ECON 333 COURSEWORK

DATE: NOVEMBER16,2011

REASONS FOR FOREIGN DIRECT INVESTMENT AND THE EFFECTS ON HOST AND SOURCE COUNTRIES

Foreign Direct Investment (FDI) is an investment that involves the inflow of foreign funds into an organization that operates in a different country of origin from the investor. For example when an American company takes a majority stake in a company in France. For an investment to be considered as FDI it is essential for a company to invest its foreign assets into domestic goods and services. Ownership of shares less than 10% and investment in stock market is not considered as foreign investment. The investment by multinational corporations can take several forms; one of this is through the purchase of an ongoing company. For example Tata Motors acquired Jaguar, Land Rover in 2007 and posted an annual profit of $1.7 billion in 2009. Rather than working its way into the competitive automobile market in Europe and America it decided to acquire JLR through FDI. Another form of FDI is by setting up a new overseas operation as either a totally owned enterprise or a joint venture. For example NTT DOCOMO INC a Japanese mobile operator merged with Tata Teleservices Limited (TTSL) and formed a new brand Tata Docomo to roll out GSM service in India. There are a number of factors that encourage MNC to gain control of foreign assets; the following are reasons that may motivate these corporations to do so: Increase sales and profits Majority of the multinationals main aim is to maximize profits. Some of the best-known and largest corporations earn millions of dollars through overseas sales in a year. For example the automobile maker Volkswagen that made its presence in India in 2007 and since then has increased sales and its presence throughout the country by increasing its dealership network.

Enter Rapidly Growing Markets

Some international markets grow at a much faster rate than others; FDI provides multinational companies with the chance to benefit of these opportunities. A good example would be China and India that have seen a growth in its annual rate recently. Over the past few years the Indian economy has grown at an annual rate of around 7.5% making it a profitable market where multinationals want to have presence.

Obtain a foothold in economic blocks There are three major international economic blocs (EU, Asian bloc and NAFTA). MNCS that acquire a company in any one of these blocs or that enter into an alliance to do business in one of these blocs obtain a number of benefits including the right to sell their output in other member countries without the burden of import duties or restriction. Protect domestic markets Many MNCS enter an international market in order to attack potential competitors and as a result prevent them from increasing their operations overseas. Likewise an MNC also enters a foreign market to bring pressure on a company that has already challenged its domestic market. An example of this is when Fuji a Japanese company began building its first manufacturing facility in the US; Kodak an American company announced its decision of opening a manufacturing facility in Japan.

Gain technological and managerial knowledge By setting up operations near those of other competitors, firms can gain technological and managerial expertise. Like Kodak could recruit some of the leading scientists after moving its research and development facilities from US to Japan. Thus, FDI helps firms monitor competition and to explore local resources.

To retain direct control Several large corporations (usually in oligopolistic and monopolistic markets) often have some unique managerial skill or

production knowledge that could be utilized profitably abroad and over which the corporations would want to retain direct control. These firms would then make direct investment abroad in the form of horizontal integration, which is the production of a differentiated product abroad that is also produced at home. Examples of this are Xerox, Toyota and IBM. Ensure uninterrupted supply of raw material Corporations may involve in direct foreign investments to obtain control of a needed raw material therefore ensuring uninterrupted supply at the lowest possible cost. This is the reason why American and foreign corporations own mines in Canada, Jamaica, Australia etc and foreigners own some coalmines in United States. This is referred to as Vertical integration. Avoid trade restrictions: FDI helps avoid trade restrictions imposed by a country in the form of tariffs and quotas. When the firms exports face high barriers to trade, local production helps avoid these barriers. An example of this would be the Japanese automotive transplants, which were due to increasing US protectionism against Japanese imports. To diversify risk: When goods produced are highly sensitive to income changes then firms may want to have access to many different markets. For example in the recent recession which hit several economies such as USA and Uk, China and India still experienced growth. Had the company been operating only in North America or in the U.K it would have suffered from the slow pace of these economies. Lower cost of production and labor: Companies can sometimes achieve substantial lower costs by producing abroad. The incentive provided by foreign governments in the form of subsidiary may also help lower cost of production. An example of this would be the mineral extraction in which the presence of large deposits of natural resources in foreign countries is considerably less than continued domestic exploration and extraction, leading to large amounts of FDI. Lower labor cost may also make a firm to consider investing in a foreign

country. Countries like China and others in South East Asia have benefitted from this.

EFFECTS OF FDI ON THE HOST COUNTRY AND HOME COUNTRY Studies conducted by several different economists such as Balasubrmanya (1996), Borensztein (1998), Olofsdotter (1998) shows that FDI has a positive effect on host countries and leads to an increase in economic growth. Few of the benefits of FDI on host countries are as follows: Leads to greater output: When multinationals invest abroad, the output tends to increase. This output is positive to the host countries economy as it promotes economic growth and also has several other advantages that are listed below. This was also proved by Lipsay and Sjoholm in 2005. Increased demand for labor and wages: Increase in the output leads to an increase in the demand for laborers (skilled or unskilled). This leads to increase in employment level and a fall in unemployment. When demand of labor increases, the wage increases too as supply remains constant. Increased exports: International capital transfers also affect the balance of payments of the host country. FDI may result in the firm exporting the goods it produces resulting in an increase in exports of the host country. Researchers Rhee and Belot in 1990 showed that multinational firms act as natural channel for knowledge of overseas markets to domestic firms and through this encourage export in the host country. Increased tax revenues: Investment in the host country leads to increase in tax revenues.

Provision of new and better technology: When countries make foreign investments, they may also bring along new technologies to the host country. Apart from the capital inflows, employment and increasing local export activity; multinational activity may lead to technology transfer to domestic firms (Caves, 1982 and Helleiner, 1989). This spillover of technology may influence the structure, conduct and performance of domestically owned firms.

The drawbacks are: Dislocation of domestic firms: The multinational company with its advance technology may harm small domestic firms in the market forcing them to exit. It may be argued that it increases competition in the market, however the company investing may take advantage of its knowledge, technical know how and exploit its resources to drive competition out of the market. Inappropriate investment and technology: Multinational Corporations try to protect their technology by using patents and brand names. This creates unfair competition giving the MNC an undue advantage against domestic firms. As argued by Hymber (1960) the corporation may try to prevent spillovers of technology to other firms. Home Country Effects Investment shift from the home country to the host it may result in job loss if MNCS find cheaper source of production abroad. One example of this is United States where high unemployment occurred in the 1930s. It became a cause of creation of Office of Foreign Direct Investment (OFDI), which aimed at reducing the outflow of U.S capital for direct investment. This also aimed to improve the balance of payment, which is affected by FDI. Another possible harmful effect of FDI by MNCS on home country is transfer pricing which is the overpricing or under pricing of products by MNCS in an attempt to shift income and profits from high tax nations to low tax nations. MNCS may also engage in

shifting their operations to lower tax nations, which would reduce tax revenue in the home country. Another problem could be the export of advanced technology joint with cheaper foreign factors to maximize corporate profits. This may weaken technological superiority and future of the home nation. To conclude it can be said that FDI does have its benefits.

Reference:
Robert e lipsey. (october 2002). home and host country effects of fdi . NBER WORKING PAPER SERIES. 1 (1), 7-15 dominick salvatore (2002). international economics . 8th ed. new delhi: wiley india. 395-410. ABC. (2010). definition of foreign direct investment. Available: http://www.economywatch.com/foreign-directinvestment/definition.html. Last accessed 22-11-2011. ABC. (2010). Mulitnational corporations and foreign direct investment. Available: http://www.usi.edu/business/cashel/241/text%20files/mnc. pdf. Last accessed 23-11-2011. Andreas Johnson. (2005). the effects of fdi on host country economic growth. ... 1 (1), 2-5.