Foreign direct investment happens when an individual or business owns 10% or more of a foreign company. If an investor owns less than 10%, the International Monetary Fund defines it as part of their stock portfolio.
A 10% ownership doesn't give the individual investor a controlling interest in the foreign company. However, it does allow influence over the company's management, operations, and policies. For this reason, governments track investments in their country's businesses.
Recent Foreign Direct Investment Trends
In 2020, global foreign direct investment fell by one-third to $1 trillion due to the effects of the global COVID-19 pandemic, according to the United Nations Conference on Trade and Development. That's far below 2016's peak level of foreign direct investment, which nearly hit $2 trillion.
Importance of FDI
Foreign direct investment is critical for developing and emerging market countries. Their companies need multinational funding and expertise to expand their international sales. Their countries need private investment in infrastructure, energy, and water to increase jobs and wages. The UN has also promoted the use of FDI to combat the impacts of climate change.
In 2020, developing countries received over half of the total global FDI. Most of those investments went to less-developed countries in Asia and Oceania.
Trade agreements are a powerful way for countries to encourage more FDI. One great example of this is the North Atlantic Free Trade Agreement (NAFTA), the world's largest free trade agreement. It increased FDI among the United States, Canada, and Mexico to $731 billion in 2015. That was just one of NAFTA's advantages.
Pros and Cons of FDI
- Diversifies investor portfolios: Individual investors have the potential to achieve greater portfolio efficiency (return per unit of risk), as FDI diversifies their holdings outside of a specific country, industry, or political system. Generally, a broader base of investments will dampen overall portfolio volatility and provide for stronger long-term returns.
- Provides technology to developing countries: Recipient businesses receive "best practices" management, accounting, or legal guidance from their investors. They can incorporate the latest technology, operational practices, and financing tools. By adopting these practices, they enhance their employees' lifestyles. That raises the standard of living for more people in the recipient country. FDI rewards the best companies in any country. It reduces the influence of local governments over them.
- Provides financing to developing countries: Recipient countries see their standard of living rise. As the recipient company benefits from the investment, it can pay higher taxes. Unfortunately, some nations offset this benefit by offering tax incentives to attract FDI.
- Promotes stable, long-term lending: Another advantage of FDI is that it offsets the volatility created by "hot money." That's when short-term lenders and currency traders create an asset bubble. They invest lots of money all at once, then sell their investments just as fast. That can create a boom-bust cycle that ruins economies and ends political regimes. Foreign direct investment takes longer to set up and has a more permanent footprint in a country.
- Not suitable for strategically important industries: Countries should not allow foreign ownership of companies in strategically important industries. That could lower the comparative advantage of the nation, according to an IMF report.
- Investors have less moral attachment: Foreign investors might strip the business of its value without adding any. They could sell unprofitable portions of the company to local, less sophisticated investors.
- Unethical access to local markets: They can use the company's collateral to get low-cost, local loans. Instead of reinvesting it, they lend the funds back to the parent company.
Tracking Foreign Direct Investment
Four agencies keep track of FDI statistics.
- The U.N. Conference on Trade and Development publishes the Global Investment Trends Monitor. It summarizes FDI trends around the world.
- The Organization for Economic Cooperation and Development publishes quarterly FDI statistics for its member countries. It reports on both inflows and outflows. The only statistics it doesn't capture are those between the emerging markets themselves.
- The IMF published its first Worldwide Survey of Foreign Direct Investment Positions in 2010. This annual worldwide survey is available as an online database. It covers investment positions for 72 countries. The IMF received help from the European Central Bank, Eurostat, the Organization for Economic Cooperation and Development, and the United Nations Conference on Trade and Development.
- The Bureau of Economic Analysis reports on the FDI activities of U.S. affiliates of foreign companies. It provides the financial and operating data of these affiliates. It says which U.S. companies were acquired or created by foreign ones. It also describes how much U.S. companies have invested overseas.
The Bottom Line
A foreign direct investment happens when a corporation or individual invests and owns at least ten percent of a foreign company. When an American tech company opens a data center in India, it makes an FDI. The BEA tracks U.S. FDI.
Many developing countries need FDI to facilitate economic growth or repair. International trade agreements have paved the way for increasing FDI flows. FDI has benefited countries through:
- Raised living standards in emerging markets
- Competitive global capital allocation
- Dampening of market volatility caused by asset bubbles
But FDI can become a disadvantage when:
- Comparative advantage is lowered by foreign investment in strategic industries.
- It strips or adds no value to businesses.
In an increasingly globalized economy, the opportunities for foreign direct investment are growing. Investing abroad may be very financially rewarding, but also consider that such investment carries weighty risks.
Frequently Asked Questions (FAQs)
What is horizontal foreign direct investment, and how does it compare to vertical FDI?
Horizontal foreign direct investment refers to a business and production model that can be replicated across multiple countries. These businesses can conduct their operations within a single country, and when they invest abroad, those investments are entirely contained within that country.
Vertical FDI involves breaking up the production and distribution processes. By fragmenting the process, vertical FDI allows a company to do each step of its process in the cheapest country for that specific step.
What kind of reserves does FDI help maintain?
FDI can help maintain stable foreign exchange reserve levels. The same factors that make FDI effective at promoting stable, long-term lending in equity markets can also apply to currency and bond markets.