BTL 724 - Foreign Investments

 

The Banking Tutor’s Lessons

BTL 724                                                                          15 -11-2024

Foreign Investments

Capital is a vital ingredient for economic growth, but since most nations cannot meet their total capital requirements  from internal resources alone, they turn to foreign investors.

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.

In this context I am going to explain the following 4 concepts ….

Foreign Direct Investments  (FDI)

Foreign Portfolio Investment (FPI) 

Outward Direct Investment (ODI)

Foreign Institutional Investors (FII)

Direct vs. Indirect Foreign Investments

Foreign investments are classified as either Direct or Indirect. Indirect investment is also known as Portfolio Investment.

Foreign Direct Investments are when investors purchase a physical asset such as a plant, factory, or machinery in a foreign country.

FDI can take two different forms: Greenfield or Mergers and Acquisitions (M&As). 

Greenfield Investment involves the creation of a new company or establishment of facilities abroad. A greenfield investment is a form of market entry commonly used when a company wants to achieve the highest degree of control over foreign activities

Mergers and Acquisitions (M&A) amounts to transferring the ownership of existing assets to an owner abroad. In a merger, two companies are merged to form one, while in an acquisition one company is taken over by another.

Foreign Indirect Investment also called Non-direct investment and  Foreign Portfolio Investments (FPI) are when investors buy stakes in foreign companies that trade on their respective stock exchanges.

Although FDI and FPI are similar in that they both involve foreign investment, there are some differences between the two.

The first difference arises in the degree of control exercised by the foreign investor. FDI investors typically take controlling positions in domestic firm and are actively involved in their management. FPI investors, on the other hand, are generally passive investors  who are not actively involved in the day-to-day operations and strategic plans of domestic companies, even if they have a controlling interest  in them.

The second difference is that FDI investors perforce have to take a long-term approach to their investments since it can take years from the planning stage to project implementation. On the other hand, FPI investors prefer a  much shorter investment horizon.

FDI  investors  cannot easily liquidate their assets  and depart from a nation, since such assets may be very large and quite illiquid.  FPI investors can exit a nation literally with a few mouse clicks, as financial assets are highly liquid and widely traded. 

Outward Direct Investment (ODI)

Outward direct investment (ODI) is a business strategy in which a domestic firm expands operations into a foreign country. Also called Outward Foreign Direct Investment or Direct Investment Abroad.

For example, some companies will make a greenfield investment — a type of foreign direct investment in which a parent company creates a subsidiary in a different country — building its operations from the bottom up. Another example of ODI occurs when a merger or acquisition takes place in a foreign country.

ODI is a natural transition for firms whose domestic markets become saturated and other profitable opportunities are available abroad.  American, European, Chinese, and Japanese firms have long made extensive investments outside of their domestic markets. Good examples include Starbucks, McDonald’s, and Ford.

ODI is different from Foreign direct investment (FDI). FDI occurs when a company purchases an interest in a company by a company located outside its own borders. ODI occurs when a resident company invests in a wholly-owned subsidiary (or joint venture) in a non-resident country, in order to expand the business.

The extent of a country’s outward direct investment may be indicative that said country’s economy is matured and experienced. ODI increases a country’s investment competitiveness.

Emerging countries often receive large amounts of ODI, due to the market’s more rapid growth rates. 

Foreign Institutional Investors (FII)

There are many ways for a foreign investor to invest in a country. The most direct method, of course, is Foreign Direct Investment. However, there are other ways to enter an economy, like Foreign Institutional Investors.

Foreign Institutional Investors (FII) are an investment fund or a gathering of investors. Such a fund is registered in a foreign country, i.e. not in the country it is investing in. Such institutional investors mostly involve hedge funds, mutual funds, pension funds, insurance bonds, debentures, investment banks etc.

We use this term FII for foreign players investing funds in the financial market of India. They play a big role in the development of our economy. The amount of funds they invest is very considerable.

So when such FII’s buy shares and securities the market is bullish and trends upwards. The opposite may also happen when they withdraw their funds from the markets. So they have considerable sway over the market.

Advantages of FII’s

FII’s will enhance the flow of capital into the country.

These investors generally prefer equity over debt. So this will also help maintain and even improve the capital structures of the companies they are investing in.

They have a positive effect on the competition in the financial markets.  FII help with the financial innovation of capital markets.

These institutions are professionally managed by asset managers and analysts. They generally improve the capital markets of the country. 

Disadvantages of FII’s

The demand for the local currency (rupee) increases. This can cause severe inflation in the economy.

These FII’s drive the fortune of big companies in which they invest. But their buying and selling of securities have a huge impact on the stock market. The smaller companies are taken along for the ride.

Sometimes these FII’s seek only short-term returns. When they pull their investments banks can face a shortage of funds.

FDI vs FII

Both FDI and FII are forms of foreign investment in a country. However, they are different in nature, target, and consequences.

FDI is a direct investment made in one particular business or company. The aim is to get a controlling interest in the business. FII, on the other hand, are funds which are invested in the foreign financial market.

There are many regulations and rules with respect to FDI. In fact, there are some industries like nuclear energy, agriculture etc. where there can be no foreign direct investment. But FII has very few barriers for entry or exit from the market.

FDI is not only transfer of funds or capital. There is a transfer of technology, R&D, know-how, strategies, technical knowledge, and many other such aspects. In the case of FII, only the transfer of funds is there.

As far as the economy in which the money is being invested, they would generally prefer FDI. Since FDI causes long-term economic growth by increasing the GDP of the country.

FII will increase the capital in an economy, but may not have a significant effect on the economic growth of a country.

In this context I am going to introduce two more concepts – Inbound and Outbound.

In forex trading, "Inbound" refers to money flowing into a country, meaning foreign currency is being exchanged for the domestic currency, while "Outbound" refers to money leaving a country, which means the domestic currency is being exchanged for foreign currency; essentially, it describes the direction of capital flow within a country's foreign exchange market,

Sekhar Pariti

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