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familiarize with the factors that motivate direct foreign investment in a country;
Structure
15.1
Introduction
15.2
15.3
15.4
15.5
15.6
15.7
Summary
15.8
15.9
Further Readings/References
15.1 INTRODUCTION
In imperfect market conditions, multinational corporations (MNCs) taking advantage
of their supremacy over the rivals in terms of cost, quality, speed and flexibility
vigorously endeavour to expand their operations in different potential countries and
for that matter adopt entry strategies based on SWOT analysis and choose a particular
mode of entry. Foreign direct investment (FDI), which involves building productive
capacity directly in a foreign country, is one of the most important modes of entry
into foreign markets. MNCs conduct FDI through joint ventures with foreign firms,
cross-border mergers and acquisitions, and formation of new foreign subsidiaries.
In foreign direct investment, the parent company builds productive capacity in a
foreign country. In a cross-border acquisition, a domestic parent acquires the use of
an asset in a foreign company. A company can acquire productive capacity in a
foreign country in one of the two ways, viz; cross-border acquisition of assets and
cross-border acquisition of stock.
Cross-border acquisition of assets is the most straightforward method of acquiring
productive capacity because only the asset is acquired without the transfer of
liabilities to the purchaser. As against this, in a cross-border acquisition of stock, an
MNC buys an equity share in a foreign company. In a cross-border merger, two firms
pool their assets and liabilities to form a new organization.
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FDI as a mode of foreign market entry provides a permanent foothold in the foreign
market and can generate high returns when managed properly. However, FDI
requires a substantial investment which entails additional risks, such as foreign
exchange risk, political risk and cultural risk that do not exist in case of domestic
investment. These additional risks may or may not be offset by higher expected
earnings. Given this risk and return complexion of FDI, MNCs obviously tend to
analyze carefully the potential benefits and costs before deciding about the kind of
FDI. Table 15.1(a) & (b) gives an overview of FDI flows by region and selected
countries for the period 1993 to 2004.
ii)
Petrochemical
..
..
...
iii) Aluminium
....
It is interesting to note that Japan, Italy, Switzerland and Australia could not attract
larger FDI inflows as compared to Spain particularly due to higher operational costs.
On account of a strong increase in foreign direct investment(FDI) flows to
developing countries, 2004 saw a slight rebound in global FDI after three years of
declining flows. At $648 billion, world FDI inflows were 2% higher in 2004 than in
2003. Inflows to developing countries surged by 40% to $233 billion, but developed
countries as a group experienced a 14% drop in their inward FDI. As a result, the
share of developing countries in world FDI inflows was 36%, the highest level since
1997. The United States retained its position as the number one recipient of FDI,
followed by the United Kingdom and China.
Some of the factors which can explain the growth of FDI in developing countries are
as follows:
1. Intense competitive pressure in domestic economy.
2. Rationalizing of production activities so as to reap economies of scale and lower
overall production costs.
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3. Higher commodity prices have stimulated FDI flows to countries rich in natural
resources such as oil and minerals.
4. Increased mergers and amalgamation activities at global level has also acted as
stimulant for FDI flows.
FDI outflows increased in 2004 by 18% to $730 billion, with firms based in
developed countries accounting for the bulk ($637 billion). In fact almost half of all
outward FDI originated from three sources: the United States, the United Kingdom
and Luxembourg. Developed countries as a group remained significant net capital
exporters through FDI; net outflows exceeded net inflows by $260 billion. While FDI
outflows from the European Union (Ell) declined by 25%, to $280 billion (a sevenyear low), most other developed countries increased their investment abroad. In the
case of the United States, outflows increased by over 90% to $229 billion, a record
high.
Countries continue to adopt new laws and regulations with a view to making their
investment environments more investor friendly. Out of 271 such changes pertaining
to FDI introduced in 2004, 235 involved steps to open up new areas to FDI along
with new promotional measures (table 15.2). In addition, more than 20 countries
lowered their corporate income taxes in their bid to attract more FDI. In Latin
America and Africa, however, a number of policy changes tended to make
regulations less favourable to foreign investment, especially in the area of natural
resources.
At the international level, the number of bilateral investment treaties (BITs) and
double taxation treaties (DTTs) reached 2,392 and 2,559 respectively in 2004, with
developing countries concluding more such treaties with other developing countries.
More international investment agreements were also concluded at the regional and
global level, potentially contributing to greater openness towards FDI. The various
international agreements are generally becoming more and more sophisticated and
complex in content, and investment-related provisions are increasingly introduced
into agreements encompassing a broader range of issues.
Foreign investors have been showing keen interest in India in recent years because of
low risk due to political and economic stability of the country and robust economic
growth as also due to favourable policy measures. According to a corporate study,
India has been found less risky than China as a business destination. India has been
ranked 10th out of 100 countries in the latest country risk analysis by Economic
Intelligence Unit. As a result, FDI flows to India, which has reached $ 5 billion in
2003 from $3.8 billion in 1999, is expected to go up to $ 13 billion in 2008.
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c)
List out three Indian Companies having gone abroad for vertical investment.
i)
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ii) ................................................................................................................................
iii) ................................................................................................................................
d) List out three Indian Companies having gone abroad for horizontal investment.
i)
................................................................................................................................
ii) ............
iii)
e) List out four Indian Companies having setup their manufacturing un its recently
in China.
i)
..................................................................................................................................
ii) ..
iii) ..
According to Ahorani, the foreign investment decision is typically a response to a
specific opportunity arising from stimulating forces inside or outside the firm, rather
than a systematic search for profitable investment opportunities abroad. The external
stimulus may originate with the host country, the MNC's clients, or distributors of its
products. Irrespective of whether the stimulus originates within the firm or from
outside, strategic motivations, such as the fear of losing a market, the "bandwagon
effect", or strong competition from abroad in the home market, would impel the firm
to seriously consider the opportunity. In addition, there are other strategic factors that
act as stimulating force for overseas investment. Thus, key factors that spur foreign
investment are discussed below:
Product and Market imperfections: MNCs possessing specific intangible capital in
the form of trade marks, patents, general marketing skills, and other organizational
abilities may be inspired to make overseas investment through new product
development and adaptation, quality control, advertising, distribution, after sales
service and the general ability to read changing market requirements and translate
them into saleable products and take advantage of market imperfections.
At times, MNCs prefer FDI to other modes of entry into overseas markets for
protecting misuse of their intangible assets by local firms. Coca-Cola chose FDI as a
mode of entry into foreign markets, and set up bottling plants instead of licensing
local firms mainly to protect the formula for its famed soft drink. If the company
licenses a local firm to produce coke, it has no guarantee that the secrets of the
formula will be maintained.
It must, however, be remembered that mere existence of market failure is not
sufficient to justify FDI, for the fact that local firms have an inherent cost advantage
over foreign investors and MNCs can succeed abroad only if the production or
marketing edge that they possess cannot be purchased or initiated by local firms.
They have to create and preserve on enduring basis effective barriers to direct
competition in product and factor markets.
Market Opportunities: Existence of tremendous market opportunities abroad and
fiercely competitive domestic market limiting the growth in demand and the
consequent decline in market share may stimulate MNCs to enter into high-potential
overseas markets. For instance, many of the developing countries, viz; Argentina,
China, Mexico, Chile and Hungary have, of late, been able to attract FDI flows
because of existence of attractive markets.
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to produce cars to escape from the US Government tariff control. The recent spurt in
FDI in Mexico and Spain can be partly attributed to the desire of MNCs to
circumvent external wade barriers imposed by NAFTA and the European Union.
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It may, however, be noted that Vernon Theory developed in the last century when the
US was the unchallenged leader in R&D capabilities and product innovations, cannot
be the only basis for justifying FDI in foreign countries in view of growing
complexity in the behaviour and strategies of MNCs on the one hand and increasing
product innovations in many advanced countries and increasing complexity in
international system of production on the other. In the changed environment, firms
may set up production plants in a number of countries right from the introduction of
new product.
Behaviour of Foreign Exchange Rate: FDI decisions of MNCs are also influenced
by exchange rate movements because cost is one of the key determinants. Firms may
be tempted to invest in a country whose currency is perceived by a firm to be
undervalued as the initial investment outlay would be low.
At times, FDI is driven by the firm's desire to offset the changing demand for its
exports owing to exchange rate fluctuations.
Financial Market Imperfections: Existence of financial market imperfections
across the globe may provide impetus to MNCs to undertake FDI. Alongside their
capability to reduce taxes and circumvent currency controls, MNCs' desire to reduce
risks of exchange rate changes, currency controls, expropriation and other forms of
government intervention through international diversification may be the driving
force for FDI. The diversification effect stemming out of operation in a number of
countries having imperfect economic cycles and diverse economic and financial
conditions tends to reduce the volatility of MNCs' earnings. In addition, the firm may
enjoy a lower cost of capital as shareholders and creditors perceive the MNCs' risk to
be lower as a result of more stable cash flows.
Inefficient Financial System: At times, inefficiency in the system of allocation of
financial resources of a country resulting in the wide gap between demand for and
supply of funds to viable organizations can attract FDI to fill this gap. For example,
China got so much FDI essentially because the domestic financial system allocated
domestic savings very inefficiently in the sense that most of the money goes to the
inefficient firms like state-owned enterprises and more efficient firms, which may in
private sector remain deprived of desired funds. It is FDI which plays a crucial role in
as much as it provides financial support to private entrepreneurs who could not get
financing from the formal financial system.
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One of the most crucial decisions to be taken by MNCs subsequent to FDI is how to
maintain their competitive edge in the current foreign market. The MNCs might have
created in the initial years barriers to entry by continuously introducing new products
and differentiating existing ones. But over a period of time, technological leads have
tendency to erode. It would, therefore, be pertinent for the MNCs to employ other
factors to replace technology as a barrier to entry. One such variable could be the
presence of economies of scale. The existence of economies of scale signifies that
there are inherent cost advantages of being large. The more significant these
economies of scale are, the greater will be the cost disadvantage faced by a new
entrant to the market.
Some MNCs such as Coca-Cola, McDonald's, Nestle and Procter & Gamble are
taking advantage of high advertising expenditures and highly developed marketing
skills to differentiate their products and keep out potential competitors who are
reluctant to incur high marketing costs of new product introduction. By so doing such
firms can exploit the premium associated with their strong brand names.
When it is found that the competitive advantages in their product lines or markets
become dissipated, it is worthwhile for the firm to enter new markets where little
competition currently exists. For example, Crown Cork and Seal, the Philadelphiabased maker of bottle top and cans, reacted to showing growth and heightened
competition in its US business by expanding overseas and set up subsidiaries in other
countries like Thailand, Malaysia, Zambia, Peru and Ecuador.
Firms can also explore the possibility of setting up subsidiaries in lower-cost
production sites because in that case costs can then be minimized by combining
production shifts with rationalization and integration of the firm's manufacturing
facilities worldwide.
Another device for successful survival could be to drop old products and turn
corporate skills to new products. Those failing to transfer their original competitive
advantages to new products or industries are left with no option but to divest their
foreign operations and return home.
As regards the utilization of the earnings generated by the foreign project, the firm
should allow its subsidiary to retain a portion of funds if that would be of more value
than the parent's use. Of course, certain proportion of the earnings will be required to
support the operations of the subsidiary but the rest of the funds could be remitted
back to the parent, sent to another subsidiary or reinvested for expansion purpose.
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Host government, while evaluating a FDI proposal, should assess its potential
advantages and disadvantage to the economy. Where the potential gains are expected
to be greater than the potential disadvantages , every attempt should be made to
provide additional concessions such as tax holiday , rent free land & buildings ,
lower interest loans , subsidized energy and reduced environment restrictions so as to
attract foreign investors , the amount of the fiscal and financial incentives which a
government provides depends to a great extent , on the extent to which the FDI
brought by the MNCs would benefit that country . Table 15.1 gives a brief overview
of the FDI investment over the years , and the contribution of FDI in gross fixed
capital formation.
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or dividend. Double tax relief is available in respect of the foreign tax suffered on
both income and other gains.
Usually, only direct foreign taxes are taken into account for double tax relief, but if a
UK company receives dividends from a foreign company in which it owns 10percent
or more of voting power, underlying taxes on profits out of which the dividends are
paid, are taken into account as well. In this case, the amount included in UK profits is
the dividend plus both the direct and underlying foreign taxes. Double tax relief is
given, but the amount of relief on overseas income cannot exceed the UK
Corporation tax.
f)
What are the various taxes which an Indian MNC is required to pay on its
investment in Britain ?
Capital Gains Tax: Capital gains taxes on foreign investments are the most
straightforward. If a company earns capital gains on the disposal of foreign assets, it
is liable to pay capital gains taxes at the rate existing in the host country.
15.7 SUMMARY
Foreign Direct Investment is one of the most important modes of entry into foreign
Markets by MNCs. MNCs conduct FDI by way of joint ventures with foreign firms,
cross-border mergers and acquisitions, and formation of new foreign subsidiaries.
There has been phenomenal growth in FDI in the world following the pursuance of
the policy of liberalization and globalization across different countries. In view of
their superior competitive advantages over local firms, MNCs extend their areas of
operations beyond domestic boundaries. According to Ahorani, the foreign
investment decision is typically a response to a specific opportunity arising from
stimulating forces inside or outside the firm, rather than a systematic search for
profitable investment opportunities abroad. There are many strategic factors that act
as stimulating force for overseas investment. One of the most crucial decisions to be
taken by MNCs subsequent to FDI is how to maintain their competitive edge in the
current market. The extent of FDI in a particular country is dependent upon a host of
factors such as the country's markets and resources, government regulations, fiscal
and financial incentives. Taxation is a crucial issue that impacts cross border
investments. Hence implications of taxation on overseas investment should be
considered in detail.
2.
Why are MNCs driving investments in South Asian Countries like Thailand,
Malaysia and Indonesia ?
3.
Why are China and India emerging as attractive centers of FDI in recent years?
4.
5.
6.
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International Investment
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7.
8.
9.
10. How does host government feel about FDI in the country?
11. "Taxation is a crucial issue that influences FDI in a country". Explain.
40
1.
2.
3.
4.
Alan C. Shapiro, "Multinational Financial Management ", John Wiley & Sons
Inc. Singapore, 2003.
5.
6.
7.
8.
Yasheng Huang, Inefficiency Attracts FDI, Business world, March 24, 2003, p-3.