Table of Contents
Introduction
Investments make or break a company's economic progression. While a company that receives substantial investment can work on building a better team and deliverables, the investing company also looks at certain factors that would ensure that its investment will have a profitable return on investments (ROI). Foreign direct investment, or FDI, is one such avenue that helps both companies to thrive.
What Is a Foreign Direct Investment (FDI)?
A category of cross-border investment where an investor residing in one economy has an ongoing interest in and establishes significant influence over a company residing in another economy is Foreign Direct Investment (FDI). For example, a company in America can help a newly established company in India reach its goals through its investments.
The ownership of 10% or more voting rights in a company in one economy by an investor residing in another country portrays such a relationship. FDI is a key component of international economic integration as it creates stable and lasting links between economies.
FDI is an important medium to transfer technology across countries. It facilitates trade globally through access to foreign markets. It is a crucial tool for economic development. This group covers indicators like the in and out values of equity, flows, and income, broken down by partner country and sector, with foreign direct investment limits.
How Does Foreign Direct Investment (FDI) Work?
Through FDI, companies and government targets projects in economies better than theirs to hunt skilled labour and offer good growth prospects. Foreign Direct Investment (FDI) brings not only equity inflows but also managerial know-how, technical know-how, new employment opportunities, improved infrastructure, and new technologies into an economy.
Foreign investors can invest in India through either of the two routes: the automatic route or the government route.
Automatic routes do not require prior government approval. This means that foreign investors do not have to go through the government or various ministries to invest in a country’s companies. Government routes have stricter rules and regulations than automatic routes.
The whole process of finding the right investor for your business in India can be confusing. It can command a lot of effort and time and is an expensive commodity. The best solution, in this case, is to contact an FDI agency.
Types of Foreign Direct Investment
There are four types of Foreign Direct Investment
1. Horizontal FDI: Horizontal FDI mainly revolves around investing funds in foreign companies in the same industry as the FDI investor owns or operates. Here a company invests in another company located in another country and produces similar goods.
2. Vertical FDI: This FDI type refers to when the investment is within the typical supply chain of companies that may or may not be in the same industry. Therefore, when vertical direct investment occurs, companies invest in foreign companies that can supply or sell their products. Vertical FDI is further classified into backward vertical integration and forward vertical integration.
3. Conglomerate FDI: When companies invest in two completely different companies in completely different industries, the transaction is known as a conglomerate FDI. Therefore, FDI is not directly related to the investor's business.
4. Platform FDI: In Platform FDI, the company goes abroad, but the manufactured products are exported to a third country.
Examples of Foreign Direct Investment
Now that you know the FDI meaning and types of FDI, let’s get into some practical examples.
● A Spain-based Zara could invest in or acquire Fab India, an Indian company that makes products similar to Zara. Since both companies belong to the same goods and apparel industry, the FDI classification is horizontal FDI.
● A Swiss coffee producer, Nescafé, can invest in coffee plantations in countries such as Brazil, Colombia, and Vietnam. This type of FDI is known as backward vertical integration because the investment firm buys the suppliers of its chain of supply. On the other hand, when a company decides to invest in another company, higher than its position in the supply chain, it is known as forward vertical integration. For example, an Indian coffee company wants to invest in a Thai food brand.
● US retailer Walmart can invest in Indian automaker TATA Motors as a conglomerate FDI.
● French perfume brand Chanel has established manufacturing facilities in the United States and exports its products to the United States, Asia, and the rest of Europe, which falls under the platform FDI.
Difference between foreign direct investment (FDI) and foreign portfolio investment (FPI)
|
Factor |
FDI |
FPI |
|
Time period |
Foreign Direct Investment (FDI) is made to make a long-term investment in a company. |
Foreign Portfolio Investment (FPI) is made to achieve a short-term gain in securities. |
|
Business acquisition |
In FDI, an investor usually acquires foreign business assets, establishing ownership or controlling interest in a company. |
There is no significant managerial control over the enterprise operations in an FPI. |
|
Liquidity |
Since the FDI is a long-term investment with controlling interest in hand, the investors own a stake that is not so liquid. |
In FPIs, investors put capital in financial assets like stocks and bonds that can be easily bought or sold. |
|
Volatility |
Most countries prefer FDIs to attract foreign investments due to their stability and long-lasting commitments. |
FPIs have a higher degree of volatility due to their tendency to flee at the first sign of economic trouble. |
Methods of Foreign Direct Investment
Broadly, there are two methods to execute a foreign direct investment (FDI):
● Greenfield investment
● Brownfield investment
In the greenfield investment strategy, the company starts business from scratch in another country. For example, Domino's and McDonald's are US-based companies that started from scratch in India. They are now leaders in their respective segments. On the other hand, in the brownfield investment strategy, the company does not build the business from scratch. Instead, they chose the path of mergers or acquisitions.
FDI Advantages and Disadvantages
Advantages of Foreign Direct Investment include-
● FDIs usually increase manufacturing activity and improve the service sector. Thus creating more employment opportunities
● Provides exclusive market access in other countries
● Builds industries and factories to improve the country's infrastructure and help underdeveloped areas develop
● It also helps improve technology and operational practices through knowledge sharing
● Exports increase when foreign investment boosts production
● Income and employment opportunities will increase, thereby the per capita income of the population
Disadvantages of FDI include the following.
● It poses risks and hinders domestic investment
● Fluctuations in exchange rates can make foreign investments risky
● It depends on the country's ever-changing political environment, foreign policy, and regulations
● Domestic companies may lose control of their business and profits
● The incentive to gain market share through foreign investment can lead to large losses for domestic and small traders
FDI has a positive impact on developing countries. However, there are some potential risks. Adverse selection and distressed selling can lead to destruction. Leverage can affect the advantage and limit its true benefits. Also, a high share of foreign direct investment in a country's total capital inflows may reflect the weakness rather than the strength of that country's institutions. Policy recommendation to improve the investment climate of both the foreign and domestic climate is necessary for developing countries.