Foreign Direct Investment (FDI): Basics, Concepts, Case Studies

Foreign direct investment (FDI) is where an individual or business from one nation, invests in another. This could be to start a new business or invest in an existing foreign owned business.

FDI implies that the investor exerts a significant degree of influence on the management of the enterprise resident in the other economy. Such investment involves both the initial transaction between the two entities and all subsequent transactions between them and among foreign affiliates, both incorporated and unincorporated. FDI may be undertaken by individuals as well as business entities.

However, when it comes to investing in foreign companies’ assests, the definition is slightly different.
According to the IMF, a foreign direct investment is where the investor purchases over a 10 percent stake in the company.

Foreign direct investment are the net inflows of investment to acquire a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor. It is the sum of equity capital, reinvestment of earnings, other long-term capital, and short-term capital as shown in the balance of payments.(WorldBank, 2019).

Anything under this amount is classed as part of a ‘stock portfolio’. For instance, this covers the small amount of stocks that the average citizen may have invested. Essentially, anything too small to influence any level of control of the firm.

Components of FDI

FDI has three components: equity capital, reinvested earnings and intra-company loans.

Equity capital is the foreign direct investor’s purchase of shares of an enterprise in a country other than its own.

Reinvested earnings comprise the direct investor’s share (in proportion to direct equity participation) of earnings not distributed as dividends by affiliates, or earnings not remitted to the direct investor. Such retained profits by affiliates are reinvested.

Intra-company loans or intra-company debt transactions refer to short- or long-term borrowing and lending of funds between direct investors (parent enterprises) and affiliate enterprises.

Types of FDI

Inward FDI: Inward FDI is foreign direct investment by a foreign firm establishing a facility within the domestic country. (IMF/OECD (2008)
Outward FDI: Outward FDI is defined the investment located within the domestic country that is acquired by a foreign owner (IMF/OECD, 2008).
Horizontal FDI: Horizontal FDI is where funds are invested abroad in the same industry. In other words, a business invests in a foreign firm that produces similar goods. For instance Nike, a US based firm, may purchase Puma, a Germany based firm. They are both in the industry of sportswear and therefore would be classified as a form of horizontal FDI.
Vertical FDI: Vertical FDI is where an investment is made within the supply chain, but not directly in the same industry. In other words, a business invests in a foreign firm that it may supply or sell too.
For instance, Hersheys, a US chocolate manufacturer, may look to invest in cocoa producers in Brazil. This is known as backwards vertical integration because the firm is purchasing a supplier, or potential supplier, in the supply chain.
We then have forwards vertical integration. So this is where a firm invests in a foreign company that is further along in the supply chain. For instance, Hersheys may look to purchase a share in Alibaba; where it sells its products.
Conglomerate FDI: Conglomerate FDI is where an investment is made in a completely different industry. In other words, it is not linked in any direct way to the investors business. For instance, Walmart, a US retailer, may invest in BMW, a German automobile manufacturer. This may seem strange to some but offers big businesses an opportunity to expand and diversify into new areas. To explain, some big businesses come to a point where the demand for its fundamental business starts to decline. In order to survive, it must invest in new ventures. Even big businesses with strong demand may look to new industries where growth and return on investment are significantly larger.

Benefits of FDI

Boost to International Trade

Foreign direct investment promotes international trade as it allows production to flow to parts of the world which are more cost effective. For instance, Apple was able to conduct FDI into China to assist with the manufacturing of its products.

However, many of the components are also shipped in from elsewhere, generally from the region of Asia. For instance, the camera is made by Sony, which sources its manufacturing in Taiwan. There is also the case of the flash memory, which is sourced by Toshiba in Japan. We also have the touch ID sensor which is made in Taiwan, and the chipsets and processors, which are made by Samsung in South Korea and Taiwan.

These are but a small handful of the components, but demonstrate how inter- connected the supply chain has become between countries. Both Samsung And Sony have conducted investment in the likes of Taiwan, China, and Japan. As a result, it has created new jobs in the region and boosted trade between the nations.

Reduced Regional and Global Tensions

As we have seen with the Apple example, a supply chain is created between countries. In part, this is created by the division of labor. For instance, South Korea may make the batteries, Taiwan the ID sensors, and Japan the cameras. As a result, they are all dependent on each other.

If there is a revolt in Taiwan, the whole process could fall apart. Without the ID sensors, the final product cannot be made, so the need for other components is also reduced. This means workers in Japan and South Korea are also affected.

As a result of this interconnected supply chain, it is in the interest of all parties to ensure the stability of its trading partners. So FDI can create a level of dependency between countries, which in turn can create a level of peace.

To use a famous metaphor, you don’t bite the hand that feeds you. In other words, if nations are reliant on each other for their income, then the likelihood of war is also reduced.

Sharing of Technology, Knowledge, and Culture

Foreign direct investment allows the transfer of technology, knowledge, and culture. For instance, when a firm from the US invests in another from India, it has a say in how the firm is run. It is in its interest to ensure the most efficient use of its resources.

What happens as a result is that useful techniques or ways of conducting business are transferred. The members of the US company may say, have you tried doing A, B, and C?

By coming in from a different cultural background and perspective, often, efficiencies can be achieved. Furthermore, there is the case of technology. It can transfer over in a number of ways. First of all, employees benefit from having first-hand access to the new technology. They may then be able to use this to start their own ventures.

Second of all, the technology could be outright purchased from a foreign nation. For instance, copyright technology could be sold from Company A in the US to Company B in India. Finally, the technology could be reverse-engineered or provide inspiration for domestic development.

Diversification

From the businesses perspective, foreign direct investment reduces risk through diversification. By investing in other nations, it spreads the companies exposure. In other words, it is not so reliant on Country A. For instance, Target derives its entire revenues from the US. Should an economic recession hit Stateside, it’s almost guaranteed to harm its profits.

By diversifying and investing in foreign markets, it allows businesses to reduce domestic exposure. So if a US firm invests in new stores in Germany, the level of risk is reduced. This is because it is not reliant on one market. Whilst there may be a decline in demand for one, there may be growth in another. To use an analogy, it’s similar to placing a bet in roulette on both red and black.

Lower Costs and Increased Efficiency

Foreign direct investments can benefit from lower labor costs. Often, businesses will off-shore production to nations abroad that offer cheaper labor. Now there is an ethical element to this than is often debated, but we will leave that aside for now. Whether it is ethical or not is irrelevant as it is a benefit to the business.

Although labor costs are lower, we must also consider productivity. For instance, one person in China may produce one unit for $1 an hour. However, an employee in the US may be able to produce 20 units for $10 an hour. So whilst a Chinese employee is cheaper, they only make 1 unit per $1, compared to 2 units per $1 in the US.

With that said, foreign direct investors will take such factors into account. And in most cases, the labor is so much cheaper than most of the productivity differentials are eliminated. This means the investment is cost-effective. In other words, more employees will be needed to make the same number of goods, but the total cost to produce is lower.

On most occasions, foreign direct investment will result in a net gain for the company. After all, it is in their interest to ensure the investment pays off. However, there are exceptions, where FDI can in fact go the other way.

Nevertheless, on the whole, FDI is generally associated with lower costs and increased cost- effectiveness.

Tax Incentives

Reduced levels of corporation tax can save big businesses billions each and every year. This is why big firms such as Apple use sophisticated techniques to off shore money in international subsidiaries.

Countries with lower tax regimes are usually those that are favoured. Examples include Switzerland, Monaco, and Ireland, among others.

Furthermore, there are also tax incentives by which the foreign government offers tax breaks to investors in a bid to encourage FDI.

Employment and Economic Boost

When money is invested in another country, it creates jobs, new companies, and new factories/buildings. This brings about new opportunities for local residents and can stimulate further growth.

With greater levels of employment being made available, it creates a greater level of purchasing power in the wider economy. If we couple this with the fact that big corporations often pay above the average to attract the best workers, we can see a spill-over effect.

With employees earning more money, they also create demand for other goods in the economy. In turn, this stimulates employment in other markets and industries.

Disadvantages of Foreign Direct Investment (FDI)

Foreign Control

One of the main fears, particularly among developing nations, is that they can essentially be brought and controlled by foreign powers. Land, labor, and capital are relatively cheap in countries such as Vietnam or Taiwan. Therefore the US or other developed nations can come in with significant sums and buy up vast sums of the country.

This is why some countries place strict restrictions on FDI. Often, investors must join a partnership with a local business in order to enter. This way there is still a level of domestic control.

Loss of Domestic Jobs

When significant sums of money are transferred to another, it is an investment that would have been used in the home market. Consequently, FDI may boost employment in foreign nations, but may temporarily reduce it at home.

Instead of the funds being invested in new factories and creating jobs, it is sent abroad instead.

As we have seen in the US, manufacturing jobs have been lost to the likes of Mexico, which can manufacture motor vehicles at a lower cost. Whilst this provides cheaper goods for the consumer, it can come at the cost of domestic jobs.

Risk of Political or Economic Change

When investing abroad, particularly in developing nations, there is huge risk that is associated. For instance, there may be huge political upheaval, or a regional war. This may consist of a new government that is not so favourable to investors.

Consequently, there is an element of significant risk. With that said, those countries and regions that have been marred with instability are usually the last to be considered for investment. We only need to look at the Middle East and Africa as examples.

Nevertheless, even in many Asian countries, there is a possibility of the unknown. With rising tensions between China and Japan, there are risks of conflict as well as political uncertainty. All of which present a higher risk.

Risk Diversification Theory of FDI

Risk diversification theory of FDI suggests that firms undertake FDI activities to diversify the risks by operating in multiple markets.

The risks of foreign investments are known as transportation costs, trade barriers (tariffs and quotas), political and economic risks. Given these risks, the theory of diversification through FDI reduces the total risk of international investments.

Diversification allows foreign firms to enjoy product and factor market diversification and it further minimizes variances in profits.

Also Read: Internationalization Theories/Models.

References

Outward FDI from Developing Countries (Developing country MNCs use OFDI to boost Innovation and Exports) | Chapter from Global Investment Competitiveness Report (Jose Ramon Perea and Matthew Stephenson)
https://elibrary.worldbank.org/doi/abs/10.1596/978-1-4648-1175-3

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Foreign Direct Investment (FDI): Basics, Concepts, Case Studies

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