Foreign Direct Investment 14.1 DEFINITION OF FDI The International Monetary Fund (IMF) defines foreign direct investment (FD) asa category of international jnvestment where @ resident in one economy (the direct investor) obtainsa lasting jnterest in an enterprise resident in another economy (the: direct: investment enterprise). Two parts of this definition namely, the lasting interest implies the existence of a long-term relationship between the direct investor and the direct investment enterprise and a significant degree of influence 0% the management and the direct investment means the acquisition of at least 10 percent of the ordinary shares or voting power of an enterprise abroad. Direct investment involves both the initial transaction between the two entities and all subsequent capital transactions between them and among affiliated enterprises, both incorporated and unincorporated. ‘As per the Organisation for Economic Cooperation and Development (OECD), a foreign direct investor can be an individual, an incorporated or unincorporated public or private enterprise, a government, a group of related individuals, or a group of related incorporated and/or unincorporated enterprises that has a direct investment enterprise-that is, a subsidiary, associate or branch-operating in a country other than the country or countries of residence of the foreign direct investor or investors. ‘The numerical guideline of ownership of 10 per cent of ordinary shares or voting stock determines the existence of a direct investment relationship. ‘An effective voice in the management, as evidenced by an ownership of at least 10 per cent, implies that the direct investor is able to influence or participate in the management of an enterprise; it does not require absolute control by the foreign investor. However in a country like India, the ownership of 10 per cent of the ordinary shares or ieeepeertiny not lead to the exercise of any significant influence while, on the other ind, in some countries a direct investor may hold less than 10 percent buthave an effective say in the management.INTERNATIONAL FINANCIAL MANAGEMENT. ign asset: investment of foreign asse® © anisations. It does not include foreign inves 7 ‘ be more useful to a country to y generally though ve ity investments are potential jes because equity invest ee of trouble, whereas FDI is durable and long important driver of growth of a country’s economy. s s into the domestic structures, equipment, ang tment into the stock markets. FD] js than investments in the equity of its ly “hot money” which can leave at the Tasting. FDI is now recognised as an Hence, FDI is 14.2. MOTIVES FOR FDI yy improves their bottom line and profitability but also MNCs consider FDI as it not onl; e hances their share holders’ wealth. The most common motives of FDI are as follows: 1. Attract new sources of demand: When an MNC reaches a stage where further growth is limited in the home country, may be on account of saturation in the market or on account of intense competition, it may consider an alternate solution to enter foreign markets. Large corporations in the US, Europe and Japan consider India, China, and South American countries as an attractive source of destination. A number of developing countries have liberalised their economies paving way for FDI. MNCs __ perceive a huge demand for their products in these countries because historically, the consumers of these countries have been denied not only quality goods by the domestic producers but procurement of goods produced by firms from other countries were also restricted. Enter new markets: Market-seeking investment is attracted by factors like host country’s market size, per capita income and market growth. For MNCs, new markets provide a chance to stay competitive and grow within the industry as well as achieve scale and scope of economies. Traditionally, market size and growth as FDI determinants to national markets for manufacturing products sheltered from international competition by high tariffs or quotas that triggered “tariffjumping” foreign direct investment. Apart from market size and trade restrictions, MNCs might be prompted to engage in market-seeking investment, when their main suppliers or customers have set up foreign producing facilities and in order to retain their business they need to follow them overseas. Nv » Exploit monopolistic advantages: Monopolistic competition is a form of imperfect competition where many competing producers sell products that are differentiated from one another. Due to market imperfections, there may be several reasons why a firm wants to make use of its monopolistic advantage itself or organise an activity for itself. Theories have suggested that a firm overcomes market imperfections by creating its own market called as internalisation. Firms will become internationalise’ if they possess resources or skills not available to other competing firms. For example> 2 | Fonsicn Dinscr Iyvastueny 449 s developed a superior technology for manufacturing a product and ha an is ifa firm ha fully in local markets, it can attempt to exploit it on exploited this advantage succes a global level. de restrictions: Todo ba are basically government placed restrictions e most common sorts of trade barriers are taxes, and embargoes. Tariffs are a fairly common form ly taxes on goods as they cross the borders of a nation. Tariffs nearly always are placed on goods that are brought into the country, as opposed to goods sold as exports, although in some cases they may go both ways. Historically, tariffs were a large source of government revenue, as they could easily be collected as a tax on ships as they landed in the nation. Subsidies are another of the common trade barriers, and are often placed to protect domestic industries. Subsidies may actually be intended to make certain key goods affordable to domestic customers, but the end result can still be to make imports non-competitive. Agri commodities are heavily subsidised, to ensure that the common man has a constant supply of affordable food. An embargo can be seen as the most extreme step of trade barriers. Embargoes basically prohibit the import or export of anything with another country. Normally MNCs pursue FDI to circumvent trade barriers. |. React to tras on trade between nations. subsidies, tariffs, quotas, duties, of trade barriers, and are essentia By diversifying internationally, an MNC can make its net cash flow less volatile. The MNC can enjoy a lower cost of capital as the share holders MINC to be lower as a result of better cash flows. and creditors perceive the risk of the MNCs diversify to restructure their existing investments so as to achieve an efficient allocation of international economic activity of the firm and also to diversify risk arising out of differences in product and factor prices. Sometimes the MNCs may adopt a Divide and Rule culture that is to say an MNC having a plant in its home country may choose to have a foreign plant to improve its bargaining position versus local labour unions. This. permits the MNC to secure lower wages than if they remained domestic. Furthermore, choosing to havea plantin more than one foreign country may lower wages further. Thus, the firm is faced with a potential link between the wage rate and its degree of geographical diversification. Economies of scale: A MNC may like to increase its production capacity by bringing about a reduction in long run average and marginal costs. The firm may like to enter new markets to increase its earnings and shareholders wealth due to economies of scale. Sometimes the MNC can resort to economies of scale that are internal to it by way of cost reduction on account of superior technology and management factors. Forexample, the removal of trade barriers by thesingle European Act allowed MNC’s to achieve economies of scale in their operations. The removal of tariffs betw: Diversify internationally: een theIreRNATIONAL. FINANCIAL MANAGEMENT = ‘ 5 abled MNC’s to achieve economies of scale ata entre i EP ey i cessive cost of exports, aiigle European plant without incurring multiple and ex« i ‘ion: ject location and labour costs can vary from, 7. Use foreign factors of production: Project I Se atid SEIS oe peony et tas oe eae aly ane bour are cheap. Labour seel n b bee pretest one MNC’s from countries with high real labour costs, ang the MNC’s either set up or acquire subsidiaries in countries with a a labour costs to supply labour intensive intermediates or final products. On the other hand, to attract such production units, the host countries establish free trade zones or export processing zones. 8. Use foreign raw materials: When the transportation costs are exorbitant, an MNC may avoid to import the raw materials from a given country, if it has plans to sell the finished product back to the consumers in that specific country. Under such circumstances, it may be advisable for the MNCs to develop the product in that country where specific raw materials are available. 9. Use foreign technology: With the broadening and deepening of the knowledge sector in the developing countries, MNC’s located in the developed economies are increasingly establishing overseas production units or acquiring existing plants abroad to Iearn about the technology being adopted by these units in foreign countries. This overseas technology is then used by the MNC’s to optimise their cost of production and improve the over all efficiency of all the units and subsidiaries located across the globe. 10. React to exchange rate movements: When an MNC identifies that a foreign currency is currently undervalued, it may take a decision to consider foreign direct The level of the real exchange rate affects FDI in variou: i leve is Ways, depend: the destination of the goods Produced. If the investor aims at pe a ieeal Sark FDI and trade are substitutes, Various mechanisms then can be considered. An en bopotte ot US ae dur the depreciation of the dollar after 1985 has eoning literature, of which Froot and Stein (1991) j ion: a strong dollar is associated with low inward FDI in me US rene eectay Forston Dinter of the dollar increases the relative wealth of foreign firms and fy — to invest in the US in a context of imperfections on the capital marker hoe capacity ~ Alternatively, iFEDI aims at producing for re-export, it complements trade, and «, the local currency reduces FDI inflows through lower competitivencet a" of 11, Political and economic environment: MNC’s normally would li setup their facilities in countries that are politically stable Ree and High volatility ofthe political environment uncertainty ofthe economic envitomnen, ambiguity of the legal system and a high corruption index are deterring factors pe MNC to locate their plant abroad. ‘The ambiguity of the legal system and problems in establishing clear ownership rights and titles are of big concern to an MNC seeking cheap factors of production. The uncertainty in the legal system gets amplified if a foreign company has close links with local businesses, is of a smaller size and relatively of a younger age. Hence, improving the legal system will help the foreign companies to develop their operations with less trouble, and thus contribute to the host country’s development. c environment is the most harmful for the investors ecomes more significant for investors trying to roving the macroeconomic stability should be ent aiming to attract skilled labour and Rand the host The uncertainty of economi seeking skilled labour. The problem bi tap into the local R and D. Hence imp: of primary importance to the govern: Dseeking FDI, the types which are considered to bring the largest benefits to country’s development. 12. Market characteristics: The best way for an MNC to penetrate a foreign market is partially dependent on the characteristics of the market. Normally US companies diversify into Europe comfortably and with a lot of ease, as both the continents enjoy a number of similarities in their economic and cultural out look. But if the same US company wants to enter Asia, the investment pattern will be different as Asians prefer to buy products manufactured in their own sub-continent. Hence, it would be advisable for companies in US to set up joint ventures in Asian countries rather than setting up their own subsidiaries in these countries. 13, Benefits over time: As conditions change over time so do the possible benefits from pursuing FDI in different countries. With the passage of time some countries may become more attractive targets than others. For example, ineighties the US companies found Canada as the most attractive investment destination but in 2010, the US companies find Europe as the attractive investment destination on account of opening of the Eastern European countries economy.452___ INTERNATIONAL FINANCIAL MANAGEMENT 14.3 COSTS AND BENEFITS OF FDI When foreign investment flows from one country to another, it not only creates benefit, : both the home country and the host country but also involves cost to both the counties Thus, when an MNC decides to go in for foreign direct investment, it should take ; account the benefits and the cost to be accrued not only to its home country but alsy the host country. The host country role is also equally important as setting up an , production unit in a host country depends on the cooperation being extended by the Io, cal government and also the industrial and economic friendly policies of the host country also on a host of incentives being provided by the host country such as concession in allotment of land and other infrastructural facilities, and also tax and other benefits. The various benefits to the host country and the home country are presented below: 14.3.1 Benefits to the Host Country 1, FDI brings in scarce foreign exchange to the host country and activates the domestic savings that would not have been put into investment in the absence of the availability of foreign exchange. When a project requires a foreign exchange component, and i the absence of the same, the domestic savings remain idle. When the FDI is available, the foreign investors are ready to share the risk with the local investors, 2. FDI brings in top management skill to the host country and reactivates the entire gambit of economic and thought process thus spurring the economic growth of he host country. 3. Along with FDI, the foreign investors make available raw materials and technology to the host country. Sometimes the raw materials are transferred to the host country’s unit at book value that significantly improves the bottom line of production of the host country’s unit and enhances its profitability. Host countries always look for technology transfer for product innovation, mass production and. making available the products at a cheaper price to the domestic customers, FDI also brings in the needed foreign investment in the field of research and development. 4. Training and development of soft skill is of the domestic industry. Host countries improve their productivity and skillets, Paramount importance to the sustenance often encourage FDI flow because they can 5. FDI helps in the improvement of balance of inflow of investment is credited to its capitalForeicn Direct Investment 453 and the host country that is helpful world reputed bri eb 4 i res as the bridge between what hay rand in the future. ae 6, FDLalso brings in the ; i ts. Brand equity se in promoting oe at should happen t© the the brand in and wh of the host country. When e economic and . al it e 1s like the core infrastructure, social infrastructure and into the gear to build and utomatically gets inl for rapid industrialisation and economic x in contract farming encourages and setting up manufacturing rd linkages: FDI linkage and majority of the fosters both backward and forwa ; : eo moduction seevood grains as a backward linkage facilities in the processing of food items is 4 forward ority « MNCs look for an integrated approach. The MNCs make demand for various inputs that helps develop the inputindustry commonl known as the crowding effect. Foreign firmsemploy local labour forceand also make available quality, goodsata competitive price and thus help in improving, the living standards of the consumers. income for the host country government. Most s to the host government * 4 MNCs are definitely 4 S° ‘of the MNCs are known to pay their tax and other dues t promptly. MNCs also help reduce the government expenditure by supplementing the government's investment activities. Thus poor economies can divert their scarce resources to the much needed social sector. - urce of tax e fits to the Home Country 14.3.2 Benel 4. Thehome country getsa steady supply ofraw had made investment in the exploration of that material like the iron ore if the investor raw material. also gets finished products at a relatively lower cost. ents of the home country improves in that the parent company ividend, royalty and technology transfer fees. to its subsidiary sometimes form a significant 2. The home country 3, The balance of paym« gets a study stream 0} 4. The export of the parent company portion. 5. It id i i provi rena for the technical and other professional personnel of the 6. The government of the host count a OE ode -y generates revenue by way of tax on the dividend 7. FDI helps to fos iti ter b ic ti eit a oe sr better political and economic ties between the host country and454 _ INTERNATIONAL FINANCIAL MANAGEMENT 14.3.3 Cost to the Host Country 1. The outflow on account of imports and the remittance of dividend oversees, payment of royalty, technical service fees etc., weakens the balance of payments. 2. Raw materials like the mineral wealth of a country are exploited and this is detrimental to the interest of the home country in the long run. ei if ibsidiary at an exorbitant price The parent company can transfer technology to its sul ani or aia ae only bits and pieces of the technology so that the subsidiary or the joint venture is completely dependent on the parent company for the technology including the product innovation. Sometimes the technology transferred may be inappropriate to the home country and the cost in this regard has to be borne by the subsidiary in the home country. s The MNC may not enlarge the scope of local employment and may also not be interested in imparting skills to the local labour. a » MNCs may float the anti pollution norms including the environmental laws of the host country. N History has shown that the MNCs with their superior technology and enormous financial power tend to muzzle the voice of the local industry. 2 The MNCs tend to charge a higher price for their products in the local market in view of their oligopolistic position. 9. Some MNCs are so powerful that they are able to dictate the policies of the host country’s government. 14.3.4 Cost to the Home Country 1. The cost that would accrue to a home country is only very small. Making investment abroad certainly takes away the capital Sky management professionals from the home country,” NuS4 #bour and top At the end of the day, MNCs are only interested in maximisi i i ‘imising the id the shareholders wealth and may not care a damn about the host cou ee ee Very often this leads to strainii i i ih ‘aining of relationship between the host country and the home ™