Download Firm-Specific Risks

Chapter 18
Foreign Direct
Investment
Theory and
Political Risk
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18.1 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 six advantages enjoyed by MNEs.
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Six advantages enjoyed by MNEs
• 1. 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)
• 2. 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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Six advantages enjoyed by MNEs
• 3. Advanced technology:
– Includes both scientific and engineering skills
• 4. 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
• 5. 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
• 6. 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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18.2 The OLI Paradigm and
Internalization
• The OLI Paradigm… why MNEs choose FDI rather than joint
ventures 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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18-7
18.3 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.
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Where to Invest?
• 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 riskadjusted 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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18.4 How to Invest Abroad:
Modes of Foreign Investment
• Ⅰ. Exporting versus production abroad:
– Advantages …none of the unique risks facing
FDI with minimal political risks
– The amount of front-end investment is typically
lower
– Disadvantages … losing markets to imitators
and global competitors
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Ⅱ. Licensing and management contracts
versus control of assets abroad
– method for domestic firms to profit from foreign
markets without the need to commit sizeable
funds
– Disadvantages :
• 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(P.459)
– similar to licensing without significant
foreign investment or exposure
– lessen political risk because the
repatriation of managers is easy
– International consulting and engineering
firms conduct on the basis of a
management contract
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Ⅲ. Joint venture versus wholly owned
subsidiary:
– Advantages 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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Ⅲ.Joint venture versus wholly
owned subsidiary:
– joint venture’s potential conflicts or difficulties
• 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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Ⅳ. Greenfield investment versus
acquisition:
– A greenfield investment is defined as
establishing a production or service
facility starting from the ground up
– 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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strategic alliance:different meanings
• 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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18.5 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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18.6 Six Corporate Strategies by
MNES
• Six corporate strategies by MNEs
– 1. Taking brands global
– 2. Engineering to innovation
– 3. Leverage natural resources
– 4. Export business model
– 5. Acquire offshore assets
– 6. Target a niche
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18.6 Defining Political Risk
–Firm-specific risks
–Country-specific risks
–Global-specific risks
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18.7 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
• Ⅰ. Predicting firm-specific risk (Micro Risk)
• Ⅱ. Predicting country-specific risk (Macro
Risk)
• Ⅲ. Predicting Global specific risks
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18.8 Ⅰ. Firm-Specific Risks
• ①. 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
• ② 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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Firm-Specific Risks
• ② Investment Insurance and Guarantees:
– OPIC
•1.Inconvertibility
•2.Expropriation
•3.War, revolution, insurrection, and
civil strife.
•4.Business income
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④ 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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18.9 Ⅱ(1) 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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18.10 Ⅱ(2) 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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18.11. Ⅲ 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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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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