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Foreign direct investment: An overview of issues
International Review of Economics and Finance 18 (2009) 1 – 2 www.elsevier.com/locate/iref
Introduction
Foreign direct investment: An overview of issues B
We start with a definition of foreign direct investment (FDI), which distinguishes it from the broader concept foreign investment. FDI is a long-term investment by a non-resident, but with control (10% or more share). Thus, it is less liquid that, for example, portfolio investment. FDI is now one of the leading modes for reaching international markets. Stock of global FDI capital is 21% of global GDP. Foreign-affiliate exports make up 33% global exports. Domestic operations of 2,400 U.S. multi-national corporations (MNCs) in 1999 accounted for 26% of GDP, 63% of exports, 37% of imports, and 38% of R&D expenditure, of the U.S. economy. There are many types of FDI. Greenfield Investment involves building new facilities or expansion of existing facilities. Mergers and Acquisitions (M&A) on the other hand is taking over an existing foreign firm, although some capacity building often takes place subsequently. Toyota opening a car factory in the U.S.A. is an example of horizontal FDI. Vertical FDI can take two forms: backward vertical and forward vertical. Toyota opening a firm in China for producing parts for its Japanese operation is an example of backward vertical FDI, and Toyota opening a dealership in Hawaii to sell Toyota cars produced in Japan is a forward vertical FDI. FDI can also involve the creation of an 100% subsidiary of an MNC. Finally, it can take the form of an International Joint Venture (IJV). The last two can be either Greenfield or M&A. 75%–90% of FDI in the U.S. is M&A, and 10%–25% greenfield. IJV has been growing by 25% annually in the U.S. During 1988–1992, 2000 IJVs were formed in the U.S. Until recently, China and India allowed FDI mostly in the form of IJV. During 1979–1993, 75% of FDI in China was IJV. IJVs are being replaced by 100% subsidiaries in China: share of IJV in FDI 51.7% in 2000, 47.6% in 2001, 38% in 2002 and 35.8% in 2003. MNCs have many motives behind FDI. It can be resource seeking: exploiting cheap labor, natural resource etc. in the host country. It can be market seeking: avoiding high transportation cost, avoiding trade restriction with quid-proquo FDI, acquiring more information about market etc. in the host country. Finally, the motive can be efficiency seeking: exploiting economy of scale. The host countries also have many motives for trying to attract FDI. FDI has the employment creation effect in the host country, not only directly but also indirectly via backward linkages. Products produced by FDI have better chance of being exported and thus FDI has a export-promotion role. FDI may provide commodities for the consumers in the host country which domestic firms cannot. FDI can also have positive impact on domestic firm via technology spillover. Technology spillover from inward FDI account for 14% of productivity growth in the U.S. Because of this the host countries use many instruments to attract FDI, and some of these instruments are: (i) fiscal incentives. According to reports, the state of Alabama in the U.S. paid Mercedes Benz $253 million ($150,000 per new job created) to establish a plant, (ii) improving domestic infrastructure, (iii) promoting local skills development, and (iv) decreasing red tape. Regulations on FDI are being removed in the host countries: during 1991–97, 94% of regulations were removed. There are of course some potential adverse effects of FDI in the host country. It can crowd out of domestic investments. Tax competition for FDI can lead to reduced tax revenue and thus public good provision. This can also have implications for many social and welfare programs. In 1996 Thailand and Philippines competed for a ☆
This introduction is based on a large literature on the economics of foreign direct investment, which, for the sake of brevity, is not referred to here.
1059-0560/$ - see front matter © 2008 Elsevier Inc. All rights reserved. doi:10.1016/j.iref.2008.02.002
2
Introduction
$500 million car plant by General Motors. Thailand won by matching the Philippines offer PLUS giving 100% tax refund on raw materials and $15 million for a training institute. Vietnam won over Philippines in 2001 for a Canon plant by offering 10-year tax holiday. Finally, competition for FDI can lead to environmental degradation and the creation of pollution haven. There is now a growing literature which focuses on firm heterogeneity to explain different modes of accessing foreign firms and to why different firms try to access different markets. The broad finding are as follows. More efficient firms are more likely to do M&A than greenfield investment More efficient firms are more likely to FDI than export U.S. MNCs are more likely to do M&A (than greenfield investment) in more developed host countries. 60% U.S. outward FDI are in developed host countries. Finally, more efficient firms go to more advanced markets, and less efficient firms go to less efficient firms. More efficient Japanese manufacturing firms go to countries such as the U.S. and Europe, while less efficient Japanese firms invest in other Asian countries. Sajal Lahiri Department of Economics, Southern Illinois University Carbondale, Carbondale, IL, 62901-4515, USA E-mail address: [email protected].
Introduction
Foreign direct investment: An overview of issues B
We start with a definition of foreign direct investment (FDI), which distinguishes it from the broader concept foreign investment. FDI is a long-term investment by a non-resident, but with control (10% or more share). Thus, it is less liquid that, for example, portfolio investment. FDI is now one of the leading modes for reaching international markets. Stock of global FDI capital is 21% of global GDP. Foreign-affiliate exports make up 33% global exports. Domestic operations of 2,400 U.S. multi-national corporations (MNCs) in 1999 accounted for 26% of GDP, 63% of exports, 37% of imports, and 38% of R&D expenditure, of the U.S. economy. There are many types of FDI. Greenfield Investment involves building new facilities or expansion of existing facilities. Mergers and Acquisitions (M&A) on the other hand is taking over an existing foreign firm, although some capacity building often takes place subsequently. Toyota opening a car factory in the U.S.A. is an example of horizontal FDI. Vertical FDI can take two forms: backward vertical and forward vertical. Toyota opening a firm in China for producing parts for its Japanese operation is an example of backward vertical FDI, and Toyota opening a dealership in Hawaii to sell Toyota cars produced in Japan is a forward vertical FDI. FDI can also involve the creation of an 100% subsidiary of an MNC. Finally, it can take the form of an International Joint Venture (IJV). The last two can be either Greenfield or M&A. 75%–90% of FDI in the U.S. is M&A, and 10%–25% greenfield. IJV has been growing by 25% annually in the U.S. During 1988–1992, 2000 IJVs were formed in the U.S. Until recently, China and India allowed FDI mostly in the form of IJV. During 1979–1993, 75% of FDI in China was IJV. IJVs are being replaced by 100% subsidiaries in China: share of IJV in FDI 51.7% in 2000, 47.6% in 2001, 38% in 2002 and 35.8% in 2003. MNCs have many motives behind FDI. It can be resource seeking: exploiting cheap labor, natural resource etc. in the host country. It can be market seeking: avoiding high transportation cost, avoiding trade restriction with quid-proquo FDI, acquiring more information about market etc. in the host country. Finally, the motive can be efficiency seeking: exploiting economy of scale. The host countries also have many motives for trying to attract FDI. FDI has the employment creation effect in the host country, not only directly but also indirectly via backward linkages. Products produced by FDI have better chance of being exported and thus FDI has a export-promotion role. FDI may provide commodities for the consumers in the host country which domestic firms cannot. FDI can also have positive impact on domestic firm via technology spillover. Technology spillover from inward FDI account for 14% of productivity growth in the U.S. Because of this the host countries use many instruments to attract FDI, and some of these instruments are: (i) fiscal incentives. According to reports, the state of Alabama in the U.S. paid Mercedes Benz $253 million ($150,000 per new job created) to establish a plant, (ii) improving domestic infrastructure, (iii) promoting local skills development, and (iv) decreasing red tape. Regulations on FDI are being removed in the host countries: during 1991–97, 94% of regulations were removed. There are of course some potential adverse effects of FDI in the host country. It can crowd out of domestic investments. Tax competition for FDI can lead to reduced tax revenue and thus public good provision. This can also have implications for many social and welfare programs. In 1996 Thailand and Philippines competed for a ☆
This introduction is based on a large literature on the economics of foreign direct investment, which, for the sake of brevity, is not referred to here.
1059-0560/$ - see front matter © 2008 Elsevier Inc. All rights reserved. doi:10.1016/j.iref.2008.02.002
2
Introduction
$500 million car plant by General Motors. Thailand won by matching the Philippines offer PLUS giving 100% tax refund on raw materials and $15 million for a training institute. Vietnam won over Philippines in 2001 for a Canon plant by offering 10-year tax holiday. Finally, competition for FDI can lead to environmental degradation and the creation of pollution haven. There is now a growing literature which focuses on firm heterogeneity to explain different modes of accessing foreign firms and to why different firms try to access different markets. The broad finding are as follows. More efficient firms are more likely to do M&A than greenfield investment More efficient firms are more likely to FDI than export U.S. MNCs are more likely to do M&A (than greenfield investment) in more developed host countries. 60% U.S. outward FDI are in developed host countries. Finally, more efficient firms go to more advanced markets, and less efficient firms go to less efficient firms. More efficient Japanese manufacturing firms go to countries such as the U.S. and Europe, while less efficient Japanese firms invest in other Asian countries. Sajal Lahiri Department of Economics, Southern Illinois University Carbondale, Carbondale, IL, 62901-4515, USA E-mail address: [email protected].