Presentation on theme: "Foreign Direct Investment Theory and Political Risk"— Presentation transcript:
1 Foreign Direct Investment Theory and Political Risk Multinational Finance
2 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.
3 Sustaining and Transferring Competitive Advantage Economies of scale and scope:Can be developed in production, marketing, finance, research and development, transportation, and purchasingLarge 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
4 Sustaining and Transferring Competitive Advantage Advanced technology:Includes both scientific and engineering skillsFinancial strength:Demonstrated financial strength by achieving and maintaining a global cost and availability of capitalThis is a critical competitive cost variable that enables them to fund FDI and other foreign activities
5 Sustaining and Transferring Competitive Advantage Differentiated products:Firms create their own firm-specific advantages by producing and marketing differentiated productsSuch products originate from research-based innovations or heavy marketing expenditures to gain brand identificationCompetitiveness of the home market:A strongly competitive home market can sharpen a firm’s competitive advantage relative to firms located in less competitive onesThis phenomenon is known as the diamond of national advantage and has four components
6 Exhibit 18.1 Determinants of National Competitive Advantage: Porter’s Diamond
7 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)
8 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.
9 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.
10 Exhibit 18.3 The FDI Sequence: Foreign Presence and Foreign Investment
11 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 risksThe amount of front-end investment is typically lower than other modes of foreign involvementSome disadvantages include the risks of losing markets to imitators and global competitors
12 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 fundsHowever, there are disadvantages which include:License fees are lower than FDI profitsPossible loss of quality controlEstablishment of a potential competitor in third-country marketsRisk that technology will be stolen
13 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 exposureManagement contracts probably lessen political risk because the repatriation of managers is easyInternational consulting and engineering firms traditionally conduct their foreign business on the basis of a management contract
14 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 businessSome advantages of a MNE working with a local joint venture partner are:Better understanding of local customs, mores and institutions of governmentProviding for capable mid-level managementSome countries do not allow 100% foreign ownershipLocal partners have their own contacts and reputation which aids in business
15 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 chosenDivergent views about the need for cash dividends, or the best source of funds for growth (new financing versus internally generated funds)Transfer pricing issuesDifficulties in the ability to rationalize production on a worldwide basis
16 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 upCompared 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 namesCross-border acquisitions are however, not without pitfalls, as firms often pay too high a price or utilize expensive financing to complete a transaction
17 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 serviceAnother level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets.
18 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 MNEsThese MNEs have not only captured large shares of their home markets, but also have tapped global markets where they are increasingly competitive
19 Foreign Direct Investment Originating in Developing Countries The Boston Consulting Group has identified six major corporate strategies employed by these emerging market MNEsTaking brands globalEngineering to innovationLeverage natural resourcesExport business modelAcquire offshore assetsTarget a niche
20 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 includeFirm-specific risksCountry-specific risksGlobal-specific risks
21 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 investorsAt the micro level, firms analyze whether their firm-specific activities are likely to conflict with host-country goals as evidenced by existing regulations
22 Predicting firm-specific risk Predicting RisksPredicting firm-specific riskDifferent foreign firms operating within the same country may have very different degrees of vulnerability to changes in host-country policy or regulationsPredicting country-specific riskPolitical risk analysis is still an emerging field, though firms need to attempt to conduct this analysis
23 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 environmentHistorically, 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
24 Negotiating Investment Agreements Firm-Specific RisksNegotiating Investment AgreementsAn investment agreement spells out specific rights and responsibilities of both the foreign firm and the host governmentThe presence of the MNE is as often sought by development-seeking host governmentsAn investment agreement should define policies on a wide range of financial and managerial issues
25 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 changesThe 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
26 Operating Strategies after the FDI Decision Some key areas of consideration include:Local sourcingFacility locationControl of transportationControl of technologyControl of marketsBrand name and trademark controlThin equity baseMultiple-source borrowing
27 Country-Specific Risk: Transfer Risk Country-specific risks affect all firms, domestic and foreign, that are resident in a host countryThe main country-specific political risks are transfer risk and cultural and institutional risks
28 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 restrictionsWhen 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
29 Exhibit 18.6 Management Strategies for Country-Specific Risks
30 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 structuresDifferences in human resource normsDifferences in religious heritageNepotism and corruption in the host countryProtection of intellectual property rightsProtectionism
31 Global-Specific Risks Global specific risks faced by MNEs have come to the forefront in recent yearsThe 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
32 Exhibit 18.7 Management Strategies for Global-Specific Risks
33 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?
34 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?
35 Exhibit Finance-Specific Factors and the OLI Paradigm (“X” indicates a connection between FDI and finance-specific strategies)
36 Exhibit 18.4 Emerging Market Multinationals and Their Global Strategies