Aofex

Introduction to Foreign Direct Investment (FDI)

UTC by Beatrice Mastropietro · 6 min read
Introduction to Foreign Direct Investment (FDI)
Photo: Depositphotos

Foreign Direct Investment (FDI) is an important topic for any global business. But before you consider FDI as an option, it’s important that you understand what this strategy entails and how it can help your company grow. This guide will provide all the necessary information on it.

Foreign direct investment (FDI) is an investment a company or individual in one country makes into business interests located in another country. This may be done to expand operations and/or activity at their current location for the foreign direct investor. Foreign direct investment can be an individual, firm, corporation, or other private entity not controlled by the state.

FDI is a popular strategy for intervention, particularly in emerging economies, and can form an essential part of development assistance and national economic policy. When the FDI comes from a foreign country and competes with the local industry, it can be considered an exterior direct investment (EDI). And when FDI comes from one’s own country, it is regarded as an interior direct investment (IDI).

What is Foreign Direct Investment (FDI)?

Foreign Direct Investment (FDI) is the process by which a company based in one country acquires a controlling interest (generally more than 50%) of an existing company in another country. It is often used as a synonym for international business cooperation or cross-border investment.

Foreign direct investment can be made by any person or firm authorized to do business in a country, not their home country. The foreign direct investor’s primary motivation for foreign direct investment is to gain non-discriminatory access to another country’s markets with goods or services, including purchasing natural resources, starting up new businesses, acquiring assets, or becoming involved in research and development.

Foreign direct investment also includes other business transactions such as purchasing a local subsidiary, joint ventures, mergers, and acquisitions between existing firms in different countries.

Foreign direct investment often results in a capital or wealth increase for both the foreign investor and the host country. The parent company may allow the affiliate to elect their managers and boards of directors, which lets them control the corporation, resulting in better performance.

Types of FDI

There are several major types of foreign direct investment worth considering.

  • Horizontal FDI

Horizontal FDI is a form of FDI where one or more firms from one country establish business operations in the territory of another country. It can occur on a unidirectional basis. For example, a company based in the United States may invest in Russia by setting up a subsidiary that produces goods for consumers in that country. It can take place on a reciprocal basis as well. For example, two companies based in Russia may invest in each other’s home country. Horizontal FDI brings the benefits of lower tariffs and improved access to resources. It can also be seen as foreign direct investment between parent companies and their subsidiaries located abroad.

  • Vertical FDI

Vertical Foreign Direct Investment (FDI) occurs when a firm purchases and controls the means of production for a good and/or service in one country to sell that same product or service to another country. This is done through the use of either technology or brand licensing.

  • Conglomerate FDI

The conglomerate theory was developed by Alfred Chandler, a US business historian. It explains the evolution of large conglomerate corporations in the United States during the twentieth century. Conglomerates are a type of diversified company that has a lot of different types of business under one roof. The conglomerate model has been used very often in Europe, particularly in the UK and France. However, conglomerate principles are not very common in other parts of Europe. The conglomerate model has continued to be famous worldwide due to its ability to spread risk and minimize losses if one unit should fail.

The conglomerate model can be used in various ways. For example, it could add value when a business adds up the cost savings of many different units, making one conglomerate, or when conglomerate subsidiaries can add value to another conglomerate subsidiaries.

The conglomerate model focuses on financial and not operational advantage because it cares about the value of its parts, not the value of the conglomerate as a whole. There are two types of conglomerate: balanced and unbalanced conglomerate. A balanced conglomerate has a group of several businesses, while an unbalanced conglomerate includes just one kind of business.

Foreign Direct Investment vs. Foreign Portfolio Investment

FDI is an investment in controlling ownership in a business in one country by an entity based in another country. The investor can be either an individual or firm, and its purpose may be capacity building, establishing business linkages, or gaining market access. Foreign Direct Investment can have strategic importance because it increases the foreign direct investor’s ownership of production within a country and controls the investing process. FDI is different from Foreign Portfolio Investment (FPI) in that FDI refers to an investment where the investor has management control over the company they are investing in. In contrast, with FPI, an investor does not actively manage the investments or the companies that issue the investments. They do not have direct control over the assets or the businesses.

Pros and Cons of FDI

Foreign Direct Investment is an important part of the global economic system. Foreign investors’ decisions about where to invest generally depend on three factors: whether there are opportunities in a particular country for selling goods or services, buying cheap labor, and transferring knowledge and technology. Countries that provide these conditions are host countries. Countries that do not provide them but have a large demand for goods and services are called target countries. Foreign direct investment is one way to close the gap between host and target countries by transferring knowledge, technology, money, and management skills.

Meanwhile, FDI can undermine the host country’s economic stability if it results in increased unemployment levels among nationals. Unemployment is already at critical levels in some developing nations. Further increasing unemployment can cause local communities to become unstable. Furthermore, with increased unemployment, national income is also reduced, leading to decreased tax revenues for governments. Governments may be forced to raise taxes on remaining employed nationals in order to make up for lost tax income. The repercussions can cause an extensive burden on the economy and decrease global competitiveness for that country’s exports.

As a result, governments may try to discourage FDI, which is likely to increase unemployment levels by restricting foreign companies from employing local workers. Foreign companies also pose a threat to some host governments who fear infringing on the government’s power.

Conclusion

Foreign direct investment (FDI) is the act of foreign companies investing in businesses within other countries. Foreign direct investments are not like portfolio investments because there is no ownership of stocks. Instead, there is actual ownership of part of the company’s property and decision-making abilities. Foreign direct investments can result in massive economic benefits for both the home and the host country. They are also the reason that there is foreign trade. Foreign direct investment has been on a steady rise since 1950 and is expected to continue growing at an exponential rate, especially in developing countries where wealth is on the rise.

Share:

FAQ

What is Foreign Direct Investment?

Foreign Direct Investment (FDI) is the process by which a company based in one country acquires a controlling interest (generally more than 50%) of an existing company in another country. It is often used as a synonym for international business cooperation or cross-border investment.

How does FDI work?

Foreign direct investment (FDI) occurs when an investor establishes foreign business operations or acquires foreign business assets, such as ownership or controlling interest in a foreign company.

What are the types of FDI?

There are three types of FDI: Horizontal FDI, Vertical FDI, and Conglomerate FDI.

What is the difference between FDI and foreign portfolio investment (FPI)?

FDI is distinguished from Foreign Portfolio Investment (FPI), which represents ownership in the securities of a corporation that are tradeable on a stock exchange. 

What are the advantages of FDI?

The main advantages are the access to knowledge, experience, and local market that are difficult to be accessed from abroad.

What are the disadvantages of FDI?

Sometimes FDI can hinder domestic investment.

guides
What Is an Initial NFT Offering (INO)? November 25th, 2021

There are a number of fundraising techniques adopted by emerging projects to enhance their business. Initial NFT offering is a rec...

What Is Metaverse? November 25th, 2021

Metaverse is an interconnected 3D virtual reality where users are free to create their own avatars and interact with others from a...

What Is GameFi (GAFI)? November 14th, 2021

The idea behind GameFi (GAFI) came from the intersection between two fast-growing industries: gaming and DeFi. We have included al...