Foreign Direct Investments and the Strategies of Multinational Corporations - Research Paper Example

FOREIGN DIRECT INVESTMENTS AND THE STRATEGIES OF MULTINATIONAL CORPORATIONS The objective of this study was to determine the decision making process of multinational companies in general with respect locating their production facilities in foreign countries, and the motives behind these decisions. The strategies employed by these firms in gaining entry and maintaining their competitive positions abroad were also to be examined in light of the prevailing theories on the subject. The study used the theories propounded by Dunning (eclectic paradigm), Giddy (internalisation), Vernon (product life cycle), Hogue (market seeking motives, among others), and others thinkers in order to shed light on the strategic behavior of multinationals. The integrative work provided by Hill and Cooke were important. Each one of these were helpful although it is probably the eclectictheory that carries the most weight, being consistent with economic theory that dictates how capital and technological resources should be allocated, namely, through the matching of locational advantages with the assets and capabilities of the multinational firm. Introduction In recent years the rapid growth in the volume of foreign direct investments (FDIs) compared to exports or licensing has been remarkable, as well as the growing number of FDIs to and from developing countries. This fact gives rise to the question why companies engage in foreign direct investments despite the difficulties and complexities involved. This paper seeks to examine the factors that influence the global location decisions of the some MNCs, their modes of entry, and the strategies that they adopt to gain entry and maintain competitiveness. Their motives as they try to exploit the advantages of foreign direct investments will be discussed, based on existing theories on the subject. Forms of foreign direct investment Foreign direct investment (FDI) is a type of international capital flow that transfers part of a firms managerial skills and knowledge abroad. . . and involves the creation of a foreign subsidiary, the assets of which are directly controlled by the parent company (Lamborn & Lepgold 2005). FDI must be distinguished from foreign portfolio investment (FPI) which involves the purchase of stocks, bonds and other financial instruments in which the businesses are either owned or operated by others. Foreign direct investments, according to Cooke (1988), may take the following form: 1. The establishment of a new enterprise in a foreign country either as a branch or a subsidiary (also called greenfield investment); 2. An expansion of an existing branch or subsidiary; or 3. The acquisition of an existing business or its assets (acquisition or merger) Mergers and acquisitions have been the more dominant form of foreign direct investment, accounting for 70 to 80 percent of the total volume, according to UN estimates for recent years. There is however a difference in FDI flows to developed countries and to developing ones; investment flows to the latter are relatively lower due to the fact that there are fewer target firms compared to developed countries. The preference by multinationals for mergers and acquisitions instead of greenfield investments is quite obvious. This can be explained by the ease with which trans-border transactions generally are carried out whereas investing in a business from the ground up can delay progress. Also, a desirable firm, if not promptly acquired by a company that first sees the opportunity, may be acquired by another. Many companies, among them Cemex of Mexico and Cadbury of UK, to cite just two examples, have grown at a rapid rate because of their adoption of the merger and acquisition strategy. Greenfield investments take time. Theoretical vis-a-vis practical aspects of FDIs The acquisition of foreign companies can be impelled by certain synergistic advantages derived from strategic assets such as established distribution networks/systems, patents or trademarks (goodwill), brand loyalty, customer relationships, and others. Though costly, mergers and acquisitions are easier and less risky to undertake than establishing a completely new one business overseas. Another form of synergy that can be acquired through this mode of entry is the improvement of operational efficiency through the transfer of technology, managerial skills and capital (Hill 2005). A well-developed information system such as those of Cemex or Wal-mart can be applied to an acquired company and drive it to increase its efficiency and productivity. FDIs are however more expensive and risky than the alternatives of exporting and licensing. Exporting is easier than FDI and risks can be substantially diminished through the employment of native agents. In the case of licensing, the costs and risks of FDI are also avoided. The uncertainties faced by a multinational in establishing a new business abroad or in acquiring an existing one can be considerable in the face of many challenges and problems because it is dealing with a foreign culture and with rules of the game that the company is unfamiliar with. Nevertheless, companies, according to Hill (2005) go into foreign direct investments because of five major factors: a) transportation costs, 2) market imperfections, 3) strategic behavior, 4) product life cycle, and 5) locational advantages. Each of these are described below. 1. Transportation costs are high when the ratio of value to cost is low, such as in the case of cement and soft drinks, which makes it economical to locate overseas and near their markets. However, if the that ratio is high, investing abroad is not as attractive as exporting or licensing. 2. The market imperfections approach, otherwise known as the internalisation theory, refers to obstacles in the free flow of product and technology. Tariffs and quotas on MNCs exports can impede trade or raise prices when products are imported to destination countries. The case of Japanese cars can be cited as a case in point: Threats of protectionist measures in the U.S. compelled Honda and other Japanese car manufacturers that followed suit to establish plants in that country, thus circumventing these threats. Impediments to the sale of know-how can arise when such cannot be adequately protected by licensing, when they are not amenable to licensing, and when tight operational control is necessary in order to maximise market share and earnings. Thus in this instance FDI would appear to be a better option than either exporting or licensing. 3. The strategic behavior explanation, as advanced by Knickerbocker (cited in Hill 2005), analyzes multinational companies as behaving in a pattern similar to that existing in a domestic oligopoly (a market structure where there are several firms). Each firm reacts to the moves of any of its rival. For example, a reduction in price by one company can trigger a matching imitative behavior in the others. In foreign direct investments, this means that a firm that makes a first move is followed by its competitor. An extension of this concept is the multi-point competition. Here two or more firms attempt to competitively engage one another in different regional markets or industries. The aim of the participants is to prevent one company from dominating a particular market, using its financial advantage to leverage its businesses elsewhere to the disadvantage of the others. The above model of strategic behavior applies to horizontal integration where firms compete in the same industries. Where backward vertical integration is concerned, strategic behavior has for its target the existence and availability of raw materials at a specific location abroad. The first mover firm obtains monopoly of a raw material, such as a mineral (e. g., bauxite in the manufacture of aluminium products). This strategy bars entry of other firms for the exploitation of that resource at that location. However, it can prove uneconomic if the same resource of significant quantity can be found elsewhere. In the case of forward vertical integration, the strategy is designed to circumvent barriers set up by other firms already doing business in a foreign country. A decision to establish a dealer network, such as that of Volkswagen when it entered the North American market, can be cited as an example. Obviously this move would be more risky and costly compared to mergers and acquisitions, but it is the strategy to use when M&A opportunities are not present. 4. The product life cycle theory was expounded by Raymond Vernon (1966, cited in Hill, 2005; Cooke 1988) offers the argument that a firm that pioneers a product at home will invest abroad in order to produce a good for foreign consumption. This arises when the domestic market becomes saturated and when strong competition is affecting profits. Producing the same product in a country where labour costs are lower would enable the company to extend the product lines economic life. 5. Location-specific advantages as a consideration for the FDI approach was expounded by British economist John Dunning (1977). Also styled as the eclectic paradigm, this reasoning says that resource (natural and low-cost manpower) endowments and locational assets can be combined with the multinational companys own assets of technology, marketing, and managerial know-how to generate advantages for a company. Dunnings logic can be extended to the diffusion of technology within a specific confine such as the Silican Valley. Here, scientists and researchers discover new technological knowledge. The number of firms located there enable the sharing of knowledge in the computer and semi-conductor industries within the area that would not have been possible if they were dispersed. Uncertainties facing firms contemplating FDI When a multinational firm contemplates foreign direct investment, it has to consider many factors that are not encountered in its decision making process at home. Among the uncertainties (Cooke 1986) that the firm will have to grapple with are the following: 1.The assessment of the economic and political environment of the host country can be quite complex, and forecasting changes can be more so. 2. Foreign exchange problems can be upsetting even if the undertaking or project is a success. The host country may not have sufficient foreign exchange, or the host government may prohibit repatriation of profits, dividends, royalties, fees, and capital. In addition, changes and fluctuations in the exchange rates may affect asset valuation. Further, exchange control regulations may exist or will be imposed constraining cross-border transactions. 3. Taxation and tax complications whereby cross-border transactions are taxed in a discriminative way when domestic transactions are not so taxed. Taxes will have to be examined on a global basis because tax efficiencies can differ and the overall impact will have to be determined. 4. The problem of control. Because the subsidiary is of considerable distance from the firms headquarters, a decision has to be made whether to send a senior manager to control the organisation, or whether local management should be given the mandate or authority to control operations. This would depend on the specific situation prevailing in the subsidiary. 5. Political decisions such as the expropriation of the firms assets by the host government can always be a risk for certain categories of governments. 6. The question of raising money or capital funds in one country for investment in another country can pose a challenge. 7. Legal and regulatory regimes. There can be legal barriers between countries which can make it difficult for an overseas investment in a successful way. This is also a problem where the government has substantial control over investments, or has antitrust and anti-monopoly regulations. The foreign government may also regulate the allowable debt ratios for foreign firms. 8. Cultural issues. The language and customs in a country have to be studied. 9. Assessing financial information from many countries can be complex because of different accounting practices, leading to problems in integrating financial reports. Motives behind foreign direct investments Cooke (1986) provided a summary of motives for domestic acquisitions. Whilst acquisition motives are complex and multivariate in character in the domestic market, the situation is more so in the case of foreign direct investments. In this context the motives can be classified as strategic, behavioral, and economic. The life-cycle hypothesis, which has been briefly mentioned above, is based on the notion that products undergo certain stages from introduction into the market to their eventual withdrawal as they are replaced by new and improved products. Research and development in an advanced country creates a new product for the domestic market and later for the foreign markets. The product is standardised and economies of scale results. As the foreign markets are developed, domestic competitors in those markets participate and competition intensifies to the point that margins are squeezed. This prompts the multinational firm to establish production facilities abroad where cheap labour is available. Vernon (1966), the author of this theory, however failed to explain the growth of FDIs of advanced countries such as Japanese and European multinationals; hence, he modified his theory by emphasising the need for an oligopolistic market structure. An innovation-based oligopoly would engage in research to develop new products and to differentiate existing products. Because of protectionist and other trade-restricting barriers in other countries, the multinational has to initiate production abroad, reducing the proportion of exports in the total production. Mature oligopolies are characterised by economies of scale and efficiency derived from learning effects in their foreign productive operations. The firm engages in aggressive competition against potential rivals in their markets and in potential markets. The moves of Toyota Motor to compete in the US market and gain a larger market share can fall in this category. To prevent instability induced by price cutting, the players follow the leader by developing new products, by tacit price collusion, joint ventures and cross investment. This has been observed when oligopolists, normally hostile competitors, agree to join knowledge and resources through joint ventures. The car industry is known for this form of cooperation, while continuing to maintain the competitiveness of their individual product brands. Tacit price collusion is resorted to in order to avoid destabilisation of the market, but this is illegal in all countries, and can subject the violators to stiff penalties from the regulatory authorities. A senescent oligopoly is one that has reached the point of old products being dropped and new ones being developed. Firms become global oligopolists only when they are able to transfer the source of their unique domestic advantages to the foreign markets. Ian Giddy (1978) wrote about the internalisation process which is the process of internalising markets across national boundaries. The theory which was later refined others (Buckley and Casson 1976; Dunning 1977) proposed that firms have firm-specific competitive advantages in the form of intangibles such as goodwill, trademarks, patents, and marketing and organisational skills. Dunnings eclectic theory, briefly described above, attempted to link these advantages to host country characteristics such as cheap labour and available raw materials. An alternative theory concerns diversification for the purpose of stabilising earnings. Companies diversify by product and by region internationally. Product diversification means that in order to reduce risk to earnings, some products must be counter-cyclical. In diversification by region, the depressed demand in some regions are offset by the pickup in demand elsewhere. The multinational achieves this beyond its own domestic market. Hogue (1967) enumerated and described other strategic motives which are in the following areas: 1) market seekers, 2) raw material seekers, 3) knowledge seekers, and 4) production efficiency seekers. Market seekers are companies that locate production facilities close to market, such as the case of Japanese and European car producers establishing manufacturing plants in North America to compete with General Motors and Ford Motors. The same strategy is used by US car companies abroad. Raw material seekers locate production facilities close to the sources of raw materials such as minerals and crude oil. Knowledge seekers acquire companies with existing technological know-how and research capabilities. Production efficiency seekers are companies which locate in countries where a specific resource is found, such as cheap labour, particularly during periods when the currency of the multinational has strengthened. Conclusion The increasing globalisation of business has been the result of the free flow of international capital. Foreign direct investment, more so than foreign portfolio investments, have played a key role in promoting the globalisation of production and markets: from developed countries to developing ones, between developed countries, and more recently, even from developing countries to developed ones. As always there are problems that result, mainly in terms of income distribution, within countries which have been recipients of FDIs. Developed countries whose outflow of FDIs have exceeded inflows have been accused of depriving domestic workers of jobs. Still, overall the results are beneficial to all participants. Multinational companies tackle the challenges and take advantage of opportunities found in foreign markets. They employ various kinds of entry modes and aggressively compete with domestic producers and among themselves, the global oligopolists. To increase their competitiveness and long-run profitability, multinationals have choosing FDIs instead of exporting and licensing as their main corporate strategy abroad. Bibliography Buckley, PI & Casson, M 1976, The future of the multinational enterprise, Holmes-Meier, New York. Cooke, TE 1986, Mergers and acquisitions, Basil Blackwell Ltd, Oxford, UK Cooke, TE 1988, International mergers and acquisitions, Basil Blackwell Ltd, Oxford, UK Dunning, JH 1977, Trade, location of economic activity, and the multinational enterprise: A search for an eclectic approach. in B. Ohlin et al. (eds), The international allocation of economic activity, MacMillan, London Dunning, JH 1981, International production and the multinational enterprise, George Allen, London Giddy, IH 1978, The demise of the product cycle model in international business theory, Columbia Journal of World Business, vol. 13. 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