Corporate Strategy: Foreign Direct Investment and Political Risk

Transcription

1 Corporate Strategy: Foreign Direct Investment and Political Risk 1 Foreign Direct Investment This chapter analyses the decision whether, where and how to undertake foreign direct investment (FDI). This chapter also describes political risks surrounding FDI and strategies that reduce this risk. 2 Foreign Direct Investment A FDI is an investment wherein the parent company maintains 100 percent operating control, takes responsibility for all the financing and takes all the risks involved in the project. Before investing abroad, it must be known whether the MNE has some sustainable competitive advantage that will enable it to produce returns that compensate for the extra risks from investing abroad (foreign exchange risk, political risk, agency costs). 3 Competitive Advantages Enjoyed by MNEs Economies of scale and Scope These can be developed in production, marketing, finance, research and development, transportation and purchasing. Large firms can advertise, distribute, and warehouse more efficiently. 1

2 Large firms have better access to funding such as Eurocurrency, Eurobonds and Euroequity. It is also possible for large firms to develop in-house research programs. 4 Competitive Advantages Enjoyed by MNEs Managerial and Marketing Expertise Multinational firms usually export to a market before establishing a production facility there. They also have prior experience in sourcing raw materials and human capital in other foreign countries through either imports, licensing or FDI. 5 Other Competitive Advantages Enjoyed by MNEs Technology Financial strength Differentiated products Competitiveness of the home market: Diamond of national advantage 6 The OLI Paradigm and Internationalization O stands for owner-specific advantages. Firms-specific, not copied. L stands for location-specific advantages. FDIs are attracted by market imperfections. I stands for Internationalization. Possession of proprietary information and control of the human capital that can generate new information through expertise and research. 2

3 7 Where to Invest In theory, the firm should 1. identify its competitive advantages; 2. search for markets with imperfection and possible comparative advantages; 3. select countries where its competitive advantages will produce returns that compensate for the risk involved. In practice, firms seem to follow behavioural approaches, one of them being called the internationalization process theory. 8 The Internationalization Process Theory The decision to invest abroad is simply a stage in the firm s development process. This decision often follows an outside proposal (e.g. government or a distributor of the firm s products) This decision may be due to the fear of losing a market. The bandwagon effect : If competitors are successful abroad, this type of investment is a must. 9 The Internationalization Process Theory The study of a large sample of Swedish MNEs has shown that 1. these firms tended to invest first in countries that were not too far in psychic term (cultural, legal and institutional environments similar to those of Sweden); 2. initial investments were modest in size; 3. once firms had learned from these investments, they were willing to take greater risks with respect to both (psychic) distance and size of investments. 3

4 10 Other Theories of FDI: Internalization Theory It can be advantageous to internalize trade of intermediate products and services within the firm. A firm looks to integration when the use of the market is costly and inefficient for undertaking certain types of transactions. A MNE will be formed when internalization occurs across borders. Example: Some OPEC oil companies have built or purchased refineries in the U.S. to be used in the process of bringing oil in the American market. 11 Other Theories of FDI: Imperfections in Securities Markets A FDI in a country with an illiquid securities market may be a good substitute to portfolio investment. Example: Heinz s operations in Zimbabwe. While Zimbabwe has no real securities market for portfolio investment, it has potential for high returns due to its arable land and welldeveloped road and rail systems. In 1982, Heinz acquired a family-owned vegetable oil and soap manufacturer in Zimbabwe, that subsequently produced Heinz tomato soup and baked beans, thus reaping Zimbabwe s high returns that were not accessible through stock exchanges. 12 Other Modes of Foreign Involvement An export or import operation based at home (least amount of risk): Requires no capital investment abroad but generally requires capital investment at home. A license or franchise agreement with a foreign firm or individual: Requires no capital investment either abroad or at home. Involves payments of royalties and fees. 4

5 Monitoring costs, costs of sharing corporate secrets with an outsider. Joint venture: Partnership with a foreign firm. Requires some capital commitment abroad, Strategic alliance: Cross-border exchange of share ownership. 13 Political Risk Management Different cultures apply different ethics to the question of honouring contracts, expecially if they were engotiated under a previous administration. An investment agreement spells out specific rights and responsibilities for both the foreign firm and the host government. The presence of MNEs in a country may arise from the local government s desire to increase foreign investment or from the MNE s desire to exploit the country s resources. 14 Political Risk Management: Investment Insurance MNEs can sometimes transfer political risk to a home-country public agency through an insurance or guarantee program. This agency usually ofers insurance for four separate types of political risk: Inconvertibility Expropriation War, revolution, insurrection and civil strife Business income 5

6 15 Operating Strategies after the FDI Decision Local sourcing Facility location Control of transportation, technology and markets Brand name and trademark control Thin equity base and multiple-source borrowing 6