This book is an exploration of the way in which risk influences the process of decision making relating to foreign direct investment. Its initial premise is that country risk is, and should be, a major deterrent to such investment. Since FDI is of increasing significance for the promotion of economic development in countries with a low level of economic development and for the maintenance of continuing growth in developed countries, it is important to understand how risk of various types constrains the flow of such investment. FDI is much more important than trade in delivering goods and services abroad (UNCTAD 2003: xvi). In 2002 global sales by multilateral enterprises reached $US18 trillion, as compared with world exports of $US8 trillion. In the same year the value added by foreign affiliates of multinational companies reached $US3.4 trillion, about one tenth of world GDP, twice the level of 1982. Because risk is a significant determinant of foreign investment there is a need for the relevant decision makers to identify, estimate and assess the relevant risk and to respond to it (Baird and Thomas 1985: 234).
This chapter considers the platform of existing theory on which an acceptable treatment of risk and FDI can be built.1 It is appropriate to consider at some length the way in which risk is treated in the financial literature and to show its limited relevance to the appraisal of foreign direct investment. It is also necessary to place the FDI decision in the context of the investment decision-making process in general.
This chapter starts by indicating how necessary it is to bring together the disparate approaches to risk in a genuinely integrated manner which assimilates all risk factors and the different disciplinary approaches to risk. It defines what risk is and shows the universality of that risk with careful distinctions made between incidence, impact and response. The analysis shows how such risk-generating events might be classified. One method of classification is by the different levels at which risk arises and has to be controlled. The analysis then turns to the response to risk by considering the appetite for risk, or degree of risk aversion, of those confronting risk. Part of such an analysis is consideration of the nature of risk exposure for organisations and individuals, notably different stakeholder groups. In conclusion, the chapter analyses the connection between risk and return which is considered a positive one by financial theorists but paradoxically has appeared in the empirical data to be negative; successful organisations are able to increase returns and reduce risk simultaneously.
This chapter analyses in what sense and why the aggregate level of foreign direct investment is lower than might be anticipated. It begins by pointing out the ambiguities of definition and the limitations of the estimates made of FDI. It goes on to explore the degree to which all economic actors, whether they are individuals, governments or companies, prefer their own. This applies to where a person works, where he/she places savings, or to the origin of the goods and services consumed by that person. It also applies to where a company invests in productive facilities, who it employs and where it purchases. It explores three arguments advanced to establish such a bias, analysing in turn the arguments based on deficiencies in market integration, the tendency for equality between national savings and national investment, and a pronounced domestic orientation in the composition of portfolios of financial assets. The chapter defines home country bias, indicates how it might be measured and seeks to explain it. It concludes by making a link between country risk and home country bias in FDI.
This chapter emphasises the importance of avoiding two types of mistakes, making a poor investment and ignoring a good one. It continues with the articulation of the formula for estimating the net present value of a single project, initially in which there is no uncertainty. The next section explores the significant measurement problems for inputs into such a formula, including the problems following from its international nature. The assumptions of the analysis are made explicit. Later sections show how such a formula over-simplifies the appraisal of an investment project, by ignoring the key issue of uncertainty. The chapter goes on to analyse the impact of uncertainty on decisions making, assuming that all the relevant risk is epistemic risk, risk arising from a lack of the relevant information. This uncertainty relates both to the identification of the project and to the reading of the environment in which the project will operate and its influence on the project. The real options approach which allows for a reduction of uncertainty is discussed.
This chapter turns from the project level to the enterprise level, mainly because an appraisal which considers an investment project in isolation is inadequate. An enterprise perspective is necessary. The chapter, therefore, adopts a strategic perspective on investment decision making, one which places the appraisal of a single investment project in the context of the overall enterprise strategy, including its relationship with other projects — past, present and future. Such a perspective stresses the role of the enterprise as a maker of strategy. It is consistent with a view which interprets most strategy as emerging from a learning process. It also discusses the strategic risk arising from the strategy of other players before presenting an expanded version of net present value and a decision rule which takes full account of uncertainty. It follows up with a review of the requirements of a relevant information strategy. The chapter concludes with an analysis of a critical aspect of strategy, the appropriate mode of entry to be adopted into international business transactions.
The present chapter takes an organisational perspective, focusing on the structure of an enterprise. The analysis concentrates on the nature of the enterprise as a network of stakeholder groups who are affected by, and have an influence on, the investment decision. This chapter explores the way in which the joint stock limited liability company privileges the one stakeholder group, the shareholders, and how various risk environments have influenced the development of the organisational framework and the relevant law, notably in the areas of limited liability and bankruptcy. It goes on to show how the way in which key decisions are made reflects relations between different stakeholder groups. These relations determine the distribution of both value and risk. Further sections consider key stakeholder relations, notably those between owners and managers, and between creditors and owners. The organisation of the enterprise and its capital structure provides the context in which investment decisions are made. The capital structure of an enterprise can influence the way in which risk affects the investment decision. The chapter concludes by considering the general nature of the decision-making process.
This chapter begins by explaining the difference between generic and specific risk. It explores the nature of generic risk, concentrating particular attention on two types of generic risk, which are potentially significant for enterprise or project risk, global and industry risk. It argues that such risks are systematic enough to be considered separately. It produces comprehensive classifications of the two risk types and indicates the steps necessary in the quantification of this risk and its later incorporation into an investment appraisal.
This chapter examines the nature of country risk as a type of systematic risk which, like industry risk, extends beyond a single enterprise, in this case to the enterprises which operate within the jurisdiction of a particular country. National frontiers are among the most clearly demarcated boundaries which exist in the economic and political world. No part of the world is outside a national jurisdiction. It is obvious who holds sovereignty and is responsible for the law and policies which operate in a particular country. Risk arises from unanticipated change in such policies. The aim of this chapter is to establish a template for a measure of generic country risk.
The final chapter in this section returns to the enterprise level and to the components/sub-components of enterprise risk, and through enterprise risk to project risk. The focus of any decision maker is the total risk which confronts the enterprise and which is relevant to the investment decision under analysis. Any enterprise in making an investment decision is faced by two different kinds of risk, the element of generic or systematic risk filtered from higher levels, considered in the previous two chapters, and the element of risk specific to the enterprise. Whatever the exact source the broader types of risk impinge on the enterprise or project in highly specific ways.
The aim of the chapter is to show how an investment project can be appraised, taking into account all the complexities of decision making. Most of the book has been devoted to placing the investment decision in its appropriate contexts, and in delineating how to identify and conceptualise the various risk environments which confront decision makers. This chapter starts by considering the two stages required in incorporating risk into the valuation of an investment project, quantification of country risk and valuation of an investment project. It brings together the different approaches — financial, strategic and organisational, and the different risk environments, culminating in the statement of an expanded net present value formula and how to determine the inputs into such a formula.
As a preliminary to the macro analysis of the relationship between FDI and risk there is a review of how decision makers respond to risk and how this affects FDI flows. This is followed by an analysis of attempts by rating agencies to measure country risk in order to discover a usable index. There are two other major themes to this chapter. The first is a profile of changing aggregate FDI stocks and flows. The chapter looks at the dramatic way in which FDI has grown over the recent past and its potential for further growth. It considers the way in which FDI fluctuates, whether there are regular cycles and of what length, and how far obvious shocks disturb such regular fluctuations. Finally, it analyses the geographical pattern of flows.
A theory is needed which justifies a clear decision rule for international investments and validates the method of measuring the variables which are inputs into a relevant valuation. There is also a need for a simple, transparent and easily comprehensible formula for making the necessary investment decisions. Neither exists: the more elegant the theory, the more unrealistic it is and the less easy it is to use; the simpler the formula and the easier it is to use, the less justified is its use by theory. There are major weaknesses with both the CAPM and real options models and serious problems with a naïve use of the present value formula. Inevitably, the prescription in this book is therefore a compromise. There is a decision rule but it is not as simple as might be hoped, which inevitably means that enterprises will continue to use as a back-up the target payback period method.
