Foreign Direct Investment and Economic Growth - Coursework Example

Foreign Direct Investment Table of Contents Introduction 3 Features of foreign direct investment 3 Foreign direct investment and economical growth 5 Foreign investment in South Africa 6 Foreign investment in China 8 Theories of FDI 10 OLI theory and investment in China and South Africa 11 Types of FDI 11 Foreign investment and corruption 12 Conclusion 12 Reference list 14 Introduction Investment in a foreign nation is done by way of direct investment in production or in a business of another nation. The process of investing involves directly buying a company or expanding the business of a country in another nation. In a broader sense, foreign direct investment or FDI includes cross-country mergers, acquisitions, building new companies and infrastructures, reinvestment of profits earned through overseas operations and intercompany loans. In respect of the national accounts of a country, FDI can be defined as the net inflow of investment. Foreign investment is of growing importance in the present globalized economy (Blonigen, 2005). Multinational firms are able to expand their business by way of such investments. Economical growth is hugely impacted in many nations by such investments. Foreign investments are utilized by the emerging nations to expand their volume of sales, exports and overall revenue earned. The emerging nations of the world such as, China, India and those of Africa, have greatly benefitted by foreign direct investments, thereby being able to increase international sales. The developed nations employ foreign investment mainly for restructuring corporations. They largely engage themselves in mergers and acquisitions through such foreign investments. Foreign investment in developed nations such as, in the US and UK, is more about maintenance and less about economical growth. The purpose of FDI in developing nations is to accelerate economic growth. Emerging nations are characterized by increasing levels of population, weak infrastructure and poor economic growth. In order to support a growing population, it is important for emerging nations to improve economical conditions. In order to do so, such nations rely upon foreign investments (Alfaro, et al., 2004). Features of foreign direct investment Some of the features of foreign investment can be described as follows (Helpman, 2006): One of the most common motives behind investing in a foreign company is to participate in its management. If a firm is successful at generating high revenues and has sufficiently high levels of goodwill, then other firms would be willing to invest in the company so as to be able to obtain a share in the profits. Investing in a foreign company also comes along with the intention to diversify products or acquire support services. For instance, a company manufacturing mobile phones might invest or procure another company that produces electronic parts, which are required in its production process. Hence, acquiring such a company might help the firm in strengthening its supply chain position. Investing in a foreign company is generally a long-term commitment by which a company invests in another company’s products or operations. The company making the investment usually has no intension to withdraw soon or seek fast capital gains. Foreign investment incorporates access to technology and raw materials. The investing companies obtain rights to utilize the raw materials available in a foreign nation through which production of goods and services are facilitated. Many IT based multinational companies are seen to invest in India because of availability of skilled labour at a cheaper price and that of economical infrastructural facilities. The investment receiving company gain access to better technologies and greater financial strength (Noorbakhsh, Paloni and Youssef, 2001). Most foreign investments are done with an intention to enter new markets by establishing sub-business units in a foreign nation. Many multinational companies are seen to invest in emerging nations of Asia and Africa with an objective of increasing customer base and revenues. This helps organizations to escape from saturated and stiff competition embedded markets of western nations (Cheung and Lin, 2004). Foreign direct investment is largely supported and welcomed in developing nations as it increases overall productive capacity. Foreign investments bring in better technology and increased financial strength for companies of the host nation. This helps the host country to develop its economy, increase overall production and generate higher revenue through exports. Such investment also helps in increasing infrastructural facilities of the host nation. The overall volume of exports and the net GDP of the host nations therefore inflate. Foreign investment effectively generates greater employment opportunities as economy of the host nation develops. This is one of the prime motives behind increasing level of FDI in the developing nations. Multinational companies also benefit from the freedom of hiring foreign employees and technicians and there is less resilience from governing authorities in this matter. Foreign investment paves way for companies to acquire a large portion of shareholdings, which consequently generates higher revenues. It also helps companies to eliminate the payment of custom duties for necessary goods and services. The government in order to attract foreign investment provides huge tax benefits to such foreign investors (Nair‐Reichert and Weinhold, 2001). One of the significant aspects of FDI in developing nations is to escape the high levels of inflations existing in the western nation. In developing nations, the rate of inflation is comparatively low that helps investors to produce at cheaper rates (Nair‐Reichert and Weinhold, 2001). Foreign direct investment and economical growth Economic growth of a nation depends upon its continuous productive capacity, which needs to be supported with savings and investments. In order to understand the role of FDI in economic growth of a nation, it is important to analyze function of capital in the economy. For economic growth, development of infrastructure and industries become highly necessary. Without capital, it is difficult for an economy to invest in industrial and infrastructural development. Developing nations, therefore, rely upon foreign investments to a large extent so as to fulfil nation’s capital requirements. Apart from financial support, foreign capital entails advanced technical know-how. With growth of industries, employment opportunities are enhanced. Local firms are able to improve their business by providing support to big multinationals in terms of raw materials and manpower. So, with growing number of multinationals entering an economy, associated local firms who act as suppliers are able to establish themselves. Studies reveal that foreign investment in developing countries has helped to render factors of production such as, labour and capital, more productive (Buckley, Clegg and Wang, 2002). The externalities associated with FDI helps in determining whether it has a positive or negative impact upon the economy. Experts are of the opinion that growth of multinational organizations reduces welfare of domestic firms. The high financial power of big multinational firms gives them supremacy over a nation’s resources. As a result, it is seen that multinational firms gain greater competitive advantage over other domestic firms. It is also observed that if multinationals do not help in generating sufficient employment in the host nation, then it may lower national welfare. Multinational firms may also cause drainage of funds if profits are largely earned by the foreign companies through export of goods and services. Hence, it can be stated that potential benefits of foreign investments in the host nation can only be realized if there is adequate infrastructural facilities and stable economy. Indigenous firms should also have ability to absorb the technologies and skills brought in by foreign firms (Grossman and Helpman, 2003). Foreign investment in South Africa Foreign investment flow has been consistently increasing in South Africa; whereas other nations of Africa, such as, Ghana and Nigeria, had faced a decline in foreign investment. Flow of FDI into South Africa was largely into the sector of consumer goods in the form of Greenfield investments. The primary motive of the South African government is to improve employment situation of the nation and to develop an equal society. Attracting FDI in order to foster economical growth and enlarging the nation’s GDP has been one of the chief motives of the government of South Africa. The government recognizes need for rebuilding the city’s image through international investment. The approach towards foreign investment has remained open and liberal. The low domestic savings of the nation has compelled it to be dependent upon foreign fund inflow (Lewis, 2001). Figure 1: Flow of FDI into African nations (Source: UNCTAD, 2013) There has been a significant transition in the nation’s approach towards FDI in recent years. Initially, it was seen that foreign nations were benefitting more through their investments in South Africa. This triggered the government to aim at receiving maximum domestic benefits through inflow of foreign investments. So, the nation has been in a process of cancelling various bilateral investment treaties, which remained accrued till end of the liberal phase. These treaties are now set to be replaced with a single domestic investment system, which offers adequate protection to investors as well as provides benefits for development of the nation (Alden and Vieira, 2005). Historically, most of the FDI into the nation has appeared to come in the form of mergers and acquisitions. The inflow of FDI has been highly volatile. High crime rate and low education levels have prevented many investors to enter into the South African market. Recent investments into the nation have been made in sectors of finance, mining and retail (Bhaumik and Gelb, 2005). Investors treat South Africa as one of the chief export platforms. The South African economy is less affected by inflation which attracts a lot of investors. Figure 2: African imports and exports (Source: MR ZINE, 2008) Foreign investment in China Foreign investment has helped China to grow immensely. It has been observed that inflow of foreign investment has been largely in coastal states of the nation. Experts are of the opinion that foreign investment in China is largely due to location advantages of the country. China attracts a large amount of investment from western nations of North America and Europe. Japan also is seen to significantly invest in China. Foreign investment had helped the nation to gain higher per capita income. Investors seem to abstain from investing in those Chinese states where concentration of state owned firms is higher. Foreign inflow of capital had helped to raise total factor productivity of the nation thereby raising the net GDP of the nation. Such a growth was facilitated because of technology transfer. Some of the prime aspects that investors consider while investing in China are discussed below (Zhang and Song, 2002). China helps to attain easy connectivity with other developing nations of Asia such as, India and Bangladesh. This facilitates ease in mobility of different resources and especially labour. Compared to other developing nations of Asia, infrastructural and social environment of China is deemed suitable for foreign investment. China itself has adequate technological strength that further attracts many foreign investors. Industries in China primarily focus on developing cost efficient products and services. This factor is especially predominant in the consumer electronics industry. Electronic goods and parts that are manufactured in China, thus, help in capturing significant market position. In addition, availability of semi-skilled and skilled labourers has also enhanced foreign investment in the nation (Gao, 2003). Source: FDI flow in China (Source: Money control, 2012) FDI has helped in increasing the level of employment generation in China. This has eased pressure upon the state owned enterprises to generate employment. On the other hand, foreign investors could benefit from availability of low priced human resource. Most of the foreign investment comes into the nation for increasing export related activities. Most western and Japanese multinational firms are seen to invest in sectors, where China does not have significant competitive advantage. In future, it is anticipated that China will be able to transform such areas with high competitive advantage, which would make the nation less dependent upon foreign capital for growth. The rate at which the economy of China appears to grow suggests that in future, the nation will have sufficient economic strength to transform state owned enterprises, which are currently lagging behind, into highly efficient organizations (Zhao and Zhu, 2000). One of the chief issues that most foreign investors face is barrier for entry. The market of China in overcrowded with indigenous producers and is highly competitive. So, small investors find it difficult to invest in the nation. For this reason, China is largely characterized by foreign investments from big corporate houses of the west and Japan (Wei, 2005). Theories of FDI The monopolistic theory This theory states that foreign multinational firms have a superior advantage over local firms in respect of superior knowledge, advanced technology and economies of scale. The strong financial position of multinational firms helps them to gain superior knowledge relating to conducting business. They also possess advanced technical know-how, which local firms cannot afford to acquire due to low financial capabilities. Multinational firms also enjoy advantages of mass scale production that is spread over a number of countries. Local firms can hardly compete with big multinational firms in terms of their production (Kinoshita and Campos, 2003). Oligopoly Theory This theory suggests that big multinational firms create entry barriers whereby new firms are discouraged to compete with them. The superior technological and financial strength of such multinational firms render them unique, making it tough for new firms to compete with them. Therefore, in order to prevent rise of competition, big multinationals consistently keep developing and growing through innovation and capturing new markets (Chowdhury and Mavrotas, 2006). Product life cycle model This theory states that a firm ventures into international expansion when products manufactured by the company become standardized and gain popularity in the international market during growth phase of the product life cycle. As demand for the product grows, firms are induced to expand their production and capture markets in foreign countries. So, if growth stage in a product’s lifecycle is strong and widespread, then it stimulates firms to expand into foreign markets through FDI mechanism (Chowdhury and Mavrotas, 2006). OLI theory and investment in China and South Africa Ownership advantages Some of the ownership advantages related to FDI in China are innovation, efficient product control systems, growth of market size and economies of scale. Ownership advantages are basically the additional capabilities which firms obtain when they operate in an international location. In South Africa, the ownership advantage would be largely related to the availability of abundant resources. Internationalization advantages Firms can operate in a wide number of markets as a result of internationalization. Not all markets are affected by the same economic forces. As a result when one market fails, firms can rely upon other markets for sustainment. Investing in China and South Africa will help companies of the western nations to get access into the Asian market which is significantly different from the market characteristics of US and UK. China and South African markets are characterized with low-priced products, high economies of scale and abundant resources. Location advantages Every nation has its own specific characteristics which investors consider while investing in a foreign country. Good infrastructural facilities, cheap and efficient production systems attract a lot of FDI into China. Similarly South Africa is characterized with abundant resources and cheap labour. Types of FDI Foreign investment can be categorized on the basis of the role of parent company in global production strategy. The types of FDI in this respect are horizontal, vertical and export platform. Horizontal FDI involves producing similar type of products and services both in host and parent nation of the company. This type of foreign investment is mainly intended for increasing market share on a global scale. It also includes buying a firm engaged in similar activities or setting up a subsidiary company in the host nation (Asiedu, 2002). Vertical FDI involves dividing the process of manufacturing geographically. In this type of investment, a firm may have its facilities scattered over different nations. This type of a strategy aims at taking advantage of geographical or resource factors that are available in a different nation. Many multinational firms take advantage of cheap availability of resources in emerging nations of the world by setting up strategic production locations therein. Export platform foreign investment takes place when a company uses another nation as a base for export. In this type of a FDI, a host nation is utilized by a company that manufactures goods or markets its products in order to export to nearby nations. For instance, Toyota has set up a truck production facility in Thailand so to cater to market needs in Asia, Australia and the Middle East (Asiedu, 2002). Foreign investment and corruption It is observed that corruption has acted as a negative factor in attracting FDI in developed nations; whereas in developing nations, it has been a helpful criterion. Investors perceive that in developing nations, corruption is a support factor that helps in accelerating commercial activities. Furthermore, developing nations are generally characterized by instable political environment. Thus, existence of corruption becomes inevitable. Foreign investors do not consider this as high threat and expect that besides development, it may become possible for developing nations to eradicate corruption from their economy (Buckley, Clegg and Wang, 2002). Conclusion From the above discussion, it can be understood that majority foreign investment plays a pivotal role in the economy of growing nations. Developed nations of the west perceive this as an opportunity for expanding their market base and utilize resources existing in such nations. In many developing nations, fragmented nature of FDI and numerous policies associated with the same confuses investors. Hence, developing nations such as China and Africa must focus upon making foreign investment related policies as liberal as possible. Globalization has driven firms to expand beyond their national boundaries. It has helped creating a common worldwide platform for firms to extend their production capabilities and reach out to markets of the world. Foreign investment helps firms to exploit natural resources existing in other nations. However, for successful growth of foreign investment, liberalization of economic policies is essential. This provides the framework for globalization. Foreign investment not only helps in developing economic tie ups between two nations, but also enhances international friendship and unity. Foreign direct investment also facilitates exchange of different cultural values, besides boosting tourism related activities. Reference list Alden, C. and Vieira, M. A., 2005. The new diplomacy of the South: South Africa, Brazil, India and trilateralism. Third World Quarterly, 26(7), pp. 1077-1095. Alfaro, L., Chanda, A., Kalemli-Ozcan, S. and Sayek, S., 2004. FDI and economic growth: the role of local financial markets. Journal of international economics, 64(1), pp. 89-112. Asiedu, E., 2002. On the determinants of foreign direct investment to developing countries: is Africa different? World development, 30(1), pp. 107-119. Bhaumik, S. K. and Gelb, S., 2005. Determinants of entry mode choice of MNCs in emerging markets: Evidence from South Africa and Egypt. Emerging Markets Finance and Trade, 41(2), pp. 5-24. Blonigen, B. A., 2005. A review of the empirical literature on FDI determinants. Atlantic Economic Journal, 33(4), pp. 383-403. Buckley, P. J., Clegg, J. and Wang, C., 2002. 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H. and Song, S., 2002. Promoting exports: the role of inward FDI in China. China Economic Review, 11(4), pp. 385-396. Zhao, H. and Zhu, G., 2000. Location factors and country-of-origin differences: An empirical analysis of FDI in China. Multinational Business Review, 8, pp. 60-73. Read More