Chapter 16

Foreign Direct
Investment and
Political Risk
 Learning Objectives

• Demonstrate how key competitive advantages

support MNEs’ strategy to originate and sustain
foreign direct investment
• Show how the OLI paradigm provides a theoretical
foundation for the globalization process
• Identify factors and forces that must be
considered in the determination of where MNEs’
invest

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 Learning Objectives cont.

• Illustrate the managerial and competitive

dimensions of the alternative methods for foreign
investment
• Learn how to define and classify foreign
investment risks
• Analyze firm-specific, country-specific, and global-
specific risks

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 Sustaining & 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
– Powerful enough to compensate the firm for the extra
difficulties of operating abroad

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 Sustaining & Transferring
Competitive Advantage

• Some of the competitive advantages enjoyed by

MNEs are:
– Economies of scale and scope
– Managerial and marketing expertise
– Advanced technology
– Financial strength
– Differentiated products
– Competitiveness of the their home market

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 Exhibit 16.1 Determinants of National
Competitive Advantage

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 The OLI Paradigm &
Internationalization

• The OLI Paradigm - framework to explain why

MNEs choose FDI rather than licensing, joint
ventures, strategic alliances, management
contracts or exporting
• The paradigm states that a firm must first have
some competitive advantage in its home market -
“O” or owner-specific – which can be transferred
abroad

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 The OLI Paradigm &
Internationalization

• The firm must also be attracted by specific

characteristics of the foreign market – “L” or
location specific – which will allow the firm to
exploit its competitive advantages in that market
• Third, the firm will maintain its competitive
position by attempting to control the entire value-
chain in its industry – “I” or internalization

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 The OLI Paradigm &
Internationalization

• Financial strategies also explain FDI

• 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

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 Exhibit 16.2 Finance-Specific Factors and
the OLI Paradigm

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 Deciding Where to Invest

• Two related behavioral theories behind FDI are

popular
• Behavioral Approach –firms tended to invest first
in countries that were not too far from their
country in psychic terms
– This included cultural, legal, and institutional
environments similar to their own

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 Deciding Where to Invest

• Network perspective – As MNEs grow they become

a network that operate either in a centralized
hierarchy or a decentralized one
– Each subsidiary competes for funds from the parent
– Member of an international network based on its industry
– The firm becomes a transnational firm

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 Modes of FDI

• Exporting vs. production abroad

– Advantages of exporting are
• None of the unique risks facing FDI, joint ventures,
strategic alliances and licensing
• Minimal political risks
• Avoids agency costs and evaluating foreign units
– Disadvantages are
• Firm is not able to internalize and exploit its
advantages
• Risks losing market to imitators and global
competitors

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 Modes of FDI

• Licensing/management contracts versus control of

assets abroad
– Advantage
• No need to commit sizable funds
– Disadvantages
• License fees are likely lower than FDI profits although
ROI may be higher
• Possible loss of quality control
• Establishment of potential competitor (even at home)
• Risk stolen technology
• High agency costs

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 Modes of FDI

• Joint ventures (shared ownership) versus wholly

owned subsidiary
– Advantages
• Local partner understands the market
• Local partner can provide competent management at
all levels
• Required by host countries
• The local partner’s contacts & reputation
• Access to technology appropriate for the market

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 Modes of FDI

• Joint ventures versus wholly owned subsidiary

– Disadvantages
• Political risk is increased if wrong partner is chosen
• Divergent views on strategy and financing issues
• Conflict of interest (transfer pricing)
• Financial disclosure between local partner and firm
• Inability of a firm to rationalize production on a
worldwide basis
• Valuation of equity shares is difficult

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 Modes of FDI

• Greenfield investment versus acquisition

– A greenfield investment is establishing a facility “starting
from the ground up”
– Here, a cross-border acquisition may be better because
the physical assets already exist, shorter time frame and
financing exposure
• However, problems with integration, paying too much
for acquisition, post-merger management, and
realization of synergies all exist

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 Modes of FDI

• Strategic alliances can take several different forms

– First is an exchange of ownership between
two firms
– It can be a defensive strategy against a takeover
– In addition to exchanging shares, a separate joint
venture can be developed
– Another level of cooperation may be a joint marketing or
servicing agreement

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 Exhibit 16.3 The FDI Sequence: Foreign
Presence & Foreign Investment

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 Predicting Political Risk

• In order for an MNE to identify, measure and

manage its political risks, it needs to define and
classify these risks
– Firm-specific risks
– Country-specific risks
– Global-specific risks

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 Exhibit 16.4 Classification of Political
Risks

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 Predicting 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 Political Risk

• 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
– Even more difficult

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 Predicting Political Risk

• Governance risks
– Ability to exercise effective control over MNEs operations
within a host country’s legal and political environment
– Conflicts of interest between objectives of MNEs and host
governments are common
– The best approach to conflict management is to anticipate
problems and negotiate understanding ahead of time

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 Firm-Specific Political Risk

• Negotiating investment agreements

– Spell out the rights and responsibilities of both the
foreign firm and the host government
– Spell out policies on financial and managerial issues:
dividends, royalty fees, loan repayments, transfer prices,
provision for arbitration, etc.
– The presence of MNEs is as often sought by
development-seeking host governments

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 Firm-Specific Political Risk

• Investment insurance and guarantees

– MNEs can sometimes transfer political risk through an
investment insurance agency
– The US investment insurance and guarantee program is
managed by the Overseas Private Investment
Corporation (OPIC)
– It’s purpose is to mobilize and facilitate US private capital
and skills in the economic development of less developed
countries

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 Firm-Specific Political Risk

• Investment insurance and guarantees – OPIC

offers coverage for four separate types of risk
– Inconvertibility - not being able to convert remittances
into dollars
– Expropriation – government seizing the assets
– War, revolution & insurrection
– Business income –loss of income due to events from
political violence that directly affect the company & its
assets

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 Firm-Specific Political Risk

• Although FDI creates obligations on the part of the

foreign subsidiary and host government,
conditions change and MNEs must be able to
adapt
• There are several strategies that MNEs can
undertake to anticipate changing conditions or
host government’s future actions and negotiate
these terms
– Local sourcing
– Facility location

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 Firm-Specific Political Risk

• Some key areas of consideration include:

– Control of transportation – important for oil and pipeline
companies
– Control of technology – patents and intellectual property
– Control of markets – bargaining power
– Brand name & trademark control
– Thin equity base – large proportion of local debt
– Multiple-source borrowing – various banks and countries

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 Country-Specific Risks

• These risks affect all firms operating within the

host country
• Main risks are
– Transfer risk
– Cultural and Institutional Risk
• MNEs can react to potential transfer risk at three
stages
– Prior to making the investment
– During operations
– Funds that cannot be moved must be reinvested in the
local country to avoid deterioration in real value

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 Exhibit 16.5 Management Strategies
for Country-Specific Risks

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 Country-Specific Risks: Transfer Risk

• Fronting loans - parent-to-subsidiary loan

channeled through a financial intermediary
– The lending parent deposits the funds in a bank, let’s say
in London
– That bank in turn “loans” this amount to the borrowing
subsidiary
– In essence, the bank “fronts” for the parent

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 Country-Specific Risks: Transfer Risk

• Creating unrelated exports

– Due to the host country’s inability to earn hard currency,
anything MNEs can do to generate export sales helps the
host country
• Special dispensation
– If the firm is in an important industry for the
development of the host country, it may bargain for a
special dispensation to repatriate some funds

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 Country-Specific Risks: 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 such as:
– Allowable ownership structure
– Human resource norms
– Religious heritage
– Nepotism and corruption in the host country
– Protection of intellectual property rights
– Protectionism

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 Global-Specific Risks

• Global-specific risks faced by MNEs have come to

the forefront in recent years:
– Terrorism and War: Crisis Planning,
– Cross-Border Supply Chain Integration
– Supply Chain Interruptions (Inventory Management,
Sourcing, Transportation)
– Antiglobalization Movement
– Environmental Concerns
– Poverty
– Cyberattacks

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 Exhibit 16.6 Management Strategies
for Global-Specific Risks

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 Summary of Learning Objectives

• The OLI Paradigm is an attempt to create a

framework to explain why MNEs choose FDI rather
than serve foreign markets through other methods
• Finance-specific strategies (proactive and reactive)
are directly related to the OLI Paradigm
• Competitive advantages stem from economies of
scale and scope, managerial and marketing
expertise, differentiated products, and
competitiveness of the home market

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 Summary of Learning Objectives

• The decision about where to invest is influenced

by economic and behavioral factors as well as the
stage of a firm’s development
• Psychic distance plays a role in determining the
sequence of FDI and later reinvestment. As firms
learn from their early investments they venture
further afield and are willing to risk larger
commitments

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 Summary of Learning Objectives

• Most international firms (parent and subsidiaries)

can be viewed as a network.
• Exporting avoids political risk but not foreign
exchange risk. It requires the least up-front
investment but it might eventually have lost those
markets to imitators and global competitors that
might be more cost efficient in production abroad
and distribution

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 Summary of Learning Objectives

• Alternative (to wholly owned foreign subsidiaries)

modes of foreign involvement exist. They include
joint venture, strategic alliances, licensing,
management contracts, and traditional exporting.
• Licensing enables a firm to profit from foreign
markets without a major up-front investment,
however disadvantages include limited returns,
possible loss of quality control, and potential to
establish future competitor

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 Summary of Learning Objectives

• The success of a joint venture depends primarily on

the right choice of a partner. For this reason and a
number of issues related to possible conflicts in
decision making between a joint venture and a
multinational parent, the 100%-owned foreign
subsidiary approach is more common

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 Summary of Learning Objectives

• Political risks can be defined by classifying them

on three levels:
– Firm-specific risks, affect the MNE at the project or
corporate level.
– Country-specific risks, affect the MNE at the project or
corporate level but originate at the country level
– Global-specific risks affect the MNE at the project or
corporate level but originate at the global level

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 Summary of Learning Objectives

• The main firm-specific risk is governance risk, the

ability to exercise control over the MNE as a
whole, globally, and within a specific country’s
legal and political environment on the individual
subsidiary level
• The most important type of governance risk arises
from a goal conflict between bona fide objectives
of governments and private firms

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 Summary of Learning Objectives

• The main tools used to manage goal conflict are to

negotiate an investment agreement; to purchase
investment insurance and guarantees; and to
modify operating strategies in production,
logistics, marketing, finance, organization, and
personnel
• The main country-specific risks are transfer risk,
known as blocked funds, and certain cultural and
institutional risks

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 Summary of Learning Objectives

• Blocked funds can be managed by at least five

different strategies: 1) considered in the original
capital budgeting analysis; 2) fronting loans; 3)
creating unrelated exports; 4) obtaining special
dispensation; and 5) planning on forced
reinvestment
• Cultural and institutional risks emanate from host
country policies with respect to ownership
structure, human resource norms, religious
heritage, nepotism and corruption, intellectual
property rights, protectionism, and legal liabilities

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 Summary of Learning Objectives

• Managing cultural and institutional risks requires

the MNE to understand the differences, take legal
actions in host-country courts, support worldwide
treaties to protect intellectual property rights, and
support government efforts to create regional
markets
• The main global-specific risks are currently caused
by terrorism and war, the anti-globalization
movement, environmental concerns, poverty, and
cyber attacks

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 Summary of Learning Objectives

• In order to manage global-specific risks, MNEs

should adopt a crisis plan to protect its employees
and property. However, the main reliance remains
on governments to protect its citizens and firms
from these global-specific threats

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