08 April 2012 Written by  Tesfaye Abate

Types of Investment

Investment may be categorized differently. From the standpoint of an individual, two types of investment may be distinguished: investment in the means of production, and purely financial investment. Both types may provide a monetary return to the investor. However, from the standpoint of the entire economy, purely financial investments appear only as title transfers, and do not constitute an addition to productive capacity.[1]

 

Investment may also be grouped into foreign (international) and local (domestic) investment. The classification of investment into foreign and domestic depends on the identity of the investor because the identity of the investor would attract several legal consequences. The identity of the investor poses different policy considerations, and this in turn attracts several legal manifestations.

 

Foreign investment is an investment by a foreign investor while a domestic investment is an investment by a domestic investor.

Foreign Investor- who is foreign investor? See Article 2(6) of Proclamation No 280/2002.

A foreign investor is one who is a foreigner not permanently residing in Ethiopia and who invests capital obtained from foreign sources or reinvests profits accruing to her/him from investment already made in Ethiopia or

A foreigner who is an Ethiopian by origin and chooses to be treated as a foreign investor and invests capital s/he raised abroad, or reinvests profits made in Ethiopia from previous foreign investment; or

An Ethiopian permanently residing abroad and chooses to be treated as a foreign investor and invests capital obtained outside Ethiopia, or reinvests profits obtained from prior foreign investment in Ethiopia, or an enterprise owned by foreign nationals who invest capital raised abroad or reinvest profits made from previous foreign investment in Ethiopia.

In general, investment made by a foreign investor is a foreign investment.

 

Foreign investment “involves the transfer of tangible or intangible assets from one country into another for the purpose of use in that country to generate wealth under the total or partial control of the owner of the assets”.[2] We observe, from this definition, that transfer of intangible asset is an essential element. Intangible assets include intellectual property rights, such as patents, copyrights, know how etc. In addition, foreign investment also includes transfer of tangible assets. The purpose of transferring tangible and intangible assets to another country is to generate wealth. Generating wealth indicates that foreign investment is profitable.

 

The term ‘foreign investment’ may also be defined as: “A transfer of funds or materials from one country (called the capital exporting country) to another country (called the host country) in return for a direct or indirect participation in the earnings of that enterprise.”[3]

 

What are the essential elements of this definition? The first essential point with regard to this definition is that it involves transfer of funds or materials. Fund denotes “the sum of money or other liquid assets established for the purpose of” investment in another country [Garner; 2004:696]. The foreign investor will transfer this fund from his/her country to another. Thus, we have two countries which involve in the transaction of foreign investment. They are: capital exporting country and host country. A capital exporting country is a state (country) from where the investor sends his/her its funds/and/or materials to invest while a host country is a country where the investment is made. In other words, a country where the fund and materials reach and the actual investment takes place is a host country. A capital exploring country is also called “home state”.[4]

The main purpose of foreign investment, according to the above definition, is to participate in the earnings of the enterprise. In other words, investment is made with the main purpose to accrue a benefit from the investment.

 

Foreign investment may be either foreign direct investment or portfolio investment.

Foreign Direct investment (FDI) is investment that is made to acquire a lasting interest the investor’s purpose being to have an effective choice in the management of the enterprise. To be more specific, a foreign direct investment is ownership of assets by foreign residents for the purpose of controlling the use of these assets.[5] In case of foreign direct investment, the foreign investor directly controls his/her assets that are made on investment in host country. For example, John is an American investor who invests on flowers in Ethiopia. He has expended Birr 1.5 million on the investment. He recruits staff working for his investment, like the guardian, secretary, flower cutters and soon. Thus, John has exerced the right of ownership over his assets directly.  Therefore, the investment is foreign direct investment.

 

According to the United Nations (UN), an investor is said to have the controlling power over the investment where s/he/it has ten percent (10%) or more of the voting powers in the firm. This is to indicate the power of the investor to decide upon the affairs of the investment. In other words, controlling the investment refers to the power to exert control on the management of the affairs of the enterprise.

 

The power to control the management of the enterprise could vary according to the type of business organization in question. For example, in cases of partnership, all shareholders have equal voting powers irrespective of their contribution unless otherwise agreed.[6] Thus, according to the principle of management of partnership, a person who contributed 1000 Birr will have equal voting power as another who contributed 100,000 Birr. However, our commercial code gives the liberty for shareholders (partners) to agree that the voting power should be as equal as the amount of the contribution of each partner.

 

On the contrary, the power of voting depends on the amount of contribution of each shareholder in case of companies. For example, according to Article 535(1) of the Commercial Code, a majority is a “majority of members representing more than one half of the capital” of the private limited company. Similarly, a shareholder in a share company has a voting power depending on the proportion to the amount of capital contributed (Art. 407(1) of the Commercial Code). For example, Azeb has contributed Birr 500 to a share company while Zinash contributed Birr 150,000 to the same company. Consequently, Zinash has the power of voting 300 times more than that of Azeb.

 

Therefore, the UN threshold of 10% of voting rights would be meaningful with regard to companies under Ethiopian law, and it would be otherwise in case of partnerships devoid of the agreement.

 

The second criterion to determine foreign direct investment is that it is made to acquire lasting interests. This means that foreign investment is made for long term.

 

What do you understand by lasting interest? Or long-term investment? In fact, there are no specific yardsticks to determine whether or not a given investment is lasting. However, we can take into account the intention of the investor. If the intent of the investor is invest for a long period of time, that would indicate the intent of such investor is to acquire a lasting interest from the investment. The amount of investment may also indicate whether or not the investment is lasting. The sector of the investment would also indicate the nature of the investment. For example, investment made on factories in general could be regarded as a long-term one  since it could not be accomplished during a short period of time.

In a foreign direct investment, the investor is entitled to protection of both the domestic law of the host state and the diplomatic protection of the home state from which it was exported[7]

 

Why such double protection is granted to a direct foreign investment?

First and for most, a foreign investor uses the economy that would have been used to advance the economy of the home state. In other words, if the investor were not investing the capital in a host country, it would have been used to promote the development of the capital exporting country.[8] For example, Mike and his two friends invest on the pharmaceutical sector in Ethiopia with a capital of 5 million Birr. There is a general presumption that if Mike and his friends did not invest such capital in Ethiopia, they would invest it in their country, they are using the wealth of their country to invest in Ethiopia. In general, foreign investors use the wealth of their country. Therefore, the home state is justified in ensuring that the resources invested in a foreign country (host state) are protected.

 

In addition, investment by its very nature requires the continuous presence of the investor and his/her its capital in the hose state.[9] Then, this requires or necessitates the protection for the person(s) (the investor) and the capital that is invested. For example, the investors should spend a certain period in the host state so long as the investment continues. To perform the investment peacefully, legal protection is essential. We have seen that personnel and the plant for the investment should be present for a long period of time in the host state. The enterprise (or the plant),as a property needs protection. Moreover, the personnel require legal protection: their rights should be protected while they are at work.

 

Further, the investment is made for the good of both nations. The investment made in the host state definitely will enhance the economic development of the host state. It would create an employment opportunity for the residents of the host state. The benefits accrue from the investment will not eventuate in the absence of such investment.[10] The capital exporting state will benefit from the profits that accrue from the investment because the investor is entitled to take the profits to his/her/ its home.

 

Foreign direct investments are made largely by multinational corporations. Multinational corporations are large business organizations so the sum of money invested is large. Further, those multinational corporations will implement a global strategy in making foreign investment. Consequently, controlling is essential for the implementation of the global strategy[11]

 

We have seen that in foreign direct investment, it is necessary for the investor to be present physically in the host state. The foreign investment has to be held in the host economy since it operates there. This will create  the conducive environment for the investor to be active participant in the economic and political process of the host state.[12]

In foreign direct investment, there is a movement of people and property from one state to another, and such movement has potential for conflict between the two states. The investor needs to keep secret the competitive advantages of that state to maximize the profit. Similarly, the host state requires to acquire a lot out of the investment such competitive interests require the protection of both the interest of the investor and the host state. Personnel attract diplomatic protection wile the property requires equal protection. Thus, it is argued that the right of alien can be extended to the protection of foreign investment. At this juncture, it is important to note that the roles of international law on foreign investment lie in the effort to extend diplomatic protection to the assets of the alien. However, this argument was criticized on the ground that it leads to unwarranted interference in the domestic affairs of the host state.[13]

Portfolio Investment- “is a movement of money for the purpose of buying shares in a company formed or functioning in another country.[14] The World Bank defines portfolio flows as consisting of “bonds, equity (comprising direct stock market purchases, American Depository Receipts (ADRs), and country funds), and money market instruments (such as certificates of deposits (CDs) and commercial paper”.[15] As we can see from these definitions, in portfolio investment, the investor purchases shares from the host country business organization. The nature of portfolio investment does not offer the opportunity to control the business organization. In other words, in portfolio investment, there is a divorce between management and control of the company and the share ownership in it.[16]

Domestic Investor-Proclamation  No 280/2002 Art 2(5) defines domestic investor as:

An Ethiopian or a foreign national permanently residing in Ethiopia having made an investment, and includes the Government, Public enterprises as well as a foreign national, Ethiopian by birth, and desiring to be considered as a domestic investor.

From this definition, we can gsee that for an investor to be regarded as a domestic investor s/he or it must either be 1) An Ethiopian national; or 2) A foreigner who is a permanent resident of Ethiopia; or 3) A person of Ethiopian origin who is no longer an Ethiopian national even where s/he does not live in Ethiopia so long as s/he chooses to be treated as a domestic investor; Or 4) Public enterprises which according to Proclamation No. 25/1992, business entities owned by the Ethiopian Government or  regional governments or other state entities in Ethiopia. In short, they are publicly owned business entities.[17]

In general, we have seen that investment may be categorized as foreign and domestic. Foreign investment may further be classified into foreign direct investment and foreign portfolio investment.

FACTORS THAT AFFECT THE DIRECTION OF FOREIGN DIRECT INVESTMENT

 

Why do you think investors wish required to invest abroad? Researchers have examined this issue almost for forty (40) years and the following three points have been forwarded as reasons for foreign investment. The first reason is that multinational companies own assets that can be profitably exploited on a comparatively large scale, organizational and managerial skills, and marketing net works. In other words, foreign investment is attractive to those who own a large amount of money and managerial skills. Secondly, the profit that could be gained from investing abroad is greater than that could be gained from the home country. Thirdly, investors decide to undertake foreign direct investment (FDI) where it is preferable to licensing the production.[18] In general, foreign investment is more profitable to the investor than domestic investment, and this attracts foreign investors.

 

There are also economic factors that determine the FDI. They are: A) market-seeking-FDIs are made in seeking market for goods and services; B) Resource/asset seeking-investors require resources or assets to produce, and therefore, they will invest in locations where resources or assets are available; C) Efficiency seeking is another factor stimulating foreign direct investment. Thus investors will undertake investments where the production is efficient in terms of cost.[19]

 

Economists have developed different theories to explain the factors that affect the direction of foreign investment. What are these theories? Let us discuss the most important ones.

 

Transportation costs-it becomes unprofitable to ship some products a long distance when transportation costs are added to production costs. For example, Cemex has undertaken FDI rather than exporting the product.  It is essential to note that transportation costs have little impact on the relative attractiveness of FDI on electronic components, personal computers, medical equipment, computer software, etc because transport costs are very minor.[20]

 

2) Market Imperfections (internalization theory) - Market imperfections provide a major explanation of why enterprises may prefer FDI to either exporting or licensing. What are market imperfections? Factors that inhibit market from working perfectly are called market imperfections. A market imperfection that is favoured by most economists is referred to as internalization theory.[21]

 

Market imperfections may arise where there are impediments to the free flow of products between nations. Thus, impediments to the free flow of products between nations decrease the profitability of exporting the products. Whenever there are market impediments, investors may opt for FDI.[22]

 

3) Competition strategy –Another theory that explains FDI is that FDI flows are a reflection of strategic rivalry between enterprises in the global market. If one enterprise cuts prices, another competitor will also do the same. On the other hand, if one raises prices, the others follow to retain their market share. Knicker Bocker argued that the same kind of imitative behaviour takes place in FDI. For instance, Toyota and Nissan responded to investment by Honda in the United States of America and Europe by undertaking their own FDI in the countries.[23]

 

It is also observable that Fuji is compelled to follow Kodak to ensure that Kodak does not gain a dominant position in the foreign market. Therefore, Fuji invests in a country where Kodak invests with the intention of not allowing Kodak to take the advantage of FDI.[24]

 

4) The Product Life Cycle –Raymond Vernon’s product life-cycle theory is also used to explain FDI. According to Vernon, an enterprise that is a pioneer in its home markets may undertake FDI to produce a product for consumption in a foreign market. For example, Xerox which produced photocopier in the United States of America, invests in Japan (Figi-Xerox) and Great Britain (Rank Xerox) to serve those markets. Then they shift their production to developing countries to satisfy the demands where labour costs are lower to produce.[25]

 

According to Vernon’s theory, firms invest in a foreign country when demand in that country will support local production, and they invest in low-cost locations. Thus, investors  invest in developing countries where production cost is low. However, it is worth noting that a large demand in a foreign country does not necessitate foreign direct investment. It may be more profitable to license instead of FDI for the production of the product.[26]

 

5) LocationSpecific advantages –According to John Dunning, location specific advantages can help to explain FDI in addition to the various factors we discussed above. Location specific advantages are advantages that arise from using local natural resources and know-how that helps the investor to produce. Dunning refers to this argument as the eclectic paradigm.[27]

 

For example, an investor will invest in a country where oil as a natural resource is abundant. In addition, an investor may invest in a country where there is low-cost highly skilled labour.

 

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[1] The New Encyclopaedia Britannica; Vol  6, 2003, Pp.  363

[2] M. Sornarajah; The International Law on Foreign Investment, Grotius Publications, Cambridge University Press, New York, 1996, p 4

[3]

[4] II SD Model International Agreement on Investment for Sustainable Development; 2005, Art. 2(I)

[5]Sornarajah; Ibid, p. 4

[6] Commercial Code  of the Empire of Ethiopia, Proclamation  No. 166 of 1960, Negarit Gazeta, 19th Year No. 3, Addis Ababa, 5th May 1960, Art. 234

[7] M. Sornarajah; Ibid, p. 5

[8] Ibid

[9] Ibid.

[10] Ibid, p 5-6

[11] Ibid, p. 6

[12] Ibid

[13] Ibid, p. 8

[14] Sornarajah; Ibid, p. 4

[15] Bhalla and Ramu; Ibid, p. 516

[16] Sornarajah,  Ibid, p. 4

[17] See Seyoum; Ibid, p. 5-6

[18] (?), Trade and Foreign Direct Investment: (?), P. 50

[19] Gibrehiwot Ageba, Investment; (Unpublished), 1999, Pp.10-11

[20] Charles W. L.  Hill; International Business: Competing in the global Market (Fourth Edition), Tata McGraw-Hill Publishing Company Limited, New Delhi, 2003, p. 213

[21] Ibid, p. 214

[22] Ibid

[23] Ibid, p. 216

[24] Ibid, Pp. 216-17

[25]Ibid, p.27

[26] Ibid

[27] Ibid, p 218

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Last modified on Friday, 07 February 2014 14:11