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298

Chapter 10

Foreign Investment: Researching Risk

“The outcome of any serious research can only be to make two questions grow where only one grew before.”

—Thorstein Veblen

Chapter ObjeCtives

this chapter will:

• Look at the forces and opportunities that support foreign investment by multinational corporations

• Discuss the role political risk plays in counterbalancing the benefits or opportunities of investing abroad

• Describe the various ways host governments control foreign investment • Present management techniques that can be used to reduce political risk when

investing abroad

Why invest aBroad? Every firm that considers investing abroad must weigh the potential advantages against the potential risks. To do that, in-house analysis must identify and evaluate key factors. There are several reasons to consider initially why firms should invest abroad, and a few general factors can be linked to the overall level of risk a particular host country holds for an MNC making a foreign direct investment. These factors include the attitude of the host country’s government, the political system in place, the level of public discon-

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Why Invest Abroad? 299

tent or satisfaction, the unification or fragmentation of the local society on cultural and religious lines, the kind of internal and external pressures faced by the government, and the history of the country in the past few decades. In the pages that follow, we address each of these concerns in turn.

A recent publication by the Economist ranked the countries of the world according to the friendliness of the business environment. The rankings reflect the opportuni- ties for, and the hindrances to, the conduct of business, as measured by the countries’ rankings in ten categories, including market potential, tax and labor market policies, infrastructure, skills, and the political environment.1 The top twenty countries are listed in Table 10.1.

bigger MarketS Many international firms decide to invest overseas to tap larger foreign markets. To keep growing, a firm must increase its sales, which may not be possible in the domestic market. Domestic markets, however large, are limited to a particular size and rate of growth and are the target of competition from other domestic firms with similar products and mar- keting capabilities. In such situations, a move overseas is a logical step for a company wanting to tap a larger market. Apart from the fact that the existence of a new, larger customer base would boost sales, overseas markets often confer additional advantages to the firm. For example, these markets may not have products that are similar to or of the same quality as those of the firm going overseas, and the competition from overseas markets may not be as strong as domestic competition.

Table 10.1 Most Business-Friendly Environments

1. Singapore 2. Switzerland 3. Finland 4. Canada/Hong Kong (tied) 6. Australia/Denmark (tied) 8. New Zealand/Sweden (tied) 10. Netherlands 11. Norway/Taiwan (tied) 13. United States 14. Germany 15. Chile 16. Belgium 17. Ireland 18. Qatar 19. France 20. Austria

Source: Economist, “Business Environment Rankings,” 61.

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hoSt-NatioN deMaNdS Occasionally firms must invest overseas to tap international markets because host-country government restrictions require that the firm’s products be manufactured locally. Such restrictions are generally imposed to boost the local economy and general domestic production and employment. Thus, the MNC that wants to tap an overseas market has to invest in overseas plants that are run by domestic managers, in local subordinates, or through some other arrangement.

ecoNoMieS of Scale A firm might want to invest in an overseas market because it is cheaper to manufacture goods locally rather than manufacturing them at home and exporting them. When the lo- cal market is large and the demand is consistent enough to justify investment in the plant and equipment needed to set up a manufacturing operation, production economies can occur through other factors. For example, the labor costs may be lower in the overseas location, the sources of raw materials may be closer to the plant in the overseas location, and the costs of shipping and marketing the products may be lower than those of home- based operations. Another important factor is the location of the firm. An overseas plant location may also be better suited to serve a third-country market.

coMpetitive MotiveS Often firms operate in head-on competition with other domestic and international firms. This type of competition is particularly severe in oligopolistic industries, where only a few large firms dominate the market. In such an environment, the moves of one firm are quickly duplicated and challenged by the others. Thus, if one firm moves abroad, its competitors make similar moves. One obvious motive for the move is to keep pace with the first firm in new markets and overall level of sales. The other motive is the need to match the overseas strategy of competitors, because if that is not done, the competition could acquire additional strength from its overseas operation, which could be leveraged in the domestic market, too. Competition often occurs between firms of different countries that dominate parts of the same industry (e.g., Caterpillar Company of the United States and Komatsu of Japan dominate the earth-moving machinery industry). If one company invades the home-country market of another, it is very likely that the competitor will be motivated to retaliate by accessing its competition’s domestic market. For example, in the 1990s, Kodak decided to enter the Japanese market to counter Fuji’s market share gains in the United States.

techNology aNd Quality coNtrol Many firms feel that if they license their technology to a company in the overseas location, their technology might be leaked to competitors. In fact, many companies, especially in

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the high-technology area, hold on to their know-how so closely that they do not license it as a matter of policy. The practice of retaining information within the company is often referred to as internalization. Some companies feel that licensing their technology may result in the licensee producing a product of inferior quality, which may be damaging to the product image. To obviate such possibilities, companies prefer to set up their own overseas manufacturing operations. Having their own operations also provides some companies with greater assurance of regular supply, better maintenance, and after-sales services for their products, which are crucial to retaining customer loyalty in a highly competitive international environment.

raW MaterialS Many firms rely on raw materials imported from abroad, a reliance that can stem from both availability and cost considerations. The raw materials may not be available in the home country, or, alternatively, it may be more economical to access raw materials from overseas than domestically if the price differences exceed the additional transportation costs. If a firm decides to rely on overseas raw materials, it often becomes dependent on a regular supply at predictable and relatively stable prices. Long-term contracts with overseas suppliers are one way of achieving predictable and stable prices. In some cases, however, companies are unwilling to take the risk of the supplier’s reneging on the con- tract so they decide to invest in extractive mining and other such raw materials sourcing operations overseas. Sometimes such investments are motivated by the consideration that the necessary technology is not available in the source country and therefore must be provided by the corporation interested in extracting the materials. Often permission from the governments of the countries where raw materials are available is centered on the type of technology the overseas corporation is able to bring to use in the extractive processes.

forWard iNtegratioN Many companies wish to eliminate middlemen from their operations and forward integrate the different stages involved in the manufacture of their products and their sales to the consumer. For example, a firm may produce a soft-drink concentrate and sell it to a local bottler overseas who bottles and sells it in foreign markets. The profits from the revenues generated from the sales of the soft drink are shared by the company producing the soft drink concentrate and the local bottler. If the company selling the concentrate had its own bottling plant in the foreign country, it would be able to control the entire operation and eliminate sharing its profits with the intermediary agent. This motivation may prompt the company manufacturing the concentrate to set up its own bottling operation overseas.

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techNology acQuiSitioN Multinational corporations often invest in other countries to gain access to new tech- nologies that are not developed in the home country. Access to new technology is often sought by the outright acquisition of new firms possessing such knowledge. These new technologies are generally intended for integration with the entire global corporate strat- egy of the MNC that acquires them. Often, the company that acquires a new technology through an overseas acquisition sets up an overseas facility, which enhances the existing operations by adding the managerial, financial, and technological strengths of the parent company.

assessing politiCal risk Political risk for multinational corporations includes adverse actions that may be taken by host-country governments against the firms. These actions can include changes in the operating conditions of foreign enterprises that arise out of the political process, either directly through war, insurrection, or political violence, or through changes in govern- ment that affect the behavior, ownership, physical assets, personnel, or operations of the firm.

Political risk does not necessarily arise out of an upheaval in the political climate of the host country. Perceptions often change within the same government, and, as a result, decisions detrimental to the interests of the firm can be made. Moreover, because policies can and do change, some degree of political risk is present in nearly all countries.

Factors responsible for political risk can be grouped into two categories: inherent and circumstantial. Inherent factors are conditions that are present constantly around the world that generate a certain danger of adverse action by host governments from the point of view of the multinational corporation (e.g., terrorism). Circumstantial factors are those conditions that can arise out of particular events in different countries.

iNhereNt cauSeS of political riSk Different Economic Objectives The motivations and goals of a US MNC are often at variance with those of the host government (see Table 10.2). A primary example is in the area of balance of payments considerations. A host country that is facing difficulties with its balance of payments might seek to conserve its resources by maximizing the inflows and minimizing the out- flows. It may also try to optimize the use of the available foreign exchange resources by placing restrictions on repatriation of profits, dividends, and royalties by a multinational corporation to its home country. The host government could also place restrictions on the time lag permitted for import and export payments, thus interfering with the MNC’s internal leading and lagging strategy, which is devised to manage its finances and avoid exchange- and interest-rate risks.

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In a leading and lagging strategy, firms decide which payables to pay early and which payables to pay late based on factors such as exchange rates, net receipts from their centralized cash management system, and the size or power of the company owed. Ad- ditionally, the leading and lagging can also pertain to the timing of collections of accounts receivable, for similar reasons.

Monetary and Fiscal Policies The monetary and fiscal policies of a host government may be at variance with an MNC’s desires. For example, a host country that is faced with impending inflationary conditions might want to raise the interest rates on bank lending, which may be detrimental to the interests of an MNC, whose costs of funds, and therefore of production, would go up correspondingly. The banks may also be directed to maintain quantitative ceilings on lending to prevent excessive increases in the money supply of the host country. The MNC, on the other hand, keen to retain its financing sources according to its own requirements, might attempt to circumvent these ceilings, further incurring the displeasure of the host government and raising a risk of further punitive action.

Similarly, fiscal policies followed by host governments may not be in the MNC’s interests. The interest of the host government is invariably to maximize revenues, while that of the MNC is to minimize its tax liability. Increasing taxes is a major inherent risk that an MNC faces while operating overseas. Moreover, some countries levy a heavier tax on the repatriated portions of an MNC’s profits, which is often in addition to the

Table 10.2 Conflicting Objectives Between Developing Countries and Multinational Corporations

Developing countries Multinational corporations

Promote local ownership Maintain global controls and efficiency Increase local ownership and control Minimize costs of technology and capital Reduce duration of contracts and change

payment Receive reasonable returns for risk

characteristics

Separate technology from private investment Provide technology as part of long-term production and market development

Eliminate restrictive business clauses in technol- ogy and investment agreements

Maintain ability to affect the use of capital, technology, and associated products

Minimize proprietary rights of suppliers Protect rights for profit from private investments Reduce contract security Use contracts to create stable business environ-

ment and to develop trust

Encourage technology and R&D transfer to host country

Maintain control of technology and R&D paid for by the company

Develop suitable products for host country Gain global economies of scale to lower costs of products

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normal corporate taxes paid by a local company. Sometimes under these regimes, sepa- rate exchange rates are specified for different transactions. The goal of the host country might be to defend a particular level of the exchange rate that it deems appropriate in the pursuit of its best economic interest. For the MNC, however, this might mean that there is an artificial distortion in the amount of funds it is able to repatriate, which adversely affects its overall profitability.

Economic Development and Industrial Policies

The industrial and economic development policies of a host country can often pose a risk for an MNC. For example, countries may want to promote certain backward geographical regions where infrastructural facilities are low and might therefore require the expan- sion of MNCs to such regions even though investment there may not be economically feasible. Many host countries want to promote domestic industry and, particularly, small and medium-size enterprises. To do so, host countries tend to provide subsidies or other fiscal incentives or reserve the production of certain goods for such industries. Another promotion mechanism is the purchase policy of the government.

In many host countries, especially less-developed countries, the government is the largest buyer of goods and services. Exclusion from government contracts, therefore, affects the sales of an MNC’s products significantly. Also, in many of the core and sensitive industries (e.g., defense and infrastructure-oriented industries), MNC participation may be prohibited. The risk arises from the possibility that some industries in which an MNC is active might be declared core industries or sensitive industries, and MNC operations may be expropri- ated or forcibly sold to local parties. The rationale behind the exclusion of MNCs from key industries is apparently apprehension in the minds of host governments that MNC control of key industries might endanger national security and hamper the ability of the government to conduct an independent foreign policy. Such policies are similar to what Vladimir Lenin referred to as the commanding heights of the economy. The commanding heights were key industries required to effectively control an economy. In the early 1900s, such industries included railroads, steel, and heavy industry. Based on many of the current barriers to foreign control, the modern-day commanding heights of the economy would appear to be banking, telecommunications, broadcasting, and other such service sector industries.

Colonial Heritage

Many host countries are former colonies that have gained their independence. The colo- nial era was marked by complete political domination by foreign powers and economic domination by foreign companies. Most of the foreign companies in that era used their privileged, often monopolistic positions to exploit local resources, markets, and labor to maximize their profits. As a result, they were seen to be a drain on the economies of the colonies, leaving a sense of distrust of MNCs in the minds of host-country governments, who fear that MNCs may still exploit their economies. As a result, they are extra careful in

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scrutinizing proposals for foreign direct investment by multinationals and monitor MNCs’ activities closely. These concerns also explain to some extent why such stringent controls are placed on MNCs’ activities. This fundamental apprehension does not permit MNCs to operate freely and creates a constant risk of adverse action by host governments.

Sociocultural Differences

To a degree, political risk arises out of the sociocultural differences between a host country and an MNC. Social codes of conduct in certain countries contrast sharply with those of the MNCs. While in a host country, an MNC’s executives face the risk of offending local sensibilities over crucial sociocultural issues. Moreover, some basic behavioral trends and norms followed by an MNC as a part of its usual way of functioning may prove offensive to the government or the clientele. For example, Western companies often have female executives representing them in meetings and negotiations, which might offend host officials or clients in Middle Eastern countries because women there are not expected to play such roles. Even relatively simple things, such as greetings, gift-giving, and hospitality, can become serious issues if they offend a key government official or a client in a host country. An MNC must always do its homework and adapt itself to local culture if it wants to avoid political risk.

circuMStaNtial cauSeS of political riSk Change of Government

A change of government is a major political risk faced by MNCs. In many countries po- litical opponents have economic policy positions different from those of the government in office, and a new government is often keen to reverse the policies of its predecessors. Thus, an MNC that has excellent relations with a host government may find its assets under the threat of expropriation because of a change in government. In addition to having a different economic policy, a new host government may be hostile toward an MNC if the company is perceived as a supporter of the new government’s political opponents.

Political risk is particularly high in countries that are in the midst of a transition from one type of political system to another, such as from a capitalist to a socialist society. In the past, in many countries that shifted from capitalist to socialist systems, entire assets of MNCs were expropriated, some with compensation, but some without.

Political Difficulties of Host Governments

In many countries where economic and social conditions are fairly unstable, it is often difficult for a government to manage the resulting public discontent. Many governments, in an attempt to shift blame for economic ills, target MNCs as the cause of those problems. The politicians in power often play on the inherent mistrust that the general public has of these foreign, wealthy, and powerful firms.

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Political Action by Other Groups MNCs also face the risk of adverse political activity from opposition parties seeking an issue about which to criticize the government. A host government’s support for an MNC provides opposition parties with an ideal issue to manipulate nationalist feelings by propagating the line that the country is exploited by the MNC and that this exploitation is supported by the incumbent party. Sociopolitical activists and environmental groups are another source of political risk. Many MNCs have large investments in factories and extractive industries, which easily attract attention. Therefore, many consumer, labor, and environmental groups can attack the safety and pollution standards of MNCs, even though those standards may be better than those of domestic corporations in the same industry. Moreover, such attacks are likely to evoke a more active response from host governments, such as penalizing the MNC more heavily than a domestic industry for similar offenses.

Bilateral Relations Between the Host and Home Governments The attitude of a host government toward an MNC is dependent on the bilateral relations between the host government and the MNC’s home government. If the MNC’s home government comes into conflict with the host government, it is likely that the latter will take direct or indirect action against the MNC. In several instances, when hostilities have broken out between two countries, the assets of MNCs have been confiscated without compensation. Even when the conflict falls short of outright war, adverse action against MNCs can result. For example, if one country faces a ban on some of its exports to an MNC’s home country, it may retaliate by blocking the repatriation of the MNC’s profits. Occasionally, action has been taken against MNCs to settle political scores. For example, if an MNC’s home country takes an opposing stance at international forums or indirectly supports the host country’s enemies, the host country can retaliate by taking action against the MNC within its jurisdiction.

Local Vested Interests MNCs also face the possibility of adverse action from the lobbying efforts of local vested interests (otherwise known as protectionist pressures). As a rule, MNCs have considerable competitive power because they enjoy many advantages. They introduce a dynamic competitive force into local economies that upsets the entrenched positions of local businesspeople by capturing market share and reducing local firms’ ability to skim off the market by charging higher prices for their products. Moreover, by introducing new products of superior quality at relatively competitive prices, an MNC is often able to expose the weaknesses of local businesses and force them to improve their own economic and operating efficiencies to regain their competitiveness in the marketplace.

While some local businesses respond to the MNC challenge in this way, many do not. These businesses try to fight the MNC’s intrusion by pressuring the government to impose restrictions on the MNC in order to increase its costs and reduce its ability to compete.

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In some cases, local vested interests lobby the government to prohibit the MNC’s entry into the country or attempt to have regulations introduced that prohibit the MNC from doing certain kinds of business. The local interest groups are thus a serious political risk in many countries. In the wake of the recent financial crisis, these pressures escalated in many markets given the economic uncertainty and the dearth of jobs.

Social Unrest and Disorder Fundamental and deep-rooted tensions in some countries fragment the local social order. Either on their own or at the manipulation of political interests, these tensions can oc- casionally erupt into riots and other acts of public violence. In such situations, the law enforcement machinery of local governments may be inadequate to protect public property against destruction and looting. MNC assets have sometimes become the targets of arson- ists and looters, especially if they are instigated by vested interests. As recent political uprisings in Syria and in Greece illustrate, political protest comes in many forms, both violent and nonviolent, but in either case, the rules of engagement for a multinational corporation could change very quickly.

types oF host-nation Control Host governments impose different types of controls on the activities of MNCs, ranging from limits on the repatriation of profits to labor controls.

liMitS oN repatriatioN of profitS Many host governments place limits and conditions on the repatriation of profits, divi- dends, royalties, technical know-how fees, and other such revenue. Some governments impose an absolute ceiling on the amount of dividends that can be repatriated each year, and in some cases, these ceilings are subject to additional conditions that stipulate a maximum percentage of profits that can be repatriated. Moreover, corporations may also be asked to meet certain financial standards, such as debt-equity ratios, before being permitted any repatriation of profits or dividends. Other countries have a hierarchal approval process. Remittances of small amounts of profits are allowed freely, but higher amounts need the approval of the authorities, which could be the central bank or the government itself.

Certain countries facing severe balance of payments problems place time restrictions on the repatriation of dividends and profits: corporations have to retain their entire earn- ings in the host country for a certain time period, which can vary from a few months to several years. In countries faced with a shortage of foreign exchange, a time constraint can appear without a specific regulation to this effect. This constraint occurs when each request for repatriation must be approved by the central bank and only a limited number of requests can be approved each year. As a result, requests are rated sequentially, and repatriation must wait, sometimes several years in countries in the midst of a serious and prolonged balance of payments crisis.

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curbiNg traNSfer priciNg Many host governments are alert to the practice of transfer pricing by MNCs. To eliminate the outflow of profits through this mechanism, they establish regulations that reduce the MNC’s ability to move funds by manipulating the company pricing structure. Normally, such regulations enable host-country authorities to disregard the internal prices charged by the parent to the subsidiary and to assess the company using an independent calcula- tion that is based on standard international prices for that commodity instead of the price shown on the books of the company. These regulations enable the host government to assess an MNC’s tax and tariff liabilities independently and reduce the advantages that an MNC tries to achieve through transfer pricing.

price coNtrolS Some host governments still have highly controlled economies. One of the important features of such an economy is the presence of price controls. An MNC entering such a country may be forced to sell its goods at the controlled prices, even though they may be well below the planned prices. In some instances, host governments require specific margins over costs. Additional controls may also be imposed, usually in situations of shortages, impending inflation, or potential or active social discontent over prices.

oWNerShip reStrictioNS Many governments restrict foreign ownership of MNCs to a certain percentage, which means that the remaining portion must be owned by local partners or offered as a public issue in the local stock market. In such situations, the company often cannot exercise total control over operations, and limits are placed on the amount of profits it can repatriate. When total ownership is in the hands of the company, a very high dividend can be declared to transfer profits and capital out of the country. If the company is partly owned by local partners, this manipulation is not possible because local shareholders can question com- pany policies. Moreover, the company cannot declare an unduly high dividend because the same level of dividend would have to be paid to local shareholders. In addition, once ownership is diluted, an MNC faces a takeover threat, because local interests can hold enough shares to acquire the local subsidiary and oust the management.

joiNt veNtureS Some countries require that MNCs come into the country only as a partner in a joint venture with a local company. The motive of the host government is to secure monitoring and control leverage over the MNC through its local joint-venture partner and to pro- mote domestic industrial capabilities by associating local companies with international corporations. These joint ventures can sometimes work to an MNC’s detriment, because a suitable joint-venture partner may not be available or the one chosen may not perform

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its share of obligations. Additionally, joint-venture partners may have differing goals, which hinders the success of the combined effort. Moreover, some MNCs are wary of joint ventures with local companies because they fear the leakage of closely held advanced technical knowledge.

Given these possibilities, joint ventures entered into by a multinational company with a host government or other entity should have clear goals, time constraints, and agreement on the limits of information sharing. All partnership eventually end, so the risk is to give up too much crucial information and, in effect, create a new competitor.

perSoNNel reStrictioNS Some host governments require that local citizens be placed on the board of directors of an MNC’s local subsidiary. In many instances conditions of an MNC’s entry into a foreign country stipulate that a certain number of top positions be filled by local citi- zens. Quite often this regulation is implemented by making a reverse condition, such as limiting the number of expatriate employees or managers a company can bring into its operations in the host country. These restrictions are made even more severe by stringent approval procedures for the issue of expatriate visas by home governments, and very often maximum salaries payable to overseas executives are subject to ceilings and higher tax rates.

iMport coNteNt One of the primary concerns of many host governments is that MNCs are a drain on the foreign exchange resources of the country because they generate profits in local curren- cies and repatriate them in foreign currencies. To ensure that this foreign exchange drain is minimized, many host countries place restrictions on the amount of imports used for manufacturing products locally. The same objective is often achieved by specifying that a certain percentage of local inputs must be used in the MNC’s product. Some MNCs that rely largely on imported inputs for the domestic market and, therefore, cannot meet the import content requirements must make up the foreign exchange loss by exporting either a certain percentage or a certain amount of their production. In other words, some sort of balance sheet of the foreign exchange inflows and outflows is drawn up and the size of the export obligation is decided on the basis of projected foreign exchange outflows of an MNC’s operations. Such restrictions can pose difficult problems for MNCs whose strategy is to basically produce and sell in the domestic market of the host country and whose products are designed for this purpose.

diScriMiNatioN iN goverNMeNt buSiNeSS Industrial policies followed by host governments are a major source of risk for MNCs. Dis- crimination in allocating government business is a major restriction on the scope and potential

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of MNC business opportunities in countries where the government plays a powerful economic role. Government purchases usually are made from domestic corporations. If such corporations happen to be the competitors of the MNC, then the former gains a major competitive edge through its access to an exclusive market. Moreover, government purchases are generally high in volume and result in substantial profits for companies who get that business.

labor coNtrolS Some countries impose fairly comprehensive labor and social controls on MNCs. The stipulation may require that the labor for the firm will be recruited only through a govern- ment agency that screens all potential employees, enabling the government to influence the production of the company by controlling the supply of labor. The compensation paid to employees can be regulated by host governments. Some host governments stipulate that the wage rates of local employees be higher than the rates paid by domestic corporations to workers performing comparable tasks. The host governments also sometimes require additional benefits for local employees, such as health insurance, various allowances, and arbitrary levels of bonuses.

assessing the risk Assessing political risk is a two-stage process. In the first stage an assessment is made of the riskiness of the host country as a place to do business. In the second stage an MNC considers the risks involved in making a particular investment. An investment should be made only if the level of risk at both stages is found to be acceptable.

aSSeSSiNg couNtry riSk Country risk is a very broad measure that focuses on the riskiness of the country as a whole as a place for MNCs to conduct business. One prime consideration is the current and anticipated future level of political stability in the country. A stable country obviously provides a better investment climate. An assessment of political conditions is made by gathering relevant information from several sources: national and international media, diplomatic assessments, and professional agencies that specialize in monitoring develop- ments in certain countries.

Some of these professionals develop their own ratings for the different degrees of risk in various countries with regard to foreign direct investment by MNCs. These ratings are developed by assigning weights to different political, social, and economic factors that could lead to political instability and disorder. These weights are then added and averaged according to a particular formula to arrive at a final rating of a country’s level of risk. Because different factors are included and the exercise of assigning risk weights is arbitrary, there is a strong element of subjectivity in this analysis. In general, Western industrialized countries carry low levels of risk for MNCs. Risks seem to increase in

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inverse proportion to the income of the countries, with the low-income countries posing higher risk. There are, however, important exceptions, because some middle-income countries prone to sociopolitical turmoil carry an even greater risk than some of the lower-income countries.

aSSeSSiNg iNveStMeNt riSk One starting point in assessing the risk attached to making investments is to investigate the attitude and actions of the host government with regard to similar investments made by other MNCs. The existence of local lobbies and the influence they exert on the gov- ernment is also a useful indicator of investment-specific risk. Powerful local lobbies in a particular industry imply higher risk.

Tax structures, industry standards, government discrimination, ownership and manage- ment requirements, repatriation conditions, export obligations, and location constraints should also be considered.

Managing risk rejectiNg iNveStMeNt Many MNCs find that the potential risks in certain countries are too great in comparison to the expected returns. Therefore, they reject the potential investment. Rejection may also occur when the initial negotiation of terms between the host country and the MNC does not result in an agreement. Because the host country is eager to attract overseas investment, the MNC rejection may sometimes prompt the host government to relax some of the conditions.

loNg-terM agreeMeNtS Many MNCs find that one way to reduce political risk is to negotiate long-term com- mitments from the host government on the regulation of the firm. Negotiating these safeguards requires skill and foresight. A balance must be struck between achieving the safest possible terms for the company and recognizing the current national policies of the host government. The limitation of these safeguards, however, is that there is no practical way to enforce them in the event that the host government reneges on its part of the contractual obligations. However, a government is less likely to take any adverse actions if it is bound by a written agreement not to do so, as compared to a situation in which it has not given any such assurances.

lobbyiNg Many MNCs resort to lobbying politicians and officials of host governments to influence the direction of policies and decisions that affect them, because much political risk arises

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from the potential actions that can be taken by host governments. Direct lobbying is done by establishing a liaison or representative office in the capital city of the host country. The representative of the company establishes direct contacts with local officials and politicians and lobbies them to maintain favorable policies for the MNC. At other times, a local liaison agent is used to lobby local officials, especially in those countries where the domestic politi- cal and official structure is complex and not easily understood by outsiders.

Indirect lobbying, or the use of news media or advertising to shape public opinion, is favored by many MNCs in countries where local officials are averse to dealing di- rectly with foreigners. Direct lobbying involves the use of influence buying or bribing of officials and politicians who are important players in the shaping of official policy and attitudes of the home government toward MNCs. Although many multinationals do not admit offering such bribes, for obvious reasons, it is a common practice in many countries.

legal actioN If threatened, MNCs can resort to legal action, but this approach is useful only in coun- tries that have an efficient legal system and independent judiciary. Recourse to the law would be warranted when an MNC is of the opinion that a new decision or regulation of the host government is illegal under the laws of the country or violates any initial agree- ments made with the host government. Legal action, however, is a last resort, taken only when there is no other option. Such actions are usually taken only by those companies that have decided to divest their investments in the host countries, because bringing a legal suit against the host government is likely to bring forth retaliation.

hoMe-couNtry preSSure Many MNCs, when faced with an adverse position taken by the host government, seek the intervention of their home governments, generally through diplomatic channels. The foreign office of the home country generally exerts informal pressure on the government of the host country to alter its attitude toward the MNCs. If the issue is important, this intervention can take place at very high levels, such as heads of state. Apart from the general threat of deterioration of bilateral relations, home governments also occasionally hold out thinly veiled threats of retaliation against the corporations of the host country in the jurisdiction of the home country or threaten to erect trade or other barriers. This channel is effective when relations with the MNC’s home country are particularly im- portant to the host country.

joiNt veNtureS aNd iNcreaSed ShareholdiNg Many MNCs decide to invest in host countries as joint-venture partners with local corporations; such ventures reduce the political risk. Once a local company is partnered with an MNC, any

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adverse government decision against the MNC also affects the local partner. A local partner would clearly exert a restraining influence on a government contemplating any such action. Moreover, the local partner, in all likelihood, would have significant contacts in the appropriate quarters of the host government that could be used for intensive lobbying on the MNC’s behalf. Moreover, many host governments take a more indulgent approach to the MNC operating as a joint venture because it is perceived as sharing its profits and technical know-how with a local company, thus mitigating the traditional exploitative image of MNCs.

Many companies achieve similar objectives by using a slightly different route. Instead of taking on a local company as a joint-venture partner, they increase the level of local shareholding. In many instances the increase in local shareholding is instituted at the behest of the host government, which imposes the increase as a condition for the MNC’s continued operation in its jurisdiction.

Increased local shareholding increases the benefits for the host country in many ways. The amount of profits to be repatriated abroad is immediately reduced when the local shareholders receive their dividends and other revenue in local currency. The foreign ex- change liability arising out of share appreciation is also reduced because the basic foreign shareholding is replaced to some extent by domestic shareholding. With a large amount of local shareholding, the policies and operations of the corporation are more open to public and government scrutiny and, therefore, control. The possibility that the MNC can indulge in financial and business transactions detrimental to the country is also reduced.

proMotiNg the hoSt couNtry’S goalS To gain the host country’s acceptance of its operations, an MNC may, as a strategic move, attempt to promote the host country’s objectives, for example, by maximizing foreign ex- change earnings. MNCs try to contribute to this objective by promoting exports of either their own products or the products of other local manufacturers. The action is strategic in that it is intended to prevent future problems and does not form a part of the normal business operations and objectives of the company. Once export earnings have been generated by the MNC for the host country, it becomes fairly difficult for the host government to justify adverse action, because the drain on foreign exchange resources is removed.

riSk iNSuraNce Many governments have agencies that offer insurance coverage against the political risks faced by MNCs operating in other countries. In the United States, the Overseas Private Investment Corporation (OPIC) guarantees risks faced by MNCs in developing coun- tries. OPIC provides coverage against various eventualities that can adversely affect the MNC in a host country, such as expropriation, blocking of repatriation of funds by a host government, and problems created by the breakdown of law and order.

The World Bank, in an effort to promote private investment in developing countries, has an agency that protects corporations that invest in such countries from different forms of

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314 Chapter 10 • Foreign Investment: Researching Risk

political risk. This agency, which began operation in 1988, is the Multilateral Investment Guarantee Agency (MIGA). Risk coverage through MIGA is intended to allay fears of political risk that prevent many MNCs from investing in developing countries, even if the latter are open to overseas investment. This agency is also discussed in Chapter 6.

coNtiNgeNcy plaNNiNg Despite whatever measures a company may adopt and however good its relations with a host government might be, there always remains a definite element of political risk of national- ization, expropriation, or some other unacceptable form of regulatory imposition or control. To guard against such an eventuality, most MNCs have a contingency plan, which may or may not be in the form of a formal document. Some contingency planning is done when the investment is first made in the host country. If a country is considered risky in terms of possible expropriation, companies try to reduce the value of their physical investment and rely more on the supply of expertise and know-how that is paid for on a short-term basis. A country also may be considered dangerous because of technology leakage. In such a situation, the MNC would probably retain the know-how at its headquarters and supply intermediate products to its subsidiary for the final stages of processing or manufacturing.

suMMary Investment in international business requires a cost-benefits analysis of the benefits gained versus the risks encountered by the investing firm. Influencing the decision to expand internationally are the opportunities to tap larger markets, host-country regulations requir- ing local production, achieving economies of scale, competition, implementing quality controls, raw materials sourcing, forward integration to eliminate middlemen, and the acquisition of new types of technologies.

Counterbalancing these factors are the political risks MNCs face from unilateral actions or expropriation by host-country governments. Political risks increase when the MNC and the host country have different economic objectives or conflicting fiscal and industrial policies. Circumstantial political risks may occur when the host government changes and the policies of the preceding government are reversed (in so-called bureaucratic govern- ments) or when the current government facing political difficulties or social unrest must amend its prior policies to the detriment of the MNC.

Host governments may also impose a variety of national controls on MNCs’ activities, including limitation on the repatriation of profits and dividends, efforts to curb transfer pricing, implementation of price controls, restrictions on foreign ownership, local staffing and management requirements, import content rules, and labor and social controls.

Assessing political risk involves first assessing the riskiness of the host country as a place to conduct operations and then identifying the level of risk assumed by the MNC for making a particular investment. Political risk cannot be eliminated completely, but management techniques can reduce the level of political risk. Such techniques include

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Bibliography 315

not investing in particular countries, establishing long-term agreements with host-country governments, lobbying, legal action if the host country has a well-developed legal system, obtaining political pressure and assistance from the MNC’s home-country government, providing for local ownership or joint venturing, promoting host-government objectives, developing contingency plans, and purchasing insurance coverage for political risk.

disCussion Questions 1. Discuss the various factors that cause multinational firms to invest abroad. 2. What is the role of political risk assessment in shaping an MNC’s foreign invest-

ment decisions? 3. Is political risk assessment an exact science? Explain. 4. How do host governments try to control the activities of MNCs within their own

countries? 5. Which of the following businesses are most and least vulnerable to expropriation?

• Accounting • Agriculture • Automobile manufacturing • Banks • Heavy equipment manufacturing • Hotels • Mining • Restaurants • Oil fields • Personal electronic goods manufacturing

6. Identify techniques that MNCs use to manage country risk.

note 1. Economist, “Business Environment Rankings,” 61.

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ager’s Guide, ed. Sypors Makridakis and Steven C. Wheelwright. 2nd ed. New York: John Wiley, 1987. Economist. “Business Environment Rankings.” Pocket World in Figures. London: Profile Books, 2011. Encarnation, Dennis J., and Sushil Vachani. “Foreign Ownership: When Hosts Change the Rules.” Harvard

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South-Western, 1991.

Globalization at the Crossroads: market Competition and the hhi The level of competition in a given market is often crucial in determining the strategic actions of multinational firms. One method of estimating the competitiveness of a given industry is known as the Herfindahl-Hirschman Index (HHI), so named after two economists who inde- pendently devised the measure. The HHI is an economic measure that is commonly used by the Federal Reserve and the Department of Justice to investigate the level of market competi- tion within an industry. In a market context, it is defined as the sum of squares of the market shares of firms within an industry, where the market shares are expressed as proportions. The measure takes into account the relative size distribution of the firms in a market. An HHI score can range between 0 and 10,000, increasing as the number of firms in a market declines and as disparity in the size between firms rises. A higher score indicates less competition in the market, with a 10,000 representing a pure monopoly. A market is considered to be less con- centrated (i.e., highly competitive) when the HHI is less than 1,500, moderately concentrated when it is between 1,500 and 2,500 and highly concentrated (i.e., less competitive) at scores above 2,500. The US Department of Justice and Federal Trade Commission provide general guidelines related to HHI score increases related to merger activity.

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Globalization at the Crossroads: Market Competition and the HHI 317

If some of the market participants are unknown, it is often reasonable to assume that the remaining, unidentified portion of the market is divided among numerous firms. Typi- cally, the highest market share assigned to the unknown players is assumed to be less than any of those with an identified share. For example, if the identified market represents 80 percent of the total, and the smallest share held by any one business is 5 percent, an analyst could assume that the remaining 20 percent of the market is divided among twenty firms (i.e., 1 percent each), or five firms (i.e., 4 percent each) or some similar multiple. Regardless, the assumption usually will have little impact on the final HHI score.

Figure 10.1 provides an example of the HHI calculation for three hypothetical industries of varying concentration. The HHI scores can display a wide range of values depending on the level of market competitiveness in a given industry.

Questions for Discussion 1. Explain how the estimation of the HHI would aid a multinational firm’s strategic

decisions. 2. Develop an HHI for an industry of your choice and interpret the results. 3. The Herfindahl Index and the Lerner Index are close cousins of HHI. Research

these two indexes and discuss their importance in assessing risk in today’s global economy.

4. What other measures are available to the multinational firm to assess market competitiveness?

Figure 10.1 Example of HHI Calculations for Three Hypothetical Industries

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318 Chapter 10 • Foreign Investment: Researching Risk

caSe Study 10.1

aMalgaMated polyMers inC.

It is Friday afternoon, and James Hyman, an executive with Amalgamated Polymers Inc., is reviewing the briefing papers for next Monday’s investment committee meeting. After all the hectic preparation and redrafting during the week that at times had threatened to spill over into Saturday, Hyman is growing increasingly tense. The briefs contain a proposal for Amalgamated Polymers to take an equity stake in Gulf Plastics, a medium-sized company producing a wide variety of plastics in Mazirban, a small but wealthy Arab country in the Persian Gulf. The proposal had been prepared by Hyman after almost six months of preliminary groundwork, and on Monday the members of the investment committee, which comprises the entire senior management of the company, will take their first look at it.

There are a number of reasons the proposal makes sense. Hyman’s company, Amalgamated Polymers Inc., is a leader in the production of plastics and similar petrochemical by-products. It is based in Edinburgh, Scotland, and has plants in Great Britain, the Netherlands, and Turkey. The company has its own in-house R&D facility, which has helped Amalgamated become one of the important forces in plastics technology during the past fifteen years. Its patented product, Amalite, is in great demand by household goods manufacturers for making such kitchen items as storage jars and plastic cutlery. Much of the company’s sales of Amalite are con- centrated in Europe and North America, but competition in these markets is growing, and there is a need to expand sales in other areas. While Amalgamated Polymers has considerable international marketing skills and sales contacts, it is essentially handicapped by a limited production capacity. To export to other markets, especially in developing countries, would require an expansion of production capacity in the existing plants or establishment of new plants. Expanding capacity in the existing plants would be difficult and expensive. The Netherlands and Edinburgh plants face severe environmental constraints and have come under pressure from local authori- ties, and particularly from environmental groups, because of their pollution-creating effects. The company has been forced to install very expensive equipment to reduce the harmful content of the emissions from its plants. Expanding capacity would no doubt give rise to pressures from local governments and other groups to install even stricter emissions-control equipment. Further, given the high labor and production costs in Edinburgh and the Netherlands, it does not make sense for the company to increase production at these plants in order to make sales in new markets, where prices have to be extremely competitive. Similar problems confront the company in

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Case Study 10.1 319

connection with opening new plants in Edinburgh and the Netherlands. High costs, environmental concerns, and high wages rule out a move to invest in new plants. Further, the company is already highly leveraged and does not want to take on ad- ditional debt to finance new operations. There is an additional problem in Turkey. Ten years ago the company had received a license to establish and open one plant under a liberal foreign investment policy adopted by the government then in power, but another government has recently taken over and reversed that policy, and the chances of getting a license for a second plant are almost zero.

The difficulties of expanding operations at its existing facilities prompted Amal- gamated Polymers to look for other options. One option is to establish a new plant in a low-cost location that is closer to potential markets. Several countries have offered themselves as potential sites for this option. The company has actively considered opening a new plant in a developing country because some of the constraints it faces in the developed countries are not present. The issue of overleveraging the firm, however, by taking on excessive debt to finance an entirely new operation continues to dog this option. Further, setting up a new plant in a developing country would require a time lag that is incompatible with the company’s need to penetrate quickly into new markets and take advantage of its technological edge in certain areas. The issue of timing is particularly important because competitive companies also have major technological research plans and could catch up very soon, eliminating the advantage enjoyed by Amalgamated.

These considerations led to the idea of taking an equity participation in an ongoing company in a middle-income or low-income country. The strategy is to infuse new technical and management capability into the company to make it internationally competitive. Once this goal is achieved, its products could be exported to other, new markets.

Mazirban offers an ideal opportunity to implement the joint-venture approach. The country is a large producer and exporter of crude oil and natural gas, which are its main sources of revenue, but, like many other states in the Persian Gulf, the government is eager to diversify the economy and invest the surplus oil revenues in new industries employing high technology. Petrochemicals are a natural choice, because the raw materials, crude oil and natural gas, are plentiful and available at minimal cost. With the collaboration of major multinational firms, the govern- ment has established several petrochemical and oil-refining complexes. To attract additional foreign investments, it has established a liberal investment policy that places virtually no constraints on overseas parties to joint ventures in Mazirban. The only important conditions are that any overseas venture in Mazirban has to be established jointly with a local party and that the terms of this venture have to be approved by the government.

(continued)

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320 Chapter 10 • Foreign Investment: Researching Risk

Case Study 8.1 (continued)

Amalgamated Polymers found a potentially ideal partner in Gulf Plastics Ltd., a major plastics company owned by members of the ruling family and based in Ochran, the main port of Mazirban. Gulf Plastics was established in 2003 and for the past nine years has concentrated on the manufacture of basic plastic products, which it markets primarily within the country. Gulf Plastics was established with the help of a Japanese petrochemical company that also helped to run the company for the first five years. A few Japanese technicians still hold key positions in the manufacturing operations division of the company. Gulf Plastics has been looking for a technical and management partner to upgrade its technology and help it move overseas.

Gulf Plastics and Amalgamated Polymers, which have compatible interests and strategies, appear to be ideal partners. The terms of the collaboration would not pres- ent a problem; they are fairly standard in the petrochemical industry, and the details can be taken care of easily. For Amalgamated, the option of a joint venture with an ongoing company in plastics manufacturing seems to address all the fundamental concerns, at least in principle. To acquire an equity stake significant enough for the company to be able to influence the management of the joint venture, Amalgamated would not be pressed too hard financially. Further, since it would supply technology and management know-how, its contribution could be capitalized to offset a significant part of the total equity contribution it would make under the proposed joint venture. Because Gulf Plastics already has the basic infrastructure set up and would be shar- ing other costs, the total costs of capacity expansion would not be too high. There also would be no difficulty in directing some of Gulf’s existing production capacity to the targeted markets, because the government of Mazirban is keen to earn foreign exchange. The costs would be further reduced because it would not be necessary, at least in the initial stages, to expand production capacity by too much.

Despite all these positives, there are a number of questions that Hyman thinks the executive committee will raise on Monday. He will have to spend the weekend in virtual self-isolation to think of what questions are likely to be raised and what responses he should have ready to justify this investment. After all, it is very impor- tant to him. If the project is approved, he will be placed in charge of his company’s side of the venture, and eventually it would mean a senior position at the plant in Mazirban, boosting his career prospects. On the other hand, if the proposal is rejected by the committee, six months of work would be wasted, and he will face the additional embarrassment of giving the news to the Mazirban government and to Gulf Plastics, who are not likely to hide their feelings.

diScuSSioN QueStioN 1. Prepare a list of possible questions that the investment committee might raise

about the proposal. What should James Hyman’s responses be?

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