The term ‘foreign direct investment’ (FDI) covers some specific forms of inter-country capital transfers. Under FDI, capital moves from one country to another not in the form of loans but in the form of business investment.
When capital is transferred in the form of loans, the creditor runs the risk of a partial or full default by the borrower. However, given this risk, the lender’s future income is certain or pre-determined. In contrast, in FDI, the investor faces market risks and uncertainties.
Return on FDI depends, amongst others, upon the success of the enterprise in which investment has been made. Consequently, it can be nil or even negative.
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It is conventional to make a distinction between two forms of foreign direct investment of which the term FDI is conventionally used for the second form.
(a) Portfolio Investment—A Pure Financial Investment:
Portfolio investment (also termed indirect or retire investment) is an investment in financial assets, such as in bonds and stocks, denominated in a national currency.
It is equivalent to an investor lending his capital in order to get a return on it (which may be fixed or variable). In this form of investment, ownership and use of capital remain separated from each other.
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Like other holders of financial assets’, a portfolio investor has only a de jure control over the invested capital without there being a de facto or an effective control over the management, policies and other decision-making processes of the fire in which investment has been made.
The return on portfolio investment depends upon the performance of purchased financial assets and includes speculative gains and losses as well. In India, inflow of portfolio investment is mostly from foreign “Financial Institutional Investors” or FIIs.
(b) Foreign Direct Investment—A Real Investment:
As stated above, the term FDI is conventionally reserved for this form of foreign investment. In contrast with portfolio investment (which is purely financial in nature), it is a real investment, that is, it is an investment in real assets, such as factories, offices, land, buildings, capital goods, inventories and so on.
It tends to be industry-specific, and location-specific. It may also manifest itself in the form of a subsidiary, a branch, a takeover, a merger, purchasing a controlling equity, and the like.
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In FDI, the investor has a (partial or full) control over the management, policies and other decision-making processes of the venture in which investment has been made.
Unlike loans, return on FDI depends upon commercial success of the venture in which investment has been made. Consequently, the investor pays adequate attention to all the relevant aspects of cost and quality of the product.
To this end, FDI is frequently accompanied by a transfer of technology, and an environment of responsive management and work culture.
It may also encourage horizontal and vertical integration. The former generally takes the route of opening new subsidiaries, backward integration or buying up existing firms in the host country.
It may even be predatory in nature in the sense of aiming at weakening or killing competition. Similarly, vertical integration is also guided by strong motives of controlling demand and supply channels and cutting costs.
Clearly, such activities of business integration may or may not be beneficial for the economy of the host country or its consumers.