Here is an essay on ‘Foreign Direct Investment’ for class 11 and 12. Find paragraphs, long and short essays on ‘Foreign Direct Investment’ especially written for school and college students.
Essay on FDI
Essay # 1. Introduction to Foreign Direct Investment:
FDI is inherently long-term in nature and gives the investor ‘control’ or ‘influence of the management’ of an overseas enterprise. The IMF defines control as the ‘holding of more than 50% of the voting power’ and significant degree of influence as a ‘holding of more than 10% and up to 50% of the voting power.’ The parent company is willing to invest time and resources (both financial and managerial) to ensure that the foreign enterprise is financially successful and maximizes the wealth of the parent company.
The outbound FDI flows from emerging markets especially BRIC countries, increased in the first decade of this century. According to RBI data, between April and December 2009, 2,984 outbound FDI proposals worth $14.3 billion were approved in India, more than 70% of which was for investment in British Virgin Islands, Mauritius, Netherlands Singapore and the USA. The definition of what constitutes FDI varies from country to country and this affects the comparability of FDI statistics.
Cross-border movements of capital create capital flows. A significant feature during 1985 to 2010 was net capital inflows or outflows into a country or several countries in a region (such as emerging market economies). Since huge capital inflows and outflows have a deleterious impact on capital markets, the foreign exchange market, investor confidence and economic performance. Countries impose restrictions on the free flow of capital, to limit its volatility. Capital outflows from a country with large and persistent current account deficit tend to exacerbate its ability to meet its external debt commitments.
Economists argue in favour of controls on capital flows. Keynes was convinced that regulation was essential, and policymakers consider several options to prevent a sudden appreciation of the real exchange rate. In 1978, economist James Tobin advocated the imposition of a tax to discourage short term capital flows. The Tobin tax has since been implemented by several countries (such as Brazil). A country in an economic crisis often imposes capital controls.
These can take the following forms:
1. Preventing residents of a country from holding their savings overseas
2. Restrictions on portfolio investment outflows
3. Prevention or restrictions of residents from buying assets overseas
4. Requiring importers to approach the central bank for foreign exchange payments
5. Surrender of foreign exchange entering the country to the central bank
6. Preventing companies from raising money through equity issues overseas
7. Restriction on foreign corporate ownership in domestic firms (FDI ceilings)
8. Foreign investment limits in domestic equity and debt markets.
The effectiveness of controls can decline over time, if they outlive their purpose, or deteriorate into bureaucratic red tapism. Since controls segregate an economy from the rest of the world, they have costs. The cost of equity is higher in a country with capital controls, because companies cannot diversify country risk. Segregation increases the cost of debt in a country with capital controls, as compared to a country without controls.
Essay # 2. Trends in Cross-Border Capital Flows:
Cross-border capital flows mirror the evolution of the international financial system. Broadly speaking, capital flows were between developed countries (North-North capital flows, so termed because of movements of capital in the northern hemisphere). During the nineteenth century, long-term capital flowed from Europe to the rest of the world.
Between 1914 and 1944, governments in developed countries struggled to keep their exchange rates stable, as the gold standard and its variants—gold bullion standard, gold exchange standard, and the Bretton Woods system, succeeded one another. Free flow of capital was restricted as governments in the UK, Germany, France, and USA funded war efforts (World Wars I and II) and dealt with Balance of Trade deficits.
The post-colonial, post-World War II era was marked by trade liberalization and strong economic growth in developed countries. Some restrictions on capital flows continued. The USA saw a shift of dollar deposits from home to other countries leading to the birth of the Eurodollar market. The floating exchange rate system which was followed by developed countries since March 1973 was formally and retrospectively ratified by IMF countries in 1976. Asian countries began altering policies to attract and favour FDI. Malaysia’s New Economic Policy in 1969 favoured foreign firms, so as to curb the power of ethnic Chinese-owned firms.
In 1973 and 1979, oil-exporting countries raised oil prices and the ‘oil shocks’ raised inflation rates in oil-importing countries, increased their import bills, and increased exchange rate fluctuations. Developed countries that imported oil began experiencing current account deficits, and a decline in opportunities for growth. Oil-exporting countries faced copious foreign exchange inflows. They placed their oil revenues as deposits in international banks, which in turn began lending these deposits for short periods, to developing economies.
Such short-term lending was used to finance consumption rather than investment. Middle-income developing countries financed their oil imports through loans from private commercial banks. Many banks from OECD countries used their petrodollar deposits to make medium- to long-term loans to developing countries. In the mid-1970s, such debt inflows fuelled growth. But as borrowed money flowed into developing economies in Latin America, their currencies appreciated making their commodity exports uncompetitive.
By 1979, the private debt of developing countries was $248 billion, much of it short term. Several Latin American countries began relying heavily on these overseas short-term loans. Simultaneously, aid from multilateral agencies into developing countries increased, as MIGA, IDA, IMF, IFC and IBRD stepped up their loan volumes. As the levels of external indebtedness rose, it resulted in debt crises, when countries were unable to repay loans. This affected cross-border capital inflows into indebted countries, many of which slipped into recession.
But international commercial banks continued to lend to the heavily indebted countries as part of the debt rescheduling agreements. Some countries such as Mexico and Chile chose debt-equity swaps to reduce their external debt, but this merely converted external debt into FDI. Mexico was the first country in 1989 to exchange its old external loans for bonds at a market rate of interest. These were called Brady bonds, after the US Treasury Secretary Nicholas Brady.
In the 1990s, cross-border capital flows picked up volume, and flowed from developed countries to Asian ‘tigers’—the rapidly growing economies of Indonesia, Thailand, Philippines, and South Korea (as external commercial borrowing), to Mexico and Russia (through dollar-denominated government debt securities). Governments, commercial banks and private sector companies in these countries indulged in unbridled overseas borrowing, to finance consumption, exports and expansion. While borrowers accepted dollar-denominated debt, their revenues were in local currencies.
There was a currency mismatch. Borrowings were often short term and were invested in areas that were highly vulnerable to international price fluctuations (such as electronic goods exports from Thailand), and in illiquid assets (such as real estate) that could not be easily converted into cash when the loans had to be repaid. This resulted in a maturity mismatch. Cross-border flows were sharply affected after the Mexican crises (1994), the Asian crisis (1997) and the Russian crisis (1998), falling to one-third of the pre-crisis levels. Post-crisis analyses found fault with the weak and poorly regulated financial systems in Asia, Mexico and Russia.
In the first decade of the twenty-first century, the USA—the world’s largest economy — experienced a ‘dotcom’ bust, and a sustained rise in housing prices. Simultaneously, equity markets in developed countries became deeper and wider. Domestic debt markets were either started from scratch, or became deeper and wider. Derivatives market volumes showed a steep increase. Financial market integration increased.
Between 2004 and 2007, average GDP growth rates in emerging market were much higher (7.9%) than those in developed countries (2.9%). Brazil, China and India experienced sustained high growth rates. Savings rates in emerging market increased while those in western countries declined. Asia became the provider of savings to the rest of the world. Much of this was invested in the financial markets of USA and UK. Emerging market economies (EMEs) began holding increasing amounts of assets in western countries and in other emerging market economies, as they channelled excess savings overseas. Total foreign holdings of major EMEs in 2006 was $8.4 trillion, compared to $3.2 trillion in 2001.
A significant portion of this was financed by accumulated foreign exchange reserves. International debt issues by governments in developing countries crosses $450 billion by 2008, and gross private portfolio inflows into EMEs were $125 billion in 2006. The financial markets of four emerging market countries—China, Mexico, Russia, and Thailand—had huge cross-border initial public offerings of $1 billion in 2006 alone. Chinese companies alone raised $169 billion through equity between 2000 and 2006. Similarly, extremely low FPI outflows from emerging market economies in the 1980s and 1990s gave way to a steep increase after 2000, as Asian countries (especially China) began acquiring overseas debt—gross FPI outflows from EMEs were $264 billion in 2006.
Essay # 3. Composition of Cross-Border Capital Flows in Emerging Markets:
Cross-border capital flows in the nineteenth century were long term in nature and financed capital formation through investment expenditure. In the latter half of the twentieth century, cross-border portfolio flows gained in volumes. By the 1990s, cross-border capital flows into emerging markets were short term in nature and were financing consumption. The fundamental difference between capital inflows through FDI and FPI into EMEs in the 1990s and 2000-2007 was that the latter occurred when EMEs were running current account surpluses. FDI flows into EMEs, estimated at $50 billion in the 1980s, increased markedly thereafter due to strong growth rates in EMEs and privatization initiatives, to $350 billion in 2006.
Impact of Free Cross-Border Capital Flows:
Neoclassical economists argued that free flow of capital (known as capital account openness) occurs due to differences in return between countries. The return on capital in developing countries is much higher than that in developed ones. So, capital flows from the latter to the former. This capital finances investment. Free flow of capital between countries enhances the efficiency of resource allocation, and improves economic growth.
But research does not provide unequivocal evidence to support this position. The Report of the Working Group of the Committee on the Global Financial System (2009) examined the effect of free flow of capital on economic growth in emerging market economies during 2000-2007. It observed that links between capital flows and growth are very complex. Though they offer benefits for the recipient and capital exporting nations, they carry substantial risks in terms of exchange rate volatility and stock market volatility.