Factors influencing Foreign Direct Investment
Factors influencing Foreign Direct Investment in a Country
Foreign Direct Investors look into various factors before making investment decision in a country. After 1990, in India, the government adopted a New Economic Policy which promoted the policy of LPG (Liberalization, Privatization and Globalization). This has resulted in promoting more foreign direct investment into the country.
Factors influencing Foreign Direct Investment in a Country
The following are the various factors an FDI look for before investment:
Investment decision of FDI(Image: Investment decisions of FDI)
1. Stability of the Government:
A stable Government is an essential prerequisite for any investment. The investor will always look for a government which is supporting investment and which will not take any steps that are anti-investment. The investor should not have any fear of take over by the government. This will enable him to go for expansion.
2. Flexibility in the Government Policy:
Certain investments were not allowed in the hands of FDI but such a rigid policy will not help in the growth of industries. With WTO regulation, government has to adopt flexible policies, permitting FDIs in all areas including those in which they were prevented previously. For example, in India, power generation was not permitted to private sector. Now, in Maharashtra, Dabhol Power Company is allowed to do so.
3. Pro-active measures of the Government to promote investment (infrastructure):
The Government should also undertake pro-active measures such as expansion of ports, captive power, development of highways, atomic power etc. These measures will attract more foreign direct investment.
4. Exchange rate stability:
Commercial viability of any FDI is based on exchange rate stability. This means that the value of domestic currency should not drop abnormally by which while repatriating the funds, the foreign investor will lose heavily. Exchange rate should be more or less the same as prevailing at the time of investment.
5. Tar policies and concessions:
Government should adopt uniform tax policies as per international norms. A heavy excise duty or sales tax or customs duty will prevent foreign direct investment. A moderate tax policy should continue so that the FDIs will feel comfortable.
6. Scope of the market:
FDIs must be in a position to exploit the market and expand both in the domestic as well as the foreign markets. This will reduce their cost of production and will give them ample scope for diversification.
7. Other favorable location factors (including logistics and labor):
The productivity of labor in the country should be high. Adequate skilled labor should be available, especially in technical areas. Different transport facilities with a proper coordination between land, rail and air should be available.
8. Return on investment:
One of the major attractions for FDIs is the profit or the return they get for the investment made. Unless the return is substantially higher than what they could have obtained in other countries, they will not venture for investment. The rectum should also be consistent and it should be increasing over a period. These factors are closely looked into while undertaking investment. The financier of the FDIs will also ensure that they get their money back as it is a safe investment.
Thus, return on investment is a major deciding factor for FDls while undertaking investment in foreign countries. They also would like to ensure that the payback period is also less so that the return is ensured within a short period. Weightage is given to each of these factors and decisions are finalized.
Factors that affect foreign direct investment (FDI)
Tejvan Pettinger September 26, 2016 economics
Readers Question: why some countries are more successful in attracting Foreign Direct Investment than others?
Foreign direct investment (FDI) means companies purchase capital and invest in a foreign country. For example, if a US multinational, such as Nike built a factory for making trainers in Pakistan; this would count as foreign direct investment.
Factors affecting foreign direct investment
1. Wage rates
A major incentive for a multinational to invest abroad is to outsource labour intensive production to countries with lower wages. If average wages in the US are $15 an hour, but $1 an hour in the Indian sub-continent, costs can be reduced by outsourcing production. This is why many Western firms have invested in clothing factories in the Indian sub-continent.
However, wage rates alone do not determine FDI, countries with high wage rates can still attract higher tech investment. A firm may be reluctant to invest in Sub-Saharan Africa because low wages are outweighed by other costs.
2. Labour skills
Some industries require higher skilled labour, for example pharmaceuticals and electronics. Therefore, multinationals will invest in those countries with a combination of low wages, but high labour productivity and skills. For example, India has attracted much investment in call centres, because a high percentage of the population speak English, but wages are low. This makes it an attractive place for outsourcing and therefore attracts investment.
3. Tax rates
Big multinationals, such as Apple, Google and Microsoft have sought to invest in countries with lower corporation tax rates. For example, Ireland has been successful in attracting investment from Google and Microsoft. In fact it has been controversial because Google has tried to funnel all profits through Ireland, despite having operations in all European countries.
4. Transport and infrastructure
A key factor in the desirability of investment are the transport costs and levels of infrastructure. A country may have low labour costs, but if there is then high transport costs to get the goods onto the world market, this is a drawback. Countries with access to the sea are at an advantage to landlocked countries, who will have higher costs to ship goods.
5. Size of economy / potential for growth.
Foreign direct investment is often targeted to selling goods directly to the country involved in attracting the investment. Therefore, the size of the population and scope for economic growth will be important for attracting investment. For example, Eastern European countries, with a large population, e.g. Poland offer scope for new markets. This may attract foreign car firms, e.g. Volkswagen, Fiat to invest and build factories in Poland to sell to the growing consumer class. Small countries may be at a disadvantage because it is not worth investing for a small population. China will be a target for foreign investment as the new emerging Chinese middle class could have very strong demand for the goods and services of multinationals.
6. Political stability / property rights
Foreign direct investment has an element of risk. Countries with an uncertain political situation, will be a major disincentive. Also, economic crisis can discourage investment. For example, the recent Russian economic crisis, combined with economic sanctions, will be a major factor to discourage foreign investment. This is one reason why former Communist countries in the East are keen to join the European Union. The EU is seen as a signal of political and economic stability, which encourages foreign investment.
Related to political stability is the level of corruption and trust in institutions, especially judiciary and the extent of law and order.
One reason for foreign investment is the existence of commodities. This has been a major reason for the growth in FDI within Africa – often by Chinese firms looking for a secure supply of commodities.
8. Exchange rate
A weak exchange rate in the host country can attract more FDI because it will be cheaper for the multinational to purchase assets. However, exchange rate volatility could discourage investment.
9. Clustering effects
Foreign firms often are attracted to invest in similar areas to existing FDI. The reason is that they can benefit from external economies of scale – growth of service industries and transport links. Also, there will be greater confidence to invest in areas with a good track record. Therefore, some countries can create a virtuous cycle of attracting investment and then these initial investments attracting more. It is also sometimes known as an agglomeration effect.
10. Access to free trade areas.
A significant factor for firms investing in Europe is access to EU Single market, which is a free trade area, but also has very low non-tariff barriers because of harmonisation of rules, regulations and free movement of people. For example, UK post Brexit, is likely to be less attractive to FDI, if it is outside the Single Market.
There are many different factors that determine foreign direct investment (FDI) and it is hard to isolate individual factors, given there are many different variables. It also depends on the type of industry. For example, with manufacturing FDI, low wage costs tend to be the most important, as they are labour intensive industry. For service sector FDI, macro-economic stability and political openness tend to be more important.
Also, it depends on the source of FDI, American firms may value political openness more than Chinese firms. Or American firms may have a preference for countries where English is spoken more.
UK – Post Brexit
If UK leaves Single market, there will be two factors which make UK less attractive as a place for FDI
Outside Single Market – possibility of tariffs or greater barriers to trade with rest of Europe. Even if tariffs to EU are low (World trade rules) there is a considerable significance of being outside Single Market which may put off firms, who prefer the security of being in a country committed to Single Market
Access to labour. The UK economy has benefited from migrant labour, e.g. construction sector has a high percentage of Eastern European workers. Without free movement of labour, there may be a greater unwillingness to invest in UK.
On the other hand, the UK may seek to attract inward investment, through aggressive cutting of corporation tax
Major Factors Affecting Foreign Direct Investment
Published on September 17, 2015
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Foreign direct investment is one of the most essential tools for growing the economy of a country. There are so many countries that struggle to attract foreign investors because of the important roles that they play in building the economy. Amongst the reasons why foreign direct investment is so important include:
It can provide substitute products and increase supply of top products in a country through imports.
It creates employment for the locals
Enhances development of local infrastructure
It enables locals to access products that are not produced within the country.
There are a number of factors that affect foreign direct investment in different countries. These include:
Government regulations and policies on investment.
Policies that are favorable to both local and foreign investors determine the amount of foreign direct investment that a country receives. A country which puts in place policies that favor the local investors more than the foreign investors can discourage foreign direct investment within its markets. In addition tax regulations can also encourage or discourage foreign investors. Double taxation for instance often reduces the number of foreign investors in a country.
Availability of raw materials and trade facilitation instruments.
Raw materials attract more investors into the country. This is because a country endowed with raw materials helps investors reduce costs of production. This is one of the reasons why many investors have recently flocked in African countries. In addition to raw materials, foreign direct investment is also affected by availability of trade facilitation instruments such as proper infrastructure.
Availability of appropriate human resources.
The human resources in a country can determine whether or not investors flock the country. A country with high numbers of skilled and educated personnel that are readily available will attract companies in need of skilled human resources. Similarly some companies which are more labour intensive will often flood poor countries with high populations because of the vast availability of cheap labor.
Economic growth of a country.
A country that progresses economically tends to attract more foreign direct investment because economic growth boosts investor confidence. Countries with high rates of economic growth also tend to have many consumers who have economic muscle and can thus afford to purchase manufactured goods. The opposite is true for countries undergoing recession which reduces spending amongst consumers.
Political stability and security of a country.
Political stability and security of a country also determine the amount of foreign direct investment that a country attracts. Countries which are politically stable and are renowned for secure systems and environments have more foreign investors. On the other hand, the countries which have insecurity issues and political instability attract fewer investors.
Cost and ease of doing business.
The cost of production is a very important factor in attracting foreign direct investment. The ease of starting and running a business also influences the decisions of foreign investors to venture into specific foreign markets. The Ease of Doing Business Index is normally used to rank the ability of countries to facilitate and expedite opportunities for the investors.
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Factors Influencing Foreign Investment Decisions
Now that you understand the basic economic reasons why companies choose to invest in foreign markets, and what forms that investment may take, it is important to understand the other factors that influence where and why companies decide to invest overseas. These other factors relate not only to the overall economic outlook for a country, but also to economic policy decisions taken by foreign governments—aspects that can be very political and controversial.
The policy frameworks relating to FDI and FPI are relatively similar, although there are a few differences.
Direct investors tend to look at a number of factors relating to how they will be able to operate in a foreign country:
the rules and regulations pertaining to the entry and operations of foreign investors
standards of treatment of foreign affiliates, compared to “nationals” of the host country
the functioning and efficiency of local markets
trade policy and privatization policy
business facilitation measures, such as investment promotion, incentives, improvements in amenities and other measures to reduce the cost of doing business. For example, some countries set up special export processing zones, which may be free of customs or duties, or offer special tax breaks for new investors
restrictions, if any, on bringing home (“re-patriating”) earnings or profits in the form of dividends, royalties, interest or other payments
The determinants of FPI are somewhat more complex, however. Because portfolio investment earnings are more likely to be tied to the broader macroeconomic indicators of a country, such as overall market capitalization of an economy, they can be more sensitive to factors such as:
high national economic growth rates
exchange rate stability
general macroeconomic stability
levels of foreign exchange reserves held by the central bank
general health of the foreign banking system
liquidity of the stock and bond market
In addition to these general economic indicators, portfolio investors also look at the economic policy environment as well, and especially at factors such as:
the ease of repatriating dividends and capital
taxes on capital gains
regulation of the stock and bond markets
the quality of domestic accounting and disclosure systems
the speed and reliability of dispute settlement systems
the degree of protection of investor’s rights
Questions for Discussion:
In what ways do the criteria for investing differ between FDI and FPI? Which countries do you think are more favorable for investment, given these criteria? Do you think these criteria are good indicators for successful investment?
What factors would you evaluate if you were an investor? Pretend you wanted to open a manufacturing plant to boost production of your wildly popular technological gizmo. What sorts of criteria would you evaluate in determining where to invest? Now pretend that you were looking for a short-term bond purchase for your company’s retirement plan. What factors would influence your decision to invest in this case?
Controversies that may arise from host country policy decisions on these aspects of the investment environment will be covered in the following section of this Issue in Depth.