussed.

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Trends in FDI B) Over the past 30 years there has been a marked increase in both the flow and stock of FDI in the world economy. The significant growth in FDI has both to do with the political economy of trade as outlined in the previous chapter and the political and economic changes that have been taking place in developing countries. C) FDI has grown more rapidly than world trade and world output for three reasons. First, firms still fear the threat of protectionism. Second, the general shift toward democratic political institutions and free market economies has encouraged FDI. Third, the globalization of the world economy is having a positive impact on the volume of FDI as firms undertake FDI to ensure they have a significant presence in many regions of the world. The Direction of FDI D) Historically, most FDI has been directed at the developed nations of the world, with the United States being a favorite target. FDI inflows have remained high during the early 2000s for the United States, with $192 billion in 2007, and also for the European Union. Inward investment into the European Union was $610 billion in 2007. E) South, East, and Southeast Asia, and particularly China, are now seeing an increase of FDI inflows. China attracted nearly $70 billion in FDI from 2005 to 2007. Latin America is also emerging as an important region for FDI. Inward investment to the region was about $126 billion in 2007. F) Gross fixed capital formation summarizes the total amount of capital invested in factories, stores, office buildings, and the like. All else being equal, the greater the capital investment in an economy, the more favorable its future prospects are likely to be. Thus, FDI can be seen as an important source of capital investment and a determinant of the future growth rate of an economy. Teaching Tip: The United Nations Conference on Trade and Development (UNCTAD) provides extensive statistics on the flows of foreign direct investment and the operations of transnational companies. For more information, go to {http://www.unctad.org/Templates/Page.asp? intItemID=1923&lang=1}.

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Country Focus: Foreign Direct Investment in China Summary This feature explores investment opportunities in China. In the late 1970s, China opened its doors to foreign investors. By the mid 2000s, China attracted $65-70 billion of FDI annually. Chinas large population is a magnet for many companies and because high tariffs make it difficult to export to the Chinese market, firms frequently turn to foreign direct investment. However, many companies have found it difficult to conduct business in China, and in recent years investment rates have slowed. In response, the Chinese government, hoping to continue to attract foreign companies has established a number of incentives for would-be investors. The following questions can be used in a discussion. 1. Consider the challenges involved with investing in China. How does Chinas political position and economic situation affect its ability to attract foreign direct investment? Discussion Points: Students will probably recognize that while on the surface, China has tremendous market potential, it is still a poor country. Anticipated demand does not always translate into actual demand. In addition, thanks to the countrys lack of a well-developed transportation system, distribution problems continue to exist, particularly outside major urban areas. In addition, the countrys highly regulated environment makes it difficult for companies to conduct business. 2. Discuss Chinas efforts to encourage investment in its underdeveloped areas. What effect will investment have on these areas? How can firms prepare for the unique challenges of operating in these areas? Discussion Points: China is making a concerted effort to continue to attract investment, especially in the countrys less developed areas. Recognizing the problems associated with its infrastructure, the country has committed $800 billion to improvements over the next decade. In addition, China is offering preferential tax breaks to countries that invest in more remote areas. Lecture Note: Some experts believe that a certain amount of interdependency has been established between the United States and China that will influence the policy decisions of the two countries. For more information, go to {http://www.businessweek.com/globalbiz/content/jul2007/gb20070718_614386.htm?chan=search}. Lecture Note: Some foreign companies with investments in China have recently become targets of intense criticism. For more details, go to {http://www.businessweek.com/globalbiz/content/may2008/gb20080530_213248.htm?chan=search}. Video Note: The iGlobe China Rising Part 1: The Boom - Chinas Rising Economy fits in well with this feature.

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The Source of FDI G) Not only has the flow of FDI been accelerating, but its composition has also been changing. For most of the period after World War II, the United States was by far the largest source country for FDI. Other important source countries include the United Kingdom, the Netherlands, France, Germany, and Japan. Together, these countries accounted for 56 percent of all FDI outflows from 1998 to 2006, and 61 percent of the total global stock of FDI in 2006. The Form of FDI: Acquisitions versus Greenfield Investments H) The majority of cross-border investment is in the form of mergers and acquisitions rather than greenfield investments. Firms prefer to acquire existing assets rather than undertake greenfield investments because (1) mergers and acquisitions are quicker to execute than greenfield investments; (2) it is easier and perhaps less risky for a firm to acquire desired assets than build them from the ground up; and (3) firms believe that they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills. The Shift to Services I) The last two decades have seen a shift in the composition of FDI away from extractive industries and manufacturing towards services. The shift to services is being driven by 1) the general move in many developed countries away from manufacturing toward services; 2) the fact that many services cannot be traded internationally, and need to be produced where they are consumed; 3) the move by many countries to liberalize their regimes governing FDI in services; and 4) the rise of Internet-based global telecommunications networks that has allowed some service enterprises to relocate some of their value creation activities to different nations to take advantage of favorable factor costs. Video Note: The iGlobe Graduate Students Recount Experiences with Globalization explores the effects
of globalization, including investment by multinational firms from the perspective of several students from different countries. The iGlobe ties in well with a discussion of what investment means to countries, and who wins and who loses.

THEORIES OF FOREIGN DIRECT INVESTMENT A) In this section of the text, several theories of foreign direct investments are discussed. These theories attempt to explain the observed pattern of foreign direct investment flows. Why Foreign Direct Investment? B) Why do so many firms apparently prefer FDI to either exporting (producing goods at home and then shipping them to the receiving country for sale) or licensing (granting a foreign entity the right to produce and sell the firms product in return for a royalty fee on every unit that the foreign entity sells)? The answer lies in the limitations of these methods for exploiting foreign market opportunities.

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Limitations of Exporting C) The viability of an exporting strategy is often constrained by transportation costs and trade barriers. Much foreign direct investment is undertaken as a response to actual or threatened trade barriers such as import tariffs or quotas. Limitations of Licensing D) There is a branch of economic theory known as internalization theory (also known as the market imperfections approach) that seeks to explain why firms often prefer foreign direct investment to licensing as a strategy for entering foreign markets. According to internationalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities. (1) First, licensing may result in a firms giving away valuable technological know-how to a potential foreign competitor. (2) Second, licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability. (3) Third, a problem arises with licensing when the firms competitive advantage is based not so much on its products as on the management, marketing, and manufacturing capabilities that produce those products. Such capabilities are often not amenable to licensing. E) So, when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing. (i) when the firm has valuable know-how that cannot be adequately protected by a licensing contract, (ii) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (iii) when a firms skills and know-how are not amenable to licensing. Advantages of Foreign Direct Investment F) It follows from the above discussion that a firm will favor FDI over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favor FDI over licensing when it wishes to maintain control over its technological know-how, or over its operations and business strategy, or when the firms capabilities are simply not amenable to licensing.

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Management Focus: Foreign Direct Investment by Cemex Summary This feature examines Cemexs rise to global status. Cemex is the worlds third largest cement company and Mexicos largest multinational company. In Mexico, Cemex is known for its efficient manufacturing and excellent customer service. Cemex began its international expansion in an effort to reduce its reliance on the Mexican market, to capitalize on demand in developing countries and its knowledge of the needs of developing companies, and finally, to increase its value by acquiring inefficient companies and transferring its skills to those companies. Cemex plans to continue its foreign expansion, and believes that China and India will be important markets in the future. The following questions can be used in a discussion. 1. Reflect on the decision made by Cemex with regard to international expansion. Why do you think the company chose to invest directly in other countries rather than export? Why was it more attractive for Cemex to acquire companies in foreign markets rather than establish its own operations? Discussion Points: Most students will quickly recognize the difficulties inherent in shipping cement. In the case of Cemex, transportation is made even more critical because of the short set time involved with its product. Cemex sells ready-mixed cement that has a life of just 90 minutes. Therefore, it is essential for Cemex to be close to its customers, which implies that exporting is not an option for the company. In addition, one of Cemexs competitive advantages lies in its superior customer service and relationship with distributors advantages that could be difficult to transfer through licensing agreements. Most students will probably suggest that Cemexs apparent preference for acquisitions over greenfield investments probably reflects the companys desire to quickly establish a presence in the foreign market. 2. What benefits does Cemex bring to host countries? Why do you think the Indonesian government was suspicious of the companys intentions there? Do you agree with the companys decision to pull out of the market? Discussion Points: Most students will probably agree that in addition to providing jobs in host countries, Cemex also brings benefits like new technology, management know-how, and marketing know-how. Students may also note that because Cemex often acquires existing companies, it helps bring these companies to full production. Many students may suggest that Cemex did not fare as well in the Indonesian market because of its dispute with the Indonesian government. Cemex had been promised a majority position in the government-owned cement company, Semen Gresik, a promise that never materialized. Students may suggest that trust is essential in business, and the fact that the Indonesian government did not follow through with its promises justified Cemexs actions in the country. Teaching Tip: To learn more about Cemexs foreign operations, go to {http://www.cemex.com/}.

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The Pattern of Foreign Direct Investment G) Observation suggests that firms in the same industry often undertake foreign direct investment around the same time and tend to direct their investment activities towards certain locations. Strategic Behavior H) One theory used to explain foreign direct investment patterns is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. Knickerbocker looked at the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms). A critical competitive feature of such industries is the interdependence of the major players: what one firm does can have an immediate impact on the major competitors forcing a response in kind. I) Knickerbockers theory can be extended to embrace the concept of multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries.) The Product Life Cycle J) Vernons view is that firms undertake FDI at particular stages in the life cycle of a product they have pioneered. They invest in other advanced countries when local demand in those countries grows large enough to support local production. They subsequently shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressures. Investment in developing countries, where labor costs are lower, is seen as the best way to reduce costs. K) What Vernons theory fails to explain, however, is why it is profitable for a firm to undertake FDI at such times, rather than continuing to export from its home base, and rather than licensing a foreign firm to produce its product. The Eclectic Paradigm L) The eclectic paradigm has been championed by the British economist John Dunning. Dunning argues that in addition to the various factors discussed above, location-specific advantages (that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets) and externalities (knowledge spillovers that occur when companies in the same industry locate in the same area) are also of considerable importance in explaining both the rationale for and the direction of foreign direct investment. POLITICAL IDEOLOGY AND FOREIGN DIRECT INVESTMENT A) Historically, ideology toward FDI has ranged from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economies. Between these two extremes is an approach that might be called pragmatic nationalism.

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The Radical View B) The radical view tracts its roots to Marxist political and economic theory. Radical writers argue that the multinational enterprise (MNE) is an instrument of imperialist domination. They see MNEs as a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries. By the end of the 1980s, however, the radical position was in retreat almost everywhere because of 1) the collapse of communism in Eastern Europe; 2) the generally abysmal economic performance of those countries that embraced the radical position, and a growing belief by many of these countries that, contrary to the radical position, FDI can be an important source of technology and jobs and can stimulate economic growth; and 3) the strong economic performance of developing countries that embraced capitalism rather than ideology. The Free Market View C) The free market view argues that international production should be distributed among countries according to the theory of comparative advantage. The free market view has been embraced by a number of advanced and developing nations, including the United States and Britain. Pragmatic Nationalism D) The pragmatic nationalist view is that FDI has both benefits - such as inflows of capital, technology, skills and jobs - and costs, such as repatriation of profits to the home country and a negative balance of payments effect. E) Recognizing this, countries adopting a pragmatic stance pursue policies designed to maximize the national benefits and minimize the national costs. According to this view, FDI should be allowed only if the benefits outweigh the costs. Shifting Ideology F) In recent years the center of gravity on the ideological spectrum has shifted strongly toward the free market stance creating a surge in FDI. However, some countries such as Venezuela and Bolivia have become increasingly hostile to FDI. The Management Focus feature on DP World provides more insight to this countertrend.

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Management Focus: DP World and the United States Summary This feature explores the reaction to the bid by DP World, a Dubai-based ports operator, to acquire P&O, a British firm that runs a network of global marine terminals. An acquisition of P&O would give DP World management of six U.S. ports. While the Bush administration claimed the acquisition posed no threat to national security, several prominent U.S. Senators raised concerns about the acquisition. Ultimately, DP World pulled out of the deal, but stated that it would look for alternative ways to enter the U.S. market, beginning with an initial public offering in 2007. The following questions can be used in a discussion. Suggested Discussion Questions 1. Do you agree with the senators who raised concerns about the DP World deal? Why or why not? Would your response be different if DP World were a British firm? Discussion Points: This issue will probably generate significant debate among students. At the heart of the issue is whether a company, because of its country of origin, should be denied ownership of something that could be important to a nations national security. Some students will probably argue that the United States was unjustified in its reaction to the deal, that DP World has a long history of American associations. Students taking this perspective will probably suggest that the United States is being prejudiced against the company simply because of its nationality. Other students however, will probably claim that DP Worlds role in with American companies to date, has not involved ownership of ports that could be important to the countrys national security. Students in this camp will probably argue that the ports should be owned by American companies, or at least companies from countries that are allies of the United States in order to preserve national security, but definitely not a state-owned company from the Middle East. The implication here is that ownership of the ports would effectively transfer to a foreign government. 2. DP World has vowed to enter the United States market in some other way. Why is the U.S. market so important to DP World? What do you think the response of the government might be to another attempt by DP World? Discussion Points: The U.S. market is important to DP World because it is an epicenter of capitalism. Goods from all over the world flow to the United States, and DP World wants to be in a position to capitalize on this. Students will probably agree that should the company make another attempt to gain a foothold in the market, the United States will be reluctant to allow DP World a significant role in the country, especially in major ports. Teaching Tip: For more information on the company and its recent developments, go to {http://portal.pohub.com/portal/page?_pageid=761,1&_dad=pogprtl&_schema=POGPRTL } and click on Marine Terminals.

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BENEFITS AND COSTS OF FDI A) Most governments take a pragmatic nationalist approach to FDI, and weigh its costs and benefits when making policy decisions. The costs and benefits of FDI differ according to whether it is considered from a host country perspective or from a home country perspective. Host Country Benefits B) The main benefits of inward FDI for a host country are: the resource transfer effect, the employment effect, the balance of payments effect, and effects on competition and economic growth. Resource-Transfer Effects C) FDI can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available. Employment Effects D) The beneficial employment effect claimed for FDI is that FDI brings jobs to a host country that would otherwise not be created there. Balance-of-Payments Effects E) The effect of FDI on a countrys balance-of-payments accounts is an important policy issue for most host governments. A countrys balance-of-payments account is a record of a countrys payments to and receipts from other countries. The current account is a record of a countrys export and import of goods and services. F) Governments typically prefer to see a current account surplus than a deficit. There are two ways in which FDI can help a country to achieve this goal. First, if the FDI is a substitute for imports of goods and services, the effect can be to improve the current account of the host countrys balance of payments. A second potential benefit arises when the MNE uses a foreign subsidiary to export goods and services to other countries. Effect on Competition and Economic Growth G) When FDI takes the form of greenfield investment, the number of players in a market increases giving consumers more choice. This can increase the level of competition in a market, driving down prices and improving the welfare of consumers. In the long term, increased competition can lead to increased productivity growth, product and process innovation, and greater economic growth.

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Host Country Costs H) Three main costs of inward FDI concern host countries; the possible adverse effects of FDI on competition within the host nation, adverse effects on the balance of payments, and the perceived loss of national sovereignty and autonomy. Adverse Effects on Competition I) Host governments sometimes worry that the subsidiaries of foreign MNEs operating in their country may have greater economic power than indigenous competitors because they may be part of a larger international organization. Adverse Effects on the Balance of Payments J) The possible adverse effects of FDI on a host countrys balance-of-payments position are twofold. First, set against the initial capital inflows that come with FDI must be the subsequent outflow of capital as the foreign subsidiary repatriates earnings to its parent country. A second concern arises when a foreign subsidiary imports a substantial number of its inputs from abroad, which results in a debit on the current account of the host countrys balance of payments. National Sovereignty and Autonomy K) Many host governments worry that FDI is accompanied by some loss of economic independence. The concern is that key decisions that can affect the host countrys economy will be made by a foreign parent that has no real commitment to the host country, and over which the host countrys government has no real control. Home Country Benefits L) The benefits of FDI to the home country arise from three sources. First, the capital account of the home countrys balance of payments benefits from the inward flow of foreign earnings. Second, benefits to the home country from outward FDI arise from employment effects. Third, benefits arise when the home country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country. Home Country Costs M) The most important concerns center around the balance-of-payments and employment effects of outward FDI. With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for domestic production.

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International Trade Theory and FDI N) When assessing the costs and benefits of FDI to the home country, keep in mind the lessons of international trade theory (chapter 5). International trade theory tells us that home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may be misplaced. GOVERNMENT POLICY INSTRUMENTS AND FDI A) The costs and benefits of the FDI from the perspective of both home country and host country have been reviewed. Next, the policy instruments that home countries and host countries use to regulate FDI are addressed. Home Country Policies B) With their choice of policies, home countries can both encourage and restrict FDI by local firms. Encouraging Outward FDI C) Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. Restricting Outward FDI D) Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. Host Country Policies E) Host countries adopt policies designed both to restrict and to encourage inward FDI. Encouraging Inward FDI F) It is increasingly common for governments to offer incentives to foreign firms to invest in their countries. G) Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI. They are also motivated by a desire to capture FDI away from other potential host countries. Restricting Inward FDI H) Host governments use a wide range of controls to restrict FDI. The two most common, however, are ownership restraints and performance requirements.

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I) The rationale underlying ownership restraints seems to be twofold. First, foreign firms are often excluded from certain sectors on the grounds of national security or competition. Second, ownership restraints seem to be based on a belief that local owners can help to maximize the resource transfer and employment benefits of FDI for the host country. International Institutions and the Liberalization of FDI J) Until recently there has been no consistent involvement by multinational institutions in the governing of FDI. With the formation of the World Trade Organization in 1995, this changed. The WTO is more involved in regulations governing FDI. FOCUS ON MANAGERIAL IMPLICATIONS A) There are several implications for managers. The text explores the implications of theory, and then the implications of government policy. The Theory of FDI B) The implications of the theories of FDI for business practice are straightforward. First, the locationspecific advantages argument associated with John Dunning helps explain the direction of FDI. However, the location-specific advantages argument does not explain why firms prefer FDI to licensing or to exporting. In this regard, from both an explanatory and a business perspective, perhaps the most useful theories are those that focus on the limitations of exporting and licensing. Government Policy C) A host governments attitude toward FDI should be an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct investment. Teaching Tip: The World Bank is an excellent resource for exploring the potential of a country for investment. Students can also access additional information on countries by typing in doing business into the home page search box. The site is available at {http://rru.worldbank.org/}.

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Critical Thinking and Discussion Questions

1. In 2004, inward FDI accounted for some 24 percent of gross capital formation in Ireland, but only 0.6 percent in Japan. What do you think explains this difference in FDI inflows into the two countries? Answer: Gross capital formation summarizes the total amount of capital invested in factories, stores, office buildings, and so on. When capital investment is high, a country has more favorable growth prospects. The difference between the rates of gross capital formation in Ireland and Japan would indicate that FDI is an important source of investment capital and economic growth in Ireland, but not in Japan. There are several reasons for this. Companies may perceive that Ireland is more attractive as a destination for their investments, or that it is easier to establish operation in Ireland than in Japan. Investors may be cautious about Japan because of its reputation for burdensome regulations. 2. Compare and contrast these explanations of FDI: internalization theory, Vernons product life cycle theory, and Knickerbockers theory of FDI. Which theory do you think offers the best explanation of the historical pattern of horizontal FDI? Why? Answer: Internalization theory seeks to explain why firms often prefer foreign direct investment to licensing as a strategy for entering foreign markets. According to internationalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities: licensing may result in a firm giving away proprietary technology, licensing does not permit a firm to maintain tight control over its activities, and licensing is not appropriate when a firms competitive advantage is based not so much on its products as on the management, marketing, and manufacturing capabilities that produce those products. Vernons product life cycle theory argues that firms undertake FDI at particular stages in the life cycle of a product they have pioneered. They invest in other advanced countries when local demand in those countries grows large enough to support local production. They subsequently shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressures. Investment in developing countries, where labor costs are lower, is seen as the best way to reduce costs. Finally, Knickerbockers theory of FDI suggests that firms follow their domestic competitors overseas. This theory had been developed with regard to oligopolistic industries. Imitative behavior can take many forms in an oligopoly, including FDI. The second part of this question is designed to stimulate classroom discussion and/or force students to think through these theories and select the one that they feel provides the best explanation for the historic pattern of FDI.

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3. Reread the Management Focus on Cemex and then answer the following questions: a) Which theoretical explanation, or explanations, of FDI best explains Cemexs FDI? b) What is the value that Cemex brings to the host economy? Can you see any potential drawbacks of inward investment by Cemex in an economy? c) Cemex has a strong preference for acquisitions over greenfield ventures as an entry mode. Why? d) Why do you think Cemex decided to exit Indonesia after failing to gain majority control of Semen Gresik? Why is majority control so important to Cemex? e) Why do you think politicians in Indonesia tried to block Cemexs attempt to gain majority control over Semen Gresik? Do you think Indonesias best interests were served by limiting Cemexs FDI in the country? Answer: a) Cemex is a cement company. Consequently, exporting is difficult because of the weight of the product. If Cemex wants to expand into new markets, the company would either need to license a local company or make an investment in the market directly. Cemexs success is due in part to its top notch customer service, and relationship with distributors. Because these advantages could be difficult to transfer, the company will probably choose to invest directly. Students should reflect on these factors as they consider the various theories to explain Cemexs FDI. b) Cemex is the third largest cement company in the world, and a powerhouse in Mexico where it controls 60 percent of the market. Cemex is highly focused on efficient manufacturing and customer service. Distributors are rewarded for their sales, as are users. The primary benefit Cemex brings to host countries involves these competitive advantages. Cemex acquires companies and then transfers technological, management, and marketing know-how to the new units, improving their performance. The company has brought several acquired companies back to full production, increasing employment opportunities in the host country as well. c) Cemex has successfully acquired established cement makers in many countries. By acquiring companies rather than establishing them from the ground up, Cemex can avoid some of the delays that could occur in the start-up phase, while at the same time, capitalize on the benefits of an established market presence. d) Much of Cemexs success appears to be built around its customer service and attention to distributors. Indeed, it could be argued that what sets Cemex apart from its competitors, or its competitive advantage, is its superior way of dealing with external stakeholders. It is significantly easier to duplicate this sort of advantage in a wholly owned operation than in a joint venture or through licensing arrangements. e) In 2006, Cemex announced that it would be pulling out of Indonesia. Cemex entered the Indonesian market in 1998, as part of an IMF sponsored privatization program. Cemex purchased a 25 percent stake in Semen Gresik, a government owned cement maker. Cemexs decision to pull out was a result of a dispute with the Indonesian government. When Cemex has entered the market, it had been promised a majority position in Semen Gresik in 2001. However thanks to the efforts of various special interest groups, permission was never granted. Whether the decision to pull was in the best interests of the country is difficult to say. Certainly it would seem that Semen Gresik could learn from Cemex, and utilize its knowledge to improve its own operations. However, allowing a foreign company to control an industry that is necessary to a country could be detrimental to the nation.

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4. You are the international manager of a US business that has just invented a revolutionary new personal computer that can perform the same functions as PCs, but costs only half as much to manufacture. Your CEO has asked you to decide how to expand into the European Union market. Your options are (i) to export from the United States, (ii) to license a European firm to manufacture and market the computer in Europe, and (iii) to set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative and suggest a course of action to your CEO. Answer: In considering expansion into the European Union, three options will be considered: FDI, licensing, and export. With export, assuming there are no trade barriers, the key considerations would likely be transport costs and localization. While transport costs may be quite low for a relatively light and high value product like a computer, localization can present some difficulties. Power requirements, keyboards, and preferences in model all vary from country to country. It may be difficult to fully address these localization issues from the United States, but not entirely infeasible. Since there are many computer manufacturers and distributors in Europe, there are likely to be a number of potential licensees. But by signing up licensees, valuable technological information may have to be disclosed, and the competitive advantage lost if the licensees use or disseminate this information. FDI (setting up a wholly owned subsidiary) is clearly the most costly and time consuming approach, but the one that best guarantees that critical knowledge will not be disseminated and that localization can be done effectively. Given the fast pace of change in the personal computer industry, it is difficult to say how long this revolutionary new computer will retain its competitive advantage. If the firm can protect its advantage for a period of time, FDI may pay off and help assure that no technological know-how is lost. If, however, other firms can copy or develop even superior products relatively easily, then licensing, while speeding up knowledge dissemination, may also allow the firm to get the quickest large scale entry into Europe and make as much as it can before the advantage is lost.

Closing Case: Starbucks Foreign Direct Investment

Summary The closing case describes the growth of Starbucks from a single store based in Seattle, to a global company with a presence in 38countries. Starbucks began its international expansion in 1995 when it established a joint venture in Japan. Since then, Starbucks has used various strategies to build its foreign presence. In Asia, its most common strategy was licensing arrangements. In Britain, Starbucks acquired an existing chain. The company pursued joint ventures in its European expansion. China is Starbucks next target. The company eventually hopes to open up to 15,000 stores outside the United States. Discussion of this case can revolve around the following questions:

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QUESTION 1: Initially Starbucks expanded internationally by licensing its format to foreign operators. It soon became disenchanted with this strategy. Why? ANSWER 1: Starbucks began its international expansion in Japan where it licensed its formula to a joint venture formed with a local company. Starbucks feared that a pure licensing agreement would not provide it with the control it felt was necessary to successfully replicate the look, feel, and experience of an American Starbucks. To help ensure continuity between its American stores, and its Japanese locations, Starbucks transferred American employees to the Japanese stores to help train workers in the Starbucks way. Starbucks shifted many of it arrangements to joint ventures and wholly owned subsidiaries in an effort to gain greater control over the operations. QUESTION 2: Why do you think Starbucks has now elected to expand internationally primarily through local joint ventures, to whom it licenses its format, as opposed to a pure licensing strategy? ANSWER 2: When responding to this question, most students will probably focus on the greater control that joint ventures provide over licensing arrangements. By using joint ventures to expand internationally, Starbucks can link up with local firms that know the market, but still maintain a greater degree of control. QUESTION 3: What are the advantages of a joint venture entry mode for Starbucks over entering through wholly owned subsidiaries? On occasion, Starbucks has chosen a wholly owned subsidiary to control its foreign expansion (e.g. in Britain and Thailand). Why? ANSWER 3: Using joint ventures has allowed Starbucks to share the cost and risk of developing its foreign markets. While a wholly owned subsidiary would give Starbucks complete control, it also implies that Starbucks would incur all of the cost and risk involved. In Britain, Starbucks did acquire an existing coffee chain that was modeled after Starbucks. Because the chain was already successful, some of the risk that would normally be associated with introducing a new concept to a foreign market was eliminated. Starbucks also shifted to a wholly owned operation in Thailand after its joint venture there experienced difficulty raising capital for further expansion. By acquiring the joint venture, Starbucks was able to gain control over the process QUESTION 4: Which theory of FDI best explains the international expansion strategy adopted by Starbucks? ANSWER 4: Internalization theory suggests that when licensing is difficult, foreign direct investment is appropriate. Starbucks seems to have followed this philosophy. Lecture Note: To extend this case discussion, consider exploring Starbucks entry into Poland. More details are available at {http://www.businessweek.com/globalbiz/content/feb2008/gb20080213_157552.htm?chan=search}.

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Continuous Case Concept

Nissan is playing catch up in China. The Japanese company, in conjunction with its Chinese partner Dongfeng Motor Group, recently established joint venture facilities in China where it hopes to increase sales by 11 percent in 2008. Nissan sees China as a tremendous opportunity both as a market and as a manufacturing location. Already, plans are in place to introduce three new models.

Ask students to predict what changes in the global auto industry might occur in the next decade as a result of Chinas move into the market. How might the patterns of FDI shift? Then, ask students to consider which theory best explains what might occur as a result of Nissans move into China. Finally, ask students to identify the benefits for China of inward FDI in the auto industry. What should be the role of Chinas government in the process? Should United States government try to deter firms from shifting production from the United States to China?

The first and third parts of this exercise can be used as an introduction to the chapter material, or together with the second question as a conclusion to the chapter. The second question can also be used by itself during the discussion of how trade theories help us understand trade patterns.

globalEDGE Exercises
Use the globalEDGE Resource Desk {http://globalEDGE.msu.edu/ResourceDesk/} to complete the following exercises.

Exercise 1
You are working for a company that is considering investing in a foreign country. Management has requested a report regarding the attractiveness of alternative countries based on the potential return of FDI. Accordingly, the ranking of the top 25 countries in terms of FDI attractiveness is a crucial ingredient for your report. A colleague mentioned a potentially useful tool called the FDI Confidence Index which is updated periodically. Find this index and provide additional information regarding how the index is constructed. Answer: The FDI Confidence Index is a study published by the consulting firm A.T. Kearney based on surveys of CEOs. Since it ranks countries in terms of their attractiveness, its listed under the category of Research: Rankings. It can be reached by either browsing to this category, or by searching for the phrase FDI Confidence using the search box located at http://globaledge.msu.edu/ResourceDesk/. Search Phrase: FDI Confidence Resource Name: A.T. Kearney: FDI Confidence Index Website: http://www.atkearney.com/ globalEDGE Category: Research: Rankings

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Exercise 2
Your company is considering opening a new factory in Latin America and management is evaluating the specific country locations for this direct investment. The pool of candidate countries has been narrowed to Argentina, Brazil, and Mexico. Prepare a short report comparing the foreign direct investment (FDI) climate and regulations of these three countries, using the Country Commercial Guides prepared by the U.S. Department of Commerce. Answer: Reports on the investment climate and regulations in countries are available in various resources. However, one of the most accessible resources is an annual guide prepared by the U.S. Department of Commerce. These guides can be accessed by searching the term country commercial guides at http://globaledge.msu.edu/ResourceDesk/. Choose the name of the country and the country commercial guides as the report type from the search engine that appears on the site. Search Phrase: Country Commercial Guides Resource Name: Country Commercial Guides for U.S. Investors Website: http://www.buyusainfo.net/adsearch.cfm?search_type=int&loadnav=no globalEDGE Category: Research: Multi-Country

Additional Readings and Sources of Information

Howard Schultz on Reinventing Starbucks http://www.businessweek.com/magazine/content/08_16/b4080000943927.htm?chan=search Forbidden Starbucks http://www.businessweek.com/globalbiz/content/jul2007/gb20070716_579557.htm?chan=search Sinosteel Presses Takeover in Australia http://www.businessweek.com/globalbiz/content/apr2008/gb2008043_332239.htm?chan=search Wal-Marts Great Indian Adventure http://www.businessweek.com/globalbiz/content/aug2007/gb2007089_986165.htm?chan=search The Challenges Facing Chinas Oil Behemoth Abroad http://www.businessweek.com/globalbiz/content/mar2008/gb2008033_616463.htm?chan=search Emerging Markets Want More from Investors http://www.businessweek.com/managing/content/may2008/ca20080515_384877.htm?chan=search

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Middle East Money Starts Flowing to Asia http://www.businessweek.com/globalbiz/content/apr2008/gb20080416_677577.htm?chan=search Multinationals: Are They Good for America? http://www.businessweek.com/magazine/content/08_10/b4074041212646.htm?chan=search

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