Understanding Foreign Direct Investment (Fdi)

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)
Definition

Foreign 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: UNCTAD)

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.

In 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:

bullet Licensing and technology transfer. Licensing and tech transfer have been essential in promoting collaboration between the academic and business communities. Ever since legal hurdles were removed that allowed universities to hold title to research and development done in their labs, licensing agreements have helped turned raw technology into finished products that are viable in competitive marketplaces. With some help from a variety of government agencies in the form of grants for R&D as well as other financial assistance for such things as incubator programs, once timid college researchers are now stepping out and becoming cutting edge entrepreneurs. These strategic alliances have had a serious impact in several high tech industries, including but not limited to: medical and agricultural biotechnology, computer software engineering, telecommunications, advanced materials processing, ceramics, thin materials processing, photonics, digital multimedia production and publishing, optics and imaging and robotics and automation. Industry clusters are now growing up around the university labs where their derivative technologies were first discovered and nurtured. Licensing agreements allow companies to take full advantage of new and exciting technologies while limiting their overall risk to royalty payments until a particular technology is fully developed and thus ready to put new products into the manufacturing pipeline. bullet Reciprocal distribution agreements. Actually, this type of strategic alliance is more trade-based, but in a very real sense it does in fact represent a type of direct investment. Basically, two companies, usually within the same or affiliated industries, agree to act as a national distributor for each other’s products. The classical example is to be found in the furniture industry. A U.S.-based manufacturer of tables signs a reciprocal distribution agreement with a Spanish-based manufacturer of chairs. Both companies gain direct access to the other’s distribution network without having to pay distributor support payments and other related expenses found within the distribution channel and neither company can hurt the other’s market for its products. Without such an agreement in place, the Spanish manufacturer might very well have to invest in a national sales office to coordinate its distributor network, manage warehousing, inventory and shipping as well as to handle administrative tasks such as accounting, public relations and advertising. bullet Joint venture and other hybrid strategic alliances. The more traditional joint venture is bi-lateral, that is it involves two parties who are within the same industry who are partnering for some strategic advantage. Typical reasons might include a need for access to proprietary technology that might tip the competitive edge in another competitor’s favor, desire to gain access to intellectual capital in the form of ultra-expensive human resources, access to heretofore closed channels of distribution in key regions of the world. One very good reason why many joint ventures only involve two parties is the difficulty in integrating different corporate cultures. With two domestic companies from the same country, it would still be very difficult. However, with two companies from different cultures, it is almost impossible at times. This is probably why pure joint ventures have a fairly high failure rate only five years after inception. Joint ventures involving three or more parties are usually called syndicates and are most often formed for specific projects such as large construction or public works projects that might involve a wide variety of expertise and resources for successful completion. In some cases, syndicates are actually easier to manage because the project itself sets certain limits on each party and close cooperation is not always a prerequisite for ultimate success of the endeavor. bullet Portfolio investment. Yes, we know that you’re paying attention and no we’re not trying to trip you up here. Remember our definition of foreign direct investment as it pertains to controlling interest. For most of the latter part of the 20th century when FDI became an issue, a company’s portfolio investments were not considered a direct investment if the amount of stock and/or capital was not enough to garner a significant voting interest amongst shareholders or owners. However, two or three companies with "soft" investments in another company could find some mutual interests and use their shareholder power effectively for management control. This is another form of strategic alliance, sometimes called "shadow alliances". So, while most company portfolio investments do not strictly qualify as a direct foreign investment, there are instances within a certain context that they are in fact a real direct investment.

Why is FDI important for any consideration of going global?

The simple answer is that making a direct foreign investment allows companies to accomplish several tasks: bullet Avoiding foreign government pressure for local production. bullet Circumventing trade barriers, hidden and otherwise. bullet Making the move from domestic export sales to a locally-based national sales office. bullet Capability to increase total production capacity. bullet Opportunities for co-production, joint ventures with local partners, joint marketing arrangements, licensing, etc;

A 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.

What would be some of the basic requirements for companies considering a foreign investment?

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: bullet assessment of internal resources, bullet competitiveness, bullet market analysis bullet market expectations.

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 business plan?

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. They include:

www.unctad.org – A number of reports on global and regional investment trends,

www.oecd.org – global foreign investment trends, country investment guides, investment reviews, analysis

www.columbia.edu/cu/libraries/indiv/business/guides/fordinv.html – a wide range of links to statistical information on global foreign direct investment.

www.doc.gov - U.S Department of Commerce website contains a wealth of information on industrial trends, overseas investment statistics, etc.

www.ita.gov – USDOC International Trade Administration - foreign/global industry studies, export statistics

www.usatrade.gov – Foreign Commercial Service – country commercial analyses, partner identification program, etc

www.itd.org – 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 agencies.

www.opic.gov – Outline of the financing and insurance programs available for American firms investing overseas. A range of country and general information links for investors.