Foreign

Direct
Investment

By- Baldeep Singh

BBA(G) Sec-A
Definition

 A foreign direct investment (FDI) is an investment in the form of a controlling

ownership in a business in one country by an entity based in another country. It is thus
distinguished from a foreign portfolio investment by a notion of direct control.
 Broadly, foreign direct investment includes "mergers and acquisitions, building new
facilities, reinvesting profits earned from overseas operations, and intra company loans". In a
narrow sense, foreign direct investment refers just to building new facility, and a lasting
management interest (10 percent or more of voting stock) in an enterprise operating in an
economy other than that of the investor.[2] FDI is the sum of equity capital, long-term capital,
and short-term capital as shown in the balance of payments. FDI usually involves
participation in management, joint-venture, transfer of technology and expertise. Stock of
FDI is the net (i.e., outward FDI minus inward FDI) cumulative FDI for any given period.
Direct investment excludes investment through purchase of shares.
 FDI, a subset of international factor movements, is characterized by controlling ownership of
a business enterprise in one country by an entity based in another country. Foreign direct
investment is distinguished from foreign portfolio investment, a passive investment in the
securities of another country such as public stocks and bonds, by the element of
"control".[1] According to the Financial Times "Standard definitions of control use the
internationally agreed 10 percent threshold of voting shares, but this is a grey area as often a
smaller block of shares will give control in widely held companies. Moreover, control of
technology, management, even crucial inputs can confer de facto control.
 An example of foreign direct investment
would be an American company taking a majority stake in a company in China. Another
example would be a Canadian company setting up a joint venture to develop a mineral
deposit in Chile.

Theoretical Background

According to Grazia Ietto-Gillies (2012), prior to Stephen Hymer’s theory regarding direct
investment in the 1960s, the reasons behind Foreign Direct Investment and Multinational
Corporations were explained by neoclassical economics based on macro economic principles.
These theories were based on the classical theory of trade in which the motive behind trade was a
result of the difference in the costs of production of goods between two countries, focusing on
the low cost of production as a motive for a firm’s foreign activity. For example, Joe S. Bain
only explained the internationalization challenge through three main principles: absolute cost
advantages, product differentiation advantages and economies of scale. Furthermore, the
neoclassical theories were created under the assumption of the existence of perfect competition.
Intrigued by the motivations behind large foreign investments made by corporations from the
United States of America, Hymer developed a framework that went beyond the existing theories,
explaining why this phenomenon occurred, since he considered that the previously mentioned
theories could not explain foreign investment and its motivations.
Facing the challenges of his predecessors, Hymer focused his theory on filling the gaps regarding
international investment. The theory proposed by the author approaches international investment
from a different and more firm-specific point of view. As opposed to traditional
macroeconomics-based theories of investment, Hymer states that there is a difference between
mere capital investment, otherwise known as portfolio investment, and direct investment. The
difference between the two, which will become the cornerstone of his whole theoretical
framework, is the issue of control, meaning that with direct investment firms are able to obtain a
greater level of control than with portfolio investment. Furthermore, Hymer proceeds to criticize
the neoclassical theories, stating that the theory of capital movements cannot explain
international production. Moreover, he clarifies that FDI is not necessarily a movement of funds
from a home country to a host country, and that it is concentrated on particular industries within
many countries. In contrast, if interest rates were the main motive for international investment,
FDI would include many industries within fewer countries.

Determinants of FDI

 Firm-specific advantages: Once domestic investment was exhausted, a firm could

exploit its advantages linked to market imperfections, which could provide the firm with
market power and competitive advantage. Further studies attempted to explain how firms
could monetize these advantages in the form of licenses.

 Removal of conflicts: conflict arises if a firm is already operating in foreign market

or looking to expand its operations within the same market. He proposes that the solution for
this hurdle arose in the form of collusion, sharing the market with rivals or attempting to
acquire a direct control of production. However, it must be taken into account that a
reduction in conflict through acquisition of control of operations will increase the market
imperfections.

 Propensity to formulate an internationalization strategy to

mitigate risk: According to his position, firms are characterized with 3 levels of
decision making: the day to day supervision, management decision coordination and long
 term strategy planning and decision making. The extent to which a company can mitigate
risk depends on how well firm can formulate an internationalization strategy taking these
levels of decision into account.

TYPES OF FDI

Strategically FDI comes in three types:

 Horizontal: where the company carries out the same activities abroad as at home (for
example, Toyota assembling cars in both Japan and the UK.

 Vertical: when different stages of activities are added abroad. Forward vertical FDI is
where the FDI takes the firm nearer to the market (for example, Toyota acquiring a car
distributorship in America) and Backward Vertical FDI is where international integration
moves back towards raw materials (for example, Toyota acquiring a tyre manufacturer or a
rubber plantation).

 Conglomerate: where an unrelated business is added abroad. This is the most unusual
form of FDI as it involves attempting to overcome two barriers simultaneously - entering a
foreign country and a new industry. This leads to the analytical solution that
internationalisation and diversification are often alternative strategies, not complements.

FDI can take the form of greenfield entry or takeover.

 Greenfield entry implies assembling all the elements from scratch as Honda did in the
UK, whereas foreign takeover means the acquisition of an existing foreign company - as
Tata’s acquisition of Jaguar Land Rover illustrates.
  Foreign takeover is often covered by the term 'mergers and acquisitions’ (M&As) but
internationally, mergers are vanishingly small, accounting for less than 1 per cent of all
foreign acquisitions.

This choice of entry mode interacts with ownership strategy – the choice of wholly owned
subsidiaries versus joint ventures to give a 2x2 matrix of choices – greenfield wholly owned
ventures, greenfield joint ventures, wholly owned takeovers and joint foreign acquisitions -
giving foreign investors choices that they can match to their own capabilities and foreign
conditions.

Basic Methods for Direct Foreign

Investment

 Sino-foreign Joint Venture

Sino-foreign Joint Venture, also known as Stock System Joint Venture, is a venture jointly
formed by foreign corporation, enterprise as well as other economic organizations or individuals
and China 's cooperation, enterprise as well as other economic organizations, which is situated in
the territory of China . Each stakeholder invests into and operates the said venture in
combination, who also shares risks, losses and profits together in accordance with investment
contribution ratio. Each capital contribution accounts for a certain share of the total investment
and foreign stakeholders should make at least a capital contribution accounting for 25% of the
total investment.
Sino-foreign Joint Venture is the method for China to utilize foreign investment directly at the
right beginning and at highest frequency. At present, such a method contributes to a considerable
share in the total foreign investment.

 Sino-foreign Cooperative Enterprises

Sino-foreign Cooperative Enterprises, also known as Contract Joint Venture, is a venture jointly
formed by foreign corporation, enterprise as well as other economic organizations or individuals
and China's cooperation, enterprise as well as other economic organizations or by the provision
of cooperation conditions, which is situated in the territory of China . And each interested party
contracts to define corresponding rights and obligations. In the case of Sino-foreign Cooperative
Enterprises, the foreign party usually provides the entire or a large portion of capital investment
 and the Chinese party offers land, factory building, utilizable equipments and facilities, a certain
amount of capital sometime.

 Sole Foreign Investment Venture

Sole Foreign Investment Venture is a venture solely invested by foreign corporation, enterprise
and other economic organization as well as individuals in accordance with laws and regulations
of China , which is situated in the territory of China . As for the Laws of Foreign Investment
Enterprise, the enterprise solely invested by foreign investors should promote our national
economy to develop and be in compliance with at least one of conditions presented as follows:
international advanced technology and equipment adopted; all or almost products to be exported.
The organizational form for foreign investment enterprise is usually corporation with limited
liabilities.

 Cooperative Development
Cooperative Development is short for the Ocean & Land Petroleum Cooperative Exploration. It
is a wildly adopted economic cooperation method in the international natural resource industry,
featuring characteristics such as high risk, high investment and high profit. Cooperative
Development falls into 3 stages, namely, detection, exploration and production. The above-
mentioned 3 methods in the Cooperative Development account for a small share.

 New Investment Methods

As expending the investment field and opening the domestic market further, we has to grope and
adopt new investment methods.

1. BOT: BOT has already been put into practice in the infrastructure field, BOT project in the
Guangxi Laibing Power Plant, for instance, which was already approved.

2. Investment Corporation: In April 1995, the Foreign Economic & Trade Administration issued
the Temporary Regulations about Investment Corporation invested by Foreign Investors in a bid
to stimulate foreign large-scale companies to implement their investment proposals. At present,
more than 160 investment corporations are founded, intensifying their own investment activities.
3. Foreign Investment Stock System Corporation: A stock system corporation can be established
via either promotion or fund raising and a foreign investment stock system corporation can shift
to the stock system limited corporation following application.

4. Acquisition: Multinational acquisition is one of major international direct investment methods.

Currently, relevant policies are under construction.

Advantages
Foreign direct investment benefits the global economy, as well as investors and recipients.

Capital goes to the businesses with the best growth prospects, anywhere in the world. That's
because investors seek the best return with the least risk. This profit motive is color-blind and
doesn't care about religion or politics.

That gives well-run businesses, regardless of race, color or creed, a competitive advantage. It
reduces the effects of politics, cronyism, and bribery. As a result, the smartest money rewards the
best businesses all over the world. Their goods and services go to market faster than without
unrestricted FDI.

Individual investors receive the extra benefits of lowered risk. FDI diversifies their holdings
outside of a specific country, industry or political system. Diversification always increases return
without increasing risk.

Recipient businesses receive "best practices" management, accounting or legal guidance from
their investors. They can incorporate the latest technology, operational practices, and financing
tools. By adopting these practices, they enhance their employees' lifestyles. That raises the
standard of living for more people in the recipient country. FDI rewards the best companies in
any country. It reduces the influence of local governments over them.

Recipient countries see their standard of living rise. As the recipient company benefits from the
investment, it can pay higher taxes. Unfortunately, some nations offset this benefit by offering
tax incentives to attract FDI.

Another advantage of FDI is that it offsets the volatility created by "hot money." That's when
short-term lenders and currency traders create an asset bubble. They invest lots of money all at
once, then sell their investments just as fast.

That can create a boom-bust cycle that ruins economies and ends political regimes. Foreign
direct investment takes longer to set up and has a more permanent footprint in a country.
 Disadvantages
Countries should not allow foreign ownership of companies in strategically important industries.
That could lower the comparative advantage of the nation, according to an IMF report.

Second, foreign investors might strip the business of its value without adding any. They could
sell unprofitable portions of the company to local, less sophisticated investors. They can use the
company's collateral to get low-cost, local loans. Instead of reinvesting it, they lend the funds
back to the parent company.

Foreign direct investment in India

Foreign direct investment (FDI) in India is the major monetary source for economic
development in India. Foreign companies invest directly in fast growing private Indian
businesses to take benefits of cheaper wages and changing business environment of
India. Economic liberalisation started in India in wake of the 1991 economic crisis and since then
FDI has steadily increased in India. It were Manmohan Singh and P. V. Narasimha Rao who
brought FDI in India, which subsequently generated more than one crore jobs. According to
the Financial Times, in 2015 India overtook China and the US as the top destination for the
Foreign Direct Investment. In first half of the 2015, India attracted investment of $31 billion
compared to $28 billion and $27 billion of China and the US respectively.

ROUTES OF FDI IN INDIA

 Automatic route: By this route FDI is allowed without prior approval by Government or
Reserve Bank of India.

 Government route: Prior approval by government is needed via this route. The
application needs to be made through Foreign Investment Facilitation Portal, which will
facilitate single window clearance of FDI application under Approval Route. The application
will be forwarded to the respective ministries which will act on the application as per the
standard operating procedure
Procedure under Automatic Route

FDI in sectors/activities permitted under automatic route does not require any prior approval
either by the Government or RBI. The investors are only required to notify the Regional office
concerned of RBI within 30 days of receipt of inward remittances and file the required
documents with that office within 30 days of issue of shares to foreign investors.

Procedure under Government Approval

FDI in activities not covered under the automatic route require prior Government approval. Such
proposals are considered by the Foreign Investment Promotion Board (FIPB), a Government
body that offers single window clearance for proposals on foreign investment in the country that
are not allowed access through the automatic route.
Government approval is required in the following cases:

Where a foreign investor has an existing joint venture/technology transfer / trademark agreement
in the same field, prior to January 12, 2005, the proposal for fresh investment / technology
transfer / collaboration / trademark agreement in a new joint venture would have to be under the
Government approval route through FIPB.
In sectors with caps, including inter-alia defence production, air transport services, ground
handling services, asset reconstruction companies, private sector banking, broadcasting,
commodity exchanges, credit information companies, insurance, print media,
telecommunications and satellites, Government approval / FIPB approval would be required in
all cases where:
An Indian company is being established with foreign investment and is owned or controlled by a
non-resident entity or
The control or ownership of an existing Indian company, currently owned or controlled by
resident Indian citizens and Indian companies, which are owned or controlled by resident Indian
citizens, is being transferred to a non-resident entity as a consequence of transfer of shares and/or
fresh issue of shares.
These guidelines do not apply for sectors/activities where there are no foreign investment caps,
that is, 100% foreign investment is permitted under the automatic route.

Sectors
 During 2014–15, India received most of its FDI from Mauritius, Singapore, Netherlands, Japan
and the US. [14] On 25 September 2014, Government of India launched Make in India initiative
in which policy statement on 25 sectors were released with relaxed norms on each sector.
Following are some of major sectors for Foreign Direct Investment.

 Infrastructure
10% of India's GDP is based on construction activity. Indian government has invested $1 trillion
on infrastructure from 2012–2017. 40% of this $1 trillion had to be funded by private sector.
100% FDI under automatic route is permitted in construction sector for cities and townships

 Automotive
FDI in automotive sector was increased by 89% between April 2014 to February 2015.[19] India
is 7th largest producer of vehicles in the world with 17.5 million vehicles annually. 100% FDI is
permitted in this sector via automatic route. Automobiles shares 7% of the India's GDP.

 Manufacturing
India is making progress turning itself into a magnet for manufacturers, the aim being to
increase the share of manufacturing in India’s GDP from a stagnant 15-16% since 1980 to 25%
by 2022 and create an additional 100 million jobs. Electronics contributes to India's success in
manufacturing but some challenges remain with foreign direct investment.

 Pharmaceuticals
Indian pharmaceutical market is 3rd largest in terms of volume and 13th largest in terms of
value. Indian pharmacy industry is expected to grow at 20% compound annual growth rate from
2015 to 2020.[21] 100% FDI is permitted in this sector.[22][23][24]

 Service
FDI in service sector was increased by 46% in 2014–15.It is US $ 1.88Bl in 2017. Service sector
includes banking, insurance, outsourcing, research & development, courier and technology
testing.FDI limit in insurance sector was raised from 26% to 49% in 2014.
 Railways
100% FDI is allowed under automatic route in most of areas of railway, other than the
operations, like High speed train, railway electrification, passenger terminal, mass rapid transport
systems etc. Mumbai-Ahemdabad high speed corridor project is single largest railway project in
India, other being CSTM-Panvel suburban corridor. Foreign investment more than ₹90,000 crore
(US$14 billion) is expected in these projects.

 Chemicals
Chemical industry of India earned revenue of $155–160 billion in 2013. 100% FDI is allowed in
Chemical sector under automatic route. Except Hydrocynic acid, Phosgene, Isocynates and their
derivatives, production of all other chemicals is de-licensed in India. India's share in global
specialty chemical industry is expected to rise from 2.8% in 2013 to 6–7% in 2023.

 Textile
Textile is one major contributor to India's export. Nearly 11% of India's total export is textile.
This sector has attracted about $1647 million from April 2000 to May 2015. 100% FDI is
allowed under automatic route. During year 2013–14, FDI in textile sector was increased by
91%. Indian textile industry is expected reach up to $141 billion till 2021.

 Airlines
Foreigner investment in a scheduled or regional air transport service or domestic scheduled
passenger airline is permitted to 100,with FDI up to 49% permitted under automatic route and
beyond 49% through goor existing airport under automatic route.