Definition and FDI trends
Introduction – Definition, and FDI trends
FDI, which is short for foreign direct investment, is defined as “investment made to acquire lasting interest in enterprises operating outside of the economy of the investor.” (UNCTAD, 2007) The relationship of FDI includes a parent enterprise and a foreign affiliate which together form a Multinational enterprise (MNE).
An emerging market can be defined as “a country in which its national economy grows rapidly, its industry is structurally changing, its market is promising but volatile, its regulatory framework favors economic liberalization and the adoption of a free-market system, and its government is reducing bureaucratic and administrative control over business activities.” (Luo, 2002)
Sumner (2008) points out that FDI to and from developing countries is increasing rapidly. In 2005 inward FDI to developing countries grew to US$335 billion, which is over one-third of global FDI inï¬‚ows. In those countries, China was the number one destination, even Africa received FDI inï¬‚ows of $31 billion in 2005.
It is explained (Jinjarak, 2007) that for developing countries, large consumer potentials, abundant and unexploited natural resources, and low labour costs are all reasons for FDI.
However, it is argued (UNCTAD, 2007) that emerging markets are outperformed by developed nations while the disparities among countries are stark. Most of the emerging markets that do relatively well are those dominate in natural resource producers or small tourism island. The bar chart below shows the average FDI inflows per capita in terms of US dollar, by region, from 2001 to 2005, in emerging markets:
Pie chart derived from (UNCTAD, 2004, in UNCTAD, 2007)
It can be seen that sub-Saharan Africa was the worst in terms of the average FDI inflows per capita and the economies in transition were the best, while Latin America and the Caribbean were not too far behind. The region of Developing Asia and Pacific was just two times as successful as sub-Saharan Africa.
Although nearly all emerging markets have more or less liberalized their FDI regimes and improved their regulatory frameworks for such investment, this process still has a long way to go as there are still many obstacles for foreign firms to operate freely in the emerging markets.
ï‚² Main body – Risk examination and recommendations
On general, the main risks associated with FDI in emerging markets are in the form of political and economic risks. Below is a list of the main risks/barriers:
– Political instability and restrictive regulations
– State intervention and non-transparency
– Lack of intellectual property protection
– Lack of quality management and skills
– Non-tariff barriers in many regions
(Gangopadhyay & Chatterji, 2005)
Political instability can be seen in the form of changing laws and regulations. Take Russia for example, MNEs are confronted with a complex and frequently changing taxation system. It is considered (Luo, 2002) that Russia has too many taxes from both the federal and regional governments, and they are often collected in short intervals. Moreover, tax laws and types of taxes tend to be modified frequently by authorities according to their budget situation. Financial constrains can also have sudden changes in the original agreements.
Moreover, the lack of experience in administrating emerging problems or experiment-type practices allowed the government pose new regulations and laws that are ambiguous and opaque (Sumner, 2008). Furthermore, the opaque rules enable the government to explain and interpret these ambiguous regulations, which in term offer them opportunities to intervene in FDI businesses. As a result, regulatory policies are particularly covert and lack of transparency to foreign firms. Take China for example, covert regulations in the Price Law are largely as a result of distorted pricing activities done by the Chinese domestic companies. Those activities are in the form of price collusion, dumping, spreading rumors of price hikes, decptive pricing strategy, manipulating prices by incorrectly categorizing commodities, illegal profiteering, as well as discriminating against some business operation in order to gain covert advantage over MNEs.
Moreover, in Russia, the legal system is also non transparent and confusing (Luo, 2002). It is often complained by the MNEs that FDI is governed by an array of rules and regulations that overlap and leave chance for divergent interpretation. Furthermore, as legislation is passed both by national and regional authorities, the regulations become more confusing. It is also complained by the foreign investors about not receiving information on legal changes concerning their rights and responsibilities in time. Part of the reasons may be that there are very few governmental authorities which are able to provide accurate and complete information on Russia’s prevailing policies and FDI treatments. MNEs in Russia are often not confident over the reliability and sustainability of FDI policies.
In terms of government restrictions, there are four points that can be taken into account. (Luo, 2002). Firstly, content localization, which means that a foreign company is required to purchase and use local materials, parts, semi-products or other supplies make by local firms in order to produce its final products. The required level of local contents varies from industries, with those involving more value-added processing or production having to face a higher local contents requirement. For example, in China, the State Council’s Automobile Industry Policy states that foreign automobile firms have to apply 40 percent local content when they start the production and after three years of operation the figure increases to 60 percent. Chile is another example. The government in Chile provides different treatments to foreign companies contingent on the use of local content. While non-discriminatory treatment is written in the law, there are still a number of special restrictions against foreign companies existing in many sectors. For example, in activities such as the merchant marines and the mass media, it is still required by the government that the presidents, managers, and the majority of directors or administrators must hold the Chilean citizenship. It also required that at least 85% of a company’s personnel must be Chilean.
The second is marketing or geographical restrictions. These restrictions forbid some certain marketing approaches, e.g., direct sales. Take China for example, MNEs in retailing and banking industries are subject to geographical restrictions. They are only allowed to provided services in the city they are located.
The third restriction is in the financing sector. In China, bank loans in both foreign exchange and Chinese yuan are highly regulated by the government. They keep a wary eye on MNE local financing when the MNEs are increasing rely on local financial resources to reduce foreign exchange risks. There are a number of rules and regulations enacted on mortgage loans, loan guarantees, loan priorities and restrictions, financing criteria and procedures and the ration of loans of Financial Affairs of Foreign-Invested Enterprises.
The fourth restriction is on unionization and labor administration. For example, China has struggled to obviate FDI entry barrier to meet the requirement of WTO membership. As a result, the government reduced many overt barriers during the entry process and enacted more covert restrictions instead.
In Brazil, FDI involving licensing and franchising and technology transfer must be registered with the National Institute of Industrial Property as well as the Department of Foreign Capital. Moreover, priority is often given to local suppliers although the law forbids the granting of preferences or differential treatment between Brazilian and foreign companies.