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Foreign Direct Investment

By Shakti G B

Foreign Investment is classified as :
o Foreign Portfolio Investment (FPI) and o Foreign Direct Investment (FDI)

FPI occurs when firms diversify their investment in international securities and often operate on the stock exchange in a foreign country with the sole objective of getting high return. FPI is doesnt involves production of goods & provision of services abroad. FDI is very much concerned with the operation & ownership of host country firm

FDI broadly takes three forms: o Green Field Investment o Mergers & Acquisitions (M & A) o Brown Field Investment Green Field Investment: Opening a branch in host country or through making investment in equity capital of host country firm. Former is also known as Financial Collaboration.
a) Wholly Owned b) Subsidiary c) Affiliate

Mergers & Acquisitions (M & As): M & As are either outright purchase of running company abroad or an amalgamation with a running foreign company. In Mergers acquiring company maintains its existence and target company loses its existence. Acquisition Both lose existence in favor of new company. M & As can be friendly or hostile. M & As are Horizontal, Vertical & Conglomerate.
o Horizontal - two are more companies engaged in similar business combine. o Vertical occurs among firms involved in different stages of production. Ex- oil exploration with refining unit.


o Routes available for FDI:  Automatic Route  Foreign Investment Promotion Board (FIPB)  Cabinet Committee of Foreign Investment (CCFI) Automatic Route
No prior Government approval is required if the investment to be made falls within the Sectoral caps specified for the listed activities. Only filings have to be made by the Indian company with the concerned regional office of the Reserve Bank of India (RBI) within 30 days of receipt of remittance and within 30 days of issuance of shares

FIPB Route: Investment proposals falling outside the automatic route would require prior Government approval. Foreign Investment requiring Government approvals are considered and approved by the Foreign Investment Promotion Board (FIPB). Decision of the FIPB usually conveyed in 4-6 weeks. Thereafter, filings have to be made by the Indian company with the RBI

CCFI Route: Investment proposals falling outside the automatic route and having a project cost of Rs. 6,000 million or more would require prior approval of Cabinet Committee of Foreign Investment (CCFI). Decision of CCFI usually conveyed in 8-10 weeks. Thereafter, filings have to be made by the Indian company with the RBI Investment proposals falling within the automatic route and having a project cost of Rs. 6,000 million or more do not require to be approved by CCFI

Theories of FDI
1. 2. 3. 4. 5. 6. McDougall Kemp Theory International Organization Theory Location Specific Theory Product Cycle Theory Internalization Approach The Eclectic Approach

MacDougall-Kemp HypothesisOne of the earliest theories developed by MacDougall (1958), subsequently elaborated by Kemp (1964). FDI moves from a capital abundant economy to a capital scarce one till the marginal productivity of capital is equal in both the countries. Industrial Organization Theoryo One of the earliest theories based on the assumptions of the imperfect market was propounded by Hymer (1976). o According Hymer an MNC with Superior technology moves to different countries to supply innovated product making in turn ample gains. Location specific Theoryo Hood & Young (1979) stree the locational facotrs. They argue that firms with low-cost technology move to lowwage countries and invest in countries to start manufacturing where trade barriers exists for imports.

Product Cycle Theory Hymer explained why foreign investment takes place, Hood & Young explained where foreign investment takes place, but it was Raymond Vernon (1966) who added when to the why and where based on data obtained from US corporate activities. Vernon feel that most of the products follow a life cycle that is divided into 3 stages. 1. Innovation Stage is characterized with quite newness of product having price-inelastic demand. 2. Maturing Product Stage appears when the product turns price-elastic along with similar products in the market. 3. Standardized Product Stage with greater price competitiveness motivates firm to start production in a

Internalization Approacho Buckley and Casson (1976) too assume market imperfection, but imperfection, in their view, is related to the transaction cost that is involved in the intra-firm transfer of intermediate products such as knowledge or expertise. o Internalization is process when an MNC passes on improved technology to its foreign subsidiary at zero/low cost in order to grab the market. Eclectic Paradigm o Dunnings eclectic paradigm is a combination of the major imperfect market-based theories of FDI, viz. industrial organization theory, internalization theory and location specific theory.

o Eclectic theory postulates that at any given time, the stock of foreign assets owned by a multinational firm is determined by a combination of firm specificity or ownership advantage (O), the extent of location-bound endowments (L), and the extent to which these advantages are marked within the various units of the firm (I). o It is the combination of three advantagesOwnership, Location and Internalization that motivates a firm to make FDI. o Foreign investment will be greater where the

Strategies For FDI

1. Firm Specific Strategy 2. Cost Economizing Strategy 3. Strategy of Entering in New Areas 4. Cross Investment Strategy 5. Joint Venture with a Rival Firm Firm Specific Strategy: It means offering new kind (Innovative) of product or differentiated product. When the product innovation strategy fails to work, a firm may adopt a product differentiation strategy. This is done through branding.

Cost-economizing Strategy: Cost can be lowered through moving firm to a raw material abundant/labor abundant location. Strategy of Entering in New Areas: Entering a new area where competition is yet to begin . Cross-investment Strategy: A firm begins its foreign to avoid price cuts competing firms. If a country A firm sets up a manufacturing or trade unit in country B, there is probability for a country B firm to operate in country A. in such cases if former goes for a cut in price, the later too will adopt the same strategy as a retaliatory

Joint-venture with a Rival Firm: Sometimes, when a rival firm in the host country is so powerful that it is not easy for MNC to compete, the later prefers to join hands with the host country firm for a joint-venture agreement and the MNC thus able to penetrate the host country Market. Whenever strategy is adopted by the MNCs abroad. There are certain necessary preconditions. 1. Firstly, they should have an idea of the profitable investment opportunities and the ways to tap those opportunities.

Costs and Benefits of FDI

Benefits to the Host Country Availability of scarce factors of production Improvement in Balance of Payment Building of Economic & Social Infrastructure Fostering of Economic Linkages Strengthening of the government budget Cost to the Host Country Strained balance of payments following reverse flow Dependence on the import of technology Employment of Expatriates Inappropriate technology Unhealthy Competition Cultural & Political

Benefits to the Home Country Availability of Raw Material Improvement in balance of payment Employment generation Revenue to the Government Improved Political Relations

Cost to the Home Country Undesired outflow of factors of production Possibility of conflict with the host country Government


Foreign direct investment (FDI) is prohibited in the following cases:  Gambling and Betting  Lottery Business  Retail Trading (except single brand retail trading-not provided in Master Circular)  Atomic Energy  Housing and Real Estates  Agriculture (with certain exceptions) and Plantations (Other than Tea plantations)

Stable democratic environment over 55 years of independence Large and growing market World class scientific, technical and managerial manpower Cost-effective and highly skilled labor & Abundance of natural resources Surveys by leading organizations rate India among the top three investment hot spots and one of the fastest growing economies in the world Well-established legal system with independent judiciary Developed banking system and vibrant capital market