Foreign Direct Investment

The term foreign direct investment (FDI) refers to the purchase of an interest in a company from an investor or company that is located outside of the borders of the company in which the investment is made. In other words, we can define foreign direct investment as a foreign investor or company purchasing interest in a company from the USA or the other way around.

Simple stock investment in a foreign company does not equate with foreign direct investment. Usually, this term is used when we describe the decision of a company or investor to purchase a generous share in a business that is outside their jurisdiction. At the same time, foreign direct investment can mean simply buying a company intending to expand the business to new regions.

How does Foreign Direct Investment Work?

In general, companies that consider foreign direct investment in a business look at companies that share the following characteristics: the company is in an open economy, the environment of that economy offers a skilled workforce, and the company has above-average growth prospects. If the country also provides light regulation, this is a plus for potential investors.

Investors don’t limit themselves to only capital investments when it comes to foreign direct investment. For instance, the investor may also provide technology, management, and equipment to ensure a profitable future for the company.

The way in which foreign direct investment differs from stock investment in a foreign company is by establishing control over the foreign business or, at least, the possibility to influence the company’s decision-makers substantially.

Due to COVID-19, in 2020, the global market faced a sudden drop in foreign direct investments. From the previous year, when global investment had been at $1.5 trillion, in 2020, this fell to $859 billion. This also happened as China dislodged the US as a top investor, attracting over $163 billion in investment, while the US only managed to attract $134 billion.

Foreign direct investments can result from various practices. The most common are opening an associate or subsidiary company, purchasing a controlling interest in a company, or mergers or joint ventures with a foreign company.

While the definition of foreign direct investment is flexible, the Organization of Economic Cooperation and Development (OECD) established that a minimum of 10% ownership stake is required. In some instances, investors can achieve effective control with less than 10% of a company's voting shares.

Types of Foreign Direct Investment

There are three categories of foreign direct investments:

• Horizontal Direct Investment: company A establishes the same type of business in another country as they have in their own country by buying interest in providers of those services in the foreign country. For example, a US cell phone provider buys phone store chains in China.
• Vertical Direct Investment: company A buys a business in another country that’s complementary to their business in their country. For example, a US fashion brand acquires interest in a leather-making factory in India.
• Conglomerate Direct Investment: company A invests in a company from another country that is unrelated to their core business.

Advantages and Disadvantages of Foreign Direct Investment

In many ways, both parties involved in this economic practice benefit from it. While foreign direct investment fosters and maintains economic growth, infrastructure development, and new jobs for both of them, it is also a way for the company that invests to expand its footprint into international markets.

The downside of foreign direct investment, however, is that it deals with regulations from multiple governments and oversight. This can lead to a higher political risk. Also, regarding vertical direct investment, it’s important to note that manufacturing is regulated differently in the US than in other countries. The above example can further underline why this is problematic from an environmental perspective. To follow the example, India doesn’t have the laws and regulations imposed in the US. That means that while the labor and materials are cheaper there, the resulting pollution is much higher, impacting the sustainability of those products.