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Foreign Direct Investment

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Title: Foreign Direct Investment


1
Foreign Direct Investment
2
Question for TodayWhy does investment capital
flow from some economies to others?
3
Why Does Capital Flow?
  • According to optimal investment analysis...
  • Whenever returns are different in two countries.
  • According to the Balance of Payments Equation...
  • It doesnt have much choice.
  • That is, it must flow into any country that is
    investing more than it is saving.

4
The MacDougall Diagramof International
Investment Flows
  • Model for understanding the interaction of supply
    of and demand for investment capital in different
    countries.
  • Provides us with a benchmark for interpreting
    cross-border capital movements.
  • Simple but quite useful

5
Optimal International Investment
x-axis measures total capital available for
investment in a country
O
Capital
6
Optimal International Investment
y-axis reflects the prevailing rate of return per
unit of capital (i.e. per ) available in a
country.
r (rate of return)
O
Capital
7
Optimal International Investment
Then draw a line which reflects the prevailing
rate of return in an economy, depending on the
total stock of capital.
r (rate of return)
O
Capital
8
Optimal International Investment
Why does the line slope downward?
r (rate of return)
O
Capital
9
Optimal International Investment
If a country only has one unit of capital, the
rate of return must be high.
r (rate of return)
O
Capital
10
Optimal International Investment
If a country only has one unit of capital, the
rate of return must be high.
r (rate of return)
Lots of land, lots of workers, little equipment,
few factories.
O
Capital
11
Optimal International Investment
r (rate of return)
As more capital is around competing, land
becomes scarce and workers become expensive.
O
Capital
12
Optimal International Investment
r (rate of return)
If k is the total stock of capital in a
particular country
O
Capital
k
13
Optimal International Investment
r (rate of return)
Then r0 is the prevailing interest rate in the
economy.
r0
O
Capital
k
14
Optimal International Investment
r (rate of return)
The shaded area then represents the economys
gross domestic product (GDP).
r0
O
Capital
k
15
Optimal International Investment
Now consider a second country with a different
(better) schedule of return possibilities...
r (rate of return)
O
Capital
k
16
Optimal International Investment
Now consider a second country with a different
(better) schedule of return possibilities...
r (rate of return)
O
Capital
k
17
Optimal International Investment
a lower supply of capital...
r (rate of return)
O
Capital
k
k
18
Optimal International Investment
a lower supply of capital...
r (rate of return)
O
Capital
k
19
Optimal International Investment
and therefore a higher prevailing interest rate.
r (rate of return)
r0
O
Capital
k
20
Optimal International Investment
r (rate of return)
Denoting variables of this second (call it
foreign) country with asterisk.
r0
O
Capital
k
21
We then can take this graph and flip it around.
r (rate of return)
r0
O
Capital
k
22
We then can take this graph and flip it around.
r (rate of return)
r0
O
Capital
k
23
Then add the graph of the original country (home
country).
r (rate of return)
r0
O
Capital
k
k
24
How far over do we bring it?
r (rate of return)
r0
r0
O
O
Capital
k
k
25
Until the length of the horizontal axis
represents the total quantity of capital in the
two economies...
r (rate of return)
r0
r0
O
O
Capital
k
k
26
So that the length from 0 to k0 is the amount of
capital in the domestic economy...
r (rate of return)
r0
r0
O
O
Capital
k0
27
So that the length from 0 to k0 is the amount of
capital in the foreign economy...
r (rate of return)
r0
r0
O
O
Capital
k0
28
Now what happens if both countries allow capital
to flow freely between them?
r (rate of return)
r0
r0
O
O
Capital
k0
29
The owners of capital in the home country are
only earning r0
r (rate of return)
r0
r0
O
O
Capital
k0
30
Whereas capital in the foreign country is earning
a higher return of r0
r (rate of return)
r0
r0
O
O
Capital
k0
31
So owners of capital in the home country will
begin to move capital overseas...
r (rate of return)
r0
r0
O
O
Capital
k0
32
Shifting k to the left
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
33
Increasing the supply of capital in the foreign
country
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
34
Decreasing the supply of capital in the home
country
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
35
Increasing interest rates in the home country
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
36
And decreasing the returns to capital in the
foreign country
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
37
When will the flows of capital from the home to
the foreign country cease?
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
38
When incentives to transfer capital no longer
exist...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
39
When rates of return to capital are equated
when r1 r1
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
40
This concept is know as Real Interest Parity
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
41
Example Japan 1980
  • Japan has severe capital controls in place.
  • Japanese investors are largely restricted from
    holding foreign assets.
  • Returns in rest of the world - especially high
    interest rates in U.S. - appear attractive to
    Japanese.
  • Japan has 11 billion in net inflows.

42
Japan in 1980.
r (rate of return)
r0
r0
O
O
Capital
k0
43
Example Japan 1980
In December, Japan passes Foreign Exchange and
Foreign Trade Control Law.
  • Large pool of savings Japan has built up over the
    years slosh onto world capital markets.
  • Japanese 11 billion inflows become 21 billion
    in outflows by 1983 and 87 billion by 1987.

44
QuestionWhich economy benefits from the flow
of capital?
45
The foreign countrys GDP increases from this...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
46
to this.
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
47
The home country loses some GDP...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
48
The home country loses some GDP...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
49
But total world production has now increased by
this amount.
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
50
For use of the home countrys capital, the
foreign country pays r1 times the amount
borrowed.
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
51
GNP (which equals GDP Overseas Income) is
therefore...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
52
So the home country GNP increases by...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
53
Similarly, after paying the interest bill, the
foreign GNP increases by...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
54
Examples
  • 1. Europe post-W.W.II.
  • 2. Latin America recent deregulation and
    privatization.
  • 3. Australia early 1900s.

55
International Capital Flows
  • Having developed a basic understanding of why
    capital flows between countries, remember that
    these flows can take three main forms
  • Portfolio Investment - ownership of corporate
    stocks, bonds, government bonds, and other bonds.
  • Intermediated Investment - short and long-term
    bank lending and deposit-taking activity.
  • Foreign Direct Investment - investment obtaining
    ownership of greater than 10 of voting shares in
    a foreign firm.
  • Why FDI? Why do we need multinationals?

56
Important FDI Facts
  • 1. FDI has grown rapidly since W.W.II and
    especially in the last 15 years. FDI stock, by
    host country, bn

57
Empirical Facts (contd)
  • 2. Developing countries account for an increasing
    share of inflows
  • - in 1995 developing countries received a record
    100 of 315 billion in inflows.
  • - excluding intra-European flows, developing
    countries received 60 of all flows in 1995 - up
    from 17 in 1989.
  • 3. Most FDI flows (97) originate in developed
    countries.
  • 4. Much two-way FDI flows (cross-hauling) takes
    place between pairs of developed countries - even
    at industry level.

58
Empirical Facts (contd)
  • 5. Most FDI production is sold in recipient
    country.
  • 6. Degree of FDI varies widely across and within
    industry. (examples Pepsi vs. Coke and Banks vs.
    Food).
  • 7. Multinationals tend to have
  • - high levels of RD
  • - large share of professional and technical
    workers
  • - products that are new or technically complex
  • - high levels of advertising and product
    differentiation.
  • - high values of intangible assets vs. market
    value.

59
Empirical Facts (contd)
  • 8. Most of US corporations international
    exposure is through FDI - not exports
  • - In-country sales of US foreign affiliates were
    1.8 trillion in 1995 vs 576 billion in
    exports.
  • - US foreign affiliates exported more than the
    US domestic operations in 1995 580 vs. 576.
  • 9. 80 of US FDI is via MA - not greenfield
    investment.
  • 10. US FDI

60
Empirical Facts (contd)
  • 8. Most of US corporations international
    exposure is through FDI - not exports
  • - In-country sales of US foreign affiliates were
    1.8 trillion in 1995 vs 576 billion in
    exports.
  • - US foreign affiliates exported more than the
    US domestic operations in 1995 580 vs. 576.
  • 9. 80 of US FDI is via MA - not greenfield
    investment.
  • 10. US FDI

1. Europe - 50 2. Latin America - 18.1 3.
Canada - 11.5 4. Japan, Australia, NZ - 9.3 5.
Rest of Asia - 9
61
Emerging Market FDI Top Recipients
62
Emerging Market FDI Top Recipients
1980
  • 1. Brazil
  • 2. South Africa
  • 3. Indonesia
  • 4. Mexico
  • 5. Singapore
  • 6. Argentina
  • 7. Malaysia
  • 8. Greece
  • 9. Taiwan
  • 10. Venezuela

63
Emerging Market FDI Top Recipients
1980
1995
  • 1. Brazil
  • 2. South Africa
  • 3. Indonesia
  • 4. Mexico
  • 5. Singapore
  • 6. Argentina
  • 7. Malaysia
  • 8. Greece
  • 9. Taiwan
  • 10. Venezuela

1. China 2. Mexico 3. Singapore 4. Indonesia 5.
Brazil 6. Malaysia 7. Argentina 8. Hong Kong 9.
Greece 10. Thailand
64
Three Questions
  • 1. What explains locational patterns of FDI? Why
    do some countries tend to be host countries and
    some source countries?
  • 2. Why is FDI undertaken instead of portfolio
    investment or intermediated investment? What
    overcompensating ownership advantage do
    foreigners have over domestic investors?
  • 3. Why does cross-hauling exist? Why do some
    countries invest directly in each other?

65
What Explains Locational Patterns of FDI?
What are some reasons certain countries are
chosen over others as targets for multinational
investment?
66
What Explains Locational Patterns of FDI?
What are some reasons certain countries are
chosen over others as targets for multinational
investment?
  • 1. Labor costs
  • 2. Access to resources
  • 3. Government policies
  • 4. Expanding markets
  • 5. Currency values
  • 6. Tax advantages
  • 7. Investment climates

67
Why FDI over Portfolio or Intermediated
Investment?
  • For FDI to be considered, the foreign investor
    must view rFDI gt rPI,II
  • From the perspective of the host country, it must
    be the case that rFDI gt rlocal
    investment
  • But these inequalities are the same, since local
    investors will equate rPI, II
    rlocal investment

68
What Makes the Return on FDI greater than that on
PI or II?
  • In other words, how do foreign corporations
    outperform domestic ones on the latters home
    turf?
  • Especially considering the foreign firm must
    incur additional costs of travel, communication,
    and monitoring...
  • ...and the foreign firm must contend with
    unfamiliar legal, distributing, and accounting
    systems.
  • Thus, an understanding of FDI must identify what
    overcompensating advantage a foreign firm has
    over domestic competition, making returns to FDI
    greater than those to Portfolio or Intermediated
    Investment.

69
Example Samsung of Korea
  • In 1996, Samsung, and many other companies in
    South Korea, Hong Kong, Singapore, Taiwan, and
    Thailand, were faced with going multinational in
    order to survive.
  • For many firms of the Asian Tigers, domestic
    labor costs have become too high to make low-tech
    manufacturing economical.
  • They look to outsource production or product
    assembly in lower-cost countries.

70
Example Samsung of Korea
  • Samsung pays its average worker in Seoul
    12.70/hour.
  • Similar work could be performed in Malaysia for
    2/hour and in China for .85/hour.
  • In outsourcing production to Malaysia, Samsung
    must become a multinational - and invest directly
    in Malaysian production facilities.
  • Why?

71
Example Samsung of Korea
  • As a multinational, Samsung feels it can more
    efficiently
  • 1. invest directly in Malaysia
  • 2. raise needed capital in Hong Kong
  • 3. safely transfer patented technology to foreign
    affiliates
  • 4. efficiently ship parts between assembly plants
  • 5. sell products throughout region

72
Major Theories of FDI 1. Technological Advantages
  • Firm-specific advantages include
  • 1. Proprietary technology and patent protection
  • 2. Proprietary information
  • 3. Production secrets
  • 4. Superior management organization
  • 5. Brand-name recognition or trademark protection
  • 6. Marketing skills
  • ...

73
2. Product Cycle Theory
  • Product development is characterized by different
    stages
  • Stage 1 Production in industrialized countries
  • - feedback from customers
  • - skilled labor
  • - high demand (for new product) covers high
    labor costs.
  • Stage 2 Production in developing countries for
    export
  • - Product faces more competitors, tougher price
    competition.
  • - Production has become standardized
    production can move to markets with
    plentiful, cheap unskilled labor for export.
  • ...

74
3. Oligopoly Models
  • Firms gain benefits from being sufficiently large
    to operate multinationally
  • A. Firms think internationally when designing
    new products in order to capture economies of
    scale (i.e. absorb high RD expenditures).
  • B. Local production improves foreign market
    penetration beyond that achieved through
    exporting.
  • C. Local production to obtain knowledge-transfers
    from competitors.
  • ...

75
4. Internalization Theory
  • Based on theory of firm developed by Ronald
    Coase.
  • Firms integrate across borders when use of market
    is costly and inefficient for certain
    transactions
  • - Enforceability of contracts
  • - Taxes paid on market transactions
  • - Difficulty defining prices
  • - Default risks associated with contracts.
  • Of course, internalization is costly as well.
  • ...

76
5. Imperfections in Securities Markets
  • When organized markets for equity and debt are
    illiquid or non-existent, FDI is a substitute for
    PI.
  • FDI obtains otherwise inaccessible high returns
    in markets with no organized securities markets.
  • FDI offers some (albeit weak) direct
    diversification benefits.
  • ...

77
6. Exchange Risk Theory
  • Investors are risk-averse.
  • As a result, they do not entirely arbitrage real
    returns across countries via portfolio and
    intermediated investment.
  • With FDI, management can structure operations
    (i.e. via multiple sourcing) to reduce currency
    risks below those of PI and II.
  • Other option-type benefits exist with respect to
    interest rate and labor cost fluctuations.
  • ...

78
Key Points
  • 1. FDI flows are growing at tremendous rate -
    especially those directed towards emerging
    markets.
  • 2. For investors to consider an overseas project
    (FDI), there must exist some overcompensating
    advantage so that
  • - returns are higher than those obtained by
    local competition
  • - returns from FDI exceed those of Portfolio or
    Intermediated Investment
  • in order to compensate for costs of doing
    business transnationally.
  • 3. A number of theories of FDI identify sources
    of these overcompensating advantages.

79
Long-Term Risky Investments Frequently
Misevaluated
  • 1. Test marketing the first of a proposed new
    family of products.
  • 2. Installing a revolutionary new processing
    technique.
  • 3. Research and development and the pilot plant
    that will be required if the research is
    successful.
  • 4. Acquiring a greenfield industrial site.
  • 5. Acquiring telecommunications or logistics
    facility that could radically alter the future
    distribution of services.
  • 6. Obtaining mineral rights at a site that will
    require extensive development.

These are all call options
80
Example Project Description
  • Phase 1 New product development
  • 18 million annual research cost for 2 years
  • 60 probability of success
  • Phase 2 Market development
  • Undertaken only if product development succeeds
  • 10 million annual expenditure for 2 years on the
    development of marketing and the establishment
    of marketing and distribution channels (net of
    any revenues earned in test marketing)
  • Phase 3 Sales
  • Proceeds only if Phase 1 and Phase 2 verify
    opportunity
  • Production is subcontracted

81
Project Assumptions
Product demand Product life Annual net cash inflow Probability
High 20 years 24 million .3
Medium 10 years 12 million .5
Low Abandon Project None .2
The results of Phase 2 (available at the end of
year 4) identify the product's market potential
82
Expected Value Calculations
Year 1 -18
2 -18
3 .6(-10) -6
4 .6(-10) -6
5-14 .6(.324.512) 7.92
15-24 .6(.324) 4.32
expected IRR 10.1
83
Expected Phase III Values
Demand Probability Value of Phase III at the end of year 4
High .3 299
Medium .5 93
Low .2 0
Expected value 136 million
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