What Is Foreign Direct Investment?

Foreign direct investment can help a country grow its economy, bring in more money for its government, and gain new technology and skills for its workers. But there are also potential risks for both the country and the investor.

What is foreign direct investment? In general, foreign direct investment (FDI) refers to an investment made by a company or person from one country into business interests in another country.

In an interview, Subhayu Bandyopadhyay, a senior economic policy advisor in the St. Louis Fed’s Research division, answered questions about foreign direct investment, including:

• What FDI is
• How foreign direct investment is different from exporting
• How countries can benefit from FDI
• What the potential risks and challenges to FDI are
• How foreign direct investment flows have changed over time

What Are Some Examples of Foreign Direct Investment?

Bandyopadhyay pointed to a definition from the U.S. perspective. In surveys on foreign direct investment in the United States, the Bureau of Economic Analysis defines FDI as the ownership or control by a foreign entity of at least 10% of the voting interest of a U.S. business or an unincorporated U.S. business enterprise, including a branch.

Bandyopadhyay broke it down with a hypothetical example: If a Japanese car company builds and owns a subsidiary plant in North Carolina, the plant is considered foreign direct investment.

The two critical parts of the type of investment are “foreign” and “direct,” explained Bandyopadhyay. The company that owns the subsidiary is not a U.S. company—the “foreign” aspect. “And the fact that the foreign company fully owns and controls this subsidiary makes it a ‘foreign direct investment,’ as opposed to, say, ‘foreign portfolio investment,’” Bandyopadhyay said. An example of a foreign portfolio investment would be a Japanese citizen buying a small noncontrolling number of stocks of a U.S. company for financial returns, he said.

Other examples of foreign direct investment are:

• Purchasing a substantial stake in a business
• Starting up a factory or office
• Joining a venture with a host country company
• Buying a building and becoming a landlord to its tenants

What’s the Difference between Foreign Direct Investment and Exporting?

If a Japanese company produces an entire car in Japan and sends it to the U.S. to sell, that’s an export, Bandyopadhyay said. But if it builds a factory in the U.S. to produce the car, the investment in the factory counts as foreign direct investment and the car is not a Japanese export to the U.S.

Note that buying the car made in a factory in the U.S. is different than buying a car shipped across the ocean to the U.S., he said. One notable benefit for the Japanese company from building the car in the U.S. rather than exporting it from Japan is that the U.S. built car wouldn’t be subject to applicable U.S. import tariffs.

Which Foreign Direct Investment Can Help GDP Growth?

To return to Bandyopadhyay’s earlier example, since the Japanese company built a new plant as a subsidiary, and that subsidiary is making cars—products—in the U.S., that foreign direct investment is boosting U.S. gross domestic product (GDP).

Not all FDI increases the host country’s GDP, however. If a foreign owner buys an asset from an entity in the U.S., that transfer of ownership still counts as foreign direct investment, Bandyopadhyay said. But it wouldn’t create more U.S. GDP if the new foreign owner just continues to provide the same services that the domestic owner had provided.

How Else Do Countries Benefit from Foreign Direct Investment?

Besides possibly boosting GDP, what are some other ways that foreign direct investment can benefit a country? According to Bandyopadhyay, benefits can include:

• Tax revenue
• Employment generation
• Technology and skill transfers

Tax Revenue

A country can levy corporate taxes on an investing company’s profits or charge for permits and licenses, in addition to other taxes, Bandyopadhyay said.

Those tax revenues can finance government services and investment. Say a poorer nation hasn’t had the money to build roads until a multinational company invests in that country. Tax revenues from the multinational company can help pay the costs, including those needed to employ people to build the roads.

“Infrastructure improves, which in turn can be helpful for the multinational company,” Bandyopadhyay said. “So, some kind of symbiosis is also possible.”

Employment Generation

A foreign company with a labor-intensive business may directly boost hiring of a country’s residents, like the hypothetical car factory subsidiary in North Carolina. But it can also help increase employment in other ways.

For example, say a multinational company opens a plant, and then cafes and eateries set up locally to serve the workers, Bandyopadhyay said.

“Those services are generating employment, not directly from the FDI, but indirectly,” he said. “So, employment generation is definitely very much a part of it.”

Technology and Skill Transfers

Technology and skills can be shared in FDI joint ventures and subsidiaries, Bandyopadhyay said.

For instance, a company in India might partner with a foreign direct investor on a part of its business. Within that joint venture, the companies may share technology.

Or a fully owned subsidiary of a U.S. company in India might hire local engineers. Those engineers learn new skills from the U.S. company. And if they later take a job in another company, they can bring the knowledge with them to impart to others.

“Basically, training a skilled workforce in new techniques can be very useful for a developing country,” he said.

What Are Potential Negative Effects of Foreign Direct Investment?

Foreign direct investment could potentially lead to weaker environmental and worker protections, Bandyopadhyay noted.

If a country doesn’t have a strong government that looks out for its people, it could allow a multinational company with an eye on its profits to degrade the environment, he said.

And even a strong government concerned about its people’s welfare might see lowering its environmental or labor standards to attract more foreign investors as a rational trade-off for adding jobs for its workers.

Foreign direct investment that creates jobs also has the potential to increase income inequality, Bandyopadhyay said. For example, it immediately creates a larger gap between the highest-skilled workers and others if a company needs to hire only a few people and takes on the best workers from an area. If, on top of that, the multinational company drives away local employers, there could be job losses and lower wages.

Nations generally gain from trade, Bandyopadhyay said, but there’s still often resistance to it. “I think that’s because trade often makes some people worse off because they cannot compete. It’s the same thing for foreign direct investment.”

What Are Risks and Challenges to Foreign Direct Investment?

Issues ranging from geopolitical concerns to regulations affect willingness to invest in a country, Bandyopadhyay said.

The potential risks and challenges can include:

• Tensions between countries: A conflict breaking out could affect subsidiaries’ supply chains.
• Political insecurities: Regime change could mean a government unfriendly to an investor’s country replaces one that’s friendly.
• Security issues: Law and order conditions, civil war or terrorism could threaten workers’ safety or the enterprise.
• Regulatory barriers: High tariffs, protectionist policies, high taxes and red tape can be challenges.
• Infrastructure issues: Power failures and poor roads could make operations difficult.

How Has the Level of Foreign Direct Investment Changed?

Globally, overall FDI rose sharply between the 1990s and the early 2000s, reflecting the increase in globalization over that period. After the onset of the Great Recession (2007-09), FDI flows moderated, Bandyopadhyay said. The chart below on net inflows of FDI as a percentage of GDP shows the trend.

The chart also shows that FDI flows have been volatile from the time of the Great Recession, marked by frequent upward and downward movements. “The future will reveal if there is any sustained positive or negative trend in these inflows,” Bandyopadhyay said.