The document discusses foreign direct investment and foreign aid. It defines FDI and foreign aid, and identifies factors that stimulate FDI. It describes different forms of foreign aid and the economic effects of FDI. Specifically, it outlines different types of FDI including horizontal and vertical FDI, and discusses the advantages and disadvantages of FDI for recipient countries.
The document discusses foreign direct investment and foreign aid. It defines FDI and foreign aid, and identifies factors that stimulate FDI. It describes different forms of foreign aid and the economic effects of FDI. Specifically, it outlines different types of FDI including horizontal and vertical FDI, and discusses the advantages and disadvantages of FDI for recipient countries.
The document discusses foreign direct investment and foreign aid. It defines FDI and foreign aid, and identifies factors that stimulate FDI. It describes different forms of foreign aid and the economic effects of FDI. Specifically, it outlines different types of FDI including horizontal and vertical FDI, and discusses the advantages and disadvantages of FDI for recipient countries.
The document discusses foreign direct investment and foreign aid. It defines FDI and foreign aid, and identifies factors that stimulate FDI. It describes different forms of foreign aid and the economic effects of FDI. Specifically, it outlines different types of FDI including horizontal and vertical FDI, and discusses the advantages and disadvantages of FDI for recipient countries.
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Handout - 08
Department of Commerce Faculty of Management Studies & Commerce University of Jaffna Programme : Third Examination in Commerce Course Title : International Trade Course Code : Com 3137 Handout Title : Foreign Direct Investment and Foreign Aid Prepared By : B.Prahalathan, Dept.of. Commerce Issue Date : 27.05.2008
Learning Objectives:
define foreign aid and investment
evaluate foreign direct investment and foreign aid identify the factors which stimulate foreign direct investment understand the different forms of foreign aid study the economic effects of foreign direct investment understand the types of foreign direct investment
Introduction After the Second World War the developing countries are making concerted efforts to achieve rapid economic growth and thereby alleviate problems of poverty and employment. The developing countries have been facing the problems of shortage of capital. To meet this shortage capital flows from the developed countries to the developing countries in the last two decades have substantially increased.
Foreign Portfolio Investment
Foreign institutions such as banks, insurance companies, companies’ managing
mutual funds and pension funds purchase stocks and bonds of companies of other countries in the secondary market. They get returns in the form of capital gain and dividends.
Foreign Direct Investment Strategies
The flow of foreign direct investment could occur through international acquisition or Green field investment. When a firm undertakes FDI, it becomes a multinational enterprise. FDI occurs when a company invests in real assets in a foreign country to produce or to market a product. 2 Mergers and Acquisitions
An international acquisition is a cross boarder investment in which a foreign
investor acquires an established local firm and makes the acquired local firm a subsidiary business within its global portfolio and local company becoming an affiliate of the foreign company. Cross-border mergers occur when the assets and operation of firms from different countries are combined to establish a new legal entity. Mergers are the most common way for multinationals to do FDI.
Greenfield Investment
This may be defined as direct investment in new facilities or the expansion of
existing facilities. Greenfield investments are the primary target of a host nation’s promotional efforts because they create new production capacity and jobs, transfer technology and know-how, and can lead to linkages to the global marketplace.
The Organization for International Investment cites the benefits of Greenfield
investment (or in sourcing) for regional and national economies to include increased employment (often at higher wages than domestic firms); investments in research and development; and additional capital investments. Criticism of the efficiencies obtained from Greenfield investments includes the loss of market share for competing domestic firms. Another criticism of Greenfield investment is that profits are perceived to bypass local economies, and instead flow back entirely to the multinational's home economy
Foreign Direct Investment Concepts
FDI can be classified as Horizontal foreign direct investment and Vertical foreign direct investment.
Horizontal Foreign Direct Investment
Horizontal foreign direct investment occurs when a multinational enterprise
(MNE) enters a foreign country to produce the same products produced at home. It represents a geographical diversification of the MNE’s established domestic product line.
Right time for Horizontal foreign direct investment could be any of the following
. When a organization can gain monopolistic characteristic in particular
area or region . When an organization competes in a growing industry
Page | 2 3 . When increased economies of scale provide major competitive advantages . When an organization has both the capital and human talent needed to successfully manage the expanded organization . When competitors are faltering due to lack of managerial expertise or a need for particular resources that an organization possesses.
Vertical Foreign Direct Investment
Vertical FDI is company’s investment into an industry abroad, which provides
control of the different stages of making its product from raw materials through production to its final distribution.
Vertical FDI may be in two types.
1. Backward vertical FDI
2. Forward vertical FDI
Backward vertical FDI
Backward FDI occurs when the MNE enters a foreign country to produce intermediaries goods that are intended to use as inputs in its home country.
Strategy when to go for backward FDI
o when an organization’s present suppliers are specially
expensive or unreliable or incapable of meeting the firm’s needs for parts, components, assemblies or raw materials o when the number of suppliers is small and the number of competitors is large o when an organization competes in an industry that is growing rapidly o when an organization has both capital and human resources needed to manage the new business of supplying its own raw materials
Forward vertical FDI
Forward FDI occurs when the MNE markets its homemade products overseas or produce final outputs in a host country using its home-supplied intermediate goods or materials
Page | 3 4
Strategy when to go for forward FDI
o when an organization’s present distributors are especially
expensive or unreliable or incapable of meeting the firm’s distribution needs o when the availability of quality distributors is so limited o when an organization has both capital and human resources needed to manage the new business of distributing its own products
Reasons for Direct Investment
- Risk reduction – minimizing risk and optimize revenue.
- introducing new technology, modern skills, innovations and new ideas
- create new employment opportunity - when part of the profit again put into the business moderation or expansion can be occurred - most direct investment flow into export industries. By increasing exports reducing imports it will improve balance of payments of capital importing country - FDI induces domestic investment in the form of joint participation or in local ancillary industries - FDI increases the productive capacity of the capital importing country - FDI induces to invest in infrastructure such as power, telecom, and developments of ports. It is not only accelerating the economic growth of the capital importing country but also attract foreign investors further.
Disadvantages of Foreign Direct Investment( FDI)
- profit exploitation - new technology doesn’t always ensure expected level of employment
Page | 4 5 - there are chances to give up activities, if it is happen, this will create severe problems - avoiding pay to tax - crate political instability - create cultural abuse - introducing corrupt culture - exploiting the resources and misuse it
Climate for the Foreign Direct Investment
In order to promote private FDI, it is necessary to create proper climate in the nation.
1. Political stability and freedom
2. Security for life and property 3. Giving tax free or tax holiday 4. Easy traveling arrangements 5. Freedom from double taxation
Types of Foreign Direct Investment
The purposes of cross boarder investment determine the types of FDI. In the literature of FDI, the term ‘seeking’ is particularly used to differentiate types of FDI. There are several types of FDI.
Transformation in both industrial and economic structures is essential conditions for
economic development. The followings are economic effects of FDI, which are vital to economic structure transformation in the long run.
1. Capital Formation Effect
2. Technology Transfer Effect 3. Entrepreneurship Learning Effect 4. Economic growth Effect 5. Market Expansion Effect 6. Employment Generation Effect 7. Social welfare effect 8. Production Mode Transfer Effect
Page | 5 6
Developing Countries and Foreign Aid
There are three motives for granting aid to the developing countries.
Economic Motives
- to escape from poverty trap
- to attain a faster growth rate - to enter fully into international trade - to provide growing markets for the products of other countries
Humanitarian Motive
- to provide better life conditions to the people those who are living in conditions of abject poverty
Political Motive
Communist and non – communist countries have extended economic aid in the expectation of obtain the political allegiance of the aid receiving countries
Needs of Developing Countries
1. Gap in savings and investment
Due to extreme poverty people have very high propensity to consume and very low propensity to save because of this investment is below the needed level. But investment necessary to generate high economic growth
2. Trade Gap
There is a severe shortage of foreign exchange. This limited the impost of the country.
3. Capital inflow
Foreign aid is a reflection of only a part of capital inflows from 1 st world to the 3rd world countries.
4. Foreign exchange gap
Page | 6 7
Forms of Foreign Aid
Foreign aid comes in different forms.
- Gifts of consumer goods: free distribution of US and European
stockpiles of food like Wheat. - Loan and Grants: Loan may be obtained on commercial forms(Market rate of interest) or on concessionary terms(below the market rate of interest) - Education: Providing scholarship, sending teachers and instructors abroad under technical assistance program. - Direct Investment: setup up of factories, mines, plantations, hotels in developing countries and form of joint venture - Technical and Direct Assistance: Advanced countries provide technical experts to advice and the developing countries in their efforts to attain growth. Under taking the construction of projects such as steel works and power station. Providing technical training programs for developing countries. - Specialist Service: The IMF, World Bank, UN and individual nations under take surveys for and offer variety of financial, technical and advisory services to developing countries.
Evaluation of Foreign Aid
1. In third world countries, government serves the interest of a narrow range
of groups in society. Due to this foreign aid diverted into meeting the requirements of their groups rather than achieving genuine economic development. 2. ‘Fashion’ in foreign aid projects change over time. 3. Foreign aid in the form of subsidised food or consumer products may be harmful to long term third world development 4. Tied foreign aid particularly in the form of loans may results in third world countries getting a worse purchase. 5. Loans have to be repaid with interest. Repayment of loans has caused economic problems for third world countries.
