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9. International Factor Movements and Multinational Enterprises (FDI). Outline. Types of investment Multinational Enterprise Motives for foreign direct investment Country risk analysis International joint ventures Effects of capital outflows: output and welfare
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9 International Factor Movements and Multinational Enterprises (FDI)
Outline • Types of investment • Multinational Enterprise • Motives for foreign direct investment • Country risk analysis • International joint ventures • Effects of capital outflows: output and welfare • Multinational enterprises as a source of conflict
Introduction • World economy is characterized by the international movement of factor inputs (L & C) foreign direct investment & multinational enterprise plays a central part in the process. • Productive factors move from abundant nations (low productivity) to nations where there are scarce (high productivity). • Productive factors flow in response to differences in returns (wages & yields). • A nation in which labor (or capital) is scare can either import labor-intensive products or import labor itself.
Foreign direct investment (FDI) • In simplest form is defined as a company from one country making a physical investment into building a factory in another country (is the establishment of an enterprise by a foreigner ). • The FDI relationship consists of a parent enterprise and a foreign affiliate which together form an international business or a multinational corporation (MNC). • In order to qualify as FDI the investment must afford the parent enterprise control over its foreign affiliate. • The IMF defines control as owning 10% or more of the ordinary shares or voting power of an incorporated firm or its equivalent for an unincorporated firm; lower ownership shares are known as portfolio investment (passive holdings of securities such as foreign stocks, bonds, or other financial assets, none of which entails active management or control of the securities' issuer by the investor)
Foreign direct investment (FDI) A foreign direct investor may be classified in any sector of the economy and could be any one of the following: • an individual; • a group of related individuals; • an incorporated or unincorporated entity; • a public company or private company; • a group of related enterprises; • a government body; • an estate (law), trust or other societal organisation; or • any combination of the above.
Foreign direct investment (FDI) The foreign direct investor may acquire 10% or more of the voting power of an enterprise in an economy through any of the following methods: • by incorporating a wholly owned subsidiary or company • by acquiring shares in an associated enterprise • through a merger or an acquisition of an unrelated enterprise • participating in an equity joint venture with another investor or enterprise
Foreign direct investment (FDI) Foreign direct investment incentives may take the following forms: • low corporate tax and income tax rates • tax holidays • other types of tax concessions • preferential tariffs • special economic zones • investment financial subsidies • soft loan or loan guarantees • free land or land subsidies • relocation & expatriation subsidies • job training & employment subsidies • infrastructure subsidies • R&D support • derogation from regulations (usually for very large projects)
Types of investment • 2 types of investments : direct and indirect investment • Direct investment • Is real investment in various sector such as manufacturing, property, construction, finance • Investors have full authority on their investment in terms of both capital and management. • When a direct investment made by foreigners (by holding largest shares in companies) – called as foreign direct investment.
FDI usually undertaken by multinational enterprises which is the main channel for the flow of international private capital. • Benefits of FDI: 1. Increased job opportunities 2. Technology transfer 3. Inflow of needed capital 4. Enhance exports activities (through multinational global network) 5. stimulate the growth of small and medium enterprises (SMEs and SMIs)
Challenges of FDI 1. High incentive cost in the form of tax exemption and providing the infrastructure 2. Intense competition for domestic investors 3. Outflow of foreign exchange in terms of revenue and dividend.
2. Indirect foreign investment • Known as portfolio or equity investments • Involves financial assets such as bon and shares 1. Investment Portfolios • A portfolio is a diversified set of investments held investor. • Investment carries risk due to fluctuations in company's stock value. If investors invest entirely in one company, their fortunes will fluctuate with those of the company and If the company goes out of business, investors lose. • Instead of investing in one company, investors may invest in a number of companies. • Can make different kinds of investments, such as bonds and commodities (like silver and gold), real estate, etc. This makes a diversified portfolio.
2. Equity investments -This takes place when a person decides to invest in a company by buying shares of stock. - or an investment in the ownership of property, in which the investor shares in gains or losses on the property. • Main features of indirect investment: 1. investors are not involved in the operation and management of the companies. 2. Investors are passive as they hold smaller shares in the companies.
3. Long term versus short-term capital • To gain from an investments depends on interest rate (dividend) and fluctuations of the local currency. • Short-term capital – refers to indirect investments which are mobile and sensitive to changes in the domestic and global economy. • Long-term capital – refers to foreign direct investment which aim to acquire returns for long term. More stable investment and less likely to be influenced by changes in the surrounding environment.
Multinational Enterprise (MNE) • Identifiable features of these businesses: • Operation in many host countries, often conduct research & development activities in addition to manufacturing, mining & extraction. • MNEs cut across national borders and directed from a company planning center, distant from host country. • Has a high ratio of foreign sales to total sales (> 25%).
MNE: Diversified Operations • Diversify their operations along vertical, horizontal and conglomerate lines within the host and source countries. • Vertical integration -Occurs when the parent MNE decides to establish foreign subsidiaries to produce intermediate goods or inputs that will be used in the production of final goods -(when one business integrates with another business at a different stage in the chain of production) -2 types: Backward integration & Forward integration
2. Horizontal integration -occurs when parent company producing a commodity in the home country sets up a subsidiary to produce the identical product in the host country (established to produce & market the parent company’s product in overseas market). - (when one business integrates with another business at the same stage in the chain of production) 3. Conglomerate integration - diversify into nonrelated markets - (when one big business integrates with another smaller business in a completely different market)
MNEs rely of FDI – acquisition of a controlling interest in an overseas company. • FDI occurs when: • Parent company obtains sufficient common stock in a foreign company to assume voting control • The parent company acquires or constructs new plants & equipment overseas • Parent company shifts funds abroad to finance an expansion of its foreign subsidiary • Earnings of the parent company’s foreign subsidiary are reinvested in plant expansion
Motives for FDI • The case for opening markets to foreign direct investment is as compelling as it is for trade. • More open economies enjoy higher rates of private investment which is a major determinant of economic growth and job creation. • Generates various spillovers such as improved management & better technology, stimulates exports of machinery and capital goods • Anticipation of future profits – investment flows from regions of low expected profit to high anticipated profit.
Other factors: • Market-demand conditions • Trade restrictions • Investment regulations • Labor costs • Transportation costs
Demand Factors • Quest for profits encourages MNEs to search for new markets and sources of demand • Tap foreign markets that cannot be maintained adequately by export products • Some parent company find their productive capacity already sufficient to meet domestic demands (market saturation) need to expand to increase growth rates. • Market competition • also influence a firm’s decision • Prevent foreign competition by acquiring foreign businesses
Cost Factors • MNEs often seek to increase profit through production costs reduction. • Forms of cost-reducing FDIs: • Procuring essential raw materials (extractive industries & agricultural commodities). E.g. Shell produces & refines oil in Indonesia • Reducing labor costs (products produced or assembled abroad to take advantage of cheap labour) • Location affecting transportation costs(when cost of transporting raw materials > cost of shipping products to markets MNE locate production facilities near to its raw materials source than markets and vice versa. • Government policies providing benefit: • Subsidies (preferential tax treatment or free factory buildings)
Country Risk Analysis • Although investing abroad can be rewarding, these activities come with risk. • Assessing the cost and benefits of doing business abroad entails analyses of country risk which includes: 1. Political risk assess the political stability of a country (e.g. government stability, corruption, domestic conflict) 2. Financial risk investigates the ability of the country to finance its debt obligations (foreign debt as a % GDP, loan default & exchange rate stability) 3. Economic risk a country’s strength & weaknesses by looking at growth rate of GDP, per capita GDP, inflation rate etc.
International Joint Ventures • Another area of MNE involvement is international joint venture. • A joint venture is a business organization established by two or more companies that combines skills and assets. • Main features – have limited objective & short lived - involve cooperation among several domestic & foreign companies. - Differs from merger because it involve a creation of new business
3 types of international joint ventures: • JV formed by two businesses that conduct business in a third country (e.g. US oil firm & UK oil firm form JV for oil exploration in the Middle East). • Formation of JV with local private interests • Participation by local government
International Joint Ventures • Reasons justifying creation of ventures: • Costs too large to be absorbed by a single company • Governmental restrictions on foreign ownership of local businesses (foreign investor is forced to either accept local equity participation or forgo operation in the country). • Viewed as a means of forestalling protectionism against imports • Disadvantages to forming venture: • Divided control; problems of ‘‘two masters’’ • Success or failure dependent on companies working together, managing differences
Effects of capital outflows:output and welfare* • The basic trade model assumes that factors of production are completely immobile between countries • With free trade, factor prices tend to equalize across countries according to the factor price equalization theorem. • Achievement of complete factor price equalization would remove the major incentive for inter-country factor movements which is obtaining higher factor rewards * Refer Beth V. Yarbrough, Robert M. Yarbrough. (2004). The World Economy – Trade and Finance, 7th ed., United States: South-Western – Thomson Learning.: Chapter 10, pp.292-301.
The primary cause of factor movements is differences in factor prices across countries. • As long as capital or labor earns a higher reward in one country than in another, the differential provides an incentive for factor movements. • Trade barriers can prevent complete equalization – plays crucial role in generating factor movements.
The welfare analysis of factor movements involves 4 questions? • How does factor movement affect total world output? • Can factor mobility increase the efficiency of the world economy? • How does factor movement affect division of welfare between 2 countries? • How does the movement affect the factors that move?
Inter-country capital mobility • Capital more mobile than labor because it does not require people to move; only capital flows from country to country in response to differences in available returns, risk, etc. • Capital usually refers to durable productive inputs such as factories, machines & equipments • Capital mobility refers international investment, borrowing & lending • 2 main categories of international capital mobility: portfolio investment & direct investment
Portfolio investment – when US firm issues bonds (borrow) & sells some of those bonds to resident of Germany (make loan to US firm) : - the transaction represent capital outflow or international purchase of asset from Germany & capital inflow or international sale of assets from US • Direct investment • E.g if US firm buys German firm or establishes subsidiary in Germany : the transaction represents an outward FDI from US and inward FDI from Germany
Effects of capital outflows:output and welfare Rate of return, r A, Country A Rate of return, r B, Country B r0 E G F r1 r1 J r0 H VMP BK VMP KA 0A K1 Ko 0B Total Capital Stock for Country A and B
Capital mobility’s effects • Assume 2 countries : A and B • The length of the horizontal axis (distance 0A 0B)= the total quantity of capital in the world. • 2 vertical axes measure rate of return to capital in the 2 countries (r A & r B ) • K0 = initial allocation of capital between 2 countries, so 0A K0 units of capital in country A & 0B K0 units capital in country B. • In each country capital earns rate of return = value of the marginal unit of capital’s productivity (VMPK) • An input’s VMP sometimes called marginal revenue product. For perfectly competitive firms, P=MR, so VMP = MPLor k X P. • VMPK= MPKX P of good produced • Curves VMPKA & VMPKB = values of the MPK in countries A and B respectively.
As quantity of C employed in a given country , the MPK, value of productivity and rate of return . • From an initial allocation of capital (Ko), capital flows from country B to country A in response to higher rate of return (roA > roB ). • The higher return in A reflects capital’s higher marginal productivity in A (point E) relative to B (point J). • This incentive will cause the capital represented by the distance between Ko K1 to move. • New capital allocation reached at K1, rate of return in the 2 countries equalize at r1A = r1B
Gains Area EGJ = measure positive effect on world output from capital shifts from B to A - divided between country A and B • Migrant C earns = FGK1Ko in A which is a gain of FGHJ over what it earned in B. Represent a gain to B because able to enjoy the income from capital (owner still resides at B) • A gains = EGF because the productivity of the migrant C more then the return paid to its owner • Both country enjoy net gain
Owners of native C in A suffer reduction in their rate of return from r0A = r1A because of capital inflow. • Workers in A gain as MPL from availability of additional C • Owners of C that remains in B benefit from the rise in the rate of return to C that occurs after the C outflow • Workers in B have less C to work with suffer reduced marginal product & earn lower wages.
International mobility of factors of production increases the efficiency of the world economy when it is based on differential productivity across countries • Mobility can also alter the distribution of income in each country between capital owners and labor
International Labor Mobility:Effects of Migration • Equalize wage rates between countries • Increase overall world output & redistribute income • May lower wage rates for some native workers • Although international labor movements can enhance the world economy efficiency, they are often restricted by government controls.
Effects of labor migration from Mexico to US US Mexico wage wage So S1 S1 16 So 10 j c 9 6 b h e i 6 3 d f a g QL QL 10 4 7 10 16 7 • Assume labor SS fixed = 7 in US & Mexico (So). • For US: Equilibrium wage = $9 & total L income = $63 (a+b) • Remaining c = $24.50 =income accruing to owners of capital • For Mexico: equilibrium wage = $3 & total L income = $21 (f+g) • Remaining h+i+j = $24.50 =income accruing to owners of capital • Suppose L move from Mexico to US in response to wage differentials
The effect of L mobility: • Suppose 3L from Mexico migrate to US US L supply curve shifts to S1 excess SS of L at $9 cause wage in US to $6. • In Mexico, L emigration shifts supply curve to S1 excess DD at wage =$3 led to in wage to $6. • L mobility equalize the wage rate in 2 countries. Effect: On output: US: expand output =$22.50 (d+e) Mexico: contraction in output = $13.50 (g+i) Net gain in world output= $9 On Income: US: gain in income = $22.50 (d+e). From this d ($18) captured by Mexican immigrants , while area e ($4.50) extra income to US owners of capital because of availability of additional L. The earnings for US workers = area b ($21) which is transferred to US owners of capital. Mexico: decrease of income = g+i ( $13.50). Remaining workers gain area h ($12) due to high wages. Mexican capital owners lose.
Immigration as an Issue Benefits • Cheap source of labor for domestic manufacturers • Indistinguishable fiscal burdens • Need for skilled people • Social security concerns • Declining birthrates • Raising life spans • Concerns • Reduces wages • Affects unskilled domestic workers • Drain on government resources • Brain drain, limiting growth potentials • Illegal immigration
Multinational Enterprises as a Source of Conflict • Advocates point out several benefits of multinational enterprises • However, critics contend that MNEs often: • Create trade restraints • Create conflict with national economic and political objectives • Have adverse effects on a nation’s balance of payments
Source of conflict: • Employment • Technology transfer • National sovereignty • Balance of payments • Taxation • Transfer pricing
Employment • The effects of MNEs on employment in both the host & home countries is the most debated issues. • MNEs yields favorable benefits to labor force in host country • Controversy arises when MNEs purchase already existing local businesses rather than to establish new ones • may not result in additional production capacity and employment • Sometimes MNEs bring in foreign managers and other top executives
Technology Transfer • FDI and MNEs serves as an effective method of transfer of technology (knowledge and skill of production) • Enhances personal contacts between subsidiaries and local firms • Technology transfer is facilitated through demonstration effect & competition effect • DE: firm showcases its operation and products • CE: encourages local firms to focus in innovation and quality improvement • Home country may react because it is detrimental to economic base of donor nations ↓export potential, job loss for their workers, lose international competitiveness decrease rate of economic growth
National Sovereignty • Another controversial issue involving MNEs is their effect on the economic and political policies of the host & home governments • Fear that presence of MNEs results in a loss of its national sovereignty • MNES may resist redistribute national income through taxation
Balance of Payments • BOP = account of the value of goods and services, capital movements, and other items flowing into or out of a country • MNEs gain by strengthening payment position • Subsidiaries tend to purchase additional capital equipment and other material from home country stimulate exports & strengthen BOP • Return inflow of income generated by overseas operations such as: • Earnings of overseas affiliates • Interest and dividends • Fees and royalties