CHAPTER 17
FOREIGN DIRECT INVESTMENT AND POLITICAL RISK
1. Evolving into Multinationalism. As a firm evolves from purely domestic into a true multinational
enterprise, it must consider (1) its competitive advantages, (2) its production location, (3) the type of
control it wants to have over any foreign operations, and (4) how much monetary capital to invest
abroad. Explain how each of these considerations is important to the success of foreign operations.
If a firm lacks sufficient competitive advantage to compete effectively in its home market, it is
unlikely to have sufficient advantages of any type to be successful in a foreign market. This is
because the competitive advantages of the home market must be enduring, transferable, and
sufficiently powerful to enable the firm to overcome the assorted difficulties of operating in a foreign
2. Market Imperfections. MNEs strive to take advantage of market imperfections in national markets
for products, factors of production, and financial assets. Large international firms are better able to
exploit such imperfections. What are their main competitive advantages?
MNEs strive to take advantage of imperfections in national markets for products, factors of
production, and financial assets. Imperfections in the market for products translate into market
3. 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. What are the necessary characteristics of this competitive advantage?
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In deciding whether to invest abroad, management must first determine whether the firm has a
4. Economies of Scale and Scope. Explain briefly how economies of scale and scope can be developed
in production, marketing, finance, research and development, transportation, and purchasing.
Economies of scale and scope can be developed in production, marketing, finance, research and
development, transportation, and purchasing. In each of these areas, being large has significant
competitive advantages, whether size is due to international or domestic operations. Production
5. Competitiveness of the Home Market. A strongly competitive home market can sharpen a firm’s
competitive advantage relative to firms located in less competitive markets. This phenomenon is
known as Porter’s “diamond of national advantage.” Explain what is meant by the “diamond of
national advantage.”
A strongly competitive home market can sharpen a firm’s competitive advantage relative to firms
located in less competitive home markets. This phenomenon is known as the “diamond of national
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Firms in industries that are surrounded by a critical mass of related industries and suppliers will be
more competitive because of this supporting cast. For example, electronic firms located in centers of
excellence, such as in the San Francisco Bay area, are surrounded by efficient, creative suppliers and
enjoy access to educational institutions at the forefront of knowledge.
A competitive home market forces firms to fine-tune their operational and control strategies for their
specific industry and country environment. Japanese firms learned how to organize to implement their
famous “just-in-time” inventory control system. One key was to use numerous subcontractors and
suppliers that were encouraged to locate near the final assembly plants.
In some cases, home country markets have not been large or competitive, but MNEs located there
have nevertheless developed global niche markets served by foreign subsidiaries. Global competition
in oligopolistic industries substitutes for domestic competition. For example, a number of MNEs
resident in Scandinavia, Switzerland, and the Netherlands fall in this category. Some of these are
Novo Nordisk (Denmark), Norske Hydro (Norway), Nokia (Finland), L.M. Ericsson (Sweden), Astra
(Sweden), ABB (Sweden/Switzerland), Roche Holding (Switzerland), Royal Dutch Shell (the
Netherlands), Unilever (the Netherlands), and Philips (the Netherlands).
6. OLI Paradigm. The OLI Paradigm is an attempt to create an overall framework to explain why
MNEs choose FDI rather than serve foreign markets through alternative modes.
7. Financial Links to OLI. Financial strategies are directly related to the OLI Paradigm.
8. Where to Invest. The decision about where to invest abroad is influenced by behavioral factors.
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Close psychic distance defined countries with a cultural, legal, and institutional environment
similar to Sweden’s, such as Norway, Denmark, Finland, Germany, and the United Kingdom.
The initial investments were modest in size to minimize the risk of an uncertain foreign
environment. As the Swedish firms learned from their initial investments, they became willing to
take greater risks with respect to both the psychic distance of the countries and the size of the
investments.
b. Explain the international network theory explanation of FDI. As the Swedish MNEs grew and
matured, so did the nature of their international involvement. Today each MNE is perceived as
being a member of an international network, with nodes based in each of the foreign subsidiaries,
as well as the parent firm itself. Centralized (hierarchical) control has given way to decentralized
(heterarchical) control. Foreign subsidiaries compete with each other and with the parent for
expanded resource commitments, thus influencing the strategy and reinvestment decisions. Many
of these MNEs have become political coalitions with competing internal and external networks.
Each subsidiary (and the parent) is embedded in its host country’s network of suppliers and
customers. It is also a member of a worldwide network based on its industry. Finally, it is a
member of an organizational network under the nominal control of the parent firm. Complicating
matters still further is the possibility that the parent itself may have evolved into a transnational
firm, one that is owned by a coalition of investors located in different countries.
9. Exporting versus Producing Abroad. What are the advantages and disadvantages of limiting a
firm’s activities to exporting compared to producing abroad?
There are several advantages to limiting a firm’s activities to exports. Exporting has none of the
unique risks facing FDI, joint ventures, strategic alliances, and licensing. Political risks are minimal.
10. Licensing and Management Contracts Versus Producing Abroad. What are the advantages and
disadvantages of licensing and management contracts compared to producing abroad?
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The main disadvantage of licensing is that license fees are likely to be lower than FDI profits,
11. Joint Venture versus Wholly Owned Production Subsidiary. What are the advantages and
disadvantages of forming a joint venture to serve a foreign market compared to serving that market
with a wholly owned production subsidiary?
A joint venture is here defined as shared ownership in a foreign business. A foreign business unit that
is partially owned by the parent company is typically termed a foreign affiliate. A foreign business
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c. If the host country requires that foreign firms share ownership with local firms or investors, 100%
foreign ownership is not a realistic alternative to a joint venture.
d. The local partner’s contacts and reputation enhance access to the host country’s capital markets.
e. The local partner may possess technology that is appropriate for the local environment or perhaps
can be used worldwide.
f. The public image of a firm that is partially locally owned may improve its sales possibilities if the
purpose of the investment is to serve the local market.
Despite this impressive list of advantages, joint ventures are not as common as 100%-owned foreign
subsidiaries because MNEs fear interference by the local partner in certain critical decision areas.
12. Greenfield Investment versus Acquisition. What are the advantages and disadvantages of serving a
foreign market through a greenfield foreign direct investment compared to an acquisition of a local
firm in the target market?
A greenfield investment is defined as establishing a production or service facility starting from the
ground up, i.e., from a green field. Compared to greenfield investment, a cross-border acquisition has
a number of significant advantages. First and foremost, it is quicker. Greenfield investment frequently
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Cross-border acquisitions are not, however, without their pitfalls. As with all acquisitions—domestic
or international—there are the frequent problems of paying too high a price or suffering a method of
financing that is too costly. Meshing different corporate cultures can be traumatic. Managing the post-
acquisition process is frequently characterized by downsizing to gain economies of scale and scope in
overhead functions. This results in nonproductive impacts on the firm as individuals attempt to save
their own jobs. Internationally, additional difficulties arise from host governments intervening in
pricing, financing, employment guarantees, market segmentation, and general nationalism and
favoritism. In fact, the ability to complete international acquisitions successfully may itself be a test
of the MNE’s competence in the twenty-first century.
13. Cross-Border Strategic Alliance. The term “cross-border strategic alliance” conveys different
meanings to different observers. What are the meanings?
The term strategic alliance conveys different meanings to different observers. In one form of cross-
14. Governance Risk.
15. Investment Agreement. An investment agreement spells out specific rights and responsibilities of
both the foreign firm and the host government. What are the main financial policies that should be
included in an investment agreement?
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An investment agreement spells out specific rights and responsibilities of both the foreign firm and
the host government. The presence of MNEs is as often sought by development-seeking host
governments as a particular foreign location sought by an MNE. All parties have alternatives and so
bargaining is appropriate.
An investment agreement should spell out policies on financial and managerial issues, including the
following:
The basis on which fund flows, such as dividends, management fees, royalties, patent fees, and
loan repayments, may be remitted
16. Investment Insurance and Guarantees (OPIC).
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Expropriation is the risk that the host government takes a specific step that for one year
prevents the investor or the foreign subsidiary from exercising effective control over use of
the property.
War, revolution, insurrection, and civil strife coverage applies primarily to the damage of
physical property of the insured, although in some cases inability of a foreign subsidiary to
repay a loan because of a war may be covered.
Business income coverage provides compensation for loss of business income resulting from
events of political violence that directly cause damage to the assets of a foreign enterprise.
17. Operating Strategies after the FDI Decision. The following operating strategies, among others, are
expected to reduce damage from political risk. Explain each one and how it reduces damage.
a. Local sourcing. Host governments may require foreign firms to purchase raw material and
components locally as a way to maximize value added benefits and to increase local employment.
From the viewpoint of the foreign firm trying to adapt to host-country goals, local sourcing
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18. Country-Specific Risk. Define the following terms:
a. Transfer risk. Transfer risk is defined as limitations on the MNE’s ability to transfer funds into
19. Blocked Funds. Explain the strategies used by an MNE to counter blocked funds.
20. Cultural and Institutional Risks. Identify and explain the main types of cultural and institutional
risks, except protectionism.
21. Strategies to Manage Cultural and Institutional Risks. Explain the strategies that a MNE can use
to manage each of the cultural and institutional risks that you identified in question 9, except
protectionism.
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Lengthy and detailed descriptions are provided in the chapter.
22. Protectionism Defined.
a. Define protectionism and identify the industries that are typically protected. Protectionism is
23. Managing Protectionism.
a. What are the traditional methods for countries to implement protectionism? Tariff and
nontariff barriers.
24. Global-Specific Risks. What are the main types of political risks that are global in origin?
25. Managing Global-Specific Risks. What are the main strategies used by MNEs to manage the global-
specific risks you have identified in question 13?
26. U.S. Anti-Bribery Law. The United States has a law prohibiting U.S. firms from bribing foreign
officials and business persons, even in countries where bribery is a normal practice. Some U.S. firms
claim this places the United States at a disadvantage compared to host-country firms and other foreign
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firms that are not hampered by such a law. Discuss the ethics and practicality of the U.S. anti-bribery
law.
MNEs are caught in a dilemma. Should they employ bribery if their local competitors use this
strategy? Alternative strategies are as follows: