THE EFFECT OF FOREIGN FIRM REFERENCE GROUPS ON POLITICAL RISK

Charles E. StevensLehigh University

Mona V. MakhijaThe Ohio State University

JSIE 2014 – Tokyo, JapanJuly 19, 2014

THE ISSUE OF POLITICAL RISK

Political risk = The negative impact of unexpected host government actions on firms’ overseas performance (Brewer, 1985; Miller, 1992)

Government intervention takes different forms Contract renegotiation Policy changes affecting firm operations, profits Expropriation

Performance & strategic implications Results in $25+ billion in lost profits per year for

multinational enterprises (MNEs) (Henisz & Zelner, 2004) Creates additional business risk that is not easily

understood (Makhija, 1993)2

CENTRAL QUESTIONS

Why does a host government intervene in firms’ operations?

When does a host government intervene in firms’ operations?

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EXPLANATIONS IN THE LITERATURE

The bargaining power paradigm (e.g. Vernon, 1971)

Host governments will intervene when their bargaining power is higher than that of foreign firm(s)

Empirical approach in the lit: assess when BP of government goes up or down relative to a foreign firm or foreign firms in a given industry

Institutional strength explanation (e.g. Henisz, 2000)

When government checks and balances are weak, government more likely to intervene into foreign firms

Empirical approach: assess institutional strength of country

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PROBLEMS REMAIN

Bargaining power & institutional strength overly-deterministic—the ability to intervene is a necessary but not sufficient condition for intervention (Minor, 1995; Stevens & Cooper, 2010)

Need more detailed insight into how government actually makes decisions about foreign firm intervention

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RESEARCH QUESTION

How do governments make the decision when to intervene?

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INFORMATION-PROCESSING PERSPECTIVE(MAKHIJA, 1993)

Governments have a set of objectives vis-à-vis foreign firms operating in their country (Kobrin, 1980; Vernon, 1971)

Governments take into account information to decide when to intervene

When they find out that their goals are not met, they will intervene in a way that will address this problem

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INFORMATION CONVEYED BY REFERENCE GROUPS

Institutional argument: MNEs’ activities are continually evaluated by external stakeholders (Hybels, 1995; Kostova et al., 2008; Eden & Lenway, 2001; Kostova & Zaheer, 1999)

Reference groups can provide information to the government (Phillips & Tracey, 2009; Suchman, 1995)

Suggests range of possible behaviors

Allow for judgments about the most desirable activities

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FOREIGN FIRMS’ REFERENCE GROUPS

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Industry (I)

1 2 3 … iC

ount

ry (C

)

1 C1I1 … C1Ii

2 C2I1

3 C3I1 …

… …

j CjI1 … CjIi

(Focal) host industry reference group of foreign firms

Within-country reference group of foreign firms

Across-country reference group of foreign firms

FOREIGN FIRM ACTIVITIES’ IMPACT ON THE HOST COUNTRY ECONOMY & INDUSTRY COMPETITIVENESS

What kinds of “activities” might governments care about?

Some foreign firm activities are important to the functioning of the overall national economyReduced unemploymentBalance of paymentsNational productivity

Other foreign firm activities impact the global competitiveness of their host industryGreater innovationHuman capital developmentCapabilities that create greater economic rents

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WHICH REFERENCE GROUP MATTERS SHOULD DEPEND ON THE GOAL

MNEs’ within-country reference group provides a comparison point for how well they are contributing to the national economy

MNEs’ across-country reference group provides a comparison point for how well they are contributing to the local industry

When they don’t compare favorably, the government is motivated to intervene, creating political risk

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CONCEPTUAL MODEL

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Government concerns

Comparison with across-country

reference group

Macroeconomic issues

Comparison with within-country

reference group

Political Risk

Industry-specific issues

Use of Reference Groups

Decision relating to policy change

MACROECONOMIC ISSUE #1: EMPLOYMENT Higher levels of employment benefit the overall economy

many ways (Dunning, 1997; Gilpin & Gilpin, 1987), including: stimulating purchasing activities increasing tax revenues promoting social stability

Maximizing employment is one of the most basic reasons why governments encourage inward FDI

These firms represent a source of employment that would not have been created by local firms alone (Dunning, 1994)

Hypothesis 1a: The higher the employment level of the foreign firms in a host industry above their within-country reference group average, the lower their political risk.

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MACROECONOMIC ISSUE #2: BALANCE OF TRADE

Balance of trade is enhanced through greater exports helps to bring in more foreign exchange stabilizes the value of the national currency reduces the likelihood of debt crises (Makhija, 1993; Vachani,

1995)

Foreign firms are often in a unique position to export MNEs are the primary conduits through which global trade

is conducted (Eden & Lenway, 2001) MNEs have access to large and globally-spanning intra-

firm and intra-industry markets that local firms might not be able to reach (Dunning, 1994; Makhija, Kim & Williamson, 1997; Rugman, 1981)

Hypothesis 1b: The higher the export intensity of the foreign firms in a host industry above their within-country reference group average, the lower their political risk.

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MACROECONOMIC ISSUE #3: FIXED CAPITAL Investments in fixed capital increase a

country’s growth potential (Kaldor, 1961; Solow, 1962)

Foreign firms are in a unique position to increase a country’s fixed capital investments because their operating scale is often much larger than that of local firms (Dunning, 1997; Eden & Lenway, 2001)

Hypothesis 1c: The higher the fixed capital intensity of the foreign firms in a host industry above their within-country reference group average, the lower their political risk.

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INDUSTRY-SPECIFIC ISSUE #1: R&D INTENSITY Industry competitiveness is driven by its ability to

innovate (Landes, 1998). Greater innovation capacity results in: new products superior quality better ability to succeed in new and varied markets enhanced process technologies (Porter, 1990).

Technological competitiveness is necessary for any industry, but the degree of technological intensity necessary for competitive advantage is industry-specific.

Hypothesis 2a: The higher the R&D intensity of the foreign firms in a host industry above their across-country reference group average, the lower their political risk.

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INDUSTRY-SPECIFIC ISSUE #2: HUMAN CAPITAL DEVELOPMENT Superior human capital within an industry

increases its ability to innovate and obtain superior performance (Dunning, 1997)

The training and skills required of human capital varies significantly across industries according to differences in managerial and technological complexities (Porter, 1990)

Hypothesis 2b: The higher the wages of the foreign firms in a host industry above their across-country reference group average, the lower their political risk.

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INDUSTRY-SPECIFIC ISSUE #3: PROFITABILITY The overall profitability of a local industry reflects

economic success. When an industry is more profitable: the government gains more tax revenues it attracts re-investment from existing firms, entry of

new local or foreign entrants, and both upstream and downstream demand in the value chain (Eden & Lenway, 2001)

The benchmark for economic success varies greatly from industry to industry (Porter, 1980)

Hypothesis 2c: The higher the profitability of the foreign firms in a host industry above their across-country reference group average, the lower their political risk.

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FOREIGN FIRM ACTIVITIES & SALIENT REFERENCE GROUPS

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Nature of economic benefit

Examples Salient reference point

Employment

Promotes social, economic, and political stability

Balance of trade

Results in favorable terms of trade, less likelihood of debt crisis

Fixed capital formation

Higher growth potential

R&D intensity

Ability to reach new markets, create new and better products

Wage levels

Signals enhanced human capital, greater purchasing power

Profitability

Indicates successful deployment of intangible resources

Within-country reference group

Across-country reference group

Strengthening of the national economy

Building up of industry competitiveness

METHODSSample: U.S. multinationals’ majority-

owned subsidiaries

13 industries across 53 host countries

Seven years of data: 2000~2006

Source: Bureau of Economic Analysis (U.S. Department of Commerce)Has been used in several other political risk

studies (Click, 2005; Kobrin, 1980, 1987) 20

COUNTRIES IN SAMPLE

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Region Country GDP/capita Region Country GDP/capitaAfrica & Middle East Egypt $1,273 Oceania Australia $37,234

Israel $20,284 New Zealand $27,530Nigeria $803Saudi Arabia $13,127 South America Argentina $4,736South Africa $5,169 Brazil $4,743Turkey $7,088 Chile $7,549

Colombia $3,405Asia China $1,777 Ecuador $2,751

Hong Kong $26,105 Peru $2,881India $735 Venezuela $5,457Indonesia $1,258Japan $36,172 Western Europe Austria $37,048Malaysia $5,499 Belgium $36,234Philippines $1,205 Denmark $47,546Singapore $29,402 Finland $37,331South Korea $17,959 France $34,002Thailand $2,828 Germany $33,514

Ireland $48,761Eastern Europe Czech Republic $12,726 Italy $30,446

Greece $21,468 Luxembourg $82,370Hungary $10,937 Netherlands $39,157Poland $7,963 Norway $65,767Russia $5,311 Portugal $18,196

Spain $26,058North & Central America Barbados $14,448 Sweden $41,042

Canada $35,119 Switzerland $51,889Costa Rica $4,633 United Kingdom $38,135Dominican Republic $3,609Honduras $1,418Mexico $7,946Panama $4,776

MEASURES: DEPENDENT VARIABLE DV measures industry-level political risk Extend methodology of Click (2005) to industry

level First model industry profitability:

Calculated the volatility of foreign firms’ profitability (ROA) in a host industry

Controlled for salient industry and country non-political sources of country risk

Remaining unexplained variance reflects political risk for that industry

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MEASURES: INDEPENDENT VARIABLES Six foreign firm

activities Employment Export intensity Fixed capital

intensity R&D intensity Human capital Profitability

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• Within-country reference group comparison:

• Across-country reference group comparison:

MEASURES: CONTROL VARIABLES

Strength of political institutions: natural log of World Bank’s “checks” index in the Database of Political Institutions (Henisz, 2004)

Industry dummy variables

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POLITICAL RISK COUNTRY RANKINGS (UN-WEIGHTED INDUSTRY AVERAGE)

1. Luxembourg2. Denmark3. Germany4. UK5. Canada8. Japan12. Mexico30. India34. China51. Ecuador52. Dominican Republic53. South Africa

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RANGE OF INDUSTRY-LEVEL RISK FOR SELECTED COUNTRIES

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Political risk

RESULTS

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Independent Variables Model 1 Model 2 (a) Model 3 (b)

Constant -3.240*** -3.197*** -3.328***

Institutional strength (ln) -0.0949* -0.092* -0.080*

H1a Employment -0.115* H1b Export intensity -0.138* H1c Fixed capital intensity -0.059***

R&D intensity -0.055

Wages -0.030

Profitability -0.067

Employment -0.269***

Export intensity 0.042

Fixed capital intensity 0.001

H2a R&D intensity -0.062* H2b Wages -0.130** H2c Profitability -0.115*

Industry controls included included included

R-Squared 0.2583 0.2996 0.3700

F-value 8.20 8.12 11.40

Number of observations 427 427 427

(a) = within-country reference group comparison

(b) = across-country reference group comparison

Robust standard errors are in parentheses

All tests are two-tailed: †p<0.10; *p<0.05; **p<0.01; ***p<0.001

IMPLICATIONS OF THE RESEARCH Foreign firms’ reference groups appear to provide salient

information that influences a government’s motivation to intervene Moves beyond traditional ‘closed dyad’ approach of political risk

studies Informs debate between Kostova et al. (2008) and Phillips & Tracey

(2009) about the role of organizational fields in IB research on MNEs

The salient point of reference shifts depending on the nature of the firms’ activity in question Activities occurring in other countries can affect the risk faced by

firms in a focal country

A government’s ability to intervene has been the traditional focus of political risk studies; we suggest a need to refocus on governments’ motivation to intervene in a complex, global economy

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ご清聴ありがとうございました !

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