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RESEARCH PROPOSAL
Psychic distance, FDI market selection and Globalization
Professor: Dr. Robbert Maseland
Paul Migdanaleuros s2021595
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Contents
I. Introduction 4
II. Literature Review 6
Psychic distance Psychic distance and market selection Globalization
III. Methodology 14
Measurements and Data Method and Model
IV. Results 16
V. Conclusions and discussion 21
VI. References 23
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Abstract
In this paper we examine the relationship between the psychic distance and the FDI market selection. More specifically, we study if the psychic distance has a negative impact to FDI location choice and if the globalization has changed this impact. In doing so, we test the FDI outwards from the USA to 28 countries between the years 1997-2008. We found evidence that only two of the five psychic distance factors (differences in languages and differences in industrial development) have a negative impact in the FDI market selection. Additionally we conclude that globalization has not adjusted the impact that factors of psychic distance have on the FDI location choice.
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I.
Introduction
Foreign direct investment according to the World Bank, are the net inflows of investment acquiring a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor. Therefore, one of the key decisions that a firm should take into account when it begin the internalization process, is the selection of the “right” country market (Brewer, 2007). Firms try to select markets in which the investment will be able to fulfill the original purpose of the investment. This is not a simple procedure, many firms face difficulties to achieve the initial targets of the investment. These difficulties arise from the fact that FDI investments take place in different counties, with existent distance in characteristics between them in several fields( economic, cultural. political etc). These kinds of dissimilarities have defined by a lot of researchers as psychic distance, correlate it with the assessed of risk and uncertainty that firms face in the internalization process (O‟Crady and H. Lane 1995, P.D Ellis 2008, J. Evans and F. Mavondo 2000, N.J. Brookes et al 2007, Dow et al. 2006, 2007, Paul Brewer 2008 etc).
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countries with higher perceived differences (dissimilar factors). In this paper we will attempt to contribute to this research focusing on the role played by globalization in this relationship. This field has remained unexplored by the international business literature. Globalization involves the removal of trade, allowing free flows of raw material and goods across the countries (Rohini Upreti, 2008). The increase in the technology sector and the growth of information flow through globalization has brought the world‟s economies closer to one another. However globalization has opened borders not only in the financial sector, but with the start of globalization people from different countries are more aware of foreign practices and characteristics around the world and are more familiar to them. As a result, people are becoming more and more aware of the different „psychic‟ characteristics of other countries. This has lead researcher to argue that traditional distance and its correlation with international process have no longer meaning in a speedily globalization world (C.L. Kuo et al ,2008).
Thus, the primary objective of this paper is to investigate if psychic distance across countries has been negatively associated with the selection of the market by multinational enterprises and if globalization has adjusted the impact that psychic distance has on the FDI location choice.
Consequently, our research questions are:
Does psychic distance have a negative impact on the FDI market selection?
Has globalization adjusted this impact?
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II. Literature review:
2.1 Psychic distance
As we stated above, the concept of the psychic distance has long been used to help understand the internalization process of the firm. The notion of psychic distance has multiple and inclusive definitions. The first who introduced the expression of psychic distance to highlight the need for a broader definition of distance in international business studies was Beckermann (1956)*1. A lot of definitions exist because psychic distance consists of several elements of which some are implicit and others are explicit. In the literature of the relationship between psychic distance and Foreign Direct Investment the dominant definition and the one that we believe can capture better the notion of psychic distance in our research is the following definition from Johanson & Wiedersheim-Paul (1975) : “psychic distance are the factors that preventing or disturbing the flow of information between the firm and the market. Examples such factor are differences in language, culture, political systems, level of education, level of industrial development etc.”
Paul Brewer (2007) stressed that psychic distance is a result of perceive differences between home and host country environment and that the larger the perceived differences among them, then the less possibility the countries will have to be selected. Therefore, psychic distance across countries and their potentially harmful consequences have received a lot of attention in the Foreign Direct Investment literature. Although, most of the studies have investigated the relationship between
1
“Apart from the general reduction in 'economic distances which would result from a reduction in the costs of air freight, for example, a special problem is posed by the existence of "psychic" distance. It is probable that the manner in which the purchases of raw materials by a firm are distributed
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psychic distance and entry mode of FDI or FDI performance, (O‟Crady and H. Lane 1995, P.D Ellis 2008, J. Evans and F. Mavondo 2000, N.J. Brookes et al 2007, P. Magnusson and B.A Boyle 2009) they have given less attention to the role that psychic distance has in the location choice of investment
Considering these, international business researchers have started to investigate the relationship between psychic distance and foreign direct investments location choice. One of the first researchers who examined the relationship between psychic distance and internationalization of the firms in foreign countries were Jan Johanson and Finn Wiedesheim Paul (1975). They studied the internalization progress which was followed by four Swedish firms in time who argued that a negative relationship exists between psychic distance and the establishments of a firm in a foreign market. They clarified that, firms of one country will invest first in neighboring and similar countries, in which the psychic distance is smaller and they are less eager to invest in dissimilar countries.
Their investigation gave stimuli to other investigators to study if psychic distance has an impact on the market selection for Foreign Direct Investments (Paul Brewer 2007, Oscar Martin et al 2008, Fardian J. Froce et al 2010, John Child 2002, Douglas Dow et al 2006,2007 etc ). Most researchers to a large extent conclude that psychic distance has a negative impact on the selection of the market for foreign direct investment and firms should give it additional importance when forming investments abroad. More precisely, they found that firms are more willing to invest in countries with closest psychic characteristics to the home country (low psychic distance between them) rather than in countries which have larger differences in psychic characteristics (high psychic distance between them). For example, one MNE which located in the United Kingdom will prefer to invest in the USA because they have the same language, same religion, identical political system, identical education levels and comparable industrial development rather than in Cuba.
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L.Zhu et al. in their investigation use as indicators of psychic distance the differences that the counties have in geographic distance, cultural distance , development level and membership and neighborhood effects in order to exam the importance of psychic distance in analyzing financial crises. Furthermore, Fabian J. Froese et al (2010) use as factors the language (having as core the English language), the knowledge (level of education), the collectivism, the uncertainty avoidance and the assertiveness. Moreover, Paul Brewer (2007) in his investigation suggests a new measure for psychic distance, arguing that commercial ties, political ties, historic ties, geographic ties, social ties, country information stock and level of development are the best‟s measures for the psychic distance and can better explain the FDI outflows. Consequently, as is obvious, there is a debate about how it is best to measure psychic distance.
In line with this debate, John Child et al (2002) in their case study seek to refine the concept of psychic distance and discuss the problem of limited range of indicators to capture the impact of psychic distance and denote the need for multidimensional measure. A researcher who investigates in deep the psychic distance and the international business practices and makes an effort to provide an answer and develop a multidimensional measure for psychic distance is Dow Douglas. In his research with Amal Karunaratna (2006), they correlate the uncertainty and the risk of a potential market with psychic distance. They develop a multidimensional instrument, the psychic distance stimuli, which according to them psychic distance can be better captured by perceiving differences in languages, education level, industrial development, political systems and time zones, and also the previous colonial ties that exist between the countries .
Consecutively to move further our investigation, we outline a brief description of the indicators that we use in our paper in order to measure psychic distance and the role that they have in international business practices.
Differences in language:
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facilitates inter-firm communication and coordination. On the other hand, if the countries do not speak the same language, it raises the level of inefficiency in communication and the transfer of information between the firms becomes more difficult (Dougals Dow 2006, John Child et al 2003, Pia Arenius 2005 etc). When a firm from a home country wants to invest abroad in another host country, the differences between languages will form communication barrier between them. In other words, are differences that distort information flows and increase uncertainty in foreign markets (Oscar Martin et al 2008) So, firms are more willing to invest in countries which have similarities in languages (Spain and Latin America) rather than invest in countries with dissimilarities (Canada and Spain). Thus, countries which have more similarities in languages are ones likely to be selected for FDI formation.
Differences in education level:
Education levels vary between countries. For instance, advanced economies have quality and more efficient education systems, which provide more superior education level than other systems in emerging economies. As a result different countries have different education system, thus different level of education in their society. According to Oscar Martin et al (2008), „the education that one receives in his country can influence the way that he presents the information they have and the way of building up arguments‟. Consequently, large differences in the education level between countries will increase the risk and the uncertainty when various firms invest abroad (D. Dow and Amal Karunaratna, 2006). Consequently, investors prefer to invest in countries with similar education levels rather than dissimilar.
Differences in industrial development:
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Differences in political systems:
The political system of the county plays a key role in the decision to invest abroad. The quality of political institutions in a country influences the cross nation practices of the country (Ricardo Flores, 2007) The decision makers for an investment in a particular country, take into account the level of democracy, the political instability, property rights and the political ties that the host and the home country may have when forming an investment abroad. In particular in many countries there is continuous communication among government - business, and government – consumer. If for example, a change in political system of a host country is perceived, then it will generate an increase in cost and uncertainty between the foreign firm and the host country (D. Dow and Amal Karunaratna, 2006). For this reason, if a firm operates in a foreign country with a different political system than the home country there is a risk of misunderstanding how the government or the firms may react in particular situations. Firms choose to invest in countries with identical and stable political systems rather than in countries with different political systems (France – Germany, France – Cuba).
Differences in religion:
In several countries religion plays also an important role in the society and as a consequence this role influences the economy of the particular country. It is significant not only because it shows the degree in which people participate in religion today but also because the impact that religion has had through history in forming people‟s norms, values and behavior (Oscar Martin et al, 2008). According to Douglas Dow (2006) religion forms a base upon which people evaluate whether certain behaviors are desirable and acceptable. Therefore, differences in religion will increase the cost of transaction and the risk of misunderstanding. .As a result, firms prefer to invest in countries with similar religious beliefs rather in religion dissimilar countries.
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systems and religion) will have a negative impact in the Foreign Direct Investments location choice.
2.2 Globalization
We want to investigate, as we prefaced in the introduction, if the impact of psychic distance in market selection choice has changed over the years. More specifically, if the impact that these differences have, has become less or not. In other words, to exam if globalization has adjusted this relationship that psychic distance has in the selection of the market for the form of foreign direct investments. Globalization according to Rohini Upreti (2008) involves the removal of trade, allowing free flows of raw material and goods across the countries. Nations and people around the world have become more and more interconnected through trade investments and other forms of interaction. As a result, a great amount of researchers have studied the role of globalization in international business literature. Nethertheless, the element of time, and as a result of globalization, has been a subject of limited interest in previous international business studies and psychic distance relationship. Researchers like Chin Lung Kuo and Wen Chang Fang( 2008), and John Child, Sek Hong Ng and Christine Wong (2002) brief discuss (without testing) the potential role of time and globalization in the relationship between psychic distance and market selection for FDI. In particularly, C. L. Kuo et al. (2008) argue that “in the rapidly globalization world and speedy development in technology have reduced the costs associated with distance, consequently they talk about the reduction of impact of psychic distance in market selection”. In addition, J. Child et al. (2002) talk about the institutions convergence in different countries during the globalization and denote that “the convergence of life styles, consumption patterns, human right standards, legal framework and business practice that are now in process in the globalized world.”
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2003, A. Zorska 2002). Particularly, the rapidly development (technology and communication portals) increases the speed and the volume of transportation and information flow and reduces the communication costs that firms from different countries face when they investment abroad ( Cairncross 1997, M. Adiwijaya and S. Pantja Djati 2008, S. Dowrick and B. DeLong 2003, A. Zorska 2002) The computers networks, mobile phones, television, ATM, personal computers and internet create linkages between economies that are located far away(M. Adiwijaya and S. Pantja Djati 2008). New ideas now can spread faster, giving the opportunity to poor counties to have access to information which they had limited access to before, making the learning process easier and offering services that earlier only colossal firms could provide (S. Dowrick and B. DeLong 2003, A. Zorska 2002). This new situation offers the opportunity to developing countries to catch up with the developed countries by adopting and adapting the benefits that emerge through globalization (S. Dowrick and B. DeLong 2003). Consequently, this leads to a shift from isolated economies with barriers to a global economy in which the connecting technologies have shaped the “global people”, who have norms and values more or less the same worldwide, reducing the existing distance between them(M. Adiwijaya and S. Pantja Djati 2008). In other words we move to a convergence world (a global village).
In line with these considerations, one of the most radical books regarding the effect of globalization and the convergence phenomenon between the countries is Thomas Freidman book “The World is flat” (1997). He argues the existence of 10 forces*2 that flattened the world via globalization and explores these 10 forces in a triple convergence situation. In the first convergence he describes how the ten flattens creates a global platform which allows different forms of collaboration. The second convergence is the appearance of a set of new business practices and skills (i.e. managers, business school, ITC specialist etc) and the third is the entrance of some three billion people in this new global playing field. He denotes that this new global field will change all our theories about economy, policy, culture etc. In other words it will change the way that people live. Additionally researcher like F. Cairncross (1997) argue that through globalization, firms will have the chance to locate the services where they can best produce rather than by near markets. People will start to speak the
2 The ten forces that T. Friedman describe are : The Berlin wall, Netscape, Work flow software, Open
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same language (English)*3 in different parts, vertical bonds between governments and the governed will be weaker and firms will have looser structures held together mostly by their cultures and their communication networks (F. Cairncross 1997). He concludes that the new globalized world will lead to the death of distance between countries.
Subsequently, in our research we expect that the rapid development of technology and communication portals via globalization has redefined the impact that psychic distance factors (differences in languages, education level, industrial development, political systems and religion) have on FDI market selection. Particularly, we believe that the impact will be reduced. Below we represent our testable hypotheses:
Hypotheses:
H1: a. Differences in languages among the countries have a negative impact on the FDI market selection
b. Globalization reduces the impact that languages have on FDI market selection H2: a. Differences in education levels among the countries have a negative impact on the FDI market selection
b. Globalization reduces the impact that education levels have on FDI market selection
H3: a. a. Differences in industrial development among the countries have a negative impact on the FDI market selection
b. Globalization reduces the impact that industrial development has on FDI market selection
3
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H4: a. Differences in political systems among the countries have a negative impact on the FDI market selection
b. Globalization reduces the impact that political systems have on FDI market selection
H5: a. Differences in religions among the countries have a negative impact on the FDI market selection
b. Globalization reduces the impact that religions have on FDI market selection III. Methodology
2. Measurements and data
In our research we make use of the five basic factors that we outlined above in the literature section (differences in languages, education level, industrial development, political systems and religion). Those factors have their own indicators which Dow and Karunaratna (2006) develop in their research. Below we represent a table with the indicators:
Languages indicators:
- difference between the major languages of any two countries, - the incidence of country i's major language in country j - the incidence of country j's major language in country i
Education level indicators:
- difference in the % of literate adults between countries i & j
- difference in the participation rates of population in 2nd level education between countries I & j
-difference in the participation rates of population in 3rd level education between countries I & j
Industrial development indicators:
-difference in US$ GDP per capita between countries -difference in energy consumption between countries
-the difference in the number of cars per 1,000 people between countries -the difference in the % non-agricultural labor between countries
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-the difference in the % of daily newspapers per 1,000 people between countries - the difference in the number of radios per 1,000 people between countries, -the difference in the number of telephones per 100 people between countries - the difference in the number of televisions per 1,000 people between countries
Political systems indicators:
- difference in the POLCON V scale between countries
-difference in the Modified POLITY IV scale between countries
-difference in the Freedom House Political Rights scale between countries -difference in the Freedom House Civil Liberties scale between countries Religion indicators:
- difference between the major religions of any two countries, - the incidence of country i's major religion in country j - the incidence of country j's major religion in country i
Data that we will utilize for the dimensions of psychic differences that we describe above and their specific score, originate from the study of Dow Douglas and Amal Karunartna (2006)*4. It calculates the perceived difference in its dimensions (and their indicators) that we outline above between the home and the host country. With the use of such data, we will be able to investigate if differences in psychic distance have a negative impact on FDI market selection.
Market selection
The outflows from a home country to the other countries reveal to us the preferences that home country have in other countries in order to form a foreign direct investment. We measure market selection for FDI as the outflows foreign investments that home country has to the host countries. More detailed in our case, the outflows of FDI from the USA to 28 other countries. We chose the USA because is the biggest economically active country in the world as it has invested in most countries all over the world and vice versa. Such a large number of the USA FDI outflows to various countries ensure that we have a healthy range of country level variance in MNE‟s FDI
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decisions. We collected our data for the outflows of FDI for the years of interest from the USA to 28 other countries, as US million dollars from the Organization for Economic Cooperation and Development (OECD).
Control variables: According to the literature we use as control variables (Douglas Dow et al. 2006, 2007, Paul Brewer 2007 etc): the midyear population for countries that we exam for all the years of interest. We gather the data from the U.S Census Bureau and is calculate in thousands dollars. We also control for GDP per capita as the gross domestic product divided by midyear population (control for the volume of exporting and importing countries), we gather this data information from the site of World Bank. Last, we control the geographic distance that the USA has with the other countries (acts as substitute for transports costs), we measure it as the distance that the capitals have in kilometers.
The appendix at the end of the paper provides results for the correlations statistics between the variables and also descriptive statistics.
3. Method and Model:
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use robust estimations to avoid the aforementioned problem in our OLS regressions that we will perform.
To move further, we need to define our basic regression model and outline our equation. Consequently, to test our hypotheses we estimated a model containing one dependent variable (Y1) five independent exogenous variables (X1, X2, X3, X4 and X5) and three control variable (X6, X7 and X8).
.Dependent variable:
Y Outflows FDI - Market selection for FDI which is measure as the outflows of FDI from
USA to other countries Independent variables:
X1 Differences in Languages- capture the perceived differences in languages between the
countries
X2 Differences in education levels- capture the perceived differences in education level
between the countries
X3 - capture the perceived differences in industrial development between the countries X4 Differences in political systems- capture the perceived differences in political systems
between the countries
X5 Differences in religion- capture the perceived differences in religions between the
countries
Control variables:
X6 Population- host nation populations in thousands
X7 GDP/capital- GDP per capital in US dollars in thousands
X8 Geographic distance– the distance in km that home country capital has with host country
capital
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Y (outflows FDI from USA) = β0 +β1 (Differences in Languages) +β2 (Differences in education levels) + β3 (Differences in industrial development)+ β4 (Differences in political systems) +β5 (Differences in religion) + β6 (Population) + β7 (GDP/capital) + β8(Geographic distance) + Error
IV. Results
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The results for the regression that were performed are not as we expected to be. More specifically:
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languages have in FDI market selection. Furthermore, the variable differences in languages appear to be statistically significant at the 5% confidence interval as their p values are lower than 0.05.This signifies that our model strong relationship between differences in languages and the direction of outflows for the USA for the years 1997-2008.
The same relationship (negative) holds for the variable differences in industrial development. As expected, the coefficient for differences in industrial development is negative (-5,016) and also we find statically 3 weak significant evidence at 10% (p-value < 0.10). Meaning that different industrial development among the host and the home country has a negative impact on the FDI market selection. Differences in education level are found as well with negative coefficient (-1,202) but it is statistically insignificant. On the other hand, the results for the signs of coefficients political system and religion are unpredictable as we show above, the signs are positive (2,820 and 1,295), meaning that our results denote that differences in religion and political systems are positively associated with the location choice for a FDI. Yet, the results point out that there is no statistical significant for these two variables in our model.
As it is evident, the interaction variables between the dummy period and the indicators of psychic distance (differences in languages, in education level, in industrial development, in political systems and in religion) are all statistically insignificant. Denoting, that there is no significant change during the globalization in the impact that these indicators have on FDI market selection.
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same level of industry development for instance a country with development in technology industry will desire to invest in another technological development countries rather in a country with agrarian industrial development).
As far as H2a is concerned, we were not able to find any evidence that differences in education levels have a negative impact on the FDI market selection. The coefficient denote negative relationship but still is statistical unimportant.
In favor of H4a and H5a the results are not as we predicted to be, H4a and H5a are not confirmed from our results. In contrast, our variables coefficients point out that differences in political systems and religions positively influence the selection of the market for FDI. This come in contrast with the results of previous researchers (Dougals Dow et al. 2006, 2007, Paul Brewer 2008, Ricardo G Flores & Ruth V Aguilera 2007 etc,) who found that there are negative relationships and not positive ones. However, the results in addition indicate that there is no statistical significant for these two variables in our model. Thus, there is also no confirmation for hypothesis H4a and H5a that differences in political systems and religion have a negative impact on FDI market selection. Our results are quite the opposite with previous researchers, indicating that there is no correlation between differences in political systems and religion with FDI market selection.
As far as the second part of our hypotheses is concerned, if globalization has reduced the impact that psychic distance indicators have on FDI market selection, it cannot been supported from our results. Meaning that there is no evidence (all the interaction variables between the dummy period and the factors of psychic distance are statistically insignificant) that globalization has adjusted and reduced the impact that psychic distance has on FDI location choice.
V. Conclusions and discussion
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calculate the averages for all the variables of interest in two different periods (1997-2002, 2003-2008). We create a dummy period variable and also generate an interaction variable with the dummy period variable and the psychic distance factors in order to be able to observe if the impact that factors of psychic distance have on FDI market selection have been reduced via the globalization. Unfortunately, our results do not support this.
Our research has concluded in several interesting conclusions. First, the importance of differences in languages and industrial development on FDI market selection. We proved that those differences have a negative impact on FDI market selection. Furthermore, our results‟ indicating that globalization has not adjusted the impact that these differences have in FDI location choice. What are interesting about our paper are the results for the other 3 dimensions of psychic distance. In our paper we found no evidence that difference in education level, political systems and religion have significant role to play (positive or negative) in FDI market selection (insignificant statistically).
This study, like the most of the empirical studies, suffers from a number of limitations. First of all we have data limitations; our data for the psychic distance dimensions is constant (it is calculated for a specific periods or years by Douglas Dow et al.2006), it is difficult to capture real changes for instance in religion over the years. The traditional believes mainly stay constant but the way that this believes affect the people in a globalized world it is complicated to capture and measure it.
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Our research, considering the limitations that we outline above, give stimuli to other international business researchers to investigate the relationship between psychic distance between the countries and globalization and by extension if globalization has adjusted the impact that psychic distance plays on FDI market selection.
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