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THE EFFECT OF FOREIGN FIRM
REFERENCE GROUPS ON POLITICAL
RISK
Charles E. Stevens
Lehigh University
Mona V. Makhija
The Ohio State University
JSIE 2014 – Tokyo, Japan
July 19, 2014
THE ISSUE OF POLITICAL RISK
 Political
risk = The negative impact of unexpected
host government actions on firms’ overseas
performance (Brewer, 1985; Miller, 1992)
 Government intervention takes different forms
 Contract renegotiation
 Policy changes affecting firm operations, profits
 Expropriation
 Performance & strategic implications
 Results in $25+ billion in lost profits per year
for
multinational enterprises (MNEs) (Henisz & Zelner, 2004)
 Creates additional business risk that is not easily
understood (Makhija, 1993)
2
CENTRAL QUESTIONS
 Why
does a host government intervene in
firms’ operations?
 When
does a host government intervene
in firms’ operations?
3
EXPLANATIONS IN THE LITERATURE
 The
bargaining power paradigm (e.g. Vernon, 1971)
Host governments will intervene when their bargaining
power is higher than that of foreign firm(s)
 Empirical approach in the lit: assess when BP of
government goes up or down relative to a foreign firm or
foreign firms in a given industry

 Institutional
strength explanation (e.g. Henisz, 2000)
When government checks and balances are weak,
government more likely to intervene into foreign firms
 Empirical approach: assess institutional strength of
country

4
PROBLEMS REMAIN


Bargaining power & institutional strength
overly-deterministic—the ability to intervene is a
necessary but not sufficient condition for
intervention (Minor, 1995; Stevens & Cooper,
2010)
Need more detailed insight into how government
actually makes decisions about foreign firm
intervention
5
RESEARCH QUESTION
 How
do governments make the decision
when to intervene?
6
INFORMATION-PROCESSING PERSPECTIVE
(MAKHIJA, 1993)



Governments have a set of objectives vis-à-vis foreign
firms operating in their country (Kobrin, 1980; Vernon, 1971)
Governments take into account information to decide
when to intervene
When they find out that their goals are not met, they
will intervene in a way that will address this problem
7
INFORMATION CONVEYED BY REFERENCE GROUPS
 Institutional
argument: MNEs’
activities are continually evaluated by
external stakeholders (Hybels, 1995; Kostova et al.,
2008; Eden & Lenway, 2001; Kostova & Zaheer, 1999)
 Reference
groups can provide
information to the government (Phillips &
Tracey, 2009; Suchman, 1995)


Suggests range of possible behaviors
Allow for judgments about the most
desirable activities
8
FOREIGN FIRMS’ REFERENCE GROUPS
Industry (I)
2
C2I1
3
C3I1
j
CjI1
2
3
…
i
…
C1Ii
…
CjIi
…
C1I1
…
1
…
Country (C)
1
(Focal) host industry reference group of foreign firms
Within-country reference group of foreign firms
Across-country reference group of foreign firms
9
FOREIGN FIRM ACTIVITIES’ IMPACT ON THE HOST
COUNTRY ECONOMY & INDUSTRY COMPETITIVENESS
 What
kinds of “activities” might governments
care about?
 Some
foreign firm activities are important to
the functioning of the overall national economy



Reduced unemployment
Balance of payments
National productivity
 Other
foreign firm activities impact the global
competitiveness of their host industry



Greater innovation
Human capital development
Capabilities that create greater economic rents
10
WHICH REFERENCE GROUP MATTERS SHOULD
DEPEND ON THE GOAL
 MNEs’
within-country reference group provides
a comparison point for how well they are
contributing to the national economy
 MNEs’
across-country reference group provides
a comparison point for how well they are
contributing to the local industry
 When
they don’t compare favorably, the
government is motivated to intervene, creating
political risk
11
CONCEPTUAL MODEL
Government concerns
Use of Reference Groups
Macroeconomic
issues
Comparison with
within-country
reference group
Decision relating
to policy change
Industry-specific
issues
Political Risk
Comparison with
across-country
reference group
12
MACROECONOMIC ISSUE #1: EMPLOYMENT
Higher levels of employment benefit the overall economy
many ways (Dunning, 1997; Gilpin & Gilpin, 1987), including:
 stimulating purchasing activities
 increasing tax revenues
 promoting social stability




Maximizing employment is one of the most basic
reasons why governments encourage inward FDI
These firms represent a source of employment that would not
have been created by local firms alone (Dunning, 1994)
Hypothesis 1a: The higher the employment level
of the foreign firms in a host industry above
their within-country reference group average,
the lower their political risk.
13
MACROECONOMIC ISSUE #2: BALANCE OF TRADE

Balance of trade is enhanced through greater exports




helps to bring in more foreign exchange
stabilizes the value of the national currency
reduces the likelihood of debt crises (Makhija, 1993; Vachani,
1995)
Foreign firms are often in a unique position to export
MNEs are the primary conduits through which global trade
is conducted (Eden & Lenway, 2001)
 MNEs have access to large and globally-spanning intrafirm and intra-industry markets that local firms might not
be able to reach (Dunning, 1994; Makhija, Kim &
Williamson, 1997; Rugman, 1981)


Hypothesis 1b: The higher the export intensity of
the foreign firms in a host industry above their
within-country reference group average, the
lower their political risk.
14
MACROECONOMIC ISSUE #3: FIXED CAPITAL



Investments in fixed capital increase a country’s
growth potential (Kaldor, 1961; Solow, 1962)
Foreign firms are in a unique position to increase
a country’s fixed capital investments because
their operating scale is often much larger than
that of local firms (Dunning, 1997; Eden & Lenway, 2001)
Hypothesis 1c: The higher the fixed capital
intensity of the foreign firms in a host
industry above their within-country
reference group average, the lower their
political risk.
15
INDUSTRY-SPECIFIC ISSUE #1: R&D INTENSITY

Industry competitiveness is driven by its ability to
innovate (Landes, 1998). Greater innovation capacity
results in:






new products
superior quality
better ability to succeed in new and varied markets
enhanced process technologies (Porter, 1990).
Technological competitiveness is necessary for any
industry, but the degree of technological intensity
necessary for competitive advantage is industryspecific.
Hypothesis 2a: The higher the R&D intensity of
the foreign firms in a host industry above their
across-country reference group average, the lower
their political risk.
16
INDUSTRY-SPECIFIC ISSUE #2: HUMAN
CAPITAL DEVELOPMENT



Superior human capital within an industry
increases its ability to innovate and obtain
superior performance (Dunning, 1997)
The training and skills required of human capital
varies significantly across industries according to
differences in managerial and technological
complexities (Porter, 1990)
Hypothesis 2b: The higher the wages of the
foreign firms in a host industry above their
across-country reference group average, the
lower their political risk.
17
INDUSTRY-SPECIFIC ISSUE #3: PROFITABILITY

The overall profitability of a local industry reflects
economic success. When an industry is more profitable:
the government gains more tax revenues
 it attracts re-investment from existing firms, entry of new
local or foreign entrants, and both upstream and
downstream demand in the value chain (Eden & Lenway, 2001)



The benchmark for economic success varies greatly
from industry to industry (Porter, 1980)
Hypothesis 2c: The higher the profitability of the
foreign firms in a host industry above their
across-country reference group average, the lower
their political risk.
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FOREIGN FIRM ACTIVITIES & SALIENT
REFERENCE GROUPS
Nature of
economic benefit
Examples
Salient reference point
Employment
Promotes social, economic, and political stability
Strengthening of the
national economy
Balance of trade
Results in favorable terms of trade, less likelihood of debt crisis
Within-country reference group
Fixed capital formation
Higher growth potential
R&D intensity
Ability to reach new markets, create new and better products
Building up of industry
competitiveness
Wage levels
Signals enhanced human capital, greater purchasing power
Across-country reference group
Profitability
Indicates successful deployment of intangible resources
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METHODS
 Sample:
U.S. multinationals’ majorityowned subsidiaries
 13
industries across 53 host countries
 Seven
years of data: 2000~2006
 Source:
Bureau of Economic Analysis (U.S.
Department of Commerce)

Has been used in several other political risk studies
(Click, 2005; Kobrin, 1980, 1987)
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COUNTRIES IN SAMPLE
Re gion
Africa & Middle East
Asia
Easte rn Europe
Country
Egypt
Israel
Nigeria
Saudi Arabia
South Africa
Turkey
GDP/capita
$1,273
$20,284
$803
$13,127
$5,169
$7,088
China
Hong Kong
India
Indonesia
Japan
Malaysia
Philippines
Singapore
South Korea
Thailand
$1,777
$26,105
$735
$1,258
$36,172
$5,499
$1,205
$29,402
$17,959
$2,828
Czech Republic
Greece
Hungary
Poland
Russia
$12,726
$21,468
$10,937
$7,963
$5,311
North & Ce ntral Ame rica Barbados
Canada
Costa Rica
Dominican Republic
Honduras
Mexico
Panama
$14,448
$35,119
$4,633
$3,609
$1,418
$7,946
$4,776
Re gion
Oce ania
Country
Australia
New Zealand
South Ame rica
Argentina
Brazil
Chile
Colombia
Ecuador
Peru
Venezuela
We ste rn Europe Austria
Belgium
Denmark
Finland
France
Germany
Ireland
Italy
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
United Kingdom
GDP/capita
$37,234
$27,530
$4,736
$4,743
$7,549
$3,405
$2,751
$2,881
$5,457
$37,048
$36,234
$47,546
$37,331
$34,002
$33,514
$48,761
$30,446
$82,370
$39,157
$65,767
$18,196
$26,058
$41,042
$51,889
$38,135
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MEASURES: DEPENDENT VARIABLE
DV measures industry-level political risk
 Extend methodology of Click (2005) to industry level


First model industry profitability:
Calculated the volatility of foreign firms’ profitability (ROA)
in a host industry
 Controlled for salient industry and country non-political
sources of country risk
 Remaining unexplained variance reflects political risk for
that industry

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MEASURES: INDEPENDENT
VARIABLES

Six foreign firm
activities






Employment
Export intensity
Fixed capital intensity
R&D intensity
Human capital
Profitability
• Within-country
reference group
comparison:
• Across-country
reference group
comparison:
23
MEASURES: CONTROL VARIABLES


Strength of political institutions: natural log of
World Bank’s “checks” index in the Database of
Political Institutions (Henisz, 2004)
Industry dummy variables
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POLITICAL RISK COUNTRY RANKINGS (UNWEIGHTED INDUSTRY AVERAGE)
1. Luxembourg
2. Denmark
3. Germany
4. UK
5. Canada
8. Japan
12. Mexico
30. India
34. China
51. Ecuador
52. Dominican Republic
53. South Africa
25
RANGE OF INDUSTRY-LEVEL RISK FOR
SELECTED COUNTRIES
Political risk
26
RESULTS
Independent Variables
Model 1
Model 2 (a)
Model 3 (b)
Constant
Institutional strength (ln)
-3.240***
-0.0949*
-3.197***
-0.092*
-3.328***
-0.080*
H1a Employment
H1b Export intensity
H1c Fixed capital intensity
R&D intensity
Wages
Profitability
-0.115*
-0.138*
-0.059***
-0.055
-0.030
-0.067
Employment
Export intensity
Fixed capital intensity
H2a R&D intensity
H2b Wages
H2c Profitability
-0.269***
0.042
0.001
-0.062*
-0.130**
-0.115*
Industry controls
included
included
included
R-Squared
F-value
Number of observations
0.2583
8.20
427
0.2996
8.12
427
0.3700
11.40
427
(a) = within-country reference group comparison
(b) = across-country reference group comparison
27
Robust standard errors are in parentheses
All tests are two-tailed: †p<0.10; *p<0.05; **p<0.01; ***p<0.001
IMPLICATIONS OF THE RESEARCH

Foreign firms’ reference groups appear to provide salient
information that influences a government’s motivation to intervene
Moves beyond traditional ‘closed dyad’ approach of political risk studies
 Informs debate between Kostova et al. (2008) and Phillips & Tracey
(2009) about the role of organizational fields in IB research on MNEs


The salient point of reference shifts depending on the nature of the
firms’ activity in question


Activities occurring in other countries can affect the risk faced by firms
in a focal country
A government’s ability to intervene has been the traditional focus of
political risk studies; we suggest a need to refocus on governments’
motivation to intervene in a complex, global economy
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