191 study of fdi activity in india and its implications

8/8/2019 191 Study of FDI Activity in India and Its Implications

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Research Report

On

Study of FDI Activity in India and its Implications

Submitted By: Nishi KumariSatyarthi

MBA-Finance & Marketing 0415870007

Under The Guidance of : Mrs. Ruchi Goel

Janhit Institute of Education & Information


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Dissertation Report Foreign DirectInvestment

Greater Noida

Acknowledgement

I take this opportunity to extend my sincerest and unflappable admiration to

Mrs Kalpana Sharma, Faculty, Janhit Institute of Education & Information for the

cooperation and support she has rendered me in my endeavor. She provided me with

the facilities and utmost co-operation for working on my project. She helped me

facilitate my dissertation by providing me with adequate assistance at all times,

valuable inputs & guidance at every stage of research process thus charting the project

towards its successful completion.

I would also like to thank Janhit Institute of Education & Information for having

presented me with the opportunity to undertake such a project which has helped me

develop deep insights about the Study of FDI Activity in India and its implications.

Every kind of possible help and support was shown by the to make this project a

success.

Nishi Kumari Satyarthi

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CERTIFICATE

TO WHOMSOEVER IT MAY CONCERN

This is to certify that the dissertation titled Study of FDI activity in India and its

implications submitted byNishi Kumari Satyarthi for the award of degree in Master

of Business Administration has been completed under my supervision and guidance.

This proves the candidates capacity for critical examination and sound judgment over

the problem studied by him.

The work is satisfactory and complete in every respect and the dissertation is ina suitable form for submission.

Mrs. Ruchi Goel

(Faculty Guide)

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TABLE OF CONTENTS

Index

Synopsis

Executive Summary

What and Why is FDI

Effect of FDI

Different between Foreign and Domestic Investment

Risks of FDI

Argument against FDI

Investment in Developing Countries

Theory of FDI

Variables in FDI Model

Investment facilitation factors

Investment promotions Model

Cost and Benefit of FDI

Strategy of FDI

From India Scenario

Policy towards FDI

NRIs and PIOs

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Why we are Here?

Why China

Steps Taken By Government

The Research

Statement Of The Objective

Primary Objective Of The Study:

Scope Of The Study:

Research Methodology

Research Design.

Sampling Plan:

Data Collection

Limitations Of The Study

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SYNOPSIS

The success of the software industry has created a new faith in Indian brain power and

this brain power is required to harness in production with efficiency and cheaper cost.

NRIs can now acquire a few acre of land to construct multi-storage apartment. This

will give a flip to the housing sector which shows a slowdown in the economy. The

tax administration in India is perceived to be extremely hostile to the non-residentdoing business in or with India.

A comprehensive legislature and policy framework needs to be promoted for a healthy

market any move to facilitate, quick, efficient and transparent transaction in the real

estate is the most soughed.

Will The current budget enable

india to attract more foreign

funds

no

cannot sayyes

23%

9%

68%

The Govt. recent idea of raising the FDI in the Public Sector Banks is most welcome

but there are many hurdles in the way yet to be amended reduction of Govt. holding

from 51% to 33% and increase of the voting right above 10%. The Govt. is yet to

clear the program of allowing 100% FDI in the private sector bank through automatic

route.

Deepak Parekh, chairman of the HDFC, private bank will be benefited from this

increased in the limit from 44% to 74% and allowed voting right beyond 10%. By

raising the FDI limit from 74% telecom operators like Bharti Televenture, Hutchison,

BPL, Idea and spice will be able to raise its fund in the international market through

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equity route. An investment of Rs 5000 crores is required in the telecom sector in the

next 3 years to meet the growing demand.

The union budget of 2003-2004 proposes to extent the facility of seeking an advances

indirect tax ruling to wholly-owned subsidies of the foreign companies from thecoming fiscal at present this facility is available only to the joint ventures.

In India it cost the same for the firm to employ and to fire. Firm should be allowed to

trim employee according to the market conditions. Extensive labours reform is the

most sought. Higher income growth coupled with a persistence approach to reforms

will attract substantially more FDI into India.

The Pravasi Bharatiya Divas Jamboree raises an important question what an

important contribution can Non-resident and people of India origin can contributed?Why Indian perform better outside rather when they are in India? We have everything

but still we cannot convert them in to higher productivity.

According to recent survey, India is losing its sheen as a foreign investment

destination, This does not gel with the recent increase in the flow of FDI OF $1.08

Billion in the first quarter of 2002-2003 which could go up to $8 billion once the RBI

begin to align FDI data with international practices. But the worrying point is that we

are receiving a lot less FDI than what we required. The tenth plan targeted a growth of

8% over 2% then the average annual growth rate achieving during the ninth plan. A

two per cent increase in the GDP required a 7 percentage point increase in the

investment. With saving continue to be 23% of GDP for quit sometime it will be

impossible that it will go up by 5 percentage point to the required 28% of the GDP in

the short run. China has demonstrated that this is possible in the short run if we can

create a sound, investment friendly environment.

There are lesson from China that we should learned, in fact China FDIs constitutes

90% from NRCs from Hong Kong, Thailand and Singapore in view of the labour

intensive goods when it open its market in 1978. Despite being centralized economy it

delegated powers for the FDI approvals in favours of the local authorities and

provincial govt. which compete with each other to woo investors.

In the first place we have to put in place legislation on FDI to give the policy requisite

visibility and build confidence among the investors. The policy have to be integrated

in the over all national economic policy. Second states need to be given primacy in the

approvals and taken on boards as stakeholders. Authorized local authority to set up

SEZs and approvals of FDI. We need to provide quick international competitive

platforms as strategic locations for relocation of labor intensive manufacture. Forth

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export oriented FDI to be given top priority with political and bureaucratic apparatus

to catalyze export led growth. And last but not the least we have to think big, plan

well and implement fast and speed up privatization process. Concentration on

education is no doubt an important objective for long lasting benefits.

My Project is base on the discussion of the above references by paying special

emphasized on WHAT, WHY AND HOW.

EXECUTIVE SUMMARY

Realizing the important contribution that private foreign capital can make to the

economic development, the Industrial Policy Resolution of 1991 ushered in major

changes to attract foreign investment in India. Such a positive and open-door policy of

India towards foreign investment and technology transfer has been in contrast to the

earlier restrictive approach. The sectors opened to foreign investment now are larger

as compared to the earlier policy. The enlarged spheres of FDI entry now include

mining, oil exploration, refining and marketing, power generation and

telecommunications, insurance, defense, print media and tourist and hotel industries.

The government also announced the opening of the Indian stock markets to direct

participation by Foreign Institutional Investors. The government has also amended the

foreign Exchange Regulation Act, introduced current account convertibility, eased

Statutory Liquidity Ratio and Cash Reserve Ratio on banks, reduced customs and

excise duties, provided insurance for non-business risks including expropriation and

so on. Following these liberalization, there has been an unprecedented growth in the

inflow of foreign investment and technology transfer into the country. Since 1991, the

composition of capital account has changed to a large extent. Non-debt creating

inflows have replaced the debit creating inflows and have increased from about 6%

during seventies and eighties to 43% during nineties. However, foreign investment is

much lesser than the countrys potential to attract and absorb it.

Between 1991 and 2001, India has received on an average US$ 2.2 billion

annually as foreign investment, as against Chinas US$ 32.2 billion during the same

period. India is placed at the 119th position in the foreign direct investment

performance index of UNCTAD. Indias index value has been pt at 0.2 against

Chinas 1.2 and Sri Lankas 0.4 and even Pakistans 0.2 which ranked higher at 114th

position (performance measured by standardizing a countrys inflows to the size of its

economy.

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One can correlate the deceleration in macro fundamentals in recent years,

adversely affecting Indias FDI potential rating.

Indias burgeoning population, debt and fiscal deficit are sustainable only if the

countrys economy grows by at least 8% annually. This requires raising the level ofinvestment from 22% of the GDP to 30%. As per the classical theory of economics by

Keynes, this investment-saving gap must be financed through foreign investment.

Foreign investment should touch $8billion if India has to achieve 8% growth.

The special features of the book are as follows:

It highlights the salient features of the policy, followed by the Government of India, as

updated up to recent Budget, with regard to foreign investment.

It portrays the patterns in the FDI and portfolio flows by country sources, major

industrial sectors and major recipient states of India.

It analyzes the extent and pattern of dependence of Indian corporate Sector on the

foreign sources.

A study of the subsidiaries of foreign companies operating in India is the special

feature of this book.

The impact analysis highlights the impact of interest rates on NRI deposits, the impact

of FII investment of Stock Market Development in India and the impact of FDI and

technology transfer on the FDI recipient companies with regard to technological

capability building, export performance and foreign exchange inflow.

A study of the determinants of FDI and portfolio flow in India points out as to what

factors affect the FDI and portfolio flows and what policy reforms are required to

attract more foreign investment.

Special emphasized for the NRIs and PIOs ,their prospects ,problems and new policy

to lure them. suggestion.

some theory of FDI is explained which being useful to analyzed.

other topics like some experts comments, risks of FDI, policy and brief comment on

the improvement of this segment.

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What and why is FDI ?

Direct Investments are those investments in which the inflows of funds is for setting

up the infrastructural sites i.e., if a foreign company wants to set up a car

manufacturing plant, then this will be considered as direct investment. Every country

would go for wooing more such investments, as it is very difficult to withdraw once

the unit set-up starts functioning.

Foreign direct investment (FDI). It is certainly seen as being preferable to other

forms of foreign capital inflow, such as commercial borrowing and portfolio

investment. Furthermore, it is considered to be eminently advantageous in its own

terms, and something to be actively sought by governments of developing countries.

Foreign investment is said to be direct when a company invests to take control of a

venture abroad. For example, a company might buy land, buildings, equipment and

inventory to set up a company abroad.

Foreign direct investments (FDIs) influence a host countrys economics in areas such

as trade balance, technology transfer, competitive structure, and employment. Some

studies, which have examined the effects of foreign direct investments in a host

countrys economy, have found that foreign firms export a higher proportion of their

output than local firms (Cohen 1975, Jo 1976).

Since the launch of "Manmohan-economics" by the Narasimha Rao government in

1991 - FDI has been touted as the magic word that will transform "under-developed"

India into an advanced nation with a "modern" infrastructure.

Every government that has followed has dutifully talked of taking steps to encourage

and expand FDI. Mr. Vajpayee in his inaugural address also spoke about the priority

the NDA government would give to promoting FDI. In his speech, Mr. Vajpayee

assumed that everyone understood and appreciated the benefits of FDI.

Attracting foreign direct investment is at the top of the agenda of most countries

around the world. Much recent research has focused on identifying which factors and

policies can influence the location decision of multinational companies. These factors

range from market size, to taxes, red-tape alleviation, laws, infrastructure, and

investment promotion. The debate is still open on what combination of factors is the

most effective for attracting FDI, especially in small developing countries

The protection of foreign investment is typically considered a matter of international

law, but domestic lawmakers have from time to time sought to influence the treatmentof investors abroad through domestic legislation. In the early 1960s, for example, the

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United States Congress passed what would become known as the "First Hickenlooper

Amendment." This law requires that the President terminate aid to any country that

has seized American-controlled property, has repudiated or nullified contracts with

Americans, or has "imposed or enforced discriminatory taxes or other exactions, or

restrictive maintenance or operational conditions," and that has failed to "discharge its

obligation under international law including speedy compensation for such property in

convertible foreign exchange, equivalent to the full value thereof. The statute

represents an attempt on the part of the United States to provide an enforcement

mechanism, through domestic law, that could carry out the American interpretation of

international law. Since its adoption, however, the First Hickenlooper Amendment has

been applied only twice, once against Ceylon in 1963 and once against Ethiopia in

1979.

It was already noted that effects (e.g., technology transfer) of FDIs on a host countrys

economy depend on the nature of the undertaken investments (Chen 1987). In this

regard, Dunning (1994) emphasized re-evaluating the benefits of FDI by explaining

that each type of FDI has its own particular way of upgrading the competitiveness of

host countries. A fundamental distinction, therefore, needs to be made both in

promotional methods and in incentives offered by host countries across types of FDI

projects (Contractor 1995).

The greater resilience in FDI flows than that of capital market flows in the face of the

financial crisis may be partly due to the fact that FDI is more responsive to long-term

growth trends than short-term changes in financial returns. FDI inflows are also

influenced in part by access to natural resources and human capital, which were not

immediately affected by the crisis.

World FDI flows have continued to grow rapidly and even accelerated somewhat in

the second half of the 1990s. These flows reached $1.3 trillion in 2000, increasing by

14% from 1999, though this pace was slightly slower than in the previous two years.

Industrial countries accounted for much of this upsurge in FDI flows. Their share inthe world FDI inflows has risen from a low of 65% in 1994 to 84% in 2000.

Why does a company invest abroad?

There are a myriad of reasons why a company decides to invest abroad. It may be

seeking new customers, it may find that there is a higher profit margin abroad it may

wish to benefit from economies of scale by increasing total output, it may which to

access new sources of material or new technology abroad it may face high tariff

barriers if it does not invest directly in a foreign county y rather than import to thatcountry and so on.

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Types of FDI: Vertical vs. Horizontal

The types of FDI can be categorized as vertical vs. horizontal based on the production

function activities. Caves (1982,p.2) described a horizontal FDI as establishing

factory facilities in different countries in order to make same or similar goods hereferred to a vertical FDI for establishing plants abroad in order to produce output that

serves an input to its other parent or subsidiary plants. Furthermore, vertical FDI

projects can be divided into two types based on the flow of interrelated production

process functions, i.e.; downstream vs. upstream integration. In the case of

downstream vertical integration, a foreign subsidiary performs an assembly function

by using inputs supplied by the parent firm or other sister subsidiaries. on the

contrary, in the case of upstream vertical integration (component specialization), the

role of a foreign subsidiary is to produce inputs and to supply them to the parent orother sister subsidiaries. The effects of FDI on a host countrys economy are different

across the vertical vs. horizontal FDI projects.

Trade effects

It is generally known that foreign affiliates play a significant role in the expansion of

the host (especially developing)countrys manufactured exports (Helliner 1973,

Cohen 1975, Nayyar 1978). For instance, it is a known fact that transnational

corporations account for a considerable share of exports (i.e., approximately one-third

or more) in at least six newly industrializing countries. These corporations have been

responsible for the strong export performance of this group of countries. In Argentina,

the Republic of Korea and Mexico, the export amount approaches one-third. in Brazil,

it is over 40 percent and in Singapore it exceeds 90 percent (UNCTC 1985,p. 113). It

is also noted that the trade effects of foreign investments very among industries,

regions as well as foreign ownership (Blomstrom 1990). However, it is believed that

the role of FDI in a host countrys trade can vary with different types of projects.

The impact of FDI on the trade balance of a host country should be analysed base onfour distinct categories: (1) export-creating, (2) export-discouraging, (3) import-

saving, and (4) import-creating (Mac Dougall 1960). However, focusing on the

FDI project as a unit of analysis is difficult to capture the effects of export-

discouraging and import-saving.

Export-Creating Effects

Export-creating effects are greater in vertical FDI projects than in horizontal FDI

projects.

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Vertical integration represents an interdependency of the stages of production, which

are linked by a flow of intermediatesz (parts, semi-processed) products between

countries. Therefore, vertical FDI, by nature, induces intra-firm trade activities. In the

case of upstream vertical integration, a foreign subsidiary especially performs

assembly functions and supplies end products to the parent firm and/or other sister

subsidiaries that are located in different countries.

Import-Creating Effects

Import-creating effects are greater in vertical FDI projects than in horizontal FDI

projects.

Due to the nature of the adjacent stage to a related set or production processing

activities, vertical FDI tends to rely more on parent companies and other subsidiaries

for tangible and intangible resources. This reflects an activity that is more import-

creating in view of host country. For instance, in an off-shore assembly operation

which is a typical type of vertical FDI, core inputs are usually imported from the

parent company or other subsidiaries.

In contrast to vertical foreign investments, the horizontal foreign investments target

relative to local market demands has an import-substitution effect. This demonstrates

that horizontal FDI projects are less import creating than vertical FDI projects.

Since the effects of FDIs on the host countrys economy depended on the nature of the

undertaken investment projects, FDI ramifications should be examined depending on

the types of FDI projects. Various types of foreign investment projects were

categorized on the basis of production function, i.e., the vertical vs. horizontal

investment.

Based on the 108 FDI projects undertaken. It was found that vertical investment

projects have a grater effect on both export-creation and import-creation activities

than so horizontal foreign investment projects.

Considering the impact of FDI inflows on the domestic financial resources and

investment for development, it can be recognized that the FDI inflows can supplement

the two in the host developing countries. While all developing countries try to attract

FDI inflows do not have a major influence on the total investment in most developing

countries. In fact for all developing countries the ratio of FDI to gross domestic

capital formation averaged only 7.4% over the 1991-98 period, although it is higher in

the manufacturing sector.

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DIFFERENCES BETWEEN FOREIGN AND DOMESTIC

INVESTMENT

When an investor considers a foreign investment, however, he immediately faces a

number of complications found in the domestic marketplace.

What then is different about foreign investment? On the financial front, multiple

currencies and multiple interest rates complicate financial management. Equally

important, the operating environment involves multiple legal system, tax authorities,

and government policies. In a nutshell, foreign investments must contend with a

simple feature that has little impact in a domestic environment: international borders.

Crossing an international border will generally result in a number of important

consequences.

Most of the financial complications resulting from crossing an international

border can be traced to two factors which have not yet been covered in this chapter:

crossing a border means that (1) multiple currencies have to be used and (2) multiple

governments can intervene. Multiple currencies imply that investors must worry

about exchange rates and exchange rate changes as well as confront multiple interest

rates and costs of capital. Multiple governments imply that investors must decipher

multiple tax codes, as well as the way domestic and foreign tax codes interact, and

must consider additional political interventions which affect operations.

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RISK OF FDI

HEDGING THE RISKS INVOLVED IN FOREIGN INVESTMENT

Whether the method used for measuring the risk attached to foreign investment andadjusting the return for this risk all analysts agree that an attempt should be made to

eliminate or at least minimize the risks attached to a specific foreign project if this is

feasible

The more common risks encountered in foreign ventures are:

Country and political risk

Technological risk

Exchange rate and inflation risk

Cost and pricing risk

Credit risk

When two parties enter into a contract in a domestic setting, we expect them to

negotiate, subject to transaction costs, the most efficient possible agreement. When a

potential investor enters into an agreement with a host nation, however, the two will

not generally arrive at the most efficient agreement. The parties are unable to reach

the optimal agreement because of the unusual nature of their relationship and the dual

roles played by the host country. The host country is not merely one of the contracting

parties, but is also able, through legislation, to establish and change the legal rules

under which the investor must operate.

Domestic legal structures, critical to the bargain struck between two private parties

under domestic law, are no longer adequate. The central problem is that a sovereign

state is not able to bind itself to a particular set of legal rules when it negotiates with a prospective investor. Regardless of the assurances given by the host prior to the

investment and, importantly, regardless of the intention of the host at the time, if it

later feels that the existing rules are less favorable to its interests than they could be, it

can change them.

Because the host may decide to change the domestic laws to suit their own purposes,

the investor cannot rely on those laws to protect his interests. The only alternative

legal structure is international law.87 unlike domestic law, the host cannot change the

requirements of international law in order to suit itself. Unfortunately for both thepotential investor and the potential host who wishes to reassure a potential investor,

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international law does not directly govern the relationship between states and firms.

Because the host may decide to change the domestic laws to suit their own purposes,

the investor cannot rely on those laws to protect his interests. The only alternative

legal structure is international law.Unlike domestic law, the host cannot change the

requirements of international law in order to suit itself..

That potential hosts and investors cannot sign a binding and enforceable contract

under international law explains why the debate over the protections afforded by

customary international law was so important. The lack of a mechanism to allow

contracting between firms and states creates a dilemma that is sometimes referred to

as a problem of "dynamic inconsistency." Dynamic inconsistency describes situations

in which a "future policy decision that forms part of an optimal plan formulated at aninitial date is no longer optimal from the viewpoint of a later date, even though no

new information has appeared in the meantime."

The particular problem facing foreign direct investment, one must consider how the

lack of contracting options affects the incentives of a government in its dealings with

a particular foreign investor. Initially, while negotiations with a firm are taking place,

the government of a potential host country, by assumption, wishes to encourage theinvestor to invest in its country. The firm, on the other hand, would like to achieve the

greatest possible return and will invest in the host country only if that country offers

the greatest anticipated profit. the host may agree to offer certain tax advantages to the

investor, it may agree to allow the repatriation of profits and it may waive certain

import restrictions that are in place in the country. The firm, on the other hand, will

provide benefits to the country in the form of employment, technology transfers, and

so on. The firm might also agree to a set of conditions on its behavior. It might

reinvest a certain percentage of profits in the business, may agree to certain labor and

environmental standards, and may offer to provide some services to the community in

which it is located.

It is not possible to write such a contract. This makes the investment problem much

more difficult. Even if an investment is valuable enough to make it worthwhile for the

country to commit to some form of concessions to benefit the investor -- favorable tax

treatment, for example -- it cannot do so. The host country can do no more than make

non-binding promises to the potential investor. If the investment takes place, it will be

based on these promises and nothing more.

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Once the firm has sunk its capital into the investment, the relationship between the

parties undergoes a dramatic transformation. The host country, in particular, faces an

entirely different set of incentives. It no longer needs to offer benefits sufficient to

attract the investment; it only has to treat the investor well enough to keep the

investment. The difference between the two time periods (before and after investment)

comes about because both the host and the investor know that once the firm has made

its investment, it typically cannot disinvest fully. In other words, once it has invested,

withdrawal would impose a cost on the firm. The host country can take advantage of

this situation, and extract additional value from the firm by, for example, increasing

the tax rate beyond the level that was agreed upon when the investment took place.

Had the firm known that the tax rate would be higher than the agreed upon level, it

may have chosen to invest elsewhere, or not to have invested at all. Once the

investment is made, however, it may be cheaper for the firm to simply pay the highertax rather than attempting to disinvest in order to reinvest in a different country.

In global terms, the efficient outcome is achieved if investment takes place where it

will earn the greatest total return. The dynamic inconsistency problem will discourage

investment that would be desirable because the firm realizes that the host will squeeze

additional value from the firm after the investment is made -- causing the firm to

avoid certain investments altogether. Furthermore, in cases in which the host is

considering expropriation, it does not face expectation damages.

Regardless of the agreement that might be reached between an investor and the host

state, once the investment is in place, the host can abrogate the agreement and impose

whatever conditions it chooses, including expropriation, as long as it pays

"appropriate" compensation. The dynamic inconsistency problem will increase the

expected cost of investment, and will, therefore, deter some investors. Given the

assumption that investment decisions are not price sensitive, however, there will be

only a modest reduction in investment relative to a contracting regime.

Jayati Ghosh - (professor of economics at Jawaharlal Nehru University, andcolumnist for Frontline magazine) - have been warning of the potential dangers

associated with FDI. He have pointed out how the majority of FDI has come in the

form of speculative investments in India's stock market, where select scripts have seen

phenomenal jumps in their stock prices, while stocks of some major Indian

manufacturing companies have languished at very low valuations. They have also

warned that such speculative investments could leave just as easily as they came,

leading to greater instability in India's financial markets.

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It was pointed out how FDI flows have simply enabled trans-national giants like Coke

and Pepsi to set up monopolies in highly profitable sectors where Indian business

concerns were already meeting the requirements of the market. Neither have these

companies brought in any valuable nor improve new technology.

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ARGUMENTS AGAINST FOREIGN INVESTMENT

Although foreign investment tends to contribute much needed resources to host

countries and developing countries sin particular, many view it with misgivings.

There are many arguments against foreign investment. Most of these arguments have

to do with conflicts between company goals and host government aspirations:

Foreign investment brings about the loss of political and economic sovereignty.

It controls key industries and export markets.

It exploits local natural resources and unskilled workers.

It undermines indigenous cultures and societies by imposing Western values and

lifestyles on developing countries.

It seems that, while foreign direct investment has the potential to contribute positively

to development, there is no guarantee that it would have no harmful impact on host

countries. But the question of foreign investment need not be a zero-sum game. A

feasible framework for investment must be set up to define the rights and

responsibilities of both parties. This framework should allow for a reasonable return

to the investor and positively contribute to the development of a host country.

Sucheta Dalal, (columnist for the Economic Times and the Indian Express) reveal

that even in the power and telecom sectors, FDI has come at a very heavy price. In a

detailed review of the highly controversial Enron Power project, Sucheta Dalal

exposed the Maharashtra Government's lies and obfuscations in this regard. She

pointed out how the Maharashtra State Electricity Board (MSEB) was paying roughly

5 Rs. a unit to Enron, but had reduced it's purchases from the Tata Electric Company

which was selling power at under 2 Rs. a unit. Since the MSEB was selling power at 3

Rs. a unit, it was effectively subsidizing the Enron Power Co.

That it may either bankrupt the state electricity board - or make the electricity

generated completely u that it may either bankrupt the state electricity board - or make

the electricity generated completely unaffordable for the Indian consumer. But it isn't

the power sector alone, where FDI flows have been problematic.

Unaffordable for the Indian consumer. But it isn't the power sector alone, where FDIflows have been problematic.

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David Woodward (The next crisis? Direct and Equity Investment in Developing

Countries; Zed Books, London and New York, 2001), in his book reveals how little

we actually know about even the extent of FDI, and especially stocks of FDI, indifferent countries. It emerges that official data - including those produced by the

International Monetary Fund (IMF) and the World Bank - almost certainly

underestimate to a substantial extent, the true value of inward FDI stocks and their

absolute rate of increase. Far from trying to improve this state of affairs, the Fund and

the Bank have promoted the liberalization of foreign investment regimes, which

actually tends to reduce the availability of data and even the possibility of collecting

it. Such lack of knowledge of the extent of inward FDI stocks can even be dangerous

in other ways.

Similarly, Woodward indicates how misleading it may be to assume that FDI

necessarily contributes to increased employment. In fact, the employment effect will

depend on a whole range of variables, including the balance between Greenfield FDI

and the purchase of existing assets; the labour intensity of new productive capacities

or new organizational techniques; the extent to which FDI-based production

substitutes for existing production and their relative labour intensities, and so on. In

general, therefore, it is not the case that FDI creates much more net employment

unless it is really very large in scale and heavily involved in Greenfield activities, and

even in such cases it need not be more employment-intensive.

Large-scale flows of FDI also have effects on other domestic economic policies.

Imposes severe constraints on domestic government policy because of the fear of

withdrawal, FDI is embodied in the presence of multinational corporations (MNCs)

which tend to be large and powerful lobbies in the matter of domestic policies. To

attract more FDI by governments with over-optimistic expectations regarding such

investment means that all sorts of concessions are offered, which may turn out to be

very expensive for the economy in the medium or long term. Woodward suggests thatsuch FDI promotion tends to focus heavily on the demand side, in terms of

requirements imposed on host countries, which involve changing their own policies in

order to make themselves more attractive.

FDI can contribute to the underlying fragility of an economy and make it more

susceptible to balance of payments crises.

First, as rapidly growing stocks of inward FDI generate similarly growing profits that

form part of the foreign exchange outflow. Secondly, when FDI fuels an increase inimports, such as capital goods for investment projects and other such payments.

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Thirdly, because current foreign exchange costs of MNCs typically exceed the foreign

exchange they tend to earn through exports of import substitution. Fourthly, through

the role played by foreign affiliates, including those FDI can contribute to large

current account deficits, which tend to precede financial crises. They can also add to

both the economic shocks preceding crises and to the process of contagion. this

involved in retailing, in changing patterns of consumption through advertising and

brand promotion.

Woodward shows that positive effects arise only where new productive capacity is

created in the export sector, or in very strongly import-substituting sectors. If FDI

takes the form of purchase of existing capacity, even in the export sector it will have a

negative foreign exchange effect even if export production goes up, unless the

productivity of capital increases enough to offset the other increased foreign exchange

costs. At lower levels of import substitution, the effects of "Greenfield" FDI on new

capacity are much more ambiguous, and may be negative.

But in the new climate, in which developing country markets are seen as riskier and

international investors are becoming more risk-averse, efforts to attract more FDI will

involve even more concessions on the terms of such investment. "The result will be to

accelerate the build-up of liabilities without a commensurate effect on the now

seriously limited capacity of national economies to bear them".

The Budget speech of the Finance Minister, in which he announced a reduction on

corporate tax paid by foreign companies from 48 per cent to 40 per cent, despite the

shocking shortfalls in tax collection. This concession was explicitly declared to be a

means of wooing more FDI into the economy.

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IS FOREIGN INVESTMENT RISKIER THAN HOME INVESTMENT?

The traditional view of foreign direct investment is that type of investment is riskier

than investment in the home country. The main differential factor is knowledge, a

company knows more about local conditions than conditions in a foreign country.

In recent years the traditional view that foreign investment is riskier than home

investment has been questioned.

The incremental risk added to the earnings of a company undertaking a direct foreign

investment can be measured in much the same way as one can measure the risk added

to the current earnings of the company by introducing a new product or project onto

the market.

A new product can diversify the existing product portfolio of a company in such a

way that it reduces the variance on the income from the product portfolio. The new

product can help to stabilize the earnings of a company and so reduce the beta or

risk attached to the earnings figure.

Much of the research that found that foreign trading and investment actually reduced

the risk attached to the earnings of a company worldwide was conducted and

published in the 1970s.

Rugman (19750), after adjusting for several factors, found that the share price or UScompanies with a higher than average percentage of foreign sales was less volatile

than companies with a lower percentage or foreign sales.

Agmon and Lessard (1977) found that the share of multinational companies with a

high fraction of foreign sales enjoyed lower betas than companies with a low fraction

of their sales being sole abroad. For example, firms with 1% to 7% of foreign sales

had betas averaging 1.04. Firms with 42% to 62% of foreign sales had betas averaging

0.88. As on e would expect companies with a high fraction of foreign sales tend to

invest more abroad.

The basic cause of this apparent anomaly is the lack of correlation between the growth

rates of the different countries of the world. Whereas local sales are falling during a

recession in one country the sales in some other country are booming. It is true that

the growth rates of the economies of the advanced industrial countries are auto

correlated (correlated through time) but the rise and fall in economic activity do not

coincide in time.

When this low correlation between the growth pattern of different countries is pluggedinto the model of foreign investment the result reduces the variance on the income

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stream of the multinational company whose income is diversified over many

countries.

Investment in developing country

In recent years, foreign direct investment ("FDI") has grown at an unprecedented rate.

Between 1986 and 1990, total world FDI flows increased from US$88 billion dollars

to US$234 billion, representing an average rate of increase of twenty-six percent in

nominal terms and eighteen percent in real terms. From 1980 to 1993, the stock of

foreign investment increased at an average annual rate of eleven percent in real terms,

reaching a total of $2.1 trillion in 1993. A significant proportion of FDI flows is

directed at developing countries. FDI flows to these countries grew from $13 billion

in 1987 to $22.5 billion in 1989 to $90.3 billion in 1995.

Developing countries have two options of raising capital. First, by creating capital

surplus from internal sources of capital formation such as controlling consumption,

reducing foreign imports and other measures such as taxation, public borrowing,

budgetary savings from current revenue and profits of public enterprises.

Bilateral Investment Treaties (BITs) have become the dominant mechanism for the

international regulation of foreign direct investment. The tremendous popularity of

these treaties is puzzling because they provide investment protections that exceed

those offered by the former rule of customary international law, the Hull Rule, towhich developing countries have long objected on sovereignty grounds. Furthermore,

as the paper demonstrates, BITs may be welfare reducing for developing countries. By

forcing LDCs to compete for inward foreign investment, and by providing a

mechanism through which developing countries are able to make binding

commitments to investors, BITs may reduce the benefit developing countries obtain

from foreign investment.

Because the treaties are bilateral in nature, however, they offer an LDC an advantage

over other countries in the competition to attract investment. For this reason,

individual countries are willing to sign such agreements, despite the fact that LDCs as

a group are harmed.

The conflicting views of developed and developing nations on the question of

compensation for expropriation is evidence of the predictable fact that one's view

regarding the appropriate standard of compensation is determined by whether one is a

net importer or exporter of investment capital. It is the direction of the flow of

investment capital and wealth and power disparities between developed and

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developing countries that gives them different perspectives on questions of investment

regulation.

A developing country would not be able to commit itself credibly to respect

agreements with investors and would, therefore, have a reduced ability to negotiatewith prospective investors in order to attract investment. This will drive up the cost of

investment and cause profitable investments that both the host and the investor wish

to undertake to be foregone because they are not rendered unprofitable by the

dynamic inconsistency problem. This is an inefficient result.

Most importantly, the investor may choose to invest without any binding

commitments from the host country because LDCs( least develop countries) offer

advantages that are unavailable in the investor's home country (e.g., low labor costs,

favorable environmental or labor laws, locational advantages, natural resources, andso on). The risk that the host will attempt to seize value from the investor can be

thought of as a random tax. The investor knows that he may or may not be subject to

this tax. He will invest despite this risk if the benefits are sufficiently large.

For developing countries as a group, however, the sensitivity of investment demand is

likely to be much lower. Consider a particular firm that is considering an investment

in a developing country. If the cost of investment rises in one country, it is likely that

the firm could find another country that also meets its needs. On the other hand, if the

cost of investment rises in all developing countries, the firm must either invest despite

the increased cost or abandon its intention to invest in a developing country. Because

the advantages offered by one developing country are much more likely to be found in

another developing country than in a developed country, the firm is much more likely

to invest in a developing country despite such an increase in the cost of investment

Because investment decisions, with respect to investment in LDCs as a group, are

relatively inelastic -- meaning that a change in price leads to only a small change in

the amount invested -- a large amount of foreign investment will take place even in

the absence of a binding contractual regime between host governments and firms.

It is demonstrated that although an individual country has a strong incentive to

negotiate with potential investors -- thereby making itself a more attractive location

than other potential hosts -- developing countries as a group are likely to benefit from

forcing investors to commit to a country through their investment before the final

terms are established . Thereby giving the host a much greater ability to gain value

from the investment. Put another way, developing countries as a group may have

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sufficient market power in the "sale" of their resources as host countries that if they

act collectively they stand to gain more than if they compete against one another and

bid down they receive.

The customary international law that has traditionally applied to takings by the hoststate is referred to as the "Hull Rule," in reference to Secretary of State Cordell Hull

who authored the most famous articulation of the rule in 1932. The key words, penned

by Hull, that have come to represent the traditional "full compensation" position is

that the expropriation of property owned by foreigners requires "prompt, adequate and

effective" compensation.

The world is very different today. The customary international law that once governed

foreign investment was successfully called into question by developing states who

advocated an alternative international norm and who ultimately left the internationalcommunity without any legal standard having the status of customary law. The Hull

rule was challenged by developing countries who claimed, on sovereignty grounds,

the right to determine how they would treat investors and the standard of

compensation that should apply if that treatment was sufficiently harmful. Although

many countries continue to advocate the Hull Rule, a sufficient number of developing

states oppose it to ensure that it can no longer be considered a rule of customary law.

Furthermore, had developing countries decided, as a group, that it served their interest

to provide greater protections for foreign investors, they could have adopted

additional General Assembly Resolutions or signed multilateral agreements to that

effect. They have done neither. One possible explanation of the behavior of LDCs is

that they have come to conclude that they will be better off if they allow themselves to

be bound through a contractual mechanism with investors.

LDC behavior can best be understood through a strategic analysis of the incentives

facing developing countries individually and as a group. first considers the efficiencyimplications of each regime, and then examines the impact of each regime on the

distribution of the gains from investment.

Once an investment is made, the firm and the host state face one another in a new

negotiating posture. The host has the power to unilaterally change the conditions

under which the firm operates and the firm's only defenses are the ability to stop

operations and pull out of the country and the reputation concerns of the host. It

would, therefore, be possible for the host to extract considerable surplus from the firm

through increased tax rates, restrictions on the repatriation of profits, domestic content

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regulations, and so on. LDCs, therefore, are better off. Although there may be a small

reduction in total investment, developing countries will gain much more from each

dollar of foreign investment that does take place.

Most developing countries have moved to market oriented and private sector ledeconomies. There is widespread reduction and removal of trade barriers, deregulation

of internal markets privatization and liberalization of technology and investment flows

at the national level.

Many developing countries and economies in transition have concluded bilateral

treaties to protect foreign direct investment (FDI) and avoid double taxation. A

number of regional schemes such as the EU (European Union), NAFTA (North

American Free Trade Agreement), ASEAN (Association of South-East Asian

Nations) and MERCOSUR (Southern Common Market), have reduced barriers to FDIor are in the process of doing so, facilitating intra-regional investment and trade flows.

At the multilateral level, the General Agreement on Trade in Services has contributed

to the liberalization of FDI in services. The FDI global regime that has emerged after

these changes though uneven, is much friendlier towards foreign investors than in the

past. This is in the context of the unprecedented changes of the late 1980s and early

1990s. The first section of this chapter focuses on these changes. The second section

specifies the policy challenge for the developing countries. The third section specifies

some serious concerns for the Indian economy.

Finally, we must consider whether or not it is reasonable to assume that investment in

developing countries would continue even if LDCs were unable to make binding

commitments. Because the lack of a method for creating binding contracts has the

effect of raising the costs of investing, whether it is reasonable to assume that the

demand for the resources of LDCs is relatively insensitive to changes in the cost of

investing. In other words, we are asking whether developing countries, if they behave

as a group, have monopolistic power. If they do not have monopolistic power,

potential investors faced with the dynamic inconsistency problem will simply chooseto invest in developed countries -- where the risks to the investment may be

considered less severe. The assumption can be justified on at least two grounds. First,

although developing countries and developed countries share certain traits, there are

enough identifiable traits of developing countries that are different from those of the

developed world to support our assumption. For example, labor in developing

countries is often extremely inexpensive relative to developed countries. Even the

threat of an increase in the wage rate in an LDC may not deter an investor because

even if there were a substantial increase in the cost of labor, it would remain below

that of the developed world. Similarly, developing countries have natural resources

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that do not exist in developed countries, or that are not as abundant. In addition, the

legal and regulatory climate of developing countries may be more advantageous for

investors.

Economic development remains an urgent global need. The need for economicdevelopment is self-raised as an automatic consequence of the globalization.

Although many countries have achieved significant increases in income in the last few

years, there still exist great international inequalities in the level of income. The

lower class of nations is still far bigger. More than two-third of the people live in

countries where the per capita income is only a tiny fraction of what it is in the highly

developed countries. To raise the standard of living of the people in such countries

and to enable them to use the fruits of scientific and technological miraculous

advances in agriculture, industry transport, communication, education, health services

ad other fields, it is almost essential that in such economies, capital formation should

take place at a higher rate than before, so that the big developmental projects may be

financed properly. Thus, for rapid economic development, the central problem is

capital formation.

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Theories of FDI

Major theories of direct foreign investment

There are many theories of DFI some compete with each other in explaining DFI, and

some complement each other. In this section, we will cover six major, distinct

theories, although there will occasionally be overlap.

Technological Advantages

A technological advantages theory of DFI asserts that firm specific advantages which

explain why firms expand domestically also explain why they expand aboard. This

theory is most closely identified with Hymer (19860, 1976), but is also examined by

Kindle berger (1969) and Caves (1971).

Oligopoly Models

Some industrial organization approaches to DFI have been formulated. Oligopoly

models of DFI that use a growth motive for corporations or a desire to maintain and

increase market share as the starting point are principal among them.

Furthermore, no specific advantages are associated with the host countries. In this

situation, DFI would be determined by variables other than the rates of return.

Exchange Risk Theory

Another macroeconomic theory of DFI is Alibers (1970) exchange risk theory, in

which the risk that exchange rate changes will severely alter the home currency value

of a foreign investment provides a barrier to portfolio investment and intermediated

investment by risk averse investors.

Evaluation of theories of DFI

This section briefly assesses how each theory of DFI meets the following three

criteria (1) locational advantages (2) why DFI is chosen over portfolio investment and

intermediated investment or the existence of an overcompensating ownership

advantage, and (3) the prevalence of cross-hauling in DFI.

It accounts for locational advantage by viewing source countries as those countries

with technological advantages and host countries as those without.

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Currency based Approaches

The currency based theories are normally based on the imperfect foreign exchange

and capital market. One such theory developed by Aliber (1971) postulates that

internationalization of firms can best be explained in terms of the relative strength ofdifferent currencies. Firms from strong currency countries move out to weak currency

countries. in a weak- currency country, the income stream is fraught with greater

exchange risk. As a result, the income of a strong currency country firm is capitalized

at a higher rate. In other words, such a firm is able to acquire a large segment of

income generation in the weak currency countrys corporate sector. The merit of

Alibers hypothesis lies in the fact that it has stood up to empirical testing. FDI in

United States, Canada and the United Kingdom has been found in consistency with

the hypothesis. However, the theory fails to explain why there is FDI in the same

currency area.

MacDougall-Kemp Hypothesis:

The literature explaining why a firm seeks to make FDI is ample. One of the earliest

theory was developed MacDougall (1958) , subsequently elaborated by Kemp (1964) .

Assuming a two-country modelone being the investing country and the other being

the host country and the price of capital being equal to its marginal productivity. They

explain that when capital move freely from one country to another, its marginal

productivity tends to equalize between the two countries. This lead to improvement, in

efficiency in the use of resources which leads ultimately to an increase in welfare. So

long as the income from foreign investment is greater than the loss of output the

investing country continues to invest abroad because it enjoy greater national income

than prior to foreign investment. The host country too witnesses increases national

income as a sequel to the greater magnitude of investment that it is not possible in the

absent of foreign investment inflow.

PRODUCT CYCLE THEORY:

Hymer explained why foreign investment takes place, Hood and Young explain

where foreign investment takes place , but it was Raymond Vernon (1966) who

added when to the why and where based on data obtained from US corporate

activities. Raymond Vernon theory is known as the Product cycle theory.

Raymond feels that most of the products follow a life cycle that is divided into three

stages. The first is known as the innovation stage. In order to compete with otherfirms and to have a lead in the market the firms innovates a product through research

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and development. The product is manufactured in the home country primarily to meet

the domestic demand, but a portion of the output is also exported to other developed

countries. The quality of the product, and not the price, forms the basis of demand

because the demand is price inelastic at this stage.

The second stage is known as maturing product stage. At this stage, demand for the

new product in other developed countries grows substantially and turns price elastic.

Rival firms in the host countries itself began to appear at this stage to supply similar

products at the lower price owing to lower distribution cost, whereas the product of

the innovator involves the transportation cost and tariff which are imposed by the

importing government. Thus in order to compete with the rival firm, the innovator

decides to set up production unit in the host countries itself that would eliminate the

transportation cost and tariff. This leads to internationalization of production. The

imposition of tariff in the host country encouraging foreign direct investment is

confirmed by Uzawa and Hamada, but they feel that entry of foreign capital in

protected industry reduces welfare in the host country.

Politico-economic Theories

The politico-economic theories concentrate on political risk. Political stability in the

host countries leads to foreign investment therein (Fdatehi-Sedah and Safizedah,

1989). Similarly, political instability in the home country encourages investment in

foreign countries (Tallman, 1988). However, Schneider and Frey (1985) believe that

the theory underlying the political determinants of FDI is less well developed than

those involving economic determinants. The political factors are only additive ones

influencing foreign investment.

The Electric Paradigm

Dunnings eclectic paradigm is combination of the major imperfect market based

theories of FDI, viz., industrial organisation theory, internalization theory and location

theory. It postulates that at any given time, the stock of foreign assess owned by a

multinational firm is determined by a combination of firm specificity or ownership

advantage (O), the extent of location bound endowments (L), and the extent to which

these advantages are marketed within the various units of the firm (I). Dunning is

conscious that configuration of the O-L-I advantages varies from one country to

another and from one activity to another and that foreign investment will be greater

where the configuration is more pronounced.

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What should a theory of DFI seek to explain?

The first challenge for a theory of DFI is to determine which countries will be source

countries (or home countries) and which will be host countries, an issue often

referred to as the locational indication. In other words, a theory of DFI should explaindata one country patterns of investment, or why certain countries (such as Japan) tend

to be home countries and certain countries (such as Mexico) tend to be host countries.

Theories of DFI should therefore indicate something in addition to or instead of the

interest rate argument for locational indication in an effort to explain why project rates

of return are higher abroad than they are domestically.

Government policies that create market imperfections can also play a part in creating

locational advantage. Large expanding markets may offer high rates of return too. Acompany may wish to set up production in such a country, rather than simply export,

to lower transportation costs and to take full advantage of the opportunities such

markets present. This may be another explanation for the manufacturing rush into

Europe. A tax argument is also associated with location advantage

WHAT ARE THE KEY VARIABLES IN THE DIRECT FOREIGN

INVESTMENT MODEL?

The following questions need to be asked before a company decides to make a direct

investment in a foreign country:

What increase in incremental demand for the products of the Company will result

from the foreign investment?

At what price in terms of foreign currency can the goods or services be sold in the

foreign market? What is the price elasticity of demand for the product in the foreign

market?

What are the fixed cost and variable costs of production in the foreign market at

various levels of output?

What is the full cost of the investment? How much of this cost can be recovered if the

project fails? What proportion of the cost of the investment can be bought in the

foreign county and how much needs to be imported? Imported from where? What

grants and tax concessions can be negotiated with the government in the foreign

country?

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What are the working capital requirements for the foreign project? Will these

requirements be very different from the requirement in the home country? For

example, must higher levels of inventory be maintained to service production because

of increased distance from suppliers?

What is the expected future rate of inflation in the foreign country? How disruptive

would a high rate of inflation be to production and sales abroad? How will the

predicted rate of inflation impact on the exchange rate between the home and the

foreign currency?

What is the cost of funds in the foreign country? What proportion of these funds can

be faired locally and what proportion must be imported from abroad? How has the

cost of funds moved in recent years in the foreign country?

Is this investment project likely to be a permanent project or a capital venture with a

fixed life? If the lifetime is short what is the likely terminal value of the project?

What are the exchange control regulations in this country? What are the rules

regarding repatriation of profits from this country? Are these rules applied rigorously?

How stable is the exchange rated between the foreign and

home currency? Are devices such as forward markets, options and swaps available in

the foreign country or elsewhere to hedge exchange rate risk?

How stable is the government of the country in which the investment is to be made?

What is the political risk index attached to this country by political risk assessors?

what tax rates and regulations are imposed in the profits made by companies in the

foreign country? Are any subsidies available to encourage foreign investment? What

is the-holding tax rate on dividends?

The above set of questions presents a formidable list of things that need to be found

out before a foreign direct investment can be properly assessed, yet it represents onlya fraction of the facts that need to be garnered by an investment team before a

decision can be taken to make a foreign investment.

The Eclectic Theory of John Dunning sets out a background for the motives for and

determinants of foreign direct investment and portfolio investment. the ownership,

location and internationalization factors have been identified for the analysis of the

determinants of the Foreign Direct Investment and Portfolio Equity Investment flows

in India.

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Economic Stability of the Country

Monetary and fiscal policies, which determine the parameters of economic stability

such as the interest rates, tax rates and the state or external and budgetary balances,

influence all types of investment, domestic or foreign.

Investment and Savings Rates in East and South East Asian economies have, by and

large, averaged higher than those registered in Latin American economies. Besides,

such rates have risen from one sub-period to the other in the former region. The

proportion of FDI in domestic investment has been found low till 1990 but has gone

up subsequently in all the sample economies except in Korea and Thailand where it

has gone down.

The influence of FDI on savings and investment has been positive (statisticallysignificant) only in three economies namely Chile, Korea and Thailand. The

experience of Argentina and Philippines in contrast where FDI has had a negative

influence on savings. The influence of FDI flows on national economies of the

developing countries, therefore, may be viewed with caution.

MODE OF INVESTMENT

Economic Determinants

Natural Resources

The most important host-country determinant of FDI has been the availability of

natural resources. According to Dunning, in the nineteenth century much of FDI by

European, United States and Japanese firms was prompted by the need to secure and

economic and reliable source of minerals, primary products for the investing

industrializing nations of Europe and North America.

National markets

From a host-countrys perspective, the relevant economic determinants for attracting

market seeking FDI include market size, in absolute terms as well as in relation to the

size and income of its population, and market growth.

Created Assets

The availability of low-cost unskilled labour largely immobile, has been the most

prominent economic determinant of FDI. This is so especially for TNCs seeking

greater efficiency in producing labour intensive final products or for TNCs producing

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final products for which some stage of production, geographically, separable from

other stages, is intensive in the use of unskilled labour.

Investment Facilitation factors

Investment facilitation factors include promotion efforts, the provision of incentives

to foreign investors, the reduction of the Hassle costs of doing business in a host-

country (e.g., reducing or eliminating corruption and improving administrative

efficiency), and the provision of amenities that contribute to the quality of life of

expatriate personnel.

Investment promotional measures

Promotional measures are taken to shorten the delayed reactions of investors to

emerging investment opportunities or to help investors, especially small and mediumsized firms, discover new opportunities that they would not find on their won. Such

actions are aimed at shortening the psychic distances between the host and home

countries.

Investment incentives

A large number of governments, especially of developed countries, compete among

themselves by offering a variety of investment incentives to attract FDI. There is

competition among OECD countries in offering investment incentives to attract FDI.E.g., Mercedez was paid US $ 2,00,000 per job created in 1996 in the US.

Earlier studies, their conclusions and limitations

Research on the effects of policy variables on FDI, especially with respect to

developing countries, more particularly India, is rather limited. While there has been

much research on the general determinants of FDI in less developed countries with

survey by Agarwal (1980). This study focuses on factors like comparative labour

costs, country size, the nature of exchange rate regime and political including political

instability.

Several more recent empirical studies on the determinants of FDI mention the

potential importance of policy-related variables such as tax rates, foreign investment

incentives and openness in the determinants of FDI. Yet in their empirical analysis,

they do not analyze them. Tsai (1994) notes the importance of qualitative factors, such

as qualitative stability and incentives, but does not include them in the empiricalanalysis on the ground that such variables are difficult to define and quantify.

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Study has confined its analysis to trace signs of the impact of foreign collaboration

on-

National Technological Capability of the Indian History,

Export performance of the subsidiaries of Foreign Companies, and

Foreign Exchange Inflows into India.

COSTS AND BENEFITS OF FDI

When direct investment flows from one country to another, it creates benefits both for

the home country and the host country. Thus when a firm decides to make FDI, it

takes into account the benefits and costs to be accrued to not only its home country

but also to the host country.

Benefits to the Host country

Availability of scarce factors of production

Some times FDI is accompanies by labour force that performs those jobs that the local

labour force is either not willing to do or is incapable of doing on account of lack of

skill. Besides, the foreign labour force infuses non-traditional mental attitudes amongthe local labour force. Also, foreign inventors make available raw material and

improved technology. At the same time, the host countries often encourage FDI

inflow because they get improved technology, and more importantly, an ongoing

access to continued research and development programmes of the investing country.

Improvement in the balance of payments

FDI helps improve the balance of payments of the host country. The inflow of

investment is credited to the capital account. At the same time, the currency accountimproves because FDI helps either import substitution or export promotion.

Building of economic and social infrastructure

When the foreign investors invest in sectors such as the basic economic

infrastructure, social infrastructure, financial markets and the marketing system, the

host country is able to develop a support system that is necessary for rapid

industrialization.

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Fostering of economic linkages

Foreign firms have forward and backward linkages. They make demand for various

inputs that in turn helps develop the input supplying industries. They employ labour

force and so help raise the income of the employed people that in turn raises the

demand and industrial production in the country.

Strengthening of government budget

The foreign firms are a source of tax income for the government. They pay not

income tax, but tariff on their import as well.

Benefits for the Home Country

FDI benefits the home country too. The country gets a supply of necessary raw

material if the investor makes investment in the exploration for a particular raw

material. The balance of payments improves insofar as the parent company gets

dividend, royalty, technical service fees and other payments and from the rising export

of the parent company to the subsidiary. If FDI takes place in order to develop a

vertical set up aboard, the export is quite significant.

Cost to the Host Country

As far as employment of locals is concerned, the MNCs normally show reluctance to

train the local people. Technology being normally capital intensive does not assure

larger employment. Sometimes, the manufacturing processes followed by the foreign

investors do no abide by the pollution norms or by the norms regarding optimal use of

the natural resources or the norms regarding location of industries. All this is not in

the host countrys interest.

The foreign investors are generally more powerful and the domestic industrialists do

no compete with hem wit the result that the domestic industry fails to grow. The

foreign companies charge higher prices for their products in view of their oligopolistic

position in the market. The foreign companies infuse foreign culture into the

industrial set up and also into the society. Sometimes they are so powerful that they

are even able to subvert the government.

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STRATEGY FOR FDI

When a firm decides to operate in a foreign land, it needs to follow a specific

strategy in order to make its operation a viable one. The strategy must be designed so

as to enable it to have an edge over competing firms, to this end, the firm mayconcentrate either on product innovation, product differentiation, on the cartels and

collusion, or on some other strategies. In fact, the strategy depends to a great extent on

how mature the product is or how designed its cost structure is. The existence of

competing firms and the opening up of the sectors to foreign investors in the host

country are some of the factors, which would influence the strategy to be employed.

Firm-specific Strategy

When a firm has already spent a huge sum of money on research and development, itnormally stresses on serving the consumers abroad with an innovated product and

this gives it a definite edge over competing firms.

When the product innovation strategy fails to work, a firm may adopt a product

differentiation strategy. This is done through putting a trademark on the product, or in

other worlds, through branding the product. Branding substitutes to a great extent the

product-innovation strategy insofar as the branded product enjoys an exclusive

status, quite different from similar products in the market.

A single brand gives a better marketing impact, eliminates confusion and reduces

advertising cost.

Cost economizing Strategy

When a firms product becomes standardized and it faces competition from similar

products of other firms, the firm tried to locate its subsidiary in a country where either

raw material or labour is cheap. Cheapness of these factors of production provides the

firm an opportunity to reduce the cost of production and to maintain an edge over

other firms. For instance, if an MNC invests broad in the raw material sector, it

would be able to get that particular raw material at a lower cost and to export it either

to he parent unit or to any other subsidiary.

Joint venture with a rival firm

Sometimes when a rival firm in the host country is so powerful that it is not easy for

the MNC to compete, the latter prefers to join hands with the host country firm for a

joint venture agreement and the MNC thus is able to penetrate the host country

market.

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Whatever strategy is adopted by the MNCs abroad, there are certain necessary pre-

conditions. First of all, they should have an idea of the profitable investment

opportunities and the ways to tap those opportunities. Secondly, each and every

strategy must be carefully evaluated since a particular project may no be competitive

on all fronts. If one strategy is not useful, the firm should go in for another strategy. If

one strategy is not useful, the firm should go in for another strategy. Thirdly, the firm

must evaluate the life span of each strategy. It must possess the flexibility of

switching over from one strategy to another, especially when the life span of a

particular strategy comes to an end.

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India scenario

In 1951 India adopted the path of planned development on the lines of the Soviet

model, but within a mixed economy framework in which both the public and private

sectors played their roles. In the following decades the union and state governments inIndia made investments directly and through their instrumentalities, while at the same

time regulating private sector investment towards realizing social goals set by the

planners. In the process India relied largely on domestic resource mobilization and to

a far lesser extent on external aid, mostly in the form of debt capital from multilateral

institutions. The inward-oriented development strategy pursued over three-and-a-half

decades did not yield expected outcomes in terms of targeted growth rates, self-

reliance or better spatial and interpersonal income distribution. On the contrary,

greater protectionist measures and multistage government interventions made India ahigh cost economy.

In June 1991 the Indian govt. went all out for foreign investments and initiated a

programme of macro economic stabilization and structural adjustment support by IMF

and World Bank. The equity participation, which was kept under 40%, has been

increased to 51% and subsequently this has been further raised. A foreign Investment

Promotion Board (FIPB) authorized to provide a single window clearance has been set

up in PMO to invite and facilitate investments in India by international companies.

The Foreign Exchange regulation Act of 1973 has been emended and restrictionplaced on foreign companies by FERA has been lifted.

During the pre-reform period neither India nor China preferred FDI though India was

open to foreign investment to a very limited extent. The policy regimes in both the

countries drastically changed in the post-reform periods, which began from 1978 for

China and mildly in 1985 and more rapidly in 1991 for India. During the reform

period both the countries welcomed FDI to play a role in their economies.

FDI SURVEY 2002 SHOWS 385 respondents from across sectors: automobiles,engineering and machinery, energy, infrastructure, information technology, food and

beverages, tourism, drugs and pharmaceuticals, consumer goods and electronics.

Turnover ranged from Rs 10 crore to Rs 850 crore.

Performance of foreign investors is satisfactory with 61% reporting profits or break-

even (36% making profits, 25% breaking even). 70% said their CAPACITY

UTILISATION was in the range of 50%-75%. This is fairly positive considering most

are new entrants.

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AP is ranked 6th in terms of FDI approvals but 3rd according to investor rankings.

These perceptions are a powerful indicator as to which states can expect to receive

higher FDI inflows in the near future. Haryana is also strikingly different. Ranking of

other states more or less coincide with FDI Approval rankings.

POLICY issues have shown a marked improvement over the last year with 93%

saying handling of approvals at the center is Good to Average, and policy related

issues such as funds flow mechanisms are effective.

It is seen that the policy framework in India dealing with foreign private investment

has changed from cautious welcome policy during 1948-66 to selective and restrictive

policy during 1967 to 1979. in the decade of eighties, it was the policy having partial

liberalization with many regulations. Liberal investment climate has been created

only since 1991. The period from 1991 till date the characterized by transparency andopenness and is intended to seek more foreign investment inflows. However, there are

some specific aspects, (e.g. lack of transparency in the approval of FI

191 study of fdi activity in india and its implications

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