What is foreign direct investment?
Foreign direct investment (FDI) is an investment made by a company or individual in one country in business interests in another country, in the form of either establishing business operations or acquiring foreign companies. FDI is distinct from portfolio investments in which an investor purchases shares of foreign companies without actively managing them.
FDI is often motivated by a company’s desire to access new markets or to take advantage of lower production costs in another country. By investing in a foreign country, companies can also hedge against risks in their home country. For example, a company that manufactures goods in China may be less exposed to fluctuations in the value of the US dollar if it also has production facilities in Europe.
There are two main types of FDI: horizontal and vertical. Horizontal FDI occurs when a company invests in a foreign country to gain access to that market, without changing the company’s core product or service. An example of horizontal FDI would be a US company opening a factory in Mexico to take advantage of lower labor costs. Vertical FDI occurs when a company invests in a foreign country to secure a supply of raw materials or to access a new technology. An example of vertical FDI would be a Japanese company investing in a Thai company that produces rubber for tires.
The benefits of foreign direct investment
FDI can bring significant benefits to the host country, including the following:
- Job creation: FDI can create new jobs, both directly through the establishment of new businesses and indirectly through the spillover effects of increased economic activity. For example, a new factory may require workers for assembly line jobs, but it may also lead to the creation of jobs in other sectors such as transportation and logistics.
- Increased tax revenue: FDI can lead to increased tax revenue for the host government, as foreign companies are generally subject to the same tax laws as domestic companies. In addition, FDI can also lead to indirect tax revenue increases, such as import duties on goods and services purchased by the foreign company.
- Foreign exchange earnings: FDI can lead to an increase in foreign exchange earnings for the host country, as foreign companies may need to convert their home currency into the local currency to make payments. Foreign exchange earnings can also come from tourism spending by employees of the foreign company or from the repatriation of profits back to the home country.
- Technology transfer: FDI can lead to the transfer of technology and know-how from the foreign company to the local economy. This can happen through the establishment of research and development centers, the training of local workers, or the licensing of technology to local companies.
- Improved infrastructure: FDI can lead to improved infrastructure in the host country, as foreign companies may invest in new roads, railways, or other projects to facilitate their operations. Infrastructure improvements can also lead to increased economic activity and job creation in the surrounding area.
The risks of foreign direct investment
FDI can also bring risks to the host country, including the following:
- Asset bubbles: FDI can lead to the formation of asset bubbles in the host country, as foreign investors may pour money into the local economy in search of high returns. This can lead to inflationary pressures and an overvalued currency, which can eventually lead to a economic downturn.
- Competition for resources: FDI can lead to increased competition for resources in the host country, as foreign companies may bid up the price of land, labor, or raw materials. This can lead to higher costs for domestic companies and reduced competitiveness in international markets.
- Political risks: FDI can be subject to political risks in the host country, as the government may change its policies or regulations in a way that negatively affects the foreign company. Political risks can also come from social unrest or instability in the country.
- Exchange rate risks: FDI can be subject to exchange rate risks, as the value of the host country’s currency may fluctuate relative to the foreign company’s home currency. This can lead to losses for the foreign company if the currency depreciates significantly.
How to attract foreign direct investment
There are a number of policies and programs that governments can use to attract FDI, including the following:
- Investment promotion: Governments can promote their country as a destination for FDI through investment promotion campaigns, trade missions, and investment fairs. They can also provide information about the local economy and business environment through investment guides and website portals.
- Investment incentives: Governments can offer a variety of investment incentives to attract FDI, such as tax holidays, reduced tariffs, and subsidies. Investment incentives can be targeted at specific sectors or regions, or they can be general incentives available to all investors.
- Investment facilitation: Governments can facilitate FDI by streamlining investment procedures and providing one-stop shop services for investors. They can also provide pre-investment counseling and post-investment support, such as help with finding local partners or navigating regulatory requirements.
The impact of foreign direct investment on the economy
FDI can have a positive or negative impact on the economy of the host country, depending on a number of factors.
FDI can have a positive impact on the economy by increasing employment, tax revenue, and foreign exchange earnings. It can also lead to improved infrastructure and technology transfer. However, FDI can also have a negative impact on the economy by causing asset bubbles, competition for resources, and exchange rate risks.
The overall impact of FDI on the economy also depends on the policies and programs that the government uses to attract and facilitate investment. If the government uses policies that are conducive to investment and provides support for investors, then the impact of FDI is likely to be positive. However, if the government uses policies that are not conducive to investment or does not provide support for investors, then the impact of FDI is likely to be negative.
The history of foreign direct investment
FDI has been a key driver of global economic growth since the end of World War II. The United Nations Conference on Trade and Development (UNCTAD) estimates that global FDI flows totaled $1.3 trillion in 2016, up from $1.1 trillion in 2015.
FDI flows have been particularly important for developing countries, which have attracted an increasing share of global FDI in recent years. UNCTAD estimates that developing countries received $687 billion in FDI in 2016, up from $641 billion in 2015.
China has been the largest recipient of FDI in recent years, attracting an estimated $135 billion in 2016. Other major recipients of FDI include the United States ($254 billion), Hong Kong ($127 billion), Singapore ($87 billion), and Brazil ($67 billion).
The future of foreign direct investment
The future of FDI is uncertain due to a number of factors, including the rise of protectionism, the slowdown of the global economy, and the increasing use of digital technologies.
The rise of protectionism is a major concern for the future of FDI. The Trump administration has been critical of FDI, and has implemented a number of policies that are designed to discourage investment from abroad. These policies include tariffs on imported goods, restrictions on investment in certain sectors, and tighter scrutiny of foreign companies.
The slowdown of the global economy is another major concern for the future of FDI. Global economic growth is expected to slow from 3.6% in 2018 to 3.3% in 2019, according to the World Bank. This slowdown is likely to lead to reduced demand for FDI.
The increasing use of digital technologies is also likely to have an impact on FDI. The rise of automation and artificial intelligence is making it possible for companies to do more with less labor, which is reducing the need for companies to invest in foreign countries to access new markets or take advantage of lower production costs.
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