Foreign Direct Investment (FDI)

Foreign Direct Investment (FDI)

Think Carefully, Invest Globally

The United States is not the only place to invest your hard-earned cash. In fact, it may not even be the best place, and risky emerging markets offer big returns, and you should watch them carefully

Consider that almost every emerging stock market open to foreign investors and tracked by the World Bank’s International finance corporation show greater returns than the Standard & Poor’s 500. And that is not one-year fluke: The IFC’s composite index of emerging stock markets for any five-year period show a mean annual report up to 30 percent, at least twice the S&P 500 return over the same period.

The catch: Emerging stock markets lack the regulatory safeguards that protect U.S. shareholders, and many of them are dominated by just a few stocks or are rife with speculation. Such instability can feed on itself. The history knows numerous examples: The horrific devaluation of the Mexican peso – 35 percent in the final 11 days of 1994 alone – sent Latin American markets into a tailspin. The IFC’s Latin American index dropped over 21 percent in the fourth quarter of that year.

You can buy foreign stocks directly, but an emerging market mutual fund may be a better bet. Professional managers examine a country‘s political stability, work ethic, education, family structure and other factors before investing. They also pay special attention to a country’s productivity rate. At least, such consideration pays off; and emerging market funds earn high actual returns. Some however take heavy hits, but experts believe most of them are poised for big growth in the long term.

For example, China, the world’s most populous nation doubles its aggregate output every 20 years. An evolving market economy and abundant labor makes it a standout. India, the world’s second most populous country has great potential, but also sporadic problems with religious opposition. Some other countries benefit from abundant natural resources, but beware of continued corruption and inflation, however.

Invest Globally. Photo by Elena

Anyway, many previously untraded stocks will become available to foreign investors. But these enormous market potential is tempered by doubts about whether it will move toward success and fear of political and exchange rate volatility in many countries.

FDI characterizes investments made in a different country than the one where the funds invested came from. The asset purchased must thus be of a dissimilar nation state than that of the investor’s home. Investment can take the form of financial, technological and even human capital (knowledge and skills development). By definition, there must be a lasting management interest - 10% of voting shares (Wan, 2010; Mossa, 2002). A smaller portion of shares describes portfolio investment. According to Caves (1971), FDI can be classified as vertical, horizontal and conglomerate. The vertical type can be further subdivided into forward and backward.

In the first decade of the millennium, FDI underwent exponential growth thanks to cross-border companies (Wan, 2010). Apparently despite the sharp rise in the 80s and 90s, the stimulating effect of FDI in developing economies continues to be debated. The optimistic school of thought rests on the neoclassical perspective and the new theory of economic growth. Radicalism is characterized by pessimism. A possibility exists that such capital brings about crowding out effects domestically, loss of autonomy and distress to local business. The author asserts that around 2010, FDI stock amounted to 1/5 of the global GDP. The reverse pattern, capital flow outwards from developing countries, also went up.

Hudson's Bay Company. Picture by Elena

Moosa (2002) draws attention to what distinguishes FDI from portfolio investment: FDI is designed for longer term and control of the assets acquired. The issue is surrounded by controversy, some seeing it as almost a new form of colonialism or imperialistic expansion. Still, FDI plays a major role in growth and economic development of the Third World and is one of the most stable international investment resources. Globally, FDI has risen since the 1980s. During those same years, the world has witnessed spectacular economic growth. There exist other forms of foreign investment than FDI. Notwithstanding, a decade later FDI represented 25% of international capital flow. Surprisingly resilient, this form of investment persisted almost unchallenged during the 1997-98 Asian financial crisis.

Scholars have examined the relationship for half a century and tend to agree on FDI furthering economic growth by modernizing the host’s technology, infrastructure, bureaucracy and so on (Wan, 2010). The author also underlines the repercussion of spillover effects of a technological nature. Figures are provided demonstrating the more pronounced positive correlation between FDI and business development, than between business growth and domestic investment; at least in the case of Latin America. In other regions, such as China, domestic influx plays a greater and more constructive role. Furthermore, it appears that the receiver country must be developed up to a certain point in order to be able to benefit from the arrangement.

References:

• Caves, R. E. (1971). International corporations: The industrial economics of foreign investment. Economica, 38 (149): 1-27.
• Moosa, I. A. (2002). Foreign direct investment: Theory, evidence and practice. Palgrave: New York, NY.
• Wan, X. (2010). A literature review on the relationship between foreign direct investment and economic growth. International Business Research, 3 (1): 52-56.