What is foreign direct investment?Posted on: March 7, 2023
by Ruth Brooks
Foreign direct investment, or FDI, occurs when an investor – such as a private company or a government – has a stake in a foreign business. There are two key elements in foreign direct investment:
- The investor is in one country, and the business in which they invest is in another.
- The investor has a controlling ownership stake – at least 10% – in the foreign business, taking an active role in its management and a lasting interest in its assets. This differs from foreign portfolio investment, which is less hands-on and more passive.
Foreign direct investments have grown alongside the rise in globalisation, increasing the flow of capital as well as economic activity and links between countries. It also plays an important role in supporting international trade, economic development, and the world economy, as well as global value chains (GVCs), which spread out production processes between different countries.
Current trends in foreign direct investment
While foreign direct investments fell as a result of the coronavirus pandemic in 2020, the Organisation for Economic Co-operation and Development (OECD) has found that global FDI flows increased 88% in 2021 to rise to about pre-pandemic levels.
It also reported that:
- The United States was the top inward FDI destination worldwide in 2021, followed by China, Canada, and Brazil for FDI inflows.
- The United States was also the largest source of FDI outflows, followed by Germany, Japan, China, and the United Kingdom.
- Completed cross-border mergers and acquisitions surpassed pre-pandemic levels by 50% in advanced economies and by 25% in emerging and developing economies.
- Greenfield investment – which occurs when a parent entity creates a subsidiary, or subsidiaries, in a foreign country – has increased in advanced economies to exceed pre-pandemic levels by 16%, but has remained flat in emerging and developing economies.
World Bank datasets similarly point to the United States and China as major players in FDI, and according to the United Nations Conference on Trade and Development (UNCTAD), global flows of foreign direct investment reached USD $1.6 trillion in 2021, highlighting the significant impact of FDI on the global economy.
What are the benefits of foreign direct investment?
Foreign direct investment can bring significant macroeconomic benefits, and is typically associated with increased economic growth and access to new international markets and trade networks. The positive effects of foreign direct investment can benefit both the host country or business at the receiving end of investment, as well as the businesses or multinational firms that are investing abroad – or both.
These benefits can include:
- job creation and a reduction in unemployment
- technological advancement and expansion, which is known as technology transfer
- diversification within both businesses and markets
- increased access to resources such as labour, materials, or skilled expertise
- cost advantages through economies of scale and efficiencies
- competitive innovation
- subsidies, tax incentives, and preferential tariffs.
There are also positive impact linkages between a country’s total FDI and its gross domestic product (GDP).
What are the challenges and concerns around foreign direct investment?
While foreign direct investment has a number of benefits, there are challenges to consider as well. For example, political unrest or conflict within certain countries or regions may have an impact on investments in these areas.
It’s also worth noting that some host countries may not welcome foreign direct investment, particularly in cases where:
- the host country wants to restrict outside influence. Examples might include defense projects or natural resources.
- the local economy and small businesses could be adversely impacted by foreign investors. This is particularly relevant where multinational enterprises can potentially drive out smaller local firms with lower prices or more competitive practices. These activities that affect domestic firms’ performance are known as spillovers.
Another common critique of foreign direct investment is that profits are made in the host country but flow out to the benefit of the investor’s country. However, many host countries work to combat this practice by limiting the profits that investors can repatriate and instead encourage them to reinvest their profits in other projects within the host country.
What is the effect of foreign direct investment in developing countries?
While many of foreign direct investment’s benefits and challenges are universal around the world, some are specific to developing countries.
For example, foreign direct investment is common within the natural resource sector, particularly in developing countries, and this can have a negative impact on natural environments and ecosystems if sufficient environmental standards and safeguards are not yet in place. However, it’s important to note that many countries have been adopting stricter regulations in this area.
Developing countries are also at greater risk for what’s known as the dual-economy effect. This occurs when an economy has a developed sector – funded through foreign direct investment and majority-owned by foreign enterprises – and an underdeveloped sector that’s owned and managed by domestic firms or local businesses. In these situations, the underdeveloped sector is typically labour-intensive, such as agriculture, and the country becomes overly reliant on the capital-heavy developed sector.
On the other hand, developing countries are more likely to benefit from the technology transfer common with foreign direct investment, along with increased employment, infrastructure projects, and so on.
According to UNCTAD’s World Investment Report 2022, foreign direct investment in developing countries increased by 30% in 2021, to USD $837 billion. It noted that the increase was “mainly the result of strong growth performance in Asia, a partial recovery in Latin America and the Caribbean, and an upswing in Africa.” For example, south-east Asian countries saw an FDI increase of 44% (to USD $175 billion) in 2021 thanks to strong investment in the manufacturing sector, the digital economy, and infrastructure.
What are the primary concerns for foreign direct investors?
When considering a foreign direct investment and FDI stock, investors will typically opt for opportunities and joint ventures in regions in which there is:
- political stability
- a sufficient workforce and human capital, whether this be skilled or otherwise
- lighter regulation, investment incentives or subsidies, and/or preferential tariffs
- easy access to the global supply chain.
Investors – and governmental investment policy and economic policy – are also likely to favour economies with greater prospects for growth, and will consider determinants for success such as market size, labour costs, and infrastructure quality.
It’s also worth noting that FDI tends to decrease during times of financial crisis and downturn.
Foreign investment versus foreign direct investment
In contrast to foreign direct investment, foreign investment – also known as portfolio investment – occurs when investors buy shares in foreign companies without any controlling stakes or management of the companies.
A popular region for foreign investment flows is the European Union (EU), which the European Commission has stated is one of the world’s main providers of foreign investment. Europe is also one of the top global destinations for international investment inputs, as well, with popular destinations including France, Spain, and Italy, among others.
Learn more about the international business environment
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