Foreign Direct Investment

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Foreign Direct Investment

1.0 Introduction

Foreign Direct Investment (FDI) simply refers to the process whereby a company in one country invests in another country. It involves movement of capital across borders and is characterized by ownership and control (Organisation for Economic Co-Operation and Development, 2002, p. 55). Companies engaging in FDI build production factories in foreign countries but which are under control and supervision of headquarters in one nation, usually, the parent country. This paper discusses the underlying reasons for undertaking FDI and examines its benefits and costs to both the home and host nations. The paper also examines the welfare impacts of FDI on both home and host countries.

2.0 Underlying Reasons for FDI

There are numerous reasons as to why companies undertake FDI. One major reason is to secure access to raw materials in a foreign nation, a process known as vertical FDI (Hess, 2008, p. 73). Vertical FDI enables a company to secure market in a foreign nation, which is a second reason for engaging in FDI. Another reason for engaging in vertical FDI is to avoid entry barriers such as tariffs and quotas which are levied on importers.

Horizontal FDI is the other form of FDI and it occurs when a company invests in the same industry in another nation (Hess, 2008, p. 73). One of the reasons why companies engage in horizontal FDI is to cut down various costs such as transportation costs, tariffs as well as costs related to risk of losing knowhow. Another major reason for engaging in horizontal FDI is to avoid trade barriers placed by host country.

Apart from the above reasons, companies engage in FDI to avoid harsh or unfavorable regulations in the home country and to enjoy incentives which may be present for industries in the host nation (Hess, 2008, p. 9). Also, companies engage in FDI to cope with situation where the production of a product switches from the exporting to importing country. Risk diversification, where a company mixes a wide variety of investments in different countries is another common reason for FDI. Finally, as John Dunning explained in the eclectic paradigm theory, companies often engage in FDI to exploit a mix Ownership, location and Internationalisation advantages in the host country.

3.0 Benefits, costs and disadvantages of FDI to host and home countries

3.1 The benefits to host countries:

Benefits to host country

Increased aggregate output

Increased employment

Increased revenue from taxation

Realization of economies of scale,

Increased exports leading to improvement of Balance of Payments, especially when FDI is in exports sector

Importation of new technology and also technical and managerial skills

Increased competition, thereby encouraging free market competition

3.2 Costs to host countries:

Loss of jobs in the domestic market

Loss of tax revenues

3.3 Disadvantages to host countries

Sometimes, FDI undermines technological superiority of home countries

Companies may avoid adhering to domestic monetary policies as they access international capital market

3.4 Benefits to home countries

Will enjoy returns on investment

Improvement Gross National Product

3.5 Costs to home countries

Loss of domestic jobs

Loss of tax revenue

3.6 Disadvantages to home countries

Undermining the technological superiority of home countries,

Circumvent domestic monetary policies by their access to international capital market (Hess, 2008, p. 7)

4.0 The welfare impacts of capital movement for both investing and host countries

One remarkable impact of FDI is that it helps to increase income of the host country (Faeth, 2010, p. 201). As expressed in Vernon’s Product cycle hypothesis, when a company invests in a foreign nation and locates its production process in that country, the host country turns switches from importing to exporting. This helps to boost the economic welfare of the host nation. However, (Faeth, 2010, p. 201) noted that when FDI is import substituting, productive efficiency in the host country may not be achieved. In such a case, the economic welfare of the host country is likely to deteriorate.

The impact of FDI on the investor country depends on various factors including the extent of utilization of investing firm’s resources, the climate of industrial relations in the host nation, the existence of relaxed or restrictive practices and the quality of manpower (Faeth, 2010, p. 201). If all these conditions are favorable, the investor will achieve productivity efficiency and higher returns and hence, enjoy welfare gains. If both the host and the investor countries achieve economic growth, the result will be an increase in overall world output. The following diagram describes the interaction between capital stocks of an investing and host countries and the value that this has on productivity and welfare:

Welfare impact of FDI

5.0 Summary

In summary, FDI is a process whereby a company invests in a foreign nation. There are numerous reasons as to why companies undertake FDI including to gain access to raw materials, access to markets, to avoid entry barriers to host nation, to cut costs, to avoid regulations in the home country, to take advantage of various incentives in the host nation, to avoid risk diversification and to avoid trade barriers. As noted in the paper, there are numerous benefits, costs and disadvantages that are experienced by both the host and home countries during FDI. Under favorable conditions, FDI can help to improve income of both host and investor countries and the result will be an improvement in overall economic welfare.

References

Hess, M. L. (2008), Doorways to Development: Foreign Direct Investment Policies in

Developing Countries, ProQuest, Washington DC

Faeth, I., (2010), Foreign Direct Investment in Australia: Determinants and Consequences, UoM

Custom Book Centre, Sydney

Organisation for Economic Co-Operation and Development (2002), Foreign Direct Investment

and the Environment: Lessons from the Mining Sector, OECD Publishing, New York