Concepts of Foreign Direct Investment

Foreign Direct Investment (FDI) is the method in which multinational companies add control or ownership of manufacturing amenities in other nations. When a company has control over a foreign company in having in it a stake of more than 10% of its equity, the former company is known as the parent company and the latter becomes the foreign affiliate. Foreign Direct Investment (FDI) is the capital invested that gives rise to sustained influence by the parent company over the management of the affiliate company.

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In broader terms, FDI comprises of the creation or acquisition of assets such as equity, houses, buildings, land, oil drilling rigs etc. as assumed by foreign companies. Such arrangements are called joint ventures when the companies act together with the local governments or firms. FDI outflows from a country imply that the country is exporting capital to buy or build production facilities, the ownership of which will remain vested with the investing company.

A country that attracts inflow of FDI is making a connection with world trading networks in financing its development goals. A company becomes a multinational company (MNC) because of the FDI process and the converse is also true in that a company which is already a MNC will generate a large number of FDI flows. This paper will examine the different concepts of FDI and how they relate to the concept of globalization from the perspective of free trade and global finance. The pattern of total, inward and outward FDI in regard to the five major economies of USA, EU, China, India, and Brazil will also be examined. Finally an analysis will be made of the future of FDI once the global recession is over.

FDI essentially has three constituents; equity capital, reinvested earnings and intra company loans. FDI is the flow of capital which is long term and leads to creation of property rights on the assets that are bought or built. FDI is considered to be heterogeneous and there are different means to invest in keeping with the purpose of the activity. The activities financed in the host country could be in an intermediary phase within a longer production process or could be leading to the manufacture of finished goods. It could also be for the purpose of designing, manufacturing and distribution in being part of the production phase for goods and services.

Typically, FDI entails the setting up of manufacturing facilities in using foreign technologies and management techniques so as to exploit the availability of low cost resources in the host country. Sales of the finished products continue to be made to the current customers of the MNCs, thus adding to the exports figures of the host country. However FDI is a resource for other market oriented activities also such as transport, banking and tourism.

From the investor’s point of view, a firm makes investment in foreign countries for several reasons. Upstream integration implies buying out a provider whose products will be then sold to it at lesser rates or be moderately altered as per features desired by the investor. By way of horizontal integration a company that makes the same product can be purchased in order to expand production facilities and to reduce costs thus leading to economies of scale.

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The investing company can use downstream integration by buying a company that uses or distributes its products so as to get value in its chain and to assertively push through its distribution process. An investor company can also purchase a firm in keeping with its diversification plans to exploit new opportunities. It is beneficial in bringing FDI for a firm that is exporting to a particular market and then deciding to build manufacturing facilities in that market to avoid tariffs and to reduce transport costs.

A country will have high outflows of FDI when companies that have a strong capital base start realizing that other countries have investment conditions that are more favourable. Exchange rates may be high in the historical perspective which makes it cheaper to buy out foreign firms. A country may be encouraged to go for larger FDI outflows when its trade balance is favourable whereby there is a positive Balance of Payments situation.

There will be increased inflow of FDI in a country when it becomes a financially attractive destination for MNCs. Such attractions relate to the host country’s GDP being high with a huge market potential. The country has advanced technical know how and there is availability of a skilled work force. Wages and cost of labour in such countries will be low and the rate of taxation would also not prove to become a pinching factor. Such countries will not be characterized in having high levels of environmental protection while tariffs will be amply protected. The laws of the country would be favourable in keeping with public incentives.

When companies bring in FDI into a country and construct new facilities for production activities instead of buying out the available facilities, they are in fact engaging in Greenfield Investments. Such investments create more jobs in the construction of the facilities and in the enrolment for the business once it starts running. The new facilities are welcomed by the respective governments since they result in more tax revenues.

But more companies prefer to bring in FDI by way of mergers and acquisitions (M&A) instead of the Greenfiled Investments since M&As are faster to take place. In a M&A, the work force and production facilities are already existing and the transfer takes place immediately which implies that the business can be commenced immediately. The speed with which formalities are completed and production is commenced has a very important bearing on the success of FDI. Another advantage of M&As pertains to the fact that when an existing company is purchased, the company already has control over a section of the market segment.

M&As entail that the management, technology and other innovative techniques of the acquired company come into the hands of the buyer company thus enabling immediate access to these important requirements of business. In recent times most of the conventional barriers to FDI have been eliminated, relaxed or reduced through treaties between different countries. Most developing countries have already made amendments in their existing regulations to attract larger FDI so as to give a boost to their economies. This is amply evident from the following table

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Regulatory Changes and FDI, 1991 to 2000.

By the year 2000, there were 1800 bilateral investment treaties operating between different countries, which imply that there were significant positive developments in the number of FDI proposals being accepted throughout the world.

Free trade, global finance and Foreign Direct Investment have now become the pillars of globalization in becoming deeply ingrained within the global economy to an extent that has never been experienced before in history. It is thus not surprising that the developed economies of the world accounted for a major share of the activities in all these spheres. The quantum of international trade had reached record levels in 2000 whereby exports were valued at over $7.6 billion.

According to the World Trade Organization, between 1990 and 2000 there was an annual growth rate of 6% in exports mainly accounted for by the developed economies of the world? The pivotal role of the developed countries in this regard becomes more apparent if we compare the volume of exports by them with that of other countries. For example the total exports by the US in 2000 crossed $1 trillion, which is more than six times the total exports from the entire African continent during the same period. Western Europe had total exports of over $3 trillion which was about 8.5 times the total exports emanating from all the Latin American countries. A summary of the major exporters and importers is given in Table II below.

The World’s Top Exporters and Importers: 2000.

Trends up to the year 2007 showed that there has been large scale flow of funds across capital markets through out the world. Global finance is characterized by a vast variety of financial institutions that engage in financial operations between and within nations. A number of principal capital markets in the world comprise of banks, securities markets, Non bank Financial institutions, markets that sell and buy government securities and foreign exchange markets that buy and sell currencies of different countries.

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Presently the conventional differences between financial institutions have been diluted considerably with the elimination of barriers and restrictions to the free transfer of capital between nations. Other actors such as MNCs have joined the fray in providing a wide array of financial services in the global markets. Banks along with depository institutions have become major players in the capital markets of the world. Banks can considerably influence the world economy by using their ability to lend.

For example, banks in the USA have for long been conducting the business of granting loans to governments and foreign companies. Many American banks have opened branches across the globe in accelerating their commitments in providing loans in the world markets. This way banks have expanded their ability in reaching out to new customers as also provided borrowers with a wider choice in seeking loan products that specifically cater to their needs (UNCTAD, 2006).

Another major component of the international capital markets is firms that deal in securities. In contrast to banks, securities firms do not grant loans nor do they attract deposits. They instead invest their clients’ money and it has now become a common practice with these firms to operate from several countries at the same time. Advancements in communication technology have made it possible for securities dealers to have immediate access to global securities markets. Online trading in securities has made the process much faster and less expensive. Internet has enabled the availability of massive financial information for investors to judge the potential of different investments. Hence securities trading and investment has become a 24 hours activity through out the world.

Foreign exchange markets also play an important role in the international network of capital markets. The contrasting element of these markets relates to dealing with national currencies which are traded in facilitating international trade. However most of the transactions in these markets are done by people who wish to capitalize on the propensity of particular currencies to appreciate against others over time. These transactions are facilitated by commercial banks, foreign exchange markets and investment banks, and other financial institutions.

Until the year 2007, EU outflows of FDI continued to increase and rose from EUR 234 billion in the previous year to EUR 260 billion. In 2005 there was a growth in FDI outflows from the EU by 65% as compared to the previous year. However there was a decline between 2001 and 2004. Inflow of FDI has also shown an increase in the EU during the last few years and it was only in 2006 that the inflows increased by 24%. In essence the EU is a net investor in that its outflows far exceed the inflows. In 2007 the FDI outflows exceeded the inflows by EUR 103 billion and in 2006 they had exceeded by EUR 108 billion over the previous years respectively. (Masahiro Kawai, 2007).

­­­­­­­­­­­­­­­­­ As regards the US, FDI has been used by MNCs, whereby American companies have been acquiring production facilities in other countries. Most of the engagement of US companies since the later part of the 20th century has been in the outflow of FDI in efforts to find cheaper modes of production and to reduce costs in order to compete in the world markets and to cope with the challenges imposed by emerging economies.

During the period 1986 to 2000, while the average GDP grew by 2.5 percent, exports grew by 5.6 percent and actual FDI inflows grew by 17.7 as a world average. It was initially the major MNCs that partook in most of the FDI flows. According to Bernard, Jensen and Schott, 90% of the exports and imports flows of the US take place through MNCs or their affiliates (A.B. Bernard et al, 2005). The FDI outflows had reached $252 billion in 2004 which was an increase from the previous year’s figure of $141 billion. It was during 2004 that US companies developed the maximum interest in acquiring corporate assets in foreign countries.

Since 1992 the FDI in China has undergone rapid growth and the country has consistently been the largest recipient of foreign investments. There were important changes in the patterns of FDI in China. In recent times however the inward investments emanating from ASEAN countries have reduced considerably and the share of the US and EU countries have been consistently increasing. Most of the FDI was initially centred on the labour intensive manufacturing industries, and after the investments in these sectors reached a saturation point, focus began to be made on industries that were technology intensive (Lardy N, 1996).

While inward FDI initially focused on the labour intensive industries in Guangdong province, developed countries began establishing technologically advanced production facilities in Jiangsu and Shanghai which continue to be the largest recipients of FDI in the country. China did not engage in outward FDI to a large scale except for small manufacturing facilities in some South East Asian countries. After China became a member of the WTO, FDI into the country continued to increase at a substantial rate and mergers and acquisitions became a vital part of foreign investments, especially in the services sector. However with the onset of the global recession, there have been adverse impacts at the micro and macro levels and Chinese authorities continue in their struggle to recoup the economy.

The Indian economy’s dynamism in a world that is quickly globalising is well recognized by a large number of researchers in recent times. After India adopted new reforms for its economy in the 1990s, there have been considerable changes that have made the economy look up in assuming a strong economic status amongst the developed countries of the world. The country has developed its economic capabilities in keeping with the expectations of the global economy. There have been a large number of mergers and acquisitions at the instance of MNCs from the US and several other companies from Europe and ASEAN countries (Hari Sud, 2006).

Going by available statistics, FDI in India has been picking up at a fast rate during the last four years although the current economic downturn has temporarily slowed international corporations in seeking partnerships in India. The inward FDI flows amounted to $3.75 billion in 2003-2004, and had increased to $4.67 billion during 2004-2005. During the last financial year, while in other parts of the world FDI inflows were declining, India witnessed an increase of 40% (Ranabir Ray Choudhury, 2005). India has been a latecomer to FDI and its share is not much but the opening up of the economy has initiated a fast rate of FDI inflows into the country as can be witnessed from the following tables.

Table III. FDI inward stock ($ Billion).

1990 2000 2004
World 1769 5781 8895
Developing Economies 364 1734 2226
India 1.7 17.5 38.7

Table IV. FDI outward stock ($ billion).

1990 2000 2004
World 1785 6148 9732
Developing Economies 147 869 1036
India 0.1 1.9 6.6

Table V – FDI inflows ($ billion).

1992-97* 1998 1999 2000 2001 2002 2003 2004
World 310.9 690.9 1086.7 1387.9 817.6 716.1 632.6 648.1
Developing economies 118.6 194.0 231.9 252.4 219.7 155.5 166.3 233.2
India 1.7 2.6 2.2 2.3 3.4 3.4 4.3 5.3

It is evident from the figures in the tables that India accounts for a rather small percentage of the global FDI flows. However it is felt by analysts that the trend is gradually picking up in making the country a very attractive destination for FDI, especially for multinational companies from the US and Europe. The rapidly burgeoning middle class in the country now has huge purchasing power

During the last fifty years multinational corporations and FDI have played a very important role in the economy of Brazil. The GDP of Brazil is the eighth largest in the world presently and the country is considered to be more advanced in terms of technology as compared to other developing and emerging economies. The present status of its industrial capabilities is primarily due to large scale penetration of FDI in the country’s economy, especially in manufacturing.

The government has relied heavily on FDI inflows since the 1990s, which has helped in adjustment of public accounts, modernization of the production facilities and for external adjustments. Brazil is also using FDI inflows for financing its Balance of Payments deficit and to finance public accounts. FDI inflows had increased sharply in 1995 as compared to the previous fifteen years. Though adversely impacted by the global recession, the Brazilian economy continues to be heated up in attracting smaller levels of foreign investments from the EU and other Latin American countries (Kelly Oliveira, 2008).

The FDI flows into Brazil have been consistently increasing over the years, which are evident from the table below, but there has been a small drop in 2006. However FDI into the country has been increasing at a much faster rate as compared to other countries and as in December 2008, the total inflows into the country stood at a record $45.1 billion (Andre Soliani et al, 2009).

Table VI. FDI Inflows, 2001 to 2006 ($ Billion).

2001 2002 2003 2004 2005 2006
Brazil 18.2 19 20 21.4 19.9 18.1

An idea of the quantum of FDI inflows, outflows, inward FDI and outward FDI for the period 1982 to 2006 can be had from the following table, which indicates that there has been an almost consistent increase in regard to all the parameters.

Selected Indicators of FDI, 1982-2006

Since 1982 there has been an almost constant increase in FDI inflows in the world and the inward and outward flows have shown a significant jump, especially after 1982. There have been exceptions in 2003 and 2005 when there was a negative growth in FDI inflows and FDI outflows respectively.

Fear has now gripped the global markets and world leaders can be seen reacting in the current challenging time of recession. People believe that as the recession gets deeper there will be retraction of the globalization process, increased insecurity and the spread of nuclear proliferation. For some time there will be increase in military spending by nations, protectionism will increase resulting in the high cost of traded goods and services. The downturn in economic activities will lead to decrease in economic freedom and considerable drop in FDI through out the world. The global financial systems are now experiencing the most severe slide since the Great Depression of 1930s. It is thus necessary to first improve the financial strength of global financial markets, which in turn will revitalize other economic activities including FDI flows into developing economies. Governments of developed economies will have to eventually respond in reducing the solvency problems of banks. With shortage of liquidity, public debt will be passed over to the public sector and only after the debt unwinds, will the downturn show signs of fading away (Ferleman, 2009).

References

A.B. Bernard, J.B. Jensen, and P.K. Schott, “Importers, Exporters and Multinationals: A Portrait of the Firms in the U.S. that Trade Goods,” 2005, NBER Working Paper No. 11404.

Andre Soliani and Iuri Dantas, Brazil’s Foreign Direct Investment Surged in December. Web.

Bruce A. Blonigen, Foreign Direct Investment Behavior of Multinational Corporations. Web.

Ferleman, Global Recession: Is it the end of the world as we know it?. Web.

Hari Sud, India Should Align FDI Definition to Standard IMF Format, 2006. Web.

Kelly Oliveira, Foreign Direct Investment in Brazil Doubles in 2007 to US$ 35 Billion, 2008. Web.

Lardy N , The role of Foreign Trade and Investment in China’s Economic Transformation. In A Walder, China’s Transitional Economy, 1996, Oxford University Press.

Masahiro Kawai, Overview of FDI. Web.

Peter Dicken, Global Shift, 5th Edition, 2007, The Guilford Press Ranabir Ray Choudhury, FDI: Pointers for the future, The Hindu Business Line.

UNCTAD, Global Foreign Direct Investment (FDI) Inflows Surged 29% to $916B in 2005, World Investment Report, UNCTAD.

Valentino Piana, Foreign Direct Investment, 2005. Web.

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