FDI vs. Trade

Course Outline

1. Introduction to FDI

2. The OLI theory of FDI2.1 Locational Advantages

2.2 Ownership Advantages

2.3 Internalization Advantages

3. Benefits and Costs of FDI

4. FDI in Real World

Introduction to FDI

How do countries and firms expand across borders?– private trade

• product trade• services trade (licensing, franchising)

– private investment• direct investment (private ownership)• portfolio investment (stocks, bonds, etc.)

– government assets• foreign currencies held by central banks

Introduction to FDI

Exporting is only one of several ways that a company can reach international markets.FDI is the most common alternative way.When a firm has an ownership interest of at least 10% in a

foreign operation, we can say that the firm is having FDI.Multinational Enterprise (MNE, the parent) operates in

more than one country and has foreign subsidiaries (affiliates)

The value of FDI between countries has grown faster than trade since 1985.

Trade among parents and affiliates accounts for approximately 33% of international trade

Introduction to FDI : The definition

• WTO (1996b) indicates that "Foreign direct investment (FDI) occurs when an investor based in one country (the home country) acquires an asset in another country (the host country) with the intent to manage that asset. The management dimension is what distinguishes FDI from portfolio investment in foreign stocks, bonds and other financial instruments."

• Second, FDI comprises three components:– a) new equity from the parent company in the home

country to the subsidiary in the host country;– b) reinvested profits of the subsidiary; and– c) long and short term net loans from the parent to the

subsidiary.

2. OLI theory of FDI

According to Dunning, for a firm, invest in foreign production (i.e., to become a MNE) can bring 3 advantages:

OwnershipLocation Internalization ( 内化 )

This is the framework of OLI theory, and many following researches built upon this framework.

Now let’s look at the detail about OLI advantages:

2.1 Locational Advantages

First, let consider the location aspects of the framework. In this aspect, FDI can be viewed as a substitute for trading in goods. Differences in factor costs and endowments are a major reason for

a firm to locate an affiliate in a foreign land. Jumping over import barriers (tariff, quota, or other terms) is an

incentive to locate a plant in another country. Higher potential growth rates and larger market sizes in host

countries also explains a FDI decision.

A domestic firm can also capture the above advantages when it establishes a plant, so the framework proposed the other two advantages that provided more insights into why an MNE will invest in the host country.

2.2 Ownership Advantages

The MNEs can use its ownership advantages to overcome some advantages of domestic firms, since they generally enjoy huge financial resources, technology, patents and other trademarks, and management, marketing and organizational skills that are not available in the host country. The affiliate of an MNE is also a member of a vast production and

marketing network with an organizational structure that reduces costs and enhances the flow of goods among countries.

MNEs tend to be successful in primary goods that require large investments, technologically advanced manufacturing, skill or information-intensive industries, and industries where spatial integration is important (such as hotels and airlines), and industries characterized by high trade barriers or transportation costs (such as automobiles). So it’s especially important for the MNEs to capture advatages that cannot be patented, such as financial systems, organizational skills, marketing expertise, industrial relations philosophy, etc.

Food is not a high-technology industry, but FDI is still very large and important. Supermarkets, advertising, and product differentiation are prevailing models for future development, which bring in opportunities.

2.3 Internalization Advantages

The internalization determines whether a FDI will win or lose. Buckley and Casson (1976) attempted to fill the gap in

the locational advantages theories by calling attention to advantages which derived from "internalization", i.e. engaging in foreign production itself, rather than sub-contracting or licensing it to a foreign firm.

The basic idea here is that there are transactions costs of various kinds involved in operating through the market mechanism.

When such costs are greater than those arising from carrying out activities within the firm, internalization, that is, establishing an overseas subsidiary, will be preferred.

3. Benefits and Costs of FDI

From the point of view of host developing countries, there are both important benefits and possibly significant costs associated with FDI.

The possible benefits include: the transfer of technology to individual firms and technological

spill-over to the wider economy; increased productive efficiency due to competition from

multinational subsidiaries; improvement in the quality of the factors of production including

management in other firms and not just the host firm; benefits to the balance of payments through the inflow of

investment funds; increases in exports; increases in savings and investment, and hence faster growth of

output and employment. Consumers may benefit both from lower prices of goods and the

introduction of new or better quality goods.

3. Benefits and Costs of FDI

The acknowledged costs include: If it fails to generate adequate linkages with the local economy,

FDI will have fewer beneficial technological spill-over effects and may, on balance, be harmful if one or more of the negative features outlined below are also present.

There may be social costs in the form of unemployment when FDI, which is relatively capital intensive, causes the more labor intensive local firms to close down, and there is a net loss of jobs.

Environmental and natural resource costs may also be involved, requiring careful consideration of the short-term advantages to be gained from an investment and the longer term implications for the country's resource base and general state of the environment.

Other less tangible costs may also arise from FDI, for example, the detrimental socio-cultural and environmental impact resulting from FDI which brings in substantial numbers of tourists, some of whom abuse local culture and traditions.

FDI in Real World

Foreign investment in (and out) of the U.S.:As U.S. firms outsource some jobs, foreigners send us

their capital for other kinds of investment!

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1982

1983

198419

8519

8619

8719

8819

8919

9019

9119

9219

9319

9419

9519

9619

97

1998

r

1999

r

2000

r

2001

r

2002

r

2003

r

2004

p

Private foreign direct investmentPrivate portfolio investmentGovernment assetsOther

Source: Bureau of Economics Analysis., International Economic Accounts of the United States. <w w w .bea.gov>, dow nloaded November 14, 2005.

Net foreign investment position of the U.S., 1982-2004

FDI in food and agriculture doesn’t always follow the aggregate trend

0

50

100

150

200

250

-

2

4

6

8

10

12All industries (left axis)

Food and agric.(right axis)

FDI flows from U.S. to abroad, 1982-2004 (US$ billions)

-2

0

2

4

6

8

Source: U.S. Bureau of Economic Analysis (w w w .bea.gov/bea/di/di1usdbal.htm), 15 Nov. 2005.

FDI flows from U.S. to abroad, 1982-2004 (US$ billions)

Note: Negative f low s imply return f low of capital by U.S. f irms.

…and there is large variation among sub-sectors!

-2

0

2

4

6

8

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Beverages

Food

Agricultural chemicals

Wholesale trade infarm productsCrops production

Livestock production

Source: U.S. Bureau of Economic Analysis (w w w .bea.gov/bea/di/di1usdbal.htm), 15 Nov. 2005.

FDI flows from U.S. to abroad, 1982-2004 (US$ billions)

Note: Negative f low s imply return f low of capital by U.S. f irms.

One reason for firms to invest (rather than trade) is to jump over trade protection

Reprinted from Anita Regmi et al., Market Access for High-Value Foods. USDA/ERS AER840, Feb. 2005 (49 pp).

Higher protection against more processed goodsis called “tariff escalation”

Reprinted from Anita Regmi et al., Market Access for High-Value Foods. USDA/ERS AER840, Feb. 2005 (49 pp).