Chapter 02 - International Trade and Foreign Direct Investment

Chapter 2

International Trade and Foreign Direct Investment

Learning Objectives

L.O. 1 appreciate the magnitude of international trade and how it has grown

L.O. 2 identify the direction of trade, or who trades with whom

L.O. 3 explain the size, growth, and direction of foreign direct investment, worldwide and in the United States

L.O. 4 identify who invests and how much is invested in the United States

L.O. 5 understand the reasons for entering foreign markets

L.O. 6 comprehend that globalization of an international firm occurs over at least seven dimensions and that a company can be partially global in some dimensions and completely global in others

Overview

This chapter addresses three major concerns, the state of international trade, that of foreign investment, and then an exploration of why businesses enter foreign markets.

International trade and foreign direct investment have grown dramatically over the last three decades. Although new trading and investment patterns are emerging, developed nations tend to trade with and invest primarily in other developed nations.

Firms go abroad either to increase profits and sales or protect them from being eroded by competition. To increase profits and sales, they may enter new markets, go to markets that promise to help them obtain greater profits, or enter markets in order to test market. The competitive moves are motivated to protect the home market, to attack competition in their home market, to protect their foreign markets, to guarantee supply of raw materials, for geographic diversification, and to satisfy management’s desire.

The traditional approach to international involvement was to begin with exporting, then setting up foreign sales companies and finally, where the sales volume warranted, establishing foreign production facilities. Increasingly, because countries have liberalized trade restrictions and IT has made communication instantaneous, companies are becoming involved in trade and FDI for many reasons.

Globalization may occur along seven dimensions: product, market, promotion, where value is added to product, competitive strategy, use of non-home country personnel, and extent of global ownership in the firm.

Suggestions and Comments

1. Students often are unaware of the rapid growth of international trade, so we discuss Figure 2.1 in class. We point out that there have been numerous changes in trade relationships as Tables 2.2 and 2.4 illustrate. Most students believe that the major trade direction is between developed and developing nations (exchanging raw materials for finished goods). Table 2.3 shows that developed nations continue to trade with other developed nations, but the increase in industrialization of developing nations is resulting in greater trade among them.

2. Generally students are surprised to learn that the United States’ share in total foreign investment is still as large as it is (Table 2.6). They also believe that Japan’s share is largest. Do you want to see how many read the assignment? Ask them which country has the largest share of foreign direct investment (U.S.).

3. There is a common misconception that firms have a choice between exporting and foreign production. We show that this choice often is unavailable when we cover the reasons for going abroad.

4. You may be interested in discussing the topic, “Does trade lead to FDI or does FDI lead to trade?” This illustrates how closely trade and FDI are interlinked.

5. This is a good time to introduce the 7 global dimensions because the issue of globalization will occur throughout our discussion of international business.

Student Involvement Exercises

1. Ask the students to check advertisements in The Wall Street Journal , the Financial Times and New York Times, for ads in which investment inducements are offered by foreign governments. Similar ads also appear in The Economist,Business Week, and Fortune. Students can also search the web to find such inducements for various countries. What kinds of inducements are offered? Does your city and state offer foreign firms inducements to invest in your area?

2. We state in the text that one reason for going overseas is to protect the firm’s foreign markets. In many countries, the major U. S. competitors are competing as they do here. The students might take an industry and see in how many countries the top two or three industry leaders are present. For example, in how many markets do Colgate-Palmolive and Procter & Gamble compete using their own local production facilities? The annual reports of these firms will tell where production facilities are.

Guest Lecturers

Some businesspeople who could contribute to the material in this chapter would be:

1. Someone in the technical department of a multinational to talk about licensing and contract manufacturing arrangements that firm has with overseas licensees.

2. Product manager of the international division of a multinational who should be knowledgeable about licensing and all the means for entering a market. Such a person can also explain why the firm went overseas.

3. Financial person in the international division who can discuss the points mentioned in questions 1 and 2 plus the return obtained from these arrangements.

4. Representatives from a foreign-owned subsidiary in your area. Ask them to tell the class what motivated their company to come to the United States and your area.

5. If you have an economic development department in your state that is active in attracting foreign investors, you may be able to get a representative to explain to the class what it does to attract foreign investors and what foreign investors are looking for. Your chamber of commerce director of economic development may have had visits from foreign company representatives that he or she is willing to share.

Lecture Outline

  1. The Opening Section

In this chapter, three topics are examined that relate directly to exporting and production in foreign countries: (1) international trade, which includes exports and imports; (2) foreign direct investment; and (3) why firms enter foreign markets. A related activity, foreign sourcing, is treated later in the text.

  1. International Trade
  1. Volume of Trade

1. The volume of international trade in goods and services was $7.9 trillion in 2000, and in 2007, $17 trillion.

2. While smaller in absolute terms, trade in services has grown faster since 1990 than has merchandise trade.

3. African trade has increased in value, but decreased in its proportion of world trade.

4. As Figure 2.1 indicates, the proportion of exports from Latin America, Africa and the Middle East has decreased.

5. North America and the EU proportions of world trade have increased. With the EU, new members account for some of the growth.

  1. Direction of Trade

1. Developed nations trade primarily with other developed nations (Table 2.4).

2. Developing nations also trade primarily with developed nations, although this proportion is declining. (Japan and U.S. are exceptions.)

3. The direction of trade frequently changes over time among nations or regions. Regional trading blocks (NAFTA, EU, ASEAN) have been trading more within themselves.

  1. Major Trading Partners: Their Relevance for Businesspeople

1. Advantages of focusing attention on a nation that is already a sizable purchaser of goods from the would-be exporter’s country include:

a.Business climate in the importing nation is relatively favorable.

b.Export and import regulations are not insurmountable.

c.There should be no strong cultural objections to buying that nation’s goods.

d.Satisfactory transportation facilities have already been established.

e.Import channel members are experienced in handling import shipments from the exporter’s area.

f.Foreign exchange to pay for the exports is available.

g.The trading partner’s government may be applying pressure on importers to buy from countries that are good customers for that nation’s exports.

2. Major trading partners of the United States.

a.Table 2.5 shows the major trading partners of the United States. Mexico and Canada are major trading partners, in great part because of their geographic proximity. Now, as members of NAFTA, their importance is growing.

  1. Rankings of America’s trading partners have changed markedly in 30 years. Asian nations have become increasingly important trade partners for both exports and imports.
  2. Many Asian countries appear as major importers of American goods because (1) their rising standards of living enable their people to afford more imported products, and export earnings provide foreign exchange to pay for imports, (2) they are purchasing large amounts of capital goods to further their industrial expansion, (3) they are importing raw materials and components to assemble into subassemblies or finished goods to subsequently export, often to the U.S., and (4) their governments, sometimes under pressure from the U.S. government, have sent buying missions to the U.S. to seek products to import.

3.Relevance for Businesspeople

For a company starting to search for new international business opportunities, the preliminary steps of studying the general growth and direction of trade andanalyzing major trading partners would provide an idea of where the trading activity is.

  1. Foreign Investment

Foreign investment is usually divided into two components: portfolio investment and direct investment. The distinction between these two has begun to blur, particularly with growing size and number of international mergers, acquisitions, and alliances.

  1. Portfolio Investment

1.Not directly concerned with the control of a firm

2.Nonresidents owned American stock and bonds with a value of $6,132 billion in 2007. Americans owned $6,649 billion in foreign securities in 2007.

  1. Foreign Direct Investment (FDI)

1.Volume.

a. The book value of all foreign direct investments was nearly $12.5 trillion at the end of 2007 (Figure 2.2).

  1. The U.S. is one of the largest investor nations, with $2.4 billion invested abroad, which was 1.6 times the FDI of the next-largest investor, the United Kingdom, and 2.2 times that of the third-largest investor, France$2.4 billion invested abroad, which was 1.6 times the FDI of the next-largest investor, the United Kingdom, and 2.2 times that of the third-largest investor, France.
  2. The proportion of FDI accounted for by the United States declined by over 47 percent between 1980 and 2006, however, from 36 to 19 percent.The proportion of FDI accounted for by the EU increased from 36 percent to 52 percent in 2006. Japan declined from 12 percent in 1990 to 4 percent in 2006. Developing countries increased their proportion of FDI, from 1 percent in 1980 to 13 percent in 2006, an increase of approximately 1,200 percent. (Fig. 2.2).

.</para>

  1. Annual FDI outflows hit a historical high in 2000—$1,201 billion, more than 250 percent of the level in 1997 (see <internalref idref="id_0073530166_001_003099" type="table">Table 2.6</internalref>). However, the slowdown that began to hit most of the world’s economies in late 2000 resulted in a subsequent decline in the overall level of annual FDI flows. By 2002, the total was only $647 billion, only about 54 percent of the 2000 figure but still the fifth-highest annual level of FDI to that point in history. Outflows subsequently increased, reaching $1,216 billion by 2006 (Table 2.6).

2.Direction. The industrialized nations invest primarily in one another just as they trade more with one another.

3.Trade and FDI

Historically, foreign direct investment has followed foreign trade because:

a.Foreign trade is less costly and less risky.

b.Management can expand the business in small increments rather than in the greater investment and market size that a foreign production facility requires.

4. Does trade lead FDI or does FDI lead trade?

a.New business environment of fewer government barriers to trade, increased competition from globalizing firms, and new production and communications technology is causing international firms to locate their production systems close to available resources. They then integrate the entire production process either regionally or globally.

b.Where to locate may be either an FDI or a trade decision.

C.U.S. Foreign Direct Investment

1.Figure 2.2 shows that the U.S. is the world’s largest foreign investor.

2.American firms have invested in developing nations, approx. 70 percent of the total.

3.U.S. investment is largely into other developed countries, to Europe, Latin America, and Asia and the Pacific.

D.Foreign Direct Investment in the United States

1.Rapid increase. FDI in the U.S. rose from $185 billion in 1985 to $1,789 billion in 2006 (Figure 2.3b). Over 85 percent was from 8 nations: (1) United Kingdom, (2) Japan, (3) Germany, (4) Netherlands, (5) France, (6) Canada, (7) Switzerland, and (8) Luxembourg.

2.Acquire going companies or build new ones?Most FDI in the U.S. has been to acquire going companies rather than to establish new ones. Reasons for this include company availability as a result of corporate restructuring, foreign company desire to gain rapid access to U.S. technology, desire to acquire known brand names, and increased international competitive pressures, including the pursuit of improved economies of scale.

IV.Why Enter Foreign Markets?
A.Increase Profits and Sales

1.Enter new markets. Managers facing a mature, saturated market at home may find that markets with rising GDP per capita and population growth appear to be attractive for doing business.

a.New market creation

b.Preferential trading arrangements. For many products, preferential trading arrangements (European Union, NAFTA) have created new, larger markets. This can be particularly important for nations that still lack sufficient market potential on their own.

c.Faster-growing markets. Many foreign markets are growing faster than the home market.

d.Improved communications.

2. Obtain greater profits.

a. Greater revenue. Where there is less competition, the firm may get a better price.

b. Lower cost of goods sold. Increasing total sales by exporting can reduce R&D costs per unit, permit economies of scale in manufacturing and other activities, and provide access government inducements.

c. Higher overseas profits as an investment motive

d. Test market. Opportunity to trial changes to any part of the marketing mix based on results from a less important foreign market; danger that a market test will give competitors an early warning.

B. Protect Markets, Profits, and Sales

1. Protect domestic market

a. Follow domestic accounts overseas

b. Attack in competitor’s home market to keep it occupied defending that market

c. Use foreign production to lower costs.Firms move part or all of their production facilities overseas to lower manufacturing costs and protect their domestic markets from lower-priced imports.

d. In-bond plant concept

2.Protect foreign markets

  1. Lack of foreign exchange–Firms produce in countries where foreign exchange for buying their exports is scarce.
  2. Local production by competitors–Firms follow competitors who invest in their export markets.
  3. Downstream markets–Some companies, such as those from OPEC nations have invested in downstream manufacturing and marketing outlets to guarantee market for their products.
  4. Protectionism–Firms go abroad when governments erect import barriers to their exports.
  5. Guarantee supply of raw materials, especially in nations that lack sufficient domestic supplies.
  6. Acquire technology and management know-how.
  7. Geographic diversification, as a means of maintaining stable sales and earnings when the domestic economy or their industry goes into a slump.
  8. Satisfy desires of management, shareholders, financial analysts, and others for continued expansion.

V.How to Enter Foreign Markets
Two ways: (1) export to them, and (2) manufacture in them.

VI.Multidomestic or Global Strategy?
Many multinationals begin their foreign operations by first exporting and then manufacturing overseas, but they also enter some markets by manufacturing. They employ all the methods we have discussed to reach their worldwide markets.

  1. The World Environment is Changing
  1. Although the linear relationship of first exporting and then manufacturing overseas still holds for many firms, manufacturing overseas still hold for many firms, changes in the world environment are affecting trade and foreign investment-(1) governments have liberalized flow of factors of production, (2) improvements in information technology enable managers to direct company activities over long distances in diverse areas. As a result, global competition has increased.
  2. Which strategy will the company follow- multinational or global; that is what can the company standardize worldwide?
  1. Seven Global Dimensions
  1. There at least seven dimensions along which management’s can standardize: (1) product, (2) markets, (3) promotion (4) where value is added to product, (5) competitive strategy, (6) use of non-home-country personnel, (7) extent of global ownership in the company.
  2. Possibilities range from zero standardization (multidomestic) to standardization along all seven dimensions (completely global). Management must decide how far the firm should go along each dimension.

Answers to Questions

  1. How large and important of a role do small and medium-sized enterprises play in generating export sales?

Technology is giving small and medium-sized enterprises the opportunity to compete in the international environment. Their role is huge.

  1. How has trade in merchandise and services changed over the past decade? What have been the major trends? How might this information be of value to a manager?

The volume of international trade in merchandise and services exceeded $4 trillion in 1990. Fourteen years later, international trade had more than doubled to $11 trillion! Trade in services has also increased. The significance of world trade cannot be overlooked. The trends are many and varied, and include trade within regional blocks. It is critical that managers understand these trends in order to develop a competitive strategy to take advantage of this growth. Also, because of increased trade, management must be prepared to face stiff competition in markets abroad as well as the home market.

  1. The greater part of international trade consists of an exchange of raw materials from developing nations for manufactured goods from developed nations. True or false? Explain.

This statement is false, but with modification. More than half the exports from developing nations are shipped to developed nations, but this percentage has been steadily declining over the last thirty years. Nearly three-fourths of exports from developed economies go to other industrialized nations. Exceptions to this developed to developing country export trend are the United States and Japan, which send a larger portion of exports to developing nations than do other developed countries.