FOREIGN DIRECT INVESTMENT September 21, 2019

What do you understand by FDI? How is it different from

Portfolio Investment? List the factors that contribute to
growth of FDI in any country & role of political risk in it?

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Introduction

1. International equity flows are the main feature of the recent globalization of capital
markets both in developing and in developed economies. These flows take two major forms:
Foreign Direct Investments (FDI) and Foreign Portfolio Investments (FPI). An empirical
regularity is that the share of FDI in total foreign equity flows is larger for developing countries
than for developed countries. Regarding the second moments of foreign equity flows, it is
known that the volatility of FDI net inflows is, in general, much smaller than that of FPI net
inflows. Moreover, empirical analysis has established that the differences in volatility between
FPI and FDI flows are much smaller for developed economies than for developing economies.
Despite the empirical interest in foreign equity flows, very little work has been done on jointly
explaining FDI and FPI in a rigorous theoretical framework.

Definition of Foreign Direct Investment

2. Foreign direct investment (FDI) is an investment made by a firm or individual in one
country into business interests located in another country. Generally, FDI takes place when an
investor establishes foreign business operations or acquires foreign business assets, including
establishing ownership or controlling interest in a foreign company. Foreign direct investments
are distinguished from portfolio investments in which an investor merely purchases equities of
foreign-based companies.
3. Foreign Direct Investment (FDI) is an investment in a business by an investor from
another country for which the foreign investor has control over the company purchased.
The Organization of Economic Cooperation and Development (OECD) defines control as
owning 10% or more of the business. Businesses that make foreign direct investments are often
called multinational corporations (MNCs) or multinational enterprises (MNEs). An MNE may
make a direct investment by creating a new foreign enterprise, which is called a Greenfield
investment, or by the acquisition of a foreign firm, either called an acquisition or brownfield
investment.

Breaking Down Foreign Direct Investment

4. Foreign direct investments are commonly made in open economies that offer a skilled
workforce and above-average growth prospects for the investor, as opposed to tightly regulated
economies. Foreign direct investment frequently involves more than just a capital
investment. It may include provisions of management or technology as well. The key feature

of foreign direct investment is that it establishes either effective control of, or at least
substantial influence over, the decision-making of a foreign business.

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Methods of Foreign Direct Investment

5. Foreign direct investments can be made in a variety of ways, including the opening of
a subsidiary or associate company in a foreign country, acquiring a controlling interest in an
existing foreign company, or by means of a merger or joint venture with a foreign company.
The threshold for a foreign direct investment that establishes a controlling interest, per
guidelines established by the Organisation of Economic Co-operation and Development
(OECD), is a minimum 10% ownership stake in a foreign-based company. However, that
definition is flexible, as there are instances where effective controlling interest in a firm can be
established with less than 10% of the company's voting shares.

Types of Foreign Direct Investment

6. Foreign direct investments are commonly categorized as being horizontal, vertical or
conglomerate. A horizontal direct investment refers to the investor establishing the same type
of business operation in a foreign country as it operates in its home country, for example, a cell
phone provider based in the United States opening stores in China. A vertical investment is one
in which different but related business activities from the investor's main business are
established or acquired in a foreign country, such as when a manufacturing company acquires
an interest in a foreign company that supplies parts or raw materials required for the
manufacturing company to make its products.
7. A conglomerate type of foreign direct investment is one where a company or individual
makes a foreign investment in a business that is unrelated to its existing business in its home
country. Since this type of investment involves entering an industry in which the investor has
no previous experience, it often takes the form of a joint venture with a foreign company
already operating in the industry.
8. Typically, there are two main types of FDI: horizontal and vertical FDI.

(a) Horizontal A business expands its domestic operations to a foreign country.

In this case, the business conducts the same activities but in a foreign country. For
example, McDonald’s opening restaurants in Japan would be considered horizontal
FDI.

(b) Vertical A business expands into a foreign country by moving to a

different level of the supply chain. In other words, a firm conducts different activities
abroad but these activities are still related to the main business. Using the same
example, McDonald’s could purchase a large-scale farm in Canada to produce meat for
their restaurants.

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9. However, two other forms of FDI have also been observed: conglomerate and platform
FDI.

(a) Conglomerate A business acquires an unrelated business in a foreign

country. This is uncommon as it requires overcoming two barriers to entry: entering a
foreign country and entering a new industry or market. An example of this would be if
Virgin Group, which is based in the United Kingdom, acquired a clothing line in France.

(b) Platform A business expands into a foreign country but the output from
the foreign operations is exported to a third country. This is also referred to as export-
platform FDI. Platform FDI commonly happens in low-cost locations inside free-trade
areas. For example, if Ford purchased manufacturing plants in Ireland with the primary
purpose of exporting cars to other countries in the EU.

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10. In other words, a firm conducts different activities abroad but these activities are still
related to the main business. Using the same example, McDonald’s could purchase a large-
scale farm in Canada to produce meat for their restaurants.

Impact of Foreign Direct Investments

11. Foreign direct investments and the laws governing them can be pivotal to a company's
growth strategy. In 2017, for example, U.S.-based Apple announced a $507.1 million
investment to boost its research and development work in China, Apple's third-largest market
behind the Americas and Europe. The announced investment relayed CEO Tim Cook's
bullishness toward the Chinese market despite a 12% year-over-year decline in Apple's Greater
China revenue in the quarter preceding the announcement. China's economy has been fuelled
by an influx of FDI targeting the nation's high-tech manufacturing and services, which
according to China's Ministry of Commerce, grew 11.1% and 20.4% year over year,
respectively, in the first half of 2017. Meanwhile, relaxed FDI regulation in India now allows
100% foreign direct investment in single-brand retail without government approval. The
regulatory decision reportedly facilitates Apple's desire to open a physical store in the Indian
market, where the firm's iPhones have thus far only been available through third-party physical
and online retailers.

Advantages of FDI
12. In the context of foreign direct investment, advantages and disadvantages are often a
matter of perspective. An FDI may provide some great advantages for the MNE but not for the
foreign country where the investment is made. On the other hand, sometimes the deal can work
out better for the foreign country depending upon how the investment pans out. Ideally, there
should be numerous advantages for both the MNE and the foreign country, which is often a
developing country. We'll examine the advantages and disadvantages from both perspectives,
starting with the advantages for multinational enterprises (MNEs).

(a) Access to markets FDI can be an effective way for you to enter into a
foreign market. Some countries may extremely limit foreign company access to their
domestic markets. Acquiring or starting a business in the market is a means for you to
gain access.

(b) Access to resources FDI is also an effective way for you to acquire important
natural resources, such as precious metals and fossil fuels. Oil companies, for example,
often make tremendous FDIs to develop oil fields.

(c) Reduces cost of production FDI is a means for you to reduce your cost of
production if the labor market is cheaper and the regulations are less restrictive in the
target foreign market. For example, it's a well-known fact that the shoe and clothing

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industries have been able to drastically reduce their costs of production by moving
operations to developing countries.

13. FDI also offers some advantages for foreign countries. For starters, FDI offers a
source of external capital and increased revenue. It can be a tremendous source of external
capital for a developing country, which can lead to economic development.
14. For example, if a large factory is constructed in a small developing country, the country
will typically have to utilize at least some local labour, equipment, and materials to construct
it. This will result in new jobs and foreign money being pumped into the economy. Once the
factory is constructed, the factory will have to hire local employees and will probably utilize at
least some local materials and services. This will create further jobs and maybe even some
new businesses. These new jobs mean that locals have more money to spend, thereby creating
even more jobs.
15. Additionally, tax revenue is generated from the products and activities of the factory,
taxes imposed on factory employee income and purchases, and taxes on the income and
purchases now possible because of the added economic activity created by the factory.
Developing governments can use this capital infusion and revenue from economic growth
to create and improve its physical and economic infrastructure such as building roads,
communication systems, educational institutions, and subsidizing the creation of new domestic
industries.
16. Another advantage is the development of new industries. Remember that an MNE
doesn't necessarily own all of the foreign entity. Sometimes a local firm can develop a strategic
alliance with a foreign investor to help develop a new industry in the developing country. The
developing country gets to establish a new industry and market, and the MNE gets access
to a new market through its partnership with the local firm.
17. Finally, learning is an indirect advantage for foreign countries. FDI exposes national
and local governments, local businesses, and citizens to new business practices, management
techniques, economic concepts, and technology that will help them develop local businesses
and industries.

Disadvantages of Foreign Direct Investment

18. Despite many benefits, there are still two main disadvantages to FDI such as:
(a) Displacement of local businesses.
(b) Profit repatriation.
19. The entry of large firms such as Walmart may displace local businesses. Walmart is
often criticized for driving out local businesses that cannot compete with its lower prices. In
the case of profit repatriation, the primary concern is that firms will not reinvest profits back
into the host country. This leads to large capital outflows from the host country. As a result,
many countries have regulations limiting foreign direct investment.

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FDI & FPI

20. Capital is a vital ingredient for economic growth, but since most nations cannot meet
their total capital requirements from internal resources alone, they turn to foreign
investors. Foreign direct investment (FDI) and foreign portfolio investment (FPI) are two of
the most common routes for investors to invest in an overseas economy. FDI implies
investment by foreign investors directly in the productive assets of another nation.

21. FPI means investing in financial assets, such as stocks and bonds of entities located
in another country. FDI and FPI are similar in some respects but very different in others.
As retail investors increasingly invest overseas, they should be clearly aware of the differences
between FDI and FPI, since nations with a high level of FPI can encounter heightened
market volatility and currency turmoil during times of uncertainty.

Examples of FDI and FPI

22. Imagine that you are a multi-millionaire based in the U.S. and are looking for your next
investment opportunity. You are trying to decide between (a) acquiring a company that makes
industrial machinery, and (b) buying a large stake in a company that makes such machinery.
The former is an example of direct investment, while the latter is an example of portfolio
investment.

23. Now, if the machinery maker were located in a foreign jurisdiction, say Mexico, and if
you did invest in it, your investment would be considered an FDI. If the companies whose
shares you were considering buying were also located in Mexico, your purchase of such stock
or their American Depositary Receipts (ADRs) would be regarded as FPI.

24. Although FDI is generally restricted to large players who can afford to invest directly
overseas, the average investor is quite likely to be involved in FPI, knowingly or
unknowingly. Every time you buy foreign stocks or bonds, either directly or through ADRs,
mutual funds or exchange-traded funds, you are engaged in FPI. The cumulative figures for
FPI are huge.

Evaluating Attractiveness
25. Because capital is always in short supply and is highly mobile, foreign investors have
standard criteria when evaluating the desirability of an overseas destination for FDI and FPI,
which include:

(a) Economic factors: the strength of the economy, GDP growth trends,
infrastructure, inflation, currency risk, foreign exchange controls.

(b) Political factors: political stability, government’s business philosophy, track

record.

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(c) Incentives for foreign investors: taxation levels, tax incentives, property rights.

(d) Other factors: education and skills of the labor force, business opportunities,
local competition.

FDI versus FPI

26. Although FDI and FPI are similar in that they both involve foreign investment, there
are some very fundamental differences between the two.

27. The first difference arises in the degree of control exercised by the foreign investor.
FDI investors typically take controlling positions in domestic firms or joint ventures and are
actively involved in their management. FPI investors, on the other hand, are generally passive
investors who are not actively involved in the day-to-day operations and strategic plans of
domestic companies, even if they have a controlling interest in them.

28. The second difference is that FDI investors perforce have to take a long-term
approach to their investments since it can take years from the planning stage to project
implementation. On the other hand, FPI investors may profess to be in for the long haul but
often have a much shorter investment horizon, especially when the local economy
encounters some turbulence.

29. Which brings us to the final point. FDI investors cannot easily liquidate their
assets and depart from a nation, since such assets may be very large and quite illiquid. FPI
investors can exit a nation literally with a few mouse clicks, as financial assets are highly
liquid and widely traded.

FDI and FPI – Pros and Cons

30. FDI and FPI are both important sources of funding for most economies. Foreign
capital can be used to develop infrastructure, set up manufacturing facilities and service hubs,
and invest in other productive assets such as machinery and equipment, which contributes to
economic growth and stimulates employment.

31. However, FDI is obviously the route preferred by most nations for attracting foreign
investment, since it is much more stable than FPI and signals long-lasting commitment. But
for an economy that is just opening up, meaningful amounts of FDI may only result once
overseas investors have confidence in its long-term prospects and the ability of the local
government.

32. Though FPI is desirable as a source of investment capital, it tends to have a much
higher degree of volatility than FDI. In fact, FPI is often referred to as “hot money” because of

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its tendency to flee at the first signs of trouble in an economy. These massive portfolio flows
can exacerbate economic problems during periods of uncertainty.

Factors affecting FDI

33. Wage Rates

(a) A major incentive for a multinational to invest abroad is to outsource labour

intensive production to countries with lower wages. If average wages in the US are $15
an hour, but $1 an hour in the Indian sub-continent, costs can be reduced by outsourcing
production. This is why many Western firms have invested in clothing factories in the
Indian sub-continent.

(b) However, wage rates alone do not determine FDI, countries with high wage
rates can still attract higher tech investment. A firm may be reluctant to invest in Sub-
Saharan Africa because low wages are outweighed by other drawbacks, such as lack of
infrastructure and transport links.
34. Labour Skills Some industries require higher skilled labour, for example
pharmaceuticals and electronics. Therefore, multinationals will invest in those countries with
a combination of low wages, but high labour productivity and skills. For example, India has
attracted significant investment in call centres, because a high percentage of the population
speak English, but wages are low. This makes it an attractive place for outsourcing and
therefore attracts investment.

35. Tax Rates Large multinationals, such as Apple, Google and Microsoft have sought
to invest in countries with lower corporation tax rates. For example, Ireland has been successful
in attracting investment from Google and Microsoft. In fact it has been controversial because

Google has tried to funnel all profits through Ireland, despite having operations in all European
countries.

36. Transport and Infrastructure A key factor in the desirability of investment are
the transport costs and levels of infrastructure. A country may have low labour costs, but if
there is then high transport costs to get the goods onto the world market, this is a drawback.
Countries with access to the sea are at an advantage to landlocked countries, who will have
higher costs to ship goods.
37. Size of Economy / Potential for Growth

Foreign direct investment is often targeted to selling goods directly to the country involved in
attracting the investment. Therefore, the size of the population and scope for economic growth
will be important for attracting investment. For example, Eastern European countries, with a
large population, e.g. Poland offers scope for new markets. This may attract foreign car firms,
e.g. Volkswagen, Fiat to invest and build factories in Poland to sell to the growing consumer
class. Small countries may be at a disadvantage because it is not worth investing for a small

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population. China will be a target for foreign investment as the new emerging Chinese middle
class could have very strong demand for the goods and services of multinationals.

38. Political Stability / Property Rights Foreign direct investment has an element
of risk. Countries with an uncertain political situation, will be a major disincentive. Related to
political stability is the level of corruption and trust in institutions, especially judiciary and the
extent of law and order.

39. Commodities One reason for foreign investment is the existence of

commodities. This has been a major reason for the growth in FDI within Africa – often by
Chinese firms looking for a secure supply of commodities.

40. Exchange rate A weak exchange rate in the host country can attract more FDI
because it will be cheaper for the multinational to purchase assets. However, exchange rate
volatility could discourage investment.

41. Clustering effects Foreign firms often are attracted to invest in similar areas to
existing FDI. The reason is that they can benefit from external economies of scale – growth of
service industries and transport links. Also, there will be greater confidence to invest in areas
with a good track record. Therefore, some countries can create a virtuous cycle of attracting
investment and then these initial investments attracting more. It is also sometimes known as
an agglomeration effect.

42. Access to free trade areas A significant factor for firms investing in Europe is
access to EU Single market, which is a free trade area but also has very low non-tariff barriers
because of harmonisation of rules, regulations and free movement of people. For example, UK
post-Brexit is likely to be less attractive to FDI, if it is outside the Single Market.

Determinants of FDI in India

43. The determinant varies from one country to another due their unique characteristics and
opportunities for the potential investors. In specific the determinants of FDI in India are: -

(a) Stable Policies India stable economic and socio policies have attracted
investors across border. Investors prefer countries which stable economic policies. If
the government makes changes in policies which will have effect on the business. The
business requires a lot of funds to be deployed and any change in policy against the
investor will have a negative effect.

(b) Economic Factors Different economic factors encourage inward FDI.

These include interest loans, tax breaks, grants, subsidies and the removal of restrictions
and limitation. The government of India has given many tax exemption and subsidies
to the foreign investors who would help in developing the economy.

(c) Cheap and skilled labour There is abundant labour available in India in
terms of skilled and unskilled human resources. Foreign investors will to take
advantage of the difference in the cost of labour as we have cheap and skilled labours.

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Example: Foreign firms have invested in BPO’s in India which require skilled labour
and we have been providing the same.

(d) Basic infrastructure India though is a developing country, it has

developed special economic zone where there have focused to build required
infrastructure such as roads, effective transportation and registered carrier departure
worldwide, Information and communication network/technology, powers, financial
institutions, and legal system and other basic amenities which are must for the success
of the business. A sound legal system and modern infrastructure supporting an
efficient distribution of goods and services in the host country.
(e) Unexplored markets In India there is large scope for the investors
because there is a large section of markets have not explored or unutilized. In India
there is enormous potential customer market with large middle class income group
who would be target group for new markets. Example: BPO was one sector where the
investors had large scope exploring the markets where the service was provided with
just a call, with almost customer satisfaction.

(f) Availability of natural resources As we that India has large volume of

natural resources such as coal, iron ore, Natural gas etc. If natural resources are
available they can be used in production process or for extraction of mines by the
foreign investors.

Political Stability
44. Foreign direct investment has an element of risk. Countries with an uncertain political
situation, will be a major disincentive. Also, economic crisis can discourage investment. For
example, the recent Russian economic crisis, combined with economic sanctions, will be a
major factor to discourage foreign investment. This is one reason why former Communist
countries in the East are keen to join the European Union. The EU is seen as a signal of political
and economic stability, which encourages foreign investment.

45. Related to political stability is the level of corruption and trust in institutions, especially
judiciary and the extent of law and order. Political risk factors are difficult to quantify. Most
studies thus far have used a particular form of political risk, the mostly commonly used proxy
being corruption, to explain its adverse effects on FDI and other economic forces. However,
various studies have empirically deduced that political risk factors play an important role in
determining FDI inflows. In this context, the government of respective countries, should try to
contain political risks to the furthest extent. Since the political indicators in the study are
categorized, it is advantageous to identify the different types of political risks which are
characteristic of the different sub-divisions. It is also important that political parties, other
stakeholders and bureaucrats in the countries take into account the fact that aggravation of
political situations in the countries would lead to an overall negative impact. The consensus,
disregarding any region or country, should be to reduce political risks and uncertainties since
political instability play an important role in the determination of FDI and consequently, the
long-run economic performance of a country.

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Conclusion
46. There are many different factors that determine foreign direct investment (FDI) and it
is hard to isolate individual factors, given there are many different variables. It also depends
on the type of industry. For example, with manufacturing FDI, low wage costs tend to be the
most important, as they are a labour intensive industry. For service sector FDI, macro-
economic stability and political openness tend to be more important.

47. Also, it depends on the source of FDI, American firms may value political openness
more than Chinese firms. Or American firms may have a preference for countries where
English is spoken more.
48. The following are some of the benefits for the host country:
(a) Economic stimulation
(b) Development of human capital
(c) Increase in employment
(d) Access to management expertise, skills, and technology

49. For businesses, most of these benefits are based on cost cutting and lowering risk. For
host countries, the benefits are mainly economic.

50. India has come a long way since 1991 in so far as quantum of FDI inflow is concerned.
The popular wisdom is that MNCs are discouraged from investing in India by bureaucratic
hurdles and uncertainty about the sincerity of the government(s) about economic reforms.
However, to date, there has been very little discussion about two important issues, namely, the
experience of MNCs that have invested in India and the relationship between their performance
and experience with the operating environment, and the extent of spill overs in the form of
transfer of technology and know-how. The importance of the former is that the satisfaction of
expectations of the MNCs that are already operational within India is, for obvious reasons, an
important pre-condition for growth in FDI inflow. Transfer of technology and know-how, on
the other hand, is at least as likely to have an impact on India’s future growth as the quantum
of FDI inflow. Indeed, to the extent that India’s future growth will depend on the global
competitiveness of its firms, the importance of such spill overs can be paramount.

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