What is FDI?

29 September 2020 (Last Updated November 27th, 2020 12:51)

What is FDI?
The Shanghai gigafactory built by US-based Tesla is an example of greenfield FDI. (Photo by STR/AFP via Getty Images)

Definitions abound, but what does foreign direct investment, commonly abbreviated to FDI, actually mean and entail? By Sebastian Shehadi of Investment Monitor.

Global foreign direct investment (FDI) transactions were worth a whopping $1.39trn in 2019, according to the UN Conference on Trade and Development (UNCTAD). Therefore, for local and national governments, business owners and CEOs, it is imperative to understand this key driver of globalisation and wealth.

Simply put, FDI is when a company establishes business operations abroad. For the most part, foreign direct investors merge with or acquire businesses that already exist overseas, or set up brand new operations of their own (known as greenfield FDI).

In any case, FDI provides full or partial control over a foreign-based entity – in fact, investors must possess at least 10% of said entity’s voting power for the transaction to be classed as FDI, according to the International Monetary Fund’s definition.

FDI is longer-term in its outlook and process compared with foreign portfolio investment (FPI), in which investors passively hold securities from a foreign country or purchase equities of foreign-based companies (such as shares, currencies and bonds).

In other words, FPI is a far more speculative and consumer-driven type of investment, since any individual can jump online and buy some stocks, for example. Conversely, FDI takes months or years of implementation and tends to seek a lasting interest in a foreign country.

Cross-border M&A

Mergers and acquisitions (M&A) makes up the vast majority of global foreign investment flows – roughly 80%, according to UNCTAD.

An acquisition is when one company takes over another and establishes itself as the new owner. On the other hand, a merger is when two businesses team up to move forward as a single new entity, rather than remain separately operated and owned.

The selling of US cloud company Mendix to Germany’s Siemens in 2018 is a good example of a foreign investment acquisition. Meanwhile, one of 2018’s largest foreign investment mergers came between France’s Essilor and Italy’s Luxottica for a whopping $56bn. It is worth noting that private equity firms and venture capital drive significant amounts of FDI M&A.

Greenfield FDI

Not all foreign investors want to merge with or acquire a pre-existing business, opting rather to establish a completely new cross-border entity themselves. This is greenfield FDI.

More specifically, greenfield FDI is when companies set up or expand their business operations abroad, creating brand new jobs and/or facilities from the ground up.

The construction of the Shanghai gigafactory by US-based Tesla in 2019 is an excellent example of this type of FDI. Google setting up its European headquarters in Dublin is another.

The general consensus is that greenfield FDI is the most productive, development-friendly and relational form of FDI because it always creates jobs or facilities, and often transfers technology and know-how to the receiving country’s economy.

This is why greenfield FDI is arguably the crown jewel of the foreign investment world, the type of foreign investment that governments are most keen to attract. Indeed, unlike greenfield FDI, cross-border M&A does not necessarily create new jobs or facilities since it only involves a change of ownership and management for an already existing business.

In this sense, cross-border M&A tends to be (for the investor) a less risky and time-consuming form of FDI, which is why it is more common than greenfield FDI and recovers more quickly after global or national economic crisis.

Meanwhile, greenfield FDI requires much more from investors insofar as they must build completely new business operations abroad, no easy feat and a big vote of confidence in the host country’s economy.

Greenfield FDI’s higher risk offers arguably higher rewards in terms of oversight. Indeed, greenfield FDI provides investors with complete control over their overseas enterprise, from start to finish, unless they are in a joint venture or a country that limits 100% foreign ownership of companies.

Avoiding real estate confusion

Greenfield FDI should not be confused with the real estate industry’s (unfortunately similar) term ‘greenfield investment’. These are two very different concepts.

In real estate, a greenfield investment is when a developer constructs a building, quite literally, from the ground up (be it domestically or abroad). The industry also uses the term ‘brownfield investment’, in which a developer repurposes an existing building, such as an old factory being converted into housing (be it domestically or abroad).

It may become confusing, therefore, when using this real estate jargon alongside FDI jargon. For example, greenfield FDI projects often create completely new facilities abroad, such as Tesla’s Shanghai gigafactory. In other words, Tesla’s greenfield FDI undertook greenfield real estate investment.

Other times, however, a greenfield foreign investor will not create brand new facilities abroad, but simply open an office in a prefabricated or already used office space. For example, a small UK tech company building a new team in Paris might refurbish one floor in a multistorey, shared office block. Therefore, this greenfield FDI undertook a brownfield real estate investment.

Since M&A only involves a change of ownership and management for an already existing business (and therefore building), many if not most cross-border M&A projects do not involve greenfield or brownfield investment in real estate.

Categories of FDI

FDI investment is often categorised as being horizontal, vertical or conglomerate.

• Horizontal: most FDI is horizontal, which is when an investor establishes the same type of business operation in a foreign country as it operates in its home country, such as when Italian renewable energy developer Enel Green Power invests in South American solar farms.

• Vertical: a vertical investment is when the investor sets up overseas business activities that are different but related to said investor’s main business. For example, a UK chocolate manufacturer such as Cadbury might invest in cocoa producers in Brazil.

• Conglomerate: a conglomerate type of FDI is when an investor sets up overseas operations in a field unrelated to its existing business in its home country. For example, US retailer Walmart may invest in German automobile manufacturer Mercedes. To compensate for their lack of experience in the new sector they are entering, conglomerate investors often undertake joint ventures with a foreign company already operating in the industry.

FDI stock and flows

FDI ‘stock’ measures the total amount of FDI accumulated by a location at a given point in time, but usually at the end of a quarter or a year.

For example, the outward FDI stock for France in 2019 would be the total capital spent by resident French companies investing in other countries that year (on top of the value of outward FDI from all previous years). Meanwhile, France’s inward FDI stock in 2019 is the total capital spent by foreign investors coming into France that year (on top of the value of inward FDI from all previous years).

FDI ‘flow’ is a slightly more nuanced metric. It records the net inward and outward investments with assets and liabilities in a given reference period. In other words, the value of FDI transactions during a given period of time, usually a quarter or year, based on equity transactions, reinvestment of earnings and intercompany loans, according to the OECD.

For example, if one is measuring China’s outward FDI flows in 2018, this would be the value of transactions that increase Chinese investors’ investments into foreign economies – such as through purchases of equity or reinvestment of earnings – minus any transactions that decrease the investment that those investors have in enterprises in foreign countries – such as sales of equity or borrowing by the resident investor from the foreign enterprise – according to the OECD’s definition.

In summary, a chart showing any given location’s FDI flows will often show many ups and downs, while its FDI stock usually displays a continually increasing cumulative figure.

Measuring FDI

There are two internationally agreed methods of measuring FDI: the asset/liability presentation and the directional presentation.

When using the asset/liability method, FDI statistics are organised according to whether the investment relates to an asset or a liability for any given location. Under the directional principle, FDI is organised according to the direction of the investment for any given location – either inward or outward FDI.

To clarify, the two methods differ in their treatment of reverse investment (which is when an affiliate company provides loans to its parent company, a transaction that blurs the lines between outward and inward FDI). Under the directional principle, reverse investment is subtracted from the total value of outward or inward FDI. In other words, it tracks the flow of FDI in just one direction, be it into or out of any given location.

On the other hand, the asset/liability includes reverse investment in its calculations, thereby netting and capturing types of financial flows within FDI. This is why the asset/liability model tends to record larger amounts of FDI than the directional principle; however, this is not always the case.

While the asset/liability method is appropriate for macroeconomic analysis (i.e. the impact on the balance of payments), the directional principle is more appropriate to assist policymakers and government officials to formulate investment policies, according to UNCTAD. This is because the directional FDI data reflects the direction of influence by the foreign direct investor underlying the investment: inward or outward FDI.

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