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Foreign Direct Investment. Question for Today: Why does investment capital flow from some economies to others?. Why Does Capital Flow?. According to optimal investment analysis... Whenever returns are different in two countries. According to the Balance of Payments Equation...

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Question for today why does investment capital flow from some economies to others l.jpg
Question for Today:Why does investment capital flow from some economies to others?


Why does capital flow l.jpg
Why Does Capital Flow?

According to optimal investment analysis...

Whenever returns are different in two countries.

According to the Balance of Payments Equation...

It doesn’t have much choice.

That is, it must flow into any country that is investing more than it is saving.


The macdougall diagram of international investment flows l.jpg
The MacDougall Diagramof International Investment Flows

Model for understanding the interaction of supply of and demand for investment capital in different countries.

Provides us with a benchmark for interpreting cross-border capital movements.

Simple but quite useful


Optimal international investment l.jpg

Optimal International Investment

x-axis measures total capital available for investment in a country

O

Capital


Optimal international investment6 l.jpg

Optimal International Investment

y-axis reflects the prevailing rate of return per unit of capital (i.e. per $) available in a country.

r

(rate of

return)

O

Capital


Optimal international investment7 l.jpg

Optimal International Investment

Then draw a line which reflects the prevailing rate of return in an economy, depending on the total stock of capital.

r

(rate of

return)

O

Capital


Optimal international investment8 l.jpg

Optimal International Investment

Why does the line slope downward?

r

(rate of

return)

O

Capital


Optimal international investment9 l.jpg

Optimal International Investment

If a country only has one unit of capital, the rate of return must be high.

r

(rate of

return)

O

Capital


Optimal international investment10 l.jpg

Optimal International Investment

If a country only has one unit of capital, the rate of return must be high.

r

(rate of

return)

Lots of land, lots of workers, little equipment, few factories.

O

Capital


Optimal international investment11 l.jpg

Optimal International Investment

r

(rate of

return)

As more capital is around competing, land becomes scarce and workers become expensive.

O

Capital


Optimal international investment12 l.jpg

Optimal International Investment

r

(rate of

return)

If k is the total stock of capital in a particular country

O

Capital

k


Optimal international investment13 l.jpg

Optimal International Investment

r

(rate of

return)

Then r0 is the prevailing interest rate in the economy.

r0

O

Capital

k


Optimal international investment14 l.jpg

Optimal International Investment

r

(rate of

return)

The shaded area then represents the economy’s gross domestic product (GDP).

r0

O

Capital

k


Optimal international investment15 l.jpg

Optimal International Investment

Now consider a second country with a different (better) schedule of return possibilities...

r

(rate of

return)

O

Capital

k


Optimal international investment16 l.jpg

Optimal International Investment

Now consider a second country with a different (better) schedule of return possibilities...

r

(rate of

return)

O

Capital

k


Optimal international investment17 l.jpg

Optimal International Investment

a lower supply of capital...

r

(rate of

return)

O

k

k

Capital


Optimal international investment18 l.jpg

Optimal International Investment

a lower supply of capital...

r

(rate of

return)

O

k

Capital


Optimal international investment19 l.jpg

Optimal International Investment

and therefore a higher prevailing interest rate.

r

(rate of

return)

r0

O

k

Capital


Optimal international investment20 l.jpg

Optimal International Investment

r

(rate of

return)

Denoting variables of this second (call it ‘foreign’) country with asterisk.

r0*

O*

k*

Capital


Slide21 l.jpg

We then can take this graph and flip it around.

r

(rate of

return)

r0*

O*

k*

Capital


Slide22 l.jpg

We then can take this graph and flip it around.

r

(rate of

return)

r0*

O*

Capital

k*


Slide23 l.jpg

Then add the graph of the original country (home country).

r

(rate of

return)

r0*

O*

Capital

k

k*


Slide24 l.jpg

How far over do we bring it?

r

(rate of

return)

r0*

r0

O

O*

Capital

k

k*


Slide25 l.jpg

Until the length of the horizontal axis represents the total quantity of capital in the two economies...

r

(rate of

return)

r0*

r0

O

O*

Capital

k

k*


Slide26 l.jpg

So that the length from 0 to k quantity of capital in the two economies...0 is the amount of capital in the domestic economy...

r

(rate of

return)

r0*

r0

O

O*

Capital

k0


Slide27 l.jpg

So that the length from 0* to k quantity of capital in the two economies...0 is the amount of capital in the foreign economy...

r

(rate of

return)

r0*

r0

O

O*

Capital

k0


Slide28 l.jpg

Now what happens if both countries allow capital to flow freely between them?

r

(rate of

return)

r0*

r0

O

O*

Capital

k0


Slide29 l.jpg

The owners of capital in the home country are only earning r freely between them?0

r

(rate of

return)

r0*

r0

O

O*

Capital

k0


Slide30 l.jpg

Whereas capital in the foreign country is earning a higher return of r0*

r

(rate of

return)

r0*

r0

O

O*

Capital

k0


Slide31 l.jpg

So owners of capital in the home country will begin to move capital overseas...

r

(rate of

return)

r0*

r0

O

O*

Capital

k0


Slide32 l.jpg

Shifting k to the left capital overseas...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide33 l.jpg

Increasing the supply of capital in the foreign country capital overseas...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide34 l.jpg

Decreasing the supply of capital in the home country capital overseas...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide35 l.jpg

Increasing interest rates in the home country capital overseas...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide36 l.jpg

And decreasing the returns to capital in the foreign country capital overseas...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide37 l.jpg

When will the flows of capital from the home to the foreign country cease?

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide38 l.jpg

When incentives to transfer capital no longer exist... country cease?

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide39 l.jpg

When rates of return to capital are equated: when r country cease?1 = r1*

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide40 l.jpg

This concept is know as: country cease?

Real Interest Parity

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Example japan 1980 l.jpg
Example: Japan 1980 country cease?

Japan has severe capital controls in place.

Japanese investors are largely restricted from holding foreign assets.

Returns in rest of the world - especially high interest rates in U.S. - appear attractive to Japanese.

Japan has $11 billion in net inflows.


Slide42 l.jpg

Japan in 1980. country cease?

r

(rate of

return)

r0*

r0

O

O*

Capital

k0


Slide43 l.jpg

Example: Japan 1980 country cease?

In December, Japan passes Foreign Exchange and Foreign Trade Control Law.

Large pool of savings Japan has built up over the years slosh onto world capital markets.

Japanese $11 billion inflows become $21 billion in outflows by 1983 and $87 billion by 1987.


Question which economy benefits from the flow of capital l.jpg
Question: country cease?Which economy benefits from the flow of capital?


Slide45 l.jpg

The foreign country’s GDP increases from this... country cease?

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide46 l.jpg

to this. country cease?

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide47 l.jpg

The home country loses some GDP... country cease?

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide48 l.jpg

The home country loses some GDP... country cease?

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide49 l.jpg

But total world production has now increased by this amount. country cease?

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide50 l.jpg

For use of the home country’s capital, the foreign country pays r1* times the amount borrowed.

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide51 l.jpg

GNP (which equals GDP + Overseas Income) is therefore... pays r

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide52 l.jpg

So the home country GNP increases by... pays r

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Slide53 l.jpg

Similarly, after paying the interest bill, the foreign GNP increases by...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0


Examples l.jpg
Examples increases by...

1. Europe: post-W.W.II.

2. Latin America: recent deregulation and privatization.

3. Australia: early 1900s.


International capital flows l.jpg
International Capital Flows increases by...

Having developed a basic understanding of why capital flows between countries, remember that these flows can take three main forms:

Portfolio Investment - ownership of corporate stocks, bonds, government bonds, and other bonds.

Intermediated Investment - short and long-term bank lending and deposit-taking activity.

Foreign Direct Investment - investment obtaining ownership of greater than 10% of voting shares in a foreign firm.

Why FDI? Why do we need multinationals?


Slide56 l.jpg

Important FDI Facts increases by...

1. FDI has grown rapidly since W.W.II and especially in the last 15 years. FDI stock, by host country, $bn:


Slide57 l.jpg

Empirical Facts (cont’d) increases by...

2. Developing countries account for an increasing share of inflows:

- in 1995 developing countries received a record $100 of $315 billion in inflows.

- excluding intra-European flows, developing countries received 60% of all flows in 1995 - up from 17% in 1989.

3. Most FDI flows (97%) originate in developed countries.

4. Much two-way FDI flows (‘cross-hauling’) takes place between pairs of developed countries - even at industry level.


Slide58 l.jpg

Empirical Facts (cont’d) increases by...

5. Most FDI production is sold in recipient country.

6. Degree of FDI varies widely across and within industry. (examples Pepsi vs. Coke and Banks vs. Food).

7. Multinationals tend to have:

- high levels of R&D

- large share of professional and technical workers

- products that are new or technically complex

- high levels of advertising and product differentiation.

- high values of intangible assets vs. market value.


Slide59 l.jpg

Empirical Facts (cont’d) increases by...

8. Most of US corporations’ international exposure is through FDI - not exports:

- In-country sales of US foreign affiliates were $1.8 trillion in 1995 vs $576 billion in exports.

- US foreign affiliates exported more than the US domestic operations in 1995: $580 vs. $576.

9. 80% of US FDI is via M&A - not greenfield investment.

10. US FDI:


Slide60 l.jpg

Empirical Facts (cont’d) increases by...

8. Most of US corporations’ international exposure is through FDI - not exports:

- In-country sales of US foreign affiliates were $1.8 trillion in 1995 vs $576 billion in exports.

- US foreign affiliates exported more than the US domestic operations in 1995: $580 vs. $576.

9. 80% of US FDI is via M&A - not greenfield investment.

10. US FDI:

1. Europe - 50%

2. Latin America - 18.1%

3. Canada - 11.5%

4. Japan, Australia, NZ - 9.3%

5. Rest of Asia - 9%



Slide62 l.jpg

Emerging Market FDI: Top Recipients increases by...

1980

1. Brazil

2. South Africa

3. Indonesia

4. Mexico

5. Singapore

6. Argentina

7. Malaysia

8. Greece

9. Taiwan

10. Venezuela


Slide63 l.jpg

Emerging Market FDI: Top Recipients increases by...

1980

1995

1. Brazil

2. South Africa

3. Indonesia

4. Mexico

5. Singapore

6. Argentina

7. Malaysia

8. Greece

9. Taiwan

10. Venezuela

1. China

2. Mexico

3. Singapore

4. Indonesia

5. Brazil

6. Malaysia

7. Argentina

8. Hong Kong

9. Greece

10. Thailand


Three questions l.jpg
Three Questions: increases by...

1. What explains locational patterns of FDI? Why do some countries tend to be host countries and some source countries?

2. Why is FDI undertaken instead of portfolio investment or intermediated investment? What ‘overcompensating’ ownership advantage do foreigners have over domestic investors?

3. Why does cross-hauling exist? Why do some countries invest directly in each other?


What explains locational patterns of fdi l.jpg
What Explains Locational Patterns of FDI? increases by...

What are some reasons certain countries are chosen over others as targets for multinational investment?


What explains locational patterns of fdi66 l.jpg
What Explains Locational Patterns of FDI? increases by...

What are some reasons certain countries are chosen over others as targets for multinational investment?

1. Labor costs

2. Access to resources

3. Government policies

4. Expanding markets

5. Currency values

6. Tax advantages

7. Investment climates


Why fdi over portfolio or intermediated investment l.jpg
Why FDI over Portfolio or Intermediated Investment? increases by...

For FDI to be considered, the foreign investor must view: r*FDI > r*PI,II

From the perspective of the host country, it must be the case that: r*FDI > r*local investment

But these inequalities are the same, since local investors will equate: r*PI, II = r*local investment


What makes the return on fdi greater than that on pi or ii l.jpg
What Makes the Return on FDI greater than that on PI or II? increases by...

In other words, how do foreign corporations outperform domestic ones on the latter’s home turf?

Especially considering the foreign firm must incur additional costs of travel, communication, and monitoring...

...and the foreign firm must contend with unfamiliar legal, distributing, and accounting systems.

Thus, an understanding of FDI must identify what ‘overcompensating advantage’ a foreign firm has over domestic competition, making returns to FDI greater than those to Portfolio or Intermediated Investment.


Slide69 l.jpg

Example: Samsung of Korea increases by...

In 1996, Samsung, and many other companies in South Korea, Hong Kong, Singapore, Taiwan, and Thailand, were faced with ‘going multinational in order to survive’.

For many firms of the ‘Asian Tigers’, domestic labor costs have become too high to make low-tech manufacturing economical.

They look to outsource production or product assembly in lower-cost countries.


Slide70 l.jpg

Example: Samsung of Korea increases by...

Samsung pays its average worker in Seoul $12.70/hour.

Similar work could be performed in Malaysia for $2/hour and in China for $.85/hour.

In outsourcing production to Malaysia, Samsung must become a multinational - and invest directly in Malaysian production facilities.

Why?


Slide71 l.jpg

Example: Samsung of Korea increases by...

As a multinational, Samsung feels it can more efficiently:

1. invest directly in Malaysia

2. raise needed capital in Hong Kong

3. safely transfer patented technology to foreign affiliates

4. efficiently ship parts between assembly plants

5. sell products throughout region


Slide72 l.jpg

Major Theories of FDI: increases by...

1. Technological Advantages

Firm-specific advantages include:

1. Proprietary technology and patent protection

2. Proprietary information

3. Production secrets

4. Superior management organization

5. Brand-name recognition or trademark protection

6. Marketing skills

...


Slide73 l.jpg

2. Product Cycle Theory increases by...

Product development is characterized by different stages:

Stage 1: Production in industrialized countries

- feedback from customers

- skilled labor

- high demand (for new product) covers high labor costs.

Stage 2: Production in developing countries for export

- Product faces more competitors, tougher price competition.

- Production has become standardized; production can move to markets with plentiful, cheap unskilled labor for export.

...


Slide74 l.jpg

3. Oligopoly Models increases by...

Firms gain benefits from being sufficiently large to operate multinationally:

A. Firms ‘think internationally’ when designing new products in order to capture economies of scale (i.e. absorb high R&D expenditures).

B. Local production improves foreign market penetration beyond that achieved through exporting.

C. Local production to obtain knowledge-transfers from competitors.

...


Slide75 l.jpg

4. Internalization Theory increases by...

Based on theory of firm developed by Ronald Coase.

Firms integrate across borders when use of market is costly and inefficient for certain transactions:

- Enforceability of contracts

- Taxes paid on market transactions

- Difficulty defining prices

- Default risks associated with contracts.

Of course, internalization is costly as well.

...


Slide76 l.jpg

5. Imperfections in Securities Markets increases by...

When organized markets for equity and debt are illiquid or non-existent, FDI is a substitute for PI.

FDI obtains otherwise inaccessible high returns in markets with no organized securities markets.

FDI offers some (albeit weak) direct diversification benefits.

...


Slide77 l.jpg

6. Exchange Risk Theory increases by...

Investors are risk-averse.

As a result, they do not entirely arbitrage real returns across countries via portfolio and intermediated investment.

With FDI, management can structure operations (i.e. via multiple sourcing) to reduce currency risks below those of PI and II.

Other option-type benefits exist with respect to interest rate and labor cost fluctuations.

...


Slide78 l.jpg

Key Points increases by...

1. FDI flows are growing at tremendous rate - especially those directed towards emerging markets.

2. For investors to consider an overseas project (FDI), there must exist some ‘overcompensating advantage’ so that:

- returns are higher than those obtained by local competition

- returns from FDI exceed those of Portfolio or Intermediated Investment

in order to compensate for costs of doing business transnationally.

3. A number of theories of FDI identify sources of these ‘overcompensating advantages.’


Long term risky investments frequently misevaluated l.jpg
Long-Term Risky Investments Frequently Misevaluated increases by...

  • 1. Test marketing the first of a proposed new family of products.

  • 2. Installing a revolutionary new processing technique.

  • 3. Research and development and the pilot plant that will be required if the research is successful.

  • 4. Acquiring a greenfield industrial site.

  • 5. Acquiring telecommunications or logistics facility that could radically alter the future distribution of services.

  • 6. Obtaining mineral rights at a site that will require extensive development.

These are all call options


Example project description l.jpg
Example Project Description increases by...

  • Phase 1: New product development

    • $18 million annual research cost for 2 years

    • 60% probability of success

  • Phase 2: Market development

    • Undertaken only if product development succeeds

    • $10 million annual expenditure for 2 years on the development of marketing and the establishment of marketing and distribution channels (net of any revenues earned in test marketing)

  • Phase 3: Sales

    • Proceeds only if Phase 1 and Phase 2 verify opportunity

    • Production is subcontracted


Project assumptions l.jpg
Project Assumptions increases by...

The results of Phase 2 (available at the end of year 4) identify the

product's market potential


Expected value calculations l.jpg
Expected Value Calculations increases by...

expected IRR = 10.1%


Expected phase iii values l.jpg
Expected Phase III Values increases by...

Expected value = $136 million


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