Download CHAPTER 18

Foreign Direct Investment Theory
and Political Risk
723g33
Multinational 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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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
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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
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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
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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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How to Invest Abroad:
Modes of Foreign Investment
• 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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How to Invest Abroad:
Modes of Foreign Investment
– 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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How to Invest Abroad:
Modes of Foreign Investment
• 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:
Modes of Foreign Investment
– 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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How to Invest Abroad:
Modes of Foreign Investment
• 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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How to Invest Abroad:
Modes of Foreign Investment
• 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 CountrySpecific 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 GlobalSpecific 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, lowcost 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
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