Foreign Direct Investment is defined as an investment of a resident in a foreign company. The resident should however have a lasting and considerable interest in the management of the foreign company. In most cases, an investor should have more than 10% of the stock value or voting shares.
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Flows relating to Foreign Direct Investment are chiefly divided into three forms that is, equity capital, intra-companies loan and reinvested earnings. Investors normally invest in the assets of foreign countries hoping that they will benefit from high interest rates, low inflation rates, as well as favorable political environment (Cutler, & Zacher, 1992).
A transnational Company has a parent company based in home country and one or more foreign affiliates based in foreign countries, commonly referred by scholars as host countries. Foreign affiliates are further divided into three categories based on the level of interest held by investors.
A subsidiary is a direct investment enterprise based in a foreign country in which an investor claims either 50% or more of the direct investment enterprise’s equity. Therefore, a non-resident owning 50% or more of a direct investment enterprise voting shares will most likely have considerable influence on direct investment enterprise management.
An associate is a direct investment enterprise based in a host country in which an individual or institutional investor owns at least 10% but not more than 50% of the voting powers of the direct investment enterprise. Voting powers is normally derived from equity shares one holds in a given incorporated enterprise, although at times partnerships and sole proprietorships may have equivalent voting powers.
On the other hand, a branch is an unincorporated direct investment enterprise in which an investor has full control over its operations. A branch, which is located in a host country, operates entirely using the name of its investor. It is put up for one or more years with the intention of producing certain goods or services. A branch is also subjected to income tax and tax exemptions.
Strategies used in Entering a Foreign Country
Direct foreign investments find their way in the host country economy via diverse strategies such as joint ventures, merger, acquisition, expansion investment, as well as Greenfield investment. A joint venture refers to a situation where two or more parties make a contractual agreement in which they agree to share losses and profits of a business.
They also agree to share capital formation and all costs associated with operating expenses. Joint ventures are normally formed for purposes of accomplishing certain objectives upon which the contract is terminated. In most cases, no new legal entity is created for purposes of undertaking joint activities. Mergers are created by two companies, which agree to operate as a single entity as opposed to operating separately.
Acquisition is a transaction that frequently takes place at the market where one firm acquires part or entire assets and liabilities of another firm. The acquired firm becomes either a subsidiary or part of the acquiring firm. For instance, Puma, which is based in France, acquired 25% of Reebok interests. The transaction made Reebok, which is based in Spain, part of Puma’s assets.
Another significant strategy for investing in a host country is through investment expansion. Investment expansion means investing assets in a foreign country. A resident might find some convincing reasons such as attractive market or cheap inputs to invest in a foreign economy.
Foreign Direct Investments and Market Trends
Recent researches indicate that transnational companies significantly participate in economic activities at local and international levels. In particular, they have significantly contributed to international trade, as well as improvement of technology. For several decades, Foreign Direct Investments continue to act as a source of finance for a number of third world countries.
From the past trend, it is estimated that the world economy will continue to grow because of increasing level of Direct Foreign Investment, as well as transnational companies. Currently, there are over 60,000 transnational companies worldwide with over 800,000 foreign affiliates distributed across the world.
The transnational companies are estimated to account for about two thirds of the global exports in which a third is attributed to intra-firm trading. The third world countries heavily rely on Foreign Direct Investments as their main source of external finance.
Categorization of FDI by Purpose
FDIs are better categorized through analyzing the motivating factor to invest in a foreign country. Investors spend their capital in a foreign country depending on a number of reasons including adequacy of raw materials, availability of technology, markets among others (Britton, 1996).
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A number of investors are attracted to foreign countries due to the existence of valuable natural resources. The common natural resources that investors tend to search for in foreign countries include oil, gas, minerals, forests and fish.
However, other agricultural products attract various investors, both individual and institutional investors. Foreign economies tend to have favorable weather and environments, with many natural resources.
A range of foreign investors target markets that are appealing to their products. Due to globalization, it has become easy for various firms to identify attracting markets for their products.
Presently, emerging markets such as Asia has attracted a good number of foreign investors since the market is adequate for various products. The European market is as well luring several reputable investors.
Efficiency in production
Growing levels of technology in the contemporary world is encouraging many companies to produce goods since relevant technology for its production processes is available.
Companies are dividing their production in accordance to comparative advantages existing in different regions. Technology enables a company to produce goods at relatively low operational costs. Such companies consider exporting their products at a comparatively cheap price in relation to their rivals.
Strategic assets such as brand names
Strategic assets that mostly attract individual and institutional investors include unique technology available at the market, specific brand name, specialized competencies, among other assets. To access such assets, companies will always form mergers with reputable foreign companies. Alternatively, they utilize other techniques such as thorough acquisition of small firms to penetrate foreign markets.
Benefits associated with inward FDI
FDI provides an economy with a source of external financing. As a nonprofessional may put it, when there is high numbers of Foreign Direct Investments, it is possible that an economy would benefit from high sources of external financing. Host countries also benefit from transfer of both hard and soft technology.
Soft technology is related to managerial skills and other organizational skills while hard technology refers to expertise associated with production processes. Host countries stand a good chance of benefiting from increased level of employment for its citizens, thus reducing the rates of unemployment (Vladimir, 2008).
Foreign companies help in promoting skills of the local residents through training. Apart from introducing new products, foreign investors also improve the quality of domestic goods and services. With the presence of foreign companies, the level of competition is likely to stiffen, which would encourage high levels of efficiency.
Domestic firms stand a chance of benefiting either directly or indirectly from foreign companies. For instance, they might use technologies used by foreign companies in manufacturing their products. Other foreign investors might provide direct financial assistance to local entities through partnerships and contracting.
With regard to foreign markets, direct investment enterprises enable a country to access international markets given that foreign enterprises manufacture brands that are exported to other nations.
Disadvantages of inward FDI
A hosting country is subjected to the risk of facing troubles associated with Balance of Payments. For instance, foreign direct enterprises normally import high levels of foreign inputs for their various projects, which pose threats associated with imbalanced accounts.
There also chances of crowding out local entities in which domestic entities would appear to face unfair market competition. Unfair competition is caused by efficiency and better performance depicted by foreign direct enterprises as opposed to local companies.
A host country is also exposed to problems associated with the use of foreign inputs greatly. Host economies at times face environmental degradation and employment devastation, especially when mergers and acquisitions take place (Holloway, 2006). Although a country expects to benefit from transfer of both soft and hard technology, it becomes contradicting that transfer of technology is limited in most cases.
FID mostly uses incentives to acquire market shares, which poses a threat to local companies since they fail to compete equally with the foreign companies. In addition, foreign enterprises embrace practices that hinder fair competition at local and foreign markets. FDI have contributed meager taxes locally as result of their transfer pricing.
Balance of Payments
Balance of Payments generally records all types of fiscal transactions between a given country and its trading partners within a specified period. It includes payment of imports and receipts of exports. A state recurrently exports and imports merchandise, services, fiscal assets and monetary transfers.
Balance of Payments accounts are prepared in domestic currency. Sources of funds for any country such as receipts of loans including investments, as well as exports are recorded as surplus. On the other hand, use of funds such as investment in foreign countries and payment of imports are recorded as deficits.
For a nation to maintain a Balance of Payment, summation of deficits and surplus should be zero. An imbalance however, occurs with capital and current account but hardly happens with reserves account. In a fixed exchange rate regime, the government would buy foreign reserves in an economy or provide foreign reserves to foreign exchange markets to maintain favorable exchange rates.
Current account indicates factor income, cash transfers and balance of trade. The balance of trade relates to the difference between exports and imports whereas factor income shows the difference between income earned from foreign investments and payments made to foreign investors.
Capital account is concerned about recording adjustments as regards to ownership of foreign assets. Capital account covers reserve account, investments and loans between a given nation and other trading partners. With capital account, interest payments and earnings on both loans and investments are excluded.
In many cases, reserves account is always recorded below capital account and therefore, it might be perceived as not forming part of the capital account. It is always expected that combination of current account and capital account will result to a balanced Balance of Payments, thus avoiding surpluses and deficits.
Current account + capital account = balancing Item
Effect of Foreign Direct Investments on Economy from a Balance of Payments Perspective
Foreign Direct Investments and Loan
It is a common event that Parent Company at times loans a subsidiary or a subsidiary loans a parent company. This is sometimes called inter-company loaning. If a subsidiary receives a loan from Mother Company, the host country will treat the transaction as receipt of funds and will be recorded in a capital account leading to increase in capital accounts.
In contrast, a drop will be recorded in the capital account of the parent company’s country. If the subsidiary loans the parent company, the host country will record a decrease in the capital account as a result of outflow of cash (Safarian, 1985).
The mother country will record an increase in capital account because of receipt of foreign reserves. The impact of loan on Balance of Payments accounts will depend on the size of the loan.
Foreign Direct Investments and Interest Rates
Dividends and interest earned on both loans, as well as equities affects the Balance of Payments current accounts. The Parent Company always charge a given interest for loans granted to its subsidiaries. Similarly, subsidiaries also impose interests on loans given to the Mother Company.
Interest imposed by a subsidiary on loan offered to the Mother Company is treated as a positive figure against the host country current account. The mother country treats the similar interest as negative figure against its current account given the fact that the Parent Company has to pay the foreign affiliate relevant interest imposed on the loan.
This transaction is therefore favorable to the host country and unfavorable to the mother country in relation to the current account. Conversely, if the parent company gives a loan to its foreign affiliate and charges a certain interest, a host country current account will decrease while the mother country current account will increase relative to the size of the loan, as well as the level of the interest rate charged.
Foreign Direct Investments and Dividends
Either an individual who owns preferred or ordinary shares of an incorporated company dividends is commonly paid shares of an incorporated company. Foreign affiliates have preferred and ordinary shares as well. For instance, an associate company has investors with a shareholding of between 10% and 50% while subsidiary has investors with a shareholding of 50% or more.
Dividends affect the current account of the Balance of Payments. Payment of dividends by a subsidiary to its investors based in mother countries leads to a reduction of the current account of the host country. The mother country treats payment of investors’ dividends by subsidiary as an increase in the current account.
It is therefore unfavorable for a host country to allow Foreign Direct Investments to engage in business considering that payment of dividends to foreign investors leads to decrease in its current account. However, it is more beneficial to the mother country since receipt of dividends by its citizens leads to increase in the current account.
Foreign Direct Investment and Capital Flight
Capital flight merely affects capital account. Capital flight has various definitions but the most appealing definition is the transfer of securities from a foreign country back to the home country or elsewhere due to fear of political risks or specific-country risks within the host country.
Investors who find host country policies unfavorable for their investments such as imposing high taxes on foreign assets find it prudent to invest elsewhere. High inflation rates, poor returns on assets, as well as unappealing exchange rates may force investors to transfer their capital elsewhere.
Capital flight leads to reduction of host country capital and thus reduction in the host country capital account. If an investor transfers capital back to his home country, the mother country will benefit through increased level of capital account.
However, the mother country capital account will likely remain at the same level considering that returns that were earned on capital while being invested in the foreign country will hardly be realized.
It therefore affects the current account negatively. On the other hand, although the host country will lose part of its capital account, it will not experience reduction in the current account since payments to foreign investors will have ceased.
Foreign Direct Investment and Reinvested Earnings
Parent companies have a variety of foreign affiliates ranging from subsidiaries to associates and branches. Parent companies sometimes find it prudent to allow foreign affiliates to invest back earned profits. As mentioned above, earnings of subsidiaries affect the current account.
A host country would gain from reinvestment by subsidiaries given that its Balance of Payments will increase. Conversely, reinvested earnings do not affect the Balance of Payments of the mother country. Transfer of profits to the home country would lead to an increase in the Balance of Payments of the mother country’s current account.
Foreign Direct Investment and Equity Capital
Individual and institutional investors in many circumstances invest in foreign equity capital. An investor who invests in equity capital benefits from either capital gains or dividends payment. Dividends are paid in a quarterly, semiannually, yearly basis or as per the agreement.
A host country always encourages foreign investments since various entities are equipped with sufficient capital to expand their operations, as well as upgrading their systems.
Increase in foreign investments means increase in foreign reserves and therefore increase in the host country capital account. The mother country will record a transfer of capital from its home country to the foreign country as a decrease in its level of capital account.
It is important for a nation to have a Balance of Payments that does not have deficits. Nonetheless, a Balance of Payments that has surplus would indicate that an economy is strong. To maintain a strong economy, a country should encourage inward Foreign Direct Investment.
This would expand its economy through advanced technology and increased employment, which favors the Balance of Payments. In addition, it should also encourage outward Foreign Direct Investment.
This would permit its citizen to earn better incomes on assets invested in foreign companies. Increased earnings lead to increase in the level of the current account. It is further concluded that foreign direct investment has both advantages and disadvantages.
Britton, N. (1996). Canada and the global economy: the geography of structural and technological change. Montreal: McGill-Queen’s Press.
Cutler, C., & Zacher, M. (1992). Canadian foreign policy and international economic regimes. Vancouver: UBC Press.
Holloway, S. (2006). Canadian foreign policy: defining the national interest. Toronto: University of Toronto Press.
Safarian, E. (1985). Foreign direct investment: a survey of Canadian research. Montreal: IRPP.
Vladimir, K. (2008). Show Me the Money: Access to Finance for Small Borrowers in Canada. York: International Monetary Fund.