Factors Influencing Foreign Direct Environment

Factors Influencing Foreign Direct Investment The world is becoming a global village and more companies are now operating at an international level. This essay critically analyses some of the factors which influence Foreign Direct Investment (FDI). Morrison (2006) defined FDI as the establishment of a company of a productive nature in a foreign country involving large volume of shareholding in foreign operations.

The essay will investigate how important FDI is in the process of globalisation and in the activities of multinational enterprises as well as examining how international trade and FDI are interlinked. There will also be a discussion of different reasons why companies decide to go international as this will highlight some of the factors which influence FDI, the benefits of FDI to both the host and home countries will be taken into account. In addition, the essay will look at different types of FDI and how these differ from each other as well as identifying strategies underlying each of these FDIs.

Issues which can have a negative impact on the company’s decision to go overseas will be critically investigated and identify why other organisations do well while others are failing after making the decision of going overseas. Furthermore, the essay will also look at the factors which should be considered by an organisation prior to making a decision of investing overseas. The essay will also discuss Political, Economical, Social and Technological (PEST) factors which can either have positive or negative impact on the company’s decision to go international.

There are so many benefits and risks associated with FDI. There will be an examination of the benefits as to whether both the international company and the host country benefit from the investment as well as analysing whether both foreign and domestic countries equally enjoy the benefits of FDI. According to Chryssocoidis et al (1997) there are five different types of foreign direct investment. The first one is taken in order to gain specific factors of production which include technical knowledge, resources, materials and brand names if these are not available in the home country or are not easily accessed.

The second type is whereby a company invest in a foreign country in order to gain access to cheaper factors of production, for example access to cheap labour. This form of FDI was developed by Raymond Vernon (1966) in his product life cycle hypothesis. He stated that governments of host countries may encourage this type of FDI in an effort to pursue an export orientated strategy development. As such, the governments of the host countries may encourage foreign investors through offering investment incentives such as grants and tax concessions.

The third form of FDI is about international competitors undertaking mutual investments in one another so as to acquire access to each other’s product ranges (Chryssochoidis et al, 1997). This resulted from increased competition among similar products and both companies find it difficult to compete in each other’s home market leading to the companies investing in each other’s area of knowledge thereby promoting each other’s sub-product specialisation in production (Chryssochoidis et al 1997). In addition, the fourth form of FDI is market seeking and it is about accessing customers in the host country.

Finally, the fifth type of FDI occurs when there is a location advantage for the foreign company in their home country but the existence of tariffs and other barriers prevent the company from exporting to the host country leading them to overcome these barriers through establishing a local presence in the host country (Chryssochoidis et al 1997). FDI plays an important role in global business; it provides companies with access to new technology, new marketing channels, cheaper production facilities and new skills (Spaulding and Graham, 2004).

For the host country, it can be a source of capital, organisational technology and management skills which in turn can bring economic development as an incentive (Spaulding and Graham, 2004). FDI has broadened its meaning into the acquisition of a lasting management interest in a firm outside the investing enterprise’s home country. For the reason above, it comes in different forms which include direct acquisition of foreign companies, construction of a factory in a foreign country and investment in joint ventures.

Britton and Worthington (2009) described FDI as an important aspect of globalisation as well as the activities of multinational companies. Over the recent years, FDI has responded to new information technology systems, the reduction in global communication costs and the liberalisation of the national regulatory framework which controls investment in enterprises, (easing of restrictions and on foreign investments and acquisition in many nations) have simplified the management of foreign investments as compared to the past ( Spaulding and Graham, 2004). These are some of the factors which fuelled FDI’s expanded role in today’s global business.

According to the UNCTAD (2004) foreign direct investment flow in developing countries has exploded through mergers and acquisition and internationalisation of production in a range of industries. FDI in developed countries rose from $481 billion in 1998 to $636 billion in 2004 (UNCTAD, 2004). Advocates of FDI suggest that the exchange of investment flows benefits both the home country and the host country, however some critics noted that multinational conglomerates are able to exploit smaller and weaker economies as well as driving out a lot of local competition.

It is true to believe that multinational conglomerates can have power over weaker economies through the exploitation of economies of scale, however, according to the United Nations report (2011) developing countries outperformed developed countries in terms of 2010 FDI attraction (UN, 2011). Small and medium sized companies always get an opportunity to become more actively involved in international business activities through FDI.

However, over half of direct foreign investment is still being made in the form of fixtures, buildings, machinery and equipment and larger multinational corporations and conglomerates still make the bigger percentage of FDI. Nevertheless, the increasingly role of the internet, the loosening of foreign direct investment restrictions and the decrease in communication costs will keep opening doors for small and medium sized companies. In developed countries; governments pay close attention to foreign direct investment because the inflow and outflow of investments can have a significant impact to their economies.

For example, the USA Department of commerce have a Bureau of Economic Analysis which is responsible for collecting information about FDI flows in order to determine the impact of such investment on the overall economy of the country. Apart from benefits derived from FDI, there are always risks associated with companies wishing to expand their operations to an international level. A company wishing to do business overseas should undergo some kind of research about the country they wish to do business in. According to (Palmer, 2000), foreign markets resent very different opportunities and threats which then company is not used to in its domestic operations.

There is a question why some companies do well while others fail when they go international. The answer could be that some companies can be easily attracted by the favourable economy of a host country without considering other factors. It is important for firms wishing to operate at an international level to gather as much information as possible about the country they are wishing to invest in.

Finding information about the political climate of a country which the foreign company wish to invest is very important prior to decision making of internationalisation. Therefore it is of paramount importance for companies wishing to go abroad to carefully study the structure of the government of that particular country so as to analyse its political environment (Keegan and Schelgemilch, 2001). Assessing the political stability of a foreign country enables the company to analyse the sovereignty of that country, threats to equity dilution and taxes.

These issues can have a negative impact on foreign companies. For example, what happened in Zimbabwe in 2010 when the president of the country threatens to seize foreign companies (BBC News, 2010). Another factor is to look at the economical environment of the targeted country. This enables the company to understand the foreign market size and potential. Information about the targeted country’s unemployment rate and consumption patterns will give the international marketer an understanding of how the market is developing in the long run (Brassington and Pettit, 2006).

There is also a need to know the stability of exchange rate, inflation and any exchange control systems. The importance of understanding the exchange control system is because if the government of the host country tightly controls their access to hard currency, this can be a problem to an importer especially when the exporter wants to be paid in hard currencies (Brassington and Pettit, 2006). In addition the international investor need information about the taxes, duties and import tariffs.

For example, UK has a highly developed economy, favourable investment climate and adequate transport infrastructure (Datamonitor, 2009), however the country is currently facing challenges of sluggish economy growth and budget deficit. This information will help the organisation to make a decision to go international and enable them to judge whether the investment is worthwhile. In addition, a company can also use social factors of the targeted country in order to understand the culture of that particular country.

According to Brassington and Pettit, (2006) special attention should be paid to socio-cultural factors. Social cultural factors include cultural difference which involves language, social structures, and religion and gender roles. These factors affect the way negotiations and transactions of the business are carried out and the way products are marketed. The differences in culture between countries have led to the failure of many international businesses (Ricks, 1993). Finally, the company need to know about the technological factors which can affect their business in a foreign land.

In other words, it is no viable to sell a product in a country where people in that country have little or no technological know-how of how the product is used. For example, an automobile company is more likely to be successful in a country where there are many automotive engineers as compared to a country with less or no access to technology. There are however, some risks associated with internationalization. Hollensen (2004) has divided these risks into three different groups which are general market risks, commercial risks and political risks.

General risks include competition from other foreign markets, language and cultural differences and differences in product specifications in foreign markets (Hollensberg, 2004). In addition there are also commercial risks which are exchange rate fluctuations when contract is made in foreign currency, difficulties in obtaining export financing and damage in the export shipment and distribution process.

Financial markets also present particular risks, as for example the 2007/08 financial instability (or ‘credit crunch’) following banking losses US sub- prime mortgage market. Political risks usually result from the intervention of the home or host country governments and these may include civil unrest, wars, terrorism, changes in government policy or law and complexity of trade documentation. The risks of internationalisation vary with the type and size of the business and some types of businesses increases the probability of these risks. It is also possible for an economy to pose high risk to investment but could have high returns prospects depending on the nature of the business.

For example, research about Foreign Direct Investment (FDI) risk in Libya suggested that high risk could lead to high gain if opportunities are pursued in Libya’s tourism, infrastructure and oil sectors (Sajjad, 2011) If a company successfully internationalise, it increases its performance, reinforce its growth and enhance competitiveness and this will support long term sustainability of the company (Nebusiness, 2010). There is also a chance of benefiting from government incentives in an effort to encourage inward investment. An international company can also cut fixed costs through achieving economies of scale.

Apart from PESTEL analysis, there are also some basic requirements for companies considering a foreign investment. This entirely depends on the size and nature of the business and the industry sector. There is a rapid globalisation and vertical integration of many industries and a firm planning to internationalise should be aware of the international trends in their industry (Spaulding and Graham, 2004). It is also important to note whether the firm’s competitors are internationalising and how these competitors are going about it and also to understand how globalisation is affecting its domestic customers.

It makes business sense to follow the expansion of key clients overseas in order to maintain an active business relationship. In addition, another reason to invest in a foreign country is to access new markets and any decision to do so should include key factors such as competitiveness, market analysis, assessment of internal resources and market expectations. It is important to know whether the firm have senior management support, the internal management support, and systems capabilities to support the foreign investment as well as continuous management of foreign subsidiaries (Spaulding and Graham, 2004).

The company should conduct an extensive market research in terms of the product or service, the industry they will be operating and local regulations governing FDI which will set the parameters for any investment decisions. In addition, there should be a realistic assessment of what resource utilisation the investment will entail. It is also important to understand the information on local industry and foreign investment regulations such as incentives, financing, distribution and profit retention. This will enable the firm to determine the most viable method of entering the foreign market: i. . ,

Greenfield, acquisitions joint ventures or mergers (Jonson et al, 2011). Some companies fail when they go international because they fail to draw reasonable expansion plan through a local vehicle. For example, if the foreign economy is characterised by government regulations, failure to contact the relevant government agencies and factor political risks and foreign exchange risks will lead to company failure in its foreign operations. As mentioned above, there is a question as to whether both the domestic and foreign countries benefit from FDI?

It is true that FDI brings a lot of benefits to both the domestic and the host countries. The benefits include helping with economic growth of the host country, improvement of trade, employment opportunities, transfer of knowledge and technology (Brooks et al, 2011). According to Luo and Shenkar (2004), many researchers have proven that developing countries usually benefit less from FDI flows as compared to developed countries. However, Lewis (2000) noted that investors seek countries that have been recently successful economically with the hope that the trend will go on in the long run.

He added that the current state of economy and the past economic stability plays an important role in the attraction of FDI. Multi-national companies MNC will have more confidence that a nation that have done well in the past is more likely to do well in future (Lewis, 2000). Generally, lesser developed nations have unstable economy and politics which is not obviously an attractive factor to foreign investors. In addition Lewis (2000) noted that human resources of a developing country are usually an important factor when attracting FDI because MNCs usually utilise labour in the host country.

Therefore MNCs are usually attracted to a nation with educated people to harbour its investment. This is not usually the case with less developed countries because governments of lesser developed countries always find it difficult to put in place continuous and supportive education systems for the benefit of their nations, thus the more educated the nation is the more it is likely to attract FDI. (Lewis, 2000). It is therefore reasonable to believe that developed countries are in a better position to attract more FDI than lesser developed countries since develop countries have stronger economies and education systems in place.

However, because developing countries have got limited resources, it is important that they know and prioritise factors which are more important than others in order to attract FDI. In summary, the essay has highlighted why FDI is an important aspect in the processes of globalisation and explained how international trade and FDI are interlinked because the need to invest overseas is an alternative way of internationalisation. The essay has also discussed the reasons why organisations export and do business overseas.

An overview of the reasons for internationalise is; the need to follow international steps, to fight aggressive competitors, choosing international market because of saturated domestic market, the need to operate in a more favourable environment particularly political and economical factors and the chance to achieve economies of scale. These reasons are not exhaustive and do vary from company to company. The essay have also covered key issues behind the decision making process of going international and discussed some of the information needed by an international company prior to making the decision to invest in a targeted country.

Attention has also been paid to the risks of internationalisation such as political risks, general market risks and commercial risks. Questions such as whether both the host and domestic companies benefit from FDI have been addressed. Finally, the benefits of internationalisation have been highlighted, it is clear that companies may go international for one reason but will have more than one incentive.