Investment opportunities have expanded more and more, and globalization has enabled yet another avenue: foreign direct investment. This form of investment allows businesses to expand their operations by investing directly in foreign countries. In terms of incoming foreign investment, China and the U.S. tend to go head-to-head. In the first nine months of 2022, for instance, the U.S. had just over $236.4 billion of foreign direct investment coming in, while China had roughly $161.9 billion. Australia was a distant third, with $71.1 billion of foreign money flowing into the country.
Want help with foreign direct investment? Consider working with a financial advisor.
What Is Foreign Direct Investment?
Foreign direct investment (FDI) occurs when a business or investor purchases a controlling interest in a company located in a foreign country. Also known as a lasting interest, a controlling interest means the investor obtains at least 10% voting power in the company in which it invests.
FDI is not to be confused with foreign portfolio investment (FPI), where investors passively hold shares in a foreign company. With FDI, the intent is to substantially influence the foreign company and take an active role in its business operations.
For the investor, the goal of FDI is to expand or enhance its existing business. This could mean building out new stores, acquiring complementary businesses or product lines or reinvesting profits from overseas operations.
Types of Foreign Direct Investment
There are several distinct kinds of FDI: vertical, horizontal, platform and conglomerate. Companies can pursue any number of these forms of FDI, depending on what makes the most sense for their business model.
Horizontal foreign direct investment occurs when a business expands its existing operations into a foreign country. For example, pay a visit to downtown Tokyo and you’ll find several 7-Eleven locations. This is an example of horizontal FDI.
Vertical FDI involves acquiring a business that complements a company’s existing business operation. If a U.S.-based coffee company acquires a farm in Columbia that grows coffee beans, this would be an example of vertical FDI.
Platform FDI involves acquiring business operations in a foreign country for the purpose of exporting a product to a third country. For example, a Chinese company that designs electronics might buy a manufacturing plant in Europe in order to export the products to other European countries.
Conglomerate FDI is less common because it involves purchasing an unrelated business in a foreign country. This may come in the form of a joint venture since the company making the investment may not have prior experience in the industry in which it is investing.
Advantages of Foreign Direct Investment
FDI can have several advantages – both for the investor and for the foreign country. While this list is not all-inclusive, it draws attention to some of the highlights.
Both the company making the investment and the foreign country can experience economic growth as a result of FDI. For instance, the company making the investment is able to expand its business footprint. Meanwhile, the new business expansion in the foreign country might use local suppliers or services as part of its business, benefiting the economy there.
Every country has its own complex economy and geopolitical concerns. While economic downturns can be global in some cases, in others, they can be isolated to one country or continent. Thus, expanding into a new country allows a company to lower the risk of an economic downturn.
Lower Labor Costs
Generally speaking, lower labor costs come in the form of outsourcing. For instance, a clothing manufacturer can outsource its operations to a foreign country, where labor costs are much lower.
Lower Unemployment Rates
Countries attracting foreign investment may see lower unemployment rates. When a foreign company sets up a new business operation there, such as a store or manufacturing plant, it will likely need workers from the foreign country to carry out day-to-day operations. This can help reduce the foreign country’s unemployment rate.
Disadvantages of FDI
Like all business decisions, pursuing FDI has its pros – and also its own set of cons.
Entering a foreign market means a company will have to deal with a foreign government and, thus, its regulations in areas such as labor and trade. As a result, FDI can increase the political risk companies face.
One of the biggest potential benefits of FDI can also become a negative depending on how the company making the investment conducts its business. It may benefit the foreign country if it reinvests its profits there or if it makes use of the foreign country’s services. However, if the company making the foreign investment doesn’t reinvest its profits in the foreign country, it can quickly become a drain on the foreign economy.
FDI allows a company or investor to buy a controlling interest in a foreign company. This is different from foreign portfolio investment, where investors passively buy stock in a foreign company. With FDI, the company making the investment is expanding the business and wants to have a controlling interest in the foreign company.
This arrangement can have advantages for both the investor and the foreign company, such as economic growth. However, it can also create a drag on the foreign economy if profits are not reinvested.
Foreign Investment Tips
- A financial advisor can help you figure out how to get into foreign direct investment. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Investing in foreign markets comes with a unique set of advantages and risks. Learn more about investing abroad.
- Investing in foreign markets can have tax implications. Investors should of whether they will have to pay taxes on foreign income.
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