Foundations of Financial Management: An Analysis (Part 84)

“It doesn’t matter about money; having it, not having it. Or having clothes, or not having them. You’re still left alone with yourself in the end.”
Billy Idol

International Financial Management

(Part D)

by

 Charles Lamson

Foreign Investment Decisions

Several explanations are offered by the Directory of American Firms Operating in Foreign Countries for the moves to foreign soil. First, with the emergence of trading blocs in Europe, American firms feared their goods might face import tariffs in those countries. To avoid such trade barriers, U.S. firms started manufacturing in foreign countries. The second factor was the lower production costs overseas. Firms were motivated by the significantly lower wage costs prevailing in foreign countries. Firms in labor-intensive industries, such as textiles and electronics, moved some of their operations to countries where labor was cheap. Third, superior American technology gave U.S. firms an easy access to oil exploration, mining, and manufacturing in many developing nations. A fourth advantage relates to taxes. The U.S.-based multinational companies (MNCs) can postpone payment of U.S. taxes on income earned abroad until such income is repatriated (forwarded) to the parent company. This tax deferral provision can be used by an MNC to minimize its tax liability. Some countries, like Israel, Ireland, and South Africa, offer special tax incentives for foreign firms that establish operations there.

The decision to invest in a foreign country by a firm operating in an oligopolistic industry is also motivated by strategic considerations. When a competitor undertakes a direct foreign investment, other companies quickly follow with defensive investments in the same foreign country. Foreign investments undertaken by U.S. soft drink companies are classic examples of this competitive reaction. Wherever you find a Coca-Cola subsidiary in a foreign country, you are likely to see a Pepsi affiliate also operating in that country.

International diversification of risks is also an important motivation for direct foreign investment. The basic premise of portfolio theory in finance is that an investor can reduce the risk level of a portfolio by combining those investments whose returns are less than perfectly positively correlated. In addition to domestic diversification, it is shown in Figure 3 that further reduction in investment risk can be achieved by diversifying across national boundaries. International stocks, in Figure 3, show a consistently lower percentage of risk compared to any given number of U.S. stocks in a portfolio. It is argued, however, that institutional and political constraints, language barriers, and lack of adequate information on foreign investments prevent investors from diversifying across nations. Multinational firms, on the other hand, through their unique position around the world, derive the benefits of international diversification. This argument has been weakened somewhat by the introduction of international mutual funds.

Figure 3 Risk reduction from international diversification

While the U.S. based firms took the lead in establishing overseas subsidiaries during the 1950s and 1960s, European and Japanese firms started this activity in the 1970s and have continued into the 21st century (Block & Hirt, p. 616). The flow of foreign direct investment into the United States has proceeded at a rapid rate. These Investments employ millions of people. It is evident that the United States is becoming an attractive site for foreign investment. In addition to the international diversification and strategic considerations, many other factors are responsible for this inflow of foreign capital into the United States. Increased foreign labor costs in some countries and saturated overseas markets in others are partly responsible. In Japan, an acute shortage of land suitable for industrial development and a near total dependence on imported oil prompted some Japanese firms to locate in the United States. In Germany, a large number of holidays, restrictions limiting labor layoffs, and worker participation in management decision making caused many firms to look favorably at the United States. Political stability, large market size, and access to advanced technology are other primary motivating factors for firms to establish operations in the United States. Also, large U.S. balance of payments deficits have spread hundreds of millions of dollars around the world for potential reinvestment in the United States, particularly by the Japanese.

To some extent foreign investors in the U.S. Treasury bond market have been bankrolling enormous budget deficits that the government has been running up when the U.S. government began falling $150 to $200 billion into the red on an annual basis in the 1980s, many analysts thought this would surely mean high inflation, high interest rates, and perhaps a recession. They also were sure there would be a "shortage of capital" for investments because of large government borrowing to finance the deficits. For the most part, foreign investors from Japan, Western Europe, Canada, and elsewhere have bailed the government out by supplying the necessary capital. Of course, this means the United States is more dependent on flows of foreign capital into the country. We must satisfy our "outside" investors or face the unpleasant consequences. During the last four decades, the U.S. has gone from being the largest lender in the world to the largest borrower.

Analysis of Political Risk

Business firms tend to make direct investments in foreign countries for a relatively long time. Because of the time necessary to recover the initial investment, they do not intend to liquidate their Investments quickly. The government may changed hands several times during the foreign firms tenure in that country; and, when a new government takes over, it may not be as friendly or as cooperative as the previous administration. An unfriendly government can interfere with a foreign affiliate in many ways. It may impose foreign exchange restrictions, or the foreign ownership share may be limited to a set percentage of the total. Repatriation (transfer) of a subsidiary's profit to the parent company may be blocked, at least temporarily; and, in the extreme case, the government may even expropriate (take over) the foreign subsidiaries assets. The multinational company may experience a sizable loss of income or property, or both, as a result of this political interference. Many U.S. firms, have lost hundreds of millions of dollars in politically unstable countries. Therefore, analysis of foreign political risk is gaining more attention and multinational firms. 

The best approach to protection against political risk is to thoroughly investigate the country's political stability long before the firm makes any investment in that country. Companies use different methods for assessing political risk. Some firms hire consultants to provide them with a report of political risk analysis. Others form their own advisory committees (little state departments) consisting of top-level managers from headquarters in foreign subsidiaries. After ascertaining the country's political risk level, a multinational firm can use one of the following strategies to guard against such risk:

1. One strategy is to establish a joint venture with a local entrepreneur. By bringing a local partner into the deal, the MNC not only limits its financial exposure but also minimizes anti-foreign feelings.

2.  Another risk management tactic is to enter into a joint venture, preferably with firms from other countries. For example, an energy company may pursue its oil production operation in Zaire in association with Royal Dutch Petroleum and Nigerian National Petroleum as partners. The foreign government will be more hesitant to antagonize a number of partner-firms of many nationalities at the same time.

3.  When the perceived political risk level is high, insurance against such risks can be obtained in advance. Overseas Private Investment Corporation (OPIC), a federal government agency, sells insurance policies to qualified firms. This agency insures against losses due to inconvertibility into dollars of amounts invested in a foreign country. Policies are also available from OPIC to insure against expropriation and against losses due to war or revolution. Many firms have used the service over the years. Private insurance companies, such as Lloyd's of London, American International Group, Inc., Cigna, and others, issue similar policies to cover political risk.

Political risk umbrella policies do not come cheaply. Coverage for projects in "fairly safe" countries can also cost anywhere from 0.3% to 12% of the insured values per year. Needless to say, the coverage is more expensive or unavailable in troubled countries. OPIC's rates are lower than those of private insurers, and its policies extend for up to twenty years, compared to 3 years or less for private insurance policies. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 615-618*

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