FOREIGN DIRECT INVESTMENT

FDI occurs when a firm invests directly in facilities to produce and/market a product in a foreign country. There is a difference in FDI and Foreign Portfolio Investment. FPI is investment by individuals, firms or public bodies in foreign financial instruments like bonds or stocks. It does not involve taking a significant equity stake and the investor does not involve himself in any way in the business decisions. When discussing FDI it is important to distinguish between flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI undertaken over a given period of time (normally a year) the stock of FDI refers to the total accumulated value of foreign owned assests at a given time. We also talk of the outflow of FDI and inflow of FDI. Several facts characterize FDI trends over the past 20 years. 1) There has been a rapid increase in the total volume of FDI undertaken. 2) There has been a change in the importance of various countries as source of FDI. There has been a decline in US as a source of FDI and Japan has emerged as a major source of FDI. 3) There has been a notable change in the direction of FDI, an increased share is directed to developing nations of Asia and Eastern Europe. 4) US has become a major receipant of FDI. 5) There has been an increase in the amount of FDI undertaken by small and medium sized enterprises.

THE GROWTH OF FDI In the past 20 years there has been a marked increase in both the flow and stock of FDI in the world economy. The increase in FDI in 80¶s was 20% above the earlier decade in the 90% it grew at 90% as compared to the 80¶s and in between `90 - `95 the increase was 16% which fell between `95 - `97 to 120% but again increased to 190% in `99 ± 2000. The growth in FDI has been faster than growth in world trade and world output. There are several reasons for this. 1) Despite decline in trade barriers there is still some fear among business firms of protectionist pressures. Therefore FDI¶s are seen as a way of circumventing future trade barriers. Japan¶s automobile companies made huge investments in the US in order to reduce exports and thus not fall in the quota traps. 2) Recent FDI¶s are driven by dramatic political and economic changes that have occurred in many developing countries. Increased economic growth, economic deregulation privatizations programmes with increased intensive for foreign investment and removal of many restrictions on FDI¶s have made these countries very attractive.

FDI by Medium-Sized & Small Firms FDI used to be associated with multi-billion dollar firms but the globalisation of world markets has been accompanied by rapid growth of FDI by small and medium sized firms. Initially US was the largest source country for FDI¶s UK a/c seconds as a source country uptill the late `80¶s. There are two trends to be seen 1) There has been a rapid increase in flow of FDI¶s in developing countries the rise in the last two decades has been very sharp. 2) In recent years there has been a rise of FDI inflow in the US so much so that the US has become the highest receipant of FDI¶s. It is very essential for these firms to move with their major customers or they may be out of business.CHANGES IN THE SOURCES OF FDI¶s Not only the outflow of FDI¶s accelerated. It has grown very rapidly as a source country. The other major sources have been Germany & France. open markets and huge potential. The factors behind the inflow into the US are 1) as the largest and richest consumer market in the world to US is very attractive to foreign firms. CHANGE in the receipients of FDI¶s Inflows of FDI¶s has also changed over a period of time. FDI by such firms has been driven by a need to stay close to major customers who have moved operations abroad. 2) In 1985 the value of the $ fell sharply at the same time value of Yen and the German mark rose. Reasons being economic growth liberalization. This made it expensive for US firms to purchase assets abroad and relatively cheap for Japanese & German firms to purchase assets in US. 3) Foreign firms also believed that they could manage US workers and assets more efficiently than US managers. The biggest Gainer in the past 20 years has been Japan. The general belief is that Japanese corporations indenting to buy American industrial base resulted in this trend but the truth is that British & Dutch investors were far higher. This was because many other countries joined the ranks. 4) The expansion of NAFTA (North American Free Trade Agreement) to include Mexico promoted some inward investment. Some times major customers may ask firms to set up plants along with them abroad because they do not find the same quality of components or they do not want to source or . US was a major source and 178 of the 382 MNC¶s were American but in the `90¶s US¶s position as a major source country started falling. but its composition has also been changed.

The existence of barriers on sale of know-how increases the profitability of FDI relative to licensing. 2) When there are barriers to sale of know-how-Barriers for free flow of products between nations decreases the profitability of exporting and make it simpler to set up manual unit in the country to tap the market. Why do firms go to the trouble of acquiring/establishing operations abroad when they have options like exporting and licensing? The puzzle is very real when FDI is expensive and risky. soft-drinks.g.provide a major explanation of why firms may prefer FDI to either exporting/licensing. The same follows for FDI eg. For product with high value-to-weight ratio where transportation cost is just a fraction of total cost exporting may be more attractive e. The possibility of foreign firms making mistakes due to ignorance is far higher. This is particularly so when products have low value-to-weight ratio. What one firm does can have an immediate impact on the major competitors forcing a response from them.when transportation costs are added to production cost it sometimes becomes unprofitable to ship some products over a large distance. software etc. . Thus if one firm in a oligopoly cuts prices it results in shifting of market share thus forcing the competitors to respond. and the goods can be produced anywhere e. computers. Market imperfection are factors that inhibit markets from working perfectly. HORIZONTAL FDI Is FDI in the same industry abroad as a firm operates in at home. A critical competitive feature of such industries is independence of the major players. 1) TRANSPORTATION:. This is more so in oligopolistic industries. Market Imperfection :. Following Competitors :. FDI are risky therefore of the problems associated with doing business in a different culture. Thus market imperfection helps in promoting FDI. There are certain costs that can alter the attractiveness of exporting and licensing. Here the products may not be easily manufactured anywhere. FDI is expensive because a firm must bear the cost of establishing production facilities in a foreign country or of acquiring a foreign enterprise. Market Imperfection arise in two circumstances 1) When there are barriers to the free flow of products.train locals to give the same quality thus to maintain their quality and reduce their work they request the firms to accompany them.g electronic components.another theory used to explain FDI is based on the idea that firms follow their domestic competition overseas. cement. If 3 firms are there in an FDI in Japan firms B & C will follow just so that they are not left behind in the competition.

Investment in specialized assets vertical FDI will occur when a firm must undertake investment in specialized assets whose value is dependent on inputs provided by a foreign supplier. 1) Backward Vertical FDI into an industry abroad that provides inputs for a firms domestic production process. a.steel etc.means the advantage that arises from utilizing resources endowments of a foreign location. or generation of knowledge in a particular field or concentration of a type of industry in one place. Rebok etc setup their own sales units rather than display. mining . If competition is to be barred through backward vertical FDI then the amount required for investment is very high. Market Power :. Thus these firms decided to enter into oil exploration themselves. These companies had backward vertial FDI in order to supply raw material to their British & Dutch refining plants and when they undertook this investment neither had domestic oil supplies. The aim is to provide components to the main industry for its operations. VERTICAL FDI Can be in two forms. The most common argument is that by vertically integrating backward to gain control over the source of raw material input a firm can shut new competition out. which BP & Shell had. Why did these companies invest in Saudi Arabia & Kuwait and not import crude oil from them? That was therefore the Saudi & Kuwaiti firms did not have know how for oil extraction.consider the case of oil refining companies like BP & Royal Dutch Shell. In case of forward vertical FDI the decision is generally taken when a company enters a new market and does not find the distribution setup fit for its product or it fells that due to the presence of other brands their brand may not get the same exposure in the existing distribution network or other companies in the same industry have separate setup therefore they have to have separate setups too. 2) Forward Vertical FDI is investment into an industry abroad that sells the output of a firm¶s domestic production eg ± Nike. In this case a specialised asset is an asset that is designed to perform a .Location Specific Advantages :. This is generally seen in capital intensive industries like oil extraction. Thus when a firm makes investments in places where the resources for the purpose of their products are easily found it is known as LSA. They did not want to license the know to the Saudi & Kuwait firm as they would then be creating competition for themselves. LSA may not be in case only of natural resources but also in the form of skilled labour.The market imperfection approach offers two explanations for vertical FDI. Market imperfection :.Firms undertake vertical FDI to limit competition and strengthen their control over the market. Impediments to the sale of know-how :. b.

If the US firm set up plant in South Africa it always has fears of the South Africa firms not keeping its word or holding it at randsom. another aspect of pragmatic nationalism is the tendency to aggressively court FDI seen to be in national interest by offering subsidies tax breaks etc.specific task and can either not be used for any other task of its value falls significantly if it is put to any other use eg. Africa. but the US firm can reduce the risk by buying out the South Africa firm before making the investment. technology transfer and jobs that come at a cost. THE POLITICAL ECONOMY OF FDI 1) The Radial View ± The radical view has its root in Marxist theory. The aim behing this investment to get the benefits of low cost labour and relazed labour health liability which is not available in the US. The customer also benefits therefore he gets the product at a lower cost. and in China it creates employment and also helps transfer of latest technology. THE BENEFITS OF FDI TO HOST COUNTRIES . Thus to avoid these conditions they adopt a pragmatic approach and design policies to maximize the national benefits. Cuba. Pragmatic Nationalism ± Some countries follow neither a radical policy nor a free market policy towards FDI but a policy easily described as pragmatic nationalism. China. a US company has a diamond polishing unit that works on 98% purity the kind of diamonds found only in South Africa. skills. Radical writers argue the MNE¶s is an instrument of imperial dominance. Thus FDI is beneficial to both the source country and the host country. From 1945 to 1989 the radical view was very influential. They feel when goods are manufactured by a foreign company rather than by a domestic company the profits from those investment go abroad components may also be from the host countries. Iran & India which adopted tough policies restricting FDI. countries in Eastern Europe. THE FREE MARKET VIEW The free market view argues that international production should be distributed among countries according to the theory of comparative advantage within this framework MNE¶s are seen as instruments for distributing goods and services from places they are produced most efficiently e.g like shifts its manufacturing facilities from US to China and Indonesia where it set up state of art plants to manufacture the shoes and 90% of the China plants production is meant for the US market. they view FDI¶s as benefits like capital infusing. The argue that MNE¶s extract profits from the host country and take them to their home country giving nothing in calue to the host country. But the mines are owned by some company that lets the US firm set its plants on the promise that they will give them 80% of their capacity worth of diamonds to polish.

Some times it is believed that the jobs created due to FDI get offset by the loss in job opportunities due to loss of market by domestic players. THE COST OF FDI TO HOST COUNTRY 1) The Adverse Effects on Competition :. a) Current A/C record transactions that pertain to 3 categories the I) merchandise trade ie export and import of goods eg. Balance-of-payment-effects :. technology and management resources that would otherwise not be available. b) Technology . This may boost the countries economy.A countries BOP a/c keep track keeps track of both its payments to and its receipt form other countries. Thus driving them out of the market. get cheaper material and other resources thus making a difference in their cost of production an advantage that indigenous industry does not enjoy.Most Govts sometimes worry that the subsidiaries of MNE¶s operating in their country have more monetary power than indigenous competitors because they may be part of a larger international organization MNE¶s ar able to generate cheaper funds. MNE¶s due to their Global reputation are also able to borrow huge sums at lower ROI and can also easily borrow money through the stock/capital market. a) Capital :.The effect FDI has on the BOP is an important policy issue for the most host Govts.The critical role of technology in economic growth is well known less developed nations have to depend on developed countries and FDI for the purpose of acquiring technology which is very difficult for them to acquire due to high costs. There is also indirect jobs created by local suppliers. b) Capital A/C records transactions that involve the purchase/sale of assets.1) Resource Transfer Effects :. distributors and consultants to improve their own management skills. Employment Effect:. MNE¶s can also help local suppliers. BOP a/c are divided into two sections a) current a/c b) capital a/c. The benefits get highly reduced if the foreign company depends highly on expatrates. autos. computers ii) export & import of services iii) Investment income . c) Management ± The foreign management skills provided through MNE and FDI may produce important benefits for the host country.FDI can make a contribution to a host economy by supplying capital. chemicals.FDI¶s bring jobs to the host country that may otherwise not have been created. Particularly beneficial may be the spin-off effect. BOP a/c :. Thus if a Japanese company purchases stock in a US company the transaction enters the US BOP as credit on capital a/c that is therefore capital is flowing into the country. .MNE¶s by virtue of their large size and financial strength have access to huge sources of finance. The indirect employment effect is often larger.

Generally a large part of the input is imported from the parent country thus resulting in outflow of foreign ex. It is felt that the foreign firm come at set their business in the host country & after some time hold the host economy at randsom. 2) The Adverse Effects on BOP :. The second arises from the foreign firm importing a substantial number of inputs.There are two main areas of concern the first being that though investment flows in it also results in outflow of the profits on investment out of the country.Many countries feel that foreign investments result in loss of economic independence. It is felt that foreign investors have no real commitment to the host economy.Govt. . have restricted the level of outflow. sometimes impose import controls to let the local industry develop to a stage where it is capable of competiting with MNE¶s and if FDI¶s in the industry are allowed then the purpose of import controls are cost. Many Govt. 3) National Sovereignty & Autonomy :.

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