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Impact Of Foreign Direct Investment

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Published: 4th May 2017 in Economics

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The word “investment” can be defined in many ways according to different theories and principles. It is a term that can be used in a number of contexts. However, the different meanings of “investment” are more alike than dissimilar. Generally, investment is the application of money for earning more money. Investment also means savings or savings made through delayed consumption. According to economics, investment is the utilization of resources in order to increase income or production output in the future. An amount deposited into a bank or machinery that is purchased in anticipation of earning income in the long run is both examples investments. According to economists, investment refers to any physical or tangible asset, for example, a building or machinery and equipment. On the other hand, finance professionals define an investment as money utilized for buying financial assets, for example stocks, bonds, gold, real properties, and precious items. In general term, Investment means the purchase of goods which are invest and not used today, which will give benefit in future. The money you earn is partly spent and rest saved for future expenses. Instead of keeping savings ideal this money is invested to earn additional income this is called investment. When an asset is bought or a given amount of money is invested in the bank, there is anticipation that some return will be received from the investment in the future. (Meaning Of Investment, 2009 ). Investment by domestic residents (individuals, companies, financial institutions and governments) in the acquisition of overseas financial securities and physical assets. Overseas investment in financial assets, in particular by institutional investors, is undertaken primarily to diversify risk and to obtain higher returns than would be achievable on comparable domestic investment. Physical foreign direct investment(FDI) in new manufacturing plants and sales subsidiaries, or the acquisition of established businesses, provide the multinational company with a more flexible approach to supplying foreign markets.

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Interest, profits and dividends gained on these foreign investments count as invisible earnings in the balance of payments, though some of this income may be reinvested overseas rather than repatriated. (Christopher Pass, 1995). The income tax treatment of foreign investment income is frequently governed by Tax Treaties between the country of the investment owner and the state where the investment is situated. (Friedman, 2007 ).Foreign Direct Investment (FDI) An investment abroad, usually where the company is being invested in is controlled by the foreign corporation. A company from one country making a physical investment into building a factory in another country. The direct investment in buildings, machinery and equipment is in contrast with making a portfolio investment, which is considered an indirect investment. (Spaulding, 2004).Foreign direct investment (FDI) is a major driver of globalization. As investment patterns of multinational enterprises become more and more complex, reliable and internationally comparable, FDI statistics are necessary for sound policy decision making. The OECD Benchmark Definition of Foreign Direct Investment sets the world standard for FDI statistics. It provides a single point of reference for statisticians and users on all aspect of FDI statistics, while remaining compatible with other internationally accepted statistical standards. (OECD, 2008) . In the past decade, FDI has come to play a major role in the internationalization of business. Reacting to changes in technology, growing liberalization of the national regulatory framework governing investment in enterprises, and changes in capital markets profound changes have occurred in the size, scope and methods of FDI. New information technology systems, decline in global communication costs have made management of foreign investments far easier than in the past. (Spaulding, Foreign Direct Investment, 2005).In recent years, given rapid growth and change in global investment patterns, the definition has been broadened to include the acquisition of a lasting management interest in a company or enterprise outside the investing firm’s home country. As such, it may take many forms, such as a direct acquisition of a foreign firm, construction of a facility, or investment in a joint venture or strategic alliance with a local firm with attendant input of technology, licensing of intellectual property. (Graham, 2005). According to the benchmark definition of the OECD and World Investment Report 2009, a direct investment enterprise is an incorporated or unincorporated enterprise in which a single foreign investor either owns 10 percent or more of the ordinary shares or voting power of an enterprise (unless it can be proved that the 10 percent ownership does not allow the investor an effective voice in the management) or owns less than 10 percent the ordinary shares or voting power of an enterprise, yet still maintains an effective voice in management. An effective voice in management only implies that direct investors are able to influence the management of an enterprise and does not imply that they have absolute control. The most important characteristics of FDI, which distinguishes it from portfolio investment, is that it is undertaken with the intention of exercising control over an enterprise. (GlobStat, 2009).Probably the most important role of FDI in a developing economy is the supply of capital, as capital deficiency is the fundamental problem in case of a developing economy. Capital formation depends on investment, which, however, implies sacrifice of consumption. (Zaidi, 2009). Developing countries [1] , emerging economies and countries in transition have come increasingly to see FDI as a source of economic development and modernization, income growth and employment. Countries have liberalized their FDI regimes and pursued other policies to attract investment. They have addressed the issue of how best to pursue domestic policies to maximize the benefits of foreign presence in the domestic economy. The study Foreign Direct Investment for Development attempts primarily to shed light on the second issue, by focusing on the overall effect of FDI on macroeconomic growth and other welfare-enhancing processes, and on the channels through which these benefits take effect. (Andru Pascal, 2002). The most profound effect has been seen in developing countries, where yearly foreign direct investment flows have increased from an average of less than $10 billion in the 1970’s to a yearly average of less than $20 billion in the 1980’s, to explode in the 1990s from $26.7billion in 1990 to $179 billion in 1998 and $208 billion in 1999 and now comprise a large portion of global FDI.. Driven by mergers and acquisitions and internationalization of production in a range of industries, FDI into developed countries last year rose to $636 billion, from $481 billion in 1998 but in south Asian developing countries in which India $123 billion of FDI inward and Pakistan $31 billion of FDI inward in 2008. (UNCTAD, 2009)


Early Investment

There have been international organizations engaged in trading activities as far back in time as 2500BC, with banks and churches also having formed international organizations throughout history (Allen, 1984). The appearance of the modern MNE, incorporating control over foreign production units, did not occur until the Nineteenth Century (Wilkins, 1977), but early resemblances to the modern MNE appeared in the 1600s and 1700s, when large trading companies from the UK and the Netherlands entered parts of Asia, the Indies and America [2] . The two largest enterprises were the British East India Company and the Dutch East India Company (Nicholas, 1988). These dominated the well-paid markets of spices, cottons and silks, and are credited as being the true pioneers of international commercial activities. Investment also later took place in the UK and French colonial territories of Latin America, Asia, Africa and Australia, with most investments being supply oriented, in the form of resource exploitation (Medard Gabel, 2003) [3] . International companies also emerged with the aim of colonizing foreign lands. One of the first was the London-based, British Virginia Company, Whose strategy was to profit from the development and colonization of Virginia in the US. Similar projects across North America were undertaken by the Dutch, the French and the Swedes. (Wren, 2006).

It is generally accepted that the true birth of the modern multinational arose in Europe in the Nineteenth Century (Wilkins, History of FDI , 2004) [4] . Examples are the Cocker ill steelworks of England that set up in Prussia; Bayer’s of Germany that set up chemical plants in the US; and Nobel’s of Sweden that set up dynamite production in Germany (Tugendhat, 1981). However, it was not until the latter part of the Nineteenth Century that larger-scale foreign direct investment started to emerge. A major motivation for the spread of these firms was the increase in the protectionist behavior of countries, which in turn was a by-product of increased nationalism. As customers mostly-preferred goods produced locally, as opposed to imported goods, firms had to set-up abroad (John Micklethwait, 2003 ). Other important reasons for the upsurge in FDI and the growth of MNE’s was the search for larger markets, as enterprises began to grow in size, and improvements occurred in transportation and communication, most notably the railways and telegraphs (Wilkins, FDI , 1998). These advances not only made it easier for parent companies to control their subsidiaries but to control them over longer distances. Up until the end of the Nineteenth Century, European firms dominated the MNE scene, but US multinationals were beginning to increase, both in number and size. Examples of US multinationals at this time include singers, which set up sewing-machine plants in Scotland, and the electrical-manufacturers Thomson-Houston, which set up in England (Attack, 1994). The increase in FDI at the turn of the Twentieth Century was halted in the inter-war period both by the destruction caused by the First World War and the threat of another war leading to discrimination against foreigners by the occupants of many countries. The First World War also resulted in European multinationals being forced to sell their pre-war investments, with political upheaval and border changes also impacting on cross-border activities (Dunning, 1983). Other factors leading to a worldwide fall in investment included the Great Depression of late 1920s and early 1930s and the substantial rise in inflation in Europe (Jones, 1995 ). By the time of the Second World War, the main stock of FDI was still held by the UK 40 per cent, while the US held 28 per cent (Jones Eric Lionel, 2000). However, after the Second World War a new wave of FDI began to emerge, arising mainly from the US. The factors behind this improvement in technology and Communication systems, greater economic and political stability, the formation of trading blocks and a more liberalized attitude from host governments (Hood, 1999). In the years after the Second World War global FDI was dominated by the United States, as much of the world recovered from the destruction brought by the conflict. The US accounted for around three-quarters of new FDI (including reinvested profits) between 1945 and 1960. Since that time FDI has spread to become a truly global phenomenon, no longer the exclusive preserve of Organization for Economic Corporation and Development (OECD) countries. FDI has grown in importance in the global economy with FDI stocks now constituting over 20 percent of global GDP.

Pakistan History

Soon after independence in 1947, Pakistan moved from a parliamentary system to a presidential one and then finally reverted to the original parliamentary system. Pakistan has a checkered history of trade liberalization and FDI promotion. Following some trade liberalization attempts in the 1960s, Pakistan qualified for Article VIII status at the IMF in 1970. Even by the mid-1980s there was still a long way to go in lifting quantitative restrictions QRs and reducing tariffs. From the mid-1980s, controls on foreign investment in manufacturing have diminished sharply, those for the service sector less so (Athukoralge, 2007)

“In spite of various bureaucratic controls, the government attitude throughout the 1950s and 1960s was favorable to private investment, the FDI regime was more liberal, although there was greater emphasis on joint ventures with minority foreign ownership and technology licensing than on FDI in fully foreign owned ventures. However, supremacy of the state and socialist ideology under a socialist government dominated policy in the 1970s. As a result, a large-scale program of nationalization of key industrial units and wide-spread control of domestic and foreign trade were instituted. The dismal economic outcome of the interventionist policies eventually paved the way for market-oriented reform. Reforms started slowly in the early 1980s as part of a widespread reform package in conformity with the World Bank conditionality. Removal of restrictions on foreign investment was a major element of the reform program. Full foreign ownership of firms, with full freedom for remittance of profit and investment proceeds, is now allowed in almost all sectors of the economy” (Athukoralge, FDI History of Pakistan, 2007).

“Independence in 1971, the Bangladesh government adopted a state-led import-substitution development strategy, which was far more interventionist than that of the united Pakistan. The new government nationalized a larger number of industrial enterprises owned by Pakistani entrepreneurs as well as all industrial enterprises with fixed assets exceeding a certain threshold level. The scope of the private sector was limited to small and cottage industry, and foreign investment was allowed only in collaboration with the public sector with minority equity participation. However, existing foreign investments (excluding those belonging to Pakistan) were spared from the sweeping nationalization drive. The socialist-oriented industrial policy of 1973 assigned a very minor role for the private sector, with some investment ceiling on new investment” (Athukoralge, History of Pakistan , 2007).

Foreign Direct Investment (FDI) has been a small but growing part of total investment in Pakistan. Data indicates that FDI in Pakistan has grown from $8 million US dollars in 1976 to $346 million dollars in 1993. During the same period, total gross fixed capital formation grew from $2.4 to $9.2 Billion dollars (international Monetary Fund). Nevertheless, excluding the non-capital part, FDI is even a smaller part of total capital formation in Pakistan than these figures reflect (Kaynak, 1999).

General Musharraf vowed to make all out efforts to improve the deteriorating economic conditions in order to eradicate poverty and hunger in the country. The bank defined essential problem areas where urgent action is needed as: (1) Build investor confidence; (2) Structural change in fiscal policy; (3) Reduction in budget deficit to more sustainable level; (4) Address the national debt servicing issue; (5) Improve exports; (6) Population control; and (7) Improve human capital. Meanwhile, there is a very low flow of Foreign Direct Investment (FDI) into the country. The FDI peaked in 1996 to $992 Million and declined to $370 Million in 1999. Another report says that FDI amounted to around $600 Million in 1999; the figure is based on the difference between the amount of FDI stocks in 1998($9.2Billion) and 1999 ($9.8 Billion). However, this constituted 0.21 percent of FDI global flows ($4.7 Trillion). FDI stocks in Pakistan in 1999 represented 4.4 percent of its GDP (Mahmood, FDI History of Pakistan , 2001). Increased Foreign Direct Investment (FDI) increased to $3.5 Billion in the last financial year, according to GOP sources. The United Nation’s World Investment Report 2006 stated that Pakistan saw a 95% growth in FDI inflows in 2005 to reach $2.183 Billion (Mahmood, 2007).

Impact of Foreign Direct Investment

Attracting foreign direct investment (FDI) has become a key part of national development strategies for many countries. They see such investments as bolstering domestic capital, productivity, and employment, all of which are crucial to jump-starting economic growth. While many highlight FDI’s positive effects, others blame FDI for “crowding out” domestic investment and lowering certain regulatory standards. The effects of FDI can sometimes barely be perceived, while other times they can be absolutely transformative. While FDI’s impact depends on many conditions, well-developed and implemented policies can help maximize its gains.

The resources in this list focus on the impact of FDI on:

Economic growth: Foreign capital stocks combined with the widespread belief that FDI is beneficial for growth triggered a large body of literature on the determinants of FDI in the Central and Eastern European transition countries. The primary goal was to locate all relevant economic and political factors which could be beneficial for FDI inflows and, by extension, for economic growth(Neuhaus, 2005).

Trade: The direct impact falls into two parts, namely an immediate effect emanating from the actual investment and the effects on the import pattern of the targeted enterprises. The former channel is generally limited to the imports of initial inputs of imported machinery and equipment (especially in Greenfield investment), or, where FDI is large compared with the size of the host economy, it may include the knock-on effect on aggregate imports from rising total domestic demand. The second channel, which essentially depends on the investors’ choice between imported and local inputs, has been studied extensively(OECD, Direct Impact of FDI on Imports, 2002).

Employment and skill levels: In response to the AFL-CIO’s (American Federation of Labor and Congress of Industrial Organizations) earlier claim that job losses result from the impact of runaway firms setting up labor- intensive operations in offshore locations, the US tariff commission analyzed then- new data on the foreign operations of US firms. It found that employment gains generated from associated exports of equipment and parts, etc. and expansion of supporting non-production jobs would be large enough to offset possible job losses arising from production displacement effects(Neil Hood, 1979). In response to the latest concerns of the US labor unions, 23 studies have investigated the impact of FDI on employment. All except one have concluded that it has a positive effect resulting in the net increase of jobs(Lee, 2002).

Technology diffusion and knowledge transfer: Are of great importance for economic development, as the adoption of new techniques, machines, and production processes is a key determinant of productivity growth. Given that most research and development (R&D) and innovation is undertaken in high income countries, most developing economies must rely largely on imported technologies as sources of new productive knowledge. This is not to say that no R&D is undertaken in developing countries; a considerable amount of follow-on innovation and adaptation does occur there, contributing to the global stock of knowledge(Smarzynska Javorcik, 2006).

Linkages and spillover to domestic firms:

FDI spillovers: An increase in the productivity of domestic firms as a consequence of the presence of foreign firms in the domestic economy.

FDI spillovers via horizontal linkages: An increase in the productivity of domestic firms resulting from the presence of foreign firms in the same industry.

FDI spillovers via forward linkages: An increase in productivity resulting from the foreign presence among the supplies of the industry in which the domestic firm operates.

FDI spillovers via backward linkages: An increase in productivity resulting from the foreign presence among the customers of the industry in which the domestic firm operates.

These spillovers may take place among domestic firms but are more likely to occur with foreign affiliated firms given their linkages with large foreign parent companies. In the case of horizontal spillovers, there are not such incentives and firms would rather protect their intellectual assets rather than risk technology leakage to competitors (OECD, FDI spillover, 2008).

Types of Foreign Direct Investment

By Direction

Inward FDI: Inward foreign direct investment is when foreign capital is invested in local resources.

Inward FDI is encouraged by:

Tax breaks, subsidies, low interest loans, grants, lifting of certain restrictions

The thought is that the long term gain is worth short term loss of income

Inward FDI is restricted by:

Ownership restraints or limits

Different performance requirements

Outward FDI: Outward foreign direct investment, sometimes called “direct investment abroad” is when local capital is invested in foreign resources.

Outward FDI is encouraged by

Government-backed insurance to cover risk

Outward FDI is restricted by

Tax incentives or disincentives on firms that invest outside of the home country or on repatriated profits

Subsidies for local businesses

Leftist government policies that support the nationalization of industries (or at least a modicum of government control) Self-interested lobby groups and societal sectors who are supported by inward FDI or state investment, for example labor markets and agriculture. Security industries are often kept safe from outwards FDI to ensure the localized state control of the military industrial complex.

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By Target

Greenfield Investment: 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. Critics contrast this to local industries whose profits are seen to flow back entirely into the domestic economy (Easson, 2004).

Mergers and Acquisitions: Transfers of existing assets from local firms to foreign firms’ takes place; the primary type of FDI. Cross-border mergers occur when the assets and operation of firms from different countries are combined to establish a new legal entity. Cross-border acquisitions occur when the control of assets and operations is transferred from a local to a foreign company, with the local company becoming an affiliate of the foreign company. Unlike Greenfield investment, acquisitions provide no long term benefits to the local economy– even in most deals the owners of the local firm are paid in stock from the acquiring firm, meaning that the money from the sale could never reach the local economy. Nevertheless, mergers and acquisitions are a significant form acquiring firm, meaning that the money from the sale could never reach the local economy. Nevertheless, mergers and acquisitions are a significant form of FDI and until around 1997, accounted for nearly 90% of the FDI flow into the United States. Mergers are the most common way for multinationals to do FDI (Jonathan Jones, 2006).

Horizontal FDI: It refers to FDI in the same industry in which the organization in the home nation.

Vertical FDI: It refers to the FDI by an organization in order to sell the outputs of domestic firms to the investment which provides inputs to the domestic organization (Misra, 2009).

Backward Vertical FDI: Where an industry abroad provides inputs for a firm’s domestic production process.

Forward Vertical FDI: Where an industry abroad sells the outputs of a firm’s domestic production.

By Motive: FDI can also be categorized based on the motive behind the investment from the perspective of the following firm:

Resource-Seeking FDI

Investments which seek to acquire factors of production those are more efficient than those obtainable in the home economy of the firm. In some cases, these resources may not be available in the home economy at all (e.g. cheap labor and natural resources). This typifies FDI into developing countries, for example seeking natural resources in the Middle East and Africa, or cheap labor in Southeast Asia and Eastern Europe (Cohen, 2007). Market-Seeking FDI Investments which aim at either penetrating new markets or maintaining existing ones. FDI of this kind may also be employed as defensive strategy; it is argued that businesses are more likely to be pushed towards this type of investment out of fear of losing a market rather than discovering a new one .This type of FDI can be characterized by the foreign Mergers and Acquisitions in the 1980’s by Accounting, Advertising and Law firms (Cohen, Market-Seeking FDI , 2007). Efficient-Seeking FDI Investments which firms hope will increase their efficiency by exploiting the benefits of economies of scale and scope and also those of common ownership. It is suggested that this type of FDI comes after either resource or market seeking investments have been realized, with the expectation that it further increases the profitability of the firm. Typically, this type of FDI is mostly widely practiced between developed economies; especially those within closely integrated markets (Cohen, Efficiency-Seeking FDI, 2007). Strategic-Asset-Seeking FDI A tactical investment to prevent the loss of resource to a competitor. Easily compared to that of the oil producers, whom may not need the oil at present, but look to prevent their competitors from having it (OECD, Strategic-Asset-Seeking FDI , 2002). Political Oppositions to FDI In the late 1960s and early 1970s foreign direct investment became increasingly politicized. Organized labor, convinced that foreign investment exported jobs, undertook a major campaign to reform the tax provisions which affected foreign direct investment. The Foreign Trade and Investment Act of 1973 (or the Burke-Hartke Bill) would have eliminated both the tax credit and tax deferral. The Nixon Administration, influential members of Congress of both parties, and well-financed lobbying organizations came to the defense of the multinational. The massive counterattack of the multinational corporations and their allies defeated this first major challenge to their interests (Finance, 2006). Private Foreign Investment Few areas in the economics of development arouse so much controversy and are subject to such varying interpretations as the issue of the benefits and costs of private foreign investment. If, however, we look closely at this controversy, we will find that the disagreement is not so much about the influence of MNCs on traditional economics aggregate such as GDP, investment, savings, and manufacturing growth rates (though these disagreements do indeed exist) as about the fundamental economic and social meaning of development as it relates to the diverse activities of MNCs. In other words, the controversy over the role and impact of foreign private investment often has as its basis a fundamental disagreement about the nature, style, and character of a desirable development process (Todaro, 1989).

Components of FDI

The components of FDI are equity capital, reinvested earnings and intra-company loans:

Equity Capital

Equity in unincorporated entities, non-cash acquisition against technology transfer, plant and machinery, goodwill, business development and similar considerations control premium and non-competition fee (Components of FDI, 2004).The foreign direct investor’s net purchase of the share and loans of an enterprise in a country other than its own.

Reinvested Earnings

The part of an affiliates earnings accruing to the foreign investors that is reinvested in that enterprise.

Intra-company Loans (Other Capital)

Short or long-term loans, trade credit, supplier’s credit, financial-leasing, financial derivatives, debt securities from parent firms to affiliate enterprises or vice versa. In the case of banks, deposits, bills and short-term loans are not included.

1.5 Benefits of FDI:

The economic benefits of FDI are real, but they do not accrue automatically. To develop the maximum benefits from foreign corporate presence a healthy enabling environment for business is paramount, which encourages domestic as well as foreign investment, provides incentives for innovation and improvements of skills and contributes to a competitive corporate climate. The net benefits from FDI do not accrue automatically, and their magnitude differs according to host country and context. The magnitude of the benefits from FDI depends on the efforts of host countries to put in place the appropriate frameworks but even less-well performing countries may benefit, inter alia by using FDI as a supplement to scarce financial resources. The factors that hold back the full benefits of FDI in some developing countries include the level of general education and health, the technological level of host country enterprises, insufficient openness to trade, weak competition and inadequate regulatory frameworks. Conversely, a level of technological, educational and infrastructure achievement in a developing country does, other things being equal, equip it better to benefit from a foreign presence in its markets (OECD, Benefits of FDI, 2002)

The Perceived Benefits of FDI

A Zero-Sum Game: As with international trade, it is argued that the free movement of investment capital increases the aggregate sum of global wealth. FDI is not a zero-sum game. If capital is allowed to flow where its owners consider it can be employed most efficiently, then the highest return on capital will be achieved. Restrictions upon FDI necessarily result in the inefficient utilization of capital. This does not, of course, mean that everyone necessarily benefits from FDI- simply that the total benefit should outweigh the total detriment. Nor, of course, does if assume that capital will always be used efficiently- though it is assumed that restrictions upon FDI flows will result in less efficient utilization than if those restrictions did not exist. If one accepts that FDI produces a net benefit in global terms, then everyone should be happy so long as that benefit is shared fairly among the host country, the home country, the firm that undertakes it, and those persons most closely affected by the activities of the firm- its shareholders, customers, suppliers and workers (Easson, Benefits of FDI, 2004).

FDI from the perspective of home countries: FDI is gen


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