Strategy of Foreign Direct Investment (FDI)

Owing to globalization and removal of trade barriers between countries international business has expanded and National Companies have been able to widen their horizons and become a strong Multinational Companies (MNCs). However, a decision to enter a new market and undertake a foreign direct investment is risky therefore a decision to make this step must be started with a self assessment. What are the core motives of pursuing this strategy? Does the firm have a sustainable competitive advantage? Where to invest? How to invest? Use direct investment or joint ventures, franchising, licensing, acquisitions of existing operations, establishing new foreign subsidiaries or just exporting. What is country risk and how to benefit from it? Further we will try to answer these questions.

Companies consider Foreign Direct Investment (FDI) because it can improve their profitability and strengthen shareholders wealth. Mainly they have two motives to undertake FDI. Revenue related and cost related motives. One of revenue related motives is to attract new sources of demand.A Company often reaches a moment where growth limited in a local market so it searches for new sources of demand in foreign countries. Some MNCs perceived developing countries such as Chile, Mexico, China, and Hungary such as an attractive source of demand and gained considerable market share. Other revenue related motive is to enter profitable markets. If other companies in the industry have proved that superior earnings can be realized in certain markets, a National Company may also decide to sell in those markets.

Some Companies exploit monopolistic advantage. If a National Company possesses advanced technology and has taken an advantage of it in domestic market, the company can attempt to exploit it internationally as well. In fact, the company may have a more distinct advantage in markets that have less advanced technology. Apart from revenue motives companies engage in FDI in an effort to reduce costs. One of typical motives of Companies that are trying to cut costs is to use foreign factors of production. Some Companies often attempt to set up production facilities in locations where land and labor costs are cheap. Many U.S based MNCs such as, Ford Motor and General Motors established subsidiaries in Mexico to achieve lower labor costs. Also, a company can cut costs by economies of scale. In addition to above stated motives companies may decide to use foreign raw materials. Due to transportation costs, a company may exclude importing raw materials from a given country if it plans to sell the finished goods back to that country. Under such circumstances, a more attractive way is to produce a product in the country where the raw materials are located.

After defining their motives managers of National Companies need to examine their domestic competitive advantages that enabled them to remain in a home market. This competitive advantage must be unique and powerful enough to recompense for possible disadvantages of operating abroad. The first comparative advantage National Companies can have is of economies of scale. It can be developed in production, finance, marketing, transportation, research and development, and purchasing. All of these niches have a comparative advantage of being large in size due to domestic or foreign operations. Economies of production come from large-scale automated plant and equipment or rationalization of production through worldwide specializations.

For example, automobile manufacturers rationalize production of automobile parts in one country, assemble it in another and sell in the third country with the location being stated by comparative advantage. Marketing economies occur when companies are large enough to use most advanced media that can provide with worldwide identification. Financial economies can be derived from availability of diverse financial instruments and resources. Purchasing economies come from large scale discounts and market power. Apart from economies of scale flourishing Companies benefit from comparative advantage in managerial and marketing expertise. Managerial expertise is an ability to manage large scale industrial organizations in foreign markets. This expertise is practically acquired skill. Most MNCs develop managerial expertise through prior foreign experience. Before making investments they initially source raw materials and human capital in other countries and overcome the supposed superior local knowledge of host country companies.

The third comparative advantage can be a possession of advanced technology. Usually, companies located in developed countries have access to up-to-date technologies and effectively use them as superiority. The fourth advantage is developing differentiated products so other firms unable to copy. Such products originate from profound research based innovations or marketing expenditures. It is difficult and costly for competitors to duplicate such products as it takes time and resources. A National Company that created and marketed such products profitably in a home market can do so in a foreign market with substantial efforts. After examining their comparative advantages companies decide where to invest. The decision where to invest is influenced by behavioral and economic factors as well as of the company’s historical development. Their first investment decision is not the same as their subsequent decisions. The companies learn from their first few foreign experiences than what they learn will influence their following investments. This process is complex which includes analysis of several factors and following various steps. In theory after defining its comparative advantage a company searches worldwide for market imperfections and comparative advantage until it finds a country where it can gain large competitive advantage to generate risk adjusted return above company`s rate. Once choice is made National Company will choose mode of entry into foreign market. Companies use several modes of entry into other countries.

The most common ways are:
• International trade
• Licensing
• Franchising
• Joint ventures
• Acquisitions of existing operations
• Establishing new foreign subsidiaries

Each method is discussed in turn with risk and return characteristics. International trade is a traditional approach that can be used by firms to penetrate markets by exporting or importing goods. This approach causes minimal risk because firms do not place large amount of their capital at risk. If the firm experiences a decline in its exporting it can normally decrease or discontinue this part of its business at a low cost.

Licensing is a popular method for National Companies to profit from international business without investing sizable funds. It requires companies to provide their technology (copyrights, patents, trademarks, or trade names) in exchange for fees or some other particular benefits. Licensing enables them to use their technology in foreign markets without a major investment in foreign countries and without the transportation costs that result from exporting. As local producer is located domestically it allows minimizing political risks. A major disadvantage of licensing is that it is difficult for company providing the technology to ensure quality control in the foreign production process. Other disadvantages include: are lower licensee fees than FDI profits, high agency cost, risk that technology will be stolen, loss of opportunity to enter licensee`s market with FDI later.

A joint venture is defined as a foreign ownership that is jointly owned. Companies penetrate foreign markets by engaging in a joint venture with firms that reside in those markets. A business unit that is owned less than 50 percent is called a foreign affiliate and joint venture falls into this category. Joint Venture with a foreign company is effective method if National Company finds a right partner. Advantages of having such partner are as follows: local partner is familiar with business environment in his country, can provide competent management, can provide with a technology that can be used in production or worldwide and the public image of the firm that is partly locally owned can increase sales and reputation. The most important is joint ventures allow two companies to apply their comparative advantage in projects. Despite notable advantages this method has disadvantages too. MNCs may fear interference by local companies in certain important decision areas. Indeed what is optimal from the point of one partner can be suboptimal for the other. Also, partners may have different views concerning dividends and financing.

Acquisition of existing operations or cross border acquisition is a purchase of an existing foreign-based firm or affiliate. Because of large investment required an acquisition of an existing company is subject to the risk of large losses.

Because of the risks involved some firms involve in partial acquisitions instead of full acquisitions. This requires a smaller investment than full international acquisitions and therefore exposes the firm to less risk. On the other hand, the firm will not have complete control over foreign operations that are only partially acquired.

Companies can also penetrate foreign markets by establishing their subsidiaries on these markets. Like to foreign acquisitions, this method requires large investment. Establishing a subsidiary may be preferred over foreign acquisition because in a subsidiary procedures can be tailored exactly to company standards. Plus less investment may be required than buying full acquisition. Still company cannot benefit from operating a foreign subsidiary unless it builds a steady customer base.

Any method that requires a direct investment in foreign operations is referred to as a foreign direct investment. International trade and licensing is not considered to be FDI because it doesn`t require direct investment in foreign operations. Franchising and joint ventures involve some investment but to a limited degree. Acquisitions and new subsidiaries require large investment therefore represent a large proportion of FDI. Many International Companies use a combination of methods to increase international business. For example the evolution of Nike began in 1962 when a business student at Stanford`s business school, wrote a paper on how a U.S. firm could use Japanese technology to break the German dominance of the athletic shoe industry in the United States. After graduation, he visited the Unitsuka Tiger shoe company in Japan. He made a licensing agreement with that company to produce a shoe that he sold in the United States under name Blue Ribbon Sports (BRS). In 1972, he exported his shoes to Canada. In 1974, he expanded his operations into Australia. In 1977, the company licensed factories in Korea and Taiwan to produce athletic shoes and then sold them in Asia. In 1978, BRS became Nike, Inc., and began to export shoes to Europe and South America. As a result of its exporting and its direct foreign investment, Nike’s international sales reached $1billion by 1997 and more than $7 billion by 2010.

A decision of why companies undertake FDI compared to other modes of entry can be explained by OLI paradigm. The paradigm tries to explain why companies choose FDI compared to other modes of entry such as licensing, joint ventures, franchising. The OLI paradigm states that a company first must have “O”- owner specific competitive advantage in a home market that can be transferred into a foreign market. Then the company must be attracted by “L”- location specific characteristics of a foreign market. These characteristics might include low cost of raw materials and labor, a large domestic market, unique sources of raw materials, or advanced technological centers. Location is important because the company have different FDI motives. By relying to location characteristics it can pursue different FDIs. It can implement either horizontal or vertical FDIs. The horizontal FDI occurs when a company locates a plant abroad in order to improve its market access to foreign consumers. Vertical FDI, by contrast, is not mainly or even necessarily aimed at selling in a foreign country but to cutting costs by using lower production costs there. The “I” stands for internalization. According to the theory the company can maintain its competitive advantage if it fully controls the entire value chain in its industry. The fully owned MNC minimizes agency costs resulted from asymmetric information, lack of trust, monitoring partners, suppliers and financial institutions. Self financing eliminates monitoring of debt contracts on foreign subsidiaries that are financed locally or by joint ventures. If a company has a low global cost and high availability of capital why share it with joint ventures, suppliers, distributers, licensees, or local banks that probably have higher cost of capital.

Properly managed FDI can make high returns. However FDI requires an extensive research and investment therefore puts much of capital at risk. Moreover, if company will not perform as well as expected, it may have difficulty selling the foreign project it created. Given these return and risk characteristics of DFI, Companies need to conducts country risk analysis to determine whether to make investments to a particular country or not. Country risk analysis can be used to observe countries where the MNCs is currently doing or planning to do business. If the level of country risk of a certain country begins to increase, the MNC may consider divesting its subsidiaries located there. Country risk can be divided into country`s political and financial risk.

Common forms of political risk include:
• Attitude of consumers in the host country
• Actions of host country
• Blockage of fund transfers
• Currency inconvertibility
• War
• Bureaucracy
• Corruption

A severe form of political risk is the likelihood that the host country will take over a subsidiary. In some cases, some compensation will be paid by the host government. In the other cases, the assets will be confiscated without compensation. Expropriation can take place peacefully or by force.

Beside political factors, financial aspects need to be considered in assessing country risk. One of the most clear financial factors is the current and potential state of the country’s economy. An MNC that exports to a foreign country or operates a subsidiary in that country is highly influenced by that country’s demand for its products. This demand is, in turn, strongly influenced by the country’s economy. A recession in that country can reduce demand for MNC `s exports or goods produced by its subsidiary.

Economic growth indicators positively or negatively can have an effect on demand for products. For instance, a low interest rates boost economy ad increase demand for MNCs` goods. Inflation rate influence customers purchasing power therefore their demand for MNC`s goods. Furthermore exchange rates capable to press on the demand for the country’s exports, which then affects the country’s production and level of income. Strong currency might reduce demand for the country’s exports, increase the volume of products imported by the country, and therefore reduce the production of country and national income.

Assume that Papa and Sons plans to build a plant in Country A. It has used country risk analysis technique and quantitative analysis to derive ratings for various political and financial factors. The purpose is to consolidate the ratings to derive an overall country risk rating. The Exhibit illustrates Papa and Sons country risk assessment. Notice in Exhibit that two political factors and five financial factors contribute to the overall country risk rating in this example. Papa and Sons will consider projects only in countries that have a country risk rating of 3.5 or higher. Based on its country risk rating Papa and Sons will not build a plant in Country A.

If the country risk is too high, then the company does not need to investigate the achievability of the proposed project any further. But some companies may undertake their projects with country risk being high. Their reasoning is that if the potential return is high enough, the project is worth undertaking. When employee safety is a concern, however, the project may be rejected regardless of its potential return. Even after a project is accepted and implemented, the MNC must continue to monitor country risk. Since country risk can change dramatically over time, periodic reassessment is required, especially for less stable countries.

Foreign Direct Investment (FDI)

A foreign direct investment (FDI) is an investment in the form of a controlling ownership in a business in one country by an entity based in another country. It is thus distinguished from foreign portfolio investment by a notion of direct control. In foreign portfolio investments an investor merely purchases equities of foreign-based companies.

Broadly, foreign direct investment includes “mergers and acquisitions, building new facilities, reinvesting profits earned from overseas operations and intra company loans”. In a narrow sense, foreign direct investment refers just to building new facility, a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor. FDI is the sum of equity capital, other long-term capital, and short-term capital as shown the balance of payments. FDI usually involves participation in management, joint-venture, transfer of technology and expertise. Stock of FDI is the net (i.e. outward FDI minus inward FDI) cumulative FDI for any given period. Direct investment excludes investment through purchase of shares.

Who can be a Foreign Investor?

A foreign direct investor may be classified in any sector of the economy and could be any one of the following:

An individual;
A group of related individuals;
An incorporated or unincorporated entity;
A public company or private company;
A group of related enterprises;
A government body;
An estate (law), trust or other societal organization; or
Any combination of the above.

How can a Foreign Investor invest his funds?

The foreign direct investor may acquire voting power of an enterprise in an economy through any of the following methods:

By incorporating a wholly owned subsidiary or company anywhere.
By acquiring shares in an associated enterprise.
Through a merger or an acquisition of an unrelated enterprise.
Participating in an equity joint venture with another investor or enterprise.

FDI incentives:

Foreign direct investment incentives may take the following forms:

low corporate tax and individual income tax rates
tax holidays
other types of tax concessions
preferential tariffs
special economic zones
EPZ – Export Processing Zones
Bonded warehouses
Maquiladoras
investment financial subsidies
free land or land subsidies
relocation & expatriation
infrastructure subsidies
R&D support
Energy
derogation from regulations (usually for very large projects)
by excluding the internal investment to get a profited downstream.

Corporate Structures:

Various Corporate structures are available for setting up a place of business. There are three (03) ways, whereby, a foreign company may have its presence in the country:

Liaison Office;
Branch Office; and
Locally incorporated subsidiary

Security of Foreign Investment:

Legislative Protection: Several laws provide protection to foreign investors/investment.

Bilateral Investment Treaties (BITs): Bilateral Agreements on Promotion and Protection of Investment (46 countries) provide the following:

The Contracting Parties shall encourage investments in their respective territories by investors of the other Contracting Parties.
Non-discrimination between local investors and foreign investors.
Equal/non-discriminatory treatment in case of compensation for losses owing to war, other armed conflicts or a state of national emergency.
Free transfer of investments, and income deriving therefrom including profits, dividends, interest income, proceeds of sales or liquidation, repayments of loans, salaries, wages and other compensation, etc.
A dispute settlement mechanism to settle any dispute between the countries with respect to the interpretation of the respective agreement and a dispute settlement procedure to settle any dispute between a host country and an investor of the other country.

Foreign Direct Investment in the Indian Realty Sector

The Indian real estate industry saw massive growth since the Government of India allowed foreign direct investment in the sector in 2005. Lured by high returns, the sector saw entry of many foreign real estate investment firms. During 2007 and early 2008, the industry achieved new heights. However, it suffered a great deal due to global economic slowdown in the middle of 2008. Foreign direct investment inflow plummeted and the industry experienced a downturn. As the economy slowly began to gain momentum, funds inflow began to increase and today the Indian realty sector is one of the most lucrative segments for investors.

Foreign Direct Investment – The Major Growth Driver

Foreign direct investment has been the major growth driver for the country’s real estate sector. According to a report by advisory firm Ernst & Young and Federation of Indian Chambers of Commerce and Industry, the sector has attracted foreign investment close to Rs 100,000 crore between April 2011 and July 2013. The report also projected the industry’s size close to US$ 78.5 billion in the financial year 2013 and US$ 140 billion by financial year 2017.

Government Initiatives

Realizing the immense potential of the sector, Indian Government is considering major changes in foreign direct investment norms to boost flow of funds. The Urban Development Ministry has proposed exemptions of all restrictions including minimum area norms for project development for all real estate firms whose foreign ownership is less than 50%. Proposal to allow real estate companies to sell undeveloped plots through automatic route subject to clearance by the Foreign Investment Promotion Board is also under consideration.

The current foreign direct investment rules do not allow a company to sell undeveloped plots, which forces them to stay with unviable projects. The ministry has also suggested a non-resident investor in a real estate firm to sell his shares to another non-resident investor free of cost. This would ease liquidity problem of foreign investors largely and boost their confidence.

Government’s initiative to set up a regulatory authority to protect consumer’s interest will also increase investment in the sector. The Confederation of Real Estate Developers’ Association of India believes that such a step would lift foreign investment by at least 20%. It feels that funds would be mainly come from the US, Gulf nations and European countries.

The Way Forward

India has a great potential to entice huge foreign investment into the real estate sector. In developed countries, the sector has reached to a point of saturation. Therefore, global players are looking at developing economies such as India for investments. However, the industry should look forward towards increasing transparency and improve project execution to increase inflow of foreign capital. One must solve land acquisition delays at the earliest to attract global firms to set up their operations in the country.

Despite several challenges, the Indian real estate industry is quite upbeat. In coming days, opportunities in the sector will attract more foreign investment that will help the industry to prosper.