#3 Foreign Direct Investment

-Determinants, Impacts and Policies-

Foreign direct investment

(FDI) is an investment made by a company or individual in one country in business interests in another
country, in the form of either establishing business operations or acquiring business assets in the other
country, such as ownership or controlling interest in a foreign company.

 on the other hand, direct investment are real investments in factories, capital goods, land, and
inventories where both capital and management are involved and the investor retains control
over use of the invested capital.
 Foreign direct investment refers to long term participation by country A into country B. It usually
involves participation in management, joint-venture, transfer of technology and expertise.
 In the international context, direct investments are usually undertaken by multinational
corporations engaged in manufacturing, resource extraction, or service.
 A foreign direct investor may be classified in any sector of the economy and could be any one of
the following:
an individual; • a group of related individuals; • an incorporated or unincorporated entity; • a
public company or private company; • a group of related enterprises; • a government body

Foreign Direct Investment (FDI) stock:

Foreign Direct Investment (FDI) stocks measure the total level of direct investment at a given point in
time, usually the end of a quarter or of a year.

Foreign Direct Investment (FDI) flow

Foreign Direct Investment (FDI) flows record the value of cross-border transactions related to direct
investment during a given period of time, usually a quarter or a year.

Types of Foreign Direct Investment

A) Horizontal FDI: With a horizontal direct investment, a company establishes the same type of
business operation in a foreign country as it operates in its home country.

McDonald's opening restaurants in Japan would be considered horizontal FDI

Horizontal FDI refers to market seeking investments, in which the MNE duplicates the production and
produces similar products or services in multiple locations.

A simple example:

Imagine a truck producer in a developed country H (“Home”) who plans to develop, manufacture and
sell a new model. This may involve years of research and development (R&D) with significant fixed costs
incurred. In order to ensure that the new model will be a profitable investment, the firm needs to
ensure a sufficiently large volume of sales. One way for the firm to increase its sales, is to expand
activities beyond the domestic market, and begin to export to a foreign country, which we refer to as
country F. This is shown in Figure සංවර්ධිත රටක H ("නිවස") ට්රක් රථ නිෂ්පාදකයෙකු නව මාදිලිෙක්

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සංවර්ධනෙ කිරීමට, නිෂ්පාදනෙ කිරීමට සහ විකිණීමට සැලසුම් කරන බව සිතන්න. සැලකිෙ යුතු ස්ථාවර පිරිවැෙක්
දැරීමට සිදුවන වසර ගණනාවක පයෙධ්ෂණ සහ සංවර්ධන (R&D) යමෙට ඇතුළත් විෙ හැකිෙ. නව මාදිලිෙ ලාභදායී
ආයෙෝජනෙක් බවට සහතික කිරීම සඳහා, සමාගමට ප්රමාණවත් තරම් විශාල විකුණුම් පරිමාවක් සහතික කළ
යුතුෙ. සමාගමට තම විකුණුම් වැඩි කර ගැනීමට එක් ක්රමෙක් නම්, යේශීෙ යවයළඳයපායළන් ඔබ්බට
ක්රිොකාරකම් පුළුල් කිරීම සහ වියේශ රටකට අපනෙනෙ කිරීම ආරම්භ කිරීමයි, එෙ අප රට F යලස හඳුන්වනු
ලැයබ්. යමෙ රූපයේ දැක්යේ.

Suppose now that there are significant trade barriers to the export market in country F (marked out as
tFH in Figure 2), for instance, emerging through tariffs on imported trucks or transport costs. If the firm
invests into an additional plant in country F and produces the model for the local market in a foreign
affiliate, it can increase its sales further by avoiding trade costs. This is shown in Figure 2 where the
investment refers to the same activity, production of trucks, taking place at home and abroad.
උදාහරණෙක් යලස, ආනෙනෙ කරන ලද ට්රක් රථ යහෝ ප්රවාහන විෙදම් මත තීරුබදු මගින් පැන නගින F (රූප
සටහන 2 හි tFH යලස සලකුණු කර ඇත) රයට් අපනෙන යවළඳයපාළට සැලකිෙ යුතු යවළඳ බාර්ක දැන් ඇතැයි
සිතමු. සමාගම F රයටහි අතියධක කම්හලකට ආයෙෝජනෙ කර වියේශීෙ අනුබේිත යේශීෙ යවයළඳයපාළ සඳහා
ආකෘතිෙ නිෂ්පාදනෙ කරන්යන් නම්, යවළඳ පිරිවැෙ මඟහරවා ගැනීයමන් එහි විකුණුම් තවදුරටත් වැඩි කර ගත
හැකිෙ. යමෙ රූප සටහන 2 හි යපන්වා ඇති අතර එහිදී ආයෙෝජනෙ එකම ක්රිොකාරකම්, ට්රක් රථ නිෂ්පාදනෙ,
යේශීෙ හා වියේශීෙ වශයෙන් සිදු යේ.

Platform FDI: export-driven FDI

Platform FDI can be seen as a more intricate(සංකීණධ) form of horizontal FDI.

Platform FDI refers to market-access driven investments, where the MNE locates production in a foreign
country positioned in proximity to the export market, as a platform, in order to facilitate affiliate exports
to that market.

Therefore, platform FDI generates exports from foreign affiliates (අනුබේර්)

B) Vertical FDI: In a vertical investment, a business acquires a complementary business in another

country.
For example, a U.S. manufacturer might acquire an interest in a foreign company that supplies it
with the raw materials it needs.

C) Conglomerate FDI: In a conglomerate type of foreign direct investment, a company invests in a

foreign business that is unrelated to its core business. Since the investing company has no prior
experience in the foreign company's area of expertise, this often takes the form of a joint
venture. සමූහ ආකාරයේ වියේශ සෘජු ආයෙෝජනෙක් තුළ, සමාගමක් සිෙ මූලික ේොපාරෙට සම්බන්ර්
යනාවන වියේශ ේොපාරෙක ආයෙෝජනෙ කරයි. ආයෙෝජන සමාගමට වියේශීෙ සමාගයම් ප්රවීණතා
ක්යෂ්ත්රයේ පූවධ අත්දැකීමක් යනාමැති බැවින්, යමෙ යබායහෝ විට හවුල් ේොපාරෙක ස්වරූපෙ ගනී.

Eclectic theory
Under this theory of John Dunning there are four types of FDI derived, they are

A) Resource seeking FDI

To seek and secure natural resources e.g. minerals, raw materials, or lower labor costs for
the investing company.

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 For example, a German company opening a plant in Slovakia to produce and re-export to
Germany

B) Market seeking FDI:

To identify and exploit new markets for the firms` finished products.

Unique possibility for some type of services for which production and distribution have to be
contemporaneous (telecom, water supply, energy supply)

C) Efficiency seeking FDI: To restructure its existing investments so as to achieve an efficient

allocation of international economic activity of the firms. සමාගම්වල ජාත්ෙන්තර ආථධික
ක්රිොකාරකම් කාෙධක්ෂමව යවන් කිරීම සාක්ෂාත් කර ගැනීම සඳහා එහි පවතින ආයෙෝජන
ප්රතිේයුහගත කිරීම.

D) Strategic asset/capabilities seeking FDI

MNCs pursue strategic operations through the purchase of existing firms and/or assets in
order to protect specific advantages in order to sustain or advance its global competitive position. MNCs
සිෙ යගෝලීෙ තරඟකාරී තත්ත්වෙ පවත්වා ගැනීම යහෝ ඉදිරිෙට යගන ොම සඳහා නිශ්ිත වාසි ආරක්ෂා කර ගැනීම
සඳහා පවතින සමාගම් සහ/යහෝ වත්කම් මිලදී ගැනීම හරහා උපාෙ මාගධික යමයහයුම් සිදු කරයි.

 Acquisition of key established local firms

 Acquisition of local capabilities including R&D, knowledge and human capital
 Acquisition of market knowledge
 Pre-empting market entrance by competitors
 Pre-empting the acquisition by local firms by competitors

Vertical: when different stages of activities are added abroad.

Forward vertical FDI is where the FDI takes the firm nearer to the market (for example, Toyota acquiring
a car distributorship in America)

Example; Forward Integration Strategy Poultry Farming

Forward integration increases your control over the distribution of your poultry products. • Process your
chicken to add value and price the poultry products competitively. You also could create direct links with
retailers to streamline your supply chain. • Forward integration in the poultry industry can do away with
the costs associated with multiple middlemen in the distribution end of your value chain. ඉදිරි
අනුකලනෙ ඔයබ් කුකුළු නිෂ්පාදන යබදා හැරීම මත ඔයබ් පාලනෙ වැඩි කරයි. • කුකුළු නිෂ්පාදනවල අගෙ එකතු
කිරීමට සහ තරඟකාරී යලස මිල කිරීමට ඔයබ් කුකුළු මස් සැකසීම. ඔයබ් සැපයුම් දාමෙ විිමත් කිරීම සඳහා ඔබට
සිල්ලර යවයළන්දන් සමඟ සෘජු සම්බන්ර්තා ඇති කර ගත හැකිෙ. • කුකුළු කමධාන්තයේ ඉදිරි අනුකලනෙ මඟින්
ඔයබ් වටිනාකම් දාමයේ යබදා හැරීයම් අන්තයේ බහුවිර් අතරමැදිෙන් සමඟ සම්බන්ර් පිරිවැෙ ඉවත් කළ හැකිෙ.

Backward Vertical FDI is where international integration moves back towards raw materials (for
example, Toyota acquiring a tyre manufacturer or a rubber plantation).

Example

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The company requires milk to make ice cream and either can buy milk from a dairy farm or other milk
supplier or could own the dairy farm itself. This ensures that it will have a steady supply of milk at its
disposal and that it will pay a reasonable price. This can protect the ice cream maker in the event that
there are several other buyers competing for the same milk supply. සමාගමට අයිස්ක්රීම් සෑදීම සඳහා කිරි
අවශ්ෙ වන අතර එක්යකෝ කිරි යගාවිපලකින් යහෝ යවනත් කිරි සැපයුම්කරුයවකුයගන් කිරි මිලදී ගත හැකිෙ,
නැතයහාත් කිරි යගාවිපලම අයිති කර ගත හැකිෙ. යමමගින් එෙ සතුව ස්ථාවර කිරි සැපයුමක් ඇති බවත් සාර්ාරණ
මිලක් යගවන බවත් සහතික කරයි. යමම කිරි සැපයුම සඳහා තවත් ගැනුම්කරුවන් කිහිප යදයනකු තරඟ කරන
අවස්ථාවක අයිස්ක්රීම් නිෂ්පාදකො ආරක්ෂා කළ හැකිෙ.

Benefits of Forward Integration

 that manufacturers can reduce steps in the distribution process and sell higher up in the distribution
process
 Manufacturers can also retain more control over the distribution and pricing of their products by
selling to retailers or customers.
 This can benefit both the manufacturing firm and the retailer or customer it sells to because one
step--and one mark-up--has been passed over.

Pulling and Pushing Factors of FDI -The gravity Concept-

The gravity concept can generally be dealt with pulling and pushing factors that influence on
international capital flows.

Traditionally, the determinants of FDI include the followings

1. Size of the Market

Large developing countries provide substantial markets where the consumers demand for certain goods
far exceed the available supplies

[Link] stability

In many countries, the institutions of government are still evolving and there are unsettled political
questions.

3. Macro-economic Environment

• Instability in the level of prices and exchange rate enhance the level of uncertaint y, making business
planning difficult.

• This increases the perceived risk of making investments and therefore adversely affects the inflow of
FDI

4. Legal and Regulatory Framework

The transition to a market economy entails the establishment of a legal and regulatory framework that
is compatible ගැළයපන with private sector activities and the operation of foreign owned companies.

5. Access to Basic Inputs

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Many developing countries have large reserves of skilled and semi-skilled workers that available for
employment at wages significantly lower than in developed countries.

6. Distance between home and host countries.

The distance between home and host country determines, by means of transport costs, moving FDI one
country to another.

[Link]

Better infrastructure development such as telecommunication, water supply, electricity, road network,
sanitary facilities …etc will attract foreign investors to establish their investment.

[Link] rate in Host country

A signification growth rate that people enjoy in host country will also have high per capita income. This
will motivate people to by products produced by MNCs. Therefore, investor get enough consumers at
the market

Advantages of FDI to the host Economy

A) Raising the Level of Investment/Filling the gap:

Foreign investment can fill the gap between required investment and locally mobilized savings.

B) Gross fixed capital formation

Another way of looking at the importance of FDI is to express FDI inflows as a percentage of gross fixed
products.

C) Upgradation of Technology
Foreign investment brings with it technological knowledge while transferring machinery and equipment
to developing countries.

D) Knowledge spillover
FDI is more than just capital, as it offers access to internationally available technologies and
management know-how

E) Improvement in Export Competitiveness

• FDI can help the host country to improve its export performance.

• By raising the level of efficiency and the standards of product quality, FDI makes a positive impact on
the host country’s export competitiveness.

F) Employment Generation
• Foreign investment can create employment in the modern sectors of developing countries.

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• Recipients of FDI training of employees in the course of operating new enterprises, which contributes
to human capital formation in the host country

G) Revenue to Government
• Profits generated by FDI contribute to corporate tax revenues in the host country

Disadvantages of Foreign Direct Investment

1. Impact on profit of domestic industries

When foreign investment is competitive with home investment, profits in domestic industries fall,
leading to fall in domestic savings.

2. Inappropriate consumption pattern

Foreign firms stimulate inappropriate consumption patterns through excessive advertising and
monopolistic market power

3. Private profit exceeds social benefit.

• Foreign firms able to extract sizeable economic and political concessions from competing governments
of developing countries.

• Consequently, private profits of these companies may exceed social benefits

4. Modern Colonization:
Development countries fear that foreign direct investment may result in a form of modern day
economic colonialism, exposing host countries and leaving them and their resources vulnerable to the
exploitations of the foreign company.

5. Pollution/ Environmental damage

• Foreign companied possibly damage the environment in host country by releasing harmful wastages
into air, land and water bodies.

6. Political interference දේශපාලන ඇඟිලි ගැසීම්

• Foreign firms may influence political decisions in developing countries.

• In view of their large size and power, national sovereignty and control over economic policies may be
jeopardized.

Positive impacts of FDI on home country

 Improve both economic and political power of home country:

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• FDI is not only beneficial to recipient countries but also brings home countries economic benefits
which depend on the effectiveness in operation of firms that they have influence on management.
Moreover, firms in host country have to depend on home country so home countries can have political
power over host countries.

 Enter new market, extend the product life cycle:

Global companies also have access to new markets in new parts of the world.

 FDI positively affects home-country export performance

through direct effects on trade as well as indirect effects through various channels:

• The direct effects depend to a large extent on the type of FDI. Vertical FDI could enhance the home
country’s exports of intermediate products (parts and components) required for assembling.

 Employment creation: Positive employment effects when the foreign subsidiary creates
demand for home-country exports:
As with the balance of payments, positive employment effects arise when the foreign subsidiary creates
demand for home-country exports of capital equipment, intermediate goods, complementary products,
and the like.

 Improve in the balance of payments:

As a result of the inward flow of foreign earnings the current account of the home country’s balance of
payment will improve. if MNE requires its home country to exports capital equipment, intermediate
goods, complementary products, etc. the balance of payment will further improve.

Negative effect on Home Economy

 Brain Drain from home country
Brain drain means that the country is losing human capital. Since human capital is an important growth
factor, brain drain can adversely affect economic growth.

Brain drain is the emigration of skilled and professional workers from a country. These people emigrate
legally, become residents or even citizens of a new country, and stay there with no intention of
returning to the home country.

 Technology Leakage:
In addition to brain drain, technology leakages can also be counted as one the costs of FDI for home
country.

Therefore, getting them leaked unintentionally(යනාදැනුවත්වම) will be costly and threatening to the
reputation and position of the home country.

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 . Capital outflow:
Since host countries enjoy capital inflow because of FDI, home countries naturally suffer from some
capital outflow.

• As a result the production in home country decreases and it sometimes result in shutting down all its
operations and completely concentrate on the host country. This badly affects the home country’s
capital funds and foundation.

 . Effect in Balance of Payment:

The most important concerns center around the balance-of-payments of outward FDI. • Capital account
of the balance of payments suffers from the initial capital outflow required to finance the FDI. • This has
to be off-set by high return from FDI

Policy challenges to make FDI work for development

 Determine whether and how FDI fits in with development objectives;

FDI is not a solution to all development problems. However, in order to find solutions to development
issues, it is important to realise that FDI is different from local investment, external aid flows, or
portfolio inflows

The existence of such differences requires that a country examines how FDI fits in with development
objectives.

 Think in terms of quality, not quantity

The facts like contribution to human capital development, linkages with the local economy are the
matter of concern.

 Prepare well

education or technology policy is required to raise the capacity of the local economy to absorb positive
spillovers and mitigate negative aspects.

A link clearly exists between FDI, trade and domestic policies

 Reduce conflict and corruption

Researches suggest that conflict and corruption deter foreign investment.

While it is more difficult and uncertain to do business in a country with more corruption and conflict,
some investment is likely to take place regardless. In particular, FDI in the extractive industries does not
have a choice but to locate near the available natural resources

 Provide appropriate infrastructure and skills.

Surveys show that a low level of appropriate skills is one of the main barriers to investing in particular
economy.

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 Implement FDI policies consistently and actively

If a country really wants to attract FDI, a change in law needs to be followed by a consistent and active
implementation of a range of FDI policies.

Countries with FDIs

India

• Over the last decades India has witnessed a steady flow of FDI in pharmaceutical, textile, railway ect,
nearly every sector received FDI.

• According to the World Investment Report 2020, India received a record-breaking $51 billion as FDI in
2019 across the sectors.

• By 2015, India had already overtaken both China and USA of FDI flux • It has resulted in infrastructure
improvements, led to job creation, increased exports, and has helped the formal sector to a great
extent.

The FDI occur in india mainly via two routes

1. Automatic route: an Indian company or a non-resident does not need any primary permission from
RBI (Reserve Bank of India) or Government for conducting FDI in India. Ex: Air Transport Services Non-
scheduled air transport services Services under Aviation sector, Airports, Biotechnology, Broadcasting
Services, Construction Development, Construction of Hospitals, Duty-Free Shops, Electronic Systems.

2. Government route: Prior permission and approval is needed compulsorily

FDIs restricted area

• Agricultural and plantation activities (excluding animal husbandry, fisheries, tea plantations,
horticulture, and pisciculture)

• Chit fund investment

• Atomic energy generation • Products manufactured by the tobacco industry such as cigarettes and
cigars • Real estate and housing • Gambling lotteries, betting business

FDIs in Netherlands

• According to UNCTAD's 2021 World Investment Report, FDI flows to the Netherlands was USD -115
billion in 2020.

• Total FDI stocks stood at USD 2.89 trillion in the same year.

What to consider if you invest in the Netherlands The main assets of the country's economy are :

• An overall stable political and macroeconomic environment above the European average, healthy
public finances and a highly developed financial sector;

• Highly developed communication and transport infrastructures

• A qualified, productive and multilingual workforce that makes it suitable for export trade

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• A strategic geographical location, which makes it a gateway to the main European markets

• Exports are diversified and external accounts are in surplus and export-friendly structures and
infrastructure.

What is DDI?
Diaspora Direct Investment (DDI) refers to direct investments from companies connected to diasporas in
productive activities in the home country (This definition does not include migrants that return to their
home society to establish businesses. )

One of the main advantages of DDI is that it is more stable than other types of FDI, particularly during
unfavorable economic conditions, because of the emotional connections of diaspora members to their
country of origin.

Diaspora members can foster those investments in two ways:

(i) those who are top executives of firms abroad and use their managerial experience and technical
know-how to persuade their respective companies to invest in their countries of origin;

(ii) those who are managers or owners of firms whose parent companies are in their countries of
destination work with start-ups in their countries of origin to help them develop and finance
commercially viable projects.

 Brain Gain:

When educated workers leave a country, that country faces a brain “drain” because it is losing skills
relevant for its economy. In general, such countries invested in the education of those emigrants.

This problem is particularly big in Africa. A brain “gain” occurs when talented migrants return to their
home countries and bring knowledge, capital, and access to advanced markets in developed countries.
Moreover, they can give advice to domestic entrepreneurs.

 Technology Transfer:

DDI is expected to bring better business practices and technology to suppliers and distributors
(particularly because diasporas know better the technological needs of the home country).

 Stable Financial Investments:

Diaspora investors are less averse to political risk and economic shocks than other foreign investors.
They are not only driven by altruism but also by other non - pecuniary reasons such as cultural affinities
and market knowledge.

 DDI Attracting FDI:

Diaspora investors and entrepreneurs can play a critical role in attracting non - resident FDI by setting
up joint ventures and promoting export for domestic companies.

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