Foreign Direct Investment - Research Paper Example

?The global economy is becoming more and more integrated and countries are now exploring ventures in other parts of the globe for sustainable and lucrative investments. Direct foreign investment (DFI) is one of the strategies which have lately been adopted by various MNCs in order to make the most of the foreign economic environments. DFI encompasses a broad spectrum of investment ranging from investment in existing companies, real estate, equity and capital market and even investment in the development of infrastructure. Acquisition of foreign entities and establishment of joint ventures abroad can also be categorized as DFI. Any capital venture, along with forecasts of return and profit, also comes with an array of risk and uncertainties. In the case of DFI the element of risk is comparatively higher as the investing entity might not be able to correctly forecast the political, economical, social, technological and legal environment of the country in which it plans to invest. There are various modes through which an organization can embark upon a venture of utilizing the factors of production of another country. On approach is to enter into a reciprocal distribution agreements with a foreign entity. Although, this strategic alliance can be regarded as solely trade based, in substance it represents direct investment. These types of transactions are usually carried out between organizations in similar industries. Reciprocal distribution agreements allow the involved entities to acquire access to each other distribution channels without having to spend extra funds on establishing one. A quite similar form of entering into a foreign market is through joint venture. In a joint venture, two parties, based on predefined terms and conditions, enters into a project with the view of obtaining strategic advantage and predetermined set of goals. Traditionally, joint ventures involved only two parties as managing more can become difficult due to conflicting interests and motives. When more than two parties are involved, the coalition is termed as a syndicate. An analysis of DFI history can elaborate on the fact that syndicates and joint ventures are usually established for the establishment of public and infrastructure related projects, in third world countries where factor of production is considerably cheaper. Acquiring equity interest in foreign countries is considered to be the most effective and easiest form DFI. From a pure financial perspective, acquiring equity interest in companies which does not give controls over the financial decisions of the local entity is not considered to be an effective FDI. By acquiring the controlling interest in a local company, a foreign country has an opportunity of obtaining strategic advantage. Another form of DFI, which has been gaining a lot of attention lately, is licensing and technology transfer between organizations. With the advancement in science and technology, the MNCs are now investing heavily in Research and Development (R&D) in order to devise cheaper, more effective and efficient ways of production. Through licensing and technology, organizations are entering into alliances with foreign entities, even academic institutions, which have brought significant advancement in the fields of medical, food and agriculture, digital media production, robotics and information technology communication. Licensing agreements are lucrative and beneficial for the companies as it allows them to take full advantage of the latest technologies and advancement, without having to expose themselves to the risk of failed R&D investments. Readymade ideas and innovations are on the shelves, and all the organization has to do, is to pay royalty. Organizations, particularly MNCs, indulge themselves in FDI bearing a defined set of motives into consideration. Enhancing profitability and shareholders wealth, reducing cost of production and improve the method of production are few. Broadly, the reasons for doing DFI can be divided into two categories; Revenue related motives and Cost related motives. Considering its revenue related motives, a company has to constantly evaluate the potential of its current market in order to identify whether it has been saturated to an extent where derivation of additional revenue is impossible. These situations often arise when there is intense competition in the home country and the growth of the company has reached its threshold. In order to survive and operate profitably, the organizations then seek other horizons. Countries such as China, India, South Korea and Malaysia are few which have been attracting foreign investors lately. With the passage of time and international trade becoming more and more regulated, the trade barriers have been abolished and consumers of developing countries are being benefited. Foreign market can proved to be profitable in cases where the factor of production in the organization’s home country is expensive. Stringent tax structure has proved to be another reason for an organization to establish its business in other parts of the world. Race for new and advance technology is becoming more vicarious among the giant MNCs. It is quite apparent that the organizations which are heavily technology driven are performing at a better pace when put in comparison with their competitors. If an organization performing well in the local market, based on the fact that it has optimized its operations using the cutting edge technology, it is expected to perform profitability in the overseas market as well. There are several countries in the world where demographic and socio-economic study can reveal exceptional potential for investment, but these countries lag behind in technological advancement. MNCs, using information technology, as their best card, can invade in such areas and can earn attractive returns on their investment. Diversification allows an organization to stabilize the financial outlook by improving its cash flows. Operating in various countries reduces the exchange risk which can arise due to the deterioration of the local currency in the global foreign exchange market. Reduction in cost of production has always been the factor which organizations all around the world are focusing on. MNCs, through DFI, can capitalize and reduce it cost of production to a considerable extent. Investment in foreign countries allows the organizations to expand their business and enlarge their product and services portfolio. Through greater economies of scale, the average cost per unit decreases with every unit produced and thus the financial position of the entity becomes strengthened. European Union (EU) has recently regulated the trading practices being conducted within and outside Europe, as a result of which corporations are now finding it much easier to establish operations facilities in foreign lands. The global economic scenario has not been quite encouraging lately. The severe repercussions of subprime mortgage crisis in United States were not only confined to the country, but the economic shock waves could be felt in the financial markets all across the globe. Inflation all around the world has adopted an upward trend with oil and gold prices rocketing sky high. Based on all these factors, the prices of most significant factors of production, land and labor, has drastically increased in certain countries. Cost of factor of production varies from country to country. MNCs are now opting to invest in countries where the labor market is skilled and demands lesser wage as compared to the labor in their home country. Companies are now adhering towards countries such as China, Mexico and Japan where the labor is considerably cheap. FDI in Mexico is reported to have recorded a 21% increase in the year 2007 which amount to US$23.3 billion. [1] Taxation structure also holds a very significant position in assessing the suitability of the country for investment related decisions. There are several tax havens in the world where the local statute exempts the levitation of taxation laws and regulation on certain forms of businesses. Cheaper and high quality raw material is another reason for the organizations to explore other areas on the globe. Exchange rate can also be a very crucial factor in deciding which country to invest in and when to invest. If the exchange rate of a country is low, an organization might adhere to invest in such country as the initial cash out flow in such country would be lower. Techniques such as hedging and setting up an effective treasury set up are imperative in such situations. FDI not only brings benefits to the investor, but it is has proved to be quite promising and prosperous for the investee country. The primary advantage of FDI is that it stimulates the economic development of the country where the investment is being made. In 90s, various developing countries which later showed progress in economic terms, did so due to the fact that most of their financings was through DFI. Whenever a country is going through economic turmoil, the government puts the task of attracting DFI as the first thing on its agenda. Transfer of technologies takes place through DFI which cannot be accomplished through mere transfer of goods or services. When foreign investors arrive, the local competition in a market increases to a much higher extent. The consumers get benefits from the increased competition as the local companies put additional efforts in order to enhance the quality of their products and services to outclass the same offered by the foreign competitors. Benefit of DFI can accrue to countries based on varying facts. Western European countries have well established market and the demands of consumer goods here is considerably higher as compared to other parts of the globe. Giant MNCs involved in the manufacturing and distribution of Fast Moving Consumer Goods (FMCG) are now being attracted more and more towards these markets as they are easily penetrable and hold sustainable growth potential. Countries situated in Latin America and Asia has also been attracting MNCs as the cost of labor and land is on the downside in these parts of the world. US based MNCs are now inclined towards establishing production facilities in these parts of the world due to the lower cost of production, as the labor and land in US costs much higher. Latin American and Asian countries have also been successful in attracting DFI as these countries have shown remarkable economic growth in the past few years. In order to keep pace with the rapid globalization, an organization needs to keep itself updated with the global trends in the industry in which it is operating. Competitor analysis is of prime importance when taking DFI decisions. If a company identifies that its competitors is increasing its operations by entering into global markets, the company needs to evaluate the strategy and the prime reason behind its competitors move. Poor planning and short sightedness can drastically damage the DFI decision. The first and foremost step to be taken by an organization, in planning its DFI decision, is to make an assessment of its internal resources. The investing company should assess whether its management has the tenacity, and its infrastructure has the stability, to manage a foreign subsidiary. Extensive market research is next on to do list. The company should assess whether foreign market has enough potential in order to assist growth and development. Demographic study of the local environment is of utmost importance which enlightens the organization about standard of living of the local consumer and presents the demand pattern in the economy. The following table illustrates the FDI inflows in few major counties of the world over the past few years. DFI can transform the economic scenario of the investee company which can be measured by evaluating the performance of its stock market. Stock market is the best indicator of economic development which reflects the current and future business opportunities. The following graph depicts the economic growth of several developing countries by evaluating their annual stock turn over. It is of strategic importance that the organizations keep on evaluating the financial and socio-economical environment of the country it has invested in. Forecasts and feasibility are based on certain judgments and assumptions which do not always turn out to be as expected. An organization needs to keep on assessing the potential of the foreign market in order to make decision whether further investment should be made, or the project is incurring losses and it would be prudent to liquate the foreign operations totally. Subsequent decision after DFI can also include decision such as establishing wholly owned subsidiary in the foreign country instead of doing business by way of direct exports. Management of foreign currency earning is also vital. Decisions such as whether the profit earned by the subsidiary should be remitted to the head quarters or should be retained by the foreign subsidiary itself hold great importance. For operating effectively and to earn profit, the management of the investing organization should keep on evaluating the exchange rate of the country it has invested in. There are always two sides of the picture, and thus DFI comes with its advantages and disadvantages. It is of principal importance for the government of any country to assess the advantages and disadvantages of DFI in order to ensure stable economic development. It has been observed that governments deter FDI that adversely affects the local manufacturers and producers. Governments are now implementing laws and establishing authorities to regulate the DFI in their countries. Barriers can be of several types, each implemented with a view of safeguarding a particular aspect of the economy. The most quickest and efficient way of entering into a foreign market is through mergers and acquisition. The government may impose restrictions according to which the local shareholders would have the majority of the shares and thus have the controlling power over the entity. Another way of restricting and regulating FDI in a country is to impose additional documentation requirement. These barriers are termed as red tape barriers according to which the investing organization has to comply with different documentation requirement of various countries and thus ends up restricting its exposure to a limited number. Other barriers which a country may impose to restrict DFI are through implementing various regulations. A government may make its tax structure stringent and rigid which could prove to be effective in deterring FDI. In addition, the government can impose additional restrictions on a foreign subsidiary relating to currency conversion, remittance of currency outside the country, employees rights etc. Ethical differences can also cause the foreign investors to look for other suitable ventures to invest in. There are certain business practices which might be ethically accepted in certain parts of the world but not in others. For example, giving monetary incentives to government authorities in China is considered as gift or grease money to speed up the administrative process, whereas the same act would be labeled as bribe in any other part of the world. MNCs might refrain from investing in such countries as giving bribe to government authorities, although ethically justified in that particular country would be in contrast with its business culture. Economies of the world are becoming interlinked at an alarming rate. A slight change in the economic environment of one country casts its effects on all the other economies of the globe. A decrease of 39 percent, from $ 1.7 trillion to a little over 1 trillion, in FDI was observed in 2009 which impacted on all countries and FDI components. [2] International trade has revolutionized tremendously and efforts are being undertaken at global level to abolish trade barriers among nations. Trading relations between the countries can only be strengthened if the organizations are able to invest in each other markets easily. DFI has an immense importance on global economic environment and it assisting the developing countries to improve their financial outlook. It becomes the responsibility of the governments, all across the globe, to establish and implement laws and regulations related to DFI so that not only foreign investors are feels invited to invest, but also the local entities interest are safeguarded. References and Work Cited [1] “Foreign Direct Investment in Mexico” economywatch.com. Web. 8 August. 2011. [2] Kuvera Chalise “Global FDI flows down by 39 per cent” businessjournalist.blogspot.com. Web. 8 August. 2011. [3] “Foreign Direct Investment (FDI) Statistics – OECD Data, Analysis and Forecasts” oecd.org. Organization for Economic Co-operation and Development. Web. 8 August. 2011 Read More