Foreign Direct Investment (FDI)

Foreign Direct Investment (FDI)

• A firm makes a Foreign Direct Investment (FDI) when it invests directly in facilities to produce or market a product in a foreign country
• FDI takes on two main forms:
  • Greenfield investment, which involves establishing a wholly new operation in a foreign country
  • Acquiring or merging with an existing firm in a foreign country
• Acquisitions can be minority (10% to 49% interest), majority (10% to 99% interest), or full outright stake (100% interest)

FDI vs. Foreign Portfolio Investment

• FDI and Foreign Portfolio Investment (FPI) are distinct from each other
• Foreign portfolio investment is investment by individuals, firms, or public bodies in foreign financial instruments, such as government bonds and foreign stocks
• FDI doesn't involve taking a significant equity stake in a foreign business entity
• FPI provides opportunities for diversification and risk reduction in international investments

Definition of Foreign Direct Investment (FDI)

• FDI is defined as an investment made by an investor of one country to acquire an asset in another country with the intent to manage that asset (IMF, 1993)
• The IMF definition of FDI includes:
  • Equity
  • Capital
  • Reinvested earnings of foreign companies
  • Inter-company debt transactions (short-term and long-term loans)
  • Overseas commercial borrowings
  • Non-cash acquisition of equity
  • Investment made by foreign venture capital investors
  • Earnings data of indirectly held FDI enterprises
  • Control premium
  • Non-competition fee
• Foreign investment and technology are important for economic development and have been used by developing countries
• Even communist countries like China have welcomed foreign investment to improve their economies

Attracting FDI

• Developing nations attract FDI using technology and management skills
• Governments offer incentives to attract multinational companies, including:
  • Tax holidays
  • Import duty exemption
  • Subsidized land and power
• FDI contributes to:
  • GDP
  • Capital formation
  • Balance of payment
  • Employment generation

Monopolistic Advantage Theory

• Stefan Hymer connected firm-specific advantages to imperfect competition models in product markets
• A direct foreign investor has a proprietary or monopolistic advantage not available to local firms
• Advantages include economies of scale, superior technology, or superior knowledge in marketing, management, or finance
• FDI occurred due to product and factor market imperfections
• The direct investor is often a monopolist or oligopolist, and governments may need to impose controls

Product and Factor Market Imperfection

• Caves (1971) theorized that a firm's ability to differentiate products, especially high-income consumer goods and services, is a key competitive advantage
• Consumers prefer goods similar to locally made products, giving the firm control over the selling price and an edge over indigenous firms
• Caves observed that companies investing overseas were typically active in industries engaging in heavy product research and marketing

Cross Investment Theory

• E. M. Graham noted cross investment between European and American firms in oligopolistic industries
• European firms invested in the U.S. when American companies expanded to Europe
• These investments would allow European subsidiaries of U.S. firms to retaliate in their home market if U.S. subsidiaries initiated aggressive tactics like price cutting

Internalization Theory

• Internalization Theory extends the market imperfection theory
• Investing in a foreign subsidiary, rather than licensing, allows the company to send knowledge across borders within the firm
• This strategy is expected to yield a better return on the investment made

FDI Approval Routes in India

• In India, FDI approvals are handled by the Reserve Bank of India and the Foreign Investment Promotion Board
• FDI approval in India is expedited by concerned agencies to attract significant foreign direct investment

Foreign Direct Investment in India

• Major economic reforms in India during the early 1990s led to liberalization and deregulation, opening markets to FDI
• Foreign direct investments in India are allowed via:
  • Financial collaborations
  • Joint ventures
  • Preferential allotments
  • Euro issues

Various Routes of FDI Approval in India

• Proposals for foreign direct investment in India are approved through two routes: the Reserve Bank of India and the Foreign Investment Promotion Board
• The Reserve Bank of India grants automatic approval to FDI proposals within two weeks, for investments up to 74%
• The Foreign Investment Promotion Board (FIPB) processes non-automatic approval cases in four to six weeks, with a liberal approach that accepts most proposals

FDI Approval, Economic Growth in India

• FDI approvals in India have increased significantly, especially in telecom, real estate, banking, and insurance
• FDI approvals generally contribute to India's economic growth
• The Indian government has undertaken a comprehensive review of FDI policy, leading to rationalization measures such as dispensing with multiple approvals, extending the automatic route, and allowing FDI in new sectors (Press Note 4, 2006 Series)
• As per current policy, FDI up to 100% is allowed under the automatic route in most sectors/activities

Automatic Route FDI

• FDI under the automatic route doesn't require prior approval from either the Government of India or the Reserve Bank of India (RBI)
• Investors only need to notify the concerned Regional Office of RBI within 30 days of inward remittances and file documents within 30 days of share issue

Routes for Foreign Direct Investment (FDI)

• Automatic Route: FDI up to 100% is permitted automatically in most sectors, except those needing government approval, including:
  • Industries requiring an Industrial License
  • Proposals with an existing Indian venture/tie-up in the same field
  • Proposals for acquiring shares in an existing Indian company
  • Proposals outside notified sectoral policy/caps or in sectors where FDI is not permitted
• Government Approval Route required for activities not covered under the automatic route, and areas/sectors/activities not open to FDI/NRI investment

Government Route of FIPB

• The Foreign Investment Promotion Board (FIPB) is a national agency that considers and recommends FDI not under the automatic route in India, providing a single window clearance

Factors Influencing FDI

• Liberalization is not the only factor attracting FDI
• Kearney's FDI Confidence Audit (February 2001) noted India's market size and potential but cited a negative regulatory environment
• Other determinants include:
  • Rule of law
  • Competitive wages
  • Labor skill
  • Infrastructure
  • Well-developed financial institutions
• Determinants of FDI can be better understood using Porter's Diamond Model of international competitiveness, which identifies factor conditions

Factor Condition

• A nation may have a comparative advantage due to factors of production
• Organizations shift production to countries with economical critical factors
• India's human resources are proven and economical compared to the US and Europe, leading to the establishment of manufacturing units
• India has the largest pool of English-speaking people in Asia, driving MNCs to shift their BPO
• India has a competitive edge in R&D and Software Development, attracting major software companies and research centers
• However, the USA has a better reputation in basic research, leading companies like establishing basic research centers in the USA

Demand Condition

• Demand is a significant factor in deciding the level of FDI
• China and India are popular FDI destinations due to high aggregate demand
• Both are among the top five countries in the world in terms of Purchasing Power Parity
• Most MNCs in sectors like Electronics, FMCG, and Automobiles invest in India and China and invest in R&D to develop products for local consumers in the low-income and middle-income groups

Related and Supported Industry

• MNCs prefer destinations with well-developed supported industries (ancillary units)
• Infrastructure investment is critical
• Well-developed ancillary units and supported industries, such as financial markets and distribution networks, facilitate FDI

Rivalry and Firm Strategy

• The competitive environment influences FDI.
• Businesses prefer investing in low-competition countries
• Even with favorable conditions, a firm's strategy determines whether to invest in attractive destinations
• Some firms aggressively pursue overseas opportunities, while others adopt a wait-and-see approach

Costs & Benefits of FDI

• Costs and benefits associated with FDI can be viewed from the perspective of the host and home country

Benefits of FDI to Host Country

• Four main benefits of FDI to the host country:
  • Resource-transfer effects
  • Employment effects
  • Balance of payments effects
  • Effect on competition and economic growth

Resource-Transfer Effects

• FDI can positively contribute to a host economy by supplying capital, technology, and management resources that would otherwise not be available
• MNEs have access to financial resources unavailable to host-country firms because of internal funding or good reputations for borrowing
• Technology can stimulate economic development and industrialization through the production process or the product itself

Employment Effects

• The effects of FDI on employment are both direct and indirect. Direct effects arise when a foreign MNE employs host-country citizens
• Indirect effects arise when jobs are created in local suppliers due to investment
• Increased local spending creates additional indirect effects
• Indirect employment effects can be as large as, if not larger than, the direct effects

Balance of Payments Effect

• The balance-of-payments effects of FDI are important for host governments concerned about current account deficits
• Three potential consequences can occur:
  • Capital inflow benefits the host country when an MNE establishes a foreign subsidiary
  • FDI can improve the current account balance if it substitutes for imports
  • The host country's balance-of-payments can also benefit when the MNE uses a foreign subsidiary to export goods and services

Effect on Competition and Economic Growth

• Greenfield FDI increases market players, improving consumer choice, competition, and welfare by driving down prices
• Increased competition stimulates capital investments in plant, equipment, and R&D, leading to productivity growth, product and process innovations, and economic growth
• FDI's impact on competition is vital in services like telecommunications, retailing, and finance, where exporting is not feasible

Costs of FDI Concern Host Countries

• Three costs of FDI concern host countries:
  • Possible adverse effects on competition
  • Adverse effects on the balance of payments
  • Perceived loss of national sovereignty and autonomy

Adverse Effects on Competition

• Host governments worry that foreign MNE subsidiaries may have greater economic power than indigenous competitors
• Part of a larger international organization, the foreign MNE can use funds from elsewhere to subsidize costs, monopolizing the market
• This concern is greater in less developed countries with few large firms

Adverse Effects on the Balance of Payments

• Two main areas concern host countries' balance of payments:
  • The initial FDI capital inflow necessitates future earnings outflows from the foreign subsidiary to its parent company, debiting the capital account
  • A foreign subsidiary's imports can negatively affect the current account

Loss of Sovereignty, Autonomy

• Host governments worry that FDI leads to a loss of economic independence
• Key decisions affecting the host country's economy will be made by a foreign parent with no real commitment nor government control

Benefits of FDI to Home Countries

• Three Benefits of FDI to the Home Country
  • The capital account of the home country benefits from the inflow of foreign earnings
  • FDI can also benefit the current account if the foreign subsidiary demands home-country exports of capital equipment and products
  • Employment effects can be realized as the foreign subsidiary creates demand for home-country exports.
• When home-country MNEs learn from exposure to foreign markets, they transfer valuable skills to the home country, fostering economic growth

Costs of FDI to Home Countries

• The most important concerns are the balance-of-payments and employment effects of outward FDI
• The home country's balance of payments suffers in three ways:
  • The initial capital outflow to finance the FDI
  • The current account suffers if the investment serves the home market from a low-cost location
  • The current account suffers if the FDI substitutes direct exports
• Employment concerns arise when FDI substitutes domestic production

Trends in FDI

• Sectors like telecommunication, construction activities, computer software and hardware are the major sectors for FDI inflows in India
• According to AT Kearney report, India ranks third on the FDI Confidence Index globally, with European and North American investors placing it third and Asia-Pacific investors ranking it fourth
• India is the top location for nonfinancial services investment and scores highly in heavy industries, light industries and financial services
• Even during the large economic crisis looming on other economies, FDI inflows to India soared from US$25.1 billion in 2007 to US$41.6 billion in 2008.
• Multinationals are managing to counter FDI restrictions and supply chain challenges at the most possible way showing path to others who are hesitant to enter Indian market

FDI in India

• Measures introduced to liberalize FDI provisions in 1991 have attracted investors
• As a result, FDI inflows to India from 1991/92 to March 2010 increased manifold compared to the period from mid-1948 to March 1990
• $6,303.36 billion FDI equity inflows occurred between August 1991 and January 2011
• The FDI inflows in India during mid-1948 were $2.56 billion, nearly doubling by March 1964 and increasing further to $9.16 billion
• India received cumulative FDI inflows of $53.84 billion during the 1948 to March 1990 period, compared to $1,418.64 billion during the August 1991 to March 2010 period.