Foreign Direct Investment Theory and Political Risk Multinational 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

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. “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, monopoly?)

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.

Exh. 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 possibly lower than FDI Possible loss of quality control Establishment of a potential competitor in third-country markets Risk that technology will be stolen

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

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: Strategic options. Better understanding of local customs, mores and institutions. Providing for capable mid-level management. (Local market). Some countries do not allow 100% foreign ownership. (Regulations). Local partners have their own contacts and reputation which aids in business. (local knowledge)

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 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 more 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.

Articles of Internationalization process of the firm: Internationalization process of the firm: Progression through internationalization, exploitative and exploratory learning. By Pieter Pauwels, Tinne Lommelen and Paul Mattyssens 2004

FDI 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

FDI 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 market

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

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 risk Political 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 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 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: Local sourcing Facility location Control of transportation Control of technology Control of markets Brand name and trademark control Thin equity base 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: 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

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

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