Foreign Direct Investment: Advantages and Disadvantages

FDI is defined as the purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control. It can be through Greenfield investment where an organisation invests in buildings or plants in a foreign country to runs its business from. FDI can also be from international mergers and acquisition activity where an organisation runs a subsidiary in a foreign country, which is seen as the preferred option in most cases as the subsidiary will already have established facilities and workforce and a presence in the country.

FDI has largely grown in the past few decades as a result of increased international trade, removal of capital controls, growth of multinational business and their needs of funding, world economy becoming more interdependent and closer financial links between countries as well as greater integration of their financial markets. However Global FDI declined in 2012, mainly due to continued macroeconomic fragility and policy uncertainty for investors and it is forecast to rise only moderately over the next two years, but this global picture is only part of it. For the first time ever developing economies absorbed more FDI than developed countries ($142billion more), with four developing economies ranked among the five largest recipients in the world. Previously they were avoided because of their weak markets and political uncertainty and corruption but in recent years a number of developing regions, such as Asia, attracted high amounts in FDI as a result of having to offer specific beneficial characteristics such as rich natural resources, cheap labour, low corporation tax rates. Furthermore, developing countries also generated almost one third of global FDI outflows, continuing an upward trend that looks set to continue.

Developing countries encourage FDI to obtain overseas resources, increase access to return markets, increase local capital markets and drive economic growth. Developing countries that attract FDI potentially benefit from resource transfer, including capital, technologies, management skills and ‘know how’ as well as increased number of employment spaces. This provides further benefits in the form of tax for that country, its government and society. Additionally, different organisations entering the same country may increase the quality of trading as part of competition, which would also potentially benefit the society.

The growth of FDI has led to a greatly increased role that Transnational Companies (TNC) now play in international production. TNC FDI has increased rapidly in the past decade due to government policy liberalisation, rapid technology changes and increased global competition for new markets. In 2005 they accounted for 10%, 17% and 13% respectively of the estimated foreign assets, sales and employment of all TNC’s worldwide with the top 10 having approximately $1.7 trillion in foreign assets (36% from the top 100) however this has slowed since 2011/12.

FDI flows for 2012 and 2013 were close but as macroeconomic conditions improve and investors regain confidence in the medium term, TNC’s may convert their record levels of cash holdings into new investments. FDI flows could then reach up to $1.8 trillion in 2015. Nevertheless, significant risks exists that could continue to affect FDI levels including structural weaknesses in the global financial system, weaker growth in the EU and significant policy uncertainty in areas crucial for investor confidence.

India is one of the world's fastest growing major economies and needs foreign capital to boost infrastructure and sustain economic growth at its near-double-digit targets. Regulatory uncertainty and bureaucratic hurdles, however, have contributed to a slowdown in inbound investment. However, India has recently become more of a target for companies for FDI especially since the commercialisation of banks and the revised allowance of FDI in additional sectors previously not available for example 100% ownership in the telecoms sectors versus the previous 74%. There have also been talks recently that India is to open its state-run railways for FDI to expand its networks and modernise its operations. A top official was quoted recently that the Indian government was to open 100% FDI in railways and are looking to attain $10billion in FDI over the next five years to improve and expand its infrastructure, spanning suburban corridors, high speed trains and freight corridors. India once had tough investment rules and had to be approved by the government but since they have eased their FDI rules this could boost the FDI India needs. 

However, the benefits for the host country for FDI may not be as beneficial and sustainable as first believed. FDI would be thought to increase capital, technology skills and knowhow to the county but large multinational corporations often have an adverse effect in the country as many local companies that are already apparent cannot compete with these corporations due to the power and brand strength they maintain so local business’ will close and the amount of people losing their job compared to the new ones that are created is greater. 

They can also impact on government decisions due to the economic power these corporations have which could potentially result in the loss of autonomy. There activities could also impact and lead to environmental damage of the local regions, human right implications, corruption, political conflicts and other issues. One of the examples could be BP and its activities in foreign countries (it had the biggest FDI in India with a $7.2billion tie uo with the country’s Reliance Industries) ,where a number of disasters caused damage to local environment and societies, including the oil spill in Mexico.

These corporations also often only invest in foreign subsidiaries to exploit local resources, avoid transportation costs and for cheaper employment rates. So once these resources are used up or a better alternative is found they will move their activities elsewhere leaving a weakened and vulnerable economy behind. 

Therefore for FDI to be seen successful, it needs to benefit both the MNC and the host country where it wishes to operate. 

But why do companies choose FDI and take the cost and risks of it, instead of perhaps exporting domestic production or licensing the right to manufacture its product to an overseas company or even franchise its operations to a foreign company? Most theories discuss (however not necessarily explain) that companies choose FDI for a number of reasons, including seeking new markets, raw materials, product efficiency, knowledge or/and political safety. 

The main reason why many companies choose FDI instead of transporting its goods is because of potentially high transportation costs especially goods that are low in value and high in weight that can be easily produced anywhere for example cement. 

Other reason of why FDI may be preferred, especially over licensing, is the risk associated with selling the ‘know-how’ and potentially loss of competitive advantage. If a company has a high competitive advantage through technology, management, marketing or product itself, giving a license to another company and transferring the knowledge may result in that company creating itself a direct competitor and often losing out to this ‘new’ competitor who exploits the knowledge. 

Finally, companies may choose FDI because of the advantages of a particular location (e.g. oil, cheap labour) so is necessary to combine the overseas resource and the firm’s assets with the advantages of maintaining the ownership of its special assets (e.g. brand, technical knowledge or management ability).