Does New Institutional Economics Helps a Business in Assessing Risk of Foreign Direct Investment - Assignment Example

Does New Institutional Economics Helps a Business in Assessing Risk of Foreign Direct Investment Background 2 Main Characteristics of the New Institutional Economics 3 Institutional Environment And institutional Change 4 Foreign Direct Investment 5 FDI Benefits to the Host Economy 5 Risk of Foreign Direct Investment 6 Assessment of Risk Associated with Foreign Direct Investment 7 New Institutional Economics and FDI 7 Institutional Determinants of FDI 8 Empirical Analysis 9 A case study of relationship between FDI and NIE 10 Implications of NIE 11 Problems with NIE 12 NIE is not a purely an economical school. NIE is a diverse way of looking at organization. It combines economics, law, organizational theory and sociology. (M. Hage, 2007)There is this misconception that NIE is very western or US approach. Due to the erosion of value system even in developed countries led to social segregation which can hamper economic development. The growing inequality and the gap between rich and poor countries have put questions on the ability of foreign institutions having solution. NIE also suffers from the means of measuring variables discussed in the theory such as transaction cost. 12 Conclusion 12 Introduction In order to fully understand and analyze the role of new institutional economics (NIE) in risk assessment of foreign direct investment (FDI), we first need to develop a sound understanding of the new institutional economy and various aspects of foreign direct investment. In this paper I will discuss what is New Institutional Economics and its background; and how it is dissimilar from traditional economics. Its various impacts and demands will also be discussed. I will also discuss help of NIE in finding solutions which were previously unresolved. What change in system is required for its implementation? NIE is not without its shortcomings it also poses some problems. In this paper we will try to analyze the impact of NIE on foreign direct investment. Does NIE help in any way assessing the risk associated with foreign direct investment? Background The term new institutional economics was invented by Oliver Williamson in 1990’s. It now refers to various active theoretical currents which believe in the importance of institutions. They also believe 1(Barnard Chavance, 2009) that importance of institutions can also be analyzed with the instruments of standard economic theory with some adjustments. He emphasized on the absence of existence of the firms in the conventional economics. He uses the cost of using the price mechanism as his basis. The search of appropriate prices and negotiation of separate contracts can be costly for individuals. Hence an individual volunteers himself under the authority of an organization or entrepreneur to sell his services to the market. Hence market transactions are eliminated and firm replaces the market thus economizing the cost of price determination. He developed the concept of transaction cost. Differing cultural values provide an advantage. The nature of the labour force shows that the cost of overcoming the difference in culture is sometimes worth the cost because of other benefits. This may not be the case always, some countries are obliged to adopt systems that are not in accordance to their customs, or companies create their own cultures. Some of the examples from the real world are former COMECON states adopting market based ideas and practices. Candidate states for membership to the E.U. adopting practices to facilitate entry. Western states adopting Japanese production systems, systems developed in a Japanese culture, because of its efficiency. All this implies that national cultural systems must adjust to the demands of modern capitalism. Inability to adjust will restrict or limit the extent the country or region is able to participate in international trade. New Institutional Economics (N.I.E.) helps in studying this problem. Main Characteristics of the New Institutional Economics New institutional economics is different from old institutional economics which was mainly based on theory. The role of institutions was also realized in pre-neoclassical economic theory, but new institutional economics goes a long way beyond that. The NIE is built on the same core assumptions but modifies it with bounded rationality. NIE consist of different theoretical strands and approaches but within the conviction that institutions does matter. The following three approaches can be identified within NIE. Property rights theory Transaction cost theory Agency theory. Transaction cost theory basically helps us in choosing various methods of distributing resources. Transaction characteristics actually determines transaction coordination mechanism and hence its cost. With risk minimization we can improve performance. Property rights theory answers how various economic factors uses property rights to stimulate activity. Agency theory deals with the delegation of authority how one person under contract allows other person to work on his behalf. This relationship works best when both parties work as utility maximizers. According to the believers of this theory institutions must have a built-in mechanism system to be effective. It can be formal or informal. Third level of analysis is based on transaction cost which requires one to look beyond the rules of the game and properly align transactions with governance structure to get the play of the game right. Fourth level of analysis deals with production function and agency theory as part of NIE provides insight into incentive adjustments. Four levels of NIE analysis can be summarized as 1. Social embeddedness which includes informal institutions, cultures, norms etc 2. Institutional environment which means rules of the game, polity, judiciary, etc. 3. Governance called play of the game, transactions and governance structures. 4. Resource Allocation, production function and agency theory. Institutional Environment And institutional Change It can be summarized in the following points. 2(Stephan J Dreyhaupt, 2006) 1. To reduce uncertainty and structural changes individuals choose the institutional environment that best suits them. 2. Transactions and production costs of the institutions affect the performance of the economy. 3. Institutional change depends on the perception of the individual actors. 4. Transaction costs and behavioral context are actually derived from ideologies and preferences. 5. Government backed institutions ensures third party enforcement and cooperation. Which is not costless and possibility of failure also exists. 6. The interaction of the cost of transactions and the distribution of coercive powers determines the shape of the development of institutions. The major interest of NIE lies in the analysis of the impact of institutions on economic behavior of firm as well as region. 3(Manuela Stoll, 2007) Institutional change is thus seen as control problem rather than an endogenous factor. According to this theory the visible structures and routines of the organization reflect the institution upon which it is based the endogenous factors and the wider environment. Foreign Direct Investment In order to fully understand and analyze and assess the risk of foreign direct investment and effect of new institutional economy we first need to fully understand what foreign direct investment is. Foreign Direct investment is different from foreign portfolio investment. Two key elements are very important in the definition of foreign direct investment and in distinguishing it from foreign portfolio investment. 4(United Nations, 2009) Foreign direct investment is the investment made by the resident of one economy into the other economy. This investment has to be of long term nature and with the intention of lasting interest. Here one clarification is necessary that country of residence is different from country of citizenship. The second important element is that the investor must have some degree of influence over the management of the organization or the enterprise. IMF has actually defined the foreign direct investment interest as 10 percent of the voting power which comes from ownership. This 10 percent limit is drawn just to enhance international comparability so that countries which are new to Balance of payment (BOP) compilation or FDI statistics can follow the international criteria. FDI Benefits to the Host Economy Whenever a MNE makes investment or with the flow of foreign direct investment the only benefit is not direct investment but the benefits are manifold. Its benefits range from increase in employment, increased output, resultant outflow of income and many other benefits. All these benefits are collectively called the spillover effect.5 (Jonathan Jones, Collin Wren, 2006). These spillover effects are not taken into consideration when investors are taking decision of FDI. The host economy can advantage of the knowledge which MNE brings with itself. Knowledge about distribution networks and export markets etc. when an MNE enters the local market it increases the productivity which is also called the market access spillover. These benefits can be categorized into the following categories 1. Productivity and market access spillover 2. Competition and linkage effect 3. Knowledge-Capital effects 4. Technological effects The domestic firm is bound to benefit from the MNE because of the linkages in supply and chain, movement of labor to MNE’s and knowledge of technology. It is said that for any MNE to enter any foreign market they must have productivity advantage over local firms only then it will be beneficial for both. Local firms will grow under the competitive environment taking advantage of the knowledge and the technology. Labor will also move to MNE and their knowledge and worth increases. How much the host economy will benefit in technology depends on the technological gap between the two countries. Risk of Foreign Direct Investment The risk of foreign direct investment flows is borne by multiple players. First and the most important one are the investors themselves. The reason being equity investments are always riskier than other investments. They have the risk of losing investment, productions and probably job in the process. The second one to be effected by risk is the host country itself. What is at risk for the host country is its macroeconomic stability. The third party involved in this risk is the financial institutions financing the FDI such as European Investment Bank EIB in case of Europe. 6(Klaus Liebscher, Oesterreichische Nationalbank, 2007) FDI is not a new phenomena but it has increased manifolds due to increased globalization. In addition to normal commercial or financial risk there are other types of risks involved as well which includes political risk, currency risk, transferability and convertibility risk and it can go as wide as civil unrest, breach of contract and denial of justice etc. Assessment of Risk Associated with Foreign Direct Investment There are various approaches through which we can measure and analyze the risk associated with foreign direct investment. It helps in making decisions on international investment projects. These theories include global capital asset pricing rule of financial theory, theories of strategy making and the real options approach, present value formula of risk assessment. All these theories help us in making a clear cut decision about foreign investment by assessing the viability of the project. New Institutional Economics and FDI Countries with similar institutional environment may have different FDI inflow patterns. What is important is that there exists a clear and positive correlation between FDI and the level of institutional governance. According to a report by OECD countries where there is efficient judicial system and the law prevails, corruption level is low, ownership is widely spread and not concentrated such countries receive more investment. According to New Institutional Economics, the FDI policy completion requires the institutional environment which is right, healthy and feasible for local competition, it also aligns the governance and underlying transactions. Institutional framework plays an important role in attracting FDI. FDI requires an investor-friendly environment, which is stable and cooperative with appropriate governance model that minimizes transaction cost and agency structure that promotes investment approach of the country. Institutional Determinants of FDI Now we will do an empirical investigation of FDI pattern with the help of the gravity model. We will try to investigate the determinants or factors of FDI with special emphasis on Institutional economics. 7(Jay J Choy, Sandra Dow, 2008). These factors help in making any country more attractive to FDI, more resilient to tackle crisis and ensure healthy competition, and more absorptive to the benefits of FDI. With globalization there is an ever increasing investment opportunity, increasing integration of economies which results in high completion in attracting FDI. The determinants of FDI are incentives or governance and corporate governance and openness to FDI. There are two opinions about this theory. Some believe that competition amongst government to attract FDI leads to incentives by governments, such as removing restrictions on the activities of MNE’s and lowering of fiscal, social, labor standards have negative impact on the host economy.8(Tim Forsyth, 2005) They see heavy FDI as actually weakness of the country’s financial and institutional system. While others believe that all these incentives given to investors to lure them to their country and retain them are actually beneficial for the host country. Therefore by giving subsidies and lowering restrictions they help attract FDI. By improving the investment climate and social and physical infrastructure, human capital and good governance the country will reap benefits of the positive spillover of FDI flows. The associated discussion has been done previously. Empirical Analysis This model is very popular due to its wide applicability. According to the gravity model of international trade the determinants of amount of trade between the two countries are its economy size, geographical distance, set of variables that determine proximity and Institutional characteristics. Now we will have a look at the model specification. Gravity model takes the following form in the international economics version of Newtonian Physics. Fij = ∞. YiYj ÷ Dij Where Fij represents amount of flows between i and j. ∞ is a constant. Y ij measures the size of i and j. Dij represents the distance between them. After applying this model to a data of panel of 61 countries following conclusions were drawn. FDI was identified as healthy cholesterol or a good thing for any economy. The positive role of other country qualities such as good governance and institutions were also identified in stabilizing economy and it improving its performance. Two stage gravity model identifies determinants of FDI with special reference to institution by controlling various traditional factors and incentives such as wages and tax rates. Our empirical analysis confirms our notion that institution does play an important role in attracting and retaining FDI and minimizing risk associated with it. A case study of relationship between FDI and NIE The level of attractiveness for FDI is dependent on many factors. Here we will discuss the case of South Eastern European countries to study the relationship. It was observed in the World Investment Report (2004) that FDI increased in countries like Poland, Czech Republic and Hungary because of large Privatization projects in these countries which improved the level of infrastructure, general economic environment, trade flows and labor productivity rates. All these factors are integral part of institutionalization. FDI inflows in these South eastern European countries was due to increased GDP, openness in trade, research and Development, employment rate and improvement in the quality of human Capital .The related determinants in these countries were identified as Market size determined by GDP growth rate Production factors cost Macroeconomic stability Quality of human capital Trade openness and increased market accessibility It was observed in the study that regardless of the financial incentives FDI inflows usually go to the countries which are already developed in order to take advantage of their economic features. 9(George M. Korres, 2007,) Hence institutionalization is the most important determinant of FDI inflows because it minimizes the risk associated with FDI. Therefore FDI supports the stronger countries rather than the weaker countries. The challenge for South East European countries therefore are to not only attract about retain this FDI for the sustained development and growth. In this highly competitive market it can only be done by investment in institutional factors such as Infrastructure, modernizing education and training system to improve quality of human capital and maintaining healthy business environment. Incentive policies should be pursued to improve macroeconomic stability, political and social liberty, and prevalence of law, strong competition and technological network. This is the key for sustained growth. From the point of view of businesses this NIE audit helps in determining the viability and efficiency of trade in the new market. Implications of NIE After discussing the importance of NIE in determining the risk of FDI it can be suggested that businesses and countries at large need to conduct an NIE audit to judged the viability of FDI and ascertain their position in this highly competitive environment. NIE audit will help them in determining if to trade in the new market and if yes then how? What would be the viable method? NIE in a way offers the tool for risk assessment. It helps the business in identifying and measuring risk associated with making foreign investment. NIE is a better tool because it not only considers the financial viability as measured by net Present value method but it takes into account various macro economic factors as well which participates in the success or failure of the venture. It can judge the adaptive efficiency of a society. Societies which are not happy with capitalism poses higher risk to FDI because of their high uncertainty level and transactional costs. Problems with NIE NIE is not a purely an economical school. NIE is a diverse way of looking at organization. It combines economics, law, organizational theory and sociology. (M. Hage, 2007)There is this misconception that NIE is very western or US approach. Due to the erosion of value system even in developed countries led to social segregation which can hamper economic development. The growing inequality and the gap between rich and poor countries have put questions on the ability of foreign institutions having solution. NIE also suffers from the means of measuring variables discussed in the theory such as transaction cost. Conclusion After discussing various factors affecting FDI and studying FDI in special reference to new institutional economy I have reached the conclusion that yes NIE helps businesses in assessing the risk of FDI. This is supported not only by theory but also by empirical evidence. A case study also helped us in proving our point. Bibliography 1(Barnard Chavance, 2009, Institutional Economics, USA, Routledge) 9(George M. Korres, 2007, Regionalization, growth and economic integration, Greece, Physica –Verlag) (7(Jay J Choy, Sandra Dow, 2008, Institutional approach to global corporate governance: Business systems and Beyond, UK, Emerald group publishing Ltd.) 5 (Jonathan Jones, Collin Wren, 2006, Foreign Direct Investment and the Regional Economy, England, Ashgate Publishing Limited) 6(Klaus Liebscher, Oesterreichische Natinalbank, 2007, Foreign direct investment in Europe: a changing landscape, England, Edward Elgar Publishing) 10(M. Hage, 2007, A stakeholders concern towards an economic theory on stakeholder governance, Neitherlands, Van Gorcum) 3(Manuela Stoll, 2007, Success in Changing Environments: Strategies and Key Influencing Factors, Germany, DUV) 2(Stephan J Dreyhaupt, 2006, Locational Tournaments in the Context of the EU Competitive Environment, Germany, DUV) 8(Tim Forsyth, 2005, Encyclopedia of International Development, USA, Routledge) 4(United Nations, 2009, Unctad Training manual on Statistics for Foreign Direct Investment and the Operation of TNC’s, Switzerland, United Nations Publications) Read More