Foreign Direct Investment Theory and Political Risk

Foreign Direct Investment Theory and Political Risk

723g33Multinational Finance

Sustaining and Transferring Competitive Advantage

• In deciding whether to invest abroad, management must first determine whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market.

• The competitive advantage must be firm-specific, transferable, and powerful enough to compensate the firm for the potential disadvantages of operating abroad (foreign exchange risks, political risks, and increased agency costs).

• There are several competitive advantages enjoyed by MNEs.

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• Economies of scale and scope:– Can be developed in production, marketing, finance, research and

development, transportation, and purchasing– Large size is a major contributing factor (due to international and/or domestic

operations)

• Managerial and marketing expertise:– Includes skill in managing large industrial organizations (human capital and

technology)– Also encompasses knowledge of modern analytical techniques and their

application in functional areas of business

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• Advanced technology:– Includes both scientific and engineering skills

• Financial strength:– Demonstrated financial strength by achieving and

maintaining a global cost and availability of capital

– This is a critical competitive cost variable that enables them to fund FDI and other foreign activities

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• Differentiated products:– Firms create their own firm-specific advantages by producing and

marketing differentiated products– Such products originate from research-based innovations or heavy

marketing expenditures to gain brand identification

• Competitiveness of the home market:– A strongly competitive home market can sharpen a firm’s competitive

advantage relative to firms located in less competitive ones– This phenomenon is known as the diamond of national advantage and

has four components

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Exhibit 18.1 Determinants of National Competitive Advantage: Porter’s Diamond

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The OLI Paradigm and Internalization• The OLI Paradigm is an attempt to create an overall framework to explain

why MNEs choose FDI rather than serve foreign markets through alternative models such as licensing, joint ventures, strategic alliances, management contracts, and exporting.– “O” owner-specific (competitive advantage in the home market that

can be transferred abroad)– “L” location-specific (specific characteristics of the foreign market

allow the firm to exploit its competitive advantage)– “I” internalization (maintenance of its competitive position by

attempting to control the entire value chain in its industry)

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Where to Invest?

• The decision about where to invest abroad is influenced by behavioral factors.

• The decision about where to invest abroad for the first time is not the same as the decision about where to reinvest abroad.

• In theory, a firm should identify its competitive advantages, and then search worldwide for market imperfections and comparative advantage until it finds a country where it expects to enjoy a competitive advantage large enough to generate a risk-adjusted return above the firm’s hurdle rate.

• In practice, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm.

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Where to Invest?• The decision to invest abroad is influenced by behavioral factors.

• The decision about where to invest abroad for the first time is not the same as the decision about where to reinvest abroad.

• In theory, a firm should identify its competitive advantages. Then it should search worldwide for market imperfections and comparative advantage until it finds a country where it expects to enjoy a competitive advantage large enough to generate a risk-adjusted return above the firm’s hurdle rate.

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Exhibit 18.3 The FDI Sequence: Foreign Presence and Foreign Investment

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How to Invest Abroad: Modes of Foreign Investment

• Exporting versus production abroad:– There are several advantages to limiting a firm’s activities to

exports as it has none of the unique risks facing FDI, Joint Ventures, strategic alliances and licensing with minimal political risks

– The amount of front-end investment is typically lower than other modes of foreign involvement

– Some disadvantages include the risks of losing markets to imitators and global competitors

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• Licensing and management contracts versus control of assets abroad:– Licensing is a popular method for domestic firms to profit from foreign

markets without the need to commit sizeable funds

– However, there are disadvantages which include:• License fees are lower than FDI profits

• Possible loss of quality control

• Establishment of a potential competitor in third-country markets

• Risk that technology will be stolen

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– Management contracts are similar to licensing, insofar as they provide for some cash flow from a foreign source without significant foreign investment or exposure

– Management contracts probably lessen political risk because the repatriation of managers is easy

– International consulting and engineering firms traditionally conduct their foreign business on the basis of a management contract

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• Joint venture versus wholly owned subsidiary:– A joint venture is here defined as shared ownership in a foreign

business– Some advantages of a MNE working with a local joint venture partner

are:

• Better understanding of local customs, mores and institutions of government• Providing for capable mid-level management• Some countries do not allow 100% foreign ownership• Local partners have their own contacts and reputation

which aids in business

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– However, joint ventures are not as common as 100%-owned foreign subsidiaries as a result of potential conflicts or difficulties including:

• Increased political risk if the wrong partner is chosen• Divergent views about the need for cash dividends, or

the best source of funds for growth (new financing versus internally generated funds)• Transfer pricing issues• Difficulties in the ability to rationalize production on a

worldwide basis

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• Greenfield investment versus acquisition:– A greenfield investment is defined as establishing a

production or service facility starting from the ground up

– Compared to a greenfield investment, a cross-border acquisition is clearly much quicker and can also be a cost effective way to obtain technology and/or brand names

– Cross-border acquisitions are however, not without pitfalls, as firms often pay too high a price or utilize expensive financing to complete a transaction

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• The term strategic alliance conveys different meanings to different observers.

• In one form of cross-border strategic alliance, two firms exchange a share of ownership with one another.

• A more comprehensive strategic alliance, partners exchange a share of ownership in addition to creating a separate joint venture to develop and manufacture a product or service

• Another level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets.

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Foreign Direct Investment Originating in Developing Countries

• In recent years, developing countries with large home markets and some entrepreneurial talent have spawned a large number of rapidly growing and profitable MNEs

• These MNEs have not only captured large shares of their home markets, but also have tapped global markets where they are increasingly competitive

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Foreign Direct Investment Originating in Developing Countries

• The Boston Consulting Group has identified six major corporate strategies employed by these emerging market MNEs– Taking brands global– Engineering to innovation– Leverage natural resources– Export business model– Acquire offshore assets– Target a niche

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Defining Political Risk

• In order for an MNE to identify, measure, and manage its political risks, it needs to define and classify these risks which include– Firm-specific risks

– Country-specific risks

– Global-specific risks

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Assessing Political Risk

• At the macro level, prior to under-taking foreign direct investment, firms attempt to assess a host country’s political stability and attitude toward foreign investors

• At the micro level, firms analyze whether their firm-specific activities are likely to conflict with host-country goals as evidenced by existing regulations

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Predicting Risks

• Predicting firm-specific risk – Different foreign firms operating within the same

country may have very different degrees of vulnerability to changes in host-country policy or regulations

• Predicting country-specific risk– Political risk analysis is still an emerging field,

though firms need to attempt to conduct this analysis

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Firm-Specific Risks

• Governance risks– Governance risk is the ability to exercise effective control over an

MNEs operations within a host country’s legal and political environment

– Historically, conflicts of interest between objectives of MNEs and host governments have arisen over such issues as the firm’s impact on economic development, the environment, control over export markets, balance of payments (to name a few)

– The best approach to conflict management is to anticipate problems and negotiate understanding ahead of time

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Firm-Specific Risks

• Negotiating Investment Agreements– An investment agreement spells out specific rights

and responsibilities of both the foreign firm and the host government

– The presence of the MNE is as often sought by development-seeking host governments

– An investment agreement should define policies on a wide range of financial and managerial issues

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Operating Strategies after the FDI Decision

• Although an investment agreement creates obligations on the part of both foreign investor and host government, conditions change and agreements are often revised in the light of such changes

• The firm that sticks rigidly to the legal interpretation of its original agreement may well find that the host government first applies pressure in areas not covered by the agreement and then possibly reinterprets the agreement to conform to the political reality of that country

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Operating Strategies after the FDI Decision

• Some key areas of consideration include:– Local sourcing– Facility location– Control of transportation– Control of technology– Control of markets– Brand name and trademark control– Thin equity base– Multiple-source borrowing

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Country-Specific Risk: Transfer Risk

• Country-specific risks affect all firms, domestic and foreign, that are resident in a host country

• The main country-specific political risks are transfer risk and cultural and institutional risks

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Country-Specific Risk: Transfer Risk

• Transfer risk is defined as limitations on the MNE’s ability to transfer funds into and out of a host country without restrictions

• When a government runs short of foreign exchange and cannot obtain additional funds through borrowing or attracting new foreign investment, it usually limits transfers of foreign exchange out of the country, a restriction known as blocked funds

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Exhibit 18.6 Management Strategies for Country-Specific Risks

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Country-Specific Risk: Cultural and Institutional Risks

• When investing in some of the emerging markets, MNEs that are resident in the most industrialized countries face serious risks because of cultural and institutional differences including:– Differences in allowable ownership structures

– Differences in human resource norms

– Differences in religious heritage

– Nepotism and corruption in the host country

– Protection of intellectual property rights

– Protectionism

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Global-Specific Risks

• Global specific risks faced by MNEs have come to the forefront in recent years

• The most visible recent risk was, of course, the attack by terrorists on the twin towers of the World Trade Center in New York on September 11, 2001.

• In addition to terrorism, other global-specific risks include the antiglobalization movement, environmental concerns, poverty in emerging markets and cyber attacks on computer information systems

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Exhibit 18.7 Management Strategies for Global-Specific Risks

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Mini-Case Questions: Mattel’s Chinese Sourcing Crisis of 2007

• Mattel’s global sourcing in China, like all other toy manufacturers, was based on low-cost manufacturing, low-cost labor, and a growing critical mass of factories competitively vying for contract manufacturing business. Do you think the product recalls and product quality problems are separate from or part of pursuing a low-cost country strategy?

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Mini-Case Questions: Mattel’s Chinese Sourcing Crisis of 2007 (cont’d)

• Whether it is lead paint on toys or defective sliding slides on baby cribs, whose responsibility do you think it is to assure safety – the company, like Mattel, or the country, in this case China?

• Many international trade and development experts argue that China is just now discovering the difference between being a major economic player in global business and its previous peripheral role as a low-cost manufacturing site on the periphery of the world economy. What do you think?

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Exhibit 18.2 Finance-Specific Factors and the OLI Paradigm (“X” indicates a connection between FDI and finance-specific strategies)

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Exhibit 18.4 Emerging Market Multinationals and Their Global Strategies

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Exhibit 18.5 Classification of Political Risks

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Exhibit 1 China-Manufactured Products Recalled by the U.S. Consumer Products Safety Commission between August 3 and September 6, 2007

Foreign Direct Investment Theory and Political Risk

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