Chapter III. Methodology and Concepts used in the study and Theories of FDI

Transcription

1 Chapter III Methodology and Concepts used in the study and Theories of FDI

2 78 CHAPTER III METHODOLOGY AND CONCEPTS USED IN THE STUDY AND THEORIES OF FDI This chapter consists of three sections. Section I relates to the methodology of the study, Section II describes the concepts used in the study and Section III depicts the theories of FDI. Section I METHODOLOGY OF THE STUDY The methodology used in the present study for the analysis of data in terms of: (i) Data Base and (ii) Tools of Analysis DATA BASE The present study entirely depends upon the secondary data published by the Secretariat for Industrial Assistance (SIA), Reserve Bank of India (RBI), United Nations Council for Trade and Development (UNCTAD) and Economic Survey of India PERIOD OF STUDY In the present study, the researcher tried to find out the impact of FDI inflows after liberalization and launching of Industrial Policy 1991 on the Indian economy, so the researcher has chosen the period of study from

3 In India, FDI regime has began to liberalize on the full scale mainly from 1991 and the Government of India announced a New Industrial Policy on July 24, SOURCES OF DATA (i) To review the first objective of the study namely policy framework of FDI in India, Data were collected from Department of Industrial Policy and Promotion, Ministry of Commerce and Industry and Government of India Reports. (ii) To analyse the second objective, namely the trends and pattern of foreign direct investment in India, the researcher has collected data from the RBI publications such as monthly Bulletin, Handbook of Statistics on Indian economy and from the publications of Secretariat for Industrial Assistance (SIA) namely SIA newsletter and SIA statistics. Both of them are official sources. RBI presents monthly and annual data on aggregated basis; SIA publishes both aggregated and disaggregated data. Hence, the researcher has used both the sources for discussing the second objective of the study. (iii) For the third objective that is, to analyse the sector-wise foreign direct investment inflows in India, data were collected from SIA news letter and SIA statistics. (iv) To analyse the fourth objective namely, the determinants of Foreign Direct Investment Inflows into various sectors of Indian economy; the

4 80 economic variables that are determining the foreign direct investment in India, Gross National Product, Export, Import, Debt GDP ratio, Foreign Exchange Reserves, Corporate Tax, Real Effective Exchange Rate and Consumer Price Index for the industrial labourers were collected from RBI Bulletin and Economic survey and Ministry of Finance, Government of India. (v) To analyse the fifth objective namely, causal nexus between FDI and Economic Growth in India, the researcher collected the FDI inflow and Gross Domestic Product at factor cost data from RBI Bulletin and Handbook of Statistics on Indian Economy. Thus, the present study depends on the data sources such as Reserve Bank of India, United Nations Council for Trade and Development, Secretariat for Industrial Assistance, Economic Survey and Centre for Monitoring Indian Economy.

5 81 TOOLS OF ANALYSIS 1. To study the first objective of the study namely, to review the India s Policy Framework on Foreign Direct Investment since Independence it has been discussed under four phases: (I) Phase I Receptive Attitude or Cautious Welcome Approach ( ) (II) Phase II Restrictive Attitude Approach ( ) (III) Phase III Gradual Liberalisation Approach ( ) (IV) Phase IV Open Door Policy (1991 onwards) The first objective has been described in detail in Chapter IV. 2. The Second objective namely, to trace the trends and pattern of Foreign Direct Investment Inflows in India during is discussed under the following heads: (i) (ii) (iii) (iv) (v) Foreign Investment Inflows in India Annual Inflows of FDI in India Country-wise Inflows of FDI into India Region-wise Inflows of FDI into India and Route-wise Inflows of FDI into India Percentage and averages are used to analyse the trends in FDI. To calculate the percentage change of FDI inflow over the previous year, a formula of the following form is used. Yt 1 - Yt 0 r = x100 Yt 0

6 82 Where, r represents percentage change over previous year Yt 1 represents current year FDI inflow Yt 0 represents previous year FDI inflow The measure of co-efficient of variation is the most commonly used measure of relative variations used to compare the variability of two or more series. Hence, the co-efficient of variation (CV) is applied in this study to assess and compare the relative volatility of FDI inflows. Coefficient of variation is estimated for Annual inflow of FDI and Foreign portfolio investment during the study period CV = σ x100 X Where, σ = coefficient of standard deviation X = mean value of the series Karl Pearson s co-efficient of correlation is used to calculate the correlation co-efficient between foreign direct investment and foreign portfolio investment. Karl Pearson s co-efficient of correlation is computed by using the following formula. r= xy 2 x x y 2

7 83 Where, r = Correlation co-efficient x = (X X ) y = (Y Y ) X and Y are mean values of x and y series. 3. The third objective of the study namely, to analyse the sector-wise foreign direct investment inflows in India A semi log linear regression model is used to compute compound growth rate for sector-wise foreign direct investment inflows in India. A semi log linear regression model of the following form is used. Where, Log Y = a + b t Log y = log of annual sector wise FDI inflow a = intercept; b = Co-efficient; t = time The following formula is used to compute the compound growth rate CGR = [(anti log b) 1] x The fourth objective of this study is to identify the determinants of Foreign Direct Investment Inflows into various sectors of Indian economy. The economic time-series data move together with related variables therefore if the researcher includes all the following variables

8 84 simultaneously in the equation there may be a possibility of multicolinearity. To identify the variables which may not be included simultaneously in the equation, a correlation matrix for all the expected explanatory variables and the dependent variables was obtained. Based on the correlation matrix nine variables were selected as possible explanatory variables. The researcher has used multiple regression models which captures the influence of all variables that are considered in this study. Thus, the multiple regression model used in this study takes the following form: FDI t = β 0 + β 1 GNP t-1 + β 2 C_GNP t + β 3 Ex + Β 4 Im+ β 5 Forex+ β 6 c_tax+ β 7 D_GDP+ β 8 REER+ β 9 C_wage+u Where, FDI t = Current year FDI inflow in India. β 0 = Constant β 1, β 2, β 3 β 9 are coefficient of explanatory variables. u = Error Term The variables are Market size proxy by GNP a year ago (GNP t-1 ) Market Potential proxy by Growth rate of real GNP (C_GNP t ) Export (Ex) Import (Im)

9 85 Foreign Exchange Reserves (Forex) Tax proxy by Corporate Tax (C_tax) Debt-GDP ratio proxy by Debt to GDP (D_GDP) Exchange Rate proxy by Real Effective Exchange Rate (REER) Cost of Labour proxy by Rate of change in the consumer price index for industrial labourers (C_wage) 5. The fifth objective of this study is to examine the causal nexus between Foreign Direct Investment and the economic growth. Granger s causality test is employed. Specifically, this study examines whether: (i) (ii) (iii) Economic Growth of a country drives the FDI inflow FDI leads the Economic Growth of a country and The two-way causal link between them Causality test might be interpreted as assessing whether another variable s lag either does or does not make a net significant incremental contribution to the movement of a dependent variable, once the own correlation of the dependent variable is taken into account. Before testing for causality, the presence of a unit root in the time series is tested by using the Augmented Dickey Fuller (ADF) test. The well known ADF test for the non-stationarity of the time series FDI / GDP t

10 86 (economic growth proxied by Gross Domestic Product) in the following form is used. t 1 n FDI = α + α T + δfdi + b FDI + ε (1) t o 1 t 1 i= t n GDP = λ + λ T + γgdp + θ GDP + ε (2) t o 1 i i= t where, FDI t and GDP t are dependent variables in current period is a difference operator T is the time trend and ε 1t and ε 2t are the disturbance term If the time series is found stationary, the classical Granger s causality test procedure (1969) can be applied to the relationship between FDI and GDP. But if they are found to be non-stationary, the test for co-integration has to be attempted. In order to test the existence of co-integration, the methodology t i t i 1t 2t developed by Engle and Granger (1987) is used. The co-integration equation takes the following form: FDI t = δ 0 + δ 1 + GDP t +u t (3) GDP t = λ 0 + λ 1 FDI t +u t (4) Where, FDI t and GDP t are dependent and D independent variables, and d denotes the number of differences in variables to get co-integration between variables. If U t of the above type of equation is I (0) or stationary, then the

11 87 variables are co-integrated at the specified (same in both variables) difference levels. It means they are on the same wavelength. The trend in both variables is canceled out. In case of co-integration, the causality is carried out within the framework of an Error Correction Model developed by Granger (1986) Engle and Granger (1987). The Error Correction Model links short run variations of the time series to the disequilibrium error (that is, the gap between actual behaviour and the long-run relationship given by the co-integration regression equation). The causality test equation based on Error correction model used in this study is the given below n n FDI t = GDPt i + βj FDI t i + u t 1 + ε1t (5) i= 1 j= 1 nt nt GDP t = λ FDI t i + λj GDPt i + u t 1 + ε2t (6) i= 1 j= 1 Where, = Number of differences in both variables to get co-integration u t 1 = One lag of estimated error term value from the respective co-integrated equations The existence of one co-integrating relationship between the two variables ensures that there existed at least one causality link between them. Testing for causality is therefore equivalent to testing for joint significance of the parameters on the assumed causal variables.

12 88 TESTING OF HYPOTHESES In this study, two hypotheses are framed. There are: Hypothesis I H 0 : There is positive relationship between FDI and FPI H 1 : There is no positive relationship between FDI and FPI This hypothesis is tested by computing Karl Pearson co-efficient of correlation and the level of significance is tested by using t test. Hypothesis II H 0 : FDI is less volatile than FPI H 1 : FDI is more volatile than FPI This hypothesis is verified by computing Co-efficient of variation.

13 89 Section - II CONCEPTS AND TERMS USED IN THE STUDY Acquisition (Company) Expansion of a company through the purchase of other businesses. If there are unincorporated, terms are agreed with the owners. If the other business is a public company, its shares are bought. Where some, but not all, of the shares of another company are bought, special rules govern the treatment of existing shareholders who do not wish to sell their holdings. Augmented Dickey-Fuller Test A test of the null hypothesis that a stochastic process is a random walk (possibly with drift and/or deterministic trend) against the alternative that it is stationary, under the assumption that the random disturbances in the model are white noise. An extension which accommodates some forms of serial correlation in the disturbances is the Augmented Dickey-Fuller (ADF) test. The test statistics under the null have non-standard distriubutions and their critical values are tabulated using computer simulations. Balance of Payment An overall statement of a country s economic transactions with the rest of the world over some period, often a year.

14 90 Capital Account A country s international transactions arising from changes in holdings of real and financial capital assets (but not income on them, which is in the current account). Includes FDI, plus changes in private and official holdings of stocks, bonds, loans, bank accounts and currencies. Debt Money owed by one person or organization to another. A debt contract states the term of borrowings: what interest and redemption payments the borrower must make, and what collateral must be provided. Debt contracts stipulate the currency in which payment is due; foreign currency debt is debt where the interest and redemption payments due are in some currency other than the debtor s own. Exchange Rate The price at which one country s currency trades for another, typically on the exchange market. Exchange Risk Uncertainty about the value of an asset, liability, or commitment due to uncertainty about the future value of an exchange rate. Unless the cover themselves in the forward market, traders with commitments to pay or receive foreign currency in the future bear exchange risk. So do holders of assets and liabilities denominated in foreign currency.

15 91 Export Goods and services produced in a country and sold to non-residents. Visible exports are goods sent abroad; invisible exports are services sold to non-residents. Equity Capital Finance for a company raised in exchange for a share of ownership. Ownership can take the form of a shareholding or of having the right to convert other financial instruments into shares. FDI Inflow Property located within the domestic country acquired by a foreign owner. FDI Outflow Property acquired abroad by a domestic owner. Financial Crisis A loss of confidence in a country s currency or other financial assets causing international investor to withdraw their funds from the country. Flow A flow, or flow variable, is an economic magnitude describing behaviour that occurs over time and is therefore meaningful only relative to the unit of time.

16 92 Examples are the value of exports (dollars per year), demand for foreign exchange (Euros per day), and migration (persons per month), contrasts with a stock. Foreign Aid Economic assistance from one country to another, the recipient typically being a less developed country. Foreign Institutional Investment An international investor based in another country, some countries place upper limits on the share of a domestic company that an FII can own. Foreign Portfolio Investment Portfolio investment across national borders and/ or across currencies. Foreign Investment The acquisition by residents of a country of assets abroad. These assets may be real, in the case of foreign direct investment, or financial, in the case of acquisition of foreign securities or bank deposits. Foreign investment may be carried out by the state or the private sector, and foreign securities acquired may represent private or government debt. Foreign Direct Investment The acquisition by residents of a country of real assets abroad. This may be done by remitting money abroad to be spent on acquiring land, constructing buildings, mines, or machinery, or buying existing foreign

17 businesses. Inward foreign direct investment similarly is acquisition by non-residents of real assets within a country. 93 Foreign Exchange Reserves Liquid assets held by a country s government or central bank for the purpose of intervening in the foreign exchange market. These include gold or convertible foreign currencies. Gross Domestic Capital Formation A measure of total investment, it thus includes investment in the country by companies owned by non-residents and excludes investment abroad by resident firms. Gross Domestic Product (GDP) The GDP of a country is defined as the total market value of all final goods and services produced within a country in a given period of time. Gross National Product (GNP) The GNP of a country is defined as the total market value of all final goods and services produced by the residents of this country in a given period of time. Horizontal FDI FDI by a firm to establish manufacturing facilities in multiple countries, all producing essentially the same thing but for their respective domestic or nearby markets. Contrasts with vertical FDI.

18 94 Import Goods and services bought by residents of a country but provided by non-residents. Visible imports are goods physically brought into the country. Imports of services, or invisible imports, may involve the supplier entering the country. Merger A combination of two or more firms into a single new firm. This takes over all assets and liabilities of the merging firms; shares in the new firm are divided between the share holders of the original firms on the agreed basis. Real Effective Exchange Rate (REER) The Real Effective Exchange Rate adjusted for inflation in each country. Trade The exchange of goods between two individuals or nations. Trade is the basic component of economic activity and is undertaken for mutual advantage. Vertical FDI FDI by a firm to establish manufacturing facilities in multiple countries, each producing a different input to, or stage of, the firm s production process.

19 95 Section III THEORIES OF FDI This section discusses the theories of foreign direct investment at macro level, micro level and development theories. THEORIES OF FOREIGN DIRECT INVESTMENT The earlier trade theories assumed that capital was immobile, but it is the movement of capital that has given rise to FDI across the globe. If there is competitive advantage to be gained multinational companies can and will get there with their investment. In order to understand the process of capital movement in the form of FDI several theories have been put forward by the economists. The FDI theories attempt to answer the following basic questions. 1. Who? (is the investor) 2. What? (the kind of Foreign Direct Investment) 3. Why? (are the MNCs investing) 4. Where? (is FDI going) 5. When? (to invest) 6. How? (the mode of entry) In the present study various theories propounded are analysed to answer the above questions.

20 96 FDI THEORIES AT THE MACRO LEVEL Capital Market Theory (1960) Capital Market Theory (1960) is one of the oldest theories of FDI which keeping with the classical tradition highlights the role of interest rate differentials and arbitrage as the explanatory variables for foreign direct investment. According to the Dynamic Macro Economic FDI Theory, FDI are a long term function of TNC strategies. The timing of investment depends on the changes in macroeconomic environment. FDI theory based on exchange rates studies the relationship between FDI flows and exchange rate changes. It states that FDI is a tool to reduce exchange rate risks. The Gravity Approach to FDI states that FDI flows are higher between countries that are geographically, economically and culturally closer. Mac Dougall Kemp Hypothesis (1962) Mac Dougall 1 Kemp 2 Hypothesis studied foreign investment in a macroeconomic environment. Assuming a two-country model, one being the investing country and the other being the host country and the price of the capital being equal to its marginal productivity, they explained that capital moves freely from a capital abundant country to a capital scarce country and in this way the marginal productivity of capital tends to get 1 2 G.D.A. Mac Dougall (1960), The Benefits and Costs of Private Investment from Abroad: A Theoretical Approach, Economic Record, Vol.36, No.73, pp M.C. Kemp (1962), Foreign Investment and the National Advantage, Economic Record, Vol.38, No.78, pp

21 equalized. This leads to improvement in efficiency in the use of resources that leads ultimately to an increase in welfare. 97 DEVELOPMENT THEORIES OF FDI Product Life Cycle Theory of Foreign Investment by Raymond Vernon 3 (1966) analyses the relationship between product life cycle and FDI flows. The theory states that FDI is seen mainly in the phases of maturity and decline in a product-life cycle. When a product enters the maturity Phase of it life cycle, multinational corporations shift the investment location to countries which offer the advantage of lower costs of production. By taking the product which is in decline phase in the home country to new markets/ developing countries MNCs also increase the survivability of the product. According to Prof. Jagadish Bhagwati this theory explains FDI in most cases where there is a shift of investment location mainly to reduce costs by exploiting foreign factor costs and thus increase the survivability of the product in a competitive struggle. The Japanese FDI theories were mainly developed in the 1970s and one of its main proponents was Terumoto Ozawa. He analysed the relationship of FDI, competitiveness and economic development. According to him there are three phases of development and each has different impact of FDI flows. 3 Raymond Vernon (1966), International Investment and International Trade in the Product Cycle, Quarterly Journal of Economics, Vol.80, No.2, May, pp

22 98 I Phase of Economic Growth the country is underdeveloped and foreign investment comes mainly to exploit the potential advantage especially of low labour costs. II Phase of Economic Growth the growing internal markets and rising standard of living draws new FDI. III Phase of Economic Growth FDI is motivated by the market and technology factors and competitiveness is based on innovation. The Five Stage Theory of John Dunning Studies (1981) The Five Stage Theory of John Dunning 4, the FDI inflow and outflow based on the stages of development in an economy. According to the theory there are five stages in economic development of a country and its impact on FDI flows in as follows, Stage I low incoming FDI and as domestic companies have no specific advantages on outgoing FDI. Stage II growing incoming FDI due to advantage especially of low labour costs with rising standard of living. More MNCs are attracted to the country. Stage III still strong FDI inflows, but their nature is changing due to rising wages. With domestic companies getting stronger and developing their competitive advantage FDI outflows take off. 4 Dunning, J.H (1981), Explaining International Production, Union Hyman, London, _ (1998) The Theory of Transnational Corporations, Transnational Corporations, Department of Economic and Social Development, Management Division, You.

23 99 Stage IV strong FDI outflow seeking advantage abroad particularly of low labour costs. Stage V FDI inflows and outflows are at equilibrium. FDI THEORIES BASED ON CURRENCY APPROACHES Aliber 5 Theory (1971) postulates that internationalization of firms can be best explained in terms of the relative strengths of different currencies. Firms from strong currency country; income stream is fraught with greater exchange risk. As a result, the income of the strong-currency country is capitalized at a higher rate. In other words, such a firm is able to acquire a large segment of income generation in the weak-currency country corporate sector. Although Aliber s hypothesis has stood up to empirical testing it fails to explain why there is FDI in same currency area. Kenneth Froot and Jermy Stein s Theory (1989) Kenneth Froot and Jermy Stein s 6 Theory is based on the strength of the currency. According to them depreciation in the real value of a currency of a country lowers the wealth of the domestic residents of vis-àvis the wealth of foreign residents. As a result, it is cheaper for the foreign firms to acquire assets of the domestic firms. Thus changes in the value of the currency are one of the determinants of FDI. 5 6 Aliber, R.Z (1971), The Multinational Enterprise in Multiple Currency World in J.H. Dunning (ed), The Multinational Enterprise (London: George Allen and Unwin), pp Froot, K.A. and J.C. Stein (1989), Exchange Rates and Foreign Direct Investment: An Imperfect Capital Market Approach, Cambridge National Bureau of Economic Research (NBER), Working Paper No.2914

24 100 Richard Caves Theory (1988) Richard Caves 7 Theory puts forth channels through which exchange rates influences FDI. Firstly, the changes in exchange rate influence the cost and revenue stream of a firm. If the domestic currency depreciates, the import bill will inflate diminishing the net income. But with depreciation if exports increase the net income will rise. Secondly, exchange rate changes influences FDI by giving rise to capital gains. Depreciation in the value of currency, which is expected to be reversed in the near future, will lead to capital gains following appreciation. In lure of gains, foreign capital will flow in. FDI THEORIES AT MICRO LEVEL Stephen Hymer s Theory of Imperfect Markets (1960) Stephen Hymer s 8 Theory of Imperfect Markets states that most foreign direct investments are undertaken by oligopolistic industries. The imperfections in the market in the form of product differentiation, marketing and managerial skills, economies of scale, better access to capital etc., confer certain advantages on MNCs over their competitors and also compensates for the additional cost of operating in an unfamiliar 7 8 Caves, R.E. (1971), International Corporations: The Industrial Economies of Foreign Investment, Transnational Corporations, Vol.38, pp.5-6, Harvard Institute of Economic Research (1988), Exchange Rate Movements and FDI in the United States, Discussion Paper, No Hymer, S.H. (1976), The International operations of National Firms: A study of Direct Investment, MIT Press, Cambridge.

25 101 environment. Multi-National Corporation (MNC) is a typically oligopolistic firm that enjoys certain firm specific advantages which are mainly technological advantages which enable a firm to produce new differentiated product. The possession of knowledge enables the firm to develop special marketing skills, superior organizational and management set-up and improved processing. It is the firm specific advantages over its competitors that help MNCs to maximize profits in the host nations despite disadvantages like lack of knowledge of language, culture, legal system, consumer preferences etc. The imperfect nature of the market prevents rival firms from availing technological advances and MNCs reap profits. The Hymer Kindleberger Theory (1969) The Hymer Kindleberger 9 Theory states that foreign owned firm would make an investment in the host country only if it possesses some compensating advantages. These advantages permit the MNCs to compete on equal terms with the indigenous firms. This is, however, not a sufficient condition for FDI since the firm has the option of licensing the advantage (technology) to an indigenous producer or exporting the product to host country. Hence certain conditions need to be satisfied for FDI to take place and they are, (i) The advantage is internally transferable that is it can be exploited by a subsidiary of the parent firm without any additional cost. 9 Kindleberger, C.P. (1969), American Business Abroad, Yale University Press, New Havens.

26 102 (ii) It is more profitable for the foreign owned firm to exploit the advantages by itself than to license it to an indigenous producer. (iii) Exporting the product to the host country is not profitable due to controls like taxes or transport cost barriers. F.T. Knick Bocker s Theory of Oligopolistic Reaction and Multinational Enterprise (1973) F.T. Knick Bocker s 10 Theory of Oligopolistic Reaction and Multinational Enterprise studied the relationship between FDI and rivalry in oligopolistic industries. Oligopoly industry is characterized by a great deal on interdependency and therefore imitative behaviour among firm is common. The same kind of imitative behaviour characterizes FDI. For example, Toyota and Nissan responded to Honda s investments in USA and Europe by undertaking their own investments in USA and Europe. The theory explains imitative FDI behaviour by firm but fails to explain why a firm decides to undertake FDI rather than export or license. Hood and Young s Location Specific Theory (1979) Hood and Young s 11 Location Specific Theory explained the where of foreign investment. The theory refers to advantages like cheap labour, abundant raw material and so on for the production of a commodity to be Knick Bocker, T. (1973), Oligopolistic Reaction and the Multinational Enterprise, Boston- Harvard Graduate School of Administration. Hood, N. and S. Young (1979), The Economies of Multinational Enterprise, Longman, London, pp

27 103 established in a particular location or country. Foreign investment may flow into countries which have import restrictions or trade barriers or to countries which offer the advantage of cheap abundant raw materials. The Eclectic Theory or OLI Paradigm of John Dunning (1988) The Eclectic Theory or OLI Paradigm of John Dunning 12 is one of the most popular theories of FDI. The theory states that when a firm enjoys three types of advantages ownership, localization and internationalization it goes for foreign direct investment. OLI paradigm answers the main question of why, where and how of FDI is an integrated framework. (i) O Ownership Advantages: to operate in foreign markets, firm must possess firm specific advantages which are not shared by their competitors. The firm specific or ownership advantages are knowledge capital (human capital, patents technologies and brand name), economies of scale and monopolistic advantages like privileged access to input and output markets through patents rights, monopoly control over natural resources etc. Ownership advantages can be easily transferred within the firm without high transaction costs and easily replicated in different countries without losing its value. (ii) L Localization Advantages: to fully exploit the O advantages the firm must choose a country, that is, conducive to exploit these 12 Dunning, J.H (1988), Explaining International Production, Union Hyman, London, (1998) The Theory of Transnational Corporations, Transnational Corporations, Department of Economic and Social Development, Management Division, You.

28 104 advantages. The localization advantages could be producing close to consumers, saving transport cost, obtaining cheap inputs, jumping trade barriers, etc. The firm can enjoy the O advantages in a country offering L advantages by arms length transactions such as export/ license/ franchise. (iii) I Internationalization Advantages: FDI can come in the form of arms length transactions when it enjoys the O and L advantages. But these have severe limitations that is, trade barriers, transaction costs, pilferage or leakage of technology, risk of broken contracts, time lags and low productivity and quality by franchises/ licenses. Therefore the internationalization route is more attractive. By opting for a joint venture or fully owned subsidiary in a foreign country MNC can fully exploit its O and L advantages. Thus according to OLI theory when firm enjoys only ownership and localization advantages it results in arms length business deals. Only when it enjoys all the three advantages that is ownership, localization and internalization FDI takes place. Buckley and Casson s Theory of Internationalization (1991) Buckley and Casson s 13 Theory of Internationalization states that foreign investment is the result of the decision of a firm to internalize a 13 Buckley, P.I and Casson, M. (1991), The Future of Multinational Enterprise, Mc Millan, London.

29 105 superior knowledge that is keeping the knowledge within the firm to maintain the competitive advantage. If a firm decides to externalize it s know how by licensing to a foreign firm then it does not make any FDI. But it decides to internalize then it must invest abroad in production facilities. The internalization benefits which manifest in the cost-free intrafirm transfer of technology or any other knowledge motivates a firm to go international. There are several stages of internalization in a firm s evolution to making foreign direct investment and they are, (i) Establish at home (ii) Arms length transactions overseas that is export or licensing. (iii) (iv) (v) (vi) Establish sales outlet in psychologically closer markets. Establish sales outlet in other markets. Foreign direct investment in psychologically closer countries. Foreign direct investment in other countries. Political Economic Theories The Politico-economic theories concentrate on political risk. Political stability in the host countries leads to foreign investment (Fetehi-Sedah and Safizedh, 1989) 14. Similarly political instability in the home country encourages investment in foreign countries (Tallman, 14 Fatehi Sedah, K. and M.H. Safizedah (1989), Association Between Political Instability and the Flow of FDI, Management International Review, Vol.29, pp

30 ) 15. However, Schneider and Frey (1985) 16 believed that the theory underlying the political determinants of FDI is less well-developed than those involving economic determinants. The political factors are only additive ones influencing foreign investment. To conclude the theoretical framework of FDI highlights the fact that FDI decisions are guided both by economic and non-economic factors Tallman, S.B. (1988), Home Country Political Risk and FDI in the United States, Journal of International Business Studies, Vol.19, pp Schneider, F and B.S. Frey (1985), Economic and Political Determinants of FDI, World Development, Vol.3, pp