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Opportunities and Threats When Engaging in FDI in Emerging Markets

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Published: 23rd Mar 2021 in Finance

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Discuss the opportunities and threats when engaging in FDI in emerging markets. What are the main drivers for the growth in outward FDI by Chinese multinational enterprises within the last decade and a half? Use cases from the course to illustrate your answer.

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In the last two decades there has been a significant change in the global FDI landscape (Carril-Caccia & Pavlova, 2018). While originally, developed economies where the main players in FDI, emerging markets have increasingly started to become both a source and a destination of such investments. For example, Carril-Caccia and Pavlova (2018) found that emerging countries even surpassed developed ones in attracting inward FDI flows (IFDI) in 2013, accounting for 56% of global IFDI. Emerging market countries have become important locations for the international activities of multinational enterprises (MNEs) because they present various opportunities for foreign investors.

The biggest opportunity of engaging in FDI in emerging markets is the potential for high growth and thus higher expected returns for investors (Legg Mason, 2019). Indeed, emerging markets are leading economic growth globally, with their GDP growth rates amounting to some of the highest in the world and projected to keep rising in the future. This growth can be traced back to various trends taking place in emerging markets, namely the large and growing population, favourable demographics, increasing urbanisation and technological innovation (Legg Mason, 2019). Indeed, emerging markets are home to the majority of the world population, which is characterized by an increasingly young and well-educated workforce and a rapidly growing urban middle-class (Legg Mason, 2019). Along with this labour pool advantage, emerging markets are promoting growth through advancing technology and innovation (Legg Mason, 2019). Finally, another opportunity of investing in emerging markets is that these types of investments can represent a good diversification strategy for the investment portfolio of a firm since emerging markets tend to perform differently than developed markets (Legg Mason, 2019).

These opportunities come with risks. Indeed, according to Gao, Jones, Zuzul and Khanna (2017), emerging markets are characterized by a high degree of potential transaction uncertainty due to institutional voids, which refer to the absence of developed regulatory, political, and legal infrastructures and institutions that can allow market transactions to occur easily. According to Gao et al. (2017), this potential transaction uncertainty can take the form of either counterparty behavioural uncertainty or environmental uncertainty. Counterparty behavioural uncertainty refers to the fact that the absence of information about a counterparty and of institutions that can enforce contracts leads to uncertainty on whether both parties to a transaction will act according to their agreements. An example of this is the risk related to intellectual property rights, since weak institutions can make proprietary information hard to protect (Alfarraj, 2016).  Another type of transaction uncertainty is environmental uncertainty, which refers for example to the risk of political shocks and wars (Gao, Jones, Zuzul, & Khanna, 2017). Indeed, one of the biggest threats encountered by MNEs when engaging in FDI in emerging markets is political risk due to unstable and volatile governments (Henisz & Zelner, 2010). Political risk can materialize in the government takeover of corporate assets, which occurs when an emerging market government seizes assets which are owned by a foreign firm, either through confiscation, expropriation or nationalization (Henisz & Zelner, 2010). Political instability, such as unexpected changes in government, can also be a cause of that happening. Corruption is another important political as well as business risk to take into account. Finally, firms operating in emerging markets also have to deal with weak physical infrastructures, such as poor transport systems that can prevent their products from reaching customers (Grishin & Walton, 2016).

The expansion of Sherritt into Cuba is the perfect example of opportunities and threats encountered by a firm when engaging in FDI in an emerging market.  Not only did Cuba have one of the most important nickel and cobalt mines in the world, but it boosted a highly educated labour force (Musacchio & Schlefer, 2011). However, Cuba lacked a developed legal system and regulations covering foreign investments (Musacchio & Schlefer, 2011). For this reason, the Sherritt-Cuba partnership had to be based on regulations and property rights wrote down in a couple of hundred documents just for the occasion, and since Cuban courts lacked any experience, the joint venture had to be subject to expatriate arbitration in Paris (Musacchio & Schlefer, 2011).

Amazon encountered similarly threatening obstacles in its expansion into emerging markets.In China, Brazil and India the e-commerce industry was rapidly expanding (Nguyen-Chyung & Faulk, 2014). However, the transportation infrastructure was weak, making distribution of Amazon’s products very difficult (Nguyen-Chyung & Faulk, 2014). In India, to counteract this problem, Amazon had to invest a lot of money in the development of its logistics infrastructure (Nguyen-Chyung & Faulk, 2014). Brazil was especially inflicted with this problem due to poor roadways and inefficient railways, ranking 104th out of 142 countries in terms of quality of infrastructure (Nguyen-Chyung & Faulk, 2014). Poor infrastructure, as well as political uncertainty, were also some of the reasons that slowed down Amazon’s expansion into other countries such as Russia (Nguyen-Chyung & Faulk, 2014).

The case of the international expansion of China National Petroleum Corporation in Sudan is another example of opportunities and threats in emerging markets. According to the UNDP (n.d.), Sudan has great economic potential, thanks to its strategic location and natural resources such as gold, oil and other mineral resources. As one of the largest oil producers in Africa, Sudan provides big opportunities for China, especially due to its  growing domestic demand (Afrol News, 2019, reference). However, international MNEs in Africa are challenged by a high degree of institutional, economic and political uncertainty, and  in the case of Sudan, problems created by institutional voids are made even worse by the war. One example of threat is the high risk of corruption. Indeed, Sudan’s position on the Corruption Perception Index of Transparency International is one of the lowest in the world (Transparency International, n.d.).

Thus, it is clear that institutional voids in emerging markets lead to an increase in costs for international MNEs due to higher levels of inefficiency and risks. However, it is important to note that institutional voids in emerging markets can represent valuable opportunities when MNEs are able to successfully deal with them (Gao, Jones, Zuzul, & Khanna, 2017). Indeed, the study of Chinese FDI conducted by Ramasamy, Yeung and Laforet (2012) suggests that MNEs controlled and backed financially by the state are actually attracted to countries with high levels of uncertainties, since they can afford to take more risks (Gao, Jones, Zuzul, & Khanna, 2017).

 As mentioned above, outward foreign direct investment (OFDI) by emerging markets such as China has also been prevailing in recent years (Wang & Zhao, 2017). According to Luo, Xue and Han (2010) the growth in OFDI by emerging countries was driven by “the rapid pace of economic development and liberal market policies implemented by home governments, along with offshore availability of market opportunities, entrepreneurial desire to hit key international markets, and strategic intent to exploit competitive advantages in cost-effective massive manufacturing” (Luo, Xue, & Han, 2010). China is the perfect example of how these factors came into play to lead the country into becoming one of the world’s leading foreign investors.

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Ramamurti and Hillemann (2018) argue that an important reason for the international expansion of Chinese MNEs is their desire to acquire strategic assets in developed countries, due to their lack of firm specific advantages such as proprietary technology, managerial know-how or brand recognition. This behaviour can be explained by the competence-constraint view, which argues that MNEs from emerging countries “use international expansion as a springboard to compensate for their competitive disadvantages” compared to developed country MNEs (Luo, Xue, & Han, 2010, p. 77).  In addition, Urdinez, Masiero and Ogasavara (2014) found that natural, and specifically energy resources, were one of the main drivers of Chinese OFDI in emerging markets in the period analysed. Indeed, the consumption of energy resources per capita and the level of urbanization in China has been rapidly increasing in the past two decades (Shen, 2005). To satisfy this demand, Chinese MNEs look to cooperate with local MNEs or acquire the rights to exploit their oil resources (Shen, 2005). This type of FDI is what Dunning (Dunning, 1998) calls resource-seeking. It often involves the construction of physical infrastructure and it is usually strategically incorporated with Chinese foreign aid and driven by geopolitical goals of the government (Milner & Tingley, 2013).

Moreover, the growth in OFDI is also due to increasingly supportive measures took on by governments in emerging economies in order to advance the expansion of local MNEs abroad (Luo, Xue, & Han, 2010). Indeed, governments have been creating an attractive climate for MNEs to invest abroad by offering them various institutional supports, both financial and non-financial, that reduce their political risk and transaction costs (Luo, Xue, & Han, 2010). Governments provide this support because they see OFDI as a way to get entry into new markets and to obtain capital, technology and knowledge from developed countries in order to strengthen their national competitiveness (Luo, Xue, & Han, 2010). According to Ramamurti and Hillemann (2018, p. 44), “Government-created advantage is the secret sauce that explains the rapid expansion of CMNEs”, where CMNEs stands for Chinese multinational enterprises. Without the government supporting the expansion strategy of its SO-MNEs, the country’s OFDI growth would have been much less. It is important to note that Chinese MNEs engaging in FDI are predominantly state-owned, thus allowing the government to strongly affect the internationalization strategy of firms.

One of the first impactful ways the government encouraged Chinese MNEs to engage in FDI abroad is with the “go global” strategy in 2000. The “go global” strategy pushed firms to expand abroad and cooperate with international markets through various policies and forms of support (administrative, financial and commercial) such as tax incentives, playing a big role in the growth of OFDI by Chinese firms in the last two decades (Davies, 2013).  An example that reflects the role of the Chinese government in FDI projects is the Belt and Road Initiative implemented in 2013, centred around increasing collaboration between Asian and European markets. This initiative also reflects the geopolitical objectives of the Chinese government, namely to strengthen relations with nearby countries and its role in international affairs (Chatzky & McBride, 2019).

The case of the international expansion of China National Petroleum Corporation in Sudan mentioned above also provides the perfect example of Chinese FDI driven by resource-seeking motives and by the supportive role of the government. Indeed, the Chinese government influenced CNPCs expansion into such a risky country due to its ownership and control over the firm (Fon, 2019). It was driven to do this by geopolitical and nationalist objectives, for example to gain access to energy resources for the home market, and it did this by providing CNPC with various forms of support (Fon, 2019). One such form of support was financial backing, which meant providing CNPC with high levels of capital to counteract the high transaction costs (Fon, 2019). Another way the government supported CNPC in Sudan was though various policies and by holding close political and diplomatic relations with the host government, which provided CNPC access to diplomatic networks and protection against various political risks such as the risk of expropriation (Fon, 2019).

In conclusion, foreign firms engaging in FDI in emerging markets are presented with various opportunities, such as competitive returns and diversification benefits, as well as threats due to the presence of institutional voids, such as higher costs and risks. Out of all of the reasons for the growth in OFDI by Chinese MNEs, the government role in influencing the internationalization strategy of its SO-MNEs, is the main reason for their increasingly high presence in emerging markets like Africa.

References

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