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Analysis of Motives and Prospects within the OLI Framework: German FDI in China

Free essayBy the year 2004, German direct investments in China amounted to nearly 2 percent of China’s total foreign direct investment at just under 1 billion Euros. This figure has continually increased since that time. Such a huge investment indicates the amount of trust Germany and other investors have on China’s economic prospects. China’s economic prospects have been on the ascendancy since China accession to the WTO and liberalization of a number of sectors of the Chinese economy in the one past decade. German direct investment in China has been in the form of establishment of new enterprises, a huge number of which are joint partnerships with Chinese partners. However, German FDI comprised a comparatively larger amount compared to Mergers and acquisitions, which amounted to 324 million Euros in the same period. Some of the motives for German FDI to China include the need to create local production capacity with the aim of gaining a foothold in the Chinese market and to benefit from the cost advantages in the Chinese market.

To analyze the motives and prospects of German FDI into China under the OLI framework, this paper will use the micro-economic and macro-economic factors in Germany using the Dunning approach. The approach will aim at identifying the advantages Germany has in creating local capacity and in utilizing the benefits of cost advantages in China. To do this, the analysis will identify the locational and cost advantages relative to other countries where Germany could have invested in order to identify the real cost and locational benefits that it acquires for investing in China. The analysis of locational advantage will incorporate an analysis of all the locational factors. These locational factors will be grouped into economic, political, and socio-cultural advantages. This is in the realization that the propensity to invest in foreign direct investments will rely on the economic characteristics of the host country, the industry characteristics and the investors’ own characteristics. This character influences the internalization decision (Krugman & Obstfeld 2012). The paper will make use of primary and secondary sources obtained from both the library and the Internet to write a comprehensive analysis.

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The OLI Framework

There are a number of Economic theories that explain how Firms internalize their activities towards foreign direct investments. A good example of the theories is the Eclectic model by J. Dunning. The Eclectic Theory is one of the most relevant and recognized of the internalization theories. It attempts to integrate a number of underlying internalization models to provide an analytical framework. According to Dunning and Lundan (2008), to understand the prospects of FDI, a systematic assessment of the internal (Micro-economic) and external (Macro-economic) factors of the organization should be done. They add that FDI is advantageous if the organization carrying the investments has, “Ownership specific advantages (O), Location advantages (L) and Internalization advantages (I)” (Dunning & Lundan 2008).

Determining FDI Advantage Using OLI Framework

FDI involves acquiring capital assets in the country. Therefore, to maximize the benefits accrued by such an investment, the firm acquires direct control of these assets. Since the cost of adjusting to cultural changes, currency risks among other such features are lower in the domestic market compared to if the company exports, the investor enjoys a compensating net, a factor that serves as a justification in setting up abroad. This is what is referred to as ownership advantage under the OLI framework, which basically implies control abroad. The advantages of gaining control of certain production facility abroad allow the investor to generate positive profits by either lowering costs or charging a higher price, especially if the competitor chooses another avenue of entering the market. Costs can be reduced because of the fact that foreign business costs are significantly reduced by investing directly.

The advantage accrued as a result of location is known as the locational advantage under the OLI framework. Locational advantage is specifically attained when the firm has access to natural resources needed to produce the product and the resources can be availed in the set location or in that location cheaper than it would otherwise. In addition, locational advantage can be attained if an organization targeting a huge number of consumers sets up its operation where these consumers are based. This would have the effect, as by reducing the cost of availing the products to the consumers, the company would therefore increase the real profits.

It is worth noting that ascertaining that accompany would have locational and ownership advantages is not enough to warrant FDI. Rather, to ensure that the choice to invest directly in a foreign country is the optimal one, the organization has to verify that it has an internalization advantage. Internalization advantage will arise if the company has diminished advantage and allows another company to use the assets.

Macro-economic Condition (External Environment Analysis)

The analysis of the macro-economic condition involves an evaluation of the overall economic conditions of China, the political condition and the socio-cultural factors. These conditions are essential while trying to understand the advantages the country has over other countries. In addition, these factors inform of the best choice of investment into the country. For instance, if a country has an unattractive social and political environment, it is unappealing to set up operations within the country. Rather, it would be better to export the company’s product into that country (Dunning & Lundan 2008).

China’s Economic Advantages

There are a number of economic factors that make China attractive compared to other countries, especially in Europe and the United States. First, China has one of the lowest labour costs among these countries. Despite the fact that the wage costs have risen steadily in the past decade, they are still well below the levels prevailing in the developed nations and are set to remain considerably low in the foreseen future. As a result, China is a very attractive manufacturing location and is preferable to all the other options available to German investors. In addition to cheaper labour, China has established a foothold in the high- tech sector.

Further, China is the second biggest economy, and it has grown in double digits for a considerably long time. The economy is set to be very important due to the increasing income and very huge population. This makes China a strategic location for both an investor who targets to serve the Chinese market and the one who wants to set up in the country to enjoy reduced costs of production (Dicken, 2003).

China’s Political Advantage

Despite Chinese political system being seemingly hard for business, the country has been making tremendous efforts to move its economy to an established market economy. There has been marked a withdrawal by the Chinese government from directly controlling the business over the last few years. There has also been increasingly laissez faire approach with regard to foreign involvement in the Chinese economy. It is very evident that the Chinese political system is a huge setback for an investor. To ensure that it is not an impediment to German investment in China, the German and Chinese governments have established very comprehensive bilateral trade and political agreements.

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In the year 2004, China and Germany established a partnership known as the ‘strategic partnership for global responsibility’, and in the year 2010, the two governments established an annual intergovernmental consultation, which discusses economic issues between the two countries among many others. This political situation gives investors across the two countries a positive advantage over their competitors. The agreements are responsible largely for the huge number of German companies investing within China. In addition, Germany and China started the dialogue with the aim of establishing the rule of law and implementing human rights within China in the year 1999. This means that German companies setting operation are not worried about the human rights records, as the governments have laid down strategies of addressing the rights issues.

China’s Socio-Cultural Advantages

China’s massive growth in the last two decades has had an impressive impact on the standard of living of its people. The average growth for the last twenty years has reached an impressive 8 % per annum. In addition, a very huge population of Chinese is living in urban centres. This has led to the creation of a very vibrant middle class with a phenomenal purchasing power. To put it into perspective, there are more than 200 cities in China with a population of more than one million people. These are considerably more people in urban areas compared to the whole of Europe and the United States. This coupled with the average growth rate of around 8 percent has created a middle class with a very huge demand for products. For instance, according to Dunning, China will account for nearly 20 percent of the world’s demand for luxury goods by the year 2015 (Dunning & Narula 2007).

In addition, all indicators are that China is set to be the leading market in the next 5 to 10 years. As a result, a huge number of multinational investors have found it very attractive to set up operations within China. The major reason for choosing FDI for these investors has been the fact that Chinese government policy and the Chinese people prefer home made products rather than importing. Government policies are very stringent on imports. This means that a company can only maximize the potential offered by the Chinese market if it sets up operations within China. This explains the increasing FDI in China by MCNs German included.

German Investment in China

German investment in China is significantly higher than China’s investment in Germany. In the year 2011, German foreign direct investment in China was worth more than EUR 35 billion. On the other hand, China’s investment in Germany was worth only USD 3.1 billion. Currently, there are more than 5,000 German companies operating within China. German investment in China has mostly been focused on motor vehicles, chemical, electrical and machinery engineering sectors. From the kind of German investment into China identified, it is clear that the main aim of the most investors is strategically positioning to take advantage of China’s economic growth and growing middle class.

China as an FDI destination

China is a unique investment destination. First, the country has a very negative image with regard to the state’s policy on labour and environmental protection. The country is amongst the biggest greenhouse gas emitters; its air and water are among the most polluted, and natural resources, including forests, have been depleted in an alarming rate among other environmental implications. Further, China has a very bad and exploitative labour policy; it is known all over the world as a market for cheap labour. Despite all these, there has been an upsurge in many firms investing directly in China. A huge number of the foreign investors have set operations within China in order to take advantage of the manufacturing inherent in the country due to the availability of cheap labour. However, an equally significant number of foreign investors have invested in China to strategically position them to take advantage of the growing demand within China (Morrison 2008).

China’s Economic Conditions

China’s growth rate and its future economic potential are immense. In addition, there have been increased efforts by the Chinese government to open up to foreign investments. This factors coupled with the large population, which creates a huge market, have opened up numerous opportunities for foreign investors. These are the major reason for the increased German direct investment in China. A good indicator of this fact is that the German investment within China has been on consumer goods, such as vehicles, and on products that target infrastructural development, such as machinery and chemicals.

Political Condition

As mentioned earlier, China’s political condition is not very attractive for foreign investors. However, there has been marked signs of improvement by the Chinese government with regard to labour, environment policies, and the openness to foreign investment. All these factors have opened up the country for FDI investments. Specifically, the fact that Germany and China have a number of bilateral agreements gives German foreign investors an advantage over competitors from the countries that have no active bilateral agreements with China.

Socio-cultural Conditions

China has a population of more than 1.3 billion people, 53.7 percent of whom live in urban settings. Due to the economic growth experienced over the last two decades, the purchasing power of this population has increased tremendously. As a result, Chinese market is a very attractive investment destination for multinationals. Setting up operations within the country guarantees not only a huge market population, but also a very powerful, in terms of purchasing powers, consumer.

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German Motives and Prospects of FDI Investment in China

Chinese market is evidently very attractive to FDI mostly due to its economic prospects and a huge population. The reason why German firms choose FDI rather than exports or outsourcing is to benefit from the economic, political, and socio-cultural advantages inherent in Ownership, Localization, and Internalization. Specifically, by choosing FDI over other strategies, German investors are able to position better than their competitors because direct control and ownership of their investments allow them to increase profits by either exploiting the chances available for lowering costs of production or by increasing prices where they have a quality advantage. Costs of operating within China are lowered especially because of the availability of labour and the fact that it can be obtained much cheaper compared to other similar markets. On the other hand, foreign investments, especially in luxury goods, can enjoy more profits by increasing their prices or volumes of sale. This is because of the huge population and growing middle class with a high purchasing power within China.

Conclusion. German motives in making foreign direct investments in China are to exploit China’s economic, socio-cultural, and political advantages. Based on the fact that Chinese market and economy are set to be the biggest in the near future, FDI investments in China guarantee a share of the growth and development projected. Therefore, German direct investment in China is also set to benefit from this.

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