FOREIGN DIRECT INVESTMENT

1. FOREIGN DIRECT INVESTMENT
THEORIES OF FOREIGN DIRECT INVESTMENT
PREPARED BY :
DEENU V R
M COM
SNGCAS CHEMPAZHANTHY

2. INTRODUCTION
Foreign investment involves capital flows from
one country to another, granting the foreign investors extensive
ownership stakes in domestic companies and assets. Foreign
investment denotes that foreigners have an active role in
management as a part of their investment or an equity stake
large enough to enable the foreign investor to influence business
strategy. A modern trend leans toward globalization, where
multinational firms have investments in a variety of countries.
Foreign investment can be in the form of Commercial loan,
Official foreign aid, Foreign Portfolio Investment or as Foreign
Direct Investment.

3. FOREIGN DIRECT INVESTMENT (FDI)
A foreign direct investment (FDI) is an investment made by a
firm or individual in one country into business interests located in another
country. It can be in the form of either establishing business operations or
acquiring business assets in other country, such as ownership or controlling
interest in a foreign company Generally, FDI takes place when an investor
establishes foreign business operations or acquires foreign business assets in
a foreign company. However, FDIs are distinguished from portfolio
investments in which an investor merely purchases equities of foreign-based
companies.

4. DEFINITION OF FDI
◦ ADRIAN BUCKLEY has explained that,
“Foreign Direct Investment is a term that is used to denote the
acquisition abroad of physical assets, such as plant, equipment, with
operational control ultimately residing with the parent company in
the home country.”
◦ RUGMAN and HODGETS define FDI as
“equity instrument invested in other nations”. They further
explain that FDI is the ownership and control of foreign assets.

5. ADVANTAGES OF FDI
1. Increased Employment and Economic Growth
2. Human Resource Development
3. Provision of Finance & Technology
4. Development of Backward Areas
5. Increase in Exports
6. Exchange Rate Stability
7. Stimulation of Economic Development
8. Improved Capital Flow
9. Creation of a Competitive Market

6. TYPES OF FDI
Foreign Direct Investment are commonly categorized as:
1 . Horizontal Investment :
• A horizontal direct investment refers to the investor establishing the
same type of business operation in a foreign country as it operates in
its home country, for example, a cell phone provider based in the
United States opening stores in China.
2 .Vertical Investment :
• A vertical investment is one in which different but related business
activities from the investor's main business are established or acquired
in a foreign country, such as when a manufacturing company acquires
an interest in a foreign company that supplies parts or raw materials
required for the manufacturing company to make its products.

7. • 3 .Conglomerate Investment :
• A conglomerate type of foreign direct investment is one where a
company or individual makes a foreign investment in a business that
is unrelated to its existing business in its home country. Since this
type of investment involves entering an industry in which the
investor has no previous experience, it often takes the form of a joint
venture with a foreign company already operating in the industry.

8. THEORIES OF FDI
Foreign Direct Investment (FDI) acquired an important role in the
international economy after the Second World War. Theoretical studies on
FDI have led to a better understanding of the economic mechanism and the
behavior of economic agents, both at micro and macro level allowing the
opening of new areas of study in economic theory.
Although several researchers have tried to explain the phenomenon of FDI,
we cannot say there is a generally accepted theory, every new evidence
adding some new elements and criticism to the previous ones.

9. THEORIES OF FDI
They grouped the theories into three categories.
1). Traditional theories
2). Modern theories and
3). Radical theories

10.  TRADITIONAL THEORY
Traditional theories are based on neo-classical economic and explain
FDI in terms of location-specific advantages.
Neoclassical economics is a broad theory that focuses on supply and
demand as the driving forces behind the production, pricing, and
consumption of goods and services. It emerged in around 1900 to
compete with the earlier theories of classical economic

11. Traditional Theory includes:
 Capital arbitrage theory
The theory states that. Direct investment flows from countries where
profitability is low to countries where profitability is high. It means therefore that
capital is mobile both nationally and internationally. But sometimes implication is
that countries with abundant capital should export and countries with less capital
should import. If there was a link between the long-term interest rate and return
on capital, portfolio investment and FDI should be moving in the same direction.
International trade theory-the country will specialize in production of,
and export those commodities which make intensive use of the country’s
relatively abundant factor.

12.  MODERN THEORY

13. Market imperfections theory is a trade theory that arises from
international markets where perfect competition doesn't exist. In other
words, at least one of the assumptions for perfect competition is
violated and out of this is comes what we call an imperfect market. We
know that a perfect market isn't really attainable. Even in the United
States, we have imperfect markets. Remember, the assumptions for a
perfect market are:
1. Buyers and sellers are both price takers
2. Companies sell virtually identical products
3. Buyers and sellers have perfect information
4. Multiple companies owns a small market share
5. There is no barrier of entry or exit

14. MNC’s often make good use of market imperfection, many of which
have been created by host country governments.
for example:
High customs duty,
Protected market ….. etc.
It was felt that this theory sufficiently explained the fast
that why European firms invested in USA, primarily because European
firms possessed the technological advantage. However, this theory has
been criticized on the ground that it leaves many other motives for FDI
unexplained

15. Product Life Cycle Theory
The Product Life Cycle Stages or International Product Life Cycle, which was
developed by the economist Raymond Vernon in 1966, is still a widely used model
in economics and marketing. Products enter the market and gradually disappear
again. According to Raymond Vernon, each product has a certain life cycle that
begins with its development and ends with its decline.
According to Raymond Vernon there are four stages in a product’s life cycle:
introduction, growth, maturity and decline. The length of a stage varies for different
products, one stage may last some weeks while others even last decades. The life
span of a product and how fast it goes through the entire cycle depends on for
instance market demand and how marketing instruments are used.

17. •The introduction stage
When an organization has developed a product
successfully, it will be introduced into the national (and international)
outlet. In order to create demand, investments are made with respect to
consumer awareness and promotion of the new product in order to get
sales going. At this stage, profits are low and there are only few
competitors. When more items of the product are sold, it will enter the
next stage automatically.

18. •The growth stage
In this stage the demand for the product increases sales. As a result,
the production costs decrease and high profits are generated. The product becomes
widely known, and competitors will enter the market with their own version of the
product. Usually, they offer the product at a much lower sales price. To attract as
many consumers as possible, the company that developed the original product will
still increase its promotional spending. At this stage, home country is trying to sell
its innovative products both in domestic and international circuit. It result in
absolute monopoly of the home country over the trading of such innovative
products in the foreign market. When many potential new customers have bought
the product, it will enter the next stage.

19. • The maturity stage
In the maturity stage, the product is widely known and is bought
by many consumers. This stage is otherwise known as stage of
standardization of product. Growing demand for the products force
the business firms to increase production volume. Some of the
business units may issue license or franchise to foreign manufacturers
for producing the product to meet their market demand. In some other
cases, parent country of the innovative product may invest funds to set
up manufacturing units in foreign countries to produce goods and sell
in that country directly eliminating the trade route system. It leads to
decrease the exports of products of the parent country.

20. • The decline stage
When foreign companies started manufacturing these innovative products
by using the local resources, it increases theirs self reliance and decreases the
requirement of exporting the same from the parent company. These companies are
also extending their business in the developing countries through export of these
innovative products. Ultimately, it discourages the growth prospective and
decreases the volume of export of the innovative country from the top level to
bottom.

21. Internationalisation Approach Theory
Internalization theory was developed by Buckley and Casson
in 1976. Initially the theory was launched by Coase in 1937. The theory
was used by John Harry Dunning as one of the components of his
eclectic paradigm or OLI model. Alan M. Rugman linked
internalization theory to his earlier work on market imperfections,
applying it empirically in a North American context. Jean-Francois
Hennart subsequently developed a variant of the theory in 1982 that
emphasized the interplay of headquarters authority and local autonomy
within the firm. Internalization theory is also closely related to Stephen
Magee’s appropriability theory.

22. Internalization theory focuses on imperfections in intermediate
product markets. Two main kinds of intermediate product are distinguished:
knowledge flows linking research and development to production, and flows
of components and raw materials from an upstream production facility to a
downstream one. Theory of internationalization is based on the assumption
that transactions are made within the organization if transaction cost
exceeds internal cost in the free market.
Internalization occurs only when firms perceive the benefits to
exceed the costs. When internalization leads to foreign investment the
firm may incur political and commercial risks due to unfamiliarity with
the foreign environment. These are known as ‘costs of doing business
abroad’, arising from the ‘liability of foreignness’. When such costs are
high a firm may license or outsource production to an independent
firm; or it may produce at home and export to the country instead.

23.  The Eclectic Paradigm of Dunning
An eclectic paradigm, also known as the ownership, location,
internalization (OLI) model or OLI framework, is a three-tiered
evaluation framework that companies can follow when attempting to
determine if it is beneficial to pursue foreign direct investment (FDI).
This paradigm assumes that institutions will avoid transactions in the
open market if the cost of completing the same actions internally, or
in-house, carries a lower price. It is based on internalization theory and
was first expounded upon in 1979 by the scholar John H. Dunning

24. •Ownership Advantages :
First of all, a company needs an ownership advantage in order to
overcome the liability of foreignness. Ownership refers to the
possession of a certain valuable, rare, hard-to-imitate, and
organizationally embedded resource that allows a company to have a
competitive advantage compared to foreign rivals. Ownership
advantages refers to the market position of a business firm in domestic
and foreign market. A company can use its local resources effectively to
have a better market proportion in the global market.

25. •Locational Advantages :
Secondly, there must be some kind of location advantage in the
market the company is trying to enter. Again, given the well-known liability
of foreignness, host countries must offer compelling advantages to make it
worthwhile to undertake FDI. These advantages can be simply geographical
(e.g. the Netherlands is in between great economies like the UK and
Germany and is moreover located next to the ocean) or are present because
of the existence of cheap raw materials, low wages, a skilled labor force or
special taxes and tariffs. A great tool to determine these location advantages
is through Porter’s Diamond model.

26. •Internationalization Advantages :
Finally, internalization advantages, signal when it is better
for an organization to produce a particular product in-house, versus
contracting with a third-party. At times, it may be more cost-effective
for an organization to operate from a different market location while
they keep doing the work in-house. If the business decides to
outsource the production, it may require negotiating partnerships with
local producers. However, taking an outsourcing route only makes
financial sense if the contracting company can meet the organization’s
needs and quality standards at a lower cost.

27. CONCLUSION
For a multinational corporation, FDI in India is a means to access new
consumption and production markets, and thereby expand its influence and
business operations. It can gain access not only to limited resources such as fossil
fuels and precious metals, but also skilled and unskilled labour, management
expertise and technologies. FDI also enables an organization to lower its cost of
production- by accessing cheaper resources, or going directly to the source of raw
materials rather than buying them from third parties. Often, there are various tax
advantages that accrue to a company undertaking FDI. This can occur when the
home country allows tax deduction on foreign income, or when the recipient
country allows tax deductions and benefits for organizations incurring FDI in that
country. Additionally, this can happen when the recipient country has a more
beneficial tax code than the home country.