Defining the Term "Foreign Direct Investment"
October 16, 2017 by Nebojša Stanković
Plenty of countries around the world are in high debt and are undergoing transition in order to prevent further economic deterioration. However, there are only a few choices in this type of situation a country can make. Serbia for example, has resolved for the least painful transition approach, relying on the foreign investments.
It is one of the most effective ways of jumpstarting an economy that is in a bad condition. Its importance is quite high, as it allows for the country to change its economic position in the future. Therefore, slowly growing countries are heavily dependent on direct foreign investments, and are taking steps to attract investors from all over the world.
Republic of Serbia is currently on this path, and as the number of investments is increasing, it is clear that it is on the right path. To make all this a reality, the Republic of Serbia relies on a variety of norms that regulate foreign direct investments.
To better understand the whole direct foreign investment concept, let’s dig a bit deeper and see what it actually represents.
What are investments?
Investments represent financial investment in development of various industrial funds, economy and variety of industrial branches. The goal is to ensure a higher amount of raw materials and workforce to stimulate the development of a particular industrial branch.
The word “investment” comes from the latin word “vestis”, which originally means clothes. It refers to putting a type of good or money in someone’s pocket. The investments are generally not perceived as expenditure, but a postponed expenditure, redirection of funds or as an immediate expense that carries a possibility of paying off in the future.
According to Mass, an investment is an immediate expense vested in an uncertain future (Mass, 1940). This means that every investment carries a certain degree of risk.
Every investment is defined by its:
- Subject – The subject is the legal entity or the individual who is making the investment.
- Object – The object is where the investment is made (industry, infrastructure, education etc.)
- Expense – The expense is the amount of investment that is going to be made.
- Effect – The effect is the result of the investment. It is usually defined as an economic value.
The history of investments
Foreign investments have appeared centuries ago. To be precise, in Europe, the first investments were started in the 16th century. These forms of investments were primarily concerned with opening of trading outposts across different countries. They were focused on trading, to ensure that traders have easier access to different types of raw materials, but in the process, they were also in a better position to trade their goods in different markets.
The industrial revolution brought about a great change in the investment world, as the first multinational companies started developing with its rise. Plenty of companies were developed during this period of time, and some of those are big investment “players” even today.
During the period between the First and Second World War, foreign investments experienced significant growth. There was a big shift in the trading world that included the switch from raw material trade to colonial trade, primarily involving oil trade.
Once the Second World War had ended, the investment “game” went through a big change. A shift from oil investments resulted in numerous investments in management of knowledge and technological advancement. These types of investments were primarily made by the USA, until the 1960s.
After that period, Europe followed the same path until 1980s, when the first investments in slowly developing countries started to occur. This coincides with the development of the modern industry. During the 1990s, foreign investments in slowly developing countries were at their peak, some of which have become powerful economies today.
All this has led to the development of two primary types of foreign investments.
Types of foreign investments
There is a big difference between the two. Direct foreign investments, about which we are going to talk in-depth later, provide a certain level of control of the investor over the company that is invested in, whereas with portfolio investments that is not the case.
These are not the only types of foreign investments, there are also motivational types, i.e. with what goal the investment was made. According to the motivation, there are four different types of investments.
- Investments aimed towards new resources – This investment refers to natural resources or cheaper or specialized workforce.
- Investments aimed towards a new market – This investment is made into markets in which there is high level of import. They are made according to the latest market trends, and for following the investor’s clients.
- Investments aimed towards an increase of productivity and production – This investment is made to rationalize (optimise) the manufacturing process and to connect with other manufacturing processes for reducing costs. In the whole process, manufacturing is specialized completely.
- Investments aimed towards holding and promoting long-term values of a company – This type of investment is made in an already existing business company. The investor either gets a high stake in the company or completely acquires it, keeping the market and profits of the company later on.
Foreign investments should also not be confused with foreign financial credit. It functions in a different way. Through a credit, the creditor does not take any stake of the company, but makes its profit through interest.
Depending on the case, this type of investment is equally risky as a direct investment, but functions on different principles. They are usually made by the International Monetary Fund, Bank of Europe or World Bank.
Forms of Foreign Direct Investments
Let’s explore what different types of foreign direct investments are, and how they are made.
Formation of new business subject
This is quite similar to the greenfield investment, however, in this process the investor is creating a completely new company that is not directly connected to any other company. It is a completely independent company.
During this process, the investor relies on his passport information for opening the company. If the investor is a legal entity, then the business name is used, followed by the registration number of the company in the home country.
Branching out investment (greenfield investment)
This type of investment involves the establishment of a branch of an already existing company.
In the Republic of Serbia, a branch of a company is not a legal entity, and the parent company is held completely responsible for the branch’s business decisions.
This means that the company is acquired by an investment in company stocks. Some argue that it is necessary to purchase at least 10% of a company, whereas others believe that this percentage should exceed 50% of company stocks.
No matter what the investment is, the investor now has a role in leading a company after the investment is made. The power of control depends on the number of stocks purchased in the foreign investment process.
While direct foreign investor does influence how the company is governed once it is acquired, he can never completely make independent decisions about the direction in which the company is going to be headed, of course, this refers to cases in which the acquired company is a manufacturer of arms and military equipment. Also, there are forbidden industry “zones” for investment, for which it is necessary to acquire permits before any investment is made.
In all the other cases, the investor can take complete control of the company, if the acquisition exceeds 50% stock ownership.
This type of investment includes an already existing business merging with another company to form a new one. This process is also regulated by the Law on Foreign investments, through which a completely new company can be formed, where both of the companies cease to exist, or one company ceases to exist.
These are not the only way in which direct foreign investments are perceived. They are also split according to correlation with domestic investments.
- Subsidized direct foreign investments – The country that is being invested in also performs some type of investment for the business, in order to create better conditions for the new company. This can have a negative effect on domestic investors, who are left facing a more competitive foreign investor.
- Additive direct foreign investments – These investments add to the investments already being made by the country, helping reach the goal of the whole investment.
Direct foreign investments can also be perceived in another way:
- Horizontal direct foreign investment – The investment is made in manufacturing of the same product from the investor’s home country.
- Vertical direct foreign investment – The investment is made for manufacturing parts of the goods, whereas other parts are manufactured in the investor’s home country.
- Conglomerate direct foreign investment – Complete investment being made by the investor is in no correlation to the home country’s economy or manufacturing.
As you can see, different authors definite how direct foreign investments are classified. But let’s go in-depth about the portfolio investments, as we have only mentioned them earlier.
As previously mentioned, portfolio foreign investments do not give the investor any control over the company that is invested in. Yet, many decide to perform this type of investment.
A good example of a portfolio investment is a Joint Venture investment, that has become increasingly popular in the past couple of decades. In this investment type, two or more individuals or legal entities join their business assets to reach a previously made goal, in a previously established time frame.
Once the business task, or business goal has been reached, the investors share the profits based on the amount of invested money or goods. In this process, they have to share the profit, but more importantly, they also share any loss, taking a smaller hit for a failed venture.
This is a lucrative option for those who want to share the risks with others. That is the primary reason why this is the investment type that many investors opt for, as any possible losses are much smaller than if they were alone in the business venture.
This is a specific type of investment, where the country’s government is creating better conditions for a foreign investor. If the country has natural resources, infrastructure, buildings and other types of facilities, they are offered to the investor to use free of charge. This is a great way to incentivise and attract multiple investors to the country. Given that these resources would remain unused, it is better to have them used by the investor and receive profit in the whole process.
This type of investment is regulated by the Law on Foreign Investments. According to the law, the investor has to participate in a tender and bid for what the country is offering. Also, the law indicates that the foreign investor can enjoy BOT (build, operate and transfer) privileges. This enables the investor to freely build, use and transfer objects, the object’s infrastructure and the whole plant.
These are the most commonly used ways in which foreign direct investments are handled and defined. It is clear that they have a great importance for a local economy, as these investments serve to jumpstart a country’s economy, by utilizing its resources and workforce.
It is important to note that no matter what type of business an investor is starting or investing in, all of its work has to comply with Serbia’s Laws on Nature and Biodiversity protection.
At the current state, the Republic of Serbia is open for different types of investments. It has already gone through various different types that have been successful. In the past, the Balkan region was quite unstable, but over the years, following the economic growth and political stability, it has become a fertile land of opportunity for investors that are looking for ways to grow their businesses.