Foreign Direct Investment: Pros, Cons and Importance

Foreign Direct Investment: Pros, Cons and Importance explained by professional Forex trading experts the “ForexSQ” FX trading team. 

Foreign Direct Investment: Pros, Cons and Importance

Definition: Foreign direct investment is when an individual or business owns 10 percent or more of a foreign company’s capital. All later financial transactions are extra direct investments, according to the International Monetary Fund. If an investor owns less than 10 percent, it’s considered an addition to his or her stock portfolio.

A 10 percent ownership doesn’t give the investor a controlling interest.

It does allow influence over the company’s management, operations and policies. For this reason, most governments want to track who invests in their country’s businesses. (Source: “Definitions of Foreign Direct Investment: A Methodological Note,” Maitena Duce, Banco de Espana, July 31, 2003.)

Importance of FDI

Foreign direct investment is critical for developing and emerging market countries. Their companies need the sophisticated investors’ funding and expertise to expand their international sales. In 2015, they received 43 percent of total global FDI. Developing Asia attracted more foreign investment than either the European Union or the United States.

The developed world also needs cross-border investment, but for different reasons. Most of these countries’ investment is via mergers and acquisitions between mature companies. These global corporations’ investments were for either restructuring or refocusing on core businesses.

In 2015, world FDI rose 38 percent to $1.76 trillion. There was a surge in cross-border mergers and acquisitions. Once the merger and acquisition activity was subtracted from the calculations, FDI only gained 15 percent. (Source: “Annual 2016 FDI Report,” UNCTAD, June 24, 2016.)

In 2014, FDI declined 16 percent to $1.2 trillion.

That unusual drop-off was investment in the developed world declined 28 percent. Most of it was a single massive U.S. divestment. In 2013, FDI was up 9 percent to $1.45 trillion. (Source: “Annual 2015 FDI Report,” UNCTAD, June 24, 2015.)

Advantages of Foreign Direct Investment

Foreign direct investment benefits the global economy, as well as investors and recipients. Capital goes to the businesses with the best growth prospects, anywhere in the world. That’s because investors seek the best return with the least risk. This profit motive is color-blind and doesn’t care about religion or politics.

That gives well-run businesses, regardless of race, color or creed, a competitive advantage. It reduces the effects of politics, cronyism and bribery. As a result, the smartest money rewards the best businesses all over the world. Their goods and services go to market faster than without unrestricted FDI.

Individual investors receive the extra benefits of lowered risk. FDI diversifies their holdings outside of a specific country, industry or political system. Diversification always increases return without increasing risk.

Recipient businesses receive “best practices” management, accounting or legal guidance from their investors.

They can incorporate the latest technology, operational practices and financing tools. By adopting these practices, they enhance their employees’ lifestyles. That raises the standard of living for more people in the recipient country. FDI rewards the best companies in any country. It reduces the influence of local governments over them.

Recipient countries see their standard of living rise. As the recipient company benefits from the investment, it can pay higher taxes. Unfortunately, some countries offset this benefit by offering tax incentives to attract FDI.

Another advantage of FDI is that it offsets the volatility created by “hot money.” That’s when short-term lenders and currency traders create an asset bubble. They invest lots of money all at once, then sell their investments just as fast.

That can create a boom-bust cycle that ruins economies and ends political regimes. Foreign direct investment takes longer to set up and has a more permanent footprint in a country. For more, see LTCM Fund crisis.

Disadvantages of Foreign Direct Investment

Countries should not allow too much foreign ownership of companies in strategically important industries. That could lower the comparative advantage of the country.

Second, sophisticated foreign investors might strip the business of its value without adding any. They can sell off unprofitable portions of the company to local, less sophisticated investors. They can use the company’s collateral to get low-cost local loans. Instead of reinvesting it, they lend the funds back to the parent company. (Source: “How Beneficial Is Foreign Direct Investment for Developing Countries?” Finance and Development Magazine, International Monetary Fund, June 2001.)

Free Trade Agreements and FDI

Trade agreements are a powerful way for countries to encourage more FDI. A great example of this is NAFTA, the world’s largest free trade agreement. It increased FDI between the United States, Canada and Mexico to $452 billion by 2012. For more, see NAFTA Advantages.

Foreign Direct Investment Statistics

Who keeps track of FDI statistics? Just about everyone. Here’s a guide to the most important agency reports.

The United Nations Conference on Trade and Development – UNCTAD publishes the Global Investment Trends Monitor. It summarizes FDI trends around the world. For example, UNCTAD reported that FDI set a record in 2012 of $1.5 trillion. It surpassed that record in 2015.

  • Organization for Economic Cooperation and Development – These FDI statistics are released quarterly for the developed countries within the OECD. It reports on both inflows and outflows. 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.
  • Bureau of Economic Analysis – This agency reports on the FDI activities of foreign affiliates of U.S. companies. It provides the financial and operating data of these affiliates. It says which U.S. companies were acquired or created by foreign ones. It also describes how much U.S. companies have invested overseas.

Foreign Direct Investment: Pros, Cons and Importance Conclusion

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