Macroeconomics

Why outward FDI should be encouraged

  • Blog Post Date22 April, 2016
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Natasha Agarwal

Independent Research Economist

agarwana3@googlemail.com

The ‘Make in India’ programme seeks to incentivise global investors to manufacture in India. In this article, Natasha Agarwal, an independent research economist argues that efforts should also be made to support Indian businesses to invest abroad as several direct and indirect benefits accrue to the home country from outward foreign direct investment.

Asian Paints (India) announced an estimated capital expenditure of US$81 million in 2014 while Mahindra and Mahindra (India) invested more than US$200 million in 2013 in a plant to produce light trucks and utility vehicles, both in Bangladesh (United Nations Conference on Trade and Development (UNCTAD), 2015). Besides intra-regional investments, Indian businesses continue to be notable investors in Africa with Tata investing in Algeria in 2014, Mumbai-based Shri Vallabh Pittie (SVP) group investing US$550 million in Ethiopia to construct Africa´s largest plant to produce cotton yarn for export, and Bharti group undertaking 11 greenfield investment projects in Nigeria and Uganda in 2014 alone making it the second largest telecoms operator in Nigeria.

UNCTAD (2015) pegs India as one of the largest outward investing economies1 Moreover, the IPA (Investment Promotion Agencies) survey also ranked India sixth among the most promising investor home economies for Foreign Direct Investment (FDI) in 2014-2016 (UNCTAD, 2015). General improvement in the policy environment in India2 and/or improvements in the policy and general macroeconomic conditions of the countries in which Indian multinationals are investing3 can explain the increasing role of Indian multinationals in the global FDI landscape.

Why do countries engage in outward FDI?

Researchers have argued on whether countries should promote the presence of foreign multinationals within their home boundaries (inward FDI), or encourage domestic multina¬tionals to venture beyond home boundaries (outward FDI). Although arguments to support inward FDI outweigh outward FDI4, direct and indirect benefits from domestic multinationals for the home country cannot be refuted.

Direct home country benefits from outward FDI

The existence, sign (positive/negative) and dimension (economic value) of direct benefits to the home country from the presence of domestic multinationals largely depend on the motives of these multinationals. These motives can be related to either firm-specific advantages5 such as a premium on intangible assets like goodwill, or other motives such as where to locate, what to locate (horizontal FDI or vertical FDI6), and how to locate (mode of entry – greenfield or brownfield investments)7. Each of these is a function of the extent of cost saving possible. For instance, domestic multinationals may be motivated to locate in countries where governments offer incentives in the form of tax holidays for a tenure, and/or prefer to operate a wholly-owned subsidiary (as against operating through exports, license or joint venture) in a foreign country that has stringent patent protection laws or to prevent foreign knowledge leakage in the host country. Accordingly, horizontal or vertical FDI has the potential of creating a complementarity and/or substitutional interaction between domestic multinationals and home country firms8, thereby having a multiplier effect on economic factors such as investment, employment, balance of payments, technology and knowledge, and political decision-making in the home country, and subsequently on the economic growth of the home country (Kokko 2006)9. For example, if the home country’s outward FDI substitute domestic investments (possibly because of diminished domestic investment opportunities) then an increase in outward FDI may decrease domestic output, thereby reducing the home country’s economic growth (Stevens and Lipsey 1992). However, if the home country’s outward FDI complements its domestic investments (where affiliate of domestic multinationals uses home inputs to produce output abroad) then an increase in domestic multinationals activities abroad may promote higher domestic output, thereby contributing positively to the home country’s economic growth (Desai et al. 2015)10.

Indirect home country benefits from outward FDI

Indirect benefits (known as spillovers) from domestic multinationals are characterised by the knowledge gathered by these multinationals. This is a function of the firm’s own superior knowledge plus the foreign knowledge it gathers by operating outside its national boundaries11. Therefore the existence, sign and dimension of indirect benefits are not only a function of home and host country characteristics but also of the amount and type of knowledge the home country gains access to. Such knowledge, even though kept secret, gradually leaks out and eventually becomes common knowledge in the home market. Therefore, the spillover assumption is reasonable as knowledge is not only limited to the receiving affiliate of domestic multinationals but are also likely to spill over to firms that come in contact, directly or indirectly, with these domestic multinationals.

The transmission of such knowledge can occur directly and indirectly. Direct transmission can occur through vertical integration of domestic multinationals with home country firms – where the demand for intermediate inputs from home country suppliers may increase when domestic multinationals successfully tap the foreign market and expand production abroad, or when home country firms become customers to domestic multinationals. Indirect transmission can occur through

  • imitation – where domestic multinationals may bring more advanced managerial strategies acquired abroad to their home market creating an opportunity for home country firms to learn through observation;
  • movement of labour – where employees of domestic multinationals that may obtain superior skills as a result of overseas experience (either directly or indirectly) can transfer these skills to future home country employers and/or start new firms in their home country;
  • (iii)
  • competition – where home country competitors of domestic multinationals may be forced to become more efficient if multinational activities in a foreign country lead to enhanced productivity;
  • (iv)
  • exports – home country firms might enter the export market due to reduction in the sunk costs of export market entry or through an increase in the productivity levels because of information externalities from domestic multinationals.

Conclusion

From viewing foreign multinationals as depleting the domestic economy prior to national liberalisation in 1991, India has started to offer significant support to them. This changing attitude is largely the result of a changing view of the role played by foreign multinationals where they are now viewed as key players in the global generation, adoption and diffusion of technology. In particular, foreign multinationals bring with them a bundle of assets which might not be available locally, such as technologies, market and employment opportunities, and capital and management skills. Such assets, through direct and indirect linkages in the host economy, gradually leak and thus have the potential to raise average productivity and innovation in the host country. Such benefits stand as a major justification to significantly increase public incentives to attract foreign multinationals.

India recently launched the ‘Make in India’ campaign to attract global investors to manufacture in India. Moreover, it has done away with several technical adversities that were blocking foreign multinationals to invest in India. However, bene?ts accruing from domestic multinationals should not be ignored, and government efforts should also be directed in supporting Indian businesses to invest abroad. As Herzer (2008) puts it: “..outward FDI allows ?rms to enter new markets, to import intermediate goods from foreign a?liates at lower prices, to produce a greater volume of ?nal goods abroad at lower cost, and to access foreign technology... outward investing ?rms combine home production with foreign production to reduce costs and to increase their competitiveness both internationally and domestically..”.

Notes:

  1. From a mere 0.04% in 1990, the outward stock of Foreign Direct Investment (FDI) as a percentage of Gross Domestic Product (GDP) for India shot up to 6.3% in 2014. Nevertheless, it still continues to be the last among the BRICS (Brazil, Russia, India, China, and South Africa) with South Africa leading the pack followed by Russian Federation, Brazil, and then China. FDI outward stock as a per cent of GDP for South Africa rose from 13.1% in 1990 to 38.3% in 2014, for Russian Federation from 1.3% in 1993 to 23.3% in 2014, for Brazil from 8.6% in 1990 to 13.4% in 2014, and for China from 1.1% in 1990 to 7% in 2014 (UNCTAD, 2015).  
  2. The Indian government along with other regulatory bodies such as the Reserve Bank of India (RBI) consistently formulate and/or update policies directed towards encouraging outward FDI from India. RBI annually updates policies on direct investments made by resident Indians in its ‘Master Circular on Direct Investment by Residents in Joint Venture (JV)/Wholly Owned Subsidiary (WOS) abroad’. Similarly, Exim Bank’s (Export Import Bank of India) support to Indian entities in their expedition overseas has increased significantly in the recent past – from 11 transactions in 2000, number of overseas investment assisted by Exim Bank increased to 48 in 2012 (Prahalathan et al. 2014). 
  3. These investments could be related to the liberalisation of market entry requirements including a reduction in investment ceiling and/or increasing market access to regions and industries; and/or improvement in business environment including reduction in bureaucracy and corruption by encouraging automatic route or ‘no-approval required’ processes. 
  4. One of the reasons could be the ease of data availability to investigate the impact of inward FDI on the host country.
  5. Firm-specific advantages could also be related to ownership advantages as Dunning’s OLI (Ownership, Location, and Internalisation) eclectic paradigm theory would suggest.
  6. Horizontal FDI relates to intra-industry investment while vertical FDI relates to inter-industry investment.
  7. Throughout the article, home country firms include both domestic firms and affiliates of foreign firms operating in the home country.
  8. "Greenfield investment is investment in new plants, whereas brownfield investment is investment in existing plants mostly through mergers and acquisitions."
  9. There are multiple ramifications to a firm choosing to produce in the horizontal industry (horizontal FDI) as compared to its choice of producing in the vertical industry (vertical FDI). The reason is the very distinction in the nature of the two forms of FDI where horizontal integration takes advantage of the closeness to foreign markets while vertical integration takes advantage of factor cost differences (differences in the costs of inputs used in the production process) (Erkilek 2003). Domestic multinationals that invest horizontally can be thought of as multi-plant firms that seek to exploit their existing advantages and replicate roughly the same activities in a foreign location and the major trigger of moving outward is the intention to reap benefits of the market opportunities abroad. On the other hand, domestic multinationals that invest vertically can be thought of as firms that geographically fragment their production into stages, typically on the basis of factor intensities, exploiting lower factor prices abroad or reducing transaction cost by internalising upstream or downstream activities (Ekholm and Markusen 2006, Kokko 2006).
  10. It should be noted that the existence, sign and dimension of direct benefits of outward FDI is also a function of home and host country characteristics. For example, one can expect higher economic growth in the home country to encourage activities abroad by domestic multinationals. Dunning (1981) and Dunning (1986) show that a steady high economic growth in the home country could foster higher level of economic development in which domestic firms would established ownership advantages before they expand operations abroad. 
  11. When addressing the spillover effects from domestic multinationals to other domestic ?rms in the home country, it is important to take into account the organisational structure of the domestic multinational. In other words, here the focus of analysis is on the domestic multinational whose headquarters is generally located in the home country. The headquarters generally undertakes R&D (Research & Development) and other strategic ?nancial and management activities. Therefore the headquarters continues to remain the main sources of proprietary advantages of domestic multinationals and only part of these technological, managerial and organisational capabilities are transferred to its foreign arm. Thus, in principle, domestic multinationals, particularly ones with headquarters mainly in the home country, are expected to have more knowledge to transfer than its foreign arm. However, the dominant role of the headquarters of the domestic multinational is partially compensated by the fact that its foreign arm can indeed accumulate further knowledge and capabilities through local R&D activities, learning and through external linkages with the host country counterparts. Hence, the relative position between the headquarters of the domestic multinational and its foreign arm cannot be expected to change signi?cantly as the growing role of the latter in technological accumulation and knowledge absorption is compensated by the fact that the headquarters of the domestic multinational can also absorb external knowledge available locally, and it will eventually gain access to foreign knowledge through their foreign arms’ reverse technology transfer (Castellani and Zanfei 2006). 

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