Chapter 18

Foreign Direct Investment Theory and Political Risk

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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.

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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

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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
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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 firms competitive advantage relative to firms located in less competitive ones This phenomenon is known as the diamond of national advantage and has four components

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Exhibit 18.1 Determinants of National Competitive Advantage: Porters Diamond

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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)

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Exhibit 18.2 Finance-Specific Factors and the OLI Paradigm (X indicates a connection between FDI and finance-specific strategies)

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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 firms hurdle rate. In practice, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm.

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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 firms hurdle rate.

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Exhibit 18.3 The FDI Sequence: Foreign Presence and Foreign Investment

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How to Invest Abroad: Modes of Foreign Investment

Exporting versus production abroad:
There are several advantages to limiting a firms 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

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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 funds

However, there are disadvantages which include:

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

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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 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

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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 business
Some advantages of a MNE working 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
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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 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

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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 up
Compared to a greenfield investment, a crossborder 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
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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 service Another level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets.

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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
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Exhibit 18.4 Emerging Market Multinationals and Their Global Strategies

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Foreign Direct Investment 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
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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

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Exhibit 18.5 Classification of Political Risks

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Assessing Political Risk

At the macro level, prior to under-taking foreign direct investment, firms attempt to assess a host countrys 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

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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

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Firm-Specific Risks
Governance risks
Governance risk is the ability to exercise effective control over an MNEs operations within a host countrys legal and political environment Historically, conflicts of interest between objectives of MNEs and host governments have arisen over such issues as the firms 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

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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 host governments
An investment agreement should define policies on a wide range of financial and managerial issues

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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

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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

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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

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Country-Specific Risk: Transfer Risk

Transfer risk is defined as limitations on the MNEs 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

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Exhibit 18.6 Management Strategies for Country-Specific Risks

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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

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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, 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

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Exhibit 18.7 Management Strategies for Global-Specific Risks

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Mini-Case Questions: Mattels Chinese Sourcing Crisis of 2007

Mattels 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?

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Mini-Case Questions: Mattels Chinese Sourcing Crisis of 2007 (contd)

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?

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Chapter 18

Additional Chapter Exhibits

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

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