Foreign direct investment (FDI) refers to money invested in business operations in a country other then a firm's home country. It can involve purchasing existing operations in a foreign country or expanding domestic operations into a new country. Foreign direct investment is contrasted with portfolio investment, which is a passive investment into a foreign country's securities, such as foreign stocks, foreign bonds, eurobonds and foreign government bonds.
Most foreign direct investment occurs as businesses look to find cheaper sources of labor, or look to find new markets for their products. Over the last several decades, regional integration has been an important part of government trade policy geared at increasing foreign direct investment - although its success is often disputed. Regional Trade blocs such as the European Union (EU), Mercosur, The Association of South East Asian Nations (ASEAN), and NAFTA have been formed to allow for the free trade of goods, people and capital between countries in the same region. These trade agreements not only break down barriers for foreign direct investment, but they also help provide a legal framework that make governments accountable for the regulation they put in place, lowering the political risks associated with FDI (the risk that a politically-initatiate change will adversely affect a business).
Despite the fact that countries spend a lot of effort attracting foreign direct investment, the success of these efforts is often disputed. This is because within these trade blocs many exceptions still exist that allow individual countries to protect important industries by mainting different rules for foreign and domestic investments. These rules typically add significant costs and compliance risk to foreign investments. Statistics show that economic growth correlates more directly to increases in foreign direct investment than the implementation of free trade agreements alone.
This may be because foreign direct investment, especially in developing countries with lower labour costs, is typically much more risky than investing at home. However, firms expect to see higher rates of return on these investments to compensate for this risk. Firms use the same type of net present value analysis for foreign investments as we use when making capital budgeting decisions at home. As a result, countries with strong economic growth signal higher returns and are likely to attract more investment than those with free trade agreements alone.