CA Foundation Business & Commercial Knowledge Study Material Chapter 4 Government Policies for Business – Foreign Direct Investment (FDI)


Meaning of FDI

Foreign Direct Investment means investment in a foreign country where the investor claims con¬trol over the investment in terms of actual power of management and effective decision-making. Foreign direct investment typically occurs in the form of setting up a subsidiary, starting a joint venture or acquiring a stake in an existing firm in a foreign country According to the Committee on Compilation of FDI in India (Oct 2002). FDI is “the process whereby residents of one country (the home country) acquire ownership of assets for the purpose of controlling the production, distribution and other activities of a firm in another country (the host country). There are three main categories of FDI-equity capital, reinvested earnings, and lending of funds by a multinational to its affiliate.

When the investor makes only investment and does not retain control over the enterprise it is known as portfolio investment. The investor is interested only in return on his capital and does not want control over the use of the invested capital. Portfolio investment is for a short period and is influenced by short-term gains. On the other hand, foreign direct investment involves long-term commitment and cannot be easily liquidated. Therefore, long-term considerations like political stability, Government policy, industrial prospects, etc. influence it. Direct investors have direct responsibility for the promotion and management of the enterprise. But portfolio investors have no direct responsibility for promotion and management of the enterprise. Portfolio investment takes place through foreign institutional investors (FIIs) like mutual funds and through American Depository Receipts (ADRs) Global Depository Receipts (GDRs) and Foreign Currency Convertible Bonds (FCCBs). ADRs, GDRs and FCCBs are securities issued by Indian companies in the foreign markets to mobilise foreign capital.

Advantages of Foreign Direct Investment

Foreign direct investment offers the following benefits:

  • FDI increases the level of investment by supplementing domestic capital. The host country gets scarce capital resources from abroad. As a result, FDI contributes towards the development of infrastructure, industry and service sector in the host country. FDI helps to enhance business activity and raise the level of economic development.
  • FDI facilitates transfer of technology, machinery and equipment to the host country. Advanced foreign technology helps to reduce costs and improve quality of products and services. Local firms get the opportunity for technology upgradation.
  • FDI can create a managerial revolution in the host country through professional man-agement and employment of sophisticated techniques of organisation and management. Local firms get access to world class management and corporate practices.
  • FDI helps to boost employment and incomes in the host country through establish¬ment of new industries and development of ancillary industries. Higher production and income in turn increase the tax revenue of the Government. Material and human resources can be utilised optimally.
  • FDI can help the host country to increase its exports and reduce imports These add to the foreign exchange resources of the country and improve its balance of payments position. In fact, the Government of India announced economic liberalisation in July, 1991 due to foreign exchange crisis.
  • FDI may help to increase competition and break domestic monopolies in the host
    country. It can overcome trade barriers like tariffs and quotas. FDI can make Indian industries globally competitive.
  • FDI offers benefits to the home country also. There is inflow of foreign currency in the form of dividend and interest. Exports of technology machinery and equipment help to enhance industrial activity and employment in the home country.
  • There is greater choice of products by consumers. Their standard of living is likely to improve due to better quality and wider choice.

Disadvantages of Foreign Direct Investment

Foreign direct investment has been criticised for the following reasons:

  • FDI tends to flow in the areas of high profits rather than in the priority sectors of the host country.
  • Considerable funds are repatriated from the host country in the form of royalty, fees, dividend, interest, etc. on FDI. Such outflows put pressure on the host country’s balance of payments. The cost of FDI is high.
  • FDI takes place mainly through multinational corporations. These corporations are large in size and have a wide resource base. They pose a threat to the domestic firms in the host country.
  • The technology brought in by the foreign investors may not be appropriate to the market size, resource base, stage of economic development and consumption needs of the host country. Excessive reliance on foreign technology may have an adverse effect on local initiative.
  • FDI poses a threat to the economic autonomy and political sovereignty of the host country. Some of the multinational corporations have destabilised governments in African countries. Excessive reliance on foreign technology may have an adverse effect on local initiative.
  • FDI can lead to adverse effects on domestic savings, and adverse terms of trade for the host country which offers special concessions to attract FDI, Some foreign investors pre-empt investment plans of domestic companies. They engage in unfair and unethical trade practices.
  • FDI may involve costs and risks for the home country. Employment opportunities may shrink and balance of payment position may suffer due to FDI.

Determinants of Foreign Direct Investment

The volume of FDI in a country depends on the following factors:

  1. Natural Resources – Availability of natural resources in the host country is a major determinant of FDI. Most foreign investors seek an adequate, reliable and economical source of minerals and other materials. FDI tends to flow in countries which are rich in resources but lack capital, technical skills and infrastructure required for the exploitation of natural resources. Though their relative importance has declined, the availability of natural resources still continues to be an important determinant of FDI.
  2. National Markets – The market size of a host country in absolute terms as well as in relation to the size and income of its population and market growth is another major determinant of FDI. Large markets can accommodate more firms and can help firms to achieve economies of large scale operations. Market access has been the main motive for investment by American companies in Europe and Asia.
  3. Availability of Cheap Labour – The availability of low cost unskilled labour has been a major cause of FDI in countries like China and India, Low cost labour together with availability of cheap raw materials enable foreign investors to minimise costs of production and thereby increase profits.
  4. Rate of Interest – Differences in the rate of interest prevailing in different countries stimulate foreign investment. Capital tends to move from a country with a low rate of interest to a country where it is higher. Foreign investment is also inspired by foreign exchange rates. Foreign capital is attracted to countries where the return on investment is higher.
  5. Socio-Economic Conditions – Size of the population, infrastructural facilities and income level of a country influence direct foreign investment.
  6. Political Situation – Political stability, legal framework, judicial system, relations with other countries and other political factors influence movements of capital from one country to another.
  7. Government Policies – Policy towards foreign investment, foreign collaborations, foreign exchange control, remittances, and incentives (monetary, fiscal and others) offered to foreign investors exercise a significant influence on FDI in a country. For example, Export Processing Zones have been developed in India to attract FDI and to boost exports.