Chapter 12 Foreign Direct Investment

1
International Business
Rakesh Mohan Joshi
Professor & Chairperson, IIFT New Delhi
Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

national Business R. M. Joshi Investment
Chapter 12
Foreign Direct
Investment
Learning Objectives
 To explain the concept of foreign direct
investment (FDI)
 To discuss various types of FDI
 To develop a conceptual understanding of
the theories of international investment
 To understand policy framework to
promote FDI
 To discuss patterns of FDI

Significance of FDI
International trade and foreign direct

investment (FDI) are the two most
important international economic activities
integrating the world economy. With the
increase in mobility of factors of production
across countries, FDI has become an
integral part of firms’ strategy to expand
international business.
Concept of FDI
In simple terms, FDI means acquiring

ownership in an overseas business entity.
Foreign direct investment occurs when an

investor based in one country (the home
country) acquires an asset in another country
(the host country) with the intent to manage
it.
Foreign Portfolio Investment (FPI)
An investment by individuals, firms, or a

public body in foreign financial instruments,
such as foreign stocks, government bonds,
etc.
In FPI, the equity stake in the foreign

business entity is not significant enough to
exert any management control.
Raison d’etre for FDI
 Cost of transportation
 Liability of foreignness

Benefits of FDI to Host Countries
 Access to superior technology

 Increased competition
 Increase in domestic investment
 Bridging host countries’ foreign exchange
gaps

Negative Impacts of FDI
 Market Monopoly
 Crowding-out and unemployment effects
 Technology dependence
 Profit outflow
 Corruption
 National security

Factors Affecting Selection of FDI
Destinations
 Cost of capital input
 Wage rate
 Taxation regime
 Cost of inputs
 Cost of logistics
 Market demand

Types of FDI
On the Basis of Direction of

Investment
Inward FDI: Foreign firms taking control over
domestic assets.
Outward FDI: Domestic firms investing overseas

and taking control over foreign assets.
On the Basis of Types of Activity
Horizontal FDI: Overseas investment in a similar activity as
carried out in the home country.
Vertical FDI: Overseas investment so as either to provide inputs
for the firm’s domestic operations or sell its domestic output
abroad.
• Backward Vertical FDI: Direct investment aimed at providing inputs
for a firm’s production processes.
• Forward Vertical FDI: Direct investment overseas aimed to sell the
output of a firm’s domestic production processes.
Conglomerate FDI: Direct investment overseas aimed at

manufacturing products not manufactured by the firm in the
home country.

On the Basis of Investment Objectives
Resource-seeking FDI: Direct investment
overseas so as to gain privileged access to
resources vis-à-vis competitor
Market-seeking FDI: Direct investment overseas
with sizeable market and growth in order to
protect existing markets, counteract competitors,
and to preclude rivals from gaining new markets
Efficiency-seeking FDI: Direct investment
overseas so as to improve efficiency and or seek
advantages of process specialization or product
rationalization

On the Basis of Entry Modes
Greenfield Investments: Overseas

investment to create new facilities or
expansion of existing facilities
Merger & Acquisitions (M&As): Transfer of

existing assets of a domestic firm to a
foreign firm that leads to mergers and
acquisitions.
On the Basis of Sector
Industrial FDI: Investment by a foreign firm in
the manufacturing sector.
Non-industrial FDI: Investment by a foreign firm
in services sector.

On the Basis of Strategic Modes
Export replacement
FDI is made as a substitute for exports in
response to trade barriers of the host
country, such as import restrictions and
prohibitive tariff structure.

Export Platforms
In order to minimize a firm’s cost of
production and distribution, FDI is made so
as to utilize the target country to serve the
global markets.

Domestic Substitution
FDI aimed to obtain cheap inputs to support
home production.

Theories of International
Investment

Capital Arbitrage Theory
FDI takes place due to differences in the
rates of return on capital across countries.

Market Imperfection Theory
To access countries with market imperfections, such
as government policies, including import restrictions
and quotas, incentives on exports, tax regimes, and
government’s participation in trade etc, FDI is often
employed as a strategic tool for international
business expansion.
Internalization Theory
When the know-how, technology, skills, or
trade secrets available with a firm are
crucial to the firm’s competitive advantage,
it needs to protect such knowledge base
within the organization. Therefore, it
expands internationally by way of FDI.

Monopolistic Advantage Theory
An MNE is believed to possess monopolistic
advantage, which enables it to operate
overseas more profitably and compete with
local firms.
International Product Life Cycle Theory
The theory provides an explanation as to

why the production locations are shifted
across countries and suggests that an MNE
prefers those countries for investment as
manufacturing locations that have market
size large enough to support local
production.
Eclectic Theory (OLI Paradigm)
It is a blend of macro-economic theory
of international trade (L) and micro-
economic theories of the firm (O&I).

The Ownership (O) Factor
Specific advantages possessed by a firm
enabling it to reap profits from overseas
investments.

The Location (L) Factor
Country specific advantage contributing to
relative attractiveness of an investment
destination

The Internalization (I) Factor
Retaining firm’s know-how within the
organization rather than transferring it to an
unrelated firm overseas.

Policy Framework to Promote FDI
Attracting FDI has become a key part of
national development strategies for most
countries. Such investments are often viewed
to augment domestic capital, employment,
and productivity, leading to economic growth.

Major Regulatory Measures & Incentives
to Promote FDI
 Screening, admission, and establishment
 Fiscal incentives
 Financial incentives
 Other incentives, such as subsidized
service fees, subsidized designated
infrastructure
 Performance requirements
Promotion of FDI in India
Institutional framework
The Department of Industrial Policy and
Promotion plays an active role in investment
promotion through dissemination of
information on investment climate and
opportunities in India. It also advises
potential investors about investment policies,
procedures, and opportunities and helps
resolve problems faced by foreign investors.

Policy Framework

•FDI Prohibited
• Retail trading (Except single brand product

retailing)
• Atomic energy
• Lottery business
• Gambling and betting sector
• Business of chit fund and nidhi company
• Plantation except tea
• Trading in Transferable Development Rights
(TDR)
• Activity/ sector not opened to private sector
investment
 FDI up to 24 per cent allowed
• Manufacture of items reserved for small
sector upto 24 per cent
• FM broadcasting
• Up-linking a news and current affairs TV
channels
• Defence production
• Insurance
• Publishing of news papers and periodicals
 FDI upto 49 per cent allowed
• Broadcasting
 Setting up hardware facilities
 Cable network:
 Direct to Home (DTH):
• Scheduled Air transport services

• Commodity exchanges
• Credit information companies
• Refining in case of PSUs
• Asset reconstruction companies
• Single brand product retailing

•FDI up to 74 per cent allowed
• ISP with gateways, radio-paging, and

end-to-end bandwidth
• Establishment and operation of satellites
• Private sector banking
• Telecommunications services
• Non-scheduled Air transport services,
ground handling services

Foreign direct investment up to 100 per
cent allowed with prior government
approval subject to conditions:
• Trading:
• Courier services
• Tea sector, including tea plantation:
• ISP without gateway, infrastructure
provider, electronic mail, and voice mail:
• Mining and mineral separation of titanium
bearing minerals and ores, its value addition
• Cigars and cigarettes manufacture
• Airports- existing projects with prior
government approval beyond 74 per cent
• Up-linking of a non-news and current affairs
TV channels
• Investing companies in infrastructure/
services sector (except telecom sector)
• Publishing of scientific magazines, specialty
journals and periodicals
 Foreign Direct Investment allowed up to
100 per cent under automatic route
• Agriculture sector
• Industrial sectors
 Mining
 Manufacturing activities
 Petroleum sector
 Power
 Special Economic Zones and Free Trade
Warehousing Zones
 Industrial Parks
 Construction development projects
• Services
• Civil aviation
• Non banking finance companies
• Trading
• In sectors/ activities not listed above, FDI is
permitted upto 100 per cent through
automatic route
Patterns of FDI
Flow of FDI: The amount of FDI undertaken over a

given time period (for example, a year). If the
investment is made by a foreign firm in a country,
known as inflow of FDI whereas investment made
overseas is termed as outflow of FDI.
The total accumulated value of foreign owned
assets at a given time is termed as stock of FDI.
FDI comprises of equity capital and re-invested
earnings as per IMF norms. Besides, capacity
expansion financed by firms of foreign origin as well
as short-term or long-term loans that form part of
original packages are also treated as FDI.

Components of FDI Flows
FDI is mainly financed by TNCs through

 Equity capital
 Intra-company loans
 Reinvested earnings

FDI Performance Indices
For carrying out cross-country comparison of
FDI performance and FDI potential, the
UNCTAD’s FDI performance and potential
indices serve as useful tools

Inward FDI Performance Index: Measure of
the extent to which a host economy receives
inward FDI relative to its economy size.
Outward FDI performance index: The ratio
of a country’s share in global FDI outflows to its
share in
the world GDP.

FDI Trends in India

Sector-wise Composition of FDI
Inflows
Figure : Sectorwise Composition of FDI Inflows*
S e rvic e s S e c to r
22.0%
o the rs
30.6%
C o m pute r S o ftwa re &

Ha rdwa re
11.5%
C he m ic a ls
2.3%
P e tro le um & Na tura l Ga s

3.1%
P o we r
M eta llurgica l Indus trie s 4.1%
Ho us ing & R ea l Es ta te Te le c o m m unic a tio ns C o ns truc tio n Ac tivitie s
3.7% 6.3% 6.7%
Auto m o bile Indus try 5.8%
4.0%
*Figures for April 2000 to May 2008

Source: Fact sheet on FDI, Department of Industrial Policy
and Promotion, Government of India, New Delhi, 2008
Country wise FDI Inflows
Figure: Country-wise Composition of FDI Inflows*
others
24.6% Mauritius
40.6%
UAE
1.1%
France
1.4%
Cyprus
1.7%
Germany
2.3% USA
Singapore
J apan Netherlands UK 7.6%
7.1%
3.1% 4.0% 6.5%
*Figures for April 2000 to May 2008

Source: Fact sheet on FDI, Department of Industrial Policy and Promotion,
Government of India, New Delhi, 2008

Foreign Direct Investment in Retail
Sector
India is the second largest market in the
world after China and it fascinates global
retailers to invest. It has opened up FDI
upto 51% in retail trade to “single brand
products” from Feb, 2006.


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Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

International trade and foreign direct

In simple terms, FDI means acquiring

Foreign direct investment occurs when an

An investment by individuals, firms, or a

In FPI, the equity stake in the foreign

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

 Access to superior technology

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

On the Basis of Direction of

Inward FDI: Foreign firms taking control over

Outward FDI: Domestic firms investing overseas

Conglomerate FDI: Direct investment overseas aimed at

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

Greenfield Investments: Overseas

Merger & Acquisitions (M&As): Transfer of

Industrial FDI: Investment by a foreign firm in

the manufacturing sector.

Non-industrial FDI: Investment by a foreign firm

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

FDI is made as a substitute for exports in

response to trade barriers of the host

country, such as import restrictions and

prohibitive tariff structure.

In order to minimize a firm’s cost of

production and distribution, FDI is made so

as to utilize the target country to serve the

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

FDI aimed to obtain cheap inputs to support

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

FDI takes place due to differences in the

rates of return on capital across countries.

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

To access countries with market imperfections, such

as government policies, including import restrictions

and quotas, incentives on exports, tax regimes, and

government’s participation in trade etc, FDI is often

employed as a strategic tool for international

When the know-how, technology, skills, or

trade secrets available with a firm are

crucial to the firm’s competitive advantage,

it needs to protect such knowledge base

within the organization. Therefore, it

expands internationally by way of FDI.

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

An MNE is believed to possess monopolistic

advantage, which enables it to operate

overseas more profitably and compete with

The theory provides an explanation as to

It is a blend of macro-economic theory

of international trade (L) and micro-

economic theories of the firm (O&I).

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

Specific advantages possessed by a firm

enabling it to reap profits from overseas

Copyright @ Oxford University Press Inter Chapter 12: Foreign Direct

Country specific advantage contributing to