Overview
Foreign Direct Investment (FDI) is a popular investment option adopted by firms in the contemporary business environment. This form of investment stream occurs when a firm decides to assume partial ownership of either a company stock or physical assets in a foreign country.
Besides, this business manoeuvre enables a firm undertaking FDI to gain a significant measure of controlling its management systems and structures. Although portfolio management and FDI are close and interrelated terms, they are quite distinct in the sense that the former does not permit any tangible degree of securing company control.
On an international scale, the inflow in FDI is often considered to start from ten percent of ownership of stocks or assets of a foreign company. In order to accomplish FDI projects, special arrangements such as mergers and acquisitions have to be effected. Alternatively, international franchising can also be used as a channel of attaining the FDI goals.
Contrary to the common perception, FDI by firms may not only flourish in economies that are in transition, but also in those economies that are emerging.
For this reason, the percentage growth of firms wishing to invest in other countries has steadily grown due to such factors like highly skilled and low cost labour resources, wider marketing base compared to the domestic economy, readily available natural resources, stable political environment as well as geographical advantage. This paper seeks to explore the key motives why firms engage in FDI in both developed and developing host countries.
Resource seeking
Empirical based research has conclusively established that the desire to seek resources is one of the driving motives why a firm would engage itself in Foreign Direct Investment (Bjorvatn & Eckel, 2006).
A company may be prompted to secure its investment abroad since the domestic ground is either too costly or lacks the relevant factors of production. It is vital to note that skilled and unskilled labour or advances in technology may markedly escalate the cost of production at the domestic level therefore leading to low returns. On the other hand, advances in technology or managerial capabilities may not be accounted for when seeking to invest abroad since such resources can be accessed readily at home though at a higher cost.
Hence, assets that are non market in nature are of utmost importance when carrying out FDI since it is impossible to transfer them through transactions. For instance, a firm may not be in a position to import high skilled and affordable labour at will owing to economic and political barriers at hand (Grossman et al., 2006).
On the other side, FDI undertakings that aim at seeking skilled labor may also demonstrate unique characteristics and patterns related to spill over in production. In other words, resource seeking FDI whether in terms of human labour or other natural factors of production such as land have equal implications and meaning to the firm in question.
The bigger picture is to obtain relatively cheap resources that can lower production costs while maximizing returns. Although resource seeking FDI may sound quite familiar with international outsourcing or better still international trade, the two elements are indeed part and parcel of investment portfolio under FDI.
In a related development, economists have used the term outsourcing with sparingly diverging meanings. In some instances, it has been used to infer to international partnerships (Eckel, 2003) while others have applied it to mean circumstances whereby companies resort to international markets to obtain intermediate inputs (Van Long, 2005).
Market seeking
Another reason why firms will undertake FDI is to seek markets for their products. A foreign market may be more appealing to a firm than the domestic one.
For instance, the host country may be supplied with the needed goods and services through the process of FDI. In particular, these may be company products that are either not available at the target market or a superior substitutes to the existing products. Besides, the foreign market can also attract consumers from the adjacent countries, thereby widening the marketing portfolio further (Driffield & Love, 2007).
Nonetheless, this form of FDI is underpinned by one main challenge in the sense that the marketing points being targeted in the foreign country may not be compatible with the location where FDI is to be undertaken. In any case, both direct and indirect can be used to carry out FDI.
In the first scenario, the host country is used as the ground for exploiting the available market. However, when the host country is used as a platform to seek other markets, it is referred to as indirect market seeking FDI. This characteristic way of exploiting the host country be seeking other adjacent marketing opportunities can also be classified as export-platform Foreign Direct Investment.
When seeking foreign markets in FDI, there are two important considerations that entrepreneurial firms have to bear in mind (Nunnenkamp & Spatz, 2002). Firstly, the prevailing economic and political factor that may affect the process of exporting goods and services from the host country especially in the case of indirect marketing is important. Secondly, the level of appropriateness in the production process is also paramount.
The host country can benefit a lot from market seeking FDI in a variety of ways. For instance, the introduction of new products and services into the new market is deemed beneficial since it will narrow down the gap as far as consumer needs are concerned. In addition, the local production is bound to go through the process of modernization.
Better methods of production will be realized in the host country. this can be explained from the fact the prevalence of competition among various firms producing similar products will be heightened.
Hence, each firm will endeavour to produce the best in a bid to capture and maintain market leadership. Nonetheless, fierce competition can also jeopardize a favourable marketing environment when local competitors crowd up for a single market. This will especially be inevitable if a larger share of the market is dominated by the foreign affiliates.
In addition, the balance of payment for the host country may be unfavourable especially in the event the situation persists for long. This will be occasioned when funds are repatriated bearing in mind that market seeking FDI is not concerned with income generation from exports. Therefore, the impact of growth brought about by efficiency seeking Foreign Direct Investment is quite stronger than this form of FDI.
Non marketable asset seeking
A business enterprise may also participate in FDI in order to accrue the benefits that arise from non-transferrable assets that cannot be transacted in the normal way (Hummels, 2007).
The characterization of such non-transferrable assets is such that they can be exploited within the target country. as a result, the firm can only benefit from this type of asset by directly investing in the host country. That is the only way through which the asset can be accessed.
Firstly, this form of FD target can be put in place through the process of agglomeration. In such as case, proximity to other companies is a crucial consideration to make before setting up the project.
Thus, the localization of the FDI will largely depends on this factor. Realistically speaking, a firm will often prefer to locate where there is a cluster of other companies so that it can be in a better position to create better linkages with key payers in its production. For example, consumers and suppliers in addition to the availability of the market endowed with adequate labour as well as spill over in technology are some of the open end benefits in this type of FDI (Bevan & Estrin, 2000).
In the case of technology, it cannot be transferred across the border without losing some value especially if it was constructed using local unique skills and competences. As consequence, a firm has to relocate some of its operations overseas in order to reap the optimum benefit of the asset whose value cannot be transferred from one location to another without losing its value.
As mentioned earlier, Foreign Direct Investment (FDI) is basically capital flow on an international level and foreign affiliates can be controlled by the mother company. With such, it implies that matters related to foreign exchange can significantly impact any FDI arrangement in place, bearing in mind the unstable nature of currency exchange rates across the globe. Perhaps, it would be pragmatic to first of all define the term.
Exchange rate is the relative value of the domestic currency compared to the price of the foreign currency. At times, exchange rates can impact FDI in totality as well as the allocation of this type of investment in multiple countries. For example, currency depreciation, the movement in exchange rate can influence FDI in two major ways. To start with, it brings about wage reduction in a country alongside lowering the cost of production compared to those of its affiliates abroad.
Hence, it is definite that when exchange rate depreciates, the overall return of foreign investors will improve. However, there are quite a number of considerations worth noting when discussing exchange rate level and its effect on foreign investment. It is against this backdrop that forms will opt to invest in both developed and developing countries that are experiencing continual fluctuations in currency exchange rates.
It is indeed a financial windfall to firms running FDI in countries where the exchange rate is grossly volatile since the major factors of production and other associated financial overheads will be reduced accordingly. This remains to be a very strong motive why forms will invest in overseas countries. Nonetheless, it should be noted that when currency exchange rates appreciate, the reverse effect on FDI is inevitable. Therefore, firms should always brace themselves for harder economic times or reduced returns in during such eventualities.
The Efficiency seeking FDI
One if the most important questions in international economics literature remain to be the effect of FDI on economies which host them. Firstly, there has been concern on the benefits that accompany FDI on the host economy and whether such benefits can boost production at the local level.
Secondly, concerns have also been raised over the possible costs that the domestic firms undergo when foreign multinationals secure their place in the local market (BenassyQuere et al., 2001). Although these are pertinent questions worth inquiring, the multinationals seeking Direct Foreign Investment often do not consider these queries beforehand since it is by far and large the concern of the host country.
In spite of this, local conditions often streamline their operations even as they seek to improve efficient abroad. For instance, production efficiency is likely to be enjoyed by the nature of the economies in both developed and developing economies which are often open to accommodate foreign investment.
Moreover, the institutional framework in place is also yet another boosting factor that sees into it that efficiency is attained by foreign firms engaging in FDI.
This framework may be in form of the existing legislations such as hustle-free registration process, minimal certification requirements as well as optimal support from the government of the day.
Operational efficiency that is being sought by an FDI firm can also be easily attained due to the prevalence of technology gap especially in developing economies.
Firms investing in countries that do have substantial technology base at their disposal may not only enjoy competitive advantage, it will also have the opportunity to improve its production efficiency since the immediate market rivals will still be lagging behind. In a similar development, efficiency in production will be at its peak owing to the competence and skill level of the available human resource.
There are quite a number of literature and empirical studies that have vividly documented the efficiency benefits at the disposal of foreign multinationals in addition to the degree of spillovers in target countries.
Trade effects
Foreign firms often have the opportunity of enjoying numerous trade benefits when operating under FDI. For instance, trade protection measures as well as certain host country restrictions may not affect the operations o Multi-national Corporations (MNCs). Although adequate literature that attempts to link trade effects with FDI motivation are not readily available, foreign companies have myriad of trade benefits compared to their domestic competitors (Glass, 2004). One outstanding benefit is the chance to serve the oversea market.
This is attributed to the fact that products manufactured by these firms do not necessarily go through the normal channels of distribution in the process of marketing and hence are not sensitive to trade barriers prevalent in the host country. however, in the market seeking FDI, the impact is negative. It is only through the resource seeking FDI that the impact is impressive since the escalated trade costs are mainly common when products are moving across countries.
Institutions
Foreign forms are bound to benefit greatly when they operate in host countries where the management of important institutions is sound enough (BenassyQuere et al., 2007). These institutions can be divided into two main categories. Firstly, those those are sensitive to socio-political factors like infrastructure and governance and those that touch on technological platform. There is sufficient evidence that well established institutions have led to improved inflows of Foreign Direct Investment.
Firstly, the development of infrastructure such as Information and Communication Technology and the transport sector has been attracting foreign firms to invest directly both n developing and developed economies (Cantwell & Mudambi, 2005). Nonetheless, it is needful to point out that resource seeking FDI may not have any impact in this regard since skilled and unskilled labour is independent of well established infrastructure.
However, as FDI for a particular form continues to grow in the host country, infrastructure becomes a necessity that cannot be ignored. Furthermore, firms engaging in FDI will be at vantage position to earn higher share of the market since a well established infrastructure will facilitate the process of exporting goods.
Good governance
Host countries that have proved of shrewd governance have continued to attract foreign investors in large numbers. Indeed, the prevalence of peace and stability through thorough enforcement of legislation is a driving force Multinationals to invest in some developing and developed countries.
Bad elements of governance such as bureaucracy and graft have repelled firms wishing to secure investment in foreign countries. Good governance remains to be a motivating factor for FDI to flourish. Although regimes vary both in governance styles and ability to host FDI from foreign Multinational Corporations, it is common perception that politically stable governments are bound to attract more foreign investment compared to volatile political environments.
A case study of some developing countries reveals that political upheavals such as coup de tats have scared away investors a great deal. In spite of the aforementioned motives why companies will opt for FDI, it is vital to note that internalization of a business enterprise has its own share of challenges and positive attributes. To begin with, FDI has the potential to increase domestic level of employment, that is, the host country benefits from employment creation (VanPottelsberghe & Lichtenberg, 2001).
In addition, in the event that the much needed infrastructure by the firm engaging in FDI is not adequate or unavailable altogether, the Multinational Corporation will invest in the infrastructure to the benefit of the host country. since FDI concentrates its effort in the flow of capital from the host country to the parent company through exports, the balance of payment for the host country is bound to be influenced positively.
This will go a long way in developing the technical efficiency of domestic supplies who will have gained the necessary knowledge, skills and competences from the operations of the Multinational Corporations (Cantwell & Narula, 2001).
In course of their operations, there will be transfer of technological know-how from the firm to the host country and consequently improve capital investment through the both the vertical and horizontal development. The demerits of FDI to the host country cannot be ignored. For instance, firms engaging in DFI often dominate the industrial sector thereby hampering the growth of domestic companies.
As technology flows from FDI to local firms, it leads to dependency syndrome by the local firms on imported technology. Worse still, ethnocentric staffing of Multinationals has also eroded the native culture since these firms are mainly managed by individuals from country while the subordinate positions are held by the local staff. Most MNCs have recorded impressive growth in their FDI activities. However, there are pertinent investment factors that can be put in place in order to boost their returns.
Some host countries are already reforming their trade policies by limiting the number of trade barriers and restrictions that have impeded foreign investment. Better still, there are fewer limitations to currency repatriation in order to promoted FDI (Anderson & van Wincoop, 2004). Besides, nations are also formulating sound and friendly company policies and code of ethics that enhance international trade and capital flow.
Conclusions
The analysis of Foreign Direct Investment (FDI) and motives why firms opt to engage in foreign investment has been on-going for considerably long period of time. Nevertheless, there are some components of FDI which economic literature has not adequately explored.
In spite of this, it is vital to reiterate that FDI refers to capital inflow in form of trade investment from foreign countries. It is increasingly becoming an expansion strategy for firms wishing to diversify their product and service portfolio as well as returns.
Three main motives stand out as the motives why firms would roll out FDI abroad. Firstly, the desire to seek resources overseas is top in the list.
Whereas technology and managerial issues may not be a real concern for firms engaging in FDI, the accessibility of cheap and skilled labour is of utmost importance and can only be availed by expanding business operations abroad where such resources are located. Other important factors of production that may be of economic interest to Multinational Corporations expanding overseas include raw materials and favourable weather and climatic patterns.
Secondly, marketing seeking FDI has also been established as a sound reason why firms will invest in a foreign country. The domestic market is often saturated with both substitute and complimentary products from rival firms. By reaching out other developing and developed countries, the market portfolio is definitely doubled. Finally, the need to obtain non-transferable assets like skilled and unskilled labour from the host country has also been a major driving factor to invest abroad.
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