Financing Global Firm, FDI & Political Risk Prepared By: Ajay Kant Sehgal (08EM-005) Amandeep Singh (08EM-007) KapilAgarwal (08EM-019)
Foreign Direct Investment • Foreign direct investment (FDI) in its classic form is defined as a company from one country making a physical investment into building a factory in another country. • It is said to be as a long-term investment by a foreign direct investor in an enterprise resident in an economy other than that in which the foreign direct investor is based. • The FDI relationship, consists of a parent enterprise and a foreign affiliate which together form a Multinational corporation (MNC).
Qualify for FDI • In order to qualify as FDI the investment must afford the parent enterprise control over its foreign affiliate. • The IMF defines control in this case as owning 10% or more of the ordinary shares or voting power of an incorporated firm or its equivalent for an unincorporated firm.
Types of FDI • Greenfield Investment • It is the direct investment in new facilities or the expansion of existing facilities. It is the principal mode of investing in developing countries. • Mergers and Acquisitions • It occurs when a transfer of existing assets from local firms takes place.
Advantages of FDI • Increase in Domestic Employment which decreases unemployment. • Investment in Needed Infrastructure. • Positive Influence on the Balance of Payments. • New Technology and “Know How” Transfer. • Increased Capital Investment. • Targeted Regional and Sectoral Development.
Disadvantages of FDI • Industrial Sector Dominance in the Domestic Market. • Technological Dependence on Foreign Technology Sources. • Disturbance of Domestic Economic Plans in Favor of FDI-Directed Activities. • “Cultural Change” Created by “Ethnocentric Staffing” The Infusion of Foreign Culture , and Foreign Business Practices
Motives of the Investing Firm • Resource Seeking : Investments which seek to acquire factors of production that are more efficient than those obtainable in the home economy of the firm. • In some cases, these resources may not be available in the home economy at all (e.g. cheap labour and natural resources). • This typifies FDI into developing countries, for example seeking natural resources in the Middle East and Africa, or cheap labour in Southeast Asia and Eastern Europe.
Contd… • Market Seeking : Investments which aim at either penetrating new markets or maintaining existing ones. • Efficiency Seeking : Investments which firms hope will increase their efficiency by exploiting the benefits of economies of scale and scope, and also those of common ownership. It is suggested that this type of FDI comes after either resource or market seeking investments have been realized, with the expectation that it further increases the profitability of the firm. Typically, this type of FDI is mostly widely practiced between developed economies; especially those within closely integrated markets (e.g. the EU).
Modes of FDI • Through financial collaborations. • Through joint ventures and technical collaborations. • Through capital markets via Euro issues. • Through private placements or preferential allotments.
Factors that attract FDI • Strong and stable government • Pro-active government policies • Natural Resource availability • Sound diversified industrial infrastructure • Comfortable power situation • Abundant skilled & qualified manpower • Harmonious industrial relations • Quality work culture • Peaceful life • Incentive packages • Cosmopolitan composition • Fluent English
Why India as an FDI Destination? • Ranked 3rd in global foreign direct investments in 2009 by UNCTAD • One of the fastest growing economies • Large English speaking population • Cost-effective and highly skilled labor • Stable democratic environment over 60 years of independence • Large and growing market • World class scientific, technical and managerial manpower • Abundance of natural resources • Well-established legal system with independent judiciary. • Developed banking system and vibrant capital market
FDI prohibited In India, FDI is prohibited in a company or a partnership firm or a proprietary concern or any entity, whether incorporated or not (such as, Trusts) which is engaged or proposes to engage in the following activities: • Business of chit fund • Nidhi company - A non-banking finance company doing the business of lending and borrowing with its members or shareholders. • Agriculture and Plantations • Manufacturing of Cigars, and cigarettes, of tobacco or tobacco substitutes • Real estate business, or construction of farm houses • Trading in Transferable Development Rights (TDRs) • Retail Trading (except single brand product retailing) • Atomic Energy • Lottery Business including Government / private lottery , online lotteries, etc. • Gambling and Betting including casinos, etc.
Major Bodies Constituted for FDI • Foreign Investment Promotion Board (FIPB), 1991 • Foreign Investment Promotion Council (FIPC), 1996 • Foreign Investment Implementation Authority (FIIA), 1999 • Investment Commission, 2004 • Secretariat for Industrial Assistance (SIA)
Reporting of FDI Reporting of inflow: • An Indian company receiving investment from outside India for issuing shares / convertible debentures / preference shares under the FDI Scheme, should report the details of the inflow to the Reserve Bank not later than 30 days from the date of receipt. Details to be reported are: • Name and address of the foreign investor/s, • Date of receipt of funds in foreign currency and its rupee equivalent, • Name and address of the Authorised Dealer through whom the funds have been received, and • Details of Government approval for the investment, if any.
Entry Routes for Investment in India Foreign Direct Investment is freely permitted in almost all sectors. Under the Foreign Direct Investments (FDI) Scheme, investments can be made by non-residents in the shares/convertible debentures/preference shares of an Indian company, through two routes – • Automatic Route, • Government Route. Under the Automatic Route, the foreign investor or the Indian company does not require any approval from the Reserve Bank or Government of India for the investment. Under the Government Route, prior approval of the Government of India, Ministry of Finance, Foreign Investment Promotion Board (FIPB) is required.
If the investor has existing venture or tie-up in India as on January 12, 2005, through investment / technical collaboration / trade mark agreement in the same field in which the Indian company, whose shares are being issued, is engaged, he has to obtain prior permission of Secretariat of Industrial Assistance (SIA) / Foreign Investment Promotion Board (FIPB), to acquire the shares. • No need of Prior Approval From FIPB,RBI,GOI. BUT The investors are only required to notify the Regional Office concerned of the Reserve Bank of India within 30 days of receipt of inward remittances. AND File the required documents along with form FC-GPR with that Office within 30 days of issue of shares to the non-resident investors.
This restriction is, however, not applicable to: • The issue of shares for investments to be made by Venture Capital Funds registered with the Securities and Exchange Board of India (SEBI); • Investments by multinational financial institutions; • Where in the existing joint venture, investment by either of the parties is less than 3 per cent; • Where the existing joint venture / collaboration is defunct or sick • For issue of shares of an Indian company engaged in Information Technology sector or in the mining sector, if the existing joint venture or technology transfer / trade mark agreement of the person to whom the shares are to be issued are also in the Information Technology sector or in the mining sector for same area / mineral.
Policy on FDI FDI up to 100% is allowed under the automatic route in all activities/sectors except the following which require approval of the Government : • Activities/items that require an Industrial License • Proposals in which the foreign collaborator has an existing venture/tie up in India in the same field • Proposals for acquisition of shares in an existing Indian company in the : • Financial services sector and • Where SEBI (Substantial Acquisition of Shares and Takeovers)Regulations, 1997 is attracted; and • All proposals falling outside notified sectoral policy/caps or under sectors in which FDI is not permitted
Proposals Requiring Govt. Approval • Application for proposals requiring prior Government’s approval should be submitted to FIPB in FC-IL form. Plain paper applications carrying all relevant details are also accepted. No fee is payable. The following information should form part of the proposals submitted to FIPB: - • Whether the applicant has had or has any previous/existing financial/technical collaboration or trade mark agreement in India in the same or allied field for which approval has been sought; and • If so, details thereof and the justification for proposing the new venture/technical collaboration (including trade marks). • Applications can also be submitted with Indian Missions abroad who will forward them to the Department of Economic Affairs for further processing. • Foreign investment proposals received in the DEA are placed before the Foreign Investment Promotion Board (FIPB) within 15 days of receipt. The decision of the Government in all cases is usually conveyed by the DEA within 30 days.
Sectoral Investment FDI in India – FDI up to 26% • Broadcasting – FM radio, TV channel • Print Media • Defence Industries • Insurance • Petroleum and Natural Gas Sector
Contd… FDI in India – FDI upto 49% • Broadcasting – Hardware facilities, Cable Network, DTH • Domestic Airlines and Air Transport Services • Telecommunication Services – basic & cellular (over 49 and up to 79% require FIBP approval) • Infrastructure • Asset reconstruction
Contd… FDI in India – FDI up to 74% • Development of existing airports • ISPs • Establishment and operation of satellites • Atomic Minerals • Private Sector banks • Single Brand retailing
Contd… FDI in India – FDI upto 100% • Greenfield Airports • Mining of coal and lignite • Petroleum Sector – Market Study and formulation • Courier services • Tea Sector • Non banking finance corporations • Domestic Airlines • Power Trading • Cigarettes • Alcohol
Special Investment Avenues • Electronic hardware and software technology parks – 100% investment, No Custom/Excise Duty • Export Oriented Units (EOUs)– 100% foreign equity • Special Economic Zone (SEZ) – No cap on foreign investment
Latest • India being ranked: • 3rd by UNCTAD for FDI • 2nd by Japan Bank as a promising country • 4th by Ernst and Young's 2010 European Attractiveness Survey • Canadian companies showing interest in India has gone up to 13.4 per cent in 2010. • FDI’s planned by Asianet, Star India & AIP Power
Political Risk Political risks are risks associated with the activities of the firm with respect to the political environment within which it operates. Political risk is not unique to international firms (Multinational Entities – MNE). Domestic companies are also subject to domestic and global political risk. In our context we deal with political risks faced by MNEs. An MNE or its subsidiaries may face risks that are at the micro level. In other words specific to the operations of that firm and a consequence of the specific relationship between the firm and the geopolitical domain in which it operates. An MNE also faces risks that would be faced by all MNEs operating in the same political domain. Such risks are specific to the country and not the specific firm. An MNE may also face risks that are faced by all companies, that is risks that are at the global level.
Political Risk • Firm specific risk Given a specific country, MNEs operating there face some similar and some dissimilar risks from the host country and its government. For instance a cooling of relationships between Saudi Arabia and the US is likely to impact the operations of McDonalds less than that of Boeing or Lockheed-Martin. As these risks are specific to the firm, it is the responsibility of the firm itself to study and predict the impact of such threats. Consulting firms exist that can provide such assessment services. Governance, that is, who has the true control of the firm, is the core issue here.
Political Risk • Firm specific risk Conflict often arises when objectives of two entities collide. Governments are normally responsive to a constituency of their own citizens or in some cases their controlling elite, often both. MNEs are normally interested in maximizing return to their shareholders. This often means maximizing the opportunity cost of their investment. Issues such as: • Perceived infringement on national sovereignty • Perceived infringement on corporate control • Foreign control of key industries • Sharing or non-sharing of control with local interests • Impact on host country’s balance of payment • Use of domestic v. foreign workers • Exploitation of natural resources
Political Risk • Firm specific risk One very important step in reducing and managing firm-specific risk is to establish an Investment Agreement (IA) between the host government and the MNE intending to invest in a given country. An IA spells out specific rights and responsibilities of both the foreign firm and the host government. Governments seek foreign investment but the presence of such investment has strings attached which may not be welcome. An IA defines policies on financial and managerial issues between the two parties and as such “clears the air”.
Political Risk • Investment Agreements An investment agreement may cover issues such as: • Basis for flow of funds, such as remittance of dividends, royalties, patent fees, management fees, and particularly loan repayments • The basis for setting transfer prices • Obligations and agreements to build, or fund social and economic overhead projects such as schools, hospitals and retirement systems • The right to export to third party countries • Methods and extent of taxation and the means and frequency by which they are revised
Political Risk • Investment Agreements • Price setting and control on goods sold in the host country • Requirements for local sourcing vs. importing including that of human resources • Access to host country capital markets, particularly long- term borrowing • Permission and extent of foreign ownership vs. extent of local ownership (joint venture) • Provisions on dispute arbitration • Provisions for planned divestment and end-game issues
Political Risk • Investment Insurance and Guarantees In order to promote commerce and global reach, many governments have programs or bodies that insure or guarantee many country and firm specific risks of MNEs of their nation. Their support usually covers the following three types of political risk: • Inconvertibility • Expropriation • Loss due to war, revolution, insurrection and civil strife
Expropriation Risk Expropriation The seizure of businesses by a host country with little, if any, compensation to the owners Indigenization laws Laws that require nationals to hold a majority interest in an operation
Political Risk • Operating Strategies Of course, it is ultimately incumbent upon the firm to safeguard itself from firm specific political risk. Some issue to consider may include: • Local sourcing • Facility location • Control of transportation • Control of technology • Control of markets • Brand name and trademark control • Thin equity base • Multiple-source borrowing
Political Risk • Country specific risk An MNE also faces risks that would be faced by all MNEs operating in the same political domain. Such risks are specific to the country and not the specific firm. The main country specific political risks are - transfer risk, and - cultural risks
Political Risk • Transfer risk Transfer risk is the risk that the MNE operating in a country is limited in moving funds freely into and out of the country. Funds that are so restricted are called blocked funds. The motivation for blocking funds is shortage of foreign currency in the host country. Restrictions range from having to inform a government of all FX transactions to a total ban on any FX out transfers. Prior to making an investment, a firm – or individual – must analyze the effect of blocked funds on expected return and opportunity costs. During operations a firm must attempt to move funds through a variety of repositioning techniques Funds that cannot be moved must be reinvested in a manner that avoids deterioration of their real value.
Political Risk • Strategies to manage transfer risk • Provide alternative conduits for repatriating funds( Dividends, Royality, Redemptions of Shares etc..) • Using fronting loans (parent company deposits fund with an international bank and that bank lends to the firm. In case of hostility between the parent country and the local country, the local govt. may still allow funds to be repaid to the international bank). • Creating unrelated exports (some new exports can be created to move the profits out) • Obtaining special dispensation ( Bargain to get at least some part of the blocked funds out). • Lead and lag payments
Country Risk • Cultural risk People of different countries may have different business processes and cultural norms. Amongst these are: • Differences in allowable ownership structure • Differences in human resources norms • Religious differences and religiously underpinned business practices • Nepotism and corruption • Protection of intellectual property rights • Protectionism • Racial discrimination or discrimination based on firm or individual’s national origin, race or religion
Predicting Country-Specific Risk In order to assess country specific risks, one needs to assess political & economic stability of a country in terms of; 1)Evidence of turmoil or dissatisfaction 2) Indicators of economic stability 3) Trends in cultural and religious activities Data can be assembled by; a) monitoring the local media (local newspapers, radio & TV broadcasts. b) publications of diplomatic sources c) Tapping knowledge of outstanding expert consultants d) Contact other businesses who have had recent experience in the host country e) Conduct on site visits f) Examine reports of the ratings agencies
Country Risk The Corruption Perception Index by Transparency International Some selected rankings: • Denmark, Finland, New Zealand 9.4 • Sweden, Singapore 9.3 • Iceland 9.2 • Netherlands, Switzerland 9.0 • Canada, Norway 8.7 • 12. UK 8.4 • 16. Germany 7.8 • 17. Japan, Ireland 7.5 • 20. USA 7.2 • 25. Spain 6.7 • 34. UAE 5.7 • 41. Czech Republic, Italy 5.2
Country Risk The Corruption Perception Index by Transparency International • 46. Bahrain 5.0 • 56. Greece 4.6 • 61. Cuba, Poland, Tunisia 4.2 • Bulgaria, Croatia, Turkey 4.1 • Brazil, China, India, Mexico, Morocco, Peru 3.5 • 79. Georgia, Granada, Saudi Arabia 3.4 • Thailand 3.3 • 105. Argentina 2.9 • 143. Russia 2.3 • 162. Venezuela 2.0 • 172. Afghanistan 1.9 • 178. Iraq 1.5 • 179. Somalia 1.4
Political Risk • Global risk Then there are risks that all businesses share in that they are at the global scale. MNEs probably will suffer more from these types of events than a small local organization. Some of these risks include: • War • Terrorism • Anti-globalization attitudes • Environmental issues • Information systems and “cyber” attacks • Corporate social responsibility
Political Risk • Corporate Governance and Social Responsibility The Principal – Agent Problem: Interests of managers vs. those of the owners/shareholders vs. those of other stakeholders Remedies and mechanisms available to moderate the Principle – Agent dilemma: • Board of Directors - Who does the board protect? The US vs. German models • Transparency – accounting, contractual and HR • Compensation models • Ownership concentration • Stock listing mix
Political Risk • Corporate Governance and Social Responsibility Corporate Governance Reform: USA – The 2002 Sarbanes –Oxley Act UK – The 1992 Cadbury Code (not legislated but widely adopted) France – New Economic Regulations (“NRE”) law in May 2001, based on the Viénot Reports of 1995 and 1999 and the Marini report of 1996 Italy – The 2003 Corporate Governance Reform Act based on the Draghi reforms of 1998 Germany- The 1998 Control and Transparency Act Japan - The 2002 Commercial Code Reform Act
Political Risk • Corporate Governance and Social Responsibility Corporate governance reforms usually concentrate on the following issues: • Board composition and responsibilities • Executive responsibilities and compensation • Accounting and transparency in accounting reporting • Legal transparency • Human relations and particularly human resource transparency and protection (whistle blower protection) • Internal controls and audits • External controls and audit
Assessing Political Risk Conglomerate Vertical Horizontal Transfer Operational Ownership control Special Investments General Investments Political Risks Adapted from Figure 10–2: A Three-Dimensional Framework for Assessing Political Risk