Corruption, Political Risk and Previous Experience in Central and Eastern European Markets - Impact on the Entry Mode Choice

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Corruption, Political Risk and Previous

Experience in Central and Eastern

European Markets - Impact on the Entry

Mode Choice

Khrystyna Vyshnevska

1

st

Supervisor: Rudi de Vries

Referent: Marjolein van Offenbeek

University of Groningen

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ABSTRACT

Building on Institutional theory and partially on Transaction Cost analysis this paper develops propositions about the influence of corruption, political risk, implementation of the control of corruption measures and previous experience of MNCs on the entry mode choice of the largest European companies. A panel data collected over the period of ten years (1996-2006) are used to examine 150 entries into the four CEE markets- Russia, Ukraine, Czech Republic and Poland. Whilst the earlier research suggests that unstable institutional environments pose threats for the MNC’s decision to internationalize (Henisz, 2000), the findings of this analysis do not fully confirm with such propositions. The results of the present study reveal that only the employment of the measures to control the corruption has an effect on the entry mode choice, resulting in a preference towards the wholly-owned entries. Interestingly, corruption, political risk and previous experience of MNCs do not appear to impact entry mode choice.

KEY WORDS: MNCs, Transaction Cost Theory, Institutional Theory, Entry Mode Choice,

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1. INTRODUCTION

The international diversification has been recognized to be a key factor affecting the growth and survival of a multinational enterprise (MNE) and has been carefully studied in the international management literature (Chang & Rosenzweig, 2001; Rodriguez et al, 2002). The decision to internationalize consists of the two important issues that a MNE has to carefully consider: the first one is the choice of the production and the second is the choice of an entry mode for a foreign market (Mudambi & Mudambi, 2002). Management literature has studied both factors surrounding the decision of international diversification for long period of time and has identified two main categories of entry: arm’s length (non-equity) modes such as exporting, licensing, etc.; and FDI - (foreign direct investment- equity) modes such as joint venture (JV) and investment via wholly owned subsidiary (WOS) (Rodriguez et al., 2002). The factors affecting the entry mode choice are generally divided into the firm-level (Delios & Beamish, 1999; Davis et al., 2000) and country-level factors. Firm-level considerations constraining or facilitating an entry to a particular market have been mostly looked at from the perspective of Transaction Cost theory (Dunning, 1981). Where the commitment of a government to a set of policies and regulations is low and risks of expropriation are high, firms will choose to minimize the commitments to a market, or avoid investment, which will results in an arms’ length (non-equity) entry modes (Henisz & Delios, 2001).Country-level factors, surrounding the decision to internationalize, have been commonly studied from the perspective of the Institutional theory and include national culture, institutional characteristics, political stability and corruption (Rosenzweig & Singh, 1991; Henisz & Delios, 2001; Uhlenbruck et al., 2006).

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provided by Getz & Volkema (2001: 9) as “the abuse of public roles and resources for private benefit or the misuse of office for nonofficial ends” This definition is also adopted by Rose-Ackerman (1978) and Shleifer & Vishny (1993).

Political risk is the second factor studied in this study and also among major country-level factors for multinationals considering investment in a host environment (North, 1991; Wheeler & Mody, 1992). Political risk or instability is defined in this paper as “the probability that the state will use its monopoly on legal coercion to renege on prior agreements with private firms in order to affect a redistribution of rents among private and public sector actors” (Holburn, 2001: 4). Once MNE enters the foreign country and sinks the assets into the operation of its subsidiary, the probability that in response to government opportunism the MNE will decide to leave the host market is less probable. As a result, this increases the ability of governments to extract additional surplus from the firm by breaking original commitment (Holburn, 2001).

The research presented in this paper studies the impact of corruption, political instability and previous experience on choice of entry mode in transition economies, particularly in Russia, Ukraine, Poland and Czech Republic. The companies contained in the dataset have already chosen to enter the CEE markets despite the risks associated with corruption and political instability, but the aim of the present research is to check whether those factors have forced the MNCs to establish shared or full ownership. Transition economies selected for the purposes of this study present very interesting cases to explore, since all four of them are presently in different stages of development from centrally-planned to market economies. The entire institutional and legal infrastructures have been drastically changed in the 1990s (Bevan et al., 2004). Such radical switches challenged businesses to manage major strategic and organizational change. Therefore, unlike the old European firms who primarily faced the traditional issues of economic development, CEE organizations had more drastic transformations. These economic experiments allowed the researchers to examine the generalisability of traditional theories and to find hidden elements that have been unnoticed when applied to mature markets (Meyer & Peng, 2005).

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(Smarzynska & Wei, 2000). The present study is aimed at addressing this gap by empirically analyzing entry modes of the 150 largest European MNEs into four CEE markets. Moreover, this paper includes a number of features that add significantly to the entry mode research. Firstly, panel data for a 10-years period was gathered for this study in order to grasp the institutional change and its impact on the entry mode in the Central and Eastern European (CEE) markets. Secondly, governmental restrictions are included as one of the control variables. This factor has been said to influence the entry of a foreign investor but is overlooked in the majority of studies (Anderson & Gatignon, 1986; Gomes-Casseres, 1990). Thirdly, an MNC’s previous regional experience was included in the present research model in order to check whether such prior regional “familiarity” will cause any change in entry decision. Finally and most importantly, this paper argues that institutional setting of a host country and uncertainties associated with it (such as corruption and political risks) are among the major factors impacting the entry mode choice.

The following research question was formulated in order to guide this study and draw the conclusions:

What is the impact of corruption, political risk and previous experience on the market entry mode of MNEs in Central and Eastern European countries?

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2. RECENT ECONOMIC DEVELOPMENTS IN CEE AREA

Foreign direct investment played a key role in the global and regional economic development during the 1990s (UNCTAD, 2003). This process was taking place simultaneously with the rigid changes in the CEE region. After the fall of the Iron Curtain in 1989 Soviet Block counties started the transition from socialistic centrally-planned economies to capitalism with parliamentary democracy (Meyer, 1995). During this transition period CEE economies permitted the entry of Western firms anticipating the positive influence on the shift toward market economies. CEE policymakers were also hoping that attraction of the foreign capital to the region would foster the knowledge transfer and provide the necessary capital for government budgets (Dunning, 1991). The inflow of the capital was also exceedingly essential for restructuring the industries and renewing the capital stock of the region (Meyer, 1995).

Integration of the CEE countries into the European Union and elimination of investment barriers has furthermore accelerated the transition process. However, the CEE region is still far from being homogeneous when it comes to foreign investment (Bevan & Estrin, 2000; Carstensen & Toubal, 2004). Both: the level and the growth of FDI, differ across the CEE countries due to different initial conditions and country-risks (Carstensen & Toubal, 2004). Furthermore, the varying levels of economic development between the accession and non-accession countries in the area are said to attract different types of FDI (UNCTAD, 2003).

Presented below are the developments of the inflow of the foreign direct investment for the period of approximately last eight years (since 2000) into the four CEE markets analyzed in this paper.

2.1. Russia

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After the collapse of the Soviet Union in 1991, Russia has started the transformation to the market economy. The economic situation has experienced a number of ups and downs but continued its recovery with the increase in GDP of $184 ,6 billion in 1999 to that of $570 billion in 2004 ( WorldBank, 2007). This tremendous economic development however, is largely attributed to the constant growth of the world oil and gas prices, as Russia continues to be one of the largest exporters of those natural resources. In the recent survey of Japanese transnational corporations (TNCs) , Russia was ranked 6th among the most promising locations for investment in 2006-2008 leaving behind even United States of America (UNCTAD, 2003). The biggest part of the Russian outward investment is still concentrated in the neighboring countries of the Commonwealth of Independent States (CIS). But despite the positive prognoses, Russia is still receiving fairly small amounts of FDI. In 2000, the Russian Federation cumulated only US$ 11 billion, which is much lower than other transition economies in the CEE area (Broadman & Recanatini, 2004). Clearly, Russia is still struggling with attracting foreign firms and improving the perception of its investment climate regardless of the attractiveness of its market (OECD, 2001; Broadman & Recanatini, 2004). The reasons for the struggle to attract the FDI have very common roots with the other economies in Eastern Europe: the need of establishment of a competent and effective judicial system; banking reform; accounting reform to promote greater transparency; reform of so-called natural monopolies in power, gas and community services and finally, reducing the overall governmental bureaucracy (US Department of State, 2006)1.

2.2. Poland

The economic changes which took place in Poland can be divided into two periods: 1989-1991 and 1992 -2001 (Domanski, 2003). In 1989 to 1991 the so called “shock therapy” was carried out to ensure a rapid transformation to market economy. This period however, was characterized by a rapid fall of GDP, high inflation, deep production decline and very low foreign direct investment.

After the complete transformation of its economic and business environment, Poland became one of the most attractive spots in the CEE region for the foreign investors. Additionally, the announcement of the accretion to the European Union in 2004 further increased the level of FDI

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(Bevan & Estrin, 2004). The United States have contributed significantly to the rise of foreign direct investment in Poland and have been the leading source of FDI in the years 1993-1997. Between 1992 and 2001 U.S. companies have invested 15 percent of the total foreign investment -US $56 billion2. The majority of the FDI flows in the area continue to be concentrated in the three economies: Poland, Czech Republic and Hungary (UNCTAD, 2002). Presently 60 percent of the European investment into Poland comes from the EU member States, out of which Germany alone accounts for 14 percent (Domanski, 2003).

2.3. Czech Republic

The Czech Republic has displayed one of the best market success stories in the CEE region. Czech government managed to attract steady and increasing flows of the foreign capital into its economy by consciously launching programmes to encourage FDI. As a result of such programmes, in 2000 the Czech Republic overtook Hungary, which previously was the leader in terms of stock of the FDI (Picciotto, 2003). The country is characterized by EBRD transition index as a low risk and a high level of reform (UNCTAD, 2004). The stock of FDI in the country amounts to around 50 percent of GDP (WorldBank, 2006). Such good results were mainly achieved through the final stages of privatization when the majority of the infrastructure sector was to be sold in 2001(Picciotto, 2003).

Nevertheless, the Czech Republic experienced a strong economic downturn in 2003 which was followed by a massive fall in FDI. This decline was largely due to the end of privatization that represented the major source of investments (UNCTAD, 2004). Severe floodings in Central Europe in August 2002, which seriously impacted Czech Republic, added up to economic decline. With the accession to the European Union and unrestricted access to the European markets, the Czech Republic experienced the boost of the foreign capital. In addition to the steady growth of the foreign investment almost 50 percent of profits earned from it are being reinvested into the Czech economy (Picciotto, 2003).

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2.4. Ukraine

Ukraine is among the largest economies not only in the CEE region, but also in Europe as a whole, with its population size close to that of France. The country has a large potential due to its large market of skilled and unskilled inexpensive labor while in general the level of education is very high (Lutz & Talavera, 2004).

However, FDI levels into Ukraine are still lagging behind when compared to other transitional economies in the region (e.g. Hungary, Poland). Foreign investors are hesitant to invest money in Ukraine and clearly prefer its less risky neighbors like Poland, Hungary and Czech Republic (as demonstrated in Table 1). The United States invests ten times more into the economy of Poland than into Ukrainian (Lutz & Talavera, 2004). The process of transition has been slowed down by immature and often corrupted institutions which significantly reduced FDI. In addition, the investment climate is still very discouraging due to substantial technological lags and lack of international cooperation (Lutz & Talavera 2004). The processes described above are interrelated to the large extend; therefore for Ukraine to attract the investment it foremost needs to establish a safe and regulated institutional system.

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Table 1 demonstrates the FDI inflows and outflows into the 4 CEE countries measured as a percentage of gross fixed capital formation and as a percentage of GDP. FDI flows as percentage of GFCF provides a measure of the net new investment by the enterprises in the domestic economy in the fixed assets. However this indicator does not provide the information about the breaking-down into sectors; or take into account factors such as depreciation or changes in the exchange rates. The second measurement is more accurate - FDI stock as a percentage of GDP and generally pictures the overall health of the economy. It represents the total dollar value of all goods and services produced over a specific time period3; and is usually used to assess the comparative attractiveness of countries to the foreign investors.

Table 1: FDI flows as a percentage of gross fixed capital formation, 2003-2005 and FDI stocks as a percentage of gross domestic product

FDI flows as a percentage of GFCF FDI stocks as a percentage of GDP Region/ economy 2003 2004 2005 1990 2000 2005

Czech Republic Inward Outward 8.6 0.8 17.2 3.5 34.0 2.7 3.7 … 38.9 1.3 46.1 3.4 Poland Inward Outward 11.6 0.8 28.4 1.8 14.6 2.7 0.2 0.6 20.5 0.6 31.1 1.6 Russian Federation Inward Outward 10.0 12.3 14.3 12.8 10.5 9.5 … … 12.4 7.8 17.3 15.7 Ukraine Inward Outward 13.8 0.1 11.7 - 45.2 1.0 … … 12.4 0.5 21.1 0.6

Source : UNCTAD, World investment report 2006, (http://www.unctad.org/en/docs/wir2006_en.pdf )

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3. THEORETICAL FRAMEWORK

3.1. Entry Mode Research

The research studying the factors surrounding the entry mode choice is vast. The most commonly applied theories are Transaction Cost analysis (TCA), Institutional theory, the Resource-based view and Dunning’s eclectic framework (OLI). These theories roughly account for 90 percent of all published works analyzing the entry modes (Brouthers & Hennart, 2007). Some studies have attempted to use other managerial frameworks to explain the entry mode choice - Agency theory (Fladmoe-Lindquist & Jacque, 1995), Bargaining Power theory (Palenzuela & Bobillo, 1999), and Resource Dependency theory (Glaister & Buckley, 1996). However such research is quite underdeveloped and therefore is not discussed in the present study.

This part of the paper shortly summarizes the major theoretical frameworks that have been applied to the decision with regards to the entry mode.

Transaction Cost Theory

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strategies of foreign investors, among others entry mode choice (Henisz, 2000; Meyer, 2001, Bevan et al., 2004).

Institutional Theory

The main argument of the Institutional theory is that the institutional environment of a country determines “the rules of the game” and therefore strongly affects the interaction between the foreign and home firms (DiMaggio & Powell, 1983; North, 1990; Brouthers & Hennart, 2007: 405). The institutional framework of a country is hard to transform and its costs determine the attractiveness of a location for foreign investor; furthermore it affects the transaction and coordination costs of production and innovation (Mudambi & Navarra, 2002; Bevan et al, 2004). Peng (2000) states that institutional arrangements and informal institutions (ranging form bureaucratic norms to clientelism) serve as the keystones for economic transactions influencing the performance and operation of the businesses. Efficient institutions are also said to lower the transaction costs and reduce the uncertainty (North, 1990). The application of the Institutional theory for the entry mode, included analyzing host country uncertainties that impact entry mode (Delios & Beamish , 1999; Brouthers & Brouthers, 2002) and examination of the host industry structure as a barrier for the entry mode ( Chen & Hennart, 2002). Furthermore, it is argued that Institutional theory serves best to explain and predict the strategies of the enterprises in emerging markets such as CEE (Hoskisson et al., 2000; Bevan et al., 2004; Uhlenbruck et al., 2006). However, the previous institutional research has received some criticism as to the lack of theoretical basis for choosing the analyzed host- environment risk factors (Brouthers & Hennart, 2007). Brouthers & Hennart (2007: 406) state that “each study seems to use those risk factors that are deemed appropriate (or available) by the authors”, because majority of the IT research papers lists different host country risks or uncertainties that might influence the mode choice.

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Resource – Based View (RBV)

Resource- base framework has been claimed as the most influential framework for understanding strategic management (Barney et al, 1991). In the heart of the RBV lies the idea that firm’s competitive advantages derive from its own resources and capabilities that are valuable, rare, non- imitable and hardly substitutable. Such competences could be represented by both: tangible and intangible assets (Tsang, 2000). By operating in foreign markets firm can develop the resources that might have not been exploited otherwise (Brouthers & Hennart, 2007). Moreover, because of acquiring of such resources and capabilities, firms obtain the sustainable competitive advantage (Foss, 1993). Large part of the RBV research has been dedicated to studying the entry mode choice for a foreign market. Experience of the MNC was among the earliest factors identified with relation to entry mode. Scholars have suggested that as the firm gains experience in the foreign markets it acquires a firm-specific advantage and will move to more complex ownership (such as WOS) (Johanson & Vahlne, 1977; Erramilli, 1991; Claver & Quer, 2005). Other RBV characteristics that have been studied and hypothesized to have an influence on the entry mode are firm-specific resources like technology and tacit knowledge (Mutinelli & Piscitello, 1998; Ekeledo & Sivakumar, 2004).

Eclectic Framework (OLI)

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investing in Turkey by Tatoglu & Glaister (1998). Recently some scholars have attempted to extend Dunning’s theory by including extra variables. For instance Tsai & Cheng (2002) have investigated the Taiwanese investments in the U.S. and included the influence of strategic variables on the entry mode choice. Their finding supported the importance of the asset-specificity and strategic investment motivations for the entry.

3.2. Institutional View and TCA in the Context of CEE

Having presented the literature review, it is evident that the research analyzing the factors surrounding the entry mode decision is abundant. For that reason it is particularly important to select the appropriate theoretical view to support the findings of this paper. Both Institutional and Transaction Cost theories are employed in this paper. It has been chosen to use only one construct of TCA - “external uncertainty” because it deals specifically with the unpredictability of the entrant’s external environment (Anderson & Gatignon, 1986). The implication of both theories has been chosen for a number of reasons.

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internal consistency when accepting local conditions that conflict with norms of the organization (Rosenzweig & Singh 1991). This in turn, will cause the MNEs to engage in strategic behavior such as alteration of the entry mode (Uhlenbruck et al., 2006). Because this analysis deals specifically with the context of the transition economies where risks associated with the institutional uncertainties are very high, this paper only employs TCA’s second main variable – external uncertainty. External uncertainty is the volatility of the firm’s environment and this factor is very important in international operations. This variable is additionally referred to as the “country risk”, because it can take many forms, such as political instability, economic fluctuations, currency changes (Anderson & Gatignon, 1986). Zhao and colleagues (2004) have performed a meta-analysis studying the importance of constructs of the TCA for the entry mode. Authors found that the country risks that have been previously identified in the scholarly works have a statistically significant impact on the entry mode choice.

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4. HYPOTHESES

4.1. Institutional Building

Conventional management literature tends to view the entry mode choice as a matter of the alignment of the control between the businesses associates (Makino & Beamish, 1998). Transaction Cost theory followers suggest that ownership equals the control (Anderson & Gatignon, 1986). Therefore the level of the ownership in a foreign enterprise presents the weighted choice between the firm’s desire to control its operations and its attitude towards the investment risk (Makino & Beamish, 1998). The present study agrees with this standpoint and highlights the importance of the institutional setting as a major barrier for the foreign investment This analysis approaches the concept of institutional building as a composite measure of the three factors- corruption, political risk and control of corruption measures.

Corruption

Entering a host business arena firms are confronted with many pressures. Some of them come from within the company itself, such as organizational practices. Others are embedded in the host institutional environment. Such pressures from the host-country institutions might force MNC to trade the ownership for legitimacy in the foreign business arena, opting for a joint venture with the local partner (Yiu & Makino, 2002). Looking at the foreign entry mode choice from the perspective of the Institutional theory, scholarly works argue that firms choose the organizational practices such as entry mode primarily in response to isomorphic pressures arising from both internal and external environment (DiMaggio & Powell, 1983).

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Azerbaijan decreases the probability of the formation of the wholly-owned subsidiary by ten to twenty percent. Studies performed by Hines (1995) and Wei (2000) provide further evidence that corruption negatively affects the FDI. Wei (1995) in particular found in his study that an increase in the corruption level from that of Singapore to that of Mexico is equivalent to raising the tax rate by over twenty percent. Management studies also propose a notion that if the corruption is wide-spread, local firms form business circles or networks in order to resort the business negotiations (Rodriguez et al., 2002). Such networks are first closed to the foreign firms, but in order to gain its legitimacy in a corrupted business setting MNE has to enter these social circles. Therefore, a firm is likely to choose a foreign partner to alleviate the risks of an uncertain environment. Yiu & Makino (2002), claim that a foreign MNC could be tempted to trade the ownership for the legitimacy in corrupted business environment. Choosing a joint venture will also help foreign MNCs to reduce the interaction with the local government and the chance to meet corrupted government officials. Forming a joint venture will not only help the foreign enterprise to alleviate some of the regulatory requirements and institutional risks but will also provide with “spillover effect” of the knowledge about local skills, labor and infrastructure ( Yiu & Makino, 2002). The following hypothesis is formulated in order to test the effect of the corruption on the entry mode choice:

Hypothesis 1:

In the presence of the high level of corruption, foreign MNEs tend to enter the market via a shared ownership (JV)

Political Risk

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Past research studying the effect of the institutional setting recognizes the importance of the political hazard for the entry mode decision (Jun & Singh, 1996; Henisz, 2000; Delios & Henisz, 2001; Bevan et al., 2004). In particular authors claim that in the context of the transition economies, foreign investors will face higher transaction costs than in developed economies because “the transition temporarily creates an incomplete institutional framework” (Bevan et al., 2004: 46). Authors further state that these costs might vary across the transition economies because of the difference in the speed of adjustment to the market economy. Delios& Henisz (2001) have conducted the most comprehensive research on the political risk; authors claim that where the credibility of the policy is low, firms will minimize the commitment to the market or even avoid investing. Other authors argue that external uncertainty of a country (which also includes the political stability) may force the investors to exert high control to manage the volatility (Bivens & Lovell, 1966). However the supporters of the Transactions Cost analysis reject this notion and state that such approach commits the foreign firm to the operation that might change as the unforeseen circumstances could develop (Anderson & Gatignon, 1986). TCA suggests that in the presence of the external uncertainty foreign investors should adopt a low-control entry mode (such as joint venture). This will reduce the risk of the product and technology becoming obsolete and allow avoiding the commitment of the resources. Institutional theory followers also agree with this proposition. Anderson & Gatignon (1986) allege that low-control mode maintains the flexibility. Choosing a low-low-control entry mode will also permit the free choice of the business partner, renegotiation of the contract terms and working arrangements. The following hypothesis is formulated in order to test the effect of the political risk on the entry mode choice:

Hypothesis 2:

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Control of Corruption

As already stated in the previous chapters of this paper, host country risks such as investment risk and are among most salient determinants of the entry mode choice ( Anderson & Gatignon, 1986; Kogut & Singh, 1988; Carstensen & Toubal, 2004). Therefore creating a proper investment climate and keeping the corruption under control is of a key importance for any transition economy willing to attract the FDI. Implementation of the anti-corruption rules varies significantly among the Central and Eastern European countries. Some economies such as Poland and the Czech Republic have started the transition process earlier on and progressed further in their institutional reorganization adopting the necessary rules and regulations (WorldBank, 2006). Other nations like Ukraine and Russia are still struggling with unstable and often corrupted institutions. The management research constantly underlines the fact that FDI is positively related to the quality of the formal and informal institutions (Bevan et al., 2004). Scholars also argue that legal developments are among the most important institutional developments that influence FDI (Bevan et al., 2004; Brouthers et al., 2004).

The entry mode literature states that foreign entrants are more likely to establish wholly-owned subsidiaries in economies that have progressed furthermost in institutional transformation (Williamson, 2000; Meyer, 2001; Dikova & van Witteloostuijn, 2007). In relatively recent research Peng (2003) argues that during the early stages of transition, when formal institutions are not fully developed and informal constraints are present, foreign entrants are likely to choose joint ventures, but further development of the institutional framework will result in formation of full-ownership entries. This paper draws the attention to the importance of the implementation of the control of the corruption as major institutional development factor. Hence the following hypothesis has been formulated:

Hypothesis 3:

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4.2. Previous Experience of MNC

Regional Experience

Scholars studying the factors impacting the entry mode often find that the host-country and regional experience plays a major role in the entry mode choice (Johanson &Vahlne, 1977; Anderson & Gatignon, 1986; Gomes- Casseres, 1989; Hennart & Reddy, 1997; Delios & Henisz, 2002).

Foreign firms are disadvantaged in comparison to local firms in their knowledge and understanding of cultural, political and economic institutions. Such knowledge is tacit and is subject to high transaction costs (Hennart, 1988, 1991). But acquiring this knowledge is vital for local operations. Thus firms that lack the experience will tend to depend on their foreign partners first, but as the experience accumulates the dependence on the local partner is less critical and therefore foreign MNEs will start exercising full control (Anderson & Gatignon, 1988). Gomes- Casseres (1989, 1990) and Yiu & Makino (2002) support this point view and predict that foreign firms are more likely to choose a wholly-owned subsidiary as they build up local experience. Experience of a specific country or region is especially valuable because it allows the firm to exploit market opportunities more efficiently. Firms that are experienced in dealing with buyers, suppliers and governments from the region are better at obtaining the knowledge to perform future tasks for market entry (Johanson & Vahlne, 1977).

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the ties to the local businesses and institutions (Meyer & Estrin, 2001). Hence the following hypothesis has been formulated:

Hypothesis 4:

MNEs with previous experience in CEE region tend to choose the full ownership (WOS) entry mode

4.3. Conceptual Model

The conceptual model presented below portrays the variables and proposed relationships among them that were analyzed in the present study. As can be seen in Figure 1, the explanatory variables (independent) are divided into two groups: the Institutional Building and the Previous Experience of the MNC. The influence of these four independent variables on the dependent variable Entry Mode is moderated by the two control variables – Firm size and Governmental Restrictions.

Figure 1: Conceptual Model

INSTITUTIONAL BUILDING 1. Corruption 2. Political stability 3. Implementation of the control of corruption CONTROL VARIABLES 1. Firm size 2. Governmental restrictions ENTRY MODE

1. Equity entry via wholly-owned subsidiary

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5. METHODOLOGY

5.1. Sample and Data Sources

Empirical analysis performed in this research is based on the panel data of 150 entry modes, comprised of the largest European MNEs having subsidiaries in the chosen four Central and Eastern European markets. The selection of the European companies has been performed with the help of AMADEUS4 database. The sample of 150 entry modes has been drawn from MNEs in 15 EU member states. It has been decided not to include the newly entered EU member states as majority of the new countries comes from the CEE region and including them in the sample would not contribute to the analysis carried out and might produce confusing findings. Additionally, the sample has been filtered to include the companies that have at least ten percent equity stake as a minimum to qualify as a foreign direct investment in any of the four CEE markets. Equity is defined as the level of control over business’s operations and amount of ownership (Pan & Tse, 2000). Limit on equity of ten percent has been set in compliance with studies performed by Benito & Gripsrud (1992), Padmanabhan & Cho (1999); Larimo (2003) and Dikova & van Wittellostuijn (2007).

CEE markets have been chosen based on the Corruption Perception Index (CPI) provided by Transparency International. The four fairly corrupted CEE economies (ranked according to CPI Index 2006) have been selected as – Russia (CPI index5 2. 5), Ukraine (CPI index 2.8), Poland (CPI index 3.7) and Czech Republic (CPI index 4.8).

The time frame for this analysis includes ten years, from 1996 to 2006. This frame has been set in order to ensure the comparability of all the indexes that are used for independent and control variables; and to achieve greater external validity of the findings.

4_{AMADEUS is a comprehensive, pan-European database containing financial information on over 7 million public} and private companies in 38 European countries. It combines data from over 35 Information Providers (IPs). Source: https://amadeus.bvdep.com. Accessed 19.09.2007

5_{CPI Score relates to perceptions of the degree of corruption as seen by business people and country analysts, and} ranges between 10 (highly clean) and 0 (highly corrupt).

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5.2. Level of Analysis

The level of the analysis of the present study can be best classified as the nation-state. This level goes beyond the traditional Institutional theory and belongs to the neo- institutional view (Scott, 2001); and hypothesizes that factors at the national level are the principal influences of the structures at the corporate level. Scott (2001) also suggests that nation-state level of the analysis captures the important forces at the national level that are often overlooked by the micro studies. Present study is primarily concerned with the impact of the factors that are controlled at the nation-state level, such as corruption and political risk. Therefore, for firms that considers the investment into the economies with high environmental uncertainty the need to build up the awareness about those factors is very high.

Yet, carrying out a multilevel study could increase the generalisability and explanatory power of the findings .This level of the analysis could not have been performed because of the complexity of such studies and the time pressure reasons. Multilevel study is “a methodology for the analysis of the data with complex patterns of variability with the focus on the nested sources of variability: for instance longitudinal measurements of objects” (Bosker & Snijders, 1999: 2) Using the multilevel analysis for the present study would allow to the detect the variability at each level of the nesting: firstly, within each individual country (Poland, Czech Republic, Russia and Ukraine) and secondly, among the countries. It would also permit to see the effect of the macro-level factors (e.g. environmental volatility) on the micro-level variables (e.g. organizational decision making).

5.3. Measures

5.3.1. Dependent Variable

The dependent variable is Entry Mode.

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between 5 and 95 percent of equity. The threshold of 95 percent has been used in previous management studies on the ownership choice (Stopford & Wells, 1972; Gatignon & Anderson, 1988; Gomes-Casseres, 1989, 1990; Hennart, 1991). The entry mode choice has been captured by a dummy variable coded as 0 for joint venture when parent owns more that 5 but less than 95 percent of subsidiary’s equity and 1 for WOS when parent owns 95 percent or more.

The data about choice of a particular entry mode by MNE was taken from the AMADEUS dataset, official websites of the companies, articles and publications.

5.3.2. Independent Variables

Based on the extensive literature review, the four independent variables were classified as– corruption, political stability, implementation of the control of corruption and previous regional experience of the parent MNC. First three variables were used to measure the Institutional Building in the host environment (Meyer, 2001).

Political stability- “measures the perceptions of the likelihood that the government will be

destabilized or overthrown by unconstitutional or violent means, including domestic violence and terrorism” (Kaumann, Kraay & Mastruzzi, 2007: 3). Political stability was captured by percentile rank provided annually by D. Kaufmann for World Bank. Indexes for the period of 1996-2006 are used. “0” corresponds to lowest rank and “100” corresponds to the highest rank.

Corruption. For the measurement of this variable the Corruption Perception Index (CPI) was

used. This index is provided annually by Transparency International. CPI indexes for the period of 1996- 2006 are employed. Overall this index measures the extent of corruption in the public and political sectors and ranges from “0” corresponding to highly corrupt countries and “10” to highly stable economies.

Implementation of the Control of Corruption- “measures the extent to which public power is

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used in this study to measure the institutional building of the host market. Implementation of the control of corruption was measured as a percentile rank provided by D. Kaufmann for World Bank on annual basis for 1996 till 2006. “0” corresponds to lowest rank and “100” corresponds to the highest rank.

Previous Regional Experience of the Parent MNC. This variable is said to significantly impact

the decision to invest in a host business environment and enhance firm’s ability to successfully manage its foreign operations (Gomes-Casseres, 1989; Hennart, 1991). Works performed by Meyer (2001) and Dikova & van Witteloostuijn (2004; 2007) found support for the influence of the previous regional experience. Every company has been checked using the AMADEUS database and company websites for having any additional subsidiaries (besides the one observed in this analysis) in the four CEE markets. If a firm was previously engaged in any of the four markets than it received a value of 0 (Variable Regional Experience is measured by a dummy, see Table 2).

5.3.3. Control Variables

Firm size and governmental restrictions were employed as the control variables.

Firm size. Firm size was used as a control variable because its influence is repeatedly underlined

in management studies (Gatignon & Anderson, 1986; Kogut & Singh 1988; Gomes- Casseres, 1989, 1990; Dikova & van Witteloostuijn, 2007). Hennart (1991) states that the smaller the firm the less likely it will have the resources and capabilities to takeover the host firm; and subsequently the more likely is the probability of a joint venture establishment to reach the economies of scale. Firm size will be measured in terms of the number of employees (Gatignon & Anderson, 1988; Meyer, 2001; Brouthers, 2002; Nakos & Brouthers, 2002).

Restriction Posed by Host Governments. Prior research has pointed out the importance of

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shared ownership. Authors also add that imposition of the ownership restrictions forces foreign firms to venture with its local partners to mitigate the liabilities. El Said & McDonald (2002) investigated the link between the institutional systems and the entry mode of the MNCs and affirm that the extensive use of the JVs in transition economies can be largely attributed to the legal restrictions, such as prohibition on the full ownership. In the present study governmental restrictions were investigated by using the Index of Economic Freedom published by Heritage Foundation for the period of 1996-2006. Employing this index was performed in line with the study of Uhlenbruck et al. (2006). In particular the Index of Investment Freedom6 was employed in this study. This index is measured as an assessment of the free flow of capital, especially foreign capital (Heritage Foundation, 2007) and ranges from “0” when foreign investment is prohibited to “100” where foreign investment is encouraged and treated the same as domestic investment.

A summary of the variables that were analyzed in this paper along with their characteristics and measurements is presented in Table 2.

6

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Table 2: Characteristics and Measurements of the Variables

Variable Type Measurement Source

Entry Mode Dependent Variable

Coded as Dummy Variable: 0 = JV 1= WOS AMADEUS, company websites, annual reports, articles and publications Corruption Independent Variable Corruption Perception Index (CPI) Transparency International

Political Risk Independent Variable Annual Index by D. Kaufmann World Bank Implementation of the control of corruption Independent Variable Annual Index by D. Kaufmann World Bank Previous Experience of Parent MNC Independent Variable

Coded as Dummy Variable 0= Has Experience

1= No Regional Experience

AMADEUS, company websites

Firm Size Control Variable

Number of Employees AMADEUS

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6. THE EMPIRICAL RESULTS

In line with the previous research examining the entry mode choice ( Nakos & Brouthers, 2002; Nakos et al., 2002; Dikova & van Witteloostuijn, 2007), a binary logistic regression has been applied because this technique allows predicting an outcome for a dichotomous and non-continuous variable, since dependent variable in this paper Entry Mode presents two categories : joint venture and wholly-owned subsidiary. Logistic regression analysis can also be used when independent variables are categorical or a mix of continuous and categorical (as can be seen in this study); and when they are not normally distributed.

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logistics analysis deals with the outliers. This particular assumption is very important for the chosen analysis because “extreme” observations can be classified by SPSS as belonging to the one category when in reality they should be classified in the other. To check if there were any violations, each variable has been firstly carefully observed using the boxplot graphical tool. This analysis revealed that independent variable Firm Size had seven cases of extreme observations. After careful consideration and analysis of the data set all of the seven cases were removed. Afterwards data has been additionally checked for outlying observations using the Casewise Diagnostics which detects the outliers that lie within more than 2 standard deviations. This technique proved that the data presented no further threats as to the violation of the third assumption of the binary logistic regression analysis.

Table 3: Descriptive Statistics and Correlations (N = 4 countries, 150 observations)

Entry Mode (0= joint venture= wholly-owned subsidiary), Regional Experience (0= has experience; 1= no regional experience)

** Correlation is significant at the 0.01 level (1-tailed). * Correlation is significant at the 0.05 level (1-tailed).

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Logistic regression analysis is similar to the simple regression (or Ordinary Least Squares) although the main difference is that this analysis predicts the logits, which are the natural log of the odds of having one or the other outcome (Hosmer & Lemeshow, 2000). To explain what the logits are and how they work the following clarification is provided:

p = count of all the cases (N)

Odds = p / (1 – p) (probability of presence of the characteristic of interest )

Logit = ln (odds) (the natural log of the odds) = ln {p / (1-p)}

Consequently the logistic regression works with the following (linear) equation: ln { p / (1 – p )} = B0 + B1X1 + B2X2 + . . . + BkXk

, where logit is the odds of having the outcome of 1 for the dependent variable (because it is dichotomous); B1, B2….Bk are the regression coefficients and X1, X2….Xk are independent and control variables.

A two-stage model was used in this study. The first model included the entire set of the explanatory variables including the control variables – firm size and governmental restrictions. The second model included only four independent variables .This has been done in order to examine the model with and without the control variables to check their influence on the overall model. The Enter method was applied to both models. This method enters all of the variables in the model and coefficients provide the measurement of how well the model fits.

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Model 2, one can clearly see that a null hypothesis is obviously rejected in both cases because chi-square test is significant at p < 0, 01. This provides the evidence that both models contain the independent variables that improve prediction of the dependent variable. Moreover -2 Log Likelihood ratio shows the improvement in the goodness of the fit of the model compared to the baseline model (provided in parentheses). Though the chi-square is moderate (25,405 for Model 1 and 15,747 for Model 2) both models demonstrate a quite high percentage of the correctly classified entry modes (76, 0 and 74, 7 percent respectively).

In Model 1, which analyzes the whole set of the explanatory variables (independent plus control) only one variable – control of corruption (p < 0, 01) was significantly related to the mode choice in the predicted direction. This provides the support for Hypothesis (3): MNC’s are more likely to enter a foreign market by means of wholly-owned subsidiary if host governments are taking measures to control the corruption. No support was found for the other hypotheses - (H: 1) a higher level of corruption in the host market did not result in preference towards a joint venture by the foreign MNC, (H: 2) a higher level of political instability did not force foreign MNCs to opt for a joint venture entry and (H: 4) previous experience with joint venture/ wholly-owned entries in the CEE region did not result in foreign MNCs having a preference towards the wholly-owned entries.

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Table 4: Logistic Regression Results (N = 4 countries, 150 observations) Variable Model 1 Model 2 Parameter Estimates Standard Error Parameter Estimates Standard Error Corruption ,789 ,418 ,858 ,394 Political Risk ,976 ,026 ,979 ,025 Control of Corruption 1,055* ,021 1,056* ,021 Regional Experience (1) 1,169 ,463 1,256 ,450 Firm Size 1,001 ,002 Government Restrictions 1,014 ,022 Constant ,633 ,923 ,854 ,824 N 150 150 Chi-Square 25,405* 15,747* -2 Log Likelihood 155,885 (157,423) 164,714 (165,563) Overall % correct 76,0 74,7 Significance ,006 ,002 Nagelkerke R² ,166 ,161

Entry Mode (0= joint venture= wholly-owned subsidiary), Regional Experience (0= has experience; 1= no regional experience). -2LL (in parentheses is given the change).

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7. DISCUSSION

The continuing globalization and integration of the emerging economies into the global marketplace increasingly pressures multinational corporations to operate in the highly corrupted and unstable economic environments (Uhlenbruck et al., 2006). As the number of studies that examine the impact of corruption and political risk is quite limited, the present study was aimed at filling this gap by addressing those issues in the context of the transition economies in the Central and Eastern Europe.

A number of interesting trends have been discovered while gathering and analyzing the dataset (See Table 5). Poland and the Czech Republic cumulatively appeared to be more appealing for the foreign investment. These economies were able to attract FDI earlier (majority of foreign entries occurred between 1980 and 1990) and greater part of the investment occurred through the wholly –owned entries. One of the major explanations for such tendencies is the relatively stable economic situation as can be proven by low indexes (in comparison with Russia and Ukraine) for corruption and political stability and earlier privatization process. In addition Poland and the Czech Republic present much better indexes of the Investment Freedom, which means that those economies encourage foreign investments and treat it the same as domestic, unlike Russia and Ukraine where foreign investment is still rather prohibited (Investment Freedom index ranges from 30 to maximum score of 50). Furthermore, while constructing the dataset it has been noted that manufacturing industries like heavy machinery, electricity, oil, etc., made their entries into the CEE countries much earlier than other industries, around the early nineteen sixties.

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steps to control the bureaucracy and corruption and therefore is perceived as being safer for investment, it attracts more investments and these investments are likely to come in form of the wholly-owned subsidiaries.

Table 5: Wholly-owned Subsidiaries versus Joint Ventures

Host Country Number of Joint Ventures Number of Wholly-owned Subsidiaries Total Czech Republic 4 25 29 (19,3 % of total no. of observations) Poland 11 50 61 (40,7 % of total no. of observations) Russia 16 27 43 (28,7 % of total no. of observations) Ukraine 9 8 17 (11,3 % of total no. of observations) Total 40 (26,7 % of total no. of observations) 110 (73,3 % of total no. of observations) 150

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institutional stability was unable to predict the outcome of owned acquisition or wholly-owned investment. A possible explanation for this finding may be that because a large part of the companies included in this sample already has a previous experience with doing business in Central and Eastern Europe (107 out of 150), corruption does not present such a huge threat for them as for the first time entering firms because those firms have possibly already entered the circles of the informal institutions and built up the necessary contacts.

High political risk (H: 2) appeared to be an insignificant predictor of the wholly-owned subsidiary establishment as well. Correlations provided by the binary logistics regression show a highly insignificant relationship with the dependent variable. This finding is consistent with the research of Oxley (1999), Dikova & van Witteloostuijn (2004) and Bevan & Estrin (2004). Possible underlying reason may be that the gains provided by the CEE markets (proximity to EU markets, cheap and skilled labor, etc.) outweigh the risks and challenges confronted there. Moreover, the risk of “sovereign default may be more of a concern for investors engaged in portfolio flows or currency speculations” (Bevan et al., 2004: 784).

No statistical support was also found for the influence of the previous regional experience (H: 4) on the choice of wholly-owned entry mode. The probable explanation for this could be that the sample for this study has been constructed from the top largest companies in Europe and those companies already have sufficient experience worldwide, so they do not require a particular regional experience in order to enter a certain market. Another opposing explanatory view is provided by a study of Nakos & Brouthers (2002), who also found no significant difference in mode choice based on previous experience. Authors state that experience might not be an important factor because “entry into the turbulent CEE markets may present a new experience for all SMEs; previously developed knowledge may not be applicable” Nakos & Brouthers (2002:58).

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8. LIMITATIONS AND SUGGESTIONS FOR THE FUTURE

RESEARCH

This study has a number of limitations. The first one concerns the use of the concepts – “corruption” and “political risk”. Employing such concepts in the study presents the subject for an argument, because they are quite difficult to define and measure. Fitzsimons & Kana (2004: 3) also acknowledge this threat, by saying that when using a measurement of corruption a researcher has to make a choice between “surveying (subjective) perceived relative levels of corruption and (more objective) experience of economic losses in broad samples of businesses with some indication of the degree of expense involved”. A suggestion for the future research would be applying an additional corruption index in the study, for example measurements of the Freedom House. Second, because only CEE markets were examined, the findings of this research might not be generalisable to more or less developed nations. Third, this study along with many others (Anderson & Gatignon, 1986; Erramilli & Rao, 1993) suffers from concentrating on the large firms. Analysis of the SMEs in the entry mode literature is quite rare. Further, because of the problems with the availability of the data and time pressure, the present study had to make use of the bimodal entry mode choice – joint venture versus wholly-owned subsidiary. This certainly limits the findings because none of the arm’s lengths entry choices were examined (e.g. licensing). Using only the bimodal entry mode choice further limits the findings because this study does not use the exact percentages of the ownership in the foreign firms. Future research is needed to explore this topic using the percentages of ownership because the large number or scholarly research (particularly Transaction Cost theory) tends to view the percentage of the ownership as a matter of weighted choice between the desired control and institutional risks in the foreign environment. Therefore knowing the exact percentages owned in the foreign firms, could provide vital information as to the exact impact of the institutional factors on the entry mode choice. Another threat to the findings of this paper is posed by the defining the concept of the “restrictions on the entry mode choice”. Controlling for such constraints is said to be quite unsatisfactory (Brouthers & Brouthers, 2003) because the actual strictness of the investment entry is very hard to measure.

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9. CONCLUSION

The present study did not aim at analyzing the underlying reasons for the existence of corruption and political volatility; however some research on the transition economies stipulates that it is the very nature of the transition environment that is so favorable for the development of the corruption (Fitzsimons, 2003: 4). This research has been carried out in line with the propositions of the traditional theoretical frameworks – Institutional theory and Transaction Cost theory.

Due to the high institutional instability investment into the transition economies bears many risks. Some economies in the CEE region still lack reliable monitoring processes, infrastructure, and resources. Institutional, political and administrative systems are often unstable (Dikova & van Witteloostuijn, 2004). Dikova & van Witteloostuijn (2004) further claim that operating in such insecure environment where local firms promote production under centralized instruction, neglect consumers and lack innovation might discourage foreign investors from acquisitions. Early works investigating the influence of such factors suggests that institutional environment presents an important determinant of entry mode (Zhao et al., 2004; Brouthers & Hennart, 2007). Such research argues that in countries with high environmental uncertainty, companies are more likely select low-investment and low-commitment entries; this will allow them to maintain flexibility in case of the need to switch business partners or leave the market completely (Brouthers et al., 2004).

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The data gathered for this study reveal that international investors still have a strong preference towards the economically and legally stable markets. Czech Republic and Poland were able to attract FDI earlier (in comparison to Russia and Ukraine) and mainly through the wholly-owned subsidiaries, which could be partially explained by the fact that those countries present significantly better corruption and political stability indexes. Ukraine and Russia are lagging behind but show the advancement, with Russia attracting almost one third of the total number of the observed entries (see Table 5).

In order to check whether the variables in Table 5 - entry mode choice and subsidiary location were associated with each other by coincidence or statically related, a Chi-square test has been performed (see Table 6). The chi-square results statistics is 13,228 with an associated p < 0, 01. This result suggests that the null hypothesis (there is no association among the variables) is rejected and the conclusion can be made that the entry mode preference is related to the subsidiary location; meaning that European MNCs entering the CEE economies, were generally more likely to form wholly-owned subsidiaries.

Table 6: Chi-Square Results

Value df Sig. Pearson Chi-Square 13,228(a) 3 ,004 Likelihood Ratio 12,862 3 ,005 Linear-by-Linear Association 7,536 1 ,006 N of Valid Cases 150

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The findings of this empirical research received the support for only one of the three factors used to measure the institutional building – implementation of the control of corruption measures (H: 3). Hence, the foreign MNCs are more likely to establish wholly-owned subsidiaries in economies that have progressed further in implementing measures to prevent the corruption, which is in line with the propositions of Institutional theory and TCA. Further results of this study show no support for the impact of the institutional building on the entry mode choice in the CEE markets (H: 1, 2 and 4). These results support the findings of Gaignon & Anderson (1988) and Delios & Beamish (1999: 929) who state that “host country risk was a less important institutional consideration than legal sanctions on foreign ownership, perhaps because of the reduced threat of expropriation”. Previous experience of the MNCs in the CEE region appeared to be an insignificant predictor as well. Controlling for firm size and governmental restrictions additionally revealed no impact on the entry mode.

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ACKNOWLEDGEMENTS

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GLOSSARY

CEE – Central and Eastern European Countries CIS – Commonwealth of Independent States CPI – Corruption Perception Index

EBRD – European Bank of Reconstruction and Development FDI – Foreign Direct Investment

GDP – Gross National Product

JV – Joint Venture

MNE – Multinational Enterprise MNC – Multinational Corporation SME – Small and Medium Enterprise NIE – New Institutional Economics OLI – Dunning’s Eclectic Framework RBV – Resource Based View

TCA – Transaction cost Analysis (synonym: TCT – Transaction Cost Perspective) TNC – Transnational Corporation

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Corruption, Political Risk and Previous Experience in Central and Eastern European Markets - Impact on the Entry Mode Choice