Foreign Direct Investment

Foreign direct investment (FDI) is the ownership of production facilities in a foreign country. To be classified as FDI, a foreign investor has to own at least 10 percent of a local company. Otherwise, if the ownership is less than 10 percent of the value of the local company, the investment is classified as portfolio investment.

The investment could be in manufacturing, services, agriculture, or other sectors. It could have originated as green field investment (building something new), as acquisition (buying an existing company) or joint venture (joint ownership with a local company).

What country characteristics attract foreign companies

Companies could start operations in a foreign country for a number of reasons:

- Access to skilled labor at lower wages
- Access to a large local market
- Access to natural resources
- Low taxes and various subsidies
- Proximity to suppliers
- Agglomeration: a large cluster of companies that work on related products and services
- Access to financing

A country could be attractive to foreign investors because of one of more of these attributes. The U.S., for example, offers an enormous domestic market, a vast network of suppliers, better access to financing than many other countries, and much more. Ireland offers low taxes and access to the large European Union market. Countries in Eastern Europe offer high skilled labor at lower wages than in Western Europe. Many countries on the African continent offer abundant natural resources.

How important is cheap labor in that mix? Notice on the chart that the U.S. still receives more FDI than China, despite the substantially lower wages in China. Clearly, cheap labor is an important factor but it is not the primary driving force for international investment.
What are the benefits from FDI for the host country

Growth in employment. When foreign companies start operation they usually hire people, especially if the investment is greenfield, i.e. if a new facility is created and if the production is more labor intensive, i.e. requires many people. Often, local companies become suppliers to a large new foreign investor and they also increase employment.

Increased foreign exchange reserves. When U.S. companies invest in Mexico, they exchange dollars for pesos to buy land and equipment and to pay wages. The U.S. investors purchase dollars from the Mexican banks. The banks can lend the dollars to Mexican firms and households or they can sell the dollars to the Mexican central bank. When the dollars end up with the Mexican central bank, it keeps them in reserves so that Mexico can pay its international debts and imports.

New technology. Foreign companies often introduce new technologies and train local personnel. Sometimes, after working at the foreign company for several years, an employee would leave and start his/her own business or would be hired by a domestic company. In that way the knowledge is transferred from the international company to the domestic companies.

Better managerial know-how. Multinationals have well functioning management structures that can be observed by local employees. These employees could spin off local companies using that managerial know-how.

New export markets. Foreign companies usually have established channels for placing their output on international markets. For example, if Ford starts making cars in Mexico, they already have plans to sell them back in the U.S. and other countries.

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