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Chapter 17

Foreign Direct
Investment and
Political Risk

Learning Objectives
Demonstrate how key competitive advantages
support a strategy to sustain direct foreign
investment
Show how the OLI Paradigm provides a
theoretical foundation for the globalization
process
Explore the motivations and factors that
determine where multinationals invest abroad
Compare and contrast the modes of foreign
investment

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Learning Objectives
Illustrate the new forces driving corporate
competition in emerging markets
Evaluate the various factors that may be used to
predict when and where political risks will arise
Describe the forms of transfer risk and how
multinationals may mitigate these blockages
Learn how to evaluate the cultural and institutional
factors often leading to firm specific political risk
Examine the unique complexities of global specific
risk

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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 firms
competitive advantage relative to firms located in less
competitive ones
This phenomenon is known as the competitive advantage
of nations and has four components as shown in Exhibit
17.1

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Exhibit 17.1 Determinants of National


Competitive Advantage: Porters Diamond

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The OLI Paradigm and


Internalization
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.
O owner-specific (competitive advantage in the home
market that can be transferred abroad)
L location-specific (specific characteristics of the foreign
market allow the firm to exploit its competitive advantage)
I internalization (maintenance of its competitive position
by attempting to control the entire value chain in its
industry)

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The Financial Strategy


Proactive Financial Strategies include:
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 and/or operating
and transaction exposure through FDI

Reactive Financial Strategies depend on


market imperfections (see Exhibit 17.2)

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Exhibit 17.2 Finance Factors and


the OLI Paradigm

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Deciding Where to Invest


The decision about where to invest abroad is influenced by
behavioral factors.
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 firms 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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Exhibit 17.3 The FDI Sequence: Foreign


Presence and Investment

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How to Invest Abroad:


Modes of Foreign Involvement
Exporting Versus Production Abroad:
There are several advantages to limiting a firms
activities to exports as exporting 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:


Modes of Foreign Involvement
Licensing and Management Contracts Versus
Control of Assets Abroad:
Licensing is a popular method for domestic firms to profit
from foreign markets without a large commitment of funds
However, there are disadvantages which include:
License fees are lower than FDI profits
Possible loss of quality control
Establishing possible competitors
Technological improvements by the licensee which then enter
your home market
Possible loss of FDI opportunity at a later date
Risk that technology will be stolen
High agency costs

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How to Invest Abroad:


Modes of Foreign Involvement
Management contracts are similar to licensing,
insofar as 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:


Modes of Foreign Involvement
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
Providing for capable mid-level management
Some countries do not allow 100% foreign ownership
Local partners have their own contacts and reputation which
aids in business
Local partners may possess key technology
Public image may be enhanced with partial local ownership

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How to Invest Abroad:


Modes of Foreign Involvement
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
Control of financing
Difficulties in the ability to rationalize production on a
worldwide basis
Issues with increased financial disclosure

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How to Invest Abroad:


Modes of Foreign Involvement
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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The Three Trade-Offs


1. Volume versus Margin
2. Rapid Expansion versus Low Leverage
3. Growth versus Dividends
. Analysts suggest that global challengers understand
emerging markets and have demonstrated
sustained innovation to remain financially healthy.
. Others argue that these three factors are likely to
be more simultaneous than causal.

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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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Exhibit 17.4 Classification of


Political 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 countrys 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

Predicting global-specific risk


Predicting global-specific risk is difficult, though new
indices will likely be developed to aid

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Firm-Specific Political Risk:


Governance Risk
Governance risk is the ability to exercise
effective control over an MNEs operations
within a host countrys legal and political
environment
Historically, conflicts of interest between
objectives of MNEs and host governments
have arisen over such issues as the firms
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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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 host governments
An investment agreement should define
policies on a wide range of financial and
managerial issues

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Investment Insurance and


Guarantees
Overseas Private Investment Corporation (OPIC)
the U.S. investment insurance and guarantee
programdesigned to facilitate private capital
investment in lesser developed countries. Offers
insurance for four types of political risk:
Inconvertibility: the risk that the investor will not be able
to convert the profits into dollars
Expropriation: the risk that the host government will take
the assets
War: self evident
Business income due to losses from political strife

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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:

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Local sourcing
Facility location
Control of transportation
Control of technology
Control of markets
Brand name and trademark control
Thin equity base
Multiple-source borrowing

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Country-Specific Risk: Transfer


Risk
Country-specific risks affect all firms,
domestic and foreign, that are resident in a
host country.
The main country-specific political risks are
transfer risk, cultural risk, and institutional
risks as demonstrated in Exhibit 17.5.

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Exhibit 17.5 Management


Strategies for Country-Specific Risks

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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.
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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Preinvestment Strategy to
Anticipate Blocked Funds
Moving blocked funds
Providing alternative conduits for repatriating
funds
Transferring pricing goods and services between
related units of the MNE
Leading and lagging payments
Signing fronting loans
Creating unrelated exports
Obtaining special dispensation

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Preinvestment Strategy to
Anticipate Blocked Funds

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Fronting Loans
Creating unrelated exports
Special dispensation
Self-fulfilling prophecies
Forced reinvestment

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Country-Specific Risk: Cultural


and Institutional Risk
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:

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Differences in allowable ownership structures


Differences in human resource norms
Differences in religious heritage
Nepotism and corruption in the host country
Protection of intellectual property rights
Protectionism
Legal liabilities

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Global-Specific Risk
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 the antiglobalization movement,
environmental concerns, poverty in emerging
markets and cyber attacks on computer information
systems (see Exhibit 17.6)

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Exhibit 17.6 Management


Strategies for Global-Specific Risks

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Global Finance in Practice 17.1

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