Foreign Direct Investment: Types, Pros, and Cons

What’s it: Foreign direct investment (FDI) is a type of investment in a country’s productive assets by foreign investors. Investors can come from companies or individuals. For 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.

The difference between foreign direct investment and 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 the narrow sense, foreign direct investment refers to developing new facilities and the acquisition of lasting ownership (20% 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 actively manage and influence the company’s operations.

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:

1. Horizontal investment
2. Vertical investment
3. Conglomerate investment
4. Platform investment

Horizontal investment

Horizontal direct investment involves building the same business operation in a host country as it does in its home country. In short, businesses carry out the same activities but in a foreign country.

For example, McDonald’s expansion in Indonesia falls into the horizontal investment category. Another example is a smartphone manufacturer based in the United States, opening a factory in China.

Vertical investment

In this case, investment takes place at a different level of the supply chain from the home country, it could be upstream or downstream. In other words, this activity is still in one supply chain with the company’s operations in the home 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.

Conglomerate investment

This type involves investing in a business that is unrelated to the parent company business. Because investors enter industries where they have no prior experience, often conglomerate investment usually takes the form of joint ventures with already-operating foreign companies.

The conglomerate investment strategy is riskier than horizontal and vertical investments. Companies need to overcome two obstacles at once to compete: entering a foreign country and entering a new industry or market.

Platform investment

Companies expand to foreign countries in the investment platform, but the output from foreign operations is exported to third countries. These investments generally occur in low-cost locations within free trade areas.

Foreign direct investment methods

A foreign company may establish an immediate presence by opening new operations in the destination country. For example, L’Oreal opened its largest factory globally, located in Cikarang, Bekasi, Indonesia. The investment reached IDR1.25 trillion. The factory will later become the production center for L’Oreal in the Southeast Asia region. 

Reinvestment of profits from operations abroad and intercompany loans to overseas subsidiaries are also included in the foreign direct investment category.

Furthermore, how foreign investors invest abroad it can take the following methods:

• Forming joint ventures with foreign companies
• Forming a subsidiary in a foreign country
• Acquiring voting shares in a foreign company
• Acquired shares in an associated company

Then, broadly speaking, the direct investment method can take two forms, namely:

• Greenfield investment
• Brownfield investment

If an investor sets up a new entity from scratch, we call it greenfield investment. In this case, investors build from the start everything needed to run a business – including infrastructure, human resources, support services, and so on.

In contrast, in brownfield investing, investors take advantage of existing businesses or facilities. Company acquisitions are an example.

Foreign direct investment advantages

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.

Foreign direct investment disadvantages

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 over-exploit human and other natural resources. They may pay less labor, deforested 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; instead, send it back to the home country. This results in large capital outflows for the host country.

How a country attracts foreign direct investment

Several countries rely on foreign direct investment inflows as a driver of economic growth. They will usually provide incentives such as:

• Offers low corporate taxes
• Provide non-tax facilities, such as soft loans and subsidies
• Promote a flexible labor market and upgrade workers’ skills
• Promote Special Economic Zones
• Invest in critical infrastructures such as roads, rail, ports, and telecommunications

Nevertheless, several other countries view foreign investment with skepticism. They tighten regulations and limit direct investment, worrying about national security and foreign ownership of their natural resources. Others fear the consequences of a possible takeover of technology companies.