What are the benefits of direct investment?

Direct investment is another form of investment, which you can explore. This article offers a basic primer with definitions as well as types, and explains what direct, or foreign direct, investment provides in case you’re interested in broadening your portfolio.

What is direct investment or foreign direct investment?

Direct investment, often called foreign direct investment (FDI), means you invest in a foreign business enterprise. It’s designed to acquire a controlling interest in the enterprise. Your direct investment provides capital funding in exchange for an equity interest without you buying regular shares of a company's stock.

Foreign direct investment can be made by individuals, but is more commonly made by companies wishing to establish a business presence in a foreign country.

What motivates foreign investors?

If you’re a foreign investor, you may have different motivations for seeking to earn profits in another country. You must decide whether you will:

• make a portfolio investment, buying stocks or bonds, often making a short-term speculative financial gain without becoming actively engaged in the daily business of the enterprise in which you invest, or
• choose the long-haul, hands-on approach of investing in an enterprise in another country with the goal of gaining control or exerting significant influence over managing the firm. Using direct investment, you can either gain a majority or minority interest in a company, but the interest acquired gives you, as the investing party, effective control.

You can gain control by more than just investing capital, but controlling assets, such as technology, is considered a critical input. In fact, FDI is often not just a simple monetary transfer of ownership or controlling interest. It can include factors such as organizational and management systems or technology.

Which way you invest in a host country depends on what your interest is. If you’re a portfolio investor, you can quickly sell a stock or bond quickly to cement a gain or avoid a loss. Most corporations, however, directly invest in a foreign company to substantially influence or control the enterprise they’re managing for a longer time.

What types of direct investment are there? 

There are three general types of fdi, or direct investment, that you can do in a foreign country: vertical, horizontal, and conglomerate.

• Horizontal: Horizontal direct investment is perhaps the most common form of direct investment. For horizontal investments, a business already existing in one country establishes the same business operations in a foreign country. A fast-food franchise based in the U.S., for instance, might open restaurant locations in China. Horizontal direct investment can also be referred to as greenfield entry into a foreign market.
• Vertical: For a vertical direct investment, you, as a foreign investor, can add foreign activities to an existing business. A North American auto manufacturer could, for example, establish dealerships or acquire a parts supply business in a foreign country.
• Conglomerate: For a conglomerate direct investment, an existing parent company in one country adds an unrelated business operation in a foreign, or host, country. This is a particularly challenging form of fdi flow in direct investment since it requires establishing a new business plus doing that in a foreign country. One example of conglomerate investing might be an insurance firm opening a resort park in a foreign country.

What can direct investment do?   

Despite the potential problems of unregulated direct investment, governments of both advanced and developing economies tend to actively seek foreign investors and the capital they bring for several reasons.

• It improves the host country’s finances: Firms that set up operations in host countries are subject to local tax laws and often significantly boost the host country’s tax revenues.
• It helps a country’s balance of payments: Because portfolio investments can be volatile, a country’s financial circumstances could get worse if investors suddenly withdrew their funds. Direct investment, on the other hand, is a more stable contributor to a country’s financial structure. Direct investors do not wish to take actions to undermine the value or sustainability of their investments.
• It helps to improve productivity: Other positive effects associated with inward direct investment include increased employment, improved productivity, and overall economic growth. Increased competition from foreign firms, whether new or acquired, often forces competitors to increase their productivity so that they don’t go out of business. Suppliers and service providers to the direct investment enterprise may also increase their productivity, often because the investor requires higher-volume or higher-quality orders. The increase in volume and variability of products and services in the economy leads to overall improvement in the market’s quality and size.
• It provides additional employment: Advanced economies attract direct investment because of their stable policies, pool of skilled workers, and sizable markets. Developing economies are more interested in greenfield investment, which creates new facilities and jobs. Governments often set up special economic zones, provide the property for construction of facilities, and offer generous tax incentives or subsidies to attract capital. These special economic zones, if properly designed, allow industries to concentrate in one geographic area, often placing suppliers close to buyers and providing the necessary infrastructure to meet investors’ requirements

Countries with a comparative advantage, such as favourable policies or a significant pool of skilled workers, frequently develop investment promotion programs, which can include marketing campaigns and even bilateral negotiations between governments and foreign firms. Unlike the tax and other fiscal incentives offered to foreign investors, information campaigns do not erode tax revenues from direct investment.

• It facilitates knowledge transfer: Host countries also benefit from a transfer of knowledge and technology, which often stems from workforce turnover. Incoming firms frequently offer more training opportunities than local employers. This knowledge is later transferred to local companies when trained employees leave the foreign enterprise for local businesses. There may also be some incidental spill-over of knowledge through informal networks when employees exchange ideas and opinions about their workplace practices.