Foreign Direct Investment: What It Is and How It Works

Understanding that investing means putting a certain amount of money into a company or business with the goal of earning a good return, today we'll define what foreign direct investment (FDI) is, its characteristics, types, examples, and its advantages.

Keep reading this weekly post and expand your financial vocabulary with our Hapinary dictionary!

Foreign Direct Investment (FDI): Definition

The definition of FDI is as follows:

• Foreign direct investment is the transfer of capital by foreign economic entities (either a company or an individual) with the goal of establishing subsidiaries or acquiring a significant stake in already established foreign companies.

This is a type of investment made outside a country's borders, seeking some form of profit or participation. However, to distinguish this from the concept of foreign indirect investment (FII), certain characteristics must be met:

• The investor must have at least 10% control of a foreign company (as academics determine), since FDI also seeks the foreign investor’s involvement in the acquired company;
• It must be made by a foreign economic entity, meaning outside the country of residence, which could be an individual, company, or government;
• The objective is typically to acquire part of the company's shares, but it could also involve expanding the business with a subsidiary (which we will clarify later in the types of FDI).

So, what's the purpose of making a direct foreign investment? Let’s answer that next:

Foreign Direct Investment: What Is It For?

Foreign direct investment generally has two purposes:

• The investor seeks to generate returns on their investment by becoming part of a company’s decision-making process;
• Or they aim to expand a parent company into other countries, as if creating subsidiaries.

What Are the Advantages of Foreign Direct Investment?

FDI can be a key factor in international economic integration because:

• It fosters more stable relationships between economies;
• It represents an important channel for sharing technology between countries;
• It promotes international trade by providing access to foreign markets;
• It influences the social and economic development of a country.

Difference Between Foreign Direct and Indirect Investment

The main difference is that foreign indirect investment involves capital injection through loans.

This means investments are loans that require the recipient to incur a debt that must be repaid by law. These loans usually come from international organizations to governments or public companies in less solid economies.

The difference lies in the form, the objective, and the risk of the investment.

FII involves an investment in the form of a loan and has a lower investment risk since the recipient is legally required to repay the loan. In contrast, FDI involves an investment seeking returns or participation in another company’s decisions and may not be profitable in the long term.

Types of Foreign Direct Investment

Like buying a company’s stock, where a relationship is established with the company from which you purchase the shares, foreign direct investment establishes a relationship with the company receiving the capital.

To classify FDI, we need to determine the relationship established between companies. Based on this, there are four types of FDI:

Horizontal FDI

This is when the investment is made in the same line of business, but within a foreign company.

For example, imagine Zara opening a store (in the same line of business) on Fifth Avenue in New York. The investment aims to expand the business and its operations in a foreign country. This is called a horizontal relationship.

Vertical FDI

This type of investment seeks to relocate part of the value chain.

Let’s imagine Zara again, establishing factories in Indonesia to produce more clothes (part of the production chain) that will later be sent to stores in more developed economies. The investment aims to make the production chain more efficient and profitable—that’s vertical FDI.

Conglomerate FDI

Here, foreign investment seeks to "create a new line of business," undertaking a different project from what is being developed in the country of origin.

The goal of conglomerate FDI is to develop a new project together with another country. For example, imagine a U.S. company partnering with a British one to develop a sustainable space vehicle.

This type of FDI is rare or difficult to coordinate because it requires overcoming both the barriers to entering a foreign country and those of entering a new market, not to mention the cultural, social, or political barriers that may exist.

Platform FDI

The last type of FDI is the opposite of the conglomerate type. By transferring capital, the goal is to carry out a similar activity to what is being done in the country of origin.

In other words, its purpose is to increase the parent company’s business, usually in low-cost areas within free trade zones. For example, imagine foreign companies investing in Mexico to sell their products later in the U.S. market.

An example of platform FDI is if Ford were to buy manufacturing plants in Ireland with the goal of exporting cars to other EU countries.

These are the four types of foreign investment. Now let’s look at some data on how much FDI Latin America received in 2018.

Foreign Direct Investment in Latin America

Foreign direct investment in Latin America increased by 13.2% in 2018 compared to the previous year, according to a report by the Economic Commission for Latin America and the Caribbean (ECLAC).

We’re talking about $184.3 billion in investments, distributed in the following sectors:

• 47% went to the manufacturing industry;
• 35% was allocated to service companies;
• 17% was assigned to natural resources.

Small businesses, startups, and innovative companies benefit the most from foreign investment, using it to strengthen their product or service.

Investing Abroad Is Possible

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Hapi is a mobile investment platform designed to help more Latin Americans gain safe and fast access to the U.S. stock market. Want to know why you can trust Hapi? Here are a few reasons:

• It’s built on high-end technology;
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• For now, Hapi lets you invest without paying any commissions and without any minimum deposits.

In conclusion, with Hapi, foreign investment is easy whether you have experience or not. Stay tuned for our next weekly post!