Points of View on FDI in Emerging Markets

Title image is of the new commercial developments in the northern suburbs of Mumbai, India.
Photo by Shaun Fynn

The entry of multinational companies in emerging markets has created a surge in economic activity and has redefined globalization. Multinationals are no longer considered marginal to an emerging market’s economy, instead they are seen as a source of market competition and industrial growth. Open economies with skilled workforces and good growth prospects tend to attract larger amounts of foreign direct investment than closed, highly regulated economies.

What is foreign direct investment? Foreign direct investment (FDI) is an investment made by a company in a country other than that in which is it based, and are investments in the country’s domestic goods and services.  This does not include foreign investments in the domestic stock market. Equity investments are more volatile and have a tendency to flow out of an economy at the first sign of trouble; conversely FDIs are invariably expected to be a relatively stable longer-term commitment on behalf of a multinational company.

What are the macro-economic determinants in attracting FDIs to an emerging economy?

  • The human resources of a country plays an important role in attracting foreign direct investors to a country. In such cases the investors are lured by the prospects of a huge customer base.
  • A strong correlation exists between FDI and a country’s market-size as measured by the gross domestic product per capita, in other words, a market with good spending capabilities offer is attractive to investors.
  • The human resources of the country is strongly instrumental in attracting direct investment from overseas. Countries like China have taken an active interest in improving the quality of their unskilled worker force. Another dimension to the human resource determinant is the availability of a relatively cheaper yet educated labor force. The business process outsourcing (BPO) revolution, as well as the boom of the Information Technology companies in countries like India is proof of the fact that the educated labor force has played an important part in attracting foreign direct investment.
  • Infrastructure facilities such as quality telecommunications, electricity, roads and railways play an important part in attracting foreign direct investors to invest in a particular country.
  • Other factors such as the appropriate regulatory environment and low corporate income taxes attract FDIs. Governments of emerging markets tend to overregulate foreign companies to protect the local industry especially the micro, small and medium enterprises (MSME). Restrictions such as joint venture and local sourcing requirements can restrict the manner in which the foreign companies are allowed to operate.

A recent example of FDI in India is the Indian government’s decision to allow IKEA to invest Rupees 10,500 crore (or USD 2 billion) to set up a wholly owned single brand retail venture in India which will provide a much needed boost to the Indian economy.  The IKEA deal creatively meets the Indian government’s requirement for single brand retailers to source 30% of the merchandise they sell from local small enterprises and vendors.  IKEA’s concern that they would not be able to meet this requirement from Day 1 led them to seek permission to be allowed to comply with this rule cumulatively over a 10 year period with both parties agreeing to a compromised period of 7 years. Their primary argument was that it takes a new IKEA store three to five years to break even. 

The arrival of IKEA in India brings with it some good business practices for the local competition. IKEA is known for innovative design of products at affordable prices. It is also known for it’s attention to cost control and operational efficiency.  IKEA’s business model is such that it does not invest in factories, instead they work closely with furniture and furnishings vendors to design and produce products to meet their global quality and supply standards. As a result, while IKEA will use Indian vendors to meet their global needs, the doors will also open for these vendors to exports through the IKEA supply chain. The global furniture industry is estimated at over $400 billion, and presently India’s export to the furniture and furnishings markets is negligible (with the exception of carved wood products). This venture of IKEA’s should help in creating manufacturing jobs in the small and medium enterprise market segment.

In summary, the perceived benefits to allowing FDIs in emerging market economies notwithstanding, there are many critics of FDIs. Most notably, criticisms are by those who consider some FDI business models as a threat to the unique structure of the particular emerging economy. For instance, in India the textile, garment and food industries feel threatened by the potential impact that large supermarket chains like Walmart and Tesco might have on the thriving local stores. The benefits are a revival of economies by raising the productivity and output of the sectors involved, the ability to raise the local standard of living, local consumers benefiting from the competition that FDIs bring since they enjoy a wider selection of goods and services at lower prices and often improved quality. This leads to increased demand and creation of new wealth.  All these benefits work if the domestic infrastructure specifically roads, public transport, power supply, and ports have the ability and capacity to support the growing demands on the country’s resources resulting from FDI activity. These are key prerequisites for an emerging market economy to be able to sustain its growth and evolution.

References:

The Determinants of Foreign Direct Investments, A. Chakrabarti.

The Truth about Emerging Markets, McKinsey Global Institute.

Policies to Attract FDI, C.Bellak, M.Leibrecht & R.Stehrer, OECD.  

Economy Watch.