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FOREIGN DIRECT INVESTMENTSOUMENDRA ROYFOREIGN DIRECT INVESTMENTWhy is FDI increasing in the world economy?Why do firms often prefer FDI to other market entry strategies?Why do firms imitate competitors with FDI strategies?Why are certain locations favored for FDI?How does political ideology affect government FDI policy? What are key FDI related costs and benefits for receiving and source countries?Foreign Direct Investment is any form of investment that earns interest in enterprises which function outside of the domestic territory of the investorFDIs require a business relationship between a parent company and its foreign subsidiaryFDI stocks now constituting 28% of the global GDP3INTRODUCTIONFOREIGN DIRECT INVESTMENTForeign direct investment (FDI): a firm invests directly in foreign facilities A firm that engages in FDI becomes a multinational enterprise (MNE)Multinational = more than one countryFactors which influence FDI are related to factors that stimulate trade4FOREIGN DIRECT INVESTMENTInvolves ownership of entity abroad forproductionMarketing/serviceR&DAccess of raw materials or other resourceParent has direct managerial controlDepending on its extent of ownership and On other contractual terms of the FDINo managerial involvement = portfolio investment 5Inward FDI and Outward FDIVertical FDI and Horizontal FDIMarket seeking FDI and Resource seeking FDIGreenfield investments and mergers and acquisitions 6TYPES OF FDITRENDS IN FDIFlow and stock increased in the last 20 yearsIn spite of decline of trade barriers, FDI has grown more rapidly than world trade becauseBusinesses fear protectionist pressuresFDI is seen a a way of circumventing trade barriersDramatic political and economic changes in many parts of the worldGlobalization of the world economy has raised the vision of firms who now see the entire world as their marketIncreased by 5.1% and stood at US $ 947 bn in 2007Number of projects 11,574 (2007)Top 10 destinations for FDI :China, US, India, UK, France, Germany, Russia, Spain , Poland and Romania

8FDI MOVEMENT IN THE WORLDFDI GROWTH IN THE WORLD ECONOMYFDI Outflow: $35 billion in 75 to $1.3 trillion in 00 to $653 billion in 03FDI Flow (from all countries): from 92 to 02 up 292%, compared to trade up 69% and world output up 28%FDI Stock: $3.5 trillion by 97 to > $7 trillion in 02In 02: 64,000 MNEs had:850,000 foreign affiliates 53 million employees $17.7 trillion in sales$8 trillions global exports ConclusionFDI flow growing faster than world trade and world output

DIRECTION AND SOURCE OF FDIMost FDI flow has been to developed countries from developed countriesMuch to the US from EU, JapanFDI increase to developing countries since 85Much to the emerging Asian and Latin America economies Africa lagging

FORMS OF FDIFDI formsPurchase of assets: why? why not?Quick entry, local market know-how, local financing may be possible, eliminate competitor, buying problemsNew investment: why? why not?No local entity is available for sale, local financial incentives, no inherited problems, long lead time to generation of salesInternational joint-ventureShared ownership with local and/or other non-local partnerShared riskALTERNATIVE MODES OF MARKET ENTRYFDIFDI - 100% ownershipFDI < 100% ownership, International Joint VentureStrategic Alliances (non-equity)FranchisingLicensingExports: Direct vs IndirectWHY FDI?FDI over exportingHigh transportation costs, trade barriersFDI over licensing or franchisingNeed to retain strategic controlNeed to protect technological know-howCapabilities not suitable for licensing/franchisingFollow few main competitorsImmediate strategic responsesPATTERN OF FDI EXPLANATIONSInternational product life-cycle (Ray Vernon)Trade theory similarityEclectic paradigm of FDI (John Dunning)Combines ownership specific, location specific, and internalization specific advantages Explains FDI decision over a decision to enter through licensing or exportsECLECTIC PARADIGM OF FDI (DUNNING)Ownership advantage: creates a monopolistic advantage to be used in markets abroadUnique ownership advantage protected through ownership e.g., Brand, technology, economies of scale, management know-howLocation advantage: the FDI destination market must offer factors (land, capital, know-how, cost/quality of labor, economies of scale) that are advantageous for the firm to locate its investment there (link to trade theory)Internalization advantage: transaction costs of an arms-length relationship --licensing, exports-- higher than managing the activity within the MNCs boundaries17GOVERNMENT POLICY AND FDIThe radical view: inbound FDI harmful; MNEsAre imperialist dominatorsExploit host to the advantage of home countryExtract profits from host country; give nothing backKeep LDCs backward and dependent for investment, technology and jobsThe free market view: FDI should be encouragedAdam Smith, Ricardo, et al: international production should be distributed per national comparative advantageAn MNE increases the world economy efficiencyBrings to bear unique ownership advantages Adds to local economys comparative advantagesHOST COUNTRY EFFECTS OF FDIBenefitsResource -transferEmploymentBalance-of-payment (BOP)Import substitutionSource of export increaseCostsAdverse effects on the BOPCapital inflow followed by capital outflow + profitsProduction input importationThreat to national sovereignty and autonomyLoss of economic independenceGOVERNMENT POLICY AND FDIHome countryOutward FDI encouragementRisk reduction policies (financing, insurance, tax incentives)Outward FDI restrictionsNational security, BOPHost countryInward FDI encouragementInvestment incentivesJob creation incentivesInward FDI restrictionsOwnership extent restrictions (national security; local nationals can safeguard host countrys interests

DECISION FRAMEWORK FOR FDIExportFDIFDIFDILicenseYesImport Barriers?NoNoYesNoAre transportation costs high?Is know-how easy to license?Tight control over foreign ops required?Is know-how valuable and is protection possible?NoYesYesNoYesBENEFITS OF FDIEconomic development of the host

Transfer of technology

Development of human capital resources

Creation of jobs

Opening export window22Company may lose ownership

Difference in language and culture

Country secrets may be disclosed

Policies adapted may not be appreciated23DISADVANTAGES OF FDIFDI Inflow in US million dollars24FDI FLOW IN INDIASectors attracting highest FDI Equity Inflows (In Rs crore)SECTOR2005-062006-072007-08 2008-09 (April-May)Cumulative (Apr.2000- May 2008)% of total inflows* Services (Financial & non-financial)2399(543)21047(4664)26589(6615)4955(1198)60652(14256)21.85Computer Software & Hardware6172(1375)11786(2614)

(1410)817(199)32984(7477)11.88%Telecommunications2776(624)2155(478)5103(1261)939(232)17687(4074)6.37Construction 667(151)4424(985)6989(1743)4846(1162)18313(4325)6.57Automobile630(143)1254(276)2697(675)1385(346)11241(2582)4.05Housing and Real estate171(38)2121(467)8749(2179)4277(1034)15439(3745)5.56Power386(87)713(157)3875(967)1771(438)11401(2643)4.11Metallurgical6540(147)7866(173)4686(1177)2563(615)9911(2377)3.57Chemicals (Other than fertilizers)1731(390)930(205)920(229)544(134)6684(1519)2.41Petroleum & Natural Gas64(14)401(89)5729(1427)106(26)8352(2007)3.01Figures in bracket are in US$ million* In terms of Rs.SOURCE: DIPP, Federal Ministry of Commerce and Industry, Government of India25SECTOR WISE FDISOURCE: DIPP, Federal Ministry of Commerce and Industry, Government of India26COUNTRY WISE SHARE IN FDITill 2006 more FII investment than FDI in India.

Reverse in China

FDI was more than ten times of ours earlier

More FDI helpful than FII

27FDI Vs FIIGLOBAL MONETARY SYSTEMINTERNATIONAL MONETARY SYSTEMCurrency exchange rates depend on the structure of the international monetary systemGenerally they are not freely convertible and do not float freelyOnly 51 were freely convertible in 1997Another 50 were pegged to the exchange rate of major currencies such as the US Dollar and the French Franc or to baskets of other currenciesAnother 45 currencies were allowed by their governments to float within a range of another currencyThis is 146 of 188 UN member nations in 1999

EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEMGold StandardCurrencies pegged to the value of gold; convertibility guaranteedBy 1880 most countries were on the gold standardAchieves balance of trade equilibrium for all countries (value of exports equals value of imports); flow of gold was used to make up differencesAbandoned in 1914; attempt to resume after WWI failed with Great DepressionBretton Woods (1944) BRETTON WOODS (1944 - 1973)44 countries met to design a new system in 1944Established International Monetary Fund (IMF) and World BankIMF maintained order in monetary systemWorld Bank promoted general economic developmentFixed exchange rates pegged to the US DollarUS Dollar pegged to gold at $35 per ounceCountries maintained their currencies 1% of the fixed rate; government had to buy/sell their currency to maintain level

THE ROLE OF THE IMF AS PER BRETTON WOODSExchange rate disciplineNational governments had to manage inflation through their money supply Exchange rate flexibilityProvided loans to help members states with temporary balance-of-payment deficit; Allowed time to bring down inflationRelieved pressures to devalueExcessive drawing from IMF funds came with IMF supervision of monetary and fiscal policiesAllowed up to 10% devaluations and more with IMF approvalTHE ROLE OF THE WORLD BANKWorld Bank (IBRD-International Bank for Reconstruction and Development) roleRefinance post-WWII reconstruction and developmentProvide low-interest long term loans to developing economiesThe International Development Agency (IDA), an arm of the bank created in 1960Raises funds from member statesLoans only to poorest countries50 year repayment at 1% per year interestCOLLAPSE OF BRETTON WOODSDevaluation pressures on US dollar after 20 yearsLyndon Johnson policiesVietnam war financingWelfare program financingNixon ended gold convertibility of US dollar in 1971US dollar was devalued and dealers started speculating against it for further devaluationBretton Woods fixed exchange rates abandoned in January 1972JAMAICA AGREEMENT 1976Floating rates declared acceptableGold abandoned as reserve asset; IMF returned its gold reserves to its members at current pricesProceeds were placed in a trust fund to help poor nationsIMF quotas member country contributions increased; membership now 182 countriesLess-develop, non-oil exporting countries given more access to IMFIMF continued its role of helping countries cope with macroeconomic and exchange rate problemsRECENT ACTIVITIES AND THE IMFMexican crisis 1995Russian crisis1995Asian crisis 1997/1998The investment boomExcess capacityThe debt bombExpanding importsThe crisisHow did the IMF do?Inappropriate policies?Moral hazardReckless behaviorNo consequencesLack of accountabilityRecord mixedIMPLICATIONS FOR BUSINESSCurrency managementThe monetary system is not perfectBoth speculative activity and government intervention affect the systemCompanies must use risk management instrumentsBusiness strategyMinimize risk by placing assets in different parts of the world, e.g., productionContract manufacturingManage company-government relations38The foreign exchange market is the mechanism by which participants:transfer purchasing power between countries;obtain or provide credit for international trade transactions, andminimize exposure to the risks of exchange rate changes.

0FUNCTIONS OF FX MARKET39CHARACTERISTICS OF FX MARKETLargest of all financial markets with average daily turnover of over $2 trillion! 66% of all foreign exchange transactions involve cross-border counterparties.Only 11% of daily spot transactions involve non-financial customers.London is the largest FX market.US dollar involved in 87% of all transactions.

39400

Market Activity 24hrs41Increasing Turnover

Daily foreign exchange market turnover in billions of US dollars

(Bank for International Settlements Triennial Central Bank Survey 2004)4142IMPORTANT CURRENCIES

4243A Spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day.The date of settlement is referred to as the value date.0TYPES OF TRANSACTIONS44An outright forward transaction (usually called just forward) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced.)0TYPES OF TRANSACTIONS45A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.Both purchase and sale are conducted with the same counterparty.Some different types of swaps are:spot against forward,forward-forward,nondeliverable forwards (NDF).0TYPES OF TRANSACTIONS460

TYPES OF TRANSACTIONS47The foreign exchange market consists of two tiers:the interbank or wholesale market (multiples of $1M US or equivalent in transaction size), and the client or retail market (specific, smaller amounts).Five broad categories of participants operate within these two tiers: bank and nonbank foreign exchange dealers, individuals and firms, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.0MARKET PARTICIPANTS48Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.They profit from buying foreign exchange at a bid price and reselling it at a slightly higher offer or ask price.Dealers in the foreign exchange department of large international banks often function as market makers.These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an inventory position in those currencies.0MARKET PARTICIPANTS49Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market.Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose.Some of the participants use the market to hedge their foreign exchange risk.0MARKET PARTICIPANTS50Speculators and arbitragers seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market.While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.

0MARKET PARTICIPANTS51Central banks and treasuries use the market to acquire or spend their countrys foreign exchange reserves as well as to influence the price at which their own currency is traded.They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System.The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens.As willing loss takers, central banks and treasuries differ in motive from all other market participants.0MARKET PARTICIPANTS52TYPES OF ACTIVITIESSpeculation An activity that leaves one open to exchange rate fluctuations where one aims to make a profit.HedgingAllows the firm to transfer exchange rate risk inherent in foreign currency transactions or positions.Arbitrage take advantage of inconsistent prices to make risk-free profits. These profits are unlikely to last long5253FOREIGN EXCHANGE RATES & QUOTATIONSA foreign exchange rate is the price of one currency expressed in terms of another currencyA foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate

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