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Factors that motivate foreign direct investment

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Published: Mon, 5 Dec 2016

Foreign direct investment is an increasing commercial trend in today’s commercial world. More and more capital is flowing from developed countries to the developing countries. Awareness among the companies about the potential of the overseas markets especially the developing markets has given boost to the flight of capital from developed world to the developing world. Companies, products and services which were once available or heard in developed world are now readily available in the developing nations. Food products, telecom services, cars, garment brands are now shifting their attention to the emerging markets due to falling revenues in the domestic market and increasing demand in the emerging markets.

Multinational organizations owing to their technological superiority, strong financial base, flexibility and speed and market expertise always seek opportunities to expand their operations in new markets [1]. Foreign direct investment is setting up productive capacity into a foreign land is the most sought modes of entry into new markets. Several well known organizations like Exxon, Toshiba, BMW, and Starbucks have made their presence felt across the globe by pursuing foreign direct investment mode. These organizations have one common underlining factor that has made their overseas move possible and that is a strong financial base. They have invested huge amount of financial and human resources in order to capitalize on the opportunities offered by the new emerging markets. They have extracted output from their superior competitive position. Along with lucrative prospects in the new economies cut throat competition in local markets, rationalizing of commercial activity to benefit from economies of scale & increasing raw material prices have prompted firms to move to area rich in natural resources.

Regional and global trade & investment agreements have stimulated the increase in foreign direct investment activity. Thanks to the increasing trade and investment agreements wide range of complex issues are considered & resolved in order to make the movement of capital and technology smooth. Foreign investors usually look for nations which are less risky and offer political and economic stability and robust economic growth due to favorable policy measures [2]

Factors motivating foreign direct investment

Considering their technological superiority, product differentiation, strong financial base, flexibility, managerial acumen, speed of delivery and market expertise the multi nationals are superior to the local firms [3]. Multi national organizations tend to capitalize on the gap in products and services in the new overseas markets and maximize their profits. Another reason for multinational organizations to move to new markets is to invest in the natural resources and prevent or control their competitors advantage in critical fields like natural resources, technological acumen etc but the main idea behind investment is increased profitability [4]

FDI as a mode of Entry:

Foreign Direct Investment is amongst the most commonly accepted entry mode along with joint ventures & acquisitions. Due to increased liberalization of trade, increased globalization and opening of the economies by big countries the foreign direct investment activity has increased especially in this decade. Taking advantage of their superior competitive positions multi nationals find it very easy and convenient to extend themselves beyond domestic borders. The foreign direct investment decision is mostly influenced by forces internal or external to organization in response to a specific opportunity abroad (Ahorani 2008).

Several factors prompt or force the organization to venture into international markets to maximize profits or maintain competitive superiority over their competitors. Other factors that determines foreign direct investment inflow into a country is the natural resources available in the host nation political & economic stability, tax exemptions & financial incentives. Probably the taxation policies are the most important considered while mulling foreign direct investment [5].

BRICs as preferred destination for foreign direct investment:

Emerging economies around the world today are the major drivers of global economy. It was India and China who spearheaded world economy out of recession. The demand for goods and services from the emerging nations and especially the BRIC economies is gathering momentum. BRIC economies feature rising middle class, high growth rates and increasing disposable income and increased purchase power. First decade of this century has come to end bringing a paradigm shift in world economic balance. Countries that prior to 1980’s were considered luggage on the global economy today are the most south after investment destinations. Dozens of economically improvised nations have come to prominence in the first decade of the 21st century. The trend of economic shift can be witnessed clearly in Brazil, Russia, India China (BRIC economies), Vietnam, Turkey, Nigeria etc. These emerging nations have played a significant role in tilting the economic domination balance from the developed world to the developing world.

New global trends like the increasing acceptance of globalization, advances in trade & services, surge in IT related services and efficient & investment friendly economic policies by the government in the emerging countries have helped the emerging economies to grow at an impressive pace. Quality man power is a major component in functioning of a company, especially for Multinational Corporation’s coordination of human resource and match of talent across borders is necessary. Presence of a well-educated & cost effective labor force in the developing nations like India, China, Brazil and Russia have attracted multinationals to invest and begin operations there (Pfeffermann and Madarassy, 1992) [9]. Combination of talented & cost effective human capital, increasing demand for capital, increasing demand for goods & services, increasing disposable income, less than mature economies & access to natural resources makes them and ideal candidate to shadow and replace the saturated developed world economies in the coming decades. The developed world economies have become less attractive due to falling demand and low economic development indices. This has prompted the commercial organizations to look towards developing world for better return on investment [7].

In this decade the BRIC economies have made the world feel their rising economic dominance & have defined a new world order. From 2000 – 2008 BRIC economies added almost 30% to global Gross domestic product in US dollar terms. During the same time the contribution of G7 economies shrunk to 40% from 70% in 90’s. The contribution of BRIC economies to the global growth has risen even more and stood around 45% in 2008 against 24% it had in 2001. BRICs’ share of global trade as of 2008 was 13%. China accounts for almost two thirds of the BRICs’ share in world trade. The depth of BRIC economic success story was reiterated in 2008 due to their resilience in the financial crisis [6]. In BRIC economies like India, Brazil, Russia domestic demand for goods and services is the main contributor to their GDP growth. On the other hand in China both net exports & domestic demand have propelled the country’s GDP to grow at an amazing 10% a year in this decade. A comparison between BRIC and developed world illustrates the striking difference in economic growth trajectory. Domestic growth in United States has slowed since 2004 and it nose dived turning negative in 2008. In Europe the domestic demand dropped significantly and the exports came to almost standstill in 2008 [6].

Why BRICs matter

For several decades into the 20th century the position of richest economies remained unchanged & unchallenged. United States of America, Great Britain, France, Japan, and Germany etc have all dominated the world economic scenario. Since late 80’s and 90’s several Asian countries like Malaysia, Singapore, Taiwan, South Korea have showed promising signs of rapid economic growth. Asian Tiger economies grew rapidly from 70’s to early late 90’s but due to their small size they were not real balance shifters and were too small to be a global super power. Countries like China, India, Brazil and Russia have risen to prominence in the last decade especially China now the worlds second largest economy is a possible contender to dislodge USA to be worlds leading economy in the decades to come [5]. BRIC nations are all major powers in there neighborhood and have large population, especially India and China accounting for 1/3rd of worlds population [5]

BRIC and overview

Brazil

Brazil is the largest country in South America as per size and population. It is the regional superpower and veils significant influence in South America. It is projected that Brazilian economy will expand by 7% in the year 2010 and will continue to grow at an average 4-5% to 5.0% for next half a decade. From 2003 to 2008 more than 34 million people entered the middle class and this number will increase by another 30 million by end of 2014. Analysts predict that by end of year 2020 Brazil will be the 5th largest economy in the world. 3/4th of its population will be in the higher or lower middle class. [5] Brazilian economic growth is fueled by domestic demand for goods and services. Following will be the growth trend in 2014 according to the industry:

Food, beverages and cigarettes: 66%

Electronic and furniture: 47%

Pharmaceutical drugs: 79%

Clothing and shoes: 68%

Personal care: 45%

Flight passengers: 77%

Automobile: 43%

Among its BRIC counterparts Brazil’s economic success is significantly highlighted by its developing capital market, efficient corporate governance which is compatible with international standards which are preferred by foreign multi nationals for investment [5]

China

China is one of the leading economies not only amongst the BRIC economies but also in the world. Chinese economy grew by an amazing 10% between year 2000 & 2010. Despite having a communist ideology, no democracy and a single party rule China today has become world’s second largest economy after United States. According to Goldman Sachs, by 2035 Chinese economy might be 17times larger as compared to 2004 statistics and might as well surpass USA to become world’s largest economy [10]. Thanks to the modern reforms it went through in the year 1978 today China is world a potential candidate for future super power due to its financial muscle. Today China is the largest exporter of finished goods and the second largest importer of goods. China has a strong influence over its Asian neighbors and the world economy [11].

India

India is world’s second most populated country in world and is the 7th largest by in the world by its physical size. The Indian economy is the world’s 11th largest by nominal GDP and the fourth largest by purchasing power parity. Following the economic crisis in early 1990’s Indian economic ideology underwent radical market reforms in year 1991. Indian economy was opened to the world after several decades of government control. Investment friendly economic policies were introduced to attract foreign investment. Thanks to these economic measures today India is world’s second fastest growing major economy after China. It is projected that on average India will grow by a healthy average of 6.9% between year 2006 to 2050. Between 2006-2020 India’s gross domestic product is expected to rise four fourfold [12]. It is expected that there will be a five fold increase in car purchase and fuel consumption will increase 3 times in India between the same period. India has been ranked 10th out of 100 countries in the latest country risk analysis by Economic Intelligence Unit. As a result, FDI flow to India, which has reached $ 5 billion in 2003 from $3.8 billion in 1999, it reached to $ 13 billion in 2008 [12].

Russia

Russia is the world’s largest nation in physical terms occupying a ninth of world’s geographical area. Russia is the world 9th most populated country. Russia has abundant natural resources. Russia holds large reserves of oil and natural gas. It has abundant reserves of minerals and ores. After break up of USSR Russia has emerged as one of the leading economies in the world. Russia averaged a growth rate of 7% in between year 1999 to 2008. Russian economy took a severe hit in 2008 economic crisis. Russia is a regional super power and holds a significant influence over its neighbors. It is expected that in 2010 Russia will grow by 4.5 % and by 4.8% in 2011.

The BRIC Drivers:

With the integration of Brazil, Russia, India and China, the so called future economic powerhouses, in the world economy gathering momentum it is ever more evident that economic and political systems in poor countries will be affected in several, complex ways. The sheer size of the BRIC economies, their phenomenal GDP growth rate, their need for energy resources & their increasing growing economic and political muscle will ensure that they will re-define the world economy & change the rules of the game. Their growing presence will change their relationship with the developed world. These economies will offer opportunities and also a stiff competition. Their competitiveness will not be limited only to the developed economies but also the poor and improvised nations.

The integration of the BRIC economies into the world economy has drastically changed the dynamics of the nature of macroeconomic and financial interdependence. Firstly the BRIC economies especially China and India are rapidly integrating their huge talented and cost effective labor forces into the world economy and growing rapidly. Each year since 2001 Indian & Chinese combined contribution into the global output growth as been around 30 percent [14]. Indian and Chinese contribution has boosted the world growth above the 4 percent threshold which is important in improving the terms & conditions of trade especially for primary commodity producers. On the financial front, demand from Asian investors, in particular the recycling of foreign exchange reserves into US securities, the Asian bid, has contributed to the low level of US interest rates which have further stimulated raw material prices [10]

Effect of BRICs on global economy

According to Goldman Sachs the BRIC nations combined are poised to overtake the United States GDP by the year 2018. By end of the coming decade both India and Russia individually will have economies larger than Canada, Italy and Spain. By 2020 it is expected that Brazil’s economy will surpass Italy. During 2000-2010 the world GDP expanded by 36.3% in purchasing power parity (ppp) terms due to strong performance by the BRIC nations. During the same time line the BRICs have increased their share of global output. Today they make up to 25% of the global economy in purchasing power parity term. By the year 2020 their share in global economy will rise to 49% i.e. BRIC’s will form about 49% of global GDP (a third of global economy in purchasing power parity terms) [16]

Though BRICs came to prominence in the last decade but the effect of their rise will be seen in the next decade. A massive middle class will be created. The middle class, households with incomes in between $6,000 – $30,000, has ballooned by hundreds of millions in the last decade and is expected to grow by millions in coming decade. This middle class boom will be mostly led by China, India & Brazil. In India expansion in middle class households will accelerate throughout this decade. As China and India are the world’s fastest growing economies and are two most populous countries increased incomes in these economies will have much greater impact on global demand [16]

Similarly the equity markets in the BRIC economies have seen strong growth. Russian traded index shot up by a whopping 884%, China H-Shares (610%), the BSE in India (319%), and the Bovespa in Brazil (294%). The immense potential of rising consumer demand in the BRICs, particularly from the middle-income section of the population may help to support market performance over the next decade, both in the BRICs and other countries that can take advantage of increased demand [4].

Rise in Income and consumption

Middle class population will rise significantly by 2020 in the BRIC world. Last decade witnessed hundreds of millions rise out of poverty in BRIC economies. Especially in China where number of people having income greater than $6000 and less than $30,000 is in hundreds of millions.

With the explosion of the middle classes, spending patterns are likely to change. This trend is expected to spread over India, Brazil and Russia and by year 2020 millions of households will come out of poverty and have incomes greater than $6,000 and less than $30,000e specially India where 400 million people live below poverty line [4]. Also there will be a expansion of the ‘upper class’ ‘upper class’ (incomes higher than $30,000) [16]

Rise in middle class & upper class means rise in income of people. This trend implies acceleration in demand potential. With increased disposable income there is increase in demand for the consumer goods and services. People tend to buy new products and services which were out of reach before. This trend results in increase in demand potential which makes these emerging markets attractive for foreign investors. People tend to spend money on commodities like in cars, leisure travel, high end lifestyle etc. These are the new visible market indicators.

Over the last decade poverty rates in the BRIC’s have fallen and this will continue well into the next decade. As industrialization takes root in developing economies it increase GDP to around $1000-$3000 which leads to increased savings and investments [16]

Emerging economies towards foreign direct investment

Several developing economies have liberalized, privatized and deregulated their economies since 1990’s in order to attract investment from developed world. Investment favorable policies have been a major part of the market liberalization era. But not all foreign direct investment related policies are investment friendly. Both encouraging and discouraging policies are part of the economic liberalization. Policies framed to increase foreign direct investment inflow like tax breaks, favorable regulatory treatment etc are aimed towards. On the other hand policies aimed towards restricting inward foreign direct investment are focused on the service sectors like banking, telecom etc [17]

foreign direct investment brings benefits like employment creation, capital accumulation, transfer of technology, improved provision of services and increased competition. These are the desired trends in the developing nations. But foreign direct investment may pose threat to the local firms. There is a good chance of displacement of local manufacturers & the work force. Government will be forced in such instances to restrict inward foreign direct investment [18].

Amongst other reasons non economic factors too play a vital role in deciding the reasons for limiting foreign ownership and control, relating to national security or economic nationalism. Service sector is more prone to strict government control and is subject to heavy restrictions. Government’s veils high degree of controls on the sensitive sectors like telecommunications, banking, transportation and electricity etc [19].

Introduction and summary

Structural policies can influence foreign direct investment patterns. Structural policies play an important role in determining foreign direct investment. The trade discussions, regional trade accords and bilateral and multilateral investment agreements have decreased barriers to foreign direct investment. Continuous WTO trade discussions & negotiations contribute to this trend. However, restrictions to foreign direct investment are still significant in some countries and industries. At the same time, there is growing recognition that labor market policies and product market regulations may have a significant indirect impact on the activities of multinational enterprises [20].

While trade and FDI liberalization have been extensive over the past two decades, further opening up borders would increase foreign direct investment integration among OECD countries. For instance, the average effect of lifting such restrictions can be substantial, with particularly strong increases in foreign direct investment to be obtained from the removal of foreign equity ceilings OECD analysis suggests that, relative to the OECD average, policy influences on foreign direct investment appear to have played different roles in different countries over the past two decades [20]

OECD empirical results suggest that labor market arrangements can influence the cross-country patterns of foreign direct investment as strongly as direct restrictions to trade and foreign direct investment. These arrangements are generally driven by policy objectives that are unrelated to foreign direct investment, but they have important side effects on the level and geographical allocation of foreign direct investment flows. Strict employment protection legislation and, especially, high labor tax wedges appear to divert foreign direct investment to locations where labor market arrangements are perceived as less costly. These results would seem to imply that, on average, the costs of job protection and labour taxation are not fully shifted onto lower (after-tax) wages. The negative effects of strict employment protection legislation on inward foreign direct investment may also be due to the fact that this legislation is likely to affect not only the returns expected from foreign investment but also their variability (e.g. by influencing the capacity of foreign affiliates to respond to supply or demand shocks) [21]

Outside free-trade areas, OECD estimates suggest that tariff barriers between the host and investor country or between the host and third-party countries discourage foreign investment. This reflects the costs that tariffs impose on re-importing to the home country, or exporting to third-party countries, the final or intermediate goods produced by foreign affiliates. Foreign direct investment restrictions often set limits on investment by foreign companies, as well as on management and organizational choices of foreign affiliates in the host country increase foreign direct investment flows that are aimed at re-exporting final or intermediate products into the home country or into other signatory countries [21]

These positive influences on foreign direct investment appear to outweigh the tendency of free-trade areas to lower the relative cost of supplying a foreign market via trade compared with local production, which would in principle depress foreign direct investment flows.

The OECD analysis suggests that free-trade areas tend, on balance, to encourage foreign direct investment both among signatory countries and, in areas that are closely integrated, also with respect to third-party countries. By enlarging the overall size of the market, these agreements tend to increase the scope for reaping economies of scale through foreign direct investment aimed at accessing local markets (so-called “horizontal” foreign direct investment) for both signatory and non- signatory countries [22]

Restrictive product- and labor-market regulations can also act as barriers to foreign direct investment. Countries where domestic product-market regulations impose unnecessary costs on businesses and create barriers to entry tend to have lower stocks of foreign capital. Similarly, strict employment protection legislation (EPL) and high labor income taxation also seem to lower inward FDI positions [13]

Attitudes and policies towards liberalization of international capital flows in general and foreign direct investment in particular have been subject to considerable controversy and flux [23]. In the developing economies liberalization policies have always been a debated issue. Opening up of economy is seen as a risk to national sovereignty due to free movement of capital. Amongst the foreign capital investment foreign direct investment, is prone to serious scrutiny by the governments as might involve major stake owned by large multinationals. It is feared that local domestic authorities will have no control over them. Due to such reasons governments tend to impose restriction on the inward foreign direct investment [23].

The different types of foreign direct investment barriers

In Inward foreign direct investment flow restrictions of foreign ownership are most common barriers. These restricted foreign ownership barriers limit the share of the investing company which is usually less than 50% and in some instances totally prohibit any ownership [25]. Government can discourage the foreign direct investment by introducing compulsory screening and approval policies. These screening and approval policies are one of the most used policies by the governments to restrict foreign direct investment in sensitive sectors of the economy. Government might add stipulations which the foreign investors have to show compulsorily, this might increase the cost of entry and discourage the capital inflow in certain areas. Government’s constraints on foreign citizen’s ability to manage the company and its operational controls also are a move that can discourage inward foreign direct investment. Restriction on movement of foreign nationals may hamper the movement of technological expertise & question the feasibility of the investment [25].

The government also systematically limits the inward foreign direct investment behind opaque private and public measures. Indeed, claims abound that such practices are used systematically to limit foreign ownership of domestic businesses. Critics of inward foreign direct investment argue that it allegedly has adverse economic effect on the host country. Adverse economic effects include balance of payments deficits, reduced domestic research and development, diminished competition, crowding-out of domestic firms and lower employment. However the analysis shows little credibility to these claim (25) Economic analysis shows that in the long run the inward foreign direct investment has little effects on the trade balance and employment. These factors are usually determined by macro economic trend. Then inward foreign direct investment does have a negative impact on the domestic competition and local research and development but it also acts as catalyst in stimulating local technical capabilities. Studies show that benefits of inward foreign direct investment are substantial (23)

Foreign direct investment is kind of global market integration which offers economic benefits to both parties according to the principle of comparative advantage. International trade on the other hand involves arms’ length transactions. Foreign direct investment is intra-firm trade and transactions in intangible assets such as National treatment involve non-discrimination in conducting business. So from national economic point of view discriminatory restrictions and special incentives are of questionable merit, at least in developed countries with well-functioning markets [26].

Sometimes the acknowledgement of the economic benefits offered by the freedom of capital movement sometimes goes against concerns like risk or loss of national sovereignty and other adverse economic consequences. Historically foreign direct investment inflow has created more controversies and conflicting views because foreign direct investment involves a controlling stake by often large multinational corporations (MNCs) over which domestic governments have little power. The controversies have mostly focused on inward foreign direct investment, due to sensitivity about foreign control over domestic industry. In the last few years, outward foreign direct investment from OECD countries to developing countries has also been the focus of criticism by NGOs and others who view such foreign direct investment as a cause of depressed labor and environmental standards [23]. Countries facing increased inflows of foreign direct investment have often experienced unease. Many developed nations have until recently resented in ward FDI flow. United States was wary of huge Japanese foreign direct investment in the 1980s. This provoked concerns about adverse effects on national security and excessive foreign control. Last two decades have seen increased acceptance & movement of the world towards foreign direct investment. Governments of the world are increasingly getting inclined to attract foreign direct investment due to benefits like employment, capital and technology transfer [27] Encouraged by the positive effects of the foreign direct investment inflow governments across the world are encouraging foreign direct investment by formulating investment friendly policies. Governments have reduced restriction on the foreign direct investment by offering incentives to the companies (UNCTAD 1996). Still, some restrictions remain in place even in countries that generally welcome foreign direct investment [28].

Summary:

BRIC economies today are at the center of trade & investment discussions. Depression & fall of demand in the western world has prompted the commercial organizations to look east for business. The BRIC economies share a common trait of rising middle class and increasing incomes along with political and economic stability. The BRIC nations are also amongst the most populated in the world. India and China together account for 2.5 billion population of the world. Hence these two obviously form a biggest market for consumer goods. It is expected India’s middle class will rise from current 50 million households to 500 million in this decade. China already has uplifted millions of people from poverty to middle class & upper middle class. BRIC nations also are blessed with natural resources and occupy a huge geographical area. Companies in the mining and energy businesses find these untapped markets lucrative due to the natural resources. They find investment in BRIC economies worth the time and financial investment. Over the next 50 years BRIC economies are expected to dominate the world economic growth charts. High growth rates and favorable market policies have made these nations a major FDI destination.

Multinational organizations opt for foreign direct investment in new markets to capitalize on the opportunities available there. Foreign direct investment has seen steep increase in last two decades due to changing attitude around the world about the foreign direct investment. Foreign direct investment prior to 1990 was seen as an unwanted intervention of foreign company into the domestic economy. In case of foreign direct investment the control of the company remains with the investor and the government or the local bodies have little control over it. Therefore foreign direct investment has always been a debated issue. Even in the developed countries where the trade and investment market is matured there are still concerns over the foreign direct investment.

Government imposes restrictions on investment in certain sectors of economy to shield the local firms from superior international competition. Governments in developing world (for eg: India) deem development of the local businesses essential for the national well being. Dependency on 100% foreign direct investment might be considered against the national interests in long run e.g. India had a closed economy prior to 1990’s economic crisis. This controversial period of closed & restrictive economy gave some local bu


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