Unit 5: International Capital Movements Chapter Notes | Business Economics for CA Foundation PDF Download

Overview

Introduction

Types of Foreign Capital

Foreign capital refers to the inflow of capital into a home country from abroad. It's important to distinguish between the movement of capital and foreign investment. Foreign capital can enter an economy in various ways, and some of the key components include:

1. Foreign Aid or Assistance:

• Bilateral Aid: Direct intergovernmental grants between countries.
• Multilateral Aid: Assistance from multiple governments pooled through international organizations like the World Bank.
• Tied Aid: Aid with specific conditions on how the funds are used, as opposed to untied aid with no such stipulations.
• Foreign Grants: Voluntary transfers of resources by governments, institutions, or organizations.

2. Borrowings:

• Direct Intergovernmental Loans: Loans between governments.
• Loans from International Institutions: Such as the World Bank, International Monetary Fund (IMF), and Asian Development Bank (ADB).
• Soft Loans: Concessional loans from organizations like the International Development Association (IDA), an affiliate of the World Bank.
• External Commercial Borrowing: Loans from foreign commercial sources.
• Trade Credit Facilities: Credit extended by suppliers to buyers for the purchase of goods.

3. Deposits from Non-Resident Indians (NRIs)

4. Investments:

• Foreign Portfolio Investment (FPI): Investments in bonds, stocks, and securities.
• Foreign Direct Investment (FDI): Investments in industrial, commercial, and other enterprises.

A detailed exploration of all types of capital movements is beyond the scope of this discussion, so the focus will be on foreign investments.

Foreign Direct Investment (FDI)

Foreign Direct Investment (FDI) refers to a long-term investment made by a resident entity in one economy into an enterprise located in another economy, reflecting a lasting interest and control. This typically involves acquiring more than 10% of the shares of the target asset.

Key Components of FDI:

• Equity Capital: Funds invested in the form of shares.
• Reinvested Earnings: Profits reinvested in the enterprise.
• Other Direct Capital: Intra-company loans between parent enterprises and affiliate enterprises.

Forms of Direct Investments:

• Opening of Overseas Companies: Establishing subsidiaries or branches in foreign countries.
• Joint Ventures: Collaborating with local firms to create joint ventures.
• Joint Development of Natural Resources: Partnering with local entities to develop natural resources.
• Acquisitions: Purchasing or annexing companies in the host country.

Types of FDI:

• Horizontal FDI: Investing in the same type of business operation abroad as in the home country. For example, a U.S.-based cell phone service provider expanding to India to offer the same services.
• Vertical FDI: Investing in different stages of the production process in a foreign country.
• Conglomerate FDI: Investing in unrelated businesses in a foreign country.

Characteristics of FDI:

• Control: The investor retains control over the use of invested capital and decision-making to the extent of its equity participation.
• Lasting Interest: There is a long-term relationship between the direct investor and the enterprise, with significant influence by the investor on the management of the enterprise.

(ii) Conglomerate Foreign Direct Investment
A conglomerate type of foreign direct investment occurs when an investor makes a foreign investment in a business that is unrelated to its existing business in its home country. This often takes the form of a joint venture with a foreign firm already operating in the industry, as the investor lacks prior experience in that particular field.

Two-Way Direct Foreign Investments
Two-way direct foreign investments refer to reciprocal investments between countries. These investments arise when certain industries are more advanced in one nation while others are more efficient in different nations. For example, the computer industry in the United States may be more advanced, while the automobile industry in Japan may be more efficient.

Foreign Portfolio Investment (FPI)

• Foreign Portfolio Investment (FPI) refers to the flow of financial capital, as opposed to real capital, without the investor gaining ownership or control. Examples of FPI include an Italian company depositing funds in an Indian or British bank, a French citizen or company buying a bond from a Swiss company or government. Unlike Foreign Direct Investment (FDI), portfolio capital generally invests in financial instruments like stocks and bonds, primarily through capital markets. These financial capital flows impact balance of payments and exchange rates more immediately than production or income generation.
• FPI is not focused on the manufacturing of goods or the provision of services. Investors in FPI do not intend to exercise voting rights or control over the companies in which they invest. Their primary goal is to earn a profitable return through investments in foreign securities, prioritizing capital safety, potential value appreciation, and generated returns. Portfolio capital typically flows to countries with demonstrated potential for higher returns and profitability.
• According to international standards, portfolio investments involve holding less than 10 percent of a company's total stake. Unlike FDIs, these investments are usually short-term and do not aim to enhance a country's productive capacity by creating capital assets. Portfolio investors assess the prospects of each potential investment independently and may shift their capital based on changing prospects, making these investments largely speculative. When investor confidence is disrupted, this capital can rapidly move from one country to another, occasionally leading to financial crises for the host country.

Difference between Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI)

• Foreign Direct Investment (FDI) involves the creation of physical assets, while Foreign Portfolio Investment (FPI) focuses on financial assets.
• In FDI, investors gain significant control and influence over the assets, whereas in FPI, investors have limited control and are primarily concerned with financial returns.
• FDI is typically a long-term investment strategy, while FPI is often short-term and speculative.
• FDI contributes to the productive capacity of the economy by creating capital assets, while FPI does not have this direct impact.

Investment

• Type of Assets: Foreign Institutional Investors (FIIs) invest only in financial assets, while Foreign Direct Investment (FDI) involves investment in physical assets.
• Investment Duration: FIIs have a short-term interest and typically invest for short periods, whereas FDIs have a long-term interest and remain invested for extended periods.
• Withdrawal Ease: Withdrawing from FDI is relatively difficult, while withdrawing from FII is relatively easy.
• Speculative Nature: FDI is not inclined to be speculative, whereas FII is speculative in nature.
• Technology Transfer: FDI is often accompanied by technology transfer, while FII is not.
• Employment Impact: FDI has a direct impact on employment and wages, whereas FII does not have a direct impact on employment and wages.
• Management and Control: FDI has an enduring interest in management and control, while FII has no abiding interest in management and control.
• Influence on Management: Securities held by FIIs are purely for financial investment with no significant influence on the management of the enterprise, while securities held by FDIs come with a significant degree of influence on the management of the enterprise.

Reasons for Foreign Direct Investment

Economic Prosperity and Capital Abundance:

• Foreign Direct Investment (FDI) typically occurs when there is economic prosperity and a relative abundance of capital in the home country.
• Many economies and organizations have a large reserve of capital looking for profitable investment opportunities.
• The primary goal of economic agents is to maximize their economic interests, and the potential for higher profits in other countries often attracts them to invest abroad.

Expectation of Higher Returns:

• The main reason for shifting capital between different regions or industries is the expectation of higher returns compared to what is possible in the home country.
• Foreign firms may find investments in a host country profitable due to firm-specific knowledge or assets, such as superior management skills or valuable patents, that give them an advantage over domestic firms.

Interdependence of National Economies:

• Increasing interdependence among national economies leads to stronger trade relations and international industrial cooperation, driving FDI.

Internationalization of Production:

• Transnational corporations increasingly invest in their subsidiaries and affiliates abroad, contributing to the internationalization of production and investment.

Economies of Scale:

• Technological advancements enable firms to achieve economies of large-scale operations, motivating them to invest internationally.

Direct Control of Production Knowledge:

• In rapidly evolving technological environments, companies may find it challenging to establish licensing agreements with foreign producers.
• Direct control over production knowledge or managerial skills becomes crucial, especially in monopolistic or oligopolistic markets.

Strategic Acquisitions:

• Acquiring promising foreign firms can be a strategic move to avoid future competition and potential loss of export markets.

Risk Diversification:

• FDI helps in risk diversification, allowing firms to mitigate the impact of recessions or downturns by spreading their investments across different regions.

Geographical Proximity:

• Shared languages, common boundaries, and geographical proximity can reduce time and transport costs, making certain foreign markets more attractive for investment.

Trade Patents and Quality Control:

• Retaining control over trade patents and ensuring consistent quality and service are essential for creating monopolies in a global context.

Resource Optimization:

• FDI promotes the optimal utilization of physical, human, financial, and other resources, enhancing overall efficiency.

Emerging Markets:

• Capturing large and rapidly growing emerging markets with substantial and increasing populations is a key driver of FDI.

Host Country Determinants of Foreign Direct Investment

Factors Influencing Foreign Direct Investment (FDI)

• Foreign Direct Investment (FDI) can be influenced by various factors, depending on whether the investment is resource-seeking, efficiency-seeking, or affected by host country conditions.

Resource - or Asset-Seeking FDI:
This type of FDI focuses on acquiring essential resources and assets. Key factors include:

• Raw Materials: Availability of necessary raw materials.
• Low-Cost Unskilled Labor: Access to affordable unskilled labor.
• Skilled Labor: Availability of skilled labor for specific tasks.
• Technological and Innovative Assets: Access to technological, innovative, and other created assets, such as brand names.
• Physical Infrastructure: Adequate physical infrastructure to support operations.

Efficiency-Seeking FDI:
This type of FDI aims to enhance efficiency by optimizing costs and resources. Key factors include:

• Costs of Physical and Human Resources: Costs associated with physical and human resources, adjusted for productivity.
• Input Costs: Costs of intermediate products and transport.
• Regional Integration: Membership in regional integration agreements that facilitate corporate networks.
• Market Policies: Policies governing market functioning and structure, including competition and mergers.
• International Agreements: Agreements related to FDI at the international level.
• Privatization Policy: Policies regarding privatization.
• Trade Policies: Coherence of trade and FDI policies.
• Tax Policy: Tax regulations and incentives.

Business Facilitation:

• Investment Promotion: Activities aimed at building a positive image and generating investments, along with investment-facilitation services.
• Investment Incentives: Incentives offered to attract investments.
• Hassle Costs: Costs related to corruption and administrative efficiency.
• Social Amenities: Availability of social amenities like bilingual schools and overall quality of life.
• After-Investment Services: Services provided after the investment is made.

 Source: International Economics (7th ed) by Dennis R. Appleyard, Alfred J. Field, and Steven L. Cobb 

Modes of Foreign Direct Investment (FDI)

Foreign direct investments can be made in a variety of ways, such as:

• Opening a subsidiary or associate company in a foreign country.
• Equity injection into an overseas company.
• Acquiring a controlling interest in an existing foreign company.
• Mergers and Acquisitions (M&A).
• Joint ventures with a foreign company.
• Greenfield investment, which involves establishing a new overseas affiliate to start production from scratch.
• Brownfield investments, where existing infrastructure is utilized through merging, acquiring, or leasing, rather than developing a new site. For example, in India, 100% FDI under the automatic route is permitted for Brownfield Airport projects.

Advantages of Foreign Direct Investment (FDI)

Foreign Direct Investment (FDI) offers several advantages to host countries, particularly in developing nations. Here are the key benefits:

• Competition and Innovation: Foreign enterprises entering a host country typically stimulate competition. This competition compels domestic businesses to improve, leading to innovations that reduce costs and enhance product quality. As a result, consumers benefit from a greater variety of better products and services at lower prices, improving their overall welfare.
• Increased Capital: FDI brings in international capital, allowing countries to invest beyond what their domestic savings would permit. This influx of capital, when combined with local labor and resources, can boost overall output and GDP, as well as increase productivity per unit of input.
• Economic Development: For emerging and developing countries, FDI can accelerate economic growth by providing essential capital, technology, management expertise, marketing strategies, and skilled labor. The technological advancements brought by foreign firms often have spillover effects, benefiting local industries and expanding the production capabilities of the host country.
• Political and Structural Reforms: The competition among national governments to attract FDI has led to important political and structural reforms. These reforms include improvements in legal systems and macroeconomic policies, making the host country more attractive to foreign investors.
• Employment Generation: FDI creates direct employment opportunities in the host country through the establishment of production bases such as factories and power plants. This initial wave of investment often leads to subsequent FDI and domestic investments in related services, generating a multiplier effect on employment and contributing to income and GDP growth.
• Indirect Employment Opportunities: In addition to direct jobs, FDI generates indirect employment opportunities through backward and forward linkages. This is particularly significant in developing countries with surplus labor, as it helps absorb excess labor caused by population pressures.
• Foreign direct investments (FDI) lead to higher wages for skilled jobs and generate more indirect employment in lower-end service sector occupations. This benefits less educated and unskilled individuals working in those sectors.
• Foreign corporations offer better access to international markets. FDI fosters people-to-people relations and strengthens bilateral and international ties, unlike portfolio investments. Increased openness to foreign capital enhances national dependence on international investors, raising the stakes for potential conflicts.
• FDI encourages the establishment of ancillary units, resulting in job creation and skill development for local workers.
• Foreign enterprises leverage their global marketing networks to promote exports from developing countries. If they produce goods with export potential, host countries can secure valuable foreign exchange for importing capital equipment or materials, aiding development plans and easing external debt.
• Effective tax measures in host countries can turn foreign investment projects into sources of new tax revenue, funding development initiatives.
• FDI often targets industries where economies of scale can be achieved, potentially lowering consumer prices. Domestic firms may struggle to generate the capital needed for large-scale production cost reductions.
• Increased competition from FDI weakens domestic monopolies, leading to higher output and lower prices.
• FDI positively impacts the host country’s balance of payments position, offering advantages over external borrowings.
• Foreign firms introduce better work culture and higher productivity standards, fostering awareness of productivity and contributing to overall human resource development.

Potential Problems Associated with Foreign Direct Investment

Foreign Direct Investment (FDI) can bring various benefits, but these benefits are not guaranteed in every case and can vary in scale. Critics of FDI, especially in the context of developing economies, argue that foreign entities are primarily driven by profit motives and are more interested in exploiting natural resources rather than addressing the development needs of host countries. They view foreign capital as a tool of imperialism, fostering dependence and increasing inequality both between and within nations.

Here are some common arguments against the entry of foreign capital:

(1) Capital-Intensive Methods. FDIs tend to focus on capital-intensive production and service methods, which require fewer workers. This approach is unsuitable for labor-abundant countries as it does not address the critical issues of poverty and unemployment.

(2) Regional Disparity and Income Inequality. FDI flows often gravitate towards regions rich in natural resources and infrastructure, potentially exacerbating regional disparities. Additionally, foreign capital can worsen existing income inequalities within the host country.

(3) Domestic Savings and Tax Revenues. In developing countries, the inflow of foreign capital may discourage domestic governments from increasing domestic savings, especially when tax mechanisms are weak. If foreign corporations receive incentives like tax holidays, the host country loses valuable tax revenues.

(4) Crowding-Out Effect. Foreign firms may finance their domestic investments by borrowing from the host country's capital market, leading to higher interest rates and crowding out domestic investments. This shift in funding preferences can divert capital away from essential development projects.

(5) Balance of Payments and Exchange Rate Instability. The anticipated benefits of improved balance of payments and currency stability may not materialize due to potential instabilities. While FDI can enhance foreign exchange, balance of payments, and currency value, the need for imported inputs and profit repatriation can strain these factors. Foreign corporations often use their regular input suppliers, leading to increased imports, while large-scale profit repatriation can negatively impact exchange rates and balance of payments.

(6) The jobs that require expertise and entrepreneurial skills for creative decision making may be retained in the home country and therefore the host country is left with routine management jobs that demand only lower levels of skills and ability. The argument of possible human resource development and acquisition of new innovative skills through FDI may not be realized in reality.

(7) High profit orientation of foreign direct investors tend to promote a distorted pattern of production and investment such that production could get concentrated on items of elite and popular consumption and on non-essential items.

(8) Foreign entities are usually accused of being anti-ethical as they frequently resort to methods like aggressive advertising and anticompetitive practices which would induce market distortions.

(9) (a). large foreign firm with deep pockets may undercut a competitive local industry because of various advantages (such as in technology. possessed by it and may even drive out domestic firms from the industry resulting in serious problems of displacement of labour. The foreign firms may also exercise a high degree of market power and exist as monopolists with all the accompanying disadvantages of monopoly. The high growth of wages in foreign corporations can influence a similar escalation in the domestic corporations which are not able to cover this increase with growth of productivity. The result is decreasing competitiveness of domestic companies which might prove detrimental to the long-term interests of industrial development of the host country.

(b) FDI usually involves domestic companies ‘off –shoring’, or shifting jobs and operations abroad in pursuit of lower operating costs and consequent higher profits. This has deleterious effects on employment potential of home country.

(c) The continuance of lower labour or environmental standards in host countries is highly appreciated by the profit seeking foreign enterprises. This is of great concern because efforts to converge such standards often fail to receive support from interested parties.

(d) At times, there is potential national security considerations involved when foreign firms function in the territory of the host country, especially when acute hostilities prevail.

(e) FDI may have adverse impact on the host country's commodity terms of trade (defined as the price of a country's exports divided by the price of its imports). This could occur if the investments go into production of export-oriented goods and the country is a large country in the sale of its exports. Thus, increased exports drive down the price of exports relative to the price of imports.

Negative Aspects of Foreign Direct Investment (FDI)

Foreign Direct Investment (FDI) is often criticized for various reasons, including the exploitation of natural resources and potential environmental harm. Here are some of the key concerns associated with FDI:

1. Exploitation of Natural Resources and Environmental Damage: Many believe that FDI leads to the ruthless exploitation of a country’s natural resources, which can result in significant environmental damage. Multinational companies may prioritize profit over environmental sustainability, leading to degradation of land, water, and air quality.

2. Emergence of a Dual Economy: With substantial FDI in developing countries, there is a risk of creating a dual economy where the foreign sector becomes highly developed while the domestic sector remains underdeveloped. This disparity can lead to economic imbalances and social tensions.

3. Loss of Sovereignty: One of the most concerning aspects of FDI is the potential loss of control by the host country over its domestic policies. Large foreign investment sectors can exert excessive power, influencing policymaking and undermining the sovereignty of less developed host countries. Multinational firms are often accused of corrupt practices, undue influence on policy decisions, and evasion of corporate social responsibility.

4. Corruption and Undue Influence: Multinational corporations involved in FDI are sometimes criticized for engaging in corrupt practices and unduly influencing local policymakers. This can lead to a lack of accountability and transparency in governance, further compromising the host country’s interests.

5. Corporate Social Responsibility (CSR) Issues: Many foreign firms are also accused of evading their corporate social responsibility obligations. This includes failing to adhere to ethical standards, labor laws, and environmental regulations, which can have detrimental effects on the host country’s social and environmental fabric.

6. Balancing Benefits and Costs: It is challenging to make a general assessment about whether the benefits of FDI outweigh the costs. Each country’s situation and each firm’s investment should be evaluated based on various considerations. The desirability of an investment depends on the specific circumstances and potential impacts involved.

Safeguards and Performance Requirements: To improve the ratio of benefits to costs associated with foreign capital, both developed and developing countries implement various safeguards and performance requirements. Some examples include:

• Domestic content requirements on inputs
• Reservation of certain key sectors for domestic firms
• Minimum percentage of local employees
• Ceilings on repatriation of profits
• Local sourcing requirements
• Stipulations for full or partial export of output to earn foreign exchange

Foreign Direct Investment in India

• Foreign Direct Investment (FDI) plays a crucial role in driving economic growth and serves as a vital non-debt financial resource for India's development. Foreign companies are attracted to invest in India due to various advantages such as tax incentives and lower labor costs. These investments contribute to technological advancement, job creation, and other benefits for the country. The influx of FDI into India is facilitated by the government's supportive policy framework, a dynamic business environment, and the country's increasing global competitiveness and economic stature.
• Recently, the Indian government has taken significant steps to relax FDI regulations across various sectors, including public sector undertakings (PSUs), oil refineries, telecommunications, and defense. As a result, FDI inflows into India reached record levels during the financial year 2020-21, with a total of US$ 81,973 million, marking a 10% increase from the previous year.
• According to the World Investment Report 2022, India improved its position among global FDI recipients, ranking eighth in 2020, up from ninth in 2019. The information technology, telecommunications, and automobile sectors were the primary recipients of FDI in FY22. Additionally, multinational companies (MNCs) have been pursuing strategic collaborations with leading domestic business groups, leading to a significant increase in cross-border mergers and acquisitions (M&A) by 83% to US$ 27 billion, particularly in the technology and health sectors.

Overseas Direct Investment by Indian Companies

Overview: India is mainly driven by domestic demand, with consumption and investment making up 70% of its economic activity. As the economy improves and recovers from the Covid-19 pandemic, India is in a relatively better position compared to the rest of the world. Despite facing significant challenges, the Indian economy remains strong due to effective policy measures. This situation allows Indian businesses to invest abroad and expand their operations in other countries.

Knowledge Spillover and Mutual Benefit:

• Investing abroad not only helps Indian companies but also brings new innovations to India through knowledge spillover. This process benefits both India and the countries where investments are made, contributing to mutual growth.

Recent Overseas Investments by Indian Companies:

• Tata Steel: In June 2022, Tata Steel announced an investment of 7 million pounds (approximately US$ 837.95 billion) for its Hartlepool Tube Mill in North-East England.
• Tata Communications: Invested US$ 690 million in its wholly-owned subsidiary in Singapore.
• Jindal Steel and Power: Invested US$ 366 million in its wholly-owned subsidiary in Mauritius.
• Wipro: Invested US$ 204.96 million in its wholly-owned subsidiary in Cyprus.
• Jindal Saw: Invested US$ 64.5 million in its wholly-owned subsidiary in the United Arab Emirates.
• Restaurant Brand Asia and Lupin Ltd: Invested US$ 141.34 million and US$ 131.25 million in their joint ventures in Indonesia and the US, respectively.
• Reliance New Energy: Invested US$ 87.73 million in its wholly-owned subsidiary in Norway.
• Mohalla Internet Pvt. Ltd.: Invested US$ 86 million in its fully owned unit in Mauritius.
• ONGC Videsh: Invested US$ 83.31 million in a joint venture in Russia.
• ICICI Bank: Formed a partnership with Santander in Britain to facilitate banking services for corporates operating in both countries.
• ANI Technologies: The promoter of OLA invested US$ 675 million in its wholly-owned subsidiary in Singapore.
• Dr. Reddy's Laboratories: Invested US$ 149.99 million in a joint venture in the US.
• Reliance New Energy: Invested a total of US$ 168.9 million in a joint venture and wholly-owned subsidiary in Germany and Norway.

Gail India, a public sector undertaking in the energy sector, made an investment of US$ 70.17 million in a joint venture and a wholly-owned unit located in Myanmar and the United States.

Oil and Natural Gas Corporation (ONGC) invested US$ 74.15 million in various countries across five different ventures.

Reliance Brands Ltd. entered into a distribution agreement with Maison Valentino, an Italian luxury fashion house, to open its first boutique in Delhi, followed by a flagship store in Mumbai.

Reliance Retail Limited formed a long-term partnership with Gap Inc. to introduce the American fashion brand, Gap, in India.

Tata Steel signed a Memorandum of Understanding (MoU) with BHP to jointly explore low-carbon iron and steelmaking technology.

Ola Electric announced plans to establish Ola Futurefoundry, a global hub for advanced engineering and vehicle design in the UK, with an investment of US$ 100 million over five years.

Essar Group of India created a joint venture with Progressive Energy of the UK to invest US$ 1.34 billion in a hydrogen manufacturing plant at the Essar Stanlow refinery complex.

Hindalco Ltd’s US subsidiary, Novelis, plans to invest US$ 365 million in a state-of-the-art vehicle recycling facility in North America.