What’s it: Foreign investment is an investment by foreigners into the domestic economy expecting some benefit in the future. The two main categories are a foreign direct investment and foreign portfolio investment.
Direct investment involves control over the management of assets and usually involves building productive assets such as production facilities. They are more long term oriented.
Meanwhile, under portfolio investment, investors buy financial instruments such as stocks and bonds in the destination country, usually for short-term purposes.
Foreign investment has pros and cons. Foreign capital creates more jobs, economic growth, and wealth in the destination country. At times, however, it gave rise to a certain amount of resistance. Foreign capital creates economic instability, especially as a result of short-term movements of capital flows.
Foreign investment is increasingly important in the current era of globalization. The world has become increasingly connected, not only through international trade but also through the capital flow. It is becoming easier for us to invest abroad. For the destination country, foreign investment is an essential source of funding for the economy, apart from national savings.
Types of foreign investment
International investment falls into the following categories:
- Foreign direct investment
- Foreign portfolio investment
Apart from the two, international capital flows also involve commercial loans and official flows. A commercial loan example is a bank loan to a foreign business or government. Meanwhile, official flows represent various financial assistance from donor countries to other countries.
Foreign direct investment
Foreign direct investment is a long-term investment and involves control over assets. Investors may take an organic strategy by building new production facilities. They can form joint ventures with foreign companies or establish subsidiaries in the destination country.
Alternatively, investors can take an inorganic strategy. They acquire foreign companies in the destination country. This strategy is faster than organic growth. Besides, investors can also avoid competitive reactions from competitors in the destination country.
The direct investment gains come from dividends, royalty payments, retained earnings, and management fees.
Types of foreign direct investment
Three types of direct investment:
- Horizontal investment
- Vertical investment
- Conglomerate investment
Under horizontal investment, investors place funds abroad in the same industry. For example, the Japanese automaker acquires a car manufacturer in the United States. Or, the company establishes a subsidiary and builds a car production facility in Indonesia.
In vertical investment, investors target the downstream industry or the upstream industry from their existing business. For example, a Japanese carmaker took over a tire supplier in Indonesia. We call this a backward vertical integration.
Another example is the company acquiring a car distributor in Indonesia. That we call forward vertical integration.
Lastly, conglomerate investment targets an industry that is entirely different from existing investors’ businesses. For example, a Japanese insurance company acquires a plantation company in Indonesia.
Conglomerate investments offer opportunities to diversify risks and returns. Each business has different growth prospects, returns, and risk exposures. Profits in one business compensate for losses in the other.
Reasons for foreign direct investment
Foreign direct investment usually comes from multinational companies. They have businesses in various countries. Meanwhile, some of their reasons for investing are:
First, to take advantage of lower input costs in other countries. That way, companies can reduce operating costs to support a competitive advantage.
Labor costs vary between countries. Developing countries like Indonesia, Vietnam, and Bangladesh offer low wages.
Labor costs often account for the majority of operating costs, especially in labor-intensive industries such as textiles. Thus, by bearing low wages and labor costs, the product is more competitive in the international market.
Second, to take advantage of the proximity to the source of raw materials or the market. It reduces transportation costs. As a result, this option is cheaper than transporting it around the world.
Third, to avoid trade protection. Tariff and non-tariff barriers often make exporters’ products less competitive in the destination country. Therefore, to overcome this, they can establish a subsidiary or take over the destination country’s company.
Fifth, to take advantage of local advantages such as labor and technology. Apart from that, investors can also use local knowledge to exploit markets in the destination country.
Advantages of foreign direct investment advantages
Foreign direct investment contains some advantages, both for investors and for destination countries. Well, some of the advantages of direct investment for investors are:
First, direct investment is a way to grow a business in the long term. Companies get wider market access. They can utilize their core competencies to exploit target markets.
Second, investors can diversify their income. They do not depend on income from their home country. Direct investment is becoming increasingly important, significantly when markets in home countries have matured or been declining.
Third, investors can access strategic resources. They open production facilities to take advantage of cheaper labor, proximity to raw materials, and lower taxes. They also take advantage of technological advances in the destination country.
Fourth, investors have full control over investment. Direct investment allows investors to get controlling shares. They actively manage the company where they put money, so they are fully responsible for the business’s risks and profits. To achieve the target and support a competitive advantage in the destination country, they can transfer technology, brand name, or management knowledge.
Fifth, investors can access potential sources of funding in the destination country. They can do round-tripping by using a subsidiary to borrow on the local capital market and then loan back to the parent company.
Meanwhile, the benefits of direct investment for the destination country are:
First, the inflow of foreign investment encourages economic growth. When foreign investors build factories, it increases production, creating more jobs and income.
Second, the foreign direct investment provides a potential supply of funds in the economy. It provides capital to finance new industries and enhance existing ones.
Third, direct investment is a means of transferring technology and knowledge. It is important to improve the quality of resources and the potential output of the economy.
Fourth, direct investment promotes competition. It reduces the monopoly power of local firms, encourages innovation and efficiency.
Fifth, direct investment contributes to corporate tax revenues. The establishment of a subsidiary increases the number of companies and the taxpayer base from the business sector.
Sixth, direct investors usually have long-term commitments. Thus, it is less prone to reversals compared to portfolio investment. They are less likely to withdraw at the first sign of trouble.
Seventh, foreign direct investment opens up new export opportunities. That brings new business and opens up additional export opportunities. The government can direct it to newly developed industries.
Disadvantages of foreign direct investment
First, the investment risk is more significant. Managing investments is becoming more complex and challenging. Investors face not only exchange rate or economic risks but also business risks. Mismanagement of the company causes significant losses.
Sovereignty concerns can also lead to protectionism and restrictions. Governments in the destination country may limit profit repatriation. They can also take unilateral steps by nationalizing foreign companies.
Second, domestic economic protection makes it more difficult for foreign investors to enter. Many countries protect certain strategic industries, such as electricity, communications, and defense, to maintain control.
Third, the presence of potential direct investment to kill local companies. Investors transfer their core competencies to subsidiaries in destination countries to support competitiveness. On the other hand, local companies are in a less competitive position, both in technology and capital. When they can’t compete, they die and leave foreign companies in the market.
Fourth, sovereignty is under threat. When dominating the domestic market, foreign companies can influence and lobby officials for legal and regulatory privileges.
Foreign portfolio investment
Portfolio investment involves buying stocks, bonds, mutual funds, exchange-traded funds (ETF), or other types of financial instruments in the destination country. They are more tradable and usually less permanent. Some take a short time, especially for speculative purposes. Meanwhile, others are longer oriented.
A special case is investing in stocks. Under portfolio investment, investors do not acquire controlling shares in a company.
Conversely, if an investor acquires controlling shares, it falls into direct investment. Specifically, the World Bank categorizes foreign direct investment when the investor acquires 10% or more of the ordinary shares with voting rights in the target company.
Investors are also more diverse than direct investment. Individuals can participate through mutual funds or pension funds. Meanwhile, direct investment usually comes from multinational companies.
Foreign portfolio investment consideration factors
Returns and risks are the primary consideration factors for portfolio investment. Returns can be capital gains, dividends, interest (coupons). Meanwhile, investment risk depends on each asset class. Because it involves different countries, risk also depends on changes in macroeconomic variables.
The following are some macroeconomic variables that are considered in foreign portfolio investment.
First is the prospect of economic growth. Foreign investors benefit from the economic prosperity of the destination country. Instead, they exit when economic growth weakens or, and is worse, a recession.
Take stocks, for example. Economic growth prospects have a positive correlation with stock market performance. When the economy is prosperous, business profits improve. It makes the company’s stock price more attractive to buyers.
Second is sovereign risk. The measure is the sovereign rating, representing the chance of default by the destination country’s government to meet its financial obligations. Global investors usually give less weight to high-risk countries, such as developing countries.
Third is the interest rate. Foreign investors get high returns when they put their money in banks in the destination country. They may also collect debt securities to get a potential price increase when future interest rates fall.
Fourth is tax and exchange rates. Both affect realized returns. Lower taxes on dividends and capital gains are desirable. However, if it goes up, the realized value of the two decreases.
Likewise, changes in exchange rates affect profits when translated into investors’ operating currencies. It is sometimes both beneficial and detrimental. A more volatile exchange rate also increases uncertainty and discourages foreign investors.
Advantages of foreign portfolio investment
First, portfolio investment is relatively liquid. Capital market instruments such as stocks, bonds, and ETFs are relatively more liquid than direct investment. They withdraw their investment at any time and get their money back faster.
Second, retail investors can participate. Buying a portfolio such as stocks and debt securities requires smaller amounts of funds than acquiring a company or establishing a subsidiary. Therefore, portfolio investment enables broader retail investor participation.
Third, the portfolio can be more diversified. Investing abroad provides investors with alternatives to diversify their portfolios. They can optimize returns and risks.
Fourth, capital inflow increases the demand base in the capital market. It is essential when companies and governments issue securities. A more extensive demand base should contribute to lower costs of funds.
Disadvantages of foreign portfolio investment
First, portfolio investments are more volatile. For destination countries, they are more prone to reversals because it is short-term oriented. Foreign investors quickly exit the market when the economy shows signs of weakness. They are also likely to exit when they find a country that offers higher returns.
The outflow of foreign capital causes exchange rate depreciation. It can destabilize an economy when it occurs on a sudden and massive scale. For this reason, some countries still adopt restrictions on capital outflows.
Meanwhile, large-scale inflows of foreign capital led to a sharp rise in asset prices. That then caused a bubble in the financial markets. Bubbles can suddenly burst and create instability in the economy.
Second, investments are vulnerable to short-term exchange rate movements. It affects the return on investment and the foreign portfolio’s total value, which is sometimes profitable and unprofitable.
Third, political and economic risks expose investment. Changes in the political environment and economic and investment policies result in changing investment norms. Many developing countries do not have the same level of political and economic stability as developed countries.
Fourth, transaction costs increase. Investors must involve more intermediaries when buying and selling securities. It increases transaction costs and reduces realized returns.
Fourth, often poor reporting makes portfolio investments harder to track. Moreover, investing involves many different instruments, including derivative instruments.