Foreign direct investments, trade & geography
- IB
Part 1.2: Multinationals and FDI
1. FDI vs. Multinational activity
Foreign direct investment (FDI)
Foreign investment = Flow of financial capital from one country to another.
Foreign direct investment (FDI) = Investor has significant degree of control of and influence
on the foreign management.
Foreign portfolio investment = Foreign investment without controlling stake.
10 percent ownership rule: Any flow of capital to a foreign firm in which the investor has
(or gains) ownership of 10 percent or more of the foreign firm is considered FDI.
FDI flows vs. FDI stocks
FDI flow = the amount of FDI moving in a certain direction during a
given time interval (e.g. one year).
› FDI inflow – The volume of FDI moving into a country.
› FDI outflow – The volume of FDI originating from a country
FDI stock = The total cumulative value of all FDI flows.
› Inward FDI stock: A snapshot of the total cumulative value of all foreign direct
investments in an economy (=cumulative value of all FDI inflows) at a given point in time
(e.g. on Dec. 31, 2018).
› Outward FDI stock: A snapshot of the total cumulative value of all foreign direct
investments held abroad by resident firms from a given country (=cumulative value of all FDI
outflows) at a given point in time
Multinational enterprise
MNE: A firm that own and controls operations in more than one country = a firm that
undertakes FDI.
One parent firm, one or more foreign affiliates (subsidiaries, branches).
1
,MNE vs. FDI
› A MNE is more than just the flow of FDI.
• Parent firms transfer more than just financial capital (e.g. intangible assets such
as know-how, brand.)
• Not all funds used for multinational financing are included in FDI data (e.g.
funds borrowed in the host country)
› Not all FDI is used to finance real economic activity (e.g. “mailbox firms” in Bermuda
Islands.)
› But correlation between FDI and other measures of MN activity (e.g. foreign sales,
employment) generally high.
Multinationals finance a substantial amount of their activities by borrowing in the host country. Why?
› Exchange rate risk: Take on liabilities and assets denominated in foreign currency to
reduce fluctuations in the value of net assets.
› Risk of expropriation: Possibility to default on foreign liabilities if foreign government
expropriates firm assets
2. Type of FDI
Two types of multinational activity (FDI)
› Horizontal (‘market-seeking’): Serving foreign markets directly (producing and selling to
customers abroad); replication of home activities in host country.
› Vertical (‘efficiency-seeking’): Sourcing from abroad; locating activities from a different
stage of the value chain to the host country. // Most real-world MNE’s do both
2
,Does FDI lead to more trade or less trade?
› FDI substitutes (Horizontal) for trade if the firm is market-seeking and trying to get around
tariffs or transportation costs.
• Producing locally avoids cost of importing.
› FDI complements (Vertical) trade in situations where FDI is efficiency- or strategic-
asset (innovation)-seeking.
• Overseas production generates exports back to the home country.
3. History and current patterns
› 1970s: FDI dominated by investments of U.S. firms in developing countries.
› 1980s: Rise of FDI by European and South- and East Asian firms. Orientation toward
developed countries (U.S. as main receiver of FDI.)
› 1990s: Rising FDI into developing countries (driven by low labor costs and economic
reforms).
› Nowadays: Most FDI flows between industrialized countries.
› Rising role of FDI in services sector, declining role of manufacturing and primary sector.
4. FDI inflows and outflows
Summary
› Foreign investment that leads to control over foreign operations is considered FDI.
› FDI is the main indicator of multinational activity.
› FDI can be a substitute or a complement to trade.
› Most FDI flows between rich countries.
3
, Part 1.3: Costs and benefits of FDI
1. Why do MNEs exist?
› Multinational activity is more than just shifting financial capital across borders:
• If differential returns to capital were the only reason, firms could just engage
in foreign portfolio investment without establishing managerial control. (less costly)
› Implies that there must be additional advantages of owning/controlling foreign operations.
• Firms have valuable assets and capabilities (firm specific advantages = FSAs)
they want to exploit in foreign markets (Resource-based view of the firm).
Firm-specific advantages
Firm-specific advantages = valuable firm-specific tangible and intangible resources and
capabilities.
Resources and capabilities generate a firm-specific advantage if they are:
• Valuable: Generate value for the firm
• Rare: Other competitors do not possess the exact same asset
• Inimitable: Other competitors can note easily copy and create this asset themself
• Non-substitutable: Vital for the firm success and cannot be replaced by another asset
› Firm-specific advantages allow the firm to overcome the inherent disadvantages of being
foreign (liability of foreignness). E.g.
• Overcoming institutional, cultural, and language barriers in the foreign country.
• Travel and communications costs (between headquarter and subsidiary).
• Other costs of doing business that native firms are not facing.
FDI vs. alternative strategies
› FDI is not the only means to exploit firm-specific advantages, alternative ways to leverage
the firm-specific assets:
• Exporting to foreign markets.
• Licensing to foreign firms.
FDI vs. exporting
Advantages of FDI over exporting:
› Utilize local resources (e.g. cheap labor). = not possible with exporting
› Circumvent (contourner) import restrictions in foreign country and avoid transportation
costs.
› Get access to trade blocs. => can be freely exported to other bloc member countries
› Proximity to foreign customers. => adapting more quickly to the taste changing
4
- IB
Part 1.2: Multinationals and FDI
1. FDI vs. Multinational activity
Foreign direct investment (FDI)
Foreign investment = Flow of financial capital from one country to another.
Foreign direct investment (FDI) = Investor has significant degree of control of and influence
on the foreign management.
Foreign portfolio investment = Foreign investment without controlling stake.
10 percent ownership rule: Any flow of capital to a foreign firm in which the investor has
(or gains) ownership of 10 percent or more of the foreign firm is considered FDI.
FDI flows vs. FDI stocks
FDI flow = the amount of FDI moving in a certain direction during a
given time interval (e.g. one year).
› FDI inflow – The volume of FDI moving into a country.
› FDI outflow – The volume of FDI originating from a country
FDI stock = The total cumulative value of all FDI flows.
› Inward FDI stock: A snapshot of the total cumulative value of all foreign direct
investments in an economy (=cumulative value of all FDI inflows) at a given point in time
(e.g. on Dec. 31, 2018).
› Outward FDI stock: A snapshot of the total cumulative value of all foreign direct
investments held abroad by resident firms from a given country (=cumulative value of all FDI
outflows) at a given point in time
Multinational enterprise
MNE: A firm that own and controls operations in more than one country = a firm that
undertakes FDI.
One parent firm, one or more foreign affiliates (subsidiaries, branches).
1
,MNE vs. FDI
› A MNE is more than just the flow of FDI.
• Parent firms transfer more than just financial capital (e.g. intangible assets such
as know-how, brand.)
• Not all funds used for multinational financing are included in FDI data (e.g.
funds borrowed in the host country)
› Not all FDI is used to finance real economic activity (e.g. “mailbox firms” in Bermuda
Islands.)
› But correlation between FDI and other measures of MN activity (e.g. foreign sales,
employment) generally high.
Multinationals finance a substantial amount of their activities by borrowing in the host country. Why?
› Exchange rate risk: Take on liabilities and assets denominated in foreign currency to
reduce fluctuations in the value of net assets.
› Risk of expropriation: Possibility to default on foreign liabilities if foreign government
expropriates firm assets
2. Type of FDI
Two types of multinational activity (FDI)
› Horizontal (‘market-seeking’): Serving foreign markets directly (producing and selling to
customers abroad); replication of home activities in host country.
› Vertical (‘efficiency-seeking’): Sourcing from abroad; locating activities from a different
stage of the value chain to the host country. // Most real-world MNE’s do both
2
,Does FDI lead to more trade or less trade?
› FDI substitutes (Horizontal) for trade if the firm is market-seeking and trying to get around
tariffs or transportation costs.
• Producing locally avoids cost of importing.
› FDI complements (Vertical) trade in situations where FDI is efficiency- or strategic-
asset (innovation)-seeking.
• Overseas production generates exports back to the home country.
3. History and current patterns
› 1970s: FDI dominated by investments of U.S. firms in developing countries.
› 1980s: Rise of FDI by European and South- and East Asian firms. Orientation toward
developed countries (U.S. as main receiver of FDI.)
› 1990s: Rising FDI into developing countries (driven by low labor costs and economic
reforms).
› Nowadays: Most FDI flows between industrialized countries.
› Rising role of FDI in services sector, declining role of manufacturing and primary sector.
4. FDI inflows and outflows
Summary
› Foreign investment that leads to control over foreign operations is considered FDI.
› FDI is the main indicator of multinational activity.
› FDI can be a substitute or a complement to trade.
› Most FDI flows between rich countries.
3
, Part 1.3: Costs and benefits of FDI
1. Why do MNEs exist?
› Multinational activity is more than just shifting financial capital across borders:
• If differential returns to capital were the only reason, firms could just engage
in foreign portfolio investment without establishing managerial control. (less costly)
› Implies that there must be additional advantages of owning/controlling foreign operations.
• Firms have valuable assets and capabilities (firm specific advantages = FSAs)
they want to exploit in foreign markets (Resource-based view of the firm).
Firm-specific advantages
Firm-specific advantages = valuable firm-specific tangible and intangible resources and
capabilities.
Resources and capabilities generate a firm-specific advantage if they are:
• Valuable: Generate value for the firm
• Rare: Other competitors do not possess the exact same asset
• Inimitable: Other competitors can note easily copy and create this asset themself
• Non-substitutable: Vital for the firm success and cannot be replaced by another asset
› Firm-specific advantages allow the firm to overcome the inherent disadvantages of being
foreign (liability of foreignness). E.g.
• Overcoming institutional, cultural, and language barriers in the foreign country.
• Travel and communications costs (between headquarter and subsidiary).
• Other costs of doing business that native firms are not facing.
FDI vs. alternative strategies
› FDI is not the only means to exploit firm-specific advantages, alternative ways to leverage
the firm-specific assets:
• Exporting to foreign markets.
• Licensing to foreign firms.
FDI vs. exporting
Advantages of FDI over exporting:
› Utilize local resources (e.g. cheap labor). = not possible with exporting
› Circumvent (contourner) import restrictions in foreign country and avoid transportation
costs.
› Get access to trade blocs. => can be freely exported to other bloc member countries
› Proximity to foreign customers. => adapting more quickly to the taste changing
4
