International Factor Movements - Foreign Direct Investment

Foreign Direct Investment

Foreign Direct Investment (FDI) is the ownership of assets in a country by foreigners where the ownership is intended to provide control over those assets. The foreign owner is often a firm. FDI is one way in which factors of production, specifically capital, move internationally. It is distinct from international borrowing and lending of capital because the intent of FDI is not simply to transfer resources; FDI is also intended to establish control.

Two aspects of the above definition are often debated due to their inherent ambiguity. First, if a firm acquires an ownership interest in another firm, how do we determine the "nationality" of either the acquiring or acquired firms? Many companies operate in multiple countries, making it difficult to assign them a nationality. For example, Honda has factories in multiple countries, including the United States, but the firm began in Japan. How, therefore, should we assign a nationality to Honda? Should it be on the basis of where the company was founded, where it primarily produces, or some other metric? Assigning a nationality is particularly problematic for firms founded countries with very small domestic markets and for companies that specifically focus on selling goods on the international market.

The second problem with FDI's definition is the meaning of "control." The U.S. Department of Commerce has defined FDI as when a single foreign investor acquires an ownership interest of 10% or more in a U.S. firm. The number 10%, however, is somewhat arbitrary, and it is easy to see how the Commerce Department's definition might not capture all instances of actual foreign control. For example, a group of investors in a foreign country could buy 9% of a U.S. firm and still use that ownership to exercise some measure of control. Alternatively, a foreign investor that purchases 10% of a U.S. firm may have no intention of exercising control over the company.

One important question economists have preoccupied themselves with regarding FDI is why ownership of domestic resources could be more profitable for foreign firms than for domestic firms. This questions rests on the assumption that, all things being equal, domestic firms should have an advantage over foreign firms in production in their in own country. There are many explanations for why foreign firms acquire control over businesses in other countries. The foreign firm may simply have greater knowledge and expertise regarding productions methods, which gives it an advantage over domestic firms. The acquisition of a foreign firm could be based on a global business strategy. Finally, foreign firms might use a different discount rate or return on investment, which are essentially "cost of capital" considerations, when evaluating investment opportunities. However, Krugman and Graham, through a survey of the relevant literature, concluded that industrial organization considerations are more likely than cost of capital concerns to be the driving force for FDI.