The ‘imports-as-competitive-discipline’ hypothesis suggests that liberal trade policies and tight competition policies are somewhat substitutes. However, the relationship between the liberalisation of FDI regimes and the necessity of competition policy is prominent. On the one hand, FDI liberalisation is a means of promoting competition among firms; on the other hand, in order to benefit adequately from FDI liberalisation, countries need to ensure that, as barriers to entry are removed, they are not replaced by anticompetitive practices of firms, not only domestic, but also foreign. According to UNCTAD (1997a), there is a direct, necessary and enlarging relationship between the liberalisation of FDI and the importance of competition policy.
Theoretically, the interface between inward FDI and competition policy is based upon the concept of market power. In the first half of the 20th century, some mainstream economic theories have sought to explain particular aspects of FDI and foreign production.
The second half of the century witnessed the introduction of more integrated theories of FDI. The most influential theory – the eclectic (Ownership-Location-Internationalisation, O-L-I) paradigm – sought to integrate streams of thinking emerged. This paradigm dates back to the 1960s. The eclectic paradigm formulated by Dunning proclaims that firms invest abroad because of the existence of the ownership, location and internationalisation advantages. According to this paradigm, the scope and pattern of international production is determined by, first, the interaction between the competitive advantages of investing
35 See Anderson and Holmes (2002) for a detailed discussion.
firms and those of the host countries, and secondly, the ways in which these firms organise their resources and capabilities across national boundaries regarding these two sets of advantages. In the 1990s, more attention was given by trade economists to incorporating relevant variables into their models of international transactions, while there was a renewal of interest in FDI as a financial phenomenon and also in its relationship with foreign portfolio investment. In the early stage of understanding of FDI, one possible explanation of FDI is that it is simply another form of international flow of financial capital based on differences in returns and risks between countries. This financial theory of direct investment is not adequate. It does not explain why this international investment would be large enough to establish managerial control over the foreign companies. Another possible explanation of FDI is that it is merely the outcome of perfect competition in which some firms almost accidentally happen to operate in more than one country. This approach is also not generally adequate. FDI is usually not easy or accidental, because establishing and managing successful operations in a foreign country are difficult. Local firms have inherent advantages in operating in their own environment. A foreign firm is at a disadvantage because it does not initially have the native understanding of local laws, customs, procedures, practices and relationships. In addition, the foreign firm has the extra costs of maintaining management control and it is expensive to operate at a distance, expensive in travel, and communication.
Then what makes it possible for a foreign firm to overcome the inherent disadvantages of being foreign? To be successful, the firm entering from abroad must have some firm-specific advantages not held by its local competitors in the host country. The firm-specific advantages sometimes lie in technology or patents. It may inhere in special access to a very large amount of capital, an amount far larger than the local firm can command. Or the firm may have marketing advantage or superior managerial know-how.
The key role played by firm-specific advantages has led scholars to move away from the models of perfect competition towards the perspectives associating FDI with one or another kind of market power. Two variants, with differing policy implications, emerged:
the Hymer view and the appropriability theory.
Hymer (1960) saw the role of firm-specific advantages as a way of combining the study of FDI with the classic model of imperfect competition in product markets. To Hymer, a
‘direct foreign investor’ is a monopolist or an oligopolist in product markets, which invests in foreign enterprises to restrain competition and protect its market power. According to Hymer, to be able to invest in production in foreign markets, a firm must posses some assets in the form of the knowledge of a public-goods character. The proprietary assets give foreign firms a competitive edge over domestic firms and allow them to overcome the transaction costs of operating across national boundaries. Hymer saw those assets as the source of a monopolistic advantage at home and abroad. This standard theory of FDI claims that ‘for direct investment to thrive there must be some imperfection in market for goods or factors, including among the latter technology, or some interference in competition by government or by firms, which separates markets’ (Kindleberger, 1969).
Hymer argued that FDI was a form of corporate behaviour associated with imperfections in home country market, particularly high entry barriers. This argumentation provided the foundation of the theory of FDI and Multinational Corporation (MNC).
The appropriability theory (cf. Magee, 1977) claimed that the key firm-specific advantages that seem to make FDI take place do not imply such major threats to market competition. The firm must undertake costly investment to develop new technologies and superior management. The firm’s challenge then is to earn an adequate return on this investment and to continue to invest to enhance its firm-specific advantages. The return
that it can earn is limited by competition from other firms, which are also attempting to build and exploit their own firm-specific advantages. Firm-specific advantages make the firm engage in FDI abroad for the same reason that make it built its own facilities, instead of buying from others, at home. In order to appropriate the potential gains from its advantage, the firm often finds that it is necessary to keep control and ownership to itself.
The economics of whether to engage in FDI is an international extension of the decision about the boundaries of the firm.
If FDI really protects market power, as Hymer implied, then a fortiori host countries should be ready to impose restrictions on it. However, the appropriability theory has different policy implications from the Hymer view. Its emphasis on the productive nature of most firm-specific advantages motivating FDI favours host-country policies that either leave FDI alone or positively encourage it with favourable government treatment. Whether FDI should be left alone or actually favoured depends on how well the firm is able to appropriate the benefits of its own productive investment. If it can do so, the government can presumably leave it alone. If it cannot and there are ‘external benefits’ of its productivity that would spillover to competitors and other firms, the government should positively subsidise inward FDI.
Practically, the interfaces between FDI and competition policy lie in four areas: 1) at-entry inward merger review, 2) outward merger review, 3) post-entry competition issues, and 4) dominant positions with international scope (UNCTAD, 1997a). For a developing country, as inward FDI plays an increasingly important role in the economy, it becomes vital to ensure the efficient functioning of markets. The efficient functioning of the market depends on the contestability36 of the markets and the nature of market competition. FDI can increase the contestability of domestic market at entry, or in the short run, but could also increase market concentration and lead to dominant positions and anticompetitive practices of MNCs after entry, or in the long run (see Section 4.2.2 for a detailed discussion). The adoption and efficient enforcement of competition policy may strengthen the way in which FDI liberalisation can enhance economic efficiency and consumer welfare and, therefore, promote the economic development of developing countries. One of the recommendations of the UNCTAD (1997a) was that member countries adopt, improve and efficiently enforce laws for the control of restrictive business practices.
Competition policy applies to all firms operating in the national territory and supplying a particular market through various modes of entry, such as imports, foreign affiliates or non-equity forms of FDI. It does not, in principle, discriminate between domestic and foreign firms or between foreign firms from different origins. Competition authority monitors the behaviour of MNCs, with an aim of ensuring that these firms (like other firms) do not abuse their market dominance nor engage in anticompetitive practices.
Inward FDI interacts with competition policy when a foreign affiliate is established by the means of International Joint Ventures (IJVs) or M&As. Sometimes, IJVs may involve a market-allocation investment cartel to restrict competition. This is especially the case when a large firm acquires or mergers with another. Such transactions need to be examined by competition authorities, particularly when they occur between competing firms. They may also be subjected to anti-monopoly provisions if they are viewed as a means of achieving or promoting a dominant position. In fact, the primal reason why competition policy has been considered imperative is the gigantic merger wave, which was a defining feature of
36 Baumol et al. (1982a) coined the term contestable to describe markets in which entry is so easy that the potential competition along suffices to eliminate excess profits. See Subsection 4.2.3 for details.
the world economy in the 1990s. A significant characteristic of the merger wave in the 1990s is the large incidence of cross-border M&As (see Subsection 2.3.1), most of which took place among developed countries. During the 1990s, a considerable proportion of FDI inflows in developing countries took the form of M&As rather than greenfield investment.
UNCTAD (1999) suggested that if China (the largest FDI recipient in developing countries, but most of its investment has been greenfield) excluded, the share of M&As in the accumulated FDI rose from 22 percent during 1988 to 1991 to an average of 72 percent in the 1992-1997 period.37 Cross-border M&A is becoming a common mode of foreign market entry in Latin America and Africa and, more recently, in Asian countries after the financial crisis (UNCTAD, 1999). The growing cross-border M&As brought about the concerns on the effects of M&As on competition and market structure. According to Lall (2000), in the absence of an effective competition policy, a liberal stance on M&As may lead to undue concentration or the suppression of competition in domestic market (see Section 4.2 for a detailed discussion). The benefits of M&As depend not only on the stance of foreign investors, but also on the policy environment of the host country and the conditions under which enterprises are acquired. To maximising the benefits and minimising the costs, a well-structured policy framework is necessary, in which competition policy seems to be crucial.
3.4.5 Evaluating the Necessity of Competition Policy for Developing Countries