Foreign Investment

The action of opening a business in a foreign country by an investor

Foreign investment is the action of opening a business in a foreign country by an investor. Investing in domestic companies or opening plants and buildings are some examples.

Multinational corporations seek this opportunity to expand their businesses worldwide. This is part of what is known as globalization.

Globalization has caused many large corporations to spread branches around the globe, integrating the world by offering the same products in different countries. 

Foreign investors can buy shares of domestic businesses. This gives them a say in managing the business they invested in. They can also open their own business in the domestic country, using their lower production cost, tax rates, etc.

These investments also help the economies grow by creating new job opportunities from businesses opening in the local country. In addition, they also increase the national income as corporations usually offer higher salaries for their employees, which boosts economic growth.  

These investments refer to global investments made by foreign individuals and businesses. These investments make up a considerable amount of a country's economy and benefit both the investor and the domestic country. 

Investors seek to invest globally to expand their business and attract new customers. Multinational corporations search for opportunities in different countries with cheaper production costs and leaner regulations. 

Another possible foreign investment would be a foreign indirect investment. With indirect investments, investors buy shares of foreign companies to diversify their portfolios. 

As globalization rises, more and more companies are spreading all over the globe, with many branches opened in different parts of many countries.

Companies have opened their factories in India, but their sales target is not. That's because of lower labor costs in such a country. 

Other multinational corporations may decide to invest in countries with lower tax rates to save their income from getting eaten by their local government. Countries such as Qatar and UAE offer investors a golden opportunity to invest with low tax rates. 

Thus investors may find it profitable, especially with the high purchasing power of people in these countries. 

Other investors may seek to invest in countries with better political and economic situations. For example, Lebanon is one of the riskiest countries to invest in. In addition, due to current hyperinflation, people have low purchasing power. 

Moreover, the economic crisis caused a lack of necessities making it harder for investors to survive.   

Foreign investment gives investors high authority in the countries they're investing in, making them actively manage domestic businesses. In some cases, with a significant equity share being funded, they can influence a business strategy. 

Local countries try to attract such investments because of the many benefits they provide, such as

  • Creating job opportunities 
  • Increasing income rate 
  • Boosting economic growth 

Foreign Direct Investment (FDI) 

Foreign direct investments are long-term physical investments made by corporations or individuals outside their borders by operating in other countries. This is done by opening new plants, factories, buildings, and equipment in the land of investment. 

Foreign direct investment can be made in various ways, such as obtaining a lasting interest in a foreign company or expanding the investor's business in a foreign country. 

Lasting Interest 

For the investment to be considered a direct investment, it should grant the foreign investor some control over the foreign business or what is known as lasting interest. Lasting interest requires investors to gain 10% of a local company's voting power. 

Once the required percentage is achieved, investors can take an active role in the management of the business and influence its operations. 

However, there are some cases where lasting interest control can occur even when the investor owns a smaller percentage than the required 10%. 

Other methods of Foreign Direct Investment (FDI)

Expanding one's business in a foreign country is also part of foreign direct investment. An American-based company opening a new headquarter in Australia is an example. 

There are many other ways an investor can acquire voting power in a foreign company, for example: 

  • Mergers and acquisitions: a merger is when two entities join forces and create one. The acquisition is when an entity takes over another one. 
  • Joint venture with a foreign company: Two firms join together to carry out a business from a separate entity.  
  • Subsidiaries of a domestic firm in a foreign country: Expanding one's domestic business portfolio by opening companies in a foreign country. 

Advantages and disadvantages of foreign direct investment (FDI)

Foreign direct investment grants both the investor and the foreign country incentives that encourage both parties to engage in this activity. 

Advantages for the investor:

  • Diversification: Expanding the investor's business by offering products and services in markets unrelated to their original market. 
  • Tax benefits: Some countries encourage investments by imposing low tax rates on investors (tax havens). Thus they will be tempted to invest in such countries as they will be saving a delicate part of their income. 
  • Lower production costs: many corporations take advantage of the lower labor cost offered by some countries, which decreases their production cost and increases their profits by reducing operating expenses.

Advantages for the host country: 

  • Economic boost: Foreign direct investment helps create job opportunities. Thus, increasing people's purchasing power boosts the host's economy. 
  • Human resource development: Foreign companies not only help the country financially. But they also help develop their human resources, providing job training and organizational and managerial skills. 
  • Increase employment rates: A direct investment into the host country will bring in more employment as the investor company will bring more business into the country. 
  • Transfer of technology: Foreign direct investment allows the transfer of technology from the business's country to the host country. Which helps local companies acquire such technology and work on upgrading it.

Despite the many advantages these investments provide, there are also some disadvantages, such as: 

  • Weakening of local businesses: Local businesses suffer while competing with foreign companies. Such as Walmart, given their low prices, thus driving out local businesses that cannot keep up with companies like Walmart. 
  • Profit repatriation: foreign investors may not keep their profits in the host country. They would transfer them to their home country, which could lead to massive capital outflow from the host country. 

Types of Foreign Direct Investment

There are four types of foreign direct investment such as: 

1. Horizontal: A business continues its regular operations but expands to a foreign country. KFC opening in Korea would be an example of that. In other words, the business maintains a similar business model in a different country. 

2. Vertical: A business expands into a foreign country to a different level of the supply chain. 

Meaning that it would still conduct the same business but with different activities. An example is Samsung opening factories in Canada to produce their products and sell them in their stores.   

3. Conglomerate: A conglomerate is a company with diversified business operations that invests in/acquires a business. They usually don't interfere much with the operations and management of the investee/acquiree company.

Berkshire Hathaway is an excellent example of a conglomerate business with subsidiaries in many countries that they acquired, operating in various sectors and industries.

4. Platform: Also known as export-platform FDI. A business expands into a foreign country, but its outputs are then exported to a third country. 

This is done in countries with low production costs and free-trade areas. An example would be Nutella opening in Vietnam to export their products to Europe. 

Foreign Portfolio Investment (FPI)

Foreign portfolio investment (FPI) is when an individual, a group of individuals, or institutions invest in financial assets of another country with.

It doesn't grant the investor full ownership of the foreign company and is considered liquid depending on the market's volatility. 

Foreign portfolio investment (FPI) is also one of the most common ways for investors to participate in a foreign economy. Investors hold the security of a foreign company with an expectation of receiving a return on their investments. 

This includes: 

  1. Stocks 
  2. Bonds
  3. ADRs ( American Depository Receipts) 
  4. EFTs (Exchange Traded Funds) 

This type of investment is less favorable to investors and has many risks accompanying it, including: 

  • Foreign investors here are at risk of share price volatility. Volatility occurs when a significant event, such as Covid-19, causes a massive drop in stock prices. 
  • Jurisdictional risk is another risk a foreign investor might face. A country changing its laws may have a significant impact on the returns of an investor. 

Foreign portfolio investment is typical among several types of investors, such as: 

  • Individuals 
  • Companies
  • Governments 

These investors generally buy financial assets of foreign companies to receive a high return along with the benefit of diversifying their portfolios by investing in different geographic locations.

Advantages of Foreign Portfolio Investment (FPI)

The major advantages of foreign portfolio investment are: 

  1. Portfolio diversification: Foreign portfolio investment helps investors diversify their investments. It enables them to achieve a higher risk-adjusted return. 
  2. International credit: Investors with global portfolios can access credit in foreign countries. This is beneficial when investors can't access credit sources in their home countries due to many factors. 
  3. Currency exchange rates: sometimes, investors come from countries with a weak currencies. Investments in countries with a powerful currency can go a long way in improving the returns of these investors. 
  4. Liquidity: when markets are liquid enough, investors can be assured that they will be able to sell their securities whenever they need the cash. 

Other types of foreign investment 

Other types are:

1. Commercial loans: Local banks issue loans to foreign companies or governments. This operation takes place between the bank and another institution. It helps cover capital expenditures and operating costs.

Commercial loans are specific to businesses rather than individuals. They use these loans to maintain their daily operations, expand their business, or refinance other debts.

Even though these loans are short-term loans, they can be renewed to expand the life of the loan. 

These loans usually require collateral such as property or equipment and proof of the ability to repay through disclosure of financial statements. In some cases, money generated from accounts receivable can be used as a loan's collateral. 

Commercial loans were once the most common type of foreign investment throughout developing countries and growing markets. However, after the 1980s, commercial loans began to disappear.

This is where direct and portfolio investments started to emerge around the globe. 

2. Official flow: Assistance received by a developing or developed country by a domestic country. Official Developmental Assistance (ODA) is a government aid that targets developing countries to improve their economic welfare. 

ODA was essential during the glow of the Covid-19 pandemic, where members of the OECD committee provided sufficient funds to donate vaccines to developing countries. 

Countries with low weak economic abilities highly depend on such assistance as it helps them stand on their legs to face difficult times.

Multilateral Development Banks (MDB)

Multilateral development banks (MDB) are another type of foreign investor. Banks focus on investing in developing countries to improve their economic situation.

Unlike other investors, these banks use their foreign investments to fund projects. This helps countries reach their economic stability. 

Countries with financial struggles usually take loans from these banks with low or no interest to fund a project. This would create jobs or solve some countries' electricity issues. An example of a multilateral development bank is the World Bank. 

Some of the projects that multilateral development banks fund: 

  • Education
  • Infrastructure
  • Energy
  • Environmental sustainability

These banks were founded in the final days of the second world war to help rebuild nations and help them rise again after the war. They focus on decreasing the economic gap between richer and poorer countries. 

There are many examples of multilateral development banks, such as: 

Multilateral development banks fund infrastructure, energy, education, and environmental sustainability projects. They function intending to improve countries' economic conditions without the purpose of achieving profits. 

Again, these banks played the role of a caring father during the global coronavirus pandemic, where they helped countries get their hands on vital funds to fight the pandemic and stand again. 

These banks now function all over the globe with massive assets amounting to trillions of dollars. 

FAQs

Excel Modeling Course

Everything You Need To Master Excel Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and Authored by Kassim Faour | Linkedin

Reviewed and Edited by Adity Salunke I LinkedIn

Free Resources

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