Evaluating Markets to Invest Abroad

ASSIGNMENT:

After analyzing the following case, elaborate an answer for this question.

1. Identify the key criteria and considerations that need to be taken into account in evaluating BFSI entry in the proposed foreign markets.

Exhibit knowledge of the major cultural, economic, social and legal environments faced by organizations.

BERTOS MANUFACTURING CORPORATION

Evaluating Markets to Invest Abroad

E. N. Roussakis and AnastasiosMoysidis

Abstract: This case deals with the key considerations when planning an international expansion through direct investment in foreign markets.These considerations must be addressed by a finance company seeking to establish foreign subsidiaries to support the international sales of its parent firm, a U.S.-based multinational enterprise (MNE). The company already operates three foreign subsidiaries–in Canada, Mexico (both NAFTA members), and the United Kingdom–but wishes to increase this network further through entry into additional markets. Ten candidate countries are being considered to determine the five most suitable for entry. Hence the need for a rational decision of where to invest.

Keywords: Subsidiaries; multinational enterprise; transnational activities; foreign direct investment; greenfield investment; leveraged institution; wholesale financing; captive finance company; retail installment contract

1 Introduction

Victoria Pernarella is a recent university graduate in business administration and a new hireinBertos Financial Services, Inc., a major finance company in Nashville, Tennessee. After a month long rotational training to gain insights into the company?s scope of activities, she was placed in the international department where she has been assigned to work on a project. Bill Pappas, her manager, had asked her to analyze a select number of foreign countries to determine the best prospects for the local establishment of subsidiary finance companies. He went on to clarify that the mode of entry into the foreign markets-acquisition of an existing company or a greenfield investment (from the ground up, that is, from a green field)–was not a primary consideration at this stage. The candidate countries were Argentina, Australia, Brazil, China, France, Netherlands, Russia, Switzerland, Turkey, and Venezuela. With finance companies highly leveraged institutions, the firm was prepared to provide the initial amount of equity capital needed for the establishment of five such institutions. At this stage therefore, the study ought to limit its recommendation to a corresponding number of foreign countries.

With this information at hand, Victoria started reflecting on the approach to use for her analysis. Sensing the need to prove her capabilities by delivering a high quality study for her first company assignment, she thought appropriate to first familiarize herself with the pertinent literature on the international expansion of multinational enterprises (MNE) in general and banks in particular, and then review background information on her employer, and the scope of activities of its financial subsidiary. Hence the sequence of the following sections which address the internationalization process (literature review on the development of MNEs), the modes of bank entry into foreign markets, background of parent company, financial subsidiary and scope of activities, and developing criteria for country recommendation.

2 Internationalization Process–A Theoretical Perspective

Recent decades have witnessed the internationalization of operations of many companies around the world, and especially U.S. corporations. Although the extent, form and pattern of their transnational activities vary according to the characteristics of the firms, the products they produce, and the markets in which they operate, they all reflect the dynamics of a changing and increasingly competitive international environment. Of the theories that have sought to explain the transnational activities of enterprises, the eclectic paradigm (Dunning, 1988) enjoys a dominant position. This concept provides a broad framework for the alternate channels of international economic involvement of enterprises and focuses on the parameters that influence individual MNE foreign investment decisions (Buckley and Casson, 1976; Dunning, 1977). Specifically, the eclectic paradigm identifies three important determinants in the transnational activities of firms– ownership, location and internalization (OLI). The first condition of the OLI configuration states that a firm must possess certain owner-specific competitive advantage in its home market that can be transferred abroad if the firm?s foreign direct investment (FDI) is to be successful. This advantage must be firm-specific, not easily copied, transferable, and powerful enough to compensate the firm for the potential disadvantages and risks of operating abroad. Certain ownership-specific competitive advantages enjoyed in the home market, such as financial strength and economies of scale, are not necessarily firm-specific because they can be also attained by other firms. Similarly, certain types of technology do not ensure a firmspecific advantage because they can be purchased, licensed or copied. Production and marketing of differentiated products, too, can lose their competitive edge to modified versions of such products promoted by lower pricing and aggressive marketing.

The second strand in the OLI model stands for location-specific advantages. That is, the foreign market must possess certain characteristics that will allow the firm to exploit its competitive advantages in that market. Choice of location may be a function of market imperfections or of genuine comparative advantages of particular places. Other important considerations that may influence the locational decision may include a lowcost but productive labor force, unique sources of raw materials, formation of a custom unions or regional trading bloc, defensive investments to counter a firm?s competitors, or centers of advanced technology.

The third component of the OLI paradigm is internalization and refers to the importance for a firm to safeguard its competitive position by maintaining control of its entire value chain in its industry. This can be accomplished through foreign direct investment rather than licensing or outsourcing. Transferring proprietary information across national boundaries within its own organization would enable a firm to maintain control of its firm-specific competitive advantage. Establishment of wholly-owned subsidiaries abroad reduces the financial agency costs that arise from asymmetric information, lack of trust and the need to monitor foreign partners, vendors, and financial intermediaries. Further, if the parent firm funds the operations of its foreign subsidiaries, self-financing eliminates the need to observe specific debt provisions that would result from local financing. If a multinational firm has access to lower global cost and greater availability of capital why subject its operations to local financial norms or share these important advantages with local joint venture partners, distributors, licensees, and banks that would probably have a higher cost of capital.

Of the three premises of the paradigm described above, the second strand (locational advantage) has been the subject of increased treatise. Although in theory market imperfections and comparative advantage are key considerations in determining the attractiveness of particular locations, in practice firms have been observed to follow a search pattern influenced by behavioral factors. As rational decisions require availability of information and facts, determining where to invest abroad for the first time is significantly more challenging than where to reinvest abroad. The implication is that a firm learns from its operations abroad and what it learns influences subsequent decisions. This premise lies behind two related behavioral theories of foreign direct investment decisions–the behavioral approach and international network theory. The former, exemplified by the Swedish School of economists (Johansen and Wiedersheim-Paul, 1975; Johansen and Valhne, 1977), sought to explain both the initial and later FDI decisions of a sample of Swedish MNEs based on these firms? scope of international operations over time. The study identified that these firms favored initially countries in “close psychic distance”; that is, they tended to invest first in countries that possessed a similar cultural, legal, and institutional environment to that of Sweden?s, e.g., in such countries as Denmark, Finland, Norway, Germany and the United Kingdom. As the firms gained knowledge and experience from their initial operations, they tended to accept greater risks both in terms of the countries? psychic distance and the size of their investments.

The development and growth of Swedish companies over time, contributed to a transformation in the nature of the parent/foreign-subsidiary relationship. The international network theory addresses this transformation by identifying such changes as the evolution of control from centralized to decentralized, nominal authority of the parent firm over the organizational network, foreign subsidiaries competing with each other and with the parent for resource allocations, and political coalitions with competing internal and external networks.

Some authors (Eiteman et al., 2010) view the internationalization of operations as an outgrowth of sequential stages in the development of a firm. They refer to this progression in the scope of business activity as the globalization process and identify three distinct phases. In the domestic phase, a company sells its products to local customers, and purchases its manufacturing and service inputs from local vendors. As the company grows to become a visible and viable competitor at home, imperfections in foreign national markets or comparative advantages of particular locations translate into market opportunities and provide the impetus for an expansion strategy. Entry into one or more foreign markets will make the company attain the international trade phase. At this stage the company imports its inputs from foreign suppliers and exports its products and services to foreign buyers. In this facet, the firm faces increased challenges of its financial management, over and above the traditional requirements of the domestic-only phase. Exports and imports expose the firm to foreign exchange risk as a result of currency fluctuations in global markets. Moreover, they expose the firm to credit risk management; assessing the credit quality of the foreign buyers and sellers is more formidable than in domestic business. When the firm senses the need to set up foreign sales and service affiliates, manufacture abroad or license foreign firms to produce and service its products, it progresses to the third phase, the multinational phase. Many multinational enterprises prefer to invest in wholly owned subsidiaries to maintain effective control of their competitive advantage and any new information generated through research. Ownership of assets and enterprises in foreign countries exposes the firm?s FDI to political risk-political events that can undermine the economic viability and performance of the firm in those countries. Political risk can range from seizure of property (expropriation) and ethnic strife to conflict with the objectives of the host government (governance risk) and limitations on the ability to transfer funds out of the host country (blocked funds).

Figure 1 portrays the sequential stages in a firm?s international expansion and provides an overview of the globalization process and the FDI decision. For a firm with a competitive advantage in its home market, a typical sequence in its international expansion would be the reach to one or more foreign markets by first using export agents and other intermediaries before engaging in direct dealings with foreign agents and distributors. As the firm learns more about foreign market conditions, payment conventions and financial institutions it feels more confident in establishing its own sales subsidiary, service facilities and distribution system. These moves culminate in foreign direct investments and control of assets abroad. Some of these assets may have been built from the ground up, or acquired through purchase of an existing firm or facility. As the level of physical presence in foreign markets increases so does the size of foreign direct investment.

 
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3 Modes of Bank Entry into Foreign Markets

Unlike industrial and manufacturing firms which have expanded internationally along the patterns suggested above (eclectic paradigm and globalization process), financial institutions have entered foreign markets primarily in response to the needs of their business clients. Indeed, this has been the case for commercial banks, the oldest and most dominant institution of the U.S. financial system. The growth of multinational corporations and the accelerating pace of globalization in business activity increased the demand for international financial services and induced the expansion of banks? international operations and presence abroad. Whether proactively (to enhance own growth and profitability) or defensively (to deny a competitor the benefit of the client?s business), banks have sought to enter foreign markets early and quickly to gain from the first-mover advantage. The rush of Western banks into Central and Eastern Europe in the 1990s exemplifies the drive to gain this first-mover advantage (Hughes and MacDonald, 2004).

In weighing entry into a foreign market a number of factors must be taken into account, including the bank?s resources (both financial and human), projected volume of international business, knowledge of–and experience with–foreign markets, banking structure and regulation in the countries targeted for entry, tax considerations, and customer profile. A key variable in the decision process is the vehicle to be used in the delivery of international services. Major banks around the world have used anyone or a combination of vehicles to structure their international operations. The lowest possible level of presence in a foreign market may be attained through a correspondent banking relationship–using a native institution to provide the financial services needed in that market. This approach may be duplicated in one or more countries abroad, as needed, for the processing of international transactions. It entails no investment and hence no exposure to the foreign market. Extension of services may be based on a reciprocal deposit account between the banks or an individual fee per transaction. A representative office enables a physical presence in a foreign market. However, it cannot provide traditional banking services; it can only engage in such activities as serving as a liaison and performing marketing function for the parent bank. As it does not constitute a legal entity it has no legal or tax liability. An agency may perform more functions than a representative office but cannot perform all banking functions (e.g., in the United States a foreign bank agency may extend local loans but cannot accept local deposits). The principal vehicle used by U.S. banks in the conduct of their activities internationally is the branch office. This office is a legal and operational part of the parent bank, backed the full resources of the parent in the performance of the banking functions permitted by the host country. Although it requires a sizable investment it enables the provision of full banking services which the prior vehicles do not. A branch office is subject to two sets of regulation–those of the home country and those of the host country. A subsidiary is a separate legal entity organized under the laws, and hence regulated by the authorities, of the host country. It is the second most important vehicle used by commercial banks for the conduct of banking business, and may be established as a new organization or through the purchase of an existing institution. Whatever the approach used in its establishment, a

subsidiary offers two important advantages over a branch: it may provide for a wider range of services, and it limits the liability of the parent bank to the amount of its equity investment in that entity. The main disadvantage of a subsidiary is that it must be separately capitalized from the parent bank, which may often entail a greater start up investment than a branch (Rose and Hudgins, 2010).

U.S. finance companies interested to expand their activities internationally take into account many of the same criteria used by banks. In structuring their international operations U.S. finance companies favor the subsidiary organizational form because of the advantages associated with this type of vehicle. Just as in U.S. financial markets, foreign financial subsidiaries are heavy users of debt in financing their operations. Principal sources of borrowed funds include bank credits and issues of debt (e.g., bonds) in capital markets to finance their lending activities in their respective markets (Madura, 2011; Gitman