FOREIGN DIRECT INVESTMENT

Foreign Direct Investment

Foreign Direct Investment

Introduction

Foreign direct investment (FDI) occurs when a foreign investor exerts direct control over domestic assets. It normally consists of an international capital flow from the home country to a host country for the purpose of acquiring partial or full ownership of tangible business activity. Technically, it is the book value of the equity held by the foreign investor that is attached to the asset (Yeung, 2007, 25).

In most cases, the asset is a firm in a developed country, such as the United States, and the equity consists of two components: ordinary (common stock) and retained earnings. If both foreign and domestic investors own the common stock, then only a portion held by foreign investors is considered to be FDI, and if only a threshold percentage is attained, that is deemed to give the foreign investor control of the business (U.S.-China Business Council, 2008, 81). In the United States, this threshold is 10%, but some countries establish a higher minimum level of stock ownership, usually 25% (Aliber 2003, pp. 91).

Types of FDI

There are two main types of FDI: One is horizontal and the other is vertical. Horizontal FDI arises when a firm duplicates its home country-based activities at the same value chain stage in a host country through FDI (Trevino, Upadhyaya, 2003, 45). For example, Ford assembles cars in the United States. Through horizontal FDI, it does the same thing in different host countries such as the United Kingdom (UK), France, Taiwan, Saudi Arabia, and Australia. Horizontal FDI therefore refers to producing the same products or offering the same services in a host country as firms do at home.

While a horizontal pattern occurs when MNCs through FDI produce the same product or service in different host countries, vertical FDI takes place when a firm through FDI moves upstream or downstream in different value chains—i.e., when firms perform value-adding activities stage by stage in a vertical fashion—in a host country. In other words, a vertical FDI arises when a multinational firm fragments the production process internationally, thereby locating each stage of production in the country where it can be done at the least cost (Buckley, Hashai, 2004, 69).

While horizontal and vertical FDI serve different purposes, the bulk of FDI seems to be horizontal rather than vertical. As mentioned earlier, when a firm engages in horizontal FDI, it establishes multi-plant operations that duplicate similar products and services in multiple countries. This implies that a firm's motive to adopt a horizontal pattern is mainly because it facilitates market access—as opposed to reducing production costs—and subsequent market share expansion. However, with vertical FDI firms engage in both FDI and exports (Graham, Marchick, 2006, 277).

Unlike horizontal FDI in that the two countries involved are of similar size, and the nature of their operations resembles more of a pair of developed countries, in vertical FDI patterns, the home country is usually much larger and the two countries involved in FDI operations look like a ...