Supervisor Prof dr A. M. Sorge
Co-assessor Dr D. Dikova
Student S.C. Koopmans (1437232)
International Economics and Business (SID) University of Groningen
July 2007
ABSTRACT
Analysing the environment of Estonia, Latvia, and Lithuania, this paper argues that the process of change from a centrally planned system to a market economy leads to high transaction cost for firms. In this thesis, a model of foreign entry mode choice is tested (how firms decide between shared ownership and wholly owned subsidiary) which includes technological, institutional, and cultural variables. Using a sample of multinationals (MNE) entering the Baltic States, transaction cost theory is applied to investigate the influence of these variables on the entry mode choice. We test if firm’s technological intensity, institutional development and cultural distance determine entry mode choices. Additionally, possible interaction effects of institutional development and cultural distance on technological intensive firms are empirically tested. In the context of transition economies, the results correctly predict hypothesis one, technological intensive firms would rather enter the Baltic States with a wholly owned (WO) subsidairy. The model shows support for a hypothesized positive relationship between institutional development and the likelihood of establishing a WO subsidiary, and thus rejects hypothesis two stating that in more institutionally advanced countries, shared ownership modes would be preferred. Thus, the paper provides evidence to support using transaction cost theory variables which predict firm’s choices between shared ownership and wholly owned subsidiary .
Key words: transaction cost theory, foreign entry mode choice, technological intensity, institutional development, cultural distance.
CONTENTS
Introduction... 4
A focus on the Baltic States... 5
Theory... 10
Hypotheses... 12
Technological intensity... 12
Institutional Development... 13
Cultural Distance... 14
Institutional Development and Technological intensity... 16
Cultural Distance and Technological intensity ... 16
Methodology... 18
Measures...18
Data Analysis...22
Results... 23
Conclusion...25
Appendix... 28
References... 30
INTRODUCTION
Until 1989, the countries of the Soviet bloc traded primarily in autarky from the world economy.
The small volumes of East-West business were conduced on the basis of counter-trade negotiated with state-trade monopolies (Meyer, 2001a). Only a few businesses operated within the region, but the collapse of Communism in 1989 brought dramatic changes. The Baltic
countries walked the path from transition to an emerging economy, which opened major business opportunities. An emerging economy can be defined as a country that satisfies two criteria: a rapid pace of economic development, and government policies favouring economic liberalization and the adoption of a free market system (Arnold & Quelch, 1998). Multinational enterprises entering transition countries have to adapt their strategies to the local institutions, different cultures and reduce exposure to highly imperfect markets.
One way to understand business strategies in emerging markets is to analyze the background of transition economies. Businesses operating in the region face a distinct institutional environment, which pre-determines the strategic opportunities for business (Peng, 2000). In the transition context, transaction cost theory is applied because of ‘weak institutions’
and high uncertainty. The theory, transaction cost analysis, combines elements of industrial organization, organization theory, and contract law to weigh the tradeoffs to be made in the entry (and by extension, degree of control) decisions (Anderson and Gatignon, 1986).
Firms seeking to perform a business function outside its domestic market choose the best
“mode of entry” (Anderson and Gatignon, 1986). The chosen mode determines the extent to which the firm gets involved in developing and implementing marketing programs in the foreign market, the amount of control enjoys over its marketing activities, and the degree to which it succeeds in foreign markets (Root, 1987). This study uses the transaction cost theory to explain how firms choose between shared ownership and wholly-owned subsidiary owned venture. The theory employed is well equipped to explain why firms prefer a wholly owned subsidiary to shared ownership (Anderson and Gatignon, 1986). The theory posits that it is more economical for the firm to establish a wholly owned subsidiary than to enter into shared ownership transactions when international markets are characterized by significant imperfections (Hill and Kim, 1988).
Scholars have done much research in the area of international entry mode selection and tended to concentrate on transaction cost explanations (Anderson and Gatignon, 1986; Hennart, 1991; Makino and Neupert, 2000). However, recent studies such as Brouthers and Brouthers (2000) have begun extending transaction cost entry mode theory by including cultural and institutional variables, as well as transaction cost variables (Brouthers, 2002). Kogut and Sing (1988) have suggested that adding both institutional and cultural variables to transaction cost theory enhances our understanding of international entry mode choice.
The objective of this paper is to enhance our understanding of the impact of transaction cost, institutional and cultural variables on international transaction cost entry theory. The study examines the impact of these variables on the strategies of multinationals entering a transition economy with shared or wholly owned ownership. Contributing to recent literature on transaction cost theory, this study additionally analyzes statistically the interaction effects of institutional development and cultural distance on technological intensive firms.
The next section discusses the evolution of the Baltic States after independence, explaining the environment in which Western firms started investing. Then the thesis represents the framework which forms the basis for transaction cost theory. This theory reviews the impact of their attributes on transaction costs and consequently on entry mode choice. In the
methodological section that follows, the data resources are described. The results are presented and interpreted in the subsequent section. The final section concludes the analysis.
A FOCUS ON THE BALTIC STATES
The Baltic States lie at the meeting point of Eastern and Western Europe and act as economic and cultural link between Russia and the West. To control ports and trade routes, several parties fought over Baltic lands. Although Baltic peoples have had many rulers, their sense of nationhood is strong. Due to their geography and shared history, particularly in the twentieth century when they endured nearly 50 years of communist rule, Baltic countries are very different. Lithuania is a Catholic country as a result of its historic ties with Poland, while for centuries German nobles ruled Estonia and Latvia, and these are now Protestant countries.
The population of the three Baltic States voted in early 1991 for withdrawal from the Soviet Union.
The people encouraged their governments to continue along the road to independence and put the Baltic question on the international agenda. In September 1991, Lithuania, Latvia and Estonia demanded and received recognition of their independence. But, on march 11, Lithuania, as the first of the three, made the decisive break with the Soviet Union. Latvia and Estonia followed which was remarkable because these republics had so many Russians natives living in them.
The Baltic Countries had similar starting points, but adopted a different management of the transition of a planned economy to a market economy. This created some divergence in the economic situations up to the mid-1990s (OECD, 2000). Unlike its Baltic neighbours, Latvia does not allow foreigners to own land and buildings, thus making it difficult to attract foreign investment (O’connor, 2003). However, under International Monetary Fund (IMF) pressure Latvia had moved to rapid reform by developing a dynamic service. In this regard, Lithuania has experienced somewhat greater success than Latvia, with the leading sources of foreign investment being Denmark, Sweden, and the USA. On the other hand, Estonia developed most rapidly and became one of the leading countries attracting investment in Eastern Europe.
The three Baltic states occupy a unique position among post-communist systems. On the one hand, they were the only Soviet republics with a recent history of independent statehood. In this respect they resembled the Central and East European countries. On the other hand, the three states had been subject to political control and repression of the same magnitude as the other Soviet republics; their economies had been completely integrated into the Soviet economic system, and they had been effectively cut off from all foreign political, economic and cultural contacts (Dobosiewicz, 1992). At the same time, however, the collective memory of the inter war republics survived the years of repression and this ultimately explains why Estonia, Latvia and Lithuania became frontrunners in the dual revolt against local communism and Moscow’s hegemony (Nørgaard and Johannsen, 1999)
Escaping from Russia’s sphere is, however, in its way an even more difficult and delicate business than was the extraction of the Baltic States from the Soviet union; for it goes against powerful strands of history and economics and, above all, because it could in some
circumstances involve ethnic conflict between Balts and local Russians. Millions of Soviet citizens who lived in former republics of the Soviet Union suddenly found themselves in a foreign country after the collapse of the Union. First measure, to ordering internal affairs for security, was continued pressure on Russia to fully withdraw troops from the Republics. This could encourage local Russians to integrate into Baltic society. Second, the West had to put pressure on the Baltic governments to guarantee the rights of local Russian population especially in the social and economic sphere. Thirdly, the West should provide more substantial, and properly coordinated aid, with the deliberate aim not simply of helping the transition to a market economy, but of minimising unemployment and reducing food prices during that transition (Lieven, 1994).
In comparison with the countries of Eastern Europe, the Baltic States were at a colossal disadvantage as they set out to free them selves from Communism and reform their states and economies. Whereas the Eastern European countries possessed at least the formal attributes of independent statehood, the Baltic States had effectively been insulated behind two iron curtains, since the Soviet frontier with Eastern Europe had also been largely closed. The Baltic economies were wholly integrated into the Soviet Union, and controlled by Moscow.
Estonia, Latvia and Lithuania are very little economies, with a combined population of just over 7 million and a significant small GDP. Although the relatively small economies of Estonia, Latvia and Lithuania do not have the market potential of most of the former Soviet Republics, they play an important role particularly in view of their geographical position. The economies can function as a bridge between East and West which gives them a bridgehead function, with Baltic Sea shipping linking them to the West more readily than overland routes. The Baltic states have traditionally had close cultural, economic and social links with the states of Northern and Western Europe and can play a role in the development of closer relations between East and West.
Among the Baltic republics, Estonia had the closest relations with Western countries during the
Soviet period because they were able to understand Finnish language. This close cultural affinity to Finland and the ties that were cultivated during the Soviet era has helped Estonia to attract significant Finnish foreign investment but surpassed by Swedish investment in the late 1990s.
Since their independence in 1991, there are important differences in the path to and destination for a market-base economy. The transition form a centrally-planned to a market economy gradually takes place. The main purpose of transition was to introduce markets as more efficient co-ordination mechanisms (Meyer, 2001a). Yet, the old economic system disintegrated before the institutions supporting a market economy were in place. As a consequence the Baltic States were experiencing severe downturns in economic growth in the beginning of the process, continuing high inflation and growing in their orientation towards the West.
A key-turn of all Baltic states was the privatization of businesses and property that during Soviet times had been owned and run by the state. The change of ownership from state-owned to decentralized private ownership is the most fundamental part of transition going from a
centralized command economy to a market economy. The main objective behind privatization is to move away from a system where the decision takers received detailed commands and
complex incentives from the higher levels in the bureaucracy to a system where the people taking decisions are economically responsible for the consequences (Haavisto, 1997).
The essence of economic transition from a planned economy to a market economy is the independent of one set of institutions governing economic activity by a different one (Meyer, 2001a). Governance of institutions encompasses laws, regulations and public institutions that determine the extent of economic freedom in a country, the security of private property rights, the costs to the private sector of complying with government regulations and legislation, the
competence and efficiency of the civil service in carrying out state activities that, in turn, affect the efficiency of private sector enterprises, the transparency of the legal system and the honesty of government officials (Slangen, van Kooten and Suchanek, 2004; Globerman and Shapiro, 2002).
The basic reason is that good governance is characterized by economic freedom, secured property rights, transparency in government, and that investment is directly encouraged by good
governance regimes. Furthermore good governance should indirectly encourage investment by increasing the scope for profitable business activities and promote economic performance.
Because the lack of institutions increases transaction costs, especially for new business relationships, and thus inhibits many potential transactions.
Since the main criteria for accession to the European Union (EU) include democratic governments, stable borders, the rule of law, respect for human rights, and a functioning market economy (Copenhagen European Council, 1993), the Baltic countries had to conform to Western European standards in these spheres. Latvia and Estonia in particular, have come under
pressure to resolve their minority issues by revising their stringent language laws and citizenship requirements in the past. In the years towards EU enlargement, above all Latvia and Lithuania, both countries have changed rapidly and moved to strengthen democratic institutions.
Sharpening the evolving identities of these countries and assess their positive functions facilitated early membership. Of course the willingness of these countries to pursue an active reform
process towards a market economy from the very first days of their independence, has been weighted heavily in deciding to admit the Baltic countries to the EU.
Since May 1, 2004 the Baltic States have been admitted as member of the European Union and of the NATO since March 29, 2004. All three countries already joined the World Trade Organization (WTO) in November 1999. Bevan and Estrin (2000) studied a learning perspective of the impact of EU accession prospects on investment to Central and Eastern Europe. They concluded that one of the key benefits of the process of enlarging the EU is the boost it gives to international investment. Inflows of investment increased sharply since 1994, when the European Union committed itself to enlarging, which helped to reinforce positive perceptions of the front- runner applicants’ suitability as investment locations. Evidence also appears after joining the EU in 2004, the Baltic countries registered strong growth in prosperity and continues to approach the EU-25 GDP level (OECD, 2000). Differences are also evident because investors no longer seem to have concerns about political and legal stability because Baltic States have become investor- friendly.
THEORY
Once a firm has decided to enter a foreign market it commonly makes two more decisions (Barkema and Vermeulen, 1998). First, the firm must decide on the percentage of ownership they desire in the foreign venture. This is known as the entry decision. Second, if a firm decides to pursue a wholly-owned venture, it must decide whether to acquire an existing venture or create a new (greenfield) venture (Brouthers and Brouthers, 2000). This is referred to as the establishment mode choice. In this study transaction cost theory explains the entry mode choice; how firms choose between wholly owned subsidiary and shared ownership.
Transaction cost theory suggests that the governance structure an MNE chooses for a venture is driven by desire to minimize transaction costs (Anderson and Gatignon, 1986;
Williamson, 1985). When a company tries to determine whether to outsource or to produce goods or services on its own, transaction costs frequently determine whether a company uses internal or external resources for products or services.
Transaction cost theory is built upon Coase’s (1937) findings in which he observed that the operation of market mechanisms is not without costs. The particular governance structure that is actually utilized in a given situation depends on the comparative transaction cost. That is, the cost of running a system including the ex ante costs of negotiating a contract and the ex post costs of monitoring the performance and enforcing the behavior of the parties to the contract (Williamson, 1985)
Williamson’s (1979) formulation of transaction cost rests on two assumptions. First, opportunism, raises the possibility that one or both firms in the exchange may conceal information or mislead one another in order to gain advantage. Cost arise to avoid uncertainty through monitoring, repeated negotiations and enforcement mechanisms. For the Baltic States, guarding against the possibility of opportunistic behavior presents a significant challenge since firms are only privatized recently and institutions under development. Secondly, bounded rationality simply suggests that perfect contracting is not possible or feasible in the face of uncertainty and so exchange partners incur costs to cope with informational uncertainties.
Transaction cost economies studies explore international entry mode choice (Anderson and Gatignon, 1986) and identifies three general attributes of transaction that influence
transaction cost perceptions: (1) asset specificity, (2) environmental uncertainty, and (3) behavioural uncertainty. TCE posits that both uncertainties and asset specificity surrounding a transaction will influence entry mode choice, and the primary determinants of cost efficiency of a governance choice (Williamson, 1996).
Asset specificity concerns a broad scope of resources particularly tailored to a relationship, and it reflects a firms ability to differentiate its strategy and products (Zhao et al., 2004). Specificity exists when a firm has unique technological intensive resources specific to the transaction.
Environmental uncertainty arises from the volatility of conditions in a target market environment (Hill and Kim, 1988). Uncertainties refer to the risks associated with a host country;
for example the ability to enforce contracts and control other types of political and legal risks (Williamson, 1985). Firms in transition economies, where the institutional framework is usually unstable during the process of change from central-plan coordination to a market economy (Swaan, 1997), tend to choose a wholly-owned subsidiary rather than an shared ownership.
Behavioral uncertainties arise from the inability of a company to predict the behavior of individuals in a foreign country (Brouthers and Nakos, 2004). According to transaction cost theory, behavioral uncertainty may lead to opportunistic behavior involving cheating, distortion of information, shirking of responsibility, and other forms of dishonest behavior (Williamson, 1985). If the costs of adoption, performance monitoring, and safeguarding against opportunistic behavior are too high, the firm will prefer a wholly owned subsidiary (Hill and Kim, 1988; Madhok, 1997).
Uncertainty arises when a firm is unable to accurately assess its agent’s performance readily available output measures (Anderson and Gatignon, 1986). Firms regard how risky an investment is, based on the fact that they are uncertain about the outcome or the interaction with environment or other players, because they lack sufficient experience. Firms lacking experience and knowledge in international business are hesitant to pursue foreign markets aggressively.
HYPOTHESES
Technological Intensity
Asset specificity refers to physical and human resources. A firm that possesses unique technology and know-how has to take extra precautions in order to protect its differentiated assets from falling into the hands of competitors (Klein, 1988). Transaction cost theory suggests that when asset technology is low, firms will incur few costs in protecting their know-how from competitors (Hennart, 1989). Low asset-specific investments involve the use of generally available knowledge; hence, firms are not concerned about protecting this knowledge from competitors, since competitors already have access to the knowledge (Williamson, 1985).
Contrary to this, when firms make high asset-specific investments, wholly owned modes of entry tend to be preferred. One of the central aspects of TCE is that the specificity of the assets employed in a transaction have a significant impact on the efficiency and opportunism (Hennart, 1991). Opportunism occurs because firms may have difficulty writing complete contracts or evaluating the partner organizations (Williamson, 1991).
Investors who want to establish affiliates to exploit their proprietary know-how (R&D) and who do not need complementary inputs from local firms want to keep full control of their
subsidiary to avoid the misappropriation of their knowledge by a partner. The larger the amount of proprietary know-how transferred to the affiliate, the greater the probability that the affiliate will be wholly-owned (Hennart, 1991). Especially in transition economies, the diffusion of knowledge is of particular concern because the institutional framework does not provide for the efficient protection of intellectual property rights (Meyer, 2001).
A potential control problem arises whenever one party can “free ride” on the efforts of others, receiving benefits without bearing costs thereby degrading the quality of products (Anderson and Gatignon, 1986). Transaction cost analysis suggests where the potential for free- riding is high, entry modes offering higher control are more efficient.
In sum, in emerging economies, the wholly-owned choice helps ensure the best deployment of its strategic assets without giving rise to uncompensated leakage to others safeguarding its proprietary R&D know-how (Luo, 2001). Thus:
Hypothesis 1: In an emerging economy, the greater the technological intensity (asset specificity), the more likely the entry is by wholly-owned subsidiary.
Institutional Development
Since the collapse of the Soviet Union, the Baltic countries are moving from socialist to private ownership, and usually from central planning to market systems of resource allocation (World Bank, 1996). Hence, the legal framework has been changed radically to create a new set of institutions during the 1990s. The pace and source of these transitions have varied dramatically in the Baltic States.
North (1990) defines institutions as the ‘the rules of the game in a society’, which include formal rules (laws, regulations, property rights) and informal constraints (customs, norms, cultures). Institutions reduce transaction costs by reducing uncertainty and establishing a stable structure to facilitate interactions (Meyer, 2001a). However this has been a particularly
challenging task for the former planned economies, which lacked even basic institutions and property rights, and had almost no experience in managing multilateral trade negotiations. MNEs lack information about local partners; they must negotiate with agents inexperienced in business negotiations; and multinationals face unclear regulatory frameworks, inexperienced
bureaucracies; underdeveloped court-systems, and corruption (Meyer, 2001a). This implies high transaction costs for West-European firms entering the Baltic States.
The institutional transition, defined as ‘fundamental and comprehensive changes introduced to the formal and informal rules of the game that affect organizations’ (Peng, 2003) directly determines a firm’s entry choice strategy and their influence varies between lower and higher levels of institutional development (Meyer et al, 2005) .In under-developed institutional environments characterized by weak property rights regimes, full ownership modes are more efficient because they reduce transaction costs of unwanted dissemination (Dikova and Witteloostuijn, 2007). Setting up a wholly-owned subsidiary protects assets better against infringement and piracy, and provides a vehicle for maximum control to safeguard proprietary knowledge (Luo, 2001).
In transition economies with institutional safeguards offering greater property rights protection, shared ownership can be more efficient by making use of a local partner’s knowledge and avoiding higher costs. Strong protection of property rights will encourage investors to seek local partners to help them negotiating the complexities of the local environment.
Hypothesis 2: In a emerging economy, the greater institutional development, the more likely the entry is by shared ownership.
Cultural Distance
Formal rules establish the permissible range of entry strategies (e.g., with respect to equity ownership) and set the stage for possible bargaining between investors and authorities (Henisz, 2000; Meyer and Peng, 2005). However, crucial in transition economies (Baltic States) are informal institutions such as managerial norms and values which consequently affect entry decisions (Meyer, 2001b).
Cultural distance indicates the difference in culture between a home country and each individual target country (Kogut and Singh, 1988; Hofstede, 1989). Hofstede (1980) suggests that some cultures are more distant than others. Due to the difficulty of integrating an already existing foreign management, an organizational fit of two firms (Jemsions and Sitkin, 1986), cultural differences are likely to be especially important in the case of entry mode choice in emerging economies. Bevan and Estrin (2000) interpret that the Baltic states have a dichotomous character owing to the fact that while they are small states that were part of the Soviet Union from 1939-91, due to a history of several occupying powers their traditions, languages and institutions are linked to border countries. Davidson (1980) traced the establishment of foreign subsidiaries and found that countries which have reputedly similar cultures are a preferred target of investment. Nordic countries represent much of the equity investment in the Baltic States. Information about a new product is disseminated more efficiently and effectively in a similar language and culture. In addition, managerial uncertainty or ignorance of local conditions will be relatively low, permitting the firm to be less risk-averse in its investment behavior (Davidson, 1980).
The costs of setting up alone a subsidiary in a culturally different environment, establishing market presence and gaining customers trust and desire to buy the products/
services, is finally keeping all that in order to achieve sustained competitive advantage over local firms which do not suffer from the liability of foreignness. This liability is not a problem for a shared ownership because a joint-venture partner typically has already customers and the market entry strategy is more efficient and less costly. A joint-venture frequently searches for local partners who are able to manage the local labor force and relationships with suppliers, buyers, and governments (Franko, 1971) as it can provide all the local information, suppliers, and distribution network.
The relationship between cultural distance and the entry mode choice is linked to transaction cost theory. Transaction cost economics helps to explain why, in high cultural
distance countries, firms prefer wholly owned modes of entry to shared ownership. TCE suggests that wholly owned modes of entry are preferred when the costs of finding, negotiating and enforcing a cooperative agreement are greater than the costs of direct control (Hennart 1989).
Brouthers and Brouthers (2001) provide additional reasons for using wholly-owned modes of entry in high cultural distance markets. Volatility in the host country, less potential partners in transaction economies and internal uncertainty to assess the performance of partner firms will increase transaction cost. Firms may more easily monitor the activities of employees and reduce uncertainty by using wholly owned modes.
Hypothesis 3: In an emerging economy, the greater the cultural distance, the more likely the entry is by wholly-owned subsidiary.
Institutional Development and Technological Intensity
Hennart (1991) confirmed the transaction cost theory that parent firms prefer shared ownership when they need to combine with other firms intermediate inputs which are subject to high market transaction costs when they enter a foreign market and need to acquire the tacit knowledge on how to operate and sell that country. Additionally Dikova and Witteloostuijn (forthcoming in JIBS) propose that in an underdeveloped institutional framework in transition economies, the transfer of knowledge may be of particular concern because of the insufficient abilities of institutions to provide protection of intellectual property rights. Hence, MNEs found in R&D intensive industries where the role of technical know-how in firm-specific advantages are critical, will most likely enter foreign markets via wholly-owned affiliates rather than subsidiaries with shared ownership. As put by Meyer (2001b), the cost of setting up a fully owned local operation for a technical intensive firm in a transition economy are high, controlling their assets, except not outweighing the transaction cost arising from operating in an imperfect market.
Building on the above arguments, as the level of development in institutional
environments decreases the transaction costs associated with international knowledge transfer providing better safeguard mechanisms against infringement and piracy, exerts a positive
moderating effect on the likelihood of investors opting for an alternative to the full ownership entry mode (Dikova and Witteloostuijn, forthcoming in JIBS).
Hypothesis 4: The joint effect of technological intensity and institutional development will have a positive effect on the likelihood of entry by wholly-owned subsidiary.
Cultural Distance and Technological Intensity
Hofstede (1980) maintains that culture is the system of beliefs and values that influence behavior within a national setting, and that since each country has a different set of beliefs and values it is likely that behavior also differ. These differences in behavior between foreign and home country cultures can create additional cost of entry, decrease operational benefits, and hamper the firm’s ability to transfer core competencies to foreign markets (Bartlett and Ghoshal, 1989). According
to a large stream of researchers, large differences in cultures initiate MNEs to exert greater control in their entry in order to minimize transaction costs (Hennart and Reddy, 1997). For example firms from high technology-intensive industries frequently enter into foreign markets to cover their costly R&D investments, reduce risk when transferring tacit knowledge for free riding effects and gain market share. However, as the Baltic workforce is still less skilled after
transformation from a planned economy to a market economy, cultural differences may create negative reactions from managers/ employees that result in resistance to adapt expertise and knowledge. These differences in values will in turn make it more difficult for them to agree on common goals, to solve problems, and to resolve conflicts than if they came from cultural identical country (Hennart and Zeng, 2002). Therefore technological intensive firms tend to exercise greater control which is necessary in a culturally distant market, because transactions in such markets generate higher information costs and are associated with greater difficulties in transferring competencies and know-how (Li and Guisinger, 1992) above all when national culture based resistance to change occurs (Harzing and Hofstede, 1996)
The Baltic states have traditionally had close cultural (language), economic and social affinity with the states of Northern and Western Europe. Under these conditions market-
contracting arrangements, or low-control modes, are favored because the threat of replacement dampens opportunism and forces suppliers to perform efficiently (Anderson and Gatignon, 1986).
Therefore, technological intensive firms entering markets with small cultural differences perceive low levels of country risk and thus use shared ownership. When markets fail, skilled/ efficient suppliers are restricted to the firm, supervision to control R&D investments is stringent. Firms entering markets characterized by large cultural differences tend to perceive high levels of country risk and therefore prefer to use wholly-owned subsidiary, reducing the risks (Hofstede, 1990).
Hypothesis 5: The joint effect of technological intensity and cultural distance will have a positive effect on the likelihood of entry by wholly-owned subsidiary
METHODOLOGY
To test the above hypotheses, data was initially obtained from the AMADEUS dataset. The database lists about 105 subsidiaries of all registered companies based in the European Union that had a percentage owner-stake in a branch subsidiary located in any of the Baltic countries, Estonia, Latvia or Lithuania and have chosen to invest there. These countries have a marketplace which offers attractive market opportunities for foreign firms since opening up to the Western World. While Eastern European countries are studied extensively, the Baltic States were chosen for this study because they were and still are in various stages of transformation and not
significantly explored. Additionally, from the latest Global Competitiveness Report 2006-2007, the Baltic countries have improved their position beyond the former communist countries like Poland, Czech Republic, and Hungary (World Economic Forum). Due to their improved position, in this study only those firms are selected for which Amadeus reported data on in 2005 and the beginning of 2006, since this survey was conducted in 2006.
Measures
The dependent variable, wholly-owned or shared ownership, is used to test the hypotheses with respect to the determinants that are related to the entry choice of multinationals into the Baltic States. The dependent variable represents foreign entry mode, defined as a dummy variable, coded 1 if wholly-owned and 0 if acquired a percentage owner stake in a local firm. The options are: (1) wholly-owned – 95% or more ownership and (0) shared ownership would be the percentage less than 95% ownership stake. The 95 percent cut off point has been used in previous studies on ownership choice (Hennart 1991, Makino 2000).
Because of the nature of the dependent variable, a binomial logistic model is used, in which the probability to wholly-owned subsidiary is explained by the variables described below.
The regression coefficients estimate the impact of the independent variables on the probability that the affiliate will be wholly-owned (more than 95 percent owned) or shared (less than 95 percent) and the relative importance of each independent variable separately and interacted.
Our hypotheses relate to three independent variables. First, technological intensity is obtained from secondary data. In past studies, technological intensity has often being estimated by the ratio of R&D expenditures to total sales, at either the industry or the firm level (Caves and Mehra, 1986; Hennart and Park, 1993; Cho and Padmanabhan, 1995). By using the Amadeus database we subsequently determined the MNE’s ISIC codes (the European version of the US SIC codes) and grouped firms in five segments according to the EBRD classification values that rank industries according to their technological intensity (5 will be for the high-technology industries, 4 for the medium-high-technology industries, 3 for medium-low-technology industries, 2 for Low-technology industries and 1 for all the other industries that are not mentioned by EBRD)
Second, cultural distance is derived from the work of Hofstede (1980). Although
Drogendijk and Slangen (2006) consider Schwartz’s (1999) more recent framework to be superior, it is too premature to dismiss Hofstede’s work reflecting national cultures. Kogut and Singh (1988) defined national cultural distance as the degree to which the cultural norms in one country differ from those in another country. The traditional Kogut and Singh (1998) index, which uses the differences in the scores of Hofstede’s (1980) dimensions of national culture ( i.e., power distance, uncertainty avoidance, individualism, and masculinity/femininity) between the foreign country entered and the MNE’s home country. These differences are corrected for differences in the variance of each dimension and then arithmetically averaged (Drogendijk and Slangen, 2006).
Algebraically: CD
j = {( I
ij – I
in ) / V
i }/ 4, Where CD
j is the cultural distance between country j and one of the Baltic countries, I
ij is country j’s score on the ith cultural dimension, I
1n is the score of a Baltic country in which the multinational has invested in, on this dimension, and V
i is the variance of each dimension i. We selected this
measure of cultural distance because of the extensive evidence the underlying Hofstede's (1980) national cultural scores
Third, institutional development is a composite measure obtained from the World Bank’s Governance Indicators (Kaufmann, Kraay and Mastruzzi, 2005) which reflect the statistical aggregation of responses on the quality of governance given by a large number of enterprise,
citizen and expert survey respondents in industrial and developing countries. Kaufmann and Mastruzzi assign economies a ranking based on six separate categories according to how far they have progressed towards each other. The categories cover voice and accountability, political stability/ no violence, government effectiveness, regulatory quality, rule of law, and control of corruption. The composite measure ranges from -2.5 to 2.5, with higher scores corresponding to higher institutional advancement. The indicators are “based on several hundred individual variables measuring perceptions of governance drawn from 37 separate data sources constructed by 31 different organizations” (Kaufmann et al., 2005: 6). This implies that these aggregate estimates are informative about changes over time in relative institutional positions of individual countries (Dikova and Witteloostuijn, forthcoming in JIBS).The Kaufmann index is measured similarly as the cultural distance. Algebraically: GG
j = {( I
ij – I
in ) / V
i }/ 6, Where GG
j is the good governance variable between country j and one of the Baltic countries, I
ij
is country j’s score on the ith governance dimension, I
in is the score of a Baltic country on this dimension, and V
i is the variance of the score of the dimension.
Finally, consistent with previous research, we included three control variables. Firm Experience is captured as a dummy, 0 being no experience and 1 experience. Host country experience enhances the ability of MNE managers to scan, process, and analyse information about a new territory, thus improving the scope of bounded rationality and mitigating transaction costs (Williamson, 1985). Foreign firms may have learned more about the region with subsidiaries in East European countries and therefore have an advantage over other companies that are not familiar with the region, reducing uncertainty associated with entering a new foreign market.
MNEs with little or no experience wanting to invest in the Baltic States will try to limit risk exposure (Chang, 1995). Barkema et al. (1996) explains that in these circumstances shared ownership is preferable because it reduces risk-taking and resource commitment and also facilitates learning through cooperation and interaction with local firms. One may therefore expect foreign firms with little experience to prefer shared ownership. By contrast multinationals that
have made previous investments in Eastern Europe have presumably accumulated the required knowledge in-house, and do not need to acquire local firms, preferring a wholly-owned subsidiary.
Firm Size is measured by total operating turn-over of the multinational. Caves and Mehra (1986) showed that the size of the entering firm is positively and significantly related to entry by wholly-owned over joint-venture. Previous scholarship indicates that larger firms tend to prefer wholly-owned entry modes (Agarwal and Rarnaswami, 1992). Wholly-owned entry modes are preferred because larger firms tend to have more resources which can be applied to new market entry. In terms of firms size, also White (1995) suggests that large retailers, with greater financial resources, are more likely to use a wholly owned subsidiary as mode of entry, whereas small retailers will evaluate the relative benefits of shared ownership; franchising, joint-ventures, distributors and agents. Because wholly-owned subsidiaries require generally more financial and managerial resources than shared ownership, firm size should be positively correlated.
Conversely, wholly-owned affiliates are discouraged, the larger the assets of the host (Baltic) partner or investment size. This view is confirmed by Kogut and Sing (1998) who significantly concluded that the larger the size of the firm the more likely it will be wholly owned. This positive relationship between firm size and entry strategy is supported by Evans (2001).
Geographical Proximity represents the distance between capital cities of source country and recipient country j in kilometres. Simple distance measures for indicating transactions costs of doing business in the Baltic States are on the face of it high because they are geographically distant from most potential investors. It is also suggested that as the physic distance between the home and foreign markets increases, the perception of risk will be greater. Consequently, firms will be unwillingly to commit substantial resources to psychically distant markets (Brouthers, 1995).
DATA ANALYSIS
Since the dataset is composed of continuous, categorical, single-scale and multiple-scale constructs, all variables were converted to standardized z-scores, prior to the analysis. Table 1 shows the means, standard deviations and table 2 the correlation coefficients for all variables under study.
[Insert Table 1 and 2 about here]
Because the dependent variable is dichotomous and binary, logistic regression is employed in SPSS to assess various determinants affecting entry mode choice. The regression coefficients estimate the impact of the independent variables on the probability that the entry will be wholly owned. The maximum likelihood estimation procedure is used after transforming the dependent into a logit variable (the natural log of the odds of the dependent occurring or not). A positive sign for the coefficient means that the variable increases the probability of wholly owned.
The model can expressed as:
P(Y) = 1/(1+e−z),
where Y is the dependent variable, and Z is the linear combination of the independent and control variables. That is,
Z = 0 + 1X1 + 2X2 + … nXn,
where is the intercept, 1… n are the regression coefficients, and X1…Xn denote the independent and control variables.
The analysis was conducted by creating three models. Model 1 estimated the main effects of the independent variables on the likelihood of a wholly owned type of entry, and models 2 and 3 add the interaction effect of institutional development and cultural distance on MNEs’
technological intensity. Before performing an interaction analysis, the predictors were centered to avoid potential multicollinearity problems The models are estimated with SPSS 12.0.1, using the maximum-likelihood method.
The classification table, serving as a basis for the rest of the output, the overall percentage of correctly classified cases is 71,.4 per cent, without including the predictors. When the
independent variables are included the model is 13,4 percent improved to 84, 8 percent.
The Omnibus test of model coefficients is an overall indication of the ‘goodness of fit’ of the model and how it performs. Since the result is highly significant value (the sig. value is ,000 which really means p<.0005) the model does fit well.
The Cox & Snell R Square and the Nagelkerke R Square provide information about the usefulness of the model and the amount of variation in the dependent variable. Output suggests that between 31,8 per cent and 45,6 percent is explained by the independent variables in the model.
RESULTS
The results of the binomial regression are presented in Table 3.
[Insert Table 3 about here]
A positive coefficient means that the independent variable tends to increase the
probability that wholly owned will be chosen and a negative coefficient signifies the opposite, hence shared ownership.
Next, the significant control variables are discussed in the entry mode choice. Consistent with past research, prior experience with investment in transition economies reveal a positive and significant relationship with entering by wholly owned mode. Firms with more experience tend to prefer wholly owned entry modes (Agarwal and Ramaswami, 1992) because through experience, firms develop systems for dealing with new market entry, thus reducing their risk and costs of entry. Unlike results from Kogut and Singh (1988) and Hennart and Park (1993) who found that previous entries by foreign investors had no influence on the entry mode. In contrast with Caves and Mehra (1996) and Hennart and Park (1993), the coefficient of the variable describing the relative firm size has the right sign but is not significant. In previous research usually the larger the size of an European multinational, the more likely that entry will be wholly owned. The insignificant coefficient for geographical proximity suggests that physic distance between firms
has no impact on entry. Researchers (Johanson and Vahle 1992, Kogut and Singh, 1988) have suggested that entering countries that are physically close reduces the level of uncertainty firms face in new markets and are easier to learn from. Apparently, the impact of distance here is not particular important for European firms entering the Baltic States
The coefficient of technological intensity is positive and significant (p < 0.05)as predicted by hypothesis 1. This confirms the view that technological intensive MNEs find wholly owned subsidiary a more effective way to transfer their advantages to the Baltic States.
Consistent finding in the model is the highly significant coefficient on institution development, which influence the entry mode choice. The sign of the coefficient of institutional development is positive, this means that with more institutional development the likelihood of firms choosing wholly owned entry (versus shared ownership) increases. This result supports Meyer findings (2001) where institutional building in transition economies increases investor’s choice for internalization, making full ownership preferable. Thus, this model has to reject hypothesis two, stating that in more institutionally advanced countries, shared ownership modes would be preferred. The results are opposite to Oxley’s research (1999) where high institutional development inhibits in particular foreign wholly owned investment, which requires negotiations with privatization agencies, restructuring former state-owned enterprises, and operational management in the ‘post-socialist’ culture. Institutional protection of investors’ proprietary assets, the need for costly governance structures is higher so that alternative ownership modes (to shared ownership) are likely to be chosen by MNEs and countries where institution building is less advanced firms find shared ownership more appealing.
This study does not find cultural distance to be important in the entry mode decision- making process and does not support hypothesis 3. Several previous studies (Kogut and Singh, 1988; Brouthers and Brouthers, 2003) observed that it was important for MNEs expanding into developed market economies. Although Brouthers and Brouthers (2000) suggest that cultural context variables need to be added to transaction cost entry mode models because they tend to influence managerial cost and uncertainty evaluations in target markets, it thus seems that the
relationship between cultural distance and entry mode choice is contextual, depending on the type or nature of a host country economy (Luo, 2001).
In the analysis, no support was found for the interaction effect of institutional development (model 2) and cultural distance (model 3) on MNEs’ technological intensity.
Although the predicted sign- cultural distance positively influences the tendency of technologically intensive MNEs to enter by wholly owned subsidiary- was correct, in both hypotheses the main effects were insignificant (p>0.05). Also the Cox & Snell R Square and the Nagelkerke R Square, which explains the amount of variation in the dependent variable, increased marginally by less than 1 percent. This indicates that the interaction between these predictors do not provide any support for hypotheses 4 and 5.
CONCLUSION
Previous studies have paid insufficient attention to entry mode selection in emerging economies (Luo, 2001). However, these economies become increasingly important to MNE operations even though their industrial and national environments are very different from those of developed market economies (Luo, 2001). The Baltic States are often characterized by moderate uncertainty, weak protection of intellectual property rights, and governmental interference. MNEs need to understand such a complex environment in which the entry mode decision is crucial.
Since the first empirical work by Williamson (1975), the theory of TCEs has quickly evolved into an established research paradigm that has prompted numerous studies in diverse domains (Zhao et al, 2004). Using logistic regression, this study offers an empirical study of the factors, that reflect asset specificity, institutional development, and cultural distance, which influence the choice of multinationals between shared ownership and wholly owned mode. The thesis provided answers to three main research questions in this study. Overall, the logistic regression validates the relative predictive strength of these determinants as theorized by TCE, and demonstrates that at least two variables exert a significant influence at an aggregate level on entry choice as hypothesized by this study. Regarding the first one, we found that within the domain of TCE there are factors that influence the choice between full or shared ownership.
Results reveal that MNEs’ technological intensity, institutional development and prior experience are influential in the complex foreign investment decision concerning entry modes, typically explained by the TCE in literature. MNEs tend to choose the wholly owned subsidiary when firms are technological intensive to avoid opportunism and diffusion. Opposed to hypothesis two, when perceived property rights protection by institutions are strong, MNEs are more likely to employ the wholly-owned entry mode. Third, the likelihood of choosing the wholly-owned mode is positively associated with an MNE’s host-country experience or its need for knowledge protection or global integration (Luo, 2001).
Regarding the second research question, the result of the interaction between a technologically intensive firm and institutional development is somewhat distorted. Without a satisfactory level of institutional development, technology transferred would not be sufficiently protected against property rights infringements (Dikova and Witteloostuijn, forthcoming in JIBS).
On the one hand, the independent variables are separately significant in TCE entry mode choice.
Institutions of a economy determine the pattern of transaction costs and consequently the choice of entry by multinationals. Also firms’ competitive advantage of technologically intensive firms is most efficiently transferred in a wholly owned subsidiary. On the other hand, the interaction between the independent variables does not give a significant result. After joining the EU - including democratic governments, rule of law, and a functioning market - the Baltic States moved to improve political, institutional and administrative systems in the region. If the legal-institutional framework can guarantee property rights, technologically intensive firms can design their corporate strategies and management procedures in response without hesitation.
Discussing the final research question, the analysis could not provide empirical support for the argument that the interaction between technologically intensive firms and cultural distance influences the entry mode choice. A possible explanation can be found in the fact that previous scholarship linking national culture distance and entry mode selection have offered contradictory empirical evidence (Brouthers and Brouthers, 2001). Some scholars found cultural distance associated with choosing wholly owned modes (Padmanabhan and Cho, 1996) while others (Kogut and Sing, 1988) found cultural distance linked to a preference for shared ownership.
Moreover, foreign companies, investing in emerging target markets, bring technology,
management know-how and access to foreign markets (Ghauri and Holstius, 1996). When firms start an operation in transition countries – like the Baltic States – the environment is usually very dissimilar to that in their home country. Dissimilarities in the economic environment, including infrastructure and level of technology, and in the political, cultural environments, pose
inducements for and obstacles to successful expansion (Ghauri and Holstius, 1996). Therefore, it is important to analyze what kinds of problems enterprises have in these countries. However at this level, technologically intensive firms do already effectively transfer their knowledge when entering transition economies and cultural dissimilarities in transition countries do no seem to play an important role, which is emphasized by the fact that cultural distance as an individual predictor did not influence the entry choice.
Finally a limitation with research on international business lies in constructed databases.
A database is of course the classic public good with resources to subsequent users. Lacking however, are longitudinal databases to track down sequences of foreign direct investments undertaken by MNEs, especially in emerging economies like the Baltic States. Also, AMADEAUS is a database which indicates the percentage of owner stake of a MNE in a foreign firm. It is possible that different entry strategies were used by multinationals when entering, but not accounted for in the database. And whether the database is up to date can be questionable due to lack of information. With using secondary data, limited information on every variable was available. Without lack of a field research on multinationals investing in the Baltic States, it was very difficult to indicate the most significant reasons for CEOs to decide to invest in those countries. Information on every variable was now received by examining secondary data.
Methodologically, future research should improve sample selection, data gathering, and research design to resolve some of the issues (Zhao et al, 2004).
APPENDIX
Table 1. Means and standard deviations of all variables.
Descriptive Statistics
Measures Mean Std. Deviation N
entry 0,714285714 0,45392065 105
cultural distance 73,2 17,50021978 105
institutional development 97,88666667 33,0646804 105 technological intensity 3,485714286 1,075194846 105 geographical proximity 1091,447619 611,930677 105
firm size 8429856,429 14424006,62 105
prior experience 0,60952381 0,49019694 105
Table 2. Correlation matrix among all variables.
Correlation matrix
Measures 1 2 3 4 5 6 7
1. entry
2. cultural distance 0,019
3. institutional development 0,217 * 0,062
4. technological intensity 0,386 ** 0,05 0,0242
5. geographical proximity 0,178 -0,05 -0,241 -0,102
6. firm size 0,066 -0,182 0,106 0,181 0,1497
7. prior experience 0,315 ** -0,114 0,06 -0,001 0,2129 0,225
* Correlation is significant at the 0.05 level (2-tailed).
** Correlation is significant at the 0.01 level (2-tailed).
Table 3: Logistic regression results—entry mode.
Logistic regression results entry mode
Variables Model 1 Model 2 Model 3
Intercept 0,178 0,012 0,003
cultural distance 0,469 0,450 0,387
institutional development 0,016 0,680 0,015
technological intensity 0,002 0,006 0,002
geographical proximity 0,387 0,563 0,380
firm size 0,606 0,497 0,643
prior experience 0,003 0,004 0,004
institutional development*technological intensity 0,890
cultural distance*technological intensity 0,946
cases in analysis 105 105 105
overall chi-square 11,028 44,554 40,919
overall % correct 84,8 84,8 84,8
Nagelkerke R square 0,456 0,496 0,463
Notes: two-tailed tests; the dependent variable is subsidiary with shared ownership (= 0) or wholly-owned subsidiary (= 1) Relevant variables are centered prior to multiplication (interaction).
