What Is Foreign Direct Investment?: Meaning, Types, Pros & Cons

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One of the striking aspects of globalization over the past few decades is the rising importance of foreign direct investment. FDI occurs whenever an investor, usually a multinational corporation, has facilities in another country such as real estate or subsidiaries over which it has control. FDI is a controversial issue in international economics. Some say it creates jobs and improves infrastructure in the recipient country, while others call it exploitative.

Direct Foreign Investment Meaning

FDI is not simply putting your money into the assets of another country. So, if you bought a few shares of stock in a foreign company, that would be a regular portfolio investment. With FDI, the idea is to own and control the foreign investment. So if a multinational acquired a controlling interest in a foreign company, or merged with a foreign company or set up a subsidiary abroad, then that would constitute FDI. The main determinant of an FDI is controlling the foreign entity. Generally, owning 10 percent or more of a foreign company's voting stock will qualify as FDI since this allows for influence over the company's operations and policy framework.

Types of Foreign Direct Investment

There are three types of FDI: horizontal, vertical or conglomerate. A horizontal investment occurs when a company opens the same type of business in the recipient country as it operates at home, for example, a U.S.-based telecommunications company opening in India. Where the business is different but related, such as a manufacturer acquiring a company that makes the main component of its products, it's called a vertical investment. A conglomerate FDI is entirely unrelated to the company's home activities. Since the investor is entering a brand new industry, he'll usually look for a foreign joint venture partner that's already operating in the target industry.

What Are the Reasons for Foreign Direct Investment?

Companies choose FDI for all sorts of reasons, most commonly to open up new sales markets abroad. Opening a subsidiary in China, for example, gives you greater proximity to the consumers in that market. Profit is a major driver, and investors will generally target FDI towards countries with low labor costs and abundant raw materials so they can produce their goods more cheaply. Tariff jumping is another motivation. For example, if a U.S. auto company wanted to sell cars to Brazil, they would have to pay tariffs at the border. But if they set up a factory inside Brazil, they could avoid tariffs by manufacturing the cars inside the destination country.

What Are the Advantages of FDI?

A lot of people like the idea of FDI because it should involve the flow of cash and technical know-how from rich countries to poor countries. When an international company comes in, it should strengthen the local economy by creating new jobs. This, in turn, boosts government tax revenues which the government can spend on services and infrastructure. Since FDI is a long-term commitment, there theoretically should be a steady growth-accelerating effect as more money trickles into the recipient country. Reducing production costs also translates to lower sales prices for consumers around the globe.

What Are the Drawbacks of FDI?

For the recipient country, allowing a foreign company to control key industries like transportation can cause serious problems down the road. If the company abandons the project, the recipient could be left with a sudden reversal of capital that it can't replace. There's also concern about where the profit from the foreign-owned company will go. The local community may benefit from jobs, but if the profits are being repatriated to the home country, this could be a drain on resources in the long run.