Foreign Direct Investment Theory and Political Risk

723g33Multinational Finance

Yinghong.chen@liu.se

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:

Sustaining and Transferring Competitive Advantage

• 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

Sustaining and Transferring Competitive Advantage

• 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

Sustaining and Transferring Competitive Advantage

• 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

Recall: Determinants of National Competitive Advantage: Porter’s Diamond

The OLI Paradigm: Why FDI?• 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.1. “O” owner-specific (competitive advantage in the home

market that can be transferred abroad)2. “L” location-specific (specific characteristics of the

foreign market allow the firm to exploit its competitive advantage)

3. “I” internalization (maintenance of its competitive position by attempting to control the entire value chain in its industry)

Where to Invest?• 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.

Exhibit 18.3 The FDI Sequence: Foreign Presence and Foreign Investment

How to Invest Abroad: 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

How to Invest Abroad: Licensing and management contracts

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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How to Invest Abroad: Licensing and management contracts• Management contracts are similar to licensing,

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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How to Invest Abroad: 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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How to Invest Abroad: joint ventures

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

How to Invest Abroad: Greenfield investment versus acquisition

• 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 costly.

How to Invest Abroad: strategic alliance

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.

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

Foreign Direct Investment Originating in Developing Countries

• The Boston Consulting Group has identified six major corporate strategies employed by these emerging market MNEs1. Taking brands global2. Engineering to innovation3. Leverage natural resources4. Export business model5. Acquire offshore assets6. Target a niche

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

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 riskPolitical risk analysis is still an emerging field, though firms need to attempt to conduct this analysis

Firm-Specific Risks: BP Global oil spilt

• 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

Firm-Specific Risks

• Negotiating Investment AgreementsAn 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 governments of host countries

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

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

Operating Strategies after the FDI Decision

• Some key areas of consideration include:1. Local sourcing2. Facility location3. Control of transportation4. Control of technology5. Control of markets6. Brand name and trademark control7. Thin equity base8. Multiple-source borrowing

Country-Specific Risk: Transfer Risk

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

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

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

Exhibit 18.6 Management Strategies for Country-Specific Risks

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:

1. Differences in allowable ownership structures

2. Differences in human resource norms

3. Differences in religious heritage

4. Nepotism and corruption in the host country

5. Protection of intellectual property rights

6. Protectionism

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Global-Specific Risks• The most visible recent risk was 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 anti-globalization movement, environmental concerns, poverty in emerging markets, etc

• IKEA and Tetra Pak

Exhibit 18.7 Management Strategies for Global-Specific Risks

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

Exhibit 18.4 Emerging Market Multinationals and Their Global Strategies

Exhibit 18.5 Classification of Political Risks

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