Handout - 08

Department of Commerce
Faculty of Management Studies & Commerce
University of Jaffna
Programme : Third Examination in Commerce
Course Title : International Trade
Course Code : Com 3137
Handout Title : Foreign Direct Investment and Foreign Aid
Prepared By : B.Prahalathan, Dept.of. Commerce
Issue Date : 27.05.2008

Learning Objectives:

 define foreign aid and investment

 evaluate foreign direct investment and foreign aid
 identify the factors which stimulate foreign direct investment
 understand the different forms of foreign aid
 study the economic effects of foreign direct investment
 understand the types of foreign direct investment

Introduction
After the Second World War the developing countries are making concerted efforts to
achieve rapid economic growth and thereby alleviate problems of poverty and
employment. The developing countries have been facing the problems of shortage of
capital. To meet this shortage capital flows from the developed countries to the
developing countries in the last two decades have substantially increased.

Foreign Portfolio Investment

Foreign institutions such as banks, insurance companies, companies’ managing

mutual funds and pension funds purchase stocks and bonds of companies of other
countries in the secondary market. They get returns in the form of capital gain and
dividends.

Foreign Direct Investment Strategies

The flow of foreign direct investment could occur through international acquisition or
Green field investment. When a firm undertakes FDI, it becomes a multinational
enterprise. FDI occurs when a company invests in real assets in a foreign country to
produce or to market a product.
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Mergers and Acquisitions

An international acquisition is a cross boarder investment in which a foreign

investor acquires an established local firm and makes the acquired local firm a
subsidiary business within its global portfolio and local company becoming an
affiliate of the foreign company. Cross-border mergers occur when the assets
and operation of firms from different countries are combined to establish a
new legal entity. Mergers are the most common way for multinationals to do
FDI.

Greenfield Investment

This may be defined as direct investment in new facilities or the expansion of

existing facilities. Greenfield investments are the primary target of a host
nation’s promotional efforts because they create new production capacity and
jobs, transfer technology and know-how, and can lead to linkages to the global
marketplace.

The Organization for International Investment cites the benefits of Greenfield

investment (or in sourcing) for regional and national economies to include
increased employment (often at higher wages than domestic firms);
investments in research and development; and additional capital investments.
Criticism of the efficiencies obtained from Greenfield investments includes the
loss of market share for competing domestic firms. Another criticism of
Greenfield investment is that profits are perceived to bypass local economies,
and instead flow back entirely to the multinational's home economy

Foreign Direct Investment Concepts

FDI can be classified as Horizontal foreign direct investment and Vertical foreign
direct investment.

Horizontal Foreign Direct Investment

Horizontal foreign direct investment occurs when a multinational enterprise

(MNE) enters a foreign country to produce the same products produced at
home. It represents a geographical diversification of the MNE’s established
domestic product line.

Right time for Horizontal foreign direct investment could be any of the
following

. When a organization can gain monopolistic characteristic in particular

area or region
. When an organization competes in a growing industry

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. When increased economies of scale provide major competitive
advantages
. When an organization has both the capital and human talent needed to
successfully manage the expanded organization
. When competitors are faltering due to lack of managerial expertise or a
need for particular resources that an organization possesses.

Vertical Foreign Direct Investment

Vertical FDI is company’s investment into an industry abroad, which provides

control of the different stages of making its product from raw materials
through production to its final distribution.

Vertical FDI may be in two types.

1. Backward vertical FDI

2. Forward vertical FDI

Backward vertical FDI

Backward FDI occurs when the MNE enters a foreign country to produce
intermediaries goods that are intended to use as inputs in its home country.

Strategy when to go for backward FDI

o when an organization’s present suppliers are specially

expensive or unreliable or incapable of meeting the firm’s
needs for parts, components, assemblies or raw materials
o when the number of suppliers is small and the number of
competitors is large
o when an organization competes in an industry that is growing
rapidly
o when an organization has both capital and human resources
needed to manage the new business of supplying its own raw
materials

Forward vertical FDI

Forward FDI occurs when the MNE markets its homemade products overseas
or produce final outputs in a host country using its home-supplied intermediate
goods or materials

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Strategy when to go for forward FDI

o when an organization’s present distributors are especially

expensive or unreliable or incapable of meeting the firm’s
distribution needs
o when the availability of quality distributors is so limited
o when an organization has both capital and human resources
needed to manage the new business of distributing its own
products

Reasons for Direct Investment

- Risk reduction – minimizing risk and optimize revenue.

- Market potential – Future returns
- Overcoming trade barriers
- Motive

- Natural resource-Seeking
- Market-Seeking
- Efficiency-Seeking
- Strategic-Asset-Seeking
- Labour –Seeking
- Technology-Seeking
- Support industry-Seeking
- Industrial facilitation-Seeking
- Strategic opportunity-Seeking

Advantages of Foreign Direct Investment (FDI)

- introducing new technology, modern skills, innovations and new ideas

- create new employment opportunity
- when part of the profit again put into the business moderation or
expansion can be occurred
- most direct investment flow into export industries. By increasing
exports reducing imports it will improve balance of payments of
capital importing country
- FDI induces domestic investment in the form of joint participation or
in local ancillary industries
- FDI increases the productive capacity of the capital importing country
- FDI induces to invest in infrastructure such as power, telecom, and
developments of ports. It is not only accelerating the economic growth
of the capital importing country but also attract foreign investors
further.

Disadvantages of Foreign Direct Investment( FDI)

- profit exploitation
- new technology doesn’t always ensure expected level of employment

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- there are chances to give up activities, if it is happen, this will create
severe problems
- avoiding pay to tax
- crate political instability
- create cultural abuse
- introducing corrupt culture
- exploiting the resources and misuse it

Climate for the Foreign Direct Investment

In order to promote private FDI, it is necessary to create proper climate in the nation.

1. Political stability and freedom

2. Security for life and property
3. Giving tax free or tax holiday
4. Easy traveling arrangements
5. Freedom from double taxation

Types of Foreign Direct Investment

The purposes of cross boarder investment determine the types of FDI. In the literature
of FDI, the term ‘seeking’ is particularly used to differentiate types of FDI. There are
several types of FDI.

1. Labour seeking
2. Natural resources seeking
3. Market seeking
4. Efficiency seeking
5. Technology seeking
6. Strategic materials seeking
7. Support industry seeking
8. Industrial facilitation seeking
9. Strategic opportunity seeking

Economic Effects of Foreign Direct Investment

Transformation in both industrial and economic structures is essential conditions for

economic development. The followings are economic effects of FDI, which are vital
to economic structure transformation in the long run.

1. Capital Formation Effect

2. Technology Transfer Effect
3. Entrepreneurship Learning Effect
4. Economic growth Effect
5. Market Expansion Effect
6. Employment Generation Effect
7. Social welfare effect
8. Production Mode Transfer Effect

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Developing Countries and Foreign Aid

There are three motives for granting aid to the developing countries.

Economic Motives

- to escape from poverty trap

- to attain a faster growth rate
- to enter fully into international trade
- to provide growing markets for the products of other countries

Humanitarian Motive

- to provide better life conditions to the people those who are living in
conditions of abject poverty

Political Motive

Communist and non – communist countries have extended economic aid in the
expectation of obtain the political allegiance of the aid receiving countries

Needs of Developing Countries

1. Gap in savings and investment

Due to extreme poverty people have very high propensity to consume and very
low propensity to save because of this investment is below the needed level.
But investment necessary to generate high economic growth

2. Trade Gap

There is a severe shortage of foreign exchange. This limited the impost of the
country.

3. Capital inflow

Foreign aid is a reflection of only a part of capital inflows from 1 st world to the
3rd world countries.

4. Foreign exchange gap

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Forms of Foreign Aid

Foreign aid comes in different forms.

- Gifts of consumer goods: free distribution of US and European

stockpiles of food like Wheat.
- Loan and Grants: Loan may be obtained on commercial forms(Market
rate of interest) or on concessionary terms(below the market rate of
interest)
- Education: Providing scholarship, sending teachers and instructors
abroad under technical assistance program.
- Direct Investment: setup up of factories, mines, plantations, hotels in
developing countries and form of joint venture
- Technical and Direct Assistance: Advanced countries provide technical
experts to advice and the developing countries in their efforts to attain
growth. Under taking the construction of projects such as steel works
and power station. Providing technical training programs for
developing countries.
- Specialist Service: The IMF, World Bank, UN and individual nations
under take surveys for and offer variety of financial, technical and
advisory services to developing countries.

Evaluation of Foreign Aid

1. In third world countries, government serves the interest of a narrow range

of groups in society. Due to this foreign aid diverted into meeting the
requirements of their groups rather than achieving genuine economic
development.
2. ‘Fashion’ in foreign aid projects change over time.
3. Foreign aid in the form of subsidised food or consumer products may be
harmful to long term third world development
4. Tied foreign aid particularly in the form of loans may results in third world
countries getting a worse purchase.
5. Loans have to be repaid with interest. Repayment of loans has caused
economic problems for third world countries.

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