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.
Understanding foreign direct investment
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. When the North American Free Trade Agreement (NAFTA) was signed between the United States, Canada, and Mexico in 1994, foreign direct investment increased in Mexico by 150% that same year despite economic problems in the country caused by a weakened peso. 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.
- 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.
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