The Present State of Foreign Direct Investment in Germany - Research Proposal Example

Finance and Accounting Table of Contents Introduction 3 1 Current trends of outward FDI and net outflows FDI in Germany 3 2 Research Aim/ Objective 4 1.3 Layout 5 2.0 Literature Review 5 2.1 Brief regarding FDI 5 2.2 Outward FDI 6 2.3Determinants of FDI 8 2.4.1 Advantages of FDI in home country 10 2.4. 2 Disadvantages of FDI 11 3.0 Findings and Discussion 12 3.1 Advantages of FDI for Germany 13 3.2 Disadvantage of FDI for Germany 17 4.0 Conclusion 17 Reference List 19 1. Introduction Foreign Direct Investment (FDI) can be characterised as a significant part of an effective and open economic system adopted by different nations. It can be considered as a key catalyst for development for an economy (Desai, Foley and Hines, 2005). However, the benefits of FDI are not always visible across the globe as the national policies and architecture is different, which leads to individual result (such as success or failure). Nevertheless, there are few challenges that are encountered by the home country as it has to establish broad, effective and transparent policy environment for the investment patterns. In this regard, distribution channels are build and human resource are implemented by the home country. Most of the FDI flows have originated from the OECD (Organisation for Economic Co-operation and Development) countries (i.e. home country); generally the developed nations have contributed towards this particular agenda regarding FDI. FDI has contributed towards a development a particular home country as it draws revenue from international markets and also gets the opportunity to adopt technologies, which are prevalent in the host countries (OECD, 2002). 1.1 Current trends of outward FDI and net outflows FDI in Germany The following figure elaborates the present state of FDI in Germany. Figure 1: FDI outflows and rate of return (2008-2012) (Source: European Commission, 2013a) From the above figure it is quite evident that rate of return of outward FDI in Germany is quite higher than the inward FDI. This indicates the fact that the companies in Germany are earning higher income by expanding its business across the globe through FDI. It is observed that the outflow has increased over the years from 2008-2011 but it has encountered sharp decline during 2012. The reason behind this decline is due to the fact that the German companies were reluctant to invest abroad and thus there were reduction outward projects. 1.2 Research Aim/ Objective The main research aim of this paper is to study FDI and advantages and disadvantages of FDI for Germany. Objectives are enumerated below: 1) To study Key determinants of FDI 2) To explore advantages of outward FDI for Germany 3) To explore disadvantages of outward FDI for Germany 1.3 Layout The report has four sections such as introduction, literature review, findings and conclusion. The topic is introduced in the first section, where a brief of FDI in Germany is also provided so as to understand the present situation. The aim of the report is also ascertained in the first section so to understand its goal. The second section, literatures gives emphasis on the main determinants of FDI and its effect on the net in the developing and developed countries. In the third section, the findings of the report are discussed elaborately so as to decipher the advantages and disadvantages of FDI in Germany. The fourth section highlights the conclusion, which gives emphasis on the main findings that are drawn from the topic. 2.0 Literature Review 2.1 Brief regarding FDI According to OECD (2002), FDI refers to the business investment that aims at building long run investment and reflects an everlasting relationship with a host country by a home country. The statistics pertaining to FDI comprise both parent enterprise investment and also the initial amounts that are required to build a relationship with the host country (OECD, 2002). These investments are in form of reinvested earnings, equity capital or intra-company loans. Types of FDI Generally, there are two significant types of FDI that are employed by companies to expand their business internationally. Greenfield investment confirms the establishment of a totally new company in international grounds including infrastructure, administration and adoption of new production system that is significant in the host country (Vasyechko, 2012). This type of FDI can also occur through joint venture with the company of the home country. Additionally, FDI can also occur through merger and acquisition, which is defined as the partial or complete purchase or takeover of an existing company in a host country (Vasyechko, 2012). These two types of FDI favour Germany to a great extent by contributing positively towards the development of the economy. 2.2 Outward FDI Outward FDI has grown rapidly in the last 35 years in the developing countries than in developed nations. The data provided by United Nations Conference on Trade and Development (UNCTAD), the developed countries had increased it FDI outflows from 0.5% in 1970 to 16% in 2008 (Herzer, 2011). However, in 2008, the outward FDI in the developing countries was $300 billion, which was three times than the total FDI outflow (Herzer, 2011). 2.2.1 Outward FDI raises domestic output at long run According to Herzer (2008), the developed countries decide to expand across the borders in order to raise domestic output in long run. He had developed the opinion that outward FDI permit the companies to import cheap raw materials from the foreign associates and increases the efficiency of producing great volume of final products at a low cost abroad. It helps the companies to enter a new foreign market and also employ its advanced technologies (Horstmann and Markusen, 1987). Hence, the multinational companies aim at combining the production function of the home country with that of the host country and increase the productivity both nationally and internationally (Damijan, Polanec, and Prasnikar, 2007). Therefore, the benefits of outward FDI in home country is generated from the increased productivity and associate function related to spillovers in the domestic companies (Buckley, Clegg and Wang, 2007). 2.2.2 Country-wise data for outward FDI The following figure highlights on the country-wise percentage of FDI outflows during 2011-2013. Figure 2: Country-wise FDI outflows (2011-2013) (Source: European Commission, 2013) It is evident from the figure provided above that outward FDI in Germany is significant in world ratio however; majority of the share is captured by Luxemburg. Germany captures 7.8% of the world market in outward FDI followed by United Kingdom and Luxemberg (European Commission, 2013). 2.3 Determinants of FDI The studies executed by different authors regarding FDI gave emphasis on the importance of the determinants and its influence the home countries. The determinant allows the firms to decide whether to operate on a foreign market or whether to go for an export agreement. According to Vasyechoko (2012) the main determinants of FDI are generally divided into three theories such as theory of the firm, international capital market theory and international trade theory. However, the three theories are further divided into further sub theories under the FDI theories. When these theories are studied separately the characteristics of each one is fragile and incomplete. Hence, those theories are rejected and Faeth (2008) gave nine theories pertaining to FDI, which can be described as the determinants of FDI. Nevertheless, few theories are explained in this paper, which are significant presently. The theories are Ownership, Leadership and Internalization (OLI) framework, Horizontal and Vertical FDI, and Political Risks. However, the OLI framework and horizontal FDI theory indicates the advantage of FDI for Germany; whereas the political risk and vertical FDI theory refers to the disadvantages of FDI for Germany. These theories are discussed henceforth. 2.3.1 OLI Framework Ownership, Leadership and Internalization (OLI) or eclectic theory of FDI was established by Dunning after combining internalization theory and traditional trade economics. The theory signifies that companies aims at producing or manufacturing in a certain foreign country and competes with local companies in the host country (Faeth, 2009). It identifies the specific advantages that the firm possesses for entering any foreign market and competing with the existing companies. The eclectic paradigm of Dunning is the most followed model to determine the empirical investigation of Foreign Direct Investment (Stefanović, 2008). It offers a holistic backbone on which the Multi-national enterprises make their decisions about moving their operation and production facilities overseas (Stefanović, 2008). Stoian, and Filippaios (2008), believed that the OLI framework can only work specific to a particular context, i.e. the success of its implementation largely depends on the type of organization, its location (country), and its industrial activities. Stoian, and Filippaios (2008) also mentioned that the return of FDI is dependent on three factors, which are, the firm’s ownership advantage, or its competitive advantages while operating in a foreign country; The factors in involving the location of the host country where the firm is going to establish its operations (Zhao and Zhu, 2000); And factors of internalization, which explains the reasons for opting for the FDI (Stoian, and Filippaios, 2008). These in turn helps to develop the German economy in the globally competitive environment. 2.3.2 Horizontal and Vertical FDI Glass (2008) in her article distinguished the horizontal FDI from Vertical FDI by mentioning that in case of horizontal FDI, the firms operate almost same business activities in several countries, whereas in case of vertical FDI, the firms outsource different stages of business activities in different countries. Markusen (1995) explained the horizontal FDI as a model which is based on trade off between fixed costs of plants and cost of trading. Comparative Advantage Depending on the trade-off outcome the decision is made as to whether the firm should go for FDI or simply go for overseas trading. If the host country is has a weaker economy, then the cost of production is higher than the cost of trading and incase the host country has a developed economy, then the firm chooses FDI over trading (Waldkirch, 2011). This helps the home country to leverage the comparative advantage of the host country, because the cost of production in the host country is lower than that of the home country (Lin and Yeh, 2005). Neary (2008) explained that the vertical FDI is associated with deciding the proper location to establish a business activity or production operation where its cost would be minimum. Here the company is faced with a tradeoff between logistics cost and lower cost of production at a foreign country. 2.4 Advantage and disadvantage of FDI for home country One of the significant advantages of FDI for home country lies in assets present in the host country, which adds up to the competitive advantage of the former (Jordaan, 2005). The assets are mostly intangible which include technology, low cost skilled labor, managerial skills. However, the chance of market failure is connected to theses assets as it is difficult to completely appropriate the outputs for these assets (Potterie and Lichtenberg, 2001). This can be the main limitation of FDI for the home country. Moreover, it is observed that, licensee do not wish to sign an agreement until the licensor shows all the intangible assets and on the other hand the licensor would not want to show all the assets until he closes the deal. The only optimum way for the firm to deal with this situation is to internalize the transaction, by developing its own production plants in the market (Blonigen, 2005). 2.4.1 Advantages of FDI in home country Avoiding export and capture whole market There are different motives behind encouraging FDI by different countries, this are discussed henceforth. The main advantage of the country involving in FDI with a host country rather than engaging in export activities is that it will get the opportunity to capture the whole market. The market size and the expected growth in demand are high and the country gets access to the regional market of the host country (Helpman, Melitz and Yeaple, 2004). Through FDI the countries which seek for natural resources can obtain huge benefit as the resources can be accessed at a cheaper rate. Adoption of new strategies related to technology and human resources FDI also enables the home country to adopt new strategies that are related advanced technologies and human resource skills. The companies distribute their production chains to different nations so that they can get the opportunity to exploit the specialised functions across value chains (United Nations Publications, 2007). The differences in skills of labour market in different nations, quality of industrial infrastructure and availability of the right amount of suppliers have developed high efficiency in FDI. Likewise, Germany encourages FDI for the above mentioned reasons, as it adds value to the total economic development. 2.4. 2 Disadvantages of FDI Shortage of fund leads to risky situation for the home country Hymer (1976) has defined FDI as international capital out flow, that involves investment in a company in other regions, and the investors have the full control over that entity. Cost of capital is not the only determinant of FDI as it fails to justify the control of investor on the entity. He had identified two reasons for simplifying the tendency of the investors to gain control over the entity operating in a foreign region. The use of assets in the foreign grounds also ensures that the investment is safe and secured. Nevertheless, if the company do not possess any fund the decision for exploiting different opportunities will be risky and even he/she can go bankrupted. This is most significant disadvantage for the home country adopting FDI to enter new markets internationally (Seo and Suh, 2006). FDI also favours diffusion of best practices that are associated with accounting policies, corporate governance and legal traditions. It also limits the ability of the government in the home country to devised bad policies pertaining to trade (Molnar, Pain and Taglioni, 2007). Political Risks ODI (1997) explained that the Political factors influencing FDI are a crucial decision making factor for a firm. In countries which are politically unstable, the low cost of resource is over shadowed by the local political disputes, which causes hindrance in the firm’s operations. The firms go for FDI in a foreign country only when they are sure that the high returns of the business is worth facing the risk of losing its capital and labor to local disputes. Although his evidence shows a direct relationship with operational hindrance and political instability, however Loree and Guisinger (1995) contradicted that the impact of FDI is context dependent, that is not all political issues has same impact on FDI. They used data from U.S.A FDI history, and found that political issues had variable impact on overseas business. They found that FDI was affected by political risk in 1982, but operations in 1977 had not been affected at all. Thus it can be said that a firm must gauge the type of political risks before opting for FDI, because not all political risks influence overseas operations. Political disputes often degrades the business relationship between two nations, thus Germany should commence its overseas business operations keeping in mind that its business activities must not get in the way of local political affairs. 3.0 Findings and Discussion Germany is considered as one of the largest outward FDI supplier in world, which ranks third as the FDI stock holder after United Kingdom and United States. According to the UNCTAD data, Germany has experienced rapid growth in foreign capital than that of the UK and US. However, there is a public policy debate in Germany pertaining to increasing labor cost (Castellani and Zanfei, 2006). The general notion of the German firm adheres to the fact that it may achieve productivity by reducing the cost and relocating their production activities to low wage countries of Eastern and Central Europe. Thus, this reduces the employment level in Germany and increase the productivity of the home country (Herzer, 2010). The advantages and disadvantages of FDI for Germany elaborated in this by emphasizing on the current data. 3.1 Advantages of FDI for Germany Increase in cash inflow in to German economy through FDI Due to globalization, FDI has become robust around the world. As is shown in the Figure 2, during 1990, the FDI cash flows accounted for about 9% of the world GDP. However, the figure has risen to about 26% in 2006. Likewise, in Germany the increase is also very significant to about 35% in 2006 from 8.9% in 1990. Figure 2: Outward FDI in Germany with respect to GDP (Source: Hamilton and Quinlan, 2008) The figure elaborates the fact that Germany has encouraged outward FDI in comparison to inward FDI over the years from 1990 to 2006. This has increased the FDI outflows and competitiveness within Germany as more companies are motivated to participate in expansion in international markets. However, the FDI inflows have assisted the country to develop more job opportunities, transfer technology and raise the innovative capacities in order to boost availability of services and goods among the German consumers. However, it is worth mentioning that outward and inward FDI has the ability to bring in economic dislocation. Despite of the adverse consequences, the net advantage to Germany is positive. Advantage of free capital flow across the borders for Germany During the financial crisis, FDI is observed to be resilient in Europe and East Asian countries. The main reason behind this is that FDI favours free capital flow across the borders and allows the home country to earn high rate of return. The international capital flow has several other benefits to the home country. It can reduce the risk that is encountered by the owner of the capital in the home country as it allows them to diversify investment and lending (Loungani and Razin, 2001). Advantage of outward FDI over inward FDI for Germany Germany is considered as the classic trading nation and the country has balanced export with that of FDI in every key market in the EU. During the late 2007, the FDI outflow exceeded 120 billion euro, which was the highest till then. After the great economic recession, the country encountered steady growth in FDI as more German firms took the opportunity in entering new markets (Moffett, Stonehill, and Eiteman, 2011). Figure 3: Outward FDI in Germany (euro) (Source: Hamilton and Quinlan, 2008) From the above figure it can be deduced that the outward FDI has encountered significant fluctuation over the over from 1990 to 2007 due to the rise and fall in demand of products and services by the German and foreign consumers. This also indicates to the fact that increased number of companies has expanded their presence through FDI in Germany and this has contributed positively towards the development of the economy. However, Kleinert and Toubal (2007), contradicted, by their studies from data collected for 1997 to 2003, that there is no significant relationship between establishing a foreign trade and the growth of the firm. Advantage due to overseas operations for Germany Wagner (2009), agreed with Kleinert and Toubal, and suggested that most of firms having productive output have overseas operations. Thus it can be stated that outward FDI has a both positive and impact on the domestic economy. The effect of FDI on the economy varies significantly across several countries. Herzer (2010) believed that FDI acts as an important tool to transfer managerial and technological expertise from the host countries. This in turn improves the competitiveness in the industry and a lot of firms from several countries try to get in to a country with a competitive advantage. Advantage pertaining to investment for Germany Deutsche Bundesbank (2006) in their monthly report stated that the German FDI stocks are mostly focused on European and North American countries. Slightly less than half of the total number of stocks is invested in the fourteen European countries and additional 30 percent in USA. The FDI investment of Germany is sector dependent; almost 71 percent of the FDI activities are focused on the service sector of which 37 percent is invested in the financial sector. The chemical and car industry accounts for 25 percent of Germany’s investment (Deutsche Bundesbank. 2006). The econometric analysis suggests that the German investments have seen a sharp increase between the years 1996 to 2005 at an average rate of almost 13 percent per year (Deutsche Bundesbank. 2006). Benefits for German economy The decision making factor for FDI are its effects on the economy from a macroeconomic perspective. The vertical FDI as discussed earlier is the distribution of the operation tasks in different countries based on the country’s comparative advantage. In case of Germany, most of the firms outsource its production process to countries with low labour costs. The main motive for horizontal FDI is saving on operational costs (Desai, Foley and Hines, 2005). On the other hand, the horizontal FDI leads to access to new markets, as same business operations are commenced in every location. It allows the firm to have close proximity to a very large customer base. Export is often followed by FDI activities, as the firm wants to deploy their distribution strategy in the market more focused at the customers (Görg, Greenaway and Kneller. 2008). 3.2 Disadvantage of FDI for Germany The effect on the domestic economy is mostly dependent on the motive of FDI operations. A firm opting for vertical FDI, where it outsources it operations to low wage countries, will result in reduction of employments in the domestic country. In case of certain overseas business deals, the home country has to rely excessively on the host countries decisions, which results in gradual loss of control over the business operations. The exchange rate fluctuation risk is poses a major threat to the home country, as it hampers the cash flow of the company, as a result it affects the entire overseas business of the nation (Blonigen, 2005). 4.0 Conclusion In recent years, the German firms have expanded their operations overseas. They have helped to open up the markets mostly by horizontal FDI. The study of the German Chamber of Commerce shows that the global expansion is a result of the growing multinational enterprises (horizontal FDI) and not because of shifting operations (vertical FDI) (GACC, 2014). The increasing competition in the market place leads the firms to opt for cost driven FDI. The Domestic firms must have certain qualities to compete in the international market, but Germany cannot always exploit these advantages, so it must shift its operations abroad in to order to have competitive advantages and thus it can ensure long term sustenance of the German firms. FDI often comes with certain short term disadvantages, like negative impact on domestic employment, but this can be compensated by long term positive effects of the foreign investment (Helpman, E. and Krugman, P. 1985). The FDI locations should be chosen carefully, keeping in mind all the risks involved, such as the political background of the host country, the current tax laws and also the competitiveness in the market. The global expansion of German companies also affects the country’s relationship with the foreign countries. Even though the Germany’s association has not changed significantly with the European countries, but the foreign trade structure has certainly undergone some changes; imports from countries like Italy, France and Spain has reduced in certain business sectors, like transportation equipment. This is because new production plants have been established in the neighbouring countries like in east and central Europe (Melitz, M.J. 2003). The empirical analysis of the data collected from 1980 to 2008 revealed that there is a long term relationship between the domestic output and the outward FDI, this also holds true for the total factor productivity (Herzer, 2010). The outward effect has a positive effect in the total factor productivity and domestic output in the long run, however short term improvements are merely insignificant. 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