The Impact of Political Risk on Foreign Direct Investment Decisions by Multinational Corporations
Chapter 1: Introduction
The purpose of this research is to investigate the impact of political risk on foreign direct investment decisions (FDI) by multinational corporations (MNCs). This introductory chapter provides an overview of the investigations research background, its aims and objectives, the research questions, methodology, the significance of the study. And provides a short account of the remaining chapters in this dissertation.
- Background to the Research
FDI has been a subject of interest for economic theorists and policy makers for decades. In the years after the Second World War, global FDI was dominated by the USA – who had a uniquely powerful position. While much of the world had experienced extensive destruction and loss of life, no battles had been fought on US soil (Jones, 2005). As such, the USA accounted for around three-quarters of new FDI between 1945 and 1960. Since then, FDI has spread to become a global phenomenon. One that is no longer the exclusive reserve of the Organisation for Economic Co-operation and Development (OECD) countries. In present day, emerging economies such Brazil, China, India and Russia have become crucial players in the field (Wolf, 2018). The United Nations Conference on Trade (UNCTAD) acknowledged that cross-border investments by MNCs around the world have still not returned to their pre-crisis peak, ten years after the 2008 global financial crisis (Donnan, 2017). Despite this, FDI has grown significantly in the global economy with stocks of FDI representing about one third of the world’s economic output (Eurostat, 2018).
FDI is considered an integral part of an open and effective international economic system and a major catalyst to development (OECD, 2002). Most countries have undergone liberalisation in their policies regarding inward investment; easing restrictions and offering tax incentives and subsidies to attract foreign capital (Aitken and Harrison, 1999). Barrell and Holland (2002) acknowledge that FDI’s importance lies in its critical difference from other forms of capital investment: firstly, FDI flows are not as volatile as other types of capital flows and secondly, the duration of the commitment it involves.
The significant increase in FDI as well as the notable growth of MNCs activities across countries has been recognised as one of the most visible signs of increasing globalisation (Hirst et al., 2015). Recent data highlights that most international investments have rotated away from emerging economies such as China and back into older, wealthier developed countries and regions in Europe and to the US (Financial Times, 2017).
In the light of globalisation and domestic market saturation MNCs face an increasingly competitive landscape, seeking to expand their operations and increase their investment opportunities outside home country. While foreign investment opportunities can be extremely rewarding, entering new markets and unfamiliar business environments can expose MNCs to new uncertainties. One of the key uncertainties of the current decade is political stability within countries, as well as between countries. While political instability within a country is commonly associated with fragile states such as Russia and Syria, it is a multidimensional construct that can also be applied to developed countries as well. Given the importance of political instability, it is somehow surprising that the impact of political risk in a host country on FDI remain unclear. Whilst survey evidence highlights that MNCs and investors do consider political instability as a major risk in the context of FDI, empirical studies often provide conflicting results. Therefore, it is one of the main objectives of this dissertation is to try and solve this intellectual puzzle in economic and political science literature by investigating the impact of political risk on FDI decisions by MNCs.
1.2: Research Aims and Objectives
The overall aim of this dissertation is twofold: firstly, to investigate impact of political risk on FDI decisions by MNCs and secondly, to identify which determinants are most successful in attracting inflows of FDI into a country and thereby contribute to existing research.
The research objectives are as follows:
- To determine the key determinants of FDI.
- To analyse the data through comparison with research to date on the types of political risks MNCs face
- To determine how MNCs manage political risks
- To reflect the extent to which political risk impacts FDI decisions by MNCs.
- determining the
- risk factors that affect inﬂow of FDI into countries
- determining the
- risk factors that affect inﬂow of FDI into countries,
- determining the
- risk factors that affect inﬂow of FDI into countries,
1.3: Research Questions
The research seeks to answer the questions outlined below.
- What are the key FDI drivers that attract MNCs into a country?
This question seeks to establish which FDI determinants are significant for attracting MNCs into a country. Answering this question will assist in achieving the overall aim and specifically objective 2.
- What are key political risks that MNC’s consider before investing in a country/region?
This question seeks to establish the key political risk factors MNCs consider before deciding to invest in a country.
- How important is political risk in explaining FDI decisions?
This question seeks to determine if there is a positive correlation between political risk and FDI decisions. Answering this question will assist in achieving objective 4.
- How do MNCs manage political risk?
This question attempts to establish how MNCs insulate themselves from political risks, if at all.
1.4: Research Methodology
This dissertation looks at the impact of political risk on FDI decisions by MNCs by conducting documentary research. The documentary research method is used in investigating and categorising physical sources, most commonly written documents, whether in the private or public domain (Payne and Payne 2004). The documents that will be used in this dissertation include: Government publications, surveys and interviews.
1.5: Significance of the Research
In today’s increasingly globalised world, FDI is a centre for discussion. Numerous studies have been undertaken regarding FDI, its determinants and beneﬁts, but very few works provide importance to the impact of political risk on the inﬂow of FDI. Previous literature on this subject matter have introduced institutional or governance issues in determining FDI inﬂow, but comprehensive frameworks in this respect is limited. Therefore, this dissertation intends to contribute to existing research by highlighting the impact of political risk on FDI.
1.6: Dissertation Structure
The rest of this dissertation consists of six chapters. This section summarises the content of each chapter.
Chapter one of this dissertation provides background information in relation to the impact of political risk on FDI decisions by MNCs. The chapter highlights the motivation for the study and provides the rationale behind the study. The research aim is clearly stated, and specific objectives outlined. Furthermore, the chapter provides the reader with an overview of the research plan and structure.
Chapter two critically reviews relevant literature regarding the macroeconomic determinants of FDI and political risk. Exploring different studies and theoretical constructs pertinent to the research topic is crucial in shaping and validating this study.
Chapter three describes and evaluates in detail the research methods employed in the dissertation and their justification of the issues highlighted in the literature review. It also provides the description of data collection techniques, framework for data analysis and discusses the limitations of the research.
Chapter four is divided into two parts. The first presents the findings from the data. The second provides a thorough analysis and interpretation of the findings, establishing if there are any important links between the findings and literature review.
Chapter five concludes by summarising the main findings from the research and reflects on the extent to which the objectives of the study were achieved. Based on the findings and analysis thereof, report whether the research question was supported or not.
Chapter six contains an analysis and evaluation of the research process, focusing on the assessment of the strengths and weaknesses of the researcher’s learning while undertaking this dissertation.
Overall, the chapter has addressed the research background, aims and objectives, research questions, methodology and pointed out the outline for the rest of the dissertation. The next chapter presents the literature review.
Chapter 2: Literature Review
This chapter provides a review of the recent contribution of literature on FDI and the determinants of such investment. In attempting to comprehend the complex factors that impact the attractiveness of particular geographic locations, it is essential that a thorough analysis of current literature is undertaken.
With the growth of FDI in recent years, there has been a growing body of research on the topic as economists, academics and policy-makers alike have sought to determine the macroeconomic factors that influence FDI. Studies on FDI flows by Asiedu (2006) and Jadhav (2012) have looked at various determinants of FDI to countries, including the relevance of trade openness, market size, labour productivity and political stability and have provided the grounding for this literature review.
2.2 Trade Openness
Reviewing the existing literature on trade openness highlights that there is not a clear definition of trade openness or trade liberalisation. For some authors, trade openness implicitly refers to trade policy orientation. For others, trade openness is a far more complex notion that covers the policy orientation of countries, in addition to other domestic policies (such as macroeconomic policies or institutional ones (Huchet-Bourdon et al., 2013). The following literature more or less relate to the two alternative definitions of trade openness mentioned above.
FDI is essential in the development of economies due to its ability to transfer technology, managerial skills and improve the overall productivity of the host nation (Ho and Rashid, 2011). As a result, many countries have adopted liberal and economic policies to attract more FDI. Several studies have investigated the link between trade openness or trade liberalisation but have drawn mixed results. Wheeler and Mody (1992) found that in the case of US firms the degree of openness of the economy had a negative impact on FDI inflows. Research in China by Li and Clarke-Hill (2004) found that more open policies on FDI had little impact on attractiveness. However, other recent studies seem to confirm a positive a relationship between trade liberalisation and FDI inflows. Hufbauer et al. (1994) showed that trade openness of the host countries pays a significant and consistent role in the investment decisions of the US and Japan. Sekkat et al. (2007) found that increased openness as well as the improvements of other aspects of the investment climate (such as the political and economic environment) is a key factor for the attractiveness of FDI. Buthe and Milner (2008) state that in order for countries to attract FDI the regulatory and government policies should be open and flexible, yet robust, in order to strike a balance between the two.
Moran (1998) suggests that a more liberal environment tends to attract more ‘dynamic’ FDI from MNCs looking to establish export-oriented operations. Azzimonti and Sarte (2007) found that a host country government that enforces strict trade laws and policies can be a hindrance to the MNC investing in that country. According to Blomstrom (2003) investment incentives can be identified as a significant determinant in attracting FDI into a country. In support of these findings, Branstetter et al., (2002) discovered that China has a high influx of FDI in selected regions as they have policies to form special economic zone that allow for investment incentives; in the form of the preferential tax and administrative treatments of MNCs located there. However, Li (2006) adds that FDI incentives encourage ‘rent seeking’ behaviours in host countries whereby governments directly pick winners and losers in the market, discriminate against small and local firms. And these ‘incentives help MNCs strengthen their completeness and their ability to monopolise the market’. Thus, Li (2006) recommends the following to attract more FDI: ‘The more cost-effective strategy to attract foreign capital is by building and strengthening the governance institutions in a country’ and by improving the ‘investment environment’.
2.3: Market Size
Market size is an important economic determinant of FDI inflows and it corresponds to the needs of firms, especially MNCs to grow and/or to stay competitive by gaining access to new markets at home and abroad and/or increasing existing market shares. Several studies have identified the domestic market size and more importantly access to larger regional market as location-specific determinants of FDI (Wheeler and Mody, 1992; Lim, 2001). Khan (2012) cite that there ought to be a significantly large market size in a country for the MNCs to reap the benefits of investing in that country, a potentially large number of users/buyers of products, commodities or services are important. In support of Khan (2012), Monterro (2008) notes that the markets size of the host country receives a great deal of attention from MNCs, especially markets which have a potential to grow. Monterrro (2008) cites that Market size is generally measured by GDP, per capita income or size of the middle class. Market size is important for FDI as it provides potential for local sales, greater proﬁtability of local sales to export sales and relatively diverse resources, which make local sourcing more feasible. Thus, a large market size provides more opportunities for sales and also proﬁts to foreign ﬁrms, and therefore attracts FDI. Further, Love and Lage-Hidalgo (2000) cite that market size positively affected investment flows from US to Mexico between 1967 and 1994. Lipsey (1999) concludes that market size is an important determinant of FDI flows to Asia for the case of those affiliates that sell mostly in the international market. This could offer an explanation as to how China, with a significantly large market size has managed to attract large inflows of FDI since the early 1980s (Lipsey, 1999).
Further reviews of literature have show that the growth of the domestic economy and host country’s market size increases inward FDI. Mody et al. (1998) found that Japanese investors in Asia considered the size of the host country’s domestic market to be an important factor in investment. Durham (2002) cites that along with market size, the prospects of growth (generally measured by growth rates) also has a positive inﬂuence on FDI inﬂows. Some evidence suggests that although the determinants for both Japanese and US MNCs are different, the market size is a shared determinant (Fountas and Aristotelous, 1995).
Siddiqi (2007) introduce another dimension in the literature by introducing the role of population size on market size and FDI inflows. Siddiqi (2007) suggests that the population of the country is a key FDI driver, because the bigger the population the bigger the market size and MNCs can take advantage of this, citing developing economies such Nigeria are potential destination for investment due their population sizes. Larger marketplace allows investors the opportunity to exploit ‘economies of scale’, thus catering for wider markets. Foreign companies are attracted to locations with rapidly expanding urban middle-class clientele, boosting high disposable incomes.
2.4: Labour Productivity
Although market size has been shown to be a very robust determinant of FDI, the quality of the human capital base is also an important asset in attracting MNCs. The OECD (2003) found that the presence of accessible human capital is an important factor when investors select an investment location. Studies by Barrell and pain (1996), UNCTAD (2008) have found that FDI increases with low-cost labour in the host country and a highly productive workforce Cheng and Kwan (2000) By contrast, Artige and Nicolini (2006) found that labour productivity was not consistent as a factor in FDI and its influence depended on the location and sector. Moreover, Groh and Wich (2009) argued that low-cost labour is not a primary motivator for investment and the combination of wage cost and productivity is more important. Sawkut et al (2007) highlight that a more educated workforce is generally more productive as it implements new technology more quickly and the level of tertiary education plays a key role in attracting high value-add MNCs (Miyamoto, 2003). Earlier empirical surveys of US MNCs in Ireland, by Gunnigle and McGuire (2001), found that labour quality and productivity was perceived favourably by executives. However, a study of US MNCs investing in Ireland and Bahrain showed that the availability of a skilled workforce was significantly more important in FDI decisions than low-cost labour (Gilmore, et al., 2003).
Azzimonti and Sarte (2007) note that lower labour costs attract FDI, this depends on the level of skills required by the MNCs and industry, however an educated labour force is critical. Drahokoupil (2008) asserts that at times having both an educated and cheap labour force is not always mutual, with higher level of skills required comes an associated cost of attaining and retaining these skills. Nonnemberg and de Mendonça (2004) cite that a country that has a high standard of education and presents a sustainable education policy that is aimed at increasing the level of education will be more attractive than a country that does not.
2.5: Political Risk
Researchers have defined political risk, in as many ways as there are authors of this topic. Therefore, it is important to elaborate on the political risk concept used. This dissertation draws from upon the definition, developed by Simon (1984), as it provides a more complete conceptualisation of the political risk facing MNCs (Oseghale, 1993). Simon (1984) defines political risk as “governmental or societal actions and policies, originating either within or outside the host country, and negatively affecting either a selected group of, or the majority of, foreign business operations and investments.”
In formulating a definition of political risk, the difference between risk and uncertainty is crucial. Risk and uncertainty are often treated as synonymous, however, there is a distinction. Firstly, the characteristics of risk are, a choice of action, a magnitude of loss, and a chance of loss. Conversely, uncertainty refers to a condition where you are not sure about the future outcomes (Gough, 1988).
2.5.1: The Relationship Between Political Risk and FDI
Swathappa (2012) suggest that macro-political risks are those risks which are country specific and affect all companies seeking opportunities to invest in the host country – examples of this macro-risks can be civil wars, protests, riots etc. Kobrin (1978) defines sovereign risk as events such as corruption, political coups, war damage etc.
According to Li (2006) the international business literature introduces an interesting intellectual puzzle regarding the impact of political risk on FDI. McKinskey (2017) note that there is a trend in executives considering political risk and instability in their investment decisions. In order to be comprehensive, the impact of political risk on FDI has been analysed from existing empirical literature.
Although there is limited literature that explicitly explores the relationship between political risk and FDI, however studies have highlighted the importance of political stability in attracting FDI into a country/region. An analysis conducted by Sekkat et al. (2007) highlights the importance of the investment environment, which not only includes traditional FDI determinants such as infrastructure endowment, but economic and political environment as well, in increasing FDI inflows. Sekkat et al. (2007) found that the improvement in the environmental and political climate can be even more important in the attraction of FDI than trade openness.
In their work, ODI (1997) and Ursprung (2002) found that FDI tends to flow into countries/regions with civil and political freedom. The authors worked with the hypothesis that ‘political repression boosts FDI’ and arrived at the conclusion that the hypothesis was not supported. On the other hand, MNCs appear to be attracted by countries/regions in which civil and political freedom is respected and upheld. Rodrik (1996) introduce another dimension in the literature by linking democracy with FDI. The study highlights democracy as a key determining factors that influences political risk and implies that countries with weaker democratic rights attract less capital from the US.
In their work, Busse and Hefeker (2005) found that some indicators for political risk and institutions closely associated with FDI, such as;
- government stability
- law and order,
- quality of the bureaucracy.
They further establish a significant link a much larger number of indicators. In addition to the three mentioned indicators, they include investment proﬁle, internal and external conﬂict, ethnic tensions and democratic accountability as important determinants of foreign investment ﬂows. The study concludes that the largest political indicators were government stability and law and order, indicating that changes in these components of political risk and institutions are highly relevant for investment decisions of multinationals.
Another paper published by Busse (2003) offered invaluable information for this dissertation, especially in the use of democracy indicators like political rights and civil liberties as linked to FDI. His findings include a clear causation for countries with improving democratic rights and liberties received more FDI per capita. The paper also shows a positive and statistically signiﬁcant relationship between democracy and FDI did not hold in the 1970s, this is when MNC’s preferred repressive regimes. The trend changed over the following years to embrace higher political rights and civil liberties of a market economy Busse (2003). Janeba (2001) uses differing government credibility as an explanation for the lack of foreign investment in many developing nations and transition economies. This study pinpoints the fact that MNC’s will invest in politically stable but high-cost locations.
In Stasavage (2002) study pertaining to political instability and private investments, he explicitly mentions that there is a negative link between macroeconomic and political uncertainty and levels of private investment. His work further reveals that when investments are irreversible, ﬁrms may delay or not pursue investment out of fear that the economic environment might change. He also reveals that political conditions affect perceived risk of opportunism for investors.
Smarzynska and Wei (2000) study the impact of corruption in a host country on foreign investors’ preference for a joint venture versus a wholly owned subsidiary and ﬁnd that as corruption leads to a less transparent bureaucratic system, foreign investors especially those with sophisticated technology, lean towards a local joint venture partner since they worry about leakage of technological know-how. They ﬁnd their results to be broadly consistent with this hypothesis. Mody et al. (2003) look at the role of information in driving FDI ﬂows, and ﬁnd that transparency can have positive impacts. Historically, an important host country determinant of FDI has been the availability of natural resources.
Schneider and Frey (1985) found that political and social unrest in the host country had a negative effect of foreign investment inflows. They report that political instability and occurrences of disorder deters risk-averse foreign investors. Singh and Jun (1995) highlight that political instability is a ‘complex phenomenon’ and the empirical evidence regarding the impact of political risk on investment is not clear due to the difficulty in gathering reliable quantitative estimates of political risk. However, for host countries with a high level of FDI (such as Ireland) the significance of political risk is found to be greater. Furthermore, Nigh (1985) found that for developed countries, the political events between the host and home countries were some significant determinants of FDI, whereas the political events within the host country itself had no impact on FDI.
Furthermore, Groh and Wich (2009) found that the political environment has less impact on FDI for more developed countries. Research by Kobrin (1979) found that institutional features such as political stability and government intervention in the economy are important determinants of foreign investment. According to Kinoshito and Campos (2002) political stability is described as a ‘necessary condition’ for a host country to attract foreign investment. Thus, political instability detracts from the local investment climate and creates an unfavourable business environment for investment (Schneider & Frey, 1985). In support of this, according to the survey of the Multilateral Investment Guarantee Agency (MIGA), foreign investors from both industrialized and developing nations chose political risks as one of the biggest challenges they face in developing and emerging markets (MIGA, 2010).
The contrast in results may reflect the difficulty in measuring perceived risk and the differing proxy indicators used to determine risk levels (Lim, 2001).
The review of relevant literature has enabled a fundamental understanding of the dynamics of political risk and its impact on FDI. This chapter has highlighted the important determinants of FDI as elucidated by the academic and empirical literature. The locational determinants of FDI are clearly driven by policy, economic and business facilitation drivers but the actual determinants depend greatly on the context and motives of the MNC. Dunning (1995) highlights that the factors of FDI are complex and there is no single explanation for all FDI determinants. Thus, the attractiveness of location is part tangible, part intangible and is strongly influenced by government within a ‘complex web of interrelated factors’. The next chapter describes and evaluates in detail the methods, techniques and procedures used in the investigation which link to the scope and aims of the dissertation.
Chapter 3: Methodology
The previous chapter provided a critical review of the literature relevant to this study. The chapter established what has been researched and published around the subject and thereby shedding light on and validating issues to be investigated in this dissertation.
This chapter describes the methodological procedures employed to answer the research question. A rationale is offered for the chosen research philosophy, approach, strategy, purpose and time-horizon. In addition, consideration of ethical issues and limitations of the research methodology are provided. Overall, the chapter facilitates replication of the research methods employed, supporting the study’s reliability (Fink, 2003).
3.2 Research Aims and Objectives
This chapter seeks to explain and justify the selection of the research methods in order to address the research questions identified in chapter one of this dissertation which are;
- What are the key FDI drivers that attract MNCs into a country?
- What are key political risks that MNC’s consider before investing in a country/region?
- How important is political risk in explaining FDI decisions?
- How do MNCs manage political risk?
3.2: Methodical Considerations
Hussey & Hussay (1997) define methodology as the overall approach of the research process starting from the theoretical underpinning to the collection and analysis of the data (Gill & Johnson 1997). Jayaratna (1998) estimates that there are over 1000 named methodologies in use around the world. Like theories, methodologies cannot be true or false, only more or less useful. The methodology in any research is supposed to specify how the research will be conducted and controlled.
The conceptual model, shown in Figure 1, demonstrates how the research question has evolved from the research literature. In order to answer the research question, a clear rational for the most appropriate methodology was sought. By considering the conceptual model, and each layer of Saunders et al.’s (2009) research ‘onion’ model, a clear framework for the most suitable research method and strategies, required to address the research question mentioned above, were found.
Saunders et al.’s (2009) research ‘onion’ model initially encouraged the researcher to determine an appropriate research philosophy. The research philosophy promotes consideration on how knowledge should be developed in order to answer the research question. Having decided on a suitable research philosophy, other methodological elements were subsequently considered.
Ellis and Levy (2009) cite that the research onion is a tool helpful for academic students to conduct the research process in a proper format by following each stages of techniques helpful in deriving results of the research process. The research onion is categorised in six divisions namely philosophies, approaches, strategies, choices, time horizons, techniques and procedures. Each layer of Saunders et al.’s (2009) research ‘onion’ are discussed in order to explain why each element was selected, and how this assisted in answering the research question.
Figure 1: Saunders et al. (2009) ‘Research Onion’
3.2.1: The External Layer
This external part of the layer is related to the philosophical view of the study. It involves three kinds of philosophy which include; ontology, epistemology and axiology. An Ontological approach was selected as the researcher focuses on identifying the real facts and figures in a detailed manner. The changes in world and actual scenario need to be shed in light under the ontology philosophy.
Hjorland (2005) suggests that there are three Ontological positions;
3.2.2: Research Philosophy
The outer layer of Saunders et al.’s (2007) research ‘onion’ refers to the research philosophy. A pragmatic approach was selected which is not committed to any one system of philosophy or reality, allowing the researcher the freedom to select procedures that best meet their needs. This approach looks at the ‘what’ and ‘how’ to research based on its intended consequences.
3.2.3: Research Approach
According to Saunders (2009), the second layer of research onion model is related to the research approach. The research approach includes the deductive and the inductive research approach (see figure 2). A deductive approach, was used for this study. In this is approach the researcher aims at finding the answer to a particular question or statement that is already available. The entire research moves into one direction so that answer to those statements or question could be found out. The statement could be in the form already accepted reality or fact (Jonas, 2007).
Figure 2: Research Approach
3.2.4: Research Strategy
The third layer is related to the selection of appropriate research style that could be helpful in identifying the data collection and data analysing sources, and most importantly how the researcher is going to use gathered data within the report (Sanders et al., 2009). There are different 7 styles available to the researcher, and these include; experiment, survey, case study, action research, grounded theory, ethnography and archival research.
An archival research strategy method was used to investigate the research question and aims/objectives. In this research design, the researcher collects the data from archives or existing data sets.
3.2.5: Research Choice
The fourth layer of the ‘research onion’ model is related to the nature of the study and is closely associated with the type of research (Saunders et al., 2009). It is to acknowledge that the nature of study could be categorised into three major elements. These elements are qualitative, quantitative or a combination of both. In these types of studies, the level of research is different, and approach also differs as per the nature of report (Barrett et al., 2011).
The quantitative method is related to the use of numbers, and special consideration is given to the implementation of statistical tools. On the contrary, qualitative research covers opinion, thought process and emotions. ‘Mixed-method’ research was chosen for this study as it incorporated the use of both quantitative and qualitative data collection techniques. According to Saunders et al. (2007), an advantage of using mixed-methods over mono-methods, is that triangulation can take place.
3.2.6: Time Horizon
The fifth layer has an association with the particular period that has been taken to complete the research. It includes two kinds of time horizon; one is cross-sectional, and another one is longitudinal. Cross-sectional is used for the shorter period, and longitudinal is used for the longer period (Saunders, 2007). Given the time constraints for this dissertation, a cross-sectional research design was chosen to provide a ‘snap shot’ of the impact of political risk on FDI.
3.2.7: Data Collection Data Analysis
For any research in order to reach its objective, the identification of an appropriate means of data collection is obligatory (Sarantakos, 1994). The final layer of Sunders ‘research onion’ model (2009) deals with the data collection and data analysis tools. Here, the researcher takes the decisions regarding the selection of most appropriate collection and analysis tools. This research employed documentary research as a tool for collecting data in the form of surveys and interviews.
After considering the most suitable research method and strategies using Saunder et al.’s (2009) research ‘onion’ model. The researcher decided to use documentary research as a data collection and analysis method for this investigation. The following section introduces the research method and offers a justification for its use in this dissertation.
3.3 Documentary Research
The issue of political risk as it pertains to FDI by MNCs was investigated in this dissertation using the documentary research method. Documentary research method refers to the analysis of documents that contains information about the phenomenon we wish to study (Bailey 1994). Payne and Payne (2004) describe the documentary method as the techniques used to categorise, investigate, interpret and identify the limitations of, most commonly written documents whether in the private or public domain.
Documentary methods differ from primary research data where the researcher is responsible for the entire research process from the design of the project, to collecting, analysing and discussing the research data (Stewart, 1984). Judd, Smith and Kidder (1991) distinguish three common characteristics of documentary methods such as:
- They rely entirely on the analyses of data collected for purposes other than those of studies in social relations;
- Documentary studies often call for ingenuity in translating existing records into quantifiable indices of some general concepts;
- Documentary studies are particularly susceptible to alternative interpretations for the natural events and their effects
3.3.1: Documentary Data Sources
Documentary research involves the use of texts and documents as source materials: government publications, newspapers, certificates, census publications, film and video, personal photographs, and innumerable other written, visual and pictorial sources in paper, electronic, or other `hard copy’ form (Payne and Payne, 2004). Within this study, various documentary sources were employed, these include surveys, industry reports and interviews conducted by the following consultancy firms and financial institutions summarised below.
Table 1: Documentary Sources Used In this Study
3.3.1: Validity and Criticisms of Documentary Method
Limitation are the boundaries that restrict the research scope and may cause difficulty in completing the research (Cooper and Schindler, 2002). A limitation documentary analysis is limited by the availability of material, missing or incomplete data, inaccuracies in material and inherent biases. Bailey (1982) cites ‘many documents provide an incomplete account to the researcher who has had no prior experience with or knowledge of the events’. Conversely, the collection and analysis of data can be time-consuming while at the same time unable to warrant validity and reliability (Saunders at al., 2012).
The documentary research method is sometimes marginalised or when used, it only acts as a supplement to the other general research methods. Despite these criticism, this method is just as good as and sometimes even more cost effective than the social surveys, in-depth interview or participant observation. The main advantage of conducting documentary research for this dissertation was the ability to gain access to information that would otherwise be difficult to obtain in any other way (Bailey, 1982). A further strength of using documentary source is the fact the research can obtain reliable data without being present in the field, which is is particularly useful given the time constraints for this dissertation.
3.3.2: Ethical Considerations
The data analysed in this dissertation were documentary sources freely available on the internet, books and other public domains, as such permission for further use and analysis within this dissertation is implied. It can therefore be concluded that there are no ethical implications to this research.
The selected research methods and analytical techniques employed were to address the research questions formulated in chapter one and gain their in-depth understanding. Overall, the chapter has addressed in detail the research strategy approaches employed in this study and pointed out the potential limitation and ethical issues. The next chapter presents research findings and analysis.
Chapter 4: Findings and Discussion
This chapter presents the findings according to research questions as outline in chapter one and follows the methodological approach outlined in chapter three. As previously mentioned the results were attained through documentary research therefore, sources vary from surveys, interviews to industry reports conducted by reputable consultancy firms and financial institutions.
In the Global Investment Competitiveness survey commissioned by the World Bank (2017) whereby 754 international business executives interviewed. Respondents considered political stability, a ‘business-friendly’ regulatory environment, and large domestic market size to be critically important determinants in FDI decision making. Conversely, financing availability in the domestic market and access to land/real estate were considered not important at all.
Table 2: Key FDI Determinants
Source: The World Bank (2017)
In partnership with World Association of Investment Promotion Agencies (WAIPA), CNBC Catalyst’s Foreign Direct investment (2017) report found that while many micro-economic factors come into play when MNCs are considering FDI location, macro-economic factors remain the most important determinants. Results from the report show that economic, political stability in addition to fiscal stability are the core foundations for attracting FDI. The report concludes that these determinants are more essential to MNCs than tax incentives.
David Evans, head of Data and Insight at CNBC adds;
“Investors look primarily for stability as in a stable and sound business environment”.
Table 3: Key FDI Determinants
Source: CNBC Catalyst (2017)
4.3: Research Question 2 Findings: Key Political Risk Factors
Accenture Consulting (2016) published a study on managing political risk, the results showed that micro-political risks (which are risk factors that are specific to an industry and may vary across different industries.) such as contract defaults, regulatory changes and taxation (see table 4) were the most mentioned risks by companies.
Table 4: Political Risks
Source: Accenture (2016)
Willis Towers Watson and Oxford Analytica (2017) conducted a series of twenty structured interviews with panellists representing some of the world’s leading multinational firms. When asked about the most important types of political risk facing MNC’s today, participants mentioned regulatory risks most frequently (see table 5). The study revealed that politically motivated regulatory change is having a significant impact on corporate risk exposure, with implications for tax rates, cross border trade and exchange transfer risk.
Respondents from the study had the following to say regarding political risk;
“If things get tricky in one place, you concentrate your efforts somewhere else until things settle down a bit”
“Risks can always be managed – the challenge is that the cost of managing these risks may make operations in a particular country unprofitable”
Table 5: Political Risks
Source: Willis Towers Watson and Oxford Analytica (2017)
According to BDO Global Risk Landscape survey (2017) 85% of respondents identify regulatory risk as the biggest risk their firms are to overcome. Regarding regulatory risks, Nigel Burbidge, a partner from the Risk Advisory Services at BDO commented the following;
“A lot of financial services businesses are still seeing the effects of regulators having an impact on their business”
“I suspect also there is a risk for businesses that are trading on a multinational basis”.
“The UK Bribery Act is beginning to have an impact on businesses that trade in parts of the world where it is more common to provide bribes.”
4.3.1: Changes in Perception Over time
The nature and perceptions of political risk have evolved over the past decade. Drawing on data and insight from the World Investment and political Risk reports published by MIGA-EIU and the World Bank, results highlighted that investors repeatedly rank political risk as a top concern when venturing abroad. The reports also revealed that between the years 2009 to 2013, adverse regulatory changes and breach of contract carried the biggest impact on companies engaged in FDI overseas. Although, no new reports have been issued since 2013, recent evidence from Accenture (2016), Willis Towers Watson and Oxford Analytica (2017) find regulatory changes as the most important risks causing financial losses for investors abroad.
4.4: Research Question 3 Findings: The Significance of Political Risk on FDI Decisions
According to the World Bank Investment and Political Risk Survey (2013) Most respondents singled out adverse regulatory changes and breach of contract as the risks that have caused cancellations, withdrawals of investments, or both (see table 5). Despite this, the table indicates that most respondents neither withdrew nor cancelled their investment projects.
Table 5: Responses to Political Risks
Source: The World Bank (2013)
These findings are supported by a later report conducted by the World Bank (2017) analysed below;
In the Global Investment Competitiveness survey commissioned by the World Bank (2017) more than three-quarters of investors surveyed in this report encountered some type of political in their investment projects overseas. According to the report, the majority of the 754 executives interviewed organise significant delay in their investments. The results also show that very few executives have cancelled a planned investment or withdrew an existing one due to political risk (see table 7).
Table 7: Firm Responses to Political Risk
Question 4 Findings: Managing Political Risks
According to a report published by Accenture (2015) on Managing Political Risk, most companies do not measure—or manage—political risk. It was found that organisations tend either to accept these risks, or to avoid opportunities altogether when they pose large political risks.
In support of the above findings, a study conducted by McKinsey & Company (2016) found that very few companies have taken steps to manage political risks. Only 13% of executives say their companies have taken active steps to address geopolitical instability and domestic political instability or gridlock. Additionally, less than one-third of executives said that political risk factors were extremely or very well integrated into their overall strategy (see table 8).
Table 8: Business trends that respondents’ organisations have taken active steps to address
Source: McKinsey & Company (2016)
The report by McKinsey & Company (2016) also considers the kinds of strategies companies are using to deal with political threats, considering their respective effectiveness. The method most commonly used by respondents is an ad-hoc internal analyses as events occur, which was cited by 43% of respondents – only 29% of respondents rate the method as very effective. Specialised external resources, such as think-tanks, were cited by 40% as important – while 29% said the measure was very effective (see table 9).
Table 9: Methods for Managing Political risks
Source: McKinsey & Company (2016)
Table 10 presents the top political risk mitigation strategies, according to Willis Towers Watson and Oxford Analytica (2017) survey, many of the executives interviewed adopt an intelligence and analysis technique to manage political risk.
In stressing the importance of political risk management strategies, one respondent said, “if you don’t understand home market risks, imagine what you don’t understand in developing markets on which upside potential is premised”.
The survey also found that the way in which companies manage political risk continues to be reactive rather than proactive. Many companies on the panel noted that political risk analysis is often valuable but rarely actionable in the short term.
One panellist added that “An unspoken assumption is that there is a solution to every problem if you work hard enough – this is not always the case with political risk, which often involves adjusting to new realities”.
Another panellist stressed, “so much of risk involves a combination of political, economic, social and environment issues that it can be hard to analyse them together within a process-driven approach”.
Table 10: Political Risk Management Strategies
Source: Willis Towers Watson and Oxford Analytica (2017)
According to Aon (2017) Global Risk Management report, risk experts have long recommended that companies employ the following proactive risk management methods;
- Establishing a structured enterprise-wide risk identification and assessment process
- Implementing a risk management performance system that assesses effectiveness across a combination of quantitative and qualitative measures
However, the results from survey (see table 10) reveal a discouraging trend. In 2017, only 40% of surveyed companies utilise a structured, enterprise-wide risk identification process (down from 46% in 2015).
The survey also revealed that across the Asia Pacific, Europe, Latin America, the Middle East, Africa and North America 56% of companies use senior management judgment and experience to address the problem of political risks. Interestingly, in 2017 15% of companies had no formalised process, which is up from 3% in 2015.
Table 10: Identification of Major Risks by Region
Source: Aon Global Risk Management survey (2017)
4.4.1: Political Risk Insurance
According to a report published by KPMG (2017) which is a global network of professional firms providing audit, tax and advisory services. With perceptions of political volatility increasing around the world the demand for political risk insurance (PRI) is growing rapidly as corporations are looking for protection against evolving terrorism and cyber threats. Currently the market size is estimated to be around £7.5bn.
Table 11 below presents the development of political risk insurance market for the next three years according to KPMG (2017). The results highlight the subtle increase in most segments, especially cyber security. It is interesting to note that this report support findings from the Aon Global Risk Management (2017) survey where respondents mentioned cyber risk (which is non-traditional type of political risk) as a risk that is of great concern for their organisations. According to the World Bank (2017) cyber risks can increasingly have political origins including war and terrorism.
Table 11: Expected Annual Growth Rates Across Market Segments (2015 to 2018)
Source: KPMG (2017)
4.5: Critical Discussion
This chapter provides a critical discussion of the findings presented above, when set against the existing literature as discussed in chapter two. The overall aim of this dissertation was to investigate the impact of political risk on FDI decision by MNCs. As noted in the literature review, there is limited literature that explicitly explores the relationship between political risk and FDI however studies have highlighted the importance of political stability in attracting FDI into a country/region. Sekkat et al (2007) highlights the importance of the investment environment, citing that the political climate can be more important to the attraction of FDI than trade openness. This view is shared by Kinoshito and Campos (2002) who describes political stability as a ‘necessary condition’ for a host country to attract FDI. Further to this, Monterro (2008) cite that the market size of the host country receives a great deal of attention from MNCs, especially markets which have a potential to grow. This is strongly evidenced in the findings for research question 1 which determined that political stability, in addition to the legal/regulatory environment and market size are important determinants in FDI decision making. Thus, the findings of the study clearly support the literature to a certain extent that political stability is a key FDI determinant.
Furthermore, Lim (2011) segments political risk into three categories micro-political, macro-political and sovereign. micro-political risks are those that apply to specific industries, firms or projects within the host country (Political Risk Group, 2017). Examples include political sanctions such as taxes and import restrictions. Swathappa (2012) suggest that macro-political risks are those risks which are country specific and affect all companies seeking opportunities to invest in the host country – examples of this macro-risks can be civil wars, protests, riots etc. Kobrin (1978) defines sovereign risk as events such as corruption, political coups, war damage etc. The findings from research question 2 determined that micro-political risk such as regulatory changes were the biggest concern for executives. In regard to how the perception of political risk has evolved over the years, results have highlighted that adverse regulatory changes and breach of contract still carry the biggest impact on companies engaged in FDI overseas. Further analysis of the finding revealed that macro-political risk such as wars and protests/strikes as well as sovereign risks such as terrorism are also important risks causing financial losses for investors abroad.
Additionally, Groh and Wich (2009) argued that the political environment has less impact on FDI inflows. On the other hand, research by Kobrin (1979) found that institutional features such as political stability and government intervention in the economy are important determinants of foreign investment. In response to research question 3, the findings support the view of Groh and Wich (2009). According to findings, very few executives have cancelled a planned investment or withdrew an existing one due to political risk.
Lastly, findings from insurance firm Zurich (2015) indicate that political risks are on the rise in executive minds. In agreement Feinberg & Gupta (2009) found that there has been a trend for MNCs to be engaging rather than avoiding investing in politically risky countries. Interestingly, the findings from research question 4 demonstrated that most MNCs do not measure or manage political risk. It was found that most firms either accept these risks, or to avoid opportunities altogether when they pose large political risks.
In summary of this chapter it is evident that MNCs have expressed great concern for political risk. It is also clear that despite the inherent importance of considering political risk, it ultimately has very little impact on FDI decisions by MNCs. As highlighted in the findings of research question 3, the majority of executives neither withdrew nor cancelled their investment projects as a result of political risk. Finally, this research has revealed that MNCs take a reactive rather than proactive approach to political risk. The following chapter provides final conclusions to the study and poses a series of recommendation for academics for areas of further research.
Chapter 5: Conclusion and Recommendations
The aim of this dissertation was to investigate the impact of political risk on foreign direct investment decisions by multinational corporations. The related objectives to achieve this aim were: To determine the key determinants of FDI. To analyse the data through comparison with research to date on the types of political risks MNCs face. To determine how MNCs manage political risks. The Final objective is to reflect the extent to which political risk impacts FDI decisions by MNCs.
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