Lesson 2

International Investment: Theory and Practice

Lesson 2 International Investment

Reading: Chap. 3, Book 1; Chap. 2 & 3, Book 2 Overview: Foreign Indirect Investment vs. FDI Investment vs. Speculation Motives for Making FDI Organizational Forms of Multinational Enterprise Characteristics of the Multinational Enterprise Modern Theories of FDI and Multinationals Porters Diamond Model Cases: Nestls Global Drive A Global Challenge for Kodak Aflacs Success in Japan

2.1 The Scope of International Investment 2 types: (1) Foreign Indirect Investment (FII) or International Portfolio Investment Investing on international financial assets. e.g. foreign bonds or stocks (2) Foreign Direct Investment (FDI) Establish joint venture or subsidiary Note: FII can be transformed into FDI. Under what condition? The shareholding of a company exceeds 10% of its stock in most cases. 2.1.1 International Portfolio Investment Q: How do investment & speculation differ? Any example?

Look at great investors & speculators

Find the differences between investment & speculation

Warren Buffett God of Stocks

George Soros Greatest Money Manager

Q. How do Investment & speculation differ?

(1) Targets: Mainly stable income v.s. profiting from price changes (2) Strategies: Long-lasting war v.s. quick battles (3) Tools: Fundamental analysis v.s. technical analysis (4) Style: Prudent () v.s. aggressive ()

2.1.2 Foreign Direct Investment (FDI)

FDI is made to establish (a) International ownership & control: Establish joint venture or subsidiary (b) Multinational Operations

Case:
Nestls Global Drive (1) How does Nestl display basic characteristics of the Multinational Enterprise (MNE)? (2) Whats the motive for Nestl to invest in other countries? Generally speaking, what are different motives for the MNEs to make FDI? Explain.

(1) Basic characteristics of the MNE

Monopolistic advantage It is derived from certain proprietary intangible assets, such as superior managerial skills, patented and unpatented innovations. International ties of common ownership It enables the parent and its subsidiaries to draw on a common pool of resources such as patents, trademarks, research facilities, information and human capital. Transnational intrafirm trade More than 60% of world trade takes place within multinational enterprises.

(2) Whats the motive for Nestl to invest in other countries? In general, what are different motives for the MNEs to make FDI?

Motives: To seek (1) market; (2) cheap labor; (3) raw materials; (4) information and technology; (5) free trade; (6) tax reduction.

2.2 Organizational Forms of the MNE

Does MNE or MNF differ from MNC or TNC? MNE (Multinational enterprise), MNF (Multinational firm) MNC (Multinational Corp. ) TNC ( Transnational Corp.) The Multinational Enterprise (MNE) can take any of the following legal forms: Sole Proprietorship: One owner with unlimited liability PartnershipMultiple owners with unlimited liability CorporationStockholders with limited liability Operational organization in foreign countries can be: Branch: No independent legal status. Subsidiary: Independent legal entity entitled to issue its own stock and bonds. Q Is there an one-person-corporation, i.e., shareholding company?

Caribbean(BVI)

BVI on the Caribbean Sea

A corporation set up there a. pay no taxes; b. can have only one shareholder; c. can have one board member; d. neednt issue an annual report; e. can use any currency for registration; f. can use any amount for registered capital.

Case Study
Aflacs Success in Japan Discussion Questions: 1. Based on Aflacs experience, what conditions should a firm have to make foreign direct investment in a foreign country? 2. Can its success be duplicated in China?

Case: Aflac in Japan

American Family Life Insurance of Columbus founded in 1955. Now its the worlds leading seller of cancer insurance, and one of the most successful foreign companies in Japan. Founders: John Amos & Tipping Point: John attended the Osaka Worlds Fair in 1970, and saw people wearing masks for fear of getting sick. He came up with the idea of selling cancer insurance to Japanese. Events: In 1974, it started its business in Japan; In 1994, it insured one in four Japanese households; The subsidiary generated 70% of Aflacs pretax earnings; Between 1990 and 2002, the subsidiary repatriated over $1 billion to the parent company.

Digression: Basic FDI Theories

(1) FDI Advantage Hypothesis Seminal analysis of the MNF by Stephen Hymer (1960), who introduced industrial organization theory (IOT) to the study of FDI. IOT explains firms performance under different market structures . Q. Whats the basic problem of making FDI? Foreignness Firms proprietary asset Firm-specific advantage compete against local firms make FDI

(2) Internalization Theory

Peter Buckley & Mark Casson Q. Given the costs of foreignness, why does the MNF choose internalization over market transactions? Basic views AInternalization of proprietary assets can best realize their full value; BThe MNF is the result of internalizing markets across national borders.

(3) OLI Advantages Theory

According to John H. Dunning, The MNC must have three advantages: (i) Ownership advantage: a proprietary asset to give it firm-specific advantage (ii) Location advantage: favorable investment conditions as country-specific advantage (iii) Internalization advantage: Internalization of the proprietary asset across national borders can best realize its full value.

Case: Aflac
Q. 1. Based on Aflacs experience, what conditions should a firm have to make FDI? Answer: 1. (1) Ownership Advantage: The firm possesses proprietary knowledge (2) Location Advantage: Japan is a well-developed economy. Income and purchasing power are high. Besides, in-house sales subsidiaries in Japanese corporations can be set up to handle insurance sales. (3) Internalization Advantage Aflac cannot realize full value of its proprietary asset through market transactions like franchising.

2. Succeed in China? Application: Porters Diamond Model

Government Firm Structure, Strategy & Rivalry

Factor Conditions

Demand Conditions

Related & Supported Industry

Chance

Porters Diamond Model Applicable to China

Government Firm Structure & Rivalry in-house sales subsidiaries, allowed,efficient foreign insurers, intense competition Demand Conditions more civilian-run firms, rising income, medical system reform credible foreign insurance

Factor Conditions plenty human resources, low cost, good infra. modern communication

Related & Supported Industry fast-developing financial industry, more investment channels, rapid expansion of foreign banks

Chance

Case: Aflac Q (ii) Can its success be duplicated in China?

Compare: Factor conditions: + Firm structure & rivalry 0 Demand: + Supporting industries: + Government: Chance: + On the whole, there are location advantages. In addition, Aflac has a proven business model. Thus, success is very likely.

Theoretical Issue: FDI as a Currency Area Phenomenon According to Aliber, a financial economist: Foreign direct investment is a currency area phenomenon. Firms in countries with strong currencies have a currency-area advantage. They can acquire foreign firms and production facilities at low costs in countries with weak currencies.

Q. In 1950s and 1960s the dollar was quite

strong, and U.S. made substantial FDI in Europe and other countries. During the 1970s and early 1980s, German mark and Japanese yen were appreciating, and there were extensive German and Japanese outward investments and the invasion of the U.S. by European MNFs. Given this development, Alibers theory seems to explain well the direction of MNFs investment in the postwar world. But Alibers theory has never been widely accepted, why?

Why not widely accepted?

Its drawbacks: (1) FDI is a long-term strategic commitment while current currency value is a short-term phenomenon. Relying on the short-term market bias to account for the long-term decision making is not logically convincing. 2It is inadequate to explain crossinvestment between currency areas.

CaseA Global Challenge for Kodak

(p12, Book 1) Kodaks crisis: In early 80s, Fuji had control over 70% of domestic film market, and started an aggressive expansion into north America and European markets, which threatened Kodaks dominant position there. Worse yet, Fuji undercut prices, and captured large market share, Kodaks profit sagged. (1) What mode of entry did Kodak use for Japanese market prior to 1980s? Why? (2) What strategy did Kodak adopt to counterattack Fujis aggressive expansion into North America markets? Why? (3) How can Kodak thrive in the new era of digital cameras?

(1) Licensing. Kodak underestimated Japanese rivals (2) From licensing to export + joint venture strategy Set up joint venture with a Japanese distributor, establish its distribution and marketing channel, and spend heavily on promotion. Reasons for the Strategic Change a. Exports + FDI can bring in more profits than licensing b. Offense is the best defense. Outcome: Kodak had great success in Japan. In 1990, its sales in Japan reached $1.3 billion. Fuji had to defend its home market, and withdrew a group of best senior executives from abroad. (3) Be a leader in digital cameras, or diversify its biz?

Recapitulation:
International Portfolio Investment differs from FDI; Investment and speculation have different characteristics; MNE can take various legal organization forms; Main motivations for FDI are seeking resources, markets, and efficiency; Mode of entry into a foreign market is an important strategic decision (Kodak); OLI advantages theory offers a guideline for making FDI decision; Porters diamond model provides a useful framework for evaluating location advantages.

Reminder: After the class discussion of the case, you can receive bonus points if a short report is submitted. It should compare analyses of the professor and others with yours. New ideas may also be provided. This report is not required, but you are encouraged to do so. If you want to do the report, it should be submitted at the beginning of the next class. An electronic copy should also be sent to TA and my e-mail box before the next class. Note: Learning is an exciting journey of new discoveries!

Preparation for the Next Class

Topic: International Trade: Theory & Practice Reading: Chap. 4 & 5, Book 1; Chap. 3 & 17, Book 2 Content: Rationale of International Trade International Trade Terms Remittance & Collection Letters of Credit Case Study: An Exchange between Tom & Huck Can Lee & Wang Help Each Other? An unexpected development What type of L/C is it? Note: Knowledge acquisition vs. skill acquisition There are tricks of trade!