The Exploration of Dunnings OLI Framework - Coursework Example

To what extent does Dunning’s OLI framework provide a realistic explanation of a multinational enterprise’s (MNE’s) decision making processes when considering where to place Foreign Direct Investment (FDI)? TABLE OF CONTENTS Introduction …………………………………………………………………………… 2 Understanding the Terms and Nuances ………………………………………..……. 3 Equating the Decision to Move Forward or Not to Move Forward ………………. 5 The Location Risk Assessment ………………………………………………..…….. 6 Conclusion ……………………………………………………………….………….. 12 References ……………………………………………………………………………. 13 FIGURES / TABLES FIGURES Figure 1 – Country Credit Curve and Corresponding Ratings ………………..… 8 TABLES Table 1 - FDI Confidence Index ………………………………………………….. 10 Table 2 - OECD Country Risk Classifications …………………………..………. 11 Introduction In delving into the extent that Dunning’s OLI (‘Eclectic Paradigm’) framework provides a realistic explanation of the decision-making the process a multinational enterprise (MNE) goes through in considering where to place Foreign Direct Investment (FDI), some interesting factors were uncovered. The three elements utilised by Dunning under his ‘Eclectic Paradigm’ are represented by Ownership, Location and Internationalisation are not equal in terms of their weighting and application in the decision process. As uncovered herein, the processes leading up to the decision to assume an FDI stance has varied procedural approaches. The first represents conducting an analysis of the firm (Ownership) that is followed by an analysis of the potential advantages the firm would receive through pursuing overseas facility location and under what guise (horizontal or vertical FDI). This examination uncovered that the core element is represented by Location, and the varied risk factors inherent in this arena. This represents the most important facet in that country selection can make or break the FDI process due to unacceptable risk in this arena that can undermine the entire process. Coincidentally, the Location facet of the OLI (‘Eclectic Paradigm’) triumvirate is the only external analysis segment in the process. The significance of this is that a company needs to equate a series of factors in this element that ultimately determines the long-term financial feasibility of the proposed FDI investment. The unequal weighting of the three elements under Dunning’s OLI approach was not a stated explanation in the materials reviewed and was only uncovered as a result of defining each element variable and investigating the components involved. The steps, as well as stages a multinational enterprise goes through in the decision-making process, is not simply moving through 1,2,3 in terms of the three elements under Dunning’s OLI in that the portions of the steps might need to be revisited based on what is uncovered in one of the segments. Unfortunately, the foregoing was also not discussed or emphasized in the materials accessed. These three elements are intertwined, thus changes or new developments necessitate re-equating prior findings in light of how they impact the overall analysis. This study will delve into the processes involved as a means to shed light on these facets in the spirit of providing an enhanced understanding. Understanding the Terms and Nuances OLI stands for Ownership, Location and Internationalisation, which represent three potential advantage facets a company uses to engage in equating the international stage in terms of investment (Brouthers et al, 1999, p. 837). In understanding what is meant by OLI, each of the three elements comprising the term need to be explained as a means to set the context of this study. With regard to Ownership, the characteristics looked for represent the firm having advantages in terms of modes and or methods of production techniques, trademarks, scale (concerning economies of operation) as well as management skills that tend to lead toward an entrepreneurial outlook (Brouthers et al, 1996, pp. 379-380). The significance of the above, along with a company having specific competitive advantages with regard to Foreign Direct Investment (FDI), represent important reasons and rationales in terms of ascertaining the potential degree(s) of success it will or might have (Bevan and Estrin, 2004, pp. 780-783). Prior to delving further into the remaining two OLI elements, an understanding of Foreign Direct Investment is needed in order to aid in setting the context. One definition stated that FDI represents “… a company from one country making a physical investment into building a factory in another country” (Going Global, 2010). It continues “… The direct investment in buildings, machinery, and equipment is in contrast with making a portfolio investment, which is considered an indirect investment” (Going Global, 2010). In another definition, FDI is defined as “A major investment by a foreign corporation … A common example of foreign direct investment is a situation in which a foreign company comes into a country to build or buy a factory” (The Free Dictionary, 2012).   As a means to clarify FDI, the Organisation for Economic Co-Operation and Development (OECD, 1999, p. 7) has constructed what they term as a benchmark definition. The OECD (1999, p. 7) states “Foreign Direct Investment reflects the objective of obtaining a lasting interest by a resident entity in an economy (direct investor) in an entity resident in an economy other than that of the investor (direct investment enterprise)”. It goes onto add that “The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence on the management of the enterprise” (OECD, 1999, p. 7). “Direct investment involves both the initial transaction between the two entities and subsequent capital transactions between them and among affiliated enterprises, both incorporated and incorporated” (OECD, 1999, p. 7). As can be seen from the complexities of FDI investment, the considerations a firm needs to take into account in some cases can be quantified, whilst in others, they cannot. This examination will bring forth both instances. In so doing, it must be remembered that the safest FDI locales might not necessarily represent ones that suit the particular demands or dictates a firm needs. The second of the three elements is represented by Location advantage that entails the presence of raw materials a firm might use, low wage demands as well as special taxes and or tariffs (Mina, 2007, pp. 340-341). In terms of a location having these within its border, or available in nearby countries, these are factors in considering the country or region as a positive environment (Mina, 2007, pp. 340-341). The presence of skilled workers that fit the needs of a particular firm, along with special governmental tax relief and or tariffs are highly important (Mina, 2007, pp. 340-341). In reviewing materials on OLI and the components of each element it was discovered that the foregoing was the core deciding factors, and also the most complex. With regard to Internalisation, Dunning (2006, pp. 139-141) tells us this represents production advantages the firm has developed within its own organisation as opposed to seeking or gaining this through a partnership, licensing and or joint venture (Dunning, 2006, pp. 139-141). The preceding represents what is termed as a core competency (Dunning, 2006, pp. 139-141). The more a company can internalise their cross border products and markets means it is more likely to engage in foreign-based production as opposed to licensing this out (Dunning, 2006, pp. 139-141).   The preceding summary introduction to Dunning’s OLI framework has been brought forth as a means to develop an understanding of how it provides insights concerning the manner multinational enterprises (MNE’s) engage in their decision making processes in an undertaking where they should place Foreign Direct Investment. Equating the Decision to Move Forward or Not to Move Forward In revisiting the three elements, the approach to Ownership sets the arena for a company equating if it has the internal business advantages, vis-a-vis its competitors (meaning production techniques, trademarks, economies of operation, management skills, etc.) (Brouthers et al, 1996, pp. 379-380). Dunning’s OLI framework leaves it to the executives of the firm or researcher to equate if the foregoing represent positive points in that no guidelines or points to equate them are provided. The same holds true with regard to Internationalisation. Ethier (1986, p. 809) stated that it “… appears to be emerging as the Caesar of the OLI triumvirate”. The rationale for this is that the first aspect in making a determination to pursue locating a plant or facility overseas, a company must first access and take stock of its capabilities, strengths, and weaknesses (Ethier, 1986, p. 809). This statement reflects the decision of a company to investigate its firm-specific advantages that represent cost-effective measures. This factor, when calculated, considers the investment costs of locating aboard taking into account areas such as lower wages, raw material costs, transport and other factors (Ethier, 1986, p. 809). Buckley and Hashai (2009, pp. 61-63) tell us that under Internationalisation it is transaction based. They advise that the facets identified under Ownership advantage (technological, marketing knowledge and or superior management) represent the company exploiting its Ownership advantage internally as opposed to utilising licensing, joint venture or other collaborative modes (Buckley and Hashai, 2009, pp. 61-63). Proceeding in this manner minimises transaction costs that are connected with the inter-firm transference of knowledge and capabilities that is proprietary (Keupp and Gassmann, 2009, pp. 603-604). In understanding the three elements of the ‘Eclectic Paradigm’, it needs to be noted that is has changed over time. It has evolved from the assumption that Ownership advantage originates in a company’s home country as a result of its motivation to internationalise as represented by market/resource/ efficiency seeking, and or other strategic global considerations. A shift in this approach has occurred in that some companies have turned to reasons such as knowledge and asset seeking as the current motivations under Internationalisation. Under knowledge asset seeking it takes the position that a firm’s Ownership advantage is not necessarily a product of its home country (Burgel et al, 2000, pp. 5-8). It has been uncovered that there are instances whereby Internationalisation advantages may be either acquired and or augmented overseas thereby providing the motivation (Burgel et al, 2000, pp. 5-8). The preceding advantage is when the firm has the specific know how to produce an item that generates cost savings as a result of technological and or process methodologies instead of simply lower-cost labour (Burgel et al, 2000, pp. 5-8). In reviewing the above, the back and forth between these two elements do not provide the decision-making facets, but rather arenas for equating if the company has the needed qualities to compete based on management’s analysis. The foregoing does not provide a comparative to aid the firm in comparing it against competitors that are sorely lacking in the OLI framework’s process. The Location Risk Assessment Country risk represents the most important facet of the OLI framework, however, its significance is not emphasized as such. In assessing country risk, there are a wide number of agencies engaged in this field as represented by Standard & Poors, Euromoney, Moody’s, Political Risk Services, Economist Intelligence Unit, AM Best and others (Ribeiro, 2002). In delving into Location advantages it is important to understand that unlike Ownership and Internationalisation, it represents the analysis of external factors. The problem with this is that in order to equate the risks involved, a company needs to develop an understanding of the varied factors comprising this arena in that there are a host of areas to consider and equate. Country risk represents one of these areas, but, it is not the only area that needs to be investigated in order to develop a clear and well-rounded picture of the external factors (Erramilli et al, 1997, pp. 741-743). One of the variables comprising country risk represents what is known as transfer and convertibility risk, along with other areas (OECD, 2011). Under transfer and convertibility risk, these are defined “… as the risk that capital and exchange controls may be imposed by government authorities that would prevent or materially impede the private sector’s ability to convert local currency into foreign currency and/or transfer funds to nonresident creditors” (AM Best, 2011). The preceding includes “… force majeure (e.g. war, expropriation, revolution, civil disturbance, floods, earthquakes)” (AM Best, 2011). AM Best (2012) “… is a full-service credit rating organisation …” that serves the insurance industry. Its rating systems are utilised by governments and corporations in accessing country risk. In explaining the complexity of transfer and convertibility risk, AM Best (2011), advises it is a component of country risk in that it represents a separate as well asa distinct category in the rating process. Dunning’s OLI framework does not explain this distinction, which was uncovered as a result of delving into a number of materials to uncover its significance. Another missing facet under Location advantages outside of Dunning’s OLI framework, but integral to the process, is the function of sovereign risk. To understand why a country might impose limitations and or suspend monetary transfer and convertibility, the link with sovereign risk holds the explanation (Nogues and Grandes, 2001, pp. 139-142). The imposition of transfer or convertibility risk limitations is a function of sovereign risk (excepting areas of force majeure) (Nogues and Grandes, 2001, pp. 139-142). It is basically when a government is under political and or economic pressure and is not able to make its foreign exchange available as a means to meet its foreign currency obligations (Cosset and Suret, 1995, pp. 307-309). The significance of understanding this is that whilst a country might appear to represent an intriguing FDI candidate, the hidden dangers in sovereign risk represent a compelling case against investment in that it contains instability elements (Cosset and Suret, 1995, pp. 307-309). Adhering strictly to the three ‘Eclectic Paradigm’ elements without taking this into account could render that exercise as moot and ineffective. A simplified means to equate if sovereign risk needs to be investigated further can be found through country default events along with credit default curves (Risk Servers, 2010). In the measurement of the sovereign event risk of a country this rating is utilised “… to read from a credit event curve” (Risk Servers, 2010). The following provides an illustration of this: Figure 1 – Country Credit Curve and Corresponding Ratings (Risk Servers, 2010) The preceding represents a hidden risk factor in assessing FDI that could easily be overlooked. This facet, FDI, is a critical component, but its parameters regarding importance are not covered under Dunning’s OLI framework. FDI has horizontal and vertical distinctions under Location advantages (Alzenman and Marlon, 2004, pp. 131-134). The difference between these two forms is represented by the fact that horizontal FDI is when a company locates a facility overseas or aboard as a means to enhance market access in terms of consumers located in foreign countries (Beugelsdijk et al, 2008, pp. 461-463). In general, it is a replication of a firm’s home country production in a foreign country (Beugelsdijk et al, 2008, pp. 461-463). In contrast to horizontal FDI, vertical FDI is not necessarily used for investing in facilities aimed at production geared for sale in foreign markets (Blonigen, 2005, pp. 391-394). The usual mode of vertical FDI seeks to take advantage of lowered productions costs (Blonigen, 2005, pp. 391-394). It may seem that since the company retains its headquarters in its home country, with its firm-specific and or ownership advantages generating headquarters service to the foreign plant that all Foreign Direct Investment tends to be vertical, but such is not the case (Blonigen, 2005, pp. 391-394). In clarifying the distinctions, Brainard (1997, pp. 527-528) states that horizontal FDI’s motive is based on what he terms as a “… proximity-concentration trade-off”. This represents constructing a plant in a foreign location produces savings with respect to trade costs in that it has better proximity to the market it serves (Brainard, 1997, pp. 527-528). He adds however that in doing so the company loses the benefit of economies of scale that would occur by adding this production at the home plant in the company’s host country (Brainard, 1997, pp. 527-528). Thus, the rationale is that the firm gains through lowered trade costs that must be balanced against production as a means to understand which mode generates the higher profit as well as return on investment costs (Brainard, 1997, pp. 527-528). In terms of vertical FDI, its motive rests in a different approach to the implications as well as determinants (Yeaple, 2003, pp. 299-301). The focus rests on how the firm can best serve its markets (Yeaple, 2003, pp. 299-301). This means either producing in its home or domestic market or through vertical means by having facilities in a less expensive foreign locale (Yeaple, 2003, pp. 299-301). The decision process in terms of vertical FDI resides in whether the savings from investing and producing in a foreign location is lower than concentrating production in the home market and assuming the tariff and other trade costs (Yeaple, 2003, pp. 299-301). In looking at empirical studies of horizontal and vertical FDI it tends to lean toward horizontal FDI as a result of what is termed as tariff jumping (Blonigen et al, 2004, p. 666). AT Kearney (2012) puts forth a ‘Foreign Direct Investment Confidence Index’ that represents an annual survey of international executives regarding their assessment of FDI in a country.   Table 1 - FDI Confidence Index (AT Kearney, 2012)   The above closely approximates the country risk rankings as compiled by OECD (2011):   Table 2 - OECD Country Risk Classifications (OECD, 2011) The higher ranking for countries is based on the opportunities offered that outweigh the moderate risks. Country risk includes calculations of the risk of investing in a country represented by changes and or stability in the business environment that could impact profits or asset value (Oetzel et al, 2001, pp, 133-135). Factors such as currency devaluation and or regulatory change frequency, currency controls, country stability factors as in mass riots, country unrest (civil wars) as well as other potential event areas are factors that might contribute to the operational risk a company might be exposed to (Meldrum, 2000, p. 42). The foregoing horizontal and vertical components under Location advantages were missing in Dunnings OLI framework as significant areas to be equated. Conclusion The exploration of Dunning’s OLI framework with regard to if it provides a realistic foundation for the decision making processes of a multinational enterprise in considering where it might place Foreign Direct Investment has revealed shortcomings. In delving into the foregoing, it was uncovered that Dunning’s OLI framework represents more of a set of parameters as opposed to a framework. This statement has been made in that in moving through the three elements comprising his ‘Eclectic Paradigm’ they represented a series of areas to check as opposed to a definitive methodology leading to the formulation of an FDI decision process. The preceding has been stated in that in moving through the foregoing three elements there were no guidelines to rate a plateau or level by which to equate if the points covered or analyzed represented a decision to move forward. The Dunning OLI framework provides direction as to the areas to delve into, however, the arrival at what constitutes a decision, or parameters to move forward and how to equate them was not described. As a result, the variables involved in the three OLI elements are covered, in a fashion. The preceding is stated in that the framework leads one in the general direction, but does not place compass marks on the map. As illustrated from the aspects covered in the Introduction segment, the ‘Eclectic Paradigm’ approach seems relatively straight forward. However, within each segment when a multinational enterprise is considering FDI, the decision-making process becomes more complex. All things being considered equal, which means that all of the three elements under the ‘Eclectic Paradigm’ are present, the Location variables represent the area that is not under the control of the company. Country risk represents the vexing element in the decision making equation in that it is an important external factor upon which ultimate success rests. A country and region might fit the raw material, labour, tax, tariff, and investment parameters, but if the country risk segment has red flags for segments that are bordering on or nearing that status, the decision to invest can be difficult or called off (Nordal, 2001, pp. 199-201). As can be deduced from its phrase, country risk represents the varied risk factors inherent when investing in a country whereby changes in the political, economic and or business climate represent long term stability factors (Alfaro et al, 2004, pp. 94-97) that must be accounted for. References Alfaro, L., Chanda, A., Kalemli-Ozcan, S., Sayek, S. (2004) FDI and economic growth: the role of local financial markets. Journal of International Economics. 64(1). pp. 94-97 Alzenman, J., Marlon, N. (2004) The merits of horizontal versus vertical FDI in the presence of uncertainty. Journal of International Economics. 62(1). pp. 131-134 AM Best (2011) Measuring Transfer and Convertibility Risk. Accessed on 24 April 2012 from http://www.ambest.com/ratings/methodology/MeasuringTransferConvertibilityRisk.pdf AM Best (2012) Who we are. Accessed on 24 April 2012 from http://www.ambest.com/about/ ATKearney (2012) Foreign Direct Investment Confidence Index. Accessed on 25 April 2012 from http://www.atkearney.com/index.php/Publications/foreign-direct-investment-confidence-index.html Beugelsdijk, S., Smeets, R., Zwinkels, R. (2008) The impact of horizontal and verticalFDI on host's country economic growth. International Business Review. 17(4). pp. 461-463 Bevan, A., Estrin, S. (2004) The determinants of foreign direct investment into European transition economies. Journal of Comparative Economics. 32(4). pp. 780-783 Blonigen, B. (2005) A Review of the Empirical Literature on FDI Determinants. Atlantic Economic Journal. 33(4). pp. 391-394 Blonigen, B., Tomlin, K., Wilson, W. (2004) Tariff-jumping FDI and domestic firms’ profits. Canadian Journal of Economics/Revue canadienne d'économique. 37(3). p. 666 Brainard, L. (1997) An empirical assessment of the proximity concentration tradeoff between multinational sales and trade. American Economic Review. 87(4). pp. 527-528 Brouthers, K., Brouthers , L., Werner, S. (1996) Dunning's eclectic theory and the smaller firm: The impact of ownership and locational advantages on the choice of entry-modes in the computer software industry. Internatyional Business Review. 5(4). pp. 379-380 Brouthers, L., Brouthers, K., Werner, S. (1999) Is Dunning's Eclectic Framework Descriptive or Normative? Journal of International Business. 30(4). p. 837 Buckley, P., Hashai, N. (2009) Formalising internatioalisation in the electic paradigm. Journal of International Business Studies. 40(6). pp. 61-63 Burgel, O., Fier, A., Lichet, G., Murray, G. (2000) Internationalisation of high tech start ups and fast growth” Evidence for UK and Germany. Centre for European Economic Research. Paper No. 00-35. pp. 5-8 Cosset, J., Suret, J. (1995) Political Risk and the Benefits of International Portfolio Diversification. Journal of Intrnational Business Studies. 26(2). pp. 307-309 Dunning, J. (2006) Comment on Dragon multinationals: New players in 21st century globalization. Asua Pacific Journal of Management. 23(2). pp. 139-141 Erramilli, M., Agarwal, S., Kim, S. (1997) Are Firm-Specific Advantages Location-Specific Too? Journal of International Business Studies. 28(4). pp. 741-743) Ethier, W. (1986) The Mulitnational Firm. Quarterly Journal of Economics. 101(4). p. 809 Going Global (2010) Understanding Foreign Direct Investment. Accessed on 24 April 2012 from http://www.going-global.com/articles/understanding_foreign_direct_investment.htm Keupp, M., Gassmann, O. (2009) The Past and the Future of International Entrepreneurship: A Review and Suggestions for Developing the Field. Journal of Management. 40(8). pp. 603-604 Meldrum, D. (2000) Country Risk and Foreign Direct Investment. Business Economics. 35(1). p. 42 Mina, W. (2007) The location determinants of FDI in the GCC countries. Journal of Multinational Financial Management. 17(4). pp. 340-341 Nogues, J., Grandes, M. (2001) Country Risk: Economic Policy, Contagion Effect or Political Noise. Journal of Applied Economics. 4(1). pp. 139-142 Nordal, K. (2001) Country risk, country risk indices and valuation of FDI: a real options approach. Emerging markets Review. 2(3). pp. 199-201 OECD (1999) OECD Benchmark Definition of Foreign Direct Investment. Paris, France. OECD OECD (2011) Country Risk Classifications. Accessed on 24 April 2012 from http://www.oecd.org/document/49/0,2340,en_2649_34171_1901105_1_1_1_1,00.html Oetzel, J., Bettis, R., Zenner, M. (2001) Countryrisk measures: how risky are they? Journal of World Business. 36(2). pp, 133-135 Ribeiro, R. (2002) Country Risk Analysis. Accessed on 25 April from http://www.gwu.edu/~ibi/minerva/spring2001/renato.ribeiro.pdf Risk Servers (2010) Country Sovereign Event Risk. Accessed on 24 April 2012 from http://www.financial-risk-manager.com/risks/country/country.html The Free Dictionary (2012) Foreign Direct Investment. Accessed on 23 April 2012 from http://financial-dictionary.thefreedictionary.com/Direct+foreign+investment Yeaple, S. (2003) The complex integration strategies of multinationals and cross country dependencies in the structure of foreign direct investment. Journal of International Economics. 60(2). pp. 299-301 Read More