Foreign Direct Investment: An Overview Essay

What is Foreign Direct Investment? Foreign direct investment (FDI) is defined as a long-term investment by a foreign direct investor in an enterprise resident in an economy other than that in which the foreign direct investor is based. The FDI relationship consists of a parent enterprise and a foreign affiliate which together form a transnational corporation (TNC). In order to qualify as FDI the investment must afford the parent enterprise control over its foreign affiliate. The UN defines control in this case as owning 10% or more of the ordinary shares or voting power of an incorporated firm or its equivalent for an unincorporated firm. Understanding Foreign Direct Investment Foreign direct investment (FDI) plays an extraordinary and growing role in global business. It can provide a firm with new markets and marketing channels, cheaper production facilities, access to new technology, products, skills and financing. For a host country or the foreign firm which receives the investment, it can provide a source of new technologies, capital, processes, products, organizational technologies and management skills, and as such can provide a strong impetus to economic development. Foreign direct investment, in its classic definition, is defined as a company from one country making a physical investment into building a factory in another country. In recent years, given rapid growth and change in global investment patterns, the definition has been broadened to include the acquisition of a lasting management interest in a company or enterprise outside the investing firm’s home country. As such, it may take many forms, such as a direct acquisition of a foreign firm, construction of a facility, or investment in a joint venture or strategic alliance with a local firm with attendant input of technology, licensing of intellectual property, In the past decade, FDI has come to play a major role in the internationalization of business. Reacting to changes in technology, growing liberalization of the national regulatory framework governing investment in enterprises, and changes in capital markets profound changes have occurred in the size, scope and methods of FDI. New information technology systems, decline in global communication costs have made management of foreign investments far easier than in the past. The sea change in trade and investment policies and the regulatory environment globally in the past decade, including trade policy and tariff liberalization, easing of restrictions on foreign investment and acquisition in many nations, and the deregulation and privatization of many industries, has probably been the most significant catalyst for FDI’s expanded role. The most profound effect has been seen in developing countries, where yearly foreign direct investment flows have increased from an average of less than $10 billion in the 1970’s to a yearly average of less than $20 billion in the 1980’s, to explode in the 1990s from $26.7billion in 1990 to $179 billion in 1998 and $208 billion in 1999 and now comprise a large portion of global FDI. Proponents of foreign investment point out that the exchange of investment flows benefits both the home country (the country from which the investment originates) and the host country (the destination of the investment). The push factors indicate the benefits to the investors and the pull factors to the host countries. First, international flows of capital reduce the risk faced by owners of capital by allowing them to diversify their lending and investment. Second, FDI allows capital to seek out the highest rate of return. Third, FDI helps to expand market. For the host countries, it can contribute to the general development as well as to the poverty reduction objective in a variety of ways. Major benefits to host countries are as follows: †¢ FDI allows transfer of technology—particularly in the form of new varieties of capital inputs—that cannot be achieved through financial investments or trade in goods and services. FDI can also promote competition in the domestic input market. †¢ Recipients of FDI often gain employee training in the course of operating the new businesses, which contributes to human capital development in the host country. †¢ Profits generated by FDI contribute to corporate tax revenues in the host country. Thus, it contributes not only to the direct source of investment but also to the government revenue. †¢ FDI helps to integrate the host countries economy to the global economy. Determinants of FDI FDI is the investment decision of profit-maximising firms facing world-wide competition and where significant differences in cost structures (due to say, factor productivity, wage differential) justify cross-border investment and production. a. Institutional features of the host country: degree of political stability and government intervention in the economy; the existence of property law legislation; the property and tax system; adequate infrastructure, etc. b. Economic factors: trade and investment regime; the degree of â€Å"openness† of the host countries, the absorptive capacity and growth prospects of the host country; fix and variable costs of production relocation; the degree of monopolistic competition which prevents the entry of other (domestic and foreign firms; general macroeconomic performance (inflation, monetary and fiscal policy) etc. c. Policy related factors: Fiscal (tax rebates and exemptions) and financial incentives (subsidized loans), laws that restrict FDI in certain sectors on the ground of political sensitivity of certain industries (oil, broadcasting, etc.); policy that restricts the degree of foreign ownership, (temporal or permanent) the remittance of interest, dividends and fees for technology and the shares allowed to foreign -owned firms through limits on capital repatriation, minimum investment, etc. d. Characteristics of the labor force: education, skills, etc. Some features of world FDI activity a. The sharp increases in world FDI activities that started after 1985. b. Increased activity and concentration of FDI. Indeed, in the 1990s, FDI has become one of the most important sources of external finance in developing countries. USA has become the largest host country in international capital markets, receiving capital from both Japan and Europe. Japan has emerged as a major home country of FDI outflows. c. Developing countries have liberalized financial markets and offered special incentives (lower taxes, subsidies for infrastructure, etc) to attract FDI in the hope of acquiring technological transfer, know-how, and in general, positive externalities. Basic types of FDI  · Greenfield investment: direct investment in new facilities or the expansion of existing facilities. Greenfield investments are the primary target of a host nation’s promotional efforts because they create new production capacity and jobs, transfer technology and know-how, and can lead to linkages to the global marketplace. However, it often does this by crowding out local industry; multinationals are able to produce goods more cheaply (because of advanced technology and efficient processes) and uses up resources (labor, intermediate goods, etc). Another downside of greenfield investment is that profits from production do not feed back into the local economy, but instead to the multinational’s home economy. This is in contrast to local industries whose profits flow back into the domestic economy to promote growth.  · Mergers and Acquisitions: transfers of existing assets from local firms to foreign firms takes place; the primary type of FDI. Cross-border mergers occur when the assets and operation of firms from different countries are combined to establish a new legal entity. Cross-border acquisitions occur when the control of assets and operations is transferred from a local to a foreign company, with the local company becoming an affiliate of the foreign company. Unlike greenfield investment, acquisitions provide no long term benefits to the local economy– even in most deals the owners of the local firm are paid in stock from the acquiring firm, meaning that the money from the sale could never reach the local economy.  · Horizontal Foreign Direct Investment: investment in the same industry abroad as a firm operates in at home.  · Vertical Foreign Direct Investment: Takes two forms: 1) Backward vertical FDI: where an industry abroad provides inputs for a firm’s domestic production process. 2) Forward vertical FDI: in which an industry abroad sells the outputs of a firm’s domestic production. FDI based on the motives of the investing firm FDI can also be categorized 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 are more efficient than those obtainable in the home economy of the firm. In some cases, these resources may not be available in the home economy at all (e.g. cheap labor and natural resources). This typifies FDI into developing countries, for example seeking natural resources in the Middle East and Africa, or cheap labor in Southeast Asia and Eastern Europe.  · Market Seeking: Investments which aim at either penetrating new markets or maintaining existing ones. FDI of this kind may also be employed as defensive strategy; it is argued that businesses are more likely to be pushed towards this type of investment out of fear of losing a market rather than discovering a new one.  · Efficiency Seeking: Investments which firms hope will increase their efficiency by exploiting the benefits of economies of scale and scope, and also those of common ownership. It is suggested that this type of FDI comes after either resource or market seeking investments have been realized, with the expectation that it further increases the profitability of the firm. Importance of FDI Making a direct foreign investment allows companies to accomplish several tasks: Avoiding foreign government pressure for local production. Circumventing trade barriers, hidden and otherwise. Making the move from domestic export sales to a locally-based national sales office. Capability to increase total production capacity. Opportunities for co-production, joint ventures with local partners, joint marketing arrangements, licensing, etc. What do companies considering FDI require? Depending on the industry sector and type of business, a foreign direct investment may be an attractive and viable option. With rapid globalization of many industries and vertical integration rapidly taking place on a global level, at a minimum a firm needs to keep abreast of global trends in their industry. From a competitive standpoint, it is important to be aware of whether a company’s competitors are expanding into a foreign market and how they are doing that. At the same time, it also becomes important to monitor how globalization is affecting domestic clients. Often, it becomes imperative to follow the expansion of key clients overseas if an active business relationship is to be maintained. New market access is also another major reason to invest in a foreign country. At some stage, export of product or service reaches a critical mass of amount and cost where foreign production or location begins to be more cost effective. Any decision on investing is thus a combination of a number of key factors including: assessment of internal resources, competitiveness, market analysis market expectations. From an internal resources standpoint, does the firm have senior management support for the investment and the internal management and system capabilities to support the set up time as well as ongoing management of a foreign subsidiary? Has the company conducted extensive market research involving both the industry, product and local regulations governing foreign investment which will set the broad market parameters for any investment decision? Is there a realistic assessment in place of what resource utilization the investment will entail? Has information on local industry and foreign investment regulations, incentives, profit retention, financing, distribution, and other factors been completely analyzed to determine the most viable vehicle for entering the market (greenfield, acquisition, merger, joint venture, etc.)? Has a plan been drawn up with reasonable expectations for expansion into the market through that local vehicle? If the foreign economy, industry or foreign investment climate is characterized by government regulation, have the relevant government agencies been contacted and concurred? Have political risk and foreign exchange risk been factored into the business plan? Policies to attract Foreign Direct Investment There is keen competition among developed and developing countries to attract foreign direct investment (FDI).This drive to lure investment often extends to the sub national level, with different regional authorities pursuing their own strategies and assembling their own baskets of incentives to attract new investments. Various reforms and strategies have been implemented, with mixed results. Some are critical of the high costs of many of these initiatives, arguing that it would be more rewarding to improve a country’s general business environment. The many different methods used by policymakers to attract FDI and their effectiveness are as follows:  · providing targeted fiscal incentives, such as tax concessions, cash grants, and specific subsidies;  · improving domestic infrastructure;  · promoting local skills development to meet investor needs and expectations;  · establishing broad-reaching FDI promotion agencies;  · improving the regulatory environment and decreasing red tape; and  · engaging in international governing arrangements. Promotional efforts to attract foreign direct investment (FDI) have become the important point of competition among developed and developing countries. This competition is also maintained when countries are adopting economic integration at another level. While some countries lowering standards to attract FDI in a â€Å"race to the bottom,† others praise FDI for raising standards and welfare in recipient countries. Countries have adopted their respective policies for attracting more investment. Some countries rely on targeted financial concessions like tax concessions, cash grants and specific subsidies. Some countries focus on improving the infrastructure and skill parameter and creating a base meet the demands and expectations of foreign investors. Others try to improve the general business climate of a country by changing the administrative barriers and red tapism. Many governments have created state agencies to help investors through this administrative paperwork. Finally most of the countries have entered into international governing arrangements to increase their attractiveness for more investment. Sound investment climate is crucial for economic growth. Microeconomic reforms aimed at simplifying business regulations, strengthening property rights, improving labor market flexibility, and increasing firms’ access to finance are necessary for raising living standards and reducing poverty in a country. Reform is necessary for creating an investment-oriented climate. Reform management matters as investment climate reforms are done politically. They often favor unorganized over organized groups and the benefits tend to accrue only in the long term, while costs are felt up front. Political decisions play a significant role in this context. Each and every country over the globe is stepping forward to change the climate for attracting more investment. Opening up of doors by most of the nations have compelled them for adopting reforms. Relaxation of rules and regulations, of course, is an essential requirement but not sufficient on its own to bring in FDI. As the study points out, business rules in India still bar FDI in most sectors. It was only last February that the government there decided to allow FDI of upto 51 percent in the single brand retail sector, which is expected to trigger a new flurry of investment. As things stand, Pakistan is far ahead of India in terms of offering all kinds of incentives to foreign investors – although some administrative bottlenecks still remain to be removed. It also boasts a high economic growth rate and there exists a consensus among all political forces on following the market economy model. Still, it has failed to catch the fancy of foreign investors at the desired level. The designated target was to raise foreign investment from 1 billion dollars to 27 billion dollars during a five-year period. That target is nowhere near realization. The government claims to have brought foreign investment to the 3 billion dollars mark this year. But that is a fallacious claim since the money has come in on account of privatization of government-owned entities. There has only been a transfer of assets from the public sector into private hands; no new generation of activity in the retail or production sector, which is badly wanted to address the twin problems of poverty and unemployment. The situation underscores the need not only to remove administrative hurdles but also to create ease of operations vis-à  -vis law and order and the socially restrictive atmosphere.