Foreign Direct Investments (FDI) - Pros and Cons

The role of foreign direct investment (FDI) in promoting growth and sustainable development has never been
substantiated. There isn't even an agreed definition of the beast. In most developing countries, other capital flows -
such as remittances - are larger and more predictable than FDI and ODA (Official Development Assistance).

Several studies indicate that domestic investment projects have more beneficial trickle-down effects on local
economies. Be that as it may, close to two-thirds of FDI is among rich countries and in the form of mergers and
acquisitions (M&A). All said and done, FDI constitutes a mere 2% of global GDP.

FDI does not automatically translate to net foreign exchange inflows. To start with, many multinational and
transnational "investors" borrow money locally at favorable interest rates and thus finance their projects. This
constitutes unfair competition with local firms and crowds the domestic private sector out of the credit markets,
displacing its investments in the process.

Many transnational corporations are net consumers of savings, draining the local pool and leaving other
entrepreneurs high and dry. Foreign banks tend to collude in this reallocation of financial wherewithal by
exclusively catering to the needs of the less risky segments of the business scene (read: foreign investors).

Additionally, the more profitable the project, the smaller the net inflow of foreign funds. In some developing
countries, profits repatriated by multinationals exceed total FDI. This untoward outcome is exacerbated by principal
and interest repayments where investments are financed with debt and by the outflow of royalties, dividends, and
fees. This is not to mention the sucking sound produced by quasi-legal and outright illegal practices such as transfer
pricing and other mutations of creative accounting.

Moreover, most developing countries are no longer in need of foreign exchange. "Third and fourth world" countries
control three quarters of the global pool of foreign exchange reserves. The "poor" (the South) now lend to the rich
(the North) and are in the enviable position of net creditors. The West drains the bulk of the savings of the South and
East, mostly in order to finance the insatiable consumption of its denizens and to prop up a variety of indigenous
asset bubbles.

Still, as any first year student of orthodox economics would tell you, FDI is not about foreign exchange. FDI
encourages the transfer of management skills, intellectual property, and technology. It creates jobs and improves the
quality of goods and services produced in the economy. Above all, it gives a boost to the export sector.

All more or less true. Yet, the proponents of FDI get their causes and effects in a tangle. FDI does not foster growth
and stability. It follows both. Foreign investors are attracted to success stories, they are drawn to countries already
growing, politically stable, and with a sizable purchasing power.

Foreign investors of all stripes jump ship with the first sign of contagion, unrest, and declining fortunes. In this
respect, FDI and portfolio investment are equally unreliable. Studies have demonstrated how multinationals hurry to
repatriate earnings and repay inter-firm loans with the early harbingers of trouble. FDI is, therefore, partly pro-
cyclical.

What about employment? Is FDI the panacea it is made out to be?

Far from it. Foreign-owned projects are capital-intensive and labor-efficient. They invest in machinery and
intellectual property, not in wages. Skilled workers get paid well above the local norm, all others languish. Most
multinationals employ subcontractors and these, to do their job, frequently haul entire workforces across continents.
The natives rarely benefit and when they do find employment it is short-term and badly paid. M&A, which, as you
may recall, constitute 60-70% of all FDI are notorious for inexorably generating job losses.
FDI buttresses the government's budgetary bottom line but developing countries invariably being governed by
kleptocracies, most of the money tends to vanish in deep pockets, greased palms, and Swiss or Cypriot bank
accounts. Such "contributions" to the hitherto impoverished economy tend to inflate asset bubbles (mainly in real
estate) and prolong unsustainable and pernicious consumption booms followed by painful busts.

Definition
Foreign direct investment (FDI) plays an extraordinary and growing role in global business. It can provide a firm
with new markets and marketing channels, cheaper production facilities, access to new technology, products, skills
and financing. For a host country or the foreign firm which receives the investment, it can provide a source of new
technologies, capital, processes, products, organizational technologies and management skills, and as such can
provide a strong impetus to economic development.   Foreign direct investment, in its classic definition, is defined
as 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. 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,   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. The sea change in trade and investment
policies and the regulatory environment globally in the past decade, including trade policy and tariff liberalization,
easing of restrictions on foreign investment and acquisition in many nations, and the deregulation and privitazation
of many industries, has probably been been the most significant catalyst for FDI’s expanded role.

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
(Source: UNCTAD)

Proponents of foreign investment point out that the exchange of investment flows benefits both the home country
(the country from which the investment originates) and the host country (the destination of the investment).
Opponents of FDI note that multinational conglomerates are able to wield great power over smaller and weaker
economies and can drive out much local competition. The truth lies somewhere in the middle.

For small and medium sized companies, FDI represents an opportunity to become more actively involved in
international business activities. In the past 15 years, the classic definition of FDI as noted above has changed
considerably. This notion of a change in the classic definition, however, must be kept in the proper context. Very
clearly, over 2/3 of direct foreign investment is still made in the form of fixtures, machinery, equipment and
buildings. Moreover, larger multinational corporations and conglomerates still make the overwhelming percentage
of FDI. But, with the advent of the Internet, the increasing role of technology, loosening of direct investment
restrictions in many markets and decreasing communication costs means that newer, non-traditional forms of
investment will play an important role in the future.   Many governments, especially in industrialized and developed
nations, pay very close attention to foreign direct investment because the investment flows into and out of their
economies can and does have a significant impact.  In the United States, the Bureau of Economic Analysis, a section
of the U.S. Department of Commerce, is responsible for collecting economic data about the economy including
information about foreign direct investment flows.  Monitoring this data is very helpful in trying to determine the
impact of such investments on the overall economy, but is especially helpful in evaluating industry segments. State
and local governments watch closely because they want to track their foreign investment attraction programs for
successful outcomes.

How Has FDI Changed in the Past Decade? 

As mentioned above, the overwhelming majority of foreign direct investment is made in the form of fixtures,
machinery, equipment and buildings. This investment is achieved or accomplished mostly via mergers &
acquisitions. In the case of traditional manufacturing, this has been the primary mechanism for investment and it has
been heretofore very efficient. Within the past decade, however, there has been a dramatic increase in the number of
technology startups and this, together with the rise in prominence of Internet usage, has fostered increasing changes
in foreign investment patterns. Many of these high tech startups are very small companies that have grown out of
research & development projects often affiliated with major universities and with some government sponsorship.
Unlike traditional manufacturers, many of these companies do not require huge manufacturing plants and immense
warehouses to store inventory. Another factor to consider is the number of companies whose primary product is an
intellectual property right such as a software program or a software-based technology or process. Companies such as
these can be housed almost anywhere and therefore making a capital investment in them does not require huge
outlays for fixtures, machinery and plants.

In many cases, large companies still play a dominant role in investment activities in small, high tech oriented
companies. However, unlike in the past, these larger companies are not necessarily acquiring smaller companies
outright. There are several reasons for this, but the most important one is most likely the risk associated with such
high tech ventures. In the case of mature industries, the products are well defined. The manufacturer usually wants
to get closer to its foreign market or wants to circumvent some trade barrier by making a direct foreign investment.
The major risk here is that you do not sell enough of the product that you manufactured. However, you have added
additional capacity and in the case of multinational corporations this capacity can be used in a variety of ways.

High tech ventures tend to have longer incubation periods. That is, the product tends to require significant
development time. In the case of software and other intellectual property type products, the product is constantly
changing even before it hits the marketplace. This makes the investment decision more complicated. When you
invest in fixtures and machinery, you know what the real and book value of your investment will be. When you
invest in a high tech venture, there is always an element of uncertainty. Unfortunately, the recent spate of dot.com
failures is quite illustrative of this point.

Therefore, the expanded role of technology and intellectual property has changed the foreign direct investment
playing field. Companies are still motivated to make foreign investments, but because of the vagaries of technology
investments, they are now finding new vehicles to accomplish their goals. Consider the following:

Licensing and technology transfer. Licensing and tech transfer have been essential in promoting collaboration
between the academic and business communities. Ever since legal hurdles were removed that allowed
universities to hold title to research and development done in their labs, licensing agreements have helped turned
raw technology into finished products that are viable in competitive marketplaces. With some help from a
variety of government agencies in the form of grants for R&D as well as other financial assistance for such
things as incubator programs, once timid college researchers are now stepping out and becoming cutting edge
entrepreneurs. These strategic alliances have had a serious impact in several high tech industries, including but
not limited to: medical and agricultural biotechnology, computer software engineering, telecommunications,
advanced materials processing, ceramics, thin materials processing, photonics, digital multimedia production and
publishing, optics and imaging and robotics and automation. Industry clusters are now growing up around the
university labs where their derivative technologies were first discovered and nurtured. Licensing agreements
allow companies to take full advantage of new and exciting technologies while limiting their overall risk to
royalty payments until a particular technology is fully developed and thus ready to put new products into the
 manufacturing pipeline.
Reciprocal distribution agreements. Actually, this type of strategic alliance is more trade-based, but in a very
real sense it does in fact represent a type of direct investment. Basically, two companies, usually within the same
or affiliated industries, agree to act as a national distributor for each other’s products. The classical example is to
be found in the furniture industry. A U.S.-based manufacturer of tables signs a reciprocal distribution agreement
with a Spanish-based manufacturer of chairs. Both companies gain direct access to the other’s distribution
network without having to pay distributor support payments and other related expenses found within the
distribution channel and neither company can hurt the other’s market for its products. Without such an
agreement in place, the Spanish manufacturer might very well have to invest in a national sales office to
coordinate its distributor network, manage warehousing, inventory and shipping as well as to handle
administrative tasks such as accounting, public relations and advertising.
Joint venture and other hybrid strategic alliances. The more traditional joint venture is bi-lateral, that is it
involves two parties who are within the same industry who are partnering for some strategic advantage. Typical
reasons might include a need for access to proprietary technology that might tip the competitive edge in another
competitor’s favor, desire to gain access to intellectual capital in the form of ultra-expensive human resources,
access to heretofore closed channels of distribution in key regions of the world. One very good reason why many
joint ventures only involve two parties is the difficulty in integrating different corporate cultures. With two
domestic companies from the same country, it would still be very difficult. However, with two companies from
different cultures, it is almost impossible at times. This is probably why pure joint ventures have a fairly high
failure rate only five years after inception. Joint ventures involving three or more parties are usually called
syndicates and are most often formed for specific projects such as large construction or public works projects
that might involve a wide variety of expertise and resources for successful completion. In some cases, syndicates
are actually easier to manage because the project itself sets certain limits on each party and close cooperation is
not always a prerequisite for ultimate success of the endeavor.
Portfolio investment. Yes, we know that you’re paying attention and no we’re not trying to trip you up here.
Remember our definition of foreign direct investment as it pertains to controlling interest. For most of the latter
part of the 20th century when FDI became an issue, a company’s portfolio investments were not considered a
direct investment if the amount of stock and/or capital was not enough to garner a significant voting interest
amongst shareholders or owners. However, two or three companies with "soft" investments in another company
could find some mutual interests and use their shareholder power effectively for management control. This is
another form of strategic alliance, sometimes called "shadow alliances". So, while most company portfolio
investments do not strictly qualify as a direct foreign investment, there are instances within a certain context that
they are in fact a real direct investment.

Why is FDI important for any consideration of going global?

The simple answer is that making a direct foreign investment allows companies to accomplish several tasks:

Avoiding foreign government pressure for local production.

Circumventing trade barriers, hidden and otherwise.
Making the move from domestic export sales to a locally-based national sales office.
Capability to increase total production capacity.
Opportunities for co-production, joint ventures with local partners, joint marketing arrangements, licensing, etc;

A more complete response might address the issue of global business partnering in very general terms. While it is
nice that many business writers like the expression, “think globally, act locally”, this often used cliché does not
really mean very much to the average business executive in a small and medium sized company. The phrase does
have significant connotations for multinational corporations. But for executives in SME’s, it is still just another
buzzword. The simple explanation for this is the difference in perspective between executives of multinational
corporations and small and medium sized companies. Multinational corporations are almost always concerned with
worldwide manufacturing capacity and proximity to major markets. Small and medium sized companies tend to be
more concerned with selling their products in overseas markets. The advent of the Internet has ushered in a new and
very different mindset that tends to focus more on access issues. SME’s in particular are now focusing on access to
markets, access to expertise and most of all access to technology.

What would be some of the basic requirements for companies considering a foreign investment?

Depending on the industry sector and type of business, a foreign direct investment may be an attractive and viable
option. With rapid globalization of many industries and vertical integration rapidly taking place on a global level, at
a minimum a firm needs to keep abreast of global trends in their industry. From a competitive standpoint, it is
important to be aware of whether a company’s competitors are expanding into a foreign market and how they are
doing that. At the same time, it also becomes important to monitor how globalization is affecting domestic clients.
Often, it becomes imperative to follow the expansion of key clients overseas if an active business relationship is to
be maintained.

New market access is also another major reason to invest in a foreign country. At some stage, export of product or
service reaches a critical mass of amount and cost where foreign production or location begins to be more cost
effective. Any decision on investing is thus a combination of a number of key factors including:

assessment of internal resources,

competitiveness,
market analysis
market expectations.

Types
A foreign direct investor may be classified in any sector of the economy and could be any one of
the following:

 an individual;
 a group of related individuals;
 an incorporated or unincorporated entity;
 a public company or private company;
 a group of related enterprises;
 a government body;
 an estate (law), trust or other societal organisation; or
 any combination of the above.