What is Foreign Direct Investments (FDI)? Definition, Importance and Types of FDI, Effect and Methodology of FDI?

Foreign Direct Investment

 Foreign direct investment ( FDI for short ) is the management of investment activities from one country to another at the individual or institutional level. In this case, the investor buys the shares or ownership of the company and takes control of the management.

Typically, multinational companies or multinational corporations (enterprises) are engaged in foreign direct investment. Foreign direct investment (FDI) is usually a long-term investment. Although the field is a particularly foreign direct investment in the medium term. 

Definitions

Foreign direct investment is an investment that provides the investor with control over the business operations of the recipient company in another country, implying direct control over the management of other assets of the recipient company.

Direct control is participation in the ownership of the company, which allows you to effectively control the management of the company. The size of the share of the company's ownership required for effective management is established by law in different countries (in Germany and the UK more than 20%, in Russia, and in several other countries more than 10%). 

Control can be exercised through the possession of technology, know-how, licensing agreements, contracts, control of the supply of materials, management agreements, and credit resources.

Investments are funds directed towards achieving goals, and not for consumption: in physical capital (equipment, machinery, buildings, and infrastructure), human capital (expenditures on education, training, development of professional mobility), technology ( R&D financing ), financial assets ( shares, bonds ).

Foreign investment is the investment of one country in another.

Direct investments are investments that provide long-term control of the investor over the business operations of the recipient company, which is how they differ from portfolio investments, which are focused on short-term financial benefits.

Types of Foreign Direct Investment

Foreign direct investment is generally of the following types-

• Horizontal FDI: In this case, a company established in one country expands its business to another country. In that country also the company continues its conventional business and products. For example, when American multinational technology company Apple Inc. builds a factory in China to make their iPhone and markets it after completing all the processes of making the iPhone, it is considered horizontal FDI. In this case, all the process of production of the product is completed in the factory established in that country and it is marketed from that country. Produced products are also exported from that country.

• Vertical FDI: In this case also the company established in one country expands its business in another country. In this case, the company stays the same but produces different production materials from different countries. For example, when KFC sets up a firm in another country and produces meat for their restaurants, it is informed as vertical FDI.

• Consolidated FDI: When a company established in one country invests or buys a business in a completely different business in another country, it is called consolidated FDI.

• Platform FDI: When a company sets up a manufacturing plant in another country and produces products and exports to a third country, it is called Platform FDI.

Main modes of FDI

• Establishment of a branch or an enterprise abroad, which is 100% owned by the investor;

• Takeover or purchase of a foreign enterprise;

• Financing the work of branches;

• Acquisition of property rights: rights to use land, natural resources, etc.;

• Granting rights to use know-how, technologies, etc.;

• Purchase of shares/shares in the authorized capital of a foreign company, giving the right to control the activities of the enterprise.

Profitability of FDI for the investor company

The investor company benefits from foreign direct investment in the markets of the host country compared to local companies:

• according to the eclectic paradigm of J. Dunning due to the geographical location of its production in the host country, absolute cost advantages due to low prices of production factors, taking market share in the country by bypassing trade barriers, due to economies of scale ;

• according to the theory of monopoly advantages by Steven Hymer and Charles Kindleberger, due to the specific advantage of the investment firm, to overcome the advantages of domestic enterprises of the host country: marketing knowledge, access to financial resources, managerial knowledge, and vertically integrated structure synergy.

• according to G. Johnson due to the technological knowledge and experience of the company;

• according to R. Caves due to product differentiation;

• according to the theory of internalization described in the works of P. Buckley and M. Casson, D. Tees, S. Meiji, and A. Rugman, by saving transaction costs associated with the search for partners in transactions, the conclusion of transactions, and control over their execution.

Positive effects of FDI

An important positive result of attracting foreign direct investment to the economy of the FDI recipient country can be the receipt and subsequent dissemination of more advanced production and management technologies. 

When implementing foreign projects, investors, as a rule, try to use the most favorable ratio of production factors available to them, including technologies in the form of patents, licenses, and know-how.

In the future, imported technologies can be distributed in the economy of the host country.

In this regard, it is interesting to divide how foreign direct investment influences the introduction of foreign technologies in recipient countries into direct and indirect ones.

The direct (immediate) impact of foreign direct investment on the introduction of foreign technologies can primarily be represented by the import of more advanced production technologies, the import of more advanced equipment, the production of more advanced products, the import of more advanced management technologies, including the management of sales of an enterprise with the participation of foreign investments.

The indirect impact of foreign direct investment on the introduction of foreign technologies, as a rule, can primarily be represented by the effect of training specialists at enterprises with foreign investment links between enterprises with foreign investment and local consumers of their products and their local suppliers, demonstration effect (demonstration of technologies used by enterprises with foreign investment and their subsequent imitation by local producers).

The degree of positive (or negative) effect of FDI attraction on the introduction of foreign technologies in the FDI recipient country largely depends on the ability of local producers to increase the level of technologies they use under the influence of the work of enterprises with the participation of foreign investments, which depends on the level of human capital development in the country FDI recipient. 

The lack of specialists capable of introducing or adopting technologies used by foreign investors can, with a high degree of probability, lead to a negative impact on the development of local companies that are competitors of enterprises with the participation of foreign investments and the displacement of local manufacturers from sales markets (if such companies exist).

Also, attracting FDI for the economy of the recipient country can lead to an increase in the pace of innovative development of the economy, primarily as a result of R&D by an enterprise with the participation of foreign investments, and indirectly - due to the effect of competition, when national enterprises competing with enterprises with the participation of foreign investments are forced to improve the technologies used.

The negative effect of FDI

A foreign investor in the host country is most often an oligopolist or monopolist in some markets, which is carried out by FDI to stifle competition and maintain market control, according to the findings of Stephen Hymer.

The negative impact of FDI on the host economy is related:

• according to the Marcusen-Horstmann- Venables model, a decrease in the welfare of national companies and their subsequent displacement from the market, since the domestic economy is small, means that national enterprises cannot provide lower average costs due to economies of scale compared to multinational corporations (MNCs);

• according to empirical studies by J. Konings, S. Dyankov, and B. Hoekman, with the absence of positive effects from technology transfer and a decrease in productivity in national companies: foreign companies pull the most qualified workforce from national companies, and the technological level of national companies of companies is at such a low level that it does not allow efficient use of advanced technologies of FDI companies;

• according to an empirical study by Beata Smarynska, which confirms the fact that investors who have come to the markets of host countries do not have high technologies, do not belong to high-tech industries, and use standard, well-established technologies, with the help of which they find markets, displacing national companies from the market;

• according to the work of S. M. Kadochnikov and the results of empirical studies by B. Aitken and A. Harrison, M. Haddad and A. Harrison, who come to the conclusion that most companies investing in the host economy are not focused on the reduction of production costs and subsequent export of products, and the conquest of the local market;

• according to the empirical study by A. Kokko, which does not confirm the hypothesis of R. Findley about the high growth rate of technical progress in the importing country in the case of technological separation of the investor from local companies.

Regulations of FDI

Modern investment processes are dichotomous - on the one hand, they are characterized by the ongoing liberalization of investment legislation, and on the other hand, by strengthening investment regulation to maintain the social orientation of the economy in developed countries.

The regulation of foreign investment is carried out both at the national and at bilateral or multilateral or regional levels.

The main source of international investment law regarding the regulation of FDI is the Agreement on Trade-Related Investment Measures ( TRIMS ). It was adopted in 1994 by the World Trade Organization during the Uruguay Round of negotiations.

Regulations in the FDI

According to UNCTAD, the total amount of FDI in the world in 2008 amounted to $2.1 trillion, which is approximately equal to 53% of the 2009 US budget ($3.9 trillion) or 10.5 times the income part of the Russian budget 2009.

At the same time, in the total volume of FDI, the share of developing economies, as a rule, accounts for more than 60%. This is explained by the fact that emerging markets, although they have an increased risk of non-return of funds, compensate for this with higher returns in a shorter time frame (in case of successful implementation of the investment project).

As of 2001, FDI in China amounted to $493 billion. In 2009, total FDI from China exceeded $180 billion.

At the end of 2010, Russia received $41.2 billion, China — $105.7 billion, and Brazil — $48.5 billion. India received — $23.7 billion. According to UNCTAD for the 2013 year, the largest recipient of direct investment in the world was the United States, followed by China, and in 3rd place - Russia (which at the same time rose to a record high place due to the deal between BP and Rosneft). 

In 2015, Russia ranked 19th in the list of countries in terms of FDI received.

FDI Methodology

There are different methods of foreign direct investment. However, most of the time the following methods can be noticed. 

• Acquisition and Merger - Acquisition is when a company or individual buys a majority stake or ownership of another company and takes control of the management of that company. The acquiring company believes at least 51% of the shares of the acquired company. In this case, large companies target relatively weak companies and buy ownership. On the other hand, when two separate companies voluntarily merge and conduct business as a completely new company, it is called a merger. In general, consolidation is done to increase market share, reduce operating costs, expand new markets, increase revenue, and above all increase company profits.

• Purchasing of voting rights of foreign companies - In this case, multinational companies buy shares or ownership of another foreign company and establish their control over the management of the company, i.e. acquire voting power.

• Doing business with a foreign company in a joint venture: Starting a business with a foreign company in a joint venture or taking a foreign company for an established business. Such investments can be made not only in business but also in research and development or any other specific work. In almost all cases, however, both parties have specific objectives and share the profits and losses proportionately among themselves.

• Doing business as a subsidiary of a foreign company - In this case, one company acts as a subsidiary of another company but the management control is in the hands of the parent company or parent company.

There are also some more field-specific approaches through which FDI is made at the individual or institutional level.

Incentives for FDI

The government of a country offers various incentives or facilities to attract foreign direct investment in its country. The following are some of the incentives mentioned below :

• Lower corporate tax rates and tax rebate benefits
• Special Economic Zones
• EPZ- Advantages of using Export Processing Zones
• Setting the desired tariff
• Duty warehouse facilities
• Subsidies on investments
• Free land or land purchase subsidy
• Subsidies for infrastructure construction
• Easy water and electricity facilities
• Assistance in research and development

The main purpose of giving all the incentives or additional facilities is to attract more and more foreign direct investment. 

However, in many countries, the government imposes various restrictions to discourage foreign direct investment in some instances. 

In some cases, the government has taken this measure to keep the domestic industry alive.

Importance and Barriers to FDI

Foreign direct investment is very important for the economic development of any country, especially a developing country. 

To accelerate the economic growth of the country, especially to strengthen industrialization, the government of that country tries to attract foreign investment. 

However, there are some barriers to foreign direct investment. The following are the common barriers to FDI.

• Bureaucratic or administrative problems
• Legal complications
• Economic condition
• Business infrastructural problems
• Political instability
• Cultural considerations
• Corruption and crime
• Lack of proprietary rights

By removing these barriers, creating a conducive environment for foreign investors, and building their confidence, foreign direct investment will increase.

The figure for FDI by country

China

For many years, China has been a priority for foreign investment due to the availability of raw materials, technological advancement, and relatively cheap and experienced manpower. Especially in the last decade, there has been a significant increase in foreign investment in China. In 2011, FDI inflows into China amounted to about ৬ 116 billion. In the first half of 2012, China's FDI inflows were about. 59.10 billion, the highest in any single country. In 2019, the amount of FDI in China was about 136 billion dollars. 

The following is a list of notable foreign companies investing in China:

1. Apple Inc.
2. Microsoft Corporation
3. Coca-Cola
4. Walmart
5. Panasonic
6. Samsung Electronics
7. General Motors
8. Toshiba Corporation
9. Hewlett-Packard
10. Volkswagen AG

United States

The United States continues to dominate foreign direct investment due to its free-market economy, strong economic system, and relatively low investment constraints. In 2011, the amount of FDI in the United States was about 226 billion dollars. 

According to the U.S. Bureau of Economic Analysis, FDI inflows to the United States in 2012 and 2013 were 256 billion and 263 billion respectively. 

According to the Global Investment Report, compiled by the United Nations Conference on Trade and Development FDI inflows to the United States in 2016 and 2017 were 26 billion and 252 billion, respectively.

The following is a list of notable foreign companies investing in the United States:

1. BP America
2. Shell Oil
3. Toyota Motor North America
4. Honda North America
5. Nissan Motor (USA)
6. Siemens
7. Nestle USA
8. Sony Corporation of America
9. HSBC Bank USA
10. Samsung Electronics

India

Opportunities for foreign direct investment in India began in 1991, mainly after the Indian economic crisis. 

At that time there was an extreme crisis in India's foreign exchange balance. Added to that is the massive revenue budget crisis. 

Recognizing the need for foreign direct investment to address this crisis, India has opened the door to foreign direct investment by foreign individuals or entities under the Foreign Exchange Management Act. But in 2015, the amount of FDI in India stood at about 63 billion. 

According to the Global Investment Report, 2019, prepared by the United Nations Conference on Trade and Development ( UNCTAD ), FDI inflows into India in 2016 and 2017 were 40 billion and 42 billion, respectively.

The following is a list of notable foreign companies investing in India: -

1. Google
2. Microsoft Corporation
3. Ford Motor Company
4. PepsiCo
5. JP Morgan
6. Siemens
7. BP PLC
8. Oppo Electronics India
9. Foshan International
10. Higher electronics

Bangladesh

Before independence in Bangladesh, ie before 1971, there was very little foreign direct investment. But since independence, various governments have from time to time changed and refined the existing laws and policies to create opportunities for foreign investment.

As well as relatively cheap labor, easy availability of raw materials and economic potential, Bangladesh has been able to attract a significant amount of foreign direct investment.

Investors from many countries like the United Kingdom, the United States, and Japan as well as China, Netherlands, Germany, and Canada are currently investing in Bangladesh. 

The Government of Bangladesh has formulated a favorable industrial policy to attract FDI as well as a wide range of incentives and incentives. 

Although excessive bureaucratic delays, irregularities, and corruption in the processing of documents, lack of necessary perseverance on the part of local entrepreneurs, Unnecessary delays, and frequent changes in import tariff policy are severely hampering real foreign direct investment. 

In 1996 and 2000, FDI inflows to Bangladesh were about 0.23 billion and 0.58 billion, respectively. 

In 2013, the amount of FDI stood at about 1.59 billion. According to the World Investment Report, 2019, prepared by the United Nations Conference on Trade and Development ( UNCTAD ), FDI inflows to Bangladesh in 2016 and 2017 stood at ৫ 2.15 billion and ৬ 3.81 billion, respectively.