Jaipur National University

SUBMITTED TO - SUBMITTED BY-

MS. RAJSHREE SHARMA MANTHAN MEHTA

ASSISTANT PROFESSOR (MBA DUAL 4th SEM.)

SCHOOL OF BUSINESS SCHOOL OF BUSINES

& MANAGEMENT & MANAGEMENT

(MAIN CAMPUS) (MAIN CAMPUS)

FOREIGN DIRECT INVESTMENT (FDI)
FDI, in its classic definition, is termed as a company of one nation
putting up a physical investment into building a facility (factory) in
another country. The direct investment made to create the buildings,
machinery, and equipment is not in sync with making a portfolio
investment, an indirect investment.

Due to fast growth and change in global investment patterns, the

definition has been expanded to include all the acquisition activities
outside the investing firm’s home country.
FDI, therefore, may take many forms, such as direct acquisition of a
foreign firm, constructing a facility, or investing in a joint venture or
making a strategic alliance with one of the local firms with an input
of technology, licensing of intellectual property.

FDI and its Types

Strategically, FDI comes in three types −
 Horizontal − In case of horizontal FDI, the company does all
the same activities abroad as at home. For example, Toyota
assembles motor cars in Japan and the UK.
 Vertical − In vertical assignments, different types of activities
are carried out abroad. In case of forward vertical FDI, the
FDI brings the company nearer to a market (for example,
Toyota buying a car distributorship in America). In case
of backward Vertical FDI, the international integration goes
back towards raw materials (for example, Toyota getting
majority stake in a tyre manufacturer or a rubber plantation).
 Conglomerate − In this type of investment, the investment is
made to acquire an unrelated business abroad. It is the most
surprising form of FDI, as it requires overcoming two barriers
simultaneously – one, entering a foreign country and two,
working in a new industry.
 FDI can take the form of greenfield entry or takeover.

 Greenfield entry refers to activities or assembling all the

elements right from scratch as Honda did in the UK.
 Foreign takeover means acquiring an existing foreign company
– as Tata’s acquisition of Jaguar Land Rover. Foreign takeover
is often called mergers and acquisitions (M&A) but
internationally, mergers are absolutely small, which accounts
for less than 1% of all foreign acquisitions.
This choice of entry in a market and its mode interacts with the
ownership strategy. The choice of wholly owned subsidiaries against
joint ventures gives a 2x2 matrix of choices – the options of which
are −

 Greenfield wholly owned ventures,

 Greenfield joint ventures,
 Wholly owned takeovers, and
 Joint foreign acquisitions.

Importance of FDI

1. Increased Employment and Economic Growth -:

Creation of jobs is the most obvious advantage of FDI. It is also one

of the most important reasons why a nation, especially a developing
one, looks to attract FDI. Increased FDI boosts the manufacturing as
well as the services sector. This in turn creates jobs, and helps reduce
unemployment among the educated youth - as well as skilled and
unskilled labour.
2. Human Resource Development -:

Skills gained and enhanced through training and experience boost the
education and human capital quotient of the country. Once developed,
human capital is mobile. It can train human resources in other
companies, thereby creating a ripple effect.  

3. Development of Backward Areas -:

This is one of the most crucial benefits of FDI for a developing

country. FDI enables the transformation of backward areas in a
country into industrial centres. This in turn provides a boost to the
social economy of the area.
 
4. Provision of Finance & Technology -:

Recipient businesses get access to latest financing tools, technologies

and operational practices from across the world.

5. Increase in Exports -:

Not all goods produced through FDI are meant for domestic
consumption. Many of these products have global markets.

6. Exchange Rate Stability -:

The constant flow of FDI into a country translates into a continuous

flow of foreign exchange. This helps the country’s Central Bank
maintain a comfortable reserve of foreign exchange.

7. Stimulation of Economic Development -:

This is another very important advantage of FDI. FDI is a source of

external capital and higher revenues for a country. When factories are
constructed, at least some local labour, materials and equipment are
utilised. Once the construction is complete, the factory will employ
some local employees and further use local materials and services.
The people who are employed by such factories thus have more
money to spend. This creates more jobs. 
These factories will also create additional tax revenue for the
Government, that can be infused into creating and improving physical
and financial infrastructure. 

8. Improved Capital Flow -:

Inflow of capital is particularly beneficial for countries with limited

domestic resources, as well as for nations with restricted opportunities
to raise funds in global capital markets.

9. Creation of a Competitive Market -:

By facilitating the entry of foreign organisations into the domestic

marketplace, FDI helps create a competitive environment, as well as
break domestic monopolies. A healthy competitive environment
pushes firms to continuously enhance their processes and product
offerings, thereby fostering innovation. Consumers also gain access to
a wider range of competitively priced products.

Conclusion -:

For a multinational corporation, FDI in India is a means to access new

consumption and production markets, and thereby expand its
influence and business operations. It can gain access not only to
limited resources such as fossil fuels and precious metals, but also
skilled and unskilled labour, management expertise and technologies.

Vehicles of FDI
  Reciprocal distribution agreements −: This type of strategic
alliance is found more in trade-based verticals, but in practical
sense, it does represent a type of direct investment. Basically,
two companies, usually within the same or affiliated industries,
but from different nations, agree to become national distributors
for each other’s products.
 Joint venture and other hybrid strategic alliances −:
Traditional joint venture is bilateral, involving two parties who
are within the same industry, partnering for getting some
strategic advantage. Joint ventures and strategic alliances offer
access to proprietary technology, gaining access to intellectual
capital as human resources, and access to closed channels of
distribution in select locations.
 Portfolio investment −: For most of the 20th century, a
company’s portfolio investments were not considered a direct
investment. However, two or three companies with "soft"
investments in a company could try to find some mutual
interests and use their shareholding for management control.
This is another form of strategic alliance, sometimes
called shadow alliances.

FDI – Basic Requirements

As a minimum requirement, a firm will have to keep itself abreast of
global trends in its industry. From a competitive perspective, it is
important to be aware if the competitors are getting into a foreign
market and how they do that.
It is also important to see how globalization is currently affecting the
domestic clients. Often, it becomes imperative to expand for key
clients overseas for an active business relationship.
New market access is also another major reason to invest in a foreign
country. At some stage, export of product or service becomes
obsolete and foreign production or location becomes 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, and
 Market expectations.

Factors that affect foreign direct investment (FDI)

1. Wage rates -:

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.

2. 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.

3. 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.

4. 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.

5. 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 population.

6. Political stability / property rights -:

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.

7. 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.

8. 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.

9. 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.

10. 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.