Unit III International Investment (25 Marks , 15 Lectures )

Foreign Investment – meaning and composition (FDI & FPI), Foreign Direct Investment:
Meaning; Determinants of FDI (resources, market size, trade barriers, economic and
business environment of the host country), Multinational corporations: meaning and
operational characteristics; Entry modes adopted by Multinational Corporations
(licensing, franchising, joint
ventures/collaborations, wholly-owned subsidiaries, mergers and acquisitions); Foreign
Portfolio Investment: Meaning; Operations of Foreign Institutional Investors; Determinants
of FPI (return on investment, level of financial sector development, capital controls,
exchange risk); Impact of FPI on capital markets and theexchangerate.
What is Foreign Investment?
Foreign investment is when a domestic investor decides to purchase ownership of an
asset in a foreign country. It involves cash flows moving from one country to another to
execute the transaction. If the ownership stake is large enough, the foreign investor may
be able to influence the entity’ s business strategy.
Summary
 Foreign investment is when investors purchase an asset in a foreign country,
resulting in the cash flow consideration transferring from one country to the
next.
 Foreign direct investments (FDIs) are long-term physical investments, such
as plants, toll roads, and bridges within foreign countries.
 Examples of FDIs include financial institutions trading equity stakes of foreign
companies on the stock exchange.
Understanding Foreign Investments
Foreign investments are often made by larger financial institutions hoping to diversify
their portfolio or expandoperations for oneof their current companies internationally. It is
oftenconsidereda move for scaling purposes or a catalyst to spur ineconomic growth.
For example, some companies may expand their offices worldwide to reach global talent
and connections. Examples would include Goldman Sachs, J.P. Morgan, Morgan Stanley,
and other large corporations. In other cases, some companies may open facilities or
operations to capitalize on cheaper labor or production costs offered in specific
countries.
For textile companies in particular, such as retail production, many factories are located
in China and Bangladesh despite sales being focussed on North America – such as
H&M or Zara – because material and labor are significantly cheaper there; thus,
outsourcing would result in higher profitability. In other cases, some large corporations
will prefer to conduct business incountries that have lower tax rates.

Direct vs. Indirect Foreign Investments

Foreign investments are typically defined as either direct or indirect. Foreign direct
investments are when investors purchase a physical asset such as a plant, factory, or
machinery in a foreign country. In contrast, foreign indirect investments are when
investors buy stakes in foreign companies that trade on their respectivestock
exchanges.
Generally speaking, direct foreign investments are favored by the foreign country over
indirect foreign investments because the assets they purchaseareconsidered long-term.
Therefore, they help boost the foreigncountry’ s economy over time.
Alternatively, indirect foreign investments are typically shorter-term investments that
aren’ t always used for the growth and development of another country’ s economy
over time.
Commercial Foreign Investments and Official Flows
Beyond direct and indirect foreign investments, commercial foreign investments and
official flows are two other types of investing methodologies conducted internationally.
Commercial loans are essentially bank loans issued by a domestic bank to a foreign
business or government. Similarly, official flows are various forms of development
assistance that developing or developed countries receive from a foreigncountry.
The Role of Multilateral Development Banks
Multilateral development banks are financial institutions that invest in foreign assets in
developing countries with the objective to stimulate and stabilize economic activity.
Rather than focusing on profit, multilateral development banks invest in projects to
support their respective country’ s economic development.
An example may be infrastructure investments, such as toll roads or bridges in foreign
countries, where thefinancing is composed of very low to zero interest debt. By doing so,
it creates new industries and opportunities within that area.
For example, the World Bank may decide to invest in a toll road in South Africa with large
amounts of debt but with very low interest. By doing so, the World Bank is not only
opening the potential of new trade opportunities for South Africa, but it also enhances
transportation activity andincreases new job opportunities for the country.
Foreign Direct Investment
Foreign direct investment happens when an individual or business owns 10% or more of
a foreign company.1 If an investor owns less than 10%, theInternational Monetary Fund
(IMF)defines it as part of their stock portfolio.
A 10% ownership doesn't give the individual investor a controlling interest in the foreign
company. However, it does allow influence over the company's management, operations,
and policies. For this reason, governments track investments in their country's
businesses.2
Recent Foreign Direct Investment Trends
In 2019, global foreign direct investment was $1.54 trillion, according to theUnited
Nations Conference on Trade and Development.3 That's a 3% increase over 2018 levels,
but it's still far below 2016's level of foreign direct investment, whichnearly hit $2 trillion.
The decline in FDI was partially due to President Donald Trump's tax cut, signed into law
on Dec. 22, 2017. The tax cut opened the door for companies to repatriate the trillions of
dollars they held in foreign cashstockpiles for a one-time tax rate of 15.5% on cash and
8% on equipment.4 In the first six months of 2018, as Trump's tax bill took effect, more
earnings were repatriated thanin 2015, 2016, and 2017 combined.
Importance of FDI
Foreign direct investment is critical for developing andemerging market countries. Their
companies need multinational funding and expertise to expand their international sales.
Their countries need private investment in infrastructure, energy, and water to increase
jobs and wages. The UN has also promoted the use of FDI to combat the impacts
of climate change.5
In 2019, developing countries received $685 billion through FDI—nearly half of total
global FDI. Most of those investments, some $475 billion, went to countries in Asia and
Oceania.3 The developed economies—such as the European Unionand the United
States—also benefit from FDI.6
Trade agreements are a powerful way for countries to encourage more FDI. A great
example of this is the North Atlantic Free Trade Agreement, the world's largest free trade
agreement. It increased FDI between the United States, Canada, and Mexico to
$731 billionin 2015.7 That was just oneof NAFTA's advantages.
Pros andCons of FDI
Pros Explained
 Diversifies investor portfolios: Individual investors have the potential to achieve
greater portfolio efficiency (return per unit of risk), as FDI diversifies their holdings
outside of a specific country, industry, or political system. Generally, a broader
base of investments will dampen overall portfolio volatility andprovide for stronger
long-term returns.8
  Provides technology to developing countries: Recipient businesses receive
"best practices" management, accounting, or legal guidance from their investors.
They can incorporate the latest technology, operational practices, and financing
tools. By adopting these practices, they enhance their employees' lifestyles. That
raises the standard of living for more people in the recipient country. FDI rewards
the best companies in any country. It reduces the influence of local governments
over them.
 Provides financing to developing countries: Recipient countries see
their standard of living rise. As the recipient company benefits from the investment,
it can pay higher taxes. Unfortunately, some nations offset this benefit by offering
tax incentives to attract FDI.2
 Promotes stable, long-term lending: Another advantage of FDI is that it offsets

thevolatility created by "hot money." That's whenshort-term lenders and currency

traders create anasset bubble. They invest lots of money all at once, then sell their
investments just as fast. That can create a boom-bust cycle that ruins economies
and ends political regimes. Foreign direct investment takes longer to set up and
has a more permanent footprint in a country.9
Cons Explained
 Not suitable for strategically important industries: Countries should not allow
foreign ownership of companies in strategically important industries. That could
lower the comparativeadvantage of the nation, accordingto anIMF report.
 Investors have less moral attachment: Foreign investors might strip the
business of its value without adding any. They could sell unprofitable portions of
thecompany to local, less sophisticated investors.
 Unethical access to local markets: They can use the company's collateral to get
low-cost, local loans. Instead of reinvesting it, they lend the funds back to
theparent company.10
 Types of Foreign Investmentin India
 Types of Foreign Investments. Funds from foreign country could beinvested in
shares, properties, ownership/ management or collaboration. . .
 Foreign Direct Investment (FDI) ...
 Foreign Portfolio Investment (FPI) ...
 Foreign Institutional Investment(FII)

WHAT ARE THE COMPONENTS OF FDI?

March 26, 2020 Fdiindia Comments 0 Comment
A foreign direct investment involves a long-term relationship between an investor and a
business. Under FDI, an investor based in one country invests in a business based in
another country. This long-term relationship reflects a lastinginterest in the business.
To uphold the lasting interest, the foreign investor is given at least 10 per cent voting
rights in the day to day functioning of the firm. Therefore, under FDI, the investors holds a
certain degree of influence on the management of the enterprise where the investment is
beingmade.
As per the international guidelines based on the recommendations by the IMF in its
Balance of Payments Manual (fiftheditions, 1993) Foreign Direct Investment is defined as
international investment that reflects the objective of a resident entity in one economy
(foreign direct investor or parent enterprise) obtaining a lasting interest and control in an
enterprise resident in an economy other than that of theforeign direct investor.
Foreign direct investment has threebasic components:
EQUITY CAPITAL: it is the overseas investor’ s purchase of shares of a business
located in another country rather than its own. An equity capital stake of 10 percent or
more, is normally considered as a thresholdfor the control of assets.
2. REINVESTED EARNINGS: it is the oversea investor’ s share (in proportion to direct
equity participation) of earnings not distributed as dividends by subsidiaries or
associates, andearnings of branches not remitted to the direct investor.
3. Other direct investment capital or inter-company debt transactions: this refers to
short- or long-term borrowing and lending of funds between direct investors (parent
enterprises) and affiliate enterprises. The borrowing and lending of funds including debt
securities and supplier’ s credits between direct investors and subsidiaries, branches
and associates.

Foreign direct investment (FDI) means companies purchase capital and invest in a
foreign country. For example, if a US multinational, such as Nike built a factory for making
trainers inPakistan; this would count as foreigndirect investment.
In summary, themain factors that affect foreign direct investment are
 Infrastructureand access to raw materials
 Communication andtransport links.
 Skills and wage costs of labour
Factors affecting foreign direct investment

1. Wage rates
A major incentive for a multinational to invest abroad is to outsource labour-intensive
production to countries with lower wages. If average wages in the US are $15 an hour,
but $1 an hour in the Indian sub-continent, costs can be reduced by outsourcing
production. This is why many Western firms have invested in clothing factories in the
Indian sub-continent.
 However, wage rates alone do not determine FDI, countries with high wage rates
can still attract higher tech investment. A firm may be reluctant to invest in
Sub-Saharan Africa because low wages are outweighed by other drawbacks,
such as lack of infrastructure and transport links.
2. Labourskills
Some industries require higher skilled labour, for example pharmaceuticals and
electronics. Therefore, multinationals will invest in those countries with a combination of
low wages, but high labour productivity and skills. For example, India has attracted
significant investment in call centres, because a high percentage of the population speak
English, but wages are low. This makes it an attractive place for outsourcing and
therefore attracts investment.
3. Tax rates
Large multinationals, such as Apple, Google and Microsoft have sought to invest in
countries with lower corporation tax rates. For example, Ireland has been successful in
attracting investment from Google and Microsoft. In fact, it has been controversial
because Google has tried to funnel all profits through Ireland, despite having operations
in all European countries.
4. Transport and infrastructure
A key factor in the desirability of investment are the transport costs and levels of
infrastructure. A country may have low labour costs, but if there is then high transport
costs to get the goods onto the world market, this is a drawback. Countries with access
to the sea are at an advantage to landlocked countries, who will have higher costs to ship
goods.
5. Size of economy / potential for growth
Foreign direct investment is often targeted to selling goods directly to the country
involved in attracting the investment. Therefore, the size of the population and scope for
economic growth will be important for attracting investment. For example, Eastern
European countries, with a large population, e.g. Poland offers scope for new markets.
This may attract foreign car firms, e.g. Volkswagen, Fiat to invest and build factories in
Poland to sell to the growing consumer class. Small countries may be at a disadvantage
because it is not worth investing for a small population. China will be a target for foreign
investment as the newly emerging Chinese middle class could have a very strong
demand for the goods and services of multinationals.
6. Political stability / property rights
Foreign direct investment has an element of risk. Countries with an uncertain political
situation, will be a major disincentive. Also, economic crisis can discourage investment.
For example, the recent Russian economic crisis, combinedwith economic sanctions, will
be a major factor to discourage foreign investment. This is one reason why former
Communist countries in theEast arekeen to join the European Union. The EU is seenas a
signal of political and economic stability, which encourages foreign investment.
Related to political stability is the level of corruption and trust in institutions, especially
judiciary and the extent oflaw and order.
7. Commodities
One reason for foreign investment is the existence of commodities. This has been a major
reason for the growth in FDI within Africa – often by Chinese firms looking for a secure
supply of commodities.
8. Exchange rate
A weak exchange rate in the host country can attract more FDI because it will be
cheaper for the multinational to purchase assets. However, exchange rate volatility could
discourage investment.
9. Clustering effects
Foreign firms often are attracted to invest in similar areas to existing FDI. The reason is
that they can benefit from external economies of scale – growth of service industries
and transport links. Also, there will be greater confidence to invest in areas with a good
track record. Therefore, some countries can create a virtuous cycle of attracting
investment and then these initial investments attracting more. It is also sometimes known
as an agglomeration effect.
10. Access to free trade areas.
A significant factor for firms investing in Europe is access to EU Single Market, which is a
free trade area but also has very low non-tariff barriers because of harmonisation of
rules, regulations and free movement of people. For example, UK post-Brexit is likely to
be less attractive to FDI, ifit is outsidethe Single Market.
Evaluation
There are many different factors that determine foreign direct investment (FDI) and it is
hard to isolate individual factors, given there are many different variables. It also depends
on the type of industry. For example, with manufacturing FDI, low wage costs tend to be
the most important, as they are a labour-intensive industry. For the service sector, FDI,
macro-economic stability and political openness tendto bemoreimportant.
Also, it depends on the source of FDI, American firms may value political openness more
thanChinese firms. Or American firms may have a preferencefor countries whereEnglish
is spoken more.
UK – Post Brexit
If the UK leaves the Single Market, there will be two factors which make the UK less
attractive as a place for FDI
 1. Outside Single Market – the possibility of tariffs or greater barriers to trade with
rest of Europe. Even if tariffs to EU are low (World trade rules) there is a
considerable significance of being outside Single Market which may put off firms,
who prefer thesecurity of beingin a country committed to SingleMarket
2. Access to labour. The UK economy has benefited from migrant labour, e.g.
construction sector has a high percentage of Eastern European workers. Without
free movement oflabour, there may bea greater unwillingness to invest in UK.
On theother hand, the UK may seek to attract inward investment, through the aggressive
cutting of corporation tax

Determinants of FDI (resources, market size, tradebarriers, economic and business

environment of the host country)

Factors influencingForeignDirect Investment in a Country

Foreign Direct Investors look into various factors before making investment decision in a
country. After 1990, in India, the government adopted a New Economic Policy which
promoted the policy of LPG (Liberalization, Privatization and Globalization). This has
resulted inpromotingmoreforeign direct investment into thecountry.
1. Stability of the Government:
A stable Government is an essential prerequisite for any investment. The investor will
always look for a government which is supporting investment and which will not take any
steps that are anti-investment. The investor should not have any fear of take over by the
government. This will enable him to go for expansion.
2. Flexibility in the Government Policy:
Certain investments were not allowed in the hands of FDI but such a rigid policy will not
help in the growth of industries. With WTO regulation, government has to adopt flexible
policies, permitting FDIs in all areas including those in which they were prevented
previously. For example, in India, power generation was not permitted to private sector.
Now, in Maharashtra, Dabhol Power Company is allowed to do so.
3. Pro-active measures of the Government to promote investment (infrastructure):
The Government should also undertake pro-active measures such as expansion of ports,
captive power, development of highways, atomic power etc. These measures will attract
more foreign direct investment.
4. Exchangerate stability:
Commercial viability of any FDI is based on exchange rate stability. This means that the
value of domestic currency should not drop abnormally by which while repatriating the
funds, the foreign investor will lose heavily. Exchange rate should be more or less the
sameas prevailing at thetime of investment.
5. Tar policies and concessions:
Government should adopt uniform tax policies as per international norms. A heavy excise
duty or sales tax or customs duty will prevent foreign direct investment. A moderate tax
policy should continue so that the FDIs will feel comfortable.
6. Scope of the market:
FDIs must be in a position to exploit the market and expand both in the domestic as well
as the foreign markets. This will reduce their cost of production and will give them ample
scope for diversification.
7. Other favorable location factors (including logistics and labor):
The productivity of labor in the country should be high. Adequate skilled labor should be
available, especially in technical areas. Different transport facilities with a proper
coordination between land, rail and air shouldbe available.
8. Return oninvestment:
One of the major attractions for FDIs is the profit or the return they get for the investment
made. Unless the return is substantially higher than what they could have obtained in
other countries, they will not venture for investment. The rectum should also be
consistent andit shouldbe increasing over aperiod. These factors are closely looked into
while undertaking investment. The financier of the FDIs will also ensure that they get their
money back as it is a safe investment.
Thus, return on investment is a major deciding factor for FDls while undertaking
investment in foreign countries. They also would like to ensure that the payback period is
also less so that the return is ensured within a short period. Weightage is given to each of
these factors and decisions are finalized.

What is a Multinational Corporation (MNC)?

A multinational corporation (MNC) is a company that operates in its home country, as
well as in other countries around the world. It maintains a central office located in one
country, whichcoordinates themanagement of all its other offices, such as administrative
branches or factories.
It isn’ t enough to call a company that exports its products to more than one country a
ultinational company. They need to maintain actual business operations in other
countries andmust make aforeign direct investment there.

Characteristics of a Multinational Corporation

The followingarethe commoncharacteristics of multinational corporations:
1. Very high assets and turnover
To become a multinational corporation, the business must be large and must own a huge
amount of assets, both physical and financial. The company’ s targets arehigh, and they
are ableto generate substantial profits.
2. Network of branches
Multinational companies maintain production and marketing operations in different
countries. In each country, the business may oversee multiple offices that function
throughseveral branches andsubsidiaries.
3. Control
In relation to the previous point, the management of offices in other countries is
controlled by one head office located in the home country. Therefore, the source of
command is found in thehomecountry.
4. Continuedgrowth
Multinational corporations keep growing. Even as they operate in other countries, they
strive to grow their economic size by constantly upgrading and by conducting mergers
and acquisitions.
5. Sophisticated technology
When a company goes global, they need to make sure that their investment will grow
substantially. In order to achieve substantial growth, they need to make use of
capital-intensive technology, especially in their production and marketingactivities.
6. Right skills
Multinational companies aim to employ only the best managers, those who are capable
of handling large amounts of funds, using advanced technology, managing workers, and
runninga huge business entity.
7. Forceful marketingand advertising
One of the most effective survival strategies of multinational corporations is spending a
great deal of money on marketing and advertising. This is how they are able to sell every
product or brand they make.

Because they use capital-intensive technology, they are able to produce top-of-the-line
products.

Reasons for Being a Multinational Corporation

There are various reasons why companies want to become multinational corporations.
Here aresome of the most common motivations:

Setting up production in other countries, especially indeveloping economies, usually

translates to spending significantly less on production costs. Though outsourcing is a
way of achieving theobjective, setting upmanufacturing plants in other countries may be
even more cost-efficient.
Due to their large size, MNCs can take advantage of economies of scale and grow their
global brand. The growth is done through strategic manufacturing/service placement,
which allows the corporation to take advantage of undervalued services across the
globe, more efficient and inexpensive supply chains, and advanced technological/R&D
capacity.

It is beneficial to set up business in countries where the target consumer market of a

company is located. Doing so helps reduce transport costs and gives multinational
corporations easier access to consumer feedback and information, as well as to
consumer intelligence.
International brand recognition makes the transition from different countries and their
respective markets easier and decreases per capita marketing costs as the same brand
vision canbe applied worldwide.

Multinational corporations are also known to hire only the best talent from around the
world, which allows management to provide thebest technical knowledge and innovative
thinkingto their product or service.

When a company produces or manufactures its products in another country where they
also sell their products, they areexempt from import quotas andtariffs.

Models of MNCs
The followingarethe different models of multinational corporations:
In the centralized model, companies put up an executive headquarters in their home
country and then build various manufacturing plants and production facilities in other
countries. Its most important advantage is being able to avoid tariffs and import quotas
and takeadvantage of lower productioncosts.

The regionalized model states that a company keeps its headquarters inone country that
supervises a collection of offices that are located in other countries. Unlike the
centralized model, the regionalized model includes subsidiaries and affiliates that all
report to theheadquarters.

In the multinational model, a parent company operates in the home country and puts up
subsidiaries in different countries. The difference is that the subsidiaries and affiliates are
more independent intheir operations.

Advantages of Being a Multinational Corporation

There are many benefits of being a multinational corporation including:

In terms of efficiency, multinational companies are able to reach their target markets
more easily because they manufacture in the countries where the target markets are.
Also, they can easily access raw materials and cheaper labor costs.

In terms of development, multinational corporations pay better thandomestic companies,

making them more attractive to the local labor force. They are usually favored by the
local government because of the substantial amount of local taxes they pay, which helps
boost the country’ s economy.
In terms of employment, multinational corporations hire local workers who know the
culture of their place and are thus able to give helpful insider feedback on what the locals
want.

As multinational corporations employ both locals and foreign workers, they are able to
come upwith products that are morecreative andinnovative.

Foreign Direct Investment

Foreign direct investments are prevalent within multinational corporations. The
investments occur when an investor or company from one country makes an investment
outside the country of operation.
Foreign investments most often occur when a foreign business is established or bought
outright. It can be distinguished from the purchase of an international portfolio that only
contains equities of the company, rather than purchasing more direct control.

The Five Common International-Expansion Entry Modes

What is the best way to enter a new market? Should a company first establish an export
base or license its products to gain experience in a newly targeted country or region? Or
does the potential associated with first-mover status justify a bolder move such as
entering an alliance, making an acquisition, or even starting a new subsidiary? Many
companies move from exporting to licensing to a higher investment strategy, in effect
treating these choices as a learning curve. Each has distinct advantages and
disadvantages. In this section, we will explore thetraditional international-expansion entry
modes. Beyond importing, international expansion is achieved through exporting,
licensing arrangements, partnering and strategic alliances, acquisitions, and establishing
new, wholly owned subsidiaries, also known as greenfield ventures. These modes of
entering international markets and their characteristics are shown in Table 7.1
“International-Expansion Entry Modes” .1 Each mode of market entry has advantages
and disadvantages. Firms need to evaluate their options to choose the entry mode that
best suits their strategy and goals.

Type of Entry Advantages Disadvantages

Low control, low local knowledge,

Exporting Fast entry, low risk potential negative environmental
impact of transportation

Less control, licensee may become a

Licensing and Fast entry, low cost, low risk competitor, legal and regulatory
Franchising environment (IP and contract law)
must be sound

Shared costs reduce Higher cost than exporting,

Partnering and investment needed, reduced or franchising; integration problemslicensing,
Strategic Alliance risk, seen as local entity between two corporate cultures

Acquisition Fast entry; known, High cost, integration issues with

established operations homeoffice
Type of Entry Advantages Disadvantages

Greenfield Venture Gain local market

(Launch of a new, knowledge; can be seen as High cost, high risk due to unknowns,
wholly owned insider who employs locals; slow entry due to setup time
subsidiary) maximumcontrol

Exporting
Exporting is the marketing and direct sale of domestically produced goods in another
country. Exporting is a traditional and well-established method of reaching foreign
markets. Since it does not require that the goods be produced in the target country,
noinvestment in foreign production facilities is required. Most of the costs associated
withexporting take theformof marketingexpenses.
While relatively low risk, exporting entails substantial costs and limited control. Exporters
typically have little control over the marketing and distribution of their products, face high
transportation charges and possible tariffs, and must pay distributors for a variety of
services. What is more, exporting does not give a company firsthand experience in
staking out a competitive position abroad, and it makes it difficult to customize products
and services to local tastes andpreferences.
Exporting is a typically the easiest way to enter an international market, and therefore
most firms begin their international expansion using this model of entry. Exporting is the
sale of products and services in foreign countries that are sourced from the home
country. The advantage of this mode of entry is that firms avoid the expense of
establishing operations in the new country. Firms must, however, have a way to distribute
and market their products inthe new country, which they typically do through contractual
agreements with a local company or distributor. When exporting, the firm must give
thought to labeling, packaging, and pricing the offering appropriately for the market. In
terms of marketing and promotion, the firm will need to let potential buyers know of its
offerings, beit through advertising, trade shows, or a local sales force.
One common factor in exporting is the need to translate something about a product or
service into the language of the target country. This requirement may be driven by local
regulations or by the company’ s wish to market the product or service in a locally
friendly fashion. While this may seem to be a simple task, it’ s often a source of
embarrassment for the company and humor for competitors. David Ricks’ s book on
international business blunders relates the following anecdote for US companies doing
business in the neighboring French-speaking Canadian province of Quebec. A company
boasted of , which translates to “used fresh milk,” when it meant to brag
of , or “fresh milk used.” The “terrific” pens sold by another
company were instead promoted as , or terrifying. In another example, a
company intending to say that its appliance could use “any kind of electrical current,”
actually stated that the appliance “wore out any kind of liquid.” And imagine how one
company felt when its product to “reduce heartburn” was advertised as one that
reduced “the warmth of heart” !2
Among the disadvantages of exporting are the costs of transporting goods to the
country, which can be high and can have a negative impact on the environment. In
addition, some countries impose tariffs on incoming goods, which will impact the firm’ s
profits. In addition, firms that market and distribute products through a contractual
agreement have less control over those operations and, naturally, must pay their
distribution partnera fee for those services.

Companies are starting to consider the environmental impact of where they locate their
manufacturing facilities. For example, Olam International, a cashew producer, originally
shipped nuts grown in Africa to Asia for processing. Now, however, Olam has opened
processing plants in Tanzania, Mozambique, and Nigeria. These locations are close to
where the nuts are grown. The result? Olam has lowered its processing and shipping
costs by 25 percent while greatly reducing carbonemissions.3
Likewise, when Walmart enters a new market, it seeks to source produce for its food
sections from local farms that are near its warehouses. Walmart has learned that the
savings it gets from lower transportation costs and the benefit of being able to restock in
smaller quantities more than offset the lower prices it was getting from industrial farms
located farther away. This practice is also a win-win for locals, who have the opportunity
to sell to Walmart, which can increase their profits and let them grow and hire more
people and pay better wages. This, in turn, helps all the businesses in the local
community.4
Firms export mostly to countries that are close to their facilities because of the lower
transportation costs and the often greater similarity between geographic neighbors. For
example, Mexico accounts for 40 percent of the goods exported from Texas.5 The
Internet has also made exporting easier. Even small firms can access critical information
about foreign markets, examine a target market, research the competition, and create
lists of potential customers. Even applying for export and import licenses is becoming
easier as moregovernments usethe Internet to facilitate these processes.
Because the cost of exporting is lower than that of the other entry modes, entrepreneurs
and small businesses are most likely to use exporting as a way to get their products into
markets around the globe. Even with exporting, firms still face the challenges of currency
exchange rates. While larger firms have specialists that manage the exchange rates,
small businesses rarely have this expertise. One factor that has helped reduce the
number of currencies that firms must deal with was the formation of the European Union
(EU) and the move to a single currency, the euro, for the first time. As of 2011, seventeen
of the twenty-seven EU members use the euro, giving businesses access to 331 million
peoplewith that singlecurrency.6
Licensing and Franchising
A company that wants to get into an international market quickly while taking only limited
financial and legal risks might consider licensing agreements with foreign companies.
An international licensingagreement allows a foreign company (the ) to sell the
products of a producer (the ) or to use its intellectual property (such as patents,
trademarks, copyrights) in exchange for royalty fees. Here’ s how it works: You own a
company in the United States that sells coffee-flavored popcorn. You’ re sure that your
product would be a big hit in Japan, but you don’ t have the resources to set up a
factory or sales office in that country. You can’ t make the popcorn here and ship it to
Japan because it would get stale. So you enter into a licensing agreement with a
Japanese company that allows your licensee to manufacture coffee-flavored popcorn
using your special process and to sell it in Japan under your brand name. In exchange,
theJapaneselicensee would pay you a royalty fee.
Licensing essentially permits a company in the target country to use the property of the
licensor. Such property is usually intangible, such as trademarks, patents, and production
techniques. The licensee pays a fee in exchange for the rights to use the intangible
property and possibly for technical assistance as well.
Because littleinvestment onthe part of the licensor is required, licensing has thepotential
to provide a very large return on investment. However, because the licensee produces
and markets the product, potential returns from manufacturing and marketing activities
may be lost. Thus, licensing reduces cost and involves limited risk. However, it does not
mitigate the substantial disadvantages associated with operating from a distance. As a
rule, licensingstrategies inhibit control and produceonly moderatereturns.
Another popular way to expand overseas is to sell franchises. Under
an international franchiseagreement, a company (the ) grants a foreign
company (the ) the right to use its brand name and to sell its products or
services. The franchisee is responsible for all operations but agrees to operate according
to a business model established by the franchiser. In turn, the franchiser usually provides
advertising, training, and new-product assistance. Franchising is a natural form of global
expansion for companies that operate domestically according to a franchise model,
including restaurant chains, such as McDonald’ s and Kentucky Fried Chicken, andhotel
chains, suchas Holiday Inn and Best Western.
Contract Manufacturing and Outsourcing
Because of high domestic labor costs, many U.S. companies manufacture their products
in countries where labor costs are lower. This arrangement is
called international contract manufacturing or outsourcing. A U.S. company might
contract with a local company in a foreign country to manufacture one of its products. It
will, however, retain control of product design and development and put its own label on
the finished product. Contract manufacturing is quite common in the U.S. apparel
business, with most American brands being made in a number of Asian countries,
including China, Vietnam, Indonesia, andIndia.[4]
Thanks to twenty-first-century information technology, nonmanufacturing functions can
also be outsourced to nations with lower labor costs. U.S. companies increasingly draw
on a vast supply of relatively inexpensive skilled labor to perform various business
services, such as software development, accounting, and claims processing. For years,
American insurance companies have processed much of their claims-related paperwork
in Ireland. With a large, well-educated population with English language skills, India has
become a center for software development and customer-call centers for American
companies. In the case of India, as you can see in Table 7.1 “Selected Hourly Wages,
United States and India” , the attraction is not only a large pool of knowledge workers
but also significantly lower wages.
Occupation U.S. Wage per Hour (per Indian Wage per Hour (per
year) year)

Middle-level manager $29.40 per hour ($60,000 $6.30 per hour ($13,000
per year) peryear)

Information technology $35.10 per hour ($72,000 $7.50 per hour ($15,000
specialist per year) peryear)

Manual worker $13.00 per hour ($27,000 $2.20 per hour ($5,000 per
per year) year)

Partnerships and Strategic Alliances

Another way to enter a new market is through a strategic alliance with a local partner. A
strategic alliance involves a contractual agreement between two or more enterprises
stipulating that the involved parties will cooperate in a certain way for a certain time to
achieve a common purpose. To determine if the alliance approach is suitable for the firm,
the firm must decide what value the partner could bring to the venture in terms of both
tangible and intangible aspects. The advantages of partnering with a local firm are that
the local firm likely understands the local culture, market, and ways of doing business
better than an outside firm. Partners are especially valuable if they have a recognized,
reputable brand name in the country or have existing relationships with customers that
the firm might want to access. For example, Cisco formed a strategic alliance with Fujitsu
to develop routers for Japan. In the alliance, Cisco decided to co-brand with the Fujitsu
name so that it could leverage Fujitsu’ s reputation in Japan for IT equipment and
solutions while still retaining the Cisco name to benefit from Cisco’ s global reputation
for switches and routers.7 Similarly, Xerox launched signed strategic alliances to grow
sales in emerging markets such as Central andEastern Europe, India, and Brazil.8
Strategic alliances andjoint ventures have become increasingly popular in recent years.
They allow companies to share the risks and resources required to enter international
markets. And although returns also may have to be shared, they give a company a
degree of flexibility not afforded by going it alonethrough direct investment.
There are several motivations for companies to consider a partnership as they expand
globally, including (a) facilitating market entry, (b) risk and reward sharing, (c) technology
sharing, (d) joint product development, and (e) conforming to government regulations.
Other benefits include political connections and distribution channel access that may
dependon relationships.
Such alliances oftenarefavorable when (a) thepartners’ strategic goals convergewhile
their competitive goals diverge; (b) the partners’ size, market power, and resources are
small compared to the industry leaders; and (c) partners are able to learn from one
another while limiting access to their own proprietary skills.
What if a company wants to do business in a foreign country but lacks the expertise or
resources? Or what if the target nation’ s government doesn’ t allow foreign
companies to operate within its borders unless it has a local partner? In these cases, a
firm might enter into a strategic alliance with a local company or even with the
government itself. A strategic alliance is an agreement between two companies (or a
company and a nation) to pool resources in order to achieve business goals that benefit
both partners. For example, Viacom (a leading global media company) has a strategic
alliance with Beijing Television to produce Chinese-language music and entertainment
programming.[5]
An alliance can serve anumber of purposes:
 Enhancing marketing efforts
 Building sales and market share
 Improving products
 Reducing production and distribution costs
 Sharingtechnology
Alliances range in scope from informal cooperative agreements to joint ventures—
alliances in which the partners fund a separate entity (perhaps a partnership or a
corporation) to manage their joint operation. Magazine publisher Hearst, for example, has
joint ventures with companies in several countries. So, young women in Israel can
read in Hebrew, and Russian women can pick up a Russian-language
version of that meets their needs. The U.S. edition serves as a starting point to
which nationally appropriate material is added in each different nation. This approach
allows Hearst to sell themagazinein more than fifty countries.[6]
Strategic alliances are also advantageous for small entrepreneurial firms that may be too
small to make the needed investments to enter the new market themselves. In addition,
somecountries require foreign-ownedcompanies to partner with alocal firm if they want
to enter the market. For example, in Saudi Arabia, non-Saudi companies looking to do
business in the country are required by law to have a Saudi partner. This requirement is
common in many Middle Eastern countries. Even without this type of regulation, a local
partner often helps foreign firms bridge the differences that otherwise make doing
business locally impossible. Walmart, for example, failed several times over nearly a
decade to effectively grow its business in Mexico, until it found a strong domestic partner
withsimilar business values.
The disadvantages of partnering, on the other hand, are lack of direct control and the
possibility that the partner’ s goals differ from the firm’ s goals. David Ricks, who has
writtena book on blunders in international business, describes the case of aUS company
eager to enter the Indian market: “It quickly negotiated terms and completed
arrangements with its local partners. Certain required documents, however, such as the
industrial license, foreign collaboration agreements, capital issues permit, import licenses
for machinery and equipment, etc., were slow in being issued. Trying to expedite
governmental approval of these items, the US firm agreed to accept a lower royalty fee
than originally stipulated. Despite all of this extra effort, the project was not greatly
expedited, and the lower royalty fee reduced the firm’ s profit by approximately half a
million dollars over the life of the agreement.” 9 Failing to consider the values or
reliability of a potential partner can becostly, if not disastrous.
To avoid these missteps, Cisco created one globally integrated team to oversee its
alliances in emerging markets. Having a dedicated team allows Cisco to invest in training
the managers how to manage the complex relationships involved in alliances. The team
follows a consistent model, using and sharing best practices for the benefit of all its
alliances.10
Partnerships in emerging markets can be used for social good as well. For example,
pharmaceutical company Novartis crafted multiple partnerships with suppliers and
manufacturers to develop, test, and produce antimalaria medicine on a nonprofit basis.
The partners included several Chinese suppliers and manufacturing partners as well as a
farm in Kenya that grows the medication’ s key raw ingredient. To date, the partnership,
called the Novartis Malaria Initiative, has saved an estimated 750,000 lives through the
delivery of 300 million doses of themedication.11
The key issues to consider in a joint venture are ownership, control, length of agreement,
pricing, technology transfer, local firm capabilities and resources, and government
intentions. Potential problems include (a) conflict over asymmetric new investments, (b)
mistrust over proprietary knowledge, (c) performance ambiguity, that is, how to “split
the pie,” (d) lack of parent firm support, (e) cultural clashes, and (f) if, how, and when to
terminate therelationship.
Ultimately, most companies will aim at building their own presence through
company-owned facilities in important international markets. or greenfield
start-ups represent this ultimate commitment. Acquisition is faster, but starting a new,
wholly owned subsidiary might be the preferred option if no suitable acquisition
candidates can be found.
Acquisitions
An acquisition is a transaction in which a firm gains control of another firm by purchasing
its stock, exchanging the stock for its own, or, in the case of a private firm, paying the
owners a purchase price. In our increasingly flat world, cross-border acquisitions have
risen dramatically. In recent years, cross-border acquisitions have made up over 60
percent of all acquisitions completed worldwide. Acquisitions areappealingbecausethey
give the company quick, established access to a new market. However, they are
expensive, whichin thepast had put them out of reachas astrategy for companies in the
undeveloped world to pursue. What has changed over the years is the strength of
different currencies. The higher interest rates in developing nations has strengthened
their currencies relative to the dollar or euro. If the acquiring firm is in a country with a
strong currency, theacquisition is comparatively cheaper to make. As Whartonprofessor
Lawrence G. Hrebiniak explains, “Mergers fail because people pay too much of a
premium. If your currency is strong, you can get a bargain.” 12
When deciding whether to pursue an acquisition strategy, firms examine the laws in the
target country. China has many restrictions on foreignownership, for example, but even a
developed-world country like the United States has laws addressing acquisitions. For
example, you must be an American citizen to own a TV station in the United States.
Likewise, a foreign firm is not allowed to own more than 25 percent of a US airline.13
Acquisition is a good entry strategy to choose when scale is needed, which is particularly
the case in certain industries (e.g., wireless telecommunications). Acquisition is also a
good strategy when an industry is consolidating. Nonetheless, acquisitions are risky.
Many studies have shown that between 40 percent and 60 percent of all acquisitions fail
to increase the market value of the acquired company by more than the amount
invested.14
Foreign Direct Investment and Subsidiaries
Many of the approaches to global expansion that we’ ve discussed so far allow
companies to participate in international markets without investing in foreign plants and
facilities. As markets expand, however, a firm might decide to enhance its competitive
advantage by making a direct investment in operations conductedin another country.
Also known as foreign direct investment (FDI), acquisitions and greenfield start-ups
involve the direct ownership of facilities in the target country and, therefore, the transfer
of resources including capital, technology, and personnel. Direct ownership provides a
highdegree of control in the operations and theability to better know theconsumers and
competitive environment. However, it requires ahigh level of resources and ahigh degree
of commitment.
Foreign direct investment refers to the formal establishment of business operations on
foreign soil—the building of factories, sales offices, and distribution networks to serve
local markets in a nation other than the company’ s home country. On the other
hand offshoring occurs when the facilities set up in the foreign country replace U.S.
manufacturing facilities and are used to produce goods that will be sent back to the
United States for sale. Shifting production to low-wage countries is often criticized as it
results in theloss of jobs for U.S. workers.[7]
FDI is generally the most expensive commitment that a firm can make to an overseas
market, and it’ s typically driven by the size and attractiveness of the target market. For
example, German and Japanese automakers, such as BMW, Mercedes, Toyota, and
Honda, have made serious commitments to the U.S. market: most of the cars and trucks
that they build in plants in the South and Midwest are destined for sale in the United
States.
A common form of FDI is the foreign subsidiary: an independent company owned by a
foreign firm (called the ). This approach to going international not only gives the
parent company full access to local markets but also exempts it from any laws or
regulations that may hamper the activities of foreign firms. The parent company has tight
control over the operations of a subsidiary, but while senior managers from the parent
company often oversee operations, many managers and employees are citizens of the
host country. Not surprisingly, most very large firms have foreign subsidiaries. IBM and
Coca-Cola, for example, have both had success in the Japanese market through their
foreign subsidiaries (IBM-Japan and Coca-Cola– Japan). FDI goes in the other direction,
too, andmany companies operating in the UnitedStates are in fact subsidiaries of foreign
firms. Gerber Products, for example, is a subsidiary of the Swiss company Novartis, while
Stop & Shop and Giant Food Stores belong to theDutch company Royal Ahold.
Where does most FDI capital end up? Figure 7.3 “Where FDI Goes” provides an
overview of amounts, destinations (developed or developingcountries), andtrends.

All these strategies have been successful in the arena of global business. But success in
international business involves more than merely finding the best way to reach
international markets. Doing global business is a complex, risky endeavor. As many
companies have learned the hard way, people and organizations don’ t do things the
same way abroad as they do at home. What differences make global business so tricky?
That’ s the question that we’ ll turnto next.
Wholly Owned Subsidiaries
Firms may want to have a direct operating presence in the foreign country, completely
under their control. To achieve this, the company can establish a new, wholly owned
subsidiary (i.e., a greenfield venture) from scratch, or it can purchase an existing company
in that country. Some companies purchase their resellers or early partners (as Vitrac
Egypt did when it bought out the shares that its partner, Vitrac, owned in the equity joint
venture). Other companies may purchase a local supplier for direct control of the supply.
This is known as vertical integration.
Establishing or purchasing a wholly owned subsidiary requires the highest commitment
on the part of the international firm, because the firm must assume all of the risk—
financial, currency, economic, and political.
The process of establishing of a new, wholly owned subsidiary is often complex and
potentially costly, but it affords the firm maximum control and has the most potential to
provide above-average returns. The costs and risks are high given the costs of
establishing anew business operation in anew country. The firm may have to acquire the
knowledge and expertise of the existing market by hiring either host-country nationals—
possibly from competitive firms—or costly consultants. An advantage is that the firm
retains control of all its operations.

McDonald’ s has a plant in Italy that supplies all the buns for McDonald’ s restaurants in
Italy, Greece, and Malta. International sales has accounted for as much as 60 percent of
McDonald’ s annual revenue.15
Cautions When Purchasing an Existing Foreign Enterprise
As we’ ve seen, some companies opt to purchase an existing company in the foreign
country outright as a way to get into a foreign market quickly. When making an
acquisition, due diligence is important—not only on the financial side but also on the side
of the country’ s culture and business practices. The annual disposable income in
Russia, for example, exceeds that of all the other BRIC countries (i.e., Brazil, India, and
China). For many major companies, Russia is too big and too rich to ignore as a market.
However, Russia also has a reputation for corruption and red tape that even its
highest-ranking officials admit. In a article, presidential economic advisor
Arkady Dvorkovich (whose office in the Kremlin was once occupied by Soviet leader
Leonid Brezhnev), for example, advises, “Investors should choose wisely” which
regions of Russia they locate their business in, warning that some areas are more corrupt
than others. Corruption makes the world less flat precisely because it undermines the
viability of legal vehicles, such as licensing, whichotherwiselead to a flatter world.
The culture of corruption is even embedded into some Russian company structures. In
the1990s, laws inadvertently encouraged Russian firms to establish legal headquarters in
offshore tax havens, like Cyprus. A tax haven is a country that has very advantageous
(low) corporate income taxes.
Businesses registered in these offshore tax havens to avoid certain Russian taxes. Even
though companies could obtain a refund on these taxes from the Russian government,
“the procedure is so complicated you never actually get a refund,” said Andrey
Pozdnyakov, cofounder of Siberian-basedElecard, in thesame article.
This offshore registration, unfortunately, is a danger sign to potential investors like Intel.
“We can’ t invest in companies that have even a slight shadow,” said Intel’ s
Moscow-based regional director Dmitry Konash about the complex structure
predicament.

Some foreign companies believe that owning their own operations in China is an easier
option than having to deal with a Chinese partner. For example, many foreign companies
still fear that their Chinese partners will learn too much from them and become
competitors. However, in most cases, the Chinese partner knows the local culture—both
that of the customers and workers—and is better equipped to deal with Chinese
bureaucracy and regulations. In addition, even wholly owned subsidiaries can’ t be
totally independent of Chinese firms, on whom they might have to rely for raw materials
and shipping as well as maintenanceof government contracts and distribution channels.
Collaborations offer different kinds of opportunities and challenges than self-handling
Chinese operations. For most companies, the local nuances of the Chinese market make
some form of collaboration desirable. The companies that opt to self-handle their
Chinese operations tend to be very large and/or have a proprietary technology base,
such as high-tech or aerospace companies—for example, Boeing or Microsoft. Even
then, these companies tend to hire senior Chinese managers and consultants to facilitate
their market entry and then help manage their expansion. Nevertheless, navigating the
local Chinese bureaucracy is tough, even for themost-experiencedcompanies.
Let’ s takea deeper look at one company’ s entry pathand its wholly owned subsidiary
in China. Embraer is the largest aircraft maker in Brazil and one of the largest in the world.
Embraer chose to enter China as its first foreign market, using the joint-venture entry
mode. In 2003, Embraer and the Aviation Industry Corporation of China jointly startedthe
Harbin Embraer Aircraft Industry. A year later, Harbin Embraer began manufacturing
aircraft.
In 2010, Embraer announced the opening of its first subsidiary in China. The subsidiary,
called Embraer China Aircraft Technical Services Co. Ltd., will provide logistics and
spare-parts sales, as well as consulting services regarding technical issues and flight
operations, for Embraer aircraft in China (both for existing aircraft and those on order).
Embraer will invest $18 million into the subsidiary with a goal of strengthening its local
customer support, given the steady growthof its business in China.
Guan Dongyuan, president of Embraer China and CEO of the subsidiary, said the
establishment of Embraer China Aircraft Technical Services demonstrates the
company’ s “long-term commitment and confidence in the growing Chinese aviation
market.” 17
Building Long-Term Relationships
Developing a good relationship with regulators in target countries helps with the
long-term entry strategy. Building these relationships may include keeping people in the
countries long enoughto form goodties, sincea deal negotiated with one personmay fall
apart if that personreturns too quickly to headquarters.

One of the most important cultural factors in China is (pronounced ),

which is loosely defined as a connection based on reciprocity. Even when just meeting a
new company or potential partner, it’ s best to have an introduction from a common
business partner, vendor, or supplier—someone the Chinese will respect. China is a
relationship-based society. Relationships extend well beyond the personal side and can
drive business as well. With guanxi, a person invests with relationships much like one
would invest with capital. In a sense, it’ s akin to the Western phrase “You owe me
one.”
Guanxi can potentially be beneficial or harmful. At its best, it can help foster strong,
harmonious relationships with corporate and government contacts. At its worst, it can
encourage bribery and corruption. Whatever the case, companies without guanxi won’ t
accomplish much in the Chinese market. Many companies address this need by entering
into the Chinese market in a collaborative arrangement with a local Chinese company.
This entry option has also been a useful way to circumvent regulations governing bribery
and corruption, but it can raise ethical questions, particularly for American and Western
companies that have adifferent cultural perspective on gift giving andbribery.

In March 2008, the Coca-Cola company and Illy Caffé Spa finalized a joint venture and
launched a premium ready-to-drink espresso-based coffee beverage. The joint venture,
Ilko Coffee International, was created to bring three ready-to-drink coffee products—
Caffè, an Italian chilled espresso-based coffee; Cappuccino, an intense espresso,
blended with milk and dark cacao; and Latte Macchiato, a smooth espresso, swirled with
milk—to consumers in 10 European countries. The products will be available in stylish,
premium cans (150 ml for Caffè and 200 ml for the milk variants). All three offerings will
be available in 10 European Coca-Cola Hellenic markets including Austria, Croatia,
Greece, andUkraine. Additional countries in Europe, Asia, North America, Eurasia, and the
Pacific were slatedfor expansion into 2009.
The Coca-Cola Company is the world’ s largest beverage company. Along with
Coca-Cola, recognized as the world’ s most valuable brand, the company markets four
of the world’ s top five nonalcoholic sparkling brands, including Diet Coke, Fanta, Sprite,
and a wide range of other beverages, including diet and light beverages, waters, juices
and juice drinks, teas, coffees, and energy and sports drinks. Through the world’ s
largest beverage distribution system, consumers in more than 200 countries enjoy the
company’ s beverages at arate of 1.5 billion servings each day.
Based in Trieste, Italy, Illy Caffé produces and markets a unique blend of espresso coffee
under a single brand leader in quality. Over 6 million cups of Illy espresso coffee are
enjoyed every day. Illy is sold in over 140 countries around the world and is available in
more than 50,000 of the best restaurants and coffee bars. Illy buys green coffee directly
from the growers of the highest quality Arabica through partnerships based on the
mutual creation of value. The Trieste-based company fosters long-term collaborations
with the world’ s best coffee growers—in Brazil, Central America, India, and Africa—
providing know-how andtechnology and offering above-market prices.
In summary, when deciding which mode of entry to choose, companies should ask
themselves two key questions:
1. How much of our resources are we willing to commit? The fewer the resources
(i.e., money, time, and expertise) the company wants (or can afford) to devote, the
better it is for the company to enter the foreign market on a contractual basis—
throughlicensing, franchising, management contracts, or turnkey projects.
2. How much control do we wish to retain? The more control a company wants, the
better off it is establishing or buying a wholly owned subsidiary or, at least,
entering via a joint venture with carefully delineated responsibilities and
accountabilities between the partner companies.
Regardless of which entry strategy a company chooses, several factors are always
important.
  Cultural and linguistic differences. These affect all relationships and interactions
inside the company, with customers, and with the government. Understanding the
local business cultureis critical to success.
 Quality and training of local contacts and/or employees. Evaluating skill sets
and then determining if the local staff is qualified is a key factorforsuccess.
 Political and economic issues. Policy can change frequently, and companies
need to determine what level of investment they’ re willing to make, what’ s
required to make this investment, and how much of their earnings they can
repatriate.
 Experience of the partner company. Assessing the experience of the partner
company in the market—withthe product and in dealingwith foreigncompanies—
is essential in selecting the right local partner.
Companies seeking to enter a foreignmarket need to do thefollowing:
 Research the foreign market thoroughly and learn about the country and its
culture.
 Understand the unique business and regulatory relationships that impact their
industry.
 Use the Internet to identify and communicate with appropriate foreign trade
corporations in the country or with their own government’ s embassy in that
country. Each embassy has its own trade and commercial desk. For example, the
US Embassy has a foreign commercial desk with officers who assist US
companies on how best to enter the local market. These resources are best for
smaller companies. Larger companies, with more money and resources, usually
hire top consultants to do this for them. They’ re also able to have a dedicated
team assigned to the foreign country that can travel the country frequently for the
later-stageentry strategies that involve investment.
Once a company has decided to enter the foreign market, it needs to spend some time
learningabout the local business culture and how to operatewithin it.

What is Foreign PortfolioInvestment (FPI)?

Foreign portfolio investment (FPI) involves an investor purchasing foreign financial
assets. The transaction of foreign securities generally occurs at an organized formal
securities exchange or through an over-the-counter market transaction.
Foreign portfolio investment is becoming increasingly more common as a means of
portfolio diversification. Often, FPIs consist of securities and alternative foreign financial
assets that are passively heldby a foreign investor.

Summary
 Generally, foreign portfolio investments consist of securities and alternative
foreign financial assets that are passively held by a foreign investor.
It involves an investor purchasing foreign financial assets.
 Foreign portfolio investors are normally exposed to increased share price
volatility, which increases their risk, and investors expect to receive
compensation for the risk they take on.
 Foreign portfolio investors can access equities, bonds, derivatives, mutual
funds, and guaranteed investment certificates, among other instruments.

Who Can Make Foreign Portfolio Investments?

Foreign portfolio investing is popular among several different types of investors.
Common transactors of foreignportfolio investment include:
 Individuals
 Companies
 Foreign governments

Benefits of Foreign Portfolio Investment

The primary benefits of foreignportfolio investment are:
Foreign portfolio investment provides investors with an easy opportunity to diversify their
portfolio internationally. An investor woulddiversify their investment portfolio to achieve a
higher risk-adjusted return, which is ultimately done to help generate alpha.

Investors may be able to access an increased amount of credit in foreign countries,

allowing the investor to utilize more leverage and generate a higher return on their equity
investment.

If investors are seeking out greater returns, they must be willing to take on greater risk.
Emerging markets canoffer investors a different risk-return profile.

As markets become more liquid, they become deeper and broader, and a wider range of
investments can be financed. Savers can invest with the assurance that they will be able
to manage their portfolio or sell their financial securities quickly if they need access to
their savings.

Increased competition for financing will lead to the market rewarding superior
performance, prospects, and corporate governance. As the market’ s liquidity and
functionality develop, equity prices will become value-relevant for investors, ultimately
drivingmarket efficiency.
Risks of Foreign Portfolio Investment (FPI)
The primary risks faced by aforeign portfolio investor are:

Across international financial markets, some are riskier than others. For example,
consider the Deutscher Aktienindex (DAX). The DAX is a stock market index of 30 major
German companies trading on the Frankfurt Stock Exchange. The DAX is historically
more volatile than theS&P 500 Index.

Jurisdictional risk can result from investing in a foreign country. For example, if a foreign
country that you were invested in drastically changes its laws, it could result in a material
impact on theinvestment’ s returns.
Moreover, many countries struggle with financial crime, such as money laundering.
Investing in countries where money laundering is prevalent increases the jurisdictional
risk faced by the investor.

Financial Assets for Foreign Portfolio Investments

The typical financial assets that can be purchased through foreign portfolio investment
include equities, bonds, and derivative instruments. These securities can be purchased
for many reasons; however, generally, foreign portfolio investment is positively influenced
by high rates of return andreductionof risk throughgeographic diversification.

Policies for Foreign PortfolioInvestment

Foreign portfolio investment is inherently volatile, and rigorously regulated financial
markets are needed to manage the risk effectively. Furthermore, the financial system
must be capable of identifying and mitigating risks for prudent and efficient allocation of
foreign or domestic capital flows.
Economic growth and development are enabled by successful financial intermediation
and the efficient allocation of credit. Financial systems can maintain their health through
the identification and management of business risks. Moreover, the financial system must
also withstandeconomic shocks.

What is Foreign PortfolioInvestment?

Foreign Portfolio Investment (FPI) involves an investor buying foreign financial
assets. It involves an array of financial assets like fixed
deposits, stocks, and mutual funds. All the investments are passively held by the
investors. Investors who invest in foreign portfolios are known as Foreign Portfolio
Investors.
Foreign Portfolios increase the volatility. As a result, it leads to increased risk. The
intent of investing in foreign markets is to diversify the portfolio and get some
handsome returnon investments. Investors expect to receive highreturns owing to
the risk they’ re willing to take. Foreign Portfolio Investment is a prominent
investment alternative nowadays. From individuals and businesses to even
Governments invest in Foreign Portfolios.
This article will take you through the benefits of foreign portfolio investment,
categories of foreign portfolio investment, criteria of FPI, and various risks
associated with it.
Benefits of Foreign Portfolio Investment
 Investment Diversity
 FPI provides investors an opportunity to diversify their portfolio. As an
investor, you can diversify your portfolio to achieve high returns. Suppose if
you incur major losses in investment assets of a Country X, you can accrue
profits in investment assets of a country Y. In this way, you can experience
less volatility in yourinvestments and increase chances of profits.
 International Credit
Investors can get access to increased amounts of credit in foreign countries.
They can broaden their credit base. By expanding their credit base, investors
can secure their line of credit. In case the domestic credit score is
unfavourable, having an international credit score can be beneficial. This
allows the investor to utilize more leverage and get high returns on equity
investment.
 Access to a Bigger Market
Sometimes, foreign market can be less competitive than the domestic market.
Hence, FPI gives you an exposure to a wider market. The foreign markets are
comparatively less saturated and hence, they may offer higher returns and
morediversity as well.
 High Liquidity
Foreign Portfolio Investments provides high liquidity. An investor can buy and
sell foreign portfolios seamlessly. This offers buying power for investors to act
when good buy opportunities arise. Investors can buy and sell trades in a
quick and seamless manner.
 Exchange Rate Benefit
 An investor canleverage the dynamic nature of international currencies. Some
currencies can drastically rise or fall, and a strong currency can be used in
investor’ s favour.
Categories in Foreign Portfolio Investment
One canregister FPI in one of thebelow categories:
 Category I: This includes investors from the Government sector. Such as central
banks, Governmental agencies, and international or multilateral organizations or
agencies.
 Category II: This category includes :
 Regulated broad-based funds such as mutual funds, investment trusts,
insurance/reinsurance companies.-
 Also include regulated banks, asset management companies, portfolio managers,
investment advisors, and managers.
 Category III: It includes those who are not eligible in the first two categories. It
includes endowments, charitable societies, charitable trusts, foundations, corporate
bodies, trusts, individuals.
Who Regulates FPI in India?
Securities and Exchange Board of India (SEBI) operates the FPIs. Recently, SEBI
has introduced theForeign Portfolio Investors Regulations, 2019. FPIs also need to
follow the Income-tax Act, 1961 and Foreign Exchange Management Act, 1999.
Eligibility Criteria forForeign Portfolio Investment
Anindividual must fulfill the following conditions to register as FPI:
  As per theIncome-tax Act 1961, the applicant should not be anon-resident Indian
 Shouldnot be a citizenof a country that falls under thepublic statement of FATF.
 Must be eligible to invest insecurities outside thecountry.
 To invest in securities, he/she must have the approval of the MOA / AOA /
Agreement.
 A certificate that grants the applicant holds an interest of the development of the
securities market.
 In case the bank is the applicant, it must belong to a nation whose central bank is a
member of the Bank for International Settlements.
Factors Affecting Foreign Portfolio Investment
Hereare some factors affecting Foreign Portfolio Investment:
 Growth Prospects
The economy of a country plays a crucial role in foreign investments. If an
economy is robust and growing, investors are more inclined to investing in the
financial assets of that country. On theother hand, if the country goes through
a financial turmoil or a recession, investors tendto withdraw their investments.
 Interest Rates
Investors yearn for a high return on investment. Hence, investors prefer to
invest in countries with high interest rates.
 Tax Rates
The tax is levied on capital gains. Higher tax rates reduces the return on
investments. Hence, investors prefer to invest in countries which have lower
tax rates.
Risks Involved in Foreign Portfolio Investment
Foreign Portfolio Investments has some risks associated with it - for both the
investors and the destination country. Hereare a few risks involvedin it:
 Political Risk Exposure
The change in the political environment may give rise to political risk. This
results in a change of investment criteria, economic policies, and repatriation
regulations.
 Low Liquidity
In developing countries, the capital market liquidity often tends to be low
resulting ina higher pricevolatility.
FAQ’ S
 Whether non-regulated entities are eligible to register as FPIs?
Non appropriately regulated entities can register under Category III FPIs.
 Do FPIs need to enroll with SEBI?
No. there is no need for FPIs to directly register from SEBI. The Registration
can be granted by adesignated depository participant (DDP) instead of SEBI.
 How long is the FPI registration valid?
The validity period of the FPI registration is permanent unless suspended or
canceled by SEBI or surrendered by the FPI, however, this is subject to
payment of the applicable renewal feeduring every three-year block.
 What is the cap formaximum shareholding by FPI?
The purchase of equity shares of each company by a single FPI must be
below 10% of the total issuedcapital of thecompany.
  Can FPIs open more than one depository account?
No. Each FPI will be allowed to open only one depository account for their FPI
investments. Further, the purchase and sale of all eligible securities must be
transacted throughthat depository account only.
 Can an FPI directly place an order with a stockbroker?
Yes. Similar to FIIs, anFPI can place orders directly with thebroker.
 Is borrowing or lending of funds or securities available in FPI?
Yes, FPIs provide investors to engage in borrowing or lending in accordance
with the Securities Lendingand Borrowing program ofSEBI.
 Can I doin Foreign PortfolioInvestments in India?
Yes. Any NRI individual or organizations can make foreign portfolio
investments in India.

Effectof Exchange Rates on FDI

Much of the traditional and modern analysis of the effects of exchange rates on FDI
reflects a partial equilibrium perspective, based on the effects of exogenous shifts in real
exchange rates on FDI flows. As discussed below, different types of disturbances may
produce different links between FDI and exchange rates.
Among the suggested links between the real exchange rate and FDI, the effect of
exchange rate changes on asset prices and costs of domestic labor and capital has
received the greatest attention. An exchange rate depreciation contributes to FDI by
lowering the cost of domestic assets to foreign investors. If the depreciation is perceived
to be temporary in real terms (as may be the case for a nominal depreciation that is
expected to feed rapidly into local factor and output prices), FDI is likely to include a
greater fraction of acquisitions of land and of other existing assets, as foreigners take
advantage of bargain prices. Depreciations that are regarded as more permanent in real
terms are likely to increase the weight of greenfield investment, through their effect on
factor costs, as foreign capital, for instance, seeks to combine with cheaper domestic
labor.
A depreciation of the real exchange rate can also lead to an increase in direct investment
inflows through its effect on relative wealth across countries (see, for instance, Froot and
Stein, 1991, andKlein and Rosengren, 1994). By increasing the relative wealth of foreign
firms, a change in the exchange rate can make it relatively easier for those firms to use
internal financing, thereby lowering the relative cost of investing. Thus, an exchange rate
depreciation wouldincreaseforeign firms’ wealth relative to domestic firms andspur an
FDI inflow.
When one considers the effect of exchange rate changes on FDI coming through its
effects on government policy, an opposite effect to that outlined above may be
envisioned. To the extent that exchange rate depreciations improve a country’ s trade
balance, they may soften protectionist policies and, with it, reduce the incentive for tariff
jumping. Further ambiguities arise when one goes beyond the examination of the effects
on FDI of exogenous shocks that cause exchange rates to fall below their long-run trend.
Indeed, one must recognize that exchange rates are themselves endogenous variables
that respond to a variety of shocks. Depending on the effects of these underlying shocks
on the long-run equilibrium exchange rate itself, empirical analysis may uncover quite
different linkages betweenexchange rate changes andFDI flows.
Despite these sources of potential ambiguity, several studies looking largely at industrial
countries have provided empirical evidence of a link between exchange rate
depreciations and increased FDI inflows—including Cushman (1985, 1987), Caves and
Mehra (1986), Culem (1988), Froot and Stein (1991), and Klein and Rosengren (1994). In
addition, Harris and Ravenscraft (1991) showed that buyers from strong-currency
countries were willing to pay significantly higher premiums than domestic buyers for the
acquisition of U.S. assets during 1970– 87.
Attention has also been devoted in the literature to the effects of greater exchange rate
volatility on FDI. Reasons for greater exchange rate volatility to both stimulate and hinder
FDI have beenpointedout in the literature. Someauthors (for example, Caves and Mehra,
1986) have emphasized the first possibility, based on the view that FDI provides
insurance against exchange rate changes by allowing a firm to shift production across
countries. From this viewpoint, greater exchange rate uncertainty is likely to cause more
FDI (see also Aizenman, 1994, for a discussion of these issues). In contrast, the view that
exchange rate volatility may reduce FDI has been emphasized by those noting the
irreversible nature of FDI (see Dixit, 1989), which causes investors to be wary of potential
exchange rate reversals when undertaking a foreign investment project that involves an
unrecoverableoutlay. This particular channel is more likely to apply when investment is of
a green-field nature, or with certain types of investment undertaken in support of trade
(for example, the cost of setting up a foreign plant, of developing a distribution network,
or of establishing brand recognition). It has also been noted that some of the
diversification motives applying to portfolio investment may extend to FDI (see Black,
1977). Exchange rate volatility should reduce portfolio investment and, by similarity (or if
FDI remains in broadly constant proportion to portfolio investment), also FDI. This
presumption is subject to qualifications, however. Countries whose exchange rates are
negatively correlated with global returns to capital (for instance, oil-exporting countries),
may actually benefit from their role as portfolio hedges. An increase in these countries’
exchange ratevolatility may actually raise their FDI inflows on diversification grounds.
Empirical evidence on the link between exchange rate volatility and FDI is limited but
tends to favor a positive link between exchange rate volatility and FDI inflows (see, for
instance, Cushman, 1985, and Caves and Mehra, 1986). In response to greater exchange
rate risk, multinationals appear to reduce exports to a foreign country but to offset this
somewhat by increasing capital inputs and production in thecountry.