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Learn what a foreign direct investment (FDI) is. Find out which types of FDIs exist and see some examples. Understand the pros and cons of foreign direct investment.Updated: 11/21/2023
Table of Contents
- Foreign Direct Investment Definition
- Types of Foreign Direct Investments
- Foreign Direct Investment Examples
- Foreign Direct Investment Advantages and Disadvantages
- Lesson Summary
- FAQs
- Activities
Foreign Direct Investment - a Business Case:
The business case below is designed for you to apply your knowledge on the topic of Foreign Direct Investment to a real-world context.
Context:
You are the chief economic policy adviser to Exxon's African operations. You have received a call from the Zimbabwe government offering its cooperation in setting up a Foreign Direct Investment in its economy. Economic turmoil in Zimbabwe's recent history has resulted in a large currency devaluation, and an economic crisis, which the government argues is a "great opportunity" for a company like Exxon's to invest in the country.
You take the following notes during your conversation with the official from Zimbabwe:
- The currency devaluation and high unemployment rate means that the cost of local labor is 50% less than the African average.
- The economic downturn has been accompanied by political unrest with citizens claiming that elections have been rigged.
- The government is willing to waive its gasoline and petroleum tax on any oil products sold to Zimbabwe consumers.
- Although the World Bank stated that Zimbabwe's recovery timeline from its economic downturn is highly uncertain, the official states that the economy is already improving.
- The government is willing to grant rapid access to necessary drilling permits for oil fields that have proven reserves.
Required:
Write a short-format essay (minimum 100 words) destined to the President of Exxon explaining the pros and cons to the Foreign Direct Investment proposed by the Zimbabwe government. In addition, do you think Exxon's agreement with the government would have a positive or negative impact on Zimbabwe's political conditions? Explain.
What are the disadvantages of foreign direct investment?
Some potential disadvantages of foreign direct investment (FDI):
- The host country can lose control over its economy, and people may lose jobs if companies relocate production to lower-cost countries.
- There can be negative impacts on the environment from foreign investment in extractive industries.
- FDI can create social tensions as foreign companies' goals conflict with local communities.
What is the meaning of foreign direct investment?
Foreign direct investment (FDI) is when a company or individual of one country invests in the business interests of another country in the form of creating or acquiring foreign companies or assets to gain a measure of control over their operation. In practical terms, it is a transfer of capital from one country to another to establish a foreign business presence.
What is the advantage of foreign direct investment?
There are several advantages associated with the foreign direct investment (FDI).
- It can provide a country with much-needed capital, which is especially important for developing countries with difficulty accessing capital markets.
- FDI can lead to the transfer of technology and know-how. This can help to boost a country's productive capacity and make its firms more competitive.
- It can create jobs and spur economic growth, which is important in times of high unemployment.
- FDI can help generate foreign exchange earnings, which can be used to finance imports or service foreign debt.
Table of Contents
- Foreign Direct Investment Definition
- Types of Foreign Direct Investments
- Foreign Direct Investment Examples
- Foreign Direct Investment Advantages and Disadvantages
- Lesson Summary
A foreign direct investment (FDI) is when a company or individual of one country invests in the business interests of another country, in the form of either acquiring foreign companies or establishing business operations. FDIs are distinct from portfolio investments as they involve a long-term relationship and control of the investee's company. Multinational corporations (MNCs) and multinational enterprises (MNEs) are two common names for foreign direct investors.
The main purpose of FDIs is to gain a foothold in new markets and access to natural resources, labor, and technology. By investing directly in another country, companies can bypass the tariffs and other trade barriers between their home country and the target market. Additionally, FDI allows companies to benefit from the lower costs associated with production in developing countries. FDIs can be made through various mechanisms, such as setting up a new subsidiary or joint venture, acquiring an existing company, or investing in real estate.
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There are four main types of foreign direct investments. The following illustrates and explains each type:
- Horizontal FDI: This is when a company expands its operations into a foreign market by opening up new facilities to produce the same types of products or services that it offers in its home market. An example would be a US-based auto manufacturer setting up a new assembly plant in Mexico.
- Vertical FDI: This is when a company expands its operations into a foreign market by creating new production stages in the value chain for its products or services. An example would be a US-based auto manufacturer setting up a new parts supplier in Mexico.
- Conglomerate FDI: This is when a company expands its operations into a foreign market through acquisitions or greenfield investments in unrelated businesses. An example would be a US-based conglomerate that owns a variety of businesses, such as a food company, a clothing company, and a bank, expanding its operations into Mexico by acquiring a Mexican food company.
- Platform FDI: It happens when a company expands its operations into a foreign market by creating new business ventures with local partners. An example would be a US-based social media company setting up a joint venture with a Canadian telecommunications company to create a new social media platform for the Canadian market.
Each of these types of foreign direct investment provides different opportunities and challenges for companies. It is important to carefully consider which type of FDI is right for a company before making any decisions.
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Here are some common real-world foreign direct investment examples. Each of these foreign direct investments (FDI) represents a different type of investment and has various motivations behind it.
- A US company builds a factory in Mexico to take advantage of lower labor costs. The first example elaborates on labor arbitrage, where a company seeks to reduce costs by relocating production to a cheaper jurisdiction.
- A Japanese company buys a majority stake in a Thai automaker. This is an example of an acquisition, where a foreign company obtains a controlling interest in a local firm.
- An Indian conglomerate acquires a British luxury hotel chain. The third example is an asset purchase, where an investor buys foreign assets for strategic reasons.
- A Chinese tech giant invests in a US-based artificial intelligence startup. This example is of a venture capital investment, where a foreign company bets on the potential growth of a promising startup.
- A Russian oil company drills for oil in Venezuela. The last example illustrates resource extraction, where a foreign company takes advantage of another country's natural resources.
These are just a few instances of foreign direct investment; there are many more types and motivations for FDI. But whatever be the reason to invest abroad, all foreign direct investments have one thing in common: they involve risk. Political instability, currency fluctuations, and differing business cultures can make foreign markets challenging to navigate. But for companies that are willing to take on the risk, foreign direct investment can be a powerful tool for growth.
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There are both advantages and disadvantages to foreign direct investment (FDI). Some advantages of FDI include:
- Access to new markets: By investing in a foreign market, companies can gain access to new consumers. This can help them to expand their customer base and increase sales.
- Technology: Foreign firms often have access to the latest technologies that they can transfer to or use for the host country. This can help to improve the productivity of local firms.
- Capital: FDI can bring much-needed capital into a country through tax revenue. This can be used to finance projects which would otherwise not be possible.
- Increased employment: FDI can create jobs both directly (by employing locals) and indirectly (by stimulating economic activity).
- Competition: By encouraging foreign firms to enter the market, local companies are forced to become more efficient and innovative in order to sustain themselves.
Some disadvantages of FDI include:
- Political instability: Investing in a country that is politically unstable can be risky. There is the potential for violence and even the confiscation of assets.
- Currency fluctuations: If a company invests in a country with a weak currency, this can lead to losses if the currency devalues.
- Cultural differences: There can be difficulties adapting to a new culture, which can lead to misunderstandings and conflict.
- Undeveloped legal system: In some countries, the legal system is not well developed. This can make it difficult to resolve disputes and protect property rights.
Companies and individuals should do their research before making any foreign investments. They should carefully consider the advantages and disadvantages to ensure that they are making the best decision for their business.
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Foreign direct investment (FDI) refers to a business interest established or acquired in another country by a firm or individual, usually through the installation of business operations or acquisition of foreign firms. Foreign direct investors are often known as multinational corporations (MNCs) and multinational enterprises (MNEs). The primary goal of FDIs is to gain a competitive advantage in new markets and access to natural resources, human labor, and technology. Although there are several benefits to establishing FDI, many risks are associated with this type of investment.
When a company invests in another company, it often relinquishes some degree of control over the investee company, which can be risky. Additionally, there is always the risk that the target market may not be receptive to foreign investment, and this can lead to a loss of the initial investment. Another risk associated with FDI is that it can create dependency. This is particularly true for developing countries with underdeveloped legal systems that become dependent on foreign companies for economic growth. Political instability in the host country could also lead to a withdrawal of foreign investment, which negatively impacts the economy of the host country. Investors must carefully evaluate the benefits and risks before making a foreign direct investment.
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Video Transcript
Definition of Foreign Direct Investment
Foreign direct investment (FDI) is an investment in a business by an investor from another country for which the foreign investor has control over the company purchased. The Organization of Economic Cooperation and Development (OECD) defines control as owning 10% or more of the business. Businesses that make foreign direct investments are often called multinational corporations (MNCs) or multinational enterprises (MNEs). An MNE may make a direct investment by creating a new foreign enterprise, which is called a greenfield investment, or by the acquisition of a foreign firm, either called an acquisition or brownfield investment.
Advantages of FDI
In the context of foreign direct investment, advantages and disadvantages are often a matter of perspective. An FDI may provide some great advantages for the MNE but not for the foreign country where the investment is made. On the other hand, sometimes the deal can work out better for the foreign country depending upon how the investment pans out. Ideally, there should be numerous advantages for both the MNE and the foreign country, which is often a developing country. We'll examine the advantages and disadvantages from both perspectives, starting with the advantages for multinational enterprises (MNEs).
- Access to markets: FDI can be an effective way for you to enter into a foreign market. Some countries may extremely limit foreign company access to their domestic markets. Acquiring or starting a business in the market is a means for you to gain access.
- Access to resources: FDI is also an effective way for you to acquire important natural resources, such as precious metals and fossil fuels. Oil companies, for example, often make tremendous FDIs to develop oil fields.
- Reduces cost of production: FDI is a means for you to reduce your cost of production if the labor market is cheaper and the regulations are less restrictive in the target foreign market. For example, it's a well-known fact that the shoe and clothing industries have been able to drastically reduce their costs of production by moving operations to developing countries.
FDI also offers some advantages for foreign countries. For starters, FDI offers a source of external capital and increased revenue. It can be a tremendous source of external capital for a developing country, which can lead to economic development.
For example, if a large factory is constructed in a small developing country, the country will typically have to utilize at least some local labor, equipment, and materials to construct it. This will result in new jobs and foreign money being pumped into the economy. Once the factory is constructed, the factory will have to hire local employees and will probably utilize at least some local materials and services. This will create further jobs and maybe even some new businesses. These new jobs mean that locals have more money to spend, thereby creating even more jobs.
Additionally, tax revenue is generated from the products and activities of the factory, taxes imposed on factory employee income and purchases, and taxes on the income and purchases now possible because of the added economic activity created by the factory. Developing governments can use this capital infusion and revenue from economic growth to create and improve its physical and economic infrastructure such as building roads, communication systems, educational institutions, and subsidizing the creation of new domestic industries.
Another advantage is the development of new industries. Remember that an MNE doesn't necessarily own all of the foreign entity. Sometimes a local firm can develop a strategic alliance with a foreign investor to help develop a new industry in the developing country. The developing country gets to establish a new industry and market, and the MNE gets access to a new market through its partnership with the local firm.
Finally, learning is an indirect advantage for foreign countries. FDI exposes national and local governments, local businesses, and citizens to new business practices, management techniques, economic concepts, and technology that will help them develop local businesses and industries.
Disadvantages to MNEs
Of course, there can also be some drawbacks for foreign direct investment. We'll start with the disadvantages for multinational enterprises (MNEs).
- Unstable economic conditions: Much of the FDI takes place in the developing world, which is thusly named because it's just developing its economic systems. The market conditions in the developing world can be quite unstable and unpredictable.
- Unstable political and legal systems: An even bigger problem may be unstable or underdeveloped political and legal systems. A company may have to deal with a corrupt or unstable political system. Additionally, the legal system may be underdeveloped. Contracts and property rights may not be easily enforced, for example.
There can also be disadvantages for foreign countries involved in FDI.
- Race to the bottom: Some have argued that developing nations are forced into a race to the bottom in labor and regulations in order to attract foreign investors who seek cheap labor and non-existent or lackadaisical regulation to maximize its profit potential. Such a race could result in severe environmental damage to the foreign country, the stripping of natural resources, and abusive labor practices that are not acceptable in the developed world.
- Crowding out local development: Foreign investment may also crush the local competition, resulting in problems in long-term economic development.
- Undue political influence: MNEs can theoretically exert a huge amount of power in a developing country because of the capital it brings into the country. This influence may be compounded if a corrupt government is in place willing to acquiesce to deals that may not be in the best interests of its citizens.
Lesson Summary
Let's review. Foreign direct investment (FDI) occurs when a business invests in a foreign country by either acquiring a foreign business that it controls or starting a business in the foreign country.
Advantages and disadvantages often depend upon whether you are the investing company or the foreign country.
Advantages for the company investing in a foreign market include access to the market, access to resources, and reduction in the cost of production. Disadvantages for the company include an unstable and unpredictable foreign economy, unstable political systems, and underdeveloped legal systems.
Advantages for the foreign country include infusion of foreign capital, increases in revenue, development of new industries, and the ability to learn from foreign investors. Disadvantages for the foreign country include getting caught in a race to the bottom resulting in poor labor treatment and environmental destruction, the risk that foreign investment will crowd out local development, and the possibility of undue political influence of foreign investors.
Learning Outcomes
Study foreign direct investment through this video lesson, then test your ability to:
- Understand what foreign direct investments (FDIs) and multinational enterprises (MNEs) are
- Note the related advantages and disadvantages for the company investing in a foreign market and for the foreign country
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