A DIRECT FOREIGN INVESTMENT is the amount invested by residents of a country in a foreign enterprise over which they have effective control. The value of direct investment may increase not only through investment of new funds, which may be remitted from abroad or borrowed locally by the foreign investor, but also through reinvestment of earnings, or the sale to the foreign affiliate of nonfinancial assets, such as a license or management services. Changes in outstanding direct investment, therefore, normally differ from international financial flows as recorded in the presentation of most balance of payments. Until the 1960s, direct foreign investment was usually considered as just one form of international capital movement, responding to differences in rates of return on capital. However, in view of the enormous development of direct investment in the postwar period, which is described briefly in Section I, this explanation has appeared to be increasingly inadequate.
While portfolio investment abroad is made to a large extent by individual investors, direct investment is made essentially by corporations. Determinants of the two types of capital flow may thus differ insofar as the objectives and constraints of the two types of investor are different. However, the interrelationship between the two types of capital flow remains a crucial point and is discussed in Section II. Under perfectly competitive conditions, markets for securities would provide a more efficient way to transfer capital internationally than would direct investment, because local enterprises could presumably operate at lower costs in their own country than could foreign firms. The determinants of direct investment must therefore be found in actual deviations from perfectly competitive conditions. The main line of modern theory of direct investment, which is reviewed in Section IV, focuses on advantages of superior “knowledge” that allow the foreign firm to obtain higher rates of return than local competitors. Other authors have stressed oligopolistic behavior and the maximization of growth rather than profit as the main determinants of direct investment (Section V). One aspect that has been relatively neglected in the literature is that of imperfections in capital markets, which cause discrepancies between “industrial” risks and rates of return of enterprises and the risks and rates of return implicit in minority holdings of their securities. Insofar as these discrepancies exist, portfolio capital movements may be expected to tend to equalize internationally the rates of return on securities, at equal risk, while direct foreign investment tends to equalize rates of return of enterprises, at equal risk. This argument, which is analyzed in Section III, may help to explain also why the flow of U. S. direct investment in Europe, in the postwar period, has been matched by an opposite flow of European portfolio investment in U. S. corporate securities.
The impact of customs duties and exchange risks on direct investment is analyzed in Section VI, where it is argued that the reserve role of the dollar and its overvaluation compared with most European currencies may have provided substantial incentives for U. S. direct investment in Europe.
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Hymer, Stephen H., and Robert Rowthorn, “Multinational Corporations and International Oligopoly: The Non-American Challenge,” in The International Corporation: A Symposium, ed. by Charles P. Kindleberger (The M.I.T. Press, 1970), pp. 57–91.
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Mr. Ragazzi, a graduate of the University of Torino and the University of Virginia, was an economist in the Eastern European Division of the European Department of the Fund when this article was written.
It is estimated that in 1914 investments abroad of the United Kingdom amounted to £4 billion. About 40 per cent of this consisted of portfolio shares of foreign and imperial railways, 30 per cent was in government and municipal bonds, 10 per cent was shares in raw material industries, and 8 per cent was shares in banking and finance, Tugendhat . The numbers in square brackets refer to items listed in the References, pp. 497–98.
Although these changes do not correspond to capital flows as recorded in the balance of payments statstistics, conceptually the two may be reconciled, for instance, for direct investment, by considering reinvested earnings as a current account receipt matched by an equal outflow of capital (Table 3).
In theory, the existence of different interest rates according to maturity for debentures that are assumed to be fixed in money value and free of default risk is explained essentially by the risk of capital gains or losses caused by possible future changes in interest rates, Tobin . In reality, debentures are usually not free of default risk, and, in addition to debentures, a large part of total financial assets consists of stocks. If the market required a premium for bearing risk, whatever its causes may be, all securities would be priced so that higher expected rates of return are associated with higher estimated risks, independent of the maturity, which is only one of the various components of risk, Lintner .
During the last century, direct investment in the United States by European individuals was common, but normally, after some time, the investor found it convenient to become a U. S. resident and the investment lost its foreign classification.
In addition to real estate, which, however, cannot be regarded as a direct investment.
Another important determinant may be liquidity, but for securities, liquidity can be regarded as one aspect of total risk (see footnote 3).
Technological developments in transportation and communications over the past two decades have certainly contributed to the development of direct investment abroad.
Numerous U. S. firms derive 30 per cent to 40 per cent, and in certain cases up to 60 per cent, of their total earnings from foreign investment.
In 1970, for instance, the market value of stocks quoted in London was almost equal to, and the value of stocks traded exceeded, that of all other European markets together. On the other hand, the market value of stocks quoted and of stocks traded in New York was greater than that in London by a ratio of, respectively, 9:1 and 7:1.
There may, of course, be other factors that make control shares more attractive than portfolio shares, particularly the tax treatment of earnings.
However, this may be related not only to the greater efficiency of the U. S. capital market, as suggested, but also to differences in the size of business cycle fluctuations.
Political and fiscal considerations also certainly play a role, but it is difficult to see how large portfolio capital inflows could occur in the absence of an efficient market, such as the New York Stock Exchange.
Larner  found, for instance, that in 1963 in 85 per cent of the 200 largest U. S. corporations, no single person or family group owned more than 10 per cent of the total outstanding corporate stocks.
It is not suggested here that one should always find a correlation between inflows of direct investment and inefficiency of stock markets, since clearly many other factors influence actual direct investment. In this respect, the value of U. S. direct investment relative to gross national product (GNP) is much larger in the United Kingdom than in other European countries, although the United Kingdom has the most developed stock market in Europe. However, figures for 1957–64 (Aliber ) shows that the outflow of direct investment from the United Kingdom largely exceeded the inflow, and that the United Kingdom had the largest net outflow of direct investment after the United States. Estimates for 1964 (Behrman ) indicate that the United Kingdom was the only European country except the Netherlands (whose stock market is more developed than those of other member countries in the European Economic Community) with a large net surplus position for direct investment. Therefore, if net instead of gross flows are considered, the United Kingdom’s example does not contradict the view that inflows of direct investment may be stimulated by the inefficiency of domestic stock markets.
Also, oligopoly, with product differentiation, can be treated as superior knowledge, since the marginal cost of exploiting the differentiated product in a foreign market is practically nil; the advantage here consists in the knowledge of the product, possibly protected by a brand name.
It is implicitly assumed here that the objective of the firm is to maximize profits. In oligopolistic markets, or when the firm seeks to maximize growth rather than profits (see Section V), direct investment may be undertaken even when its return is lower than the possible income from the sale of the license.
Between 1964 and 1969, U. S. gross receipts from sale of knowledge (royalties, license fees, and rentals) to foreign subsidiaries of U. S. companies and to nonaffiliated foreign firms, respectively, amounted to US$2.6 billion and US$2.4 billion (the latter including also management and service fees), U. S. Department of Commerce , “Policy Aspects of Foreign Investment by U. S. Multinational Corporations,” p. 37.
A recent study by the Harvard Business School, “U. S. Multinational Enterprises and the U. S. Economy,” in , found that a number of case studies confirmed this general description of an industry life cycle. It found also that, between 1950 and 1970, for a large sample of industries, the share of world production made in the United States declined sharply, while that of U. S. companies’ total production, made in both the United States and abroad, declined much less markedly. The thesis that U. S. direct investment abroad is of a defensive nature has also been advanced by Hymer and Rowthorn , although their argument is that U. S. firms invest abroad in order to maintain their world market share at a time when GNP in the United States is growing less rapidly than in other developed countries (see Section V). Various empirical studies have found a positive correlation between inflows of direct investment and the rate of growth of GNP, Spitäller .
Good examples are International Business Machines, which produces parts for its 360 computers in several different countries, or Ford Motor Company, which produces gears for tractors in the United States, transmissions in Belgium, and engines in the United Kingdom, Tugendhat .
Profit is regarded as a constraint rather than as a target in itself, in the sense that the achievement of a minimum rate of profit is necessary to finance further growth and to retain control of the firm.
William Lever, the founder of the Lever Brothers soap empire, is quoted as saying in 1902, “The question of erecting works in another country is dependent upon the tariff or duty . . . When the duty exceeds the cost of separate managers and separate plants, then it will be an economy to erect works in the country . . . Tugendhat , p. 14.
Lower labor costs abroad are commonly regarded as a major determinant of U.S. direct investment abroad. This view is theoretically invalid unless qualified as in the text that follows.
In this section, consideration is given only to direct investment in industries producing mainly for the local market. As pointed out by Rhomberg , changes in the exchange rate have opposite effects on the rate of return of export-oriented industries, that is, industries whose payments in local currency exceeds revenues in local currencies.
This has clearly been true for the United States, where losses of reserves, owing to the special position of the dollar, were not a serious constraint on domestic policies.
This is explained largely by the reserve role of the dollar.
In 1964 the outflow of U. S. funds for direct investment in Europe jumped to US$1.3 billion, compared with an average of US$0.8 billion in the previous three years; one may suspect that this increase was stimulated by the restrictions on U. S. purchases of European securities.
Throughout the text, reference is made only to borrowing by the parent company to increase its equity in the subsidiary (which is what is meant by “direct investment”). While borrowing by the subsidiaries is not considered here, it rose from 38.2 per cent of the total assets of U. S. subsidiaries abroad in 1966 to 41.5 per cent in 1969, Berlin .
These limits varied according to the geographical areas and were much stricter for developed countries in Western Europe than for other areas.