5.5 Foreign direct investment

Foreign direct investment (FDI) is a key driver of global economic growth. It involves companies or individuals investing in businesses in other countries, typically by acquiring at least 10% of voting stock to gain control over operations and management.

FDI can take various forms, including greenfield investments, brownfield investments, and equity or non-equity modes. Motives for FDI range from market-seeking to resource-seeking, efficiency-seeking, and strategic asset-seeking, each influenced by economic, political, and cultural factors.

Definition of foreign direct investment

• Foreign direct investment (FDI) refers to the investment made by a company or individual from one country into a business or corporation located in another country
• FDI involves establishing a lasting interest and control in a foreign enterprise, typically through the acquisition of at least 10% of the voting stock or ordinary shares
• FDI differs from portfolio investment, which involves purchasing securities without gaining control over the foreign company's operations and management

Types of foreign direct investment

Greenfield vs brownfield investments

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• Greenfield investments involve establishing a new venture from the ground up in a foreign country, such as building a new factory or office
• Brownfield investments involve acquiring or leasing existing facilities in a foreign country and adapting them to the investor's needs
• Greenfield investments often require more capital and time but offer greater control over the venture, while brownfield investments can provide faster market entry and lower initial costs

Horizontal vs vertical FDI

• Horizontal FDI occurs when a company invests in a foreign country to produce the same goods or services as it does in its home country (automotive manufacturers setting up production plants in multiple countries)
• Vertical FDI involves investing in a foreign country to acquire inputs or sell outputs related to the company's main business
  • Backward vertical FDI seeks to secure raw materials or components (oil company investing in foreign oil fields)
  • Forward vertical FDI aims to control distribution channels or get closer to customers (software company establishing sales offices abroad)

Equity vs non-equity modes

• Equity modes of FDI involve ownership of foreign assets through direct investment in a company's shares or the establishment of a wholly-owned subsidiary
• Non-equity modes include contractual agreements such as licensing, franchising, and management contracts, which allow a company to enter a foreign market without direct ownership
• Equity modes offer greater control and potential profits but also higher risks and commitment, while non-equity modes provide more flexibility and lower resource requirements

Motives for foreign direct investment

Market-seeking FDI

• Market-seeking FDI aims to access new markets or expand the company's presence in existing foreign markets
• Investors may be attracted by the size, growth potential, or purchasing power of the host country's consumer base
• Market-seeking FDI often involves adapting products or services to local preferences and establishing distribution networks (fast-food chains expanding to emerging markets)

Resource-seeking FDI

• Resource-seeking FDI seeks to secure access to natural resources, raw materials, or low-cost labor in the host country
• Investors may be motivated by the abundance, quality, or cost advantages of the host country's resources (mining companies investing in resource-rich developing countries)
• Resource-seeking FDI can help companies reduce production costs, ensure supply stability, or gain a competitive edge

Efficiency-seeking FDI

• Efficiency-seeking FDI aims to rationalize production processes and exploit economies of scale or scope across multiple locations
• Investors may seek to optimize their global value chains by locating different stages of production in countries with comparative advantages (IT companies outsourcing software development to countries with skilled, low-cost labor)
• Efficiency-seeking FDI can help companies reduce costs, increase productivity, and enhance their international competitiveness

Strategic asset-seeking FDI

• Strategic asset-seeking FDI involves acquiring assets such as advanced technology, brand names, or management expertise to strengthen the company's global competitive position
• Investors may target foreign companies with complementary capabilities, intellectual property, or market access (pharmaceutical companies acquiring biotech startups for their drug pipelines)
• Strategic asset-seeking FDI can help companies acquire new competencies, enter new markets, or leapfrog competitors

Determinants of FDI flows

Economic factors

• Market size and growth potential of the host country, as measured by GDP, population, and per capita income
• Availability and cost of production factors such as natural resources, labor, and infrastructure
• Macroeconomic stability, including low inflation rates, stable exchange rates, and sustainable fiscal and external balances
• Openness to trade and investment, as indicated by the host country's trade-to-GDP ratio and the presence of free trade agreements

Political and institutional factors

• Political stability and the absence of conflicts, civil unrest, or frequent policy changes that could disrupt business operations
• Quality of institutions, including the rule of law, property rights protection, contract enforcement, and the absence of corruption
• Regulatory environment, such as the ease of doing business, tax policies, and the presence of investment promotion agencies
• International investment agreements and bilateral investment treaties that provide legal protection and dispute resolution mechanisms for foreign investors

Cultural and geographic factors

• Cultural distance between the home and host countries, which can affect communication, negotiation, and management styles
• Language barriers and the availability of bilingual or multilingual workforce
• Geographic proximity and the presence of shared borders, which can facilitate trade, logistics, and personal interactions
• Time zone differences and their impact on coordination and communication between the parent company and foreign subsidiaries

Impact of FDI on host countries

Economic growth and development

• FDI can stimulate economic growth by increasing capital formation, creating jobs, and boosting exports
• Foreign investors often bring advanced technology, management practices, and access to global markets, which can enhance the productivity and competitiveness of local firms
• FDI can also contribute to infrastructure development and the modernization of key sectors such as energy, transportation, and telecommunications

Technology and knowledge spillovers

• FDI can facilitate the transfer of technology and know-how from foreign investors to local firms through various channels such as licensing, supplier relationships, and labor mobility
• Local firms can learn from the best practices of foreign investors and adopt new production methods, quality standards, and organizational innovations
• Spillovers can also occur through demonstration effects, as local firms observe and imitate the successful strategies of foreign competitors

Employment and skill development

• FDI can create direct employment opportunities in the foreign-invested enterprises, as well as indirect jobs through backward and forward linkages with local suppliers and distributors
• Foreign investors often provide training and skill development programs for their local employees, which can upgrade the human capital in the host country
• The presence of foreign firms can also stimulate the emergence of a more educated and skilled workforce, as local universities and vocational schools adapt their curricula to meet the needs of the foreign investors

Trade and balance of payments

• FDI can boost the host country's exports by integrating local firms into global value chains and providing access to the foreign investor's distribution networks
• Foreign-invested enterprises often have a higher propensity to export than local firms, due to their international orientation and competitive advantages
• FDI can also help the host country diversify its export basket and reduce its vulnerability to commodity price fluctuations
• However, FDI can also lead to increased imports of intermediate goods and repatriation of profits, which may worsen the host country's balance of payments position

Impact of FDI on home countries

Domestic investment and employment

• Outward FDI can divert resources from domestic investment and lead to job losses in the home country, particularly in labor-intensive industries
• However, FDI can also create new demand for home-country exports of intermediate goods and services, which can support domestic employment
• Outward FDI may also help home-country firms remain competitive and preserve jobs in the long run by allowing them to access new markets and reduce production costs

Competitiveness and productivity

• Outward FDI can enhance the competitiveness of home-country firms by providing access to new technologies, knowledge, and best practices from abroad
• Investing in foreign markets can also help home-country firms achieve economies of scale and scope, which can boost their productivity and profitability
• However, outward FDI may also expose home-country firms to increased competition from foreign rivals and put pressure on their domestic operations

Repatriation of profits

• Outward FDI can generate income for the home country through the repatriation of profits, dividends, and royalties from foreign subsidiaries
• This can improve the home country's balance of payments and provide additional resources for domestic investment and consumption
• However, the timing and magnitude of profit repatriation may be affected by exchange rate fluctuations, tax policies, and reinvestment decisions of the foreign subsidiaries

Policies to attract and regulate FDI

Investment promotion agencies

• Many countries have established investment promotion agencies (IPAs) to attract and facilitate FDI inflows
• IPAs provide information and assistance to foreign investors, such as market intelligence, site selection, and administrative support
• IPAs also engage in marketing and branding activities to promote the country's investment opportunities and improve its image among foreign investors

Tax incentives and subsidies

• Governments often offer tax incentives and subsidies to attract FDI, such as tax holidays, reduced corporate tax rates, and exemptions from import duties
• These incentives can compensate foreign investors for the additional costs and risks of investing in a new market and make the country more competitive relative to other investment destinations
• However, tax incentives can also lead to revenue losses for the government and create distortions in the allocation of resources across sectors and firms

Intellectual property rights protection

• Strong intellectual property rights (IPR) protection can attract FDI by reassuring foreign investors that their technology, brands, and trade secrets will be safeguarded
• IPR protection can also stimulate innovation and technology transfer by providing incentives for foreign firms to engage in R&D and licensing activities in the host country
• However, overly stringent IPR protection may also hinder the diffusion of knowledge and technology to local firms and consumers

Environmental and labor regulations

• Governments may use environmental and labor regulations to ensure that FDI projects meet certain standards and contribute to sustainable development
• Such regulations can help prevent the exploitation of workers, the degradation of natural resources, and the pollution of the environment by foreign investors
• However, excessively strict or inconsistent regulations may also deter FDI by increasing the costs and uncertainties of doing business in the host country

Risks and challenges of FDI

Political and economic instability

• Political instability, such as frequent changes in government, social unrest, or armed conflicts, can disrupt business operations and increase the risk of expropriation or nationalization of foreign assets
• Economic instability, such as high inflation, currency volatility, or sovereign debt crises, can erode the value of foreign investments and make it difficult to repatriate profits
• Foreign investors may require higher returns or risk premiums to compensate for the additional uncertainty and vulnerability associated with investing in unstable environments

Cultural differences and adaptation

• Cultural differences between the home and host countries can create misunderstandings, conflicts, and adaptation challenges for foreign investors
• Differences in language, communication styles, social norms, and business practices can hinder effective collaboration and decision-making between foreign managers and local employees or partners
• Foreign investors may need to invest in cross-cultural training, localization of products and services, and adaptation of management practices to bridge the cultural gap and succeed in the host country

Reputational risks and controversies

• Foreign investors may face reputational risks and controversies related to their business practices, labor conditions, environmental impact, or political ties in the host country
• Negative publicity, consumer boycotts, or NGO campaigns can damage the brand image and sales of foreign firms, particularly in sensitive sectors such as extractive industries or manufacturing
• Foreign investors may need to engage in stakeholder dialogue, corporate social responsibility initiatives, and transparency measures to mitigate reputational risks and maintain their social license to operate

Trends and patterns in global FDI

Regional and sectoral distribution

• FDI flows have become increasingly concentrated in a few large economies, particularly in Asia and North America
• The services sector has attracted the largest share of FDI in recent years, particularly in industries such as finance, telecommunications, and business services
• Manufacturing FDI has shifted towards higher value-added activities and knowledge-intensive industries, such as electronics, chemicals, and automotive

Emerging market multinationals

• Emerging market multinationals have become increasingly important sources of outward FDI, particularly from countries such as China, India, and Brazil
• These firms often seek to acquire strategic assets, such as technology, brands, or distribution networks, to upgrade their capabilities and compete in global markets
• Emerging market multinationals may also face challenges related to their limited international experience, cultural differences, and political sensitivities in host countries

Impact of economic crises and shocks

• Economic crises and shocks, such as the global financial crisis of 2008-2009 or the COVID-19 pandemic, can have a significant impact on FDI flows
• During crises, FDI inflows may decline as foreign investors become more risk-averse and face liquidity constraints or falling demand in their home markets
• However, crises may also create opportunities for foreign investors to acquire assets at discounted prices or enter markets with less competition
• The impact of crises on FDI may vary across sectors and countries, depending on their exposure to the shock and their policy responses

Case studies of notable FDI projects

Successful FDI ventures

• Volkswagen's investment in China: The German automaker has established a strong presence in China through joint ventures with local partners, adapting its products to Chinese consumer preferences and benefiting from the country's growing middle class
• Intel's investment in Costa Rica: The US semiconductor company has established a major manufacturing and R&D hub in Costa Rica, taking advantage of the country's skilled workforce, political stability, and attractive investment incentives
• Unilever's investment in India: The Anglo-Dutch consumer goods company has a long history of investing in India, building a diversified portfolio of local brands and distribution networks, and contributing to the country's economic and social development

Failed or controversial FDI projects

• Shell's investment in Nigeria: The Dutch oil company has faced criticism and legal challenges related to its environmental and human rights record in the Niger Delta, including oil spills, gas flaring, and conflicts with local communities
• Foxconn's investment in Wisconsin: The Taiwanese electronics manufacturer's planned investment in a large manufacturing facility in Wisconsin has faced delays, cost overruns, and skepticism about the number and quality of jobs created, leading to a scaling back of the project
• Bechtel's investment in Bolivia: The US engineering firm's privatization and management of the water system in the city of Cochabamba led to a popular uprising and the eventual cancellation of the contract, highlighting the risks of FDI in politically sensitive sectors

Future outlook for FDI

Changing global economic landscape

• The rise of emerging markets, particularly in Asia and Africa, is likely to shift the geographic distribution of FDI flows and create new opportunities and challenges for foreign investors
• The increasing importance of the digital economy and the fourth industrial revolution may change the nature and location of FDI, with a greater emphasis on intangible assets, data flows, and innovation networks
• The growing role of state-owned enterprises and sovereign wealth funds as outward investors may create new forms of competition and collaboration with private foreign investors

Role of technology and digitalization

• The rapid advancement of digital technologies, such as artificial intelligence, blockchain, and the Internet of Things, is likely to transform the operations and strategies of foreign investors
• Digitalization may enable new forms of cross-border investment and value creation, such as digital platforms, e-commerce, and remote service delivery
• However, the digital economy may also create new risks and challenges for foreign investors, such as cybersecurity threats, data privacy regulations, and the need for digital skills and infrastructure

Sustainable and responsible investment

• There is a growing demand for foreign investors to align their strategies and practices with sustainable development goals and responsible business conduct
• This may involve integrating environmental, social, and governance (ESG) criteria into investment decisions, engaging in stakeholder dialogue and partnerships, and measuring and reporting on the impact of FDI projects
• Governments and international organizations may also use sustainability standards and incentives to guide and regulate FDI flows, such as green bonds, carbon pricing, and human rights due diligence
• The COVID-19 pandemic has highlighted the importance of resilience, inclusiveness, and sustainability in FDI, and may accelerate the shift towards more responsible and future-oriented investment strategies