Definition of Foreign Direct Investment
Foreign direct investment is that investment, which is made to serve the business interests of the investor in a company, which is in a different nation distinct from the investor's country of origin.
A parent business enterprise and its foreign affiliate are the two sides of the FDI relationship. Together they comprise an MNC. The parent enterprise through its foreign direct investment effort seeks to exercise substantial control over the foreign affiliate company. 'Control' as defined by the UN, is ownership of greater than or equal to 10% of ordinary shares or access to voting rights in an incorporated firm. For an unincorporated firm one needs to consider an equivalent criterion.
Ownership share amounting to less than that stated above is termed as portfolio investment and is not categorized as FDI.
Classification of Foreign Direct Investment
Foreign direct investment may be classified as Inward or Outward.
Foreign direct investment, which is inward, is a typical form of what is termed as 'inward investment'. Here, investment of foreign capital occurs in local resources.
The factors propelling the growth of Inward FDI comprises tax breaks, relaxation of existent regulations, loans on low rates of interest and specific grants. The idea behind this is that, the long run gains from such a funding far outweighs the disadvantage of the income loss incurred in the short run.
Flow of Inward FDI may face restrictions from factors like restraint on ownership and disparity in the performance standard.
Foreign direct investment, which is outward, is also referred to as “direct investment abroad”. In this case it is the local capital, which is being invested in some foreign resource. Outward FDI may also find use in the import and export dealings with a foreign country. Outward FDI flourishes under government backed insurance at risk coverage.
Outward FDI faces restrictions under a host of factors as described below:
Tax incentives or the lack of it for firms, which invest outside their country of origin or on profits, which are repatriated
Industries related to defense are often set outside the purview of outward FDI to retain government's control over the defense related industrial complex
Subsidy scheme targeted at local businesses
Lobby groups with vested interests possessing support from either inward FDI sector or state investment funding bodies
Government policies, which lend support to the phenomenon of industry nationalization
Foreign direct investment may be further classified by their set target. The areas here are Greenfield investment and Acquisitions and Mergers.
Greenfield investments involve the flow of FDI for either building up of new production capacities in the host nation or for expansion of the existent production facilities of the host country. The plus points of this come in form of increased employment opportunities, relatively high wages, R&D activities and capacity enhancement.
The flip side comes in the form of declining market share for the domestic firm and repatriation of profits made to a foreign country, which if retained within the country of origin could have led to considerable capital accumulation for the nation.
Multinationals mostly rely on mergers to bring in FDI. Until 1997 mergers and acquisitions accounted for around 90% of FDI flow to the US economy. FDI flow through acquisitions does not render any long run advantage to the economy of the host nation as under Greenfield investments.
Some other types of foreign direct investment in vogue are termed as Horizontal FDI, Forward Vertical FDI, Vertical FDI and Backward Vertical FDI.