Foreign Direct Investment

What It Means

When a business or firm invests its money or other resources in business activities outside its home country, it is known as foreign direct investment (FDI). Foreign direct investment typically involves constructing a factory or manufacturing facility in another country or providing equipment or buildings to a company in another country. It can also mean that the firm in the home country manages a foreign company or invests in a project with a foreign company. For example, if a U.S.-based automaker built a manufacturing plant in Indonesia, it would be making a foreign direct investment. The U.S. automaker buying a company in another country would be another example of FDI.

The practice of FDI has many benefits. When a company invests money or resources abroad, it automatically gains access to that country’s economic market, which expands its opportunities to sell its products. It also might have access to cheaper production facilities, new technology, or new products that it is unable to get at home; these factors can help increase its efficiency.

The country in which the investment is made, called the host country, also benefits from FDI: it gains new technology, products, and business or manufacturing skills that help to stimulate economic growth. These benefits can improve the country’s economic conditions by raising the income levels of workers or developing the country’s market for goods and services.

In recent decades the barriers that regulate trade between nations (called international trade) have been gradually reduced, allowing countries to trade goods and services freely with one another and, as a result, enabling more foreign direct investment to take place. Both increased trade and increased FDI have paved the way for firms all over the world to set up their production facilities at the location that is best for that activity, even if it is in another country. A firm can design a product in one country, manufacture its components in factories located in another country, and assemble the product in yet another country. The product may end up being sold anywhere in the world.

When Did It Begin

The increase in international trade since World War II (1939–45) has laid the groundwork for the worldwide growth of foreign direct investment. Since the 1940s the barriers to international trade, such as high tariffs (taxes) on imported manufactured goods, have been lowered. The General Agreement on Tariffs and Trade (GATT) was a contract signed in 1948 by 23 nations, including the United States, for the purposes of promoting trade agreements among members. GATT and other agreements helped to establish worldwide trade and to increase the ways in which companies invested their resources in foreign locations. For smaller firms, investing internationally provided opportunities to become more actively involved in the global marketplace. Larger firms were able to build entire offices in other countries and integrate deeply into local economies; large companies with many locations worldwide came to be known as multinationals.

In 1995 GATT was succeeded by the World Trade Organization (WTO). By 1999 the volume of world trade had grown to almost 20 times what it had been in 1950, an increase caused in large part by steady growth in foreign direct investment.

More Detailed Information

Companies that want resources such as cheap labor and close proximity to natural resources may need to set up part of their operations in foreign locations in order to obtain those resources. For several decades American, European, and Asian companies have found cheap labor in countries in Southeast Asia and Eastern Europe where the local economies are not developed. Unlike workers in the United States and other developed countries, workers in these countries are generally unorganized (not united to protect their rights and improve their working conditions), which greatly lowers the chance that they will strike (protest by stopping their work) or issue demands for higher wages. For close proximity to natural resources, many companies from the United States and elsewhere have located manufacturing or office buildings in the Middle East and Africa, where there are countries rich in such resources as petroleum, coal, iron ore, and copper.

Accounting firms, advertising firms, and law firms also invest their resources in other countries, typically when they are seeking new clients for their services. A business that does this is said to be broadening its market. For example, a law firm based in New York City that provides legal services to clients of Czech descent might determine that having an office in Prague (the capital of the Czech Republic) would help it gain more Czech clients. If the firm already had clients in Prague, investing in opening an office and hiring Czech lawyers would help sustain the relationships with those clients and also support the local Czech economy by providing jobs for lawyers.

Another reason why firms invest in other countries is to take advantage of what are known as economies of scale and scope. Economy of scale refers to the way that the cost of producing a good goes down when the quantity of the good being produced goes up. Large manufacturing facilities, such as car factories, are generally able to make goods more efficiently than smaller facilities, because the larger facilities can mass-produce goods using assembly lines and automated machinery. For example, if a U.S.-based maker of silicon chips opens a manufacturing plant in the Latin American country of Costa Rica, it can bring its advanced manufacturing technologies and facilities to a place where the real estate is cheaper than in the United States and the cost of paying workers is significantly lower. In addition, the company is taxed at a very low rate by the Costa Rican government, and it receives subsidies (government-supported reductions in price) for electricity and water. These benefits all contribute to lowering the cost of each computer chip that is manufactured in the Costa Rican plant.

Economy of scope is a theory that states that the average cost of production goes down as the number of different types of goods produced goes up. For example, a paper-product company that manufactures a variety of products, from paper plates to paper napkins to note cards, will have facilities that can share the production of different goods, which will reduce the overall cost of producing each good. The costs of making diverse products for one company are cheaper than the costs of producing each one in a separate facility. For example, suppose that a Chinese razor-blade manufacturer has built up a global distribution network for shipping its razors to many different countries. If that company is purchased by a U.S. battery manufacturer, then the battery manufacturer can increase its efficiency by using the distribution network of the razor manufacturer to ship both razors and batteries to other countries. The investment in the Chinese company gives the U.S. company a new advantage.

Recent Trends

Large companies such as Boeing, General Motors, and Ford were among the first to make significant investments in other countries and to become what are now called multinational corporations. Today medium-sized companies are also participating in the trend to invest abroad, which has further increased the amount of cross-border investment. According to the United Nations (an organization that fosters political, legal, and economic cooperation among countries), between 1984 and 1997 the total annual flow of foreign direct investment from all countries increased from $42 billion to $430 billion. This was more than double the rate at which world trade grew during that period.

Between 1991 and 1996 more than 100 countries made 599 changes in laws pertaining to foreign direct investment. The majority of these changes involved loosening the regulations for foreign investment in the home country in order to make it easier for foreign companies to enter their markets. The decrease in regulations improved the ability of countries to trade goods and services across borders. When both trade and investment are open between countries, it is easier for companies to find and develop the best location for production.