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Foreign Direct Investment (FDI)

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Foreign Direct Investment

FDI increases economic growth and trade.

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TPP

A rice farmer displays a banner reading 'Stop TPP participation' during an anti Trans-Pacific Partnership (TPP) free trade talks rally in Tokyo. FDI can put small farmers out of business.

Credit: KAZUHIRO NOGI/AFP/Getty Images

Definition: Foreign direct investment is of growing importance to global economic growth. This is especially important for developing and emerging market countries. FDI from investors in developed areas like the European Union and the U.S. provide funding and expertise to help smaller companies in these emerging markets to expand and increase international sales. In 2012, these emerging markets became the greatest beneficiary of FDI. Inflows exceeded those to developed countries by $130 billion.

The developed world also receives its fair share of cross-border investment, but of a different nature. Most of this was mergers and acquisitions between mature companies. These already-global corporations are engaged in restructuring or refocusing on core businesses. However, it gets recorded as FDI. This type of investment is more about maintenance, and less about making great strides in economic growth. (Source: UNCTAD, Annual FDI Report)

What Exactly Is Foreign Direct Investment?

The International Monetary Fund defines FDI as when one individual or business owns 10% or more of a foreign company's capital. Every financial transaction afterwards is considered by the IMF as an additional direct investment. If an investor owns less than 10%, it is considered as nothing more than an addition to his/her stock portfolio.

With only a 10% ownership, the investor may or may not have the controlling interest in the foreign business. However, even with just 10%, the investor usually has significant influence on the company's management, operations and policies. For this reason, most governmental agencies want to keep tabs on who is investing in their country's businesses. (Source: Definitions of Foreign Direct Investment: A Methodological Note, Maitena Duce1, Banco de Espana, July 31, 2003)

Advantages of Foreign Direct Investment

Foreign direct investment has many advantages for both the investor and the recipient. One of the primary benefits is that it allows money to freely go to whatever business has the best prospects for growth anywhere in the world. That's because investors aggressively seek the best return for their money with the least risk. This motive is color-blind, doesn't care about religion or form of government.

This gives well-run businesses -- regardless of race, color or creed -- a competitive advantage. It reduces (but, of course, doesn't eliminate) the effects of politics, cronyism and bribery. As a result, the smartest money goes to the best businesses all over the world, bringing these goods and services to market faster than if unrestricted FDI weren't available.

Investors receive additional benefits. Their risk is reduced because they can diversify their holdings outside of a specific country, industry or political system. Diversification always increases return without increasing risk.

Businesses benefit by receiving management, accounting or legal guidance in keeping with the best practices practiced by their lenders. They can also incorporate the latest technology, innovations in operational practices, and new financing tools that they might not otherwise be aware of. By adopting these practices, they enhance their employees' lifestyles, helping to create a better standard of living for the recipient country. In addition, since the best companies get rewarded with these benefits, local governments have less influence, and aren't as able to pursue poor economic policies.

The standard of living in the recipient country is also improved by higher tax revenue from the company that received the foreign direct investment. However, sometimes countries neutralize that increased revenue by offering tax incentives to attract the FDI in the first place.

Another advantage of FDI is that it can offset the volatility created by "hot money." Short-term lenders and currency traders can create an asset bubble in a country by investing lots of money in a short period of time, then selling their investments just as quickly. This can create a boom-bust cycle that can wreak economies and political regimes. Foreign direct investment takes longer to set up, and has a more permanent footprint in a country.

Disadvantages of Foreign Direct Investment

Too much foreign ownership of companies can be a concern, especially in industries that are strategically important. Second, sophisticated foreign investors can use their skills to strip the company of its value without adding any. They can sell off unprofitable portions of the company to local, less sophisticated investors. Or, they can borrow against the company's collateral locally, and lend the funds back to the parent company. (Source: IMF, Finance and Development Magazine, Prakash Loungani and Assaf Razin, How Beneficial Is Foreign Direct Investment for Developing Countries?, June 2001)

Free Trade Agreements and FDI

Free trade agreements encourage foreign direct investment. For example, the largest free trade agreement is NAFTA, or the North American Free Trade Agreement. This increased FDI between the U.S., Canada and Mexico to $594.2 billion.

Foreign Direct Investment Statistics

Who keeps track of FDI statistics? Apparently, everyone. Here's a guide to the most important agencies.
  • United Nations - The United Nations Conference on Trade and Development (UNCTAD) publishes the Global Investment Trends Monitor. This summarizes FDI trends around the world. For example, UNCTAD reported that FDI in 2012 declined to $1.3 trillion, instead of rising to $1.6 trillion as it had forecast. This was after setting a record of $1.5 trillion in 2011.
  • OECD - These FDI statistics are released quarterly for the developed countries within the OECD. It reports on both inflows and outflows, so the only statistics it doesn't capture are those between the emerging markets themselves.
  • IMF - In 2010, the IMF published its first Worldwide Survey of Foreign Direct Investment Positions. This annual worldwide survey is available as an online database. It covers investment positions from 2009 on for 72 countries. The IMF assembled this information with the help of the European Central Bank, Eurostat, OECD, and UNCTAD.
  • BEA - This agency reports on the FDI activities of foreign affiliates of U.S. companies. This provides the financial and operating data of these affiliates, as well as which U.S. companies were acquired or created by foreign companies. It also describes how much investment U.S. companies have made overseas.  Article updated March 27, 2013

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