Foreign Direct Investment: Trends and Determinants | Free Essay Example

Foreign Direct Investment: Trends and Determinants

Words: 1760
Topic: Business & Economics


Foreign direct investment is guided by various theoretical approaches. Theories of FDI provide a guideline, motivation, and direction of FDI application. These theories can either be macro or micro. As the paper reveals, macro-level theories of FDI explain various macroeconomic factors that are responsible for FDI uptake. Macroeconomic theories of FDI address the force behind foreigners investing in a host country. Some of these motivators may include the GDP of the host country, market size, the presence of natural resources, the state of infrastructure, political position, and the economic growth rate. On the other hand, micro-level FDI theories explain various factors that come into play at the company level.

Macro-level FDI Theories

Capital Market Theory

The capital market theory stipulates that FDI is driven by interest rates. The theory was developed by Boddewyn in 1985. It presents three factors that fuel the adoption of FDI in developing countries. According to Zhang (2001), undervalued exchange rates in developing countries pave a way for a low cost of production of goods and services. Secondly, most of the developing countries have no organised securities. Hence, when one makes a long-term investment in such countries, the FDI becomes the securities. This observation means that it is better to engage in FDI, rather than buying securities in developed nations (Nwankwo, Ademola & Kehinde 2013).

The utilisation of FDI in developing countries is also motivated by the inadequate knowledge concerning a host country’s securities by most foreigners. This situation makes many people fail to understand why growing economies adopt FDIs that permit the control of assets. The timing of FDI depends on the changes in the macroeconomic environment. Such macroeconomic factors in the investment environment include domestic investments, the productivity of trade, and openness to exchange, gross domestic product (GDP), and exchange rates (Baltabaev 2014). These factors determine how FDI moves in the environment. The theory presents FDI as a long-term strategy in multinational companies.

Exchange Rate and Economic Geography theory

The exchange rate and economic geography theory presents a relationship between exchange rate in a particular country and foreign direct investment. According to this theory, FDI significantly affects the exchange rates in a host country. It presents FDI as a major tool for the exchange rate reduction in a host country. The theory is anchored on the economic geography of a particular country. It explains the reason why internationally successful companies come up in certain countries. Various enabling or inhibiting factors such as the presence of natural resources, infrastructures, labour, and demand for goods and services locally determine FDI uptake in a certain country (Agada & Okpe 2002).

Local resources that a foreign investor may consider before undertaking an investment are controlled by the local government and political systems. Therefore, it is important for the exchange rate and political influence and boundaries to be considered while opting for FDI (Zhang 2001). The theory elucidates the presence of more economically developed cities, counties, or regions within a given country.

The level of relationships between countries that engage in economic transactions also determines FDI uptake in the respective countries. For instance, close geographical, cultural, or economic relationships enhance the flow of FDI between nations. The relationship factor, which influences the level of FDI, is highest when the affiliation is mutual (Chia & Ogbaji 2013). Traditional factors that dictate the affairs of any two countries, for instance their sizes, distance between them, development levels, and investor protection, are important variables that this theory addresses when it comes to FDI.

Micro-level FDI Theories

The Theory of Existence of Firm-specific Advantage

The premise of subsistence of firm-specific advantage was developed by Stephen Hymer in 1976 (Wilson & Baack 2012). The supposition is based on the premise that all firms consider investing in foreign markets following some gains that they foresee, for instance the economies of scale, superior management, and the presence of raw materials, trade patents, and names. This theory holds that a smooth flow of markets in a particular environment reduced trade barriers. In such a setting, competition becomes healthy even in the global front. FDI becomes the better option in international trade. Most of the local companies stand at a point of advantage in investing in their immediate market since they are more informed about it. On the other hand, FDI depends on a firm’s understanding of the market and its capacity to identify its (the market) points of imperfection (Wilson & Baack 2012).

FDI thrives in such an environment since imperfection opens another route that alters the normal competition within a given market. The market advantage supposition attributes the success or failure of FDI in individual firms and not the capital markets or economies. According to Durham (2004), a firm can use FDI to change its knowledge base and resources into a means of production in a foreign market. It strategically addresses FDI situation in oligopolistic markets. For instance, in every foreign investment, two parties come into play. One of them creates intermediate products while the other develops finished products (Wilson & Baack 2012).

In FDI, each of these investors independently makes a resolution on whether to venture into a foreign market. Changes must be witnessed whenever any of the two companies enters a foreign market. For example, a direct spillover of production technology must be witnessed. Such a situation translates into a reduced cost of production in the local markets. In most cases, firms will track their competitors in foreign markets to avoid making losses at the entry level. The theory presents FDI as a defensive move to venture into a foreign market (Wilson & Baack 2012). Such competing firms in oligopolistic markets result in actions and counter actions in foreign markets. Most firms that involve themselves in FDI follow the market leaders. Hence, when a market leader engages in FDI, other firms also turn to it. The oligopolistic equilibrium remains.

The Internalisation and Electric Theory of FDI

The internalisation and electric theory of FDI is a hybrid that was developed by Buckley and Casson in 1976 in conjunction with John Dunning. The theory holds that companies turn to their monopolistic advantage because of market imperfections. Using a firm’s own markets makes it easy for a company to overcome market limitations. Instead of using intermediate businesses, companies can adopt the technique of vertical integration of operations of their affairs (Escobari &Vacaflores 2015).

The speculation is also based on a firm’s ability to eliminate competition by developing a competitive edge in the market. The conjecture is drawn from other FDI theories. For instance, internalisation theory, which was the initial component, is applied in the electric theory (the other component) to explain the flow of FDI. Electric theory borrows from both macroeconomic and microeconomic theories of FDI (Wilson & Baack 2012).

It is also based on advantages such as possession, position, and internalisation (Forte, & Moura 2013). For instance, the possession of some intangible assets that a firm can transfer to a foreign market makes it stand at an advantage since it will incur lower operations cost. In the same way, ownership of natural resources, brands, and trademarks are also advantageous in FDI. Location advantages such as communication, infrastructure, culture, resources, and markets also affect FDI uptake. Internalisation comes in after the first two factors since firms must be profitable through their understanding of foreign environments.

Cost-Benefits Analysis of FDI

Cost-benefits analysis of FDI is a technique for determining the viability and limitations of options that gratify dealings, actions, or practical demands for a business such as FDI. The major beneficiaries of FDI happen to be both the host country and the investors (Agada & Okpe 2002). In their opinion, Escobari and Vacaflores (2015) claim that FDI offers an opportunity for money to reach businesses with prospects for growth across the world. Investors are given an opportunity to invest anywhere in the world for best returns. This flexibility makes FDI overcome barriers such as colour, race, politics, and religion. It makes a business competitive in its line of transaction. Another benefit of FDI is that it gives individual investors an opportunity to diversify their investments from one country (Forte & Moura 2013).

Such diversification increases investment returns while at the same time reducing risk. Agada and Okpe (2002) reveal how the recipient businesses also reap from guidance from business leaders in venturing into foreign markets. This guidance may take the form of legal, financial, knowledge, or technological support. The guidance also benefits the human resources since companies endeavour to keep with best practices. FDI results in the rising of living standards in the host country (Chia & Ogbaji 2013). For example, in Nigeria, GDP has continued to increase with an increase in FDI. In Nigeria, by 2012, FDI was at 3,199.89 dollars while the GDP was 261,855. When the FDI increased in 2013 to 6, 7400.00 dollars, the GDP also rose to 285,655 following the increased tax revenue from FDI adding to the national kitty.

According to Onu (2012), job opportunity, learning experience, and trade are also enhanced. As Baltabaev (2014) confirms, a foreign firm can own strategically important companies in a certain country through FDI. It can exercise undue control of resources to the disadvantage of its citizens, for instance, the ownership of oil extraction companies by Japanese people in Nigeria. Since FDI is mainly undertaken by competitive companies, mostly from foreign nations, foreign investors end up exploiting the available resources without benefiting the host country’s economy (Nwankwo, Ademola & Kehinde 2013). Besides, foreign investors may use their company as local collateral in borrowing and investing the money back to their motherland (Bemde-Nabende, Ford & Slater 2002). This possibility does benefit the host country. In addition, FDI may result in unfair business competition with locals since foreign investors may adopt the low-cost production strategy (Onu 2012).


As discussed in this study, there has been an increase in FDI across developed and developing nations. FDI involves organic or inorganic acquisition of controlling the ownership of a business by a foreign entity. FDI has always taken the form of mergers and accusations, new facilities, and investment of foreign capital. FDI theories may either take macro-level form such as the capital market theory, rates theory, dynamic theory, economic, geography, and institutional-based theories, or the micro-level forms such as the existence of firm-specific advantages theory, internalisation and electric theory, and oligopolistic FDI theories. FDI can be a beneficial and costly affair for both the foreign investor and the host country. Hence, it is important for investors to weigh the costs and benefits of the FDI before undertaking any investment.


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