Foreign Direct investment

By | May 5, 2020

Foreign Direct Investment (FDI) is the investment by the nation in another nation in manufacturing or business either by purchasing a corporation or extending its business abroad. Usually, it is through securities and shares.

According to the Financial Times, “Standard definitions of control use the internationally agreed 10% threshold of voting shares, but this is a grey area as often a smaller block of shares will give control in widely held companies. Moreover, control of technology, management even crucial inputs can confer de facto control.’

According to the WTO, “FDI occurs when an investor based in one country acquires an asset in another country with the intent to manage that asset. Initially, control was a main criterion for the foreign inward investment, but what constituted control was not made specific. Thus, this moderation was done. The current definition of FDI as endorsed by the IMF (1993) and OECD (1996) have shifted their emphasis from control to lasting interest by direct investor in a company resident in a country other than the country of the investor. The lasting interest refers to the long-term relationship between the direct investment company and the investor who has a significant amount of influence on the management of the enterprise.

FDI pertains to foreign capital inflows that investing money in the economy’s production capability and are generally preferred over other forms of external financial services since they are generating non-debt, non-volatile and their gains rely on the overall performance of investor funded projects.

The RBI has projected the following characteristics of FDI:

  • The undistributed profits which are invested in the affiliates in the host country are not counted as actual FDI inflows.
  • The overseas commercial borrowings like bonds, grants, trade credits, financial leasing are also excluded from FDI inflows.
  • According to IMF guidelines, if a non-resident initially buy 10% or more equity through a portfolio route but buys additional shares in subsequent transactions and now holds investment over 10% these additional shares will be regarded as a part of FDI. However, many FIIs holding well over 20% equity in the shape of American Depository Receipts and Global Depository Receipts also do not form part of FDI.

Types of Foreign Investment:

Foreign investment occurs in three forms, i.e. Foreign Direct Investment (FDI), Foreign Portfolio Investment (FPI) and Foreign Institutional Investment (FII).

  • Foreign Direct Investment (FDI) takes place when a company invests directly in facilities in a foreign nation to produce or market a product. A company becomes a multinational company once it undertakes FDI.
  • Foreign Portfolio Investment (FPI) is an investment made by foreign nations/ business entities and non-residents in Indian securities including company shares, treasury bonds, corporate debt, convertible financial investments, infrastructure securities etc. The purpose is to ensure controlled interest in India at an investment, i.e lower than FDI, with the flexibility of entrances and exits.
  • Foreign Institutional Investment (FII) is an investment in securities, real estate and other investment assets by foreign entities, investors are mutual fund firms, hedge fund firms etc. The motive isn’t to control interest, but to expand the hedging investment portfolio and can earn high yields with rapid entry and exit. The difference between FPI and FDI is significant to categorise the capital inflows in the country.

Need for FDI:

FDI surpasses the drawbacks of exporting and licensing. Exporting involves the production of goods and services at home while licensing grants rights to other foreign entities. There are high transportation costs and trade barriers in exporting. Licensing may lead to giving away valuable technological know-how to potential foreign competition. Licensing also doesn’t give proper control over the management, marketing and manufacturing strategy of the licensee. This is known as internalisation theory which explains the reason to undertake FDI instead of licensing. Also, when the core competency of a firm lies in its manufacturing capabilities, marketing and management capabilities, then licensing is not effective. Thus, when the transportation costs are high and there are numerous trade barriers, then a firm will favour FDI in comparison to exporting. Similarly, when the capability of the firm is not docile to licensing, then FDI is preferred.

Types of FDI:

1. On the basis of Modes of Entry:

Greenfield Investment: It comprises of establishing an entirely new company in the host country. It is advantageous because it transfers technical know-how, managerial skills, products and methods. However, it comprises of huge capital outlay and difficult procedures of setting up the business.

Brownfield Investment: It comprises acquiring an already existing entry in the host country. They are quick to implement hence they are beneficial for companies as there are reduced costs. They are used to gain an edge over international and national competitors.

2. On the basis of Types of Activity:

Horizontal FDI: It comprises of investment in companies in a foreign country that have the same kind of operations, activity, customers, that are being performed by the company in the home country

Vertical FDI: When foreign companies undertake activities that are not similar but related to the key activities performed by the home country company, it is termed as vertical FDI. It can assume the shape of a backward FDI or forward FDI. These are

  • Backward FDI: When the assets are acquired to provide inputs for the production of the firm located either in the home country or any other location. Thus, the firm assumes the role of a supplier to the main company.
  • Forward FDI: It occurs when the company invests or acquires another company to provide a marketing network, mixing up operations, assembly and other products that are produced in the home country can be sold to other firms globally. Thus, here the firm assumes the role of a buyer for the main company.
  • Conglomerate FDI: When the company invests and acquires in firms that perform no similar production activities, then it is called conglomerate FDI. The activities of the two firms are not related to each other.