What is a Foreign Direct Investment (FDI)?

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Definition:

A foreign direct investment (FDI) is when an individual or entity makes a long-term investment and gains influence in a foreign business.

🤔 Understanding FDI

A foreign direct investment (FDI) occurs when a person or company makes a long-term investment in a business in another country. FDI involves creating a lasting relationship with and gaining significant influence in the foreign firm. Just buying a small amount of stock doesn’t count — Usually, at least a 10-percent stake is required. Through FDI, companies can lower production costs and gain access to markets. For the destination country, FDI can be a source of resources and technology, and can spur economic growth and development. On the other hand, it comes with risks for investors and can raise concerns about foreign influence in target countries.

Example

A fictional American company, Acme Software, wants to establish a software development team in the Philippines. The goal is to bring on more programmers while keeping costs low. The company sends an executive to Manila to establish an office. She sets up a local limited liability company and rents office space.

Next, she contracts recruiters, posts job ads, and interviews programmers. She hires and trains the new team members. All of the money for this comes from the US, so Acme Software is making a foreign direct investment in the Philippines.

Takeaway

Foreign direct investment is like your rich relative from abroad putting you through college…

By paying your tuition, your wealthy foreign uncle is investing in you and your future. With foreign direct investment (FDI), a person or organization in one country invests in a business in another country. This could mean setting up a new firm, acquiring an existing one, or buying a significant stake in a company. However, small investments in securities, such as stocks, are not usually considered FDI.

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Tell me more…

What is foreign direct investment (FDI)?

Foreign direct investment (FDI) occurs when a company, individual, or government invests significantly in a business in another country. FDI involves more than providing short-term financing or buying a small amount of equities. Instead, the investor has a long-term interest and significant influence in the foreign firm. The Organization for Economic Co-operation and Development (OECD) defines FDI as acquiring 10 percent or more of a company’s shares.

FDI can involve setting up a brand new company from scratch, like building a new manufacturing plant. Companies can also work with existing firms through mergers, acquisitions, and joint ventures. They can buy a significant chunk of stock in a foreign enterprise. Or they can gain influence in other ways, like subcontracting, franchising, licensing, and more. Regardless of what FDI looks like, the investor is making a lasting commitment.

Why is foreign direct investment important?

Foreign direct investment (FDI) is vital to the global economy. Many multinational corporations rely on FDI to access global supply chains, reduce costs, and secure access to new markets. This can result in competitive advantages.

For example, a large company like Ford Motors assembles automobiles in the US but sources many parts from other countries. Ford has assembly plants in China and Mexico, where cheaper labor allows the company to assemble cars at a lower cost. Ford can also send low-cost car parts from Mexico to the US to reduce domestic production costs.

Ford has invested considerable sums in foreign operations. In China, Ford put $760M into a single production plant in Hangzhou in 2012.

FDI allows Ford to expand production, source cheaper parts and components, and may make it easier to sell in local markets. Thailand, for example, places hefty tariffs on imported automobiles, which Ford avoids by operating plants locally.

FDI can also benefit the receiving country by strengthening its economy and may contribute to global political stability.

How does foreign direct investment help countries?

Investments, in general, spur economic growth. When a company invests in a new manufacturing plant, for example, it'll need to buy land, materials, and labor to build it. Suppliers, construction workers, and others will benefit from the income.

When the plant opens up, the workers it hires will get paid and go on to spend their money at local restaurants, grocery stores, and other businesses. The government, meanwhile, benefits from the tax revenues it collects from workers and companies. All of these activities encourage economic development.

Foreign direct investment (FDI) can also provide countries with resources they might otherwise lack to develop industries. That can include capital or innovative technology.

FDI can be especially beneficial for emerging markets. By providing access to resources and spurring economic development, FDI can help lift people out of poverty.

FDI flows have also proven to be a resilient source of funding. For example, during the 1997-98 global financial crisis, FDI into many Asian countries remained stable even as other revenue sources dried up. FDI can also help a country protect against the risk of losses in an economic downturn by diversifying its sources of funding. If the receiving country, or one source country, goes through an economic contraction, funds from other countries may still be available.

Also, FDI can promote economic cooperation and potentially political stability. If countries have a vested interest in each other, that can reduce the chance of conflict. After World War II, many European countries pursued greater economic cooperation — Now, the European Union is a powerful regional block. If Germany and France were to go to war or have a political spat, it would hurt their intertwined economies, so both have good reasons to avoid conflict.

What are the drawbacks of FDI for countries?

Sometimes foreign direct investment raises concerns that foreign interests can gain too much influence in a host country. This is especially true when the investor is based in a powerful country, such as the US or China, or is a large firm investing in a smaller country.

FDI can also be harmful if companies use it to pass on damaging effects of production. For example, many industrial activities, such as manufacturing and resource extraction, produce pollution and otherwise hurt the environment. When a firm sets up a plant or mine in another country, it could reap the profits while passing the environmental and health costs to the local community

FDI is highly uneven — Some countries and regions enjoy large investments and others receive little. FDI often flows from one developed country to another developed country, with the US regularly leading the world as a recipient. Many Asian countries — including China, Vietnam, and Singapore — enjoy strong FDI inflows. While Singapore, a city-state home to about 5.7M people, received $78B in FDI in 2018, while the entire continent of Africa only got $46B.

What is a foreign portfolio investment?

A foreign portfolio investment involves buying stocks, bonds, or other securities to add to your investment mix. An example of this could be purchasing shares of a Chinese tech giant or bonds from a Japanese automobile company.

A foreign portfolio investment generally acts like other investments in your portfolio. Stocks, bonds, and other securities (such as options) are liquid, meaning you can sell them quickly. When you buy stocks, you're not necessarily committing to a long-term relationship with a company.

The average investor also doesn't participate in a company's management or day-to-day operations. When someone engages in FDI, however, he or she takes an active role in the venture. That could mean managing a manufacturing plant or buying equipment and agreeing to a long-term partnership with a local company. Either way, there's a relationship. To count as FDI, the investor generally has to buy at least a 10-percent stake in the company — enough to have some influence over how it runs.

What are the types of foreign direct investments?

Foreign direct investments can be divided into three categories: horizontal, vertical, and conglomerate:

  • Horizontal FDI occurs when a company sets up a business or operation in a foreign country that is similar to its operations at home. For example, if a large American retailer opens retail stores in Mexico, it is making a horizontal foreign direct investment.
  • Vertical FDI involves companies taking control of more parts of their supply chains. A retailer can set up a plant to produce clothing, as well as plantations to source cotton. The retailer now controls more of the supply line.
  • Conglomerate FDI is when a company makes an investment in another country that has nothing to do with its domestic business — It is not in the same industry nor part of its supply chain. For example, an American retailer could open up a theme park in Canada.

What are the pros and cons of foreign direct investment?

When a person or company invests in a foreign business, they expose themselves to risks. Some dangers are geopolitical. For example, in 2009, Venezuelan President Hugo Chavez nationalized the assets of some foreign oil contractors. The contractors had invested machinery, money, and talent in Venezuela, but lost at least some of those assets when the government took control of them.

Managing global operations can also be very difficult. During the COVID-19 outbreak, for example, many US companies found their supply chains strained because of manufacturing shutdowns around the world. Many companies also had to cancel business trips and repatriate domestic staff based in foreign countries, among other challenges.

Exchange rates can also have a major impact on FDI and may pose a serious risk. Some companies invest in foreign countries due to their lower labor and production costs. If the destination country’s currency appreciates relative to the source country’s currency, production and labor costs for the investor will rise. This could reduce or wipe out cost savings due to FDI. Conversely, if a country’s currency depreciates, that could make it a more attractive destination for FDI.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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