What is Foreign Direct Investment? Advantages, Disadvantages

What is Foreign Direct Investment (FDI)?

Foreign direct investment (FDI) is the direct ownership of facilities in the target country. It involves the transfer of resources including capital, technology, and personnel. Direct foreign investment may be made through the acquisition of an existing entity or the establishment of a new enterprise.

Direct ownership provides a high degree of control in the operations and the ability to better know the consumers and competitive environment.

However, it requires a high level of resources and a high degree of commitment.

As increased globalization in business has occurred, it’s become very common for big companies to branch out and invest money in companies located in other countries. These companies may be opening up new manufacturing plants and attracted to cheaper labor, production, and fewer taxes in another country.

For example General Motors and Volkswagen have invested billions in China, starting more than a decade ago. Ford is rushing to catch up by adding production capacity and expanding its dealer network in China. Ford and its joint-venture partner, Chang’an Ford Mazda Automobile, plan to start producing next-generation Ford Focus models at a new, $490 million plant in Chongqingin 2012.

Features of FDI

FDI is an economic driver of country’s growth and it is a non-debt financial resource. Foreign countries are investing in India due to cheap labour, tax exemptions, etc.

There are various features of FDI, some of which are as follows:

• FDI is made in countries with open economy that have potential growth prospects and skilled workforce.
  
  
• FDI does not offer quick capital gains as it involves long-term commitment.
  
  
• Investment from foreign countries worth 10% or more is considered as FDI according to economic cooperation and development.
  
  
• FDI involves not only capital investment but also technological or management

Motives for FDI

• Market seeking: At times, organisations make investments on foreign markets to promote or exploit new markets. Reasons may include the sheer size of the market or an expected growth of the same and then generate profit. Investment is made to access low-cost raw materials, labour pools, infrastructure, etc. Market seekers are companies that are involved in investment in a specific country or region to provide goods and services. ‰‰
  
  
• Resource seeking: Companies looking for resources are encouraged to invest abroad to acquire specific resources at a lower cost than in their own country if these resources could be obtained.
  
  
• Economic Development: A steady flow of foreign investment translates into a perpetual flow of foreign exchange. This in turn helps the country’s Central Bank to maintain a steady reserve of foreign exchange, which ensures stable exchange rates.
  
  
• Creation of a competitive market: By opening doors for foreign organisations to the domestic marketplace, FDI helps to carve a competitive environment as well as discard domestic monopolies. A healthy competitive environment encourages firms to regularly enhance their processes and product offerings. Thus, FDI fosters innovation and consumers are also benefitted as they have an array of competitively priced products.
  
  
• Human Resource Development: Human capital refers to the knowledge and competence of the workforce. Skills gained and enhanced through training and experience boost the education and human capital quotient of the country. Once developed, human capital is mobile. It can train human resources in other companies, thereby creating a ripple effect.
  
  
• Development of backward areas: FDI enables the transformation of backward areas in a country into industrial centres. This in turn provides a boost to the social economy of the area. For example, the Hyundai unit at Sriperumbudur, Tamil Nadu in India exemplifies this process.

Types of FDI

• Conglomerate FDI: Investment in two totally different companies of completely different industries is known as the conglomerate FDI. Conglomerate FDI is the one in which an investment is made by an organisation in a completely different industry. For example, Walmart can invest in the Indian car manufacturer, TATA Motors. ‰‰
  
  
• Platform FDI: In this type of FDI a foreign organisation invests by establishing a manufacturing unit. However, the products manufactured in a foreign nation are further exported to other nations. The French perfume brand, for example, Chanel, has established a production facility in the USA and exported products to countries elsewhere in America, Asia, and Europe. ‰‰
  
  
• Vertical FDI: This FDI occurs if an investment in a company that can or cannot necessarily belong to the same industry is made within the typical supply chain. In addition, vertical FDIs are classified as vertical integrations and vertical integrations forwards. For example, Swiss coffee producer giant Nescafe may invest in coffee plantations of less developed nations including Brazil, Columbia, or Vietnam. This type of FDI is known as vertical backward integration. ‰‰
  
  
• Horizontal FDI: In this type of FDI, a foreign based organisation would invest in the organisation belonging to the same sector or manufacturing similar products. For example, the Spanish company Zara may invest in or purchase the Indian company Fab India, which also produces similar products as NMIMS Zara does. Since both the companies belong to the same industry of merchandise and apparel, the FDI is classified as horizontal FDI.

Advantages of Foreign Direct Investment

• Capital inflows create higher output and jobs.
  
• Capital inflows can help finance a current account deficit.
  
  
• Long term capital inflows are more sustainable than short term portfolio inflows. e.g. in a credit crunch, banks can easily withdraw portfolio investment, but capital investment is less prone to sudden withdrawals.
  
  
• Recipient country can benefit from improved knowledge and expertise of foreign multinational.
  
  
• Investment from abroad could lead to higher wages and improved working conditions, especially if the MNCs are conscious of their public image of working conditions in developing economies.

Disadvantages of Foreign Direct Investment

• Gives multinationals controlling rights within foreign countries. Critics argue powerful MNCs can use their financial clout to influence local politics to gain favourable laws and regulations.
  
  
• FDI may be a convenient way to bypass local environmental laws. Developing countries may be tempted to compete on reducing environmental regulation to attract the necessary FDI.
  
  
  
• FDI does not always benefit recipient countries as it enables foreign multinationals to gain from ownership of raw materials, with little evidence of wealth being distributed throughout society.
  
  
• Multinationals have been criticised for poor working conditions in foreign factories (e.g. Apple’s factories in China)