Direct foreign investment is investment in real assets, rather than financial assets such as securities. This investment may take the form of joint ventures with foreign firms, formation of foreign subsidiaries, or the acquisition of existing foreign firms. Although the investment is in real assets, this may be accomplished by a position in financial assets that is large enough to provide influence over management (a 10 percent or greater position is sometimes considered sufficient). Foreign investment in the United States grew steadily during the 1970s, but experienced a surge during the middle and late 1980s. The high levels of foreign investment led to concerns about a loss of control over domestic economic activity, or "economic sovereignty," and the effect of foreign ownership on national security.
Studies of foreign investments in the United States indicate that the primary vehicle was acquisition, but the acquisitions were managed in basically the same way as domestic firms, and the overall impact of foreign investment is positive. Despite the large size and prominence of some investments, and their potentially large impact in specific areas, overall foreign investments are relatively insignificant relative to the size of the U.S. economy. With the economic slowdown of the early 1990s, and a drop-off in the rate of foreign investment, concerns about economic sovereignty became muted. Attitudes toward foreign investment also changed somewhat as localities vied to attract investment for economic stimulus. Another factor was a surge in foreign investment by U.S. firms during the late 1980s, and this trend continued into the 1990s. Finally, foreign investment may help offset decreases in domestic investment during periods of economic slowdown.
The benefits motivating foreign direct investment are complex and usually firm-specific. A primary motivation is the exploitation of oligopoly (or monopoly) power such as proprietary technology, brand names, or management know-how. Entry into more profitable markets is an obvious attraction, and new and possibly large markets may produce economies of scale. Access to foreign factors of production or technology, and reaction to trade restrictions or exchange rate movements, have also provided a motivation.
An important benefit of direct investment is diversification. National economies are in different stages of their economic cycles, and move differently. Just as diversification of a security portfolio across firms that react differently to economic cycles will reduce the variability of portfolio returns, investment across national economies reduces the volatility of the firms' cash flow. This reduces the possibility of inadequate liquidity and should increase the value of the firm.
These benefits must be weighed against the potential costs of foreign investment. National interests, as noted, are involved and may lead to restrictions. Diversification may reduce variability over the longer run, but exposes the firm to potential short term variability, especially through exchange rate movements. International management is also more complex and difficult, involving not only a larger organization but also different laws, conditions, and customs. The uncertainty surrounding the likely outcomes, and the possibility of undesirable outcomes, is larger for foreign investment than for domestic investment. Especially for smaller or emerging economies, the concerns of national economic sovereignty may lead to protectionism and restrictions, such as limits on repatriation of profits.
On a global basis, and over a long time, it is generally agreed that a free flow of capital is beneficial, since it promotes an efficient allocation of resources. For shorter periods, and within a given country or region, the impact is mixed. For the individual firm the foreign direct investment decision requires consideration of factors beyond those encountered domestically. It appears that there is no overall answer to the desirability of foreign direct investment on either the national or firm level, and that individual analysis of each project is required.
[ David E. Upton ]
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Madura, Jeff. International Financial Management. 5th ed. Cincinnati: South-Western Publishing, 1998.