Foreign Direct Investment

Topics: Investment, Foreign direct investment, Macroeconomics Pages: 7 (1788 words) Published: March 19, 2011
Chapter 4


FDI is the outcome of Mutual interest of MNC’s and host countries. The FDI refers to the investment of MNC'’ in host countries in the form of creating productive facilities and having ownership and control. On the other hand if MNC or a foreign organization or a foreign individual buys bonds issued by host country it is not FDI, as it has no attached management or controlling interest. Such investments are called Portfolio Investments.

In developing countries FDI is seen as a useful source of funds. LDC’s look upon FDI as a source to bridge their demand supply gap of funds. It represents an important source of non-debt inflow that often brings along with it new technology and management expertise. It is also an important vehicle of growth as it links international markets, and plays an important role in creating new employment and economic revitalization.

Why FDI?

FDI is risky and expensive/costly when compared with licensing. FDI is risky because of problems associated with doing business in another county with alien culture and legal environment. There are different rules of the game. The FDI is expensive because of the reason that the investing firm must bear the cost of establishing production facilities in a host country or bear the cost of acquiring a foreign firm.

There are at least six important reasons why FDI flows:

1) Transportation Costs
2) Market Imperfection
3) Competition
4) Product Life Cycle
5) Locational Advantages
6) Potential of Developing Countries.

1) Transportation Costs:

Goods may be having low value/weight ratio (ex. Soft Drink, Cement etc). Due to high cost of transportation in such cases, attractiveness to export decreases and establishing manufacturing facility in host country is preferred. It is also because MNC’s prefer a location to manufacture from where exporting to nearby regions becomes cheaper in terms of transportation costs.

2) Market Imperfections (International Theory):

This theory explains 2 major impediment barriers to exporting and barriers to sale of know how. The barrier to exports are imposed by government through tariffs, Quotas and restrictions on import of goods. Hence, exports to such countries is restricted. Sale of know-how through licensing has some attached disadvantage – (1) Firm gives away its know-how to a potential foreign competitors. Ex: RCA corps. of USA gave license to Sony and Matushita of Japan to produce colour TV. RCA saw this as a good way of earning profits. But Sony and Matushita quickly assimilated RC’s technology and used it to enter into US Market, compete with RCA only. RCA now is reduced to a minor player in its own home market. (2) License does not give the chance to Licensor to exercise right control on manufacturing, marketing and to implement right strategies in foreign country – and this may be required to exploit full profit potential of business. Where tight control on foreign entity is required, FDI is preferable. (3) The company’s know how may include management know-how and marketing know-how. Consider Toyota. Globally it is acknowledged as Leading Auto Producer and is credited with pioneering the development of new production process, known as lean-producer that enables it to produce high quality products and low costs as compared to global competitors. Its competitive advantage comes from management and process know-how, which cannot be licensed. Toyota is therefore increasingly pursuing FDI strategy for growth.

Further, if markets were perfect, all factors of production (except land) would be mobile and freely transferable. In real life, markets are imperfect and factors of production are somewhat immobile. Thus, it is worthwhile for MNC’s to survey markets to determine if they can benefit from the cheaper cost of producing in those markets. For instance, Japanese companies are using Mexico as a low labour cost country for...
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