Model Answer
0 min readIntroduction
Globalization has led to increased cross-border capital flows, primarily through Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). Both are crucial for economic development, but they differ significantly in terms of control, duration, and risk. Understanding these differences, alongside theories explaining FDI patterns like the Product Life Cycle theory, is vital for policymakers aiming to attract beneficial foreign capital. India, for instance, has actively promoted FDI through policy reforms, witnessing a substantial inflow in recent years, reaching $84.835 billion in FY23-24 (DPIIT data).
Foreign Direct Investment (FDI)
FDI refers to an investment made by a firm or individual in one country into business interests located in another country. It involves establishing business operations or acquiring substantial ownership in existing foreign firms. FDI is typically long-term and reflects a lasting interest in the foreign economy.
Foreign Portfolio Investment (FPI)
FPI involves the purchase of financial assets, such as stocks and bonds, in a foreign country without acquiring controlling ownership. FPI is generally short-term, driven by financial returns, and characterized by higher liquidity and volatility compared to FDI.
Differences between FDI and FPI
| Feature | Foreign Direct Investment (FDI) | Foreign Portfolio Investment (FPI) |
|---|---|---|
| Control | Significant control or ownership | No control or minimal influence |
| Duration | Long-term commitment | Short-term investment |
| Risk | Lower risk due to direct involvement | Higher risk due to market volatility |
| Liquidity | Lower liquidity | Higher liquidity |
| Motivation | Market access, resource seeking, efficiency seeking | Financial returns, diversification |
The Product Life Cycle (PLC) Theory of FDI
The Product Life Cycle (PLC) theory, developed by Raymond Vernon in 1966, explains the pattern of FDI based on the stages a product goes through – introduction, growth, maturity, and decline. It suggests that the location of production shifts as a product matures.
Stage 1: Introduction
Initially, the product is produced and sold in the innovator country (typically developed nations). FDI is minimal at this stage as the company focuses on domestic production and market development. Demand is limited, and production costs are high.
Example: The initial production of smartphones was concentrated in the US and Japan.
Stage 2: Growth
As demand grows, the innovator country begins to export the product to other developed countries. FDI starts to emerge as companies establish sales subsidiaries in foreign markets to facilitate distribution and marketing.
Example: As smartphones gained popularity, companies like Apple and Samsung established sales and marketing operations in Europe.
Stage 3: Maturity
Demand plateaus in developed countries, and the product becomes standardized. Production shifts to developing countries with lower labor costs to maintain competitiveness. This is the stage where significant FDI occurs, with companies establishing production facilities in these countries.
Example: The majority of smartphone manufacturing now takes place in countries like China and Vietnam.
Stage 4: Decline
Demand declines in all markets. Production may be consolidated in a few low-cost locations, or the product may be discontinued. FDI may decrease as companies exit markets or reduce production capacity.
Example: Production of older generation mobile phones has largely shifted to very low-cost manufacturing locations or ceased altogether.
Conclusion
In conclusion, FDI and FPI represent distinct forms of international investment, differing in control, duration, and risk profiles. The Product Life Cycle theory provides a valuable framework for understanding the evolution of FDI patterns, demonstrating how production locations shift as products mature and become standardized. Understanding these dynamics is crucial for governments seeking to attract FDI and promote sustainable economic growth, particularly in the context of global value chains and evolving technological landscapes.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.