Performance of foreign subsidiaries in transition economies
University of Groningen
International Economics and Business Master’s Thesis
Wim Rosier 1258273 August 2008
Supervisor: Prof. Dr. H. van Ees
ABSTRACT
Contents
Introduction 3
Literature review
Internationalization of corporate activity 6 A resource based view of MNE performance 7
Munificence 12
Institutional Context of Transition Economies 14
Research Questions 17
Methods and Data
Introduction
Trends towards globalization of production and consumption have led to an enormous increase in foreign investment in the last decades. FDI flows increased sharply from less than 13$ billion in 1970 to more than 208$ billion in 1990 and continuing to rise to almost 1400$ billion in 2000 (UNCTAD, World Investment Report 2003). This contributed to a great interest in the field of MNE performance. When firms do business overseas, ceteris paribus, they incur higher costs than when conducting the same business in their home market (Griffin and Pustay, 2005). This can be due to for instance differences in culture, legal and institutional infrastructure, language barriers, lack of knowledge of the foreign market or increased expenses of communications and operations over longer distances. To be able to overcome these increased costs firms need to be able to create higher margins abroad. To address this issue, Dunning developed the OLI paradigm. In this OLI paradigm it is assumed FDI can be explained by three factors. The ownership advantages of firms (O), containing a set of advantages belonging to who is going to produce abroad. The location factors (L) that influence where the firm is going to produce and the internalization factor (I) that explains why firms engage in FDI rather than licensing foreign firms to use their assets (Dunning, 1993; Stoian and Filippaios, 2008). In order for firms to be able to earn higher margins than its competitors and successfully engage in business overseas they need to possess certain advantages over local firms. These advantages are usually intangible and can be easily transferred within the MNE, for instance knowledge, a strong brand name, economies of scale or access to financial capital. These advantages can be used in the subsidiaries of an MNE abroad in order to offset the cost disadvantage the MNE faces compared to local firms.
When a firm possesses such competitive advantages and decides to invest abroad, the firm needs to decide where it will invest. The location advantages of a country are then used to determine which country the MNE will invest. Location advantages are for example the cost and quality of production factors, quality of infrastructure, size of the market, political stability and cultural distance from the home country.
transaction costs will lead to higher costs when dealing with local agents and establishing a subsidiary becomes a more attractive option.
While many papers have been written about setting up subsidiaries, or subsidiary strategies and subsidiary roles in the MNE, relatively few papers analyze subsidiary performance. The few papers that have addressed subsidiary performance are mostly concerned with developed countries. The majority of subsidiaries in developed countries have a long lifetime, for instance, in 1996 in the UK 52.6 percent of the foreign-owned firms already existed for more than 22 years (Griffith and Simpson, 2003). Research on subsidiary performance in transition economies is rare and the results might differ from the results on the performance in developed countries, because their country environment is different.
In transition economies, the institutional framework in the countries is unstable during the process of transition. Regulations are unclear, legal systems not fully developed and bureaucracy and corruption might be present. While stable institutions reduce uncertainty and thereby reduce transaction costs, the opposite is often true in transition countries. In addition, new potential investors lack information about the business environment and about competitors and potential partners. This creates uncertainty about the protection of property rights. These factors combined increase transaction costs for firms willing to invest in transition economies and therefore investors would prefer to internalize their transactions and establish subsidiaries as a mode of entry. Moreover, subsidiary performance may be affected. Firms lacking experience with this type of institutional environment may lack the context-specific knowledge to exploit their resources in transition economies (Dyer and Singh, 1998). Undeveloped institutions may require to be supplemented by location specific knowledge or require different ways of resource exploitation (Brouthers, Brouthers and Werner, 2008). Every institutional barrier adds costs for a foreign investor and affects its profitability. Furthermore foreign firms may face additional costs understanding firms and individuals active in an unfamiliar institutional context.
subsidiaries’ financial reports can reduce errors in these aspects. Including data of all subsidiaries in a certain industry gives a better overview of the complete business environment. This enables a more accurate comparison between the performances of all subsidiaries active in a certain industry.
The research question that I will attempt to answer is: What characteristics of the subsidiary, its parent firm and the environment affect the performance of subsidiaries in transition economies?
This thesis aims to contribute to current literature by attempting to explain subsidiary performance using empirical data of subsidiaries in a number of transition economies.
Literature Review
Internationalization of corporate activity
Traditionally multinational enterprises (MNEs) were seen as large firms that partly due to their size and experience were able to develop competitive advantages which allowed them to expand overseas (Caves, 1971). In the Uppsala model, Johanson and Vahlne, 1977, argue that firms start their internationalization process by engaging in arm’s length transactions with close markets. The concept of close markets in this context refers to cultural distance or psychic distance rather than physical closeness. Psychic distance has been defined by Johanson and Vahlne (1977) as the sum of factors preventing the flow of information from and to the market. Examples are differences in language, education, business practices, culture, and industrial development. Over time firms gain market knowledge and commitment to foreign markets which leads to international commitments in other markets and following exporting through local agents by the formation of subsidiaries. The decline in communication and transportation costs and product life cycles over the past decades have enabled firms to operate internationally cheaper. Therefore also smaller firms have been able to become active internationally. This had let to the emergence of born global firms in literature. Born global firms are smaller than the traditional MNEs and almost from the moment of their founding aim at international markets. According to some researchers the traditional view that firms have several stages of internationalizing was no longer able to explain this behavior of these born global firms (Bell, 1995; Coviello and Munro, 1995; Hashai and Almor, 2004). However even in born global firms stages of international expansion can be identified. Empirical evidence shows that these firms first tend to enter psychically close foreign markets, then enlarge their commitment in these markets and later on enter more psychically distant markets (Stray, Bridgewater and Murray, 2001; Coviello and Munro, 1997; Hashai and Almor, 2004). By going through these stages, they follow much faster, but similar paths of internationalizing as traditional MNEs do. The high speed these firms internationalize makes the concept of MNE performance increasingly relevant.
One reason is to keep resource advantages within the firm rather than transferring them to local agents. This can occur when the costs of transferring these resources are too high, for example in service industries where much of the knowledge assets of the MNE are in the form of human capital and this knowledge cannot be easily transferred. On the other hand, transferring of knowledge is also expensive when it is very easily transferred. Property rights can be hard to define so local partners might be able to replicate them and start competing with the MNE. This can be avoided by drawing up extensive contracts, but this might be more costly than starting up an own subsidiary and in transition economies contracts might be more difficult to enforce. This difficulty causes firms to prefer internalized structures for their foreign operations (Williamson, 1985; Hennart, 1986, 1991).
The uncertainty inherent to most collaborative business ventures makes it difficult or impossible to create perfect contracts that will resolve all possible future problems and conflicts (Macneil, 1980). Due to differences between laws and practices across boundaries, these problems are complicated in international collaborations (Crespy, 1986).
Wholly-owned ventures enable MNEs to keep control over their operations and the resource-based advantages involved and they thereby reduce the risk of dissipation of assets.
When an MNE deals with external agents, there are also costs involved with monitoring the behavior and performance of the employees and management of those agents. While local agents often have better knowledge about the country and market environment its goals are not always the same as those of the MNE. A local firm may not have the same incentive to uphold the reputation of the brand or product of the MNE (Navaretti and Venables, 2004). In absence of proper monitoring it might not be obvious to the MNE if a low level of sales is due to a poor market situation or difficult environment or due to low effort on the side of the agent it uses. In such situations, MNEs will more often establish wholly-owned subsidiaries.
A resource based view of MNE performance
There are two main models of firm performance, the resource-based view (RBV) and the industry view. Until the late 1980s the majority of literature on firm performance was focused on the principle that the performance of a firm was largely influenced by factors of the industry it was active in and the position the firm had in that industry. But empirical research started to show that there were greater differences in the performance of firms in the same industry than between industries (Fay, 1996). This could not be explained by the industry view and therefore the resource-based view was developed.
The resource-based view assumes that gaining and preserving competitive advantages stems from a firm’s resources and capabilities (Barney, 1991). It is assumed that firms within an industry have different sets of resources at their disposal and this heterogeneity between firms is maintained over time as resources are not perfectly mobile. Therefore firms within a single industry have different levels of growth and performance. The resource based view contrasts with the industry view, which assumes performance stems mainly from the general environment a firm operates in. Since the RBV focuses on the heterogeneity of the resources of a firm rather than the environment, it is useful to analyze the factors that affect subsidiary performance in a certain environment.
The performance of subsidiaries of multinational firms is not always the same as the performance of national firms. Relative to domestic firms, MNEs face additional costs for doing their business overseas. Therefore it is assumed they possess firm-specific advantages that they can transfer to their foreign subsidiaries to overcome these costs (Hymer, 1970,1976). International expansion is a means for an MNE to exploit their resource advantages abroad (Prahalad and Lieberthal, 1998). Foreign subsidiaries of an MNE require these resource advantages in order to successfully compete with local firms. Subsidiaries have resources that are ‘location bound’ (Rugman and Verbeke, 1992), but also resources that are not and can be used by the MNE in other countries. These resources contribute to firm-specific advantages of the MNE as a whole (Birkinshaw, Hood and Johnsson, 1998).
sustained. For instance a patent owned by a MNE can be exploited by multiple subsidiaries, to sell their product or service in foreign markets, without losing value in the home market of the MNE.
Property-based resources can only be used by one party at the same time. If used for one purpose it cannot be used for another purpose simultaneously and their use is finite. An example of this is financial resources. A firm using financial resources to start a new production plant will not be able to reuse these same financial resources for another purpose.
The transfer of technology, managerial skills and property-based resources from the MNE can improve the performance and efficiency of local subsidiaries due to this technology and skills being provided to this subsidiary by the MNE. As previously mentioned, this set of technology and skills are part of the knowledge-based resources a MNE possesses and these resources can generate advantages in the home country of the MNE that can be exploited overseas. These knowledge-based resources consist of two types, technological and marketing resources both of which have an effect on the operations and performance of a firm (Kim and Hwang, 1992; Erramilli, Agarwal and Kim, 1997; Kotabe, Srinivasan and Aulakh, 2002; Song, Droge, Hanvanich and Calantone, 2005). Technological resources are assets that can be used to develop new products, improve products or improve the production process used to create these products (Moorman and Slotegraaf, 1999; Silverman, 1999). Since technological resources are knowledge-based resources, they can be used continuously and do not diminish in value. Such resources therefore give firms incentives to expand internationally with the purpose to put these resources to use in foreign locations (Buckley and Casson, 1976). Empirical studies show that firms with high levels of technology have more multinational activities than low technology firms (Jones, 1999; Crick and Jones, 2000). Because transition economies are characterized as being uncertain and rapidly developing, the lifespan of property based resources may be hard to predict (Yang, Yiyun and Zafar, 2007). Knowledge-based resources can help firms adapt to this changing environment and if necessary develop new products (Mahoney and Pandian, 1992). Therefore knowledge-based resources could be more relevant than property-based resources in explaining firm performance in transition economies. Therefore the effects of this knowledge on the performance of subsidiaries will be tested later on in this thesis.
subsidiaries. Additionally the growth of global communications over the past decades leads to spillover effects across borders, in marketing areas such as brand reputation.
One type of property-based resources necessary for international expansion is financial resources (Doukas and Lang, 2003). These finances can be raised internally or externally. A MNE can use profits to start or expand a subsidiary, thereby providing the subsidiary with financial resources, giving it advantages over local firms who might not be able to raise money as easily. Receiving external funding is also easier for a large MNE than a small local firm. Since there is less risk of a large firm defaulting on its debt, banks are more willing to hand out loans to large international corporations than to small independent firms. This is especially true in the case of this thesis as during and after the transition from a planned to a market economy it was more difficult to gather funds for new investments than it was in developed countries. Because capital markets were underdeveloped during the moment of their transition foreign subsidiaries had much more capital at their disposal than local firms and were able to make larger investments. Therefore a subsidiary of a larger MNE has advantages over a small independent firm raising capital for its investments.
a firm to collect market-specific knowledge (Carlson, 1975). This difference between markets is commonly referred to as the psychic distance (Vahlne and Wiedersheim, 1973).
Carlsson, Nordegren and Sjoholm, 2004 found that subsidiaries from Scandinavian firms with experience in Hong Kong, Singapore and Taiwan performed better in the Chinese market than firms without such experience. Therefore it is also expected that a firm already active in other CEE markets has less difficulty gaining market-specific knowledge of another CEE market, than a firm who has not been active in a similar market and will perform better (Vermeulen and Barkema, 2001). The effects of host county and general experience will both be tested in this thesis to test these assumptions.
As stated in the introduction, there are additional costs involved when conducting business overseas. The above mentioned resources provide an MNE with advantages that enable them to successfully compete with local firms. While larger firms are likely to possess more of such resource and knowledge advantages, firm size has additional effects that need to be included when looking to compare the performance of subsidiaries.
To include the effects of firm size it is necessary to look at the effects of economies of scale and scope. While larger firms already have more resources at their disposal, these aforementioned effects magnify these advantages.
Economies of scale refers to the decline of the average costs as the production increases. The effects of this can occur in any department of a firm such as production, R&D, financing, distribution and marketing. Larger firms can benefit from these advantages and therefore larger firms are expected to perform better on average.
Munificence
One of the reasons for firms to invest abroad is to exploit their competitive advantages in another market. Often this is not sufficient to create sustainable competitive advantages abroad however. The incorporation of location-specific advantages (differences in factor costs between countries) as used in Dunning’s transaction cost theory increases the ability to explain the success of international operations.
Environmental munificence refers to abundance or scarcity of resources needed by firms in an environment (Staw and Szwajkowski, 1975; Dess and Beard, 1984; Castrogiovanni, 1991; Wan and Hoskisson, 2003) and has been shown in empirical studies to impact firm performance (Beard and Dess, 1981; Brouthers et al., 2008). This munificence differs between countries, meaning different opportunities and threats are present in a country’s environment and a firm has to deal with this accordingly. Opportunities are for instance production factors necessary in a firm’s production process, but also refer to the development of institutions or quality of infrastructure. A munificent environment is rich with production factors and has well developed institutions. Such an environment is more attractive for MNEs who will look for markets where their technological advantages can best be used and a munificent environment has been shows to increase firm performance (Randolph and Dess, 1984). On the other hand a country with low munificence has scarce resources and firms active in such an environment will have to pay higher costs for these resources.
The performance of MNEs and its subsidiaries is therefore also dependent on this munificence of the countries they are active in.
firm. Differences in factor costs, corporate culture, the competitive environment and demand conditions cause firms to follow different strategies abroad.
When an MNE is looking to exploit technological or resource advantages abroad, they will choose a country where their technology or resources can be exploited best. Dunning describes this as location-specific advantages. To most effectively exploit technological advantages, certain location advantages may need to be present, for instance abundance of production factors, distribution channels, the quality of the legal system and infrastructure, etc (Chen, 2005).
But also when the home country of an MNE has a low abundance of resources they may gain resource advantages by starting a subsidiary in a country where resources are abundant. This enables the MNE to gain resource advantages not only in its home country, but also among established subsidiaries in other countries. Hereby MNEs look for opportunities across all environments they are active in (de Jong, Binh and van Ees, 2008).
A high quality infrastructure reduces firms’ costs of obtaining inputs for their production process and reduces their costs of shipping the final product to its customers. Additionally, high quality infrastructure enables firms to more efficiently communicate and transport between different business units of its own corporation. Infrastructure has been proven to affect firm performance in various empirical studies, such as (Mody and Srinivasan, 1998). While a MNE can provide subsidiaries with financing from internal capital markets, if available MNEs will likely use local capital markets for funding of investments in order to reduce capital costs. Using local capital markets enables the subsidiary to use tax deductions on interest expenses and hedge again currency risk (Feldstein, 1994). Therefore a country with high quality financial markets will likely attract more multinational activity and have a positive effect on the performance of subsidiaries active in that country. Makino, Isobe and Chan, 2004, showed empirically that host country effects tend to be more critical than home country effects in explaining variance in subsidiary performance in developing countries.
1990). For example a strong law enforcement system can serve to protect competitive advantages of MNEs such as copyrights and patents. Shleifer (1997), Kaufmann (1997) and Frye and Shleifer (1997) found that in transition economies a weak legal system holds back the private sector. MNEs will not invest in transition economies unless there is reasonable security for their investments. Johnson, McMillan and Woodruff (2000) argue that the main cause of divergence in Central and Eastern Europe are caused by the difference in the protection of property rights.
However the similarity between institutions between the home country of a MNE and the host country of a subsidiary are relevant as well. The more similar the institutions of the MNE’s home country are to the host country, the less foreign the host country is for that MNE (Zaheer and Mosakowski, 1997), which will facilitate operations.
If such location advantages are present technological advantages developed by the MNE can be better exploited by the subsidiary and resource advantages can be more easily distributed. Since the relevance of country effects is theoretically and empirically proven in previous studies, I will test whether home country effects are present in the sample used in this thesis as well.
Institutional Context of Transition Economies
The fact that institutions are relevant for firm performance has long been argued, however there are two main aspects relevant specifically for transition economies. When a country follows the transition process, two main things are influencing the environment: the reallocation of resources from the state to the private sector and the restructuring of existing firms to increase their efficiency (Blanchard, 1998). Privatization and the transfer of ownership from the state to the private sector help to create a competitive market economy and the state needs to reform its institutions to support the privatization process.
very dynamic within the transition period and formal and informal institutions are constantly being modified or replaced. During central planning businesses were highly regulated, commercial banks did not exist and the countries were nearly isolated from market economies. When the countries reformed towards a market economy, new institutions emerged or existing institutions changed. Such changes in institutions led to private ownership, less government intervention, emergence of commercial banks and foreign trade (Tihanyi and Roath, 2002). In a market economy the goal of firms is to increase efficiency and maximize profit and during a transition institutions need to be established to enable such an environment.
Weak intellectual property rights deter FDI in high tech sectors, but not in lower tech sectors (Javorcik, 2004), so it is expected that foreign investment in low tech sectors was initially higher than in high tech sectors. Another market characteristic in transition economies is that due to the difficulty to raise financial and human capital, entrepreneurship is low (McMillan and Woodruff, 2002) and firms rely more on internal capital markets.
Research Questions
Continuing with the theory of the previous section, the main research question I would like to answer is:
What characteristics of the subsidiary, its parent firm and the environment affect the performance of subsidiaries in transition economies?
And the specific research questions are:
What characteristics of a subsidiary are relevant for its performance?
What characteristics of an MNE are relevant for the performance of its subsidiaries?
What characteristics of a transition economy are relevant for the performance of subsidiaries active in such an environment?
As mentioned in the literature review, there have been many empirical studies of firm productivity and performance. Howenstine and Zeile (1994) find that foreign-owned subsidiaries are more capital intensive and larger than domestic firms. One reason for this is that foreign subsidiaries are generally larger than domestic firms. The size of a firm can be an advantage because of the ability to spend high amounts on marketing the product, to enforce patents and to achieve economies of scale (Kimura, 1989). The size of a firm enables it to bear these costs. Large firms can also possess advantages of greater risk-bearing capacity, produce differentiated products, brand names and have price-setting power (Siddharthan, 2004).
Recent studies such as (Vaona and Pianta, 2008), found that large firms perform better than medium and small sized firms in both product and process innovation. And innovation is positively associated with firm performance (Thornhill, 2006; Van Leeuwen and Klomp, 2006).
than smaller firms, because they can be better prepared for the environment, especially in terms of facing competition. Therefore the first hypothesis states:
H1: The size of the subsidiary has a positive effect on the subsidiary performance.
A subsidiary can not only gain advantages from its own size, but also from the size of its owner. A subsidiary backed by a large multinational can receive resources, such as financial support from its owner through internal capital markets and its owner can possess intangible assets which can give the subsidiary competitive advantages. In transition economies especially internal capital markets can be important due to underdeveloped external capital markets in the environment. Large firms can also share the previously mentioned size advantages, such as the ability to spend high amounts on marketing the product, the ability to enforce patents, to spend higher amounts on research and development, economies of scale, greater risk-bearing capacity, brand names etc with their subsidiaries. Among MNEs, larger firm size facilitates risky geographical expansion (Paul and Wooster, 2008), therefore larger MNEs are more likely to invest in unstable environments such as transition economies. MNE size has been shown to have a positive effect on subsidiary performance in various studies such as Brouthers, et al., 2008; Fang, et al., 2007.
This leads to the second hypothesis:
H2: The size of the MNE has a positive effect on the subsidiary performance.
Intangible assets are more often than tangible assets able to lead to a competitive advantage. Intangible assets such as knowledge enable the subsidiary to increase labor productivity, which in turn leads to higher performance.
knowledge-based resources in this new market (Delios and Beamish, 2001). These resources in turn provide the subsidiary with competitive advantages in the host country. Empirical studies also confirm that transfer of intangible assets, such as knowledge between a MNEs parent and its foreign subsidiaries contributes to the performance of the subsidiary (Nakamura and Nakamura, 2004). Assuming MNEs would like their subsidiaries to perform at the best of their capabilities and since in the case of wholly owned subsidiaries the risk of knowledge dissipation is negligible it is believed MNEs that possess a larger amount of knowledge can share a larger amount of knowledge with their subsidiaries. However there is empirical evidence that in transition economies firms with firm-specific intangible assets are more likely to delay their investment until a later stage of the transition process until institutions are further developed and their investments are better protected ((Paul and Wooster, 2006; Czarnitzki and Kraft, 2006). Firms with intangible assets that have already decided to invest however are expected to be able to gain advantages from these assets, therefore:
H3: The amount of knowledge of the MNE has a positive effect on the performance of the subsidiary.
While knowledge-based resources are an advantage for subsidiaries of MNEs, lack of knowledge about the local cultural, political and economical institutions is a disadvantage. Organizational capacity is a source of competitive advantage and a firm’s experience in the host country will help develop the required knowledge. More effect, less costly solutions to problems might be achieved from the experience of previous subsidiaries. The importance of a firm’s international experience on their foreign operations was recognized in theory in 1977 by Johanson and Vahlne in their Uppsala model. They thought of international expansion as an incremental process where firms face uncertainty when entering a new market and have to acquire the knowledge required to cope with this uncertainty by gaining experience abroad. Lack of experience increases unfamiliarity and causes relational hazards (Gaur and Lu, 2007). Host country experience enhances the ability of managers to scan, process and analyze information about new investment countries and enables them to cope with uncertainty, different economic, political and legal systems, as well as cultural distance (Siripaisalpipat and Hoshino, 2000), thereby reducing transaction costs.
Experience also reduces the uncertainty associated with assessing the probably economic worth of entering a foreign market (Barkema and Vermeulen, 1998). This would lead to more successful subsidiaries of firms who gained more international experience. Secondly the cost of business abroad varies from country to country and understanding what activities can overcome these costs increases with market experience. MNEs with greater international presence are likely to have a superior position in selecting market segments, differentiating product offerings, accessing promotion channels, and building up corporate and product image (Mitchell, Shaver, and Yeung, 1992; Yadong and Peng, 1999). Expansion into transition economies that are characterized by a high degree of institutional uncertainty is more difficult and requires more organizational learning than expansion into developed economies (Peng and Luo, 2000). Since experience is the primary source of learning in organizations (Barkema and Vermeulen, 1998), international experience can enable MNEs to cope better with the uncertainty in the environment of transition economies. Based on this explanation it is expected that:
H4: The amount of international experience of the MNE has a positive effect on the performance of the subsidiary.
Therefore it is expected that:
H5: The amount of host country experience of the MNE has a positive effect on the performance of the subsidiary.
As mentioned in the literature review, there are several country specific aspects that have an effect on the performance of a subsidiary. Firms can create advantages in their home country that can be exploited overseas. This can be especially relevant in a transition setting. Since the environment in a transition country is very different from that of a developed country, the MNEs that come from that more munificent environment can draw advantages from their home country environment. Developed countries have more developed financial institutions which lead to cheaper financing for MNEs. Secondly well-trained managers are hard to find in transition economies, so a MNE can draw these skills from its home country.
Another aspect of the home country that can have an effect on the performance of its subsidiaries is the psychic distance between the home and host country of the subsidiary. The more similarity between institutions between the home country of a MNE and the host country of its subsidiary, the less foreign the host country is for that MNE (Zaheer and Mosakowski, 1997), which will facilitate operations.
H6: The home country the MNE is located in is relevant for the performance of its subsidiaries.
TABLE 1
High and low technology classification
High and medium high technology sectors Low and medium-low technology sectors
Aerospace Rubber and plastic
Computers, office machinery Shipbuilding
Electronics-communications Other manufacturing
Pharmaceuticals Non-ferrous metals
Scientific instruments Non-metallic mineral products
Motor vehicles Fabricated metal products
Electrical machinery Petroleum refining
Chemicals Ferrous metals
Other transport equipment Paper printing Non-electrical machinery Textile and clothing
Food, beverages, and tobacco Wood and furniture
Sources: OECD
Following OECD classifications, we consider the items in the left column as high tech and the items in the right column as low tech as shown in Table 1.
Hypotheses 4 and 5 are related to each other, but the reason to test both is that the expectations are slightly different and to find out if the effects of general international experience and host country experience overlap or have different results and therefore they are also tested separately.
Methods and Data Sample
The main source of data used in this thesis is Amadeus, a database containing financial information about European companies published by Bureau van Dijk. This database contains information about firm ownership, firm’s subsidiaries, employment, assets, operating revenue and the sector it is active in. Since our research tests the performance in transition economies I created a dataset of Western European firms that own subsidiaries in Central and Eastern European countries.
regional integration in Central and Eastern Europe (UNCTAD, 2000) and were and still are the major recipients of foreign investment in Central and Eastern Europe.
Their transition paths have been similar in speed of development of institutions. Around the time of the collapse of the Soviet Union many papers were published about the best way this transformation could be accomplished. At approximately the same time, between 1986 and 2000, the flows of foreign direct investment grew enormously (Navaretti and Venables, 2004). FDI was seen as one of the main solutions to quickly increase development levels in the countries of Eastern Europe. One of the papers written in that time was The Process of Socialist Economic Transformation (Fischer and Gelb, 1991). The authors argued that besides several initial conditions necessary for the reform process, “opening the economy to foreign trade is the best way of ensuring a rational price system”. FDI was supposed to play a crucial role in the economic development of these transition economies and, considering the initial conditions of institutional development and macroeconomic stabilization (Grogan and Moers, 2001) were met, foreign investments would eventually lead to a level of development similar to that of Western Europe. These views led to an enormous increase of foreign investment in the area. Since serious foreign investment in this area started only around 1989-1990, all foreign investment data is recent and this makes it an interesting area to research the performance of foreign subsidiaries. Initially the majority of investment was attracted based on low wage rates and other resources. Currently, since the Czech Republic, Poland and Hungary were all admitted to the European Union in 2004 and there are still relatively low wages, foreign investment is still strong. Many firms have established subsidiaries over the past years and the countries are an interesting location for firms willing to produce for the European market. These circumstances made the manufacturing sector the sector most penetrated by foreign investors and therefore that is the sector this research will focus on. The sample consists of 546 subsidiaries of MNEs located in Western Europe. The dataset was created in Amadeus by selecting all firms in Poland, Hungary and the Czech Republic then selecting only those in the manufacturing sector in the country and filtering out all domestically owned firms. I then created a table with firm names, employees and revenue of the subsidiary from 2005.
Then this data was exported and I looked up who the owners of these subsidiaries were, meanwhile filtering out those owned by private individuals.
TABLE 2 Sample distribution Sample size Average number employees firm Average number employees owner Average number subsidiaries owner Average intangible assets owner in thousand Euros Poland 282 534 57242 288 2388025 Hungary 96 482 38065 125 1742240 Czech Republic 168 606 67603 353 2190693 Total 546 547 57125 279 2213763 Source: Amadeus
Table 2 shows the distribution of the sample for Poland, Hungary and the Czech Republic separately and for the combined sample.
Definition of variables Dependent variable
Following literature, specifically Andersson, Forsgren and Pedersen, 2001, I chose the sales volume (revenue) as a measure of subsidiary performance. “Because firms are reluctant to provide information about their transfer pricing practices, tax considerations and other financial transactions inside the MNC, the traditional financial measures seem even more questionable and inappropriate when it comes to subsidiary performance. Instead, measures such as sales volume and market share expansion seem more appropriate as measures of the market performance.”
Independent variables
For the size of the subsidiary I use the number of employees who work at that specific subsidiary. This is a common measure used in research of a similar type and used in empirical papers such as in Fang et al., 2007 and in Vachani, 2005. The figures for the number of employees are found in the Amadeus database.
As a proxy to measure the MNE’s knowledge I use the stock of intangible assets as reported in the company’s balance sheets. Following Liu et al., 2000, I assume intangible assets to be a “proxy for the stock of knowledge they (the firm) accumulate over time through R&D investments”. The data used in this research is taken from the Amadeus database.
For the international experience variable, I use the total number of subsidiaries owned by the MNE. This measure is also used in for example Fey et al, 2007. A more common method is the number of years the MNE is active in international operations, however due to data availability I used the former method.
For the variable host country experience, similarly as for international experience, I use the number of subsidiaries owned by the MNE in the country of the subsidiary. A more common way to operationalize this variable is to use the number of years the firm has been active in the host country, but due to data availability reasons I used the total number of subsidiaries the MNE owns in the host country.
Since the dataset only consists of subsidiaries in the manufacturing sector and all the owners of these subsidiaries are located in Western Europe it is controlled for many industry and country effects. I will include dummy variables for the country of the subsidiary to investigate whether or not there are any country effects that have an effect on performance in order to test the sixth hypothesis.
Methods
To measure the effects of our variables on firm performance we will perform a linear regression with as independent variable our measure for performance and as dependent variables:
Ps = β0 + β1*Ss + β2*Si + β3*Ai + β4*XIi + β5*XHi + β6*COUNTRYi + β7*HITECH + ε
TABLE 3 Variables Variables Definition
Independent
Ps The sales revenue of subsidiary s Dependent
Ss The size of the subsidiary s
Si The size of the MNE that owns subsidiary s
Ai The stock of intangible assets of the MNE of subsidiary s XIi The international experience of the MNE that owns subsidiary s XHi The host country experience of the MNE that owns subsidiary s COUNTRY A set of dummy variables for the host country of the subsidiary (for
example value is 1 if the subsidiary is located in Poland, and the value is 0 if it is not)
HITECH A dummy variable, which takes the value 1 if the company is located in a high or medium-high technology sector, and the value 0 if it is located in a medium-low or low technology sector.
To estimate the model above ordinary least squares (OLS) is used. A level of significance (α) of 0.05 will be used since this is the most common level used in similar research. The correlation between the independent variables will be calculated and if needed changes to the regression will be made. For the regression calculations Eviews will be used.
When using a simple linear regression model, there are a number of assumptions being made. Ps = β0 + β1*Ss + β2*Si + β3*Ai + β4*XIi + β5*XHi + ε
The second assumption is that we assume that the independent variables explain the dependent variable. This means that β0, β1, etc are constants and for all values of the independent variable the expected value of the dependent variable can be explained by the above equation. This assumption holds because the independent variables in our model are expected to explain Ps.
The third assumption is that all explanatory variables are uncorrelated with the error term. This holds because we assume that the variance of the random error is equal to the variance of the dependent variable, since β0, β1, etc are constants and Ps and ε differ only by constants that have no effect on the variance.
The fourth assumption is that the values of ε are uncorrelated with each other. Since the value of ε for a certain value of one of the independent variables, is not related to the value of ε for any other value of the independent variables, neither is the value of Ps for a certain value of the independent variables related to the value of Ps for any other value of the independent variables. This means that there is no serial correlation or autocorrelation present. We do not however deal with a time series and we assume that the values of the error term are uncorrelated.
The fifth assumption is that the independent variables are not random and the error term has a constant variance, so no heteroscedasticity is present.
Under the above assumptions, the estimators b0, b1, etc of the slope parameters β0, β1, etc have the smallest variance of all linear and unbiased estimators of β0, β1, etc. They are the so-called best linear unbiased estimators.
There is a final assumption, and that is that the values of ε are normally distributed, because Ps is a linear function of ε and Ps is a normally distributed variable.
When we look at the histograms of the variables of our model (Appendix A), it shows that they do not appear to be normally distributed. However they do not appear to be random, so the fifth assumption holds. The log of the variable can be used to reduce the outliers (Appendix B), however they do not becomes normally distributed.
The histogram of the residuals (Appendix C) shows the variance of the dependent variable, since β0, β1, etc are constants and Ps and ε differ only by constant that have no effect on the variance. The residual graph (Appendix C) shows some outliers, but no clear presence of autocorrelation.
The Durbin-Watson statistic is 1.774877. T = 546, K = 5. The values are dLc =1.613 and dUc = 1.736. Since d > dUc there is statistical evidence that the error terms are not positively
autocorrelated and the fourth assumption of OLS holds.
TABLE 4
White heteroscedasticity test
Variable Coefficient t-Statistic Probability
C -6.54E+10 -1.808949 0.0710
EMP 1.77E+08 49404828 0.0004
EMP^2 19704.67 5097.294 0.0001
SIZE -506833.2 1185683. 0.6692
SIZE^2 4.549931 3.294004 0.1678
SUBS 1.58E+08 2.67E+08 0.5536
SUBS^2 -264109.2 157103.5 0.0933
R-squared 0.324530 F-statistic 43.00030
Durbin-Watson stat
2.069076 Prob(F-statistic) 0.000000
Finally I will test for correlation between the dependent variables (Table 5) TABLE 5 Correlations Ss Si Ai XIi XHi Ss 1 0.352 0.205 0.217 0.199 Si 0.352 1 0.851 0.654 0.508 Ai 0.205 0.851 1 0.744 0.496 XIi 0.217 0.654 0.744 1 0.300 XHi 0.199 0.508 0.496 0.300 1
This shows that there is correlation between some of the dependent variables, specifically between the size of the MNE and its intangible assets, but I do not believe it to have a significant effect on the conclusions that will be drawn from the results of this research.
The expected results as explained in the hypothesis section are summarized in table 6. TABLE 6
Expected Results
Variable Expected Sign
Positive Positive Positive Positive Positive Positive/Negative Ss is the size of firm i
Si is the size of the MNE that owns firm i
Ai is the stock of intangible assets of the MNE that owns firm i XIi is the international experience of the MNE that owns firm i XHi is the host country experience of the MNE that owns firm i COUNTRY
Results
TABLE 7
Results from tests of predictions for the full sample of subsidiaries Dependent Variable: Ps
Method: Least Squares
Variable Coefficient t-Statistic Probability
C -59210.18 13952.91 0.0000 Ss 326.6295 11.85450 0.0000 Si 0.522393 0.228545 0.0227 Ai 0.001339 0.002610 0.6082 XIi -138.7143 55.65002 0.0130 XHi 941.2952 1972.945 0.6335 R-squared 0.644544 F-statistic 192.9339 Durbin-Watson stat 1.789564 Prob(F-statistic) 0.000000
The intangible assets and the host country variable are not significant at the 5% level (Table 7) and therefore we remove it from our regression, leading to the results from Table 8.
TABLE 8
Significant results from tests of predictions for the full sample of subsidiaries Dependent Variable: Ps
Method: Least Squares
Variable Coefficient t-Statistic Probability
C -56892.52 13296.25 0.0000 Ss 327.4407 11.64925 0.0000 Si 0.545502 0.219891 0.0134 XIi -122.7767 47.05238 0.0093 R-squared 0.644544 F-statistic 192.9339 Durbin-Watson stat 1.789564 Prob(F-statistic) 0.000000
In line with our expectations both the size of the MNE and the size of the subsidiary have a significant effect on the performance of subsidiaries in our dataset. The majority of the performance difference is explained by the size of the subsidiary itself. The number of subsidiaries the MNE owns has a significant negative effect on the performance of subsidiaries it owns.
TABLE 9
Results from tests of the host country dummy variables on performance Variable Coefficient Std. Error Prob.
DUMMYHU 5865.793 27964.45 0.8339 DUMMYCZ -18950.29 22802.46 0.4063 DUMMYPL 12580.99 20857.75 0.5466
When each dummy variable is tested separately in the regression model (if the subsidiary is from the country in question the value of the dummy variable is 1, otherwise 0), there is no evidence that the host country of the subsidiary in this case has any significant effect on its performance. This is in line with our expectations, because the countries are similar and MNEs invest in these countries often for the same reasons. Therefore there is no reason to expect significant performance differences between subsidiaries located in each country. It is also possible the number of data entries for each country is too small (for instance 96
subsidiaries located in Hungary) for a significant effect to be noticeable. TABLE 10
Results from tests of the home country dummy variables on performance Variable Coefficient Std. Error Prob.
GERMANY 1866.244 25132.51 0.9402 FRANCE -18376.46 27285.27 0.5009
When testing home country dummies separately in the regression, similarly as with the host country dummies, there is also no significant effect of the home country of the MNE on the performance of its subsidiaries. While the theory of munificence expects different home countries of MNEs to lead to differences in performance of their subsidiaries I find no evidence for this. This can be due to the fact that the countries in this dataset are all Western European and the differences between them are too small to have a significant effect on performance.
TABLE 11
Results from tests of the high tech dummy variable on performance Variable Coefficient Std. Error t-Statistic Prob.
HITECH -15914.06 22372.71 -0.711316 0.4772
subsidiary active in a high-tech or in a low-tech sector. This is not what I expected, since in most similar research high-tech firms perform better. My results might be due to the transition environment, where the assets of high-tech firms are not as well protected and therefore MNEs are less willing to supply their subsidiaries with assets that are at risk of dissipation. When the relationship between the stock of intangible assets and the HITECH dummy is tested (Table 12), it shows that there is a positive and significant relationship. So companies with subsidiaries located in a high or medium-high technology sector have a significantly higher stock of intangible assets, however R squared is almost 0 and this relationship does not directly translate to a significant performance difference.
TABLE 12
Results from tests of the high tech dummy variable on intangible assets Dependent Variable: Assets
Method: Least Squares
Variable Coefficient t-Statistic Probability
C 1878247. 262011.9 0.0000 HITECH 900701.1 419932.4 0.0324 R-squared 0.008447 F-statistic 4.600474 Durbin-Watson stat 2.046411 Prob(F-statistic) 0.032409
Discussion
The main research question I attempt to answer in this thesis is: “What characteristics of the subsidiary, its parent firm and the environment affect the performance of subsidiaries in transition economies?”. In line with other empirical research done in the field of subsidiary performance, size turns out to be the main variable that affects the performance of a subsidiary. While it might be logical that a firm with a higher number of employees has a higher output, there is evidence that firms with more employees are also more productive; however this cannot be significantly proven with the data used in this research. Larger subsidiaries generally have more resources at their disposal, which can provide them with competitive advantages. Furthermore, larger firms can gain economies of scale in any department of their organization such as production, R&D, financing, distribution and marketing. When a larger subsidiary adds related products to their portfolio, they can draw advantages from economies of scope. They can share or reuse the facilities (buildings, distribution channels, etc) that they created for another product for this new product. Economies of scope can also occur in marketing when a firm markets additionally products under a previously created brand.
Another variable that is proven to have a significant influence on the performance of a subsidiary is the size of the MNE that owns the subsidiary. This is in line with previous research, such as Brouthers, et al., 2008 and Fang, et al., 2007. The influence of the MNE size on the performance of its subsidiaries is due to the advantages larger firms have over its competitors. Large firms possess more resources, which can give subsidiaries competitive advantages in many ways such as through copyrights and patents, financial resources, marketing resources and managerial skills.
Kraft (2006) they found that R&D has a positive effect on performance in Western Germany, while it has a negative effect on firm performance in Eastern Germany. Reasons for this can be that firms that depend on advantages stemming from intangible assets, such as R&D spending, require high investments in order to get profits on their investments. These investments are risky in a transition environment and therefore firms dependent on intangible assets for their competitive advantages are reluctant to make investments in such an environment where the risk of dissipation of assets is high. Therefore the transition environment affects the willingness to entry the market and subsequently the performance of firms active in that market.
Contrary to the expectations, the more subsidiaries a MNE has, the lower the performance of the average subsidiary of such a firm. This might be due to two reasons. First it is likely that for a MNE which possesses many subsidiaries, that every of its individual subsidiaries are smaller. Since the performance of a larger subsidiary is higher than the performance of a smaller subsidiary, this might explain part of the negative sign. A second reason might be that for a firm that has many subsidiaries, its organizational structure becomes more complicated and therefore higher organizational costs become a factor. Since this research does not incorporate the organizational aspects of performance, such as management structures, more research could be done to explain the negative relationship between the number of subsidiaries an MNE possesses and the performance of its subsidiaries.
Though insignificant in this research, the sign of the host country experience is, as expected, positive, giving evidence that while having more subsidiaries is not always an advantage, having more subsidiaries in the same country does appear to lead to host country experience advantages. Firms who are active with more subsidiaries in the same host country can gain experience and knowledge about the environment faster and therefore perform better than firms with just a single subsidiary in a host country. A more extensive analysis on this subject could be done with a more extensive dataset to confirm these expectations.
TABLE 13
Summary of expected results compared to outcome of tests
Variable Expected Sign Result Positive Positive Positive Positive Positive Insignificant Positive Negative Positive Positive, Insignificant Ss is the size of firm i
Si is the size of the MNE that owns firm i
Ai is the stock of intangible assets of the MNE that owns firm i XIi is the international experience of the MNE that owns firm i XHi is the host country experience of the MNE that owns firm i
Home country dummies Positive /
Negative
Conclusion
I was able to answer some of the research questions and prove that certain factors of the subsidiary and its owner have a significant effect on the performance of a subsidiary in a transition economy, mainly through size advantages. The effect of the transition country itself is harder to prove, because there is no direct empirical comparison with developed countries, but I believe the environment to be of influence on the effects the other variables have on performance. Most notably the transition environment causes firms with high R&D (and therefore high intangible assets) not to invest or to invest less, leading to insignificance in the intangible assets variable. Secondly it leads to a situation where high tech firms are not significantly more profitable than low tech firms (the coefficient is even negative) while high tech firms are more profitable in developed economies.
The results of this paper could provide some insight in the area of subsidiary performance of Central and Eastern Europe and possibly other transition economies. It may provide policy makers in transition economies with guidelines concerning the attraction of foreign investment and could have policy implications concerning the height of foreign investment incentives, since some subsidiaries are expected to become more successful than others. Secondly it could aid managers contemplating to establish a subsidiary in a certain area, since it could be used to give rough estimates of performance expectations and comparing their success factors with those of competing firms.
.
A limitation of the research is that it only looks at the manufacturing industry and therefore the application of this research on other sectors of the economy could still be examined. Another limitation is that this research does not include organizational variables, such as management structures, which may affect the performance of subsidiaries. Inclusion of organizational variables might be able to accept or reject the hypothesis that a too complex organizational structure causes the performance of subsidiaries of MNEs to decrease as the number of subsidiaries it owns increases.
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