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Students Zone - Answers to End of Chapter Questions

CHAPTER 7: FDI

1. Using information in Table 7.3, calculate the growth rate of FDI inflows for LDC’s between 1992 – 2003 and discuss the technological impact of this on the local firms.

Answer

(172 033 – 118 596) / 118 596 = 45 %

This a considerable increase in FDI inflows into LDCs between 1992 and 2003 which should have a discernible impact on the economies of LDCs. MNCs are more likely to bring their technologies with them when they set up their production facilities in LDCs since they are very unlikely to acquire them locally. There are two kinds of technological effect: direct and indirect. The direct effect occurs through the transfer of technologies to a local affiliate, which would adopt the same production techniques as the parent company. The indirect effect occurs through technology spillovers.

Technologies may spread to new users through both formal and informal means. Local firms may learn about the technology of a MNC in a formal way by being directly associated with it, for example in a joint venture or under a license, or informally by being connected with the MNC through a 'linkage'. Linkages may either be backward, which arise from the local MNC's relationship with local suppliers, or forward that stem from contact with local customers. Moreover, technological know-how may spread through employees switching firms from MNCs to local firms. However, the impact of technology transfer would ultimately depend upon whether the local firms are strong enough to compete with the new technology by gradually adapting to it or too weak to withstand the technological impact and go under.

2. Explain what the ‘O’ stands for in ‘OLI paradigm’? Give examples of firms which have used this specific advantage in determining their direct investment.

Answer

‘O’ in OLI paradigm stands for ‘ownership-specific advantages’ which refer to certain types of knowledge and privileges that a firm possesses but which are not available to its competitors. These advantages arise because of the imperfections in commodity and factor markets. Ownership-specific advantages include technical advantages such as patents, unavailable technology and management‑organizational techniques; the advantages arising from operating in an oligopolistic market such as those associated with joint R&D and economies of scale; financial and monetary advantages due to preferential access to capital markets so as to obtain cheaper capital; and privileged access to raw materials or minerals that becomes an ownership‑specific advantage.

Examples are Microsoft holding a patent on a particular software product, Shell having privileged access to Nigerian oil reserves, and pharmaceutical companies such as GSK operating in oligopolistic markets due to the huge R&D expenditure they undertake.

3. To what extent are radical explanations of FDI valid?

Answer

Radical explanations of FDI are still relevant today at least to some extent due to the following factors. Firstly, the bulk of the activities of the MNCs take place among the developed countries and only a small proportion relates to the LDCs. Secondly, despite the recent increase in the share of LDCs in world FDI flows, they are heavily concentrated on a handful of countries. Thirdly, the attitude of rich countries towards LDCs and FDI is less than desirable. The IMF, the WB and the EU advocate that LDCs liberalise and deregulate their policies regarding foreign investment but the rules of the game seem to favour the interests of the rich countries to the detriment of the developmental efforts of LDCs.

4. Table 7.2 indicates that FDI grew by almost 1000 per cent during the period 1982-2003 while exports grew by only 400 per cent in the same period. What is the implication of this difference in the two growth rates for business firms? (Hint: refer also to chapter 3.)

Answer

In conjunction with the fact that recent years have witnessed increased globalisation of the world economy helped by technological development as well as the liberalisation and privatisation policies followed by many governments in the 1980s, it means that M&A activity has grown at unprecedented rates in recent rates. This in turn implies that MNCs have assumed an increasingly important role in the global economy. In fact they account for some 80 per cent of world trade and an equal proportion of the private R&D expenditure. This has been achieved via vertical and horizontal integration of firms on an international scale. It also implies increased concentration of business activities (see chapter 1).

5. Tables 7.3 and 7.6 indicate that recently intra-EU FDI has increased in relation to extra-EU FDI. Can you give explanations for this?

Answer

ne explanation is the dramatic increase in cross-border M&As with in the EU. The number of cross-border intra-EU M&As increased from less than 100 in 1986 to well over 800 in 1991, and there was a similar rise in the number of extra-EU M&As targeting EU companies (see Chapter 7). However, the number of extra-EU bids, i.e. EU companies bidding for firms outside EU, fell in the late 1980s. The main cause for these developments was the planned completion of the Single European Market (SEM) in late 1992.

The introduction of the Euro Zone and the accession of another 15 (mainly East-European) countries into the EU are the additional factors contributing to the increase of intra-EU FDI.

6. Automotive, pharmaceuticals and software sectors are among the ones attracting most FDI in recent times in the EU. Can you explain this?

Answer

For automotive and software sectors one reason could be demand-oriented factors, that is, FDI driven by the size of the EU market (market-seeking FDI). Another reason would be LSA due to the fact that the EU market contains well educated and skilled but relatively cheap labour particularly in the case of Britain and the CEECs (resource-seeking FDI).

For pharmaceuticals and automotive sectors the main reason would be economies of scale again related to the size of the EU market (efficiency-seeking FDI)

7. Should LDCs try to attract FDI? What are the implications of FDI inflows for the labour and capital markets of LDCs?

Answer

One of the main and common characteristics of LDCs is that they need large amounts of capital to finance their developmental efforts and yet they lack capital. Therefore, they try to attract as much FDI as possible to fill this gap. However, FDI inflows are mixed blessing for a developing country since their economic impact could be negative as well as positive.

Positive effects of FDI on the labour market can be direct, that is new jobs are created; or they can be indirect, through new posts created along the value chain. Furthermore, MNCs may create spill-overs and increase the overall knowledge of local workers in an indirect fashion and thus raise labour productivity. However, the incoming MNC will fail to increase employment in the recipient country if they simply displace domestic production thus making workers redundant in the domestic firms. Additionally, in sectors where there is shortage of labour, the MNC will be in a position to offer better pay to workers and thus ‘crowd out’ the local firms. Moreover, it is possible that foreign-owned firms can influence the distribution of incomes because they demand different types of labour and pay higher wages to skilled workers. As foreign firms engage in business on international scale, they require more skilled workers in terms of managerial skills to run their day-to-day operations as efficiently as possible. Furthermore, as MNCs possess technologies and R&D facilities of the highest standards, they require skilled workers who can operate such technologies and are fast learners. All these factors compel MNCs to pay higher wages to more skilled workers as they are left with little choice due to the relative lack of skilled labour in most developing countries and thereby possibly increasing wage inequality between skilled and unskilled workers.

As for the capital market, developing countries hope that MNCs will bring in enough capital which will be available for local firms to borrow and realize their investment projects and that this will lead to strong and sustained growth.

If, however, MNCs entering developing countries choose to finance their investment from local financial markets and therefore compete with domestic firms for the capital available, they could end up driving the local firms out of business. It is a fact that MNCs are more profitable and possess more assets than domestic firms in developing countries and they may therefore be regarded as a more secure borrower compared with domestic firms and thereby absorb the available capital. This is the so-called 'crowding out' effect. It is further argued that the crowding out impact of inward FDI on domestic capital accumulation is sector specific. In particular, foreign investment in the high-wage manufacturing sector may have a far greater impact on capital available to domestic firms than in the primary sector. There is also the controversy regarding the role of FDI in creating growth. Some studies indicate that although growth often attracts FDI, there does not seem to be enough evidence to suggest that FDI contributes to growth.

Some argue that the effect of FDI on the capital market is not clear-cut, and that it depends on the characteristics of the investment, the recipient country, and the timing of the investment. Even if the firms facing credit constraints had savings put aside for investment purposes, they may not be able to channel these funds into productive investments because of the poorly developed financial markets, which exacerbate the credit deficiency in the market. Therefore, the foreign capital channelled through FDI, serves as provider of new capital and also it bypasses the undeveloped domestic institutions in channelling the funds into productive investment. In this it partially replaces domestic banks or venture capitalists in the process of financial intermediation.

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