The Nature of Foreign Direct Investments - Essay Example

Understanding Foreign Direct Investment (FDI) Introduction World trade is actually not a new phenomenon as many ancient civilizations traded with other countries for several kinds of basic necessities and vanities. Nevertheless, we are now in a state where international transactions are an integral part of the contemporary business and working environment. The aim of this paper is to discuss the nature of Foreign Direct Investment (FDI)) and the issues related to this subject with the goal of determining its importance in the subject of globalization. Defining FDI Foreign Direct Investment (FDI) broadly refers to different forms of investment with two commonalities: a) the investment is earning interest and b) it is invested outside the domestic operations of the investor. The second commonality mentioned is usually taken to be the more important defining feature of the two. FDI denotes a degree of direct ownership whereas indirect investments are those gaining exposure to enterprises without investing directly such as listed securities, investment funds and derivatives. (Blomstrom and Globerman, 2001) Previously, FDIs referred only to physical investments made by a local company to a foreign setting. Building factories, providing machineries and equipment were considered as FDIs while portfolio investments were considered as an indirect investment. However, the rapid globalization of markets served as an impetus to broaden the definition of FDI to include the lasting ownership of shares of companies and enterprises. As such, joint ventures, alliances where a company provides technological support and licensing of intellectual property and direct acquisition of a firm are now considered to be FDIs. (Sullivan and Sheffrin, 2003) The current requirement is that an international business relationship must be formed between the local entity and the foreign affiliate. Foreign Direct Investors can either be a private or a public entity and may involve an incorporated or unincorporated organization or a lone individual. In any case, the foreign entity should provide the local entity a certain level of control in its management. According to the International Monetary Fund (IMF), control can come in the form of a 10% ownership as a minimum. In cases where this are not present, the investment made is known as portfolio investment. The ownership implies that the investor is afforded control in the management and decision-making of the enterprise. However, the data from the Organisation for Economic Cooperation and Economic Development indicate that there are countries where the 10% ownership is treated in a flexible manner to accommodate local legal and business environment circumstances. There are cases where the ownership is less than 10% but the investor is afforded an effective voice and there are cases where exercise of influence control is not given even if the investor exceeds 10% ownership. FDI Classification According to UNCTAD (2007), FDIs are classified according to certain defined factors. A classification based on the direction of FDI generates two broad types: outward-bound and inward-bound. Outward-bound FDIs are those investments provided by local entities to foreign partners while inward-bound FDIs have local entities as the beneficiary of investments from abroad. FDIs can also be classified according to the nature it is conducted. Vertical Foreign Direct Investments exist when a local entity owns some shares in a foreign enterprise and is using the business arrangement to either generate supplies or be the one supplying. Horizontal Foreign Direct Investment occurs when a local entity, usually a multinational company, establishes a similar business operation in foreign settings. FDIs can also be classified according to its motives. If the FDI was made to explore new opportunities in new markets or strengthen the existing market structure, we have a 'market-seeking FDI'. When the FDI was made because the foreign setting provides resources that are not locally available at the same degree, we have a 'resource-seeking FDI'. In cases where investments involved transfer of strategic assets for achieving economies of scaled, the FDI is termed as 'efficiency-seeking FDI'. A more specific typology of Foreign Direct Investments is provided by Phillips & Yeh (2000) as well as Khan (2001). Investments can come in the following forms: Equity Joint Ventures (EJVs) - The investor and the foreign entity enters into an agreement where both parties pool money to operate a business venture. Profits and losses are shared proportional to the equity stake. Wholly foreign-owned subsidiaries (WFSs) - Investors can establish wholly-owned subsidiaries or companies in the foreign nation and will be solely responsible for capital, marketing and management. The profits after tax are permitted to be remitted overseas. Contractual joint ventures (CJVs) - In this venture, the foreign entity provides all the physical infrastructures and labour services while the investor provides the capital and technical support systems. CJVs are usually short-term and flexible thus more appealing to foreign investors. Joint explorations - This type usually exist in business concerned in finding resources such as minerals and petrochemicals. Offshore oil explorations are usually of the joint explorations type. In this arrangement, the investor and the foreign entity enters into a business relationship where the take different levels of risk. For example, the investor may agree to provide the capital for the exploration stage whereas the foreign party only contribute during production. Compensation trade (product buy-back) - Almost similar to barter, compensation trade involves the investor receiving payments in the form of goods as returns for the investment made. The goods received may bear no relation to the investments made by the investors. There are other forms of investment and cooperation such as various processing, assembly, leasing arrangements. A more popular kind is where the investor supplies the materials for foreign entities to process according to the investor's design. Significance of FDIs Foreign direct investment (FDI) plays an important role in global business as it provides several opportunities not only to the receiving country but to the host as well. Previously, FDIs where conducted mostly in developed nations. However, the 2008 data from the United States Bureau of Economic Analysis (BEA) indicates that developing countries are experiencing rapid growth in FDIs. In the 1970's, only a yearly average of $10 billion worth of inward FDIs were placed in developing nations across the globe. This increased to $20 billion in the 1980's and became $26.7 billion in the 1990's. By 1998, the figure exploded into $481 billion and $636 billion in 1999. This was primarily due to the mergers and acquisition and the outsourcing of production in a range of industries. It should be noted, however, that there is an uneven spread of FDI with concentrations mainly in China and Singapore in the case of Asia. (UNCTAD, 2008) In developed countries, FDI is also increasing especially in the United States where many major corporations are established. BEA provides historical data for Foreign Direct Investments in the US and is shown in Table 1: Table 1: US Foreign Direct Investment (BEA, 2008) Period FDI Outflow FDI Inflows Net 1960-69 $ 42.18 bn $ 5.13 bn + $ 37.04 bn 1970-79 $ 122.72 bn $ 40.79 bn + $ 81.93 bn 1980-89 $ 206.27 bn $ 329.23 bn + $ 122.96 bn 1990-99 $ 950.47 bn $ 907.34 bn + $ 43.13 bn 2000-07 $ 1,629.05 bn $ 1,421.31 bn + $ 207.74 bn According to the statistical data provided by the CIA World Fact book (2009), the total global FDI amounts to $ 16,650 trillion with the United States and the United Kingdom with the largest stock of FDI. The leading countries and their share of FDIs are shown in Table 2: Country Stock of FDI at home Date of Information (USD) United States 2,220,000,000,000 2008 est. United Kingdom 1,409,000,000,000 2008 est. Hong Kong 1,235,000,000,000 2008 est. France 1,234,000,000,000 2008 est. Germany 924,700,000,000 2008 est. China 758,900,000,000 2007 est. Belgium 733,900,000,000 2008 est. Netherlands 726,900,000,000 2008 est. Spain 606,800,000,000 2008 est. FDI is generally seen as the stimulus for initial macroeconomic development as it provides the necessary funds and business support systems that could not have been provided by the local business environment. Aside from this, FDIs also have other functions such as raising total productivity and efficient use of resources. According to the OECD (2002), the benefits of the FDIs are realized through three channels: a) linkage between foreign trade flows, b) spill-over effects on the host country's business sectors and c) direct impact on the host economy's structural factors. Many studies such as those by Barrell and Pain (1997) and Aitken and Harrison (1999) have been made to determine the extent of benefits that FDI provides to receiving countries. The general conclusion was that it provides a level of productivity and growth income that is beyond the capacity of domestic investment. However, the benefits of FDIs are not fully realized in the least developed economies due to the presence of 'threshold externalities" such as low level of education, infrastructure, technology and health. Also, there may not be enough domestic capital for local business to grab the opportunities presented by the investment. However, with the proper support of the host country, FDI can improve three main areas: a) trade and investment. b) technology transfers and c) human capital enhancements. These are discussed further in the following: a. Trade and investment Research suggests that the impact of FDIs can differ across countries and business sectors. However, there is a growing consensus from these empirical studies showing that FDIs have long term contributions especially in imports and exports. FDIs provide the necessary funding for establishment of factories which can put the host country in a competitive position. It integrates the local economy in the world economy as exports and imports become important commodities in the global market. A clear example of how FDI boosts exports is in helping host countries extract, process their minerals and market it globally. FDIs also develop and strengthen the international networks available to the host country as it boosts the economic prowess and ability of the host country to attract and support investments. Economic Processing Zones (EPZs) that attracts international trade flows were also made possible with the entry of FDIs. b. Technology Transfers Technology transfer is considered by many researchers to be the greatest benefit of FDIs aside from the immediate availability of capital. Multinational companies have research and development (R&D) activities that is beyond the capability of the host country. In many cases, multinational companies possess a higher level of technology than the host country. With the entry of FDIs and the provision of technical support systems, technological spillovers can occur. For example, investors usually provide not only financial but also technical assistance to their suppliers to improve production. They also provide training, education in best practices for production and management and also in the modernizing and upgrading of facilities. c. Human Capital Enhancements In the effort to attract FDIs, government bodies seek to improve and enhance its human capital. Thus, it provides special training, seminars and legislation providing its working populace to improve their skills. Employment in the offices and production facilities of multinational companies provides the employee to gain technical knowledge, managerial skills and global professionalism. MNCs will also seek to improve the skills and abilities of its workforce so as to improve its operations. When a worker also moves to another firm or becomes an entrepreneur himself, he carries with him the knowledge and understanding of best practices. Multinational companies are known to provide more training than their domestic counterparts but the magnitude of their training and seminars is smaller than that provided by the educational system of the host country. Nonetheless, FDIs provide the government a 'demonstration effect' or an idea of what skills are in demand and thus enable them to provide education that is useful in the future. Negative Impacts of FDIs FDIs can greatly alter the business environment and drive out local business competitors but many enterprises have been known to revise their business to accommodate indirect business opportunities presented by FDIs. When factories are established, for example, many entrepreneurs revert from competitor to contractor and supplier. FDIs usually involved outsourcing which can mean reduced employment opportunities for people where the FDI was coming from. These concerns are generating significant protests resulting to a tighter trade regulations imposed by authorities. Some countries have been known to close their markets from imports because it is replacing domestically produced goods. This concern is valid but outward FDIs can also result to affordability and innovation. Conclusion FDIs are an integral part of global trade and it provides benefits not only to the investor but to the host country as well. It provides new business opportunities, capital, technology, processes and products. The globalization of trade will ensure that it will be a very important determinant of the future of many societies. References: Aitken, B. J. and A. E. Harrison (1999). Do Domestic Firms Benefit from Direct Foreign investment Evidence from Venezuela. American Economic Review, 89(3): 605-618. Barrell, R. and N. Pain (1997). Foreign Direct investment, Technological Change, and Economic Growth within Europe. Economic Journal 107: 1770-10786. Blomstrom, M., A. Kokko and S. Globerman (2001). The Determinants of Host Country Spillovers from Foreign Direct Investment: A Review and Synthesis of the Literature", in Pain, N., Inward investment, technological change and growth: The impact of multinational corporations on the UK economy, Basingstoke: Palgrave: 34- 65. Bureau of Economic Analysis (2008). US FDI. Retrieved August 16, 2009 from http://www.bea.gov/international/xls/table1.xls Central Intelligence Agency (2009). Stock of Foreign Direct Investment. Retrieved August 16, 2009 from https://www.cia.gov/library/publications/the-world-factbook/rankorder/2198rank.html Khan, Zafar Shah (2001) Patterns of Direct Foreign Investment, World Bank Discussion Papers. Washington, D.C.: The World Bank. Organization for Economic Cooperation and Development (2002). Foreign Direct Investment for Development: MAXIMISING BENEFITS, MINIMISING COSTS. OECD Publications. Phillips, D. R. and A. G. O. Yeh (2000), "Foreign Investment and Trade - Impact on Spatial Structure of the Economy." London: Routledge, pp. 224-248. Sullivan, Arthur and Sheffrin, S. (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 551 UNCTAD (2008). Historical Data of FDI. Retrieved Aug. 17, 2009 from http://www.unctad.org/sections/dite_fdistat/docs/wid_cp_us_en.pdf Read More