Foreign direct investment

Foreign direct investment (FDI) is direct investment into production in a country by a company in another country, either by buying a company in the target country or by expanding operations of an existing business in that country.

Foreign direct investment is done for many reasons including to take advantage of cheaper wages, special investment privileges such as tax exemptions offered by the country as an incentive to gain tariff-free access to the markets of the country or the region.

Why do FDI expand to Less developed economies?

Less developed countries have huge untapped natural resources. Moreover, these countries lack the capital investment and the technology to tap into these resources. This provides FDI with a lot of opportunity to exploit these resources and earn high returns on their investments.

In recent years, FDI has been used more as a market entry strategy for investors, rather than an investment strategy. Despite the decline in trade barriers, FDI growth has increased at a higher rate than the level of world trade as businesses attempt to circumvent protectionist measures through direct investments. With globalization, the horizons and limits have been extended and companies now see the world economy as their market.

Additionally for investors, FDI provides the benefits of reduced cost through the realization of scale economies, and coordination advantages, especially for integrated supply chains. The preference for a direct investment approach rather than licensing and franchising can also been viewed in terms of strategic control, where management rights allows for technological know-how and intellectual property to be kept in-house.

Less developed countries usually have less stringent labour and environment laws. This provides MNCs with an opportunity to lower their cost of production by taking advantage of these loopholes.

Labour is usually cheaper and available in abundance in LDCs. The MNCs can considerably lower their cost of production. This gives advantage to the MNCs to compete in the international market.

LDCs understand the importance of FDIs and have special policies to attract them. This might involve tax holidays, provision of cheaper land and government support. All these factors make it an attractive proposition for FDIs to invest in LDCs. examples include, tax holidays, Duty exemptions and drawbacks, Export tax exemptions, Subsidized credits and Credit guarantees.

Some developing countries provide great promises in terms of being emerging markets. Brazil as well as India and China are all markets with huge populations and growing incomes. As incomes rise, the demand for all normal goods and services will increase, and there is thus potential for substantial profits to be made by companies that manage to establish a presence in these markets.

Benefits of FDI

One of the advantages of foreign direct investment is that it helps in the economic development of the particular country where the investment is being made. This is especially applicable for developing economies. During the 1990s, foreign direct investment was one of the major external sources of financing for most countries that were growing economically. It has also been noted that foreign direct investment has helped several countries when they faced economic hardship.

An example of this can be seen in some countries in the East Asian region. It was observed during the 1997 Asian financial crisis that the amount of foreign direct investment made in these countries was held steady while other forms of cash inflows suffered major setbacks. Similar observations have also been made in Latin America in the 1980s and in Mexico in 1994-95.

Resource transfer, in terms of capital and technical knowledge, is also a key motivator that encourages inward FDI.

FDI allows the transfer of technology—particularly in the form of new varieties of capital inputs—that cannot be achieved through financial investments or trade in goods and services. FDI can also promote competition in the domestic input market.

Recipients of FDI often gain employee training in the course of operating the new businesses, which contributes to human capital development in the host country.

Profits generated by FDI contribute to corporate tax revenues in the host country.

Foreign investment gives advantages in terms of export market access arising from economies of scale in marketing of foreign firms or from their ability to gain market access abroad. Besides their contributions through joint ventures, foreign firms can serve as catalysts for other domestic exporters. In an empirical analysis, the probability a domestic plant will export was found to be positively correlated with proximity to multinational firms

Foreign investment can aid in bridging a host country’s foreign exchange gap. Growth requires investment and investment requires saving-whether domestic or foreign. Two gaps may exist in the economy: insufficient saving to support capital accumulation to achieve a given growth target; and insufficient foreign exchange to transform domestic to foreign resources. If investment requires imported inputs, then domestic saving may not guarantee growth if the saving cannot be converted to foreign exchange to acquire imports. Capital inflows help ensure that foreign exchange will be available to purchase imports for investment.

Disadvantages of FDI

• Loss of sovereignty by host nation.
• MNC have their parent companies and shareholders in the country of origin. Repatriation of profits by MNC to the parent country causes a flow of capital out of the developing country. This might also lead to depletion of foreign exchange reserves with the host country.
• There is a chance of rise in inflation.
• The country or industry that attracts foreign investment may become entirely dependant for growth and increase the risk.
• If the domestic companies are not competitive and efficient, they may suffer losses.
• In absence of proper regulatory policies, MNCs might exploit the labour and natural resources.
• Foreign direct investment is an expensive and risky option for companies than licensing and exporting. They face expropriation, political risk and currency inconvertibility.
• Capital intensive technology, by the MNC, rather than labour-intensive technology limits benefits to host country.
• In very poor nations, MNCs may sometimes exert political control in other to suit their vested interests. This might bring about political stability and chaos in the host nation.