The Effect of Foreign Firm Reference Groups on Political Risk

1. The Effect of Foreign Firm Reference Groups on Political Risk Charles E. Stevens Lehigh University Mona V. Makhija The Ohio State University JSIE 2014 – Tokyo, Japan July 19, 2014

2. The issue of political risk • Political risk = The negative impact of unexpected host government actions on firms’ overseas performance (Brewer, 1985; Miller, 1992) • Government intervention takes different forms • Contract renegotiation • Policy changes affecting firm operations, profits • Expropriation • Performance & strategic implications • Results in $25+ billion in lost profits per year for multinational enterprises (MNEs) (Henisz & Zelner, 2004) • Creates additional business risk that is not easily understood(Makhija, 1993)

3. Central questions • Why does a host government intervene in firms’ operations? • When does a host government intervene in firms’ operations?

4. Explanations in the literature • The bargaining power paradigm (e.g. Vernon, 1971) • Host governments will intervene when their bargaining power is higher than that of foreign firm(s) • Empirical approach in the lit: assess when BP of government goes up or down relative to a foreign firm or foreign firms in a given industry • Institutional strength explanation (e.g. Henisz, 2000) • When government checks and balances are weak, government more likely to intervene into foreign firms • Empirical approach: assess institutional strength of country

5. Problems remain • Bargaining power & institutional strength overly-deterministic—the ability to intervene is a necessary but not sufficient condition for intervention (Minor, 1995; Stevens & Cooper, 2010) • Need more detailed insight into how government actually makes decisions about foreign firm intervention

6. Research question • How do governments make the decision when to intervene?

7. Information-processing perspective(Makhija, 1993) • Governments have a set of objectives vis-à-vis foreign firms operating in their country (Kobrin, 1980; Vernon, 1971) • Governments take into account information to decide when to intervene • When they find out that their goals are not met, they will intervene in a way that will address this problem

8. Information conveyed by reference groups • Institutional argument: MNEs’ activities are continually evaluated by external stakeholders (Hybels, 1995; Kostova et al., 2008; Eden & Lenway, 2001; Kostova & Zaheer, 1999) • Reference groups can provide information to the government (Phillips & Tracey, 2009; Suchman, 1995) • Suggests range of possible behaviors • Allow for judgments about the most desirable activities

9. foreign firms’ reference groups

10. Foreign firm activities’ impact on the host country economy & industry competitiveness • What kinds of “activities” might governments care about? • Some foreign firm activities are important to the functioning of the overall national economy • Reduced unemployment • Balance of payments • National productivity • Other foreign firm activities impact the global competitiveness of their host industry • Greater innovation • Human capital development • Capabilities that create greater economic rents

11. Which reference group matters should depend on the goal • MNEs’ within-country reference group provides a comparison point for how well they are contributing to the national economy • MNEs’ across-country reference group provides a comparison point for how well they are contributing to the local industry • When they don’t compare favorably, the government is motivated to intervene, creating political risk

12. Conceptual model

13. Macroeconomic issue #1: Employment • Higher levels of employment benefit the overall economy many ways (Dunning, 1997; Gilpin & Gilpin, 1987), including: • stimulating purchasing activities • increasing tax revenues • promoting social stability • Maximizing employment is one of the most basic reasons why governments encourage inward FDI • These firms represent a source of employment that would not have been created by local firms alone (Dunning, 1994) • Hypothesis 1a: The higher the employment level of the foreign firms in a host industry above their within-country reference group average, the lower their political risk.

14. Macroeconomic issue #2: Balance of trade • Balance of trade is enhanced through greater exports • helps to bring in more foreign exchange • stabilizes the value of the national currency • reduces the likelihood of debt crises (Makhija, 1993; Vachani, 1995) • Foreign firms are often in a unique position to export • MNEs are the primary conduits through which global trade is conducted (Eden & Lenway, 2001) • MNEs have access to large and globally-spanning intra-firm and intra-industry markets that local firms might not be able to reach (Dunning, 1994; Makhija, Kim & Williamson, 1997; Rugman, 1981) • Hypothesis 1b: The higher the export intensity of the foreign firms in a host industry above their within-country reference group average, the lower their political risk.

15. Macroeconomic issue #3: Fixed Capital • Investments in fixed capital increase a country’s growth potential (Kaldor, 1961; Solow, 1962) • Foreign firms are in a unique position to increase a country’s fixed capital investments because their operating scale is often much larger than that of local firms (Dunning, 1997; Eden & Lenway, 2001) • Hypothesis 1c: The higher the fixed capital intensity of the foreign firms in a host industry above their within-country reference group average, the lower their political risk.

16. Industry-specific issue #1: R&D intensity • Industry competitiveness is driven by its ability to innovate (Landes, 1998). Greater innovation capacity results in: • new products • superior quality • better ability to succeed in new and varied markets • enhanced process technologies (Porter, 1990). • Technological competitiveness is necessary for any industry, but the degree of technological intensity necessary for competitive advantage is industry-specific. • Hypothesis 2a: The higher the R&D intensity of the foreign firms in a host industry above their across-country reference group average, the lower their political risk.

17. Industry-specific issue #2: Human capital development • Superior human capital within an industry increases its ability to innovate and obtain superior performance (Dunning, 1997) • The training and skills required of human capital varies significantly across industries according to differences in managerial and technological complexities (Porter, 1990) • Hypothesis 2b: The higher the wages of the foreign firms in a host industry above their across-country reference group average, the lower their political risk.

18. Industry-specific issue #3: profitability • The overall profitability of a local industry reflects economic success. When an industry is more profitable: • the government gains more tax revenues • it attracts re-investment from existing firms, entry of new local or foreign entrants, and both upstream and downstream demand in the value chain (Eden & Lenway, 2001) • The benchmark for economic success varies greatly from industry to industry (Porter, 1980) • Hypothesis 2c: The higher the profitability of the foreign firms in a host industry above their across-country reference group average, the lower their political risk.

19. Foreign firm activities & salient reference groups

20. Methods • Sample: U.S. multinationals’ majority-owned subsidiaries • 13 industries across 53 host countries • Seven years of data: 2000~2006 • Source: Bureau of Economic Analysis (U.S. Department of Commerce) • Has been used in several other political risk studies (Click, 2005; Kobrin, 1980, 1987)

21. Countries in sample

22. Measures: Dependent variable • DV measures industry-level political risk • Extend methodology of Click (2005) to industry level • First model industry profitability: • Calculated the volatility of foreign firms’ profitability (ROA) in a host industry • Controlled for salient industry and country non-political sources of country risk • Remaining unexplained variance reflects political risk for that industry

23. Measures: Independent variables • Within-country reference group comparison: • Across-country reference group comparison: • Six foreign firm activities • Employment • Export intensity • Fixed capital intensity • R&D intensity • Human capital • Profitability

24. Measures: Control variables • Strength of political institutions: natural log of World Bank’s “checks” index in the Database of Political Institutions (Henisz, 2004) • Industry dummy variables

25. Political risk country rankings (un-weighted industry average) 1. Luxembourg 2. Denmark 3. Germany 4. UK 5. Canada 8. Japan 12. Mexico 30. India 34. China 51. Ecuador 52. Dominican Republic 53. South Africa

26. Range of industry-level risk for selected countries Political risk

27. Results

28. Implications of the research • Foreign firms’ reference groups appear to provide salient information that influences a government’s motivation to intervene • Moves beyond traditional ‘closed dyad’ approach of political risk studies • Informs debate between Kostova et al. (2008) and Phillips & Tracey (2009) about the role of organizational fields in IB research on MNEs • The salient point of reference shifts depending on the nature of the firms’ activity in question • Activities occurring in other countries can affect the risk faced by firms in a focal country • A government’s ability to intervene has been the traditional focus of political risk studies; we suggest a need to refocus on governments’ motivation to intervene in a complex, global economy

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