Do MNEs Outperform Their Local Counterparts in China Market?
-The Role of Firms’ Capabilities
Bih Jane Liu
National Taiwan University
Department of Economics
10, 2011
Abstract
The proposition that MNEs outperform their local counterparts has been regarded as the “stylized fact” in the literature of firm performance, where the firm-specific advantages enjoyed by MNEs over local firms are documented as the main source of their superior performance. Such a “stylized fact” has been challenged by several studies using different country data and dealing with different econometric problems. However, so far consistent results have not been reached yet. This paper intends to provide one systematic explanation to illustrate the condition under which MNEs may or may not outperform local firms. Specifically, we show that firms’ capabilities play a crucial role in determining their relative performance.
Key words: Profitability, MNEs, Dynamic Capability, China
JEL Classification: F23, F29
- Introduction
It is often argued that China is a tough market to do business because the trade barriers there are so widespread and the competition is so fierce. According to the annual Doing Business survey conducted by the World Bank, China was placed the 92th on a list of 142 countries for overall ease of doing business in 2006,[1] which seems to support the general view that the uncertain and complex markets in China presents daunting challenges to multinational enterprises (MNEs). Compared to their local counterparts in China, MNEs have to overcome the liability of foreignness stemming from various barriers such as formal, informal and hidden rules and regulations. In addition, the logistics and distribution problems in the highly fragmented China market are also the major hurdles that MNEs have to overcome in order to be profitable. On the other hand, as part of established global enterprises, MNEs possess firm-specific advantages (Dunning, 2001), which lend them over local firms special benefits, such as proprietary technology, superior organizational and managerial skills, and captive access to parents’ R&D and information network (Kumar, 1990). It is therefore not clear how profitable MNEs can be in China market and whether or not MNEs outperform their local counterparts.
Earlier studies on the performance of MNEs and local firms have found that MNEs display higher productivity and profitability than local firms (referred to as the “stylized fact” hereafter), because the benefits from firm-specific advantages they possess more than compensate for the higher costs stemming from operating in a foreign environment (e.g., Vernon, 1971; Grant, 1987; Caves, 1996). Some case studies, however, show the result opposite to this “stylized fact”, for example, in the studies of Sri Lanka (Wijewardena, 1995), UK (Kumar, 1984) and the U.S. (Mataloni, 2000). More recent studies, which take into account firms’ heterogeneity and deal with various issues related to regression estimation, also reach mixed conclusions. Some show that MNEs outperform local firms in total factor productivity even after firms’ characteristics are controlled for (Doms and Jensen, 1998). In contrast, others show that MNEs’ superior performance disappear when firms’ heterogeneity and industry effects are controlled for (Globerman et al., 1994), input simultaneity and measurement errors are addressed (Griffith, 1999), and endogeneity problems are taken into account (Benfratello and Sembenelli, 2006). Although some reasons have been provided as to what causes MNEs to perform worst than local firms, e.g., tax-related incentives (Landefeld et al., 1992) and oligopolistic rivalry concern (Kumar, 1984),[2] whether the “stylized fact” holds remain a puzzle and deserve more research.
In this paper, we argue that MNEs may not outperform local firms and that a crucial factor determining the relative performance is the heterogeneity of firms’ capabilities. We show that there are indeed two types of firms, i.e., more competent firms and less competent firms (denoted respectively as competent firms and inept firms hereafter),[3] which have distinct capabilities and behave differently. Two hypotheses are tested in the paper, including (1) adopting more aggressive strategies tends to increase the profitability of competent firms, but lower that of inept firms; (2) among the competent group of firms MNEs are more profitable than local firms, whereas among the inept group it is the other way around. Here, the aggressive strategies refer to adopting more capital-intensive technology, engaging in more R&D, innovation and high degree of product differentiation activities, and undertaking larger long-run debt load. The reasoning lying behind Hypothesis 1 is because competent firms tend to have superior dynamic capabilities to execute aggressive strategies and turn them into a profitable endeavor. Aggressive strategies, on the other hand, may be a perilous adventure for inept firms due to their lack of dynamic capabilities, which make them bear higher costs without much benefit. Hypothesis 1 holds for both MNEs and local firms. Hypothesis 2 illustrates the importance of negative effect of liability of foreignness on profitability, especially for less competent MNEs in a highly fragmented host market with widespread trade barriers.
Using manufacturing firms operating in China and aiming at China market as the case study, we find statistical support for the two hypotheses when the sample is dividing firms into two groups (competent firms and inept firms). The two hypotheses remain valid even when firm ownerships, firm features and industry effects are controlled for. The empirical support for Hypothesis 1 implies that without distinguishing the two types of firms, the conclusions regarding the effects of the strategic variables on profitability in fact reflect the net effect of the two opposite forces for different groups of firms. This helps explain why mixed conclusions are often found in the literature regarding the relationship between strategic variables and profitability (see discussion in Section 2).
A dichotomy pattern on the relative performance of MNE and local firms emerges from the study which supports Hypothesis 2: MNEs are more profitable than their local counterparts for the competent group, but less so for the inept group. The former is consistent with most literature which emphasizes the importance of firm-specific ownership advantages MNEs possess, which lend them over local firms higher profitability. We argue here that in addition to ownership advantages, firms’ capabilities do matter. While the stylized fact does hold for competent MNEs who tend to make the best use of their ownership advantages, it is not valid for less competent firms. Without superior dynamic capabilities to overcome all sorts of uncertainty and challenges in a foreign market environment, the extra efforts and costs stemming from coping with the liability of foreignness for inept MNEs are likely to be large relative to the ownership benefits. This makes inept MNEs less profitable than their local counterparts. Moreover, MNEs tend to adopt more aggressive strategies than local firms for both competent and inept groups, which reinforces the dichotomy pattern when Hypothesis 1 is taken into consideration.
The paper is organized as follows. Section 2 discusses different features and behaviors of competent firms and inept firms, from which two testable hypotheses are derived. Section 3 introduces two measures of performance in profitability, provides preliminary statistics, and conducts some statistical tests regarding whether MNEs outperform their local counterparts. Here, MNEs include firms originated from Hong Kong, Macau and Taiwan (denoted as HMT), firms from regions other than HMT, and joint-venture within MNEs. Local firms include state-owned enterprises, collectives, shareholding firms, private firms and joint-venture among local firms. We focus on the study of non-exporters in order to isolate the complex effects of exporting on profitability. Section 4 presents the empirical model which addresses the endogeneity of strategic variables. The regression results related to two hypotheses are also discussed. The last section concludes.
- Theoretical Considerations
In this section we begin with the explanation of why the two types of firms, i.e., competent firms and inept firms, may have distinct performance and behave differently. We then argue that MNEs may not outperform local firms and the relative performance of MNEs to local firms will depend on the group to which they belong.
Competent Firms vs. Inept Firms
It is often argued that competent firms are intrinsically different from inept firms. Corporate culture, which mediates the behavior of individuals and economizes on more formal administrative methods, is shown to be a de facto system that governs firms (Teece and Pisano, 1994) and therefore is a crucial factor that differentiates competent firms from inept firms.[4] According to Osborne and Cowen (2002), competent firms tend to be those with good corporate culture.[5] For example, they tend to have a simple and compelling vision for the future, believe that the vision can bring success, have plain vanilla values (e.g., fair play, cultivating self-confidence, recognition) to conduct the business, and be proud of their company but commit to learn from every mistake and every success. Moreover, they genuinely respect peers and work hard to maintain the long-term relationship with peers.
Under good corporate culture environment, competent firms are able to attract exceptional people who are highly competitive and motivated to work for the companies. As a result, they are more likely to develop dynamic capabilities and form solid strategies (Osborne and Cowen, 2002). Dynamic capabilities, as suggested by Teece and Pisano (1994) and Luo (2000), include a strong base of established resources, the ability to efficiently deploy these resources, and the aptitude to continuously create bundles of new resources and knowledge. With dynamic capabilities, firms can generate firm-specific advantages which are difficult to imitate, effectively use the resources and advantages to exploit market opportunities, and develop new knowledge to strengthen their dynamic competitive advantages which are vital to firms’ growth and profitability. Inept firms, on the contrary, may not have good corporate culture and are not able to develop capabilities to form effective strategies and to successfully execute the strategies. Therefore, competent firms tend to be those with higher performance in profitability as compared to inept firms.
Although dynamic capabilities are essential to firm profitability, they are difficult to measure and are not readily observed.[6] However, some observable indicators may be used to characterize the presence and strength of dynamic capabilities (Ballantine et al., 1992; Acquaah and Chi, 2007). Such indicators (referred to as strategic variables hereafter) include the technology choice, R&D and innovation efforts, product differentiation and debt load. In the following, we will discuss how these strategic variables are correlated with dynamic capabilities and thus the profitability of firms.
Technology Choice. In a country where labor is abundant, labor-intensive technology is the appropriate technology for firms to adopt, as it reflects the country’s comparative advantage revealed by Heckscher-Ohlin Theory. Low capital-intensive technology therefore is profit-enhancing. However, adopting capital-intensive technology tends to improve a firm’s production efficiency and therefore increase profit margin. But capital-intensive technology is costly thereby eroding a firm’s profit. Since competent firms are more capable than inept firms, we expect competent firms are more able to benefit from adopting capital-intensive technology, while inept firms are more profitable if they adopt labor-intensive technology.
R&D and Innovation Efforts. Firms can develop technology capabilities through R&D (UN and Cuervo-Cazurra, 2008), which is often believed by many CEOs and managers as a critical source of firm value creation. But spending on R&D does not guarantee success. Earlier cross-sectional studies show a robust conclusion that firm performance (e.g., productivity) is positively affected by R&D efforts (e.g., Griliches, 1996; Cohen and Klepper, 1996). A more recent study by Booz Allen Hamilton (2005), on the other hand, finds no discernable link between R&D and nearly all performance measures (including growth, profitability, and shareholder return) except gross margins. Such a mixed conclusion, as we will show in the following sections, may be a result of ignoring the fact that different types of firms may possess different extent of capabilities. Without superior capabilities to effectively exploit the technological know-how and apply the knowledge for commercial purpose, inept firms may not be able to create high value from R&D spending. Competent firms, on the other hand, tend to possess capabilities to turn R&D spending into a more profitable endeavor. Moreover, there exist spillovers from other firms’ R&D. Whether other firms’ R&D spillover effects are positive may also depend on which group a firm belongs to. Inept firms may face more intensified competition if other firms increase their R&D efforts, leading to negative R&D spillovers. Competent firms, on the other hand, have higher absorptive capability and are better able to learn from other firms’ R&D, which may more than offset the competition effects. R&D spillovers therefore are positive. In addition, if we use the output share of new product as a measure of innovation (which reflects a bundle of firm resources such as R&D spending, technology and managerial skills), there is a positive relationship between new product activity and profitability for competent firms due to their competency. The relationship may be negative for inept firms because the costs of engaging in new products exceed the benefits.
Product Differentiation. Firms may adopt the strategy of product differentiation to establish a defensible niche through advertising (Ballantine et al., 1992), which tends to create consumer loyalty (Anastassopoulos, 2004) and hence increase sales and revenue. But high advertising expenditures increase the cost of sales and lower profits. The net effect of advertising on profitability therefore depends on the two forces. Since competent firms have the capability to make the best use of the advertising, we expect a positive effect, i.e., revenue generated by advertising more than offset the cost it involves. For the inept firms, the effect is negative.
Debt Burden. In general, a higher long-run debt ratio indicates a larger interest burden and is therefore negatively related to profitability. But access to long-run debt can facilitate innovative firms to invest in productivity-enhancing yet risky project, which is often highly profitable should the project succeed. Also, according to the tax hypothesis, long-term debt enables firms to avoid more taxes, an effect that is more attractive the higher the firms’ profitability. We therefore expect the long-run debt burden to have a larger positive (or smaller negative) effect on the profitability for competent firms than for inept firms.
The above discussions imply that the strategies adopted by different types of firms may create different value to firms according to their capabilities: competent firms have the capabilities to make their capital-intensive technology, R&D and innovation efforts, advertising spending, product differentiation, and debt financing a more profitable endeavor. Inept firms, on the other hand, may suffer from the costs these activities bring without much benefit. Summarizing the above discussions, we have
Hypothesis 1. Adopting more aggressive strategies tends to increase the profitability of competent firms but lower that of inept firms. Moreover, competent firms tend to enjoy positive R&D spillovers from other firms whereas inept firms may be negatively affected by other firms’ R&D activities as they intensify competition.
Performance of MNEs vs. Local Firms
The literature has shown that MNEs tend to develop firm-specific ownership advantages, which together with internalization advantages and location advantages (denoted as OLI advantages hereafter), as asserted by Dunning’s eclectic paradigm (Dunning, 2001), are crucial in making MNEs more profitable than local firms (Wang et al., 2002). Being part of established global enterprises, the ownership advantages MNEs possess include having higher bargaining power, better access to finance and information network, and enjoying captive access to parent’s research laboratories. All these advantages make MNEs more likely to reap substantial benefits and economies of scale as compared to local firms (Kumar, 1984, 1990).[7]
However, MNEs also face various challenges in the host markets. Unlike local firms who operate within a single regulatory system and have better knowledge of local markets, MNEs face conditions that are heterogeneous with their home base which makes their management and business become more complicated and risky. The liability of foreignness (LOF) arises which includes three factors, namely exchange risk of operating businesses in foreign countries, local authorities’ discrimination against foreign firms, and unfamiliarity with local business environment (Petersen and Pedersen, 2002). Because of LOF, extra efforts and costs are required to operate successfully in the local markets. The liability of foreignness can therefore be broadly defined as all additional costs MNEs incur that local firms would not incur (Zaheer, 1995)