What is Foreign Investment?
The term “foreign investment” refers to the flow of capital from one country/ nation to another. As a result, the foreign investors gain ownership in the domestic companies of the host countries. In other words, these investments offer the foreign investors an active role in the domestic company’s management through their equity stake, which is large enough to enable these investors to influence important business strategies.
How does Foreign Investment work?
In the last couple of decades, globalization has scaled newer heights as more and more companies increased their presence in various countries across the world. Some multinational companies tend to start new production units in a different country in order to leverage opportunities available there, such as cheaper production and labor costs. In some other cases, these large corporates carry out their businesses in those countries where they enjoy better tax benefits. Basically, these countries attract foreign investors by offering favorable tax laws, and the multinational companies reap the benefits by relocating their headquarters or parts of their businesses to these countries.
Example of Foreign Investment
There are many companies that have expanded their offices across the globe to reach out to a larger talent pool. For example, multinational companies like J.P. Morgan, Goldman Sachs, and Morgan Stanley have huge set-ups in Asian countries that primarily capitalize on the cheap labor available in these countries. Further, many textile companies, such as H&M or Zara, whose businesses are focused on the North American market, have their manufacturing units in China and Bangladesh because of significantly cheaper raw material and labor costs in these regions.
Types of Foreign Investment
It can be classified into two broad categories:
1. Foreign Direct Investment (FDI)
When a company or individual acquires more than a 10% stake in another company in a foreign country, then it is known as foreign direct investment or FDI. In this type of investment, the investor gains controlling power and the ability to influence key business decisions within the company. It can be further classified into two categories:
- Horizontal FDI: When foreign investors acquire or merge with businesses similar to their own but operating in different countries, then it is known as horizontal FDI. The objective behind this type of investment is to get hold of a larger market share in order to become a global leader.
- Vertical FDI: When foreign investors acquire or merge with companies that operate in another country and in different businesses than the investors, then it is known as vertical FDI. However, the acquisitions are usually part of value chain expansion, such as investing in downstream or upstream companies to gain operational synergy.
2. Foreign Indirect Investment
When a company or individual purchases stocks of a company that is trading in the stock market of a foreign country but the investment value doesn’t exceed 10% of the available stocks in that company, then it is known as foreign indirect investment.
The following are some of the major advantages:
- It results in increased business activities (manufacturing as well as services) in the host country leading to the creation of more employment opportunities.
- Foreign investors are able to access the market of a country other than their own.
- It helps in the infrastructural development of the host country as new business units and plants are set up.
- It helps develop new technologies and improve operational practices through knowledge sharing between the host country and foreign investors.
The following are some of the major disadvantages:
- It can be a risky proposition as it may hinder investment from the domestic players.
- In the case of volatile exchange rates, it remains exposed to significant exchange rate risk, which is a critical factor.
- An unstable political environment may result in unfavorable foreign policies and investment regulations, an important consideration for foreign investors.
- In many cases, the existing owners of the domestic company have to relinquish their control of the company’s business decisions in exchange for foreign investment.
- Small traders and business owners usually find it difficult to survive in a market where foreign investment makes an entry as they tend to various aggressive strategies to wipe out the competition to gain the maximum market share.
Why Foreign Investment is Important?
Typically, large multinational companies invest in various countries across the globe with the intent of diversifying their operational presence, expanding the market, and leveraging the inherent regional benefits. On the other hand, the host countries tend to attract foreign investors to spur economic growth and infrastructural development. Overall, it is a very important economic phenomenon as it results in a win-win situation for both foreign investors and host countries.
The following are some of the key takeaways of the article:
- First, it is the investment made by foreign investors in the domestic companies of another country.
- Large multinational companies employ foreign investment to diversify their operational presence, expand the market, and leverage the inherent regional benefits.
- While foreign direct investment refers to the purchase of more than a 10% equity stake in a foreign company; while foreign indirect investment refers to investment value that doesn’t exceed 10% of the available stocks in the foreign company.
- It results in a win-win situation for the foreign investors as well as the host countries. However, small traders and business owners at times are adversely impacted due to such investments.
So, it can be said that it marks the entry of foreign investors into other countries. It can trigger economic growth in the host countries by developing infrastructure, creating jobs, sharing knowledge, etc. Further, the large multinational companies leverage the foreign investment route to diversify their operational presence, expand the market, and reap tax benefits. In short, it is beneficial to both foreign investors and host countries.
This is a guide to Foreign Investment. Here we also discuss the definition, working, example, types, and importance along with advantages and disadvantages. You may also have a look at the following articles to learn more –