FOREIGN DIRECT

INVESTMENT
SOUMENDRA ROY

FOREIGN DIRECT INVESTMENT

Why is FDI increasing in the world
economy?
Why do firms often prefer FDI to
other market entry strategies?
Why do firms imitate competitors
with FDI strategies?
Why are certain locations favored for
FDI?
How does political ideology affect
government FDI policy?
What are key FDI related costs and

INTRODUCTION
Foreign Direct Investment is any form of
investment that earns interest in enterprises
which function outside of the domestic
territory of the investor
FDIs require a business relationship between a
parent company and its foreign subsidiary
FDI stocks now constituting 28% of the
global GDP
3

FOREIGN DIRECT
INVESTMENT
Foreign direct
investment (FDI):

a firm
invests directly in foreign facilities

A firm that engages in FDI becomes a

multinational enterprise (MNE)
Multinational
country

more

than

one

Factors which influence FDI are related

to factors that stimulate trade

FOREIGN DIRECT
INVESTMENT
Involves ownership
of entity abroad for
production
Marketing/service
R&D
Access of raw materials or other resource
Parent has direct managerial control
Depending on its extent of ownership and
On other contractual terms of the FDI
No managerial involvement = portfolio
investment

TYPES OF FDI
Inward FDI and Outward FDI
Vertical FDI and Horizontal FDI
Market seeking FDI and Resource seeking
FDI
Greenfield investments and mergers and
acquisitions

TRENDS IN FDI
Flow and stock increased in the last 20 years
In spite of decline of trade barriers, FDI has
grown more rapidly than world trade
because
Businesses fear protectionist pressures
FDI is seen a a way of circumventing
trade barriers
Dramatic
political
and
economic
changes in many parts of the world
Globalization of the world economy has
raised the vision of firms who now see the
entire world as their market

FDI MOVEMENT IN THE

WORLD
Increased by 5.1% and stood at
US $ 947 bn in 2007
Number of projects 11,574
(2007)
Top 10 destinations for FDI :
China, US, India, UK, France,
Germany, Russia, Spain , Poland
and Romania
8

FDI GROWTH IN THE WORLD

ECONOMY
FDI Outflow: $35 billion in 75 to $1.3 trillion in
00 to $653 billion in 03
FDI Flow (from all countries): from 92 to 02 up
292%, compared to trade up 69% and world
output up 28%
FDI Stock: $3.5 trillion by 97 to > $7 trillion in
02
In 02:
64,000 MNEs had:
850,000 foreign affiliates
53 million employees
$17.7 trillion in sales
$8 trillions global exports

Conclusion

DIRECTION AND SOURCE OF FDI

Most FDI flow has been to developed
countries from developed countries
Much to the US from EU, Japan
FDI increase to developing countries
since 85
Much to the emerging Asian and
Latin America economies
Africa lagging

FORMS OF FDI

FDI forms
Purchase of assets: why? why not?
Quick entry, local market know-how, local
financing may be possible, eliminate
competitor, buying problems
New investment: why? why not?
No local entity is available for sale, local
financial incentives, no inherited problems,
long lead time to generation of sales
International joint-venture
Shared ownership with local and/or other
non-local partner
Shared risk

ALTERNATIVE
MODES
MARKET ENTRY
FDI
FDI - 100% ownership
FDI < 100% ownership,
International Joint Venture
Strategic Alliances (non-equity)
Franchising
Licensing
Exports: Direct vs Indirect

OF

WHY FDI?
FDI over exporting
High transportation costs, trade
barriers
FDI over licensing or franchising
Need to retain strategic control
Need to protect technological knowhow
Capabilities
not
suitable
for
licensing/franchising
Follow few main competitors
Immediate strategic responses

PATTERN OF FDI
EXPLANATIONS
International product life-cycle

(Ray

Vernon)
Trade theory similarity
Eclectic paradigm of FDI (John Dunning)
Combines ownership specific, location
specific, and internalization specific
advantages
Explains FDI decision over a decision
to enter through licensing or exports

ECLECTIC PARADIGM OF FDI

(DUNNING)
Ownership advantage: creates a monopolistic
advantage to be used in markets abroad
Unique
ownership
advantage
protected
through ownership
e.g., Brand, technology, economies of scale,
management know-how
Location advantage: the FDI destination
market must offer factors (land, capital, knowhow, cost/quality of labor, economies of scale)
that are advantageous for the firm to locate its
investment there (link to trade theory)
Internalization advantage: transaction costs
of an arms-length relationship --licensing,

GOVERNMENT POLICY AND FDI

The radical view: inbound FDI harmful; MNEs
Are imperialist dominators
Exploit host to the advantage of home
country
Extract profits from host country; give
nothing back
Keep LDCs backward and dependent for
investment, technology and jobs
The free market view: FDI should be
encouraged
Adam Smith, Ricardo, et al: international
production should be distributed per national
comparative advantage
An MNE increases the world economy

HOST COUNTRY EFFECTS OF FDI

Benefits
Resource -transfer
Employment
Balance-of-payment (BOP)
Import substitution
Source of export increase
Costs
Adverse effects on the BOP
Capital inflow followed by capital outflow
+ profits
Production input importation
Threat to national sovereignty and
autonomy

GOVERNMENT POLICY AND FDI

Home country
Outward FDI encouragement
Risk reduction policies (financing, insurance,
tax incentives)
Outward FDI restrictions
National security, BOP
Host country
Inward FDI encouragement
Investment incentives
Job creation incentives
Inward FDI restrictions
Ownership extent restrictions (national
security; local nationals can safeguard host

DECISION FRAMEWORK FOR

FDI Import
Are transportation costs
high?

No

Yes

Is know-how easy to
license?

Barriers?

No

Yes

No

FDI

Yes

FDI

Yes

FDI

No

License

Yes

Tight control over foreign ops

required?
No

Is know-how valuable and is

protection possible?

Export

BENEFITS OF FDI
Economic development of the host
Transfer of technology
Development of human capital resources
Creation of jobs
Opening export window

22

DISADVANTAGES OF FDI
Company may lose ownership
Difference in language and culture
Country secrets may be disclosed
Policies adapted may not be appreciated

23

FDI FLOW IN INDIA

25000

20000

15000

10000

5000

FDI Inflow in US million dollars

24

SECTOR WISE FDI

Sectors attracting highest FDI Equity Inflows (In Rs crore)

SECTOR

2008-09
(April-May)

Cumulative
(Apr.2000May 2008)

% of total
inflows*

2005-06

2006-07

2007-08

2399
(543)

21047
(4664)

26589
(6615)

4955
(1198)

60652
(14256)

21.85

Computer Software &

Hardware

6172
(1375)

11786
(2614)

(1410)

817
(199)

32984
(7477)

11.88%

Telecommunications

2776
(624)

2155
(478)

5103
(1261)

939
(232)

17687
(4074)

6.37

Construction

667
(151)

4424
(985)

6989
(1743)

4846
(1162)

18313
(4325)

6.57

Automobile

630
(143)

1254
(276)

2697
(675)

1385
(346)

11241
(2582)

4.05

Housing and Real estate

171
(38)

2121
(467)

8749
(2179)

4277
(1034)

15439
(3745)

5.56

Power

386
(87)

713
(157)

3875
(967)

1771
(438)

11401
(2643)

4.11

Metallurgical

6540
(147)

7866
(173)

4686
(1177)

2563
(615)

9911
(2377)

3.57

Chemicals (Other than

fertilizers)

1731
(390)

930
(205)

920
(229)

544
(134)

6684
(1519)

2.41

64
(14)

401
(89)

5729
(1427)

106
(26)

8352
(2007)

3.01

Services (Financial & nonfinancial)

Petroleum & Natural Gas

Figures in bracket are in US$ million

* In terms of Rs.
SOURCE: DIPP, Federal Ministry of Commerce and Industry, Government of India

25

COUNTRY WISE SHARE IN FDI

Mauritius
Singapor
e
UK
USA
Cyprus
Japan
Netherla
nds
Germany
UAE
Japan
SOURCE: DIPP, Federal Ministry of Commerce and
Industry, Government of India
26

FDI Vs FII
Till 2006 more FII investment than FDI in India.
Reverse in China
FDI was more than ten times of ours earlier
More FDI helpful than FII

27

GLOBAL MONETARY SYSTEM

INTERNATIONAL MONETARY SYSTEM

Currency exchange rates depend on the
structure of the international monetary system
Generally they are not freely convertible and
do not float freely
Only 51 were freely convertible in 1997
Another 50 were pegged to the exchange
rate of major currencies such as the US
Dollar and the French Franc or to baskets of
other currencies
Another 45 currencies were allowed by their
governments to float within a range of
another currency
This is 146 of 188 UN member nations in
1999

EVOLUTION OF THE
MONETARY SYSTEM

INTERNATIONAL

Gold Standard
Currencies pegged to the value of gold;
convertibility guaranteed
By 1880 most countries were on the gold
standard
Achieves balance of trade equilibrium for
all countries (value of exports equals
value of imports); flow of gold was used
to make up differences
Abandoned in 1914; attempt to resume
after WWI failed with Great Depression
Bretton Woods (1944)

BRETTON WOODS (1944 1973)

44 countries met to design a new system in

1944
Established International Monetary Fund
(IMF) and World Bank
IMF maintained order in monetary system
World Bank promoted general economic
development
Fixed exchange rates pegged to the US
Dollar
US Dollar pegged to gold at $35 per ounce
Countries maintained their currencies
1% of the fixed rate; government had to
buy/sell their currency to maintain level

THE ROLE OF THE IMF AS PER

BRETTON WOODS

Exchange rate discipline

National governments had to manage
inflation through their money supply
Exchange rate flexibility
Provided loans to help members states with
temporary balance-of-payment deficit;
Allowed time to bring down inflation
Relieved pressures to devalue
Excessive drawing from IMF funds came with
IMF supervision of monetary and fiscal
policies
Allowed up to 10% devaluations and more
with IMF approval

THE ROLE OF THE WORLD BANK

World Bank (IBRD-International Bank for
Reconstruction and Development) role
Refinance post-WWII reconstruction and
development
Provide low-interest long term loans to
developing economies
The International Development Agency
(IDA), an arm of the bank created in 1960
Raises funds from member states
Loans only to poorest countries
50 year repayment at 1% per year

COLLAPSE OF BRETTON WOODS

Devaluation pressures on US dollar after 20
years
Lyndon Johnson policies
Vietnam war financing
Welfare program financing
Nixon ended gold convertibility of US
dollar in 1971
US dollar was devalued and dealers
started speculating against it for further
devaluation
Bretton Woods fixed exchange rates
abandoned in January 1972

JAMAICA AGREEMENT 1976

Floating rates declared acceptable
Gold abandoned as reserve asset;
IMF returned its gold reserves to its members
at current prices
Proceeds were placed in a trust fund to help
poor nations
IMF quotas member country contributions
increased; membership now 182 countries
Less-develop, non-oil exporting countries
given more access to IMF
IMF continued its role of helping countries cope
with macroeconomic and exchange rate
problems

RECENT ACTIVITIES AND THE IMF

Mexican crisis 1995
Russian crisis1995
Asian crisis 1997/1998
The investment boom
Excess capacity
The debt bomb
Expanding imports
The crisis

How did the IMF

do?
Inappropriate
policies?
Moral hazard
Reckless
behavior
No
consequences
Lack of
accountability
Record mixed

IMPLICATIONS FOR BUSINESS

Currency management
The monetary system is not perfect
Both speculative activity and government
intervention affect the system
Companies must use risk management
instruments
Business strategy
Minimize risk by placing assets in different
parts of the world, e.g., production
Contract manufacturing
Manage company-government relations

FUNCTIONS OF FX MARKET
The foreign exchange market is the
mechanism by which participants:
transfer purchasing power between
countries;
obtain or provide credit for international trade
transactions, and
minimize exposure to the risks of exchange
rate changes.

38

CHARACTERISTICS OF FX MARKET
Largest of all financial markets with average
daily turnover of over $2 trillion!
66% of all foreign exchange transactions
involve cross-border counterparties.
Only 11% of daily spot transactions involve
non-financial customers.
London is the largest FX market.
US dollar involved in 87% of all
transactions.

39

Market Activity 24hrs

40

Increasing Turnover

Daily foreign exchange market turnover in billions of US dollars

(Bank for International Settlements Triennial Central Bank Survey 2004)
41

IMPORTANT CURRENCIES

42

TYPES OF TRANSACTIONS
A Spot transaction in the
interbank market is the purchase
of foreign exchange, with delivery
and payment between banks to
take place, normally, on the
second following business day.

The date of settlement is referred

to as the value date.
43

TYPES OF TRANSACTIONS
An outright forward transaction (usually
called just forward) requires delivery at
a future value date of a specified amount
of one currency for a specified amount of
another currency.
The exchange rate is established at the
time of the agreement, but payment and
delivery are not required until maturity.
Forward exchange rates are usually
quoted for value dates of one, two, three,
six and twelve months.
Buying Forward and Selling Forward
describe the same transaction (the only
44

TYPES OF TRANSACTIONS
A swap transaction in the interbank
market is the simultaneous purchase and
sale of a given amount of foreign
exchange for two different value dates.
Both purchase and sale are conducted
with the same counterparty.
Some different types of swaps are:
spot against forward,
forward-forward,
nondeliverable forwards (NDF).
45

TYPES OF TRANSACTIONS

46

MARKET PARTICIPANTS
The foreign exchange market consists of
two tiers:
the interbank or wholesale market
(multiples of $1M US or equivalent in
transaction size), and
the client or retail market (specific,
smaller amounts).
Five broad categories of participants
operate within these two tiers: bank and
nonbank foreign exchange dealers,
individuals and firms, speculators and
arbitragers, central banks and treasuries,
47

MARKET PARTICIPANTS
Banks and a few nonbank foreign
exchange dealers operate in both the
interbank and client markets.
They profit from buying foreign exchange
at a bid price and reselling it at a
slightly higher offer or ask price.
Dealers
in
the
foreign
exchange
department of large international banks
often function as market makers.
These dealers stand willing at all times to
buy and sell those currencies in which
they specialize and thus maintain an
48

MARKET PARTICIPANTS
Individuals (such as tourists) and firms (such
as importers, exporters and MNEs) conduct
commercial and investment transactions in
the foreign exchange market.
Their use of the foreign exchange market is
necessary but nevertheless incidental to
their underlying commercial or investment
purpose.
Some of the participants use the market to
hedge their foreign exchange risk.
49

MARKET PARTICIPANTS
Speculators and arbitragers seek to profit
from trading in the market itself.
They operate in their own interest,
without a need or obligation to serve
clients or ensure a continuous market.
While dealers seek the bid/ask spread,
speculators seek all the profit from
exchange rate changes and arbitragers try
to profit from simultaneous exchange rate
differences in different markets.
50

MARKET PARTICIPANTS
Central banks and treasuries use the market to
acquire or spend their countrys foreign exchange
reserves as well as to influence the price at which
their own currency is traded.
They may act to support the value of their own
currency because of policies adopted at the national
level or because of commitments entered into
through membership in joint agreements such as the
European Monetary System.
The motive is not to earn a profit as such, but rather
to influence the foreign exchange value of their
currency in a manner that will benefit the interests of
their citizens.
As willing loss takers, central banks and treasuries
differ in motive from all other market participants.
51

TYPES OF ACTIVITIES
Speculation
An activity that leaves one open to
exchange rate fluctuations where one
aims to make a profit.
Hedging
Allows the firm to transfer exchange
rate risk inherent in foreign currency
transactions or positions.
Arbitrage

take
advantage
of
inconsistent prices to make risk-free
profits. These profits are unlikely to last
long
52

FOREIGN EXCHANGE
QUOTATIONS

RATES

&

A foreign exchange rate is the price

of one currency expressed in terms
of another currency
A foreign exchange quotation (or
quote) is a statement of willingness
to buy or sell at an announced rate

53