and host country effects

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Fafo-report 2008:45 ISBN 978-82-7422-655-5 P.O.Box 2947 Tøyen

Torunn Judith Kvinge Essays on foreign direct investments

and host country effects

The long-run relationship, the lasting interest, the control aspect, and the transfer of assets related to foreign direct investments are generally assumed to create distinctive economic consequences for the host economies. In the public debate, multinational enterprises often seem to be perceived either as highly beneficial or as obstacles to prosperous development, probably because there are truly two sides to foreign direct investments. On the one hand, genuine competencies often constitute owner-specific advantages of multinational enterprises and these competencies might be expected to spill over to the host economies.

On the other hand, the factors promoting foreign direct investments also create industry entry barriers and it is empirically well established that there is a positive correlation between foreign ownership and the concentration level in a sector. In this thesis various host country effects is studied from different angles.

The thesis is organized as follows: Essay 1 gives a brief introduction to Dunning’s eclectic paradigm and shows how a broad range of theories can be sorted and understood in relation to the constituting parts of the paradigm. Furthermore, these different theoretical contributions serve as a background for a general discussion of host country effects. Essay 2 focuses on location advantages, development in foreign direct investments, and some possible host country effects in Norway. Essay 3 provides a survey of the empirical literature on externalities related to foreign direct investments. Essay 4 contains an econometric analysis of productivity growth and possible spillover effects regarding foreign takeovers in the Norwegian manufacturing industry with ownership advantages as the focal point.

Finally, internalization advantages are at the centre of attention in Essay 5. The research question—whether there are any patterns in takeovers that are followed by closures of the acquired plants—is analysed using data of Swedish multinational enterprises’ foreign direct investments in OECD countries.

Essays on foreign direct investments and host country effects

Doctoral dissertation

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Torunn Judith Kvinge

Essays on foreign direct investments and host country effects

Fafo-report 2008:45

Doctoral dissertation

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ISBN 978-82-7422-655-5 ISSN 0801-6143

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Acknowledgements

The work with the thesis was mainly conducted at Fafo Institute for Labour and Social Research in Oslo during 1998–2002. At Fafo I am especially indebted to Tone Fløtten, Bjørne Grimsrud, and Jon Hippe for being supportive through the later stages of my work. During 1998–2002 I also had the opportunity to collaborate with Leo Grünfeld at the Norwegian Institute of International Affairs (NUPI), Grete Rusten at the Institute for Research in Economics and Business Administration (SNF), and Rajneesh Narula at the Centre for Technology, Innovation and Culture (TIK), University of Oslo on different projects related to foreign direct investments. They shared their expertise with me and I am grateful for our productive discussions.

In 1998 I visited the Research Institute of Industrial Economics (IUI) in Stockholm for three months. I would like to express my appreciation of Pontus Braunerhjelm, Jörgen Nilsson, and Pehr-Johan Norbäck at IUI for their support and hospitality. This winter I also participated in a doctorate course at the Stockholm School of Economics, given by Magnus Blomström. The course was an excellent kick-off for my later work.

Most of the conclusions were already written by late 2002. However, due to various circumstances I was not able to complete the last draft and submit the dissertation at that time.

The manuscript ended in a drawer, where it more or less rested in peace for several years.

Thanks to the encouragement of Helge Hveem and lately of Merle Jacob at TIK the work was brought to life again and has to some extent been updated.

I am indebted to a number of people for helpful suggestions and comments on earlier drafts of the thesis, and in particular to Bjørn Terje Asheim and Ådne Cappelen who stepped in as supervisors in the last phases of the process. Essay 2 draws partly on Kvinge and Narula (2001), FDI in Norway’s Manufacturing Sector. I am grateful to Leo Grünfeld, Grete Rusten and Berit Teige for comments on an earlier draft of the paper. A previous version of Essay 3 was published at TIK with the title Knowledge diffusion through FDI—established wisdom or wishful thinking? This essay was also improved by comments from Jan Fagerberg and Ari Kokko. Terje Skjerpen and Sverre Herstad provided constructive comments on Essay 4. My stay in Sweden resulted in Essay 5. Pontus Braunerhjelm and Ari Kokko offered helpful suggestions for improvements to a first draft. Thanks to you all. Needless to say, I am responsible for the result, including remaining errors.

I am also grateful to those who collected and structured data at IUI (including Katariina Hakkala and David Zimmermann) and at Statistics Norway (especially Leiv Ryalen and Sissel Fjeld), to Shankat Zamani at Fafo for helping with computer problems, and to Online English (www.oleng.com.au) as well as Sudha Menon for improving the language.

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The work with the thesis was mainly financed through a three-year scholarship from the Research Council of Norway, a scholarship from P.W. Røwdes Foundation (which made it possible for me to take four months‘ leave to concentrate on the thesis during 2002), and a travel grant from Norfa. During spring this year TIK generously gave me a scholarship and an office at the university. The financial support is gratefully acknowledged. Finally, I would like to thank my family and friends, who always encouraged me in my work.

Oslo, July 2007

Torunn Kvinge

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Introduction

The purpose of this thesis is to study the effects on a host country of direct investments across national borders. The fundamental difference between foreign direct investment (FDI) and portfolio investment is that FDI principally involves the transfer of technology and skills while capital per se is of less importance (Dunning 1988). During the past two decades, FDIs have experienced remarkable growth rates, and multinational enterprises (MNEs) now play a significant role in the world economy.¹ The long-run relationship, the lasting interest, the control aspect, and the transfer of assets related to foreign direct investments are generally assumed to create distinctive economic consequences (both positive and negative) for the host economies.

In the public debate, MNEs often seem to be perceived either as highly beneficial or as obstacles to prosperous development, probably because there are truly two sides to FDI. On the one hand, genuine competencies often constitute owner-specific advantages of multinational enterprises and these competencies might be expected to spill over to the host economies. On the other hand, the factors promoting FDI also create industry entry barriers and it is empirically well established that there is a positive correlation between foreign ownership and the concentration level in a sector (Caves 1996). Today, a large proportion of the world‘s natural resources are distributed among MNEs, which often constitute oligopolies.

Their ownership advantages are due to high sunk costs, for example, connected with mining.

The internalization of transactions within an MNE (as an alternative to arms-length trade or licensing) is mostly related to market imperfections. These are sometimes created by government policy but are also a consequence of the public-good nature of knowledge, the creation of branded products, and high entry barriers. In the context of research and development (R&D) activities, some market failures are due to the difficulties of specifying complete contracts associated with uncertain outcomes. Furthermore, market failures may occur because of inadequate protection of proprietary information. In addition to these transaction-related factors, knowledge and problem solving are often embedded in organizational routines, which make some firms better at exploring technical opportunities and translating them into specific marketable products (see Dosi 1988).

Within the discipline of economics, research on FDI has to a large extent built on the seminal work of John H. Dunning (1977, 1988). This thesis also draws on Dunning‘s

―eclectic paradigm‖ or ―OLI framework‖ and its applications. The thesis is organized as

1 In 2004, for instance, employment in foreign affiliates of multinational enterprises was estimated at more than 57 million people, that is, about three times as many as 20 years earlier. During the same period, the assets of the foreign affiliates expanded more than 17 times (UNCTAD 2005:14).

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follows: Essay 1 gives a brief introduction to the eclectic paradigm and shows how a broad range of theories can be sorted and understood in relation to the constituting parts of the paradigm. Furthermore, these different theoretical contributions serve as a background for a general discussion of host country effects. Essay 2 focuses on location advantages, development in foreign direct investments, and some possible host country effects in Norway.

Essay 3 provides a survey of the empirical literature on externalities related to foreign direct investments. Essay 4 contains an econometric analysis of productivity growth and possible spillover effects regarding foreign takeovers in the Norwegian manufacturing industry with ownership advantages as the focal point. Finally, internalization advantages are at the centre of attention in Essay 5. The research question—whether there are any patterns in takeovers that are followed by closures of the acquired plants—is analysed using data of Swedish multinational enterprises‘ foreign direct investments in OECD² countries.

After studying the subject from different angles, the emerging impression is that it is not possible to arrive at a conclusion on unambiguous host country effects related to FDI, whether positive or negative. Rather, results seem to differ regarding different groups of stakeholders, sectors, nationality of the investing enterprise, and the motive behind the investment.

Outline of the essays

The eclectic paradigm has proved to constitute a solid framework for research on foreign direct investments; a broad range of theories can be organized under each of its three pillars, namely the ownership, the localization, and the internalization advantages. The aim of Essay 1, Foreign direct investments and host country effects—some theoretical considerations, is to discuss and synthesize some of the theoretical contributions focusing on possible host country effects, among which are effects connected with externalities of foreign investments. First, theories on the varieties of capitalism, national business systems, and competitive advantages of nations all facilitate understanding of the ownership advantages of multinational enterprises. The industrial organization tradition provides the tools for understanding the internalization advantages related to foreign direct investments while trade theories, agglomeration theories, and theories about national innovation systems offer a framework for understanding location-specific advantages.

Externalities are assumed to take place when the entry or presence of MNE affiliates leads to productivity or efficiency improvements in the host country and the MNEs do not internalize all the benefits (Blomström and Kokko 1998). Four different initial externalities of FDI in the host country are explored. First, there may be externalities related to the public nature of knowledge. Second, the host economy may experience increased social returns

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because foreign affiliates introduce modern technology that gives firms and consumers further down the value chain better value for money than previously. Third, local firms may be pushed or inspired to improve their productivity as a result of forward and backward linkages with foreign MNE affiliates; increased competition may force firms to adopt more efficient methods or to work harder. Fourth, MNEs may provide the infrastructure and production facilities that are vital for agglomeration economies to be developed or maintained.

In addition, host country effects related to different combinations of ownership, localization, and internalization advantages are discussed. To clarify ideas I distinguish between three main categories of MNEs: the branders, the oligopoly players, and the technological frontrunners.

Industrial clusters are characterized by related industries that are embedded within a supporting infrastructural and institutional environment (Porter 1990, 1998). Essay 2, Functional industrial clusters as determinants of foreign direct investments in remote areas?, addresses the question of whether location advantages are connected with a country‘s functional industrial clusters³, using Norway as an example. Furthermore, in this essay I emphasize the interconnections between FDI and the formation of industrial clusters; that is, foreign MNEs may invest in existing clusters to obtain access to local knowledge, but they may also contribute to cluster development.

At the beginning of the 20th century, FDI in Norway was mainly resource seeking. With the help of foreign capital, the required infrastructure, as well as backward and forward linkages, was created and industrial clusters emerged in the production of metals, paper and pulp, and in the last half of the century, also in the production of petroleum. However, foreign MNEs did not play a similarly important role in developing maritime and seafood clusters.

Several companies that developed within industrial clusters internalized their former location- specific advantages into owner-specific assets. Domestic interest groups, or the state, partly control some of these enterprises, which in the 1990s represented location-specific advantages in the form of created assets (see Kvinge and Narula 2001). Foreign subsidiaries are significantly more likely to be found in highly concentrated segments within a sector than are Norwegian-controlled establishments.

In the context of the manufacturing industry only, foreign majority ownership became more important in all five industrial clusters between 1991 and 1999, and their growth was higher than that of other sectors. However, construction, consumer goods, and machinery and equipment remained the most important sectors in terms of employment in majority-owned foreign firms in the manufacturing industry, which suggests market-seeking investments. The growth in FDI has not primarily been in the R&D-intensive sectors of the industry, but

3 Functional industrial clusters are defined in accordance with the Norwegian Porter studies that were conducted during the 1990s.

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foreign-controlled firms have increased their importance in these sectors. This does not imply that the levels of R&D activities of MNEs in Norway are high. In fact, R&D activities seem to be highest in the domestic MNEs (Herstad et al. 2006).

While FDI was important for the development of the Norwegian manufacturing sector a century ago, this seems to be much less the case today. Although employment in foreign- controlled establishments doubled during the 1990s, FDI as a percentage of GDP is relatively low in Norway, compared with other small European countries. This might have to do with the industrial structure, but also with the fact that domestic owner groups have been unwilling to reduce their stake. Greenfield investments very seldom take place in highly industrialized countries and growth in FDI therefore mostly comes through mergers and acquisitions—so also in Norway. Furthermore, the figures on foreign ownership conceal the fact that large amounts of FDI probably came from foreign affiliates of Norwegian MNEs during the 1990s.

In Essay 3, Knowledge diffusion through foreign direct investments—established wisdom or wishful thinking?, it is suggested that the form and degree of external economies, as well as potential for knowledge diffusion, depends on development in the host economy. To absorb new knowledge, the necessary learning capability must exist. This learning capability is assumed to improve over time as the country goes through the main development stages. As a result, one can expect an inverse U-shaped pattern to describe knowledge spillovers. In the first stages of development, knowledge spillovers are relatively small because of the low absorption capacity of host country firms. In addition, when foreign affiliates use outdated technology and conduct few or no R&D activities in the host economy, there is little knowledge to be spilled. Knowledge spillovers may reach a peak when domestic firms have developed high absorptive capacities and a technology gap remains between the home country of the multinational enterprise and that of the host country. In later stages of development, the learning capability of the host country is high. Because of the small differences in the knowledge accumulated between home and host economies—although there may be unidentified information to be transferred or interchanged—knowledge spillovers from foreign affiliates to the domestic economy are probably relatively small.

Furthermore, in the later stages of development, FDI might be more of the asset-seeking type than of the asset-exploiting type. Foreign affiliates tapping into local knowledge bases may cause knowledge leakages. Nevertheless, host country multinational enterprises are also supposed to conduct strategic asset-seeking investments abroad, which might generate positive domestic spillovers.

A survey of empirical contributions examining knowledge transfer through FDI—using a production function approach—is presented within the framework of the Investment Development Path (Dunning and Narula 1996). The empirical work on developing countries suggests that foreign affiliates are often more efficient than are domestic firms, which may be

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because of the owner-specific advantages of MNEs. However, it is not possible to provide robust statements about causality concerning ownership and productivity development based on industry-level data or data relating to only one year. When locally owned firms perform better than other firms in sectors with a high degree of foreign ownership, it may be because MNEs invest in the most profitable industries. Studies based on firm-level panel data generally provide mixed evidence of spillovers due to foreign ownership in developing countries. Where knowledge diffusion does seem to occur, host country firms must have the technical skills needed to absorb the foreign technology. The most prevalent spillovers in developing countries, which are described in the studies reviewed, occur when there are imports of superior technology and enhanced competition. Externalities connected to agglomeration economies are seldom explicitly discussed in the literature.

In economies in transition, the empirical work suggests that advanced technology is transferred primarily through foreign MNEs. There is also some evidence of knowledge diffusion through vertical linkages and through arms-length trade, but there is less indication of horizontal knowledge diffusion. Foreign firms may be reluctant to divulge unpatented advanced technology. There may, therefore, be little scope for the diffusion of knowledge to competing firms in the same sector. Furthermore, domestic firms may be crowded out by competition from foreign affiliates.

The evidence on spillovers in OECD countries is mixed. FDI seems to contribute to agglomeration economies in Ireland and in the UK. There are also spillovers due to intensified competition in developed economies. When knowledge spillovers exist, they may be bidirectional.

Essay 4, Manufacturing performance in Norway: Does foreign control play a positive role?, provides an empirical analysis of productivity in the Norwegian manufacturing industry from 1990 to 1999 within a framework that permits the simultaneous estimation of price–cost margins, scale economies, and productivity. MNEs are often assumed to have specific ownership advantages, which enable them to compete with domestic firms in the host countries. These advantages are included in those connected with economies of scale and scope and established brands with positive mark-ups. Although profits of foreign affiliates may be superior, productivity may be inferior. Several studies find a significantly negative relationship between concentration and industry productivity (Nickell 1996). As a result, MNEs may, one the one hand, have higher productivity than national firms because of specific advantages. On the other hand, when these advantages cause MNEs to operate in uncompetitive markets, they may have lower productivity than other companies.

Furthermore, as a result of the tax advantages associated with multinationality, the required rate of return might be lower in MNEs than in strictly domestic establishments.

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Ultimately, estimated differences in productivity may simply be due to errors in variables or model misspecification.

Besides comparing foreign-controlled and domestically controlled establishments, I investigate whether productivity improves following a takeover by a foreign MNE. As foreign control might result from self-selection into industries with relatively high productivity and productivity growth, simultaneity is therefore controlled for. Mark-ups and economies of scale were on average higher in foreign-controlled than in other establishments two years after the takeover took place, while productivity growth did not differ when comparing all foreign-controlled establishments with domestically controlled and minority-owned foreign establishments. There were, however, several differences related to sector and to the

‗nationality‘ of the acquiring MNEs. Productivity growth was, for example, found to be higher in German-Swiss subsidiaries in some of the R&D-intensive sectors within the petro- industrial and the metal industrial clusters. Negative spillover effects occurred in several sectors and may indicate that a strong competition effect weakened uninational establishments. In other sectors, however, positive spillovers were connected with additional foreign majority ownership. The direction and degree of spillovers vary with industry and home country of the MNE, although it is difficult to discover any systematic pattern related to these differences.

The main objective of Essay 5, Horizontal investments—substituting imports or limiting competition?, is to empirically explore the connections between proximity and scale economies when the closure of affiliates is allowed for. The reasoning is as follows: In OECD countries, there have been almost no tariffs since the 1990s. Most trade costs relate to transportation, vary by industry, and depend on the distance between the exporting country and the importing countries. The closer the host market, the greater are the benefits of supplying the foreign market from already existing plants. I further assume that the greater the scale economies at the plant level, the more the firm earns by concentrating production in few locations. By taking over a competitor, an MNE can better exploit economies of scale and gain greater access to the former competitor‘s distribution channels.

I examine the survival propensity of foreign affiliates taken over by Swedish multinationals between 1974 and 1998. The analysis is limited to OECD countries. The analysis shows that the propensity to survive is lower when the affiliate had previously been a production affiliate of another enterprise; when there is horizontal (rather than vertical) integration, the smaller are economies of scale at the affiliate level relative to other affiliates of the same parent MNE, and the larger is the MNE (based on total sales). However, the degree of multinationality (measured by number of foreign affiliates), the size and purchasing power of the foreign market, and the distance from the home country do not seem to affect the survival propensity. This finding might of course be because of misspecifications of the

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model, but might also indicate that factors other than transaction costs and economies of scale are important for international production to take place. One such factor could be the embeddedness of competencies in national innovation systems. Although information may be transferred worldwide, some knowledge is local, having been generated by the country‘s pre- existing comparative advantages and is interrelated with cultural factors.

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References

Blomström, M., Kokko, A. (1998), Multinational corporations and spillovers, Journal of Economic Surveys 12(2), 1-31

Caves, R. E. (1996), Multinational enterprise and economic analysis. Second edition. New York: Cambridge University Press

Dosi, G. (1988), Sources, procedures and microeconomic effects of innovation, Journal of Economic Literature 26, 1120-1171

Dunning, J.H. (1977), Trade, location of economic activity, and the MNE: A search for an eclectic approach, in Ohlin, B., Hesselborn, P-O, Wijkman, P.M. (eds.), The international allocation of economic activity. London and Basingstoke: Macmillan

Dunning, J.H. (1988), Explaining international production. London: Unwin Hyman

Dunning, J.H., Narula, R. (1996), The investment development path revisited. Some emerging issues, in Dunning, J. H., Narula, R. (eds.), Foreign direct investment and governments.

London and New York: Routledge

Herstad, S.J., Sandven, T., Kaloudis, A. (2006), Utenlandske investeringer i norsk FoU. Oslo:

NIFU-STEP rapport 1/2006 (in Norwegian)

Kvinge, T., Narula, R. (2001), FDI in Norway‘s manufacturing sector. Oslo: Centre for technology, innovation and culture, University of Oslo, Working Paper No 9/2001

Nickell, S. (1996), Competition and corporate performance, Journal of Political Economy 104 (4), 724−746

Porter, M.E. (1990), The competitive advantage of nations. New York: Free Press

Porter, M.E. (1998), Clusters and the new economies of competition, Harvard Business Review 76 (6), 77–90

UNCTAD (2005), World Investment Report 2005: Transnational corporations and the internationalization of R&D. New York and Geneva: United Nations

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Essay 1

Foreign direct investments and host country effects—some theoretical considerations

1 Introduction

A wide range of questions regarding the phenomenon of foreign direct investments (FDIs) through multinational enterprises have emerged, for instance the effects on sovereignty of national policy makers; challenges associated with the amalgamation of different business cultures and labour relation models; and developments in the distribution of technology, employment and income at home and abroad. In this essay, I will focus on general economic effects for countries hosting subsidiaries of multinational enterprises.

One of the best-known initial contributions to explaining FDIs is Stephen Hymer‘s PhD thesis, presented in 1960 and published in 1976. Hymer was puzzled by the fact that countries abundant in capital hosted investments of foreign companies and that American-controlled enterprises operating in foreign countries borrowed from abroad. Furthermore, instead of engaging in pure money assignment through portfolio investments, it appeared that the foreign companies wanted to exercise control by engaging in production through a target host-country firm. Hymer concluded that FDIs were connected with different forms of market imperfections. Multinational enterprises presumably develop some owner-specific advantages that make cross-border operations profitable. Furthermore, instead of renting or selling their skills to foreign producers, they undertake production to be able to fully appropriate the returns on their assets.

Dunning (1958) elaborated on the idea of owner-specific advantages and advantages connected with the internalization of transactions within the enterprise and also introduced particular location-specific advantages of the host country as factors influencing the choice between FDIs and other forms of serving a foreign market.⁴ His eclectic paradigm was first presented in 1976 (published in 1977). Through subsequent work, the paradigm has been refined and extended to also embrace the interdependencies of owner-specific advantages (O advantages), location-specific advantages (L advantages) and internalization advantages (I advantages). I quote Dunning (1988:25–26) at length on key propositions of the eclectic paradigm.

4 The questions Dunning put forward in his PhD thesis on US direct investments in British manufacturing industry, published in 1958 (Dunning, J.H. (1958), American Investment in British Manufacturing Industry. London: Allen & Unwin), were whether the US firms investing had any ownership advantages over UK firms and whether these advantages were to some extent transferable across national borders. Furthermore, he assumed that exploitation of such potential ownership advantages would depend on location-specific factors in the UK (see Dunning 2003).

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The principal hypothesis on which the eclectic paradigm of international production is based is that a firm will engage in foreign value-adding activities if and when three conditions are satisfied: These are:

(1) It possesses net O advantages vis-à-vis firms of other nationalities in serving particular markets. These O advantages largely take the form of the possession of intangible assets or of the advantages of common governance which are, at least for a period of time, exclusive or specific to the firm possessing them.

(2) Assuming condition (1) is satisfied, it must be more beneficial to the enterprise possessing these advantages to use them (or their output) itself rather than to sell or lease them to foreign firms: this it does through an extension of its existing value-added chains or the adding of new ones. These advantages are called internalization (I) advantages.

(3) Assuming conditions (1) and (2) are satisfied, it must be in the global interests of the enterprise to utilize these advantages in conjunction with at least some factor inputs (including natural resources) outside its home country; otherwise foreign markets would be served entirely by exports and domestic markets by domestic production. These advantages are termed the locational (L) advantages of countries.

The eclectic paradigm has turned out to constitute a solid framework for economic research on FDIs through multinational enterprises. A broad range of theories can be organized with regard to each of the three pillars: the O, the L and the I. The aim of this paper is to synthesize some of the theoretical contributions as a background for the discussion of possible host country effects. The paper proceeds as follows; in the next section central concepts and definitions will be presented. A presentation of O, L and I advantages is the theme of Section 3. In the literature, considerable focus has been on owner-specific advantages connected to unique competencies of multinational enterprises. Section 4 deals with such owner-specific advantages as well as location-specific advantages and internalization advantages with regard to knowledge. Externalities and other host country effects are dealt with in Section 5. Section 6 concludes the essay.

2 Central concepts

The idea of lasting interest seems to have settled as a central principle in definitions of FDIs.

For instance, according to the OECD⁵ definition, ―[f]oreign direct investment reflects the objective of obtaining a lasting interest by a resident entity in one economy (‗direct investor‘) in an entity resident in an economy other than that of the investor (‗direct investment enterprise‘). The lasting interest implies the existence of a long-run relationship between the direct investor and the enterprise and a significant degree of influence on the management of the enterprise.‖ (OECD 1996:7–8)

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UNCTAD⁶ also draws attention to the lasting interest of the investing enterprise, but in addition emphasizes the control aspect. ―[A] foreign direct investment is an investment involving a long-term relationship and reflecting a lasting interest and control by a resident entity in one economy (foreign direct investor or parent enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDI enterprise or affiliate enterprise or foreign affiliate).‖ (UNCTAD 2005a:297)

There also seems to be some disagreement about how large the ownership stake should be to constitute control. At least 10 per cent of the ordinary shares or voting power ―is normally considered as the threshold for the control of assets‖ (UNCTAD 2005a:297). However, according to the OECD (1996:8), ―[a]n effective voice in the management, as evidenced by an ownership of at least 10 per cent, implies that the direct investor is able to influence or participate in the management of an enterprise; it does not require absolute control by the foreign investor‖. The majority of FDIs have been undertaken by multinational enterprises that establish or acquire subsidiaries in countries other than the home country. Nevertheless, Private Equity funds (PE funds)⁷ have arisen lately as an important source of FDI, mainly in the form of mergers and acquisitions. In the World Investment Report 2006, UNCTAD reports that PE funds accounted for about one fifth of the cross-border mergers and acquisitions taking place during 2005. In the remainder of this essay, focus will be on subsidiaries of multinational enterprises.

A multinational enterprise may have many ultimate owners with different nationalities.

Furthermore, these owners may change relatively often, for instance, when the shares are traded on the stock market. According to convention, the definition of the enterprise‘s home country is not based on the nationality or citizenship of the direct investor but on the concept of residency in terms of the economic territory of a country.⁸ A disadvantage of using the residency of the organization as a definition is that enterprises might be registered in countries (for instance, so-called tax havens) without having any activities there (except perhaps a post box). As capital becomes more global, it gets more difficult to trace the ultimate owners and sources of capital.

6 United Nations Conference on Trade and Development

7 According to Wikipedia; ―Private equity commonly refers to any type of equity investment in an asset in which the equity is not freely tradeable on a public stock market. More accurately, private equity refers to the manner in which the funds have been raised, namely on the private markets, as opposed to the public markets. […] Large PE funds might invest in companies listed on public exchange markets and take them private. Passive institutional investors may invest in private equity funds, which are in turn used by private equity firms for investment in target companies. Private equity funds typically control management of the companies in which they invest, and often bring in new management teams that focus on making the company more valuable.‖ (http://en.wikipedia.org/wiki/Private_equity)

8http://www.unctad.org/sections/wcmu/docs/C2em18p44_en.pdf;

https://www.imf.org/External/NP/sta/bop/pdf/diteg12.pdf

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There is a large diversity of enterprises with cross-border activities regarding for instance size, age, and sector. In the literature, a distinction is often made between a multinational enterprise (MNE) and a transnational company (TNC). Briefly, the differences are related to the degree of multinationality and embeddedness in the home country. While the MNE is assumed to invest in several subsidiaries abroad with headquarters and base at home, the TNC constitutes more a network of different but interrelated activities all over the world (see, for instance, Morgan (2001) for a comprehensive overview of different definitions applied and a discussion of the properties of these different types of organizations). Unless otherwise stated, I apply the notion of an MNE for all types of enterprise involving cross-border value-adding activities.

3 Three interconnected advantages

Dunning (1988) emphasizes that there is interdependency between the owner-specific, location-specific and internalization advantages. To understand why, how and where FDI through MNEs occur, and what the host country effects are, all three aspects should be taken into consideration.

Owner-specific advantages

One can distinguish between three main types of owner-specific advantages related to the privileged possession of products and technology, organizing skills and the advantages that arise from multinationality. Owner-specific advantages might originate from the home country, the industry or exclusively from the enterprise. For example, a country‘s comparative advantages may equip that country‘s enterprises with owner-specific (or competitive) advantages (Dunning 1988).

Products and technology may be connected with access to natural resources not available to competitors. Research and development may result in exclusive patents or trademarks. In both instances, the ownership of these assets comprises barriers to competition, i.e. constitutes factors for achieving market power. Dunning emphasizes that ―the O advantages arise not only from the exclusive possession of certain assets, but from the ability and willingness of firms to internalize the use of these assets‖. (Dunning 1988:29–32) The owner-specific assets are most effectively exploited through the internalization of cross-border transactions for reasons such as asymmetric information and control over quality or technology diffusion.

Multinationality per se or the internalization of transactions within the firm may offer the opportunity to reduce tax payments through, for example, optimal transfer pricing. Lower input prices may be due to discounts for significant customers or to relatively inexpensive internally generated funds (which arise in imperfect credit markets). MNEs have scale

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advantages in marketing and may be able, through vertical integration, to organize production across nations to exploit the competitive advantages of different locations.

[I]t is the combination of the assets which the firm posses prior to the act of FDI and those which it may acquire as a result of FDI, together with the entrepreneurship and judgement capabilities of the main decision takers, which comprise the competitive or ownership-specific advantage of firms. Dunning (1988:5)

There are several challenges connected with the transfer of assets across borders, for example varieties in cultural codes among countries. Home countries to some extent practice different business systems and this might be mirrored in the way MNEs internationalize, the governance systems applied as well as their organizational capabilities (Moen and Lilja 2001). Then again, experiences gained through internalization will probably lead to changes in the way future activities are organized. Morgan comments as follows (2001:2).

[O]nce firms become international in their scope, they incorporate within their organizational space new social actors. Depending on the nature and extent of internalization, one can identify a range of new social actors whose presence within the firm will make the reproduction of old routines problematic. For example, firms may internationalize their shareholding base, bringing in new types of investors with distinctive expectations about issues such as performance and transparency. Firms with overseas production facilities will bring in their host country nationals. Host country managers may have their own distinct views on ‗how to manage‘ as well as their own interests in career progression and development. Technical and supervisory staff will have their own views on their distinctive package of skills and how these should be used, as will shop-floor employees, who will also have a view on appropriate systems of collective representation.

The literature on varieties of capitalism distinguishes between coordinated market economies, such as Germany, the Nordic countries and Japan, and liberal market economies, such as the United Kingdom (UK) and the United States (US). The distinction relates to the financing of firms, corporate governance, education and training, human resource management and labour relations. According to this theory, diversified quality production is primarily found within coordinated market economies such as the German and Nordic national business systems. A characteristic of these systems is consensus-based relations between employers and employees as well as between private companies and governments, fostering problem-solving knowledge and interactive learning in the workforce, which may contribute to incremental innovations. Liberal market economies, on the other hand, are assumed to encourage more radical innovations (Hall and Soskice 2001; Soskice 1999).⁹

Assuming the home country‘s model of organizing working life is also embedded in the companies when they become multinationals, the host country effects that are due to different forms of capitalism are neither clear nor easily explained. One issue is whether all surviving

9 See also the discussion of these issues in Asheim and Gertler (2005).

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systems are capable of performing adequately or whether there are other reasons for their coexistence. An explanation suggested by Soskice is that different innovation systems and forms of production demand different forms of organization. Another explanation may be related to the mutual learning of best practice. As suggested by Gertler (2001:21), ―while firms‘ practices may converge, this does not necessarily translate into convergence of national systems, especially when the firms in question are multinational ones. For example, it will be considerably easier for a German firm to adopt Anglo-American practices by implementing these at production sites in the US or the UK than in its domestic operations.‖ The reason is that, to some extent, foreign affiliates are embedded in a local institutional system, incorporating rules about, for example, working time, employee participation and bargaining.¹⁰

Internalization advantages

Consistent with the theory of the firm (represented, for example, by Coase 1937), transactions may be internalized within an enterprise because of market imperfections. The theory of the firm also applies to MNEs, but in addition to transaction costs arising because of problems of coordination, communication and control, they may arise because of foreignness itself (Buckley and Casson 1976).¹¹ Dunning (1988) differentiates between structural market failure, cognitive market failure and market failure that arises because of public interventions.

Structural market failure arises where there are barriers to competition and economic rents are earned; where transaction costs are high; or where the economies of interdependent activities cannot be fully captured. Cognitive market failure occurs wherever information about the product or service being marketed is not readily available, or it is costly to acquire. […] Public intervention in the allocation of resources may also encourage enterprises to internalize intermediate products markets.

Dunning (1988:22–23)

10 ―At the global level, large corporate actors are allegedly learning from each other, so that the most successful corporate practices are emulated and diffused cross-nationally at an increasingly rapid pace.

In the late 1980s and early 1990s, considerable attention was devoted to the diffusion of methods of production and workplace organization perfected by Japanese producers of cars and consumer electronics, in which American, Canadian, and European manufacturers were shown to be learning methods such as just-in-time, kaizen/continuous improvement, and other aspects of ‗lean production‘

techniques from their Japanese competitors (Womack et al. 1990) Since the resurgence of the United States economy beginning in the second half of the 1990s, American practices have apparently become the object of global firms‘ affections, with large corporations in Europe and Asia adopting the core characteristics of US-style ‗shareholder-capitalism‘: especially flexible labour market practices, ‗re- engineering‘, and the empowerment of shareholders (The Economist, 1996a, 1996b).‖ Gertler (2001:6) [Womack, J., Jones, D., Roos, D. (1990), The Machine that Changed the World. New York:

Macmillan]

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In a perfectly contestable market¹², new entrants are assumed to have access to the same technologies and to be able to meet the same market demands as incumbent firms, and there are assumed to be no sunk costs¹³. In other words, entry and exit are straightforward and costless. According to Dunning (1988), provided there are no market failures, there is no motivation for FDI to take place. That is, domestic firms along with imports would serve each national market.

In the Industrial Organization (IO) literature (see, for instance, Schmalensee 1989; Shy 1995; Sutton 1991; Tirole 1988), market concentration is explained by the existence of barriers to entry in individual industries. Sunk costs are perceived as the main factors constituting barriers to entry.¹⁴ They create first-mover advantages for incumbents and may prevent entrepreneurs from earning a positive profit. Furthermore, a negative relationship between market size and market concentration sometimes occurs; that is, an increase in market size would raise the profitability of incumbents and thereby motivate potential entrants to surmount that barrier, which would reduce concentration.

According to Sutton (1991), this size–structure relationship is only valid for certain groups of industries. More importantly, it does not apply to those industries in which advertising and R&D expenditures play a significant role. This is because the amount of advertising and R&D may be chosen to create barriers to entry, which are also sustainable in large markets.¹⁵

Horstmann and Markusen (1987) perceived the incentives for FDI arising from the large costs associated with monitoring an agent‘s actions (for example, to ensure that the licensee maintains the licensing firm‘s reputation). Because of the public goods property of knowledge-based assets, a firm that licenses its expertise risks the licensee appropriating the technology and becoming a competitor of the licensing firm. To prevent owner-specific information from becoming public knowledge, the MNE may decide to transfer technology internally through FDI.

Tariffs and taxes are examples of public interventions that might influence FDI. Tax reduction through optimal transfer pricing between different entities located in different countries is an advantage of undertaking transactions across borders within a single enterprise. Moreover, firms can circumvent antitrust regulations by internalizing trade within the same enterprise. Because internal transactions are typically unobserved and because

12 Baumol et al. (1982:5) define ―a perfectly contestable market as one that is accessible to potential entrants and has the following two properties: First, the potential entrants can, without restriction, serve the same market demands and use the same productive techniques as those available to the incumbent firms. (…) Second, the potential entrants evaluate the profitability of entry at the incumbent firms‘ pre- entry prices.‖

13 Sunk costs may be defined as expenses that are not recoverable (see Baumol et al. 1982:7).

14 Gilbert (1989) provides an overview of different definitions of barriers to entry.

15 Within the IO literature, many contributions seek to explain market structure by applying game theory with an emphasis on the endogeneity of barriers to entry.

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regulations differ explicitly for internal and external transactions, international firms may avoid legal restrictions. In addition, price discrimination in different markets may raise the possibility of arbitrage among the retailers serving the markets. To avoid arbitrage, a manufacturer may incorporate distribution and supply the low-price market herself (Tirole 1988).

FDI may take the form of greenfield investments or takeovers. Gilbert and Newbery (1992) review the theoretical and empirical research on the choices of entry mode and show that mergers and acquisitions (M&As) is preferred to greenfield investment when the target industry is concentrated.¹⁶

Within the IO tradition, there is comprehensive discussion of the motivations for M&As and of the advantages and disadvantages for the firms involved.¹⁷ Despite the fact that theoretical and empirical research reveals that M&As are not generally consistent with profit maximization, FDI has long taken the form of cross-border M&As. Intensified M&A activity in the 1990s occurred simultaneously when economic integration, privatization, and deregulation were introduced in several markets.¹⁸ Acquisition may be chosen to enter a foreign market because of its relatively low cost and/or because it is the best strategy for exercising market power in the relevant market.¹⁹ Obstacles to the implementation of new governance systems might, however, be more severe in takeovers than in greenfield investments. An idiosyncratic culture may have emerged in existing enterprises and it might be difficult to change established customs (see, for instance, Kvinge and Ulrichsen forthcoming).

According to Dunning (2003:36), MNEs use takeovers to augment their existing owner- specific advantages by capturing ―the technological and marketing synergies offered by firms in other countries‖ and by tapping ―into the created assets of foreign competitors, suppliers, customers and those offered by national educational and innovatory systems‖. In UNCTAD‘s (2000) World Investment Report, access to strategic assets (such as R&D, technical know- how, patents, brand names, the possession of local permits and licenses, and the supplier or distribution network) is also given as an important motivation for cross-border M&As, although speed is assumed to be the most vital factor.

M&As often represent the fastest means of reaching the desired goals when expanding domestically or internationally. For example, when time to market is vital, the takeover

16 For further discussion of the choice between greenfield investment and takeovers, see, for example, Buckley and Casson (1998); Harzing (2000); Norbäck and Persson (2002); Svensson (1998).

17 See Farrell and Shapiro (1990); Gilbert and Newbery (1982); Horn and Persson (2001); Jacquemin and Slade (1989); Kamien and Zhang (1990); Perry and Porter (1985); Salant et al. (1983); Stigler (1950); Tombak (2002).

18 Neary (2003) draws on the traditions of both IO and international trade theory and investigates how trade liberalization can lead to cross-border merger waves.

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of an existing firm in a new market with an established distribution system is far more preferable to developing a new local distribution and marketing organization.

UNCTAD (2000:140)

Access to strategic assets may be important when the MNE seeks increased market power, efficiency gains through synergies or entry into a foreign market. An additional driving force behind M&As, presented in the World Investment Report of 2000, is the personal motivation of management (empire building to enhance personal prestige, job security and remuneration).

According to Buckley (1985:10), the internalization of markets by MNEs may impose barriers to new entry: ―[t]he multinational is thus seen as both responding to market imperfections and creating them‖. The owner-specific advantages of MNEs are related to sunk-cost investments in R&D, large-scale production facilities, marketing, patents and trademarks. Furthermore, the costs of entering foreign markets (based on, for example, translating documents, acquiring information, advertising and marketing) are not usually recoverable. Owner-specific assets, which constitute a source of first-mover advantage, could also lead enterprises to adopt a multinational strategy to deter entry by local firms (Ganslandt 1998).

It is empirically well established that there is a positive correlation between foreign ownership and seller concentration (Caves 1996). Furthermore, the factors promoting FDI (such as advertising and R&D) often create industry entry barriers. However, Caves (1996:86) argues that:

[e]ven if oligopoly and foreign investment share common structural causes, either one could still wield some causal influence on the other. But we must tread cautiously when specifying the causal mechanisms and testing them so as to control for their common causes.

As long as countries employ different taxation systems and it is difficult to control transactions within MNEs, tax revenues in host as well as home countries might be reduced as a result of FDI. Tariffs may motivate FDI as a way of obtaining access to foreign markets. In this way, new competencies can be fostered in infant industries and employment possibilities created for people in the host country.

Location-specific advantages

According to Dunning (1988:33–34), location-specific advantages ―comprise three components: the availability and real costs of resources (including infrastructure resources) which can only be used by enterprises in the locations in which they are sited, unavoidable or non-transferable costs and benefits, such as taxes, subsidies, investment constraints, training

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grants, local labour requirements, etc., […] and the costs of shipping products from the country of production to the country of marketing‖.

Assets of the host country include natural resources, labour supply, specialized know-how and skills. These are also the factors that are assumed to generate the comparative advantages of countries, because of either relative factor costs or unique technology.²⁰ In accordance with ongoing economic globalization, assets are more easily internationally dispersed, and prices on capital and labour may in the future be equalized between countries (Chapman and Walker 1991; Chesnais 1992; Maskell and Malmberg 1999). Even if labour and capital costs equalize and modern technology is available in most regions, learning is essentially a localized process, embedded in regional values, institutions and history. Storper (1997:5) emphasizes so-called untraded interdependencies (including conventions, informal rules, and habits) as constituting region-specific assets in production. ―These assets are a central form of scarcity in contemporary capitalism, and hence a central form of geographical differentiation in what is done, how it is done, and in the resulting wealth levels and growth rates of regions.‖ This indicates that different locations will also retain comparative advantages related to their specific competencies in a highly globalized economy.

Location-specific advantages of host countries are also associated with market size.

Market size is the result of competing agglomeration and dispersion forces and the interplay between production costs (scale economies) and transaction costs connected to transportation and tariffs. The greater the internal economies of scale in production and the lower the transportation costs, the more likely it is that firms will concentrate production in a limited number of assembly sites. A central location within a region optimizes market access and is probably chosen when there are substantial internal economies of scale in production.

According to agglomeration theories, external economies of scale are also important to the location decisions of firms (Marshall 1936). External economies are either technological or pecuniary (Scitovsky 1954). An example of technological externalities is knowledge diffusion; that is, one firm gains access to another firm‘s competence without paying for it. A common labour pool facilitates such knowledge diffusion.

By agglomeration in particular places, firms in the same and related industries allow the development of pools of appropriately skilled and interested workers in which traditions and skills are transferred within families as well as through on-the-job

20 According to traditional trade theory (for an introduction, see, for example, Dixit and Norman 1980), countries gain maximal welfare if they export goods in which they have comparative advantages and import goods in which they have comparative disadvantages in production. However, a country only has comparative advantages in low-skilled, labour-intensive assembly if capital, technology and knowledge are immobile across borders or when its inhabitants are prevented from enhancing their competencies or from using better equipment. As emphasized by Maskell and Malmberg (1999:172),

―one effect of the ongoing globalization is that many previously localized capabilities and production factors become ubiquities.‖

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training and specialized educational and training programmes, themselves made economic by the concentration of local demand. Hayter (1997:330)

Pecuniary externalities are assumed to operate through the market mechanism and are, for example, related to positive backward and forward linkages between firms.

Backward and forward linkages, technological externalities and sunk costs are assumed to generate the self-reinforcing agglomeration of economic activities (see, for example, Fujita et al. 1999; Henderson et al. 2001; Krugman 1991). For example, the higher demand for a certain type of intermediate good, the easier it is for suppliers to reach the necessary critical mass to exploit internal economies of scale, which in turn may lower prices and thereby create pecuniary externalities for producers that use these intermediates. Productivity is unchanged, but profits may increase (Forslid et al. 1999). Centrifugal forces pull in opposite directions. According to Henderson et al. (2001:84), such forces are of three types.

One is negative externalities from congestion. Another is supply of immobile factors, the prices of which will be bid up in centres of activity, encouraging firms to move to lower factor cost locations. And the third is the extent of the market, limited by the presence of geographically dispersed demand for output. Thus, if labour is dispersed it encourages a dispersed location of firms for both supply and demand reasons.

U-shaped relationships between trade costs and agglomeration are discussed in the literature. When trade costs are low, the distances between suppliers and customers may increase, and agglomeration forces will be weakened. When trade costs are high, firms may decide to serve customers from several production sites. Therefore, agglomeration occurs with intermediate trade costs, while low or high trade costs may result in dispersion of economic activity (assuming that other sources of dispersion are unchanged).

A large volume of work in economic geography is concerned with the results of the competition between agglomeration and dispersion forces (see, for example, Brühlhart 1998;

Forslid and Wooton 1999; Forslid et al. 1999; Krugman and Venables 1995). Some theoretical traditions give special emphasize to the stickiness²¹ of places due to localized knowledge and institutional factors (see, for example, Amin and Thrift 1994; Asheim 2001;

Asheim and Gertler 2005; Gertler 2004; Gertler et al. 2000; Maskell and Malmberg 1999;

Storper 1997; Porter 1990, 1998).²²

21 See Markusen, A. (1996), Sticky places in slippery space: a typology of industrial districts, Economic Geography 72(3), pp. 293–313

22 According to Maskell and Malmberg (1999:173), ―The institutional endowment should be defined broadly, embracing all the rules, practices, routines, habits, traditions, customs and conventions associated with the regional supply of capital, land and labour and the regional market for goods and services. It also includes the entrepreneurial spirit, the moral beliefs, the political traditions and decision-making practices, the culture, the religion and other basic values characterising the region‖.

and host country effects

Torunn Judith Kvinge Essays on foreign direct investments