Analysis of advantages and disadvantages of FDI
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With the development of economic globalization, foreign direct investment (FDI) is increasingly being recognized as an important factor in the economic development of countries. Although FDI began centuries ago, the biggest growth has occurred in recent years. This growth resulted from several factors, particularly the more receptive attitude of governments to investment inflows, the process of privatization, and the growing interdependence of the world economy.
Foreign direct investment (FDI) occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country (charles w.l.hill, “International business”). FDI takes on two main forms; the first is a green-field investment, which involves the establishment of a wholly new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country. On the other hand, FDI is divided into two kinds; horizontal FDI (market-expansion investments) which is investment in the same industry abroad as a firm operates in at home; And vertical FDI (resource-seeking investments), which comprises two forms further; the first is backward vertical FDI investing an industry abroad that provides inputs for a firm’s domestic production process. The second is forward vertical FDI in which an industry abroad sells the foods of a firm’s domestic production processes.
Analysis of advantages and disadvantages of FDI
In addition to FDI, the firms are also able to expand foreign market by means of exporting and licensing.
Compared with exporting and licensing, the advantages of FDI for companies
1. Low transportation cost. As far as the firms which mainly adopt horizontal FDI are concerned, transportation cost must normally be considered to production costs. When the firm produces a low value-to-weight ratio production such as margarine newspaper and the like, relative to exporting, FDI would only need a low transportation cost. But for products with a high value-to-weight ratio, transport costs are a minor component of total landed cost. In this case, the advantage of FDI over exporting is very limited.
2. Avoidance of trade restriction. For various reasons, many countries might make it impractical in many ways for companies to reach their market potential through exportation alone. The primary form of impediment to exporting is import barrier. Many countries’ governments place tariffs on imported goods and limit import through the imposition of quotas, both of which make exporting unprofitable. On the other hand, it increases the profitability of FDI. Thus, for entering countries that place tariffs but have a large growing market potential such as China, many firms choose FDI and/ or licensing to expand their foreign markets.
3. Advantage of tax incentives. In some developing countries, on the one hand, they need to place tariffs on imported goods for protecting their own firms, on the other, they also strive to create a favorable and enabling climate to attract FDI, which brings capital, facilitates the transfer of technology, organizational and managerial practices and skills as well as access to international markets. Therefore, some countries offer tax incentives to attract investment. For those multinational companies located in high tax rate’s nations such as UK, and US, invest in a country which exists tax incentives is a good way to reduce tax.
4. Avoidance of an uncertain cost structure created by foreign exchange. When a firm adopts exporting to be a primary method for expansion of foreign market, one of the main risks it has to be faced with is mismatch of currency of firm’s cash inflow and cash outflow. Cost and revenue are derived from different denominations, once the main currency in home country strengthens, income created by host country’s currency might no longer cover costs. To the contrary, FDI makes sure all costs and revenue are derived from the same currency. Thus, it reduces risk arisen by foreign exchange.
5. Avoidance of consumer-imposed restrictions. In some countries, there are not only trade barrier imposed by government, but also limitations imposed by consumers. Take South Korea as a example, many Korean may prefer to buy domestically produced goods even when they are more expensive, largely because of their nationalism. Another worry about foreign-made goods is that service and replacement parts will be difficult to obtain. In this situation, undertaking FDI is a better choice than exporting.
6. Use of local raw materials and market testing. As we have known, different countries have different tastes and requirements to the same goods. Thus, a multinational company often must alter a product to suit local tastes and requirements. It means that local raw materials and market testing may be used. In the situation, exporting is difficult and expensive. When firms think licensing is unsafe to protect their know-how, the best way to expand foreign market is FDI.
7. Protection to firms’ know- how. Some companies enjoy the competitive advantages derivable from their technological, marketing or management know-how, part of who adopt licensing to expand foreign market. The main merit of licensing is that it would not have to bear the costs and risks yet it could earn a good return from its know- how in the form of royalty fees. Meanwhile, however, utilization of licensing might take several risks.
First, licensing may result in that its licensee assimilates this firm’s technologies and become a potential foreign competitor. Whatever companies, planning to do a horizontal or vertical investment abroad, may suffer a future competition for licensee can grasp advanced technologies from licenser, and use it to compete directly against licenser. To the contrary, FDI can prevent firm’s know-how from being used by other firms. Therefore, undertaking horizontal FDI and backward vertical FDI will occur respectively when firm has predicted a potential risk to the sale of know- how.
Second, licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country. Generally, when a firm undertakes licensing to a foreign company, control over production, marketing, and strategy are granted to its licensee in return for a loyalty fee. This point might produce a divergence between licenser and licensee’s strategies, and sometimes hard to conciliate. If tight control over a foreign entity is desirable, FDI is preferable to licensing.
The disadvantages of FDI for the companies:
1. FDI is more expensive than exporting and licensing. As notes earlier, FDI may undertake the two forms: green-field investment in a new facilities and acquisition or merger with an existing local firm. When other thing being equal, firms will have to spend a large number of money establishing production facilities in a foreign country or acquiring a foreign enterprise. Conversely, when a firm exports, it need not bear the cost of FDI. When a firm licenses its know-how, it doesn’t need to pay any costs and can gain some profits from licensee.
2. FDI is more risky than exporting and licensing. Firstly, as far as a multinational company is concerned, the most important factor that attracts it to invest abroad is a stable political circumstance and a relatively open free market. Nevertheless sometimes this factor is highly unpredictable. If a firm does a FDI abroad, it normally has to face more political risks than exporting and licensing. In general, risks can be broken down into three categories (1) expropriation. The host country’s government will claim ownership of firm’s property. (2) Currency inconvertibility. (3) Political violence. Secondly, although a firm does a judicious choice as it decides to invest in a foreign market, it might still be faced with another risk associated with doing business in another culture where the “rules of game” may be very different. A case in this point is a huge cultural difference between the East and the West. A firm lying in a side plans to invest in the other side, if it ignores cultural difference or misunderstand; it may make costly mistakes, even totally fail. Conversely, exporting and licensing are relatively secure. Firms need not comprehend and interpret cultural and environmental difference. They can use a native sales agent to reduce the risks associated with selling abroad.
Factors for international manufacturing business in choosing a strategy to expand foreign market
As for firms engaged in international manufacturing business, when they decide which form is preferable to expand their foreign market, exporting, licensing or FDI, it is necessary to consider the below several factors.
Firstly, transportation costs should be an important factor to consider. As noted earlier, for products with a low value-to-weigh ratio, exporting will become unprofitable to ship these products. To the contrary, for products with a high value-to-weigh ratio, transportation costs play a trivial role on choosing exporting, licensing and FDI. Focusing on manufacturing firms which mainly produce household such as refrigerators, washing machines vacuum cleaners, whose products mostly belong to low value-to-weigh ratio products, exporting is not a good option. Conversely, for manufacturing firms which produce software, personal computers and so on, there is little impact on the relative attractiveness of exporting, licensing and FDI.
Secondly, trade barrier is also a vital factor to consider in deciding whether exporting is a good option or not. When host countries place tariffs on the imported foods, for example, China places a relatively high tariff on the imported auto largely for protecting native auto industry, as for manufacturing firms which intend to expand their auto products into china’s market, exporting is costly. If these firms don’t want to be unprofitable, they have to increase price of products, which makes them be an inferior position in the competition with native auto companies. Therefore, if there exists some trade barrier, exporting from home country to host country is not sensible option.
Generally, if there not exist high transportation costs and trade barrier, it is sensible and reasonable for international manufacturing companies to undertake exporting as a form of expanding foreign market and vice versa.
When exporting is not optimal as explained above, firms may choose licensing or FDI. Obviously, licensing is much cheap and low risky. But meanwhile, whether licensing is suitable for a manufacturing firm, the below factors cannot be ignored.
First, for those companies which manufacture high technology products (personal computer, electronic chip), it is unbearable to license their core technology to a potential foreign competitor. Although licensing is a good way to earn a good return from firm’s technological know-how, any firms are unwilling to provide potential foreign competitors which may compete with it in the future with their own advanced technology.
Second, for those companies which need to maintain tight control around the globe, licensing is not good option. Licensing doesn’t usually provide a tight control for multinational manufacturing firms. If a manufacturing firm in these two situations (1) global oligopolies; (2) intense cost pressures industries, undertakes licensing to expand their foreign market, it may have to encounter a dilemma: on the one hand, licensees always take their own benefits into account firstly. On the other, the center, according to firm’s whole benefits, need to disperse manufacturing to locations around the globe where factor costs are most favorable to minimize costs. When there is a discrepancy between multinational firm and its subsidiary, it is not easy to conciliate, as there is few restrictions on whether the same strategies the licensee should adopt with the center.
Third, for multinational manufacturing firms which have management and marketing know-how such as Toyota, licensing a foreign firm to manufacture a particular product seldom raises any competitive advantages for licensee. Because these kinds of know-how is difficult to codify and define and cannot be written down in a licensing contract, firms possessing management and marketing know-how wouldn’t undertake licensing.
According to presentation above, we have known only if a manufacturing firm has know-how amenable to licensing and can be protected by licensing contract, also, firm doesn’t require tight control over foreign operation, it will consider licensing to be a preferable form to FDI.
For a manufacturing firm possessing abundant capital and preparing for expand into foreign market, when it cannot achieve the above conditions for exporting and licensing, it normally takes FDI into consideration. On the other hand, if a firm is in an oligopoly, it will be forced to undertake FDI for not being knocked out if its main competitors have established a subsidiary abroad.
Charles W. L. Hill, University of Washington, “International Business” 4th edition
John D.Daniels, Lee H.Radebaugh, “International Business Environment and Operations” 7th edition
Richard A.Brealey, Steward C.Mers, “Principle of Corporate Finance” 7th edition