Foreign Direct Investment and Balance of Payments

Foreign direct investment (FDI) is cross-border investment through which an investor acquires a lasting interest and significant influence in an enterprise in another economy. In the balance of payments, it is recorded in the financial account through changes in direct-investment assets and liabilities. Net FDI shows the balance between direct investment entering and leaving the reporting economy.

How net FDI is measured

For a country, net FDI inflow is broadly measured as the net incurrence of direct-investment liabilities minus the net acquisition of direct-investment assets. In simpler terms, it is inward FDI minus outward FDI, after accounting for withdrawals or disinvestment.

• Direct-investment transactions include equity capital, reinvested earnings and inter-company debt between related enterprises.
• Reinvested earnings are recorded even when profits are not actually remitted: the investor's share is treated as income payable and then reinvested.
• A positive net figure indicates that inward direct investment exceeds outward direct investment; a negative figure indicates the reverse.
• Gross inward FDI should therefore be distinguished from net FDI, which captures the balance of inward and outward direct-investment transactions.

How FDI finances a current account deficit

A current account deficit occurs when payments for goods, services and income exceed corresponding receipts from abroad. Under the balance-of-payments accounting framework, this gap must be matched by net capital and financial inflows, a reduction in foreign exchange reserves, or a combination of these, apart from errors and omissions.

• Positive net FDI creates a financial-account inflow and provides foreign exchange that can finance payments associated with the current account deficit.
• If FDI inflows are sufficient, the deficit can be financed without an equivalent depletion of foreign exchange reserves or additional external borrowing.
• FDI finances a current account deficit but does not eliminate the underlying excess of current payments over receipts.
• Equity FDI is generally considered non-debt-creating capital because it does not require fixed interest or principal repayments.
• FDI is usually more stable than short-term portfolio flows because it is associated with productive assets and lasting managerial interest.
• Not every recorded FDI transaction brings immediate foreign exchange: reinvested earnings are imputed as income payable and then reinvested.

Long-term effects and limitations

The external-sector effect of FDI depends on its stability and productive use, rather than merely its recorded volume.

• Export-oriented FDI can expand export earnings, while domestic production may replace some imports.
• FDI may initially increase imports of machinery, technology and intermediate goods.
• Profit and dividend remittances subsequently create primary-income outflows on the current account.
• Inter-company debt within FDI can generate repayment obligations, even though equity FDI is non-debt-creating.
• Stable FDI can reduce dependence on external borrowing and associated refinancing and debt-servicing risks.
• Thus, FDI may ease current financing pressures, while its eventual effect on the current account depends on exports, import requirements and income remittances.