Sukhmandeep singh L-2010/11-BS-07-MBA (AB)

Meaning
In simple terms, FDI means acquiring

ownership in an overseas business entity. It is the movement of capital across national frontiers, which gives the investor control over the assets acquired.

FDI is the largest source of external finance for developing countries. It plays a crucial role in the development process of host economies. It also has a significant role in enhancing exports of host countries. FDIs are generally preffered to other forms of external finance because these are nondebt creating, non volatile and the returns depend on the performance of the project financed by the investors.

Reasons of its superiority to other type of capital flows

Firms entering a host country through FDI

have a long term perspective in contrast to foreign lenders and portfolio investors. Debt inflows may finance consumption whereas FDI is more likely to be used to improve productivity. Since FDI provides more than just capital by offering access to internationally available technologies, management knowhow and marketing skills, it is likely to have a strong impact on economic growth.

Benefits of FDI
Access to superior technology Increased competition Increase in domestic Investment Bringing host countries foreign

exchange gaps

Negative impact of FDI

Market monopoly Crowding out and unemployment

effects Technology dependence Profit outflow Corruption National security

Factors effecting selection of FDI destinations

Cost of capital input: It includes interest

rate and financial capital employment for setting up of plant or the rent. Wage rate: It is highly significant for manufacture of labour-intensive products. Taxation regime: IT is the prevailing taxation rates of the host countries for investment purposes like large number of countries provide tax holidays to foreign companies in order to attract FDI Cost of logistics: Includes availability of various modes of transportation and their cost. Market Demand: Includes consumer preference, income level, and investment decisions.

Types of FDI
On the basis of direction of investment On the basis of type of activity On the basis of investment objectives On the basis of entry modes On the basis of sector On the basis of strategic modes

On the basis of direction of Investment

Inward FDI: Foreign firms taking control

over domestic assets is termed as inward FDI. From an Indian perspective, direct investments made by foreign firms such as Suzuki, Honda, Electrolux etc. Outward FDI: Domestic firms investing overseas and taking control over foreign assets is known as outward FDI. It is also known as Direct Investment Abroad. Examples: Tata Motors, Infosys, Videocon etc.

On the basis of types of activity

Horizontal FDI: It is when a firm invests

in a foreign country in similar production activity as carried out in home country. Vertical FDI: It is when direct investments in industries abroad so as to either provide inputs for the firms domestic operations or sell its domestic outputs overseas. Backward vertical FDI: It is when direct investment overseas aimed at providing inputs for the firms production processes in the home country. It is common in extractive industries.

Forward Vertical FDI: Direct investment in

a foreign country aimed to sell the output of the firms domestic production processes is referred to as forward vertical FDI. Conglomerate FDI: Direct investment overseas aimed at manufacturing products not manufactured by the firm in the home country is termed as conglomerate FDI.

On the basis of Investment Objectives

Resource seeking FDI: in order to gain

privileged access to resource vis--vis competitors, MNEs invest in countries with availability of natural resources. The major determinants include:

1. Availability of raw material 2. Complementary factors of production 3. Physical infrastructure

 Market seeking FDI: MNEs invest in

countries with sizeable market and growth opportunities in order to protect existing markets, counteract competitors and to preclude rivals or potential rivals from gaining new markets. The major economic determinants include: 1. Market size 2. Market growth 3. Regional integration

 Efficiency seeking FDI: A firm may

1. 2. 3. 4.

strategically opt for it as a part of regional or global product rationalization and/or to gain advantages of process specialization. The major determinants of it are: Productivity adjusted labour costs Availability of skilled labour Availability of business related services Trade policy

On the basis of Entry Modes

Greenfield investments: investing in

creation of new facilities or expansion of existing facilities is termed as Greenfield investment. The selection of FDI mode is influenced by: 1. Institutional factors 2. Cultural factors 3. Transactional cost factors

Mergers and acquisitions: For establishing

overseas production facilities, mergers and acquisitions are crucial tools for a firms internationalization strategy. M&As have become an increasingly popular mode of investment among firms worldwide in order to enhance their competitiveness so as to consolidate, protect and advance their position by acquiring companies internationally.

On the basis of sector Industrial FDI:

1.

2. 3. 4.

Investments by foreign firms in the manufacturing sector is termed as industrial FDI. Major objectives include: To achieve cost efficiencies by way of taking advantage of availability of raw material inputs and manpower at cheaper costs. To bypass trade barriers such as high import tariffs and other import restrictions. To be closer to the markets and serve them more efficiently. To have physical presence due to

 Non-Industrial FDI:

Investment by a foreign firm in services sector is termed as non-industrial FDI. Major reasons for non-industrial FDI are: 1. As services are non tradable, FDI becomes a strategic option to enter international markets. 2. To overcome regulatory obstacles. 3. To create regular contact with the customers

On the basis of strategic modes

Export replacement: in response to trade

barriers of the host country, such as import restrictions and prohibitive tariff structure, FDI is made a substitute for exports. It is aimed to serve the target market and its surroundings effectively. Every mode for such type of FDI is typically through M&As.

Export platforms: In order to minimize a

firms cost of production and distribution, FDI is made as to utilize the target country to serve the global markets. The competitive advantage and incentive offered by the host country plays a crucial role in attracting such FDI.
Domestic substitution: The basic objective

of firms in this kind of FDI is to obtain cheap inputs to support home production. Bilateral trade agreements play an important role in FDIs to promote substitution.

Theories of International Investment

Capital arbitrage theory: This theory of

capital arbitrage is more suitable for foreign portfolio investments where the return on capital are crucial in short term. A firm has long term interest in FDI, variety of multiple factors influence the investment decisions besides higher rate of returns. Therefore, scope of this theory is limited to provide a broad explanation of FDI.

Market imperfection theory: Factors that

inhibit markets from working perfectly are known as market imperfections. Government policies, including import restrictions and quotas, restrictions on FDI, tax regimes are its examples which create market imperfection. Basic objective of such restrictive measures is to promote a countrys industrial development and manage the balance of trade.

Monopolistic Advantage Theory: An MNE is believed to possess monopolistic advantage, which enables it to operate overseas more profitably and compete with local firms. The benefit possessed by the firm maintains its monopolistic power in the market is termed as monopolistic advantage. For a firm to invest in physical resources overseas, following are the conditions required. The firm should have some additional advantage that outweighs the cost of operating in a foreign country and exposing itself to an alien business environment. The firm can exploit such specific advantage only through control of foreign operations by ownership rather than other low-risk means of market access requiring less commitment of resources such as exporting and licensing.

1.

2.

International product life cycle theory

It says that a product gains monopolistic

advantage by innovation of a product or process technology and markets the product domestically or in overseas market through exports. The product is initially manufactured in the country of innovation even though the cost of production in other countries may be lower. Subsequently, in the growth phase when product becomes standardized the innovating firm takes advantage of lower cost of manufacturing abroad and starts investing in other countries to create its own manufacturing facilities.

Eclectic theory
The ownership (O) factor: for an

investing firm to be profitable overseas, it needs to possess some core competencies or specific advantages not shared by its competitors. Such advantages are termed as ownership factors. An MNE has some advantages like: 1. Intangible assets 2. Tangible assets 3. Size economy

 Location factor: The location advantage or

factor of a host country is the key determinant to its relative attractiveness as an investment destination. The major advantages are: 1. Economic 2. Socio-Cultural 3. Political

 Internalization factor: this factor explains

the entry mode used by an MNE to access international markets. The core competencies and know-how possessed by the firm form the basis of economic gains. A firm attempts to internalize its operations 1. to protect its proprietary knowledge from competitors 2. To protect itself against market uncertainties 3. To create and maintain monopolistic or oligopolistic powers in market by placing entry barriers to its competitors.

FDI Recent Global Trend

Capital Arbitrage Theory

In an article published in 1958, Modigliani and

Miller propounded their view which is known as Modigliani-Miller Approach. Their approach is identical with the net operating income approach. They have also concluded that in the absence of taxes, a firms market value and the cost of capital remain constant to the changes in capital structure. In other words, an optimum capital structure does not exits. The net operating income approach leads to the same conclusion, but Modigliani and miller have provided a behavioral justification in favor of this conclusion. That is, they refer to a particular behavior of the investors in

Process
If the price of a product is unequal in two markets,

traders buy it in the market where price is low and sell it in the market where price is high. This phenomenon is known as price differential or arbitrage. As a result of this process of arbitrage, price tends to decline in the high-priced market and price tends to rise in the low-priced market unit the differential is totally removed. Modigliani and Miller explain their approach in terms of the same process of arbitrage. They hold that two firms, identical in all respects except leverage cannot have different market value. If two identical firms have different market values, arbitrage will take palce unit difference in the

Top Ten Acquisitions and Mergers till date

Tata Steels mega takeover of European steel major

Corus for $12.2 billion. The biggest ever for an Indian company. This is the first big thing which marked the arrival of India Inc on the global stage. The next big thing everyone is talking about is Tata Nano. Vodafones purchase of 52% stake in Hutch Essar for about $10 billion. Essar group still holds 32% in the Joint venture. Hindalco of Aditya Birla groups acquisition of Novellis for $6 billion. Ranbaxys sale to Japans Daiichi for $4.5 billion. Sing brothers sold the company to Daiichi and since then there is no real good news coming out of

ONGC acquisition of Russia based Imperial

Energy for $2.8 billion. This marked the turn around of Indias hunt for natural reserves to compete with China. NTT DoCoMo-Tata Tele services deal for $2.7 billion. The second biggest telecom deal after the Vodafone. Reliance MTN deal if went through would have been a good addition to the list. HDFC Bank acquisition of Centurion Bank of Punjab for $2.4 billion. Tata Motors acquisition of luxury car maker Jaguar Land Rover for $2.3 billion. This could probably the most ambitious deal after the Ranbaxy one. It certainly landed Tata Motors into lot of trouble.

Wind Energy premier Suzlon Energys

acquistion of RePower for $1.7 billion. Reliance Industries taking over Reliance Petroleum Limited (RPL) for 8500 crores or $1.6 billion.

India is second largest market in the world after China and it fascinates global retailers to invest . Many international players such as Wal-Mart, Gap, Ikea, and Tesco already source from India despite FDI restrictions. Major pros and cons of opening up FDI in the retail sector are discussed here

Pros
FDI in retail would benefit the consumer by offering

him more choice, better services, wider access, easier credit and better shopping experience. Modern retailing will benefit local retailing by forcing it to re-invent as has been the case of China. It will lead to higher standard of quality, introduce best practices and more skilled employment. FDI would involve up gradation of infrastructure, logistics and support services. It will help Indian products get global recognition. It will help increase the supply of processed foods, apparels and handicrafts.

Cons
FDI in retail would wipe out traditional stores as

they will not be able to match the standards. The unrecognized sector would obviously lose its place and edge in the retail market. It would mean legalizing the predatory practices of the MNC retail chains Retail FDI will promote a standardized form of global foreign culture. Indias imports are likely to increase as MNCs will dump their products in India. Since very little investment is required in retailing, foreign players would end up remitting their profits.