Copyright © 2010 Pearson Prentice Hall. All rights reserved. Chapter 18 Foreign Direct Investment Theory and Political Risk

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 18.1 Determinants of National Competitive Advantage: Porter’s Diamond

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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)

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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 risk- adjusted return above the firm’s hurdle rate.

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 18.3 The FDI Sequence: Foreign Presence and Foreign Investment

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved Defining Political Risk –Firm-specific risks –Country-specific risks –Global-specific risks

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved Predicting Risks Ⅰ. Predicting firm-specific risk (Micro Risk) Ⅱ. Predicting country-specific risk (Macro Risk) Ⅲ. Predicting Global specific risks

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved. Firm-Specific Risks ② Investment Insurance and Guarantees: –OPIC 1.Inconvertibility 2.Expropriation 3.War, revolution, insurrection, and civil strife. 4.Business income 18-25

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 18.6 Management Strategies for Country-Specific Risks

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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, 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 18.7 Management Strategies for Global-Specific Risks

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 18.2 Finance-Specific Factors and the OLI Paradigm (“X” indicates a connection between FDI and finance-specific strategies)

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 18.4 Emerging Market Multinationals and Their Global Strategies

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 18.5 Classification of Political Risks

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 1 China-Manufactured Products Recalled by the U.S. Consumer Products Safety Commission between August 3 and September 6, 2007