Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Aspect
Explanation
Definition
Foreign Direct Investment (FDI) refers to the investment made by individuals, companies, or entities from one country into business interests located in another country. Unlike portfolio investments, FDI involves acquiring a significant ownership stake (usually at least 10%) in a foreign business entity, such as a subsidiary, joint venture, or branch. FDI plays a crucial role in international economics and global business.
Forms of FDI
FDI can take several forms, including: 1. Greenfield Investment: Establishing a new business or facility in a foreign country. 2. Mergers and Acquisitions (M&A): Acquiring an existing foreign company or merging with it. 3. Joint Ventures: Partnering with a local company to create a new business entity. Each form has its advantages and challenges.
Motivations
Companies engage in FDI for various reasons, such as: 1. Market Access: Expanding into new markets to access a larger customer base. 2. Resource Acquisition: Gaining access to natural resources, technology, or skilled labor. 3. Cost Reduction: Lowering production costs or benefiting from tax incentives. 4. Risk Diversification: Spreading business risks across multiple markets. 5. Competitive Advantage: Enhancing global competitiveness.
Benefits of FDI
FDI can have several positive impacts on both the host and home countries: 1. Economic Growth: Attracting FDI can stimulate economic activity and GDP growth. 2. Job Creation: FDI projects often create jobs for local populations. 3. Technology Transfer: Local industries can benefit from advanced technologies brought by foreign investors. 4. Infrastructure Development: FDI can lead to infrastructure improvements. 5. Increased Trade: FDI can boost exports and imports.
Challenges and Risks
While FDI offers opportunities, it also poses challenges: 1. Political Risk: Changes in government policies can affect FDI projects. 2. Economic Volatility: Currency fluctuations and economic downturns can impact FDI returns. 3. Cultural Differences: Adapting to foreign cultures and business practices can be challenging. 4. Legal and Regulatory Hurdles: Navigating foreign laws and regulations is often complex. 5. Competitive Pressures: Local competitors may pose challenges.
Host Country Impact
The impact of FDI on the host country can be multifaceted: 1. Positive Effects: Increased employment, technology transfer, and infrastructure development. 2. Negative Effects: Possible exploitation of local resources, environmental concerns, and competition with local businesses. Host countries often implement policies to maximize benefits and minimize risks.
Home Country Impact
The home country of the investing entity can also be influenced by FDI: 1. Capital Outflow: FDI involves sending funds abroad, which can affect domestic investment. 2. International Trade: FDI can enhance international trade by strengthening global supply chains. 3. Competitive Advantage: Home country companies can gain competitive knowledge from global operations.
Government Policies
Governments play a crucial role in regulating and encouraging FDI. Policies may include offering tax incentives, reducing trade barriers, establishing special economic zones, and ensuring legal protections for foreign investors. The aim is to create an attractive investment climate.
Foreign direct investment is a critical component of growing economies that are transitioning from agriculture and raw material exports to rapid industrialization.
The firms in these economies require capital to expand beyond their own borders, while governments use FDI capital to create jobs, build infrastructure, or invest in energy and water security.
Free trade agreements are one way that foreign direct investment can be stimulated.
Canada also benefitted from the agreement, receiving $16 billion in FDI revenue in just five years.
Three components of foreign direct investment
Foreign direct investment is comprised of three basic components:
Equity capital
This, as we noted in the introduction, involves an investor purchasing shares in a business located in another country.
Once the 10% threshold has been reached, the investor is assumed to have some control over company assets.
Reinvested earnings
This describes the investor’s share of earnings that are not distributed as dividends by affiliates or not remitted to the investor.
In other words, this is capital that is reinvested into the company.
Other direct investment capital or inter-company debt transactions
This encompasses the borrowing or lending of funds between the direct investor and branches, associates, or subsidiaries.
These funds may take the form of debt securities or supplier’s credits.
Foreign direct investment types
There are also four general types of foreign direct investment:
Horizontal
Where an investor invests funds abroad in the same industry that produces similar products and services.
American company Nike may choose to invest in German firm Puma since they are both involved in athletic apparel and sports footwear.
Vertical
Here, the investment is made within a supply chain that may or may not be the same as the investment firm’s industry.
Starbucks, for example, invest in the coffee producers that supply it with premium coffee beans around the world.
In some instances, the other company in the supply chain may be acquired completely.
Conglomerate
Foreign direct investment is said to be conglomerate when there is no relationship between companies or industries.
Investors in this scenario sometimes enter into joint ventures to compensate for their lack of experience in an industry.
Platform
A more complex form where a business establishes a presence in another country to manufacture products that are then exported to a third country.
In a hypothetical example, Volkswagen may invest in manufacturing facilities in China to then export vehicles to other parts of Asia.
Case Studies
Equity Capital Example:
In 2017, Japanese technology conglomerate SoftBank acquired a 15% stake in Uber, an American ride-hailing company. This acquisition allowed SoftBank to have a significant say in Uber’s management and decision-making processes.
Reinvested Earnings Example:
Assume a French automobile company, Peugeot, has a subsidiary in India. Instead of sending back the profits to France, Peugeot reinvests the earnings into the Indian subsidiary to expand its manufacturing facilities and enhance its research capabilities.
Other Direct Investment Capital Example:
Microsoft, an American company, lends funds to its subsidiary in the UK for the development of a new data center. This loan agreement is an example of inter-company debt transactions.
Horizontal FDI Example:
Toyota, a Japanese automaker, establishes a production plant in the United States, where it produces cars for the American market. This is a horizontal investment because Toyota is investing in the same industry abroad as it operates in at home.
Vertical FDI Example:
Apple, an American tech giant, invests in a rare earth mine in Africa. These rare earth materials are vital for the production of Apple’s devices. This is a vertical investment because Apple is investing in a supply chain that’s related to its primary industry.
Conglomerate FDI Example:
Assume a South Korean electronics company, Samsung, decides to invest in a Brazilian coffee plantation. There’s no direct relationship between electronics and coffee farming, making this a conglomerate FDI. Samsung might form a joint venture with a local Brazilian company to manage the plantation.
Platform FDI Example:
Swedish furniture manufacturer IKEA sets up a production facility in Vietnam, utilizing the country’s lower labor costs. The products manufactured in this facility are then exported to markets in Southeast Asia and Australia.
When the European Union signed a free trade agreement with South Korea, many European companies increased their investments in South Korea, expecting better access to its markets and expecting fewer trade barriers.
Key takeaways
Foreign direct investment (FDI) involves the purchase of an interest in a company by an entity that is located in another country. Free trade agreements are one way that foreign direct investment can be stimulated.
Foreign direct investment is also critical to the growth of emerging economies. It contains three components that describe the nature of the investment and the entities involved: equity capital, reinvested earnings, and other investment capital or debt transactions.
There are four types of foreign direct investment: horizontal, vertical, conglomerate, and platform. Each type is associated with a different investment strategy.
Key Highlights
Foreign Direct Investment (FDI): FDI occurs when an individual or business purchases an interest of 10% or more in a company operating in a different country. It involves acquiring shares in a foreign business and can lead to influence or participation in the management of the enterprise.
Importance of FDI: FDI is crucial for growing economies transitioning from agriculture and raw material exports to industrialization. It provides capital for firms to expand beyond their borders and enables governments to create jobs, build infrastructure, and invest in key sectors.
Components of FDI: FDI consists of three basic components: equity capital (share ownership), reinvested earnings (earnings not distributed as dividends but reinvested into the company), and other direct investment capital or inter-company debt transactions (borrowing or lending of funds between the investor and subsidiaries or associates).
Types of FDI: There are four general types of FDI:
Horizontal: Investing in the same industry that produces similar products and services.
Vertical: Investing within the supply chain, either in the same or related industries.
Conglomerate: Investing in unrelated industries or companies.
Platform: Establishing a presence in a foreign country to manufacture products exported to a third country.
Stimulating FDI: Free trade agreements, like NAFTA, can stimulate FDI by fostering economic cooperation and providing investment opportunities in partner countries.
What are the three components of foreign direct investments?
The three components of foreign direct investments are:
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Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
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Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
