Applicability of Theories on Foreign Direct Investment

Last Updated: 07 Sep 2020
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Basic economic principles show there is an inverse relationship between planned investment and interest rate (Case and Fair 2004). This explains that during regimes of high-interest rates, the volume of planned investments goes down. Yeaple and Nocke (2005) developed the assignment theory to analyze foreign direct investments. In this theory, firms have two choices. One choice is to build a new plant in a foreign market while the other is engaged in the cross-border acquisition. One or both actions may be taken simultaneously.

The decision of what action to take is determined by factors in the investment firm and the country where the investment will be established. The analysis showed that when there are similarities in factor prices between the countries of the investor and the country where investment is going to take place, the cross-border acquisition is preferred. On the other hand, a significant difference in the factors of production, like wages, makes the building of new plants more feasible. Jose Pedro Pontes (2004) showed the interrelationship of foreign direct investments, trade, and trade costs.

He said investment does not take place when the market size is small. The reason is the firm cannot breakeven and therefore the investment project will not be profitable. Assuming the cost of exporting goods to the target country is low, it may be preferable to trade than to invest. If the market in the target country is large enough, at least to guarantee revenues that will cover the fixed costs of the planned investment, there is a high probability that foreign direct investment will be undertaken.

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Pontes’ theory allows stages of production to be undertaken in separate locations as well as trade-in finished goods and components. In this age of globalization, the required market size is not hard to attain. Efficient distribution within a contiguous and defined geographic area resulting from market integration can be achieved with modern supply chain management. Blomstrom & Kokko (2003) noted the effectiveness of government incentives in motivating foreign firms to invest. In return for enjoying tax holidays, import subsidies, and other incentives, the multinational firm contributes technology and skills to the local economy.

But the authors believe local firms should likewise be motivated to absorb these technology and skill spillovers. Otherwise, direct investment benefits are not maximized by the host country.

Analysis and Conclusion

In relation to the subprime crisis, an increase in interest rate is most likely to happen. Affected countries will have the tendency to raise their interest rates in order to control the flow of mortgage funds. Since interest costs are significant in the profitability of manufacturing operations, Zimatsu faces the threat of high-interest rates.

Since the total effects of the subprime problem are not totally known yet, this is an undefined variable that the company will have to endure as it decides on foreign direct investment in South America. In a high-interest scenario, the company may consider a merger over acquisition or new plant investment so as not to be dependent on loan capital. The company can also abandon its plan for direct investment and becoming a “truly global company” and concentrate on exporting to the Latin American countries. The company's decision to engage in market development is a good strategy to answer the threat of an economic slowdown in its existing markets.

Globalization has resulted in organized market integration. An investment in Brazil, allows Zimatsu to expand its markets further to the other Latin American countries. Attaining breakeven remains to be a major concern as the forces of demand and supply services as a barrier to market entry. The company has to investigate the possibility of market supply saturation for its products. The manufacture of consumer appliances does not require high technology. We can presume a good number of manufactures in Brazil and the rest of Latin America.

It is still possible to enter the market if South Korean technology can offer new ways of supporting modern lifestyles. Another entry possibility is to assemble components made in Korea so as to take advantage of lower labor costs and minimize fixed costs. Government incentives can help make the investment effort feasible. A review of these incentives in the region will help to pinpoint the exact location of the investment. Another related factor is the ability of the local firms to absorb the technology that Zimatsu will introduce. This has a direct bearing on the efficiency of local production in the host country.

Given the subprime situation and the available theories on direct foreign investment, Ziatsu may proceed with caution. A merger or joint venture is recommended in order to limit the amount of the investment as long as interest rate volatility exists. To avoid damaging foreign exchange fluctuations, domestic borrowing is encouraged. In the case of greenfield investment, Zimatsu can start with an assembly effort that does not require as much capital input and technology transfer compared to full manufacturing operations.


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