Foreign direct investment


Foreign direct investment is an ownership stake in a company, made by a foreign investor, company, or government from another country. More specifically, it describes a controlling ownership of an asset in one country by an entity based in another country. The magnitude and extent of control, therefore, distinguishes it from a foreign portfolio investment or foreign indirect investment. Foreign direct investment includes expanding operations or purchasing a company in the target country.

Definitions

Broadly, foreign direct investment includes mergers and acquisitions, building new facilities, reinvesting profits earned from overseas operations, and intra company loans. A narrow definition employed by the World Bank considers foreign direct investment to be a lasting management interest of 10% or more of voting stock in an enterprise operating in an economy other than that of the investor. FDI is the sum of equity capital, long-term capital, and short-term capital as shown in the balance of payments. FDI usually involves participation in management, joint-venture, transfer of technology and expertise. Stock of FDI is the net cumulative FDI for any given period. Direct investment excludes investment through purchase of shares.
FDI, a subset of international factor movements, is characterized by controlling ownership of a business enterprise in one country by an entity based in another country. Foreign direct investment is distinguished from foreign portfolio investment, a passive investment in the securities of another country such as public stocks and bonds, by the element of "control". According to the Financial Times, "Standard definitions of control use the internationally agreed 10 percent threshold of voting shares, but this is a grey area as often a smaller block of shares will give control in widely held companies. Moreover, control of technology, management, even crucial inputs can confer de facto control."

Theoretical background

Before Stephen Hymer's seminal work on FDI in 1960, no theory existed that dealt specifically with FDI. However, there are theories that dealt generally with foreign investments. Both Eli Heckscher and Bertil Ohlin developed the theory of foreign investments by using neoclassical economics and macroeconomic theory. Based on this principle, the differences in the costs of production of goods between two countries cause specialisation of jobs and trade between countries. Reasons for differences in costs of production can be explained by factor proportions theory. For example, countries with a greater proportion of labour will engage in labor-intensive industries while countries that have a greater proportion of capital will engage in capital-intensive industries. However, such a theory makes the assumption that there is perfect competition, there is no movement of labour across country borders, and the multinational companies assumes risk neutral preferences. In 1967, Weintraub tested this hypothesis by collecting United States data on rate of return and flow of capital. However, the data failed to support this hypothesis. Data from surveys on the motivation of FDI also failed to support this hypothesis.
Intrigued by the motivations behind large foreign investments made by corporations from the United States of America, Hymer developed a framework that went beyond the existing theories, explaining why this phenomenon occurred, since he considered that the previously mentioned theories could not explain foreign investment and its motivations. Facing the challenges of his predecessors, Hymer focused his theory on filling the gaps regarding international investment. The theory proposed by the author approaches international investment from a different and more firm-specific point of view. As opposed to traditional macroeconomics-based theories of investment, Hymer states that there is a difference between mere capital investment, otherwise known as portfolio investment, and direct investment. The difference between the two, which will become the cornerstone of his whole theoretical framework, is the issue of control, meaning that with direct investment firms are able to obtain a greater level of control than with portfolio investment. Furthermore, Hymer proceeds to criticize the neoclassical theories, stating that the theory of capital movements cannot explain international production. Moreover, he clarifies that FDI is not necessarily a movement of funds from a home country to a host country, and that it is concentrated on particular industries within many countries. In contrast, if interest rates were the main motive for international investment, FDI would include many industries within fewer countries.
Another observation made by Hymer went against what was maintained by the neoclassical theories: foreign direct investment is not limited to investment of excess profits abroad. In fact, foreign direct investment can be financed through loans obtained in the host country, payments in exchange for equity, and other methods.
The main determinants of FDI is side as well as growth prospectus of the economy of the country when FDI is made. Hymer proposed some more determinants of FDI due to criticisms, along with assuming market and imperfections. These are as follows:
  1. Firm-specific advantages: Once domestic investment was exhausted, a firm could exploit its advantages linked to market imperfections, which could provide the firm with market power and competitive advantage. Further studies attempted to explain how firms could monetize these advantages in the form of licenses.
  2. Removal of conflicts: conflict arises if a firm is already operating in foreign market or looking to expand its operations within the same market. He proposes that the solution for this hurdle arose in the form of collusion, sharing the market with rivals or attempting to acquire a direct control of production. However, it must be taken into account that a reduction in conflict through acquisition of control of operations will increase the market imperfections.
  3. Propensity to formulate an internationalization strategy to mitigate risk: According to his position, firms are characterized with 3 levels of decision making: the day to day supervision, management decision coordination and long-term strategy planning and decision making. The extent to which a company can mitigate risk depends on how well a firm can formulate an internationalization strategy taking these levels of decision into account.
Hymer's importance in the field of international business and foreign direct investment stems from him being the first to theorize about the existence of multinational enterprises and the reasons behind FDI beyond macroeconomic principles, his influence on later scholars and theories in international business, such as the OLI theory by John Dunning and Christos Pitelis which focuses more on transaction costs. Moreover, "the efficiency-value creation component of FDI and MNE activity was further strengthened by two other major scholarly developments in the 1990s: the resource-based and evolutionary theories." In addition, some of his predictions later materialized, for example the power of supranational bodies such as International Monetary Fund or the World Bank that increases inequalities, a phenomenon the United Nations Sustainable Development Goal 10 aims to address.

Types of FDI

The types of FDI investments can be classified from the perspective of the investor/source country and the host/destination country. From the investor perspective, it can be divided into horizontal FDI, vertical FDI, and conglomerate FDI. From the perspective of the destination country, FDI can be divided into import-substituting, export-increasing, and government initiated FDI. Horizontal FDI arises when a multination corporation duplicates its home country industry chain into the destination country to produce similar goods. Vertical FDI takes place when a multinational corporation acquires a company to exploit the natural resources in the destination country or by acquiring distribution outlets to market its products in the destination country. Conglomerate FDI is the combination between horizontal and vertical FDI.
Platform FDI is the foreign direct investment from a source country into a destination country for the purpose of exporting to a third country.

Methods

The foreign direct investor may acquire voting power of an enterprise in an economy through any of the following methods:
  • by incorporating a wholly owned subsidiary or company anywhere
  • by acquiring shares in an associated enterprise
  • through a merger or an acquisition of an unrelated enterprise
  • participating in an equity joint venture with another investor or enterprise

    Forms of FDI incentives

Foreign direct investment incentives may take the following forms:
Foreign Direct Investment tends to increase with the democracy index of the country for countries where the share of natural resources in total exports is low. For countries with high natural resource export share, the FDI tends to decrease with a higher democracy index.
A 2010 meta-analysis of the effects of foreign direct investment on local firms in developing and transition countries suggests that foreign investment robustly increases local productivity growth.
From 1992 until at least 2023, the United States and China have been the top two destinations for FDI.