Foreign Direct Investment (FDI)

What Is a Foreign Direct Investment (FDI)?

Foreign Direct Investment, also known as FDI, is a cross-border investment in which a corporation or an individual from one country invests in the business interests of another nation. This can be executed by acquiring businesses or ownership of the business.

FDI is a type of influence from one nation or individual to another nation, or organization present in a foreign country with a long-term interest.

FDIs include cash inflows through foreign investors and the import of key technologies, knowledge, skills, and expertise. It can be characterized as one of the finest non-debt sources of financing for economic development.

Such capital transactions and proceedings are considered direct investments between the direct investor and foreign direct investment enterprise. The direct enterprise part in a foreign nation is usually a branch that is wholly joined and owned.

10% of voting power by a direct investor carrying ownership should be sustained. The IMF advises it as an ideal percentage expression between Foreign Direct Investment and a shareholding portfolio investment. 

One key characteristic of foreign direct investment is that it is predominantly possible in developing nations with abundant growth potential and a skilled workforce.

The decision to set up depends on several factors, such as

• Domestic Regulations
• Industrial Regulations
• Government Subsidies
• Tax Regulations In The Foreign Country
• Currency Exchange Rate
• Government Restrictions, and
• Political Agendas.

Foreign Direct Investment is one key factor that has increased as a result of globalization. Globalization has accelerated since the end of the 20th century. MNCs and corporations optimize it to exploit differences in costs of production among nations.

It is important in economic cooperation as it generates stability and long-term connections between integrated economies. It is a key mode for technological transfer between nations, enhances international trade through trade liberalization, and promotes economic development.

Understanding Foreign Direct Investments (FDIs)

Foreign direct investments (FDIs) are characterized by the purchase of assets in another nation that gives the acquirer direct control over the assets. Examples of FDIs may include the purchase of land and buildings or the acquisition of controlling interests in corporations, which may include real estate or factories.

The investments could be made inorganically by acquiring businesses or corporations. Or, the FDIs can be executed organically by expanding existing businesses or corporations in the target country.

The key feature of an FDI is the acquisition of control in the target company's day-to-day affairs to influence the direction and operations of the firm. This is a major differentiating factor between an FDI and a Passive Foreign Portfolio Investment.

It is important to remember that an FDI approval process can take several weeks and requires extensive checks on the investor's background and business.

Foreign Direct Investments (FDIs) Process In The Republic Of India

The approval process in India can take up to 8-12 weeks which includes strict background and feasibility checks. The approval process can include:

• Filing the application online on the National Single Window System (NSWS)
• Preparations of FDI application as per the requirements and formats required under NSWS
• Uploading the documents digitally signed by authorized personnel filing the application
• Examination of relevant documents by relevant administrative ministries and departments for the respective sector under which FDI is offered
• DPIIT then identifies and transfers the application to the relevant authority.

The parties involved have other obligations and requirements in addition to these. These may include reporting obligations, pricing guidelines, and compliance with the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, as amended from time to time.

FDI and Investment Approaches

There are particularly two approaches to FDIs, that is macro and micro approaches. 

From a macro perspective, FDIs' have an effect on host nations which involves analyzing the overall impact on various factors, such as economic growth, technological development, and income distribution.

The Macro FDI approach constitutes the the use of macroeconomic models and data to estimate the results of FDIs on the host nation's economy.

On the other hand, the Micro FDI approach focuses on the behavior and performance of individual firms engaging in FDI. This particular approach involves analyzing the motivations, strategies, and performance of multinational companies and their subsidiaries in host nations.

The micro-level approach typically involves researching firm-level data and case studies to understand the factors that influence MNCs' investment performance decisions. 

The key factor is an ongoing interest that evaluates a long-term relationship between both parties. Control is crucial in FDI as it indicates the proper intention to influence and impact a foreign organization’s investment operations. 

In addition, some greenfields and brownfields investments are applied to international organizations.

Greenfields occur when a large company enters emerging markets to construct new plants and factories. On the contrary, brownfields occur when an organization buys a current production facility to generate new production activity.

They are fast to implement and less costly than greenfield investments. However, there are a few limitations, such as cultural differences, outdated equipment, and redundant current employees. 

Types of Foreign Direct Investment (FDIs)

Foreign direct investments are investments in foreign countries that involve the acquisition of controlling interests in businesses or the purchase of real estate or productive assets.

There are four types of FDIs that are to be discussed, which include

• Horizontal FDIs
• Vertical FDIs
• Conglomerate FDIs
• Platform FDIs

Horizontal FDIs

Horizontal is when an organization expands its domestic functions and enters a foreign nation. However, all business activities are done the same in a foreign country. 

Horizontal is a foreign direct investment scheme that occurs between industrialized nations to prevent trade barriers, capitalize on technical excellence, and improve access to the domestic economy.

The majority of FDI is horizontal rather than vertical. Most of it is attracted to large competitive markets rather than lower prices and cost cuts. Horizontal FDI focuses on catering to the foreign host market, but vertical FDI is subject to the domestic one.

Horizontal FDI focuses on mitigating trade costs, and the domestic country is considered much larger than the foreign country. 

Vertical FDIs

The alternate type is Vertical, where an organization expands into a foreign nation by shifting its business activities into a value chain that is still related to the core business.

Vertical FDI is when an industrialized nation reduces costs by relocating a production process to a country with low wages.

Vertical involves both foreign direct investment and exports. It also highlights cost-cutting and saving to achieve economies of scale. As such, there are smaller price changes. Vertical is also given the name of international outsourcing.

Conglomerate FDIs

An FDI is defined as a foreign investment by a company from the source nation in a company in the host nation whose business operations are totally distinct from the core operations of the source nation's company.

Conglomerate FDI is a form of diversification where a source nation's company seizes the opportunity to invest to add business expertise or initiate business operations in a new country.

This type of investment can be an adventure for the investing company as the company needs to navigate through various cultural, logistical, and financial challenges.

Platform FDIs

A type of foreign investment in a domestic company with the primary purpose of exporting the produced products to a third country. These investments are typically common in nations that are FDI-hungry. Here, luxury items are marketed by famous fashion companies and manufactured.

These investments act as tools for countries to attract foreign business investments that significantly contribute towards economic growth and development.

Promoting FDI for Economic Growth

Several government entities promote foreign direct investment in their nations to stimulate job creation, expand know-how and labor skills, and improve economic growth. In addition, governments look for ways to expand their economies and attract capital and R&D to their countries. 

Governments encourage FDI in multiple ways. Some of the ways are discussed as follows:

1. The first method involves financial incentives such as loans, tax cuts, and insurance schemes to foster an organization’s foreign investments. 
2. Foreign governments also promote local infrastructural improvements in transportation and energy to encourage industries to invest. 
3. Governments also invest in education by improving workforce skills and knowledge as part of human capital development, this makes countries more attractive for a higher return on investment and value. 
4. Foreign governments also promote political and economic stability for domestic businesses by endorsing stability and transparency in policies, guaranteeing no changes in legal systems and operational reforms.

FDI Advantages and Disadvantages

There are several advantages and disadvantages of FDI. The first advantage is economic growth.

Advantages include:

• Economic Growth: FDI improves manufacturing, decreasing structural, frictional, and seasonal unemployment in a nation. In addition, more job creation improves buying power, leading to more economic productivity and growth. Customers are also granted more consumer choices at a cost-effective, low price.
• Human Capital Development: Another advantage is human capital development. Human capital optimizes skills, knowledge, and competencies. Employees can achieve skills using training and experience to boost the combined skills of the domestic workforce.  
• Technological Transfer: Technology can improve a country’s economic efficiency, performance, and productivity since advanced infrastructure and innovation can cut costs and boost investment in the domestic economy. It involves generating jobs and employment to attract FDI.
• Exportation Increases: A positive net can also increase exports; thus, foreign direct investment is improved due to more investors' attraction to trade. Moreover, there will be a positive exchange rate impact as it will stabilize and balance the economy.
• Improved Competition: Lastly, it enhances competition within the market by creating a competitive environment where organizations continuously develop their value propositions and systems to support innovation. 

Disadvantages include:

• Domestic Market Hindrance: The entry of foreign companies may pose a threat to local companies. The grip and presence of domestic companies have will be compromised as there is a chance foreign companies may provide better products and services.
• Political Risks: It also poses political risks since each government has restrictions and regulations to protect domestic countries from takeovers and intense competition. Therefore, political implications negatively affect investment and trade. 
• Exchange Rate Depreciation: It can also harm the exchange rates, giving rise to inflation and reducing the buying power of consumers. This can also adversely threaten costs since investment in foreign countries is high and expensive.

FDIs have a significant role in a country's economic development, but the disadvantages should not be overlooked.

COVID-19 and FDI

COVID-19 was a driving force in the surge of FDI in 2020. It is reported that international FDI decreased by 35%, valued at $1 trillion, in 2020 from the previous year, 2019. The rapid shortfall highly impacted emerging market economies, reduced by 58%.

In an emerging market economy, FDI rates were versatile and fragile in Asia, and a reduction of 8% was seen. Essentially, all elements were negatively impacted. There was a halt in M&A activity across borders, and investment flows declined by 50%.

However, countries in the developing economy, such as China, benefitted from investment flow which increased by 6%. China sustained the pandemic’s effects due to the resilience of its economy, trade liberalization, and efforts to maintain investments.

The pandemic created an important responsibility for an investment policy. As a result, in the year 2020, 42% of new measures for policies regarding foreign investment were increased in contrast to 2019.

As the pandemic rose, the trend gravitated towards restrictive measures and regulatory policies. Thus, 41% of these policy measures in 2020 were part of all the new investment policy regulations.

15% of the policy schemes developed in 2020 were related to trade liberalization in several industries. FDI liberalization policies include a diverse portfolio of media, defense, and manufacturing industries.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Foreign Aid

• Foreign Investment

• Gross Domestic Product (GDP)

• Net International Investment Position (NIIP)

• International Trade