Foreign Direct Investment (FDI) Theory and Political Risk
Slide 2
Chapter Outline Foreign Direct Investment (FDI) Global Trends
in FDI Why Do Firms Invest Overseas? FDI Sequence and Entry Mode
Political Risk Firm-specific risk Country-specific risk
Global-specific risk 2
Slide 3
FOREIGN DIRECT INVESTMENT 3
Slide 4
Global Trends in FDI Several developed nations are the sources
of FDI outflows. Most world-wide FDI comes from the developed
world. This implies that MNCs domiciled in these countries should
have certain comparative advantages in undertaking overseas
investment projects. Both developing and developed nations are the
recipient of inflows of FDI. Some developing countries, like China
and Mexico, have begun to undertake FDI, albeit on a modest scale.
4
Slide 5
Average Annual FDI (in US$ billion) 2004-2008 5
Slide 6
Foreign Direct Investment as a Percentage of GDP 6
Slide 7
Cross- Border Mergers and Acquisitions, 1990 2009 (in millions
of dollars) 18-7
Slide 8
Why Do Firms Invest Overseas? Trade barriers Labor market
imperfections Intangible assets Vertical integration Product life
cycle Shareholder diversification 8
Slide 9
Why Do Firms Invest Overseas? Trade Barriers Government action
leads to market imperfections. Tariffs, quotas, and other
restrictions on the free flow of goods, services, and people. The
Commerce Department of U.S., in its finding over illegal subsidies,
said solar panels imported from China now dominating the U.S.
market would face a duty of 2.9% to 4.73%. (March 12, 2012, LA
Times) Trade restrictions on Honda-made cars. France imposes on
Lockheed missiles to protect its own defense industry. Trade
barriers are pro-producers but anti-consumers. 9
Slide 10
Why Do Firms Invest Overseas? Trade Barriers - Purposes To
protect domestic employment Auto industry in Detroit, Steel
industry To protect consumers Mad cow diseases To enhance national
security Defense-related industries To retaliate Trade wars 10
Slide 11
Why Do Firms Invest Overseas? Labor Market Imperfections Among
all factor markets, the labor market is the least perfect. Recall
that the factors of production are land, labor, capital, and
entrepreneurial ability. Example: Outsourcing in India for
technicians and engineers, Nike factory in China, Apple assembly
line in China If there exist restrictions on the flow of workers
across borders, then labor services can be underpriced relative to
productivity. The restrictions may be immigration barriers or
simply social preferences. 11
Slide 12
Labor Costs around the Globe (2008) Country Average Hourly Cost
($)Country Average Hourly Cost ($) Germany$41.46Spain$23.61
Belgium$39.22Korea$13.82 Sweden$38.08Israel$13.91
U.K.$28.22Taiwan$6.95 Australia$31.51Hong Kong$5.78
Canada$29.72Brazil$5.96 Italy$31.11Mexico$2.93
France$31.60Philippines$1.10 U.S.$25.33China$0.81 Japan $22.90
12
Slide 13
Hourly Compensation Costs in Manufacturing Selected Countries,
in U.S. dollars, 2009 13
Slide 14
Why Do Firms Invest Overseas? Intangible Assets Coca-Cola has a
very valuable asset in its closely guarded secret formula. To
protect that proprietary information, Coca-Cola has chosen FDI over
licensing. Licensing may facilitate technologies leakages to
foreign competitors. Since intangible assets are difficult to
package and sell to foreigners, MNCs often enjoy a comparative
advantage with FDI. Patents, inventions, formulas, designs,
copyrights, and trademarks 14
Slide 15
Why Do Firms Invest Overseas? Vertical Integration MNCs may
undertake FDI in countries where inputs are available in order to
secure the supply of inputs at a stable accounting price. Vertical
integration may be backward or forward: Backward: e.g., a furniture
maker buying a logging company. Forward: e.g., a U.S. auto maker
buying a Japanese auto dealership. 15
Slide 16
Why Do Firms Invest Overseas? Product Life Cycle In the early
stage, the pioneering U.S. firm produces domestically. FDI takes
place when product maturity hits and cost becomes an increasingly
important consideration for the MNC. U.S. firms develop new
products in the developed world for the domestic market, and then
markets expand overseas. 16
Slide 17
Why Do Firms Invest Overseas? Product Life Cycle Quantity The
U.S. Less advanced countries production New product Maturing
product Standardized product exports consumption imports production
imports exports 17
Slide 18
Why Do Firms Invest Overseas? Shareholder Diversification Firms
may be able to provide indirect diversification to their
shareholders through FDI if there exists significant barriers to
the cross-border flow of capital for individual investors. When a
firm holds assets in many countries through FDI, cash flows are
internationally diversified. Thus, shareholders indirectly benefit
from international diversification However, capital markets across
countries are increasingly integrated and market imperfections are
less severe now. Managers, therefore, probably cannot add value by
diversifying for their shareholders, if the shareholders can do so
themselves at lower cost. 18
Slide 19
Competitive Advantage In deciding whether to invest abroad,
management must first determine whether the firm has a sustainable
competitive advantage. 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. Economies of
scale and scope Managerial and marketing expertise Advanced
technology / Differentiated products Financial strength 19
Slide 20
Competitive Advantage Economies of scale and scope: Large size
is a major contributing factor Managerial and marketing expertise:
Includes skill in managing large industrial organizations (human
capital and technology) Advanced technology / Differentiated
products: Includes both scientific and engineering skills Such
products originate from research-based innovations or heavy
marketing expenditures to gain brand identification Financial
strength: Demonstrated financial strength by achieving and
maintaining a global cost and availability of capital in order to
fund FDI and other foreign activities 20
Slide 21
Global 100 by CNNMoney 21
Slide 22
The FDI Sequence 22
Slide 23
How to Invest Abroad: Modes of Foreign Investment Exporting
versus production abroad: Several advantages to limiting a firms
activities to exports 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 (i.e., starting
costs) is typically lower than other modes of foreign involvement
Firms facing highly uncertain demand abroad typically being by
exporting rather than producing abroad Some disadvantages of
exports include The inability to realize the full sales potential
of a product The risks of losing markets to imitators and global
competitors Losing the opportunity to show a greater commitment to
the local market A high transportation cost and tariffs 23
Slide 24
How to Invest Abroad: Modes of Foreign Investment Licensing
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 Example: The beer, brewed in U.S.
license by Miller Brewing Company, is a brand owned by the German
firm. Example: Calvin Klein brand names used by local producer in
Thailand However, there are disadvantages which include: License
fees are lower than FDI profits Possible loss of quality control
Risk that technology will be stolen by potential competitor in the
local market 24
Slide 25
TOP 100 Licensors 1 Disney Consumer Products 2 Phillips-Van
Heusen 3 Warner Bros. Consumer Products 7 Major League Baseball 9
Cherokee Group 11 General Motors 13 Westinghouse 16 Mattel Brands
Consumer Products 18 Sony Pictures Consumer Products 25 Sunkist
Growers 27 BBC Worldwide 28 Liz Claiborne 29 Perry Ellis
International Inc. Source: licensemag.com 25
Slide 26
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 Some countries do not allow 100% foreign ownership Local
partners have their own contacts and reputation which aids in
business Example: Sony-Ericsson on electronics, GE-Toshiba on
nuclear energy 26
Slide 27
How to Invest Abroad: Modes of Foreign Investment Joint venture
versus wholly owned subsidiary: Some disadvantages of joint venture
partner are: Political risk is increased if the wrong partner is
chosen. Control of financing is another problem. Often, local and
foreign partners may have divergent views about all strategic
decision, operation, and distributing profits. 27
Slide 28
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 A cross-border acquisition is clearly much quicker and
can also be a cost effective way to obtain technology and/or brand
names - Purchase of existing business. Represents 40-50% of FDI
flows. Cross-border acquisitions are however, not without pitfalls,
as firms often pay too high a price or utilize expensive financing
to complete a transaction Cross-border acquisitions are a
politically sensitive issue: Greenfield investment is usually
welcome. Cross-border acquisition is often unwelcome. 28
Country Risk Analysis The assessment of the potential risks and
rewards associated with making investments and doing a business in
a country. It involves with measuring Political stability Frequency
of changes of government, the level of violence in the country,
corruption Economic factors Inflation, BOP deficits, GDP growth
Subjective factors A general perception of the countrys attitude
toward private enterprise Political risk and uncertain property
rights Government expropriation Capital flight The export of
savings by a nations citizens because of fears about the safety of
their capital 31
Slide 32
32 Country Risk Ratings Across Countries Source: Transparency
International is a global civil society organization that has
developed a Corruption Perceptions Index, which represents the
perception of corruption in a countrys public sector. The index
relies on assessments and business surveys by institutions.
Slide 33
Corruption Index Ratings for Selected Countries (Maximum rating
= 10. High ratings indicate low corruption.) 33
Slide 34
Corruption Perceptions Index The index, which is published by
Transparency International, reflects the degree to which corruption
is perceived to exist among public officials and politicians. In
2001, 91 countries are ranked on a clean score of 10. Rank Country
Score 1Finland9.9 3New Zealand9.4 4Singapore9.2 7Canada8.9
13U.K.8.3 14Hong Kong7.9 16Israel7.6 16U.S.A.7.6 18Chile7.5
20Germany7.4 21Japan7.1 Rank Country Score 23France6.7
26Botswana6.0 27Taiwan5.9 38South Africa 4.8 42South Korea4.2
46Brazil4.0 51Mexico3.7 57Argentina3.5 57China3.5 79Russia2.3
88Indonesia1.9 34
Slide 35
Legal System Quality 35
Slide 36
Sovereign Credit Ratings by Standard & Poors 36
Slide 37
Country Rating Moodys (2013)
CountryRatingCountryRatingCountryRatingCountryRating ArgentinaB3
Hong Kong Aa1NetherlandAaaSpainBaa3 AustraliaAaaIndiaBaa3 New
Zealand AaaSwitzerlandAaa AustriaAaaIndonesiaBaa3NorwayAaaSwedenAaa
BelgiumAa3IrelandBa1PortugalBa3TaiwanAa3
CanadaAaaItalyBaa2PhilippineBa1ThailandBaa1 DenmarkAaaJapanAa3S.
AfricaBaa1TurkeyBa1 FinlandAaaMalaysiaA3S. KoreaAa3U.S.Aaa
FranceAa1MexicoBaa1SingaporeAaaU.K.Aa1 GermanyAaa 37
Slide 38
Classification of Political Risks 38
Slide 39
Defining Political Risk Political risk The risk of loss when
investing in a given country caused by changes in a country's
political structure or policies, such as tax laws, tariffs, credit
risk, legal protection, expropriation of assets, or restriction in
repatriation of profits. Classifications Firm-specific risks
Country-specific risks Global-specific risks 39
Slide 40
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 Examples:
Price controls by the local government, Limited access to
host-country capital market, Discriminatory taxation on foreign
company Expropriation 40
Slide 41
Examples The WSJ reports in December 23, 2009 Hanoi Weighs
Price Controls, Tightens Grip Foreign Investors Grow Concerned as
Conservative Factions in Vietnam Reverse Liberalization Trend Amid
Downturn In December 2004, the U.S. Department of Commerce
published the report of Pharmaceutical Price Controls in OECD
Countries: Implications for U.S. Consumers, Pricing, Research and
Development, and Innovation In January 2010 the government of
Pakistan threatened to cancel the $3 billion Reko Diq copper and
gold project led by Canadian investor Barrick Gold 41
Slide 42
Country-Specific Risk Country-specific risks affect all firms,
domestic and foreign, that are resident in a host country The main
country-specific political risks transfer risk and cultural and
institutional risks 42
Slide 43
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 That is, it involves
uncertainty regarding cross-border flows of capital. 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 43
Slide 44
Country-Specific Risk: Cultural and Institutional Risks
Examples Differences in allowable ownership structures Japan,
Korea, Mexico, and China require majority local ownership U.S.
protection over defense-related firms such as Boeing. Differences
in human resource norms Female employees in Middle Eastern
countries Differences in religious heritage Nepotism and corruption
in the host country Indonesia under Suharto government, U.S defense
industry Protection of intellectual property rights Music copyright
infringement in China and Korea Protectionism Defense and
Agricultural industries 44
Slide 45
Differences in Religious Heritage 45
Slide 46
Intellectual Property Infringement In China, Fake louis vuitton
in Korea, Replica Rolex in ebay 46
Slide 47
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 antiglobalization
movement, environmental concerns, poverty in emerging markets and
cyber attacks on computer information systems 47
Slide 48
Antiglobalization Movement 48
Slide 49
Global-Specific Risk 49
Slide 50
Variables used in PRSs Political Risk Score 50
Slide 51
Political Risk Points by Component 51
Slide 52
Current Risk Ratings and Composite Risk Forecasts 52
Slide 53
The ICRG Risk Components 53
Slide 54
Country and Political Risk Ratings for Selected Countries
54
Slide 55
Measuring Political Risk The host countrys political and
government system A country with too many political parties and
frequent changes of government is risky. The track records of
political parties and their relative strength If the socialist
party is likely to win the next election, watch out. 55
Slide 56
Measuring Political Risk Integration into the world system
North Korea and Iran are examples of isolationist countries
unlikely to observe the rules of the game. Ethnic and religious
stability Look at recent genocides around the world. Regional
security Kuwait is a nice enough country, but its in a rough
neighborhood. 56
Slide 57
Measuring Political Risk Key economic indicators Political risk
is not entirely independent of economic risk. Severe income
inequality and deteriorating living standards can cause major
political disruptions. In 2002, Argentinas protracted economic
recession led to the freezing of bank deposits, street riots, and
three changes of the countrys presidency in as many months. 57
Slide 58
Hedging Political Risk Geographic diversification Simply put,
dont put all your eggs in one basket. Minimize exposure Form joint
ventures with local companies. Local government may be less
inclined to expropriate assets from their own citizens. Join a
consortium of international companies to undertake FDI. Local
government may be less inclined to expropriate assets from a
variety of countries all at once. Finance projects with local
borrowing. 58
Slide 59
Hedging Political Risk Insurance The Overseas Private
Investment Corporation (OPIC), a U.S. government federally-owned
organization, offers insurance against: 1.The inconvertibility of
foreign currencies. 2.Expropriation of U.S.-owned assets.
3.Destruction of U.S.-owned physical properties due to war,
revolution, and other violent political events in foreign
countries. 4.Loss of business income due to political violence.
59
