Foreign Direct Investment and Forwarding Contracts - Assignment Example

Question 1 Foreign Direct Investment Foreign direct investment refers to free flow of capital goods from one country to another. Individual or corporate investors decide to set up companies or buy substantial shares of companies abroad to pursue their investment agendas. According to Jones and Wren (2006:22-25), companies and individuals in the United Kingdom have invested heavily in foreign countries since nineteenth century. Wei and Balasubramanyam (2004:178) claimed that objectives of investors, foreign direct investment and economic policies as well as business environment in foreign countries are major factors that influence free flow of capital from one country to the other. Most foreign investors target manufacturing, mining, building and service sectors because they have higher return on capital. Specifically, lower production and non-production costs, growing markets, investment incentives, stable macroeconomic environment and access to resources in foreign countries are some of the forces driving cross border transfer of capital. Firstly, lower production cost greatly influence investor’s decision to invest. Every company aspires to achieve cost leadership. The lower the production costs, the higher the likelihood of making profits and attaining a larger market share. This is because it allows the companies to reduce the price of the finished product without incurring losses and compromising the quality of the output. Cost leadership is a definite competitive advantage to the producing companies. The production costs include cost of raw materials, direct labour and transportation cost for both raw materials and labour used in production process. When raw materials and direct labour are readily available near the production plant, transportation costs of both the direct labour and the raw materials to the factory are lower. Therefore, most individuals and corporate investors invest in foreign countries where the raw materials are readily available to minimize the transportation costs thus reducing the production costs. Furthermore, companies shift their operations to areas where the direct labour wage rate is lower. Lower labour rates enable the production foreign company to lower production cost substantially. According to Kumar (2002:136), dying and printing industry was set in Fraukhabad to make use of the readily available skilled labour that was cheaper. The availability of highly skilled direct labour and good infrastructure in East Europe has significantly lowered the cost of production making the country attractive to foreign direct investment from developed European countries. Secondly, lower non-production cost also influence the decision to invest. Lower non production cost directly corresponds to higher operation profits and investors earn more for every unit of investment they make. In addition, lower non-production costs enable the investors save on costs. Low labour and corporate tax rates, lower lease and property rates, lower transportation and lower energy costs as well as lower tort litigation and compliance costs are some of the non-productive cost that lead to significant increase in the net profit resulting from business operation. This is because lower costs translate to lower expenses that the company incurs to bring the manufactured good to the customer. OECD (2008) said that the Nokia Company, manufacturer of Nokia handsets in Finland has invested heavily in foreign countries. The company has located 44 per cent of its production to Asian countries because Asian countries have lower labour rates as compared to Finland. Asian countries are also attractive because it has efficient production network thus reducing the overall cost of production and expenses. European investors have exported most of their productive processes to East Europe. This is because East Europe has a definite advantage of lower transportation cost and readily available skills hence making it attractive. Readily availability of skilled workers makes it cheaper to employ and retain employees because demand outstrips the supply. Wei and Balasubramanyam (2004) claimed Mozambique attract foreign direct investment because it has a lower tariff structure of about 14 per cent. Therefore, investors invest in foreign countries to take advantage of lower cost of production and overall expenses to increase their returns. Thirdly, growing market is a driving force to investing in foreign countries. Large and promising markets attract economies of scale for production, marketing and distribution activities of the company. This enables the company to price its products slightly lower due to the advantages attained from economies of scale without compromising on the profits that the company anticipates to earn. Growing markets with many players also provide an opportunity for acquiring and taking over weaker competitors who struggle to achieve their market targets. Economies of scale and favorable acquisition of weaker companies provides an opportunity to earn long term profits. This makes expanding markets that have impressive growth rates attractive to foreign investors. The markets in Europe have reached the maturity level and profitability has reduced significantly. According to Morroni (2009: 208), in the last 15 years, most European investors are investing in East Europe and China because their markets are growing towards maturity. This is because there is adequate market for the goods and services in growing and developing markets. Furthermore, when investors set up companies in foreign countries, they may increase the demand of their goods or services because they are able to penetrate the foreign market in which they are located easily. Fourth, foreign countries have developed incentives for foreign direct investors. Government policies in source and host countries largely dictate whether investors can invest in foreign countries or not. The Chinese government initiated a strategy in 2000 to enable investors from china to invest in foreign countries that have substantial resources and market potential. As a result, Chinese construction firms undertake most infrastructural projects in African Countries like Kenya. The go global Chinese government strategy allows own or resident investors to move capital freely to other countries. On the other hand, foreign direct investment recipient adopt measures that attract foreign investors. The governments of receiving countries embrace policies that are investment friendly. The government may reduce the corporate tax rates, reduce formal requirements necessary to start and run a company, improve its governance structures and stabilize both the country’s political environment. For example, the country may adopt slightly lower corporate tax rates as compared to other countries, ensure speedy litigation of torts, develop transparent and straight forward procurement policies and strictly adhere to the application of rule of law in dealing with matters relating to business. The governments also develop and pursue policies that promote country’s political stability to prevent civil wars and other political related unrests that cause losses to investors. The above government initiatives assure investors of business continuity in the foreign land. Fifth, some foreign countries have adequate natural resources. Most of the developed countries have exploited most of their non-renewable natural resources. As a result, it is becoming difficult and extremely costly to exploit dwindling natural resources in their countries for the purpose of continued production. At that point in time, it is prudent to seek for alternative sources of the raw materials to continue production and sustain or improve the profitability of the company. Consequently, investors are looking towards developing countries especially those found in African because they have plenty reserves of unexploited resources that need to be harvested and processed to finished products. Morroni (2009) cited availability of good quality raw materials and top quality accessories as well as efficient production network in Asian countries. These resources have attracted foreign direct investment from European countries. China is a country that has developed immense interest in African countries since the year 2000 because Africa is becoming the source of both energy and natural resources necessary for the production of finished goods. Other country in Africa considered rich in minerals is Congo. Diamonds, cobalt, zinc, manganese, gold, silver, cadmium, tin, coal and oil make Congo a promising African country for foreigners to invest in. Sixth, stable macroeconomic environment is an important factor that dictates foreign direct investment. According to OECD (2008: 66) investors are moving away from countries with highly controlled economic system such as China to less controlled countries in Africa. Wei and Balasubramanyam (2004) cited Mozambique as an African country that have attracted foreign direct investment because it improved it macroeconomic environment. The African country reduced inflation rate dramatically and privatized over 900 state enterprises. Most of the state enterprises that were privatized were in the banking and manufacturing sector. Countries that have more stable macroeconomic environments record high levels of economic growth. Therefore, there is a possibility for the companies hosted by such countries to grow and develop nearly at the same or even higher rate. A country with weak GDP growth rates and lower purchasing power of its citizens is not attractive to investors who wish to obtain market from the residents of the host country. This is because they may take a long time to make significant profits or even recoup their investments. Furthermore, a country that has consistently appreciating currency may not be very attractive to exporters. Appreciating currencies cause exchange rate currency related losses. This is common in the matured markets. There are very good reasons why companies invest abroad. However, investing abroad pose challenges to both the host nation and the foreign investors. The challenges that come with foreign investment include compromising with defense capabilities of the host nations, repatriation of profits abroad, foreign exchange currency fluctuations and labour malpractices. First, the ability of the host country to defend itself is impaired. This is because expatriates working in the host country can leak highly classified information to hostile countries that may lead to national insecurity. Some countries in Africa rich in natural resources are constantly at war. This is because some of the foreign investors supply arms to gangs in a bid to gain control of mining fields. Secondly, foreign companies take most of the profits back to their countries and leave very little for the locals. As a result, the host countries gain marginally from those investors. Thirdly, millions of money invested in foreign countries may cause high levels of inflation. In addition, they may cause drastic foreign currency exchange fluctuations thus destabilizing the macroeconomic environment. Fourthly, some foreign companies may apply labour practices that are unacceptable to the government and the local employees. The foreign companies may offer very low wages and poor working condition. As a result, people work hard and fail to improve their lives. Those working in the poor conditions may suffer from work related occupational diseases and accidents. The second category of challenges affects the investors. Political instabilities, economic challenges, and weak governance in host countries are some of the challengers that pose real threat to the investment of the foreigners. First, political instabilities in host countries cause a lot of distress and losses to the foreign investors. According to Kannen (2007), civil wars, coups, riots are some of the examples of political instabilities bedeviling some of the developing countries that foreign investors put their money. Political instabilities lead to acts of violence against companies especially foreign ones. As a result, companies’ properties are seized or destroyed by gangs, government officials or irate citizens. Furthermore, foreign workers may be kidnapped or even killed during civil unrests. This is because foreign companies are often viewed as intruders or outsiders. Other challenges faced by foreign companies include unfair license revocation, withdrawals of copyrights and pursuance of nationalization policies by host governments. Therefore, both the citizens and government of the host country are suspicious of the impact of foreigners to their political and economic stability. For example, large scale violence and civil unrests in Thailand, Congo, Myanmar, Indonesia and Malaysia have caused foreigners to loose millions of monies in terms of loss in revenues due to disruptions and destruction of property. The second challenge to investors is economic hardships. Some countries provide subsidies and low interest loans to local firms. This provides unfair competitive advantage to the foreign investors. Other economic challenges include low per capita income and slow economic growth in host countries. The third challenge faced by foreign investors is weak governance in host governments. The cost of government failures and corruptions increase the cost of doing business in the host countries. Developing countries do not have free press. In addition, they have weak judicial system and audit institutions making corruption to thrive. Onkvisit and Shaw (2004:133) revealed that corruption add between 20- 30 percent to the cost of building contracts. Most companies bribe government officials to be given a contract or market for the product they produce. For example, Lockheed admitted receiving $ 1 million to help company sell planes to Egypt. Finally, differences in culture of both the foreigners and host country citizen may cause a lot of difficulty in understanding and applying business concepts. For example, an American firm lost a contract worth billion of dollars in Greece because the Americans tried to impose their time consciousness custom to the local negotiators of Greece. Setting time limits to Greece negotiators was unacceptable. Question 2 Your company exports 15% of its output and all exports are denominated in foreign currency. Your product involves import content and you import the required input from two separate countries in order to help safeguard supply. Your imports are denominated in the currency of your supplies. You are due to receive $1million exports receipts in 90 days and have to make payment for $100,000 worth of imports ( at today exchange rates) to your suppliers in countries A and B. You have the following information: Today spot rates $1 = 0.75 units of currency A $1 = 2.5 units of currency B Today Forward rates $1 = 0.79 units of currency A $1 = 2.3795 units of currency B Figure 1- The nature of your company’s foreign exchange exposure and the associated risk Date Spot rate US $ value Change Forward rates US $ value FV of contract Change currency A 0.75 1000000 750000 0.79 1000000 790000 4000 currency B 2.5 100000 250000 2.3795 100000 237950 -12050 Actions considered when dealing with any exposure and risk There are various approaches to deal with exposures and risks associated with foreign exchanges. Hedging is used by companies to limit (reduce) or eliminate financial losses caused by foreign currency exchange risk. Hedging refers to financial instrument deriving value from core assets. Forward contracts, currency swaps and currency option are major types of hedging commonly used to minimize or remove the foreign exchange risks facing a company. First, forward contracts help to eliminate or minimize the risks and exposures caused by foreign exchange currencies changes. Forward contracts refer to financial contracts that lock in an exchange rate that will apply to a future transaction. They are non- standardized contracts between two parties binding them to sell or buy specified amount of foreign currency at a pre-agreed currency rate on a specified date. The forward contracts are negotiated between an individual or company and a commercial bank via a telecommunication network such as the internet or the telephone. It states the exact date and the amount of money to purchased or sold and is usually tailored to meet the needs of the firm. In order to apply the foreign exchange forward contract, it is important to provide two currencies that will be involved in the transaction as well as the expiry date. However, it is important to allow some flexibility by providing more than a single maturity date. In addition, forward contracts also imply to future currencies. Future currencies require the suppliers to physically deliver agreed amount of currency at the maturity date as per the terms of the contract. It is a standard contract that is in foreign currency denominations. Secondly, currency swaps help to reduce the risks involved in foreign currency exchange. Currency swaps are agreements entered directly between parties or intermediaries to exchange cash flows in future according to the pre agreed formula. A liability or asset can be transformed from one currency to another currency via currency swap. For example, a company in Mundania may have to borrow Japanese yen to purchase manufacturing equipment from Japan. The Mundanian firm may be exporting fruits to the United Kingdom and will be receiving its income in the United Kingdom pounds. United Kingdom pounds would have to be converted to Japanese yen every time the principles and interests have to be paid to the Japanese manufacturer. As a result, the Mundanian firm will be exposed to foreign exchange fluctuations. The fluctuations may result to losses to the Mundanian Company if the pound weakens against the Japanese yen. This makes the company incur foreign exchange losses. According to Kevin (2009:127), such losses may be avoided if there is a currency swap between Japanese manufacturers and the Mundanian Company. Currency swaps may also reduce the cost of borrowing loans when companies exchange their liabilities and assets because the transaction costs that accompany borrowings are avoided. Thirdly, currency options can be used to minimize losses that result from foreign exchange currency fluctuations. Currency options are financial instruments that give a right to an individual but do not oblige him or her to perform a transaction using a stated amount of currency. It gives the owner the right to purchase a specific amount of currency at a given price at a given future time. Currency option locks maximum exchange rate for a given currency in the future. If currency rises beyond an agreed price, the owner will buy the currency at a lower price as agreed than a spot rate. However, if the price (spot rate) of the currency is lower than the agreed exchange rate, the owner may choose to use the spot rate but forfeit the premiums paid for the transaction. Question 3 Figure 2- Computed grommet /pound forward exchange rates for year 1-5   Period of borrowing/ lending (years) Mundanian Interest rates annualized sterling Interest rates annualized Spot price (S) 1+ f 1 + b ((1+ f) ÷ (1 + b)) ((1+ f) ÷ (1 + b))n Gr/£ 1 0.15 0.1 5 1.15 1.1 1.045454545 1.045455 5.227273 2 0.18 0.1075 5 1.18 1.1075 1.065462754 1.135211 5.676054 3 0.225 0.1125 5 1.225 1.1125 1.101123596 1.335083 6.675414 4 0.27 0.1075 5 1.27 1.1075 1.146726862 1.729179 8.645895 5 0.28 0.105 5 1.28 1.105 1.158371041 2.085636 10.42818 Forward exchange rates = S × ((1+ f) ÷ (1 + b)) n f= foreign (Mundanian Interest) interest rate b= base (sterling) interest rate Gr/£=grommet /pound forward exchange rates n= period of borrowing/ lending in years S=Spot price Forward contracts are normally popular among most global investors. However, credit risk, lack of liquidity and non-regulation are some of the disadvantages that bedevil the use of forward contracts as compared to the options. First, credit risk is a real risk facing the forward foreign exchange contracts. Naturally, forward contracts are agreements to pay or receive a certain amount of foreign currency or undertake transactions at a given foreign currency rate in future time. However, one party to the agreement may fail to honour the promise to pay or deliver the sum of currency agreed upon when the contract was created. The other party that was suppose to receive the agreed amount of foreign currency may be disadvantaged if the giving party failed to deliver the agreed currency amount. Secondly, lack of liquidity is a major problem with forward contracts. There is no money that exchanged hands when the contract was entered into by the two parties. This makes it extremely difficult for one party of the agreement to honour the agreement because the company or the individual may not be having the money to meet financial obligations as they fall due. Therefore, the parties to the contract should always ensure that the other party to the contract must be having sufficient foreign currency to be able to supply it when the contract matures. Thirdly, forward contracts are usually unregulated and standardized. This means that people who enter into such agreements do so at their own peril. If the other party fails to honour part of their agreement, the other party may find it extremely difficult to enforce the contract or seek compensation from the party that breached the contract. Even they are structures to do so, it may take a lot of time thus wasting company’s time. This means that every party to the contract must take extreme measures to ensure that the other party will honour the agreement. In most cases, only companies that understand and have develop long term relationships can be comfortable with this kind of arrangement to reduce the risks and exposures of foreign exchange currency fluctuations. References Ferrell, O., Fraedrich, J. & Ferrell, L 2006, Business ethics: ethical decision making and cases, 7thedn, Cengage Learning, New York. Jones, J. & Wren, C 2006, Foreign direct investment and the regional economy, Ashgate Publishing, Ltd. England. Kannen, T 2007, Direct Investments in Foreign Countries. GRIN Verlag, Germany. Kevin., S 2009, Fundamentals of International Financial Management , PHI Learning Pvt. Ltd., New Delhi. Kumar, N. &Kumar, N.2002, Managerial Economics, PVT. LTD., New Delhi. Morroni, M 2009, Corporate governance, organization and the firm: co-operation and outsourcing in the global economy. Edward Elgar Publishing, England. OECD 2008, China: encouraging responsible business conduct, OECD Publishing, France. OECD 2008, Economic Surveys: Finland 2008, OECD Publishing, France. Onkvisit, S. & Shaw, J 2004, International marketing: analysis and strategy, 4thedn, Routledge, New York. Wei, Y., & Balasubramanyam, V 2004, Foreign direct investment: six country case studies, Edward Elgar Publishing, Cheltenham, United Kingdom Read More