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GLOBAL BUSINESS

Third Edition

Mike W. Peng, Ph.D. Jindal Chair of Global Business Strategy

Executive Director, Center for Global Business Jindal School of Management University of Texas at Dallas

Fellow, Academy of International Business

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To Agnes, Grace, and James

Preface ix

About the Author xix

Part 1 Laying Foundations 1

Chapter 1: Globalizing Business 2

Chapter 2: Understanding Formal Institutions: Politics, Laws, and Economics 32

Chapter 3: Emphasizing Informal Institutions: Cultures, Ethics, and Norms 62

Chapter 4: Leveraging Resources and Capabilities 92

PengAtlas 1 118

Integrative Cases 124

Part 2 Acquiring Tools 139

Chapter 5: Trading Internationally 140

Chapter 6: Investing Abroad Directly 174

Chapter 7: Dealing With Foreign Exchange 204

Chapter 8: Capitalizing on Global and Regional Integration 232

PengAtlas 2 264

Integrative Cases 270

Part 3 Strategizing around the Globe 285

Chapter 9: Growing and Internationalizing the Entrepreneurial Firm 286

Chapter 10: Entering Foreign Markets 310

Chapter 11: Managing Global Competitive Dynamics 336

Chapter 12: Making Alliances and Acquisitions Work 364

Chapter 13: Strategizing, Structuring, and Learning around the World 394

PengAtlas 3 424

Integrative Cases 428

Part 4 Building Functional Excellence 465

Chapter 14: Competing on Marketing and Supply Chain Management 466

Chapter 15: Managing Human Resources Globally 492

Brief Contents

Brief Contents v

Chapter 16: Financing and Governing the Corporation Globally 522

Chapter 17: Managing Corporate Social Responsibility Globally 552

PengAtlas 4 578

Integrative Cases 582

Glossary 598

Name Index 607

Organization Index 617

Subject Index 621

Preface ix

About the Author xix

Part 1 Laying Foundations 1

Chapter 1: Globalizing Business 2

What Is Global Business? 4

Why Study Global Business? 10

A Unified Framework 14

What Is Globalization? 18

Global Business and Globalization at a Crossroads 21

Organization of the Book 25

Chapter 2: Understanding Formal Institutions: Politics, Laws, and Economics 32

Understanding Institutions 35

What Do Institutions Do? 36

An Institution-Based View of Global Business 38

Political Systems 40

Legal Systems 43

Economic Systems 47

Debates and Extensions 48

Management Savvy 54

Chapter 3: Emphasizing Informal Institutions: Cultures, Ethics, and Norms 62

Where Do Informal Institutions Come From? 64

Culture 65

Cultural Differences 70

Ethics 78

Norms and Ethical Challenges 80

Debates and Extensions 81

Management Savvy 84

Chapter 4: Leveraging Resources and Capabilities 92

Understanding Resources and Capabilities 94

Resources, Capabilities, and the Value Chain 96

From SWOT to VRIO 100

Debates and Extensions 104

Management Savvy 109

Part 1 Integrative Cases 124

1.1 Coca-Cola in Africa 124

1.2 Whose Law Is Bigger: Arbitrating Government-Firm Disputes in the EU 126

1.3 Fighting Counterfeit Motion Pictures 128

1.4 Brazil’s Embraer: From State-Owned Enterprise to Global Leader 131

1.5 Microsoft in China 136

Part 2 Acquiring Tools 139

Chapter 5: Trading Internationally 140

Why Do Nations Trade? 143

Theories of International Trade 145

Realities of International Trade 158

Debates and Extensions 163

Management Savvy 166

Chapter 6: Investing Abroad Directly 174

Understanding the FDI Vocabulary 176

Why Do Firms Become MNEs by Engaging in FDI? 180

Realities of FDI 186

How MNEs and Host Governments Bargain 190

Debates and Extensions 192

Management Savvy 195

Chapter 7: Dealing with Foreign Exchange 204

What Determines Foreign Exchange Rates? 206

Evolution of the International Monetary System 214

Strategic Responses to Foreign Exchange Movements 218

Debates and Extensions 221

Management Savvy 225

Table of Contents

Chapter 11: Managing Global Competitive Dynamics 336

Competition, Cooperation, and Collusion 339

Institutions Governing Domestic and International Competition 343

Resources Influencing Competitive Dynamics 346

Attacks, Counterattacks, and Signaling 350

Local Firms versus Multinational Enterprises 351

Debates and Extensions 352

Management Savvy 356

Chapter 12: Making Alliances and Acquisitions Work 364

Defining Alliances and Acquisitions 367

Institutions, Resources, Alliances, and Acquisitions 368

Formation of Alliances 374

Evolution and Dissolution of Alliances 376

Performance of Alliances 378

Motives for Acquisitions 379

Performance of Acquisitions 383

Debates and Extensions 384

Management Savvy 386

Chapter 13: Strategizing, Structuring, and Learning around the World 394

Multinational Strategies and Structures 396

How Institutions and Resources Affect Multinational Strategies, Structures, and Learning 404

Worldwide Learning, Innovation, and Knowledge Management 408

Debates and Extensions 412

Management Savvy 415

Part 3 Integrative Cases 428

3.1 Wikimart: Building a Russian Version of Amazon 428

3.2 Private Military Companies 431

3.3 Amazon, Bookoff, and the Japanese Bookselling Industry 435

3.4 Huawei’s Intellectual Property War 438

3.5 Is A Diamond (Cartel) Forever? 446

3.6 The TNK-BP Joint Venture 452

Chapter 8: Capitalizing on Global and Regional Integration 232

Global Economic Integration 234

Organizing World Trade 237

Regional Economic Integration 240

Regional Economic Integration in Europe 242

Regional Economic Integration in the Americas 248

Regional Economic Integration in the Asia Pacific 250

Regional Economic Integration in Africa 252

Debates and Extensions 253

Management Savvy 256

Part 2 Integrative Cases 270

2.1 Canada and the United States Fight Over Pigs 270

2.2 Foreign Direct Investment in the Indian Retail Industry 272

2.3 The Fate of Opel 274

2.4 Jobek do Brasil’s Foreign Exchange Challenges 276

2.5 The EU–Korea Free Trade Agreement 279

Part 3 Strategizing around the Globe 285

Chapter 9: Growing and Internationalizing the Entrepreneurial Firm 286

Entrepreneurship and Entrepreneurial Firms 289

Institutions, Resources, and Entrepreneurship 289

Growing the Entrepreneurial Firm 293

Internationalizing the Entrepreneurial Firm 298

Debates and Extensions 301

Management Savvy 303

Chapter 10: Entering Foreign Markets 310

Overcoming the Liability of Foreignness 312

Where to Enter? 315

When to Enter? 318

How to Enter? 320

Debates and Extensions 326

Management Savvy 329

Contents vii

3.7 Geely’s Acquisition of Volvo 455

3.8 Hilton Welcomes Chinese Travelers at Home and Abroad 459

Part 4 Building Functional Excellence 465

Chapter 14: Competing on Marketing and Supply Chain Management 466

Three of the Four Ps in Marketing 468

From Distribution Channel to Supply Chain Management 474

The Triple As in Supply Chain Management 475

How Institutions and Resources Affect Marketing and Supply Chain Management 478

Debates and Extensions 481

Management Savvy 483

Chapter 15: Managing Human Resources Globally 492

Staffing 495

Training and Development 500

Compensation and Performance Appraisal 502

Labor Relations 505

Institutions, Resources, and Human Resource Management 506

Debates and Extensions 511

Management Savvy 513

Chapter 16: Financing and Governing the Corporation Globally 522

Financing Decisions 525

Owners 526

Managers 528

Board of Directors 532

Governance Mechanisms as a Package 534

A Global Perspective 536

Institutions, Resources, and Corporate Finance and Governance 538

Debates and Extensions 543

Management Savvy 544

Chapter 17: Managing Corporate Social Responsibility Globally 552

A Stakeholder View of the Firm 555

Institutions, Resources, and Corporate Social Responsibility 561

Debates and Extensions 568

Management Savvy 569

Part 4 Integrative Cases 582

4.1 ESET: From a “Living-Room” Firm to a Global Player in the Antivirus Software Industry 582

4.2 Dallas Versus Delhi 586

4.3 Microfinance: Macro Success or Global Mess? 587

4.4 Sino Iron: Engaging Stakeholders in Australia 589

4.5 Foxconn 595

Glossary 598

Name Index 607

Organization Index 617

Subject Index 621

viii Contents

Preface

The first two editions of Global Business aspired to set a new standard for interna- tional business (IB) textbooks. Based on the enthusiastic support from students and instructors in Australia, Brazil, Britain, Canada, China, Egypt, France, Hong Kong, India, Indonesia, Ireland, Israel, Lithuania, Malaysia, Puerto Rico, Russia, Slovenia, South Africa, South Korea, Taiwan, Thailand, and the United States, the first two editions achieved unprecedented success. A Chinese translation is now available and a European adaptation (coauthored with Klaus Meyer) has been suc- cessfully launched. In short, Global Business is global.

The third edition aspires to do even better. It continues the market-winning framework centered on one big question and two core perspectives pioneered in the first edition, and has been thoroughly updated to capture the rapidly moving research and events of the past few years. Written for undergraduate and MBA students around the world, the third edition will continue to make IB teaching and learning more (1) engaging, (2) comprehensive, (3) fun, and (4) relevant.

More Engaging As an innovation in IB textbooks, a unified framework integrates all chapters. Given the wide range of topics in IB, most textbooks present the discipline in a fashion that “Today is Tuesday, it must be Luxembourg.” Very rarely do authors address: “Why Luxembourg today?” More important, why IB? What is the big ques- tion in IB? Our unified framework suggests that the discipline can be united by one big question and two core perspectives. The big question is: What deter- mines the success and failure of firms around the globe? To address this question, Global Business introduces two core perspectives, (1) the institution-based view and (2) the resource-based view, in all chapters. It is this relentless focus on our big question and core perspectives that enables this book to engage a variety of IB topics in an integrated fashion. This provides unparalleled continuity in the learning process.

Global Business further engages readers through an evidence-based approach. I have endeavored to draw on the latest research rather than the latest fads. As an active researcher myself, I have developed the unified framework not because it just popped up in my head when I wrote the book. Rather, this is an extension of my own research that consistently takes on the big question and leverages the two core perspectives.1

1 For the big question, see M. W. Peng, 2004, Identifying the big question in international business research, Journal of International Business Studies, 35: 99–108. For the institution-based view, see M. W. Peng, S. L. Sun, B. Pinkham, & H. Chen, 2009, The institution-based view as a third leg for a strategy tripod, Academy of Management Perspectives, 23(3): 63–81; M. W. Peng, D. Wang, & Y. Jiang, 2008, An institution-based view of international business strategy: A focus on emerging economies, Journal of International Business Studies, 39: 920–936. For the resource-based view, see M. W. Peng, 2001, The resource-based view and international business, Journal of Management, 27: 803–829.

x Preface

Another vehicle to engage students is debates. Most textbooks present knowledge “as is” and ignore debates. But obviously our field has no shortage of debates. It is the responsibility of textbook authors to engage students by introducing cutting- edge debates. Thus, I have written a beefy “Debates and Extensions” section for every chapter.

Finally, this book engages students by packing rigor with accessibility. There is no “dumbing down.” No other competing IB textbook exposes students to an article on how to save Europe by the Managing Director of the International Monetary Fund (In Focus 8.1), a commentary on China’s ten years in the World Trade Organization by the US Ambassador to China (Emerging Markets 8.1), and a Harvard Business Review article on China’s outward foreign direct investment (authored by me—Emerging Markets 6.1). These are not excerpts but full-blown, original articles—the first in an IB (and, in fact, in any management) textbook. These highly readable short pieces directly give students a flavor of the original insights.

More Comprehensive Global Business offers the most comprehensive and innovative coverage of IB topics available on the market. Unique chapters not found in other IB textbooks are:

Chapter 9 on entrepreneurship and small firms’ internationalization. Chapter 11 on global competitive dynamics. Chapter 16 on corporate finance and governance. Chapter 17 on corporate social responsibility (in addition to one full-blown

chapter on ethics, cultures, and norms, Chapter 3). Half of Chapter 12 (alliances and acquisitions) deals with the inadequately

covered topic of acquisitions. Approximately 70% of market entries based on foreign direct investment (FDI) around the world use acquisitions. Yet, none of the other IB textbooks has a chapter on acquisitions—clearly, a missing gap.

The most comprehensive topical coverage is made possible by drawing on the latest and most comprehensive range of the research literature. Specifically, I have accelerated my own research, publishing a total of 30 articles since 2010 after I finished the second edition.2 I have drawn on such latest research to inject cutting- edge thinking into the third edition.

In addition, I have also endeavored to consult numerous specialty journals. For example, the trade and finance chapters (Chapters 5–7) draw on the American Eco- nomic Review, Journal of Economic Literature, and Quarterly Journal of Economics. The entrepreneurship chapter (Chapter 9) consults with the Journal of Business Venturing and Entrepreneurship Theory and Practice. The marketing and supply chain chapter (Chapter 14) draws heavily from the Journal of Marketing, Journal of International Mar- keting, and Journal of Operations Management. The corporate finance and governance chapter (Chapter 16) is visibly guided by research published in the Journal of Finance and Journal of Financial Economics.

The end result is the unparalleled, most comprehensive set of evidence-based insights on the IB market. While citing every article is not possible, I am confident

2 All my articles are listed at www.mikepeng.com and www.utdallas.edu/~mikepeng. Go to “Journal Articles.”

Preface xi

that I have left no major streams of research untouched. Feel free to check the Name Index to verify this claim.

Finally, the third edition of Global Business continues to have a global set of cases contributed by scholars around the world—an innovation on the IB market. Virtually all other IB textbooks have cases written by book authors. In comparison, this book has been blessed by a global community of case contributors who are based in Austria, Brazil, China, France, Germany, Hong Kong, India, and the United States. Many are experts who are located in, or are from, the countries in which the cases take place. For example, we now have a Brazil case penned by a Brazil-based author (see the Integrative Case on Jobek do Brasil), and two China cases written by China-based authors (see the Integrative Cases on Geely’s acquisition of Volvo and Sino Iron in Australia). This edition also features a Russia case contributed by the world’s top two leading experts on Russian management (see the Integrative Case on Wikimart). The end result is an unparalleled, diverse collection of case materials that will significantly enhance IB teaching and learning around the world.

More Fun If you fear that this book must be very boring because it draws so heavily on cur- rent research, you are wrong. I have used a clear, engaging, conversational style to tell the “story.” Relative to rival books, my chapters are generally more lively and shorter. Some reviewers have commented that reading Global Business is like read- ing a “good magazine.” A large number of interesting anecdotes have been woven into the text. In addition to examples from the business world, non-traditional (“outside-the-box”) examples range from ancient Chinese military writings to mu- tually assured destruction (MAD) strategy during the Cold War, from Shakespeare’s The Merchant of Venice to Tolstoy’s Anna Karenina. Popular movies such as A Few Good Men, Devil’s Advocate, and Legally Blonde are also featured. In addition, numerous Opening Cases, Closing Cases, and In Focus boxes spice up the book. Check out the following fun-filled features:

Partying in Saudi Arabia (Chapter 3 Opening Case) Adding value to the dirtiest job online (In Focus 4.2) Why are US exports so competitive? (Chapter 5 Opening Case) A sticky business in Singapore (In Focus 5.1) Cry for me, Argentina (Chapter 6 Closing Case) The Greek tragedy (Chapter 8 Closing Case) The world’s best place to make Viagra (In Focus 10.1) A fox in the hen house (In Focus 11.2) Brazil’s Whopper deal (Emerging Markets 12.2) Mickey goes to Shanghai (Chapter 13 Opening Case) Wolf wars (Chapter 17 Closing Case) Milton Friedman goes global (Emerging Markets 17.1)

There is one Video Case from BBC News to support every chapter. While vir- tually all competing books have some videos, none has a video package that is so integrated with the learning objectives of every chapter.

Finally, as a new feature introduced since the second edition, PengAtlas allows you to conduct IB research using informative maps and other geographic and cultural literacy tools to enhance your learning.

xii Preface

More Relevant So what? Chapters in most textbooks leave students to figure out the crucial “So what?” question for themselves. In contrast, I conclude every chapter with an action-packed section titled “Management Savvy.” Each section has at least one table (or one teachable slide) that clearly summarizes the key learning points from a practical standpoint. No other competing IB book is so savvy and so relevant.

Further, ethics is a theme that cuts through the book, with at least one “Ethical Dilemma” feature and a series of Critical Discussion Questions on ethics in each chapter. Finally, many chapters offer career advice for students. For example:

Chapter 1 In Focus 1.3 directly addresses a question many students would ask: What language and what fields should I study?

Chapter 4 develops a resource-based view of the individual—that is, about you, the student. The upshot? You want to make yourself into an “untouch- able” who adds valuable, rare, and hard-to-imitate capabilities indispensable to an organization. In other words, you want to make sure your job cannot be outsourced.

Chapter 15 offers tips on how to strategically and proactively invest in your career now—as a student—for future international career opportunities.

What’s New in the Third Edition? Most importantly, the third edition has (1) highlighted the executive voice by draw- ing more heavily from CEOs and other business leaders, (2) dedicated more space to emerging economies, and (3) enhanced the quantity and variety of cases.

First, since Global Business aims to train a new generation of global business lead- ers, the third edition has featured more extensive quotes and perspectives from global business leaders. These are longer and more visibly prominent break-out quotes—not merely single quotes typically embedded (or “buried”) in paragraphs. In Chapter 1 alone, you will enjoy such insightful quotes from (1) GE’s current chairman and CEO and (2) GE’s former chairman and CEO. In later chapters, the following global business leaders will share their thoughts with you:

Applied Materials’ human resource executive Argentina’s president Bayer North America’s CEO Dow Chemical’s CEO IBM’s CEO IBM’s chief procurement officer IMF’s managing director—a full article TNK-BP’s chairman and CEO and Alfa Group’s founder US Ambassador to China—a full article US Secretary of Justice (representing the Department of Justice’s challenge of AT&T’s proposed merger with T- Mobile) US Secretary of Treasury (on the US-China Strategic and Economic Dialogue) Whole Foods’ co-founder and CEO WTO’s director-general

Second, this edition builds on Global Business’s previous strengths by more prom- inently highlighting global business challenges in and out of emerging economies. This is both a reflection of the global realities in which emerging economies have

Preface xiii

played a more prominent role and a reflection of my own strong research interest in emerging economies. Specifically, in the third edition, (1) a new Emerging Markets in- chapter feature is launched in every chapter, and (2) 18 out of 23 (78%) of the longer Integrative Cases deal with emerging economies (including one case on Central and Eastern Europe, two cases each on Africa, Brazil, Russia, and India, and six on China).

Third, in response to students’ and professors’ enthusiasm about the wide- ranging and globally relevant cases in previous editions, the third edition has fur- ther enhanced the quantity and variety of cases. The number of Integrative Cases has increased from 15 to 23—a 53% increase. The variety has also been enhanced not only in terms of the geographic diversity noted above, but also in terms of the mix of longer cases and shorter cases. In addition, I have pushed myself to partici- pate more actively in case writing. Therefore, I am very proud to report that of the 23 Integrative Cases in the third edition, I personally wrote 10 (43%). This com- pares very favorably to the one Integrative Case out of a total of 15 that I personally authored in the second edition (representing a mere 7%).

Of course, in addition to these new features, every chapter has been thoroughly updated. Of the 23 Integrative Cases, 19 (83%) are new to this edition. PengAtlas maps have also been updated to capture the latest statistics.

The new BBC News Video Cases provide current, real-world examples of key course topics. The set covers such diverse countries as Brazil, China, Cuba, Dubai, India, Thailand, and Uruguay, and features a broad array of industries from high- tech manufacturing to goat farming.

Support Materials A full set of supplements is available for students and adopting instructors, all de- signed to facilitate ease of learning, teaching, and testing.

Global Business CourseMate. Cengage Learning’s Global Business CourseMate brings course concepts to life with interactive learning, study, and exam prepara- tion tools that support the printed textbook. Through this website, available for an additional fee, students will have access to their own set of PowerPoint® slides, flashcards, and games, as well as the Learning Objectives and Glossary for quick reviews. A set of auto-gradable, interactive quizzes (prepared by Timothy R. Muth of Florida Institute of Technology) will allow students to instantly gauge their comprehension of the material. The quizzes are all tagged to the book’s Learn- ing Objectives, Bloom’s taxonomy, and national standards. Finally, Global Business CourseMate includes interactive maps that delve more deeply into key concepts presented in the book.

Product Support Website. The flashcards, Learning Objectives, and Glossary are available for quick reference on our complimentary student product support website.

Webtutor on BlackBoard® and Webtutor on WebCT.™ Available on two differ- ent platforms, Global Business Webtutor enhances students’ understanding of the material by featuring the Opening Cases and Video Cases, as well as the Glossary, study flashcards, and interactive maps that delve more deeply into key concepts presented in the book.

CengageNOW™ Course Management System. Designed by instructors for instructors, CengageNOW™ mirrors the natural teaching workflow with an

xiv Preface

easy-to-use online suite of services and resources, all in one program. With this system, instructors can easily plan their courses, manage student assignments, automatically grade, teach with dynamic technology, and assess student progress with pre- and post-tests tagged to course outcomes and national standards. For students, study tools include flashcards, PowerPoint® slides, media quizzes, guided cases, and a set of quizzes based on interactive maps that enhance comprehen- sion of the material and develop cultural and geographic literacy. Diagnostic tools create a personalized study plan for each student that focuses their study efforts. CengageNOW™ operates seamlessly with WebCT™, Blackboard®, and other course management tools.

Global Economic Watch. Cengage Learning’s Global Economic Watch helps instructors bring these pivotal current events into the classroom through a powerful, continuously updated online suite of content, discussion forums, testing tools, and more. The Watch, a first-of-its-kind resource, stimulates discussion and understanding of the global downturn with easily integrated teaching solutions:

A thorough overview and timeline of events leading up to the global economic crisis are included in the ebook module, Impact of the Global Economic Crisis on Small Business

A content-rich blog of breaking news, expert analysis, and commentary— updated multiple times daily—plus links to many other blogs

A powerful real-time database of hundreds of relevant and vetted journal, newspaper, and periodical articles, videos, and podcasts—updated four times every day

Discussion and testing content, PowerPoint® slides on key topics, sample syllabi, and other teaching resources

History is happening now, so bring it into the classroom with The Watch at www.cengage.com/thewatch.

Instructor’s Resource CD (IRCD). Instructors will find all of the teaching resources they need to plan, teach, grade, and assess student understanding and progress at their fingertips with this all-in-one resource for Global Business. The IRCD contains:

Instructor’s Manual—This valuable, time-saving Instructor’s Manual in- cludes comprehensive resources to streamline course preparation, including teaching suggestions, lecture notes, answers to all chapter questions, and Integrative Case discussion guides. Also included are discussion guidelines and answers for the Video Cases, prepared by Carol Decker.

Test Bank—The Global Business Test Bank in ExamView® software allows instructors to create customized texts by choosing from 35 True/False, 35 Multiple Choice, and at least 8 short answer/essay questions for each of the 17 chapters. Ranging in difficulty, all questions have been tagged to the text’s Learning Objectives, Bloom’s taxonomy, and other national standards to ensure that students are meeting the course criteria.

PowerPoint® Slides—This comprehensive set of more than 250 Powerpoint® slides will assist instructors in the presentation of the chapter material, en- abling students to synthesize key global concepts.

Global Business DVD. Perhaps one of the most exciting and compelling bonus features of this program, these 17 short and powerful video clips, produced by BBC

Preface xv

News, provide current and relevant real-world examples. The set covers such di- verse countries as Brazil, China, Cuba, Dubai, India, Thailand, and Uruguay, and features a broad array of industries from high-tech manufacturing to goat farming.

Instructor Product Support Website. For those instructors who prefer to access supplements online, the Instructor’s Manual, PowerPoint® slides, and Test Bank are also available through the instructor’s product support website.

Acknowledgments As Global Business launches its third edition, I first want to thank all the customers— professors, instructors, and students around the world who have made the book’s success possible. A special thank-you goes to my friend and colleague, Klaus Meyer (China Europe International Business School), who spearheaded the develop- ment of International Business, which was tailored for European (or, more broadly, European, Middle Eastern, and African [EMEA]) students. Klaus has made Global Business more global.

At UT Dallas, I thank my colleagues Dan Bochsler, Larry Chasteen, Tev Dalgic, Van Dam, Greg Dess, Dave Ford, Richard Harrison, Maria Hasenhuttl, Charlie Hazzard, Marilyn Kaplan, Seung-Hyun Lee, Elizabeth Lim, John Lin, Livia Markóczy, Joe Picken, Roberto Ragozzino, Orlando Richard, Jane Salk, Mary Vice, Eric Tsang, and Habte Woldu, as well as the supportive leadership team—Hasan Pirkul (dean), Varghese Jacob (associate dean), and Greg Dess (area coordinator). I also thank my two PhD students, Brian Pinkham (now at Texas Christian University) and Steve Sauerwald, for their research assistance. Three PhD students (Canan Mutlu, Brian Pinkham, and Weichieh Su) and five MBA students (Simon Ebenezer, Matthew Lafever, Katie Metzler, Katie Ryan, and Chris Spartz) authored excellent case materials.

At South-Western Cengage Learning, I thank the “Peng team:” Erin Joyner, Publisher; Michele Rhoades, Senior Acquisitions Editor; Jennifer King, Developmen- tal Editor; Emily Nesheim and Tamborah Moore, Senior Content Project Managers; Jonathan Monahan, Marketing Manager; Stacy Shirley, Senior Art Director; and Tamara Grega, Editorial Assistant.

In the academic community, I thank Ben Kedia (University of Memphis) for inviting me to conduct faculty training workshops in Memphis every year since 1999, and Michael Pustay (Texas A&M University) for co-teaching these workshops with me—widely known as the “M&M Show” in the IB field. Discussions with over 200 colleagues who came to these faculty workshops over the last decade have helped shape this book into a better product. I also appreciate the meticulous and excellent comments from the reviewers:

Nadeem M. Firoz (Montclair State University) Andrew Fleck (Fox Valley Technical College) Anna Helm (George Washington University) P. Michael McLain (Hampton University) Mark Quinn (Xavier University of Louisiana) Al Saber (Friends University) Sudhir Sachdev (Farmingdale State College)

Continued thanks to the reviewers of the previous editions:

Syed Ahmed (Cameron University) Richard Ajayi (University of Central Florida, Orlando)

xvi Preface

Basil Al-Hashimi (Mesa Community College) Verl Anderson (Dixie State College of Utah) Peter L. Banfe (Ohio Northern University) Lawrence A. Beer (Arizona State University) Tefvik Dalgic (University of Texas at Dallas) Tim R. Davis (Cleveland State University) George DeFeis (Monroe College, Bronx) Ping Deng (Maryville University) Norb Elbert (Eastern Kentucky University) Joe Horton (University of Central Arkansas) Samira Hussein (Johnson County Community College) Ann L. Langlois (Palm Beach Atlantic University) Lianlian Lin (California State Polytechnic University, Pomona, California) Ted London (University of Michigan) Martin Meznar (Arizona State University, West) Dilip Mirchandani (Rowan University) Timothy R. Muth (Florida Institute of Technology) Don A. Okhomina (Fayetteville State University) William Piper (Alcorn State University) Charles A. Rarick (Barry University) Tom Roehl (Western Washington University) Bala Subramanian (Morgan State University) Gladys Torres-Baumgarten (Kean University) Susan Trussler (University of Scranton) William R. Wilkerson (University of Virginia) Attila Yaprak (Wayne State University)

In addition, I thank many colleagues who provided informal feedback to me on the book. Space constraints here force me to only acknowledge colleagues who wrote me since the second edition, since colleagues who wrote me earlier were thanked in earlier editions.

Paul Beamish (University of Western Ontario, Canada) Santanu Borah (University of North Alabama, USA) Thierry Brusselle (Chaffey Community College, USA) Lauren Carey (University of Miami, USA) Ping Deng (Maryville University, USA) Todd Fitzgerald (Saint Joseph’s University, USA) Dennis Garvis (Washington and Lee University, USA) John Gerace (Chestnut Hill College, USA) Mike Geringer (Ohio University, USA) C. Gopinath (Suffolk University, USA) Charlie Hazzard (University of Texas at Dallas, USA) Chad Hilton (University of Alabama, USA) Anisul Islam (University of Houston, USA) Basil Janavaras (Minnesota State University, USA) Marshall Shibing Jiang (Brock University, Canada) Somnath Lahiri (Illinois State University, USA) Ann Langlois (Palm Beach Atlantic University, USA) Lianlian Lin (California State Polytechnic University, USA) Dong Liu (Georgia Institute of Technology, USA)

Preface xvii

David Liu (George Fox University, USA) Ted London (University of Michigan, USA) Charles Mambula (Langston University, USA) Daniel McCarthy (Northeastern University, USA) Hemant Merchant (Florida Atlantic University, USA) Debmalya Mukherjee (University of Akron, USA) Asmat Nizam (Universiti Utara, Malaysia) Kenny Oh (University of Missouri at St. Louis, USA) Eydis Olsen (Drexel University, USA) Sheila Puffer (Northeastern University, USA) Gongming Qian (Chinese University of Hong Kong, China) David Reid (Seattle University, USA) Surekha Rao (Indiana University Northwest, USA) Al Rosenbloom (Dominican University, USA) Anne Smith (University of Tennessee, USA) Clyde Stoltenberg (Wichita State University, USA) Steve Strombeck (Azusa Pacific University, USA) Sunny Li Sun (University of Missouri at Kansas City, USA) Qingjiu (Tom) Tao (James Madison University, USA) Vas Taras (University of North Carolina at Greensboro, USA) Rajaram Veliyath (Kennesaw State University, USA) Jose Vargas-Hernandez (Universidad de Guadalajara, Mexico) Loren Vickery (Western Oregon University, USA) George White (Old Dominion University, USA) Habte Woldu (University of Texas at Dallas, USA) Richard Young (Minnesota State University, USA) Wu Zhan (University of Sydney, Australia)

I also want to thank three very special colleagues: Liu Yi (Shanghai Jiaotong University), Xie En, and Wang Longwei (Xi’an Jiaotong University) in China. They loved the book so much that they were willing to endure the pain of translating it into Chinese. Their hard work has enabled Global Business to reach wider audiences globally. For the third edition, 28 colleagues graciously contributed cases:

Christoph Barmeyer (Passau University, Germany) Dirk Michael Boehe (Insper Institute of Education and Research, Brazil) Charles Byles (Virginia Commonwealth University, USA) Peggy Chaudhry (Villanova University, USA) Jessica Chelekis (University of Southern Denmark, Denmark) Yuan Yi Chen (Hong Kong Baptist University, China) Zhu Chen (PFC Energy, Beijing, China) Simon Ebenezer (University of Texas at Dallas, USA) Juan España (National University, USA) Steven Globerman (Western Washington University, USA) Matthew Lafever (University of Texas at Dallas, USA) Ulrike Mayrhoder (University Lyon 3, France) Daniel McCarthy (Northeastern University, USA) Katie Metzler (University of Texas at Dallas, USA) Klaus Meyer (China Europe International Business School, China) Susan Mudambi (Temple University, USA) Canan Mutlu (University of Texas at Dallas, USA)

xviii Preface

Brian Pinkham (Texas Christian University, USA) Sheila Puffer (Northeastern University, USA) Katie Ryan (University of Texas at Dallas, USA) Arnold Schuh (Vienna University of Economics and Business, Austria) Chris Spartz (University of Texas at Dallas, USA) Charles Stevens (University of Wyoming, USA) Weichieh Su (University of Texas at Dallas, USA) Sunny Li Sun (University of Missouri at Kansas City, USA) Michael Young (Hong Kong Baptist University, China) Yanli Zhang (Montclair State University, USA) Alan Zimmerman (City University of New York, USA)

In addition, the work of the following prominent authors was reprinted to grace the pages of this book:

Rohit Deshpande (Harvard Business School) and Anjali Raina (HBS India Research Center, India)—coauthor of “The Ordinary Heroes of the Taj” Mikhail Fridman (TNK-BP and Alfa Group, Russia)—chairman and CEO of TNK-BP and founder of Alfa Group Vijay Govindarajan and Chris Trimble (Dartmouth College)—coauthor of Reverse Innovation Christine Lagarde (International Monetary Fund)—Managing Director of the IMF Gary Locke (US Embassy, Beijing, China)—US Ambassador to China Michael Porter (Harvard Business School) and Mark Kramer (FSG)—coauthor of “Creating Shared Value” Jack Welch and Suzy Welch (BusinessWeek)—Jack is the retired chairman and CEO of GE and Suzy is a former editor of Harvard Business Review

Last, but by no means least, I thank my wife Agnes, my daughter Grace, and my son James—to whom this book is dedicated. I have named Agnes CEO, CFO, CIO, CTO, and CPO for our family, the last of which is coined by me, which stands for “chief parenting officer.” When the first edition was conceived, Grace was three, and James one. When the second edition came out, Grace declared a career inter- est in being a rock star, and James a race car driver. Now my ten-year-old Grace, already a voracious reader and writer, can help me edit, and my eight-year-old James can help me enter grades. Grace is writing and editing her 17th short story, called My Magic Life, and James is very interested in creating Lego models. For now, Grace wants to be a lawyer, and James a banker. As a third-generation professor in my family, I can’t help but wonder whether one (or both) of them will become a fourth-generation professor. To all of you, my thanks and my love.

MWP

December 1, 2012

About the Author

Mike W. Peng is the Jindal Chair of Global Business Strategy at the Jindal School of Management, University of Texas at Dallas, a National Science Foundation CAREER Award winner, and a Fellow of the Academy of International Business. He is also Executive Director of the Center for Global Business, which he founded. At UT Dallas, he has been the number-one contributor to the 45 top journals tracked by Financial Times, which has ranked UT Dallas as a top-20 school in research world- wide and its MBA and EMBA programs increasingly in the top tier.

Professor Peng holds a bachelor’s degree from Winona State University, Minnesota, and a PhD degree from the University of Washington, Seattle. Between 2005 and 2011, he was the first Provost’s Distinguished Professor at UT Dallas, a chair position that was created to attract him to join the faculty. He had previously been an associate professor (with tenure) at the Ohio State University. Prior to that, he had served on the faculty at the Chinese University of Hong Kong and the University of Hawaii. He has taught in five states in the United States (Hawaii, Ohio, Tennessee, Texas, and Washington) as well as China, Hong Kong, and Vietnam. He has also held visiting or courtesy appointments in Australia, Britain, China, Denmark, Hong Kong, and the United States. In addition to these countries, he has presented papers in Austria, Brazil, France, Germany, Japan, Macau, Puerto Rico, Singapore, South Korea, Switzerland, and Taiwan.

Professor Peng is one of the most prolific and most influential scholars in inter- national business (IB). During the decade 1996–2006, he was the top-seven con- tributor to IB’s number-one premier outlet: Journal of International Business Studies. His research is also among some of the most widely cited—both the United Nations and the World Bank have cited his work. A Journal of Management article found him to be among the top 65 most widely cited management scholars, and an Academy of Management Perspectives study found him to be the fourth most influential manage- ment scholar both inside and outside of academia (measured by academic citations and non-edu Google webpages) among professors who obtained their PhD since 1991. Overall, Professor Peng has published over 100 articles in leading journals, over 30 pieces in non-refereed outlets, and five books. Since the launch of Global Business’s second edition, he has published not only in top IB journals, such as the Academy of Management Journal, Journal of International Business Studies, Journal of World Business, and Strategic Management Journal, but also in leading outlets in op- erations ( Journal of Operations Management), entrepreneurship ( Journal of Business Venturing and Entrepreneurship Theory and Practice), and human resources (Interna- tional Journal of Human Resource Management).

Professor Peng’s market leading textbooks, Global Business, Global Strategy, and GLOBAL, are studied in over 30 countries and have been translated into Chinese, Spanish, and Portuguese. A European adaptation, International Business (with Klaus Meyer), has been successfully launched.

Professor Peng is active in leadership positions. He has served on the edito- rial boards of AMJ, AMR, JIBS, JMS, JWB, and SMJ, and guest-edited a special

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issue for the JMS. At the Academy of International Business (AIB), he co-chaired the AIB/JIBS Frontiers Conference in San Diego (2006), guest-edited a JIBS special issue (2010), chaired the Emerging and Transition Economies track for the Nagoya conference (2011), and chaired the Richard Farmer Best Disserta- tion Award Committee for the Washington conference (2012). In 2012, he was elected to be a Fellow of the AIB, joining a distinguished group of about 80 senior scholars who made most significant contributions to IB. At the Strategic Manage- ment Society (SMS), he was elected to chair the Global Strategy Interest Group. He also co-chaired the SMS Special Conference on China in Shanghai (2007). He served one term as Editor-in-Chief of the Asia Pacific Journal of Management. During his editorial tenure, he managed the doubling of submission numbers and the successful bid to enter the Social Sciences Citation Index (SSCI), which reported APJM’s first citation impact to be 3.36 and rated it as the top 18 among 140 management journals for 2010.

Professor Peng is also an active consultant, trainer, and keynote speaker. He has provided on-the-job training to over 300 professors. He has consulted and been a keynote speaker for multinational enterprises (such as AstraZeneca, Berlitz, KOSTA, Nationwide, SAFRAN, and Texas Instruments), non-profit organiza- tions (such as Greater Dallas Asian American Chamber of Commerce and World Affairs Council of Dallas-Fort Worth), educational and funding organizations (such as Harvard University Kennedy School of Government, Hong Kong Research Grants Council, National Science Foundation of the United States, Social Sciences and Humanities Research Council of Canada, and the University of Memphis), and national and international organizations (such as the US-China Business Council, US Navy, and World Bank).

Professor Peng has attracted close to $1 million in external funding. His hon- ors include a National Science Foundation CAREER Grant, a US Small Business Administration Best Paper Award, a (lifetime) Distinguished Scholar Award from the Southwestern Academy of Management, and a (lifetime) Scholarly Contribu- tion Award from the International Association for Chinese Management Research. He has been quoted in The Economist, Newsweek, Dallas Morning News, Smart Business Dallas, Atlanta Journal-Constitution, The Exporter Magazine, The World Journal, Business Times (Singapore), Sing Tao Daily (Vancouver), and Brasil Econômico (São Paulo), and on the Voice of America.

Laying Foundations

Chapters 1 Globalizing Business

2 Understanding Formal Institutions: Politics, Laws, and Economics

3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms

4 Leveraging Resources and Capabilities

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Learning Objectives

After studying this chapter, you should be able to

1-1 explain the concepts of international business and global business, with a focus on emerging economies.

1-2 give three reasons why it is important to study global business.

1-3 articulate one fundamental question and two core perspectives in the study of global business.

1-4 identify three ways of understanding what globalization is.

1-5 state the size of the global economy and its broad trends and understand your likely bias in the globalization debate.

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Globalizing Business

In 1994, when Mahindra & Mahindra (M&M) arrived in the United States, it was already a powerhouse in its native India. The company, founded as a steelmaker in 1945, had entered the agriculture market nearly 20 years later, partnering with International Harvester to manufacture a line of sturdy 35-horsepower tractors under the Mahindra name.

The Mahindra tractors became very popular in India. They were affordably priced and fuel efficient, two qualities highly valued by thrifty Indian farmers, and the machines were sized appropriately for small Indian farms. Over the years, M&M continued to in- novate to perfect its offerings, and its tractors prolif- erated throughout India’s vast agricultural regions. The Mahindra brand became well established and respected. By the mid-1990s, the company was one of India’s top tractor manufacturers—and it was ready for new challenges. The lucrative US market beckoned.

When Mahindra USA (MUSA) opened for busi- ness, Deere & Company—famous for its John Deere brand—was the dominant player. Deere’s bread and butter were enormous machines ranging as high as 600 horsepower for industrial-scale agribusiness. Rather than trying to develop a product that could com- pete head-on with Deere, M&M aimed for a smaller agricultural niche, one in which it could grow and make the most of its strengths.

Mahindra figured its little tractor would be perfect for hobby farmers, landscapers, and building contractors. The machine was sturdy, extremely reliable, and priced to sell. With a few modifications for the US market—such as supersized seats and larger brake pedals to accommo- date larger American bodies—Mahindra was good to go.

But the company was far from home and hardly a household name. The few Americans who had heard of the brand thought of it variously as “red,” “foreign,” or “cheap.” Even domestic competitors were barely aware of the newcomer. Deere gave more of its atten- tion to Case and New Holland than to Mahindra. Fly- ing below the radar, MUSA decided to make its mark through personalized service.

MUSA built close relationships with small dealer- ships, particular family-run operations. Rather than saddle dealers with expensive inventory, MUSA allowed them to run on a just-in-time basis, offering to deliver a tractor within 24 to 48 hours of receiving the order. MUSA also facilitated financing. In return, Mahindra benefited from the trust the dealers enjoyed in their communities.

MUSA also built close relationships with custom- ers. Some 10% to 15% of M&M tractor buyers got phone calls from the company’s president, who asked whether they were pleased with the buying experience and their new tractors. The company also offered special incentives—horticultural scholarships,

O p e n i n g C a s e

EmErging markEts: Mahindra & Mahindra versus John Deere

4 Part One Laying Foundations

for example—to neglected market segments such as female hobby farmers.

This high-touch strategy paid off handsomely. MUSA’s US sales growth averaged 40% per year from 1999 to 2006. This prompted David C. Everitt, president of Deere’s agricultural division, to remark that Mahindra “could someday pass Deere in global unit sales.”

Deere responded with short-lived—and seemingly desperate—cash incentives to induce Mahindra buy- ers to trade for a Deere. This had the unintended effect of promoting M&M’s brand (“And we didn’t even pay for it,” said Anjou Choudhari, CEO of M&M’s farm equipment sector from 2005 to 2010). Mahindra fired back with an ad featuring the headline: “Deere John, I have found someone new.”

As Mahindra enjoyed growing success in America, Deere struggled to gain a foothold in India. Unlike

Mahindra, which had innovated both its product and its processes for the US market, Deere tried to tempt Indian farmers with the same product that had under- written its success at home. The strategy did not work, and Deere was forced to re-engineer its thinking as well as its product.

“We gave a wake-up call to John Deere,” noted Choudhari. “Our global threat was one of the motiva- tions for Deere to design a low-horsepower tractor—in India and for India.”

In the meantime, M&M has become the number- one tractor maker worldwide, as measured by units sold.

Source: This case was written by Professors Vijay Govindarajan and Chris Trimble (both at the Tuck School of Business, Dartmouth College). It was an excerpt from V. Govindarajan & C. Trimble, 2012, Reverse Innova- tion (pp. 10–11), Boston: Harvard Business Review Press.

How do firms such as Mahindra & Mahindra and Deere compete in India, the United States, and elsewhere? What determines the success and failure of these firms—and numerous others—around the world? This book will address these and other impor- tant questions on global business.

1-1 What Is Global Business? 1-1a Defining International Business and Global Business Traditionally, international business (IB) is defined as a business (or firm) that en- gages in international (cross-border) economic activities. It can also refer to the action of doing business abroad. The previous generation of IB textbooks almost always takes the foreign entrant’s perspective. Consequently, such books deal with issues such as how to enter foreign markets and how to select alliance partners. The most frequently discussed foreign entrant is the multinational enterprise (MNE), de- fined as a firm that engages in foreign direct investment (FDI) by directly investing in, controlling, and managing value-added activities in other countries.1 Using our Opening Case, traditional IB textbooks would focus on how MNEs such as Deere enter India by undertaking FDI there. MNEs and their cross-border activities are, of course, important, but they only cover one side of IB—the foreign side. Students educated by these books often come away with the impression that the other side of IB—namely, domestic firms—does not exist. Of course, that is not true. Do- mestic firms such as Mahindra & Mahindra do not just sit around in the face of foreign entrants. Domestic firms actively compete and/or collaborate with foreign entrants such as International Harvester. Sometimes strong domestic firms such as Mahindra & Mahindra have also gone overseas themselves. Overall, focusing on the foreign entrant side captures only one side of the coin at best.2

There are two key words in IB: international (I) and business (B).3 However, many previous textbooks focus on the international aspect (the foreign entrant) to such an extent that the business part (which also includes domestic business) almost

Learning Objective Explain the concepts of international business and global business, with a focus on emerging economies.

1-1

International business (IB)

(1) A business (or firm) that engages in international (cross- border) economic activities and/ or (2) the action of doing busi- ness abroad.

Multinational enterprise (MNE)

A firm that engages in foreign direct investment (FDI).

Foreign direct investment (FDI)

Investment in, controlling, and managing value-added activities in other countries.

Chapter 1 Globalizing Business 5

disappears. This is unfortunate, because IB is fundamentally about B in addition to being I. To put it differently, the IB course in the undergraduate and MBA curri- cula at numerous business schools is probably the only one with the word “business” in its title. All other courses you take are labeled management, marketing, finance, and so on, representing one functional area but not the overall picture of business. Does it matter? Of course! It means that your IB course is an integrative course that has the potential to provide you with an overall business perspective (rather than a functional view) grounded in a global environment. Consequently, it makes sense that your textbook should give you both the I and B parts, not just the I part.

To cover both the I and the B parts, global business is defined in this book as business around the globe—thus, the title of this book is Global Business (not IB). In other words, global business includes both (1) international (cross-border) busi- ness activities covered by traditional IB books and (2) domestic business activities. Such deliberate blurring of the traditional boundaries separating international and domestic business is increasingly important today, because many previously national (domestic) markets are now globalized.

Consider the competition in college textbooks, such as this Global Business book you are studying now. Not long ago, competition among college business textbook publishers was primarily on a nation-by-nation basis. The Big Three—South-Western Cengage Learning (our publisher, which is the biggest in the college business textbook market), Prentice Hall, and McGraw-Hill—primarily competed in the United States. A different set of publishers competed in other countries. As a result, most textbooks studied by British students would be authored by British professors and published by British publishers, most textbooks studied by Brazilian students would be authored by Brazilian professors and published by Brazilian publishers, and so on. Now South- Western Cengage Learning (under British and Canadian ownership), Pearson Pren- tice Hall (under British ownership), and McGraw-Hill (still under US ownership) have significantly globalized their competition, thanks to the rising demand for high- quality business textbooks in English. Around the globe, they are competing against each other in many markets, publishing in multiple languages and versions. For in- stance, Global Business and its sister books, Global Strategy, GLOBAL (paperback), and International Business (an adaptation for the European market), are published by dif- ferent subsidiaries in Chinese, Spanish, and Portuguese in addition to English, reach- ing customers in over 30 countries. Despite such worldwide spread of competition, in each market—down to each school—textbook publishers have to compete locally. In other words, no professor teaches globally, and all students study locally. This means that Global Business has to win adoption from every class, every semester. Overall, it becomes difficult to tell in this competition what is international and what is domestic. Thus, “global” seems to be a better word to capture the essence of this competition.

1-1b Global Business and Emerging Economies Global Business also differs from other books on IB because most focus on competi- tion in developed economies. Here, by contrast, we devote extensive space to com- petitive battles waged throughout emerging economies, a term that has gradually replaced the term “developing countries” since the 1990s. Another commonly used term is emerging markets (see PengAtlas Map 1.1). How important are emerging economies? Collectively, they now contribute approximately 45% of the global gross domestic product (GDP), as shown in Figure 1.1. Note that this percentage is adjusted for purchasing power parity (PPP), which is an adjustment to reflect the dif- ferences in cost of living (see In Focus 1.1). Using official (nominal) exchange rates

Global business

Business around the globe.

Emerging economies

A term that has gradually re- placed the term “developing countries” since the 1990s.

Emerging markets

A term that is often used in- terchangeably with “emerging economies.”

Gross domestic product (GDP)

The sum of value added by resident firms, households, and governments operating in an economy.

Purchasing power parity (PPP)

A conversion that determines the equivalent amount of goods and services that different currencies can purchase.

6 Part One Laying Foundations

Figure 1.1 The Contributions of Emerging Economies Relative to Developed Economies (World %)

80 90 10060 7050403020100

Developed economies

FDI outflows

GDP (nominal exchange rates)

Exports of goods and services

FDI inflows

GDP (purchasing power parity)

Population

BRIC Emerging economies excluding BRIC

Sources: Data extracted from (1) United Nations, 2011, World Investment Report 2011, New York and Geneva: UN; (2) World Bank, 2012, World Development Indicators database, Washington: World Bank. All data refer to 2011.

GDP, GNP, GNI, PPP—there is a bewildering variety of acronyms that are used to measure economic develop- ment. It is useful to set these terms straight before pro- ceeding. Gross domestic product (GDP) is measured as the sum of value added by resident firms, households, and governments operating in an economy. For exam- ple, the value added by foreign-owned firms operating in Mexico would be counted as part of Mexico’s GDP. However, the earnings of non-resident sources that are sent back to Mexico (such as earnings of Mexicans who do not live and work in Mexico and dividends received by Mexicans who own non-Mexican stocks) are not in- cluded in Mexico’s GDP. One measure that captures this is gross national product (GNP). More recently, the World Bank and other international organizations have used a new term, gross national income (GNI), to supersede GNP. Conceptually, there is no difference between GNI and GNP. What exactly is GNI/GNP? It comprises GDP plus income from non-resident sources abroad.

While GDP, GNP, and now GNI are often used as yardsticks of economic development, differences in cost of living make such a direct comparison less mean- ingful. A dollar of spending in, say, Thailand can buy a lot more than in Japan. Therefore, conversion based on purchasing power parity (PPP) is often necessary.

The PPP between two countries is the rate at which the currency of one country needs to be converted into that of a second country to ensure that a given amount of the first country’s currency will purchase the same volume of goods and services in the second country (see Chapter 7 for details). According to the In- ternational Monetary Fund (IMF), the Swiss per capita GDP is $81,161 based on official (nominal) exchange rates—higher than the US per capita GDP of $48,387. However, everything is more expensive in Switzerland. A Big Mac costs $6.81 in Switzerland versus $4.20 in the United States. Thus, Switzerland’s per capita GDP based on PPP becomes $43,370—lower than the US per capita GDP based on PPP, $48,387 (the IMF uses the United States as benchmark in PPP calculation). On a worldwide basis, measured at official exchange rates, emerging economies’ share of global GDP is approxi- mately 26%. However, measured at PPP, it is about 43% of the global GDP. Overall, when you read statis- tics about GDP, GNP, and GNI, always pay attention to whether these numbers are based on official exchange rates or PPP, which can make a huge difference.

Sources: Based on (1) Economist, 2012, Big Mac index, January 14: 93; (2) Economist, 2006, Grossly distorted picture, February 11: 72; (3) International Monetary Fund, 2012, World Economic Outlook, April, Washington, DC: IMF.

Setting the Terms Straight IN Focus 1.1

Gross national product (GNP)

GDP plus income from non- resident sources abroad.

Gross national income (GNI)

GDP plus income from non- resident sources abroad. GNI is the term used by the World Bank and other international organizations to supersede the term GNP.

Chapter 1 Globalizing Business 7

without adjusting for PPP, emerging economies contribute about 26% of the global GDP. Why is there such a huge difference between the two measures? Because the cost of living (such as housing and haircuts) in emerging economies tends to be lower than that in developed economies. For instance, one dollar spent in Mexico can buy a lot more than one dollar spent in the United States.

Table 1.1 lists the 33 countries that are classified as “developed economies.” The rest of the world (more than 150 countries) can be broadly labeled as “emerging economies.” Of these emerging economies, Brazil, Russia, India, and China—commonly referred to as BRIC—command more attention. As a group, they generate 17% of world exports, absorb 16% of FDI inflows, and contribute 28% of world GDP (on a PPP basis). Commanding a lion’s share, BRIC contrib- ute 62% of the GDP of all emerging economies (on a PPP basis). BRIC also generate 8% of world FDI outflows. MNEs from BRIC (such as Mahindra & Mahindra in the Opening Case) are increasingly visible in making investments and acquiring firms around the world.4 Clearly, major emerging economies (es- pecially BRIC) and their firms have become a force to be reckoned with in global business.5 In addition to BRIC, other interesting terms include BRICS (BRIC + South Africa), BRICM (BRIC + Mexico), and BRICET (BRIC + Eastern Europe and Turkey).

Does it make sense to group so many countries with tremendous diversity in terms of history, geography, politics, and economics together as “emerging economies”? As compared to developed economies, the label of “emerging econo- mies,” rightly or wrongly, has emphasized the presumably homogenous nature of so many different countries. While this single label has been useful, more recent research has endeavored to enrich it.6

Specifically, the two dimensions illustrated in Figure 1.2 can help us differenti- ate various emerging economies.7 Vertically, the development of market-supporting political, legal, and economic institutions has been noted as a crucial dimension of

BRIC

Brazil, Russia, India, and China.

Table 1.1 Classifying Developed Economies versus Emerging Economies

33 developed economies as classified by the International Monetary Fund (IMF)

Australia Hong Kong Portugal

Austria Iceland Singapore

Belgium Ireland Slovak Republic

Canada Israel Slovenia

Cyprus Italy South Korea

Czech Republic Japan Spain

Denmark Luxembourg Sweden

Finland Malta Switzerland

France Netherlands Taiwan

Germany New Zealand United Kingdom

Greece Norway United States

All the other 149 economies are classified by the IMF as emerging economies

Source: IMF, www.imf.org. The IMF recognizes 182 countries and economies. It labels developed economies “advanced economies” and labels emerging economies “emerging and developing economies.”

8 Part One Laying Foundations

institutional transitions in many emerging economies.8 Horizontally, the develop- ment of infrastructure and factor markets is also crucial.

Stereotypical or traditional emerging economies suffer from both the lack of institutional development and the lack of infrastructure and factor market development. Most emerging economies 20 years ago would have fit this descrip- tion. Today, some emerging economies that have made relatively little progress along these two dimensions (such as Belarus and Zimbabwe) still exist.

However, a lot has changed. A great deal of institutional development and in- frastructure and factor market development have taken place. Such wide-ranging development has resulted in the emergence of a class of mid-range emerging econo- mies that differ from both traditional emerging economies and developed econ- omies. For example, the top down approach to government found in China has facilitated infrastructure and factor market development. But China’s political and market institutions tend to be underdeveloped relative to physical infrastructure. Alternatively, India has strong political institutions supporting market institutions (although there is still significant corruption in government bureaucracies). While Indian government policy reforms have facilitated better market institutions and associated economic development, world-class physical infrastructure is lacking. In the middle area of Figure 1.2, Brazil and Russia can be placed as examples. In these mid-range emerging economies, there are some democratic political institutions (despite the recent setback in Russia—see Chapter 2 Opening Case) and some in- frastructure and factor market development. Finally, some economies have clearly graduated from the “emerging” phase and become what we call “newly developed economies.” South Korea may be an exemplar country as it has more balanced development in both institutional development and infrastructure/factor markets.

1-1c Base of the Pyramid and Reverse Innovation The global economy can be viewed as a pyramid (Figure 1.3). The top consists of about one billion people with per capita annual income of $20,000 or higher.

Mid-Range Emerging

Economies (e.g., INDIA)

Mid-Range Emerging

Economies (e.g., CHINA)

Traditional Emerging

Economies (e.g., BELARUS)

Less

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Figure 1.2 A Typology of Emerging Economies

Source: Adapted from R. Hoskisson, M. Wright, I. Filatotchev, & M. W. Peng, 2013, Emerging multinationals from mid-range economies: The influence of institutions and factor markets, Journal of Management Studies (in press).

Chapter 1 Globalizing Business 9

These are mostly people who live in the developed economies in the Triad, which consists of North America, Western Europe, and Japan. Another billion people earning $2,000 to $20,000 per year make up the second tier. The vast majority of humanity—about five billion people—earn less than $2,000 per year and com- prise the base of the pyramid (BOP). Most MNEs focus on the top and second tiers and end up ignoring the base of the pyramid.9 An increasing number of such low- income countries have shown a great deal of economic opportunities as income levels have risen (see the Closing Case). More Western MNEs, such as GE, are in- vesting aggressively in the base of the pyramid and leveraging their investment to tackle markets in both emerging and developed economies.

One interesting recent development out of emerging economies is reverse innovation—an innovation that is adopted first in emerging economies and then diffused around the world.10 Traditionally, innovations are generated by Triad-based multinationals with the needs and wants of rich customers at the top of the pyramid in mind. When such multinationals entered lower-income economies, they tended to simplify the product features and lower the prices. In other words, the innovation flow is top down. However, as Deere & Company found out in India, its large-horsepower tractors designed for American farmers were a poor fit for the very different needs and wants of Indian farmers. Despite Deere’s efforts to simplify the product and reduce the price, the price was still too high in India. Instead, Mahindra & Mahindra brought its widely popular small-horsepower tractors that were developed in India to the United States, and carved out a growing niche that eventually propelled it to be the world’s largest tractor maker by units sold (see the Opening Case). In response, Deere abandoned its US tractor designs and “went native” in India, by launching a local design team charged with developing something from scratch—with the needs and wants of farmers in India (or, more broadly, in emerging economies) in mind. The result was a 35-horsepower tractor that

Triad

North America, Western Europe, and Japan.

Base of the pyramid (BoP)

Economies where people make less than $2,000 per capita per year.

Reverse innovation

An innovation that is adopted first in emerging economies and is then diffused around the world.

Base of the Pyramid Per capita GDP/GNI < $2,000

Approximately five billion people

Second Tier Per capita GDP/GNI $2,000–$20,000

Approximately one billion people

Top Tier Per capita GDP/GNI > $20,000

Approximately one billion people

Sources: Adapted from (1) C. K. Prahalad & S. Hart, 2002, The fortune at the bottom of the pyramid, Strategy+Business, 26: 54-67; (2) S. Hart, 2005, Capitalism at the Crossroads (p. 111), Philadelphia: Wharton School Publishing.

Figure 1.3 The Global Economic Pyramid

10 Part One Laying Foundations

Table 1.2 Why Study Global Business?

Enhance your employability and advance your career in the global economy

Better preparation for possible expatriate assignments abroad

Stronger competence in interacting with foreign suppliers, partners, and competitors and in working for foreign-owned employers in your own country

was competitive not only with Mahindra in India, but also in the United States and elsewhere. In both cases, the origin of new innovations is from the base of the pyramid. The flow of innovation is bottom up—in other words, reverse innovation.

The reverse innovation movement suggests that emerging economies are no longer merely low-cost production locations or attractive new markets (hence the term “emerging markets”). They are also sources of new innovations that may not only grow out of BOP markets, but also have the potential to go uphill to penetrate into the top of the global economic pyramid. In a Harvard Business Review article, Jeff Immelt, chairman and CEO of a leading practitioner of reverse innovation, GE, noted:

To be honest, the company is also embracing reverse innovation for defensive rea- sons. If GE doesn’t come up with innovations in poor countries and take them glob- al, new competitors from the developing world—like Mindray, Suzlon, Goldwind, and Haier—will. . . GE has tremendous respect for traditional rivals like Siemens, Philips, and Rolls-Royce. But it knows how to compete with them; they will never destroy GE. By introducing products that create a new price-performance paradigm, however, the emerging giants very well could. Reverse innovation isn’t optional; it is oxygen.11

As advised by GE’s Immelt, today’s students—and tomorrow’s business leaders— will ignore the opportunities and challenges at the base of the pyramid at their own peril. This book will help ensure that you will not ignore these opportunities.

1-2 Why Study Global Business? Global business (or IB) is one of the most exciting, most challenging, and most relevant subjects offered by business schools. Why study it? There are at least three compelling reasons why you should study global business—and study hard (Table 1.2).

First, mastering global business knowledge helps advance your employability and career in an increasingly competitive global economy. Take a look at the Open- ing Day Quiz in Table 1.3. Can you answer all the questions correctly? If not, you will definitely benefit from studying global business.

The answer to Question 1 is empirical—that is, based on data. You should guess first and then look at the label of your shirt yourself or ask a friend to help you. The key here is international trade. Do you wear a shirt made in your own country or another country? Why?

In Question 2, smart students typically ask whether the mobile device (such as a smartphone or an iPad) means the motherboard or the components. My answer is: “I mean the whole device, all the production that went into making

Learning Objective Give three reasons why it is important to study global business.

1-2

Chapter 1 Globalizing Business 11

the machine.” Then some students would respond: “But they could be made in different countries!” My point exactly. Specifically, the point here is to appreciate the complexity of a global value chain, with different countries making different components and handling different tasks. Such a value chain is typically managed by an MNE, such as Apple, Dell, Foxconn, HP, Lenovo, or Samsung. The capabilities necessary to organize a global supply chain hints at the importance of resources and capabilities—one of the two key themes of this book.

Question 3 is deceptively simple. Unfortunately, 100% of my own students— ranging from undergraduates to PhDs—miss it. Surprise! The Group of 20 (G-20) only has 19 member countries. The 20th member is the European Union (EU)—a regional bloc, not a single country (see PengAtlas Map 1.1). Ideally, why the G-20 is formed in such an interesting way will make you more curious about how the rules of the game are made around the world. In this case, why are 19 countries in, but numerous others are out? What is special about the EU? Why are other regional blocs not included in the G-20? What about the G-7? What about other groups of countries (see Figure 1.4)? A focus on the rules of the game—more technically, institutions—is another key theme of the book.

Question 4 will really frighten you. Some students would typically clarify: “Do you mean the few security guards looking after the closed plant?” “Not necessarily,” I would point out. “The question is: How many jobs will be kept by the company?” Students would eventually get it: even adding a few jobs as security guards at the closed plant, the most optimistic estimates are that only 30 to 50 jobs may be kept. Yes, you guessed it, these jobs typically are high-level positions such as the CEO, CFO, CIO, factory director, and chief engineer. These managers will be sent by the MNE to start up operations in an emerging economy. You need to realize that in a 2,000-employee plant, even if you may be the 51st-highest-ranked employee, your fate may be the same as the 2,000th employee. You really need to work hard and work smart to position yourself as one of the top 50 (preferably one of the top 30). Doing well in this class and mastering global business knowledge may help make it happen.

Group of 20 (G-20)

The group of 19 major countries plus the European Union (EU) whose leaders meet on a biannual basis to solve global economic problems.

Table 1.3 Opening Day Quiz

1. Which country made the shirt you are wearing? 2. Which country made your mobile communication device? (A) China (A) China (B) Malaysia (B) Germany (C) Mexico (C) Singapore (D) Romania (D) Taiwan (E) US (E) US

3. How many countries does the G-20 have? 4. A 2,000-employee manufacturing plant is closing in a developed economy, and production is moving to an emerging economy. How many of the 2,000 jobs will the company keep?

(A) 0 (B) 5–10 (C) 10–20 (D) 20–30 (E) 30–50

(A) 20 (B) 21 (C) 22 (D) 19 (E) 18

12 Part One Laying Foundations

In addition to the first reason to equip you with relevant knowledge, the second compelling reason why you should study global business is related to Question 4. Because many ambitious students aspire to join the top ranks of large firms, expertise in global business is often a prerequisite. Today, it is increasingly difficult, if not impossible, to find top managers at large firms without significant global competence. Of course, eventually hands-on global experience, not merely knowledge acquired from this course, will be required. However, mastery of the knowledge of, and demonstration of interest in, global business during your education will set you apart as a more ideal candidate

to be selected as an expatriate manager (or “expat”)—a manager who works abroad—to gain such an experience (see Chapter 15 for details).

Thanks to globalization, low-level jobs not only command lower salaries but are also more vulnerable. However, high-level jobs, especially those held by expats, are both financially rewarding and relatively secure. Expats often command a signifi- cant international premium in compensa- tion—a significant pay raise when work- ing overseas. In US firms, an expat’s total compensation package is approximately $250,000 to $300,000 (including perks and benefits; not all is take-home pay). When they return to the United States after a tour of duty (usually two to three

Expatriate manager

A manager who works abroad, or “expat” for short.

International premium

A significant pay raise when working overseas.

Brazil

India

South Africa

Brunei Cambodia Indonesia

Laos Malaysia Myanmar

Philippines Singapore Thailand Vietnam

Italy France

Germany Japan

UK Canada

USA

Shanghai Co-op Organization

BRIC

IBSA ASEAN +3G7

Kazakhstan Kyrgyztan Tajikistan

Uzbekistan

Russia

China

Argentina Australia Mexico Turkey

European Union

G20

Japan

South Korea

Figure 1.4 Country Groupings in the 21st Century

Source: Adapted from C. Dhanaraj & T. Khanna, 2011, Transforming mental models on emerging markets (p. 696), Academy of Management Learning and Education, 10(4): 684-701. G7 = Group of Seven; G20 = Group of Twenty; BRIC = Brazil, Russia, India, and China; IBSA = India-Brazil-South Africa Dialogue Forum; Shanghai Co-op Orga- nization = Shanghai Co-operation Organization; ASEAN = Association of Southeast Asian Nations. © Academy of Management.

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What are some of the benefits you may enjoy as an expatriate manager?

Chapter 1 Globalizing Business 13

years), a firm that does not provide attractive career opportunities to experi- enced expats often finds that they are lured away by competitor firms. Competi- tor firms also want to globalize their business, and tapping into the expertise and experience of these former expats makes such expansion more likely to succeed. And yes, to hire away these internationally experienced managers, competitor firms have to pay an even larger premium. This indeed is a virtuous cycle.

This hypothetical example is designed to motivate you to study hard so that someday, you may become one of these sought-after globe-trotting managers. But even if you don’t want to be an expat, we assume that you don’t want to join the army of the unemployed due to factory closings and business failures.

Lastly, even if you do not aspire to compete for the top job at a large company and instead work at a small firm or are self-employed, you may find yourself dealing with foreign-owned suppliers and buyers, competing with foreign-invested firms in your home market, or perhaps even selling and investing overseas. Alternatively, you may find yourself working for a foreign-owned firm, your domestic employer acquired by a foreign player, or your unit ordered to shut down for global consoli- dation. Any of these is a likely scenario, because approximately 80 million people worldwide—including 18 million Chinese, six million Americans, and one million British—are employed by foreign-owned firms. Understanding how global business decisions are made may facilitate your own career in such firms. If there is a stra- tegic rationale to downsize your unit, you want to be prepared and start polishing your résumé right away. In other words, it is your career that is at stake. Don’t be the last in the know!

In short, in this age of global competition, “how do you keep from being Bangalored or Shanghaied” (that is, having your job being outsourced to India or China)?12 To avoid the fate humorously portrayed in Figure 1.5, a good place to

Figure 1.5 Jobs Outsourced

Source: Harvard Business Review, 2012, April: 34.

14 Part One Laying Foundations

start is to study hard and do well in your IB course. Also, don’t forget to put this course on your résumé!

1-3 A Unified Framework Global business is a vast subject area. It is one of the few courses that will make you appreciate why your university requires you to take a number of seemingly unrelated courses in general education. We will draw on major social sciences, such as economics, geography, history, political science, psychology, and sociology. We will also draw on a number of business disciplines, such as strategy, finance, and marketing. The study of global business is thus very interdisciplinary. It is quite easy to lose sight of the forest while scrutinizing various trees or even branches. The subject is not difficult, and most students find it to be fun. The number-one student complaint (based on previous student feedback) is that there is an overwhelming amount of information. Honestly, this is also my number-one complaint as your author. You may have to read and learn this material, but I have to bring it all together in a way that is understandable and in a (relatively) compact book that does not go on and on and on for 900 pages.

To make your learning more focused, more manageable, and (hopefully) more fun, in this section we will develop a unified framework (shown in Figure 1.6). This will provide great continuity to facilitate your learning. Spe- cifically, we will discipline ourselves by focusing on only one most fundamen- tal question and two core perspectives. A fundamental question acts to define a field and to orient the attention of students, practitioners, and scholars in a certain direction. Our “big question” is: What determines the success and fail- ure of firms around the globe?13 To answer this question, we will introduce only two core perspectives throughout this book: (1) an institution-based view and (2) a resource-based view.14 The remainder of this section outlines this framework.

Learning Objective Articulate one fundamental question and two core perspectives in the study of global business.

1-3

Fundamental question: What determines the success and failure

of firms around the globe? Resource-based view:

Firm-specific resources and

capabilities

Institution-based view: Formal and informal

rules of the game

Figure 1.6 A Unified Framework for Global Business

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Chapter 1 Globalizing Business 15

1-3a One Fundamental Question What is it that we do in global business? Why is it so important that practically all students in business schools around the world are either required or recommended to take this course? While there are certainly a lot of questions to raise, a relentless interest in what determines the success and failure of firms around the globe serves to focus the energy of our field. Global business is fundamentally about not limit- ing yourself to your home country. It is about treating the entire global economy as your potential playground (or battlefield). Some firms may be successful domesti- cally but fail miserably overseas. Other firms successfully translate their strengths from their home markets to other countries. If you were expected to lead your firm’s efforts to enter a particular foreign market, wouldn’t you want to find out what drives the success and failure of other firms in that market?

Overall, the focus on firm performance around the globe defines the field of global business (or IB) more than anything else. Numerous other questions and topics all relate in one way or another to this most fundamental question. There- fore, all chapters in this book will be centered on this consistent theme: What de- termines the success and failure of firms around the globe?

1-3b First Core Perspective: An Institution-Based View15

An institution-based view suggests that the success and failure of firms are enabled and constrained by institutions. By institutions, we mean the rules of the game. Doing business around the globe requires intimate knowledge about both formal rules (such as laws) and informal rules (such as values) that govern competition in various countries. If you establish a firm in a given country, you will work within that country’s institutional framework, which consists of the formal and informal institutions that govern individual and firm behavior. Firms that do not do their homework and thus remain ignorant of the rules of the game in a certain country are not likely to emerge as winners.

Formal institutions include laws, regulations, and rules. For example, Hong Kong’s laws are well-known for treating all comers, whether from neighbor- ing mainland China (whose firms are still technically regarded as “non-domestic”) or far-away Chile, the same as they treat indigenous Hong Kong firms. Such equal treatment enhances the potential odds for foreign firms’ success. It is thus not sur- prising that Hong Kong attracts a lot of outside firms. Other rules of the game discriminate against foreign firms and undermine their chances for success. India’s recent attraction as a site for FDI was only possible after it changed its FDI regula- tions from confrontational to accommodating. Prior to 1991, India’s rules severely discriminated against foreign firms. As a result, few foreign firms bothered to show up, and the few that did had a hard time. For example, in the 1970s, the Indian gov- ernment demanded that Coca-Cola either hand over the recipe for its secret syrup, which it does not even share with the US government, or get out of India. Painfully, Coca-Cola chose to leave India. Its return to India since the 1990s speaks volumes about how much the rules of the game have changed in India.

Informal institutions include cultures, ethics, and norms. They also play an important part in shaping the success and failure of firms around the globe. For example, individualistic societies, particularly the English-speaking countries such as Australia, Britain, and the United States, tend to have a relatively higher level of

16 Part One Laying Foundations

entrepreneurship as reflected in the number of business start-ups. Why? Because the act of founding a new firm is a widely accepted practice in individualistic societ- ies. Conversely, collectivistic societies such as Japan often have a hard time foster- ing entrepreneurship. Most people there refuse to stick their neck out to found new businesses because it is contrary to the norm.16

Overall, an institution-based view suggests that institutions shed a great deal of light on what drives firm performance around the globe.17 Next, we turn to our second core perspective.

1-3c Second Core Perspective: A Resource-Based View18

The institution-based view suggests that the success and failure of firms around the globe are largely determined by their environments. This is certainly correct. Indeed, India did not attract much FDI prior to 1991 and Japan does not nurture a lot of internationally competitive start-ups because of their institutions. However, insightful as this perspective is, there is a major drawback. If we push this view to its logical extreme, then firm performance around the globe would be entirely determined by environments. The validity of this extreme version is certainly ques- tionable.

The resource-based view helps overcome this drawback. While the institution- based view primarily deals with the external environment, the resource-based view focuses on a firm’s internal resources and capabilities. It starts with a simple observa- tion: In harsh, unattractive environments, most firms either suffer or exit. However, against all odds, a few superstars thrive in these environments. For example, despite the former Soviet Union’s obvious hostility toward the United States during the Cold War, PepsiCo began successfully operating in the former Soviet Union in the 1970s (!). Most of the major airlines have been losing money since September 11, 2001. But a small number of players, such as Southwest in the United States, Ryanair in Ireland, and Hainan Airlines in China, have been raking in profits year after year. In the fiercely competitive fashion industry, Zara has been defying gravity (see In Focus 1.2). How can these firms succeed in such challenging environments? What is special about them? A short answer is that PepsiCo, Southwest, Ryanair, Hainan, and Zara must have certain valuable and unique firm-specific resources and capabilities that are not shared by competitors in the same environments.

Doing business outside one’s home country is challenging. Foreign firms have to overcome a liability of foreignness, which is the inherent disadvantage that foreign firms experience in host countries because of their non-native status.19 Just think about all the differences in regulations, languages, cultures, and norms. Think about the odds against Mahindra & Mahindra when it tried to eat some of John Deere’s lunch in the American heartland (see the Opening Case). Against such significant odds, the primary weapons that foreign firms such as Mahindra & Mahindra employ are overwhelming resources and capabilities that can offset their liability of foreignness.20 Today, many of us take it for granted that the best-selling car in the United States rotates between the Toyota Camry and the Honda Civic, that Coca-Cola is the best-selling soft drink in Mexico, and that Microsoft Word is the world’s number-one word-processing software. We really shouldn’t. Why? Because it is not natural for these foreign firms to dominate non-native markets. These firms must possess some very rare and powerful firm-specific resources and capabilities that drive these remarkable success stories and are the envy of their rivals around the globe. This is a key theme of the resource-based view, which

Liability of foreignness

The inherent disadvantage that foreign firms experience in host countries because of their non- native status.

Chapter 1 Globalizing Business 17

Zara is one of the hottest fashion chains. Founded in 1975, Zara’s parent, Inditex, has become a lead- ing global apparel retailer. Since its initial public of- fering (IPO) in 2001, Inditex quadrupled its sales (to $19.1 billion or €13.8 billion) and profits. It doubled the number of its stores of eight brands, of which Zara contributes two-thirds of total sales. Zara succeeds by first breaking and then rewriting industry rules— also known as industry norms.

Rule number one: The origin of a fashion house usually carries some cachet. However, Zara does not hail from Italy or France—it is from Spain. Even within Spain, Zara is not based in a cosmopolitan city like Barcelona or Madrid. It is headquartered in Arteixo, a town of only 25,000 people in a remote corner of northwestern Spain that a majority of this book’s readers would have never heard of. Yet, Zara is active not only throughout Europe, but also in Asia and North America. As of 2012, the total number of stores is over 4,200 in 64 countries. Zara stores occupy some of the priciest top locations: Champs-Elysées in Paris, Ginza in Tokyo, Fifth Avenue in New York, Galleria in Dallas, and Huaihai Road in Shanghai.

Rule number two: Avoid stock-outs (a store run- ning out of items in demand). Zara’s answer? Occa- sional shortages contribute to an urge to buy now. With new items arriving at stores twice a week, experienced Zara shoppers know that “If you see something and don’t buy it, you can forget about coming back for it because it will be gone.” The small batch of merchandise during a short window of opportunity for purchasing motivates shoppers to visit Zara stores more frequently. In London, shop- pers visit other stores an average of four times a year, but frequent Zara 17 times a year. There is a good reason to do so: Zara makes about 20,000 items per year, about triple what Gap does. “At Gap, everything is the same,” says one Zara fan, “and buying from Zara, you’ll never end up looking like someone else.”

Rule number three: Bombarding shoppers with ads is a must. Gap and H&M spend on average 3% to 4% of their sales on ads. Zara begs to differ: It

devotes just 0.3% of its sales to ads. The high traffic in the stores alleviates some needs for advertising in the media, most of which only serves as a reminder to visit the stores.

Rule number four: Outsource. Gap and H&M do not own any production facilities. However, out- sourcing production (mostly to Asia) requires a long lead time, usually several months. Again, Zara has decisively deviated from the norm. By concentrating (more than half of) its production in-house (in Spain, Portugal, and Morocco), Zara has developed a super- responsive supply chain. It designs, produces, and delivers a new garment to its stores worldwide in a mere 15 days, a pace that is unheard of in the industry. The best speed the rivals can achieve is two months. Outsourcing may not necessarily be “low cost,” be- cause errors in prediction can easily lead to unsold in- ventory, forcing retailers to offer steep discounts. The industry average is to offer 40% discounts across all merchandise. In contrast, Zara sells more at full price and, when it discounts, it averages only 15%.

Rule number five: Strive for efficiency through large batches. In contrast, Zara intentionally deals with small batches. Because of its flexibility, Zara does not worry about “missing the boat” for a season. When new trends emerge, Zara can react quickly. More interestingly, Zara runs its supply chain like clock- work with a fast but predictable rhythm: Every store places orders on Tuesday/Wednesday and Friday/ Saturday. Trucks and cargo flights run on established schedules—like a bus service. From Spain, shipments

Zara Deviates from Industry Norms IN Focus 1.2

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18 Part One Laying Foundations

focuses on how winning firms acquire and develop such unique and enviable resources and capabilities and how competitor firms imitate and then innovate in an effort to outcompete the winning firms.

1-3d A Consistent Theme Given our focus on the fundamental question of what determines the success and failure of firms around the globe, we will develop a unified framework by organiz- ing the material in every chapter according to the two core perspectives, namely, the institution-based and resource-based views. With our unified framework—an innovation in IB textbooks—we will not only explore the global business “trees,” but also see the global business “forest.”

1-4 What Is Globalization? Globalization, generally speaking, is the close integration of countries and peoples of the world. This abstract five-syllable word is now frequently heard and debated. Those who approve of globalization count its contributions to include greater eco- nomic growth and standards of living, increased technology sharing, and more extensive cultural integration. Critics argue that globalization undermines wages in rich countries, exploits workers in poor countries, grants MNEs too much power, and destroys the environment. So, what exactly is globalization? This section out- lines three views on globalization, recommends the pendulum view, and introduces the idea of semiglobalization.

1-4a Three Views on Globalization Depending on what sources you read, globalization could be

a new force sweeping through the world in recent times a long-run historical evolution since the dawn of human history a pendulum that swings from one extreme to another from time to time

An understanding of these views helps put the debate about globalization in perspective. First, opponents of globalization suggest that it is a new phenomenon

Learning Objective Identify three ways of understanding what globalization is.

1-4

Globalization

The close integration of coun- tries and peoples of the world.

reach most European stores in 24 hours, US stores in 48 hours, and Asian stores in 72 hours. Not only do store staff know exactly when shipments will arrive, regular customers know it too, thus motivating them to check out the new merchandise more frequently on those days, which are known as “Z days” in some cities.

Zara has no shortage of competitors. Why has no one successfully copied its business model of “fast fashion”? “I would love to organize our business like

Inditex [Zara’s parent],” noted an executive from Gap, “but I would have to knock my company down and rebuild it from scratch.” This does not mean Gap and other rivals are not trying to copy Zara. The question is how long it takes for rivals to out-Zara Zara.

Sources: Based on (1) BusinessWeek, 2009, 100 best global brands, September 28: 44-60; (2) BusinessWeek, 2006, Fashion conquis- tador, September 4: 38-39; (3) Economist, 2012, Fashion forward, March 24: 63-64; (4) K. Ferdows, M. Lewis, & J. Machuca, 2004, Rapid-fire fulfillment, Harvard Business Review, November: 104-110; (5) www.zara.com.

IN Focus 1.2 (continued)

Chapter 1 Globalizing Business 19

beginning in the late 20th century, driven by recent technological innovations and a Western ideology focused on exploiting and dominating the world through MNEs. The arguments against globalization focus on environmental stress, social injustice, and sweatshop labor but present few clearly worked-out alternatives to the present economic order. Nevertheless, anti-globalization advocates and protesters often argue that globalization needs to be slowed down, if not stopped.21

A second view contends that globalization has always been part and parcel of human history. Historians are debating whether globalization started 2,000 or 8,000 years ago. The earliest traces of MNEs have been discovered in Assyrian, Phoenician, and Roman times.22 International competition from low-cost countries is nothing new. In the first century a.d., the Roman emperor Tiberius was so concerned about the massive quantity of low-cost Chinese silk imports that he imposed the world’s first known import quota of textiles.23 Today’s most successful MNEs do not come close to wielding the historical clout of some MNEs, such as Britain’s East India Company during colonial times. In a nutshell, globalization is nothing new and will probably always exist.

A third view suggests that globalization is the “closer integration of the countries and peoples of the world which has been brought about by the enormous reduction of the costs of transportation and communication, and the breaking down of artificial barriers to the flows of goods, services, capital, knowledge, and (to a lesser extent) people across borders.”24 Globalization is neither recent nor one-directional. It is, more accurately, a process similar to the swing of a pendulum.

1-4b The Pendulum View on Globalization The pendulum view probably makes the most sense because it can help us under- stand the ups and downs of globalization. The current era of globalization origi- nated in the aftermath of World War II, when major Western countries committed to global trade and investment. However, between the 1950s and the 1970s, this view was not widely shared. Communist countries, such as China and the Soviet Union, sought to develop self-sufficiency. Many non-communist developing coun- tries, such as Brazil, India, and Mexico, focused on fostering and protecting do- mestic industries. But refusing to participate in global trade and investment ended up breeding uncompetitive industries. In contrast, four developing economies in Asia—Hong Kong, Singapore, South Korea, and Taiwan—earned their stripes as the “Four Tigers” by participating in the global economy. They became the only economies once recognized as less developed (low-income) by the World Bank to have subsequently achieved developed (high-income) status (see Table 1.1).

Inspired by the Four Tigers, more and more countries and regions—such as China in the late 1970s, Latin America in the mid-1980s, Central and Eastern Europe in the late 1980s, and India in the 1990s—realized that joining the world economy was a must. As these countries started to emerge as new players in the world economy, they become collectively known as “emerging economies.” As a result, globalization rapidly accelerated.

However, globalization, like a pendulum, is unable to keep going in one direc- tion. Rapid globalization in the 1990s and the 2000s saw some significant back- lash. First, the rapid growth of globalization led to the historically inaccurate view that globalization is new. Second, it created fear among many people in devel- oped economies that they would lose jobs. Emerging economies not only seem

20 Part One Laying Foundations

to attract many low-end manufacturing jobs away from developed economies, but they also increasingly appear to threaten some high-end jobs. Finally, some factions in emerging economies complained against the onslaught of MNEs, alleging that they destroy local companies as well as local cultures, values, and environments.

While small-scale acts of vandalizing McDonald’s restaurants are reported in a variety of countries, the December 1999 anti-globalization protests in Se- attle and the September 2001 terrorist attacks in New York and Washington have been undoubtedly the most visible and most extreme acts of anti-globalization forces at work. As a result, international travel was curtailed, and global trade and investment flows slowed in the early 2000s. Then in the mid-2000s, however, worldwide GDP, cross-border trade, and per capita GDP all soared to historically high levels.

Unfortunately, the party suddenly ended in 2008. The 2008–2009 global economic crisis was unlike anything the world had seen since the Great De- pression (1929–1933). The year 2008 showed, for better or worse, how intercon- nected the global economy has become. Deteriorating housing markets in the United States, fueled by unsustainable subprime lending practices, led to mas- sive government bailouts of financial services firms. Initially, most of the world probably shared the sentiment expressed by Brazilian President Luiz Inacio Lula da Silva that the crisis would be “Bush’s crisis” (referring to President George W. Bush) and would have nothing to do with “us.” However, the crisis quickly spread around the world, forcing numerous governments to bail out their own troubled banks. Global output, trade, and investment plummeted, while unemployment skyrocketed. The 2008–2009 crisis became known as the Great Recession. Rightly or wrongly, many people blamed globalization for the Great Recession.

After unprecedented intervention in developed economies where governments ended up being many banks’ largest shareholders, confidence was growing that the global economy had turned the corner and that the recession was ending.25 How- ever, starting in 2010, the Greek debt crisis and then the broader PIGS debt crisis (“PIGS” refers to Portugal, Ireland or Italy, Greece, and Spain) erupted. Fiscally more responsible EU countries that adopted the euro as the common currency, such as Germany and France, felt compelled to bail out the countries in crisis. The already slow recovery in Europe thus became slower, and unemployment hovered at very high levels (see Chapter 8).

Overall, economic recovery is likely to be slow in developed economies, whereas emerging economies are likely to rebound faster. The recession reminds all firms and managers of the importance of risk management—the identification and as- sessment of risks and the preparation to minimize the impact of high-risk, unfor- tunate events.26 As a technique to prepare and plan for multiple scenarios (either high risk or low risk), scenario planning is now extensively used by firms around the world.27 For example, many European firms have been preparing for a possible (but unlikely) scenario that Greece (or Germany) may leave the euro zone. As far as the direction of economic globalization is concerned, the recovery may see more protectionist measures, since the stimulus packages and job creation schemes of various governments often emphasize “buy national” (such as “buy American”) and “hire locals.” In short, the pendulum is swinging back.

Like the proverbial elephant, globalization is seen by everyone yet rarely com- prehended. The sudden ferocity of the 2008–2009 crisis surprised everybody— ranging from central bankers to academic experts. Remember all of us felt sorry

Risk management

The identification and assess- ment of risks and the preparation to minimize the impact of high- risk, unfortunate events.

scenario planning

A technique to prepare and plan for multiple scenarios (either high or low risk).

Chapter 1 Globalizing Business 21

when we read the story of a bunch of blind men trying to figure out the shape and form of the elephant. We really shouldn’t. Although we are not blind, our task is more challenging than the blind men who study a standing animal. Our beast— globalization—does not stand still and often rapidly moves, back and forth (!). Yet, we try to live with it, avoid being crushed by it, and even attempt to profit from it. Overall, relative to the other two views, the view of globalization as a pendulum is more balanced and more realistic. In other words, globalization has both rosy and dark sides, and it changes over time.

1-4c Semiglobalization Despite the debate over it, globalization is not complete. Do we really live in a glo- balized world? Are selling and investing abroad just as easy as at home? Obviously not. Most measures of market integration, such as trade and FDI, have recently scaled new heights but still fall far short of pointing to a single, globally integrated market. In other words, what we have may be labeled semiglobalization, which is more complex than extremes of total isolation and total globalization. Semiglobal- ization suggests that barriers to market integration at borders are high but not high enough to insulate countries from each other completely.28

Semiglobalization calls for more than one way of doing business around the globe. Total isolation on a nation-state basis would suggest localization—a strategy of treating each country as a unique market. So an MNE marketing products to 100 countries will need to come up with 100 versions of local cars or drinks. This approach is clearly too costly. Total globalization, on the other hand, would lead to standardization—a strategy of treating the entire world as one market. The MNE in our previous example can just market one version of “world car” or “world drink.” But the world obviously is not that simple. Between total isolation and total globalization, semiglobalization has no single right strategy, resulting in a wide variety of experimentations. Overall, (semi)globalization is neither to be opposed as a menace nor to be celebrated as a panacea; it is to be engaged.

1-5 Global Business and Globalization at a Crossroads Twenty-first century business leaders are facing an enormous challenge. This book provides a basic guide to meeting that challenge. As a backdrop for the remainder of this book, this section makes two points. First, a basic understanding of the global economy is necessary. Second, it is important to critically examine your own personal views and biases regarding globalization.

1-5a A Glance at the Global Economy The global economy at the beginning of the 21st century is an approximately $60 trillion economy (total global GDP calculated at official, nominal exchange rates). While there is no need to memorize a lot of statistics, it is useful to remem- ber this $60 trillion figure to put things in perspective.

One frequent observation in the globalization debate is the enormous size of MNEs. If the largest MNE, Wal-Mart, were an independent country, it would be the 22nd largest economy—its sales are smaller than Indonesia’s GDP but larger

semiglobalization

A perspective that suggests that barriers to market integration at borders are high, but not high enough to insulate countries from each other completely.

Learning Objective State the size of the global economy and its broad trends and understand your likely bias in the globalization debate.

1-5

22 Part One Laying Foundations

than Poland’s. The sales of the largest EU-based MNE, BP, were larger than the GDP of each of the following EU member countries: Norway, Denmark, Greece, and Ireland. The sales of the largest Asia Pacific–based MNE, Sinopec, were larger than the GDP of each of the following Asia Pacific countries: Malaysia, Singapore, and New Zealand. Today, over 77,000 MNEs control at least 770,000 subsidiaries overseas.29 Total annual sales for the largest 500 MNEs exceed $20 trillion (about one third of global output). Table 1.4 documents the change in the makeup of the 500 largest MNEs. In general, MNEs from the Triad dominate the list. The United States has generally contributed about one third of these firms, and has experi- enced some reduction in numbers recently. The EU has maintained a reasonably steady share of about one third of these firms. From its heyday in the 1990s, Japan has experienced the most dramatic variation (roughly corresponding to its eco- nomic boom and bust with several years of delay).

Among MNEs from emerging economies, those from BRIC contribute 83 firms to the Fortune Global 500 list, which is more than the number of Fortune Global firms from Japan. In particular, MNEs from China have come on strong.30 Beijing is now headquarters to 41 Fortune Global 500 firms, more than New York’s 27. MNEs based in emerging economies are often regarded as “Third World multinationals,” “dragon multinationals,” or simply “emerging multinationals.”31 Clearly, Western rivals cannot afford to ignore these new MNEs, and students studying this book need to pay attention to these emerging multinationals.

1-5b The Globalization Debate and You As a future business leader, you are not a detached reader (see In Focus 1.3). The globalization debate directly affects your future.32 Therefore, it is imperative that you participate in the globalization debate instead of letting other people

Table 1.4 Recent Changes in the Fortune Global 500

2005 2006 2007 2008 2009 2010

Developed economies

United States 170 162 153 140 139 133

European Union 165 165 170 163 161 149

Japan 70 67 64 68 71 68

Switzerland 12 13 14 15 15 15

Canada 14 16 14 14 11 11

Australia 8 8 8 9 8 8

Emerging economies

China 20 24 29 37 46 61

India 6 6 7 7 8 8

Brazil 4 5 5 6 7 7

Russia 5 4 5 8 6 7

BRIC 35 39 46 58 67 83

Sources: The most recent Fortune Global 500 list (for 2010) was published in Fortune, July 25, 2011.

Chapter 1 Globalizing Business 23

make decisions on globalization that will significantly affect your career, your consumption, and your country. It is important to know your own biases when joining the debate. By the very act of taking an IB course and reading this book, you probably already have some pro-globalization biases, compared to non- business majors elsewhere on campus and the general public in your country.

You are not alone. In the last several decades, most executives, policy makers, and scholars in both developed and emerging economies, who are generally held to be the elite in these societies, are biased toward acknowledging the benefits of globalization. Although it has long been known that globalization carries both benefits and costs, many of the elite have failed to take into sufficient account the social, political, and environmental costs associated with globalization. However, just because the elite share certain perspectives on globalization does not mean that most other members of the society share the same views. Unfortunately, many of the elite fail to understand the limits of their beliefs and mistakenly assume that the rest of the world thinks like them. To the extent that powerful economic and political institutions are largely controlled by the elite in almost every country, it is not surprising that some anti-globalization groups, feeling powerless, end up resorting to unconventional tactics such as mass protests to make their point.

Many of the opponents of globalization are nongovernmental organizations (NGOs) such as environmentalists, human rights activists, and consumer groups.

Nongovernmental organization (NGO)

An organization that is not affiliated with governments.

On September 3, 2007, Markéta Straková of Tabor, the Czech Republic, wrote to BusinessWeek colum- nists Jack Welch and Suzy Welch:

I am thinking of studying Portuguese, but in your opinion, what language should I learn to succeed in the world of business? And what fields of study hold the most potential?

Jack Welch was the former chairman and CEO of General Electric (GE), and Suzy Welch was the former editor of Harvard Business Review. They wrote back in the same issue of BusinessWeek:

You’re on to something with Portuguese, since it will give you a leg up in several markets with good potential, such as Brazil and some emerg- ing African nations. Spanish is also a good choice, as it will allow you to operate with more ease throughout Latin America, and, increas- ingly, the United States. But for our money— and if you can manage the much higher order of commitment—Chinese is the language to learn. China is already an economic powerhouse. It

will only gain strength. Anyone who can do busi- ness there with the speed and intimacy that flu- ency affords will earn a real competitive edge.

As for what to study—and if you want to be where the action is now and for the next couple of decades—consider the industries focused on alternative sources of energy. Or learn ev- erything you can about the confluence of three fields: biotechnology, information technology, and nanotechnology. For the foreseeable future, the therapies, machines, devices, and other products and services that these fields bring to market will revolutionize society—and business.

That said, when it comes to picking an edu- cation field and ultimately a career, absolutely nothing beats pursuing the path that truly fas- cinates your brain, engages your energy, and touches your soul. Whatever you do, do what turns your crank. Otherwise your job will always be just work, and how dreary is that?

What Language and What Fields Should I Study? IN FOcus 1.3

Source: http://www.businessweek.com/stories/2007-09-02/from-hero- to-zero.

24 Part One Laying Foundations

Ignoring them will be a grave failure when do- ing business around the globe. Instead of view- ing NGOs as opponents, many firms view them as partners. NGOs do raise a valid point when they insist that firms, especially MNEs, should have a broader concern for the various stake- holders affected by the MNEs’ actions around the world. At present, this view is increasingly moving from the peripheral to the mainstream (see Chapters 3 and 17).

It is certainly interesting, and perhaps alarming, to note that as would-be business leaders who will shape the global economy in the future, current business school students already exhibit values and beliefs in favor of globalization similar to those held by execu-

tives, policy makers, and scholars and different from those held by the general public. Shown in Table 1.5, US business students have significantly more positive (almost one-sided) views toward globalization than the general public. While these data are based on US business students, my lectures around the world suggest that most business students around the world—regardless of their nationality—seem to share such positive views on globalization. This is not surprising. Both self-selection to study business and socialization within the curriculum, in which free trade is widely regarded as positive, may lead to certain attitudes in favor of globalization. Consequently, business students tend to focus more on the economic gains of glo- balization and less on its darker sides.

Current and would-be business leaders need to be aware of their own biases embodied in such one-sided views toward globalization. Since business schools aspire to train future business leaders by indoctrinating students with the domi- nant values that managers hold, these results suggest that business schools may have largely succeeded in this mission. However, to the extent that current man- agers (and professors) have strategic blind spots, these findings are potentially alarming. They reveal that business students already share these blind spots. De- spite possible self-selection in choosing to major in business, there is no denying that student values are shaped, at least in part, by the educational experience that business schools provide. Knowing such limitations, business school professors and students need to work especially hard to break out of this mental straitjacket.

Table 1.5 Views on Globalization: General Public versus Business Students

Percentage answering “good” for the question: Overall, do you think globalization is good or bad for

General public1 (N = 1,024)

Business students2 (N = 494)

US consumers like you 68% 96%

US companies 63% 77%

The US economy 64% 88%

Strengthening poor countries’ economies 75% 82%

Sources: Based on (1) A. Bernstein, 2000, Backlash against globalization, BusinessWeek, April 24: 43; (2) M. W. Peng & H. Shin, 2008, How do future business leaders view globalization? (p. 179), Thunderbird International Business Review, 50 (3): 175-182. All differences are statistically significant.

Why do protestors like these object to globalization?

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Chapter 1 Globalizing Business 25

In order to combat the widespread tendency to have one-sided, rosy views, a significant portion of this book is devoted to the numerous debates that surround globalization.33 Beyond the globalization debate that this chapter considers, debates are systematically introduced in every chapter to provoke more critical thinking and discussion. Virtually all textbooks uncritically present knowledge “as is” and ignore the fact that the field is alive with numerous debates. No doubt, debates drive practice and research forward. Therefore, it is imperative that you be exposed to cutting-edge debates and encouraged to form your own views. In addition, ethics is emphasized throughout the book. A featured Ethical Dilemma can be found in every chapter. Two whole chapters are devoted to ethics, norms, and cultures (Chapter 3) and corporate social responsibility (Chapter 17).

Organization of the Book This book has four parts. Part I is foundations. Following this chapter, Chapters 2, 3, and 4 address the two leading perspectives—namely, institution-based and resource- based views. Part II covers tools, focusing on trade (Chapter 5), foreign investment (Chapter 6), foreign exchange (Chapter 7), and global and regional integration (Chapter 8). Part III sheds light on strategy. We start with the internationalization of small, entrepreneurial firms (Chapter 9), followed by ways to enter foreign markets (Chapter 10), to manage competitive dynamics (Chapter 11), to make alliances and acquisitions work (Chapter 12), and to strategize, structure, and learn (Chapter 13). Finally, Part IV builds excellence in different functional areas: marketing and supply chain (Chapter 14), human resource management (Chapter 15), finance and cor- porate governance (Chapter 16), and corporate social responsibility (Chapter 17).

C h a p t e r S u m m a r y

1.1 Explain the concepts of international business and global business, with a focus on emerging economies.

IB is typically defined as (1) a business (firm) that engages in international (cross-border) economic activities, and (2) the action of doing business abroad.

Global business is defined in this book as business around the globe. This book has gone beyond competition in developed economies by devot-

ing extensive space to competitive battles waged in emerging economies and the base of the global economic pyramid.

An interesting recent development out of emerging economies is reverse innovation.

1.2 Give three reasons why it is important to study global business.

Enhance your employability and advance your career in the global econo- my by equipping yourself with global business knowledge.

Better preparation for possible expatriate assignments abroad. Stronger competence in interacting with foreign suppliers, partners, and com-

petitors and in working for foreign-owned employers in your own country. 1.3 Articulate one fundamental question and two core perspectives in the study

of global business.

IB’s most fundamental question is: What determines the success and failure of firms around the globe?

26 Part One Laying Foundations

The two core perspectives are (1) the institution-based view and (2) the resource-based view.

We develop a unified framework by organizing materials in every chapter according to the two perspectives guided by the fundamental question.

1.4 Identify three ways of understanding what globalization is.

Some view globalization as a recent phenomenon, and others believe that it has been a one-directional evolution since the dawn of human history.

We suggest that globalization is best viewed as a process similar to the swing of a pendulum.

1.5 State the size of the global economy and its broad trends, and understand your likely bias in the globalization debate.

The total size of global GDP (calculated at the official, nominal exchange rate) is approximately $60 trillion.

MNEs, especially large ones from developed economies, are sizable economic entities.

Current and would-be business leaders need to be aware of their own hid- den pro-globalization bias.

K e y T e r m s

Base of the pyramid 9 BRIC 7 Emerging economies 5 Emerging markets 5 Expatriate manager

(expat) 12 Foreign direct investment

(FDI) 4 Global business 5 Globalization 18 Gross domestic

product (GDP) 5

Gross national income (GNI) 6

Gross national product (GNP) 6

Group of 20 (G-20) 11 International business

(IB) 4 International

premium 12 Liability of foreignness 16 Multinational enterprise

(MNE) 4

Nongovernmental organization (NGO) 23

Purchasing power parity (PPP) 5

Reverse innovation 9 Risk management 20 Scenario planning 20 Semiglobalization 21 Triad 9

r e v i e w Q u e s T i o n s

1. What is the traditional definition of IB? How is global business defined in this book?

2. Compare PengAtlas Maps 2.1 (Top Merchandise Importers and Exporters), 2.2 (Top Service Importers and Exporters), and 2.3 (FDI Inflows and Out- flows) and note that the United States is number one in all categories except one. What is it? Many people feel that is a big problem; do you? In your opin- ion, what—if anything—should be done about that?

3. Compare PengAtlas Maps 2.1 (Top Merchandise Importers and Exporters), 2.2 (Top Service Importers and Exporters), and 2.3 (FDI Inflows and Out- flows) once again and note the BRIC countries that are referenced in this chapter. Which of the BRIC countries is most often among the categories in those maps? Do you think that the long-term trend will be for that country to continue to become more important and perhaps surpass the United States,

Chapter 1 Globalizing Business 27

or do you think that it may decline, and one of the other BRIC countries will become more important? Why?

4. ON CULTURE: Not all people in your country support globalization, and some say it is because they feel that globalization is an economic threat. However, to what extent they may also feel that it is a threat to their culture? What about you? To what extent do you feel that globalization is either an economic or cultural threat to your country?

5. Discuss the importance of emerging economies in the global economy. Use current news.

6. What is your interest in studying global business? How do you think it may help you succeed in the future?

7. If you were to work as an expatriate manager, where would you like to go, and what type of work would you like to do? Why?

8. How would you describe an institution-based view of global business?

9. How would you describe a resource-based view of global business?

10. After comparing the three views of globalization, which seems the most sen- sible to you and why?

11. What is semiglobalization, and what factors contribute to it?

12. Do those who protest against globalization make any valid point(s) that all people, whether for or against globalization, should consider?

13. You may view yourself as objective and neutral regarding globalization, but do you sense any bias that you may have, one way or the other? What bias most likely exists on the part of other students taking this course?

14. Given the size of the global economy and the size of some of the large cor- porations, do you think it is possible to carve out a niche that you can exploit as a small businessperson? Or do you feel that the most practical way to participate in the global economy is to do so as an employee or manager in a global corporation?

c R I T I c a L D I s c u s s I o N Q u E s T I o N s

1. A classmate says: “Global business is relevant for top executives such as CEOs in large companies. I am just a lowly student who will struggle to gain an entry-level job, probably in a small domestic company. Why should I care about it?” How do you convince your classmate that global business is some- thing to care about?

2. ON CULTURE: Thomas Friedman, in his book The World is Flat (2005), suggests that the world is flattening—meaning that it is increasingly interconnected by new technology such as the Internet. This can raise the poor from poverty, nurture a worldwide middle class, and even spread democracy. On the other hand, this presents significant challenges for developed economies, whose employees may feel threatened by competition from low-cost countries. How does this flattening world affect you?

3. ON ETHICS: What are some of the darker sides (in other words, costs) as- sociated with globalization? How can business leaders make sure that the benefits of their various actions (such as outsourcing) outweigh their draw- backs (such as job losses in developed economies)?

28 Part One Laying Foundations

4. ON ETHICS: Some argue that aggressively investing in emerging economies is not only economically beneficial but also highly ethical, because it could lift many people out of poverty (see the Closing Case). However, others cau- tion that in the absence of reasonable hopes of decent profits, rushing to emerging economies is reckless. How would you participate in this debate?

G L o B a L a c T I o N

1. Chemical companies are among the largest firms worldwide. Two approaches to evaluating their operations are by capital spending and by research and development (R&D) spending. Access a resource that provides this information about top global chemical producers. Then compare the top five capital-spending and R&D-spending chemical companies. Are any companies found on both lists? What insights does this information provide?

2. One important aspect of globalization is the fundamental stability of the global economic order currently in place. Thus, FDI intentions can be influ- enced by its perceived sustainability to some degree. Identify the three most important issues related to global economic stability over the next 20 years. Be sure to discuss the sample surveyed to provide the appropriate frame of reference for discussion.

v I D E o c a s E

After watching the video on New Balance, discuss the following:

1. What will determine the success or failure of New Balance?

2. What view of globalization is suggested through the New Balance Company?

3. What impact will emerging economies and the Trans-Pacific Partnership have on New Balance?

4. With regard to New Balance, what are the costs and benefits of globalization?

5. Is globalization the solution to profitability?

Consumers in remote areas of emerging economies have limited opportunities to buy global brands, and even fewer opportunities to connect to the supply chains of MNEs. Direct sales companies such as Avon are growing their markets and profits by tapping the potential of buyers and sellers at the base of

the pyramid. An estimated one billion consumers, between the poorest of the poor and the rising middle class, spend up to one-third of their income on personal care items, electronics, and snack food. These consumers often differ greatly in interests and behaviors from consumers in urban centers. By

EMERGING MARKETS: Direct Selling at the Base of the Pyramid

Ethical Dilemma

C L O s i n g C a s e

C o p y r i g h t 2 0 1 2 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

Chapter 1 Globalizing Business 29

working in direct sales, millions of women are gaining skills and experience as micro-entrepreneurs, and while doing so, are changing social norms and ideas of global beauty.

Direct sales companies employ more than two million people in Brazil. A team of researchers took an in-depth look at women who work in direct sales in the municipality of Ponta de Pedras, on Marajó Island in the remote lower Amazon. This local econ- omy revolves largely around seasonal agricultural production of the açaí fruit, with almost no job oppor- tunities for women before MNE direct sales compa- nies entered the marketplace. Traveling to homes by canoe and by road, the women sell beauty products from US-based Avon and the more expensive Brazil- based Natura, and inexpensive household goods and clothing from the Brazilian catalog company Hermes. In an area with approximately 12,000–13,000 female residents, Avon has around 175 direct sales repre- sentatives, Hermes counts around 200, and Natura has between 15 and 20.

The MNE direct sales companies overcome roadblocks by leveraging the representatives’ keen awareness of local consumer tastes, brand prefer- ences, and complex local business norms and prac- tices. The representatives disseminate information about new products and translate product informa- tion into terms that are relevant to their customers. To be effective, they identify meaningful segments, within which they exercise some flexibility in sup- pressing or promoting differences between the global brands and the local products. Almost all of the women consider their work “successful” if they are able to make a small profit or break even. Most direct sales representatives earn on average 80 reais (approximately $35) per order, which they typically send in once a month or every other month. For di- rect sales representatives in Ponta de Pedras, the income they earn is not meant to support their fam- ily, but it is a crucial secondary income over which they have sole control. They use this money to pro- vide clothing for their children and to purchase new products for themselves, which can translate into a sense of empowerment and an enhanced role in the family and community. Soon after building their initial network, many representatives start to

represent other companies. Since the economy re- volves around the agricultural season, there is also a season for increased sales. This seasonal cycle is one of their most difficult challenges. The only way to make any sales in Ponta de Pedras is to offer in- formal credit, typically allowing customers to pay up front for one-half or one-third of the cost, and then pay the remaining amount owed at a later date. As the local Avon coordinator stated, “If she doesn’t sell on credit, she’s not going to sell anything. All of her products will stay with her.”

Product catalogs and television commercials promote the glamour of the cosmetics and beauty products in Brazil, but some representatives and customers have very little exposure to television, print media and the Internet, or urban lifestyles. The identification with values and brands falls along a continuum from global to local. This identification is affected by the levels of exposure to media, the degree of urban-rural circulation, and the patterns of urban-rural communication. Building from their community roots, the sales representatives create a channel for discussing the relevant differences between local, traditional products and modern, global consumer brands. Local values can be expressed with the simultaneous identification of global and local standards. For example, perfumes, colognes, soaps, and lotions are the most popular beauty products in Ponta de Pedras, and most residents purchase these products from both Avon and Natura representatives. Smelling good is culturally very important in the Amazon, coinciding with other practices such as frequent bathing— on average, three to four times per day. Make-up

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30 Part One Laying Foundations

and cosmetics, on the other hand, do not connect nearly as much with local values, but wearing make- up is an index of identification with global beauty standards.

The direct sales representatives play a bridging role between local and global ideals of beauty and fashion. Through interpersonal discussions, these female entrepreneurs form and leverage a success- ful system in which customers can simultaneously identify with global ideals of beauty and femininity, and express their locally based differences, ideals, and values. This system is more dynamic, interactive, and customized than what traditional, store-based retailing offers. Overall, the direct sales networks in remote areas reconcile local and global values on beauty and femininity for customers, create stronger brand relationships to the benefit of the MNEs, and help to improve the income and quality of life of the many individuals involved.

CASE DISCUSSION QUESTIONS: 1. What are the advantages to a consumer in the

remote Amazon of buying a beauty product from a direct sales representative, over buying the product from a retail store in the nearest town?

2. What are some of the “rules of game” affecting an Avon representative in the remote Amazon?

3. Natura and Avon are direct competitors in this market. Compare and contrast their resources and capabilities.

4. ON ETHICS: Avon knows that many of its sellers will not make large profits. Comment on the eth- ics of the business model.

5. ON ETHICS: Some critics question whether it is ethical to aggressively market “non-essentials” (such as cosmetics) to very low income customers who may end up spending up to one-third of their income on such items. What do you think?

[Journal acronyms] AMP—Academy of Management Perspectives; AMR—Academy of Management Review; APJM—Asia Pacific Journal of Management; BW—BusinessWeek (before 2010) or Bloomberg Busi- nessweek (since 2010); GSJ—Global Strategy Journal; HBR—Harvard Business Review; JBV—Journal of Business Venturing; JIBS—Journal of International Business Studies; JIM—Journal of International Manage- ment; JM—Journal of Management; JMS—Journal of Management Stud- ies; JWB— Journal of World Business; MBR—Multinational Business Review; MIR—Management International Review; SMJ—Strategic Man- agement Journal

1 This definition of the MNE can be found in R. Caves, 1996, Mul- tinational Enterprise and Economic Analysis, 2nd ed. (p. 1), New York: Cambridge University Press; J. Dunning, 1993, Multinational Enter- prises and the Global Economy (p. 30), Reading, MA: Addison-Wesley. Other terms are multinational corporation (MNC) and transnational corporation (TNC), which are often used interchangeably with MNE. To avoid confusion, in this book, we will use MNE.

2 O. Shenkar, 2004, One more time: International business in a global economy (p. 165), JIBS, 35: 161–171. See also J. Boddewyn, B. Toyne, & Z. Martinez, 2004, The meanings of “international man- agement,” MIR, 44: 195–215; J.-F. Hennart, 2009, Down with MNE- centric models! JIBS, 40: 1432–1454.

3 C. Pitellis, 2009, IB at 50, AIB Insights, 9 (1): 2–8.

4 A. Bhattacharya & D. Michael, 2008, How local companies keep multinationals at bay, HBR, March: 85–95; A. Cuervo-Cazurra,

2007, Sequence of value-added activities in the multinationaliza- tion of developing country firms, JIM, 13: 258–277; B. Elango & C. Pattnaik, 2007, Building capabilities for international opera- tions through networks, JIBS, 38: 541–555; I. Filatotchev, R. Strange, J. Piesse, & Y. Lien, 2007, FDI by firms from newly industrialized economies in emerging markets, JIBS, 38: 556–572; M. Garg & A. Delios, 2007, Survival of the foreign subsidiaries of TMNCs, JIM, 13: 278–295; S. Klein & A. Worcke, 2007, Emerging global con- tenders, JIM, 13: 319–337; N. Kumar, 2009, How emerging giants are rewriting the rules of M&A, HBR, May: 115–121; P. Li, 2007, Toward an integrated theory of multinational evolution, JIM, 13: 296–318; Y. Luo & R. Tung, 2007, International expansion of emerging market enterprises, JIBS, 38: 481–498; D. Yiu, C. Lau, & G. Bruton, 2007, In- ternational venturing by emerging economy firms, JIBS, 38: 519–540.

5 B. Aybar & A. Ficici, 2009, Cross-border acquisitions and firm val- ue, JIBS, 40: 1317–1338; L. Cui & F. Jiang, 2010, Behind ownership decision of Chinese outward FDI, APJM, 27: 751–774; P. Deng, 2009, Why do Chinese firms tend to acquire strategic assets in interna- tional expansion? JWB, 44: 74–84; P. Gammeltoft, H. Barnard, & A. Madhok, 2010, Emerging multinationals, emerging theory, JIM, 16: 95–101; G. Gao, J. Murray, M. Kotabe, & J. Lu, 2010, A “strategy tri- pod” perspective on export behaviors, JIBS, 41: 377–396; M. Guillen & E. Carcia-Canal, 2009, The American model of the multinational firm and the “new” multinationals from emerging economies, AMP, 23: 23–35; S. Gubbi, P. Aulakh, S. Ray, M. Sarkar, & R. Chittoor, 2010, Do international acquisitions by emerging-economy firms

N o T E s

Sources: This case was written by Professors Jessica Chelekis (University of Southern Denmark) and Susan M. Mudambi (Temple University). © Jessica Chelekis and Susan M. Mudambi. Reprinted with permission. It was based on (1) J. Chelekis & S. M. Mudambi, 2010, MNCs and micro-entrepreneurship in emerging economies: The case of Avon in the Amazon, Journal of International Management, 16: 412-424; (2) R. Wilk, 1995, The local and the global in the political economy of beauty: From Miss Belize to Miss World, Review of International Political Economy, 2(1): 117–134; (3) World Federation of Direct Selling Associations (WFDSA), 2009, International statistics, http://www.wfdsa.org/statistics.

Chapter 1 Globalizing Business 31

create shareholder value? JIBS, 41: 387–418; S. Sun, M. W. Peng, B. Ren, & D. Yan, 2012, A comparative ownership advantage frame- work for cross-border M&As, JWB, 47: 4–16.

6 R. Sharma, 2012, Breakout Nations, New York: Norton.

7 R. Hoskisson, M. Wright, I. Filatotchev, & M. W. Peng, 2013, Emerg- ing multinationals from mid-range economies, JMS (in press).

8 M. W. Peng, 2003, Institutional transitions and strategic choices, AMR, 28: 275–296.

9 T. London, 2009, Making better investments at the base of the pyr- amid, HBR, May: 106–113; T. London & S. Hart, 2004, Reinventing strategies for emerging markets, JIBS, 35: 350–370; C. K. Prahalad, 2005, The Fortune at the Bottom of the Pyramid, Philadelphia: Wharton School Publishing.

10 V. Govindarajan & C. Trimble, 2012, Reverse Innovation (p. 4), Boston: Harvard Business Review Press.

11 J. Immelt, V. Govindarajan, & C. Trimble, 2009, How GE is dis- rupting itself, HBR, October: 56–65.

12 BW, 2007, The changing talent game (p. 68), August 20: 68–71.

13 M. W. Peng, 2004, Identifying the big question in international business research, JIBS, 35: 99–108.

14 K. Meyer, S. Estrin, S. Bhaumik, & M. W. Peng, 2009, Institutions, resources, and entry strategies in emerging economies, SMJ, 30: 61–80.

15 J. Dunning & S. Lundan, 2008, Institutions and the OLI paradigm of the multinational enterprise, APJM, 25: 573–593; M. W. Peng, S. Sun, B. Pinkham, & H. Chen, 2009, The institution-based view as a third leg for a strategy tripod, AMP, 23: 63–81; M. W. Peng, D. Wang, & Y. Jiang, 2008, An institution-based view of international business strategy, JIBS, 39: 920–936.

16 S. Lee, Y. Yamakawa, M. W. Peng, & J. Barney, 2011, How do bank- ruptcy laws affect entrepreneurship development around the world? JBV, 26: 505–520.

17 J. Cantwell, J. Dunning, & S. Lundan, 2010, An evolutionary ap- proach to understanding international business activity, JIBS, 41: 567–586; B. Kim & J. Prescott, 2005, Deregulatory forms, variations in the speed of governance adaptation, and firm performance, AMR, 30: 414–425.

18 M. W. Peng, 2001, The resource-based view and international business, JM, 27: 803–829.

19 J. Johanson & J. Vahlne, 2009, The Uppsala internationalization process model revisited: From liability of foreignness to liability of outsidership, JIBS, 40: 1411–1431.

20 H. Barnard, 2010, Overcoming the liability of foreignness with- out strong firm capabilities, JIM, 16: 165–176.

21 BW, 2006, Free trade can be too free, July 3: 102–104; H. Chang, 2008, Bad Samaritans, New York: Bloomsbury; A. Giddens, 1999, Runaway World, London: Profile.

22 K. Moore & D. Lewis, 2009, The Origins of Globalization, New York: Routledge.

23 D. Yergin & J. Stanislaw, 2002, The Commanding Heights (p. 385), New York: Simon & Schuster.

24 J. Stiglitz, 2002, Globalization and Its Discontents (p. 9), New York: Norton.

25 M. W. Peng, R. Bhagat, & S. Chang, 2010, Asia and global busi- ness, JIBS, 41: 373–376.

26 L. Purda, 2008, Risk perception and the financial system, JIBS, 39: 1178–1196; N. Taleb, D. Goldstein, & M. Spitznagel, 2009, The six mistakes executives make in risk management, HBR, October: 78–81.

27 S. Lee & M. Makhija, 2009, The effect of domestic uncertainty on the real options value of international investments, JIBS, 40: 405–420.

28 P. Ghemawat, 2003, Semiglobalization and international business strategy, JIBS, 34: 138–152.

29 United Nations (UN), 2010, World Investment Report 2010 (p. 10), New York and Geneva: UN.

30 M. W. Peng, 2012, The global strategy of emerging multinationals from China, GSJ, 2: 97–107.

31 P. Aulakh, 2007, Emerging multinationals from developing econ- omies, JIM, 13: 235–240; J. Mathews, 2006, Dragon multinationals as new features of globalization in the 21st century, APJM, 23: 5–27; R. Ramamurti & J. Singh (eds.), 2009, Emerging Multinationals from Emerging Markets, New York: Cambridge University Press.

32 T. Friedman, 2005, The World Is Flat, New York: Farrar, Straus, & Giroux; R. Rajan, 2010, Fautlines, Princeton, NJ: Princeton University Press.

33 M. W. Peng, S. Sun, & D. Blevins, 2011, The social responsibility of international business scholars, MBR, 19: 106–119; D. Rodrik, 2011, The Globalization Paradox, New York: Norton.

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Learning Objectives

After studying this chapter, you should be able to

2-1 explain the concept of institutions and their key role in reducing uncertainty.

2-2 articulate the two core propositions underpinning an institution-based view of global business.

2-3 identify the basic differences between democracy and totalitarianism.

2-4 outline the differences among civil law, common law, and theocratic law.

2-5 understand the importance of property rights and intellectual property rights.

2-6 appreciate the differences among market economy, command economy, and mixed economy.

2-7 participate in two leading debates concerning politics, laws, and economics.

2-8 draw implications for action.

Understanding Formal Institutions: Politics, Laws, and Economics

Russia is not the Soviet Union. But what is it? Most of the news we read (in the West) on Russia seems nega- tive. Corruption is widespread (Russia ranks 146th out of 180 countries according to Transparency International). National mood seems gloomy. More than half of the entrepreneurs and college students surveyed in Russia indicate an interest in living abroad (although few will ac- tually emigrate). In 2004, Russia was downgraded from “Partly Free” to “Not Free”—on a 1-3 scale of “Free,” “Partly Free,” and “Not Free”—by Freedom House, a leading nongovernmental organization (NGO) promot- ing democracy. In 2012, Vladimir Putin was re-elected as president (after serving as president for two terms be- tween 2000 and 2008 and as prime minister between 2008 and 2012). The election was largely symbolic as all viable candidates were not allowed to run against him. Widespread protests against Putin broke out. In the international community, commentators bearish on Russia have suggested kicking Russia out of the BRIC group given its alleged lack of dynamism, and focusing more business attention on China, India, and Brazil.

Is Russia really that bad? The answer is: No! While Russia’s GDP is smaller than China’s and Brazil’s, it is larger than India’s. Russia’s per capita GDP, approxi- mately $16,000 (at purchasing power parity), is one- third higher than Brazil’s, three times China’s, and five times India’s. Simply put, Russia is too big and too rich to

ignore. None of the high-tech giants (such as Cisco, HP, and Intel) and industrial and consumer goods firms (such as Carrefour, Danone, IKEA, Nestlé, PepsiCo, and Unile- ver) has announced plans to quit Russia. Russia’s eco- nomic growth may not be as fast as China’s or India’s, but it will certainly be higher than US or EU growth. Although Russia has yet to become a member of the World Trade Organization (WTO), it exports more than 30% of its GDP, in contrast to 26% for China, 25% for In- dia, and 13% for Brazil, all of which are WTO members. Despite all the media attention on outward foreign direct investment (OFDI) coming from China (and, to a lesser extent, from India), Russia is the single largest foreign direct investor among BRIC countries. Russia’s OFDI stock is larger than Brazil’s, India’s, and, yes, China’s.

Because Russia is so large and complex, how to “read” Russia has remained a constant debate. The de- bate centers on political, economic, and legal dimensions. Politically, Russia has indeed become less democratic. Understandably, certain segments of the population (es- pecially the better educated), inspired by more liberal ide- als, are disappointed by the return of Putin, who is viewed as status quo, unable to bring about political reform. But a more relevant question is: Is Russia better off under Putin’s more authoritarian rule since 2000, compared with Boris Yeltsin’s more democratic (and more chaotic) rule in the 1990s? Russia under Putin between 2000 and

O p e n i n g C a s e

EmErging markEts: The Peril and Promise of Russia

Ethical Dilemma

34 Part One Laying Foundations

2008 grew 7% annually, whereas Russia under Yeltsin during the 1990s experienced a catastrophic economic decline. Anyone complaining about Putin’s authoritarian manners should be reminded of the remarkable contrast between the ways the state tackled two major crises in 1998 and 2008. In 1998, the Yeltsin government defaulted on its debt and devalued the ruble. In 2008, when the global financial tsunami hit, the Putin government tapped into a stabilization fund (supported by oil and gas exports) to prevent a sharp devaluation of the ruble, launched a $200 billion stimulus package, injected liquidity into the banking system, and bailed out some key companies. None of the above was possible in 1998, because the Yeltsin government was hopelessly drowning in debt.

Economically, the Russian economy indeed has great room for development. It is overly dependent on oil and gas exports, and not sufficiently innovative to charge ahead. In the World Economic Forum’s Global Competitiveness Report, Russia ranks only 51st in inno- vation (out of 133 countries), behind China (26th) and In- dia (30th). Dmitry Medvedev, who served as president between 2008 and 2012 (while Putin was prime minister), published an article in 2009 titled “Russia Forward!” “Should we drag a primitive economy based on raw materials and endemic corruption into the fu- ture?” he asked. In 2010, Medvedev, an avid iPad user, created a major center for innovation in Skolkovo in the Moscow suburbs as well as numerous technoparks and special economic zones throughout the country.

Legally, establishing the rule of law that respects pri- vate property is one of the priorities. In a society whereby nobody had any significant private property until recent- ly, how a small number of individuals became super-rich oligarchs (tycoons) almost overnight is intriguing. By the 2000s, the top ten families or groups owned 60% of Russia’s total market capitalization. Should the govern- ment protect private property if it is acquired through illegitimate or “gray” means? Most oligarchs obtained their wealth during the chaotic 1990s. Since these oli- garchs have acquired wealth, they have demanded that the government respect and protect their private assets. The government thus faces a dilemma: Redistributing wealth by confiscating assets from the oligarchs creates more uncertainty, whereas respecting and protecting the property rights of the oligarchs results in more re- sentment among the population. Thus far, except when a few oligarchs, notably Mikhail Khodorkovsky, have

threatened to politically challenge the government, the government has sided with the oligarchs. The oligarchs quickly learned to play by Putin’s two simple rules: (1) do not get involved in politics and (2) pay your taxes. Mind- ing their own business, oligarchs run their firms more efficiently than other types of business owners (except foreign owners) in Russia.

Where exactly is Russia heading? One school of thought argues that it will depend on whether the (new) Putin presidency will deliver. It is important not to gener- alize from the anti-Putin protests in Moscow to the rest of Russia. In March 2012, while Putin received 64% of the vote nationwide, he only received less than 50% in Moscow. While more people in Moscow are better edu- cated and more liberal, the rest of the country may be more traditionalist. In Putin’s earlier presidency, he prom- ised and largely delivered higher incomes and stronger stability. This time, Putin promised large pay increases for the military, teachers, and doctors (a promise that no American president has been able to make in recent times), and he is likely to deliver again. Another school of thought argues that despite its former superpower sta- tus, Russia has become a “normal,” middle-income coun- try. Democracies in this income range (think of Argentina in 1990 and Mexico in 2000) are rough around the edges. They tend to have corrupt governments, high income inequality, concentrated corporate ownership, and turbu- lent economic performance. In all these aspects, Russia may be quite “normal.” However, these flaws are not nec- essarily incompatible with further political, economic, and legal progress down the road. At the end of day, despite the often negative reporting on Russia, big political risks, such as reverting back to the old Soviet regime, seem reasonably remote. Putin has said repeatedly: “One who does not regret the passing of the Soviet Union has no heart; one who wants to bring it back has no brain.”

Sources: I thank Professors Dan McCarthy and Sheila Puffer (Northeastern University) for their helpful comments on this case. Based on (1) R. Abdelal, 2010, The promise and peril of Russia’s resurgent state, Harvard Busi- ness Review, January: 125–129; (2) Economist, 2011, Another great leap forward? March 13: 27–28; (3) Economist, 2011, The long life of Homo sovieticus, December 10: 27–29; (4) Economist, 2011, Time to shove off, September 10: 27–29; (5) Economist, 2012, Moscow doesn’t believe in tears, March 10: 62–63; (6) Economist, 2012, Moscow spring, February 11: 12; (7) Economist, 2012, The beginning of the end of Putin, March 3: 15; (8) S. Michailova, S. Puffer, & D. McCarthy, 2012, Russia: As solid as a BRIC? Critical Perspectives on International Business; (9) S. Puffer & D. McCarthy, 2007, Can Russia’s state-managed, network capitalism be competitive? Journal of World Business, 42: 1–13; (10) A. Shleifer & D. Treisman, 2005, A normal country: Russia after communism, Journal of Economic Perspectives, 19: 151–174; (11) www.freedomhouse.org.

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 35

Why is Western news reporting on Russia so negative? Does Russia really have a democracy (see PengAtlas Map 1.2)? Does it matter? Is democracy the best political system to develop Russia’s economy? Does Russia have the rule of law? If your firm is considering investing in emerging economies, should it consider Russia? As the Open- ing Case illustrates, answers to these questions boil down to institutions, popularly known as the “rules of the game.” As economic players, firms play by these rules. However, institutions are not static, and they may change, resulting in institutional transitions—“fundamental and comprehensive changes introduced to the formal and informal rules of the game that affect firms as players.”1 Russia’s institutional transi- tions from a communist totalitarian state to a market economy with regular elections (never mind the imperfections) are certainly extraordinary.

Overall, the success and failure of firms around the globe are, to a large extent, de- termined by firms’ ability to understand and take advantage of the different rules of the game. In other words, how firms play the game and win (or lose), at least in part, depends on how the rules are made, enforced, and changed. This calls for firms to constantly mon- itor, decode, and adapt to the changing rules of the game in order to survive and prosper. As a result, such an institution-based view has emerged as a leading perspective on global business.2 This chapter first introduces the institution-based view. Then, it focuses on formal institutions (such as political systems, legal systems, and economic systems). Informal institutions (such as cultures, ethics, and norms) will be discussed in Chapter 3.

2-1 Understanding Institutions Building on the “rules of the game” metaphor, Douglass North, a Nobel laure- ate in economics, more formally defines institutions as “the humanly devised con- straints that structure human interaction.”3 An institutional framework is made up of formal and informal institutions governing individual and firm behavior. These institutions are supported by three “pillars” identified by Richard Scott, a leading sociologist. They are (1) regulatory, (2) normative, and (3) cognitive pillars.4

Shown in Table 2.1, formal institutions include laws, regulations, and rules. Their primary supportive pillar, the regulatory pillar, is the coercive power of governments. For example, while many individuals and companies may pay taxes out of their patriotic duty, a larger number of them do so in fear of the coercive power of the government if they are caught not paying.

On the other hand, informal institutions include norms, cultures, and ethics. The two main supportive pillars are normative and cognitive. The normative pillar refers to how the values, beliefs, and actions of other relevant players—collectively

Learning Objective Explain the concept of institutions and their key role in reducing uncertainty.

2-1

Table 2.1 Dimensions of Institutions

Degree of formality Examples Supportive pillars

Formal institutions Laws Regulatory (coercive)

Regulations

Rules

Informal institutions Norms Normative

Cultures Cognitive

Ethics

Institutions

Formal and informal rules of the game.

Institutional transitions

Fundamental and comprehen- sive changes introduced to the formal and informal rules of the game that affect firms as players.

Institution-based view

A leading perspective in global business that suggests that the success and failure of firms are enabled and constrained by institutions.

Institutional framework

Formal and informal institutions governing individual and firm behavior.

Formal institutions

Institutions represented by laws, regulations, and rules.

Regulatory pillar

The coercive power of governments.

Informal institutions

Institutions represented by cultures, ethics, and norms.

Normative pillar

The mechanism through which norms influence individual and firm behavior.

36 Part One Laying Foundations

known as norms—influence the behavior of focal individuals and firms.5 The recent norms centered on rushing to invest in China and India have prompted many Western firms to imitate each other without a clear understanding of how to make such moves work. Cautious managers resisting such “herding” are often confronted by board members and investors: “Why are we not in China and India?” In other words, “Why don’t you follow the norm?”

Also supporting informal institutions, the cognitive pillar refers to the internal- ized, taken-for-granted values and beliefs that guide behavior.6 For example, what triggered whistleblowers to report Enron’s wrongdoing was their belief in what’s right and wrong. While most employees may not feel comfortable with organiza- tional wrongdoing, the norm is not to “rock the boat.” Essentially, whistleblowers choose to follow their internalized personal beliefs on what is right by overcoming the norm that encourages silence.

How do these three forms of supportive pillars combine to shape individual and firm behavior? Let us use two examples—one at the individual level and another at the firm level. First, speed limit formally defines how fast drivers can go. However, many drivers adjust their speed depending on the speed of other vehicles—a form of normative pillar. When some drivers are ticketed by police because they drive above the legal speed limit, they protest: “We are barely keeping up with traffic!” This statement indicates that they do not have a clear cognitive pillar regarding what is the right speed (never mind the posted speed limit signs); they often let oth- er drivers define the right speed. Second, in 2008, a year during which Wall Street had to be bailed out by trillions of taxpayer dollars, Wall Street executives paid themselves $18 billion in bonuses. The resulting public outcry was understand- able. However, by paying themselves so handsomely, these executives did not com- mit any crime or engage in any wrongdoing. Therefore, the regulatory pillar had little teeth. Rather, this was a case of major clashes between the normative pillar and cognitive pillar held by these executives. In the minds of these executives sup- ported by their own cognitive pillar, they deserved such bonuses. What they failed to read was the normative pressure coming from an angry public.

2-2 What Do Institutions Do? While institutions do many things, their key role, in two words, is to reduce uncertainty.7 By signaling which conduct is legitimate and which is not, institutions constrain the range of acceptable actions. In short, institutions reduce uncertainty, which can be potentially devastating.8 Political uncertainty, such as terrorist attacks and ethnic riots, may render long-range planning obsolete. Political deadlocks in Washington have made the US government “less stable, less effective, and less predictable,” which led Standard & Poor’s to downgrade its triple A credit rating to AA+.9 In Focus 2.1 illustrates some pitfalls of such a lack of predictability. Economic uncertainty such as failure to carry out contractual obligations may result in economic losses. During the Great Recession, a number of firms, such as Dow Chemical and Trump Holdings, argued that the “unprecedented economic crisis” should let them off the hook.10 Force majeure is a long-standing legal doctrine that excuses firms from living up to the terms of a deal in the event of natural disasters or other calamities. But is the economic crisis a force majeure? If the argument prevails, critics contend, then every debtor in a country suffering economic crisis can avoid paying debts. While these arguments are debated in court battles, a great deal of economic uncertainty looms on the horizon.

Norms

Values, beliefs, and actions of relevant players that influence the focal individuals and firms.

Cognitive pillar

The internalized (or taken-for- granted) values and beliefs that guide individual and firm behavior.

Learning Objective Articulate the two core propositions underpinning an institution-based view of global business.

2-2

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 37

Uncertainty surrounding economic transactions can lead to transaction costs, which are defined as costs associated with economic transactions—or, more broadly, costs of doing business. Oliver Williamson, a leading theorist who won the Nobel Prize in economics in 2009, refers to frictions in mechanical systems: “Do the gears mesh, are the parts lubricated, is there needless slippage or other loss of energy?” He goes on to suggest that transaction costs can be regarded as “the economic counterpart of frictions: Do the parties to exchange operate harmoni- ously, or are there frequent misunderstandings and conflicts?”11

Transaction costs

The costs associated with economic transactions or, more broadly, the costs of doing business.

As formal institutions, regulations are supposed to reduce uncertainty. However, the recent proliferation of regulations in the United States seems to enhance uncertainty. The Dodd-Frank law of 2010 has become Exhibit A in this debate. Its aim is noble: to prevent another financial crisis by improving transparency and forbidding banks from taking on excessive risk. But at 848 pages, it is simply too complex. Hardly anyone in America has read Dodd-Frank. Voracious Chinese officials, who pay close attention to regu- latory developments elsewhere, half-jokingly shared with an Economist correspondent that nobody out- side Beijing has the stomach to read Dodd-Frank in full, and the Economist correspondent protested be- cause at least one Economist colleague in New York, in order to work on one report, read all 848 pages of verbiage.

It is not just the mammoth length, but also the uncertainty embedded in Dodd-Frank that makes it very scary to the business community. Of the 400 specific rules it mandates, only 93 have been final- ized and the rest is yet to be filled in. So, US financial services firms must cope with a law that is “partly un- intelligible and partly unknowable.” When uncertainty is gradually removed, the true nature of the beast be- comes striking. For example, sections 404 and 406 of Dodd-Frank only consume a couple of pages. In October 2011 regulators finally transformed these few pages into a form that hedge funds and other financial services firms must fill out: that form itself goes on and on and on to 192 pages (!). It would cost each firm $100,000–$150,000 the first time it is filled out, and $40,000 every year after.

Given the princely sums hedge funds make, per- haps they should just cough up the costs and get the form filled out. But the larger point is whether the benefits outweigh the costs of such complicat- ed rule-making. In comparison, the 1864 law that set up America’s banking system went to 29 pages. The Federal Reserve Act of 1913 was only 32 pages. The Glass-Steagall law, which was a response to the earlier Wall Street crash of 1929, ran to only 37 pages. Dodd-Frank is 23 times longer than Glass-Steagall.

Although extreme in its length, Dodd-Frank is part of wider trend of increasingly complicated rule- making and ever increasing costs of compliance. The Sarbanes-Oxley (SOX) law, enacted a decade ago to prevent Enron-style frauds, have made it so hard to list shares on US stock exchanges that US firms increas- ingly list elsewhere or go private, whereas foreign firms shy away from US listings. The upshot? US share of global initial public offerings (IPOs) dropped from 67% in 2002 (when SOX passed) to 16% in 2011. Obama’s health care reform law of 2010 generates 30 minutes of paperwork for every hour spent treating a patient. BB&T, a regional bank, disclosed the following in its annual filing to the SEC: “Additional regulations result- ing from Dodd-Frank may materially adversely affect BB&T’s business, financial condition, or results of op- erations.” Given that banks and numerous other firms have to lay off employees to stay afloat, one has to won- der how many jobs have been (or will be) destroyed by these new regulations. Not surprisingly, the Economist has nicknamed Dodd-Frank “Dodd-Frankenstein.”

Sources: Based on (1) Economist, 2012, Over-regulated America, February 18: 9; (2) Economist, 2012, Too big not to fail, February 18: 22–24.

Regulating America IN FoCus 2.1 Ethical

Dilemma

38 Part One Laying Foundations

One important source of transaction costs is opportunism, defined as self- interest seeking with guile. Examples include misleading, cheating, and confus- ing other parties in transactions that will increase transaction costs. Attempting to reduce such transaction costs, institutional frameworks increase certainty by spelling out the rules of the game so that violations (such as failure to fulfill a contract) can be mitigated with relative ease (such as through formal arbitration and courts).

Without stable institutional frameworks, transaction costs may become prohibi- tively high, to the extent that certain transactions simply would not take place. For example, in the absence of credible institutional frameworks that protect investors, domestic investors may choose to put their money abroad. Although Africa is starv- ing for capital, rich people in Africa put a striking 39% of their assets outside of Africa.12 Similarly, rich Russians often choose to purchase a soccer club in London or a seaside villa in Cyprus, instead of investing in Russia.

Institutions are not static. Institutional transitions are widespread in the world. Institutional transitions in some emerging economies, particularly those moving from central planning to market competition (such as China, Poland, Russia, and Vietnam), are so pervasive that these countries are simply called “transition econo- mies” (a subset of “emerging economies”). Institutional transitions in countries such as China, Cuba (see the Closing Case), India, Russia (see the Opening Case), and South Africa create both huge challenges and tremendous opportunities for do- mestic and international firms.13

Having outlined the definitions of various institutions and their supportive pillars as well as their key role in uncertainty reduction, next we will introduce the first core perspective on global business—an institution-based view.

2-3 An Institution-Based View of Global Business Shown in Figure 2.1, an institution-based view focuses on the dynamic interac- tion between institutions and firms, and considers firm behaviors as the outcome of such an interaction.14 Specifically, firm behaviors are often a reflection of the formal and informal constraints of a particular institutional framework.15 In short, institutions matter.

opportunism

The act of seeking self-interest with guile.

Learning Objective Identify the basic differences between democracy and totalitarianism.

2-3

Figure 2.1 Institutions, Firms, and Firm Behaviors

Institutions Firms

Firm Behavior

Dynamic

Interaction

Industry conditions and firm-specific

resources and capabilities

Formal and informal

constraints

en ga

ge L

ea rn

in g

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 39

How do institutions matter? The institution-based view suggests two core propositions (Table 2.2). First, managers and firms rationally pursue their interests and make choices within institutional constraints. In Brazil, government tax revenues at all levels reach 35% of GDP, much higher than the average for emerging economies. (For example, Mexico’s is 18% and China’s is 16%.) Not surprisingly, the gray market in Brazil accounts for a much higher percentage of the economy than in Mexico and China.16 Likewise, in the United States, the Obama administration’s proposal to tax the overseas earnings of US-based multinationals, which are currently exempt from US taxes, met fierce resistance from the business community. Having already paid overseas taxes, US-based multinationals naturally resented having to pay $190 billion extra US taxes, when their global competitors pay lower taxes. “Doesn’t the Obama administration recognize that most big US companies are multinationals that happen to be headquartered in the United States?” asked Duncan Niederauer, CEO of NYSE Euronext in a BusinessWeek interview.17 One case in point is Seagate Technology, a formerly Silicon Valley-based disk-drive maker that incorporated in the Cayman Islands a few years ago.18 Avoidance of such a financial hit was one of the reasons behind Seagate’s move, and more US-based multinationals are likely to follow Seagate. Both Brazilian firms’ migration to the gray market and US firms’ interest in migrating overseas are rational responses when they pursue their interests within formal institutional constraints in these countries.

Obviously, nobody has perfect rationality—possessing all the knowledge under all circumstances. So, Proposition 1 specifically concerns bounded rationality, which refers to the necessity of making rational decisions in the absence of complete information.19 Without prior experience, many managers from emerg- ing multinationals from BRIC are getting their feet wet overseas. Numerous in- dividuals getting involved in counterfeiting do not know exactly what they are getting into. So, emerging multinationals often burn cash overseas, and coun- terfeiters sometimes land in jail, which are examples of these decision makers’ bounded rationality.

The second proposition is that while formal and informal institutions combine to govern firm behavior, in situations where formal constraints are unclear or fail, informal constraints play a larger role in reducing uncertainty and providing con- stancy to managers and firms. For example, since the formal regime collapsed with the disappearance of the former Soviet Union, it has been largely the informal con- straints, based on personal relationships and connections (called blat in Russian) among managers and officials, that have facilitated the growth of many entrepre- neurial firms.20 In today’s Russia, there are informal but clear rules of engagement for oligarchs, such as avoiding politics and paying taxes (see the Opening Case).

Bounded rationality

The necessity of making rational decisions in the absence of complete information.

Table 2.2 Two Core Propositions of the Institution-Based View

Proposition 1 Managers and firms rationally pursue their interests and make choices within the formal and informal constraints in a given institutional framework

Proposition 2 While formal and informal institutions combine to govern firm behavior, in situations where formal constraints are unclear or fail, informal constraints will play a larger role in reducing uncertainty and providing constancy to managers and firms

40 Part One Laying Foundations

Many observers have the impression that relying on informal connections is only relevant to firms in emerging economies and that firms in developed econo- mies only pursue “market-based” strategies. This is far from the truth. Even in developed economies, formal rules only make up a small (although important) part of institutional constraints, and informal constraints are pervasive. Just as firms compete in product markets, they also fiercely compete in the political mar- ketplace characterized by informal relationships.21 Basically, if a firm cannot be a market leader, it may still beat the competition on another ground—namely, the non-market, political environment. In September 2008, a rapidly falling Merrill Lynch was able to sell itself to Bank of America for a hefty $50 billion. Supported by US government officials, this megadeal was arranged over 48 hours (shorter than the time most people take to decide on which cars to buy), and the negotiations took place inside the Federal Reserve building in New York. In contrast, Lehman Brothers failed to secure government support and had to drop dead by filing for bankruptcy. Overall, the skillful use of a country’s institutional frameworks to ac- quire advantage is at the heart of the institution-based view.

While there are numerous formal and informal institutions, in this chapter we focus on formal institutions (informal institutions will be covered in Chapter 3). Chief among formal institutions are (1) political systems, (2) legal systems, and (3) economic systems. Each is briefly introduced next.

2-4 Political Systems A political system refers to the rules of the game on how a country is governed politically. At the broadest level, there are two primary political systems: (1) democ- racy and (2) totalitarianism. This section first outlines these two systems and then discusses their ramifications for political risk.

2-4a Democracy Democracy is a political system in which citizens elect representatives to govern the country on their behalf. Usually, the political party with the majority of votes (such as Putin’s United Russia party illustrated in the Opening Case) wins and forms a gov- ernment. Democracy was pioneered by Athenians in ancient Greece. In today’s world,

Britain has the longest experience of running a democ- racy (since the founding of its Parliament in the 1200s), and India has the largest democracy (by population).

One fundamental aspect of democracy that is rel- evant to the effective conduct of global business is an individual’s right to freedom of expression and orga- nization. For example, starting up a firm is an act of economic expression, essentially telling the rest of the world: “I want to be my own boss! And I want to make some money!” In most modern democracies, this right to organize economically has not only been extended to domestic individuals to firms, but also to foreign in- dividuals and firms that come to do business. While those of us fortunate enough to be brought up in a de- mocracy take for granted the right to found a firm, we

Learning Objective Outline the differences among civil law, common law, and theocratic law.

2-4

Political system

The rules of the game on how a country is governed politically.

Democracy

A political system in which citizens elect representatives to govern the country on their behalf.

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What fundamental aspect of democracy is relevant to the conduct of global business?

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 41

should be reminded that this may not necessarily be the case under other political systems. Before the 1980s, if someone had dared to formally found a firm in the for- mer Soviet Union, he or she would have been arrested and shot by the authorities.

2-4b Totalitarianism The opposite end of democracy is totalitarianism (also known as dictatorship), which is defined as a political system in which one person or party exercises abso- lute political control over the population. This section outlines four major types of totalitarianism.

Communist totalitarianism centers on a communist party. This system was embraced throughout Central and Eastern Europe and the former Soviet Union until the late 1980s. It is still practiced in China, Cuba (see the Closing Case), Laos, North Korea, and Vietnam.

Right-wing totalitarianism is characterized by its intense hatred against communism. One party, typically backed by the military, restricts political freedom, arguing that such freedom would lead to communism. In postwar decades, the Philippines, South Africa, South Korea, Taiwan, and most Latin American countries practiced right-wing totalitarianism. Most of these coun- tries have recently become democracies.

Theocratic totalitarianism refers to the monopolization of political power in the hands of one religious party or group. Iran and Saudi Arabia are leading examples.

Tribal totalitarianism refers to one tribe or ethnic group (which may or may not be the majority of the population) monopolizing political power and op- pressing other tribes or ethnic groups. Rwanda’s bloodbath in the 1990s was due to some of the most brutal practices of tribal totalitarianism.

2-4c Political Risk While the degree of hostility toward business varies among different types of totali- tarianism (some can be more pro-business than others), totalitarianism in general is not as good for business as democracy. Totalitarian countries often experience wars, riots, protests, chaos, and breakdowns, which result in higher political risk— risk associated with political changes that may negatively impact domestic and for- eign firms (see Emerging Markets 2.1).22 The most extreme political risk may lead to nationalization (expropriation) of foreign assets. This happened in many totali- tarian countries from the 1950s through the 1970s. It has not become a thing of the past. Zimbabwe has recently demanded that foreign mining companies cede 51% of their equity without compensation.23 It is hardly surprising that foreign mining companies are sick and tired and would rather go to “greener pastures” elsewhere.

Firms operating in democracies also confront political risk. However, such risk is qualitatively lower than that in totalitarian states. For example, Quebec’s poten- tial independence from the rest of Canada creates some political risk. Although firms highly exposed to Quebec experience some drop in their stock price, there is no general collapse of stock price in Canada or flight of capital out of the country.24 Investors are confident that should Quebec become independent, the Canadian democracy is mature enough to manage the break-up process in a relatively non- disruptive way.

Totalitarianism (dictatorship)

A political system in which one person or party exercises ab- solute political control over the population.

Political risk

Risk associated with political changes that may negatively im- pact domestic and foreign firms.

42 Part One Laying Foundations

The Middle East is not known for political stability. Yet, multinational oil companies typically have to work with totalitarian governments in this oil-rich region if these multinationals desire to have a presence there. One crucial question is: What should these firms do when political risk rises?

In 2011, this question turned from being a theoreti- cal one to a highly practical one. Starting in Tunisia and Egypt, a series of protests and uprisings engulfed the region since January 2011. The spring of 2011 quickly earned a special name, the Arab Spring, which will be recorded as a turning point in the history of the Middle East.

Nowhere are the decisions made by multinational executives more hair-raising than in Libya. Before 2011, Libya was Africa’s third largest and the world’s 17th largest oil producer, pumping out 1.6 million bar- rels (about 2% of world total) per day. Over 85% of its crude oil was exported. About a third went to Italy, 14% to Germany, 10% each to France and China, and 5% to the United States. Libya’s state-owned National Oil Corporation (NOC) accounted for approximately 50% of the oil output, and the rest was produced by ENI of Italy, Statoil of Norway, Repsol of Spain, Wintershall (a subsidiary of BASF) of Germany, OMV of Austria, Gazprom of Russia, Sinopec of China, and ConocoPhillips, Occidental Petroleum, Marathon, and Hess of the United States. In addition, BP of Britain, Shell of the Netherlands, and ExxonMobil of the United States had signed leases but were still in exploration stages and were not producing oil when violence broke out.

The high-stakes drama in Libya started in February 2011, when protesters and government forces clashed. The confrontation quickly became a civil war between the rebel-controlled east (cen- tered on Benghazi) and the government-controlled west (centered on Tripoli, the capital). As violence escalated, foreign governments ordered evacuations

of their nationals, and so did multinational oil com- panies. Multinationals either completely shut down their production or left the remaining Libyans to run the uncertain operations.

In March 2011, in the face of a humanitarian di- saster that would be unleashed by government forces approaching Benghazi, air strikes were launched by al- lied forces. Spearheaded by the French, UK, and US forces in the initial salvos, the allied forces eventually included militaries from 17 countries. There were 13 from NATO countries, three from the Arab League (Jordan, Qatar, and United Arab Emirates), and one country that is neither a member of NATO nor the Arab League, Sweden.

The two recent revolutions in Tunisia and Egypt were quick and had relatively low casualties. They lasted a couple of weeks and resulted in the depar- ture of their dictators at a cost of about 200 deaths in Tunisia and 800 in Egypt. International forces did not intervene militarily. However, the civil war in Libya, in- volving allied air strikes, was significantly longer and bloodier, with casualties estimated to be between 20,000 and 30,000.

While the decision to evacuate expatriates (foreign nationals) and shut down production was relatively straightforward, executives caught in the middle of all of the above had to scratch their heads regarding what to do next. Attacks on oil fields by the rebels, by the pro-Qaddafi forces, and by the allies were all reported but seldom confirmed. Executives not only had fiduciary (required by law) responsibility to safe- guard shareholders’ assets, but also moral and ethi- cal responsibility to look after employees and their families. Most employees were Libyan and were not evacuated. About the remaining assets and employ- ees in Libya, the CEO of Austria’s OMV told reporters in April 2011: “We have no precise information at all; we have no official contact at all; we are dependent on random contact.”

Managing Political Risk in Libya

E m E r g i n g m a r k E t s 2 . 1

Ethical Dilemma

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Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 43

Obviously, when two countries are at each other’s throats, we can forget about doing business between them (perhaps other than smuggling).25 No two democ- racies have reportedly gone to war with each other. Thus, the recent advance of democracy and retreat of totalitarianism is highly beneficial for global business. It is not a coincidence that globalization took off in the 1990s, a period during which both communist and right-wing totalitarianism significantly lost its power and de- mocracy expanded around the world.

2-5 Legal Systems A legal system refers to the formal rules of the game on how a country’s laws are enacted and enforced. By specifying the do’s and don’ts, a legal system reduces transaction costs by minimizing uncertainty and combating opportunism. This section first introduces the three legal traditions and then discusses crucial issues associated with property rights and intellectual property.

2-5a Civil Law, Common Law, and Theocratic Law Laws in different countries typically are not enacted from scratch, but are often transplanted—voluntarily or otherwise—from three legal traditions (or legal fami- lies): (1) civil law, (2) common law, and (3) theocratic law (Table 2.3). Each is briefly introduced here.

Civil law was derived from Roman law and strengthened by Napoleon’s France. It is “the oldest, the most influential, and the most widely distributed around the world.”26 It uses comprehensive statutes and codes as a primary means to form legal judgments. Over 80 countries practice civil law.

Common law, which is English in origin, is shaped by precedents and traditions from previous judicial decisions. Common law has spread to all English-speaking countries and their (former) colonies.

Relative to civil law, common law has more flexibility because judges have to re- solve specific disputes based on their interpretation of the law, and such interpretation

Learning Objective Understand the importance of property rights and intellectual property rights.

2-5

Legal system

The rules of the game on how a country’s laws are enacted and enforced.

Civil law

A legal tradition that uses com- prehensive statutes and codes as a primary means to form legal judgments.

Common law

A legal tradition that is shaped by precedents and traditions from previous judicial decisions.

Italy’s ENI, a big player in Libya, walked a fine line between the rebels and the regime. While ENI shut down most production and talked with the rebels, it still supplied natural gas to the government-controlled Tripoli. ENI presumably did this to hedge its bets while the Qaddafi regime hung on and also to fulfill some of its ethical responsibility to its gas clients stuck in a war zone. When the Italian government called for Qaddafi’s ouster and Italian fighters were dropping bombs on government forces, ENI’s balancing act was extraordinarily challenging. ENI “risks angering both sides no matter what they do,” noted an expert.

US firms ConocoPhillips, Marathon, and Hess took a different approach, which was totally passive. They kept plans and opinions to themselves. Typical of an “ostrich” approach, a ConocoPhillips spokesman in April 2011 told reporters: “We do not have anyone available to discuss Libya.”

After eight months of fighting, Qaddafi was cap- tured and killed in October 2011. Then the rebels, who had organized as the National Transitional Council, de- clared an end to the Libyan civil war. How oil compa- nies pick up the pieces remains to be seen.

Sources: Based on (1) Al Jazeera, 2011, NTC declares liberation of Libya, October 23; (2) Bloomberg Businessweek, 2011, Where has Libya’s oil gone? April 18: 11–12; (3) Economist, 2011, Islam and the Arab revolutions, April 2: 11; (4) Economist, 2011, The colonel is not beaten yet, April 2: 41–42.

44 Part One Laying Foundations

may give new meaning to the law, which will shape future cases. Civil law has less flexibility because judges only have the power to apply the law. On the other hand, civil law is less confrontational, because comprehensive statutes and codes serve to guide judges. You may have seen common law in action in Hollywood movies such as A Few Good Men, Devil’s Advocate, and Legally Blonde. Common law is more con- frontational, because plaintiffs and defendants, through their lawyers, must argue and help judges to favorably interpret the law largely based on precedents. This confrontation is great material for movies. In contrast, you probably have rarely seen a civil law court in action in a movie—you have not missed much, because civil law lacks the drama and its proceedings tend to be boring. In addition, contracts in common law countries tend to be long and detailed to cover all possible con- tingencies, because common law tends to be relatively underdefined. In contrast, contracts in civil law countries are usually shorter and less specific because many issues typically articulated in common law contracts are already covered in compre- hensive civil law codes.

The third legal family is theocratic law, a legal system based on religious teach- ings. Examples include Jewish law and Islamic law. Although Jewish law is followed by some elements of the Israeli population, it is not formally embraced by the Israeli government. Islamic law is the only surviving example of a theocratic legal system that is formally practiced by some governments, such as those in Iran and Saudi Arabia. Despite popular characterization that Islam is anti-business, it is important to note that Mohammed was a merchant trader and the tenants of Islam are pro- business in general. However, the holy book of Islam, the Koran, advises against certain business practices. In Saudi Arabia, McDonald’s operates “ladies only” res- taurants to be in compliance with the Koran’s ban on direct, face-to-face contact between men and women (who often wear a veil) in public. Also in Saudi Arabia, banks have to maintain two retail branches: One for male customers manned by men and another for female customers staffed by women. This requirement obvi- ously increases the property, overhead, and personnel costs. To reduce costs, some foreign banks, such as HSBC, staff their back office operations with both male and female employees who work side by side.27

Overall, as an important component of the first, regulatory pillar, legal systems are a crucial component of the institutional framework. They directly impose do’s and don’ts on businesses around the globe. Overall, under the broad scope of a legal system, there are numerous components. Two of these, property rights and intellectual property, are discussed next.

Theocratic law

A legal system based on religious teachings.

Table 2.3 Three Legal Traditions1

Civil law countries Common law countries Theocratic law countries

Argentina, Austria, Belgium, Brazil, Chile, China, Egypt, France,

Germany, Greece, Indonesia, Italy, Japan, Mexico, Netherlands, Russia, South Korea, Sweden, Switzerland,

Taiwan

Australia, Canada, Hong Kong, India, Ireland,

Israel, Kenya, Malaysia, New Zealand,

Nigeria, Singapore, South Africa, Sri Lanka, United Kingdom, United

States, Zimbabwe

Iran, Saudi Arabia, United Arab Emirates2

1 The countries are examples and do not exhaustively represent all countries practicing a particular legal system. 2 Certain parts of Dubai (an emirate within the UAE), such as the Dubai International Finance Center, practice common law.

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 45

2-5b Property Rights Regardless of which legal family a country’s legal system belongs to, one of the most fundamental economic functions that a legal system serves is to protect property rights—the legal rights to use an economic property (resource) and to derive in- come and other benefits from it. Examples of property include homes, offices, and factories. (Intellectual property will be discussed in the next section.)

What difference do property rights supported by a functioning legal system make? A lot. Why did developed economies become developed (remember, for example, the United States was a “developing” or “emerging” economy 100 years ago)? While there are many answers, a leading answer, which is most forcefully put forward by Hernando de Soto, a Peruvian economist, focuses on the role played by formal institutions, particularly the protection of property rights afforded by a functioning legal system.28 In Africa, only approximately 1% of land is formally registered.29 In developed economies, every parcel of land, every building, and every trademark is represented in a property document that entitles the owner to derive income and other benefits from it, and prosecute violators through legal means. Because of the stability and predictability of such a legal system, tangible property can lead to an invisible, parallel life alongside its material existence. It can be used as collateral for credit. For example, the single most important source of funds for new start-ups in the United States is the mortgage of entrepreneurs’ houses.

However, if you live in a house but cannot produce a title document specify- ing that you are the legal owner of the house (which is a very common situation throughout the developing world, especially in shanty towns), no bank in the world will allow you to use your house as collateral for credit. To start up a new firm, you end up having to borrow funds from family members, friends, and other acquain- tances through informal means. But funds through informal means are almost cer- tainly more limited than funds that could have been provided formally by banks. As a result, in the aggregate, because of such under-funding, the average firm size in the developing world is smaller than that in the developed world. Such insecure property rights also result in using technologies that employ little fixed capital and do not entail long-term investment (such as R&D). These characteristics do not bode well in global competition, where leading firms reap benefits from economies of scale, capital-intensive technologies, and sustained investment in R&D. What the developing world lacks and desperately needs is formal protection of property rights in order to facilitate economic growth.

2-5c Intellectual Property Rights While the term “property” traditionally refers to tangible pieces of property (such as land), intellectual property specifically refers to intangible property that is the result of intellectual activity (such as books, videos, and websites). Intellectual property (IP) rights are rights associated with the ownership of intellectual property. They primarily include rights associated with (1) patents, (2) copyrights, and (3) trade- marks.

Patents are legal rights awarded by government authorities to inventors of new products or processes, who are given exclusive (monopoly) rights to derive income from such inventions through activities such as manufactur- ing, licensing, or selling.

Property rights

The legal rights to use an economic property (resource) and to derive income and benefits from it.

Intellectual property

Intangible property that is the result of intellectual activity.

Intellectual property (IP) rights

Rights associated with the own- ership of intellectual property.

Patent

Exclusive legal right of inventors of new products or pro- cesses to derive income from such inventions.

46 Part One Laying Foundations

Copyrights are the exclusive legal rights of authors and publishers to publish and disseminate their works (such as this book).

Trademarks are the exclusive legal rights of firms to use specific names, brands, and designs to differentiate their products from others.

Because IP rights are usually asserted and protected on a country-by-country basis, one pressing issue arises internationally: How can IP rights be protected when countries have uneven levels of rights enforcement? The Paris Convention for the Protection of Industrial Property is the “gold standard” for a higher level of IP rights protection. Adopting the Paris Convention is required in order to become a signatory country to the WTO’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) (see Chapter 8). Given the global differences in the formal rules, much stricter IP rights protection is provided by TRIPS. Once countries join TRIPS, firms are often forced to pay more attention to innovation.

IP rights need to be asserted and enforced through a formal system, which is designed to provide an incentive for people and firms to innovate and to punish violators. However, the intangible nature of IP rights makes their protection dif- ficult.30 Around the world, piracy—unauthorized use of intellectual property—is widespread, ranging from unauthorized sharing of music files to deliberate coun- terfeiting of branded products. Different countries have developed “distinctive competencies.” For example, China is known for fake DVDs and Rolexes. Russia is a powerhouse for counterfeit software. Ukraine is famous for bootlegged optical discs. Paraguay is well known for imitation cigarettes. Italy is a leading producer of counterfeit luxury goods. Florida has developed a strong reputation for fake aircraft parts.31

Overall, an institution-based view suggests that the key to understanding IP rights violation is to realize that IP violators are not amoral monsters, but ordinary people and firms. Given an institutional environment of weak IP rights protection, IP violators have made a rational decision by investing in skills and knowledge in this business (Proposition 1 in Table 2.2). When filling out a survey asking, “What is your dream career?,” no high-school graduate will answer: “My dream career

is counterfeiting.” Nevertheless, thousands of individuals and firms voluntarily choose to be involved in this business worldwide. Stronger IP protection may reduce their in- centive to do so. For example, counterfeit- ers in China will be criminally prosecuted only if their profits exceed approximately $10,000. No counterfeiters are dumb enough to keep records showing they make that much money. If they are caught and are found to make less than $10,000, they can usually get away with a $1,000 fine, which is widely regarded as a (small) cost of doing business. However, IP reforms to criminalize all counterfeiting activities re- gardless of the amount of profits, which have been discussed in China, may signifi- cantly reduce counterfeiters’ incentive.

Exclusive legal right of authors and publishers to publish and disseminate their work.

Trademark

Exclusive legal right of firms to use specific names, brands, and designs to differentiate their products from others.

Piracy

Unauthorized use of intellectual property.

What other examples of pirated intellectual property can you think of?

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Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 47

2-6 Economic Systems An economic system refers to the rules of the game on how a country is governed economically. At the two ends of a spectrum, we can find (1) a market economy and (2) a command economy. In between, there is a mixed economy.

A pure market economy is characterized by the “invisible hand” of market forces first noted by Adam Smith in The Wealth of Nations in 1776. The government takes a hands-off approach known as laissez faire. Specifically, all factors of production should be privately owned. The government should only perform functions that the private sector cannot perform (such as providing roads and defense).

A pure command economy is defined by a government taking, in the words of Lenin, the “commanding height” in the economy. All factors of production should be government-owned or state-owned, and all supply, demand, and pricing are planned by the government. During the heydays of communism, the former Soviet Union and China approached such an ideal.

A mixed economy, by definition, has elements of both a market economy and a command economy. It boils down to the relative distribution of market forces ver- sus command forces. In practice, no country has ever completely embraced Adam Smith’s ideal laissez faire. Here is a quiz: Which economy has the highest degree of economic freedom (the lowest degree of government intervention in the econo- my)? Hint: Given extensive government intervention since 2008, it is obviously not the United States (see In Focus 2.1). A series of surveys report that it is Hong Kong (the post-1997 handover to Chinese sovereignty does not make a difference).32 The crucial point here is that even in Hong Kong, there is still some noticeable govern- ment intervention in the economy. During the aftermath of the 1997 economic cri- sis, when the share prices of all Hong Kong listed firms took a nose dive, the Hong Kong government took a highly controversial action. It used government funds to purchase 10% of the shares of all the “blue chip” firms listed under the Hang Seng index. This action did slow down the sliding of share prices and stabilized the economy, but it turned all the “blue chip” firms into state-owned enterprises (SOEs)—at least 10% owned by the state. At the height of the global financial crisis in 2008 and 2009, most governments in developed economies took similar action by bailing out their banks and turning them into SOEs.

Likewise, no country has ever practiced a complete command economy, despite the efforts of communist zealots throughout the Eastern bloc during the Cold War. Poland never nationalized its agriculture. Hungarians were known to have second (and private!) jobs while all of them theoretically only worked for the state. Black markets hawking agricultural produce existed in practically all communist coun- tries. While the former Soviet Union and Central and Eastern European coun- tries threw away communism, even ongoing practitioners of communism, such as China, Cuba (see the Closing Case), and Vietnam, have embraced market reforms. Even North Korea is now interested in attracting foreign investment.

The economic system of most countries is a mixed economy. When we say a country has a “market economy,” it is really a shorthand version for a country that organizes its economy mostly (but not completely) by market forces and that still has certain elements of a command economy. China, Russia, Sweden, and the United States all claim to have a “market economy,” but the meaning is different in each country. In short, “free markets” are not totally “free” (see In Focus 2.1). It boils down to a matter of degree. Overall, it may be prudent to drop the “F” word (“free”) from the term “free market economy.” Instead, it makes sense to

Learning Objective Appreciate the differences among market economy, command economy, and mixed economy.

2-6

Economic system

Rules of the game on how a country is governed economically.

Market economy

An economy that is character- ized by the “invisible hand” of market forces.

Command economy

An economy that is character- ized by government owner- ship and control of factors of production.

Mixed economy

An economy that has elements of both a market economy and a command economy.

State-owned enterprise (SOE)

A firm owned and controlled by the state (government).

48 Part One Laying Foundations

acknowledge that there is a variety of capitalism, with each version of “market economy” differing in some ways.33

2-7 Debates and Extensions Formal institutions such as political, legal, and economic systems represent some of the broadest and most comprehensive forces affecting global business. They provoke some significant debates. In this section, we focus on two major debates: (1) drivers of economic development and (2) private ownership versus state ownership.

2-7a Drivers of Economic Development: Culture, Geography, or Institutions? The differences in economic development around the globe are striking (see PengAtlas maps 1.1, 3.4, and 3.5). The highest and lowest per capita income countries are Norway ($76,450) and Burundi ($110), respectively. Why are some countries such as Norway so developed (rich), and some African countries such as Burundi so underdeveloped (poor)? More generally, what drives economic devel- opment in different countries?

Scholars and policy makers have debated this important question since Adam Smith’s time.34 Various debate points boil down to three explanations: (1) culture, (2) geography, and (3) institutions. The culture side argues that rich countries tend to have smarter and harder-working populations driven by a stronger moti- vation for economic success (such as the Protestant work ethic identified by Max Weber—see Chapter 3). However, it is difficult to imagine that on average, Norwe- gians are nearly 700 times smarter and harder at work than Burundians. This line of thinking, bordering on racism, is no longer acceptable in the 21st century.

The geography school of thought in this debate suggests that rich countries (such as the United States) tend to be well endowed with natural resources. How- ever, one can easily point out that some poor countries (such as the Democratic Republic of Congo [Zaire]) also possess rich natural resources, and that some rich countries (such as Denmark and Japan) are very poor in natural resources. In ad- dition, some countries are believed to be cursed by their poor geographic location, which may be landlocked (such as Malawi) and/or located near the hot equator zone infested with tropical diseases (such as Burundi). This argument is not convincing either, because some landlocked countries are phenomenally well developed (such as Switzerland), and some countries near the equator have accomplished enviable growth (such as Singapore). Geography is important, but not destiny.

Finally, institutional scholars argue that institutions are “the basic determinants of the performance of an economy.”35 Because institutions provide the incentive structure of a society, formal political, legal, and economic systems have a significant impact on economic development by affecting the incentives and the costs of do- ing business.36 In short, rich countries are rich because they have developed better market-supporting institutional frameworks. Specifically, several points can be made:

It is economically advantageous for individuals and firms to grow and special- ize in order to capture the gains from trade. This is the “division of labor” thesis first advanced by Adam Smith (see Chapter 5).

A lack of strong formal, market-supporting institutions forces individuals to trade on an informal basis with a small neighboring group and forces firms

Learning Objective Participate in two leading debates concerning politics, laws, and economics.

2-7

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 49

to remain small, thus foregoing the gains from a sharper division of labor by trading on a large scale with distant partners. For example, most of the trans- actions in Africa are local in nature, and most firms are small. Over 40% of Africa’s economy is reportedly informal, the highest proportion in the world.37

Emergence of formal, market-supporting institutions encourages individuals to specialize and firms to grow in size to capture the gains from complicated long-distance trade (such as transactions with distant, foreign countries). As China’s market institutions progress, many Chinese firms have grown their size.

When formal, market-supporting institutions protect property rights, they will fuel more innovation, entrepreneurship, and thus economic growth. While spontaneous innovation existed throughout history, why has its pace acceler- ated significantly since the Industrial Revolution starting in the 1700s? In no small measure, this was because of the Statute of Monopolies enacted in Great Britain in 1624, which was the world’s first patent law to formally protect the IP rights of inventors and make innovation financially lucrative.38 This law has been imitated around the world. Its impact is still felt today, as we now expect continuous innovation to be the norm. This would not have happened had there not been a system of strong protection of IP rights. Why do we now routinely expect IT products to double their computing power roughly every two years? The answer is certainly not because humans (or even IT geniuses) are two times smarter every two years—the key is institutions affording better and stronger IP protection that fuels such relentless (and, yes, routine!) innovation.39

These arguments, of course, are the backbone of the institution-based view of global business. Championed by Douglass North, the Nobel laureate quoted ear- lier, this side has clearly won the debate on the drivers of economic development. However, the debate does not end, because it is still unclear exactly what kind of political system facilitates economic development.

Is a democracy conducive to economic growth? While champions of democracy shout, “Yes,” the fastest-growing major economy in the last three decades, China, remains totalitarian. The growth rate of India, the world’s largest democracy, in the same period is only about half of China’s. In another example, Russia grew faster under Putin’s more authoritarian rule during the 2000s compared with the 1990s, when Russia was presumably more democratic under Yeltsin (see the Open- ing Case). On the other hand, no one can seriously argue for a case for totalitari- anism in order to facilitate economic development. In an influential 2012 publica- tion concerned about the decline of US competitiveness and the rise of Chinese competitiveness, strategy guru Michael Porter nevertheless wrote, “We do not want to copy China, whose speed comes partly from a political system unacceptable to Americans.”40 The few examples of “benign” totalitarian regimes that delivered strong economic growth, such as South Korea and Taiwan, have become democra- cies in the last two decades. Overall, there is no doubt that democracy has spread around the world (from 69 countries in the 1980s to 117 in the 2000s). However, whether democracy necessarily leads to strong economic development is still sub- ject to debate (see the Opening Case).

2-7b Private Ownership versus State Ownership41

Private ownership is good. State ownership is bad. Although crude, these two state- ments fairly accurately summarize the intellectual and political reasoning behind

50 Part One Laying Foundations

Table 2.4 Private Ownership versus State Ownership

Private ownership State ownership

Objective of the firm Maximize profits for private owners who are capitalists (and maximize shareholder value for shareholders if the firm is publicly listed).

Optimal balance for a “fair” deal for all stakeholders. Maximizing profits is not the sole objective of the firm. Protecting jobs and minimizing social unrest are legitimate goals.

Establishment of the firm Entry is determined by entrepreneurs, owners, and investors.

Entry is determined by government officials and bureaucrats.

Financing of the firm Financing is from private sources (and public shareholders if the firm is publicly traded).

Financing is from state sources (such as direct subsidiaries or banks owned or controlled by governments).

Liquidation of the firm Exit is forced by competition. A firm has to declare bankruptcy or be acquired if it becomes financially insolvent.

Exit is determined by government officials and bureaucrats. Firms deemed “too big to fail” may be supported by taxpayer dollars indefinitely.

Appointment and dismissal of management

Management appointments are made by owners and investors, largely based on merit.

Management appointments are made by government officials and bureaucrats who may also use non-economic criteria.

Compensation of management

Managers’ compensation is determined by competitive market forces. Managers tend to be paid more under private ownership.

Managers’ compensation is determined politically with some consideration given to a sense of fairness and legitimacy in the eyes of the public. Managers tend to be paid less under state ownership.

Sources: Extracted from text in (1) M. W. Peng, 2000, Business Strategies in Transition Economies (p. 19), Thousand Oaks, CA: Sage; (2) M. W. Peng, G. Bruton, & C. Stan, 2012, Theories of the (state-owned) firm, working paper, University of Texas at Dallas.

three decades of privatization around the world between 1980 and 2008. Table 2.4 summarizes the key differences between private ownership and state ownership. As providers of capital, private owners are otherwise known as capitalists, and their central role in the economic system gives birth to the term “capitalism.” State own- ership emphasizes the social and public nature of economic ownership, and leads to the coinage of the term “socialism.” Obviously, both forms of ownership have their own pros and cons. The debate is about which form of ownership is better— whether the pros outweigh the cons.

The debate on private versus state ownership has underpinned much of the global economic evolution since the early 20th century. The Great Depression (1929–1933) was seen as a failure of capitalism and led numerous elites in devel- oping countries and a non-trivial number of scholars in developed economies to favor the Soviet-style socialism centered on state ownership. As a result, the postwar decades saw an increase in state ownership and a decline in private ownership. State ownership was not only extensive throughout the former Eastern bloc (the former Soviet Union, Central and Eastern Europe, China, and Vietnam), but was also widely embraced throughout developed economies in Western Europe. By the early 1980s, close to half of the GDP in major Western European countries such as Britain, France, and Italy was contributed by SOEs.

Experience throughout the former Eastern bloc and Western Europe indicated that SOEs typically suffer from a lack of accountability and a lack of economic ef- ficiency (see the Closing Case). SOEs were known to feature relatively equal pay

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 51

between the managers and the rank and file. Since extra work did not translate into extra pay, employees had little incentive to improve the quality and efficien- cy of their work. Given the generally low pay and the non-demanding work environment, formerly Soviet SOE employees summed it up well: “They pretend to pay us, and we pretend to work.”42

As Britain’s prime minister, Margaret Thatcher privatized a majority of British SOEs in the 1980s. Very soon, SOEs throughout Central and Eastern Europe followed suit. After the former Soviet Union collapsed, the new Russian government unleashed some of the most aggressive privatization schemes in the 1990s. Eventually, the privatization movement became global. In no small part, such a global move- ment was championed by the Washington Consensus, spearheaded by two Washington-based international organizations: the Interna- tional Monetary Fund (IMF) and the World Bank. One core value of the Washing- ton Consensus is the unquestioned belief in the superiority of private ownership over state ownership. The widespread privatization movement suggested that the Washington Consensus clearly won the day—or it seemed.

But in 2008, the pendulum suddenly swung back (see Chapter 1). During the unprecedented recession, many governments in developed economies bailed out numerous failing private firms using public funds, effectively turning them into SOEs. As a result, all of the arguments in favor of private ownership and “free mar- ket” capitalism collapsed. Since SOEs had such a dreadful reputation (essentially a “dirty word”), the US government has refused to acknowledge that it has SOEs. Instead, it admits that the United States has “government-sponsored enterprises” (GSEs) such as General Motors (nicknamed “Government Motors”) and Citigroup (nicknamed “Citigovernment”).

Conceptually, what are the differences between SOEs and GSEs? Hardly any! The right column in Table 2.4 is based on my own research on the “classical” SOEs in pre-reform China and Russia published more than a decade ago. This column also accurately summarizes what is happening in developed economies featuring GSEs now. For example, protecting jobs is one of the stated goals behind bailouts. Entry and exit are determined by government officials, and some firms that have been clearly run into the ground, such as AIG and GM, are deemed “too big to fail” and are bailed out with taxpayer dollars. The US government has forced the exit of GM’s former chairman and CEO, and is now directly involved in the appointment of executives at GM and other GSEs. Not surprisingly, the US government is now drafting rules to regulate executive compensation.

One crucial concern is that despite noble goals to rescue the economy, pro- tect jobs, and fight recession, government bailouts may encourage moral hazard— recklessness when people and organizations (including firms and governments) do not have to face the full consequences of their actions.43 In other words, capi- talism without the risk of failure becomes socialism. It is long known that man- agers in SOEs face a “soft budget constraint” in that they can always dip into state coffers to cover their losses.44 When managers in private firms who make

Washington Consensus

A view centered on the unques- tioned belief in the superiority of private ownership over state ownership in economic policy making, which is often spear- headed by two Washington- based international organiza- tions: the International Monetary Fund and the World Bank.

Moral hazard

Recklessness when people and organizations (including firms and governments) do not have to face the full consequences of their actions.

Are the income and jobs of these automobile manufacturing workers in China affected by the move toward privatization in that country?

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risky decisions to “bet the farm” find out these decisions have turned sour but their firms will not go under—thanks to generous bailouts—they are likely to embrace more risk in the future. In other words, bailouts foster the kind of think- ing among managers regarding state coffers and taxpayer dollars: “Heads I win, tails you lose.” Per Proposition 1 (Table 2.2), these managers are being perfectly rational: Taking on risks, if successful, will enrich their private firms, their owners (shareholders), and themselves; if unsuccessful, the government will come to the rescue. Having bailed out failing private firms once, governments that not long ago were the strongest champions of “free markets” now increasingly find it hard to draw the line.

Far from being swept to the dustbin of history, SOEs as an organizational form have shown some amazing longevity. Today, SOEs represent approximately 10% of the global GDP. Even in developed (OECD member) countries, they command 5% of the GDP.45 From the ashes of the Washington Consensus emerged a Beijing Con- sensus, which centers on state ownership and government intervention. Anchored by SOEs, China over the past 30 years has grown its GDP by 9.5% per year and its international trade volume by 18% per year. SOEs represent 80% of China’s stock market capitalization. But China is not alone. In Russia the figure is 62% and in Brazil 38%.46 Overall, nine of the top 15 largest initial public offerings (IPOs) since 2005 are SOEs (Table 2.5). For policymakers in developed economies, one impor- tant dimension of this debate is about how to view the incoming investments from state-owned entities such as sovereign wealth funds (SWFs) from emerging econo- mies (see Emerging Markets 2.2).

Beijing Consensus

A view that questions Washington Consensus’ belief in the superi- ority of private ownership over state ownership in economic policy making, which is often associated with the position held by the Chinese government.

sovereign wealth funds (sWFs)

A state-owned investment fund composed of financial assets such as stocks, bonds, real estate, or other financial instruments funded by foreign exchange assets.

Table 2.5 State-Owned Enterprises (SOEs) Represent 9 of the 15 Largest Initial Public Offerings (IPOs) since 2005

Company Industry Year Value ($ billion)

Agricultural Bank of China (SOE) Finance 2010 22.1

Industrial & Commercial Bank of China (SOE) Finance 2006 21.9

AIA (Hong Kong) Insurance 2010 20.5

Visa (United States) Finance 2008 19.7

General Motors (United States) (SOE) Automotive 2010 18.1

Bank of China (SOE) Finance 2006 11.2

Dai-ichi Life Insurance (Japan) Insurance 2010 11.1

Rosneft (Russia) (SOE) Oil & gas 2006 10.7

Glencore International (Switzerland) Mining 2011 10.0

China Construction Bank (SOE) Finance 2005 9.2

Electricité de France (SOE) Utility & energy 2005 9.0

VTB Group (Russia) (SOE) Finance 2007 8.0

Banco Santander Brasil Finance 2009 7.5

China State Construction Engineering Corporation (SOE) Construction 2009 7.3

Iberdrola Renovables (Spain) Utility & energy 2007 6.6

Source: Adapted from Economist, 2012, New masters of universe (p. 8), Special Report: State Capitalism, January 21: 8.

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 53

A sovereign wealth fund (SWF) is a state-owned in- vestment fund composed of financial assets such as stocks, bonds, real estate, or other financial instru- ments funded by foreign exchange assets. Invest- ment funds that we now call SWFs were first created in 1953 by Kuwait. Both the United States and Canada have had their own SWFs (at least at the state and provincial level, such as the Alaska Permanent Fund and Alberta Heritage Fund).

In the recent crisis, SWFs came to the rescue. They represent approximately 10% of global invest- ment flows. For example, in 2007, the Abu Dhabi Investment Authority injected $7.5 billion (4.9% of equity) into Citigroup. In 2008, China Investment Corporation (CIC) invested $5 billion for a 10% equity stake in Morgan Stanley. While most SWFs make rela- tively passive investments, some have become more active, direct investors as they hold larger stakes in recipients.

Such large-scale investments have ignited the de- bate on SWFs. On the one hand, SWFs have brought much-needed cash to rescue desperate Western firms. On the other hand, concerns are raised by host countries, which are typically developed economies. One primary concern is national security in that SWFs may be politically (as opposed to commercially) moti- vated. Another concern is SWFs’ inadequate transpar- ency. Governments in several developed economies, in fear of the “threats” from SWFs, have been erect- ing anti-SWF measures to defend their companies.

Foreign investment certainly has both benefits and costs to host countries. However, in the absence of any evidence that the costs outweigh benefits, the rush to erect anti-SWF barriers is indicative of protectionist (or, some may argue, even racist) sentiments. For execu- tives at hard-pressed Western firms, it would not seem sensible to ask for government bailouts on the one hand, and to reject cash from SWFs on the other hand. Most SWF investment is essentially free cash with few

strings attached. For example, CIC, which now holds 10% of Morgan Stanley equity, did not demand a board seat or a management role. For Western policymakers, it makes little sense to spend taxpayers’ dollars to bail out failed firms, run huge budget deficits, and then turn away SWFs. Commenting on inbound Chinese invest- ment in the United States (including SWF investment), an American expert (Steve Globerman) and a Canadian expert (Daniel Shapiro) note:

It seems feckless on the part of US policymakers to stigmatize Chinese investment in the United States based upon imprecise and likely exagger- ated estimates of the relevant costs and risks of that investment.

At least some US policymakers agree. In the September/October 2008 issue of Foreign Affairs, then- Secretary of the Treasury Henry Paulson commented:

These concerns [on Chinese investment] are misplaced . . . the United States would do well to encourage such investment from anywhere in the world—including China—because it rep- resents a vote of confidence in the US economy and it promotes growth, jobs, and productivity in the United States.

Lastly, thanks to the financial crisis in 2008-2009, recent SWF investment in developed economies suf- fered major losses. Such a “double whammy”—both the political backlash and the economic losses—has severely discouraged SWFs. As a result, the reces- sion put a premium on maintaining a welcoming cli- mate. As part of the efforts to foster such a welcom- ing climate in times of great political and economic anxiety, both US and Chinese governments confirmed the following in the US-China Strategic and Economic Dialogue (S&ED) in July 2009:

The United States confirms that the Commit- tee on Foreign Investment in the United States

Welcoming versus Restricting Sovereign Wealth Fund Investments

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(CFIUS) process ensures the consistent and fair treatment of all foreign investment without prej- udice to the place of origin. The United States welcomes sovereign wealth fund investment, including that from China. China stresses that investment decisions by its state-owned invest- ment firms will be based solely on commercial grounds.

Beyond bilateral negotiations such as the US-China S&ED, in September 2008, major SWFs of the world at a summit in Santiago, Chile, agreed to a voluntary code of conduct known as the Santiago Principles. These prin- ciples are designed to alleviate some of the concerns for host countries of SWF investment and to enhance the transparency of such investment. These principles represent an important milestone of SWFs’ evolution.

Sources: Based on (1) V. Fotak & W. Megginson, 2009, Are SWFs welcome now? Columbia FDI Perspectives, No. 9, July 21, www.vcc.columbia.edu; (2) S. Globerman & D. Shapiro, 2009, Economic and strategic considerations surrounding Chinese FDI in the United States (p. 180), Asia Pacific Jour- nal of Management, 26: 163–183; (3) H. Paulson, 2008, The right way to engage China. Foreign Affairs, September/October, www.foreignaffairs.org; (4) Sovereign Wealth Fund Institute, 2012, About sovereign wealth fund, www.swfinstitute.org; (5) United Nations (UN), 2010, World Investment Report 2010 (p. xviii), New York and Geneva: UN; (6) US Department of the Treasury, 2009, The First US-China Strategic and Economic Dialogue Economic Track Joint Fact Sheet, July 28, Washington.

Table 2.6 Implications for Action

When entering a new country, do your homework by having a thorough understanding of the formal institutions governing firm behavior.

When doing business in countries with a strong propensity for informal relational exchanges, insisting on formalizing the contract right away may backfire.

2-8 Management Savvy Focusing on formal institutions, this chapter has sketched the contours of an institution-based view of global business, which is one of the two core perspec- tives we introduce throughout this book. (Chapter 3 will reinforce this view with a focus on informal institutions.) How does the institution-based view help us answer the fundamental question that is of utmost managerial concern around the globe: What determines the success and failure of firms around the globe? In a nutshell, this chapter suggests that firm performance is, at least in part, determined by the institutional frameworks governing firm behavior. It is the growth of the firm that, in the aggregate, leads to the growth of the economy. Not surprisingly, most devel- oped economies are supported by strong, effective, and market-supporting formal institutions, and most underdeveloped economies are pulled back by weak, inef- fective, and market-distorting formal institutions. In other words, when markets work smoothly in developed economies, formal market-supporting institutions are almost invisible and taken for granted. However, when markets work poorly, the absence of strong formal institutions may become conspicuous.

For managers doing business around the globe, this chapter suggests two broad implications for action (Table 2.6). First, managerial choices are made rationally within the constraints of a given institutional framework. Therefore, when entering a new country, managers need to do their homework by having a thorough under- standing of the formal institutions affecting their business. The rules for doing business in a democratic market economy are certainly different from the rules in a totalitarian command economy. In short, “when in Rome, do as the Romans do.” While this is a good start, managers also need to understand why “Romans” do

Learning Objective Draw implications for action.

2-8

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 55

things in a certain way by studying the formal and informal institutions governing “Roman” behavior.47 Of course, merely mastering the rules of the game will not be enough. The firm will also need to develop firm-specific resources and capabilities to take advantage of the rules of game. In the midst of a horrific recession, Merrill Lynch’s skillful maneuvers to save itself and Lehman Brothers’ failed attempt to garner political support serve as two cases in point.

Second, while this chapter has focused on the role of formal institutions, man- agers should follow the advice of the second proposition of the institution-based view: In situations where formal constraints are unclear or fail, informal con- straints (such as relationship norms) will play a larger role in reducing uncertainty. This means that when doing business in countries with a strong propensity for informal, relational exchanges, insisting on formalizing the contract right away may backfire.48 Because these countries often have relatively weak legal systems, personal relationship building is often used to substitute for the lack of strong legal protection.49 Attitudes such as “business first, relationship afterwards” (have a drink after the negotiation) may clash with the norm the other way around (lav- ish entertainment first, talk about business later). For example, we often hear that because of their culture, the Chinese prefer to cultivate personal relationships (guanxi) first. This is not entirely true, because in the absence of a strong legal and regulatory regime in China, investing in personal relationships up front may simply be the initial cost one has to pay if interested in eventually doing business together. Such investment in personal relationships is a must in countries ranging from Argentina to Zimbabwe. The broad range of these countries with different cultural traditions suggests that the interest in cultivating what the Chinese call guanxi, which is a word found in almost every culture (such as blat in Russia and guan he in Vietnam), is not likely to be driven by culture alone, but more signifi- cantly by common institutional characteristics—in particular, the lack of formal market-supporting institutions.

C h a P T E R s u M M a R y

2.1 Explain the concept of institutions and their key role in reducing uncertainty.

Institutions are commonly defined as the rules of the game. Institutions have formal and informal components, each with different sup-

portive pillars. Their key function is to reduce uncertainty, curtail transaction costs, and

combat opportunism. 2.2 Articulate the two core propositions underpinning an institution-based

view of global business.

Proposition 1: Managers and firms rationally pursue their interests and make choices within formal and informal institutional constraints in a given institutional framework.

Proposition 2: When formal constraints are unclear or fail, informal con- straints will play a larger role.

2.3 Identify the basic differences between democracy and totalitarianism.

Democracy is a political system in which citizens elect representatives to govern the country.

Totalitarianism is a political system in which one person or party exercises absolute political control.

56 Part One Laying Foundations

2.4 Outline the differences among civil law, common law, and theocratic law.

Civil law uses comprehensive statutes and codes as a primary means to form legal judgments.

Common law is shaped by precedents and traditions from previous judicial decisions.

Theocratic law is a legal system based on religious teachings, such as Islamic law.

2.5 Understand the importance of property rights and intellectual property rights.

Property rights are legal rights to use an economic resource and to derive income and other benefits from it.

Intellectual property refers to intangible property that is the result of intel- lectual activity.

2.6 Appreciate the differences among market economy, command economy, and mixed economy.

A pure market economy is characterized by laissez faire and total control by market forces.

A pure command economy is defined by government ownership and con- trol of all means of production.

Most countries operate mixed economies, with a different emphasis on market versus command forces.

2.7 Participate in two leading debates concerning politics, laws, and economics.

(1) What drives economic development: Culture, geography, or institu- tions? (2) Private ownership versus state ownership.

2.8 Draw implications for action.

Have a thorough understanding of the formal institutions before entering a country.

Insisting on formalizing the contract in initial negotiations may backfire in some countries.

Beijing Consensus 52 Bounded rationality 39 Civil law 43 Cognitive pillar 36 Command economy 47 Common law 43 Copyright 46 Democracy 40 Economic system 47 Formal institutions 35 Informal institutions 35 Institutional framework 35 Institutional transitions 35 Institutions 35

Institution-based view 35 Intellectual property 45 Intellectual property (IP)

rights 45 Legal system 43 Market economy 47 Mixed economy 47 Moral hazard 51 Norms 36 Normative pillar 35 Opportunism 38 Patent 45 Piracy 46 Political risk 41

Political system 40 Property rights 45 Regulatory pillar 35 Sovereign wealth

fund (SWF) 52 State-owned enterprise

(SOE) 47 Theocratic law 44 Totalitarianism

(dictatorship) 41 Trademark 46 Transaction costs 37 Washington Consensus 51

K e y T e r m s

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 57

R E v I E W Q u E s T I o N s

1. ON CULTURE: Is there any relationship between the culture of a given coun- try and the extent to which it will likely have a dynamic, growing economy? Are there cultures that would be more likely to limit economic growth and even result in poverty? Defend your answer.

2. Compare PengAtlas Maps 1.1 (Developed Economies and Emerging Econo- mies) and Map 1.2 (Political Freedom Around the World). To what extent do developed economies tend to have a high level of political freedom—or is there any relationship? If there is a relationship, is it causal or coincidental? Explain.

3. Compare PengAtlas Map 1.3 (Legal Systems Around the World) and Map 1.1. In your opinion, what stands out to you regarding each category of legal system? Are there any relationships? If so, are they causal or coincidental? Defend your answer.

4. How can the rules of the game reduce uncertainty?

5. Do rules of the game promote or prevent opportunism? Defend your answer.

6. Do you agree that managers and firms really pursue their interests? Why or why not?

7. What are examples of informal constraints that affect global business firms?

8. What are the pros and cons of expanding into a democratic country?

9. What are the pros and cons of expanding into a totalitarian country?

10. Would you rather do business in a country that uses civil law or common law? Why?

11. What are some of the issues to consider before doing business in a theocracy?

12. What is the relationship between property rights and economic development?

13. Why is it important to protect IP rights?

14. Under what circumstances would it be easier to do business in a command economy than a market economy?

15. Many view the United States as a mixed economy. In your opinion, is the mix changing? If so, how? Is it shifting more to a command economy or a market economy? Defend your answer.

16. In your opinion, which is most important to economic development— culture, geography, or institutions? Defend your answer.

17. Given whatever plans you have for the future, do you feel you would have the greatest likelihood of success in a firm under private ownership or state ownership? Why?

18. Why is it important to understand formal institutions before entering a country? Explain by using an example.

19. ON CULTURE: Why is understanding of human relations within a culture sometimes more important than legal expertise?

58 Part One Laying Foundations

C R I T I C a L D I s C u s s I o N Q u E s T I o N s

1. How do you explain your country’s economic success (or failure)?

2. What is your view on the debate between private ownership and state ownership?

3. ON ETHICS: As manager, you discover that your firm’s products are coun- terfeited by small family firms that employ child labor in rural Bangladesh. You are aware of the corporate plan to phase out the products soon. You also realize that once you report to the authorities, these firms will be shut down, employees will be out of work, and families and children will be starving. How do you proceed?

4. ON ETHICS: Your multinational is the largest foreign investor and enjoys good profits in (1) Sudan where government forces are reportedly cracking down on rebels and killing civilians, and (2) Vietnam where religious leaders are reportedly being prosecuted. As country manager, you understand that your firm is pressured by activists to exit these countries. The alleged government actions, which you personally find distasteful, are not directly related to your operations. How would you proceed?

G L o B a L a C T I o N

1. Evaluating political risk is an important element of country risk analysis. In fact, your personal interest relates to countries in the Middle East and North Africa region that have a high political risk. Provide a brief overview of the region and the reasoning behind assessing these countries that have been assessed with high political risk. From this list, which country has the highest overall country risk?

2. Since you work for a diversified multinational corporation, economic risk across different sectors of the world economy is an integral part of analysis as it indicates the future business prospects for specific industries. Evaluate the risk assessment of three industry sectors that are available to analyze. Prepare a report, and provide a recommendation concerning which industry and region would be most beneficial to your company.

v I D E o C a s E

After watching the video on India and China’s economies, discuss the following:

1. What impact do the political systems of each country have on their efforts toward globalization?

2. How do IP rights differ between India and China? What distinctive compe- tencies in IP exist for India and China?

3. Describe how India and China are market economies.

4. Does India have an opportunity to overtake China? Why or why not?

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 59

Cuba is the only practitioner of communism in the Western Hemisphere. Five decades of communism have delivered some accomplishments. Life expec- tancy (at 79 years) is on par with that of the United States, and Cuba has more doctors per person than Britain and France. Social benefits cover everyone from cradle to grave, providing free world-class health care and education in addition to free pensions and funerals. However, people are poor and income is low. The average monthly wage is only $19. Food is often in shortage, forcing the government to ration food. Cuba’s 11 million people enjoy only 600,000 cars that have an average age of 15 years. Half of them belong to the state.

Raúl Castro, the younger brother of the 85-year-old leader Fidel Castro, took over as Cuba’s president in 2008 and as first secretary of the Communist Party in 2011. (For compositional simplicity, this case will refer to each Castro brother by his first name.) Raúl has been busy, transferring a substantial chunk of the state-owned enterprises (SOEs) to private hands, freeing about 130 political prisoners, and signing the UN convention on human rights, something that Fidel had refused to do. While change seems to be in the air, there are limits—after all, Raúl is also a Castro. Neither “reform” nor “transition” is allowed to be mentioned. These words immediately bring back the painful memory of the collapse of the Soviet Union, which overnight withdrew subsidies and traumatized Cuba’s leaders. Instead, the changes are labeled “up- dating,” in which “non-state actors” and “co-opera- tives” will be tolerated. “But,” noted the Economist, “whatever the language, this means an emerging pri- vate sector.”

Thanks to the Soviet collapse, the Cuban econo- my shrank by a painful 35% between 1989 and 1993. In desperation, Fidel declared a national emergency, opened Cuba for foreign direct investment (FDI) and mass tourism, and legalized small family business- es and the use of the dollar. He also found a new

benefactor, Venezuela president Hugo Chávez, who provided Cuba with cheap oil. In exchange, Fidel sent 20,000 doctors and professionals to work in Venezu- ela. As a result, the regime’s demise, widely predicted by the anti-Castro Cuban American community, did not materialize. After surviving the emergency, Fidel went back to the old ways. Many family businesses and foreign ventures were shut down, and the dollar ceased to be legal tender in 2004.

This time, Raúl has proclaimed that changes are here to stay. While Fidel has a massive ego and is famously ideological, Raúl is more modest and more pragmatic. Raúl seems to realize that Cuban commu- nism lives on borrowed time. The economy is terribly unproductive. Cuba has a legendary agricultural past— think of its world-famous cigars and sugar. However, state ownership of farms has been disastrous. Output per head of sugar in 2012 has dropped to an eighth of its level in 1958. State farms control 75% of arable land, but 45% of this lies idle. Raúl has allowed pri- vate farmers and co-ops to lease idle state land. Yet, private farmers have a hard time scraping a living off the land. This is not because the land is not fertile; it is. It is because of the grip of Acopio, the state-owned monopoly supplier of seeds, fertilizer, and equipment as well as the monopoly purchaser of farm produce. There is hardly a market to motivate farmers to try harder.

EmErging markEts: The Future of Cuba

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In manufacturing and services, SOEs are also noto- rious for shoddy quality and low pay. But there is one advantage in working for SOEs: plenty of opportunities to pilfer (steal) supplies from the workplace. Employ- ees’ justification goes like this: The SOE belongs to the state, which belongs to the people—that is, us. Since our wages are so low, we should feel free to take home the stuff that, after all, belongs to us anyway (!). Experi- menting on a limited scale, Raúl has allowed private entrepreneurs to own and operate small shops such as barber shops, beauty parlors, and restaurants, as well as private taxis. Although by global standards, these entrepreneurial opportunities are extremely limited, they nevertheless have attracted well-educated (but starving) professionals, such as teachers, doctors, and accountants, to join the private sector. For example, a doctor who used to make $23 per month can now take home $40 in an improvised craft shop.

Slowly but surely, outside influence has arrived. While US firms cannot do business in Cuba, multination- als from Brazil, Canada, China, and Spain have no such

institution-based barriers. In 2012, 2.7 million tourists (a record) visited Cuba. While the US embargo is still tech- nically in effect, from Miami, eight flights—technically labeled “charter” (not regularly scheduled) flights—go to Havana every day. Although still healthy, Raúl is already 80. The days of the Castros running the show in Cuba are clearly numbered. What does the future hold for Cuba?

CASE DISCUSSION QUESTIONS: 1. Why has state ownership of farms resulted in a

disaster in Cuban farming?

2. ON ETHICS: What are the norms governing employee behavior in Cuban SOEs? Are these norms right or wrong?

3. The Economist predicted that “whatever the in- tentions of Cuba’s communist leaders, they will find it impossible to prevent the island from mov- ing to some form of capitalism.” Do you agree or disagree?

4. Should foreign firms be interested in entering Cuba?

Sources: Based on (1) Economist, 2012, Edging toward capitalism, March 24: 7–9; (2) Economist, 2012, Revolution in retreat, March 24: 3–4; (3) Economist, 2012, The deal’s off, March 24: 5–7; (4) Economist, 2012, The Miami mirror, March 24: 10–11.

N o T E s

[Journal acronyms] AER—American Economic Review; AME—Acad- emy of Management Executive; AMJ—Academy of Management Journal; AMP—Academy of Management Perspectives; AMR—Academy of Man- agement Review; APJM—Asia Pacific Journal of Management; B&P— Business & Politics; BW—BusinessWeek (before 2010) or Bloomberg Businessweek (since 2010); HBR—Harvard Business Review; JBV— Journal of Business Venturing; JEL—Journal of Economic Literature; JEP—Journal of Economic Perspectives; JIBS—Journal of International Business Studies; JMS—Journal of Management Studies; JPE—Journal of Political Economy; JWB—Journal of World Business; SMJ—Strategic Management Journal; WSJ—Wall Street Journal

1 M. W. Peng, 2003, Institutional transitions and strategic choices (p. 275), AMR, 28: 275–296.

2 M. W. Peng, S. Sun, B. Pinkham, & H. Chen, 2009, The institution- based view as a third leg for a strategy tripod, AMP, 23: 63–81; M. W. Peng, D. Wang, & Y. Jiang, 2008, An institution-based view of international business strategy, JIBS, 39: 920–936.

3 D. North, 1990, Institutions, Institutional Change, and Economic Perfor- mance (p. 3), New York: Norton.

4 W. R. Scott, 1995, Institutions and Organizations, Thousand Oaks, CA: Sage.

5 D. Philippe & R. Durand, 2011, The impact of norm-conforming behaviors on firm reputation, SMJ, 32: 969–993.

6 S. Hannah, B. Avolio, & D. May, 2011, Moral maturation and moral conation, AMR, 36: 663–685; S. Nadkarni & P. Barr, 2008,

Environmental context, managerial cognition, and strategic action, SMJ, 29: 1395–1427; B. Tyler & D. Gnyawali, 2009, Managerial collec- tive cognitions, JMS, 46: 93–126.

7 M. W. Peng, 2000, Business Strategies in Transition Economies (pp. 42–44), Thousand Oaks, CA: Sage.

8 O. Branzai & S. Abdelnour, 2010, Another day, another dollar, JIBS, 41: 804–825; M. Czinkota, G. Knight, P. Liesch, & J. Steen, 2010, Terrorism and international business, JIBS, 41: 826–843; H. de Soto, 2011, The destruction of economic facts, BW, May 2: 60–63; T. Khoury & M. W. Peng, 2011, Does institutional reform of intellectual property rights lead to more inbound FDI? JWB, 46: 337–345; S. Lee, Y. Yamakawa, M. W. Peng, & J. Barney, 2011, How do bankruptcy laws affect entrepreneurship development around the world? JBV, 28: 505–520.

9 Economist, 2011, Looking for someone to blame, August 13: 25–26.

10 BW, 2009, The financial crisis excuse, February 23: 32.

11 O. Williamson, 1985, The Economic Institutions of Capitalism (pp. 1–2), New York: Free Press.

12 P. Collier & J. Gunning, 1999, Explaining African economic per- formance, JEL, 37: 64–111.

13 A. Cuervo-Cazurra & L. Dau, 2009, Promarket reforms and firm profitability in developing countries, AMJ, 52: 1348–1368; G. McDermott, R. Corredoira, & G. Kruse, 2009, Public-private institutions as catalysts of upgrading in emerging market societ- ies, AMJ, 52: 1270–1296; M. Wright, I. Filatotchev, R. Hoskisson, &

Chapter 2 Understanding Formal Institutions: Politics, Laws, and Economics 61

M. W. Peng, 2005, Strategy research in emerging economies, JMS, 42: 1–33.

14 M. W. Peng, 2002, Towards an institution-based view of business strategy, APJM, 19: 251–267; C. Stevens & J. Cooper, 2010, A behav- ioral theory of governments’ ability to make credible commitments to firms, APJM, 27: 587–610.

15 A. Chacar, W. Newburry, & B. Vissa, 2010, Bringing institutions into performance persistence research, JIBS, 41: 1119–1140; R. Coeurderoy & G. Murray, 2008, Regulatory environments and the location decision, JIBS, 39: 670–687; K. Huang & F. Murray, 2009, Does patent strategy shape the long-run supply of public knowl- edge? AMJ, 52: 1193–1221; S. Julian, J. Ofori-Dankwa, & R. Justis, 2008, Understanding strategic responses to interest group pres- sures, SMJ, 29: 963–984; T. Kochan, M. Guillen, L. Hunter, & S. O’Mahony, 2008, Public policy and management research, AMJ, 52: 1088–1100; T. Kostova, K. Roth, & M. T. Dacin, 2008, Institu- tional theory in the study of multinational corporations, AMR, 33: 994–1006; B. Lee, 2009, The infrastructure of collective action and policy content diffusion in the organic food industry, AMJ, 52: 1247–1269; C. Marquis & Z. Huang, 2009, The contingent nature of public policy and the growth of US commercial banking, AMJ, 52: 1222–1246; K. Pajunen, 2008, Institutions and flows of foreign direct investment, JIBS, 39: 652–669; T. Tong, T. Alessandri, J. Reuer, & A. Chintakananda, 2008, How much does country matter? JIBS, 39: 387–405.

16 Economist, 2007, Heavy going (p. 5), April 14: 5–7.

17 BW, 2009, NYSE chief Duncan Niederauer on Obama and busi- ness (p. 15), June 8: 15–16.

18 BW, 2009, The overseas tax squeeze, May 18: 18–20.

19 D. Ariely, 2009, The end of rational economics, HBR, July: 78–84; P. Rosenzweig, 2010, Robert S. McNamara and the evolution of mod- ern management, HBR, December: 87–93.

20 M. W. Peng, 2001, How entrepreneurs create wealth in transition economies, AME, 15: 95–108; S. Puffer & D. McCarthy, 2007, Can Russia’s state-managed, network capitalism be competitive? JWB, 42: 1–13.

21 L. Capron & O. Chatain, 2008, Competitors’ resource-oriented strategies, AMR, 33: 97–121; G. Holburn & R. Bergh, 2008, Making friends in hostile environments, AMR, 33: 521–540; S. Lux, T. Crook, & D. Woehr, 2011, Mixing business with politics, JM, 37: 223–247; C. Oliver & I. Holzinger, 2008, The effectiveness of strategic political management, AMR, 33: 496–520; M. Ozer & S. Lee, 2009, When do firms prefer individual action to collective action in the pursuit of cor- porate political strategy? B&P, 11: 1–21.

22 W. Henisz, E. Mansfield, & M. von Glinow, 2010, Conflict, secu- rity, and political risk, JIBS, 41: 759–764; J. Oetzel & K. Getz, 2012, Why and how might firms respond strategically to violent conflict? JIBS, 43: 166–186.

23 Economist, 2012, Wish you were mine, February 11: 51–52.

24 M. Beaulieu, J. Cosset, & N. Essaddam, 2005, The impact of politi- cal risk on the volatility of stock returns, JIBS, 36: 701–718.

25 R. Click & R. Weiner, 2010, Resource nationalism meets the mar- ket, JIBS, 41: 783–803; Q. Li & T. Vashchilko, 2010, Dyadic military conflict, security alliances, and bilateral FDI flows, JIBS, 41: 765–782.

26 R. La Porta, F. Lopez-de-Silanes, A. Shleifer, & R. Vishny, 1998, Law and finance (p. 1118), JPE, 106: 1113–1155.

27 The author’s interview, Middle East Women’s Delegation visiting the University of Texas at Dallas, January 23, 2006.

28 H. de Soto, 2000, The Mystery of Capital, New York: Basic Books.

29 W. Easterly, 2008, Institutions: Top down or bottom up? AER, 98: 95–99.

30 P. Chaudhry & A. Zimmerman, 2009, The Economics of Counterfeit Trade, Berlin: Springer; C. Hill, 2007, Digital piracy, APJM, 24: 9–25.

31 M. W. Peng, 2006, Dealing with counterfeiting, in M. W. Peng, Global Strategy (pp. 137–138), Cincinnati: South-Western Cengage Learning.

32 Heritage Foundation, www.heritage.org.

33 M. Carney, E. Gedajlovic, & X. Yang, 2009, Varieties of Asian capitalism, APJM, 26: 361–380; P. Hall & D. Soskice, 2001, Varieties of Capitalism, Oxford, UK: Oxford University Press.

34 A. Deaton, 2010, Understanding the mechanisms of economic development, JEP, 24: 3–16; D. Ray, 2010, Uneven growth, JEP, 24: 45–60; D. Radrik, 2010, Diagnostics before prescription, JEP, 24: 33–44; M. Rosenzweig, 2010, Microeconomic approaches to devel- opment, JEP, 24: 81–96.

35 D. North, 2005, Understanding the Process of Economic Change (p. 48), Princeton, NJ: Princeton University Press.

36 D. Acemoglu, 2010, Theory, general equilibrium, and political economy in development economics, JEP, 24: 17–32; D. Acemoglu & J. Robinson, 2012, Why Nations Fail, New York: Crown; R. Barro & X. Sala-i-Martin, 2003, Economic Growth, Cambridge, MA: MIT Press.

37 Economist, 2005, Doing business in Africa, July 2: 61.

38 D. North, 1981, Structure and Change in Economic History (p. 164), New York: Norton.

39 Y. Lu, E. Tsang, & M. W. Peng, 2008, Knowledge management and innovation in the Asia Pacific (p. 359), APJM, 25: 361–374.

40 M. Porter & J. Rivkin, 2012, Choosing the United States (p. 90), HBR, March: 80–93.

41 State ownership is also often referred to as “public ownership.” However, since a lot of privately owned firms are publicly listed and traded that can cause confusion, I have decided to use “state owner- ship” here to minimize confusion.

42 M. W. Peng, 2000, Business Strategies in Transition Economies (p. 24), Thousand Oaks, CA: Sage.

43 P. Bernstein, 2009, The moral hazard economy, HBR, July-August: 101–102; S. Harrington, 2009, Moral hazard and the meltdown, WSJ, May 23, online.wsj.com.

44 J. Kornai, 1992, The Socialist System, Princeton, NJ: Princeton Uni- versity Press.

45 M. W. Peng, G. Bruton, & C. Stan, 2012, Theories of the (state- owned) firm, Working paper, University of Texas at Dallas.

46 Economist, 2012, The rise of state capitalism, January 21: 11.

47 R. Orr & W.R. Scott, 2008, Institutional exceptions on global projects, JIBS, 39: 562–588.

48 D. Malhotra, 2009, When contracts destroy trust, HBR, May: 25.

49 C. Su, Z. Yang, G. Zhuang, N. Zhou, & W. Dou, 2009, Interper- sonal influence as an alternative channel behavior in emerging mar- kets, JIBS, 40: 668–689.

To r

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Learning Objectives

After studying this chapter, you should be able to

3-1 define what culture is and articulate its four main manifestations: language, religion, social structure, and education.

3-2 discuss how cultures systematically differ from each other.

3-3 understand the importance of ethics and ways to combat corruption.

3-4 identify norms associated with strategic responses when firms deal with ethical challenges.

3-5 participate in three leading debates concerning cultures, ethics, and norms.

3-6 draw implications for action.

Emphasizing Informal Institutions: Cultures, Ethics, and Norms

The Swiss unit of French engineering giant Alstom builds infrastructure projects, especially power sta- tions, all over the world. As is typical for engineering and construction firms, Alstom sends its engineers out, often on short-term expatriate assignments for a few months. These construction projects are typi- cally in remote locations far away from major cities, and the engineers have to become accustomed to working with a local workforce and living in the lo- cal community. They thus have to learn to adapt— quickly.

Cultural differences often become most evident when people enjoy social events ranging from lunch meetings to parties. A Swiss Alstom engineer recalls his experience when partying with colleagues in Saudi Arabia:

Once there was a farewell for someone from the building site. On this occasion, there was a little celebration. We were told, at midday, that there would be a party after work. We waited and were wondering what would happen, where they would do it, and if they would bring something. There were neither chairs nor tables. Around 2 PM, they came with huge aluminum tablets, the size of a wagon wheel, filled up with rice, and in the middle a huge piece of mutton, grilled mutton. Finally, three or four of these tablets

were on the floor of the workshop. They just put them on the floor! Of course we had cleaned up before. They came dressed in their celebratory dresses, and we expected some sort of cer- emony. But they just sat down on the floor in the white gowns, around the tablets, and started eating.

The [Swiss] colleague who was with me was a vegetarian. He said, “I won’t squat on the floor like that, and I won’t eat anything either.” Every- one had a piece of mutton in his hand—it was incredible. One would hold the mutton, and an- other pulled out a chunk and passed it to me: “Here, mutton, that’s good, you must eat!” We had no plates, nothing. Everyone grabbed from the party bowl, and scooped out a handful of rice. And now, my mate said: “I won’t squat on the floor like that.” I said, “Come on, let’s just sit down. You don’t have to eat mutton, but you can at least do as if you are.”

Our Saudi colleagues were very happy that we were there, and that they could invite us for this meal. It was important to them that we would participate. We had known these people from work, but still, initially, the atmosphere was a bit uncomfortable. We didn’t know how to behave. But then, after we sat down, and meat

O p e n i n g C a s e

EmErging markEts: Partying in Saudi Arabia

64 Part One Laying Foundations

Why does partying in Saudi Arabia involve people picking meat from the same piece of mutton and scooping rice with their bare hands? Why did one Swiss colleague initially feel uncomfortable? Why did the other Swiss colleague (the author) have a different attitude when participating in this “strange” party? Why did the Saudi colleagues have immense joy when hearing Swiss colleagues speak a few words of Arabic? After the party, did the Saudi and Swiss colleagues work more closely and effectively? More fundamentally, what informal institutions govern individual behavior and firm behavior in different countries?

This chapter continues our coverage of the institution-based view, which began with formal institutions in Chapter 2. Here we focus on informal institutions represent- ed by cultures, ethics, and norms. As informal institutions, cultures, ethics, and norms play an important part in shaping the success and failure of firms around the globe. Remember that the institution-based view suggests two propositions. First, manag- ers and firms rationally pursue their interests within a given institutional framework. Second, in situations where formal institutions are unclear or fail, informal institutions play a larger role in reducing uncertainty. The first proposition deals with both formal and informal institutions. The second proposition hinges on the informal institutions we are about to discuss. As the Opening Case shows, informal institutions are about more than just how to wine and dine properly. Informal institutions can facilitate better relationships among people who come from different backgrounds, which is why they deserve a great deal of our attention.1

Where Do Informal Institutions Come From? Recall that any institutional framework consists of formal and informal institutions. While formal institutions such as politics, laws, and economics (see Chapter 2) are important, they make up a small (although important) part of the “rules of the game” that govern individual and firm behavior. As pervasive features of every economy, informal institutions can be found almost everywhere.2

Where do informal institutions come from? They come from socially trans- mitted information and are a part of the heritage that we call cultures, ethics, and norms. Those within a society tend to perceive their own culture, ethics, and norms as “natural, rational, and morally right.”3 This self-centered mentality is known as ethnocentrism. For example, many Americans believe in “American exceptionalism”—that is, the United States is exceptionally well endowed to lead the world. The Chinese call China zhong guo, which literally means “country in the

Ethnocentrism

A self-centered mentality held by a group of people who per- ceive their own culture, ethics, and norms as natural, rational, and morally right.

was passed around, it became real interesting. We talked and relaxed. My mate also sat down and afterwards he said he enjoyed it very much. The English vocabulary of those people was quite limited, so we had to talk “with hands and feet.” Even so, we were chatting about work, what kind of rice this was, and what was in the rice. It was typical Saudi rice with raisins and the taste was quite fantastic. We couldn’t talk much,

the language barrier was just there. But then we picked up a few bits of Arabic, and the next morning we could say “Good morning” in Arabic. Everyday a word more, they had immense joy hearing us speak Arabic.

Source: N. Felix, 2007, Dann hat man es gewusst, und dann war gut (p. 30), in M. Spisak and H. Stalder (eds.), In der Fremde (pp. 29–37). Bern, Switzerland: Haupt. The original was in German, and was translated by Professor Klaus Meyer (China Europe International Business School). © Haupt Bern. Reproduced with permission.

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 65

middle” or “middle kingdom.” Ancient Scandinavians called their country by a similar name (midgaard).

Recall from Chapter 2 that informal institutions are underpinned by the two normative and cognitive pillars, while formal institutions are supported by the reg- ulatory pillar. While the regulatory pillar clearly specifies the do’s and don’ts, in- formal institutions, by definition, are more elusive. Yet, they are no less important. Thus, it is imperative that we pay attention to the three major aspects of informal institutions highlighted in this chapter: culture, ethics, and norms.

3-1 Culture Out of many informal institutions, culture probably is most frequently discussed. This section first defines culture, and then highlights four major components.

3-1a Definition of Culture Among hundreds of definitions of culture, we will use the definition proposed by the world’s foremost cross-cultural expert, Geert Hofstede, a Dutch professor. He defines culture as “the collective programming of the mind which distinguishes the members of one group or category of people from another.”4 Before proceed- ing, it is important to clarify two points to minimize confusion. First, although it is customary to talk about American culture or Brazilian culture, there is no strict one-to-one correspondence between cultures and nation-states. Within many mul- tiethnic countries such as Belgium, Brazil, China, India, Indonesia, Russia, South Africa, Switzerland, and the United States, many subcultures exist.5 Emerging Markets 3.1 shows that North Vietnam and South Vietnam, continue to be differ- ent even 40 years after unification. Second, there are many layers of culture, such as regional, ethnic, and religious cultures. Within a firm, one may find a specific organizational culture (such as the IKEA culture). Having acknowledged the valid- ity of these two points, we will follow Hofstede by using the term “culture” when discussing national culture—unless otherwise noted. This is not only a matter of ex- pediency, but also a reflection of the institutional realities of the world with about 200 nation-states.

Each one of us is a walking encyclopedia of our own culture. Due to space constraints, we only highlight four major components of culture: (1) language, (2) religion, (3) social structure, and (4) education.

3-1b Language Among approximately 6,000 languages in the world, Chinese is the largest lan- guage in terms of the number of native speakers.6 English is a distant second, fol- lowed closely by Hindi and Spanish (Figure 3.1). Yet, the dominance of English as a global business language, known as the lingua franca in the jargon, is unmistak- able.7 This is driven by two factors. First, English-speaking countries contribute the largest share of global output (Figure 3.2). Such economic dominance not only drives trade and investment ties between English-speaking countries and the rest of the world, but also generates a constant stream of products and services marketed in English—think about the ubiquitous Hollywood movie, the Economist magazine, and Google.

Learning Objective Define what culture is and articulate its four main manifestations: language, religion, social structure, and education.

3-1

Culture

The collective programming of the mind that distinguishes the members of one group or cat- egory of people from another.

Lingua franca

A global business language.

66 Part One Laying Foundations

Second, recent globalization has called for the use of one common language. Countries sharing a common official language obviously will find it easier and cheaper to trade with each other. Interestingly, countries that do not share a common official language—as long as they share a common foreign language— may still benefit from increased trade and investment. In European countries where English is not an official language, the ability to speak English fluently helps facilitate bilateral trade significantly. Hypothetically, if English proficiency in all European countries were to increase by 10% (while keeping UK and Irish profi- ciency levels constant), intra-Europe trade would grow by 15%. Bringing up the English proficiency of all Europeans to the level of the Dutch (which is very high) would boost intra-Europe trade by 70%.8

Around the world, non-native speakers of English who can master English, such as the Taiwanese-born Hollywood director Ang Lee, Icelandic-born singer Björk, and Colombian-born pop star Shakira, increasingly command a premium in jobs and compensation. This fuels the rising interest in English. The European Union (EU) insists that documents be translated into all official languages. The 23 official languages for 27 member countries make this requirement almost impossible to

In 2015, Vietnam celebrates 40 years of unification. In 1975, North Vietnam “liberated” South Vietnam and renamed Saigon, capital city of the South, Ho Chi Minh City. With different dialects, food, and weather, the two regions have always been very different. Northerners are considered serious and bookish, while Southerners tend to be flexible and flamboyant—similar to the stereotypes of Scandinavians and Mediterraneans in Europe. The Vietnam War (which the Vietnamese call the “American War”) exacerbated these differences. North Vietnam has been under communist rule since 1954. South Vietnam has had much more recent expe- rience with capitalism. The diaspora of Southerners, who fled from the Northern communists in the 1970s, has become the Viet Kieu—overseas Vietnamese. Viet Kieu have flocked to the South since the beginning of the Doi Moi (market liberalization) policy in 1986. Despite the harsh communist re-education programs

to cleanse the Southerners of capitalist values, the economic center of gravity remains in the South. Ho Chi Minh City, with 9% of the nation’s population, has recently contributed 17% of national output, 30% of foreign investment, and 40% of exports. Its per capita income is four times the national average.

Four decades after the war, Ho Chi Minh City’s sky- line is again emblazoned with American brands such as Citigroup and Sheraton. In 2004, when United Airlines resumed flights to Ho Chi Minh City, it was pleasantly surprised to find that the city’s airport code was still SGN. When I taught in the country’s first Executive MBA (EMBA) program (consisting of both Northerners and Southerners) in Hanoi in 1997, my South Vietnamese EMBA students advised me: “No need to call that city Ho Chi Minh City. It has too many words. Every- body just calls it Saigon in the South.” It seems that in Vietnam—war or peace—old habits die hard.

North Vietnam versus South Vietnam

E m E r g i n g m a r k E t s 3 . 1

Sources: Based on (1) Author’s interviews; (2) Business Times (Hanoi), 2012, City GDP growth rate rises in first quarter, April 6, businesstimes.com.vn; (3) Economist, 2005, America lost, capitalism won, April 30: 37–38; (4) K. Meyer & H. Nguyen, 2005, Foreign investment strategies and sub-national institutions in emerging markets: Evidence from Vietnam, Journal of Management Studies, 42: 63–93; (5) D. Ralston, V. T. Nguyen, & N. Napier, 1999, A comparative study of the work values of North and South Vietnamese managers, Journal of International Business Studies, 30: 655–672.

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Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 67

Figure 3.2 Native Speakers of Top Six Languages as Percentage of Contribution to World Output

Sources: Author’s estimates based on data in World Bank, 2009, World Development Indicators database (www.worldbank.org).

English (40%)

Japanese (13%)

German (7%)

Chinese (6%)

French (6%)

Spanish (4%)

Others (24%)

Figure 3.1 Native Speakers of Top Six Languages as Percentage of World Population

Sources: Author’s estimates based on data in (1) The Economist Atlas, 2005, London: The Economist Books; (2) D. Graddol, 2004, The future of language, Science, 303: 1329–1331; (3) S. Huntington, 1996, The Clash of Civiliza- tions and the Remaking of World Order, New York: Simon & Schuster. Only native speakers (people who speak a language as a first language/mother tongue) are included in our calculations.

Chinese (20%)

English (6%)

Hindi (5%)

Spanish (5%)

Arabic (4%)

Russian (4%)

Others (56%)

68 Part One Laying Foundations

satisfy. For example, hardly anyone can fluently translate Estonian into Portuguese. An Estonian document needs to be translated into English, which then can be translated into Portuguese. Translators well versed in English, thus, are in much greater demand.

On the other hand, the dominance of English, which does give native speakers of English a great deal of advantage in global business, may also lead to a disad- vantage. An expatriate manager not knowing the local language misses a lot of cultural subtleties and can only interact with locals fluent in English. Weak (or no) ability in foreign languages makes it difficult (or impossible) to detect translation errors, which may result in embarrassments. For example, Coors Beer translated its slogan “Turn it loose!” into Spanish as “Drink Coors and get diarrhea!” Ford mar- keted its Nova car in Latin America with disastrous results—“Nova” means “no go” in Spanish.9 To avoid such embarrassments, you will be better off if you can pick up at least one foreign language during your university studies.

3-1c Religion Religion is another major manifestation of culture. Approximately 85% of the world’s population reportedly has some religious belief (see PengAtlas Map 1.4). The four leading religions are (1) Christianity (approximately 1.7 billion adherents), (2) Islam (1 billion), (3) Hinduism (750 million), and (4) Buddhism (350 million). Of course, not everybody claiming to be an adherent actively practices a religion. For instance, some Christians may go to church only once every year—during Christmas.

Because religious differences have led to numerous challenges, knowledge about religions is crucial even for non-religious managers. For example, in Christian countries, the Christmas season represents the peak in shopping and consump- tion. In the United States, half of the toys are sold in one month before Christmas. Since (spoiled) kids in America consume half of the world’s toys and virtually all toys are made outside the United States (mostly in Asia), this means 25% of the world toy output is sold in one country in a month, thus creating severe production, distribution, and coordination challenges. For toy makers and stores, missing the boat from Asia, whose transit time is at least two weeks, can literally devastate an entire season (and probably the entire year).

Managers and firms ignorant of religious differences may end up with embar- rassments and, worse, disasters. For example, a US firm blundered in Saudi Arabia by sending a meticulously prepared proposal bound with an expensive pigskin leather cover, hoping to impress the clients. The proposal was never read and soon rejected, because Muslims avoid pig products. The hope is that religiously sensitive managers and firms will avoid such blunders in the future.

3-1d Social Structure Social structure refers to the way a society broadly organizes its members—with rigidity or flexibility. There are two key terms. Social stratification is the hierarchi- cal arrangement of individuals into social categories (strata) such as classes, castes, and divisions within a society. Social mobility refers to the degree to which members from a lower social category can achieve a higher status. In general, highly strati- fied societies have a low degree of social mobility. For example, India is well known for its caste system, in which individuals born into the lowest caste would have very little chance of breaking into the social circles and jobs occupied by members of

Social structure

The way a society broadly organizes its members.

Social stratification

The hierarchical arrangement of individuals into social categories (strata) such as classes, castes, or divisions within a society.

Social mobility

The degree to which members from a lower social category can rise to a higher status.

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 69

the highest caste. Britain historically had a rigid class system with low social mobil- ity. Only in newer environments, such as Australia, Canada, and the United States, could upwardly mobile but lower-class British individuals have greater chances of advancing socially and economically. It was this relatively loose social structure and high social mobility in the newly founded English-speaking colonies and countries that attracted waves of British immigrants from the lower social strata in the last several centuries.

Social structure is the outcome of a society’s formal and informal rules of the game that give birth to its norms and values. In China, pronounced social stratifica- tion can be found along the urban-rural divide. While urban dwellers around the world often informally look down on rural residents (by calling them “rednecks” or “country bumpkins”), in China such discrimination is enhanced by formal laws known as the official residence (hukou) system. Approximately 80% of Chinese citi- zens whose identification (ID) cards specify their official residence to be in rural areas have no health insurance, cannot compete for high-class urban jobs at state- owned firms, and cannot send their children to urban schools—all of which are priv- ileges enjoyed by urban dwellers. As migrant workers, many rural residents travel to urban areas to find low-end jobs and live in shanty towns. Although they may be un- officially living in urban areas, they have very little hope of achieving social mobility.

Multinational enterprises (MNEs) operating in highly socially stratified coun- tries need to be sensitive to local norms. The most suitable person for a job may not necessarily be the most technically qualified individual. Hiring managers from traditionally lower socioeconomic strata to supervise employees from more presti- gious socioeconomic backgrounds may torpedo workplace morale and create hard feelings.

At the same time, it is important to note that all societies evolve. Even socially rigid societies such as India, Britain, and China have experienced institutional transitions that have facilitated social mobility in recent decades. For example, in India, the caste system has been legally banned (although it is still widely practiced informally). In the last two decades, Britain have been slowly moving toward a rela- tively “classless” society similar to that of the United States. Likewise, the last three decades of economic reforms in China have made a large number of entrepreneurs with rural backgrounds very affluent. Owning companies and properties and creat- ing jobs in urban areas, they can hardly care less about their lack of urban ID cards. While these entrepreneurs are clearly exceptions rather than the rule, they do help break down barriers for social mobility during China’s institutional transitions.

3-1e Education Education is an important component of any culture (see PengAtlas Map 1.5). From an early age, schools teach children mainstream values and norms and fos- ter a sense of cultural identity. In collectivistic societies, schools often foster col- lectivistic values and emphasize the “right” answers in learning. In individualistic societies, schools emphasize individual initiatives and encourage more indepen- dent thinking with a lot of questions with “no right or wrong answers”—think of all the debates introduced in this book.

In socially rigid societies, education—especially access to a small number of elite schools and universities—is one of the primary means to maintain social strat- ification. In an effort to limit access, Cambridge and Oxford Universities, until recently, guaranteed a certain percentage of entry positions for graduates from

70 Part One Laying Foundations

prestigious private schools (such as Eton). Here is a quiz: Which is the most selective university in the world? The answer is the Indian Institute of Management (IIM). Every year, its seven campuses accept only 1,500 students out of approximately 300,000 applicants—a 0.5% accep- tance ratio (!). Such limited access to higher education opportunities fosters social stratification.

On the other hand, in socially mobile societies, ed- ucation is typically one of the leading forces to break down social barriers. In Britain, the number of universi- ties expanded from 46 to 84 in the 1990s and then to 115 in the 2000s, resulting in significantly broader access to higher education by more members of the society. Britain is not alone in this regard. Overall, the dramatic expansion of higher education around the world in postwar decades has facilitated more social mobility.

In addition to language, religion, social structure, and education, there are numerous other manifesta- tions of culture. However, if we keep going with these differences, this chapter—in fact, this book—may never end, given the tremendous differences around the world. Readers will be frustrated with a seemingly ran- dom collection of the “rules of the game”: Do this in Muslim countries, don’t do that in Catholic countries, and so on. While all these are interesting “trees,” let us not forget that we are more interested in the “forest.” The point about seeing the “forest” is to understand how cultures are systematically different. This is done next.

3-2 Cultural Differences Before reading this chapter, every reader already knows that cultures are differ- ent. There is no controversy in stating that the Indian culture is different from the Indonesian culture. But how are the Indian and Indonesian cultures systematically different? This section outlines three different ways to understand cultural differ- ences systematically: (1) context, (2) cluster, and (3) dimension approaches. Then, culture is linked with different firm behavior.

3-2a The Context Approach Of the three main approaches probing into cultural differences, the context ap- proach is the most straightforward, because it relies on a single dimension: con- text.10 Context is the underlying background upon which social interaction takes place. Figure 3.3 outlines the spectrum of countries along the dimension of low context versus high context. In low-context cultures (such as North American and Western European countries), communication is usually taken at face value without much reliance on unspoken context. In other words, “No” means “No.” In contrast, in high-context cultures (such as Arab and Asian countries), communication relies a lot on the underlying unspoken context, which is as important as the words used. For example, “No” does not necessarily mean “No.”

Learning Objective Discuss how cultures systematically differ from each other.

3-2

Context

The underlying background upon which social interaction takes place.

Low-context culture

A culture in which communica- tion is usually taken at face value without much reliance on unspo- ken context.

High-context culture

A culture in which communica- tion relies a lot on the underlying unspoken context, which is as important as the words used.

How is higher education related to social stratification and culture?

hr is

S ch

m id

t/ iS

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P ho

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 71

Why is context important? This is because failure to understand the differ- ences in interaction styles may lead to misunderstanding. For instance, in Japan, a high-context culture, negotiators prefer not to flatly say “No” to a request. They will say something like “We will study it” or “We will get back to you later.” Their negotiation partners are supposed to understand the context of these responses that lack enthusiasm and figure out that these responses essentially mean “No” (although “No” is never mentioned). In the United States, a low-context culture, lawyers often participate in negotiations, by essentially attempting to remove the “context”—a contract should be as straightforward as possible, and parties are not supposed to “read between the lines.” Because of this reason, negotiators from high-context countries (such as China) often prefer not to involve lawyers until the very last phase of contract drafting. In high-context countries, initial rounds of ne- gotiations are supposed to create the “context” for mutual trust and friendship. For individuals brought up in high-context cultures, decoding the context and acting accordingly are their second nature. Straightforward communication and confron- tation, typical in low-context cultures, often baffle them.

3-2b The Cluster Approach The cluster approach groups countries that share similar cultures together as one cluster. There are three influential sets of clusters (Table 3.1). The first is the Ronen and Shenkar clusters, proposed by management professors Simcha Ronen and Oded Shenkar.11 In alphabetical order, these clusters are: (1) Anglo, (2) Arabic, (3) Far Eastern, (4) Germanic, (5) Latin American, (6) Latin European, (7) Near Eastern, and (8) Nordic.

The second set of clusters is called the GLOBE clusters, named after the Global Leadership and Organizational Behavior Effectiveness project led by management professor Robert House.12 The GLOBE project identifies ten clusters, five of which use identical labels as the Ronen and Shenkar clusters: (1) Anglo, (2) Germanic Europe, (3) Latin American, (4) Latin Europe, and (5) Nordic Europe. In addition, GLOBE has (6) Confucian Asia, (7) Eastern Europe, (8) Middle East, (9) Southern Asia, and (10) Sub-Saharan Africa, which roughly (but not completely) correspond with the respective Ronen and Shenkar clusters.

The third set of clusters is the Huntington civilizations, popularized by po- litical scientist Samuel Huntington. A civilization is “the highest cultural group- ing of people and the broadest level of cultural identity people have.”13 Shown in Table 3.1, Huntington divides the world into eight civilizations: (1) African, (2) Confucian (Sinic), (3) Hindu, (4) Islamic, (5) Japanese, (6) Latin American, (7) Slavic-Orthodox, and (8) Western. While this classification shares a number of similarities with the Ronen and Shenkar and GLOBE clusters, Huntington’s

Cluster

Countries that share similar cultures.

Civilization

The highest cultural grouping of people and the broadest level of cultural identity people have.

Figure 3.3 High-Context versus Low-Context Cultures

Chinese Korean Japanese Arab

Spanish American, British,

Canadian

Scandi- navian

German, Swiss

High-context cultures

Low-context cultures

High context

Low context

en ga

ge L

ea rn

in g

72 Part One Laying Foundations

Western civilization is a very broad cluster that is subdivided into Anglo, Germanic, Latin Europe, and Nordic clusters by Ronen and Shenkar and GLOBE. In addi- tion to such an uncontroversial classification scheme, Huntington has advanced a highly controversial idea that the Western civilization will clash with the Islamic and Confucian civilizations in the years to come.

For our purposes, we do not need to debate the validity of Huntington’s pro- vocative thesis of the “clash of civilizations”—we will leave your political science or international relations classes to debate that. However, we do need to appreciate the underlying idea that people and firms are more comfortable doing business with other countries within the same cluster/civilization. This is because common language, history, religion, and customs within the same cluster/civilization reduce the liability of foreignness when operating abroad (see In Focus 3.1). For example, Hollywood movies are more likely to succeed in English-speaking countries. Most foreign investors in China are from Hong Kong and Taiwan—in other words, they are not very “foreign.”

Table 3.1 Cultural Clusters1

Ronen and Shenkar Clusters2 GLOBE Clusters3 Huntington Civilizations

Anglo Anglo Western (1)4

Arabic Middle East Islamic

Far East Confucian Asia Confucian (Sinic)

Germanic Germanic Europe Western (2)

Latin America Latin America Latin American

Latin Europe Latin Europe Western (3)

Near Eastern Southern Asia Hindu

Nordic Nordic Europe Western (4)

Central and Eastern Europe Eastern Europe Slavic-Orthodox

Sub-Saharan Africa Sub-Saharan Africa African

Independents: Brazil, India, Israel, Japan

Japanese

1 This table is the first time these three major systems of cultural clusters have been compiled side by side. Viewing them together can allow us to see their similarities. However, there are also differences. Across the three systems (columns), even though clusters sometimes share the same labels, there are still differences. For example, Ronen and Shenkar’s Latin America cluster does not include Brazil (which is regarded as an “independent”), whereas GLOBE and Huntington’s Latin America includes Brazil. 2 Ronen and Shenkar originally classified eight clusters (in alphabetical order, from Anglo to Nordic), covering 44 coun- tries. They placed Brazil, India, Israel, and Japan as “independents.” Upon consultation with Oded Shenkar, my col- leagues and I more recently added Central and Eastern Europe and Sub-Saharan Africa as two new clusters—see Peng, Hill, and Wang (2000) cited as (3) below. 3 GLOBE includes ten clusters, covering 62 countries. 4 Huntington includes eight civilizations, in theory covering every country. For the Western civilization, he does not use such labels as Western 1, 2, 3, and 4 as in the table. They are added by the present author to establish some rough correspondence with the respective Ronen and Shenkar and GLOBE clusters.

Sources: Based on (1) S. Huntington, 1996, The Clash of Civilizations and the Remaking of World Order, New York: Simon & Schuster; (2) R. House, P. Hanges, M. Javidan, P. Dorfman, & V. Gupta (eds.), 2004, Culture, Leader- ship, and Organizations: The GLOBE Study of 62 Societies, Thousand Oaks, CA: Sage; (3) M. W. Peng, C. Hill, & D. Wang, 2000, Schumpeterian dynamics versus Williamsonian considerations, Journal of Management Studies, 37: 167–184; (4) S. Ronen & O. Shenkar, 1985, Clustering countries on attitudinal dimension, Academy of Manage- ment Review, 10: 435–454.

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 73

Learning Objective Understand the importance of ethics and ways to combat corruption.

3.3

“Central Europe” is both an ancient concept and a modern one. As a modern concept, it has only been used widely in the last two decades after the end of the Cold War. Between 1945 and 1989, the Cold War fostered East-West conflicts and Europe was split in the middle by the Iron Curtain. As mem- bers of the Warsaw Pact, (former) Czechoslovakia, Hungary, and Poland were widely regarded by peo- ple outside the region as “Eastern European” (or simply Eastern or Soviet bloc) countries. In other words, the Cold War convention of bipolar terms of “East” and “West” did not permit thinking of any part of Europe in the middle that was neither East nor West.

The end of the Cold War and the removal of communism throughout the former Eastern Bloc facilitated new thinking. “Central Europe,” as part of a new region called “Central and Eastern Europe” (CEE), has become a widely used label both by people in this region and outsiders. So, what exactly is Central Europe? If this concept is meaningful, it has to be different from Western, Eastern, and Southeastern Europe (see PengAtlas Map 2.4). Two definitions have emerged. The first includes the former Eastern bloc countries of the Czech Republic, Hungary, Poland, and Slovakia, as well as Croatia and Slovenia (which broke away from the former Yugoslavia). These countries have long been influenced by Western European culture because they were converted to Roman Catholicism about 1,000 years ago. Western Christendom’s centuries-long confrontation with the Oriental and Islamic empire of the Ottoman Turks also helped define Central Europe as a cultural and historical region. This is because many battles against the Turks, fought by forces drawn throughout Europe, took place in this region, which was known as the “bulwark of Europe.” The common fate of these smaller countries, which lost their independence due to conquests by powerful neighbors such as Austrians, Germans, Russians, and Turks, also binds them together. A second definition of Central Europe is to not only include these countries mentioned in the first definition, but also add Germany and Austria,

which historically and contemporarily have special relationships with the region. “Central Europe” as a historical concept grew out of a German term, Mitteleuropa, and German used to be the lingua franca among Central Europeans. Many of these independent countries used to be part of the Austrian (and between 1867 and 1918 Austrian-Hungarian) empire. Today, an increasing number of Germans and Austrians—together with Czechs, Hungarians, Poles, Slovaks, and Slovenes—call themselves “Central Europeans.”

Highlighting a common Central European identity is not just an academic exercise. It has profound geo- political and business implications. The first defini- tion enables Central Europeans to break away from the “Eastern Europe” (or Soviet bloc) image, and to position themselves as politically, economically, and socially more advanced relative to Russia and other former Soviet countries. This facilitated entrance into the European Union (EU). In 2004, the Czech Republic, Hungary, Poland, Slovakia, and Slovenia be- came full-fledged EU members. Citizens from these countries can now travel freely, without passport con- trol or visa headaches, into Austria, Germany, or any other EU country. The second definition facilitates many multinationals to establish their CEE headquar- ters in Vienna, with responsibilities to cover the entire region.

However, as Central European countries be- come more “normal” (after all, they have met all EU accession criteria and become members), many multinationals are rethinking why they even want to have a separate regional headquarters for CEE. Few multinationals bother to have a separate “Western Europe” headquarters. As the 2008–2009 global financial crisis and the 2010–2012 euro crisis (also known as the Greek crisis) hit, many multination- als have been thinking about shutting down CEE headquarters to cut costs—or to set up a new regional headquarters in Moscow or St. Petersburg to emphasize the “R” in “BRIC.” In other words, if the EU represents the quintessential “West- ern Europe,” then Central European countries, all

IN FoCuS 3.1 Defining Central Europe

74 Part One Laying Foundations

3-2c The Dimension Approach While both the context and cluster approaches are interesting, the dimension ap- proach is more influential. The reasons for such influence are probably twofold. First, insightful as the context approach is, context only represents one dimension. What about other dimensions? Second, the cluster approach has relatively little to offer regarding differences of countries within one cluster. For example, what are the differences between Italy and Spain, both of which belong to the same Latin Europe cluster according to Ronen and Shenkar and GLOBE? By focusing on multiple dimensions of cultural differences both within and across clusters, the dimension approach has endeavored to overcome these limitations. While there are several competing frameworks,14 the work of Hofstede and his colleagues is by far the most influential and thus is our focus.

Hofstede and his colleagues have proposed five dimensions (Figure 3.4). First, power distance is the extent to which less powerful members within a country expect and accept that power is distributed unequally. For example, in high power distance Brazil, the richest 10% of the population receive approximately 50% of the national income, and everybody accepts this as “the way it is.” In low power distance Sweden, the richest 10% only get 22% of the national income. Even within the same cluster, there are major differences. For example, in the United States, subordinates often ad- dress their bosses on a first-name basis, a reflection of a relatively low power distance. While this boss, Mary or Joe, still has the power to fire you, the distance appears to be shorter than if you had to address this person as Mrs. Y or Dr. Z. In low power distance American universities, all faculty members, including the lowest ranked assistant pro- fessors, are commonly addressed as “Professor A.” In high power distance British uni- versities, only full professors are allowed to be called “Professor B.” (Everybody else is called “Dr. C” or “Ms. D” if D does not have a PhD). German universities are per- haps most extreme: Full professors with PhDs need to be honored as “Prof. Dr. X”— your author would be “Prof. Dr. Peng” if I were to work at a German university.

Second, individualism refers to the perspective that the identity of an individual is fundamentally his or her own, whereas collectivism refers to the idea that the identity of an individual is primarily based on the identity of his or her collective group (such as family, village, or company). In individualistic societies (led by the United States), ties between individuals are relatively loose and individual achievement and freedom are highly valued. In contrast, in collectivist societies (such as many countries in Af- rica, Asia, and Latin America), ties between individuals are relatively close and col- lective accomplishments are often sought after. In Chinese restaurants, most dishes are served “family style” to be shared by all the people around the table. In American

Power distance

The extent to which less power- ful members within a country expect and accept that power is distributed unequally.

Individualism

The idea that an individual’s identity is fundamentally his or her own.

Collectivism

The idea that an individual’s identity is fundamentally tied to the identity of his or her collec- tive group.

of which are EU members now, may no longer need to be viewed as a “special” case with all the attention and affection lavished on them as in the immediate aftermath of the Cold War. The question currently confronting many policymakers, scholars, and managers in the region is: Other than being a historical, cultural, and geographical concept, what

are the values of highlighting a Central European identity?

Sources: Based on (1) author’s interviews; (2) Z. Bakay, 2012, Overview of CEE economies and future outlook, presentation at CEE Research Conference, WU, Vienna, Austria, March; (3) L. Johnson, 1996, Central Europe, Oxford, UK: Oxford University Press; (4) A. Schuh, 2012, Business and management research on CEE, presentation at CEE Research Conference, WU, Vienna, Austria, March.

IN FoCuS 3.1 (continued)

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 75

restaurants, most dishes are served “individual style” to be only enjoyed by particular persons who order them. Shown in our Opening Case, some Swiss engineers who came from an individualistic culture were astonished when partying with their collec- tivistic colleagues in Saudi Arabia, where everybody would pick meat from the same piece of mutton and scoop rice from the same party bowl using their bare hands.

Third, the masculinity versus femininity dimension refers to sex role differentia- tion. In every traditional society, men tend to have occupations that reward asser- tiveness, such as politicians, soldiers, and executives. Women, on the other hand, usually work in caring professions, such as teaching and nursing, in addition to being homemakers. High-masculinity societies (led by Japan) continue to maintain such a sharp role differentiation along gender lines. In Saudi Arabia, women are not allowed to drive cars. In low masculinity societies (led by Sweden), women increas- ingly become politicians, scientists, and soldiers (think about the movie GI Jane), and men frequently assume the role of nurses, teachers, and househusbands.

Fourth, uncertainty avoidance refers to the extent to which members in dif- ferent cultures accept ambiguous situations and tolerate uncertainty. Members of high uncertainty avoidance cultures (led by Greece) place a premium on job security and retirement benefits. They also tend to resist change, which, by defi- nition, is uncertain. Low uncertainty avoidance cultures (led by Singapore) are characterized by a greater willingness to take risk and less resistance to change.

Masculinity

A relatively strong form of societal-level sex role differentiation whereby men tend to have occupations that reward assertiveness and women tend to work in caring professions.

Femininity

A relatively weak form of societal-level sex role differen- tiation whereby more women occupy positions that reward as- sertiveness and more men work in caring professions.

uncertainty avoidance

The extent to which members in a culture accept or avoid ambiguous situations and uncertainty.

Figure 3.4 Hofstede Dimensions of Culture

Sources: Based on (1) G. Hofstede, 1993, Cultural constraints in management theories, Academy of Management Executive, 7: 81–94; (2) G. Hosftede, 1997, Cultures and Organizations: Software of the Mind (pp. 25, 26, 53, 84, 113, 166), New York: McGraw-Hill. For newest update, see www.geerthofstede.com.

Individualism

Masculinity

Uncertainty Avoidance

Long-Term Orientation

Power Distance

Russia

Germany

118

China

USA

Brazil

Japan

Sweden

Singapore

Pakistan

To determine the cultural characteristics of a country, compare the number and vertical distance (higher means more) of that country on a particular cultural dimension (color coded and labeled on the right side of the exihibit) with those of other countries. For example, with a score of 80, Japan has the second highest long-term orientation; it is exceeded only by China, which has a score of 118. By contrast, with a score of 0, Pakistan has the weakest long-term orientation.

76 Part One Laying Foundations

Finally, long-term orientation emphasizes perseverance and savings for future betterment. China, which has the world’s longest continuous written history of approximately 4,000 years and the highest contemporary savings rate, leads the pack. On the other hand, members of short-term orientation societies (led by Pakistan) prefer quick results and instant gratification.

Overall, Hofstede’s dimensions are interesting and informative. They are also largely supported by subsequent work. It is important to note that Hofstede’s di- mensions are not perfect and have attracted some criticisms (see In Focus 3.2). However, it is fair to suggest that these dimensions represent a starting point for us trying to figure out the role of culture in global business.

Long-term orientation

Dimension of how much emphasis is placed on perse- verance and savings for future betterment.

Despite the influence of Hofstede’s framework, it has attracted a number of criticisms:

Cultural boundaries are not the same as national boundaries.

Although Hofstede was careful to remove some of his own cultural biases, “the Dutch software” of his mind, as he acknowledged, “will remain evident to the careful reader.” Being more familiar with Western cultures, Hofstede might inevita- bly be more familiar with dimensions relevant to Westerners. Thus, crucial dimensions relevant to Easterners (Asians) could be missed.

Hofstede’s research was based on surveys of more than 116,000 IBM employees working at 72 national subsidiaries from 1967 to 1973. This had both pros and cons. On the positive side, it took place not only in the same industry, but also in the same company. Otherwise, it would have been difficult to determine whether findings were due to differences in national cultures or industry or organizational cultures. However, because of such a single firm/single industry design, it was possible that Hofstede’s findings captured what was unique to that industry or to IBM. Given anti-American sentiments in some countries, some individuals might refuse to work for an American employer. Thus, it was difficult to ascertain whether employ- ees working for IBM were true representatives of their respective national cultures.

Because the original data are now 40 years old, critics contend that Hofstede’s framework would

simply fail to capture aspects of recent cultural change.

Hofstede responded to all four criticisms. First, he acknowledged that his focus on national culture was a matter of expediency with all its trappings. Second, since the 1980s, Hofstede and colleagues relied on a questionnaire derived from cultural dimensions most relevant to the Chinese, and then translated it from Chinese to multiple languages. That was how he un- covered the fifth dimension, long-term orientation (originally labeled “Confucian dynamism”). In response to the third and fourth criticisms, Hofstede pointed out a large number of more recent studies conducted by other scholars, using a variety of countries, industries, and firms. Most results were supportive of his find- ings. Overall, while Hofstede’s work is not perfect, on balance, its values seem to outweigh its drawbacks.

Criticizing Hofstede’s Framework IN FoCuS 3.2

Sources: Based on (1) T. Fang, 2010, Asian management research needs more self-confidence: Reflection on Hofstede (2007) and beyond, Asia Pacific Journal of Management, 27: 155–170; (2) G. Hofstede, 2006, What did GLOBE really measure? Journal of International Business Studies, 37: 882–896; (3) G. Hofstede, 2007, Asian management in the 21st century, Asia Pacific Journal of Management, 24: 411–420; (4) M. Javidan, R. House, P. Dorfman, P. Hanges, & M. Luque, 2006, Conceptualizing and measuring cultures and their consequences, Jour- nal of International Business Studies, 37: 897–914; (5) B. Kirkman, K. Lowe, & C. Gibson, 2006, A quarter century of Culture’s Conse- quences, Journal of International Business Studies, 37: 285–320; (6) K. Leung, R. Bhagat, N. Buchan, M. Erez, & C. Gibson, 2005, Cul- ture and international business, Journal of International Business Stud- ies, 36: 357–378; (7) R. Maseland & A. van Hoorn, 2009, Explaining the negative correlation between values and practices: A note on the Hofstede-GLOBE debate, Journal of International Business Studies, 40: 527–532; (8) B. McSweeney, 2002, Hofstede’s model of national cul- tural differences and their consequences, Human Relations, 55: 89–118; (9) L. Tang & P. Keveos, 2008, A framework to update Hofstede’s cultural value indices, Journal of International Business Studies, 39: 1045–1063.

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 77

3-2d Culture and Global Business A great deal of global business activities are consistent with the context, cluster, and dimension approaches on cultural differences. For example, the average length of contracts is longer in low-context countries (such as Germany) than in high-context countries (such as Vietnam). This is because in high-context countries, a lot of agreements are unspoken and not necessarily put in a legal contract.

Also, as pointed out by the cluster approach, firms are a lot more serious in preparation when doing business with countries in other clusters, compared with how they deal with fellow countries within the same cluster. Recently, countless new books have been published on “how to do business in China.” Two decades ago, gurus wrote about “how to do business in Japan.” But has anyone ever seen a book in English on “how to do business in Canada”?

The Hofstede’s dimension approach is also often supported in the real world. For example, managers in high power distance countries, such as France and Italy, have a greater penchant for centralized authority. Solicitation of subordinate feed- back and participation, widely practiced in low power distance Western countries (known as empowerment), is often regarded as a sign of weak leadership and low integrity in high power distance countries, such as Egypt, Russia, and Turkey.15

Individualism and collectivism also affect business activities. Individualist US firms may often try to differentiate themselves, whereas collectivist Japanese firms tend to follow each other. Because entrepreneurs “stick their neck out” by founding new firms, individualistic societies tend to foster a relatively higher level of entre- preneurship.

Likewise, masculinity and femininity affect managerial behavior. The stereo- typical manager in high-masculinity societies is “assertive, decisive, and ‘aggressive’ (only in masculine societies does this word carry a positive connotation),” whereas the stylized manager in high-femininity societies is “less visible, intuitive rather than decisive, and accustomed to seeking consensus.”16

Managers in low uncertainty avoidance countries (such as Britain) rely more on experience and training, whereas managers in high uncertainty avoidance coun- tries (such as China) rely more on rules. In addition, cultures with a long-term orientation are likely to nurture firms with long horizons. For example, Japan’s Matsushita has a 250-year plan, which was put together in the 1930s.17 While this is certainly an extreme case, Japanese and Korean firms tend to focus more on the long term. In comparison, Western firms often focus on relatively short-term prof- its (often on a quarterly basis).

Overall, there is strong evidence pointing out the importance of culture.18 Sen- sitivity to cultural differences does not guarantee success, but can at least avoid blunders. For instance, a Chinese manufacturer exported to the West a premium brand of battery called White Elephant without knowing the meaning of this phrase in Western culture. In another example, when a French manager (a man) was transferred to a US subsidiary and met his American secretary (a woman) the first time, he greeted her with an effusive cheek-to-cheek kiss, a “Hello” that would be harmless in France. However, the secretary later filed a complaint for sexual ha- rassment. More seriously, Mitsubishi Motors, coming from Japan, which leads the world in masculinity, encountered major problems when operating in the United States, where there is more female participation in the labor force (indicative of a high level of femininity). In 1998, its North American division paid $34 million to settle sexual harassment charges.

78 Part One Laying Foundations

3-3 Ethics Cross-cultural differences can be interesting, but they can also be unethical, all de- pending on the institutional frameworks in which firms are embedded. This topic is discussed in this section.

3-3a Definition and Impact of Ethics Ethics refers to the principles, standards, and norms of conduct governing individ- ual and firm behavior.19 Ethics is not only an important part of informal institutions, but is also deeply reflected in formal laws and regulations. To the extent that laws reflect a society’s minimum standards of conduct, there is a substantial overlap be- tween what is ethical and legal, and between what is unethical and illegal. However, there is a gray area because what is legal may be unethical.

Recent scandals (such as Enron and Siemens) have pushed ethics to the forefront of global business discussions. Numerous firms have introduced a code of conduct—a

set of guidelines for making ethical decisions.20 There is a debate on firms’ ethical motivations. A negative view suggests that firms may simply jump onto the ethics “bandwagon” under social pressures to appear more legitimate without necessarily becoming better. A positive view maintains that some firms may be self-motivated to “do it right” regardless of pressures. An instrumental view believes that good ethics may simply be a useful instrument to help make money.

Perhaps the best way to appreciate the value of ethics is to examine what happens after some crisis. As a “reservoir of goodwill,” the value of an ethi- cal reputation is magnified during a time of crisis. After the November 26, 2008, terrorist attacks on the Taj Mahal Palace Hotel in Mumbai that killed 31 people (including 20 guests), the hotel received only praise. Why? The surviving guests were over-

whelmed by employees’ dedication to duty and their desire to protect guests in the face of terrorist attacks. Eleven employees laid down their lives while helping between 1,200 and 1,500 guests safely escape. Paradoxically, catastrophes may allow more ethical firms such as the Taj, which are renowned for their integrity and customer service, to shine.21 The upshot seems to be that ethics pays.22

3-3b Managing Ethics Overseas Managing ethics overseas is challenging, because what is ethical in one country may be unethical elsewhere.23 Facing such differences, how can managers prepare themselves?

Two schools of thought exist.24 First, ethical relativism refers to an extension of the cliché “When in Rome, do as the Romans do.” If women in Muslim countries are discriminated against, so what? Likewise, if industry rivals in China can fix prices, who cares? Isn’t that what “Romans” do in “Rome”? Second, ethical imperialism refers to the absolute belief that “There is only one set of Ethics (with the big E), and we have it.” Americans are especially renowned for believing that their ethical

Learning Objective Understand the importance of ethics and ways to combat corruption.

3-3

What do you think an employer’s code of conduct should say about respect for people’s religious beliefs and practices?

C ar

di na

l/C or

bi s

Ethics

The principles, standards, and norms of conduct that govern individual and firm behavior.

Code of conduct

A set of guidelines for making ethical decisions.

Ethical relativism

A perspective that suggests that all ethical standards are relative.

Ethical imperialism

A perspective that suggests that “there is one set of Ethics (with a capital E) and we have it.”

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 79

values should be applied universally. For example, since sexual discrimination and price fixing are wrong in the United States, they must be wrong everywhere else. In practice, however, neither of these schools of thought is realistic. At the extreme, ethical relativism would have to accept any local practice, whereas ethical imperial- ism may cause resentment and backlash among locals.

Three “middle-of-the-road” guiding principles have been proposed by Thomas Donaldson, a business ethicist (Table 3.2). First, respect for human dignity and basic rights (such as those concerning health, safety, and the needs for education instead of working at a young age) should determine the absolute minimal ethical thresholds for all operations around the world.

Second, respect for local traditions suggests cultural sensitivity. If gifts are banned, foreign firms can forget about doing business in China and Japan. While it is illegal for corporations to hire employees’ children and relatives instead of more qualified applicants according to US equal opportunity laws, Indian companies routinely practice such nepotism, believing it strengthens employee loyalty. What should US companies setting up subsidiaries in India do? Donaldson advises that such nepotism is not necessarily wrong—at least in India.

Finally, respect for institutional context calls for a careful understanding of local institutions. Codes of conduct banning bribery are not very useful unless accompanied by guidelines for the scale of appropriate gift giving or receiving. Citigroup allows employees to accept non-cash gifts whose nominal value is less than $100. The Economist lets its journalists accept any non-cash gift that can be consumed in a single day—thus, a bottle of wine is acceptable, but a case of wine is not. Overall, these three principles, although far from perfect, can help managers improve the quality of their decisions.

3-3c Ethics and Corruption Ethics helps to combat corruption, often defined as the abuse of public power for private benefits, usually in the form of bribery (in cash or in kind).25 Corruption dis- torts the basis for competition that should be based on products and services, thus causing misallocation of resources and slowing economic development.26 Some evi- dence reveals that corruption discourages foreign direct investment (FDI).27 If the level of corruption in Singapore (very low) were to increase to the level in Mexico (in the middle range), it reportedly would have the same negative effect on FDI inflows as raising the tax rate by 50%.28

Corruption is pervasive in many parts of the world. Many US firms complain that they are unfairly restricted by the Foreign Corrupt Practices Act (FCPA), a law enacted in 1977 that bans bribery to foreign officials. They also point out that over- seas bribery expenses were often tax-deductible (!) in many EU countries such as

Corruption

The abuse of public power for private benefits, usually in the form of bribery.

Foreign Corrupt Practices Act (FCPA)

A US law enacted in 1977 that bans bribery of foreign officials.

Table 3.2 Managing Ethics Overseas: Three “Middle-of-the-Road” Approaches

Respect for human dignity and basic rights

Respect for local traditions

Respect for institutional context

Sources: Based on text in (1) T. Donaldson, 1996, Values in tension: Ethics away from home, Harvard Business Review, September-October: 4–11; (2) J. Weiss, 2006, Business Ethics, 4th ed., Cincinnati: South-Western Cengage Learning.

80 Part One Laying Foundations

Austria, France, Germany, and the Netherlands—at least until the late 1990s. How- ever, even with the FCPA, there is no evidence that US firms are inherently more ethical than others. The FCPA itself was triggered by investigations of many corrupt US firms in the 1970s. Even the FCPA makes exceptions for small “grease” payments to get goods through customs abroad. Most alarmingly, a World Bank study reports that despite over three decades of FCPA enforcement, US firms actually “exhibit systematically higher levels of corruption” than other OECD firms (original italics).29

Overall, the FCPA can be regarded as an institutional weapon in the fight against corruption.30 Recall that every institution has three supportive pillars: regulatory, nor- mative, and cognitive (Table 2.1). Despite the FCPA’s formal regulatory “teeth,” for a long time, there was neither a normative pillar nor a cognitive pillar. The norms among other OECD firms used to be to pay bribes first and get a tax deduction later (!)—a clear sign of ethical relativism. Only in 1997 did the OECD Convention on Combat- ing Bribery of Foreign Public Officials commit all member countries (essentially all developed economies) to criminalize bribery. It went into force in 1999. A more ambi- tious campaign is the UN Convention against Corruption, signed by 106 countries in 2003 and activated in 2005. If every country criminalizes bribery and every firm resists corruption, their combined power will eradicate it. However, this will not hap- pen unless FCPA-type legislation is institutionalized and enforced in every country.

3-4 Norms and Ethical Challenges As an important informal institution, norms are the prevailing practices of rele- vant players—the proverbial “everybody else”—that affect the focal individuals and firms. How firms strategically respond to ethical challenges is often driven, at least in part, by norms. Four broad strategic responses are: (1) reactive, (2) defensive, (3) accommodative, and (4) proactive strategies (see Table 3.3).

A reactive strategy is passive. When problems arise, denial is usually the first line of defense. In the absence of formal regulation, the need to take necessary action is neither internalized through cognitive beliefs nor becoming any norm in practice. For example, Ford marketed the Pinto car in the early 1970s, knowing that its gas tank had a fatal design flaw that could make the car susceptible to exploding in rear-end collisions. Citing high costs, Ford decided not to add an $11 per car im- provement. Sure enough, accidents happened, and people were killed and burned in Pintos. Still, Ford refused to recall the Pinto for several years, and more lives were lost. Only in 1978, under intense formal pressures from the US government

Learning Objective Identify norms associated with strategic responses when firms deal with ethical challenges.

3-4

Table 3.3 Strategic Responses to Ethical Challenges

Strategic responses Strategic Behaviors Examples in the text

Reactive Deny responsibility, do less than required

Ford Pinto fire (the 1970s)

Defensive Admit responsibility but fight it, do the least that is required

Nike (the 1990s)

Accommodative Accept responsibility, do all that is required

Ford Explorer roll-overs (the 2000s)

Proactive Anticipate responsibility, do more than is required

BMW (the 1990s)

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 81

and informal pressures from the media and consumer groups, did Ford belatedly recall all 1.5 million Pintos.31

A defensive strategy focuses on regulatory compliance. In the absence of regu- latory pressures, firms often fight informal pressures coming from the media and activists. In the 1990s, Nike was charged with running “sweatshops,” while these in- cidents took place in its contractors’ factories in Indonesia and Vietnam. Although Nike did not own or manage those factories, its initial statement, “We don’t make shoes,” failed to convey any ethical responsibility. Only when several senators began to suggest legislative solutions did Nike become more serious.

An accommodative strategy features emerging organizational norms to accept responsibility and a set of increasingly internalized cognitive beliefs and values to- ward making certain changes. These normative and cognitive values may be shared by a number of firms, thus leading to new industry norms. Recently, Nike and the entire sportswear industry became more accommodative.

In another example, in 2000, when Ford Explorer vehicles equipped with Fire- stone tires had a large number of fatal roll-over accidents, Ford evidently took the painful lesson from its Pinto fire fiasco in the 1970s. It aggressively initiated a speedy recall, launched a media campaign featuring its CEO, and discontinued its 100-year-old relationship with Firestone. While critics argue that Ford’s accom- modative strategy was to place blame squarely on Firestone, the institution-based view (especially Proposition 1 in Chapter 2) suggests that such highly rational ac- tions are to be expected. Even if Ford’s public relations campaign was only “window dressing,” publicizing a set of ethical criteria against which it can be judged opens doors for more scrutiny by concerned stakeholders. It probably is fair to say that Ford became a better corporate citizen in 2000 than it was in 1975.

Finally, proactive firms anticipate institutional changes and do more than is re- quired (see the Closing Case). In 1990, BMW anticipated its emerging responsibility associated with the German government’s proposed “take-back” policy, requiring automakers to design cars whose components can be taken back by the same manu- facturers for recycling. BMW not only designed easier-to-disassemble cars, but also signed up the few high-quality dismantler firms as part of an exclusive recycling infrastructure. Further, BMW actively participated in public discussions and suc- ceeded in establishing its approach as the German national standard for automo- bile disassembly. Other automakers were thus required to follow BMW’s lead. But they had to either fight over lower-quality dismantlers or develop in-house disman- tling infrastructure from scratch.32 Through such a proactive strategy, BMW set a new industry standard, facilitating the emergence of new environmentally friendly norms in both car design and recycling.

Overall, while there is probably a certain element of “window dressing,” the fact that proactive firms are going beyond the current regulatory requirements is indicative of the normative and cognitive beliefs held by many managers at these firms on the importance of doing the “right thing.”33

3-5 Debates and Extensions Informal institutions such as cultures, ethics, and norms provoke a series of signifi- cant debates. In this section, we focus on three of them: (1) Western values versus Eastern values, (2) cultural convergence versus divergence, and (3) opportunism versus individualism/collectivism.

Learning Objective Participate in three leading debates concerning cultures, ethics, and norms.

3-5

82 Part One Laying Foundations

3-5a Economic Development: Western Values versus Eastern Values This is another component of the debate on the drivers of economic development first discussed in Chapter 2. Here our focus is on the role of informal cultural values. About 100 years ago, at the apex of Western power (which ruled the ma- jority of Africans and Asians in colonies), German sociologist Max Weber argued that it was the Protestant work ethic that led to the “spirit of capitalism” and strong economic development. As a branch of Christianity (the other two branches are Catholic and Orthodox), Protestantism is widely practiced in English-speaking countries, Germany, the Netherlands, and Scandinavia. This is where the Industrial Revolution (and modern capitalism) took off. Weber suggested that the Protestant emphasis on hard work and frugality is necessary for capital accumulation—hence the term “capitalism.” Adherents of other religious beliefs, including Catholicism, are believed to lack such traits. At that time, Weber’s view was widely accepted.

Such belief in the superiority of Western values has recently been challenged by two sets of Eastern values: (1) Islamic and (2) Asian (Confucian). The first is the challenge from Islamic fundamentalism, which, rightly or wrongly, argues that it is Western dominance that causes the lackluster economic performance of Muslim countries. Aggressive marketing of Western products in these countries is seen as a cultural invasion. Islamic fundamentalists prefer to go “back to the roots” by mov- ing away from Western influence. While the majority of Islamic fundamentalists are peaceful, a small number of radical fundamentalists have become terrorists (such as those involved in “9/11”).

A second challenge comes from East Asia, whose values center on Confucianism, which is based on the teachings of Confucius, an ancient Chinese scholar who lived more than 2,000 years ago. Confucianism is not a religion but a set of moral codes guiding interpersonal relationships, which emphasize respect, loyalty, and reciproc- ity. A hundred years ago, Weber criticized Confucianism as a leading cause of Asian backwardness. However, winds change. In postwar decades, while Western economic growth has been stagnant, it is Confucian Asia—first led by Japan in the 1960s, then the four Tigers in the 1970s, and China since the 1980s—that has generated the fastest economic growth in the world and for the longest time. Interestingly, the same Con- fucianism, trashed by Weber, has been widely viewed as the engine behind this “Asian economic miracle.” Not only do Asians proudly proclaim the validity of such “Asian

values,” leading Western scholars increasingly endorse such a view. For example, Hofstede’s fifth dimension, long- term orientation, was originally labeled simply as “Confu- cian dynamism.” In 1993, the World Bank published a ma- jor study, entitled The East Asian Miracle, with one key word: Confucianism.34

While Islamic fundamentalists prefer to drop out of the game of economic development, Asian value pro- ponents claim to have beaten the West at its own game. However, any declaration of winning the game needs to be viewed with caution. By 1997, much of Asia was suddenly engulfed in a financial crisis. Then—guess what?—Confucianism was blamed by both Asians and non-Asians for having caused such hardship (!). Respect, loyalty, and reciprocity were suddenly viewed as inertia,

Is this fast-food restaurant an example of Western values or Eastern values or a blending of the two?

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pr es

s/ A

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Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 83

nepotism, and cronyism. Fast-forward to 2010: Asia had not only recovered from the 1997 crisis, but had also quickly rebounded from the 2008–2009 recession.35 With the emergence of Confucian China as a global economic powerhouse, the Asian values gurus again are practicing their craft—although with a lower voice this time.

As we can see from this wide ranging debate, our understanding of the connection between cultural values and economic development is very superficial. To advocate certain cultural values as key to economic development may not be justified. A new gen- eration of students and managers needs to be more sophisticated and guard against such ethnocentric thinking. One speculation is that if there will ever be an African eco- nomic take-off, there will be no shortage of gurus pontificating on how the African cul- tural values provide such a booster behind Africa’s yet-to-happen economic take-off.

3-5b Cultural Change: Convergence versus Divergence Every culture evolves. A great debate thus erupts on the direction of cultural change. In this age of globalization, one side of the debate points out a great deal of con- vergence, especially toward more “modern,” Western values such as individualism and consumerism. As evidence, convergence gurus point out the global interest in Western products such as Levi’s jeans, iPods, and MTV, especially among the youth.36

However, another side argues that Westernization in consumption does not nec- essarily mean Westernization in values. In a most extreme example, on the night of September 10, 2001, terrorists enjoyed some American soft drinks, pizzas, and mov- ies, and then went on to kill thousands of Americans the next day.37 More broadly, the popularity of Western brands in the Middle East does not change Muslim val- ues. In another example, the increasing popularity of Asian foods (such as sushi) and games (such as Pokémon and Bakugan) in the West does not necessarily mean that Westerners are converging toward “Asian values.” In short, the world may con- tinue to be characterized by cultural divergence.

A “middle-of-the-road” group makes two points. First, the end of the Cold War (see In Focus 3.2), the rise of the Internet, and the ascendance of English all offer evidence of some cultural convergence—at least on the surface and among the youth. For example, relative to average citizens, younger Chinese, Japanese, and Russian managers are becoming more individualistic and less collectivistic. Second, deep down, cultural divergence may continue to be the norm. Therefore, perhaps a better term is “crossvergence,” which acknowledges the validity of both sides of the debate.38 This idea suggests that when marketing products and ser- vices to younger customers around the world, a more “global” approach (featuring uniform content and image) may work, whereas when dealing with older, more tradition-bound consumers, local adaptation may be a must.

3-5c Opportunism versus Individualism/Collectivism39

As noted in Chapter 2, opportunism is a major source of uncertainty that adds to transaction costs, and institutions emerge to combat opportunism.40 However, crit- ics argue that emphasizing opportunism as “human nature” may backfire.41 If firm A insists on specifying minute details in a contract in order to prevent firm B from behaving opportunistically in the future, A is likely to be regarded by B as being not trustworthy and being opportunistic now. This is especially likely to be the case if B is from a high-context (or collectivist) society. Thus, A’s attempts to combat op- portunism may beget opportunism.

84 Part One Laying Foundations

Transaction cost theorists acknowledge that opportunists are a minority in any population. However, theorists contend that because of the difficulty in identify- ing such a minority of opportunists before they cause any damage, it is imperative to place safeguards that, unfortunately, treat everybody as a potential opportun- ist. For example, thanks to the work of only 19 terrorists, millions of air travelers around the world since September 11, 2001, now have to put up with heightened security. Everybody hates it, but nobody argues that it is unnecessary. This debate, therefore, seems deadlocked.

One cultural dimension, individualism/collectivism, may hold the key to an im- proved understanding of opportunism. One common stereotype is that players from collectivist societies (such as China) are more collaborative and trustworthy and that those from individualist societies (such as the United States) are more competitive and opportunistic.42 However, this is not necessarily the case. Collectivists are more collaborative only when dealing with in-group members—individuals and firms re- garded as a part of their own collective. The flip side is that collectivists discriminate more harshly against out-group members—individuals and firms not regarded as part of “us.” On the other hand, individualists, who believe that every person (firm) is on his or her (its) own, make less distinction between in-group and out-group. Therefore, while individualists may indeed be more opportunistic than collectivists when dealing with in-group members (this fits the stereotype), collectivists may be more opportu- nistic when dealing with out-group members. Thus, on balance, the average Chinese is not inherently more trustworthy than the average American. The Chinese motto regarding out-group members is: “Watch out for strangers. They will screw you!”

This helps explain why the United States, the leading individualist country, is among societies with a higher level of spontaneous trust, whereas there is greater interpersonal and interfirm distrust in the large society in China.43 This also ex- plains why it is so important to establish guanxi (relationship) for individuals and firms in China; otherwise, life can be very challenging in a sea of strangers.

While this insight is not likely to help improve airport security screening, it can help managers and firms better deal with one another. Only through repeated social interactions can collectivists assess whether to accept newcomers as in-group mem- bers. If foreigners who, by definition, are from an out-group refuse to show any inter- est in joining the in-group, then it is fair to take advantage of them. For example, don’t ever refuse a friendly offer of food or drink from a Saudi businessman—that is considered an affront (see the Opening Case). Most of us do not realize that “Feel free to say no when offered food or drink” reflects the cultural underpinning of indi- vidualism. This misunderstanding, in part, explains why many cross-culturally naïve Western managers and firms often cry out loud for being taken advantage of in col- lectivist societies—they are simply being treated as “deserving” out-group members.44

3-6 Management Savvy One leading contribution of the institution-based view is to emphasize the impor- tance of informal institutions—cultures, ethics, and norms—as the bedrock propel- ling or constraining business around the globe. How does this perspective answer our fundamental question: What determines the success and failure of firms around the globe? The institution-based view argues that firm performance is, at least in part, determined by the informal cultures, ethics, and norms governing firm behavior.

For savvy managers around the globe, this emphasis on informal institutions sug- gests two broad implications. First, it is necessary to enhance cultural intelligence, defined as an individual’s ability to understand and adjust to new cultures.45

In-group

Individuals and firms regarded as a part of “us.”

out-group

Individuals and firms not regarded as a part of “us.”

Learning Objective Draw implications for action.

3-6

Cultural intelligence

An individual’s ability to understand and adjust to new cultures.

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 85

Nobody can become an expert, the chameleon in Table 3.4, in all cultures. How- ever, a genuine interest in foreign cultures will open your eyes. Acquisition of cul- tural intelligence passes through three phases: (1) awareness, (2) knowledge, and (3) skills.46 Awareness refers to the recognition of both the pros and cons of your “mental software” and the appreciation of people from other cultures. Knowledge refers to the ability to identify the symbols, rituals, and taboos in other cultures— also known as cross-cultural literacy. While you may not share (or may disagree) with their values, you will at least obtain a roadmap of the informal institutions govern- ing their behavior. Finally, skills are based on awareness and knowledge, plus good practice (Table 3.5). Of course, culture is not everything. It is advisable not to read too much into culture, which is one of many variables affecting global business.47 However, it is imprudent to ignore culture.

While skills can be taught, the most effective way is total immersion within a for- eign culture. Even for gifted individuals, learning a new language and culture to func- tion well at a managerial level will take at least several months of full-time studies. Most employers do not give their expatriates that much time to learn before sending them abroad. Thus, most expatriates are inadequately prepared, and the costs for firms, individuals, and families are tremendous (see Chapter 15). This means that you, a student studying this book, are advised to invest in your own career by picking up at least one foreign language, spending one semester (or year) abroad, and reaching out to make some international friends who are taking classes with you (and perhaps

Table 3.4 Five Profiles of Cultural Intelligence

Profiles Characteristics

The Local A person who works well with people from similar backgrounds but does not work effectively with people from different cultural backgrounds.

The Analyst A person who observes and learns from others and plans a strategy for interacting with people from different cultural backgrounds.

The Natural A person who relies on intuition rather than on a systematic learning style when interacting with people from different cultural backgrounds.

The Mimic A person who creates a comfort zone for people from different cultural backgrounds by adopting their general posture and communication style. This is not pure imitation, which may be regarded as mocking .

The Chameleon A person who may be mistaken for a native of the foreign country. He or she may achieve results that natives cannot, due to his or her insider’s skills and outsider’s perspective. This is very rare.

Sources: Based on (1) P. C. Earley & S. Ang, 2003, Cultural Intelligence: Individual Interactions Across Cultures, Palo Alto, CA: Stanford University Press; (2) P. C. Earley & E. Mosakowski, 2004, Cultural intelligence, Harvard Business Review, October: 139–146.

Table 3.5 Implications for Action: Six Rules of Thumb When Venturing Overseas

Be prepared

Slow down

Establish trust

Understand the importance of language

Respect cultural differences

Understand that no culture is inherently superior in all aspects

86 Part One Laying Foundations

sitting next to you). Such an investment during university studies will make you stand out among the crowd and propel your future career to new heights (see In Focus 1.3).

Second, managers need to be aware of the prevailing norms and their transi- tions globally. The norms around the globe in the 21st century are more culturally sensitive and ethically demanding than, say, in the 1970s. This is not to suggest that every local norm needs to be followed. However, failing to understand and adapt to the changing norms by “sticking one’s neck out” in an insensitive and unethical way may lead to unsatisfactory or disastrous results. The best managers expect norms to shift over time by constantly deciphering the changes in the informal “rules of the game” and by taking advantage of new opportunities. How BMW managers proac- tively shaped the automobile recycling norms serves as a case in point.

C H A P t E r S u M M A r y

3.1 Define what culture is and articulate its four main manifestations: language, religion, social structure, and education.

Culture is the collective programming of the mind, which distinguishes one group from another.

Managers and firms ignorant of foreign languages and religious traditions may end up with embarrassments and, worse, disasters when doing business around the globe.

Highly stratified societies have a low degree of social mobility, and vice versa. Education fosters a sense of cultural identity by teaching children the main-

stream values and norms. 3.2 Discuss how cultures systematically differ from each other.

The context approach differentiates cultures based on the high-context versus low-context dimension.

The cluster approach groups similar cultures together as clusters and civili- zations.

Hofstede and colleagues have identified five cultural dimensions: (1) power distance, (2) individualism/collectivism, (3) masculinity/femininity, (4) uncer- tainty avoidance, and (5) long-term orientation.

3.3 Understand the importance of ethics and ways to combat corruption.

When managing ethics overseas, two schools of thought are ethical relativ- ism and ethical imperialism.

Three “middle-of-the-road” principles help guide managers make ethical decisions.

The fight against corruption around the world is a long-term, global battle. 3.4 Identify norms associated with strategic responses when firms deal with

ethical challenges.

When confronting ethical challenges, individual firms have four strategic choic- es: (1) reactive, (2) defensive, (3) accommodative, and (4) proactive strategies.

3.5 Participate in three leading debates concerning cultures, ethics, and norms.

(1) Western values versus Eastern values, (2) cultural convergence versus divergence, and (3) opportunism versus individualism/collectivism

3.6 Draw implications for action.

It is important to enhance cultural intelligence, leading to cross-cultural literacy.

It is crucial to understand and adapt to the changing norms globally.

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 87

K e y T e r m s

Civilization 71 Cluster 71 Code of conduct 78 Collectivism 74 Corruption 79 Context 70 Cultural intelligence 84 Culture 65 Ethical imperialism 78 Ethical relativism 78

Ethics 78 Ethnocentrism 64 Femininity 75 Foreign Corrupt

Practices Act (FCPA) 79

High-context culture 70 Individualism 74 In-group 84 Lingua franca 65

Long-term orientation 76 Low-context culture 70 Masculinity 75 Out-group 84 Power distance 74 Social mobility 68 Social stratification 68 Social structure 68 Uncertainty avoidance 75

r e v i e w Q u e s T i o n s

1. ON CULTURE: As you review how cultures differ from each other, imagine that you want to develop a flexible and mobile work force that is not controlled by a given culture but could easily relocate to countries with a variety of different cultures. You want people who can easily and effectively fit in so as to be accept- ed by employees and customers. In your opinion, what are some of the barriers or issues that you would encounter, and how might you achieve your objective?

2. Compare PengAtlas Map 1.4 (Religious Heritage) and Map 1.5 (Select World Literacy Rates Among Adults over Age 15). Which do you think has a more powerful effect in both the cultural and economic realm? Why? If your answer is “Both of the above,” is one of the two a bit more powerful in creating a uni- fied culture, and the other more powerful in creating a dynamic economy? Explain your answer.

3. Compare PengAtlas Map 3.2 (Top Reformers in Doing Business) 2008–2009) with Maps 1.4 and 1.5. Are there any relationships between reformers and reli- gious heritage? Why or why not? If there are any relationships, are they causal or coincidental? Any relationship between reformers and educational level? Why or why not? If there are any relationships, are they causal or coincidental? Defend your answer.

4. What might need to be considered in promoting from within in a highly stratified society? Explain.

5. ON CULTURE: Suppose the education system of a given country teaches values that can make it very difficult to do business profitably in the country. Is that an impossible barrier, or is there anything that can be done to change that or cope with it? Defend your answer.

6. Non-verbal communication (e.g., tone of voice, gestures, facial expressions) can be important in all cultures, but would it be more important in a high- context or low-context culture? Why?

7. What are the pros and cons of doing business in a culture characterized as individualistic?

8. What are the pros and cons of doing business in a culture characterized as collectivist?

9. Some countries have a long tradition of bribery for public officials. Is it “ethical imperialism” to prohibit companies in one’s own country from en- gaging in bribery when doing business in countries with such traditions? Why?

88 Part One Laying Foundations

10. Why is the fight against corruption a long-term battle?

11. Does corruption always involve only money? If not, what else might be in- volved?

12. Although a proactive strategy may always seem most desirable in dealing with ethical challenges, are there any circumstances under which a reactive strategy may be the best strategy or even the only strategy? Explain.

13. In dealing with changing global norms, does that mean that you should re- ject your own values and go along with whatever now seems to be in vogue? Defend your answer.

C r I t I C A L D I S C u S S I o n Q u E S t I o n S

1. ON CULTURE: When you take an airline flight, the passenger sitting next to you tries to have a conversation with you. He or she asks, “What do you do?” You would like to be nice, but don’t want to give too much information about yourself (such as your name). How would you answer this question? A typical US manager may say: “I am a marketing manager”—without mentioning the employer. A typical Japanese manager may say: “I work for Honda.” Why are there such differences?

2. ON ETHICS: Suppose you work for a New Zealand company exporting a container of kiwis to Haiti or Iraq. The customs official informs you that there is a delay in clearing your container through customs, and it may last a month. However, if you are willing to pay an “expediting fee” of US$200, he will try to make it happen in one day. What are you going to do?

3. ON ETHICS: Most developed economies have some illegal immigrants. The United States has the largest number: approximately 10 million to 11 million. Without legal US identification documents, they cannot open bank accounts or buy houses. Many US firms have targeted this population, accepting their ID issued by their native countries and selling them products and services. Some Americans are furious with these business practices. Other Americans suggest that illegal immigrants represent a growth engine in an economy with relatively little growth elsewhere. How would you participate in this debate?

G L o b A L A C t I o n

1. ON CULTURE: Religion is an integral component of your company’s opera- tions because it manufacturers food products according to Islam’s Halal requirements. Top management wants information concerning the largest populations of Islam worldwide in order to develop the company’s distribu- tion capabilities. Provide a report with any information relevant to this com- pany-wide initiative. What recommendations can you provide to the company?

2. One approach to understanding corruption perceptions is to compare in- formation across a variety of countries. As such, your company has had operations in South America for some time. However, there has not been an internal evaluation of perceived regional corruption to date. Therefore, you have been asked to provide insight on this topic for each country in South America. Based on an annual corruption perceptions index, develop a brief report and recommendations for the entire company.

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 89

v I D E o C A S E

After watching the video on goat farming, discuss the following:

1. ON CULTURE: How might cultural differences impact the success of goat farming?

2. ON CULTURE: Does cultural convergence/cultural divergence exist with re- gard to goat meat being used in restaurants?

3. How has opportunism and individual/collectivism contributed to the suc- cess of goat farming?

4. Can cultural intelligence be unethical?

5. What future strategic actions should be taken to ensure the success of this industry?

Founded in 1870, Chiquita is a leading international producer, marketer, and distributor of bananas, other tropical fruits such as pineapples and avocadoes, as well as salads. Headquartered in Cincinnati, Ohio, Chiquita employs more than 21,000 people on six con- tinents. Chiquita’s early history (when it was named the United Fruit Company) was better known as an aggressive and exploitative multinational that treated some of the Central American countries in which it op- erated as “banana republics.” However, Chiquita’s re- cent efforts to be a socially responsible firm have truly made it stand out among industry peers. Chiquita is committed to conducting business ethically—not only in compliance with the letter and spirit of the law, but also as an industry leader in doing the right things to do.

In Chiquita’s core product markets, it views its mission is “to help the world’s consumers broaden mindsets about nutrition and bring healthy, nutritious, and convenient foods that taste good and improve people’s lives.” Joining the army to fight obesity, Chiquita in 2011 became a strategic partner with the US Department of Agriculture (USDA) to promote the new MyPlate dietary guidelines. A large part of Chiquita’s corporate social responsibility (CSR) efforts involves how it treats employees and stakeholders

around the world. More than a decade ago, Chiquita adopted the Social Accountability 8000 (SA8000) labor rights standard developed by Social Account- ability International (SAI). SA8000 prohibits the use of child labor and forced labor, monitors health and safety measures, and promotes appropriate working

Chiquita Sticks Its Bananas Out

C L O S i n g C A S e Ethical Dilemma

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hours and fair compensation. One crucial component of SA8000 is to reach a global agreement with local and international foodworkers’ unions. On the en- vironmental dimension, Chiquita has been working with Rainforest Alliance since 1992. By 2000, 100% of the plantations owned by Chiquita were certified by Rainforest Alliance as engaging in sustainable farming practices. In 2011, in response to the de- mands made by a green group called ForestEthics, Chiquita agreed not to buy fuel made from Canadian tar sands. Extracting oil from tar sands is energy- intensive and dirty. Environmentalists worked vigor- ously to block a pipeline—Keystone—which would carry such oil from Canada to the United States.

However, not all is rosy for Chiquita’s CSR efforts. Its agreement not to buy fuel made from Canadian tar sands provoked a pro-business lobby in Canada called EthicalOil.org to launch a boycott of Chiquita, with mounting losses (although Chiquita would not quan- tify such losses). Its work with SA8000 and Rainforest Alliances adds to its cost—think about all the expens- es involved in the hiring of so many people to engage in certification, auditing, and compliance. Neither Dole nor Del Monte, its two main rivals, bothers to follow Chiquita to sign a global union agreement, leaving Chiquita to be the high-cost (and less price- competitive) producer. What has Chiquita received in return for all its good work? Big retailers increasingly

dump Chiquita and place orders with Dole, Del Monte, and other smaller plantations whose environmental practices may not be as sustainable and whose labor practices may not be as worker-friendly as Chiquita. Driven by one of its core values, integrity (the other three are respect, opportunity, and responsibility), Chiquita in 2003 became the only American company to voluntarily admit to the US Department of Justice that it had paid protection money to Colombian para- military militia that surrounded its plantations. The payoff for such honesty was a series of American and Colombian lawsuits against it.

Chiquita’s conspicuous lack of reward for its good deeds is frustrating. Even the head of the international foodworkers’ union was sympathetic, saying, “It’s not sustainable for any company in a competitive sector to make progress and gain no recognition for it.”

CASE DISCUSSION QUESTIONS: 1. ON ETHICS: Why has Chiquita chosen to be

proactive along a number of CSR dimensions?

2. ON ETHICS: Why has Chiquita not been suc- cessful in changing industry norms?

3. ON ETHICS: As Chiquita’s CEO, what are you going to recommend to the board?

4. ON ETHICS: As Dole’s or Del Monte’s CEO, what are you going to do in response to Chiquita’s moves?

Sources: Based on (1) Economist, 2012, Going bananas, March 31: 74; (2) www.chiquita.com.

[Journal acronyms] AMJ—Academy of Management Journal; AMR— Academy of Management Review; APJM—Asia Pacific Journal of Manage- ment; HBR—Harvard Business Review; JIBS—Journal of International Business Studies; JM—Journal of Management; JMS—Journal of Man- agement Studies; JWB—Journal of World Business; MIR—Management International Review; PR—Personnel Review; RES—Review of Economics and Statistics; SMJ—Strategic Management Journal.

1 A. Katou, P. Budhwar, H. Woldu, & A. Al-Hamadi, 2010, Influence of ethical beliefs, national culture, and institutions on preferences for HRM in Oman, PR, 39: 728–745; J. Salk & M. Brannen, 2000, National culture, networks, and individual influence in a multina- tional management team, AMJ, 43: 191–202; M. Witt & G. Redding, 2009, Culture, meaning, and institutions, JIBS, 40: 859–885.

2 S. Nadkarni & P. Barr, 2008, Environmental context, manage- rial cognition, and strategic action, SMJ, 29: 1395–1427; B. Olson, Y. Bao, & S. Parayitam, 2007, Strategic decision making within Chinese firms, JWB, 42: 35–46; B. Tyler & D. Gnyawali, 2009, Mana- gerial collective cognitions, JMS, 46: 93–126.

3 G. Hofstede, 1997, Cultures and Organizations (p. xii), New York: McGraw-Hill.

4 Hofstede, 1997, Cultures and Organizations (p. 5).

5 C. Chan, S. Makino, & T. Isobe, 2010, Does sub-national region matter? SMJ, 31: 1226–1242; W. Shi, S. Sun, & M. W. Peng, 2013, Sub-national institutional contingencies, network positions, and IJV partner selection, JMS (in press).

6 D. Graddol, 2004, The future of language, Science, 303: 1329–1331.

7 W. Barner-Rasmussen & C. Aarnio, 2010, Shifting the faultlines of language, JWB, 46: 288–295; A. Harzing, K. Koster, & U. Magner, 2011, Babel in business, JWB, 46: 279–287; J. Heikkila & A. Smale, 2011, The effects of language standardization on the acceptance and use of e-HRM systems in foreign subsidiaries, JWB, 46: 305–313; J. Usunier, 2011, Language as a resource to access cross-cultural equivalence in quantitative management research, JWB, 46: 314–319; L. Zander, A. Mockaitis, & A. Harzing, 2011, Standardization and contextualization, JWB, 46: 296–304.

n o t E S

Chapter 3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms 91

8 J. Fidrmuc & J. Fidrmuc, 2009, Foreign languages and trade, work- ing paper, Uxbridge, UK: Brunel University.

9 D. Ricks, 1999, Blunders in International Business, 3rd ed., Oxford, UK: Blackwell.

10 E. Hall & M. Hall, 1987, Hidden Differences, Garden City, NY: Dou- bleday.

11 S. Ronen & O. Shenkar, 1985, Clustering countries on attitudinal dimension, AMR, 10: 435–454.

12 R. House, P. Hanges, M. Javidan, P. Dorfman, & V. Gupta (eds.), 2004, Culture, Leadership, and Organizations: The GLOBE Study of 62 Societies, Thousand Oaks, CA: Sage.

13 S. Huntington, 1996, The Clash of Civilizations and the Remaking of World Order (p. 43), New York: Simon & Schuster.

14 S. Schwartz, 1994, Cultural dimensions of values, in U. Kim et al. (eds.), Individualism and Collectivism (pp. 85–119), Thousand Oaks, CA: Sage; F. Trompenaars, 1993, Riding the Waves of Culture, Chicago: Irwin.

15 C. Fey & I. Bjorkman, 2001, The effect of HRM practices on MNC subsidiary performance in Russia, JIBS, 32: 59–75; J. Parnell & T. Hatem, 1999, Behavioral differences between American and Egyptian managers, JMS, 36: 399–418; E. Pellegrini & T. Scandura, 2006, Leader-member exchange (LMX), paternalism, and delega- tion in the Turkish business context, JIBS, 37: 264–279.

16 Hofstede, 1997, Cultures and Organizations (p. 94).

17 C. Bartlett & S. Ghoshal, 1989, Managing Across Borders (p. 41), Boston: Harvard Business School Press.

18 X. Chen & S. Li, 2005, Cross-national differences in coopera- tive decision-making in mixed-motive business contexts, JIBS, 36: 622–636; R. Friedman, S. Chi, & L. Liu, 2006, An expectancy model of Chinese-American differences in conflict-avoiding, JIBS, 37: 76–91; K. Lee, G. Yang, & J. Graham, 2006, Tension and trust in international business negotiations, JIBS, 37: 623–641; S. Lee, O. Shenkar, & J. Li, 2008, Cultural distance, investment flow, and control in cross-border cooperation, SMJ, 29: 1117–1125; L. Metcalf, A. Bird, M. Shankarmahesh, Z. Aycan, J. Larimo, & D. Valdelamar, 2006, Cultural tendencies in negotiation, JWB, 41: 382–394; W. Newburry & N. Yakova, 2006, Standardization preferences, JIBS, 37: 44–60; G. Van der Vegt, E. Van de Vliert, & X. Huang, 2005, Location-level links between diversity and innovative climate depend on national power distance, AMJ, 48: 1171–1182.

19 L. Trevino & K. Nelson, 2004, Managing Business Ethics, 3rd ed. (p. 13), New York: Wiley; L. Trevino, G. Weaver, & S. Reynolds, 2006, Behavioral ethics in organizations, JM, 32: 951–990.

20 R. Durand, H. Rao, & P. Monin, 2007, Code of conduct in French cuisine, SMJ, 28: 455–472; J. Stevens, H. K. Steensma, D. Harrison, & P. Cochran, 2005, Symbolic or substantive document? SMJ, 26: 181–195.

21 R. Deshpande & A. Raina, 2011, The ordinary heroes of the Taj, HBR, December: 119–123.

22 E. G. Love & M. Kraatz, 2009, Character, conformity, or the bottom line? AMJ, 52: 314–335.

23 D. McCarthy & S. Puffer, 2008, Interpreting the ethicality of cor- porate governance decisions in Russia, AMR, 33: 11–31; A. Spicer, T. Dunfee, & W. Bailey, 2004, Does national context matter in ethical decision making? AMJ, 47: 610–620.

24 This section draws heavily from T. Donaldson, 1996, Values in tension, HBR, September–October: 4–11.

25 K. Martin, J. Cullen, J. Johnson, & K. Parboteeah, 2007, Deciding to bribe, AMJ, 50: 1401–1422.

26 C. Robertson & A. Watson, 2004, Corruption and change, SMJ, 25: 385–396; S. Lee & K. Oh, 2007, Corruption in Asia, APJM, 24: 97–114; S. Lee & S. Hong, 2012, Corruption and subsidiary profit- ability, APJM (in press); J. H. Zhao, S. Kim, & J. Du, 2003, The impact

of corruption and transparency on foreign direct investment, MIR, 43: 41–62; J. Zhou & M. W. Peng, 2012, Does bribery help or hurt firm growth around the world? APJM (in press).

27 S. Globerman & D. Shapiro, 2003, Governance infrastructure and US foreign direct investment, JIBS, 34: 19–39.

28 S. Wei, 2000, How taxing is corruption on international inves- tors? RES, 82: 1–11.

29 J. Hellman, G. Jones, & D. Kaufmann, 2002, Far from home: Do foreign investors import higher standards of governance in transi- tion economies (p. 20), Working paper, Washington: World Bank (www.worldbank.org).

30 A. Cuervo-Cazzura, 2008, The effectiveness of laws against brib- ery abroad, JIBS, 39: 634–651; C. Kwok & S. Tadesse, 2006, The MNC as an agent of change for host-country institutions, JIBS, 37: 767–785.

31 D. Gioia, 2004, Pinto fires, in Trevino & Nelson, 2004, Managing Business Ethics (pp. 105–108).

32 S. Hart, 2005, Capitalism at the Crossroads, Philadelphia: Wharton School Publishing.

33 M. Barnett & A. King, 2008, Good fences make good neighbors, AMJ, 51: 1150–1170; A. King, M. Lenox, & A. Terlaak, 2005, The stra- tegic use of decentralized institutions, AMJ, 48: 1091–1106.

34 World Bank, 1993, The East Asian Miracle, Washington: World Bank.

35 M. W. Peng, R. Bhagat, & S. Chang, 2010, Asia and global busi- ness, JIBS, 41: 373–376.

36 T. Levitt, 1983, The globalization of markets, HBR, May-June: 92–102.

37 National Commission on Terrorist Attacks on the United States, 2004, The 9/11 Report (p. 364), New York: St. Martin’s.

38 C. Carr, 2005, Are German, Japanese, and Anglo-Saxon strategic decision styles still divergent in the context of globalization? JMS, 42: 1155–1188; G. Hirst, P. Budhwar, B. Cooper, M. West, C. Long, C. Xu, & H. Shipton, 2008, Cross-cultural variations in climate for autonomy, stress, and organizational productivity relationships, JIBS, 39: 1343–1358; S. Speck & A. Roy, 2008, The interrelationships between television viewing, values, and perceived well-being, JIBS, 39: 1197–1219.

39 This section draws heavily from C. Chen, M. W. Peng, & P. Saparito, 2002, Individualism, collectivism, and opportunism: A cultural per- spective on transaction cost economics, JM, 28: 567–583.

40 O. Williamson, 1985, The Economic Institutions of Capitalism, New York: Free Press.

41 S. Ghoshal & P. Moran, 1996, Bad for practice, AMR, 21: 13–47.

42 J. Cullen, K.P. Parboteeah, & M. Hoegl, 2004, Cross-national dif- ferences in managers’ willingness to justify ethically suspect behav- iors, AMJ, 47: 411–421.

43 F. Fukuyama, 1995, Trust, New York: Free Press.

44 S. Goodman, 2009, Where East Eats West, Charleston, SC: Book- Surge/Amazon.

45 J. Johnson, T. Lenartowicz, & S. Apud, 2006, Cross-cultural com- petence in international business, JIBS, 37: 525–543; Y. Kandogan, 2011, Determinants of individuals’ preference for cross-cultural literacy, JWB, 46: 328–336; A. Molinsky, 2012, Code switching be- tween cultures, HBR, January: 140–141.

46 Hofstede, 1997, Cultures and Organizations (p. 230).

47 O. Shenkar, 2012, Beyond cultural distance, JIBS, 43: 12–17; K. Singh, 2007, The limited relevance of culture to strategy, APJM, 24: 421–428; L. Tihanyi, D. Griffith, & C. Russell, 2005, The effect of cultural distance on entry mode choice, international diver- sification, and MNE performance, JIBS, 36: 270–283; S. Zaheer, M. Shomaker, & L. Nachum, 2012, Distance without direction, JIBS, 43: 18–27.

Learning Objectives

After studying this chapter, you should be able to

4-1 define resources and capabilities.

4-2 explain how value is created from a firm’s resources and capabilities.

4-3 articulate the difference between keeping an activity in-house and outsourcing it.

4-4 understand how to use a VRIO framework.

4-5 participate in two leading debates concerning leveraging resources and capabilities.

4-6 draw implications for action.

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Leveraging Resources and Capabilities

In January 2012, Eastman Kodak Company, commonly known as Kodak, filed for Chapter 11 bankruptcy pro- tection. Founded in 1880, Kodak pioneered photo- graphy technology and photographic film and brought them to the masses of the world. During most of the 20th century, Kodak held a dominant position in photographic film. In 1976, it enjoyed a 90% market share of photographic film and an 85% market share of camera sales in the United States. Until the 1990s, it had been regularly voted as one of the world’s top-five most valuable brands. The Kodak name in fact was so recognizable that its tagline, “Kodak moment,” entered everyday language as an important event worthy of capturing on film. It is hard to believe now, but Kodak was indeed the Google of its day.

So, what happened? Essentially, Kodak’s expertise in photographic film used to be valuable, unique, and hard-to-imitate. Its formidable organization, which in 1988 employed a sizable army of 145,000, was able to deliver film rolls to the far corners of the world. But the digital revolution wiped out all these advantages.

In a world full of digital cameras made by Canon, Nikon, Sony, and Samsung, Kodak digital cameras had a small market share. To be sure, Kodak was not a late mover in digital technology. In fact, Kodak was the first mover: it invented the digital camera in 1975. But the popular perception that Kodak was a later mover in

digital technology was largely correct. It only started marketing digital cameras in the early 2000s—too late.

In a nutshell, Kodak’s early success became its curse. Its seemingly unassailable competitive position fostered an unimaginative and complacent corporate culture that failed to anticipate the rapid diffusion of digital technology that literally ate its traditional market for lunch. In 1979, an internal guru on digital technology wrote a report to management that today reads like a prophecy. The report predicted how different segments of the market would migrate from film to digital, start- ing with US government satellite reconnaissance, then professional photography, and finally the mass mar- ket—by 2010. This penetrating report was only a few years off. Yet, tragically, both the digital camera inven- tion and the prediction were ignored by Kodak manag- ers, who could not imagine a world without film.

During the 1990s, instead of investing in digital technology, Kodak focused on its only viable rival at that time, Fujifilm. Refusing to outsource production to cut costs, Kodak kept making film by itself. In the 2000s, Kodak belatedly built a digital camera business, which lasted only a few years before camera phones started to push aside single-purpose digital cameras. Kodak ended up losing $60 on every digital camera it sold. With a new CEO who had stepped in during 2005, Kodak attempted to become a powerhouse of

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Kodak’s Last Moment

94 Part One Laying Foundations

Why was Kodak able to be the “Google of its day” in the 20th century? As competi- tion moved from photographic film to digital technology, what did Kodak’s competitors, such as Canon, Nikon, Sony, Samsung, and even its archrival Fujifilm, have that Kodak did not have? The answer must be that certain resources and capabilities specific to the winning firms—Kodak in the 20th century and its rivals in the 21st century—were not shared by competitors. This insight has been developed into a resource-based view, which has emerged as one of the two core perspectives on global business.1

One leading tool in global business is SWOT analysis. A SWOT analysis determines a firm’s strengths (S), weaknesses (W), opportunities (O), and threats (T). In global business, the institution-based view deals with the external O and T, enabled and con- strained by formal and informal rules of the game (see Chapters 2 and 3). The resource- based view builds on the SWOT analysis,2 and concentrates on the internal S and W to identify and leverage sustainable competitive advantage.3 In this chapter, we first define resources and capabilities and then discuss the value chain analysis, concen- trating on the decision to keep an activity in-house or outsource it. We then focus on value (V), rarity (R), imitability (I), and organization (O) through a VRIO framework. Debates and extensions follow.

4-1 Understanding Resources and Capabilities One basic proposition of the resource-based view is that a firm consists of a bundle of productive resources and capabilities.4 Resources are defined as “the tangible and intangible assets a firm uses to choose and implement its strategies.”5 There is

Resource-based view

A leading perspective in global business that posits that firm performance is fundamen- tally driven by differences in firm-specific resources and capabilities.

SWOT analysis

A tool for determining a firm’s strengths (S), weaknesses (W), opportunities (O), and threats (T).

Resources

The tangible and intangible assets a firm uses to choose and implement its strategies.

Learning Objective Define resources and capabilities.

4-1

digital printing. But with the technological tsunami first brought by digital cameras and then by camera phones, Kodak felt powerless to catch up. In January 2012, with its forces shrunk to only 18,000, Kodak gave up by fil- ing for bankruptcy and listing $6.9 billion in liabilities. In February 2012, it announced that it would stop making digital cameras itself and would license its brand name to other camera manufacturers. Instead, it would focus on photo printing, through retail and online services as well as desktop inkjet devices.

In contrast, managers at Kodak’s archrival Fujifilm were quicker in unwinding the work of their previous generations. Since 2000, it has spent $9 billion to ac- quire 40 companies, slashed costs and thousands of jobs, and diversified. Fujifilm viewed film to be a bit like skin: both contain collagen. Just as photos fade because of oxidation, cosmetics products preserve skin with anti- oxidants. Deploying its collection of 200,000 chemical compounds, Fujifilm tapped into 4,000 of them that are related to anti-oxidants. Based on such research, Fujifilm launched a line of cosmetics, named Astalift, that it

successfully sold in Asia and Europe. In addition, Fujifilm made optical films for LCD flat-panel screens. In this re- gard, Fujifilm was decidedly “un-Japanese” as few large Japanese firms acted so fast, dismantled their traditional business, and went on an acquisition spree. In summary, the Economist noted that “surprisingly, Kodak acted like a stereotypical change-resistant Japanese firm, while Fujifilm acted like a flexible American film.” Commenting on Kodak’s last moment, the Economist concluded:

Unlike people, companies can in theory live for- ever. But most die young. Fujifilm has mastered new tactics and survived. Film went from 60% of its profits in 2000 to basically nothing, yet it found new sources of revenue. Kodak, along with many a great company before, appears simply to have run its course. After 132 years it is posed, like an old photo, to fade away.

Sources: Based on (1) Eastman Kodak Company, 2011, 2010 Form 10-K, New York: SEC; (2) Economist, 2012, The last Kodak moment? January 14: 63-64; (3) Economist, 2012, Turn around? January 21: 8; (4) www.kodak.com.

Chapter 4 Leveraging Resources and Capabilities 95

some debate regarding the definition of capabilities. Some scholars define them as “a firm’s capacity to dynamically deploy resources,” suggesting a “dynamic capabilities” view that emphasizes a crucial distinction between resources and capabilities.6

While scholars may debate the fine distinctions between resources and capa- bilities, these distinctions are likely to “become badly blurred” in practice.7 Was Kodak’s R&D prowess a resource or capability? How about Fujifilm’s ability to turn around in response to the digital revolution? For current and would-be managers, the key is to understand how these attributes help improve firm performance, not to figure out whether they should be defined as resources or capabilities. There- fore, in this book, we will use the terms “resources” and “capabilities” interchange- ably and often in parallel. In other words, capabilities are defined here the same as resources.

All firms, even the smallest ones, possess a variety of resources and capabilities. How do we meaningfully classify such diversity? One useful way is to separate the resources and capabilities into two categories: tangible and intangible (Table 4.1). Tangible resources and capabilities are assets that are observable and easily quantified. They can be broadly organized in four categories: financial, physical, technological, and organizational resources and capabilities.

By definition, intangible resources and capabilities are harder to observe and more difficult (or even impossible) to quantify (see Table 4.1). Yet, it is widely

Capability

The tangible and intangible assets a firm uses to choose and implement its strategies.

Tangible resources and capabilities

Assets that are observable and easily quantified.

Intangible resources and capabilities

Assets that are hard to observe and difficult (if not impossible) to quantify.

Table 4.1 Examples of Resources and Capabilities

Tangible resources and capabilities

Examples

Financial Ability to generate internal funds Ability to raise external capital

Physical Location of plants, offices, and equipment Access to raw materials and distribution channels

Technological Possession of patents, trademarks, copyrights, and trade secrets

Organizational Formal planning, command, and control systems Integrated management information systems

Intangible resources and capabilities

Examples

Human Managerial talents Organizational culture

Innovation Research and development capabilities Capacities for organizational innovation and change

Reputational Perceptions of product quality, durability, and reliability Reputation as a good employer Reputation as a socially responsible corporate citizen

Sources: Adapted from (1) J. Barney, 1991, Firm resources and sustained competitive advantage, Journal of Man- agement, 17: 101; (2) R. Hall, 1992, The strategic analysis of intangible resources, Strategic Management Journal, 13: 135–144.

96 Part One Laying Foundations

acknowledged that they must be there, because no firm is likely to generate competitive advantage by relying on tangible resources and capabilities alone. Ex- amples of intangible assets include human, innovation, and reputational resources and capabilities.

It is important to note that all resources and capabilities discussed here are merely examples and that they do not represent an exhaustive list. As firms forge ahead, discovery and leveraging of new resources and capabilities are likely. See In Focus 4.1 to see Honda’s efforts to leverage and extend its resources and capabili- ties in engine technology to launch the HondaJet.

4-2/4-3 Resources, Capabilities, and the Value Chain If a firm is a bundle of resources and capabilities, how do they come together to add value? A value chain analysis allows us to answer this question. Shown in Panel A of Figure 4.1, most goods and services are produced through a chain of vertical

Learning Objective Explain how value is created from a firm’s resources and capabilities.

4-2

Honda is renowned for leveraging its core competency in internal combustion engines by competing not only in automobiles and motorcycles, but also in boat en- gines and lawn mowers. And now Honda is taking to the skies. Are you ready for a HondaJet?

Having taken its maiden flight in 2003, HondaJet is now being introduced to the business jet (corpo- rate aviation) market. Michimasa Fujino, president and CEO of Honda Aircraft Company, Inc., reports that the company will be delivering several aircraft to early customers in 2013, increasing production through- out 2014, and reaching full production capacity— approximately 70 to 100 small jets annually—in 2015.

Currently, however, the HondaJet is still under- going extensive testing in the process of FAA and EASA certification. These tests are especially impor- tant given that Honda is incorporating a number of technological innovations in aviation design. Perhaps the most notable of these is Honda’s over-the-wing engine-mount configuration, which Honda claims dra- matically improves performance and fuel efficiency by reducing aerodynamic drag. The new design, which gives the HondaJet a distinctive appearance, also reduces noise and increases both cabin and cargo capacity. Another innovation is the “next generation” glass flight deck, which Honda describes as “the most advanced available in any light business jet.”

Honda Aircraft Company, a wholly owned subsid- iary of American Honda Motors Inc., was founded in 2006. At Honda Aircraft’s world headquarters campus in Piedmont Triad International Airport, Greensboro, North Carolina (near the birthplace of aviation, where the Wright brothers took their first flight), state-of- the-art R&D and manufacturing work is being per- formed. In a nutshell, the question now is: “How high can HondaJet fly?”

Sources: Based on (1) K. Arcieri, 2012, Mass production of HondaJet expected later this year, The Business Journal, May 14, http://www .bizjournals.com/triad/news/2012/05/14/honda-aircraft-co-to-begin- mass.html (accessed August 14, 2012); (2) R. Goyer, 2012), Honda jet makes progress, Flying Magazine, May 15, http://www.flyingmag.com/ aircraft/jets/honda-jet-makes-progress (accessed August 14, 2012); (3) http://hondajet.honda.com (accessed February 29, 2012).

Does Honda Know How to Fly? IN FOCuS 4.1

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Chapter 4 Leveraging Resources and Capabilities 97

activities (from upstream to downstream) that add value—in short, a value chain. The value chain typically consists of two areas: primary activities and support activities.8

Each activity requires a number of resources and capabilities. Value chain analysis forces managers to think about firm resources and capabilities at a very micro, activity-based level.9 Given that no firm is likely to be good at all primary and support activities, the key is to examine whether the firm has re- sources and capabilities to perform a particular activity in a manner superior to competitors—a process known as benchmarking in SWOT analysis. If managers find that their firm’s particular activity is unsatisfactory, a decision model (shown in Figure 4.2) can remedy the situation. In the first stage, managers ask, “Do we really need to perform this activity in-house?” Figure 4.3 introduces a framework to take a hard look at this question. The answer boils down to (1) whether an

Value chain

A series of activities used in the production of goods and services that make a product or service more valuable.

Benchmarking

Examining whether a firm has resources and capabilities to perform a particular activity in a manner superior to competitors.

Figure 4.1 The Value Chain

Panel A. An Example of Value Chain with Firm Boundaries

Support activities

Support activitiesPrimary activities

INPUT

Components

Final assembly

Marketing

OUTPUT

Research and development Infrastructure

Logistics

Human resources

Primary activities

INPUT

Components

Final assembly

Marketing

OUTPUT

Research and development Infrastructure

Logistics

Human resources

Panel B. An Example of Value Chain with Some Outsourcing

Note: Dotted lines represent firm boundaries.

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98 Part One Laying Foundations

Do we really need to perform this activity

in-house? Do we have the resources and

capabilities that add value in a way better

than rivals do?

Outsource, sell the unit,

or lease its services to other firms

Yes (keep doing it)

Yes

Acquiring necessary resources and

capabilities in-house

Accessing resources and capabilities through

strategic alliances

Figure 4.2 A Two-Stage Decision Model in Value Chain Analysis

activity is industry-specific or common across industries, and (2) whether this ac- tivity is proprietary (firm-specific) or not. The answer is “No” when the activity is found in Cell 2 in Figure 4.3 with a great deal of commonality across industries and little need for keeping it proprietary—known in the recent jargon as a high de- gree of commoditization. The answer may also be “No” if the activity is in Cell 1 in Figure 4.3, which is industry-specific but also with a high level of commoditization. Then, the firm may want to outsource this activity, sell the unit involved, or lease the unit’s services to other firms (see Figure 4.2). This is because operating mul- tiple stages of uncompetitive activities in the value chain may be cumbersome and costly.

Commoditization

A process of market competition through which unique products that command high prices and high margins gradually lose their ability to do so, thus becoming commodities.

Cell 1 Outsource

Cell 2 Outsource

Cell 4 ???

Cell 3 In-House

Common across industries

Industry specific

Industry specificity

High commoditization

Proprietary (firm-specific)

Commoditization versus

proprietary nature of the activity

Figure 4.3 In-House versus Outsource

Note: At present, no clear guidelines exist for Cell 4, where firms either choose to perform activities in-house or outsource.

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Chapter 4 Leveraging Resources and Capabilities 99

Think about steel, definitely a crucial component for automobiles. But the question for automakers is: “Do we need to make steel by ourselves?” The require- ments for steel are common across end-user industries—that is, the steel for auto- makers is essentially the same for construction, defense, and other steel-consuming end-users (ignoring minor technical differences for the sake of our discussion). For automakers, while it is imperative to keep the automaking activity (especially en- gine and final assembly) proprietary (Cell 3 in Figure 4.3), there is no need to keep steel making in-house. Therefore, although many automakers, such as Ford and GM, historically were involved in steel making, none of them does it now. In other words, steel making is outsourced and steel commoditized. In a similar fashion, Ford and GM no longer make glass, seats, or tires as they did before.

Outsourcing is defined as turning over an organizational activity to an outside supplier that will perform it on behalf of the focal firm.10 For example, many con- sumer products companies (such as Nike), which possess strong capabilities in upstream activities (such as design) and downstream activities (such as market- ing), have outsourced manufacturing to suppliers in low-cost countries. A total of 80% of the value of Boeing’s new 787 Dreamliner is provided by outside suppli- ers. This compares with 51% for existing Boeing aircraft.11 Recently, not only is manufacturing often outsourced, a number of service activities, such as IT, HR, and logistics, are also outsourced. The driving force is that many firms, which used to view certain activities as a very special part of their industries (such as airline reservations and bank call centers), now believe that these activities have relatively generic attributes that can be shared across industries. Of course, this changing mentality is fueled by the rise of service providers, such as IBM and Infosys in IT, Manpower in HR, Foxconn in contract manufacturing, and DHL in logistics. These specialist firms argue that such activities can be broken off from the various client firms (just as steel making was broken off from automakers decades ago) and lever- aged to serve multiple clients with greater economies of scale.12 Such outsourcing enables client firms to become “leaner and meaner” organizations, which can bet- ter focus on their core activities (see Figure 4.1 Panel B).

If the answer to the question, “Do we really need to perform this activity in- house?” is “Yes” (Cell 3 in Figure 4.3), but the firm’s current resources and capabili- ties are not up to the task, then there are two choices (see Figure 4.2). First, the firm may want to acquire and develop capabilities in-house so that it can perform this particular activity better.13 Second, if a firm does not have enough skills to develop these capabilities in-house, it may want to access them through alliances.

Conspicuously lacking in both Figures 4.2 and 4.3 is the geographic dimension— domestic versus foreign locations.14 Because the two terms “outsourcing” and “off- shoring” have emerged rather recently, there is a great deal of confusion, especially among some journalists, who often casually equate them. So, to minimize confu- sion, we go from two terms to four terms in Figure 4.4, based on locations and modes (in-house versus outsource):15

Offshoring—international/foreign outsourcing Onshoring—domestic outsourcing Captive sourcing—setting up subsidiaries to perform in-house work in foreign

locations Domestic in-house activity

Outsourcing—especially offshoring—has no shortage of controversies and debates (see the Debates and Extensions section). Despite this set of new labels,

Learning Objective Articulate the difference between keeping an activity in-house and outsourcing it.

4-3

Outsourcing

Turning over an organizational activity to an outside supplier that will perform it on behalf of the focal firm.

Offshoring

Outsourcing to an international or foreign firm.

Onshoring

Outsourcing to a domestic firm.

Captive sourcing

Setting up subsidiaries abroad so that the work done is in-house but the location is foreign. Also known as foreign direct investment (FDI).

100 Part One Laying Foundations

we need to be aware that “captive sourcing” is conceptually identical to foreign direct investment (FDI), which is nothing new in the world of global business (see Chapters 1 and 6 and PengAtlas Map 2.3 for details). We also need to be aware that “offshoring” and “onshoring” are simply international and domestic variants of out- sourcing, respectively. While offshoring low-cost IT work to India, the Philippines, and other emerging economies has been widely practiced, interestingly, eastern Germany; northern France; and the Appalachian, Great Plains, and southern re- gions of the United States have emerged as new hotbeds for onshoring.16 In job- starved regions such as Michigan, high-quality IT workers may accept wages 35% lower than at headquarters in Silicon Valley.

One interesting lesson we can take away from Figure 4.4 is that even for a single firm, value-adding activities may be geographically dispersed around the world, taking advantage of the best locations and modes to perform certain ac- tivities. For instance, a Dell laptop may be designed in the United States (domes- tic in-house activity), its components may be produced in Taiwan (offshoring) as well as the United States (onshoring), and its final assembly may be done in China (captive sourcing/FDI). When customers call for help, the call center may be in India, Ireland, Jamaica, or the Philippines, manned by an outside service provider—Dell may have outsourced the service activities through offshoring.

Overall, a value chain analysis engages managers to ascertain a firm’s strengths and weaknesses on an activity-by-activity basis, relative to rivals, in a SWOT analysis. The recent proliferation of new labels is intimidating, causing some gurus to claim that “21st century offshoring really is different.”17 In reality, it is not. Under the skin of the new vocabulary, we still see the time-honored SWOT analysis at work. The next section introduces a framework on how to do this.

4-4 From Swot to Vrio18

Recent progress in the resource-based view has gone beyond the traditional SWOT analysis. The new work focuses on the value (V), rarity (R), imitability (I), and orga- nizational (O) aspects of resources and capabilities, leading to a VRIO framework. Summarized in Table 4.2, addressing these four important questions has a number of ramifications for competitive advantage.

Learning Objective Understand how to use a VRIO framework.

4-4

VRIO framework

The resource-based framework that focuses on the value (V), rarity (R), imitability (I), and organizational (O) aspects of resources and capabilities.

Mode of activity

Cell 1 Captive

sourcing/FDI

Cell 3 Domestic in-house

Cell 2 Offshoring

Cell 4 Onshoring

Location of

activity

Foreign location

Domestic location

In-House Outsourcing

Figure 4.4 Location, Location, Location

Note: “Captive sourcing” is a new term, which is conceptually identical to “foreign direct investment” (FDI), a term widely used in global business. See Chapter 6 for details.

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Chapter 4 Leveraging Resources and Capabilities 101

4-4a Value Do firm resources and capabilities add value? The preceding value chain analy- sis suggests that this is the most fundamental question to start with.19 Only value- adding resources can lead to competitive advantage (see In Focus 4.2), whereas non-value-adding capabilities may lead to competitive disadvantage. Shown by the Opening Case on Kodak, with changes in the competitive landscape, previous value-adding resources and capabilities may become obsolete. The evolution of IBM is another case in point. IBM historically excelled in making hardware, in- cluding tabulating machines in the 1930s, mainframes in the 1960s, and PCs in the 1980s. However, as competition heated up, IBM’s capabilities in hardware not only added little value, but also increasingly stood in the way for it to move into new areas. Since the 1990s, IBM has been transformed into focusing on more lucrative software and services, where it has developed new value-adding capabilities, aiming to become an on-demand computing service provider for corporations. As part of this new strategy, IBM purchased Pricewaterhouse Coopers (PwC), a leading tech- nology consulting firm, in 2002 and sold its PC division to Lenovo in 2004. In 2011, IBM proudly celebrated its 100th anniversary. The transformation and triumphs of IBM stand in radical contrast with the struggles and frustrations at another iconic American firm that is even older than IBM: Kodak (see the Opening Case).

The relationship between valuable resources and capabilities and firm per- formance is straightforward. Instead of becoming strengths, non-value-adding resources and capabilities, such as IBM’s historical expertise in hardware, may become weaknesses. If firms are unable to get rid of non-value-adding assets, they are likely to suffer below-average performance.20 In the worst case, they may become extinct, a fate IBM narrowly skirted during the early 1990s and Kodak struggled to avoid (see the Opening Case). According to IBM’s new CEO Ginni Rometty:

Whatever business you’re in, it’s going to commoditize over time, so you have to keep moving it to a higher value and change.21

4-4b Rarity Simply possessing valuable resources and capabilities may not be enough. The next question is: “How rare are valuable resources and capabilities?”22 At best, valuable

Table 4.2 The VRIO Framework: Is a Resource or Capability . . .

Valuable? Rare? Costly to imitate?

Exploited by organization?

Competitive implications

Firm performance

No — — No Competitive disadvantage

Below average

Yes No — Yes Competitive parity Average

Yes Yes No Yes Temporary competitive advantage

Above average

Yes Yes Yes Yes Sustained competitive advantage

Persistently above average

Sources: Adapted from (1) J. Barney, 2002, Gaining and Sustaining Competitive Advantage, 2nd ed. (p. 173), Upper Saddle River, NJ: Prentice Hall; (2) R. Hoskisson, M. Hitt, & R.D. Ireland, 2004, Competing for Advantage (p. 118), Cincinnati: South-Western.

102 Part One Laying Foundations

but common resources and capabilities will lead to competitive parity but not an advantage. Consider the (nearly) identical aircraft made by Boeing and Airbus used by numerous airlines. They are certainly valuable, yet it is difficult to derive competitive advantage from these aircraft alone. Airlines have to work hard on how to use these same aircraft differently.

Only valuable and rare resources and capabilities have the potential to pro- vide some temporary competitive advantage. Overall, the question of rarity is a reminder of the cliché: If everyone has it, you can’t make money from it. For ex- ample, the quality of the American Big Three automakers is now comparable with the best Asian and European rivals. However, even in their home country, the Big Three’s quality improvements have not translated into stronger sales. Embarrass- ingly, in 2009, both GM and Chrysler, despite the decent quality of their cars, had to declare bankruptcy and be bailed out by the US government (and in the case of GM, also by the Canadian government). The point is simple: Flawless high quality is now expected, is no longer rare, and thus provides no advantage.

The Internet has enabled some of the noblest human spirit in collaboration to shine—think of Wikipedia. However, the Internet has also unleashed some of the most nasty, disgusting, and hurtful expressions to be used as weapons of choice. In online communities, discussion boards, and social media, the lethal combi- nation of anonymity and opinion have often resulted in discussions going out of control, cussing and swear- ing increasingly dominating the air. Although such un- civil comments represent fewer than 10% of online comments, they often command disproportionate attention, resulting in headaches, embarrassments, and disasters for established companies, nonprofits, and government agencies. Such uncivil comments have also presented wonderful opportunities for a new breed of entrepreneurs known as moderators (or “mods”), who can add a great deal of value.

Moderators delete uncivil comments, scold the people behind them (such as “We don’t call each other a—holes”), and in the case of repeat offenders, ban their accounts from airing their profanity. Working at home (or during vacation), moderators can make between $40,000 and $80,000 annually. But they need to be prepared for daily exposure to extreme rac- ism and bigotry, images of pedophilia, and other un- desirable expressions. Such clean-up is arguably the dirtiest job on the Internet. “Sometimes you feel like you need to spend two hours in the shower because

it is so disgusting,” said Keith Bilous, founder of the Winnipeg, Canada-based ICUC Moderation.

Employing over 200 moderators, ICUC Modera- tion has emerged as a global leader with $10 million in revenue. Its clients include Calvin Klein, Chevron, Intel, Molson, National Public Radio, Scotiabank, Starbucks, Virgin Group, and the Government of Canada. London-based eModeration is another leader, which has 160 moderators with $7 million in revenue. Its clients include the BBC, the Economist, ESPN, HSBC, Lego, MTV, Oprah, and Sony Ericsson. In 2010, Nestlé’s public relations (PR) department at- tempted to address criticisms from Greenpeace on Nestlé’s Facebook page, which was not professionally moderated. It turned out to be a PR disaster. The expe- rience, judgment, and expertise of moderators would have contained such a firestorm before it exploded.

Many firms, such as the New York Times, moder- ate their own websites. But the trend is to increasingly outsource such work to professional online content and community moderation service providers, such as ICUC Moderation and eModeration, which typically charge $30 to $40 per hour. However, competition is rapidly becoming global, with Indian and Filipino ser- vice providers offering deals to clients at $5 per hour.

Sources: Based on (1) Bloomberg Businessweek, 2011, The dirtiest job on the Internet, December 5: 95–97; (2) www.emoderation.com; (3) www.icucmoderation.com.

Adding Value to the Dirtiest Job Online IN FOCuS 4.2 Ethical

Dilemma

Chapter 4 Leveraging Resources and Capabilities 103

4-4c imitability Valuable and rare resources and capabilities can be a source of competitive advan- tage only if competitors have a difficult time imitating them. While it is relatively easier to imitate a firm’s tangible resources (such as plants), it is a lot more challeng- ing and often impossible to imitate intangible capabilities (such as tacit knowledge, superior motivation, and managerial talents).

Imitation is difficult. Why? Two words: causal ambiguity, which refers to the difficulty of identifying the causal determinants of successful firm performance.23 What exactly has caused IBM to be such an enduring and continuously relevant company? IBM has no shortage of competitors and imitators. Rumors about IBM’s end erupt periodically (and almost became true at least once in the early 1990s). Yet, IBM has always been able to turn around by discarding businesses that it once dominated (think of PCs) and constructing a new portfolio of products and services that add value. Recently, its service businesses had 32% margins, and its software businesses enjoyed 88% margins.24

One natural question is: “How does IBM do it?” Usually, a number of resources and capabilities will be nominated, such as an innovative culture, a commitment to customer relationships, a willingness to change, a strong leadership team, and a multinational presence. While all of these resources and capabilities are plausible, what exactly is it? This truly is a million (or billion) dollar question, because know- ing the answer is not only intriguing to scholars and students, it can also be hugely profitable for IBM’s rivals. Unfortunately, outsiders usually have a hard time un- derstanding what a firm does inside its boundaries. We can try, as many rivals have, to identify IBM’s recipe for success by drawing up a long list of possible reasons, labeled as “resources and capabilities” in our classroom discussion. But in the final analysis, as outsiders we are not sure.25

What is even more fascinating for scholars and students, and more frustrating for rivals, is that often managers of a focal firm such as IBM do not know exactly what contributes to their firm’s success. When interviewed, they can usually gener- ate a long list of their contributing factors, such as a strong organizational culture, a relentless drive, and many other attributes. To make matters worse, different managers within the same firm may have a different list. When probed as to which resource or capability is “it,” they often suggest that it is all of the above in com- bination. This is probably one of the most interesting and paradoxical aspects of the resource-based view: If insiders have a hard time figuring out what unambigu- ously contributes to their firm’s performance, it is not surprising that outsiders’ efforts in understanding and imitating these capabilities are usually flawed and often fail.

Overall, valuable and rare, but imitable, resources and capabilities may give firms some temporary competitive advantage, leading to above-average perfor- mance for some period of time. However, such advantage is not likely to be sus- tainable. Shown by the example of IBM, only valuable, rare, and hard-to-imitate resources and capabilities may potentially lead to sustained competitive advantage.

4-4d organization Even valuable, rare, and hard-to-imitate resources and capabilities may not give a firm a sustained competitive advantage if it is not properly organized. Although movie stars represent some of the most valuable, rare, and hard-to-imitate (as well as highest-paid) resources, most movies flop. More generally, the question of

Causal ambiguity

The difficulty of identifying the actual cause of a firm’s successful performance.

104 Part One Laying Foundations

organization asks: “How can a firm (such as a movie studio) be organized to develop and le- verage the full potential of its resources and capabilities?”

Numerous components within a firm are relevant to the question of organization.26 In a movie studio, these components include tal- ents in “smelling” good ideas, photography crews, musicians, singers, makeup artists, ani- mation specialists, and managers on the busi- ness side. These components are often called complementary assets,27 because by themselves they cannot generate box office hits. For the fa- vorite movie you saw most recently, do you still remember the names of its makeup artists? Of course not—you probably only remember the stars. However, stars alone cannot generate hit movies either. It is the combination of star resources and complementary assets that cre- ate hit movies. “It may be that not just a few resources and capabilities enable a firm to gain

a competitive advantage but that literally thousands of these organizational at- tributes, bundled together, generate such advantage.”28

Another idea is social complexity, which refers to the socially complex ways of organizing that are typical of many firms. Many multinationals consist of thou- sands of people scattered in many different countries. How they overcome cultural differences and are organized as one corporate entity and achieve corporate goals is profoundly complex. Oftentimes, it is their invisible relationships that add value. Such organizationally embedded capabilities are thus very difficult for rivals to imitate. This emphasis on social complexity refutes what is half-jokingly called the “Lego” view of the firm, in which a firm can be assembled (and disassembled) from modules of technology and people (a là Lego toy blocks). By treating employees as identical and replaceable blocks, the “Lego” view fails to realize that social capital associated with complex relationships and knowledge permeating many firms can be a source of competitive advantage.

Overall, only valuable, rare, and hard-to-imitate capabilities that are organi- zationally embedded and exploited can possibly lead to sustained competitive advantage and persistently above-average performance. Because capabilities cannot be evaluated in isolation, the VRIO framework presents four intercon- nected and increasingly difficult hurdles for them to become a source of sustain- able competitive advantage (Table 4.2). In other words, these four aspects come together as one “package.”

4-5 Debates and Extensions Like the institution-based viewed outlined in Chapters 2 and 3, the resource-based view has its fair share of controversies and debates. Here, we introduce two leading debates: (1) domestic resources versus international (cross-border) capabilities and (2) offshoring versus nonoffshoring.

Complementary assets

The combination of numerous resources and assets that en- able a firm to gain a competitive advantage.

Social complexity

The socially intricate and interdependent ways firms are typically organized.

Learning Objective Participate in two leading debates concerning leveraging resources and capabilities.

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Hit movies require more than just star power—money- making movies require complementary assets. What do you think some of these assets might be?

Chapter 4 Leveraging Resources and Capabilities 105

4-5a Domestic Resources versus international (Cross-Border) Capabilities Do firms that are successful domestically have what it takes to win internation- ally? If you were to ask managers at The Limited Brands, their answer would be “No.” The Limited Brands is the number one US fashion retailer. It has a success- ful retail empire of 4,000 stores throughout the country and leading brands such as The Limited, Victoria’s Secret, and Bath & Body Works. Yet, it has refused to go abroad—not even to Canada. On the other hand, the ubiquitous retail outlets of LVMH, Zara, and United Colors of Benetton in major cities around the world suggest that their answer would be “Yes!”

Some domestically successful firms continue to succeed overseas. For example, Swedish furniture retailer IKEA has found that its Scandinavian-style furniture, combined with do-it-yourself flat packaging, is popular around the globe. IKEA thus has become a global cult brand. The young generation in Russia is now known as the “IKEA Generation.” However, many other firms that are formidable domestically are burned badly overseas. Wal-Mart withdrew from Germany and South Korea. Similarly, its leading global rival, France’s Carrefour, had to exit the Czech Republic, Japan, Mexico, and South Korea. Starbucks has failed to turn its bitter brew into sweet profits overseas.

Are domestic resources and cross-border capabilities essentially the same? The answer can be either “Yes” or “No.” This debate is an extension of the larger debate on whether international business (IB) is different from domestic business. The argument that IB is different from domestic business is precisely the argument for having stand-alone IB courses in business schools. If the two are essentially the same, then it is possible to argue that IB fundamentally is about “business,” which is well covered by strategy, finance, and other courses. (Most textbooks in these areas have at least one chapter on “international topics.”) This question is obviously very important for companies and business schools. However, there is no right or wrong answer.

4-5b offshoring versus Not offshoring As noted earlier, offshoring—or, more specifically, international (offshore) outsourcing—has emerged as a leading corporate movement in the 21st century. Outsourcing low-end manufacturing to countries such as China and Mexico is now widely practiced. But increased outsourcing of high-end services, particularly IT and other business process outsourcing (BPO) services, to countries such as India is controversial. Because digitization and commoditization of service work are enabled only by the very recent rise of the Internet and the reduction of interna- tional communication costs, it is debatable whether such offshoring proves to be a long-term benefit or hindrance to Western firms and economies.

Proponents argue that offshoring creates enormous value for firms and economies. Western firms are able to tap into low-cost yet high-quality labor, trans- lating into significant cost savings. Firms can also focus on their core capabilities, which may add more value than noncore (and often uncompetitive) activities. In turn, offshoring service providers, such as Infosys and Wipro, develop their core competencies in IT/BPO. A McKinsey study reported that for every dollar spent by US firms’ offshoring in India, US firms save 58 cents (see Table 4.3). Overall, $1.46 of new wealth is created, of which the US economy captures $1.13, through cost savings

Business process outsourcing (BPO)

Outsourcing business processes to third-party providers.

106 Part One Laying Foundations

and increased exports to India, which buys Made-in-USA equipment, software, and services. India captures the other 33 cents through profits, wages, and taxes.29 While acknowledging that some US employees may regrettably lose their jobs, offshoring proponents suggest that, on balance, offshoring is a win-win solution for both US and Indian firms and economies. In other words, offshoring can be conceptualized as the latest incarnation of international trade (in tradable services), which theoreti- cally will bring mutual gains to all involved countries (see Chapter 5).

Critics of offshoring make three points on strategic, economic, and political grounds. Strategically, according to some outsourcing gurus, if “even core functions like engineering, R&D, manufacturing, and marketing can—and often should— be moved outside,”30 what is left of the firm? In manufacturing, US firms have gone down this path before, with disastrous results. In the 1960s, Radio Corporation of America (RCA) invented the color TV and then outsourced its production to Japan, a low -cost country at that time. Fast-forward to 2010: the United States no longer has any US-owned color TV producers left. The nationality of RCA itself, after being bought and sold several times, is now Chinese (France’s Thomson sold RCA to China’s TCL in 2003). Critics argue that offshoring nurtures rivals.31 Why are Indian IT/BPO firms now emerging as strong global rivals to Western firms such as IBM? It is in part because they built up their capabilities doing work for IBM in the 1990s, particularly by working to help the IT industry prevent the “millennium bug” (Y2K) problem.

In manufacturing, many Asian firms, which used to be original equipment man- ufacturers (OEMs) executing design blueprints provided by Western firms, now want to have a piece of the action in design by becoming original design manufactur- ers (ODMs) (see Figure 4.5). Having mastered low-cost and high-quality manufac- turing, Asian firms such as BenQ, Compal, Flextronics, Hon Hai/Foxconn, and Huawei are indeed capable of capturing some design function from Western firms such as Dell, HP, Kodak, and Nokia. Therefore, increasing outsourcing of design work by Western firms may accelerate their own long-run demise. A number of Asian OEMs, now quickly becoming ODMs, have openly announced that their real ambition is to become original brand manufacturers (OBMs). For example, HTC has emerged as a hot new OBM whose “HTC” branded smartphones enjoy a higher

Original equipment manufacturer (OEM)

A firm that executes design blueprints provided by other firms and manufactures such products.

Original design manufacturer (ODM)

A firm that both designs and manufactures products.

Original brand manufacturer (OBM)

A firm that designs, manufac- tures, and markets branded products.

Table 4.3 Benefit of $1 US Spending on Offshoring to India

Benefit to the United States $ Benefit to India $

Savings accruing to US investors/ customers

0.58 Labor 0.10

Exports of US goods/services to providers in India

0.05 Profits retained in India 0.10

Profit transfer by US-owned operations in India back to the US

0.04 Suppliers 0.09

Net direct benefit retained in the United States

0.67 Central government taxes 0.03

Value from US labor reemployed 0.46 State government taxes 0.01

Net benefit to the United States 1.13 Net benefit to India 0.33

Source: Based on text in D. Farrell, 2005, Offshoring: Value creation through economic change, Journal of Management Studies, 42: 675–683. Farrell is director of the McKinsey Global Institute, and she refers to a McKinsey study.

Chapter 4 Leveraging Resources and Capabilities 107

smartphone market share in Apple’s homeland, the United States (see Emerg- ing Markets 4.1). Thus, according to critics of offshoring, isn’t the writing already on the wall? A new case in point is the inability of US firms to manufacture the Amazon Kindle (see the Closing Case).

Economically, critics contend that they are not sure whether developed economies, on the whole, actually gain more. While shareholders and corporate high-flyers embrace offshoring (see Chapter 1), offshoring increasingly results in job losses in high-end areas such as design, R&D, and IT/BPO. While white-collar individuals who lose jobs will naturally hate it, the net impact (consolidating all economic gains and losses including job losses) on developed economies may still be negative (see the Closing Case).

Finally, critics make the political argument that many large US firms claim that they are global companies and, consequently, that they should neither repre- sent nor be bound by American values any more. According to this view, all that these firms are interested in is the cheapest and most exploitable labor. Not only is work commoditized, people (such as IT programmers) are degraded as trad- able commodities that can be jettisoned. As a result, large firms that outsource work to emerging economies are often accused of being unethical, destroying jobs at home, ignoring corporate social responsibility, violating customer privacy (for example, by sending medical records, tax returns, and credit card numbers to be processed overseas), and in some cases undermining national security. Not sur- prisingly, the debate often becomes political, emotional, and explosive when such accusations are made.

It is important to note that this debate takes place primarily in developed econo- mies. There is relatively little debate in emerging economies because they clearly stand to gain from such offshoring to them. Taking a page from the Indian playbook, the Philippines, with numerous English-speaking professionals, is trying to eat some of India’s lunch. Northeast China, where Japanese is widely taught, is positioning itself as an ideal location for call centers for Japan. Central and Eastern Europe

INPUT

Research & development

Components

Final assembly

Marketing

OUTPUT

INPUT

Research & development

Components

Final assembly

Marketing

OUTPUT

An example of OEM An example of ODM

Figure 4.5 From Original Equipment Manufacturer (OEM) to Original Design Manufacturer (ODM)

Note: Dotted lines represent organizational boundaries. One further extension is to become an original brand manufac- turer (OBM), which would incorporate brand ownership and management in the marketing area. For graphic simplicity, it is not shown here.

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Everyone has heard of Apple and its iPhone, which set the smartphone market on fire when it first appeared in 2007. Fast forward to 2012: Which company had the highest smartphone market share in the United States? Not Apple (20% market share), not Samsung (20%), and not Blackberry (9%). The winner was HTC, which commanded a 25% market share. “Apple iPhone’s market share was lower than what?” some of you may ask.

Founded in Taiwan in 1997, HTC was an “unlikely leader” in the smartphone world infested by global heavyweights, according to Bloomberg Business- week. Founded as High Tech Computer, the firm fol- lowed the well-known Taiwanese outsourcing formula of designing and manufacturing gadgets for other companies without a brand name of its own. The plain- vanilla original name (which the firm no longer uses) was as low-profile as a corporate name could be. The firm toiled for a long time in obscurity as an original design manufacturer (ODM), quietly designing and making high-end smartphones for leading Western mobile operators such as Verizon and Orange. HTC’s first big contract came when Microsoft asked it to make smartphones. HTC quickly became the world’s top producer of Windows phones. It set up its US headquarters in Bellevue, Washington, a Seattle sub- urb where Microsoft was headquartered. Like many contract manufacturers, HTC worried that a brandless firm would permanently remain a low-margin manu- facturer of commodity products. What was worse was that the already razor-thin margin would be squeezed even further as clients shopped for lower-cost produc- ers (read: China). The solution was usually to launch a firm’s own brand to command higher margins and more respect—in other words, to become an original brand manufacturer (OBM) just like Apple. However, Taiwanese (and Asian) firms attempting to overcome this hurdle usually had to face a “double whammy”: (1) a lack of capabilities in innovation and branding, and

(2) the loss of clients, which did not want to do busi- ness with an emerging rival. Such a “double whammy” forced many manufacturers to remain on the low-cost treadmill. How did HTC overcome such a challenge?

Three things stand out. First, as emphasized by Cher Wang, HTC’s chairwoman, in media interviews, HTC was never engaged in original equipment manu- facturing (OEM). From the start, it had always been an ODM—emphasizing the “design” function that was lacking among most OEM manufacturers (such as Foxconn or Hon Hai, the largest Taiwanese OEM). The difference was nontrivial: HTC had developed world- class design and innovation capabilities. It began de- signing some of the world’s first touch screen and wireless handheld devices as early as 1998.

Second, HTC was very skillful in collaborating with larger firms. Such successful collaborations—in com- bination with its design prowess—led to a series of enviable first-mover accomplishments in this rapidly developing industry. These accomplishments included creating the world’s first touch screen smartphones as the Treo for Palm and the iPAQ for Compaq (2000); developing the first Microsoft-powered smartphone (2002) and the first Microsoft 3G smartphone (2005); the world’s first smartphone powered by Google’s Android operating system, which was promoted as a free, open-source system (2008); and the first 4G- capable phone in the United States (2010).

Third, unlike many Asian firms that had a hard time globalizing their operations due to language barriers and cultural constraints, HTC was a “born global” firm. E-mails and documents were in English from day one. CEO Peter Chou, according to the Econo- mist, sounded more like a Silicon Valley management guru than a typical Asian corporate patriarch. “Instead of telling them what to do, I want people to have the freedom to explore their talent,” Chou said. Such an open culture made HTC a more attractive employer for Western talents. In 2006, HTC attracted Horace Luke,

HTC: From ODM to OBM

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Chapter 4 Leveraging Resources and Capabilities 109

gravitate towards serving Western Europe. Central and South American countries want to grab call center contracts for the large Hispanic market in the United States.

4-6 Management Savvy How does the resource-based view answer the big question in global business: “What determines the success and failure of firms around the globe?” The answer is straightforward. Fundamentally, some firms outperform others because they possess some valuable, rare, hard-to-imitate, and organizationally embedded re- sources and capabilities that competitors do not have.

The resource-based view thus suggests four implications for action (see Table 4.4). First, there is nothing very novel in the proposition that firms “compete on resources and capabilities.” The subtlety comes when managers attempt to distinguish resources and capabilities that are valuable, rare, hard-to-imitate, and organizationally embedded from those that do not share these attributes. In oth- er words, the VRIO framework can greatly aid the time-honored SWOT analysis,

Learning Objective Draw implications for action.

4-6

a rising star at Microsoft. He had been the creative director of Windows Mobile. At HTC, Luke created an innovation infrastructure of fast-moving development teams. Some of these teams were based in Seattle. In 2011, HTC also opened a research and develop- ment (R&D) office in Durham, North Carolina. Chou also proudly noted in a 2010 interview that at the top management level, more than half of the CEO’s direct reports were not Taiwanese.

Sticking its neck out as a new OBM, HTC started to develop its own brand in 2006. By 2008, when its first Android phone was marketed, it was branded as “HTC.” As Google built an ecosystem based on Android to wage its battle with Apple, HTC gained tre- mendous visibility as Google’s leading Android partner. Since then, HTC took off. In 2011, it displaced Acer and was ranked number one among Taiwan’s global brands by Interbrand, which listed its brand as number 98 in the world. In 2011, it was named “Device Manufac- turer of the Year” by the Mobile World Congress. Also, its market value surpassed that of Nokia to become the third largest smartphone maker in the world (by market value), behind only Apple and Samsung. When asked about Apple in interviews, Chou acknowledged that despite HTC smartphones’ attractive features,

they would not attract crowds eager to lay their hands on new gadgets during “midnight madness” sales outside Apple stores. “HTC is HTC,” asserted Chou. “I don’t care about the iPhone. I don’t even look at it.”

Apple, on the other hand, took HTC’s challenge very seriously. In addition to vigorously competing on the product dimension, Apple sued HTC for 20 counts of patent violations in 2010. This was part of a broader Apple strategy to slow the ascendance of Android phones made by HTC, Samsung, and Motorola. Led by HTC, Android phones rocketed from less than 3% market share in 2009 to 48% in 2011. In addition to HTC, Apple also sued Samsung, Motorola, and Google itself. In response, HTC countersued Apple for infringing on five of HTC’s patents and sought to ban Apple products manufactured in Asia from being im- ported into the United States.

As HTC’s fight with Apple spilled over from product markets to courts, HTC, the clear underdog, claimed that it had sufficient patents to deal with Apple. “Patent lawsuits are normal,” Wang answered the media. “Chinese firms have seldom used this strategic weap- on. So we are setting an example.” Likewise, Chou said, “If HTC can do a good job and set an example in innova- tion, we can inspire other companies to try the same.”

Sources: Based on (1) 21 Century Business Insights, 2011, HTC: Can being itself allow it to surpass Apple? October 1: 58–59; (2) Bloomberg Business- week, 2010, A former no-name from Taiwan builds a global brand, November 1: 37–38; (3) Bloomberg Businessweek, 2011, Android’s dominance is patent pending, August 8: 36–37; (4) Economist, 2009, Upwardly mobile, July 11: 68; (5) Economist, 2011, Android alert, July 23: 64; (6) Interbrand, 2011, Taiwan top 20 global brands 2011, www.brandingtaiwan.com.

110 Part One Laying Foundations

Table 4.4 Implications for Action

Managers need to build firm strengths based on the VRIO framework.

Relentless imitation or benchmarking, while important, is not likely to be a successful strategy.

Managers need to build up resources and capabilities for future competition.

Students need to make themselves into “untouchables” whose job cannot be easily outsourced.

especially the S and W parts. Because managers cannot pay attention to every capa- bility, they must have some sense of what really matters. One common mistake that managers often make when evaluating their firms’ capabilities is failing to assess them relative to rivals’, thus resulting in a mixed bag of both good and mediocre capabilities. The VRIO framework helps managers make decisions on what capa- bilities to focus on in-house and what to outsource. Capabilities not meeting the VRIO criteria need to be jettisoned or outsourced.

Second, relentless imitation or benchmarking, while important, is not likely to be a successful strategy.32 By the time Elvis Presley died in 1977, there were a little over 100 Elvis impersonators. After his death, the number skyrocketed.33 But obvi- ously none of these imitators achieved any fame remotely close to the star status attained by the King of Rock ’n’ Roll. Imitators have a tendency to mimic the most visible, the most obvious, and, consequently, the least important practices of win- ning firms (and musicians). At best, follower firms that meticulously replicate every resource possessed by winning firms can hope to attain competitive parity. Firms so well endowed with resources to imitate others may be better off by developing their own unique and innovative capabilities (see In Focus 4.3).

Would you be surprised that Hyundai’s Genesis was named the North American Car of the Year for 2009 by its auto industry peers, beating all the usual suspects? Would you believe an authoritative J.D. Power survey reported that Hyundai has better qual- ity than Toyota and Honda? Trouble is, just like you, most American car buyers don’t buy it. Only 23% of all new-car buyers in the United States bother to consider buying a Hyundai. This compares with 65% and 50% for Toyota and Honda, respectively (before Toyota’s mass recalls in 2010).

Make no mistake: Hyundai is very capable. It is the fastest-growing automaker in the US market in the 2000s. Between 2008 and 2009, it doubled its market share from 2% to 4%, whereas most rivals

lost market share. Hyundai benefitted from consum- ers’ desire to “trade down” in hard times. Elbowing its way into the entry-level market, Hyundai captured many value-conscious buyers, who appreciated the more tangible equipment and performance at lower prices. For high-end buyers, it is the intangible repu- tation and mystique that count. Hyundai audacious- ly compared its Genesis luxury sedan with both the BMW 5 series and the Lexus ES350, but does Hyundai have what it takes to win the hearts, minds, and wallets of high-end car buyers?

Sources: Based on (1) BusinessWeek, 2007, Hyundai still gets no re- spect, May 21: 68–70; (2) Economist, 2009, Sui Genesis, March 7: 71; (3) PR Newswire, 2009, Hyundai leads all automotive brands in market share growth this year, November 3, www.prnewswire.com; (4) www.jdpower.com.

Hyundai’s Uphill Battle IN Focus 4.3

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Chapter 4 Leveraging Resources and Capabilities 111

Third, a competitive advantage that is sustained does not imply that it will last forever, which is not realistic in today’s global competition. Managers’ failure to appreciate this insight can run an otherwise highly capable firm to the ground, as evidenced by Kodak’s last moment in the Opening Case. In fact, competitive advantage has become shorter in duration.34 All a firm can hope for is a com- petitive advantage that can be sustained for as long as possible. Over time, all advantages erode.35 Each of IBM’s product-related advantages associated with tabulating machines, mainframes, and PCs was sustained for a period of time. But eventually, these advantages disappeared. The lesson for all firms, including current market leaders, is to develop strategic foresight—“over-the-horizon radar” is a good metaphor. Such strategic foresight enables firms to anticipate future needs and move early to identify and develop resources and capabilities for fu- ture competition.

Finally, here is a very personal and relevant implication for action. As a stu- dent who is probably studying this book in a developed (read: high-wage and thus high-cost!) country such as the United States, you may be wondering: What do I get out of this? How do I cope with the frightening future of global competi- tion? There are two lessons you can draw. First, the whole debate on offshoring, a part of the larger debate on globalization, is very relevant and directly affects your future as a manager, a consumer, and a citizen. So, don’t be a coach potato! You should be active, get involved, and be prepared because it is not only “their” debate, it is yours as well. Second, be very serious about the VRIO framework of the resource-based view. While the resource-based view has been developed to advise firms, there is no reason you cannot develop that into a resource-based view of the individual. In other words, you can use the VRIO framework to make your- self into an “untouchable”—a person whose job cannot be outsourced, as Thomas Friedman defines it in The World Is Flat (2005). An untouchable individual’s job cannot be outsourced because he or she possesses valuable, rare, and hard-to- imitate capabilities indispensable to an organization. This won’t be easy. But you really don’t want to be mediocre. A generation ago, parents told their kids, “Eat your food—kids in China and India are starving.” Now, Friedman would advise you, “Study this book and leverage your education—students in China and India are starving for your job.”36

C h a P T E R S u M M a R y

4.1 Define resources and capabilities.

“Resources” and “capabilities” are tangible and intangible assets a firm uses to choose and implement its strategies.

4.2 Explain how value is created from a firm’s resources and capabilities.

A value chain consists a stream of activities from upstream to downstream that add value.

A SWOT analysis engages managers to ascertain a firm’s strengths and weaknesses on an activity-by-activity basis relative to rivals.

4.3 Articulate the difference between keeping an activity in-house and outsourcing it.

Outsourcing is defined as turning over all or part of an organizational activity to an outside supplier.

112 Part One Laying Foundations

An activity with a high degree of industry commonality and a high degree of commoditization can be outsourced, and an industry-specific and firm- specific (proprietary) activity is better performed in-house.

On any given activity, the four choices for managers in terms of modes and locations are (1) offshoring, (2) onshoring, (3) captive sourcing/FDI, and (4) domestic in-house activity.

4.4 Understand how to use a VRIO framework.

A VRIO framework centers on value (V), rarity (R), imitability (I), and or- ganizational (O) attributes of resources and capabilities.

A VRIO framework suggests that only resources and capabilities that are valuable, rare, inimitable, and organizationally embedded will generate sustainable competitive advantage.

4.5 Participate in two leading debates concerning leveraging resources and capabilities.

(1) Domestic resources versus international capabilities and (2) offshoring versus not offshoring.

4.6 Draw implications for action.

Managers need to build firm strengths based on the VRIO framework. Relentless imitation or benchmarking, while important, is not likely to be a

successful strategy. Managers need to build up resources and capabilities for future competition. Students are advised to make themselves into “untouchables” whose jobs

cannot be outsourced.

K E y T E R M S

Benchmarking 97 Business process

outsourcing (BPO) 105 Capability 95 Captive sourcing 99 Causal ambiguity 103 Commoditization 98 Complementary

assets 104 Intangible resources and

capabilities 95

Offshoring 99 Onshoring 99 Original brand

manufacturer (OBM) 106

Original design manufacturer (ODM) 106

Original equipment manufacturer (OEM) 106

Outsourcing 99 Resources 94 Resource-based

view 94 Social complexity 104 SWOT analysis 94 Tangible resources

and capabilities 95 Value chain 97 VRIO framework 100

R E V I E W Q u E S T I O n S

1. Describe at least three types of tangible and intangible resources and capabilities.

2. In the text, are human resources used as an example of tangible or intan- gible resources? Do you agree with that classification? Why or why not?

3. What is meant by “commoditization”?

4. When analyzing a value chain with a VRIO framework, what is the most important question to begin with and why?

Chapter 4 Leveraging Resources and Capabilities 113

5. Show how the rarity of capabilities is an advantage for both a firm and a job seeker.

6. What is the difference between outsourcing and captive sourcing?

7. How can SWOT analysis be used in value chain analysis? Use an example to support your answer.

8. Which is more difficult: imitating a firm’s tangible resources or its intan- gible resources?

9. How do complementary assets and social complexity influence a firm’s organization?

10. If a firm is successful domestically, is it likely to be successful internation- ally? Why or why not?

11. After reviewing the arguments for and against offshoring, state your opin- ion on this issue.

12. ON CULTURE: How can differences in values and traditions affect the success of offshoring?

13. Identify a developed country on PengAtlas Map 1.1, and explain why it may be the location of offshoring from a firm in an emerging economy.

14. What is one common mistake that managers often make when evaluating their firm’s capabilities?

15. What is the likely result of relentless imitation or benchmarking?

16. Why is it a good idea for the VRIO framework to focus on future competition?

17. Check Map 1.1, and imagine that your firm is headquartered in a developed country. Pick an emerging economy that your firm may enter. Explain what resources and capabilities your firm has that may enable it to succeed in this new market.

C R I T I C a l D I S C u S S I O n Q u E S T I O n S

1. Pick any pair of rivals (such as Samsung/Sony, Nokia/Motorola, Boeing/ Airbus, and Apple/HTC) and explain why one outperforms another.

2. Rank your business school relative to the top three rival schools in terms of the following six dimensions. If you were the dean with a limited bud- get, from a VRIO standpoint, where would you invest precious financial resources to make your school number one among rivals. Why?

Your school Competitor 1 Competitor 2 Competitor 3

Perceived reputation

Faculty strength

Student quality

Administrative efficiency

Information systems

Building maintenance

114 Part One Laying Foundations

3. ON ETHICS: Since firms read information posted on competitors’ websites, is it ethical to provide false information on resources and capabilities on corporate websites? Do the benefits outweigh the costs?

G l O B a l a C T I O n

1. Currently, your firm has manufacturing and logistics units in the Russian cities of Moscow and Saint Petersburg, which provide access to Russia’s vast countrywide market. However, recent business regulations have discour- aged growth in specific regions of the country. As such, you have been asked to reconfigure your firm’s strategy in Russia. Identify the location(s) where you should move operations. Provide detailed and compelling rationale to support your decision.

2. The technology company that you work for wants to enter a foreign market for the first time. The objective is for the firm to make a sustainable inter- national investment that can create long-term competitive advantages and allow it to be recognized as important in the industry. Evaluate the opportu- nities available to your company by assessing the national conditions among leading emerging economies.

V I D E O C a S E

After watching the video on Dubai, discuss the following:

1. What resources, capabilities, and competencies does Dubai have?

2. What strengths, weaknesses, opportunities, and threats exist for Dubai?

3. How is value created from Dubai’s resources and capabilities?

4. Does Dubai have the framework for sustainable competitive advantage?

5. How important is strategic sourcing to such futuristic success exhibited by Dubai?

Amazon’s Kindle is a revolutionary e-reader device de- veloped by Amazon’s Lab126 unit based in California. Kindle 1, which retailed for $399 and could hold approximately 200 e-books, sold out in its first six hours when it debuted in November 2007. Since then, Amazon unleashed a series of more powerful, but

cheaper, Kindle models. In 2011, for the first time, Amazon sold more Kindle copies of books than print copies. Yet no US-based manufacturer is able to make this cutting-edge, high-tech product in the United States. Its components are made in China, Taiwan, and South Korea, and its final assembly is in China.

EmErging markEts: Why Amazon’s Kindle Cannot be Made in the United States

Ethical Dilemma

C L O s i n g C a s e

Chapter 4 Leveraging Resources and Capabilities 115

Why Kindle cannot be made in its home country has become a new exhibit in the debate about the future of the US economy. Since no US-based manufacturer has the capabilities to produce Kindle at home, Amazon has no choice but to outsource Kindle’s production to Asia. Critics argue that after decades of outsourcing production to low-cost countries, US firms have lost not only millions of low-skill jobs but also the ability to make the next generation of high-tech, high-value goods. In addition to Kindle, the not-made-in-USA list includes electric-car batteries, light-emitting diodes, and carbon-fiber components of Boeing’s 787 Dreamliner.

The common belief is that as long as US firms control upstream R&D and design activities and downstream branding, marketing, and distribution services in a value chain, their competitiveness will remain unchallenged in global competition. Outsourc- ing basic manufacturing will not be a grave problem. However, critics argue that when a large chunk of val- ue-adding activities, such as manufacturing, is taken out of a country, employment opportunities for these activities shrink, experienced people change careers, and smart students avoid these “dead-end” fields. Eventually, a critical mass of capabilities is lost and will no longer be able to support upstream and down- stream activities, which will be forced to migrate too.

Consider the migration of PC production. Original equipment manufacturers (OEMs) in Asia, for sure, offered compelling low-cost solutions to US firms. US firms initially did not feel threatened. However, prod- uct innovation for new gadgets and process innovation in manufacturing are intertwined. PC designers need to interact with manufacturing specialists frequently

in order to optimize the design. When the loss of US- based manufacturing makes US design engineers less able to handle complex new designs, plenty of such opportunities to work with manufacturing specialists in Asia make Asian design engineers more capable. Thus, the erosion of PC manufacturing capabilities leads to the erosion of PC design skills. Ferocious product market competition often forces US firms to relinquish the design function to their Asian suppliers, which then become original design manufacturers (ODMs) (see Figure 4.5). Of course, one solution is to jettison a US PC brand all together, as evidenced by IBM’s sale of its PC division to China’s Lenovo. Lenovo thus becomes an original brand manufacturer (OBM). Today for all the remaining US-owned PC brands, with the exception of Apple, every laptop is not only manu- factured but also designed in Asia. Competing with them are a bunch of PC brands from Taiwan, such as Acer, BenQ, ASUS, Advantech, HTC, and MSI—in addition to Lenovo from China, Samsung and LG from South Korea, and Sony and Toshiba from Japan.

Nevertheless, the migration of PC production still fits the theory of product life cycle (that is, US- based firms manufactured and designed PCs first, and then gradually the production and design func- tions migrated to Asia). However, the theory of prod- uct life cycle no longer seems valid in the case of Amazon’s Kindle. US-based firms simply do not have a chance to manufacture it, which does not generate a single US manufacturing job at a time when the US unemployment rate is sky-high. In another high- tech industry, the $30 billion global solar industry, the United States has a chance to be a contender in man- ufacturing. However, the odds are not great because the United States produces just 5% of the world’s solar panel cells, while China is already the number- one player, making more than 50%.

General Electric’s (GE) CEO Jeff Immelt has re- cently admitted that GE has probably gone too far in outsourcing. He has labeled the notion that the United States could remain an economic superpower by relying solely on services and consumption “flat wrong.” Recently, Ford’s chairman Bill Ford and Dow Chemical’s CEO Andrew Liveris have openly called for “industrial policy,” an unpopular term (in the La

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116 Part One Laying Foundations

n O T E S

[Journal acronyms] AME—Academy of Management Executive; AMJ— Academy of Management Journal; AMR—Academy of Management Review; BW—BusinessWeek (before 2010) or Bloomberg Businessweek (since 2010); HBR—Harvard Business Review; JIBS—Journal of International Busi- ness Studies; JIM—Journal of International Management; JM—Journal of Management; JMS—Journal of Management Studies; JWB—Journal of World Business; MIR—Management International Review; OSc— Organization Science; SMJ—Strategic Management Journal

1 J. Barney, 1991, Firm resources and sustained competitive advan- tage, JM, 17: 99–120; M. W. Peng, 2001, The resource-based view and international business, JM, 27: 803–829.

2 A. Cuervo-Cazurra & L. Dau, 2009, Promarket reforms and firm profitability in developing countries, AMJ, 52: 1348–1368; G. Gao, J. Murray, M. Kotabe, & J. Lu, 2010, A “strategy tripod” perspective on export behaviors, JIBS, 41: 377–396; K. Meyer, S. Estrin, S. Bhaumik, & M. W. Peng, 2009, Institutions, resources, and entry strategies in emerging economies, SMJ, 30: 61–80; D. Sirmon, M. Hitt, J. Arregle, & J. Campbell, 2010, The dynamic in- terplay of capability strengths and weaknesses, SMJ, 31: 1386–1409.

3 F. Acedo, C. Barroso, & J. Galan, 2006, The resource-based theory, SMJ, 27: 621–636; J. A. Adegbesan, 2009, On the origins of com- petitive advantage, AMR, 34: 463–475; S. Newbert, 2007, Empirical research on the resource-based view of the firm, SMJ, 28: 121–146; D. Sirmon, M. Hitt, & R.D. Ireland, 2007, Managing firm resources in dynamic environments to create value, AMR, 32: 273–292; M. Sun & E. Tse, 2009, The resource-based view of competitive advantage in two-sided markets, JMS, 46: 45–64.

4 M.W. Peng & P. Heath, 1996, The growth of the firm in planned economies in transition, AMR, 21: 492–528. See also W. Egelhoff & E. Frese, 2009, Understanding managers’ prefer- ences for internal markets versus business planning, JIM, 15: 77–91; A. Goerzen & P. Beamish, 2007, The Penrose effect, MIR , 47: 221–239; H. Greve, 2008, A behavioral theory of firm growth, AMJ, 51: 476–494; J. Steen & P. Liesch, 2007, A note on Penrosian growth, resource bundles, and the Upssala model of international- ization, MIR, 47: 193–206; T. Reus, A. Ranft, B. Lamont, & G. Adams,

2009, An interpretive systems view of knowledge investments, AMR, 34: 382–400.

5 J. Barney, 2001, Is the resource-based view a useful perspective for strategic management research? (p. 54) AMR, 26: 41–56.

6 G. Lee, 2008, Relevance of organizational capabilities and its dynamics, SMJ, 29: 1257–1280; D. Teece, G. Pisano, & A. Shuen, 1997, Dynamic capabilities and strategic management, SMJ, 18: 509–533.

7 J. Barney, 2002, Gaining and Sustaining Competitive Advantage, 2nd ed. (p. 157), Upper Saddle River, NJ: Prentice Hall.

8 M. Porter, 1985, Competitive Advantage, New York: Free Press.

9 A. Parmigiani, 2007, Why do firms both make and buy? SMJ, 28: 285–311; M. W. Peng, Y. Zhou, & A. York, 2006, Behind make or buy decisions in export strategy, JWB, 41: 289–300.

10 S. Beugelsdijk, T. Pedersen, & B. Petersen, 2009, Is there a trend toward global value chain specialization? JIM, 15: 126–141; K. Coucke & L. Sleuwaegen, 2008, Offshoring as a survival strategy, JIBS, 39: 1261–1277; J. Hatonen & T. Eriksson, 2009, 30+ years of research and practice of outsourcing, JIM, 15: 142–155; P. Jensen, 2009, A learning perspective on the offshoring of advanced services, JIM, 15: 181–193; B. Kedia & D. Mukherjee, 2009, Understanding offshoring, JWB, 44: 250–261; K. Kumar, P. van Fenema, & M. von Glinow, 2009, Offshor- ing and the global distribution of work, JIBS, 40: 642–667; S. Mudam- bi & S. Tallman, 2010, Make, buy, or ally? JMS, 47: 1434–1456; G. Trautmann, L. Bals, & E. Hartmann, 2009, Global sourcing in inte- grated network structures, JIM, 15: 194–208; C. Weigelt & M. Sarkar, 2012, Performance implications of outsourcing for technological in- novations, SMJ, 33: 189–216.

11 BW, 2006, The 787 encounters turbulence, June 19: 38–40.

12 S. Lahiri, B. Kedia, & D. Mukherjee, 2012, The impact of management capability on the resource-performance linkage, JWB, 47: 145–155; R. Mudambi & M. Venzin, 2010, The strategic nexus of offshoring and outsourcing decisions, JMS, 47: 1510–1533; H. Safizadeh, J. Field, & L. Ritzman, 2008, Sourcing practices and boundaries of the firm in the financial services industry, SMJ, 29: 79–91.

United States at least) that is otherwise known as government intervention by picking winners. How- ever, by bailing out Detroit and rescuing Wall Street, the US government has been dragged into “industrial policy” without much of a clear long-term policy. At a time when global competition is heating up, how to beef up the manufacturing (and other) capabilities of US firms in order to enhance US competitiveness un- doubtedly remains job number one for numerous ex- ecutives and policymakers. But what does the future hold for future versions of the Amazon Kindle?

CASE DISCUSSION QUESTIONS: 1. From a resource-based view, what resources

and capabilities do Asian firms involved in the production of Amazon’s Kindle have that US firms do not have?

2. What are the differences between the produc- tion of PCs and the production of Amazon’s Kindle?

3. From an institution-based view, what should the US government do to foster US competitiveness?

Sources: Based on (1) BusinessWeek, 2009, Can the future be built in America? September 21: 46–51; (2) BusinessWeek, 2009, Top 20 Taiwan global brands 2009, November 23: 43; (3) C. Weigelt, 2009, The impact of outsourcing new technologies on integrative capabilities and performance, Strategic Management Journal, 30: 595–616; (4) L. Pierce, 2009, Big losses in ecosystem niches: How core firm decisions drive complementary product shakeouts, Strategic Management Journal, 30: 323–347; (5) G. Pisano & W. Shih, 2009, Restoring American competitiveness, Harvard Business Review, July-August: 114–125; (6) Y. Su, E. Tsang, & M. W. Peng, 2009, How do internal capabilities and external partnerships affect innovativeness? Asia Pacific Journal of Management, 26: 309–331.

Chapter 4 Leveraging Resources and Capabilities 117

13 D. Gregorio, M. Musteen, & D. Thomas, 2009, Offshore out- sourcing as a source of international competitiveness of SMEs, JIBS, 40: 969–988; D. Griffith, N. Harmancioglu, & C. Droge, 2009, Governance decisions for the offshore outsourcing of new product development in technology intensive markets, JWB, 44: 217–224; C. Grimpe & U. Kaiser, 2010, Balancing internal and external knowl- edge acquisition, JMS, 47: 1483–1509; M. Kenney, S. Massini, & T. Murtha, 2009, Offshoring administrative and technical work, JIBS, 40: 887–900; A. Lewin, S. Massini, & C. Peeters, 2009, Why are companies offshoring innovation? JIBS, 40: 901–925; Y. Li, Z. Wei, & Y. Liu, 2010, Strategic orientation, knowledge acquisition and firm performance, JMS 47: 1457–82.

14 J. Doh, K. Bunyaratavej, & E. Hahn, 2009, Separable but not equal, JIBS, 40: 926–943; J. Hatonen, 2009, Making the locational choice, JIM, 15: 61–76; R. Liu, D. Fails, & B. Scholnick, 2011, Why are dif- ferent services outsourced to different countries? JIBS, 42: 558–571; M. Demirbag & K. Glaister, 2010, Factors determining offshore location choice for R&D projects, JMS, 47: 1534–1560; S. Zaheer, A. Lamin, & M. Subramani, 2009, Cluster capabilities or ethnic ties? JIBS, 40: 944–968.

15 F. Contractor, V. Kuma, S. Kundu, & T. Pedersen, 2010, Reconcep- tualizing the firm in a world of outsourcing and offshoring, JMS, 47: 1417–1433.

16 A. Pande, 2011, How to make onshoring work, HBR, March: 30.

17 D. Levy, 2005, Offshoring in the new global political economy (p. 687), JMS, 42: 685–693.

18 Barney, 2002, Gaining and Sustaining Competitive Advantage (pp. 159–174).

19 R. Adner & R. Kapoor, 2010, Value creation innovation ecosys- tems, SMJ, 31: 306–333; F. Bridoux, R. Coeurderoy, & R. Durand, 2011, Heterogenous motives and the collective creation of value, AMR, 36: 711–730; A. Capaldo, 2007, Network structure and innova- tion, SMJ, 28: 585–608; O. Chatain & P. Zemsky, 2011, Value creation and value capture with frictions, SMJ, 32: 1206–1231; J. Grahovac & D. Miller, 2009, Competitive advantage and performance, SMJ, 30: 1192–1212; T. Holcomb, M. Holmes, & B. Connelly, 2009, Making the most of what you have, SMJ, 30: 457–485; M. Kunc & J. Morecroft, 2010, Managerial decision making and firm perfor- mance under a resource-based paradigm, SMJ, 31: 1164–1182; V. La, P. Patterson, & C. Styles, 2009, Client-perceived performance and value in professional B2B services, JIBS, 40: 274–300.

20 D. Sirmon, S. Gove, & M. Hitt, 2008, Resource management in dyadic competitive rivalry, AMJ, 51: 919–935.

21 BW, 2011, Can this IBMer keep Big Blue’s edge? October 31: 31–32.

22 F. Aime, S. Johnson, J. Ridge, & A. Hill, 2010, The routine may be stable but the advantage is not, SMJ, 31: 75–87; D. Tzabbar, 2009, When does scientist recruitment affect technological repositioning? AMJ, 52: 873–896.

23 A. King, 2007, Disentangling interfirm and intrafirm casual ambiguity, AMR, 32: 156–178; T. Powell, D. Lovallo, & C. Caringal, 2006, Causal ambiguity, management perception, and firm perfor- mance, AMR, 31: 175–196.

24 BW, 2011, Can this IBMer keep Big Blue’s edge?

25 S. Jonsson & P. Regner, 2009, Normative barriers to imitation, SMJ, 30: 517–536; M. Lieberman & S. Asaba, 2006, Why do firms imitate each other? AMR, 31: 366–385; F. Polidoro & P. Toh, 2011, Letting rivals come close or warding them off? AMJ, 54: 369–392.

26 M. Chari, S. Devaraj, & P. David, 2007, International diver- sification and firm performance, JWB, 42: 184–197; S. Ethiraj, N. Ramasubbu, & M. Krishnan, 2012, Does complexity deter customer-focus? SMJ, 33: 137–161; M. Gruber, F. Heinemann, M. Brettel, & S. Hungeling, 2010, Configurations of resources and capabilities and their performance implications, SMJ, 31: 1337–1356; M. Kotabe, R. Parente, & J. Murray, 2007, Antecedents and outcomes of modular production in the Brazilian automo- bile industry, JIBS, 38: 84–106; R. Ployhart, C. Van Iddekinge, & W. Mackenzie, 2011, Acquiring and developing human capital in service contexts, AMJ, 54: 353–368; R. Sinha & C. Noble, 2008, The adoption of radical manufacturing technologies and firm survival, SMJ, 29: 943–962; K. Srikanth & P. Puranam, 2011, Integrating dis- tributed work, SMJ, 32: 849–875.

27 T. Chi & A. Seth, 2009, A dynamic model of the choice of mode for exploiting complementary capabilities, JIBS, 40: 365–387; A. Hess & F. Rothaermel, 2011, When are assets complementary? SMJ, 32: 895–909; N. Stieglitz & K Heine, 2007, Innovations and the role of complementarities in a strategic theory of the firm, SMJ, 28: 1–15.

28 J. Barney, 1997, Gaining and Sustaining Competitive Advantage (p. 155), Reading, MA: Addison-Wesley.

29 D. Farrell, 2005, Offshoring, JMS, 42: 675–683.

30 M. Gottfredson, R. Puryear, & S. Phillips, 2005, Strategic sourcing (p. 132), HBR, February: 132–139.

31 C. Rossetti & T. Choi, 2005, On the dark side of strategic sourcing, AME, 19 (1): 46–60.

32 K. Kim & W. Tsai, 2012, Social comparison among competing firms, SMJ, 33: 115–136.

33 D. Burrus, 2011, Flash Foresight (p. 11), New York: HarperCollins.

34 M. Chari & P. David, 2012, Sustaining superior performance in an emerging economy, SMJ, 33: 217–229; R. D’Aveni, G. Dagnino, & K. Smith, 2010, The age of temporary advantage, SMJ, 31: 1371–1385.

35 G. Pacheco-de-Almeida, 2010, Erosion, time compression, and self-displacement of leaders in hypercompetitive environments, SMJ, 31: 1498–1526.

36 The author’s paraphrase based on T. Friedman, 2005, The World Is Flat (p. 237), New York: Farrar, Straus, & Giroux.

118

Map 1.1 Developed Economies, Emerging Economies, and the Group of 20 (G-20)

Sources: IMF, www.imf.org; US Census Bureau, International Database; World Factbook, 2012. The IMF recognizes 182 countries and economies. It labels developed economies “advanced economies,” and labels emerging economies “emerging and developing economies”.

part 1atlas

Greenland

Estonia Latvia

Poland

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Portugal

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Spain

Iceland Norway Finland

Austria

DenmarkUnited Kingdom

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ARCTIC OCEAN

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Developed Economies

BRIC Emerging Economies

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Member of the Group of 20 (G-20)

Mexico

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Part 1 Atlas 119Part 1 Atlas 119

Estonia Latvia

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Russia

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124 Part One Laying Foundations

Coca-Cola in Africa1

Mike W. Peng (University of Texas at Dallas)

I n t e g r a t i v e C a s e 1 . 1

Already in all African countries, Coca-Cola has committed $12 billion to invest in the continent between 2010 and 2020. Why does Coca-Cola show such strong commitments to Africa?

Founded in 1892, Coca-Cola first entered Africa in 1929. While Africa had always been viewed as a “backwater,” it has recently emerged as a major growth market com- manding strategic attention. Of the $27 billion that Coca-Cola’s chairman and CEO Muhtar Kent prom- ised to invest in emerging economies between 2010 and 2020, $12 billion will be used to beef up the plants and distribution facilities in Africa. Why does Coca-Cola show such strong commitments to Africa? Both the push and pull effects are at work.

The Push

The push comes from the necessity to find new sources of growth for this mature firm, which has promised in- vestors 7%–9% earnings growth. On July 14, 1998, its stock reached a high-water mark at $88. But it dropped to $37 in 2003. In 2011, it rallied 30% over the past year and reached $67 on December 1. Can Coca-Cola’s stock reach higher?

Its home markets are unlikely to help. Between 2006 and 2011, US sales declined for five consecutive years. Further, health advocates accused Coca-Cola of con- tributing to an epidemic of obesity in the United States and proposed to tax soft drinks to pay for health care. While Coca-Cola defeated the tax initiative, it is fair to say the room for growth at home is limited. In Europe and Japan, sales are similarly flat. Elsewhere, in China, strong local rivals have made it tough for Coca-Cola to break out. Its acquisition of a leading local fruit juice firm was blocked by the government, which did not seem to bless Coca-Cola’s further growth. In India, Pepsi is so popular that “Pepsi” has become the Hindi shorthand for all bottled soft drinks (including Coke!). In Latin America, sales are encouraging but growth may be limited. Mexicans on average are already

1) This research was supported by the O. P. Jindal Chair at the Jindal School of Management, University of Texas at Dallas. All views and errors are those of the author. © Mike W. Peng. Reprinted with permission.

guzzling 665 servings of Coca-Cola products every year, the highest in the world. There is only so much sugary water one can drink every day.

The Pull

In contrast, Coca-Cola is pulled by Africa, where it has a commanding 29% market share versus Pepsi’s 15%. With 65,000 employees and 160 plants, Coca-Cola is Africa’s largest private sector employer. Yet, annual per capita consumption of Coca-Cola products is only 39 servings in Kenya. For the continent as a whole, disposable income is growing. In 2010, 60 million Africans earned at least $5,000 per person, and the number is likely to reach 100 million by 2014. While Africa indeed has some of the poorest countries in the world, 12 African countries (with a combined population of 100 million) have a GDP per capita that is greater than China’s. Coca-Cola is hoping to capitalize on Africa’s improved political stability and physical infrastructure. Countries not fighting civil wars make Coke’s operations less disruptive, and new roads penetrating the jungle can obviously elevate sales.

Coca-Cola is already in all African countries. The challenge now, according to CEO Kent, will be to deep dive into “every town, every village, every town- ship.” This will not be easy. War, poverty, and poor infrastructure make it extremely difficult to distrib- ute and market products in hard-to-access regions. Undaunted, Coca-Cola is in a street-by-street campaign to increase awareness and consumption of its products. The crowds and the poor roads dictate that some of the deliveries have to be done manually on pushcarts or trolleys. Throughout the continent, Coca-Cola has set up 3,000 Manual Distribution Centers. Taking a page from its playbook in Latin America, especially Mexico, Coca-Cola has aggressively courted small corner stores. Coca-Cola and its bottlers offer small corner store own- ers delivery, credit, and direct coaching—ranging from how to save electricity to advice on buying a house after vendors make enough money.

In Africa, US-style accusations of Coca-Cola’s al- leged contribution to the obesity problem are unlikely.

Part One Integrative Cases 125

After all, the primary concern in many communities is too few available calories of any kind. However, this does not mean Africa is Coca-Cola’s marketing Shangri-la, free from any criticisms. It has to defend itself from critics that accuse it of depleting fresh water, encouraging expensive and environmentally harmful refrigeration, and hurting local competitors who hawk beverages. In response, Coca-Cola often points out the benefits it has brought. In addition to the 65,000 jobs it has directly created, one million local jobs are indirectly created by its vast system of distribution, which moves beverages from bottling plants deep into the villages and the bush a few crates at a time.

The Future

“Ultimately,” the Economist opined, “doing business in Africa is a gamble on the future.” Overall, CEO Kent is very optimistic about Africa. In his own words at a media interview:

Africa is the untold story, and could be the big story, of the next decade, like India and China were this past decade. The presence and the significance of our business in Africa is far greater than India and China even today. The relevance is much bigger . . . In Africa, you’ve got an incredibly young population, a dynamic population. Huge disposable incomes. I mean, $1.6 trillion of GDP, which is bigger than

Russia, bigger than India. It’s a big economy, and so rich underground. And whether the next decade becomes the decade of Africa or not, in my opinion, will depend upon one single thing—and everything is right there to have it happen—that is better gover- nance. And it is improving, there is no question.

Case Discussion Questions

1. Why is Coca-Cola so interested in Africa, which is typically regarded as part of the base of the global economic pyramid?

2. What unique resources and capabilities does Coca-Cola have that will help it compete well in Africa?

3. What are the drawbacks of making such large- scale commitments to Africa?

4. Do stakeholders in the United States and Africa who criticize Coca-Cola have a reasonable case against it?

Sources: Based on (1) M. Blanding, 2010, The Coke Machine, New York: Avery; (2) Bloomberg Businessweek, 2010, Coke’s last round, November 1: 54–61; (3) Bloomberg Businessweek, 2010, For India’s consumers, Pepsi is the real thing, September 20: 26-27; (4) Bloomberg Businessweek, 2011, Can Coke surpass its record high of $88 a share? June 6: 49–50; (5) Economist, 2006, Business in Africa, September 9: 60–62; (6) Economist, 2008, Index of happiness, July 5: 58; (7) D. Zoogah, M. W. Peng, & H. Woldu, 2012, Linking management research and African organizations, working paper, University of Texas at Dallas.

126 Part One Laying Foundations

Whose Law Is Bigger: Arbitrating Government-Firm Disputes in the EU1

Brian C. Pinkham (Texas Christian University)

I n t e g r a t i v e C a s e 1 . 2

Formal institutional frameworks such as investment laws and treaties are designed to facilitate certainty and predictability. But what can foreign firms that have already invested in host countries do if these frameworks change?

One of the key concerns as a multinational enter- prise (MNE) making foreign direct investment (FDI) is how to take advantage of incentives in different host countries while safeguarding investor interests if something goes awry. This issue may arise when countries change regimes, like when the Central and Eastern European (CEE) countries joined the European Union (EU) in 2004–2007. Similarly, when a country nationalizes an industry like Argentina did with utilities (such as water and gas) in 2001 and with the Spanish oil firm Repsol in 2012, it would leave many foreign investors without recourse for recoup- ing their investments. Courts in Argentina were un- able to enforce investor contracts and the government refused to repay investors. However, since these con- tracts fell under the protection of a series of bilateral investment treaties (BITs) between Argentina and other countries (typically one BIT covers one pair of countries), aggrieved firms can file for binding arbi- tration proceedings through the International Center for Settlement of Investment Disputes (ICSID), which is based in Washington, DC.

Binding arbitration is a private forum for contract dispute resolution. Its functions are similar to those of an international court, but it uses experts, rather than judges, to decide complex disputes. While arbitra- tion awards do not change laws (they merely interpret laws), binding arbitration has the benefit of enforce- ment in multiple jurisdictions under the New York Convention of 1958 and the ICSID Convention. A to- tal of 146 countries are signatories. Therefore, binding arbitration awards made in one country are enforce- able in 145 other countries. This includes awards made against other signatory countries, such as Argentina. Generally, countries that lose cases pay voluntarily. However, even as recently as 2012 Argentina continues

1) © Brian C. Pinkham. Reprinted with permission.

to be reluctant to pay. Many of these firms, such as Vivendi and Siemens, are seeking Argentine assets in other signatory countries.

The EU law is starting to feel the pressure of these government–firm investment disputes. To attract FDI before joining the EU, Hungary and Romania in the 1990s and the early 2000s offered large and lucrative incentives in long-term contracts. However, because Hungary and Romania joined the EU in 2004 and 2007, respectively, the incentives became illegal under the EU law. This is because the EU law forbids any dis- crimination against any EU member countries and firms. Any BIT between, for example, Hungary (a non- member until 2004) and Austria (an EU member) that gives Austrian firms preferential treatment and invest- ment incentives, by definition, discriminates against firms from other EU countries. Therefore, such BITs were declared illegal by the EU and contracts signed under the BITs were forcibly withdrawn by Romania and Hungary in 2008.

MNEs from the EU (Sweden and Belgium) and the US responded to the 2008 abrogation of their contracts in Hungary and Romania by seeking rem- edies in arbitration instead of national courts. For ex- ample, Micula, a firm from Sweden, is suing Romania for unilaterally removing tax and custom duties from the contracts. In Hungary, several foreign electricity producers are suing for breach of long-term power supply contracts based on unilateral change of elec- tricity pricing. These contracts fell under the BITs between the contracting countries. Because the con- tracts are unenforceable under EU law, but enforce- able under the BITs in place at the time of contract- ing, these cases present a larger question: Which law takes precedence?

Recent arbitration suggests that the EU law is sec- ondary to original commitments—that is, local laws and BITs at the time of original contracting are to be respected if they clash with the EU law. For example, in 2008, a Dutch sugar company received an award of €25 million against the Czech Republic based on a contract under a Dutch-Czech BIT from the 1990s. The arbitration tribunal sent a clear message by excluding

Part One Integrative Cases 127

the argument that the treaty ceased to have force upon the Czech Republic’s entry into the EU in 2004. Likely responding to this message, the EU Commission is taking an active role in the current proceedings involv- ing Hungary and Romania, seeking to intervene in the arbitration decisions.

Case Discussion Questions

1. ON ETHICS: If the EU law is bigger, the MNEs lose billions of euros. If the EU law is second- ary, the governments (and ultimately the tax- payers) in the host countries must pay. From a (formal) legal standpoint, which law should come first? From an informal (ethical) stand- point, which law should come first?

2. From an institution-based view, explain why the MNEs in this case filed through arbitration and not in courts in the host countries.

3. As an investor, do you want to support BITs and arbitration or rely on local court systems?

Sources: Based on (1) International Center for Settlement of Investment Disputes, 2009, http://icsid.worldbank.org/ICSID/Index.jsp; (2) S. Pignal & N. Tait, 2009, EU leaves sour aftertaste, Financial Times, June 22, 2009; (3) B. C. Pinkham & M. W. Peng, 2012, Arbitration and cross-border transac- tion costs, working paper, Texas Christian University and University of Texas at Dallas; (4) United Nations Commission on International Trade Law, 2009, http://www.uncitral.org; (5) L. E. Peterson, Investment Arbitration Reporter, 2(8), 2009.

128 Part One Laying Foundations

Fighting Counterfeit Motion Pictures1

Alan Zimmerman (City University of New York, College of Staten Island)

Peggy Chaudhry (Villanova University)

I n t e g r a t i v e C a s e 1 . 3

The scale and scope of counterfeiting, especially in motion pic- tures, make it very challenging to combat counterfeiting. Are current anticounterfeiting measures effective?

Big Business

Counterfeiting is big business. It is a problem that has been haunting businesspeople for millennia. The first producer’s marks appeared on pottery in China about 4,000 years ago. And it was not much later when coun- terfeiters saw the advantage of copying successful prod- ucts. In the Roman Empire, a well-known brand name for oil lamps was FORTIS. So many artifacts with this name have been found that it is evident that widespread product copying took place at the time.

What exactly is a counterfeit product? A common definition is that “any unauthorized manufacturing of goods whose special characteristics are protected as intellectual property rights (IPR) constitutes product counterfeiting.” IPR includes copyrights, patents, and trademarks. The scope of counterfeiting is widespread with traditional products ranging from footwear to computer software to watches to cigarettes. The pirates have also diversified their product offerings to non-traditional goods in health and safety areas, such as pharmaceuticals and aircraft parts. The total size of the counterfeit market is nearly impossible to accu- rately determine, but it appears to be growing rapidly. In 1985, the annual worldwide product counterfeit market was estimated at about $25 billion. Today, a number of organizations claim that more than 5% of world trade consists of counterfeit goods and some estimate the total from $200 billion to $500 billion annually.

A number of reasons have been given for the growth of counterfeits. An in-depth analysis shows many driving forces, including the low investment required to get into a market combined with easily available cheap technology, globalization and lower trade barriers, powerful worldwide brands, ongoing consumer willingness to buy counterfeit product, and

1) © Alan Zimmerman and Peggy Chaudhry. Reprinted with permission.

especially weak national and international enforce- ment of IPR. Each of these forces relate to the basic issues discussed in this text. Industry structures such as entry barriers that can be overcome by technol- ogy and the continuing importance of worldwide brands are important. Firm-specific resources such as the ability to copy product, find distribution out- lets, and secure financing make certain pirate firms successful.

But it is clear that the overriding driver of the growth of counterfeit products lies within institution- al frameworks. A number of multilateral organiza- tions exist to protect IPR, including the World Trade Organization’s Trade Related Aspects of Intellec- tual Property Rights (TRIPS), the World Intellectual Property Organization (WIPO) that is charged with implementing the provisions of the Paris Convention dealing with patents and trademarks, and the Bern Convention that focuses on copyrights. In addition, nongovernmental organizations (NGOs), such as the International Anticounterfeiting Coalition (IACC), the Business Software Alliance (BSA), and the Software Information Industry Association (SIIA), deal with chronic piracy. A critical problem lies in enforcement. While in the United States, convicted counterfeiters may be fined millions of dollars and spend years in prison even for a first offense, in many countries coun- terfeiters can get away with small fines and virtually no danger of a prison sentence. The US Trade Representa- tive (USTR) reports each year on the IP environment within each US trading partner. Countries that fail to enforce their IPR laws are subject to penalties from the US government.

Despite the plethora of governmental and nongov- ernmental agencies attempting to control counterfeit product, the failure of enforcement at national and international levels has allowed pirates to operate with impunity in many countries. For example, the infamous Ciudad del Este in Paraguay has been de- scribed as the Wild West for its illicit trade. Other problem countries for IPR protection described in our 2009 book, The Economics of Counterfeit Trade:

Part One Integrative Cases 129

Governments, Consumers, Pirates, and Intellectual Prop- erty Rights, are Argentina, Brazil, Chile, China, Egypt, India, Israel, Lebanon, Mexico, Russia, Thailand, Turkey, Ukraine, and Venezuela, which are host countries notorious for counterfeit shopping districts (such as Xiushui Market—formerly known as Silk Alley—in Beijing).

Counterfeit Motion Pictures

One critical worldwide problem is the illegal copy- ing of motion pictures. The box office for films in the United States was estimated at $10.6 billion in 2010 (the same as 2009) and globally at $31.8 billion (an 8% increase over 2009). For example, Disney’s Ratatouille was launched simultaneously in 33 countries in mul- tiple languages and earned more than $300 million in international sales on the third weekend of its debut in 2007. With this type of revenue, the Motion Pic- ture Association of America (MPAA or MPA) tries to improve the image of “Hollywood.” It reports several reasons why the industry should be nurtured, since it employs over 2.5 million professionals (ranging from costume designers to set builders), contributes almost $80 billion per year to the US economy, and is the only US industry that has a positive balance of trade in all of its foreign markets.

A 2009 article in The Wall Street Journal authored by one of us (Chaudhry), “Getting Real About Fakes,” reported that over 50% of 2,000 consumers surveyed in Brazil, Russia, India, China, and the United States had obtained a fake movie in either a physical or virtual market and that the average frequency of ac- quisition was three times during the past year. Despite the well-publicized efforts of many national govern- ments and international as well as nongovernmental institutions, the counterfeit product market appears to be growing at a rapid pace. The world of counter- feiting seems subject mainly to informal norms and beliefs. The advent of easy and inexpensive commu- nications allows all the players in this business to rely on relationship-based informal networks while easily avoiding detection.

Many actions aimed at slowing down product counterfeiting have been offered by a number of re- searchers. Studies of these recommended actions show that some are particularly ineffective. In particu- lar, actions directed at consumers, whose willingness to buy counterfeit products including pirated mov- ies is undaunted, seem fruitless. The MPA is target- ing young consumers on its website and even has

prepared material for the Weekly Reader that educates fifth-grade students through a story of “Lucky and Flo,” two dogs who sniff out fake DVDs by sensing the chemicals used to manufacture this product. Obviously, the goal is to create better cybercitizens by educating youth to reinforce the concept that using fake movies is stealing and analogous to shoplifting. Nevertheless, most studies report that consumers generally see purchasing a counterfeit good as a vic- timless crime. In addition, the industry has followed in the footsteps of Apple iTunes, and there are now several ways to obtain movies legally through the web at places like MovieFlex and Netflix. Today, consum- ers can obtain Ice Age: Dawn of the Dinosaurs at Amazon Video on Demand for $6.99 that gives them the flex- ibility to watch this film through their television, a computer, a portable video device, or “save it for later” in a video library.

The most effective anticounterfeiting action is straightforward—registering trademarks/patents/copy- rights in the relevant jurisdictions. In addition, other effective actions focus on distributors and employees and local law enforcement. The MPA has developed a multipronged action plan ranging from publication of the “Top 25 University Piracy Schools” to commercials featuring Jackie Chan and Arnold Schwarzenegger riding motorcycles in their “Mission to Stop Piracy” advertisement. A few years ago, the MPA used the “You Can Click But Can’t Hide” campaign to educate consumers about the ease of finding someone who has illegally downloaded a movie from the web. This prompted bloggers to create their own anti -antipiracy campaign, “You Can Sue, But You Can’t Catch Everyone.” Current ads at the MPA website focus on illegally filming movies in the theater with the slogans, “Lights. Camera. Busted.” and “Leave Your Camera at Home. Do Not Record in This Theater.”

It may be that over time the growth and sophisti- cation of particular markets will reduce counterfeit- ing. Pressures from legitimate suppliers have certainly made product counterfeiting less widespread in the United States, Japan, Hong Kong, Taiwan, and South Korea as these markets mature. In the meantime, to limit the harm counterfeiters can do to their brands, owners of IPR must have effective ongoing antipiracy programs that have the attention of top management.

Case Discussion Questions

1. Why do some entrepreneurs choose a strategy of product counterfeiting?

130 Part One Laying Foundations

2. What are the main drivers in the growth of prod- uct counterfeiting?

3. Review the antipiracy advertisements on the MPAA website. Do you think these types of ads will effectively deter illegally filming movies in the theater and posting on the web? In your opin- ion, what anticounterfeiting actions would the MPAA have to develop to realistically get con- sumers to stop using illegal movies?

4. Why do the authors assert that “the world of counterfeiting seems subject mainly to informal norms and beliefs”?

5. What are the most effective actions firms can take to protect their products from being counterfeited?

Sources: Based on (1) K. Barry, 2007, Counterfeits and Counterfeiters: The Ancient World; (2) C. Bialik, 2006, Efforts to quantify sales of pirated goods lead to fuzzy figures, The Wall Street Journal, October 19: B1; (3) P. Chaudhry & S. Stumpf, 2009, Getting real about fakes, The Wall Street Journal, August 19, http://online.wsj.com; (4) P. Chaudhry & A. Zimmerman, 2009, The Economics of Counterfeit Trade: Govern- ments, Consumers, Pirates and Intellectual Property Rights, Heidelberg, Germany: Springer-Verlag; (5) V. Cordell, N. Wongtada, & R. Kieschnick, 1996, Counterfeit purchase intentions: Role of lawfulness attitudes and product traits as determinants, Journal of Business Research, 35: 41–53; (6) International Anti-Counterfeiting Coalition, 2007, Get Real—The Truth about Counterfeiting; (7) J. Kay, 2007, Ratatouille becomes 10th Disney film to gross $300 million overseas, http://www.screendaily.com; (8) Motion Picture Association of America, 2005, The Cost of Movie Piracy; (9) Motion Picture Association of America, http://www.mpaa.org; (10) S. Ono, 1999, Overview of Japanese Trademark Law, Chapter 2; (11) T. Stern, 1985, Foreign product counterfeiting, Vital Speeches of the Day, Volume LI, No. 22; (12) G. Tom, B. Garibaldi, Y. Zeng, & J. Pilcher, 1998, Consumer demand for counterfeit goods, Psychology and Marketing, 15: 405–421; (13) D. J. Weinterfeldt, L. Dow & P. Albertson, 2002, Historical Trademarks: In Use since 4000 BC, International Trademark Association; (14) United States Trade Representative, 2007, Special 301 Report.

Part One Integrative Cases 131

Brazil’s Embraer: From State-Owned Enterprise to Global Leader1

Juan España (National University)

I n t e g r a t i v e C a s e 1 . 4

How does Embraer grow to become a global leader in the highly competitive aircraft manufacturing industry?

In 1994, when Fernando Henrique Cardoso was elect- ed as Brazil’s new president, the economy was unstable and experiencing hyperinflation of about 2,000% per year. As a finance minister in the previous administra- tion, Cardoso and his team had introduced econom- ic measures centered on the Real Plan. This plan was very successful and by 1997 inflation had been brought down to international levels. Macroeconomic reforms and price stability revived the economy. Brazil had been the world’s economic miracle of the 1970s and most of the 1980s. With a steady course, it could now look forward to a new era of growth. An important part of the reforms was the privatization of key state- owned enterprises (SOEs). One of them was Embraer, the short form for Empresa Brasileira de Aeronautica, S. A. (Brazilian Aeronautics Company). Embraer’s stock is traded on the Sao Paulo Bovespa and has been listed on the New York Stock Exchange (NYSE: ERJ) since 2000.

Origins

Embraer was created in 1969 by a military govern- ment determined to provide Brazil with the capacity to produce military aircraft. The company was set up as a mixed enterprise, with the Brazilian state retain- ing a 51% majority of the voting shares and the rest held by private investors. Production started in 1970 and the company became profitable the next year and remained so until 1981. Propelled by government pro- curement and fiscal support, Embraer soon produced internationally successful models, such as the turbo- prop models EMB 110 Bandeirante transport aircraft and its larger, 30-seat successor, the EMB 120 Brasilia, as well as the Tucano military trainer.

The company is located in San Jose dos Campos, in the state of Sao Paulo, in the corridor between the cities of Sao Paulo and Rio de Janeiro. This part of Brazil is called “Technology Valley,” with industrial

clusters in the aerospace, telecommunications, auto- mobile, and petroleum sectors. Educational centers have been created in the area offering aerospace- related programs. Embraer’s distinctive competencies are the areas of R&D, design, product development, system integration, assembly, and technical assistance in aircraft manufacturing.

Product Range

Embraer’s product range includes commercial, mili- tary, and corporate aircraft, with commercial sales in 2009 accounting for 66% and the fast-growing corpo- rate segment (also known as executive aviation) repre- senting 14% (see Exhibits 1, 2, and 3). By comparison, commercial and corporate sales represented about 80% and 6% of total sales in 2002.

In 1989, Embraer introduced the 35-seat ERJ 135 and the 50-seat ERJ 145 regional jets to meet increasing demand for jets to replace turboprop models. Regional jets are smaller and less costly to acquire and operate than larger jets such as the Boeing 737. They are a cost-effective alternative to serve mid-range routes and to feed passengers from smaller airports to major hubs replacing larger planes that were underutilized in short-haul flights. Sales of Embraer’s new family of regional jets took off rapidly.

By 1994, Embraer had reached world market shares of 31% and 42% in the regional jet and the military trainer markets, respectively. However, it was facing se- vere challenges. A downturn in demand in the airline 1) © Juan España. Reprinted with permission.

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132 Part One Laying Foundations

industry had led to a serious decline in commercial aircraft sales, while export financing was drying up due to the expiration of the Brazilian government Finex program. These and other factors contributed to a sense of disarray at Embraer at a time when major reforms such as privatization were transforming the

Brazilian economy. In December 1994, Embraer was privatized, and acquired by a consortium of Brazilian institutions headed by a local investment bank. The Brazilian government retained a golden share that allowed it to veto certain strategic actions such as a takeover by a foreign company.

Commercial Aircraft

Turboprop EMB 110 Bandeirante (produced until 1990)

EMB 120 Brasilia

Regional Jets ERJ 145 family (37–50 passengers)

ERJ 170, 175, 190, 195 (80–122 passengers)

Military Aircraft

Tucano: Military trainer, produced since 1980. Used by air forces around the world.

EMB 314 Super Tucano

AMX International Fighter, in service with the Brazilian and Italian Air Forces

ERJ 145 military variants: EMB 145 AEW&C, EMB145 RS/AGS

KC 390 military tanker/transport being developed for the Brazilian military

Corporate Aircraft

Phenom 100, 300

EMB Legacy 450, 500, 600

EMB Lineage 1000

Agriculture Aircraft

Ipanema: The world’s first alcohol-powered airplane. More than 4,000 units sold.

Exhibit 3 Product Range

2009

North America 43%

Brazil 4%

Europe 18%

Others 7%Asia Paci�c

18%

Latin America 10%

Exhibit 2 Revenue by Region

Source: www.embraer.com

Exhibit 1 Revenue by Segment

Source: www.embraer.com

2009

Commercial Aviation 66.7%

Executive Aviation 14.3%

Defense 6.9%Customer Support

10.4%

Others 1.7%

Part One Integrative Cases 133

By 1998, buoyed by the success of its ERJ family of jets introduced in 1989, Embraer had become the world’s leader in the regional jet market, surpassing its main rival, Bombardier of Canada. In 1999, Embraer became Brazil’s leading exporter and accounted for about 7% of all of Brazil’s exports of manufactured goods.

In 1999, after a $1 billion investment in develop- ment, Embraer introduced the E-Jet family, consist- ing of the 80-seat ERJ 170, the 110-seat ERJ 190, and the 122-seat ERJ 195 airliners. They are comparable to Boeing 737 and DC-9 airliners. These jets proved to be very successful and the first one was delivered in 2002. Bombardier had no comparable models to compete against this new line of Embraer planes. Currently, Bombardier offers the original jet series, the 50-seat CRJ 100 and CRJ 200, which are identical except that CRJ 200 has more powerful engines. Bom- bardier also developed the CRJ 700, CRJ 900, and CRJ 1000, which are simply stretched versions of the CRJ 200 and have a capacity of 70, 90, and 100 passengers, respectively. However, in July 2004, Bombardier an- nounced the development of the C Series consisting of the CS 100 (100–125 seats) and the CS 300 (120–150 passengers). The launch year has been set as 2013. The C Series jets are comparable to the Boeing 787 and the Airbus 350.

Supply Chain

Embraer’s production structure gives the company a competitive edge. Its supply network consists of three layers. At the first level, risk (or strategic) partners carry most of the risk of innovation and operate on the basis of long-term contracts. At the second level, international suppliers provide equipment, systems, and components. At the third level are the national subcontractors that supply services and products fol- lowing Embraer’s specifications. They are retained on the basis of purchase orders and can be easily replaced. Embraer trains employees of these suppliers. They re- present a diversified local network of about 30 small and medium-sized firms mostly located in close prox- imity of Embraer, and are typically founded by previ- ous employees of the company. The number of these suppliers has gradually been reduced. For instance, while the ERJ 145 program had about 400 suppliers, the newer ERJ 170/190 program had around 20. Sup- pliers must be ISO9000 certified.

Embraer develops new products using a “co-design” approach that involves risk partners that carry most

of the risk of innovation. Risk partners are also re- sponsible for aggregating subsystems and components into modules (complete, recognizable subunits of the airplane). This modular assembly system reduces the number of suppliers and shifts risk and costs from the company to suppliers. These supply chain innova- tions provide Embraer with a competitive edge result- ing from reduced levels of risk, reduced R&D costs, re- duced complexity of the production process, increased quality, increased innovation, and—in the case of ERJ 170/190—a 33% shorter product development process (from 54 to 36 months).

The new family of regional jets, the ERJ 170/190, was designed through a cooperative system. Embraer’s design process consists of three phases: (1) the initial definition phase that is performed before the risk partners are selected, (2) the joint definition phase that is carried out by all risk partners and involves assigning the design of different parts of the aircraft to different partners, and (3) the detailed design and certification phase during which the risk partners finish all details and the aircraft seeks certification in different national markets.

Over the years, Embraer has attempted to address issues of strategic importance such as dependency on international suppliers, low local content of its prod- ucts, a lack of government support for R&D, and a lack of an internal market intelligence unit. To alleviate these obstacles, Embraer has engaged in corporate ca- pacity building at various levels.

The level of dependency on international contrac- tors is illustrated by the fact that about 95% (by vol- ume) of the equipment, materials, and components are purchased on international markets. The total national (Brazilian) content in each airplane is only about 40%, with risk partners accounting for an ad- ditional 38% of the total cost of an airplane. Embraer is attempting to increase local sourcing, mainly by at- tracting international suppliers to set up operations in Brazil. Some progress has been made in this area. For example, in 2003, Japan’s Kawasaki opened a wing- production plant within Embraer’s Gaviao Peixoto facility, joining other international companies that have set up plants in Brazil, such as C&D Aerospace, Sonaca, Goodyear, and ELEB. In 2008, Embraer took full ownership of ELEB, a former joint venture (JV) of Embraer with Liebherr of Germany, and this sub- sidiary now exports landing gear and hydraulic equip- ment to aerospace firms in the United States, Asia, and Europe.

134 Part One Laying Foundations

Embraer faces hurdles in the creation of knowledge and specialized suppliers. It lacks a targeted govern- ment program focusing on R&D and the creation of small high-tech suppliers to the aerospace industry. In addition, the company’s relationships with universities are rather informal and not comparable to the struc- tured ties found between companies and university- based R&D centers in the United States and Europe. In order to expedite the process of innovation and knowledge creation, Embraer is considering creating its own corporate university.

For many years, Embraer had relied on external consultants to produce market studies of the commer- cial aircraft industry. In 1998, it established its own market intelligence unit, with the ultimate goal of pro- ducing good estimates while at the same time internal- izing market analysis into the company’s competitive strategy.

International Operations

Embraer sells civil and military aircraft around the world, and has established plants, sales, and mainte- nance centers in China, France, Portugal, Singapore, and the Unites States. A new dimension in Embraer’s relations with the outside world was initiated in 1999 when the company established a strategic alliance with a French consortium formed by Dassault, Aerospatiale Matra, Thompson-CSF, SNECMA, and EADS (the parent company of Airbus). These companies acquired about 8% of Embraer’s equity. The pact would have allowed Embraer access to new military and civil avia- tion technology. Among other projects, the agreement envisaged the assembly of France’s Mirage fighter jets in Brazil. However, EADS sold its equity in 2007 and the Mirage project was never carried out. In 2005, a consortium consisting of Embraer and EADS acquired control of OGMA, Portugal’s formerly state-owned aerospace firm. OGMA would provide service and perform certification procedures for Embraer aircraft in Europe.

In 2002, Embraer established a JV with Aviation In- dustry of China II (AVIC II), opening a plant in Harbin, China, to produce ERJ 145 regional jets. The first jet was produced in 2003, and a total of 25 would be deliv- ered to Hainan Airlines by 2011.

Challenges for the Future

As of 2010, Embraer can look back to major achieve- ments that have turned it into the world’s third largest

commercial aircraft manufacturer in terms of sales, surpassed only by Boeing and Airbus. However, many significant challenges lie ahead.

Embraer is preparing to face another difficult year as the world economy and commercial carriers experi- ence the worst crisis since World War II. Many orders have been downsized or cancelled, and Embraer is expecting a 10% sales decline for 2010. The company is reacting to the crisis by cutting staff and adopting other cost-reduction measures, but there is no end in sight for the downturn in the world economy. To make matters worse, Bombardier has received several orders for its new C Series jets due for delivery starting in 2013, and Embraer, whose models go up to 122 seats, has nothing to offer in the 149-seat range. In addition, the Brazilian real appreciated by 35% against the US dol- lar in 2009, and this will ultimately show as increased costs at Embraer, where about 40% of expenditures are denominated in the real.

There are a few bright spots in this otherwise bleak landscape: Sales of the expanded line of corpo- rate jets are growing fast and making up for lost rev- enue in other areas, and domestic sales are expected to reach $500 million in 2010 driven by purchases by the new Brazilian discount airline Azul (founded by Brazilian-born David Neeleman, the previous CEO of a US discount airline JetBlue). Azul ordered 76 of the 118-seat ERJ 190. In addition, new lines of financing have been offered: China’s CDB Leasing Co., a unit of China Development Bank, awarded Embraer a $2.2 billion loan for the sale of Embraer planes, and the Brazilian state bank BNDES plans to step up financing of Embraer sales from the previous level of 30% to as much as 60% in 2010. With an order back- log of about $18 billion at the beginning of 2010 and new sources of financing lined up, Embraer is confi- dent that it can weather the current crisis and grow again.

Case Discussion Questions

1. Perform a brief SWOT analysis of Embraer.

2. From a resource-based view, what are the key success factors behind Embraer’s success in the market for regional jets?

3. What changes do you foresee over the next five years in the market for regional jets?

4. Since September 11, 2001, demand in the air- line industry has been unstable or deteriorating.

Part One Integrative Cases 135

How can Embraer grow and remain profitable in such an environment?

5. How can Embraer’s international operations be upgraded to increase its competitiveness?

Sources: Based on (1) R. Bernardes, 2003, Passive Innovation System and Local Learning: A Case Study of Embraer in Brazil, Fundação SEADE, November; (2) Bloomberg, 2009, Embraer bets on Brazil market as global sales

decline, December 23; (3) Bombardier’s website, www.bombardier.com; (4) Embraer’s website, www.embraer.com; (5) J. España, 2004, Explain- ing Embraer’s hi-tech success: Porter’s diamond, new trade theory, or the market at work, Journal of the American Academy of Business, 4(1), March; (6) P. Figueiredo, S. Gutenberg, & R. Sbragia, 2008, Risk sharing partnerships with suppliers: The case of Embraer, Journal of Technology Management and Innovation, 3(1); (7) V. Frigant & Y. Lung, 2003, Geographical proximity and supplying relationship in modular production, Actes du GERPISA, No. 34; (8) Newsweek, 2006, Embraer: An ugly duckling finds its wings, July 31; (9) E. Leslie, 2002, How Brazil Beat Hyperinflation, UCLA Latin America Center.

136 Part One Laying Foundations

Microsoft in China1

Mike W. Peng (University of Texas at Dallas)

I n t e g r a t i v e C a s e 1 . 5

How does Microsoft change its approach to China? What are the changed results and the remaining challenges?

From a Disastrous Start to a Sweet Spot

Microsoft’s first decade in China was disastrous. It es- tablished a representative office in 1992 and then set up a wholly owned subsidiary Microsoft (China) in 1995. The firm quickly realized that it did not have a market share problem—everybody was using Windows. The problem was how to translate that market share into revenue, since everybody seemingly used pirated versions. Microsoft’s solution? Sue violators in Chinese courts. But Microsoft lost such lawsuits regularly. Alarmed, the Chinese government openly promoted the free open-source Linux operating systems. For security reasons, the Chinese government was afraid that Microsoft’s software might contain spyware for the US government. Internally, Microsoft’s executives often disagreed with this confrontational strategy. Its coun- try managers came and went—five in a five-year period. Two of them later wrote books criticizing this strategy. These books revealed that Microsoft’s antipiracy policy was excessively heavy-handed, and that their authors’ efforts to educate their bosses in headquarters in Redmond, Washington (a Seattle suburb), were deeply frustrated.

Fast forward to 2007. President Hu Jintao visited Microsoft and paid Bill Gates a visit at his house as a dinner guest. “You are a friend to the Chinese people, and I am a friend of Microsoft,” Hu told Gates. “Every morning I go to my office and use your software.” Starting in the mid 2000s, the Chinese government required all government agencies to use legal software and all PC manufacturers to load legal software before selling to consumers. Prior to these requirements, Lenovo, the leading domestic PC maker, had only shipped about 10% of its PCs that way. Many foreign (and some US) PC makers in China sold numerous machines “naked,”

implicitly inviting their customers to use cheap illegal software. From a disastrous start, Microsoft today is in a sweet spot in China. So, what happened?

The Changes

In a nutshell, Microsoft radically changed its approach to China in its second decade in the country. In China, it became the “un-Microsoft”: pricing at rock bottom instead of insisting on one very high “global price”; abandoning the confrontational, litigious approach in defense of its intellectual property rights (IPR); and closely partnering with the government as opposed to fighting it (as it was doing back home when it was sued by the US government).

To be sure, the strategic changes were gradual. In 1998, Gates sent Craig Mundie, who headed the firm’s public policy group, to Beijing. Mundie urged for strategic changes. He brought 25 of Microsoft’s 100 vice presidents for a week-long “China Immersion Tour.” Also in 1998, in part as a gesture of goodwill, Microsoft set up a research center in Beijing, which emerged to become the premier employer for top-notch software talents.

Within Microsoft, debates raged. Given the size of the country, changing the China strategy would inevitably lead to changing the global strategy, which was centered on a global, “one-size-fits-all” set of prices (such as $560 for the Windows and Office toolset as in the United States). The heart of the question was: “Does Microsoft need China?” As late as in 2004, its CFO, John Connors, argued “No” publicly. Connors was not alone. On the face of it, nobody needed China less than Microsoft, which became a dynamo without many China sales. However, in the long run, China’s support of Linux could pose dangers to Microsoft. This was because a public infrastructure for a software industry built around Linux could generate an alternative ecosystem with more low-cost rivals that break free from dependence on Windows. By the early 2000s, concerned about this competitive threat, Gates increas- ingly realized that if the Chinese consumer were going to use pirated software, he would rather prefer it to be Microsoft’s.

Part One Integrative Cases 137

In 2003, Tim Chen, a superstar China manager at Motorola, was hired as Corporate Vice President and CEO of Greater China Region for Microsoft. Led by Chen, Microsoft quit suing people and tolerated piracy. Instead, it worked with the National Development Reform Commission to build a software industry, with the Ministry of Information Industry to fund labs jointly, and with the Ministry of Education to finance computer classrooms in rural areas. Overall, it elevated its R&D presence, trained thousands of professionals, and invested close to $100 million in local firms. In response to Chinese government concerns about the alleged US government spyware embedded in Microsoft’s software, in 2003 the firm offered China (and 59 other countries) the fundamental source code for Windows and the right to substitute certain portions with local adaptation—something Microsoft had never done before. Only after such sustained and multidimensional efforts did the Chinese government bless Microsoft’s business by requiring that only legal software be used by government offices and loaded by PC makers. Although Microsoft never disclosed the depth of the discount it offered to the Chinese government, a legal package of Windows and Office could be bought for $3 (!). In Chen’s own words:

With all this work, we start changing the percep- tion that Microsoft is the company coming just to do antipiracy and sue people. We changed the company’s image. We’re the company that has the long-term vision. If a foreign company’s strategy matches with the government’s development agenda, the govern- ment will support you, even if they don’t like you.

The Challenges

Microsoft now has its own five-year plan to match the Chinese government’s. But not all is rosy when working closely with the Chinese government. Problems have erupted on two fronts. First, Microsoft continues to be frustrated by the lack of sufficient progress on IPR. While not disclosing country-specific sales numbers,

CEO Steve Ballmer complained in an interview in 2010 that, thanks to IPR problems, “China is a less interest- ing market to us than India . . . than Indonesia.”

Second, Microsoft has been criticized by free speech and human rights activists for its “cozy” relationship with the Chinese government. While largely unscrutinized by the media, the Chinese version of Microsoft MSN has long filtered certain words such as “democracy” and “freedom.” In 2010 Google butted heads with the Chinese government and openly called for Microsoft (and other high-tech firms) to join its efforts. Microsoft refused. Instead, Microsoft took advantage of Google’s trouble. It set up an alliance with Google’s number- one rival in China, Baidu, to provide English-language search results for Baidu from its Bing search engine. Such search results, of course, would be subject to po- litical censorship. In 2011, anyone in China searching “ jasmine,” in either Chinese (on Baidu) or English (on Baidu and routed through Bing), would find this term to be unsearchable—thanks to the Jasmine Revolution (otherwise known as the Arab Spring).

Case Discussion Questions

1. From an institution-based view, what are the major lessons from Microsoft’s strategic changes?

2. From a resource-based view, what valuable and unique resources and capabilities does Microsoft have in the eyes of the Chinese users and the government?

3. Why does Microsoft feel threatened by Linux in China and globally?

4. ON ETHICS: As a Microsoft spokesperson, how do you respond to free speech and human rights critics?

Sources: Based on (1) CFO, 2004, Does Microsoft need China? August 10, www.cfo.com; (2) Fortune, 2007, How Microsoft conquered China, July 23: 84–90; (3) Guardian, 2010, We’re staying in China, March 25, www.guardian.co.uk; (4) Guardian, 2011, Microsoft strikes deal with China’s biggest search engine Baidu, July 4, www.guardian.co.uk; (5) Microsoft, 2006, Microsoft in China, www.microsoft.com; (6) South China Morning Post, 2010, Beijing flexes its economic muscle, July 27: B8.

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7 Dealing with Foreign Exchange

8 Capitalizing on Global and Regional Integration

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Learning Objectives

After studying this chapter, you should be able to

5-1 use the resource-based and institution- based views to answer why nations trade.

5-2 understand classical and modern theories of international trade.

5-3 realize the importance of political realities governing international trade.

5-4 participate in two leading debates concerning international trade.

5-5 draw implications for action.

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* This case only deals with US merchandise (goods) exports. In service exports, the United States is even more competitive. It is the undisputed global champion every year. In 2011, US service exports were $578 billion, ahead of the second largest service exporter, the United Kingdom (which exported $274 billion), by a wide margin (see Table 5.1). While the United States is also the world’s largest service importer (with $391 billion im- ports in 2011), it has always run a service trade surplus.

Between the publication of Global Business’s sec- ond edition (with 2008 data) and third edition (with 2011 data), China dethroned Germany to become the world’s export champion. Widely reported, China’s rise as the world’s top export nation created both sensa- tions and concerns. Yet, what was little reported by the media was that the United States also surged ahead of Germany and is now the world’s second largest exporter—never mind all that talk about the decline of US competitiveness.

In 2011, the United States exported a record $1.48 trillion, with an enviable 16% annual increase.* While behind China’s $1.90 trillion exports, the US out- sold the long-time export champion, Germany, which exported $1.47 trillion, and the previously (and still) for- midable Japan, which exported $823 billion. What were the top US export categories? Refined petroleum prod- ucts, civilian aircraft, semiconductors, passenger cars, and telecom equipment. The top five export states were Texas (which exported one-sixth of the nation’s total exports), California, Illinois, Louisiana, and New York. The US Department of Commerce proudly noted that “fueling our economic recovery, exports are a bright spot in the US economy.” Further, the United States is “on track to meet the President’s National Export Initia- tive goals of doubling US exports by the end of 2014.”

Why are US exports so competitive? What is unique

about US exports? What has been driving their recent

rise in a very bleak global economic environment that

has barely recovered from the Great Recession of 2008

and 2009? On top of the Great Recession, one can add

more recent catastrophes such as the Japanese earth-

quake, the Thai floods, the euro zone crisis, and the Mid-

dle East turmoil. To make a long story short, first, US

exports have to deliver value. Consider civilian aircraft. One crucial reason that the new Boeing 787 Dreamliner

became the hottest-selling airliner prior to its launch is

its ability to reduce fuel consumption by 15%—music

to the ears of airline executives who suffer from sky-

rocketing oil prices. Second, US exports also have to

be rare and hard to imitate, considering that virtually all self-respecting governments are urging their own firms

to export more in an effort to combat recession. There

is no shortage of global rivals tearing apart US prod-

ucts and trying to reverse-engineer them. European,

Russian, and Chinese aerospace firms are doing this

Trading Internationally

O p e n i n g C a s e

Why Are US Exports So Competitive?

142 Part Two Acquiring Tools

at this moment by trying to out-Boeing Boeing. While Airbus has been quite successful, neither the Russian nor the Chinese civilian aircraft makers have much pres- ence in export markets. Finally, US exporters have to organize themselves in a more productive and efficient manner relative to their global rivals. It is hard enough to design and manufacture world-class airliners, but it is no less challenging to operate service, training, and main- tenance networks for airlines that cannot afford any equipment breakdown for a long period—on a world- wide basis and for 20 to 30 years after the initial sale.

While the products themselves have to be strong and competitive, Uncle Sam has also helped. At least ten federal agencies offer export assistance: the De- partments of Commerce, State, Treasury, Energy, and Agriculture as well as the Office of US Trade Represen- tative (USTR), the Export-Import Bank (Ex-Im Bank), the US Agency for International Development (USAID), the Overseas Private Investment Corporation (OPIC), and the Small Business Administration (SBA). Since only approximately 1% of all US firms export and of them 58% export to just one country, clearly more as- sistance will be helpful if more firms are interested in joining the export game.

In addition to routine export assistance, new initia- tives focus on negotiating free trade agreements (FTAs) with trading partners. As of this writing, the United States has 12 FTAs in force with 18 countries: Australia, Bahrain, Chile, DR-CAFTA (Dominican Republic-Central America FTA, which covers Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, and Nicaragua), Israel, Jordan, Morocco, NAFTA (which covers Canada and Mexico), Oman, Peru, Singapore, and South Korea. In addition, two FTAs with Panama and Colombia were negotiated, but they are still pending Congressional ap- proval. FTAs typically reduce trade barriers to US exports and create a more stable and transparent trading envi- ronment. In the first FTA with an East Asian country, the South Korea–US FTA (also known as KORUS), which was enacted at the end of 2011, both countries agreed to eliminate 95% of tariffs on goods within five years. For example, South Korea agreed to phase out a 40% tariff on US beef imports, and the United States agreed to waive a 2.5% tariff on Korean auto imports.

In addition to FTAs, the US government often nego- tiates with other foreign governments for better market

access and terms of trade for US exporters. The push to get the Chinese to let the yuan appreciate so that the dollar can be cheaper and US exports can be more competitive is a case in point. Despite an allegedly “ar- tificially” low yuan and a government eager to promote China’s own exports, China rose from being the ninth largest US export market in 2001 to the third largest in 2011 (behind Canada and Mexico). During that pe- riod, US exports to China jumped over 400%, while US exports to the rest of the world only grew 55%. Given the still huge US trade deficit (of which the US–China trade deficit is the largest component), clearly there is more room to push US exports.

In addition to formal institutions, informal norms and values, both at home and abroad, play a role be- hind US exports. At home, all the talk about the virtue and necessity of energy conservation and going green evidently has slowly become a part of the American cultural norm. One piece of evidence is that US oil con- sumption has declined since 2006. This helps explain why refined petroleum products (such as gasoline, diesel, and jet fuel) recently shot ahead of civilian air- craft to become the number-one export category. This is partly because much of the refining capacity the United States added in the past decade is now geared toward exports. While gurus write about the decline of US influence, the informal norms of consuming and appreciating US products seem to proliferate over- seas. In Paris metro (underground) stations, almost every other poster seems to be about a Hollywood blockbuster (in March 2012, it was Target). In Accra, the middle class flock into Ghana’s first KFC and lick their fingers greased by grown-in-USA chicken. If you are studying this book outside the United States, then you are a US export customer, too. Enjoy!

Sources: This case draws on a long line of my own research on US export strategy, starting with my PhD dissertation (cited as 5 below) and most recently with an interview with the Dallas Morning News on Texas export competitiveness (cited as 3 below). This case is based on (1) Bloomberg Businessweek, 2012, Yum’s big game of chicken, March 29: 64–69; (2) Bloomberg Businessweek, 2011, The real way a trade deal gets done, October 24: 30–32; (3) Dallas Morning News, 2012, Texas exports spike higher on energy goods, February 23; (4) Economist, 2010, Go sell, March 13: 32; (5) M. W. Peng, 1998, Behind the Success and Failure of US Export Intermediaries, Westport, CT: Quorum; (6) US Commercial Service, 2012, export.gov; (7) US Department of Commerce, 2012, New export data show 36 states experienced double digit growth of merchandise exports, International Trade Administration press release, February 23; (8) Washington Post, 2011, America’s top export in 2011 was . . . fuel? December 31.

Chapter 5 Trading Internationally 143

Why are US exports so competitive in the world? Why are exports a bright spot in this economy? More generally, how does international trade contribute to a nation’s economic growth and prosperity? International trade is the oldest and still the most im- portant building block of international business. It has never failed to generate debates. Debates on international trade tend to be very ferocious, because so much is at stake. We begin by addressing a crucial question: Why do nations trade? Then we outline how the two core perspectives introduced in earlier chapters—namely, resource-based and institution-based views—can help answer this question. The remainder of the chapter deals with the theories and realities of international trade. As before, debates and im- plications for action follow.

5-1 Why Do Nations Trade? Internationally, trade means export (sell abroad) and import (buy from abroad). Table 5.1 provides a snapshot of the top ten exporting and importing nations in the two main sectors: merchandise (goods) and services. In merchandise exports, China, the United States, and Germany are the top three. In merchandise imports, the top three are the United States, China, and Germany. In services, the United States is both the largest exporter and the largest importer. Britain and Germany are the top two and three service exporters, and Germany and China are the top two and three service importers (see PengAtlas Map 2.1 and 2.2).

Relative to domestic trade, international trade entails much greater complexi- ties (see PengAtlas Map 2.1 and 2.2). So, why do nations go through these trou- bles to trade internationally?1 Without getting into details, we can safely say that there must be economic gains from trade. More importantly, such gains must be shared by both sides—otherwise, there will be no willing exporters and importers. In other words, international trade is a win-win deal. Figure 5.1 shows that world trade growth (averaging over 5% between 1991 and 2011) routinely outpaces GDP growth (averaging nearly 3% during the same period). In 2009, a very difficult year, trade had a more severe drop than GDP. Otherwise, in every other year, trade growth exceeded GDP growth.

Why are there gains from trade?2 How do nations benefit from such gains? The remainder of the chapter will answer these questions. Before proceeding, it is important to clarify that “nations trade” is a misleading statement. A more accurate expression should be: “Firms from different nations trade.”3 Unless different governments directly buy and sell from each other (such as arms sales), the majority of trade is conducted by firms, which pay little attention to country-level ramifications. For example, Wal-Mart imports a lot into the United States and does not export much. Wal-Mart thus directly contributes to the US trade deficit (a nation imports more than it exports), which is something the US government does not like. However, in most countries, governments cannot tell firms, such as Wal-Mart, what to do (and not to do) unless firms engage in illegal activities. Therefore, we need to be aware that when we ask, “Why do nations trade?” we are really asking, “Why do firms from different nations trade?” When discussing the US–China trade whereby China runs a trade surplus (a nation exports more than it imports), we are really referring to thousands of US firms buying from and selling to China, which also has thou- sands of firms buying from and selling to the United States. The aggregation of such buying (importing) and selling (exporting) by both sides leads to the

Learning Objective Use the resource-based and institution-based views to answer why nations trade.

5-1

Export

Selling abroad.

Import

Buying from abroad.

Merchandise

Tangible products being traded.

Services

Intangible services being traded.

Trade deficit

An economic condition in which a nation imports more than it exports.

Trade surplus

An economic condition in which a nation exports more than it imports.

144 Part Two Acquiring Tools

Table 5.1 Leading Trading Nations

Top 10 merchandise

exporters

Value ($ billion)

World share (%)

Annual change

(%)

Top 10 merchandise

importers

Value ($

billion)

World share (%)

Annual change

(%)

1 China 1,899 10.4% 20% 1 United States 2,265 12.3% 15%

2 United States 1,481 8.1% 16% 2 China 1,743 9.5% 25%

3 Germany 1,474 8.1% 17% 3 Germany 1,254 6.8% 19%

4 Japan 823 4.5% 7% 4 Japan 854 4.6% 23%

5 Netherlands 660 3.6% 15% 5 France 715 3.9% 17%

6 France 597 3.3% 14% 6 United Kingdom 636 3.5% 13%

7 South Korea 555 3.0% 19% 7 Netherlands 597 3.2% 16%

8 Italy 523 2.9% 17% 8 Italy 557 3.0% 14%

9 Russia 522 2.9% 30% 9 South Korea 524 2.9% 23%

10 Belgium 476 2.6% 17% 10 Hong Kong, China

511 2.8% 16%

World total 18,215 100% 19% World total 18,380 100% 19%

Top 10 service

exporters

Value ($ billion)

World share (%)

Annual change

(%)

Top 10 service

importers

Value ($ billion)

World share (%)

Annual change

(%)

1 United States 578 13.9% 11% 1 United States 391 10.1% 5%

2 United Kingdom 274 6.6% 11% 2 Germany 284 7.3% 8%

3 Germany 253 6.1% 9% 3 China 236 6.1% 23%

4 China 182 4.4% 7% 4 United Kingdom 171 4.4% 7%

5 France 181 3.9% 11% 5 Japan 155 4.3% 6%

6 India 148 3.6% 20% 6 France 141 3.6% 7%

7 Japan 143 3.4% 3% 7 India 130 3.4% 12%

8 Spain 141 3.4% 14% 8 Netherlands 118 3.1% 12%

9 Netherlands 128 3.1% 11% 9 Italy 115 3.0% 5%

10 Singapore 125 3% 12% 10 Ireland 113 2.9% 6%

World total 4,150 100% 11% World total 3,470 100% 11%

Source: Adapted from World Trade Organization, 2012, World trade 2011, prospects for 2012, press release (Appendix Tables 3 and 5), April 12, Geneva: WTO (www.wto.org). All data are for 2011.

country-level balance of trade—namely, whether a country has a trade surplus or deficit.

Having acknowledged the limitations of the expression that “nations trade,” we will still use it. Why? Because it is commonly used and serves as a short-hand version of the more accurate but more cumbersome expression that “firms from different nations trade.” This clarification does enable us to use the two firm-level perspectives introduced earlier—namely, the resource-based and institution-based views—to shed light on why nations trade.

Balance of trade

The aggregation of importing and exporting that leads to the coun- try-level trade surplus or deficit.

Chapter 5 Trading Internationally 145

Recall from Chapter 4 that it is valuable, rare, inimitable, and organization- ally derived (VRIO) products that determine the competitive advantage of a firm. Applying this insight, we can suggest that valuable, rare, and inimitable products generated by organizationally strong firms in one nation can lead to the competitive advantage of its exports (see the Opening Case).4 Further, re- call from Chapters 2 and 3 that numerous politically and culturally derived rules of the game (known as institutions) constrain and facilitate individual and firm behavior. For example, although American movies are the best in the world, Canada, France, and South Korea limit the market share of American movies. Thus, various regulations create trade barriers around the world. On the other hand, we also see the rise of rules and organizations that facilitate trade, such as those advocated by the World Trade Organization (WTO) (see Chapter 8).

Overall, why are there economic gains from international trade? According to the resource-based view, this is because some firms in one nation generate exports that are valuable, unique, and hard-to-imitate that firms from other nations find it beneficial to import. How do nations benefit from such gains? According to the institution-based view, different rules governing trade are designed to share (or not to share) such gains.5 The remainder of this chapter expands on these two perspectives.

5-2 Theories of International Trade Theories of international trade provide one of the oldest, richest, and most influ- ential bodies of economics, whose founding is usually associated with the publica- tion of British economist Adam Smith’s The Wealth of Nations in 1776. Theories of

Learning Objective Understand classical and modern theories of international trade.

5-2

Figure 5.1 Growth in World Trade Outpaces Growth in World GDP (Annual % Change)

Source: World Trade Organization, 2012, World trade 2011, prospects for 2012, press release, April 12, Geneva: WTO (www.wto.org). “P” in “2012P” and “2013P” refers to prediction.

15.0

10.0

5.0

0.0

25.0

210.0

215.0 2005 2006 2007 2008 2009 2010 2011 2012P 2013P

Exports

GDP

Average GDP growth 1991–2011

Average export growth 1991–2011

146 Part Two Acquiring Tools

international trade predate Adam Smith. In fact, Adam Smith wrote The Wealth of Nations to challenge an earlier theory: mercantilism. In this section, we briefly review major theories of international trade: (1) mercantilism, (2) absolute ad- vantage, (3) comparative advantage, (4) product life cycle, (5) strategic trade, and (6) national competitive advantage. The first three are often regarded as classical trade theories, and the last three are viewed as modern trade theories.

5-2a Mercantilism Widely practiced between the 1600s and the 1700s, the theory of mercantilism viewed international trade as a zero-sum game. Its theorists, led by French statesman Jean- Baptiste Colbert, believed that the wealth of the world (measured in gold and silver at that time) was fixed, and that a nation that exported more and imported less would enjoy the net inflows of gold and silver and thus become richer. On the other hand, a nation experiencing a trade deficit would see its gold and silver flowing out and, con- sequently, would become poorer. The upshot? Self-sufficiency would be best.

Although mercantilism is the oldest theory in international trade, it is not an extinct dinosaur. Very much alive, mercantilism is the direct intellectual ancestor of modern-day protectionism, which is the idea that governments should actively protect domestic industries from imports and vigorously promote exports (see the Closing Case). Many modern governments may still be mercantilist at heart. Think about all these export assistance programs run by many governments (see the Opening Case). Has anyone seen an import assistance program?

5-2b Absolute Advantage The theory of absolute advantage, advocated by Adam Smith in 1776, opened the floodgates of the free trade movement that is still going on today. Smith argued that in the aggregate, the “invisible hand” of markets, rather than governments, should determine the scale and scope of economic activities. This is known as laissez faire (see Chapter 2). By trying to be self-sufficient and (inefficiently) produce a wide range of goods, mercantilist policies reduce the wealth of a nation in the long run. Smith thus argued for free trade, which is the idea that free market forces should determine how much to trade with little (or no) government intervention.

Specifically, Smith proposed a theory of absolute advantage: With free trade, each nation gains by specializing in economic activities in which it has absolute advantage. What is absolute advantage? It is the economic advantage one nation enjoys that is absolutely superior to other nations. For example, Smith argued that because of better soil, water, and weather, Portugal enjoyed an absolute advantage over England in the production of grapes and wines. Likewise, England had an absolute advantage over Portugal in the production of sheep and wool. England could grow grapes at a greater cost and with much lower quality—has anyone heard of any world-famous English wines? Smith suggested (1) that England should spe- cialize in sheep and wool, (2) that Portugal should specialize in grapes and wines, and (3) that they should trade with each other. Here are two of Smith’s greatest insights. First, by specializing in the production of goods for which each has an absolute advantage, both can produce more. Second, by trading, both can benefit more. By specializing, England produces more wool than it can use, and Portugal produces more wine than it can drink. When both countries trade, England gets

Classical trade theories

The major theories of interna- tional trade that were advanced before the 20th century, which consist of (1) mercantilism, (2) absolute advantage, and (3) comparative advantage.

Modern trade theories

The major theories of international trade that were advanced in the 20th century, which consist of (1) product life cycle, (2) strategic trade, and (3) national competitive advantage of industries.

Theory of mercantilism

A theory that suggests that the wealth of the world is fixed and that a nation that exports more and imports less will be richer.

Protectionism

The idea that governments should actively protect domestic industries from imports and vig- orously promote exports.

Free trade

The idea that free market forces should determine how much to trade with little or no govern- ment intervention.

Theory of absolute advantage

A theory that suggests that un- der free trade, a nation gains by specializing in economic activi- ties in which it has an absolute advantage.

Absolute advantage

The economic advantage one nation enjoys that is absolutely superior to other nations.

Chapter 5 Trading Internationally 147

more (and better) wine and Portugal more (and better) wool than either country could produce on its own. In other words, international trade is not a zero-sum game as suggested by mercantilism. It is a win-win game.

How can this be? Let us use an example with hypothetical numbers (Figure 5.2 and Table 5.2). For the sake of simplicity, assume there are only two nations in the world: China and the United States. They only perform two economic activi- ties: growing wheat and making aircraft. Production of wheat or aircraft, naturally, requires resources such as labor, land, and technology. Assume that both are equally

Is it necessary for a country to have an absolute advantage in some activity, such as the production of a particular crop, in order to participate in inter- national trade?

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148 Part Two Acquiring Tools

endowed with 800 units of resources. Between the two activities, the United States has an absolute advantage in the production of aircraft—it takes 20 resources to produce an aircraft (for which China needs 40 resources), and the total US capac- ity is 40 aircraft if it does not produce wheat (point D in Figure 5.2). China has an absolute advantage in the production of wheat—it takes 20 resources to produce 1,000 tons of wheat (for which the United States needs 80 resources) and the total Chinese capacity is 40,000 tons of wheat if it does not make aircraft (point A). It is important to note that the United States can grow wheat and that China can make aircraft, albeit inefficiently. But because both nations need wheat and aircraft, with- out trade, they produce both by spending half of their resources on each—China at point B (20,000 tons of wheat and 10 aircraft) and the United States at point C (5,000 tons of wheat and 20 aircraft). Interestingly, if they stay at points A and D, respectively, and trade one-quarter of their output with each other (10,000 tons of Chinese wheat with 10 American aircraft), these two countries, and by implication the global economy, both produce more and consume more (Table 5.2). In other words, there are net gains from trade based on absolute advantage.

5-2c Comparative Advantage According to Adam Smith, each nation should look for absolute advantage. How- ever, what can nations do when they do not possess absolute advantage? Continuing our two-country example of China and the United States, what if China is absolutely inferior to the United States in the production of both wheat and aircraft (which is the real case today)? What should China do? What should the United States do? Obviously, the theory of absolute advantage runs into a dead end.

In response, British economist David Ricardo developed a theory of comparative advantage in 1817. This theory suggests that even though the United States has an absolute advantage over China in both wheat and aircraft, as long as China is not equally less efficient in the production of both goods, China can still choose to specialize in the production of one good (such as wheat) where it has comparative advantage—defined as the relative (not absolute) advantage in one economic activity that one nation enjoys in comparison with other nations. Figure 5.3 and

Theory of comparative advantage

A theory that focuses on the relative (not absolute) advantage in one economic activity that one nation enjoys in comparison with other nations.

Comparative advantage

Relative (not absolute) advan- tage in one economic activity that one nation enjoys in com- parison with other nations.

Table 5.2 Absolute Advantage

Total units of resources 5 800 for each country Wheat Aircraft

(1) Resources required to produce 1,000 tons of wheat and 1 aircraft.

China US

20 resources 80 resources

40 resources 20 resources

(2) Production and consumption with no specialization and without trade (each country devotes half of its resources to each activity).

China (point B) US (point C)

Total production

20,000 tons 5,000 tons 25,000 tons

10 aircraft 20 aircraft 30 aircraft

(3) Production with specialization (China specializes in wheat and produces no aircraft, and the United States specializes in aircraft and produces no wheat).

China (point A) US (point D)

Total production

40,000 tons 0

40,000 tons

0 40 aircraft 40 aircraft

(4) Consumption after each country trades one-quarter of its output while producing at points A and D, respectively (Scenario #3).

China US

Total consumption

30,000 tons 10,000 tons 40,000 tons

10 aircraft 30 aircraft 40 aircraft

(5) Gains from trade: Increase in consumption as a result of specialization and trade (Scenario #4 versus #2).

China US

110,000 tons 15,000 tons

0 110 aircraft

Chapter 5 Trading Internationally 149

Table 5.3 show that China’s comparative advantage lies in its relatively less ineffi- cient production of wheat: If China devotes all resources to wheat, it can produce 10,000 tons, which is four-fifths of the 12,500 tons the United States can produce. However, at a maximum, China can only produce 20 aircraft, which is merely half of the 40 aircraft the United States can make. By letting China specialize in the pro- duction of wheat and importing some wheat from China, the United States is able to leverage its strengths by devoting its resources to aircraft. For example, if (1) the United States devotes four-fifths of its resources to aircraft and one-fifth to wheat (Point C in Figure 5.3), (2) China concentrates 100% of its resources on wheat (Point E), and (3) they trade with each other, both countries produce and consume more than what they would produce and consume if they inefficiently devote half of their resources to each activity (see Table 5.3).

Table 5.3 Comparative Advantage

Total units of resources 5 800 for each country Wheat Aircraft

(1) Resources required to produce 1,000 tons of wheat and 1 aircraft.

China US

80 resources 64 resources

40 resources 20 resources

(2) Production and consumption with no specialization and without trade (each country devotes half of its resources to each activity).

China (point F) US (point B)

Total production

5,000 tons 6,250 tons 11,250 tons

10 aircraft 20 aircraft 30 aircraft

(3) Production with specialization (China devotes all resources to wheat, and the United States devotes one-fifth of its resources to wheat and four-fifths of its resources to aircraft).

China (point E) US (point C)

Total production

10,000 tons 2,500 tons 12,500 tons

0 32 aircraft 32 aircraft

(4) Consumption after China trades 4,000 tons of wheat for 11 US aircraft while producing at points E and C, respectively (Scenario #3).

China US

Total consumption

6,000 tons 6,500 tons 12,500 tons

11 aircraft 21 aircraft 32 aircraft

(5) Gains from trade: Increase in consumption as a result of specialization and trade (Scenario #4 versus #2).

China US

11,000 tons 1250 tons

11 aircraft 11 aircraft

B F

Chinese Production

US Production

C G

2.5

6.25

12.5

0 10 20 30 40 Aircraft

W he

at (0

00 t

o ns

)

Figure 5.3 Comparative Advantage

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Again, there are net gains from trade; this time from comparative advantage. One crucial concept here is opportunity cost—given the alternatives (other oppor- tunities), the cost of pursuing one activity at the expense of another activity. For the United States, the opportunity cost of concentrating on wheat at point A in Figure 5.3 is tremendous relative to producing aircraft at point D, because it is only 25% more productive in wheat than China but 100% more productive in aircraft.

Relative to absolute advantage, the theory of comparative advantage seems counterintuitive. However, this theory is far more realistic and useful in the real world. While it is easy to identify an absolute advantage in a highly simplified, two- country world as in Figure 5.2, how can each nation decide what to specialize in when there are over 200 nations in the world? It is simply too challenging to ascer- tain that one nation is absolutely better than all others in one activity. Is the United States absolutely better than China as well as all other 200 nations in aircraft pro- duction? European nations that produce Airbus obviously beg to differ. The theory of comparative advantage suggests that even without an absolute advantage, the United States can still profitably specialize in aircraft as long as it is relatively more efficient than others. This insight has greatly lowered the threshold for specializa- tion because absolute advantage is no longer required.

Where do absolute and comparative advantages come from? In a word, produc- tivity. Smith looked at absolute productivity differences, and Ricardo emphasized relative productivity differences—in this sense, absolute advantage is really a special case of comparative advantage. But what leads to such productivity differences? In the early 20th century, Swedish economists Eli Heckscher and Bertil Ohlin argued that absolute and comparative advantages stem from different factor endowments, namely, the extent to which different countries possess various factors, such as labor, land, and technology. This factor endowment theory (or Heckscher-Ohlin theory) proposed that nations will develop comparative advantage based on their locally abundant factors. Numerous examples support the theories of comparative advantage and factor endowments. For example, Brazil is blessed by an abundant supply of sunshine, soil, and water, which make it a world-class player in agricul- tural products (see the Closing Case). In another example, when Indian firms set up call centers to service Western clients, they use human labor, a resource that is very abundant in India, to replace some automation functions when answering the phone—telephone automation technology has been developed in the West be- cause of a labor shortage. Western clients are happier because they can actually talk to a live person instead of a machine (press 1 for this, press 2 for that).

In summary, classical theories, (1) mercantilism, (2) absolute advantage, and (3) comparative advantage (which includes factor endowments), had evolved from approximately 300 to 400 years ago to the beginning of the 20th century. More recently, three modern theories, outlined next, emerged.

5-2d Product Life Cycle Up to this point, classical theories all paint a static picture: If England has an abso- lute or comparative advantage in textiles (thanks to its favorable weather and soil), it should keep producing textiles. However, this assumption of no change in fac- tor endowments and trade patterns does not always hold in the real world. While Adam Smith’s England over 200 years ago was a major exporter of textiles, to- day England’s textile industry is insignificant. So, what happened? While one may argue that in England, weather has changed and soil has become less fertile, it is

Opportunity cost

Cost of pursuing one activity at the expense of another activity, given the alternatives (other opportunities).

Factor endowment

The extent to which different countries possess various fac- tors of production such as labor, land, and technology.

Factor endowment theory (Heckscher-Ohlin theory)

A theory that suggests that nations will develop comparative advantages based on their locally abundant factors.

Chapter 5 Trading Internationally 151

difficult to believe that weather and soil have changed so much in 200 years, which is a relatively short period for long-run climatic changes. In another example, since the 1980s, the United States turned from being a net exporter to a net importer of personal computers (PCs), while Malaysia transformed itself from being a net im- porter to a net exporter of PCs—and this change has nothing to do with weather or soil change. Why do patterns of trade in PCs change over time? Classical theories would have a hard time answering this intriguing question.

In 1966, American economist Raymond Vernon developed the product life cycle theory, which is the first dynamic theory to account for changes in the pat- terns of trade over time.6 Vernon divided the world into three categories: (1) lead innovation nation (which, according to him, is typically the United States), (2) other developed nations, and (3) developing nations. Further, every product has three life cycle stages: new, maturing, and standardized. Shown in Figure 5.4, in

Product life cycle theory

A theory that accounts for changes in the patterns of trade over time by focusing on product life cycles.

A. United States

Production

Consumption

New Product

Maturing Product

Product Life Cycle Stages

Standardized Product

B. Other Advanced Countries

C. Developing Countries Trade Volume

Trade Volume

Imports Exports

Figure 5.4 Theory of Product Life Cycles

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the first stage, production of a new product (such as a TV) that commands a price premium will concentrate in the United States, which exports to other developed nations. In the second, maturing stage, demand and ability to produce grow in other developed nations (such as Australia and Italy), so it is now worthwhile to pro- duce there. In the third stage, the previously new product is standardized (or com- moditized). Thus, much production will now move to low-cost developing nations, which export to developed nations. In other words, comparative advantage may change over time.

While this theory was first proposed in the 1960s, some later events (such as the migration of PC production) have supported its prediction. However, this theory has been criticized on two accounts. First, it assumes that the United States will always be the lead innovation nation for new products. This may be increasingly invalid. For example, the fanciest cell (mobile) phones are now routinely pioneered in Asia and Europe. Second, this theory assumes a stage-by-stage migration of pro- duction, taking at least several years (if not decades). In reality, however, an increas- ing number of firms now simultaneously launch new products (such as iPads) around the globe.

5-2e Strategic Trade Except mercantilism, none of the theories above has anything to say about the role of governments. Since the days of Adam Smith, government intervention has usu- ally been regarded as undesirable. However, government intervention is extensive and is not going away. Can government intervention actually add value? Since the 1970s, a new theory, strategic trade theory, has addressed this question.7

Strategic trade theory suggests that strategic intervention by governments in certain industries can enhance their odds for international success. What are these industries? They tend to be highly capital-intensive, high entry-barrier industries in which domestic firms may have little chance without government assistance. These industries also feature substantial first-mover advantages— namely, advantages that first entrants enjoy and do not share with late entrants. One leading example is the commercial aircraft industry. Founded in 1915 and strengthened by large military orders during World War II, Boeing has long dominated this industry. In the jumbo jet segment, Boeing’s first-mover advan- tages associated with its 400-seat 747, first launched in the late 1960s, are still significant today. Alarmed by such US dominance, in the late 1960s, British, French, German, and Spanish governments realized that if they had not inter- vened in this industry, individual European aerospace firms on their own might have been driven out of business by US rivals. Therefore, these European govern- ments agreed to launch and subsidize Airbus. In four decades, Airbus has risen from nowhere to a position where it now has a 50–50 split of the global market with Boeing.

How do governments help Airbus? Let us use a recent example: the very large, super-jumbo aircraft, which is larger than the Boeing 747. Both Airbus and Boeing are interested in entering this market. However, the demand in the next 20 years is only about 400 to 500 aircraft, and a firm needs to sell at least 300 just to break even, which means that only one firm can be profitably supported. Shown in Figure 5.5 (Panel A), if both enter, the outcome will be disastrous

Strategic trade theory

A theory that suggests that strategic intervention by governments in certain indus- tries can enhance their odds for international success.

First-mover advantage

Advantage that first movers enjoy and do not share with late entrants.

Chapter 5 Trading Internationally 153

Boeing

Airbus

Enter

Enter Don’t Enter

Don’t Enter

(Cell 1) $5 billion, –$5 billion

(Cell 2) $30 billion, 0

(Cell 3) 0, $20 billion

(Cell 4) 0, 0

Boeing

Airbus

Enter

Enter Don’t Enter

Don’t Enter

(Cell 1) –$5 billion, –$5 billion

(Cell 2) $20 billion, 0

(Cell 3) 0, $20 billion

(Cell 4) 0, 0

Figure 5.5 Entering the Very Large, Super-Jumbo Market?

Panel B. With $10 Billion Subsidy from European Governments (Outcome 5 Airbus, Boeing)

Panel A. Without Government Subsidy (Outcome 5 Airbus, Boeing)

because each will lose $5 billion (Cell 1). If one enters and the other does not, the entrant will make $20 billion (Cells 2 and 3). It is possible that both will enter and clash. If a number of European governments promise Airbus a subsidiary of, say, $10 billion if it enters, then the picture changes to Panel B. Regardless of what Boeing does, Airbus finds it lucrative to enter. In Cell 1, if Boeing enters, it will lose $5 billion as before, whereas Airbus will make $5 billion ($10 billion subsidy with a $5 billion loss). So, Boeing has no incentive to enter. Therefore, the more likely outcome is Cell 2, where Airbus enters and enjoys a profit of $30 billion. Therefore, the subsidy has given Airbus a strategic advantage, and the policy to assist Airbus is known as a strategic trade policy.8 This has indeed been the case, as the 550-seat A380 has recently entered service.

Strategic trade theorists do not advocate a mercantilist policy to promote all in- dustries. They only propose to help a few strategically important industries, such as the solar panel industry (see Emerging Markets 5.1). However, this theory has been criticized on two accounts. Ideologically, many scholars and policy makers are un- comfortable. What if governments are not sophisticated and objective enough to do this job? Practically, a lot of industries claim that they are strategically important. For example, after “9/11,” American farmers successfully argued that agriculture is a strategic industry (guarding food supply against terrorists) and extracted more subsidies. Since the 2008–2009 crisis, practically every self-respecting industry in every country that has dished out a stimulus package can expect some handouts from its government. Overall, where to hold the line between strategic and non- strategic industries is tricky.

Strategic trade policy

Government policy that provides companies a strategic advantage in international trade through subsidies and other supports.

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According to strategic trade theory, strategic inter- vention by governments in certain industries can enhance their odds for international success. The rapidly growing solar panel industry has become the newest testing ground for this theory. Transforming sunlight into electricity, with no need to burn fos- sil fuel and pollute the air, solar panels not only are green but can also support a lot of jobs, exports, and taxes. Many governments dish out subsidies to both solar panel producers and end-users to encour- age more demand. European governments have been very aggressive. Passengers on a train ride in Germany passing through many villages and towns can see a fairly large number of roofs equipped with solar panels. The US solar panel industry has received significant funding from federal and state support. Despite the high-profile 2011 bankruptcy of Solyndra, a firm that received a $535 million fed- eral loan guarantee, the Obama administration an- nounced that it would not back off from its clean energy policy. However, given the worsening bud- getary constraints and bad experiences such as Solyndra, US and EU governments have become more cautious. The Chinese government is by far the most eager practitioner of strategic trade theo- ry. In 2010 alone, China Development Bank provided $30 billion in low-cost loans to the country’s top five solar panel producers.

The upshot? A decade ago, most of the world’s solar panels—in a much smaller industry—were made by European, American, and Japanese produc- ers. Today, Chinese firms have captured more than half of the world market. Among the world’s top five producers, three are Chinese: Suntech (NYSE: STP), Yingli (NYSE: YGE), and Trina (NYSE: TSL) are,

respectively, the top, fourth, and fifth, measured by megawatt shipments. While US firm First Solar is the world’s second largest producer, the total US share in manufacturing is just 5%. The price of the silicon-based solar panels fell from $1.80 per watt in 2011 to 90 cents in 2012. In the process, a number of firms such as Solyndra have been elbowed out of business.

Unable to compete with Chinese firms on cost or financing, some US and EU firms have sued their Chinese rivals for dumping and for receiving “im- proper” (or “unfair” or “predatory”—pick your choice of words) subsidies. In addition to pointing out the subsidies dished out by the US and EU governments, Chinese firms noted that cheap imports can generate a lot of local jobs because fitting panels to buildings will always be a local business. At $6.50 per watt for residential installation, Western importers that buy cells from China and install them can make a good living with a great deal of profit. Wider installation of solar panels can obviously reduce carbon emis- sions. Stuck in this ethical and economic dilemma, the US government imposed a 4.73% import tariff on solar panel imports from China in March 2012. As far as tariffs are concerned, this amount was largely “symbolic,” according to an expert. In comparison, Chinese tire makers suffered a 35% US import tariff in 2009. As a result, shares of the listed Chinese solar panel makers shot up. Some of them are listed in New York (see above), so their American sharehold- ers also loved it. In the long run, this exchange of trade blows will lead Chinese firms (1) to start setting up plants to produce in the United States, and (2) to sell more domestically—from a merely 5% in 2010 to 30% in 2012.

Applying Strategic Trade Theory to Solar Panels

E m E r g i n g m a r k E t s 5 . 1

Ethical Dilemma

Sources: Based on (1) Bloomberg Businessweek, 2012, China escapes steep tariffs, March 26: 26; (2) Bloomberg Businessweek, 2012, Firing up China’s solar market, March 19: 67–68; (3) D. Darling & F. Bourda, 2013, SolarWorld USA, in M. W. Peng, Global Strategy, Cincinnati: South-Western Cengage Learning; (4) Economist, 2012, The boomerang effect, April 21: 8–11.

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5-2f National Competitive Advantage of Industries The most recent theory is known as the theory of national competitive advan- tage of industries. This is popularly known as the “diamond” theory because its principal architect, Harvard strategy professor Michael Porter, presents it in a diamond shaped diagram (Figure 5.6).9 This theory focuses on why certain in- dustries (but not other industries) within a nation are competitive internation- ally. For example, while the Japanese automobile industry is a global winner, the Japanese service industry is notoriously inefficient. Porter is interested in finding out why.

Porter argues that the competitive advantage of certain industries in different nations depends on four aspects that form a “diamond.” First, he starts with factor endowments, which refer to the natural and human resource repertoires noted by the Heckscher-Ohlin theory. Some countries (such as Saudi Arabia) are rich in natural resources but short on population, and others (such as Singapore) have a well-educated population but few natural resources. Not surprisingly, Saudi Arabia exports oil, and Singapore exports semiconductors (which need abundant skilled labor). While building on these insights from previous theories, Porter argues that factor endowments are not enough.

Second, tough domestic demand propels firms to scale new heights. Why are American movies so competitive worldwide? One reason is that American movie- goers demand the very best “sex and violence” (two themes that sell universally if artfully packaged). Endeavoring to satisfy such domestic demand, movie studios unleash Madagascar 3 after Madagascar and Madagascar 2, and Spider-Man 3 after

Theory of national competitive advantage of industries (diamond theory)

A theory that suggests that the competitive advantage of certain industries in different nations depends on four aspects that form a “diamond.”

Country factor

endowments

Domestic demand

conditions

Firm strategy, structure, and

rivalry

Related and supporting industries

Figure 5.6 National Competitive Advantage of Industries: The Porter Diamond

Source: M. Porter, 1990, The competitive advantage of nations (p. 77), Harvard Business Review, March–April: 73–93. Reprinted with permission.

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Spider-Man and Spider-Man 2—each time packing more excitement. Thus, abilities to satisfy a tough domestic crowd may make it possible to successfully deal with less demanding overseas customers.

Third, domestic firm strategy, structure, and rivalry in one industry play a huge role behind its international success or failure. One reason that a number of Chinese manufacturing industries are so competitive globally—coining the term the “China Price”—is that their domestic rivalry is probably the most intense in the world. Think of appliances, cell phones, furniture, and pianos. The price wars keep everyone lean, and most firms struggle to make a profit. However, the few top firms (such as Pearl River Piano) that win the tough competition domestically may have a relatively easier time when venturing abroad because overseas competition is less demanding.

Finally, related and supporting industries provide the foundation upon which key industries can excel. In the absence of strong related and support- ing industries such as engines, avionics, and materials, a key industry such as aerospace cannot become globally competitive. Each of these related and sup- porting industries requires years (and often decades) of hard work. For instance, emboldened by the Airbus experience, Chinese, Korean, and Japanese govern- ments poured money into their own aerospace industry. Eventually, they all re- alized that Europe’s long history and excellence in a series of crucial related and supporting industries made it possible for Airbus to succeed. A lack of such industries made it unrealistic for the Chinese, Korean, and Japanese aerospace industry to take off.

Overall, Porter argues that the dynamic interaction of these four aspects ex- plains what is behind the competitive advantage of leading industries in different nations. This theory is the first multilevel theory to realistically connect firms, indus- tries, and nations, whereas previous theories only work on one or two levels. How- ever, it has not been comprehensively tested. Some critics argue that the “diamond” places too much emphasis on domestic conditions.10 The recent rise of India’s IT industry suggests that its international success is not entirely driven by domestic demand, which is tiny compared with overseas demand—it is overseas demand that matters a lot more in this case.

5-2g Evaluating Theories of International Trade In case you are tired after studying the six theories, you have to appreciate that we have just gone through over 300 years of research, debates, and policy changes around the world in about 12 pages (!). As a student, that is not a small accomplish- ment. Table 5.4 enables you to see the “forest.” As you review these theories, keep the following four points in mind.

First, the classical pro-free trade theories seem common sense today. However, we need to appreciate that they were revolutionary 200 years ago, when the world was dominated by mercantilistic thinking. Second, all theories simplify to make their point. Classical theories rely on highly simplistic assumptions of a model consisting of only two nations and two goods. Third, the theories also assume perfect resource mobility—the assumption that one resource removed from wheat production can be moved to make aircraft. In reality, farm hands will have a hard time assembling modern aircraft. Finally, classical theories assume no foreign exchange complica- tions and zero transportation costs.

Resource mobility

Assumption that a resource used in producing a product for one industry can be shifted and put to use in another industry.

Chapter 5 Trading Internationally 157

So, in the real word of many countries, numerous goods, imperfect resource mobility, fluctuating exchange rates, high transportation costs, and product life cycle changes, is free trade still beneficial as Smith and Ricardo suggested? The answer is still “Yes!” as worldwide data support the basic arguments of free traders such as Smith and Ricardo.11 (See “Debates and Extensions” for disagreements.)

Table 5.4 Theories of International Trade: A Summary

Classical theories Main points Strengths and influences Weaknesses and debates

Mercantilism (Colbert, 1600s–1700s)

International trade is a zero-sum game—trade deficit is dangerous.

Governments should protect domestic industries and promote exports.

Forerunner of modern-day protectionism.

Inefficient allocation of resources.

Reduces the wealth of the nation in the long run.

Absolute advantage (Smith, 1776)

Nations should specialize in economic activities in which they have an absolute advantage and trade with others.

By specializing and trading, each nation produces more and consumes more.

The wealth of all trading nations, and the world, increases.

Birth of modern economics.

Forerunner of the free trade movement.

Defeats mercantilism, at least intellectually.

When one nation is absolutely inferior than another, the theory is unable to provide any advice.

When there are many nations, it may be difficult to find an absolute advantage.

Comparative advantage (Ricardo, 1817; Heckscher, 1919; Ohlin, 1933)

Nations should specialize in economic activities in which they have a compar- ative advantage and trade with others.

Even if one nation is absolutely inferior than another, the two nations can still gainfully trade.

Factor endowments underpin comparative advantage.

More realistic guidance to nations (and their firms) interested in trade but having no absolute advantage.

Explains patterns of trade based on factor endowments.

Relatively static, assuming that comparative advantage and factor endowments do not change over time.

Modern theories

Product life cycle (Vernon, 1966)

Comparative advantage first resides in the lead innovation nation, which exports to other nations.

Production migrates to other advanced nations and then developing nations in different product life cycle stages.

First theory to incorporate dynamic changes in patterns of trade.

More realistic with trade in industrial products in the 20th century.

The United States may not always be the lead innovation nation.

Many new products are now launched simultane- ously around the world.

Strategic trade (Brander, Spencer, Krugman, 1980s)

Strategic intervention by governments may help domestic firms reap first- mover advantages in certain industries.

First-mover firms, aided by governments, may have better odds at winning internationally.

More realistic and positively incorporates the role of governments in trade.

Provides direct policy advice.

Ideological resistance from many “free trade” scholars and policy makers.

Invites all kinds of industries to claim they are strategic.

National competitive advantage of industries (Porter, 1990)

Competitive advantage of different industries in different nations depends on the four interacting aspects of a “diamond.”

The four aspects are (1) factor endow- ments, (2) domestic demand, (3) firm strategy, structure, and rivalry, and (4) related and supporting industries.

Most recent, most complex, and most realistic among various theories.

As a multilevel theory, it directly connects research on firms, industries, and nations.

Has not been comprehensively tested.

Overseas (not only domes- tic) demand may stimulate the competitiveness of certain industries.

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Instead of relying on simple factor analysis, modern theories rely on more real- istic product life cycles, first-mover advantages, and the “diamond” to explain and predict patterns of trade. Overall, classical and modern theories have significantly contributed to today’s ever deepening trade links. Yet, the victory of classic and modern pro-free trade theories is not complete. The political realities governing international trade, outlined next, indicate that mercantilism is alive and well.

5-3 Realities of International Trade The political realities of the world suggest that as “rules of the game,” plenty of trade barriers exist. Although some are being dismantled, many will remain. Let us examine why this is the case. To do so, we will first discuss the two broad types of trade barriers: tariff barriers and non-tariff barriers.

5-3a Tariff Barriers A tariff barrier is a means of discouraging imports by placing a tariff (tax) on im- ported goods. As a major tariff barrier, an import tariff is a tax imposed on a good brought in from another country. Figure 5.7 uses rice tariffs in Japan to show that there are unambiguously net losses—known as deadweight costs.

Panel A: In the absence of international trade, the domestic price is P1 and do- mestic rice farmers produce Q 1, determined by the intersection of domestic supply and demand curves.

Panel B: Because Japanese rice price P1 is higher than world price P2, foreign farmers export to Japan. In the absence of tariffs, Japanese farmers reduce out- put to Q 2. Japanese consumers enjoy more rice at Q 3 at a much lower price, P2.

Panel C: The government imposes an import tariff, effectively raising price from P2 to P3. Japanese farmers increase production from Q 2 to Q 4, and con- sumers pay more at P3 and consume less by reducing consumption from Q 3 to Q 5. Imports fall from Q 2Q 3 in Panel B to Q 4Q 5 in Panel C.

Classical theorists such as Smith and Ricardo would have advised Japan to enjoy the gains from trade in Panel B. But political realities land Japan in Panel C, which, by limiting trade, introduces total inefficiency represented by the area consisting of A, B, C, and D. However, Japanese rice farmers gain the area of A and the govern- ment pockets tariff revenues in the area of C. Therefore:

Net losses (deadweight) 5 Total inefficiency 2 net gain

5 Area (A 1 B 1 C 1 D) 2 Area (A 1 C)

5 Area (B 1 D)

The net losses (areas B and D) represent unambiguous economic inefficiency to the nation as a whole.12 Japan is not alone in this regard. A Microsoft Xbox 360 con- sole that retails for $360 in the United States costs $1,000 (!) in Brazil, after adding im- port tariffs.13 In 2009, the United States slapped a 35% import tariff on tires made in China. Brazilian Xbox gamers and American tire buyers have to pay more, and some may be unable to afford the products. While not being able to get your arms around an Xbox will have no tangible damage, some economically struggling US drivers who should have replaced their worn-out tires may be forced to delay replacing their tires.

Learning Objective Realize the importance of political realities governing international trade.

5-3

Tariff barrier

Trade barrier that relies on tariffs to discourage imports.

Import tariff

A tax imposed on imports.

Deadweight cost

Net losses that occur in an economy as a result of tariffs.

Chapter 5 Trading Internationally 159

Figure 5.7 Tariff on Rice Imports in Japan

Quantity

Domestic supply

Domestic demand

P ri

Imports without tariff

Q2 Q1 Q3

Panel B. Imports with no tariff

Quantity

Domestic supply

Domestic demand

P ri

Panel A. No International trade

Quantity

Domestic supply

Domestic demand

P ri

Panel C. Imports with tariff

Imports with tariff

Ta ri

CB DA

Q2 Q1 Q5Q4 Q3

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According to the US Tire Industry Association, some may be killed should they be involved in accidents before they are able to afford the now more expensive tires.14

Given the well-known net losses, why are tariffs imposed? The answer boils down to the political realities. Although “everybody” in a country suffers because of higher prices, it is extraordinarily costly, if not impossible, to politically organize geographically scattered individuals and firms in order to promote free trade. On the other hand, special interest groups tend to be geographically concentrated and skillfully organized to advance their interests. In Japan, although farmers repre- sent less than 5% of the population, they represent disproportionate votes in the Diet (Japanese parliament).15 Why? Diet districts were drawn up in the aftermath of World War II, when most Japanese lived in rural areas. Such districts were never re-zoned, although the majority of the population now lives in cities. Thus, when the powerful farm lobby speaks, the Japanese government listens.

5-3b Nontariff Barriers (NTBs) Today, tariff barriers are often criticized around the world. Nontariff barriers (NTBs) are now increasingly the weapon of choice in trade wars. NTBs include (1) subsidies, (2) import quotas, (3) export restraints, (4) local content requirements, (5) admin- istrative policies, and (6) antidumping duties.

Subsidies, as noted earlier, are government payments to domestic firms (see Emerging Markets 5.1). Similar to their colleagues in Japan, European farmers, who represent 2% of the EU population, are masters of extracting subsidies. The EU’s Common Agricultural Policy (CAP) costs European taxpayers $150 billion per year, eating up 40% of the EU budget. European consumers do not like CAP, and governments and farmers in developing countries eager to export their food- stuffs to the EU hate it.

Import quotas are restrictions on the quantity of imports. They are worse than tariffs, because foreign goods can still be imported if tariffs are paid. Quotas are thus the most straightforward denial of absolute or comparative advantage. For ex- ample, between 2003 and 2009, Australia annually exported 770,000 head of live cattle to Indonesia, to the delight of Indonesian beef lovers. However, since 2009, im-

port permits suddenly became harder to obtain. A quota of only 500,000 head of imported cattle was set for 2011.16 For Indonesia, a densely populated island nation, importing beef from a sparsely populated cattle country next door would tap into Australia’s comparative advantage and would be win-win for both countries. But with the shrinking quota, Aussie cattle exporters are devastated, and Indonesian beef lovers have to put up with skyrocketing prices—and some of them may have to simply quit eating beef.

Because import quotas are protectionist pure and simple, there are political costs that countries have to shoulder in today’s largely pro-free trade environ- ment. In response, voluntary export restraints (VERs) have been developed to show that on the surface, exporting countries voluntarily agree to restrict their exports. VERs, in essence, are export quotas. One of

Nontariff barrier (NTB)

Trade barrier that relies on nontariff means to discourage imports.

Subsidy

Government payment to domestic firms.

Import quota

Restriction on the quantity of imports.

Voluntary export restraint (VER)

An international agreement that shows that exporting countries voluntarily agree to restrict their exports.

How do import quotas affect businesses and consumers in both the importing and exporting countries?

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the most (in)famous examples is the VERs that the Japanese government agreed in the early 1980s to restrict US-bound automobile exports.17 This, of course, was a eu- phemism because the Japanese did not volunteer to restrict their exports. Only when faced with concrete protectionist threats did the Japanese reluctantly agree.

Another NTB is local content requirements, which require a certain proportion of the value of the goods made in one country to originate from that country. The Japanese automobile VERs are again a case in point here. Starting in the 1980s, because of VERs, Japanese automakers switched to producing cars in the United States through foreign direct investment (FDI—see Chapter 6 for details). However, such factories initially were “screw driver plants,” because a majority of components were imported from Japan and only the proverbial “screw drivers” were needed to tighten the bolts. To deal with this issue, many countries impose local content re- quirements, mandating that a “domestically produced” product will still be treated as an “import” subject to tariffs and NTBs unless a certain fraction of its value (such as 51% specified by the Buy America Act) is produced locally.

Administrative policies refer to bureaucratic rules that make it harder to import foreign goods (see In Focus 5.1). Since 2008, Indonesia and Malaysia have lim- ited imports to certain (but not all) ports. India has banned Chinese toys, citing safety concerns. Argentina has recently ordered importers of foreign cars to find export buyers of Argentine wines; otherwise, port authorities would not release imported cars. Foreign print publications, including time-sensitive newspapers and magazines, are held at the Buenos Aires airport unless subscribers go there to pay an additional fee.

Singapore is famous for its high standards of tidiness and for the stringent policies that support public clean- liness. Beginning in 1992, policy makers banned the sale of chewing gum in an effort to avoid the messy and unsightly problem of improperly disposed used chewing gum. US gum manufacturers missed the op- portunity to sell their products to four million Singapor- eans. Wrigley, maker of several leading chewing-gum brands, pressured US legislators and trade represen- tatives to do something. The ban did not discriminate against foreign gum because no producer existed in Singapore, nor did it violate any of Singapore’s other WTO responsibilities. So the only way for the United States to get Singapore to remove or loosen the anti- gum policy was to negotiate. In 2001, the two coun- tries began talks to reach a broad US-Singapore Free Trade Agreement. Wrigley made sure that the agenda included an unlikely item that turned out to be quite sticky: the chewing-gum ban.

At first, Singapore agreed to allow in only me- dicinal-purpose gums prescribed by a doctor (for example, products to help stop smoking or to treat chronic dry mouth). Wrigley and its supporters were not satisfied. More negotiations followed. Finally, Singapore agreed to permit sales, but only of gums with proven health benefits, only by licensed dentists or pharmacists, and only if the customer gave his or her name to the seller. This sufficed to gain entry for Wrigley’s sugar-free Orbit brand of gum, which claims to strengthen tooth enamel. Singapore’s stiff penalties for gum-related littering remain. Fines of over $200 plus a trip to court are common. Some pharmacists seem a bit puzzled. After all, they sell more serious drugs with fewer restrictions.

Source: Adapted from B. V. Yarbrough & R. M. Yarbrough, 2006, Sticky business in Singapore, in The World Economy (7th ed.) (p. 237), Cincinnati: South-Western Cengage Learning.

A Sticky Business in Singapore IN FOCuS 5.1

Local content requirement

A requirement stipulating that a certain proportion of the value of the goods made in one country must originate from that country.

Administrative policy

Bureaucratic rules that make it harder to import foreign goods.

162 Part Two Acquiring Tools

Finally, the arsenal of trade warriors also includes antidumping duties. Chapter 11 will expand the discussion on dumping (selling below cost) and anti- dumping duties in much greater detail.

Taken together, trade barriers reduce or eliminate international trade. While certain domestic industries and firms benefit, the entire country—or at least a ma- jority of its consumers—tends to suffer. Given these well-known negative aspects, why do people make arguments against free trade? The next two sections outline economic and political arguments against free trade.

5-3c Economic Arguments against Free Trade Two prominent economic arguments against free trade are: (1) the need to protect domestic industries and (2) the necessity to shield infant industries. The oldest and most frequently used economic argument against free trade is the urge to protect domestic industries, firms, and jobs from “unfair” foreign competition—in short, protectionism. The following excerpt is from an 1845 petition of the French candle makers to the French government:

We are subject to the intolerable competition of a foreign rival, who enjoys such superior capabilities for the production of light, that he is flooding the domestic market at an incredibly low price. From the moment he appears, our sales cease, all consumers turn to him, and a branch of French industry whose ramifications are in- numerable is at once reduced to complete stagnation. This rival is nothing other than the sun. We ask you to be so kind as to pass a law requiring the closing of all windows, skylights, shutters, curtains, and blinds—in short, all openings, holes, chinks, and fis- sures through which sunlight penetrates . . . .18

Although this was a hypothetical satire written by a French free trade advocate Fredric Bastiat 160 years ago, these points are often heard today (see the Closing Case). Such calls for protection are not limited to commodity producers like candle makers. Highly talented individuals, such as American mathematicians and Japa- nese sumo wrestlers, have also called for protection. Foreign math PhDs grab 40% of US math jobs, and recent US math PhDs face a jobless rate of 11%. Thus, many American math PhDs have called for protection of their jobs. Similarly, Japanese sumo wrestlers insist that foreign sumo wrestlers should not be allowed to throw their weight around in Japan.

Another argument is the infant industry argument. If domestic firms are as young as “infants,” in the absence of government intervention they stand no chance of surviving and will be crushed by mature foreign rivals. Thus, it is imperative that governments level the “playing field” by assisting infant industries. While this argu- ment is sometimes legitimate, governments and firms have a tendency to abuse it. Some protected infant industries may never grow up—why bother? When Airbus was a true “infant” in the 1960s, it no doubt deserved some subsidies. However, by the 2000s, Airbus had become a giant that could take on Boeing. (In some years, Airbus outsells Boeing.) Nevertheless, Airbus continues to ask for subsidies, which European governments continue to provide.

5-3d Political Arguments against Free Trade Political arguments against free trade advance a nation’s political, social, and en- vironmental agenda regardless of possible economic gains from trade. These

Antidumping duty

Tariffs levied on imports that have been “dumped” (selling below costs to “unfairly” drive domestic firms out of business).

Infant industry argument

The argument that if domestic firms are as young as “infants,” in the absence of government intervention, they stand no chances of surviving and will be crushed by mature foreign rivals.

Chapter 5 Trading Internationally 163

arguments include (1) national security, (2) consumer protection, (3) foreign policy, and (4) environmental and social responsibility.

First, national security concerns are often invoked to protect defense-related in- dustries. Many nations fear that if they rely on arms imports, their national security may be compromised if there are political or diplomatic disagreements between them and the arms-producing nation. France has always insisted on maintaining an independent defense industry to produce nuclear weapons, aircraft carriers, and combat jets. While the French can purchase such weapons at much lower costs from the United States that is eager to sell them, the French answer has usually been “No, thanks!”

Second, consumer protection has frequently been used as an argument for na- tions to erect trade barriers. In the early 2000s, a single case of mad cow disease in Canada led the United States to completely ban beef imports from Canada. In another example, American hormone-treated beef was banned by the EU between 1989 and 1995 because of the alleged health risks. Even though the United States won a WTO battle on this, the EU has still refused to remove the ban.

Third, foreign policy objectives are often sought through trade intervention. Trade embargos are politically motivated trade sanctions against foreign countries to signal displeasure. Many Arab countries maintain embargoes against Israel. The United States has embargoed against Cuba, Iran, North Korea, Sudan, and Syria. In 2009, DHL paid a record fine of $9.4 million because it had violated US embar- goes and sent shipments to Iran, Sudan, and Syria. According to a US Treasury Department statement, DHL “may have conferred a significant economic benefit to these sanctioned countries that potentially created extraordinarily adverse harm.” What are such dangerous shipments? Condoms, Tiffany jewelry, and radar detec- tors for cars, according to the same Treasury Department statement.19

Finally, environmental and social responsibility can be used as political argu- ments to initiate trade intervention against certain countries. In a “shrimp-turtle” case, the United States banned shrimp imports from India, Malaysia, Pakistan, and Thailand, because shrimp were caught in their waters using a technique that also accidentally trapped sea turtles, an endangered species protected by the United States. These nations were upset and brought the case to the WTO, alleging that the United States invoked an environmental law as a trade barrier. The WTO sided with those nations and demanded that the US ban be lifted, and the United States later complied.

5-4 Debates and Extensions International trade has substantial mismatch between theories and realities. This section highlights two leading debates: (1) trade deficit versus surplus and (2) clas- sical theories versus new realities.

5-4a Trade Deficit versus Trade Surplus Smith and Ricardo would probably turn in their graves if they heard that one of today’s hottest trade debates still echoes the old debate between mercantilists and free traders 200 years ago. Nowhere is the debate more ferocious than in the United States, which runs the world’s largest trade deficit (combining the US deficit in merchandise trade with its surplus in service trade). In 2006, it reached a record-breaking $760 billion (6% of GDP). Thanks to reduced US (import)

Trade embargo

Politically motivated trade sanc- tions against foreign countries to signal displeasure.

Learning Objective Participate in two leading debates concerning international trade.

5-4

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consumption due to the Great Recession and beefed-up export efforts (see the Opening Case), the US trade deficit was “only” $560 billion (4% of GDP) in 2011. Should this level of trade deficit be of concern?

Armed with classical theories, free traders argue that this is not a grave con- cern. They argue that the United States and its trading partners mutually benefit by developing a deeper division of labor based on comparative advantage. Former Secretary of the Treasury Paul O’Neill went so far as to say that trade deficit was “an antiquated theoretical construct.”20 Paul Krugman, the 2008 Nobel laureate in economics, argued:

International trade is not about competition, it is about mutually beneficial exchange. . . . Imports, not exports, are the purpose of trade. That is, what a country gains from trade is the ability to import things it wants. Exports are not an objective in and of themselves: the need to export is a burden that a country must bear because its import suppliers are crass enough to demand payment.21

Critics strongly disagree. They argue that international trade is about competition—about markets, jobs, and incomes. In 2009, President Obama an- nounced the goal of doubling US exports within the next five years. Highlighting the importance of exports, Boeing CEO Jim McNerney said: “Every time a Boeing 777 lands in China, it lands with about 4 million parts reflecting the workman- ship of some 11,000 small, medium, and large suppliers.”22 Trade deficit has always been blamed on a particular country with which the United States runs the largest deficit, such as Japan in the 1980s. Because the US trade deficit with China reached $296 billion in 2011 (over half of the total deficit), the recent trade deficit debate is otherwise known as the China trade debate (Table 5.5). While the United States runs trade deficits with all of its major trading partners—Canada, the EU, Japan, and Mexico—and is in trade disputes with them most of the time, the China trade debate is by far the most emotionally charged and politically explosive.

5-4b Classical Theories versus New Realities While the first debate (mostly on China) is primarily about merchandise trade and unskilled manufacturing jobs that classical theories talk about, the second debate (mostly on India) is about service trade and high-skill jobs in high technology such as IT. Typically dealing with wheat from Australia to Britain on a slow boat, classi- cal theorists certainly could not have dreamed about using the Internet to send this manuscript to India to be typeset and counted as India’s service exports. In addi- tion to the traditional label of “trade in services,”23 a new jargon is “trade in tasks.”24

We already discussed a part of this debate in Chapter 4 when focusing on out- sourcing. That debate deals with firm -level capabilities; here, let us examine country - level and individual-level ramifications. Classical theorists and their modern-day disciples argue that the United States and India trade by tapping into each other’s comparative advantage. India leverages its abundant, high-skill, and low-wage labor. Americans will channel their energy and resources to higher-skill, higher- paying jobs. While regrettably certain Americans will lose jobs, the nation as a whole benefits, so the theory goes.

But, not so fast!—argued retired MIT economics professor Paul Samuelson. In an influential 2004 paper, Samuelson suggested that in a more realistic world, India can innovate in areas that the United States traditionally enjoys comparative

Chapter 5 Trading Internationally 165

advantage, such as IT.25 Indian innovation can reduce the price of US software exports and curtail the wage of American IT workers. Despite the availability of cheaper goods (which is a plus), the net effect may be that the United States is worse off as a whole. Samuelson is not an anti-globalization ideologue. Instead, he won a Nobel Prize for his penetrating research on the gains from international trade, and his mainstream economics textbook has trained generations of students (including your author). Now even Samuelson is not so sure about one of the founding pillars of modern economics, comparative advantage.

The reaction has been swift. Within the same year (2004), Jagdish Bhagwati, an Indian-born Columbia University trade expert, and his colleagues countered Samuelson by arguing that classical pro-free trade theories still hold.26 Bhagwati and colleagues wrote:

Imagine that you are exporting aircraft, and new producers of aircraft emerge abroad. That will lower the price of your aircraft, and your gains from trade will di- minish. You have to be naïve to believe that this can never happen. But you have to be even more naïve to think that the policy response to the reduced gains from trade is to give up the remaining gains as well. The critical policy question we must address is: When external developments, such as the growth of skills in China and India, for

Table 5.5 Debate on the US Trade Deficit with China

US trade deficit with China is a huge problem US trade deficit with China is not a huge problem

Naïve trader versus unfair protectionist (in China) The United States is a “naïve” trader with open markets.

China has “unfairly” protected its markets.

Market reformer versus unfair protectionist (in the US) China’s markets are already unusually open. Its trade volume

(merchandise and services) is 75% of GDP, whereas the US volume is only 25%.

Greedy exporters Unscrupulous Chinese exporters are eager to gut US

manufacturing jobs and drive US rivals out of business.

Eager foreign investors Two-thirds of Chinese exports are generated by foreign-

invested firms in China, and numerous US firms have invested in and benefited from such operations in China.

The demon who has caused deflation Cheap imports sold at “the China price” push down

prices and cause deflation.

Thank China (and Wal-Mart) for low prices Every consumer benefits from cheap prices brought from

China by US firms such as Wal-Mart.

Intellectual property (IP) violator China is a major violator of IP rights, and US firms lose

$2 billion a year.

Inevitable step in development True, but (1) the US did that in the 19th century (to the British),

and (2) IP protection will improve in China.

Currency manipulator The yuan is severely undervalued (maybe up to 40%),

giving Chinese exports an “unfair” advantage in being priced at an artificially low level.

Currency issue is not relevant The yuan is somewhat undervalued, but (1) US and other

foreign firms producing in China benefit, and (2) yuan appreciation will not eradicate US trade deficit.

Trade deficit will make the United States poorer Since imports have to be paid, the United States borrows

against its future with disastrous outcomes.

Trade deficit does not cause a fall in the US standard of living As long as the Chinese are willing to invest in the US economy

(such as Treasury bills), what’s the worry?

Something has to be done If the Chinese don’t do it “our way,” the United States

should introduce drastic measures (such as slapping 20%–30% tariffs on all Chinese imports).

Remember the gains from trade argued by classic theories? Tariffs will not bring back US jobs, which will simply go to

Mexico or Malaysia, and will lead to retaliation from China, a major importer of US goods and services.

Sources: Based on (1) BusinessWeek, 2004, The China price, December 6: 102–112; (2) BusinessWeek, 2009, Free trade in the slow lane, September 21: 50; (3) China Business Review, 2008, US exports to China hit new high, September-October: 36–39; (4) Economist, 2005, From T-shirts to T-bonds, July 30: 61–63; (5) G. Locke, 2011, A message from the US Ambassador to China, China Business Review, October: 16; (6) O. Shenkar, 2005, The Chinese Century, Philadelphia: Wharton School Publishing.

166 Part Two Acquiring Tools

instance, do diminish the gains from trade to the US, is the harm to the US going to be reduced or increased if the US turns into Fortress America? The answer is: The US will only increase its anguish if it closes its markets.27

In any case, according to Bhagwati and colleagues, the “threat” posed by In- dian innovation is vastly exaggerated and offshoring is too small to matter much. Although approximately 3.4 million US jobs may be outsourced by 2015 (see Chapter 4), we have to realize that in any given year, the US economy destroys 30 million jobs and creates nearly the same, thus dwarfing the effect of offshoring. Further, Bhagwati argues that newer and higher-level jobs will replace those lost to offshoring. One huge problem in the middle of the jobless recovery from the Great Recession is: Will there be enough of such jobs in the United States?

5-5 Management Savvy How does this chapter answer the big question in global business, adapted for the context of international trade: What determines the success and failure of firms’ ex- ports around the globe? The two core perspectives lead to two answers. Fundamen- tally, the various economic theories underpin the resource-based view, suggesting that successful exports are valuable, unique, and hard-to-imitate products gener- ated by certain firms from a nation (see the Opening Case). However, the political realities stress the explanatory and predictive power of the institution-based view: As rules of the game, institutions such as laws and regulations promoted by various spe- cial interest groups can protect certain domestic industries, firms, and individuals, erect trade barriers, and make the nation as a whole worse off (see the Closing Case).

Three implications for action emerge (Table 5.6). First, location, location, location! In international trade, savvy managers’ job number one is to leverage comparative advantage of world-class locations. For example, one crucial reason behind China’s rise as the world’s top exporting nation is that many non-Chinese managers at non-Chinese firms have discovered China’s comparative advantage as a low-cost production location. As a result, they set up factories and export from China—two-thirds of Chinese exports are generated by such foreign-invested firms.

Second, comparative advantage is not fixed (see In Focus 5.2). Managers need to constantly monitor and nurture the current comparative advantage of a loca- tion and take advantage of new promising locations. Managers who fail to realize the departure of comparative advantage from certain locations are likely to fall behind. For example, numerous German managers have moved production else- where, citing Germany’s relatively reduced comparative advantage in basic manu- facturing. However, they still concentrate top-notch, high-end manufacturing in Germany, leveraging its excellence in engineering.

Third, managers need to be politically active if they appreciate the gains from trade. In times of economic difficulties, governments are often under pressure to

Learning Objective Draw implications for action.

5-5

Table 5.6 Implications for Action

Discover and leverage comparative advantage of world-class locations.

Monitor and nurture the current comparative advantage of certain locations, and take advantage of new locations.

Be politically active to demonstrate, safeguard, and advance the gains from international trade.

Chapter 5 Trading Internationally 167

adopt protectionist policies (see the Closing Case). While managers at many un- competitive firms have long mastered the game of twisting politicians’ arms for more protection, managers at competitive firms, who tend to be pro-free trade, have a tendency to shy away from “politics.” They often fail to realize that free trade is not free—it requires constant efforts and sacrifices to demonstrate, safeguard, and advance the gains from such trade. For example, the US-China Business Coun- cil, a pro-free trade (in particular, pro-China trade) group consisting of 250 large US firms that are active in China (such as Coca-Cola and GE), has stood up and spoken out against various “China bashers.”

C H A P T E R S u M M A R y

5.1 Use the resource-based and institution-based views to answer why nations trade.

The resource-based view suggests that nations trade because some firms in one nation generate valuable, unique, and hard-to-imitate exports that firms in other nations find it beneficial to import.

The institution-based view argues that as rules of the game, different laws and regulations governing international trade aim to share gains from trade.

5.2 Understand classical and modern theories of international trade.

Classical theories include (1) mercantilism, (2) absolute advantage, and (3) comparative advantage.

Modern theories include (1) product life cycles, (2) strategic trade, and (3) “diamond.”

Making stuff has dwindled from nearly 40% of Britain’s GDP in the late 1950s to not much more than 10% now. What remains survives for a reason. General Motors’ Luton factory this year [2011] will produce 70,000 Vauxhall Vivaro vans and other ve- hicles, more than 60% for export.

Prime Minister David Cameron has latched on to manufacturing as a cure for Britain’s economic hang- over and its 7.9% jobless rate. “If you’re trying to make the economy grow long term on a sustainable basis, manufacturing is where we need to be,” says Vince Cable, UK Business Secretary. “One of the main growth sectors of the economy in recent years has been banking. For reasons that are blindingly obvi- ous, that’s not going to be so important in the future.”

Starting a new Industrial Revolution will be hard. Government efforts to cut red tape produce plenty

of their own. “If you were to write on a board how many agencies and support schemes there are, you would be amazed,” says Bill Parfitt, GM UK’s chairman.

Economists and some manufacturing executives also say that boosting manufacturing may be unwise. British manufacturing as a share of GDP is smaller than Germany’s 20%, yet it is similar to the US and France, which have big service sectors. Britain may have reached an equilibrium between the two sec- tors. “I don’t think any economists believe that growth in the next five to 20 years will be driven by manufacturing,” says Jonathan Portes, director of the National Institute of Economic and Social Research.

Sources: Excerpted from Bloomberg Businessweek, 2011, Cameron tries to reindustrialize Britain, September 5: 15.

Britain’s New Industrial Revolution? IN FOCuS 5.2

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5.3 Realize the importance of political realities governing international trade.

The net impact of various tariffs and NTBs is that the whole nation is worse off while certain special interest groups (such as certain industries, firms, and regions) benefit.

Economic arguments against free trade center on (1) protectionism and (2) infant industries.

Political arguments against free trade focus on (1) national security, (2) consumer protection, (3) foreign policy, and (4) environmental and so- cial responsibility.

5.4 Participate in two leading debates concerning international trade.

(1) Trade deficit versus trade surplus and (2) classical theories versus new realities.

5.5 Draw implications for action.

Be accurately aware of the comparative advantage of certain locations and leverage their potential.

Monitor and nurture the current comparative advantage and take advan- tage of new locations.

Be politically active to demonstrate, safeguard, and advance the gains from international trade.

K e y T e r m s

Absolute advantage 146 Administrative policy 161 Antidumping duty 162 Balance of trade 144 Classical trade

theories 146 Comparative

advantage 148 Deadweight cost 158 Export 143 Factor endowment 150 Factor endowment

theory (Heckscher- Ohlin theory) 150

First-mover advantage 152

Free trade 146 Import 143 Import quota 160

Import tariff 158 Infant industry

argument 162 Local content

requirement 161 Merchandise 143 Modern trade

theories 146 Nontariff barrier

(NTB) 160 Opportunity cost 150 Product life cycle

theory 151 Protectionism 146 Resource mobility 156 Services 143 Strategic trade policy 153 Strategic trade

theory 152

Subsidy 160 Tariff barrier 158 Theory of absolute

advantage 146 Theory of comparative

advantage 148 Theory of

mercantilism 146 Theory of national com-

petitive advantage of industries (diamond theory) 155

Trade deficit 143 Trade embargo 163 Trade surplus 143 Voluntary export

restraint(VER) 160

r e v i e w Q u e s T i o n s

1. Look at PengAtlas Maps 2.1 (Top Merchandise Importers and Exporters) and 2.2 (Top Service Importers and Exporters). Compare the global posi- tion of the United States in merchandise versus service imports and exports.

Chapter 5 Trading Internationally 169

a. Does the United States have an advantage globally in either merchandise or services? Does it have an advantage in both? If it has any type of ad- vantage, is it absolute or comparative? Or does it have a disadvantage in both? Explain your answers.

b. Imagine that you were asked to give reasons why you think it is good, from the US perspective, to have its position among the countries of the world as the top importer in both merchandise and services. What rea- sons would you mention?

2. Looking at PengAtlas Maps 2.1 and 2.2, given the size of US exports, why does the United States import so much? Why not use resources in the US to produce the things the US currently imports instead of using them to pro- duce exports?

3. ON CULTURE: Mercantilism involved a relatively significant amount of government control over both domestic and international activity, whereas Smith’s concept of absolute advantage focused on relative economic free- dom and minimal government controls over domestic and international eco- nomic activity. Do you think that the values prevalent in America’s culture today are more in line with those of the mercantilists or those of Smith? If there is some combination of Smith and mercantilism, which tends to be dominant? Defend your answer.

4. The rules of the game for international trading can be quite complex, so why do nations routinely engage in this activity?

5. Name and describe the two key components of a balance of trade.

6. Compare and contrast the three modern theories of international trade.

7. What are two primary economic arguments that critics use against free trade?

8. Summarize four political arguments against free trade.

9. Is a persistent trade deficit a matter of grave concern? Why or why not?

10. Will the service trade benefit or hurt rich countries?

11. What are some of the factors that managers need to consider when assessing the comparative advantage of various locations around the world?

12. Why is it necessary for business people to monitor political activity concern- ing international trade?

C R I T I C A L D I S C u S S I O N Q u E S T I O N S

1. Is the trade policy of your country’s government protectionist? Why?

2. What is the ratio of international trade (exports + imports) to GDP in your country? How about the ratio for Brazil, China, Egypt, the EU, India, Japan, Russia, Singapore, Turkey, and the US? Why are there such differences?

3. ON ETHICS: As a foreign policy tool, trade embargoes, such as US embargoes against Cuba, Iraq (until 2003), and North Korea, are meant to discourage foreign governments. But they also cause a great deal of misery among the population (such as shortages of medicine and food). Are embargoes ethical?

4. ON ETHICS: While the nation as a whole may gain from free trade, there is no doubt that certain regions, industries, firms, and individuals may lose

170 Part Two Acquiring Tools

their jobs and livelihood due to foreign competition. How can the rest of the nation help the unfortunate ones cope with the impact of international trade?

G L O B A L A C T I O N

1. Cities worldwide differ considerably along many dimensions. However, one facet of trading internationally is to identify global cities to base a network of operations. Choose one dimension on which to measure different cities. Then, develop a report that discusses your findings in detail.

2. At times, corporate tax rates in specific locations can be considered a trade barrier to business development. As a result, locations that have lower tax rates may encourage corporations to conduct operations or relocate head- quarters there. Find a list of tax rates for a variety of locations. If you were part of a company seeking to relocate its operations, which location(s) would you recommend and why?

V I D E O C A S E

After watching the video on Cuba’s economy, discuss the following:

1. Can Cuba effectively become a free market economy?

2. Could the US benefit from lifting the embargo on Cuba?

3. What are Cuba’s comparative advantages relative to the US?

4. What impact does the embargo have on Cuba?

5. What do multiple trade theories have to say about Cuba?

A pine tree in a forest in Finland needs 50 years before it can be felled to make paper. A eucalyptus tree in coastal Brazil is ready in seven. Grapes in France can only be harvested once a year. Grapevines in north- eastern Brazil can bear fruit twice a year. Chicken and hog farmers in Canada have to consume energy to heat the barns. Their competitors in Brazil need no energy to heat their animals’ dwellings. Blessed by an abundant supply of sunshine, soil, and water, Brazil is a pre-eminent player in agricultural products such as beef, coffee, poultry, soybeans, and sugar— in which Brazil is either the world’s top producer, top

exporter, or both. Brazil’s agricultural prowess may be the envy of many less-endowed countries, but in Brazil it has become a source of frustration. For much of the 20th century, the Brazilian government sought to deviate from Brazil’s dependence on agriculture- based commodities and to industrialize, often with little regard for comparative advantage. Their favor- ite policy was protectionism, which often did not succeed.

Brazil’s market opening since the 1990s led more Brazilians to realize that the country’s comparative advantage indeed lies in agriculture. One commodity

EMERGING MARKETS: Brazil’s Quest for Comparative Advantage

Ethical Dilemma

C L O S i n g C A S E

Chapter 5 Trading Internationally 171

that can potentially transform the low prestige associated with agricultural products is sugar cane- based ethanol. Brazil is a world leader in the pro- duction of ethanol, which has been mandated as an additive to gasoline used in cars since the 1970s. A system to distribute ethanol to gas stations, an odd- ity in the eyes of the rest of the world until recently, now looks like a national treasure that is the envy of the world. At present, no light vehicle in Brazil is allowed to run on pure gasoline. Since 2007, the mandatory blend for car fuels is at least 25% ethanol. Brazil currently produces 18 billion liters of ethanol, of which it exports 4 billion—more than half of world- wide exports. Ethanol now accounts for 40% for the fuel used by cars in Brazil. As the global ethanol trade is estimated to rise 25-fold by 2020, Brazil’s compara- tive advantage in agricultural products is destined to shine.

However, the government under President Dilma Rousseff continues to believe that Brazil has to build up a world-class manufacturing base in order to modernize its economy. Standing in the way is the (in)famous “Brazil cost,” thanks to the rising costs of energy, raw materials, and wages. Operating costs in Brazil are now higher than in many developed econo- mies. One industry association official commented:

If you were to take a factory by helicopters from Germany to Brazil, your costs would jump

48% as soon as you touched down. Those of us producing in Brazil are doomed to be uncompetitive.

The government does want to help by protecting uncompetitive industries. In this respect, Rousseff has not deviated from her days as a graduate student studying developmental economics with some of Brazil’s most left-wing professors. Since taking power in 2011, she has imposed tariffs on shoes, textiles, chemicals, and even Barbie dolls. Brazil also threat- ens to tear up an agreement with Mexico that allows free trade in cars, because in 2011 Mexico exported $2 billion worth of cars to Brazil, but Brazil only recip- rocated with $372 million.

The “Brazil cost” has also been aggravated by the strength of the real, which has appreciated 38% against the dollar since 2009. The phenomenal export success of Brazil’s agricultural products and minerals and the lackluster condition of its manufacturing in- dustries can force Brazil to reassess its comparative advantage. One expert noted: “The economy needs to redirect resources to where it is competitive. That is actually a healthy process.” The catch, of course, is only if there is sufficient political will.

CASE DISCUSSION QUESTIONS: 1. What is Brazil’s agriculture so competitive?

Why do its manufacturing industries lack competitiveness?

2. Why have Brazil’s governments in both the 20th and 21st century been eager to develop world- class manufacturing?

3. How can Brazil shift some of its resources from uncompetitive industries to competitive industries?

4. ON ETHICS: While President Rousseff’s critics accuse her of ignoring Brazil’s lack of compara- tive advantage in manufacturing, her supporters argue that her policies force Brazil to reduce its dependence on foreign-made manufacturing goods. If you were to participate in this debate, which side would you be on?

Sources: Based on (1) author’s interviews; (2) Bloomberg Businessweek, 2012, Look who’s bringing up the rear, March 26: 9–10; (3) Economist, 2007, The economy of heat, April 14: 8–9; (4) Economist, 2012, Two ways to make a car, March 10: 48–49; (5) L. F. Monteiro, 2011, Is God Brazilian? pre- sentation at the Strategic Management Society Conference on Latin America, Rio de Janeiro, March 11; (6) World Bank, 2008, Biofuels: The promise and the risks, in World Development Report 2008 (pp. 70–71), Washington: World Bank.

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N O T E S

[Journal acronyms] AER—American Economic Review; BW—BusinessWeek (prior to 2010) or Bloomberg Businessweek (since 2010); EJ—Economic Journal; HBR—Harvard Business Review; JEL—Journal of Economic Lit- erature; JEP—Journal of Economic Perspectives; JIE—Journal of International Economics; JIBS—Journal of International Business Studies; JM—Journal of Management; JMS—Journal of Management Studies; QJE—Quarterly Jour- nal of Economics; RES—Review of Economics and Statistics

1 E. Helpman, M. Melitz, & Y. Rubinstein, 2008, Estimating trade flows, Q JE, 123: 441–487; D. Jacks, C. Meissner, & D. Novy, 2008, Trade costs, 1870–2000, AER, 98: 529–534; R. Kali & J. Reyes, 2007, The architecture of globalization, JIBS, 38: 595–620.

2 M. Amiti & J. Konings, 2007, Trade liberalization, intermedi- ate inputs, and productivity, AER, 97: 1611–1638; W. Antweiler, B. Copeland, & M. S. Taylor, 2001, Is free trade good for the envi- ronment? AER, 91: 877–908; C. Arkolakis, S. Demidova, P. Kelnow, & A. Rodriguez-Clare, 2008, Endogenous variety and the gains from trade, AER, 98: 444–450.

3 J. Baggs & J. Brander, 2006, Trade liberalization, profitability, and financial leverage, JIBS, 37: 196–211.

4 M. W. Peng, 2001, The resource-based view and international business, JM, 27: 803–829. See also A. Bernard & J. Jensen, 1999, Exceptional exporters performance, JIE, 47: 1–25; D. Greenawy & R. Kneller, 2007, Firm heterogeneity, exporting, and foreign direct investment, EJ, 117: 134–161; E. Helpman, Melitz, & S. Yeaple, 2004, Export versus FDI, AER, 94: 300–316.

5 J. Ederington, 2002, International coordination of trade and domestic policies, AER, 91: 1580–1593; G. Maggi & A. Rodriguez- Calre, 2007, A political-economy theory of trade agreements, AER, 97: 1374–1406.

6 R. Vernon, 1966, International investments and international trade in product life cycle, Q JE, May: 190–207.

7 This theory is sometimes referred to as “new trade theory.” How- ever, it is now nearly 30 years old and no longer that new. There- fore, to avoid confusion, we label this “strategic trade theory.” See J. Brander & B. Spencer, 1985, Export subsidies and international market share rivalry, JIE, 18: 83–100; P. Krugman (ed.), 1986, Strate- gic Trade Policy and the New International Economics, Cambridge, MA: MIT Press.

8 P. Krugman, 1994, Peddling Prosperity (p. 238), New York: Norton.

9 M. Porter, 1990, Competitive Advantage of Nations, New York: Free Press.

10 H. Davies & P. Ellis, 2001, Porter’s Competitive Advantage of Nations: Time for the final judgment? JMS, 37: 1189–1215.

11 D. Bernhofen & J. Brown, 2005, An empirical assessment of the com- parative advantage gains from trade, AER, 95: 208–225; J. Frankel & D. Romer, 1999, Does trade cause growth? AER, 89: 379–399.

12 S. Bradford, 2003, Paying the price, RES, 85: 24–37; A. Panagariya, 2002, Cost of protection, AER, 92: 175–179; S. Tokarick, 2008, Dispelling some misconceptions about agricultural trade liberaliza- tion, JEP, 22: 199–216.

13 BW, 2009, Seeking the next billion gamers, July 6: 54.

14 Tire Industry Association (TIA), 2009, Tire Industry Association ex- presses disappointment with President’s decision concerning Chinese tire tariff, September 14, Bowie, MD: TIA, www.tireindustry.org.

15 Economist, 2011, Electoral reform in Japan, January 29: 40–41.

16 Economist, 2011, A row over cows, February 17: www.economist.com.

17 S. Berry, J. Levinsohn, & A. Pakes, 1999, Voluntary export re- straints on automobiles, AER, 89: 400–430.

18 F. Bastiat, 1964, Economic Sophisms, edited and translated by A. Goddard, New York: Van Norstrand.

19 USA Today, 2009, DHL will pay $9.4M fine to settle shipping dis- pute, August 7: 2A.

20 BW, 2005, America’s trade deficit, October 3: 31.

21 P. Krugman, 1993, What do undergrads need to know about trade? (p. 24), AER, 83: 23–26.

22 Fortune, 2010, Why free trade matters to companies like Caterpil- lar, July 26: 40.

23 J. Boddewyn, M. Halbrich, & A. Perry, 1986, Service multination- als, JIBS, 17: 41–57; J. Francois & B. Hoekman, 2010, Services trade and policy, JEL, 48: 642–692.

24 G. Grossman & E. Rossi-Hansberg, 2008, Trading tasks, AER, 98: 1978–1997.

25 P. Samuelson, 2004, Where Ricardo and Mill rebut and confirm arguments of mainstream economists supporting globalization, JEP, 18(3): 135–146.

26 J. Bhagwati, A. Panagariya, & T. Sribivasan, 2004, The muddles over outsourcing, JEP, 18(4): 93–114.

27 J. Bhagwati & A. Panagariya, 2004, Trading opinions about free trade (p. 20), BW, December 27: 20.

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Learning Objectives

After studying this chapter, you should be able to

6-1 use the resource-based and institution- based views to answer why foreign direct investment (FDI) takes place.

6-2 understand how FDI results in ownership, location, and internalization (OLI) advantages.

6-3 identify different political views on FDI based on an understanding of its benefits and costs to host and home countries.

6-4 participate in two leading debates concerning FDI.

6-5 draw implications for action.

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Investing Abroad Directly

Until 2009, Germany was the world’s long-time export champion. Yet, German firms increasingly find it necessary to reduce production at home and to invest abroad. The reason? The “Made in Germany” label has become both a blessing and a curse. As a blessing, German engineering, craftsmanship, and emphasis on reliability and durability have won customers all over the world. As a curse, such a quest for perfection, obsession with details, and (over) engineering come at a price that Germany may not be able to afford. Expensive products built to last do not bring much repeat business. While BMW and Mercedes cars set global standards, Germany has a lot of less visible but equally successful champion products in their respective domains, which are produced by small- and medium-sized Mittelstand. For example, Neumann microphones, which have captured songs from sing- ers ranging from Elvis Presley to Celine Dion, will last 22 years before they need repair. But they don’t come cheap: a single top-of-the-line, made-in-Germany Neumann microphone costs $6,450.

The little Neumann microphone is a good reflec- tion of many German firms’ dilemma. It is often too expensive to produce in Germany, especially for labor-intensive products, which cost over $20 per hour. The labor market is also inflexible, often guarded by pro-labor government regulations and unions. In

response, German firms have undertaken two coping strategies. First, many German firms, via foreign direct investment (FDI), perform much of the labor-intensive manufacturing abroad, and then bring components home to add a magical German finishing touch, which adds value. As a result, the share of imported inputs to German exports has increased from 30% in 1995 to 40% currently.

A second strategy, also via FDI, is simply to pro- duce the whole thing abroad. Even when servicing the domestic German market, firms find that China can be ideal to handle time-insensitive goods. For time-sensitive goods, FDI in Central European coun- tries such as Bulgaria, the Czech Republic, Hungary, and Poland can largely get the job done. When ser- vicing overseas customers, producing in locations closer to them, especially for bulky products such as automobiles, can cut not only labor costs but also hefty transportation and insurance bills. In 1990, BMW was synonymous with “Made in Germany.” In 2012, in addition to Germany, BMW made cars in Austria, Brazil, Britain, China, Egypt, Indonesia, Malaysia, Philippines, Russia, South Africa, Thailand, the United States, and Vietnam. While labor costs go down, does quality suffer? A little, but not much. For example, Continental, a tire maker, makes tire sen- sors in both China and Germany. The only difference

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176 Part Two Acquiring Tools

is a slightly higher failure rate of two parts per million in China, compared with 0.8 parts per million in Germany.

FDI recipient economies are naturally happy. Central Europe, in particular, has benefitted from German (and other EU) firms’ “nearshoring.” Yet, Germany has been suffering from relatively high unemployment rates of 8% (although not as high as the unemployment rates in Greece and Spain, which hover between 15% and 20%). More than 50% of German job-seekers have been looking for more than one year, but few of them are inter- ested in migrating to Poland or Bulgaria (let alone China or South Africa) to accept lower wages. Because of the welfare needs to support the army of unemployed, the

tax burdens for firms and employees who have jobs end up becoming more crushing. Because of this vicious circle, out of necessity, many German firms have to shut down factories and move abroad. Recently, Continental closed a plant near Hanover, losing 320 jobs and attract- ing political criticism. In response, its CEO argued, “My duty is to my 80,000 workers worldwide.” He further commented that if wages were set by the market (as opposed to being jacked up by inflexible rules), more German jobs would be saved.

Sources: Based on (1) www.bmwgroup.com; (2) Economist, 2006, The problem with solid engineering, May 20: 71–73; (3) Economist, 2009, The export model sputters, May 9: 53–54; (4) Economist, 2006, Waiting for a wunder, February 11: 1–16; (5) B. Venohr & K. Meyer, 2009, Uncommon common sense, Business Strategy Review, Spring: 39–43.

Why are German firms increasingly interested in outward foreign direct investment (FDI)? Is it because of the push of high labor costs at home? The pull of low labor costs and lucra- tive markets abroad? Or both? Recall from Chapter 1 that FDI is defined as directly invest- ing in activities that control and manage value creation in other countries.1 Also recall from Chapter 1 that firms that engage in FDI are known as multinational enterprises (MNEs). On a worldwide basis, FDI has been experiencing a modest recovery after the setback unleashed by the Great Recession of 2008–2009. While most developed economies are slowly recovering, emerging economies as a group for the first time attracted more than half of the FDI inflows in 2010. Firms from emerging economies generated nearly 30% of FDI outflows worldwide.2 Overall, cautious optimism is now in the air.

This chapter starts by first clarifying the terms. Then we address a crucial question: Why do firms engage in FDI? We outline how the two core perspectives introduced earlier—namely, resource-based and institution-based views—can help answer this question. Debates and implications for action follow.

6-1 Understanding the FDI Vocabulary Part of FDI’s complexity is associated with the vocabulary. We will try to reduce this complexity by setting the terms straight in this section.

6-1a The Key Word Is Direct International investment can be made primarily in two ways: FDI and foreign port- folio investment (FPI). FPI refers to investment in a portfolio of foreign securities, such as stocks and bonds, that do not entail the active management of foreign assets. Essentially, FPI is “foreign indirect investment.” In contrast, the key word in FDI is direct—the direct, hands-on management of foreign assets. While reading this book, some of you may have some FPI—that is, you own some foreign stocks and bonds. However, as a student taking this course, it is by definition impossible that you are also engaging in FDI at the same time, which requires you to be a manager getting your feet “wet” by actively managing foreign operations.

Learning Objective Use the resource-based and institution-based views to answer why foreign direct investment (FDI) takes place.

6-1

Foreign portfolio investment (FPI)

Investment in a portfolio of foreign securities such as stocks and bonds.

Chapter 6 Investing Abroad Directly 177

For statistical purposes, the United Nations defines FDI as an equity stake of 10% or more in a foreign-based enterprise.3 Without a sufficiently large equity, it is difficult to exercise management control rights—namely, the rights to appoint key managers and establish control mechanisms. Many firms invest abroad for the explicit purpose of managing foreign operations, and they need a large equity, sometimes up to 100%, to be able to do that.

6-1b Horizontal and Vertical FDI FDI can be horizontal or vertical. Recall the value chain from Chapter 4, whereby firms perform value-adding activities stage-by-stage in a vertical fashion, from upstream to downstream. When a firm duplicates its home country-based activities at the same value-chain stage in a host country through FDI, we call this horizontal FDI (see Figure 6.1). For example, BMW makes cars in Germany. Through hori- zontal FDI, it does the same thing in the United States (see the Opening Case). Overall, horizontal FDI refers to producing the same products or offering the same services in a host country as firms do at home.

If a firm moves upstream or downstream in different value-chain stages in a host country through FDI, we label this vertical FDI (Figure 6.2). For exam- ple, if BMW (hypothetically) only assembles cars and does not manufacture components in Germany, but in Indonesia it enters into components manufac- turing through FDI (an upstream activity), this would be upstream vertical FDI. Likewise, if BMW does not engage in car distribution in Germany but invests in car dealerships in Egypt (a downstream activity), it would be downstream vertical FDI.

6-1c FDI Flow and Stock Another pair of words often used is flow and stock. FDI flow is the amount of FDI moving in a given period (usually a year) in a certain direction (see PengAtlas Map 2.3). FDI inflow usually refers to inbound FDI moving into a country in a year,

Management control rights

The rights to appoint key managers and establish control mechanisms.

Horizontal FDI

A type of FDI in which a firm duplicates its home country-based activities at the same value chain stage in a host country.

Vertical FDI

A type of FDI in which a firm moves upstream or downstream at different value chain stages in a host country.

Upstream vertical FDI

A type of vertical FDI in which a firm engages in an upstream stage of the value chain in a host country.

Downstream vertical FDI

A type of vertical FDI in which a firm engages in a downstream stage of the value chain in a host country.

FDI flow

The amount of FDI moving in a given period (usually a year) in a certain direction.

FDI inflow

Inbound FDI moving into a country in a year.

INPUT

Value Chain

Research & development

Components

Final assembly

Marketing

OUTPUT

INPUT

Value Chain

Research & development

Components

Final assembly

Marketing

OUTPUT

Operations in home country Operations in host country

Horizontal FDI

Figure 6.1 Horizontal FDI

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and FDI outflow typically refers to outbound FDI moving out of a country in a year. Figures 6.3 and 6.4 illustrate the top 10 economies receiving inflows and generat- ing outflows. FDI stock is the total accumulation of inbound FDI in a country or outbound FDI from a country. Hypothetically, between two countries A and B, if firms from A undertake $10 billion of FDI in B in Year 1 and another $10 billion in Year 2, then we can say that in each of these two years, B receives annual FDI inflows

FDI outflow

Outbound FDI moving out of a country in a year.

FDI stock

Total accumulation of inbound FDI in a country or outbound FDI from a country across a given period (usually several years).

INPUT

Value Chain

Research & development

Components

Final assembly

Marketing

OUTPUT

INPUT

Research & development

Components

Final assembly

Marketing

OUTPUT

Operations in home country Operations in host country

Upstream vertical FDI

Downstream vertical FDI

Value Chain

Figure 6.2 Vertical FDI

Figure 6.3 Top 10 Economies Receiving FDI Inflows (Billions of Dollars)

Source: Adapted from CIA, The World Factbook, 2011.

1. United States

0 50 100 150 200 250 300

4. United Kingdom

2. France

3. Hong Kong, China

6. Belgium

5. Germany

10. Netherlands

9. Canada

8. Spain

7. China

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Chapter 6 Investing Abroad Directly 179

of $10 billion and, correspondingly, A generates annual FDI outflows of $10 billion. If we assume that firms from no other countries undertake FDI in country B, and prior to Year 1 no FDI was possible, then the total stock of FDI in B, by the end of Year 2, is $20 billion. Essentially, flow is a snapshot of a given point in time, and stock represents cumulating volume.

6-1d MNE versus Non-MNE An MNE, by definition, is a firm that engages in FDI when doing business abroad. Note that non-MNE firms can also do business abroad by (1) exporting and importing, (2) licensing and franchising, (3) outsourcing, (4) engaging in FPI, or other means. What sets MNEs apart from non-MNEs is FDI. An exporter has to undertake FDI in order to become an MNE. In other words, BMW would not be an MNE if it made all its cars in Germany and exported them around the world. BMW became an MNE only when it started to invest abroad directly (see the Opening Case).

Although a lot of people believe that MNEs are a new organizational form that emerged recently, that is not true. MNEs have existed for at least 2,000 years, with some of the earliest traces discovered in the Assyrian, Phoenician, and Roman times.4 In 1903 when Ford Motor Company was founded, it exported its sixth car. Ford almost immediately engaged in FDI by having a factory in Canada that produced its first output in 1904.5 It is true that MNEs have experienced significant

Figure 6.4 Top 10 Economies Generating FDI Outflows (Billions of Dollars)

Source: Adapted from CIA, The World Factbook, 2011.

0 50 100 150 200 250 300 350 400

1. United States

2. France

4. Germany

6. Hong Kong, China

7. Switzerland

8. Japan

9. Belgium

3. United Kingdom

5. Netherlands

10. Spain

180 Part Two Acquiring Tools

growth since World War II. In 1970 there were approximately 7,000 MNEs world- wide. In 1990 there were 37,000 MNEs, with 170,000 foreign affiliates. By 2010 over 82,000 MNEs managed approximately 810,000 foreign affiliates.6 The value added produced by MNEs rose from 7% of world GDP in 1990 to 25% ($16 trillion) in 2011.7 Clearly, there has been a proliferation of MNEs lately.

6-2 Why Do Firms Become MNEs by Engaging in FDI? Having set the terms straight, we need to address a fundamental question: Why do so many firms—ranging from those in the ancient world to today’s BMW, Wal-Mart, and Samsung—become MNEs by engaging in FDI? Without getting into details, we can safely say that there must be economic gains from FDI. More importantly, given the tremendous complexities, such gains must significantly outweigh the costs. What are the sources of such gains? The answer, as suggested by British scholar John Dunning and illustrated in Figure 6.5, boils down to firms’ quest for ownership (O) advantages, location (L) advantages, and internalization (I) advantages—collectively known as the OLI advantages.8 The two core perspectives introduced earlier, resource-based and institution-based views, enable us to probe the heart of this question.

In the context of FDI, ownership refers to MNEs’ possession and leveraging of certain valuable, rare, hard-to-imitate, and organizationally embedded (VRIO) assets overseas. Owning the proprietary technology and the management know- how that go into making a BMW helps ensure that the MNE can beat rivals abroad.

Location advantages are those enjoyed by firms because they do business in a certain place. Features unique to a place, such as its natural or labor resources or its location near particular markets, provide certain advantages to firms doing business there. For example, Vietnam has emerged as a convenient location for MNEs that want to diversify away from coastal China due to rising labor costs. From a resource-based view, an MNE’s pursuit of ownership and location advantages can be regarded as flexing its muscles—its resources and capabilities—in global competition.

Internalization refers to the replacement of cross-border markets (such as exporting and importing) with one firm (the MNE) locating in two or more coun- tries. For example, instead of selling its technology to an Indonesian firm for a

Learning Objective Understand how FDI results in ownership, location, and internalization (OLI) advantages.

6-2

OLI advantages

A firm‘s quest for ownership (O) advantages, location (L) advantages, and internalization (I) advantages via FDI.

Ownership

An MNE’s possession and leveraging of certain valuable, rare, hard-to-imitate, and organizationally embedded (VRIO) assets overseas in the context of FDI.

Location

Advantages enjoyed by firms operating in a certain location.

Internalization

The replacement of cross-border markets (such as exporting and importing) with one firm (the MNE) locating and operating in two or more countries.

Internalization advantages

FDI/MNELocationadvantages

Ownership advantages

Figure 6.5 Why Do Firms Become MNEs by Engaging in FDI? An OLI Framework

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fee (which is a non-FDI-based market-entry mode technically called licensing), BMW chooses to have some FDI in Indonesia. In other words, external market transactions (in this case, buying and selling of technology through licensing) are replaced by internalization. From an institution-based view, internalization is a response to the imperfect rules governing international transactions—known as market imperfections (or market failure). Evidently, Indonesian regulations gov- erning the protection of intellectual property, such as BMW’s proprietary tech- nology, do not give BMW sufficient confidence that its rights will be protected. Therefore, internalization is a must.

Overall, firms become MNEs because FDI provides the three-pronged OLI advantages that they otherwise would not obtain. The next three sections outline why this is the case.

6-2a Ownership Advantages All investments, including both FDI and FPI, entail ownership of assets. So, what is unique about FDI? This section (1) highlights the benefits of direct ownership and (2) compares FDI to licensing when entertaining market entries abroad.

6-2b The Benefits of Direct Ownership Remember, the key word of FDI is direct, and it requires a significant equity ownership position. The benefits of ownership lie in the combination of equity ownership rights and management control rights. Specifically, it is significant own- ership rights that provide much needed management control rights. In contrast, FPI represents essentially insignificant ownership rights but no management control rights. To compete successfully, firms need to deploy overwhelming resources and capabilities to overcome their liabilities of foreignness (see Chapters 1 and 4). FDI provides one of the best ways to facilitate such extension of firm-specific resources and capabilities abroad.

6-2c FDI versus Licensing When entering foreign markets, basic entry choices include (1) exporting, (2) licensing, or (3) FDI. Successful exporting may provoke protectionist responses from host countries, thus forcing firms to choose between licensing and FDI (see Chapters 5 and 10). Between licensing and FDI, which is better? Three reasons may compel firms to prefer FDI to licensing (Table 6.1).

First, FDI affords a high degree of direct management control that reduces the risk of firm-specific resources and capabilities being opportunistically taken advantage of. One of the leading types of risks abroad is dissemination risks, de- fined as the possibility of unauthorized diffusion of firm-specific know-how. If

Dissemination risk

The risk associated with unauthorized diffusion of firm-specific know-how.

Table 6.1 Why Firms Prefer FDI to Licensing

FDI reduces dissemination risks.

FDI provides tight control over foreign operations.

FDI facilitates the transfer of tacit knowledge through “learning by doing.”

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a foreign company grants a license to a local firm to manufacture or market a product, the licensee (or an employee of the licensee) may disseminate the know- how by using it against the wishes of the foreign company. For instance, Pizza Hut found out that its long-time licensee in Thailand disseminated its know-how and established a direct competitor, simply called The Pizza Company, which con- trolled 70% of the market in Thailand.9 While owning and managing proprietary assets through FDI does not completely shield firms from dissemination risks (af- ter all, their employees can quit and join competitors), FDI is better than licensing that provides no such management control. Understandably, FDI is extensively used in knowledge-intensive, high-tech industries, such as automobiles, electron- ics, chemicals, and IT.

Second, FDI provides more direct and tighter control over foreign operations. Even when licensees (and their employees) harbor no opportunistic intention to take away “secrets,” they may not follow the wishes of the foreign firm that provides the know-how. Without FDI, the foreign firm cannot order or control its licensee to move ahead. For example, Starbucks entered South Korea by licensing its format to ESCO. Although ESCO soon opened ten stores, Starbucks felt that ESCO was not aggressive enough. But there was very little Starbucks could do. Eventually, Starbucks switched from licensing to FDI, which allowed Starbucks to directly call the shots and promote the aggressive growth of the chain in South Korea.

Finally, certain knowledge (or know-how) calls for FDI rather than licensing. Even if there is no opportunism on the part of licensees and if they are willing to follow the wishes of the foreign firm, certain know-how may be simply too difficult to transfer to licensees without FDI. Knowledge has two basic categories: (1) explic- it and (2) implicit. Explicit knowledge is codifiable (that is, it can be written down and transferred without losing much of its richness). Tacit knowledge, on the other hand, is noncodifiable and its acquisition and transfer requires hands-on practice. For instance, a driving manual represents a body of explicit knowledge. However, mastering this manual without any road practice does not make you a good driver. Tacit knowledge is evidently more important and harder to transfer and learn—it can only be acquired through learning by doing (in this case, driving practice supervised by an experienced driver). Likewise, operating a Wal-Mart store entails a great deal of knowledge, some explicit (often captured in an operational manual) and some tacit. However, simply giving foreign licensees a copy of the Wal-Mart operational manual will not be enough. Foreign employees will need to learn from Wal-Mart personnel side by side (learning by doing).

From a resource-based standpoint, it is Wal-Mart’s tacit knowledge that gives it competitive advantage (see Chapter 4). Wal-Mart owns such crucial tacit knowledge, and has no incentive to give it away to licensees without having some management control over how such tacit knowledge is used. Therefore, properly transferring and controlling tacit knowledge calls for FDI. Overall, ownership advantages enable the firm, now becoming an MNE, to more effectively extend, transfer, and leverage firm-specific capabilities abroad.10 Next, we discuss location advantages.

6-2d Location Advantages The second key word in FDI refers to a foreign location. Given the well-known li- ability of foreignness, foreign locations must offer compelling advantages.11 This section (1) highlights the sources of location advantages and (2) outlines ways to acquire and neutralize location advantages.

Chapter 6 Investing Abroad Directly 183

6-2e Location, Location, Location Certain locations possess geographical features that are difficult to match by others. We may regard the continuous expansion of international business, such as FDI, as a never-ending saga in search of location-specific advantages. For example, although Austria politically and culturally belongs to the West, the coun- try is geographically located in the heart of Central and Eastern Europe (CEE). In fact, Austria’s capital Vienna is actually east of Prague in the Czech Republic and Ljubljana in Slovenia. Not surprisingly, Vienna is an attractive site as MNE regional headquarters for CEE. Similarly, Miami is blessed by its location close to Latin America and the Caribbean. It also has excellent air links with all major cities in North America. Miami thus advertises itself as the “Gateway of the Americas.” Locations such as Vienna and Miami naturally attract a lot of FDI.

Beyond natural geographical advantages, location advantages also arise from the clustering of economic activities in certain locations—referred to as agglomeration. For example, the Netherlands grows and exports two-thirds of the worldwide exports of cut flowers. Slovakia produces more cars per capita than any other country in the world, thanks to the quest for agglomeration benefits by global automakers. Dallas attracts all the world’s major telecom equipment makers and many telecom service providers, making it the Telecom Corridor. Overall, agglomeration advantages stem from:

Knowledge spillovers—knowledge being diffused from one firm to others among closely located firms that attempt to hire individuals from competitors.12

Industry demand that creates a skilled labor force whose members may work for different firms without having to move out of the region.

Industry demand that facilitates a pool of specialized suppliers and buyers also located in the region.13

6-2f Acquiring and Neutralizing Location Advantages Note that from a resource-based view, location advantages do not entirely overlap with country-level advantages such as factor endowments discussed in Chapter 5. Location advantages are the advantages one firm obtains when operating in one location due to its firm-specific capabilities. In 1982, General Motors (GM) ran its Fremont, California, plant into the ground and had to close it. Reopening the same plant, Toyota in 1984 initi- ated its first FDI project in the United States (in a joint venture (JV) with GM). Since then, Toyota (together with GM) has leveraged that plant’s location advan- tages by producing award-winning cars that American customers particularly like—the Toyota Corolla and Tacoma. The point is: it is Toyota’s unique capabilities applied to the California location that literally saved this plant from its demise. The California location in itself does not provide location advantages per se, as shown by GM’s inability to make it work prior to 1982.

Firms do not operate in a vacuum. When one firm enters a foreign country through FDI, its rivals are likely to follow by undertaking additional FDI in a host coun- try to either (1) acquire location advantages themselves

Agglomeration

Clustering of economic activities in certain locations.

Knowledge spillover

Knowledge diffused from one firm to others among closely located firms.

What advantages did Volkswagen enjoy as one of the first foreign entrants into China’s auto market?

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or (2) at least neutralize the first mover’s location advantages. These actions to follow competitors are especially likely in industries characterized by oligopoly— industries populated by a small number of players (such as aerospace and semi- conductors).14 The automobile industry is a typical oligopolistic industry. In China, Volkswagen was the first foreign entrant, starting production in 1985 and enjoying a market share of 60% in the 1990s. Now, every self-respecting global automaker has entered China trying to eat some of Volkswagen’s lunch. Overall, competitive rivalry and imitation, especially in oligopolistic industries, underscores the impor- tance of acquiring and neutralizing location advantages around the world.

6-2g Internalization Advantages Known as internalization, another great advantage associated with FDI is the abil- ity to replace the external market relationship with one firm (the MNE) owning, controlling, and managing activities in two or more countries.15 This is important because of significant imperfections in international market transactions. The institution-based view suggests that markets are governed by rules, regulations, and norms that are designed to reduce uncertainties.16 Uncertainties introduce transaction costs—costs associated with doing business (see Chapter 2). This section (1) outlines the necessity of combatting market failure and (2) describes the benefits brought by internalization.

6-2h Market Failure International transaction costs tend to be higher than domestic transaction costs. Because laws and regulations are typically enforced on a nation-state basis, if one party from country A behaves opportunistically, the other party from country B will have a hard time enforcing the contract. Suing the other party in a foreign country is not only costly, but also uncertain. In the worst case, such imperfec- tions are so grave that markets fail to function, and many firms choose not to do business abroad to avoid being “burned.” Thus, high transaction costs can result in market imperfections (market failure)—the imperfections of the market mecha- nisms that make transactions prohibitively costly and sometimes make transactions unable to take place. However, recall from Chapter 5 that there are gains from trade. In response, MNEs emerge to overcome and combat such market failure through FDI.

6-2i Overcoming Market Failure Through FDI How do MNEs combat market failure through internalization? Let us use a simple example: An oil importer, BP in Britain, and an oil exporter, Nigerian National Petroleum Corporation (NNPC) in Nigeria. For the sake of our discussion, assume that BP does all its business in Britain and that NNPC does all its business in Nigeria—in other words, neither of them is an MNE. BP and NNPC negotiate a contract that specifies that NNPC will export from Nigeria a certain amount of crude oil to BP’s oil refinery facilities in Britain for a certain amount of money. Shown in Figure 6.6, this is both an export contract (from NNPC’s perspective) and an import contract (from BP’s standpoint) between two firms.

However, this international market transaction between an importer and an exporter may suffer from high transaction costs. What is especially costly is

Oligopoly

Industry dominated by a small number of players.

Market imperfection (market failure)

The imperfection of the market mechanisms that make transactions prohibitively costly and sometimes make transactions unable to take place.

Chapter 6 Investing Abroad Directly 185

the potential opportunism on both sides. For example, NNPC may demand a higher-than-agreed-upon price, citing a variety of reasons such as inflation, natu- ral disasters, or simply rising oil prices after the deal is signed. BP thus has to either (1) pay more than the agreed-upon price or (2) refuse to pay and suffer from the huge costs of keeping expensive refinery facilities idle. In other words, NNPC’s opportunistic behavior can cause a lot of BP’s losses.

Opportunistic behavior can go both ways in a market transaction. In this particular example, BP can also be opportunistic. For instance, BP may refuse to accept a shipment after its arrival from Nigeria citing unsatisfactory quality, but the real reason could be BP’s inability to sell refined oil downstream because gasoline demand is going down. (In a recession, the jobless do not need to commute to work.) NNPC is thus forced to find a new buyer for a huge tankerload of crude oil on a last-minute, “fire sale” basis with a deep discount, losing a lot of money.

Overall, in a market (export/import) transaction, once one side behaves opportunistically, the other side will not be happy and will threaten or initiate law suits. Because the legal and regulatory frameworks governing such international transactions are generally not as effective as those governing domestic transac- tions, the injured party will generally be frustrated while the opportunistic party can often get away. All of these are examples of transaction costs that increase international market inefficiencies and imperfections, ultimately resulting in market failure.

In response, FDI combats such market failure through internalization. The MNE reduces cross-border transaction costs and increases efficiencies by replacing an ex- ternal market relationship with a single organization spanning both countries—in a process called internalization (transforming the external market with in-house links).17 In theory, there can be two possibilities: (1) BP undertakes upstream vertical FDI by owning oil production assets in Nigeria or (2) NNPC undertakes downstream vertical FDI by owning oil refinery assets in Britain (Figure 6.7). FDI essentially transforms the international trade between two independent firms in two countries to intrafirm trade between two subsidiaries in two countries controlled by the same MNE.18 The MNE is thus able to coordinate cross-border activities better. Such advantage is called internalization advantage.

Intrafirm trade

International transactions between two subsidiaries in two countries controlled by the same MNE.

Oil exploration

Value Chain Value Chain

Oil production

Oil refinery

Gasoline distribution

Oil exploration

Oil production

Oil refinery

Gasoline distribution

NNPC in Nigeria BP in Great Britain

An import/ export contract

Figure 6.6 An International Market Transaction between Two Companies in Two Countries

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Overall, the motivations for FDI are complex.19 Based on the resource-based and institution-based views, we can see FDI as a reflection of both (1) firms’ motiva- tion to extend firm-specific capabilities abroad and (2) their responses to overcome market imperfections and failures.

6-3 Realities of FDI The realities of FDI are intertwined with politics. This section starts with three political views on FDI, followed by a discussion of pros and cons of FDI for home and host countries.

6-3a Political Views on FDI There are three primary political views. First, the radical view is hostile to FDI. Tracing its roots to Marxism, the radical view treats FDI as an instrument of impe- rialism and as a vehicle for exploitation of domestic resources by foreign capitalists and firms. Governments embracing the radical view often nationalize MNE assets, or simply ban (or discourage) inbound MNEs. Between the 1950s and the early 1980s, the radical view was influential throughout Africa, Asia, Eastern Europe, and Latin America.20 However, the popularity of this view is in decline worldwide, because (1) economic development in these countries was poor in the absence of FDI, and (2) the few developing countries (such as Singapore) that embraced FDI attained enviable growth (see Chapter 1).

On the other hand, the free market view suggests that FDI, unrestricted by government intervention, will enable countries to tap into their absolute or comparative advantages by specializing in the production of certain goods and services. Similar to the win-win logic for international trade as articulated by Adam Smith and David Ricardo (see Chapter 5), free market-based FDI will lead to a win-win situation for both home and host countries. Since the 1980s,

Learning Objective Identify different political views on FDI based on an understanding of its benefits and costs to host and home countries.

6-3

Radical view on FDI

A political view that is hostile to FDI.

Free market view on FDI

A political view that sug- gests that FDI unrestricted by government intervention is the best.

Oil exploration

Value Chain Value Chain

Oil production

Oil refinery

Gasoline distribution

Oil exploration

Oil production

Oil refinery

Gasoline distribution

Nigeria Great Britain

Figure 6.7 Combating Market Failure Through FDI: One Company (MNE) in Two Countries1

1 In theory, there can be two possibilities: (1) BP undertakes upstream vertical FDI by owning oil production assets in Nigeria, or (2) NNPC undertakes downstream vertical FDI by owning oil refinery assets in Great Britain. In reality, the first scenario is more likely.

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a series of countries, such as Brazil, China, Hungary, India, Ireland, and Russia, have adopted more FDI- friendly policies.

However, in practice, a totally free market view on FDI does not really exist. Most countries practice prag- matic nationalism—viewing FDI as having both pros and cons and only approving FDI when its benefits outweigh costs. The French government, invoking “economic patriotism,” has torpedoed several foreign takeover attempts of French firms. The Chinese gov- ernment insists that automobile FDI has to take the form of JVs with MNEs so that Chinese automakers can learn from their foreign counterparts.

More countries in recent years have changed their policies to be more favorable to FDI. Even hard core countries that practiced the radical view on FDI, such as Cuba and North Korea, are now experimenting with some opening to FDI, which is indicative of the emerging pragmatic nationalism in their new thinking. However, since the 2008–2009 recession, there is some creeping increase of protec- tionism in the form of policies discouraging inbound FDI in some countries (see the Closing Case).

6-3b Benefits and Costs of FDI to Host Countries Underpinning pragmatic nationalism is the need to assess the various benefits and costs of FDI to host (recipient) countries and home (source) countries. In a nutshell, Figure 6.8 outlines these considerations. This section focuses on host countries, and the next section deals with home countries.

Cell 1 in Figure 6.8 shows four primary benefits to host countries:21

Capital inflow can help improve a host country’s balance of payments. (See Chapter 7 for more coverage on balance of payments.)

Technology, especially more advanced technology from abroad, can create technology spillovers that benefit domestic firms and industries.22 Local rivals,

Pragmatic nationalism on FDI

A political view that only approves FDI when its benefits outweigh its costs.

Technology spillover

Technology diffused from foreign firms to domestic firms.

Effects of FDI

Cell 1 Capital inflow, technology, management, job creation

Cell 3 Earnings, exports, learning from abroad

Cell 2 Loss of sovereignty, competition, capital outflow

Cell 4 Capital outflow, job loss

Recipients versus sources

Host (recipient) countries

Home (source) countries

Benefits Costs

Figure 6.8 Effects of FDI on Home and Host Countries

Why have some countries welcomed FDI, like US-based Ford’s plan to build this manufacturing plant in China?

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after observing such technology, may recognize its feasibility and strive to imitate it. This is known as the demonstration effect—sometimes also called the contagion (or imitation) effect.23 It underscores the important role that MNEs play in stimulating competition in host countries.24

Advanced management know-how may be highly valued. It is often difficult for indigenous development of management know-how to reach a world-class level in the absence of FDI.25

FDI creates jobs, both directly and indirectly. Direct benefits arise when MNEs employ individuals locally. In Ireland, more than 50% of the Irish manufacturing employees work for MNEs.26 In the UK, the largest private- sector employer is an MNE: India’s Tata has 45,000 employees in the UK working for a variety of businesses such as Jaguar, Land-Rover, Tata Steel (formerly Corus), Tata Tea (formerly Tetley), and Tata Consultancy Ser- vices.27 In the United States, foreign automakers such as BMW, Honda, Hyundai, Kia, Toyota, and Volkswagen will add an estimated 25,000 jobs by 2015.28 Indirect benefits include jobs created when local suppliers in- crease hiring and when MNE employees spend money locally resulting in more jobs.

Cell 2 in Figure 6.8 outlines three primary costs of FDI to host countries: (1) loss of sovereignty, (2) adverse effects on competition, and (3) capital outflow. The first concern is the loss of some (but not all) economic sovereignty associ- ated with FDI. Because of FDI, decisions to invest, produce, and market products and/or to close plants and lay off workers in a host country are being made by foreigners—or if locals serve as heads of MNE subsidiaries, they represent the in- terest of foreign firms. Will foreigners and foreign firms make decisions in the best interest of host countries? This is truly a “billion dollar” question. According to the radical view, the answer is “No!” because foreigners and foreign firms are likely to maximize their own profits by exploiting people and resources in host countries. Such deep suspicion of MNEs leads to policies that discourage or even ban FDI. On the other hand, countries embracing free market and pragmatic nationalism views agree that despite some acknowledged differences between foreign and host country interests, there is a sufficient overlap of interests between MNEs and host countries. Thus, host countries are willing to live with some loss of sovereignty (see In Focus 6.1).

A second concern is associated with the negative effects on local competi- tion. While we have just discussed MNEs’ positive effects on local competition, it is possible that MNEs may drive some domestic firms out of business. Having driven domestic firms out of business, MNEs, in theory, may be able to mo- nopolize local markets. While this is a relatively minor concern in developed economies, this is a legitimate concern for less developed economies, where MNEs are of such a magnitude in size and strength and local firms tend to be significantly weaker. For example, as Coca-Cola and PepsiCo extend their “cola wars” from the United States around the world, they have almost “accidentally” wiped out many of the world’s indigenous beverage companies, which are—or were—much smaller.

A third concern is associated with capital outflow. When MNEs make profits in host countries and repatriate (send back) such earnings to headquarters in home countries, host countries experience a net outflow in the capital account in their balance of payments. As a result, some countries have restricted MNEs’

Demonstration (contagion or imitation) effect

The reaction of local firms to rise to the challenge demonstrated by MNEs through learning and imitation.

Chapter 6 Investing Abroad Directly 189

6-5

Britain is no stranger to FDI. Historically, the development of many countries such as Australia, Canada, India, and the United States benefited from FDI outflows from Britain. But now the news about FDI in Britain tends to focus on FDI inflows. Iconic brands and companies seem to slip out of British hands repeatedly. Cadbury was taken over by Kraft. The Rover Group was bought by BMW, but BMW failed to turn it around (except for do- ing well with the smaller MINI division). The Land Rover part of the Rover Group was then sold to Ford, which more recently sold it to India’s Tata. The Rover brand itself was sold to China’s Nanjing Auto. Thanks to large inflows of FDI, a foreign firm is now Britain’s largest private-sector employer: Tata UK has 45,000 employees—slightly ahead of BAE Systems (formerly known as British Aerospace). In addition to these high-profile cases, the extent of FDI’s penetration into the British economy is indeed striking. The Economist noted the following example:

Consider an imaginary Englishman’s day. He wakes up in his cottage near Dover, ready to commute to London. Chomping a bowl of Weetabix, a British breakfast cereal resem- bling (tasty) cardboard, he makes a cup of tea. His private water comes from Veolia, and his electricity from EDF (both French firms). Thumps at the gate tell him another arm of Veolia is emptying his bins. He takes the new high-speed train to London: it is part-owned by the French firm Keolis, while the tracks belong to Canadian pension funds. At St. Pancras station, a choice of double-decker buses awaits. In the last couple of years, one of the big London bus companies was bought by Netherlands Railways. A second went to Deutsche Bahn, the German railway company. In March 2011, a third was taken over by RATP, the Paris public- transport authority (its previous owner was also French). . . . As for Weetabix, a French billionaire is interested in buying the firm. Yet, Britain still feels British.

For three decades, the consensus seems to be that Britain gains more by welcoming FDI, which is a vote of confidence in the country’s business climate. Behind only the United States and China, Britain typically attracts more FDI than its European neighbors—a well-deserved bragging right. Although patriotism runs deep, the specific link between sovereignty and corporate ownership does not seem very strong in Britain. But increasingly, many people in Britain are not so sure that the benefits of FDI outweigh the costs. The most basic anxiety is that foreign ownership may lead to factory closures and job losses. More strategically, as head offices close, Britain risks becoming a “branch factory” economy. When the going gets tough, foreign multinationals are more likely to preserve factories and jobs in their home countries and put British jobs on the chopping block. Debates on how to fend off foreigners (and foreign firms) to defend British ownership rage. Advocates of more protectionist policies point to Germany, whose officials complain about a swarm of (largely American) “locusts” devouring its Mittelstand, the private companies behind Germany’s export prowess. Such British advocates also cheer France’s decision to designate Danone a firm in a “strategic industry” that would qualify for government protection should foreign rivals come sniffing.

Defenders of more open policies on FDI inflows make four points. First, if foreigners think they can do a better job of managing British operations, “good luck to them,” according to the Economist. “The Spanish firm Ferrovial can hardly do a worse job of running London’s Heathrow airport than did BAA, the British firm it took over.” Second, being bought by foreign multinationals tends to boost productivity. Four out of five MINIs made in Oxford are now exported, and one in six BMWs sold is a made-in-Britain MINI. This contrasts sharply with the sorry state of Rover and MINI cars when under British ownership. Third, head offices and their jobs often stay. After GE bought Amersham, a British nuclear medicine systems firm, it moved GE Medi- cal’s head office from Milwaukee, Wisconsin, to

The Pros and Cons of FDI in Britain IN FOcUs 6.1 Ethical

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190 Part Two Acquiring Tools

ability to repatriate funds. Another issue arises when MNE subsidiaries spend a lot of money to import components and services abroad, which also results in capital outflow.

6-3c Benefits and Costs of FDI to Home Countries As exporters of capital, technology, management, and (in some cases) jobs, home (source) countries often reap benefits and endure costs associated with FDI that are opposite to those experienced by host countries. In Cell 3 of Figure 6.8, three benefits to home countries are:

Repatriated earnings from profits from FDI. Increased exports of components and services to host countries. Learning via FDI from operations abroad.

Shown in Cell 4 in Figure 6.8, costs of FDI to home countries primarily center on (1) capital outflow and (2) job loss. First, since host countries enjoy capital inflow because of FDI, home countries naturally suffer from some capital outflow. Less confident home country governments often impose capital controls to prevent or reduce FDI from flowing abroad. However, this concern is now less significant, as many governments realize the benefits eventually brought by FDI outflows.29

The second concern is now more prominent: job loss. Many MNEs simultane- ously invest abroad by adding employment overseas and curtail domestic produc- tion by laying off employees. It is not surprising that politicians, union members, journalists, and activists in many developed economies have been increasingly vocal in calling for restrictions on FDI outflows.

How MNEs and Host Governments Bargain MNEs react to various policies by bargaining with host governments. The outcome of MNE-host government relationship, namely, the scale and scope of FDI in a host country, is a function of the relative bargaining power of both sides—the ability to extract favorable outcome from negotiations due to one party’s strengths. MNEs typically prefer to minimize the intervention from host governments and maximize the incentives provided by host governments. Host governments usually want to ensure a certain degree of control and minimize the incentives provided to MNEs. Sometimes host governments “must coerce or cajole the multinationals into undertaking roles that they would otherwise abdicate.”30 However, host governments have to “induce, rather than command,” because MNEs have options elsewhere.31 Different countries, in effect, are competing with each other for precious FDI dollars.

Bargaining power

Ability to extract favorable outcome from negotiations due to one party’s strengths.

Buckinghamshire. Finally, considering that British firms actively invest abroad, protectionist policies at home will certainly invite retaliation abroad. While debates rage, it is clear that blocking FDI inflows would undermine Britain’s long-standing support for

open markets, which would reduce its attractiveness as a place to do business.

Sources: Based on (1) Economist, 2010, Small island for sale, March 27: 75–77; (2) Economist, 2011, A very British paradox, June 18; (3) Economist, 2011, Tata for now, September 10: 61–62.

IN FOcUs 6.1 (continued)

Chapter 6 Investing Abroad Directly 191

Shown in In Focus 6.2, FDI is not a zero-sum game. The negotiations are char- acterized by the “three Cs”: common interests, conflicting interests, and compro- mises32 (Figure 6.9). The upshot is that despite a variety of conflicts, there are conditions within which the interests of both sides may converge on an outcome that makes each side better off.33

Intel began operating in Israel in 1974 with five employees. By 2000, Intel had a major facility in Kiryat Gat in southern Israel. Intel had invested $1.5 billion in this facility, and had benefited from a previous law sup- portive of FDI by receiving a grant worth 32% of the investment. The law subsequently had been changed, and the maximum level of a grant was reduced to 20% of new FDI projects. In 2000, Intel decided to invest in three new production facilities: one in the United States, one outside the US, and the third one to be either inside or outside the US. Intel approached the Israeli government, suggesting that it would be ready to build a new facility in Israel, provided that it would receive a reasonable amount of support.

Because of the security conflicts, Israel is usually regarded as a high-risk country for FDI. However, the security issue has two sides. In addition to the risk side, one positive side is the large and continu- ous investment in security by the Israeli govern- ment, which has generated a high-quality workforce capable of performing cutting-edge, high-tech work that is desirable for Intel. Israel, on the other hand, was interested in securing Intel’s further investment in order to attract other MNEs. Therefore, both sides shared some common interests.

However, the negotiations quickly revealed some conflicting interests. Intel, fully aware of the new law, asked the Israeli government to specify the level and nature of support. The government refused, prior to re- ceiving a request from Intel on what Intel deemed the minimum level of support. In other words, both sides refused to be precise. Intel wanted to maximize the support, which the government preferred to minimize.

The Israeli government knew that Intel was interested but that it was also considering other sites such as Ireland. The government’s main

problem was the limited budget to support FDI and the opportunity cost of not being able to support other projects should Intel be supported. The gov- ernment team came back offering to replace the grant by a tax relief with the same present value. Intel rejected this offer, arguing that switching from a grant to a tax relief would have a negative effect on the operational profit, which was the main per- formance measure. The Israeli team responded by offering a grant to be paid against tax payments over time. This would allow Intel to reduce the capi- tal investment by the present value and the depre- ciation. This would have a positive impact on op- erational profit. Intel eventually accepted the new offer. It invested $2 billion on a new facility next to the existing one in Kiryat Gat and another $1 billion to upgrade the existing facility.

These negotiations were successful, because both sides reached a number of compromises. Intel not only accepted a substantially lower level of support (from 32% to 20% of the investment), but also agreed not to bargain for a cash grant up front. Israel agreed to maximize the level of support per the new law, and also shifted the cost for sup- porting this much needed, high-profile project from a high opportunity cost area (a direct cash grant for large-scale support) to a lower opportunity cost area (lower tax receipts in the future). Today, the new Kiryat Gat manufactures processors that are exported around the world. Intel is Israel’s largest private employer with 6,600 employees in produc- tion and R&D facilities in Kiryat Gat and five other locations.

Sources: Based on (1) T. Agmon, 2003, Who gets what: The MNE, the nation state, and the distributional effects of globalization, Journal of International Business Studies, 34: 416–427; (2) www.intel.com.

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192 Part Two Acquiring Tools

Typically, FDI bargaining is not one-round only. After the initial FDI entry, both sides may continue to exercise bargaining power. One well-known phenomenon is the obsolescing bargain, referring to the deal struck by MNEs and host governments, which change their requirements after the initial FDI entry. It typically unfolds in three rounds:

In Round One, the MNE and the government negotiate a deal. The MNE usually is not willing to enter in the absence of some government assurance of property rights and incentives (such as tax holidays).

In Round Two, the MNE enters and, if all goes well, earns profits that may become visible.

In Round Three, the government, often pressured by domestic political groups, may demand renegotiations of the deal that seems to yield “excessive” profits to the foreign firm (which, of course, regards these as “fair” and “normal” profits). The previous deal, thus, becomes obsolete. The government’s tactics include removing incentives, demanding a higher share of profits and taxes, and even expropriation (confiscating foreign assets) (see the Closing Case).

At this time, the MNE has already invested substantial sums of resources (called sunk costs) and often has to accommodate some new demands. Otherwise, it may face expropriation or exit at a huge loss (see the Closing Case). Not surprisingly, MNEs do not appreciate the risk associated with such obsolescing bargains. Unfortunately, recent actions in Argentina, Venezuela, Bolivia, and Ecuador suggest that obsolesc- ing bargains are have necessarily become obsolete (see the next section for details).

6-4 Debates and Extensions As an embodiment of globalization, FDI has stimulated a lot of debates. This section highlights two: (1) FDI versus outsourcing and (2) facilitating versus confronting inbound FDI.

6-4a FDI versus Outsourcing While this chapter has focused on FDI, we need to be aware that FDI is not the only mode of foreign market entry. Especially when undertaking a value chain analy- sis regarding specific activities (see Chapter 4), a decision to undertake FDI will

Obsolescing bargain

The deal struck by MNEs and host governments, which change their requirements after the initial FDI entry.

Expropriation

Government’s confiscation of foreign assets.

sunk cost

Cost that a firm has to endure even when its investment turns out to be unsatisfactory.

Learning Objective Participate in two leading debates concerning FDI.

6-4

Common interests

Compromises

Conflicting interests

Figure 6.9 How MNEs Negotiate with Host Governments: The Three Cs

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Chapter 6 Investing Abroad Directly 193

have to be assessed relative to the benefits and costs of outsourcing. Recall from Chapter 4 that in a foreign location, overseas outsourcing becomes “offshoring,” whereas FDI—that is, performing an activity in-house at an overseas location— has been recently labeled “captive sourcing” by some authors (see Figure 4.4). One strategic debate is whether FDI (captive sourcing) or outsourcing will serve firms’ purposes better.

The answer boils down to (1) how critical the activity being considered to perform abroad is to the core mission of the firm, (2) how common the activity is being undertaken by multiple end-user industries, and (3) how readily avail- able the overseas talents to perform this activity are. If the activity is marginal, is common (or similar) across multiple end-user industries, and is able to be provided by proven talents overseas, then outsourcing is called for. Otherwise, FDI is often necessary. For instance, when Travelocity outsourced its call center operations to India, its rival Sabre carefully considered its options. Sabre eventually decided to avoid outsourcing and to initiate FDI in Uruguay.

6-4b Facilitating versus Confronting Inbound FDI Despite the general trend toward more friendly policies to facilitate inbound FDI around the world, debates continue to rage. At the heart of these debates is the age-old question discussed earlier and illustrated in the Closing Case and In Focus 6.1: Can we trust foreign firms in making decisions important to our economy?

In developed economies, backlash against inbound FDI from certain countries is not unusual. In the 1960s, Europeans were concerned about the massive US FDI in Europe. In the 1980s, Americans were alarmed by the signifi- cant Japanese inroads into the United States. Over time, such concerns subsided. In 2006, a controversy erupted when Dubai Ports World (DP World), a United Arab Emirates (UAE) government-owned company, purchased US ports from an- other foreign firm, Britain’s P&O. This entry gave DP World control over terminal operations at the ports of New York/New Jersey, Philadelphia, Baltimore, Miami, and New Orleans. Although the UAE has been a US ally for three decades, many politicians, journalists, and activists opposed such FDI. In this “largest political storm over US ports since the Boston Tea Party,”34 DP World eventually withdrew. Similarly, Chinese firm CNOOC’s bid for US firm’s Unocal and another Chinese firm Chinalco’s bid for Australia’s Rio Tinto were torpedoed by a politicized process. Recent media sensation often focuses on China’s rise as an active foreign investor, and some reporting has fostered a view of the alleged “China threat” brought by such FDI, which cannot be substantiated by hard evidence (Emerging Markets 6.1).35

In some parts of the developing world, tension over foreign ownership can heat up. There were numerous incidents of nationalization and expropriation against MNE assets throughout the developing world between the 1950s and the 1970s. Given the recent worldwide trend toward more FDI-friendly policies, many people thought that such actions were a thing of the past. During 2006, individuals holding such a view had a rude awakening. In March 2006, Venezuelan President Hugo Chavez ordered Chevron, Royal Dutch, Total, ENI, and other oil and gas MNEs to con- vert their operations in the country into forced JVs with state-owned, Venezuelan firm PDVSA with PDVSA holding at least 60% of the equity. When France’s To- tal and Italy’s ENI rejected such terms, their fields were promptly seized by the

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The notion of the so-called “China threat” pervades the media in the West today. According to many writers, Chinese multinationals are—to paraphrase the Economist—intent on “buying up” the world. Such sensational reporting creates three lasting impressions: (1) China is one of the world’s biggest overseas investors. (2) Among the emerging econo- mies, it is the largest foreign investor. (3) China’s out- ward foreign direct investment (OFDI) is very global. Is there any hard evidence based on data to support these claims?

Unfortunately, none of these impressions can be substantiated by hard evidence. Take the notion that China invests abroad more than any other country does. According to the United Nations’ World In- vestment Report 2011, China and Hong Kong were not among the top three direct foreign investors in 2010. They were No. 5 and No. 4, respectively (with Hong Kong ahead of China)—well behind the United States, France, and Germany (see Figure 6.4). In 2010, when FDI outflows from China broke its own record (reaching $68 billion), the US/China difference was five times. Overall, China’s OFDI stock was only 6% that of the US. Therefore, if Chi- nese companies could buy up the world with that tiny sum, then US companies would have done that 16 times.

There is also a widespread perception that China must be the largest foreign investor among the emerg- ing economies. Again, that is not the case, according to UN data. While China’s stock of OFDI, at 1.46% of the worldwide total, is three times India’s (0.5%) and ahead of Brazil’s (0.9%), Russia has far more OFDI stock (2.12%) than China. Yet, nobody worries about the “Russia threat”—at least not since 1991, when the Soviet Union collapsed.

Finally, Chinese OFDI is not global, because Chinese companies have not invested all over the world. Hong Kong commanded 67% of China’s OFDI

stock, while the rest of Asia received 9%. Significant round tripping of Chinese capital, via Hong Kong, has taken place in order to take advantage of Chinese regulations in favor of “foreign” capital. Of the 12% of China’s OFDI stock that Chinese companies invested in Latin America and the Caribbean, tax havens like the Cayman Islands and the British Virgin Islands absorbed 11%. As Beijing’s control of Hong Kong intensifies, it is likely that the Cayman Islands and the British Virgin Islands as tax havens increasingly assume the role that Hong Kong has traditionally played—to facilitate significant capital round tripping. By contrast, China’s OFDI in Europe (4% of its OFDI stock), North America (2%), and Oceania (3%) was relatively small, while Africa accounted for just 4% of China’s OFDI stock.

The world outside Hong Kong accounts for just about one-third of China’s stock of OFDI, which only represents 1.46% of the worldwide stock of OFDI. Do a little math, you can see that Chinese companies have invested a mere 0.03% of the worldwide stock of OFDI in North America (that is: 1.46% of world- wide total × 2% invested in North America). In dol- lar terms, that is about $6.3 billion. Note this is the stock of China’s OFDI—meaning the accumulation of all such investments over the years. In comparison, the revenue of the smallest US company on the For- tune Global 500, Bristol-Myers Squibb (ranked 500th in 2010), was $19 billion in just one year. The upshot? China’s OFDI, while emerging and increasing, is insig- nificant in North America and certainly does not de- serve the media hoopla.

Overall, the UN data show that because of its relatively small scale and limited geographic scope, China’s OFDI can hardly threaten any country. Em- bracing pragmatic nationalism, policymakers the world over would do well to consider both the pros and cons, and when the economic benefits outweigh the costs, to approve Chinese investments—just as they would in the case of FDI from other countries.

An Evidence-Based View on Why Chinese FDI Is Not a Threat

E m E r g i n g m a r k E t s 6 . 1

Ethical Dilemma

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government.36 On May 1 (“May Day” in the socialist world), 2006, the Bolivian military stormed MNEs’ oil fields and proclaimed control. President Evo Morales declared, “The plunder [by MNEs] has ended.”37 Soon after, in late May 2006, Ecuador expropriated the oil fields run by America’s Occidental Petroleum. More recently, in May 2012 Argentina nationalized YPF, which was owned by Spain’s Rep- sol (see the Closing Case).

It is important to note that the anti-MNE actions in Latin America were not sudden, impulsive policy changes. The politicians leading these actions were all democratically elected. These actions were the result of lengthy political debates concerning FDI in the region, and such takeovers were popular with the pub- lic. Until the 1970s, Latin American governments had often harshly confronted MNEs. Only in the 1990s when these countries became democratic did they open their oil industry to inbound FDI. Therefore, the 180-degree policy reversal is both surprising (considering how recently these governments welcomed MNEs to arrive) and not surprising (considering the history of how MNEs were dealt with in the region). While some argue that the recent actions were driven by industry-specific dynamics (oil prices skyrocketed so that governments could not resist the urge of their “grabbing hand”), others suggest that these actions repre- sent the swing of a “pendulum” toward more confrontation (see Chapter 1 on the “pendulum” on globalization).

6-5 Management Savvy The big question in global business, adapted to the context of FDI, is: What determines the success and failure of FDI around the globe? The answer boils down to two components. First, from a resource-based view, some firms are very good at FDI because they leverage OLI advantages in a way that is valuable, unique, and hard for rival firms to imitate (see the Opening Case). Second, from an institution-based view, the political realities either enable or constrain FDI from reaching its full economic potential (see the Closing Case). Therefore, the success and failure of FDI also significantly depends on institutions governing FDI as “rules of the game.”

As a result, three implications for action emerge (Table 6.2). First, carefully assess whether FDI is justified, in light of other possibilities such as outsourcing and licensing. This exercise needs to be conducted on an activity-by-activity basis as part of the value-chain analysis (see Chapter 4). If ownership and internaliza- tion advantages are deemed not crucial, then FDI is not recommended.

Learning Objective Draw implications for action.

6-5

When unemployment is high and jobs are hard to come by, turning away investments from the economy

with the largest foreign exchange reserves in the world does not make much sense.

Sources: Adapted from M. W. Peng, 2012, Why China’s investments aren’t a threat, Harvard Business Review, February 13, blogs.hbr.org. Underlying research can be found in (1) M. W. Peng, 2011, The social responsibility of international business scholars: The case of China, AIB Insights, 11(4): 8–10; (2) M. W. Peng, 2012, The global strategy of emerging multinationals from China, Global Strategy Journal, 2(2): 97–107; (3) M. W. Peng, S. Sun, & D. Blevins, 2011, The social responsibility of international business scholars, Multinational Business Review, 19(2): 106–119. Additional sources are (4) Economist, 2010, Buying up the world, November 13: cover story; (5) D. Lampton, 2010, Power constrained: Sources of mutual strategic suspicion in US-China relations, NBR Analysis, 93: 5–25, Seattle: National Bureau of Asian Research; (6) United Nations, 2011, World Investment Report 2011, New York and Geneva: UN.

196 Part Two Acquiring Tools

Second, once a decision to undertake FDI is made, pay attention to the old adage: “Location, location, location!” The quest for location advantages has to create a fit with the firm’s strategic goals. For example, if a firm is searching for the best “hot spots” for innovations, certain low-cost locations that do not generate sufficient innovations will not become very attractive (see Chapters 10 and 13).

Finally, given the political realities around the world, be aware of the institutional constraints. Savvy MNE managers should not take FDI-friendly policies for grant- ed. Setbacks are likely. The global economic slowdown has made many developed economies less attractive to invest in, and the credit crunch means that firms are less able to invest abroad. Attitudes toward certain forms of FDI are changing, which may lead to FDI policies to become more protectionist. In the long run, the interests of MNEs in host countries can be best safeguarded if MNEs accom- modate, rather than neglect or dominate, the interests of host countries (see the Closing Case). In practical terms, contributions to local employment, job training, education, and pollution control will tangibly demonstrate MNEs’ commitment to host countries.

C h a p t e r S u m m a r y

6.1 Use the resource-based and institution-based views to answer why FDI takes place.

The resource-based view suggests that the key word of FDI is direct, which reflects firms’ interest in directly managing, developing, and leveraging their firm-specific resources and capabilities abroad.

The institution-based view argues that recent expansion of FDI is indicative of generally more friendly policies, norms, and values associated with FDI (despite some setbacks).

6.2 Understand how FDI results in ownership, location, and internalization (OLI) advantages.

Ownership refers to MNEs’ possession and leveraging of certain valu- able, rare, hard-to-imitate, and organizationally embedded (VRIO) assets overseas.

Location refers to certain places’ advantages that can help MNEs attain strategic goals.

Internalization refers to the replacement of cross-border market relation- ship with one firm (the MNE) locating in two or more countries. Internal- ization helps combat market imperfections and failures.

Table 6.2 Implications for Action

Carefully assess whether FDI is justified in light of other foreign entry modes such as outsourcing and licensing.

Pay careful attention to the location advantages in combination with the firm’s strategic goals.

Be aware of the institutional constraints and enablers governing FDI and enhance FDI’s legitimacy in host countries

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Chapter 6 Investing Abroad Directly 197

6.3 Identify different political views on FDI based on an understanding of its benefits and costs to host and home countries.

The radical view is hostile to FDI, and the free market view calls for minimum intervention in FDI.

Most countries practice pragmatic nationalism, weighing the benefits and costs of FDI.

FDI brings a different (and often opposing) set of benefits and costs to host and home countries.

6.4 Participate in two leading debates concerning FDI.

(1) FDI versus outsourcing and (2) facilitating versus confronting inbound FDI.

6.5 Draw implications for action.

Carefully assess whether FDI is justified, in light of other options, such as outsourcing and licensing.

Pay careful attention to the location advantages in combination with the firm’s strategic goals.

Be aware of the institutional constraints governing FDI and enhance legitimacy in host countries.

K e y T e r m s

Agglomeration 183 Bargaining power 190 Contagion (imitation)

effect 188 Demonstration effect 188 Dissemination risk 181 Downstream vertical

FDI 177 Expropriation 192 FDI flow 177 FDI inflow 177 FDI outflow 178 FDI stock 178

Foreign portfolio investment (FPI) 176

Free market view 186 Horizontal FDI 177 Knowledge spillover 183 Internalization 180 Intrafirm trade 185 Location 180 Management control

rights 177 Market imperfection

(market failure) 184 Obsolescing bargain 192

OLI advantages 180 Oligopoly 184 Ownership 180 Pragmatic

nationalism 187 Radical view 186 Sunk cost 192 Technology spillover 187 Upstream vertical

FDI 177 Vertical FDI 177

r e v i e w Q u e s T i o n s

1. What is the primary difference between FDI and FPI?

2. How does the resource-based view suggest that the key word of FDI is direct?

3. How does horizontal FDI compare to vertical FDI?

4. How does internationalization help combat market imperfections and failures?

5. Briefly summarize each of the three OLI advantages.

6. Discuss the pros and cons of FDI versus licensing.

198 Part Two Acquiring Tools

7. Devise your own example of agglomeration that demonstrates your under- standing of the concept.

8. Compare and contrast the three political views of FDI.

9. Describe two benefits and two costs to a host country of FDI and to a home country of FDI.

10. Given that outsourcing is a viable alternative to FDI, what issues should be considered before a firm decides between the two?

11. ON CULTURE: Many people in the United States are opposed to both outsourcing and FDI. Would it be easier to get such people to accept one of these alternatives, and if so, which one? Why or why not?

12. Why do some countries object to inbound FDI?

13. In the United States, many states and cities deliberately seek investment in their states and communities by firms from other parts of the country. Why are some of those who seek investment from elsewhere in the US worried about investment from overseas?

14. What issues should a savvy manager consider when evaluating a particular location for FDI?

15. Some Americans feel that US-based firms should not undertake FDI in other countries because it results in expanding business opportunities in those countries and does not benefit the United States. How may the data on PengAtlas Map 2.3 be used to refute that view?

16. Consider PengAtlas Map 2.3 showing US FDI, and then look at PengAtlas Maps 2.1 and 2.2. Given the possibility that some US imports are from operations in which US firms have made FDI, how does that affect your view of the trade deficit? Does it make the deficit seem like less of a problem or greater? Explain your answer.

17. In questions 12, 13, and 15, we have noted controversies regarding FDI in terms of both inflows and outflows. Regarding PengAtlas Map 2.3, public concern about FDI often focuses on the FDI of US-based companies, and some argue that investment going overseas may otherwise have occurred within the US. However, the map also shows that the US is a major recipi- ent of such investment from overseas—but some who oppose FDI outflows also oppose FDI inflows. They fear that the United States is losing control over its economy as a result of such inflows. Do you think the two views are compatible? Why or why not?

c R I T I c A L D I s c U s s I O n Q U E s T I O n s

1. Identify the top five (or ten) source countries of FDI into your country. Then identify the top ten (or 20) foreign MNEs that have undertaken inbound FDI in your country. Why do these countries and companies provide the bulk of FDI into your country?

2. Identify the top five (or ten) recipient countries of FDI from your country. Then identify the top ten (or 20) MNEs headquartered in your country that have made outbound FDI elsewhere. Why do these countries attract FDI from the top MNEs from your country?

Chapter 6 Investing Abroad Directly 199

3. ON ETHICS: Undertaking FDI, by definition, means not investing in the MNE’s home country. What are the ethical dilemmas here? What are your recommendations, as (1) MNE executives, (2) labor union leaders of your domestic (home country) labor forces, or (3) host country officials?

G L O B A L A c T I O n

1. Your MNE is looking to evaluate the industrial capabilities of various locations worldwide. Based on readily available data concerning the potential and performance of different countries, the information you provide will drive future investment by your company. Choose a country from Asia, Europe, North America, and South America, and summarize your findings about each. Of the four countries from four continents, how would you rank them? Why?

2. The main premise for development at your company in the coming years is to shift its offshore services to Africa. As such, you have been asked to develop a report that evaluates which African countries have increased the possibility of creating a long-term advantage for your company. Also, be sure to include the African countries that have decreased their capacity to create a long-term advantage. Can you generate a top-five list and a bottom-five list from Africa for this purpose?

V I D E O c A s E

After watching the video on Thailand’s booming economy, discuss the following:

1. How do firms in Asia (in this case, in Thailand) overcome market failure?

2. What costs and benefits do US-based Ford and British companies experi- ence as a result of FDI in Thailand?

3. What role does Thailand’s location play in its booming economy? Is agglom- eration involved?

4. Are there confrontations with inbound FDI?

5. Should foreign-invested and domestic firms sell more to domestic consumers in Thailand?

Argentina’s relationship with foreign investors in its energy industry has historically been rocky. The govern- ment in 1955 canceled international oil contracts signed by a previous president, Perón, in 1952. The next president signed new contracts in 1958, which were nullified in 1963 by a different president. Foreign

oil companies were then invited to return in 1966, expelled in 1973, and again encouraged to enter after 1976. Not surprisingly, many foreign investors shied away from this country.

Since the 1990s, the pro-market reform poli- cies that were centered on trade liberalization,

EMERGING MARKETS: Cry for Me, Argentina

Ethical Dilemma

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200 Part Two Acquiring Tools

deregulation, and privatization have brought more sta- bility. More foreign investors showed up. In 1993, YPF, the formerly state-owned oil giant, was privatized. In 1999, Spain’s Repsol bought 57% of the shares of YPF and became its controlling shareholder. Although Argentina suffered from the government’s default on its $155 billion public debt (a world record at that time) in 2002, and the country has struggled to recover since then, Repsol’s operations have been relatively smooth—until recently.

In 2012, Argentina again was engulfed in a major crisis. Given the severe trade deficit, the government, under President Cristina Fernández de Kirchner, unleashed a series of radical measures to curb imports. Importers of foreign cars were re- quired to find export buyers of Argentine wines; otherwise, port authorities would not release their cars. Foreign print publications, including maga- zines and newspapers, were held at the Buenos Aires airport unless subscribers went there to pay a highly unpopular additional fee—an import tax or tariff of sorts.

In addition to making the life of Argentine firms and citizens harder, Fernández also targeted foreign direct investors. Specifically, Repsol was singled out as a high-profile target for nationalization (or expropriation). Repsol’s alleged wrongdoing was that it failed to boost oil and natural gas production needed to keep up with rising local demand. In 2003, when Néstor Kirchner, Fernández’s late husband and predecessor, took office, Argentina was a net energy exporter. Ten years later, Argentina imported 15% more than its energy production, resulting in more

than $10 billion of cash outflows. The government argued that the largest producer, YPF, which contrib- uted 45% of the country’s energy production, was responsible for this mess. In Fernández’s own words in her announcement:

If YPF’s policy continues—draining fields dry, no exploration, and practically no investment— the country will end up having no viable fu- ture, not because of a lack of resources but because of business policies. . . . Our goal is for YPF to be aligned with the interests of the country. When corporate interests are not aligned with national interests, when compa- nies are concerned only with profits, that’s when economies fail, which is what hap- pened globally in 2008 and what happened to Argentina in 2002.

In the words of a Congressional leader, who participated in the debate on the YPF renationalization bill submitted by the president:

All oil companies that operate in Argentina, Repsol and the rest, have to work in the public interest, which in this case means energy self sufficiency for Argentina. . . . Repsol invested little in Argentina. But it was YPF and Argentine oil that financed Repsol’s growth around the world.

Fernández framed the YPF renationalization as central to fulfill her campaign pledges to tighten the interventionist policies in order to rescue the economy. YPF was an iconic symbol of national pride, and the cash-strapped government would love to have its revenues, estimated at $1.3 billion a year. Fernández’s measures were popular with ordinary Argentines. Many of them blamed free market re- forms such as privatization of the 1990s to be a cause of the economic devastation of the 2000s. Not sur- prisingly, the YPF renationalization bill passed Con- gress by a landslide. In May 2012, Fernández signed the measure into law and formally (re)nationalized— for the time being without compensation—Repsol’s assets, which according to Repsol would be valued at more than $9.3 billion.

Outraged, both Repsol and the Spanish govern- ment protested, but there was little they could do.

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Chapter 6 Investing Abroad Directly 201

Argentina had little FDI in Spain, while Spanish FDI in Argentina’s highly regulated banking, telecommunica- tions, and utilities industries could suffer if tensions were to escalate between the two countries. In retaliation, Spain quickly moved to limit imports of biofuels from Argentina, which annually exported $1 billion to Spain. Spain also threatened to initiate complaints to the World Trade Organization, called for EU-wide boycotts of Argentine products, and took the case to the World Bank’s International Center for Settlement of Investment Disputes (ICSID). In response, Fernández said:

This president is not going to respond to any threats . . . because I represent the Argentine people. I’m the head of the state, not a thug.

Argentina might indeed be defiant, because it already had a very bad record at ICSID, whereby one-quarter of all ICSID cases had been brought against Argentina (thanks to its 2002 default). While renationalizing YPF brought more revenues and helped the president gain more popularity, according to the Economist, “it is a disaster for Argentina.” In the short run, the fight over the valuation of the firm already began in negotiations between Argentina and Repsol. In the long run, such expropriation has grave ramifi- cations far beyond the oil industry and beyond for- eign investors from Spain (Argentina’s largest foreign investor). In fairness, Fernández also nationalized the

country’s private pension funds and (re)nationalized the flagship airline, Aerolineas Argentinas. So, she did not just target foreign investors such as Repsol. Nevertheless, foreign investors entertaining large- scale entries in the rapidly growing Latin American region are likely to be lured more strongly by Brazil, Chile, and Mexico, as opposed to risking their capital in a country known to be a global rule-breaker.

CASE DISCUSSION QUESTIONS: 1. What are the costs and benefits of FDI inflows

for a host country such as Argentina?

2. Will foreign firms such as Repsol make decisions in the best interest of Argentina?

3. ON ETHICS: As a Spanish manager at YPF, how would you cooperate with the Argentine government to expropriate YPF? If you were an Argentine manager at YPF, would your action be different?

4. ON ETHICS: If you were a member of Argentina’s Congress, would you vote to support Fernán- dez’s renationalization bill for YPF?

5. ON ETHICS: If you were a member of the arbitration panel assembled by ICSID (which would require you to come from a neutral country—neither from Argentina nor Spain), how much compensation would you think Argentina’s government should pay YPF?

Sources: Based on (1) Bloomberg Businessweek, 2012, Argentina goes rogue again, April 23: 16–17; (2) Economist, 2012, Cristina scrapes the barrel, April 21: 16; (3) Economist, 2012, Fill ’er up, April 21: 49–50; (4) M. Guillen, 2001, The Limits of Convergence (p. 135), Princeton, NJ: Princeton University Press; (5) Reuters, 2012, Argentina moves to seize control of Repsol’s YPF, April 17, www.reuters.com; (6) Reuters, 2012, Argentina nationalizes oil company YPF, May 4, www.reuters.com; (7) Reuters, 2012, Spain has few ways to pressure Argentina over YPF, April 18, www.reuters.com.

[Journal acronyms] AER—American Economic Review; AMJ— Academy of Management Journal; AMR —Academy of Management Review; BW—BusinessWeek (before 2010) or Bloomberg Businessweek (since 2010); CFDIP—Columbia Foreign Direct Investment Perspectives; EJ—Economic Journal; FEER—Far Eastern Economic Review; GSJ— Global Strategy Journal; IBR—International Business Review; JMS— Journal of Management Studies; JIBS—Journal of International Business Studies; JWB—Journal of World Business; MBR—Multinational Busi- ness Review; MIR—Management International Review; RES—Review of Economics and Statistics; SMJ—Strategic Management Journal.

1 R. Caves, 1996, Multinational Enterprise and Economic Analysis, 2nd ed. (p. 1), New York: Cambridge University Press.

2 United Nations, 2011, World Investment Report 2011 (overview, p. 2), New York and Geneva: United Nations.

3 United Nations, 2005, World Investment Report 2005 (p. 4), New York and Geneva: United Nations.

4 K. Moore & D. Lewis, 2009, The Origins of Globalization, New York: Routledge.

5 M. Wilkins, 2001, The history of MNE (p. 13), in A. Rugman & T. Brewer (eds.), The Oxford Handbook of International Business, 3–35, New York: Oxford University Press.

6 United Nations, 2009, World Investment Report 2009 (p. xxi), New York and Geneva: UN.

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7 United Nations, 2011, World Investment Report 2011 (p. viii).

8 J. Dunning, 1993, Multinational Enterprises and the Global Econo- my, Reading, MA: Addison-Wesley. See also C. Pitelis, 2007, Edith Penrose and a learning-based perspective on the MNE and OLI, MIR, 47: 207–219.

9 FEER, 2002, Pepperoni power, November 14: 59–60.

10 B. Elango & C. Pattnaik, 2007, Building capabilities for inter- national operations through networks, JIBS, 38: 541–555; D. Yiu, C. M. Lau, & G. Bruton, 2007, International venturing by emerging economy firms, JIBS, 38: 519–540.

11 J. Galan, J. Gonzalez-Benito, & J. Zuniga-Vincente, 2007, Fac- tors determining the location decisions of Spanish MNEs, JIBS, 38: 975–997; R. Grosse & L. Trevino, 2005, New institutional eco- nomics and FDI location in Central and Eastern Europe, MIR , 45: 123–135.

12 N. Driffield & J. Love, 2007, Linking FDI motivation and host economy productivity effects, JIBS, 38: 460–473; P. Ghauri & P. Rao, 2009, Intellectual property, pharmaceutical MNEs, and the develop- ing world, JWB, 44: 206–215; M. Hansem, T. Pedersen, & B. Petersen, 2009, MNC strategies and linkage effects in developing countries, JWB, 44: 121–130; F. Hatani, 2009, The logic of spillover inception, JWB, 44: 158–166; G. Santangelo, 2009. MNCs and linkages creation, JWB, 44: 192–205; X. Tian, 2007, Accounting for sources of FDI tech- nology spillovers, JIBS, 38: 147–159.

13 B. McCann & T. Folta, 2009, Demand- and supply-side agglomera- tions, JMS, 46: 362–392; J. Scott-Kennel, 2007, FDI and local linkages, MIR, 47: 51–77; J. Singh, 2007, Asymmetry of knowledge spillovers be- tween MNCs and host country firms, JIBS, 38: 764–786; S. Tallman, M. Jenkins, N. Henry, & S. Pinch, 2004, Knowledge, clusters, and competitive advantage, AMR, 29: 258–271.

14 F. Knickerbocker, 1973, Oligopolistic Reaction and Multinational En- terprise, Boston: Harvard Business School Press.

15 S. Feinberg & A. Gupta, 2009, MNC subsidiaries and country risk, AMJ, 52: 381–399.

16 L. Alfaro, S. Kalemli-Ozcan, & V. Volosovych, 2008, Why doesn’t capital flow from rich to poor countries? RES, 90: 347–368; L. Allen, S. Chakraborty, & W. Watanabe, 2011, FDI and regulatory remedies for banking crises, JIBS, 42: 875–893; C. Peinhardt & T. Allee, 2012, Dif- ferent investment treaties, different effects, CFDIP, 61: 1–3.

17 P. Buckley & M. Casson, 1976, The Future of the Multinational Enter- prise, London: Macmillan; S. Chen, 2010, A general TCE model of international business institutions, JIBS, 41: 935–959.

18 I. Filatotchev, R. Strange, J. Piesse, & Y. Lien, 2007, FDI by firms from new industrialized economies in emerging markets, JIBS, 38: 556–572.

19 J. Galan & J. Gonzalez-Benito, 2006, Distinctive determinant fac- tors of Spanish FDI in Latin America, JWB, 41: 171–189.

20 R. Vernon, 1977, Storm over the Multinationals, Cambridge, MA: Harvard University Press.

21 P. Dimitratos, I. Liouka, & S. Young, 2009, Regional location of MNC subsidiaries and economic development contribution, JWB, 44: 180–191; J. Oetzel & J. Doh, 2009, MNEs and development, JWB, 44: 108–120; M. Yamin & R. Sinkovics, 2009, Infrastructure or FDI? JWB, 44: 155–157.

22 B. Jindra, A. Giroud, & J. Scott-Kennel, 2009, Subsidiary roles, ver- tical linkages, and economic development, JWB, 44: 167–179; X. Liu, C. Wang, & Y. Wei, 2009, Do local manufacturing firms benefit from transaction linkages with MNEs in China? JIBS, 40: 1113–1130; K. Meyer & E. Sinani, 2009, When and where does FDI generate posi- tive spillovers? JIBS, 40: 1075–1094.

23 C. Altomonte & E. Pennings, 2009, Domestic plant productivity and incremental spillovers from FDI, JIBS, 40: 1131–1148; B. Javorcik, 2004, Does FDI increase the productivity of domestic firms? AER, 94: 605–627.

24 G. Blalock & D. Simon, 2009, Do all firms benefit equally from downstream FDI? JIBS, 40: 1095–1112.

25 K. Bunyaratavej, E. Hahn, & J. Doh, 2008, Multinational invest- ment and host country development, JWB, 43: 227–242.

26 F. Barry & C. Kearney, 2006, MNEs and industrial structure in host countries, JIBS, 37: 392–406.

27 Economist, 2011, Tata for now, September 10: 61–62.

28 BW, 2011, Surprise! Carmakers are a recovery bright spot, November 7: 19–20.

29 P. Braunerhjelm, L. Oxelheim, & P. Thulin, 2005, The relation- ship between domestic and outward FDI, IBR, 14: 677–694.

30 P. Evans, 1979, Dependent Development (p. 44), Princeton, NJ: Princeton University Press.

31 C. Lindblom, 1977, Politics and Markets (p. 173), New York: Basic Books.

32 T. Agmon, 2003, Who gets what, JIBS, 34: 416–427.

33 M. W. Peng, 2000, Controlling the foreign agent, MIR, 40: 141–165.

34 Economist, 2006, Trouble on the waterfront, February 25: 33–34.

35 M. W. Peng, 2011, The social responsibility of international busi- ness scholars: The case of China, AIB Insights, 11(4): 8–10; M. W. Peng, 2012, The global strategy of emerging multinationals from China, GSJ, 2: 97–107; M. W. Peng, S. Sun, & D. Blevins, 2011, The social responsibility of international business scholars, MBR , 19: 106–119.

36 BW, 2006, Venezuela: You are working for Chavez now, May 15: 76–78.

37 Economist, 2006, Bolivia: Now it’s the people’s gas, May 6: 37–38.

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Learning Objectives

After studying this chapter, you should be able to

7-1 understand the determinants of foreign exchange rates.

7-2 track the evolution of the international monetary system.

7-3 identify firms’ strategic responses to deal with foreign exchange movements.

7-4 participate in three leading debates concerning foreign exchange movements.

7-5 draw implications for action.

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Dealing with Foreign Exchange

Cellebrations, a wine shop in the inner Sydney suburb of Newtown, sells Moët & Chandon Brut Impérial, a popular French Champaign produced by LVMH Moët Hennesy Louis Vuitton, for A$49.99 (US$52.61) a bottle. Wine House, a Melbourne-based online store, is selling LVMH’s Chandon Green Point Cuvée 1995, a sparkling wine produced in Australia’s Yarra Valley, for A$52. Much to the dismay of Australia’s wine industry, its days of offering lower-priced alternatives to French vintages are fading.

With the Australian dollar at record levels against the euro, Aussie vintners are caught in a double-bind: Exports have been slammed as the cost of Australian wine has risen overseas, while oenophiles back home are embracing European bottles that suddenly are bargains. Imported wine has rarely been more afford- able, with prices for some labels dropping 30%. “It’s absolutely fantastic,” says Jeremy Oliver, a Melbourne- based wine critic. “If you have A$100 (US$105) in your pocket, that will get you a top bottle of Australian cab- ernet or shiraz. Today it also buys you a pretty serious Bordeaux, a very good Italian from any region, or a sen- sational Spanish red.”

Australia, the world’s largest wine exporter by volume outside of Europe, saw the value of its ex- ports decline to the lowest level in a decade in 2011, falling 10% from a year earlier, to A$1.89 billion. At

Melbourne-based Treasury Wine Estates, the world’s second-biggest publicly traded vintner and owner of the Lindeman’s and Penfolds brands, sales in the US, its largest market, fell 15%, to A$803 million in the year through June 2011. The currency hit is more pronounced in Europe, where the euro fell 8.9% over the last three months [in 2011] to make it the worst- performing major currency against the Australian dollar, compared with a 2.2% decline for the US dollar.

That’s quite a turnabout. Driven by signature brands such as Yellow Tail and Jacob’s Creek and support from influential critics such as Robert Parker, Australia’s ex- ports rose more than fourfold in the 10 years to 2007, when they peaked at 786 million liters. Australia over- took France as Britain’s top supplier of imported wine in 2005 and for a brief time in 2008 was the front-runner in the United States.

Then things turned. Competition had for years been increasing from other emerging wine areas such as Argentina, Chile, and South Africa when a domes- tic glut in Australia put too much low-quality product on the market. In 2009 bush fires swept through the wine country of Victoria state, incinerating vineyards and tainting grapes with smoke. Exports have dropped 11% in the past four years, to 703 million liters in 2011.

The high price of labor and land and the small-scale nature of middle-market wineries in Australia also make

O p e n i n g C a s e

Australian Wine: Made from the Grapes of Currency Wrath

206 Part Two Acquiring Tools

it hard to compete with imports, says Oliver. “You can get seriously interesting, diverse wineries from Europe, South America, and South Africa for A$25 a blow retail,” he says. “In Australia today, the small guys trying to do the equivalent are finding it very hard to get anything in the bottle for under A$45.”

Since 2005, Australia’s wine import volumes have risen 95%. French wine imports have risen 58%. Every six weeks, for instance, importer John Baker ships in a refrigerated container carrying about 10,800 bottles of French wine to his 270-square-meter (2,900-square-foot)

refrigerated warehouse in the Sydney suburb of Artar- mon. That’s double the import volume of five years before at his business, Bordeaux Shippers. The Aussie dollar is worth €.81 now, compared with €.54 when he started in 2003. “I’ve been selling a 2001 vintage Château tour du Haut Moulin, that’s a 10-year-old wine from Bordeaux, and it’s A$39 retail; that wine really should be A$80,” he says.

Source: Excerpted from Bloomberg Businessweek, 2012, The grapes of currency wrath, January 30: 22–23

Why is the value of currencies so important to the Australian wine industry? What determines foreign exchange rates? How do foreign exchange rates affect trade and investment? How can firms respond strategically? This chapter addresses these crucial questions. At the heart of our discussion lie the two core perspectives introduced ear- lier: the institution-based and resource-based views. Essentially, the institution-based view suggests that domestic and international institutions influence foreign exchange rates and affect capital movements. In turn, the resource-based view sheds light on how firms can profit from favorable foreign exchange movements or avoid being crushed by unfavorable movements by developing their own firm-specific resources and capabilities.

We start with a basic question: What determines foreign exchange rates? Then, we track the evolution of the international monetary system, and continue with firms’ strategic responses.

7-1 What Determines Foreign Exchange Rates? A foreign exchange rate is the price of one currency, such as the dollar, in terms of another, such as the euro. Table 7.1 provides some examples. An appreciation is an increase in the value of the currency, and a depreciation is a loss in the value of the currency. This section addresses a key question: What determines foreign exchange rates?

7-1a Basic Supply and Demand The concept of an exchange rate as the price of a commodity—one country’s currency—helps us understand its determinants. Basic economic theory suggests that the price of a commodity is most fundamentally determined by its supply and demand. Strong demand will lead to price hikes, and oversupply will result in price drops. Of course, we are dealing with a most unusual commodity here, money, but the basic underlying principles still apply. When the United States sells products to China, US exporters often demand that they be paid in US dollars— the Chinese yuan is useless (technically, non-convertible) in the United States. Chinese importers of US products will have to generate US dollars somehow in

Learning Objective Understand the determinants of foreign exchange rates.

7-1

Foreign exchange rate

The price of one currency in terms of another.

Appreciation

An increase in the value of the currency.

Depreciation

A loss in the value of the currency.

Chapter 7 Dealing with Foreign Exchange 207

order to pay for US imports. The easiest way to generate US dollars is to export to the United States, whose buyers will pay in US dollars. In this example, the dollar is the common transaction currency involving both US imports and US exports. As a result, the demand for dollars is much stronger than the demand for yuan (while holding the supply constant). Worldwide, a wide variety of users outside the United States, such as Chinese exporters, Swiss bankers, and Russian mafia members, prefer to hold and transact in US dollars, thus fueling the demand for dollars. Such a strong demand explains why the US dollar has been the most sought-after currency in postwar decades (see Figure 7.1). At present, over 80% of

Table 7.1 Examples of Key Currency Exchange Rates

US Dollar (US$)

Euro (€)

UK Pound

(£)

Swiss Franc (CHF)

Mexican Peso

Japanese Yen (¥)

Canadian Dollar (C$)

Canadian Dollar (C$) 1.00 1.31 1.58 1.09 0.08 0.012 ---

Japanese Yen (¥) 81.00 105.96 128.46 88.10 6.16 --- 81.14

Mexican Peso (MXN$) 13.14 17.20 20.85 14.30 --- 0.162 13.17

Swiss Franc (CHF) 0.92 1.20 1.46 --- 0.07 0.011 0.92

UK Pound (£) 0.63 0.82 --- 0.69 0.05 0.008 0.63

Euro (€) 0.76 --- 1.21 0.83 0.06 0.009 0.77

US Dollar (US$) --- 1.31 1.59 1.09 0.08 0.012 1.00

Source: These examples are from April 13, 2012. The rates may change. Adapted from Wall Street Journal, 2012, Key currency cross rates, April 13 (online.wsj.com). Reading vertically, the first column means US$1 5 C$1 5 ¥81 5 MXN$13.14 5 CHF 0.92 5 £0.63 5 €0.76. Reading horizontally, the last row means €1 5 US$1.31; £1 5 US$1.59; CHF 1 5 US$1.09; MXN$1 5 US$0.08; ¥1 5 US$0.012; C$1 5 US$1.

Figure 7.1 The US Dollar’s Share of World Total (%)

Source: Based on data in Economist, 2010, Beyond Bretton Woods 2 (p. 85), November 6: 85–87.

Foreign exchange transactions

90%

80%

70%

60%

50%

40%

30%

20%

10%

International reserves

Cross-border bank deposits

US share of world GDP

208 Part Two Acquiring Tools

the world’s foreign exchange transactions are in dollars. Approximately 65% of the world’s foreign exchange holdings are in US dollars, followed by 26% in euros, 4% in pounds, and 3% in yen.1

Because foreign exchange is such a unique commodity, its markets are influ- enced not only by economic factors, but also a lot of political and psychological factors. The next question is: What determines the supply and demand of foreign exchange? Figure 7.2 sketches the five underlying building blocks: (1) relative price differences, (2) interest rates and monetary supply, (3) productivity and balance of payments, (4) exchange rate policies, and (5) investor psychology.

7-1b Relative Price Differences and Purchasing Power Parity Some countries (such as Switzerland) are famously expensive (see the Closing Case), and others (such as the Philippines) are known to have cheap prices. How do these price differences affect exchange rates? An answer is provided by the theory of purchasing power parity (PPP), which is essentially the “law of one price.” The theory suggests that in the absence of trade barriers (such as tariffs), the price for identical products sold in different countries must be the same. Otherwise, traders (or arbitrageurs) may “buy low” and “sell high,” eventually driving prices for identical products to the same level around the world. The PPP theory argues that in the long run, exchange rates should move toward levels that would equalize the prices of an identical basket of goods in any two countries.2

One of the most influential, and certainly most fun-filled, applications of the PPP theory is the Big Mac index, popularized by the Economist magazine. The Econ- omist’s “basket” is McDonald’s Big Mac hamburger, which is produced in about 120 countries. According to the PPP theory, a Big Mac should cost the same any- where around the world. In reality, it does not. In January 2012, a Big Mac cost $4.20 in the United States and 15.37 yuan in China, which was $2.44 according to the nominal exchange rate of 6.3 yuan to the dollar. If the Big Mac indeed costs the same, the de facto exchange rate based on the Big Mac index became 3.66 yuan to the dollar (that is, 15.37 yuan/$4.20). According to this calculation, the yuan was

Figure 7.2 What Determines Foreign Exchange Rates?

Supply & demand of foreign exchange

Relative price differences & PPP

Productivity & balance of payments

Interest rates & money supply

Exchange rate policies

Investor psychology

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Chapter 7 Dealing with Foreign Exchange 209

42% “undervalued” against the dollar ([6.3–3.66]/6.3)—the second most extreme in the Big Mac universe behind the Indian rupee, which was 60% “undervalued” (Figure 7.3). In other words, the Big Mac in China and the Maharaja Mac in India (where the beef-based Big Mac is not available) had the best “value” in the world, based on official exchange rates.

Although the Big Mac index is never a serious exercise, it has been cited by some US politicians as “evidence” that the yuan is artificially undervalued. This claim has been disavowed by the Economist itself. More seriously, we can make four observations:

The Big Max index confirms that prices in some European countries are very expensive. A Big Mac in Switzerland was the most expensive in the world, cost- ing $6.81 (see the Closing Case).

A Big Mac in China and Russia and a Maharaja Mac in India are cheap in dollar terms. This makes sense because a Big Mac is a product with both trad- ed and non-traded inputs. To simplify our discussion, let us assume that the costs for traded inputs (such as flour for the bun) are the same. It is obvious that non-traded inputs (such as labor and real estate) are cheaper in emerg- ing economies.

The Big Mac is not a traded product. No large number of American hamburger lovers would travel to China simply to get the best deal on the Big Mac, and then somehow take with them large quantities of the made- in-China Big Mac (perhaps in portable freezers). If they were to do that, the Big Mac price in China would be driven up and the price in the United States would be pushed down—remember supply and demand?

After having a laugh, we shouldn’t read too much into this index. PPP signals where exchange rates may move in the long run. But it does not suggest that the yuan should appreciate by 42% or that the Swiss franc should depreciate

Figure 7.3 The Big Mac Index

Local currency under (2) / over (1) valuation against the dollar, %

Switzerland

Brazil

Australia

Canada

Euro area

nilUnited States

Japan

Britain

Turkey

Russia

China

India

40 20 2 0 1 20 40 60

Big Mac price, $

6.81

5.68

4.94

4.73

4.43

4.20

4.16

3.82

3.54

2.55

2.44

1.62

210 Part Two Acquiring Tools

by 62% next year. According to the Economist, anyone interested in the PPP theory “would be unwise to exclude the Big Mac index from their diet, but Super Size servings (of this index) would equally be a mistake.”3

7-1c Interest Rates and Money Supply While the PPP theory suggests the long-run direction of exchange rate movement, what about the short run? In the short run, variations in interest rates have a pow- erful effect. If one country’s interest rate is high relative to other countries, the country will attract foreign funds. Because inflows of foreign funds usually need to be converted to the home currency, a high interest rate will increase the demand for the home currency, thus enhancing its exchange value.

In addition, a country’s rate of inflation, relative to that prevailing abroad, affects its ability to attract foreign funds and hence its exchange rate. A high level of inflation is essentially too much money chasing too few goods in an economy— technically, an expansion of a country’s money supply. A government, when facing budgetary shortfalls, may choose to print more currency, which tends to stimu- late inflation. In turn, this would cause its currency to depreciate. This makes sense because, as the supply of a given currency increases while the demand stays the same, the per-unit value of that currency goes down. For example, the policy of “quantitative easing” (a euphemism for printing a large amount of money) is one of the reasons behind the recent decline of the value of the US dollar. In short, the exchange rate is very sensitive to changes in monetary policy.

7-1d Productivity and Balance of Payments In international trade, the rise of a country’s productivity, relative to other coun- tries, will improve its competitive position—this is the basic proposition of the the- ories of absolute and comparative advantage discussed in Chapter 5. More foreign direct investment (FDI) will be attracted to the country, fueling demand for its home currency. One recent example is China. All of the China-bound FDI inflows in dollars, euros, and pounds have to be converted to local currency, boosting the demand for the yuan and hence its value. Other examples are not hard to find. The rise in relative Japanese productivity over the past four decades led to a long- run appreciation of the yen, which rose from about ¥310 5 $1 in 1975 to ¥81 5 $1 in 2012.

Recall from Chapter 5 that changes in productivity will change a country’s balance of trade. A country highly productive in manufacturing may generate a merchandise trade surplus, whereas a country less productive in manufactur- ing may end up with a merchandise trade deficit. These have ramifications for the balance of payments—officially known as a country’s international transac- tion statement, including merchandise (goods) trade, service trade, and capital movement. Table 7.2 shows that the United States had a merchandise trade deficit of $738 billion and a service trade surplus of $179 billion in 2011. In addition to merchandise and service trade, we add receipts on US assets abroad (such as repatriated earnings from US multinational enterprises [MNEs] in Ireland and dividends paid by Japanese firms to American shareholders), subtract payments on US-based foreign assets (such as repatriated earnings from Canadian MNEs in the United States to Canada and dividends paid by US firms to Dutch shareholders),

Balance of payments

A country’s international transac- tion statement, which includes merchandise trade, service trade, and capital movement.

Chapter 7 Dealing with Foreign Exchange 211

and government grants and private remittances (such as US foreign aid thrown at Iraq and the money that Mexican farm hands in America sent home). After doing all of the math, we can see that the United States ran a $464 billion current ac- count deficit. Technically, the current account balance consists of exports minus imports of merchandise and services, plus income on US assets abroad, minus pay- ments on foreign assets in the United States, plus unilateral government transfers and private remittances.

A current account deficit has to be financed by financial account—consisting of purchases and sales of assets. This is because a country needs to balance its ac- counts in much the same way that a family arranges its finances. Any deficit in a family budget has to be financed by spending from savings or by borrowing.4 In a similar fashion, the overall US deficit of $122 billion was financed by spending from savings and borrowing (selling US government securities such as Treasury bonds).

To make a long story short, a country experiencing a current account surplus will see its currency appreciate; conversely, a country experiencing a current ac- count deficit will see its currency depreciate. This may not happen overnight, but it will happen in a span of years and decades. The current movement between the yuan (appreciating) and the dollar (depreciating) is but one example. Going back to the 1950s and the 1960s, the rise of the dollar was accompanied by a sizeable US surplus on merchandise trade. By the 1970s and the 1980s, the surplus gradually turned into a deficit. By the 1990s and the 2000s, the US current account deficit be- came ever increasing, forcing the dollar to depreciate relative to other currencies

Table 7.2 The US Balance of Payments (Billion Dollars)

I. Current Account

1. Exports of goods (merchandise) 1,497

2. Imports of goods (merchandise) 22,235

3. Balance on goods (merchandise trade—lines 1 1 2) 2738

4. Exports of services 608

5. Imports of services 2429

6. Balance on services (service trade—lines 4 1 5) 179

7. Balance on goods and services (trade deficit/surplus—lines 3 1 6) 2559

8. Income receipts on US-owned assets abroad 733

9. Income payments on foreign-owned assets in the US 2503

10. Government grants and private remittances 2135

11. Balance on current account (current account deficit/surplus—lines 7 1 8 1 9 1 10) 2464

II. Financial Account

12. US-owned private assets abroad (increase/financial outflow 5 2 [negative sign]) 2396

13. Foreign-owned private assets in the US 738

14. Balance on financial account (lines 12 1 13) 342

15. Overall balance of payments (Official reserve transactions balance—lines 11 1 14) 2122

Source: This is a simplified table adapted from US Department of Commerce, Bureau of Economic Analysis, 2012, US International Transactions: Fourth Quarter and Year 2011, Table 1, March 14, Washington: BEA (www.bea.gov [accessed April 10, 2012]). This table refers to 2011. Numbers may not add due to rounding.

212 Part Two Acquiring Tools

in developed economies such as the euro, the Canadian dollar, the Australian dollar (see the Opening Case), and the Swiss franc (see the Closing Case) as well as currencies in emerging economies such as the yuan and the real (see Emerging Markets 7.1). Broadly speaking, the value of a country’s currency is an embodiment of its economic strengths, as reflected in its productivity and balance-of-payments

Having quickly shaken off the world recession, many countries in Latin America are prospering again. The region’s economies grew by an average of 6% in 2010, according to a preliminary estimate by the United Na- tions Economic Commission for Latin America and the Caribbean. This strong performance, linked in large part to the global commodity boom, has attracted big inflows of foreign cash. With that has come a familiar problem: the region’s currencies have soared in value against the dollar, making life uncomfortable for Latin American manufacturers. They find themselves priced out of export markets or struggling to compete with cheap imports. Worried governments are launching a battery of measures to try to restrain the value of their currencies. Will they work?

In January 2011 alone, Chile announced it would buy $12 billion of foreign reserves in the year and Brazil began requiring its banks to cover 60% of their bets against the dollar with deposits at the Central Bank that will attract no interest. Peru is buying dollars, too, and similarly ex- tended reserve requirements for banks’ sales of foreign exchange. Central banks in Mexico and Colombia are in- tervening to buy dollars. Chile’s announcement prompted an immediate fall in the peso, and other currencies have temporarily stabilized, but there is no guarantee that these measures will be effective in the immediate term.

In part, stronger currencies reflect Latin America’s stronger economies. The commodity boom plays to the region’s comparative advantage: China and India are gobbling up Brazilian soybeans and iron ore, Chil- ean copper, and Peruvian silver. Brazil and Colombia have both made big oil discoveries. These countries

all have fairly sound economic policies, and their finan- cial systems are deepening. With money cheap and returns too poor in the rich world, Latin America has become a tempting destination for investors. Guido Mantega, Brazil’s finance minister, has blamed the Brazilian real’s strength and his country’s rising import bill both on loose monetary policy in the United States and China’s refusal to allow the yuan to appreciate.

But this is becoming too much of a good thing. The real has appreciated by 38% against the dollar over the past two years (2009–2010), for example. Overall, Latin America posted a current-account sur- plus of 1.6% of GDP in 2006; in 2011 it is likely to post a deficit of similar magnitude, according to the IMF. There are other signs of overheating: inflation for non-tradable products in Chile is 6.4%, and Brazilian wages are increasing at double-digit rates.

Affected businesses are howling. Chile’s wineries need an exchange rate of 530 pesos to the dollar (at the start of January 2011 it was at 464) to be profitable, according to René Merino, who represents the indus- try. In Brazil, São Paulo’s industrialists’ association claims that “excessive imports” of consumer goods have led to a “dizzying process of deindustrialization,” costing 46,000 manufacturing jobs and $10 billion in lost output in the first nine months of 2010.

Uncomfortably strong currencies and overheating economies pose an excruciating dilemma for policy- makers. If central bankers raise interest rates to curb inflation, they risk driving up the currency further. But if their interventions in the foreign exchange market drive the currency down, they may boost inflation.

Strong Economies and Strong Currencies in Latin America

E m E r g i n g m a r k E t s 7 . 1

Ethical Dilemma

Source: Excerpted from Economist, 2011, Waging the currency war, January 13, www.economist.com. © The Economist Newspaper Limited. Repro- duced by permission.

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Chapter 7 Dealing with Foreign Exchange 213

positions. Overall, the recent pressure for the US dollar to depreciate is indicative of the relative (not absolute) decline of the US economic strengths, compared with its major trading partners.

7-1e Exchange Rate Policies There are two major exchange rate policies: (1) floating rate and (2) fixed rate. Governments adopting the floating (or flexible) exchange rate policy tend to be free market believers, willing to let the demand-and-supply conditions determine exchange rates—usually on a daily basis via the foreign exchange market. However, few countries adopt a clean (or free) float, which would be a pure market solution. Most countries practice a dirty (or managed) float, with selective government in- terventions. Of the major currencies, the US, Canadian, and Australian dollars, the yen, and the pound have been under managed float since the 1970s (after the collapse of the Bretton Woods system—see next section). Since the 1990s, several emerging economies, such as Brazil, Mexico, and South Korea, have also joined the managed float regime. Despite complaints from the US government, China currently does not fix its currency. Since 2005, China has been allowing the yuan to float—specifically to appreciate by 24% (from 8.3 yuan to the dollar in 2005 to 6.3 yuan to the dollar in 2012).

The severity of intervention is a matter of degree. Heavier intervention moves the country closer to a fixed exchange rate policy, and less intervention enables a country to approach the free float ideal. One main objective for intervention is to prevent the emergence of erratic fluctuations that may trigger macroeconomic turbulence.5 Some countries do not adhere to any particular rates. Others choose target exchange rates—known as crawling bands or, more vividly, “snake in a tube” (intervention will only occur when the “snake” craws out of a tube’s upper or lower bounds).

Another major exchange rate policy is the fixed rate policy—countries fix the exchange rate of their currencies relative to other currencies. Both political and economic rationales may be at play. During the German reunification in 1990, the West German government, for political considerations, fixed the exchange rate between West and East German mark as 1:1. In economic terms, the East German mark was not worth that much. Politically, this exchange rate reduced the feel- ing of alienation and resentment among East Germans, thus facilitating a more smooth unification process. Of course, West Germans ended up paying more for the costs of unification. Economically, many developing countries peg their cur- rencies to a key currency (often the US dollar). There are two benefits of a peg policy. First, a peg stabilizes the import and export prices for developing countries. Second, many countries with high inflation have pegged their currencies to the dollar in order to restrain domestic inflation. (See Debates and Extensions for more discussion.)

7-1f Investor Psychology While theories on price differences (PPP), interest rates and money supply, balance of payments, and exchange rate policies predict long-run movements of exchange rates, they often fall short of predicting short-run movements. It is investor psychol- ogy, some of which is fickle and thus very hard to predict, that largely determines short-run movements. Professor Richard Lyons at the University of California,

Floating (flexible) exchange rate policy

A government policy to let supply-and-demand conditions determine exchange rates.

Clean (free) float

A pure market solution to determine exchange rates.

Dirty (managed) float

Using selective government intervention to determine exchange rates.

Target exchange rate (crawling band)

Specified upper or lower bounds within which an exchange rate is allowed to fluctuate.

Fixed exchange rate policy

A government policy to set the exchange rate of a currency relative to other currencies.

Peg

A stabilizing policy of linking a developing country’s currency to a key currency.

214 Part Two Acquiring Tools

Berkeley, is an expert on exchange rate theories. However, he was baffled when he was invited by a friend, a currency trader, to observe currency trading firsthand:

As I sat there, my friend traded furiously all day long, racking up over $1 billion in trades each day. This was a world where the standard trade was $10 million, and a $1 million trade was a “skinny one.” Despite my belief that exchange rates depend on macroeconomics, only rarely was news of this type his primary concern. Most of the time he was reading tea leaves that were, at least to me, not so clear. . . . It was clear my understanding was incomplete when he looked over, in the midst of his fury, and asked me: “What should I do?” I laughed. Nervously.6

Investors—currency traders (such as the one Lyons observed), foreign portfolio investors, and average citizens—may move as a “herd” at the same time in the same direction, resulting in a bandwagon effect. The bandwagon effect seemed to be at play in 2008, when the Icelandic krona lost more than half of its value against key cur- rencies such as the US dollar, the euro, and the pound sterling.7 Essentially, a large number of individuals and firms exchanged the krona for the key foreign currencies in order to minimize their exposure to Iceland’s financial crisis—a phenomenon known as capital flight. This would push down the demand for, and thus the value of, the domestic currency. Then, more individuals and companies joined the “herd,” further depressing the exchange rate and worsening a major economic crisis.

Overall, economics, politics, and psychology are all at play. The stakes are high, yet consensus is rare regarding the determinants of foreign exchange rates. As a result, predicting the direction of currency movements remains an art or, at best, a highly imprecise science.

7-2 Evolution of the International Monetary System Having outlined the basic determinants of exchange rates, let us undertake a his- toric excursion to trace the three eras of the evolution of the international mon- etary system: (1) the gold standard, (2) the Bretton Woods system, and (3) the post-Bretton Woods system.

7-2a The Gold Standard (1870–1914) The gold standard was a system in place between 1870 and 1914, when the value of most major currencies was maintained by fixing their prices in terms of gold. Gold was used as the common denominator for all currencies. This was essentially a global peg system, with little volatility and every bit of predictability and stabil- ity. To be able to redeem its currency in gold at a fixed price, every central bank needed to maintain gold reserves. The system provided powerful incentives for countries to run current account surpluses, resulting in net inflows of gold.

7-2b The Bretton Woods System (1944–1973) The gold standard was abandoned first in 1914 when World War I broke out. Sev- eral combatant countries printed excessive amounts of currency to finance their war efforts. After the war, especially during the Great Depression (1929–1933), countries engaged in competitive devaluations in an effort to boost exports at the expense of trading partners. But no country could win such a “race to the bottom,” and the gold standard had to be jettisoned.

Bandwagon effect

The effect of investors moving in the same direction at the same time, like a herd.

Capital flight

A phenomenon in which a large number of individuals and com- panies exchange domestic cur- rency for a foreign currency.

Gold standard

A system in which the value of most major currencies was maintained by fixing their prices in terms of gold.

Common denominator

A currency or commodity to which the value of all currencies are pegged.

Learning Objective Track the evolution of the international monetary system.

7-2

Chapter 7 Dealing with Foreign Exchange 215

Toward the end of World War II, at an allied conference in Bretton Woods, New Hampshire, a new system—known simply as the Bretton Woods system—was agreed upon by 44 countries. The Bretton Woods system was centered on the US dollar as the new common denominator. All currencies were pegged at a fixed rate to the dollar. Only the dollar, as the official reserve currency, was convertible into gold at $35 per ounce. Other currencies were not required to be gold convertible.

It was the Bretton Woods system that propelled the dollar to the commanding heights of the global economy (see Figure 7.1). This was also a reflection of the higher US productivity level and the large US trade surplus with the rest of the world in the first two postwar decades. This was not surprising, because the US economy contributed to approximately 70% of the global GDP at the end of World War II and was the export engine of the world.

7-2c The Post–Bretton Woods System (1973–present) By the late 1960s and early 1970s, a combination of rising productivity elsewhere and US inflationary policies led to the demise of Bretton Woods. First, (West) Germany and other countries caught up in productivity and exported more, and the United States ran its first post-1945 trade deficit in 1971. This pushed the (West) German mark to appreciate and the dollar to depreciate—a situation very similar to the yen-dollar relationship in the 1980s and the yuan-dollar relationship in the 2000s. Second, in the 1960s, in order to finance both the Vietnam War and Great Society welfare programs, President Lyndon Johnson increased government spending not by additional taxation but by increasing money supply. These actions led to rising inflation levels and strong pressures for the dollar to depreciate.

As currency traders bought more German marks, Germany’s central bank, the Bundesbank, had to buy billions of dollars in order to maintain the dollar/mark exchange rate fixed by Bretton Woods. Being stuck with massive amounts of the dollar that was worth less now, Germany unilaterally allowed its currency to float in May 1971.

The Bretton Woods system also became a pain in the neck for the United States, because the exchange rate of the dollar was not allowed to change unilaterally. Per Bretton Woods agreements, the US Treasury was obligated to dispense one ounce of gold for every $35 brought by a foreign central bank such as the Bundesbank. Consequently, there was a hemorrhage of US gold flowing into the coffers of for- eign central banks. In August 1971, in order to stop such hemorrhaging, President Richard Nixon unilaterally announced that the dollar was no longer convertible into gold. After tense negotiations, major countries collectively agreed to hammer the coffin nails of the Bretton Woods system by allowing their currencies to float in 1973. In retrospect, the Bretton Woods system had been built on two condi- tions: (1) the US inflation rate had to be low and (2) the US could not run a trade deficit. When both of these conditions were violated, the demise of the system was inevitable.

As a result, today we live in the post–Bretton Woods system. The strengths lie in its flexibility and diversity of exchange rate regimes (ranging from various schemes of floating systems to various ways of fixed rates). Its drawback is turbulence and un- certainty (see the Opening and Closing Cases and Emerging Markets 7.1 and 7.2). Since the 1970s, the US dollar is no longer the official reserve currency. However, it has retained a significant amount of “soft power” as a key currency (see Figure 7.1).

Bretton Woods system

A system in which all currencies were pegged at a fixed rate to the US dollar.

Post–Bretton Woods system

A system of flexible exchange rate regimes with no official common denominator.

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7-2d The International Monetary Fund (IMF) Although the Bretton Woods system is no longer with us, one of its most enduring legacies is the International Monetary Fund (IMF), founded in 1944 as a “Bretton Woods institution.” (The World Bank is the other Bretton Woods institution.) The IMF’s mandate is to promote international monetary co- operation, exchange stability, and orderly exchange arrangements.

Lending is a core responsibility of the IMF, which provides loans to countries suffering from balance- of-payments problems. The IMF can be viewed as a lender of last resort to help member countries out of financial difficulty. Where does the IMF get its funds?

The answer boils down to the same principle on where insurance companies get their funds to pay for insurance coverage. For the same reason that insurance com- panies obtain their funds from insurance subscribers who pay a premium, the IMF collects funds from member countries. Each member country is assigned a quota, which determines its financial contribution to the IMF, its capacity to borrow from the IMF, and its voting power.

By definition, the IMF’s lending refers to loans, not free grants. IMF loans have to be repaid in one to five years. Although payments have been extended in some cases, no member country has defaulted. An ideal IMF loan scenario would be a balance-of-payments crisis that threatens to severely disrupt a country’s fi- nancial stability, such as when it imports more than it exports and cannot pay for imports.

While an IMF loan provides short-term financial resources, it also comes with strings attached. These strings are long-term policy reforms that recipient coun- tries must undertake as conditions of receiving the loan. These conditions usually entail belt-tightening, pushing governments to embark on reforms that they other- wise probably would not have undertaken (Table 7.3). For example, when the IMF (together with the EU) provided a loan to Greece in 2010, the Greek government agreed to cut wages and pensions by 15% to 20% in order to pay for government debt. Since the 1990s, the IMF has helped Mexico (1994), Russia (1996 and 1998), Asia (Indonesia, South Korea, and Thailand, 1997), Turkey (2001), Brazil (2002), Iceland (2008), Ukraine (2008), Hungary (2008), Greece (2010), and several others. While the IMF has noble goals, its actions are not without criticisms (see In Focus 7.1).8

International Monetary Fund (IMF)

An international organization that was established to promote international monetary coopera- tion, exchange stability, and or- derly exchange arrangements.

Quota

The weight a member country carries within the IMF, which determines the amount of its financial contribution (technically known as its “subscription”), its capacity to borrow from the IMF, and its voting power.

Table 7.3 Typical IMF Conditions on Loan Recipient Countries: From IMF 1.0 to IMF 2.0

IMF 1.0 IMF 2.0

Balance budget by slashing government spending (often cutting social welfare)

Expand fiscal spending by stimulating more economic activity

Raise interest rates to slow monetary growth and inflation

Ease money supply, and reduce interest rates to combat deflation and recession

Can you think of any reason why some people object to the IMF’s actions in various countries?

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Chapter 7 Dealing with Foreign Exchange 217

The complexity of the IMF’s actions means that it cannot please everyone. First, the IMF’s critics ar- gue that the IMF’s lending may facilitate more prob- lems because of moral hazard. Moral hazard refers to recklessness when people and organizations (includ- ing governments) do not have to face the full conse- quences of their actions. Moral hazard is inherent in all insurance arrangements, including the IMF. Basi- cally, knowing that the IMF would come to the rescue, certain governments may behave more recklessly. For example, between 1958 and 2001, Turkey was res- cued by 18 (!) IMF loans.

A second criticism centers on the IMF’s lack of accountability. Although the IMF can dictate terms over a host country that is being rescued and receiv- ing loans, none of the IMF officials is democratically elected, and most of them do not have any deep knowledge of the host country. Consequently, they sometimes make disastrous decisions. For example, in 1997–1998, the IMF forced the Indonesian gov- ernment to cut back drastically on food subsidies for the poor. Riots soon exploded. Hundreds of people were killed, and property was damaged. Then, the IMF reversed its position by restoring food subsidies. However, in some quarters, the bitterness was all the greater. A lot of protesters argued: If food subsidies could have been continued, why were they taken away in the first place?

A third and perhaps most challenging criticism is that the IMF’s “one-size-fits-all” strategy may be inappropriate. Since the 1930s, in order to maintain more employment, most Western governments have abandoned the idea to balance the budget. Deficit spending has been used as a major policy weapon to pull a country out of an economic crisis. Yet, the IMF often demands governments in more vulner- able developing countries, in the midst of a major crisis, to balance their budgets by slashing spending (such as cutting food subsidies). These actions often make the crisis far worse than it needs to be. After the IMF came to “rescue” countries affected by the 1997 Asian financial crisis, unemployment rate was

up threefold in Thailand, fourfold in South Korea, and tenfold in Indonesia. Many scholars are surprised that the IMF would pursue its agenda in the absence of conclusive research and with the knowledge of re- peated failures.

After a period of relative inactivity in the early 2000s, the IMF went back to action again, starting in late 2008, rescuing ten countries, mostly in emerg- ing Europe (Georgia, Hungary, Ukraine, Latvia, Serbia, Belarus, Armenia, and Romania), in five months. Shown in Table 7.3, balancing budgets and raising interest rates were the IMF’s standard weapons of choice that it would impose on loan-recipient coun- tries. In most emerging European countries, the IMF has still prescribed such bitter “medicines.”

However, the momentum of the criticisms, the severity of the global crisis, and the desire to better serve the international community have facilitated a series of IMF reforms since 2009. Some of these re- forms represent a total, 180-degree change from its previous direction, resulting in what Time dubbed an “IMF 2.0.” For example, the IMF now starts to pro- mote more fiscal spending in order to stimulate the economy and to ease money supply and reduce in- terest rates, given the primary concern for the global economy now is deflation and recession, but not infla- tion. Obviously, the IMF’s change of heart is affected by the tremendous stimulus packages unleashed by developed economies since 2008, which result in skyrocketing budget deficits. If the developed econo- mies can (hopefully) use greater fiscal spending and budget deficits to pull themselves out of the crisis, the IMF simply cannot lecture developing economies that receive its loans to balance their budgets in the middle of a crisis. Further, given the stigma of receiv- ing IMF loans and listening to and then implementing IMF lectures, many countries avoid the IMF until they run out of options. In response, in April 2009, the IMF unleashed a new Flexible Credit Line (FCL), which is particularly useful for crisis prevention by providing the flexibility to draw on it at any time, with no strings attached—a radical contrast to the requirement to be

IMF 2.0? IN FoCus 7.1 Ethical

Dilemma

218 Part Two Acquiring Tools

7-3 Strategic Responses to Foreign Exchange Movements From an institution-based view, knowledge about foreign exchange rates and the international monetary system (including the role of the IMF) helps paint a broad picture of the “rules of the game” that govern financial transactions around the world.9 Armed with this knowledge, savvy managers need to develop firm-specific resources and capabilities to rise to the challenge—or at least to prevent their firms from being crushed by unfavorable currency movements. This section out- lines the strategic responses of two types of firms: financial and non-financial companies.

7-3a Strategies for Financial Companies One of the leading strategic goals for financial companies is to profit from the for- eign exchange market. The foreign exchange market is a market where individuals, firms, governments, and banks buy and sell foreign currencies. Unlike a stock ex- change, the foreign exchange market has no central, physical location. This market is truly global and transparent. Buyers and sellers are geographically dispersed but constantly linked (quoted prices change as often as 20 times a minute).10 The market opens on Monday first in Tokyo and then Hong Kong and Singapore, when it is still Sunday evening in New York. Gradually, Frankfurt, Zurich, London, New York, Chicago, and San Francisco wake up and come online.

Operating on a 24/7 basis, the foreign exchange market is the largest and most active market in the world. On average, the worldwide volume exceeds $2 trillion per day. To put this mind-boggling number in perspective, the amount of one single day of foreign exchange transactions roughly doubles the amount of entire worldwide FDI outflows in one year and roughly equals close to one-eighth of

Learning Objective Identify firms’ strategic responses to deal with foreign exchange movements.

7-3

Foreign exchange market

The market where individuals, firms, governments, and banks buy and sell foreign currencies.

in compliance with IMF-imposed targets as in tradi- tional IMF loans. Mexico, Colombia, and Poland have used the FCL so far.

Further, the IMF 2.0 has become three times bigger—leaders in the G20 Summit in London in 2009 agreed to enhance the IMF’s funding from $250 billion to $750 billion. Of the $500 billion in new funding (tech- nically Special Drawing Rights [SDRs]), the US, the EU, and Japan are each expected to contribute $100 billion. China has signed up for $40 billion. Further, injection of substantial funding from emerging economies has led the finance ministers of Brazil, Russia, India, and China (BRIC), who met in 2009, to call for better rep- resentation of these countries. However, enhancing voting rights for emerging economies would result in

reduced shares for developed economies. Even with the IMF’s new proposed change to vote shares, Brazil, with 1.72% of the votes (up from the current 1.38%), will still carry less weight than Belgium (with 1.86%, down from the current 2.09%). Such points of con- tention continue to rage throughout IMF discussions. Therefore, IMF reforms will be a long-term undertak- ing that will not stop any time soon.

Sources: Based on (1) Economist, 2009, A good war, September 19: 83–84; (2) Economist, 2009, Mission possible, April 11: 69–71; (3) Econ- omist, 2009, New fund, old fundamentals, May 2: 78; (4) Economist, 2010, Beyond Bretton Woods 2, November 6: 85–87; (5) A. Ghosh, M. Chamon, C. Crowe, J. Kim, & J. Ostry, 2009, Coping with the crisis: Policy options for emerging market countries, IMF staff position paper, Washington: IMF; (6) R. Rajan, 2008, The future of the IMF and the World Bank, American Economic Review, 98: 110–115; (7) J. Stiglitz, 2002, Globalization and Its Discontents, New York: Norton; (8) Time, 2009, International Monetary Fund 2.0, April 20.

IN FoCus 7.1 (continued)

Chapter 7 Dealing with Foreign Exchange 219

worldwide merchandise exports in one year. Specifically, the foreign exchange market has two functions: (1) to service the needs of trade and FDI and (2) to trade in its own commodity—namely, foreign exchange.

There are three primary types of foreign exchange transactions: (1) spot trans- actions, (2) forward transactions, and (3) swaps. Spot transactions are the classic single-shot exchange of one currency for another. For example, Canadian tourists buying several thousand euros in Italy with Canadian dollars will get their euros from a bank right away.

Forward transactions allow participants to buy and sell currencies now for future delivery, typically in 30, 90, or 180 days, after the date of the transaction. The primary benefit of forward transactions is to protect traders and investors from being exposed to the fluctuations of the spot rate, an act known as currency hedging. Currency hedging is essentially a way to minimize the foreign exchange risk inherent in all non-spot transactions, which characterize most trade and FDI deals.11 Traders and investors expecting to make or receive payments in a foreign currency in the future are concerned whether they will have to make a greater payment or receive less in terms of the domestic currency, should the spot rate change. For example, if the forward rate of the euro (€/US$) is exactly the same as the spot rate, the euro is “flat.” If the forward rate of the euro per dollar is higher than the spot rate, the euro has a forward discount. If the forward rate of the euro per dollar is lower than the spot rate, the euro then has a forward premium.

Hypothetically, assume that (1) today’s exchange rate of €/US$ is 1, (2) a US firm expects to be paid €1 million six months later, and (3) the euro is at a 180-day forward discount of 1.1. The US firm may take out a forward contract now and convert euro earnings into a dollar revenue of $909,091 (€1 million/1.1) after six months. Does such a move make sense? There can be two answers. “Yes,” if the firm knew in advance that the future spot rate would be 1.25. With the forward contract, the US firm would make $909,091 instead of $800,000 (€1 million/1.25)—the dif- ference is $109,091 (14% of $800,000). However, the answer would be “No” if the spot rate after six months were actually below 1.1. If the spot rate had remained at 1, the firm could have earned $1 million, without the forward contract, instead of only $909,091. This simple example suggests a powerful observation: Currency hedging requires firms to have expectations or forecasts of future spot rates relative to forward rates.

A third major type of foreign exchange transactions is swap. A currency swap is the conversion of one currency into another in Time 1, with an agreement to revert it back to the original currency at a specific Time 2 in the future. Deutsche Bank may have an excess balance of pounds but needs dollars. At the same time, Union Bank of Switzerland (UBS) may have more dollars than it needs at the moment, but it is looking for more pounds. They can negotiate a swap agreement in which Deutsche Bank agrees to exchange with UBS pounds for dollars today and dollars for pounds at a specific point in the future.

The primary participants of the foreign exchange market are large inter- national banks such as Citigroup, Deutsche Bank, and UBS that trade among them- selves. How do these banks make money by trading money? They make money by capturing the difference between their offer rate (the price to sell) and bid rate (the price to buy)—the bid rate is always lower than the offer rate. The dif- ference of this “buy low, sell high” strategy is technically called the spread. For example, Citigroup may quote offer and bid rates for the Swiss franc at $1.0877

spot transaction

The classic single-shot exchange of one currency for another.

Forward transaction

A foreign exchange transaction in which participants buy and sell currencies now for future delivery.

Currency hedging

A transaction that protects traders and investors from exposure to the fluctuations of the spot rate.

Forward discount

A condition under which the forward rate of one currency relative to another currency is higher than the spot rate.

Forward premium

A condition under which the forward rate of one currency relative to another currency is lower than the spot rate.

Currency swap

A foreign exchange transaction between two firms in which one currency is converted into anoth- er at Time 1, with an agreement to revert it back to the original currency at a specified Time 2 in the future.

offer rate

The price to sell a currency.

Bid rate

The price to buy a currency.

spread

The difference between the offer price and the bid price.

220 Part Two Acquiring Tools

and $1.0874, respectively, and the spread is $0.0003. That is, Citigroup is willing to sell 1 million francs for $1,087,700 and to buy 1 million francs for $1,087,400. If Citigroup can simultaneously buy and sell 1 million francs, it can make $300 (the spread of $0.0003 3 1 million francs). Given the instantaneous and trans- parent nature of the electronically linked foreign exchange market around the globe (one new quote in London can reach New York before you finish reading this sentence), the opportunities for trading, or arbitrage, can come and go very quickly. The globally integrated nature of this market leads to three outcomes:

Razor-thin spread. Quick (often literally split-second) decisions on buying and selling (remem-

ber Lyon’s observation earlier). Ever-increasing volume in order to make more profits (recall the daily volume

of $2 trillion). In the example above, $300 is obviously just a few “peanuts” for Citigroup. Do a little math: How much trading in Swiss francs does Citigroup have to do in order to make $1 million profits for itself?

7-3b Strategies for Non-Financial Companies How do non-financial companies cope with the fluctuations of the foreign ex- change market—broadly known as currency risks? There are two primary strat- egies: (1) currency hedging (as discussed earlier) and (2) strategic hedging.12 Currency hedging is risky in case of wrong bets of currency movements. For ex- ample, most airlines in the world engage in currency hedging to manage fuel cost fluctuations, and most suffered losses in 2008. In July 2008, oil price was at a record high, $147 per barrel. Some airlines entered 180-day forward transac- tions with foreign exchange traders at, say, $100 per barrel. This looked like a fantastic deal, representing 32% savings. However, by early 2009, oil was trading at only $41 per barrel. But some airlines were bound by the contract to purchase oil at $100 per barrel; they were thus paying 144% (!) more than they needed to for their fuel.

Strategic hedging means spreading out activities in different currency zones in order to offset the currency losses in certain regions through gains in other regions.13 Therefore, strategic hedging can be considered as currency diversifica- tion. It reduces exposure to unfavorable foreign exchange movements. Strategic hedging is conceptually different from currency hedging. Currency hedging fo- cuses on using forward contracts and swaps to contain currency risks, a financial management activity that can be performed by in-house financial specialists or out- side experts (such as currency traders). Strategic hedging refers to geographically dispersing operations—through sourcing or FDI—in multiple currency zones. By definition, this is more strategic, involving managers from many functional areas (such as production, marketing, and sourcing) in addition to those from finance.

Overall, the importance of foreign exchange management cannot be overem- phasized for firms of all stripes interested in doing business abroad. Firms whose performance is otherwise stellar can be devastated by unfavorable currency move- ments. For example, the Brazilian real appreciated by 38% against the dollar be- tween 2009 and 2010. Brazilian manufacturers thus had a hard time competing with cheap imports (see Emerging Markets 7.1). On the other hand, thanks to crises in countries such as Greece, Ireland, and Portugal, the euro depreciated

Currency risk

The potential for loss associated with fluctuations in the foreign exchange market.

strategic hedging

Spreading out activities in a number of countries in different currency zones to offset any currency losses in one region through gains in other regions.

Chapter 7 Dealing with Foreign Exchange 221

sharply against the dollar and the Swiss franc during the same period. While euro zone exporters such as Daimler-Benz (maker of Mercedes cars) and EADS (manu- facturer of Airbus jets) could not be happier, Swiss exporters struggled (see the Closing Case).

From a resource-based view, it seems imperative that firms develop resources and capabilities that can combat currency risks, in addition to striving for excel- lence in, for example, operations and marketing.14 Developing such expertise is no small accomplishment, because, as noted earlier, prediction of currency move- ments remains an art or a highly imprecise science. Precisely because of such chal- lenges, firms able to profit from (or at least avoid being crushed by) unfavorable currency movements will possess some valuable, rare, and hard-to-imitate capabili- ties that are the envy of rivals.

7-4 Debates and Extensions In the highly uncertain world of foreign exchange movements, stakes are high, yet consensus is rare, and debates are numerous. We review three major debates here: (1) fixed versus floating exchange rates, (2) a strong dollar versus a weak dollar, and (3) hedging versus not hedging.

7-4a Fixed versus Floating Exchange Rates15 Since the collapse of the Bretton Woods system in the early 1970s, debate has never ended on whether fixed or floating exchange rates are better.16 Proponents of fixed exchange rates argue that fixed exchange rates impose monetary discipline by pre- venting governments from engaging in inflationary monetary policies (essentially, printing more money). Proponents also suggest that fixed exchange rates reduce uncertainty and thus encourage trade and FDI, not only benefiting the particular economy but also helping the global economy.

Proponents of floating exchange rates believe that market forces should take care of supply, demand, and, thus, price of any currency. Floating exchange rates may avoid large balance-of-payments deficits, surprises, and even crises. In other words, flexible exchange rates may help avoid the crises that occur under fixed ex- change rates when expectations of an impending devaluation arise. For example, Thailand probably would not have been devastated so suddenly in July 1997 (gener- ally regarded as the triggering event for the 1997 Asian financial crisis) had it op- erated a floating exchange rate system. In addition, floating exchange rates allow each country to make its own monetary policy. One major problem associated with the Bretton Woods system was that other countries were not happy about pegging their currencies to that of the United States, which practiced inflationary monetary policies in the late 1960s.

There is no doubt that floating exchange rates are more volatile than fixed rates. Many countries have no stomach for such volatility. The most extreme fixed rate policy is through a currency board, which is a monetary authority that issues notes and coins convertible into a key foreign currency at a fixed exchange rate. Usually, the fixed exchange rate is set by law, making changes to the exchange rate politically very costly for governments. To honor its commitment, a currency board must back the domestic currency with 100% of equivalent foreign exchange.

Learning Objective Participate in three leading debates concerning foreign exchange movements.

7-4

Currency board

A monetary authority that issues notes and coins convertible into a key foreign currency at a fixed exchange rate.

222 Part Two Acquiring Tools

In the case of Hong Kong’s currency board, every HK$7.8 in circulation is backed by US$1. By design, a currency board is passive. When more US dollars flow in, the board issues more Hong Kong dollars and in- terest rates fall. When more US dollars flow out, the board reduces money supply and interest rates rise. The Hong Kong currency board has been jokingly de- scribed as an Asian outpost of the US Federal Reserve. This is technically accurate, because interest rates in Hong Kong are essentially determined by the US Fed- eral Reserve. While the Hong Kong currency board was a successful bulwark against speculative attacks on the Hong Kong dollar in 1997 and 1998, it has been dragged down by the weakening US dollar recently.17

7-4b A Strong Dollar versus a Weak Dollar In recent years, the debate on the value of the dollar is closely related to the debate on the value of the yuan.18 The value of the US dollar is a trillion-dollar question. At present, 65% of the world’s foreign exchange holdings are in dollars, while the US share of global GDP is only 24% (see Figure 7.1). The recent economic turmoil has intensified the global debate on the proper value of the dollar (see Table 7.4). In terms of international trade competitiveness, a strong dollar may make it harder for US firms to export and to compete on price when combating imports. Con- versely, a weak dollar may facilitate more US exports and stem import growth. Since the Plaza Accord of 1985, after which the dollar declined sharply against the Japanese yen, the United States has been pursuing a “cheap dollar” policy in order

Table 7.4 A Strong Dollar versus a Weak Dollar

Panel A. A Strong (Appreciating) Dollar

Advantages Disadvantages

US consumers benefit from low prices on imports.

Lower prices on foreign goods help keep US price level and inflation level low.

US tourists enjoy lower prices abroad.

US firms find it easier to acquire foreign targets.

US exporters have a hard time to compete on price abroad.

US firms in import-competing industries have a hard time competing with low-cost imports.

Foreign tourists find it more expensive when visiting the US.

Panel B. A Weak (Depreciating) Dollar

Advantages Disadvantages

US exporters find it easier to compete on price abroad.

US firms face less competitive pressure to keep prices low.

Foreign tourists enjoy lower prices in the US.

Foreign firms find it easier to acquire US targets.

The US can print more dollars to export its problems to the rest of the world.

US consumers face higher prices on imports.

Higher prices on imports contribute to higher price level and inflation level in the US.

US tourists find it more expensive when traveling abroad.

Governments, firms, and individuals outside the US holding dollar-denominated assets suffer from value loss of their assets.

How are you personally affected by fluctuations in currency exchange rates?

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to facilitate more exports and reduce trade deficits. Unfortunately, the policy has backfired. While US exports did rise (in 2011 US merchandise exports grew 16% compared with 2010), US trade deficits remained consistently high. In part, this was due to China’s (pre-2005) policy to peg its yuan to the dollar, which made the yuan cheap. Since 2005, the United States has been complaining that China has not let its currency appreciate enough.

After being burned by the most horrific economic recession that the world had seen since the Great Depression, a number of governments, firms, and experts around the world are arguing for the proper valuation of the dollar. In addition to debating what the “fair” value of the dollar is, a new voice is now calling for aban- doning the dollar as a de facto reserve currency. (Since the demise of the Bretton Woods system in the 1970s, the US dollar is no longer the official reserve cur- rency, but it has retained some characteristics of a reserve currency due to its “soft power.”) Leading this new global movement is China. China is America’s number- one creditor country and holds about $2.2 trillion in foreign exchange reserves, two-thirds of which are denominated in dollars. Since the yuan is not internation- ally accepted (technically non-convertible), China does not suggest that the yuan be used to replace the dollar. Instead, China has proposed to use Special Drawing Rights (SDRs), already created by the IMF, to replace the dollar as a global reserve currency. While this proposal is made in the name of promoting global stability, China is not totally altruistic. Since the US budget deficit has exploded and the US Federal Reserve has been printing a ton of new money to fund stimulus packages, China is deeply worried that a cheapening dollar will be a nasty hit to Chinese holdings of US Treasury bonds. There is some fundamental soul-searching among Beijing’s economic mandarins. Their policy of keeping the yuan low versus the dollar to promote exports and then to recycle export earnings to buy US Trea- sury bonds has backfired. Even the typically timid, state-controlled media in China are now full of criticisms of the Chinese government’s “irresponsible” investment policy, which ends up investing hard-earned dollars from a developing economy to subsidize a very rich economy. China’s proposal to dethrone the dollar as a domi- nant currency, although clearly a long shot, quickly garnered support from Russia and Brazil. In 2009, the United Nations Conference on Trade and Development issued a supportive opinion:

An economy whose currency is used as a reserve currency is not under the same obli- gation as others to make the necessary macroeconomic or exchange-rate adjustments for avoiding continuing current account deficits. Thus, the dominance of the dollar as the main means of international payments also played an important role in the build-up of the global imbalances in the run up to the financial crisis.

The United States, on the other hand, has every interest in keeping the dollar’s status quo as a (de facto) reserve currency around the world so that China and other surplus countries will keep buying Treasury bonds—for lack of a better al- ternative. While China has continued to buy new Treasury bonds, it has taken two concrete steps. First, in 2009 China arranged more than $120 billion in currency swaps with its trading partners such as Argentina, Belarus, Indonesia, Malaysia, and South Korea. The People’s Bank of China, the central bank, made yuan avail- able to pay for imports from these countries if they are short on dollars. Second, some Chinese exporters started to settle certain transactions in Hong Kong and in Africa with yuan (see Emerging Markets 7.2)—the first step for the yuan’s eventual international convertibility.

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7-4c Currency Hedging versus Not Hedging Given the unpredictable nature of foreign exchange rates, it seems natural that firms that deal with foreign transactions—both financial and non-financial types, both large and small firms—may want to engage in currency hedging. Firms that fail to hedge are at the mercy of the spot market.

Yet, surprisingly, many firms do not bother to engage in currency hedging. Some euro zone exporters simply insist on payment in euros, and some Chinese exporters have started to insist on payment in yuan (see Emerging Markets 7.2). Among the largest US firms, only approximately one-third hedge. The standard argument for currency hedging is increased stability of cash flows and earnings. In essence, currency hedging may be regarded as a form of insurance, whose cost may be outweighed by the protection it provides. However, many large firms, such as 3M, John Deere, and ExxonMobil, do not care about such insurance. Managers argue that currency hedging eats into profits. A simple forward contract may cost

In 2000, trade between China and Africa was only $10 billion. In 2010, the volume rocketed ahead to reach $127 billion. While China has become Africa’s number- one trading partner, the downside of such intense trading is the complication of having to deal with cur- rency fluctuation. The vast majority of the trade deals between China and Africa are conducted in US dollars, which have fluctuated substantially. Since the dollar is likely to depreciate and the yuan is likely to correspond- ingly appreciate further, Chinese exporters with costs in yuan and payments in dollars stand to lose. While currency hedging using forward contracts is an obvious coping strategy, many small exporters cannot afford the expenses. In addition, currency hedging is not risk- free. Wrong bets may end up burning firms big time.

To better cope with currency fluctuation, one straightforward mechanism for Chinese export- ers is to insist on payment in yuan. The question is: Why would African importers agree to pay in yuan? Two compelling reasons stand out. First, Chinese

exporters can save approximately 7% to 10% of their costs if they are paid in yuan. If they can share some of these gains with their African trading partners with lower prices, the new deal to use yuan as the common transaction currency becomes a win-win solution for both sides. Second, an increasing number of Chinese firms have engaged in foreign direct investment (FDI) in Africa. Their subsidiaries in Africa would be comfort- able to use yuan to buy supplies, components, and manufactured products from home. Johannesburg, South Africa-based Standard Bank, which is the larg- est bank in Africa, estimated that by 2015, 40% of the China-Africa trade (worth $100 billion) may be settled in yuan. This would significantly eliminate the head- ache of currency fluctuation for Chinese exporters. While this amount will represent less than 10% of China’s total exports and less than 1% of worldwide exports, it represents a small step of the yuan’s rising popularity as a major currency for international trade around the world.

Chinese Exporters Cope with Currency Fluctuation in Africa

E m E r g i n g m a r k E t s 7 . 2

Sources: Based on (1) 21st Century Business Insights, 2011, Renminbi is popular in Africa, September 16: 26; (2) G. Allard, 2012, Chinese OFDI in Africa, in I. Alon, M. Fetscherin, & P. Gugler (eds.), Chinese International Investments (pp. 279–299), New York: Palgrave; (3) www.standardbank.com.

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Chapter 7 Dealing with Foreign Exchange 225

up to half a percentage point per year of the revenue being hedged. More compli- cated transactions may cost more. As a result, many firms believe that the ups and downs of various currencies even out in the long run. Some, such as IBM, focus on strategic hedging (geographically dispersing activities) while refraining from currency hedging. Whether such a “no currency hedging” strategy outperforms a currency hedging strategy remains to be seen.

7-5 Management Savvy The big question in global business, adapted to the context of foreign exchange movements, is: What determines the success and failure of currency manage- ment around the globe? The answer boils down to two components. First, from an institution-based standpoint, the “rules of the game”—economic, political, and psychological—enable or constrain firms. Shown in the Closing Case, Swiss export- ers’ frustration with the appreciation of the Swiss franc relative to the euro stems from the centuries-old policy of Switzerland to maintain its political and economic independence. While all of Switzerland’s neighboring countries have joined the EU and adopted the euro, Switzerland will not. Se