Foreign Direct Investment Theory
and Political Risk
723g33
Multinational Finance
Yinghong.chen@liu.se
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 firm’s
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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Determinants of National Competitive Advantage: Porter’s
Diamond
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The OLI Paradigm: Why FDI?
• 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.
1. “O” owner-specific (competitive advantage in the home
market that can be transferred abroad)
2. “L” location-specific (specific characteristics of the foreign
market allow the firm to exploit its competitive
advantage)
3. “I” internalization (maintenance of its competitive
position by attempting to control the entire value chain in
its industry, monopoly?)
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Where to Invest?
• 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
firm’s 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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Exh. 18.3 The FDI Sequence: Foreign Presence and Foreign Investment
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How to Invest Abroad:
Exporting versus production abroad
 There are several advantages to limiting a firm’s
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:
Licensing and management contracts
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 possibly lower than FDI
• Possible loss of quality control
• Establishment of a potential competitor in thirdcountry markets
• Risk that technology will be stolen
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How to Invest Abroad:
Licensing and management contracts
• Management contracts are similar to licensing,
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: 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: Strategic options.
• Better understanding of local customs, mores and
institutions.
• Providing for capable mid-level management. (Local
market).
• Some countries do not allow 100% foreign ownership.
(Regulations).
• Local partners have their own contacts and reputation
which aids in business. (local knowledge)
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How to Invest Abroad: joint ventures
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: Greenfield
investment versus acquisition
• 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 more costly.
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How to Invest Abroad: strategic alliance
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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Articles of Internationalization
process of the firm:
• Internationalization process of the firm:
Progression through internationalization,
exploitative and exploratory learning.
By Pieter Pauwels, Tinne Lommelen and Paul
Mattyssens 2004
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FDI 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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FDI Originating in Developing Countries
• The Boston Consulting Group has identified six
major corporate strategies employed by these
emerging market MNEs
1. Taking brands global
2. Engineering to innovation
3. Leverage natural resources
4. Export business model
5. Acquire offshore assets
6. Target a niche market
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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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Assessing Political Risk
• At the macro level, prior to under-taking
foreign direct investment, firms attempt to
assess a host country’s 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: BP Global oil spilt
• Governance risks
• Governance risk is the ability to exercise effective
control over an MNEs operations within a host
country’s legal and political environment
• Historically, conflicts of interest between
objectives of MNEs and host governments have
arisen over such issues as the firm’s 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 governments of host
countries
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:
1. Local sourcing
2. Facility location
3. Control of transportation
4. Control of technology
5. Control of markets
6. Brand name and trademark control
7. Thin equity base
8. Multiple-source borrowing
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Country-Specific Risk: Transfer Risk
• Country-specific risks affect all firms, domestic
and foreign, that reside 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 MNE’s
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 CountrySpecific 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:
1. Differences in allowable ownership structures
2. Differences in human resource norms
3. Differences in religious heritage
4. Nepotism and corruption in the host country
5. Protection of intellectual property rights
6. Protectionism
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Global-Specific Risks
• The most visible recent risk was 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 anti-globalization movement,
environmental concerns, poverty in emerging
markets, etc
• IKEA and Tetra Pak
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Exhibit 18.7 Management Strategies for GlobalSpecific Risks
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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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Exhibit 18.4 Emerging Market Multinationals and Their Global
Strategies
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Exhibit 18.5 Classification of Political
Risks
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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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