Monday, 28 January 2008

Risk and Sunk Costs

There is a growing literature in economics that examines the behaviour of firms when undertaking FDI and/or exporting. These heterogeneous firm models use "sunk costs" to differentiate between exporters and domestic only producers (which are always a majority of firms) or multinational and domestic firms.

There is still, to my mind, on ongoing debate as to how large these costs actually are.

This comment by China Vortex (H/T: China Law Blog) presents an interesting perspective on how some of these costs can be derived related to "risk" especially concerning the different behaviour of Western and Chinese firms in relation to African investments.

Risk is in the eye of the beholder [China Vortex]

In the west, there is a whole industry called “risk consultancy”. Basically, this industry is built around informing large- and medium-sized corporations about risk. Originally, this was built around business risk and would answer questions like “How safe is it to invest $500M in an industrial diamond mine in the Congo (formerly Zaire)?” The consulting firm would then send practice consultants to the target country, where they would study sunk costs (including bribes which were never written about in the report, regulations, who was related to the president, political opposition, major competing firms, etc.) Most of these questions were positioned as questions which any board would ask the CEOs before they would greenlight an investment.

Underlying all this is the belief, at least in west and among western corporations that “risk” is something which can be quantified and measured objectively.

One of the big topics in the west now is China’s investments in Africa. What is fascinating about China’s investments in Africa is that while the amounts of money and people who go to Africa are huge, China really doesn’t have risk consultancies, and Chinese really have not yet started thinking in terms of quantifying risk in the ways western corporations have.

So how have the Chinese judged risk so far, and will the present method change over time to something more akin to the western way of thinking? When it comes to Chinese investments in Africa, many of the early-stage investments were a part of Chinese foreign policy aimed at securing raw materials for manufacturing, and more importantly, energy sources. The typical model has been to find a country, build a new palace for the president and a new sports stadium to win over the people. This would help state-owned construction firms to gain a footing in the country, which were then quickly followed by Chinese logistics firms and wholesale distribution firms which would sell products to the local African population.

Viewing the local African population as customers were one area where Chinese viewed Africa fundamentally differently from the west. While Beijing, Shanghai and the Chinese tier one and tier two cities are relatively modern, it is very easy to forget that when it comes to pervasive poverty, China is only 10-20 years removed from the levels of African poverty. Basically, Chinese companies know how to sell to poor people because they had lots of practice in China.


China Law Blog's comment is also illuminating for economists.

The high margins American companies expect and their high labor costs are no doubt factors, but I also wonder if it is not just plain and simple risk aversion based on an unwillingness to risk jeopardizing that which has already been achieved. All I know is that I have worked with an untold number of companies over the years that have come to the brink of going into an emerging market country (including China), but then backed down at the last minute because of some (often very small) risk that would not be present stateside.

In the West it is widely perceived that US firms are greater risk takers than European firms with greater entrepreneurial drive. I suspect CLB's comments only apply to the large US multinationals and not the more nimble small and medium sized companies who may be in less need of their expensive lawyers.


1 comment:

Anonymous said...

Actually, my comments apply more to mid-sized and small companies because those are the companies that make up the overwhelming bulk of our client base. The big multinationals go into China because they feel they must and because they can afford most any losses. It is the 200 employee company that I feel has been too slow to go overseas. They seem to feel that if they remain domestic, nothing will change. I analogize it to the person who thinks that by earning 3% per year on their retirement account through an FDIC insured bank account they are minimizing their risk.