DIRECT FOREIGN INVESTMENT In the last chapter, we considered international investment in the form of

portfolio investment, such as the purchase of a stock or bond issued in a foreign currency. There is, however, another type of international investment activity called direct foreign investment. Direct foreign investment is the spending by a domestic firm to establish foreign operating units. In the U.S. balance of payments, direct investment is distinguished from portfolio investment solely on the basis of percentage of ownership. Capital flows are designated as direct investment when a foreign entity owns 10 percent or more of a firm, regardless of whether the capital flows are used to purchase a new plant and equipment or to buy an ownership position in an existing firm. The growth of direct foreign investment spending corresponds to the growth of the multinational firm. Although direct investment is properly emphasized in international trade discussions of the international movement of factors of production, students should be able to distinguish portfolio investment from direct investment.

202 International Money and Finance

Theories of direct foreign investment typically explain the incentive for such investment in terms of some imperfection in free-market conditions. If markets were perfectly competitive, the domestic firm could just as well buy foreign securities to transfer capital abroad rather than actually establishing a foreign operating unit. One line of theorizing on direct foreign investment is that individual firms may not attempt to maximize profits, which would be in the interest of the firm’s stockholders; instead, they would attempt to maximize growth in terms of firm size. This is a concept that relies on an oligopolistic form of industry that would allow

a firm to survive without maximizing profits. In this case, direct foreign investment is preferred since domestic firms cannot depend on foreign- managed firms to operate in the domestic firm’s best interests.

Other theories of direct foreign investment are based on the domestic firm possessing superior skills, knowledge, or information as compared to foreign firms. Such advantages would allow the foreign subsidiary of the domestic firm to earn a higher return than is possible by a foreign- managed firm.

Direct investment has become an increasingly important source of finance both for developing countries and developed countries. Figure 11.1 illustrates how inflows of direct foreign investment to developed countries and developing countries have changed in recent times. Developing countries have seen a steady upward trend on foreign direct investment inflows during the 1990 2010 period, except following the recessions of 2000 and 2008. In 2010 the foreign direct investment into developing countries was very close to that of the developed ones.

1400 Developed 1200

Developing 1000

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Figure 11.1 also shows an upward trend in foreign direct investment in the developed countries. In addition to the trend, there are two periods of higher than usual investment. From the mid-1990s to the end of the 1990s, Europe and the U.S. saw a sharp increase in the investment flow. This has been called the “Great IT investment boom.” A similar boom occurred about 2003 2007, and was associated with increased housing speculative activity. Also here Europe and the U.S. were the favorite targets for the investment flows. By 2009 the investment boom had disappeared and foreign direct investment appears to be back at its normal trend.

Direct foreign investment is often politically unpopular in developing countries, and increasingly so also in developed countries, because it is associated with an element of foreign control over domestic resources. Nationalist sentiment, combined with a fear of exploitation, has often resulted in laws restricting direct investment. Although direct foreign investment is feared, it may be very beneficial for countries. Direct foreign investment may contribute more to economic development than do bank loans, since more of the funds go to actual investment in productive resources. Bank loans to sovereign governments were (and are) often used for consumption spending rather than investment. In addition, direct foreign investment may involve new technologies and productive exper- tise not available in the domestic economy. If foreign firms make a bad decision regarding a direct investment expenditure, the loss is sustained by the foreign firm, and no repayment would be necessary. In contrast, if the domestic government uses bank loans inefficiently, the country still faces

a repayment obligation to the foreign banks.

DIRECT FOREIGN INVESTMENT In the last chapter, we considered international investment in the form of