Foreign Direct Investment and Political Risk International Financial Management Dr. A. DeMaskey

Learning Objectives How do firms become multinational? Why do firms locate production overseas? What is country risk? Political risk? How do we measure political risk?

How Do Firms Become MNCs? Exporting/Importing Licensing Franchising Joint Ventures Acquisitions De Novo Start Up Low Risk/Low Return Strategy (early phase) (intermediate phase) High Risk/High Return Strategy (advanced phase) Foreign Direct Investment

Global Trends in FDI Total annual worldwide FDI flows of $830 billion FDI Outflows Strong preference to invest in developed countries Biggest targets are U.K. and Germany Comparative advantages FDI Inflows U.S. is an attractive source of FDI Other popular destinations include China, Mexico, and Spain Locational advantages

Why Do Firms Invest Overseas? Market Imperfections (Kindleberger (1969) and Hymer (1975)) Imperfections in Product Markets Factor Markets Capital Markets

Key Factors in Locating Production Overseas Trade Barriers Imperfect Labor Markets Intangible Assets Vertical integration Product Life Cycle Capital Market Imperfections Market Failure Imperfections

Hourly Labor Costs in the Manufacturing Sector (2001)

Political Risk and FDI Risk of loss to the parent firm due to adverse political developments in the host country. Outright expropriation Unexpected changes in tax laws

Types of Political Risk Depending on incidence: Macro risk Micro risk Depending on manner: Transfer risk Operational risk Control risk

Examples of Political Risk China in 1949 Cuba in 1960 Egypt in the early 1950s

Key Factors in Political Risk Analysis Host country’s political and government system Track records of political parties and their relative strength Integration into the world system Host country’s ethnic and religious stability Regional security Key economic indicators Capital flight POR Index

Measuring Political Risk In-house experts Outside experts; Morgan Stanley provides in-depth analysis of country/political risks Euromoney provides country ratings by Political risk Credit risk Economic performance

Economic and Political Factors Underlying Country Risk Fiscal irresponsibility Monetary instability Controlled exchange rate system Wasteful government spending Quality of natural, human, and financial resources Adjustment to external shocks Market-oriented vs. statist policies

Useful Web Sites for Assessing Country Risk What are the political and financial outlook for various countries? Consult the Country Commercial Guides prepared by embassy staff at http://www.usatrade.gov/website/ccg.nsf/ccghomepage?openform. Refer to the CIA’s World Factbook at http://www.odci.gov/. Visit http://biz.yahoo.com/ifc/ More …

Useful Web Sites for Assessing Country Risk How risky is your country? Look up: http://www.worldbank.org/data/wdi2001/pdfs/tab5_2.pdf http://www.prsgroup.com/icrg/icrg.html http://www.institutionalinvestoronline.com/ http://www.euromoney.com/ http://www.moodys.com/moodys/cust/loadBusLine.asp?busLine=sovereign http://www.standardpoor.com/