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What is Foreign Direct Investment, Horizontal and Vertical

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INTRODUCTION

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.”

While gains to host countries i.e. recipients of FDI from foreign or international investments are many, in comparison to other foreign investments, the advantages of FDI can take several other forms. Given the appropriate host-country policies and existence of reliable and sufficient infrastructure, it is expected that FDI, at a micro level, contributes to the transfer of technology or even triggers technology spillovers.

As FDI comes in many forms and therefore results in new varieties of capital inputs, it promotes a healthy competition in the domestic input market. The host country could also benefit from training and development of its workforce as FDI helps human capital formation across different economic sectors. Clearly, all these in turn contribute to the economic growth of the host country.

In addition to these economical benefits, FDI could also improve environmental and social conditions in the host country by, inter alia, transferring “cleaner” technologies, thereby leading to more socially responsible corporate policies. At a macro level, FDI contributes to international trade integration not least because it results in a more competitive business environment for multinational companies (MNCs). MNCs compete globally through investing their assets into domestic markets of different host countries.

Types of FDI

There are two main types of FDI: One is horizontal and the other is vertical. Horizontal FDI arises when a firm duplicates its home country-based activities at the same value chain stage in a host country through FDI. For example, Ford assembles cars in the United States. Through horizontal FDI, it does the same thing in different host countries such as the United Kingdom (UK), France, Taiwan, Saudi Arabia, and Australia. Horizontal FDI therefore refers to producing the same products or offering the same services in a host country as firms do at home.

While a horizontal pattern occurs when MNCs through FDI produce the same product or service in different host countries, vertical FDI takes place when a firm through FDI moves upstream or downstream in different value chains i.e. when firms perform value-adding activities stage by stage in a vertical fashion in a host country. In other words, a vertical FDI arises when a multinational firm fragments the production process internationally, thereby locating each stage of production in the country where it can be done at the least cost. For example, if Peugeot (the French automaker) only assembles cars and does not manufacture components in France, but in the UK, it can be said that Peugeot enters into components manufacturing through FDI. This pattern is called “upstream vertical FDI.” In a similar vein, if Volkswagen (the German automaker) does not engage in car distribution in Germany and, instead, invests in car dealerships in Saudi Arabia (a downstream activity), it can be said that Volkswagen is engaged in “downstream vertical FDI.”

While horizontal and vertical FDI serve different purposes, the bulk of FDI seems to be horizontal rather than vertical. As mentioned earlier, when a firm engages in horizontal FDI, it establishes multi-plant operations that duplicate similar products and services in multiple countries. This implies that a firm’s motive to adopt a horizontal pattern is mainly because it facilitates market access as opposed to reducing production costs and subsequent market share expansion. However, with vertical FDI firms engage in both FDI and exports. Unlike horizontal FDI in that the two countries involved are of similar size, and the nature of their operations resembles more of a pair of developed countries, in vertical FDI patterns, the home country is usually much larger and the two countries involved in FDI operations look like a developed home country and a developing host country. Put simply, in horizontal FDI patterns, the main objective to be met is how best to serve the host market (abroad), whereas in vertical FDI models, the primary objective of a firm is how best to serve the domestic (home) market.