Foreign Direct Investment in the World Economy

Recognize current trends regarding foreign direct investment (FDI) in the world economy.

When discussing foreign direct investment, it is important to distinguish between the flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI undertaken over a given time period (normally a year). The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. We also talk of outflows of FDI, meaning the flow of FDI out of a country, and inflows of FDI, the flow of FDI into a country.

Flow of FDI

The amount of direct investment into a country in a defined time period undertaken by foreign entities (FDI inflow), or the amount of direct investment into foreign countries made by entities resident in a country in a defined period of time (FDI outflow).

Stock of FDI

The cumulative value of direct investments that have been made by foreign entities in a country at a given point in time.

Outflows of FDI

Flow of foreign direct investment out of a country.

Inflows of FDI

Flow of foreign direct investment into a country.

TRENDS IN FDI

The past 35 years have seen a marked increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from $25 billion in 1975 to $1.5 trillion in 2011 (see Figure 8.1). FDI outflows did contract to around $1.1 trillion in 2009 in the wake of the global financial crisis after hitting a record $2 trillion in 2007, but they have since recovered.2 In general, however, over the past 30 years the flow of FDI has accelerated faster than the growth in world trade and world output. For example, between 1992 and 2010, the total flow of FDI from all countries increased around ninefold while world trade by value grew fourfold and world output by around 55 percent.3 As a result of the strong FDI flows, by 2010 the global stock of FDI was about $20 trillion. Multinationals accounted for one-quarter of global GDP in 2010. The foreign affiliates of multinationals had more than $32 trillion in global sales and accounted for one-tenth of global GDP and one-third of global exports.4

FIGURE 8.1 FDI Outflows, 1982–2011 ($ billions)

FDI has grown more rapidly than world trade and world output for several reasons. First, despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Second, much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world’s developing nations. The general shift toward democratic political institutions and free market economies that we discussed in Chapter 3 has encouraged FDI. Across much of Asia, eastern Europe, and Latin America, economic growth, economic deregulation, privatization programs that are open to foreign investors, and removal of many restrictions on FDI have made these countries more attractive to foreign multinationals. According to the United Nations, some 90 percent of the 2,700 changes made worldwide between 1992 and 2009 in the laws governing foreign direct investment created a more favorable environment for FDI.5

The globalization of the world economy is also having a positive effect on the volume of FDI. Many firms now see the whole world as their market, and they are undertaking FDI in an attempt to make sure they have a significant presence in many regions of the world. For reasons that we shall explore later in this book, many firms now believe it is important to have production facilities based close to their major customers. This, too, creates pressure for greater FDI.

ANOTHER PERSPECTIVE Zambia experiences large FDI increase for 2011

Inward foreign investment into Zambia increased significantly in 2011, arresting a downward trend that followed the 2008 financial crisis. In 2011 there were record levels of FDI into the country, with 26 investments made and more than $2.3bn [billion] invested. This led to the creation of more than 10,000 jobs. When compared with 2010 data, the number of investments increased by 86 percent, the level of capital investment increased by 74 percent, and the number of jobs created increased by 273 percent. This assertion is attributed to the efforts made by the Zambian government to make the country more attractive to potential investors. Much of this increase in 2011 can be explained by large-scale investments in the metals sector, with eight investments in this sector creating more than 6500 jobs and garnering $1.8bn in investments.

Source: http://www.fdiintelligence.com/Trend-Tracker/Zambia-experiences-large-FDI-increase-for-2011

THE DIRECTION OF FDI

Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the others’ markets (see Figure 8.2). During the 1980s and 1990s, the United States was often the favorite target for FDI inflows. The United States has been an attractive target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI. Investors include firms based in Great Britain, Japan, Germany, Holland, and France. Inward investment into the United States remained high during the 2000s and stood at $210 billion in 2011. The developed nations of the European Union have also been recipients of significant FDI inflows, principally from the United States and other member-states of the EU. In 2011, inward investment into the EU was $414 billion. The United Kingdom and France have historically been the largest recipients of inward FDI.6

FIGURE 8.2 FDI Inflows by Region, 1995–2010 ($ billions)

Even though developed nations still account for the largest share of FDI inflows, FDI into developing nations has increased markedly (see Figure 8.2). Most recent inflows into developing nations have been targeted at the emerging economies of South, East, and Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient of FDI, which attracted about $60 billion of FDI in 2004 and rose steadily to hit a record $124 billion in 2011.7 The reasons for the strong flow of investment into China are discussed in the accompanying Country Focus. Latin America is the next most important region in the developing world for FDI inflows. In 2011, total inward investments into this region reached $216 billion. Brazil has historically been the top recipient of inward FDI in Latin America. At the other end of the scale, Africa has long received the smallest amount of inward investment; $54 billion in 2011. In recent years, Chinese enterprises have emerged as major investors in Africa, particularly in extraction industries where they seem to be trying to assure future supplies of valuable raw materials. The inability of Africa to attract greater investment is in part a reflection of the political unrest, armed conflict, and frequent changes in economic policy in the region.8

COUNTRY FOCUS Foreign Direct Investment in China

Beginning in late 1978, China’s leadership decided to move the economy away from a centrally planned socialist system to one that was more market driven. The result has been nearly three decades of sustained high economic growth rates of around 10 percent annually compounded. This growth attracted substantial foreign investment. Starting from a tiny base, foreign investment increased to an annual average rate of $2.7 billion between 1985 and 1990 and then surged to $40 billion annually in the late 1990s, making China the second biggest recipient of FDI inflows in the world after the United States. By late 2000, China was attracting between $80 billion and $100 billion of FDI annually, with another $60 billion a year going into Hong Kong. In 2011, a record $124 billion was invested in China and another $78.4 billion in Hong Kong. Over the past 20 years, this inflow has resulted in the establishment of more than 300,000 foreign-funded enterprises in China. The total stock of FDI in mainland China grew from almost nothing in 1978 to $578 billion in 2011 (another $1.1 trillion of FDI stock was in Hong Kong).

The reasons for this investment are fairly obvious. With a population of more than 1.3 billion people, China represents the world’s largest market. Historically, import tariffs made it difficult to serve this market via exports, so FDI was required if a company wanted to tap into the country’s huge potential. China joined the World Trade Organization in 2001. As a result, average tariff rates on imports have fallen from 15.4 percent to about 8 percent today, reducing this motive for investing in China (although at 8 percent, tariffs are still above the average of 3.5 percent found in many developed nations). Notwithstanding tariff rates, many foreign firms believe that doing business in China requires a substantial presence in the country to build guanxi, the crucial relationship networks (see Chapter 4 for details). Furthermore, a combination of relatively inexpensive labor and tax incentives, particularly for enterprises that establish themselves in special economic zones, makes China an attractive base from which to serve Asian or world markets with exports (although rising labor costs in China are now making this less important).

Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China. Blinded by the size and potential of China’s market, many firms have paid less attention than perhaps they should have to the complexities of operating a business in this country until after the investment has been made. China may have a huge population, but despite decades of rapid growth, it is still relatively poor. The lack of purchasing power translates into relatively immature market for many Western consumer goods outside of relatively affluent urban areas such as Shanghai. Other problems include a highly regulated environment, which can make it problematic to conduct business transactions, and shifting tax and regulatory regimes. For example, a few years ago, the Chinese government suddenly scrapped a tax credit scheme that had made it attractive to import capital equipment into China. This immediately made it more expensive to set up operations in the country. Then there are problems with local joint-venture partners that are inexperienced, opportunistic, or simply operate according to different goals. One U.S. manager explained that when he laid off 200 people to reduce costs, his Chinese partner hired them all back the next day. When he inquired why they had been hired back, the executive of the Chinese partner, which was government owned, explained that as an agency of the government, it had an “obligation” to reduce unemployment.

To continue to attract foreign investment, in late 2000 the Chinese government has committed itself to invest more than $800 billion in infrastructure projects over 10 years. This should improve the nation’s poor highway system. By giving preferential tax breaks to companies that invest in special regions, such as that around Chongqing, the Chinese have created incentives for foreign companies to invest in China’s vast interior where markets are underserved. They have been pursuing a macroeconomic policy that includes an emphasis on maintaining steady economic growth, low inflation, and a stable currency—all of which are attractive to foreign investors. Given these developments, it seems likely that the country will continue to be an important magnet for foreign investors well into the future.

Sources: Interviews by the author while in China; United Nations, World Investment Report, 2009 (New York and Geneva: The United Nations, 2009); Linda Ng and C. Tuan, “Building a Favorable Investment Environment: Evidence for the Facilitation of FDI in China,” The World Economy, 2002, pp. 1095–114; and S. Chan and G. Qingyang, “Investment in China Migrates Inland,” Far Eastern Economic Review, May 2006, pp. 52–57.

THE SOURCE OF FDI

Since World War II, the United States has been the largest source country for FDI, a position it retained during the late 1990s and early 2000s. Other important source countries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countries accounted for 60 percent of all FDI outflows for 1998–2010 (see Figure 8.3). As might be expected, these countries also predominate in rankings of the world’s largest multinationals.9 These nations dominate primarily because they were the most developed nations with the largest economies during much of the postwar period and therefore home to many of the largest and best capitalized enterprises. Many of these countries also had a long history as trading nations and naturally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enterprises based there have been at the forefront of foreign investment trends.

FIGURE 8.3 Cumulative FDI Outflows, 1998–2010 ($ billions)

This being said, it is noteworthy that Chinese firms have started to emerge as major foreign investors. In 2005, Chinese firms invested some $15 billion internationally. Since then, the figure has risen every year, hitting $68 billion in 2010. Firms based in Hong Kong accounted for another $76 billion of outward FDI in 2010. Much of the outward investment by Chinese firms has been directed at extractive industries in less developed nations (e.g., China has been a major investor in African countries). A major motive for these investments has been to gain access to raw materials, of which China is one of the world’s largest consumers. There are signs, however, that Chinese firms are starting to turn their attention to more advanced nations. In 2010, Chinese firms invested $5 billion in the United States, up from $146 million in 2003.10

THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTS

FDI can take the form of a greenfield investment in a new facility or an acquisition of or a merger with an existing local firm. UN estimates indicate that some 40 to 80 percent of all FDI inflows were in the form of mergers and acquisitions between 1998 and 2010. In 2001, for example, mergers and acquisitions accounted for 78 percent of all FDI inflows. In 2004, the figure was 59 percent. The figure slumped to 22 percent in 2009, reflecting the impact of the global financial crisis and the difficulties of financing acquisitions through the public capital markets before rising again to around 40 percent in 201011 However, FDI flows into developed nations differ markedly from those into developing nations. In the case of developing nations, only about one-third or less of FDI is in the form of cross-border mergers and acquisitions. The lower percentage of mergers and acquisitions may simply reflect the fact that there are fewer target firms to acquire in developing nations.

When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake greenfield investments? We shall consider this question in depth in Chapter 12. For now, we will make a few basic observations. First, mergers and acquisitions are quicker to execute than greenfield investments. This is an important consideration in the modern business world where markets evolve very rapidly. Many firms apparently believe that if they do not acquire a desirable target firm, then their global rivals will. Second, foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trademarks or patents, distribution systems, production systems, and the like. It is easier and perhaps less risky for a firm to acquire those assets than to build them from the ground up through a greenfield investment. Third, firms make acquisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology, or management skills (see the next Management Focus on Cemex for an example). However, as we shall discuss in Chapter 12, there is evidence that many mergers and acquisitions fail to realize their anticipated gains.12

• QUICK STUDY

1. How important has FDI been in the world economy during the last three decades? What explains the growth in FDI?

2. Why has the United States been a favored target for inward FDI? Why has China?

3. Why have developed nations been the source of most outward FDI?

4. What do you think explains the recent rise of China as a source of outward FDI?

Theories of Foreign Direct Investment

LEARNING OBJECTIVE 2

Explain the different theories of FDI.

In this section, we review several theories of foreign direct investment. These theories approach the various phenomena of foreign direct investment from three complementary perspectives. One set of theories seeks to explain why a firm will favor direct investment as a means of entering a foreign market when two other alternatives, exporting and licensing, are open to it. Another set of theories seeks to explain why firms in the same industry often undertake foreign direct investment at the same time and why they favor certain locations over others as targets for foreign direct investment. Put differently, these theories attempt to explain the observed pattern of foreign direct investment flows. A third theoretical perspective, known as the eclectic paradigm, attempts to combine the two other perspectives into a single holistic explanation of foreign direct investment (this theoretical perspective is eclectic because the best aspects of other theories are taken and combined into a single explanation).

Eclectic Paradigm

Argument that combining location specific assets or resource endowments and the firm’s own unique assets often requires FDI; it requires the firm to establish production facilities where those foreign assets or resource endowments are located.