How Cultural, Political/Legal and Economic Factors Affect Your Selection of Potential Market for Foreign Direct Investment
We help with your
How Cultural, Political/Legal and Economic Factors Affect Your Selection of Potential Market for Foreign Direct Investment
It is important to take note that every business and organization has it business environment. Thus, it is consists of different factors which affect and influence the entire organization and the market. There are micro-environment factors that are directly connected to the company, in physical and organizational manner – meaning these factors are connected to the behaviors and factors related to the suppliers and intermediaries as well as the employees. All of these factors are controlled and influenced by the organization itself. However, the most important factors, lie on the macro-environment, which are inevitable and cannot be controlled by the organization, and it can create great influence over the organization. There factors are located in national and global level, which are outside the organizational and physical influence of the business (Swarbrooke and Horner, 2001). As a result, these factors are being considered by different companies in all the strategies, efforts and actions that they will create in the future. This is particularly, because of the fact that currently, the world of business being affected by globalization, where in more and more companies, particularly those huge multinational companies are focusing on expanding their business in different parts of the globe via different modes of entry. Currently, there are different modes of entry use in international expansion, which include licensing, strategic alliances, acquisitions and the establishments of wholly owned subsidiaries. Among these, wholly owned subsidiaries and acquisitions are considered as foreign direct investment, which offer companies the greater presence and control over the international markets (Hitt, Ireland and Hoskisson, 2009).
This paper will tackle the impact of the different cultural, political/legal and economic factors affect the selection of potential market for foreign direct investment (FDI). Thus, it will focus on the importance of initial scan or evaluation of the environment before making decisions of international expansion.
Foreign Direct Investment
FDI is “the process whereby residents of one country (the source country) acquire ownership of assets for the purpose of controlling the production, distribution and other activities of a firm in another country (the host country)” (cited in Moosa, 2002). According to the International Monetary Fund, FDI is “an investment that is made to acquire a lasting interest in an enterprise operating in an economy other than that of the investors, the investor’s purpose being to have an effective voice in the management of the enterprise” (cited in Moosa, 2002). In connection, according to the United Nation (1999), FDI is “an investment involving a long-term relationship and reflecting a lasting interest and control of resident entity in one economy (foreign direct investor or parent enterprise) in an enterprise resident in an economy other than of the foreign direct investor (FDI enterprise, affiliate enterprise or foreign affiliate)” (cited in Moosa, 2002).
Therefore, based on these definitions, it show that FDI is considered as a means of transferring capital, technology and managerial skills from the source country to the host country, which can be trade-oriented or anti-trade-oriented. FDI is trade-oriented if it helps to create an excess demand for imports and an excess supply of exports at the original terms of trade, thus, the anti-trade-oriented is the opposite (Goldstein, 1991).
FDI is considered as one of the most important decisions to be made by any organization because it will cost these companies a lot – costs, efforts and skills, which can be wasted if not planned and implemented properly.
Literatures tackles micro- and macro-environmental factors in explaining the inward flow of FDI towards the host countries. Micro pertains on the motives of individual companies in expanding to another foreign markets via wholly owned subsidiaries and joint ventures, than using licensing or exporting. One of the example is the study of Aharoni (1966) about the FDI by US companies abroad by focusing on the attributes of the investment itself. The study was supported by the study of Caves (1974) and Grubaugh (1987). On the other hand, macro-environmental factors pertain on the different country-level variables which include the exchange and interest rates. Examples are the study of Green and Cunningham (1975), Culem (1988) and United Nations Centre on Transnational Corporations (1992) and Lipsey (1999) which analyzed, evaluated and explained why investors choose a specific country to another.
It is important to consider that both of these factors are important in studying FDI, for these two factors complement each other. The eclectic theory of Dunning (1980) and Dunning (1997) explained that the both macro- and micro-environmental factors helps companies to focus on the firm-specific advantages such as brand name, technologies, which the company may have relative to their competitors, which enables them to benefit from internalizing of the market for the said advantages in the hierarchy of the company when it expands in other countries, thus, location advantages help to attract FDI to one country to another (Thomas, 2001).
Therefore, it shows that the primary motivational factors which push and drive companies in choosing the country to invest with are factors which will offer those companies with competitive advantages, which include the costs they will have to spend during the initial or preliminary operations and performance, at the same time, focus on the different skills and knowledge that that are needed in order to come up with the different procedures and processes needed in order to establish FDI in the chosen country.
As have mentioned in the theory of eclectic theory, deciding regarding FDI focuses on the mix of ownership (O), location (L) and internalization (I) advantages and edges of the chosen country with other countries (Dunning and Narula, 1996). If it is accepted that the tendency and inclination of the firm of the country to invest in other countries, is a function of their ability to obtain and take advantage of different internally yielding assets – thus, the higher the level of this ability, the higher the possibility of successful foreign investments. With this, it is vital for any company planning to implement FDI to analyze the different attributes of different countries to invest to by focusing on the different factors such as political/legal, economic and social factors, due to the fact that different countries are unique on their own way. Thus, this uniqueness can offer both benefits and risks for the company.
Macro-Environmental Factors in FDI Decisions
The initial procedure done in internationalization or foreign expansion is analyzing and evaluating the different advantages which different countries can offer towards the firm. This is very important because it can help in order to choose the best country which can offer the best environment and market for the business. As have mentioned, different nation or state have their own competitive advantages that are based on its resources, such as physical location, population, etc., together with the different advantages related to social, political/legal and economic. Strategists have agreed that analyzing and understanding the business environment is considered as a vital element in the development of effective, efficient, timely and successful corporate strategy (Lukac, 2008).
However, in connection, it is also important to consider the fact that different countries, have its different characteristics and attributes which can offer risks or disadvantages for the company. This pertains on the impact of culture and overall characteristics of the country, which consequently, affect the different aspect of the country, such as the economic condition of the country, the different laws, regulations and policies being implemented, together with the different social movements and changes in the environment, which in the end, directly affect the behavior of the market.
The next part of the paper will explain further the importance of considering and analyzing political/legal, economic and social factors in the environment in choosing the country for FDI.
Different political and legal factors in the environment can greatly affect the different opportunities and threats to be faced by the industry and the companies operating within (Gupta, Gollakota and Srinivasan, 2005). Political/legal factors pertains on the different actions and strategies being implemented by the countries, which help to ease the entry of foreign investment in their specific countries. This include implementations of policies regarding tax incentives, worker-training support packages, good transportation facilities and telecommunication facilities. It is also important to focus on the different financial incentives to be offered towards the foreign investors, which include personal and corporate taxation (Gilmore et al.. 2003). Most importantly, it is important to include that FDI is directly affected by the tax system of both the home and host country. This is the reason why tax policies influence the incentives which is connected to foreign investments, together with how the investment is financed (Goldstein, 1991).
On the other hand, it is also important to consider that different countries or governments have their different policies and standards in handling FDI. There are some governments that are somewhat loose in handling FDI, while there are some that are strict. For example, before China opened up for foreign investments, companies who wish to enter the Chinese market, particularly the automotive industry are required to partner with a local Chinese company or manufacturer, thus, the control of technology and knowledge will be handled by the local partner.
Above all, political stability or risk is the risk that a host government will unexpectedly change the “rules of the game” within which the business operates (Butler and Joaquin, 1998). It can also be connected to the risks of unpleasant consequence from the different political events (Gilmore et al.. 2003). For example, the sudden decision of the host government to inflict restrictions on capital repatriation to the home country of the investors can largely affect the cash flows to be received by the parent company (Moosa, 2002). In addition, political instability or risks can create different problems, which include economic risks, uncertainty created by the regulations and policies of the government; at the same time, it can also create conflicting legal authorities, that may lead to corruption; it can also lead to potential nationalization of private assets (Hitt, Ireland and Hoskisson, 2009).
It will be highly risk for a company to choose a politically unstable country for FDI, because of the conflicts and chaos that it has to face with the government officials, together with the rage that it will have to face from the citizens of that country, at the same time, consider the overall impact of that choice towards the overall image of the company, worldwide.
The entire state of the economy of the country has a vital and important influence towards the structure of the industry, as well as the overall profitability of individual company (Gupta, Gollakota and Srinivasan, 2005). The economic variables pertains on the different costs which will be shouldered by the foreign investors upon entering a given market or country. For instance, the changes in the interest rate and exchange rate. Foreign operations is in demand of vital commitment in capital, particularly if they are undertaken in capital intensive sectors, where in there is high economies of scale (Kyrkilis and Pantelidis, 2003). On the other hand, according to Aliber (1970) companies from countries with the strong currencies can help to support the foreign investments in strong manner, when they operate in countries with weak currencies. The approval of the home country currency lowers the capital requirements of foreign investments in domestic currency units which help the investing abroad company to raise capital in easier manner, compare with the case of depreciated currency (Kyrkilis and Pantelidis, 2003).
The availability of important resources is also important in the process of choosing the appropriate country for FDI, particularly the issue of human resource or labor force. The availability of skilled workers, together with the cost of skilled labor is important. This is because it enables companies to gain and maintain competitive advantage by having the best labor force for different procedures in the business, which include R&D, marketing, management and different foreign operations (Kyrkilis and Pantelidis, 2003). This is one of the primary reasons why more and more companies are investing in China and India, due to the availability of high-skilled worker, at the same time, low paying labor force, which enables multinational companies to take advantage of that cost-reduction in the overall production and manufacturing.
Above all, it is important to focus on the openness of the economy or the liberalization of the foreign economic transaction of the company (Kyrkilis and Pantelidis, 2003). This is because it is helpful in entering the economy in smooth manner.
Factors related to the social aspects of the business environment are also vital in deciding or selecting the country for FDI. This is particularly because of the fact that changes in the social aspect of the business environment, can also affect the political and economic condition of the industry and the market. In addition, social or demographic factors in the business can greatly influence the internal customers or employees, the end-customers, together with the suppliers and other important entities of the business.
In particular, the social factors are important decision-making criteria in FDI, because of its direct and huge impact in the result of investment. First, the social changes in the environment can affect how the people interact, connect and behave in the specific country. Thus, the issue of cultural closeness must be considered. The study of Benito and Gripsrud (1992) showed the difficulties and hardship that companies or firms have faced due to the distance between the culture of the host company with the foreign country. This primarily focus on building relationship with the employees and the market. It is important to focus on the impact of cultural differences towards the organizational behavior, which can affect the motivations and overall performance of the employees, which consequently affect the overall operation of the company. It is also important to consider the difference between the consumers form the motherland of the company, with the foreign country, therefore, it is important to consider on the different procedures such as marketing, management, innovation, training and development, etc., in order to ensure that the overall strategies will be successful.
Political/legal, economic and social factors are important factors to be considered in selecting the right or the most advantageous country for FDI. These factors are considered as interrelated, therefore, any problems or opportunities in one aspect can result to problems or opportunities to another aspect. All countries have opportunities to be offered, however, all countries have problems and risks to be considered in order to ensure that costly FDI will be successful. Via analysis and evaluation of the different macro-environmental factors in the business environment – political, economic and social, companies will be able to decide to which country, the company will benefit more, and to which country the company’s capabilities, skills and assets will complement well. Therefore, it will be helpful in order to come up with the greater strategies on internationalization. The current macro-environmental factors affecting the country, can help multinational companies to consider those promising countries and skip those somewhat problematic and chaotic.
Aharoni, Y. (1966). The foreign investment decision process. Boston: Harvard Business School Press.
Aliber, R. Z. (1970). ‘A theory of foreign direct investment’. In C. P. Kindleberger (ed). The International Corporation. Cambridge, MA: MIT Press.
Benito, G. R. and Gripsrud, G. (1992). ‘The expansion of foreign direct investments: Discrete rational location choices or a cultural learning process?’. Journal of International Business Studies. 23(3), 461 – 476.
Butler, K. C. and Joaquin, D. C. (1998). ‘A note on political risk and the required return on foreign direct investment’. Journal of International Business Studies. 29(3), 599 – 608.
Caves, R. E. (1974). ‘Causes of direct foreign investment: Foreign firm’s shares in Canadian and UK manufacturing industries’. Rev. Econ. Stat. 53(3), 279 – 293.
Culem, C. (1988). ‘The location determinants of direct investment among industrialized countries’. Eur. Econ. Rev. 32, 885 – 904.
Dunning, J. H. (1980). ‘Toward an eclectic theory of international production: Some empirical tests’. Journal of International Business Study. 11(1), 9 – 31.
Dunning, J. H. and Narula, R. (1996). ‘The investment development path revisited: Some emerging issues’. In J. Dunning and Narula, R. (eds). Foreign Direct Investment and Government: Catalysts for Economic Restructuing. London: Routledge.
Dunning, J. H. (1997). Multinational enterprises and the global economy. Workingham, Berks, UK: Addison-Wesley.
Gilmore, A., O’Donnell, A., Carson, D. and Cummins, D. (2003). ‘Factors influencing foreign direct investment and international joint ventures: A comparative study of Northern Ireland and Bahrain’. International Marketing Review. 20(2), 195 – 215.
Goldstein, M. (1991). Determinants and systematic consequences of international capital flow: A study. International Monetary Fund.
Green, R. and Cunningham, W. (1975). ‘The determinants of US foreign investment: An empirical examination’. Manag. Int. Rev. 15, 113 – 120.
Grubaugh, S. (1987). ‘Determinants of direct foreign investment’. Rev. Econ. Stat. 69(1), 149 – 152.
Gupta, V., Gollakota, K. and Srinivasan, R. (2005). Business policy and strategic management: Concepts and applications. New Delhi: Prentice Hall of India Private Limited.
Hitt, M., Ireland, D. and Hoskisson, R. (2009). Strategic management: Competitiveness and globalization: Concepts and cases. Cengage Learning.
Kyrkilis, D. and Pantelidis, P. (2003). ‘Macroeconomic determinants of outward foreign direct investment’. International Journal of Social Economics. 30(7), 827 – 836.
Lipsey, R. (1999). ‘The location characteristics of US affiliates in Asia’. NBER Working Paper. Cambridge, MA.
Lukac, D. (2008). Key success factors for foreign direct investment (FDI): The case of FDI in western Balkan. Diplomica Verlag.
Mossa, I. (2002). Foreign direct investment: Theory, evidence and practice. Palgrave Macmillan.
Swarbrooke, J. and Horner, S. (2001). Business travel and tourism. Butterworth-Heinemann.
Thomas, D. (2001). ‘Country-of-origin determinants of foreign direct investment in an emerging market: The case of Mexico’. Journal of International Management. 7(1), 59 – 79.
United Nations Centre on Transnational Corporations (1992). The determinants of foreign direct investment. New York: United Nations.