What’s it: Foreign direct investment (FDI) is a type of capital flow where investors from outside a country invest in its productive assets. Investors can come from companies or individuals. Companies they become multinational companies because they now operate in more than one geographic location.
Foreign direct investment is a driving aspect of international economic integration. It creates stable and long-lasting relations between different countries. It is also an essential channel for technology transfer between countries. It also promotes international trade through access to foreign markets and can be a driver of economic growth.
Foreign direct investment vs. foreign portfolio investment
Foreign direct investment contrasts with foreign portfolio investment. For portfolio investment, investors are only eyeing corporate securities in a host country, either in stocks, bonds, or other types of securities.
Portfolio investment does not last. It does not involve building assets such as the establishment of factories. It quickly flows out when economic conditions in the host country deteriorate or when international markets improve. Hence, portfolio investment is often referred to as “Hot money.”
Meanwhile, in a narrow sense, foreign direct investment refers to developing new facilities and the acquisition of lasting ownership (10% or more of the voting shares) in companies operating in the host country.
The foreign direct investment allows control over the company’s operations. Such ownership allows foreign investors to manage and influence the company’s operations actively.
That is what distinguishes direct investment and foreign portfolio investment. Direct investment usually involves participation in management, technology transfer, and expertise. Meanwhile, portfolio investment is not. Portfolio investment only takes short-term benefits such as capital gains, interest rate spreads, and translation gains.
Types of foreign direct investment
Foreign direct investment can generally take four forms:
- Horizontal investment
- Vertical investment
- Conglomerate investment
- Platform investment
Horizontal investment
Horizontal investment involves replicating a successful business model in a new country. This approach allows companies to leverage their existing brand recognition, operational expertise, and marketing strategies to tap into new markets and customer bases.
While the core business model remains the same, companies engaging in horizontal investment may adapt their product offerings or marketing strategies to cater to local tastes and preferences. For instance, McDonald’s tailors its menu to incorporate regional ingredients and flavors from different countries.
Horizontal investment can be a fast and efficient way to enter a new market. Companies can leverage their existing infrastructure and know-how to establish operations quickly, minimizing the time and resources needed to get started. This approach is often favored by established brands looking to expand their global footprint.
Vertical investment
Vertical investment involves acquiring or establishing operations at different stages of a company’s supply chain within a foreign country. For example, a manufacturing company in the United States acquires a stake in a European supplier of parts or raw materials. As another example, McDonald’s acquired a large scale farm in Indonesia to provide meat.
This strategy can offer several benefits:
- Cost reduction and efficiency: By owning or controlling parts of their supply chain, companies can potentially reduce costs associated with raw materials, parts, or logistics. Vertical integration can also streamline production processes and improve overall efficiency.
- Quality control and security of supply: Vertical investment allows companies to exert greater control over the quality and consistency of their inputs. This can be particularly important for industries where product quality is paramount. Additionally, securing reliable sources of raw materials or parts can be a concern, and vertical integration can mitigate this risk.
Conglomerate investment
Conglomerate investment involves entering a new industry or sector altogether in a foreign country. This strategy can be riskier than horizontal or vertical investment as companies venture outside their core area of expertise. However, it can also offer significant growth opportunities:
- New markets and revenue streams: By entering a new industry, companies can diversify their revenue streams and tap into new markets with high growth potential. This approach can be particularly attractive for companies that have reached maturity in their existing markets.
- Risk management: Conglomerate investment can also help to spread risk across different industries. This can be a valuable strategy for mitigating the impact of economic downturns or industry-specific challenges.
Platform investment
Platform investment is a strategic approach where companies establish a presence in a foreign country specifically to export goods to third-party nations. These investments are typically situated in locations that offer several key advantages:
- Cost-effectiveness: Platform investments often target countries with lower labor and operational costs compared to their home base. This allows them to produce goods at a competitive price point for export.
- Free trade agreements: Companies may choose to locate their platform investments in countries with favorable free trade agreements. These agreements eliminate or reduce tariffs and other trade barriers, making it easier and cheaper to export goods to other countries.
- Strategic location: Proximity to major shipping lanes or regional markets can be a significant advantage for platform investments. Efficient transportation infrastructure allows companies to quickly and cost-effectively deliver their products to international buyers.
For instance, a multinational electronics company might establish a manufacturing plant in a Southeast Asian country with free trade agreements with the US and Europe. This platform investment would allow them to leverage lower production costs while benefiting from duty-free access to major markets.
Foreign direct investment methods
Foreign direct investment (FDI) isn’t a one-size-fits-all strategy. Investors have a toolbox of methods at their disposal to establish a presence and conduct business in a new country. Let’s delve deeper into these methods:
Establishing new operations (greenfield investment)
Imagine a foreign company building a factory from the ground up in a new country. This is a classic example of a greenfield investment. Here’s what it entails:
- Building from scratch: Greenfield investments involve starting a new business venture from the very beginning. Investors need to secure land, construct facilities, hire a workforce, and establish all necessary infrastructure.
- Tailor-made operations: Greenfield investments allow companies to design their operations from scratch to suit their specific needs and production processes. This can be particularly advantageous for companies with innovative technologies or unique business models.
- Long-term commitment: Greenfield investments typically represent a significant long-term commitment to a foreign market. The substantial resources required to establish new operations signal a strong belief in the host country’s potential.
For example, Tesla’s Gigafactory in Nevada is a prime example of a greenfield investment. The company built a massive production facility from the ground up to manufacture electric vehicles and battery packs.
Acquiring existing assets (brownfield investment)
Not every company wants to build everything from scratch. Brownfield Investments offer an alternative approach:
- Acquiring existing businesses: Brownfield investments involve acquiring an existing business or assets in a foreign country. This can be a faster and less resource-intensive way to enter a new market compared to a greenfield investment.
- Leveraging established infrastructure: By acquiring an existing business, investors can take advantage of its existing infrastructure, such as factories, offices, and distribution networks. This can significantly reduce the time and cost required to become operational.
- Established customer base: In some cases, brownfield investments allow companies to inherit an existing customer base in the foreign market. This can provide a valuable head start in establishing brand recognition and market share.
For instance, Coca-Cola, a global beverage giant, frequently utilizes brownfield investments. The company often acquires local bottling companies in new markets to expand its distribution network and brand reach.
Other FDI methods
Beyond establishing new operations or acquiring existing ones, foreign investors have other methods at their disposal:
- Joint ventures: This involves partnering with a local company in the host country to establish a new business venture. This allows foreign investors to benefit from the local partner’s expertise and market knowledge.
- Acquiring shares: Investors can acquire voting shares in a foreign company, giving them a degree of ownership and influence over its operations. This approach allows them to gain exposure to a foreign market without assuming full control.
- Reinvestment of profits: Profits earned from existing foreign operations can be reinvested back into the business to expand operations or capabilities in the host country.
The choice of the FDI method depends on several factors, including the investor’s risk tolerance, available resources, and strategic objectives in the target market.
Benefits of foreign direct investments
Foreign direct investment offers benefits not only to investors but also to destination countries.
For businesses, foreign direct investment offers benefits in the form of:
- Market diversification. It helps investors explore new markets and expand overseas markets. This is important when the home country’s market has reached a mature phase with low growth opportunities.
- Tax incentives. The host country’s government usually gives some incentives, such as taxes, to attract foreign capital. Accordingly, investors will pay lower taxes compared to their home countries. This ultimately increases profitability.
- Access to cheaper labor and sources of raw materials. In developing countries, labor and raw material costs are relatively inexpensive. Foreign investors can exploit both to support profitability and create a competitive advantage in the global market.
Meanwhile, the benefits for the host country are:
- Driving economic growth. This investment is one component of the gross domestic product (GDP). So, the more significant the investment, the bigger the GDP.
- Human capital development. Better training for local workers will lead to increased human capital.
- Increase in employment. Investment creates new jobs, increases the demand for labor, and reduces the number of unemployed.
- Access to expertise, skills, and technology. Transferring technology and knowledge can help a country diversify its economy and reduce dependence on primary products.
- Addressing the domestic saving gap. The investment allows more capital per worker used in production.
- Growing export capacity. The host country can open up foreign direct investment for strategic export sectors.
- More competition. The presence of foreign companies increases competition in the local market. Tighter competition can lead to access to cheaper and more varied products. Apart from that, the competition also spurs innovation.
Drawbacks of foreign direct investments
While it offers several advantages, critics also view foreign direct investment with skepticism. They reasoned that it could cause losses such as:
- Economic inequality. A strong elite may benefit greatly from foreign investment. It does not flow fairly to society at large.
- Exploitative practices. Investors may overexploit human and other natural resources. They may pay less labor, deforest to set up factories and dump hazardous waste into the environment.
- Limited job creation effect. Foreign companies may bring in their own managers and specialists instead of hiring local workers.
- Local business closings. Large foreign companies’ entry threatens local businesses and forces them to go bankrupt due to more limited competitiveness.
- Profit repatriation. The foreign company may not reinvest profits in the host country but send them back to the home country, resulting in large capital outflows for the host country.
How a country attracts foreign direct investment
Foreign direct investment (FDI) is a lifeblood for many economies. Countries around the world actively compete to attract these investments, knowing they can be a powerful engine for growth. Let’s explore the tools countries use to entice foreign investors:
Offering incentives
Imagine a country rolling out the red carpet for foreign investors. Here are some of the goodies they might offer:
Tax breaks: Competitive corporate tax rates are a major draw. Lower taxes mean investors get to keep more of their profits, making the investment more attractive.
Financial assistance: Some countries offer additional financial incentives, such as soft loans, subsidies, or grants, in addition to tax breaks. These can significantly reduce foreign investors’ upfront costs.
A skilled workforce: A well-educated and trained workforce is essential for any business. Countries may invest in education and training programs to ensure a pool of qualified workers that meet the needs of foreign investors.
Flexible labor laws: Some countries offer greater flexibility in labor regulations, allowing businesses to operate more efficiently. This can be attractive to investors seeking to control costs and optimize their operations.
Special Economic Zones (SEZs): These designated areas offer a special set of rules and regulations, often with simplified bureaucracy, tax breaks, and streamlined infrastructure. SEZs can be havens for foreign investors looking for a hassle-free entry point into a new market.
Infrastructure investments: Strong infrastructure, including reliable transportation networks, efficient communication systems, and dependable utilities, is essential for businesses to thrive. Countries may invest heavily in infrastructure development to create an attractive environment for foreign investors.
The skeptics of FDI
While many countries embrace FDI, others are more cautious. Here are some of the concerns that lead to a more skeptical view:
National security: Some governments worry that foreign ownership of critical industries or resources could pose a national security threat. This can lead to restrictions on foreign investment in sensitive sectors.
Loss of control over resources: Countries rich in natural resources may be wary of foreign companies extracting and profiting from these resources without adequate benefit to the local population. This can lead to stricter regulations on resource exploration and development.
Job market concerns: Some countries fear that foreign companies may bring in their own workforce or automate jobs, leading to unemployment among the local population. This can lead to policies that protect domestic jobs or encourage technology transfer from foreign investors.
The debate over foreign direct investment is complex, with both potential benefits and drawbacks. By understanding the strategies used to attract FDI and the concerns surrounding it, we can gain a more nuanced perspective on this powerful economic force.
