Foreign Direct Investment (FDI) is defined as a process where residents from another country acquire ownership of assets of a firm in a foreign country with the purpose of controlling production, distribution among other purposes (Moosa 2002 p.1). The IMF defines FDI as ‘ an investment that is made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor, the investor’s purpose being to have an effective voice in the management of the enterprise’ (Moosa 2002 p.1). Terms like ‘control’ and ‘controlling interests’ are used in majority of its definition to distinguish FDI from portfolio investment, which seeks not to control a lasting interest but a minimum of 10% shareholding.
Reasons for Foreign Direct Investment: eclectic paradigm
Wide-ranging theoretical and empirical research has been carried out to explain reasons for a company’s engagement in FDI. Hess (2008) has delved into various classic theories of trade and foreign direct investment (Hess 2008 p. 48). Of these theories, eclectic paradigm appears more convincing. The Eclectic paradigm (OLI, Ownership-Location-Internationalization) is determined by three sets of advantages; ownership, location, and internationalization. Dunning (1980) revealed different types of ownership-specific advantages; location advantages, and internationalization advantages (Dunning 1988). According to Duning (1980), location advantages are as a result of variations in factor endowment, transport costs and distance, incentives, artificial barriers, and infrastructure.
Internationalization advantages arise from market failures- risks and uncertainties (Buckley 1988). These risks and uncertainties result from a firm’s ability to exploit the economies of scale in an imperfect market coupled with cases where trading in a particular good or service leads into costs and benefits occurring outside that transaction. Consequently, these costs and benefits are not reflected in the terms of agreements between transacting parties.
When firms decide on international production (FDI), they consider 3 sets of forces; the competitive advantage, the extent of a firms perception of interest to internalize markets, and the extent of a firm’s choice to locate value adding activities in foreign countries.
In general, FDI plays an indispensable role in global business. It is practiced by multinational companies whose operations are based in several foreign countries but headquartered in one country. For example, Nestle, the chocolate manufacturer, is a Swiss company with operations all over the world. Foreign subsidiary is another important aspect of FDI where companies own whole or partial control of foreign companies.
There are several ways in which multinationals can engage in FDI. One of such ways is through the purchase of an existing company like in the example of where Santander Central Hispano bought Abbey National of the United Kingdom. Another form of FDI involves setting up new overseas operations either partially or wholly.
Based on the eclectic paradigm, several reasons explaining why multinational corporations engage in FDI are evident, these are:
Increase sales and profits
Multinationals engage in foreign investment with a basic aim of increasing sales and profits. This is the first and the most important goal of multinational DFI. They are not steered by any altruistic motives to benefit the developing economies but rather exploit their natural resources. What the MNCs want is an opportunity to make sure that their investments make them more benefits than costs.
Big multinationals pocket millions of dollars each year from overseas sales. In Europe for example, the Shell has over 75% of its assets in foreign markets. Nestle, a Swiss company, has nearly 90% of its assets outside Switzerland that has a relatively smaller economy. The same applies for the revenues of these multinationals. For Shell, an approximately 50% of its annual total revenue come from outside its domestic markets. As for BP, around 70% of its revenue originates outside the domestic markets. Foreign markets have more lucrative opportunities than home markets.
Enter rapidly growing markets
International markets do not grow at the same rate. Some grow faster than others. FDI provides multinational with a rare chance to tap these opportunities. Accessing new market is a major consideration when companies consider foreign investment. Companies understand that at a certain point, exporting a product or a service will attain a certain critical mass of amount and cost where investing in a foreign country becomes cost effective. A decision to invest is therefore a combination of assessment of internal resources, competitiveness capacity, and market analysis and expectation.
For example, the Chinese markets are predicted to grow at an annual rate of 8%. With its GDP in the range of US 1 Trillion, most multinational corporations are likely find a very high demand for their products that domestic Chinese companies cannot satisfy. Africa has also rapidly growing markets that continue to attract large multinationals especially in the ICT and other industries.
Reduce production costs
Multinationals aim at reducing the production costs while they engage in foreign direct investment. This is despite the fact that they can import cheap raw materials. However, they want to benefit from cheap labor available in another company. Companies find it worthwhile to move production close to the source of supply rather than import the materials. Investing in overseas production facilities where cheap raw materials are available saves them additional costs of transporting the materials especially when importing the materials is no longer necessary. Additionally, companies use less costs in shipping home finished products.
A good example is Japan which lack adequate land for majority of its manufacturing industries. The companies invest in other countries like China and Scotland where land is available. Companies look at geographic areas where labor costs are lower. Canadian companies have in recent past crossed borders to invest in the US where there are lower labor costs.
Companies also consider energy factor when investing in foreign countries. This is if the cost of energy for production is high in the home country than in the foreign country. This may make multinationals set up operational overseas near sources cheap of energy.
Transportation is another important factor that companies consider. This is evident in Chinese textile companies that have gained advantages in the US market even after factoring in transportation expenses.
Gain a foothold in economic blocs
Many of the Multinationals operate within the ‘triad’ nations. The ‘triad’ is composed of three major trading and investment blocs in international arena- the US, EU, and Japan. If an MNC acquires a company within this bloc or enters into an alliance with a company operating here, it obtains a variety of benefits which comprises the right to sell their products without being burdened by the import duties and other restrictions. The EU alone has up to 15 member countries comprising among others Austria, Finland and Sweden. 13 more states are considering joining the bloc. For international companies seeking to get a foothold in this region, it is paramount that this be achieved through FDI. Other blocs like the Asian bloc comprising of Australia, China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, and Thailand. Another bloc in the making is NAFTA that will be made up of the US, Canada, Mexico and maybe Chile. This will make up three important triads thus necessitating any company with an interest to do business globally to have its presence in all the blocs.
Protect domestic markets
This is yet another major reason for companies engaging in foreign direct investment. Many MNCs enter international market with an aim of attacking their potential competitors and prevent them from expanding into overseas markets. This is because the attacked companies are less likely to expand as they will be busy defending their home markets. Correspondingly, a company may enter a foreign market so as to bring down pressure on a foreign company that has already challenged its operations at its domestic market. A good example is when Fuji started building its first production facility in the US. 10 days later, Kodak-a US company, announced its plan to open production plant in Japan, the home to Fuji.
Acquire technological and managerial knowhow
Sometimes, MNCs invest in foreign countries aiming to acquire technological and managerial skills (Shapiro 2003 p.34). They do this by setting up production facilities near those of its competitors. This explains why Kodak, for example, moved its research and development facilities to Tokyo. The company aimed at tapping scientist from Japanese universities and at the same time monitoring competition. Kodak built 180,000 square foot research and development offices and trained its top scientists to assists in recruitment. This was exactly what Japanese companies did in the US. They (Kodak) started financing research by university scientists, offering scholarship to leading Japanese science or engineering students and later recruiting them into the company. Due to this move, Japan is currently the leading center for Kodak’s worldwide research efforts in its product development.
Protect foreign markets
According to Rugman (2003), multinational corporations engage in FDI with an aim of protecting their foreign markets (Rugman 2003). Between 1981 and 1991, total number of service stations decreased by almost 50%. Sensing danger, BP realized it had to make some substantial investment to upgrade its service stations if it was to survive in this market. The company, which refines and markets petroleum products, decided that to attract an increasing number of customers to its service stations, it was capable of benefiting handsomely if it moved the products directly to the consumers by bypassing the middlemen.
Some MNCs with already established products at home choose to venture into other markets in other industrialized countries due to ready demand for their goods and services (Hess 2002 p. 48). This high demand makes multinational companies to decide to invest in manufacturing capabilities in the foreign countries with an aim of cutting transportation costs. During Europe’s industrial development, there was saturation in market in Britain with textile products; as a result, textiles from Britain were exported to foreign markets. This trend led to the emergence of a wave of industrialization and investment.
Avoid state trade barriers
Multinational corporations engage in foreign direct investment as a mechanism of avoiding state trade barriers, which could be very high. Foreign countries impose high tariffs with an aim of protecting domestic firms against cheap foreign imports. According to Hess (2002), the differences between import complementing in the US i.e. investments that competes directly with domestic businesses make home firms to line up in favor foreign firms importing goods into the local market. Therefore, through Foreign Direct investment, foreign and home firms line up against protection. However, tariff jumping is only popular with experienced multinationals.
To gain advantage of ownership, location and internationalization
Through foreign direct investment, MNC stand gaining additional benefits such as international transfer pricing, ability to shift assets to different currency to make profits, diversifying investment portfolio and the opportunities to form parallel production capacity in more than one country to shield against possible slowdowns and / or labor unrests. MNCs estimate the competition and single out countries with equal policies on the free movement of capital as similar risks of investment. These multinationals will look at factors such as market structure, natural resources, labor, closeness to market, legal and business environment and other policies as providing locational advantages. Companies consider foreign direct investment by internationalizing capital, technology and management through direct regulation in their foreign holdings. This is instead of leaving full control of these companies to the local managers, giving them freedom or being involved in uncertain and uncontrolled portfolio investment.
Obtain local support
Dynamic FDI brings to the host country durable and stable capital flows as the investment is concentrated in long term assets. The introduction of foreign funds into a country’s economy contributes to the collective demand of the economy. This ultimately leads to the growth of the economy of the receiving country.
For any economy to grow by 8% per year, an investment of around 30-40 percent of its GDP is necessary. Majority of the national saving usually do not hold this amount of money. This investment gap can only be met by foreign investments in terms of FDI. Governments across the globe attempt to avail various incentives to foreign investors in a bid to attract them.
To attract this much needed foreign direct investment, host countries offer a variety of incentives ranging from lowered taxes, rationalized registration and application procedures and financing from local government. MNCs also receive greater access to local resources. MNCs consider FDI because a simple local sales office or alliances with local businesses is not considered an FDI and therefore does not attract local support. Companies have to show commitments in terms of their capital evidenced through buildings, machineries and equipment. Physical investments such as setting up production facilities and other service facilities lead to a near automatic embracement by the host countries.
Beginning in 1980’s, governments in Southern Africa (SADC) have relaxed their regulations for investors. Today, there is an easy entry for foreign investors, ability to borrow locally has been made easy and land and mining concessions have been relaxed. Host governments offer incentives in a variety of forms such as fiscal (reduced taxes, tax holidays, subsidies, exemption from import duties, accelerated depreciation allowances, investment allowance), financial (grants and loans), and rule based incentives(CUTS 2001).
FDI is a driver for international trade with the majority of companies trying to create a foothold in international markets by establishing operations in foreign countries or acquiring existing businesses there. FDI is higher in the industrialized countries than in less developed countries like those in Eastern Europe, Korea, and Singapore. FDI takes place both within and outside the ‘triad’. An example is the US, which is a major target investment ground by foreign countries but it also invests elsewhere. While investing, MNCs face several barriers such as innovation, factor conditions, demand conditions, rivalry, and structure and so on.
Multinational corporations have a number of reasons for opting direct foreign investment. The companies gain advantages such as acquiring lower-cost factors of production, knowledge acquisition and regulation of highly efficient factors of production, better facilities for distribution, monopolistic and oligopolistic opportunities and exploiting imperfect markets.
Increasing sales and profit maximization is the most prominent reason for engaging in foreign direct investment. FDI provides companies in small home economies to seek markets across the border. Some companies engage in FDI aiming to benefit from a rapidly growing market like evidenced by high investment into Chinese market by many MNCs.
Still, others enter into foreign markets because the cost of production is lower in those countries than at home. This could be in terms of labor, transportation, raw materials, and energy. The existence of the ‘triad’ economic blocs is a motivation to these MNCs as they strive to gain a foothold in these regions. This is mainly because of the benefit that accompanies their presence. Protection of both the domestic and foreign markets also comes out clearly as a major reason for engaging in FDI.
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Dunning, J.H., 1980. “Toward an eclectic theory of international production: Some empirical tests”, Journal of International Business Studies, Vol. 11 No. 1, pp. 9-31.
Hess, M., 2008. Doorways to development: Foreign direct investment policies in developing countries. New Orleans, ProQuest.
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Rugman, A.M., 1982. New Theories of the Multinational Enterprise. London, Croom Helm and New York, St. Martin’s.
Shapiro, A.C., 2003. Multinational Financial Management, 7th Edition. New York, Wiley.