Foreign Direct Investment Meaning, Types

Table of Contents:-

  • Meaning of Foreign Direct Investment
  • Definition of Foreign Direct Investment
  • Determinants of FDI

Meaning of Foreign Direct Investment

It refers to an investment made by a company based in one country, into a company based in another country. Foreign direct investment means cross-border investment made by a resident in one economy in an enterprise in another economy, to establish a lasting interest in the investee economy.

Foreign direct investment (FDI) is allowed through various investment channels, but it is not limited to the following forms of investments:

1) Through joint ventures, technical and financial collaborations.
2) Through capital markets via Euro issues,
3) Through private placement or preferential allotments.

When forming objectives and implementing strategies in a variety of country environments for FDI, firms must either handle international business operations on their own or collaborate with other companies. Direct investment in the foreign market ranges from wholly owned operations to partially owned subsidiaries, joint ventures, equity alliances, licensing, franchising, management contracts, and turnkey operations. Two types of foreign direct investment (FDI) do not involve collaboration between wholly-owned operations and partially-owned operations with the remainder widely held.

Definition of Foreign Direct Investment

According to the International Monetary Fund’s Balance of Payments, Manual, “FDI is an investment that is made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor, the investor’s purpose being to have an effective voice in the management of the enterprise”.

According to the United Nation’s World Investment Report (UNCTAD, 1999), “FDI is an investment involving a long-term relationship and reflecting a lasting interest and control of a resident entity in one economy (foreign direct investor or parent’ enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDI enterprise, affiliate enterprise or foreign affiliate)”.

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Determinants of FDI

The volume of foreign direct investment (FDI) in a country depends upon several following factors:

  1. Return and Risk
  2. Natural Resources
  3. Rate of Return on the Underlying Project
  4. Market Size
  5. Availability of Cheap Labour
  6. Political Situation
  7. Need for Internalisation
  8. International Immobility of Factors of Production
  9. Socio-Economic Conditions
  10. Strategic and Long-term Factors

1) Return and Risk

When the assumption of risk neutrality is relaxed, the risk becomes another variable upon which the FDI decision is made. If this proposition is accepted, then the differential rates of return hypothesis become inadequate, in which case we resort to the diversification (or portfolio) hypothesis to explain FDI.

2) Natural Resources

The availability of natural resources in the host country is a major determinant of FDI. Most foreign investors seek an adequate, reliable and economical sourer of minerals and other metals FDI tends to flow in countries that are rich in resources but lack the technical skills, capital and infrastructure required for the exploitation of natural resources. Though their relative importance has declined, the availability of natural resources continues to be an important determinant of POL

3) Rate of Return on the Underlying Project

The differential rates of return hypothesis represent one of the first attempts to explain FDI flows. This hypothesis postulates that capital flows from countries with low rates of return to countries with high rates of return occur in a manner that ultimately results in the equalization of ex-ante real rates of return.

4) Market Size

The volume of FDI in a host country depends on its market size. This hypothesis is particularly valid for the case of import-substituting foreign direct investment (FDI). As soon as the size of the market of a particular country has grown to a level warranting the exploitation of economies of scale, it becomes an attractive prospect for foreign direct investment (FDI) inflows.

5) Availability of Cheap Labour

The availability of low-cost skilled labour has been a major case of FDI in countries like China and India. Low-cost labour together with the availability of cheap new materials enables foreign investors to minimise costs of production and thereby increase profits.

6) Political Situation

Political stability, legal framework, judicial system, relations with other countries and other political environment factors influence the movements of capital from one country to another.

7) Need for Internalisation

According to the internalisation hypothesis, FDI arises from efforts by firms to replace market transactions with internal transactions. For example, firms often encounter challenges when purchasing oil products from the market. In such a case firms may decide to acquire a foreign refinery. These problems arise from imperfections and failure of markets for intermediate goods, including human capital, and knowledge marketing and management expertise.

8) International Immobility of Factors of Production

According to the location hypothesis, FDI exists because of the international immobility of some factors of production such as labour and natural resources This immobility leads to location-related differences in the costs of factors of production.

9) Socio-Economic Conditions

The size of the population, infrastructural facilities and income level of a country influence direct foreign investment.

10) Strategic and Long-Term Factors

Some strategic and long-term factors have been put forward to explain FDI. These factors include the following:

i) The desire to gain and maintain a foothold in a protected market or to gain and maintain a source of supply that may prove useful in the long run.

ii) The desire to induce the host country into a long commitment to a particular type of technology.

iii) The desire on the part of the investor to defend existing foreign markets and foreign investments against competitors.

iv) The need to develop and sustain a parent-subsidiary relationship.

v) Competition for market shares among oligopolists and the concern for strengthening bargaining positions.

vi) The advantage of complementing another type of investment.

vii) The economies of new product development.

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