Trends of Foreign Direct Investments in Emerging Markets

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Topic: Business & Economics
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[toc title=”Contents”]

  1. Abstract
  2. Introduction
  3. Research objectives
  4. Literature Review
  5. Impact of Environmental Factors on the Trends of FDI in the Emerging Markets
  6. The relevance of the Emerging Markets to the Leading Multinational Corporations
  7. Challenges Faced by Multinational Companies in the Emerging Markets
  8. Summary
  9. References

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Abstract

Foreign direct investment has become very popular as corporate organizations try to expand their market share. It is important to understand the current trends in foreign direct investments in emerging markets. This research reveals that unlike before when the foreign direct investment was dominated by large corporations, the mid-sized companies have also become active players as the competition becomes stiff in the global market.

The research has discussed the impacts of environmental factors on the trends of foreign direct investment in emerging markets. The research looks at some of the social, economic, and political factors that may affect these trends. From this discussion, it is clear that these socio-economic and political factors have a massive impact on the trends in foreign direct investment.

The research also looks at the relevance of the emerging markets to the leading multinational corporations. It is revealed that the emerging markets offer this corporation an opportunity to expand their operation. They offer cheap labor and a ready market for the finished products.

The research then focuses on the challenges faced by multinational companies in the emerging markets. Factors such as political instability, corruption, insecurity, and poorly developed infrastructure are some of the issues that have been identified. The research used scholarly peer-reviewed articles and books.

Introduction

The emerging technologies in transport, communication, and other sectors have turned the world into a small global village where the trade goes beyond the national borders. Froot (2008) defines foreign direct investment as “An investment made by a company or entity based in one country, into a company or entity based in another country.”

Foreign direct investment in the emerging markets is taking a new approach that is slightly different from that was taken by multinational corporations in the past decades. According to Moran (2006), in the past, platform foreign direct investment was very popular. During this time, most of the multinationals that expanded their operations to the emerging markets were exporting their products as a way of expanding their market coverage.

However, a new trend in the emerging markets where firms are embracing both horizontal and vertical foreign direct investments is becoming common (Froot, 2008).

Most of the multinationals have realized that instead of making their products in the home country and exporting the finished products, it would be good to duplicate its home-country activities in the host country. This does not only help in cutting the cost of operations, but it also increases convenience in delivering products to the market at the right time and in the right state.

Starbucks, Wal-Mart, Dunkin’ Donuts, and IKEA are some of the leading firms that have embraced the horizontal foreign direct investment approach. Other firms such as Coca Cola, Pepsi, Mercedes Benz, and General Motors are using vertical foreign direct investment in various countries around the world.

As Ehrhardt and Brigham (2014) note, these firms have realized that the changing political climate in these emerging markets needs an approach that would make a firm acceptable by the local populace. This research focuses on the trends in foreign direct investment in emerging markets.

Research objectives

It is important to define the objectives of the research in clear terms. According to Azman-Saini and Law (2010), measuring the success of a given research project is always done based on specific objectives. The researcher will then analyze if the outcome of the research meets the set objectives.

For this reason, it was important to set clear objectives that will be used to determine the level of success in this study. The researcher will be interested in investigating the trends of foreign direct investment in emerging markets.

The following are some of the specific objectives for this study.

  • To determine the impact of the socio-political and economic environment on the trends of foreign direct investment in the emerging markets
  • To investigate the relevance of the emerging markets to some of the leading multinational corporations
  • To identify some of the challenges faced by the multinational companies in emerging markets when making foreign direct investments.

The researcher seeks to achieve these objectives by conducting research from the existing literature. The research will use books and reliable peer-reviewed journals relevant to this field.

Literature Review

Foreign direct investment is a topic that has attracted the attention of scholars who are interested in understanding some of the emerging trends that affect the players in one way or the other. It is important to review some of the reports that other scholars have written on this topic. Foreign direct investment has become one of the main solutions for large corporations to expand their market share.

According to Xiaoying and Xiaming (2005), foreign direct investment is taking a new shape as colonialism and neocolonialism end. The emerging markets in Africa, parts of Asia, and Latin America are becoming important frontiers for foreign companies seeking to expand their operations.

The study by Froot (2008) revealed that within the last decade, Asian countries had experienced a massive inflow of foreign investors who are seeking to expand the operations of their business units. International firms have realized that they can use foreign direct investment to gain a competitive advantage in the market.

Foreign direct investment is no longer a tool used by the world powers to control the emerging world. The multinational corporations are now using this tool to expand their market.

According to Barbopoulos, MacInnes, and McColgan (2014), firms are grappling with the increasing levels of competition in the local markets because of the emergence of new firms. The only options for many firms are to expand to the international markets as a way of expanding the market share. The figure below shows the estimates of the value of investment flows into emerging markets obtained from the International Monetary Fund.

Net Inflows of Direct Investment into Emerging Market
Figure 1: Net Inflows of Direct Investment into Emerging Markets Source (IMF, 2013)

The graph above shows that there has been a consistent rise in foreign direct investment in the emerging markets over the past two decades. This may be attributed to a number of reasons, as will be discussed later in this paper. With the advanced means of communication and transport facilities, it has become easy for firms to consider expanding to the global market without much struggle.

As Borensztein, De Gregorio, and Lee (1998) says, it is now possible for a firm headquartered in New York to have its production plant in India and markets in all parts of the world. Advanced communication tools make the work of monitoring these overseas plants very easy. Technology is one of the main reasons why foreign direct investment has become very popular, especially among the multinational corporations.

According to Chiou, Hung, and Shu (2013), foreign direct investment has become very common in the current global society. Firms are considering spreading out their operations to various parts of the world for various reasons. Some are trying to ensure that they expand their market share in order to compensate for the lost customers in the home market because of the entry of more competitive firms.

Others consider it as a way of spreading risks so that if an economic crisis such as recession hits the home country, they still can benefit from their overseas businesses. Other firms may be looking for ways of cutting their costs of operations by moving some activities to the overseas.

Irrespective of the reason why a firm decides to go global, some factors should always be considered because they may have a far-reaching impact on these firms.

According to Ehrhardt and Brigham (2014), numerous environmental factors may affect trends in foreign direct investment in emerging markets. It is important to understand the factors and their impact on foreign direct investment in emerging economies. The following are some of the broad areas that needed emphasis when investigating these factors.

Social factors

Farrell, Remes, and Schulz (2004) say that the ability of a firm to be successful in a given foreign market may be affected by a number of social factors. The social structure of a given society will always define the buying pattern for a given product. The socio-cultural beliefs have serious impacts on the kind of products that people will buy in the market. This may affect the ability of a firm to enter a given market with its products.

According to Froot (2008), a good example is the expansion plan of Burger King. This firm has been making positive efforts to expand its market to other markets other than the United States. After experiencing massive success in the developed economies, this firm decided that it was time to try the emerging markets as a way of expanding its operations and increasing its customer base.

The next lucrative market was India, with a population of about 1.2 billion people. However, this firm found out that the Indian market was very different from that in the developed economies. Burger King found out that religious practices in this country prohibit people from taking meat (Xiaoying & Xiaming, 2005).

It was unfortunate to realize that out of such a big population as that of India; Burger King could not have a substantial customer base because of the nature of its products. This means that the management will be forced to find alternative products that will be suitable in this market, or else it may be completely locked out.

According to Gomes, Neto, and Veiga (2013), this is a common challenge for many firms who are trying to expand their market share through foreign direct investment. Sometimes a firm may find a marketing message that is very successful in the home country very offensive in the host country due to some social beliefs.

As Gupta (2010) advises, the best way of dealing with social issues is to investigate and develop an understanding of any new market before making an investment. Of interest should be to develop the product and a promotional campaign that is conscious of the local environmental factors.

Economic factors

The economic environment is another definitive factor that highly influences foreign direct investment. According to Haar (2012), one of the very first questions that many companies ask before making an entry into a new market is the ability of that particular market to purchase its products.

Some of the manufacturers of high-range cars find themselves locked out of the emerging markets because of the prohibitive prices of their products that these markets cannot afford (Froot, 2008). This is so because the market is looking for a different category of products that is within their financial range.

Toyota managed to surpass General Motors to become the world’s top car manufacturer because of the massive opportunities in the emerging markets. Using quality control tools such as Total Quality Management, the firm was able to manage the quality of its products and lower its cost of production, the fact that it made its products fairly priced (Chiou, Hung & Shu, 2013).

This made them very popular in the emerging market. The success of Toyota in its foreign direct investment into the emerging market is a clear demonstration of the financial capacity of the customers in the emerging market.

As Herrera-Echeverri, Haar, and Estévez-Bretón (2014) say, most of these customers are very sensitive when it comes to pricing of the products. This scholar says that over the past decade, many international firms have been trying to find ways of pricing their products in order to tap into the massive potential in the emerging markets.

It is important to note that a large section of the customers in the emerging markets have limited capacity to purchase very expensive products. Some of the firms, especially those from Asian Tigers, have learned ways of lowering the costs of their products in order to attract consumers in the emerging markets. Other firms have decided to select market niches that they can meet their demands in the best way possible.

According to Gupta (2010), the size of the middle class in emerging countries is increasing very rapidly. This means that the purchasing power in these markets is also on the rise. This explains why Apple and Samsung have been very successful in these markets.

They have been able to understand the needs and capacity of their target market, and have developed products to meet these needs at costs that are affordable. The figure below shows the trends in foreign direct investment. It shows that more investors now prefer moving to emerge markets than going to developed economies.

According to Xiaoying and Xiaming (2005), many organizations have realized that the emerging markets have greater potential as compared to some of the developed economies for foreign investors. For this reason, there has been a massive inflow of foreign direct investment in these emerging markets, as shown in the figure below.

Foreign Direct Investment in Emerging Markets
Figure 2: Foreign Direct Investment in Emerging Markets. Source (UNCTAD, 2014)

As shown in the figure above, there has been a consistent rise in the inflow of foreign investment into these emerging markets for the last twenty years.

As Moran (2006) notes, the instability of the economy in some of these markets also poses threats to effective foreign direct investment. Some of the revolutions that have become common in these emerging markets in Africa and Asia have affected the economies of these countries, making them unviable options of investment.

Political factors

The political factors are very important in defining the trends in foreign direct investment in emerging markets. One of the most important aspects of the political environment is security. The research done by Ok (2004) revealed that many businesses have failed because of insecurity. The scholar insists that security is the first factor that any business entity will consider before making an investment decision into a given region.

An investor will need assurance that the investment will not be looted or destroyed in any way. According to Froot (2008), a market with unstable political structures is bound to have security problems. Egypt was once one of the most attractive destinations among the emerging markets.

It was considered a very secure country until a popular revolution forced President Hosni Mubarak out of power. This has brought total chaos into the country. Gupta (2010) says that foreigners are always the worst hit when chaos erupts in foreign markets. This is what was witnessed in Egypt. Foreign businesses have been subject to vandalism and looting.

Traveling within the city of Cairo has become very dangerous, especially when the protestors are on the road. This has changed everything in terms of foreign direct investment in this country. Many foreign and even local investors are moving to other safer countries within the region because of the issue of insecurity.

The same case has been witnessed in Syria and Iraq that have experienced prolonged revolutionary demonstrations for the past several years. According to Xiaoying and Xiaming (2005), foreign investors have been seriously affected by the ongoing insecurity in the country.

On the other hand, emerging markets that have experienced prolonged periods of political stability have benefited a lot from foreign direct investment. One such country is India. The following graph shows the impressive growth of inward foreign direct investment in the country

Foreign Direct Investment into India
Figure 3: Foreign Direct Investment into India. Source (Government of India, 2014)

According to Singh (2005), political instability also has a ripple effect on other aspects of the economy.

When a country is subjected to constant revolutionary demonstrations such as that witnessed in Egypt, Syria, and Iraq, it becomes very difficult for people to engage in income-generating activities. In most cases, people are forced to stay indoors because of security concerns.

This means that their purchasing ability will be reduced if not eliminated. This makes it impossible to engage in any trading activities.

According to Tanaka (2011), some of the countries in the emerging economies have been classified as unfriendly to foreign direct investment because of their political structure. It is very dangerous when the host government gets involved in the internal affairs of an independent foreign firm operating within its borders. The government is the regulator and provider of basic amenities.

It should restrict their activities to this without engaging in activities that may affect the ability of foreign firms to operate freely. According to Waheeduzzman and Rau (2006), in the recent past, the Indian political class was notorious for interfering with the internal affairs of both the local and international firms, especially during the campaigns.

They will order these firms to lower their product prices or increase their employees’ pay in order to win the trust of the electorate. This is unprofessional and very detrimental to achieving success.

When such cases occur frequently, then it becomes difficult to conduct a successful business venture. In many countries in the Middle East, such as Saudi Arabia, the government closely controls the business environment. The heavy presence of government within a given market makes it difficult to operate.

The relevance of the Emerging Markets to the Leading Multinational Corporations

According to Wood, Mazouz, Yin, and Cheah (2014), it is important to determine the relevance of the market before making a decision to venture into it. Scholars have been trying to explain the relevance of the emerging markets to the leading multinational organizations.

It is a fact that most of these corporations have been making efforts to venture into these markets. This is a clear indication that they find these markets to be relevant to their businesses. At this stage, it will be important to look at the specific issues that these business entities find attractive in the emerging markets.

Large population

A large population is one of the factors that are driving investors into emerging markets. The population size is important to a firm in terms of labor and market. Many American firms were finding it very costly to manufacture their goods within the home country.

The main reason was the cost of labor in the local market. They are forced to relocate their plants to the emerging economies where the cost of labor remains cheap. The massive population in these emerging economies has reduced the cost of labor because there is always an alternative if one is not willing to accept the set prices.

The advancement in technology in the emerging markets and the improved levels of education have also helped improve the quality of labor in the market. The research was done by Xia, Ma, Lu, and Yiu (2014) revealed that it is common to find that a diploma holder in the United States may demand a high salary.

It is apparent that Chinese employees with advanced levels of education will be able to perform better compared to the less educated employees in the United States. It is, therefore, unrealistic for the less qualified employee to demand more pay. It is on this basis that many firms have considered transferring their production plants to other countries.

The second aspect of the population is the market. India is home to about 1.2 billion people. Indonesia has a population of 253,609,643, while Brazil is home to about 202,656,788. Any business entity cannot ignore this massive market. This explains why many multinational corporations have been keen on tapping into the Chinese and Indian markets.

According to Xiaoying and Xiaming (2005), the market size matters a lot when it comes to business operations, irrespective of its purchasing power. These people will need to buy different items that will make it possible for them to lead normal lives.

The only thing that a business entity will need to do is to provide products they need at affordable prices. This will make it possible for them to make purchases of these products. Breaking the bulk into smaller, affordable units will be of great importance in such markets.

The expanding middle class

The research by Yan, Yu, and Haiyang (2014) revealed that the middle class drives the emerging economies. In the past two decades, the size of the middle class has been expanding rapidly in most of the emerging markets. Countries such as India, Brazil, South Africa, and Russia have been experiencing massive economic growth in the recent past. Many firms prefer operating in regions with large size of middle-class people.

They form the most attractive class for many business entities. According to Haar (2012), this class is better than the upper-class members of society are. The members of the upper class have the capacity to purchase any products they may want. However, they are always very choosy, and sometimes meeting their demands is not easy. Confining them to one region is also not possible because they travel a lot.

On the other hand, the problem with people in the low class is the lack of ability to purchase given products. They may have the willingness to purchase given products, but their financial position makes it impossible. They are always keen on issues of quantity and quality. It is because of these factors that many firms prefer to operate in a region where there is a high concentration of people in the middle class.

They are assured that the business will not be affected in any way. This is the reason why the new trend in Foreign direct investment currently targets countries with high populations of the middle class. It explains why India has become very popular among the multinational corporations.

Unexploited opportunities

According to the research by Singh (2005), it is revealed that one of the main reasons why a firm may be attracted to a given region is the possibility of exploiting a given vacuum in the market. It is one of the main drivers for a firm to invest in a given business in a particular market.

Developed nations such as the United States and Europe have exploited most of the traditional industries because of many years of economic prosperity. However, this is not the case in many developing economies. Many businesses are coming into the emerging economies, especially in Africa, to exploit some of the opportunities that are ignored by the local players.

One of the biggest opportunities that have attracted foreign direct investment into emerging markets is the health sector. In these countries, many people rely on ill-equipped understaffed public hospitals when they need health services. However, there are classes of the middle-income people and rich who are willing to pay more to get better services.

Most of them are forced to travel to Europe and the United States to get these specialized medical services. Multinational corporations have identified this gap, and are currently establishing private hospitals to target this population. The same case has also been seen in the field of education.

Foreign investors are establishing colleges and other tertiary level colleges to tap into the population that has been moving to foreign countries to get these services. Some of the African nations are yet to exploit their natural resources fully. Many international firms have been exploring Africa in an attempt to tap into the rich mineral resources.

Challenges Faced by Multinational Companies in the Emerging Markets

It is now clear why many multinational organizations are moving into emerging markets, especially in South America, Asia, and Africa. The trend is influenced by the desire to capitalize on the available market and cheap labor.

However, Ok (2004) says that the market in the emerging economies poses some serious challenges that may hamper this growth. It is important to understand these challenges in order to develop a mechanism of managing them. The following are some of the issues that may affect the normal operations within the emerging markets.

Political interference

Political interference is one of the leading challenges in foreign direct investment in emerging countries. According to Haar (2012), some of the political leaders have stakes in various industries. They use their positions in the government to either frustrate foreign firms that are operating in the same industries as theirs or extort money from these foreigners.

The government of the United Arab Emirates established a policy, which required that all the foreign investors had to give up to 51% of their shares to the locals (Xiaoying & Xiaming, 2005). This means that a foreign investor will come with the idea and money to invest, and then find a way of giving 51% of its shares to the locals who just sit and wait for such investment opportunities.

This has forced some players to avoid such markets. The policy has become common in Middle East countries such as Saudi Arabia and Pakistan (Gupta, 2010). This is limiting the space for foreigners to operate independently in the market.

In some cases, political leaders may demand that they should be incorporated in the ownership of the business without contributing anything towards the same. This has reduced the competitive space for foreign direct investment in the country. As mentioned before, issues such as setting unfair prices or labor costs also pose serious threats to these foreign investors, as seen in the case of India.

Corruption

Corruption is one of the biggest challenges that affect foreign direct investment in emerging markets. According to Ehrhardt and Brigham (2014), many governments around the world have set numerous processes that have to be followed by business entities that wish to start operating in their country.

It is normal for a country to set up requirements that have to be met by the foreign investors, and it will be normal for them to set up ways of determining if these foreign companies have met the set criteria. However, it is common to find a situation where these processes are duplicated at various stages, and in every stage, there is a price to pay.

Other than the normal fee set by the government, these officials would demand bribes in order to approve the certification. In such situations, it is common to find files for those unwilling to pay the price missing, with no one willing to trace them. Nigeria is one of the most attractive markets in Africa because of its large population and rich oil reserves (Abubakar, 2014). However, it is one of the most corrupt countries in the world.

Every officer responsible for any process of registration will demand a bribe in order to speed up the process. As the regulator, the government itself is highly corrupt. It is common for the top government officials in this country to ask for financial favors from the business society, especially foreign investors.

Those who are willing to play along in such a corrupt environment are able to operate without problems. Those that are not willing to engage in this unethical business practices are easily forced out of the market. The figure below shows the survey that was conducted in Nigeria to determine the level of corruption in the government offices.

Levels of Corruption in Nigerian Public Institutions
Figure 4: Levels of Corruption in Nigerian Public Institutions Source (Yan, Yu, and Haiyang, 2014)

Based on these findings, over 58% of the respondents felt that all the public officials in Nigeria are involved in corrupt dealings in one way or the other. Another 37% felt that some of the officials practice corruption in their official capacity.

This means that over 95% of the respondents agree that corruption is rampant within this country. Only 2% of the respondents had a contrary opinion. This is a very grim statistic because the respondents must have witnessed these cases of corruption in these offices. It demonstrates the uphill task that a foreign investor will have to face when operating in this market.

Winning government tenders in mega projects such as the construction of infrastructure means patting with a substantial amount of money. Not all businesspersons are always willing to engage in these compromises. Such individuals may need to consider other markets despite the lucrative opportunities that may exist in these countries.

Insecurity

Insecurity is another issue that many firms are grappling within some of the emerging markets. Hong Kong is one of the most attractive foreign markets that have attracted many firms. Large multinational corporations like Google have set up their regional headquarters in this city because of its improved infrastructure. However, the recent cases of the demonstration are causing panic among the business fraternity.

The strikes, organized by university students, turned chaotic when the police engaged the students (Hunt, 2014). This led to massive destruction within the city. Such events have serious negative impacts on the business fraternity. During such incidents, businesses are brought to a standstill.

In Somalia, the Alshabab fighters make it impossible to trade in this country. The same problem is witnessed in Nigeria, where Boko Haram is raking havoc in the northern part of the country (Abubakar, 2014). Pakistan is dealing with the problem of Hamas, which is also a big threat to Israel. The same problem is experienced in Congo, a country that is rich in rare earth metals (McCluskey, 2014).

These insurgencies cause serious security threats to not only the people but also the existence of businesses. In some of these emerging markets, the security system is either weak or completely compromised. Cases of attacks by armed robbers are common, making it difficult to conduct business peacefully.

Poorly developed infrastructure

Infrastructural development is very important in any business venture. According to the research by Tanaka (2011), most of the developing economies have very poor infrastructures that make it difficult to operate successful businesses in them.

Most of the roads in some of the developing economies are impassible, especially when it rains. Cases, where bridges are swept away, are also common, and when this happens, the business is brought to a halt. Occurrences are very costly, especially when transporting highly perishable goods.

According to Borensztein, De Gregorio, and Lee (1998), the poor state of the roads and the increasing size of traffic cause regular traffic jams in most of these countries. Johannesburg, Nairobi, Lagos, Rio, and Mumbai have some of the worst traffic jams in the world.

One can spend over three hours on a journey of 20 kilometers leading to the city center. The ill-trained traffic marshals controlling these major highways within these cities are always overwhelmed by the situation.

The railway system in most of the developing countries has been on a consistent decline since the end of colonization. There has been no attempt to modernize the rail system that would otherwise boost transportation. The communication system in these countries is not as developed as it is in the leading economies.

According to Gupta (2010), the cost of communication in emerging economies is very expensive. The capital market in these regions is not also as well established as it is in the leading economies. These factors make it difficult to trade in these markets. It forces a firm to develop measures that may help in countering these problems.

Poor disaster response systems

According to Law (2010), another factor that makes it difficult to operate in the emerging markets is poor disaster response systems. Some natural disasters cannot be controlled, such as earthquakes, cyclones, or floods. In India, cases of deaths and property caused by natural disasters such as floods are common.

African countries have some of the worst disaster response systems, even in major cities such as Abuja, Lagos, Cairo, Nairobi, and Johannesburg. Tanaka (2011) says that dealing with simple cases such as fire breakouts is an issue in this city. Partly, this is caused by poor transport systems and traffic jams that make it difficult for the rescue team to arrive at the site of the accident in time.

Laxity in the parts of the authorities involved and ill training on rapid response to disaster is another possible reason. It means that if a firm lacks internal disaster response systems, then rescuing property during cases of fire breakouts or any other related disaster may not be possible.

This increases the cost of operation because the business entity will have to take a comprehensive insurance cover just in case of such eventualities. The slow processing of the compensations from the insurance companies would worsen such eventualities.

There are cases where the insurance company would reject the claim. In such corrupt systems, the officials of such insurance companies, in conspiracy with the government officials, would demand bribes before they can approve the case.

Summary

This research focused on the trends in foreign direct investment. It is clear from the discussion that trends in foreign direct investment are changing rapidly as the world embraces technology. The geographical barriers that affected free trade between countries no longer exist because of the invention of improved transport and communication systems.

This has enhanced the ability of individual firms to make foreign direct investments. However, some socio-economic and political factors have direct impacts on this foreign investment either positively or negatively. The most important thing for a foreign firm willing to operate in any foreign market is to conduct research before making an entry. Some countries are so corrupt that it may be difficult for a foreign firm to run an honest business.

With the current trends of foreign direct investment in the emerging markets, it is very likely that these economies may not be as attractive as they are today. The chances are that they may get flooded, making them unattractive to foreign investors.

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