8. Foreign Direct Investment – Fundamentals of International Business

CHAPTER 8

Foreign Direct Investment

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

  • Identify the different forms of foreign direct investment (FDI) in the global economy
  • Examine the economic rationale underlying FDI behaviour
  • Understand why firms often prefer direct investment as a strategy for entering a foreign market over alternatives such as exporting and licensing
  • Determine the costs and benefits of FDI for home and host countries
  • Understand FDI flows in the global and Indian context</LO>

TECNO CAPTURES THE AFRICAN MARKET

Transsion is a Chinese smartphone manufacturer which has beaten Apple in the African market. It used the well-known strategy of ‘Think Global Act Local’, to beat its rivals Samsung, Apple, Huawei and Xiaomi.

Transsion’s route to success was different from other Chinese companies’, such as Huawei and Xiaomi, which started operations in China before expanding overseas. Transsion built its business in Africa for the African consumer, based on the experience of its founder George Zhu who spent a decade in the country gathering experience to launch his brand. It was encouraged by the Chinese government’s ‘Going Out’ strategy, which was pushing Chinese firms to explore new markets, especially in China. The mobile phone was a rare luxury in Africa—giving Transsion a fertile market to invade and explore.

Transsion captured 50 per cent of the African market through its pricing and customization strategies. It introduced the Tecno handset in Nigeria with dual sim cards to help the customers avoid keeping multiple sims for different locations. It added local languages such as Amharic, Hausa and Swahili to its keyboards. Phones were also given a longer battery life to help consumers to cope with long hours of power shutdown. Cameras in Tecno phones are customized to capture African complexions. These cameras adjust more light for darker skin, allowing better pictures and selfies as compared to those clicked on other phones.

Tecno’s stores carry no Chinese characters or signs of being a Chinese brand. This helps the Chinese TNC to project itself as an African company, which appeals to the consumer. The African image is reinforced in countries like Ethiopia, where all Tecno phones are assembled locally. The TNC employs 700 workers to assemble Shenzhen-manufactured screens, circuit boards and batteries, giving a daily output of 2,000 smartphones and 4,000 feature phones. Transsion has a local African workforce of 10,000 employees, compared to 6,000 in China. Its low-cost African workforce helps it keep down prices making it the cheapest and most affordable brand in Africa.

Tecno’s next global target market is India—where it aims to capture the market with screens that can be easily accessed with oily, greasy fingers – for the typical Indian customer who wants to make a call and eat at the same time!

References: The Chinese phone giant that beat Apple to Africa, https://edition.cnn.com, last accessed on 11 October 2018.

INTRODUCTION

This chapter examines the economic rationale behind foreign direct investment (FDI). It also explores different theories, which explain the growth of FDI as a means of growing international presence and the different forms it takes, and examines the factors driving a firm to choose FDI and the benefits FDI has for both home and host countries.

FDI as a mode of foreign entry occurs when a firm invests directly in production or other facilities in a foreign country over which it has effective control.

 

FDI as a mode of foreign entry occurs when a firm invests directly in production or other facilities in a foreign country over which it has effective control.

FDI: A CLASSIFICATION

FDI can be classified in several different ways. We classify it on the basis of whether it is aimed at asset creation or asset acquizition, nature of business activity, and on the motives driving it.

 

FDI can be classified according to the asset-based view, according to the nature of business activity and according to the motives for which it is done.

Asset-based View

According to this viewpoint, FDI can be classified into four categories:

  1. Greenfield investment is an investment process which results in the creation of new assets and production facilities in the host country. It is a long-term proposition in which an overseas production facility is set up from scratch.

     

    Greenfield investment results in the creation of new assets and production facilities in the host country.

  2. A merger is the amalgamation of two existing enterprises. It is a voluntary and permanent combination of two businesses which integrate their operations and identities with those of the other. The merged enterprise then functions as a new entity. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, Daimler Chrysler, was created.

     

    A merger is the amalgamation of two existing enterprises.

  3. An acquisition is the purchase of an existing business venture in a foreign country. It is a mode of FDI entry which allows a firm to establish itself in a short period of time since it takes over a running enterprise. From a legal point of view, the target company ceases to exist, the buyer ‘swallows’ the business and the buyer’s stock continues to be traded. It can be through the purchase of a minority stake (where a firm purchases 10–49 per cent of the company’s stock) or a majority stake (where a firm acquires over 50 per cent stock). An acquisition can be hostile if the acquired company is unwilling to be bought, or it can be friendly and with the consent of the acquired enterprise.

     

    An acquisition is the purchase of an existing business venture in a foreign country.

  4. Brownfield investment is a combination of greenfield investment and mergers and acquisitions. It denotes an investment where an existing firm acquires another firm and infuses it with fresh capital and assets after the acquisition.

     

    Brownfield investment is a combination of greenfield investment and mergers and acquisitions.

Nature of Business Activity

According to this classification, FDI can be classified into three categories:

  1. Horizontal FDI takes place when a firm invests abroad in the same industry in which it operates in the home country. It therefore represents, a geographical diversification of the TNC’s established domestic product line. Most Japanese TNCs, for instance, begin their international expansion with horizontal investment because they believe that this approach helps them to share experience, resources, and knowledge already developed at home, and helps to reduce the risk of operation in a foreign market. The acquisition of Ranbaxy Laboratories Limited, a leading Indian pharmaceutical TNC by Japan’s Daiichi Sankyo is an example of horizontal FDI.

     

    Horizontal FDI takes place when a firm invests abroad in the same industry in which it operates in the home country.

  2. Vertical FDI refers to investment in activities along the firm’s existing supply chain to avail the benefits of vertical integration. It occurs when the TNC enters a foreign country to produce intermediate goods that are intended for use as inputs in its home country’s (or in other subsidiaries) production process (this is called backward vertical FDI), market its homemade products overseas, or produce final outputs in a host country using its home-supplied intermediate goods or materials (this is called forward vertical FDI). Global firms such as Royal Dutch Shell p.l.c., BP p.l.c., and Consolidated Goldfields Corporation are classic examples of vertically integrated multinationals. An example of backward vertical FDI is offshore extractive investments in petroleum and minerals. For example, ONGC, which is in the business of petroleum refining in India, has purchased oil fields in South Africa, and has won exploration rights for a major project in Venezuela through a tie-up with Spain’s Repsol. This is an example of backward integration for assured supply of inputs into a firm’s downstream operations. An example of forward vertical integration is the establishment of an assembly plant or a sales branch overseas to be able to sell the firm’s domestic output abroad. For example, when Volkswagen entered the US market, it acquired a large number of dealers to distribute its product rather than distribute its product through independent US dealers.

     

    Vertical FDI refers to investment in activities along the firm’s existing supply chain to avail the benefits of vertical integration.

  3. Conglomerate FDI refers to investment made by a TNC to manufacture products which are not being manufactured by the parent company at home. For example, TNCs based in Hong Kong often set up foreign subsidiaries or acquire local firms in mainland China to manufacture goods that are unrelated to the parent company’s product portfolio. The main purpose is to seize emerging market opportunities and capitalize on their established business and personal networks with the mainland, which Western TNCs do not have.

     

    Conglomerate FDI refers to investment made by a TNC to manufacture products which are not being manufactured by the parent company at home.

Horizontal FDI is the fastest route for the firm to establish its competitive advantage in the host country, since its key competencies, whether technological or organizational, are generally more transferable and applicable to the host-country operations through horizontal FDI than through conglomerate or vertical FDI. Conglomerate FDI is relatively less popular because it involves establishing market power and a competitive position in the host country in unrelated areas of work.

Motive-based View

FDI can also be classified on the basis of the motive of investment.

  • Resource-seeking FDI is motivated by the desire to acquire particular resources at a lower real cost than could be obtained in the home country. Resource-seekers can be further classified into three groups—those seeking physical resources; those seeking plentiful supplies of cheap and/or skilled labor; and those seeking technological, organizational, and managerial skills. Recent incidents by Indian and Chinese firms in search of oil and in other extractive industries in Africa are all examples of resource-seeking FDI.

     

    Resource-seeking FDI is an attempt to acquire particular resources at a lower real cost than could be obtained in the home country.

  • Market-seeking FDI is targeted at increasing market share and sales growth in a foreign market. Apart from market size and the prospects for market growth, the reasons for market-seeking FDI are to follow the firm’s main suppliers or customers who may have set up foreign producing facilities abroad or the firm may want to service markets in which its competitors have a presence. For instance, the Essar group from India acquired a controlling stake in the telecom assets of UAE-based Warid Telecom, which has a presence in Uganda and Congo. It already had a presence in Africa in the mobile telephony services in Kenya where it operates under the brand name ‘YU’ and services over 600,000 customers. Thus, the Essar group hopes to become an active player in the growing telecom market in Africa by providing assistance for network expansion and for marketing in these markets.

     

    Market-seeking FDI is targeted at increasing market share and sales growth in a foreign market.

  • Efficiency-seeking FDI aims to take advantage of different factor endowments, economic systems, policies, and market structures to concentrate production in a limited number of locations and reduce cost of operation. It attempts to rationalize the structure of established resource-based or marketing-seeking investment in such a way that the firm can gain from the common governance of geographically dispersed activities. Efficiency gains are the results of synergies arising out of the pooling of management resources, and revenue enhancement is through the use of common facilities and the economies of large-scale production. Recent acquisitions by Indian IT firms such as Navion Software Corporation in China by MphasiS and eJiva by Mascot Office Systems Limited in the US led to increased value as a result of increase in the employee strength. Skill-set enhancement can also lead to increased efficiency as in the case of the acquisition of Orbitech by Polaris Software Lab Limited. While Polaris was looking for a specialized product suite, Orbitech needed efficient marketing and service support; since the merger, Polaris has become a large, specialized company in the banking, financial services and insurance (BFSISI) sector offering solutions, products, and transaction services.

     

    Efficiency-seeking FDI aims to take advantage of different factor endowments, economic systems, policies, and market structures to concentrate production in a limited number of locations and reduce cost of operation.

  • Strategic asset-seeking FDI attempts to sustain or enhance international competitiveness through asset acquisition. Merger with or acquisition of an existing company is the most inexpensive method of acquiring strategic assets such as R&D, technical know-how, patents, brand names, local permits, licences, and supplier and distributor networks. Strategic created assets may take years to develop and may be crucial to increase the firm’s competitive advantage. For example Wipro, which is a diversified Indian conglomerate, bought out the business of Yardley, one of the world’s oldest cosmetics brands in Asia, the Middle East, Australia, and North and West Africa. The acquisition hopes to give a strategic boost to Wipro’s foothold in the high growth markets of the Middle East and to double its revenue earnings.

     

    Strategic asset-seeking FDI attempts to sustain or enhance international competitiveness through asset acquisition.

Bird’s-eye View

FDI is a mode of foreign entry which gives the investing TNC the right of control over productive assets in another country. FDI may take several forms such as greenfield investment, brownfield investment or a merger. It may be motivated by the search for markets, resources, increased efficiency or a combination of all these.

MODES OF FDI ENTRY

A TNC can make its FDI investment in a foreign market through different modes of entry.

Branch Office

A branch office is a legal extension of an existing parent foreign entity engaged in production and operating activities, but with no legal existence of its own. Branch offices are entitled to run businesses within a specified scope or location. This distinguishes them from representative offices which are prohibited from direct profit-making business activities and can only serve as liaison offices. Branch offices can be opened in another country or even in another region of the host country to expand its operations there. Branch offices are usually used for expansion by transnational banks, law firms, and accounting or consulting companies. Establishing a branch office is the easiest and a low-risk mode of foreign entry. However, since it does not have an independent legal status, the parent often has to bear the additional risk of any charges brought against it.

 

A branch office is a legal extension of an existing parent foreign entity engaged in production and operating activities, but with no legal existence of its own.

Strategic Alliances

Strategic alliances are cooperative agreements between potential or actual competitors. They can be formal agreements with equity stakes or short-term contractual agreements for cooperation in a specific task. These agreements are aimed at sharing or co-developing of products, technologies or services through exchange between firms. These alliances are of two types—equity joint ventures and cooperative joint ventures.

Equity Joint Venture

An equity joint venture entails establishing a new entity that is jointly owned and managed by two or more parent firms in different countries. To set up an equity joint venture, each partner contributes cash, facilities, equipment, materials, intellectual property rights, labor, or land use rights. These collaborative arrangements could have an equal ownership pattern, that is, a 50–50 ownership or in any other proportion, according to the law of the land.

Cooperative Joint Venture

A cooperative joint venture (also known as contractual joint venture) is a collaborative agreement in which both profit sharing and responsibility sharing are defined as per the terms of a contract between the two parties. The profit-sharing arrangement is not necessarily according to each partner’s per centage of the total investment. Each partner/co-venturer cooperates as a separate legal entity and bears their liabilities. Most cooperative joint ventures do not involve the creation of an independent corporate entity but follow carefully defined rules regarding allocation of tasks and costs, and revenue sharing.

The increase in the number of such alliances among TNCs all over the world is transforming the global business environment as it facilitates foreign market entry, and helps firms share fixed costs and risks and benefits from the synergies of complementary skills and assets. These alliances are gaining importance worldwide as global competition intensifies for access to markets, products, and technologies. Most large TNCs such as Motorola, Inc., Siemens AG, Sony Corporation, General Motors (GM), Daimler AG, and Toyota Motor Corporation have built such alliances. For example, in Japan alone, Royal Dutch Shell has established more than 30 joint ventures. As a means of survival and growth, strategic alliances have become a fundamental element of many TNCs’ key global business strategies.

Wholly Owned Subsidiary

A wholly owned subsidiary is an entry mode in which the investing firm owns 100 per cent of the new entity in a host country. This new entity may be built from scratch by the investing firm (greenfield investment) or through a merger and acquisition with a local business. During the 1990s, Japan’s Kao Corporation established a large number of wholly owned manufacturing and marketing subsidiaries overseas. The establishment of a large, wholly owned project abroad can be a complex, costly, and lengthy process. TNCs must choose between the importance of protecting core technology and manufacturing and marketing processes on the one hand, and the costs of establishing a new operation on the other. Many TNCs choose this alternative only after expanding into markets through other modes that have helped them accumulate host-country experience.

 

A wholly owned subsidiary is an entry mode in which the investing firm owns 100 per cent of the new entity in a host country. This new entity may be built from scratch by the investing firm (greenfield investment) or through a merger and acquisition with a local business.

Advantages:

The advantages of a wholly owned subsidiary are:

  • It is a preferred mode of entry when a firm has a strong competitive advantage in technological competence, since it offers increased flexibility and control.
  • It allows international managers the freedom to make their own decisions without the burden of an uncooperative partner.
  • A firm is able to get 100 per cent profits for itself instead of having to share them.
  • Wholly owned subsidiaries also allow foreign investors to set up and protect their own processes and procedures, which leads to more careful strategic and operational management.

Disadvantages:

The disadvantages of a wholly owned subsidiary are:

  • It entails both high costs and risks. The firm has to incur the entire capital expenditure of setting up in a foreign market and the risks associated with it.
  • It has to rely on indigenous agents to make liaisons on its behalf and help procure land, materials, and services.
  • Host governments often impose restrictions on investment and operation in industries that are vital to its economy.
  • Since wholly owned subsidiaries operate without the control of local partners, investment approval authorities often require higher standards on pollution control, technological level, capital contribution, foreign exchange administration, etc. from them as preconditions for approval.

Forms of Wholly Owned Subsidiaries: Greenfield Investment versus Mergers and Acquisitions

A TNC can set up a wholly owned subsidiary, through either greenfield investment or international mergers and acquisitions (M&As).

A greenfield investment refers to the setting up of a new business through the establishment of fully owned new facilities and operations by a TNC in another country.

An international merger and/or acquisition (M&A) is a cross-border transaction in which a foreign investor acquires an established local firm and makes the acquired local firm a subsidiary business within its global portfolio.

A merger and acquisition has the following advantages as compared to a greenfield investment:

  • The international acquisition of a local firm or another foreign company with local ventures is the quickest way to expand one’s investment in the target country.
  • An acquisition is useful for entering sectors where entry for new investment is restricted.
  • An acquisition begins to generate cash flows and profits faster than a greenfield investment since it is a running enterprise.
  • An acquisition gives the acquirer immediate access to local resources such as land, manufacturing facilities, distribution channels, supply networks, skilled labor and customer base. Foreign investors generally target enterprises with strong market niches in sectors with potential for growth.

A merger and acquisition has the following risks/disadvantages as compared to a greenfield investment:

  • Gaining government approval for the transfer of ownership and clearance of property titles is often difficult to get.
  • Foreign investors need to be careful to obtain accurate information, particularly concerning existing liabilities, when buying into an existing business.
  • International mergers and acquisitions inevitably face many challenges, especially during early operations. The fundamental challenges are often rooted in cross-national differences in culture, managerial styles, and corporate values. To overcome these challenges, international managers need to develop a new corporate mission, vision, and strategic objectives. It is also important to integrate communications and human resources. The new organization must develop mechanisms to identify the most appropriate organizational structures and management roles in order to enhance administrative efficiency and operational effectiveness.

Umbrella Holding Company

An umbrella holding company is an investment company that brings all the firm’s existing investments such as branch offices, joint ventures, and wholly owned subsidiaries under one umbrella in order to combine sales, procurement, manufacturing, training, and maintenance within the host country. It is often seen that many large TNCs try to combine production divisions for different sub-units under a common umbrella in an important destination. For example, DuPont set up DuPont China Ltd as its holding company to unite various joint ventures in the pharmaceutical and plastics divisions under a common coordinated management.

 

An umbrella holding company is an investment company that brings all the firm’s existing investments such as branch offices, joint ventures, and wholly owned subsidiaries under one umbrella in order to combine sales, procurement, manufacturing, training, and maintenance within the host country.

Differences Between Joint Ventures and Mergers

  • The major difference between joint ventures and mergers is that the former involves formation of a third entity (for example, an equity joint venture) whose duration is often limited and specified in the contract, whereas the latter does not have a specific duration and may or may not lead to the formation of an independent new entity.
  • Joint venture parties remain independent after forming a venture but two parties are integrated into a single organization after a merger.
  • Also, mergers combine all of the partners’ assets (though some may be combined later), while a joint venture involves only some of those assets.

Bird’s-eye View

There are several modes of foreign market entry which may be classified as FDI. These include the branch office, strategic alliances, wholly owned subsidiary and an umbrella holding company.

FDI: AN EVALUATION

FDI flows have beneficial effects on both the home country—from where they originate, and the host country where they finally reach.

Host-country Perspective

Spillover Effects

FDI as a source of capital contributes to the host economy by bringing with it capital, technology, and management resources.

Financial resources: Many large TNCs have access to financial resources which supplement the domestic capital available and help to spur the rate of investment. This is a significant contribution for countries where the domestic saving rate is low.

Technology: FDI often carries with it the benefits of technology, which is crucial in economic development. Technology may be incorporated either in the production process itself (for example, the technology for discovering, extracting and refining oil) or in the product (for example, personal computers or laptops). This is a significant advantage for less developed countries which lack the research, development resources and skills required to develop their own indigenous product and process technology.

Innovation: FDI also leads to innovation and increased knowledge, which are eventually dispersed throughout the many levels of the local economy. The extent to which local firms can take advantage of this depends on a host of other factors such as local infrastructure and government policies.

Management skills: Foreign management skills acquired through FDI may also produce important benefits for the host country. Foreign managers trained in the latest management techniques can often help to improve the efficiency of operations in the host country.

Beneficial spin-off effects also arise when local personnel who are trained to occupy managerial, financial and technical posts in the subsidiary of a foreign TNC leave a firm, and help to establish indigenous firms. Similar benefits arise when the superior management skills of a foreign TNC stimulate local suppliers, distributors, and competitors to improve their own management skills.

Employment effects: FDI facilitates the creation of jobs both directly and indirectly. Direct employment is the result of the foreign TNC creating jobs for the local population as a result of increased investment. Indirect employment effects arise as a result of increased investment which, in turn, is the result of increased consumption expenditure.

Balance of Payments Effect

FDI has four important balance of payments effects for a host economy:

  • The establishment of a foreign subsidiary results in a one-time capital inflow in the economy’s balance of payments account.
  • If the FDI is a substitute for imports of goods or services, it improves the current account balance.
  • A third potential benefit arises when the TNC uses a foreign subsidiary to export goods and services to other countries.
  • FDI also leads to repatriation of profits and dividends, adding to the income of the home-country shareholders.

Competition and Economic Growth

The existence of competition among producers results in the efficient functioning of markets. FDI in the form of greenfield investment results in the creation of a new enterprise, increasing the number of players and competition in the domestic market. This, in turn, drives down prices and increases consumer welfare. Increased competition also stimulates capital investment by firms in the domestic market in the form of plant equipment and R&D, as they struggle to gain an edge over their rivals. The long-term results include increased productivity, product and process innovation, and greater economic growth.

Home-country Perspective

FDI has a number of beneficial effects on the home country such as:

Increased foreign earnings: FDI is a major source of foreign earnings in the form of repatriated dividends, licence fees, etc. The current account of the balance of payments account also benefits if the foreign subsidiary is successful in creating demand for home-country exports.

Employment effect: The home country experiences positive employment effects when the foreign subsidiary creates demand for home-country exports of capital equipment, intermediate goods, and complementary products.

Acquisition of skills: The home-country TNC learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country. This amounts to a reverse resource transfer effect. Through its exposure to a foreign market, a TNC can learn about superior management techniques as well as product and process technologies. These resources can then be transferred back to the home country, contributing to its economic growth.

Benefits of differences in industrial structure: It is seen that national markets in the home and host country are different in terms of industry lifecycle stages and in consumer purchasing power. For instance, many emerging economies present vast market opportunities for TNCs to attain above-average returns since they are able to satisfy huge unsatisfied demand which is the result of earlier government intervention. Footwear and apparel companies such as Adidas, Reebok and Nike turned their attention to developing country markets like India to benefit from the growing demand caused by the economic upswing in the 1990s.

Increasing return from ownership advantages: Ownership advantages are the advantages arising out of the possession of proprietary knowledge, resources, or assets possessed by the TNC. The possession of these intangible assets (for example, reputation, brand image, and unique distribution channels) or proprietary knowledge (for example, technological expertise, organizational skills, and international experience) becomes a source of competitive advantage, which can be exploited by the TNC in foreign markets.

Ensuring growth from organizational learning: FDI creates a diverse and varied operating environment for the firm, allowing it to develop diverse capabilities, and providing it with broader learning opportunities than are available to a domestic firm. The exposure to new markets, new practices, new ideas, new cultures, and even new competition leads to the development of new capabilities, which become organizational resources. For example, many early movers entering China, such as Motorola, Kodak, Philips, Sony, and Occidental Petroleum, realized that the Guanxi or relationship-building (personal ties with the local business community) skills they learned in China were equally applicable to their businesses in Russia, Hungary, Egypt, Southeast Asia, and Latin America.

GLOBAL FDI PATTERNS

The last few years have witnessed several changes in the nature and magnitude of global trade and investment flows. Among these changes is the new phenomenon of outward foreign direct investment (OFDI) from developing countries with a significant influence on the trade and on investment across the world.

Traditionally, developing countries have been dependent upon the developed countries for trade and investment. The developed countries not only provided the developing countries with markets for their goods, but also acted as a source of foreign capital for these capital-scarce countries.

As developing countries competed amongst themselves to receive a pie of the market share and foreign capital from these countries, it led to an unequal distribution of economic power, where the developed countries had a lot more leverage and control over the developing countries. However, the phenomenon of South–South trade and investment cooperation is bringing about significant changes in this power imbalance in the international economy. Moreover, for the capital-scarce, least developed countries, such FDI from developing countries is of immense importance. It is in this context that the new phenomenon of increased FDI from India and China, to the continent of Africa assumes importance.

The global economy today, is on the threshold of a fourth industrial revolution, driven by new frontier technologies and advances in robotization that have made production better, cheaper and faster. The new industrial revolution can promote economic growth and sustainable development through industrial upgrading and leapfrogging as a result of new technologies. However, the accelerating pace of technological innovation can also cause economic disruption and increased inequality. These features are reflected in the changing pattern of FDI flows in the global economy.

Trends in FDI

The past 30 years have seen a marked increase in both the flow and stock of FDI in the world economy. FDI flows refer to the amount of investment flows over a given period of time, whereas stock refers to the total accumulated value of foreign-owned assets at a given time. The flow of FDI in the last three decades has increased faster than the growth in world trade. This is because despite a general decline in trade barriers over the past 30 years, business firms still fear trade protectionist measures and see FDI as a way of getting around future trade barriers.

The average yearly flow of FDI increased from about USD 25 billion in 1975 to a record USD 1.3 trillion in 2000, before slumping dramatically in 2004 to USD 620 billion.

Global FDI flows were severely affected worldwide by the economic and financial crisis and declined to USD 1,697 billion in 2008 but began to recover in 2009, and reached USD 1.45 billion in 2013. The recovery was stronger and faster to developing and transition economies, which received 50 per cent of the total global FDI flows in 2010 and 54 per cent of global inflows in 2013.

Global FDI flows were recorded at USD 1.43 trillion in 2017 which was a decline of 23 per cent compared to the previous year, as a result of a fall of 22 per cent in cross-border mergers and acquisitions. This is in sharp contrast to the growth seen in GDP, trade and other cross – border capital flows in the same year. Total capital flows increased from 5.6 to 6.9 per cent of GDP in 2017,1 as a result of increased bank lending and portfolio investment.

Direction of FDI

Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the other’s markets. The US has often been the favourite target for FDI inflows. Historically, the US has been an attractive target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a favourable political environment, and the openness of the country to FDI. Investors have included firms based in the United Kingdom, Japan, Germany, the Netherlands, and France.

The share of the developed nations in general and US in particular has gradually declined and was reduced to 39 per cent of the global total at USD 566 billion in 2014. The developing countries received a record level of 57 per cent of the global total in 2013. The share of inward FDI flow to developed economies almost doubled to USD 962 billion in 2015.

FDI flows to developing economies remained stable at USD 671 billion, and saw no recovery after the 10 per cent drop in 2016. FDI flows to Africa continued to slide, reaching USD 42 billion, which was a decline of 21 per cent from 2016. The decline was concentrated in the larger commodity exporters. Asia was the largest recipient of FDI with recorded flows of USD 476 billion. FDI to Latin America and the Caribbean was recorded at USD 151 billion which was an increase of 8 per cent, as a result of the region’s economic recovery.

The decline in inward FDI flows was concentrated in the developed economies which received USD 712 billion—a sharp decline of 37 per cent. Cross-border M&As registered a 29 per cent decrease, FDI flows to transition economies declined by 27 per cent, to USD 47 billion, the second lowest level since 2005.2

FDI Outflows

TNCs from developed countries have traditionally accounted for the majority of FDI outflows since they possessed greater ownership or monopolistic advantages, have been global innovators and have had the dynamic capabilities necessary for successful venturing abroad.

During 1998–2000, the Triad countries (US, Europe, and Japan) accounted for 85 per cent of FDI outflow and 78 per cent of outward FDI stock, with much of it going to other Triad countries. In 2007, the developed countries continued to remain the largest net outward investors as outflows rose to record levels of USD 1,692 billion. The largest investors were the US, the United Kingdom, France, Germany and Spain, which accounted for 64 per cent of the total global FDI outflow. Global FDI outflows were USD 14.1 trillion in 2013.

In 2015 FDI outflows from developed economies increased by 33 per cent to USD 1.1 trillion, following three years of decline. As a result, developed countries accounted for 72 per cent of global FDI outflows in 2015, an increase of 61 per cent compared to 2014. This increase marks the end of a period of almost uninterrupted relative decline in global FDI that began in 2007. Despite the increase in FDI outflows in 2015, developed country outward FDI remained 40 per cent short of its 2007 peak.

Europe was the largest investor in outward FDI flows accounting for USD 576 billion worth of investment. Japanese TNCs were the world’s second largest investors, followed by investments from North America.

Outward FDI from the developing countries began in the decade of the 1990s. It was led by FDI outflows from Latin America and the Caribbean that leaped from an average of USD 15 billion a year in 1991–2000 to USD 48 billion annually in 2003–2009, driven by the emergence of TNCs from the region since 2003. Outward FDI from developing and transition economies reached USD 388 billion in 2010. Chinese companies have continued their buying spree, actively acquiring overseas assets in a wide range of industries and countries, and overtaking Japanese companies in total outward FDI. All of the big outward investor countries from Latin America—Brazil, Chile, Colombia, and Mexico increased their acquisitions abroad, particularly in developed countries where investment opportunities have arisen in the aftermath of the 2008 crisis. In contrast, outflows from major investors in West Asia fell significantly, due to large-scale divestments and redirection of outward FDI from government-controlled entities to support their home economies weakened by the global financial crisis. FDI outflows declined from most developing and transition regions as a result of declining commodity prices and depreciating national currencies along with geopolitical risks as contributing factors. China was the only exception as its outward FDI increased from USD 123 billion to USD 128 billion, making it the world’s third largest investor after the US and Japan.

Developed economies continue to dominate global OFDI. The share of the developed world was recorded at USD 1 trillion in 2017 which was 71 per cent of the global total. Leading contributors to outward FDI were US, Japan, UK and Hong Kong.

FDI outflows from the developing economies were recorded at USD 381 billion in 2017, while those from transition economies rose by 59 per cent over the previous year to USD 40 billion. Outward FDI flows by MNEs from developing economies declined by 6 per cent in 2017, largely due to reduced flows from China. The decline of investment from Chinese MNEs was the result of policies restrictions on outward FDI, in reaction to significant capital outflows during 2015– 2016, mainly in industries such as real estate, hotels, cinemas, entertainment and sport clubs.3

An important development has been the increase in the number of State-owned TNCs to 550 from both the developed and developing countries, accounting for USD 2 trillion global foreign assets in 2013. The majority of the State-owned enterprises (SOEs) that acquired foreign assets in 2012 were from developing countries; and the majority of the acquisitions carried out by them have been strategic asset seeking (e.g., technology, intellectual property, brand names) and natural resource seeking.

Sovereign Wealth Funds (SWFs) contributed USD 6.7 billion, with cumulative total of USD 130 billion. Cumulative FDI by SWFs is estimated at USD 127 billion, most of it in finance, real estate, construction and utilities. In terms of geographical distribution, more than 70 per cent of SWFs’ FDI in 2012 was targeted at developed economies. The combined assets of the 73 recognized SWFs around the world were valued at an estimated USD 6.4 trillion—which has the potential to become a huge resource for development financing.

FOREIGN INVESTMENT IN INDIA

The trade channel has traditionally been considered the main mode of global integration of economies. Since the 1970s, however, with increasing mobility of capital, investment is the new face of economic and global integration. The Indian economy has been an increasing part of global inter-connectedness with changes in policy contributing to both change in nature and magnitude of capital flows.

Policy Perspective

A historical account of the policy approach to international investment in India suggests that, in the early 1950s, there was a complex network of controls imposed on all external transactions between residents and non-residents, with the view to developing the domestic economy. External financing, therefore, was predominantly done through official flows made up of aids and grants from the 1950s to the 1970s.

In the 1980s, a widening current account deficit, increasing financial requirements, and the diminishing role of official aid led to a shift in the policy choice towards commercial borrowings from international capital markets. External commercial borrowings (ECBs) were, however, regulated by an approval procedure subject to conditions on cost, maturity, end use, and ceiling. In the second half of the 1980s, financial institutions and public sector undertakings (PSUs) increased their participation in the international bond market, as a result of which the share of ECBs in net capital flows to India more than doubled to 27 per cent in the 1980s from that in the 1970s.

The 1990s marked a regime shift in capital flows with private flows in the form of ECBs, which became the dominant flow of capital along with non-resident Indian (NRI) deposits and short-term trade credits. Policy changes in the 1990s were the result of the adoption of an overall macroeconomic stabilization and reform package in the aftermath of the balance of payment crisis of 1991.

The major characteristics of this policy change are as follows:

  • There was a hierarchy assigned to different kinds of flows with FDI being preferred in comparison to foreign portfolio investment (FPI).
  • Within the hierarchy, there was a preference for inflows which were liberalized earlier and faster as compared to outflows.
  • Restriction on capital inflows continued to exist and took the form of both quantity and price controls. Controls on outflows, however, were only quantity-based.

Following the global financial crisis and consequent to downgrading of sovereign ratings, firms’ access to global markets virtually dried up. Due to the global financial crisis, the sensitivity of capital flows to financial shocks has been highlighted. As a result, the Reserve Bank of India (RBI) has adopted a policy of adjustment of interest rates on NRI deposits, relaxing the ECBs for corporates, allowing ECBs access to non-banking financial companies and housing finance and relaxation in interest rates for trade credit. Overall, there has been a prudent management of the capital account. Based on this, India’s foreign investment policy can be broadly classified into four phases:

  1. Cautious non-discrimination in controls from 1948 to the mid-1960s.
  2. Selective restrictions and control from the mid-1960s to the end of the 1970s. During this period, the Monopolies and Restrictive Trade Practices Act (MRTP) (1969), the Foreign Exchange Regulation Act (FERA) (1973) and the Industrial Licensing Act (1973) were the main instruments of policy control.
  3. Gradual and partial liberalization in the 1980s with special incentives for investment in export-oriented units.
  4. Wide ranging liberalization since 1991, under which FDI up to 100 per cent is allowed under the automatic route in most activities, but some sectors have a ceiling on investment from the view point of financial stability or other domestic economy considerations.

Prior to the economic reforms in 1991, FDI in India was adversely affected by the following factors:

  • The public sector was assigned a monopoly, or a dominant position, in the most important industries and, therefore, the scope of private investment, both domestic and foreign, was limited.
  • When the public sector enterprises needed foreign technology or investment, there was a marked preference for foreign government sources, such as aid or loans.
  • Government policy towards foreign capital was very selective. Foreign investment was normally permitted only in high-technology industries in priority areas, and in export-oriented industries.
  • Foreign equity participation was normally subject to a ceiling of 40 per cent, although exceptions were allowed on merit.
  • Payment of dividends abroad, repatriation of capital, as well as inward remittances were subject to stringent laws like the Foreign Exchange Regulation Act (FERA) of 1973, which discouraged foreign investment.
  • Corporate taxation was high and tax laws and procedures were complex.

Sectoral Dimensions of FDI Flows

FDI is prohibited in the following activities/sectors:

  • Retail trading (except single-brand product retailing)
  • Lottery business including government/private lottery and online lotteries
  • Gambling and betting including casinos
  • Business of chit fund
  • Nidhi company
  • Trading in transferable development rights (TDRs)
  • Real estate business or construction of farm houses
  • Manufacturing of cigars, cheroots, cigarillos, and cigarettes of tobacco

Activities/sectors not opened to private sector investment include atomic energy and railway transport (other than mass rapid transport systems). Besides foreign investment, foreign technology collaboration in any form including licensing for a franchise, trademark or brand name, and management contracts are also completely prohibited for the lottery business, and gambling and betting activities.

The sectoral dimensions of FDI flows provide important insights of sector-specific pull factors as well as industry-specific FDI policies and regulations. FDI in India has been concentrated in a number of sectors as discussed here:

  • Unlike the dominance of manufacturing in East Asian economies, FDI in India is concentrated in the services sector. Information technology has enabled a greater growth potential and tradability of a number of business and professional services. With greater potential for growth of such services, FDI has emerged as a vehicle for cross-border delivery of services.
  • Within the services sector, financing, insurance, real estate and business services have witnessed a large increase in their share in FDI flows to India between 2002–2003 and 2007–2008. Computer services have also remained a key sector for FDI as captive business process outsourcing (BPOs) or subsidiaries have been the principal mode of offshore delivery.
  • The manufacturing sector which constituted about 50 per cent of total FDI in the 1990s, has witnessed a sharp fall in its share to about 19 per cent in 2007–2008. Although the growth of FDI in the manufacturing sector has remained steady, it is the rapid expansion of FDI in services that has resulted in the shrinking of its share in manufacturing.
  • The construction sector has emerged as the next important sector attracting FDI with an average share of around 10 per cent during 2002–2008.

In 2015 FDI equity inflow of USD 14.3 billion went into services segments, viz. financial and non-financial, hotels and tourism, telecommunication, trading, computer software and hardware. FDI flows of merely USD 4 billion appears to have been invested into the manufacturing sector (power, automobiles, chemicals and drugs and pharmaceutical industries). In the financial year 2016-17, total FDI of US $ 60.08 billion has been received, which is an all-time high.

FDI in manufacturing is relevant from the standpoint of creating jobs and shifting workers from farms to factories. It is also important from the perspective of achieving the ‘Make in India’ goal, aiming to increase the share of manufacturing in gross domestic product to 25 per cent by 2022. It appears that FDI inflows are a reflection of a broader, global feature of subdued manufacturing due to overcapacity. This shows a pessimistic outlook for manufacturing.

FDI Policy Changes

There have been some significant policy changes in FDI during 2015–16. Investment in the following sectors has been permitted subject to the equity cap as given in Table 8.1.

There have also been some significant policy changes in 2018. These are listed as under:

  • 100 per cent FDI under automatic route for Single Brand Retail Trading4
  • 100 per cent FDI under automatic route in Construction Development
  • Foreign airlines allowed to invest up to 49 per cent under approval route in Air India
  • FIIs/FPIs allowed to invest in Power Exchanges through the primary market
  • Definition of ‘medical devices’ amended in the FDI Policy

Geographical Composition

Cumulative FDI inflows received by India during April 2000–March 2016 amounted to USD 424,167 billion. Out of this USD 288,513 was in the form of equity flows and the rest consisted of re-invested earnings and other capital. The major geographical sources of FDI flows in India are Mauritius, the US, the United Kingdom, Singapore, Germany, Japan, and the Netherlands contributing 71 per cent of total FDI during the 1990s. They continued to dominate FDI in India during the 2000s and in current decade as well, with a share exceeding 70 per cent; however, their shares have been volatile. For example, although FDI from Mauritius has dominated in volume since the 1990s, it has been fluctuating between 62 per cent and 49 per cent from 2007 to 2008. Table 8.2 shows FDI inflows to India from 1991–1992 till 2017–2018.

Outward Indian FDI

OFDI from India is not a new phenomenon, although it has gathered steam in the last few years. The earliest examples of OFDI were investments by the Arvind Mafatlal Group in textiles in 1920, in a cotton-spinning operation in Uganda. In 1950s, the Aditya Birla Group similarly invested in Africa and in Southeast Asia between 1965–1981. In the early 1960s, large Indian conglomerates such as the Tata Group and Kirloskar Brothers Limited expanded their activities into Africa and Sri Lanka and Ranbaxy set up its first joint venture abroad in Nigeria in 1977. These investments were, however, modest and hardly detectable in FDI statistics. In the late seventies and early eighties, there was a more perceptible increase in OFDI, but it was only with economic reforms in 1991 that OFDI from India picked up in earnest; and, since 2001, investment has surged.

 

Table 8.1 FDI Sectoral Profile

References: Consolidated FDI Policy Circular of 2016, dipp.nic.in, last accessed on 8 October 2018.

 

Table 8.2 FDI Inflows to India

References: FDI Statistics, http://dipp.nic.in, last accessed on 8 October 2018.

The growing competitiveness of Indian firms and their desire to venture abroad to access wider global markets, operate near client locations, and acquire technology, raw materials and brands are the key drivers pushing Indian firms to invest abroad. The significant policy changes that began in 2000 have contributed to the rapid expansion of OFDI from India. Subsequent to the phased liberalization in the regime for foreign investment, investment in joint ventures and wholly–owned subsidiaries emerged as the key vehicles for facilitating global expansion by Indian companies. The existence of bilateral investment and double taxation treaties helped to increase the confidence of the Indian investing firm.

The major policy initiatives responsible for increase in outward FDI are:

  • Increasing permission to invest in joint ventures and wholly owned subsidiaries up to 400 per cent of capital by way of special-purpose vehicles.
  • Permission for the swap of shares put under the automatic route, to hedge exchange risk on overseas investment and to invest in the financial sector subject to certain conditions.
  • Permission to invest in the financial sector subject to certain conditions.

In terms of numbers, outward FDI from India touched a record high of USD 13 billion between April and December 2008. After reaching the historic high of USD 44 billion during the financial year 2010, India’s OFDI plummeted during the next two years, reaching USD 27 billion, owing to global financial crisis and its domestic economic problems. However during 2013–14, investment activity showed moderate signs of recovery and were recorded at USD 36 billion, accounted for by 5,128 Indian firms as against 4,524 firms in 2010.5 OFDI from India increased from USD 1,818 million in May 2015 to USD 2,694 million in May 2016.

While there had been waves of Indian OFDI in the 1980s, the OFDI of the 1990s was larger and more durable and included more industries and a broader selection of developing countries. Thus, the level of investment increased from an average of USD 5 million a year before 1991 to USD 132 million after 1991, and the stock of OFDI rose from an average of USD 95 million in 1980–1990 to USD 720 million in 1991–2000. The total number of approved OFDI projects was 2,562 in the 1990s, almost 11 times more than the number of projects approved in 1975–1990.

In terms of location, a very significant shift took place as well. While 86 per cent of OFDI previously went to developing countries, this share fell to approximately 40 per cent during the 90s. Among the developed countries, it was particularly the United Kingdom and the US that dominated. The last couple of years have seen developing economies again accounting for a majority of India’s investment, receiving about 60 per cent of the total outflows (UNCTAD FDI Statistics 2013).6

India’s foreign direct investment (FDI) outflows more than doubled in 2017 to USD 11.3 billion. Important Outward FDI deals from India included, a purchase of 15 per cent by state-owned oil and gas company Oil and Natural Gas Corporation Ltd (ONGC) in an offshore field in Namibia from Tullow Oil (founded in Ireland and headquartered in the United Kingdom) in 2017. By the end of 2017, ONGC had 39 projects in 18 countries, producing 285,000 barrels of oil and oil-equivalent gas per day.7

CHAPTER SUMMARY
  • FDI occurs when a firm invests directly in production or other facilities in a foreign country over which it has effective control.
  • As a mode of foreign entry, FDI reflects the desire of a firm to utilize its competitive advantage for growth and profit through investment in foreign lands.
  • The emergence of FDI flows between countries has benefits and costs for both the home and the host country.
  • FDI is classified according to three factors—asset creation or asset acquisition, nature of business activity, and motives driving the investment.
  • Horizontal FDI takes place when a firm invests abroad in the same industry in which it operates in the home country.
  • Horizontal FDI is a safe way to enter a foreign market because it produces the same product as the parent company, and so experience and infrastructure are easily shared.
  • Vertical FDI refers to investment in activities along the firm’s existing supply chain to avail the benefits of vertical integration.
  • Vertical FDI acts as an intermediary or finishing stage in the production process, offering either inputs to the parent or final access to a foreign market.
  • Lastly, if the investment produces a product entirely unrelated to the parent’s products, it is a conglomerate FDI.
  • FDI can be resource-seeking, market-seeking, efficiency-seeking, and strategic asset-seeking.
  • FDI entry is of four types—branch offices, strategic alliances, wholly owned subsidiaries, and umbrella holding companies.
  • There have been three waves of outward FDI from the developing world. The first wave was from the 1960s to the mid-1980s, the second wave was from the mid-1980s to the 1990s and the third wave was from the 1990s to the 2000s.
  • With changes in policy since the 1990s, the Indian economy has contributed to both change in nature and magnitude of capital flows. Indian OFDI has increased substantially with Indian firms emerging as global giants.
KEY TERMS
  • Greenfield investment
  • Merger
  • Acquisition
  • Brownfield investment
  • Horizontal FDI
  • Vertical FDI
  • Conglomerate FDI
  • Resource-seeking FDI
  • Market-seeking FDI
  • Efficiency-seeking FDI
  • Strategic asset-seeking FDI
  • Branch office
  • Strategic alliances
  • Wholly owned subsidiary
  • Umbrella holding company
  • FDI flows
  • Stock
DISCUSSION QUESTIONS
  1. Discuss the different forms that FDI activity can take.
  2. What are the different modes of entry for a firm undertaking FDI activity?
  3. Enumerate the basic features of the theories which explain FDI behaviour.
  4. Distinguish between FDI theories for firms from developed and developing countries. To what extent are these theoretical explanations borne out by the experiences of real business?
  5. Discuss the effects of FDI on home and host countries.
  6. Explain the policy framework for FDI in the Indian context.
  7. ‘Liberalization of the economy has been a driving force for FDI flows in the Indian context’. Do you agree? Explain with reference to both policy and experience.
  8. Distinguish between:
    1. Horizontal and vertical FDI
    2. Market-seeking and strategic asset-seeking FDI
    3. Greenfield and brownfield investment
    4. Branch office and umbrella holding companies
  9. Briefly explain the policy and flow of outward FDI (OFDI) from India.
EXAMINATION QUESTIONS
  1. Write short notes on: (7, 7)
    1. Indian joint ventures abroad

      [B.Com (Hons.), 2010]

    2. Indian joint ventures and acquisitions abroad

      [B.Com (Hons.), 2009]

  2. What are the measures taken by the Government of India to promote FDI in India? (8)

    [B.Com (Hons.), 2008, 2011]

  3. Write short notes on: (5, 5)
    1. Types of FDI
    2. Strategic alliances

      [B.Com (Hons.), 2014]

  4. Identify the mode of entry in the following cases, and explain its advantages and disadvantages: (7.5, 7.5)
    1. Airtel has purchased Zain Telecommunications in South Africa.
    2. There are a large number of Pizza Hut restaurants in India but none of them are owned by Pizza Hut.

      [B.Com (Hons.), 2015]

  5. What are the measures taken by the Government of India to promote FDI in India? Briefly analyse the impact of such measures in recent years. (15)

    [B.Com (Hons.), 2018, B.Com 2018]

  6. Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). Which factors motivate foreign investment? (8)

    [B.Com (Hons.), 2017]

  7. Explain the concept of strategic alliances. Briefly explain the advantages and disadvantages of strategic alliances. (7)

    [B.Com (Hons.), 2018]

  8. Briefly explain Indian Joint Ventures and Acquisitions abroad. (8)

    [B.Com (Hons.), 2018]