Foreign Direct Investment and the Regional Economy

Jonathan Jones, Colin Wren

• Publisher: Routledge
• Year: 2016
• Topic: Business
• eBook ISBN:
  9781317134046
• Subtopic: Business General
• Index: Business

The 'boom' in foreign direct investment (FDI) since the mid-1980s, continues to be paramount in policy interest. This book reviews the literature on the nature of FDI and reports the recent results on the performance of FDI plants in order to show the implications for regional economic development. It presents new evidence on the nature and performance of these plants, using a unique dataset that has been constructed and rigorously analyzed by applying econometric techniques. The role of FDI in economic development has long been poorly understood and this book contributes to improving understanding, and is of direct policy relevance. An examination is made of the generation, theory and location of FDI, as well as its implications for regional and national development. In addition to this, analysis is made of the issues at the project and plant levels, related to investment, employment and firm survival.

Part 1

Theory and Pattern of FDI

Chapter 1

Background

Foreign direct investment (FDI) is the name given to the process where a firm from a country provides capital to an existing or newly-created firm in another country. For example, a foreign firm may decide to set-up production in the UK and by so doing will be engaging in the process known as FDI. Firms locating production in more than one country are often referred to as multinational enterprises (MNEs). Over the last four decades, the number of MNEs and the level of FDI in the global economy have risen spectacularly, with world FDI inflows rising by one-hundred-and-twenty-fold, from $13 billion in 1970 to $1,492 billion by the year 2000.1 Not only is this a huge increase in absolute terms, but it indicates the importance of FDI to the world economy; FDI flows in the year 2000 made up nearly $50 for every $1,000 of GDP compared with less than $1 in 1970. A major beneficiary of this increased flow of FDI has been the United Kingdom (UK), with levels of inflows per $1,000 of GDP consistently above average world levels since the 1970s and the highest of any nation over the 1990s.

The purpose of this chapter is to provide a brief introduction to foreign direct investment and to review the overall pattern of FDI in the world economy and UK. This encompasses a discussion of formal definitions, the evolution of FDI and a review of its contemporary setting. The chapter begins by defining FDI, before examining the role that MNEs play in international production. The chapter then proceeds to look at the history of international investment, from its origins in the Fourteenth Century through to its modern form, highlighting the important role that FDI played in the Twentieth Century, especially in the latter-half of this century. The reasons why an upsurge in FDI occurred are then considered, of which a main component seems to be the rise in merger and acquisition activity. Attention then turns to the UK, which has traditionally been the main recipient of FDI outside of the US. An examination is undertaken of the countries that have been the main providers of inward investment to the UK. This analysis allows the current main sources of FDI to be placed in an historical context, and gives a comprehensive review of the factors generating inward investment to the UK.

Definition of Foreign Direct Investment

The standard definition of foreign direct investment is given by the Organisation for Economic Cooperation and Development (OECD, 1996). A key aspect of this is that it represents the notion of one enterprise in a particular country having a degree of control over another enterprise in a different country, as opposed to just the provision of financial capital. It is classed as, “investment that adds to, deducts from or acquires a lasting interest in an enterprise operating in an economy” arising from outside the country in order to “have an effective voice in the management of the enterprise” (OECD, 1996, p. 7). In the event that a foreign investor does not have an effective voice in the management of the company, then the investment is classified as ‘portfolio investment’.

A natural question to ask of this definition is what constitutes an “effective voice” in a company? Continuing the OECD benchmark definition, it is when “a firm in one country has a foreign investor controlling 10 per cent or more of the equity capital or voting power in the firm” (OECD, 1996, p. 8). An exception to this is when the 10 per cent is insufficient for the investor to have control in the management of the firm, or conversely when the investor has management control in the firm even though it owns less than 10 per cent of the equity capital. The United Kingdom, as with almost all other countries, uses the OECD benchmark definition of FDI, although up until 1999 the UK used a 20 per cent instead of 10 per cent lower bound level of equity capital.2 Even though the threshold level of equity capital was 10 percentage points higher in the UK, Walker (1983) notes that in practice the amount of investment between 10 and 20 per cent is very small in volume, so it makes virtually no difference to the official figures.

The OECD recommended procedure for calculating FDI flows is given in Table 1.1. It is calculated as the sum of four components: retained earnings, equity capital, intra-company loans and intra-company borrowing. Retained earnings are profits generated and kept by the overseas enterprise. These are classified as FDI, despite there is no cross-border transfer of capital, as the investor has the choice of either taking the retained earnings made by the overseas enterprise to their home country or by reinvesting them back into the enterprise.3 The remaining rows of Table 1.1 show the other flows of capital that occur between the direct investor and the overseas enterprise and that are treated as FDI. For example, the transfer of shares or loans between the investor and the enterprise will result in a flow of capital into the overseas enterprise and therefore an increase in FDI. The final row of Table 1.1 shows the outflows that may occur from the overseas enterprise, for example, when the overseas enterprise is borrowing money from the host country to supply to the direct investor. Any outflows are deducted from the inward FDI flow into the host country, and are a disinvestment. If the overseas enterprise lends a greater amount of money to the direct investor than the amount it receives from the overseas enterprise then a negative inflow of FDI occurs.4

Table 1.1 OECD Benchmark Definition of FDI

The above definition of FDI provides a benchmark calculation that allows a degree of transparency in comparing international direct investment flows. In practice though, the calculation of FDI is difficult. This is because of different laws and regulations that exist between countries on how to record and measure components of FDI. Examples include the measurement of intra-company loans, the recorded date of the realisation of project investments, the implementation of internationally-agreed guidelines for measuring balance of payments and the lack of data for many developing countries (Stocker, 2000). An as alternative way of measuring the scale of FDI in a country, data can be examined on the employment or sales of overseas enterprises. FDI is increasingly concentrated in the hands of a number of large enterprises known as multinational enterprises (MNEs).

The Multinational Enterprise

The presence and significance of multinational enterprises in the global economy is growing. UNCTAD (2004) estimate that there are at present over 60,000 MNEs in the world with production occurring in over 900,000 foreign affiliates. In total, multinational enterprises account for around one-tenth of world GDP and one-third of world exports. These figures are increasing, demonstrating the growing levels of international production by multinational enterprises in the world economy. However, it is only a relatively small number of MNEs, originating in a handful of countries that exert a dominant influence on international production. The top 100 multinational enterprises in 2002 (as calculated by UNCTAD) made up just 0.2 per cent of the overall number of MNEs in the world, yet accounted for 14 per cent of total MNE sales.5 A heavy concentration of these enterprises by source country is evident, as over 80 of the top 100 MNEs have headquarters in either the United States or the European Union. Indeed, 71 of the top 100 MNEs have headquarters in just 4 countries: the United States, the United Kingdom, France and Germany.

Definitions of MNEs were not formed until the 1960s, so that research on multinational enterprise is relatively new. Prior to 1960 a firm that operated in more than one country was known either as a ‘multi-territorial firm’ or as a ‘firm engaged in FDI’ (Dunning, 1996). Even in the 1970s a universal definition was not in use, with Tugendhat (1981) classifying firms that produce and sell goods in different countries as ‘international firms’, leaving the term MNE to apply only to larger international companies, although a formal definition was not given. Moosa (2002) provides a distinction between three terms – international, multinational and transnational corporations – which are, or have been, commonly used to define the international operations of firms. An international corporation is a company that is concerned solely with importing and exporting goods between countries. The term multinational applies when the international operations of a firm begins to involve actual production in another country. The term transnational company is used when the firm becomes globally active to such an extent that its identity becomes detached and independent from its home or any other particular country.6 In practice, the terms multinational and transnational corporations are often used synonymously (see below).

Formal definitions of multinational enterprise are given by the Organisation of Economic Cooperation and Development and by UNCTAD in its World Investment Report. The OECD classifies MNEs as “companies or other entities established in more than one country, and so linked that they may co-ordinate their operations in various ways” (OECD, 2000, p. 17).7 The term ‘entities’ covers the parent and other related entities of the company, although the former will be the main source of influence. A similar definition is issued by UNCTAD, although its definition refers to transnational corporations rather than multinational enterprises. A transnational corporation is “an enterprise whether of public, private or mixed ownership, comprising entities in two or more countries, regardless of the legal form and fields of activity of these entities” (UNCTAD, 2003, p.66). The corporation has a ‘common strategy’ through one or more decision-making centres, but where one or more of these centres exercises a significant influence over the activities of the others. A key role of the corporation is “to share knowledge, resources and responsibilities with the others” (UNCTAD, 2003, p.66). As with the OECD definition, the corporation refers to the enterprise as a whole, and so includes all its various entities.8

Many authors treat foreign direct investment and multinational enterprises as one and the same thing, with John et al (1997) suggesting that the terms FDI and MNE are treated synonymously with each other.9 Dunning and Pearce (1995) state that since MNEs finance overseas subsidiaries from their funds through capital markets or reinvested earnings, then these overseas affiliates are the same as foreign direct investment. However, Hennart (2001) points out that FDI will not give a perfect measure of MNE activity as foreign plants can raise capital by borrowing from the host country, thus understating MNE growth. Wilkins (2001) also points out that FDI is just one of many activities that a MNE carries out, as follows, “A multinational enterprise provides intra-firm connections … it is not merely a channel for one-time transactions but a basis for different sorts of internal and external organisational relationships” (p. 6). For studies of MNEs these issues are of interest, but for the study of FDI the point is that multinational enterprise can be seen as the vessel for FDI. The evolution of MNEs and the history of FDI are now charted from their early conception through to their current form.

The History of International Investment

Early Investment

There have been international organisations engaged in trading activities as far back in time as 2500BC, with banks and churches also having formed international organisations throughout history (see Ghertman and Allen, 1984). The appearance of the modern MNE, incorporating control over foreign production units, did not occur until the Nineteenth Century (Wilkins, 1977), but early resemblances to the modern MNE appeared in the 1600s and 1700s, when large trading companies from the UK and the Netherlands entered parts of Asia, the Indies and America.10 The two largest enterprises were the British East India Company and the Dutch East India Company (Carlos and Nicholas, 1988), which dominated the lucrative markets of spices, cottons and silks, and are credited as being the true pioneers of international commercial activities. Investment also later took place in the UK and French colonial territories of Latin America, Asia, Africa and Australia, with most investments being supply oriented, in the form of resource exploitation (Gabel & Bruner, 2003).11 International companies also emerged with the aim of colonising foreign lands. One of the first was the London-based, British Virginia Company, whose strategy was to profit from the development and colonisation of Virginia in the US. Similar projects across North America were undertaken by the Dutch, the French and the Swedes.

It is generally accepted that the true birth of the modern multinational arose in Europe in the Nineteenth Century (Wilkins, 1986).12 Examples are the S.A. Cockerill steelworks of England that set up in Prussia; Bayers of Germany that set up chemical plants in the US; and Nobels of Sweden that set up dynamite production in Germany (Tugendhat, 1981). However, it was not until the latter part of the Nineteenth Century that larger-scale foreign direct investment started to emerge. A major motivation for the spread of these firms was the increase in the protectionist behaviour of countries, which in turn was a by-product of increased nationalism. As customers mostly-preferred goods produced locally, as opposed to imported goods, firms had to set-up abroad (Micklethwait and Wooldridge, 2003). Other important reasons for the upsurge in FDI and the growth of MNEs was the search for larger markets, as enterprises began to grow in size, and improvements occurred in transportation and communication, most notably the railways and telegraphs (Wilkins, 1988). These advances not only made it easier for parent companies to control their subsidiaries but to control them over longer distances.

Up until the end of the Nineteenth Century, European firms dominated the MNE scene, but US multinationals were beginning to increase, both in number and size. Examples of US multinationals at this time include Singers, which set up sewing-machine plants in Scotland, and the electrical-manufacturers Thomson-Houston, which set up in England (Atack and Passell, 1994). By the turn of the century, US firms were amongst the world’s largest firms and included enterprises such as Rockerfeller’s Standard Oil and Ford. The growth of US multinationals continued as they took advantage of the growing size of the American market, which according to Chandler (1987) enabled them to acquire skills such as mass production and mass marketing, and to exploit economies of scale. Factors such as market size, cultural factors, geography and government...

Table of contents

• Cover Page
• Half Title page
• Title Page
• Copyright Page
• Contents
• Figures
• Tables
• Preface
• Introduction
• 1 Theory and Pattern of FDI
• 2 Inward Investment in a Regional Economy
• Data Appendix The Inward Investment Dataset
• Bibliography
• Index