Foreign Direct Investment

Foreign Direct Investment

Definition
•Foreign Direct investment is a process whereby residents
of one country (source country) acquire ownership of
assets in another country for the purpose of controlling
production and distribution and other activities
•IMF defines FDI as an investment that is made to acquire
lasting interests (10% or more of shares) in an enterprise
operating in an economy other than that of an investor, the
investor’s purpose being to have a voice in the
management of the enterprise
•Broadly, FDI includes mergers and acquisitions, building
new facilities, reinvesting profits earned from overseas
operations and intra company loans
•A firm that engages in FDI becomes a multinational
enterprise (multi=many, so multinational means operating
in more than one country)
•FDI may be for production, marketing, service provision,
research and development, or for access to raw material
•When a company owns only a smaller percentage of
shares (<10%), it will have no managerial involvement
• It is known as portfolio investment
Types of FDI
•There are three types of FDI: Greenfield investment,
Merger and Acquisition (M&A) and Brownfield investment
1.Greenfield investment: The term "green field investment"
refers to the type of FDI where a company builds operations in
a foreign market starting from scratch, or a so-called green
field.
• These projects are FDIs that provide the highest degree
of control for the sponsoring company when compared
to other methods of FDI, such as foreign acquisitions
Types
2.Merger and Acquisition: This involves either
• A purchase of an operating company abroad or
• An amalgamation with a running foreign company
For a merger: the acquiring company maintains its
existence and the target company loses its existence
For an amalgamation: both lose their existence in the
favour of a new company
Mergers and acquisition are either horizontal or vertical
conglomerate
Types
•Horizontal Conglomerate: is a type of merger and
acquisition when two or more firms that engage in similar
activities combine
•Vertical conglomerate: is the type of merger and
acquisition when two firms that are in different stages of
production of a single final product combine, e.g. oil
exploration with a refinery
3.Brown Field Investment: is a combination of greenfield
and M&A to replace plant and machinery in the target
company
Global Trend in FDI (Figures in Billions of $)
FDI in the World for 2016
FDI in the Top ten recipients (Figures in Billions $)
FDI to Developing economies fell in 2016
Reasons
1.Slowing economic growth affecting the starting of new
businesses and discouraging M&As
2.Falling commodities prices discouraged raw material seeking
FDIs
Trend of Greenfield and Cross Border M&A FDIs
Theories of FDI
MacDougall Kemp Hypothesis
•According to the hypothesis FDI moves from capital abundant
economy to capital scarce economy till the marginal production
is equal in both countries
•This leads to improvement in efficiency in utilization of
resources, and ultimately increase in welfare
•FDI is a result of differences in capital endowments
•It was developed by MacDougal (1958 and elaborated by Kemp
1964)
Theories of FDI
Industrial Organization theory
•According to this theory, MNC with superior technology moves
to different countries to supply innovated products and make
big profits
•Krugman (1989) points out that it was technological advantage
possessed by the European countries which led to massive
investments in the USA
•Technological superiority is the main driving force for FDI
rather than capital abundance according to IOT.
Theories of FDI
Currency Based approach
•A firm moves from strong currency country to weak currency
country
•Aliber (1971) postulates that firms from strong currency
countries move out to weak currency countries
•Froot and Stain (1989) holds that depreciation in real value of
currency of a country lowers the wealth of domestic residents
vis a vis the wealth of foreign residents, making it cheaper for
foreign firms to acquire assets in such countries
•So FDIs move from strong currency countries to weak ones
Theories of FDI
Location Specific Theory
•Hood and Young (1979) stress on the location factor
•According to them, FDI moves to countries with abundant raw
materials and cheap labour force
•Since real wage cost varies among countries, firms with high
technology move to low wage countries
•Abundance of raw material and cheap labour force will attract
FDI to flow to those countries
Theories of FDI
Product Cycle Theory
•FDI takes place only when the product in question achieve
specific stage in its life cycle
•Vernon (1966) points out that any product passes through the
stages of Introduction, growth, maturity and decline stage
•At maturity stage, the demand for the product in developed
countries grow substantially and rival firms enter production
•To compete with rivals, innovators set up production in host
countries to save on tariffs and transport costs
Theories of FDI
Political Economy Theories
•These concentrate on political risks
•Political stability in the host country leads to higher inflows of
FDI
•Fatehi-Sedah and Safizeha (1989) are the authors of this theory
•A similar theory by Tallman (1988) emphasized that political
instability in the host country encourages FDI in other countries
Why do Multinationals Invest overseas
•John Dunning (1977) identifies four reasons
1.Market Seeking (horizontal): Firms invest overseas to take the
advantage of markets of greater dimensions
• When producers have saturated sales in their home
market the only way to expand is to invest overseas,
especially when the producers believe that investment
overseas will bring higher returns than additional
investment at home
• “the minimum size of market needed to support technological
development in certain industry is now larger than the largest
2.Resource Seeking (vertical):
•A company may find it cheaper to produce its product in a
foreign subsidiary for the purpose of selling it either at home or
in foreign markets
•So a multinational may aim to acquire particular types of
resources that are not available at home (natural resources or
raw materials) or that are available at a lower cost (such as
unskilled labour that is offered at a cheaper price than at the
home market
•Less costly access to inputs of production attracts MNEs
3.Strategic Asset Seeking
•The purpose of the investment is that of acquiring and
complement a new technological base rather than exploiting the
existing asset
•The firm seeks to gain access to knowledge or competences
that are not inside it
•This may involve partnerships with other existing foreign firms
that specialize in certain aspects of production
4.Efficiency Seeking
•The firm may invest overseas to take advantage of differences
in the availability and costs of traditional factor endowment in
different countries
•The firm may also seek to take advantage of the economies of
scale and scope, of differences in consumer tastes and supply
capabilities
•The firm may also seek to lower tariffs, or to follow a more
favourable exchange rate
How to Invest Abroad: Modes of Involvement
Multinational Corporations operate in the following ways:
1.Franchising
•In this form, multinational corporation grants firms in foreign
countries the right to use its trademarks, patents, brand names
etc.
•The firms get the right or licence to operate their business as
per the terms and conditions of franchise agreement
•They pay royalty or licence fee to multinational corporations
•In case the firm holding franchise violate the terms and
conditions of agreement, the licence may be cancelled
2.Branches
•In this system, multinational corporation open branches in
different countries
•The branches work under the direction and control of head
office
•The headquarters frames policies to be followed by the
branches
•Every branch follows laws and regulations of the head office
and host company
3.Subsidiaries
•A multinational corporation may establish wholly owned
subsidiaries in foreign countries
•In case of partly owned subsidiaries, people in the host
countries also own shares
•The subsidiaries in foreign country follow the policies laid down
by the holding company (parent company
•A multinational company can expand its business operations
through subsidiaries
4.Joint Venture
•In this system a multinational corporation establishes a
company in foreign country in partnership with local firms
•The multinational and local firm share the ownership and
control of the business
•Generally, the multinational provides technology and
managerial skill and the day to day management is left to the
local firm
•E.g. Maruti Suzuki is a joint venture between the Japanese
Company Suzuki and the Indian Company Maruti
FDI in Developing Countries
The data from UNCTAD shows

•Developing countries are not the major recepients of FDI
•Asian Developing countries receive far more FDI than the other
developing countries
Factors that determine the FDI flow
1.Growth Rate and openness to trade
•Countries with high growth rate and more open to global
market through international trade are more likely to be
successful in attracting FDI than others
•Market seeking FDIs prefer investing in these countries because
of large internal market
•These save on transport and marketing costs
•However, if they target a market other than local, then
openness to trade is a huge factor
2.Business Environment
•Countries that provide better business friendly environment
receive more FDI
•MNCs seek to invest where input costs and operation costs as
well as hidden costs are low
•MNCs seek places where skilled-labour is plenty and low cost
•MNCs seek to invest where infrastructure is developed:
electricity is available and reliable, transport and
communication efficient and
•MNCs seek destinations where investment rules are friendly
3.Foreign Aid Recipients
•It is argued that countries that receive foreign development aid
tend to welcome FDI
•They have more friendly environment that assures the MNCs of
safe and profitable investment destination
•They have lower political risk: Since they depend on aid, it is
difficult for them to nationalize the assets invested in FDI
Foreign Direct Investment and Country Risk
•Country Risk refers to the whole environment of uncertainty
about the returns that an investor is dealing with in a particular
country
•There are two major types of Country risk that are of concern
to multinational: Political risk and Financial Risk
•Political Risk is the risk that returns to investment may suffer
as a result of low institutional quality and political instability
•Low institutional quality: refers to inadequacies and loopholes
in laws and mechanism of enforcing the law (in this case that
pertains to business operations)
•Low institutional quality: affect the operations of MNC in the
following way
1.Increase sunk costs: this includes such costs in the initial
stages of a business transaction such as cost of acquiring
information
2.Increase uncertainty associated with human interactions:
• In this case it is about whether or not the contracts
agreed upon are going to be fulfilled
• Such environment causes the risk premiums to be high
3.Increase operating costs due to long delays, red-tape, bribes
•Political Instability
•This refers to the situation where there are ethnic tensions,
internal conflicts, lack of law and order, lack of democratic
accountability, high corruption, and lack of government stability
•All these cause an environment of uncertainty and hence repel
the FDIs
•Financial Risk
•This is the risk that a country may not pay its foreign liabilities
•Financial risk is normally caused by the macroeconomic
conditions of the country, especially the situation of high debt,
high inflation and exchange rate instability
•High Debt relative to GDP reduces the ability of the country to
pay its debts
• This condition does not attract FDI
•Exchange rate instability and High inflation
• These cause uncertainty in the financial plans of the MNC
Advantages of FDIs to Developing Countries
A. Resource Transfer Advantages
1.Capital: MNCs are large and strong financially, and can have
access to financial resources not accessible to host country firms
• This could be from their own internal sources or
because of their reputation
2.Technology: many developing countries lack research and
development resources and skills required to develop their own
indigenous products and processes
• FDI coming through MNC can bring that technology
3. Management: Foreign management skills can be acquired
through FDI.
• This is especially when host government forces MNC to
reserve managerial positions for the local managers
• Sometimes the local managers trained by MNCs can move
to foreign firms
B. Employment Effects: FDIs bring jobs to a host country that
would not otherwise be created there: Direct effect is the
employment of citizens, indirect effect is through job creation
due to investment and spending by MNC employees
C. Balance of Payment Effects
Generic Balance of Payments
A Current Account
1 Net Exports/imports of goods (trade balance)
2 Net exports/imports of services
3 Net transfers (sums sent home by migrants and permanent workers abroad & gifts
A 1 to 3 = Current Account Balance
B Capital Account (capital transfers: purchase and sale of fixed assets e.g. real estates)
C. Financial Account
1. Net Foreign direct investment
2. Net Portfolio investment
3. Other financial items
A+B+C = Basic balance
D. Net Errors and Omissions (missing data such as illegal transfers)
E. Reserves and related items (changes in official reserves including gold, foreign exchange and IMF position)
C. Balance of Payment Effects
When a MNC establishes a foreign subsidiary
•Capital account of the host country benefits from the initial
capital inflow – a one-time-only effect
If the FDI invests in the production of a good that is a substitute
for imports
•It can improve the balance of the current account of the host
country balance of payments
• e.g. If Toyota builds a factory in Tanzania, Tanzanians will
be buying cars locally produced – reducing imports
D. Effects on Economic Growth
•Efficient functioning of markets depends on an adequate level
of competition among producers
•FDI increases consumer choice and hence competition level in
the national markets
• Prices will be reduced and economic welfare improve
•Increased competition stimulates investment in factories,
equipment and Research and development
•Long term result is: increased productivity, product innovations
and ultimately economic growth
Disadvantages of FDIs to Developing Countries
Adverse effects on Competition
1.Multinationals are strong financially and technologically
• They have thus the advantage of being able to produce at
low cost
• This may drive local competitors out of business and let
the MNC monopolise the market
• This is of special concern to businesses of developing
countries
2.Threat to infant industries
• Indigenous infant firms may not be able to develop
Adverse effects on the Balance of payments
If multinationals are not properly regulated
1.All profits will be outflowing to the home country
• These will be recorded as debits on the capital account of
the balance of payments
2.The foreign subsidiary will import a substantial number of its
inputs from abroad, which results in a debit on the current
account of the host country’s balance of payment
Effects to national sovereignty and autonomy
Many host governments worry that FDI is accompanied by some
loss of economic independence
•Many key decisions that affect the host country’s economy will
be made by a foreign parent company
• That has no real commitment to the host country and
• Over which the host country government has no control

Foreign Direct Investment

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Foreign Direct Investment

The data from UNCTAD shows

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