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SFM/U2 Topic 8 Foreign Direct Investment and Foreign Institutional Investment

A foreign direct investment (FDI) is an investment in the form of a controlling ownership in a business in one country by an entity based in another country. It is thus distinguished from a foreign portfolio investment by a notion of direct control.

The origin of the investment does not impact the definition, as an FDI: the investment may be made either “inorganically” by buying a company in the target country or “organically” by expanding the operations of an existing business in that country.

Broadly, foreign direct investment includes “mergers and acquisitions, building new facilities, reinvesting profits earned from overseas operations, and intra company loans”. In a narrow sense, foreign direct investment refers just to building new facility, and a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor.

FDI is the sum of equity capital, long-term capital, and short-term capital as shown in the balance of payments. FDI usually involves participation in management, joint-venture, transfer of technology and expertise. Stock of FDI is the net (i.e., outward FDI minus inward FDI) cumulative FDI for any given period. Direct investment excludes investment through purchase of shares.

FDI, a subset of international factor movements, is characterized by controlling ownership of a business enterprise in one country by an entity based in another country. Foreign direct investment is distinguished from foreign portfolio investment, a passive investment in the securities of another country such as public stocks and bonds, by the element of “control”. According to the Financial Times, “Standard definitions of control use the internationally agreed 10 percent threshold of voting shares, but this is a grey area as often a smaller block of shares will give control in widely held companies. Moreover, control of technology, management, even crucial inputs can confer de facto control.

Impact of Foreign Direct Investment on  Economy

Foreign Direct Investment (FDI) plays an important role in the growth and development of an economy. It is more important where domestic savings is not sufficient to generate funds for capital investment. Not only it supplements the investment requirements of an economy but also it brings new technology, managerial expertise and adds to foreign exchange reserves.

FDI inflow is more beneficial particularly to developing and emerging countries than the developed ones. IMF has defined FDI as “a category of international investment that reflects the objective of a resident entity in one economy (direct investor or parent enterprise) obtaining a lasting interest and control in an enterprise resident in another economy (direct investment enterprise)”.

Prior to 1980s, economic theories were not delving extensively on the aspects of foreign direct investment and Multi-lateral enterprises (MNEs). During last three decades globalization has been the key to almost all countries’ economic policies. An important aspect of globalization is FDI inflows from home countries to host countries.

Though there is no general rule of developed and developing countries as home and host countries respectively, however, mostly it is seen that FDI flows from developed countries to developing and emerging countries. There has been growing competition among developing and emerging countries to attract FDI. India is not left behind in this regard.

FDI is believed to play many important roles in the host countries. It has different effects on different countries based on the host country policies, investment climate and other domestic macroeconomic conditions.

The first and foremost is, it acts as a capital supplement to the domestic capital for investment demand. Apart from capital it brings new, innovative technology to the host countries. In many countries it also promotes competition among the domestic firms to improve their level of technology adoption.

Effectively, they invest more in research and development (R & D) to upgrade their technology. With increased investment as supplement to domestic capital, it also generates more employment opportunities. With keen interest in the investee firms through FDI, the foreign firms improve their managerial competence, which also improves managerial skills in the country through competition and dissemination of the new ideas and skills.

The firms with improved technology and competition produce quality products, which are exportable, thus it improves the level of export and degree of openness of the host countries. With foreign partners, there are better tie ups with the importing firms abroad for potential exportable domestic products. With improvement in exports the foreign exchange earnings of the host countries gets boosted. Capital flow through FDI and improved export earnings can also increase the level of foreign exchange reserve in the host countries.

With higher foreign exchange reserve, the demand for domestic currency will go up. Hence the domestic currency of the host country is expected to appreciate as against the basket of foreign currencies mostly of trade partners.

FDI is also believed to improve the Gross domestic product (GDP) of the host country through improved production and competition among the domestic firms. With improved production and more employment, it also can improve gross domestic capital formation (GDCF) which cater to the increasing requirement of domestic investment in the country. Further, with competition, improvement in technology, the performance of the investee firms as well as other domestic firms can improve. Thus it can have a positive impact on return on capital and thereby on the stock prices.

Keeping in view the above mentioned relationships between inward FDI and other macroeconomic variables, which has already been found by some of the earlier researchers, this study tries to empirically establish the relationship between FDI and other macroeconomic variables in Indian context after undergoing some of the existing work in this area across economies.

Foreign Portfolio Investment (FPI)

Foreign Portfolio Investment (FPI) is an investment by foreign entities and non-residents in Indian securities including shares, government bonds, corporate bonds, convertible securities, infrastructure securities etc.  The intention is to ensure a controlling interest in India at an investment that is lower than FDI, with flexibility for entry and exit.

Foreign Institutional Investment (FII)

Foreign Portfolio Investment (FPI) is an investment by foreign entities in securities, real property and other investment assets. Investors include mutual fund companies, hedge fund companies etc. The intention is not to take controlling interest, but to diversify portfolio ensuring hedging and to gain high returns with quick entry and exit.

The differences in FPI and FII are mostly in the type of investors and hence the terms FPI and FII are used interchangeably.

The Securities Market in India is regulated by Securities and Exchange Board of India (SEBI). Refer to the article on SEBI to get more information on this topic.

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