Understanding Foreign Direct Investment

Foreign direct investments (FDIs), also sometimes called direct foreign investment (DFIs), boost economic growth, provide job opportunities and offer expansion for businesses and governments beyond their borders. FDIs are substantial, lasting investments in a foreign business made by a company or government.

FDI investors not only put up capital but typically take controlling positions in firms or are actively involved in their management. In addition to business acquisition, FDIs may involve acquiring a source of materials, expanding a company’s footprint or building a multinational presence. 

Why should you care about foreign direct investment? It drives economies, changes the technological landscape and offers significant incentives for business and growth avenues for host countries, companies and governments. Read on to understand the types of FDI, along with risks and benefits. 

What is Foreign Direct Investment?

Foreign direct investment is the acquisition of controlling ownership or significant stake in a foreign enterprise by an individual, company or government. Direct foreign investment establishes substantial influence or effective control over foreign business. FDIs go beyond capital investment and usually include provisions for management, technology and equipment.

When looking for FDIs investment opportunities, investors generally seek target firms or projects in open economies with a skilled workforce and above-average growth prospects. Light government regulation or tax advantages are a major plus. 

Foreign direct investment differs from portfolio investment. Foreign portfolio investment involves purchasing securities such as stocks and bonds on an exchange in foreign countries. Foreign direct investment is direct investment into building or purchasing businesses and associated infrastructure in a foreign country. 

FDIs can play a significant role in driving technology transfer, improving productivity and creating job opportunities in the target nation. The United Nations Conference on Trade and Development reports a rebound in inflows of FDI in 2020 and 2021 in spite of the global pandemic.

As of 2021, more than $1.8 trillion in foreign direct investments were made globally. The United States was the top FDI destination worldwide, followed by China, Canada, Brazil and India. The U.S. was also the global leader in FDIs to other countries, followed by Germany, Japan, China and the United Kingdom.

Motives for Direct Foreign Investment

The motives for foreign direct investments usually come down to three factors: ownership advantages, location advantages and internalization advantages. Government policies and incentives play a major role in motivating foreign investors. For example, favorable tax treatment, rebates, grants or other incentives can promote economic growth in the country by bringing in direct foreign investment. 

Governments and companies may choose FDIs for economic or strategic motives. 

• Economic motives: Much of FDI centers on economic motives. Companies and governments choose to invest in foreign countries to expand their footprint into international markets. These foreign markets may offer tax advantages, grants and other economic incentives that make the move economically strategic. FDI can foster economic growth in the recipient countries through the construction of new infrastructure and new jobs for local workers. 
• Strategic motives: Companies or governments may choose FDI to increase market presence, build brand recognition and diversify business operations across markets. These strategic moves can lead to lower operational costs, acquisition of new material sources, new technology acquisitions and lower personnel costs.  

Types of Direct Foreign Investment

There are various types of foreign direct investments generally classified as horizontal, vertical, conglomerate or platform.

Horizontal Foreign Direct Investment

With horizontal FDI a business expands domestic operations to a foreign country. Examples of horizontal FDI are established brands opening stores in a new market, like McDonald’s opening restaurants in Europe and Asia. Advantages include expansion to new markets, while disadvantages include new regulatory risks and building the company's presence from the ground up in new countries. Horizontal FDI can take different forms, namely:

• Greenfield investments: With greenfield investments, companies set up new facilities or operations in a foreign country. In this case, the parent company creates a subsidiary in a different country, building its operations from the ground up. Advantages include complete control of the venture, along with possible tax breaks or financial incentives. Disadvantages include greater capital outlay and complex planning.
• Merger and acquisitions: In the case of mergers and acquisitions, a business acquires an existing business in the host country. Advantages include built-in existing infrastructure, employees and management. However, risks include major layoffs, new management takeovers and poorly managed transitions. 
• Joint ventures: Collaborative ventures between foreign and domestic companies. Advantages include existing staff, market understanding, infusion of capital and infrastructure, along with expertise or products shared between the companies. Disadvantages include possible conflicts in management styles, trust or business goals. 

Vertical Foreign Direct Investment

With vertical FDI, the business expands into a different level of the supply chain in the foreign country. For example, when a major U.S. restaurant chain expanded to Spain, its business model involved purchasing farms and sourcing local produce. Advantages of vertical expansion include the acquisition of sourcing materials or control of a greater portion of the supply chain. Disadvantages include expansion into new industry chains and the need for new management and expertise for expansion.     

Conglomerate Foreign Direct Investment

In a conglomerate FDI, the business acquires an unrelated business in a foreign country. This is relatively uncommon but allows businesses to expand to new industries and countries simultaneously. 

Advantages include expansion to new industries, while disadvantages include the risks and difficulties associated with navigating a new country's legal and business landscape while acquiring the personnel and expertise to succeed in a new industry. 

Platform Foreign Direct Investment

With a platform called FDI, a business expands into a foreign country and exports the products to a third country. Platform FDI happens in low-cost, free-trade locations like Southeast Asia. For example, many U.S. manufacturers purchase factories in Asia or Latin America with the intention of exporting the final products. 

Benefits of Foreign Direct Investment

There are diverse benefits of foreign direct investments, from economic growth to sourcing materials. Key benefits include:

• Economic growth and development
• Transfer of technology, knowledge and managerial expertise between countries
• Job creation and enhancing employment opportunities 
• Poverty reduction and raising living standards in the host country
• Infrastructure development, including contributions to physical and social infrastructure in host countries
• Encouraging sustainable practices and responsible business conduct

Challenges and Risks of Foreign Direct Investment

While direct foreign investment offers many opportunities, it can also be fraught with challenges. Risks and challenges associated with foreign direct investments include:

• Political and legal risks because of changes in government policy, expropriation and disputes 
• Economic risks because of currency fluctuations, market volatility and economic instability
• Social and environmental risks, including the impact on local communities, cultural norms and exploitation of natural resources.

Using Foreign Direct Investment

Direct foreign investment offers expansionary opportunities, tax advantages and simultaneous economic growth. While FDI is usually employed by large companies or governments with significant resources, companies of all sizes can benefit from FDI for expansionary activities. 

As an individual investor, you can look at a company's portfolio of FDI to understand potential growth and economic opportunities. Learn more about individual investing here. 

Frequently Asked Questions