This article was written by Jeffrey P. Graham and R. Barry Spaulding
and originally appeared on the now defunct Citibank international business portal.
Copyright © Citibank. All Rights Reserved.
Understanding Foreign Direct Investment (FDI)
direct investment (FDI) plays an extraordinary and growing role in global
business. It can provide a firm with new markets and marketing channels, cheaper
production facilities, access to new technology, products, skills and financing.
For a host country or the foreign firm which receives the investment, it can
provide a source of new technologies, capital, processes, products,
organizational technologies and management skills, and as such can provide a
strong impetus to economic development.
Foreign direct investment, in its classic definition,
is defined as a company from one country making a physical investment
into building a factory in another country.
The direct investment in buildings, machinery and equipment is in
contrast with making a portfolio investment, which is considered an indirect
investment. In recent years, given rapid growth and change in global investment
patterns, the definition has been broadened to include the acquisition of a
lasting management interest in a
company or enterprise outside the investing firm’s home country. As such, it
may take many forms, such as a direct acquisition of a foreign firm,
construction of a facility, or
investment in a joint venture or strategic alliance with a local firm with
attendant input of technology, licensing of intellectual property,
In the past decade, FDI has come to play a
major role in the internationalization of business. Reacting to changes in
technology, growing liberalization of the national regulatory framework
governing investment in enterprises, and changes in capital markets profound
changes have occurred in the size, scope and methods of FDI. New information
technology systems, decline in global communication costs have made management
of foreign investments far easier than in the past. The sea change in trade and
investment policies and the regulatory environment globally in the past decade,
including trade policy and tariff liberalization, easing of restrictions on
foreign investment and acquisition in many nations, and the deregulation and
privitazation of many industries, has probably been been the most significant
catalyst for FDI’s expanded role.
The most profound
effect has been seen in developing countries, where yearly foreign direct
investment flows have increased from an average of less than $10 billion in the
1970’s to a yearly average of less than $20 billion in the 1980’s, to
explode in the 1990s from $26.7billion in 1990 to $179 billion in 1998 and $208
billion in 1999 and now comprise a large portion of global FDI.. Driven by mergers and acquisitions and
internationalization of production in a range of industries, FDI into developed
countries last year rose to $636 billion, from $481 billion in 1998 (Source:
Proponents of foreign investment point out that the exchange of investment flows benefits both the home country (the country from which the investment originates) and the host country (the destination of the investment). Opponents of FDI note that multinational conglomerates are able to wield great power over smaller and weaker economies and can drive out much local competition. The truth lies somewhere in the middle.
For small and medium sized companies, FDI represents an opportunity to become more actively involved in international business activities. In the past 15 years, the classic definition of FDI as noted above has changed considerably. This notion of a change in the classic definition, however, must be kept in the proper context. Very clearly, over 2/3 of direct foreign investment is still made in the form of fixtures, machinery, equipment and buildings. Moreover, larger multinational corporations and conglomerates still make the overwhelming percentage of FDI. But, with the advent of the Internet, the increasing role of technology, loosening of direct investment restrictions in many markets and decreasing communication costs means that newer, non-traditional forms of investment will play an important role in the future. Many governments, especially in industrialized and developed nations, pay very close attention to foreign direct investment because the investment flows into and out of their economies can and does have a significant impact. In the United States, the Bureau of Economic Analysis, a section of the U.S. Department of Commerce, is responsible for collecting economic data about the economy including information about foreign direct investment flows. Monitoring this data is very helpful in trying to determine the impact of such investments on the overall economy, but is especially helpful in evaluating industry segments. State and local governments watch closely because they want to track their foreign investment attraction programs for successful outcomes.
How Has FDI Changed in the Past Decade?
As mentioned above, the overwhelming majority of foreign direct investment is made in the form of fixtures, machinery, equipment and buildings. This investment is achieved or accomplished mostly via mergers & acquisitions. In the case of traditional manufacturing, this has been the primary mechanism for investment and it has been heretofore very efficient. Within the past decade, however, there has been a dramatic increase in the number of technology startups and this, together with the rise in prominence of Internet usage, has fostered increasing changes in foreign investment patterns. Many of these high tech startups are very small companies that have grown out of research & development projects often affiliated with major universities and with some government sponsorship. Unlike traditional manufacturers, many of these companies do not require huge manufacturing plants and immense warehouses to store inventory. Another factor to consider is the number of companies whose primary product is an intellectual property right such as a software program or a software-based technology or process. Companies such as these can be housed almost anywhere and therefore making a capital investment in them does not require huge outlays for fixtures, machinery and plants.
many cases, large companies still play a dominant role in investment activities
in small, high tech oriented companies. However, unlike in the past, these
larger companies are not necessarily acquiring smaller companies outright.
There are several reasons for this, but the most important one is most
likely the risk associated with such high tech ventures.
In the case of mature industries, the products are well defined. The
manufacturer usually wants to get closer to its foreign market or wants to
circumvent some trade barrier by making a direct foreign investment. The major
risk here is that you do not sell enough of the product that you manufactured.
However, you have added additional capacity and in the case of multinational
corporations this capacity can be used in a variety of ways.
High tech ventures tend to have longer incubation periods. That is, the product tends to require significant development time. In the case of software and other intellectual property type products, the product is constantly changing even before it hits the marketplace. This makes the investment decision more complicated. When you invest in fixtures and machinery, you know what the real and book value of your investment will be. When you invest in a high tech venture, there is always an element of uncertainty. Unfortunately, the recent spate of dot.com failures is quite illustrative of this point.
Therefore, the expanded role of technology and intellectual property has changed the foreign direct investment playing field. Companies are still motivated to make foreign investments, but because of the vagaries of technology investments, they are now finding new vehicles to accomplish their goals. Consider the following:
simple answer is that making a direct foreign investment allows companies to
accomplish several tasks:
more complete response might address the issue of global business partnering in
very general terms. While it is
nice that many business writers like the expression, “think globally, act
locally”, this often used cliché does not really mean very much to the
average business executive in a small and medium sized company.
The phrase does have significant connotations for multinational
corporations. But for executives in
SME’s, it is still just another buzzword.
The simple explanation for this is the difference in perspective between
executives of multinational corporations and small and medium sized companies. Multinational corporations are almost always concerned with
worldwide manufacturing capacity and proximity to major markets.
Small and medium sized companies tend to be more concerned with selling
their products in overseas markets. The
advent of the Internet has ushered in a new and very different mindset that
tends to focus more on access issues. SME’s
in particular are now focusing on access to markets, access to expertise and
most of all access to technology.
Depending on the
industry sector and type of business, a foreign direct investment may be an
attractive and viable option. With rapid globalization of many industries and
vertical integration rapidly taking place on a global level, at a minimum a firm
needs to keep abreast of global trends in their industry. From a competitive
standpoint, it is important to be aware of whether a company’s competitors are
expanding into a foreign market and how they are doing that. At the same time,
it also becomes important to monitor how globalization is affecting domestic
clients. Often, it becomes imperative to follow the expansion of key clients
overseas if an active business relationship is to be maintained.
New market access
is also another major reason to invest in a foreign country. At some stage,
export of product or service reaches a critical mass of amount and cost where
foreign production or location begins to be more cost effective. Any decision on
investing is thus a combination of a number of key factors including:
From an internal
resources standpoint, does the firm have senior management support for the
investment and the internal management and system capabilities to support the set
up time as well as ongoing management of a foreign subsidiary? Has the company
conducted extensive market research involving both the industry, product and
local regulations governing foreign investment which will set the broad market
parameters for any investment decision? Is there a realistic assessment in place
of what resource utilization the investment will entail? Has information on
local industry and foreign investment regulations, incentives, profit retention,
financing, distribution, and other factors been completely analyzed to determine
the most viable vehicle for entering the market (greenfield, acquisition,
merger, joint venture, etc.)? Has a plan been drawn up with reasonable
expectations for expansion into the market through that local vehicle? If the
foreign economy, industry or foreign investment climate is characterized by
government regulation, have the relevant government agencies been contacted and
concurred? Have political risk and foreign exchange risk been factored into the
Outside of the
analysis of internal resources, a vast amount of information is needed to assess
the viability and ultimate method of foreign investment as outlined above. Much
of this information is available online through a range of websites and portals.
– A number of reports on global and regional investment trends,
global foreign investment trends, country investment guides, investment reviews,
– a wide range of links to statistical information on global foreign direct
- U.S Department of Commerce website contains a wealth of information on
industrial trends, overseas investment statistics, etc.
– USDOC International Trade Administration - foreign/global industry studies,
– Foreign Commercial Service – country commercial analyses, partner
identification program, etc
– A joint venture between the World Bank and WTO, the site contains links to a
wide range of country and regional reports, information local government
– Outline of the financing and insurance programs available for American firms
investing overseas. A range of country and general information links for
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