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Outline:
✦ Market Imperfections that Lead to FDI:
→ Market failure or imperfections in general.
→ Product and factor markets.
→ Financial markets.
1
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.
2
According to this theory, MNC’s have intangible
capital in the form of trademarks, patents, general
marketing skills, and other organizational abilities.
3
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.
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.
10
→ Internalorganization 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.
11
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.
12
Foreign firms operating in these markets must enjoy
some competitive advantages over local firms in order
to compensate for such inherent disadvantages as:
13
The most important competitive advantages enjoyed
by multinational corporations include:
Advantages in the goods market:
Product differentiation
Unique marketing skills
Collusion in pricing
16
Financial Market Imperfections
Is a competing (complementing) hypothesis for
explaining FDI.
17
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.
MNCs can control the mode and timing of
internal financial transfers and thereby maximize
global profits.
– Mode of Transfer
◆ Transfer pricing
– Timing Flexibility
◆ Leading and lagging
19
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.
22
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.
24
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)
25
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.
26
Control through internal handling of operations
rather than through contracts with other
companies is often called internalization
Bandwagon Syndrome
28
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.
31
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.
Managing Political Risk
✦ Pre-investment Planning
✦ Operating Policies
✦ Post Expropriation Policies 32
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 Risk Indicators
✦ 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
33
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.
34
Political Risk Assessment for FDI
✦ 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.
39
✦ 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.
40
Managing Political Risks
Pre-investment Planning:
* Avoidance
* Insurance
* Negotiating the environment
* Structuring the investment
41
→ 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
42
→ PostExpropriation Policies:
* Rational negotiation
* Applying power
* Legal Remedies
* Management surrender
43
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 risk44.
✦ 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.
45
Definition of Terms
✦ 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
Examples:
(1) Gulf oil in 1975 was able to negotiate a very
favorable relationship with the Marxist MPLA
during the Angolan civil war.
47
✦ 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.
48
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.
58
Quantitative Factors <cont.> Qualitative Factors <cont.>
External Accounts - Income distribution
-Total reserves - Homogeneity of population
- Total reserves changes over time - Investment in human capital
- Reserves minus gold - Poverty
- Reserves minus gold over time - Existence of widespread corruption
- Availability IMF credit - Importance of social security
- IMF credit to gross reserves - Education level of population
- Net foreign assets - Regional economic structure
- External assets commercial banks - Degree of development and
- Reserves to imports diversification of economy
- Months-of-imports covered by reserves - Infrastructures
- External debt to reserves - Energy position
- Short-term external debt to reserves - State of economy and prospects
- Debt service ratio (and over time) - Quality of government
- Public debt to exports (goods and - Fiscal and monetary policies
services) - Effectiveness of monetary policies
- External debt to GDP - Government’s economic development
- Interest payments to exports (G & S) plans
59
Quantitative Factors <cont.> Qualitative Factors <cont.>
- Current investment service ratio (includes - Current account adjustment policies
debt service and profits on foreign owned - Persistent overspending in public
investments) sector
- Principal payments to total external debt - Wage-price policies
- Total foreign debt - Exchange rate policies
- Debt growth (%) - Import restraint policy
- External debt to current account receipts - Control of inflation
- Composition external debt - Foreign exchange controls
- Debt to Western banks - Regulatory policies in financial sector
- Time profile ratios
- Banking system
- Share short-term debt in total
- Domestic capital markets
- Borrowing on international markets
- Sophistication financial institutions
- Eurocurrency loans and bonds
- Relative importance of private
- Average spread Euromarket borrowing
investments
- Current account
- Access to foreign capital markets
- Current account imbalance over time
- Reputation for economic stability
- Current account imbalance to exports (G & S)
- Country’s repayment record
- Current account to GDP
- Current collection experience 60
Quantitative Factors <cont.> Qualitative Factors <cont.>
-Overall balance of payments over time
-Basic balance of payments over time -Quality of management in public
-Trade balance and private sector
-Trade balance over time -Availability of technical and
-Exports (goods)
-Export trends over time management skill
-Export concentration, excluding oil -Effectiveness of entrepreneurial class
-Export vulnerability -Labor force
-Export stability
-Export diversity
-Ability to take part in complex
-Export market concentration modern occupations
-Export goods and services -Unemployment as percent of labor
-Imports (goods)
force
-Import trends over time
-Import composition -External debt under control
-Import compressibility -Import composition
-Import dependence -Quality relationship with major
-Petroleum imports
-Trade account improvement/deterioration trading partners
-Terms of trade over time -Quality of relationship with U.S.A.
-Main trading partners -Quality of relationship with IMF
-Percentage change exports to percentage
change imports
-Willingness to provide data
-Import coverage (imports to exports)
61
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 62
✦ Web Resources:
Moody’s: www.moodys.com
S&P www.standardandpoors.com
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