Foreign Direct Investment, Location and Competitiveness

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FOREIGN DIRECT INVESTMENT, LOCATION AND COMPETITIVENESS

PROGRESS IN INTERNATIONAL BUSINESS RESEARCH Series Editors: Ulf Andersson and Torben Pedersen Volume 1:

Progress in International Business Research – Edited by Gabriel R. G. Benito & Henrich R. Greve

PROGRESS IN INTERNATIONAL BUSINESS RESEARCH VOLUME 2

FOREIGN DIRECT INVESTMENT, LOCATION AND COMPETITIVENESS EDITED BY

JOHN H. DUNNING Rutgers University, USA and Reading University, UK

PHILIPPE GUGLER University of Fribourg, Switzerland and NCCR Trade Regulation, World Trade Institute, Berne, Switzerland

Amsterdam – Boston – Heidelberg – London – New York – Oxford Paris – San Diego – San Francisco – Singapore – Sydney – Tokyo JAI Press is an imprint of Elsevier

JAI Press is an imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP, UK Radarweg 29, PO Box 211, 1000 AE Amsterdam, The Netherlands 525 B Street, Suite 1900, San Diego, CA 92101-4495, USA First edition 2008 Copyright r 2008 Elsevier Ltd. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone (+44) (0) 1865 843830; fax (+44) (0) 1865 853333; email: [email protected]. Alternatively you can submit your request online by visiting the Elsevier web site at http://www.elsevier.com/locate/permissions, and selecting Obtaining permission to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent veriﬁcation of diagnoses and drug dosages should be made British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-0-7623-1475-1 ISSN: 1745-8862 (Series) For information on all JAI Press publications visit our website at books.elsevier.com Printed and bound in the United Kingdom 08 09 10 11 12 10 9 8 7 6 5 4 3 2 1

The Editors would like to express their gratitude to Mr. Je´roˆme Da¨llenbach, NCCR Trade Regulation of the World Trade Institute, Berne, Switzerland, and to Mrs. Julie Michel, research assistant at the University of Fribourg, Switzerland, for their efﬁcient help in the realization of this book.

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CONTENTS xi

LIST OF CONTRIBUTORS SERIES EDITORS’ PREFACE Ulf Andersson and Torben Pedersen INTRODUCTION John H. Dunning and Philippe Gugler

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PART I: RECENT ADVANCES IN THE DETERMINANTS AND STRATEGY OF MULTINATIONAL BUSINESS ACTIVITY MULTINATIONAL ENTERPRISE, IMPERIALISM, AND THE KNOWLEDGE-DRIVEN STATE Mark Casson, Ken Dark and Mohamed Azzim Gulamhussen

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ARE MULTINATIONALS SUPERIOR OR JUST POWERFUL? A CRITICAL REVIEW OF THE EVOLUTIONARY THEORY OF THE MNC Mats Forsgren

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THE LOCATIONAL DETERMINANTS OF FOREIGN DIRECT INVESTMENT IN EUROPEAN UNION CORE AND PERIPHERY: THE INFLUENCE OF MULTINATIONAL STRATEGY Dimitra Dimitropoulou, Robert Pearce and Marina Papanastassiou

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CONTENTS

PART II: DETERMINANTS OF LOCATION COMPETITIVENESS OF COUNTRIES SPACE, LOCATION AND DISTANCE IN IB ACTIVITIES: A CHANGING SCENARIO John H. Dunning

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MICROECONOMIC DETERMINANTS OF LOCATION COMPETITIVENESS FOR MNES Christian H. M. Ketels

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CORPORATE INCOME TAXATION IN CENTRAL AND EASTERN EUROPEAN COUNTRIES AND TAX COMPETITION FOR FOREIGN DIRECT INVESTMENT Christian Bellak and Markus Leibrecht

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PART III: EMERGENT AND DEVELOPING COUNTRIES COMPETITIVENESS AND THE LOCATION OF FIRMS LOCATION-SPECIFIC ADVANTAGES AND REGIONAL COMPETITIVENESS: A STUDY OF FINANCIAL SERVICES MNES IN HONG KONG Kirstie Tam, James Newton, Roger Strange and Michael J. Enright

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INSTITUTIONAL REFORM, FDI AND THE LOCATIONAL COMPETITIVENESS OF EUROPEAN TRANSITION ECONOMIES John H. Dunning

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Contents

PARTIAL ACQUISITION: THE OVERLOOKED ENTRY MODE Kristian Jakobsen and Klaus E. Meyer

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PART IV: TOWARDS A MORE COHERENT INTERNATIONAL POLICY FRAMEWORK ON FDI FOSTERING FIRMS’ AND LOCATIONS’ COMPETITIVENESS GENERAL AGREEMENT ON INVESTMENT: DEPARTURE FROM THE INVESTMENT AGREEMENT PATCHWORK Philippe Gugler and Vladimir Tomsik

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ACHIEVING A BALANCE IN THE RIGHTS/ OBLIGATIONS OF COMPANIES/COUNTRIES Stephen Young and Ana Teresa Tavares-Lehmann

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OUTWARD FDI FROM EMERGING MARKETS: SOME POLICY ISSUES Karl P. Sauvant

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LIST OF CONTRIBUTORS Mohamed Azzim Gulamhussen

Department of Finance, ISCTE Business School, Lisbon, Portugal

Christian Bellak

Department of Economics, Vienna University of Economics, Vienna, Austria

Mark Casson

Centre for Institutional Performance, The University of Reading Business School, UK

Ken Dark

Centre for Institutional Performance, The University of Reading Business School, UK

Dimitra Dimitropoulou

Department of Economics, The University of Reading Business School, UK

John H. Dunning

Rutgers University, USA University of Reading, UK

Michael J. Enright

School of Business, University of Hong Kong, China

Mats Forsgren

Department of Business Studies, Uppsala University, Uppsala, Sweden

Philippe Gugler

Faculty of Economics and Social Sciences, University of Fribourg, Fribourg, Switzerland

Kristian Jakobsen

Department of International Economics and Management, Copenhagen Business School, Denmark

Christian H. M. Ketels

Institute for Strategy and Competitiveness, Harvard Business School, Boston, MA, USA xi

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LIST OF CONTRIBUTORS

Markus Leibrecht

Department of Economics, Vienna University of Economics, Austria

Klaus E. Meyer

School of Management, University of Bath, UK

James Newton

School of Business, University of Hong Kong, China

Marina Papanastassiou

Department of International Economics and Management, Copenhagen Business School, Denmark

Robert Pearce

Department of Economics, The University of Reading Business School, UK

Karl P. Sauvant

Columbia Law School, The Earth Institute, Columbia University, New York, NY, USA

Roger Strange

Department of Management, King’s College London, UK

Kirstie Tam

School of Business, University of Hong Kong, China

Ana Teresa Tavares-Lehmann

CEMPRE/FEP, University of Porto, Portugal

Vladimir Tomsik

Czech National Bank, Prague, Czech Republic

Stephen Young

CIER, University of Glasgow, UK

SERIES EDITORS’ PREFACE This book series aim is to be an outlet for research exposing the progress of the international business ﬁeld. Having as its main source, the papers accepted and presented at the annual European International Business Academy (EIBA) Conference ensures a wide range of high quality research to choose from. The appearance of the ﬁrst volume of Progress in International Business Research was timely at the 2006 EIBA Conference in Fribourg, Switzerland, and is a veriﬁcation of the aim of this series. The guest editors, Professors Gabriel R. G. Benito and Henrich R. Greve, managed to attract highly esteemed scholars and produce an interesting and very thoughtful book setting the standards for the volumes to come at a very high level. This serial endeavour to have an impact on the progress of the ﬁeld of international business by publishing some of the most interesting, presentations, keynote speeches, high quality papers and research ideas that for different reasons might not reach the typical publication outlets. The book in your hand, the second volume of Progress in International Business Research, contains selected papers from essentially the 2006 EIBA Conference. It is our belief that this volume will contribute to the always important topic of foreign direct investments, location and competitiveness, and be a source of knowledge for scholars in the ﬁelds of international business, strategic management, marketing, economics and organisation studies. This particular volume will also be of high value to both policy makers and decision makers in the business community as it deals with the determinants and strategy of multinational business activity. The guest editors of this volume, Professors John H. Dunning and Philippe Gugler, have put together a very appealing and timely book that includes some of the highlights of the 2006 EIBA Conference. We are certain that the book will further fuel the debate on key issues in international business on location and competitiveness. We are convinced that this volume of Progress in International Business Research will meet the high standards set by the ﬁrst volume and be of great value for the scholar, manager and policy making institution that takes the time to read its content and learn from the collective wisdom brought by the authors of the included chapters. xiii

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SERIES EDITORS’ PREFACE

The Editors would like to express their gratitude to Mr. Je´roˆme Da¨llenbach, NCCR Trade Regulation of the World Trade Institute, Berne, Switzerland, and to Mrs. Julie Michel, Research Assistant at the University of Fribourg, Switzerland, for their efﬁcient help in the realization of this book. Ulf Andersson Torben Pedersen Series Editors

INTRODUCTION This book focuses on the theme of the EIBA 2006 Annual Conference, which took place at the University of Fribourg in Switzerland in December 2006. The theme of the conference was ‘Regional and National Drivers of Business Location and Competitiveness’. All contributions to this book (with one exception) are based on the papers and keynote addresses presented during the conference. The purpose of this collection of chapters is to analyse from several angles, factors which may explain, and/or inﬂuence the relationship between the competitiveness of multinational enterprises (MNEs) and the countries in which they operate. On the one hand, when deciding where to site their various value-added activities, MNEs compare the relative location-speciﬁc (competitive) advantages of particular countries and of their domestic ﬁrms. On the other hand, MNEs can, and often do, contribute to the competitiveness of the countries in which they operate through various spill-over effects induced inter alia by their ownership-speciﬁc advantages. The increasing competition between countries to attract inward foreign investment through a variety of incentive programmes, as well as the emergence of new MNEs from developing countries, require further research on how the spatial dimension of their activities interfaces with the competitiveness of both home and host countries. The book comprises four parts. The ﬁrst part addresses recent advances in the determinants and strategy of multinational business activity. In their chapter, Mark Casson, Ken Dark and Mohamed Azzim Gulamhussen consider how far historical evidence supports the theory of the imperial expansion of the knowledge-driven state, and the allied expansion of MNEs headquartered in the imperial metropolis (or in major regional capitals). They argue that the expansion of states and multinationals at particular times in history, and from particular places, can be explained by the localised development of new knowledge and its subsequent diffusion through business and political imperialism. Mats Forsgren’s chapter deals with the so-called Evolutionary Theory of the Multinational Firm put forward by Kogut and Zander during the 1990s. The author presents a critical review of the reasons why the MNE is a xv

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superior form of organisation, as suggested by received theory. Important issues addressed include the relationship between the concept of ‘social community’ and the concept of the ‘ﬁrm’, the relationship between the MNE and its environment, the emphasis on knowledge sharing as a criterion for the growth and spread of MNEs, the role of the headquarters and the concept of evolution in the evolutionary theory. The chapter ends with some reﬂections on the societal role of the MNE in the context of the evolutionary theory. The contribution by Dimitra Dimitropoulou, Robert Pearce and Marina Papanastassiou brings together and reformulates three areas of literature and investigation: (i) the determinants of ﬂows of foreign direct investment (FDI) into European economies; (ii) the formulation and investigation of the MNE as a dynamic differentiated network, operationalised through a range of strategic motivations; and (iii) the investigation of European integration perceived as a core/periphery country segmentation. The authors identify the motivations of MNEs and how these inﬂuence their choice of location within the European Community. A distinctive facet of this chapter is its investigation and formalisation of the core/periphery deﬁnition. The second part of the book relates to the determinants of location competitiveness of countries. In his chapter, John Dunning, ﬁrst describes the main trends in the geography of FDI over the last 15 years and the reasons behind them. He then goes on to argue that international business (IB) scholars need to pay more attention to the spatial implications of institutional distance. The chapter explains why and how globalisation is forcing researchers to look more closely at the content and quality of institutions as the location-speciﬁc advantages, and suggests that the limited empirical evidence which is available points to a positive relationship between the growth of FDI, the upgrading of a host country’s institutions and its competitiveness. Christian Ketels’s chapter analyses the microeconomic determinants of the competitiveness of locations for MNEs. The author presents an analytical framework to examine how microeconomic factors inﬂuence the competitiveness of a given location and how the relevant determinants create challenges that are fundamentally different from macroeconomic conditions. Christian Ketels points out some of the individual microeconomic elements that inﬂuence attractiveness. In particular, drawing on the work of Michael Porter and others, he discusses the role of the diamond of business environment conditions, the presence of clusters, the role of wages and other local costs, and the role of the economic size of country in which the location is situated. He also looks at how these individual elements are combined in a speciﬁc location to create unique value. The

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notion of a locational competitiveness strategy is explored and developed. His chapter concludes with a discussion of the implications of his ﬁndings for public and private leaders. In their chapter, Christian Bellak and Markus Leibrecht tackle a number of speciﬁc issues regarding the determinants of the location competitiveness of countries, which are currently being debated within the European Union (EU). These include the role and inﬂuence of tax competition, which has recently engaged the attention of several EU Member States, at least partly as a result of the enlargement of the EU. Governments in Central and East European Countries (CEECs) have frequently been accused of engaging in tax competition at the cost of the ‘old’ EU member countries. The goal of the contribution of Bellak and Leibrecht is to examine the extent to which (if at all) tax competition for FDI is a driver of falling corporate income tax rates in the CEECs. The third part of the book focuses on the competitiveness of emergent and developing countries and the locational responses of both indigenous and foreign-owned ﬁrms. In their chapter, Kirstie Tam, James Newton, Roger Strange and Michael J. Enright focus on the location-speciﬁc advantages of an economy as key components of its overall competitiveness. Yet location-speciﬁc advantages, despite being a key component of Dunning’s celebrated eclectic paradigm, appear to have been neglected in IB research, particularly as far as their impact on FDI and MNE activity is concerned. This chapter presents the results of an empirical study of location-speciﬁc advantages in the ﬁnancial services sector in Hong Kong. It offers a detailed approach based on both the OLI (Ownership, Location and Internalisation) paradigm and Michael Porter’s diamond of national competitiveness. By quantifying the competitive strengths and weaknesses of a location with a high level of detail and prioritising each location-speciﬁc advantage in an industry-speciﬁc manner, the authors believe that their approach would allow researchers and practitioners to gain a better understanding of which aspects of locations best meet the needs of different industries and could inform the resource allocation decisions of both policymakers and industry practitioners. In his chapter, John Dunning evaluates the importance of a set of competitive enhancing variables affecting the decision of MNEs to invest in the European transition economies. He pays a special attention to the content and quality of the institutions in these economies, and concludes that, relative to traditional cost and marketing locational advantages these are the most important determinants of the spatial distribution of inward FDI; and particularly so in the case of the less prosperous transition economies.

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In their chapter, Kristian Jakobsen and Klaus E. Meyer investigate when and where partial cross-border acquisitions are likely to take place and why investors may prefer a partial acquisition to a complete one. In this investigation, the authors present new evidence from two major research projects that surveyed the partial acquisitions by foreign investors in seven different emerging economies. Inter alia, they ﬁnd that this mode of entry by foreign MNEs is particularly prevalent across emerging economies. In less developed economies, they appear to substitute for full acquisitions, even in relatively advanced emerging economies such as South Africa. The authors discuss theoretical arguments as to why investors opt for a partial acquisition and illustrate some of their contentions with some very interesting case studies. They further assert that while the literature on choice of entry modes has largely focused on the investing ﬁrms, it is no less essential to understand the seller’s perspective, in any attempt to explain why partial acquisitions emerge as the mutually agreed outcome. The fourth part of this book seeks to tackle one of the most difﬁcult to resolve issues pertaining to the highly fragmented, and often uncoordinated international regulatory framework on government FDI. Part IV contains papers presented at special sessions of the 2006 EIBA Conference which was organised under the auspices of the National Centre of Competence in Research (NCCR) Trade Regulation led by the World Trade Institute in Berne. In their chapter, Philippe Gugler and Vladimir Tomsik explore the various levels of the international investment agreements (bilateral, regional, plurilateral and multilateral) in order to present and discuss the patchwork that currently characterises the international investment regulation framework. They discuss whether a General Agreement on Foreign Direct Investment (GAFDI) could usefully replace the current ‘spaghetti bowl’ of international investment arrangements. They argue that through FDI and trade, ﬁrms in each country are able to specialise in producing what they can produce most efﬁciently. Trade facilitates this process by allowing an economy to specialise in those activities in which it has a comparative advantage. FDI can facilitate this process by increasing the international mobility of, and thus the efﬁcient use of, the world’s supply of capital, technology, organisational, managerial and marketing skills. Gugler and Tomsik argue that a GAFDI would not only support FDI, but would also advance the competitiveness of the economies and the efﬁcient allocation of the scare resources. They claim that a multilateral framework on FDI between the participating countries should lead to a more coherent international framework on this key component of international trade. However, to achieve this goal, the authors stress the need for key

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controversies to be carefully and honestly addressed. These issues include the degree of liberalisation of rules governing the entry of foreign investment, the treatment during the post-establishment phase, the macroeconomic effects of FDI, the environmental concerns, the protection of social and human rights and the competition issues. In their chapter, Stephen Young and Ana Teresa Tavares-Lehmann brieﬂy review the current situation with respect to multilateral investment agreements (MIAs), and the extensive debate and controversy surrounding the theme – and they set their discussion within the wider context of the discussions about globalisation and its effects on the role of multilateral institutions. The authors highlight the key issue governing the whole debate on the adoption of multilateral rules on investment, i.e. the ‘shifting policy pendulum’ between forces for liberalisation and regulation. Using economic and bargaining power arguments, they analyse how we got to where we are. Then they focus on new issues for inclusion when balancing the rights and obligations of companies with those of countries. Many of these ‘new issues’, they assert, are not simply concerned with FDI and MNEs, and hence do not come within the remit of WTO, or of an MIA, therefore raising the level of complexity, and diminishing the likelihood of an easy consensus (e.g. the environment and human rights issues). Finally, the chapter discusses one of the most important issues which will need to be tackled in future attempts to elaborate international rules on FDI, i.e. the issue of the corporate social responsibility. In his contribution, Karl Sauvant makes an interesting link to the several features addressed in this book by discussing some of the policy issues relating to the growth of emerging country MNEs and their implications for home country locational advantages. His chapter offers some ideas on the policy and institutional regimes of outward FDI that would be appropriate to achieve the goal of advancing the growth and performance of home countries. Karl Sauvant also discusses how to manage the public reaction in developing countries to their outward FDI, and that in host countries to inward FDI from developing countries. It is hoped that the reader will ﬁnd these various, but closely linked, contributions both enjoyable and intellectually stimulating. We believe that they address some of the crucial issues now demanding the attention of IB teachers and researchers. John H. Dunning Philippe Gugler Editors

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PART I: RECENT ADVANCES IN THE DETERMINANTS AND STRATEGY OF MULTINATIONAL BUSINESS ACTIVITY

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MULTINATIONAL ENTERPRISE, IMPERIALISM, AND THE KNOWLEDGE-DRIVEN STATE Mark Casson, Ken Dark and Mohamed Azzim Gulamhussen 1. INTRODUCTION This chapter presents a novel theory of imperialism, inspired by the economic theory of the multinational enterprise. It is based on an analogy between an empire and a multinational ﬁrm: an empire is regarded simply as a multinational state. At ﬁrst sight this analogy appears outrageous. The dangers of arguing by analogy are well known. But this chapter shows that the analogy is well founded because it is based on well-established economic principles. The thrust of the chapter is that these principles are sufﬁciently general that they apply to states as well as to ﬁrms. The basic building block of modern international relations is the nation state (Boddewyn, 1988). The basic building block of the modern economy is the ﬁrm. A multinational ﬁrm is a special type of ﬁrm that controls subsidiaries based in different states. An empire is a special type of state that controls subordinate states in different countries. Logically, they are isomorphic to each other. The reason for the isomorphism is that both states and ﬁrms are institutions; the basic economic principles used in international business theory apply to institutions generally and are Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 3–28 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00001-5

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independent of the speciﬁc form that these institutions take. Hence they apply to states just as much as they apply to ﬁrms. This isomorphism suggests some ‘politically incorrect’ conclusions. Just as multinationals can beneﬁt their host countries, so empires can actually beneﬁt their subordinate states. The analysis does not predict that they will always do so, but it shows that they could do so. Furthermore, it predicts the conditions under which the beneﬁts will tend to outweigh the costs so far as subordinate states are concerned. The conditions under which empires beneﬁt subordinate states are analogous to the conditions under which host countries beneﬁt from inward investment. Authoritarian empires are unlikely to beneﬁt subordinate states but consultative empires may do so. The analysis has important implications for the study of modern international business. Firms interact with their environments and the system of international relations is a crucial part of the environment confronting multinational ﬁrms (Bell, Butler, & Heffernan, 1995). This system determines the political risks faced by foreign investors and the barriers to trade faced by exporters. Empires are a key feature of this environment; the history of international business in the twentieth century cannot be understood without reference to the decline of the British Empire after World War I and the rise of the US ‘empire’ after World War II. Both the British Empire and the US ‘empire’ promoted free trade and the rule of law, encouraging ﬁrms to proﬁt from exporting and investment (Cain & Hopkins, 1993). The British Empire fostered ‘free-standing’ multinationals, whilst the early post-war US ‘empire’ fostered hierarchical multinationals instead (Wilkins & Schroter, 1998). During the inter-war period, when no single empire was dominant, protectionism prevailed and the political risks of international investment were high; as a result, the international economy was dominated by import-substituting investment coordinated by international cartels. Imperial historians can also beneﬁt from the analysis. It identiﬁes important similarities between different empires which have not been systematically analysed before. It also suggests some important differences over time, with the evolution of empires being driven by changes in technology, transport and communications, and by ideological movements too. This suggests a distinctive trajectory along which the organisation of empires has evolved (Dark, 1998). The analysis links the evolution of imperialism to the evolution of multinational ﬁrms. Modern multinational ﬁrms are a feature of modern imperialism (Hymer, 1968; Wallerstein, 1980). All empires have a tendency to incubate multinationals, but not all empires have the technology and

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resources to support their operations, or an ideology that legitimates them. The analysis therefore predicts that empires and multinationals co-evolve; furthermore, it explains the conditions that favour this co-evolution, and predicts the speciﬁc forms that it will take. The chapter is structured as follows. The general principles underlying international business theory are brieﬂy summarised. The role of knowledge is examined, with special reference to the discovery and exploitation of knowledge within the ﬁrm. The similarities and differences between states and ﬁrms are then examined. Both states and ﬁrms rely heavily on knowledge. But while ﬁrms embody knowledge in so-called private goods, states embody knowledge in local public goods. Furthermore, whilst ﬁrms tend to specialise in a small number of goods, states typically have a very wide range of goods in their portfolios. While many of the goods produced by ﬁrms can be traded internationally, most of the goods generated by states are produced and consumed locally. Finally, ﬁrms compete under the rule of law, whilst rival states do not, and may resort to violence. When these similarities and differences are synthesised, it can be seen that a theory of imperialism emerges naturally from a theory of the multinational ﬁrm, but with distinctive features that reﬂect the differences between ﬁrms and states. The implications of this theory provide a rich research agenda, which is outlined in the conclusion.

2. THE LOGIC OF THE MULTINATIONAL ENTERPRISE: KNOWLEDGE AS AN INTANGIBLE GLOBAL PUBLIC GOOD Buckley and Casson (1976) argue that the internal exploitation of knowledge is the hallmark of the modern multinational ﬁrm. The theory of imperialism presented here asserts that this is true of empires too. Empires exploit knowledge in the same way as ﬁrms. Knowledge is an intangible global public good. This is true of all knowledge, including the knowledge exploited by multinationals and the knowledge exploited by empires. These three attributes of knowledge will be considered in turn. It is the combination of all the three attributes that is crucial to the theory developed below. Knowledge is intangible because it has a symbolic rather than physical form. Although knowledge can be embodied in various forms, e.g. in the design of plant and machinery, in its purest form it is abstract.

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Abstract knowledge is a public good because it can be shared. In the literature of public goods, the uses of a public good are ‘non-rival’. This means that the use of a public good by one person does not prevent its use by someone else. A person who passes on knowledge to another person does not thereby lose the knowledge, and it is this property that makes knowledge a public good. By contrast, a private good can be used by only one person at a time. Embodied knowledge may well be a private good. A ﬁrm that sells a machine to another ﬁrm loses the use of the machine as soon as the other ﬁrm begins to use it instead. In its abstract form, therefore, knowledge is a public good; it is shared through inter-personal communication, normally by writing or word-of-mouth. Once knowledge becomes embodied, though, it may behave more like a normal private good. Knowledge is a global public good because it is potentially relevant everywhere. Scientiﬁc laws, for example, are universal, and so knowledge of how a law works in one place is also knowledge about how the same law works in another place. Not all knowledge pertains to scientiﬁc laws, of course. Knowledge about a speciﬁc event at a speciﬁc place may well be of only local interest but, considered as a proposition, knowledge of a local event is still true everywhere even if it is only relevant in one particular place. Local propositions can still be of general interest, however, for when knowledge of many events at different places is synthesised, patterns may emerge which are suggestive of new scientiﬁc laws. The global capture of local information is therefore very relevant to the progress of knowledge, when knowledge is considered as a global public good. Some knowledge is of intrinsic interest; people will often buy a book because it will entertain them, or satisfy their curiosity. In economic terms, this knowledge is a ﬁnal good. A lot of knowledge is instrumental, however. This is the kind of knowledge exploited by multinational ﬁrms, and it is also exploited by states. Some knowledge has both intrinsic and instrumental value e.g. much of the scientiﬁc knowledge alluded to above. Knowledge put to instrumental use is an intermediate product rather than a ﬁnal product; it does not satisfy human wants directly, but provides the means to produce other goods and services that will. Knowledge is also subjective. Any proposition, however conﬁdently stated, amounts, in practice, to no more than a strongly held belief. However, much evidence may have accumulated in support of a scientiﬁc theory, for example, there is always a possibility – however small – that new evidence might come to light to refute it. Whilst some knowledge may be objectively true, and other ‘knowledge’ may be subjectively false, no-one knows for sure which is which, and so there is often no consensus on the issue.

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It is a matter of judgement as to whether new evidence is likely to appear. Some people may think it likely, others think it unlikely, while some may regard it as impossible. People may therefore reject ‘knowledge’ in which others believe. This subjectivity of judgement makes the exploitation of knowledge a speculative activity. Those who exploit an item of instrumental knowledge are implicitly backing their judgement that the knowledge is sound, whilst those who decline to exploit it are implicitly backing their judgement that it is unsound (Casson, 1982). A person (or group of people) who believe that they have superior knowledge can, in principle, proﬁt from the exploitation of this knowledge. Acquiring knowledge can be costly, and so some expensive types of knowledge may never be discovered unless there is an incentive to proﬁt from their discovery. Because knowledge is a public good, however, people who exploit discoveries may suffer competition from imitators. Imitators can ‘free ride’ on the innovators by waiting to see whether their innovations work and then copying them if they do. To discourage imitators, innovators need to capitalise on their ‘ﬁrst mover advantage’. This requires a sophisticated strategy for exploiting their advantage, which may involve heavy advertising of a brand, locking in suppliers and building up a ‘ﬁghting fund’ in case a price war should develop. Without a prospective reward for innovation, private individuals will be reluctant to invest in acquiring the relevant knowledge in the ﬁrst place. In principle, people could specialise in the discovery process by selling their discoveries to other people who would then exploit them. This would allow the discoverers to concentrate on what they do best – discovery – whilst leaving others to do what they do best – namely exploitation. There is a problem, however. The subjectivity of knowledge means that potential buyers of a piece of knowledge may be unsure of its reliability. They may demand evidence. But once the evidence is supplied to them, they become fully acquainted with the knowledge, and so there is no reason for them to buy it. They can go ahead and exploit it on their own, and the discoverer will therefore get no reward for their effort. In anticipation of this outcome, the discoverer will make no effort, and so there will be no knowledge to sell. This is known as the ‘buyer uncertainty’ problem. An obvious solution to this problem is to confer a legal right to exploitation on the discoverer of the knowledge. This is the principle behind the modern patent system. The discoverer licenses the patent to the person who exploits it. Even if the licensee already knows how the patent works, he cannot exploit it without purchasing the licence ﬁrst.

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Patents only apply to certain types of knowledge, however, e.g. concerning particular inventions. Other types of knowledge, in particular administrative systems, are not covered. Even when patents are available, the cost to the patentee of protecting his right may be considerable. Patenting a right may only serve to advertise its existence, encouraging rivals to patent ‘me too’ variants. To pre-empt rivals, ﬁrms often patent variants of their main inventions themselves. Even then, they may require deep pockets to hire expensive lawyers to defend their rights in court. When patents are not applicable, the discoverer of knowledge must exploit his knowledge himself. Instead of advertising his knowledge for sale, he keeps its existence secret. He integrates forward from discovery into exploitation, since he cannot trust other people to exploit the knowledge on his behalf. This is the principle of ‘internalisation’; the discoverer embodies his knowledge directly in a speciﬁc good or service. The precise form that this good or service takes depends upon the type of knowledge involved. The modern multinational typically exploits knowledge of customer problems, by developing a unique method of solving them. For example, the ﬁrm may have recognised a consumer requirement for better home entertainment, and may have developed a new electronic product to satisfy this need at acceptable cost. A ﬁrm typically generates its knowledge through market research, or R&D, or a combination of the two. It designs a product which embodies this knowledge, and delivers the product to its customers. Typically this product is a private good. A different item, of the same design, is sold to each customer for their exclusive use. In the case of consumer electronics it is a gadget that the customer purchases and consumes. In manufacturing industries the private good is typically a physical product, whereas in service industries the private good consists of manual work, training, or consultancy. Manufactured products are usually mass-produced, whilst services are customised, though not invariably so. When a consumer problem transcends different cultures and climates then the ﬁrm’s solution is of global signiﬁcance, and so the potential market for its goods and services is global too. Goods which are easily transported can be exported from the ﬁrm’s home country, but goods which are difﬁcult to transport must be produced in each of the local markets. Services are inherently difﬁcult to transport. Manual services require the supplier to be on-the-spot, while the delivery of knowledge-intensive services, such as customised training and consultancy, normally calls for face-to-face communication. When goods are difﬁcult to transport, local markets cannot be served by exports and so have to be served by foreign investment instead. The ﬁrm sets up a global network of subsidiaries to supply its local customers.

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Certain countries may pose political risks, however, which make foreign investments insecure. The multinational must trade-off the risk of investment against the cost of exporting the good or licensing its production to an independent local ﬁrm. Licensing represents the ‘arm’s length’ alternative to internalisation, in which an internal ﬂow of knowledge to a subsidiary is replaced by a contractual relationship with an independent local ﬁrm. The geographical boundary of the ﬁrm’s operations is set at the margin where the expected proﬁt from an additional foreign investment is just equal to the expected cost involved. The ﬁrm invests in all the countries within this margin and declines to invest in those outside it. From this perspective, the multinational ﬁrm emerges to exploit knowledge on a global basis. It embodies abstract knowledge in products that are produced and delivered locally using a network of subsidiaries in different countries. The scope of the network is determined by the economics of internalisation (Buckley & Hashai, 2004). An empire emerges for very similar reasons. The logic of exploiting privileged knowledge is exactly the same. The type of knowledge exploited is different, however, and so too are the products in which this knowledge is embodied. The principle of internalisation explains the boundaries of an empire in the same way that it explains the boundaries of a multinational ﬁrm, although the speciﬁc factors that govern the location of the boundary are different in each case. These differences explain why the boundaries of empires do not coincide exactly with the boundaries of multinational ﬁrms.

3. THE ECONOMIC LOGIC OF THE STATE: THE PROVISION OF LOCAL PUBLIC GOODS A state may be deﬁned as an administrative unit with the power to tax and coerce its citizens. A typical state is a political unit with an urban-based bureaucratic government. The knowledge exploited by a state is of three main kinds: Knowledge about how to deliver public services (e.g. education and health). How to organise private enterprise (devising transparent legal systems, stable banking systems, and effective regulatory regimes). How to defend a country and, where appropriate, win a war.

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A knowledge-driven state that innovates a new method of delivering public services, regulating private industry, or ﬁghting wars has an incentive to expand its boundaries in the same way as a multinational ﬁrm. The key feature of these three types of knowledge is that when exploited, they involve the delivery of local public goods. Local public goods are goods that are shared by people living and working in a particular territory. Three examples will illustrate the point: Law and order. If there are criminals at large then no-one can move about safely, whilst if crime is under control, and criminals are imprisoned, then everyone can move about safely. A person who sets out to make the environment safe for themselves normally makes it safe for everyone else as well; the beneﬁts are shared. Standards and conventions are of no value unless everyone follows them. Thus, everyone beneﬁts when each individual independently decides to conform to a standard or convention. Infrastructure projects, such as roads, bridges and ferries, are very expensive, and cannot normally be undertaken just for the beneﬁt of just a single person. Once built, however, there is usually sufﬁcient capacity for everyone to use them as they wish. Hence a facility provided for one person can be used by everyone else as well. These local services either cannot be supplied unless they are shared (e.g. law and order), have no value unless they are shared (e.g. standards and conventions), or cannot repay their ﬁxed costs unless they are shared (e.g. infrastructure such as roads). Hence it is either not feasible to supply the good to one person rather than another, or it is pointless, or uneconomic, to do so. It is important to note that these local public goods are final public goods rather than intermediate public goods, like the knowledge that is used in their production. Many of the local public goods provided by the state are not only nonrival in consumption; but they are non-excludable and non-rejectable too (Samuelson, 1954; Olson, 1965). The classic example is defence. When one person is defended by an army his neighbour can also be defended too: thus defence is non-rivalrous. The army cannot easily defend one person but not another; it defends everyone from attack, and so defence is non-excludable. If the army is willing to ﬁght then the citizen will be defended whether they like it or not: thus defence is also non-rejectable. The non-excludable nature of many local public goods exacerbates the ‘free rider’ problem. Because it is difﬁcult to exclude people from the beneﬁts

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of local public goods, it is difﬁcult to persuade people to pay for their use. Each individual prefers that someone else should pay instead. Unlike knowledge, where patents and secrecy can be employed as an exclusion mechanism, there is no easy way to exclude local people from the beneﬁts of an orderly and secure society. If everyone refuses to pay in the hope that others will pay instead, then local public goods cannot be provided at all. The solution is a system in which if one person pays then everyone pays. Since no-one wants to pay, coercion is required, and since people only want to pay once, coercion must be monopolised. This leads to a system in which the state ﬁnances the provision of public goods through taxation on a monopolistic basis. The non-rejectability of some local public good is sometimes used to reinforce the argument for taxation, on the grounds that everyone beneﬁts from a public good whether they want it or not. The argument is spurious, however, because some of those who do not want the good may positively dislike it. Acrimonious debates in local communities often centre on the provision of non-rejectable goods; the losers may blame the ‘tyranny of the majority’ when they are forced to consume goods that they dislike. Most of the public goods supplied by the state are delivered as services; few manufactured goods are supplied by the state. In free enterprise economies, manufactured goods are predominantly supplied by ﬁrms. Firms also supply services, but these are services from which people are easily excluded – e.g. while people may derive a general sense of amenity from living near a coffee bar, they can only get a coffee by paying for it. Furthermore, a typical ﬁrm supplies a single product, or a range of products within a single industry. The state, on the other hand, normally supplies the entire range of public goods that people require. Although ﬁrms sometimes evolve into diversiﬁed conglomerates, few ﬁrms have ever become quite so diversiﬁed as a typical state. States are consequently deﬁned in terms of the territory they control rather than the products they supply, whilst ﬁrms are deﬁned in terms of the products they supply rather than the territories they control. States specialise in the geographical dimension but not in the product dimension, whilst ﬁrms specialise in the product dimension but not in the geographical dimension; indeed, the lack of specialisation in the geographical dimension is one of the hallmarks of the modern ‘global ﬁrm’.

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4. COMPETITION BETWEEN FIRMS AND COMPETITION BETWEEN STATES Since ﬁrms specialise in supplying private goods, the natural ﬁeld of competition between ﬁrms is a market for some private good. Since states specialise in monopolising the supply of local public goods, the natural ﬁeld of competition between states is a particular territory. The major difference between ﬁrms and states with regard to competition, however, relates not to the ﬁelds within which they compete, but to the degree of violence they employ. Firms generally compete within a territory controlled by a state. While multinationals may compete in several national markets, each of these markets will normally be controlled by a state. Assuming that each state performs its role properly, the rule of law will prevail in each market, even though the rule may be slightly different in each case. This does not apply to competition between states, however. In the absence of a super-state, there is no rule of law governing competition between states. There are various conventions, such as the Geneva Convention, but their authority is moral rather than legal. Moreover, whilst these conventions regulate the use of violence, they do not outlaw violence altogether. States may therefore go to war over their competing aims to gain control of a particular territory. In the course of this war, they may destroy each others’ property and kill each others’ troops. Whilst ﬁrms may ﬁght for dominance in a market, they do not employ such violent tactics. Under a rule of law, rival states would compete for a territory by making the best offer to the owner or occupier, but outside the rule of law they can simply invade the territory. If they need an excuse, they may invent an injustice, such as claiming that one of their citizens has been wrongly imprisoned. The systematic exploitation of violence is thus a crucial aspect of competition between states (Brewer, 1990). For a private ﬁrm, the innovation of a new and improved product may be a sufﬁcient weapon with which to win control of a market, but for a state it is the development of a military weapon that is more likely to hold the key to success. A clever business strategy for a competitive ﬁrm may be to threaten its closest rival with a price cut, whilst a clever military strategy for a competitive state may be to threaten overwhelming violence unless its rival surrenders its territory without a ﬁght. Firms not only compete in product markets; they also compete for resources such as minerals and other raw materials. The same applies to states. States not only compete to ‘sell’ their services to households in return

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for taxation; they also compete for control of resources in mineral-rich territories. But once again, while ﬁrms will normally negotiate for the rights to these resources, states may simply invade the territory and occupy it. Thus, while ﬁrms acquire dominance through contracts – purchasing inputs, transforming them into outputs, and selling the resulting product – states acquire dominance by subduing a population, taxing them, and expropriating their resources. A state does not have to resort to coercion, of course. It can enter a territory because it has been invited to do so. A small state that is threatened by its neighbour may invite a large and powerful state to take it over in return for protection. Similarly, a large state that does not wish to go to war may decide to purchase resources rather than take them by force. The state does not have to use violence, but it has the option of doing so if it wishes. While a ﬁrm that resorts to violence against a competitor will be punished by the state, there is no-one to punish a state for resort to violence except another more powerful state. An important consequence is that while competition between ﬁrms is often good, competition between states is often bad. Firms do not usually sell in perfectly competitive markets, of course. This is particularly true of multinationals who are exploiting a knowledge advantage and therefore enjoy a potential monopoly in some product niche. But when ﬁrms throughout an industry invest in R&D on a regular basis, established products are always being challenged by new ones. Even if competition by price is limited, competition by innovation may be intense. Such innovation is usually considered to be socially beneﬁcial. Even if a ﬁrm retains its monopoly position, the threat of entry by potential competitors will keep it ‘on its toes’ and oblige it to sustain its own innovation in order to remain ahead of the ﬁeld (Baumol, Panzar, & Willig, 1982). By contrast, competition between states may result in war. Even if the state with superior knowledge wins the conﬂict, considerable death and destruction may ensue in the process. Given that some locations are naturally more attractive than others, the states that occupy the best locations are always under the most serious threat. These states need heavy military investment for purely defensive purposes. One way of spreading the cost of this investment is to offer to defend other territories too. Indeed, if the residents of these other territories refuse, then military superiority can be used to invade – or at least to threaten an invasion. In this way empires are likely to expand from prosperous states that initially invest in military power for defensive purposes. Alternatively, the most attractive locations may have already

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fallen into the hands of the strongest military powers, which then increase the scope of their empire in order to defray the additional cost of defending the valuable territory they have acquired.

5. ECONOMIES OF SCALE IN THE SIZE OF THE STATE The preceding discussion suggests that the role of violence in competition between states generates an important economy of scale to the size of state. Other things being equal, if two states engage in war, the larger state is more likely to win. It can ﬁeld a bigger army, because it has a larger population on which to draw. It can also resource the army with weapons by drawing upon its artisan labour force. To be more precise, there is an economy of relative size: it is the size of the army relative to the opposition that is crucial. In practice, of course, other things will not be equal. Some populations may be younger, or ﬁtter, or better trained than others. The quality of the weapons may differ because of differences in technology or access to raw materials from which they can be manufactured. Medical technology may be important in preventing the spread of disease amongst the troops, and allowing soldiers to recover from their injuries. An entrepreneurial ability to anticipate the enemy’s manoeuvres and neutralise them may also be important. Thus superior access to an entire range of knowledge is important to the state. While the knowledge relevant to a ﬁrm is often speciﬁc to the industry in which it is based, the knowledge required by a successful state is extremely varied. It includes not only a wide range of military arts and sciences, but knowledge relevant to civilian matters too. A state with an effective political and legal system, for example, will incur lower transaction costs in running the economy, and therefore be more efﬁcient in both maintaining a high civilian standard of living and in provisioning its army. This helps to explain why political leaders are often said to require generalist rather than specialist knowledge. A state that possesses a knowledge advantage can, in principle, share this advantage internally because it is a public good. However, a state will not want to share its military knowledge with its enemies, because this will neutralise its advantage. It may not want to share civilian knowledge either, if this can be exploited proﬁtably through imperial expansion. Moreover, it is often difﬁcult to separate civilian and military knowledge completely,

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because civilian knowledge – e.g. regarding transport and logistics – often has military applications. Unlike the situation for a ﬁrm, therefore, the licensing of knowledge is not normally a viable option for the state. This is reﬂected in the fact that even today, when patent rights are routinely traded, military technologies are not available on the open market. The market is internalised within empires or between groups of allied states. No state would licence a technology to an enemy because there would be no way of enforcing the non-competitive requirement that the technology should not be used against them at a later date. The competitive advantages of a state are not conﬁned to the size of its army and the quality of its military technologies, however. Some states have borders that are more easily defended than others. Island states have a natural advantage over land-locked states because a seaborne invader is always vulnerable at the point at which they land. A rocky coastline with few natural harbours is readily defensible compared to a land-locked country surrounded by open plains. Border defences also offer an economy of scale amongst land-locked states: the larger the country, the smaller the length of boundary relative to the area enclosed, and hence the lower the unit cost of policing the border. The main exception is where a land-locked country can rely on mountain ranges to provide a natural defence. However, the advantages of the island state and the disadvantages of the land-locked state are heavily eroded once military encounters take place in the air. A further advantage of a large state arises from the unequal distribution of the earth’s resources, which means that certain types of resource are clustered in certain areas. Resources found in one area may be required for production activities that are best located in other areas. Furthermore, consumers in each area may prefer variety in their consumption, rather than the monotonous mix of goods produced from local resources alone. A large area is likely to contain a wider variety of resources, and therefore support a higher standard of living. Each area can export the resources in which it is comparatively rich and import resources in which it is comparatively poor. A high proportion of this trade can be undertaken within the boundaries of the state when the state itself is large. A small country must either become dependent on other countries for key supplies, or accept a more monotonous style of consumption. When inter-state relations are poor, the large state is much better placed than the small state to exploit the gains from trade as described by Heckscher and Ohlin (1933). Large-scale trade requires infrastructure to support it. Standardisation is important in both the design and operation of this infrastructure. Basic

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operational standards are necessary for safety purposes – e.g. conventions to pass to the right or left, and agreement on the language to be used for communication. Construction standards are necessary to ensure interoperability – e.g. standardisation of railway gauges, and the sizes of containers. A large state is well-positioned to impose such standards over an extensive area. Heavy freight can be moved long distances much more easily over sea than over land. Sea transport is risky however. The technology required to manage these risks is crucially important, including techniques of navigation, shipbuilding, and harbour construction. When complementary resources are distributed around the perimeter of a sea or ocean, there are enormous economic gains to the improvement of maritime technology. Members of an island or coastal state are in a much better position to acquire a lead in maritime technology because of their regular use of the sea. In economic terms, therefore, a maritime state built around a coastline may be far more viable than a state based on an extensive land-locked territory. The maritime empire may have longer borders to defend, but much of the border will be coastal, and the value of its trade will be much greater because of the greater diversity of the resources it can access, and lower transport costs. Trade also requires appropriate legal institutions (North, 1990). There is more to law and order than simply maintaining the peace between citizens. Individuals who can acquire ownership of private goods are more likely to develop a strong work ethic than those who have to share everything they acquire with other people. Once property rights become alienable, trade can ﬂourish. Institutions of voluntary association are crucial to the systematic development of trade. Merchants can form trading companies with branches in different ports, and producers can combine their capitals to exploit economies of scale. Clubs and societies organised on a nonproﬁt basis can foster trust between business people in related ﬁelds. To fully exploit the gains from trade across a large area, a state must also invest in a sophisticated set of legal institutions to facilitate commercial activity.

6. THE SOCIAL BASIS OF THE NATION STATE The implication of the preceding discussion is that large states tend to be more efﬁcient than small ones. Small states can beneﬁt by merging into larger states in order to pool their resources and eliminate the costs of

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policing boundaries between them. If this process were to continue indeﬁnitely, it would culminate in the formation of a single world superstate. Such a state would require only a small army since, being fully inclusive, it would have no enemy, and would therefore only need sufﬁcient force to quell some faction that decided to break away. This raises the question of why there is no world super-state. The answer seems to lie in the fact that people everywhere are strongly attached to a notion of diversity – they like to believe that in some respects they are fundamentally different from other people (Gellner, 1987). This difference is associated with the territory in which they reside. They are reluctant to surrender their sense of identity in return for purely material beneﬁts, even when these include military security. People with a shared identity who know that they form a majority in a small state are reluctant to sacriﬁce that identity in return for becoming a minority in a larger and more prosperous state. People have always been capable of strong attachments. Attachment to family, for example, ensures that parents care for their children and that children care for their aged relatives. Although people form new attachments through their life, these supplement rather than replace their previous ones. The major attachments that have a distinctive territorial dimension are to language, religion, landscape, and social institutions. Many people love the landscape of the place in which they were born, even though it may be a grimy industrial town. People may also become attached to local institutions, even ones that seem primitive or even barbaric to other people. The more strongly these attachments are felt, the more anxious people become about the threat that globalisation – or indeed any form of economic integration poses to their ‘way of life’. Because these attachments have a territorial dimension, they naturally tend to be shared by people living in the same area. A group of people who share a common attachment to a given place, and the religion, language, and social ritual associated with it, may be termed a nation. Small groups of this type may also be known as a folk. Folk may in turn correspond to a tribe, clan, or extended family which have inhabited a particular area ‘for time immemorial’, as it is sometimes said. A state whose borders correspond to the nation’s territory may then be known as a nation state. From the nineteenth century onwards, the concept of the nation state was exploited by politicians who sought to convince the citizens of large countries, whose society was increasingly dislocated by mass industrialisation, that they had a common ancestry in some ancient folk. The ensuing

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folk rivalry fuelled international conﬂicts that led to World War I, and ultimately brought nationalism into bad repute. It is unfortunate that the terms nation and state are often conﬂated in everyday use. Indeed, the very concept of a ‘multinational’ refers to nations when what is really meant is states. For the sake of clarity, this chapter has maintained throughout the distinction between the state as a territorially based organisation and the nation as the identity of the major group that inhabits the territory controlled by this state. Despite suggestions to the contrary, attachment itself is not irrational, although it may appear unreasonable to outsiders. It is simply a feature of people’s preferences. Indeed, attachment is entirely consistent with the basic economic principle that different people have different preferences; it simply explains it in terms of geographical differences in the places where people were born. Given the importance of territorial attachments, there are rational grounds for people to oppose integration into a super-state. Since majorityrule democracies can easily oppress minorities, democracy offers no guarantee of security in a super-state (Alesina, Perotti, & Spolare, 1995). Indeed, the administrative complexity created by cultural diversity in a super-state is exceedingly great. To eliminate diversity in the demand for public services, homogenising measures are likely to be taken, and these measures are likely to be determined by the views of the most numerous group. Thus conﬂicts that had been avoided through the elimination of inter-state rivalry would re-surface in political conﬂicts between social groups with different traditions within the super-state. If the super-state broke up a result of mass secessions, then the resultant number of separate states might exceed the number of independent states from which it was originally formed. This analysis therefore suggests that the geographical boundaries of the state are set at the margin where the scale economies of mutual defence are offset by the disadvantages of cultural heterogeneity. In terms of internalisation theory, this is the marginal principle that determines the boundary of the state. Given that national identity is such an important limitation on the size of a state, an expanding empire must sooner or later engage with this issue. A promising approach is to generalise the bonds of affection between people with shared identities by creating another source of identity at a higher level (Jones, 2006). People who share the generalised identity can then trust each other in the same way that they trust the members of their own particular group. People learn that those who might have been their enemies (because

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they did not belong to the original group) are now their friends (because they belong to the new group). Effective leadership is needed to engineer a cultural change of this kind. A charismatic leader may ﬁrst persuade the leaders of the smaller groups that the interests of their groups would be better served by merging into a larger group, so that these leaders can then recommend the change to their followers. The leader also needs to explain to the other leaders why they need to follow him instead of someone else. The success of the integrated group will depend upon the speciﬁc values and beliefs promoted by the new leader. The values that are promoted must strengthen the performance of the group in both the military and civilian ﬁelds. Functionally useful values need to be promoted which, by encouraging curiosity and intellectual rigour, promote the accumulation of reliable knowledge, and by promoting hard work, loyalty, and respect for others, allow people to work in teams (Casson, 2006). Just as multinationals need effective business leadership to build and sustain their knowledge advantages in the production of private goods, so empires require political leaders who can do the same for the provision of public goods. Political leadership is potentially more challenging because of the sheer diversity of public goods produced by the state. The demanding nature of the challenge, coupled with the natural scarcity of talent, may explain why many political leaders achieve such limited success. It also explains why historical cases of successful imperialism are relatively few and therefore merit careful study.

7. TREATIES: THE MARKET ALTERNATIVE TO INTERNALISATION BY THE STATE The trade-off between the beneﬁts of scale and the costs of cultural diversity can be improved by giving constituent social groups a high degree of autonomy. One approach is for a group of small states to enter into treaties with each other. Treaties represent the arm’s length alternative to internalisation so far as states are concerned. Each state, for example, could be a classic nation state whose territory is occupied by a single folk. These states could then contract with each other on various levels. The options listed below are ranked in ascending order of political integration, and correspond to increasing levels of trust between the states. If trust builds up through repeated interactions, then the ranking will correspond to the sequence in which the various types of agreement are normally made

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between a given set of parties: Non-aggression treaty. The worst-case scenario – namely warfare – is ruled out by an agreement that no state will be the ﬁrst to invade any other state. This is a minimal undertaking, since it is compatible with the states remaining in complete autarky. Most-favoured nation treaty. The states agree that each state will offer all the others the best terms that they offer to any state anywhere in the world. This is typically applied to tariff rates, although in principle it can be applied to any issue. Customs union or free-trade treaty. The states agree to remove obstacles to trade. This may include the complete elimination of tariffs, and possibly non-tariff barriers too. Non-tariff barriers are often linked to idiosyncratic safety provisions which are removed through standardisation. Administrative procedures may be harmonised too. Defensive alliance. The states agree to pool their military resources in order to protect themselves against a common enemy. This is likely to be linked to the development of a common foreign policy. When a treaty is established, a council of members is usually created, supported by a small bureaucracy. This council allows representatives of the member states to air their grievances and resolve disputes through discussion. Punishment of offenders and compensation for victims may also be negotiated. Enforcement of treaty obligations remains a problem, however. While a council may exert peer-group pressure on a deviant member, this may be an insufﬁcient deterrent. Enforcement is most likely if there is a dominant partner which has the power to punish others. Since no-one can punish the dominant partner, however, the partner requires a strong reputation for self-restraint if they are to be trusted by the other members. In practice, many treaties are signed after wars in which one of the parties has triumphed over the others and where the others are therefore in no position to refuse to comply. This explains why so many treaties are regarded as ‘unequal treaties’ by some of the countries that have signed up to them. Although a treaty is the analogue of a contract, it is not the same thing as a contract, because a contract is implemented under a rule of law whereas an inter-state treaty is not. It is implemented either by peer-group pressure, or by the threat of punishment by a dominant power. The only exception to this is a defensive alliance, in which a majority of partners, acting in concert, command sufﬁcient force to deter an individual deviant state.

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8. THE ORGANISATIONAL STRUCTURE OF THE STATE A second approach to reconciling scale with national diversity is to adopt a decentralised structure within a large political organisation. This is the imperial model, and is of considerable historical interest for students of the multinational ﬁrm. Most empires have been structured as a collection of separate nation states which are dependencies of an imperial state. The imperial state plays a coordinating role which, in a federation, would be played by a council instead. The imperial state plays the same role within an empire as does the headquarters within the multinational ﬁrm. Conversely, the dependent state plays the same role as the foreign subsidiary within a multinational. Just as there are many types of headquarters–subsidiary relationship within a multinational, there are many sorts of relationship between an imperial power and its dependencies. In both cases the main difference lies in the degree of subsidiary autonomy – indeed, in recent debates over the future of the European Union, the term ‘subsidiarity’ has achieved precisely this meaning. There are two distinct aspects to subsidiary autonomy. The ﬁrst concerns the dependent state’s freedom from interference – the ‘negative freedom’ so much emphasised in Anglo-American political discourse – while the second concerns its right to be consulted and to inﬂuence decisions – the ‘positive freedom’ emphasised in continental European political thought. A common guarantor of negative freedom is a small imperial headquarters. Because a small headquarters lacks the resources to ‘micromanage’ individual dependencies, a commitment to a small headquarters gives credibility to a promise not to interfere in local affairs. The role of the headquarters, on this model, is to set overall imperial strategy. Without positive freedom for dependencies, however, this strategy may be determined without reference to their own speciﬁc circumstances. Failure to consult dependencies makes it more difﬁcult for them to manage their own affairs because a mistaken decision at imperial headquarters may create a problem that could have been avoided. Thus, time and effort that could have been devoted to new initiatives has to be devoted to ‘ﬁre-ﬁghting’ problems created by the headquarters. Opportunities may be wasted too. A subsidiary may acquire important information or knowledge that would beneﬁt the empire as a whole, but which the headquarters simply ignores. The home country of an empire usually provides not just the headquarters but also a range of strategic resources used by the rest of the empire. In the

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case of the nineteenth century British Empire, for example, London provided an extensive range of legal and ﬁnancial services, whilst the industrial Midlands and the North provided exports of sophisticated capital goods such as machine tools, ships, and railway locomotives. The availability of strategic resources from the home country can be a major constraint on the performance of an empire, just as the limitations of source country capabilities can seriously constrain the performance of a multinational ﬁrm. This is a natural generalisation of Penrose’s (1959) insight that the availability of resource to the headquarters of a ﬁrm limits its rate of growth. Contrary to Penrose’s original analysis, however, the resource demands in the present model are related to the size of the empire, rather than to its rate of growth. Capacity constraints on the size of an empire are likely to be particularly severe when the source country is relatively small. In this respect, for example, the limited resources of the British economy before World War I appear to have been a greater constraint on imperial development than were the resources of the US after World War II (O’Brien, 1988). In earlier centuries both the Portuguese and Dutch empires appear to have suffered from serious limitations of home-country size. The natural solution to over-burdened or inadequate facilities in the source country is to mandate other countries to ﬁll the resource gap. A multinational, for example, may mandate some of its subsidiaries to develop products for particular market niches, by delegating R&D responsibilities from its central laboratory. By analogy with this, an empire facing supply constraints in its headquarters country may mandate some of its dependent countries to produce strategic goods and services of their own. Although the British Empire had no deliberate strategy of devolving responsibility in this way, it recognised different degrees of ‘subsidiary autonomy’. The distinctions were expressed in political rather than economic terms, however. Thus there were dominions, colonies, protectorates, and mandated territories, as well as countries outside the Empire (particularly in Latin America) which were merely under British inﬂuence. Perhaps the most striking example of an empire that devolved responsibility away from headquarters was the Roman empire under Constantine the Great, where a second headquarters was established in Constantinople with its own distinctive culture, designed apparently to compensate for the deﬁciencies of Rome in servicing the Empire in the east. The value of autonomy to a dependency depends on how much tax, or overhead contribution, it is expected to pay to the imperial headquarters. There is usually a short-term incentive for a headquarters to ‘sweat’ its

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dependencies, even though in the long run this may destabilise the empire as a whole. A consultative approach can help to address this problem, by alerting the headquarters to local problems before they get out of control. In this connection it is interesting to note that the modern US ‘empire’ operates a consultative system using a range of multilateral treaty organisations such as the United Nations, World Trade Organisation, World Bank, and the International Monetary Fund (Kennedy, 1987). In addition, selected states belong to NATO, OECD, and G8. These organisations provide a consultative forum that alerts the US administration to problems with its foreign policy. At the same time, the US can use its inﬂuence as a dominant stakeholder to ensure that the people appointed to key positions in these organisations are sympathetic to its own agenda. It can also restrict decisions on key issues to a small group of countries which are, to varying degrees, economically or militarily dependent on the US.

9. THE FIRM AND THE STATE: A SUMMARY OF THE FINDINGS Although the preceding analysis has ranged widely, the basic points are very simple. They all involve an analogy between the state and the ﬁrm, and in particular between an empire and a multinational ﬁrm. Although this analogy may seem somewhat outrageous when baldly stated, it encapsulates some analytical propositions which have never, it seems, been made fully explicit before. While ﬁrms compete in the product dimension, states compete in the territorial dimension. Firms serve markets using plants, ofﬁces, and laboratories, whilst states serve taxpayers using a wide range of establishments including military installations, hospitals, schools, roads, and government ofﬁces. Firms compete on the basis of civilian technologies concerned with the speciﬁc products that they supply. The state uses both military and civilian technologies, with the latter being focussed on routine procedures for collecting taxes and distributing basic services. Firms compete using business strategies to maximise proﬁt margins and market share, whilst states compete to conquer territory and administer it. The role of knowledge as an intangible intermediate global public good is central to this analysis. It is a common factor that links the ﬁrm and state, with differences in the relevant ﬁelds of knowledge explaining many of the differences between them. The relationship between ﬁrm and state is

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State

Control

Legislate

Exhort

Administer

Military

Local public services

Private goods

Military

Fig. 1a.

Social interaction

Civilian

Four Main Areas of State Application of Knowledge.

R&D

Production of product range

Fig. 1b.

Application of Proprietary Knowledge by a Firm.

illustrated diagrammatically in terms of knowledge ﬂows in Figs. 1a and 1b. The ﬁgure emphasises that the knowledge base required by a successful state is far wider than the knowledge base required by an individual; ﬁrm. This is because ﬁrms are more specialised than states in the product dimension. The ﬁgure identiﬁes four main types of knowledge that a state requires, namely: Military knowledge; Knowledge relating to the provision of public goods; Knowledge relating to design the institutions required for efﬁcient provision of private goods by ﬁrms; and Knowledge of social interactions needed to encourage the diffusion of functionally useful values and beliefs.

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To sustain its dominance over a signiﬁcant period of time a state needs to be strong in all four areas, and to have superiority in at least one. A small degree of superiority in the military dimension is equivalent to a much larger degree of superiority in any of the other areas. However, military superiority coupled with deﬁciencies in the other areas does not provide a sustainable basis for empire. Whilst it may facilitate proﬁtable raiding and extortion in the short run, it is not sufﬁcient to maintain prosperity in the long run. To stay ahead of the competition, an imperial state must retain its lead in selected ﬁelds of knowledge. This lead is constantly obsolescing as other countries ‘catch up’ through imitation, espionage, and other mechanisms. Countries under new leadership may unexpectedly emerge to challenge imperial dominance, and so to sustain its lead an imperial state must monitor potential competitors very carefully. The main hypotheses that can be derived using this framework may be summarised as follows: Trade and investment ‘follow the ﬂag’: The analysis clearly indicates a symbiotic relationship between the ﬁrm and the state. Extending the borders of the state facilitates the expansion of the ﬁrm by reducing the costs of serving markets and accessing raw materials (Jones, 1998). Enterprising individuals will prefer to operate within an empire because of the superior facilities it provides. For example, a ﬁrm that cannot gain access to a foreign market using normal business strategies may turn to the state and ask for political or military support. A single dominant empire promotes global trade and investment more than do competing empires. While competition between ﬁrms is often good, competition between states is usually bad. The Cold War between the US and the Soviet Union was bad for trade and investment, but the collapse of the Soviet Union and the consequent dominance of the US has been good for trade. The collapse of the US and the supremacy of the Soviet Union might also have been good for trade and investment – provided, of course, that the inefﬁciencies of central planning did not obstruct trade more than political uniﬁcation promoted it. Superior military technology, combined with adequate knowledge in other ﬁelds, leads to the conquest of other states and the subsequent diffusion of the military technology to these states in order to defend them against rivals. In the same way superior product technology, supported by sufﬁcient general knowledge to sustain the lead, induces a ﬁrm to conquer

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foreign markets and to transfer technology to them through foreign direct investment in order to consolidate its position there. Superior military technology is most likely to emerge in states which have successfully occupied valuable locations and need to invest in their defence. Natural transport and communication hubs with a resourcerich hinterland make particularly favourable locations for imperial powers. The same geographical features make a location attractive for the headquarters of multinationals, and for the location of its R&D. Superior civilian technology may also be transferred through empires. Colonies exemplify the transfer of administrative procedures to newly settled or occupied countries. The superiority of the local administrative systems makes colonial locations particularly attractive for the location of multinational subsidiaries. Nationalism is a serious limitation on the growth of empires. Extensive empires are most likely to survive if they can retain legitimacy by using highly decentralised systems of governance. These systems not only allow considerable autonomy to dependent states, but also provide them with opportunities to inﬂuence imperial policy itself. Consultative boards and assemblies allow imperial policy to be inﬂuenced without interference in the domestic affairs of the headquarters country. Nationalism can also create obstacles to market entry for multinationals, and increase the risk of expropriation (Rugman, 2005). Nationalism also calls for sensitive ‘cross-cultural management’ in foreign subsidiaries. Nationalism is therefore a common factor affecting the boundaries of both the ﬁrm and the state. Dependencies are most likely to beneﬁt from empire when they possess strategic resources that the home country does not possess. Ideally these resources should complement the home country’s resources rather than substitute for them. This encourages the home country to invest in the dependency. The strategic resources should be based on human skills and ingenuity; raw materials and fertile land may simply encourage the enslavement of the local population. If the population is educated and skilled, they are more likely to be treated well, and to be consulted on imperial policy. They may even be recruited into the headquarters administration. These contacts will allow the dependency to discourage imperial policies that might inadvertently impede its local development.

Overall, these hypotheses provide a rigorous foundation for future study of the ‘co-evolution’ of ﬁrms and states.

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ACKNOWLEDGMENTS We are grateful to Janet Casson and George Tridimas for advice and comments on this chapter. Preliminary versions of this chapter was presented to the Association of Business Historians Annual Conference at Queen Mary, University of London, June 2006, and the European International Business Association Conference, Fribourg, in December 2006. We are grateful to Danny Van Den Bulcke, Peter Buckley, John Dunning, Phillipe Gugler, Niron Hashai and Alain Verbeke for invaluable comments.

REFERENCES Alesina, A., Perotti, R., & Spolare, E. (1995). Together separately? Issues on the costs and beneﬁts of political and ﬁscal unions. European Economic Review, 39, 751–758. Baumol, W. J., Panzar, J. S., & Willig, R. D. (1982). Contestable markets and the theory of industry structure. New York: Harcourt Brace Jovanovich. Bell, M., Butler, R., & Heffernan, M. (1995). Geography and imperialism, 1820–1940. Manchester: Manchester University Press. Boddewyn, J. J. (1988). Political aspects of MNE theory. Journal of International Business Studies, 19, 341–363. Brewer, T. (1990). Marxist theories of imperialism: A critical survey (2nd ed.). London: Routledge. Buckley, P. J., & Casson, M. (1976). The future of the multinational enterprise. London: Macmillan. Buckley, P. J., & Hashai, N. (2004). A global system view of ﬁrm boundaries. Journal of International Business Studies, 35(1), 33–45. Cain, P. J., & Hopkins, A. G. (1993). British imperialism: Innovation and expansion 1688–1914; Crisis and deconstruction, 1914–1990. London: Routledge. Casson, M. (1982). The entrepreneur: An economic theory. Oxford: Martin Robertson. Casson, M. (2006). Cultural determinants of economic performance. In: D. Throsby & V. Ginsburgh (Eds), Handbook of the economics of culture and the arts (pp. 359–397). Amsterdam: North-Holland. Dark, K. R. (1998). The waves of time: Long-term change and international relations. London: Frances Pinter. Gellner, E. (1987). Culture, identity and politics. Cambridge: Cambridge University Press. Heckscher, E., & Ohlin, B. (1933). Interregional and international trade. Cambridge, MA: Harvard University Press. Hymer, S. H. (1968). The large multinational corporation: An analysis of some motives for the international integration of business. Revue Economique, 19(6), 949–973 (translated by Natalie Vacherot and reprinted in Mark Casson (Ed.). (1990). Multinational corporations (pp. 3–31). Edward Elgar). Jones, E. L. (2006). Cultures merging. Princeton, NJ: Princeton University Press. Jones, G. G. (Ed.) (1998). The multinational traders. London: Routledge.

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Kennedy, P. (1987). The rise and fall of the great powers. New York: Random House. North, D. C. (1990). Institutions, institutional change and economic performance. Cambridge: Cambridge University Press. O’Brien, P. K. (1988). The costs and beneﬁts of British imperialism, 1846–1914. Past and Present, 120, 163–200. Olson, M. (1965). The logic of collective action. Cambridge, MA: Harvard University Press. Penrose, E. T. (1959). The theory of the growth of the firm. Oxford: Blackwell. Rugman, A. (2005). The regional multinationals: MNEs and ‘global’ strategic management. Cambridge: Cambridge University Press. Samuelson, P. A. (1954). The pure theory of public expenditure. Review of Economics and Statistics, 36(4), 387–389. Wallerstein, I. (1980). The modern world system II: Mercantilism and the consolidation of the European world economy. New York: Academic Press. Wilkins, M., & Schroter, H. (1998). Free-standing firms in the world economy. Oxford: Oxford University Press.

ARE MULTINATIONALS SUPERIOR OR JUST POWERFUL? A CRITICAL REVIEW OF THE EVOLUTIONARY THEORY OF THE MNC Mats Forsgren 1. INTRODUCTION IB scholars have put a considerable amount of effort into explaining why multinational companies (MNCs) are superior to other ﬁrms or to other modes of operation. The fact that MNCs are large and operate in several countries has made it natural to focus on why they are superior rather than whether they are indeed superior at all. A closer look at the different MNC theories, though, reveals that the basic argument for this supremacy has varied over the years. Stephen Hymer’s main focus was to explain the ability of foreign ﬁrms to establish operations in other countries despite having to bear the liability of foreignness (Hymer, 1976). He suggested that MNCs have ﬁrm-speciﬁc advantages that are large enough to out-compete the advantage of local ﬁrms in terms of their better market knowledge. Hymer’s perspective of the multinational ﬁrm, though, is as much an issue of reduced competition, through the exploitation and enhancement of market power, as a question of a ﬁrm-speciﬁc advantage in itself (Yamin, 1991). His concern was the MNCs’ above-normal proﬁts and

Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 29–50 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00002-7

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monopolistic behavior, evident through different forms of collusions and means of conﬂict resolution between ﬁrms, including mergers, acquisitions or strategic alliances across borders. Dividing up countries and markets between large actors with the aim of controlling competition is part of that story. Some ﬁrms are MNCs because, for some reason, they possess market power. Whatever the origin of that market power, the existence of MNCs does not automatically imply that ﬁrms of this type are more efﬁcient, just that they can do things due to market imperfections that other ﬁrms cannot do. The application of transaction cost (TC) theory to the MNC implies a change in focus, from the market structure and the position of the MNC in the market, to the internal characteristics of the MNC, as a ﬁrm. One basic assumption is that MNCs are superior because they solve the problem of high transactions costs through internalization (Buckley & Casson, 1976). The superiority is explicitly linked to the MNC, as an organization, per se, and not to its position in the market. Firms become MNCs because certain interdependent operations have to be located in different countries and the coordination between these operations is conducted more efﬁciently within one ﬁrm/hierarchy than between independent ﬁrms. The MNC is, simply speaking, more cost efﬁcient, also from a societal point of view. A fundamental part of that argument is that a hierarchy can curb opportunism more successfully than contracts between independent agents. It is a question of dealing with natural market imperfections (market failure) arising from certain characteristics of the asset to be exploited, rather than those occurring because of the impact of market power or structural imperfections (Hennart, 1991). During the 1990s Bruce Kogut and Udo Zander launched a theory of MNC supremacy, called the Evolutionary Theory of MNCs (Kogut & Zander, 1992, 1993, 1995a, 1995b, 1996). The theory has had a substantial impact on subsequent research on the MNC. Similarly to the internalization model, it claims the idea that MNCs are superior mainly because they are ﬁrms, and ﬁrms possess certain characteristics. However, there are also fundamental differences that the authors claim offer a more accurate explanation for the supremacy of the MNC. First of all, Kogut and Zander (K&Z) posit that the hierarchy, as a means to reduce transaction costs by curbing opportunistic behavior, is not the main advantage of the MNC. Instead, MNCs should be conceptualized as ‘‘social communities’’ that serve as an efﬁcient mechanisms for the creation and transfer of knowledge across borders (Kogut & Zander, 1993). The MNC is a repository of social knowledge, which is embedded in

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the competence of individuals and the organizing principles of work. The boundaries of the MNC demarcate qualitative changes in the reservoir of social knowledge, because learning is developed through shared identities within the MNC, and higher-order organization principles and routines establish coordination among individuals with disparate expertise (Kogut & Zander, 1996). As a result of sharing identities and organization principles developed over time, it is much easier to recombine and transfer technology inside an organization in comparison between independent ﬁrms. Here lies the main reason for the supremacy of the MNC, a supremacy that becomes more salient, the less codiﬁable and teachable the technology is. So, when the internalization model talks about the ability of the hierarchy to reduce transactions costs between units and about opportunistic behavior inside the MNC, K&Z talk about shared identities and established routines that facilitate the transfer of knowledge between the same units. Although the latter model is claimed to be dynamic, while the internalization model is static, both models deal with the same basic problem: how to transfer assets/ technology/knowledge between agents. There are barriers to such transfer which need to be addressed. In the internalization model, one main reason for the barriers is opportunistic behavior, and the solution is ﬁat through the MNC’s hierarchy. In K&Z’s model, the barrier is constituted of the difﬁculties in explaining and understanding know-how, and the solution is developing a common identity for the individuals and implementing the same organizational routines throughout the MNC. While both the conceptualization of the basic problem and the factors that solve the problem differ between the models, the overall result becomes strikingly similar: the MNCs are supreme because, as ﬁrms, they have certain characteristics. Although K&Z argue that the ﬁrm, as a repository of knowledge, constitutes the MNCs main competitive strength, the fundamental demarcation in terms of efﬁciency is basically between ﬁrms and non-ﬁrms, and not among ﬁrms (Kogut & Zander, 1995).

2. THE EVOLUTIONARY THEORY OF THE MNC – A CRITICAL REVIEW One basic assumption of the evolutionary theory of the MNC is that the ﬁrm must be understood primarily as a social community, and not only as an ownership system (Kogut & Zander, 1993). Another is that there is ‘‘more’’ social knowledge possessed by individuals within a ﬁrm than

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outside it, which then implies that the ﬁrm – and therefore the MNC – is superior in terms of communication and learning through the transfer of knowledge (Kogut & Zander, 1996). So far, the evolutionary theory of the MNC has been scrutinized mainly from the perspective of TC theory. For instance, it has been claimed that the concept of opportunism cannot be left out from a theory about the supremacy of MNCs (Foss, 1996). It has also been argued that K&Z’s theory is a model of market failure anyway, even if opportunism is left out (Love, 1995; McFetridge, 1995). However, the critique from a TC perspective does not change the basic assertion that MNCs are successful because they are superior to other forms. There are, though, several other problems related to the evolutionary theory more fundamental for the possibility to claim that MNCs are superior. Some of these problems will be addressed, as follows, in the discussion below: the relationship between the concept of identity and the concept of ﬁrm, the distinction between the MNC and its environment, the MNC as a repository for knowledge sharing, power – including the role of headquarters (HQ) in MNCs – and, ﬁnally, the concept of evolution.

3. THE RELATIONSHIP BETWEEN ORGANIZATIONAL IDENTITY AND SUPREMACY OF MNCS The evolutionary theory of the MNC predicts that the basic driver of the MNC as a social community is the concept of a shared identity between the individuals. Shared identity not only lowers the cost of communication, but also establishes explicit and implicit rules that facilitate coordination and learning, which consequently leads to the superior performance of MNCs (Kogut & Zander, 1996, p. 503). A closer look at the concept of identity, though, reveals that the link between a shared identity and the MNC – as a ﬁrm – is rather obscure. The concept of shared identity is based on the notion that, in parallel with their self-interest, every individual wants to belong to and cooperate in a group of individuals. These individuals share a sense of identity because they share common backgrounds, perspectives and competencies and because they interact with each other. The identity evolves over time through cooperation and communication between individuals in the group. It is a reasonable assumption in line with observations of human behavior that common identities develop within groups of individuals, and that these

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identities can facilitate communication between individual K&Z, though, do not deal with the problem of equating the group, in which individuals share a common identity, with the ﬁrm in general, and with the MNC in particular. And even if we do assume that groups can be social communities with common identities, the evolutionary theory does not offer any explanation of how these characteristics can be transformed into an advantage to the ﬁrm as a whole. On the contrary, there seems to be an inherent contradiction in the way K&Z deal with the concept of identity and the concept of ﬁrm (MNC) supremacy. They point out that an important strength of every ﬁrm is specialization through the division of labor, both vertically and horizontally, and that division of labor generates the learning dynamic in which people become increasingly more competent in their specialization (Kogut & Zander, 1996, p. 505). At the same time, it is within these groups of specialization that we can expect common identities to be developed and communication to be facilitated. As a consequence, and in line with K&Z’s argument, it is reasonable to expect that a ﬁrm, and not least an MNC, which incorporates geographic specialization, holds several, sometimes conﬂicting, identities (Buckley & Carter, 2004). This is indicative of a problem, not of supremacy. It is reasonable to assume that developing a common identity within a certain community, such as a professional group of marketing specialists, would have a negative impact on the level of interaction of these people with those in other communities, such as those involved in production. After all, this is what identity is about. If ‘‘everybody’’ shares the identity, the concept loses its meaning. Thus, a pertinent problem in the MNC is to integrate different professional groups. This problem becomes more serious the more the groups have developed common identities. K&Z are aware of this inconsistency in their reasoning, as they point out that identities are rarely singular, with the identity associated with the ﬁrm being only one of several possible identities (Kogut & Zander, 1996, p. 513). But they avoid drawing the obvious conclusion from this observation when it comes to the supremacy of MNCs. Instead, they try to save the theory by either assuming that technology drives the coherence of the ﬁrm (individuals value their membership in, e.g., a chemical firm or a steel firm) or by pointing out that the MNC can diversify its business. They conclude, though, that ‘‘y the coherence of the ﬁrm is the notional consistency of its businesses as understood by its members, and for that matter, outside investors and consumers’’ (Kogut & Zander,1996, p. 514). To summarize, there seems to be much left to explain why an assumed knowledge and learning advantage arising from common identities within

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groups can be transferred to supremacy at the ﬁrm level. Another illustration of the same problem is that the concept of the ﬁrm in the evolutionary theory is underspeciﬁed. In their reasoning, K&Z’s perspective seems to vary between one in which the ﬁrm is one and the same as a group of individuals with a common identity and, one in which it is a more complicated entity incorporating several communities, that is, more similar to a ‘‘real’’ MNC. This ambivalence is also illustrated in the way K&Z deal with the ﬁrm and the concept of social community. On one hand, the ﬁrm is deﬁned as a social community, and on the other, a ‘‘y social community is called a ﬁrm’’ (Kogut & Zander, 1996, p. 504). If the latter statement is acceptable, the supremacy of the MNC is easier to accept. However, it is against our common apprehension of what we mean by an MNC in real life. The reasoning about the connection between social community and the MNC supremacy runs the risk of being tautological.

4. THE MNC AND ITS ENVIRONMENT Another problem with the evolutionary theory of the MNC is the sharp demarcation between what is outside the ﬁrm and what is inside it. The (legal) border makes all the difference, and the surrounding environment plays no speciﬁc role in K&Z’s explanation of the supremacy of the MNC. The environment of the MNC seems to be considered to be rather similar to the market in economic theory. This is somewhat surprising as K&Z put so much emphasis on knowledge exchanges between individuals and units, presuming these to be fundamental ingredients in every social community and a demonstration of a common identity. It is difﬁcult to understand why these exchanges would be radically different outside the legal border of the ﬁrm from within it. On the contrary, a reasonable assumption would be that the ‘‘networks’’ of exchanges of information and knowledge that are so crucial in K&Z’s discussion of MNC supremacy often include actors outside the legal border. K&Z’s use of the expression ‘‘y the social community is called a ﬁrm’’ is therefore understandable. It demonstrates that the theory implies that, in the ﬁrst instance, ‘‘the ﬁrm’’ is conceptualized not as an ownership system, but as a community of individuals with a common identity. Hereby, the sharp distinction between the environment and the ﬁrm as an ownership system as laid out in K&Z’s treatment becomes quite an anomaly in their theory. The problem, though, is that ownership systems, rather than social communities, are what we refer to when we talk about MNCs like General Electric or ABB.

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A related issue is the conclusion that there is ‘‘more’’ social knowledge inside a ﬁrm/an MNC than between ﬁrms, making it easier for knowledge to be transferred between sub-units within the MNC than between the MNC and outside partners. In a nutshell, this constitutes the supremacy of MNCs. However, K&Z do not really explain why this should be so, for the simple reason that they treat the business environment of the MNC as a ‘‘market’’ in the traditional way. Transactions between independent ﬁrms are, at least implicitly, less path-dependent, more short-term oriented and based primarily on price considerations. Transactions within ﬁrms are, by deﬁnition, embedded in long-term social relationships reﬂecting mutual adaptation of activities and resources. This sharp distinction between the external side and the internal side of an MNC, though, runs against a lot of research on markets as business networks. First, there is extensive empirical evidence that transactions between ﬁrms often have a long-term orientation and are characterized by a high degree of mutual adaptation of resources and activities, that is, a high degree of relational embeddedness (Ha˚kansson & Snehota, 1995; Uzzi, 1996, 1997). Furthermore, an investigation of external and internal customer–supplier relationships among a large number of MNC subsidiaries reveals that the case of a subsidiary having a high degree of external embeddedness and a low degree of internal embeddedness is as common as the opposite case (Forsgren, Holm, & Johanson, 2005). Therefore, it is questionable whether the concept of social community and common identity are the most appropriate ways to differentiate the MNC from its environment. Apparently, we can also expect ‘‘islands’’ of social community and common identities in the ‘‘market,’’ similar to those we ﬁnd within the ﬁrm. So, whether there is ‘‘more’’ social knowledge within the ﬁrm than in the market is an empirical question that has to be addressed before we could conclude that the level of social knowledge constitutes the basic supremacy of the MNC.

5. KNOWLEDGE TRANSFER A basic standpoint in the evolutionary theory is that MNCs specialize in recombination and internal transfer of tacit knowledge. It is claimed that the MNC possesses superior efﬁciency as an organizational vehicle by which to transfer this knowledge across borders (Kogut & Zander, 1993). This notion, though, stands in contrast to the strikingly high extent to which persons in a large organization seem to be ignorant of what others within it do (Kogut & Zander, 1996, with reference to Girin, 1995). In a study

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of 98 subsidiaries belonging to 15 Swedish MNCs, only about 10% could be characterized as ‘‘Integrated Players’’ (Andersson & Forsgren, 2001), while the majority had a very low degree of knowledge integration with the rest of the MNC. In an investigation of 255 German foreign-owned subsidiaries, a similar pattern was found (Kutscker & Schurig, 2002). Large organizations are as much like ‘‘seas of ignorance’’ as they are webs of shared knowledge (Postrel, 2002). If recombination and transfer of knowledge are the main attributes of MNCs, it is rather surprising that the absence of knowledge transfer between units and individuals seems to be at least as prominent as its presence. A basic problem with the concept of knowledge transfer in the evolutionary theory of the MNC is the limited discussion of how the different units, which are supposed to be heavily involved in knowledge transfer with each other, are related in operational terms. On one hand, specialization and division of labor between units seem to play an important role, especially in relation to the discussion about identity. Thus the units can be said to have different – and complementary – capabilities. On the other hand, in the discussion about knowledge transfer, the relationships between the units seem to be of a different kind; the units are involved in similar activities (often in different parts of the world) and therefore need similar capabilities. It is, of course, reasonable to expect that both kinds of relationships exist in a real MNC (and that, for some units, there might be no relationship at all except that of belonging to the same legal owner). However, knowledge transfer and learning can be totally different things depending on what kind of relationships we are talking about. One way to deal with this issue is to apply Richardson’s model of industry organization to the MNC (Richardson, 1972). This means that, at any point in time, the units of the MNC represent different activities, products, markets and competences. Simply speaking, the activities of two units can either be built on the same type of capability or be related to each other in terms of product or service ﬂows, e.g., as customers and suppliers. In the ﬁrst case, the subsidiaries are dependent on similar capabilities for their operations, but they are not directly dependent on each other for their ongoing business (except that they may be competitors). We can call this case a horizontal relationship. In the second case, they are forced to coordinate their activities because their roles are complementary, but the activities in each subsidiary are based on different capabilities. We can call this case a vertical relationship. The concept of similarity and complementary are independent of each other, which means that one unit can be more or less similar to other units in

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terms of capabilities, yet complementary in terms of coordination of activities with these units. However, it is reasonable to expect that in most relationships, one type dominates over the other. Horizontal relationships are typical when, e.g., two subsidiaries are operating in different countries, but in the same type of business, e.g., producing and selling a certain product. Vertical relationships dominate in situations in which one subsidiary is related to another through a value chain. These two relational dimensions inﬂuence the type of knowledge transfer occurring between units as well as the conditions for the very existence of knowledge transfer. Knowledge transfer in the situation of similarity is primarily a question of exploiting new knowledge, such as a product innovation, on a larger scale by equalizing capabilities between units. This is analogous to the ‘‘teacher– student’’ situation in which the student, the receiving unit, is learning how to apply and beneﬁt from knowledge new to him or her that, for some reason, is located in another unit, the teacher (Lane & Lubatkin, 1998). This is the classical case of moving a certain piece of knowledge within an MNC from one place to another place to attain a higher degree of economy of scale. It might also be a good example of the type of knowledge transfer that is most commonly connected to the social beneﬁts of MNCs: knowledge that is developed by the MNC in a certain country is supposed to move and be utilized by units in another country at little or no cost. The receiving country is also supposed to beneﬁt from this knowledge transfer. However, to what extent the MNC actually plays an important role as a vehicle for horizontal knowledge transfer is far from obvious. It has been demonstrated that knowledge transfer between ‘‘equals’’ has to overcome many barriers. For instance, the ‘‘teacher’’ does not want to teach, and/or the ‘‘student’’ does not want to learn. That is, there is a lack of motivation associated with the assignment of a role on both sides of the relationship. Furthermore, time and cost considerations will often limit the actual ﬂow of knowledge transfer (Allen, 1977; Szulanski, 1996; Forsgren et al., 2005). Another problem is that the more similar two units are in terms of their capabilities, the greater their potential for competition over charter, and therefore the less willingness there is likely to be to share knowledge (Galunic & Eisenhardt, 1996; Gupta & Govindarajan, 2000; Persson, 2006). There can also be a lack of absorptive capacity on the receiver side owing to the tacitness of the new knowledge and the speciﬁcity of the context in which the new knowledge was developed increasing the difﬁculties associated with transferring the knowledge to a new context. For instance, it has been demonstrated that context speciﬁcity in terms of a high degree of subsidiary external embeddedness has a positive impact on a subsidiary’s own market

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performance (Andersson, Forsgren, & Holm, 2002), but a negative impact on the transfer of knowledge from the subsidiary to the rest of the MNC (Holmstro¨m, 2004; Persson, 2006). So, even if we assume that more knowledge transfer is always better than less for MNC performance1, it would still appear that there are some serious obstacles to horizontal knowledge transfer. However, and maybe more interestingly, there is reason to question the implicit assumption made in the evolutionary theory that equalizing capabilities between units is always a good thing. Research on horizontal knowledge transfer inside organizations tends to emphasize the process of knowledge sharing without explicitly considering whether the potential difﬁculties and drawbacks of knowledge sharing outweigh the beneﬁts. The value of a ﬁrm’s knowledge resources must be assessed by examining the outcome of task performance, rather than by measuring the levels of stock or ﬂows of knowledge in the organization (Haas & Hansen, 2005; Persson, 2006). There is always an opportunity cost in searching and transferring knowledge in terms of the time taken away from working with other aspects of the task. It has also been demonstrated empirically that units can actually be worse off when they obtain knowledge transferred from other units in the organization, since utilizing such knowledge can have a negative impact on task performance in certain situations. It has also been suggested that knowledge transfer may reﬂect existing norms and incentives in the organization rather than improving the efﬁciency of the outcome (Haas & Hansen, 2005). In the case of vertical relationships, knowledge transfer in an MNC must be analyzed in relation to the division of labor and specialization. In contrast to the horizontal case, we are dealing with complementary capabilities that need to be coordinated rather than transferred. That is, the division of labor rests on the idea of not equalizing capabilities between units as that would harm the economies of scale inherent in specialization. If the customer acquires the same capability as the supplier, there would be no specialization. So what do we mean by knowledge transfer in this case? The concept transfer in the vertical case is somewhat misleading because rather than transferring a certain capability from one unit to another, transfer refers to the question of one sub-unit understanding what its partner can do, without having any ideal of imitating it or doing the same thing itself. Such understanding is important in situations of problem-solving in the value chain. For instance, it seems obvious that communication across specialities is an important factor in making product development projects more successful (Hoopes & Postrel, 1999) and that close relationships between customers and suppliers are conducive for mutual problem-solving (von Hippel, 1988;

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Ha˚kansson, 1989). However, it has also been convincingly argued that there is always a trade off between specializing more and increasing trans-specialist understanding. The basic reason for this is that specialization and transspecialist understanding are substitutes for one another, not complementary, as is often implicitly assumed in, e.g., contingency theory (see e.g., Lawrence & Lorch, 1967). In many cases, one specialist’s capability buffers the other from needing to understand its problem, in a similar way to how having a stock of inventory between two stages of production allows each stage to optimize its own work cycle without synchronizing the units. In other cases, though, trans-specialist understanding can compensate for inferior specialization capability (Postrel, 2002, p. 311–312). One important conclusion that can be drawn from this reasoning is that trans-specialist understanding is not a prerequisite for the efﬁciency of a work-ﬂow system. On the contrary, based on the usual assumption that existent knowledge facilitates more learning in the same ﬁeld rather than in new ﬁelds, investing in specialized knowledge is often cheaper than investing in trans-specialist understanding. This implies an organization economy in which the ‘‘black-box principle’’ (of having a highly capable specialty that is opaque to others) is a common state of affairs, although interrupted by ‘‘islands’’ of understanding across specialties (Postrel, 2002). The fact that these ‘‘islands’’ play a vital role in certain situations, and also happen to be important features of management, should not mislead us into thinking that interaction, in terms of trans-specialist understanding, is always the dominant feature of any MNC. It probably is not, and should not be. An even more important conclusion is that the islands of understanding across specialties may or may not coincide with the border of the firm. They may be as salient between independent ﬁrms as within them, e.g., between customers and suppliers, or in strategic alliances, etc. Therefore, it is doubtful whether the MNC has any particular characteristics from a knowledge processing view, as is suggested by the evolutionary theory. There are ‘‘islands’’ of trans-specialist understanding in different contexts – and not only or particularly in ﬁrms/MNCs – but maybe they exist to a much lesser extent that we tend to assume.

6. THE MNC AS A SOCIAL COMMUNITY – A RATIONALIZED MYTH? The proposition that learning through knowledge processing is the essence of the organizational life of an MNC – and therefore the base of its

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supremacy – seems, at ﬁrst glance, relevant in a world that is often referred to as ‘‘The Knowledge Society’’. It is also tempting to assume that the greater the ﬂow of knowledge, the better, because of the emphasis on innovation as the factor behind the source of success. In that sense, the evolutionary theory of the MNC is closely related to Hedlund’s metaphor of the ‘‘ﬁrm as a brain’’ (Hedlund & Rolander, 1990). However, as we have indicated above, the conceptualization of the MNC as a social community with a common identity is problematic. Maybe the concept of the MNC as an advanced repository of knowledge is as much a ‘‘rationalized myth’’ (Meyer & Rowan, 1977) as the traditional assumption that ﬁrms are organizations with well-deﬁned goals. As a social community and as a repository of social knowledge, the MNC seems to fulﬁll the characteristics of a rationalized myth as it is widely believed, but difﬁcult to verify empirically (Scott, 1981). As in the metaphor of the ﬁrm as a brain the evolutionary theory tends to conceptualize the MNC as a network in which ‘‘everyone’’ is socially connected to everyone else. The most important aspect of that concept seems to be the idea that membership in an MNC indicates a commitment to a common organizational identity. It is, perhaps, a little unfair to accuse K&Z of claiming that all employees in a large MNC are committed in that sense. There is no discussion, though, about a possible dividing line between those sharing a common identity and those not, except for the notion that those involved in different specialties can have different identities owing to the identity associated with their specialization (Kogut & Zander, 1996, p. 513). It is probably fair, though, to argue that when K&Z elaborate on the concept of identity it is implicitly limited to the higher echelons of the organization; top management, division managers and (maybe) subsidiary managers. In this sense, K&Z can be said to adopt a rather elitist view of commitment and identity. What a more limited commitment among the large number of employees (for instance, providing ﬁrst of all livelihood) means for the possibility of the MNC to function as a social community is not addressed.2 This is a serious limitation because the idea of the MNC as a repository of knowledge cannot be meaningfully constrained to a limited group of managers. It must include a larger group of organization members. In that sense, the evolutionary theory of the MNC contains an obvious tension between a ‘‘sociological theory’’ of a ﬁrm as a dynamic group of knowledgeable and cooperative individuals, and as a theory of leadership and management executed by a small and homogenous group of managers. It is also far from clear what impact a common identity has on the actual transfer of knowledge between sub-units. It has been demonstrated that

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shared values (Ghoshal & Nohria, 1997), a concept closely related to having a common identity, between subsidiaries and corporate HQ have limited explanatory power when it comes to justifying the extent to which subsidiaries are involved in knowledge sharing inside the MNC. The closeness of their relationships with their sister units, in terms of their business activities, seems to be much more important (Forsgren et al., 2005). This result could illustrate that conceptualizing the phenomenon of shared values – or a common identity – between subsidiaries and the HQ in an MNC is misleading. If knowledge transfer is primarily a question of relationships between subsidiaries rather than between subsidiaries and HQ, it follows that ‘‘horizontal’’ common identities are more important than ‘‘vertical’’ common identities. The result also indicates that common identity between corporate units is something that is built up gradually in the course of business interactions. That is, business exchange comes ﬁrst, common identity later.

7. POWER AND THE ROLE OF HQ IN THE EVOLUTIONARY THEORY OF THE MNC In the management-oriented literature about shared values (see e.g., Ghoshal & Nohria, 1997), one underlying assumption is that HQ creates (or should create) a common identity among its subsidiaries in accordance with its own values. Apart from the acknowledged difﬁculties that anyone, including HQ, will encounter when it comes to changing basic values or business logics (Hofstede, Neuijen, Daval Ohayv, & Sanders, 1990; Sta˚hl, 2004), there is also reason to question the image of the HQ as orchestrating the knowledge process in the MNC. We might agree that this is one of HQ’s most important roles, but it is quite another matter whether HQ succeeds in fulﬁlling this role. The evolutionary theory does not deal explicitly with the problem of bounded rationality at the HQ level. The basic perspective adopted in this theory seems to be that HQ’s role is to stimulate a common identity within the ﬁrm/group through developing higher organizational principles and routines. The social knowledge is assumed to be bound in these principles and routines. However, how that conceptualization is related to the role of the HQ is not dealt with particularly. The more one emphasizes that knowledge is context speciﬁc and action oriented (Giddens, 1984), the more difﬁcult it is to look upon HQ as an ‘‘insider’’ in these contexts. For instance, there is reason to assume that the business networks in which the different subsidiaries are embedded constitute important action-oriented

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contexts (Forsgren et al., 2005). We cannot take it for granted that HQ is a member of these contexts. The question, then, is to what extent HQ can develop routines and higher organizational principles speciﬁcally to connect the different contexts and become involved in those to which it is not a member. This is actually a question of ‘‘sheer ignorance’’ (Kirzner, 1997; Goodall & Roberts, 2003) in the sense that subsidiaries, and not HQ, possess a certain type of social knowledge, but more fundamental than this is the fact that HQ does not know what they don’t know. Or, expressed differently, the organization principles and the routines that are developed at the HQ level may have only a limited impact on the transfer of knowledge between knowledge contexts, such as business networks. The problem of ‘‘sheer ignorance’’ is not of course restricted to HQ. No sub-unit has full insight into any other unit’s life. It can be argued that even in such situations, a central authority may represent the least-cost response to the problem of coordinating sub-units’ actions (Foss, 2002). For instance, if it is necessary to reach an agreement on which subsidiary should take care of which market or country in order to avoid duplication, then an autocratic decision may offer the most efﬁcient solution, even in the presence of ‘‘sheer ignorance’’ at the HQ level. A decision must be made. However, there is a problem in that dispersed knowledge is normally combined with dispersed interests in the MNC. Interests are socially embedded in speciﬁc contexts of knowledge. Thus, the MNC is dominated by several local rationalities emanating from the subsidiaries’ various business networks rather than a common rational (Forsgren et al., 2005). Consequently, even if a central decision to divide the markets up among the subsidiaries were rational from an overall point of view, the subsidiaries could refuse to accept such a decision. More importantly, the dispersed knowledge also gives them power to offer effective resistance. The evolutionary theory is a model of ‘‘harmony’’ rather than of power and conﬂict. K&Z point out that the concept of power is more or less omitted in their model, although they argue that the general characterization of ‘‘social behavior y in terms of discourse, identity and structure’’ would still be the same (Kogut & Zander, 1996, p. 516). It is difﬁcult, though, to ignore the issues of power and conﬂict if the supremacy of the MNC is analyzed. The idea that MNCs are analogous to social communities with common identities is, at least implicitly, built on the idea that there is no antagonism or diversity in terms of goals and interests, or at least that any conﬂict that does exist does not create any severe problems. But if there are instances of antagonism or low goal congruence, which some argue is quite often the case, not least in MNCs (Birkenshaw & Hood, 1998;

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Galunic & Eisenhardt, 1996; Asakawa, 2001; Mudambi & Navarra, 2004), this would have a negative impact on the supremacy of the MNC as a vehicle for knowledge transfer. On a more general level, we can distinguish between two perspectives in terms of the internal ‘‘life’’ of a social system, e.g., an MNC. The ﬁrst perspective considers actors to be pursuing their own preferences in negotiations among other actors with conﬂicting interests. Similar to what has been labeled ‘‘the logic of expected consequences’’ in international relations (see e.g., March & Olsen, 1998) or ‘‘rent-seeking’’ among subsidiaries in multinationals (Mudambi & Navarra, 2004), the extent to which there will be any cooperation and knowledge transfer between actors will depend on their bargaining position and on the consequences the actors expect there will be for themselves. The other perspective is less interest based and more identity based. It focuses on the idea that rules, practises and identities are developed over time in a social system which will work as a corrective to ‘‘rent-seeking’’ behavior. Actors are prepared to pay less attention to their own preferences and follow certain rules and practises even if that means that they have to sacriﬁce some of their own interests for the sake of the organization as a whole. Identities rather than partial interests are what affect organizational behavior. In the context of international relations, this has been called ‘‘the logic of appropriateness’’ (March & Olsen, 1998) and, in an MNC context ‘‘proﬁt-seeking behavior’’ (Mudambi & Navarra, 2004). It is reasonable to assume that both phenomena exist in an MNC. Some subsidiaries are more inclined to try to pursue their own interests, while the behavior of other subsidiaries is more ‘‘collectivistic’’ than ‘‘individualistic.’’ Even more interesting, perhaps, is the fact that one and the same subsidiary can follow both forms of logic, although the balance between them can vary over time. The evolutionary theory seems to lean solely on the ‘‘logic of appropriateness.’’ Subsidiaries are supposed to behave in accordance with a common identity and rules related to this identity. There is no room for ‘‘rent-seeking.’’ This is an extreme standpoint (although maybe not so extreme if compared with the common textbook stance adopted in business administration), especially if we realize that MNCs are much less stable entities than, e.g., states. Employees come and go, ﬁrms are acquired and merged and the possibility to develop a common identity must be seen in this context of instability. The ‘‘logic of expected consequences’’ is probably always a prominent part of the MNC’s ‘‘internal life’’ and should not be left out in an analysis of MNC supremacy.

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8. THE CONCEPT OF EVOLUTION IN THE EVOLUTIONARY THEORY OF THE MNC A common assumption in evolutionary theory in general is that social evolution is equivalent to ‘‘advancement’’ (Granovetter, 1979). This also appears to be valid for the evolutionary theory of the MNC. The MNC is conceptualized not only as a repository of knowledge in general, but also, at least implicitly, as a more advanced form of such a repository than other social systems (Kogut & Zander, 1993). The MNC is, in that sense, presumed to be the most advanced form so far. The idea of advancement in evolutionary theory, though, has been the object of criticism by several scholars (Popper, 1945; Perrow, 1986). It has been pointed out that the possibility to rank social systems according to their ‘‘efﬁciency’’ or ‘‘adaptive capacity’’ is not feasible because (a) comparisons of utility between social systems cannot be made meaningfully, and (b) the nature of the systems in question does not lend itself to useful predictions of future problem-solving (Granovetter, 1979, p. 508). Related to these issues is the notion that ranking entails a view of social systems as coherent, welldeﬁned and self-contained systems. It is questionable if MNCs fulﬁll these criteria. Furthermore, there is also a tendency to equate efﬁciency with technical complexity, even though it can be shown that there is no automatic correlation between these two dimensions (Granovetter, 1979, p. 493). In addition, it must also be pointed out that, even if technical complexity can produce a higher level of efﬁciency in a social system, the idea that such a system implies a higher order rests on the assumption that the system is always operating at the maximum level. If it does not, efﬁciency constitutes a necessary, but not a sufﬁcient, condition for superiority. An MNC in a monopolistic situation might provide a good example of such a case. To sum up, it is reasonable to issue a warning for the functionalistic feature of the evolutionary theory of the MNC. Like evolutionary theory in general, when applied to the MNC, the evolutionary theory runs the risk of rationalizing rather than analyzing existing social arrangements.

9. CONCLUSIONS The discussion above has cast some doubt on the assertion that MNCs are social communities with supreme abilities to combine and transfer tacit knowledge across geographic and functional barriers. There are several

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reasons for this. First, it is questionable whether an MNC can be conceptualized as just one social community with a common identity, and as a consequence, with an advanced ability to process knowledge. Second, the evolutionary theory of MNCs treats the environment in a rather superﬁcial way and ignores the possibility that social communities can exist in other settings. It is not without doubt that there is more social knowledge inside than outside an MNC. Third, the evolutionary theory also seems to ignore the cost of knowledge transfer inside an MNC, by taking it for granted that more knowledge transfer is better than less knowledge transfer under all circumstances. It also disregards the fact that knowledge transfer means different things depending on the type of relationship between sub-units of an MNC. Fourth, it disregards the problem of commitment and identity being, primarily, a matter of relevance to the top management, which has far reaching consequences for the possibility of perceiving the MNC to be a repository of social knowledge with a common identity. Fifth, evolutionary theory does not deal with the role of the HQ and the problem of bounded rationality. The fact that the HQ is, to a large extent, an outsider in terms of the creation and processing of knowledge, and how this affects the possibility of HQ playing a coordinating role in different contexts, is not dealt with. Sixth, the evolutionary theory of MNCs is primarily a model about ‘‘harmony,’’ rather than about power, conﬂicts and the absence of congruent goals. If we apply a more ‘‘federative’’ view, the MNC should be conceptualized as an arena for conﬂict, in which knowledge possessed locally can be used as a source of power. This view would at least imply substantial malfunction of the MNC as a vehicle for recombining and transfer of knowledge. So, if we cannot be sure that MNCs are superior forms of organizing, what are the main characteristics of the MNC? First of all, few would deny that the most important feature of an MNC is its strength vis-a`-vis that of the surrounding society. It is important to recognize that MNCs, as large and powerful entities, not only adapt to the environment but also shape it (see Casson et al. in this volume). It has been argued that the failure to see that society is adaptive to organizations is a signiﬁcant drawback of most organization theory (Perrow, 1986). That also goes for internalization theory and the evolutionary theory of the MNC. Neither of these theories seem to be concerned with the fact that MNCs control the environment in which they operate. This stands in sharp contrast to Hymer’s main concern about the market power of the MNC and the impact of the MNC on the society. No changes have occurred to the behavior of MNCs since Hymer’s writings were published that give reason to conclude that this concern is less valid today. MNCs are more powerful now than ever before. The functionalist feature of

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internalization theory and evolutionary theory, implying that MNCs are good more or less by deﬁnition, though, has obscured our vision on this point. We should not make the same mistake as Hymer, though, and conclude that the possibility of MNCs to mobilize powerful resources and shape the environment is synonymous with complete control (Yamin & Forsgren, 2006). MNCs are powerful tools in the hands of their leaders, but they are imperfect, incompletely controlled, tools, and the management is engaged in a never-ending struggle to maintain its control over the organization (Perrow, 1986). We often take it for granted that top managers have full control over their MNC, or at least model them as though this were the case. To some extent, this reﬂects the tendency to adopt a humble attitude towards power in the business community, not least among IB researchers, and the unrealistic assumptions about what top managers can actually do.3 Top managers are powerful, but their power is always likely to be contested by other groups in the MNC. It is like riding a horse without reins. The ride will be full of surprises and irrationalities. What consequences does this have for society at large? In contrast to functionalistic theories, like internalization theory and evolutionary theory, it becomes much more relevant to discuss the means by which society can control MNCs. As MNCs are not good or more advanced by deﬁnition, it is appropriate to discuss the requirements that need to be imposed on their social behavior. Popper made an insightful statement that ‘‘y of controlling the rulers, and of checking their power, was in the main an institutional problem – the problem, in short, of designing institutions for preventing even bad rulers from doing too much damage’’ (Popper, 1945, p. 131). This is still highly relevant, especially in situations where MNCs can be conceptualized as paradoxical combinations of powerful resource constellations and incomplete control. The series of scandals and mismanagements in the business community (e.g., Enron, Skandia, Parmalat, Ahold, etc.) are in themselves striking arguments for the ‘‘need to control the rulers.’’ The issue of corporate social responsibility (CSR) illustrates this point. CSR can, broadly, be deﬁned as the efforts corporations make above and beyond regulations to balance the needs of stakeholders with a need to make a proﬁt. There is also a ﬁrm belief that corporations in a market economy can ‘‘do well’’ on the business front and ‘‘do good’’ in society, at the same time, without mandatory regulations – enabling them to both save the world and make a decent proﬁt. However, even though most MNCs now issue a voluntary social and environmental report alongside their regular annual ﬁnancial report, it is questionable whether this has altered the overall landscape in a profound way (Doane, 2005). There are indications that

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MNCs are as much regulating the CSR ﬁeld as being regulated by it, and that CSR can also be seen as a rationalized myth, in terms of a new management trend (Sahlin-Andersson, 2006). One reason is maybe also that initiatives, like protecting natural assets, are difﬁcult to agree upon in the ‘‘federative’’ MNC, especially if it is unlikely that the pay-off is within a two to four year time horizon. Short-term interests have a good chance of winning over social responsibility by referring to the requirements of the stock market. The fact that MNCs are powerful vis-a`-vis governments and occupy strong market positions also stands in sharp contrast to the belief that competitive pressure will lead to more competition over ethical issues, as highlighted by an increasing number of award schemes for good companies. Intensive and successful lobbying by MNCs and their associations are probably more in line with the MNC as a powerful actor in the society. If we adopt the perspective that MNCs have access to powerful resources, although under incomplete control, what does it mean? Are we back to Hymer’s original concern about the societal role of the MNC? If so, what kind of analytical tools do we need to examine this role? Is it even possible for a society to control the ‘‘rulers’’ of MNCs when they are, in fact, difﬁcult to identify in the ﬁrst place? How can regulations be effective in such a situation? Are ‘‘bilateral’’ negotiations between local governments and MNC subsidiaries the only practical solution? Or, is a rule-based international system with transparent standards, effective monitoring and fair enforcement the only possible solution (Kobrin, 2005)? These and related issues are more urgent than ever before for IB researchers to address (Eden & Lenway, 2001). However, as the discussion above has demonstrated, the evolutionary theory of the MNC does not lend itself to such a task. Or maybe, more accurately, the perspective of evolutionary theory tends to render these questions irrelevant.

NOTES 1. This assumption can be questioned though if extensive knowledge transfer leads to the sub-units becoming too similar. 2. Maybe the most obvious case of a common identity can be found between top managers in different MNCs, rather than between top managers and employees in a particular MNC (see, e.g., Korten 2001). 3. An excellent example of this is the article by Bartlett and Ghoshal in SMJ, ‘‘Beyond the M-from: Towards a managerial theory of the ﬁrm,’’ which, basically, is a mouthpiece for the way in which Percy Barnevik, the former president of ABB, looks upon leadership (Bartlett & Ghoshal, 1993).

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Ha˚kansson, H. (1989). Corporate technological behaviour: Cooperations and networks. Routledge: London. Ha˚kansson, H., & Snehota, I. (1995). Developing relationships in business networks. Routledge: London. Hedlund, G., & Rolander, D. (1990). Action in heterarchies: New approaches to managing the MNC. In: C. A. Bartlett, Y. Doz & G. Hedlund (Eds), Managing the global firm. London: Routledge. Hennart, J.-F. (1991). The transaction cost theory of the multinational enterprise. In: C. Pitelis & R. Sugden (Eds), The nature of the transnational firm. London: Routledge. von Hippel, E. (1988). Sources of innovation. Oxford: Oxford University Press. Hofstede, G., Neuijen, D., Daval Ohayv, D., & Sanders, G. (1990). Measuring organizational cultures: A qualitative and quantitative study across twenty cases. Administrative Science Quarterly, 35, 286–316. Holmstro¨m, C. (2004). In search of MNC competitive advantage: The role of foreign subsidiaries as creators and disseminators of knowledge. Doctoral dissertation, Department of Business Studies, Uppsala University. Hoopes, D. G., & Postrel, S. (1999). Shared knowledge, ‘‘glitches’’, and product development performance. Strategic Management Journal, 20, 837–865. Hymer, S. (1976). The international operations of national firms: A study of foreign direct investments. Cambridge, MA: MIT Press. Kirzner, I. M. (1997). Entrepreneurial discovery and the competitive market process: An Austrian approach. Journal of Economic Literature, XXXV, 60–85. Kobrin, S. (2005). Multinational corporations and human rights: Does ‘‘private’’ political authority imply public liability? Academy of International Business. Insights., 5(4), 3–7. Kogut, B., & Zander, U. (1992). Knowledge of the ﬁrm, combinative capabilities and the replication of technology. Organization Science, 3(3), 76–92. Kogut, B., & Zander, U. (1993). Knowledge of the ﬁrm and the evolutionary theory of the multinational corporation. Journal of International Business Studies (Fourth Quarter), 625–645. Kogut, B., & Zander, U. (1995a). Knowledge and the speed of transfer and imitation of organizational capabilities: An empirical test. Organization Science, 6(1), 76–92. Kogut, B., & Zander, U. (1995b). Knowledge, market failure and the multinational enterprise: A reply. Journal of International Business Studies (Second Quarter 1995), 417–426. Kogut, B., & Zander, U. (1996). What ﬁrms do? coordination, identity, and learning. Organization Science, 7(5), 502–518. Korten, D. C. (2001). When corporations rule the world. Bloomﬁeld, CT: Kumarian Press. Kutscker, M., & Schurig, A. (2002). Embeddedness of subsidiaries in internal and external networks: A prerequisite for technological change. In: V. Havila, M. Forsgren & H. Ha˚kansson (Eds), Critical perspectives on internationalization. Amsterdam: Pergamon. Lane, P., & Lubatkin, M. (1998). Relative absorptive capacity and interorganizational learning. Strategic Management Journal, 19(5), 461–467. Lawrence, P., & Lorch, J. (1967). Organization and environment. Cambridge, Mass: Harvard University Press. Love, J. H. (1995). Knowledge, market failure and the multinational enterprise: A theoretical note. Journal of Business Studies (Second Quarter), 399–407. March, J. G., & Olsen, J. P. (1998). The institutional dynamics of international political orders. International Organization, 52(4 Autumn), 943–968.

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McFetridge, D. G. (1995). Knowledge, market failure and the multinational enterprise: A comment. Journal of International Business Studies (Second Quarter), 409–415. Meyer, J. W., & Rowan, B. (1977). Institutionalized organizations: Formal structure as myth and ceremony. American Journal of Sociology, 83, 340–363. Mudambi, R., & Navarra, P. (2004). Is knowledge power? Knowledge ﬂows, subsidiary power and rent-seeking within MNCs. Journal of International Business Studies, 35, 385–406. Perrow, Ch. (1986). Complex organizations: A critical essay. New York: Random House. Persson, M. (2006). Unpacking the flow: Knowledge transfer in MNCs. Doctoral dissertation, Department of Business Studies, Uppsala University. Popper, K. R. (1945). The open society and its enemies. Vol. II. The high tide of prophecy: Hegel, Marx and the aftermath. London: Routledge & Kegan Paul. Postrel, S. (2002). Islands of shared knowledge: Specialization and mutual understanding in problem-solving teams. Organization Science, 13(May–June), 303–320. Richardson, G. B. (1972). The organization of industry. Economic Journal, 82, 883–896. Sahlin-Andersson, K. (2006). Corporate social responsibility: A trend and a movement, but of what and for what? Corporate Governance, 6, 595–608. Scott, R. W. (1981). Organizations: Rational, natural and open systems. Englewood Cliffs, NJ: Prentice Hall. Sta˚hl, B. (2004). Innovation and evolution in the multinational enterprise. Doctoral dissertation, Department of Business Studies, Uppsala University. Szulanski, G. (1996). Exploring internal stickiness: Impediments to the transfer of best practise within the ﬁrm. Strategic Management Journal, 17(Winter Special Issue), 27–43. Uzzi, B. (1996). The sources and consequences of embeddedness for the economic performance of organizations: The network effect. American Sociological Review, 61, 674–698. Uzzi, B. (1997). Social structure and competition in interﬁrm networks: The paradox of embeddedness. Administrative Science Quarterly, 42(1), 35–67. Yamin, M. (1991). A reassessment of Hymer’s contribution to the theory of the transnational corporation. In: N. Pitelis & R. Sugden (Eds), The nature of the transnational firm. London: Routledge. Yamin, M., & Forsgren, M. (2006). Hymer’s analysis of the multinational corporation: Power retention and the demise of the federative MNE. International Business Review, 15, 166–179.

THE LOCATIONAL DETERMINANTS OF FOREIGN DIRECT INVESTMENT IN EUROPEAN UNION CORE AND PERIPHERY: THE INFLUENCE OF MULTINATIONAL STRATEGY Dimitra Dimitropoulou, Robert Pearce and Marina Papanastassiou 1. INTRODUCTION One of the key themes implicit in the analysis and testing of multinational enterprise (MNE) behaviour over the past two decades has been the evolving interrelationship between corporate integration and economic integration (Dunning & Robson, 1988; Papanastassiou & Pearce, 1994; Pearce & Papanastassiou, 1997; Balasubramanyam & Greenaway, 1992; Tavares, 2001). Here we seek to elaborate on aspects of this by testing the determinants of foreign direct investment (FDI) into the individual countries of the European Union (EU), over the period 1980–2001, in the light of a diversity of strategic roles or motivations pursued in the networked operations of contemporary MNEs. The view of the MNE central to this Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 51–79 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00003-9

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approach suggests it is now ‘seeking to use the increasing freedoms of international transfers, reﬂecting the essence of economic globalization, to leverage the differences between economic areas’ (Pearce, 2006a, p. 41). Applying this to our investigation here sees the current EU as embodying a range of countries at different stages of development and industrialization, such that MNEs have the potential to build community-wide strategic networks and interdependencies by reacting positively to particular deﬁning and idiosyncratic features of individual member economies (or sub-regions within them). To facilitate meaningful empirical investigation, and reﬂecting a popular characterisation, we seek to operationalise the perceived core/ periphery dichotomy of EU members. The narrative underpinning the emergence of strategic heterogeneity in MNEs’ European operations can start by suggesting that, at the beginning of the process of regional integration, the dominant role of most subsidiaries was a market-seeking (MS) supply of individual national markets. A key conditioning factor driving this multidomestic (Porter, 1986) portfolio of competitively separated operations was the persistence of high levels of trade barriers.1 The lowering of trade barriers central to the implementation of the EEC/EU exposed the inefﬁciency of individual subsidiaries and, therefore, the innate dysfunctionality of such a group of similar local-supply operations. The pervasive MNE reaction to this was a move towards a coherent region-wide strategy, building individual subsidiaries into a network pursuing competitiveness across the integrating group of economies. Two newer motivations that emerged within this differentiated network will be tested here. It can also be acknowledged, though, that the emerging EU networks may still encompass a more contemporary variant of MS, suggesting the continued value of a ‘presence effect’ (Buckley & Artisien, 1988) allowing subsidiaries to respond to distinctive characteristics and needs. In terms of the two emergent motivations, leveraging particular facets of national economies for EU-wide competitiveness, efficiency seeking (ES) builds an integrated supply network, so that different parts of the current product range are produced in the most cost-effective location. This accepts the persistence of different levels of development amongst member states, alongside other natural differentiating characteristics (climate, heritage/ tradition, culture, etc.), so that input differences can attract production of different mature goods. But as countries do develop over time one manifestation of this is usually the emergence of a distinctive national science base (or national system of innovation), possessing different technological capacities and creative potentials. Accessing aspects of this

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to support their need to generate new goods and services provides the knowledge-seeking (KS) motivation in contemporary MNEs. The fact that success in the generation of national systems of innovation is really only manifest through achievement of different capacities, suggests that MNEs’ KS, in an advanced region such as the EU, needs to be exercised in several different countries. In the next section, we address the issue of allocating EU members to the ‘core’ and ‘periphery’, ultimately drawing out the value of interpolation of an ‘intermediate’ grouping of countries. Then, in Section 3, we elaborate on the application of the three MNE strategic motivations to the idea of stratiﬁed groupings of EU economies and derive the independent variables used to proxy them. Section 4 reviews the dependent variable and the econometric methodology selected. The results are presented and discussed in Section 5, whilst the ﬁnal section draws out the concluding interpretation.

2. CORE AND PERIPHERY 2.1. Background The terms ‘core’ and ‘periphery’ are widely used by policy makers, regional and trade economists and economic geographers, as well as by the general public. In most of these instances this phraseology is employed to describe regional disparities in terms of economic performance, development and industrialisation. The term ‘periphery’ is reserved for geographical areas which are thought to be more backward compared to other regions in the same country or with other countries in a wider regional context, such as that of the EU. Peripheral areas are traditionally considered to be less industrialised and specialising in labour-intensive activities, and some of their characteristics are usually thought to be lower incomes, higher unemployment levels, decreased productivity and limited innovative activity. Regional economic paradigms associate these characteristics with distance from valuable resources (Schu¨rmann & Talaat, 2002) or economic gravity which dilutes the further away from the centre (Gren, 2003) and with accessibility (Spiekermann & Neubauer, 2002; Erkut & O¨zgen, 2003; Schu¨rmann & Talaat, 2002; Gren, 2003). In such paradigms core and periphery is identiﬁed on a geographical basis, where core is the central location or locations and periphery is situated at some distance from it. Within the EU-15 context, economic disparities between countries display a geographic pattern which seems to some extent to agree with the

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aforementioned view. Before the recent accession of Central and Eastern countries, which has supposedly created a ‘new periphery’, the relatively more developed members had been centrally situated in the European continent, whereas the poorer members had been located at the edge of the EU and in particular the Southernmost region of Europe. However, these models do not appear to explain how other countries located in the geographical periphery of the continent, such as some Scandinavian countries, record high economic performance and display few of the factors which are traditionally identiﬁed with the periphery. They thus focus more on why economic activity is concentrated in speciﬁc regions irrespective of whether these are located in the centre or not (Krugman, 1990; Krugman & Venables, 1995).2 In the ‘new economic geography’ models, transport costs also matter for the emergence of core–periphery patterns, but there is no precise geographical motif linked to the divergence or convergence of regions. Regional disparities and the existence of laggard regions/countries within the EU has been a primary concern of EU policy, which has supported the members with the lowest relative per capita GDP levels (Spain, Greece, Portugal and Ireland) through the establishment of the Cohesion Fund in 1994, as well as with regional assistance through the Structural Funds.3 EU regional and cohesion policies and, more importantly, the processes of regional integration are believed to have improved cohesion within the EU and to have decreased economic disparities between countries (and regions). The actual signiﬁcance of integration to regional differences has proved to be a far too complex issue for a real consensus in favour of either ‘convergence’ or ‘divergence’ to arise among academics and politicians. Nevertheless, evidence has suggested that economic growth and investment increased in the poorer regions since the announcement of the Single Market Programme. The question is to what extent is the distinction between core and periphery that is commonly used by policy makers in the EU appropriate for examining the locational determinants of FDI? Theoretically, this is supported by the concept of the investment development path (IDP) which associates the direct investment position of countries with their level of development and with speciﬁc locational advantages. This implies that countries in the same stages of development will possess similar location characteristics. Following this premise, it may or may not be plausible that the traditional periphery of the EU, namely Spain, Portugal, Greece and Ireland, all belong in the same stage of development and would therefore have similar characteristics with regards to FDI attraction. Similarly, it may

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or may not be reasonable to group all the other EU countries together under the title ‘core’. The following discussion on EU disparities and cohesion policy, and on the IDP theory, will be useful for forming a better conceptualisation of what is periphery and what is core, and for designing the groupings of countries to be used as sub-samples in the subsequent analysis.

2.2. Defining Core and Periphery in EU-15 2.2.1. EU Economic and Social Cohesion Policy With the exception of the Cohesion Fund, which is still allocated to the poorest countries in the union, EU policy for economic and social cohesion is focused on providing assistance for the development of regions within countries. In order for a member country to be eligible for Cohesion Funds assistance the basic criterion is per capita GDP lower than the average EU levels and, to a certain degree, the term ‘cohesion countries’ in the EU (i.e. those entitled to help from the Cohesion Fund) has become synonymous with ‘periphery’. Spain, Portugal and Greece (and until recently Ireland) record the lowest per capita GDP levels in the union, and display most of the other features associated with peripherality in the core–periphery paradigms noted earlier: low incomes and productivity, high unemployment levels, weak infrastructure and poor human capital endowment. At the same time the cohesion policy of the EU recognises that periphery is a complex concept which does not limit itself to income levels only. The report on economic and social cohesion (CEC, 2004) discusses different peripherality indicators and factors which disrupt the economic and social cohesion between member states, such as unemployment, poverty, accessibility and R&D creation. The term ‘periphery’, with its geographical connotation, is nowadays used with reservation in EU policy making. EU Structural Funds currently target mainly two types of region: laggards in economic development (Objective 1) and regions which are going through socio-economic restructuring (Objective 2). Table 1 gives a summary of the Structural Funds budget for 2000–2006. All other regions belong in Objective 3 which refers to EU-wide issues, such as targeting unemployment and modernising agriculture. Most EU countries have some Objective 1 regions, but the majority of the problematic regions are concentrated in the South, in the Scandinavian countries and in some areas of Ireland and the UK. Greece consists in its entirety of laggard regions (i.e. under Objective 1) and the same is true for more than half of the

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Table 1. The Budget of Structural Funds for EU-15, 2000–2006. Million EUR: Commitments in 2004 Prices Objective Objective Objective Cohesion Population in % of 1 2 3 Fund Objective 1 and Population Objective 2 Areas (Million) Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg The Netherlands Portugal Spain Sweden UK EU-15

288 690 0 1,008 4,201 22,035 23,143 3,409 24,424 0 136 21,010 42,061 797 6,902 150,104

740 486 199 541 6,569 3,776 0 0 2,749 44 861 0 2,904 431 5,068 24,367

585 817 397 442 5,013 5,057 0 0 4,129 44 1,866 0 2,363 795 5,046 26,553

0 0 0 0 0 0 3,388 584 0 0 0 3,388 12,357 0 0 19,717

2.270 1.269 0.538 2.650 20.412 24.447 10.476 0.965 26.704 0.117 2.324 6.616 32.027 1.674 18.909 149.130

28.2 12.5 10.2 51.7 34.0 29.8 100.0 26.6 46.5 28.2 15.0 66.6 80.7 18.9 32.2 40.3

Source: Adapted from European Commission website – Inforegio.

territories of Spain and Portugal (Table 1). At ﬁrst glance, the map of EU regional policy supports the traditional core–periphery pattern. Countries such as Germany, the Netherlands, Austria, Denmark, the UK and Belgium/Luxembourg, located in the central area of the EU, have almost no Objective 1 regions and a far larger number of regions which are neither Objective 1 nor Objective 2. To the extent that EU regional policy can be useful for classifying countries an important feature is nevertheless that discriminating simply between countries which belong in the periphery and countries which belong in the core is a grave oversimpliﬁcation. The case of Ireland is a useful point of reference here. In 2004 assistance to Ireland as part of the Cohesion Fund of the EU was terminated after its per capita GDP surpassed the 90% of EU-average threshold. Ireland had been receiving economic support through the Cohesion Fund since 1994 and was still eligible in 2000, when the 2000–2006 programme was designed (CEC, 2006). But, in the past

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decade, Ireland has achieved remarkably high rates of GDP and employment growth, as well as a marked increase in investment activity and FDI ﬂows, both inward and outward. In terms of development, as well as locational advantages, it would be misleading to consider Ireland as still part of the periphery of the EU-15. On the other hand, since this development is fairly recent and its FDI status is not mature, it would not be part of the core either, and might better be considered as some intermediate type of country. Other countries also display characteristics similar to both core and periphery. For instance, Italy is a highly industrialised country with high income levels, yet the presence of a considerable number of Objective 1 regions means that 46.5% of its population live in regions with severe economic problems or structural issues (Objectives 1 and 2) (CEC, 2006). Thus, Italy’s FDI pattern and location advantages are likely to differ from both ‘core’ and ‘periphery’ countries. On the other hand, the Scandinavian countries, in particular Sweden and Finland, are located in the geographical periphery and have a relatively large number of Objective 1 regions, due mainly to low population density in such areas. Yet the GDP per capita levels in these countries, and their wage and employment rates, are considerably higher than those of Spain, Portugal and Greece, as is the level of industrialisation and their commitment to creating new technology (CEC, 2004). EU economic and social policy is useful in identifying countries with similar levels of development and, to the extent that this policy also inﬂuences development, it is in fact a very pertinent point of reference. Nevertheless, it is also obvious that, in many ways, the deﬁnition of peripherality based on EU economic and social policy only is no easy task and may be misleading. Therefore, in order to group countries in categories which are relevant for the analysis of the location of FDI, the conclusions drawn from the discussion so far will be complemented using the concept of the IDP, which states that a country’s level of development and the degree to which it is involved in direct investment are interrelated. The following section will examine the application of the IDP to extend the classiﬁcation of EU-15 countries. 2.2.2. The Investment Development Path In the IDP (Dunning, 1981; Narula, 1996; Dunning & Narula, 1996) countries are classiﬁed into ﬁve different stages of development related to their net outward FDI position. Each stage is therefore marked by certain relative levels of inward and outward FDI, and also by certain types of

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locational advantages associated with that particular level of economic development. The ﬁrst two stages of the IDP describe countries in the early stages of development, with low levels of FDI involvement, and do not apply to the circumstances of any EU-15 countries in the last two decades.4 Stage three, however, could very well be used to represent countries with characteristics of what has up to now been referred to as periphery.5 Core countries, on the other hand, would be at stage ﬁve of the IDP or, at the very least, at stage four and approaching ﬁve.6 Because of the countryspeciﬁc nature of the IDP, studies which attempt to classify to different stages on the path not only examine the net outward FDI position but also look at the rate of growth of outward and inward investment and endeavour to review other revealing country features, such as ownership advantages of indigenous ﬁrms, type of investment activity, country policies and infrastructure. Due to the number of countries involved in this analysis, it is not possible to conduct such a detailed examination for each one, so our conclusions will be based almost exclusively on previous literature and on the net outward investment position. The previous discussion identiﬁed Germany, France, the Netherlands, the UK, Austria and Belgium/Luxembourg as central ‘core’ countries, based on their involvement in the cohesion policy and their economic development features. Of these the most developed in terms of FDI and the IDP are Germany, France, the Netherlands and the UK. These are countries which studies identify as belonging in stage ﬁve, or between stages four and ﬁve, of the IDP (Clegg & Scott-Green, 1999; Narula, 1996; Dura´n & U´beda, 2001). Regarding the case of Belgium/Luxembourg, there exists limited literature on their IDP. According to Bellak (2000), the IDP position of small countries is determined by geography and ‘the industrial structure of domestic industries and the policies pursued’ and this may be what characterises both Austria and Belgium/Luxembourg. Both have sometimes been associated with stages four and ﬁve of the IDP (Dura´n & U´beda, 2001, 2005; Narula, 1996). However, the FDI position of each appears quite different to that of the other. In terms of inward ﬂows Austria is an underperformer according to the UNCTAD deﬁnition7 and its inward and outward FDI stocks are well below those of the four core countries mentioned above, as well as those of Ireland. Conversely, Belgium/Luxembourg are frontrunners in inward FDI and have recorded the highest levels of outward FDI in the EU, relative to their size, in recent years, ranking ﬁrst in EU countries for FDI stocks as a percentage of gross ﬁxed capital formation (UNCTAD, 2002). It seems that,

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despite other similarities in size and location, the current IDP stages of Austria and Belgium/Luxembourg are different. Austria possibly due to lack of ownership advantages of domestic ﬁrms has probably not yet achieved stage four of the IDP (Bellak, 2000). Belgium/Luxembourg, on the other hand, have managed to remain both an attractive location and a mature foreign investor. Belgium/Luxembourg could therefore be classiﬁed in IDP stage four, or in the intermediate country grouping, for the purpose of this analysis. Similarly, there is lack of extensive academic work on the IDP of the three Scandinavian countries and Italy. Nevertheless, the classiﬁcation of Denmark, Finland, Sweden and Italy in stage four of the IDP (Clegg & Scott-Green, 1999; Narula, 1996; Zander & Zander, 1996) features in most IDP-related studies. These, together with Belgium/Luxembourg, will form the intermediate countries category in the analysis of locational advantages. Based on the earlier discussion, Greece, Spain and Portugal all seem to belong in the periphery of the EU. Greece and Portugal can almost certainly be classiﬁed in the stage three (or between stages three and four) IDP grouping of countries, their cases being examples of developed countries with relatively high per capita incomes and rising wages, production of standardised goods and growing demand for sophisticated products, and an increase in the rate of growth of outward direct investment relative to inward (Narula, 1996). The afﬁliation of either country in this stage of the IDP can be both contested and supported from other evidence. Castro (2004) suggests that Portugal may have entered stage four of the IDP since the mid-1990s, but his conjecture is presented with considerable caution. Thus, although research on the IDP of peripheral EU countries is not extensive, it can be asserted that both Greece and Portugal are in stage three (or between stages three and four) (Narula, 1996; Dura´n & U´beda, 2005; Castro, 2004; Filippaios & Stoian, 2005). Concerning the third peripheral country, Spain, the picture is somewhat less clear. Evidence suggests that Spain moved slowly along the IDP, and was probably still in stage three at least as late as the beginning of the 1990s (Dura´n & U´beda, 2005; A´lvarez, 2001; Clegg & Scott-Green, 1999; Narula, 1996). However, it is debated whether Spain’s later trajectory has now led the country to stage four or whether it is still lagging behind.8 Given the complexity and distinctiveness of any country’s IDP it is not surprising that consensus in this matter is difﬁcult to achieve. Spanish outward FDI increased substantially in the late 1990s, but the features of Spain’s investment, both inward and outward, still do not seem to correspond to

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that of a highly industrialised developed country of stage four or ﬁve on the IDP, and imply that its entrance into stage four, if it has occurred, is very recent and may not be particularly sustainable. Overall, high income levels and rise in outward FDI, as well as a lot of dynamism in some speciﬁc technologically intensive sxcectors (Zayas, 1998), characterises Spain’s economy. But at the same time there are low levels of general technological capabilities, and limited commitment to creating more, as well as lack of embeddedness of foreign ﬁrms in the national knowledge creating environment (Zayas, 1998). These features then suggest that Spain was probably still not in stage four by 2001 (which is the end year for our dataset) or, at the very least, that it has remained between stages three and four of the IDP for the most part of the past two decades. Ireland is another example of a late-industrialising country but, as mentioned earlier, it has a somewhat different success story and a very particular FDI relationship with the rest of the world. Early in the 1980s, Ireland focused its economic development around direct investment from abroad and implemented policies which aimed at its attraction (UNCTAD, 2002). As a result, Ireland’s inward FDI as a percentage of its gross ﬁxed capital formation increased from 12.8% in the 1990s to 107.1% in 2000 (UNCTAD, 2002) which placed it in third place as host country for FDI for the period 1998–2000. This phenomenal increase in inward investment into Ireland is hardly matched by outward ﬂows in the last two decades, and consequently the position of Ireland on the IDP implies a similar conclusion to the cases of Spain and Portugal. However, studies on the IDP of countries (Clegg & Scott-Green, 1999; Dura´n & U´beda, 2001, 2005; Go¨rg & Ruane, 1999) mostly assume that Ireland reached stage four early on in the last decade. This may be explained by Ireland’s particular FDI circumstances. Because of the remarkable levels of inward FDI, it has been difﬁcult to achieve a positive investment position, as expected by the IDP, even though its level of development may be higher than that of countries such as Portugal and Spain. As a matter of fact, outward FDI ﬂows as a percentage of gross ﬁxed capital formation more than doubled in the period 1996–2000 compared to the ﬁve previous years, from an average of 4.0% to 13.8% (UNCTAD, 2002, p. 319). This evidence suggests that Ireland probably is in stage four of the IDP, as professed in several studies, and will be part of the extended model of intermediate countries in the following analysis. To conclude, based on the previous discussion, countries will be divided into three distinct categories, which we will term ‘periphery’, ‘core’ and ‘intermediate’. These groupings are set out in Table 2.

The Locational Determinants of Foreign Direct Investment

Table 2. Model Model Model Model Model

1 2 3 4 5

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Classiﬁcation of Countries for Estimation Purposes. Greece, Spain, Portugal Austria, Greece, Spain, Portugal Denmark, Finland, Sweden, Belgium/Luxembourg, Italy Denmark, Finland, Sweden, Belgium/Luxembourg, Italy, Ireland France, Germany, The Netherlands, UK

3. EUROPEAN CORE/PERIPHERY AND MNES’ STRATEGIC MOTIVATIONS It is the central theme of this investigation that MNEs respond to the differences in potential locations in the light of their own range of strategic motivations. This means that innate differences in the characteristics of what we have designated as core, periphery and intermediate countries of the EU need not serve to simply attract or repel FDI, but rather to determine the nature (i.e. the role to be played) of MNE investment. Fulﬁlment of the different objectives pursued by MNEs’ dispersed operations depend on different advantages supplied by particular locations. Thus, this section elaborates on the three generic motivations attributed to MNEs’ strategic portfolios and relates these to the independent variables used in the tests to differentiate characteristics of the separate EU host countries.

3.1. Market-Seeking In its basic manifestation MS (Behrman, 1984; Dunning, 1993, 2000; Manea & Pearce, 2004) would involve locating an investment in a particular country in order, speciﬁcally, to supply that country’s market. In its traditional manifestation MS behaviour would have occurred as a response to some form of trade restraint, which prevented the MNE from supplying the market from a lower-cost production site elsewhere. From this it follows that this type of MS operation would be seeking to defend proﬁtability, rather than to enhance it in any distinctive way. However, the essential context for the period analysed here has been one of European integration, with lowering of trade restraints and the projection of the central ethos of a ‘single market’. Any persisting MS behaviour would need to be understood within that context.

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One possible explanation for continued MS positioning of operations within the EU would then be a much more proactive market expanding (and, therefore, proﬁtability enhancing) addressing of the characteristics of speciﬁc (here national) economies. Thus MNEs would establish production, as well as marketing, operations in a particular economy in order to tailor supply to meet distinctive consumer tastes in a more competitively responsive manner. A second possibility could embody echoes of the earlier type of MS motivation in a strategically myopic decision process by external (non-European) MNEs establishing production facilities in the EU for the ﬁrst time. Here, it can be speculated, the decision to locate supply in the EU may be a negative/defensive response to the remaining (and possibly increasing) external tariffs (i.e. fear of ‘fortress’ Europe) rather than a positive/optimising reﬂection on internal free trade. Then the persisting MS mindset underlying the entry decision may cause the pioneering facility to be located in a more impressive market environment (rather than a less obviously amenable, but potentially more cost-competitive, ‘peripheral’ site). Two of our independent variables relate directly to the MS motivation. The ﬁrst of these is the GDP of each national economy for each year ($US million), suggesting simply that the sheer size of a national economy serves as an indicator of the potential proﬁts available from supply of the market (Culem, 1988; Veugelers, 1991; Wheeler & Mody, 1992; Braunerhjelm & Svensson, 1996). Then the traditional articulation of MS would be that MS-oriented MNEs would, at a point in time, invest more in larger economies and, over time, expand their investment in a particular economy in line with its market growth. As we have noted, though, this view of MS is also dependent on the presence of quite extensive restraints on trade (Barrell & Pain, 1999a, 1999b; Neven & Siotis, 1996). The second of these variables is GDP per capita (PERCAP), which can be related to the more contemporary variant of MS motivation (Filippaios, Kottaridi, Papanastassiou, & Pearce, 2004; Chakrabarti, 2001). As already suggested, across as extensive a geographical space as Europe, along with its notable differences in average income levels, there is plenty of scope for signiﬁcant taste differences. GDP per capita may then serve as ‘an indicator of both the extent of these taste differences (increasing prosperity may give consumers the ability to manifest previously suppressed sources of demand individualization) and the willingness of MNEs to respond to them through subtle locally responsive product differentiation’ (Dimitropoulou & Pearce, 2006, p. 186). PERCAP may also indicate the degree of potential for accessing locally the types of human capital (e.g. market researchers, design

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engineers, technologists) that can secure the implementation of locally responsive adaptation and development. Indeed, this can lead to the acknowledgement that PERCAP may also proxy availability of creative inputs that relate to the alternative KS motivation. Overall, the logic of MS suggests that its persistence as an inﬂuence on FDI decision making would be strongest and most carefully executed in large high-income economies. Thus, the two direct indicators of MS (GDP, PERCAP) would be more likely to provide signiﬁcant results in core and, perhaps, intermediate country sub-samples than in the periphery. The process of European integration represents, in effect, an increasing openness to trade in the union’s individual members. We have already indicated ways in which this is central to strategic choice and reconﬁguration by MNEs. To reﬂect this, a variable (OPEN) is constructed to trace changes in these economies’ openness over time and the differences in levels between them. Thus, OPEN is calculated as ‘exports plus imports divided by GDP for each host country in each year’. A very low value of OPEN would imply an economy that is isolated from international trade (presumably due to mainly policy-related factors) so that MNEs could be attracted to invest in it to supply the local market, but would be unlikely to do so as a base for supply of export markets. Thus, a negative relationship would be expected between OPEN and FDI ﬂows when MNEs are pursuing mainly MS objectives. As OPEN takes higher values, however, it becomes less necessary (and probably less viable) to produce in an economy as a means of supplying the local market. Indeed, higher degrees of openness are likely to relate (with a degree of two-way causation) to the ES use of an economy as a source of export-oriented supply. So the emergence of ES as a strategic objective in MNEs’ operations in a grouping of countries would result in a positive relationship between OPEN and FDI ﬂows. The speculation of the persistence of some, more competitively responsive, MS activity in core countries would then provide a less decisive prediction for emergence of a positive sign in OPEN than could be expected for the periphery.

3.2. Efficiency-Seeking The second strategic motivation considered is ES, which involves the establishment of production subsidiaries in particular locations as a means to enhance (and ideally optimise) the cost efﬁciency with which goods can be supplied to price-competitive markets. The ES aim of MNEs is thus to generate integrated supply networks in which different parts of a product

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range are produced in different locations, such that the inputs required by the technology are those that reﬂect a country’s current sources of static comparative advantage. The efﬁciency secured by this matching of MNE technology with host-country inputs is then augmented through the economies of scale achieved by successful export orientation. In ways already alluded to here, the process of European integration is likely to have propelled MNEs towards this type of networking, with the EU periphery countries most likely to have attracted this type of ES activity. Our set of independent variables includes three that reﬂect ES motivation with different degrees of directness. Firstly, unit labour costs (ULC) (Cushman, 1987; Culem, 1988; Veugelers, 1991; Wheeler & Mody, 1992; Barrell & Pain, 1996, 1999a,b) provide a measure of the cost per unit of output of what is normally presumed to be the key input inﬂuencing pureES motivation. Secondly, a broader measure of an economy’s revealed competitiveness in trade (COMP) is used (Filippaios et al., 2004) in the form of ‘exports divided by exports plus imports’. Thus ‘the higher the value of this ratio, or the more pronounced or sustained its rise over time, the more likely it is to reﬂect the presence of sources of international competitiveness in any economy that may attract MNEs’ (Dimitropoulou & Pearce, 2006, p. 187). Though variations in value of COMP will obviously reﬂect variations in ULC, it can also reﬂect a wide range of other factors manifest in an economy’s competitiveness. In particular, in our view of MNEs’ strategic diversity, rising values of COMP could reﬂect trade performance that derives from the improved quality and originality of goods provided from an economy. Tapping into these manifestations of an economy’s innovative distinctiveness could then reﬂect the KS aim of modern MNEs. Thirdly, we have reviewed, in the previous subsection, how the variable OPEN may distinguish ES from MS contexts.

3.3. Knowledge-Seeking The MS and ES motivations have been seen to involve either defending (MS) or enhancing (ES) the proﬁts to be earned from mature products and technologies. The KS motivation then targets the generation of new sources of competitiveness to secure future market position. Thus, a central feature in the strategic reconﬁguration of MNEs in recent decades has been the inclusion of KS activity amongst their most important internationalised functions. Two aspects of KS which have been subjected to extensive analysis and investigation are the (substantially interrelated) decentralisation of R&D

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and innovation in MNEs (Pearce, 2006b). Central to the emerging comprehension of these processes has been MNEs’ response to knowledge heterogeneity, in the understanding that, with their growth and development, individual countries have generated different capacities in terms of technology stocks, research programmes and trajectories and creative human capital. Selective KS, tapping into these country-speciﬁc sources of competitive regeneration, is then another crucial facet of MNEs’ FDI location choice. The association of these potentials with more industrially and scientiﬁcally mature economies provides the expectation that KS inﬂuences will impinge more on FDI in the core than in the periphery. Two variables are used to provide indicators of the types of scientiﬁc and innovative capacities of host economies that could attract MNEs’ KS FDI. Firstly, total expenditure on R&D (business and government funded) as a proportion of GDP (RAD) (Wheeler & Mody, 1992; Braunerhjelm & Svensson, 1996; Barrell & Pain, 1999a). This can be seen as an input measure that would indicate forward-looking science-based potentials in an economy that MNEs would consider involving themselves with through their current investments. Secondly, the measure of the number of patent applications to the European patent organisation per million of population (PAT) serves as an output measure of how effective a country’s science base, and industry-based creative activity, has been in generating patentable new knowledge. Thus, high values of PAT would indicate the presence of a creative milieu that MNEs should consider involving themselves with.

3.4. FDI Stock (Agglomeration) Partly as a control the regressions also include the values of FDI stock ($US) in each country lagged by one year (FST). This could acknowledge the possibility that, in a rather myopic and mechanical way, new investments are simply made in countries that have already demonstrated the ability to attract and retain FDI. One facet of this could be reinvestment by existing subsidiaries from their own proﬁtability. This need not, of course, be a reﬂexive and routine decision but would, hopefully, be validated as a logical strategic expansion by embodying one of the motivations already reviewed. In terms of new-entry investments, FST could be more proactively interpreted as an indicator of agglomeration potentials deriving

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from interactive or spillover beneﬁts from co-location with longerestablished operations of other MNEs.

4. METHODOLOGY The analysis of FDI in the EU core and periphery uses the country groupings deﬁned in the models derived in Section 2 (Table 2), and the independent variables discussed in Section 3 to reﬂect the strategic heterogeneity of contemporary MNEs. (The sources for these independent variables are provided in the appendix.) The FDI data that provides the dependent variable was obtained from the OECD International Direct Investment Statistics dataset and includes FDI inﬂows of all countries in the EU before the latest accession of Eastern Europe countries. For each of the countries inward direct investment ﬂows were collected for the time period 1980–2001.9 The panel structure for each of the models was selected through a process of LR tests, designed to test which panel speciﬁcation was best for the data. Initially, the tests suggested that a two-way ﬁxed effects structure was preferred over a simple pooled model or a one-way ﬁxed effects model for all groupings of countries.10 However, the structure of the data here delivers a large T (number of years) compared to N (the number of groups in the panel; here the number of countries in each model). For that reason it is considered simpler, as well as more systematic, to opt for a one-way ﬁxed effects structure, where the intercept is assumed to vary across years, and not across countries, and the country heterogeneity is captured by country dummy variables (Greene, 2003). The results of LR tests comparing this structure and the pooled model support this approach. Two-stage least squares estimation is used, since with OLS it is possible that the regressors are correlated with the residuals. The results of tests for endogeneity are not always harmonious.11 The Wu test rejects exogeneity (or no correlation between the regressors and the residuals) in all models except model 5 (at the 5% level) and model 2 (at the 1% level). The Hausman test, on the other hand, suggests the need for 2SLS estimation only for models 1 and 4. Since non-rejection of the key hypothesis of exogeneity suggests that the two stage least squares (2SLS) and ordinary least squares (OLS) are not signiﬁcantly different,12 the incongruity of the tests is not critical and it is reasonable, in favour of conformity, to consider and draw conclusions from the 2SLS estimates even when zero hypothesis (H0) has not been rejected. Tables 3(a) and 3(b), therefore, report 2SLS tests with one-way ﬁxed effects.

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5. RESULTS 5.1. Main Tests 5.1.1. Periphery In Table 3(a) model 1 reports the results for the three ‘basic’ periphery countries (Greece, Spain and Portugal). Here, rather against prediction, MS appears to be the most clearly validated motivation for FDI, with GDP per Table 3(a).

Two-Stage Least Squares Regression – One-Way Fixed Effects.a Peripheral Countries

GDP GDP per capita Openness Competitiveness Unit labour cost Patents R&D FDI stock

Model 1b

Model 2b

0.108 (1.606) 3.955*** (2.920) 46,152.6** (2.383) 177,507.4*** (3.525) 0.322** (2.278) 91.089 (0.127) 56,109.3*** (3.612) 0.345*** (2.960)

0.200*** (3.277) 0.778 (0.908) 33,401.8 (1.618) 45,768.8 (0.799) 0.650 (0.333) 121.872* (1.918) 18,797.9 (1.567) 0.242 (1.649) 48,989.1** (2.350) 57,442.4** (2.287) 76,453.0*** (3.511) 76

Austria Greece Portugal Number of observations

7,272.5 (0.318) 46,970.3** (2.268) 57

Notes: *Denotes statistical signiﬁcance at 10%. **Denotes statistical signiﬁcance at 5%. ***Denotes statistical signiﬁcance at 1%. a Using White’s VC matrix for robust standard errors. T-ratios in parenthesis. b Spain excluded to avoid dummy variable trap.

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Table 3(b).

Two-Stage Least Squares Regression – One-Way Fixed Effects.a Intermediate and Core Countries

GDP GDP per capita Openness Competitiveness Unit labour cost Patents R&D FDI stock Belgium/Luxembourg Denmark Finland

Model 3b

Model 4b

Model 5c

0.109 (1.348) 3.835** (2.186) 142,813.4** (2.581) 407,546.5** (2.300) 0.943** (2.130) 11.961 (0.063) 7,407.1 (0.256) 0.396 (1.062) 64,666.2 (0.880) 5,065.2 (0.098) 48,462.4 (0.983)

0.029 (0.360) 0.421 (0.368) 155,091.8** (2.511) 469,364.0 (2.496) 0.294 (0.744) 291.1** (2.158) 35,070.4 (1.608) 0.172 (0.523) 80,033.3 (0.938) 15,449.5 (0.283) 35,486.1 (0.701)

0.048 (1.560) 24.536** (2.313) 12,614.2 (0.180) 1,362,813.8** (2.594) 0.024 (0.135) 693.3* (1.722) 86,078.9** (2.147) 0.234 (1.205)

France

27,007.1 (1.268)

Ireland

53,051.9 (0.498)

The Netherlands Sweden

55,909.8 (0.840) 38,148.4 (1.108)

48,286.9 (1.425)

UK Number of observations

95

114

Notes: *Denotes statistical signiﬁcance at 10%. **Denotes statistical signiﬁcance at 5%. ***Denotes statistical signiﬁcance at 1%. a Using White’s VC matrix for robust standard errors. T-ratios in parenthesis. b Italy excluded to avoid dummy variable trap. c Germany excluded to avoid dummy variable trap.

165,532.4** (2.277) 76

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69

capita (PERCAP) signiﬁcantly positive and GDP clearly positively signed. Furthermore the signiﬁcant negative result for OPEN would suggest that low trade-orientation attracts FDI, a situation compatible with MS. The signiﬁcant negative result for COMP indicates that sources of revealed competitiveness in these periphery countries are not ones that seem to attract MNEs. This enigmatic result is compounded by the signiﬁcant positive result for ULC. A quite conventional interpretation of this result would be that higher ULC reﬂects skilled-labour inputs into capitalintensive processes for manufacture of higher-value-added goods. This would be counterintuitive in the context of core–periphery analysis, however. This will be further investigated in the next Section 5.2. The results for PAT and RAD clearly support the expectations of an absence of KS in MNEs’ periphery-country operations, though there is no logical extension to explain higher levels of RAD actually alienating FDI (RAD signiﬁcantly negative). The FDI stock variable (FST) is signiﬁcantly negative. This may reﬂect a growing sense of investment saturation (or crowding out) in these areas following higher earlier levels of FDI growth. This might also incorporate a view that the type of antecedent FDI in these countries was not such as to generate agglomeration beneﬁts for new investors. Model 2 tests the extended periphery grouping, adding Austria to the three countries of model 1. MS remains the most clearly validated motivation, though now more strongly through GDP than PERCAP. ULC, OPEN and COMP retain the same signs as in model 1, but lose signiﬁcance, suggesting that here Austria interjects different behaviour to the basic periphery. In the same way Austria does seem to have some positive effect on KS, since PAT now becomes signiﬁcantly positive whilst RAD (while clearly remaining negatively signed) loses signiﬁcance. The dummy variable results (with Spain as the omitted country) suggest quite strong country-speciﬁc factors, especially in model 2. Thus Portugal is signiﬁcantly positive in both the models, Greece becomes signiﬁcantly positive in model 2, where Austria is also signiﬁcantly positive. This could reﬂect particular policy-based incentives for investment attraction. 5.1.2. Core Turning to the other extreme of our analytical spectrum model 5, Table 3(b), tests the four ‘core’ countries. Here the decisive and distinctive result is the strong evidence of the presence of KS motivation in MNEs’ operations in these countries, with PAT and RAD both signiﬁcantly positive. To associate

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this KS pursuit of new sources of competitiveness in these economies with an apparent lack of expectation of efﬁciency in current supply there might be over-interpretation. Nevertheless, ULC and OPEN are insigniﬁcant and COMP is signiﬁcantly negative. Whilst GDP is positively signed and quite close to signiﬁcance (at 10%) PERCAP is negatively signed and signiﬁcant. Thus, MS seems rather less inﬂuential on FDI in the core than in the periphery. Country-speciﬁc effects may also be less inﬂuential in the core, with only the UK signiﬁcant and negatively signed. Though traditionally UK is thought of as a favoured location for FDI from outside Europe, this result could suggest that over the period 1980–2000 MNEs began increasingly to see it as a less committed component of an integrating Europe (compared, at least, to Germany, France and the Netherlands).

5.1.3. Intermediate Countries Model 3 (Table 3(b)) tests the basic group of intermediate countries (i.e. Belgium/Luxembourg, Denmark, Finland, Sweden, Italy), whilst model 4 adds Ireland (considered somewhat sui generic due to its signiﬁcant evolution – especially with regard to FDI – over the period). The results for these countries could be expected to either fall neatly between those of core and periphery (especially if these had conformed to a priori expectation), or reﬂect a less coherent mixture of the outcomes for both. The latter may be the more prevalent. There is no sign of the MS inﬂuence apparent in the periphery, and model 3 shares the core’s statistically negative sign on PERCAP. In common with the periphery (especially model 1) OPEN is negative and signiﬁcant in both these intermediate groupings. By comparison with models 1 and 5 COMP is positive and signiﬁcant in models 3 and 4. ULC is signiﬁcantly positive in model 3, suggesting that the attracting source of competitiveness might here be labour skill in higherquality goods supply. Interestingly ULC then loses signiﬁcance and has a smaller (though still positive) coefﬁcient in model 4, which would be compatible with the view that (at least over the period covered) Ireland’s key attracting factor had been cost-efﬁcient labour in standardised production. There is no signiﬁcant evidence that KS factors have any positive inﬂuence on FDI in the intermediate countries. None of the dummy variables are signiﬁcant in these models, again indicating no obvious role for countryspeciﬁc effects.13

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5.2. Tests with Relative ULC The idea of countries in the EU in some sense competing for FDI is likely to be most appropriate where several countries are capable of providing particular inputs at very similar quality or effectiveness. In such cases investment choices can be mutually exclusive, such that where one location is selected to play a role other similarly viable sites will not then be required to do so. This is not likely to be relevant to MS where, in our analysis, countries would attract FDI if particular characteristics took sufﬁciently high absolute values. Similarly, the attributes of countries that attract KS FDI are deﬁned more through different potentials and creative distinctiveness. It is, therefore, in ES, and in particular the cost efﬁciency of similarly skilled (or, especially, unskilled) labour, that very careful choice between substitute locations becomes relevant. The often weak or counterintuitive performance of ULC in the tests reported in Tables 3 may then reﬂect the wide range of skill levels and labour-market conditions across the EU. ES-oriented FDI choice may evaluate ULC in a country relative to that of a more select group of alternative locations. Therefore, models 1, 3 and 5 were rerun with the original value of ULC replaced by unit labour costs in the host country relative to the periphery average unit labour cost (ULCp) and core average (ULCc). Both measures are in logs, which means that when ULC in the host country is equal to the appropriate average (ULCp:ULCc) the effect on FDI will be zero. The tests are 2SLS estimates. For the periphery tests (Table 4) the formulation of ULC in relative terms clearly rehabilitates the view of these countries as attracting ES-oriented FDI through the provision of cost-effective labour supplies. The competitiveness variable now takes the predicted positive sign indicating FDI responding to countries that already reveal competitiveness in trade performance. OPEN now becomes signiﬁcantly positive, which is again compatible with an export-oriented economy attraction of ES behaviour. The positive presence of MS activity and absence of KS, shown in Table 3(a), remain in place here. In the tests of intermediate countries ULC relative to periphery average (ULCp) is signiﬁcantly negative. This would indicate that these countries remain involved in competing for the types of ES-motivated FDI clearly associated with the periphery. By contrast ULC relative to the core (ULCc) is positive but insigniﬁcant. This would suggest lack of competition with the types of labour the core countries offer to MNEs’ strategic emphases there. COMP remains positive but insigniﬁcant, whilst OPEN is again signiﬁcant

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Table 4.

Regression Testsa with Relative Unit Labour Costs.

GDP GDP per capita Openness Competitiveness ULC ULCp ULC ULCc Patents R&D FDI stock Greece Portugal

Model 1b

Model 3c

Model 5d

0.108 (1.598) 3.952*** (2.981) 0.3268** (2.308) 39,750.0 (1.29) 46,499.0** (2.281) 217,303.2*** (3.189) 91.70 (0.129) 56,184.6*** (3.664) 0.3482*** (3.664) 7,028.0 (0.307) 46,795.0** (2.254)

0.1160 (1.471) 3.919** (2.286) 0.9799** (2.312) 52,328.7 (0.417) 139,448.2** (2.568) 351,169.8 (1.585) 15.710 (0.083) 6,772.4 (0.237) 0.4004 (1.089)

0.0487 (1.569) 24.766** (2.377) 4.68E-02 (0.266) 30,416.3 (1.484) 10,485.6 (0.148) 108,368.2** (2.424) 694.8* (1.745) 87,419.9** (2.189) 0.2147 (1.147)

Belgium/Luxembourg

57,892.9 (0.803) 8,649.6 (0.169) 52,133.0 (1.070) 41,167.6 (1.167)

Denmark Finland Sweden France The Netherlands UK Number of observations

57

95

28,039.5 (1.412) 54,889.1 (0.833) 168,429.5** (2.412) 76

Notes: *Denotes statistical signiﬁcance at 10%. **Denotes statistical signiﬁcance at 5%. ***Denotes statistical signiﬁcance at 1%. a Two-stage least squares, with one-way ﬁxed effects. Using White’s VC matrix for robust standard errors. T-ratios in parentheses. b Spain excluded to avoid dummy variables trap. c Italy excluded to avoid dummy variables trap. d Germany excluded to avoid dummy variables trap.

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and positive. These tests again provide the same interpretation for MS and KS in intermediate countries as in Table 3(b). Core-country ULC compared to periphery-country average (ULCp) is totally insigniﬁcant. This is compatible with the absence in MNE corecountry strategy of the types of ES behaviour apparent in the periphery and intermediate grouping. However, core-country ULC relative to the corecountry average (ULCc) is signiﬁcant and negative. This suggests that location decisions in these countries can be inﬂuenced by cost-related features of the types of skilled high-value-added labour that might only be available in these countries. COMP remains negatively signed (as in Table 3(b)) but is now insigniﬁcant. MS and KS are again unchanged from the earlier test.

6. CONCLUSIONS The empirical tests of FDI ﬂows into individual EU-15 member economies broadly reﬂect both a range of MNE strategic motivations, and the activation of these in terms of a perceived differentiation of the EU economies and their attracting characteristics (here operationalised through the addition of an ‘intermediate’ grouping between the more familiar ‘core’ and ‘periphery’). The results can also be interpreted as validating a view of a reconﬁguration of MNEs’ strategies in Europe away from a multidomestic emphasis on MS, towards the more integrated, region-wide, positionings reﬂected in ES and KS. The results for the main MS variables (GDP, PERCAP) tend to be inconsistent and often counterintuitive, suggesting the strongest persistence of MS in periphery economies and negative results (for PERCAP) in the core. This is consistent with MS no longer being a routine systematic consideration for FDI location decision making in the EU, but still a factor that can impact in ad hoc ways in particular locations at particular times (for reasons suggested in Section 3.1). By contrast the results for ES, as derived from the tests using relative ULC (Section 5.2), point to a very carefully considered facet of location decisions. These results suggest very close comparison of what must then be considered to be competing locations for cost-effective supply of mature goods. As would be anticipated this emerges very decisively in the periphery, and quite clearly also in the intermediate country, results for relative ULC. Interestingly then the results for the core suggest that ULC are also a determinate inﬂuence there, but only relative to other core countries. This indicates that MNEs perceive a segmentation of

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labour supply within the EU, but with a notable response to the cost efﬁciency of competitive sources of the different skill/productivity levels within country groupings. The tests also validate the emergence of KS as an MNE motivation that impinges systematically on FDI location choice. As would be predicted KS is most decisively inﬂuential in the more technologically evolved core countries, where both the input (RAD) and output (PAT) measures are signiﬁcantly positive as determinants of FDI ﬂows. By contrast, but again as would be expected, there is no sign of KS in the traditionally deﬁned periphery (where RAD is actually signiﬁcantly negative in most tests). These results would appear to deﬁne the potential and the challenge facing, in particular, lower-income countries seeking to secure sustainable growth and development within EU integration. Attraction of ES activity of MNEs can provide a source of export-oriented competitiveness that also interjects impetus to industrialisation. However, this depends on short-term cost effectiveness, which runs the risk of inculcating policy postures that are then alien to any forms of expenditure that do not result in immediate efﬁciency and productivity. This may rule out any form of skill upgrading (training or retraining) in labour that does not relate to immediate production needs and, certainly, does not provide a context for more forward-looking speculative investment in R&D and other innovation-related activity. But our results also imply that, ultimately, the logic of sustainable growth (and the embedding of MNEs’ operations in this) does require a move to those characteristics (skilled high-productivity labour working with more capital and with advanced technology, R&D and innovation-oriented talents) that attract KS. Ultimately our analysis is supportive of two conclusions. Firstly, that the revitalisation of the EU as a distinctive competitive force in the global economy requires that its internal development and integration moves towards more widespread emphasis on creative higher-value-added activity (our KS) and away from (but initially building on) routine low-cost supply (our ES). Secondly, that MNEs (European and external) can be strongly supportive of this, providing EU and national policy makers understand these ﬁrms as having multiple objectives and motivations, such that the competitive evolution of MNEs (their KS needs) are potentially interdependent with the sources of national/regional economic development.

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NOTES 1. For reviews of the early empirical literature on FDI into Europe see Yannopoulos (1990), UNCTAD (1992) and Dunning (1997). 2. See also Neary (2001) for an exposition of these models. 3. In particular for the Mediterranean regions of France, Greece and Italy, the Integrated Mediterranean Programmes, towards the end of the 1980s, provided signiﬁcant assistance in terms of funds to these ‘peripheral regions’. 4. In stage one a country has very limited location advantages and attracts little or no inward FDI. Few domestic ﬁrms possess any competitive ownership advantage, so there is no outward FDI. In stage two ‘generic’ location advantages begin to attract inward FDI, but there is still little outward FDI (Dunning & Narula, 2004, Fig. 3.3, p. 45). 5. In stage three created-asset type location advantages have been developed and attract rising inward FDI. These assets have also led to stronger domestic industry leading to emerging outward FDI. 6. In stage four a country has strong location advantages in created assets which still attract inward FDI, but have now also provided domestic ﬁrms with strong ownership advantages, such that their outward FDI exceeds the inward FDI. In stage ﬁve net FDI ﬂuctuates around zero with strong inward and outward FDI. 7. According to UNCTAD an underperformer is a country which has not received the expected inﬂows of FDI in a given period, whereas a frontrunner is a country which has both realised relatively high inﬂows compared to similar countries and which was thought to have relatively high potential for inward FDI also. The classiﬁcation of Austria and Belgium/Luxembourg in those categories was realised for the periods 1988–1990 and 1998–2000. 8. For studies discussing the IDP of Spain from the mid-1990s onwards see Dura´n and U´beda (2001, 2005), Verspagen (1999), A´lvarez (2001) and Zayas (1998). 9. The data were transformed into US dollars from Euros using the end of year exchange rate (OECD International Direct Investment Statistics) and was deﬂated using the GDP deﬂator (OECD online statistics: National Accounts of OECD countries). 10. Comparison of the random effects and ﬁxed effects was not possible as the variance-covariance matrix was singular and the Hausman statistic could therefore not be computed. Our conclusion from this is that we should not reject the null hypothesis of both estimators being consistent. In this case we will present the ﬁxed effects estimator. 11. The hypothesis of no correlation with the residuals was tested using both a Wald and a Wu test, according to the Hausman speciﬁcation. The Wald statistic failed to give a reasonable result (negative result in some cases) in all instances where a 2SLS estimation was compared to the OLS method, probably due to singularity of the difference of the variance matrices. 12. Under the null both estimators are consistent but the 2SLS estimator is less efﬁcient.

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13. In terms of signs the dummy variables are negative for the Nordic countries (Denmark, Finland and Sweden) but positive for Belgium/Luxembourg and Ireland (compared to the omitted Italy). This may be an indication of the effect that Nordic countries’ geographical peripherality may have on attraction of investment ﬂows and therefore could suggest a different grouping of this categorisation of countries, with more focus on geography.

REFERENCES A´lvarez, M. (2001). Espana y la senda de desarrollo de la inversion directa: Una aproximocin. Iet document de treball, Institut d’Economia de Barcelona (abstract only in English). Balasubramanyam, V. N., & Greenaway, D. (1992). Economic integration and foreign direct investment: Japanese investment in the EC. Journal of Common Market Studies, 30(2), 175–193. Barrell, R., & Pain, N. (1996). An econometric analysis of US foreign direct investment. Review of Economics and Statistics, 78, 200–207. Barrell, R., & Pain, N. (1999a). Domestic institutions, agglomeration and foreign direct investment in Europe. European Economic Review, 43, 925–934. Barrell, R., & Pain, N. (1999b). Trade restraints and Japanese direct investment ﬂows. European Economic Review, 43, 29–45. Behrman, J. N. (1984). Industrial policies: Industrial restructuring and transnationals. Lexington, MA: Lexington. Bellak, C. (2000). The investment development path of Austria. Working Paper series. Department of Economics, Vienna University of Economics. Braunerhjelm, P., & Svensson, R. (1996). Host country characteristics and agglomeration in foreign direct investment. Applied Economics, 28, 833–840. Buckley, P. J., & Artisien, P. (1988). Policy issues of intra-EC direct investment. In: J. H. Dunning & P. Robson (Eds), Multinationals and the European community (pp. 105–128). Oxford: Blackwell. Castro, F. B. (2004). Foreign direct investment in a late industrialising country: The Portuguese IDP revisited. FEP Working Paper no. 147. Universidade do Porto, Faculdade de Economia do Porto. CEC. (2004). A new partnership for cohesion: Convergence, competitiveness, cooperation. Third Report on Economic and Social Cohesion. COM/2004/107, Ofﬁce for Ofﬁcial Publications of the European Community, Luxembourg. CEC. (2006, April). Website of the commission of the European communities. http:// ec.europa.eu/ Chakrabarti, A. (2001). The determinants of foreign direct investment: Sensitivity analysis of cross-country regressions. Kyklos, 54, 89–114. Clegg, J., & Scott-Green, S. C. (1999). The determinants of new foreign direct investment capital ﬂows into the European Community: A statistical comparison of the USA and Japan. Journal of Common Market Studies, 37(4), 597–616. Culem, G. G. (1988). The locational determinants of direct investment among industrialised countries. European Economic Review, 32, 885–904.

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Cushman, D. O. (1987). The effects of real wages and labor productivity on foreign direct investment. Southern Economic Journal, 54, 174–185. Dimitropoulou, D., & Pearce, R. (2006). Foreign direct investment ﬂows into an integrating Europe: MNE strategy and location decisions, 1981–2001. In: F. M. Fai & E. J. Morgan (Eds), Managerial issues in international business (pp. 180–194). London: Palgrave Macmillan. Dunning, J. H. (1981). Explaining the international direct investment position of countries: Towards a dynamic or developmental approach. Weltwirtschaftliches Archiv, 117, 30–64. Dunning, J. H. (1993). Multinational enterprise and the global economy. Wokingham: AddisonWesley. Dunning, J. H. (1997). The European internal market programme and inbound foreign direct investment – Parts 1 and 2. Journal of Common Market Studies, 35(1), 1–30 and 35(2), 189–223. Dunning, J. H. (2000). The eclectic paradigm as an envelope for economic and business theories of MNE activity. International Business Review, 9(2), 163–190. Dunning, J. H., & Narula, R. (1996). The investment development path revisited: Some emerging issues. In: J. H. Dunning & R. Narula (Eds), Foreign direct investment and governments: Catalysts for economic restructuring (pp. 1–41). London: Routledge. Dunning, J. H., & Narula, R. (2004). Multinationals and industrial competitiveness: A new agenda. Cheltenham: Edward Elgar. Dunning, J. H., & Robson, P. (1988). Multinational corporate integration and regional economic integration. In: J. H. Dunning & P. Robson (Eds), Multinationals and the European Community (pp. 1–23). Oxford: Blackwell. Dura´n, J., & U´beda, F. (2001). The investment development path: A new empirical approach and some theoretical issues. Transnational Corporations, 10(2), 1–35. Dura´n, J., & U´beda, F. (2005). The investment development path of newly developed countries. International Journal of the Economics of Business, 12(1), 123–137. Erkut, G., & O¨zgen, C. (2003). The economic and spatial peripherality of border regions in Southeastern Europe, European Regional Science Association, Conference Papers. Filippaios, F., Kottaridi, C., Papanastassiou, M., & Pearce, R. (2004). Empirical evidence on the strategic behaviour of US MNEs within the framework of dynamic differentiated networks. In: J-L. Muchielli & T. Mayer (Eds), Multinational firms’ location and the new economic geography (pp. 178–204). Cheltenham: Elgar. Filippaios, F., & Stoian, C. (2005). Where to, Odysseus? The quest of Greek firms to expand abroad. Working Paper no. 104. Kent Business School. Go¨rg, H., & Ruane, F. (1999). European integration and peripherality: Are there lessons from Ireland. Economic Papers 9910, Trinity College Dublin, Department of Economics. Greene, W. (2003). Econometric analysis (5th ed.). Upper Saddle River, NJ: Prentice Hall. Gren, J. (2003). Reaching the peripheral regional growth centres: Centre-periphery convergence through the structural funds’ transport infrastructure actions and the evolution of the centre-periphery paradigm. European Journal of Spatial Development, 3, 1–20. Krugman, P. (1990). Increasing returns and economic geography. NBER Working Paper no. 3275. National Bureau of Economic Research, Washington. Krugman, P., & Venables, A. J. (1995). Globalization and the inequality of nations. NBER Working Paper no. 5098. National Bureau of Economic Research, Washington. Manea, J., & Pearce, R. (2004). Multinationals and transition. London: Palgrave.

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Narula, R. (1996). Multinational investment and economic structure: Globalisation and competitiveness. London: Routledge. Neary, J. P. (2001). Of hype and hyperbolas: Introducing the new economic geography. Journal of Economic Literature, 39(2), 536–561. Neven, D., & Siotis, G. (1996). Technology sourcing and FDI in the EC: An empirical evaluation. International Journal of Industrial Organisation, 14, 543–560. Papanastassiou, M., & Pearce, R. (1994). Host-country determinants of the market strategies of US companies’ overseas subsidiaries. Journal of the Economics of Business, 1(2), 199–217. Pearce, R. (2006a). Globalisation and development: An international business strategy approach. Transnational Corporations, 15(1), 39–74. Pearce, R. (2006b). Technology strategy in the competitive evolution of multinationals. Paper submitted to European International Business Academy Conference, 2006. Pearce, R., & Papanastassiou, M. (1997). European markets and the strategic roles of multinational enterprise in the UK. Journal of Common Market Studies, 35(2), 243–266. Porter, M. E. (1986). Competition in global industries: A conceptual framework. In: M. E. Porter (Ed.), Competition in global industries (pp. 15–60). Boston, MA: Harvard Business School Press. Schu¨rmann, C., & Talaat, A. (2002). The European peripherality index. Conference Papers. European Regional Science Association. Spiekermann, K., & Neubauer, J. (2002). European accessibility and peripherality: Concepts, models and indicators. Working Paper no. 9. Nordregio, Stockholm. Tavares, A. T. (2001). Systems, evolution and integration: Modelling the impact of economic integration on multinationals’ strategies. PhD Thesis, University of Reading. UNCTAD. (1992). The determinants of foreign direct investment: A survey of the evidence. New York: United Nations. UNCTAD. (2002). World investment report. New York and Geneva: United Nations. Verspagen, B. (Ed.) (1999). Technology, economic integration and social cohesion: The policy challenges. Technical Report, Targeted Socio-Economic Research, European Commission. Veugelers, R. (1991). Locational determinants and ranking of host countries: An empirical assessment. Kyklos, 44, 363–382. Wheeler, D., & Mody, A. (1992). International investment location decisions: The case of US ﬁrms. Journal of International Economics, 33, 57–76. Yannopoulos, G. N. (1990). Foreign direct investment and European integration: The evidence from the formative years of the European Community. Journal of Common Market Studies, 28, 236–259. Zander, I., & Zander, U. (1996). Sweden: A latecomer to industrialisation. In: J. Dunning & R. Narula (Eds), Foreign direct investment and governments – Catalysts for economic restructuring (pp. 101–141). London: Routledge. Zayas, J. M. (1998). Multinational and national firms in the process of technology internationalisation: Spain as an intermediate case. Documentos de Trabajo del Instituto de Anlisis Industrial y Financiero. Complutense University of Madrid.

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APPENDIX COMP

OPEN

FST GDP

PERCAP

ULC

PAT

RAD

Exports with the world divided by exports plus imports with the world in US$: UNCTAD Handbook of Statistics Online. Exports plus imports with the world in US$ divided by GDP in US$ at current prices and exchange rates: UNCTAD Handbook of Statistics Online; National Accounts of OECD, Vol. 1. FDI stock of previous year in US$: OECD Online Statistics, Direct Investment Data. Gross domestic product at prices and exchange rates of 1995 (US$m): OECD Online Statistics, National Accounts of OECD Countries, Vol. 1. GDP per capita at prices and exchange rates of 1995 (US$): OECD Online Statistics, National Accounts of OECD Countries, Vol. 1. Unit labour cost in US$, calculated as employee compensation (ILO, Statistical Databases) by GDP per employment (OECD Online Statistics, National Accounts of OECD Countries, Vol. 1). Number of patent applications to the European Patent Organisation per million inhabitants: OECD Online Statistics, Main Science and Technology Indicators. Total expenditure on R&D as a percentage of GDP: OECD Online Statistics, Main Science and Technology Indicators.

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PART II: DETERMINANTS OF LOCATION COMPETITIVENESS OF COUNTRIES

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SPACE, LOCATION AND DISTANCE IN IB ACTIVITIES: A CHANGING SCENARIO John H. Dunning 1. INTRODUCTION The last two decades have witnessed a number of dramatic changes in the location of international business (IB) activity and of our understanding of its determinants. Globalization, technological advances, the emergence of several new players on the world economic stage, and a new focus on the role of institutions and belief systems in the resource allocative process have been the main triggers for change. Globalization, through removing many of the natural and artiﬁcial barriers to cross border information ﬂows and transactions has widened the options of ﬁrms in their locational choices. Technological advances have, by lowering both transport and communication costs, helped to overcome many of the obstacles to transversing space. The astonishing growth of the Chinese economy from being the 10th largest in the world in 1980 to the 4th largest in 2006; and the opening up of India and Central and Eastern European countries to the demands of the global market place, is reconﬁguring the spatial landscape of economic activity. Research on the determinants of foreign direct investment (FDI) has increasingly pointed to the signiﬁcance of institutional- and governance-related variables.

Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 83–109 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00004-0

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Moreover, in spite of several current challenges to globalization – and it is by no means irreversible – the trend towards more interdependency and integration of physical and human resources seems set to continue over the next two decades or more. Spatial issues are, of course, the life and blood of IB scholarship. The changes just described offer huge intellectual challenges both to scholars interested in the locational strategies of ﬁrms – and especially those of multinational enterprises (MNEs) – and to those researching into the actions of extra market actors, as each seeks to advance their economic and social goals in a global market economy. Of course, international economists have long since attempted to identify and evaluate the determinants of cross border economic activity. Yet until fairly recently these endeavours have been conducted within the context of arms length trade and under very restrictive assumptions. Over the years, several kinds of explanation have emerged. Each is now acknowledged as being useful in explaining particular kinds of trade, or trade between different kinds of countries. Each is strongly situational. The consequences of each strongly depend on the structure of markets within which trade is conducted, the strategy of the trading ﬁrms, the policies of the governments of the trading partners, and the content and form of the world trade order, as decided by such organizations as the World Trade Organization (WTO). Each of the explanations, however, does contain a number of common ingredients. These, we believe, no less apply to other kinds of cross border transactions, e.g. FDI which will be the focus of our talk. Such ingredients are threefold. The ﬁrst is the form and content of factor endowments – both natural and created – possessed by the trading or investing entities. This comprises the physical environment (PE) within which ﬁrms make their locational choice. The second is the policies and institutions of the participating organizations. Together with the needs and aspirations of the various constituents of society, these make up the human environment (HE) facing ﬁrms. The third is the speciﬁc situations under which particular products can be produced and traded; e.g. whether they are subject to economies of scale or scope, and/or whether the ﬁrms producing them, beneﬁt from being part of a geographical cluster of related ﬁrms or institutions. This I shall refer to as the contextual environment (CE) facing ﬁrms. Moreover, all kinds of international activity are presented with apparent spatially related paradox, which, I shall argue, has become more challenging over the last 20 years. The paradox is that in spite of the widening geographical options which globalization offers firms, in some sectors at least, production is becoming increasingly concentrated in particular locations?

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And this is not just so at a country level but at a sub-country (micro regional level). Such a paradox is contained in a phrase ﬁrst used by Anne Markusen (1996) viz. ‘sticky places within slippery space’.

2. GEOGRAPHICAL PATTERNS OF FDI (1990–2005) Let us return to IB activity and concentrate on what we shall term MNE-related activity. Such a concept treats the MNE as a system of interrelated value adding operations across geographical space, or over which it exerts some kind of continuing inﬂuence and control (e.g. be it by ownership or some kind of non-equity alliance or set of alliances). In practice, of course, we do not have any comprehensive measure of this kind. At a micro level, we are mainly limited to the sales, assets or employment of the leading MNEs under their direct governance. At a macro level, scholars rely on data on stocks and ﬂows of FDI, the main modality by which this control is legitimized. In Fig. 1, we set out the changing geographical distribution of the stock of inbound FDI between 1990 and 2005 between three main regions of the world, viz. the developed countries, the developing countries, and the transition economies of Central and Eastern Europe.1 These data show two main things. First, the substantial growth of FDI in all regions of the world – both in absolute amounts, and relative to the GDP of recipient countries. Second, the increasing spatial diversiﬁcation of FDI – particularly towards developing and transition economies. Such a geographical widening of MNE activity would have been even more apparent had only greenﬁeld FDI been taken into account. According to UNCTAD (2006), 63% of greenﬁeld projects undertaken by foreign MNEs in the years 2002–2005 were located in developing or transition economies. The continued dominance of the US and Europe as the leading recipients of inward FDI is, at least partly explained, by the huge intra Triad merger and acquisition boom of the 1990s and 2004/2005. Between 1990 and 2000, for example, cross border M&As accounted for more than one half of new FDI, more than 90% of which were within the developed world (UNCTAD, 2000). How does one explain this latter phenomena? I suggest that it was partly the result of the opportunities and competitive pressures engendered by globalization, partly a reﬂection of the growing complexities of modern production and organizational systems; and partly the increasing premium of speed in translating innovation into marketable products. This was also a period during which capitalism came of age, and when the growth of

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1990

0.1

20.7

1990-2005 increase

27.0

28.1

5.1 67.7

63.2

6.2

79.2

$1,789,303 million (8.5%) Developed Countries

$10,129,739 million (22.7%) Developing Countries

$8,340,436 million (35.4%) Transition Economies

Fig. 1. Geographical Distribution of Stock of Inward Direct Investment (%) 1990 and 2005 (% in Brackets Indicate Inward FDI Stocks as % of GDP of Regions Concerned). Source: UNCTAD (2006).

efﬁciency and asset augmenting FDI, helped by regional integration schemes, led to a new conﬁguration of cross border cooperative ventures, and the growth of the network economy. In the renewed interest in M&As (since 2004) the emerging economies, notably China and India, have started to become important players. However, although, at a global level, the geographical structure of FDI between regions has only modestly changed at a country level, there have been considerable variations. Tables 1 and 2 set out some of these; inter alia, they show, for example, the growing attraction of Asian Latin America to inward investors. Within Central and Eastern Europe, it was the more developed transition economies and those which have privatized the most successfully since 1989 which increased their share the most. It has only been in the last three years, that Russia has begun to attract sizeable ﬂows of new FDI.2 The ﬁnal column of Table 1 sets out the Economists Intelligence Unit’s (EIU) predictions for the growth of inward FDI stocks between 2005 and 2010. It can be seen that these predictions suggest a narrowing of the growth gap between the countries attracting the largest and smallest increase in inbound FDI in the 1990s.

Space, Location and Distance in IB Activities

Table 1.

87

Changes in Inward Direct Investment Stock by Region 1990–2010.

Developed countries Western Europe North America Japan Oceania Developing countries Africa Latin America Asia Oceania Transition countries Central and Eastern Europe All countries

2000 (1990=100)

2005 (2000=100)

2010 (Expected) (2005=100)

273.3 289.5 510.7 166.6

203.8 134.9 200.5 195.6

154.8 177.3 138.3 130.0

258.6 605.2 550.3

175.2 173.9 145.8

164.5 150.7 155.2

9320.3 324.3

315.0 174.6

177.6 161.8

Source: UNCTAD (2006) and Economists Intelligence Unit (EIU) World investment prospects to 2010.

If one breaks down the ﬁgures further, one observes three other characteristics, each of which has locational implications and each of which is the direct result of globalization and technological change. I refer you to Fig. 2. The ﬁrst observation is that within the value chain of MNEs (and particularly that of manufacturing MNEs) one has seen a gradual geographical decentralization of R&D (UNCTAD, 2005). Partly this is the result of a spatial broadening of all kinds of innovatory capabilities. Partly it is the outcome of a change in the ownership of such facilities, consequential upon asset augmenting FDI. And partly, it reﬂects the trend towards engaging in specialized or networked R&D (i.e. of efﬁciency seeking or asset augmenting kind) (Pearce, 1999; Kuemmerle, 1999). The second characteristic is the growth of the tertiary sector, which, itself, is partly a reﬂection of a more liberalized treatment by governments towards FDI (e.g. especially in Europe and some developing countries) in services; partly to the dramatic lowering of transport and communication costs; partly to global competitive pressures; and partly to the desire of many new players to gain a ﬁnancial infrastructure as a base for further internationalization. Of the worldwide growth in the stock of inward FDI between 1990 and 2004, 66% was in service sectors (67% in the case of developed and 64% in the case of developing countries (UNCTAD, 2006). Increasingly MNEs are engaging in a

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Table 2.

Major Recipients of Inward Direct Investment Growth 1990–2010. 2000 (1990=100)

2005 (2000=100)

2010 (2005=100)

3,043.5 3,886.6 934.5 1,010.5 1,057.2 510.9 683.1 433.3 NA

194.6 278.1 164.4 117.0 258.5 200.5 168.6 215.7 411.4

151.6 268.1 134.0 147.2 143.8 168.9 212.9 145.6 NA

2. Around average growth Sweden Brazil Chile France Germany Spain US

743.7 276.6 276.7 299.1 244.0 237.2 318.3

182.5 195.2 195.3 231.0 185.1 235.2 129.3

138.3 151.1 171.7 158.3 127.9 139.1 182.0

3. Below average growth Australia Canada Italy Taiwan UK

150.9 188.6 201.9 180.6 215.1

189.8 167.8 181.5 238.5 186.2

131.5 153.7 155.8 155.9 154.7

4. World

324.3

174.6

161.8c

1. Above average growth BVb and Cayman Isles Central Europea China Hong Kong India Japan Republic of Korea Mexico Russia

Source: UNCTAD (2006) and EIU World Investment Prospects to 2010. a Comprising Czech Republic, Hungary, Poland and Slovakia. b British Virgin Isles. c Excluding tax haven regions. NA: not available.

cross border FDI in services integration. Recent examples of this, in both developed and developing countries, are the growth of offshoring investment in business services, e.g. call centres, and that of regional ofﬁces (UNCTAD, 2004). The third characteristic, which embraces the other two, is the changing motives for FDI. Each of these essentially represents the ‘push’ factor for spatial diversiﬁcation. As of the mid-1980s, FDI in the developed countries,

Space, Location and Distance in IB Activities 1.

1990-2005

89

A SUBSTANTIAL INCREASE IN FDI RECEIVED BY ALL REGIONS, BUT A % SHIFT TO DEVELOPING COUNTRIES/TRANSITION ECONOMIES/TAX HAVENS.

2005-2010

RATES OF GROWTH EXPECTED TO BECOME MORE EVEN OVER NEXT HALF-DECADE.

2.

PART OF GROWTH IN FDI STOCKS AS A % OF GDP OF BOTH DEVELOPED AND DEVELOPING COUNTRIES REPRESENTS A CHANGE IN OWNERSHIP OF EXISTING ASSETS, AS A RESULT OF CROSS BORDER M&As, RATHER THAN A REDISTRIBUTION IN THE INTERNATIONAL GEOGRAPHY OF ECONOMIC ACTIVITY.

3.

THERE HAS BEEN A MODEST GEOGRAPHICAL DECENTRALISATION OF R&D ACTIVITIES BY MNEs, MAINLY TO THE LARGER DEVELOPING COUNTRIES, NOTABLY CHINA

4.

THE FASTEST RATE OF RECENT GROWTH OF INWARD FDI HAS BEEN IN THE SERVICE SECTOR. AGAIN THE SHARE ATTRACTED TO DEVELOPING COUNTRIES HAS INCREASED (FROM 12% IN 1989-91 TO 21% IN 2002-4).

5.

SINCE 1990, IN BOTH DEVELOPED AND DEVELOPING COUNTRIES, M&As HAVE BECOME A MORE IMPORTANT COMPONENT OF INWARD AND OUTWARD FDI. MNEs ARE INCREASINGLY SEEKING TO AUGMENT, AS WELL AS TO EXPLOIT, THEIR GLOBAL COMPETITIVE ADVANTAGES.

Fig. 2.

Changes (and Expected Changes) in Geography of Inward FDI 1990–2010.

was mostly either market or horizontal efficiency seeking; and, in the developing countries, a mosaic of market, natural resource or vertical efficiency seeking. Each of these motives for FDI can be loosely described as asset or competence exploiting FDI, i.e. geared towards the exploitation of an existing set of resource, capabilities, market, access and institutional advantages by MNEs in a foreign location. While we would accept that a choice of the right mode to do this, and the right location to do it efﬁciently, may help to protect or augment the ﬁrms competitive advantages in the next

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period of time, essentially its purpose is to use existing assets to generate more value. In the early 2000s at least – and again as a direct result of exogenous economic and social changes – quite a high proportion (no one can speculate how much) of FDI was designed to augment the existing competitive advantages of the investing ﬁrms by creating or acquiring new value. Such value may take the form of new technologies, managerial and organizational competences, institutions, distribution systems and so on. Until very recently this kind of investment had its own geography; it was directed almost exclusively to the advanced industrial countries. But compared to the 1990s, what is new is the (emergence of) the asset augmenting FDI by developing countries, as noticeably witnessed by Lenovo’s purchase of the PC division of IBM in the US in 2004 and Tatas bid for the Corus Steel company in 2006. There is also a limited amount of asset augmenting investment among and between Latin American and Asian countries. Such asset augmenting FDI is perceived by developing countries as one way to help them speed up their technological and economic development. Whether the purchasers have the institutional or organization competences to enable them to efﬁciently utilize the O speciﬁc advantage they acquire remains to be seen. To what extent do these changes in the geography of FDI reﬂect a trend towards regionalization of MNE activity, rather than a globalization of such activity? Some pertinent observations, backed up by data published by UNCTAD (2006), are set out in Fig. 3. In particular the ﬁgure makes three points, which between them suggest that the answer to this question is likely to be both country and industry speciﬁc (Rugman & Verbeke, 2004; Dunning, Fujita, & Yakova, 2007). Finally, I repeat an earlier point that, since a sizeable part of FDI since 1990 has taken the form of M&As, while this may effect the locational proﬁle of the acquiring ﬁrms, its impact on the spatial geography of macro economic activity may be negligible. A change in the nationality of ownership of ﬁrms may be both differently motivated and have different locational characteristics than that of a greenﬁeld FDI.

3. THE BASIC ‘PULL’ FACTORS I have cited some motives for FDI – and of how each of these may both inﬂuence and be inﬂuenced by the strategy of MNEs. What now of the pull factors, which in essence, are concerned with the attractions of a particular

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· BOTH INWARD AND OUTWARD FDI IS CONCENTRATED IN TWO OF THE THREE MAIN REGIONS OF THE WORLD VIZ. THE AMERICAS, EUROPE AND ASIA. TO THAT EXTENT MNE ACTIVITY IS REGIONALISED RATHER THAN GLOBALISED.

· BETWEEN 1990 AND 2005, REGIONAL INTEGRATION IN EUROPE HAS LED TO MORE INTRA REGIONAL INWARD AND OUTWARD FDI. HOWEVER ELSEWHERE, THE TREND HAS BEEN TOWARDS A SLIGHTLY MORE GEOGRAPHICAL DISPERSION OF FDI.

· THERE IS ALSO SOME SUGGESTION THAT THERE IS A TREND TOWARDS MORE CLUSTERING BY EUROPEAN FIRMS IN CULTURALLY SIMILAR REGIONS, BUT LESS SUCH CLUSTERING BY NON EUROPEAN FIRMS (WITH THE EXCEPTION OF CHINA).

Fig. 3.

Regionalization or Globalization?

location – whether it be the ‘home’ country of the investing ﬁrm or another country or indeed regions within those countries. Fig. 4 sets out three of the basic factors which ﬁrms consider in making their locational choices; and which governments normally incorporate into their policies to ensure that both inward and outward FDI helps to promote their economic and social objectives. While each of these factors is country or region speciﬁc, their signiﬁcance or value can ﬂuctuate in response to both endogenous and exogenous events.

3.1. Endowments These comprise the form and content of natural, e.g. primary resources, or created assets, e.g. machines and equipment, and human knowledge. They also include the extent, content and quality of markets. They can be looked at from a static or dynamic perspective. They may be tangible, e.g. buildings and indigenous resources and capabilities. At a micro level, in explaining a ﬁrm’s competitive edge, both the resource based and evolutionary theories are relevant. Between them, they make up the PE for business, which embraces all factor inputs and markets (or potential markets) which are necessary to produce goods and services.

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· QUANTITY AND QUALITY OF INDIGENOUS RESOURCES, CAPABILITIES AND MARKETS (RCM): (THE PHYSICAL ENVIRONMENT (PE)). NATURAL CREATED

· POLICIES, INSTITUTIONS, VALUES, AND RELATIONSHIPS: THE HUMAN ENVIRONMENT (HE).

· EXTERNALITIES RELATING TO PE AND/OR HE. ECONOMIES OF SCALE AND SCOPE CLUSTERING LEARNING OPPORTUNITIES.

Fig. 4.

The Country or Regional ‘Pull’ Factors Attracting FDI.

3.2. Policy, Institutions and Values Here we come to the HE affecting locations. We use the Northian (2005, p. 7) deﬁnition of the HE as a human construct of rules, norms, conventions and ways of doing things that define the framework of human interaction. Such an environment consists of the culture, mindsets and belief systems which affect the content of institutions and the institutional matrix making up any society. These, in turn, embrace a host of formal incentive mechanisms fashioned by governments, and informal norms, conventions and customs, internalized by the constituents of the global economy. Institutions are the instruments guiding the policies of governments’ behaviour, the strategies of ﬁrms and the attitudes and behaviour of special interest groups and individuals. Their content and effectiveness may be inﬂuenced by traditional family and social mores, voters at the ballot box, by the lobbying of ﬁrms, by the advocacy and actions of non-governmental organizations (NGOs), by the decree of governments and by decisions made by supranational entities. Some examples of institutional measures which national governments may use to promote a more efﬁcient and socially acceptable creation and use of resources, capabilities and markets (RCM) are set out in Fig. 5.3

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1. INSTITUTIONS OF ECONOMIC ADJUSTMENT AND STABILISATION 2. INSTITUTIONS STRENGTHENING ECONOMIC MOTIVATION 3. INSTITUTIONS OF PRIVATE PROPERTY PROTECTION

BELIEF SYSTEMS

4. INSTITUTIONS PROMOTING FREEDOM OF ENTERPRISE 5. INSTITUTIONS OF RULE SETTING AND SOCIETAL GUIDANCE (E.G. CSR)

PE (RCM)

6. INSTITUTIONS PROMOTING COMPETITION 7. INSTITUTIONS FURTHERING SOCIAL EQUITY AND ACCESS TO OPPORTUNITY 8. INSTITUTIONS WHICH ASSIST PRODUCTIVE DIALOGUE WITH SUPRANATIONAL ENTITIES.

Fig. 5.

Belief Systems and Institutions Underpinning National Government Policies to Upgrade PE. Source: Adapted from Rondinelli (2005).

I do not have time to explore the important differences between the PE and the HE. I would, however, make two points: (i) An increasing amount of macro data is supporting the proposition that the HE and particularly the institutions embedded in it – are an important determinant of economic performance and growth. However, how important they are and whether they lead or respond to increases in factor productivity is strongly contextual, and appears to be related to a country’s stage of development, and the quality of its governance (Glaeser, La Porta, Lopez de Silanes, & Scheifer, 2004). (ii) As our global environment becomes more uncertain; as goals of its constituents become more multifaceted, complex and interdependent; as free rider problems intensify and public goods take on an international dimension; and as economic activity becomes more human intensive; so the transaction costs of such activity become increasingly critical (Van Tulder & Van der Zwart, 2006). It is the quality and ability of a country or region’s institutions to minimize these transaction costs of cross border stakeholder relations, which provide the impetus to upgrade its

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PE, and, which in turn, will determine its economic success. And, I believe that what applies to countries no less applies to firms.

3.3. Externalities The third pull factor is the ambience for learning and capturing the gains of the externalities associated with particular locations. This needs to be related to the extent to which the spatial concentration of economic activities leads to the beneﬁts of economies of scale and scope; but also (and these may not always go together) whether there are clustering or agglomerative economies, arising from the ﬁrm being part of a spatial complex of interrelated activities.

4. RECENT DEVELOPMENTS AND THE PULL FACTORS Earlier, I identiﬁed three main ingredients of our changing world scenario – globalization, technology and the emergence of new players. How have these features affected the relevance of the three pull factors just identiﬁed? Taking endowments ﬁrst, the answer is that the emergence of new players has added to the availability of RCM, and the opportunities for global sourcing. A good deal of early global sourcing by Russian and Chinese ﬁrms has been of a resource seeking kind; while much of the inbound investment into China has been designed to capture new markets. In addition, globalization and technological advances have added to the continued importance of the location of R&D. The need to form alliances because of technological complexities in the production process; the relocation of many kinds of service activities aided and abetted by advances in E-commerce; the need to become more competitive by continually seeking better locations for product innovation and improvement; each of these factors is leading to a reconﬁguration of pull factors. At the same time, these same forces are increasing the signiﬁcance of institutions and of institutional distance as a location speciﬁc determinant. Why is this? It is partly that PE can be more easily transferred across boundaries; partly that some transaction costs associated with the PE are being overcome; partly that the functions and legitimacy of the main welfare creating and sustaining entities are being increasingly questioned; and, it is

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partly because the cognition, motives, and incentive structures underlying the creation and utilization of ﬁrm and country speciﬁc assets is becoming more signiﬁcant. Lastly what of agglomerative economies? These must be considered as part of both institutions (the HE) and RCM (the PE). We have asserted that globalization is not only demanding that ﬁrms should become more competitive, but that it better enables them to tap into spatially distant PEs and HEs. We have also suggested that the increasing complexity of innovatory and production systems across the globe which impact on both asset creation and asset deployment, has made and is making for both disinternalization and more cooperative ventures. As part of the asset augmenting process, in addition to offering a common pool of labour and other local externalities, spatial clustering may facilitate the learning process of its participating ﬁrms. This is clearly so in the case of several emerging and transition economies. Yet it also reﬂects the growing importance of clusters of related activities as they impact on both ﬁrm and country speciﬁc institutional constraints and incentive structures. We conclude at this point. The changing geographical pattern of MNE activity reﬂects changes in the three main pull ingredients we have identiﬁed, together with the changing motives underpinning the push factors for FDI. We have also suggested that there is accumulating evidence that, since growth and competitiveness of countries is being inﬂuenced by both macro and micro institutions (though how much and in what way is strongly contextual), the content and quality of a nation’s institutions is playing a more important role in decision taking. This not only applies to inward FDI viewed from a host country perspective, but also to outward FDI viewed from a home country perspective. Many developing countries anxious to catch up with their more developed counterparts are re-examining their institutional matrices with a view to assisting their own ﬁrms to become MNEs or engage in outbound contractual relations and networks.

5. INSTITUTIONAL DISTANCE In the next part of my presentation I would like to share with you some thoughts on distance as a distance-related institutional cost. A reading of the recent literature about the role of distance in IB activity leaves the reader completely confused. At one extreme, there are scholars who proclaim geography is dead or does not matter any more (Cairncross, 2000); at the other, there are those who argue that the way in which ﬁrms

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respond to differences in the content and quality of location speciﬁc variables is becoming an increasingly critical determinant of their global competitiveness. In a sense, there is truth in both views: much depends on the context in which they are applied. In the case of the PE, for example, there is evidence that, because of the miniaturization of the physical content of products, and the substantial reduction in transportation and communication costs, and of artiﬁcial barriers to cross border commerce, it matters less than it did where particular products are produced. In the case of the HE, however, at the present stage and structure of globalization, there is mounting evidence that at least some of its location bound contents do matter, and that far from decreasing, some kinds of spatial costs are rising.

5.1. Distance and the PE Let me illustrate these propositions by referring to Fig. 6 which identiﬁes some different distance costs. First, let us look at those primarily affecting the PE: 1. Transport costs: These have generally fallen due (a) to many products being smaller, less bulky; (b) more advances in transport technology; (c) replacement of some products/services previously traded by computer-related services. In addition, some products are being increasingly traded – e.g. services, parcels, etc. by DHL, FEDEXPRESS and similar carriers. However, an increase in the rate of depletion of non-renewable resources and the emphasis being placed on reducing carbon emissions may reverse this trend. 2. Tariffs and non-tariff barriers: These too have been drastically reduced as a result of regional integration and various tariff reduction rounds. The average tariff on goods traded at the end of 2005 was 4% cf. 15% 20 years previously. 3. Communication costs: Both intra MNE and extra MNE cross border costs have dramatically fallen as a result of advances in communication technologies – notably email and the telephone; and, also, an increasing awareness of producers and consumers about production and consumption opportunities across the globe. As a result of the fall in these distance costs – again mainly the result of globalization and technological advances – we see the comparative advantage of the international HE (as a pull factor for FDI) shifting, with distance-related purchases or sales gaining relative to those nearer. Again,

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· THOSE PART OF THE PE TRANSPORT COSTS TARIFF AND NON-TARIFF BARRIERS COMMUNICATION COSTS EACH OF THESE HAS FALLEN – SOMETIMES DRAMATICALLY SO - OVER PAST TWO DECADES; AND IN DOING SO HAS AFFECTED SCOPE AND CONTENT OF INTERNATIONAL DIVISION OF LABOUR. AT THE SAME TIME THE DEPLETION OF NON-RENEWABLE RESOURCES AND THE CHALLENGE POSED BY GLOBAL WARMING AND OTHER ENVIRONMENT CONCERNS MAY INCREASE ABOVE COSTS.

· THOSE PART OF THE HE TRANSACTION COSTS OF HUMAN RELATIONSHIPS. FACTORS AFFECTING CROSS BORDER INSTITUTIONAL DISTANCE - GLOBALISATION - TECHNOLOGY - POLICIES - AGGLOMERATIVE (CLUSTERING) ECONOMIES - MORAL AND ETHICAL ISSUES: CORPORATE SOCIAL RESPONSIBILITY.

Fig. 6.

Some Distance Costs.

measures to reduce global warming, or to encourage consumers to ‘buy locally’ may change the balance of comparative advantage yet again. At the same time, we see, as part of the adoption of globally enhancing policies on the part of both ﬁrms and countries, the need for more ﬂexibility in the product and production strategies of ﬁrms, and of the institutions, e.g. national innovatory systems, competition policies, intellectual property protection, market facilitating measures and safety net provisions, of governments. Furthermore, with the growth of the knowledge economy, we see a rise in efﬁciency seeking and geographically more concentrated FDI both in specialized products and processes – including R&D – which, in turn, may

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lead to more complex technologies, alliance networks and a clustering of related activities. While each or all of these changes in the PE might be expected to lead to an increase in MNE activity and changes in its geography, any increase in distance distorting policy measures by governments (e.g. those designed to encourage FDI in place of imports) might reduce it. And, for very different reasons, so might a rise in cross border transport costs lead to a fall in some kinds of export oriented FDI.

5.2. Distance and the HE Now let us consider the concept of distance, which reﬂects differences in the HE of different countries. In the literature this has variously been referred to as psychic, relational, cultural and institutional distance. Essentially each of these reflect the transaction costs associated with engaging in commercial relations (trade, FDI, alliances), and particularly those in cases where goals, perceptions, institutions, mindsets and belief systems are different from one another. To overcome or minimize such market failures associated with negotiation, information asymmetries, interpretations of corporate social responsibility (CSR) of human rights and of acceptable business practices (to name but a few), the relevant institutions – at a ﬁrm and country or even at the international level – may need to be reconﬁgured and/or upgraded. This is why emphasis is increasingly being placed on institutional distance, as differences in institutions and institutional matrices across national borders affect the behaviour and motivations of the main players in the economies in question. They are the instruments by which cultural, psychic and relationship distance is widened or narrowed. How have the three events earlier identiﬁed affected institutional distance? First, the various tools of globalization, e.g. TV, travel and the Internet, have given individuals and organizations increasing awareness of the diversity of national values and belief systems, and hence of the transaction costs of harmonizing or reconciling such differences. These are especially likely to be important in relational intensive activities, e.g. research and development, learning and services of one kind or another. In such cases, given the freedom, and reduced costs of overcoming physical distance, globalization allows ﬁrms to locate in countries and regions where the institutional distance is least. Advances in technology, through increasing the need for alliances and knowledge networks, point to a similar conclusion. This obviously places locations which are institutionally distanced from each other, or ﬁrms not willing or capable of overcoming

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such distance, at a disadvantage. The solution is clearly to enhance the quality of institutions to counter these affects – providing this is costeffective. This is why various studies, e.g. Meyer (2004) and Glaeser et al. (2004), have shown that such proactive strategies by national governments, and the improvement of corporate governance practices by indigenous ﬁrms, have led to more inbound FDI than those which have not.4 To be effective, agglomerative economies also need a favourable HE. This takes the form of relational capital which essentially comprises the cognition, motivation and behaviour of decision takers as they interact with each other, and the quality of their emotional skills. Networks can only function efﬁciently if there is trust, honesty and other informal bonding of institutions within and between the collaborating ﬁrms. Such beneﬁts, which range from learning economies through to the sharing of a variety of common services, require not only a PE in which ﬁrms can exploit or upgrade their competitive advantages, but an HE which minimizes the transaction costs of doing so. To take advantage of agglomerative or clustering economies, ﬁrms may need to improve their own relational assets. On the other hand, for countries to fully capture the beneﬁts of inward direct investment, they may need to provide the incentive structures and enforcement structures for such clusters to operate effectively. Neither course of action is costless, but Ceteris paribus, one might hypothesize that those locations which have got the institutions in place for ﬁrms to maximize the beneﬁts from clustering, will be the most successful in attracting inward FDI.

6. CHALLENGES FOR THE FUTURE What does my crystal ball tell me about the geography of FDI in say 2027 a year in which I shall celebrate my 100th birthday? I refer you to Fig. 7. Compared to the 2005 distribution of the world stock of inward FDI, I would speculate that while the share of many developing and transition economies-Asian economies, especially China, and some African countries will show the greatest percentage growth in FDI over the next two decades (probably by (around) 10-percentage points), I would nonetheless expect the Triad nations to continue to be the leading locational attractions for all forms of FDI. Perhaps, more signiﬁcantly, I believe that the relative importance of both outward and inward MNE activity (e.g. as expressed by the ratio between the FDI stock and GDP) – again barring a retreat from globalization – will continue to rise, but perhaps, at a reduced rate. I would

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· INCREASED SHARE OF FDI DESTINED TO TODAY’S DEVELOPING COUNTRIES, BUT EXISTING TRIAD NATIONS REMAIN MAIN RECIPIENTS.

· CONTINUED, BUT MORE MODEST, RISE IN % OF GDP OF COUNTRIES ACCOUNTED FOR BY FDI STOCKS.

· SOME INCREASE IN GLOBALISATION C.F. REGIONALISATION; BUT EVENTS E.G. GLOBAL WARMING, AND ANY MOVEMENT TOWARDS PROTECTIONISM, COULD REVERSE THIS TREND.

· FURTHER (RELATIVE) RISE IN EFFICIENCY AND ASSET AUGMENTING FDI. · CONTINUAL RESTRUCTURING OF OWNERSHIP OF CROSS BORDER ASSETS. · A MORE INTEGRATED APPROACH TOWARDS REDUCING PHYSICAL AND INSTITUTIONAL DISTANCE COSTS.

· RISING IMPORTANCE OF BUSINESS/SOCIETY MANAGEMENT AND RELATIONAL ASSETS. MORE ATTENTION BY MNEs TO PROMOTING WIDER DEVELOPMENT GOALS, BOTH IN RESPECT OF PE AND HE.

· MARKED INCREASE IN SOUTH/SOUTH NATURAL RESOURCE SEEKING FDI; AND ITS (DISTINCTIVE) CHARACTERISTICS AND IMPLICATIONS.

· MORE PARTNERSHIPS BETWEEN MNEs AND GOVERNMENTS. · A RISE IN NON-ERGODIC UNCERTAINTY MEANS THAT PREDICTIONS ARE MORE DIFFICULT TO MAKE.

Fig. 7.

John Dunning’s Crystal Ball: Up to 2027.

also expect there to be at least some increase in globalization (cf. regionalization) as the leading MNEs from the three main regions in the world, i.e. the Americas, Europe and Asia and the Paciﬁc, increasingly seek a presence in each other’s territories. I would further expect there to be a relative increase in both horizontal and vertical efﬁciency seeking, and in asset augmenting FDI, although, increasingly, I suspect that our traditional delineations of different motives for FDI will become less meaningful. Again, the geography of each of the main forms of FDI is likely to reﬂect (a) the distribution of natural resources and created assets, (b) the content and quality of national institutions and policies and (c) the role played by both national governments and

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supranational entities in affecting the pattern and pace of economic development and/or of the global market economy. I must own, however, I am presently a little sceptical about the likely success of the kind of cross border M&As now being coordinated by some Third World MNEs. These, as Alan Rugman, I believe, correctly points out, are often based on country speciﬁc rather than firm specific O advantages of the purchasing companies (notably in China’s case the access to plentiful supplies of liquid assets). The critical question, however, is whether companies like Lenovo and Tata possess the kind of complementary assets (e.g. coordinating skills to make efﬁcient use of the knowledge, technology and management capabilities) they acquire. More generally, I would anticipate a further reduction in institutionally related distance costs, and a more integrated strategy by both ﬁrms and governments towards overcoming physical and institutional distance costs; although this rather assumes that Samuel Huntingdon’s (1996) Clash of civilization and similar dire predictions do not come about. Again depending on developments in the WTO, I would hope that artiﬁcial barriers to trade and FDI would continue to fall. However, rising energy costs and attempts to tax carbon emissions on air freight might halt the current trend towards the outsourcing of tangible inputs. As real labour costs rise in the middle income developing countries, FDI in (unskilled or semi-skilled) labour intensive activities might be expected to diminish. But the availability and quality of skilled and professional labour – and, indeed, of all forms of physical and human knowledge is likely to increase. This, in turn, requires a continued upgrading and reconﬁguration of the institutional infrastructure of the likely recipient economies. The quality of relational capital and the increasing engagement of MNEs in CSR activities are both likely to be increasingly important competitive advantages of MNEs particularly in promoting economic development, while the same is true of the ethical wealth of nations as a country speciﬁc location advantage I also expect a renaissance in natural resource based FDI, particularly by China. Who can conjecture about such variables as international terrorism and climate change? The course of the former seems almost non-ergodic, i.e. unpredictable: but the implications of the latter could be critical to MNEs in many sectors. Nicholas Stern and his committee who have recently published a 700-page report on climate change pay little attention to this issue (Stern, 2006). But, on poverty reduction, I do believe a greater cooperation between national governments, supranational entities and MNEs has the potential to dramatically increase FDI ﬂows to the poorer

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nations – and particularly sub-Saharan Africa. I am considerably more optimistic on this front than I was a decade ago. One thing I think is for sure. That is that because of the growing uncertainties, complexities and volatility of the quickly moving global economy, the future of sustainable resources, climate change and of inter country belief systems and institutions, it is becoming increasingly difﬁcult to make reliable medium to long-term predictions either about the spatial distribution of MNE activity or about its determinants. But no doubt, scholars such as ourselves will continue to try and do so!

7. CONCLUSIONS AND POLICY IMPLICATIONS I conclude with two casual empiricisms, three propositions and a few policy implications!

7.1. Casual Empiricisms The costs of physical distance are, in general, declining – and in some cases, dramatically so. This offers widening opportunities to MNEs to traverse space and to better exploit the international division of labour. Whether this leads to more spatial diversiﬁcation or concentration of FDI is likely to be both ﬁrm and country speciﬁc. The costs of traversing institutional distance are, in the early 2000s, increasing. This is simply because globalization is opening up the new opportunities for commercial intercourse between individuals and organizations with different goals, mindsets and ways of doing business. It is here where the emergence of new global players such as China and India are exposing existing players to unfamiliar cultures, belief systems and ideas about CSR. So while institutional distance may be falling among countries converging in market systems, ideologies and economic management, as a whole, the role of institutions in reducing transaction costs (e.g. by harmonization or reconciliation of values) becoming more important. Even within geographical areas where culture-related institutional distance is low, there may be other imperatives to reconﬁgure or upgrade institutions to lower costs of uncertainty or complexity, e.g. in technological advanced and human intensive activities.

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7.2. Three Propositions Next let me offer you, in Fig. 8, just three propositions relating to distance and MNE which I believe are worthy of more serious empirical testing. The ﬁrst (and most straightforward) of these asserts that, to be economically successful, countries must ensure that the content and quality of their institutions such as to ensure that their resources, capabilities and market accessing are created and used in the most efﬁcient and socially acceptable way. Table 3 gives some illustrations of the mix between the qualities of the HE and PE, and the likely ability of countries to attract inward FDI based on a number of efﬁciency enhancing economic and policy variables identiﬁed by UNCTAD (2006), for the period 2002/2004. Table 4 identiﬁes some countries which have been the most and least successful in upgrading

PROPOSITION 1 THE HE SHOULD BE CONSIDERED ALONGSIDE, BUT SEPARATELY FROM, THE PE AS A DETERMINANT OF IB ACTIVITY. MORE SPECIFICALLY, THE SUCCESSFUL NATIONS AND FIRMS WILL BE THOSE THAT PROVIDE THE APPROPRIATE INSTITUTIONAL INFRASTRUCTURE TO ENSURE THAT THEIR RCMs ARE USED EFFECTIVELY. (THE ROLE OF EXTRA MARKET ORGANISATIONS IS LIKELY TO BE CRITICAL IN DETERMINING THE CONTENT AND QUALITY OF HE. PROPOSITION 2 WHILE PHYSICAL DISTANCE MAY HAVE MIXED EFFECTS ON INFLUENCING THE GEOGRAPHY OF FDI, (DEPENDING ON THE MOTIVES UNDERPINNING IT), INSTITUTIONAL DISTANCE IS LIKELY TO ACT AS A DETERRENT TO IT. PROPOSITION 3 REDUCING INSTITUTIONAL DISTANCE IS LIKELY TO BE MOST EFFECTIVE WHEN IT PROMOTES THE COMPARATIVE DYNAMIC ADVANTAGE (CDA) OF THE RCMs OF THE PARTICIPATING COUNTRIES. THIS SUGGESTS THAT A SELECTIVE APPROACH TO INSTITUTIONAL UPGRADING AND CONVERGENCE MAY BE NECESSARY.

Fig. 8.

The HE and PE: Three Propositions.

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Table 3. Relationship Between HE and PE of Countries 2002–2004. Superior

Less advanced primary producers; oil rich countries (25 countries: average IPI 85)

Most industrialized nations. Advanced Asian economies, E.G. Singapore, Hong Kong, Taiwan. (25 countries: average IPI 30)

HE (institutions)

Industrializing (less advanced) C.&E. Europe/LA/Asian countries: Sub-Saharan African countries. (48 countries: average IPI 108)

Japan: Industrializing C. & E. Europe /LA/Asian countries E.G. India, Indonesia, Brazil, North Africa (42 countries: average IPI 60)

Inferior Inferior

PE (RCM)

Superior

Note: IPI: Inward FDI performance index of UNCTAD. Source: Author’s estimate based upon data contained in UNCTAD (2006, Table A.1.9, p. 277) and World Economic Forum (2005).

Table 4.

Examples of Changing HE and PE of Countries 1990/2004.

Most improvement ΔHE (institutions)

Least improvement

India, Japan, South Africa

Much of Asia, Central and Eastern Europe

Mainly industrialized countries, Russia, less advanced African, Asian, LA countries, most middle Eastern countries

China

Least improvement

ΔPE (RCM)

Most improvement

Note: IPI: inward FDI performance index of UNCTAD. Source: Author’s estimate based upon data contained in UNCTAD (2006, Table A.1.9, p. 277) and World Economic Forum (2005).

their PEs and HEs over the period 1990–2004. The question arises – can such an analysis be used to identify successful firms? There are currently some hints emerging from the work of such scholars as Peng, Lee, and Wang (2005) and Lu (2006), on the concept of institutional relatedness as a competitive asset, which, together with its strategic intent, might inﬂuence the extent and pattern of a ﬁrm’s diversiﬁcation. The second proposition states that while physical distance (e.g. transport costs and tariff barriers) is likely to have mixed effects on inward direct

Space, Location and Distance in IB Activities

Table 5.

HE closeness (institutions)

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Geography of us Direct Investment Stock 2005a (Figures in Brackets Indicate Share of Stock Of Outward FDI). Japan, Australasia and more advanced Asian developing countries (17.5%)

Western Europe, Canada (67.6%)

Africa, China and middle east least advanced Asian economies (4.4%)

Latin American and transition countriesa (10.5%)

PE closeness (RCM) Note: IPI: inward FDI performance index of UNCTAD. Source: Author’s estimate based upon data contained in UNCTAD (2006, Table A.1.9, p. 277) and World Economic Forum (2005). a Excluding tax haven countries.

investment (it is, for example, likely to encourage import substituting market seeking but to deter efficiency seeking FDI), institutional distance is likely to deter FDI. Table 5 illustrates this contention using the geography of US direct investment in 2005. Here we see it is concentrated in those countries or regions in which both institutional distance is least.5 Again can such an approach be applied at the ﬁrm level? The third proposition is a little more complex. It argues that different sectoral deployments of the RCM of a particular country, notably those designed to advance its dynamic comparative advantage (CDA) require particular kinds of institutional infrastructure. We give three examples: 1. For countries whose CDA is likely to lie in its knowledge intensive industries, it might be expected that institutional upgrading should be focused on innovation systems and intellectual property rights. 2. For natural resource rich countries, it might be expected that institutional upgrading should be focused on upgrading the physical infrastructure and on the legal system relating to questions of land tenure, ownership of mineral rights, contracts and the obsolescence bargain. 3. For countries seeking to produce intermediate goods or services for the international market place institutional upgrading might be expected to focus on competition policies, export promotion and on bilateral investment treaties.

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7.3. Normative Implications Finally, what are the normative implications of our conclusions about space, distance and FDI activity? In the short time available I can only offer just a few bullet points, which are highlighted in Fig. 9: National policies to attract FDI and the locational strategies of MNE need to be increasingly directed to overcoming institutional distance. However, in which direction, how much and in respect of what kind of FDI is likely to be both country and sector speciﬁc and needs to be related to the costs and beneﬁts of institutional change. Since the main costs of institutional distance reﬂect those to do with cross border differences in the HE, these can only be resolved as a result of some kind of bilateral or multilateral concord. It is here where one gets into evaluating the merits of codes of conduct, global reporting initiatives, standardizing standards, the idea of a common ethic and so on. And this is exactly where issues such as CSR and the ethical wealth of nations 1.

LOCATIONAL COMPETITIVENESS AND MNE PERFORMANCE: STILL A NEGLECTED ISSUE.

2.

NATIONAL FDI POLICIES NEED TO BE DIRECTED TO REDUCING INSTITUTIONAL DISTANCE.

3.

NEED FOR BILATERAL/MULTINATIONAL CONCORD. BUT OF WHAT KIND?

4.

INCREASED EMPHASIS REQUIRED OF ALL STAKEHOLDERS ON CONTENT OF INTERNATIONAL CORPORATE SOCIAL RESPONSIBILITY AND ETHICAL WEALTH OF NATIONS: ARE GLOBAL INITIATIVES WITH RESPECT TO SUCH ISSUES (A) DESIRABLE, (B) FEASIBLE IN LESSENING INSTITUTIONAL DISTANCE?

5.

MORE RESEARCH NEEDED AS TO HOW INSTITUTIONAL REGIMES, AS A FIRM SPECIFIC COMPETITIVE AND A COUNTRY SPECIFIC COMPARATIVE ADVANTAGE, MAY AFFECT THE RCMs OF EACH.

Fig. 9.

Conclusions: Distance and FDI.

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(as vividly illustrated by Tom Donaldson (2005)) become quite critical. What, for example, is the signiﬁcance of the content and quality of social capital, respect for environmental integrity, the avoidance of bribery and corruption, the importance of accurate information, the assurance that contracts will not be broken? For these public ‘goods’, as well as fuelling the PE, act as commodities of intrinsic value and thus help fashion the HE. On these issues, we are at the very early stages of studying how reducing institutional space can be best tackled; and, indeed, for what reasons and to what extent should it be reduced? In our evolving global economic scenario, both ﬁrm and country institutional regimes are becoming just as important as the content and quality of factor endowments as a location speciﬁc competitive asset. Indeed, they are likely to be more embedded as both formal and informal institutional change takes time to overcome established mindsets! Yet even accepting they are location speciﬁc, it does not follow that they cannot be changed. Indeed as with RCM they can be as part of a ﬁrm’s competitive and a country’s comparative advantage (or disadvantage) which effects and is affected by their respective PEs, and the goods and services they produce and trade (Amable, 2003). Why are some ﬁrms or countries better at innovation than others? Why are some better at producing products which are labour intensive? How come differences in goals, attitudes and actions of cross border stakeholders, e.g. with respect to ISO standards, child labour, fairness of taxes, the environment, competition policy and climate change best be overcome (Kolk & Pinske, 2005)? Why do some ﬁrms and countries better generate high value service activities and not others? Why do industrial clusters seem to be located in some countries and not others? Partly, I suggest the answer to these questions depends on their comparative institutional as well as their competitive RCM advantages. How and why then is FDI attracted to countries with institutional advantages? How may it affect them? Can the MNE be a modality for reducing institutional distance – for lowering the transaction costs of traversing space? Already there is some evidence from Japan, for example, that Western MNEs are affecting (and for good according to Ozawa, 2003, 2005) various aspects of Japanese institutional framework. The same is true a propos foreign MNEs in China transmitting knowledge about and inﬂuencing the content and quality of a variety of home country institutions (competition and innovating policy); of their transfer of ISO standards, of anti-corruption measures (Kwok & Tadesse, 2006) and CSR

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(Husted & Allen, 2006); and also of some asset augmenting investment, e.g. French FDI in pharmaceutical industry is designed to capture the beneﬁts of superior institutions. Indeed, look hard enough and you will ﬁnd the literature from the research of scholars in the late 1950s and 1960s, through to the work of Bruce Kogut, Eleanor Westney, Odile Shenkar and others, many examples of how the L advantages of countries has been affected by the cross border transfer of institutional practices. The challenge of matching national institutional regimes with each other or with some kind of global institutional framework is an exciting area which offers huge research opportunities and challenges to IB scholars. It puts a new focus on the spatial dimensions and drivers of competitiveness. I hope this conference will take the debate a further step forward.

NOTES 1. As deﬁned by the UN. The classiﬁcation of Central and Eastern Europe no longer exists, as several of the erstwhile communist countries are now treated as part of the Economic Community. 2. UNCTAD data suggest the inbound FDI to Russia increased from $32.2 billion in 2000 to $132.9 billion in 2005. 3. Equally it would be possible, though it is not done here, to identify the institutions ‘owned’ or created by other stakeholders, e.g. individuals, families, enterprises, NGOs and supranational enterprises. Taken in to and at any given moment of time they would make up the institutional framework of the global economy. 4. For a discussion of alternative strategies of ﬁrms to reduce institutional distance – within the context of international corporate responsibility (ICR) see van Tulder and van der Zwart (2006). 5. Which implies that institutional distance might be an important variable inﬂuencing the regional concentration of fdi (see Rugman & Verbeke, 2004; Dunning et al., 2007).

REFERENCES Amable, B. (2003). The diversity of modern capitalism. Oxford: OUP. Cairncross, F. (2000). The death of distance: How the communications revolution will change our lives. Cambridge, MA: Harvard Business School Press. Donaldson, T. (2005). The ethical wealth of nations. Journal of Business Ethics, 3, 25–36. Dunning, J. H., Fujita, M., & Yakova, N. (2007). Some macro data on the regionalisation/ globalisation debate: A comment on the Rugman/Verbeke analysis. Journal of International Business Studies, 38(1), 1–23.

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Glaeser, E. L., La Porta, R., Lopez de Silanes, L., & Scheifer, A. (2004). Do institutions cause growth? NBER Working Paper no. 10568. National Bureau for Economic Research, Cambridge, MA. Huntingdon, S. (1996). The clash of civilizations. New York: Simon & Schuster. Husted, B. N., & Allen, D. B. (2006). Corporate social responsibility in the multinational enterprise: Strategic and institutional approaches. Journal of International Business Studies, 37(6), 838–849. Kolk, A., & Pinske, J. (2005). Business responses to climate change: Identifying emergent strategies. California Management Review, 47(3), 175. Kuemmerle, W. (1999). The drivers of foreign direct investment into research and development: An empirical investigation. Journal of International Business Studies, 30(1), 1–24. Kwok, C. C. Y., & Tadesse, S. (2006). The MNC as an agent for change for host-country institutions: FDI and corruption. Journal of International Business Studies, 37(6), 767–785. Markusen, A. (1996). Sticky places in slippery space: A typology of industrial districts. Economic Geography, 12(3), 293–313. Meyer, K. J. P. (2004). Perspectives on multinational enterprises in emerging economies. Journal of International Business Studies, 35(4), 259–276. North, D. C. (2005). Understanding the process of economic change. Princeton, NJ: Princeton University Press. Ozawa, T. (2003). Japan in an institutional quagmire: International business to the rescue? Journal of International Management, 9, 219–235. Ozawa, T. (2005). Institutions, industrial upgrading and economic performance in Japan. Cheltenham: Edward Elgar. Pearce, R. D. (1999). Decentralised R&D and strategic competitiveness: Globalised approaches to the generation and use of technology in multinational enterprises. Research Policy, 28(2–3), 157–178. Peng, M. W., Lee, S.-H., & Wang, D. L. (2005). What determines the scope of the ﬁrm over time: A focus on institutional relatedness. Academy of Management Review, 30(3), 622–633. Rondinelli, D. A. (2005). Assessing government policies for business competitiveness in emerging market economies. An institutional approach. In: R. Grosse (Ed.), International business and government relations in the 21st century (pp. 395–420). Cambridge, MA: Cambridge University Press. Rugman, A. M., & Verbeke, A. (2004). A perspective on the regional and global strategies of multinational enterprises. Journal of International Business Studies, 19, 363–375. Stern, N. (2006). The economics of climate change. London: HMSO. UNCTAD. (2000). World investment report. Cross border mergers and acquisitions and development. New York and Geneva: UN. UNCTAD. (2004). World investment report 2004. The shift towards services. New York and Geneva: UN. UNCTAD. (2005). World investment report. Transnational corporations and the internationalisation of R&D. New York and Geneva: UN. UNCTAD. (2006). World investment report. FDI from developing and transition economies. Implications for development. New York and Geneva: UN. Van Tulder, R., & Zwart, Van der (2006). International business-society management. London and New York: Routledge. World Economic Forum. (2005). The global competitive report 2005–2006. London: Palgrave Macmillan.

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MICROECONOMIC DETERMINANTS OF LOCATION COMPETITIVENESS FOR MNES Christian H. M. Ketels 1. INTRODUCTION The concept of microeconomic competitiveness, introduced by Porter (1990) in his ‘The competitive advantage of nations,’ has over the last few years become an increasingly important tool for many policy makers. It is less obvious that business leaders (and researchers in the ﬁeld of international business) have drawn on the competitiveness concept to the same degree, despite the strong reception of other elements of Porter’s work (1980, 1985). This is ironic as the competitiveness concept is fundamentally grounded in the analysis of companies and the impact of locational factors on their ability to successfully compete. In this chapter, we will reﬂect on the most recent learnings on microeconomic competitiveness, using both conceptual work and a range of recent location-speciﬁc analyses, and relate these back to the decisions faced by multinational companies: What are the dimensions that they should consider when evaluating different locations for their activities? How are trends in the global economy affecting the role of location and the nature of competition among them? And what is the agenda that multinational companies face as a consequence?

Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 111–131 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00005-2

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We ﬁnd that microeconomic factors are increasing in importance for companies as well as locations. The role they play is getting more strategic, i.e. more related to the unique market position a company or location takes. Generic microeconomic qualities are necessary, but provide less and less sustainable competitive advantages.

2. ELEMENTS OF LOCATIONAL COMPETITIVENESS Locations compete for companies’ activities based on the conditions that they provide for their operation. The more productive companies can be at a location, the more successful this location will be in competition with other locations. And the more productive the companies located there, the higher the level of prosperity that the location can sustain. Productivity is more than technical efﬁciency. It includes companies’ ability to increase the value of their activities by creating stronger brands, more differentiated value propositions, and new ways to serve their markets. Standard economic models are often not designed to capture the multiple dimensions in which companies can compete even on a given market. As a consequence, productivity improvements in such models can only take the former of higher efﬁciency, i.e. higher levels of production of a given good or service for a given amount of factor inputs. Empirically, however, the ability to increase value by improving the good or service through additional features, service elements, or new distributional channels are at least as important for companies to increase their economic success.

2.1. Drivers of Competitiveness The critical question for locations, then, is which factors make the highest contribution to company productivity. There are three different sets of factors that differ signiﬁcantly in whether purposeful action can inﬂuence them and in how this inﬂuence can take place: the overall legacy of a location, the general economic context, and the microeconomic competitiveness, i.e. the quality of the business environment, the strength of clusters, and the sophistication of companies (Fig. 1). 2.1.1. Legacy: Location, Size, and History The productivity potential of different locations is affected by the legacy it faces in terms of location, size, and economic history. These factors can only

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Direct impact on company productivity Yes

Yes

Directly affected by policy

Business environment quality

No

Context

Cluster

No

Fig. 1.

Company sophistication

Legacy

Business Environment Dimensions.

be managed in terms of the impact they have on the productivity of companies located there; they can never be completely changed. Being close to major trade routes, in the neighborhood of other prosperous and competitive regions, or otherwise endowed with natural resources or attractive geographic or climate features is an asset that locations are randomly exposed to. If such a locational advantage exists, government policy can, however, have an inﬂuence on whether it becomes economically effective. Locations need to provide the right infrastructure and economic environment that creates the opportunity for companies to draw on such an asset. Singapore was an attractive market at a major international trade route. But it took the investment in an efﬁcient port infrastructure and the emergence of competitive transportation and logistics capabilities to leverage this asset. After regaining independence, Estonia found itself in close proximity to prosperous countries in Northern and Western Europe (Porter & So¨lvell, 2005). But it took decisive political steps, in particular the

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acceptance of widespread foreign direct investment (FDI) even in sectors like banking that other locations consider as ‘strategic’, to create the tight economic connection that turn geographic proximity into an economic beneﬁt. Norway found in the 1970s huge oil and gas deposits off its coast. But it took the existence of relevant engineering and other capabilities from related clusters like the maritime cluster to turn this opportunity into an asset the spun the development of a cluster of oil and gas service companies.1 Through this cluster, Norway was able to create signiﬁcant additional value on top of the revenues generated from the sales of natural resources. In turn, if locations ﬁnd themselves in a remote geographic position or in a neighborhood in which economic integration is for political reasons problematic, they need to ﬁnd speciﬁcally active steps to overcome this challenge. Iceland draws on the extensive network of international contacts historically created through its ﬁshing companies to overcome its isolation as an island in the North Atlantic. Israel has created a ‘virtual neighborhood’ with the United States through a deep set of linkages between the countries, partly compensating for its economic isolation in the Middle East. Countries of large size have an inherent advantage in terms of their attractiveness as a market. Even if barriers to trade are high, the ability to serve the local demand can be enough to motivate a foreign investor to come in. For countries like Brazil, this has been a major advantage. But whether or not pure size in terms of population also translates into an attractive large market, depends in addition on the policies that the country adopts. For China and India, their large size became a much more important factor as economic policies changed and created the potential for signiﬁcant domestic market growth. A country’s history can have an additional impact on its competitiveness as a location for FDI. Speciﬁc cultural traits, an economic structure affected by communist legacy, or the existence to strong ties with countries in distant region of the world as part of a colonial history affect the ease with which high levels of productivity can be reached, the existence of local business opportunities, and the opportunities to use the location as a base to serve foreign markets.

2.1.2. Context The macroeconomic, social, political, and legal context is the second large group of factors that inﬂuence the productivity that companies reach in a given location. These factors can be shaped by government policy. They only create changes in terms of productivity, however, if companies respond

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and change the way in which they operate – they create the opportunity for higher prosperity, not prosperity directly. The overall context affects the productivity through its impact on companies’ planning horizon. Companies are less likely to make long-term commitments on new technologies and new ways of doing business that require longer pay-back periods, if the context creates a high degree of uncertainty. Uncertainty can come from all dimensions of the context: it can be the result of unstable macroeconomic conditions, of an unreliable legal and political system, and of social or political tensions that have the potential to undermine the fundamental nature of institutions or decision making. In such a context, companies might make incremental investments to react opportunistically to market opportunity, but they are unlikely to achieve the overall transformations that are required to move to a fundamentally higher trajectory of competitiveness. This is the case in a country like Russia, where the oil-driven growth in the economy has led many companies to start investing, but where these investments remain typically limited to increasing productive capacity, not to transform the productive potential of companies (Porter & Ketels, forthcoming 2007). The overall context also has an effect on the costs of doing business in a country. Companies can manage a more challenging context, but this adds to their operational costs and thus reduces their productivity. Typical examples are the costs of insurance against inﬂation or exchange rate ﬂuctuations, of small-scale corruption, or of lengthy decision processes by courts of government agencies. In many developing countries in particular, the exposure to macroeconomic shocks as a consequence of the dependence on volatile commodity export prices and the weakness of many institutions create a challenging context, reducing the level of productivity companies can reach and thus eating into the level of prosperity that these countries can achieve. 2.1.3. Microeconomic Conditions Microeconomic conditions are the third group of factors that affect company productivity (Porter, 1990). They consist of the microeconomic business environment, the presence of clusters, and the sophistication of companies. All of these dimensions have a direct impact on company productivity. Business Environment. The microeconomic business environment consists of four interrelated areas collectively known as the diamond, following the graphical representation that Michael Porter introduced in 1990. Factor conditions relate to the quality and availability of factor inputs, government services, and public infrastructure. The context for ﬁrm strategy

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and rivalry describes the government policies and company behavior that affects the nature of competition on domestic markets. Related and supporting industries capture the presence of suppliers, services providers, and cooperation partners that create opportunities to specialize activities. Demand conditions are given by the pressure companies experience from domestic buyers and consumers laws to improve productivity and innovate. Strengths and weaknesses in these areas interact in systemic ways; they do not just add up cumulatively. For example, access to a well educated labor force provides more advantages if competition is intense and domestic customers demand new and differentiated products and services. To understand why companies located in Japan came to dominate the global market for car navigation systems, for example, it is important to understand the unique environment in Japan in terms of all four dimensions, not just one (Porter, Ishikura, & Ketels, 2007). Japan had a unique combination of factors that drove productivity and innovation by companies in this market. Competing countries and regions in North America and Europe matched only some of these conditions, but never all. Clusters. An important dimension of strong business environments are clusters, geographic agglomerations of companies, specialized suppliers and service providers, and associated institutions in a particular ﬁeld (Porter, 1998a). Clusters are driven by externalities and complementarities of various types, like supplier relationships, the use of a common labor market, or knowledge spill-overs. Some linkages exist between companies within one industry, while others link different industries together. They cross the divide between manufacturing and services, a distinction that is becoming increasingly meaningless in the modern economy. Clusters are a natural manifestation of the role of specialized knowledge, skills, infrastructure, and supporting industries at a particular location in enhancing productivity, innovation, and new ﬁrm creation. They reﬂect modern approaches to company management. A focus on core activities that are crucial given a company’s strategic positioning increases the role of suppliers and other external conditions for company performance. And the increasing importance of open networks of companies and research institutions in innovation has raised the importance of clusters. Clusters increase their effectiveness if they can rely on institutions for collaboration. These institutions – trade associations, entrepreneur networks, standard setting agencies, quality centers, technology networks, and many others – are neither government agencies, educational institutions, nor private ﬁrms. They play an essential role in connecting the parts of the

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diamond and fostering efﬁcient collective activities to upgrade competitiveness that are often overlooked. In emerging economies like Russia, they are particularly important in enabling a better dialog between government and the business community. Companies. The structure and performance of companies related to value chain scope, operational efﬁciency, and strategic positioning is a ﬁnal component of microeconomic competitiveness (Porter, 1980, 1985, 1996). The value chain scope of companies deﬁnes which activities a company conducts in-house, and which activities are purchased on the market. In many developing and emerging economies, there is a tendency to focus on a relatively narrow band of primary activities in the relevant industry value chain but provide many of the supporting activities in-house. The lack of control across primary activities limits the opportunities for strategic differentiating, while the lack of outsourcing of secondary activities reduces efﬁciency. In countries like Russia, the lack of outsourcing also becomes a barrier for foreign investors: they are used to operate value chains that are much more focused on key primary activities but are constrained in their growth because the market for support services is much less developed due to the lack of demand from local companies (Porter & Ketels, forthcoming 2007). The operational efﬁciency and the strategic positioning of local companies that are suppliers and service providers affect the productivity with which companies can operate in a location. Lower levels of productivity and competition based on costs rather than on the provision of specialized and differentiated products and services limit the strategic choices that a company faces in a given location.

2.2. Other Factors Wage (or more broadly: local factor input cost) levels and the strength of social capital are other factors that are often discussed in assessments of locational competitiveness. We ﬁnd that these are important dimensions in their indirect impact on the drivers of competitiveness, in particular the microeconomic conditions. It is misleading, however, to see them as direct drivers of locational competitiveness. 2.2.1. Cost Levels Companies are interested not only in the productivity they can reach at a given location, but in the share of the value generated that they are able to

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capture. The level of wages, energy costs, real estate, and other local factor input costs relative to the level of productivity with which these factor inputs can be employed is the crucial determinant for the attractiveness of a location to investors. Empirical work shows that countries like the United States can remain attractive despite a relatively high absolute level of wages, because relative to the quality of the microeconomic business environment, these wages are moderate compared to other countries (Porter, Ketels, & Delgado, 2006). The amount of time it takes for cost levels and for competitiveness to change can be quite different, creating opportunities or challenges for countries in the adjustment phase. For Estonia and its Baltic neighbors, dramatic reforms in the context for strategy and rivalry in addition with a solid legacy in skills and infrastructure created a sudden jump in competitiveness. Wages did not adjust as quickly and for a number of years the Baltic countries were very attractive locations for foreign investors. This imbalance is currently narrowing, and the challenge for the Baltic countries is now to adopt policies that will continue their competitiveness (Ketels, 2007). For Germany, the challenge was that relative competitiveness had eroded while wage growth remained signiﬁcant for many years. The resulting imbalance resulted in a signiﬁcant level of unemployment. The imbalance has only recently been narrowed by a combination of economic reforms (that will improve competitiveness over time) and wage restraint (that has an immediate effect). Sustained imbalances between cost levels and competitiveness are a signal of deep structural problems in the economy. If cost levels remain too high, structural unemployment is almost inevitable and the attractiveness for investments from multinational companies is low. If cost levels remain too low, the share of the value captured by companies is overly high while prosperity levels in the location remain low. 2.2.2. Social Capital The strength and structure of social institutions and the level of trust between the public and the private sector as well as between companies in the private sector are an important determinant of a location’s ability to improve its competitiveness over time. Saxenian (1996) argues that the difference in success between the IT clusters in Silicon Valley and the Boston Route 128 area was a result of the open culture of collaboration at the West Coast vs. the closed culture of corporate silos at the East Coast. For companies, the competitiveness of a location depends not only on the speciﬁc nature of the business environment they face at the time of their

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investment. It is also driven by their perception on whether the region will develop over time. And it is important whether government and other institutions have the willingness and ability to help the company when new, unexpected challenges arise that can only be solved if these partners cooperate with the company. In Costa Rica, the signiﬁcant personal involvement of the President in the process of attracting a major investment by Intel was important not only to shape the right business environment conditions at the time, but also as a signal that the government would be available as a partner once Intel had established operations (Porter & Ketelho¨hn, 2005). Implications for Locations. The recognition of the role that microeconomic factors play indicates that locations have to consider a wide range of factors in order to strengthen their competitiveness. Contextual conditions like macroeconomic stability and political institutions are important, but not sufﬁcient. But the many different microeconomic determinants of competitiveness need to be addressed as well; they are necessary to enable companies to achieve higher levels of productivity. And they are inﬂuenced by many different levels of government as well as many non-government institutions, including companies. Microeconomic competitiveness requires locations to make choices. While it is possible (and, indeed, increasingly necessary) for a location to provide a good overall context, it is much more problematic to achieve high levels of performance on all dimensions of microeconomic competitiveness.2 Locations need to deﬁne the role they want to play in the global economy, in terms of the activities on which they want to focus and the value they want to provide. Once such a choice has been made, locations can differentiate those dimensions of the microeconomic environment in which they need to excel from those in which they merely need to meet the offer of competing locations.

3. THE IMPACT OF GLOBALIZATION The global economy is experiencing a number of important changes that have a profound impact on the way that locations compete and are viewed by companies. These changes have affected the relative demand and supply on international markets, exerting differential impact on locations depending on their specialization proﬁle (Council on Competitiveness, 2007). And they affected the way that locations compete with each other, changing the relative importance of factors inﬂuencing competitiveness.

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3.1. Key Trends in the Global Economy The global economy is in the midst of a change process affecting markets, value chains, and access to knowledge and technology.3 In the past, a few locations in Europe and North America provided the key markets for most industries and companies. If a location could provide access to these markets, it had a signiﬁcant advantage relative to peers in a less advantageous position. Now, many more markets, especially in different parts of Asia, have become attractive markets. Russia has emerged as an important market with double-digit growth rates and attractive margins for many international companies. Brazil and other Latin American countries continue to have signiﬁcant potential, even though their performance remains below other emerging economies. Overall, more locations are attractive as markets or as platforms to access nearby markets. In the past, locations competed for entire industries or signiﬁcantly integrated parts of a company’s value chain. A location had to be attractive for the overall set of activities, while advantages that applied only to narrow elements of a value chain conferred little beneﬁt. Now, changes in technology and the reduction of politically induced barriers to trade and investment across borders have created opportunities for value chains to be broken up. Companies can distribute individual activities across different locations and manage value chains that stretch across geography. This allows them to beneﬁt from more narrow, location-speciﬁc beneﬁts and combining them in new ways. In the past, companies could sustain strong market positions based on their preferential access to suppliers of leading technology or to sources of leading knowledge. This beneﬁted locations in advanced economies that were the home of most advanced suppliers and research activities. Now, the leading suppliers of machinery are offering their technology globally, giving companies the potential to use that technology independent of location. Knowledge has become much more global, too, with emerging economies like China and India making strong efforts to import knowledge and increase their capabilities to absorb it.

3.2. Changes in Relative Demand and Supply of Locational Qualities These changes in the global economy have changed the relative value of speciﬁc strengths and weaknesses locations might have. On the supply side of the global economy, the increasing intensity of competition between

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locations creates pressure to provide regional business environments that can support high productivity based on unique, often cluster-related strengths. This favors small countries with an institutional structure to pursue such strategies, while large countries like Russia often ﬁnd it challenging to create multiple regional strategies. The integration of emerging markets, China and India in particular, has created an abundance of low-skill labor, making it increasingly harder for countries like Russia to follow the example of the Asian countries by growing exports based on low labor costs. Together with rapid technological change biased toward skill, the abundance of low-cost labor has rapidly increased the returns to knowledge and education. Locations that provide access to skills and to clusters as hotbeds of innovation capture increasing value, while those that provide lowcost labor might generate employment but only little prosperity. On the demand side of the global economy, quickly growing populations and a high speed of catch up – a consequence of internal policy reforms – have made the emerging economies signiﬁcantly more important drivers of global economic growth. The proﬁle of their demand, more biased toward natural resources and capital goods critical in the early stages of investmentdriven growth, beneﬁts locations specialized in these product categories. This has helped many natural resource-rich economies but also traditional suppliers of capital goods like Germany.

3.3. Changes in the Competition Among Locations The changing nature of the global economy has changed the competition among locations in three important ways: it has increased the intensity of competition among them, it has led to successful locations to be more specialized, and it has increased the level of interconnections across regions. More locations than ever are vying to attract business activities from foreign investors. In the past, only a few locations could provide the general conditions that had to be met for a multinational company to become interested. Some locations could overcome this barrier due to a large home market behind trade barriers or due to an endowment of natural resources. But for those activities where companies had a true choice of where to put them, a few advanced economies were the only real entries on companies’ long lists. This situation has dramatically changed. Many more locations are providing sufﬁcient basic conditions to conduct many types of activities, especially in manufacturing. Domestic policy reforms, inter- and supranational institutions (WTO and EU), and changes in technology have

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played their part. As a consequence, the intensity of rivalry among locations has markedly increased. This continues to create a lot of anxiety, especially in those more advanced locations that used to compete on relatively lower cost levels and are not under pressure from emerging economies that have improved their business environments by enough to severely limit the wage premiums that the lower segment of advanced locations can sustain. The locations that prosper in this new situation are the ones that are specializing around speciﬁc clusters and activities and are building unique sets of advantages to support high productivity in these areas. Specialization provides the basis for distinguishing the role that these locations play in the global economy relative to other locations. And they provide the basis to reach higher levels of productivity. Countries like Ireland or Singapore have achieved their success with a clear concentration on a number of industries. And in the United States, the country that has been a large integrated market with few barriers to trade and investment across regions, successful regions have clearly differentiated proﬁles in terms of their cluster specialization.4 Locations are also getting more connected and interlinked with other locations. Specialization and the focus on leveraging the unique combination of local assets and capabilities is a compliment to strong external linkages, not an alternative. The more specialized a region, the more it needs to rely on complimentary activities in other locations providing other elements of industry value chains. And the more specialized region, the more it is going to sell to markets and clusters focused on downstream value chain activities in other locations. Countries like Sweden that have beneﬁted signiﬁcantly from globalization have done so because they were specialized in areas in which global demand was rising and they had a base on strong multinational companies that provided multiple linkages to other locations in the world (Ketels & So¨lvell, 2006a; Porter & Ketels, 2007). Fig. 2 provides an example from the global footwear industry. There are a number of locations in the world economy that have specialized in footwear activities. These locations do not compete had on, however, but instead have specialized on different markets or activities and are often tightly interlinked through multinational companies like Nike have activities in different locations.

3.4. Implications The changes in the global economy have increased the relative role of microeconomic factors as determinants of locational competitiveness.5

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Romania • Production subsidiaries of Italian companies

Portugal • Production • Focus on shortproduction runs in the medium price range

United States • Design and marketing • Focus on specific market segments like sport and recreational shoes and boots • Manufacturing only in selected lines such as hand-sewn casual shoes and boots

123

• Focus on lower to medium price range

Italy • Design, marketing, and production of premium shoes

China • OEM Production •

Focus on low cost segment mainly for the US market

• Export widely to the world market Vietnam/Indonesia Brazil • Low to medium quality finished shoes, inputs, leather tanning • Shift toward higher quality products in response to Chinese price competition

• OEM Production • Focus on the low cost segment mainly for the European market

Fig. 2. Networks of Specialized Footwear Clusters. Source: Research by HBS student teams in 2002 – Van Thi Huynh, Evan Lee, Kevin Newman, Nils Ole Oermann.

The overall context that countries provide has become a necessary condition that more and more locations meet; it is no longer sufﬁcient to win. Countries that rely on macroeconomic reforms alone – in particular stabilization of ﬁscal policies and opening of trade barriers – have in many cases experienced growth spurts driven by one-time improvements in efﬁciency and signiﬁcant growth in domestic demand. But without additional reforms in microeconomic fundamentals they have failed to achieve the structural improvements in locational competitiveness they were hoping for. Multinational companies entered the market to serve the growing local demand but not to build signiﬁcant platforms for exports. And domestic companies could not improve their productivity enough to become signiﬁcantly stronger players in global value chains. This could result in macroeconomic imbalances when local demand overshot export potential that could undermine the sustainability of the gains in context. Countries like Argentina experienced such a negative dynamic in the recent past. The three Baltic countries are currently in a situation where they need to take steps to avoid such an outcome. Countries that build strong microeconomic foundations in addition to a solid context have been able to overcome the limitations of their own market

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and became a platform to serve the global economy in speciﬁc market segments. Multinational companies are increasing the number of locations in which they are present. And they are more likely to view locations as parts of global value chains, not just markets to be served. Domestic companies that could beneﬁt from strong microeconomic foundations at their home location could more easily enter new markets or become valuable partners in global value chains. Countries like Singapore have followed this path in the past. Iceland has more recently undergone a dramatic transformation with a similar approach of improving microeconomic foundations while aggressively integrating into the global economy.

4. THE AGENDA FOR MULTINATIONAL COMPANIES The changes in the global economy have important repercussions for many companies (Berger, 2006). It has created many new opportunities by allowing companies to draw on the unique assets and capabilities of a broader range of locations and to serve a wider range of markets. But it has also created new challenges by exposing companies to competition from a wider range of companies located elsewhere and to competition from companies that can tap into business environments with a different proﬁle of strengths and weaknesses. Locational factors, in particular differences in microeconomic fundamentals, are becoming a more important aspect of competitive interaction between companies. The increasing role of location has been reinforced by other changes in the way companies operate. These changes are partly driven by the changing nature of global competition but they are also the result of independent changes in technologies and company practices. First, companies have started to focus more on core activities and competencies (Hamel & Prahalad, 1990). This trend, driven by the need to achieve higher levels of proﬁtability, has made companies more dependent on external suppliers and service providers. The efﬁciency of such relations depends both on their geographic proximity and on the quality of the external linkages a location provides. Second, companies are becoming more reliant on knowledge and new ideas as sources of value creation. This trend, driven by the decreasing proﬁtability of traditional production activities, has made companies more dependent on innovation, a process that increasingly occurs in ‘open’ networks (Chesbrough, 2003) that connect a company with other

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institutions. The presence and strengths of such networks is a key dimension of the microeconomic conditions that a location provides (Ketels, 2005). In both cases, the role of location and its microeconomic foundations increases.

4.1. The Role of Multinationals In the old world of signiﬁcant barriers of trade, multinational companies export the competitive advantages that they have been able to build in one location to other locations. How this was done, i.e. by exports, licenses, or by FDI, and where it was done to, i.e. to which markets, were the main questions that multinational companies had to address in a way that maximized their proﬁtability. In this old world there were also signiﬁcant differences in overall context between locations. Multinational companies originate in those few countries that met the basic contextual requirements for long-term investments in business activities. In the new environment of lower barriers to trade and investment and a huge increase in the number of locations that provide the basic conditions for business activity, the core questions that multinational companies have to address are different (Doz, Santos, & Williamson, 2001; Porter, 1998b; Porter & So¨lvell, 1998). Multinational companies now connect business activities across different locations and orchestrate value chains in order to leverage the complimentary strengths of different locations in adding value to the ﬁnal good or service, independently of where it is consumed. As connectors, multinational companies often play a crucial role in creating the connections between locations that were identiﬁed as an increasingly important factor in global competition across geographies.6 As orchestrators,7 multinational companies identify local clusters and companies that can provide speciﬁc value and integrate their activities with those of other clusters and companies. An increasing share of multinationals’ value added resides in managing value chains across locations, not in the speciﬁc activities that are part of the value chain. Competitive advantages of multinationals, too, need to migrate to the activities that are critical in this context, i.e. recognizing attractive market opportunities, identifying local capabilities, leveraging them for speciﬁc value chains, and integrating them with other activities across different locations. In this new environment, there is also a new role for smaller- and mediumsized companies that have traditionally not been much affected by foreign markets. While in the past they did not have the resources to actively penetrate foreign markets, the barriers to do so are now considerably

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smaller. For these companies, the traditional approach of multinational companies, i.e. the export of competitive advantages through the presence on foreign markets, is now becoming a viable model.

4.2. Location as a Role for Business Leaders The analysis of microeconomic drivers of competitiveness and the changing nature of competition among locations in the emerging global economy suggest the broader locational agenda that multinational companies need to consider (Fig. 3). Leveraging the locations in which a company is present in order to deﬁne sustainable competitive advantages is a ﬁrst ongoing task business executives face. The location(s) a company is active in provide it with a unique set of external conditions. The challenge is to deﬁne a strategy that leverages the advantages that the existing environment in this location confers and minimizes the weaknesses that it might impose.

Traditional roles of locational analysis Picking a location: Where do we locate which activity in sync with our strategic position?

Location

Strategy

Leveraging a location:

Improving a location:

How do we derive strategic benefits from the characteristics of our location?

How can improve the value of our location in supporting our strategic position?

New roles of locational analysis

Fig. 3.

Location as Strategic Management.

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A good example is the Norwegian company FAST Search & Transfer. FAST provided advanced Internet search technology. At its Norwegian home location, FAST had access to strong skills through its proximity to the country’s leading technical university. But it faced signiﬁcant weaknesses in terms of a small home market and no advanced marketing expertise. FAST decided to sell its technology as an Intranet solution to large companies and a build-in technology to large Internet sites like Yahoo. In a very different environment, FAST’s US competitor Google had instead chosen to build a consumer brand itself and become a large player in the consumer marketing market. Both companies are highly successful but they have chosen very different strategies that were at least in part shaped by the very different locational conditions they faced at their home location. The second task company executives face is the choice of locations that provide the highest value to their business. But while in the past this choice was a large but ultimately operational question, it now achieves a truly strategic dimension; the set of locations that a company can tap into through the geographic placement of its activities becomes an important source of competitive advantages, not just a determinant of its cost level. Companies strategic opportunities are shaped by the assets and capabilities they can leverage in these locations. For the German car manufacturer BMW, for example, strategic considerations played a signiﬁcant role when evaluating where to place a new large manufacturing site for its 3-series product line. BMW was looking for a location that was attractive in terms of costs but also in terms of supporting its strategic positioning as a producer of up-to-date highperformance cars. It ended up placing the plant in Leipzig, Germany. While Leipzig was not the best choice in terms of costs, a location in Germany was considered as a strong asset to support BMW’s brand. And the business environment in the region enabled production to start a few months earlier than would have been possible in competing regions in Eastern Europe. The third task company executives face is whether they can make investments in the business environment of their locations to improve their value for the company. While the overall context is something that companies have only very limited ability to affect, the microeconomic foundations are the result of choices in which companies do play an important role. They can work with local universities in shaping education programs that provide critical skills, work with other companies to raise the proﬁle of the region, or participate in activities of local investment attraction agencies to attract companies that strengthen the local cluster.8 Such investments of time and money can be as or more effective in improving the

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economic performance of the company than investment in internal capabilities. An example is Dow Chemical, the US chemical company (Ketels & Fear, 2006). After a huge investment into acquiring and modernizing a chemical plant in the East German region around Schkopau, its chief executive Bart Groot realized that long-term success was only likely if the region would perform well more generally. Groot invested a signiﬁcant amount of his time to mobilize other company executives to improve the public perception of the region and to create an institutional structure in which the private and the public sector could work together to strengthen the microeconomic foundations of the region.

5. CONCLUSIONS: LOCATIONAL COMPETITION MOVING FROM BEST PRACTICE TO STRATEGIC POSITIONING Competition among locations has gotten more intense, the set of activities for which locations compete has become more granular, and a number of the traditional sources of competitive advantage that companies could rely on have diminished in importance. In this new competitive environment, microeconomic factors have become a much more important differentiator of locational competitiveness. For companies, these changes have moved a company’s locational footprint from an issue of operational efﬁciency, i.e. where can this activity be conducted at the lowest costs, to one of strategic positioning, i.e. where can this activity be conducted to a source of competitive advantage relative to the company’s competitors. Multinational companies compete through the locations in which they are present, not only through the internal capabilities and assets that they control. All companies can inﬂuence the role of their locations through new channels: they can set their strategic position in ways that makes optimal use of the locations in which they are present. And they can invest in the locations in which they operate in order to increase the value they provide given the company’s strategy. For locations, these qualitative changes in the role of locations for companies’ competitive success have created new demands. They need to understand the speciﬁc needs of companies given their individual strategies, not just the generic needs of all companies in a given industry. They need to develop own strategies, i.e. a speciﬁc position that deﬁnes how the location

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is providing unique value as a place to do business in the global economy. And they need to ﬁnd new ways of interacting with companies to mobilize them in the process of improving the competitiveness of the location. The processes described here are part of the reality that locations and companies face today. Some have already adopted strategies and action agendas that acknowledge the increasing role of locations.9 Others will be pushed in this direction by the power of market forces in the near future. The reorganization of the global economic geography that is under way is complex and will undoubtedly be accompanied by mistakes (Kinkel, 2004) and overshooting. But the fundamental forces of the new opportunities that companies and locations can exploit in the emerging global economy are setting a clear direction toward a more efﬁcient geographic distribution of economic activities across locations, with higher levels of specialization and uniqueness enabling higher productivity and better economic performance for locations and companies.

NOTES 1. See the discussion in Reve and Jakobsen (2001). 2. Hausmann, Rodrik, and Velasco (2005) make a related argument, noting that unique bottlenecks limit growth of economies and only policies that address these speciﬁc bottlenecks can propel higher prosperity. 3. See the contributions in Passow and Runnebeck (2005). 4. The lower regional specialization level in Europe might indeed be an important driver of Europe’s lower relative productivity and sluggish performance on the Lisbon-Agenda. See Midelfart-Knarvik, Overman, Redding, and Venables (2000), and Ketels and So¨lvell (2006b). 5. This assessment thus differs signiﬁcantly from the view in Cairncross (2001). 6. Saxenian (2006) focuses on the role individual entrepreneurs play in this context. 7. Hinterhuber (2002) introduces this term but does not make the connection to integration of activities across locations. 8. See So¨lvell, Lindqvist, and Ketels (2003) more generally on such initiatives. 9. Boeing and the network of locations it uses to support the development and production of the Boeing 787 is a recent example. See Gapper (2007).

REFERENCES Berger, S. (Ed.) (2006). How we compete: What companies around the world are doing to make it in today’s global economy. New York: Currency Doubleday. Cairncross, F. (2001). Death of distance: How the communications revolution is changing our lives. Boston, MA: Harvard Business School Press.

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Chesbrough, H. (2003). Open innovation: The new imperative for creating and profiting from technology. Boston, MA: Harvard Business School Press. Council on Competitiveness. (2007). Competitiveness index: Where America stands. Washington, DC: Council on Competitiveness. Doz, Y., Santos, J., & Williamson, P. (2001). From global to multinational. Boston, MA: Harvard Business School Press. Gapper, J. (2007). A cleverer way to build a Boeing. Financial Times (July 9). Hamel, G., & Prahalad, C. K. (1990). The core competence of the corporation. Harvard Business Review, 68(3), 79–93. Hausmann, R., Rodrik, R., & Velasco, V. (2005). Growth diagnostics. Working Paper. Harvard University – Kennedy School of Government, Boston, MA. Hinterhuber, A. (2002). Value chain orchestration in action and the case of the global agrochemical industry. Long Range Planning, 35, 615–635. Ketels, C. (2007). Latvia: Ready to enter the next stage? op-ed, Diena, June 13. http://search.ft.com/ftArticle?queryText=A+clever+way+to+build+a+Boeing&aje= true&id=070708004065&ct=0 Ketels, C., & Fear, J. (2006). Cluster development in Mitteldeutschland. HBS Case 707-004. Harvard Business School Press, Boston, MA. Ketels, C. H. M. (2005). Innovation und Cluster. In: H. Barske, A. Gerybadze, L. Hu¨nninghausen & T. Sommerlatte (Eds), Das innovative Unternehmen. Du¨sseldorf: Symposium Verlag. Ketels, C., & So¨lvell, O. (2006a). State of the region-report 2006: The top of Europe in global competition. Copenhagen: Baltic Development Forum. Ketels, C., & So¨lvell, O. (2006b). Clusters in the EU-10 new member countries. Brussels: European Commission-DG Industry. Kinkel, S. (Ed.) (2004). Erfolgsfaktor standortplanung. Heidelberg: Springer Verlag. Midelfart-Knarvik, K. H., Overman, H. G., Redding S. J., & Venables A. J. (2000). The location of European industry. EU Economic Paper no. 142. European Commission, Brussels. Passow, S., & Runnebeck, M. (Eds). (2005). What’s next: Strategic views on foreign direct investment. Stockholm: Invest in Sweden Agency ISA with UNCTAD and WAIPA. Porter, M. E. (1980). Competitive strategy: Techniques for analyzing industries and competitors. New York: The Free Press (Republished with a new introduction, 1998). Porter, M. E. (1985). Competitive advantage: Creating and sustaining superior performance. New York: The Free Press (Republished with a new introduction, 1998). Porter, M. E. (1990). The competitive advantage of nations. New York: The Free Press. Porter, M. E. (1996). What is strategy. Harvard Business Review (November–December), 61–78. Porter, M. E. (1998a). Clusters and competition: New agendas for governments, companies, and institutions. In: M. Porter (Ed.), On competition. Boston, MA: Harvard Business School Press. Porter, M. E. (1998b). Competing across locations: Enhancing competitive advantage through a global strategy. In: M. Porter (Ed.), On competition. Boston, MA: Harvard Business School Press. Porter, M. E., & Ketelho¨hn, N. W. (2005). Building a cluster: Electronics and information technology in Costa Rica. Harvard Business School Case 703-422. Boston, MA: Harvard Business School Press. Porter, M. E., & Ketels, C. H. M. (2007). Competitiveness in the global economy: Sweden’s position. Presentation given to the Globalization Council of the Swedish government.

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Porter, M. E., & Ketels, C. H. M. (forthcoming 2007). Russian competitiveness audit. Moscow: Center of Strategic Research (CSR). Porter, M. E., & So¨lvell, O. (1998). The role of geography in the process of innovation and sustainable competitive advantage of ﬁrms. In: A. D. Chandler, Jr., P. Hagstro¨m & O¨. So¨lvell (Eds), The dynamic firm. Oxford: Oxford University Press. Porter, M. E., & So¨lvell, O. (2005). Estonia in transition. Harvard Business School Case 702-436. Boston, MA: Harvard Business School Press. Porter, M. E., Ishikura, Y., & Ketels, C. (2007). Car navigation systems: Sustaining Japan’s competitiveness, draft case. Boston, MA: Institute for Strategy and Competitiveness. Porter, M. E., Ketels, C., & Delgado, M. (2006). Building the microeconomic foundations of prosperity: Findings from the business competitiveness index. The global competitiveness report 2006–2007. In World Economic Forum, New York: Palgrave. Reve, T., & Jakobsen, E. (2001). Et Verdiskapende Norge. Oslo: Universitetsforlag. Saxenian, A.-L. (1996). Regional advantage: Culture and competition in Silicon Valley and Route 128. Boston, MA: Harvard Business School Press. Saxenian, A.-L. (2006). The new argonauts: Regional advantage in a global economy. Boston, MA: Harvard Business School Press. So¨lvell, O., Lindqvist, G., & Ketels, C. (2003). The cluster initiative Greenbook. Stockholm: Ivory Tower.

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CORPORATE INCOME TAXATION IN CENTRAL AND EASTERN EUROPEAN COUNTRIES AND TAX COMPETITION FOR FOREIGN DIRECT INVESTMENT Christian Bellak and Markus Leibrecht 1. INTRODUCTION Against the background of the Eastern enlargement of the European Union (EU) and in particular in the light of falling corporate income tax rates in Central and Eastern European Countries (CEECs), tax competition has recently emerged in the public debate of several EU Member States. CEEC governments are frequently accused of engaging in corporate income tax competition for foreign direct investment (FDI) at the cost of the ‘‘old’’ EU member countries. It has been argued that costs arise, because of a fall in production or a reduction in tax revenues from corporate proﬁts or an underprovision of public services or a shift of the tax burden to less mobile factors. Moreover, these costs are amended by costs related to the high transfer payments to the CEECs via the EU-budget. Fostered attempts to coordinate or even harmonize corporate income taxes in the EU are requested.

Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 133–156 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00006-4

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A number of empirical studies analyzed the existence of tax competition particularly among OECD countries, while evidence for CEECs is lacking. These studies may be separated into ﬁrst and second generation direct1 studies. First generation studies like Rodrik (1997), Slemrod (2004), Winner (2005) and Garretsen and Peeters (2007) explain the variability in tax rates (either statutory tax rates (STRs), implicit tax rates, tax-to-GDP-ratios or forward-looking tax rates) usually by factors like the openness of an economy, the size of the country, the one-period lagged tax rate and proxies for the macroeconomic and budgetary conditions of a country. These studies inter alia ﬁnd that tax rates fall with the openness of countries and that tax rates are positively related to the size of a country (e.g. Rodrik, 1997; Slemrod, 2004). Both results are consistent with the theoretical tax competition literature. Garretsen and Peeters (2007) additionally ﬁnd that agglomeration matters for the level of the corporate income tax rate as ‘‘core’’ (i.e. more centrally located or agglomerated) countries have higher tax rates. Winner (2005) shows that tax competition pressures have intensiﬁed since the mid-1980s and that there is a shift of tax burden to relatively immobile labor. The distinguishing feature of second generation studies is that they model and test for strategic interactions between jurisdictions via estimation of tax reaction functions (see Brueckner, 2003 for a survey). Roughly speaking, the tax rate of a country is a function of the (weighted) average tax rate of all competitor jurisdictions (Devereux, Lockwood, & Redoano, 2004). These studies may be further separated into within-country studies – dealing with strategic interactions on the local or state level – and international studies (see Grifﬁth & Klemm, 2005). Only few studies are available which analyze strategic interactions in tax setting at the international level, that is between nations. Among the seminal papers in this respect is Devereux et al. (2004). The authors provide a theoretical model of corporate income tax competition from which tax reaction functions are derived. These are then estimated using data on the corporation tax regimes of 21 OECD countries from 1982 till 1999. The authors ﬁnd evidence for strategic interactions in the setting of STRs on corporate income as well as effective marginal tax rates (EMTRs) of the Devereux and Grifﬁth (1999) type. This is the evidence for tax competition for mobile proﬁt (via lowering of STRs) and for capital earning just the cost of capital (via lowering EMTRs). Yet, strategic interaction in effective average tax rates (EATRs) which are especially relevant when dealing with tax competition for FDI (see below) is not directly modeled.2

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These studies suffer from one main drawback – they do not clearly separate tax competition as the driver of falling tax rates from other causes. As stressed recently by Grifﬁth and Klemm (2005), Slemrod (2004) or Nicode`me (2006), falling tax rates may be caused by other factors than tax competition. For example, the implementation of common intellectual trends in tax setting, like tax rate-cut-cum-base-broadening or changes in the political stance toward less government intervention and hence lower tax burdens may lead to falling tax rates. Also ‘‘yardstick competition’’ may cause falling tax rates (see below). Moreover, joining an economic union may be accompanied by a reduction in taxes. This last point is relevant especially for the EU, which, for example, applies to the parent subsidiary directive that abolishes withholding taxes on repatriated dividends. Therefore, analysis of the political reasons behind tax rate cuts is crucial. The goal of this chapter is to examine whether tax competition for FDI indeed is a driver of falling corporate income tax rates in the CEECs. Thereby, as the econometric approaches outlined above do not explicitly isolate the political aim of tax rate cuts, we do not follow these approaches.3 Rather, we proceed by stating a deﬁnition of tax competition from which preconditions for tax competition for FDI are derived. The fulﬁllment of these preconditions is analyzed qualitatively or quantitatively depending on the precondition in question. The chapter starts from a deﬁnition of tax competition and a discussion of four preconditions of corporate income tax competition for FDI (Section 2). Section 3 asks whether these four preconditions are fulﬁlled for the CEECs. Section 4 concludes.4

2. DEFINITIONS AND PRECONDITIONS OF TAX COMPETITION Competition may be deﬁned as ‘‘a rivalry between individuals (or groups or nations). It arises whenever two or more parties strive for something that all cannot obtain’’ (Stigler, 1988, p. 581). As capital is a scarce resource this applies to FDI as well. Until recently, the literature on tax competition devoted little attention in providing a clear deﬁnition of tax competition. This gap was ﬁlled by Wilson and Wildasin (2004). They deﬁne tax competition in a broad sense as ‘‘any form of non-cooperative tax setting by independent governments’’ (Wilson & Wildasin, 2004, p. 1066). This deﬁnition is very general and encompasses several different forms of competition where tax setting may play a role. In particular it includes

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yardstick competition, which is based in Hirschman’s (1970) terminology upon the ‘‘voice’’ option of decision makers (Wildasin, 2005; Brueckner, 2003): yardstick competition here resembles rivalry for votes in which tax policies of independent jurisdictions are a source of information for voters. Moreover, yardstick competition may even exist in the case of fully closed economies (Devereux et al., 2004). It is not concerned with shifts of resources and hence tax bases from one jurisdiction to another. This last aspect, capturing the exit option of Hirschman (1970), is a crucial feature of tax competition in a ‘‘narrow’’ sense. Tax competition in a narrow sense is deﬁned by Wilson and Wildasin (2004) as ‘‘non-cooperative tax setting by independent governments under which each government’s policy choices inﬂuence the allocation of mobile tax bases among ‘‘regions’’ represented by these governments’’ (Wilson & Wildasin, 2004, p. 1067). In this deﬁnition, the independent jurisdictions are linked via tax revenue effects due to an increase or decrease in the tax base via induced resource ﬂows. This narrow deﬁnition clearly excludes yardstick competition as it resembles the exit option. Moreover, the focus upon mobile bases and on the exit option implies ‘‘horizontal’’ tax competition between jurisdictions of the same level (e.g. local governments or states), an open economies issue. Hence, ‘‘vertical’’ tax competition, which refers to governments of different levels (i.e. federal, state and local governments) ‘‘competing’’ for a given tax base is also excluded from this deﬁnition of tax competition (Wilson & Wildasin, 2004). This deﬁnition captures precisely what is meant by fostered corporate income tax competition due to EU Eastern enlargement. The term ‘‘non-cooperatively’’ encompasses the rivalry aspect of competition for a certain resource (e.g. capital including FDI) and the corresponding tax base. It also means that a government does not take into account the impact of its decisions upon other governments. Its tax-related measures exert ﬁscal externalities such as tax base externalities upon other jurisdictions (see Hauﬂer, 2001) which are not internalized. Clearly, government policies are dependent via trade ﬂows or capital ﬂows etc. in open economies. Yet, in the narrow deﬁnition of tax competition governments are ‘‘independent’’ if they have sufﬁcient ﬁscal sovereignty to use taxation actively as a policy choice. For example, the CEECs have sufﬁcient ﬁscal sovereignty in setting direct taxes, even as members of the EU, as direct taxation is mainly in the hands of the EU Member States (e.g. European Commission, 2001). Based on this ‘‘narrow’’ deﬁnition of tax competition the following preconditions for horizontal corporate income tax competition for FDI can

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be isolated (also see Krogstrup, 2004, p. 5; Grifﬁth & Klemm, 2005, p. 25; Feld, 2005, p. 127): 1. Governments reduce tax rates on corporate income which are relevant for FDI decisions of multinational enterprises (MNEs). 2. One explicit motivation of tax-rate cuts is to attract FDI or to react to downward revisions of other countries’ corporate income tax rates to avoid loosing investment. 3. FDI is technically possible and MNEs make use of this possibility. 4. Corporate income taxes are a signiﬁcant determinant of FDI. Each of these preconditions is included in the narrow deﬁnition of tax competition: the ﬁrst precondition reﬂects the government’s policy choice. The question is, whether governments indeed are reducing tax rates which are conceptually relevant for FDI decisions of MNEs. The second precondition represents the rivalry aspect included in the deﬁnition (‘‘noncooperatively’’). Thus, this precondition separates tax competition for FDI from other reasons of falling tax rates, some of which have been brieﬂy mentioned above. Precondition three reﬂects the mobility element included in the deﬁnition. Horizontal tax competition can only occur among sufﬁciently open economies and only if MNEs indeed undertake FDI. Precondition four refers to the impact that government policy choices have on the allocation of resources and tax bases between countries given the sensitivity of FDI with respect to (w.r.t.) corporate income taxes. In the remainder of the chapter the ﬁrst three preconditions are discussed on the basis of descriptive evidence. The fourth precondition is analyzed via a survey of empirical studies dealing with the tax rate sensitivity of FDI in CEECs. Thereby we focus upon seven CEECs (BG, CZ, HU, PL, RO, SI and SK) which have (recently) joined the EU plus HR, which is an EU-candidate country (CEEC-8 for short).

3. EVIDENCE FOR THE PRECONDITIONS OF TAX COMPETITION IN THE CEEC-8 3.1. Evidence for Precondition One Before presenting evidence for precondition one it is necessary to discuss which measure of the corporate income tax burden is appropriate for analyzing FDI decisions. In other words, it is necessary to establish which

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tax rate government should reduce for attracting FDI and thus which measure is crucial when analyzing tax competition for FDI. Different measures are discussed in the literature (see, e.g., OECD, 2000b for an overview). While each measure has advantages and disadvantages, the choice of the most appropriate measure of the corporate income tax burden should be guided by the underlying research question. It is well established in the literature (e.g. Devereux, 2006a) that forward-looking effective tax rates (FETRs), which are derived from the cash ﬂows generated by a hypothetical investment project and the relevant tax codes, have several conceptual advantages for analyzing investment decisions: (i) FETRs distinguish between domestic investments and FDI (domestic vs. bilateral effective tax rates). (ii) They are calculated either as EATRs on inframarginal investments or as EMTRs on marginal investments. (iii) They reﬂect the investment decision of an MNE which is also ‘‘forward-looking’’ and they therefore show the (dis-)incentives taxes exert on investment decisions. Disadvantages include the relatively high degree of complexity in the calculation of these rates, i.e. the net present value of a hypothetical investment has to be calculated with and without taxation, and the fact that tax planning activities of MNEs can be addressed to a limited extent (e.g. tax efﬁcient form of ﬁnancing the investment) only. The investment decision of an MNE can be split into four levels (see Devereux & Grifﬁth, 2002; Devereux, 2006a for details): 1. Level 1 is concerned with discriminating between different types of market servicing, most importantly whether to produce at home (and export) or to produce abroad (engage in FDI). 2. Level 2 includes the decision where to invest, given that level 1 has resulted in a decision to invest abroad. 3. Level 3 governs adjustments to scale, i.e. expansion or downscaling of an existing investment abroad. 4. Level 4 is concerned with the place of declaration of the proﬁt earned given the decision to invest in a particular location. Levels 1 and 2 comprise discrete and infra-marginal (i.e. proﬁtable) and level 3 is concerned with marginal investment decisions. The two FETRs mentioned above are now directly related to the ﬁrst three levels in the following way: on the one hand, EATRs are directly related to the decision to produce abroad or at home (level 1) and where to invest (level 2), ranking the investment opportunities according to their net-of-taxes proﬁtability. Thereby bilateral EATRs (BEATRs) are especially relevant for FDI

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decisions as all relevant tax laws (home country, host country, international and supranational) are captured. EMTRs directly impact on the optimal scale of an investment (level 3) conditional upon the choice of an investment location.5 Finally, level 4 decisions should not be addressed with effective tax rates but with the STRs as MNEs have already taken advantage of all possible tax allowances at this stage of decision making. Crucially, FDI decisions often are infra-marginal (e.g. Devereux & Hubbard, 2003; Devereux & Grifﬁth, 2002; Markusen, 2002) and therefore should primarily be driven by the BEATR.6 This is particularly important for the CEECs as these are young market economies where FDI is a relatively recent phenomenon. Thus, it is plausible that FDI consists of new and infra-marginal investments. Moreover, as some of the CEECs only recently signed double taxation agreements (e.g. Slovenia with Austria and the US; or Hungary with several home countries of FDI) or have changed withholding taxes on repatriated proﬁts or – to a minor extent – interests during the last years (e.g. the New EU Member States due to the adoption of the EU-parent-subsidiary and the EU-interest and royalties payments directive) it is especially important to focus on average tax rates on a bilateral level. Finally, substantial differences in the overall withholding tax rates on repatriated dividends and interests exist between the various home countries of FDI. These changes and differences are well captured by BEATRs, which is the tax variable of main interest when dealing with FDI decisions of MNEs, especially in the CEECs. The BEATRs shown below are calculated closely following Devereux and Grifﬁth (1999). They are calculated for the CEEC-8 and their seven most important home countries of FDI in terms of the share in FDI stock – AT, DE, FR, IT, NL, UK, US.7 Basically, the BEATR developed by Devereux and Grifﬁth (1999) refers to the scaled difference between the pre- and posttax economic rent (greater than zero) of an FDI with a given ﬁnancial pre-tax rate of return. The post-tax economic rent is, inter alia, a function of the tax laws of (i) the host country (e.g. tax allowances, stock valuation, STR on corporate income, local business taxes, withholding taxes on repatriated proﬁts, taxes on interests paid to the parent company and allowances for corporate equity); (ii) the home country (e.g. STR on corporate income and cost disallowance rules); (iii) of international tax law (e.g. double taxation avoiding method for repatriated dividends and interest) and (iv) of supranational tax law (e.g. EU-parent-subsidiary-directive, decisions of EC-Court of Justice (e.g. Bosal and Marks & Spencer case)). The CEEC-8 have undergone a considerable tax-reform process during the past decade, corporate income taxation being no exception. While the

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tax-reform process ‘‘was not uniform across countries’’ (e.g. Grabowski, 2005, p. 294), several clear trends are discernable w.r.t. corporate income taxation (see Tables 1(a) and 1(b) and Fig. 1): 1. STRs have been reduced considerably during the past decade along with other deductible items. In general, these changes have lowered the BEATRs of foreign investors signiﬁcantly. 2. The downward movement of various tax parameters gained momentum in the year 2000. Moreover, Table 1(b) suggests that these steps have not been taken independently by the respective governments (cf. precondition 2). 3. The decreasing width of the boxplots over time implies that the BEATRs are converging. 4. The relatively large drop in the median BEATR in 2004 is partly due to the adoption of the parent subsidiary directive by the New EU Member States (HU, CZ, PL, SK and SI) in the year 2004. Note that this drop in the BEATRs is an example for falling tax rates which is not caused by tax competition forces. Thus, the CEEC-8 have reduced BEATRs substantially. Whether these cuts really are aimed to attract FDI or not to loose it respectively, is addressed in the next subsection.

3.2. Evidence for Precondition Two For the fulﬁllment of precondition two it is hard to provide quantitative evidence. We have surveyed (a) documents of international organizations (e.g. OECD, World Bank) and other sources for evidence in earlier years; (b) stability and convergence programs submitted by CEEC governments to the European Commission for evidence from 2003 onwards and (c) webpages of Investment Promotion Agencies (IPAs) for the most recent evidence for precondition two. 3.2.1. International Institutions and Related Sources The early years of transformation to market economies were strongly inﬂuenced by the question what type of tax structure the CEECs should adopt. The reform of the Soviet-type corporate income tax was driven by the desire to ‘‘use the tax code to promote or guide certain types of investment activities’’ (Martinez-Vazquez & McNab, 1997, p. 12). Thereby special and more generous tax provisions were granted to foreign investors

HU CZ PL SK SI BG HR RO

CEEC-8 Tax Parameter: Initial Parameters in 1995.

Corporate Income Tax Rate (%)

Depreciation Method: Machinery

Depreciation Rate (%): Machinery

Depreciation Method: Building

Depreciation Rate (%): Building

Inventory Valuation

18.60 41.00 40.00 40.00 30.00 40.00 25.00 38.00

Straight line (SL) Declining balance (DB) Straight line Declining balance Straight line Declining balance Straight line Straight line

14.30 12.50 10.00 12.50 33.30 16.30 4.00 15.70

Straight line Declining balance Straight line Declining balance Straight line Declining balance Straight line Straight line

2.00 2.22 2.50 2.00 10.00 4.00 3.30 2.00

Average cost Average cost LIFO Average cost LIFO LIFO LIFO FIFO

Notes: LIFO, last in ﬁrst out; FIFO, ﬁrst in ﬁrst out. Source: IBFD (various years).

Corporate Income Taxation in CEECs and Tax Competition for FDI

Table 1a.

141

142

Table 1b.

HR RO

1996

1997

1998

1999

STR

STR STR STR

drb/drm

STR STR STR STR STR STR

drb STR STR

STR/dmm/ dmb/drm

2000

2001

2002

2003

2004

2005 STR

STR

STR STR STR STR/drb STR/drb STR

STR STR STR

STR STR

STR/dmm/ drm

STR

STR

STR STR drm/drb drm/drb STR/dmm

STR/ACE

drb

drb

STR STR

STR drb STR

Notes: STR indicates a change in the STR on corporate income; dmm indicates a change in depreciation method (machinery); drm indicates a change in depreciation rate (machinery); dmb indicates a change in depreciation method (building); drb indicates a change in depreciation rate (building); ACE indicates allowance for corporate equity cancelled. Source: IBFD (various years).

CHRISTIAN BELLAK AND MARKUS LEIBRECHT

HU CZ PL SK SI BG

CEEC-8 Tax Parameter: Main Changes 1996–2005.

Corporate Income Taxation in CEECs and Tax Competition for FDI

143

60

BEATR

40

20

0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 line: Mean BEATR 1995-2005

Fig. 1.

Bilateral EATRs of CEEC-8 (1995–2005). Source: Own calculations based on Devereux and Grifﬁth (1999).

(ibid., p. 13). Although some of the CEEC-8 have reduced tax provisions granted solely to foreign investors by the mid of the 1990s (OECD, 1995), many tax incentives to attract FDI remained in force also in the second half of the 1990s (Mitra & Stern, 2002; Grabowski, 2005). These incentives often were tax base related (tax holidays; special deductions etc.). Policies changed substantially by the year 2000 with tax rate reductions - motivated inter alia by the desire to attract FDI (see below) - gaining momentum (cf. Table 1(b)). This shift toward tax rate incentives is closely related to the announcement of EU accession of most of the CEEC-8. In particular, EU state aid rules disallow several tax-related incentives. Hence, the drop in the STRs may be considered as a compensation for the abolishment of such tax incentives (see Devereux, 2006b; Grabowski, 2005). But the crucial point is that the reduction in STRs is not mandatory. Hence, in contrast to the drop of the BEATRs in 2004 which was partly due to the adoption of the EU-parent-subsidiary directive, these changes in STRs are not driven by EU-legislation per se.

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3.2.2. Stability and Convergence Programs8 The goal of attracting FDI can be found in most of the stability and convergence programs available. Examples are: 1. ‘‘y it is a priority to improve the FDI attracting capability of the economy and to increase the integration level of already completed foreign investments. Favorable environment is created for foreign investments through the introduction of a ‘‘single window administration system,’’ the low corporate income tax rate, the tax allowances relating to development expenses and the indispensable infrastructure investments y’’ (HU convergence report 2003/2004, p. 9; with similar comments in the reports 2004/2005, p. 8 and 2005/2006, p. 8). 2. ‘‘Tax rates reduction in direct taxes should be considered as the most important. These changes were oriented toward improving the situation of enterprises and attracting direct investments’’ (PL convergence report 2003/2004, p. 36). 3. ‘‘The philosophy behind the introduction of single rate tax was to improve the production capacity of the economy through the inﬂow of foreign investment, better incentives for work and business’’ (SK convergence report 2003/2004, p. 10). 4. ‘‘Continuing the privatization process and attracting more foreign direct investment remain the challenges for the oncoming year.’’ ‘‘y gradual reducing of the corporate income tax rate from 25% to 20% and keeping the extensive tax relief for research and development should stimulate ﬁrms’ investment in development’’ (SI convergence and stability report 2006/2007 report, p. 8). 5. ‘‘The statutory corporate income tax, authors (CIT) rate will gradually be reduced to 24%. The tax rate reduction is an important measure to maintain the competitiveness of the Czech Republic in the Central European region, as many other countries including Poland, Hungary and Slovakia have already slashed CIT rates to attract foreign investors. The planned cuts, together with the measures proposed for the second stage of the reform, will reduce the effective CIT rate to a level comparable with neighboring countries joining the EU’’ (CZ convergence report 2003/2004, p. 47). 6. Moreover, the Economic and Fiscal Policy Guidelines for the Period 2007–2009 of the Croatian Ministry of Finance:9 state: ‘‘y since high tax burden does not promote consumption or investments, and taking into account the lower level of tax burden in the new member states that are also Croatia’s competitors when it comes to attracting foreign direct

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investments, Croatia must continue reducing its share of tax revenues and social contributions in GDP.’’ The last three quotes are especially interesting. Quote (4) implies that SI, which had a constant STR and very stable allowances from 1996 onwards, will use corporate income taxation as a means to attract FDI in the future.10 The same can be deduced from quote (6) for HR. Quotes (5) and (6) are insightful as they demonstrate that tax cuts indeed may be driven by tax rate cuts in competitor countries. Moreover, quote (5) signals that governments indeed have a look at the effective tax rate on corporate income. 3.2.3. Webpages of IPAs A look at the webpages of various IPAs yields inter alia the following evidence for taxes being used as an instrument to attract FDI: 1. The Romanian IPA explains why foreign investors should choose their country as follows: ‘‘Competitive Tax Policy: 16% Flat Tax. The cuts affect income tax and corporate proﬁt tax, as well as the levy on dividends, within a reduced and simpliﬁed tax regime. The aim of the 9 points cut is to encourage growth and foreign investment.’’11 2. The Bulgarian IPA states that investing in BG is advantageous due to ‘‘yThe lowest operational costs and tax rates in Europe’’ with a ‘‘10% corporate income tax rate from January 1st, 2007.’’12 Summarizing, the qualitative evidence given in this section strongly suggests that precondition two is fulﬁlled for the CEEC-8.

3.3. Evidence for Precondition Three As all but one country of the CEEC-8 are members of the EU in 2007 the ﬁrst part of precondition three, namely that FDI is technically possible, can be regarded as fulﬁlled: New EU Member States have to adopt the acquis communautaire of the EU, which has as one of its pillars the freedom of capital movement. The ‘‘FDI Regulatory Restrictiveness’’ of the OECD (see Koyama & Golub, 2006) measures the regulatory discrimination against FDI (increasing values of the index imply an increasing regulatory restrictiveness). This measure is in 2006 below the OECD-average for CZ, HU, SK and RO. For PL and SI it is only slightly above the OECDaverage and well below of the ‘‘FDI Regulatory Restrictiveness’’ of AT, which is in this respect among the most restrictive OECD countries

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(Koyama & Golub, 2006)13. Thus, as inward FDI in CEECs was possible only to a limited extent prior to 1990 (see, e.g., Dell’mour, 2006) the CEECs have carried out wide-ranging measures to liberalize laws and regulations toward capital inﬂows as well as measures to secure property rights. Kobrin (2005) structures these different measures into eight categories: (1) promotional measures, like the establishment of IPAs; (2) regulations allowing foreign ownership; (3) FDI approval procedures; (4) operational conditions, including performance requirements; (5) protections of property rights, including regulations for dispute settlements; (6) sectoral liberalizations; (7) corporate regulation, including ﬁnancial market laws and (8) foreign exchange controls. Using data from the UNCTAD database, Kobrin (2005) ﬁnds that the 19 CEECs included in his analysis14 carried out 228 changes of FDI policy in one of the eight categories during 1992 and 2001. Among them 206 changes are easing and 22 are hampering FDI inﬂows. By far most changes occurred in the categories: promotional measures (1), sectoral liberalization (6), operational conditions (4) and protections of property rights (5). Further, speciﬁc evidence for the CEEC-8 is available for some of Kobrin’s eight categories. Concerning category (1) IPAs have been set up by most the CEECs quite at an early stage: 5 countries have established an IPA by the year 1995, SK followed in 2001, RO in 2002 and HR in 2005. With respect to various other categories of Kobrin (2005) Fig. 2 and Table 2 show three measures for the CEEC-8: (i) the number of bilateral investment treaties (BITs) signed by the CEEC-8 and the seven home countries of FDI mentioned above (proxy for category 5); (ii) tariff revenues in percent of imports (proxy for categories 2 and 3) and (iii) the degree of current account convertibility (full convertibility or not; proxy for category 8). BITs are an indicator for property rights protection. Tariff revenues in percent of import value and current account convertibility are proxies for the openness of an economy for inward FDI and, hence are of particular relevance when analyzing the technical possibility of inward FDI. Typically, countries with low trade barriers also tend to have low barriers to inward FDI (Shatz & Venables, 2003) and the existence of foreign exchange controls signals that proﬁts may not be repatriated without problems (Javorcik & Spatareanu, 2005). The bars in Fig. 2 show the average number of BITs signed by the CEEC-8 in a particular year. As the maximum value possible is seven the ﬁgure shows that the CEEC-8 have concluded BITs with most of the main home countries of FDI already by the year 2000. Yet, BG, SI and HU have not signed a BIT with the US by 2006, whereas the EU non-Member State

147

8

10

7

9 8

6

7 6

5

5 4

4 3

3 2

2 1

1 0 2006

2004 2005

2003

2002

2001

BITs and Tariff Revenues of the CEEC-8. Source: Tariff revenues: EBRD (various years); BITs: UNCTAD (2006a).

Table 2. Country

2000

Average Tariff Revenues

Average No. of BITs (MAX = 7)

Fig. 2.

1999

1998

1997

1995

1996

1994

1993

1992

1991

1989 1990

1988

1987

0

Tariff Revenues in percent Imports

Average Number of BITs

Corporate Income Taxation in CEECs and Tax Competition for FDI

Current Account Convertibility in CEEC-8. BG

HR

CZ

HU

PL

RO

SK

SI

Full current account convertibility since 1999 1995 1995 1996 1995 1998 1995 1995 Source: IMF (various years a) and EBRD (various years).

HR has signed BITs with all seven home countries of FDI countries by the year 2001. The falling trend in tariffs indicates the increase in the openness of the CEEC-8 and the reduction of restrictions on inward FDI since the mid-1990s.15 Moreover, most of the CEEC-8 have full convertibility since 1995 (cf. Table 2). Tariff revenues and current account convertibility are only rough proxies for the level of obstacles for inward FDI. Unfortunately, no comprehensive quantitative evidence for the level of restriction on inward FDI is available for the period since 1990. Yet, some qualitative information about restrictions on inward FDI (categories 2, 3 and 6 of Kobrin, 2005) and restrictions of liquidations of FDI (category 4) is available from IMF (various years b), UNCTAD (2006b) and OECD (2002, 2001, 2000a). According to the IMF, restrictions on inward FDI include approval procedures as well as sectoral restrictions in force. Restriction on liquidations measure whether invested capital can be repatriated without

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legal barriers. Four of the CEEC-8 restricted liquidations of FDI: SI until 1993 (regulations of the former Socialist Federal Republic of Yugoslavia are applied), RO until 1994, PL in 1990 and BG until 1991. Restrictions on inward FDI are more common. The restrictions applied are rather diverse (e.g. prohibition of FDI in certain sectors; approval and registration requirements; equity and loan requirements). Although information on restriction on inward FDI is not available for all years and is not entirely consistent with the information given for former years and across sources the information from IMF (various years b), UNCTAD (2006b) and OECD (2002, 2001, 2000a) can be summarized as follows: all countries apply restrictions of different degrees (prohibition, approval requirements and registration requirements) on inward FDI in sensible (strategic) sectors and industries (especially seaport, defense, airports, air trafﬁc, real estate transactions, legal services, telephone network and services) throughout the period covered. Moreover, some countries apply restrictions on the organizational form of FDI (especially joint venture requirements, minimum capital requirements and prohibition of wholly owned foreign companies) during the early years of transition. Yet, over time sectors precluded for FDI are opened up to nonresidents and stateowned ﬁrms are privatized, approval requirements are substituted by registration requirements or restrictions are abolished altogether, at least in non-sensible sectors. This process can be sketched by the example of SI: SI reduced restrictions substantially over the years starting with the level of restrictions applied by the former Socialist Federal Republic of Yugoslavia (Foreign Investment Act of 1988 (see OECD, 2002)). In 1993, a new legislation was passed, which abolished a large number of the stipulations of the Foreign Investment Act. For instance, the new legislation abolishes many approval requirements and introduces registration requirements instead. Yet, it still prohibits FDI in various sectors (e.g. in the military equipment ﬁeld, rail and air transport, communications and telecommunications, insurance, publishing and mass media). This ban was widely substituted by approval requirements via new laws in 1997, 1999 (Foreign Exchange Act) and 2003, respectively. Especially the Foreign Exchange Act is seen as a cornerstone of liberalization (OECD, 2002). It fully replaces the Foreign Investment Act of 1988 and it allows FDI in several sectors where it was formerly prohibited. Moreover, this act includes a timetable for the elimination of several sectoral restrictions still remaining in 1999 (OECD, 2002). Hence, with the 2003 act investments by nonresidents in production and trade of military equipment are no longer precluded but now require approval only.

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Moreover, restrictions on foreign participation in investment funds management companies are eliminated under the new Investment Fund Management Companies Act (OECD, 2002). Yet, in 2006 still some sectoral restrictions apply, especially in the transport and the electricity sector (see Koyama & Golub, 2006). Similar developments exist in other CEEC-8 countries: for instance, HU abolishes approval restrictions in the banking sector by 1996 (Act on Credit Institutions and Enterprises; OECD, 2000a). According to Koyama and Golub (2006) HU especially applies restrictions in the transport sector in 2006. HR substitutes the ban on FDI in the ﬁnancial sector in 1993 by a registration requirement and BG applies relatively strong restrictions on the organizational form of FDI in conjunction with approval requirements (e.g. FDI is subject to approval when foreign participation exceeds 50% in limited liability ﬁrms) until 1991. Yet, in 1992 these requirements are substituted by registration requirements, which are abolished completely in 1999 for non-sensible sectors (IMF, various years b). RO takes steps to ease inward FDI starting with 1995. By 2001 inward FDI may take place in all economic sectors with the exception of ﬁnancial, banking, insurance, re-insurance sectors as well as some sectors protected by special laws (UNCTAD, 2006b). In 2006, RO applies relatively strong restrictions in the air transport sector (Koyama & Golub, 2006). The legal framework for FDI in the 1990s in PL is mainly set up by the Foreign Investment Law of 1991 (UNCTAD, 2006b). Based on this law foreign investors have generally access to the economy. Yet, this act explicitly precludes inward FDI in the airport sector and requires approval in the banking, insurance, telecommunication, TV broadcasting sectors to name just a few. PL still applies comparably strict regulations on inward FDI in 2006 as the ‘‘FDI Regulatory Restrictiveness Index’’ of PL is above the OECD-average with relatively strong restrictions applied in the telecom, the banking and the air transport sector (Koyama & Golub, 2006). Unlike PL the regulatory framework for FDI has been widely liberalized in CZ and SK since the beginning of transition (see OECD, 2001; UNCTAD, 2006b). SK applies sectoral restrictions on FDI in the air transport, the accounting and the electricity sector in 2006 (Koyama & Golub, 2006). According to OECD (2001) CZ has already widely removed restrictions on inward FDI with the OECD membership in 1995. Since then remaining sectoral restrictions were further eased. Indeed, the ‘‘FDI Regulatory Restrictiveness Indexes’’ of CZ and SK are the lowest among the CEEC included in Koyama and Golub (2006). The levels in 2006 are comparable with those of Portugal, Spain, Denmark or the US.

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Given the information on the inward restrictions applied and by considering the development of the other measures shown (especially tariff revenues and current account convertibility) it is safe to conclude that inward FDI in the CEEC-8 has been technically possible to a large extent at least since the mid-1990s. Moreover, the empirical evidence on FDI in the CEEC-8 also clearly shows that MNEs are increasingly using the possibilities to invest in the CEEC-8 (cf. Fig. 3 and Lane & Milesi-Ferretti, 2006 for a recent survey). Thereby, PL, CZ and HU are the main target countries of FDI. When putting the inward FDI stock in relation to a country’s population, CZ and HU remain the main host countries of FDI with SI and SK now being ranked above PL. Moreover, recent data (see WIIW, 2006 for details) signal that FDI in the manufacturing sector in percent of total inward FDI is declining. This latter point is of interest as with this sectoral change also the importance of the various determinants of FDI may change. According to Sto¨whase (2005) the role of taxes as a determinant of FDI increases in importance with an increasing share of FDI in the service sector. He ﬁnds that the tax-rate elasticity of FDI is substantially higher for the tertiary sector than for the secondary and the primary sector, with the latter being unaffected by tax incentives. FDI in the primary sector is predominantely driven by the endowment with natural resources. FDI to the secondary sector may be attracted to a lesser extent by low taxes than FDI to the tertiary sector due to relatively high transportation costs and relatively high plant level economies of scale in manufacturing.

80000

PL RO SI SK

BG HR CZ HU

70000 60000 50000 40000 30000 20000 10000

Fig. 3.

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

0 1993

FDI Inward Stock in mn. USD

90000

FDI Inward Stock of CEEC-8 (1993–2004). Source: WIIW (2006).

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3.4. Evidence for Precondition Four A range of studies provide a growing body of evidence on the magnitude of tax rate elasticities of FDI in general, and in Europe in particular (see DeMooij & Ederveen, 2003, 2005). Yet, some studies included in these surveys are based on STRs and most importantly do not include CEECs as host countries of FDI. Bellak, Leibrecht, and Ro¨misch (2005) surveyed eight available studies on FDI to the CEECs which also used STRs as a measure of the tax burden. They found a median tax rate elasticity of –1.45 with some of the elasticities included being not statistically signiﬁcantly different from zero. Hence, following these studies it would be questionable whether precondition four is fulﬁlled. But as argued the above studies based on STRs use a ﬂawed measure of the corporate income tax burden when dealing with FDI decisions. Bellak and Leibrecht (2005, 2007b) overcome this problem by using BEATRs described above as well as other measures of corporate income tax burden in a panel-gravity model aiming to explain FDI in CEEC-8. Using this better measure of corporate income tax burden Bellak and Leibrecht indeed ﬁnd a tax rate elasticity of FDI w.r.t. the BEATR which is in line with the DeMooij and Ederveen studies (cf. Table 3). Moreover, they ﬁnd that the comparably low tax rate elasticity of –1.45 derived from studies using STRs is indeed partly explained by using an inferior measure of corporate income tax burden. Replacing BEATRs with STRs in their speciﬁcation yields a substantially lower and marginally insigniﬁcant semi-elasticity (see Bellak & Leibrecht, 2005 for details).16 In line with the literature (e.g. Devereux & Hubbard, 2003; Devereux & Grifﬁth, 1998) they also ﬁnd that the bilateral EMTR is not a statistically and economically signiﬁcant driver of FDI in CEEC-8 (Bellak & Leibrecht, 2007b). Table 3. Tax Rate Elasticities of FDI in CEECs. Measure of Corporate Income Tax Burden

Number of Semi-Elasticities

Median Value

38* 18** 5***

1.71 4.43 0.10

Statutory tax rate Bilateral effective average tax ratea Bilateral effective marginal tax ratea Notes: *Coefﬁcients included are not always signiﬁcant. **Each semi-elasticity included is statistically signiﬁcant. ***Semi-elasticities not statistically signiﬁcant. a Results speciﬁcally for bilateral FDI in CEEC-8.

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Thus, given the results based on the BEATRs, precondition four for tax competition for FDI can be considered as fulﬁlled. Moreover, as mentioned above, as the service sector is gaining importance the role of taxes as a determinant of FDI probably will increase in the future.

4. CONCLUSIONS All four preconditions for corporate income tax competition are fulﬁlled for the CEEC-8. Tax competition for FDI is indeed a driver of the falling tax rates in these countries. The results imply that fostered attempts to coordinate corporate income tax laws and systems in Europe should set in to restrain the scope for national tax policy, if negative economic impacts of tax competition are feared. Yet, if tax competition is seen as a positive device to speed up policy innovations and to tame the Leviathan, EU authorities should have an eye only on leveling the playing ﬁeld to avoid harmful tax competition. Indeed, the latter seems to be the stance of the European Commission (e.g. European Commission, 2001). Therefore, tax policy in the EU will be determined mainly by national tax policy in the foreseeable future. Tax competition for FDI and falling (effective) tax rates on corporate income will be present in the years ahead. Indeed, some ‘‘old’’ EU Member States, which are among the largest investors in the CEECs, already started to lower their corporate income tax burden in response to the tax rate cuts by the CEECs (e.g. Austria, the Netherlands and Germany). However, even in the corporate income tax competition case it is likely that there will be a convergence of corporate income tax systems due to the workings of tax competition itself, that is via tax harmoniztion by implicit agreement (Wildasin, 2002). A better way to proceed may be the introduction of tax coordination measures which combine the positive aspects of tax competition with that of tax coordination. A minimum STR on corporate income paired with suitable measures to avoid competition via other parts of the corporate tax system could be a viable policy option in this respect (see, e.g., Bellak & Leibrecht, 2007a for further details).

ACKNOWLEDGMENT This research has been carried out under research grant F-2008 of the Austrian Science Funds project on International Tax Coordination.

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NOTES 1. Direct studies in contrast to indirect studies have tax rates as endogenous variable. Indirect studies aim to explain FDI inter alia by tax rates. Thus, indirect studies are concerned with a precondition for corporate income tax competition only (Grifﬁth & Klemm, 2005 and below). 2. However, as the EATR crucially depends on the STR (see Devereux & Grifﬁth, 1999 for details), interactions in the setting of statutory tax rates may be seen as indirect evidence for interactions in the setting of EATRs. 3. Moreover, as the CEECs are young market economies, the time span for which data are available is rather low so that the possibilities to base our analysis on the ﬁrst and second generation models are limited. Indeed, most of the econometric direct studies mentioned are based on data at least from the early 1980s onwards. 4. The following discussion updates and extents parts of the analysis given in Bellak and Leibrecht (2007a). 5. Note that location decisions are also indirectly determined by EMTRs as these rates determine the optimal output level of an investment, which in turn determines the level of proﬁt. But the after-tax proﬁt an investment is directly determined by the EATR (see Devereux & Grifﬁth, 1998). 6. Moreover, the EATR is a weighted average of the EMTR and the (adjusted) STR on corporate income, with the weight depending on the cost of capital and the (assumed) pre-tax ﬁnancial rate of return of the investment. Thus, the EATR also indirectly captures the EMTR (see Devereux & Grifﬁth, 1999 for details). 7. Note that we consider neither the sphere of the shareholder nor net wealth taxes or real estate taxes because we are concerned with corporate income taxation and because net wealth and real estate taxes do not play a signiﬁcant role in the CEECs considered here (also see Finkenzeller & Spengel, 2004). Moreover, special tax incentives are not included. Due to this last reason the tax rates shown should be considered as an ‘‘upper bound’’ of the effective corporate income tax burden on FDI. 8. Download at http://europa.eu.int/comm/economy_ﬁnance/about/activities/ sgp/scplist_en.htm (accessed April 1, 2007). 9. http://www.mﬁn.hr/?upit=tax+reform&siteid=5&x=0&y=0 (accessed April 1, 2007). 10. SI actually reduced the statutory tax rate on corporate income to 23% in 2007. Moreover, the rate will be reduced to 20% by 2010. 11. Reasons to invest: http://www.arisinvest.ro/level1.asp?ID=198&LID=2 (accessed April 1, 2007). 12. Why invest in Bulgaria? http://www.investbg.government.bg/index.php?sid=15 (accessed 2007). 13. For BG and HR Koyama and Golub (2006) do not provide data. 14. Including the CEEC-8. 15. The average value of tariff revenues slightly above 1% in 2004 is mainly due to BG. 16. The estimate is included in the median value of –1.71 in Table 3, which therefore differs from the –1.45 given in Bellak et al. (2005).

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OECD. (2001). OECD investment policy review – Czech Republic. Paris. OECD. (2002). OECD investment policy review – Slovenia. Paris. Rodrik, D. (1997). Has globalization gone too far? Washington, DC: Institute for International Economics. Shatz, H. J., & Venables, A. J. (2003). The geography of international investment. In: G. L. Clark, M. Feldman & M. S. Gertler (Eds), The Oxford handbook of economic geography (pp. 125–145). New York: Oxford University Press. Slemrod, J. (2004). Are corporate tax rates, or countries, converging? Journal of Public Economics, 88, 1169–1186. Stigler, G. J. (1988). Competition. In: J. Eatwell, M. Milgate & P. Newman (Eds), The New Palgrave Dictionary of Economics (Vol. 1 (A–D), pp. 531–536). London and Basingstoke: The New Palgrave, Macmillan Press. Sto¨whase, S. (2005). Tax-rate differentials and sector-speciﬁc foreign direct investment: Empirical evidence from the EU. FinanzArchiv, 61, 535–558. UNCTAD. (2006a). Investment instruments online: Bilateral investment treaties database. Geneva. UNCTAD. (2006b). Country fact sheets database. Geneva. WIIW. (2006). WIIW database on foreign direct investment in Central, East and Southeast Europe. Vienna. Wildasin, D. E. (2002). Tax coordination: The importance of institutions. Swedish Economic Policy Review, 9, 171–194. Wildasin, D. E. (2005). Fiscal competition: Implications for political economy. IFIR Working Paper no. 2005-05. Lexington (Kentucky): Institute for Federalism and Intergovernmental Relations. Wilson, J. D., & Wildasin, D. E. (2004). Capital tax competition: Bane or boon? Journal of Public Economics, 88, 1065–1091. Winner, H. (2005). Has tax competition emerged in OECD countries? Evidence from panel data. International Tax and Public Finance, 12, 667–687.

PART III: EMERGENT AND DEVELOPING COUNTRIES COMPETITIVENESS AND THE LOCATION OF FIRMS

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LOCATION-SPECIFIC ADVANTAGES AND REGIONAL COMPETITIVENESS: A STUDY OF FINANCIAL SERVICES MNES IN HONG KONG Kirstie Tam, James Newton, Roger Strange and Michael J. Enright 1. INTRODUCTION Location-speciﬁc advantages (LSAs) are key components of the overall competitiveness of an economy. Yet LSAs, despite being a key component of Dunning’s celebrated eclectic paradigm, would appear to have been a neglected factor in international business (IB) research, particularly as far as the impact on foreign direct investment (FDI) and multinational enterprise (MNE) activity is concerned (Dunning, 1998, p. 45). Ricart, Enright, Ghemawat, Hart, and Khanna (2004, p. 190) suggest that understanding locations, or in their term ‘places’, is very complex and that ‘distinctions among nations remain peripheral to much of the strategy literature and strategy practice, which is perhaps one reason why ﬁrms seem to be blindsided by differences in markets and business practices, public policies, macroeconomics, and institutional frameworks’. Dunning (1998) too points Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 159–174 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00007-6

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out that physical and human infrastructure, the macroeconomic environment and institutional framework are nowadays even more decisive for MNEs whatever their motivation for seeking foreign locations. Thus, the links between LSAs, national economic competitiveness, and the location strategies of MNEs would appear to be a fruitful area for investigation. This chapter presents the results of an empirical study of LSAs in the ﬁnancial services sector in Hong Kong. Three issues are addressed. The ﬁrst considers the nature of the LSAs in the industry, or more succinctly what constitutes the relevant set of variables. The second examines the relative importance of each of these LSAs in the ﬁnancial services industry. The third assesses the competitive strengths and weaknesses of Hong Kong with regard to this comprehensive list of potential LSAs. Policy conclusions are then derived using a matrix constructed from survey data which explores Hong Kong’s competitiveness with regard to each of the LSAs. This analysis is then used to throw light on how various LSAs might inﬂuence the relocation or de-location of MNEs, which themselves impact upon the overall competitiveness of the Hong Kong economy.

2. REVIEW OF THE LITERATURE Notwithstanding the contemporary focus of IB scholars on the ﬁrm, whether that is rooted in internalization theory or in the resource-based theory of the ﬁrm, Dunning (1998) notes that earlier work by IB scholars such as Vernon (1966, 1974) and Wells (1972) gave pride of place to locational variables as determinants of FDI. He goes on to suggest that the shift to the contemporary emphasis on the ownership and internalization advantages of the MNE occurred in the mid-1970s when IB scholars (see, e.g., Buckley & Casson, 1976; Hennart, 1982; Rugman, 1981) redirected attention away from the act of FDI per se, towards the institution making the investment. Dunning suggests that this more recent lack of attention to location by IB scholars could have arisen from an assumption that the location decision principles are the same for both international as well as domestic locations. Thus, scholars were either satisﬁed with existing explanations or as Dunning (1998, p. 49) points out ‘maybe they were just not interested ’ (emphasis added). Buckley and Ghauri (2004, p. 94) place economic geography in a prime place in the analysis of the strategies and impacts of MNEs, arguing that ‘the input of lessons from economic geography is becoming more important in understanding the key developments in international business’. MNE

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strategies, they contend (Buckley & Ghauri, 2004, p. 82), ‘revolve around the ability of MNEs to subdivide their activities more precisely and to place them in the optimal location’ (emphasis added). Reinforcing the point, Buckley and Ghauri (2004, p. 91) point to the limited attention that locations have attracted in more recent research, noting that despite sporadic attention to the geographical sources of competitiveness of international ﬁrms, these have not, ‘as yet, become a mainstream preoccupation of international business theory’. This omission becomes, for Ricart et al. (2004, p. 189) even more critical, and they argue that IB ‘by deﬁnition, is about the interaction of ﬁrms and geographies’ and that locations are ‘in fact the distinctive content of international business strategy’ (Ricart et al., 2004, p. 196). They suggest that IB strategy is distinct from mainstream, or single country, business strategy only because of differences between locations. Hence, location speciﬁcity is essential to the possibility of international strategy having a distinctive content. They too suggest that a focus on locations, and possibly the question of why locations differ, could be a response to the issue of what forms the next ‘big question’ in IB research. The real problem, they argue, is the co-location of different places with different types of ﬁrms. Buckley and Ghauri (2004) too note the importance of the co-location of ﬁrms and places, since activities interact with their immediate hinterlands and this has profound consequences for changing economic power and development. The literature on regional clustering (the co-location of ﬁrms in the same and related industries) and the interaction of clusters with the strategies of MNEs provide some leverage on these questions. Enright (1998, 2003) argued that, whereas the ﬁrm strategy literature tended to focus on activities, resources, and knowledge that were found within ﬁrms, the regional clustering literature focused on activities, resources, and knowledge found within regions. In the context of the Hong Kong ﬁnancial service sector, Enright (2000a) posited an ‘interdependent’ model of cluster development, in which foreign MNEs and local circumstances provided the conditions for dynamic cluster development. Birkinshaw (2000) addressed the potential impact of MNEs on different stages of cluster development. In their work on the ‘metanational’ ﬁrm, Doz, Santos, and Williamson (2001) suggested that ﬁrms should choose to take advantage of pockets of capabilities and learning wherever they can be found. The importance of a renewed research emphasis on location, and on the role of location-bound assets, is further highlighted by the increase in strategic asset-seeking FDI over the past two decades. This has made the location decision more complex as ﬁrms look to complement their existing

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ownership advantages with other, critical, location-bound resources and assets. Dunning (1998, 2000) further points out that this is also increasingly true of traditional market and resource-seeking FDI as MNEs now seek locations which offer the best economic and institutional facilities for their core competencies to be efﬁciently utilized. For the locations themselves, this trend suggests a greater emphasis on the signiﬁcance of created assets and, in particular, those assets which may be enhanced by the policies and actions of host governments. Hence, governments need to understand how their actions may optimize their location-bound assets to achieve the most effective complementarities with the assets of mobile investors. This would involve an appreciation of the changing locational requirements of mobile investors and would throw up new challenges to governments at both the national and regional levels in their micro-organizational and competitiveness-enhancing policies. One issue, then, is to identify the appropriate location-bound assets that can complement ﬁrms’ core competencies and to determine which locations have, or have the potential to develop, those assets.

3. LOCATION-SPECIFIC ADVANTAGES In attempting to determine the relevant set of LSAs, Michael Porter’s (1990) work offers a valuable starting point. Porter postulates that success for a given industry in international competition depends on the relative strength of that industry with regard to a set of business-related features or ‘drivers’ of competitiveness, namely ‘factor conditions’; ‘demand conditions’; ‘related and supporting industries’; and ‘ﬁrm strategy, structure, and rivalry’. ‘Government’ and ‘chance’ are viewed as inﬂuencing competitiveness through their impact on the four basic drivers. This framework, or variations thereof, has been used in a number of studies of industries and of individual economies. But both the concept of competitiveness, and Porter’s framework, have been the subject of criticism. First, Paul Krugman (1994) speciﬁcally criticized the idea that nations, or locations, compete in the same way that ﬁrms compete, and his wide-ranging critique attacks this concept, the empirical evidence for national competition, and the policies that follow from what he terms ‘a dangerous obsession’ (Krugman, 1994, p. 28). Krugman’s critique, however, has itself been criticized as collapsing all approaches into a single notion and thus of being less relevant to certain speciﬁc conceptualizations and approaches (Rapkin & Strand, 1995). Furthermore Porter focuses on the competition between, and competitiveness of, speciﬁc industries in

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different locations, rather than on the competition between national economies. A second criticism is that Porter places government outside of the core determinants. Third, many authors have claimed that Porter’s framework pays insufﬁcient attention to relevant factors such as globalization (Dunning, 1993), multinational companies (Dunning, 1993; Rugman & Verbeke, 1993), technology (Narula, 1993), comparative advantages (Waverman, 1995), wage rates and exchange rates (Daly, 1993), lead ﬁrms and entrepreneurs (Cho, 1994), and resource endowments (Cartwright, 1993). Several authors have questioned the validity of the model, and the conclusions drawn from the model, for particular economies such as Australia (Yetton, Craig, Davis, & Hilmer, 1992), Austria (Bellak & Weiss, 1993), Canada (Rugman & d’Cruz, 1993), Hong Kong (Redding, 1994), Mexico (Hodgetts, 1993), New Zealand (Cartwright, 1993), and South Korea (Cho, 1994). Fourth, more general criticisms include claims that Porter’s work lacks meaningful linkages with underlying theory (Waverman, 1995), and that it is so elastic as to be able to explain virtually anything that one wishes to explain (Redding, 1994)! Rugman and d’Cruz (1993) suggested a ‘double diamond’ approach, and argued that the competitive advantages conferred by host countries on MNE afﬁliates were also of importance. And Enright, Scott, and Dodwell (1997) proposed an alternative advance on Porter’s framework based on the notion that the LSAs that contribute to ﬁrm competitiveness vary by industry. Expanding the number of factors, they postulated that such competitiveness was a function of six broad factors, namely ‘inputs’, ‘industrial and regional clustering’, ‘inter-ﬁrm competition and cooperation’, ‘industrial and consumer demand’, ‘institutions and agendas’, and ‘internal organization and strategy of ﬁrms’, testing the framework by means of a qualitative study of a number of different industries in Hong Kong. The approach was further elaborated in a study of the tourism industry in Hong Kong (Enright & Newton, 2004). A recurring feature of much of the prior empirical work has been a reliance on secondary, rather than primary, data. One exception is Dunning and Lundan (1998) who investigated the extent to which ﬁrms’ sourcing of speciﬁc advantages was dependent on foreign resources and capabilities. They used the Rugman and d’Cruz (1993) ‘double diamond’ extension of Porter (1990) as their analytical framework, and reported the results of a questionnaire survey of 147 of the world’s largest MNEs. But their study was concerned to establish the characteristics of the ﬁrms that were heavily reliant on foreign sourcing, rather than those attributes of potential

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locations that would be considered important. Two other studies deserve a mention as they both deal exclusively with the location choices of ﬁnancial service ﬁrms. Nachum (2000) investigated the determinants of inward FDI by ﬁnancial and professional services MNEs, by looking at the distribution across the various US states. Her econometric results showed that industry output in the host location, the total FDI stock, the quality of the labour force, and the level of urbanization all had signiﬁcant positive impacts. Frost and Zhou (2000) investigated the location of research and development activities of foreign ﬁrms in the US and found support for locationbound technological capabilities and evolutionary behaviour on the part of the ﬁrms. Finally Outreville (2007) reported signiﬁcant positive correlations in a cross-country study between the numbers of foreign ﬁnancial institutions and various explanatory variables such as population, GDP per capita, the size of the ﬁnancial sector, an index of human capital, government effectiveness, political risk, corruption perception, and country risk.

4. THE PRESENT STUDY The present study draws upon this previous work, but greatly expands the number of potential LSAs that are considered (see Table 1). A survey instrument was then constructed on the basis of these 34 LSAs, and distributed to managers working in ﬁnancial services MNEs in Hong Kong. The respondents were ﬁrst asked to identify Hong Kong’s relevant competitor cities in the ﬁnancial services industry, by ranking the cities in terms of their attractiveness as an FDI alternative to Hong Kong: from 1 (the most attractive) to 6 (the least attractive). The respondents were then asked to rate the importance of each of the 34 factors for the ﬁnancial services industry on a ﬁve-point Likert scale (with 1=very unimportant, 2=unimportant, 3=neutral, 4=important, 5=very important). Finally, the respondents were asked to rate the competitiveness of Hong Kong, relative to its main competitors in the region, on each of the factors, again on a ﬁvepoint Likert scale (with 1=much worse, 2=worse, 3=same, 4=better, 5=much better). The survey instrument was distributed by mail to the managers of the ﬁnancial service MNEs, identiﬁed by their membership of chambers of commerce and professional industry associations. A total of 152 useable responses were received. This methodology improves upon that adopted in the previous work in three important ways. First, Porter’s four-part framework has the

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Table 1. The Location-Speciﬁc Advantages. Broad Factors Inputs

Industrial and consumer demand

Inter-ﬁrm competition and cooperation Industrial and regional clustering Internal organization and strategy of ﬁrms Institutions, social structures, and agendas

Advantages Transportation facilities, communication network, staff skills, access to information, local managerial skills, banking and ﬁnancial system, geographic location, level of technology, staff costs, other infrastructure, costs of ofﬁce space, other costs China market potential, Asia-Paciﬁc market potential, local market size, local market sophistication Good ﬁrm cooperation, tough local competition Support from related industries, presence of other multinationals Strategies of other multinationals, strategies of local ﬁrms Political stability, free port status, government policy, cleanliness of governmenta, overall economic condition, transparency in policymaking, investment incentives, tax regime, education and training institutions, regulatory framework, strong currency, social and community institutions

a

A term that is a widely understood euphemism in the Asia-Paciﬁc region for ‘lack of corruption’.

considerable beneﬁt of simplicity, but it does not capture the full complexity of the determinants of a location’s competitiveness in a particular industry. Here, a much larger range of potential LSAs is considered. Second, Porter’s framework has a major drawback at the operational level in that it does not provide any mechanism for prioritizing the sources of competitiveness. While this shortcoming might not be critical for industries in which a given location is ahead in all possible sources of advantages, it is critical for industries in which a given location might have a mix of advantages and disadvantages. The absence of a prioritization mechanism makes the framework perhaps useful for ex-post rationalization or why a given industry from a given country succeeds or fails in international competition, but not useful for ex-ante prediction. Third, on a conceptual level, most studies of competitiveness, including Porter (1990), assess the competitiveness of an industry without an appropriate context. Competitiveness cannot be assessed in a vacuum. A given location is competitive or uncompetitive in

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an industry, not in the abstract but against relevant competing locations (Enright & Newton, 2004). Hong Kong was selected as the location for this survey of ﬁnancial sector MNEs, partly because it is a signiﬁcant host location for a wide range of MNEs, partly because of its overall economic importance in the Asia-Paciﬁc region, and partly because Hong Kong is a major ﬁnancial centre in the region (Enright, 2000a, b). In 2005, FDI into Hong Kong reached US$ 35.9bn, which was second in Asia and seventh in the world (Invest Hong Kong, 2006). The city is a strategic point for entry to the China market and the Asia-Paciﬁc market as well as a regional centre from which ﬁrms manage Asian operations. Some 3,800 overseas and Mainland companies operate regional headquarters or ofﬁces in Hong Kong (Invest Hong Kong, 2006). Hong Kong was ranked among the top six or seven international ﬁnancial centres, outside the major league of New York, London, and Tokyo but within a second tier comparable to Singapore and other European centres such as Frankfurt, Zurich, and Paris (Jao, 1997; Liu & Strange, 1997). Hong Kong was recognized as Asia’s third largest international banking centre in terms of the volume of external transactions in 2005, had the world’s fourth largest securities and Asia’s most important fund raising securities market, with a total raised capital of US$38bn in 2005, was the second most developed insurance market in the region after Japan in terms of per capita insurance premium, and the leading fund management centre in Asia, with the highest concentration of international fund managers. With 71 of the world’s 100 largest banks (by assets), Hong Kong has one of the highest concentrations of international banks in the world (HKTDC, 2006). At the end of September 2005, there were 131 licensed banks, 36 restricted license banks, and 35 deposit-taking companies in business. These 202 authorized institutions operate a comprehensive network of 1,311 local branches. Of these 202 authorized institutions, 177 are beneﬁcially owned by interests from 30 countries. In addition, there are 86 local representative ofﬁces of overseas banks in Hong Kong (Hong Kong Monetary Authority, 2006). The banking sector has attracted FDI totalling HK$ 481.2bn (US$ 61.9bn) at end 2004, accounting for 13.7% of total FDI stock in Hong Kong. The insurance sector attracted US$10.3bn and other ﬁnancial services US$19.1bn (Invest Hong Kong, 2006).

5. SURVEY RESULTS AND ANALYSIS The survey results indicated that Hong Kong’s major competitor in the Asia-Paciﬁc region is Singapore, followed by Shanghai, Taipei, and Tokyo.

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Table 2. Location-Speciﬁc Advantages in the Financial Services Industry. Location-Speciﬁc Advantage Communication network Banking and ﬁnancial system Access to information Regulatory framework Staff skills Political stability Transparency in policy-making Cleanliness of government Government policy Local managerial skills Staff costs Tax regime Level of technology Costs of ofﬁce space Overall economic condition Geographic location Transportation facilities Other infrastructure Asia-Paciﬁc market potential Local market size Local market sophistication Other costs Investment incentives Strong currency China market potential Education and training institutions Support from related industries Presence of other multinationals Good ﬁrm cooperation Strategies of other multinationals Social and community institutions Tough local competition Strategies of local ﬁrms Free port status

Importance

Relative Competitiveness of Hong Kong

4.57 4.51 4.40 4.40 4.38 4.32 4.19 4.11 4.11 4.06 4.03 4.03 4.00 3.98 3.98 3.94 3.92 3.88 3.84 3.80 3.76 3.74 3.68 3.61 3.60 3.55 3.45 3.43 3.37 3.36 3.30 3.27 3.13 3.10

3.99 4.08 3.83 3.64 3.29 3.39 3.76 3.61 3.43 3.29 1.99 3.73 3.49 1.80 3.02 4.05 3.99 3.67 3.34 3.36 3.57 2.12 3.05 3.44 4.13 3.14 3.26 3.43 3.23 3.24 3.28 3.00 3.20 3.74

Shanghai was Hong Kong’s most important competitor location for FDI in the China market. The survey results are summarized in Table 2: the 34 LSAs are listed in order of their mean ratings for their importance to the ﬁnancial services industry, whilst the ﬁnal column details the relative competitiveness of Hong Kong with respect to each LSA. The two

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measures can be combined in a manner that is useful for the assessment of location-speciﬁc competitiveness, and priorities for managerial action can be determined, by means of a matrix approach. Drawn from the marketing literature (see Martilla & James, 1977; Ennew, Reed, & Binks, 1993) in which it is generally referred to as importance performance analysis (IPA), the technique ﬁrst plots the importance measures of the LSAs for the industry (on the vertical axis) against their competitiveness in the location, or performance, measures (on the horizontal axis). There are two ways in which the matrix can be constructed. The simplest way is to plot the axes at scores of 2.5: i.e. the mid-points of the ﬁve-point Likert scales. However, as Oh (2001) has argued, a more valid and useful construction is to set the axes at the mean scores for importance (3.85) and competitiveness (3.37). The resulting matrix offers a readily accessible tool for managers in both private and public sectors. Fig. 1 shows the resulting matrix for the ﬁnancial services sector in Hong Kong. Cell I captures the factors that are the best ﬁt between the most critical needs of ﬁrms and the strongest advantages of the location, showing those factors that were identiﬁed both as being high in importance for ﬁnancial service industries and in which Hong Kong possessed marked competitive advantages. Four factors stand out: the communication network, the access to information, the regulatory framework, and the banking and ﬁnancial system, the latter suggesting agglomeration effects. The importance of institutions is emphasized by the presence of transparency (in policy-making), cleanliness (or lack of corruption) of government, and government policy in this cell. The importance of ICT is reinforced by the presence of the factor of level of technology. Cell IV displays those factors that the respondents in the industry perceive as important but in which the location is not competitive. Hong Kong’s most critical competitive disadvantage, therefore, lies in costs, of both ofﬁce space and personnel. Four factors lie around the axis representing the average rating of Hong Kong’s competitiveness. Staff skills are rated as being very important for ﬁnancial service ﬁrms, though Hong Kong is marginally below average in their provision. Similarly, local managerial skills were below average when considered against regional competing locations, but were rated lower than staff skills. The difference in importance between the higher rated staff skills and the lower rated local managerial skills may suggest that MNEs in ﬁnancial services place greater reliance on expatriate management than local, which could have implications for local management training inititives – and MBA programmes!

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5 IV

I

Industry specific importance

3 9

5

23 11 22 26

4

6

10

7

20 19 12

17 8

25

16 13

4

1 2

14

21 24

28

15

31 32

29 30 34 27 III

33

II

18

3 1

2

3

4

5

Location specific competitiveness

Fig. 1. The Importance/Competitiveness Matrix for the Financial Services Industry. Note: 1, Geographic location; 2, Transportation facilities; 3, Communication network; 4, Other infrastructure; 5, Banking and ﬁnancial system; 6, Costs of ofﬁce space; 7, Staff costs; 8, Other costs; 9, Staff skills; 10, Local managerial skills; 11, Access to information; 12, Level of technology; 13, Local market size; 14, Local market sophistication; 15, China market potential; 16, Asia-Paciﬁc market potential; 17, Overall economic condition; 18, Free port status; 19, Cleanliness of government; 20, Government policy; 21, Investment incentives; 22, Political stablility; 23, Regulatory framework; 24, Strong currency; 25, Tax regime; 26, Transparency in policy-making; 27, Social and community institutions; 28, Education and training institutions; 29, Good ﬁrm cooperation; 30, Tough local competition; 31, Support from related industries; 32, Presence of other multinationals; 33, Strategies of local ﬁrms; 34, Strategies of other multinationals.

However Cell IV, it should be stressed, shows factors that are above average in industry-speciﬁc importance and which are therefore of primary concern to practitioners in private and public sectors. The two remaining cells, however, capture factors that are rated below average importance, segmenting them into those in which the location is competitive relative to other regional locations (Cell II) and those in which the location is less competitive than its rivals (Cell III).

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Cell III therefore shows those factors in which Hong Kong is relatively uncompetitive, but where the low industry-speciﬁc importance lowers the priority that should be accorded to these factors by either public or private decision-makers. Interestingly, the factor of investment incentives is captured in this cell suggesting that such incentives may not be as salient as policy-makers may perceive, at least in ﬁnancial services. Thus, despite Hong Kong’s relatively low location-speciﬁc competitiveness in this factor, it is not signiﬁcant for this industry which would appear to lend support for Hong Kong’s neutral investment policies. Among the other factors captured here are a number of those related to other ﬁrms, including good ﬁrm cooperation, tough local competition, support from related industries, strategies of local ﬁrms, and strategies of other multinationals. The low importance ascribed to the factor of support from related industry is interesting in relation to Porter’s model that posits supporting and related industries as one of the four key variables in determining competitiveness. Whilst Hong Kong may be less competitive than its regional rivals in this factor and the other market-related factors, it is, again, a low priority for the ﬁnancial services industry. Cell II captures those factors that, again, are of low industry-speciﬁc importance, but here are factors of high location-speciﬁc competitiveness. Two factors are clearly located within this cell, China market potential and free port status. The strong location-speciﬁc rating given to China market potential conﬁrms the perception of Hong Kong’s role as a gateway for business to China. However, the low industry-speciﬁc importance suggests that China’s regulations regarding foreign ﬁnancial service investments, for the moment, lowers the value of the factor for this industry. Hong Kong’s competitive position in the factor of strong currency reinforces the view that the long-standing ‘hard’ peg to the US dollar, which also withstood the turbulence of the 1997 Asian ﬁnancial crisis, is a location-speciﬁc competitive advantage. However, its low industry-speciﬁc importance may cause some reﬂection amongst policy-makers in Hong Kong. That the factor is of low importance for MNEs in such a key industry as ﬁnancial services, may help inform the debate on Hong Kong’s (and by extension China’s) ﬁxed exchange rate regime. These ﬁndings for Cells II and III illustrate the value for the location of including those factors rated below average in industry-speciﬁc importance. Cell II can identify factors where there may be a risk of wasting resources, if the competitiveness of the location is due to resources being committed to those factors. Similarly, Cell III can identify factors which, despite their lack of competitiveness, have no need of improvement, at least for this industry.

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6. CONCLUSIONS This study makes a contribution to the literature on LSAs by advancing a methodology that develops a more detailed, ﬁne-grained approach that goes beyond the broad categorizations of both the OLI (ownership, location, and internalization) paradigm and Porter’s determinants of national competitiveness. This methodology ﬁlls a gap in the OLI literature and overcomes a number of shortcomings in the competitiveness literature, by quantifying both the relative competitiveness of the LSAs in a particular location (Hong Kong) and the industry-speciﬁc importance of these LSAs. This approach allows researchers to better understand which aspects of locations best meet the needs of different industries. This further overcomes the limitations of approaches to competitiveness that focus on general, aggregate assessments of locational competitiveness without regard for differential needs of different industries. The methodology is also of value to industry participants and to policymakers. By co-locating LSA and industry-speciﬁc importance measures in the matrix approach, ﬁrms are offered a technique to help in FDI location decisions. The approach also offers policy-makers the tools to help decide not only what changes may be desirable, but also what changes may be unnecessary. Furthermore, the approach also offers an analysis to aid resource allocation decisions, should resources be committed to factors that are of low industry-speciﬁc importance. In the speciﬁc case selected for this study (i.e. the ﬁnancial services sector in Hong Kong), the methodology helps to develop an improved understanding of the reasons why Hong Kong attracts FDI in this industry and the matrix approach demonstrates the number and range of LSAs, important to the industry, and in which Hong Kong is competitive. The results are of value not only to actors in Hong Kong, but also to those in other locations, where policy-makers may wish to attract FDI in this sector and to ﬁrms seeking locations which will add to their competitiveness. However, the survey results are for Hong Kong alone, and this necessarily limits the applicability of the ﬁndings. Future work in other locations will improve and reﬁne the overall approach. In summary, this study has advanced knowledge of the nature and range of LSAs and their role in developing the competitiveness of locations, and of ﬁrms which combine their competitive advantages with those of the locations. It has reﬁned a robust method for the measurement of LSAs and their assessment along industry-speciﬁc lines that can be readily replicated in other jurisdictions. Finally, it has provided a quantitative, theoretically informed empirical analysis that offers a basis for strategy development and policy formulation.

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REFERENCES Bellak, C. J., & Weiss, A. (1993). A note on the ‘Austrian’ diamond. Management International Review, 33(2), 109–118. Birkinshaw, J. (2000). Upgrading of regional clusters and foreign investment. International Studies of Management and Organization, 30(2), 93–113. Buckley, P. J., & Casson, M. (1976). The future of the multinational enterprise. London: Macmillan. Buckley, P. J., & Ghauri, P. N. (2004). Globalisation, economic geography and the strategy of multinational enterprises. Journal of International Business Studies, 35(2), 81–98. Cartwright, W. R. (1993). Multiple linked diamonds and the international competitiveness of export-dependent industries: The New Zealand experience. Management International Review, 33(2), 55–70. Cho, D.-S. (1994). A dynamic approach to international competitiveness: The case of Korea. In: R. Fitzgerald (Ed.), The competitive advantages of far eastern business (pp. 17–36). Newbury Park: Frank Cass. Daly, D. J. (1993). Porter’s diamond and exchange rates. Management International Review, 33(2), 119–134. Doz, Y., Santos, J., & Williamson, P. (2001). From global to metanational: How companies win in the knowledge economy. Boston, MA: Harvard Business School Press. Dunning, J. H. (1993). Internationalizing Porter’s diamond. Management International Review, 33(2), 7–15. Dunning, J. H. (1998). Location and the multinational enterprise: A neglected factor? Journal of International Business Studies, 29(1), 45–67. Dunning, J. H. (2000). Regions, globalization, and the knowledge economy: The issues stated. In: J. H. Dunning (Ed.), Globalization, regions, and the knowledge-based economy (pp. 7–41). Oxford: Oxford University Press. Dunning, J. H., & Lundan, S. M. (1998). The geographical sources of competitiveness of multinational enterprises: An econometric analysis. International Business Review, 7(2), 115–133. Ennew, C. T., Reed, G. V., & Binks, M. R. (1993). Importance-performance analysis and the measurement of service quality. European Journal of Marketing, 27(3), 59–70. Enright, M. J. (1998). Regional clusters and ﬁrm strategy. In: A. Chandler, O¨. Sølvell & P. Hagstro¨m (Eds), The dynamic firm: The role of technology, strategy, organizations, and regions (pp. 315–342). Oxford: Oxford University Press. Enright, M. J. (2000a). Globalization, regionalization, and the knowledge-based economy in Hong Kong. In: J. H. Dunning (Ed.), Globalization, regions, and the knowledge-based economy (pp. 381–406). Oxford: Oxford University Press. Enright, M. J. (2000b). Regional clusters and multinational enterprise: Independence, dependence, or interdependence? International Studies of Management and Organization, 30(2), 114–138. Enright, M. J. (2003). Regional clusters: What we know and what we should know. In: J. Bro¨cker, D. Dohse & R. Soltwedel (Eds), Innovation clusters and interregional competition (pp. 99–129). Berlin: Springer Verlag. Enright, M. J., & Newton, J. (2004). Tourism destination competitiveness: A quantitative approach. Tourism Management, 25(6), 777–788.

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Enright, M. J., Scott, E. E., & Dodwell, D. (1997). The Hong Kong advantage. Hong Kong: Oxford University Press. Frost, T., & Zhou, C. (2000). The geography of foreign R&D within a host country. International Studies of Management and Organization, 30(2), 10–43. Hennart, J. F. (1982). A theory of multinational enterprise. Ann Arbor, MI: University of Michigan Press. Hodgetts, R. M. (1993). Porter’s diamond framework in a Mexican context. Management International Review, 33(2), 41–54. Hong Kong Monetary Authority. (2006). Banking policy and supervision: The three tier banking system. Hong Kong: Hong Kong Monetary Authority. Hong Kong Trade Development Council (HKTDC). (2006). Profiles of Hong Kong’s major service industries: Banking and finance. Hong Kong: Hong Kong Trade Development Council. Invest Hong Kong. (2006). Key statistics on investment. Jao, Y. C. (1997). Hong Kong as an international financial centre: Evolution, prospects and policies. Hong Kong: City University of Hong Kong Press. Krugman, P. (1994). Competitiveness: A dangerous obsession. Foreign Affairs, 73(2), 28–44. Liu, Y.-C., & Strange, R. (1997). An empirical ranking of international ﬁnancial centers in the Asia-Paciﬁc region. The International Executive, 39(5), 651–674. Martilla, J. A., & James, J. C. (1977). Importance-performance analysis. Journal of Marketing, 41(1), 77–79. Nachum, L. (2000). Economic geography and the location of TNCs: Financial and professional service FDI to the USA. Journal of International Business Studies, 31(3), 367–385. Narula, R. (1993). Technology, international business and Porter’s ‘diamond’: Synthesizing a dynamic competitive development model. Management International Review, 33(2), 85–107. Oh, H. (2001). Revisiting importance-performance analysis. Tourism Management, 22(6), 617–627. Outreville, J. F. (2007). Foreign afﬁliates of the world largest ﬁnancial groups: Locations and governance. Research in International Business and Finance, 21(1), 19–31. Porter, M. E. (1990). The competitive advantage of nations. New York: The Free Press. Rapkin, D. P., & Strand, J. R. (1995). Competitiveness: Useful concept, political slogan, or dangerous obsession? In: D. P. Rapkin & W. P. Avery (Eds), National competitiveness in a global economy (pp. 1–21). Boulder, CO: Lynne Rienner. Redding, S. G. (1994). Competitive advantage in the context of Hong Kong. In: R. Fitzgerald (Ed.), The competitive advantages of far eastern business (pp. 71–89). Newbury Park: Frank Cass. Ricart, J. E., Enright, M. J., Ghemawat, P., Hart, S. L., & Khanna, T. (2004). New frontiers in international strategy. Journal of International Business Studies, 35(3), 175–200. Rugman, A. M. (1981). Inside the multinationals: The economics of internal markets. London: Croom Helm. Rugman, A. M., & d’Cruz, J. R. (1993). The ‘double diamond’ model of international competitiveness: The Canadian experience. Management International Review, 33(2), 17–40. Rugman, A. M., & Verbeke, A. (1993). Foreign subsidiaries and multinational strategic management: An extension and correction of Porter’s single diamond framework. Management International Review, 33(2), 71–84.

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Vernon, R. (1966). International investment and international trade in the product life cycle. Quarterly Journal of Economics, 80, 190–207. Vernon, R. (1974). The location of economic activity. In: J. H. Dunning (Ed.), Economic analysis and the multinational enterprise. London: Allen and Unwin. Waverman, L. (1995). A critical analysis of Porter’s framework on the competitive advantage of nations. In: A. M. Rugman, J. van den Broeck & A. Verbeke (Eds), Beyond the diamond: Research in global strategic management (pp. 67–96). Greenwich: JAI Press. Wells, L. T. (1972). The product life cycle and international trade. Cambridge, MA: Harvard University Press. Yetton, P., Craig, J., Davis, J., & Hilmer, F. (1992). Are diamonds a country’s best friend? A critique of Porter’s theory of national competition as applied to Canada, New Zealand and Australia. Australian Journal of Management, 17(1), 89–119.

INSTITUTIONAL REFORM, FDI AND THE LOCATIONAL COMPETITIVENESS OF EUROPEAN TRANSITION ECONOMIES$ John H. Dunning 1. INTRODUCTION This chapter addresses the role of institutions and institutional reform as a country-speciﬁc competitive enhancing advantage affecting the location of inbound foreign direct investment (FDI). Our focus of interest will be on the European transition economies. Our thesis (backed up by a limited amount of econometric and ﬁeld research) is that the extent and quality of a nation’s institutions and its institutional infrastructure (II) is becoming a more important component of both (a) its overall productivity and (b) its capacity to attract inbound FDI. This, in turn, reﬂects the belief by private corporations (both foreign and home based) that the role played by location bound institutions and organizations in 21st century society is becoming an

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This is an adapted and updated version which was ﬁrst published in Grosse, R. (Ed.). (2005). International business and governments in the 21st century. Cambridge: Cambridge University Press.

Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 175–201 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00008-8

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increasingly critical determinant of the successful deployment of their own ownership-speciﬁc, but often mobile, assets. This chapter proceeds in the following way. First, we shall offer a simple analytical framework which might help us to explore the thesis set out above. Second, we shall identify the more signiﬁcant ﬁrm-speciﬁc strategies and the policies of host transition governments, which have both fashioned and been in response to changes in the world economic and political scenario over the past decade or so; and how these have affected the locational pull and push of multinational enterprise (MNE) activity. In particular, we shall examine the evidence of the links between the upgrading of the II of 16 Central and Eastern European countries and their propensity to attract inbound FDI (vis a vis other areas in the world). Can we, in fact, identify the kinds of institutional upgrading which are likely to exert a greater pull for new FDI? Third, we shall examine the recent and likely future locational competitiveness of the 16 Central and Eastern European transition economies as viewed by actual or potential foreign investors. In particular, we will explore the proposition that any attempt to assess the willingness and capability of particular countries to upgrade their II must take account of their unique economic, cultural and social characteristics, and their competitive positions vis a vis that of other nations, as it affects the kind of inbound MNE activity it is designed to attract.

2. THE FRAMEWORK FOR ANALYSES 2.1. Why is II an Important Locational Asset? We start by deﬁning the more important terms we use. We shall take Douglass North’s (1990, 1999, 2005) concept of institutions as the formal conventions (typically called rules), and the informal conventions (typically called standards) of society;1 and that of individuals and organizations as the entities which devise and implement these institutions. These entities comprise each of the stakeholders (ﬁrms, civil society, consumer groups, labour unions and governments) that make up a society. In North’s view, the purpose of rules and conventions (institutions) is to deﬁne the rules by which the objectives of society (in this case upgrading competitiveness and attracting FDI) are formulated, monitored and enforced. But the objectives of the players (the organizations) are to use the institutions in a way which will best advance their own interests.

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By the II we mean the over-arching environment in which the institutions and organizations operate. Taking a recent deﬁnition by Mudambi and Navarra (2002, p. 638), the II of a country embraces its ‘political institutions such as regime type, the national structure of decision taking and the judicial system, economic institutions, such as the structure of the national factor market and the terms of access to international factors of production and socio-cultural factors such as informal norms, customs, mores and religions’. The key feature of institutions and the II of which they are part is that they are location bound extra market instruments designed to empower, facilitate and regulate economic activity (including inbound FDI), by reducing the transaction costs of such activity. Such transaction costs are well known to international business (IB) scholars. They represent the ‘hassle’ costs of doing business, and the uncertainties arising from possible opportunism, moral hazards and incompleteness in commercial dealings. They include search, negotiation and enforcement costs. The purpose of an effective and market facilitating II is to reduce or counteract these costs, which inter alia include inadequate property rights, the absence of a properly regulated banking system, widespread corruption, imperfect or undeveloped ﬁnancial markets and weak incentive structures; and by so doing, both enhance the trust, reciprocity and commitment among social and economic agents, and upgrade the competitiveness of ﬁrms.2 There has been a good deal of research on how an underdeveloped or inefﬁcient II might inhibit FDI into host economies, just as much as inadequate market opportunities, high production costs, or inappropriate macro-economic or micro-management policies of governments.3 Building an efﬁcient and socially acceptable II has been, and continues to be, particularly challenging in the case of transition economies; and the speed and extent to which this can be efﬁciently achieved with minimum social disruption is proving to be a critical factor in inﬂuencing the willingness and capability of a country to adjust to the demands of global capitalism, and to attract inbound MNE activity.

2.2. The Analytical Framework We start by making reference to three ﬁgures. The ﬁrst (Fig. 1) identiﬁes three groups of generic variables which empirical research has shown to inﬂuence inbound FDI into all economies. It also indicates that the principal economic determinants (and, to some extent, the other two) are inﬂuenced by the motives for inbound MNE activity or growth of such activity, and

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Host Country Perspective 1. Policy framework for FDI Economic, political and social stability Rules regarding entry and operations Standards of treatment of foreign affiliates

· · · · · · · · · ·

Type of FDI by motives of MNEs

A. MarketSeeking

Policies on functioning and structure of markets (especially competition and M&A policies) International agreements on FDI Privatization policy Trade policy (tariffs and NTBs) and coherence of FDI and trade policies

B. Resourceseeking

Fiscal incentive (including tax credits) Industrial/Regional Policies Social, environmental, security policies

C. Efficiencyseeking

Investing Firm Perspective

·· · · · · · · · · · · ·

II. Economic determinants

Market size and per capital income Market growth Access to regional and global market Country specific consumer preferences Structure of markets Opportunities for branding Competences of local suppliers

Land and building costs rents and rates Cost of raw materials, components, parts Low-cost unskilled labour

Availability & cost of skilled labor Cost of resources and assets listed under B adjusted for productivity of labour inputs Other input costs, e.g. transport and communication costs to and from and within host economy Membership of a regional integration agreement conducive to promoting a more cost-effective inter-country division of labour

III Business institutional facilitation

· · · · · · ·

· · ·

Physical infrastructure (ports, roads, power, telecommunications)

Pre- and post-investment services (e.g. one stop shopping)

·

Clustering, networking, opportunities for learning.

Good infrastructure and support services, e.g. banking, legal accountancy services Social capital; economic morality Region-based cluster and network promotion

Source: Adapted from UN (1998) and Dunning (2004)

Investment incentives and promotion schemes High quality institutions (eg. innovation systems, property right protection) Social amenities (bilingual schools, quality of life, etc.)

Fig. 1.

D. Asset-seeking

Technological, managerial relational and other created assets

Macro-innovatory, entrepreneurial & educational capacity/environment

The Determinants of FDI Viewed from a Host Country and Investing Firm Perspective.

Institutional Reform, FDI and the Locational Competitiveness of European TEs 179

also its mode of entry (e.g. by greenﬁeld venture or by merger or acquisition (M&A)). As classiﬁed, the institutionally related determinants are spread across each of the three groups. Indeed, in a real sense, they are the ‘umbrella’ which affects the efﬁciency of each of the other determinants. Those which are directly under the control of governments also come within the ambit of the policy framework, which itself, reﬂects one of the modalities which both helps create, implement and monitor the II. However, the extent and pattern of business facilitating variables, notably minimal bureaucracy and corruption, and good infrastructural support services, are even more critically dependent on the quality of a society’s belief systems; while most of the market oriented economic determinants themselves, depend on the underlying incentive structures and enforcement procedures. In this ﬁgure, we have highlighted those determinants which – in the judgement of both host economies and MNEs – research has suggested have become relatively more important in the last decade. Most of these reﬂect the consequences of recent technological advances (especially the burgeoning of E-commerce), globalization and the advent of alliance capitalism (Dunning, 1998); and of how these, in turn, have widened the options open to MNEs in their choice of locations, not only between, but within, countries. Although the ﬁgure does not relate the suggested determinants of FDI to particular stages of the value chain, e.g. pre-production and post-production activities of the investing companies, it may be used in this way. Nor does it distinguish between particular kinds of host or home economies. We make this point because it is important to acknowledge that the signiﬁcance of the determinants of FDI including the composition and inﬂuence of a country’s II is likely to be highly context speciﬁc. The second ﬁgure (Fig. 2) is adapted from an interesting article, published ﬁve years ago, in the International Business Review (Seth, Guisinger, Ford, & Phelan, 2002). Fig. 2 may be broken down into two parts. The top part of the ﬁgure identiﬁes the push and pull factors inﬂuencing the siting of MNErelated activity.4 Although there is nothing particularly novel in its contents, they do serve to emphasize that the capability and willingness of countries – including transition economies – to attract inbound FDI, rests not only on an adequate understanding of the resources, capabilities, institutions and markets which comprise their unique location competitive advantages, but also an appreciation of the particular siting needs of (different kinds of) MNEs, and the forces affecting their global or regional production and marketing strategies. Countries which are successful in matching their own location bound assets to the ownership (but often mobile) advantages of

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“PUSH” FACTORS

“PULL” FACTORS

·

Competitive Intensity from Local Firms and MNEs.

· ·

Policy Liberalization

Finite Absorptive Capacity for FDI

· · ·

Institutional Environment

·

Sound Infrastructure

· · ·

Reducing Profit Margins Oligopolistic Rivalry

Stable Political and Economic Environment

LIKELY REPLICATION OF SIMILAR CYCLE TO FDI DESTINATION IN REGION C

Low Real Wages Lucrative Domestic and/or Regional Markets

Changing Trend of FDI Capital

FDI DESTINATION IN REGION A

LEVELS OF INSTITUTIONAL MEASURES TO ATTRACT FDI 1. Healthy General Trade and FDI Environment (Macro level) 2. Incentives for Specific Industries/Sectors in the Economy (Sectoral Level) 3. Incentives for Specific Projects (Individual project level).

FDI DESTINATION IN REGION B

FDI DESTINATION IN REGION C

“BASKET OF PREREQUISITES”

and Economic Stability · Political of Law and an Independent Judiciary ·· Rule Sound Technological Base and Infrastructure Skilled Labor ·· Technically Low Wages and Affluent Domestic and/or · Large Regional Markets Cultural or Institutional Distance · Low Investment Friendly Policies Restrictions on Indigenous Content · Minimal and Profit Repatriation · Investment/Taxation Incentives.

EVALUATION OF THE INSTITUTIONAL ENVIRONMENT OF ALTERNATIVE LOCATIONS FOR ATTRACTING INWARD FDI

Fig. 2.

Push and Pull Factors and Institutional Measures Attracting FDI. Source: Adapted from Figure 2 (p. 695) of Sethi et al. (2002).

Institutional Reform, FDI and the Locational Competitiveness of European TEs 181

ﬁrms (both foreign and domestic), are likely to achieve the best results in upgrading or restructuring their indigenous resources, capabilities and social capital to meet their developmental objectives. The second and lower part of Fig. 2 sets out the institutionally related variables under the control of host governments which research has suggested are necessary (but not a sufﬁcient) condition for attracting inward FDI. The speciﬁc measures identiﬁed are not very different from those set out in Fig. 1, and many are policy oriented.5 However, the ﬁgure, additionally, classiﬁes these measures by the context of the level of action – whether, for example, it is macro, sectorally, ﬁrm or project based – each of which, to be effective, requires different institutional and organizational experiences and expertise. The third scheme is an adaptation of one earlier prepared by a British consultancy group which aims to assess the special features of FDI and its likely impact on the competitiveness of the UK economy. We have adapted this ﬂow chart in Fig. 3 to take into account some of the speciﬁc characteristics of transition economies. We present it here, as it suggests a useful template by which host governments – including those of transition economies – can judge not only the worthwhileness of inbound FDI, but also the appropriateness of their economic policies and the adequacy and quality of the business environment under their jurisdiction. Again, we have highlighted the components of the ﬁgure which seem to us to be most clearly dependent on, or reﬂective of, the indigenous II and related support mechanisms. So much for our analytical framework. The next part of the chapter looks at the interaction between the push and pull factors by considering some of the more important changes in (a) the strategies of foreign investors or potential foreign investors, and (b) the competitive position and policies of economies it does, and so in the light of changes in the global economic and political scenario over the last decade or so.

3. INTERACTION BETWEEN THE PUSH AND THE PULL FACTORS 3.1. The Strategies of (Foreign) MNEs All national, or regional governments, in seeking to devise appropriate institutions, organizations and policies to upgrade their domestic competitiveness need to be cognizant of the evolving strategies of existing and potential foreign investors, as they seek to advance their own objectives.

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Vision & objectives Production processes Incentive structures Labour use/training Technology & innovation Entrepreneurship

Contractual arrangements Visits Informal liaison Other

Supplier Impact Quality Enhancement

Foreign Direct Investment: Special Features Product & Markets Customer/supplier arrangements Financial management/Organization structure Competitive stimulus

Transmission Competitive spur Visibility Product availability Other

Enhanced product quality Lower prices Visits Other

Competitor Impact Upgrading of behavioural norms

Displacement

Efficiency gains Technology upgrade Reliability

Mechanism Training provision Labour supply Technological base Other

Customer Impact

Business Environment

Technology upgrade

Human resources and skills base

Reduced prices Efficiency gains Logistic improvement Skills upgrade

Technology infrastructure Transport infrastructure More competition

After-sales service

Enforcement mechanisms Incentives

Adverse effects

Competitive Advantage of Domestic Firms Price Marketing skills Speed of service Reputation Costs Product design Specialised expertise Quality Responsiveness to clients. Flair and creativity Improved Performance of Domestic Firms Sales Employment Investment Institutional upgrading Exports Productivity Relational capital Entrepreneurship

Fig. 3.

Assessing the Features and Impact of FDI: A Flow Chart.

Institutional Reform, FDI and the Locational Competitiveness of European TEs 183

For it is in their desire to advance these strategies that the locational attractions of possible host countries are evaluated. Here, we would highlight some strategic changes of the last decade or so, each of which is tending to affect the push of more FDI towards transition economies. Some of these are reactive to exogenous changes in the global technological, economic and political scenario; others are reﬂective of industry- or ﬁrm-speciﬁc changes. Some speciﬁcally affect the institutional capacity of particular organizations; and others the broader political economic framework within which MNEs operate. A useful examination of the speciﬁc institutional imperatives of globalization is set out in Rondinelli (2005) and Rondinelli and Behrman (2000). In particular, the authors identify the role of ethical norms, property rights, private enterprise, development, support of competition, equality of opportunity and safety nets, and democratic governance. The moral challenges of global capitalism is also the theme of Dunning (2003) and of Donaldson (2007). We present these brieﬂy and without detailed comment:6 (i)

Due both to the opening up of the global market place – including regional integration – and technological advances – particularly in cross border communications – there is a movement by most MNEs to integrate and rationalize their foreign value added activities on regional or global lines. Inter alia this means an increased inter-country specialization of products, processes and functions, which, in turn, is leading to more cross border transactions goods, services and assets (Palmisano, 2006). In particular, as far as the European transition economies are concerned, this suggests they must view their own location bound competitive and comparative advantages, not only from the viewpoint of how far these might advance the global or European strategies of MNEs – especially their innovation and sourcing options, and the extent to which they are prepared to devolve decision taking to their afﬁliates – but of how competitive their II is in relation to that of other similar economies seeking to attract the same kind of FDI. (ii) In the last decade or so, due again to the added competitive pressures resulting from globalization and technological advances, MNEs have increasingly engaged in outward FDI to protect or augment their global competitive advantages.7 Up to the present time, most of this asset seeking FDI (see Fig. 1) has occurred between the advanced industrialized nations, and has taken the form of M&As.8 However, there are signs that, at least as far as some Asian and the more advanced European transition economies are concerned, the importance of this

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kind of MNE activity is increasing. Undoubtedly, some FDI in privatization schemes is of an asset augmenting nature; and such investment may well become more important in the future. The point which needs stressing however, is that both the consequences of, and the policy and institutional-related variables which may affect such FDI are likely to be very different from that of asset exploiting investment (Wesson, 2003; UNCTAD, 2006; Dunning & Lundan 2007). (iii) Hand in hand with a more centralized control strategy demanded of MNEs engaging in integrated international production has come a decentralization or subsidiarity of some kinds of decision taking, and the rise in the entrepreneurial capabilities of MNEs’ subsidiaries as creators as well as exploiters of assets. Julian Birkinshaw and Neil Hood (1998), Alan Rugman and Alain Verbeke (2001) and Bob Pearce (1999) are among those economists who have written extensively on this issue. But for our purposes, it poses the question ‘What institutions, organizations and policies of transition economies are most likely to encourage MNEs to sustain, build up and upgrade the value added of their subsidiaries’ capabilities – including the higher grade administrative and innovatory functions – in a way consistent with the resources capabilities and goals of those economies? Lessons from Singapore and Hong Kong about the II necessary to attract and sustain regional ofﬁces and the Bangalore region in India in its bid to become a world centre for innovation and production computer software development are particularly apposite here.9 This issue of subsidiary development is also related to the geographical clustering of interdependent activities which, itself, may be thought of as a form of II infrastructure. (iv) Finally, such ‘shocks’ as 9/11 and the London bombings of 2005, and violent conﬂict in the Middle East are having, and are likely to continue to have, an affect on the global rise, assessments and value adding strategies of MNEs (Suder, 2007, Oetzel, Getz, & Ladek 2007). For example, the impact of terrorist activities directed to countries which are perceived to be either ones which are most likely to be targeted, and/or are least sympathetic to the policies of the home governments is likely to be a very negative one. The concept of psychic distance has always been well embedded in IB studies. A new dimension of this concept – namely institutional distance – is likely to affect the investment portfolios of MNEs as to where they might wish to site their higher value and more sensitive activities, e.g. research and development and some forms of subcontracting (Dunning, 2006). Over the last decade or so, however, it would seem that the institutional distance between the European

Institutional Reform, FDI and the Locational Competitiveness of European TEs 185

transition economies and the major source investing countries is not increasing on this account.

3.2. The Opportunities and Challenges Offered by Transition Economies Technological advances and sweeping changes in the global economic scenario have no less inﬂuenced the country-speciﬁc opportunities and challenges affecting the pull of FDI; and none so much as those within the transition economies of Central and Eastern Europe. At the same time, there are responses to these events which to a greater or lesser degree are affecting all countries. Chief among these are the increased competitive pressures among ﬁrms brought about by the new openness in the regional and/or global trading and investment regimes. This has underlined the need of previously protected economies both to upgrade the efﬁciency of, and to restructure, their production and marketing capabilities in line with their (perceived) long-term comparative advantages. To promote these objectives, and to do so speedily, the technology, management and organizational skills, and markets offered by foreign MNEs have been particularly welcomed. But to attract such assets, host countries, and particularly the transition economies, have had to reconﬁgure their macro-economic and micro-management policies and their II’s in such a way as to meet the needs of the investing corporations. Bearing in mind the relatively footloose nature of some kinds of FDI – particularly that of a market or efficiency kind within a regionally integrated area – what then are the unique location bound advantages, and the II underpinning them, which a particular country or region can offer both existing and potential foreign investors seeking to advance their own strategic goals? The second critical new development of the past decade, which is inﬂuencing the ability of countries to attract inbound FDI – and, in particular, the role of institution building, and related government policies – is the advent of new means of communication – and especially the E-commerce and the Internet – which, by lowering many spatial transaction costs, are having a major effect on the locational preferences of MNEs.10 This is seen to be particularly the case with respect to their sourcing of standardized, but relatively labour intensive, goods and services. And it is these areas (e.g. motor vehicle components, garment manufacturing, routine operations of banks and insurance companies, and call centres) in which the transition economies, along with other countries at the intermediate stages of their investment development paths (Dunning & Narula, 1996), are able

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to demonstrate a comparative advantage. At the same time, viewed from a developmental perspective, it is important that the transition economies learned from the experience of such Asian economies as Singapore, South Korea and Taiwan11 of the need to continually restructure and upgrade their location-speciﬁc endowments (especially their institutions which help promote human resource development and innovatory capacity); and, in so doing, not only attract a better quality of FDI, but help their own indigenous ﬁrms to become outward foreign investors.12 A third element of the changing characteristics of country-speciﬁc advantages concerns the increasing attention now being paid to sub-national clusters of economic activities, particularly in large and medium size economies. Here, the work of Michael Porter (1998) and Michael Enright (2002) is particularly germane. It is quite clear from the research into the intra-national location strategies of both domestic and foreign ﬁrms, that the extent and content of the II of particular regions or districts – and especially the incentive structures, the quality of educational institutions, the communications infrastructure, the entrepreneurial culture, social capital, and the provision of industrial and science parks – is one of the most powerful pull factors they can offer. This is particularly likely to be so when such inducements are ‘tailor made’ to the kind of FDI they are seeking to attract. Clearly, there are very speciﬁc opportunities and challenges now being faced by the ex-Communist countries. None is more relevant than those arising from the change in the ownership of productive assets demanded by the market economy; and the consequential need to drastically lower the transaction and coordination costs of doing business. This, perhaps more than anything else, requires a wholesale reconﬁguration of the organizational and economic management of both private ﬁrms and governments of the transition economies. We have already referred to some of these, and there is a substantial literature on the subject (see especially Holland, Sass, Benacek, & Gronicki, 2000 and Bevan, Estrin, & Meyer, 2004). For now, however, we are interested in seeing how important the various competitive enhancing measures just described have been in affecting recent FDI inﬂows into the European transition economies.

4. THE EMPIRICAL EVIDENCE Let us then turn to review the empirical evidence of the signiﬁcance of institutional and policy-related variables on the ‘pull’ factors inﬂuencing the

Institutional Reform, FDI and the Locational Competitiveness of European TEs 187

location of FDI – both in European transition economies taken as a group, and within particular transition economies. Up to now, the research studies fall into two main groups. First, there are the statistical and econometric exercises which seek to quantify the relationship between FDI inﬂows (or changes in the stock of inward FDI) and selection of explanatory, including institutionally related, variables. These normally use published data, largely from ofﬁcial sources such as the European Bank for Reconstruction and Development (EBRD), the OECD and the UN. Second, there are the ﬁeld surveys which are primarily designed to extract the opinion of existing and/or potential foreign investors about the location-speciﬁc competitive advantages perceived to be offered by the transition economies; and to rank in importance (what they perceive to be) the critical determinants of recent past, and likely future, FDI commitments. In the paragraphs which follow, we shall focus on two recent empirical exercises, both of which are comprehensive in scope and detail, in as much as they draw heavily on data and opinions used in previous studies. The statistical and econometric exercises use mainly multivariate regressions to assess the signiﬁcance of either a proxy for institutions in toto, or for particular institutional-related variables as determinants of FDI ﬂows. Both time series and cross-sectional studies, or a combination of the two using panel data, are commonly deployed. For the purposes of this chapter, we shall detail just one of the most recent and, at the time of writing, unpublished studies (Bevan et al., 2004). This draws upon a panel of information for the years 1994–1998 compiled by the major source investing countries (the EU, US, Japan, Korea, Switzerland in respect of FDI in 10 transition economies seeking accession to the EU, plus Russia and the Ukraine).13 As to the general impact, it was found that, after eliminating the effects of a number of control variables such as market size, cultural, linguistic and geographic distance and labour costs, there was a positive but (at 6%) not a highly signiﬁcant relationship between the level of inbound FDI and a composite index of II.14 Of the individual II variables, both change of ownership (in the form of privatization) and private sector development were seen to be positively, though not signiﬁcantly, correlated to FDI ﬂows, again once control variables were taken into account. In particular, the creation of new markets, including those relating to FDI and cross border alliance formation, were shown to reduce transaction costs associated with uncertainty, bureaucracy and opportunism. Rather more signiﬁcantly, the quality, accountability, and transparency of the ﬁnancial sector and the pace of banking reform were seen

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to be signiﬁcantly correlated with FDI ﬂows; but non-bank institutional upgrading, e.g. with respect to capital markets appeared to be less so. However, the liberalization of domestic markets, the strengthening of competition policies and a movement towards more open trading regimes were seen to have had a strong positive effect, as was that of the upgrading of the legal system. One further ﬁnding of this study was that foreign investors appeared to be more concerned with the quality of formal institutions than they were with informal ones. These results all point to the importance of institution building as a necessary pre-requisite for FDI. They conﬁrm and extend those of earlier studies such as those by Lansbury, Pain, and Smidkova (1996), the EIU (2001), Holland et al. (2000) and Bevan, Estrin, and Meyer (2000).15 The EIU statistical exercise, based on FDI ﬂows into 27 Central and East European countries between 1996 and 2000, found that among the signiﬁcant explanatory variables, the quality of the business environment and the privatization variable were both highly signiﬁcant, along with market size, wage costs and a natural resource variable (EIU 2002).16 This study also suggested that institutional upgrading in anticipating that accession to the EU, have also helped to reduce both the domestic and intra-European transaction and coordinating costs of the newer members. However, the case of Greece, which did not sufﬁciently engage in institutional and policy reform, at the time of her entry into the EC shows that accession does not automatically result in increased FDI ﬂows (Kekic, 2002). Two other recent studies of inward FDI in some 13 Central and Eastern European economies are also worthy of note. Using panel data and a variety of statistical models embracing the period 1990 to 1999, Grosse and Trevino (2003) found that, while the role of institution building was generally similar in the economies studied to that in other emerging markets, it tended to play a rather more signiﬁcant role. In particular, the authors noted (the right kind of) bilateral investment treaties, the degree of enterprise reform, repatriation rules, and the reduction of the level of government corruption were particular pulls in attracting FDI. The second and more qualitatively oriented study by Meyer and Jensen (2005) attempted to identify the kind of institutional and policy-related measure implemented by some 15 European transition economies to attract inward FDI. They also found that foreign investors pursuing greenﬁeld entry strategies had more degrees of freedom with respect to their intra-country locational choices (Meyer & Jensen, 2005, p. 144). Most surveys of business opinion tend to conﬁne themselves to identifying (a) the strength or weakness of different locational determinants (usually on

Institutional Reform, FDI and the Locational Competitiveness of European TEs 189

a Likert Scale) and changes in these, and (b) how any particular determinant differs in its perceived signiﬁcance across countries. Let us illustrate from just one major annual survey undertaken by the EIU which attempts to calculate a Business Environment Index (BEI) for some 82 countries. The index is derived from data and opinions culled from other published sources,17 and a series of business surveys conducted by the EIU itself. It is made up of an unweighted average of rankings for 10 broad determinants of competitiveness and 91 individual components.18 The most recently compiled information was collected for two time periods. The ﬁrst was for the years 2000–2005 and the second 2006–2010 (EIU & CPII, 2006). We consider two sets of data. The ﬁrst are those which relate to the rankings assigned to some speciﬁc institutions of all countries – and how they compared with those assigned to Western Europe and Latin America,19 and to policy-related determinants for the European transition economies as a whole. The second classiﬁes the 16 economies into two groups and compares the signiﬁcance of II-related assets with that of more traditional location-speciﬁc variables covered by the survey. Table 1 sets out scores – on a range of 1–5, 5 being the most conducive to the competitiveness and 1 the least conducive – for a selection of 21 of the 91 variables which, in our judgement, best relate to II and policy-related variables. These data show: (i)

For 2001–2005, the average overall BEI score for the 16 European transition economies20 identiﬁed by the EIU was 3.0 compared with that of 3.8 for Western Europe, 2.8 for Latin America and 3.2 for all countries. Between 2006 and 2010, the corresponding scores are expected to rise to 3.3, 4.0, 3.0 and 3.4, respectively, with the East European countries recording the greatest absolute percentage increase. (ii) The scores assigned to the II variables for East European countries for the years 2001–2005 were, on average, ranked lower than the non-II variables; and also to the scores of the II proxies assigned to Western European and Latin American countries. Those II variables ranked the lowest included the protection of intellectual property rights, the promotion of competition, stock market capitalization, the transparency and efﬁciency of the legal system, corruption, the quality of the ﬁnancial regulatory system, the infrastructure for retail and wholesale distribution, access to ﬁnance for investment, and the consistency and fairness of the tax system. Looking forward to 2006–2010, the scores of each of these competitiverelated variables was expected to rise – and particularly in respect of the

190

Table 1.

Indicator Scores for Selected Institution-Related Variables in the EIU Business Ranking Model (i) 2001–2005 and (ii) 2006–2010. 2001–2005 World

Central and Eastern Europe

Western Europe

Latin America

World

Central and Eastern Europe

Western Europe

Latin America

3.2

3.0

3.8

2.8

3.4

3.3

4.0

3.0

3.4 3.5

3.4 3.5

4.3 3.9

2.8 3.1

3.5 3.6

3.6 3.8

4.4 4.0

2.8 3.3

2.8 2.8

3.5 2.3

3.5 4.1

2.6 2.4

3.0 3.0

2.4 2.9

3.8 4.3

2.8 2.6

2.7 3.4

2.2 3.3

3.9 3.7

1.9 3.7

2.8 3.5

2.3 3.4

4.2 3.8

2.1 3.7

3.8 4.1

3.6 3.4

4.8 4.5

3.3 3.1

3.8 4.2

3.7 4.1

4.8 4.9

3.3 3.6

3.1

2.2

3.5

2.4

3.0

2.8

3.6

2.8

JOHN H. DUNNING

A. Overall BEI scorea B. Political/social Risk of social unrest Government policy towards business Quality of bureaucracy Transparency and fairness of legal system Corruption Openness of national culture to foreign inﬂuences Institutional underpinning Risk of expropriation of foreign assets Distortions arising from lobbying of special interest groups

2006–2010

3.5

3.6

4.0

3.4

3.8

3.8

4.3

3.3

3.0

2.6

4.0

3.0

3.6

3.4

4.4

3.4

3.0

2.4

4.0

2.3

3.3

3.1

4.2

2.5

3.0 3.2

2.3 2.6

4.3 4.3

2.3 2.3

3.2 3.4

2.6 3.0

4.4 4.5

2.4 2.6

3.3

2.9

4.5

3.1

3.3

3.1

4.5

2.5

3.0

2.4

4.2

2.4

3.3

3.1

4.5

2.5

3.7

3.2

4.8

3.0

3.9

3.9

4.9

3.1

3.1

2.6

4.4

2.5

3.4

3.3

4.6

2.8

2.8 3.4

2.3 3.6

3.6 3.9

2.8 3.2

3.3 3.6

3.2 3.8

4.0 4.1

3.0 3.5

3.0

3.2

3.1

2.8

3.2

3.2

3.5

2.8

Source: Economist Intelligence Unit (EIU) (2006). a Out of 5.

Institutional Reform, FDI and the Locational Competitiveness of European TEs 191

C. Economic Policies towards foreign capital Quality of ﬁnancial regulatory system Consistency/fairness of tax system Stock market capitalism Access to ﬁnance for investment Reliability of telecoms network Infrastructure for distribution Degree to which private property rights are protected Intellectual property right protection Promotion of competition Tariff and non-tariff protection Restrictiveness of labour laws

192

JOHN H. DUNNING

content and quality of political and social institutions; and to do so proportionately more so in Central and Eastern Europe than elsewhere. (iii) Turning now to the business attitudes towards more policy-related variables, other data published by the EIU (not presented here) reveal that both the macro- and micro-management policies – taken as a group – were ranked more favourably than were the II variables (EIU, 2006). More especially labour-related policies, the tax burden and the corporate tax rate were three of the policy variables in which Central and Eastern Europe was perceived to have comparative locational advantage vis a vis Western Europe and Latin America. The comparative disadvantages most often identiﬁed were competition and anti-corruption policies. However, taken as a whole, the policy scores were lower than in all other parts of the world except the Middle East.21 Again, in the 2006–2010 period the rankings for each of these variables in Central and Eastern Europe were expected to improve, both absolutely and relatively to those in other regions. Tables 2(a) and 2(b) sets out some further details for the 16 European transitional economies for which the EIU published data. For each country, scores of 1–10 were assigned to each of the 10 categories of the BEI for 2001–2005 and 2006–2010. Based on their GDPs per head,22 we classiﬁed these countries into two groups. Those with per capita incomes of $10,000 or above for 2003–2005, namely Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia comprised the ﬁrst group. Those with per capita incomes of below $10,000 in this period, namely Azerbaijan, Bulgaria, Kazakhstan, Romania, Russia, Serbia and the Ukraine made up the second group. We also added India and China for purposes of comparison. We might highlight three main points from this table, and also from Table 3 which gives average scores for the II and other variables for each of the 16 countries: (i)

For the more advanced transition economies, the scores for the institution-related categories23 were roughly the same as those for the other categories in the 2001–2005 period. For the less advanced transition economies, the II variables were ranked considerably lower than those of the other variables. Broadly the same picture emerged in respect of the 2006–2010 scores. (ii) There is a strong suggestion that, as economic development and restructuring proceeds, the scores likely to be assigned to the institution-related

Institutional Reform, FDI and the Locational Competitiveness of European TEs 193

Table 2(a). Business Environment Scores for European Transition Economies (TEs) India and China (i) 2001–2005 and (ii) 2006–2010. 2001–2005 Less Advanced TEs ($7,278)a

India ($3,187)a

China ($5,631)a

6.8 7.9 5.8 6.4

4.4 5.5 3.4 3.6

5.5 5.9 5.2 5.0

4.6 5.5 3.9 3.8

7.5

5.3

5.1

6.0

6.2 6.6 6.5

3.5 3.9 4.8

5.1 4.8 3.1

5.3 3.6 4.5

7.2

7.0

7.8

7.8

5.3 8.1

6.0 5.7

7.6 3.7

8.5 6.0

6.6

5.8

5.8

5.8

6.7

5.1

5.3

5.6

More Advanced TEs ($14,524)a A. Institution-related variables Political environment Political stability Political input Policy towards private enterprises and competition Policy towards foreign direct investment Taxes Financing Infrastructure B. Other determinants Macro-economic environment Market opportunities Foreign trade and exchange controls The labour market Overall score

Source: EIU (2006). Scores range from 1 to 10, a score of 10 being perceived as the best for business. a GDP per capita (US$ PPP) 2003–2005.

variables not only rise, but rise relative to that of the other categories. Particular examples, as shown in Table 2, include the quality of institutions promoting private enterprise, the political environment and ﬁnancing (mostly one suspects the quality of the ﬁnancial regulatory system and distortion (or the absence of same) in ﬁnancial markets). Again, as Table 3 shows, the most impressive II upgrading is predicted to occur in the less developed transition economies, and especially in Azerbaijan, Romania, Russia, Serbia and the Ukraine. (iii) Looking at the comparative strengths and weaknesses of the institutionalrelated categories for the 16 countries identiﬁed, we see that in the 2001–2005 period, the perceived strengths of the less developed transition

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JOHN H. DUNNING

Table 2(b). Business Environment Scores for European Transition Economies (TEs) India and China (i) 2001–2005 and (ii) 2006–2010. 2006–2010 Less Advanced TEs ($11,819)a

India ($11,918)a

China ($10,069)a

7.2 8.0 6.5 7.5

4.9 5.8 4.1 4.9

5.7 6.3 5.2 6.0

4.6 5.1 4.2 4.8

8.0

5.6

6.4

6.9

6.8 7.4 7.3

5.9 5.5 5.4

6.3 5.9 4.1

5.3 3.6 5.4

7.6

7.5

6.6

7.8

5.7 8.4

6.1 7.3

7.6 6.4

8.5 7.8

More Advanced TEs ($21,824)a A. Institution-related variables Political environment Political stability Political effectiveness Policy towards private enterprises and competition Policy towards foreign direct investment Taxes Financing Infrastructure B. Other determinants Macro-economic environment Market opportunities Foreign trade and exchange controls The labour market Overall score

6.9

6.1

6.4

6.2

7.5

5.4

6.1

6.4

Source: EIU (2006). Scores range from 1 to 10, a score of 10 being perceived as the best for business. a Estimated GDP per capita (US$ PPP) 2008–2010.

economy countries were their political stability, their policies towards FDI, and their weaknesses a high level of bureaucracy, corruption, distortions arising from lobbying by special interest groups, political effectiveness and organizational infrastructure. For the more advanced transition economies (which currently receive the great bulk of inbound FDI), the perceived strengths were their attitudes towards FDI and exchange controls, political stability and the macro-economic environment, improved corporate governance and the regulatory framework; and their weaknesses, the consistency and fairness of their tax systems, their communications infrastructure, their cumbersome or excessive bureaucracies, and their lack of transparency and accountability in public administration.

Table 3.

2001–2005 Total

BER

2006–2010

FDI Per Capita $a

GDP Per Capita $b

Inst

Other

More Advanced TEs (Mates) Croatia 5.7 Czech Republic 6.9 Estonia 7.6 Hungary 6.8 Latvia 6.8 Lithuania 6.6 Poland 6.6 Slovakia 6.8 Slovenia 6.7

5.7 6.8 7.7 6.7 6.9 6.4 6.5 6.8 6.8

5.7 7.2 7.4 6.9 6.7 6.9 7.0 6.9 6.7

335 628 834 405 172 180 183 349 385

11,412 17,009 14,675 15,258 11,478 12,990 11,942 14,672 21,283

All mates

6.7

6.7

6.8

386

Less advanced TEs (Lates) Azerbaijan Bulgaria Kazakhstan Romania Russia Serbia Ukraine

4.5 5.9 5.1 5.7 5.3 4.8 4.5

3.7 5.7 4.7 5.3 4.0 4.5 3.6

5.5 6.4 6.3 6.2 7.3 5.2 6.2

All matesc

5.1

4.3

6.1

Total

BER

FDI Per Capita $a

GDP Per Capita $b

Inst

Other

6.5 7.5 7.8 7.3 7.2 7.1 7.1 7.5 7.3

6.6 7.7 8.1 7.4 7.4 7.2 7.3 7.4 7.4

6.2 7.6 7.4 7.1 6.8 7.1 6.9 7.5 7.1

414 557 840 450 291 346 224 389 380

16,000 24,849 24,820 21,838 19,232 20,770 17,182 21,939 29,783

14,524

7.3

7.2

7.3

432

21,824

246 230 179 174 61 118 5.2

4,800 8,228 7,362 7,802 9,906 6,515 6,243

5.3 6.7 5.7 6.6 6.1 6.0 5.4

4.4 6.5 4.8 6.3 4.9 5.6 4.6

6.5 6.5 7.2 6.9 7.7 6.3 6.5

194 289 334 285 154 242 92

11,429 12,348 12,624 11,716 15,234 9,821 9,562

151

7,278

6.0

5.3

6.8

227

11,819

Note: BER, business environment rankings; Inst, II variables; other, other variables in BER. a FDI per capita ($) inbound FDI ﬂows per capita averaged over two ﬁve-year periods (viz. 2001–2005 and 2006–2010). b GDP per capita ($) GDP per capita at purchasing power parity averaged over 1=two three-year periods (viz. 2003–2005 and 2008–2010). c Unweighted average.

Institutional Reform, FDI and the Locational Competitiveness of European TEs 195

Business Environment Rankings, FDI per capita and GDP per capita for 16 European Transition Economies 2001–2005 and 2006–2010.

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JOHN H. DUNNING

Table 2 also shows the relative strengths and weaknesses of the two leading Asian economies undergoing signiﬁcant structural transformation. In India’s case, its main strength was perceived to lie in its macro-economic environment and political stability, and its weaknesses in its transport and power infrastructure, and in its banking and ﬁnancial regulatory mechanisms. In China’s case there were similar strengths and weaknesses;24 though China’s policy towards private enterprise was thought to be less conducive to inbound FDI than that of India.25 Finally in Table 3, we relate the business environment ranking of the 16 transition economies to their GDP per capita and their inward FDI per capita. The data show that, there is a positive correlation between the BER scores for FDI per capita and GDP per capita in both the 2001–2005 and 2006–2010 periods. However, the relative significance of the II variables in attracting FDI seems to be most marked in the case of the less advanced transition economies in the 2001–2005 period. The lesson here seems to be that at a certain GDP per capita level the relative importance of the II as a variable inﬂuencing FDI inﬂows decreases.

5. CONCLUSIONS This chapter has sought to assess the signiﬁcance of II as a locational competitive variable inﬂuencing the size of FDI ﬂows into the European transition economies. It began by examining the critical role of the institutional environment (comprising both institutions and the strategies and policies of organizations relating to these institutions) in lowering the transaction costs of both domestic and cross border business activity. It then set up an analytical framework for identifying the determinants of FDI, how these had changed over recent years, and which were likely to be the most important from the viewpoint of host transition economies. Section 3 of the chapter then went on to describe the reconﬁguration of the main push factors affecting the current strategy and behaviour of MNEs brought about by recent changes in the global economy; and also the main pull factors determining the location-speciﬁc competitiveness of countries and regions wishing to attract the resources and capabilities which foreign investors were perceived to possess. This section concluded with some observations as to the type of asset based advantages transition economies should strive to develop. Section 4 then turned to consider the results of two major empirical exercises on the particular role of institution-related competitiveness as a

Institutional Reform, FDI and the Locational Competitiveness of European TEs 197

determinant of FDI ﬂows into transition economies. The econometric study showed that, after allowing for control variables, the quality of the II was positively, and for some kinds of institutions, signiﬁcantly related to FDI ﬂows. The ﬁeld study indicated that (proxies for) the quality of II in the less advanced transition economies were generally thought to be less conducive to FDI than those possessed by other economies, and also of the non-II determinants of FDI. However, it was generally expected that, over the period 2005–2010, the quality of II of both groups of transition economies would improve relative to that of other economies, and, that, in consequence, they would gain an increasing share of inbound FDI.26 Other data also suggest that the prospects of accession to the EC, and the beneﬁts likely to be conferred, is becoming an important inducement to many (if not all) transition economies to upgrade their II. A ﬁnal part of the chapter also made some comparisons and contrasts between the competitive advantages (and disadvantages) of European transition economies and that of India and China as a location for inbound MNE activity.

NOTES 1. Examples of such rules and conventions include formal contracts and guarantees, bankruptcy laws, the legal system, property rights and trademarks. 2. For an excellent survey of different types of institution and how their upgrading might enhance economic development and the transition process see the chapter by Dennis Rondinelli (2005). For an examination of the reasons for private enterprise development posed by the transition from state planned to market economies in Central and Eastern Europe see Behrman and Rondinelli (1999). For an application of the investment development path to the restructuring of Central and Eastern European economies, see the chapter by Meyer and Jensen in this volume. 3. Bevan et al. (2004), Bevan and Estrin (2000), Meyer (2001a, 2001b), and Meyer and Jensen (2005). 4. We use the expression ‘MNE-related activity’ to embrace both FDI and nonequity cooperative forms of cross border value adding activity. 5. We accept, following our discussion on p. 2, that the distinction between a policy and an institutionally related variable is not always easy to draw. However, the content and boundaries of each are distinct. Policy usually refers only to government action, and it is partly dependent on the character and quality of the institutions in which it is embedded. One may imagine a case of inappropriate policies within a sound II; but also of sound policies made ineffective by inadequate institutions. At the same time, while many organizations affecting institutional capability and FDI are non-governmental, e.g. civil society, business organizations, governments, etc., in a variety of ways, may affect the adequacy and impact of these on their competitive enhancing goals.

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6. For an extensive discussion of the changing global or regional strategies of MNEs see the annual World Investment Reports published by UNCTAD. 7. By the same token an increasing proportion of inbound FDI has been of this kind. 8. Some 75% of M&A purchases between 1990 and 2000 took place between the US, Europe and Japan. See e.g. UNCTAD (2001). 9. As, for example, described in several chapters in Dunning, (2000). 10. For a detailed examination of the affect of E-commerce on IB activity see Dunning and Wymbs (2001). 11. For a study of the relationship between the investment development path and the structural upgrading of Korean and Taiwanese industries between the mid-1960s and early 1990s see Dunning, Kim, and Lin (2001). 12. For one of the ﬁrst careful examinations of the outward FDI by Central European transition economies, see Svetlicic and Rojec (2003). See also UNCTAD (2006). 13. These are Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia. 14. The European Bank for Reconstruction and Development regularly compiles such an index for each of the transition economies. See e.g. EBRD (2000). 15. Another study on FDI in Latin America also concluded that ‘privatization was the most highly signiﬁcant independent variable to help explain inward FDI in Latin America’ (Trevino, Daniels, Abelaez, & Upadhyaya, 2002). (Also signiﬁcantly positively related to FDI inﬂows was the liberalization of capital markets). The methodology of this study is of particular interest as the authors’ measure of privatization subtracted out FDI in the privatized sector. The results then implied that a change of ownership as an institutional reform does much more than simply attracting FDI to a previously closed sector. 16. According to the model ‘market size, the quality of the overall business environment, wage costs, natural resource endowments and privatization methods statistically explain almost the entire inter-country variation in FDI receipts in the region in 1996–2000’ (EIU 2002, p. 87). 17. As described by EIU (2006) p. 65–70 and 294–304. Regrettably this report does not identify the number of ﬁrms completing the nine page Business Rankings Questionnaire, the answers to which formed an important part of the BEI. 18. These could quite readily be reclassiﬁed using the seven kinds of institutions identiﬁed by Denis Rondinelli (2005). These are institutions of economic adjustment and stabilization, e.g. macro economic adjustment policies; institutions strengthening economic motivation, e.g. FDI policies, labour markets; institutions of private property protection; institutions promoting freedom of enterprise, e.g. political liberalization, quality of ﬁnancial regulatory system; institutions of rule setting and societal guidance, e.g. effectiveness and fairness of legal system, policies for controlling corruption, quality of bureaucracy; institutions promoting competition, e.g. trade and investment, liberalization, competition policy, and institutions promoting social equity and access to opportunity. 19. As an example of a developing region. 20. In alphabetical order these countries are Azerbaijan, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Kazakhstan, Latvia, Lithuania, Poland, Romania, Russia, Serbia, Slovakia, Slovenia, and the Ukraine.

Institutional Reform, FDI and the Locational Competitiveness of European TEs 199 21. These scores were not broken down for each country for each of 91 individual items. 22. Calculated in $ at PPP. 23. We have had to be rather arbitrary in classifying the components, as, in some cases, policy and institution-related variables were difﬁcult to distinguish from each other. 24. China’s main comparative advantage rested on its market opportunities and macro-economic environment. In both cases in 2001–2005 China was ranked among the top three of the developing and transition economies covered by the EIU survey. 25. Again, it is difﬁcult to generalize for large economies like India and China as there are large differences in the institutional environment between the major industrial conurbations and the rest of the countries. 26. The EIU’s prediction is that the share of the world’s inbound FDI stock directed to the 16 Central and Eastern European economies is likely to increase from 25% in 2001 to 4.8% in 2010 (EIU, 2006, p. 280–281).

REFERENCES Behrman, J. N., & Rondinelli, D. A. (1999). The transition to market oriented economies in Central and Eastern Europe: lessons for private enterprise development. Global Focus, II(4), 1–13. Bevan, A., & Estrin, S. (2000). The determinants of foreign direct investment in transition economies. CEPR Discussion Paper no. 2638. Centre for Economic Policy Research, London. Bevan, A., Estrin, S., & Meyer, K. (2000). Institution building and the integration of Eastern Europe in international production. Discussion Paper Series no. 11. Centre for New and Emerging Markets, London. Bevan, A., Estrin, S., & Meyer, K. (2004). Foreign investment location and institutional development in transition economies. International Business Review, 13(1), 43–64. Birkinshaw, J. M., & Hood, N. (Eds). (1998). Multinational corporate evolution and subsidiary development. London: Macmillan. Donaldson, T. (2007). The ethics of international business. New York: Oxford University Press. Dunning, J. H. (1998). Location and the multinational enterprise: A neglected factor. Journal of International Business Studies, 29(1), 45–66. Dunning, J. H. (Ed.) (2000). Regions, globalization and the knowledge based economy. Oxford: University Press Oxford (see especially Chapters 1, 13, 14, 15 and 16). Dunning, J. H. (Ed.) (2003). Making globalization good: The moral challenges of global capitalism. Oxford: Oxford University Press. Dunning, J. H. (2004). Determinants of foreign direct investment: Globalization induced changes in the role of fdi policies. In: World bank towards pro poor policies. Washington, DC: World Bank. Dunning, J. H. (2006). Space, location and distance in IB activity: A changing scenario. Reading: Reading Business School (Mimeo).

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Dunning, J. H., Kim, C.-S., & Lin, J.-D. (2001). Incorporating trade into the investment development path: A case study of Korea and Taiwan. Oxford Development Studies, 29(2), 45–54. Dunning, J. H., & Lundan, S. (2007). Multinational enterprises and the global economy. Cheltenham, UK: Edward Elgar. Dunning, J. H., & Narula, R. (Eds). (1996). Foreign direct investment and governments. London and New York: Routledge. Dunning, J. H., & Wymbs, C. (2001). The challenge of electronic markets for international business theory. International Journal of the Economics of Business, 8(2), 273–302. Economist Intelligence Unit (EIU). (2001). East European investment prospects. London: EIU. Economist Intelligence Unit (EIU). (2002). World investment prospects (2002 edition). London: EIU. Economist Intelligence Unit (EIU) and Columbia Program on International Investment (CPII). (2006). World investment prospects to 2010. Burn or backlash? London and New York: EIU and CPII. Enright, M. J. (2002). Geographics and international business: A three dimensional approach. Paper presented at Academy of International Business Annual Meeting at San Juan, Puerto Rico, July. European Bank for Reconstruction and Development (EBRD). (2000). Transition report. EBRD, London. Grosse, R. (Ed.) (2005). International business and government relations in the 21st century. Cambridge: Cambridge University Press. Grosse, R., & Trevino, L. J. (2003). New institutional economics and FDI location in Central and Eastern Europe (Mimeo). Phoenix, AZ: American Graduate School of International Management . Holland, D., Sass, M., Benacek, V., & Gronicki, M. (2000). The determinants and impact of FDI in Central and Eastern Europe: A comparison of survey and econometric evidence. Transnational Corporations, 9(3), 162–212. Kekic, L. (2002). Foreign direct investment and the East European transition. In: V. EIU (Ed.), World investment report (2002 edition) (pp. 76–92). London: EIU. Lansbury, M., Pain, N., & Smidkova, K. (1996). Foreign direct investment in Central Europe since 1990: An econometric study. National Institute Economic Review, 156, 104–124. Meyer, K. (2001a). International business research in transition economies. In: A. Rugman & T. Brewer (Eds), Oxford handbook on international business (pp. 716–759). Oxford: Oxford University Press. Meyer, K. (2001b). Institutions, transaction costs and entry mode choice in Eastern Europe. Journal of International Business Studies, 32(2), 357–368. Meyer, K. E., & Jensen, C. (2005). Foreign direct investment and government policy in Central and Eastern Europe. In: R. Grosse (Ed.), International business and government relations in the 21st century (pp. 119–146). Cambridge: Cambridge University Press. Mudambi, R., & Navarra, P. (2002). Institutions and international business: A theoretical overview. International Business Review, II(6), 635–646. North, D. C. (1990). Institutions, institutional change and economic performance. New York: Cambridge University Press. North, D.C. (1999). Understanding the process of economic change. Occasional Paper no. 6. Institute of Economic Affairs, London. North, D. (2005). Understanding the process of Economic change. Princeton: Princeton University Press.

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Oetzel, J., Getz, S., & Ladek, S. (2007). The role of multinational enterprises in responding to violent conﬂict: A conceptual model and framework for research. American Business Law Journal, 44, 331–358. Palmisano, S. (2006). The globally integrated enterprise. Foreign Affairs (May/June), 127–136. Pearce, R. D. (1999). The evolution of technology in multinational enterprises: The role of creative subsidiaries. International Business Review, 8, 125–148. Porter, M. E. (1998). On competition. Boston, MA: Harvard Business School Press. Rondinelli, D. A. (2005). Assessing government policies for business competitiveness in emerging market economies: An institutional approach. In: R. Grosse (Ed.), International business and government relations in the 21st century (pp. 395–420). Cambridge: Cambridge University Press. Rondinelli, D. A., & Behrman, J. H. (2000). The institutional imperatives of globalization. Global Focus, 12(1), 65–78. Rugman, A. M., & Verbeke, A. (2001). Subsidiary-speciﬁc advantages in multinational enterprises. Strategic Management Journal, 22(3), 237–250. Sethi, D., Guisinger, S., Ford, D. L., & Phelan, S. E. (2002). Seeking greener pastures: A theoretical and empirical investigation into the changing trend of foreign direct investment ﬂows in response to institutional and strategic factors. International Business Review, II(6), 685–706. Suder, G. S. (Ed.) (2007). Corporate strategies under international terrorism and adversity. Cheltenham, UK: Edward Elgar. Svetlicic, M., & Rojec, M. (Eds). (2003). Facilitating transition by internationalization. Aldershot (UK) and Burlington (USA): Ashgate. Trevino, L. J., Daniels, J. D., Arbelaez, H., & Upadhyaya, K. P. (2002). Market reform and foreign direct investment in Latin America: Evidence from an error correction model. The International Trade Journal, XV1(4), 367–392. UNCTAD. (2001). World investment report. Cross-border mergers and acquisition. New York and Geneva: UN. UNCTAD. (2006). World investment report. FDI from developing and transition economies. Implications for development. New York and Geneva: UN. Wesson, T. (2003). Foreign direct investment and competitive advantage. Cheltenham, Gloucestershire: Edward Elgar.

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PARTIAL ACQUISITION: THE OVERLOOKED ENTRY MODE Kristian Jakobsen and Klaus E. Meyer 1. INTRODUCTION Multinational enterprises (MNEs) engaging in foreign direct investment (FDI) combine their ownership advantages with locational advantages of the host country (Dunning, 1992). They can access such locational advantages through different modes of entry. Research on entry modes mostly takes a theory-driven approach distinguishing modes either by ownership or based on the ‘‘build or buy’’ decision (Meyer, 2001; Luo, 2002; Brouthers & Hennart, 2007). This approach, however, disguises the richness of entry modes as a means to combine ownership and locational advantages. Many ﬁrms enter by partial acquisition (PA), especially in transition economies. These PAs combine elements of joint ventures (JVs), namely shared ownership, and of acquisitions, namely taking over an existing operation. Yet, they also have unique features that have been overlooked by prior research. The understanding of PAs is also important to government policy makers as they are the seller side of a privatization by ‘‘partial divestment’’. PAs are a form of acquisition as the investor acquires an equity stake in existing organization, yet without obtaining full equity ownership. Hence, the investors lack full control over the strategy of the business and thus have limited power to effect organizational change. PAs occur in many different facets – in some cases the investor takes over management control and

Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 203–226 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00009-X

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engages directly in the strategic management of the ﬁrm, in other cases the acquirer acts more like a ﬁnancial investor or venture capitalist, advising and possibly indirectly inﬂuencing the management, but not taking over direct control. What all PAs have in common are two deﬁning characteristics: (1) an existing organization and (2) shared ownership among one or more owners. This deﬁnition suggests that a combination of the theoretical literatures on, respectively, joint versus wholly owned and acquisition versus greenﬁeld may provide an appropriate explanation of the phenomenon. However, this does not hold true, as we will argue and demonstrate with empirical data in this chapter. We review PAs in the context of other modes of entry or expansion, and outline their unique characteristics. We present empirical evidence from two recent research projects covering seven emerging economies in Central and Eastern Europe (CEE), Asia and Africa (Estrin & Meyer, 2004; Meyer & Estrin, 2007) to investigate when and where foreign entrants use PAs. We ﬁnd them to be fairly common across a wide range of emerging economies, despite the disadvantages of having operational responsibilities for an existing ﬁrm without carrying full equity control. We then proceed to discussing the reasons why both buyers and sellers may prefer a PA over other modes, despite these disadvantages. We conclude by outlining future research agendas to investigate not only PAs, but also to address conceptual challenges arising from our discussion for the validity of ﬁndings of earlier entry strategy research.

2. PAS AS AN ENTRY MODE 2.1. Defining PAs FDI is an investment in a company in another country with the aim to inﬂuence its business strategies (Dunning, 1992). This deﬁnition distinguishes FDI from portfolio investment, where equity stakes are too low to exert substantive control, and from contractual relations that normally do not involve equity participation. We focus on entry modes of foreign direct investors. Categories of entry modes for foreign direct investors are normally deﬁned by their ownership, and whether a new legal entity is created or an existing entity is being taken over. Hence, a greenﬁeld operation is a wholly owned

Partial Acquisition: The Overlooked Entry Mode

Full equity control

Shared equity control

Fig. 1.

205

New organization

Existing organization

Greenfield

Acquisition

Joint Venture

Partial Acquisition

Ownership Control and the Make or Buy Decision.

new venture, while an acquisition is deﬁned as obtaining full ownership control of an existing local ﬁrm. A JV is deﬁned as the establishment of a new venture owned by one or more foreign owners and one or more local owners, while a PA is deﬁned as the acquisition of a substantive stake in an existing local ﬁrm. We operationalize these deﬁnitions as follows: following common practice, we consider investment in equity stakes below 10% as portfolio investment (OECD, 1996), which we do not consider in our analysis. We draw the boundary between partial and full ownership at 95% foreign equity stake. These operationalizations are fairly robust in that few FDI projects would shift into other categories if the boundaries change by small increments. Fig. 1 illustrates the features of PA shared with other modes of entry. Like a full acquisition, a PA relies on an existing business organization with all of the advantages and disadvantages associated with this. Much like a JV, the acquirer, however, does not obtain full claim to the residual proceeds nor does the acquirer hold complete equity control. It is the combination of these primary features that distinguishes the PA from the three other principal modes of entry and helps us deﬁne what constitutes a PA. 2.2. Challenges to Classifying Entries The formal deﬁnition appears fairly clear, yet case evidence suggests that classifying modes in practice is not as easy. For instance, studies in CEE (Artisien-Maksimenko & Rojec, 2001), China (Tsang, 2003) and Vietnam (Nguyen, Nguyen, & Tran, 2004) show that it is fairly common to transfer state assets into a jointly owned new legal entity. Legally, this is a JV because a new legal entity has been created. However, this type of investment de facto

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involves the partial transfer of ownership rights to an existing organization, hence for strategic purposes it resembles a PA. Following Estrin and Meyer (2004) we refer to this type of entry mode as ‘‘JV Type II’’; Tsang (2003) uses the term ‘‘acquisition JV’’. Furthermore, many full acquisitions related to a privatization come with signiﬁcant contractual limitations on what the acquirer is allowed or obliged to do often within a certain time period; a type we refer to as ‘‘contractually restrained acquisitions’’. For example, contracts with privatization agencies often require an investor to commit to employment guarantees or capital investment as a condition for the deal to be approved (Uhlenbruck & De Castro, 1998; Meyer, 2002). In other cases, a government agency may retain a golden share with veto rights for certain strategic decisions. Thus, contrary to common perceptions, full equity ownership does not always provide full control. A different obstacle to classifying entries is the instability of the ownership arrangement. Many – but not all – PAs are from the outset planned to be taken over by the foreign investor within the foreseeable future. In many cases, the foreign investor even attained management control ahead of acquiring majority equity ownership. In these cases, the shared ownership is a temporary phenomenon, called ‘‘staged acquisitions’’ by Meyer and Tran (2006). Analysts would however ﬁnd it hard to distinguish temporary and stable PAs at the outset.

2.3. Types of Owners The identity of the local partner varies considerably in PAs and can have a crucial inﬂuence on the operation of the PA. In some cases the partner may be a single entity, e.g. the state or a large industrial group, while in other cases ownership may be dispersed between large numbers of small private owners. In transition economies in CEE, the PAs are in particular associated with the transfer of state assets into private hands. A number of different privatization methods have been employed, including direct sale to foreign owners, transfer of ownership to insiders of the ﬁrm or broader transfers into public hands (Estrin, 2002). Thus, foreign acquirers are confronted with a diversity of ownership constellations across CEE. If the acquisition occurs directly from the privatization agency or a government ministry, foreign acquirers have to deal directly with a state

Partial Acquisition: The Overlooked Entry Mode

207

owner. In other cases, new owners (and thus the ‘‘sellers’’ of the ﬁrm) include managers and/or employees of the ﬁrm. Some countries experimented with privatization programmes designed to spread ownership of formerly stateowned enterprises (SOEs) broadly, usually through voucher-based schemes. However, the recipients of the vouchers would often invest them in funds, often indirectly controlled by the state, hence inadvertently transferring control rights back into the states sphere. Potential acquirers may thus be negotiating with state-backed investment funds. A primary challenge for the acquirer is that these owners pursue different objectives that may conﬂict with the objectives of the acquirer. Particularly, the state or management/employee owners are likely to pose special challenges for the acquirer. These types of owners are likely to have special interest in the ﬁrm and pursue objectives other than solely proﬁt maximization. This can be at odds with the interest of the foreign owner and complicates both the initial negotiation process and the management of the operation after the investors has assumed its equity stake. In most of our discussion, we assume that the acquirer is a multinational ﬁrm taking a strategic interest in the partially acquired ﬁrm. This is however not always the case, as a PA may be undertaken for a number of other reasons. For example, private equity funds acquire equity stakes with the aim of beneﬁting from increased stock values, while helping management to improve the performance of the ﬁrm (or even introducing new management). Since these investors actively inﬂuence the ﬁrm’s strategy and equity stakes typically over 10%, this does not qualify as portfolio investment. However, the dynamics of post-acquisition change are quite different than if the acquirer is an MNE aiming to integrate the acquired unit with its global operations. This form of investment is however of lesser importance in emerging economies and does not contribute much to the PAs analysed in the data presented later in this chapter.

3. THEORETICAL PERSPECTIVES The OLI paradigm (Dunning, 1992) proposes three necessary conditions for FDI to take place. It suggests that a foreign investor must hold ownership (O) advantages that can be exploited in the foreign market. Furthermore, there must be locational (L) advantages that encourage local production. Finally, there should be drivers for internalization (I) that encourages

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internalization of the control rights in the hand of the foreign investor. It is particularly the acquisition and internalization of these location-speciﬁc advantages that is essential to understand why ﬁrms use PA as an entry mode. Nonetheless, despite the sheer size of the mode choice literature in general (Brouthers & Hennart, 2007), we know surprisingly little about the use of PAs. And what little we do know may not be relevant for emerging economies. Why might our current theoretical understanding of PAs fail to capture the motives behind them in emerging economies? Transaction cost economists explain the partial internalization in JVs by double market failure (Hennart, 1991). The project depends on contributions from two or more partners, yet the markets for these contributions from the parents are subject to market failure, i.e. transaction costs are high. A JV structure can overcome the inherent opportunism problem by making both parties residual claimants and thus aligning their interests. Hence, the method of remunerating the input providers is seen as the main motivation for shared ownership. Brouthers and Hennart (2007) apply this logic and conclude that JVs and PAs are conceptually the same. This argument may be quite useful to explain newly established JVs, yet we consider it misguided to apply the same reasoning to explain the choice of PAs. What distinguishes a PA is that a share of the ownership of all organizational resources of the local ﬁrm is transferred to a new owner; hence the market failure appears to be of a different nature than that motivating establishment of a JV. A small number of studies have considered PAs as a distinct entry mode. Chen and Hennart (2004) suggest an asymmetric information view: an acquirer facing difﬁculties in valuating the underlying assets would favour a PA over a full acquisition. This would force the seller to provide the acquirer with a ‘‘hostage’’, something the seller would avoid if the underlying asset is a ‘‘lemon’’. It also ensures that the seller continues to act in the best interest of the business. In transition economies, the nature and importance of asymmetric information may however be different. Evidence suggests that valuations of state enterprises in CEE widely differed between potential buyers and sellers, which greatly complicated negotiations processes (Ferris, Yoshi, & Makhija, 1995; Antal-Mokos, 1998; Meyer, 2002; Tsang & Yip, 2007). On the one hand, the greater institutional distance between the home and host country would increase asymmetric information between the foreign buyer and the local seller.

Partial Acquisition: The Overlooked Entry Mode

209

Hence, the underlying assumption that sellers understand the market value of the assets better than prospective buyers is doubtful at best. In particular, the disparity between the value of assets in their current use compared to their ﬁrst best use would tend to be much higher, due to the weaknesses of incumbent management and rapidly changing industry structures. The seller’s knowledge about the potential value of the assets of the local ﬁrm is thus limited. Consequently, in the transition context, the asymmetric information argument may not be applicable in the form proposed by Chen and Hennart (2004). Another study by Duarte and Garcia-Canal (2004) suggests that in high risk contexts, such as emerging economies, ﬁrms may prefer to limit their ﬁnancial exposure by decreasing their equity commitment and pursue a PA. However, this argument is fragile at best. For one, from a transaction cost perspective (Williamson, 1975) higher levels of uncertainty is likely to lead to more frequent and more substantial needs for strategic and operational realignments, with corresponding increases in holdup problems. Hence, higher levels of uncertainty should all else being equal lead to a greater drive to internalize, not less. Furthermore, from a ﬁnancial perspective, it is not clear that retaining local shareholder(s) would reduce the cost of capital. Local owners may attach a smaller risk premium to local assets, yet they also face insufﬁcient diversiﬁcation opportunities, inefﬁcient capital markets and weak institutional protection. International business (IB) scholars may be too accustomed to view the choice of entry mode from the perspective of the foreign acquirer. This may be misleading in transition economies, where ﬁrms are often acquired from the state or from the employee owners. Ultimately, the host governments decided to change the economic system from central planning to a more market-based system. Similarly, employees in employee-owned ﬁrms decide if and when to externalize the management rights and the residual claim to that enterprise. In state- or employee-owned ﬁrms, the owner(s) have a vested interest in maximizing the combined value of both their equity stake and other resources, such as labour, that are tied to the ﬁrm. Especially, the protection of jobs is often a major concern for sellers in transition economies. The main motive of PAs is thus not to maximize the economic efﬁciency of the acquired unit by curbing opportunism, but rather to provide protection against harmful (autonomous) adaptation (Hayek, 1945; Williamson, 1975). Thus, the choice of entry mode is not a unilateral decision made by the acquirer but the result of a negotiated process between two or more parties.

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4. EMPIRICAL EVIDENCE FROM QUESTIONNAIRE SURVEYS Empirical evidence on PAs in a wide range of emerging economies is available from two surveys conducted in emerging economies. The ﬁrst survey was conducted using a set of countries from Asia and Africa, while the second survey was conducted in transition economies in CEE. Together, these surveys represent more than 1,000 observations in seven countries: India, Vietnam, Egypt, South Africa, Hungary, Poland and Lithuania. The data collection process has been described in Estrin and Meyer (2004) for the Asian survey and Meyer and Estrin (2007) for the CEE survey. These data illustrate the distinct features of PAs, which IB scholars ought to consider when advancing their theories. All the statistical analyses were conducted using the SPSS software package. The correlation matrix in Table 1 reports the bivariate relationships between the included variables. 4.1. Location Table 2 indicates a fairly consistent distribution of PAs across all seven countries with investors in India being the least likely to use PAs and those in Table 1.

1 Subsidiary size 2 LN(subsidiary size) 3 Change in employment 4 Absolute change in employment 5 Government inﬂuence 6 Resource transfer (principal component) 7 Human resource development (principal component)

Mean, Standard Deviation and Correlation Matrix. Mean

SD

374.63 3.37 9.70

2284.13 1.81 231.14

45.96

226.72

2.94

1

2

1 0.48** 1 0.84** 0.34**

3

4

0.46** 0.79**

1

1.24

0.08

0.17** 0.08

0.14**

0.00

1.00

0.05

0.00

1.00

0.05

0.12*

6

7

1

0.87**

0.03

5

0.11*

0.05

Notes: Poland, Lithuania and Hungary only. Levels of signiﬁcance: *po0.1, **po0.05, ***po0.01.

0.03

0.07

1 0.02

1

0.11* 0.39** 1

Partial Acquisition: The Overlooked Entry Mode

Table 2.

211

Distribution of Afﬁliates by Entry Mode (% of Afﬁliates).

Entry Mode Greenﬁeld Joint venture Acquisition Partial acquisition

Hungary

Lithuania

Poland

Egypt

India

South Africa

Vietnam

43 23 25 9

40 19 30 11

42 20 21 16

46 37 5 12

35 53 4 7

31 23 31 14

56 32 2 11a

Note: Column total=1007rounding. Source: Meyer et al., in Meyer and Estrin (2007). a Vietnam: Partial acquisitions were deﬁned as JV where local ﬁrms transfer part of the existing operation to the newly created JV.

Poland being the most likely with, respectively, 7% and 16% of all entries. However, these ﬁgures may possibly under represent the true importance of PAs because of deal structures that for practical purposes resembles PAs but legally are JVs (Tsang, 2003; Estrin & Meyer, 2004). In the case of Vietnam, no PAs have been captured by the survey; however, a large number of foreign entries followed the ‘‘JV Type II’’ mode which had been listed as a separate option in the Vietnam version of the questionnaire (Nguyen et al., 2004), and which we tabulate here as PA. In contrast, full acquisitions are rare in Egypt, India and Vietnam compared to the three CEE countries and South Africa. An important reason for this factor is related to legal ownership restrictions in these countries and the liquidity of markets for corporate equity. Hence, institutional factors are clearly an important determinant in the entry mode choice as MNEs normally expanding by acquisitions need to ﬁnd alternative means to access local resources. This suggests that the theoretical position of Brouthers and Hennart (2007) to isolate the make or buy namely full or partial ownership decision is not very helpful to understand the realities of business in emerging economies. Firms need to consider all the available alternatives simultaneously. More importantly, our evidence establishes PAs as an important entry mode in its own right in emerging economies, especially transition economies. For the remaining empirical analysis, we focus on the CEE data set to ensure that meaningful comparisons can be made to full acquisitions.

4.2. Subsidiary Size Table 3 reports the initial mean ﬁrm size in terms of number of employees and the natural log of the number of employees1 for different entry modes, along

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KRISTIAN JAKOBSEN AND KLAUS E. MEYER

Table 3.

Mean Initial Size of the Local Enterprise by Entry Mode.

Entry Mode

Subsidiary Size Mean

Greenﬁeld Joint venture Acquisition Partial acquisition

38.23 66.65 275.11 2665.02

F Eta

SD 99.54 141.16 530.65 6589.15

LN(Subsidiary Size) Mean

SD

2.60 3.15 4.37 5.07

1.29 1.38 1.68 3.38

17.60*** 0.347

41.92*** 0.496

Note: See Table 1.

with an analysis of variance (ANOVA) signiﬁcance test of the variation (F ) and the Eta measure of association. For a relationship between a continuous dependent variable and an independent variable that have a limited number of categories the Eta measure is similar to the correlation coefﬁcient. For each (ANOVA) test the F-value and the Eta measure of association is calculated. The F-value is derived using the formula: F¼

SST=ðZ 1Þ SSE=ðN 1Þ

where (Z1) is the degrees of freedom for the independent variable and (N1) is the degrees of freedom for the sample. SST, the total sum of squares is calculated by aggregating the squared difference between Y and the grand mean Y G : X 2 SSE ¼ Y YG SSE, the sum of squares error is then calculated by aggregating the squared difference between Y and the treatment mean Y mode : X 2 SSE ¼ Y Y mode Finally, the measure of association is derived by the formula: rﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃ ðSST SSEÞ Eta ¼ SST Due to the limited number of full acquisitions in the Asia–Africa data set (Table 2), we include only the CEE countries. The results suggest that PAs are

Partial Acquisition: The Overlooked Entry Mode

213

on average larger than entries by any other mode, including full acquisitions. This suggests that PAs have a comparatively large economic impact on host countries and account for a substantial share of the employment of foreignowned ﬁrms. Understanding the peculiarities of this entry mode should therefore be of great practical concern to both policy makers and business strategists. This strong association between size and PA suggests that it may be necessary to control for this inﬂuence in some of the subsequent empirical analysis. We thus adopt a stepwise approach estimating the marginal contribution of the entry mode using a methodology adapted from Cantwell and Mudambi (2000). We ﬁrst regress, using an OLS regression, the dependent variable Y against the independent variable X which either takes the values of subsidiary size if the expected relationship is mathematically conditioned or LN(subsidiary size) if the expected relationship is conceptually conditioned: Y ¼ a þ bX þ u We then collect the residual denoted by r of this regression and use them as the dependent variable in a one-way ANOVA test with the entry mode choice as the independent variable. The key advantage of this technique over a multivariate OLS regression is that this method eliminates any multicollinearity between subsidiary size and entry mode. Furthermore, it is hierarchical in the sense that the size effect is controlled for before conducting the ANOVA on the marginal inﬂuence of the entry mode choice.2

4.3. Governmental Influences Table 4 reports the relationship between government inﬂuence on a business and entry mode. The variable government influence is measured as a 5-point Likert scale variable; see the Appendix for a description of this variable. The initial values suggest stronger government inﬂuences on PAs. However, when correcting for subsidiary size using the two-step approach, the overall signiﬁcance of the relationship disappears. Hence, the effect of government inﬂuence appears to be largely derived from the size of the enterprise; in other words, the political establishment is more likely to interfere the larger the enterprise – but not in PAs per se. This suggests two important factors that may explain the use of PAs in transition economies: ﬁrst of all, employment is a major concern for governments in transition economies, as suggested above when discussing

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Table 4.

Mean Inﬂuence of Local Governments by Entry Mode.

Entry Mode

Greenﬁeld Joint venture Acquisition Partial acquisition F Eta

Government Inﬂuence

Government Inﬂuence (with Control for Size)

Mean

SD

Mean

SD

2.76 2.92 3.05 3.34

1.24 1.25 1.24 1.07

0.06 0.00 0.03 0.14

1.29 1.22 1.19 1.04

3.78** 0.150

0.33 0.051

Note: See Table 1.

types of owners. Moreover, governments have the means and the incentive to indirectly interfere in the operation of ﬁrms, regardless of entry mode. Full ownership in itself is thus not necessarily sufﬁcient to guaranty complete managerial control. Consequently, foreign owners may more willingly accept some form of shared ownership if it provides an element of protection against adverse interference by the state (Meyer, 2002).

4.4. Resource Transfers A common concern about PAs is that investors may be reluctant to transfer resources, especially hard to value and intangible assets, to their new afﬁliate if they do not control the use of these transferred resources, and have to share any rents thus generated with a local co-owners. Table 5 reports the relationship between entry mode and the transfer of knowledge to the afﬁliate. Two proxies for transfers are used, investment in human resource development and the foreign subsidiary’s access to resources from the parent company. The human resource measure is a principal component based on three 7-point Likert scale variables (see Appendix). The Cronbach’s alpha test yielded a result of (0.801) indicating a good ﬁt. As larger enterprises are more likely to have formal human resource development programmes we account for this by adopting the two-step approach regressing the principal component against the LN(subsidiary size). The residual is then used as the dependent variable in the ANOVA test. The second measure is a principal component based on three 7-point Likert scale measures of perceived access to ﬁnancial, managerial and

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215

Table 5. Human Resource Development and Resources Access from Foreign Parent. Entry Mode

Human Resource Development (with Control for Size) Mean

Greenﬁeld Joint venture Acquisition Partial acquisition F Eta

SD

0.16 0.08 0.06 0.36

1.02 0.91 1.01 1.11 3.425** 0.164

Access to Resources from the Parent (with Control for Size) Mean

SD

0.14 0.20 0.01 0.12

1.01 1.08 0.80 1.01 2.287* 0.135

Note: See Table 1.

technological resources from the parent company. The Cronbach’s alpha test yielded a result of (0.797) indicating a good ﬁt. Both measures were found to be signiﬁcantly related to entry mode at the 5% and 10% level, respectively. The results show that PAs are less likely than any other mode to beneﬁt from investment in human capital and also receive comparatively less resources from the foreign investor. This remarkable ﬁnding has substantive implications as it suggests that PAs may be at a substantial operational disadvantage compared to other modes. On both items, greenﬁeld projects seem to receive most support from the foreign parent. Resources transfers tend to be low in both JVs and PAs, which support the argument that shared ownership would reduce investors’ incentives to share knowledge with a new afﬁliate. Investment in human capital is on average lower in PAs compared to any other mode. This is likely to be the consequence of the combination of organizational inertia in an inherited organization and adverse incentives arising from shared ownership. A similar concern arises with respect to foreign investors’ willingness to invest in risky organizational change processes if they do not have full control (Meyer & Estrin, 2007). Table 6 reports the relationship between change in employment and entry mode choice, the ﬁrst is a simple means test reporting the mean change in employment per year,3 namely the choice of entry mode. The ANOVA test on the difference of means suggests that PAs would tend to destroy jobs. However, when controlling for the initial size of the operation, using our two-step approach, the results change substantially. PAs are no longer associated with employment destruction, but surprisingly

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Table 6. Employment Effects by Entry Mode. Entry Mode

Change in Employment per Year

Mean Greenﬁeld Joint venture Acquisition Partial acquisition

18.34 6.90 2.23 171.80

F Eta

SD 65.70 18.60 154.64 634.67

8.025*** 0.248

Change in Employment per Year (with Control for Size) Mean

SD 70.54 23.52 136.08 296.67

1.05 10.05 1.09 29.35 0.915 0.086

Absolute Change in Employment per Year (with Control for Size) Mean

SD

2.59 0.97 9.89 9.38

61.23 122.24 17.34 262.19 0.345 0.053

Note: See Table 1.

show a small though insigniﬁcant propensity to create or preserve jobs. Finally, we investigate the absolute value of the change in employment across entry modes. The results again do not indicate signiﬁcant deviation across entry modes when corrected for initial size. The job destruction in PAs thus arises from the much larger size of PAs at the outset; it is not caused by the choice of PA as an entry mode per se. Many state-owned ﬁrms in CEE employed before privatization a substantially larger work force than what was required. A reduction of employment in large enterprises may thus be a necessary part of the restructuring (Estrin, 2002), and PA is chosen as an organizational form to implement this aim. The propensity of PAs to create or destroy jobs after controlling for size is not signiﬁcantly different from other modes. If it was true that local co-owners obstruct restructuring that involves lay-offs, we would see a positive coefﬁcient after controlling for size and a negative coefﬁcient when considering the absolute value of the change. The coefﬁcients are both positive – but the F-statistic shows that this effect is clearly not statistically signiﬁcant. Thus, the impediments to full control may be offset by countervailing forces. As previously suggested, even in full acquisitions, employees or the government could potentially constrain the operational ﬂexibility of the foreign-owned subsidiary indirectly. Another possibility is that there are some intrinsic advantages of partnering with local stakeholders. A partnership with local stakeholders

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may provide the subsidiary with a shield against adverse opportunistic activities by other stakeholders. Hence, the operational freedom of a PA may in fact be comparatively larger. It is also possible that local co-owners may facilitate access to new business licences and permits, real estate, etc., therefore contributing to new growth opportunities. Finally, an alternative explanation is that co-ownership with employees could encourage smoother redeployment of resources into more productive uses.

4.5. Summary We ﬁnd that PAs are fairly commonly used across emerging economies, even in relatively advanced ones such as South Africa. The propensity for PAs varies across countries as for all modes of entry, which suggest that institutional, locational and cultural aspects play an important role in the entry mode choice. Furthermore, our data indicate that PAs tend to be larger in terms of employment than other foreign entries. Considering the fairly consistent use across a broad range of transition economies and their comparatively large economic impact on the host countries, PAs clearly merit scholarly attention. Our exploratory analysis of the characteristics of PAs shows distinct features. Some of these features appear to the size differences, while others are not: We ﬁnd indirect evidence of increased government inﬂuence in large enterprises pointing to the possibility that ﬁrms chose PAs to align the host countries interests with that of the investor or as a shield against possible adverse government interference. We ﬁnd lower transfers of resources from the foreign investor and less investments in human resource development in PAs, pointing to a combination of lower incentive to transfer resources and organizational friction or inertia. We ﬁnd no evidence to suggest that PAs are organizationally more rigid. Retention rates and overall organizational change are not signiﬁcantly affected by the limited control, suggesting a series of possible countervailing forces facilitating growth opportunities. These results should however be treated as preliminary. Even though we control for size of the afﬁliate, rigorous analysis would call for multivariate techniques. Our exploratory analysis thus mainly services to outline challenges for future research.

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5. MOTIVES: ACQUIRER’S PERSPECTIVE What advantages and disadvantages does a PA offer? Unlike a JV, the advantage derived from a local co-owner is unlikely to be related directly to market knowledge, managerial skills, etc. Similar to a full acquisition we may expect these to reside within the acquired organization. However, there may still be a unique set of advantages that makes a PA an attractive entry mode.

5.1. Reduced Ex-ante Contracting Costs The process of acquiring a local ﬁrm in a transition economy can be a slow and difﬁcult exercise (Artisien-Maksimenko & Rojec, 2001) that runs the risk of being hijacked by various groups of stakeholders (Antal-Mokos, 1998). As suggested above, ownership of assets in transition economies is often in the hands of stakeholders that have other primary interests than proﬁt maximization, most notably protecting jobs. Even when stakeholders are not directly involved in the negotiation process they may still successfully exert indirect pressure. Antal-Mokos (1998) and Meyer (2002) provide several examples of ex-ante negotiations that have failed or been drawn out due to intervention by other stakeholders in the process. It is also common in transition economies that an acquirer contractually commits to undertake a certain level of investment, or, for instance, not to close plants or lay-off employees within a certain period. For example, Rieber & Søn a Norwegian operator in the food retail industry acquired Delecta SA, an employee-owned ﬁrm in Poland, and contractually obliged not to make changes within a three-year period (Dale, 2006). We have no way of segmenting acquisitions that are contractually restricted from acquisitions that are not, however anecdotal evidence suggests that this has been fairly frequent. Consequently, the relative level of operational freedom enjoyed by full acquisitions should not be overestimated. Local ownership participation may ease some of hurdles and thus speed up the negotiation process. For the foreign investor, a PA may be the fastest way to gain access to a market and secure early mover advantages. Thus, Jakobsen (2006a) ﬁnds that early entry through PA enhances the performance of a new operation. Hence, a key advantage of PAs may be to reduce the ex-ante contracting costs.

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5.2. Legitimacy Retaining a local partner may also enhance the legitimacy of the venture in the host country. Even in developed market economies, public opinion may perceive the acquisition of a local ﬁrm by a foreign enterprise with some misgivings (Crystal, 2003). This is particularly important in transition economies where governmental agencies often have indirect means to inﬂuence the prosperity of a business. An ownership stake by the state in the local ﬁrm is thus a potential mean to align the interests of the foreign partner and the government (Meyer, 2002). Our study suggests that PAs may enjoy certain advantages in gaining access to new growth opportunities on account of local ownership participation. Even when the partner is not a state owner or an employee owner, the presence of a local partner may deﬂect some of the misgivings in the host country.

5.3. Increased Governance Cost However, there are also disadvantages associated with joint ownership. Retaining a local partner raises the governance costs of the venture (Luo, 2002). In uncertain environments that require frequent strategic and operational adaptation, the need to negotiate changes with a local partner may signiﬁcantly affect the enterprise’s ability to speedily affect changes consequently increasing the governance cost. This may especially be a problem when the local partner has different objectives which will often be the case with employee or state owners.

5.4. Weak Incentives Moreover, the absence of full ownership and the lower residual claim this implies reduces the attractiveness of ﬁnding opportunities for the transfer of resources from the foreign parent to the local subsidiary. In essence the PA mode lacks the high powered incentives of a wholly owned subsidiary. Evidence from this study suggests that both the transfer of resources from the foreign parent and investments in human resource development may be impaired in PAs.

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6. MOTIVES: SELLERS PERSPECTIVE A PA is the outcome of an agreement between an investor and the previous owner(s) of the ﬁrm. While the entry modes choice literature has largely focused on investors, it is essential to also understand the seller’s perspective to explain why PAs emerge as the mutually agreed outcome.

6.1. Retain Stakeholder Influence Possibly the strongest motive for local owners to prefer a partial divestment (a PA seen from the seller’s perspective) is the desire to retain some inﬂuence in the enterprise. Sellers in transition economies often have other stakes in the enterprise apart from their equity stakes. Hence, they are naturally reluctant to completely turn over control to an outside owner, even when this is necessitated by the need for external ﬁnancial, managerial and technological resources. In order to protect their interests they may turn to contractual provisions. However, this type of contracting is likely to be extremely cumbersome in high uncertainty environments, like transition economies, and in organizations that require extensive restructuring. A partial divestment is thus a deal structure that balances the need to protect the interests of the stakeholders while ensuring that ex-ante contracting costs stay within acceptable limits. The evidence in this study does suggest that PAs are larger in terms of employment, which again would suggest that the mode choice is motivated by labour concerns.

6.2. Rent Appropriation Foreign direct investors are motivated by their desire to exploit their ownership advantages in another country (Dunning 1992). They may enter by acquisition if they are conﬁdent that they can create more value from the acquired organization than the previous owners. In competitive markets for corporate governance, we would expect some of this additional value to accrue to the seller through the acquisition premium. However, local owners in rapidly changing environments are often poor at pricing their own assets, let alone estimating their potential value in their ﬁrst best use – a reverse asymmetric information problem (Jakobsen, 2006b). Local owners may therefore prefer to retain a stake in the enterprise to ensure that they get a share of the increased value of the ﬁrm.

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6.3. Incompatible Investment Time Horizons There are of course also disadvantages to retaining an ownership stake. Often, foreign investors take a long-term investment horizon, and focus on expanding and consolidating their market position, which means the free cash ﬂows generated by the enterprise, will usually be reinvested in the business. In contrast, local owners may prefer that some of the free cash ﬂow is released as dividends. They may also risk that the discrepancy in the investment horizon could lead the foreign owner to deliberately depress dividends with the implicit aim of forcing them to sell out.

6.4. Governance Concerns Another potential source of discomfort for a local minority partner is the often poor minority shareholder protection offered in transition economies. While low dividend pay outs may strain the minority partner, the multinational company (MNC) may pursue business practises that are directly harmful to the minority partner. Particularly, transfer pricing policies may be a source of contention between the partners.

7. CONCLUSIONS 7.1. Public Policy Implications Policy makers in governments, see partial divestment, as a means to privatize SOEs. This form of attracting FDI, however, has some unique characteristics, and thus impact on the host economy. Contrary to journalistic opinions, PAs are not associated with the destruction of jobs; rather this effect is attributable to the large size of many PAs in transition economies. However, we ﬁnd that PAs are associated with fewer resource transfers from the investor, and less investment in human capital in particular. Policy makers may consider PAs useful to soften the economic and social impact of the transfer of ownership in large ﬁrms subject to signiﬁcant structural changes in the industry. However, this softened social impact of necessary economic restructuring may come at the cost of slower efﬁciency gains and delayed upgrading of the resources and capabilities of the ﬁrm. Thus, it would be ill advised to pursue such a policy indiscriminately; hence

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general legislation promoting or limiting the choice of entry modes is likely to be economically suboptimal.

7.2. Future Directions for the Study of PAs Our analysis suggests that the existing literature fails to capture essential aspects of PAs. Firstly, we argue that the assertion by Brouthers and Hennart (2007) that the method of remunerating the input providers is the main determinant of both JVs and PAs is insufﬁcient to explain PAs. Secondly, we argue that Chen and Hennart’s (2004) asymmetric information view on PAs fails in transition economies because of probably important reverse asymmetric information effects. We argue that PAs are preferred when the seller wish to protect upstream resources from harmful autonomous adaptation (Williamson, 1975). Consequently, the preference for a PA is at least in part motivated by the seller’s desire to influence the decisions made by the jointly owned economic unit. Evidence to support this argument was found in relation to the employment in PAs. This argument provides an alternative view to the remuneration of input providers argument (Brouthers & Hennart, 2007), which holds that partial ownership aligns the interests of the owners, hence effectively eroding the scope for self-serving opportunism. Future research on entry mode choices should therefore take a more nuanced approach. In particular, future studies should recognize that mode choices are rarely unilaterally but rather the outcome of a bilateral negotiation process. Furthermore, the underlying assumptions of many traditional approaches may fail to capture the motives of the entry mode choice in emerging economies. Hence, studies in these economies promise to produce results that may broaden our understanding of the nature and boundaries of the ﬁrm.

7.3. Challenges for Theorizing in IB Research Our analysis of PAs raises major concerns with respect to the dominant avenues for theory building in IB research, especially with respect to foreign entry modes (cf. Brouthers & Hennart, 2007). In particular, our digging deeper in the character of this particular mode reveals that theories often make implicit assumptions about the nature of entry mode that do not represent a close depiction of the real world.

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Firstly, the (often implicit) assumption that decisions on ownership and on acquisition versus greenﬁeld are independent clearly does not hold. Hence, the assumption that decisions are separate, or at least analytically separable, has to be re-examined. There is little empirical evidence of such a separation. Hence, Fig. 1 serves to classify modes, but it is insufﬁcient to build explanatory models on these two dimensions only, as PAs are subject to inﬂuences that cannot be explained by combining these two perspectives. Moreover, PAs share with both JVs and acquisitions the access to resources held by local ﬁrms, albeit under different legal and organizational arrangements. Since the question of whether or not such local resources are needed is a key starting point for planning an FDI project, it is more likely that the initial decision is between greenﬁeld and modes providing resource access, and in the second stage the appropriate mode is selected for accessing these resources (Meyer, Estrin, & Bhaumik, 2005; Jakobsen, 2006b). Secondly, the (often implicit) assumption that entry modes are clearly delimitated using the logic of Fig. 1 is challenged by the observation from case research (Estrin & Meyer, 2004; Meyer & Tran, 2006; Meyer & Estrin, 2007) that certain projects are in fact hard to classify. Speciﬁcally, where are the boundaries between (a) JV and PAs in the case of JV Type II and (b) partial and full acquisitions in the case of staged acquisitions or contractually restrained acquisitions? Thirdly, the (often implicit) assumption that mode choice is primarily decided by the investor based on costs and beneﬁts of alternative arrangements does not hold. Rather, PAs are the outcome of a bilateral bargaining process between buyer and seller – and similar bargaining with local partners occurs in the case of JVs (Harrigan, 1988) and acquisitions. Finally, the (often implicit) assumption that initial ownership arrangements are fairly stable clearly does not hold for PAs (Meyer & Tran, 2006), nor does it hold for JVs (Harrigan, 1988; Buechel, 2002). Rather, PAs are often transitory arrangement aimed at full acquisitions in form of staged acquisitions. Future research thus may need to focus more on dynamic processes of entry and the post-entry development, rather than at entry mode as a cross-sectional phenomenon.

NOTES 1. Since the relationship between size and entry mode choice is not expected to be strictly linear and since the type of dependent variable has a long tail the natural log tends to provide more robust results.

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2. Consider the government inﬂuence in the next section. If we make the plausible case that governance inﬂuence is larger in partial acquisitions because they are large then it makes sense to eliminate this proponent ﬁrst. 3. These variables have been deﬁned as [(employment at the time of survey – employment in ﬁrst year of operations)/age of subsidiary in years].

REFERENCES Antal-Mokos, Z. (1998). Privatisation, politics, and economic performance in Hungary. Cambridge: Cambridge University Press. Artisien-Maksimenko, P., & Rojec, M. (2001). Foreign investment and privatization in Eastern Europe: An overview. In: P. Artisien-Maksimenko & M. Rojec (Eds), Foreign investment and privatization in Eastern Europe (p. 1). Baskingstoke: Palgrave. Brouthers, K. D., & Hennart, J.-F. (2007). Boundaries of the ﬁrm: Insights from international entry mode research. Journal of Management, 33(3), 395–425. Buechel, B. (2002). Joint venture development: Driving forces towards equilibrium. Journal of World Business, 37(3), 199–207. Cantwell, J., & Mudambi, R. (2000). The location of MNE R&D activities: The role of investment incentives. Management International Review, 40, 127–148. Chen, S.-F., & Hennart, J.-F. (2004). A hostage theory of joint ventures: Why do Japanese investors choose partial over full acquisitions to enter the United States? Journal of Business Research, 57(10), 1126–1134. Crystal, J. (2003). Unwanted company: Foreign investment in American industries. Ithaca, NY: Cornell University Press. Dale, K. (2006). Entering into Poland: An examination of how entry mode affects transfer of knowledge and human management resource integration. Unpublished master thesis. Copenhagen Business School, Copenhagen. Duarte, C. L., & Garcia-Canal, E. (2004). The choice between joint ventures and acquisitions in foreign direct investments: The role of partial acquisitions and accrued experience. International Business Review, 46(1), 39–58. Dunning, J. H. (1992). Multinational enterprises and the global economy. Addison-Wesley: Harlow. Estrin, S. (2002). Competition and corporate governance in transition. Journal of Economic Perspectives, 16(1), 101–124. Estrin, S., & Meyer, K. E. (Eds). (2004). Investment strategies in emerging markets. Aldershot, UK and Northampton, MA: Edward Elgar. Ferris, S. P., Yoshi, Y. P., & Makhija, A. K. (1995). Valuing an East European company. Long Range Planning, 28(6), 48–60. Harrigan, K. R. (1988). Joint ventures and global strategy. Columbia Journal of World Business, 14(2), 36–64. Hayek, F. (1945). The use of knowledge in society. American Economic Review, 35, 519–530. Hennart, J.-F. (1991). The transaction cost theory of the multinational enterprise. In: C. N. Pitelis & R. Sudgen (Eds), The nature of the transnational firm. London: Routledge.

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Jakobsen, K. (2006a). First mover advantages in Central and Eastern Europe: A comparative analysis of performance measures. In: J. Larimo & S. Rumpunen (Eds), Internationalization and management of foreign operations (pp. 365–387). Vaasa: University of Vaasa. Jakobsen, K. (2006b). The choice of entry mode in transition economies: The role of partial acquisition. Conference Paper. European Academy of International Business. Oslo, December. Luo, Y. (2002). Capability exploitation and building in a foreign market: Implications for multinational enterprises. Organization Science, 13(1), 48–63. Meyer, K. E. (2001). International business research in transition economies. Oxford handbook of international business (pp. 716–759). Oxford: Oxford University Press. Meyer, K. E. (2002). Management challenges in privatization acquisitions in transition economies. Journal of World Business, 37(4), 266–276. Meyer, K. E., & Estrin, S. (Eds). (2007). Acquisition strategies in European emerging economies. Baskingstoke: Palgrave Macmillan. Meyer, K. E., Estrin, S., & Bhaumik, S. (2005). Greenfield versus cooperative entry in emerging economies: A resource-based and institutional perspective. Working Paper. Centre for New and Emerging Markets, London Business School. Meyer, K. E., & Tran, Y. T. T. (2006). Market penetration and acquisition strategies for emerging economies. Long Range Planning, 39(2), 177–197. Nguyen, H. T., Nguyen, V. H., & Tran, N. C. (2004). Vietnamese case studies. In: S. Estrin & K. E. Meyer (Eds), Investment strategies in emerging economies. Cheltenham: Elgar. OECD. (1996). OECD benchmark definition of foreign direct investment. Paris: OECD (www.oecd.org/dataoecd/10/16/2090148.pdf, accessed May 2007). Tsang, E. W. K. (2003). Resistance to restructuring in Sino-foreign joint ventures: Toward a preliminary model. Journal of Organizational Change Management, 16, 205–222. Tsang, E. W. K., & Yip, P. S. L. (2007). Economic distance and survival of foreign direct investments. Academy of Management Journal, 50(5). Uhlenbruck, K., & De Castro, J. (1998). Privatization from the acquirer’s perspective: A mergers and acquisitions based framework. Journal of Management Studies, 35, 619–640. Williamson, O. E. (1975). Markets and hierarchies: Analysis and antitrust implications. New York: Free Press.

APPENDIX. SELECTED ITEMS FROM THE CEE SURVEY INSTRUMENT Government Influence Single item measure on the following statement (scale: 1=agree not at all, 5=fully agree): ‘‘In our industry, it is important to maintain close personal contact with key officials at the national level.’’

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Availability of Resources Three items measure on the following statements (scale: 1=not at all, 5=to a large extent): ‘‘Your firm can readily obtain financial resources from the parent firm to finance its expansion.’’ ‘‘Your firm can readily obtain managerial resources from the parent firm.’’ ‘‘Your firm can readily obtain technological resources from the parent firm.’’ Human Resources Three items measure on the following statements with respect to the last three years (scale: 1=not at all, 5=to a large extent): ‘‘The firm has invested in training and education of its full-time employees.’’ ‘‘There are formal training programs to teach new hires the skills needed to perform their jobs.’’ ‘‘Formal performance appraisals are used to facilitate promotion decisions or to develop employees.’’

PART IV: TOWARDS A MORE COHERENT INTERNATIONAL POLICY FRAMEWORK ON FDI FOSTERING FIRMS’ AND LOCATIONS’ COMPETITIVENESS

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GENERAL AGREEMENT ON INVESTMENT: DEPARTURE FROM THE INVESTMENT AGREEMENT PATCHWORK Philippe Gugler and Vladimir Tomsik 1. INTRODUCTION Comprehensive multilateral rules governing international economics are currently limited to trade issues. Even though the World Trade Organization (WTO) agreements contain major loopholes, the multilateral rules on trade constitute a broad range of rights and obligations under which regional, plurilateral and bilateral agreements, as well as national laws, all regulate trade issues. Although foreign direct investment (FDI) has increased signiﬁcantly over the last two decades, outpacing the already signiﬁcant expansion of trade during the same period (UNCTAD, 2005a, p. 14), the current international legal framework for FDI is highly fragmented (Gugler, 2006). This framework consists of a wide variety of national and international rules and principles that differ in form, strength, and coverage. The result is an increasingly complex international setting for international investment in which governments must ensure consistency between differing sets of obligations.

Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 229–254 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00010-6

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One of the striking characteristics of the present investment rules is the diversity of approaches and legal architectures. In many cases, countries are simultaneously parties to bilateral, regional, plurilateral, and multilateral agreements. These agreements can be binding or non-binding, with or without commitments on admission, with or without provisions on corporate behaviour, may use top-down or bottom-up approaches, and be part of or outside the context of broader trade agreements (Graham, 2000). While this diversity of approaches does raise important issues of policy coherence, it also reﬂects the variety of ways in which participating countries have managed to ﬁnd a balance between advantage and mutual beneﬁts in rule-making in this area. It is seldom easy for a government to relinquish some of the discretion it has in particular policy area. But governments have been persuaded of the beneﬁts of doing just that in the area of trade policies (Dunning, 2001). What they have given up in terms of policy discretion by accepting WTO rules and disciplines is more than compensated by the increased predictability and stability of trade policies. Every country gains from the stimulus which this, together with trade liberalization, gives to trade and trade-related investment. Multinational enterprises (MNEs), in particular, can generate substantial gains for the host countries (Muchlinski, 1995). There are various reasons why the MNEs have reached their current size – increasing returns to scale, their R&D policies, better organizational structures, and other factors. Put simply, the MNEs have higher competitiveness potential. However, under the current fragmented framework the MNEs cannot develop their competitiveness potential fully. Fragmented investment agreements and commitments, as well as the lack of coherent national regulations in some countries, obviously prevent the MNEs from making optimal use of their advantages (Sornarajah, 1994) and such impediments to competitiveness adversely affect the competitiveness of the host countries themselves. An opportunity to bind liberalized FDI rules would greatly enhance their credibility and value in the eyes of foreign investors. It would also make the FDI policies of other countries much more predictable, for example, as regards the use of incentives in competing to attract FDI. Enhancing the credibility of one’s own FDI regime would be especially beneﬁcial to less developed countries competing against the wealthy, developed countries for FDI. Given the increasing inseparability of economic developments, as well as of policy formulation, in these two areas, it is not surprising that many of the issues arising out of the interlinkages between trade and FDI have to do with policy coherence. First, there is the problem of rule coherence among agreements and instruments dealing with investment at various levels

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ranging from the national to the multilateral. The existence of a large number of overlapping legal instruments and initiatives in the investment area leads to risks of confusion, uncertainties, and legal conﬂicts, especially where the agreements in question have different architectures. There is also the issue of coherence in efforts to further develop international cooperation in the areas of trade and investment. Clearly, the interrelation between these policy areas should be handled in a way that does not compartmentalize policy areas that are, in reality, becoming increasingly intertwined. A lack of coherence of rules and policy poses a danger to security and predictability, which are basic goals of trade and investment agreements. FDI, like trade, is particularly sensitive to uncertainty and instability. Indeed, the long-term commitment that an investing company makes, through the transfer of resources and establishment of commercial operations in another country, makes it particularly sensitive to risk, not only to the investment itself, but also to the trade ﬂows on which the viability of the investment depends. This chapter surveys and explores all levels of the international investment agreements (bilateral, regional, plurilateral, and multilateral) in order to present and discuss the current patchwork in the international investment regulation framework. We also discuss whether a General Agreement on Investment could offer a way out from this ‘‘spaghetti bowl’’ of international investment arrangements and could therefore contribute to enhancing the competitiveness of host and home countries in the ﬁeld of international business.

2. INVESTMENT REGULATION AT THE BILATERAL LEVEL Bilateral investment treaties (BITs) for promotion and protection of foreign investment have emerged as the predominant source of rules for the treatment of foreign investment. The growth in the number of BITs has been especially signiﬁcant since the late 1980s. UNCTAD reports (UNCTAD, 2006) that there are now around 2,500 BITs and more than 2,600 double taxation treaties in existence. The importance of BITs stems not only from the sharp increase in their use, but also from the fact that many recent regional and plurilateral investment arrangements incorporate concepts and standards derived from these treaties. BITs tend to be relatively brief and broadly comparable in structure. Virtually, all contain provisions on scope of application, admission of investments, general treatment standards,

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standards of treatment on speciﬁc matters, and dispute settlement (see Table 1). Despite this similarity in structure and areas of substantial convergence, there are also areas characterized by wide variation in the substantive provisions (UNCTAD, 2005b). BITs are usually reciprocal in nature, setting forth rules applicable to investments made by either party in the territory of the other party. While designed to promote and protect foreign investment, BITs seldom contain positive obligations for home countries to take measures to foster investments by their nationals in the territory of the other party. The promotion of foreign investment is sought, instead, through reductions in various types of uncertainty peculiar to such investment. BITs typically contain a broad, ﬂexible concept of investment. Foreign investment is viewed as a form of property and is usually deﬁned through an openended list of assets, including movable and immovable property, ownership rights in companies, claims to money, and intellectual property rights. The scope of the investments covered by the BITs in some cases has been expressly limited to investments made in accordance with the domestic law of the host state or to investments approved or duly registered by the host

Table 1. Deﬁnition of investment Market access

Post admission provisions

Investor protection

Dispute settlement

Common Elements of BITs. Broad and open-ended deﬁnition of foreign investment is usually adopted. Entry and establishment are subject to national laws and regulations. BITs usually do not affect the right to regulate the admission of foreign investors. Fair and equitable treatment of foreign investors. Principle of national treatment for foreign investors, but often subject to qualiﬁcations and exceptions. MFN treatment, subject to standardized exceptions. Right of the host country to expropriate foreign investors, subject to the condition that expropriation is non-discriminatory and accompanied by adequate compensation. Guarantee of free transfer of payments, of capital and returns, related to foreign investment, often qualiﬁed by exceptions in case of balance of payments problems. State-to-state dispute settlement provisions, and increasingly also investor-to-state dispute settlement.

Source: Based on UNCTAD (2004, 2005b).

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state. Another important aspect is the deﬁnition of the persons and companies which will be treated as investors of one of the parties. In this respect, BIT practice is marked by important discrepancies, especially in regard to the deﬁnition of corporate nationality. The criteria most frequently used are the place of incorporation, the location of the registered ofﬁce or seat of a company, and the nationality of the ownership or controlling interest. Some BITs rely on one of these as the sole criterion, while in other cases corporate nationality is deﬁned on the basis of a combination of these criteria. Two main approaches to the admission of foreign investment can be identiﬁed in the BITs. Most BITs require that, subject to their domestic laws, parties shall encourage and admit in their territories investments by nationals and companies of the other party. The reference to domestic laws means that the commitment to encourage foreign investment is subject to any existing or future restrictions on the entry of foreign investment contained in domestic legislation. The priority accorded in these BITs to domestic laws reﬂects the fact that these treaties have been designed primarily to regulate the treatment of foreign investment after admission. A fundamentally different approach to the admission of foreign investment is found in most BITs concluded by the US. These require commitments with respect to both admission (market access) and to subsequent treatment of investments (inter alia national treatment), subject, however, to the right of each party to make or maintain exceptions in sectors or matters speciﬁed in an annex to the BITs (Gugler & Tomsik, 2006a).

3. INVESTMENT REGULATION AT THE REGIONAL AND PLURILATERAL LEVELS At the regional and plurilateral levels, a distinction can be made between arrangements that cover only foreign investment and arrangements that integrate rules on foreign investment into a broader framework of rules aimed at economic cooperation and integration. Examples of the latter include the Treaty establishing the European Community, the North American Free Trade Agreement (NAFTA) and the European Energy Charter Treaty. The former type of agreement has been used in the Organization for Economic Co-operation and Development (OECD) Codes of Liberalization of Capital Movements and Current Invisible Operations and the Asia-Paciﬁc Economic Cooperation (APEC) Non-Binding

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Investment Principles. In regard to their objectives and coverage, these arrangements show greater diversity than BITs. For example, some are aimed primarily at the removal of investment barriers between the parties, while others are more inspired by the promotion and protection approach typical of BITs. Also, while most regional and plurilateral arrangements focus on questions relating to the admission and treatment of investment, the OECD Declaration on International Investment and MNEs addresses certain subjects not typically dealt with in investment agreements, such as norms for corporate conduct and procedures for the resolution of jurisdictional conﬂicts. Among the agreements dealing with foreign investment as part of a comprehensive framework for regional cooperation, the most far-reaching approach is contained in the EC Treaty. It envisages the removal of restrictions on the right of establishment and movement of capital as one of the means of establishing a common market, something that distinguishes it from all other arrangements in the ﬁeld of foreign investment. Even where, as in the case of the investment provisions of the NAFTA and the BITs concluded by the US with third countries, the entry of foreign investment is subject to binding commitments, the scope of such obligations is less farreaching than the requirements of the EC Treaty regarding the right of establishment and free movement of capital (Gugler & Tomsik, 2006a). Articles 52–58 of the EC Treaty provide for the progressive elimination of restrictions on the freedom of establishment of natural and legal persons having the nationality of one Member State in the territory of another Member State, and Articles 67–73 address the progressive elimination of restrictions on the free movement of capital. In contrast, the investment provisions in Chapter 11 of the NAFTA are more comparable to BITs. In common with BITs, the provisions of Chapter 11 include a broad deﬁnition of the term investment, general standards of treatment (including national treatment, most-favoured nation (MFN) treatment, and treatment in accordance with international law), speciﬁc standards for compensation in the case of expropriation and in the case of losses suffered as a result of armed conﬂict or civil strife, transfers, and a mechanism for arbitration of disputes between an investor and a party to the NAFTA (see Table 2). The European Energy Charter Treaty establishes a legal framework for the promotion of long-term cooperation in the energy sector and encompasses trade, competition, technology, access to capital, investment promotion and protection, and environment matters. Although limited in its sectoral coverage, the large number of countries involved makes this Treaty

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Survey of the Key Provisions in Chapter 11 of NAFTA.

Scope of application Investment liberalization

Investment protection

Dispute settlement

Asset-based deﬁnition of investment. National and MFN treatment granted to both the pre and post-admission phase of the investment process. Top-down approach. Prohibition of performance requirements. Includes both direct and indirect expropriation, such as governmental measures having an equivalent effect to expropriation. Member states are required to provide fair and equitable treatment and full protection and security while ensuring a minimum standard of treatment of that required by international law. Both state-to-state and investor-to-state dispute settlement procedures.

Note: Based on NAFTA.

unique among binding international arrangements containing substantive standards for the treatment of investment. As with the investment provisions of the NAFTA, the Treaty is comparable to BITs in regard to the substantive rules for the treatment of foreign investment (Articles 10–17) and the procedure contained in Article 26 for international arbitration of disputes between an investor and a contracting party. On the other hand, a notable difference between this Treaty and NAFTA is that, while in regard to the treatment of investment after admission the Treaty requires contracting parties to accord the better of either national treatment or MFN treatment to investors from other contracting parties, in respect of the admission of investment it only requires contracting parties to endeavour to accord such treatment. Among the regional and plurilateral arrangements devoted to foreign investment, mention should be made of the legally binding OECD Codes of Liberalization of Capital Movements and Current Invisible Operations. They aim at the progressive non-discriminatory liberalization of restrictions on inward and outward capital and current payments, subject to the possibility of country-speciﬁc reservations, general exceptions and temporary derogations. The Capital Movements Code was amended in 1984 to include right of establishment. The treatment of investment after admission is subject to a separate OECD instrument, the National Treatment Instrument, which is part of the Declaration on International Investment and MNEs. This declaration and its annexes also contain guidelines for the

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conduct of the MNEs, procedures for cooperation to avoid or minimize the imposition of conﬂicting requirements on MNEs, and procedures for cooperation in regard to investment incentives and disincentives. The APEC Non-Binding Investment Principles deal with transparency, non-discrimination between source economies, national treatment, investment incentives, performance requirements, expropriation and compensation, repatriation and convertibility, settlement of disputes, entry and sojourn of personnel, avoidance of double taxation, investor behaviour, and removal of barriers to capital exports. Apart from the fact that the principles are not legally binding, in most instances their formulation is considerably less speciﬁc and less stringent than in comparable recent investment arrangements (Gugler & Tomsik, 2006b). An important advantage of bilateral, regional, and plurilateral investment agreements, is that they can be tailored to the speciﬁc circumstances of the parties concerned, such as development status. However, as the number of such agreements continues to increase, different standards and disciplines are beginning to be imposed on foreign investments. This might create confusion for MNEs operating on a global scale (WTO, 1998, p. 47). A comprehensive set of consistent multilateral rules on foreign investment could allow for a stable, transparent, and consistent environment for ﬁrms operating internationally, whatever be their ownership structure or place of incorporation. The global application of broadly similar investment disciplines would overcome the complexity facing investors from the existing framework of bilateral, regional, and plurilateral investment treaties and agreements and thus facilitate compliance. Furthermore, a set of multilateral rules on investment would enhance the predictability of the legal and regulatory environment in host economies.

4. INVESTMENT REGULATION AT THE MULTILATERAL LEVEL AND THE WTO RULES Although several efforts have been made to agree on binding multilateral instrument containing comprehensive substantive rules on foreign investment, none has so far been successful (Folly, 2006). The two most important recent initiatives were those undertaken within the WTO and within the OECD. These two initiatives are discussed below. Ministers from WTO member countries decided at the 1996 Singapore Ministerial Conference to set up three working groups: on trade and

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investment, on competition and investment, and on transparency in government procurement. These three issues were included on the Doha Agenda. The mandate for the working groups was to prepare the basis for negotiations on these three issues after the 2003 Cancun Ministerial Conference. However, in August 2004, it was agreed to drop these three issues from the Doha Agenda. The Working Group on Trade and Investment did not formulate a draft agenda – which was not an obligation under its mandate – but it did create a forum that collated numerous analyses of the relations between trade and investment alongside country experiences regarding national investment policies, the existing international instruments for regulating trade and investment, and so on (see WTO, various volumes). Important concerns were also raised during the OECD negotiations on the Multilateral Investment Agreement (MIA). Discussions there focused upon the problem of the loss of freedom to regulate the entry of FDI that may have been implied by formal provisions dealing with the liberalization of investment rules. In May 1995, the OECD Council decided to start negotiations aimed at reaching a Multilateral Agreement on Investment (MAI). The main feature of the proposed agreement was the top-down approach to liberalization of investment regimes through the application of national treatment and MFN treatment standards to both the establishment and the subsequent treatment of investment, a broad, asset-based deﬁnition of investment, provisions on country-speciﬁc reservations, standstill and roll-back obligations, provisions on transparency of domestic laws, regulations and policies, a limited set of general exceptions, standards for the protection of investments (general treatment standards and speciﬁc standards on expropriation and compensation, transfer of funds, protection from civil strife, and so forth), and dispute settlement procedures through state–state arbitration and investor–state arbitration. In addition, consideration was being given to the possible inclusion of disciplines on investment incentives, movement and employment of key personnel, corporate practice, and privatization. The negotiated agreement was expected to be a free-standing international treaty open to all OECD members and the EU and to accession by non-OECD Member countries. Nevertheless, the negotiations failed in April 1998. The WTO covers two major agreements that address investment directly: the General Agreement on Trade in Services (GATS) and the Agreement on Trade-Related Investment Measures (TRIMs Agreement). Three further agreements – the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS Agreement), the Government Procurement Agreement, and the ASCM – have only indirect effects on investment (Gugler & Tomsik, 2006b).

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Of all the existing WTO agreements, the GATS deals most with investment issues: one of the four modes of the supply of services covered by GATS – the establishment of a commercial presence – relates directly to investment. One of the key principles of investment treatment – MFN treatment – has become a general obligation for dealing with investment in the Agreement. However, market access and national treatment obligations for investment apply only to those sectors and modes of supply that have been included in the schedules of commitments submitted by the Members. The GATS is explored in more detail below. The TRIMs Agreement bans a limited number of performance requirements as far as they are inconsistent with General Agreement on Tariffs and Trade (GATT) provisions on national treatment and quantitative restrictions. All Members had to notify and phase out contravening measures, although developing and least-developed countries were granted generous transition periods. The Agreement has considerably enhanced the transparency of investment policies worldwide. Nevertheless, the Agreement is limited to measures affecting trade in goods. The TRIPs Agreement provides protection for intangible assets that form the basis of the activities of multinational corporations. The agreement stipulates the minimum standards for the protection of intellectual property rights that had already been set by other international organizations, such as the World Intellectual Property Organization. Nevertheless, it further requires that members provide effective legal procedures and remedies for the enforcement of such rights. The Agreement on Government Procurement (GPA) deals with public procurement and services because GATS excludes these issues. The GPA requirements deal with investment relating to procurement of foreign products or services as well as to goods or services produced by locally established foreign suppliers. The Agreement on Subsidies and Countervailing Measures (ASCM) deals with subsidies. The Agreement includes in its deﬁnition of subsidies a number of commonly used investment incentives, but it does not address this subject in terms of discrimination between foreign and domestic investment. Thus, this Agreement tackles investment directly but it does not lead to any signiﬁcant incompatibility between foreign and domestic investment. As mentioned above, of all the existing WTO rules, the GATS deals most with investment issues. The supply of many services to a market is difﬁcult or impossible without the physical presence of the service supplier. Article I.2 of the Agreement deﬁnes trade in services as encompassing four modes of supply, including the supply by a service supplier of one Member, through commercial

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presence in the territory of any other Member. The term commercial presence is deﬁned in Article XXVIII(d) as any type of business or professional establishment, including through (1) the constitution, acquisition or maintenance of a juridical person, or (2) the creation or maintenance of a branch or a representative ofﬁce, within the territory of a Member for the purpose of supplying a service. As a consequence, the GATS covers forms of establishment which correspond to the notion of FDI. Another investment-related mode of supply covered by Article I.2 is the supply by a service supplier of one Member, through presence of natural persons of a Member in the territory of any other Member. This mode of supply is closely related to the commercial presence mode of supply, in that it includes temporary entry of business visitors and intra-company transfers of managerial and other key personnel. All WTO Members have established speciﬁc commitments under the GATS in relation to the four modes of supply. These commitments bind governments to guaranteed conditions of market access and national treatment in respect of the modes and sectors indicated in schedules of speciﬁc commitments. In the absence of speciﬁcations to the contrary, members guarantee both the right of market entry (Article XVI) and the right to national treatment (Article XVII) in scheduled sectors. A list of six conditions that may be imposed on market access is contained in Article XVI. Four of these relate to different kinds of quantitative limitations that may apply to foreign services or service suppliers. The other two conditions are relevant only to commercial presence. They involve measures which restrict or require speciﬁc types of legal entity or joint venture through which a service supplier may supply a service and limitations on the participation of foreign capital in terms of a maximum percentage limit on foreign shareholding or the total value of individual or aggregate foreign investment. Limitations on national treatment are not similarly deﬁned, and may encompass any form of discrimination, as indicated in a member’s schedule. The GATS embodies a framework of rules establishing the context in which the schedules of speciﬁc commitments must be read, including those relating to investment. Some of these rules are generally applicable, while others apply only in the situation where a member has assumed a speciﬁc sectoral commitment. The most important rule of general application is MFN treatment. Thus, GATS requires that members extend MFN treatment in all service sectors. Certain transparency obligations are also of a general nature. But many other provisions, covering such matters as domestic regulation, monopolies and exclusive service suppliers, payments and transfers, and balance-of-payments measures, are only relevant in the context of speciﬁc commitments.

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A distinction can be made between a negative list and a positive list approach to deﬁning the scope of an agreement. Under the negative list approach, governments must specify the sectors or measures to which obligations do not apply. Under the positive list approach, by contrast, the requirement is to list those sectors or measures in respect of which obligations are to be assumed. In discussions on the best approach to identify the extent of commitments, it has been argued that the negative list approach provides greater transparency and encourages governments to be more forthcoming in negotiations in respect of their commitments. It has also been pointed out that under a negative list approach, new activities arising from technological advances will automatically be covered, whereas explicit provision would have to be made for such activities to be covered under the positive list approach. A number of the international agreements discussed previously rely on a negative list approach. In fact, the GATS is a hybrid of the two approaches, containing a positive listing of sectors and a negative listing of limitations on market access and national treatment. The GATS largely uses the selective liberalization approach to provide market access and national treatment to foreign suppliers of services, i.e. to foreign investors in the ﬁeld of services. Regarding the investment provisions embedded in the GATS, we can say that the GATS is unique in comprising general obligations applicable to all sectors (some exemptions are, of course, possible) and speciﬁc commitments on market access and national treatment for selected sectors. These commitments can be combined in several ways; for example, a country can impose no restrictions on market access and/or to national treatment, or it can impose explicitly listed restrictions to market access and/or national treatment. All those commitments embedded within the GATS are legally binding. Without doubt, the GATS has successfully created investment commitments, which are even reviewed periodically in the spirit of progressive market liberalization, and as it stands the GATS has underpinned the ﬁrst step in the departure from the investment agreement patchwork towards a possible General Agreement on Investment.

5. TOWARDS THE GENERAL AGREEMENT ON INVESTMENT: INSPIRATIONS FROM THE GATS In this section, we will look at the GATS as a possible model for the potential General Agreement on Foreign Direct Investment (GAFDI).

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The GATS has one incontestable advantage over the various hypothetical proposals for investment agreements – the GATS has already been adopted and therefore we can be sure that, at least in the mid-1990s, it was a realistic agreement. It is true, though, that it was adopted at a time of unusually favourable international relations and during a period when the antiglobalization attitudes we are familiar with today were not yet in full swing. Still, the adoption of the GATS should not be attributed solely to favourable external conditions, but also to its structure. It is because of this structure and above all because of its unique combination of the negative and the positive list approach that we consider that it might serve as a model for the future GAFDI. The advantage of the positive list approach over the top-down or negative list approach is its greater ﬂexibility (Gugler & Tomsik, 2006a). Use of the negative list approach might lead some countries to feel deprived of an important policy tool. The important point is that for some sectors and industries it is very difﬁcult to anticipate future development and character at the moment of writing down the negative list. Here, the combined national and MFN approach offers less ﬂexibility to host countries in FDI ﬂows into such sectors. In this sense, the GATS provides a more realistic approach for dealing with admission of foreign investment (Sauve´, 2006). The positive list approach would probably permit more gradual liberalization, with which some countries may be more comfortable. In the GATS, no member of the WTO is forced to make any commitments in any given sector. It can be assumed that the hybrid, GATS-like, approach to a GAFDI would be favoured by most countries (including the developing ones) because it would give them the ﬂexibility they need to pursue their development policies. Nevertheless, in the past, the negative list, in which countries listed individual measures they wanted to reserve from an agreement’s treatment obligations, has been favoured by some of the key players in the ﬁeld of international investment (e.g. the US). However, the GATS type model has disadvantages as well – most notably that the level of investment liberalization is likely to be much lower than if the top-down approach were adopted. Generally: experience with GATS showed that a positive list approach was preferable when a new area was for the ﬁrst time the subject of liberalization at a multilateral level. Although the positive list approach seems at ﬁrst glance to be much less liberal than the negative list approach, the process of gradual liberalization, which would be contained in the agreement in a similar way to the way it is in the GATS, could lead to similar results. Under the GATS, the process of gradual liberalization is organized in the following way. The members in the

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consecutive rounds of negotiations are supposed to increase the number of sectors inscribed in their schedules and gradually eliminate the market access and national treatment exemptions. In this sense, the GATS liberalization mechanism is similar to the GATT rounds, but here the trade in services supplied via the ‘‘commercial presence’’, i.e. effectively FDI in services sectors, is being liberalized as well (which is not the case in the GATT). The process of gradual liberalization contained in the GATS could serve as a model for gradual liberalization in the GAFDI not only as a general framework, but also in the details. For example, under the GATS, members can modify their commitments no sooner than three years after the commitments were made. And, even then, they have to negotiate compensation with members adversely affected by the modiﬁcation. Therefore, it is not surprising that modiﬁcations of the commitments, which would make them less liberal, are seldom made. This combination of freedom in making the commitments with the rigidity of the commitments once they are made, could be very useful in the GAFDI as well. Although the freedom of the members to make the commitments that they want may seem to be insufﬁciently liberal, in general the countries have good incentives to open up. After all, today’s system of investment incentives and the so-called race to the bottom are symptoms of the fact that many governments want to attract FDIs. Rigidity of the commitments already made (rigidity against reducing liberalization, the commitments can be unilaterally made more liberal at any time of course) is necessary because it offers the investors some certainty that their investment projects will not be closed or that they will not have to sell their investments shortly after the projects commenced. If the commitments could be freely modiﬁed or even withdrawn, governments would have a tool for easy and legal property extraction. Although it would be highly damaging for the reputation of the country in question, in some cases governments might take recourse to this action. The question is: How should the rigidity of the commitments be in the GAFDI? Should the commitments be strictly treated as being permanent, or would some conditions entitle the members to make the commitments less liberal or to withdraw them altogether (as under the GATS). The second possibility seems to us more realistic and at the same time almost as liberal as the ﬁrst one. If the members cannot see any possible way to modify or withdraw a speciﬁc commitment, they would be less willing to make the commitments because they have no loophole for dealing with unpredictable situations. This is not the case if there is at least a hypothetical way to

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withdraw, although it would entail difﬁcult and costly negotiations with affected members. Of course, the compensation negotiations would ensure that the member countries would withdraw their commitments only in very rare situations. We mentioned above that the GAFDI should cover the main reasons why some countries are still reluctant to open up to foreign investments. Potential balance-of-payments issues are one such reason. We believe that balance-of-payments safeguards should be contained in the GAFDI. Today, it is widely believed that fast capital movements may have serious and adverse effects even from the macroeconomic point of view. Also, exchange rates may substantially and for a long time deviate from levels determined by fundamental factors. The Asian ﬁnancial crisis in 1998 showed that even relatively healthy and fast-growing economies (e.g. South Korea) are not immune to outward capital ﬂights, erratic exchange rates and interest rate developments, etc. It is also true that the more open the economy is to foreign capital ﬂows the deeper are the impacts of such events. Although such turbulent developments are often only temporary, they can cause episodes of unemployment and/or inﬂation and of course they can shake the positions of political parties and governments. Given this fact, it is understandable that governments want to retain some control over capital movements. Here, the GATS may serve again as a model for developing the GAFDI. Under the GATS (Article XII), the members may adopt restrictions on trade and transactions related to the commitments in the event of ‘‘serious balance-of-payments and external ﬁnancial difﬁculties’’. The ‘‘serious difﬁculties’’ are not described in detail and thus the members might be tempted to take recourse to this article whenever minor balance-ofpayments problems emerge. So that this does not happen, the members must consult about their restrictions with a special Committee on Balanceof-Payments Restrictions and ﬁndings and conclusions by the International Monetary Fund are also to be accepted. In addition, it should be noted that the condition of non-discrimination must be maintained under the regime of the restrictions. This is logical because if the member is really experiencing balance-of-payments troubles, there is no point in discriminating between different members. The experience so far suggests that this approach is balanced in the sense that it gives the members sufﬁcient autonomy in their balance-of-payments policies, while it ensures at the same time that the members do not abuse their rights and the investors do not usually get trapped in a currency or in assets they no longer want.

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Taxation is another bone of contention as far as foreign investments are concerned. Anti-globalization activists often argue that the transnational corporations (TNCs) have, due to their unique position and size, the power to evade tax systems in the countries where they operate. Admittedly, a combination of transfer pricing and tax havens can allow this to happen. The GATS does not offer a deﬁnitive solution to this problem. However, the GATS does contain, in an article on general exceptions (Article XIV), a paragraph which enables the members to adopt measures which are inconsistent with national treatment. The members can adopt such measures if the difference in treatment ‘‘is aimed at ensuring the equitable or effective imposition or collection of direct taxes in respect of services or service suppliers of other Member’’. Given that national treatment is one of the cornerstones of the GATS and that the possible exception from it is described only in rather general terms, the paragraph could be dangerous for the whole agreement. Nevertheless, so far it does not seem to have led to any erosion of the national treatment condition. Therefore, this article could also be an inspiration for the GAFDI, although it cannot solve the taxation issues altogether. But the very presence of a similar article in the GAFDI could perhaps inﬂuence the tax behaviour of the TNCs and make the GAFDI more attractive for governments. Dispute settlement procedures usually make up an important part of bilateral or regional investment treaties. However, if the GAFDI were to be agreed within the WTO (as with the GATS), this would not have to be the case. The GAFDI could make use of the existing dispute settlement institutions and mechanisms within the WTO. It should be noted though, that such an approach has the disadvantage that it provides only for the settlement of disputes between member countries and not of investor– country or country–investor disputes. Thus, the settlement of such disputes would be only indirect and probably lengthier. When considering the GATS as a framework for international rules on investment, two points are particularly noteworthy with regard to the content and structure of the Agreement. These are relevant to any consideration of how a broad-based international investment agreement might be structured. First, the GATS does not contain the kind of investment protection provisions commonly found in many of the bilateral and regional investment arrangements discussed at the beginning of this chapter. Nor does it embody such features as a mechanism allowing private investors direct access to an international dispute settlement mechanism. On the other hand, by treating investment as one element of trade in services, the GATS addresses not only the terms and conditions under which a

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foreign investor may enter the market, but also deals with establishment – or in other words, the conditions of operation in the post-establishment phase. The latter is also a feature of many of the bilateral and regional investment agreements referred to above. Second, in deﬁning national treatment as an obligation that relates only to scheduled commitments, the GATS departs from a number of other intergovernmental investment agreements in which national treatment has the same status as MFN, namely a principle of general application (but subject, in many cases, to reservations). Moreover, the GATS sets up a structure in which it is possible for governments, in agreement with trading partners, to condition national treatment, or to grant it partially. Similarly, the market access concept contained in Article XVI of GATS permits governments to condition the extent to which entry by foreign suppliers will be permitted. This capacity to open domestic markets to competition from foreign suppliers by degrees is achieved in other agreements through exceptions and reservations. The GATS is one of the few agreements covering foreign investment, which is both multilateral and binding. Because of the multilateral nature of the GATS, both existing and future bilateral and regional investment agreements will need to take its provisions fully into account, particularly the strong MFN commitment.

6. KEY ISSUES OF THE GENERAL AGREEMENT ON INVESTMENT John Dunning states that ‘‘multi-lateral action may still be necessary and may still be addressed to regulating MNE activity. However, today, its main thrust is to ensure that the global economic order works so as to ensure that MNEs and other cross-border actors optimize their contribution to the capabilities and competitiveness of Nation States’’ (Dunning, 1993, p. 587). A multilateral framework on foreign investment should lead to a more coherent international framework on foreign investment. However, to achieve this goal, key controversies should be carefully addressed in order to ﬁnd a consensus on a multilateral framework on FDI. Among the key issues to be tackled in such an agreement are: the degree of liberalization of rules governing the entry of foreign investment; the treatment in force in the postestablishment phase; the macroeconomic effects of FDI; the environmental concerns; and the protection of social and human rights (Cosbey, 2005; Mann, Moltke, Peterson, & Cosbey, 2005).

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Liberalization, in the context of FDI, involves the reduction of restrictions on the entry of foreign companies (UNCTAD, 2004, p. 24). Screening of investments is still common although it tends not to be too strict and demanding. It may be assumed that such screening is subject to considerable inﬂuence by political pressure groups. Such restrictive, and thereby market-distorting, governmental measures need to be removed. The catchphrase here should be fair competition in contestable markets. However, developing countries in particular may prefer to retain screening powers in order to protect infant industries. Of the two basic model BITs, only the treatment provisions of the ‘‘North American model’’ apply to the pre-establishment phase, while the ‘‘European model’’ covers only investment post-establishment (Gugler & Tomsik, 2006a). The choice of one of these two rival models in a multilateral framework will generate much debate. The existence of two competing models may prolong negotiations about a possible future framework. A second principal category of issues concerns ‘‘investment protection’’. Positive standards of treatment, particularly directed at the elimination of discrimination of foreign investors, are common. In certain treaties, the standards of treatment are also applied to the pre-entry phase. The most common standards of treatment are the ‘‘most-favoured nation’’ standard, the national treatment standard and the standard of ‘‘fair and equitable’’ treatment. In the case of developing countries, the question that arises is whether they can preserve sufﬁcient policy space to promote their development. Therefore, most provisions allow for certain exceptions (e.g. referring to public order and health). As the extent of these exceptions and their impact are subject to interpretation, substantial uncertainty remains both for the investor and for the host state. This often results in unwieldy agreements in which the exceptions complicate the application. Another controversial topic is the amount of compensation due for breach of the provisions of the agreement. Opinions range from full compensation (including future proﬁts) to no compensation at all. Several BITs contain references to adequate compensation. All these issues give rise to scores of legal problems that may lead to disputes. Investor–state dispute settlement methods are hence necessary to translate the standards into action. The potential costs of adhering to an investment agreement for host states are a limitation of their sovereignty and the risk of ﬁnancial crises. In order to protect investors, many BITs expand the notion of ‘‘expropriation’’ to cover so-called regulatory takings. All government measures that are seriously detrimental to an investor’s interests or affect foreign investors in a disproportionate way, entail compensation. Obviously, this raises the risk of

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unduly limiting the generally acknowledged regulatory powers of the host State. For example, the French considered the MAI an unacceptable threat to national sovereignty. The MAI was designed as a pure investorprotection instrument and was therefore considered an anachronism, which failed to reﬂect the recent transformation in political discourse. This discourse did not challenge the importance of free private enterprise as such but rather its legitimacy as a potential violator of human rights, an abuser of market power, a corruptor and a polluter. Civil society stressed the need for standards for conduct of TNCs and criticized the MAI for the imbalance between investor rights and obligations. It has been argued that foreign investors could secure additional property rights, which would be more substantial than many host States had anticipated (Hallward-Driemeier, 2003, p. 4). This could lead to problems of moral hazard and adverse selection as these provisions could be used as an insurance against ‘‘normal’’ business risks. Another point of controversy concerns the macroeconomic aspects of FDI. Capital account liberalization was initially thought to lead to the efﬁcient allocation of savings in the global economy and to allow citizens to diversify their portfolios. However, according to authors such as Singh (2003), this liberalization has led instead to an increase in economic and ﬁnancial crises, with subsequent implications for economic meltdown. Although FDI is generally regarded to be much more stable, this view seems to be contradicted by empirical evidence. The opponents of full liberalization argue that FDI entails considerable foreign exchange liabilities and may lead to a liquidity crisis especially in the case of developing countries. Therefore, the government must screen the amount and timing of inward FDI (Singh, 2003, p. 208). Constraints on capital movements might channel the conduct of investors into a more development-friendly direction. In view of these risks, further evidence on the causal link between ﬁnancial liberalization, banking crises, and currency crises is necessary. Otherwise, the economic and social costs of ﬁnancial crises may end up surpassing the potential beneﬁts of liberalization. Questions concerning the inﬂuence of FDIs on competition in local goods markets also emerge. A fear of powerful multinational monopolies is deﬁnitely one of the traditional anti-globalization arguments. The negative impacts of cartels in international trade have been widely recognized for long time. For example as early as 1948, the Havana Charter for an International Trade Organization declared the following practices to be subject to investigations: ﬁxing prices, allocating or dividing any territorial market, allocating customers, ﬁxing sales or purchase quotas, limiting

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production, etc. These concerns are much more important today than 60 years ago. However, more efforts have been devoted to ﬁghting not high monopoly mark-ups in international trade but the opposite – negative mark-ups, i.e. ﬁghting ‘‘dumping’’. The aim of various anti-dumping policies was to ﬁght especially those practices which can result in so-called predatory pricing. Predatory pricing is an anti-competitive practice by which a ﬁrm tries to eliminate weaker competitors from the market. Usually, the term ‘‘predatory pricing’’ means selling below marginal costs, while ‘‘dumping’’ refers to selling below average unit costs.1 The WTO rules allow for antidumping actions by national authorities. In the case of suspected dumping the importing country can impose a provisional anti-dumping duty. If the subsequent inquiry does not prove the existence of the dumping, the duty should be reimbursed. Although cases of dumping and predatory pricing in international trade will continue to emerge from time to time, the framework within which this issue is treated, is already well established. On the other hand, a suitable multilateral treatment for an opposite issue is lacking – that of the so-called hardcore cartels. Cartels may be deﬁned as agreements between ﬁrms (which would otherwise be in competition with one other) aimed at ﬁxing the prices, allocating the markets, reducing output, etc. This deﬁnition, however, is not clear-cut. In order for any multilateral framework on the hardcore cartels to be agreed, some consensus is necessary on what the hardcore cartels are. Should joint venture and joint marketing arrangements be treated as cartels as well? Or should the term be applied both to horizontal and to vertical arrangements? Similar issues were raised in the negotiations within the OECD and resulted in the following OECD deﬁnition of a hardcore cartel: ‘‘an anti-competitive agreement, anticompetitive practice or anti-competitive arrangement by competitors to ﬁx prices, make rigged bids (collusive tenders), establish output restrictions or quotas, or share or divide markets by allocating customers, suppliers, territories or lines of commerce’’. It should be noted, however, that hardcore cartels do not include ‘‘agreements, concerted practices or agreements that (i) are reasonably related to the lawful realization of cost-reducing or output reducing efﬁciencies; (ii) are excluded directly or indirectly from the coverage of a Member country’s own laws; or (iii) are authorized in accordance with those laws’’. Thus, for example, joint ventures and similar activities are excluded from being deﬁned as cartels. Also ‘‘cooperation agreements’’ between small ﬁrms with insufﬁcient resources and foreign companies are exempt because their intention is not to eliminate

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competition. The question is whether this deﬁnition would also be acceptable for the developing countries. If not, it could not become a starting point for a broader multilateral framework on competition. Empirically, it seems that the inﬂuence of cartels in international trade is not negligible. Of course, given the half-secret character of the cartels, it is very difﬁcult to quantify their impact. According to an estimate, one set of cartels affected products representing 7% of developing countries’ imports or 1.2% of their GDP.2 The same study estimated that, before the cartels were dismantled, the prices of the goods in question had been 20–40% higher than they were afterwards. Examples of cartels, which are believed to have been internationally relevant, are the citric acid conspiracy, cartels in synthetic ﬁbres, photographic equipment, television equipment, chemical textile products, micro-crystalline cellulose, food preservatives and others. The issue of hardcore cartels is in some cases treated by bilateral agreements between countries. Such bilateral competition agreements exist between the US and Japan, the US and Australia, and the US and the European Communities. There are also clauses in the regional investment treaties, such as the NAFTA, which can foster competition policies. However, it is clear that bilateral treatment of the cartels is currently not sufﬁcient because it is a global phenomenon that affects a wide range of products used and consumed globally. Furthermore, there are indications that once the cartels are detected, investigated, and punished in countries with sufﬁcient legislation, the cartels tend to redirect their operations into jurisdictions which lack sufﬁcient competition laws. Thus, in a world of relatively free trade, the effects of national competition legislation can be reduced if there is no similar legislation in trading partner countries. Theoretically it is also possible that a producer is in line with domestic competition legislation (it does not collude with another domestic producer) but it colludes with producers abroad (who are not subject to national competition laws). We should remember that national competition legislations and policies vary substantially across countries – from highly institutionalized and developed ones as is the case in the EU to being virtually non-existent in many developing countries. Clearly, these profound differences will make any negotiations on a multilateral competition framework very difﬁcult. Another problem to be faced by the potential multilateral competition framework is a combination of transfer pricing and tax havens. Transfer pricing of products by the TNCs enables them to transfer proﬁts to countries with low proﬁt taxes. Obviously, it is in the interest of such countries that the corporations subject to the tax laws have high

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proﬁts – regardless of how these high proﬁts were achieved. Therefore, countries, which serve as tax havens for the TNCs, proﬁt from cross-border collusive practices if the cartel members pay taxes there. In order for the multilateral framework on competition to be effective, it must contain several elements. The ﬁrst is an element of notiﬁcation, which requires authorities that are in the process of investigation and prosecution of international hardcore cartels to notify this promptly to the responsible authorities in the countries in which the cartel members may be operating. Other elements are mandatory consultations and assistance. The consultations require authorities that are investigating an alleged cartel to engage in discussions with authorities in other member countries whose interests may be affected. Assistance would cover not only general assistance in terms of sharing of expertise, enforcement techniques, etc., but also an exchange of information. Such an exchange of information is crucial if collusive behaviour is to be proved. This element will be very difﬁcult to negotiate, as countries are naturally reluctant to exchange conﬁdential information because of legal and institutional constraints. Another question is whether new multilateral institutions should be created. Although in theory the national competition authorities could be sufﬁcient, the creation of some kind of a Competition Policy Committee would be very useful. Such a committee could serve as a forum at which the member countries could exchange general information on their competition legislation (which would undoubtedly continue to evolve) and their enforcement practices. It could also coordinate actions by national competition authorities and strengthen their contacts in a similar way to the NAFTA Working Group on trade and competition. Another question is concerned with the basic principles on which the multilateral competition framework is to be based. Can the principles of MFN and national treatment, which are the cornerstones of many bilateral and regional investment and trade treaties, also be the cornerstones of the multilateral competition framework? There are unlikely to be any problems with the MFN condition as it is unlikely that a competition authority would accept a certain type of anti-competitive behaviour from ﬁrms originating in one country while prohibiting it for ﬁrms from another country simply on the grounds of the countries of origin of the ﬁrms. Also, the principles of transparency and due process are widely accepted. The principle of national treatment is much more contentious though. For instance, developing countries might fear that if the principle of national treatment was followed strictly, it would undermine their national industrial policies, as such policies are traditionally directed at privileging domestic over foreign

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producers. Similar arguments restrict not only a multilateral competition framework, but also a multilateral investment framework in general (see above). Here, the combination of positive and negative list approaches used in the GATS could serve as a model. The NT principle could be applied only to sectors transparently inscribed by member countries in their schedules. In fact when looking at existing national competition laws, one can ﬁnd a wide array of sectoral and non-sectoral exemptions, so a multilateral competition framework (if it is to be adopted) must not contravene the national exclusions and exemptions. A more technical question is whether the framework should enable the socalled leniency programmes. Leniency programmes are measures that provide incentives for the members of a cartel to participate in disclosing the existence of their cartel, giving the information necessary for breaking the cartel, etc. The logic of leniency measures is based on the so-called prisoners’ dilemma – if the incentives are correctly set up, one or more members of the cartel will provide information which will lead to punishment of the members. The incentives take the form of reductions in the ﬁnes paid by enterprises providing information or, in extreme cases, such ﬁrms may be granted immunity from ﬁnes or criminal prosecution. Experience with the leniency programmes, e.g. in the EU is promising, so from this point of view the multilateral competition framework should at least allow for the possibility of such measures. Some general questions concerning the competition framework remain and will remain unanswered for some time. One of the most important of these is whether the multilateral competition framework can be adopted before national competition policies are developed in all the member countries. This question arises because it is hard to assess when a competition policy is ‘‘developed’’. Obviously, all the members of the multilateral framework have to have at least some competition authorities because without them neither the gathering and sharing of information nor any investigation would be possible. On the other hand, the existence of a multilateral competition framework could improve and cultivate the national competition policies of less developed members. The debates regarding the MAI have highlighted several issues that would play an important role within a general framework on foreign investment. These include the ‘‘development’’ dimension of such an agreement, environmental concerns, and social and human rights. Initiatives have recently been undertaken under the auspice of the UN as well by some research institutes in order to address these issues within the framework of a MAI. Given the complexity of all the dimensions to be taken into account,

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the progress towards a less fragmented framework will need further analyses. Studies on the key dimensions of rules governing foreign investments should be designed to promote both the ﬁrms’ efﬁciency and the economic development and competitiveness of host and home countries. Furthermore, the challenge is not only to ‘‘open’’ the framework to new issues, but also to consider it from a dynamic perspective. As stated by Dunning, the interaction between governments and MNEs is a dynamic and iterative process (Dunning, 1993, p. 547).

7. CONCLUSIONS The need for the General Agreement on Investment can be seen in the example of a dramatic proliferation of various international agreements in the past. Many of these agreements have been concluded bilaterally, others are regional or plurilateral. There are now around 2,500 BITs in existence, more than 2,600 double taxation treaties, some 200 regional cooperation arrangements, and some 500 multilateral conventions and instruments governing cross-border investment ﬂows. Investors are now facing a patchwork of bilateral, sub-regional, regional, and even multilateral agreements, which is associated with a number of serious systematic dangers. Different agreements often have different coverage of issues and may even apply different rules. Separate negotiations increase the risk of inconsistent rules being established in different agreements. All of these factors tend to lead to confusion, uncertainty, and even legal conﬂict. Finally, but signiﬁcantly, the presence of different agreements increases the costs of doing business. Undoubtedly, a clear regulatory framework would, inter alia, foster the operation of the MNEs because they would be able to develop their competitive potential further than they are currently able to do. If the superior competitiveness of the MNEs is due to increasing returns to scale, a clear framework would reduce the uncertainty of the MNEs and thus increase the size and geographical allocation of their economic activities. If their superior competitiveness rests on superior organizational structures, technologies, research or other advantages, a clear framework would be conducive to enabling the ﬁrms to develop their potential. Therefore, countries participating in a multilateral framework on FDI would attract more MNEs than those which do not participate. At the same time, the multilateral framework could lead not only to higher FDI in the participating countries, but it could also be used to induce

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the investors to comply with different rules on labour treatment, various development objectives of the less developed countries, etc. Thus, a multilateral framework could enable any possible negative inﬂuences of FDIs to be mitigated or partially regulated. There should be no doubt that the multilateral framework on FDI would lead to a more coherent international framework for regulating foreign investments and it would promote FDI and doing business. Following the failure to install a multilateral framework on foreign investment within the OECD as well as within the WTO, opinions diverge as to whether approaches to regulating FDI through multilateral regulations should continue. We are convinced that these failures should not be read as a signal to abandon the search for multilateral rules. Rather, these failures may be considered an indication of the importance of multilateral regulations on investment and of the fact that governments have not yet identiﬁed an appropriate negotiating agenda (Mann et al., 2005, p. viii). Indeed, the increasing importance of FDI makes the current legal situation unsatisfactory. A comprehensive multilateral legal framework for FDI would help to reduce transaction costs and thereby enhance the economic beneﬁts of these investments.

NOTES 1. See, e.g., UNCTAD (2002). 2. The World Development Report 2001 cited, e.g., in WTO (2002).

REFERENCES Cosbey, A. (2005). International investment agreements and sustainable development: Achieving the millennium development goals. Winnipeg, Canada: ISSD. Dunning, J. H. (1993). Multinationals enterprises and the global economy. Wesley: Addison. Dunning, J. H. (2001). Governments, globalization, and international business. Oxford: Oxford University Press. Folly, D. (2006). The international framework on investment and the shift toward a multilateral agreement on investment. Switzerland: University of Fribourg. Graham, E. (2000). Fighting the wrong enemy, antiglobal activists and multinational enterprises. Washington, DC: Institute for International Economics. Gugler, P. (2006). Towards a coherent multilateral framework on FDI. Academy of International Business Insight, 6(1), 8–12.

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Gugler, P., & Tomsik, V. (2006a). The North American and European approaches in the international investment agreements. Working Paper no. 2006/04. World Trade Institute, Berne. Gugler, P., & Tomsik, V. (2006b). A comparison of the provisions affecting investment in the existing WTO obligations. Working Paper no. 2006/15. World Trade Institute, Berne. Hallward-Driemeier, M. (2003). Do bilateral investment treaties attract foreign direct investment? Only a bit y and they could bite. Washington, DC: The World Bank. Mann, H., Moltke, K., Peterson, L. E., & Cosbey, A. (2005). IISD model international agreement on investment for sustainable development. Winnipeg, Canada: ISSD. Muchlinski, P. T. (1995). Multinational enterprises and the law. Oxford: Blackwell. Sauve´, P. (2006). Multilateral rules on investment: Is forward movement possible? Journal of International Economic Law, 9(2), 325–356. Singh, A. (2003). Capital account liberalization, free long-term capital ﬂows, ﬁnancial crises and economic development. Eastern Economic Journal, 29(2), 191–216. Sornarajah, M. (1994). The international law on foreign investment. Cambridge: Cambridge University Press. UNCTAD. (2002). Closer multilateral cooperation on competition policy: The development dimension. Geneva: WT/WGTCP/W/197. UNCTAD. (2004). International investment agreements: Key issues (Vol. I–III). New York and Geneva. UNCTAD. (2005a). World investment report 2005. New York and Geneva. UNCTAD. (2005b). International investment instruments: A compendium (Vol. I-XIV). New York and Geneva. UNCTAD. (2006). World investment report 2006. New York and Geneva. WTO. (1998). Report of the working group on the relationship between trade and investment to the general council. Geneva. WTO (2002). WT/WGTCP/W/194 communication from Switzerland – provisions on hardcore cartels. Geneva. WTO. (various volumes). Annual report. Geneva.

ACHIEVING A BALANCE IN THE RIGHTS/OBLIGATIONS OF COMPANIES/COUNTRIES Stephen Young and Ana Teresa Tavares-Lehmann 1. INTRODUCTION The history of international investment agreements (IIAs) has seen radical shifts in the public policy pendulum as represented by the balance of forces for regulation as compared with liberalization (Brewer & Young, 2001). In the recent past, liberalization forces have predominated, leading to strong bargaining power for multinational ﬁrms (multinational enterprises, MNEs) in their relationships with host governments – in all countries but especially those in the developing world. Since the ﬁnal years of the last millennium, a new wave has begun to emerge, putting back on the agenda the issue of the obligations of companies and the rights of the countries (and communities) in which they operate. The objective of this chapter is to review these developments and discuss options for progress both within and outwith the World Trade Organization (WTO), where the aim is to improve the development prospects of poor countries. Within the continued liberalization framework existing currently in the global economy, the continued ﬂow of foreign direct investment (FDI) by MNEs has a crucial role to play. However, this chapter proposes that the role of MNEs’ should be expanded to encompass wider economic

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and social responsibilities if the forces of anti-globalization and protectionism are to be forestalled. The remainder of this chapter is structured as follows. Section 2 will provide a brief background of the current state-of-play in terms of international investment regulation, characterizing the evolution at the multilateral level, and the current patchwork regarding IIAs. Section 3 will address the ‘shifting policy pendulum’ between forces for liberalization and regulation and, using economic and bargaining power arguments, will analyze how we got to where we are. Section 4 will focus on new issues for inclusion in order to balance rights and obligations of companies/countries, many of which are sensitive and not within the remit of the WTO, or of a multilateral investment agreement, hence increasing the complexity and making a consensus more difﬁcult to reach. Section 5 will debate options for progress. The ﬁnal part presents some concluding remarks.

2. STATE-OF-PLAY WITH IIAS International investment regulation is an area prone to considerable controversy. In particular, an agreement on multilateral investment rules has not been reached and it does not seem likely to be accomplished in the near future (Young & Tavares, 2004). The issue has been debated since the 1940s, when the Havana Charter that would have created the International Trade Organization was rejected by the US Congress. FDI-related provisions were included, and were among the least consensual. Since then, and as Brewer and Young (2000) put it, the history of multilateral investment rules is a tale of successive disappointments. After that big blow in the 1940s, FDI was vastly neglected in the agenda of multilateral institutions – especially of the General Agreement on Tariffs and Trade (GATT), that instead focused its negotiations on trade matters.1 Only in the context of the Uruguay Round (1986–1995) were FDI issues brought again to the fore, as part of a series of agreements (some with an explicit investment content) that underlay the inception of the WTO, such as the Agreement on Trade-Related Investment Measures (TRIMs), the Agreement on Trade-Related Intellectual Property Rights (TRIPs), the General Agreement on Trade in Services (GATS), the Agreement on Subsidies and Countervailing Measures (SCMs), and the Agreement on Dispute Settlement Understanding (DSU). Nevertheless, these agreements seem to address investment only in a collateral way, meaning that they were

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not designed speciﬁcally with investment issues in mind (Sauve´ & Wilkie, 2000; Young & Tavares, 2004). More recently, and within the scope of the WTO, FDI-related matters were brought again to the discussion. The Doha Round (launched in November 2001) explicitly included investment themes in (among others) negotiations related to the GATS, the TRIPs Agreement, in the Antidumping and Subsidies Agreements; and even special working groups were set up in order to study the relationship between trade and investment, between competition and investment, and on transparency in government procurement. Progress with the Doha ‘Development’ Round has been far from paciﬁc and smooth, and suffered a serious setback in Cancu´n, 2003, when the 5th Ministerial Conference of the WTO ended abruptly, with a group of developing countries walking out of the negotiations. Since then, investment issues kept being mentioned, but without much progress, and prospects for a multilateral investment agreement seem as unlikely as ever (Young & Tavares, 2004). In all, and as often stated (see chapter by Gugler and Tomsik, 2008) there is probably no better word to describe the current situation regarding international investment regulation than ‘patchwork’. We have brieﬂy characterized the situation at the multilateral level. However, the architecture of international investment regulation is more multi-level and complex than that. Various overlapping levels coexist and interact, often being contradictory – hence leading to a manifest lack of systemic coordination (Tavares, 2001). There are investment rules at the multilateral, regional (trade/investment blocs), bilateral/national, and even sub-national levels. The sophistication and depth of such rules is highly variable among levels, and even within the same level (Young & Tavares, 2004). Presently, the most important instrument for the international protection of FDI is at the bilateral level. Bilateral investment treaties (BITs) have proliferated immensely in recent years – according to the latest World Investment Report, there are already more than 2,500 BITs in place (UNCTAD, 2006).2 Such proliferation, and clear preference for a bilateral approach can be explained by the lack of measurable beneﬁts from the existence of a multilateral framework, vis-a`-vis the reduction of government discretion/autonomy and the high adjustment costs perceived to be implied by multilateralism (Lengyel & Ventura-Dias, 2004). BITs have existed since 1959, and are seen as speciﬁcally relevant when host countries’ institutions and property rights are weak. Put very simply, they mainly aim to protect subsidiaries of MNEs from discrimination, grant national- and mostfavoured nation treatment, protect from risks like expropriation, capital

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transfer restrictions, losses due to war, etc. Countries signing them expect to have greater FDI inﬂows. However, studies testing the relevance of BITs as FDI determinants have not found a signiﬁcant inﬂuence of such agreements on FDI inﬂows, hence questioning their real effectiveness (UNCTAD, 1998; Hallward-Driemeier, 2003). There is also considerable diversity at intermediate levels between fully ﬂedged multilateralism, and outright bilateralism. In this vein, a vast array of agreements at the plurilateral and regional levels are in place, thus contributing to a more diverse and complex picture. Examples are the agreements at the level of the NAFTA, OECD, APEC, among others (for a more comprehensive review, see Brewer & Young, 2000; Kennedy, 2003; Gugler and Tomsik, 2008). Another aspect that needs to be taken into account and one that does not make this ‘fabric’ of IIAs tighter and more coordinated is the tough competition for FDI (Tavares & Young, 2003) that marked very strongly the last decade. In almost all countries (and even in many sub-national jurisdictions), investment agencies were created, aiming to embark on the proactive attraction of FDI and subsidiaries of multinational ﬁrms. This meant developing (sometimes more successfully, sometimes less) a strategic approach toward attracting FDI, trying to differentiate their ‘locational product’ and hence trying to retain all possible discretion in terms of providing the maximum possible amount of incentives of several kinds. This means an adverse context toward policy coordination (e.g. ﬁscal) and surrender of sovereignty over policies adopted, and over the generous incentives offered to MNEs. In particular, developing countries seem to be quite adverse to the idea of being forced to harmonize their policies with those of their developed counterparts, given the high expected adjustment costs, the loss of sovereignty implied, and the likely inability to undertake domestic reform because of the implacable adjustment path required, that may impede such countries to focus on national priorities. Countries want control over pace, sequencing, and liberalization of reform (Young & Tavares, 2004). Even if most countries, developed and developing alike, are ready to give generous incentives to MNEs, research has questioned the efﬁciency of such incentives, and the positive net impact of many subsidy-induced FDI operations (for a deeper analysis, see Tavares & Young, 2005). This would bring back the pertinence of pondering the advantages of a broader FDI-related agreement, thereby avoiding the dead-weight losses implied by escalation in this tough race (sometimes even within countries, and within the same regionally integrated bloc). It is not the aim of this chapter to

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debate all pros and cons of a broader (speciﬁcally, multilateral) investment agreement.3 However, it is interesting to observe how the policy pendulum has swung over the years, which is the objective of the subsequent section.

3. THE SHIFTING POLICY PENDULUM Since the 1940s, the policy pendulum between the forces for regulation and those for liberalization has swung considerably. Fig. 1 charts the pathways underlying this policy pendulum. From the time of the Havana Charter until the late 1960s, liberalization tendencies were moderate toward weak (at the latest part of this phase). Forces for regulation were weak, meaning that, probably owing to its newness and relative incipience of the idea, the establishment of investment rules did not arouse great passions. The situation changed considerably in the late 1960s, in a phase that lasted until the early 1980s. This era, marked by economic crisis worldwide forces for regulation weak

strong

strong

Early 1980smid 1990s

forces for liberalization

late 1990searly 2000s

1940slate 1960s Late 1960searly 1980s

weak

Fig. 1.

The Shifting Policy Pendulum. Source: Brewer and Young (2001).

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(with the oil shocks and the ensuing recession) represented a hostile environment for FDI. In particular, forces for regulation dominated, and FDI was rather controlled than left to its own devices. The early 1980s saw a major turnaround in this environment and, until the mid-1990s, the context was one of liberalization, with very weak proregulation forces. It represented the ‘liberal era’, not only in investment, but also in trade and related issues. Markets were king. The last years (late 1990s–early 2000s) witnessed an increase in the strength of forces toward regulation, although still in a context of strong liberalization tendencies. However, it seems that at present liberalization tendencies are weakening, being plausible to propose that an increasing ‘controlling’ trend might emerge, given the impact of some ‘new’ issues on the FDI policy agenda (such as environmental concerns, human/labor rights, corporate social responsibility (CSR), among others). The growing awareness of these issues is in great part due to the increasing power and impact on the public opinion of new actors/pressure groups, like the variety of non-governmental organizations (NGOs) and other movements. It is pertinent to question why this path occurred from the 1940s until the present, and the theoretical and practical reasons underlying how we got to where we are. In the ﬁrst phase (1940s–late 1960s) there was a relative indifference as FDI-related policy was not yet very high on the agenda. In the late 1960s and especially in the 1970s and early 1980s the situation moved toward a strong controlling stance given aspects such as the protagonism and growing importance from US and later European and Asian MNEs, that scared countries that did not expect such protagonism. Other reasons were the global recession due to successive oil shocks, and the dominant political, ideological, and political economy perspective on ‘dependency’ and ‘imperialism’, especially against the US and US multinationals. In this phase, bargaining models (Fagre & Wells, 1982; Lecraw, 1984; Kobrin, 1987) were developed in order to understand relations between MNEs and developing country governments, confrontational and tense at that time. The ﬁrst generation of these models, dating from the 1960s–1970s, depicted a situation where there was a one-to-one negotiation between a MNE and a government, with the speciﬁc entry terms depending on the relative power of the bargaining agents (Ramamurti, 2001; Young & Hood, 2003). From the early 1980s until the mid-1990s, there was a tremendous shift toward liberalization, following the inﬂuence of liberal regimes in the US, the UK and other countries, the changed perception that MNEs would usually bring positive spillovers to the host economy, and the lack of popularity of traditional bargaining frameworks – all this contributed to a

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very explicit liberal stance, and a positive perspective on the contribution of MNEs. Finally, in the late 1990s, early 2000s, the situation is again shifting, though it is not clear exactly where it is going to end: the context is one of strong liberalization tendencies, yet these are weakening, and allowing more controlling arguments to gain currency. This led to a ‘second generation’ of bargaining models (Ramamurti, 2001),4 that take into account the increasing bargaining power of MNEs (that can leverage and capitalize the advantages of the spread of their value chains and sophisticated international production systems), the decreased power of nation states (all desperate to attract FDI, thus making incredible concessions to MNEs), and the multilevel, multi-party potential of the bargain. It is not uncommon at present to read reports of MNEs playing states against one another, in order to squeeze the maximum of investment incentives (Ghauri & Oxelheim, 2003). This recent evolution, encompassing a ‘cautious’ shift toward less liberalization and possibly greater controlling proclivity cannot be divorced from the current debate regarding globalization and its effects, and the skepticism that globalization will always be ‘good’ (Stiglitz, 2002). The increasingly vociferous civil society (that manifested itself especially after the WTO Ministerial Meeting at Seattle in 1999, where anti-globalization movements – as we know them now – gained prominence for the ﬁrst time) is amplifying the need to question the beneﬁts of globalization (and their ultimate actors, MNEs), and pushing toward greater regulation and control. The advent of new/emerging issues not traditionally taken into account in the FDI-regulation debate is contributing to shift this pendulum more toward a careful, not so liberal, stance vis-a`-vis investment rules. This stems in great part from the potential adverse effects perceived to be implied by the operation of MNEs in host countries (and often their supranational, transborder impact), in areas like the environment (e.g. climate change), competition policy, human/labor rights, among others, that will be developed in the next section.

4. ISSUES FOR INCLUSION IN IIAS TO BALANCE RIGHTS AND OBLIGATIONS OF COMPANIES/COUNTRIES The range of issues that entered the debate recently is very encompassing. Recent initiatives (such as the Multilateral Agreement on Investment (MAI) and the UN Global Compact) have been calling attention to formerly

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neglected aspects pertaining to these ‘new issues’. The MAI (abandoned in 1998) already considered the development dimension of investment agreements (in this case, at the multilateral level), as well as referring to environmental concerns, and human and social rights. The UN Global Compact (launched in 1999 (UN, 2000)), launched to promote global corporate citizenship, embraced 10 principles, including those related to human rights (principles 1 and 2), environment (principles 7 to 9), and anticorruption behavior (principle 10). The inclusion of these ‘new’ issues resulted from reality (reﬂecting the importance given to such matters and the questioning of simple truths such as that spillovers from FDI are always positive, as well as a more informed stance about imminent degradation of natural and, in some cases, of human conditions). What needs to be understood also is that in the past, the FDI-related framework (especially at the dominant, bilateral level) emphasized mainly the rights of companies and the obligations of host countries vis-a`-vis such ﬁrms. The latter tended to gain more and more power, making some governments (especially from small and/or developing countries) virtually incapable of negotiating in a fair and balanced way with such ﬁrms. This created a growing sense of uneasiness in many nations, that manifested itself quite strongly in the ﬁasco of the Cancu´n negotiations in 2003, when a group of developing countries abandoned the table, for several reasons, among which disagreement over investment regulation was important. The current consciousness that the quality of the environment is a growing concern, that labor/human rights are experiencing degradation in many circumstances, that globalization is promoting efﬁciency quite reasonably, yet not always in an equitable or ‘developmental’ way, that multinationals often embark on anti-competitive practices, both in terms of increasing unhealthily market power, and/or adopting dumping behavior to destroy domestic companies, is leading to a more careful consideration of a range of issues that were absent from the traditional agenda. These issues are varied and complex, and include:

Balancing efﬁciency and equity Economic development and poverty reduction Sustainable development Environmental rules (particularly climate change) Labor and employment rights Human rights Competition policy and restrictive business practices

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4.1. Balance Between Efficiency and Equity/Economic Development and Poverty Reduction As regards the balance between efﬁciency and equity, there are some doubts whether the seemingly more efﬁcient allocation of resources promoted by globalization is leading to a more equitable outcome (Hirst & Thompson, 1996; Stiglitz, 2002). The active debate on globalization highlights the possibility of asymmetric costs and beneﬁts to different actors, and of a potential widening gap between gainers and losers. Asymmetries in the international distribution of income – particularly between developed and developing nations – are often alluded to, as well as disparities on the distribution of the income by social group. This issue can be linked to the contribution of FDI to economic development and poverty reduction. The fact that MNEs lead to positive spillovers to the local economy, hence performing a ‘developmental’ role has often been debated. Indeed, the vast literature on FDI impact led to mixed results (for a review, see Go¨rg & Strobl, 2002; Tavares & Young, 2005). Moreover, the effect of multinationals’ activities on the domestic distribution of income is also unclear. As regards strictly the impact of multinationals on wages, the empirical literature mainly concludes that MNEs pay greater wages than their domestic counterparts (Brown, Deardorff, & Stern, 2003; Velde & Morrissey, 2003; Go¨rg, Strobl, & Walsh, 2007) – therefore, leading in principle to poverty reduction. For instance, the paper by Velde and Morrissey (2003) is a study based on ﬁve African countries. Focusing speciﬁcally on wage inequality, Figini and Go¨rg (2006), in an empirical study using Irish data, found evidence in favour of an inverted-U relationship between wage inequality and the presence of multinationals, i.e., with increasing presence of MNEs, wage inequality ﬁrst increases, reaches a maximum, and decreases eventually, ceteris paribus.5 Hence, there are still concerns that MNEs may lead to increased inequality.

4.2. Environmental Rules (Particularly Climate Change) and Sustainable Development Environment and sustainability are key themes nowadays, for developed and developing countries. The growing consciousness that human activity is producing irreparable damage to the environment is making actors (individuals, organizations, governments alike) rethink the way they lead

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their lives. The effects of climate change, in particular, are obvious and a cause for deep concern. Although this is not per se and speciﬁcally a FDI-related issue, it will have an impact on the way MNEs operate, and will mean that stricter environmental compliance rules will tend to be imposed. This, again not a FDI-speciﬁc theme, and not even one within the remit of the WTO, will mean that we need here also to promote a fairer balance between the obligations of companies and rights of countries, in the vein argued in this chapter. Some less scrupulous MNEs will relocate where they undertake environmental dumping, and where they can obtain permission for greater CO2 emissions. The possibility of having a great allowance for emissions is even heralded as a kind of FDI incentive. However, the Kyoto Protocol and the growing strength of the NGO/ consumer lobby is putting pressures on MNEs in this area, as they did successfully in respect of CSR.6 MNEs are already responding to these pressures (Kolk & Pinkse, 2007).

4.3. Labor and Employment Rights, and Human Rights Another controversial area relates to the potential negative contribution of MNEs to labor/employment rights, and even to human rights, in some cases. Indeed, it has been argued that MNEs, often due to the growing competitive pressure they face worldwide, and especially in the main markets and in the most dynamic sectors, are becoming increasingly obsessed with cost reduction, doing whatever they can to save on aspects such as social contributions, and other beneﬁts given to their workers. The restructuring of key industries is affecting successive waves of mergers and acquisitions (M&As) with a considerable employment impact, implying massive shedding of workers. MNEs are often accused of affecting social dumping, having no respect for workers’ rights. However, and even if they can correspond to the truth in a considerable number of cases, these concerns are often rejected by studies on developing countries that defend MNEs (which, apart from paying better wages as we saw before provide better working conditions than their local counterparts). Furthermore, it is argued that multinationals are typically not attracted preferentially to countries with weak labor standards (Brown et al., 2003). As the same study (pp. 52–53) notes ‘However, as an empirical matter, some anecdotal evidence notwithstanding, there is virtually no careful and systematic evidence demonstrating that, as a generality, multinational ﬁrms adversely

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affect their workers, provide incentives to worsen working conditions, pay lower wages than in alternative employment, or repress worker rights. In fact, there is a very large body of empirical evidence indicating that the opposite is the case. Foreign ownership raises wages both by raising labor productivity and expanding the scale of production, and, in the process, improving the conditions of work.’ Civil society groups can still point to company-speciﬁc examples where exploitation appears to have occurred, and hence labor and human rights need to continue to be vigorously defended.

4.4. Competition Policy and Restrictive Business Practices Multinationals are often accused of having an anti-competitive behavior, both in terms of building strong market power (in the limit, leading to monopolies), as well as in terms of undertaking dumping and predatory pricing practices to annihilate domestic competitors. This is a cause for preoccupation especially in the case of countries with weak industrial structures and weak indigenous industrial fabric, whose domestic ﬁrms cannot withstand the competition from their foreign (stronger) counterparts. It is thus an issue particularly applicable to developing nations. The chapter by Gugler and Tomsik (2008) refers to these issues, speciﬁcally to the potential impact of FDI on competition, and on how competition (and speciﬁc themes such as cartels) was included in former versions of in the international investment regulatory agenda. Some BITs and regional agreement investment provisions (such as those of the NAFTA) tackle anticompetitive practices, such as cartels. However, cartels are often global phenomena, beyond the reach of bilateralism and regionalism. Thus, efﬁcient treatment of them would occur only at a multilateral level, thereby avoiding arbitrage between jurisdictions as well. Recently, national and regional competition authorities proliferated. Even if the actions of these national competition authorities can be potentially quite effective, some need for coordination exists – the issue is then is whether coordination is more informal, voluntarily undertaken between authorities, or more institutionalized (e.g. through a Competition Policy Committee as Gugler and Tomsik suggest earlier in this volume). For instance, the NAFTA Working Group on Trade and Competition could provide an inspiration for a coordinated approach. In respect of developing countries, competition policy is one area where proposed amendments to special and differential treatment (see proposals

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by Hoekman, Michalopoulos, & Winters, 2004 below) would remove reciprocity requirements because of the high costs and limited beneﬁts from implementing anti-trust rules.

5. OPTIONS FOR PROGRESS Emerging from the above discussion, it is evident that ways have to be found to improve the balance in the global trade and investment framework. This requires greater obligations for ﬁrms and increased rights for countries, especially developing nations, within a context in which the basic principles of global liberalization threaten to be undermined by the growth of bilateralism (and potentially regionalism), on the one hand; and the emergence of new issues such as the environment, human rights, sustainable and equitable development. A number of options for progress are now considered.

5.1. Rules-Based Multilateralism: A Sector-Specific Approach The discussion above has indicated that progress on investment agreements in the WTO may not be possible or desirable (Young & Tavares, 2004). Nevertheless, there already exists one WTO agreement which incorporates FDI, namely the GATS, established in 1994. Why has it been possible to introduce FDI into the GATS but not more widely within the WTO? There are several explanations. First, in a number of service sectors, products are non-tradable, meaning a requirement for FDI to supply markets. Second, there is evidence that FDI is beneﬁcial for host economies, as a source of new knowledge and competitive stimulus, and because FDI may assist host countries to introduce and export more advanced products (Hoekman, 2006; Markusen, Rutherford, & Tarr, 2005). Third, it is argued (Bhattari & Whalley, 1998) that the distribution and size of the gains from market integration may be more equally shared between large and small countries in services than in goods. Given the importance of the services sector in national economies (representing between 35% of GDP in lowest income countries and over 70% in the OECD countries – Hoekman, 2006) and in global FDI ﬂows (72% in 2001–2002 according to UNCTAD, 2004 estimates), a multilateral agreement clearly represents an important step forward. In addition, the productivity of the services sector is of signiﬁcance for the growth prospects

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of countries. For example, research by Mattoo, Rathindran, and Subramanian (2006) estimated that economies with open ﬁnancial and telecommunication sectors grew about 1 percentage point faster than others. Full liberalization was associated with an average growth rate 1.5 percentage points above other nations. Much less information is available for developing countries. However, in a study of 86 developing countries in telecommunications, Fink, Mattoo, and Rathindran (2003) found that a comprehensive reform program, including both privatization and competition and supported by an independent regulator, produced a 21% higher level of labor productivity compared to years of partial and no reform. This study covered the period 1985–1999, while the big stimulus likely to be generated by mobile phones is essentially a phenomenon of the 2000s. Despite the apparent beneﬁts of a multilateral regime incorporating FDI, the GATS has apparently played only a limited role in liberalization processes. Hoekman (2006) suggests that because of the importance of domestic regulatory policies, the incentive for unilateral reform may be larger in services than in goods; and he concludes that excluding EU members, most reforms have been undertaken by countries autonomously. There can still be a role for the WTO in supporting the implementation of reforms. Thus, Hoekman and Mattoo (2006) argue the case for using the WTO to assist developing countries in assessing the state of their service sectors; in providing assistance to support liberalization; and in monitoring the delivery and effectiveness of reform. By this means the GATS could become a mechanism not just to promote services liberalization but also to assist domestic services reform. In respect of FDI there are still many barriers both in terms of ownership limitations and operating restrictions. Service industries will continue to grow rapidly and, because of their ubiquitous nature, represent an important contributor to ﬁrm competitiveness. So even in the manufacturing sector the service content is rising because of the importance of value chain activities such as R&D, design, ﬁnance, and sales, marketing and distribution. To date the GATS has not had an important role to play in FDI liberalization, but into the future an enhanced role should not be discounted.

5.2. Multilateralizing Regionalism There is a longstanding debate concerning whether regional integration agreements (RIAs) are complementary or competitive in terms of their role in liberalizing the world economy (Kobrin, 1995; Brewer & Young, 2000).

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The fact is that such RIAs exist and are likely to become more important into the future, as existing arrangements, particularly the EU and NAFTA, expand membership and extend their ‘hub and spoke’ systems. The future in East Asia is more questionable. Certainly there are numerous initiatives under negotiation or already signed, including, for example, the ASEAN-China Free Trade Area (FTA), the ASEAN-Korea FTA, and the ASEAN-Japan FTAs, but these are relatively undisciplined and there are calls for binding the unilateral tariff-cutting within the WTO system (Baldwin, 2006). In respect of improving a balance in the rights of countries within multilateral agreements there is an argument for suggesting that RIAs may actually help to achieve this. Thus, the relatively greater homogeneity of countries within regional blocs may make it easier to achieve a common bargaining position than in the more heterogeneous WTO. And the route to trade and investment liberalization for the global economy is rather similar to that for a particular region. A contrary perspective is that while RIAs liberalize internally, they may lead to a world of regions which are more restrictive against trade from outside the bloc and which could generate trade wars. However the main three blocs of Europe, North America, and East Asia all have ‘leaky’ and ‘fuzzy’ boundaries (Baldwin, 2006) such that potential protectionism may be circumvented by multinationals as they seek to secure their supply chains which are not only regional but also global. As RIAs evolve alongside the WTO, there is a need for mechanisms to ensure greater coordination and integration between the forms of institutions. Suggestions have been made (Hoekman & Kostecki, 2001; Brewer & Young, 2000) to strengthen the process of examining agreements; to establish multilateral rules relating to accession clauses in RIAs for new members (especially for associate status countries); and to strengthen multilateral disciplines in respect of rules of origin for RIAs. In reality, according to Baldwin (2006): ‘The WTO has been little more than an ‘‘innocent bystander’’ in the massive spread of regionalism’. In order to make progress, Baldwin (2006) has suggested focusing more on improving information and coordination as a less contentious way of progressing toward the long-term goal of ‘multilateralizing regionalism’ (that is incorporating and integrating RIAs within the global framework of the WTO). Three roles are suggested for the WTO: ﬁrst, providing clearer information and a better informed understanding of the effects of multilateralizing regionalism. Second, establishing a negotiating forum for the standardization and harmonization of rules of origin. The third proposal is particularly relevant to this chapter because of its focus upon hub and spoke relationships. There are potentially large asymmetries in bargaining

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power especially between small nation RIA spoke partners and large hubs such as the EU or NAFTA when the former may be dependent on the hub market. The suggestion, therefore, is for the WTO to establish a forum of ‘spoke countries’. The objective would be to set up an advisory center focusing upon North–South and South–South RIAs (where the WTO’s Advisory Centre on WTO Law might be used as a model) to improve the knowledge and skills of spoke members in negotiations. Since RIAs are here to stay and their importance in the global economy likely to increase, efforts to multilateralize regionalism are important alongside other measures in efforts to balance rights and obligations.

5.3. Rules-Based Approach, with Gradation of Rules There are already amendments to the principle of universality within the WTO, as represented by special and differential treatment (S&DT) for developing nations. This was incorporated into the GATT in 1979, permitting preferential market access for developing countries, limiting reciprocity in negotiating rounds to levels ‘consistent with development needs’, and providing developing countries greater freedom in trade policies than would otherwise be allowed by GATT rules (Hoekman et al., 2004). There has been much criticism of S&DT, in part related to wider criticisms of import-substituting policies in developing countries. Their value has also been questioned since tariff-cutting in successive negotiating rounds has diminished the preferences for developing countries. Furthermore, sectors of major importance to developing countries like agriculture and textiles and clothing were excluded from the GATT and dealt with on an ad hoc basis. In any event the pressures to take greater account of development needs surfaced at the end of the 1990s as part of wider criticisms of multinationals and global capitalism, and the failure to launch a new Millennium Round of trade negotiations (Brewer & Young, 2000, p. 277–279). After much acrimonious discussion, the Doha Round of negotiations was eventually launched in 2003 as a so-called Development Round (see Hoekman, 2002). In the Doha Ministerial Declaration there was a call for a review of the S&DT provisions, to strengthen them and make them ‘more precise, effective and operational’ (para 44). Progress since then has been patchy to say the least and the 2003 deadline for agreeing new provisions was not achieved. In a subsequent paper, Hoekman et al. (2004) presented some ideas for progress, focusing upon, ﬁrst, improvements in market access; second,

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rebalancing existing agreements, such as agriculture, and amending others; and, third, development assistance to build institutional and trade capacity. The starting point is a redeﬁnition of the countries to be permitted S&DT. The current WTO classiﬁcation distinguishes between LDCs, other developing countries and developed economies. These authors propose that only a subset of developing countries should be eligible, namely the LDCs plus ‘other low income and small developing countries with weak institutional capacity’ (Hoekman et al., 2004, p. 504). This is a strongly desirable reform, albeit also very politically sensitive. In relation to the ﬁrst issue above, the recommendation is to expand market access through the abolition by industrial countries of export subsidies and non-tariff barriers for labor-intensive products of interest to the poor and small developing countries group. The tariff target is 5% in 2010 and zero in 2015 (the date set for the achievement of the Millennium Development Goals). It is recognized that some (although not matching) reciprocal concessions will be necessary by the poor and low income countries. The latter is clearly a big question for negotiations. The second issue concerns agriculture and amendments to other agreements. The proposals to rebalance the rules in agriculture would involve allowing special safeguards for low income countries, speciﬁcally emphasizing measures to improve food security and to stimulate agricultural production of the poor in rural areas. Amendments to rules would focus upon removing reciprocity requirements in policy areas that are costly and resource intensive to implement or are not development priorities for poor and small developing countries (and where in truth the effects upon developed country investors are likely to be quite small). These policy areas might include TRIPS, customs valuation, competition policy and procurement. The third set of proposals by Hoekman et al. (2004) concern development assistance to build institutional and trade capacity and enable poor countries to beneﬁt from improved access to industrialized country markets. Such assistance to build supply-side capacity and capabilities and improve trade mechanisms, as well as assisting technology development is essential if poor countries are to beneﬁt from liberalized markets. Since the assistance has to be tailored to individual country needs, there are issues to be resolved concerning what assistance is to be provided and to which countries; whether or not this will be linked somehow to the implementation of WTO agreements (Finger & Schuler, 2000); and the relationship with bilateral donor support schemes which commonly address supply capacity and trade support measures.

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5.4. Combined Rules-Based and Voluntary Approach The possible options for progress outlined above do not in the main tackle the basic requirement for improving the rights of developing countries. The exception concerns the proposals by Hoekman et al. (2004) for deepening S&DT for the key group of the poorest and small countries. And even here it appears that country-speciﬁc solutions will be required in implementing the recommendations on building supply-side capacity and improving trade mechanisms.7 In the light of this, it is worth considering the potential for taking a different approach to some of the developmental challenges facing poor countries, focusing upon voluntary initiatives from both public policy (at different levels) and from multinational ﬁrms. The growing interest in voluntarism derives in signiﬁcant part from the notion of CSR which is crucial to the management of the costs and beneﬁts of business activities to stakeholders, both internal (employees, shareholders, investors) and external (public governance organizations, civil customers, suppliers, other enterprise, civil society) (Fox, Ward, & Howard, 2002). CSR has emerged as a major agenda item for ﬁrms and governments because of the risks and social consequences of globalization for developing countries. The World Business Council for Sustainable Development (WBCSD, 2002) deﬁnes CSR as: ‘The commitment of business to contribute to sustainable development, working with employees, their families, the local community and society at large to improve their quality of life’. What is particularly interesting in the context of this chapter, is the observation by Fox et al. (2002, p. 1) that ‘there is a dynamic linkage between voluntary approaches and regulation and the potential for voluntary initiatives of various kinds to crystallize, over time, into mandatory minimum standards’. There are a large number and range of voluntary initiatives operating at different levels (multilateral, regional, national, and sub-national) and involving public institutions, governments, and ﬁrms. Space does not permit commentary on all these non-binding initiatives, and so a number of illustrations will be presented. From the international public policy perspective, codes of conduct or guidelines for MNEs were much in vogue during the regulatory era of the 1970s. Among such voluntary initiatives, The OECD Guidelines for Multinational Enterprises (1976/2000) (www.oecd.org/daf/investment/guidelines) was a signiﬁcant initiative to set principles and standards for responsible business conduct by MNEs in areas including information disclosure, employment and industrial relations, human rights, environment, science and technology, combating bribery, etc. The OECD Guidelines have been

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updated regularly, most recently in 2000. From the same era is the ILO’s Tripartite Declaration of Principles Concerning Multinational Enterprises and Social Policy (1977) (www.ilo.org/public/english/employment/multi/index.htm) which provides guidelines for MNEs, governments, and employers’ and workers’ organizations in the areas of employment, training, conditions of work and life, and industrial relations. A much more recent initiative is the UN Global compact (www.unglobalcompact.org), launched in 2000 with the aim of promoting global corporate citizenship. Speciﬁcally the Global Compact’s 10 principles focus upon human rights, labor standards, the environment and anti-corruption with the involvement of 3,800 participants including 2,900 businesses from 100 countries along with representation from UN agencies, labor and civil society. While these various initiatives are partly complementary, there are also signiﬁcant areas of overlap in terms of participation and coverage. The OECD Guidelines are implemented through the member governments of the OECD together with a number of non-members, and a cooperative project has been launched to improve business governance via the Guidelines in China and by Chinese MNEs. The ILO Declaration is narrowly focused upon employment, working conditions, and industrial relations aiming at a wide range of participant organizations. The UN Global Compact is designed as a network-based initiative with a multi-tier governance framework operating at both global (Global Compact Leaders Summit) and local network levels. The local networks, currently 50 in number, comprise groups of participants within a particular country, whose role is to assist local ﬁrms and MNE subsidiaries in the implementation of its 10 principles, and to root the Global Compact within different cultural contexts. It is debatable how signiﬁcant these multilateral initiatives are. The OECD Guidelines probably suffers from its association with regulationoriented 1970s era, and its developed country sponsorship may be a negative at the host (developing) country level. Forty-one percent of the respondents to a 2006 survey of the Fortune 500 companies indicated that their companies ‘use the Guidelines as a reference’.8 The genesis of the ILO Declaration may create similar negative perceptions, as might its focus upon labor issues. The UN Global Compact is by comparison wide in coverage and more inclusive in terms of participation. Its decentralized operational approach is valuable too, something which has also been implemented by the OECD through its mechanism of National Contact Points (NCP). What is perhaps most important is that there are now attempts to coordinate activities among the three multilateral institutions within an international CSR framework.

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There is little doubt that CSR (and the associated pressure from shareholder groups, civil society, and other stakeholders) has altered MNE perspectives toward developing countries. An OECD survey at the end of the 1990s identiﬁed 233 codes of conduct, setting out behavioral standards that companies pledge to follow (primarily CSR principles), most of them relating to individual ﬁrms (www.oecd.org//ech/act/codes/ht; see also Brewer & Young, 2000, p. 284, for a brief review). NGOs have been skeptical of codes, viewing them as mere public relations exercises; and certainly if they are to be effective, they have to be more than altruism and philanthropy. Interestingly, Husted and Allen (2006) found that local CSR issues were more likely to appear on the strategic agendas of multidomestic and transnational rather than global MNEs. However, there is at least anecdotal evidence that within large MNEs the CSR units may be organizationally separate from the product divisions and hence not integrated into mainstream corporate activities. Nevertheless, there are positive signs, with illustrations in Africa, for example, of MNEs either singly or in groups seeking to integrate local suppliers within their regional as well as local supply chains.9 One interesting initiative in this regard is Business Action for Africa (www.businessactionforAfrica.org)10 which focuses upon the six themes of governance and transparency, trade, the business climate, enterprise and employment, human development, and perceptions of Africa.

6. CONCLUDING REMARKS What appears to emerge from all of this is that the major challenge in improving the rights of countries and the obligations of ﬁrms lies less in multilateralism and the WTO than in country-speciﬁc initiatives, which are in our view outside the remit of the WTO. We are supportive of new proposals in respect of S&DT within the WTO which are designed to address difﬁculties facing all developing countries (speciﬁcally the poorest and smallest developing nations). But country-speciﬁc programs are a step too far for the WTO, especially when there are already large numbers of initiatives at the country level undertaken by other multilateral institutions (e.g. World Bank, IMF), regional organizations (e.g. EU), and national governments. At all of these levels there is a requirement for greater integration of effort to limit competition and confusion, and improve coordination and clarity. As has been argued elsewhere, ‘the hierarchical donor–recipient of most aid programs has to be replaced by collaborative

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relationships with national governments in developing countries; this, in turn, requires a planning framework for prioritizing and directing donor resource allocations’ (Young & Hood, 2003, p. 268). A problem which still remains concerns the limited capacity and capability of developing country bureaucracies to implement the initiatives which emanate from foreign donor agencies. In some ways the direct involvement of multinationals with host developing countries (at ﬁrm but also government levels) is helpful since it is hands-on and business-related. This is very obviously the case with supplier linkage programs where an element of training is almost inevitably involved. However, a feature of MNE activity (especially large Western multinationals) is their involvement in wider aspects of private sector development such as sectoral training initiatives, advice on trade and investment policy, investment promotion and after-care, etc. Young and Hood (2003) have proposed the notion of an ‘alliance compact’ between MNEs and developing country governments as an evolving partnership, taking the form of a non-binding semi-formal agreement between parties, updated annually. It is suggested that the MNE afﬁliate-host country agreement would be prepared on an individual company basis, recognizing that only a small group of the largest MNEs would be involved, at least in the ﬁrst instance. The idea has some similarities with, for example, the Business Action for Africa initiative discussed above, but it emphasizes the implementation dimensions more strongly. In addition it is not top down in character, stressing instead collaboration and partnership. In this chapter we have attempted to consider ways of achieving a balance in the rights/obligations of ﬁrms/countries. Our view is that these go beyond the WTO’s remit and require voluntarism alongside regulation. Of course it is important that the WTO remains as the central institution for liberalizing and regulating the global trade and investment system. Therefore, reporting mechanisms have to be found to ensure that MNE host country partnership activities are not totally divorced from the WTO.

NOTES 1. Between the 1940s and the 1990s, there were however a range of initiatives at the OECD and UN level, notably the binding codes of the OECD on Liberalization of Capital Movements and Current Invisible Operations (1963), the voluntary

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OECD Guidelines for Multinational Enterprises (1976, and regularly updated), and the draft (voluntary) UN Code of Conduct on Transnational Corporations (submitted in 1990 but not ﬁnished). More recently, the draft OECD Multilateral Agreement on Investment (MAI), which aimed to provide a comprehensive multilateral framework, had its negotiations suspended with no agreement. For a more thorough historical account of investment-related rules, see Brewer and Young (2000), and Gugler and Tomsik (2008). 2. For a more detailed overview of investment regulation at the bilateral level (as well as the regional and plurilateral levels) see the chapter by Gugler and Tomsik (2008). This chapter also addresses in detail relevant agreements covering investment-related issues such as the GATS, TRIPs, TRIMs, SCMs, among others. 3. This is done to a certain extent in Young and Tavares (2004) and in Gugler and Tomsik (2008). 4. For a more thorough development of bargaining power arguments, and whether competition can be replaced or complemented by cooperation, see Young and Hood (2003) who propose an ‘alliance compact’ between companies and countries. 5. This study aimed to test the Kuznets (1955) hypothesis, according to which, in order to increase economic growth and development, income inequality has ﬁrst to increase, then decreasing at a later stage. 6. There is more on CSR in Section 5 of this chapter. 7. It is beyond the scope of this chapter to consider multilateral institutional alternatives to the WTO to handle important global issues like the environment, labor, and human rights issues, etc., but, for example, an organization such as the International Labor Organization (ILO) is an obvious player in respect of labor matters. 8. See ‘The Contribution of the OECD Guidelines for Multinational Enterprises to Managing Globalization’ (www.oecd.org/dataoecd/5/34/38543990.pdf). 9. This information was obtained from an UNCTAD Expert Meeting on Best Practices and Policy Options in the Promotion of SME-TNC Business Linkages, Geneva, 6th–8th November 2006, attended by one of the authors. 10. Its corporate sponsors are Anglo American, BAT, De Beers, Diageo, International Business Leaders Forum, MSD, SABMiller, Shell, Unilever, and Visa.

REFERENCES Baldwin, R. E. (2006). Multilateralising regionalism: Spaghetti bowls as building blocs on the path to global free trade. The World Economy, 29(11), 1451–1518. Bhattari, K., & Whalley, J. (1998). The division and size of gains from liberalization in service networks. NBER Working Paper no. 3374. London: Centre for Economic Policy Research. Brewer, T. L., & Young, S. (Eds). (2000). The multilateral investment system and multinational enterprises. Oxford: Oxford University Press. Brewer, T. L., & Young, S. (2001). Multilateral institutions and policies: Their implications for multinational business strategy. In: A. M. Rugman & T. L. Brewer (Eds), The Oxford handbook of international business (pp. 283–313). Oxford: Oxford University Press.

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OUTWARD FDI FROM EMERGING MARKETS: SOME POLICY ISSUES Karl P. Sauvant Outward foreign direct investment (OFDI) from emerging markets (essentially all non-OECD countries) has risen considerably during the past decade, reaching $210 billion in 2007, for a stock of some $1.5 trillion. As in the case of developed countries, the bulk of this investment is accounted for by a limited number of economies, with ten of them responsible for 83% in 2005. An increasing number of emerging market ﬁrms are joining the rank of multinational enterprises (MNEs), i.e. ﬁrms controlling assets abroad. This development raises at least two policy-oriented questions:1 1. How should the policy regime for OFDI from emerging markets look like to support the competitiveness of the ﬁrms involved and the performance of their home countries? 2. How to manage the public reaction in emerging markets to their OFDI and in host countries to inward FDI from emerging markets?

1. THE POLICY REGIME FOR OFDI FROM EMERGING MARKETS Governments of emerging markets seeking to establish a policy regime for OFDI face a dilemma. They may recognize that OFDI is important for the

Foreign Direct Investment, Location and Competitiveness Progress in International Business Research, Volume 2, 279–284 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1745-8862/doi:10.1016/S1745-8862(07)00012-X

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competitiveness of their ﬁrms. The reason is that a portfolio of locational assets is increasingly important as a source of the international competitiveness of ﬁrms as it provides access not only to markets but also to the range of resources that are needed for the production process. This is particularly important in a world economy that is open and in which competition is everywhere, because of the liberalization of the trade, FDI and technology regimes – in other words, foreign ﬁrms can compete with emerging market ﬁrms on the latter’s home turf through imports, inward FDI and technology-transfer agreements. If emerging market ﬁrms cannot do the same – and, in the context of FDI, if they cannot improve their competitiveness through OFDI – they are handicapped: they are deprived of one source of competitiveness, namely a portfolio of locational assets. This applies not only to production OFDI but also to trade supporting FDI. Hence one side of the dilemma is that OFDI, as a source of the competitiveness of emerging market ﬁrms, should be an option available to these ﬁrms if and when they are required to take advantage of it. This is a micro-level consideration related to OFDI from emerging markets. The other side of the dilemma concerns the macro-level. More speciﬁcally, most emerging markets perceive themselves as (and in most cases are) importers of capital, not exporters of capital. This is so by virtue of being an emerging market and, hence, typically facing a balance-of-payment constraint. In any event, the priority for them is to build domestic productive capacity and increase domestic employment; to do so abroad appears, at a minimum, counter-intuitive and, at worst, unpatriotic. Permitting OFDI – let alone encouraging it – is therefore not a natural or logical thing to do. Most emerging markets, therefore (and not surprisingly) have followed a restrictive policy towards ODFI. How to resolve this dilemma between the micro-level competitiveness requirements of ﬁrms and the macro-level development constraints of governments?2 One answer for many countries is to liberalize the OFDI regime gradually, e.g. by permitting OFDI up to a certain ceiling (which can be raised), allowing it in certain sectors that are priority for the host country, or on meeting certain criteria (e.g. impact on employment, the balance of payments) – and relaxing these criteria over time. But even phased liberalization raises a number of questions. For example, how does a country protect itself against capital ﬂight and round-tripping? (A good part of Russian FDI in Cyprus, Chinese FDI in Hong Kong and Brazilian FDI in taxhavens, for example, may well be of this nature.) What are the risks when liberalizing OFDI in certain sectors and not others – for

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the country (has it picked the right sectors?) and the companies involved (is the competitiveness of companies in non-liberalized sectors compromised?)? Should a country aim for a neutral OFDI regime or, like virtually all OECD countries do, go all the way and protect and even facilitate OFDI?3 (Some developing countries have moved in this direction, too). In other words, there are a number of questions with which emerging markets grapple – and we have no convincing answers, let alone solid policy advice. This is a wide ﬁeld for urgent policy-oriented research.

2. HOW TO MANAGE THE PUBLIC REACTION TO OFDI FROM EMERGING MARKETS? To begin with, OFDI is not yet an issue in emerging markets – with the emphasis being on ‘‘yet’’. In the great majority of countries, little attention is being paid to it, both by the public and the government. In fact, only a few countries have a well thought-through policy in this area. These include Singapore which seeks to develop, through OFDI, an ‘‘external wing’’ of its economy, and China, with its ‘‘Go Global’’ policy.4 But most countries have no coherent framework. Even in a country like Brazil, where the President not long ago proclaimed that he would like to see a dozen well-known Brazilian MNEs, there was no follow-up on the policy side. This may change with the growth of OFDI from emerging markets, as the magnitudes reached for individual countries can no longer be ignored. Moreover, successful take-overs of ﬁrms in developed countries are almost celebrated as national victories – witness, for example, the successful bid of Tata (India) for Corus (Netherlands/UK) – which brings the issue to the attention of the public. The question is, of course, how long national pride in such ‘‘victories’’ can trump the macro-economic side of the dilemma. For the public (and especially trade unions), emerging markets are, after all, primarily capital importing economies; considerations of corporate competitiveness may not count much for it. Sooner or later, therefore, it is quite likely that the question of how good OFDI is for emerging markets as home countries will become a political issue in a number of these countries. (We are quite familiar with this development as, at the end of the 1960s, and driven by trade unions, there was a wide-ranging debate in the United States about the merits of OFDI; a more recent example is the reaction, especially in the US, to the offshoring of services.)

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What this calls for is an informed debate in emerging markets that are becoming home countries about the importance of OFDI and the role it plays in national development. We will need to undertake much more systematic research to be fully prepared for this debate. There is also a host country side to OFDI from emerging markets that needs to be managed. Interestingly enough, the host countries that so far have reacted most to such investment are developed countries – ‘‘interestingly’’ because it is these countries that, traditionally, have been at the forefront of promoting a liberal FDI regime. Yet, there is a distinct move towards a kind of FDI protectionism in these countries, focused largely on cross-border mergers and acquisitions (M&As), especially (but not only) by ﬁrms from emerging markets. This reaction is ampliﬁed when strategic sectors or national champions are involved, and, in particular, when the acquirer is a state-owned company.5 The state-owned aspect (as regards emerging market ﬁrms) has acquired a particularly sharp edge with the growth of Sovereign Investment Agencies which have considerable resources at their disposal and, increasingly, seek to invest them in ﬁrms abroad. In the United States, this has already led to an expansion of the mandate of the Committee on Foreign Investment in the United States (CFIUS). It is quite conceivable that a number of countries in Europe (if not the European Union itself) may establish CFIUS-type screening mechanisms. While, in principle, they would screen cross-border M&As from all countries, chances are that the principal targets are those involving parent ﬁrms headquartered in emerging markets, and especially state-owned enterprises among them. The reasons are manifold. Partly, there is a concern that emerging market MNEs may have imperfect corporate governance standards or pay less attention than their Northern competitors to social, environmental and human rights issues. In the case of state-owned enterprises, there is furthermore the concern that these may have easier access to ﬁnance and hence be in a better position to prevail in M&A bidding contests. More basic is the fear that state-owned enterprises may not work according to the logic of the market but rather manage their foreign afﬁliates in the interest of the policy objectives of their home country governments. And, most basic, perhaps, emerging market MNEs are ‘‘the new kids on the block’’. Since they are here to stay – and, in fact, bound to become more important as emerging markets develop successfully – the challenge is to integrate them smoothly into the world FDI market. And, as we know from other contexts (especially relations among states), integrating emerging powers in an established order is not easy, as it implies that the relative importance of

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other players will be diminished, if they do not disappear altogether (e.g. through M&As). To manage the reaction in home and host countries to OFDI from emerging markets presents therefore a set of challenges for which we need to prepare ourselves. This is all the more important as OFDI is an additional – and important – channel through which emerging markets are integrated into the world economy. But it is also important because the rise of emerging market MNEs, if not properly managed, could contribute to a general backlash against FDI and the open regulatory framework that governs it to a large extent. These are two policy areas – the appropriate policy regime for OFDI from emerging markets and the challenge of managing the public reaction to such investment – that I think are among the key policy issues that need to be addressed. They open a wide ﬁeld for urgent policy-oriented research.

NOTES 1. For a discussion of the range of issues related to the rise of emerging market MNEs, see Sauvant (forthcoming), as well as UNCTAD (2006). 2. Besides, there is the question: is what is good for, say Infosys, also good for India? After all, Infosys seeks to maximize its proﬁts, and takes its decisions accordingly. And, the more transnationalized Infosys becomes, the less likely it is that its decisions will pay special attention to the requirements of India. As a global player, its interests are global, not national. 3. This is examined by Theodore H. Moran, ‘‘What Policies Should Developing Country Governments Adopt Toward Outward FDI? Lessons from the Experience of Developed Countries’’, in Sauvant (forthcoming). 4. See Sauvant (2005). 5. This is part of a broader reaction to FDI, possibly even a backlash. See Sauvant (2006). Also see Sauvant (2007).

REFERENCES Sauvant, K. P. (2005). New sources of FDI: The BRICs. Outward FDI from Brazil, Russia, India and China. Journal of World Investment & Trade, 6(October 2005), 639–709, available at http://www.cpii.columbia.edu/ Sauvant, K. P. (2006). A backlash against foreign direct investment? In: L. Kekic & K. P. Sauvant (Eds), World Investment Prospects to 2010: Boom or Backlash? (pp. 71–77). London, UK: The Economist Intelligence Unit Ltd., available at http://www.cpii.columbia.edu/

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Sauvant, K. P. (2007). Regulatory risk and the growth of FDI. In: L. Kekic & K. P. Sauvant (Eds), World Investment Prospects to 2011: Foreign Direct Investment and the Challenge of Political Risk. London, UK: The Economist Intelligence Unit Ltd., avaliable at http://www.cpii.columbia.edu/ Sauvant, K. P. (Ed.) (forthcoming). In: K. Mendoza & I. Ince (Eds), The Rise of Transnational Corporations from Emerging Markets: Threat or Opportunity? London: Edward Elgar. UNCTAD. (2006). World Investment Report 2006: FDI from Developing and Transition Economies. Implications for Development. Geneva: UNCTAD.