Types of Foreign Direct Investment
In this article, we will see what is Foreign Direct Investment (FDI), what are the types and methods of FDI. In the current economic environment, there are no isolated economies anymore. All countries now function on a global level. And hence we have a strong global economy, where there are very few barriers to the flow of goods and money. This opens up avenues for international investments as well.
What Is Foreign Direct Investment (FDI)?
- Foreign direct investment (FDI) is an investment made by a company or individual in one country in business interests in another country. FDI is done in the form of either establishing business operations or acquiring business assets in the other country, such as ownership or controlling interest in a foreign company.
- FDIs are different from foreign portfolio investments (FPIs) in which an investor merely purchases and passively holds the equities of foreign-based companies.
- These investments are commonly made in open economies that offer a skilled workforce and above-average growth prospects for the investor, as opposed to tightly regulated economies.
- Foreign direct investment usually involves more than just a capital investment. It may include provisions of management or technology as well.
Lasting Interest and the Element of Control
1. Lasting Interest : An investment into a foreign firm is considered an FDI if it establishes a lasting interest. A lasting interest is established when an investor obtains at least 10% of the voting power in the firm.
2. Element of Control : The key to foreign direct investment is the element of control. Control represents the intent to actively manage and influence a foreign firm’s operations. This is the major differentiating factor between FDI and a passive foreign portfolio investment. Thus, key feature of FDI is that it is an investment made that establishes either effective control of, or at least substantial influence over, the decision making of a foreign business.
3. For this reason, a 10% stake in the foreign company’s voting stock is necessary to define FDI.
4. The Flow of FDI : The amount of FDI undertaken over a period.
- Outflow of FDI are the flows of FDI out of a country
- Inflow of FDI are the flows of FDI into a country
Types of Foreign Direct Investment
Foreign direct investments have 4 types as being Horizontal, Vertical, Conglomerate and Platform FDI.
A. Horizontal Investments :
- A horizontal direct investment refers to the investor establishing the same type of business operation in a foreign country as it operates in its home country.
- Thus, horizontal FDI occure when the multinational firm undertakes the same production activities in multiple countries.
- Example : Apple based in the United States opens stores in India that would be called horizontal investment. Also, Coke, Pepsi, Samsung, HSBC etc expanded internationally by way of horizontal FDI.
B. Vertical Investments :
- A vertical investment is one in which different but related business activities from the investor’s main business are established or acquired in a foreign country.
- Vertical FDI takes place when the multinational fragments the production process internationally, locating each stage of production in a country with the least cost.
- Therer are 2 types of Vertical FDIs : Forward Vertical FDI & Backward Vertical FDI
- Forward Vertical FDI : In this, the FDI brings the company nearer to a market. For example, Toyota buying a car distributorship in America.
- Backward Vertical FDI : In this, the international integration goes back towards raw materials. For example, Toyota getting majority stake in a tyre manufacturer or a rubber plantation.
C. Conglomerate Investments :
- A conglomerate type of foreign direct investment is one where a company or individual makes a foreign investment in a business that is unrelated to its existing business in its home country.
- Thus, in conglomerate investments, a business acquires an unrelated business in a foreign country. This is uncommon as it requires overcoming two barriers to entry: entering a foreign country and entering a new industry or market.
D. Platform FDI :
- In a Platform type of FDI, a business expands into a foreign country but the output from the foreign operations is exported to a third country. This is also referred to as Export-Platform FDI.
- Platform FDI commonly happens in low-cost locations inside free-trade areas.
- For example, if Ford purchased manufacturing plants in Ireland with the primary purpose of exporting cars to other countries in the EU.
Methods of Foreign Direct Investment
FDI also have categorization based on how it enters the other country:
- Subsidiary or Associate Company : One way to enter another countries market is through setting up a subsidiary in other country. That would help in getting access to other country market and use its resources for e.g., affiliate and subsidiary banks are the most popular setups for foreign market entry.
- Merger or Acquisition : Another way to enter a country is by merger. For e.g., Sun pharma acquisition of Ranbaxy.
- Greenfield Investment : FDI is made in new/upcoming facilities. They are the main area of interest for the host nation as it boosts expansion, economy, jobs and technological advances. Eg. Walmart opening retail stores in India.