Foreign Direct Investment

Foreign Direct Investment is the engine of internationai business. In contrast to portfolio investment, which is the purchase of financial securities in other firms for the purpose of realizing financial gains when these marketable assets are sold, FDI is defined as the investment of equity funds across national boundaries. Every time a company builds a factory or plant, opens a branch, subsidiary or representative office; purchases a distributor, plant, or competitor; or acquires control of a natural resource, it is engaging in FDI. Unlike trade, FDI represents the physical expansion of operations across national borders. The multinational enterprise (MNE) is a company that has established an international presence by engag¬ing in FDI.

(2) A foreign affiliate can obtain financing either from its parent (or other parts of the MNE) or from outside lenders and investors (for instance, banks or the buyers of bonds that the affiliate issues). Only the former is foreign direct invest¬ment, and it is often a small part of the total financing of the affiliate. For all MNEs in the world in 2000, foreign affiliates had $21 trillion of financing in place, but only $6 trillion of that financing was provided by foreign direct invest¬ment by the muitinational enterprises. Evidence for U.S.-based multinationals indicates that borrowing in the host countries provides more than half of the out¬side financing.

(3) Why does FDI provide so little of the affiliates' total funding? An important reason is that a parent firm wants to reduce the risks to which its foreign activities are exposed. One risk is unexpected changes in exchange rates, which can alter the value of its direct investments. A good risk-reducing strategy for a parent company that has foreign-currency assets in its affiliates is to take on foreign-currency liabilities as well, by borrowing in foreign currencies that are used to finance the affiliate.