What is Foreign Direct Investment in Economics?

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FDIs are often mentioned in news bulletins with titles like “India remains attractive for FDI investors”, India’s FDI rank rises to 7th position despite falling inflows” etc.So, what is an FDI?

Foreign direct investment is a type of investment that is conducted with companies in a foreign country. Any type of investment comes with potential risks but keeping aside that, it has also lots of benefits to offer. However, there is not only one type of investment that companies may engage themselves in. Four different types of FDIs are available.

In this article, we will read about what Foreign Direct Investment is, how it works, the types of FDI, advantages, and disadvantages.

We also have a FAQ section where some of the most asked questions are answered.

What is Foreign Direct Investment?

  • Foreign Direct Investment is an investor’s, a company’s, or a government’s ownership share in an organization located in a foreign country.
  • This means the investor and the recipient are in two different countries.
  • In a Foreign Direct Investment, either you acquire a significant stake in a foreign business, or you make a purchase.
  • FDI is about obtaining a lasting interest from a resident entity in one economy to a destination-based entity residing in another.
  • Lasting interest refers to the long-term relationship between the two economies.
  • The investor exercises a significant amount of control over the management of the enterprise.
  • It is a type of stock investment that promotes and improves economic relations between foreign countries.
  • Businesses go into foreign direct investments to spread their operations on a multinational level.
  • It is separate from foreign portfolio investment where the foreign entity purchases equity shares of a company.

How Does Foreign Direct Investment Work?

  • Investors, companies, or governments look for open economies with target firms or projects to conduct FDI.
  • For that, one needs a skilled workforce, management, technology, equipment, and also prospects for growth.
  • A little bit of government regulation is also fine.
  • FDI sometimes goes beyond capital or stock investment.
  • FDI helps one to have strong control over foreign business and decision-making.

What are the Advantages and Disadvantages of Foreign Direct Investment?

Advantages of Foreign Direct Investment

The advantages of Foreign Direct Investment mainly include economic development and is dependent on the host country’s systems and infrastructure. Let us read the other advantages:

1. New and Best Practices

  • FDI introduces new technologies to foreign countries which aid their development.
  • It also brings innovation to businesses.
  • The recipient also learns new ways to accomplish goals based on the prevalent goals worldwide.
  • With FDIs, the lifestyle of the workforce also significantly increases.

2. High Standard of Living

  • FDIs raise the standard of living for the recipient country.
  • The contributors pay a lot of sums to the recipient in foreign financing.
  • The recipient in turn needs to pay huge amounts of taxes to the government.
  • The taxes thus earned benefit the people of the nation.

3. Negates Hot Money

  • FDI negates the volatile effects of hot money.
  • Hot money is the quick transfer of funds between the markets of foreign countries to earn a short-term profit.
  • It can lead to market instability and the entire nation can be ruined.

Other Advantages

FDI doesn’t create debt, is non-volatile and the ROI is dependent on the performance of the target firm or projects that are financed by foreign investors.

FDI easily manages the hot money problem.

Disadvantages of Foreign Direct Investment

1.    Unsuitable for Major Industries

FDI is not suitable for major industries strategic to the nation. If a nation grants foreign ownership in such industries, it could lose its comparative advantage.

2. More Give Than Take Policy

Many of the organizations draw maximum figures out of foreign business while it does not add anything in return.

The foreigners in a country may sell off less profitable organizational aspects to inferior investors.

3. Adopting Wicked Ways

Investors often choose immoral ways to get access to a foreign market.

For example, an investor may avail themselves of low-cost loans by providing an organization’s collateral. He may then use the funds to lend to the foreign organization instead of going reinvesting.

4. High Political Risk

FDI is regulated and overseen by multiple governments which leaves it prone to a high level of political risk.

What is the Importance of Foreign Direct Investment for Developing Economies?

Foreign Direct Investment is mainly important for the economic development of the country. However, it has also different factors which is why it is deemed important. Some of the reasons are presented below:

  • Having a diverse investment portfolio is good for the investor and FDI has a lot to contribute to such a portfolio.
  • FDI promotes stable long-term lending.
  • It brings new technologies to developing countries and also provides financing.
  • FDI introduces technological know-how and the expertise of management.
  • It creates more employment opportunities.
  • FDI contributes to the development of infrastructure in developing countries.
  • FDI sets forth economic repair.

What are the Types of Foreign Direct Investment?

The types of Foreign Direct Investment are:

Horizontal Foreign Direct Investment

  • In a horizontal FDI, a company has twin business operations in two different countries.
  • Thus it operates in both the home country and the foreign country.
  • For example, a cellphone provider in a home country purchases a chain of phone stores in a foreign country.

Vertical Foreign Direct Investment

  • In a Vertical FDI, a business in a home country may acquire a complementary business in a different country.
  • For example, a business purchasing raw materials from another country.

Conglomerate Foreign Direct Investment

  • In Conglomerate FDI, a company starts a joint venture with a company whose core business is different from it.
  • The home country has no expertise in the foreign company’s field, which often results in a joint venture between the two.

Platform FDI

In Platform EDI, a company expands its business in a foreign company but sells its manufactured goods in a third country.

For example, a brand setting up its manufacturing plant in a foreign country but selling manufactured goods in a third country.

Foreign Direct Investment in India

  • FDI is a key element in India’s economic growth.
  • The 1991 crisis has set forth economic liberalization in India and the introduction of Foreign Direct Investment is a part of that.
  • It was introduced in that year under the Foreign Exchange Management Act (FEMA) by the then finance minister, Dr. Manmohan Singh.
  • FDI has made considerable progress in the country.
  • The main sectors that result in capital inflows from other countries include telecommunications, computer software, and hardware and construction activities.
  • India is at the top when it comes to greenfield FDI ranking.
  • It is also a part of the top 100 clubs on the Ease of Doing Business (EoDB) index that is published by the World Bank.

Final Thought!

Foreign Direct Investment is not only beneficial for a business that is eager to try out a new venture in a foreign world, but it is also good for the economy of the country.

In addition, FDI is also reported to remain resilient during financial crises which makes it ideal over other forms of capital inflows.

Despite everything, evidence also suggests that a high FDI may be a sign of weakness rather than its strength.

It is claimed to be higher in riskier countries with measurements carried out based on credit ratings for sovereign debt and other indicators.

To solve this, developing countries must try to improve the investment climate for both domestic as well as foreign capital through the introduction of different policies.

Frequently Asked Questions (FAQs)

What is FDI and how it works?

Foreign Direct Investment is an investment in a foreign company owned by an investor, a company, or a government.

Investors look for firms or projects for FDI.

For that purpose, an investor seeks a skilled workforce, management, technology, equipment, and also prospects for growth.

What are the 4 types of FDI?

The four types of FDI are:

Horizontal FDI: A company sets its twin company in a foreign country.

Vertical FDI: A business purchasing raw materials from a foreign country.

Conglomerate FDI: A business whose ownership stake is with a business with a completely different level of expertise than the core one.

Platform FDI: A business expanding to a foreign country and selling manufactured goods in a third country.

Who introduced FDI in India?

Finance minister Manmohan Singh (1991) introduced FDI in India under the Foreign Exchange Management Act (FEMA).

Which sector has the highest FDI in India?

The highest FDI Equity Inflow in India during the Financial year 2021-22 is Computer Software and Hardware (24.60%).

What is India’s rank in FDI 2022?

India holds the 7th rank in FDI 2022 according to the findings of the WR 2022.

Which country is top in FDI?

The United States is the top country with an inward foreign direct investment of all economies in 2021.

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