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F O R E I G N DIRECT

INVESTMENT
by Valentino Piana (2005)

Contents
1. Significance
2. Composition
3. Determinants
4. Impact on other variables
5. Long-term trends
6. Behaviour during the business cycle
7. Industry life cycle
8. Data
9. Related papers
10. Specialized magazines
Significance
W he n a firm controls (or have a strong say in) another firm located abroad, e.g. by
owing more than 10% of its equity, the former is said "parent enterprise" (or "investor")
and the latter "foreign affiliate".
Foreign Direct Investment (FDI) is the financial investment giving rise and sustaining
over time the investor's significant degree of influence on the management of the
affiliate.
T he initial investment can be the purchase of an existing firm (by acquisition or by
merger, the so-called "M&A") as well as the foundation of a new legal entity who usually
- but not necessarily - makes a green-field re a l investment (e.g. building a factory) in
the foreign country [1].
In a broader definition, FDI consists of the acquisition or creation of assets (e.g. firm
equity, land, houses, oil-drilling rigs,...) undertaken by foreigners. If in these enterprises
they are not alone but act together with local firms and/or governments, one talks of
"joint ventures".
A country outflows of FDI means that it is "exporting money" to "buy" or "build"
foreign productive capacity, whose ownership will remain in the first country's hands.
Fo r a country, attracting an inflow of FDI strengthen the connection to wo rld trade
networks and finance its development path. However, unilateral massive FDI to a
country can make it dependent on the external pressure that foreign owners might exert
on it.
Since it is through FDI that a firm becomes a multinational, one could say that the
it's the FDI process that generates MNC (multinational companies). The reverse is also
true: firms that are already multinational generate the majority of FDI flows.
Composition
FDI has three components:
- equity capital;
- reinvested earnings, the investor's share of earning not distributed as dividends by
affiliates, in proportion to its share in the equity (say for instance 50% in a certain joint
venture);
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- intra-company loans, when the investor borrows funds to the affiliate, usually without
the intention of asking the money back.
T o better understand their defining characteristics, you should consider that FDI are
flows of capital that share the following features:
- they are long-term (in contrast to portfolio investment in bonds and in short-term
speculation in shares);
- they give rise to a property right on the asset built or bought (in contrast to foreign
aid).
However, FDI is quite heterogeneous and one should distinguish several kinds, e.g. by
looking at the following factors:
a . whether the activity in the host country is just an intermediate phase in a longer
production chain or it gives rise to a finished good;
b . the production phase performed in the host country (design, manufacture,
distribution);
b. where the outcome of the process in the host coutry will be sold (there or abroad).
T h e "classical" FDI is a manufacture plant using foreign technology and management
techniques to exploit low-cost local resources, with sales made to the present clients of
the investor (thus, usually involving exports). However, market-oriented FDI as well as
FDI in other sectors (e.g. tourism resorts, banks, transport,...) are important phenomena
as well.
Determinants
A t investor's level, a firm can decide to make a foreign investment because of many
factors, including:
1 . upstream integration, by purchasing a provider, whose input will now be sold
cheaper (or exclusively) to it or be differentiated along particular features;
2. horizontal integration, by purchasing a firm making the same product, to expand
its production, reduce costs, improving logistics;
3. downstream integration, by purchasing a firm using or distributing its products,
to get higher value added along the chain and to aggressively push distribution;
4. diversification, by purchasing a firm doing somewhat different activities than the
purchaser, to seize new opportunities.
A firm already exporting to a market can decide to make a FDI and build there a
productive unit to reduce the transport cost and avoid tariff barriers.
I n another vein, FDI is the chosen vehicle used by a foreign firm having a
monopolistic advantage vis-a-vis other firms in the market. Host country conditions are
such that the application of the advantage enables the generation of economic profits,
higher than the expected profit to be gained from selling or licensing the advantage to
other firms.
Access to a privileged network of input-output relationships as well as of knowledge
providers is an important objective of many FDI initiatives.
N o t e that strictly financial consideration are important as well, since a current
positive cash-flow is conducive to look for investment opportunites.
Together with "rational" reasons, the specific country chosen can often be forecast by
an external observer in terms of "imitation" , being the same as the target country of
other FDI.
At country level, outflows of FDI are high when:
firms have sound financial conditions but consider that other countries have more
favourable investment conditions;
the exchange rate is "high" in an historical perspective (e.g. after a re-valuation) so
foreign firms are "cheap" and exports are braked - in this case FDI substitutes
exports;
the trade balance is positive, with exports higher then imports, since capital flows
usually compensate the commercial flows;
Inflow of Foreign Direct Investments increases with the attractiveness of the country,
due to the following factors in different proportions depending on the industry and the
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country:
1. large GDP and market potential;
2.1. advanced know-how;
2.2. skilled work-force;
3.1. low labour cost and wages;
3.2. low taxation;
3.3. lower environmental protection;
4. high tariff protection;
5.1. favourable laws and public incentives;
5.2. intentional and professional territorial marketing.
I n particular, the establishment and the skills of an Investment Promotion Agency,
actively looking for investors in industries and activities for which the country has a
competitive advantage and a strong need, can make the difference, both in quantity,
quality and positive effects of FDI.
O n a sub-national level, FDI usually concentrates in the richest part of the
country, where wages are higher, also because there the investor can find a better
infrastructure and easier logistical accessibility from abroad. This empirical evidence
weakens the relationships between FDI and low wages.
In macroeconomic terms, net inflow of FDI often occurs when the country has a trade
deficit.
Impact on other variables
A. Financial variables
T h e equity capital component of FDI generates an increase in "total equity" of the
foreign economy. Note that the latter is not equal to total assets in the aggregated
balance sheet.
As an inflow of capital it is, FDI changes the balance of payments. Other things
equal, if not sterilized, FDI increases the official reserves of foreign currency.
B. External trade and industrial variables
A particularly strong FDI concentrated in a short period of time (e.g. a purchase of a
newly privatized big state company) can lead to a re-valuation of the currency exchange
rate.
I f significant flows of FDI are aimed to real investments (e.g. building a factory),
then total investment will rise, other things equal.
Usually, in this case, the foreigners will import machines as well as raw and
intermediate inputs for the production process (from their country or their providers'
one). For both reasons, imports will rise after a FDI inflow.
If the good produced in the host country is sold there, consumption composition will
change, possibly with a loss in market shares of local producers and of foreing producers
based abroad. in the latter case, FDI is crowding out imports. If the product is new for
the host country, it fills a gap and increases the variety of available goods, thus opening
the path to higher productivity for industrial users and higher satisfaction for consumers.
For instance, a FDI in an electricity generation plant will allow more firms to operate in
the region and wider availability of energy for inhabitants.
If, instead, the production is exported, FDI boosts exports of the host country,
providing it with foreign currency.
If FDI is targeted to green-field investment, employment will rise, possibly involving
a Keynesian multiplier of income and consumption. If FDI is targeted to an acquisition of
a large inefficient firm, the priority of profits will possibly lead, in the short run, to
waves of dismissals and a rise of unemployment.
Wages are usually higher in foreign affiliates than in local firms, sometimes with the
crowding out of the latter on the labour market (i.e. they do not find any more workers
at the previous level of wage and they are not profitable at the new level, because of
their lagging productivity).
C. Know ledge and entrepreneurial variables
U s ua l l y, foreign firms have higher productivity than local ones, since the foreing
ownership prompts managers to use non-locally available knowledge, both incorporated
and not-incorporated in machines, which often constitute an innovation.
The local workforce is put into contact with that knowledge and, more in general, with

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the foreigners' mentality.


All this might generate knowledge spillovers to workers, as well as to local providers
(e.g. forced to adopt ISO certification or specific methods of production) and to local
competitors (who could imitate the foreign firm).
Thus, a mid-term effect of FDI can be the mushrooming of new businesses in the
same industry by competitors and past key workers. In parallel, the presence of a big
foreign investor can re-orient the education & training courses offered in the region,
giving rise to a "pool" of specialized skills, which in turn become a competitive
advantage for the investor as well as an incentive for other international firm to locate
there.
D. Political variables
Far-sighted politicians can use FDI for their country to catch up with world standards in
certain industries, prompting a fast development of the economy, by attracting and
selecting the investors.
However, large and concentrated FDI can exert external pressure to obtain a
preferential treatment against the local firms, giving rise to political attrition between
the two groups. The external pressure can take the form of funds for electoral expenses
of certain parties or of corruption of bureacrats and politicians, the more so the money
at stake is huge in comparision with the typical wage of the officer.
Foreign-owned managers risk to exhibit a radical "ignorance of law", since the law is
written in a not-known language and they have no experience with it. In this case, the
management behaves as it wants, leaving to lawyers and bribery the task to make the
activity "compliant" with regulation.
FDI in non-democratic countries can exploit the lack of free trade unions and active
citizens to carry out activities banned in democratic countries. However, FDI is a "window
to the world", thus in a longer time perspective, it's conducive to openness, sometimes
to the same development of democracy.
E. Caveat
All this can be the effect of FDI provided they are big with respect to the host economy.
By contrast, for most countries and for most of their history, FDI stocks and flows are
quite small and their (positive or negative) effects simply do not influence the
aggregate, which is rather determined by other factors.
Long-term trends
During the relatively stable UK-dominated w orld system of 19th century, globalization
boosted FDI from the core to the semi-periphery and to colonies. The subsequent
conflict between "core countries" exploded in two global wars, with international trade
collapse, protectionism, nationalization of foreing affiliates and FDI crise.
The US-dominated world system of the second half of 20th century showed a strong
trend of increasing FDI.
Howe ve r, this overall general tendency is structurally unstable: nervous short-run
"flames" of FDI reach a short list of "target" countries, with abrupt crashes (as with the
East Asia boom and crise in the last decade of the century).
Debt crises are a dramatic end of FDI "flames" (as in Argentina, Russia, Brazil during
the same period), in interaction with external aid, currency crises, bank crashes and
political turm-oil.
Behaviour during the business cycle
Being pro-cyclical and lagged, inflows of FDI usually arrive late after robust signs of
recovery and growth. The international press helps to tune the sentiment of
international investors, providing a kind of "early signal" of FDI inflows in case of "good
coverage".
Outflows of FDI can arise especially in two subsequent periods:
a . at the end of the business cycle when very liquid firms try to extend their assets
abroad;
b. during recession, when the interest rate is low but no investment opportunity are
evident in the domestic economy.
Industry life cycle
F D I comprehends cross-border Mergers & Acquisition, thus they retain some of their
hectic movements, with accelerated boost and severe crashes.
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hectic movements, with accelerated boost and severe crashes.


Looking instead to the industrial side, FDI can be framed in the "product life cycle" as
an emerging feature of the moment when, after a "dominant design" has put a
temporary end to p ro d uct innovation, a new phase of cost control is leading to
movements in the production preferred location, by transferring active factories from
core countries to semi-peripheries where production costs are lower. This movement
goes together with semi-periphery firms imitating the core countries' innovators.
In the perspective of a competition among countries to attract foreign investors, a
low-wa ge , low-tax country attracts investments from abroad thanks to a relatively
acceptable dotation of infrastructure and technical expertise, until other even-lowerwage & tax country substitute it. T h i s contributes to a geographical earthquake-like
movement of FDI from a "centre" to its neighbours and to further "peripheries".
Data
FDI Inflows, outflows, inward stock and outward stock in 200 countries - a long timeseries (1970-2003)
FDI by both country and sector
UNIDO survey on the investors' decision-making process
Survey on foreign investors in Russia
ATKearney FDI Confidence Index
Measures of Foreign Assets and Liabilities in 66 Industrial and Developing Countries
(1970-1998)
Prospects for FDI Flows, Transnational Corporation Strategies and Promotion Policies:
20042007
Related papers
As s es s ing the employment effect of FDI inflows to Egypt: Does the mode of entry
matter? (2008)
Human capital as a determinant of Foreign Direct Investment: Egypts case
Spillover effects of FDI on innovation in China
Technology Transfer through FDI in Top-10 Transition Countries: How Important are
Direct Effects, Horizontal and Vertical Spillovers?
Industrial location and local incentive policies in Brazil
FDI in Africa
Are FDI attracted by weak environmental regulations?
Human capital skilling, FDI and economic development
Human capital and inward FDI
A critical view of FDI
H o w performance gaps between domestic firms and foreign affiliates matter for
economic policy
F o re i g n direct investment spillovers within and between sectors: Evidence from
Hungarian data
The Myth of FDI Impact on Growth in the SADC Region: The Case of Zimbabwe
Reinvested Earnings Matter
China: an emerging FDI outward investor
Export-oriented services: FDI in developing countries
Technological integration and global marginalisation of Central and East European
economies: the role of FDI and alliances
Germany FDI determinants: evidence from micro-data
The role of FDI in China's rapid transformation

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India's position in the attraction of FDI: a survey by the Federation of Indian Chambers
of Commerce
Specialized magazines
FDI Magazine
NOT ES
[1] The word "investment" has two somewhat different meanings. "Real investment" is
a n investment in macroeconomic terms, giving rise to material and immaterial assets,
as registered in the balance sheet. "Financial investment" is the purchase of bonds,
shares, and other financial instruments. A financial investment in a newly-founded
entreprise can give rise to its equity.
I n simple words, a person who has large savings can decide to invest them, say, in
shares. A business producing a good with bright market perspectives can decide to
invest in new machines to produce more units of the good. The former is a "financial
investment", the second a "real investment".
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