AJAFIN 6605-08

FOREIGN DIRECT INVESTMENT (FDI) & POLITICAL AND COUNTRY RISK ANALYSES

FDI is the acquisition of fixed plants and equipment abroad. Outline: 3 Market Imperfections that Lead to FDI: → Market failure or imperfections in general. → Product and factor markets. → Financial markets.
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FDI Theories:
Theory of Industrial Organization (IO)
 

Provides insights into how firms behave in markets. It offers some explanations on the general circumstances under which exporting, licensing, or local production will be the preferred alternatives for exploiting foreign markets. The theory focuses on imperfect products and factor markets.

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According to this theory, MNC’s have intangible capital in the form of trademarks, patents, general marketing skills, and other organizational abilities. Exporting: will be preferred if MNCs' intangible assets - trademarks, patents, marketing or organizational abilities - can be embodied in the form of "hard-to-copy" products or products without adaptation.

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Licensing and Joint Ventures: will be preferred
where the technology can be unbundled, transmitted objectively, and where the price is right. Also where the market is segmented and legal intensity problems can be overcome.

Foreign Direct Investment: will be preferred if the
technology is "inseparable" from the firm.

Internalizing the market for an intangible asset by setting up a FDI makes economic sense if the benefits from circumventing market imperfections outweigh the administrative and other costs of central (internal) control.
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General Market Failures or Imperfections

Market and firms are alternative instruments for completing a related set of transactions. Execution takes place across markets (externalization) or within a firm (internalization) depending on the relative efficiency of each mode. Costs of writing/executing contracts across markets depend on the human decision makers and the objective properties of the market. Similar set of factors apply to transactions within the firm.
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To understand why firms internalize, we must examine environmental and human factors that make writing/executing complex contingent claims or contracts costly and hence why firms turn to internalization. Why the Firm and not the Market? The firm is an institution that hires factors of production to produce goods and services. Markets are also institutions that can coordinate economic decisions. Why should some economic activities take place in the one or the other? The answer is 'cost'.
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Firms internalize economic activities because of a number of factors including: transaction costs, economies of scale and economies of team production (specialization). Transaction costs include: the costs of finding someone with whom to do business, the costs of reaching agreement on the exchange, and, the costs of ensuring such agreements are fulfilled. Markets require that buyers and sellers find each other, get together, and negotiate. They also usually require lawyers to draw up contracts. Rather than buying a good or service on a market, firms can reduce such cost by internalizing their production.
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The Factors: Bounded Rationality: The limited capacity of the human mind to formulate and solve problems compared to the size of the problems. Economic agents are limited in neurophysiological, language, technical, and legal senses to identify future contingencies and specify, ex-ante, appropriate responses. With these limitations long-term contracts may be supplanted by internal organization. Opportunism: Lack of candor or honesty in transactions, selfinterest seeking with guile.
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Competitive - Monopoly - Monopsony Environments: A competitive environment faces little risk of opportunism, but competitive environments often degenerate to monopoly/monopsony environments. Many transactions that involve large number of qualified bidders at the outset are transformed into small number supply conditions at contract execution and renewal. Opportunism comes in the form of cost-overruns, inflated prices, substandard qualities, etc.

Asymmetric Information:
obtains when one party to an exchange is much better informed than the other regarding the underlying conditions. The other party cannot achieve information parity except at a great cost. 9

Advantages of Internal Organizations
Parties to an internal exchange are less able to appropriate/ capitalize on subgroup gains at the expense of the whole firm. Hence there exists a reduced incentive to behave opportunistically. → Internal organization can be more effectively monitored/audited. → Internal organizations are able to settle disputes better/ faster. → Efficient codes are more apt to evolve and be employed with confidence by parties in one organization.

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→ Internal

organization promotes convergent expectations.
The existence of market failures alone may not be sufficient to justify FDI. MNCs can succeed abroad only if their proprietary technology cannot be easily purchased or duplicated by local competitors. MNCs must continue to create/preserve effective barriers to direct competition in product and factor markets.
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Products and Factor Market Imperfections
Proponents: Stephen Hymer (1960); Charles Kindleberger (1969) and Richard Caves (1971)

Market imperfections may occur naturally, but they are usually attributed to policies of firms and governments. For example: Firms in oligopolistic industries seek to create unique competitive advantages through product differentiation.
Governments create market imperfections through tariffs and non-tariff barriers to trade, preferential purchasing policies, tax incentives, capital market controls and similar policies. Other government created market imperfections include EU, ECOWAS, European Free Trade Association (EFTA), OPEC, NAFTA, etc.
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Foreign firms operating in these markets must enjoy some competitive advantages over local firms in order to compensate for such inherent disadvantages as:

· Lack of knowledge about local customs.

· Differences in local tastes. · Unfamiliar legal systems. · Greater communication and control costs

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The most important competitive advantages enjoyed by multinational corporations include:

Advantages in the goods market: Product differentiation Unique marketing skills Collusion in pricing Advantages in the factor market: Techniques protected by patents Special (superior) management skills Financial strength and access to diversified capital markets
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Economies of Scale and or Scope: Economies of scope exists whenever the same investment can support multiple profitable activities less expensively in combination than separately (as in flexible manufacturing). Internal and external Horizontal and vertical
Internal Economies of Scale: A firm’s per-unit cost of production declines as its production increases  External Economies of Scale: Firm’s average cost of production declines as production within its industry increases. Critical mass of firms exchanging ideas and workers moving among firms (synergy)

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Advantages From Government Policies: → Regulations limiting output → Regulations limiting entry into an industry → Taxation policies → Free trade agreements → Subsidies

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Financial Market Imperfections

Is a competing (complementing) hypothesis for explaining FDI. Multinational corporations are able to use a network of financial linkages to exploit wide variations in national tax systems and significantly reduce costs and barriers to international financial transfers.

The ability to transfer funds and to reallocate resources or profits internally present MNCs with several types of arbitrage opportunities including:
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   

Tax Arbitrage Financial Market Arbitrage Regulatory System Arbitrage Use of internal financial transactions to confront various financial market imperfections
Tax Arbitrage: Ability to reduce tax burdens by shifting profits from high-tax to low-tax subsidiaries. Financial Market Arbitrage: By transferring funds among units, MNCs are able to circumvent exchange controls, earn higher yield on excess funds, reduce cost of borrowed funds and tap previously inaccessible financial markets. 18

Regulatory System Arbitrage: When unit profits are impacted by government regulations or union pressures, MNCs are able to exploit market imperfections for negotiating advantages. internal financial transfers and thereby maximize global profits.
– Mode of Transfer x Transfer pricing – Timing Flexibility x Leading and lagging
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 MNCs can control the mode and timing of

Notes:  Extant literature on MNE and FDI focuses mainly on advanced economies.

Emerging literature explores multinationals from developing economies New studies combine country characteristics and social relations as determinants of FDI. Firm and country characteristics are combined with institutional, political, economic, and cultural connections between source and hosts countries of FDI. 20


Theory of Developing Country MNEs:

Vernon (1966) sees FDI as a natural stage in the life cycle of a new product from its introduction to its maturity and eventual decline. Dunning (1981) and Ozawa (1992) propose a more general approach called “Investment Development Cycle”. It states that initial inward investment (stage 1) will be low labor cost and raw materials, with almost no outward investment. In the second stage, firms will initiate outward investment and seek low labor cost locations, while inward FDI will be market seeking. In the last stage, both inward and outward FDI will be market oriented. 21

In Wells (1983) and Lall (1986), Third World MNEs are viewed as relatively passive recipients of technology and skills at the mature stage of their life cycles… and that third world MNEs will develop smaller scale, labor intensive, multipurpose, technologies that use locally available inputs and allow them to compete on low price, rather than product differentiation and innovation. But look at Tata Motors of India!

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Other FDI Theories: FDI decisions result from a complex process motivated by strategic, behavioral, and economic considerations.

 Strategic

Considerations for FDI fall into in several classifications (not mutually exclusive): - Market seekers - Raw material seekers - Production efficiency seekers - Knowledge seekers - Political safety seekers 23

 Behavioral

Motives for FDI:

Contend that FDI is often motivated by a strong stimulus from the external environment or from within the organization on the basis of personal biases, needs, and commitments of individuals or groups. The investigation process is very crucial.
 Economic

Rationale for FDI:

Based on the theory of imperfections in individual national markets for products, factors of production, and financial assets.
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 Defensive

FDI: May be motivated by:

-

Follow the leader behavior/strategy Desire to establish credibility with local customers Grow-to-survive philosophy A desire to gain knowledge by acquiring firms with valuable expertise - A need to follow the customer (service firms)

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 The 

Theory of Internalization:

Holds that firms having competitive advantages because
of their ability to generate valuable proprietary information can only capture the full benefit of innovation through FDI.

In a desire to control the use of proprietary information MNCs are reluctant to unbundle their services to host countries in the form of management contracts and licensing agreements. They thus internalize Desire to deny rivals access to competitive resources is referred to as appropriability theory.
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Control through internal handling of operations rather than through contracts with other companies is often called internalization Compare Theory of Externalization Complementarity of Trade and FDI
FDI usually not a substitute for trade. About one third of world trade is intra-firm. Many exports from parent to subsidiary would not occur if FDI does not exist.
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• • •

 The  The

Product Cycle Hypothesis Eclectic Theory Theory (Risk Diversification Hypothesis)

 Portfolio

Oligopoly Model - (Exploiting Quasi-monopoly Advantages) (imitative behavior by rival firms in an oligopolistic industry)

 Disclosure  Political

Paradox and Team Organizations

Safety/Appeasement Motives Syndrome
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 Bandwagon

Strategies of MNCs
Some MNCs rely on product innovation, others on product differentiation, yet others on cartels and collusion to protect themselves from competitive threats.

Innovation Reliant MNCs
These MNCs create barriers to entry by continually introducing new products and differentiating existing ones - large R&D budgets; large pool of technical personnel as opposed to factory personnel; behavior closely resembles that described by the product life cycle.
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"Matured" MNCs: Feature product differentiation; high advertising expenditures; highly developed marketing skills; economies of scale/scope. "Aging" MNCs: Their strategy includes entering new markets where market imperfections still exist, e.g., Developing countries. Forming cartels 3 Market sharing 3 Using global scanning capacity to seek lower-cost production sites 30
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Political and Country Risk Analysis: An Outline:

Problems of Definition Government Action Vs. Environmental Changes Operational Definition "Discontinuities in the business environment occasioned by political developments"
Between Political and Economic Risks

 Distinction

Actors responsible for each condition

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 Macro

Approach Vs. Micro Approach

Macro-measurement:

Aggregate subjective assessments - expert opinion- generated, e.g., BERI, BIIER or BI, also Nikkei BI. Others employ quantified indicators of economic, social, and political factors, e.g., PSSI and Ecological Models. Micro-measurement: Companies differ in their susceptibility to political risks: Therefore extractive industries, utilities, financial services, manufacturing (heavy industries), service multinationals face different levels of risk.

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Managing Political Risk
Pre-investment Planning Operating Policies Post Expropriation Policies

3 3

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 Country

Risk Analysis

Banks tend to address external environmental issues in terms of country risk. Political risk is treated as a subset of country risk. Definitions: Political Risk, Country Risk
 Country
3 3

Risk Indicators

3

3

Political factors: market oriented or statist policies Economic factors: capital flight, fiscal irresponsibility monetary instability, exchange rate instability, Subjective factors: attitude towards private enterprise, attitude towards multinationals. Indexes of political risk: BERI, PSSI, POR, CI, etc
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Bank Assessment of Country Risk.
Management of country risk: Avoidance; Adaptation; Dependency; Hedging; · Proactive Strategies -(Operational) - Control of vital technology, - Develop local allies, - Local borrowing, - Multiple production sources, - Transfer-pricing capability, * for managing exchange controls * for exploiting discriminatory taxation - Lobby local (host) government officials or business leaders - Take out OPIC/MIGA insurance.
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Political Risk Assessment for FDI
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Problems of Definition:
Most studies identify political risk with government actions that impact on business operations. Others have defined political risk on the basis of environmental changes due to political developments like acts of violence, instability, riots that have repercussions on business activity.

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These Definitions are Interdependent.
Environmental changes can prompt government actions as much as government action/activity can provoke environmental developments.
Robock (CJWB, 1971) offered an operational definition of political risk as follows: "discontinuities in the business environment

occasioned by political developments."

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Distinction Between Political and Economic Risks:

Political Risks: stem from changes in policy positions or environmental conditions. Economic Risks: are associated with changes concerning market, competitive, and technological factors that diminish a firm's effectiveness and profit potential.

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Actors responsible for political risks becoming an actuality are more easily identifiable than those responsible for the economic risks becoming an actuality.

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Country, industry, and firm characteristics influence the political vulnerability and intensity of political risk for a business firm. 36

Macro Approach:

Dimensions that affect all business enterprises in general.

Micro Approach: Dimensions that impact in a selective manner on specific business activity. Macro Measurement: A number of commercial and academic political risk forecasting models are available. * BERI - Business Environment Risk Index. * BIIER- Business International Index for Environmental Risk

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These are aggregate subjective assessments of a panel of experts (typically via a Delphi Method).
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3

3

3 3

Others rely on quantified indicators of economic, social, and political factors, e.g., Political System Stability Index (PSSI) suggested by Haendel and West (1975). Ecological Model Approach - based on the proposition that the crucial measure of stability is the frustration level in society. Profit Opportunity Recommendation Rating (POR) Global Corruption Index
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Micro Measurement: Companies differ in their susceptibility to political risk, depending on their industry, size, composition of ownership, level of technology, and degree of vertical integration, e.g., - Extractive Industries, e.g., gold, oil, etc. - Utilities - Financial Services - Manufacturing - Service Multinationals
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3

In general the greater the perceived or actual benefit of a MNC to the host economy, and the more expensive its replacement by a purely local operation, the lower the degree of political risk to a MNC. When a MNC invests in a foreign country, it is writing a call option to the host government. The host government will exercise this option, such as expropriating the MNC property, only if the gains exceed the strike price, i.e., the option is in the money.

3

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Managing Political Risks
Pre-investment Planning: * Avoidance * Insurance * Negotiating the environment * Structuring the investment

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→ Operating

Policies:

* Planned divestment
* * * * * * * * Short-Term profit max
Changing the perceived benefit/cost ratio of host govt.

Developing local stockholders Adaptation e.g., lobbying/politicking International production "network" strategy Controlling the location of intangible assets Local purchasing strategy "Sourcing" and "movement" of funds policy
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→ Post

* * * *

Expropriation Policies: Rational negotiation Applying power Legal Remedies Management surrender

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 Country

Risk Analysis:

Country risk analysis is now a standard procedure in international lending: In the 1970s big money center banks and regional banks lent billions of dollars to developing and socialist countries.
The international debt crisis that followed in the wake of "unrestricted" lending has drawn attention to the need to assess "factors" that affect the likelihood that a "nation" can be in default.

Instead of political risk, banks prefer to discuss external environmental issues in terms of "country risk". Political is treated as a subset of country risk. 44

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Country risk analysis embodies the assessment of the potential risks associated with doing business in the political, economic, cultural and social environment of a country. It examines “Political Economy”, the interaction of politics and economics, to uncover political factors that give rise to particular economic policies (monetary and fiscal policies, exchange rate policies, trade controls, labor laws, property rights, etc)

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Definition of Terms
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Political risk can be defined as political events that have potential to cause financial, strategic or personnel losses for a firm. Country risk refers to elements of risk inherent in doing business in the economic, social, and political environment of another country. A political event in itself does not necessarily constitute a risk to business. Even a revolution as the most dramatic form of political instability is neither a necessary nor a sufficient condition for changes in policy relevant to foreign investment (Kobrin, 1979). 46

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Examples:

(1) Gulf oil in 1975 was able to negotiate a very favorable relationship with the Marxist MPLA during the Angolan civil war. (2) Dow chemical was able to re-enter Chile after the overthrow of Salvador Allende in 1973. (3) Iraq- Kuwait- Desert Storm- (Gulf War), 1992, provide booming business to oil fire fighting companies, and patriot missile manufactures
( e.g. Raytheon).
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3

The linkage between political events and risks is often rooted in managerial decisions or the absence of such decisions. Political turbulence and uncertainty can be proactively managed into targets of competitive opportunity - if management understands the multidimensional and complex nature of political risk. Socio-cultural, political, and economic phenomena are highly interrelated.
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3

3

Different kinds of political risk events can be divided into either:

Extra-legal: any event that originates from outside the existing authority such as terrorism, sabotage, military coups, revolutions, etc. Legal-Governmental: a direct product of the ongoing political process and includes such events as democratic elections, changes in the law concerning trade, labor, joint-venture, subsidy, technology, monetary, and developmental policies.
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Country-Risk Indicators: 3 Fiscal irresponsibility: government deficit as a percentage of GNP. 3 Degree of waste in the economy. 3 Coverage ratio = Exports/(Debt service). 3 Resource base: natural, human, and financial resources. A nation with substantial resources (oil, gold, diamond) is a better economic risk. 3 Capital flight = export of savings by citizens of a nation because of safety concerns. 3 Expropriations 3 Inflation, BOP deficits, Growth rate of GDP, Money supply growth rate, etc 50

Indicators of Long-run Economic Health
3

3

3 3 3 3 3
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Incentives that reward risk-taking in productive ventures. Legal system that promotes the development of free markets. Minimal government intervention in the economy. Stable macroeconomic policies. Open economy. Incentives to save and invest. Political safety.
Existence of basic human rights and freedom of the press.
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Market-oriented Vs Statist Policies:
Empirical evidence since the end of WWII shows that market economies work and command economies do not.
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In a market economy (capitalism), economic decisions are made by individual economic agents based on prices of good , services, capital, labor, land, and other factors. In a command economy (socialism/communism), the leaders decide what, how, where, who, and quantity of production, and then command others to follow the 52 central plan.

3

3

The basic difference between a market economy and a command economy is the way they harness information and incentives. Markets work because economic decisions are made by those who have the information necessary to determine the trade-off that must be made and the appropriateness of those trade-offs given their unique skills, circumstances, and preferences … along with market prices that indicate the relative values and costs placed on those activities by the society. Pure command economies are now (2000s) rare except Cuba and North Korea.

3

3

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3

Many nations follow statist policies in which markets are combined with heavy government intervention in the economy through various regulations, tax and spending policies. The state typically owns critical industries e.g. minerals, air transportation, telecommunications, aerospace, healthcare, oil, and power generation. The centralization of economic power in the state as seen in developing/third world countries has turned the state into a huge patronage machine and generated a complex and corrupt bureaucracy to administer illdefined and all-encompassing rules and regulations.
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3

3

As a result, corrupt and inept officials use the controls and regulations to enrich themselves and further the interests of their ethnic groups, and/or religious, or professional class, at the expense of national economic health and well-being. Examples: Russia, India, Pakistan, Indonesia, The Philippines, Malaysia, Mexico, Most countries in Africa, Middle and South America, Middle East, and Eastern Europe.

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Also compare and contrast: former East and West Germany, North and South Korea, Hong Kong and Taiwan with Mainland China, and Singapore with Malaysia.
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Applications
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As a result of the 1991 Gulf war, many MNCs reassessed their exposure to country risk and revised their operations accordingly. With the Asian crisis of 1997-98, many MNCs realized that they had underestimated the potential problems that could occur in high growth Asian Emerging Markets. After 9/11 attack on the U.S., many MNCs adjusted their business operations in countries where U.S. firms may be targets of terrorists.
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APPENDIX COMMONLY USED VARIABLES IN COUNTRY RISK ANALYSIS
Quantitative Variables Qualitative Factors - Type of government

Macroeconomic - GDP growth (nominal & in real terms) - Per Capita GDP level - Per Capita GDP increase (real terms) - Savings to GDP (over time) - - Investments to GDP (over time) - Share foreign trade in GDP - Current account deficit to GDP (over time) - Debt service to GDP - Debt service to savings - Debt service to public revenues - Debt interest and direct investments earnings of foreigners to GDP - Short term external debt to GDP - Foreign debt to GDP - External liabilities (debt and quality) to GDP

- Orderliness of political succession - Political stability - Leadership ability demonstrated by present government - External political threats (war) - Potential domestic political threats (political unrest, riots, radical changes of policy) - Existence of political opposition - Political freedom - Ethnic minorities - Persistent internal political chaos - Effectiveness of government in formulating policies regarding important social and political problems
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Quantitative Factors <cont.>
- Consumer prices index CPI (over time)

Qualitative Factors <cont.>
- Institutions designed to provide for resolution of political and social - Government’s ability to institute economic reforms - Institutional structures designed to bring competing influences to bear upon government policies - Ideological differences between ruling parties and political opposition - Foreign investment climate - Threat of nationalization - Refusal to compensate expropriated investors - Nationalization-expropriation record - Hospitality to private and foreign capital
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- Wholesale prices index WPI (over time) - Comparison CPI and WPI - Money supply growth - Money supply growth to GDP growth - Domestic assets banking system (over time) - Domestic credit creation (over time) - Currency to total bank deposits - Governmental spending to GDP - Tax revenues to GDP - Government deficit to GDP - Military spending to GDP - Level of short-term interest rates (over time) - Relative purchasing power of currency (inflation rate to exchange rate changes)

Quantitative Factors <cont.>
External Accounts -Total reserves - Total reserves changes over time - Reserves minus gold - Reserves minus gold over time - Availability IMF credit - IMF credit to gross reserves - Net foreign assets - External assets commercial banks - Reserves to imports - Months-of-imports covered by reserves - External debt to reserves - Short-term external debt to reserves - Debt service ratio (and over time) - Public debt to exports (goods and services) - External debt to GDP - Interest payments to exports (G & S)

Qualitative Factors <cont.> - Income distribution

- Homogeneity of population - Investment in human capital - Poverty - Existence of widespread corruption - Importance of social security - Education level of population - Regional economic structure - Degree of development and diversification of economy - Infrastructures - Energy position - State of economy and prospects - Quality of government - Fiscal and monetary policies - Effectiveness of monetary policies - Government’s economic development plans
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Quantitative Factors <cont.>
- Current investment service ratio (includes debt service and profits on foreign owned investments) - Principal payments to total external debt - Total foreign debt - Debt growth (%) - External debt to current account receipts - Composition external debt - Debt to Western banks - Time profile ratios - Share short-term debt in total - Borrowing on international markets - Eurocurrency loans and bonds - Average spread Euromarket borrowing - Current account - Current account imbalance over time - Current account imbalance to exports (G & S) - Current account to GDP

Qualitative Factors <cont.>
- Current account adjustment policies - Persistent overspending in public sector - Wage-price policies - Exchange rate policies - Import restraint policy - Control of inflation - Foreign exchange controls - Regulatory policies in financial sector - Banking system - Domestic capital markets - Sophistication financial institutions - Relative importance of private investments - Access to foreign capital markets - Reputation for economic stability - Country’s repayment record - Current collection experience 60

Quantitative Factors <cont.>
-Overall balance of payments over time -Basic balance of payments over time -Trade balance -Trade balance over time -Exports (goods) -Export trends over time -Export concentration, excluding oil -Export vulnerability -Export stability -Export diversity -Export market concentration -Export goods and services -Imports (goods) -Import trends over time -Import composition -Import compressibility -Import dependence -Petroleum imports -Trade account improvement/deterioration -Terms of trade over time -Main trading partners -Percentage change exports to percentage change imports -Import coverage (imports to exports)

Qualitative Factors <cont.>
-Quality

of management in public and private sector -Availability of technical and management skill -Effectiveness of entrepreneurial class -Labor force -Ability to take part in complex modern occupations -Unemployment as percent of labor force -External debt under control -Import composition -Quality relationship with major trading partners -Quality of relationship with U.S.A. -Quality of relationship with IMF -Willingness to provide data
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Other Variables
- Major natural resources - Population growth - Population density - Degree of literacy of people - Per capita expenditure on education - Percentage of university graduates in population - Density of medical facilities - Gainful employment ratio - Employment by economic sector - Unemployment trend - Degree of union organization - Consumption (individual households) - Extent of industrialization - Import substitution industries - Membership in trade pacts - Membership in political and economic power blocks - Bankruptcy rate

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Web Resources: Moody’s: www.moodys.com S&P www.standardandpoors.com

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