Firms are continually looking for investment options to maximize their return on capital entrusted upon them by the shareholders. Given the sluggish economic growth in the developed markets of the west and the rise of East Asian and South American economies, companies are looking further afield to exploit opportunities in these emerging markets. The trend for moving to distant lands is further supported by the forces of globalization that have led o emergence of a near homogenous consumer culture. Emerging middle classes in these rapidly growing economies promise continued demand for products.
There are two main avenues that companies pursue in their quest to serve the emerging economies. Firms can start from scratch by building brand new facilities in the target markets. This also requires hiring local manpower to man their operations. This can be expensive and time consuming. Besides, many local laws in the target markets put restrictions on the level of ownership that foreigners hold.
To circumvent these restrictions, firms opt to acquire local firms in their target markets. The investing firm takes over a local entity as a going concern. The advantage of such mode of entry is that the investing form can hit the ground running as all the production and marketing infrastructure is intact. However, it is likely that the acquiring firm may fail to synergize operations of the merged entities resulting in a messy operation.
Factors that drive firms to embark on investing in emerging markets: Mercedes Benz green field investment and Volkswagen acquisition
Volkswagen acquired Skoda following the latter’s string of losses. Years of underinvestment in research and development made the company’s production facilities outdated and low quality output. In 1991, VW bought 30% stake in Skoda and invested heavily in research and development and human resource training to boost the product quality. The result was a resurgent Skoda brand that was overwhelmingly accepted by the market.
Mercedes Benz wanted to lunch its products in India. Given the location of its production facilities in high wage countries, importing foreign made products into the Indian market was going to be uncompetitive. Besides, well healed rivals had already made inroads into the market with favorable prices. In 2007, the company acquired 100 acres of land to put up a manufacturing plant in Pune, India. The plant had an annual capacity of more than 5000 units and used local labor and materials save for those that couldn’t be found in the country.
The following are the reasons that drive a company to pursue investment opportunities in foreign countries;
Most western countries have high wages relative to their Asian, African and South American counterparts. They also have cheaper resources for use in the manufacturing process. The cheaper resources enable the company to realize low per unit costs which can be passed on to the consumers. Mercedes Benz had this strategy when it entered the Indian market. Importing finished units from the nearest production facility would result in higher prices that could delay market uptake. The high import taxes would also result even higher process compared to other brands competing in the same category. Cheaper Indian labor, lower taxes and lower cost of main raw materials led to the decision to embark on the investment.
Expanding the product base
Entry into the foreign market offers chances of expanding the product base. To make the company’s products appeal to the local clientele, the products must be tailored to meet the specifications of the local market. the result is an extended and diversified product base. For instance, VW acquisition of Skoda led to the addition of another product to sell alongside the VW brands. Skoda, whose motherland was in the Czech Republic, closely resembles VW in both quality and reliability. VW offered the Skoda brands for sale most of Asia, Africa and South America.
Expand revenue base
Mature markets in the developed world offer limited prospects for growth. With the rising incomes of emerging markets, firms are keen to exploit their potential. For instance, Mercedes Benz entry into the Indian market followed successes of its rivals in the same market category (Audi and BMW). The rising incomes in these emerging markets and the countries surrounding them make for a very attractive offer for the investing firms to ignore. This contrasts with most western markets where high gas prices and a contracting economy have forced customers to opt for economy car models.
Competition in the domestic market
Competition is stiff in most developed markets. Customers are also discriminative and with little switching costs, they can opt for competing brands. Often, price based competition thins margins making companies realize very low profitability despite low volumes. For these reasons, firms look for options out of their domestic fronts to escape the cutting throat competition. The best option is to venture in far flung markets surging with demand and where competition is not based on pricing.
Massive investment in plant and equipment leads to incurrence of very high fixed costs. To break even, firms have to move large volumes. This implied demand cannot come from their domestic markets and thus they venture in foreign markets to move large documents to meet their operational expenses.
Rigid policies in the domestic market
Domestic restrictions in the local market constrict the firm’s ability to wring out profits. these range from safety to environmental regulations that severely limit the firm’s ability to operate profitably. Emerging markets promise fewer restrictions as they seek to attract capital into their economies to provide employment for their surging populations. This makes these destinations fertile grounds to acquire related firms or establish Greenfield investment.
Other likely factors leading to investment in foreign companies
Most investing firms possess operative advantage relative to the local firms. Due to their superior investment in research and development, they have amassed a number of patents and manufacturing skills that rivals that of domestic firms. They also have access to a lot of capital from their home markets owing to their track record and operational relationships with major world financiers. Therefore, these forms are able to invest in huge plants or acquire extensive operations in foreign markets. This affords them economies of scale that is passed on to the consumers as reduced price. foreign firms are also able to develop superior product differentiation. The marginal cost of transferring their superior knowledge and experience in foreign markets is lower than that of local firms that have to invest full cost to realize such experience and knowledge advantage.
On the contrary, local firms lack financial muscle to invest in research and development. They cannot also invest in large buyouts due to limited resources at their disposal. As a result, they develop weak supply chains, have fewer patents and have very low economies of scale leading to higher per unit costs.
b. oligopolistic advantage
Oligopolies enjoy limited competition owing to huge entry barriers in their line of business. in their bid to retain their position, the firms embark on a defensive investment pattern such as acquiring foreign based players that offer vertical integration to their businesses. for instance, western based oil companies acquire oil prospecting licenses in the emerging markets of Asia, south America and Africa in a bid to safeguard their power in the already established markets. This ensures their continued supply in to feed their markets.
This mode of investments is different from the monopolistic advantage in that while oligopolistic investment is done to erect barriers to entry of other firms, monopolistic advantaged firms seek to exploit their position in the market without locking out prospective competitors and instead relying on their economic and knowledge.
c. product life cycle
Vermon (1971) came up with this theory to explain the gradual shift tat firms experience to foreign direct investment from exporting. At the start, firms come up with an innovative product and enjoy monopolistic advantage at home. It therefore specializes in the production of the innovative product and exports. It soon standardizes its production and invests abroad to exploit its monopolistic advantages. It soon attracts competition and soon looks to venture into other foreign markets to exploit its monopolistic powers.
d. Eclectic theory
Put forward by dunning (1988), the theory follows in the wisdom of Peter Drucker who explained that firms can sustain competitive market advantage by virtue of having production facilities in the main markets. Therefore, while exporting offers the much important entry to the foreign markets, sustained competitiveness can only emanate from establishing physical presence in these markets and customizing their offerings to suit the customers in these markets.
Dunning (1988) explained that there are three variables that drive firms to embark on FDI. These are country specifies factors, company specific factors and internalization factors. Country specific factors relate to location variable including the political environment, geographical and economic factors, government policy, and the presence of infrastructure to aid in the process of manufacturing and distribution. This is what informed Mercedes Benz investment in Pune, India. The company’s management looked at the burgeoning middle class, he rapidly growing economy, the developed manufacturing infrastructure and the favorable government policies aimed at attracting foreign investment. The company sought to take advantage of that with the setting up of the fully fledged plant to serve the Indian market.
Dunning gave company specific factors as management effectiveness, structure and processes as well as the technological advantages that the investing form possesses. In targeting a foreign investment, the firm considers the target company’s structure and operations relative to its own and seeks points of improvement that can create sustained competitive advantage. This is the consideration that informed VW takeover of Skoda. VW had a superior management that would turn around Skoda and create an outstanding brand in the market. it also had superior technology that enabled Skoda to remake its products into a more suitable product for its target market. VW changed Skoda structure to accommodate the changes in product research and development strategy that the later was to adopt to compete in the markets as well as VW. The result was a very acceptable brand just as that of the parent company.
Internalization refers to the company’s inherent flexibility in adapting t the changed conditions in the target investment markets. Firms that have an inherent ability to adapt to changing market conditions are likely to invest in foreign markets if they sense opportunity.
Risks in foreign direct investment
Investing in a foreign country entails assumption of inherent risks. The risks mostly involve political and economic uncertainty that every country faces and which has a direct impact on the firms operations. Political risks gauge a country’s willingness and ability to meet its foreign obligations. Economic risk is an expression of a country’s ability to sustain economic expansion necessary to spur demand of the firm’s products.
Political risks that a firm may experience
Strength and stability of government
Political risks depends on a variety of factors the most important factor being the stability of central government. The government is crucial in maintaining law and order, observing rule of law and enforcing contracts. Without a central strong central government, it is not possible to maintain lawful operations in the country. Secondly, the attitudes of labor unions pose political risks. *** cite that the government is the single most important determinant of foreign direct investment that a country holds due to its enactment of policies supportive of business.
The attitude of labor unions poses enormous risks to the investing firms. Labor unions that have extensive membership can cripple operations of a firm in their quest for higher pay for their members. They can increase the cost of doing business and can initiate litigation leading to enormous cost to the organization. They can also initiate wage increases that can render the investment uncompetitive.
Government takeover of investment
There is a possibility of the government taking over the investment that a company has established. It may be a partial or total takeover of the firm or even a forced sale of shareholding to the local investors keen to divert policies of the company in annual general meetings through their voting power. This is most prevalent in mining sectors. In most cases, government urges renegotiation of contracts that had earlier been signed. This leads to incurrence of loss or lower profits.
Political unrest refers to the violence that breaks out as a result of fallout of the political processes. The general population feels that it cannot pursue political settlement due to the weak institutions in the country and resorts violence. Violence leads to stoppage of economic activities as looting and theft takes center stage. Capital flows out of the country and local people’s purchasing power erodes. Resolution process takes long even the firm’s commitment fall due. The firm has to meet its maturing obligations from its capital as production cannot take place.
These are restrictions that arise after establishing the operations. For instance, the regulatory authorities can insist that the supervisory activities must be held by locals. They can also change operational rules restricting say the opening and closing hours of business. Further, they can also impose restrictions on repatriation of capital despite the investment from the parent company coming from abroad. That means that foreign firms wanting to put in additional investment to boost their operations hesitate as they have doubts as to whether they will repatriate their investment. These add to operational risks of the firm and reduce a firm’s competitiveness.
Other political risk factors
Other factors that add to operational risk factors include the government promotion of buy local attitude meant to put the foreign firms at odds with the local population. The locals are inspired to buy their own local products no matter their quality as a sign of patriotism. The result is that despite the foreign firm’s investment in quality, customers prefer lower quality products in the name of patriotism.
Public attitude also plays a major role in increasing political risk. In emerging markets, the population tends to see limited opportunity to improve their living standards. They therefore shun luxury items made by the foreign firms despite their ability to buy such products. The gap between the aspirations of the local population and their expectations contributes to political risk. Government attitude also plays an important factor. Some unstable governments blame the foreign investors for instability especially in the mineral sector. The result is bad publicity and sanctions in other sensitive markets that promise higher return.
Radical shifts in government policies that typically arise from change of government also pose political risks. For instance the change from right to left leaning governments are often accompanied by change in monetary and fiscal policies. In other cases, change in government results in restrictions of trade or enactment of trade agreements with other countries. In both cases, political risks increase and set off other risk worst of them being competition from other players in the trading block and foreign currency losses.
Mitigating measures that a firm should take to safeguard itself against political risk
Given the risk that a firm is exposed to, it is important to take measures to safeguard it against losses arising from the crystallization of political risk. The most common measure is to seek a foreign investment guarantee from OPIC (Overseas Private Investment Corporation). OPIC provides coverage against losses occurring from expropriation, war or civil disorder and non-convertibility of profits for repatriation.
The other method entails striking harmonious chord with the local population. This means avoiding behavior that stirs trouble with the local government or its people. Investing firms should engage in social responsibility initiatives and fight the impression that they have come to exploit their natural resources.
There is no nation state that can tolerate penetration of its markets by a foreign company if it perceives its economic, social, political and economic well being are under threat. Firms cannot shield themselves from all political risks. It is therefore prudent for an investing firm to assess both political and economic risks that come with the investing opportunity. It should also take preventive measures such as engaging the local community in social responsibility initiatives and obtaining investment guarantees from OPIC among other measures. In most cases, the political and economic risks posed by the investing opportunity tails in comparison to the benefits that the firms seeks to gain. This fact has led to the widespread investment by foreign firms in green fields and acquisition in pursuit of opportunity