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The relationship between FDI and international trade

Trade and foreign investment are different but related types of transactions that play fundamental roles in the global economy.

Foreign direct investment (FDI) and international trade are both drivers of the global economy, facilitating the cross-border transfer of goods, services and capital around the world.

Research shows that the relationship between FDI and international trade is often complementary rather than competitive, although they represent different types of transaction and play different economic roles.

Neither has escaped criticism and both have faced growing opposition from protectionist governments, despite the positive impacts they can have on recipient countries.

What is FDI?

A foreign direct investment involves a company or individual based in one country investing business interests in another country. These investments are typically in foreign business operations or assets, rather than buying and selling equities that are considered portfolio investments.

Countries around the world track the levels of FDI they attract as an indicator of economic performance, with high inbound FDI seen as both a sign of economic growth and a creator of it.

Greenfield FDI involves setting up a new business, subsidiary or facility in a different country, and is associated with job creation and the transfer of goods and skills into the host country. Mergers and acquisitions can also be counted as FDI but only when they represent a change in active ownership rather than the trading of minority stocks and shares by passive investors.

FDI is typically split between horizontal, vertical and conglomerate investments:

• A horizontal investment sees an investor establishing the same type of business in a new market as to the one it operates in its country of origin.

• Vertical investments are made in different but related business activities.

• Conglomerate investments are made in business activities unrelated to those of its existing business in its home market.

When a manufacturing company builds a factory in a new country, this is horizontal FDI. When it then acquires an active interest in a foreign company that supplies raw materials for its manufacturing plants, this is vertical FDI. If it then decided to invest in a telecommunications company in the host country, this would be conglomerate FDI.

FDI can be measured in stock or flows. FDI stock measures all direct investments held by non-residents in a country during a specific reporting period. Inward stock is the value of investments owned by foreign companies in a host nation, while outward stock is the value of investment held by domestic companies overseas.

FDI flows relate to cross-border investment completed during the reporting period either into a country (inward flows) or out of a country (outward flows).

What is international trade?

International trade is the buying and selling of products and services on international markets. This activity increases consumer choice, creating competitive markets that should result in reduced end prices and increased quality of products and services.

Natural resources are unevenly shared across the globe, but international markets allow countries to trade what resources or capital they have for the resources they need.

The different forms of trade are import, export and entrepot:

• Imports are goods/services transported into a country.

• Exports are goods/services transported out of a country.

• Entrepot trade is when goods/services are imported into a country to be stored before being re-exported to another country.

International trade is widely seen as positive for the global economy, although it is argued that smaller countries can be disadvantaged due to specialisation.

Free trade leads to specialisation, where countries with a comparative advantage of producing certain goods domestically will become major exporters of those goods, while other countries will focus on goods that they have a comparative advantage in producing.

To protect industries potentially threatened by global trade, a government can choose to implement protectionist policies, such as tariffs or trade barriers. These will make it more difficult for foreign imports to compete with domestically produced goods.

Due to specialisation, free trade can lead to FDI. If a multinational enterprise needs goods that are cheaper to produce in a foreign market it is advantageous for it to establish operations in that market to benefit from its comparative advantage. Governments may seek to encourage this type of FDI if it brings jobs, skills and investment into their country.

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