Unit 3: Foreign Direct Investment

Transcription

1 ECON 401 The Changing Global Economy Unit 3: Foreign Direct Investment Unit Overview Introduction The growth of foreign direct investment (FDI) is a key aspect of today s global economy. World GDP increased by 45 percent between 1992 and 2006, but FDI increased by 700 percent. The acceleration of economic development in many parts of the less developed world is tied to increases in FDI. FDI may provide more (and cheaper) capital, access to new technologies and business practices, and improved access to developed country markets. FDI growth reflects the growing relative importance of multinational corporations (MNCs) in the global economy. While the investment activities of these giants often bring important economic benefits, critics are concerned that these MNCs may possess undue political influence and distort the pattern of economic development. Note: The textbook refers to multinational corporations as multinational enterprises or MNEs. Either term is acceptable, but we use MNC throughout these course materials. Web Links These articles on the WTO Web site address specific issues related to foreign direct investment. Foreign direct investment seen as primary motor of globalization, says WTO Director-General Trade and foreign direct investment New Report by the WTO Does globalization cause a higher concentration of international trade and investment flows? (select ERAD under the year 1998) References Statistics Canada. (2008). Canada s international investment position, Catalogue No X. Ottawa: Minister of Industry. Page 1 of 52

2 Section 3.1: Foreign Direct Investment Reading Assignment and Learning Objectives In the textbook: Chapter 7 (pp ; pp ; pp ) Closing Case: Cemex's Foreign Direct Investment (pp ) After completing Section 3.1, you should be able to describe recent trends in the levels and directions of foreign direct investment (FDI) in Canada and worldwide. define the following terms: foreign portfolio investment foreign direct investment multinational enterprise licensing internalization theory green-field investments location-specific advantages explain the market imperfection theory of FDI. explain the strategic behavior theory of FDI. explain the main factors that will determine whether a firm will export, license, or engage in FDI. discuss the main costs and benefits of FDI to host or receiving nations. discuss the main costs and benefits of FDI to sending nations. explain why the composition of foreign direct investment has shifted more toward services over the past two decades. Types of Foreign Investment The integrated nature of economies and financial markets has increased the ease and flexibility with which foreign investors and corporations can seek out and take advantage of opportunities that yield higher rates of return, diversified portfolios, and reduced risk. This Page 2 of 52

3 section describes some basic theories of foreign investment and reasons that firms undertake foreign direct investment rather than simply exporting products. We will also discuss recent patterns of foreign investment in Canada. Foreign investment can take different forms. One is simply to lend money (in the form of bank loans or new bond purchases) or to buy relatively small blocks of stock in companies. The injection of funds into the host economy does not involve any control over the assets of that country. There is foreign funding but no foreign ownership or control; the transaction transfers funds and represents a portfolio investment. This type of investment is called foreign portfolio investment and involves very low transaction and transportation costs, as it is often just an electronic transfer of funds. Foreign investment can also involve the outright purchase of a Canadian asset such as a factory. This type of investment is called foreign direct investment (FDI), and can take the form of purchasing enough stock in an existing firm to become a controlling shareholder, taking over a firm outright or building a new plant or enterprise from scratch. It may or may not result in additional investment in Canada, depending on the financing. If the foreign investor uses their own funds to create a new plant in Canada, Canada s capital stock has increased and, therefore, Canada s capacity to produce goods and services has increased. Even if the foreign investor buys an existing plant from Canadian owners, it may eventually lead to new capital formation (investment). In that case, the Canadian seller would have to use the money from the sale to create new capital in Canada. If the seller uses the money to buy assets in another country, spends it on high living, or uses it to retire somewhere warm, Canada does not benefit from increased capacity. Similarly, if the foreign investor uses Canadian funds for their venture into Canada, there is no gain. A substantial number of foreign takeovers are financed by loans from Canadian banks. With FDI, a firm could have a significant ownership in a foreign operation and the potential to affect managerial decisions. By using FDI, multinational corporations are able to circumvent the effects of changing exchange rates, enabling them to secure and maintain market share. A firm may choose to undertake FDI in a particular foreign market or region because of location-specific advantages, perhaps to gain access to specific natural resources (e.g., Alberta s energy industry) or expertise (e.g., Silicon Valley in California or Ottawa), or to be located near customers, specific feedstocks, or suppliers with unique characteristics (e.g., Fort Saskatchewan s petrochemical industry). Recent FDI Trends in Canada Table 3.1 highlights Canada s current international investment position, with information on direct and portfolio investment by Canadians abroad as well as foreign investment in Canada. The important trend to observe from this table is the significant gap between total Canadian investment abroad ($1,176,870,000) and total foreign investment in Canada ($1,309,392,000). The predominance of foreign investment in Canada has been a key feature in Canada for years; in 2007, direct investment abroad decreased due to the appreciation of the Canadian dollar against foreign currencies. Canadian direct investments abroad are denominated in foreign currencies. Consequently, the appreciation of the Page 3 of 52

4 Canadian dollar lowered the value of the assets held abroad. Canadian investment abroad is split between direct and portfolio investment, as is foreign investment. There are significantly more holdings of Canadian stocks than bonds. Table 3.1 Canada s International Investment Position, 2007 Assets Canadian Direct Investment Abroad $ 514,540,000 Portfolio Investment 346,765,000 (Foreign Bonds: $136,701,000) (Foreign Stocks: $210,064,000) Other Investment 315,565,000 (Loans: $76,122,000) (Allowances: $0) (Deposits: $156,890,000) (Official International Reserves: $40,593,000) (Other Assets: $41,960,000) Total 1,176,870,000 Liabilities Foreign Direct Investment in Canada $ 500,851,000 Portfolio Investment 486,738,000 (Canadian Bonds: $382,080,000) (Canadian Stocks: $82,658,000) (Canadian Money Market Instruments: $21,999,000) Other Investment 321,804,000 (Loans: $52,971,000) (Deposits: $243,525,000) (Other Liabilities: $25,307,000) Total 1,309,392,000 Net International Investment Position -132,522,000 Adapted from Statistics Canada. (2008). Canada s international investment position, Second Quarter Catalogue No X, Minister of Industry. Note. Discrepancies due to rounding. Figure 3.1 and Figure 3.2, below, illustrate (by geographic area) the foreign direct investment flows in Canada from abroad and the direct investment abroad by Canadians. Note that other EU includes Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Austria, Finland, Sweden, Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and Slovenia. Figure 3.1 FDI in Canada, 2007 (percent of total) Page 4 of 52

5 Source: Statistics Canada. (2008). Canada s international investment position, Second Quarter Catalogue No X, Minister of Industry. According to the figures above, the United States is, by far, the largest direct investor in Canada, followed by other EU countries (excluding the United Kingdom). The American share of total foreign direct investment has fallen steadily since its peak of 70 percent in This is despite the fact that the overall level of FDI in Canada has nearly doubled over this period. As we discussed in Unit 1, the relative share of US investment has fallen as the relative shares of other nations have risen, led by strong FDI from the United Kingdom and other EU nations. Direct investment in Canada by foreign companies has been expanding rapidly, and this has had a major impact on the Canadian economy. It has affected Canadian trade, employment prospects, industrial and business location, and regional economic growth prospects, and it has also led to the appreciation of the Canadian dollar. Figure 3.2 Canadian FDI Abroad, 2007 (percent of total) Source: Statistics Canada. (2008). Canada s international investment position, Second Quarter Catalogue No X, Minister of Industry. In 2007, US assets accounted for only 44 percent of total Canadian direct investment Page 5 of 52

6 abroad, the lowest proportion on record. American investors accounted for 58 percent of FDI in Canada. Net direct investment with the United States has never been positive, meaning that American investors have always held more assets in Canada than Canadian investors have held in the United States. Figure 3.3 below highlights the trends in Canada s direct investment abroad (outflows) and foreign direct investment in Canada (inflows). Since 1980, the average annual inflow of FDI totalled $204.4 billion and grew by an annual average rate of 7.9 percent. By comparison, the average annual outflow of direct investment totalled $207.9 billion and grew at an average annual rate of 11.3 percent. Figure 3.3 Canada s International Investment Position (millions of dollars) Source: Statistics Canada. (2008). Canada s international investment position, Second Quarter Catalogue No X, Minister of Industry. The influx of FDI into Canada was significant in the early 1980s more than twice that of Canadian direct investment abroad. Even during the Canadian recessions of the early 1980s and 1990s, FDI continued to expand. One of the attractions of the Canadian economy was the Canadian dollar, which was undervalued against the US dollar, making Canadian purchases cheaper for foreigners. Land and labour costs were significantly lower than in competing countries. As well, the Canadian dollar returns abroad rose, due to a dollar appreciation against other major currencies. Foreign investors were attracted to Canada s dynamic and stable economy and favourable political environment. The significance of NAFTA also created a new market for foreign investors. Governments at all levels in Canada provide a favourable investment climate for foreign companies. Not only does the federal government place few restrictions on foreign investors, but provincial and municipal governments compete vigorously for investments by offering tax and financial incentives. Canadian direct investment abroad has become greater than foreign direct investment in Canada. This change occurred in This unprecedented trend reflects an economy in an expansionary phase of the business cycle, with strong natural resource prices. Firms earning strong corporate profits are able to invest abroad. In addition, Canadian investors holdings of foreign stocks have risen due to the higher foreign content limits for Registered Retirement Savings Plans. The rapid rise in inflows can also be interpreted by comparing this trend with Canada s production and trade patterns over the same period. Despite the Page 6 of 52

7 general decline in trade barriers, growth in foreign direct investment since 1980 has exceeded growth in nominal GDP and exports. Globally, FDI has taken off since the mid 1970s. In 1975, global FDI amounted to $25 billion. It increased to $1.2 trillion in 2000, and remained at this level until Rates of growth of world output, trade, and FDI provide a picture of the globalizing economy. Consider the following: Between 1992 and 2006, world output increased by 45 percent. Between 1992 and 2006, world trade increased by 150 percent. Between 1992 and 2006, FDI increased by 700 percent. Why has FDI increased so rapidly? There are a number of reasons: FDI can help a firm overcome trade barriers. Deregulation and privatization has opened up economic space that had been closed off to private investment in the past. Trade and investment are complements, not substitutes, in many cases. A high proportion of trade consists of intra-firm trade between divisions of a single firm. Firms may invest in many different regions in order to best capture location economies. The new information and communication technologies have reduced the cost of managing at a distance. Russia and eastern Europe are no longer under communist rule. Government regulations that limited FDI in many countries have been replaced by a new receptiveness to FDI. Many multinational firms wanting to sell in multiple markets may believe they need a presence close to their consumers in order to serve them properly. In other words, they feel exporting is a poor substitute for direct investment. It should not be surprising that most FDI comes from the developed world, but it may be surprising that most FDI goes to the developed world. As Figure 7.3 on page 244 of the textbook shows, although FDI flowing to the developed world has increased substantially over the 1990s and beyond, the proportion going to the developing world has increased marginally. Theories of Foreign Direct Investment Hill identifies five key factors that help to explain the relative attractiveness of FDI, exporting, and licensing: transportation costs market imperfections strategic behaviour product life cycle location-specific advantages Page 7 of 52

8 If transportation costs are relatively high, then exporting may simply not be cost effective. Cement, for example, is not widely traded. Many international firms have developed unique competitive advantages on the basis of their technology, marketing strategies, or management know-how and ability. If this collective know-how is employed across a wider market, profits will be greater. A firm will choose FDI over licensing if the costs of doing so are lower. Transportation costs, tariffs, and non-tariff barriers often raise the cost of exporting. Licensing is the main method by which firms sell the rights to their know-how. Unfortunately, markets for such knowledge are likely to be incomplete. A licence generally gives the purchaser the right to use the production methods, technologies, and management and marketing practices of the seller. However, it is difficult to protect ownership once the information has been shared. Hill refers to the case of RCA, which licensed its technology to Sony and Matsushita. Soon after, the Japanese companies were able to take the US technology, make some minor adaptations to it that rendered US patents invalid, and produce in competition with RCA. Sony managed to capture much of RCA s market in the United States. Pricing is also difficult with a licensing agreement. Skills, know-how, and procedures are extremely difficult to specify, let alone price efficiently, because the true value of the technology or the management practice cannot really be known until it has been employed in the field by the licensee. Only the seller has a good idea of how much these are worth (sometimes even the seller cannot value this properly), and the buyer has inadequate information. This alone precludes an efficient market solution. The selling firm may also be concerned about the purchaser's devaluing the selling firm s brand value. A restaurant chain may highly value its reputation for a clean eating environment, but by licensing its brand, it runs the risk of finding itself working with a partner that does not wish to pay the costs of keeping such a clean environment. The brand may become devalued or the selling firm may have to spend a lot of money monitoring and enforcing very detailed licensing agreements. A licensee that is given a regional exclusive agreement may not expand as rapidly as the selling firm wishes. The selling firm relinquishes substantial control over production and expansion, and the selling firm may not wish to give up so much control. Licensing is unlikely to be an efficient solution when one of the following three conditions applies: The selling firm has valuable know-how that cannot be protected in a licensing contract. The selling firm wishes to have control over the business strategy of the licensee in order to maximize global profits. The selling firm s know-how is simply not amenable to licensing. (Hill, p. 251) Hill (pp ) summarizes two alternative explanations of FDI. Strategic Behaviour theory begins with the assumption that FDI is a strategic tool of oligopolistic competitors. Raymond Vernon's Product Life Cycle theory argues that a firm will pioneer a new product in its home market first, but as the market for the product grows in other regions, and as production methods become routine and standardized, it may be profitable to shift Page 8 of 52

9 production to other locations with lower labour costs. Vernon argued that many firms FDI in developing countries fits this explanation. Location-Specific Advantages There are some resources or assets that may be more valuable in one location than in others. Obviously, this applies to resource-based industries and agriculture. It also applies to a number of technologically advanced industries. Silicon Valley in California has become one of the world s leading centres of cutting-edge research and development for the computing and semiconductor industries. Local universities turn out large numbers of graduates who are well trained for these sectors. There are hundreds of small firms that are world leaders in niche markets. The knowledge that exists in Silicon Valley is difficult to reproduce elsewhere. Firms seeking to establish production and new product development in these sectors will seek to go where the best knowledge is and can be tapped into fairly easily. The existence of such pools of knowledge or talent (think of the fashion design houses in France and Italy) tends to attract new entrants and the expansion of existing firms. This knowledge pool constitutes an external benefit that is available only in this location. This also explains why governments everywhere attempt to subsidize the development of centres of excellence for particular sectors or technology applications. They are attempting to catch up and overtake the first-mover advantage claimed by Silicon Valley and similar centres in other sectors. See Figure 7.6 in the textbook (p. 266) for a useful decision framework that firms implicitly use when facing the decision to export, license, or engage in FDI. Benefits and Costs of FDI The major benefits of FDI are the following: increased access to capital access to superior technology access to superior management methods (pp ) FDI will often mean an injection of new investment in the host country. This is one of the main benefits of FDI. Multinational firms can often access international capital at a lower price than is available to domestic firms. In addition, FDI is often attached to investment decisions that local firms are unprepared or unwilling to make, thus increasing the domestic rate of investment and economic growth. New technologies are often not for sale or lease but become available only if the owners of those technologies decide to invest in the domestic market. Governments will often attempt to negotiate terms that include provisions for the transfer of technology to other sectors of the local economy. Multinational firms are usually unwilling to license or sell key technologies, but host economies can capture many of the benefits of these technologies through FDI. These are the resource-transfer effects that host countries are most interested in capturing. FDI from global multinational firms often brings new technologies and management practices that are simply not available elsewhere. Local managers hired by multinational Page 9 of 52

10 firms learn new managerial practices. Host governments often attempt to maximize the local benefit of the investment by ensuring that provisions are made for local training and hiring, local purchasing, technology transfers to local partners, and so on. Section 3.2, The Age of the Multinational, examines these issues in more depth. Hill identifies three additional benefits: a. b. c. employment effects balance-of-payments effects effects on competition and economic growth FDI alone will not have an impact on the rate of unemployment in an economy at or near full employment, but in some less developed countries (LDCs), FDI will usually contribute to a relative expansion of the higher paid segment of the labour force. Multinational firms operate in sectors that typically pay wage rates that are between 50 percent and 100 percent higher than local wage rates for comparable skill levels. In countries where regulations keep labour markets from approaching full employment levels, FDI alone can cause the rate of unemployment to fall. FDI normally involves flows of capital in both directions. Initially, capital flows in as a multinational firm acquires local assets or builds facilities. This produces an initial positive impact on the host country s balance of payments through enhanced exports. Study Questions Provide complete answers for each of the following study questions you need to be able to explain how and why a factor or consideration is important or relevant. Students often lose marks on their assignments or examinations by providing answers that are too short and incomplete. Some questions have answers provided at the end of this section. The rest of the answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre What is the difference between a green-field investment and acquiring or merging with an existing firm? Describe the trends and characteristics of FDI in the past 30 years. Consider why firms selling products with low value-to-weight ratios choose FDI over exporting. Answer What are location-specific advantages, and why might they be an important factor in explaining FDI? Answer Under what circumstances might a firm prefer to engage in FDI rather than exporting or licensing? Answer What are the advantages and disadvantages of licensing as compared to FDI? Answer What are the main advantages of FDI for host (recipient) countries? What are the potential costs of FDI for host (recipient) countries? Page 10 of 52

11 9. What are the possible costs and benefits of FDI for sending (home) countries? 10. Which theoretical explanation (or explanations) of FDI best explain(s) Cemex's FDI? Answer Answers to Selected Study Questions 3. Products with low value-to-weight ratios, such as soft drinks or cement, are frequently produced in the market where they are consumed. When transportation costs are added to production costs, it becomes unprofitable to shift such products over a long distance. For firms that can produce low value-to-weight products at almost any location, the attractiveness of exporting decreases and FDI or licensing becomes more appealing. Back 4. Location-specific advantages are advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets. Natural resources such as oil and minerals, for example, are specific to certain locations. Firms must undertake FDI to exploit such foreign resources. Back 5. A firm will favour foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favour foreign direct investment over licensing (or franchising) when it wishes to maintain control over its technological know-how or its operations and business strategy or when the firm's capabilities are simply not amenable to licensing, as may often be the case. Back 6. Licensing occurs when a domestic firm (the licensor) licenses a foreign firm (the licensee) to produce the licensor s product, to use its production processes, or to use its brand name or trademark. In return, the licensor collects royalty fees on every unit the licensee sells or on total revenues. The advantage of this type of arrangement over FDI is that the licensor does not have to pay (in terms of cost, time, or risk) to open up a foreign market, as this has already been established by the licensee. There are several disadvantages to licensing as a strategy to exploit foreign market opportunities. Licensing may require that a firm relinquish valuable knowledge or technology to a potential foreign competitor. Licensing does not give the firm adequate control over the manufacturing, marketing, and strategy-making aspects of a business located in a foreign country. As well, the firm providing the licence may not feel that the licensee is adequately exploiting all of the profit potential inherent in the foreign market. Back 10. Cemex is a cement company. Consequently, exporting is difficult because of the weight of the product. If Cemex wants to expand into new markets, the company would either need to license a local company or make an investment in the market directly. Cemex s success is due in part to its top-notch customer service and its relationship with distributors. Because these advantages could be difficult to transfer, Page 11 of 52

12 the company will probably choose to invest directly. Back Section 3.2: The Age of the Multinational Reading Assignment and Learning Objectives In the Reading File: Age of the Multinational, by Robert Gilpin. The Challenge of Global Capitalism: The World Economy in the 21st Century, pp In the textbook: Government Policy Instruments and FDI, pp In the DRR: Worldbeater, Inc. The Economist, November 22, 1997, pp After completing Section 3.2, you should be able to explain how MNCs have accelerated the integration of the global economy. describe how the national ownership of MNCs has changed over the past 40 years. describe the regional allocation of MNC investment. explain why countries are interested in attracting MNC investment. explain some potential costs and concerns related to MNC investment. explain the meaning of performance requirements. discuss why there is no set of international rules governing global investment that would be similar to global trading rules. discuss what principles might be built into a new Multilateral Agreement on Investment (MAI). The Age of the Multinational Enterprise and FDI In the assigned reading Age of the Multinational, Gilpin examines how MNCs have established an overwhelming and growing presence in the global economy. MNCs are behind much of the very rapid growth in FDI over the past 25 years. An MNC may be defined as a firm of a particular nationality with partially or wholly owned subsidiaries Page 12 of 52

13 within two or more national economies (Gilpin, p. 164). In earlier days, the purpose of much investment by MNCs was to gain access to raw materials or to establish a presence in a major market that was protected by tariffs. FDI was often seen as a way of jumping over tariff walls. FDI by MNCs has now changed in dramatic ways. The globalization of production introduced in Unit 1 describes how MNCs have begun to unbundle the components and services that are used to produce a final product and reallocate the production site for each separate component or service to the most efficient location. Outsourcing is a part of this phenomenon. We have seen that FDI has grown much faster than trade over the past quarter century, and FDI is the way in which MNCs expand into new territory. MNCs are key actors in the emergence of the global economy. Technological change and a more open, market-friendly approach to FDI has facilitated MNC expansion. The new communications technologies have greatly reduced the cost of managing at a distance. Industrial and distribution systems can be effectively managed on a global scale now. This has greatly reduced the costs of such coordination, essentially permitting firms, for the first time, the opportunity to search the world for the best location for a specific activity. In the not too distant past, communication and coordination costs would simply rise too rapidly if an organization tried to globalize production the way many MNCs do today. The globalization of production via FDI is integrating the world economy in a much more profound way than the globalization of markets ever could. As MNCs search the world for the best location for a new call centre, a new factory to produce tires, or a site to conduct research and development activities, national governments come to understand that their economic success will depend, in large part, on developing the ability to find a niche or a role to play in the global investment plans of MNCs. Corporate investment strategy is affected by many policies of potential host countries: tariff policies, tax policies, regulatory environment, and so on. Although initially the United States dominated MNC FDI, the situation has changed dramatically since MNC FDI has grown rapidly in Europe, Japan, South Korea, Canada, and, to a lesser extent, a few Southeast Asian countries. At present, MNC FDI is concentrated in the high-income regions of the world. North American, European, and Japanese MNCs are largely investing in each other s markets. MNC activity in less developed countries is still surprisingly small, although it is growing rapidly. As Figure 6.1 in Gilpin shows, MNC FDI in less developed countries rose from about US$22 billion in 1990 to over US$120 billion by MNC FDI in the less developed regions was very concentrated as well China alone received over 31 percent of the FDI going to less developed countries. Mexico, Brazil, Poland, Indonesia, and Malaysia also received significant amounts. Very little MNC FDI was recorded in Africa. MNCs are crucial sources of capital, technology, management methods, and access to new markets for almost all countries, especially the less developed countries that, in the absence of MNCs, simply would not have access to these benefits. National policy makers have come to recognize that market-friendly regimes have simply outperformed market-unfriendly regimes in all regions of the globe. As a result, there has been a shift worldwide, from regulatory regimes that attempt to keep out MNCs toward regulatory regimes that attempt to attract MNC investment. Page 13 of 52

14 Economic and Political Significance of the MNC Gilpin comments that a bargaining relationship exists between MNCs and host governments. While it is true that attracting the investment of MNCs can accelerate economic development, the terms on which that investment is available are very important. Host nations will attempt to maximize the external benefits that may arise. For example, a government might seek to ensure that locals are employed, trained, and taught how to use specific technologies seek to ensure that the MNC meets export targets and sources inputs from domestic producers attempt to force the MNC to work in partnership with a local firm and promote technology transfer to that firm. These obligations are called performance requirements. While host governments are interested in deriving maximum benefit from the MNC, the MNC will also attempt to bargain for maximum benefits for itself. This bargaining is not a one-time affair; it will continue as long as the MNC continues to operate in the host country. The MNC may seek a wide range of benefits, including protection from import competition lower tax rates subsidized power and water tax holidays direct and indirect subsidies research and development tax credits low-interest loans a less burdensome regulatory environment improved public infrastructure. Many nations also wish to protect certain sectors of the economy from foreign involvement. Canada, for example, limits the activities of foreign firms in banking, airlines, and all media or cultural industries such as film, television, radio, and publishing. Governments that are home to a large number of MNCs worry from time to time about possible negative impacts of MNC investment in other countries. The question that is asked is, Wouldn t it be better for us if company X invested at home rather than in a foreign country? It is important to remember the comparative advantage argument raised when we examined trade. Free trade allows each region to specialize in those activities for which it possesses a comparative, or relative, advantage. As resources are limited, it is best to focus on what we do best and not try to do all things. MNC investment abroad produces the same kind of advantages. It permits those agents with unique technologies or business practices to locate production facilities in the most efficient location. For example, an American MNC might choose to operate its call centre out of India. If it was prohibited from doing so, then it would be at a competitive disadvantage compared to other international firms that were free to locate production and other facilities in the most desirable location. There is also no guarantee that this investment would take place by the firm in the United States. The firm might simply buy call centre services from an Indian firm operating in India. Page 14 of 52

15 Nations that are home to many MNCs often object to the performance requirements imposed by other governments. These are often seen as detrimental to the home country. Boeing has recently signed an agreement with China to produce aircraft in China, but under the terms of the agreement, Boeing must form a joint partnership with a Chinese firm and produce the aircraft in China. The United States is concerned that China may gain access to valuable technology which might have military applications. Gilpin (p. 181) notes that regionalization, as opposed to globalization, characterizes much MNC investment in recent years. American MNCs focus on Mexico and Latin America, European MNCs are focusing on eastern Europe, and Japanese MNCs are concentrated in the lower income areas of Asia. This may permit MNC networks to remain physically closer to their main markets, while taking advantage of lower wage costs in nearby regions. In the assigned textbook reading (pp ), Hill notes that many governments have policies that both promote and restrict outward and inward FDI. This may not be as contradictory as it sounds. Canada, for example, attempts to attract MNC investment in most sectors, but has regulations in place that limit foreign investment in banking, transportation, cultural industries, and other sectors. Over the past 20 years or so, there has been a growing recognition that MNC investment can, and usually does, accelerate economic growth, especially in the less developed regions of the world, and more countries have adopted MNC-friendly investment policies that are designed to attract, as opposed to repel, foreign investment. However, it is still a major political issue in most countries that attract substantial amounts of FDI; concern that local control or national sovereignty will be reduced due to the dominating position of these foreign entities is seldom far from the surface. Rules for FDI and MNCs World trade is governed via a host of global (e.g., WTO) and regional (e.g., NAFTA) trade agreements that set out the rules that all must follow. Free trade agreements usually require that signatories agree not to impose tariffs on goods from other parties to the agreement and spell out, often in great detail, the limits on the use of non-tariff barriers (rules on subsidies, anti-dumping, and so forth). Normally, a general objective is to ensure that foreign goods are treated in the same manner as domestically produced goods. This kind of trading regime provides the incentive structure that will permit firms to produce efficiently on a global basis. It is somewhat odd that no similar agreements exist with respect to investment rules. No common set of rules exists, so each nation must establish its own rules. Economists generally favour an even-playing-field approach, one that would ensure that foreign firms are treated in the same way as domestic firms with respect to rules governing investments, but this is seldom the case. It is fairly easy for MNCs to set up operations in the United States, and few performance requirements are needed. In Canada, it is easy for MNCs to set up operations in many sectors; indeed, foreign MNCs dominate many sectors of the Canadian economy. In other sectors, foreign ownership is severely limited. In Europe and much of the developing world, detailed performance requirements are the norm. Japan has shown little interest in permitting foreign MNCs access to the local marketplace and has used a variety of bureaucratic measures to keep them out. South Korea and many other LDCs have adopted Page 15 of 52

16 aggressive industrial policies that aim to develop local industrial champions in major sectors of the economy. These governments provide subsidies and various types of protection to these firms, including a type of infant industry protection model in which the government picks out and protects firms it hopes will develop into leading world-class firms. Gilpin argues that globally, efficiency could be enhanced if the world were able to develop a global investment regime based on universal and neutral principles analogous to the free trade principle (p. 191). This would have the same advantages as a global free-trade agreement, in that investment and output would tend to move according to the dictates of comparative advantage, not according to which government was offering the largest subsidies at the moment. A global investment regime would likely have the following characteristics: the right of establishment the right of national treatment the right of non-discrimination (Gilpin p. 183) In 1995, the United States proposed a Multilateral Agreement on Investment (MAI) that attempted to establish such global principles. Massive opposition to this idea arose in many countries. It quickly became apparent that such an agreement would limit the ability of states to pursue independent industrial policies or policies to promote and subsidize approved firms. Such policies are firmly entrenched in many nations. Gilpin sees little hope for such an international rules-based approach to global investment. There are a number of difficult technical questions, such as how to tax profits earned in a supply chain that includes more than one nation. However, the major challenges are political. The terms under which investment takes place are seen as critical by many national governments, and they are not willing to surrender their right to negotiate technology transfer, employment, export, and local content performance requirements. Study Questions Provide complete answers for each of the following study questions you need to be able to explain how and why a factor or consideration is important or relevant. Students often lose marks on their assignments or examinations by providing answers that are too short and incomplete. The answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre Why does Gilpin regard the post-1980 era as the era of the MNC? Describe how the pattern of ownership of MNCs has changed over the past 25 years. What are the possible advantages to a nation of attracting MNC investment? What are the major concerns that national governments may have with respect to attracting MNC investment? What kinds of policies might national governments use to attract MNC investment? Define performance requirements and indicate when they might be used. Page 16 of 52

17 7. 8. What are the arguments in favour of developing a global set of rules governing MNC investment? Why has it been so difficult for nations to agree on such a set of rules? ECON 401 The Changing Global Economy Unit 4: The Global Monetary System Unit Overview Introduction Unit 3 discussed the tremendous growth in capital flows over the past 30 years. The volume of foreign direct investment has grown much more rapidly than the volume of world trade in recent years. There are several potential benefits to this trend, including the ability of capital to move into regions where it is scarce and valuable. Foreign direct investment can make a positive contribution to a host economy by supplying capital, new technology, and management resources that would otherwise not be available. This is particularly the case for the less developed countries and poorer regions of the world. Firms and governments around the world are increasingly able to access the global capital markets. Innovations in telecommunications systems have created instantaneous access to global financial markets, while the banking industry is being revolutionized to meet the needs of institutional changes required to remain competitive. These technological advances have created new opportunities to develop alternative banking instruments, and they provide greater access to financing. Capital can be moved around the globe at a keystroke, and at virtually no cost. In Unit 4, we will look at the specific functions of the foreign exchange market tools designed to deal with and manage the risk of adverse consequences of unpredictable changes in exchange and interest rates different types of exchange rate regimes current theories used to determine the future value of exchange rates growth of global capital markets. Page 17 of 52

18 There are many debates surrounding the global financial market instability. While the International Monetary Fund (IMF) has pushed LDCs toward financial market liberalization, many economists have challenged this wisdom. These debates and the recent experience in Mexico, the Congo, and Russia are examined briefly in this unit, and the Asian crisis is examined more fully in Unit 5. Web Links The following Web links highlight some interesting issues related to the role of the IMF and the debate that surrounds that effectiveness of the IMF s macroeconomic stabilization policies (see Section 4.4). The IMF at a Glance International Capital Markets: Developments, Prospects, and Key Policy Issues Finance and Development The IMF and its Critics The following Web links highlight some interesting issues related to global capital market (see Section 4.5) as presented by the IMF as well as some issues surrounding the use of capital controls. IMF Global Financial Stability Report Institute of Economic Affairs IMF Policy Discussion Paper References World Bank. (2002). Globalization, growth, and poverty: Building an inclusive world economy. Washington, DC and New York: World Bank and Oxford University Press. Section 4.1: Foreign Exchange Markets Reading Assignment and Learning Objectives In the textbook: Chapter 9 (pp only) Page 18 of 52

19 After completing Section 4.1, you should be able to describe the major functions of the foreign exchange market. explain the factors that determine the demand and supply of foreign exchange. define spot exchange rates. define forward exchange rates. define foreign exchange risk. describe how firms might use forward exchange markets to manage foreign exchange risk. explain the meaning of the following terms: exchange rate currency speculation currency swaps arbitrage. Foreign Exchange Rates You have probably bought an American dollar at one time or another. Before vacationing in the United States, you might go to your bank to buy American dollars and pay for them with Canadian dollars. Foreign exchange markets deal in American dollars, Canadian dollars, pounds sterling, and all other currencies. These markets are complex networks of institutions, banks, foreign exchange dealers, and government agencies through which the currency of one country may be exchanged for that of another. In many ways, these markets operate in the same way as the markets for apples or French wine. There is a supply of a foreign currency and a demand for it; in a free market, supply and demand interact to determine the price. Your textbook defines an exchange rate as the rate at which one currency is converted into another (p. 324). There are two ways to report the exchange rate between Canadian and US currency: one way is to state that one Canadian dollar is now worth US$0.82, and the other is to report that one US dollar is worth Can$1.22. In one sense, the price of a currency is unique. We can speak of the price of the Canadian dollar, for example, only by relating it to the value of another currency, often the US dollar. We could, however, correctly speak of the price of Canadian dollars measured in Turkish lire or British pounds. When we speak of the price of beef, chicken, or stereos, on the other hand, we measure price in terms of units of the domestic currency. To convert US$1 into Canadian dollars, perform the following calculations: Page 19 of 52

20 1 current exchange rate = 1 $0.82 = Can$1.22 To convert Can$1 into US dollars, perform the following calculations: 1 current exchange rate = 1 $1.22 = US$0.82 Under a flexible exchange rate system, the value of a currency is determined by the demand and supply for that currency. This is determined in the foreign exchange market. The demand for US dollars comes mainly from non-us citizens or firms who wish to buy American goods and services, travel to the United States, or invest in the United States. International visitors to the United States must first go to their local bank to purchase US dollars (by selling local currency to their bank) in order to have US currency to spend while in the country. If you live in Europe and want to purchase American-produced cars, CDs, or beer, you must arrange to acquire US dollars to buy the goods. These transactions show up in the Balance of Payments as exports from the United States. If Toyota, the Japanese car producer, wishes to build a car plant in the United States, it must exchange its Japanese yen for US dollars in order to make this investment in the United States. If an individual living in Malaysia wishes to buy shares in a firm listed on the New York Stock Exchange (NYSE), he will first have to sell some Malaysian currency in order to buy US dollars to make the purchase. Often the individual is not even aware that such an exchange takes place. The Malaysian investor will likely have an account with a Malaysian stockbroker and enter an order to purchase stocks on the NYSE. His Malaysian currency account is reduced by a certain amount, and the broker makes the purchase on his behalf. The demand for US currency is determined largely by exports of US goods foreign direct investment into the United States the purchase of US financial instruments by those living outside the United States foreign visitors to the United States. These are the major determinants of demand, but there are a few other activities that produce a demand for US currency. Factors that influence the value of currency include political instability investor psychology perception and rumour the level of domestic and foreign economic activity the level of domestic and foreign interest rates bandwagon effects (which will be discussed in the next section). As you know from your introductory economics course, demand is only one side of the equation. Where does the supply come from? It is helpful to remember that, in a foreign exchange market, those supplying one currency in the marketplace do so only to purchase Page 20 of 52

21 another currency. If I sell US dollars in the foreign exchange market, I am doing so to purchase another currency. Who in the United States will want to sell US dollars in order to purchase Japanese yen, Canadian dollars or other currencies? The answer is, those in the United States who wish to purchase goods produced abroad make investments in other countries purchase stocks, bonds, or other financial instruments issued in other countries travel to other countries. You will notice that this list is a mirror of the list above that explains the demand for US currency. Not surprisingly, the demand curve for US dollars has the familiar downward slope. If the price of US currency (in terms of foreign currency) rises, the quantity demanded will fall. For example, if the cost of purchasing one US dollar rises (in terms of Canadian dollars), which is the same as stating that the value of the Canadian dollar falls, Canadians will buy fewer US goods; Canadian FDI into the United States will fall; purchases of US stocks, bonds, and other financial instruments by Canadian residents will fall; and Canadians will take fewer holidays in the United States. If the price of US dollars is relatively high, it will be more expensive in terms of local currency, and individuals and firms will reduce their purchases of US dollars. The supply curve also looks like a normal supply curve, although in the case of foreign exchange, it is important to remember that the supply of US dollars in the marketplace really represents the demand for all currencies other than the US dollar. Why does the supply of US dollars slope upward, as in Figure 4.1 below? If the price of the US dollar rises, then, by definition, the price of the currency it is being measured against has fallen, and the quantity of the non-us currency demanded will go up as its price has fallen. To US residents, a rise in the US dollar means that foreign travel becomes cheaper, foreign goods become cheaper, it becomes cheaper (in terms of US dollars) to buy foreign stocks and bonds, and so on. Figure 4.1 The Demand and Supply of Foreign Exchange Page 21 of 52