Role of Foreign Direct Investment in the Growth of an Economy

Foreign Direct Investment

A lot of you must have heard of Foreign Direct Investment (FDI) but, do you understand what an FDI do? A foreign direct investment (FDI) is a measure adopted by a nation to attract foreign investments contributing to the growth of its economy. The investment gained by hosting nation can be in the form of controlled ownership by a business based in another country. In this section, you will learn about the working and role of FDI contributing to the growth of an economy.

What is Foreign Direct Investment?

Foreign Direct Investment (FDI) is made by a business established in a foreign country into another company in the host country. The investment is attracted by foreign countries to boost the economy of the host country. An FDI occurs when a firm invests a certain amount of capital into the business of another or a foreign economy. The investment is made to establish a lasting interest between the two economies. An FDI not only promotes the economic growth of the host nation; also, it enhances the financial relationship between the two countries contributing to the mutual benefits of both the economies.

In simple words, FDI acts as an intermediate between two economies of the world and developing an economic relationship between the two. The role of FDI in the sustainability of an economy is crucial as it is different from other portfolio investments. This is the reason that FDI in various countries is considered as a significant source of the economic growth of that nation. Thus, the foreign direct investment can either be initiated by occupying a lasting interest or the expansion of a firm into an international economy.

What Are the Types of FDI?

5 Types of FDI Known in the Market

• Horizontal: As the name suggests, this investment deals among many economies in a horizontal way; i.e., the investment made by a firm or an individual carries all the operations on the investing company on its soil. In this type of investment, it is imperative for investors to operate in the same industry but two different countries. For example, an IT firm of the US invests in IT firm of the UK.
• Vertical: In this type of investment, the area of operation of the investor and the host is different but somewhere related. It is essential for the investor's primary business to acquire or establish shares of a firm in the host country. Thus, the fundamental difference between horizontal and vertical FDI is the difference between the area of operation of investor and host.
• Conglomerate: It is most popular among investors due to the challenges it possesses for every firm investing in a foreign land. The purpose of this investment is to dominate an international market with a business different from that of the host. For example, if an automobile manufacturer of Japan invests in a mobile phone company in the US; the first challenge faced by the investor will be to gain operational control on foreign soil; and then secondly, to survive on a strange land dealing in a new industrial segment.
• Greenfield: In this investment, the investor depends on another investing company to begin its operations in a foreign land.
• Foreign Takeover: It operates on the name of an alien merger, acquisition or takeover working on foreign land.

How Does Foreign Direct Investment Work?

Foreign direct investment (FDI) works in the direction to boost the growth of an economy and global business. It is capable of benefitting an organization by exposing them to new global markets and their channels, technological access, financing, etc. An FDI plays a significant role in the development of a host economy as it provides with new technologies and capital. Moreover, it benefits the host by introducing new techniques and practical management skills providing a thrust to economic development.

Nowadays, the extensive dependency on technology and intellectual property has affected foreign direct investment in numerous ways. There are still many firms in the market seeking an opportunity to make overseas investments to expand their business in the international market. But, the unpredictable behavior of the market makes it quite challenging for the firms to establish their business globally. Thus, FDI works as a medium between an investor and a host allowing them to build themselves in the global market.

What Are Examples of Foreign Direct Investment?

• To understand FDI, you can learn about the North Atlantic Free Trade Agreement (NAFTA), the world's most significant free trade agreement. Being a key player of FDI, trade agreements are widely popular among various economies of the world to boost FDI. As a result of this, NAFTA contributed enormously to increase FDI between the US, Canada, and Mexico to $452 billion in 2012. This is considered among the NAFTA's most significant achievements to date.
• Another notable example of FDI can be observed in a joint venture between a German and Japanese train company. The train companies of the two economies have worked collectively to assemble high-speed trains in Japan. In this case, the investment made by the German firm can be considered as FDI from Germany to Japan. Thus, the joint venture between the two nations has contributed significantly to the development of both economies.

Why is Foreign Direct Investment Important?

3 Significant Features of Foreign Direct Investment

• Foreign direct investment is crucial for the development of emerging economies globally as it provides the funds needed to expand international sales. Also, FDI benefits them with the expertise of developed nations contributing to the increasing growth of emerging economies.
• Another significance possessed by FDI is that it provides emerging economies with considerable investments in infrastructure, water, and energy resources. This contributes to an increase in employment opportunities and wages helping the weaker section of the society to sustain independently.
• FDI also pays a crucial role in the sustainability of the developed economies like the European Union and the US. Developed economies like these depend on FDI for reasons other than that of the emerging economies. The investments made by these countries are made through mergers and acquisitions trading between full-fledged companies. Thus, the investment by these economies is made to fulfill their purpose of re-framing the primary business.

According to a global report, the emerging economies received $694 billion, or 58% of total global FDI including 43 worldwide investment. It was observed that investments touched the mark of 8% in emerging Asia receiving $502 billion.

Advantages & Disadvantages of Foreign Direct Investment

Advantages

• FDI has a far-reaching effect on the global economy benefitting the investors and hosts participating in the trade. The capital invested in the trade is utilized for the development of business in any part of the world.
• The profit earned through this trade is unbiased as it is not affected by any religion or politics. This provides the business with a competitive advantage regardless of race, color, or creed minimizing the effects of politics and corruption.
• FDI plays a crucial role in diversifying the possession of an individual investor beyond the boundaries of a specific economy. Thus, FDI lowers the risk of failure providing the investor with extra benefits of diversification.
• It helps the host to receive the best practices regarding management, accounting, or legal advice from their investors. It benefits the host with the latest technologies and their operational practices with the help of financial instruments.
• Another significant advantage of FDI is that it commences the volatility of "hot money" creating an asset bubble. It allows investors to invest a large sum of money together and then sell the total investment quickly.

Disadvantages

• According to a report released by the International Monetary Fund (IMF), an FDI can cause a decline in the comparative advantage of an economy.
• Secondly, there is a possibility that foreign investors might lose the morality of the business failing to contribute to its promotion. Being unaware of the business operations, they could end up selling unprofitable portions to local investors leading to a decline in business.

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