Note on Foreign direct investment -Types, Nature, Objectives, Advantage, Theories and Growth

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Foreign Direct Investment

Foreign Direct Investment
Foreign Direct Investment
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Foreign direct investment refers to the investment placed directly in business operation in a foreign country. In other words, foreign direct investment is the act of moving the capital across the border for the purpose of actively controlling property and ownership of a company in a foreign land. When a firm undertakes a foreign direct investment, it becomes a multinational company or multinational enterprise. Foreign direct investment also occurs when a firm buys an existing company in a foreign country. So, foreign direct investment is capital investment made by one country to another country. It can be done by

  • Starting a subsidiary for local manufacturing. It is fully owned and controlled company.
  • Acquisition of existing foreign company.
  • Participation in joint venture with a local partner.
  • Portfolio investment in the share of foreign companies.
  • Support for a project in foreign company.

Types of foreign direct investment

Foreign direct investment takes on main two forms. They are

Greenfield investment and acquisitions: Greenfield investment is also known as direct investment acquisition. Greenfield investment and acquisitions are to establish a wholly new industry or operation in foreign country. It can also involve acquisition where a company can acquire other foreign company with a minority share such as 10% to 49%, majority share such as 50% to 99% or even with full outright stake. A company can also purchase a sufficient share in another foreign country's company to obtain its significant management and make direct investment in that venture. Acquiring a sufficient share in another foreign country's company is known as acquisition.

Foreign portfolio investment: Foreign portfolio investment is an investment by individuals, firms or public organization in foreign financial instruments. Example: government funds, foreign stocks etc. Such purchase of share and bonds aims at obtaining returns on the funds invested. Importantly foreign portfolio investment does not involve taking a significant equity stake in a foreign business entity. Such that the entity stake is less than 10%. Foreign portfolio investment is also known as a noncontrolling interest as such investment have generally no intention to control the organization but only a goal of earning returns on investment.

Nature of foreign direct investment

Horizontal and vertical foreign direct investment

Horizontal foreign direct investment is the investment in the same industry abroad as a firm operates at home. For example, Nepal oil corporation who sell the oils in Nepal if they open in India for selling the oil then it is a horizontal foreign direct investment. If they invest in Qatar mineral resources of oil then it is vertical foreign direct investment.

Dabur India has invested in Nepal in the same industry Ayurveda herbal product, tooth product etc. On the other hand, vertical foreign direct investment is the investment in an industry abroad that provides inputs or sells output from a firm's domestic operations. Vertical foreign direct investment is of two types. They are backward vertical foreign direct investment and forward vertical foreign direct investment.

There is backward vertical foreign direct investment in extractive industries like oil extraction, copper mining etc. It is so because they obtain imports of oil copper from mines abroad and use these raw materials in their real stream operation of oil refining and copper productions respectively at home. Extractive industries collect inputs from abroad and use for the domestic purpose. There is a forward vertical foreign direct investment in which an industry abroad sells the output of a firm's domestic production. Forward vertical foreign direct investment is less common than backward.

Objectives of foreign direct investment

Following are the objectives of foreign direct investment.

  • Expand sales in foreign market.
  • Gain access to raw materials supplies.
  • Take advantage of cheap labor.
  • Transfer capital, technology management, and marketing skills to foreign countries.

Advantages of foreign direct investment

Capital transfer: Foreign direct investment is an important means of capital transfer of foreign countries. It is a great support for international business to balance capital country wise.

Productivity improvement: Foreign direct investment facilitates technology transfer. The result of technology upgrading is productivity improvement. 

Management development: Local manager gets trained in foreign firms. They acquire new concept, tools, and technology of management. Management development takes place.

Employment: Foreign country generates new employment. Direct investment system provides excellent job opportunities in world level.

Better product quality: Foreign direct investment helps to produce the best product in the market.

Export: Foreign direct investment helps to increase sales throughout the world. It helps to expand the market in the international business.

Foreign direct investment as an alternative to trade

Foreign direct investment has emerged in recent years as an alternative to international trade whereas international trade and investment are two major component of international business. Historically, international business has been a prominent feature of the economic development of a number of countries for at least past 150 years but the wave of foreign direct investment issues was noticed more lately. US companies started foreign direct investment in western Europe between 1946 and the mid-1960s. Similarly, developed countries prefer trade, developing countries prefer foreign direct investment. Trade and foreign direct investment are mutually influential. Foreign direct investment increases trade in developing countries. Foreign manufacturing by foreign direct investment decreases trade from developed countries.Trade is increasingly becoming dependent on investment.

Hence, foreign direct investment and trade are complimentary to each other. Developing countries prefer foreign direct investment rather than impact from developed countries. For them, foreign direct investment is an important and beneficial alternative to importing trade. Manufacturing facilities established from foreign direct investment also promote export to developed countries.

Foreign direct investment theories

The theory explains international foreign direct investment. The important theories are:

Product life cycle: This theory states that production location of the product shift to different category stage of different nation. For example, a new product is first manufactured by the USA and it is exported to the other developing markets. Manufacturing is shifted to other developed countries as competition increases. As the competition is further intensified manufacturing is shifted to developing countries.

Market imperfection theory: This theory states that market imperfection is the base of foreign investment. In an international market, high level of competition happens between the countries.  For example, USA and UK grabbed wider range of markets in an international level business. Hence, their standard determination is high rank applied Kindle Berger imperfection theory because this theory is determined on the basis of market covering range in international level.

Monopolistic advantage theory: The market which has no perfect competition is known as imperfect market or market imperfection. For example monopolistic market. This theory has been proposed by Stephen Hymer in 1960s. This theory states that foreign direct investment occurs largely in oligopolistic industries. This decision to invest in the foreign market is based on certain advantages possessed by foreign firms over local firms. There can be economies of scale, superior technology or skill management, production, marketing, analyzing, directing, handling and financing process. Hence, there is a monopolistic benefit over local firms that is their exist product market imperfections.

Electric theory: This theory is asserted or miscellaneous theories as it combines the diverts elements of some of the foreign direct investment theories. This theory is also known as Dunning electric theory of international production as Jhon Dunning explained it in his book" Explaining international production" in 1988. This theory explains that a firm goes abroad for investment due to the following three comparative advantages.

  • Ownership specific advantages: A firm can reap or grasp the benefits of technology, knowledge, and monopolistic advantages when it invests in foreign countries.
  • Location-specific advantages: A firm investing abroad can generate more profit due to the location advantages including physical, economic and political benefits. If the political system and the government of that foreign country provide a free business environment, discounts, and incentives in business through economic policies the firm can be in all win situation. Availability of physical resources in that country also can yield better advantage to the firm.
  • Internationalization advantages: The firm when goes abroad for investment can gain higher returns in licensing, franchising or exportation rather than functioning in full operation. A firm can transfer its superior technology or management to other foreign countries so that it can gain higher returns on technology or inter-property right and management royalty from those foreign countries.

Growth trends of foreign direct investment

Fall in global foreign direct investment inflows: According to world investment report, global foreign direct investment inflows recovered after 2010 till 2013. Inflows fell by 16% in 2014 because of the fragility of global economic policy uncertainty and increased Geo- political risk. 

 

Rise in inward foreign direct investments to developing economics: Among the top 10 foreign direct investment recipients in the world, 5 are developing economics.

The following points summarize the global trend of foreign direct investment growth and direction as explained by "UNCIAP'S" latest report of foreign direct investment.

  • Foreign direct investment declines drastically in 2008 and 2009 but it is currently recovering after 2010. Foreign direct investment flows are accepted to reach the level of $ 1.6 trillion in 2014 and $ 1.8 trillion in 2015. (UNCIAD world investment report, 2013)
  • Foreign direct investment is expected to span as countries have continued with their economic liberalization programs. Liberalization has gained speed as there are more countries joining the bilateral and regional economic integration and co-operation. For example NAFTA, NAFTA, EU, BIMSTEC, ASEAN.
  • Cross boarder mergers and acquisitions have increased. It is the indication of an increment in foreign direct investment in the form of merger and acquisition.
  • Transnational companies (TNC'S) has continued to contribute global business and economy highlight importance of their roles.
  • Demand for the foreign direct investment's in infrastructure building is increasing.
  • In the global foreign direct investment, there has been a marked shift towards the service sectors. It means that there is a priority to invest in service sector also.

Growth trend in Nepal

  • Foreign direct investment inflow increased after the restoration of democracy in 1990 as country adopted liberal and open market policy.
  • Foreign investment and technology transfer Act was enforced in 1992 to replace old Act 1981 that supported foreign direct investment inflow.
  • Political instability is blamed for the slow growth of foreign direct investment inflows into Nepal.
  • After promulgation of the constitution making Nepal a federal democratic republic in September 2015, foreign direct investment inflows are expected.

 

References

Pearce, J.A., & Robinson, R.B. (2012).Strategic management: Formulation, Implementation, and Control.New York: McGraw Hill Irwin

Johnson G., Scholes K., Whittington R. (2008). Exploring corporate strategy (8thed.). Pearson:Edinburgh Gate, Prentice hall:

  • Foreign direct investment refers to the investment placed directly in business operation in a foreign country. In other words, foreign direct investment is the act of moving the capital across the border for the propose of actively controlling property and ownership of a company in a foreign country.
  • Foreign direct investment takes on main two forms.
  • Foreign portfolio investment is investment by individuals, firms or public organization in foreign financial instruments.
  • Horizontal foreign direct investment is the investment in the same industry abroad as a firm operates at home.
  • Vertical foreign direct investment is the investment in an industry abroad that provides inputs or sells outputs from a firm's domestic operations.
  • Foreign direct investment and trade are complimentary to each other.
  • Product life cycle: This theory states that production location of the product shift to different category stage of different nation.
  • Market imperfection theory: This theory states that market imperfection is the base of foreign investment. In an international market, high level of competition happen between the countries
  • Monopolistic advantage theory: The market which has no perfect competition then it is known as imperfect market or market imperfection.
  • Electric theory: This theory is asserted or miscellaneous theories as it combines the diverts elements of some of the foreign direct investment theories.
  • According to world investment report, global foreign direct investment inflows is recovered after 2010 till 2013. Inflows fell by 16% in 2014 because of the fragility of global economic policy uncertainty and increased Geo- political risk.
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