DIRECT INVESTMENT



Direct investment generally refers to situations in which a company has established manufacturing facilities in another country, either through a wholly owned subsidiary or as a joint venture partner with a partial ownership stake. Direct investments are governed by the laws of both the country in which the parent company is domiciled and the country in which the subsidiary does business. In cases where international trade sanctions have been imposed or the host country has appropriated the assets of the subsidiary, international law may pertain as well.

Interest in direct investments in foreign-based enterprises grew strongly in the late 1960s and early 1970s, as American companies sought to augment corporate growth through expansion into new markets. This created a basis for criticism in sociopolitical circles, as some studies indicated that such practices were extractive and exploitative.

Direct investment came under scrutiny again in the late 1980s as British and Japanese companies took aggressive actions to establish foreign subsidiaries, primarily in the United States. Far from being extractive, these enterprises boasted job creation and support of local economies. The driving force behind these enterprises, however, was circumvention of trade duties on imported goods.

There are several economic advantages provided by direct investment, which is why a foreign country would welcome the establishment of such a subsidiary within its borders. First, direct investment by a foreign company facilitates the diffusion of superior technologies and managerial techniques into the country, generally enhancing the position of domestic manufacturers across all industries. Second, establishment of a subsidiary facilitates trade, allowing the host nation to more fully employ its own assets, whether through cheaper labor, access to raw materials, or employment of other companies. Third, the introduction of a foreign subsidiary can raise standards of efficiency for domestic firms, which must compete with the foreign subsidiary.

Disadvantages stem primarily from the ability of the foreign parent company to extract economic profits from the operations of its subsidiary and repatriate them out of the country. Another disadvantage may lie in the fact that the subsidiary may divert the employment of national assets, such as labor and capital, away from other activities that may be more beneficial to the economy.

A hypothetical illustration of forms of direct investment may be provided by the fictional Acme Electronics Company, an American manufacturer of television sets. In this example, assume that Acme's American market is growing at 2 percent annually in terms of volume, but that pricing pressure from competitors yields negative profit in that market. An analysis of foreign markets indicates demand for television sets is growing by 20 percent in Argentina and Brazil.

Acme funds the development of a wholly owned subsidiary in Brazil to produce television sets for that market. As part of an industrial policy to support the growth of domestic companies, however, Argentine law precludes the establishment of wholly owned subsidiaries. In Argentina, an Acme subsidiary must provide for at least 50 percent ownership by an Argentine company.

The Brazilian enterprise, capitalized at $400,000, is wholly owned by Acme. An identical plant in Argentina requires investments of $200,000 from Acme and $200,000 from an Argentine joint venture partner.

While both enterprises pay local taxes and other fees in each country, Acme may repatriate all the profits from its Brazilian operation, but is entitled to repatriate only half the profits from its Argentine business, commensurate with its ownership interest. The other half belongs to Acme's Argentine joint venture partner.

In addition to advantages from expansion into more profitable, higher-growth markets, direct investment may yield other important benefits to the parent company. The parent company may enjoy numerous economies of scale and economies of scope from foreign operations. In the case of Acme Electronics, the company already has the technology and managerial expertise to produce television sets in the United States, and merely extends those advantages to foreign markets through its subsidiaries. These may be considered "internal" economies, because they provide room for greater capacity without substantial additional investment.

In addition, Acme's competition in its foreign markets may not be as well developed. Therefore it enjoys a greater advantage over competing enterprises that may be realized in terms of greater market share and profitability.

RECENT TRENDS IN DIRECT
INVESTMENT

Foreign direct investment (FDI) grew at a phenomenal rate during the last two decades of the 20th century, both in developing countries and in the United States and other developed nations. Between 1980 and 1997, FDI outflows increased at an average rate of about 13 percent a year, compared with average growth rates of 7 percent for both world exports of goods and services and for world gross domestic product. In 1998 global FDI outflows and inflows reached the $430 to $440 billion range. Some 54,000 transnational corporations had $3.4 trillion invested in 449,000 foreign affiliates. These figures represented a marked expansion of international production by transnational corporations.

Another trend noted in FDI in the United States by foreign corporations for the 1990s was an increase in the amount of FDI accomplished through mergers rather than through establishing subsidiaries. The Survey of Current Business showed that more than 90 percent of FDI during 1997 took the form of mergers, reflecting a steady upward trend since 1992 when mergers accounted for only 69 percent of FDI. Also of interest was the fact that less than 3 percent of FDI in the United States in 1997 was from Japan, reflecting Japan's economic troubles.

Between 1980 and 1990 the number of American-based employees of foreign corporations more than doubled, from 2.0 million to 4.7 million. Many were employed in automobile production plants set up by subsidiaries of Japanese companies. In the 1990s, though, there was little increase in employment by foreign companies, because the prevalence of mergers did not result in any substantial job creation. The job market was very tight during this period, however, so there was minimal economic impact from the rise in mergers by foreign corporations.

After FDI in the United States peaked at an all-time high of $79.9 billion in 1996, the amount foreigners spent to buy U.S. companies or establish new businesses in the United States declined 11.4 percent to $70.8 billion in 1997. During this period FDI was affected by a strong U.S. dollar, which made U.S. assets more expensive to foreign companies, and Japan's economic problems. The Asian financial crisis of 1997-98 also affected FDI by Asian companies in other parts of the world and diminished FDI somewhat by the United States and other nations in countries such as Thailand, Indonesia, and South Korea. The People's Republic of China also noted a decline in FDI and was implementing measures to encourage more FDI. Mexico and Canada experienced substantial growth in FDI, due in part to the North American Free Trade Agreement.

[ John Simley ,

updated by David P. Bianco ]

FURTHER READING:

De Santis, Solange. "U.S. Companies Increasingly Look to Canada to Make Their Initial Foray into Foreign Lands." Wall Street Journal, 15 July 1998, A10.

"Direct Investment." USA Today International Edition, II June 1998, 8A.

Donnelly, James H., and others. Fundamentals of Management. 10th ed. NP: McGraw-Hill Higher Education, 1997.

"Government Seeks Ways to Lure Sagging Direct Investment." Business Korea, October 1998, 63.

Griffin, Ricky W., and Ronald J. Ebert. Business. 5th ed. Paramus, NJ: Prentice Hall, 1998.

Mallampally, Padma, and Karl P. Sauvant. "Foreign Direct Investment in Developing Countries." Finance and Development, March 1999, 34 +.

McDaniels, lain K. "A Slow Year for Foreign Investment." China Business Review, January/February 1999, 34.

Melloan, George. "Asia Revives, but Whither Japan and China?" Wall Street Journal, 2 March 1999, A19.

Millman, Joel. "Asian Firns Plunge into Mexico on Nafta's Promise: Investment Is Boon to Manufacturing." Wall Street Journal, 14 August 1998, A13.

"The Trouble with Mergers." Economist, 30 January 1999, 30.



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