Foreign Direct Investment (FDI): Nature, Benefits, Costs

The development of a country is measured with statistical indexes such as income per capita income/ GDP, life expectancy, and literacy rate.

GDP is a measure of both output and income. Growth of output is necessary for the growth of income. Per capita, GDP is the nation’s GDP divided by its population. Growth of per capita GDP means more goods and services per person.

In most cases, higher per capita GDP will mean that the typical person has a better diet, improved health and access to medical services, a longer life expectancy, and greater educational opportunities.

Countries are categorized as less developed because of their poverty and low average incomes, lack of good human resources, and low economic diversification.

Developing countries are, in general, countries that have not achieved a significant degree of industrialization relative to their populations and which have, in most cases, a medium to the low standard of living.

There is a strong correlation between low income and high population growth. Other terms sometimes used are less developed countries (LDCs), least economically developed countries (LEDCs)

Expected Role of Government of LDCs

The economic, political, and legal environments are major determinants of economic growth. Governments help promote economic growth when they focus on two core functions:

• Provision of a legal, regulatory, and monetary environment that enforces contracts and protects people and their property from the actions of aggressors (both domestic and foreign), and,
• Provision of a limited set of public goods like roads and national defense that are difficult to provide through markets.

However, as governments expand beyond these core functions, the beneficial effects will eventually wane and become negative.

Foreign Direct Investment (FDI)

FDI occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country.

When Starbucks invested $10 million in Starbucks coffee of Japan in 1996, it was engaging in its first foreign direct investment.

Once a firm undertakes FDI, it becomes a multinational enterprise (the meaning of multinational being “more than one country”).

FDI takes on two main forms. The first is a green-field investment, which involves the establishment of a wholly new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country.

Acquisitions Can be a minority (where the foreign firms takes a 10 percent to 49 percent interest in the firm’s voting stock), majority (foreign interest of 50 percent to 99 percent), or full outright stake (foreign interest of 100 percent).

Economic Rationale of FDI

Our central objective will be to identify the economic rationale that underlies foreign direct investment. Finns often view exports and FDI as substitutes for each other.

For example, when deciding to serve the North American market, Toyota had to choose between exporting and foreign direct investment in North American production facilities.

Although Toyota initially served the North American market through exports, increasingly it has turned to FDI.

These theories also need to explain why it is preferable for a firm to engage in FDI rather than licensing.

Licensing occurs when a domestic firm, the licensor, licenses to a foreign firm, the licensee, the right to produce its product, to use its production process, or to use its brand name or trade mark. In return for giving the licensee these rights, the licensor collects royalty fees on every unit the licensee sells or on total licensee revenues.

The advantage claimed for licensing over FDI is that the licensor does not have to pay for opening a foreign market; the licensee does that. Nor does the licensor have to bear the risks associated with opening a foreign market.

However, despite these attractions, many firms are reluctant to engage in straight licensing arrangements, preferring to make some kind of foreign direct investment.

Nature of FDI

Horizontal foreign direct investment is FDI in the same industry in which a firm operates at home. Starbucks’ acquisition of Seattle Coffee in Britain is an example of horizontal FDI.

Vertical foreign direct investment is investment in an industry that provides inputs for a firm’s domestic operations, or it may be FDI in an industry abroad that sells the outputs of a firm’s domestic operations.

Differences between FDI and FPI

FDI (Foreign Direct Investment) refers to international investment in which the investor obtains a lasting interest in an enterprise in another country.’

Most concretely, it may take the form of buying or constructing a factory in a foreign country or adding improvements to such a facility, in the form of property, plants, or equipment.

FDI is calculated to include all kinds of capital contributions, such as the purchases of stocks; as well as the reinvestment of earnings by a wholly owned company incorporated abroad (subsidiary), and the lending of funds to a foreign subsidiary or branch.

The reinvestment of earnings and transfer of assets between a parent company and its subsidiary often constitutes a significant part of FDI calculations.

FDI is more difficult to pull out or sell off. Consequently, direct investors may be more committed to managing their international investments, and less likely to pull out at the first sign of trouble.

On the other hand, FPI (Foreign Portfolio Investment) represents passive holdings of securities such as foreign stocks, bonds, or other financial assets, none of which entails active managemeiit or control of the securities’ issuer by the investor.

Unlike FDI, it is very easy to sell off the securities and pull out the foreign portfolio investment. Hence, FPI cqn be much more volatile than FDI.

For a country on the rise, FPI can bring about rapid development, helping an emerging economy move quickly to take advantage of economic opportunity, creating many new jobs and significant wealth.

However, when a country’s economic situation takes a downturn, sometimes just by failing to meet the expectations of international investors, the large flow, of money into a country can turn into a stampede away from it.

Comparison chart

#FDIFPIWhat is investedFDI involves the transfer of non- financial assets e.g. technology and intellectual capital, in addition to financial assets.FPI involves only investment of financial assets.Stands for. FDI stands for Foreign Direct InvestmentFPI stands for Foreign Portfolio InvestmentVolatilityHaving smaller in net inflowsHaving larger net inflowsManagementProjects are efficiently managedProjects are less efficiently managedInvolvement- direct or indirectInvolved in management and ownership control; long-term interestNo active involvement in management. Investment instruments that are more easily traded, less permanent and do not represent a controlling stake in an enterprise.Sell offIt is more difficult to sell off or pullout.It is fairly easy to sell securities and pull out because they are liquid.Comes fromTends to be undertaken by Multinational organizationsComes from more diverse sources e.g. a small company’s pension fund or through mutual friends held by individuals; investment via equity instruments (stocks) or debt (bonds) of a foreign enterprise.

The Benefits of FDI to the Host Countries

In this section, we will see the four main benefits of FDI for a host country: the resource-transfer effect, the employment effect, the balance-of-payment effect, and the effect on competition and economic growth.

Resource transfer effect

Foreign direct investment can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available and thus boost that country’s economic growth rate.

Capital

Many MNEs, by virtue of their large size and financial strength, have access to financial resources not available to host-country firm.

These funds may be available from internal company sources, or, because of their reputation, large MNEs may find it easier to borrow money form capital markets than host-country firms would.

This consideration was a factor in the Venezuelan government’s decision to invite foreign oil companies to enter into joint ventures with PD VS A, the state owned Venezuelan oil company, to develop Venezuela’s oil industry.

Technology

The crucial role played by technological progress in economic growth is now. widely accepted. Technology can stimulate economic development and industrialization.

However, many countries lack the research and development resources and skills required to develop their own indigenous product and process technology.

This is particularly true of the world’s less developed nations. Such countries must rely on advanced industrial nations for much of die technology required to stimulate economic growth and FDI can provide it.

Management

Foreign management skills acquired through FDI may also produce important benefits for the host country.

Beneficial spin-off effects arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help to establish indigenous firms.

Similar benefits may arise if the superior management skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own. management skills.

Employment effect

The beneficial employment effect claimed for FDI is that it brings jobs to a host country that would otherwise not be created there. As we saw in the opening case of Toyota in France, employment effects are both direct and indirect.

Direct effects arise when a foreign MNE employs a number of host-country citizens. Indirect effects arise when jobs are created in local suppliers as a result of the investment and when jobs are created because of increased local spending by employees of the MNE.

The indirect employment effects are often as large as, if not larger than, the direct effects. The opening case revealed that Toyota’s investment in France created 2,000 direct jobs and perhaps another 2,000 jobs in support industries.

Balance-of-payment effects

FDI’s effect on a country’s balance-of-payments accounts is an important policy issue for most host governments. Here we will examine the link between FDI and the Balance-of-payment accounts.

Given the concern about current account deficits, the balance-of-payments effect of FDI can be an important consideration for a host government

First, when an MNE establishes a foreign subsidiary, the capital account of the host country benefits from the initial capital inflow. However, this is a one-time-only effect.

Second, if the FDI is a substitute for imports of goods or services, it can ‘ improve the current account of the host country’s bajance-of-payments.

Much of the FDI by Japanese automobile companies in the United States and United Kingdom, for example can be seen as substituting for imports ‘ from Japan.

Thus, the current account of the US balance-of-payments has improved somewhat because many Japanese companies are now supplying the US market from production facilities in the United States, as opposed to facilities in Japan.

A third potential benefit to the host country’s balanCe-of payments position arises when the MNE uses a foreign subsidiary to export goods and services to other countries.

Effect on competition and economic growth

Economic theory tells us that the efficient functioning of markets depends t on an adequate level of competition between producers.

By increasing consumer choice, foreign direct investment can help to increase the level of competition in national markets, thereby driving down prices and increasing the economic welfare of consumers.

Increased competition tends to stimulate capital investments by firms in plant, equipment, and R&D (research and development) as they struggle to gain an edge over their rivals.

The long-term results may include increased productivity growth, product and process innovations, and greater economic growth.

FDI’s impact on competition in domestic markets may be particularly important in the case of services, such as telecommunications, retailing, and many financial services, where exporting is often not an option because the service has to be produced where it is delivered.

The Costs of FDI to Host Countries

Three costs of FDI concern host countries. They arise from possible adverse effects on competition within the host nation, adverse effects on the balance of payments, and the perceived loss of national sovereignty and autonomy.

Adverse effects on competition

If it is part of a larger international organization, the foreign MNE may be able to draw on funds generated elsewhere to subsidize its costs in the host market, which could drive indigenous companies out of business and allow the firm to monopolize the market.

Once the market was monopolized, the foreign MNE could raise prices above those that would prevail in competitive markets, with harmful effects on the economic welfare of the host nation.

Adverse effect on balance of payments

There are two main areas of concern with regard to the balance-of- payments. First, the initial capital inflow that comes, with FDI must be the subsequent outflow of earnings from the foreign subsidiary to its parent company. Such outflows show up as a debit on the capital account.

A second concern arises when a foreign subsidiary imports a substantial number of its inputs from abroad, which results in a debit on the current account of the host country’s balance of payments. Those worsen balance of payment.

National sovereignty and autonomy

Many host governments worry that FDI is accompanied by some loss of economic independence.

The concern is that key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control.

A quarter of century ago this concern was expressed by several European countries, who feared that FDI by US MNEs was threatening their national sovereignty.

The same concerns are now surfacing in the United States with regard to European and Japanese FDI. The main fear seems to be that if foreigners own assets in the United States, they can somehow “hold the country to economic ransom.”

Benefits of FDI to the home country

The benefits of FDI to the home country arise from three sources. First,* and perhaps most important, the capital account of the home country’s balance of payments benefits from the inward flow of foreign earnings.

Thus, one benefit to Japan from Toyota’s investment in France are the earnings that are subsequently returned to Japan from France. FDI can also benefit the current account of the home country’s balance of payments if the foreign subsidiary creates demands for home-country exports of capital equipment, intermediate goods, complementary products, and the like.

Second, benefits to the home country from outward FDI arise from employment effects.

As with the balance of payments, positive employment effects arise when the foreign subsidiary creates demand for home-country exports of capital equipment, intermediate goods, complementary products and so on.

Thus, Toyota’s investment in auto assembly operations in Europe has benefited both the Japanese balance of payments position and employment in Japan, because Toyota imports some component parts for its European-based auto assembly operations directly from Japan.

Third, benefits arise when the home-country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country. This amounts to a reverse resource transfer effect.

Through its exposure to a foreign market, an MNE can learn about superior management techniques and superior product and process technologies. These resources can then be transferred back to the home country, contributing to the home country’s economic growth rate.

Costs of FDI to the home country

Against these benefit must be set the apparent costs of FDI for the home (source) country. The most important concerns center around the balance of payments and employment effects of outward FDI.

The home country’s balance of payments may suffer in three ways.

First, the capital account of the balance of payments suffers from the initial capital outflow required to finance the FDI.

Second, the current account of the balance of payments suffers if the purpose of the foreign investment is to serve the home market from a low-cost production location.

Third, the current account of the balance of payments suffers if the FDI is a substitute for direct exports from Japan, the current account position of Japan will deteriorate.

With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for domestic production.

One obvious result of such FDI is reduced home country employment. If the labor market in the home country already very tight, with little unemployment, this concern may not be that great.

However the home country is suffering from unemployment, concern about the export of jobs may arise.

For example, one objections frequently raised by US labor leaders to the free trade pact between the United States, Mexico and Canada is that the United States will lose hundreds of thousands of jobs as US firms invest in Mexico to take advantage of cheaper labor and then export back to the United States.