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Types & Factors affecting Foreign Investments

Types & Factors affecting Foreign Investments

With the rapid spread of globalization, the countries are witnessing an increase in financial investments into other nations. Foreign investment is largely seen as a catalyst for economic growth. 

As globalization increases, more and more companies have branches in countries around the world. For some multinational corporations, opening new manufacturing and production plants in a different country is attractive because of the opportunities for cheaper production and labor costs. 

On the other hand, it harms small and domestic businesses because they have insufficient funds to compete against giant corporations. It also encourages steady movement of cash flows within nations.

Foreign investments can be made by individuals, but are most often endeavors pursued by companies and corporations with substantial assets looking to expand their reach.  

Foreign investments are typically defined as either direct or indirect. 

Foreign Direct Investments 

Foreign direct investments are when investors purchase a physical asset such as a plant, factory, or machinery in a foreign country. 

Generally speaking, direct foreign investments are favored by the foreign country over indirect foreign investments because the assets they purchase are considered long-term. Therefore, they help boost the foreign country’s economy over time.

There are two types of foreign direct investment:

1. Horizontal Investment– When an investor establishes a similar type of business in a foreign country or when two companies of the same industry (operating in different countries) merge, it is known as horizontal investment. A company pursues this kind of investment to gain market share and become a global leader.

2. Vertical Investment– It refers to when a company of one country acquires or merges with a firm in another country, irrespective of their business fields. For example, a manufacturing business of one country acquiring the supplier of raw materials for the production of another country. A company indulges in this type of investment to remove the dependency on others and achieve economies of scale. 

Foreign Indirect Investments 

Foreign indirect investments are when investors buy stakes in foreign companies that trade on their respective stock exchanges.

These are typically shorter-term investments that aren’t always used for the growth and development of another country’s economy over time. 

In general, this form of foreign investment is less favorable, as the domestic company can easily sell off their investment very quickly, sometimes within days of the purchase. This type of investment is also sometimes referred to as a foreign portfolio investment (FPI). Indirect investments include not only equity instruments such as stocks, but also debt instruments such as bonds.

Strategy to Acquire

  • Greenfield Investment– In this strategy, the company starts its business operation in another country from scratch. For example, Domino’s and McDonald’s are US-based companies that started their business in India from zero. Currently, they are leading in their segments.
  • Brownfield Investment– In this strategy, the company does not create its business from scratch. Instead, they choose mergers or acquisitions. Recently, another US-based company, Walmart Inc acquired Flipkart, an Indian company, thus acquiring all its assets and liabilities. 

Routes

  • Automatic route: In the automatic course, foreign companies/institutions do not require any approval of the government or any agencies for investing in another country.
  • Approval route:– In the approval route, foreign companies/institutions require approval from the government or any specified body of the country where they want to invest.

A nation’s government decides which business investment can come via the automatic or approval route. Generally, if a country’s government wishes to boost its economy, they allow direct foreign investment funds.

FDI & FII in the Global Economy

According to World Investment Report, 2023, after a strong rebound in 2021, global FDI fell by 12% in 2022 to $1.3 trillion, due mainly to overlapping global crises – the war in Ukraine, high food and energy prices, and soaring public debt. 

The decline was felt mostly in developed economies, where FDI fell by 37% to $378 billion. 

But flows to developing countries grew by 4% – albeit unevenly, with a few large emerging countries attracting most of the investment while flows to the least developed countries declined. 

On a positive note, greenfield investment project announcements were up 15% in 2022, growing in most regions and sectors.  

Industries struggling with supply chain challenges, including electronics, semiconductors, automotive and machinery, saw a surge in projects, while investment in digital economy sectors slowed. 

The developing countries’ need for funds highlighted by the report suggests a gap of about $4 trillion per year – up from $2.5 trillion in 2015 when the SDGs were adopted.    

What stalls Foreign Investments?

Along with international crises or external factors, lacuna in domestic unfavourable conditions analyzed through PESTEL (Political, Economic, Social, Technological, Environmental, Legal) analysis also discourage foreign investments.

Other than above mentioned external and domestic factors, REPUTATION of a country, a non-measurable factor plays a vital role in receiving foreign investments. 

The reputation factor and its impact however, can be judged through the reports of the Global Financial Action Task Force. 

Financial Action Task Force & Foreign Investments 

The Financial Action Task Force (FATF) leads global action to fight money laundering, the financing of terrorism and the proliferation of weapons of mass destruction. Its 38 members, supported by the FATF Secretariat, oversee the evaluation of 205 jurisdictions that have 

committed to implement the FATF standards.

The FATF shares up-to-date information on the latest risks, trends and methods with law enforcement agencies, financial intelligence units and other agencies  globally. 

High-risk jurisdictions and those with strategic deficiencies are systematically and publicly identified by the FATF. This impacts foreign direct investments (FDI) and their international reputation and is effective in securing critical action.

For a country on the blacklist, FATF calls on other countries to apply enhanced due diligence and countermeasures, increasing the cost of doing business with the country and in some cases severing business relations altogether. 

Even countries placed on the gray list could experience a disruption in capital flows. One possible mechanism is de-risking, whereby banks exit relationships with customers that are based in high-risk countries to reduce compliance costs.  

Another is market enforcement, whereby investors use gray-listing as a heuristic for evaluating the risk of doing business with a country, and therefore reallocate resources to reduce their exposure to the country.

FATF Black List Countries are (Democratic People’s Republic of Korea, Iran and Myanmar). 

Grey List Countries are (Barbados, Bulgaria, Burkina Faso, Cameroon, Croatia, Democratic Republic of Congo, Gibraltar, Haiti, Jamaica, Mali, Mozambique, Nigeria, Philippines, Senegal, South Africa, South Sudan, Syria, Tanzania, Türkiye, Uganda, United Arab Emirates, Vietnam and Yemen). 

IMF working paper by Kida & Paetzold (2021) analyzed the impact of gray-listing on capital flows in a sample of 89 emerging and developing countries in 2000–2017. It has used quarterly data on capital flows from the IMF Financial Flows Analytics (FFA) database. The data on gray-listing come from FATF public statements, which are issued three times a year (February, June, and October) and FATF annual reports. During this period, 78 countries have been gray-listed at least once (not all of them remain in the estimation sample due to missing values). 

The paper finds a large, significant negative effect of gray-listing on capital inflows. 

The empirical results suggest that capital inflows decline on average by 7.6% of GDP when the country is gray-listed. 

The results also suggest that FDI inflows decline on average by -3.0% of GDP, portfolio inflows decline on average by -2.9% of GDP, and other investment inflows decline on average by -3.6% of GDP. 

The estimated impacts are all statistically significant. 

Another study showed there is a notable reduction in the ratio of foreign direct investment to GDP (on average, 2% when a country has low FATF scores, and reductions of up to 5% on average if the country is included on the Black List. 

Therefore, it can be inferred that by keeping an eye on FATF reports foreign investors secure their funds ultimately controlling the inflow of investment in a country. 

Vaibhavi Pingale

Ms. Vaibhavi Pingale is a Visiting Faculty of Economics at Gokhale Institute of Politics and Economics, Pune & at Savitribai Phule Pune University. She is pursuing her PhD. She has been actively writing media articles other than academic research.

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