The role of foreign direct investment

The role of foreign direct investment

Foreign direct investment (FDI): a firm based in one country establishes its presence  in another country by providing long term investment.

FDI strategies can be categorised into three different types…

Horizontal: the company carries out the same activities as it does abroad. For example, Tesco is a UK supermarket that now has stores in 11 other countries. It is now not only the leading supermarket in the UK, but also in Ireland, Hungary, Malaysia, and Thailand.

Vertical: the company carries out different stages of activities abroad. For instance, in 2014 Jaguar Land Rover opened up its first full overseas manufacturing plant in China.

Conglomerate: the company carries out activities unrelated to its domestic business. For example, the Swire Group has its headquarters in London, many of its businesses in the Asia-Pacific region and operations predominantly in Hong Kong and Mainland China. Its businesses are diverse, although most focus on property, aviation, beverages, marine services, or trading and industrial.

FDI can also be separated into two different types…

Greenfield investment: the company starts a new venture abroad by constructing new factories or stores. For instance, Starbucks and MacDonalds tend to do this.

Browfield investment: the company purchases existing factories or stores to begin new production.

FDI usually leds to the cormation of multinational cooperations. These are defined as firms which have established, through FDI, production or other operations in multiple countires.

Ultimately MNCs expand into economically less developed countries in order to either increase their sales or to reduce their costs, and therefore increase their profit margins. Here are some more detailed reasons for MNCs expanding abroad…

  1. Natural resources are only available for extraction from certain locations, therefore, it may be more feesible to have refineries nearby, such as for oil and copper.

  2. Labour costs are often lower in developing countries, so MNCs employ workers in these countries in an attempt to lower prooduction costs.

  3. Developing countries tend to have slacker regulatory framework, meaning that there are fewer restrictions on business activities. This gives greater freedom to MNCs and can with lowering costs of production. For example, laws concerning environmental safeguarding may not be as well enforce, thereby giving firms more choice of where to set up factories.

These are the characteristics that developing countries tend to have which attract FDI:

  • Low cost factor inputs, including low labour costs and natural resources.

  • A regulatory framework that favours profit repatriation.

  • Favourable tax rules as firms generally prefer to pay lower taxes as then more of their revenue can be kept as profit.

  • Stable macroeconomic environment and political as this gives MNCs greater certainty that they will profit from their investments.

  • Weak regulatory system and environmental laws.

  • Weak trade unions as it is easier to hire and fire workers. Also these would otherwise give workers greater power to bid up wages.

  • Cultural similaries, perhaps due to proximiy or former colonies.

  • Plentiful natural resources

  • High levels of labour productivity and human capital

  • High quality infrastructure, including roads and ports

Advantages of MNCs

  • Increases empoyment opportunities for locals

  • Improves the productivity of the workforce by providing training and education

  • Increases the speed of the transfer and diffusion of technology

  • Adds to the investment that domestic savings finance

  • Corrects a current account deficit as the investment is an initial inflow and the MNCs products may generate a flow of export earning

  • Increases tax revenues which can then be spent by the government to aid growth and development

Disadvantages of MNC

  • They may import intermediate goods rather than domestic suppliers

  • They may become a monopoly, therefore eradicating competition from domestic producers

  • Repatriation of profits and payments of royalties may led to outward flows of foreign exchange and worsen the balance of payments

  • Tax concessions may mean that tax revenues collected from MNCs are substantially less than they should be

  • If MNCs use capital intensive technolgies, rather than labour intensive, then fewer job opportunities may be created than expected

  • They may bring workers from their own country, instead of employing locals

  • The job opportunities may be low skilled and without training, so the workforce will not improve their skills

  • MNCs may worsen the unequal income distribution, by only providing job opportunities in urban areas

  • The goods and services produced by the MNC may be of no interest or use to local consumers