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 a) its competitive advantages, b) its production
location, c) the type of control it wants to have over any foreign operations, and d) how much
monetary capital to invest abroad. Explain how each of these considerations is important to
the success of foreign operations.
The firm must decide upon the degree of control it will need over the foreign operation,
recognizing that greater control usually involves both greater risk and a greater investment.
Viewing a spectrum of degrees of control, licensing and management contracts provide a low
level of control (along with a low level of financial investment); joint ventures necessitate a
somewhat higher level of control; and greenfield direct investments and/or acquisition of an
existing foreign firm require the highest degree of control (along with a higher level of
financial investment).
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 opportunities for MNEs. Large international firms are better able to exploit such
competitive factors as economies of scale, managerial and technological expertise, product
3. Competitive Advantage. When firms decide to invest in foreign countries, their decision is
based on the competitive advantage of the firm as well as those of the host country. What are
some of competitive advantages enjoyed by both the firms and host nations?
The competitive advantages enjoyed by MNEs include economies of scale and scope,
4. Economies of Scale and Scope. It is recognized that economies of scale and scope reduce
the average costs of MNEs. Should MNEs avoid excessive expansion to avoid potential
diseconomies of scale and scope?
Economies of scale exist when costs per unit fall as the number of units produced rises.
Economies of scope in multi-business unit MNEs exist when economic benefits or synergies
accrue because multiple businesses operate under one parent MNE.
5. Competitiveness of the Home Market. One method by which MNEs can increase
profitability and competitiveness is to operate in competitive home markets. What are the
factors that can enhance a home country’s competitive advantage?
Highly competitive home markets can sharpen a firm’s competitiveness in comparison to
other firms operating in less competitive home nations. There are four factors that can
improve competitiveness. First, the availability of cheap and quality inputs in a nation will
6. OLI Paradigm. The OLI paradigm attempts to explain why MNEs choose FDI to alternative
modes of foreign market entry. Explain how the financial strategies of MNEs are directly
related to the OLI Paradigm.
Until recently, the global market was dominated by MNEs from developed economies.
According to the World Bank, emerging economies accounted for 49% of global GDP in
7. Financial Links to OLI. Financial strategies are directly related to the OLI Paradigm.
a. Explain how proactive financial strategies are related to OLI. Proactive financial
strategies can be controlled in advance by the MNE’s financial managers. These include
strategies necessary to gain an advantage from lower global cost and greater availability
of capital. Other proactive financial strategies are negotiating financial subsidies and/or
reduced taxation to increase free cash flows, reducing financial agency costs through FDI,
and reducing operating and transaction exposure through FDI.
8. Where to Invest. The decision about where to invest abroad is influenced by behavioral
factors.
a. Explain the behavioral approach to FDI. The behavioral approach to analyzing the FDI
decision is typified by the so-called Swedish School of economists. The Swedish School
has rather successfully explained not just the initial decision to invest abroad but also
later decisions to reinvest elsewhere and to change the structure of a firm’s international
involvement over time. Based on the internationalization process of a sample of Swedish
9. Investing Abroad. What are the factors that lead a firm to expand its investment and
production operations into new foreign markets?
Before deciding to invest abroad, firms and MNEs have to consider a number of factors. First
and foremost, in order to be able to successfully invest abroad, firms have to compare and
consider whether their competitiveness increases if they move abroad or stay at home. They
10. Licensing and Management Contracts Versus Producing Abroad. What are the
advantages and disadvantages of licensing and management contracts compared to producing
abroad?
Licensing is a popular method for domestic firms to profit from foreign markets without the
need to commit sizable funds. Since the foreign producer is typically wholly owned locally,
political risk is minimized. In recent years a number of host countries have demanded that
MNEs sell their services in “unbundled form” rather than only through FDI. Such countries
would like their local firms to purchase managerial expertise and knowledge of product and
factor markets through management contracts, and purchase technology through licensing
agreements.
MNEs have not typically used licensing of independent firms. On the contrary, most
licensing arrangements have been with their own foreign subsidiaries or joint ventures.
License fees are a way to spread the corporate research and development cost among all
operating units and a means of repatriating profits in a form more acceptable to some host
countries than dividends.
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 repatriation of managers is easy. International
consulting and engineering firms traditionally conduct their foreign business on the basis of a
management contract.
11. MNE Entry in a Foreign Market. What is the optimal entry mode into a foreign market for
MNEs that require tight control over technological know-how? Explain.
MNEs have various methods for entering a foreign market, such as exports, Greenfield
investment, licensing, mergers, acquisitions, franchising, joint ventures, and wholly-owned
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 requires extended periods of physical construction and
13. Strategic Alliance. What are the main advantages and disadvantages that parties should
consider before forming strategic alliances?
Strategic alliances are cooperative agreements between actual or potential competitors
through exchanging stock, establishing a separate joint venture by each for producing
separate products, or founding joint marketing and servicing agreements. The main
14. Governance Risk. Explain the methods by which MNEs can tackle issues of governance as
they expand into new nations.
While the MNE tries to fulfill the objectives of its stakeholders, the host governments’ main
objective is to meet the development demands of the economy. This might lead to conflicts
between both parties as MNEs complain about legislative, bureaucratic, and tax restrictions.
15. Host Government Investment Duties. Host governments often engage investment advisers
to assist them with investments, investment agreements, and investment insurance. What are
advisors’ responsibilities for each of these matters?
16. Common Forms. Define the following types of political risk:
a. Adverse regulatory change
b. Breach of contract
c. Expropriation
a. Adverse regulatory change, also termed regulatory risk, refers to changes in host country
regulations that alter operating conditions of investments. As noted, we refer to ‘adverse’
changes, as few multinationals enjoy changes that reduce cost or operating requirements
b. Breach of contract refers to losses arising from a government or state-owned-enterprise
breaking or breaching of a business contract with the foreign private investor. A
A short list of deal-specific issues leading to breach of contract would include the following:
1) how the contract was awarded, bid or no-bid; 2) what contractual payment structure is
used, cost-plus, fixed price, or other; 3) is the contract still relevant, the obsolescing bargain
principle.
17. Lawful Expropriation. What criteria have to be met for a government’s seizure of a
company’s business to be considered ‘’lawful’ by international law?
The state, any state, has the sovereign right under international law to take property held by
private entities, domestic or foreign, through expropriation for economic, political, or social
reasons. (The taking of domestic property is referred to as eminent domain.) But in order to
be ‘lawful’ under international law, the expropriation needs to meet four criteria:
1. Property has to be taken for a public purpose
18. Political Risks. What are the various micro and macro political risks that MNEs have to
assess before deciding to invest in a foreign country?
Political risks are classified into micro (or firm-specific) risks and macro (or country-specific
and global-specific) risks. Firm-specific risks affect the MNE at the project or corporate
level, the most important being the governance risk. Country-specific risks originate at the
19. Blocked Funds. Why do MNEs operate in countries that impose transfer restrictions and
how can they manage impending transfer risks?
Among the political risks that MNEs face are the risks that the governments of these nations
can pass unexpected laws or take measures that prohibit or limit the remittance of revenues
20. Emerging Market Cultural Risks. Give examples of the cultural risks specific to emerging
markets that MNEs could encounter?
MNEs usually face cultural problems when moving to new locations. When it comes to
21. Emerging Market Institutional Risks. It is commonly argued that many cultural risks in
emerging market economies can be reduced by institutional development. Do you agree?
Explain.
At face value, some cultural risks in emerging market economies appear to be unavoidable
due to their being a result of social norms. For example, one risk inherent in these nations is
that the cultural norms of strong family ties may give birth to nepotism. This may not result
22. Sovereign Credit Risk. Is sovereign credit risk an example of a micro or macro risk? How
can it impact MNEs?
Sovereign credit risk arises when a borrower country becomes unable or unwilling to fulfill
its sovereign debt obligations, whether those of principal amount payments and/or interest
payments. Many developing countries faced such risks in the 1990s and several European
nations faced sovereign risk crises in the wake of the global financial crisis. Sovereign credit
23. MNEs and Protectionism. Answer the following questions:
a. What are the main reasons that emerging economies protect their domestic markets?
a. Emerging economies impose restrictions on free trade in order to protect their country’s
economy. In addition to the conventional infant industry argument, restricting foreign
imports would help solve balance-of-trade deficits, increase GDP growth, generate jobs,
and raise its people’s standard of living.
24. Political Risks. Should MNEs worry more about micro, country-specific, or global political
risks?
Micro-level political risks are industry or project-specific risks. Country-specific political
risk deals with the probability that political decisions, events, or conditions will significantly
affect the objectives, operations profitability of businesses. Examples of decision-related
political risks are nonmarket macroeconomic and social policies such as fiscal policy,
monetary policy, and trade barriers. Event-related political risks include revolutions,
25. Mitigating Political Risks. Explain whether it is more feasible for MNEs to manage or
mitigate micro, country-specific, or global political risks.
In some cases, MNEs are able to transfer political risk to a home-country public agency
through investment insurance and guarantee programs. Some of the risks that are covered by
these schemes are expropriation risks, asset loss/damage, reduction of income due to political
violence, and inability to convert domestic to foreign currencies. This means that insurance
26. Reputation Risk. MNEs are forbidden to engage in unethical transactions by the local anti-
bribery, anti-child-labor law, and anti-corruption laws of the countries in which they operate
as well as those of their home country. With the rise in global ethical concerns, the MNE can
develop reputational risks if it outsources some of its operations to corruption-prone
suppliers. Discuss how MNEs can limit these risks.
Chapter 17 Foreign Direct Investment and Political Risk ▪ 120
27. Blocked Funds. Explain the strategies used by an MNE to counter blocked funds.
What can a multinational firm do to transfer funds out of countries having exchange or
remittance restrictions? At least six popular strategies are used:
1. Providing alternative conduits for repatriating funds
2. Transfer pricing goods and services between related units of the MNE
3. Leading and lagging payments