What Is Direct Investment?

Author:Tadeusz Galeza and James Chan

What Is Direct Investment? Finance & Development, September 2015, Vol. 52, No. 3

Tadeusz Galeza and James Chan

Investors often seek profits from a long-term stake in a foreign operation

Foreign investors can have myriad motivations for seeking to earn profits in another country. But they have fundamentally two core choices when deciding how to deploy their capital.

They can make a portfolio investment, buying stocks or bonds, say, often with the idea of making a short-term speculative financial gain without becoming actively engaged in the day-to-day running of the enterprise in which they invest.

Or they can choose the long-haul, hands-on approach—investing in an enterprise in another economy with the objective of gaining control or exerting significant influence over management of the firm (which usually involves a stake of at least 10 percent of a company’s stock). In the most extreme case, investors may build new facilities from scratch, maintaining full control over operations.

It is the intent of lasting interest that is the crucial component of direct investment. A portfolio investor can sell a stock or bond quickly—whether to cement a gain or avoid a loss. Most corporations entering a foreign market through direct investment expect to substantially influence or control the management of the enterprise over the long haul.

Faces of investmentA number of factors influence a company’s decision to engage in direct investment, including analysis of the trade costs with a foreign country. If these costs—including tariffs (taxes on imports), trade barriers such as quotas, and transportation—are higher than the cost, including the costs of production abroad, of establishing presence in the foreign country, the business will maximize its profits through direct investment.

Companies may invest with the idea of producing components that become part of a bigger product. An automaker may invest in a plant to build transmissions that are shipped to a final assembly plant in another country. This so-called vertical direct investment accounts for most of the investment by advanced economies in developing ones. The cost advantages associated with investing in a foreign country—and in many cases performing only a portion of the production process in that country—drive such investment. Abundant or unique natural resources or low labor costs influence the decision to move production overseas and import intermediate or final products from subsidiaries in...

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