What is a foreign portfolio investment

International financial and economic relations

Heribert Dieter

Professor Dr. Heribert Dieter studied political science and economics at the Free University of Berlin and received her doctorate there with a thesis on Australian foreign trade policy. In 2005 he published his habilitation thesis on "The Future of Globalization".
Dieter works as a scientist in the Global Issues Research Group of the Science and Politics Foundation (Berlin) and is an adjunct professor at the University of Potsdam and visiting professor for international political economy at the Zeppelin University in Friedrichshafen.

The advantages and disadvantages of cross-border investments are repeatedly and controversially discussed in public. They offer a wide range of opportunities that can contribute to the economic revitalization of regions. At the same time, they harbor the risk that the opportunities offered by a liberal world economy will be used unequally.

Paul Feng is the head of the Chinese Midea group, which will take over the German robot manufacturer KUKA in 2016. Feng at the Hanover industrial fair 2017 (& copy picture-alliance / dpa, Silas Stein)

Cross-border investments are an important element of international financial and economic relations. This includes all cross-border investments, including securities investments (portfolio investments).

Investments from abroad are often a politically controversial issue. In Germany, for example, the takeover of the robot manufacturer KUKA by a Chinese company was discussed intensively in 2016: Will the German economy be damaged by the flow of technological knowledge to China? Is it unwise to rebel against foreign investments and doesn’t it make sense for foreign companies to invest in Germany?

These questions are by no means only discussed in Germany. In economic history there are many cases of foreign investments that have been accompanied by intense criticism. This is especially true for well-known companies. In Switzerland, for example, the takeover of the insolvent airline Swissair by Lufthansa was initially sharply criticized. Only at the second attempt did the Swiss state and the shareholders of Swiss agree to the takeover.

Forms of investment and their evaluation

Foreign investments come in different forms. The benefits and risks are to be assessed differently. The best-known form is direct investment: This involves investing in a new company or buying shares in an existing company.

Companies from country A often set up a factory in country B. An example from Europe: The car manufacturer Daimler is building a plant for the production of the Mercedes B-Class in Kecskemet, Hungary, and is investing one billion euros in this project. This has economic advantages for the target country of the investment: On the one hand, jobs are created in the plant itself, on the other hand, the construction of an automobile factory attracts other investors, especially from the supplier industry. It is also possible that workers will gain knowledge and skills in the factories built by foreign investors, which they can then use to set up their own new businesses. In the ideal case, a sustainable economic upswing develops through foreign investments.

In earlier epochs, foreign direct investment was often viewed critically. In the so-called developing countries in particular, they were often seen as a problem: the foreign investors would exploit the local workforce, and the long-term benefit for the domestic economy was limited because it could not develop its own industry. Another undesirable side effect of foreign investments is "poaching in the labor market": Highly qualified workers, such as teachers or engineers, can be recruited from foreign companies with higher wages and then used for low-skilled jobs. They are then absent from their apprenticeships.

Foreign investments can also be made in other forms. One that has already been mentioned is the takeover of a domestic company by a foreign one. Buying a domestic company is rarely a purely economic issue, but often arouses emotions. This is once again shown by the example of Swissair: the airline was considered to be the embodiment of Swiss national pride. Takeovers of existing companies are often criticized as an undesirable sell-out of a country's economic know-how.

If one differentiates between direct investments, which go hand in hand with the development of new production capacities (so-called greenfield investments), and mergers and acquisitions, the following picture emerges for 2015: New industrial settlements worldwide rose by eight percent compared with 2014 to 766 billion US dollars. Almost as high was the volume of cross-border mergers and acquisitions, at $ 721 billion. However, this direct investment increased by 67 percent compared to 2014.

The interest rate policy of the major central banks, which makes the financing of large takeovers easier to finance through a low interest rate level, is an essential factor for the pronounced buying interest of companies. Just as home builders can afford a larger home when interest rates are low, companies can also finance very large acquisitions when interest rates are low.
Finally, there is a third form of portfolio investment. Here, too, capital flows abroad or from abroad. The focus is on the interest in participating in the profits of a company. A takeover of the company or the control of the business operations are not intended for portfolio investments. An example is the purchase of Deutsche Telekom shares by an Australian. The aim of the investment is to profit from dividends and possible price increases in the share, but not to control the company.

Source text

Advantages and disadvantages of foreign direct investment

[…] In principle, most economists agree that such investments are of considerable economic benefit. When a foreign company uses its own technology and capital to build a new factory, or when a company buys shares in a foreign company and gains control of it, it can be mutually beneficial. The takeover of control usually goes hand in hand with the introduction of new technology and new management structures, which in turn ensure increased productivity. The capital flows mainly from advanced to less developed economies.

From this point of view, FDI seems to represent the "good" globalization. But this neglects the role of the so-called "special purpose vehicles", which - especially in Europe - make an ever larger proportion of foreign direct investments. These are usually umbrella companies that are used to manage large amounts of capital abroad without establishing a real physical or economic presence. The suspicion is that this only happens to avoid tax payments, to take advantage of bilateral tax treaties or to obtain special tax treatment.

[…] This in turn shows that we have to make a clear distinction between "productive" and strictly "balance sheet" or "financial" foreign direct investments. It goes without saying that the majority of the latter transactions are primarily carried out in countries with low corporate taxes (Ireland) or advantageous international tax treaties (Netherlands, Luxembourg).

This sometimes leads to quite astonishing statistics. According to official European trade statistics, the EU is the largest net exporter of computer services - ahead of the USA. The fact that a large part of these supposed EU exports come from Ireland, however, suggests that American technology companies divert their profits through direct investments to Ireland in order to benefit from the tax laws there. The latest decision by the EU Commission to demand a substantial back tax payment from Apple points in this direction. From a macroeconomic perspective, it is clear that such a structured capital flight cannot have any positive macroeconomic effects on balance. [...]

Daniel Gros, "Globalisierung", in: Internationale Politik (IP) January / February 2017, p. 62 ff. (Here p. 66 f.)