Different Types of Foreign Direct Investment - Dissertation Example

?Foreign Direct Investment Table of Contents Foreign Direct Investment Table of Contents 2 Introduction 3 Foreign Direct Investment 4 Different Types of Foreign Direct Investment 5 Importance of FDI for the firms 7 The Different Types of Motivation for FDI: The Development of Global Value Chains 10 Conclusion 13 Reference 15 Introduction In the 1990s, Foreign Direct Investment happened to the developing countries and gradually had become the one of the most significant sources of financing. Undoubtedly, this has given a rise in FDI volume and was accompanied by a considerable change in its composition. It has been noticed that in the countries, particularly undertaking privatisation of various public enterprises, investments in the form of mergers and acquisitions have experienced a rapid growth than those investments in the new Greenfield investments. The 1990s had witnessed a dramatic growth in the foreign direct investments to the developing countries. In the late 1980s, the net direct investment flows to the countries amounted from the 0.5 percent of their overall GDP to more than 2.5 percent in the year 2000-2001. The dramatic growth in FDI was particularly experienced in Latin America (Calderon, Loayza & Serven, “Introduction”). After 1994, with the steep decline in other private external flows, the significance of foreign direct investment has increased as the significant source of external financing to the developing world. Over the last few decades, the outsourcing from the foreign countries has become a significant strategic issue. This has been in the wake of increasing recognition of the benefits, provided by the effective outsourcing and international product strategies. In the quest for greater efficiency and cost savings, a number of companies have decided to source parts and components at a reduced cost from the suppliers across the globe. Hence, the importance of FDI has increased with the passing days. This report is an effort to look into the foreign direct investment from both the perspectives of domestic and foreign countries. There can be several benefits which can lead a host country to welcome the foreign direct investments while there are number motivations behind such decisions of the investing firms. All these have been discussed to have a more detailed look at the foreign direct investments taking reference from several articles and books, as well as the online resources. At the end, a conclusion has been inferred from the discussion carried out in different segments. Foreign Direct Investment Foreign Direct Investment is a form of investment which earns interest in the enterprises, functioning outside of the domestic territory of the investors. The foreign direct investment requires a business relationship between the parent company and its subsidiaries (EconomyWatch, “Types of Foreign Direct Investment: An Overview”). The term ‘Foreign Direct Investment’ can be defined in several ways. “Foreign Direct Investment (FDI) is the process whereby residents of one country (the source country) acquire ownership of assets for the purpose of controlling the production, distribution and other activities of a firm in another country (the host country)” (Moosa, p.1). According to International Monetary Fund’s Balance of Payments Manual, foreign direct investment is made to acquire an interest in any organisation, operating in a foreign economy; in this case, the investor aims to have to an effective voice in the organisation management. Back in the year 1999, the United Nations World Investment Report has defined FDI as an investment which involves a long term relationship and reflects a long-term interest and control of an entity in an organisation, in any foreign country. While compared to various forms of international investment, the distinctive feature of FDI is that it enables the investor to have control over management policy and decisions of the organisation in the foreign country. A number of researchers have argued that the element of control has provided the direct investors with an informational advantage over both the foreign portfolio investors and domestic savers. Different Types of Foreign Direct Investment The foreign direct investment considers the interrelation between the parent enterprise and a foreign affiliate. These two entities together form a transnational corporation. The investment must enable the parent company to have control over the foreign enterprise to qualify as Foreign Direct Investment. The United Nation has defined the control as being the owner of 10 % or more of the ordinary shares or voting power of the incorporated organisation or equivalent for any unincorporated organisation. There can be different kinds Foreign Direct Investments. The following discussion has articulated about all these types of foreign direct investments. Greenfield Investment The Greenfield investment means the expansion of any existing facility or any direct investment into new facility; the expansion would be in an area where there would be no existing facilities around. As the name suggests, it denotes building up some project or facility on green field like forest or farmland. However, with the time the term has become more broad and metaphoric. The word now denotes to building up any new set up from scratch. The host nations may go for Greenfield investment to create new production capacity, employment, to get knowledge about the managerial skills, transfer technology. Even the Greenfield investment can lead the organisations to get linked to the global market place. The organisation often does this by curving out the local industries and multinationals are able to produce the goods at cheap rates. This has been possible because of advanced technology and efficient processes. At the same time, linking up the multinational enterprises would enable the company to have efficient usage of the resources like intermediate commodities and labour etc. However, the crowding out of the local industry can have an adverse effect for the host country. Another disadvantage of the Greenfield investments is that the profit amount from the production does not feed back into the economy of the host country. However, instead the profit would feed back into the multinational’s home country. In this way, curving out the local companies may put an adverse effect as the profit of the local companies flow back into the local economy to promote the domestic growth. Brownfield Investment Brownfield Investment is quite related to ‘Greenfield Investment’. In Brownfield investment, “site in advance used for a "un-clean" business purpose, such as a steel mill or oil refinery, is cleaned up and used for a less polluting purpose, such as commercial office space or a residential area” (Investments and Income, “Brownfield Investments”). Mergers and Acquisitions Mergers and acquisitions can be assumed to be the primary kind of foreign direct investments. Mergers and acquisitions enable transfer of existing assets from the local firms to the foreign firms. Cross border mergers occur as the control of assets and operational control would be transferred from a local organisation to a foreign firm. In this process, the local firm become affiliate of the foreign company. It has been noticed that in Greenfield investments, the local economy get long term benefits while acquisition has failed to provide any long term benefit to the local economy. In more precise terms, the owners of the local organisations are paid in stock from the acquiring firms and it means that the local economy never get the money from the sales. Despite of this, mergers and acquisitions are quite significant form of foreign direct investment. Apart from these, foreign direct investments can take two different broad categories: Horizontal and Vertical Foreign Direct Investments. In Horizontal Foreign Direct Investment, the investment would happen in the same industry as the foreign firm operates at its domestic country. In backward vertical FDI, a foreign industry offers the inputs for a firm’s local production while in forward vertical FDI, an industry from abroad sells off the output of the firm’s local production. Importance of FDI for the firms Foreign Direct Investment (FDI) provides the firms with a significant source of capital. Adding to it, the firms also get benefited from the up-to-date technology. Otherwise, it would be difficult for the firms to generate this amount of capital through domestic savings. Moreover, it would have been difficult for the firms to import the necessary technology from the abroad, which can result in a risky and expensive proposal in the absence of requisite experience on the same. Over the years, the firms get benefited in several ways through foreign direct investment, which otherwise would not be possible by the organisations. The advantages would include transfers of general knowledge on some specific technologies in production and distribution, work experience for the work force, the establishment of finance related and trading networks and industrial upgrading (Oxford University Press, “The importance of foreign direct investment”). The foreign Direct Investment is expected to bring in positive advancements in the management and accounting processes. At the same time, with the direct investment telecommunication service area also expected to be upgraded and enhanced towards more effective communication and networking processes. Foreign Direct Investment also improves the productivity of the invested capital and enables the host country to attract more capital on some favourable terms, which in turn reflects the enhancement of country’s competitiveness. It has been noticed that by altering the country’s comparative advantages and enhancing its competitiveness through technology transfer and other myriad effects, both foreign and domestic investment can change a country’s volume and pattern of trade in several directions towards the enhancement of income. In the earlier years, many countries try to attract foreign direct investment to boost the productivity and to be able to fetch other associated benefits. The rationale behind such increased effort to attract more FDI has surely emerged from the beliefs that it brings in several positive effects such as technology transfers and productivity gains. With the help of this foreign direct investment, recipient countries are expected to introduce new processes to the domestic market. The recipient countries can also be benefited in offering training to the employees and getting access to the global market, which is quite necessary in this era of globalisation. Adding to all these, the relative stability of FDI have also contributed to the increasing emphasis on the FDI among all the capital flows. So, it would not be wrong to say, with the use of FDI, the countries can increase domestic productivity which in turn would contribute to the overall economic growth in the domestic country. The domestic companies can also be benefited by the accelerated dissemination of new technologies as foreign companies introduce new products or service processes to the domestic market. Even. Some researchers have pointed out that the domestics companies even might get benefited from just observing the foreign firms and the technology usage by them. In some cases, the technology diffusion can occur with the domestic employees moving from the foreign firms to the domestic ones. Along with direct capital financing, the benefits have suggested that FDI can play a significant role in enhancing the national economy and to promote economic growth. It cannot be denied that the FDI can contribute to the development efforts of a country. However, the quantity and quality of the foreign direct investment depends on the domestic market conditions including the policy environment of the local country with the availability of the productive assets and infrastructure. The Different Types of Motivation for FDI: The Development of Global Value Chains Historically, the companies have invested considerably in the overseas facilities to avail the access to locally bound natural resources and to become closer to the customers and markets. The companies can get access to the markets which otherwise would have been irrelevant because of high tariff and non tariff protections. In the academia, investment motivated by these types of factors is referred as ‘horizontal FDI’. In the recent times, multinational enterprises from the developed countries started investing overseas in order to fetch the advantages of cross border factor cost differences and to gain the facilities of an available and abundant technology pool and a wide resource of skilled personnel. In literature, this is known as ‘vertical FDI’. Apart from that, there are many other reasons which have been influential and motivational factors for the multinational enterprises to establish overseas production facilities and cross border sourcing. One of the significant reasons is reduced inventory cost. The enterprises can reduce the inventory cost using the just in time techniques for delivering the parts and components. This would also help the enterprises to make efficient utilisation of capacity and the significant core capabilities. Through the establishment of overseas production facilities, the multinational enterprises get access to specialised specific skills and resources which the company could not develop or acquire on its own or through mergers and acquisitions. Some more reasons can also be there. The multinational enterprises also get benefited taking privileges of special taxation policies and economic investment incentives of the host country. By dealing in overseas facilities, the multinational companies can fetch advantages through special tariff treatments involving the host country and significant trading partners. There can be different modes of entry of foreign direct investment: the main modes being Greenfield investment, mergers and acquisitions and the subsidiary modes are joint venture and expansion investment. The organisations conduct foreign direct investment by either getting involved in cross border acquisitions or engaged in Greenfield investment. “Cross-border acquisitions involve firms trading heterogeneous corporate assets to exploit complementarities, while Greenfield FDI involves building a new plant in the foreign market. In equilibrium, Greenfield FDI and cross-border acquisitions co-exist, but the composition of FDI between these modes varies with firm and country characteristics” (Nocke & Yeaple, “Abstract”). The organisations dealing in Greenfield investment are methodically more efficient than those dealing in the cross border acquisitions. A major part of trade literature is unable to distinguish among the modes, in which any multinational company can enter into a foreign market. Despite of this fact, the multinational enterprises do not perceive the cross border acquisitions and Greenfield FDI as the perfect substitutes to each other. Moreover, the government of several host countries view the cross border acquisition different from the Greenfield FDI. Few changes in the FDI policies and variation in the characteristics of the country are likely to affect both the cross border acquisitions and Greenfield FDI, however, in different ways. In cross border acquisition, the multinational enterprise can enter into the foreign market by purchasing an existing company; while in Greenfield projects the multinational companies enter into the foreign market by building up new set ups in the foreign country. Based on the investing firms’ motivations behind the foreign direct investments, foreign direct investment can take different forms. Market Seeking: Sometimes, the investing firms primarily concentrate on maintaining the existing markets or penetrating the new ones. In many cases, it has been noticed that this kind of investment are more likely to happen when the investing firms are afraid of losing out the local market or they find the market getting saturated. Foreign Direct Investment of this kind can be assumed as a defensive strategy of the organisations. Although the motive behind this kind of investment is market seeking, however the primary motive is expansion of the business to get rid of saturation in the local markets. Resource Seeking: In this era of globalisation, firms are crossing the boundaries in the search of human resources, advanced technology and accelerated processes. The process of seeking resources has become easier with the foreign direct investments. These are the investments seeking to get hold of the factors of production which are more productive that those obtainable in the domestic economy of the firms. It can also happen that the resources are not at all available in the domestic economy of the investing firms. For an instance, there can unavailability of natural resources like fertile land, coal or the unavailability of cheap labour can also make the firms seeking resources in other countries. In most of the cases, even the motivation behind the foreign organisations investing into the developing countries is the human resources at a cheaper price. For an instance, foreign companies enter into the Eastern Europe and Southeast Asia in the search of cheap labour while move to Middle East and Africa to acquire the resources. Efficiency Seeking: It cannot be denied that through increasing the economies of scale and scope, an organisation can increase the efficiency of the operational process and can offer products and services at a much reduced rates. With the globalisation, firms do not mind breaking the country barriers to increase their efficiency by exploiting the economies of scale and scope as well as the common ownership, attained by foreign direct investments. It has been noticed that these kinds of investments take place after the market and resource seeking investments are realised. The firms carry out these kinds of investments in the expectations to further enhance the profitability of the firms by curving out the cost of revenue and other operational costs. These kinds of foreign direct investments can mostly be seen in the developed countries or those knitted in a closely integrated market like European Union. Conclusion Undoubtedly, in this era of globalisation Foreign Direct Investment has contributed significantly by enabling the organisations to take the advantages of new resources, new markets and increased efficiency. It would be very wrong to think that one country would have sufficient amount of required resources, cheap labour and efficient operational processes to increase the productivity and hence the significant of FDI has increased by enabling the firms to take the advantages of globalisation. One firm can make direct investments into another firm in any foreign country to fetch the required advantages, necessary for its smooth operations, increased market share and enhanced profitability. This changing picture has also changed the attitudes and government policies towards FDI as well as the characteristics of the same. However, it is time that the host countries must think about their profitability and benefits. The Foreign direct investment must bring in equal benefits for both the host and the foreign countries. Reference Calderon, C. Loayza, N. & Serven, L. “Introduction”. January, 2004. Greenfield Foreign Direct Investment and Mergers and Acquisitions: Feedback and Macroeconomic Effects. January 17, 2011. < http://www-wds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2004/02/10/000012009_20040210154909/Rendered/PDF/325780wps3192.pdf>. EconomyWatch. “Types of Foreign Direct Investment: An Overview”. No Date. Foreign Direct Investment (FDI). January 17, 2011. . Investments and Income. No Date. Foreign Direct Investments (FDI). January 17, 2011. < http://www.investmentsandincome.com/investments/foreign-direct-investments.html>. Moosa, A. I. Foreign Direct Investment. New York: Palgrave, 2002. Nocke, V. & Yeaple, S. “Abstract”. December, 2004. An Assignment Theory of Foreign Direct Investment. January 17, 2011. . Oxford University Press. “The importance of foreign direct investment”. No Date. Economics 11e. January 17, 2011. . Read More