INTERNATIONAL

UNIT 4 SECTION 4 FOREIGN DIRECT INVESTMENT

BUSINESS Unit 4, section 4: Foreign direct investment

You are welcome to Section four of unit 4. A number of theories have been
advanced to explain why and how international investment occurs. There
are several forms of international investment; examples are foreign direct
investment (FDI), management contract and licensing. This Section is to
expose you to the issues of foreign direct investment including the forms of
FDI and reasons for both Vertical and Horizontal FDI.

By the end of the Section, you should be able to;

 explain foreign direct investment
 enumerate the forms of foreign direct investment and explain any one

Foreign Direct Investment Explained

International investment theory is alternatively called FDI theory. There is
no one definition for FDI but the classical one defines it ‘as a company from
one country making a physical investment into building a factory in another
country. FDI refers to resources invested in business activities in a host
country, that is, outside the home country with the investing firm having
active control over property and assets located in the host country. Foreign
Direct Investment (FDI) is equity funds invested in other nations. It is the
ownership and control of foreign assets. It differs from portfolio investment in
that it allows the MNE to have direct control of the operations of its foreign
operations. This allows the incorporation of the foreign unit into the MNEs
overall strategy.

The world’s three largest economies - United States, the European Union and
Japan - conduct most of the world’s trade and FDI. Collectively, these areas
are referred to as the “triad”- a group of three major trading and investment
blocs in the international arena. While the vast majority of FDI takes place
among industrialised countries, developing countries are also large recipients
of FDI. Recently, China has moved quickly to establish itself as a major
player. Despite the increase of international activity by these countries and
other emerging economies, such as Singapore, Australia, India and Canada,
MNEs from the triad will continue to account for most of the world’s FDI and
trade.

Forms of Foreign Direct Investment

FDI could take several forms - horizontal FDI and vertical FDI (backward
vertical FDI and forward vertical FDI). With horizontal FDI, the
international business operates in the same industry in both the host and home
countries. For example, Zoom Lion Ghana Ltd. is into waste management in
Angola (a host country) and Ghana (home country). Vertical FDI takes two
forms - backward vertical FDI and forward vertical FDI. Backward vertical

FDI refers to investment by an international business into an industry that

supplies inputs in the host nation for production processes of the international
business in the home country. Forward vertical FDI is investment by an

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international business into an industry in a host country that sells output of the
international business' production processes in the home country. Most car-
manufacturing companies engage in forward vertical FDI whereby the cars are
manufactured in the home country and sold in the companies' sales outlets
in host countries. Examples include Silver Star, Mechanical Lloyds and
CFAO Motors who serve as company outlets for Mercedes Benz, BMW and
Kia cars respectively.

Reasons for Horizontal Foreign Direct Investment

International businesses may engage in horizontal FDI for a number of
reasons. These include;
 High transportation cost: An international business may engage in
horizontal FDI when it produces goods that have high transportation
cost especially goods with relatively low-value-to-weight ratio. These
goods are not profitable when transported over long distance at high
cost; examples are cement, soft drinks and sugar.
 Market imperfections: A foreign market may be imperfect in both access
and factor mobility. Thus it may be extremely difficult to export finished
products into certain countries due to strict government intervention (such
as high tariffs and embargos) that is costly for those who want to engage in
trade. Investing in the host country to offer the same products as in the
home country may be the ideal and sometimes the only available option.
 Following competitors: This is usually the norm in an oligopolistic
industry where leading industry giants (who are few in number) have to
stay in tune with each other in order to maintain power and control in
the industry. These industry giants are better able to maintain power
when they invest in the same industry abroad and follow each other
wherever possible. This is because when one firm goes abroad, it can
have a major adverse impact on key competitors, hence forcing them to
also follow suite.
 Product life cycle: At the growth stage in a product's life cycle, an
international business may invest in other countries when demand in
those countries grows large enough to support gains from local
production.

Reasons for Vertical Foreign Direct Investment

Vertical FDI, both forward and backward, may take place for two key
reasons.
 To gain market power: International businesses can gain market power by
limiting competition or strengthening control over assets. They can do
these through vertical FDI. Specifically, an international business that
wants to limit competition may take steps to own (for example through
purchase) and have control over the main source of raw material
(backward vertical FDI) in the industry which may be located in another
country. Similarly, going abroad may make a business more powerful

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(such as ability to pursue predatory pricing to discourage competition)

through its size and associated benefits such as economies of scale.
 Market imperfections: As with horizontal FDI, vertical FDI may take
place due to market imperfections such as imperfections in market access
and in factor mobility.

Foreign Direct Investment (FDI) - (asset ownership and long time frame) is
the ultimate commitment level of internationalisation. FDI (typically long-
term) is a foreign-market entry strategy that gives investors partial or full
ownership of a productive enterprise. The firm establishes a physical
presence abroad through acquisition of productive assets such as capital,
technology, labour, land, plant, and equipment.
Now assess your understanding of this Section by answering the following
self-assessment questions. Good luck!

Activity 4.4
 In a short essay, explain why FDI is a particularly risky foreign entry
strategy. How is FDI different than international portfolio investment?

Did you score all? That’s great! Keep it up

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