Chapter 16 Foreign Direct Investment and Political Risk

Sustaining and Transferring Competitive Advantage

-To invest abroad, firm must first determine the competitive advantage that enables it to compete
effectively in home market.

Competitive advantage must be

-Firm-specific

-Transferable

-Powerful enough to compensate the firm for the extra difficulties of operating abroad.

Examples of CA enjoyed by MNES

-Managerial and marketing expertise

-Advanced technology

-Differentiated products

-Economies of scale and scope

-Financial strength

-Competitiveness of their home market

Determinants of National Competitive Advantage

(i) Factor conditions

-(Factors of production-land , labor , capital ,technology can provide specific labor skill sets or
complex technology support)

(ii) Demand Conditions

(The nature of local customers-demanding,diligent,sophisticated focused on specific issues of quality

or safety to build competitiveness)

(iii) Related Industries

(Integration of related suppliers and partner firms, including government is advantaged)

(iv) Firm strategy, Structure and Rivalry

(adapt to local markets by altering strategy and structure to find the best fit for profitable growth)

The OLI Paradigm & Internationalization

OLI Paradigm

O-Owner specific

-framework to explain why FDI are chosen by MNEs rather than licensing, joint ventures, strategic
alliances, management contracts or exporting.

-states that firm must first have some competitive advantage in its home market which can be
transferred abroad.
L-Location specific

-allow the firm to exploit its competitive advantages in market

I-Internalization

-maintain its CA by attempting to control the entire value-chain in its industry.

Financial Strategies

(i) Proactive Financial Strategies

-Strategies to gain advantage from lower global costs
-Greater availability of capital
-Negotiating financial subsidies or tax breaks to enhance cash flow
-Reduce financial agency costs/operating transaction exposure through FDI

(ii) Reactive Financial Strategies

-depend on market imperfections.

Deciding Where To Invest

(i) Behavioural Approach

-firm invest first in countries nearer to them.
-similar cultural, legal and institutional environments to their own.

(ii) Network perspective

-As MNEs grow, they become a network that operate either in a centralized hierarchy or
a decentralized one.
-Each subsidiary competes for funds from the parent.
-The firm becomes a transnational firm.

Modes of FDI
(i) Exporting
Advantage
Minimal political risks
Avoids agency costs and evaluating foreign units
None of the unique risks facing FDI ,joint ventures ,strategic alliances and
licensing.
Disadvantage
Firm is not able to internalize and exploit its advantages.
Risks losing market to imitators and global competitors.

(ii) Licensing
Advantage
No need to commit sizable funds.
Disadvantage
License fees are likely lower than FDI profits although ROI may be higher
Possible loss of quality control
High agency costs
Establishment of potential competitor (even at home)
Risk stolen technology

(iii) Joint ventures

Advantage
Local partner understands the market and provide competent management at
all levels.
Required by host countries.
Access to technology appropriate for the market.
The local partner’s contacts and reputation.
Disadvantage
Inability of a firm to rationalize production on a worldwide basis.
Conflict of interest (transfer pricing)
Political risk is increased if wrong partner is chosen.
Divergent views on strategy and financing issues.
Financial disclosure between local partner and firm.
Valuation of equity shares is difficult.

(iv) Greenfield investment- establishing a facility “starting from the ground up”
Acquisition will be better because the physical assets already exist, shorter time
frame and financing exposure.
Problems: intergration, paying too much for acquisition, post-merger
management and realization of synergies all exist.

(v) Strategic alliances

-exchange of ownership between two firms.
-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.

THE FDI SEQUENCE: FOREIGN PRESENCE AND FOREIGN INVESTMENT

Predicting political risk

Macro level: prior to under-taking foreign direct investment, firms attempt to
assess a host country’s political stability and attitude toward foreign investors.
Micro level: firms analyse whether their firm-specific activities are likely to
conflict with host-country goals as evidenced by existing regulations.
Firm-specific risks
Country-specific risks
Global-specific risks
Classification of political risks
Predicting firm- Predicting Predicting global- Governance
specific risk country-specific specific risk risks
risk
-Different foreign -Political risk -Even more hard -Ability to
firms operating analysis is still an to be predicted. exercise
within the same emerging field, effective
country may have though firms control over
very different need to attempt MNEs
degrees of to conduct this operations
vulnerability to analysis within a host
changes in host- country’s
country policy or legal and
regulations political
environment
-Conflicts of
interest
between
objectives of
MNEs and
host
governments
are common
-The best
approach to
conflict
management
is to
anticipate
problems and
negotiate
understanding
ahead of time

Firm-Specific Political Risk

-Spell out the rights and responsibilities of both the foreign firm and the host
government
-Spell out policies on financial and managerial issues: dividends, royalty fees,
loan repayments, transfer prices, provision for arbitration, etc.
-The presence of MNEs is as often sought by development-seeking host
governments

Investment insurance and guarantees

-MNEs can sometimes transfer political risk through an investment insurance
agency
-The US investment insurance and guarantee program is managed by the
Overseas Private Investment Corporation (OPIC)
-It’s purpose is to mobilize and facilitate US private capital and skills in the
economic development of less developed countries
-OPIC
Inconvertibility - not being able to convert remittances into dollars
Expropriation – government seizing the assets
War, revolution & insurrection
Business income –loss of income due to events from political violence that
directly affect the company & its assets

Although FDI creates obligations on the part of the foreign subsidiary and host
government, conditions change and MNEs must be able to adapt.

There are several strategies that MNEs can undertake to anticipate changing
conditions or host government’s future actions and negotiate these terms.
-Local sourcing
-Facility location

Consideration for firm-specific political risk

-Control of transportation – important for oil and pipeline companies
-Control of technology – patents and intellectual property
-Control of markets – bargaining power
-Brand name & trademark control
-Thin equity base – large proportion of local debt
-Multiple-source borrowing – various banks and countries

Main risks
-Transfer risk
-Cultural and Institutional risk

React to potential transfer risk at three stages

-Prior to making the investment
-During operations
-Funds that cannot be moved must be reinvested in the local country to avoid
deterioration in real value
Country-specific risks: transfer risk
Fronting loans - parent-to-subsidiary loan channeled through a financial intermediary
-The lending parent deposits the funds in a bank, let’s say in London
-That bank in turn “loans” this amount to the borrowing subsidiary
-In essence, the bank “fronts” for the parent

Creating unrelated exports

-Due to the host country’s inability to earn hard currency, anything MNEs can do to
generate export sales helps the host country
Special dispensation
-If the firm is in an important industry for the development of the host country, it may
bargain for a special dispensation to repatriate some funds