Foreign Direct Investment

LEA RN IN G OBJ ECTIV ES

1. Understand the types of international investments.

2. Identify the factors that influence foreign direct investment (FDI).

3. Explain why and how governments encourage FDI in their countries.

Understand the Types of International Investments

There are two main categories of international investment—portfolio investment and

foreign direct investment. Portfolio investment refers to the investment in a company’s
stocks, bonds, or assets, but not for the purpose of controlling or directing the firm’s
operations or management. Typically, investors in this category are looking for a
financial rate of return as well as diversifying investment risk through multiple markets.

Foreign direct investment (FDI) refers to an investment in or the acquisition of foreign

assets with the intent to control and manage them. Companies can make an FDI in
several ways, including purchasing the assets of a foreign company; investing in the
company or in new property, plants, or equipment; or participating in a joint venture
with a foreign company, which typically involves an investment of capital or know-how.
FDI is primarily a long-term strategy. Companies usually expect to benefit through
access to local markets and resources, often in exchange for expertise, technical know-
how, and capital. A country’s FDI can be both inward and outward. As the terms would
suggest, inward FDI refers to investments coming into the country and outward FDI are
investments made by companies from that country into foreign companies in other
countries. The difference between inward and outward is called the net FDI inflow,
which can be either positive or negative.
Governments want to be able to control and regulate the flow of FDI so that local
political and economic concerns are addressed. Global businesses are most interested in
using FDI to benefit their companies. As a result, these two players—governments and
companies—can at times be at odds. It’s important to understand why companies use
FDI as a business strategy and how governments regulate and manage FDI.

Factors That Influence a Company’s Decision to Invest

Let’s look at why and how companies choose to invest in foreign markets. Simply
purchasing goods and services or deciding to invest in a local market depends on a
business’s needs and overall strategy. Direct investment in a country occurs when a
company chooses to set up facilities to produce or market their products; or seeks to
partner with, invest in, or purchase a local company for control and access to the local
market, production, or resources. Many considerations influence its decisions:

 Cost. Is it cheaper to produce in the local market than elsewhere?

 Logistics. Is it cheaper to produce locally if the transportation costs are

significant?

 Market. Has the company identified a significant local market?

 Natural resources. Is the company interested in obtaining access to local

resources or commodities?

 Know-how. Does the company want access to local technology or business

process knowledge?

 Customers and competitors. Does the company’s clients or competitors

operate in the country?
  Policy. Are there local incentives (cash and noncash) for investing in one
country versus another?

 Ease. Is it relatively straightforward to invest and/or set up operations in the

country, or is there another country in which setup might be easier?

 Culture. Is the workforce or labor pool already skilled for the company’s needs
or will extensive training be required?

 Impact. How will this investment impact the company’s revenue and

profitability?

 Expatriation of funds. Can the company easily take profits out of the country,
or are there local restrictions?

 Exit. Can the company easily and orderly exit from a local investment, or are
local laws and regulations cumbersome and expensive?

These are just a few of the many factors that might influence a company’s decision. Keep
in mind that a company doesn’t need to sell in the local market in order to deem it a
good option for direct investment. For example, companies set up manufacturing
facilities in low-cost countries but export the products to other markets.

There are two forms of FDI—horizontal and vertical. Horizontal FDI occurs when a

company is trying to open up a new market—a retailer, for example, that builds a store
in a new country to sell to the local market. Vertical FDI is when a company invests
internationally to provide input into its core operations—usually in its home country. A
firm may invest in production facilities in another country. When a firm brings the
goods or components back to its home country (i.e., acting as a supplier), this is referred
to as backward vertical FDI. When a firm sells the goods into the local or regional
market (i.e., acting as a distributor), this is termed forward vertical FDI. The largest
global companies often engage in both backward and forward vertical FDI depending on
their industry.

Many firms engage in backward vertical FDI. The auto, oil, and infrastructure (which
includes industries related to enhancing the infrastructure of a country—that is, energy,
communications, and transportation) industries are good examples of this. Firms from
these industries invest in production or plant facilities in a country in order to supply
raw materials, parts, or finished products to their home country. In recent years, these
same industries have also started to provide forward FDI by supplying raw materials,
parts, or finished products to newly emerging local or regional markets.

There are different kinds of FDI, two of which—greenfield and brownfield—are

increasingly applicable to global firms. Greenfield FDIs occur when multinational
corporations enter into developing countries to build new factories or stores. These new
facilities are built from scratch—usually in an area where no previous facilities existed.
The name originates from the idea of building a facility on a green field, such as
farmland or a forested area. In addition to building new facilities that best meet their
needs, the firms also create new long-term jobs in the foreign country by hiring new
employees. Countries often offer prospective companies tax breaks, subsidies, and other
incentives to set up greenfield investments.

A brownfield FDI is when a company or government entity purchases or leases existing

production facilities to launch a new production activity. One application of this strategy
is where a commercial site used for an “unclean” business purpose, such as a steel mill
or oil refinery, is cleaned up and used for a less polluting purpose, such as commercial
office space or a residential area. Brownfield investment is usually less expensive and
can be implemented faster; however, a company may have to deal with many challenges,
including existing employees, outdated equipment, entrenched processes, and cultural
differences.
You should note that the terms greenfield and brownfield are not exclusive to FDI; you
may hear them in various business contexts. In general, greenfield refers to starting
from the beginning, and brownfield refers to modifying or upgrading existing plans or
projects.

Why and How Governments Encourage FDI

Many governments encourage FDI in their countries as a way to create jobs, expand
local technical knowledge, and increase their overall economic standards.Ian
Bremmer, The End of the Free Market: Who Wins the War Between States and
Corporations (New York: Portfolio, 2010). Countries like Hong Kong and Singapore
long ago realized that both global trade and FDI would help them grow exponentially
and improve the standard of living for their citizens. As a result, Hong Kong (before its
return to China) was one of the easiest places to set up a new company. Guidelines were
clearly available, and businesses could set up a new office within days. Similarly,
Singapore, while a bit more discriminatory on the size and type of business, offered
foreign companies a clear, streamlined process for setting up a new company.

In contrast, for decades, many other countries in Asia (e.g., India, China, Pakistan, the
Philippines, and Indonesia) restricted or controlled FDI in their countries by requiring
extensive paperwork and bureaucratic approvals as well as local partners for any new
foreign business. These policies created disincentives for many global companies. By the
1990s (and earlier for China), many of the countries in Asia had caught the global trade
bug and were actively trying to modify their policies to encourage more FDI. Some were
more successful than others, often as a result of internal political issues and pressures
rather than from any repercussions of global trade.UNCTAD compiles statistics on
foreign direct investment (FDI): “Foreign Direct Investment database,” UNCTAD
United Nations Conference on Trade and Development, accessed February 16,
2011, http://unctadstat.unctad.org/ReportFolders/reportFolders.aspx?
sRF_ActivePath=P,5,27&sRF_Expanded=,P,5,27&sCS_ChosenLang=en.
How Governments Discourage or Restrict FDI

In most instances, governments seek to limit or control foreign direct investment to

protect local industries and key resources (oil, minerals, etc.), preserve the national and
local culture, protect segments of their domestic population, maintain political and
economic independence, and manage or control economic growth. A government use
various policies and rules:

 Ownership restrictions. Host governments can specify ownership restrictions

if they want to keep the control of local markets or industries in their citizens’
hands. Some countries, such as Malaysia, go even further and encourage that
ownership be maintained by a person of Malay origin, known locally
as bumiputra. Although the country’s Foreign Investment Committee guidelines
are being relaxed, most foreign businesses understand that having
a bumiputra partner will improve their chances of obtaining favorable contracts
in Malaysia.

 Tax rates and sanctions. A company’s home government usually imposes

these restrictions in an effort to persuade companies to invest in the domestic
market rather than a foreign one.

How Governments Encourage FDI

Governments seek to promote FDI when they are eager to expand their domestic
economy and attract new technologies, business know-how, and capital to their country.
In these instances, many governments still try to manage and control the type, quantity,
and even the nationality of the FDI to achieve their domestic, economic, political, and
social goals.

 Financial incentives. Host countries offer businesses a combination of tax

incentives and loans to invest. Home-country governments may also offer a
 combination of insurance, loans, and tax breaks in an effort to promote their
companies’ overseas investments. The opening case on China in Africa illustrated
these types of incentives.

 Infrastructure. Host governments improve or enhance local infrastructure—in

energy, transportation, and communications—to encourage specific industries to
invest. This also serves to improve the local conditions for domestic firms.

 Administrative processes and regulatory environment. Host-country

governments streamline the process of establishing offices or production in their
countries. By reducing bureaucracy and regulatory environments, these countries
appear more attractive to foreign firms.

 Invest in education. Countries seek to improve their workforce through

education and job training. An educated and skilled workforce is an important
investment criterion for many global businesses.

 Political, economic, and legal stability. Host-country governments seek to

reassure businesses that the local operating conditions are stable, transparent
(i.e., policies are clearly stated and in the public domain), and unlikely to change.

Ethics in Action

Encouraging Foreign Investment

Governments seek to encourage FDI for a variety of reasons. On occasion, though, the
process can cross the lines of ethics and legality. In November 2010, seven global
companies paid the US Justice Department “a combined $236 million in fines to settle
allegations that they or their contractors bribed foreign officials to smooth the way for
importing equipment and materials into several countries.”Kara Scannell, “Shell, Six
Other Firms Settle Foreign-Bribery Probe,” Wall Street Journal, November 5, 2010,
accessed December 23,
2010, http://online.wsj.com/article/SB100014240527487048052045755943113010439
20.html. The companies included Shell and contractors Transocean, Noble, Pride
International, Global Santa Fe, Tidewater, and Panalpina World Transport. The bribes
were paid to officials in oil-rich countries—Nigeria, Brazil, Azerbaijan, Russia,
Turkmenistan, Kazakhstan, and Angola. In the United States, global firms—including
ones headquartered elsewhere, but trading on any of the US stock exchanges—are
prohibited from paying or even offering to pay bribes to foreign government officials or
employees of state-owned businesses with the intent of currying business favors. While
the law and the business ethics are clear, in many cases, the penalty fines remain much
less onerous than losing critical long-term business revenues.Kara Scannell, “Shell, Six
Other Firms Settle Foreign-Bribery Probe,” Wall Street Journal, November 5, 2010,
accessed December 23,
2010, http://online.wsj.com/article/SB100014240527487048052045755943113010439
20.html.

Did You Know?

Hong Kong: From Junks to Jets? The Rise of a Global Powerhouse

Policies of openness to FDI and international trade have enabled countries around the
world to leapfrog economically over their neighbors. The historical rise of Hong Kong is
one example. Hong Kong’s economic strengths can be traced to a combination of
factors, including its business-friendly laws and policies, a local population that is
culturally oriented to transacting trade and business, and Hong Kong’s geographic
proximity to the major economies of China, Japan, and Taiwan.

Hong Kong has always been open to global trade. Many people, from the Chinese to the
Japanese to the British, have occupied Hong Kong over the centuries, and all of them
have contributed to its development as one of the world’s great ports and trading
centers.
In 1997, Hong Kong reverted back to Chinese control; however, free enterprise will be
governed under the agreement of Basic Law, which established Hong Kong as a separate
Special Administrative Region (SAR) of China. Under its Basic Law, in force until 2047,
Hong Kong will retain its legal, social, economic, and political systems apart from
China’s. Thus, Hong Kong is guaranteed the right to its own monetary system and
financial autonomy. Hong Kong is allowed to work independently with the international
community; to control trade in strategic commodities, drugs, and illegal
transshipments; and to protect intellectual property rights. Under the Basic Law, the
Hong Kong SAR maintains an independent tax system and the right to free trade.

Hong Kong has an open business structure, which freely encourages foreign direct
investment. Any company that wishes to do business here is free to do so as long as it
complies with local laws. Hong Kong’s legal and institutional framework combined with
its good banking and financial facilities and business-friendly tax systems have
encouraged foreign direct investment as many multinationals located their regional
headquarters in Hong Kong.

As a base for doing business with China, Hong Kong now accounts for half of all direct
investments in the mainland and is China’s main conduit for investment and trade.
China has also become a major investor in Hong Kong.

Culturally, many foreign firms are attracted to Hong Kong by its skilled workforce and
the fact that Hong Kong still conducts business in English, a remnant of its British
colonial influence. The imprint of the early British trading firms, known as hongs, is
particularly strong today in the area of property development. Jardine Matheson and
Company, for instance, founded by trader William Jardine, remains one of Hong Kong’s
preeminent firms. In many of these companies, British management practices remain
firmly in place. Every aspect of Hong Kong’s business laws—whether pertaining to
contracts, taxes, or trusts—bears striking similarities to the laws in Britain. All these
factors contribute to a business culture that is familiar to people in many multinationals.
Chinese cultural influences have always affected business and are increasingly so today.
Many pundits claim that Hong Kong already resembles China’s free-trade zone. And,
indeed, the two economies are becoming increasingly intertwined. Much of this
economic commingling began in the 1990s, when Hong Kong companies began
relocating production centers to the mainland—especially to Guangdong province.

Because of the shift in production to mainland China and other Asian countries, there is
not much manufacturing left in Hong Kong. What remains is light in nature and veers
toward high-value-added products. In fact, 80 percent of Hong Kong’s gross domestic
product now comes from its high value-added service sector: finance, business and legal
services, brokerage services, the shipping and cargo industries, and the hotel, food, and
beverage industry.

Local Hong Kong companies, as well as foreign businesses based there, are uniquely
positioned to play important roles as brokers and intermediaries between the mainland
and global corporations. Doing business in China is not only complex and daunting but
also requires connections, locally known as guanxi, to influential people and an
understanding of local laws and protocol. Developing these relationships and this
knowledge is almost impossible without the assistance of an insider. It is in this role that
the Hong Kong business community stands to contribute enormously.

Hong Kong’s openness to foreign investment coupled with its proximity to China will
ensure its global economic competitiveness for decades to come.

KEY TA KEA WA YS

 There are two main categories of international investment: portfolio investment and
foreign direct investment (FDI). Portfolio investment refers to the investment in a
company’s stocks, bonds, or assets, but not for the purpose of controlling or directing
the firm’s operations or management. FDI refers to an investment in or the acquisition of
foreign assets with the intent to control and manage them.
 Direct investment in a country occurs when a company chooses to set up facilities to
produce or market its products or seeks to partner with, invest in, or purchase a local
company for control and access to the local market, production, or resources. Many
considerations can influence the company’s decisions, including cost, logistics, market,
natural resources, know-how, customers and competitors, policy, ease of entry and exit,
culture, impact on revenue and profitability, and expatriation of funds.

 Governments discourage or restrict FDI through ownership restrictions, tax rates,

and sanctions. Governments encourage FDI through financial incentives; well-
established infrastructure; desirable administrative processes and regulatory
environment; educational investment; and political, economic, and legal stability.