22 Foreign Direct Investment-I

Vishal Kumar

1. Learning Outcome

After completing this module, you will be able to:

i. Understand the need of Foreign Investments.

ii. Understand the meaning and concept of Foreign Direct Investment

iii. Understand the types of FDI, and

iv. Know about various advantages and disadvantages of FDI

2. Introduction

With the rapidly changing world economy, every country across the globe is trying to integrate its economy with rest of the world and the process is known as globalization. Globalization, as a process of integration of economies across the globe, usually encompasses many ways and one such visible way is the inflow of Foreign Direct Investment (FDI). In recent times, FDI has come out as a buzzword in international trade and have received significant consideration in the foreign trade policies. It represents movement of capital, both short term and long term, in and out of a country with the purpose of buying physical and financial assets to start a business. It specifies the transfer of bundle of resources across the national boundaries, which includes capital, technology, management and marketing expertise. Although the process of FDI is universal phenomenon, the developing countries, however, are trying hard to attract more of it to bridge the resource gaps for their economic development.

“The Foreign Direct Investment (FDI) is the process by which the resident of one country (generally the source country) acquires the ownership of assets for the purpose of controlling the production, distribution and other productive activities of a firm in another country (generally the host country)”.

Today the world is rapidly becoming interdependent. Not only the goods and services but the financial transactions are also moving beyond the boundaries of the countries. Today, in fact the world has become a small village. With the emergence of integration of global markets, international financial flows have so far been in excess for the goods and services among the countries dealing in international business. Out of different types of financial inflows, the FDI has played a vital role in the process of economic development of the country. Further FDI is also considered as an important element in the development strategy of the developing countries among the various forms of foreign assistance. Usually FDI and FII flows are preferred over the other form of external financing because they are not debt creating, non-volatile in nature and their returns are also depending upon the projects financed by the investor.

3. Meaning and Concept of Foreign Direct Investment

Foreign Direct Investment (FDI) is defined as “investment made to acquire lasting interest in enterprises operating outside the economy of the investor.” It is the process whereby residents of one country acquire ownership of assets for the purpose of controlling the production, distribution, and other activities of a firm in another country. The International Monetary Fund’s (IMF) balance of payment manual defines FDI as “an investment that is made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor”.

The FDI creates the relationship of ‘a parent company’ and ‘a foreign affiliate’ which jointly form a Multinational corporation (MNC). Foreign Direct Investment will be considered when the investment is made by the parent company which has direct control over its foreign affiliate.

FDI plays a pivotal role in the growth of global business. It opens new vistas for a firm in the form of new international markets and marketing channels, cheaper production facilities, access to new technologies, products, financing and skills. The firm which receives the investment or for a host country, it can provide a source of new technology, capital, product, management skills and also can provide a strong drift to economic development.

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In the recent past Foreign Direct Investment has played a key role in the internationalization of business. In response to changes in technology, liberalization of the national regulatory framework which governs investment in multinational companies and changes in capital markets, fundamental modifications have occurred in the scope, size and methods of Foreign Direct Investment. Growth of ICT and decline in the global communication costs has made the foreign investments far easier than in the past. Major changes in international trade and investment policies, tariff liberalization, easing of restrictions in foreign investment, global regulatory environment in the past decade and the deregulation and privatization of many industries, has been considered as the most significant catalyst for FDI’s expanded role.

4. Types of FDI

♦ ON THE BASIS OF DIRECTION

Inward FDI

Inward foreign direct investment (FDI) is a peculiar form of inbound investment when foreign capital is invested in local resources. Inward FDI is encouraged by:

Subsidies, tax breaks, low interest loans, lifting of certain restrictions and grants etc.
The thought is that the worth of long term gain is more than the short term income loss.

Inward FDI is restricted by:

Differential performance requirements
Ownership restraints or limits

Outward FDI

Outward foreign direct investment (FDI), also called as direct investment abroad, is an investment when local capital is invested in foreign resources. It can also be used to invest in the commodities of foreign country in the form of imports and exports.

Outward FDI is encouraged by:

Insurance to cover the future risk backed by the Government

Outward FDI is restricted by:

Subsidies for local businesses
Tax incentives or disincentives on firms that invest outside the boundary of the home country or repatriations of the profits.
Collectivists government policies that support the nationalization of industries
Security industries are often kept safe from outwards FDI to ensure localized state control of the military industrial complex
Societal sectors who are supported by inward FDI or state investment, e.g. agriculture and labour markets.

♦ ON THE BASIS OF TARGET

Greenfield Investments

Greenfield investments are the main target of a host country’s promotional efforts because it creates new production capacity, jobs, technology transfer and knowhow, and can lead to linkages to the international marketplace. The Organization for global Investment acknowledges the benefits of Greenfield investment for regional and national economies which is helpful to increase the employment opportunities even at higher wage rates than domestic firms, investments in research and development projects and additional capital investments. Greenfield investments are criticized because it includes the loss of market share for competing domestic companies, profits are perceived to bypass local economies and instead flow back entirely to the multinational’s home country.

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Mergers and Acquisitions

Cross-border mergers occur when the operations and assets of firms from multiple countries are combined to establish a new entity i.e. when the control business including assets and operations of domestic company is transferred to a foreign company and the domestic company becomes an affiliate of the foreign company. In this type of FDI acquisitions provide no long term benefits to the host country’s economy as in the case of Greenfield Investment. In most of the deals, the owners of the local firm are paid in stock from the acquiring firm i.e. the money realized from the acquiring firm could never reach the local economy. But still mergers and acquisitions are very important form of FDI.

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Horizontal FDI

Horizontal FDI occurs when the multinational company undertakes the same production activities in multiple countries i.e. an investment made by a MNC in different countries across the globe. The investment is made for conducting the same type of business as already operated by the company in different countries. For example, if a pharmaceutical company set up its plant outside its national boundary then it is horizontal Foreign Direct Investment. Horizontal FDI results in the expansion of parent company’s business and brings FDI in the other economy.

Vertical FDI

As discussed above horizontal FDI is the investment in same kind of industry in different countries. Vertical FDI is investment in the related industries in the chain of vertical integration. Here Vertical integration refers to the expansion of a firm into a stage of the production process other than that of the original business. For example a company such as TATA Steel which makes steel can integrate vertically by expanding its activities toward the source of raw materials such as iron, coal and limestone production, or toward the sale of the end product as Tata iron. So in this context, Tata Steels could have backward FDI if it opened a new iron mine in Indonesia, or forward FDI if it opened a subsidiary in the US to sell its steel.

♦ ON THE BASIS OF MOTIVE

FDI can also be classified based on the motive behind the investment from the perspective of the investing firm:

Resource Seeking

Investments which seek to acquire factors of production that is more efficient than those available in the home economy of the firm is called as Resource Seeking FDI. Sometimes these resources are not available in the home country at cheaper rates like labour and other natural resources. This increases the dependence of under developed countries to developed countries for natural resources, skilled human resources and cheap labour.

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Market-SeekingInvestments which aim at either discriminating new markets or maintaining existing ones is called as Market Seeking FDI. Foreign Direct Investment of this kind may also be employed as defensive strategy because it is generally argued that the companies are tend towards this type of investment out of fear of losing a market rather than discovering a new one. Such type of FDI can be characterized by the foreign Mergers and Acquisitions in the 1980’s by Accounting, Law and Advertising firms.

Efficiency-Seeking

Investments which firms expect will increase their efficiency by exploiting the benefits of economies of scale and economies of scope and also those of common ownership is called as Efficiency Seeking FDI. This type of Foreign Direct Investment comes after either resource or market seeking investments have been realized, with the expectation that it will further increase the firm’s profitability.

Strategic-Asset-Seeking

Strategic Asset Seeking FDI is a tactical investment to prevent the gain of resource to a competitor. For example the producer of oil whom may not need the oil at present, but look to prevent their competitors from having it in order to have the competitive edge.

5. Advantages of Foreign Direct Investments

Economic development: Foreign Direct Investment helps in the economic development of the host country where the investment is being made. FDI is especially applicable for the economically developing countries. During the decade of the 90s FDI was one of the major external sources of financing for most of the countries that were growing from an economic perspective. It has also been seen that foreign direct investment has helped several countries when they have faced economic hardships which could be clearly seen in some countries of the East Asian region. During the financial crisis of 1997-98 it was observed that the amount of foreign direct investment made in these countries was pretty steady. But the other forms of cash inflows in a country like debt flows and portfolio equity had suffered major setbacks. Similarly, it has been observed that in Latin America during 1980s and in Mexico during 1994-95.

Human capital resources: When foreign direct investment is received from another country the host country can also develop its human capital resources by providing training to its employees on the operations of a particular business from foreign country. The profits generated due to the foreign direct investments can also be used by the country for developing its human capital base.

Transfer of technologies: Foreign direct investment also permits the transfer of technologies. Transfer of technologies is done basically in the way of provision of capital inputs. Technology cannot be transferred by merely trading of goods and services as well as investment of financial resources. Transfer of technologies can only be made under a legal binding contract between two countries. It also assists in the promotion of the competition within the local input market of a country.

Job opportunity: Foreign direct investment helps in creating new jobs in a particular country. FDI also helps in increasing the salaries of the workers which enables them to get access to a better lifestyle and more facilities in life. It has normally been observed that foreign direct investment allows for the development of the manufacturing sector of the recipient country. FDI can also bring in advanced technology and skill set in a country. Foreign direct investment brings the venture capital into the country and also increases the scope for new research activities being undertaken.

Export-Import: Foreign direct investment also opens up the new vistas for imports and exports that allow countries the opportunity to export their superior products, services and technologies to foreign countries. It has also observed that as a result of receiving foreign direct investment from other countries, it has been made possible for the recipient countries to keep their interest rates at a lower level.

Income generation: Foreign direct investment assists in increasing the income that is generated through revenues realized through taxation. FDI also plays a crucial role in increasing the productivity of the host countries. In case of countries that make foreign direct investment in other countries this process has positive impact as well. The corporates of these countries get an opportunity to explore newer markets and thereby generate more income and profits.

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FDI makes easier for the business entities to borrow finance at lesser rates of interest. The biggest beneficiaries of these facilities are the small and medium-sized business enterprises. Foreign direct investment leads to increase in profits within different industries as well as tax cuts and expanded marketability for singularly differing industries. Many times procurement of material, buildings, and labour can be obtained at a fraction of the cost in host countries than would be the case within the company’s home country. But it is always good to keep in mind the host countries economy and market. Corporates are often forced to abide by local regulations rather than the regulations of their home country. On the other hand, the host country benefits due to the increase in jobs, increase in the productivity and increase in the capital base due to investment made by the foreign country. Often times dying economies can be revived in the process of becoming a host for certain industries or markets in which that industry or market had not previously been. This is especially the case with third world countries that are trying to catch up to industrial nations or who need a boost due to changes in regional climates or in the advent of recovery from the aftermath of civil or world war.

5. Disadvantages of Foreign Direct Investment

Although Foreign Direct Investment has bundle of advantages but still certain issues are evolved with the emergence of investment made by the foreign country in the host country’s economy. The disadvantages of FDI occur usually in case of matters related to operation, distribution of the profits made on the investment and the human resource. One of the most indirect disadvantages of foreign direct investment is that the economically weaker section of the host country is always put out when the stream of foreign direct investment is adversely affected. The situations in countries like Singapore, Chile, Ireland and China corroborate such an opinion. It is normally the responsibility of the host country to limit the extent of impact that may be made by the foreign direct investment. The host country should make sure that the entities making the foreign direct investment in their country are following the environmental, cultural, governance and social regulations that have been laid down in the country.

The other disadvantages of foreign direct investment are discussed as follows:

Many times it has been observed that certain foreign policies are adopted that are not appreciated by the workers of the recipient country. Foreign direct investment sometimes is also not favourable for the countries which are investing in the host country.
Foreign direct investment may impose high travel and communications expenses. The difference in the socio-culture environment that exists between the country of the investor and the host country could also pose certain problems in case of foreign direct investment.
At times it has been observed that there is considerable instability in a particular geographical region.

This causes a lot of inconvenience to the investing country.

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Another major disadvantage of foreign direct investment is that there is a chance that a company may lose out on its ownership to an overseas company. This may cause many companies to approach foreign direct investment with a certain amount of caution.
The size of the market, as well as, the condition of the host country could be important factors in the case of the foreign direct investment. In case the host country is not well connected with their more advanced neighbors, it poses a lot of challenge for the investors.
At times it has been observed that the governments of the host country are facing problems with foreign direct investment. It has less control over the functioning of the company that is functioning as the wholly owned subsidiary of an overseas company. This leads to serious issues. The investor does not have to be completely obedient to the economic policies of the country where they have invested the money.
The foreign direct investments may also have adverse effects on the balance of payments of a country.

Even in view of the various disadvantages of foreign direct investment it may be said that foreign direct investment has played an important role in shaping the economic fortunes of a number of countries around the world.

6. Summary:

In this module we have learnt that FDI has come out as a buzzword in international business and have received significant consideration in the foreign trade policies. It represents movement of capital, both short term and long term, in and out of a country with the purpose of buying physical and financial assets to start a business. It specifies the transfer of bundle of resources across the national boundaries, which includes capital, technology, management and marketing expertise. The module also put light on the role of FDI in the development of economy as it plays a pivotal role in the growth of international business. It opens new vistas for a firm in the form of new international markets and marketing channels, cheaper production facilities, access to new technologies, products, financing and skills. The firm which receives the investment or for a host country, it can provide a source of new technology, capital, product, management skills and also can provide a strong drift to economic development.

Suggested Readings

Sundharam K.P.M. and Datt Ruddar (2010). Indian Economy, S. Chand & Sons, New Delhi.
Sharan Vyptakesh (2003). International Business: Concept, Environment and Strategy. Pearson Education, New Delhi
Cullen. (2010). International Business. Routledge.
Bennett Roger (2011). International Business. Pearson Education, New Delhi
Paul Justin (2010). Business Environment-Text and Cases. Tata McGraw Hill, New Delhi.
Cherunilam Francis (2010). International Business. Prentice Hall of India Private Limited. New Delhi.
Cherunilam Francis (2013). Global Economy and Business Environment. Himalaya Publishing House, New Delhi.
Levi MauriceD. (2009). International Finance. Routledge.
Conklin David w. (2011). The Global Environment of Business. Sage Publications.
Mithani D M. (2009). Economics of Global Trade and Finance. Himalaya Publishing House New Delhi.
Cherunilam Francis (2011). International Business Environment. Himalaya Publishing House, New Delhi.
Saleem Shaikh (2010). Business Environment. Pearson Education, New Delhi.