Foreign Direct Investment (FDI) – Meaning, Types, Advantages & Disadvantages

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What is Foreign Direct Investment?

The concept of foreign direct investment has gained massive popularity in recent times. A foreign direct investment primarily benefits both parties involved in the transaction. Hence, it is an attractive mode of investment.

When a company (foreign company – located outside the country) invests in a domestic company by purchasing the interest of that company, it is known as foreign direct investment. The investment can be made either by a foreign company as a whole or an investor.

The term FDI is often used to describe the acquisition of a significant stake by a foreign entity. It can be done for several purposes, primarily to boost the global presence, expand its business to a larger scale, etc. Though this concept speaks of investment, it is not necessarily a stock investment made by the investing company.

Working of Foreign Direct Investments (FDI)

Some of the factors that play a significant role in investors’ decision-making process are:

• Economies where the government regulation is stabilised. Thus, this ensures due control.
• Economies wherein there is a surge in a skilled workforce.
• Economies offering more-than-average growth prospects.

As the FDI is a far-sighted concept, it includes making provisions for equipment, technology, and professional high-level management. It depicts that FDI is far beyond capital investment.

FDIs help build a robust control of the business. It might also influence the firm’s decision-making activities substantially.

Some of the special considerations are as follows:

• When an entity intends to invest in a foreign company, it looks to have control reasonably. Control is one of the critical elements of FDI. It describes the intent of the investing entity to supervise and oversee the operations of the firm, be an active manager, and influence decision-making.
• The Organisation of Economic Co-operation and Development (OECD) has set aside a threshold limit for foreign direct investment to qualify as having a controlling interest in the entity it invests. Per the OECD guidelines, a minimum of 10% ownership stake in a foreign-based company will be eligible for a controlling interest. However, there have been instances when an effective control has been established in a company with less than 10% of voting shares.

What are the various types of Foreign Direct Investment?

Foreign direct investment can be categorized as horizontal, vertical, or conglomerate.

• In the case of a horizontal direct investment, a company tries to build a similar type of business function in a foreign country as it does in its home country – for example, a Korea-based cell phone provider investing in a chain of mobile phone outlets in Russia.
• In the case of a vertical direct investment, a business aims to acquire a complementary business, i.e., a business which will complement its current business operation in a different country. For example, an India-based manufacturer is eyeing an interest acquisition in a China-based company that supplies the raw materials it needs for its primary business in its home country.
• Another type of FDI is the conglomerate. In this case, a company invests in a foreign company with an unrelated business operation regarding its primary business. As the business is not related, the investing entity will not have expertise in the lines of business of foreign companies. This is when they enter a joint venture.

The rise of FDI in India

Even amid the COVID-19 pandemic-induced disruptions, which began way back in March 2020 with a series of lockdowns, the Indian economy has grown with about USD 22.53 billion worth of direct investments from April to June 2021 quarter. This is about 90% higher than the comparative quarter of 2020, when the economy was at a standstill owing to the pandemic. 

The automobile industry received about 27% of FDI equity inflow, making it the highest foreign direct investment receiving sector. The other sectors, such as computer hardware and software, accounted for about 17% of FDI inflow, and the services sector had around 11% FDI inflow. 

Of this total number of USD 22.53 billion,  approximately 98% of the investments have come in from the automatic route, which means that the investing entity does not require government approval for making this investment. Also, it indicates the relaxation in trade restrictions of FDI in India. This relaxation of FDI in India has led India to rank higher in the World Bank’s list of nations of ease of doing business by 79 positions. India is now ranked in the 63rd position out of the list of 190 countries. 

This shift and upward movement of India’sIndia’s rank has happened between 2014 to 2019, as per the report released in December 2020. India is expected to get into the list of top 50 nations for ease of doing business by the close of the coming financial year.

Why importance must be given to boost FDI for India:

As there is a tremendous boost in the Indian economy due to the benefits of FDI, India must have the investments coming on a more significant scale. It helps support the non-debt financial resource acting as a relief for a developing economy. Companies investing in India also get the advantages of FDI like reduced wage cost and improved technical know-how, which facilitates employment growth at an overall level.

The Indian government to solidify the interest favoring foreign direct investments has eased the norms in several sectors. The following are power and stock exchanges, defence units, and PSU refineries, which have led to a sharp increase in investments in these sectors. With this move of creating favorable policies, the government has ensured a constant flow of capital into the economy. Both parties immensely build their economies through the benefits of FDI.

Now that we have got a fair idea about the basics and background of foreign direct investments let us look at the advantages of foreign direct investment:

Increase in Economic growth:

One of the benefits of FDI is the creation of jobs. A developing nation is always on the lookout to attract heavy foreign investments as it leads to an overall improvement in the way an economy functions. It also helps improve the standard of living of the people. One of the more significant benefits of foreign investment is that it focuses on driving up the results of the service and manufacturing sectors of the nation and helps combat the fight against rising unemployment rates. 

As the income earning capacity of the people increases, it leads to more disposable income in the hands of the people. The more disposable income, the higher the buying power, which provides an overall boost to the nation’s economic condition.

Development of human capital:

Every entity intending to grow its business through foreign investments invests a part of its capital in developing the required human resource. As the lower-level management and the staff carry out the implementation of the strategies of the top management, the due focus must be given to developing their competency and knowledge base. 

The people of lower-level management learn and receive a scope to enhance their skills by gaining experience in their allocated tasks. This can be achieved by conducting training sessions across all departments. The practice adopted by the organisation to develop the skills of their workforce creates a ripple effect in the economy, and other sectors try to follow suit.

Technology:

Foreign companies derive enormous benefits from FDI through improved technology and tools. Newer and improved operational practices are adopted to make the vision a reality. Utilising the latest financial tools across all company sections ensures improved effectiveness and efficiency in conducting operations.

Rise in exports:

The FDI usually does produce goods keeping the global markets in mind, and therefore the goods produced by them are export compatible. This leads to an increase in exports, and it is achieved by creating 100% export-oriented units.

Facilitates the stability in the exchange rate:

If the economy successfully maintains a constant flow of foreign capital through FDI, it simply translates into a flow of regular foreign exchange in the country. This flow will help build a growing foreign exchange reserve, ultimately stabilising the exchange rates, which the Central Bank maintains.

FDI leads to the creation of a Competitive Market:

Another advantage of foreign direct investment is that it facilitates the entry of foreign entities into the local marketplace. This move helps to build and sustain a healthy competitive environment. When a healthy competitive environment is built, it will further help to break down the domestic monopolies. 

It encourages firms and their people to develop a shared vision and go beyond their call of duty to deliver improved services and products through renewed processes. Due to this, there has been a tremendous rise in innovations in the domestic marketplace in recent times. As newer and more valuable products get introduced in the market, the consumers get access to better quality and a wide range of products priced competitively.

Helps in combating climate change:

Due to the mounting issues surrounding climate change, the United Nations has encouraged the route of foreign direct investments, realizing that it will help fight the problems.

What are the benefits of foreign direct investment?

Having gone through the advantages of foreign direct investment, let us get an overview of the benefits of FDI. 

They are as follows:

Stimulates the economic development of a nation:

When there is a rise in foreign investments, it may lead to the development of factories to manufacture goods. It will give rise to employment, thereby improving the employability rate. It further helps to generate tax revenue and the regular tax revenue of the Government. This tax revenue can be reinfused into the economy to better infrastructure not just physically but financially.

Ease in conducting the international trade:

As every country lays its import tariff, it isn’t easy to conduct trade. To ensure that the sales targets and overall goals are achieved, most economic sectors need to have their international presence in place. This can be accomplished by adopting the foreign direct investment methodology. It helps to meet the demands and requirements efficiently.

What are the other advantages of FDI?

A few more points need to be considered apart from those mentioned above. 

Stated below are the other advantages of FDI. 

• It helps in the revolutionary transformation of the underdeveloped areas of the nation into a full-fledged industrial sector.
• Goods can be promoted and marketed via FDI both in the domestic and international markets, in turn contributing to the nation’s foreign exchange revenues.

Like other investment avenues, FDI also has advantages and disadvantages, primarily geo-political. It might impact domestic investments, trigger risks for the country’s political changes, and may or may not positively influence exchange rates always.