Simona Dutta Dept. Of Commerce, SOL University of Delhi Unit III: International Investment Types of international investment; international investment theories - market imperfections theory, internalization theory, strategic behaviour, international product life cycle theory, Dunning’s eclectic paradigm; costs and benefits of FDI to host and home countries; Global trends in FDI. COST & BENEFITS OF FDI (I) BENEFIT TO HOST COUNTRY 1) Resource transfer effects: Inward FDI can make a positive contribution to the host country’s economy by supplying capital, technology & management resources that would otherwise not be available. 2) Financial Resources: Many large MNEs have access to financial resources which supplement the domestic capital available & help to spur the rate of investment, which is good for countries where saving rate is low. 3) Employment Effects: The beneficial employment effect claimed for FDI is that it brings jobs to the host countries that would otherwise not be created there. 4) Balance of Payment: A country’s balance of payment accounts keeps track of both its payment to and its receipt from other countries. FDI has some important BOP effects for a host country: a) Results in a one time capital inflow in the economy’s BOP account. b) FDI as a substitute for imports of goods and services, improves the current account of the host’s countries’ BOP. For instance:- Much of the FDI by Japanese automobile companies in the US and UK substitutes fore imports from Japan. c) Potential benefit arises when the MNE uses a foreign subsidiary to export goods and services to other countries. 5) Competition & Economic growth: The existence of competition among producers results in the efficient functioning of the markets. FDI in the form of Greenfield investment results in the creation of a new enterprise, increasing the number of players & competition in domestic market. BENEFITS OF FDI TO HOME COUNTRY 1) Employment Effect: Benefits to the home country from outward FDI arise from employment effects. Home country experiences positive employment effects when the foreign subsidiary creates demand for home country exports of capital equipment, intermediate goods, complementary products. 2) Increased Foreign Earnings: FDI is a major source of foreign earnings in the form of repatriated dividends, license fees, etc. 3) Acquisition of skills: The home country MNE learns valuable skills from its exposure to foreign markets that can be transferred back to the home country. 4) Advantages of Difference of Factor Endowments: Through FDI, the firms owns & controls actual operations overseas and can consequently capture the entire profit margin that otherwise must be shared between an importer & exporter. 5) Ensuring growth from Organizational learning: FDI creates a diverse & varied operating environment for the firm, allowing it to develop diverse capabilities & providing it with broader learning opportunities than available to a domestic firm. COST TO HOST COUNTRY Main costs of inward FDI that give rise to concern in host countries are: 1) Adverse effect on competition: Sometimes 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 organizations. As such, the foreign MNE may be able to draw on funds generated elsewhere to subsidize its costs in the host market, which could drive indigenous out of business and allow the firm to monopolize the market. Once the market was monopolized, the foreign MNE could raise prices above those that would prevail in competitive markets, with harmful effects on the economic welfare of the host nation. This concern tends to be greater in countries that have few large firms of their own that can compete with the subsidiaries of foreign MNEs. 2) Adverse Effect on the Balance of Payment: The possible adverse effects of FDI on a host country’s balance of payment position are twofold. a) Foreign subsidiary repatriates earnings to its parent company. Such outflows show up as a debit on the current account of the balance of payments. b) When a foreign subsidiary imports a substantial number of its inputs from abroad, which also results in a debit on the current account of the host’s country’s balance of payments. 3) National Sovereignty and Autonomy: Many host countries worry that FDI is accompanied by loss of economic independence. Key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control. COST TO HOME COUNTRY The most important concerns center around the balance of payments and employment effects of outward FDI. The home country’s trade position (its current account) may deteriorate if the purpose of the foreign investment is to serve the home market from low cost production location. For instance, when a US textile company shuts its plants in South Carolina and moves production to Central America, imports into the US rose and trade position deteriorated. INTERNATIONAL PRODUCT LIFE CYCLE THEORY International product life cycle theory was authored by Raymond Vernon, an American economist, from Harvard university in the 1960s, to explain the cycle the products go through when exposed to an international market. The product life cycle describes how a product matures and declines because of internationalization. Raymond Vernon theory also explains when FDI took place. The graphs below represent the trade cycles of a particular product cycle. As the product and the market for the product matures and changes, the countries of its production and export shifts. Vernon’s theory suggests that early in a product’s life cycle all the parts and labour associated with that product come from the area where it is invented. After the product is adopted & used in the global market, production gradually moves away from the point of origin & in some situations the product becomes an item that is imported by its original country of invention. Product is initially designed and produced in the US(Innovating Country). At this time, the production is highly capital and skilled labor- intensive. The country possesses the income to purchase the product in its new-product stage, in which it was relatively high priced. Other advanced countries, too, commerce their production at time t1 only & continue to be net importers. In the maturing product stage, production capability expands rapidly in other advanced countries. At the time t2, less-developed countries begin their production, although they continue to be net importers. In the standardized production, the stage sees the comparative advantage of production and export shifts to less-developed countries. The product is a relatively mass-produced product that can be made with increasingly less-skilled labor. With this, the US reduces domestic production and increases imports. Other advanced countries produce and export, although export peaks as the less-developed countries expand the production and become net exporters themselves. Thus, Vernon's theory suggests that early in a product's life cycle, all the parts and labor associated with that product come from the area where it was invented. After the product is adopted and used in the global market production, it gradually moves away from the point of origin. In some situations the product becomes an item that is imported by its original country of invention. (I) New product stage : In this stage, a company in a developed country will innovate a new product; the market for this product will be small and sales will be relatively low as a result. Innovative products are created in a developed nation because of the buoyant economy, which means people have more disposable income to use on new products. Company will keep the manufacture of the product local(innovating country) so that as process issues arise or need to modify the product in its infancy stage, changes can be implemented without too much risk and without wasting time. As sales increase, company may start to export the product out to other developed nations to increase sales and revenue. This is a straightforward step towards the internationalization of a product because the appetites of people within developed nations tend to be quite similar. (II) Maturing Product stage: Manufacturer of the product will open up production plant in other advanced countries to reduce the production cost and meet the increasing demand. Product development in the innovating country can still occur at this stage because there is still some room to adapt and modify the product if needed. Although the unit costs have decrease due to the decision to produce the product in other advanced countries, the manufacturer of the product will still require a highly skilled labor force. Local competition to offer alternatives start to form as the product becomes more matured and affordable, it begins to reach the countries that have a less developed economy and demand from those nations start to grow. Since the firm decides to shift its location of production to countries where the cost of production is less, FDI in low cost producing nations takes place. (III) Standardized Product Stage: At this stage, exports to nations with the less developed economy begin in earnest. Competitive product offers saturate the market which means that the original innovator of the product loses their competitive edge on the basis of innovation. Corporation focuses on driving down the production cost by moving facilities to nations where the average income is much lower and by standardizing and streamlining the manufacturing methods needed to make the product. The local workforce and lower income nations are then exposed to the technology and methods to make the product and competitors begin to rise. Meanwhile demand in the original nation, where the product came from, begins to decline. Market for the new product is now completely saturated and the innovating corporation leaves the manufacture of the product in low-income countries and switches its focus to a new product. Also developed countries are investing in innovating new technologies with new products, then, another new cycle starts. Unit IV: International Business Environment Political systems, legal systems, and economic systems; Elements of political, legal, economic and cultural environment relevant for international business, and associated risks; Framework for analyzing political, legal, economic and cultural environment across countries. INTERNATIONAL BUSINESS ENVIRONMENT Differences can & do have major implications for the practice of international business. They have profound impact on : 1) Benefits, costs& risks associated with doing business in different countries 2) Way in which operations in different countries should be managed. 3) Strategy International firms should pursue in different countries. CLASSIFICATION OF INTERNATIONAL BUSINESS ENVIRONMENT 1) MICRO AND MACRO ENVIRONMENT: Micro environment defined as the forces in the firm’s immediate environment which directly influence the firm’s decisions and operations. These include suppliers, various market intermediaries and service organisations such as middlemen, transporters, advertising and marketing research agencies, competitors customers and general public. Macro environment consists of broader forces which affect the firm as well as the other forces in the firm’s micro environment. These include factors such as political, legal, economic, social etc. Firms need to continuously monitor changes in these environmental forces and devise strategies to cope with them. 2) DOMESTIC, FOREIGN & GLOBAL ENVIRONMENT This classification is based on the location at which environmental forces exist and operate. Domestic environment consists of factors such as competitive structure, economic climate, political and legal factors which are essentially uncontrollable by a firm. These factors operate at the national level and the firms are generally familiar with them. Foreign environment consists of factors like social, political, economic, legal and cultural prevailing in a foreign country. Global environment transcends national boundaries and is not confined in its impact to just one country. Global environment exerts influence over domestic as well as foreign countries. It comprises of forces like world economic conditions, international financial systems, international agreements and treaties and regional economic groupings. COMPONENTS OF INTERNATIONAL BUSINESS ENVIRONMENT
POLITICAL ENVIRONMENT LEGAL ENVIRONMENT ECONOMIC ENVIRONMENT SOCIO-CULTURAL ENVIRONMENT TECHNOLOGICAL ENVIRONMENT DEMOGRAPHIC ENVIRONMENT (I) POLITICAL ENVIRONMENT Political system of a country shapes its economic & legal system. Political system is the system of governance in an economy. It includes the complete set of institutions, political organizations & interest groups. It also includes political ideology of government regarding foreign investment, foreign trade, tariffs, LPG, political stability, etc. Political systems can be assessed according to two dimensions- a) The degree to which they emphasize collectivism as opposed to individualism b) The degree to which they are democratic or totalitarian These dimensions are interrelated Collectivism: It refers to a political system that stresses the primary of collective goals over individual goals. When collectivism is emphasized, the needs of society s a whole are generally viewed as being more important than individual freedoms. The idea is to manage state owned enterprise to benefit society as a whole, rather than individual capitalists. Individualism: It stresses that the interests of the individual should take precedence over the interests of the state. Aristotle argued that individual diversity & private ownership are desirable; private property is more highly productive than communal property & thus stimulate progress. DEMOCRACY: It refers to a political system in which govt. is by the people, exercised either directly or through elected representatives. Based on the belief that citizens should be directly involved in decision making. TOTALITARIANISM: Monopolization of political power in the had of an individual or a group of individuals with virtually no opposition. Communist Totalitarianism- totalitarian dictatorship- eg. China, Cuba Theocratic Totalitarianism- Political power is monopolized by a party, group or individual that governs according to religious principles. Eg. Saudi Arabia POLITICAL RISKS Refers to the changes in the political environment that may adversely affect the profit & other goals of a business enterprise. Risks Related to Government Trade policies: Tariffs, exchange-rate controls, quotas, export/import license requirements, other trade barriers (embargos, sanctions) Political risks tends to be greater in countries experiencing social unrest & disorder. Risks Related to Government Economic Policy: Transfer Risks: Controlling foreign investment through taxes- govt. interfere with the firm’s ability to shift funds in & out the country. Ownership Risks: threatened for transfer of assets from company to local ownership through: - Confiscation (without compensation) - Expropriation (some reimbursement) - Nationalization (local government takes over) - Domestication (transfer to local enterprises) Risks Related to Labor and Action Groups Operating Risks: Ongoing operations of a firm & safety of its employees are threatened through changes in law, tax codes, terrorism, etc. Minimizing Political Risk Understand both ruling and opposition parties. Remain politically neutral. Be exemplary corporate citizens. Sell a quality product or service that is essential for local development. Partner with local companies and create local expertise. Use local suppliers. Obtain insurance coverage against expropriation, nationalization, confiscation, and terrorism.
