What is Foreign Direct Investment?
Foreign direct investment (FDI) takes place when an investor establishes foreign business operations or acquires foreign business assets, including establishing ownership or controlling interest in a foreign company. Simply put, FDI is when an investor establishes business operations abroad.
How Does FDI Work?
According to the International Monetary Fund’s definition, investors must possess at least 10% of a foreign-based entity’s voting power for the transaction to be classed as FDI. The key to FDI is the element of control. Control represents the intent to actively manage and influence a foreign firm’s operations.
For the most part, foreign direct investors:
2. Acquire businesses that already exist overseas or
3. Set up brand new operations of their own (known as greenfield FDI).
With FDI, foreign companies are directly involved with day-to-day operations in the other country. This means they aren’t just bringing money with them, but also knowledge, skills, and technology.
A merger is an agreement that unites two or more existing companies into one new company, meaning that merged companies team up to move forward as a single new entity, rather than remain separately operated and owned. After a merger, shares of the new company are distributed to existing shareholders of both original businesses. There are several types of mergers and also several reasons why companies complete mergers. Mergers are most commonly done to gain market share, grow revenues, reduce costs of operations, expand to new territories, unite common products and increase profits.
One example of a merger happened in 2000 when AOL and Time Warner vertically merged* in a $164 million deal considered one of the biggest flops ever.
* a vertical merger occurs when two companies operating at different levels within the same industry's supply chain combine their operations.
An acquisition is when one company takes over another and establishes itself as the new owner.
Acquisitions, sometimes called takeovers, generally carry a more negative connotation than mergers. As a result, acquiring companies may refer to acquisition as a merger even though it's clearly a takeover. An acquisition takes place when one company takes over all of the operational management decisions of another company. Acquisitions require large amounts of cash, but the buyer's power is absolute. A good example of a foreign investment acquisition is the selling of US cloud company Mendix to Germany’s Siemens in 2018.
3. Greenfield FDI
Not all foreign investors want to merge with or acquire a pre-existing company, opting rather for establishing a completely new cross-border entity themselves. This is greenfield FDI. More specifically, greenfield FDI is when companies set up or expand their business operations abroad, creating brand new jobs and/or facilities from the ground up. Greenfield FDI is the most productive, development-friendly, and relational form of FDI because it always creates jobs or facilities, and often transfers technology and know-how to the receiving country’s economy. And this is why greenfield FDI is arguably the crown jewel of the foreign investment world, the type of foreign investment that governments are most keen to attract. Cross-border mergers and acquisition do not necessarily create new jobs or facilities since it only involves a change of ownership and management for an already existing business.
Greenfield FDI’s higher risk offers arguably higher rewards in terms of oversight. Indeed, greenfield FDI provides investors with complete control over their overseas enterprise, from start to finish, unless they are in a joint venture or a country that limits 100% foreign ownership of companies.
An example of greenfield FDI is the construction of the Shanghai Giga factory by US-based Tesla in 2019.
What are the advantages and disadvantages of FDI?
Some of the benefits for investors:
1. Market diversification
3. Lower labor costs
4. Tax incentives
The following are some of the benefits for the host country:
1. Access to management expertise, skills, and technology
2. Increase in employment
3. Economic stimulation
4. Development of human resources
5. Resource transfer
6. Increased productivity
Disadvantages to FDI for the host country:
1. Displacement of local businesses (for example, the entry of large companies such as Walmart)
2. Profit repatriation (when the company is not reinvesting profits back into the host country, that leads to capital outflows)
However, it is quite apparent that the benefits outweigh the cons.
FDI in Figures
- According to the UN Conference on Trade and Development (UNCTAD), FDI transactions were worth a whopping $1.39trn in 2019
- One of the largest mergers in history was in 2000 when Vodafone acquired Mannesmann for $181 billion to create the world’s largest mobile telecommunications company
- According to UNCTAD mergers and acquisitions make up the vast majority of global foreign investment flows – roughly 80%
- As of 2020, the U.S. is second to China in attracting FDI
- In 2020 COVID-19 fallout sinks global FDI flows by 38% compared to 2019, to $846 billion, their lowest level since 2005
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