Foreign Direct Investment Theory and Strategy Chapter 17 Foreign Direct Investment Theory and Strategy

Foreign Direct Investment Theory & Strategy: Learning Objectives Demonstrate how key competitive advantages support MNEs’ strategy to originate and sustain foreign direct investment Show how the OLI paradigm provides a theoretical foundation for the globalization process Identify factors and forces that must be considered in the determination of where MNEs’ invest Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Foreign Direct Investment Theory & Strategy: Learning Objectives Illustrate the managerial and competitive dimensions of the alternative methods for foreign investment Identify the strategies used by MNEs originating in developing countries to compete in global markets Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Market Imperfections: A Rationale for the MNE MNEs strive to take advantage of imperfections in national markets These imperfections for products translate into market opportunities such as economies of scale, managerial or technological expertise, financial strength and product differentiation Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Sustaining & 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 In order to sustain a competitive advantage it must be: Firm-specific Transferable Powerful enough to compensate the firm for the extra difficulties of operating abroad Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Sustaining & Transferring Competitive Advantage Some of the competitive advantages enjoyed by MNEs are: Economies of scale and scope Managerial and marketing expertise Advanced technology Financial strength Differentiated products Competitiveness of the their home market Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exhibit 17.1 Determinants of National Competitive Advantage: Porter’s Diamond Copyright © 2009 Pearson Prentice Hall. All rights reserved.

The OLI Paradigm & Internationalization The OLI Paradigm (Buckley & Casson, 1976; Dunning 1977) is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative modes such as licensing, joint ventures, strategic alliances, management contracts and exporting The paradigm states that a firm must first have some competitive advantage in its home market - “O” or owner-specific – which can be transferred abroad Copyright © 2009 Pearson Prentice Hall. All rights reserved.

The OLI Paradigm & Internalization The firm must also be attracted by specific characteristics of the foreign market – “L” or location specific – which will allow the firm to exploit its competitive advantages in that market Third,the firm will maintain its competitive position by attempting to control the entire value-chain in its industry – “I” or internalization This leads to FDI rather than licensing or outsourcing Copyright © 2009 Pearson Prentice Hall. All rights reserved.

The OLI Paradigm & Internalization Financial strategies are directly related to the OLI Paradigm in explaining FDI Strategies can be proactive , controlled in advance by the management team Strategies can also be reactive, depend on discovering market imperfections Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exhibit 17.2 Finance-Specific Factors and the OLI Paradigm: “X” indicates a connection between FDI and finance-specific strategies Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Where to Invest Two related behavioral theories behind FDI that are most popular are Behavioral approach to FDI International network theory Behavioral Approach – Observation that firms tended to invest first in countries that were not too far from their country in psychic terms This included cultural, legal, and institutional environments similar to their own Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Where to Invest International network theory – As MNEs grow they eventually become a network, or nodes that operate either in a centralized hierarchy or a decentralized one Each subsidiary competes for funds from the parent It is also a member of an international network based on its industry The firm becomes a transnational firm, one that is owned by a coalition of investors located in different countries Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How to Invest Abroad: Modes of FDI Exporting vs. production abroad Advantages of exporting are None of the unique risks facing FDI, joint ventures, strategic alliances and licensing Political risks are minimal Agency costs and evaluating foreign units are avoided Disadvantages are Firm is not able to internalize and exploit its advantages Risks losing market to imitators and global competitors Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How to Invest Abroad: Modes of FDI Licensing/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 sizable funds Disadvantages of licensing are License fees are likely lower than FDI profits although ROI may be higher Possible loss of quality control Establishment of potential competitor Possible improvement of technology by local license which then enters firm’s original home market Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How to Invest Abroad: Modes of FDI Possible loss of opportunity to enter licensee’s market with FDI later Risk that technology will be stolen High agency costs Management contracts are similar to licensing insofar as they provide for some cash flow from foreign source without significant investment or exposure These contracts lessen political risk because the repatriation of managers is easy Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How to Invest Abroad: Modes of FDI Joint ventures versus wholly owned subsidiary A joint venture is a shared ownership in a foreign business This is a viable strategy if the MNE finds the right local partner Some advantages include The local partner understands the market The local partner can provide competent management at all levels Some host countries require that foreign firms share ownership with local partner Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How to Invest Abroad: Modes of FDI Joint ventures versus wholly owned subsidiary Advantages of joint ventures The local partner’s contacts & reputation enhance access to host country’s capital markets The local partner may possess technology that is appropriate for the local environment The public image of a firm that is partially locally owned may improve its position Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How to Invest Abroad: Modes of FDI Joint ventures versus wholly owned subsidiary Disadvantages of joint ventures Political risk is increased if wrong partner is chosen Local and foreign partners have divergent views on strategy and financing issues Transfer pricing creates potential for conflict of interest Financial disclosure between local partner and firm Ability of a firm to rationalize production on a worldwide basis if that would put local partner at disadvantage Valuation of equity shares is difficult Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How to Invest Abroad: Modes of FDI Greenfield investment versus acquisition A greenfield investment is establishing a facility “starting from the ground up” Usually require extended periods of physical construction and organizational development Here, a cross-border acquisition may be better because the physical assets already exist, shorter time frame and financing exposure However, problems with integration, paying too much for acquisition, post-merger management, and realization of synergies all exist Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How to Invest Abroad: Modes of FDI Strategic alliances can take several different forms First is an exchange of ownership between two firms It can be a defensive strategy against a takeover In addition to exchanging shares, a separate joint venture can be developed Another level of cooperation may be a joint marketing or servicing agreement Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exhibit 17.3 The FDI Sequence: Foreign Presence and Foreign Investment Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Strategies Employed by Emerging Market MNEs Taking brands global Engineering to innovation Leverage natural resources Export successful business model Acquire offshore assets Target a market niche Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Exhibit 17.4 Emerging Market Multinationals and Their Global Strategies Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Summary of Learning Objectives In order to invest abroad a firm must have a sustainable competitive advantage in the home market. This must be strong enough and transferable to overcome the disadvantages of operating abroad Competitive advantages stem from economies of scale and scope, managerial and marketing expertise, differentiated products, and competitiveness of the home market The OLI Paradigm is attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through other methods Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Summary of Learning Objectives Finance-specific strategies are directly related to the OLI Paradigm, including both proactive and reactive strategies The decision about where to invest is influenced by economic and behavioral factors Psychic distance plays a role in determining the sequence of FDI Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Summary of Learning Objectives Most international firms can be viewed from a network perspective. The parent firm and each of the subsidiaries are members of the network Exporting avoids political risk but not foreign exchange risk. It requires the least up-front investment but it might eventually have lost those markets to competition Alternative modes of FDI exist, such as joint ventures, strategic alliances, licensing, management contracts, and traditional exporting Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Summary of Learning Objectives Licensing enables a firm to profit from foreign markets without a major up-front investment,however disadvantages include limited returns, possible loss of quality control, and potential to establish future competitor The success of a joint venture depends primarily on the right partner. For this reason a number of issues related to possible conflicts in decision making exist Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Summary of Learning Objectives Six major strategies used by emerging market MNEs are: Taking brands global Engineering to innovation Leverage natural resources Export successful business model Acquire offshore assets Target a market niche Copyright © 2009 Pearson Prentice Hall. All rights reserved.