Chapter 4

FOREIGN DIRECT INVESTMENT

FDI is the outcome of Mutual interest of MNC’s and host countries. The FDI refers to the
investment of MNC'’ in host countries in the form of creating productive facilities and
having ownership and control. On the other hand if MNC or a foreign organization or a
foreign individual buys bonds issued by host country it is not FDI, as it has no attached
management or controlling interest. Such investments are called Portfolio Investments.

In developing countries FDI is seen as a useful source of funds. LDC’s look upon FDI as a
source to bridge their demand supply gap of funds. It represents an important source of non-
debt inflow that often brings along with it new technology and management expertise. It is
also an important vehicle of growth as it links international markets, and plays an important
role in creating new employment and economic revitalization.

Why FDI?

FDI is risky and expensive/costly when compared with licensing. FDI is risky because of
problems associated with doing business in another county with alien culture and legal
environment. There are different rules of the game. The FDI is expensive because of the
reason that the investing firm must bear the cost of establishing production facilities in a host
country or bear the cost of acquiring a foreign firm.

There are at least six important reasons why FDI flows:

(1) Transportation Costs

(2) Market Imperfection
(3) Competition
(4) Product Life Cycle
(5) Locational Advantages
(6) Potential of Developing Countries.
 Transportation Market Competition
Costs Imperfection

Why FDI?

Locational Product Life

Developing
Advantage Cycle
country’s
Potential

1) Transportation Costs:

Goods may be having low value/weight ratio (ex. Soft Drink, Cement etc). Due to high
cost of transportation in such cases, attractiveness to export decreases and establishing
manufacturing facility in host country is preferred. It is also because MNC’s prefer a
location to manufacture from where exporting to nearby regions becomes cheaper in
terms of transportation costs.

2) Market Imperfections (International Theory):

This theory explains 2 major impediment barriers to exporting and barriers to sale of
know how.
The barrier to exports are imposed by government through tariffs, Quotas and restrictions
on import of goods. Hence, exports to such countries is restricted. Sale of know-how
through licensing has some attached disadvantage – (1) Firm gives away its know-how to
a potential foreign competitors. Ex: RCA corps. of USA gave license to Sony and
Matushita of Japan to produce colour TV. RCA saw this as a good way of earning
profits. But Sony and Matushita quickly assimilated RC’s technology and used it to enter
into US Market, compete with RCA only. RCA now is reduced to a minor player in its
own home market.
(2) License does not give the chance to Licensor to exercise right control on
manufacturing, marketing and to implement right strategies in foreign country – and this
may be required to exploit full profit potential of business.
Where tight control on foreign entity is required, FDI is preferable. (3) The company’s
know how may include management know-how and marketing know-how. Consider
Toyota. Globally it is acknowledged as Leading Auto Producer and is credited with
pioneering the development of new production process, known as lean-producer that
enables it to produce high quality products and low costs as compared to global
competitors. Its competitive advantage comes from management and process know-how,
which cannot be licensed. Toyota is therefore increasingly pursuing FDI strategy for
growth.
Further, if markets were perfect, all factors of production (except land) would be mobile and
freely transferable. In real life, markets are imperfect and factors of production are
somewhat immobile. Thus, it is worthwhile for MNC’s to survey markets to determine if
they can benefit from the cheaper cost of producing in those markets. For instance, Japanese
companies are using Mexico as a low labour cost country for production. Many
organizations have established subsidiaries in countries where production costs are low such
as Mexico, Malaysia, Hong Kong and Taiwan.

3) Competition:

FDI often takes place due to rivalry among the firms in global market. Assume A, B, and
C are in competition and are in oligopolistic market in Home Market. If A established a
subsidiary in a foreign country and is successful, B & C will follow suit. For example,
Honda undertook FDI in USA and Europe in 80’s soon Toyota and Nissan followed to
ensure that their relative market position remains undisturbed.

4) Product Life Cycle Theory / Seeking New Source of Demand:

Prof. Venon argued that often the same company that pioneers product in its home country
undertakes to produce and market it abroad because in its home country the product
reaches maturity and stagnation stage. Thus Xerox of US introduced the photocopier in
USA and it was Xerox that set up Fuji-Xerox in Japan and Rank-Xerox in U.K. to serve
these markets. The firm shifts production to developing countries when the product
standardization and market situation give rise to price competition and cost pressures.
Investment in developing countries where labour costs are lower is seen as the best way to
escape from such competition and reduce costs.

5) Locational Advantages:

Certain location – specific advantages attract the FDI – e.g. Availability of natural
resources (e.g. Oil deposit). Another advantage is availability of skilled human resources.
Ex. BPOS in India, Hyundai, the Auto giant of Korea has chosen India and China as FDI
locations because of availability of skilled labour at low wage rate.

6) Potential in Developing Countries:

Besides producing marketing potential the developing countries produce environment for
such FDI. A developing country is usually characterized by low savings, low capital,
stock and low investment. Such a country looks for external source to bridge its
resources gap. Hence, FDI is encouraged. The LDC’s also often receive technology,
work culture and advanced managerial techniques along with FDI. In view of the
immense benefits of FDI the LDC’s produce suitable policy environment to attract them.
Benefits of FDI to Host Country

1) FDI helps to bridge the gap between supply of the Domestic Savings and the Demand
for the investible resources in host countries.

2) FDI not only provides the finance but also provides managerial, administrative and
technical, HRD expertise, new technology, research, development and innovations in
products and techniques of production, which are in short supply in LDC’s.

3) FDI encourages local enterprises to invest more itself in ancillary industries or in

collaboration with foreign enterprises.

4) FDI adds more value added to output in host country than the return on capital from
foreign investments. Thus in this sense social returns are greater than the private
returns on foreign investment.

5) FDI also brings revenue to the government of the host country in terms of taxes.

FDI in India (India’s Experiences)

India needs FDI to accelerate pace of its development. India is an economy with huge
market, a vast pool of skilled and unskilled workers, fairly good legal system associated with
law and order, liberalization and globalization oriented policies. Therefore, India is a rightful
destination for flow of FDI. In particular, India has provided following policy measures to
attract the FDI.

1) India has devalued its currency and has made it convertible on current account.

2) India has signed the multilateral investor protection treaty to protect the interest of
foreign investors.

3) For 51 priority industries, automatic clearance is given by RBI, without referring to

Government for FDI. For speedy approval of other cases as well as for attracting
FDI, the Foreign Investment Promotion Board (FIPB) is established.

4) For reducing the time lag between approval and implementation of the FDI projects,
the Foreign Investment Implementation Board has been set up.

5) Apart from structural reforms and dismantling regular environment, the Government
has opened up all areas, except Agriculture and plantations for foreign
investments….etc.

All these measures have resulted in positive results. The FDI flows into India has surged
from $97 million in 1990-91 to $2633 million in 2000-01 and further to $3.6 million in 2002-
03. In fact the world has experienced in the last one-decade dramatic FDI flows, but a large
portion of FDI has flown to developing countries. The U.S. was the largest recipient of FDI,
followed by China. In fact, the total inflow of FDI into developing countries is less than
what US alone has received.
Why India received Low Inflow of FDI?

Reasons for low inflow of FDI into India are as follows:

1) Tight bureaucratic controls and delay in approvals and implementation of schemes,

together with red tapism and corruption have hindered the smooth inflow of FDI into
India.

2) Despite cheap labour, high cost of production, rigid labour laws, non-existence of
sufficient backward linkages and the reservation of items of small industry sector are
some other reasons for low FDI.

3) The common attitude of misguided dislike and hostility to FDI has prevented smooth
inflow of FDI.

4) Poor and inadequate physical infrastructure like telecommunication, power supply,

water supply, road and railways transportation have deferred the smooth inflows of
FDI.

5) The exit routes/policies for FDI are not defined adequately and clearly.

6) Enron experience is still fresh in minds of Foreign Investors and has been inhibiting
factor.

FDI and China

For the last few years particularly in last 7 to 8 years, China has been the largest receiver of
FDI, among the host developing countries. The FDI received by India in the last 10 years
has been less than one-tenth of what is received by China. Of the total FDI to China about
80% has come from Asian countries – Hong Kong (now part of China), Singapore, Korea
and Japan, with the balance 20% coming from USA and Europe. It has been reported that
foreign investment and ownership in China has accounted for 12% to 15% of industrial
production there with manufacturing concentrated in toys, shoes, electrical appliances and
other labour intensive sectors.

The reasons for the rise in FDI to China are multiple. With a population of 1.2 billion
people, China represents largest market potential in the world. A combination of cheap
labour, tax incentives, provision of special economic zones with special incentives, has
helped the flow of FDI to China. The import tariff and structure vis-à-vis other policy
environment is such that MNC’s and other foreign investors are induced to bring FDI to
China. China has in the recent years committed over $800 billion to improvements of roads
and in and other infrastructure in China. China was also been pursuing macro economic
policy that includes an emphasis on maintaining steady economic growth, low inflation and a
stable currency, all of which are attractive for Foreign Investment.

----------------------------------------------------------------------------------------------------