control the organization.

So, they are also known

as a non-controlling interest. Companies use
portfolio investments primarily for short-term
financial gains.
When
discussing
foreign
direct
investment, it is important to distinguish between
the flow of FDI and stock of FDI. The flow of
FDI refers to the amount of FDI undertaken over
a given period of time (normally a year). The
stock of FDI refers to the total accumulated value
of foreign-owned assets at a given time.

Foreign Direct Investment

Meaning
Foreign direct investment occurs when a
firm invests directly in facilities to produce and/or
market a product in a foreign country. A direct
investment is one that gives the investor a
controlling interest in a foreign company. They
are commonly known as foreign direct
investments (FDIs). In FDIs, control on the
company need not be a 100-percent or even a 50
percent interest. If a company holds a minority
stake and the remaining ownership are widely
dispersed, no other owner may be able to counter
the company effectively. When two or more
companies share ownership of an FDI, the
operation is a joint venture. When a government
joins a company in an FDI, the operation is called
a mixed venture, which is a type of joint venture.
Foreign Investment and Technology
Transfer Act-1992 of Nepal defined foreign
investment as investment in share (equity) and
investment made in the form of loan or loan
facilities. The act was amended in 1996 with 100
percent equity participation possible in all
industrial enterprises except for cottage and some
specific type of industries especially reserved for
domestic investment. But, the transfer of
technology is possible even in case of cottage
industries. According to the U.S. Department of
Commerce, FDI occurs whenever a U.S. citizen,
organization, or affiliated group takes an interest
of 10 percent or more in a foreign business entity.
Once a firm undertakes FDI, it becomes a
multinational enterprise.
Companies may choose FDI as a way to
access certain resources or reach a market. Today,
about 63000 companies worldwide have FDIs that
encompass every type of business function
extracting raw materials from the earth, growing
crops, manufacturing products or components,
selling output, providing various services, and so
on.
FDI takes on two main forms. The first is
a green-field investment, which involves the
establishment of a wholly new operation in a
foreign country. The second involves acquiring or
merging with an existing firm in foreign country.
Acquisitions can be a minority (where the foreign
firm takes a 10 percent to 49 percent interest in
the firms voting stock), majority (foreign interest
of 50 percent to 99 percent), or full outright stake
(foreign interest of 100 percent). There is an
important distinction between FDI and foreign
portfolio investment (FPI). Foreign portfolio
investments are the purchase of shares and bonds
to obtain a return on the funds invested.
Generally, such investments have no intention to

Growth and Direction of FDI

Growth or Trend in FDI
The past 20 years have seen a marked
increase in both the flow and stock of FDI in the
world economy. The average yearly flow of FDI
increased from about $25 billion in 1975 to a
record $ 1.3 trillion in 2000, before slumping
dramatically onward 2001, recording to $620
billion. Between1975 and 2001 the flow of FDI
not only accelerated but also accelerated faster
than the growth in world trade. For example,
between 1990 and 2001, the total flow of FDI
from all countries increased about 365 percent,
while world trade grew by some 75 percent and
world output by 26 percent. As a result of the
strong FDI flow, by 2001 the global stock of FDI
exceeded $6.6 trillion.
FDI has grown more rapidly than world trade
and world output for several reasons. In spite of
decline of trade barriers, FDI has grown more
rapidly than world trade because:
Business firms still fear protectionist
pressures
FDI is seen a way of circumventing trade
barriers. For example, much of the Japanese
automobile companies investment in the
United States during the 1980s and 1990s was
driven by a desire to reduce exports from
Japan, thereby alleviating trade tensions
between two countries.
Much of the recent increase in FDI is being
driven by the dramatic political and economic
changes in many parts of the world.
Globalization of the world economy has
raised the vision of firms who now see the
entire world as their market
In contrast to the long-run trend,
between 2000 and 2004 the value of FDI slumped
almost 50 percent from $1.3 trillion to about $620
billion. The slowdown in FDI flows has been most
pronounced in developed nations. The most
notable decline was in the levels of cross-border
mergers and acquisition. For example, in 2000,
there were some 7900 cross-border deals totaling $

1.1 trillion. In 2001, the number of cross-border

mergers and acquisitions fall to less than 6000
deals totaling $ 554 billion.
The slow-down in FDI flows observed in
2001 and onwards will probably the temporary. It
appears to reflect three related development:
1. General slowdown in the growth rate of the
world economy
2. Heightened geopolitical uncertainty following
the September 11, 2001 attack on the United
States; and
3. Bursting of the stock market bubble in the US,
which limited the ability of many companies to
raise additional capital to finance aggressive
FDI activity.

concentrated on Mexico and Brazil and was a

response to reforms in the region, including
privatization, the liberalization of regulations
governing FDI, and the growing importance of
regional free trade area such as NAFTA (North
American
Free
Trade
Agreement)
and
MERCOSUR (Pact between Argentina, Brazil,
Paraguay, and Uruguay to establish a free trade
area). At the other end of the scale, Africa received
the smallest amount of inward investment, about
$6 billion in 2002. The inability of Africa to attract
greater investment is in part a reflection of the
political unrest, armed conflict, and frequent
changes in economic policy in the region.
.

Source of FDI

Direction of FDI

Since World War II, the United States has

been by far the largest source country for FDI.
During the late 1970s, the United States still
accounted for about 47 percent of all FDI
outflows from industrialized countries, while the
second place United Kingdom accounted for
about 18 percent. U.S. firms so dominated the
growth of FDI in the 1960s and 70s, that the
words American and multinational became almost
synonymous. By 1980, out of the worlds largest
382 multinationals 178 were U.S. firms, 40 of
them were British. During 1985-90, the United
States slipped to third place behind Japan and the
United Kingdom. Since then United States
regained its dominant position in every year but
1999 and 2000, when the U.K. was the largest
source country. However, as a percentage of total
outward FDI flows, the U.S. share declined to less
than 20 percent by 1998-2001. The source of FDI
by country remains highly concentrated, with five
countries generally accounting for more than twothirds of all foreign direct investment outflows.
The countries United States, Japan, United
Kingdom, France, and Germany have
dominated foreign direct investment outflows for
much of the last two decades. As might be
expected, these countries also predominate in
rankings of the worlds largest multinational. As
of 2001, 26 percent of the worlds 100 largest
multinationals were U.S. enterprises; 17 percent
were Japanese; 12 percent were French; 12
percent were German; and 10 percent were
British.

Historically, most FDI has been directed

at the developed nations of the world as firms
based in advanced countries invested in other
markets. The US has been the favorite target for
FDI inflows. This trend continued in the late
1990s, when the United States was again the
largest recipient of FDI, accounting for $ 281
billion of the $1.3 trillion in global FDI, while
Western Europe was the largest single regional
recipient of FDI, with $633 billion in inflows.
Historically, the United States has been an
attractive target for FDI because of its large and
wealthy domestic markets, its dynamic and stable
economy, a favourable political environment, and
the openness of the country to FDI.
While developed nations still account for
the largest share of FDI inflows, FDI into
developing nations has increased. From 1985 to
1990, the annual inflow of FDI into developing
nations averaged $27.4 billion, or 17.4 percent of
the total global flow. By 1997, the inflow of FDI
into developing nations had risen to $149 billion,
or 37 percent of the total. In 2004, the flow into
developing nations accounted about 46 percent of
the total and reached to about $290 billion. Most
recent inflows into developing nations have been
targeted at the emerging economies of South, East,
and Southeast Asia. Driving much of the increase
has been the growing importance of China as a
recipient of FDI. Starting from a tiny, foreign
investment surged to an annual average rate of
$2.7 billion between 1985 and 1990 and than
surged to reach $40 billion annually in the late
1990s, making China the second biggest recipient
of FDI inflows in the world after the United States.
Latin America emerged as the next most
important region in the developing world for FDI
inflows. In 2000, total inward investments into this
region reached about $86 billion, and it remained
at that level during 2001 before dropping to $62
billion in 2002. Much of this investment was

FDI as an Alternate to Trade

In fact FDI is an alternate to trade. But it
is worth examining whether FDI is better than
trade especially when the fulfillment of major
international business objectives is concerned. Let
us assume the objectives to be:
1. Expansion in sales and, thereby, in revenue
2. Acquisition of resources
3. Minimisation of risk through diversification

4. Political motive
Sales can be expanded also through greater
magnitude of exports. But there are cases when
export has only a limited scope. In such cases, FDI
is made to generate sales. FDI overcomes the
transportation cost involved in export. It is true
that if the same product is exported to different
markets, the firm produces more, exports more,
and achieves economies of scale that largely
compensates the transport cost. But when the
product is differentiated, depending upon varying
consumptions pattern in different markets,
economies of scale cannot be achieved. FDI is
better alternative in the sense that products with
dissimilar features are produced in different
countries in order to meet the specific demands of
consumers there. It is only way to generate sales.
Again, it is not only transport cost but also
tariff and non-tariff barriers that are overcome by
FDI. The generation of export is often
handicapped by high tariff or non-tariff barriers
imposed by importing countries. But if the
exporting firm begins production in the importing
country, trade barriers do not come in the way. The
product becomes cheaper in the hands of the host
country consumers. The firm finds itself in a
competitive position and is able to raise its sales.
Apart from the generation of sales and
revenue, the issue of the acquisition of resources is
also important. Resources can be imported, but the
import is possible only when the exporter agrees to
export. On the other hand, FDI is a more reliable
means to acquire resources. In the last quarter of
the 19th century and the early decades of the 20 th
century, a good number of the British firms were
engaged in mining activities. Even today, we find
that Digital Equipment has made investments in
India in order to access Indian software talent.
Again, a large number of firms from industrialized
countries have moved to developing countries to
reap the benefit of cheap labour in the host
countries. Suzuki produces cars with cheap Indian
labour and exports them to the international
market at competitive rates. Sometimes it is the
cheap raw material that attracts FDI. Indian firms
have moved to Sri Lanka for the manufacturing of
rubber products and to Nepal for the manufacture
of herbal products. Thus FDI is more effective
than other modes for the purpose of acquisition of
resources.
Maximization of return cannot be thought of
in isolation of risk. With a given level of return,
the risk has to be minimized. It can no doubt be
minimized through the diversification of trade
among larger number of countries. But the
diversification process is easier in case of FDI. A
firm can make investment in different countries;
can source inputs from different countries, and can

market its products in different countries. It is

possible that the currency of a country from where
the inputs are imported appreciates or it may be
that the political relation with that country
deteriorates. In such cases, risk can be reduced
through diversifying the sources of inputs.
FDI is a better instrument to develop
harmonious political relationship with other
countries. It is a fact that a political motive is not
the primary motive behind FDI, but it is definitely
complementary to more important economic
motives. The USA has made huge investments in
some of Caribbean countries. One of the reasons is
that these countries were opposed to the Cuban
communist regime.
FDI is better than trade because:
1. Different markets can better be served
with differentiated products
2. FDI overcomes tariff and transport cost
involved in trade
3. It is a better means to acquire resources
from the host country
4. It reduces financial risk through greater
diversification
5. It creates harmonious political relations.

Foreign Direct Investment (FDI)

Theories
It is a matter of great concern that why
firms go to the trouble of acquiring or establishing
operations abroad, when the alternatives of
exporting and licensing are available. Other
things being equal, FDI is expensive and risky
compared to exporting or licensing. FDI is
expensive because a firm must bear the costs of
establishing production facilities in a foreign
country or of acquiring a foreign enterprise. FDI
is risky because of the problems associated with
doing business in another culture where the rules
of the game may be very different. When a firm
exports, it need not bear the costs of FDI, and the
risks associated with selling abroad can be
reduced by using a native sales agent. Similarly,
when a firm licenses its know-how, it need not
bear the costs or risks of FDI. So why do many
firms apparently prefer FDI over either exporting
or licensing? To answer this various FDI theories
have been developed. In other words there are
various theories used to explain FDI. Some of
them are discussed as under:

The Product Life Cycle Theory of FDI

It was Raymond Vernon who explained
when the foreign investment takes place, based on
data obtained from US corporate activities.
Raymond Vernons theory is known as the
product life cycle (PLC) theory. The product life

cycle hypothesis asserts that, like people, products

are conceived and born, mature, decline and
eventually die. Hence, a product has a life cycle
comprising a series of stages.
Vernon feels that most products follow a
life cycle that is divided into three stages. The
first is known as the innovation stage. In order
to compete with other firms and to have a lead in
the market, the firm innovates a product with the
help of research and development. The product is
manufactured in the home country primarily to
meet the domestic demand, but a portion of the
output is also exported to other developed
countries. The quality of the product, and not the
price, forms the basis of demand because the
demand is price inelastic at this stage.
The second stage is known as maturing
product stage. At this stage, the demand for the
new product in other developed countries grows
substantially and it turns price-elastic. Rival firms
in the host country itself begin to appear at this
stage to supply similar products at a lower price
owing to lower distribution cost, whereas the
product of the innovator is often costlier as it
involves the transportation cost and tariff that is
imposed by the importing government. Thus in
order to compete with rival firms, the innovator
decides to set up a production unit in the host
country
itself,
which
would
eliminate
transportation cost and tariff. This leads to
internationalization of production.
In the final or standardized product
stage, a standardized product and its production
techniques are no longer the exclusive possession
of the innovating firm, rival firms from the home
country itself, or from some other developed
countries, put stiff competition. This is not
unusual because the follow-the-leader theory
developed by Knickerbocker (1973) suggests that
there is a tendency among followers to snatch the
benefits of international production from the
innovator. At this stage, price competitiveness
becomes even more important; and in view of this
fact, the innovator shifts the production to a low
cost location, preferably a developing country
where labour is cheap. The product manufactured
in a low cost location is exported back to home
country or to other developed countries.
The product life cycle theory clearly
explains the early post-Second World War
expansion of US firms in other countries. But
with changes in the international environment,
different stages of product life cycle did not
necessarily follow in the same way. Vernon
himself has pointed out this limitation in his later
writing, showing how in the second stage itself
firms were found moving to the developing world
to reap the advantages of cheap labour. This was

possible with the narrowing of the information

gap.

Market Imperfection
Market imperfections provide a major
explanation of why firms may prefer FDI to either
exporting or licensing. Market imperfections are
factors that inhibit markets from working
perfectly. In the international business literature,
the marketing imperfections approach to FDI is
typically referred to as internalization theory.
With regard to horizontal FDI (Horizontal
FDI is investment in the same industry abroad as
a firm operates in at home.); market imperfections
arise in two circumstances: when there are
impediments to the free flow of products between
nations, and when there are impediments to the
sale of know-how. (Licensing is a mechanism for
selling know-how). Impediments to the free flow
of products between nations decrease the
profitability of FDI relative to FDI and licensing.
Impediments to the sale of know-how increase the
profitability of FDI relative to licensing. Thus, the
market imperfections explanation predicts that
FDI will be preferred whenever there are
impediments that make both exporting and the
sale of know-how difficult and/or expensive.
Impediments to Exporting
Governments are the main source of
impediments to the free flow of products between
nations. By imposing tariffs on imported goods,
governments increase the cost of exporting
relative to FDI and licensing. Similarly, by
limiting imports through the imposition of quotas,
governments increase the attractiveness of FDI
and licensing. For example, the wave of FDI by
Japanese auto companies in the United States
during the 1980s was partly driven by
protectionist threats from Congress and by quotas
on the importation of Japanese cars. For Japanese
auto companies, these factors have decreased the
profitability of exporting and increased the
profitability of FDI.
Impediments to the Sale of Know-How
The competitive advantage that many
firms enjoy comes from their technological,
marketing,
or
management
know-how.
Technological know-how can enable a company
to build a better product; for example, Nokias
technological know-how has given it a strong
competitive position in the global market for
wireless telephone equipment. Alternatively,
technological know-how can improve a
companys production process in comparison with
competitors. For example, many claim that
Toyotas competitive advantage comes from its
superior production system. Marketing know-how

can enable a company to better position its

products in the marketplace; the comparative
advantage of such companies as Procter &
Gamble seems to come from superior marketing
know-how. Management know-how with regard
to factors such as organizational structure, human
relations, control systems, planning systems,
inventory management, and so on can enable a
company to manage its assets more efficiently
than competitors.
If we view know-how (expertise) as a
competitive asset, it follows that the larger the
market in which that asset is applied, the greater
the profits that can be earned from the asset. For
example, Nokia can earn greater returns on its
know-how by selling its wireless telephone
equipment worldwide than selling it only in its
native Finland. However, this alone does not
explain why Nokia undertake FDI (the company
has production locations around the world). For
Nokia to favour FDI, two conditions must hold.
First, transportation costs and/or impediments to
exporting must rule out exporting as an option.
Second, there must be some reason Nokia cannot
sell its wireless know-how to foreign producers.
Since licensing is the main mechanism by which
firms sell their know-how, there must be some
reason Nokia is not willing to license a foreign
firm to manufacture and market its cellular
telephone equipment. Other things remaining the
same, licensing might look attractive to such a
firm, since it would not have to bear the costs and
risks associated with FDI yet it could still earn a
good return from its know-how in the form of
royalty fees.
According to economic theory, there are
three reasons the market does not always work
well as a mechanism for selling know-how.
First, licensing may result in a firms giving away
its know-how to potential foreign competitors.
Second, licensing does not give a firm the tight
control over manufacturing, marketing, and
strategy in a foreign country that may be required
to profitably exploit its advantage in know-how.
With licensing, control over production,
marketing, and strategy is granted to a licensee in
return for a royalty fee. However, for both
strategic and operational reasons, a firm may want
to retain control over these functions. For
example, a firm might want its foreign subsidiary
to price and market very aggressively, but the
licensee may be unable to do this. When tight
control over a foreign entity is desirable,
horizontal FDI is preferable to licensing.
Third, a firms know-how may not be controlled
by licensing. This is particularly true of
management and marketing know-how. It is one
thing to license a foreign firm to manufacture a

particular product, but quite different to license

the way a firm does business, i.e., how it manages
its process and markets its products.
All of this suggests that when one or
more of the following conditions holds, markets
fail as a mechanism for selling know-how and
FDI is more profitable than licensing: (1) when
the firm has valuable know-how that cannot be
adequately protected by a licensing contract, (2)
when the firm needs tight control over a foreign
entity to maximize its market share and earnings
in that country, and (3) when a firms skills and
know-how are not controlled by licensing.

Monopolistic Advantage
Companies invest directly only if they
think they hold some supremacy over similar
companies in countries of interest. The advantage
results from a foreign companys ownership of
some resource patents, product differentiation,
management skills, access to markets
unavailable at the same price or terms to the local
company. This situation is often called a
monopoly advantage. Because of the increased
cost of transferring resources abroad and the
perceived greater risk of operating in a different
environment, the company will not move unless it
expects a higher returns than it can get at home
and unless it thinks it can outperform local firms.
Companies from certain countries may
enjoy a monopoly advantage if they can borrow
capital at a lower interest rate than companies
from other countries. Prior to World War I, Great
Britain was the largest source of direct investment
because of the strength of the pound sterling and
resulting lower interest rates on borrowing
sterling funds. From World War II until the mid1980s, the strength of the US dollar gave
advantage to US firms. After that, this advantage
shifted to Japanese companies, until the Japanese
yen weakened in 1997. More recently, capital
markets have become so international that
companies can more easily borrow abroad if
interest rates are lower there.
A similar advantage occurs when the
foreign companys currency has high buying
power. During the two and a half decades
following World War II, the US dollar was very
strong. By converting dollars to other currencies,
US companies could purchase more in foreign
countries than they could in the United States.
This advantage was an incentive for US
companies to make foreign investments. They
could add production capacity more cheaply
abroad than at home.

Eclectic Theory
Advantages)
5

(Location-Specific

The British economist John Dunning has

argued that in addition to the various factors,
location-specific advantages can explain the
nature and direction of FDI. By location-specific
advantages, Dunning means the advantages that
arise from using resource endowments or assts
that are tied to a particular foreign location and
that a firm finds valuable to combine with its own
unique assets (such as the firms technological,
marketing, or management know-how). Dunning
accepts the internalization argument that market
failures make it difficult for a firm to license its
own unique assets (know-how). Therefore, he
argues that combining location-specific resource
endowments and the firms own unique assets
often requires FDI. It requires the firm to
establish production facilities where those foreign
resource endowments are located. (Dunning refers
to this argument as the eclectic paradigm.)
An obvious example of Dunnings
arguments is natural resources, such as oil and
other minerals, which are specific to certain
locations. Dunning suggests that a firm must
undertake FDI to exploit such foreign resources.
This explains the FDI undertaken by many of the
worlds oil companies, which have to invest
where oil is located to combine their
technological and managerial knowledge with this
valuable location-specific resource. Another
example is valuable human resources, such as low
cost, highly skilled labour. The cost and skill of
labour varies from country to country. Because
labour is not internationally mobile, according to
Dunning it makes sense for a firm to locate
production facilities where the cost and skills of
local labour are most suited to its particular
production processes.
However, the implications of Dunnings
theory go beyond basic resources such as
minerals and labour. Consider Silicon Valley,
which is the world center for the computer and
semiconductor industry. Many of the worlds
major computer and semiconductor companies,
such as Apple Computer, Silicon Graphics, and
Intel, are located close to each other in the Silicon
Valley region of California. As a result, much of
the
cutting-edge
research
and
product
development in computers and semiconductors
occur here. According to Dunnings arguments,
knowledge being generated in Silicon Valley with
regard to the design and manufacture of
computers and semiconductors is available
nowhere else in the world. As it is
commercialized,
that
knowledge
diffuses
throughout the world, but the leading advantage
of knowledge generation in the computer and
semiconductor industries is to be found in Silicon
Valley. In Dunnings language, this means Silicon

Valley has a location-specific advantage in the

generation of knowledge related to the computer
and semiconductor industries. In part, this
advantage comes from the extreme concentration
of intellectual talent in this area, and in part it
arises from a network of informal contacts that
allows firms to benefit from each others
knowledge generation. Economists refer to such
knowledge spillovers as externalities, and one
well-established theory suggests that firms can
benefit from such externalities by locating close
to their source.
Evidence suggests that European,
Japanese, South Korean, and Taiwanese computer
and semiconductor firms are investing in the
Silicon Valley region, precisely because they wish
to benefit from the externalities that arise there.
Others have argued that direct investment by
foreign firms in the U.S. biotechnology industry
has been motivated by desires to gain access to
the unique location-specific technological
knowledge of U.S. biotechnology firms.
Therefore, Dunnings theory seems to be useful
addition to FDI theories, because it helps to
explain how location factors affect the direction
of FDI.
From above discussion it can be
concluded that FDI by MNCs, according to
Dunning, results from the following three
comparative advantages which they enjoy:
1. Firm specific advantages (i.e., ownership
specific advantages)
2. Internalization advantages and
3. Location-specific advantages.

Political Ideology and Foreign Direct

Investment
Historically, one important determinant of
a governments policy toward FDI has been its
political ideology. Ideology toward FDI ranged
from a dogmatic radical stance that is hostile to
all FDI at one extreme to an adherence to the
noninterventionist principle of free market
economics at the other. Between these two
extremes is an approach that might be called
pragmatic nationalism.
The Radical View
The radical view traces its roots to
Marxist political and economic theory. Radical
writers argue that the MNE is an instrument of
imperialist domination. They see the MNE as a
tool for exploiting host countries to the exclusive
benefit of their capitalist-imperialist home
countries.
They argue that MNEs extract
profits from the host country and take them to
their home country, giving nothing of value to the
host country in exchange. For example, they note
that key technology is tightly controlled by the

MNE, and that important jobs in the foreign

subsidiaries of MNEs go to home country
nationals rather than to citizens of the host
country. According to radical view, because of
this, FDI by MNEs of advanced capitalist nations
keeps the less developed countries of the world
relatively backward and dependent on advanced
capitalist nations for investment, jobs, and
technology. Thus, according to the extreme
version of this view, no country should ever
permit foreign corporations to undertake FDI,
since they can never be instruments of economic
development, only of economic domination.
Where MNEs already exist in a country, they
should be immediately nationalized.

argues that FDI is a benefit to both the source

country and the host country.
In recent years, the free market view has
been rising in power worldwide, spurring a global
move toward the removal of restrictions on
inward and outward foreign direct investment.
However, in practice no country has adopted the
free market view in its pure form (just as no
country has adopted the radical view in its pure
form). Countries such as Britain and US are
among the most open to FDI, but the governments
of these countries both have a tendency to
intervene. Britain does so by reserving the right to
block foreign takeovers of domestic firms if the
takeovers are seen as contrary to national
security interests or if they have the potential for
reducing competition. US controls on FDI are
more limited and largely informal. For political
reasons, the United States will occasionally
restrict US firms from undertaking FDI in certain
countries (e. g., Cuba and Iran). In addition, there
are some limited restrictions on inward FDI. For
example, foreigners are prohibited from
purchasing more than 25 percent of an US airline
or from acquiring a controlling interest in a US
broadcast television network. Since 1989, the
government has had the right to review foreign
investment on the grounds of national security.

The Free Market View

The free market view traces its roots to
classical economists and the international trade
theories of Adam Smith and David Ricardo. The
intellectual case for this view has been
strengthened by the market imperfections
explanation of horizontal and vertical FDI. The
free market view argues that international
production should be distributed among countries
according to the theory of comparative advantage.
Countries should specialize in the production of
those goods and services that they can produce
most efficiently. Within this framework, the MNE
is an instrument for dispersing the production of
goods and services to the most efficient locations
around the globe. Viewed this way, FDI by MNE
increases the overall efficiency of the world
economy.
Consider a well-publicized decision by
IBM in the mid-1980s to move assembly
operations for many of its personal computers
from the US to Mexico. IBM invested about $ 90
million in assembly facility with the capacity to
produce 100,000 PCs per year, 75 percent of
which were exported back to the US. According
to free market view, moves such as this can be
seen as increasing the overall efficiency of
resource utilization in the world economy.
Mexico, due to its low labour costs, has a
comparative advantage in the assembly of PCs.
According to the free market view, by moving the
production of PCs from the US to Mexico, IBM
frees US resources for use in activities in which
the US has a comparative advantage (e.g., the
design of computer software, the manufacture of
high-value-added
components
such
as
microprocessors, or basic R & D). Also,
consumers benefit because the PCs cost less than
they would if they were produced domestically. In
addition, Mexico gains from the technology,
skills, and capital that IBM transfers with its FDI.
Contrary to the radical view, the free market view

Pragmatic Nationalism
In practice, many countries have adopted
neither a radical policy nor a free market policy
toward FDI, but instead a policy that can best be
described as pragmatic nationalism. The
pragmatic nationalist view is that FDI has both
benefits and costs. When a foreign company
rather than a domestic company produces
products, the profits from that investment go
abroad. Many countries are also concerned that
foreign-owned manufacturing plant may import
many components from its home country, which
has negative implications for the host countrys
balance-of-payment position.
Recognizing this, countries adopting a
pragmatic stance pursue policies designed to
maximize the national benefits and minimize the
national costs. According to this view, FDI should
be allowed only if the benefits outweigh the costs.
Japan offers an example of pragmatic nationalism.
Until the 1980s, Japans policy was probably one
of the most restrictive among countries adopting a
pragmatic nationalist stance. This was due to
Japans perception that direct entry of foreign
(especially US) firms with ample managerial
resources into the Japanese markets could hamper
the development and growth of its own industry
and technology. This belief led Japan to block the
majority of applications to invest in Japan.
However, there were always exceptions to this

policy. Firms that had important technology were

often permitted to undertake FDI if they insisted
that they would neither license their technology to
a Japanese firm nor into joint venture with a
Japanese enterprise. IBM and Texas Instruments
were able to set up wholly owned subsidiaries in
Japan by adopting this negotiating position. From
the perspective of the Japanese government, the
benefits of FDI in such areas the stimulus that
these firms might impart to the Japanese economy
outweighed the perceived costs.
Another aspect of pragmatic nationalism
is the tendency to aggressively court FDI believed
to be the national interest by, for example,
offering subsidies to foreign MNEs in the form of
tax breaks or grants. The three main ideological
positions regarding FDI are summarized in
Figure-1.

Impact

of

FDI

on

and wealth. FDI is frequently viewed as

instrumental in promoting industrial growth and
trade particularly in host countries. FDI maintains
relatively open economies, stable macro
economic conditions and limited restrictions on
foreign exchange transactions. It frequently
stimulates
competition,
productivity
and
innovation by local suppliers because local
suppliers compete for lucrative contracts with
multinational enterprises. Further, it generates
income and employment opportunities resulting
in higher wages, competitive price, more revenue,
skill and technology transfer and increased
foreign exchange earnings. It contributes to the
development of a host country by increasing the
countrys investment level beyond what would be
permitted by domestic saving alone. Similarly, it
enhances entrepreneurial capability when the
foreign firms bring with it some firm specific
knowledge in the form of technology, managerial
expertise, and marketing know-how. It also allows
new local entrants to learn about export markets;
provides training for workers and stimulates
competition with local firms.
However, FDI is not without controversy.
Many countries that opened their markets to FDI
experienced economic and social disruptions;
they also watched investments by MNEs
constrain existing or potential domestic
companies. MNEs have also run into problems;
many made big foreign investments that have
performed poorly. As a result, the first years of
the twenty-first century saw declining volume of
FDI worldwide.

Economic

Figure 1
Political Ideology toward FDI

Ideology

Characteristics

Host-Government
Policy Implications

Radical

Marxist
roots
views the MNE
as an instrument
of
imperialist
domination

Prohibit FDI &

nationalize
subsidiaries of
foreign-owned
MNEs

Free market

Classical
economic roots
Views the MNE
as an instrument
for
allocating
production
to
most
efficient
locations

No restriction
on FDI

Views FDI as
having
both
benefits
and
costs

Restrict
FDI
where
cost
outweigh benefits
Bargain
for
greater
benefits
and fewer costs
Aggressively
court
beneficial
FDI by offering
incentives

Pragmatic
nationalism

The Benefits of FDI to the Host

Country

Development
FDI has come to be seen as a major
contributor to growth and development, bringing
capital, technology, management expertise, jobs,

Availability of Scarce Factors of Production

FDI helps attain a proper balance between
different factors of production through the supply
of scarce factors and fosters the pace of economic
development. FDI brings in capital and
supplements the domestic capital. This is a
significant contribution where the domestic
savings rate is too low to match the warranted rate
of investment. FDI brings in scarce foreign
exchange, which activates the domestic savings
that would not have been put into investment in
the absence of foreign exchange availability. It
also happens when local investors are afraid of
the large risk involved in the investment project.
In case of FDI, foreign investors share the risk
and the investment project is implemented.
One can say that a country can get scarce
foreign exchange also through foreign borrowing
and other forms of investment. But FDI is
superior to all of them. It is because FDI, which

takes a longer-term view of the market, is more

stable than non-FDI flows.
Sometimes FDI is accompanied by labour
force that performs jobs that the local labour force
is either not willing to do or is incapable of doing
on account of lack of desired skill. Besides, the
foreign labour force infuses non-traditional
mental attitudes among the local labour force.
Besides, foreign investors make available
raw material and improved technology. Raw
material is normally not a very important
consideration for the host country, but this factor
becomes significant when the question of some
vital raw material is concerned. At the same time,
host countries often encourage FDI inflows
because they procure improved technology; and
more importantly, an ongoing access to continued
research and development programmes of the
investing country. Statistics reveal that over 90
percent of the R & D activities giving rise to the
creation of new product and process technology
are concentrated in seven industrialized countries.
Other countries reap the benefit from these
innovative activities when they are transferred to
them in the form of FDI through MNCs. The
transfer takes two forms one is internalized to
the affiliates under the same ownership and
control and other is externalized to other firms in
the forms of franchises, licenses, sub-contracting,
and so on. Whatever the mode of transfer, it
benefits the recipient. In the short term, the
benefit manifests in the form of increased
productivity, new products, and lower costs. In
the long term, it depends on how much the
recipient learns from the technology and is able to
deepen and develop its own capabilities. For the
economy as a whole, the benefits also include the
diffusion of technology and its spillovers to other
firms. As regards diffusion, it depends on how
intense the linkages are in the host country. Since
MNCs prefer to establish linkages with foreign
firms, local linkages are often poor.

According to a UN report (2002), inward

FDI by foreign multinationals has been a major
driver of export-led economic growth in a number
of developing and developed nations over the last
decade. For example, in China exports have
increased from $26 billion in 1985 to over $250
billion by 2001. According to UN data, much of
this export growth was due to the presence of
foreign multinationals that invested heavily in
China during the 1990s.
Create Employment Opportunities
Another benefit claimed for FDI is that it
brings jobs to a host country that would otherwise
not be created there. The effects of FDI on
employment are both direct and indirect. Direct
effects arise when a foreign MNE employs a
number of host-country citizens. Indirect effects
arise when jobs are created in local suppliers as a
result of the investment and when jobs are created
because of increased local spending by employees
of the MNE.
Building
of
Economic
and
Social
Infrastructure
When foreign investors invest in sectors
such as basic economic infrastructure, social
infrastructure, financial markets, and marketing
system, the host country is able to develop a
support system that is required for rapid
industrialization. Even if there is not investment
in these sectors, the very presence of foreign
investors in the host country creates a multiplier
effect. A support system develops automatically.
Fostering of Economic Linkage
Foreign firms have forward and backward
linkages. They make demand for various inputs,
which in turn helps develop input supplying
industries. They employ labour force, which helps
raise the income of employed people, which in
turn raises the demand and industrial production
in the country. In all, the total investment in the
host country increases by more than the amount
of FDI. This is nothing but the crowding-in
effect of FDI.

Improvement in the Balance-of-Payments

FDI helps improve the balance-ofpayments of the host country. The inflow of
investment is credited to the capital account of the
host country. At the same time, the current
account improves because FDI helps either import
substitution or export promotion. The host
country is able to produce items that were being
imported earlier. FDI is able to augment export
because foreign investors bring in the knowledge
of exporting mechanics and of foreign markets.
They bring in improved technology to produce
goods of international standards and at lower cost.
They possess a world-reputed brand name, which
is helpful in promoting export.

Strengthening of Government Budget

Foreign firms are a source of tax revenue
for the government. They pay not only income tax
but also the tariff on their import. At the same
time they help reduce governmental expenditure
requirements
through
supplementing
the
governments investment activities. All this eases
the burden on the government budget.

and the payments of dividend, technical service

fees, royalty, and so on deteriorates the balance of
payments. Raw materials are exploited keeping in
view the interest of the home country, which
sometimes mars the interest of the host country.
Again, the parent company supplies the
technology to the subsidiary, but normally does
not disseminate it to the host market. The result is
that the host country remains dependent on the
home country for the technology, which is often
received at an exorbitant price. Sometimes the
technology is inappropriate for the local
environment and in that case, the loss to the host
country is large.
As far as employment of the locals is
concerned, MNCs normally show reluctance to
train local people. Technology is normally capital
intensive, which does not assure larger
employment.
Sometimes, manufacturing by the foreign
investors does not abide by the pollution norms,
the norms regarding optimal use of natural
resources, or the norms regarding location of
industries. All this goes against the interest of the
host country.
Foreign investors are generally more
powerful. Domestic industrialists do not compete
with them, with the result that the domestic
industry fails to grow. This is nothing but the
crowding-out effect of FDI. Foreign companies
infuse foreign culture into the industrial set-up
and also in the society. Sometimes, they are so
powerful that they are able to subvert the
government.

Benefits of FDI to the host country can be

summarized as:

1. They promote transfer of technology,

capital and managerial and entrepreneurial
skills (the factors of production) in favour
of the host country.
2. They increase the exports of the host
country; thus it helps improve the countrys
balance of payments.
3. They generate jobs to reduce unemployment
problems.
4. They increase availability of improved
quality-products for local consumers of the
host country.
5. They improve competition in the host
country by ending domestic monopolies.
6. The host country also benefits from the
knowledge and expertise of MNCs.
MNCs improve them continuously through
efficient R&D activities.
7. They increase the government revenue of
the host country, as they are the major
source of payments of tariff, taxes and other
charges.
Benefits of FDI to the Home Country
FDI benefits the home country too. The
country gets the supply of necessary raw material
if the investor makes investments in the
exploration of a particular raw material. The
balance-of-payments improves insofar as the
parent company gets dividend, royalty, technical
service fees, and other payments.
Benefits to the home country from
outward FDI arise from employment effects.
Positive employment effects arise when the
foreign subsidiary creates demand for homecountry
exports
of
capital
equipment,
intermediate goods, complementary products, and
the like.
Moreover, the government of the home
country generates revenue by taxing the dividend
and other earnings of the parent company. There
is also revenue from tariff on imports of the
parent company from its subsidiary abroad.
Again, since FDI is a complement to foreign aid,
it helps develop a closer political tie between the
home country and the host country, which is
beneficial for both countries.

The Costs of FDI to the Home Country

There are certain apparent costs of FDI
for the home country. The most important
concerns center around the balance-of-payments
and employment effects of outward FDI. The
home countrys balance-of-payments may suffer
in three ways. First, the capital account of the
balance of payments suffer from the initial capital
outflow required to finance the FDI. This effect is
usually more than offset by the subsequent inflow
of foreign earnings. Second, the current account
of the balance-of-payments suffers if the purpose
of the foreign investment is to serve the home
market from a low-cost production location.
Third, the current account of the balance-ofpayments suffers if the FDI is a substitute for
direct exports.
With regard to employment effects, the
most serious concerns arise when FDI is seen as a
substitute for domestic production. This was the
case with Toyotas investment in Europe. One
obvious result of such FDI is reduced homecountry employment. If the labour in the home
country is already very tight, with little

The Costs of FDI to the Host Country

It is a fact that the inflow of foreign
investment helps improve the balance-ofpayments, but the outflow on account of imports

10

unemployment, this concern may not be that

great. However, if the home country is suffering
from unemployment, concern about the export of
jobs may arise. For example, one objection
frequently raised by U.S. labour leaders to the
free trade pact between the United States, Mexico,
and Canada is that the United States will lose
hundreds of thousands of jobs as U.S. firms invest
in Mexico to take advantage of cheaper labour
and then export back to the United States.

FDI due to the fact that most of the determinants

just mentioned above are not so favourable for
FDI in these countries.

FDI and Least Developed Countries

(LDCs)
Foreign Direct Investment is the outcome
of the mutual interest of multinational firms and
host countries. In LDCs, the FDI is increasingly
seen as a useful source of funds. It has many
benefits over other forms of foreign investments
that make it attractive for developing country
which always has resource limitations and looks
upon foreign investment to bridge the demandsupply gap. It can become an important vehicle
for economic growth by bringing new skills in
workers, integrating economy internationally by
linking external resource markets, and providing
new markets for domestically produced products.
It also plays an important role in the creation of
new employment and economic revitalization.
Nepal as an economy sandwiched
between the two large emerging economies in the
world has low-cost labour, relatively more liberal
foreign investment policy, and rich natural
resources. Nepali manufacturers have free access
to the Indian market, and tariffs on imported raw
materials and components are lower here than
other south Asian countries. These facts indicate
that Nepal is a potentially attractive location for
foreign investors. But, due to the political
instability along with other various reasons, Nepal
has not been able to attract FDI.
The FDIs in developing countries are
governed by various factors, which can very well
be called determinants of FDI. These
determinants are related to the laws and
regulations of the country, general business
environment, administrative procedures, resource
cost structure, and even factors like proximity to
the investing country, and cultural ties between
two-party countries. These factors form a
complex set of considerations. It is difficult to
identify a single factor in isolation which can
fully explain competitiveness of a country in
attracting FDI. But it is worthwhile to analyze
these factors in isolation and in comparison with
those of competing countries to get a fair
understanding of the nature and scope of a
country in attracting FDI. Least developed
countries like Nepal have not been able to attract

11