Foreign Direct Investment, Horizontal and Vertical

There has been a tremendous growth in foreign or international investment since 1990s. The underlying reasons for such international flows of capital can be attributed to several factors. International investment, for example, allows capital to find the highest rate of return, helps the owner of capital to diversify his or her lending and therefore reduces the associated risk, contributes to further development and spread of best practices in corporate governance and accounting rules, and finally it prevents the government from pursuing poor policies.

The aforementioned advantages of the free flow of capital across national borders can be realised through two primary kinds of international investment: (1) Foreign Portfolio Investment (FPI) and (2) Foreign Direct Investment (FDI). While FPI is defined as investment in a portfolio of foreign securities such as stocks and bonds, it does not entail the active management of foreign assets. In other words, FPI is “foreign indirect investment” in that it represents passive holdings of foreign securities not least because the investor does not have control over the securities' issuer. Exchange rates, interest rates, and tax rates on interest or dividends are factors that directly impact on FPI.

In contrast, FDI refers to those investments that involve an equity stake of 10 percent or more in a foreign-based enterprise. FDI requires the direct and active hands-on management of foreign assets. An example of FDI is when a Japanese company takes a majority stake in a company in America, Iran, or elsewhere. In comparison to FPI, FDI requires exercising management control rights, inter alia, the rights to appoint key managers, and to establish control mechanisms. Due to the importance of management control and the need to managing foreign operations, many firms these days even invest in a large equity of up to 100 percent just to be able to exercise management control rights.

The key difference between FDI and FPI therefore is that FDI investors not only take both ownership and control positions in the domestic firms, but also are regarded as the managers of the firms under their control. In other words, while FPI investors gain ownership positions in the domestic firms, they do not exercise control over domestic firms and must therefore delegate decisions to managers, thereby limiting their freedom to make decisions because the managers' agenda may not be always consistent with that of the owners. Based on such argument or more specifically due to an agency problem between managers and owners, FPI projects are managed less efficiently than FDI projects. This in turn has resulted in a dramatic rise in FDI in recent decades and led some international business scholars to view it as an important aspect of globalization.

Overall, the basic entry choices into foreign markets can be categorized into three strategies: exporting, licensing, and FDI. As it is often the case, successful exporting can provoke protectionist responses from host countries, thereby forcing firms to choose between licensing and FDI. There are three reasons that may compel firms to prefer FDI to licensing: (1) FDI reduces dissemination risk—i.e., the risk associated with unauthorized diffusion of firm-specific know-how; (2) FDI results in more direct and tighter managerial control over foreign operations; and (3) FDI promotes the transfer of tacit knowledge through “learning by doing.”

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