Foreign Direct Investment

13 May, 2022 - 00:05 0 Views
Foreign Direct Investment

eBusiness Weekly

Dr Keen Mhlanga

A huge population around the globe has made the question, “what should l do with money?’ Often business minded people and risk takers always conclude investing as the best opinion.

Money is defined as medium stock of exchange characterised by durability, portability, divisibility, uniformity, limited supply, and acceptability hence such characters create a better feeling of rather investing it.

Investing is defined as the act of allocating resources, usually money, with the expectation of generating an income or profit.

You can invest in endeavours, such as using money to start a business, or in assets, such as purchasing real estate in hopes of reselling it later at a higher price.

Both definitions share a common goal which is room to grow or expand one’s money hence others participate in foreign direct investments (FDI).

FDI is an investment from a party in one country into a business or corporation in another country with the intention of establishing a lasting interest.

Lasting interest differentiates FDI from foreign portfolio investments, where investors passively hold securities from a foreign country.

A foreign direct investment can be made by obtaining a lasting interest or by expanding one’s business into a foreign country.

An investment into a foreign firm is considered an FDI if it establishes a lasting interest.

A lasting interest is established when an investor obtains at least 10 percent of the voting power in a firm. The key to foreign direct investment is the element of control.

Control represents the intent to actively manage and influence a foreign firm’s operations.

This is the major differentiating factor between FDI and a passive foreign portfolio investment.

For this reason, a 10 percent stake in the foreign company’s voting stock is necessary to define FDI.

However, there are cases where this criterion is not always applied.

For example, it is possible to exert control over more widely traded firms despite owning a smaller percentage of voting stock.

Typically, there are two main types of Foreign direct investments namely horizontal and vertical FDI.

Horizontal is whereby a business expands its domestic operations to a foreign country. In this case, the business conducts the same activities but in a foreign country. For example, McDonald’s opening restaurants in Japan would be considered horizontal FDI.

In a vertical FDI a business expands into a foreign country by moving to a different level of the supply chain. In other words, a firm conducts different activities abroad but these activities are still related to the main business.

Using the same example, McDonald’s could purchase a large-scale farm in Canada to produce meat for their restaurants. However, two other forms of FDI have also been observed: conglomerate and platform FDI.

Conglomerate is when a business acquires an unrelated business in a foreign country.

This is uncommon, as it requires overcoming two barriers to entry: entering a foreign country and entering a new industry or market.

An example of this would be if Virgin Group, which is based in the United Kingdom, acquired a clothing line in France. Platform FDI is when a business expands into a foreign country but the output from the foreign operations is exported to a third country.

This is also referred to as export-platform FDI. Platform FDI commonly happens in low-cost locations inside free-trade areas. For example, if Ford purchased manufacturing plants in Ireland with the primary purpose of exporting cars to other countries in the EU.

In 2020, global foreign direct investment fell by one-third to $1 trillion due to the effects of the global Covid-19 pandemic, according to the United Nations Conference on Trade and Development. That’s far below 2016’s peak level of foreign direct investment, which nearly hit $2 trillion.

Companies considering a foreign direct investment generally look only at companies in open economies that offer a skilled workforce and above-average growth prospects for the investor.

Light Government regulation also tends to be prized.

Foreign direct investment frequently goes beyond capital investment. It may include the provision of management, technology, and equipment as well.

A key feature of foreign direct investment is that it establishes effective control of the foreign business or at least substantial influence over its decision-making. Foreign direct investment is critical for developing and emerging market countries.

Their companies need multinational funding and expertise to expand their international sales.

Their countries need private investment in infrastructure, energy, and water to increase jobs and wages.

The UN has also promoted the use of FDI to combat the impacts of climate change.

Trade agreements are a powerful way for countries to encourage more FDI. One great example of this is the North Atlantic Free Trade Agreement (NAFTA), the world’s largest free trade agreement.

It increased FDI among the United States, Canada, and Mexico to $731 billion in 2015. That was just one of NAFTA’s advantages.

Foreign direct investment offers advantages to both the investor and the foreign host country.

These incentives encourage both parties to engage in and allow FDI. Businesses therefore benefit Diversified investor portfolios: Individual investors have the potential to achieve greater portfolio efficiency (return per unit of risk), as FDI diversifies their holdings outside of a specific country, industry, or political system.

Generally, a broader base of investments will dampen overall portfolio volatility and provide for stronger long-term returns. Recipient businesses receive “best practices” management, accounting, or legal guidance from their investors.

They can incorporate the latest technology, operational practices, and financing tools. By adopting these practices, they enhance their employees’ lifestyles.

That raises the standard of living for more people in the recipient country. FDI rewards the best companies in any country. It reduces the influence of local governments over them.

Recipient countries see their standard of living rise. As the recipient company benefits from the investment, it can pay higher taxes. Unfortunately, some nations offset this benefit by offering tax incentives to attract FDI.

Another advantage of FDI is that it offsets the volatility created by “hot money.” That’s when short-term lenders and currency traders create an asset bubble.

They invest lots of money all at once, then sell their investments just as fast. That can create a boom-bust cycle that ruins economies and ends political regimes.

Foreign direct investment takes longer to set up and has a more permanent footprint in a country.

The creation of jobs is the most obvious advantage of FDI, one of the most important reasons why a nation (especially a developing one) will look to attract foreign direct investment.

FDI boosts the manufacturing and services sector which results in the creation of jobs and helps to reduce unemployment rates in the country.

Increased employment translates to higher incomes and equips the population with more buying powers, boosting the overall economy of a country.

Human capital involved the knowledge and competence of a workforce. Skills that employees gain through training and experience can boost the education and human capital of a specific country.

Through a ripple effect, it can train human resources in other sectors and companies.

Targeted countries and businesses receive access to the latest financing tools, technologies, and operational practices from all across the world.

The introduction of newer and enhanced technologies results in company’s distribution into the local economy, resulting in enhanced efficiency and effectiveness of the industry.

The flow of FDI into a country translates into a continuous flow of foreign exchange, helping a country’s Central Bank maintain a prosperous reserve of foreign exchange which results in stable exchange rates.

By facilitating the entry of foreign organisations into the domestic marketplace, FDI helps create a competitive environment, as well as break domestic monopolies.

A healthy competitive environment pushes firms to continuously enhance their processes and product offerings, thereby fostering innovation.

Consumers also gain access to a wider range of competitively priced products.

Despite many benefits, there are still disadvantages of foreign direct investments. Countries should not allow foreign ownership of companies in strategically important industries.

That could lower the comparative advantage of the nation, according to an International Monetary Fund report. Foreign investors might strip the business of its value without adding any.

They could sell unprofitable portions of the company to local, less sophisticated investors.

They can use the company’s collateral to get low-cost, local loans. Instead of reinvesting it, they lend the funds back to the parent company.

In the case of profit repatriation, the primary concern is that firms will not reinvest profits back into the host country. This leads to large capital outflows from the host country.

As a result, many countries have regulations limiting foreign direct investment.

Both economic theory and recent empirical evidence suggest that FDI has a beneficial impact on developing host countries.

But recent work also points to some potential risks: it can be reversed through financial transactions; it can be excessive owing to adverse selection and fire sales; its benefits can be limited by leverage; and a high share of FDI in a country’s total capital inflows may reflect its institutions’ weakness rather than their strength.

Though the empirical relevance of some of these sources of risk remains to be demonstrated, the potential risks do appear to make a case for taking a nuanced view of the likely effects of FDI.

Policy recommendations for developing countries should focus on improving the investment climate for all kinds of capital, domestic as well as foreign.

Dr Keen Mhlanga is the executive chairman of Finking Financial Advisory. He can be contacted on [email protected] or +263719516766

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