Using empirical evidence, discuss the various reasons for FDI. Are any of the reasons more prominent? Foreign Direct Investment is a difficult subject to argue because it involves both positive and negative debates in the increasingly globalise financial environment. Some advantages of FDI for the host country include: a stimulation of economic activity and an increase in the level of employment, a freer flow of capital, stimulating the local economy, and overcoming impediments to trade.
One the other side, the disadvantages of FDI for the host country include a longer-term balance of payments loss as funds are remitted overseas, a loss of political and economic sovereignty, and a destabilisation of monetary policy and large international currency flows. Through this essay, we will first try to define the concept of Foreign Direct Investment. We will then analyse the theories and arguments as to why FDI can benefit and disadvantage both the companies and governments.
The United Nations Conference on Trade and Development and the International Monetary Fund both defined the Foreign Direct Investment as an investment that involves a long-term relationship reflecting a lasting interest of an entity resident in one economy (direct investor) in an entity resident in an economy other than that of the investor. The direct investor’s purpose is to exert a significant degree of influence on the management of the enterprise resident in the other economy.
In terms of the definition, there are two distinctive features of FDI in comparison with portfolio investment, which is a pure transfer of capital and concerned with realizing immediate income or capital gains. FDI involves ownership (in part or whole) and control of a foreign operation, including decision-making, subsequent production, and marketing activities, etc. FDI is usually accompanied by the transference of a bundle of capital, technology, and entrepreneurial skills across national boundaries.
The majority of the FDI comes from multinational companies. Those companies are therefore the dominant vehicle for FDI, while FDI is a means of fulfilling the objectives of those multinational companies (Daniels and Radebaugh, 2006). A Multinational Company is by definition “a company that takes a global approach to foreign markets and production” (Daniels ; Radebaugh, 2006). The principle objective of those companies is to secure the least cost of production of goods for world markets.
In their book International Business (2006), Daniels and Radebaugh point out that there are three major operating objectives, involving sales expansion, resource acquisition, and risk minimization. Therefore, FDI is generally an integral part of the global corporate strategy for companies operating in oligopolistic markets. Now, according to the market imperfection theory. By assuming that the firms that wants to undertake international production are at a disadvantage when compared with the local firms. This is mainly due to their unfamiliarity with the local market conditions.
Additional costs are therefore incurred in terms of communication, administration and transportation. As a result of this multinationals must possess certain advantages over local firms for FDI to be successful. Hymer (1960) discusses such conditions and along with Kindleberger (1969) says that there must be market imperfections for FDI to thrive. The conclusion drawn from Kindleberger (1969) and Hymer (1960) is that the multinational must have secured internally transferable advantages before it undertakes FDI.
These allow it to overcome its lack of knowledge of the local conditions and allow it to compete with the local firms. Market imperfections which encourage FDI include technological advantages, informational advantages, managerial capacity, access to raw materials and trade barriers. If a company is in the possession of superior management or the current management expertise is under used then they can exploit this advantage when undertaking FDI. If the management capacity is not there then this provides a barrier to FDI.
Overall, it is necessary for the multinational to have at least one some firm-specific advantage – the source of market imperfection – giving it an edge over domestic producers. Michalet and Chevalier (1985) cited over thirty reasons given by French multinationals for undertaking FDI, however most of the reasons cited related to some form of market imperfection. The firm must also be able to transfer any advantages it has in the market over borders and into foreign countries so that it can exploit them. Market imperfections arise from imperfect information or imperfect competition.
For example, if the supplier of critical input of a firm has some monopoly power, then the supplied firm will face higher prices than it would under perfect competition. Therefore the firm may internalize the supply source by purchasing it. If the supplier happens to based in another country, then the firm has undertaken Foreign Direct Investment. The second most important theory for a company to undertake FDI is probably the Internalisation Theory. That theory suggests that a firm internalises a transaction whenever the cost of using markets is higher than organising it internally.
Multinationals will tend to develop and use their own internal organizational hierarchy whenever intra-firm transactions are less costly than market transactions. This theory could answer the question as to why firms prefer to go to the lengths of undertaking FDI as opposed to licensing or exporting. Coase (1937) suggested that the external market mechanism inflicts high transaction costs in writing up a contract, agreeing a contract price and so on. He argued that these transactions could be internalised whenever this is more effective in cost terms than using the external market mechanism.
Buckley and Casson (1976) developed this into an explanation of multinational activity, arguing that the influence of market imperfections as a causative factor for leading to internalisation. The incentive to internalise depends on four key groups of factors: industry specific factors such as economies of scale and external market structure; region specific factors such as geographical distance and cultural differences and nation specific factors such as political and fiscal conditions.