EPGDIB-03

FDIs and Multinationals

Patterns, Impacts & Policies

Debajyoti Saha (Roll-23),Pallav Vikash Chatterjee (Roll-57) 7/18/2011 [Type the abstract of the document here. The abstract is typically a short summary of the contents of the document. Type the abstract of the document here. The abstract is typically a short summary of the contents of the document.]

Analysis on FDI and Multinationals : Patterns, Impacts and Policies

1. Foreign direct investment (FDI): It refers to the net inflows of investment to acquire a lasting
management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor. It is the sum of equity capital, reinvestment of earnings, other long-term capital, and short-term capital as shown in the balance of payments. It usually involves participation in management, joint-venture, transfer of technology and expertise. There are two types of FDI: inward foreign direct investment and outward foreign direct investment, resulting in a net FDI inflow (positive or negative) and "stock of foreign direct investment", which is the cumulative number for a given period. Direct investment excludes investment through purchase of shares. FDI is one example of international factor movements. Key features of FDI are: Control High commitment of capital, personnel, and technology Access to foreign markets Access to foreign resources Higher foreign sales than exports Ownership

1. Different forms of FDI:

Two main forms of FDI include Greenfield investments and mergers or acquisitions.

Greenfield investment: Involves establishments of a wholly new operation in a foreign country. In such sort of FDI, the parent company starts a new venture in a foreign country by constructing new operational facilities from the ground up. In addition to building new facilities, most parent companies also create new long term jobs in the foreign country by hiring new employees. Mergers and acquisitions: Acquisition means that a company buys an existing company. This can be of a minority (10-49 % interest in firms voting stock), majority (foreign interest of 50-99 %) or full outright stake (foreign interest of 100 %).

Generally it is observed that firms prefer merger & acquisitions over green field investments because M&A are quicker to execute. Another reason can be foreign target firms can have valuable strategic assets like trademarks or patents, brand loyalty, production systems, customer relationships, distribution systems and so on. Also acquiring firms believe that they can increase the efficiency of the acquired unit by transferring technology, capital or management skills.

1. Motivation factors for FDIs:

3.1 Marketing factors:

Market size & growth Desire to maintain market share Desire to follow customers Desire to follow competition Establish export base Maintain close customer contacts

3.2 Cost factors: Desire to be near source of supply Lower labor costs Availability of raw materials Availability of capital/technology Lower transportation costs Financial inducements by governments Infrastructure

3.3 Investment climate: Political stability Limitations on ownership Tax policy Exchange rate stability Trade barriers Government attitude towards FDI

1. Types of objectives of FDI projects:

4.1 Market seeking: To serve local and regional demand. Reason for market-seeking FDI projects may be explained by the relative production and transaction costs of servicing markets through export or local production. Especially economies of scale, transportation costs, and exchange rates may influence the trade-off between exports and foreign production. Firms with low degrees of plant-level economies of scale and high transportation costs are more inclined to undertake market-seeking FDI projects. Need to stay closer to customers is another objective 4.2 Resource seeking: Objective of resource seeking FDI is to exploit comparative advantages of the country. Firms can allocate production resources in countries where factor prices are low relative to firms productivity. Another advantage may be access to raw materials, part and components. 4.3 Knowledge seeking: Such FDI projects are undertaken to maintain or develop a better competitive position in certain product or geographical markets. This competitive position can be achieved by acquiring technological knowledge and capabilities and management expertise 4.4 Efficiency-seeking: The purpose if efficiency seeking FDI projects is to rationalize the structure of established production units in such a way that a firm can benefit from the common governance of economic activities in different locations.

2. Home country effects of FDI:

5.1 Productivity: FDIs affect positively the productivity of the MNE in its home country. Reasons are:

Opening of new channel of international sourcing of technological, managerial, host country conditions/market related knowledge Exploitation of firm level scale economies Possible change in composition of production inputs, i.e.-specialization effecttaking advantage of international division of labor within a MNE

The knowledge transfer effect may also be translated into positive spillover effects on other national firms in the home country. Transferred knowledge may concern technology, marketing, foreign market related information, information that will make easier for other firms to become international. Worker mobility effect accounts for the productivity improvement of the local firm in home country. 4.2 Domestic employment & skill composition: To study this effect lets divide FDIs into two categories based on their motive:

Resource seeking FDI These aim to acquire specific resources (cheap & well motivated unskilled labor) at a lower cost than could be obtained in home country. They are more likely to relocate some of the labor intensive activities in low cost countries, as these initiatives are driven by differences in factor endowments between home and host countries, and they are explained by the need to exploit location specific factors of production. This will cause the structure of domestic employment to change, reducing employment level. In fact increased efficiency associated to the new structure of production chain can enhance parent companys competitive position and increase its market share through positive externalities exerted on domestic production and demand. Additionally, as the presence abroad might stimulate exports, foreign production will positively impact domestic production, thus complementing it. As far as impact on skill composition, resource seeking investments lead to skill upgrading at home, as they often occur through the relocation of labour intensive production phases to foreign countries where wages are lower. Market seeking FDI Aim to supply goods/services to markets in target countries or adjacent countries. On one hand foreign affiliates often substitute previous exports from parent company. If this is the case then, foreign activities reduce production and employment at home country. On the other hand when foreign activities replicates abroad only the final segments of production, demand for intermediate goods/services produced by the parent company would rise, thus increasing domestic production and relevant employment at home.

4.3 Effects on business environment: It refers to subcontracting relations and local externalities induced by the demand for specialized inputs, services, managerial and operative skills and it has to do with supporting firms employment effect. Production in foreign affiliates can induce: Substitutive effects on domestic employment in local context in which the MNE operates due to (i) reduction of domestic low skilled labor, (ii) loss of market shares by local suppliers, loss of opportunity to grow and learn through the relationship with parent firm, (iii) write-off of previous sub contracting relations Complementary effects, whenever the enhanced competitive position of the parent company and its additional demand for specialized inputs do increase the externalities on the local context. Transfer of production abroad may have a positive effect when parent company suppliers become suppliers for foreign affiliates. In such a case market for suppliers expands. Resource seeking FDI can induce upgrading in local system and in supply chain competitiveness by promoting differentiation in specialization and competencies between countries.

1. Host country effects of FDI:

FDI can contribute to host country development in many ways even when the foreign firms do not provide externalities: Primary contributions will add to host country growth and welfare: Foreign investors bring new products, improved quality, and/or lower prices to consumers in host country. Foreign investors provide additional resources (capital, technology, management) to raise the level of domestic output and to engage in existing activities more efficiently providing cheaper goods to consumers. For example investor in London acquires a chain of restaurants in Delhi, providing capital for reconstruction. Foreign investors provide technologies, management techniques, marketing techniques and quality control that enable host country to penetrate international markets and earn foreign exchange and/or allow competitive substitution of imports. For example- Brazil reduces import of paints as a result of Sherman Williams investment; GM expands its Hungarian plant to supply 1.6 litre Audi engines to its assembly sites throughout the European Union.

Secondary contributions via backward linkages may add to host country growth and welfare without necessarily providing externalities:

Foreign investor provides new demand from its local subsidiary for host country suppliers to meet, using operations they already know how to undertake. For example- Ericssons plant in Philippines purchases boxing and shipping materials from Philippine suppliers. Foreign investor provides new demand from foreign subsidiaries for host country suppliers to meet, with coaching from foreign subsidiaries about how to provide inputs at cheaper cost or with more reliability, for example MOTOROLA farms out printed circuit board assembly to two electrical firms in Singapore to which it provides instructions about what machinery to purchase and how to carry out quality control procedures.

Externalities:

Enhances the productivity of the host country firms by opening of new channel of international sourcing of technological, managerial, market related knowledge. This is accomplished by factor mobility between host company firms and foreign firms. Foreign investors provide host country firms that become suppliers the opportunity to offer the new goods/services to other buyers in the host economy. Foreign investors provide host country firms that originate as suppliers new opportunities to become producer of goods/services to other buyers in the international economy. For example, Malaysian machine tool firms that originated selling equipment and services to INTEL in Malaysia follow the MNC to China, and begin to sell equipment and services to US, Europe, and Japanese firms in Chinese market.

1. Role of incentives in promoting inward FDI:

Foreign Direct Investment is increasingly being recognized as an important factor in economic development of countries. The attitude towards inward foreign direct investment (FDI) has changed considerably over the last couple of decades, as most countries have liberalized their policies to attract all kinds of investment from multinational corporations (MNCs).On the expectation that MNCs will raise employment, exports, or tax revenue, or that some of the knowledge brought by the foreign companies may spill over to the host country private sector, many governments have also introduced various forms of investment incentives, to encourage foreign owned companies to invest in their jurisdiction. The incentives can take the following forms. Low corporate taxes & income tax rates Tax holidays Preferential tariffs

Special economic zones Export processing zones Investment financial subsidies Soft loans/Loan guarantees Free land or land subsidies Job training and employment subsidies Infrastructure subsidies R&D support Derogation from regulations

Few practical examples of incentives towards inward FDI: Governments of Britain and France competed with each other on the incentives they offered Toyota to invest in their respective countries. Kentucky in United States offered Toyota an incentive package worth $112 million to persuade it to build its US automobile assembly plants there. The package included tax breaks, new state spending on infrastructure, and low-interest loans. British government provided an estimated $30,000 and $50,000 per employee to attract Samsung & Siemens respectively to the North East of England in late 1990s.

Government incentives and policies and their role in attracting FDI:

FDI according to Dunning emerges due to ownership, internalization and locational advantages. Foreign companies will be attracted to the host country if it can seek significant locational advantages in the host country. But with rising pressures of globalization induced competitiveness, the locational advantages based on only the economic conditions may not be able to sustain their strength of attracting FDI. Possessing the principal determinants like market size, real income levels, skill levels, infrastructure and other resources, favorable trade policies and macroeconomic stability may not be sufficient for the host countries to attract FDI. For this matter focus now has shifted to government policies in addition to economic conditions as determinant of FDI. Government policies influencing the inflow of FDI can be broadly categorized into the following three categories:

A)

Overall economic policy that increases locational advantages for FDI by improving following economic fundamentals of the host country: Market size: Large market size generates scale economies while growing market improves market potential and attracts FDI. Cost factors: Includes cost of labor, cost of capital and infrastructure costs. Lower wage rates, availability of skilled labor aids FDI. Also lower interest rates increases domestic consumption leading to more FDI inflows. Higher the infrastructure present, lower is infrastructure costs and more will be FDI inflows. Real exchange rates: Foreign investors seem to gain from devalued exchange rate of the host country. They may gain due to larger buying power in host countries. Also they can produce more cheaply and export more easily. Macroeconomic stability: Macroeconomic variables like inflation, budget, balance of payments affect FDI inflows. For instance exchange rate can adversely affect the competitiveness of the plants in different countries. Stability of exchange rates of the currency in host country encourage investment by foreign firms as it increases uncertainty regarding the future economic and business prospects of the host country. Overall economic stability: Financial health of the host economy is capture by the ratio of external debts to exports. It is expected that lower this ratio higher is the probability of economic stability in the country. Resulting in more FDI inflows.

A) National FDI policies reduce transaction costs of foreign firms entering the economy:

Tariff policies: FDI is deterred by the high tariffs or non tariff barriers on imported inputs and is attracted to more open economies. Higher openness to trade to attract higher FDI inflows. Policies can be categorized into:

Fiscal incentives: Reduces tax burden of a firm. It includes tax concessions in the form of reduction of the standard corporate income-tax rate, tax holidays, depreciation allowances on capital taxes, exemption from import duties and duty drawbacks on exports. It also includes provision of guarantee for repatriation of investments and profits and establishing mechanisms for settlements of investment disputes. Financial incentives: These include grants, subsidized loans and loan guarantees, publicly funded venture capital and government insurance at preferential rates.

A)

Removal of restrictions: Due to the enforcement of TRIMS (Trade Related Investment Measures) following restrictions were eliminated: Entry barriers Ownership & control restrictions Allowing only fixed portion of foreign owned capital in an enterprise Compulsory joint ventures Mandatory transfer of ownership to local private firms over a period of time Restrictions on reimbursements of capital upon liquidation Restrictions on employment of foreign key personnel, and performance requirements, sourcing, training requirements, export targets.

With the removal of these restrictions, FDI inflows increase.

ARE THE INCENTIVES OFFERED TO FDI JUSTIFIED:

So far we have discussed how government incentives and policies attract FDI inflows. But it needs to be investigated whether these incentives are justified. These will be justified only if the host nation is subjected to welfare effects resulting out of FDI inflows. Otherwise these incentives are not worth taking. FDIs are expected to generate spillovers which mean the positive effects/benefits emanating from FDI, which go beyond the direct benefits. Foreign MNCs may: Contribute to efficiency by breaking supply bottlenecks Introduce new know-how by demonstrating new technologies and training workers who later take employment in local firms Improve allocative efficiency by entering into industries with high entry barriers and reducing monopolistic distortions. Also stimulates competition and efficiency Transfer techniques for inventory and quality control and standardization to their local suppliers and distribution channels. Force local firms to increase their quality managerial efforts or to adopt some managerial and marketing techniques used by MNC. Enhance productivity of local firms with knowledge/technology transfer Force domestic firms to modernize by imposing on them minimum standards of quality, delivery dates , prices, etc in their supplies of parts and raw materials

Now if the host nations are subjected to spillover/welfare effects or not, depends on the following:

Absorptive capacity:

Transfer of ownership advantages and firm specific advantages (FSA) depends on the absorptive capacity of the host nation. Ideally the technology gap (productivity differentials between domestic firms and foreign firms) should not be too wide or too less. If too wide, then there will be no spillover benefit and if too small then there will be no FSA for the foreign MNC. Domestic firms can only benefit if the technology gap between the foreign company and domestic firm is not too wide so that domestic firms can absorb the knowledge available from the foreign company. Domestic firms using unskilled labor and backward production technology cannot learn from the foreign MNC. For this matter technology gap should be moderate. Domestic firms with productivity levels similar to foreign MNC are more capable of absorbing the transferred technology. Also firms which are more R & D intensive will have more absorptive capacity. Generally it is found that exporting firms which are more R & D intensive and relatively better technology have higher absorptive capacity than the non- exporting domestic firms.

Agglomeration, Clusters/Networks, Knowledge sourcing

Clusters refer to geographical agglomerations of small to medium-sized firms specialized in one or few related sectors. Such clusters contain production and social networks that can generate external economies, knowledge spillovers and innovation. Cluster firms are featured by a high degree of specialization and complementarity which generates knowledge creation and knowledge transfer. As a result of these clusters can be extremely competitive and resulting in positive spillover effects. CONCLUSION: As discussed above spillover benefits of foreign firms are not automatic, the government must be very careful in the provision of incentives to FDI seeking firms. Sometimes in the process of competing very hard to attract FDIs, government end up overbidding and the foreign firms may well surpass the level of spillover benefits resulting in welfare losses to host economy. Since the potential of spillovers is not likely to be realized unless local firms have the ability and motivation to learn from MNCs and to invest in new technology, the incentives to promote FDI will be inefficient unless they are complemented with measures to improve the local learning capability and to maintain a competitive local business environment. Based on these arguments, some propositions to the design of FDI incentives may be:

Incentives should be available on equal terms to all investors irrespective of industry and nationality of investor. Motive for supporting foreign investors should be to balance social and private returns to investment. Local firms should be subdized to strengthen their capacity to absorb foreign technology and skills. Modernization of infrastructure, education, training, R&D, linkages between foreign and local firms need to be promoted. Performance based incentives should be given to foreign companies. Incentives should be considered as part of economys innovation and growth policies rather than a policy area that is only relevant for foreign firms.