Foreign Expansion: Entry Mode and Network Pattern of the Japanese Firms in Europe

Transcription

1 Foreign Expansion: Entry Mode and Network Pattern of the Japanese Firms in Europe Ilian Petrov Somlev (Doctoral Program in Quantitative Finance and Management) Advised by Professor Yasuo Hoshino Submitted to the Graduate School of Systems and Information Engineering in Partial Fulfillment of the Requirements for the Degree of Master of Management at the University of Tsukuba January 2003

2 Acknowledgements I would like to express my gratitude to my advisor, Professor Yasuo Hoshino, as well as to all professors at the Graduate School of Systems and Information Engineering at the University of Tsukuba for their support and helpful advices. I would like to thank my Japanese teachers at the International Student Center at the University of Tsukuba for their efforts to push my Japanese language abilities to the level necessary for understanding the various Japanese data sources. Finally, I am obliged to the Japanese Ministry of Education, Culture, Sports, Science and Technology (Monbukagakusho) for its financial assistance without which this study would not have been possible. ii

3 CONTENTS ABBREVIATIONS... V INTRODUCTION... 1 PART I THEORY AND ITS APPLICATION Theoretical review Entry mode theories Theories of MNE Empirical studies PART II DESIGN OF THE STUDY Variables controlled by the design Europe, Japan, and ultimate Japanese parents PART III EMPIRICAL ANALYSIS Analysis of network extensiveness Analysis of manufacturing commerce substitution Analysis of entry mode Testing for contingencies by region Testing for contingency by region, for greenfield ventures only Testing for contingencies by sector PART IV CONCLUSION AND LIMITATIONS REFERENCES APPENDIX: LIST OF THE SAMPLED 462 COMPANIES iii

4 LIST OF TABLES TABLE 1 THEORIES OF MNE AND ENTRY MODE AND PARALLELS BETWEEN THEM...63 TABLE 2 JAPANESE FDI IN EUROPE AND THE REST OF THE WORLD (US$ MILLION) 63 TABLE 3 ANALYSIS OF NETWORK EXTENSIVENESS...64 TABLE 4 ANALYSIS OF COMMERCE-MANUFACTURING SUBSTITUTION...66 TABLE 5 CHI-SQUARE AND PAIR-WISE T-TESTS FOR WOS/JV DIFFERENCE BY REGION...68 TABLE 6 CHI-SQUARE TEST FOR WOS/JV INDEPENDENCE FORM INDUSTRY AND PAIR-WISE T-TESTS FOR WOS/JV DIFFERENCE BY INDUSTRY (ALL FIRMS, COUNTS)...69 TABLE 7 PAIR-WISE T-TESTS FOR WOS/JV DIFFERENCE BY INDUSTRY (ALL FIRMS, UNADJUSTED SERENDIPITY)...69 TABLE 8 THE INDUSTRIAL DISTRIBUTION IN THE UK RELATIVE TO THE OTHER REGIONS, IN PERCENTAGES OF THE SUBSIDIARY COUNTS...69 LIST OF FIGURES FIGURE 1: JAPANESE FDI IN EUROPE: UJPS BY INDUSTRY AND TRANSACTIONS...61 FIGURE 2: LEVELS OF ANALYSIS AND FLOW OF RESEARCH...62 iv

5 Abbreviations EU European Union FDI foreign direct investment GTC general trading company JV joint venture M&A merger and acquisition MCR manufacturing-commerce subsidiary ratio MNE multinational enterprise OLI ownership, location, internalization PAH proprietary asset hypothesis TA transactional advantage TC transaction cost UJP ultimate Japanese parent WOS wholly owned subsidiary v

6 Introduction The most difficult challenge to the study of multinational enterprise (MNE) activities has been the creation of a comprehensive theory of MNE and foreign direct investment (FDI) (Krugman and Obstfeld 2000). In addressing this challenge the scholars in international business have preferred microeconomic perspective or explanation of the MNE activity to international economics or general equilibrium ones (Caves 1996). The multitude of the MNE theories focus on specific issues, such as inter-firm relationships, information and learning, significance of tangible and intangible resources, or industry structure (Williamson 1985, Casson 1995, Penrose 1972, Porter 1985). Some authors (Caves 1996, Dunning 1988) have combined several issues in one theory, which usually lacks the parsimony and the efficiency of the single-issue models. Taking this challenge, the present paper tries to combine the issues found relevant in theory in order to analyze the foreign expansion pattern of the Japanese firms in Europe. If we define a firm with foreign sales or production subsidiaries as an MNE, then the main elements of the MNE activity are the motivation to become an MNE, the international market selection, entry mode choice, developing of investment networks, and profitability related to the international operations. Investment networks include the industrial and geographical distribution of all subsidiaries of a given parent in a given region or in the world, and the entry mode associated with them. The entry mode choice usually decomposes to FDI vs. exporting choice and those two options are sometimes considered as 1

7 the end-points of a continuum of choices. The paper, however, views the exporting firms (a firm that has no subsidiaries whatsoever outside its home country) as domestic. They are participants in international trade, exposed somewhat to foreign markets, the distribution to which they do not control, and occupying a gray zone between domestic companies with sales only at home and MNEs. Therefore, entry mode in such a context decomposes to entry via new venture vs. acquisition and to entry via wholly owned subsidiary (WOS) vs. joint venture (JV). From all the elements of MNE activity the profitability is the most difficult to analyze because there are many exogenous variables influencing it besides the endogenous variables like the international market selection and entry mode. Furthermore, common explanatory variables could affect both the market choice and the entry mode (Andersen 1997) and putting the latter two together as regressors for profitability would cause collinearity problems. Therefore the paper aims at studying the elements of the MNE activity in a unified framework, which is the analysis of the investment networks of each parent firm. In this analysis market selection reduces firstly to choices between the regions in the world, and secondly to choices among the countries within those regions. In addition, the analysis of investment network patterns naturally focuses on the MNE and attempts no comparisons between the group of MNEs and that of non-mnes. As an ultimate aim (not achieved at present), network analysis will help locate the subsidiaries at the root-base of the economic activities of the Japanese parent firms in Europe. By analyzing the factors that influence the performance of these root companies better judgment is possible for the profitability of the regional operations viewed as a whole. The 2

8 influential scholars in the field of MNE and FDI have emphasized such a point of view (Dunning 1993, Rugman 1979). The main proposition concerning the strategy of the MNEs is that it is regional in nature. Investment networks in one region depend on the region characteristics and have little in common with the investment networks in other regions. This is simplification of reality because production in one region may be intended for the markets of another, yet it is useful simplification to start with. The main justification of it is the different strategic uses the MNEs have of each region as well as the specific political and economic circumstances of each of them. The region under focus in this study is Europe (including Russia and Turkey), and it has 30 countries divided to 6 sub-regions. Region 1 includes the Britain and Ireland, region 2 includes the core countries of the European Union (Germany, France, Benelux, and Austria) and Switzerland, and region 3 includes the Scandinavian four (Norway, Sweden, Finland, and Denmark). Region 4 includes Portugal, Spain, Italy and Greece (the southern periphery of the EU), region 5 includes Poland, Czech Republic, Hungary, Turkey and Russia, and region 6 includes the remaining 8 countries (Slovakia, Slovenia, Croatia, Malta, Cyprus, Bulgaria, Ukraine and Romania). A corollary of this main proposition is that it is possible to observe the main regional influences on the network strategy in a cross-sectional study. If all important driving forces for the creation of the regional sales and production network have been operative only in particular time intervals, then it would not be possible to understand the present state of the foreign operations without performing a longitudinal study. This is ascertained not to be the 3

9 case, at least with respect to the most important network features. Time influences the contraction or expansion of investment activities but their distribution depends on more static, cross-sectional factors. The main novelty of the research is its focus on the MNE parent, called ultimate Japanese parent or UJP, instead on the separate subsidiaries (or transactions) in order to study the network pattern. Figure 1 illustrates the parallel UJP local subsidiaries sample features and gives a glance to this approach. Figure 2 explains how the new approach incorporates both a MNE level of analysis - the unit of network pattern analysis being the UJP - and an analysis of the entry mode choice, carried on an individual subsidiary level with the unit of analysis being the separate transaction. The entry mode is an ingredient of the network pattern, which is supposedly less dependent on the individuality of the UJP, but more on the transactional situation. Therefore, it is justified to have two separate levels of analysis. Another argument of the paper is that instead of focusing on the issues influencing entry mode and networks separately, as most of the research has done, we would profit from studying them altogether. Many empirical studies test hypotheses based on one of the theories of MNE by using for variable operationalization proxies that often surpass the scope of that theory. Viewing all issues together would greatly enhance validity (complementarity and exhaustiveness) of measures. The paper has four parts. Part I reviews the theory of MNE and its application to empirical studies, and stresses the difference between hypothesis testing and data exploration. Part II explains the strong points of the study design as well as the features of the transactions between Europe and Japan. Part III analyses empirically the available data. Section 3.1 4

10 carries out an analysis of the extensiveness of the FDI network. Section 3.2 continues the network pattern analysis by adding the feature of manufacturing - trade substitution. Section 3.3 reveals some of the important contingencies of entry mode. Part IV proposes extensions of the research and concludes the study. 5

11 Part I Theory and its application 1.1 Theoretical review Entry mode theories International business scholars have used three single-issue theories and one framework to study foreign entry mode in both manufacturing and services: the resource-based theory, the transaction cost theory, the behavioral approach and the eclectic framework (Andersen 1997, Casson 1995, Williamson 1985, Dunning 1993). Resource-based theories explain entry mode by firm s experiential knowledge 1 or firm s capabilities in general. When the firm s experiential knowledge is the main explanatory variable, the entry mode develops as a time-dependent establishment chain (no export -> export via independent representative -> sales subsidiary -> manufacturing abroad 2 ) because increased market knowledge leads to increased market commitment. When firm s capabilities is the main explanatory variable, internalization (collaboration) occurs if the erosion in the value of the firm s know-how is due mostly to ownership effect than to location effect (location effect than to ownership effect). While resource-based theories stress the significance of the firm s experiential 1 Experiential knowledge, like expertise in cross-cultural management, is different from formal knowledge, i.e. hard facts obtainable from consulting company (Meyer and Skak 2002). 2 One weakness of the establishment chain proposition is the omission of cooperative modes of entry like joint venture (JV) or licensing. See Andersen 1997 for review of this school of thought. 6

12 knowledge or the value of the firm s capabilities, transaction cost theory claims that the key consideration in selecting entry mode is cost minimization of the transaction. The unit of analysis switches from the firm in resource-based theories to the transaction, or inter-firm relationship. The core dimensions of the transaction are specific assets, frequency of economic exchange and uncertainty surrounding the exchange of resources between buyer and seller (Williamson 1985). The focus is on the inter-organizational governance of seller-buyer relationship with internalization concurring with increase in specificity, uncertainty and frequency. Transaction cost (TC) theory includes explicitly resource transferability, while resource-based theory assumes it implicitly. The TC theory has been modified in the empirical research to include non-transaction cost and benefits, such as coordination of strategies of MNEs, and moderating factors like external uncertainty, internal uncertainty and firm size (Andersen 1997). In addition, the classifications of entry mode assume that the concepts of control and integration are closely related, and this has focused the research on intra-firm issues like seller s choice of entry mode, or internal uncertainty like the entrant s inability to determine its agent s performance. This means that, probably due to measurement and prediction difficulties, or to the limited inclusiveness of explanatory variables, inclusion of firm factors often supplements the TC minimization assumption 3. The behavioral approach emphasizes perceptions, learning, knowledge and innovation (Vermeulen and Barkema 2002). It usually has application in 3 It is evident that there is some overlap between both theories discussed so far, especially the correlation between the frequency of economic exchange and experiential knowledge. 7

13 devising secondary variables, moderating the relationships between the primary ones. As such it finds its place implicitly in other theories, especially when culture, trust and learning arguments buttress the major (TC or resource-based) theoretical propositions. The eclectic framework combines TC theory with resource-based theory (and international trade theory (Andersen 1997)). The explanation factors are ownership, location and internalization factors. The former includes firm-specific assets, skills, firm size and multinational experience. The ownership factors provide the firm with competitive advantage. Location factors reflect the host country market potential, investment risk, cultural similarity to the investing country and level of production costs. Internalization factors refer to the costs of choosing vertical integration versus market transaction (Dunning 1988, 1993), and as such correspond to the cost of the transaction. The OLI advantages reflect the need of control and resource availability 4. The challenges to the applicability of the framework are to avoid overlapping explanations of entry mode (see footnote 3 above), to ensure parsimony, and to analyze the interaction between the factors. Location advantages, in addition, explain not only entry mode but probably also international market selection. Most research takes for granted the entering firm freedom to choose an entry mode in any host country. However, if government restrictions on ownership exist, international market selection and entry mode choices might not be 4 The logic of the OLI-control/resource availability correspondence, however, differs across the empirical studies that employed the eclectic, or OLI framework. See the review of the empirical studies below. Further developments of the framework consist in inclusion of strategic variables and contingency characteristics of resource requirements and control factors (Andersen 1997, p. 35). 8

14 independent decision processes (Andersen 1997). Some studies were capable of including this consideration within the OLI framework (Padmanabhan and Cho 1996). One general feature of entry mode theories is their static nature, the only exception being the resource-based establishment chain theory. Most empirical studies have utilized them as explanatory grounds of the entry mode choice at a given time in a cross-sectional setup. The results explain the internationalization profiles of the firms at a given time, but these profiles may change (or might have changed) over time (Calof and Beamish 1995). This change is often concurrent with the development of the strategic networks of the investing firms. In conclusion, we may point out that the eclectic framework contains explanatory variables not only for the entry mode, but also for the MNE activity in general. The consistent application of OLI theories to entry mode, and in fact, the often-interchangeable usage of entry mode and MNE activity, reveal the significance of the concept of entry mode. It expresses the degree of internationalization of the firm and is probably the single most essential feature of the MNE activity (Nitsch, Beamish and Makino 1996, p. 30). However, entry mode is not synonymous with MNE activity, nor the four entry mode theories discussed so far are the only ones to explain that activity. MNE activity comprises motivational factors for investing, entry modes and international market selection (static aspect) and their evolution (dynamic aspect) within the MNE network strategy, and performance monitoring, measurement and evaluation. The organizational approach (Hymer 1960), the product life cycle model, the exchange rate approach (Rugman 1979) and 9

15 other theories besides the eclectic framework and its TC and resource-based components have aimed at explaining the MNE activity, or the internationalization of the firm. More thorough elucidation of the original theories about the MNE activity is necessary and follows below Theories of MNE Although in his economic analysis of the MNE Caves defines the MNE as an enterprise that controls and manages production establishments - plants - located in more than one country (Caves 1996), the claims that follow are equally applicable to firms in service industries with any kind of subsidiary. Exporting, which is a gray zone from an MNE point of view, is a widely expanded subject of the field of international economics and therefore lies outside the scope of the internationalization theories. The latter try to start where exporting ends: with the question why does a firm engages in technology and other capital factor transfer in order to organize a business activity in a foreign country, instead of only exporting to or importing from that country? International economics has explained the MNE as simply an arbitrager of equity capital who moves it from countries where its return is low to countries where it is high (Caves 1996, p. 24). This claim, however, is too general because it does not differentiate between industries. The latter is crucial for the theory of MNE because MNEs are logically incompatible with purely competitive industries (Hymer 1960, Chapter 1). In such a way Hymer argued against the capital-arbitrager theory and laid the foundations for a microeconomic explanation of the MNE, which still assumes that the MNE 10

16 goes abroad to raise its total profit (Caves 1996, Chapter 2). International economic theories of international factor movements approach differently the issues of international labor mobility, international borrowing and lending and direct foreign investment (or MNE). As regards with the latter, international economics sees the MNE as something more than just another vehicle for international borrowing and lending. The reason is that the parent does not always or only transfer resources, and it is the acquisition of control that is the most important. The subsidiary does not simply have a financial obligation to the parent company; it is part of the same organizational structure (Krugman and Obstfeld 2000). More recently the international economic theory of the MNE have separated the issue to theory of location, which coincides broadly with the comparative advantage theory of international trade, and theory of internalization. The latter one tries to explain why investment transactions are carried out more profitably within a firm rather than between firms by descending to much more microeconomic level than most of the general equilibrium explanations. On this level two influential views have given the reasons for existence of the MNE: the technology transfer 5, according to the first view, and vertical integration, according to the second one (Krugman and Obstfeld 2000). Both views refer to the transaction advantages or transaction costs. Caves (1996) elaborates the first view extensively, while Williamson (1985) professes the second one. The main claim of Caves (1996) is that transactional advantages (TAs) of 5 Technology is broadly defined as any kind of economically useful knowledge, and therefore this comprises both technology in a narrow sense and marketing advantages. 11

17 placing the plants under common administrative control should exist. In the horizontally integrated MNE case, these TAs are technology and marketing ability. Technology is defined as knowledge how to produce cheaper or better products at given input prices. Marketing ability includes the ability of the company to differentiate itself from rivals (branding skills, including advertisement) and to successfully sell its products. Both TAs are inseparable from the employees' skills, and are observable. The number of patents issued and R&D expenditures relative to sales serve as measurements for technology. The former is a fair proxy for technology if the patent process is impartial in all countries, while the latter is an indicator with less validity since the R&D may be fruitless and sales fluctuate widely due to other factors except technology 6. The number (or presence) of trademarks and advertising expenditures to sales (again the latter is a less valid proxy) measure the marketing ability. The marketing skills may arise from two different strategies, however, namely extensive advertising strategy and distribution system developer strategy. Since the latter is non-exportable (even if trademarks exist), only the former will enjoy the TAs in multinational setting 7. Caves first named the above claim the intangible asset hypothesis in the first edition of his work and later changed the name to proprietary asset hypothesis (Caves 1996). In Dunning's terms (Dunning 1988 s OLI paradigm) these TAs are ownership advantages, because they belong to the firm. The reason why TAs necessitate common administrative control of the 6 Furthermore, what matters are the consolidated R&D expenses of the MNE, even though the R&D efforts seldom go beyond the home base of the MNE due to economies of scale and the strategic role of the R&D (Caves 1996, Chapter 7). 7 Analysis of buyers preferences reveals that the made-in label plays an important role, however big the marketing skills of the MNE (Somlev 2001). 12

18 different plants (not necessarily in different countries) is market failure. The intangible asset market fails because of their public good nature, the economics of information inherent to them, and their inseparability from the employees 8. Therefore, the TAs mean internalization advantages as well. TAs comprise both of ownership advantages and internalization advantages. Two qualifications of the dynamics of the proprietary asset hypothesis follow. First, the TA-abundant firm may be only exporter with no production subsidiaries abroad. However, since both of the TAs are unlimited in capacity, unlimited expansion is possible that will soon surpass the boundaries of the home market and will be directed to countries with comparative advantage. The limits to that expansion include the limited ability to expand the necessary management skills and the limited ability to expand the capital base (both could be named "bounded" ownership advantages, in contrast to the unbounded TAs). Second, once the firm's TAs make it expand production beyond its home the costs of learning the ways of doing things in a new legal and cultural system will cause, ceteris paribus, the FDI to occur in markets where the investor faces the least disadvantage of language and culture (Caves 1996). Yet, this may be overruled by the factors for the FDI substitution of export. The FDI is more likely in the bigger markets from all of the markets where exporting ceased to be the option, despite the fact that the smaller ones are more culturally similar to the investors' milieu. But if within a common economic zone (the EU, or Mercosur) exporting is facilitated, then the cultural proximity becomes crucial in the locational decision for a production base within that zone. With the increase in the foreign experience this cultural 8 Caves reviews the possibility of licensing the technology in Caves 1996, Chapter 7. 13

19 proximity importance for the debut FDI seems less important. While it is the management limits to expansion that stand behind the importance of culture in location decisions, the fund-raising limitations shape entry mode decisions and necessitate the creation of international joint ventures. If raising fund ability is limited, then a firm experience "general asset insufficiency" and needs a JV partner to supply tangible assets. If ability to raise funds is present, but specific assets such as local firms' ownership advantages (e.g. local distribution networks) are needed then the JV partner fulfills specific asset insufficiency and is likely to be a local firm. In summary, while the TAs will make the firm always expand, and always via WOS mode (to have a JV partner means sharing the TAs, which, similarly to the market failure reasons, is not an option), the limits imposed by the other assets could sometimes bring about a JV, either to supply a tangible, or specific intangible asset, but never management for its own sake (equivalent to TAs sharing). Some claims within the proprietary asset hypothesis (PAH), such as the inseparability of the TAs from the employees, could be overstated (if you have the scheme, you can learn it), yet other authors like Hayek and Polanyi confirm it (Williamson 1985). In fact, most of the PAH claims are similar to the Penrose s (1972) theory that internal inducements result in firm growth. The expansion argument of Caves is similar to Penrose's, especially concerning the management role as both inducement and limit to the growth (Penrose 1972). The Penrose's argument differs, however, in viewing both tangible and intangible resources, or more exactly, the pool of unused productive services of the resources, as internal inducement for expansion. 14

20 Management is to find them in Penrose's view, while in the TAs hypothesis they are readily observable and infinite because of their public good nature. Penrose also claims expansion to be infinite but makes no reference to the intangible assets particularly, rather to the indivisibility of the assets in general and the possibility of change in their use. Vertically integrated MNEs internalize the market for the intermediate product, because of contracting costs and uncertainties due to opportunism and bounded rationality (present in the TAs too). Here the transactional hypothesis includes only internalization advantages (and no ownership ones), which are the same transaction costs Williamson (1985) refers to and which have been connected to the entry mode above. Asset specificity, uncertainty and frequency not only explain the preference for WOS, but also the internalization of activity by the MNE. Two additional points arise however with respect to the MNE activity. First, often buyer-supplier relations create specific client knowledge, a sort of intangible asset, and therefore of ownership advantage. Second, the horizontally integrated (induced by the TAs) MNEs bring about vertically integrated activity as well - forward integration into information collecting, or disintegration of the production (offshore procurement). The first point shows that when a firm is backward integrating (into resources) it is likely only internalization advantages to exist, arising from market failure, but when a firm is integrating forward both ownership and internalization advantages (that is to say TAs) exist. The specific client knowledge explains why suppliers become MNE if their buyers are already MNEs they follow their clients. The second point shows the difficulty of separating horizontal MNE activity from a vertical one, which parallels the 15

21 difficulty of differentiating between the technology transfer view of internalization and the vertical integration one. Generally, in horizontal expansion the parent and subsidiary outputs are substitutes, while in a vertical expansion they are complementary. A third, minority view, called diversification hypothesis for MNEs and FDI, claims that MNEs advance to foreign markets and to new product lines in order to diversify business risks among product and geographical space (for exporting and FDI) and among labor markets (for FDI only). It is justified either because shareholders do not want to diversify directly, but use the MNEs shares instead (weak claim, since mutual funds are alternative), or because the management is risk-averse and can impose itself on shareholders. Both justifications are weak and do not explain exactly the diversification across countries or across products. The TAs and vertical integration hypotheses do not work in the latter case either, because technology, marketing skills and transactions seem limited to a given product scope. Yet, some unused capacity always remains in both the tangible and intangible assets and Penrose s claim that expansion based on this unused capacity occurs most often by product diversification seems to be the most suitable explanation. In summary, the unlimited capacity of the TAs logically leads to foreign operations (either exports or FDI) most likely in countries with big and rich markets 9, and if FDI is the choice, most probably in legally and culturally similar countries. If only internalization advantages along the vertical chain 9 Concerning trade, of course, the international trade theorists arguments are much better tuned to the problem. However, the arguments for comparative advantage do not apply for oligopolistic markets, which come logically with the TAs. It is in oligopolistic markets where the intra-industry trade occurs, and it is explained by economies of scale and not by comparative (or absolute) advantage (Krugman and Obstfeld 2000). 16

22 induce FDI, then it happens either because the foreign country is abundant in input raw materials (backward integration), or because the foreign country is abundant with labor (vertical disintegration of production). Finally, if the internally induced expansion process finds productive opportunities abroad, diversification is possible with either exporting or FDI. With exception of the vertically integrated MNEs the hypotheses above give no clue as to why FDI will be preferred to exports. The choice between the export and FDI depends on 1) tariffs, 2) economies of scale coexisting with foreign markets of bigger size, 3) taxes, and 4) real production cost differentials. It has been shown in 1980s that FDI and exports are substitutes, and the offshore-induced intra-mne trade only weakens but does not reverse the substitution (Caves 1996). The technology transfer (PAH) and vertical integration views of the MNE activity have explanatory power concerning the MNE distribution among sectors. The MNE distribution among nations, on other hand, has been accounted for by using the variables market size, raw and labor resources, and tariffs. If we suppose that MNEs are industry distributed and general comparative advantage determines the prevalence of given industries in a country, then it also explains why MNEs exist there. But it could be that this prevalence is caused by the MNE presence. The other empirical factors tariffs and market size also attract FDI. In general, location theory stems from comparative advantage theory of international trade when the markets are somewhat competitive and open, and from the economies of scales and market size effects when the markets are rigid or protected. Table 1 summarizes the theories of MNE activity and entry mode and 17

23 presents the parallels that exist between them (see Table 1). In order to understand how these theories have been applied in empirical research, Section 1.2 reviews the empirical studies on entry mode and MNE involvement, and summarizes the underlying theoretical propositions, the explanatory variables and samples used, and the obtained results. 1.2 Empirical studies In a survey of leading US firm in the leasing industry, Agarwal and Ramaswami (1992) collected the perceptual measures of the OLI factors from the firm managers. They used total sales, multinational experience, and ability to differentiate the output as ownership advantage variables, market size and investment risk as location variables, and contractual risk as an internalization advantage variable. Since they focus on a service industry (horizontal FDI) there is no need to include production cost differentials in the locational factors. By design this is a static research introducing for the first time an analysis of the effect of the interaction among the OLI factors on the entry mode. Entry mode splits to no involvement, export (or cross-border leasing), JV, and WOS; and the countries, which the managers assess for investing, are the UK, Japan and Brazil. Without an analysis of 77% non-respondents, the authors proceed with 97 firms each with three countries to assess for entry mode (285 cases). After the authors reduce firm size and multinational experience to one factor because of high correlation, and after they do a necessary for the factor interaction analysis transformation of their variables, they find out that firm size (and experience) and market size make 18

24 firms choose WOS to JV mode but play no role in exporting FDI choice. 10 Investment risk results in avoidance of FDI as expected, but market size and investment risk jointly have the same effect, although market size alone attracts WOS mode of FDI. This interaction reveals the investors risk-aversion and could be useful in explaining the FDI dynamism in one host country. The paper discussed so far is grounded in TC theory and it seems to reflect both the Caves and Williamson s views of TCs (Agarwal and Ramaswami 1992, p. 2). The authors overcome TC measurement problems by using perceptual measures, and reflect well the technology and marketing firm abilities with their ability to differentiate and total sales variables. The design one investor three destinations requires location factors and their market size and investment risk variables are the most adequate for a service industry. Perhaps cultural distance is the only moderator they fail to include. The analysis also assumes implicitly that no government restriction on ownership choice exist in the leasing industry of the UK, Japan and Brazil in However, since entry mode is a choice preference, not a real-world decision, the assessing managers themselves might have ignored government restrictions. This points to the problem of using a choice preference and not realized entry for a dependent variable. Therefore, although the authors try to unify MNE activity (involvement or not) and entry mode choice, they lean strongly to the latter because they do not consider at all real world intensity of involvement. In contrast, Padmanabhan and Cho (1996) include explicitly government 10 The finding that firm experience means involvement choice is a tautology result if the experience is in the same three countries. The finding that contractual risk and ability to differentiate separately lead to choice of exporting over FDI is an unexpected result. 19

25 restrictions and cultural distance in their analysis of WOS JV choice. Based on TC theory 11, OLI paradigm and the bargaining power model, they study 1519 (839 after omission of missing variable cases) manufacturing subsidiaries of 402 Japanese parents in 45 countries between They find that culture and (not surprisingly) host policy are significant, in addition to the confirmed significance of firm abilities like experience and R&D intensity. In addition, the authors segregate the sample to three sub- samples to analyze the interaction and nonlinear effects (Padmanabhan and Cho 1996, p. 54). However, their Hofstede cultural distance measurements are rather dubious and they fail to differentiate between industries 12. They fail to include location (e.g. market size and labor cost) and internalization factors (contractual risks) as well, which is a significant drawback in a design with 45 different FDI destinations around the world. Overall, the focus on the effect of culture and host policy on entry mode made the sample too diverse to handle analytically, and the analysis itself failed to incorporate many necessary control factors. It would be much better to reduce the sample scope to a given region in order to control to a certain degree for cultural distance and government policy and at the same time to be able to analyze in greater depth the factors influencing not only the entry mode but also the extensiveness and other features of the MNE activities in that region. Most of the empirical studies use TCs in either one or both of Williamson s 11 Their variables reflect Caves conception of TAs, which is justified only to the extent the differentiation between horizontal and vertical integration in manufacturing FDI is possible. In their study the wide diversity of countries make it hardly justifiable. 12 The latter is somewhat mitigated by the fact that many of their variables, like parent-subsidiary product relatedness and the size of investment as percent of total size, are relative. Yet, important variables like government restrictions and R&D intensity differ between industries. 20

26 and Caves conceptions, and most papers utilize the OLI factors as a frame for control factors. Shortcomings exist precisely where the latter is not used. The present study focuses on the way the MNE expands its activity, which includes entry mode and the degree and type of network extensiveness in foreign markets. Therefore, it has to incorporate all available theories, and especially theories of growth like Penrose s, in order to explain involvement while controlling for all possible effects those theories suggest. Since the theories discussed above do not make specific claims with regards to the extensiveness of the MNE activity, the present study consists of more explorative elements and fewer tests of a priori given theoretical claims. Nevertheless, it is necessary to ground the analysis in the existing theory, and to this end three generic hypotheses are proposed now and qualified in Part III. Because firm resources form the central part of the claims of Caves and Penrose and because strategy varies across industry (Makino and Neupert 2000), it is natural to relate firm internationalization with firm resources given the industry. Hypothesis I: Firm resources explain firm s degree of foreign expansion, when industry is controlled for. Because horizontal FDI are generally regarded as a substitute of exports (Caves 1996, Chapter 2), the increase of the number of production subsidiaries in the European network of the Japanese MNE will bring a decrease in the number of commerce subsidiaries. Hypothesis II: In the case of well-developed networks of Japanese MNEs in Europe, manufacturing activity will tend to substitute exporting activity. 21

27 The PAH will not generally suggest creation of joint venture because this choice will erode the MNE proprietary assets. However, some circumstances like asset insufficiency or government incentives may force such a choice. At present the second proposition only will be investigated. Hypothesis III: JV choice arises from government incentives. The hypotheses above adopt the view of Penrose and Caves and discard the vertical integration approach because the Japanese manufacturing FDI in Europe are mainly horizontally integrated. The next part justifies this claim. In addition, there are no controls for culture, government host policy and location factors because the design of the study automatically places the MNEs on equal grounds with respect to these factors, as Part II will explain. The empirical studies above were selected precisely because they cover a wider range of issues, controls, and methodology in relation to MNE entry mode and internationalization. The following chapter will give additional justification of the choice (and omission) of independent variables in the proposed hypotheses. Then in Part III, Hypothesis I will be split to three more specific hypotheses. 22

28 Part II Design of the study 2.1 Variables controlled by the design A basic proposition of the present study is that MNE strategy is regional in nature, where region means broadly continent. There are two broad justifications for this claim. First, investment cites are geographically more distant, and economically and politically more diverse between regions than within regions. Second, the data of Japanese MNEs in Europe suggests that the links between subsidiaries in Europe and those in other regions are weak and that the MNEs have a tendency to segregate their networks inter-regionally. The data from the Toyo Keizai Database (Toyo Keizai Inc. 2001) show that for only about 1 % of the Japanese subsidiaries in Europe the immediate or intermediate parent is in a third region. Almost all subsidiaries, related in European networks or not, are immediately owned by parents situated in Japan. Integration is usually much stronger within regions than between them. This is especially true for Europe, with her long history of integration. Naturally, the countries in this region remain culturally as diverse as they could be, but the political and economical aspects of integration, which are of foremost interest to the MNEs, bring the European countries close as a common market (Deutsch 1999, Lane 1995). The paper views Europe as a common market, therefore it disregards the distribution among countries of the FDI, except for a part of the WOS-JV choice analysis. This one investor one 23

29 destination design requires no control for culture or government policy, and of location factors as well. These factors do matter for the intra-european distribution of the investment, but this is not the focus of the analysis. The generic hypotheses introduced at the end of Part I ignored the TC conceptions of Williamson in addition to culture, host regulations and location variables. This is justifiable on the grounds that the Japanese FDI in Europe are horizontal rather than vertical. If this is really the case, internalization occurs due to failure of the market for proprietary assets and not of the market for intermediate goods, and thus only Caves and the closely related Penrose s theories remain applicable. It is difficult to ascertain that the Japanese investments in Europe are horizontal, but two observations justify such a claim. First, compared to other markets Europe is one of the richest in the world, although not that populous, and production costs are high. Second, the motivation of the Japanese MNEs to invest in this region suggests strong horizontal orientation (Kreinin et al. 1999, Blanpain and Hanami 1993). A JETRO survey of the Japanese FDI in the European manufacturing industries reveals that the main reasons for investing are first, part of globalization strategy (73%), second, shift from exports to local production to meet local demand (40%), third, to meet consumers needs (30%), fourth, expansion of market due to EU economic integration and/or rise in protectionism as a result (20%), and fifth, to supply parts to other Japanese subsidiaries in Europe (Blanpain and Hanami 1993). With exception of globalization strategy, these motives point unequivocally the horizontal nature of the investments. In addition, vertical FDI are rare outside the manufacturing industries. Globalization strategy, according to many empirical studies (Porter 1985, 24

30 Makino and Delios 2000), means mainly competitive reaction in oligopolistic industries, and necessity for production cost reduction. The latter implies vertical integration; however, considering the many cheaper than Europe production cites, it remains the former to fill the content of globalization strategy in Europe. In that case it usually has significance with respect to the timing of the investment, which is of little relevance in the present cross-sectional analysis. The case for horizontal FDI in Europe might be defended additionally with analysis of the activity descriptions of the subsidiaries, as well as with a better analysis of the motivation the Japanese firms have to invest in Europe compared to other destinations. Toyo Kezai Inc. (2001) provides both sets of data, the analysis of which in future revision of the paper will improve the horizontal FDI claim. In summary, Japanese parents in each respective industry face in Europe the same level of protectionism and the same unified market (Deutsch 1999). Those two conditions put all investors (industry-wise) on equal grounds with respect to their FDI exporting choice. Those who prefer only exporting without having involvement at least with a sales subsidiary are not MNEs. The design of the study assures, however, that those MNEs that have invested in Europe differ not in the conditions they face but in their investment strategy. The differences the analyses in Part III will reveal, therefore, can be rightly attributed to differences in MNE strategies. 25

31 2.2 Europe, Japan, and ultimate Japanese parents Europe is an important destination for the Japanese MNEs. Over the 1990s the region had attracted between 20 to 30% of the annual FDI outflows from Japan. This significance has not changed during the past several years. Especially in the last three years of 1990s Europe surpassed even the US in inflows received from Japan (see Table 2). Because the EU is the largest receiver of FDI with more than 30% of the world FDI inflows, the level of the Japanese MNE investment still reflects some Asian and American bias. European FDI inflows have grown in the last years, with those from Japan standing at 8 to 10% of all FDI coming to Europe. This reflects the strong inter-european and American position on the common market. The unit of analysis in the first two sections of Part III is the UJP, therefore an exact definition of this concept is necessary. To this purpose, following Beamish et al. (1997) a differentiation is made between ultimate and immediate parent of a subsidiary. First, suppose a subsidiary A in Europe belongs entirely to a subsidiary B in Europe (B holds 100% of the shares of A) and B is a joint venture between a local (European) firm C and a Japanese firm D, both of which hold 50% of B firm. In this case, A is a wholly owned subsidiary (WOS) of B, the immediate parent. If we want to see where the ownership ultimately resides, however, we have to admit that C and D ultimately own A, or that firm A is a joint venture (JV). Second, suppose that a subsidiary in Europe belongs entirely to a Japanese firm A, which in turn belongs entirely to another Japanese firm B. While the immediate parent is firm A, the ultimate one is firm B. 26

32 These two cases exemplify the two general issues involved in the definition of the ultimate parent firm in the case of Japanese MNEs investing in Europe. If there is no local or third country partner involved, and the subsidiaries can be traced to a single Japanese parent A, then they are all WOSs and belong to A. If more than or exactly 50% of the A s shares belong to another Japanese firm B, then again the subsidiaries are WOSs but belonging this time to B. The reason to delete the immediate parent A in favor of B comes from the theory of the MNE. Since the firm advantages (Caves 1982) or the firm total fixed assets (Penrose 1972) are important, the organizational form does not matter or at least not as much. Firm A has organized some of its assets by creating firm B and then has used them to invest in Europe. Attributing the FDI characteristics to firm B alone would be an underestimation error of the scope of those advantages. This is especially true when both the Japanese firms A and B have shares in the subsidiary. This subsidiary is not a JV; it is a WOS, and firm B has to be deleted. Finally, if firm A owns less than 50% of firm B then the latter is not obsolete, and it will be the ultimate parent of the WOS, or one of the ultimate shareholders in a JV with A (a related-japanese parent JV). In the case where a local partner exists, it may be argued that its influence is not limited by a minority position. Therefore, any subsidiary created by a JV is a JV itself, especially if it is in the same host country and the ownership chain is not too long. The length of the chain of ownership matters for the scope of influence of the UJP in both cases of having and not having a non-japanese partner. The above qualifications justify strongly the concept of ultimate parent. 27

33 Cases of long ownership chain or of a JV created in a different (from its parent JV) European country are rare among the Japanese subsidiaries in Europe. Most of the deleted Japanese companies belong 80% or more to their parents, and most of the non-deleted related Japanese JVs (related-jjv) have parents who cross-own about 20% of their shares. This clustering on both ends makes the 50% cut-off point more valid and reliable. However, having the data in accordance with the UJP concept requires correcting the database to some extent. 13 With the above qualifications of the data, the population of the UJPs having FDI transactions in Europe becomes 981 firms (Toyo Keizai Inc. 2001). Those 981 firms have 3497 FDI transactions, and have created 3273 subsidiaries in Europe. Because about 200 of those subsidiaries have two and in a few cases more than two UJP (the rest are WOSs and JVs with local partners) the number of the FDI transactions exceeds slightly the number of subsidiaries (see Figure 1). Figure 1 also shows that for 252 manufacturing UJPs there is no data for assets, however, these parents have a small proportion of the total transactions in Europe. They represent small companies, whose omission will not bias the analysis towards big companies, because very few of the 462 remaining for study UJPs are of large size. The focus is on manufacturing UJPs in order to reduce the versatility across industries of factors that influence FDI strategy. In addition, the most of the 13 The Toyo Keizai Database has the deficiency, in view of the above definition, to stop at the moment the residence of a parent becomes Japanese in order to pick up the UJP. In this way, for example, Pentax Sales Company and Asahi Optical co-own Pentax GmbH in Germany, and both are considered as the UJPs of this related-japanese parent JV. However, Pentax Sales is a small company, owned 100% by Asahi Optical, which is in fact the only UJP. The correction requires deleting Pentax Sales from the list of the UJPs and regarding the subsidiary Pentax GmbH as a WOS of Asahi Optical. 28