Foreign Direct Investment

Foreign Direct Investment Definition

Foreign direct investment definition refers to when a company that is headquartered in another country has a controlling ownership stake in a company that is located in another country. Foreign direct investment (FDI) is an investment made in another country to establish a controlling ownership stake.

Controlling ownership stake is what differentiates foreign direct investment from foreign portfolio investments, where investors buy and passively hold securities from a foreign country.

Foreign direct investment does not take place only in building new factories in a foreign country.

The definition of foreign direct investment also refers to the acquisition of a long-term management interest (ten percent or more of the enterprise's voting stock) in a company that is active in an economy that is not the investor's own.

Foreign direct investment can take place in the following ways:

• Mergers and Acquisitions (M&A)
• Construction of new facilities
• Reinvesting earnings obtained from overseas activities
• Intra-company loans

Foreign Direct Investment Example

Foreign direct investment examples include mergers and acquisitions, the construction of new facilities, and intra-company loans from entities from one country to another country.

Fig. 1 - Foreign direct investment in the US. Source: FRED Economic Data³

Figure 1 shows the foreign direct investment in the United States from 2000 to 2022. The vertical axis shows the US dollars in millions of dollars, and the horizontal axis is the time period. Foreign direct investment in the US peaked in 2015, after which it declined. However, FDI in the US started to increase after 2020.

Types of Foreign Direct Investment

The two main types of foreign direct investment are:

• Horizontal FDI and
• Vertical FDI.

Types of Foreign Direct Investment: Horizontal FDI

Horizontal FDI is one of the most common types of foreign direct investments.

In this scenario, one firm invests in another company situated in a foreign nation but produces items comparable to those produced by the first company.

Horizontal foreign direct investment is the kind of FDI that has occurred here since both firms are involved in the retail and garment sector.

Types of Foreign Direct Investment: Vertical FDI

Another type of foreign direct investment is vertical FDI.

The company that is invested in or acquired does not have to belong to the same industry but is part of the supply chain process.

Therefore, when vertical foreign direct investment takes place, a company invests in a business located in another country that either supplies or sells goods.

This kind of foreign direct investment is referred to as vertical FDI since the investing company acquires a supplier in the supply chain.

Advantages of Foreign Direct Investment

Some advantages of foreign direct investment include an increase in the total addressable market, lower labor costs, an increase in employment, and economic stimulation, as seen in figure 2 below.

• Increase in total addressable market. Companies that expand their business operations in another country experience an increase in their customer base. Individuals from the foreign country now have access to the goods or services from the foreign country, which in turn, increases the firm's profits.
• Lower labor costs. A company may enjoy paying lower wages by shifting some of its business operations to another country. By opening new factories, they can manufacture their goods at lower costs. This then helps the firm cut costs and increase profit.
• Increase in employment. The hosting country will experience an increase in employment as the demand for labor increases by the funds coming through FDI. Foreign companies will need to hire local labor, which helps develop the local economy.
• Economic stimulation. The recipient nations see an improvement in their overall standard of living. In addition to the increase in employment numbers, the hosting country benefits from the tax they collect from foreign companies, which they can use to stimulate their economy by investing in infrastructure, schools, and other projects.

Disadvantages of Foreign Direct Investment

Some of the main disadvantages of foreign direct investment include displacing local businesses, exploitation, and political risk, as seen in Figure 3.

• Displacing local business. Local businesses may not be able to survive when large companies enter the local markets. That's because these foreign companies might have cost advantages that enable them to sell at lower prices or a valuable brand identity that makes everyone buy from them. This results in a loss for local businesses.
• Exploitation. Companies might enter a foreign market to have access to cheap labor costs. There are many instances in which foreign companies have made use of below-minimum-wage labor to cut their costs. Some of them have gone as far as child labor to shrink costs.
• Political risk. Companies that engage in FDI risk incurring a loss when investing in politically unstable countries. A simple shift in the regime could lead to the company having its investment wiped out.

Theories of Foreign Direct Investment

Theories of foreign direct investment were established by neoclassical economists. Neoclassical economics main principle suggests that the market is in perfect competition.

The theories of neoclassical economics were based on the classical theory of trade in which the driving force behind trade was a result of the difference in production costs between two countries, focusing on the low cost of production as a driving factor behind a firm's foreign activity.

Basically, the main incentive a firm has to engage in foreign direct investment and the reason FDI takes place in the first place is the lower cost of production in the hosting country.

In addition to the theories of foreign direct investment made by neoclassical economists, other theories suggest that the reason behind foreign direct investment is also the interest rate and the loans that hosting countries can extend to foreign companies.