FDI and Multinational Corporations Essay

FDI and Multinational CorporationsAccompanying the increase in world trade over the period since the Second World War, there has been an equally rapid growth of private foreign investment.

Much of this has taken the form of companies setting up or acquiring a controlling interest in overseas subsidiaries/ affiliates. Today, most large companies and many medium-sized firms operate in more than one country. Such companies have come to be variously referred to as multinational companies (MNCs), multinational enterprises (MNEs) or transnational corporations (TNCs). The largest among them have overseas operations that match or exceed the size of their domestic operations. (Ranked by foreign assets, Royal Dutch Shell, part Dutch and part British, is ranked as the world’s largest company with assets of $102 billion, closely followed by Ford, Exxon, General Motors and IBM, all of the USA.) Such companies invariably operate on a global basis, planning their activities on a regional or international scale. One consequence is that the production of many goods has become transnational.

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Overseas investment by companies to set up a new overseas subsidiary or acquire a controlling interest in another company is referred to as direct investment abroad or foreign direct investment (FDI).This is different from investment by individuals and financial institutions in the purchase of interest-bearing securities, which is called portfolio investment. Direct investment abroad is one way in which companies can expand their operations internationally. When a potential host country examines its policies toward foreign investment, perhaps the most fundamental issue that it must face is whether foreign investment is helpful or harmful in the development process.

 In this work, the reasons why MNCs may undertake FDI are discussed. In this paper, we also discuss the growth of the MNC over the past half-century and what factors best explain the reasons why firms may invest abroad. MNCs’ policies under which foreign investment can have negative consequences for host country are analyzed. Our concern is with the impact of MNCs on world trade. In the beginning of the paper, the importance of MNCs in world trade is, therefore, discussed. We shall see that a close relationship exists between the incentive of firms to internalize their markets for intermediate goods and services through FDI and the importance of multinational trade in total trade.

Since the Second World War the growth of foreign direct investment and the emergence of the MNC began. The FDI which occurred in the world took the form of one-way FDI, mainly by U.S. MNCs in Western Europe.

Such FDI could be adequately explained by the wish of U.S. MNCs to more effectively exploit the technological and marketing advantages that they enjoyed in a number of branches of manufacturing. Although they could have done so through exporting, the need arose as many of their products reached maturity to seek out ways of servicing foreign markets at lower cost. The establishment of one or more subsidiaries abroad enabled them to cut transport costs, circumvent tariffs and non-tariff barriers and take advantage of lower production costs abroad.

However, such one-way FDI rapidly gave way to two-way FDI as firms in other advanced industrialized countries (Western Europe and Japan) developed new ownership-specific advantages in particular branches of manufacturing, which they, too, sought to exploit by producing abroad. An interesting observation is that much of this two-way FDI takes place in the same branch of manufacturing. In other words, it constitutes what may be called intra-industry FDI.It may be that producing abroad is viewed as an alternative to exporting.

Much investment by United States MNCs in the first two decades after the Second World War in Western Europe was undertaken for this reason. However, direct investment may equally well be undertaken for efficiency-seeking reasons. A company may shift its production of a particular good or just a particular stage in the production process to another country to take advantage of differences in costs or a more favorable environment.

In industries dominated by a small number of sellers, the decision to invest abroad may be dictated merely by the need to prevent rivals from securing an advantage.The function of foreign direct investment (FDI) really defines the MNC, distinguishing it from a national corporation, whether the investment is in the form of acquiring wholesale or manufacturing facilities. The first wave of multinationals (Dutch and British) were largely trading companies that invested in extractive plants for natural resources and in wholesale and service facilities. Theories, however, about multinational corporate behavior focused increasingly on the subsequent patterns of corporate investment in manufacturing facilities, with an emphasis on the transplant of manufacturing facilities abroad, to what was alternatively described as the Third World, the underdeveloped world, the lesser-developed countries, the periphery, or, in contemporary parlance, the emerging markets.The effects of foreign direct investment (FDI) on the home countries of multinational corporations (MNCs) have been discussed for several decades, but the topic has attracted renewed attention in the international debate during the past few years. In the 1970s and to a greater extent the 1980s, the example set by the European companies was followed by Japan. In the past, Japanese companies had shown themselves much more reluctant to invest abroad preferring to service their foreign markets through exporting.

Such overseas investment as they did undertake was more directed to the South-East Asian region mainly to overcome rising wage costs at home. One reason for the low level of Japanese FDI was the restrictions placed by the authorities on outward investment. In the late 1960s, however, these were gradually relaxed as the Japanese balance of payments moved into surplus. Initially, FDI took the form of the establishment of subsidiaries by Japanese manufacturing companies in North America and Western Europe, mainly as a means of circumventing the growing number of trade restrictions which these regions were imposing on Japanese exports.

Substantial investments were made in the creation of new subsidiaries in both of these regions in an attempt to get round these restrictions. For example, Markusen (1995) found that Japanese FDI in Europe was systematically related to the level of effective protection and the existence of a revealed comparative advantage on the part of Japanese firms. In the late 1980s and early 1990s, this trend was further encouraged by the rapid appreciation of the yen, which significantly reduced the profitability of producing and exporting from Japan. In the second half of the 1980s, however, investments in the tertiary sector (finance and services) came to account for the largest proportion of Japanese FDI. More recently, a growing proportion of Japanese FDI has gone to developing countries mainly in the East and South East Asian region. One reason for this was the need to counteract growing trade restrictions against Japanese-produced goods in western markets and to find lower cost locations for production. However, another reason was the increasing importance of the newly industrializing economies of East Asia as markets for Japanese goods and services.

By the 1990s, Japan had become the world’s leading source of FDI. Nevertheless, Japanese FDI still accounted for only 2.4% of GNP, compared with 4.4% in the US and 6.3% in Germany (Kuznetsov 1994). The collapse of the Japanese ‘bubble economy’ after 1990 has seen a dramatic fall in Japanese FDI.Recently, there has been a significant growth of direct investment by companies in the newly industrializing countries. For the first time ever, South Korea (1990) and Taiwan (1991) have become net exporters of FDI (Bailey & Sugden 2000).

As with Japan, a key factor has been the lifting of exchange controls on capital outflows in these countries as the current account of the balance of payments swung into surplus in the second half of the 1980s. An increasing amount of FDI by these countries has been directed towards South East Asia and China. Largely, this has been in response to rising costs at home and the appreciation of local currencies. The perspective on China as a developing country has immediate implications in the assessment of direct foreign investment issues.

Many developing countries, because of their poverty and small size, have limited markets for new products and new technologies. China’s large size, in terms of its population and geography will be more adaptable to new methods and also more capable of local production than is true in many developing countries (Hipple 1995). Like Japanese investment in the region, much of it has been designed to relocate the production of certain low value-added goods to countries where labor costs are lower. However, a number of companies in these countries have also been active in establishing subsidiaries in the western industrialized countries.

As with Japanese FDI, this has been motivated by a proliferation of trade restrictions against the products of East Asian countries. In some cases, the subsidiaries established have been little more than ‘screwdriver’ plants concerned only with the assembly of a product using kits imported from the parent company. Thus, the names of Korean conglomerates such as Daewoo and Samsung have become well known to most North Americans and Europeans. The current financial crisis afflicting these economies, however, has resulted in a downturn of such investment.The growing importance of FDI in the services sector is of particular interest. While, in the early part of the post-war period, FDI in manufacturing predominated, today, in many countries, services account for the largest proportion of FDI. Some writers have talked of the ascendancy of the service-sector multinational, a trend which they see as certain to continue in the next century (Bailey ; Sugden 2000).

This is, in part, due to the nature of service provision. Many services have to be produced and consumed at the same time. Production and consumption cannot be separated as with goods because services cannot be stored. Therefore, if service firms are to provide services to buyers located in another country, they must establish a physical presence in the foreign country in order to do so.

Although this will not always entail direct investment, it frequently does. However, other factors have also been at work. Many service firms tend to follow manufacturing MNCs because manufacturing firms are major buyers of their services. Thus, when manufacturing MNCs invest heavily in a particular region, service MNCs tend to follow suite. Another reason has been the gradual liberalization of services trade in many parts of the world. Governments have seen that there are important advantages which accrue from deregulating the service sector and allowing more foreign service firms to enter the local market. A further cause of the growing reason of MNCs’ FDI in services has been a tendency for many manufacturing MNCs to diversify into services, providing their own services through the establishment of their own service subsidiaries.Another reason is the desire on the part of investors to minimize risk through diversification.

It is argued that investors are risk-averse. For this reason they seek a portfolio of investments which minimizes the variance of the return on an investment. They can achieve this by spreading their investments over a number of holdings rather than placing them all in one basket.

The only requirement is that the return on each holding should be negatively correlated such that when one investment earns a bad return another earns a good return. It is argued that imperfections in the capital market make it costly for an individual investor to achieve such an ‘efficient’ portfolio. An alternative is for investors to invest their funds with an investment or unit trust, which will achieve the necessary portfolio diversification on their behalf. The trust will also have better information about different shares and their prospects than the individual investor who could only obtain such information at great expense. Nevertheless, there is still a cost for the trust in obtaining the information required to guarantee individual investors’ optimum diversification. Because of these costs, trusts often spread investments over a relatively small number of fairly large shareholdings.

However, by buying shares in an internationally diversified MNC, individual shareholders may be able to spread their investments more efficiently.Internationally diversified MNCs provide shareholders with risk minimization because (1) they produce a number of largely unrelated products and (2) they are located in a number of different countries. In other words, both product and geographical diversification is achieved. A slump in the demand for one product may be offset by buoyant demand for another or depressed demand in one geographical market may be offset by rising sales in another. Thus, the conglomerate or internationally diversified MNC may be viewed in the words of Alan Rugman as ‘a potential surrogate vehicle for financial asset diversification’ (Jovanovic 2001).

Moreover, conglomerate MNCs provide not only investors, but also risk-averse managers, with reduced risk. Salaried managers may attach as much importance to stable salaries and job security as to maximization of earnings. It is sometimes argued that in the modern corporation true power resides with managers and not shareholders. In the desire to minimize risk through diversification, the interests of shareholders and investors may be the same.A further explanation for FDI has been suggested by Aliber (Jovanovic 2001). Aliber regarded the internationally diversified MNC as largely a currency-area phenomenon.

Investors who place their funds in assets denominated in different currencies are subject to the risk that the currency in which the assets are denominated will depreciate. One way of protecting a short-term investment against currency risk is by taking out forward cover. However, forward cover is not free and is usually available only for short-term investments. It follows that, if investors are to be persuaded to hold investments in weak or soft currencies which carry a high risk of depreciation, the interest paid must contain a premium to compensate them for the risk of currency depreciation. For investments in some countries where there are additional risks (e.

g. the risk of the government suddenly imposing controls on the withdrawal of funds), the interest premium will be higher. However, Aliber has suggested that investors who buy shares in a company are myopic, acting as if all their investments were in a single currency area even when some of the assets of the company may be held outside the country and denominated therefore in a different currency. It follows that MNCs based in strong or hard currency countries will enjoy a financial advantage over other locally based firms in weak or soft currency countries. They will be able to obtain capital more cheaply which could cancel out any disadvantage that they might otherwise face in competing with local firms. (In effect, this is another form of owner ship-specific advantage that was discussed above).Specifically, Aliber applied his theory to U.S.

direct investment abroad in the 1950s and early 1960s when the U.S. dollar was still a hard currency and when U.S. firms were beginning to expand abroad especially into Western Europe through acquisitions of companies in countries with relatively weak currencies.

U.S. MNCs, the argument went, were able to raise capital at lower cost than their European rivals, which meant that the future earnings from the companies acquired could be capitalized at a higher rate than for European concerns.

The argument, however, was no longer valid after the dollar weakened in the late 1960s and 1970s. In theory, it could explain some acquisitions abroad by MNCs in other strong currency countries in the 1970s and 1980s such as West Germany or Japan. This might have been the case where there was no other obvious motive for acquisition, such as the desire to take advantage of lower costs or gain easier access to foreign markets.

However, a great deal of FDI in recent decades has been two-way FDI with companies in different counties each investing in the markets of the other. Aliber’s theory clearly explains only one-way FDI and that from a strong to a weak currency country.As mentioned earlier, another concept that gained popularity among academics and policy makers in Latin America during the 1970s was that of “unbundling” the package of capital, technology, and management with which MNCs confronted host countries. Presumably, it was both convenient and possible to separate the component elements of this package and negotiate each one separately, thus obtaining better conditions. This notion fits nicely with the assumption that the presence of domestic investors in an MNC’s ownership structure would lead the firm to be more responsive to national needs and exert a countervailing force against the natural tendency of MNCs to extract “higher-than-normal” economic rents from host countries. These were the views underlying the legislation that forced existing foreign firms to spin off to local investors specific parts of their equity, prohibited the entry of new wholly owned foreign firms and, in general, gave preferential treatment to joint ventures among foreign and domestic firms.

The “market imperfections” explanations of direct investment take many different forms. One of these finds the reason why MNCs may undertake FDI. According to this theory, MNCs have a special advantage in their ability to differentiate products and, by direct investment, can extract monopoly profits based on this ability. While this is a theory that may explain some cases, it is difficult to accept it as a completely general theory. It does not explain why local entrepreneurs cannot be sold or rented those product-differentiating skills, perhaps for a share of whatever local monopoly profits there are to be gained.In this sense, investment by MNCs from the richer states is a basic mechanism for the transfer of technology from those that have it to those that do not. Poor states are not merely capital depositories; they also benefit from the technologies embodied in the capital invested from abroad, and especially in the case of FDI as opposed to other forms of capital transfers from rich to poor states. Since developing countries lack the managerial and technical skills required for fueling development, foreign direct investment in particular has been seen as a key element in North-South interaction that aided the process of economic growth and the convergence of incomes between rich and poor.

Through this process of the diffusion of capital and technology, developing countries were expected to take off into self-sustaining growth, achieving higher stages of development and catching up with the rich (Hipple 1995). Not only does FDI bring technology, but the MNC also transfers a package of institutional attributes of the modern corporation that helps to transform tradition-bound, particularistic societies of the developing areas. Indeed, some recent studies conclude that FDI has been one of the most effective means for the transfer of technology and of knowledge (Hipple 1995). These studies have concluded that multinational capital is crucial for improving productivity and standards of living in developing areas.By the early 1970s, the United States had become more of a foreign investor than an exporter of domestically manufactured goods. FDI has become a very important factor in the world economy. International production by MNCs had surpassed trade as the main component of international economic exchange.

Foreign production by the affiliates of American corporations was over four times as great as American exports abroad. Moreover, a substantial proportion of American exports of manufactured goods were really transfers from an American branch of an MNC to an overseas branch. Many host country governments see MNCs’ contribution to the host country’s socio-economic development. I made a number of references to the possible relevance for China of the theories of direct foreign investment.

However, there are relatively few immediate consequences of the FDI for policy in China or in any other country. Rather, the theories suggest issues that require individual attention in each country receiving foreign investment. The MNCs’ investment projects contribute to employment creation, financial stability, foreign exchange and balance-of-payments enhancement, worker-skill development and infrastructure development. Host countries see these MNCs as friendly, contributory and helpful organizations, well assimilated and integrated into the host country’s socio-economy. Therefore, FDI which includes these elements would contribute to reducing country risk.

However, the role of the multinational corporation in the economic development of a country can take negative forms. A common complaint voiced against multinational corporations is that they do not bring capital, but instead borrow locally to finance their activities. Therefore, it is argued, they do not contribute to aggregate capital formation, but simply shift it to their operations.BibliographyBailey D.,Harte G.,Sugden R. 2000, ‘Corporate disclosure and the deregulation of international investment’, Accounting, Auditing & Accountability Journal, 12 April, vol.

13, no. 2, pp. 197-218.

Hipple, F. Steb. 1995, Multinational companies in United States international trade: a statistical and analytical sourcebook. Westport, Conn.: Quorum Books.

Jovanovic, Miroslav N. 2001, Geography of Production and Economic Integration. London: Routledge.Kuznetsov, A. P. 1994, Foreign investment in contemporary Russia: managing capital entry. New York: St Martin’s Press.

Markusen, James R. 1995, ‘The Boundaries of Multinational Enterprises and the Theory of International Trade,’ Journal of Economic Perspectives 9(2), 169-189.;


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