Foreign Direct
Investment (FDI)
Theory and Political Risk
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
FOREIGN DIRECT
INVESTMENT
3
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
50
19.5
29.4
22.9
75.1
64.2
65.7
58.5
36.1
33.2
5.1
22.1
10.2
47.6
26.7
Outflows
129.6
137.2
106.7
150
33
148.8
200
93.5
79.5
51.8
48.3
100
22.7
10.8
24
250
Inflows
188.9
212.3
Average Annual FDI (in US$ billion)
2004-2008
0
5
Foreign Direct Investment as a
Percentage of GDP
6
CrossBorder
Mergers
and
Acquisitions
, 1990–
2009
(in millions
of dollars)
18-7
Why Do Firms Invest Overseas?
•
•
•
•
•
•
Trade barriers
Labor market imperfections
Intangible assets
Vertical integration
Product life cycle
Shareholder diversification
8
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
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
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
Labor Costs around the Globe
(2008)
Average Hourly
Country
Cost ($)
Average Hourly
Country
Cost ($)
Germany
$41.46
Spain
$23.61
Belgium
$39.22
Korea
$13.82
Sweden
$38.08
Israel
$13.91
U.K.
$28.22
Taiwan
$6.95
Australia
$31.51
Hong Kong
$5.78
Canada
$29.72
Brazil
$5.96
Italy
$31.11
Mexico
$2.93
France
$31.60
Philippines
$1.10
U.S.
$25.33
China
$0.81
Japan
$22.90
12
Hourly
Compensation
Costs in
Manufacturing
– Selected
Countries, in
U.S. dollars,
2009
13
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
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
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
The U.S.
Quantity
Why Do Firms Invest Overseas?
Product Life Cycle
New product
Quantity
Less
advanced
countries
exports
Maturing product
imports
Standardized product
exports
imports
New product
Maturing product Standardized product
17
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
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
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
Global 100 by CNNMoney
21
The FDI Sequence
22
How to Invest Abroad:
Modes of Foreign Investment
• Exporting versus production abroad:
– Several advantages to limiting a firm’s 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
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
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
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
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
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
Top 10 Cross-Border M&A Deals
1998-2009
Year
($ b) Acquirer
Home
Target
Host
2000
202.8 Vodafone AirTouch PLC
U.K.
Mannesmann AG
Germany
2007
98.2 RFS Holdings BV
U.K.
ABN-AMRO
Holdings NV
Netherlands
1999
74.3 Royal Dutch Petroleum
Netherlands
Shell Transport &
Trading
U.K.
1998
60.3 Vodafone Group PLC
U.K.
AirTouch
U.S.
2008
52.2 InBev NV
Belgium
Anheuser-Busch
U.S.
2000
48.2 British Petroleum Co.
U.K.
Amoco
U.S.
2009
46.7 Roche Holding AG
Switzerland
Genentech, Inc
U.S.
1998
46.0 France Telecom SA
France
Orange PLC
U.K.
2000
40.5 Daimler-Benz AG
Germany
Chrysler Corp.
U.S.
1999
40.4 Vivendi SA
France
Seagram Co. LTD Canada
29
POLITICAL RISK
30
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 country’s attitude toward private enterprise
– Political risk and uncertain property rights
• Government expropriation
– Capital flight
• The export of savings by a nation’s citizens because of fears about the safety
of their capital
31
Country Risk Ratings Across Countries
32
Source: Transparency International is a global civil society organization that has developed a Corruption Perceptions Index,
which represents the perception of corruption in a country’s public sector. The index relies on assessments and business
surveys by institutions.
32
Corruption Index Ratings for Selected Countries
(Maximum rating = 10. High ratings indicate low corruption.)
33
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
1
3
4
7
13
14
16
16
18
20
21
Country
Finland
New Zealand
Singapore
Canada
U.K.
Hong Kong
Israel
U.S.A.
Chile
Germany
Japan
Score
9.9
9.4
9.2
8.9
8.3
7.9
7.6
7.6
7.5
7.4
7.1
Rank
23
26
27
38
42
46
51
57
57
79
88
Country
France
Botswana
Taiwan
South Africa
South Korea
Brazil
Mexico
Argentina
China
Russia
Indonesia
Score
6.7
6.0
5.9
4.8
4.2
4.0
3.7
3.5
3.5
2.3
1.9 34
Legal System Quality
35
Sovereign
Credit
Ratings by
Standard &
Poor’s
36
Country Rating – Moody’s (2013)
Country Rating
Country Rating
Country
Argentina B3
Hong
Kong
Aa1
Netherland Aaa
Spain
Australia Aaa
India
Baa3
New
Zealand
Aaa
Switzerland Aaa
Austria
Indonesia Baa3
Norway
Aaa
Sweden
Aaa
Belgium Aa3
Ireland
Ba1
Portugal
Ba3
Taiwan
Aa3
Canada
Italy
Baa2
Philippine Ba1
Thailand
Baa1
Denmark Aaa
Japan
Aa3
S. Africa
Baa1
Turkey
Ba1
Finland
Aaa
Malaysia A3
S. Korea
Aa3
U.S.
Aaa
France
Aa1
Mexico
Singapore Aaa
U.K.
Aa1
Aaa
Aaa
Germany Aaa
Baa1
Rating Country
Rating
Baa3
37
Classification of Political Risks
38
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
Firm-Specific Risks: Governance Risks
• Governance risk is the ability to exercise effective
control over an MNEs operations within a host
country’s 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
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
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
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
• 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
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
Differences in Religious Heritage
45
Intellectual Property Infringement In
China, Fake louis vuitton in Korea,
Replica Rolex in ebay
46
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
Antiglobalization Movement
48
Global-Specific Risk
49
Variables used in PRS’s Political Risk
Score
50
Political Risk Points by Component
51
Current Risk Ratings and
Composite Risk Forecasts
52
The ICRG Risk Components
53
Country and Political Risk Ratings
for Selected Countries
54
Measuring Political Risk
• The host country’s 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
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 it’s in a rough
neighborhood.
56
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, Argentina’s protracted economic
recession led to the freezing of bank deposits,
street riots, and three changes of the country’s
presidency in as many months.
57
Hedging Political Risk
• Geographic diversification
– Simply put, don’t 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
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