Foreign Direct Investment (FDI) : GED Explains

FDI: The increase in international capital interdependence is a core element of globalization. Foreign direct investment (FDI) plays a central role here. Often, such as in the case of Chinese FDI in Europe, it can be viewed with scepticism or even fear by domestic markets, but should it? This blog post describes the most important motives and consequences associated with such investments.

FDI – What is it?

Foreign investment occurs when the investor does not come from the country in which the investment is made. When it comes to types of investment, a differentiation should be made between direct and portfolio investment.

Two essential features of direct investment are 1) that the business relationship targeted is long term and 2) that the investor intends to exert a significant degree of influence on company management. Portfolio investment, on the other hand, targets a short or a medium-term business relationship.

The main motive for portfolio investment is the revenue it brings, i.e. prospects for the highest-possible return. However, there is no intention of exerting an influence on the management of the company involved.

Why do companies invest overseas?

There are numerous motives for foreign direct investment (FDI):

• One central argument is the increase in sales which can be achieved because production in the country of the sales market reduces the cost of transport to the sales market and because it allows tariff and non-tariff trade barriers to be circumvented. Furthermore, production in the country of the sales market allows exchange rate fluctuations to be sidestepped, which in turn saves on the costs of hedging against such fluctuations.
• Production in the country of the sales market has the advantage of allowing access to public tenders, which results in additional sales opportunities.
• Foreign direct investment (FDI) allows for production to be relocated to regions with lower production costs. The associated cost reductions may include multiple cost elements (wage costs, environmental costs or environmental requirements, taxes, minimum social standards, etc.). Lower costs in turn permit increased sales and increased returns. This cost reduction leads not only to increased sales in the country of production, but also to a higher sales volume in all markets.
• The acquisition of production facilities overseas ultimately permits access to resources that are either not available at all or not available to the desired extent domestically. In addition to natural raw materials, this predominantly concerns access to technologies or technological and organizational knowledge. This knowledge may then be used in the investor’s own country as well.

What effects may occur in the target country of the investment?

Foreign direct investment has a range of positive effects for the country in which it is made (target country):

• First there is the expansion of production sites and infrastructure in the target country. The resulting increase in overall economic production capabilities leads to stronger economic growth and the creation of new jobs. Income rises as a result of this increased economic growth. This means that in less developed economies, a reduction in poverty is also to be expected.
• Another positive effect comes from access to new technologies and the modernization of the structure of the domestic economy. In addition to technological innovations, there are also organizational innovations that optimize operational procedures in the target country. Technological and organizational innovations increase target country competitiveness and export potential and thus lead it to become more strongly integrated into the global economy. Furthermore, the increase in productivity associated with these innovations provides additional growth stimulus.

However, such desired effects may also be coupled with several possible negative consequences:

• It is conceivable that domestic investment or even local companies could be displaced in the target country. This would be particularly problematic for the labor market in the target country if investors were to bring in workers from their home country. In this case, there would be increased unemployment in the target country.
• A second fear stems from the possibility that the foreign capital owners could withdraw all profits gained from their investment from the target country. This means they would also lay claim to the goods and services corresponding to these profits. The desired rise in material living conditions in the target country would – at least in part – fail to materialize.

Are negative effects also possible for the countries of origin of the direct investment?

In addition to the aforementioned positive effects, carrying out direct investment overseas also has several possible negative consequences for the country of origin of the investments:

• The first of these consequences is the fear that investment overseas would lead to an outsourcing of production. The resulting drop in employment in the country of origin leads to a rise in unemployment there, which in turn is associated with wage pressure.
• Negative consequences for the labor market of the country of origin can also arise if the investment overseas leads to a reduction of domestic investment in the country of origin, thus weakening domestic economic growth. This weak growth also has a negative influence on employment and wages in the country of origin.
• Furthermore, there is the fear that the foreign direct investment would be accompanied by the export of technology and know-how, thus weakening the competitiveness of the country of origin.
• For the government finances in the country of origin, there is the additional danger that foreign direct investment would be made for reasons relating to tax avoidance and that it would lower government revenue in the country of origin by transferring profits to countries with cheaper tax rates.

What does empirical analysis say about the effects of foreign direct investment?

The aforementioned potential consequences of foreign direct investment facing the countries involved have been the subject of numerous empirical studies. The most important results of these investigations can be summarized as follows (for the statements below, see OECD 2002, pgs 3-18, Nunnenkamp, pgs 187-109, 201-212):

• Overall productivity and national income rise in the target country due to higher capital stock and the resulting transfer of technology. The rise in national income manifests itself in the form of higher gross domestic product per capita. The transfer of technology does not usually go hand in hand with a large decrease in the competitiveness of the country of origin.
• Domestic investment in the target country is displaced to some extent. However, on balance the capital flow is higher, i.e. investment rises in the target country.
• Normally, competition in the target country increases as new providers come along. This leads to cost pressure, which manifests itself in the form of price decreases and causes a rise in the purchasing power of consumers in the target country. However, there are also cases in which the market entry of multinational companies increases market concentration in the target country. The resulting restriction of competition comes at consumers’ expense.
• The relocation of production overseas does not necessarily go hand in hand with a drop in employment in the country of origin. The partial relocation of production activities overseas frequently strengthens the competitive position of the company making the investment. This safeguards jobs in the country of origin.
• The transfer of profits to tax havens leads to a reduction in government revenue for the countries of origin.

In summary, it can be said that the positive effects of foreign direct investment (FDI) in target countries (increased productivity, employment and income) are greater on balance. However, individual sectors and groups in the target country may lose out. In the countries of origin, the relocation of production may lower levels of employment and income within individual sectors and groups, but here too, the overall economic positives outweigh the negatives on balance.