Capital is a crucial part of economic growth. However, some countries cannot meet their capital requirement. This is when foreign investments come and help. The most common ways of investing in other countries are foreign direct investment (FDI) and foreign portfolio investment (FPI).
With FDI, investors put their money directly in the productive assets of a foreign economy. When it comes to FPI, we speak of investing in financial assets like stocks and bonds that belong to entities overseas. In some terms, both of these investment types are similar. Yet there are clear differences between them, too. For retail investors, it is vital to be informed about the differences between them. Mainly, it is important to know because markets with high FPIs tend to be heightened and highly volatile at uncertain times. Meanwhile, FDI is considered to be less volatile.
Examples of FPI and FDI
Let’s imagine a situation where a multi-millionaire from Germany is deciding whether to invest in company acquisition in a foreign country that produces industrial machinery or to buy a large stock of the company that makes machinery. The first option is an example of foreign direct investment and the second – of the foreign portfolio investment.
It is thought traditionally that FDI is a privilege of big investors who have enough capital for investing directly into a foreign economy. Meanwhile, an average investor would probably choose FPI. Basically, buying foreign stock and bonds, mutual funds or exchange-traded funds means becoming engaged in FPI.
Attractiveness of investments
Capital is always in demand and is very mobile. To evaluate the level of its desirability, investors use standard criteria:
- Political factors – government’s approach to business, political stability
- Economic factors – GDP trends, currency risk, inflation, the strength of the economy
- Motivations for foreign investors – tax incentives, taxation levels, property rights
- Other factors – local competition, skills and education of the labor force, and others.
The first difference between FDI and FPI is the level of control the foreign investor obtains. Typically, FDI investors are active participants and decision-makers in the companies they invest in. When we speak of FPI investors, they are usually quite passive and are not involved in the daily activities of the company. Unless FPI investors have a controlling interest in the company, they do not engage in strategic planning either.
The second difference is the timing. FDI investors take a long-term approach to their investments since it may take years before the project is completely launched. As for FPI, investors can profess in the long run but more often invest in a shorter timeline. In other words, in the case of economic turbulences, FPI investors can quickly leave the nation and liquidate their assets. But for FDI this procedure may not be this easy.
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