Module : Foreign Direct Investment

Introduction:

Module Outcome:

Specific Learning Outcomes:

5.1
5.2 Discuss the barriers of foreign direct investment.
 Let’s get
ready to
ENGAGE!

Pre-Activity!
 Let’s What Is a Foreign Direct Investment (FDI)?

EXPLORE!

How a Foreign Direct Investment Works?

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.

The Bureau of Economic Analysis (BEA), which tracks expenditures by foreign direct investors into U.S.
businesses, reported total FDI into U.S. businesses of $4.46 trillion at the end of 2019. Manufacturing repre -
sented the top industry, with just over 40% of FDI for 2019.

Special Considerations

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 estab-
lished by the Organisation of Economic Co-operation and Development (OECD), is a minimum 10% owner-
ship stake in a foreign-based company. However, that definition is flexible, as there are instances where effec-
tive controlling interest in a firm can be established with less than 10% of the company's voting shares.

Types of Foreign Direct Investment

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 for-
eign 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.

A conglomerate type of foreign direct investment is one where a company or individual makes a for-
eign investment in a business that is unrelated to its existing business in its home country.

72
 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 com-
pany already operating in the industry.

Example of Foreign Direct Investments

Examples of foreign direct investments include mergers, acquisitions, retail, services, logistics, and
manufacturing, among others. 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 an-
nounced 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 fueled by an influx of FDI targeting the nation's high-tech manufactur-
ing 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 2017.3 Meanwhile, relaxed FDI regulations in India now allows 100%foreign
direct investment in single-brand retail without government approval.4 The regulatory decision
reportedly facilitates Apple's desire to open a physical store in the Indian market. Thus far, the firm's
iPhones have only been available through third-party physical and online retailers.

Frequently Asked Questions

What is Foreign Direct Investment (FDI)?

Foreign Direct Investment (FDI) is the practice of starting or investing in businesses in foreign
countries. For example, if an American multinational firm opens up operations in China or India, either by
opening up its own premises or by partnering with a local firm, that investment would be considered part
of FDI. Economists track the flows of FDI between countries as this is seen as an important contribu-tor to
economic growth.

What are the advantages and disadvantages of Foreign Direct Investment (FDI)?

FDI can help foster and maintain economic growth, both for the recipient country and for the coun-
try making the investment. For example, a developing country might benefit from incoming FDI as a way
of financing the construction of new infrastructure or providing employment for its local workforce. On
the other hand, multinational companies can benefit from FDI as a way to expand their footprint into in-
ternational markets. One of the main disadvantages of FDI, however, are that it tends to rely on the in-
volvement or oversight of multiple governments, leading to higher levels of political risk.

What are some examples of Foreign Direct Investment (FDI)?

One of the largest examples of Foreign Direct Investment (FDI) today is the Chinese initiative known
as One Belt One Road (OBOR). This program, sometimes referred to as the “Belt and Road” initia-tive,
involves contributing substantial FDI toward a range of infrastructure programs throughout Africa, Asia,
and even parts of Europe. The FDI is typically funded by Chinese state-owned enterprises or other
organizations associated with the Chinese government. Similar programs are also undertaken by other
nations and international bodies, such as Japan, the United States, and the European Union (EU).
 Let’s
Motives for Foreign Direct Investment
EXPLAIN!

Why opt for FDI?

The meaning of FDI is not restricted only to international movement of capital. Its definition also en-
compasses the international movement of elements that are complementary to capital - such as skills, process-
es, management, technology etc.

There is a difference between FDI and FPI (Foreign Portfolio Investments), wherein the investor pur-
chases equity of foreign companies. FPI means only equity infusion, and does not imply the establishment of a
lasting interest.

FDI can be Greenfield, wherein an organisation creates a subsidiary concern in another country and
builds its business operations there from the ground up. Greenfield investments provide the highest degree of
control to the organisation. It can construct the production plant as per its specifications, employ and train hu-
man resources as per company standards, as well as design and monitor its operational processes.

Alternatively, FDI can be brownfield - wherein an organisation expands by way of cross-border mer-
gers, acquisitions and joint ventures - by either leasing or purchasing existing facilities for its production. The
clear advantage of brownfield investments is the savings in cost and time for starting up, as well as engaging
in construction activities. Addition of equipment to an existing facility also qualifies as brownfield investment.

It is difficult to overstate the global and macroeconomic significance of FDI. As per UNCTAD (United
Nations Conference on Trade and Development), global FDI amounted to around $ 1.8 trillion in 2015.

There are many ways in which FDI benefits the recipient nation:

1. Increased Employment and Economic Growth

2. Human Resource Development

1. Development of Backward Areas

This is one of the most crucial benefits of FDI for a developing country. FDI enables the transfor-
mation of backward areas in a country into industrial centres. This in turn provides a boost to the social
economy of the area. The Hyundai unit at Sriperumbudur, Tamil Nadu in India exemplifies this process.

2. Provision of Finance & Technology

Recipient businesses get access to latest financing tools, technologies and operational practices
from across the world. Over time, the introduction of newer, enhanced technologies and processes results
in their diffusion into the local economy, resulting in enhanced efficiency and effectiveness of the indus-
try.

3. Increase in Exports

Not all goods produced through FDI are meant for domestic consumption. Many of these products
have global markets. The creation of 100% Export Oriented Units and Economic Zones have further as-
sisted FDI investors in boosting their exports from other countries.

4. 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. This in turn ensures
stable exchange rates.

5. Stimulation of Economic Development

This is another very important advantage of FDI. FDI is a source of external capital and higher rev-
enues 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. These factories will also create additional tax revenue for the Govern-
ment, that can be infused into creating and improving physical and financial infrastructure.

6. 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.

7. 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 innova-
tion. Consumers also gain access to a wider range of competitively priced products.
 Let’s
EXPLAIN! The Barriers of FDI

Political Risk and FDI

In assessing investment opportunities in a foreign country, it is important for a parent firm to take
into consideration the risk arising from the fact that investments an located in a foreign country. A sover-
eign country can take various actions that ma) adversely affect the interests of MNCs. In this section, we
are going to discuss how « measure and manage political risk, which refers to the potential losses to the
parent firm resulting from adverse political developments in the host country. Political risk: range from
the outright expropriation of foreign assets to unexpected changes in the tax laws that hurt the profitabil-
ity of foreign projects.

Political risk that firms face can differ in terms of the incidence as well as the manner in which po-
litical events affect them. Depending on the incidence, political risk can be classified into two types:

1. Macro risk, where all foreign operations are affected by adverse political developments in the host
country.

2. Micro risk, where only selected areas of foreign business operations or particular foreign firms are
affected.

The communist victory in China in 1949 is an example of macro risk, whereas the predicament of En-
ron India, which we will discuss shortly, is ~~ example of risk.
Depending on the manner in which firms are affected, political risk can be classified into three types: 10
Transfer risk, which arises from uncertainty about cross-border flows of capital, payments, know-
how, and the like.
Operational risk, which is associated with uncertainty about the host country's policies affecting the
local operations of MNCs.
Control risk, which arises from uncertainty about the host country's policy
regarding ownership and control of local operations.
Examples of transfer risk include the unexpected imposition of capital controls, inbound or out-
bound, and withholding taxes on dividend and interest payments. Examples for operational risk, on the
other hand, include unexpected changes in envi•ronmental policies, sourcing/local content require-
ments, minimum wage law, and restriction on access to local credit facilities. Lastly, examples of control
risk include restrictions imposed on the maximum ownership share by foreigners, mandatory trans•fer
of ownership to local firms over a certain period of time (fade-out requirements), and the nationalization
of local operations of MN Cs.
Recent history is replete with examples of political risk. As Mao Ze-dong took power in China in
1949, his communist government nationalized foreign assets with little compensation. The same hap-
pened again when Castro took over Cuba in 1960. Even in a country controlled by a noncommunist gov-
ernment, strong nationalist senti•ments can lead to the expropriation of foreign assets. For example,
when Gama! Nasser seized power in Egypt in the early 1950s, he nationalized the Suez Canal, which was
controlled by British and French interests. Politically, this move was immensely popu•lar throughout the
Arab world.
 The frequency of expropriations of foreign-owned assets peaked in the 1970s,
when as many as 30 countries were involved in expropriations each year. Since then, however, expropria-
tions have dwindled to practically nothing. This change reflects the popularity of privatization, which, in
turn, is attributable to widespread failures of state-run enterprises and mounting government debts
around the world. This, however, does not mean that political risk is a thing of the past. In 1992, the En-
ron Development Corporation, a subsidiary of the Houston-based energy company, signed a contract to
build the largest-ever power plant in India, requiring a total invest•ment of $2.8 billion. Severe power
shortages have been one of the bottlenecks hinder•ing India's economic growth. After Enron had spent
nearly $300 million, the project was canceled by Hindu nationalist politicians in the Maharashtra state
where the plant was to be built. Subsequently, Maharashtra invited Enron to renegotiate its contract. If
Enron had agreed to renegotiate, it may have had to accept a lower profitability for the project. As can be
seen from the Enron fiasco, the lack of an effective means of enforc•ing contracts in a foreign country is
clearly a major source of political risk associated with FDI.

Political risk is not easy to measure. When Enron signed the contract to build a power plant in In-
dia, it perhaps could not have anticipated the victory of the Hindu nationalist party. Many businesses
domiciled in Hong Kong were nervous about the intentions of Beijing in the post-1997 era. Difficult as it
may be, MNCs still have to measure political risk for foreign projects under consideration. Experts of po-
litical risk analysis evaluate, often subjectively, a set of key factors such as:

• The host country's political and government system: Whether the host country has a political and
administrative infrastructure that allows for effective and streamlined policy decisions has im-
portant implications for political risk. If a country has too many political parties and frequent
changes in government (like Italy, for example), government policies may become inconsistent and
discon•tinuous, creating political risk.

• Track records of political parties and their relative strength: Examination of the ideological orien-
tations and historical track records of political parties would reveal a great deal about how they would
run the economy. If a party has a strong nationalistic ideology and/or socialist beliefs, it may
implement policies that are detrimental to foreign interests. On the other hand, a party that subscribes
to a liberal and market-oriented ideology is not very likely to take actions to damage the interests of
foreign concerns. If the former party is more popular than the latter party and thus more likely to
win the next general elec•tion, MNCs will bear more political risk.

• Integration into the world system: If a country is politically and economically isolated and seg-
mented from the rest of the world, it would be less willing to observe the rules of the game. North
Korea, Iraq, Libya, and Cuba are examples. If a country is a member of major international organi-
zations, such as the EU, OECD, and WTO, it is more likely to abide by the rules of the game, reduc-
ing political risk. In the same vein, as China joins the World Trade Organization (WTO), MNCs
operating in China may face less political risk.

• The host country's ethnic and religious stability: As can be seen from the civil war in Bosnia, do-
mestic peace can be shattered by ethnic and religious conflicts, causing political risk for foreign
business. Additional examples are provided by Nigeria, Rwanda, Northern Ireland, Turkey, Israel,
Sri Lanka, and Quebec.
 • Regional security: Real and potential aggression from a neighboring country
is obviously a major source of political risk. Kuwait is an example. Countries like South
Korea and Taiwan may potentially face the same risk depending on the future course of
political developments in East Asia. Israel and its Arab neigh•bors still face this risk as well.

• Key economic indicators: Often political events are triggered by economic situations. Political risk thus is
not entirely independent of economic risk. For example, persistent trade deficits may induce a host coun-
try's government to delay or stop interest payments to foreign lenders, erect trade barriers, or suspend the
convertibility of the local currency, causing major difficulties for MNCs. Severe inequality in income distri-
bution (for example, in many Latin American countries) and deteriorating living standards (as in Russia
after the collapse of the Soviet Union) can cause major political disturbances.

Political Risk Analysis: Vietnam

Political Strengths

• Political stability with Communist Party in government since end of the country's civil war in 1975
Widespread support for the CPV (Vietnam Communist Party) reflects its success in raising living
standards and creating and maintaining security

Political Weaknesses

• Inconsistent and evolving regulations Unreliable legal system and corruption

• A lack of financial transparency, insufficient protection for Economic Indicators

minority owners, and poor corporate governance.
• GDP ($US bn) -199
Economic Strengths
• GDP per capita ($US) -2,171
• Transformation to market oriented economy since late 1980s
• Real GDP growth (15-year aver-
• High GDP growth facilitated by foreign investment age,%) -6.5
• Well educated and cheap labor force • Fiscal balance(% of GDP) -(5.6)
• Sizable natural resources a~d advantageous location • Public debt(% of GDP) -55.0
Economic Weaknesses • Foreign direct investment(% of
• Large fiscal and trade deficits and weak banking system GDP) -6.1

• Plethora of state-owned enterprises and less diversification • Current account(% of GDP) -0.7

• Industry and credit policies favor state-owned enterprises • External debt(% of GDP) -22,8

Political & Governance Indicators • Foreign reserves(% of GDP) -16.8

• World Bank Ranking - Ease of doing business– 90th/183

• Freedom House - Political rights and civil liberties– Not Free

• Transparency International Ranking• Corruption Perception Index– 112th/180

• OECD country risk rating– 5 (Scale: 0-7, 0 is least risk, 7 is highest risk)