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INTERNATIONAL FINANCE

Assignment
On
Cost Benefits of Foreign direct Investment

Submitted to:
Dr. S. Rajithakumar
Associate Professor
School of Management Studies
Cochin University of Science and Technology
Submitted by,
Jidhin Joseph P. S
Roll no: 20
MBA FT (Semester- III)

FOREIGN DIRECT INVESTMENT


According to the International Monetary Fund, foreign direct investment, commonly
known as FDI, refers to an investment made to acquire lasting or long-term interest in
enterprises operating outside of the economy of the investor. The investment is direct
because the investor, which could be a foreign person, company or group of entities, is
seeking to control, manage, or have significant influence over the foreign enterprise. The
impact of most FDI can be classified into two broad categories which can then be used to
analyse its contribution to development. In this section we focus on the direct and indirect
financial benefits and the indirect benefits are discussed briefly in the subsequent section.
FDI is a major source of external finance which means that countries with limited
amounts of capital can receive finance beyond national borders from wealthier countries.
Exports and FDI have been the two key ingredients in China's rapid economic growth.
According to the World Bank, FDI and small business growth are the two critical
elements in developing the private sector in lower-income economies and reducing
poverty.
For low-income countries, FDI can have major effects on the amount of production in a
country. According to the United Nations, FDI has greatly increased the growth rate of
the economies of low- income countries, allowing them to grow more rapidly than
developed countries. Foreign direct investment comes with its own costs and benefits, as
the organization or business providing the funding is concerned with securing advantages
in the nation in which it is investing.

Costs & Benefits of FDI


Costs to Host Country
There are three primary ways in which one can study potential costs to a host country of
FDI:

Adverse effect on home manufacturers

Adverse effects on BOP

National sovereignty is at stake

With the inflow of international trade and international companies, development of the
host company can be hampered. The manufacturers of that country are affected by
competition. This includes new management practices and technological advances that
might make foreign countries winners and therefore affect their bottom line. The nation is
also besieged by international companies that might give a new twist to the ethics and
functioning of a country. The main threats to host country are
Threats on organized and unorganized retail players.
Replacement of established national brands by the brands of the retail gains. For e.g WalMart is committed to buying the best goods at the cheapest prices to give its customers
the best value for money. That is why it sources so heavily from China. 70% of
merchandise in Wal-Mart contains components made in China. Even though Wal-mart
may not continue heavy operations in china but would continue heavy sourcing from
china market to cater to the world markets at lower prices. Low prices of Chinese
products can easily convince Indian price consciousness mentality. Acceptance towards
Chinese brands can create a direct threat on Indian established brands providing best
quality products with reasonable prices.

While the levels of FDI tend to be resilient during periods of economic uncertainty, it has
the potential of adversely affecting the net capital flow of a developing economy
especially if it does not have a healthy and sustainable FDI schedule.
FDIs may enter the host country for unique strategic reasons but there is ultimately the
need to achieve returns on investments. For e.g. paying a premium for the price of labour
may improve the consumption power of workers, but it also has the detrimental ability of
disrupting the local employment market. When prices rise, supply increases while
demand falls. Similarly, when the price of labour increase, wage premiums in this case,
this creates a distortion and creates disequilibrium in the labour market. Job matching
stops being efficient and may even create unemployment.
Need to ensure that entities that make Foreign Direct Investment in these countries
comply with environmental regulations.
The host country has a number of state secrets is something that not meant to be exposing
to the world.

Benefits
Business Sectors
Foreign investors may change the balance among types of businesses in a country. If
investors from abroad decide that they want to invest in banks, rather than farms or
manufacturing firms, the low-income nation will now have a more developed financial
sector. This may not be the policy that the leaders or citizens of the country desire.
Foreign direct investment may also focus on producing crops meant for export, such as
coffee or tobacco, rather than crops the citizens of the low-income country need for their
own consumption, such as corn or rice. This may lead to a famine if the farmers in the
low-income country reduce production of staple crops.

Political Issues
Politicians receive support from external investors. A company that wishes to invest in a
low-income country can select a nation that does not have strong labor regulations or in
which workers are not paid high wages. The foreign investor may support an
authoritarian dictatorship because it protects private property rights and can forcibly
increase productivity, according to the University of Pennsylvania. A foreign investor
that invests in a dictatorship also provides additional funding for the army and other
security forces, which serve to keep the dictatorship in power.
Regional Balance
Foreign direct investment can alter the economic, demographic and political balance
between and among the regions or provinces in a country. Investors in Mexico establish
factories in northern Mexico since these factories are convenient for transporting supplies
to customers in the United States. Residents of the southern states do not receive as many
infrastructural investments and with them, jobs, and thus the investment provides an
incentive for these residents to move to the northern states. Politicians who govern the
northern states gain additional resources, as well as the responsibilities of managing a
larger population.
Local Businesses
Foreign direct investment provides benefits to existing businesses in a country. Many
nations require foreign investors to have local partners before setting up a factory or to
purchase a certain percentage of their inputs from local suppliers.
Direct and Indirect financial benefits

i. The direct Balance of payments impact how FDI generates a net inflow or net
outflow on the balance of payments account initially and over time through the interplay
of new investment, reinvestments, disinvestments and profit remittances
ii. The indirect balance of payment impact whether FDI, through its impact on trade
generates more exports or imports
iii. Benefits for Domestic Resource Mobilization such as tax revenue for the state and the
costs in terms of providing subsidies etc
Indirect spill-over benefits such as
i. Jobs created and destroyed
ii. Technology transfer
iii. Skills transfer
iv. Growth
v. Forward and backward linkages with the local economy etc
Let us look at the financial aspects in some detail
When FDI, say $100 million, first flows into a country, the normal assumption is that an
equivalent amount of foreign exchange has come into the country. While it makes sense
at an intuitive level, in reality the net flow of FDI into the country may have a
substantially different impact. This could happen for a variety of reasons some of which
are listed below
The direct Balance of payments impact

The initial purchase of the equity could be party or wholly funded locally. For example,
when the Japanese tyre-maker Bridgestone purchased the US based Firestone in 1988, the
deal was financed primarily through loans from the United States meaning there was little
new money coming into the United States
A significant amount of FDI, especially in the primary (extractive) and manufacturing
(high value) sectors is highly capital intensive. Moreover most of the sophisticated
equipment is imported which means that much of the initial investment flows out in the
form of payments for import of equipment
When FDI enters a country in the form of M&A especially with either a domestic
player or another previous MNC owner, the proceeds of the sale paid often do not stay in
the country and thus generate an offsetting outflow which neutralizes any impact on the
balance of payments.
Once allowance is made for reinvested profits as well as profit remittances, net FDI
flows into developing countries and hence their overall impact on the balance of payment
shrinks into insignificance. In fact since FDI is a for profit investment, it follows
naturally that investors will take more money out of the country than they put in. So the
direct balance of payments impact of FDI over the long term is always negative.
Another statistics are that section was how large the stock of FDI in developing
countries has become. The official figures are now close to 30% of GDP but as we have
highlighted, the real figure is likely to be at least 2-3 times higher. This means that the
potential for a substantial negative balance of payment impact from FDI is very high in
the event that investments are wound up.
The indirect balance of payment impact

When FDI is targeted towards the domestic market, whether in the services sector or the
manufacturing sector, it usually generates a net negative external balance impact in the
long run. Import content of goods and services sold to domestic consumers in developing
countries is usually non negligible and often quite significant. This translates into a
negative trade balance impact of FDI.
When FDI is oriented primarily towards the export market, it has the potential to
generate significant external balance gains though some of these might be offset if the
import content of exports is high. India, Malaysia and Taiwan are amongst the countries
that have reported net exports from FDI.
It is thus far from obvious that FDI flows generate a net positive impact on the external
balance of a developing country. If anything, the likelihood of a long term negative
impact on the external balance is much higher except perhaps in the case of an export
oriented extractive or manufacturing sector.
The tax impact of FDI
A direct and often cited link between FDI and development is through the public
revenues generated in the form of taxes as well as royalties (in the extractive sector).
Public revenues raised from FDI can be used for targeted development expenditure such
as provision of education, health and other public services and construction of basic
public infrastructure.

Reference

www.economywatch.com
http://blogs.worldbank.org
www.transtutors.com

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