Foreign Direct Investment

Foreign direct investment (FDI) is an important factor in acquiring investments and grow the local market with foreign finances when local investment is unavailable. There are various formats of FDI and companies should do a good research before actually investing in a foreign country.

It has been proved that FDI can be a win-win situation for both the parties involved. The investor can gain cheaper access to products/services and the host country can get valuable investment unattainable locally.

There are various vehicles through which FDI can be acquired and there are some important questions the firms must answer before actually implementing a FDI strategy.

FDI – Definition

FDI, in its classic definition, is termed as a company of one nation putting up a physical investment into building a facility (factory) in another country. The direct investment made to create the buildings, machinery, and equipment is not in sync with making a portfolio investment, an indirect investment.

In recent years, due to fast growth and change in global investment patterns, the definition has been expanded to include all the acquisition activities outside the investing firm’s home country.

FDI, therefore, may take many forms, such as direct acquisition of a foreign firm, constructing a facility, or investing in a joint venture or making a strategic alliance with one of the local firms with an input of technology, licensing of intellectual property.

FDI and its Types

Strategically, FDI comes in three types −

  • Horizontal − In case of horizontal FDI, the company does all the same activities abroad as at home. For example, Toyota assembles motor cars in Japan and the UK.

  • Vertical − In vertical assignments, different types of activities are carried out abroad. In case of forward vertical FDI, the FDI brings the company nearer to a market (for example, Toyota buying a car distributorship in America). In case of backward Vertical FDI, the international integration goes back towards raw materials (for example, Toyota getting majority stake in a tyre manufacturer or a rubber plantation).

  • Conglomerate − In this type of investment, the investment is made to acquire an unrelated business abroad. It is the most surprising form of FDI, as it requires overcoming two barriers simultaneously – one, entering a foreign country and two, working in a new industry.

FDI can take the form of greenfield entry or takeover.

  • Greenfield entry refers to activities or assembling all the elements right from scratch as Honda did in the UK.

  • Foreign takeover means acquiring an existing foreign company – as Tata’s acquisition of Jaguar Land Rover. Foreign takeover is often called mergers and acquisitions (M&A) but internationally, mergers are absolutely small, which accounts for less than 1% of all foreign acquisitions.

This choice of entry in a market and its mode interacts with the ownership strategy. The choice of wholly owned subsidiaries against joint ventures gives a 2x2 matrix of choices – the options of which are −

  • Greenfield wholly owned ventures,
  • Greenfield joint ventures,
  • Wholly owned takeovers, and
  • Joint foreign acquisitions.

These choices offer foreign investors options to match their own interests, capabilities, and foreign conditions.

Why is FDI Important?

FDI is an important source of externally derived finance that offers countries with limited amounts of capital get finance beyond national borders from wealthier countries. For example, exports and FDI are the two key ingredients in China's rapid economic growth.

According to the World Bank, FDI is one of the critical elements in developing the private sector in lower-income economies and thereby, in reducing poverty.

Vehicles of FDI

  • Reciprocal distribution agreements − This type of strategic alliance is found more in trade-based verticals, but in practical sense, it does represent a type of direct investment. Basically, two companies, usually within the same or affiliated industries, but from different nations, agree to become national distributors for each other’s products.

  • Joint venture and other hybrid strategic alliances − Traditional joint venture is bilateral, involving two parties who are within the same industry, partnering for getting some strategic advantage. Joint ventures and strategic alliances offer access to proprietary technology, gaining access to intellectual capital as human resources, and access to closed channels of distribution in select locations.

  • Portfolio investment − For most of the 20th century, a company’s portfolio investments were not considered a direct investment. However, two or three companies with "soft" investments in a company could try to find some mutual interests and use their shareholding for management control. This is another form of strategic alliance, sometimes called shadow alliances.

FDI – Basic Requirements

As a minimum requirement, a firm will have to keep itself abreast of global trends in its industry. From a competitive perspective, it is important to be aware if the competitors are getting into a foreign market and how they do that.

It is also important to see how globalization is currently affecting the domestic clients. Often, it becomes imperative to expand for key clients overseas for an active business relationship.

New market access is also another major reason to invest in a foreign country. At some stage, export of product or service becomes obsolete and foreign production or location becomes 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, and
  • market expectations.

A firm should seek answers to the following seven questions before investing abroad −

  • From an internal resources standpoint, does the firm have senior management support and the internal management and system capabilities to support the setup time and an ongoing management of a foreign subsidiary?

  • Has the company done enough market research in the domains, including industry, product, and local regulations governing foreign investment?

  • Is there a realistic judgement in place of what level of resource utilization the investment will offer?

  • Has information on local industry and foreign investment regulations, incentives, profit sharing, financing, distribution, etc., completely analyzed to determine the most suitable vehicle for FDI?

  • Has an adequate plan been made considering reasonable expectations for expansion into the foreign market via the local vehicle?

  • If applicable, have all the relevant government agencies been contacted and concurred?

  • Have political risk and foreign exchange risk been judged and considered in the business plan?

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