FDI 2024 revised

Foreign Direct Investment (FDI)

Definition of FDI

FDI stands for foreign direct investment, which involves a business from one nation making a significant investment in another nation. It typically requires a direct long-term investment and an equity stake of 10% or more in foreign-based enterprises, which allows the investor to exercise control over management decisions and operations. Companies have several avenues to engage in FDI, including:

• Starting a new business. This allows for complete control over the establishment and initial strategies.

• Investing in existing foreign-owned businesses. This can provide immediate access to existing market share and operational frameworks.

• Wholly acquiring existing businesses. This action provides the investing company full ownership and operational control.

Examples:

• Walmart has successfully acquired several Chilean grocery chains while retaining their original names, demonstrating its strategy of expanding its market presence without losing brand identity.

• Sherwin Williams Paints operates in over 120 countries, leveraging local production facilities to better cater to regional market needs and potentially reduce logistical costs.

• Geely, the Chinese automotive manufacturer, boasts global R&D centers and design studios, allowing it to harness innovation from various markets and effectively compete on a global scale.

Multinational Enterprises (MNEs)

Definition:

MNEs are companies that engage in FDI when conducting business abroad, typically operating across multiple countries. They play a crucial role in the global economy by promoting international trade and investment flow.

Characteristics:

MNEs engage in a range of activities, including:

• Exporting and Importing: Moving goods and services across borders to meet international demand.

• Licensing and Franchising: Allowing foreign parties to use the company’s intellectual property or business model under defined conditions.

• Outsourcing: Delegating certain business functions to external firms to capitalize on competitive advantages.

Examples of MNEs:

Notable MNEs include Walmart, Microsoft, Apple, Nestle, Sony, and Coca-Cola, all of which have successfully established their presence in international markets.

Why MNEs Invest Abroad

Advantages of FDI:

MNEs prefer FDI due to several strategic advantages, including:

• Direct control over foreign operations, which fosters improved management and alignment with corporate objectives.

• Location advantages stemming from:

  • Natural geographical features, such as favorable climates for agriculture or access to waterways for transport (e.g., the Netherlands for flower production).

  • Skilled labor: Availability of skilled workforce and lower labor costs for unskilled positions can make operations more cost-effective.

  • Knowledge spillover within regions, as seen in tech hubs like Silicon Valley, where proximity to other innovative companies fosters collaboration and idea exchange.

  • Specialized suppliers and buyer networks, which enhance operational efficiencies.

Internalization:

Internalization refers to replacing cross-border market interactions with firm-owned operations in multiple countries. This strategy reduces cross-border transaction costs, thereby increasing efficiency and converting independent firm trade into controlled intra-firm trade among subsidiaries.

Strategic Choice for FDI:

Firms choose to engage in FDI for strategic reasons when:

• Production abroad is cheaper than at home, reducing overall costs.

• High transportation costs make international movement of products impractical.

• Domestic capacity is insufficient to meet demand, prompting expansion abroad.

• Products require significant alterations to meet the preferences of foreign consumers.

• Governments implement restrictions on imports of foreign products, which may necessitate local production.

• Consumers manifest a preference for locally-sourced products, urging companies to establish a local presence.

Modes of Entry Into Foreign Markets

Non-Equity Modes:

• Direct Exports: These involve selling goods or services directly overseas without establishing a physical presence in the foreign market.

• Licensing/Franchising: This allows overseas parties to utilize the company’s intellectual property, expanding the brand internationally without substantial capital investment.

• Contractual Agreements: These are formal arrangements that do not involve an equity stake but may include service contracts or supply agreements.

Equity Modes (FDI):

• Wholly Owned Subsidiaries (WOS): This occurs when a company owns 100% of a foreign business operation, providing complete control over its management and operations.

• Joint Ventures (JVs): A partnership between two or more firms where resources, risks, and profits are shared. Types include:

  • Minority JVs: One partner holds a minority stake.

  • Majority JVs: One partner holds a majority stake, influencing decisions.

  • 50/50 JVs: Equal ownership allows for collaborative decision-making.

• Acquisitions: Involve purchasing existing companies to gain immediate control and market share.

• Greenfields: These entail establishing new operations from scratch, providing complete control, but also requiring substantial investment and time.

Acquisition vs Greenfield Investment:

• Acquisition

  • Benefits:

    • Avoids start-up costs and often leads to easier financing due to existing operational structures.

    • Offers immediate cash flow and reduces risks associated with market entry.

• Greenfield Investment

  • Constructing new facilities enables the firm complete control over operations and strategic direction, useful in markets lacking viable acquisition opportunities.

Types of FDI:

Horizontal FDI:

Involves producing the same products/services abroad as at home, maintaining operations in the same industry as the home country.

Vertical FDI:

Engages in different stages of the supply chain, which can be:

• Upstream: Involves sourcing production inputs (e.g., acquiring raw materials).

• Downstream: Refers to retail or distribution channels (e.g., Hershey's investing in cocoa production and its retail processes).

Implications for Business

Decision Framework - Factors Affecting Investment Decision:

• Transportation Costs and Tariffs: High transportation costs and tariffs significantly affect whether a company opts for exporting or FDI.

• Know-how Licensing: The ability to license proprietary knowledge influences a firm’s entry strategies into foreign markets.

• Control Requirements: The need for management control will often guide the choice between horizontal FDI and licensing arrangements.

Benefits and Disadvantages of FDI:

Benefits for MNEs:

• Lower labor costs often lead to improved bottom lines and cost-effectiveness in operations.

• Increased efficiency and operational savings can result from controlling foreign operations.

• Overcoming the liability of foreignness is facilitated through brand establishment in new markets.

Benefits for Host Countries:

• Promotes employment and economic growth by creating new jobs and investment in local communities.

• Enhances markets with diversified options, leading to increased consumer choice.

• Boosts infrastructure and tax revenues, providing essential services and development opportunities for residents.

Disadvantages for MNEs:

• Political and economic risks in host countries can affect operational stability.

• Labor unrest and operational challenges can arise when managing foreign workforces.

Disadvantages for Host Countries:

• Risks include foreign entities potentially monopolizing market control, limiting local businesses’ growth.

• Increased pollution and resource exploitation may occur as MNEs prioritize profitability over environmental sustainability.

• Profit repatriation can hinder local economies, as wealth is transferred back to the foreign parent company rather than reinvested locally.

Global FDI Trends and Impact of COVID-19

2020 FDI Decline:

In 2020, global FDI flows dropped by 42%, marking the lowest level in 25 years.

• Significant Decreases:

  • FDI in developed countries decreased by 69%.

  • North America experienced a 46% decline in investment flows.

  • In contrast, developing countries only saw a 12% decrease, with East Asia remaining the largest host region due to its economic resilience.

2023 Recovery in Canada:

Post-pandemic, Canada has attracted FDI due to its economic stability, access to diverse markets, and favorable infrastructure conditions.

• The US is the largest investor in Canada, accounting for approximately 46% of total FDI inflows.

Investment Climate in Canada:

• Governmental Initiatives: The establishment of ‘Invest in Canada’ aims to promote FDI and economic growth through targeted investments.

• Tax Environment: Competitive tax rates and incentives to maximize capital recovery, along with tariff-free inputs for manufacturing, enhance the country’s attractiveness for FDI.

Canada’s Competitiveness:

• Canada consistently ranks among the top in the G20 for business ease and complexity.

• A high FDI stock to GDP ratio is indicative of favorable investment conditions for international businesses.

Canadian Direct Investment Abroad:

• Most Canadian direct investments are made outside their own niches, reflecting a strategy to diversify and seek growth in global markets. Sectors like finance and utilities showcase varied investment patterns, demonstrating adaptability.

Trade Agreements and Investment Flows:

Strengthened ties with Asia-Pacific countries via agreements like CPTPP have fostered two-way investment flows between Canada and member nations.

Future Prospects:

The potential for growth in foreign relations as Canada positions itself favorably for international investment is promising. This comprehensive examination of FDI not only highlights its significance in reshaping global commerce but also accentuates Canada’s strategic advantages and its continuous evolution in the international economic landscape.