Foreign Investment plays an essential role in ensuring economic growth and prosperity, creating highly-compensated jobs, spurring innovation, and driving exports, it also benefits the investor in a lot of ways.

We will dive deeper into these topic to see what foreign investment is, types of foreign investment and its benefits to the investor and the host country.

What is Foreign Investment?
How Does Foreign Investment Work?
Example of Foreign Investment
What Are The Types of Foreign Investment?
Reasons Firms Engage in Foreign Investment
Pros and Cons of Foreign Direct Investment
What Are The Benefits of Foreign Investment?
What is The Impact of Foreign Direct Investment?
Why is FDI Important to Developing Countries?
How Can Developing Countries Increase FDI?
How Does FDI Benefit the Home Country?
How Does FDI Benefit the Host Country?

What is Foreign Investment?

Foreign investment involves capital flows from one country to another, granting the foreign investors extensive ownership stakes in domestic companies and assets.

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Foreign investment denotes that foreigners have an active role in management as a part of their investment or an equity stake large enough to enable the foreign investor to influence business strategy. A modern trend leans toward globalization, where multinational firms have investments in a variety of countries.

How Does Foreign Investment Work?

Foreign investment is largely seen as a catalyst for economic growth in the future. Foreign investments can be made by individuals, but are most often endeavors pursued by companies and corporations with substantial assets looking to expand their reach.

As globalization increases, more and more companies have branches in countries around the world. For some multinational corporations, opening new manufacturing and production plants in a different country is attractive because of the opportunities for cheaper production and labor costs.

Additionally, these large corporations frequently look to do business with those countries where they will pay the least amount of taxes. They may do this by relocating their home office or parts of their business to a country that is a tax haven or has favorable tax laws aimed at attracting foreign investors.

Example of Foreign Investment

Trade agreements are a powerful way for countries to encourage more FDI. A great example of this is the North Atlantic Free Trade Agreement, the world’s largest free trade agreement. It increased FDI between the United States, Canada, and Mexico to $731 billion in 2015. That was just one of NAFTA’s advantages.

Foreign Direct Investment Statistics

Four agencies keep track of FDI statistics.  

1. The U.N. Conference on Trade and Development publishes the Global Investment Trends Monitor. It summarizes FDI trends around the world.
2. The Organization for Economic Cooperation and Development publishes quarterly FDI statistics for its member countries. It reports on both inflows and outflows. The only statistics it doesn’t capture are those between the emerging markets themselves.
3. The IMF published its first Worldwide Survey of Foreign Direct Investment Positions in 2010. This annual worldwide survey is available as an online database. It covers investment positions for 72 countries. The IMF received help from the European Central Bank, Eurostat, the Organization for Economic Cooperation and Development, and the United Nations Conference on Trade and Development.
4. The Bureau of Economic Analysis 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.

What Are The Types of Foreign Investment?

There are four different types of foreign investment. These are Foreign Direct Investment (FDI), Foreign Portfolio Investment (FPI), official flows, and commercial loans. These types of foreign investments differ primarily in who gives the loan and how engaged the investor is with the receiver of the loan.

Foreign Direct Investment (FDI)

FDIs occur when a company invests in a business that is located in another country. In order for a private foreign investment to be considered an FDI, the company that is investing must have no less than 10% of the shares belonging to the foreign company.

In these international business relationships, the company that is investing is known as the parent company, whereas the foreign company is known as a subsidiary of the parent company. Multinational corporations, which spread among several nations, often begin with FDIs.

Foreign Portfolio Investment (FPI)

FPIs also occur when foreign investments are made by a company. They may also be made by an individual who has mutual funds. Whereas an FDI allows the investing company to own shares of the subsidiary company, an FPI may be more temporary.

Investment instruments, such as stocks and bonds, are normally traded in FPIs. Stocks and bonds are examples of investments that are easily traded. A company that has stocks and bonds from a foreign company does not necessarily have a share in that company in which it is investing.

Official Flows

The foreign investment known as official flow occurs between nations instead of between companies. In cases of official flow, a more developed or economically prosperous nation will invest money in a nation that is less developed. A recipient nation of an official flow investment will typically receive financial support, as well as higher grade technology and aid in government and economic management.

Commercial Loan

A commercial loan is a type of foreign investment that normally occurs in the form of a bank loan. This kind of investment may occur between nations or between businesses that are in different countries. While a commercial loan may be made by an individual, it would normally occur between larger organizations.

Commercial loans were the most common kind of foreign investment until the 1980s, especially in cases in which investments were going to the companies and governments of economically developing countries. Since then, FPIs and FDIs have been much more common.

The term globalization is normally used to describe the phenomenon of increased use of FPIs and FDIs. Whereas commercial loans are issued by banks and backed by a government, FPIs and FDIs are private investments.

Reasons Firms Engage in Foreign Investment

Most foreign direct investment is undertaken by firms and multinational corporations, who hope to benefit from some of these advantages:

1. Take advantage of lower labour costs in other countries (e.g. India is one of biggest recipients of FDI, where labour costs are much lower than in the OECD.
2. Take advantage of proximity to raw materials rather than transport them around the world.
3. Avoid tariff barriers and other non-tariff barriers to trade.
4. Reduce transport costs. For example, by producing cars in the UK, Nissan has lower transport costs for selling to the UK market.
5. Opportunities for using local knowledge to help tap into domestic markets. For example, by investing in a foreign country and working with local workers, a multinational can gain a better insight into what works well for local markets.

Pros and Cons of Foreign Direct Investment

Foreign direct investment (FDI) is made into a business or a sector by an individual or a company from another country. It is different from portfolio investment, which is made more indirectly into another country’s economy by using financial instruments, such as bonds and stocks.

There are various levels and forms of foreign direct investment, depending on the type of companies involved and the reasons for investment. A foreign direct investor might purchase a company in the target country by means of a merger or acquisition, setting up a new venture or expanding the operations of an existing one.

Other forms of FDI include the acquisition of shares in an associated enterprise, the incorporation of a wholly-owned company or subsidiary and participation in an equity joint venture across international boundaries.

If you are planning to engage in this kind of venture, you should determine first if it provides you and the society with maximum benefits. One good way to do this is by evaluating its advantages and disadvantages.

Pros

1. Economic Development Stimulation

Foreign direct investment can stimulate the target country’s economic development, creating a more conducive environment for you as the investor and benefits for the local industry.

2. Easy International Trade

Commonly, a country has its own import tariff, and this is one of the reasons why trading with it is quite difficult. Also, there are industries that usually require their presence in the international markets to ensure their sales and goals will be completely met. With FDI, all these will be made easier.

3. Employment and Economic Boost

Foreign direct investment creates new jobs, as investors build new companies in the target country, create new opportunities. This leads to an increase in income and more buying power to the people, which in turn leads to an economic boost.

4. Development of Human Capital Resources

One big advantage brought about by FDI is the development of human capital resources, which is also often understated as it is not immediately apparent. Human capital is the competence and knowledge of those able to perform labor, more known to us as the workforce.

The attributes gained by training and sharing experience would increase the education and overall human capital of a country. Its resource is not a tangible asset that is owned by companies, but instead something that is on loan. With this in mind, a country with FDI can benefit greatly by developing its human resources while maintaining ownership.

5. Tax Incentives

Parent enterprises would also provide foreign direct investment to get additional expertise, technology and products. As a foreign investor, you can receive tax incentives that will be highly useful in your selected field of business.

6. Resource Transfer

Foreign direct investment will allow resource transfer and other exchanges of knowledge, where various countries are given access to new technologies and skills.

7. Reduced Disparity Between Revenues and Costs

Foreign direct investment can reduce the disparity between revenues and costs. With such, countries will be able to make sure that production costs will be the same and can be sold easily.

8. Increased Productivity

The facilities and equipment provided by foreign investors can increase a workforce’s productivity in the target country.

9. Increment in Income

Another big advantage of foreign direct investment is the increase of the target country’s income. With more jobs and higher wages, the national income normally increases. As a result, economic growth is spurred. Take note that larger corporations would usually offer higher salary levels than what you would normally find in the target country, which can lead to an increment in income.

Cons

1. Hindrance to Domestic Investment

As it focuses its resources elsewhere other than the investor’s home country, foreign direct investment can sometimes hinder domestic investment.

2. Risk from Political Changes

Because political issues in other countries can instantly change, foreign direct investment is very risky. Plus, most of the risk factors that you are going to experience are extremely high.

3. Negative Influence on Exchange Rates

Foreign direct investments can occasionally affect exchange rates to the advantage of one country and the detriment of another.

4. Higher Costs

If you invest in some foreign countries, you might notice that it is more expensive than when you export goods. So, it is very imperative to prepare sufficient money to set up your operations.

5. Economic Non-Viability

Considering that foreign direct investments may be capital-intensive from the point of view of the investor, it can sometimes be very risky or economically non-viable.

6. Expropriation

Remember that political changes can also lead to expropriation, which is a scenario where the government will have control over your property and assets.

7. Negative Impact on the Country’s Investment

The rules that govern foreign exchange rates and direct investments might negatively have an impact on the investing country. Investment may be banned in some foreign markets, which means that it is impossible to pursue an inviting opportunity.

8. Modern-Day Economic Colonialism

Many third-world countries, or at least those with history of colonialism, worry that foreign direct investment would result in some kind of modern-day economic colonialism, which exposes host countries and leave them vulnerable to foreign companies’ exploitation.

What Are The Benefits of Foreign Investment?

The following points highlight the top three benefits of foreign investment.

1. New Jobs

Firstly, foreign investment is likely to accelerate the rate of growth of developing countries and create more jobs and incomes in the process. However, there is a limit to the number of jobs created directly by foreign investment due to the fact that host countries often impose restric­tions on the entry of foreign capital in certain industries.

Since foreign capital is not allowed in a number of industries, the employment potential of such investment is often limited.

Usually, LDCs invite foreign investment in highly capital-intensive in­dustries such as iron and steel, petrochemicals, oil drilling or mineral extraction. Since capital goods are expensive and often require modern (sophisticated) technology to operate, foreign firms can build up a capital- intensive industry much faster than the developing country.

In fact, multi­national corporations not only import capital but also act vehicles for the transfer of advanced technology to developing countries. However, most industries set up with foreign capital, may provide direct employment to just 300-400 workers.

But, it may have secondary effects. The creation of these few hundred jobs, along with other expenditures by the refinery or mill, will stimulate the economy by raising incomes across the economy, through the multiplier effect.

2. New Technology

Economic growth depends not only on the growth of resources (such as growth of the labour force, bringing new land under cultivation and capital formation such as setting up of new factories or power plants, or constructing new roads and highways) but on technologi­cal progress as well.

Technological progress has the effect of raising the productivity of existing resources. But, technological progress depends on investment in scientific research. This is a costly affair. Most LDCs do not have sufficient resources to finance such research programs.

This is why most expenditures on research and development are made in the major industrial countries like Japan, the USA, Canada, France, Germany, etc. These are the countries which develop most of the new processes that make production more efficient. For the LDCs, with limited scientific resources, industrial nations are a very important source of information, technology and expertise.

The ability of foreign firms to utilise modern sophisticated technology in a developing country depends to some extent on having an abundant supply of engineers and technical personnel in the host (capital-importing) country.

India and Mexico have a fairly number of technically qualified personnel in the persons. This means that new technology can be adopted relatively easily and quickly. Other countries where there is a dearth of such personnel must train workers and then pay them handsome compensation to keep from migrating to industrial countries.

3. Foreign Exchange Earnings

LDCs also expect that foreign investment will improve their balance of payments. This expectation is based on a very simple assumption: the multinational firms located in LDCs increase ex­ports and generate greater foreign exchange earnings that can be used for importing capital goods (required for producing export items) or for repay­ing foreign debt.

If foreign firms produce import-substitute items — both capital goods and consumption goods — which were previously imported, the balance of payments position is likely to improve. However, this is not the whole truth.

In fact, foreign firms may cause balance of payments problem of a serious nature by sending back a major portion of their earnings every year to the home (capital-exporting) country. Such a problem may arise if the value of profits repatriated by foreign firms exceeds the value of foreign exchange earned by exports.

What is The Impact of Foreign Direct Investment?

Foreign direct investment (FDI) influences the host country’s economic growth through the transfer of new technologies and know-how, formation of human resources, integration in global markets, increase of competition, and firms’ development and reorganization.

Empirically, a variety of studies considers that FDI generates economic growth in the host country. However, there is also evidence that FDI is a source of negative effects.

The main idea that stands out is that the effects of FDI on economic growth are dependent on the existing or subsequently developed internal conditions of the host country (economic, political, social, cultural or other).

Thus, the host countries’ authorities have a key role in creating the conditions that allow for the leverage of the positive effects or for the reduction of the negative effects of FDI on the host country’s economic growth.

Why is FDI Important to Developing Countries?

FDI has become an important source of private external finance for developing countries. It is different from other major types of external private capital flows in that it is motivated largely by the investors’ long-term prospects for making profits in production activities that they directly control.

Foreign bank lending and portfolio investment, in contrast, are not invested in activities controlled by banks or portfolio investors, which are often motivated by short-term profit considerations that can be influenced by a variety of factors (interest rates, for example) and are prone to herd behavior.

These differences are highlighted, for instance, by the pattern of bank lending and portfolio equity investment, on the one hand, and FDI, on the other, to the Asian countries stricken by financial turmoil in 1997: FDI flows in 1997 to the five most affected countries remained positive in all cases and declined only slightly for the group, whereas bank lending and portfolio equity investment flows declined sharply and even turned negative in 1997.

While FDI represents investment in production facilities, its significance for developing countries is much greater. Not only can FDI add to investible resources and capital formation, but, perhaps more important, it is also a means of transferring production technology, skills, innovative capacity, and organizational and managerial practices between locations, as well as of accessing international marketing networks.

The first to benefit are enterprises that are part of transnational systems (consisting of parent firms and affiliates) or that are directly linked to such systems through nonequity arrangements, but these assets can also be transferred to domestic firms and the wider economies of host countries if the environment is conducive.

The greater the supply and distribution links between foreign affiliates and domestic firms, and the stronger the capabilities of domestic firms to capture spillovers (that is, indirect effects) from the presence of and competition from foreign firms, the more likely it is that the attributes of FDI that enhance productivity and competitiveness will spread.

In these respects, as well as in inducing transnational corporations to locate their activities in a particular country in the first place, policies matter.

How Can Developing Countries Increase FDI?

Recent data shows that FDI in developing countries increasingly flows to medium and high-skilled manufacturing sectors, involving elevated income levels

Strategies for attracting quality FDI

1. Open markets and allow for FDI inflows. Reduce restrictions on FDI. Provide open, transparent and dependable conditions for all kinds of firms, whether foreign or domestic, including: ease of doing business, access to imports, relatively flexible labour markets and protection of intellectual property rights.
2. Set up an Investment Promotion Agency (IPA). A successful IPA could target suitable foreign investors and could then become the link between them and the domestic economy. On the one side, it should act as a one-stop shop for the requirements investors demand from the host country. On the other side, it should act as a catalyst in the host’s domestic economy, prompting it to provide top notch infrastructure and ready access to skilled workers, technicians, engineers and managers that may be required to attract such investors (Moran, 2014; Barnes et al., 2015; Harding and Javorcig, 2012).Moreover, it should engage in after-investment care, acknowledging the demonstration effects from satisfied investors, the potential for reinvestments, and the potential for cluster-development because of follow-up investments.
3. Think carefully about sectors/activities to be targeted. Investment and location decisions of suppliers may be dependent on those of prime multinational investors in the host economy (McKinsey, 2001; Javorcik et al., 2006).
4. Put up the infrastructure required for a quality investor: such as sufficient close-by transport facilities (airport, ports), adequate and reliable supply of energy, provision of an adequately skilled workforce, facilities for the vocational training of specialised workers, ideally designed in cooperation with the investor (Ibid.).
5. Strengthen backward linkages from FDI into the indigenous economy. Allow for the competitive pressure of foreign entrants on their local suppliers to raise competitiveness of the latter (Rhee et al., 1990), and allow for multiple forms of direct assistance from foreign to domestic firms, in the form of training, help with setting up production lines, management coaching regarding strategy and financial planning, financing, assistance with quality control and introduction to export markets (Javorcik and Spatareanu, 2005; Blalock and Gertler, 2008; Godart and Görg, 2013; Görg and Seric, 2016).
6. Encourage spillovers from FDI into the indigenous economy. Local firms set up by managers who had started in multinational firms are more successful and more productive than others (Görg and Strobl, 2005). Managers of local firms gain knowledge of new technologies and marketing techniques by studying and imitating their multinational competitors (Javorcic and Spatareanu, 2005; Boly et al., 2015). Similarly, worker movements from multinational to local firms spread knowledge and skills.
7. Encourage first-time foreign direct investors. Foreign firms that are not already part of an extensive network of subsidiaries are readier to accept linkages to domestic suppliers (Amendolagine et al., 2015).
8. Encourage foreign direct investors from diaspora members. These are also more likely to generate linkages to domestic firms and contribute to the internationalisation of the host country (Boly et al., 2014).
9. Provide access to credit by reforming domestic financial markets. Setting-up a business-friendly financial system helps indigenous firms to respond to challenges and impulses from foreign entrants, to self-select into supplier status, and to thereby grow and prosper (Alfaro et al., 2009).
10. Set up a vendor development programme to support the match making process between foreign customer and local supplier. To strengthen the capacity of the domestic economy, it may offer financing opportunities to indigenous suppliers for required investment on the basis of purchase contracts from foreign buyers (see the Local Industry Upgrading Program (LIUP) of Singapore), or reimburse the salary of a manager in a foreign plant acting as a talent scout among domestic suppliers (see the example of the Singapore’s Economic Development Board).
11. Shape Export Processing Zones (EPZs) in a way that they spearhead into the domestic economy. Avoid EPZ regulations discriminating against the creation of local supplier relationships. Set up a secondary industrial zone for local suppliers, be it as a geographical site adjacent to formal export processing zones, or be it as a legal status allowing for easy foreign-domestic linkages with, for example, databanks and “marriage counselors”, to assist in supplier selection (Moran et al., 2016).
12. Refocus the “Who Is Us?” perspective and address related concerns adequately. “Us” should be understood as the firms that are most beneficial to the domestic economy irrespective of the nationality of their owners. Therefore, the firms that create the highest-skilled and highest-paying jobs, the least-expensive products, and the most competitive exports are considered “Us” (Reich, 1990).
13. Be patient and rely on the gradual structural transformation of the domestic economy. Investors may come in waves. For example, first, investors in thermionic tubes, valves and transistors, then, in television and broadcasting systems, and finally, in computers, computer peripherals, and data processing systems. Along such avenues, FDI may contribute to diversifying and upgrading domestic production

How Does FDI Benefit the Home Country?

The benefit to the home country also includes the factors similar to that of host country. In terms of balance of payments, what is debit to host country is credit to home country. The outward FDI also leads to creation of new job market with great expertise and necessary skills.

Reverse resource transfer effect takes place whenever resources like managerial skills are transferred back to the home country. The profit of the foreign firm goes back to the home country unlike domestic producers which contributes to their country. The home country is exposed to create new market share and it is liable to create many in the future.

How Does FDI Benefit the Host Country?

Hill (2005) suggested that there are three main benefits to the host country derived out of FDI. They are resource transfer effects, employment effects and balance of payment effects. Whenever a company invests in a foreign firm, the resources are capital, technology and managerial skills.

In terms of capital, the host country will have a higher financial status than the home country. The change in technology and managerial skills will have a drastic effect on the operations carried out by the company. In the host country due to FDI, it creates many employment opportunities through which the citizens of that particular country would be benefited.

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The balance of payments keeps tracks of FDI inflow and outflows through two types of accounts, current account and capital account. “The current account is a record of a country’s export and import of goods” (Hill, 2005) and the capital account maintain purchase or sale details of assets by the country.

By using FDI, the country can achieve a current account surplus (where exports are greater than imports) and reduce the current account deficit (where imports are greater than exports).

Final Thoughts

Investing into another country’s economy, buying into a foreign company or otherwise expanding your business abroad can be extremely financially rewarding and might provide you with the boost needed to jump to a new level of success.

However, foreign direct investment also carries risks, and it is highly important for you to evaluate the economic climate thoroughly before doing it.

Also, it is essential to hire a financial expert who is accustomed to working internationally, as he can give you a clear view of the prevailing economic landscape in your target country. He can even help you monitor market stability and predict future growth.

Remember that we live in an increasingly globalized economy, so foreign direct investment will become a more accessible option for you when it comes to business. However, you should weigh down its advantages and disadvantages first to know if it is the best road to take.