Master Thesis
‘Chinese outward foreign direct investment and the
impact of divestment’
Author: Moritz Finkeldey Student Number: 1896776 Address: Deichreihe 6a 21706 Drochtersen Germany Phone Number: +316 202109080 Email: moritzfinkeldey@hotmail.com
University: University of Groningen Faculty: Faculty of Economics and Business Specialty: MSc International Business and Management
Abstract:
I explore the evolution of China’s outward foreign direct investment (FDI), which over the past few years significantly increased. Subsequently, outward FDI may result in potential divestment rates. Therefore, I identify contextual main drivers surrounding divestment decision making and their potential interrelationships. I propose a model that connects environmental conditions such as risk and uncertainties, external stakeholders and government incentives of host- countries with firm- level factors including corporate political strategy, real options, financial and strategic considerations, organizational inertia and managerial attachment, corporate governance, and sunk costs. This model proposes specific links and examines the direct and moderating effects on divestment behavior.
ACKNOWLEDGEMENTS
I would like to thank Rajiv Kozhikode for supervising and guiding me through this research.
Moritz Finkeldey
Table of Contents
1. Introduction ... 1
2. Background Literature ... 3
2.1 Evolution of Chinese FDI ... 3
2.2 Definition of divestment ... 6
2.3 Factors: ... 7
2.3.1 Firm level factors ... 8
2.3.2 Environmental conditions ... 22
3. The Model: Factors Affecting Divestment Behavior ... 30
4. Conclusion ... 32
4.1 Conclusion and discussion ... 32
4.2 Complete model ... 33
4.3 Empirical research ... 34
References ... 36
http://www.unctad.org/sections/dite_dir/docs/wir2010_anxtab_2.pdf ... 45
1 | P a g e 1. Introduction
Emerging economies increasingly have enlarged their outward foreign direct investment (FDI) to both developed and developing countries in recent years (Cheung & Qian, 2009). Foreign direct investment (FDI) is defined as ‘a cross-border investment made by a company with the purpose of obtaining a long-term equity interest in a foreign enterprise, and thereby exerting a considerable degree of influence on the operations of that enterprise’ (Benito, 1997: 1365). For example, the evolution of Chinese firms’ FDI has steadily developed from attracting inward FDI toward engaging in outward FDI from the 1980’s to present (Yeung & Liu, 2008). Particularly, the liberalization of the Chinese economy led to a steep increase in outward FDI from 2000 until today. In line with explanations of Chinese FDI, various scholars explored this field and investigated this evolution (TABLE 5).
It seems, however, that many scholars pay exclusive attention to internationalization trajectories of Chinese firms’ FDI. The majority of research focuses on the differentiation between state- owned and non- state owned firms, which emphasizes motives and reasons to engage in outward FDI. However, to the best of my knowledge, no studies currently exist that have investigated the reverse effect, namely the divestment behavior of Chinese companies to withdraw from both developed and developing countries. This study therefore addresses some major shortcomings in the literature, with regards to the question whether Chinese firms also divest and thus ‘deliberately and voluntarily reduce or eliminate actively controlled foreign subsidiaries and branches through sale or liquidation’ (Boddewyn, 1983: 1). I argue that various factors which are categorized into environmental and firm- level factors significantly may impact divestment decision making of emerging economies such as China. These aspects may influence state- owned and non- state owned companies differently due to differing objectives of outward FDI. On the one hand, state- owned companies’ motives to invest abroad might be rather related to political and strategic considerations rather than conscious profit maximization strategies (Chen & Young, 2009; Wang, 2002). On the other hand, non- state owned firms may be more motivated to pursue profit maximization strategies (Chen & Young, 2009).
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category affecting divestment behavior. Therefore, the majority of most prior studies have been devoted to (1) identifying the factors and examining their effects and (2) presenting strategies to reduce them. However, there is a distinct need for researchers to explore the moderating effect of environmental conditions on firm- level factors that determine the eventual divestment decision of emerging economies’ firms. This paper fills the gap by presenting a model that connects the moderating impact of environmental factors to the firm –level factors. In particular, I aim to explain firm- level factors such as corporate political strategies, real options, corporate governance, organizational inertia and managerial attachment, financial and strategic considerations, and sunk costs, which are moderated by risk and uncertainty, government incentives, and external stakeholders. Most of these factors have been considered in prior studies on FDI, outward FDI and divestment behavior. However, this research addresses the nature and strength of other decision-influencing factors as well, which have not specifically been considered in the field of divestment behavior. Due to this reason, I pursue an explanation of the interlinkages of these factors, which are significant in the field of increasing outward FDI of emerging economies such as China.
3 | P a g e 2. Background Literature
This chapter reviews the background of Chinese FDI. This includes the evolution from attracting FDI to outward FDI. Next, the concept of divestment is explained, exploring various prior studies on divestment. This is followed by an indication of the main drivers of divestment behavior, subdivided into firm- level and environmental conditions. These determinants are extensively discussed. Subsequently, hypotheses are proposed to what extent these factors affect divestment behavior.
2.1 Evolution of Chinese FDI
The rapid growth of key emerging economies (such as Brazil, China, Russia, and India) is reflected in the global expansion of their multinational corporations (MNCs). These countries have increased their outward FDI to both developing and developed countries over the past few years (Cheung & Qian, 2009). The Chinese government and Chinese MNCs since the late 1980s have moved away from only exporting and hence earning foreign currency or foreign inward capital. In addition, China increasingly began attracting inward investment and eventually became the world’s second largest host nation to FDI, by the mid-1990s (Wang, 2002). FDI is defined ‘as a cross-border investment made by a company with the purpose of obtaining a long term equity interest in a foreign enterprise, and thereby exerting a considerable degree of influence on the operations of that enterprise (Benito, 1997: 1365). Through this influence a
trade surplus and massive amounts of foreign exchange reserves were generated. As China has continuously liberalized its domestic economy and encourages its manufacturers to internationalize and invest overseas, capital inflows as well as outflows are generated, as markets become integrated and create opportunities for Chinese firms to increase outward investment (Yang, 2004; Brienen, 2010).
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requirements for screening and monitoring. In stage four (1999- 2002), China entered the World Trade Organization, and consequently recognized the importance of global trade and production networks. New policies and incentives were put in place in order to encourage Chinese firms to invest abroad. Last, stage five (2002- Present) displays an enormous increase in outward FDI due to new government policies and the pursued liberalization of the Chinese economy. The Chinese government has followed a strategy to create world class companies and brands. It has focused on creating incentives for outward investment; streamlining administrative procedures, including greater transparency of rules and decentralization of authority to local levels of government; easing capital controls; providing information and guidance on investment opportunities; and reducing investment risks (Yeung & Li 2008).
The liberalization of the Chinese economy furthermore has given firms an opportunity to diversify their real investment portfolios (Brienen, 2010). This outward foreign direct investment therefore targets the world economy, in both developed and developing countries (Brienen et al., 2010) in order to diversify holdings of foreign exchange reserves away from fixed income assets towards equity assets (Globermann & Shapiro, 2009). Yeung and Liu (2008), attribute Chinese outward FDI particularly to certain macroeconomic factors comprising trade surpluses, supportive policy measures and access to loans of foreign currency from state banks. Furthermore, the government established institutional investor programs, which allow Chinese citizens to invest in foreign equity markets and introduced the sovereign wealth fund, China Investment Corp., which guides and promotes outward foreign direct investment (Cheung & Qian, 2009). As table 1 presents, Chinese outward FDI increased from 0.830 Billion of US dollars in 1990 to 68 Billion of US dollars in 2010. Stage five therefore represents a significant change in outward FDI of Chinese firms.
TABLE 1
FDI outflows China (billions of US dollars); World Investment Report, 2010
Year 1990 1995 2000 2005 2010 FDI Outflows 0.830 2 0.916 12.261 68
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in addition appear to be rather rudimentary than the more matured courses of internalization. Athreye and Kapur (2009) argue that due to a lack of ownership advantages, Chinese firms’ internationalization strategies are rather through acquisition than greenfield investments. Most of this Chinese outward FDI has focused on oil and petroleum (with China National Petrol Corporation and China National Offshore Oil Corporation leading the charge), construction (China State Construction Corporation), shipping (China Shipping), telecoms (China Mobile and China Telecom), and steel (Shanghai Baosteel) (Athreye & Kapur, 2009).
Ownership of Chinese firms needs to be categorized into state, legal persons, foreign financial institutions (only for some qualified listed firms), and individual investors (Chen & Young, 2009). According to Chen and Young (2009), the government has more than 50% of the voting rights in 31.4% of the listed companies, and controls 65.9% of all non-tradable shares in 2008 (Morck, Yeung, & Zhao, 2008). Thus, regional or central governments and their associated ministries dominate corporate decision making. Moreover, as the government represents the largest shareholder of the majority of Chinese firms, ‘it has been able to establish, govern, and direct the state’s strategic orientation and the trajectories of national economic development’ (Yeung & Liu, 2008: 1). According to Chen and Young (2009), Chinese firms that are controlled by the government undertake ambitious, high profile cross border mergers and acquisitions. Non- state owned companies decide to engage in outward FDI in order to surpass home-based restrictions due to monopolistic presence of large state-owned enterprises in certain sectors and state intervention in industrial policies, or to extend competitive advantages internationally (Yeung & Liu, 2008).
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Chinese government plays an important role in the internationalization process, Wang (2002) discusses other drivers for outward FDI such as political and strategic considerations. Yeung and Liu (2008) identify economic diplomacy to be a main driver of outward FDI by many mainland transnationals that are state- owned. Chen and Young (2009) support this view and relate China’s internationalization strategies to factors including national pride and industrial policies to follow government directives rather than conscious profit maximization strategies. State- owned companies may exercise their monopolistic power without consideration of business risks and fear of failures. According to Yeung and Li (2008), they have become “too big” to fail and “too powerful” to be questioned. Due to the intensive state support of Chinese firms, outward FDI will continue to be boosted due to easier access to financial resources (Yeung & Liu, 2009). As can be seen Chinese firms, involving state- owned and non-state- owned firms increasingly engage in outward FDI.
2.2 Definition of divestment
Even though FDI stands for a long-term commitment to a foreign operation, divestments or exits, plant closure or sell offs, frequently occur either as a necessity or due to strategic alignment (Boddewyn, 1979). One finding from the broad literature on divestment is that various authors investigate divestment behavior including various drivers (Table 6, 7 & 8). For example prior research has classified divestment into various categories. Benito (1997), groups divestment as strategic decisions into three categories: (1) reallocation or concentration of productive resources at a national, regional, or global level (2) change of foreign market servicing mode, e.g. from local production to export or (3) a complete withdrawal from a host country. Hamilton and Chow (1993) on the other hand identified three main streams to classify divestment behavior: industrial organization, finance, or corporate strategy. Despite slightly different categorizations, existing theory (Hamilton & Chow, 1993; Benito, 1997) identified three categories of essential factors affecting companies’ motivation to divest: the economic and political conditions in which a foreign unit operates; the governance - or management - problems associated with foreign operations; and the strategic fit between the parent company and a foreign subsidiary.
7 | P a g e buyout (LBO) (Brauer, 2009: 345). Duhaime and Grant (1984: 301) describe corporate divestment ‘as a firm's decision to dispose of a significant portion of its assets’. According to Benito (2005) divestment is the closure or sell-off of units in foreign locations, or conversely units owned by foreign firms. Boddewyn (1979) suggests that firms follow either offensive divestment strategies because of promising opportunities elsewhere, or for defensive or planned motives. The seizure of foreign production operations should be categorized into forced or deliberate divestment (Benito, 1997). Forced divestment refers to a forced capture of a foreign business unit through actions such as nationalization, expropriation, and confiscation, in which the ownership changes (Kobrin, 1980; Akhter & Choudhry, 1993). By contrast, firms engage in deliberate divestment due to strategic considerations or financial considerations and voluntarily liquidate or sell of all active operations (Boddewyn, 1979). According to Haynes et al (2002), deliberate divestment generally occurs due to environmental changes and firm-specific circumstances affecting the optimal level of diversification across an organization’s corporate
portfolio. Belderbos (2003) identified three kinds of divestments: (1) subsidiary closure indicates that a firm liquidates the entire affiliate (2) plant closure implies that the subsidiary ceased all manufacturing activities and only remained active in import wholesaling and marketing activities while (3) production line closure implies that the subsidiary ceased manufacturing the product, however manufactures other existing or new products.
Previous literature has argued that divestment is in fact a reversal of past managerial diversifying expansions and its subsequent investments (Haynes et al., 2002). It is essential for researchers and managers to understand the reasons affecting divestment decisions- making, in order to manage firm- level as well as environmental factors to raise the likelihood of rather deliberately than forced divestment. In sum, both Hamilton and Chow’s (1993) and Benito’s (1997) models of factors affecting divestment behavior, which emphasize environmental and firm- level determinants will serve as a basis for the future discussion of factors influencing divestment behavior.
2.3 Factors:
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(Table 2). Firm- level factors either enhance or reduce a company’s probability to divest a business unit. Consequently, hypotheses are proposed to the impact of firm- level factors on divestment behavior. In a similar vein, environmental conditions directly affect divestment behavior, but at the same time either enhance or weaken the effect of firm- level factors. Thus, interrelationships with firm- level factors are established, resulting in different propositions.
TABLE 2
Effects on divestment behavior of a business unit
Firm- level factors Effect
Pro- active corporate Political Strategy Negative
Real Options Negative
Strong Corporate Governance Positive
Organizational Inertia and Managerial Attachment Negative
Financial Considerations Positive
Environmental Conditions
External Stakeholders Negative
Industry Uncertainties Positive
Uncertainties Positive
Political uncertainties Positive
Government Incentives (of competing host- countries) Positive
Macroeconomic uncertainties Negative
Government policy uncertainties Positive
Strategic considerations Positive
Sunk Costs Negative
2.3.1 Firm level factors
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considerations, and sunk costs. The concepts are explained including their relationships with divestment, which results in the proposition of the respective hypotheses.
2.3.1.1 Corporate political strategy
According to Weidenbaum (1980) corporate political strategy represents a firm’s active position toward public policy, by anticipating and incorporating future policies, regulations and prospective adjustment needs into upcoming strategies of the firm, in order to take advantage of potential business opportunities. The author further emphasizes the need for proactive behavior in order to shape policies and to achieve political objectives. By contrast, passivity and lack of direct participation in the public policy process prevents a company from shaping government policies toward their own interests. Hillman and Hitt (1999) argue that a corporate political strategy requires certain specific strategies and tactics. The authors distinguish transactional approach from the relational approach, which firms may choose to develop. Under the first approach, companies await a change of an important public policy issue before aligning a strategy in a relatively short-term exchange relationship. The latter refers to building relationships and trust between suppliers and requesters of public policy over the long-term, which eventually reduces transaction costs (Hillmnan & Keim, (1995). Nahapiet and Ghoshal (1998) additionally discuss relational approaches to political strategies and conclude that it facilitates frequent cooperative exchange and develops into social capital or intangible assets respectively (Kindleberger, 1970).
As can be seen, building relationships and trust with policy makers reduces environmental uncertainties, which results in the development of social capital or intangible assets. Due to this divestment behavior is reduced. Therefore:
H1: Proactive behavior toward political strategies negatively affects divestment behavior.
2.3.1.2 Real options
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behavior (Belderbos & Zou, 2009). Both growth and switch options enable a firm to adjust the distribution of manufacturing activities over locations under conditions of uncertainty (Belderbos & Zou, 2009). Kogut and Kulatilaka (1994) argue that investments in foreign affiliates can serve as ‘a ‘platform’ for future expansion, creating growth options that the multinational firm otherwise would not be able to obtain’ (Belderbos & Zou, 2009: 601). Timely investments in foreign subsidiaries facilitate learning effects; help build relationships with local suppliers; customers and government institutions; local responsiveness; and to overcome drawbacks of foreign environments (Belderbos & Zou, 2009; Chang, 1996; Song, 2002). This platform allows a company to quickly expand across an area if expansion opportunities arise and uncertainty is resolved. Various authors (Belderbos & Zou, 2009; Chang, 1996; Song, 2002) argue that the value of growth options of the platform investment rises with the level of uncertainty, particularly in emerging markets with higher growth potential, and greater macroeconomic and policy uncertainty. Furthermore, a growth option represents prospective additional value on top of the net present value if, for example, expansion plans can be followed due to favorable exchange rate changes. Consequently this leads to shifts in manufacturing and intra-firm imports of subsidiaries (Rangan, 1998; Trigeorgis, 1993; Vassolo et al., 2004; Belderbos & Zou, 2009). Another aspect of real options is linked to strategic considerations such as relocation of manufacturing plants in order to respond to changing cost differentials and market opportunities (Belderbos & Zou, 2009). Switch options provide firms with operational flexibility to adjust subsidiaries’ capacity to uncertain cost and market conditions, or potential expansion plans to conflicting macroeconomic developments (Belderbos & Zou, 2009; Gomes & Ramaswamy, 1999; Tang & Tikoo, 1999). This adjustment process aims to lower operational costs and increases firm value (Belderbos & Zou, 2009).
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maintain even unprofitable business units. In particular, MNEs with a portfolio of foreign business units possess growth and switch options. The corporate network in terms of investments, divestments and real option values is considered rather on a multinational portfolio level than on individual subunits. However, this implies that both growth and switch options of subsidiaries can overlap and thus become partly redundant due to interlinked uncertainty profiles, which in turn reduce the real option value of the multinational firm’s portfolio (Girotra et al., 2007; Vassolo et al., 2004). Therefore, Belderbos and Zou (2009) argue that at the host country level subsidiaries need to be distinguished between a subsidiary that effectively functions as a single platform in one country and entails the option value, and one or more subsidiaries in one country that share the responsibilities of platforms. The latter that have overlapping technological performance characteristics, possess less option value and eventually were found to be more likely divested (Vassolo et al., 2004). Furthermore, the authors conclude that uncertainty creates organizational inertia. According to Belderbos and Zou (2009: 613) organizational inertia is ‘a reluctance to divest manufacturing plants even under adverse circumstances’. Kouvelis et al. (2001), argue that organizational inertia is linked to uncertainty as initial decisions are not reversed even if environmental changes adversely affect the profitability of the strategy chosen and would call for a change in strategy. Real option theory suggests that uncertainty and a certain level of irreversibility of investments impede a firm in responding to environmental changes and therefore, create organizational inertia and real option value for platform subsidiaries (Belderbos & Zou, 2009). Hence:
H2: Real options negatively affect divestment behavior.
2.3.1.3 Corporate governance
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the board of directors and the exercise of voice by blockholders (Dalton et al., 1998; David, Hitt, & Gimeno, 2001; Shimizu & Hitt, 2005). According to the agency theory, a strong corporate governance mechanism needs to be in place in order to avoid opportunistic behavior and organizational inertia (Dalton et al., 1998; Fama & Jensen, 1983; Bergh, 1995 & 1997). According to Clark and Wringley (1997), the separation of ownership from control may enhance managers’ discretionary power and result in opportunistic behavior to follow personal goals. Strong corporate governance is predicted to take more timely action to under-performance. Management that holds equity is more incentivized to maximize profits, and can be more controlled through active shareholders (Morck et al., 1988). Similarly, Jensen (1986) and Hoskisson et al. (1994) argue that weak or inadequate corporate governance may result in the allocation of financial resources to unprofitable investments, high diversification, poor strategy formulation, and slower decision making about undesirable decisions, leading to a high leverage. It is suggested that firms subsequently must repay high interest costs, which in turn result in a higher probability for divestment, as firms are forced to sell assets to pay down debt (Haynes et al., 2002). In sum, strong corporate behavior positively affects divestment behavior of business units due to various reasons mentioned above. Therefore, the hypothesis is formulated as follows:
H3: Strong corporate governance positively affects divestment behavior.
2.3.1.4 Organizational inertia and managerial attachment
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The survival of a subsidiary depends on the provision of financial resources, technology, and markets by the parent which requires attachment and commitment throughout the company (Li, 1995). As shown by Li (1995) and Nees (1981) managerial attachment is another factor affecting divestment decision- making and displays an exit barrier for companies. Duhaime and Grant (1984) discuss exit barriers originating from personal attachment, which result in negative divestment decisions. Managerial attachment tends to lead to too much focus and commitment toward prior strategic decision, preventing a timely strategic change (Ocasio, 1997; Prahalad & Bettis, 1986; Weick, 1995; Shimizu & Hitt, 2005). It hinders managers in making divestment decisions since admitting failures could negatively affect one’s career (Dalton et al., 1998). Managerial attachment toward a business unit may ignore poor performance and consequently cause delayed response and a lower likelihood for divestment decisions as managers still might believe in an acquisition’s success (Ocasio, 1997; Prahalad & Bettis, 1986; Porter, 1987; Shimizu & Hitt, 2005). This managerial hubris impacts top management’s divestment behavior, as poor performance is overlooked and considered as a temporal snapshot and hold up (Levitt & March, 1988). By contrast, Gilmour (1973) find that at the corporate firm level, top management replacement tended to commence divestment decisions due to personal detachment from business units, which subsidiaries’ managers unlikely implement (Duhaime & Grant, 1984). To conclude, poor decision making on top management level, manager’s unwillingness to divest, bureaucracy and inflexible practices, resistance to change is generated, which prevents organizations from divesting business units. Moreover, managerial attachment is excessive commitment toward a prior strategic decision which delays decision making, prevents organizational change, ignores performance aspects, and therefore reduces the probability of divestment. Hence:
H4: Organizational inertia and managerial attachment negatively affect divestment behavior.
2.3.1.5 Financial considerations
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operations, modernizing or making new investments, increased firm- value, and high leverage. Therefore, the hypothesis is formulated:
H 5: Financial aspects positively affect divestment behavior.
2.3.1.6 Strategic considerations
According to Boddewyn (1979: 23), ‘a poor financial situation is only a necessary condition but not a sufficient one to generate divestment’. Various authors point out that divestment motives are made for reasons other than performance aspects or business failure
(Weston, 1989; Benito, 2005; Belderbos, 2003; Pennings & Sleuwaegen, 2000). However, new market opportunities can lead to divestment of existing activities, including both home-country-activities and host-country- home-country-activities, if strategic considerations appear (Berry, 2010). In addition, Boddewyn (1979) argues that financial considerations become of minor importance if there is a strategic misfit. Various authors (Benito, 1997; Harrigan, 1980; Hamilton & Chow, 1993) consider divestment from a strategic management perspective looking at theories of product life-cycle approach or corporate portfolio perspective. These theories deal with strategic choices for declining business lines and a set of assets, products, and activities that need to be assessed according to financial or strategic aspects respectively. Strategic considerations are significantly interrelated with exit costs or exit barriers. Exit decisions and exit barriers must be considered from a strategic perspective that is of high importance to the corporate entity (Harrigan, 1982). Harrigan (1981) indicated that strategic considerations deter companies to divest. In a similar vein Caves and Porter (1977), discuss intangible assets as exit barriers. A high quality image or strong corporate recognition created by previous R&D, production, or advertising expenditures may be harmed by exiting a foreign market. Additionally, a unit also might be maintained for face-saving aspects as otherwise reputation might be damaged (Boddewyn, 1979; Belderbos, 2003). Furthermore, divestment decisions may lead to a loss of goodwill and loyalty in customers or distribution channels, which could spill over to other businesses and hurt the company. The interrelatedness between units is another major aspect with regards to divestment and potentially could rather be harming if units are reliant on each other. Last, contractual obligations impede a company to withdraw (Harrigan, 1981).
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profitable operations is considered to be a crucial competitive advantage. It enhances profitability through the transfer of production to existing plants at lower costs and the option to vary capacity loadings of different plants in response to relative cost (Kogut and Kulatilaka, 1994; Belderbos, 2005; Pennings & Sleuwaegen, 2000). Particularly, geographically diversified, multinational companies that are expanding are more likely to encounter relocation pressures on their investments involving re-structuring processes (Berry, 2010; Belderbos, 2003). According to Benito (2005), strategic considerations with regards to economies of scope and local responsiveness concerns involve frequent modifications in a company’s competitive posture and in the configuration of its units spread around the world (Benito, 2005). Economies of scale are another driver for re-structuring choices (Benito, 2005). Firms are driven to achieve advantages in economies of scale through standardizing products and processes (Yip, 1989). This however requires the company to set up large manufacturing, distribution or other value activities. Increasing the scale of manufacturing operations requires investments in assets such as factory buildings and machinery (Benito, 2005). According to the efficiency-seeking motive, a re- structuring of operations is pursued in order to take advantage of cheaper input costs, to provide opportunities to reconfigure resources across geographic markets, to exploit managerial resources, and optimize performance (Berry, 2010; Haynes et al., 2002). In addition, capacity-constrained capabilities, which are restrictions on international and product market diversification, force firms to find the optimal use for resources, and also lead to considerations about relocation strategies (Levinthal & Wu, 2009).
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in addition could lead to diseconomies of scale such as higher transportation costs. More distant suppliers and markets, and more complex unit interrelatedness impede a company in managing subsidiaries (Benito, 2005).
Maksimovic and Phillips (2001) suggest that industry influences can impact both diversification and divestment decisions. Performance is significantly influenced by focusing on core activities (Helfat & Raubitschek, 2000). Predominantly declining and mature markets are characterized by firm exits that seek new market opportunities through diversification (Levinthal & Wu, 2009). Similarly, several studies identify industry profitability and performance to affect firm diversification (Rumelt, 1982; Chang, 1992; Lang & Stulz, 1994; Delios & Beamish, 1999).
As stated by Li (1995), product diversification between the subsidiary and parent MNC determines the probability of divestment. As Caves (1982: 335) suggests, ‘the more remote the business of the new subsidiary from the core product areas of the parent activities, the greater is the uncertainty involved’. Additionally, parent MNC’s managers more likely tend to divest subsidiaries, the more the company is diversified due to geographical and emotional distance (Wright & Thompson, 1987). The authors find that diversification leads to firm withdrawal due to various reasons including failing to achieve economies of scale and scope, firms’ exposure to unfamiliarity, difficulties in building inter-firm linkages, or increasing transaction costs. In addition, high levels of product diversification can also lead to a lack of internal control systems that prevent a firm from effectively managing a diversified corporate portfolio (Bergh, 1997; Haynes et al., 2002). Higher levels of diversification imply weak corporate governance, which impedes a firm to efficiently manage subunits (Haynes et al., 2002). Boddewyn (1979) argues that integrating subsidiaries may cause difficulties due to a company’s ability to cope with size and complexity, as well as poor and inexperienced staffing and supervision problems, mistakes in planning and operations, and poor coordination which negatively affect divestment behavior.
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subsidiaries. Setting up a subsidiary in a related business is facilitated if previous exports have taken place. Hence, the subsidiary may benefit from pre- existing resources and tangible assets, relations with customers, suppliers and distribution channels, which in turn reduce uncertainty (Newbound, et al., 1978). Moreover, economies of scope can be achieved through the co-specialization between activities and/or organizational entities in interdependent units. Advantages can be achieved through sharing distribution networks in the marketing of different product lines (Benito, 1997). By contrast, unrelated diversification tends to hinder a company in achieving those advantages, and consequently affects a firm’s performance negatively due to increased uncertainties of unfamiliarity with market conditions, products and technology (Li, 1995). In addition, unrelated diversification primarily benefits a company financially from augmentation in profits or cross-subsidization of businesses (Salter & Weinhold, 1979). Financial aspects such as the subsidiary’s capability to contribute to that cross-subsidization impact divestment motives to exit from of unrelated units (Dundas & Richardson, 1982). Hence, a higher risk of product diversification can be expected and as a result divestment decisions are likely to increase for unrelated foreign subsidiaries (Bane & Neubauer, 1981; Duhaime & Grant, 1984). A counterargument to this logic however is that diversification in fact may enhance a firm’s management of subsidiaries, as the company is required to build managerial capabilities (Hitt et al. 1997). Due to these side-effects of the learning and adjustments processes, divestment motives consequently arise from modification processes across the corporate portfolio. Benito (2005), states that the probability of divestment decisions decreases with the level of independency, as by contrast a higher level of interdependency results in the achievement of scope advantages, which can increase the likelihood of divestment (Benito, 2005).
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theory and resource based view suggest the expansion into new product areas and new knowledge depends on a firm’s core competencies (Helfat & Raubitschek, 2000; Berry, 2010). Berry (2010) also argues that managing previous non- core investments in related or unrelated industries may become more difficult than managing core activities (Berry, 2010). Thus, the tendency for divestment behavior rises with the level of diversification into unrelated industries, the focus on core activities, and relocation aspects. Therefore:
H 6: Strategic considerations due to a high level of diversification into unrelated industries, focusing on core activities and relocation aspects positively affect divestment behavior.
2.3.1.7 Sunk costs
Clarke and Wrigley (1997) discuss the concept of sunk costs and state that firms when entering a new market must assess opportunities as well as possibilities of losing their initial investment. The costs of divestment and sunk costs are interrelated and can be expected to be high if sunk costs arise, which cannot be recovered in case of this divestment (Belderbos, 2003; Shapiro & Khemani, 1987). Firms that decide to divest may abandon and loose its collected expertise and stock of non-saleable capital (Clarke & Wrigley, 1997). Sunk costs arise if a company decides to leave an industry, fixed investments or adjustment costs in a new plant are made and a plant closure exceeds these costs (Belderbos, 2003). According to Shapiro and Khemani (1987), sunk costs originate from investments in assets which are durable and firm- or product-specific. These investments in durable tangible specific assets discourage divestment decisions and function as exit barriers (Siegfried & Evans, 1994; Belderbos, 2003; Staw, 1981). Sunk costs create exit barriers, as investments in specific assets, both tangible and intangible assets, represent non-recoverable costs which tie firms to investments. Sunk costs are particularly high if large capital investments in machinery and buildings in the subsidiary are needed (Belderbos, 2003). Divesting a unit through the sale of both tangible and intangible assets often incur losses due to significant discount to the original value of the investments (Belderbos, 2003). Various studies (Shapiro & Khemani, 1987; Benito, 1997) discuss the relationship between investments in assets with sunk cost characteristics. These signal a credible commitment to remain in the market. Particularly industries with large plants and large firms show restricted mobility and hence an inability to divest units (Shapiro & Khemani, 1987). Hence:
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Environmental conditions include risk and uncertainty, government incentives and external stakeholders. These factors directly affect the divestment decision process, however also interact with firm- level factors and hence function as a moderator. Therefore, interrelationships between these categories of determinants are established in this section.
2.3.2.1 Risk and uncertainty
The potential relationship between environmental conditions and firms’ divestment behavior stems from previous research on firms’ motives to divest due to future economic, political, social, and cultural events. According to Benito (1997: 1368), firms engaging in FDI ‘face higher risk due to potential abrupt changes in the economic, social, and political conditions of a host country’. Sachdev (1976) mentions environmental factors such as commercial difficulties; risk and uncertainty about political and economic developments; difficulties about obtaining government licenses to operate; stronger competition from local and other foreign firms; withdrawal of government incentives; problems in obtaining foreign exchange to repatriate profits and fees to impact divestment motives. In addition, Boddewyn (1979) identified reasons such as soaring energy costs, rising nationalist mindsets, increased government controls, leftist advances, unfavorable community reactions to polluting facilities, and growing worker participation in decision making.
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TABLE 3
General Environmental Uncertainties; Miller (1992)
Political uncertainties
War Revolution Coup d'6tat
Democratic changes in government Other political turmoil
Government policy uncertainties
Fiscal and monetary reforms Price controls
Trade restrictions Nationalization Government regulation Barriers to earnings repatriation Inadequate provision of public services
Macroeconomic uncertainties
Inflation
Changes in relative prices Foreign exchange rates Interest rates Terms of trade
Social uncertainties
Changing social concerns Social unrest
Riots
Demonstrations
Small-scale terrorist movements
Natural uncertainties
Variations in rainfall Hurricanes Earthquakes Other natural disasters
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technology (Boddewyn, 1979). According to Agarwal (1980), high political risk deters FDI, and host countries respond to this by providing incentives to companies. Next, MNEs face government policy uncertainties in both home- country and host countries, which include unexpected fiscal and monetary reforms, price controls, trade barriers, threat of nationalization, changes in government regulation, barriers to earnings repatriation, and the provision of public services. For example, trade barriers impede movements or usage of assets and therefore influence firms’ divestment behavior (Benito, 1997). In order to avoid political pressure, firms consequently may divest and rather rely on foreign distributors, agents, majority partners, and licensees (Boddewyn, 1979). As stated by Oxelheim and Wihlborg (1987) macroeconomic uncertainties are movements in exchange rates, interest rates, or prices. These factors may affect prices of inputs and goods as well as providing arbitrage opportunities for firms (Miller, 1992). This reduces the probability of divestment due prospective future opportunities namely real options value (Belderbos & Zou, 2009). According to Miller (1992), social uncertainty refers to beliefs, values, and attitudes that are not represented in government policies or business practices, and result from the unpredictability of collective society’s action. Social uncertainty is characterized by social unrest, riots, demonstrations or small-scale terrorist movements.
Industry uncertainties (see table 4) involve industry dynamics such as input market uncertainty, product market uncertainty, and competitive uncertainty.
TABLE 4
Industry Uncertainties; Miller (1992)
Input market uncertainties
Quality uncertainty Shifts in market supply
Changes in the quantity used by other buyers
Product market uncertainties
Changes in consumer tastes Availability of substitute goods Scarcity of complementary goods
Competitive uncertainties
Rivalry among existing competitors New entrants
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which can be compensated by cost saving adjustments in operations such as advertising, manufacturing or distribution. Even in adverse demand conditions, firms can maintain operations if these cost advantages can be achieved (Harrigan, 1982). Firms that enjoy these advantages and expect good prospects are less likely to exit because the market still remains attractive even in a declining demand of products (Harrigan, 1981). In addition, subsidiaries that should have been divested due to poor performance are kept to avoid cash requirements from severance payments or to avoid recognizing reporting losses that would be incurred on disposal (Harrigan, 1982). However, firms which cannot absorb this declining growth and cannot benefit from cost advantages are more likely to exit (Harrigan, 1982). Further, second-movers tend to be more largely impacted by declining sales and are therefore more likely to exit. Companies introducing well-timed new technologies to a mature industry may still encounter difficulties if excess capacities arise. Therefore, excess must be balanced out with a decline in demand in order to prevent declining profitability (Harrigan, 1982).
To conclude the effects of uncertainties on divestment behavior, this paragraph discusses the relationship between general environmental uncertainty and divestment. Miller (1992) discusses organizational responses to uncertainties and concludes that divestment of the specialized assets is one possible strategy to avoid uncertainty and risk associated with operating in a given product or geographic market. By contrast Bergh and Lawless (1998), argue that increasing uncertainty leads to higher information-processing requirements and costs. This environmental uncertainty leads toward more centralization, which however results in the possibility of greater internal information asymmetries, information overload and prospective divestment of value-creating potential (Keats & Hitt, 1988). Bergh and Lawless (1998) state that environmental uncertainty more likely increases divestment behavior due poor decision- making. Nevertheless, Belderbos and Zou (2009) argue that macroeconomic uncertainty creates organizational inertia and therefore prevents companies from strategic changes and divestment of manufacturing plants even under adverse circumstances.
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H 8: The negative effect of pro- active corporate political strategies on divestment behavior is weakened by political risks and uncertainties,
Second, real options such as growth and switch options represent opportunities for taking advantage of environmental uncertainties. As mentioned earlier, the value of both the growth options of the platform investment and the flexibility of switch options increases with the level of uncertainty (Belderbos & Zou, 2009). The value of real options arises if the uncertainty of an environmental change causes a company to implement a strategic change. Therefore, option value under uncertainty states that even under- performing business units are maintained due to sunk costs as well as costly and time consuming rebuilding of market positions (Belderbos & Zou, 2009). Under these circumstances, uncertainty functions as a moderator on firms’ divestment behavior. Moreover, uncertainty is believed to create organizational inertia which in addition negatively influences divestment behavior (Belderbos & Zou, 2009). Therefore:
H 9: An increase in the general environmental uncertainty enhances the negative effect of real options on divestment behavior.
By contrast, macroeconomic uncertainties negatively affect divestment behavior. Organizational inertia is created, which impedes managers from divesting business units (Belderbos & Zou, 2009). In addition, Miller (1992) argues that real option value arises under macroeconomic uncertainty, which reduces the likelihood of divestment (Belderbos & Zou, 2009). Thus, macroeconomic uncertainties negatively affect divestment behavior. Hence, financial considerations positively affect divestment behavior however the effect is weakened by the negative impact of macroeconomic uncertainties. Therefore:
H 10: The positive likelihood of firm withdrawal arising from financial considerations is weakened by macroeconomic uncertainties, which reduces the probability of divestment.
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uncertainties such as unexpected fiscal and monetary reforms, price controls, trade barriers, threats of nationalization, changes in government regulation, barriers to earnings repatriation and the provision of public services positively affect divestment behavior (Benito, 1997). By combining the arguments for both strategic considerations and government policy uncertainties with regards to divestment behavior the following hypothesis is proposed:
H 11: The positive effect of the existence of government policy uncertainties strengthens the positive impact of strategic considerations on divestment behavior.
Competitive uncertainties positively affect divestment behavior. It becomes obvious that these unpredictable factors weaken the negative impact of organizational inertia and managerial attachment, which consequently enhances the likelihood of divestment. Hence:
H 12: Competitive uncertainties weaken the negative effect of organizational inertia and managerial attachment on divestment behavior of business units.
2.3.2.2 Government incentives
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infrastructure, certain subsidized services, market preferences, and favored treatment on foreign exchange (Gergely, 2003).
Both investment decisions and divestment decisions depend on a MNC’s strategy and motivation (pursuing resources, market, factors), size, experience, whether the investment is a new one or an expansion, and the MNCs’ country of origin (Gergely, 2003). Even though the author argues that incentives impact MNCs’ location decisions less significantly, the provision of financial incentives may still affect location decisions. As can be seen, governments provide incentives to attract FDI and divert it away from competing host countries or states and cities respectively (Gergely, 2003). Hence, diverting FDI away from competing host countries results in subsequent divestment from these host countries. Therefore, government incentives of competing host- countries positively affect divestment behavior. The negative effect of sunk costs on divestment is weakened by government incentives from a competing host country, provided that non- recoverable costs are exceeded by incentives. Hence:
H 13: The negative effect of sunk costs on firm withdrawal is weakened by government incentives from other host countries, which positively affects divestment.
2.3.2.3 External stakeholders
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However, the shortcoming of external stakeholders refers to the agency theory, which states that due to information asymmetry and decision uncertainty a lack of governance transparency exists, which displays an information risk for external stakeholders (Jensen & Meckling 1976; Eisenhardt 1989; Archambeault et al., 2008). The authors highlight the need for accurate information systems that facilitate monitoring of managers or agents, in order to assess potential performance problems. Mandatory disclosure requirements and governance disclosures (e.g., audit committee reports, reports on internal control over financial reporting) enable external stakeholders to gain more adequate information about companies (Archambeault et al., 2008). Hence:
H 14: External stakeholders weaken the positive effect of strong corporate governance on the divestment behavior of business units.
3. The Model: Factors Affecting Divestment Behavior
In the previous chapter I discussed the background of China’s evolution of outward FDI and explained the concept of divestment. Determinants of divestment behavior were categorized into firm- level and environmental factors, and accordingly defined, which led to the hypotheses on the effect of divestment behavior. In this chapter I discuss the conceptual framework’s interrelationships elements that are significantly affecting divestment behavior. Empirical results are beyond the goals of this paper, although I later discuss those issues for future research opportunities. Instead I offer a framework illustrating the firm- level factors affecting divestment behavior, and subsequently the environmental conditions that may moderate these impacts.
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affect firms’ to consider divestment. Environmental characteristics include external stakeholders, competitive uncertainties, general uncertainties, political uncertainties, government incentives, macroeconomic uncertainties, and government policy uncertainties (Table 8). Previous researchers (Benito, 1997; Hamilton & Chow, 1993) identified environmental factors however did not specify to what extent which uncertainties concretely affect divestment. Furthermore, incentives and external stakeholders additionally may affect divestment behavior, but have not yet been identified as environmental factors in divestment literature, to my best knowledge. Therefore, these specific environmental aspects have been chosen as moderators or independent variables respectively.
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First, I explore to what extent the negative effect of pro- active corporate political strategies on divestment behavior is weakened by political risks and uncertainties which increase the likelihood of divestment. Second, I discuss the effect of an increase in the general environmental uncertainty, which consequently enhances the negative effect real options on divestment behavior, and results in a significant lower probability of firm withdrawal. Third, I argue that the positive likelihood of firm withdrawal arises from financial considerations, which however is weakened by macroeconomic uncertainties, which reduces the likelihood of divestment. Fourth, the positive effect of the existence of government policy uncertainties strengthens the positive impact of strategic considerations on divestment behavior which leads to a significant probability of firm withdrawal. Fifth, competitive uncertainties weaken the effect of organizational inertia and managerial attachment on divestment behavior of business units, which consequently leads to a higher likelihood of divestment. Sixth, the negative effect of sunk costs on firm withdrawal is weakened by government incentives from other host countries, which results in a more likely divestment decision- making. Last, I discuss the relationship of external stakeholders and strong corporate governance on the divestment behavior of business units, and argue that the former weakens the positive effect of the latter, which reduces the likelihood of divestment. In sum, I suggest that environmental factors will enhance or weaken the firm- level effect of divestment behavior respectively.
4. Conclusion
4.1 Conclusion and discussion
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Different from prior studies exploring the effect of both categories individually, this research illustrates the interaction of the moderating role of environmental conditions on firm- level factors and consequently on divestment decision- making. Even though environmental conditions directly determine divestment behavior, this study focuses on the moderating role. Therefore, hypotheses have been formulated proposing interrelationships for future research. Third, I incorporated additional factors affecting firm- level factors including corporate political strategies and environmental conditions involving government incentives and external stakeholders to the determinants of divestment behavior. To my best knowledge these factors have not been discussed in previous literature. Furthermore, even though prior studies argued about the impact of risk and uncertainty on firm withdrawal, this research more extensively differentiated the various categories of these environmental conditions subdividing it into political, government policy, macroeconomic, social, natural, and industry uncertainties according to Miller (1992). Therefore, this research extends existing literature and contributes to further research on divestment behavior. My paper also displays significant managerial implications. Particularly, the role of emerging economies such as China in outward FDI and potential divestment behavior shows the significance for managers to acknowledge divestment as a necessity or due to strategic alignment (Boddewyn, 1979). Thus, it is crucial that managers understand the interrelationships between divestment and the main drivers of this decision-making process. Without recognizing the existence of, for example, organizational inertia and managerial attachment companies may not consider possible divestment strategies.
While the conceptual model contributes significantly to existing divestment theories, some of the following limitations can be addressed in future studies.
4.2 Complete model
A more comprehensive model is necessary for future research, which includes a complete set of both firm- level and environmental factors. Although the model does not reflect a complete set of factors that may affect divestment behavior, it serves as an inspiration for divestment
researchers to more accurately explore the effects of various firm- level factors, and the
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explain how those affect divestment behavior. I only focus on a set of seven firm- level factors and seven environmental factors. For example, the general environmental uncertainties involve also natural and social uncertainties, which have not been discussed in this paper. Supplementary firm- level factors involve entry modes, firm age and size, experience and learning, culture, labor relations, new market opportunities, R&D intensity, and local responsiveness (Benito, 1997; Berry, 2010, Clark and Wrigley, 1997; Li, 1995; Belderbos, 2003; Shimizu & Hitt, 2005). Therefore, additional determinants may contribute to an extended explanation of divestment behavior. Second, taking into account the complete set of emerging countries such Brazil, China, Russia, and India will again lead to a more representative sample of emerging economies
engaging in outward FDI, possibly confronted with the necessities or strategic considerations to divest business units due to both firm- level and environmental factors. Third, I expect that the extent to which the determinants of divestment behavior will vary for both state owned and non- state owned Chinese companies in developed and developing countries. Due to this nature of ownership differences, firms may respond differently in their divestment decision- making strategies. For example, state- owned firms’ divestment behavior may not be affected by financial considerations in the same way non state- owned companies are. Furthermore, even though political uncertainty may be higher in developing countries, state -owned companies may be more willing to invest and maintain investments due to strategic considerations different to those of non- state owned companies. Next, environmental conditions may also directly affect divestment behavior and hence function as independent variables. Therefore, the impact of firm- level and environmental conditions on divestment decisions making has to be investigated individually, as well as the moderating role of environmental conditions on firm- level factors and their interrelationships with regards to divestment at the same time. Last but not least, developing a complete model involves the incorporation of empirically- developed evidence on Chinese firms’ divestment behavior, which would be of great value.
4.3 Empirical research
I expect future research to attempt to connect the proposed hypotheses to potential empirical variables. Empirical evidence of the propositions has to be collected through the
operationalization of prior studies. First, it must be acknowledged that this requires a
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term interval (Benito, 1997). Benito (1997) provides guidance on how to operationalize research on divestment behavior. The author, first analyzed secondary data such as annual reports on FDI, and followed this up a decade later to indicate potential divestment. Next, various authors
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