Imperfect market theories and inflow of foreign direct investment

By Indra Giri on October 19, 2016

The current trends of foreign direct investment show a stark increase in Asian developing countries. However, the flow has been declining in other regions, especially in the developed economies. The inflow of foreign funds to India nearly doubled, reaching an estimated US$59 billion (Unctad 2015). Measures taken by the government to improve the investment climate have had a remarkable impact along with the business environment of the country. The emergence of India as one of the preferred investment location can be explained by imperfect market theory.

The imperfect market is characterized by information asymmetry, government intervention, barriers to entry and exit of firms, and differentiated products. It involves strategic decision making on the part of individual firms to invest with a risk factor (Mankiw 2009). In other words, the imperfect market is a market that fails to the standards set by Marshall for perfect markets. This is an attempt to link the theory of imperfect market proposed by economists over the period with the trends in capital flows to India. India is one of the top three FDI destinations according to the UNCTAD Business Survey in 2015.

2005 2010 2013 2014
FDI inflows 7621.77 27417.08 28199.45 34416.76
FDI outflows 2985.49 15947.43 1678.74 9848.44
Personal remittances, % of GDP 2.69 3.2 3.61 3.43

Financial Flows, India (In millions of dollars) (Source: Unctad 2015)

Industrial-organizational theory

The first theory of imperfect market which led to the flow of funds is the industrial organization theory. In the case of foreign investments, the major tasks faced by the investors for venturing in other countries was the competition from the local entities. This is due to the fact that the locals have a better understanding of the market in terms of ease of working, language, rules and regulations, and attitude. This competition can only be dealt favorably if the investment origin countries bring in superior technology in the process (Nayak & Choudhury 2014). When the large Multinational companies entered the Indian economy they not only brought funds but also other important modern technology. This includes superior management skills, brand names, marketing and management skills, and economies of scale. As a result, it helped them to overcome disadvantages from the changing environment.

According to the industrial organization theory, investors choose the host country depending on the comparative advantage of transportation and local regulatory trade barriers (Wilhelms et al. 1998). Many empirical studies have strongly advocated this theory as a major determinant of foreign direct investment. Also, the researchers have theoretically examined the reasons for it with respect to  individual case studies (Kinoshita et al. 1998; Wilhelms et al. 1998)

Internationalization theory in imperfect market conditions

Internationalization theory shifts the focus of the international investment theory from country-specific to industry-level. It focuses more on the determinants of foreign direct investment to generate business. Internationalization theory is also explained as internalization theories in the literature. These theories lead to a reduction in costs by increasing the number of transactions within subsidiaries.

A firm may choose to internalize by integrating backward and forward linkage. The output of one subsidiary can be used as an input to the production of another. Similarly, technology generated by one subsidiary can be input to another subsidiary (Nayak & Choudhury 2014). When internalization involve operations in different countries then it is known as foreign direct investment. This theory is combined with other principles like organizational behavior, location of the firm’s operations and theories of innovation which help firms to achieve greater benefits (Buckley & Casson 2009). Such theories are more market-driven and take advantage of transfer pricing, reduce risks, and increase profits.

Imperfect market theory of FDI and major companies investing in India
Major foreign investors in India ( 2000-2011) Source ( DIPP, 2015)

A study by Cortili et al. (2012) explores the characteristics of Italian foreign direct investment in India and provided a comprehensive empirical analysis. In terms of internationalization goals he concludes that the main aim of the Italian companies was a new market opportunity. Similarly, Park (2004) examined how Korean companies such as Hyundai Motors, have invested in India and formed joint ventures with Indian companies. They have also made greenfield investments in automobiles, consumer goods, and other sectors. Thereby, it can be seen that the Internationalisation theory has been playing an important role in attracting foreign funds in India.

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The eclectic or ownership, location and internalization (OLI) paradigm

The eclectic paradigm theory proposed by Dunning 1980, suggested that a firm will invest in foreign countries under three conditions:

  1. There are relative ownership advantages in comparison to other firms. Owner advantages specific to firms such as skills, R&D, marketing, scientific and technical works optimally utilized can overcome the additional costs of establishing production facilities. These advantages must be excludable to compete in a foreign market.
  2. The advantages of internalization is more beneficial than transferring them to foreign firms through lease or selling.
  3. Prevalence of locational advantages by ownership. This can be in terms of a large market to benefit from large scale economies, cheaper cost of production, superior infrastructure. Similarly, the presence of non-transferable advantages that can be used simultaneously by firms will also lead to the flow of funds in foreign countries (Ghosh 2014).

This theory synthesizes the above two theories added with locational benefits and is also called Ownership, Location, and Internalization (OLI) paradigm. When there are internationalization gains in absence of locational advantage by investing abroad, the obvious choice is the increase in production at home and export of produce. However, when firms having ownership experience and locational advantage, it is more profitable to produce abroad. Similarly, if there are no internalization gains then the firm is better off licensing its own advantage to foreign firms (Nayak & Choudhury 2014).

Very few researchers have attempted to study the relationship between the inflow of foreign direct investment and the OLI paradigm independently for the Indian scenario. However, a number of empirical studies related to the inflow and outflow of foreign capital consider this model as an important theory (Ghosh 2014; Adjabeng 2013).

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Foreign exchange rate theory

The foreign exchange rate is the relative strength of various currencies. High volatility of currency reflects economic instability and discourages the inflow of foreign funds and portrays uncertainty in the future.  A recent study by Khandare 2016, examined the impact of the exchange rate on foreign direct investment in India and China. Foreign direct investment in India increased by 458.89 times whereas in China is increased by 29.43 times both in absolute terms for the period 1991 to 2014.

At the same time, the exchange rate shows the 2.68 times decrease of the Indian rupee and 1.15 times decrease in Chinese Yuan in terms of the US dollar. Its findings concluded that there is a positive correlation between the inflow of foreign direct investment and the exchange rate in India. As per the study, one unit increase in the exchange rate will raise foreign investment by 0.605 units in India (Khandare 2016).

Above explained are the main determinant theories of foreign direct investment in an imperfect market theory conditions. Apart from these other factors may include political stability, taxation policy, inflation, trade policy among others. However, the actual flow of foreign funds depends on factors that may be country-specific, regional, or firm-specific. So, generalizations in this respect may not be totally fair to other cases.


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