8.5 Multinational Enterprises (MNEs) and Their Effects

The international movement of capital, which is significantly conducted by multinational enterprises (MNEs) through foreign direct investment (FDI), is often a contentious issue. This is largely due to the considerable power that these typically large firms have. Governments are often concerned about whether the interests of MNEs are in line with the economic well-being of their countries. Such concerns loom large for developing countries whose control over economic resources is often less than that of MNEs. However, they can also be significant for advanced countries, where inward FDI is often scrutinized before any approval can be given. In the United States, for example, the Committee on Foreign Investment has the power to block or limit FDI in U.S. firms and has, in the past few decades, rejected deals involving Chinese investment.

In this section, we will examine the role played by MNEs in the international movement of capital investment. Specifically, MNEs represent the main channel through which FDI is conducted. Since FDI can flow into or out of any country, we will consider its effects on both the “source” or “home” country and the “host” country, along with its impact on international trade. Before doing so, however, we will describe FDI and MNEs and explore some of the principal reasons for their existence.

Foreign Direct Investment

Foreign direct investment (FDI) is a flow of funding provided by an investor or a lender in order to set up or acquire foreign business operations or to expand or finance an existing foreign business that the investor already owns or controls (Pugel, 2020). The ideas of ownership and control are critical to the meaning of direct investment. The consensus regarding the extent of ownership that allows sufficient influence over the management of the business enterprise is ten (10) percent.

In actuality, a multinational enterprise involves much more than a flow of FDI. This is partly because foreign subsidiaries tend to get only a small proportion of their total funding from the MNE. Subsidiaries tend to get substantial amounts of funding from their host countries. This is usually part of the MNE’s risk management strategy. Important risks for the MNE are exchange-rate risk and political risk. Exchange-rate risk is the risk that changes in currency value can negatively affect the value of the MNE’s direct investment, while political risk stems from changes in host-country policies in ways harmful to the MNE. Both of these risks can be mitigated by borrowing in the host country. In addition, MNEs transfer things other than direct investment to their subsidiaries, such as technology, marketing capabilities, and managerial practices.

Multinational Enterprises (MNEs)

A multinational enterprise usually owns and controls business operations in more than one country. In a multinational enterprise, we can distinguish the parent firm from its subsidiaries. The parent firm represents the headquarters of the enterprise and is located in the home country. The parent firm usually has one or more subsidiaries located in one or more countries (Carbaugh, 2015; Pugel, 2020.). A multinational enterprise typically has a large quantity of sales in foreign markets relative to its total sales. MNEs may be vertically integrated, horizontally integrated, or conglomerates.

Vertical integration can be forward or backward. Backward integration occurs when the parent company establishes subsidiaries to produce inputs or components used in making the final product. Forward integration occurs when, for instance, the parent company involved in manufacturing sets up subsidiaries abroad to market its product to consumers. Horizontal integration occurs when the parent company engaged in production in the home country replicates its production operations in subsidiaries in other countries. Horizontal integration is often motivated by the need to be close to foreign consumers, high transportation costs, or high levels of import against imports. Last, sometimes firms may diversify their operations into completely different lines of business. An example of conglomerate integration is the acquisition of Whole Foods, a grocery chain, by Amazon, a technology company.

Reasons for the Existence of MNEs

The basic reason for the movement of capital across national borders is the same as that for international trade. More open economies are likely to experience comparatively high rates of private investment, which is critical to in productivity gains and economic growth. In international trade, products move from countries where their value is low to countries where they are valued highly. In a similar way, capital moves from countries where it experiences lower returns to countries where higher returns are anticipated. When their saturated home markets deliver limited returns, private businesses are likely to be interested in setting up operations in other countries, creating multinational enterprises.

While the quest for returns might prompt the reallocation of capital across countries, it is not enough to explain why investors will be interested in owning and operating foreign business operations. In other words, it is not enough to explain why MNEs develop.

We can distinguish five broad factors that, together, help explain the existence of multinational enterprises. These are as follows:

• inherent disadvantages of being foreign;
• advantages that are specific to the firm;
• considerations related to location;
• internalization advantages; and
• oligopolistic rivalry.

Foreign firms face inherent disadvantages when trying to compete with foreign rivals in their own domestic markets. The foreign firm must face a number of additional costs of managing any business operation at a distance. Not only is it more costly for the foreign firm to operate at a distance, but there is also heightened risk associated with an initial lack of understanding of local customs, laws, practices, and relationships. Other important risks that confront the foreign firm when operating abroad are exchange-rate risk and country risk, which arise when political and economic actions in the foreign country are harmful to the direct investment of the MNE. Thus, there are good reasons why MNEs should not exist.

In order to overcome these disadvantages of operating at a distance, the foreign firm must have some assets and characteristics that are not held by its rivals in the local market. It must possess assets such as proprietary technology, differentiated products, superior management capability, and easy access to financial capital. Such assets provide the foreign firm with a degree of market power that can allow it to offset the disadvantages of being foreign. Even so, the foreign firm must decide whether it is worthwhile to own and manage business operations in another country, as against exporting from its home market or licensing to a rival in the target country.

There are certain considerations that can influence the decision as to whether to locate production abroad or in its domestic market. Such considerations include the availability of productive resources, economies of scale, government policies towards importing and foreign investment (e.g., tariffs, subsidies), the existence of large markets, transportation costs, and the likelihood that products will need to be adapted to cater to local tastes. If resource conditions are favourable, economies of scale are limited, tariff protection is high, the target market is large, transportation costs are high, and local tastes are peculiar, it is more likely that the foreign firm will establish business operations abroad.

Even if the foreign firm rules out exporting as a means of satisfying the target market, it still must decide whether to set up its own business operations using FDI or to license its particular assets to local firms. A license is an agreement for one firm to use assets of another firm in its production, with restrictions on how the assets can be used and with payments for the right to use the assets. While licensing helps the foreign firm avoid the disadvantages of being foreign, there are advantages to the foreign firm of keeping its assets in-house. Such internalization advantages stem from the foreign firm avoiding the costs of finding a suitable licensee (at the right terms) and the risks of losing control of its assets. The establishment of foreign business operations using FDI keeps the firm’s assets under its control. With FDI, the foreign firm is better able to maximize the returns from its assets.

Last, multinational enterprises are often large firms that compete aggressively in a global market. Their decisions about where to locate production facilities using FDI is often to prevent rival firms from gaining any significant competitive advantage in the target market. For example, when it was evident that the motor vehicle market in China was set for significant long-term growth, all the major automakers established a presence in the Chinese market in short order.

The Effects of FDI on Home and Host Countries

Outflows of FDI can hurt workers and reduce tax revenues in the home country as production and employment are shifted to other countries. The owners of multinational enterprises gain from outward FDI through higher returns on investment that is available in foreign markets. With outward FDI, the home country forgoes external benefits such as increased worker skills and efficiency gains associated with the application of new technologies. In practice, advanced countries impose little or no restrictions on outward FDI.

Workers in host countries through the creation of new jobs and the development of new worker skills. In a similar way, other host-country suppliers of inputs also gain. Host-country governments receive a net benefit as long as the tax revenues on the profits of MNE subsidiaries are more than sufficient to cover the cost of any additional government services provided to MNE subsidiaries. FDI can cause local firms in competition with the MNE to lose market share or to go out of business. MNEs may bring external benefits with FDI in the form of better technologies, better managerial capabilities, and improved worker skills. The general view is that host countries gain overall from inward FDI. Supporting this view is the fact that many countries – particularly developing countries – have removed or reduced previous restrictions on inward FDI. Indeed, FDI is being actively encouraged by many developing countries.

The Impact of FDI on International Trade

MNEs are heavily involved in international trade. It is estimated that intra-firm trade represents between a half and two-fifths of the total volume of world trade in goods and services. Sometimes, FDI is a substitute for trade. This might be the case, for instance, when economies of scale are not important, transportation costs are high, or import barriers are high. If economies of scale are limited, it is more likely that the MNE will establish production facilities in different countries than centralize operations in the home country. If transportation costs are high relative to value, the MNE may seek to reduce costs by establishing subsidiaries in other countries. Last, MNEs may choose to locate production behind high tariff walls. Sometimes, FDI is a complement to trade. Production in the foreign country may require the supply of inputs by the MNE. Also, trade in final products made by the MNE may grow because of the presence of subsidiaries in the host country improves the marketing of other products made by the MNE. Most studies conclude that FDI is complementary to international trade.

References

Carbaugh, R.J. (2015). International economics, (15th ed.). Cengage Learning.

Pugel, T. A. (2020). International economics, (17th ed.). McGraw-Hill.