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What is Foreign Direct Investment?
Foreign direct investment can be defined as an investment done by an individual or an organization of one country into another organization/company of another country. This happens when an organization wants to expand into another country or want to have a ‘lasting interest’ in the company of another company.
The Organization for Economic Co-operation and Development (OECD) mentions that if any foreign investor has 10% or more ownership of the voting power in the organization of another country, we will call it ‘lasting interest’.
Having lasting interest helps the foreign individual or the organization to have a meaningful influence on the management of the company.
In this article, we will go in depth about how foreign direct investment works and in how many ways companies can use FDI to their advantage.
Methods of Foreign Direct Investment (FDI)
There are many ways through which FDI is done. Here we will talk about the most prominent methods and types of Foreign direct investment. Methods of FDI can be divided into two broad categories – greenfield investments and brownfield investments.
When a company of a different country invests in a business of another country or want to expand their horizon in another country, two things become important. One is how they should build up their business or influence to generate enough revenue in a foreign country. And another is what would be the most profitable methods of FDI.
To understand this, let’s look at two methods of FDI –
#1 – Greenfield Investments:
Many companies of foreign countries believe that they should start everything from scratch. If they become interested in FDI, they would build up their own factory in a different country, they would train people to work in their factory/organization, and they would try to provide offerings as per the culture of the country. We can take the example of McDonald and Starbucks. They both started everything from scratch and they are now the prominent brands in India. These are called greenfield investments.
#2 – Brownfield Investments:
This is a short-cut method of the previous method. In this methods of FDI, the foreign businesses don’t take the pain of building up to something from scratch in another country. They expand their business by either going for cross-border mergers and acquisitions. Doing this allows them to start their heads-up right away without building anything from zero. The example of this is Tata Motors’ acquisition of Jaguar. Tata Motors didn’t need to build a new factory in the UK but started running the business from the existing factory of Jaguar.
Types of Foreign Direct Investment
There are two types of foreign direct investment. One is a horizontal foreign direct investment and another is the vertical foreign direct investment.
Let’s understand these two briefly.
#1 – Horizontal FDI
This is the most common types of foreign direct investment. In this case, a company merges with another company of another country to get stronger in the market and the products/services offered are of a homogeneous nature. It’s done first to have a piece of market share in the foreign market and next to reduce competition.
#2 – Vertical FDI
When a company of one country acquires or merges with another company of different country just to add more value to their value chain, it would be called vertical FDI. For example, if a company invests in a foreign company just to have a supplier producing raw materials for them, it would be a vertical FDI.
In these two types of Foreign Direct Investment, one thing is common. These FDI should be brownfield investments, because, for greenfield investments, everything is built from scratch.
Foreign Direct Investments can also be divided into another two types – inward FDI and outward FDI.
Inward FDI is invested in the local resources. And outward Foreign Direct Investment is defined as the investments made abroad that are thoroughly backed by the government.
Factors that Ensure Foreign Direct Investment
There are a series of factors that ensure that a foreign investor or an organization would be interested to invest in the business of another country. Let’s have a quick look at these factors –
- Open Economy: The first prerequisite of whether a foreign investor would be interested to invest in a business of another country is the type of economy the country runs. If it’s a closed economy, it would be difficult for any foreign investor to invest in another business in the country. Foreign direct investments are made when the country has an open economy and the country has openness toward growth.
- Above-Average Growth Scenarios: The foreign investors won’t be interested in a mature or saturated market. If a country is developing or developed but has room for above-average growth, the foreign direct investment would be made. Precisely, the businesses and the individuals that would like to make the FDI needs to see whether they have any growth prospects in near future in a different country or not. If there’s no growth prospect, why would anyone be interested?
- Skilled Workforce: If we take the example of McDonald, we would be able to say that to expand to the developing country like India, they need a skilled workforce. The skilled workforce would be teachable; they should be having the basic skills of communication, technical expertise (if required), and the ability to learn. Without a skilled workforce, FDI won’t be able to create any value.
- Government Support: This is the most important aspect of all. If in a country, the government doesn’t welcome FDI, the country won’t receive any foreign direct investment. Since the foreign nationals need to go through a lot of convincing if the government doesn’t support, they usually don’t choose to invest in a country that discourages FDI.
Even if on the surface, it seems that FDI is quite good for developing countries, we should also pay heed to the disadvantages of Foreign Direct Investment as well.
One of the biggest disadvantages of Foreign Direct Investment is to let the foreign investors take ownership of the industries of a country that’s strategically important to that particular country. The government should always ensure that the foreign investors should not get more than 10% of ownership in those industries that the country is quite good at.
It’s true that it ensures that the businesses are well run, the global economy gets improved, and the investors also receive good returns on their investments. However, every country should think strategically about FDI before accepting it.
This has been a guide to what is Foreign Direct Investments. Here we discuss types of FDI, methods of FDI and factors that ensure such direct investments. You may learn more about economics from the following articles –