Foreign direct investment

Overview

Foreign direct investment and whether globalisation has increased or reduced economic instability.

What you need to know

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Questions from this subtopic

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1. 1

   What is foreign direct investment?

   Model answer

   Foreign direct investment is investment by a firm or individual in one country to acquire a lasting management interest in an enterprise in another country, usually taken to mean a holding large enough to confer significant influence over the business. It covers building a new facility abroad, buying an existing foreign company, and reinvesting profits earned by a foreign affiliate. It is distinguished by the intention to control and operate rather than merely to hold a financial claim.

2. 2

   What is the difference between foreign direct investment and portfolio investment?

   Model answer

   Foreign direct investment involves acquiring control of productive assets abroad and typically brings the investor's technology, management and access to markets with it, whereas portfolio investment is the purchase of shares or bonds purely as a financial asset without control. Direct investment is comparatively illiquid and long-lived, since factories cannot be sold overnight, while portfolio investment can be reversed within days. This makes direct investment a more stable source of external finance for a host country and portfolio flows a potential source of sudden withdrawal.

3. 3

   What is the difference between greenfield and brownfield foreign direct investment?

   Model answer

   Greenfield investment builds an entirely new facility in the host country, adding directly to its capital stock and creating new jobs and productive capacity. Brownfield investment, usually a merger with or acquisition of an existing local firm, changes ownership rather than adding capacity, at least initially. Greenfield investment is generally more welcome to host governments for that reason, although an acquisition can bring in capital and expertise that rescues or expands an underperforming business.

4. 4

   Explain why a firm might choose foreign direct investment rather than simply exporting to a market.

   Model answer

   Producing inside the market avoids tariffs, quotas and transport costs and removes exchange rate risk on the sales side, since revenues and many costs are then in the same currency. It places the firm close to customers so it can tailor products and respond quickly, and it may be the only way to serve markets where local content requirements or public procurement rules favour domestic production. Where the motive is cost rather than market access, investing abroad gives the firm direct control over cheaper labour, resources or a specialist skill base that arm's-length purchasing could not secure.

5. 5

   How does inward foreign direct investment benefit the country that receives it?

   Model answer

   It raises the capital stock and therefore productive capacity without requiring domestic saving, and it creates employment directly in the new operation and indirectly among local suppliers and in the shops and services on which the wages are spent. It transfers technology, quality standards and management practice, which spill over to domestic firms through supplier relationships and through workers who later move on. It widens the tax base and, where the output is exported, improves the current account. The wages and orders it generates are spent again within the host economy, so the gain spreads more widely.

6. 6

   What can go wrong for a country that relies on inward foreign direct investment?

   Model answer

   Profits are ultimately repatriated to the parent country, appearing as an outflow on the primary income section of the current account that can in time exceed the original inflow. Foreign firms may drive out domestic competitors, use imported components rather than local suppliers so the promised linkages never form, and keep the high-value research and headquarters functions at home so the host gets only routine assembly. Multinationals can also exert leverage over governments to secure subsidies, tax concessions or lighter regulation, and their plants can be closed and relocated with little notice, leaving a region exposed.

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