International Business - Foreign Direct Investment

 

Foreign Direct Investment – Benefits and Costs

            Foreign Direct investment occurs when a firm invests directly in facilities to produce or market a good or service in a foreign country. World Investment Report defines FDI as an investment involving a long-term relationship and reflecting a lasting interest and control by a resident entity in one economy in an enterprise resident in an economy other than that of the foreign direct investor. FDI may be undertaken by individuals as well as business entities. FDI has three components: Equity Capital, Reinvested earnings and Intra-company loans. The flow of FDI refers to the amount of FDI undertaken over a given time period. This comprises capital provided by a foreign direct investor to an FDI enterprise, or capital received from an FDI enterprise by a foreign direct investor. The stock of FDI refers to the total accumulated value of foreign owned assets at a given time.

Forms of FDI:

Greenfield investments: Involves the establishment of a new operation in a foreign country

Acquisitions: Acquiring or merging with an existing firm in the foreign country

Theories of Foreign Direct Investment:

Theory of Capital Movements: The existence of perfectly competitive market, considered foreign investments as a form of factor movement to take advantage of the differential profit.

Market Imperfections Theory/ Monopolistic Advantage Theory: Foreign direct investment occurred largely in oligopolistic industries rather than in industries operating under near perfect competition.

Internalization Theory: Foreign investment results form the decision of a firm to internalize a superior knowledge. Methods of internalization includes formal ways like patents and copy rights and informal ways like secrecy and family networks.

Appropriability Theory: A firm should be able to appropriate the benefits resulting from a technology it has generated.

Location Specific Advantage Theory: Foreign investment is pulled by certain location specific advantages such as labor costs, marketing factors, trade barriers and government policies.

Eclectic Theory – John Dunning: The foreign investment by MNCs results from three comparative advantages such as location, firm and internalization. The theory failed to explain the foreign investment for acquisitions.

Knickerbocker’s Theory of Oligopolistic and Multinational Enterprise: When one firm, especially leader in an oligopolistic industry entered a market, other firms in the industry follow it to defend their market share from being taken away by the initial investor with the advantage of local production.

Benefits and Costs of FDI:

Host-Country Benefits:

Resource-transfer effects: FDI 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.

Employment effects: FDI brings in job opportunities when a foreign multinational enterprise invest in new industry or expand the acquired enterprise either by employing a number of host country citizens.

Balance of Payments effects: If the FDI is substitute for imports of goods or services, the effect can be to improve the current account of the host country’s balance of payments.

Effect on Competition and Economic Growth: When FDI takes the form of a greenfield investment, it results in the establishment of new enterprise, increasing the number of players in a market thus increases the level of competition fostering the economic welfare of consumers by driving down prices. The long-term results would be like increased productivity growth, product and process innovations, and greater economic growth.

Host- Country Costs:

Adverse effects on Competition: When FDI takes the form of acquisition of established enterprise or merging of two or more enterprises, it would result in reduction of competition level in that market, thus creating a monopoly power for the foreign firm, reduced consumer choice and increase in price level.

Adverse effects on the Balance of Payments: The initial capital inflow that comes with the FDI must be the subsequent outflow of earnings from the foreign subsidiary to its parent company. Such outflows show up as capital outflow on balance of payments accounts. 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.

Effects on National Sovereignty and Autonomy: The FDI is accompanied by some loss of economic independence of the host governments that affects the host country’s economy because of loss of control over it and the lack of commitment by the foreign company.

Home-Country Benefits:

Balance of Payments effects: The home country’s balance of payments benefits from the inward flow of foreign earnings; also benefits from the demands created for home country exports of capital equipment, intermediate goods, complementary products.

Employment effects: When a foreign subsidiary creates demand for home-country exports, positive employment effects arise, thus benefiting the home country from outward FDI.

Reverse Resource-transfer effect: When the home country MNE learns valuable skills, superior management techniques and superior product and process technologies, from its exposure to foreign markets that can be subsequently transferred back to the home country, thus contributing to the economic growth rate of the home country.

Home-Country Costs:

Balance of Payments effects: The balance of payments suffers from the initial capital outflow required to finance the FDI. The current account of the balance of payments suffers if the purpose of the foreign investment is to serve the home market form a low-cost production location. The current account of the balance of payments suffers if the FDI is a substitute for direct exports.

Employment effects: When FDI is regarded as a substitute for domestic production, the result would be reduced home-country employment.