Foreign Direct Investment

Definition

Foreign direct investment (FDI) refers to the investment made by an individual or a company in one country into business interests located in another country. This can take the form of establishing new operations, acquiring existing companies, or expanding the operations of an existing foreign business.

5 Must Know Facts For Your Next Test

1. Foreign direct investment can lead to economic convergence by helping less developed countries catch up to more developed ones through the transfer of technology, skills, and capital.
2. FDI flows are a key component of a country's trade balance and financial capital flows, as they represent long-term investment in productive assets rather than short-term portfolio investments.
3. The pros of trade deficits associated with FDI include access to new technologies, management expertise, and job creation, while the cons include potential job displacement and competition with domestic firms.
4. Exchange rate policies can influence the attractiveness of a country for foreign direct investment, as a stable and predictable exchange rate can provide more certainty for investors.
5. The diversity of countries and economies across the world can lead to different levels of FDI, as investors may seek out countries with more favorable business environments, infrastructure, and labor markets.

Review Questions

• Explain how foreign direct investment can contribute to economic convergence between developed and developing countries.
  • Foreign direct investment (FDI) can facilitate economic convergence by allowing less developed countries to access capital, technology, and management expertise from more developed economies. This can help boost productivity, create jobs, and spur economic growth in the host country, enabling it to catch up to the living standards of the more advanced nations. FDI can also lead to the transfer of skills and the adoption of more efficient production methods, further narrowing the development gap between countries.
• Describe the relationship between foreign direct investment, trade balances, and flows of financial capital.
  • Foreign direct investment is a key component of a country's trade balance and financial capital flows. FDI represents long-term investment in productive assets, rather than short-term portfolio investments. Inflows of FDI can contribute to trade deficits, as the foreign company may import capital goods and intermediate inputs to establish or expand its operations in the host country. However, the presence of FDI can also lead to increased exports, as the foreign company may leverage the host country's resources and comparative advantages to serve global markets. The flows of financial capital associated with FDI can also have a significant impact on a country's overall balance of payments and exchange rate dynamics.
• Evaluate the potential pros and cons of trade deficits associated with foreign direct investment for the host country.
  • The trade deficits that can arise from foreign direct investment (FDI) can have both positive and negative implications for the host country. On the positive side, FDI can provide access to new technologies, management expertise, and job creation, which can boost productivity and economic growth. However, the cons include potential job displacement as domestic firms may struggle to compete with the foreign entrants, and there may be concerns about the repatriation of profits by the foreign companies, leading to a net outflow of financial resources. Policymakers must carefully weigh these tradeoffs and implement appropriate measures to ensure that the benefits of FDI, such as technology transfer and skill development, outweigh the potential costs to the domestic economy.

Related terms

Multinational Corporation (MNC): A large company that has operations and assets in multiple countries, often engaging in foreign direct investment to expand its global reach.

Portfolio Investment:

Investment in foreign securities, such as stocks and bonds, without the intention of controlling the foreign company, in contrast to foreign direct investment.

Host Country: The country that receives the foreign direct investment, where the foreign company establishes or expands its operations.