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Regulatory distance leads to a higher propensity for Greenfield investment, while cognitive distance lowers the likelihood that foreign investors enter by ...

THE CONCEPT OF “DISTANCE” IN INTERNATIONAL BUSINESS – CULTURE, REGULATION AND COGNITION – AND ITS RELEVANCE TO MULTINATIONALS’ ENTRY MODE DECISION DELIA IONA CU ∗ Research Assistant Copenhagen Business School PhD candidate, CERGE-EI, Prague [email protected] KLAUS E. MEYER Research Professor Copenhagen Business School [email protected], [email protected] SAUL ESTRIN Professor London Business School [email protected]

Abstract The concept of ‘distance’ has been of pivotal interest to international business scholars aiming to explain variations in international business strategies and operations across foreign countries. The further a certain host country is away from the origins of a multinational enterprise (MNE), the more it has to manage cultural, regulatory and cognitive differences, and to develop appropriate entry strategies, organizational forms, and internal procedures to accommodate these differences. Scholarly research has focused primarily on the concept of psychic distance, and empirical work used indices based on Hofstede (1980) to proxy distance. However, a broader range of aspects of distance influences international business. In this paper, we extend the notion of distance to incorporate cultural, institutional and cognitive aspects. Using a unique dataset of foreign direct investment in emerging economies that incorporates multi-host as well as multihome countries, we show that these aspects affect entry mode decisions in different ways, and they moreover interact with both the investor’s experience and with the relative importance of the pertinent operation for the investing MNE.

Author contact: Delia Iona cu, Copenhagen Business School, Howitzvej 60, 2000 Frederiksberg, Denmark, tel.: (+45) 3815 3033, fax.: (+45) 3815 2500, [email protected]


INTRODUCTION The concept of ‘distance’ has been of pivotal interest for international business scholars aiming to explain variations in international business strategies and operations across foreign countries. The further a certain host country is away from the origins of a multinational enterprise (MNE), the more it has to deal with differences in culture, in laws and regulations, and in organizational practices and routines, and to develop appropriate entry strategies, organizational forms, and internal procedures to manage these differences. International business research has focused primarily on the concept of psychic distance, which captures primarily cultural differences, but as an eclectic concept also incorporates other aspects of distance (Johansen and Vahlne, 1977). Empirical work measures distance primarily by indices developed by Kogut and Singh (1988) on the basis of Hofstede’s (1980) work on national culture. Using this construct, several studies showed that the cultural distance between FDI’s host and home countries influences entry mode choice (Kogut and Singh 1988, Anderson and Gatignon, 1986, Agarwal, 1994). However, a broader variety of aspects of distance affect MNEs’ entry mode decision. Distance is of particular concern when operating in emerging economies, since a lower level of institutional development in these countries raises concerns such as incomplete legal codes governing market transactions, low level of law enforcement and lax intellectual property rights protection. In addition, managerial and commercial practices and routines used in organizations and the way the information is filtered and processed by employees are different from the extant ones in Western countries. These regulatory and cognitive aspects create uncertainties and generate restriction that MNEs have to accommodate, and, therefore, impact entry mode choice (Luo, 2001, Meyer 2001). As MNEs originating from countries with similar background possess capabilities to operate in such an environment, distance in regulatory and 2

cognitive institutional aspects between the host and the home country influences MNEs’ entry strategies. However, with the notable exception of Xu and Shenkar (2002), researchers have ignored these aspects. In this paper, we extend the notion of distance to incorporate cultural, regulatory and cognitive aspects, following recent theoretical work by Scott (1995/2001) and Kostova (1998). We thus complement indices based on Hofstede’s work, which capture mainly normative aspects of culture, with indices of regulatory and cognitive distance. We draw on widely available country-level data, and, thus, expect that our suggested complementary indices can be applied in a large number of studies in the international business field. Besides discussing the need for an alternative, enriched construct of distance, this study aims to show that MNEs and project characteristics interact with different aspects of distance and moderate entry mode choices. Previous research has already indicated that firm characteristics (Agarwal, 1994; Park and Ungson, 1997) and country characteristics (Brouthers and Brouthers, 2001) might moderate the impact of cultural distance on entry strategies. In this paper we add to these efforts by studying the interaction effects between a broader concept of distance and project specific characteristics. The analysis is carried out on a set of 208 foreign affiliates in manufacturing industry that started operating in India, Vietnam, Egypt and South Africa after 1990. These countries are at different stages of economic development and have substantial differences in their institutional environment. In addition, the MNEs in our sample originate from 48 different countries, including mature market economies as well as emerging markets. Consequently, the special appeal of this dataset is the high variations in cultural and institutional contexts not only among the source countries but also among the recipients. Therefore the results are unlikely to be driven by idiosyncrasies of a particular source or host country. 3

We find that different aspects of distance vary in their impact on strategic decisions: cultural distance has no direct effect, but it interacts with both the investor’s international experience and with the relative importance of the pertinent operation for the investing MNE. Regulatory distance leads to a higher propensity for Greenfield investment, while cognitive distance lowers the likelihood that foreign investors enter by Greenfield investment. INSTITUTIONAL DISTANCE The concept of psychic distance has been used extensively in international business research to explain the variation of corporate behaviour across borders. It aims to capture “the sum of factors preventing the flow of information from and to the market” and therefore, among other things, it encompasses “differences in language, education, business practices, culture and industrial development” (Johanson and Vahlne, 1977, p. 24). In empirical studies, however, psychic distance is mostly proxied by cultural distance and measured with the index developed by Kogut and Singh (1988) on the basis of Hofstede’s (1980) work on national culture.1 Hofstede measures culture on four scales, masculinity-femininity, individualism-collectivism, uncertainty avoidance, and power-distance. These concepts capture primarily attitudes and norms held by individuals in a society, which is only a subset of ‘culture’ albeit an important one. However, when entering a foreign market, MNEs interact with a complex local environment, which, in addition to culture, includes legal, political, social, and education systems, all being part of a multifaceted institutional environment (Coase, 1998). Recent developments in institutional theory and international business provide us with an alternative, broader construct for capturing the full realm of distance. Kostova (1998) proposes a new measure of cross-country distances that aims to capture the complexity of a country’s 1

An indication of the popularity of the measure is frequency of citations to Kogut and Singh (1988). According to the SSCI database, the paper was cited 260 times from 1988 to 2003, of which 28 times in the year 2003.


institutional environment. Following Scott (1995/2001), her country institutional profile index encompasses three different dimensions: a regulatory, a cognitive, and a normative one. The regulatory pillar reflects the existing laws and regulations in a region or country and the extent to which these rules are effectively monitored and enforced. The cognitive pillar rests on the cognitive structures embedded in a society, that is, the widely shared social knowledge and cognitive categories (e.g. schemata and stereotypes) used by the people of a given country (Markus and Zajonc 1985). The normative pillar consists of beliefs, values, norms that define the expected behaviour in a society. 2 Applied to different aspects of international business, the regulatory, cognitive, and normative pillars have already been shown to have an impact on several investment practices and aspects related to MNE’s operations in foreign countries. For instance, each institutional dimension is likely to facilitate or impede the transfer of strategic organizational practices from a parent company to a recipient (Kostova and Roth, 2002) and to insure the acceptance of its norms and practices within the socially constructed system of rules, norms, and cognitive frames in different host environments (Kostova and Zaheer, 1999). Foreseeing these relations, MNEs can adjust their strategies to facilitate the transfer of business practices and to obtain legitimacy in foreign countries. The ease and the extent of adjustment will depend on MNE’s familiarity with a country’s institutional profile (Xu and Shenkar, 2002). Therefore the all three dimensions of distance as defined by Scott (1995/2001) are highly relevant for MNEs’ choice of their entry mode.


We henceforth use the terms normative distance and cultural distance interchangeably. Theoretically, the former is a narrower concept. But this distinction is not made in prior international business literature, where Hofstede’s indices – which actually measure normative aspects of culture – are used as proxy for culture.


THE IMPACT OF INSTITUTIONAL DISTANCE ON THE ENTRY MODE CHOICE When expanding into foreign countries, MNEs have to adapt their strategies, particularly their entry mode choice, in order to mitigate the uncertainties of their future operation in a foreign country (Anderson and Gatignon, 1986) and, meanwhile, to earn legitimacy in the new context while maintaining internal consistency (Kostova and Roth, 2002). Familiarity with the new circumstances helps MNEs to get a better knowledge of the foreign environment and, therefore, to achieve and maintain synergy both with MNE’s and host country’s contexts. Such familiarity, could be gained through previous commercial/investment experience in the country (Johansen and Vahlne, 1977) or similarity of domestic and host environments (Kogut and Singh, 1988). However, empirical studies on the impact of similarity of home and foreign environments on the entry mode choice have been inconclusive (Shenkar, 2001; Brouthers and Brouthers, 2001). For example, Pan (1996) finds a positive correlation between control over the affiliates and cultural distance while Kogut and Singh (1988) report the opposite. The cause for this inconsistency is, probably, due to weaknesses of the measure rather than to the futility of such construct. Several authors suggest analysing the impact of cultural distance jointly with other institutional measures that moderate uncertainty and may induce adjustments in foreign operations (Agarwal 1994, Sutcliffe and Zaheer 1998, Brouthers and Brouthers 2001). Yet, so far no empirical study has analysed how distance in these institutional aspects affect the entry mode decision. Moreover, the theoretical arguments for linking distance with mode choice have been drawn from transaction cost economics, which suggests that MNEs react to uncertainty per se by adjusting their entry decisions. This approach, however, does not distinguish between cultural distance and other factors that prompt uncertainties (Harzing, 2003). As a remedy, several scholars recommend using institutional theory when assessing the link between institutional environments and MNEs’ decision on entry mode (Lu 2002, Xu and Shenkar, 2002). Especially 6

when investigating entry strategies in emerging markets this is an appropriate way to proceed since “… in the early stages of market emergence, institutional theory is preeminent in helping to explain impacts on enterprise strategies” (Hoskisson et al., 2000, p. 252). Recent research in institutional theory offers a broad perspective for understanding the entry choice of MNEs. Organizations act in a complex environment formed by regulative, cognitive and normative factors. All these dimensions exert pressures and expectations (Scott, 1995/2001). In order to manage them and to earn legitimacy in distinct local environments, organizations adjust their strategies (Oliver, 1991; D’Aunno, Sutton, and Price, 1991). These adjustments may be, however, not uniform across the institutional dimensions, as the regulatory, cognitive, and normative pillars are based on different types of motivation – coercive, mimetic, or normative, respectively. Therefore, they exert dissimilar pressures on organizations. For example, favourable cognitive and normative institutional factors facilitate the internalisation of an organizational practice by MNE affiliates, while in a favourable regulatory environment a parent’s request to adopt a practice may be perceived as an external coercion that impedes its internalisation (Kostova and Roth, 2002). Consequently, institutional theory points to the necessity to distinguish between different aspects of institutions. Hypotheses Adopting successful practices of their parents and earning legitimacy are of vital importance for MNEs’ affiliates. Due to unfamiliarity with the local environment, costs steaming from geographic distance and restrictions on foreign investors, foreign firms are bound to have lower profitability than their local competitors. Consequently, it is crucial for MNEs to transfer their organizational practices that constitute an important source of competitive advantage to their affiliates in order to overcome their liability of foreignness (Kogut, 1991; Grant, 1996). In


addition, local firms develop organizational structures and cultures that are consistent with isomorphic pressures in their local environment. They are thus adapted to local institutional structures. Foreign affiliates, however, should accommodate these pressures and earn legitimacy in order to insure their survival and success in the new context (Hannan and Freeman, 1977). Having to gain legitimacy with both the local environment and with the worldwide organization of the MNE, subsidiaries of multinational firms are therefore subject to institutional dualism (Kostova and Roth 2002). Distances in the three different institutional pillars put different strains on the tension stemming from local and corporate institutional pressures. Thus, Kostova (1999) argues that a high normative, regulatory or cognitive institutional distance between the host and home country impedes the transfer of strategic organizational practices from a parent company to a recipient. If a practice is inconsistent with existing local regulations, norms or cognitive structures, then the employees may be reluctant to implement it, or might face problems in understanding and learning it. Meanwhile, it is especially normative and cognitive distance between an acquired business unit and the parent organization that inhibit its ability to attain legitimacy with the local context (Kostova and Zaheer, 1999). In contrast, regulatory aspects are more formalized and thus easier understood by MNEs, and accepted as cause for local adaptation. Therefore, while a high normative and cognitive distance impedes the adoption of an MNE’s practice as well as restrains the affiliate’s capacity to establish legitimacy, a high regulatory distance is likely to have a negative effect only on the adoption of an MNE’s practice. Acquisitions and JVs face high pressures to gain legitimacy and adopt some local practices and, therefore, to remain or become, in case of JVs agreements, similar to local firms (Rosenzweig and Nohria, 1994). Therefore choosing one of these entry modes seems more appropriate for MNEs when attaining legitimacy is more of an issue than transferring own 8

practices to affiliates. On the other hand, Greenfield investors establish a new organization by recruiting and training staff individually, and creating an organizational structure that matches the MNE’s global structures (Bartlett and Ghoshal, 1989). Consequently MNEs are more likely to choose a Greenfield entry when transmitting own practices to their affiliates is of a more concern than earning and maintaining legitimacy. As we discussed above, when the regulatory distance increases it becomes more difficult for affiliates to adopt practices of their parents. By setting up a Greenfield investment, the MNE can partially alleviate this problem because they can create the new organization after their own image, e.g. by recruiting suitable individuals and by training them in the parent firm’s organizational practices (see Figure 1). Thus, we expect that an increase in regulatory distance would have a positive impact on MNEs’ propensity to set Greenfield investments: Hypothesis 1a: MNEs are more likely to choose Greenfield investment than acquisition or joint venture when the regulatory distance between the home and the host countries is large. However, a high normative or cognitive institutional distance has a negative impact on both practice adoption and affiliates’ ability to earn legitimacy. The degree to which one or the other reason prevails is often practice-dependent (Zaheer, 1995) and is sensitive to specific contextual variables (Rosenzweig and Nohria, 1994). Herein lays the need to interact distances in these institutional aspects with such variables. On one hand, obstacles to practice adaptation in existing organizations would encourage Greenfield investment. On the other hand, obstacles to gaining legitimacy would encourage joint venture or acquisition entry. Hence, the aggregate effect is theoretically ambiguous. However, we believe that in developing countries the need to gain legitimacy and thus access to local business networks outweighs other considerations, and thus hypothesize that normative and cognitive distance would encourage JV entry or acquisitions. 9

Hypothesis 1b: MNEs are less likely to choose Greenfield investment than acquisition or joint venture when the cultural (normative) distance between the home and the host countries is large. Hypothesis 1c: MNEs are less likely to choose Greenfield investment than acquisition or joint venture when the cognitive distance between the home and the host countries is large. The above discussions suggest that different facets of the institutional distance are conceptually and empirically distinct. A comprehensive understanding of the effect that institutional distance have on MNEs’ mode of entry choice would thus require that all three measures of institutional distance be used simultaneously to explain the choice of entry mode. THE INTERRACTION OF INSTITUTIONAL DISTANCE WITH FIRM AND PROJECT CHARACTERISTICS Contextual variables like the affiliate’s embeddedness in the local environment and foreign parent’s characteristics influence the degree to which local isomorphic pressures faced by an affiliate are stronger than corporate ones (Rosenzweig and Nohria 1994). We would expect that MNEs are more inclined to choose entry mode(s) characterized by ease in accommodating the highest pressure. Therefore we conjecture that the extent to which the affiliate is embedded in the local environment and characteristics of the foreign parent moderate the impact of institutional distances on MNEs’ entry mode decisions. In what follows we analyze two such characteristics: the relative size of the affiliate as a measure of the level of local embeddedness and foreign parent’s international experience. The relative size of the operation Overseas affiliates vary in their relative importance for the investing MNE. When MNEs seek to set large Greenfield operations with respect to their own size, internal constraints may inhibit the


establishment of the new affiliate. Assuming that there is a maximum rate at which firm can recruit and train managers, firms expanding rapidly may experience a shortage in personnel (Penrose, 1959). Similarly, setting a large Greenfield affiliate requires a larger financial effort that the MNE might not be able to afford. Therefore, MNEs aiming to establish large affiliates relative to their size might need to obtain additional managerial and/or financial resources either by acquiring a local firm or setting a JV with a partner. Accordingly, several studies established that larger affiliates are less likely in form of Greenfield (Kogut and Singh 1988, Hennart and Park 1993, Brouthers and Brouthers 2000). A large subsidiary, relative to the size of its parent, commands more attention from top management than a smaller operation as it has a stronger impact on corporate performance. Moreover, the transfer of practices becomes both crucial and more difficult because the parent has fewer resources and experiences. Large acquisitions take on the character of mergers in that both organizations have to adjust to each other, rather than the small acquired unit adapting to the established practices of the new parent. Such a merger process requires far more intensive interaction between individuals, and thus cross-cultural communication (Haspeslagh and Jemison, 1991). Similarly, when setting up a JV agreement the MNE exposes itself to problems regarding intercultural negotiations that are likely to result in a decreased performance of the affiliate (Brett and Okumura, 1998). Cross-cultural communication is however more likely to fail the higher the normative and cognitive distance between the organizations. This is because differences in scripts, schemas, norms or values impede information sharing between individuals from different cultures and might inhibit their ability to search for better alternatives. Hence, in a distant market, obstacles to establishing and managing an acquisition or joint venture rise disproportionately. Thus, firms wishing to establish a large operation would be more likely to choose Greenfield then they would be in nearby locations. 11

Hypothesis 2: MNE’s establishing a large affiliate (relative to their own size) are less likely to enter by Greenfield investment, yet this effect is weaker in countries with high normative and cognitive distances. Experience in developing countries Emerging markets share several characteristics that differentiate them from developed markets. Problems with law enforcement are symptomatic in these countries, raising concerns regarding foreign investors’ ability to enforce contracts and agreements. In addition, firms from developing countries have not as much of marketing capabilities, resource endowments (Hitt et al. 2000), and experience in forming and managing strategic alliances as their counterparts from industrialized nations (Lewin, Long and Carroll, 1999). Given these differences, skills developed though prior experience in developed countries are often inappropriate or impossible to apply in emerging markets (Tallman, 1992). Therefore recent research investigating international business practices in such regions tends to emphasize the role of regional experience for the MNEs’ strategic decisions, rather than more general measures of international experience or host country experience (Delios and Henisz 2003, Uhlenbruck 2004, Henisz, 2003). Given the difference in resource endowments and capabilities that often exist between firms in industrialized and less industrialized countries, it is likely that in acquisitions and JVs between firms from these different regions, the configuration of objectives between partners is different (Child and Faulkner 1998, Hitt et al. 2000). The divergence in partners’ objectives undermines the profitability of affiliates and the stability of relationships. MNEs with some prior experience in these countries might have already developed routines that are adapted to the particular context of emerging markets, which help them to overcome the restructuring challenges facing acquisitions and the coordination problems with local partners. Meanwhile,


they are more likely to identify local partners with converging objectives. Consequently, prior experience in emerging markets eases MNEs’ selection process of most suitable partners and has a positive impact on the profitability and stability of subsidiaries that involve a local partner. MNEs with greater international experience are expected to have a less parochial attitude and allow their affiliates to adopt more local practices (Stopford and Wells, 1972; Rosenzweig and Nohria, 1994). However, since the experience accumulated in developed markets tends not to be easily transferable to emerging markets (Tallman, 1992), we conjecture that only MNEs that have some prior experience in developing countries are likely to develop a more cosmopolitan perspective. Consequently, we expect that the adverse effect that normative, regulatory and cognitive institutional distances exert on parent practice adoption and therefore on the MNEs propensity to acquire or set JVs will be eased once the foreign parent has some prior experience in emerging markets. Hypothesis 3: MNEs with previous commercial experience in developing countries are less likely to enter by Greenfield investment, and this effect is stronger for distant countries in the normative, regulatory and cognitive institutional aspects. INDICES OF INSTITUTIONAL DISTANCE

In this section we develop institutional measures that are relevant for the entry mode choice. Regulatory dimensions relevant to the entry mode decision regard the existence of laws, rules and government policies that influences the establishment of a foreign affiliate and its future operation. Therefore, a broad range of regulatory aspects should be covered: the ease of obtaining business license, corruption within the bureaucracy, labour regulations, environmental regulations, consumer safety regulations, worker health regulations, and regulations that impose a burden on business. All these aspects are captured by the Regulatory factor of the Economic 13

Freedom Index 2000 published by The Heritage Foundation. We computed the regulatory distance as the absolute value of the difference between the regulatory measures of the home and host country. The normative pillar of a country’s institutional profiles consists of values and norms. Values define what is preferred or desirable while norms specify how things should be done. Three out of the four cultural dimensions defined by Hofstede (1980) capture aspects of expected social behaviour: Power Distance describes the expected behaviour toward higher and lower rank people,




attitude toward




Masculinity/Feminity captures the accepted behaviour according to one’s gender (Hofstede and Bond, 1988). In addition, the normative dimension encompasses beliefs and assumptions about the human nature that exist in one society. These beliefs are reflected in an individual’s attitude and quest for truth. More precisely, on the religious or philosophical level, individuals from some societies believe in an ultimate truth and adhere to strict laws and rules that lead them to it. Unusual situations make them feel uncomfortable and so they rather avoid them. However, in other societies people are relativist, have as few rules as possible, and feel at much more ease in unstructured situations. These aspects are captured by the forth dimension of Hofstede’s culture construct – Uncertainty Avoidance. As already mentioned, an extensive literature shows the relevance of distance in Hofstede’s cultural construct for the entry mode decision. Therefore we use as a proxy for the normative distance an index based on Hofstede’s cultural construct that we compute in the following way: D= i

( I i ,host − I i ,origin ) 2 Vi


where Ii,host (Ii,origin) is the ith dimension of the index for the host country (country of origin) and 14

Vi is the variance of the ith dimension.

The cognitive pillar comprises frames, routines and scripts used by individuals in one society to judge and to assign meaning to a phenomenon and to solve problems. The existent cognitive frames held by employees in organizations determine which information is retained and how it is processed, organized and interpreted. They also shape the preset routines or recipes developed by organizations in order to provide guidance and reduce the discretion of the individuals when attempting to solve problems. Both – the way new information is processed by managers and other employees and the relevance of developed and adopted routines – affect the future operation and performance of foreign affiliates. These aspects are difficult to measure, especially by readily available data. However, individuals with higher education are more likely to spot and adequately process essential information and are more receptive to innovation (Becker, 1970; Rogers and Shoemaker, 1971; Kimberly and Evanisko, 1981). In addition, in comparison with individuals that are mainly interested in their own community, individuals oriented towards society beyond own community are also more committed to attain professional goals and therefore are more likely to adopt innovations at their workplace (Merton, 1957). Therefore, highly educated employees or employees that have a more cosmopolitan attitude are more incline to contribute to the realm of valuable routines developed in organization. Moreover, people that are more exposed to new information and technology have a broader scope to add to the sphere of organizational knowledge and routines. We aim to measure the availability of employees with high education level by the percentage of economically active population that has attained at least tertiary education and with the average schooling years in the total population. The number of computers and Internet hosts per 1000 persons captures peoples’ exposure to new information, technology and routines. We also use the latter measure as an indicator for a society’s level of cosmopolitanism. 15

Data for the four aspects of the cognitive distance comes from various sources. We consulted ILO Yearbook of Labour Statistics, OECD Statistics, and country Statistical Offices to collect data on the percentage of economically active population that has attained at least tertiary education. The average schooling years in the total population comes from Barro and Lee’s (2000) dataset on educational attainment. For the number of computers and Internet hosts per 1000 persons we used the World Development Indicators. We used data for the year 2000. Crombach’s alpha analysis showed a 0.60 inter-item correlation and therefore we compute a cognitive distance using a formula as above. The advantages of the above constructs rest on the fact that they are based on readily available data for almost all developing and developed economies. In addition, with the exception of Hofstedes’s (1980) cultural dimension, these indexes are reported each year, starting at least from 1995, making them suitable to be used with recent sets of data. METHODOLOGY AND RESULTS Data While the proposed measures of institutional distance have been taken from publicly available sources, we use data from a recent FDI survey in emerging markets to capture project and firm specific effects (Estrin and Meyer, 2004). The base population for the survey study has been defined as all registered foreign direct investment projects established between 1990 and 2000, with a minimum employment of 10 persons, and minimum foreign equity stake of 10%. The questionnaire was administered to foreign investment companies in the four countries between November 2001 and April 2002 by local research institutions. They send the questionnaire to a stratified random sample drawn from the base population. In most cases, they followed up by sending specifically trained assistants to interview the CEO or an appropriate


manager in the firm. In some case, questionnaires were received by mail, but this method alone generally would have been insufficient to obtain satisfactory return. Response rates vary between 10% in Egypt and 31% in South Africa. A total of 613 responses were received. For this study, we use only the manufacturing subset that consisted of 327 foreign affiliates. After accounting for missing values we obtained 208 useable observations for this analysis. Dependent variable Mode of entry is a dummy variable that takes a value of 1 if the foreign operation was set up as a

Greenfield investment and a value of 0 otherwise. We classified a newly established operation as Greenfield investment if it was fully owned by foreign parents and did not involve takeover of a local firm. In our sample, most foreign operations were set up as Greenfield investment while acquisition projects were the least numerous. Independent Variables The focal independent variables of this research, the measures of institutional distance, have been introduced above. The hypothesised interaction effects are tested on the basis of the survey data. The relative size affiliate/parent takes into account the relative turnover in the affiliate and in the parent company for the year 2001. It comes from the survey and was assessed based on a Likerttype scale from one (0.0-0.1%) to six (over 20%). The level of parent’s experience in developing countries is captured by a dummy variable that takes a value of 1 if the foreign investor has had

prior commercial experience in the host country or in other emerging markets. In line with previous findings in the literature, we introduce a number of control variables to account for firm and project specific influences on mode choice: market seeking (the percentage of output sold in the domestic market during the first year of business operation), the sources of main resources (the percentage of the main resource that was obtained from the 17

foreign parent firm during the first two years of operation), the level of R&D intensity of the foreign parent (the worldwide expenditure of the foreign parent firm on R&D as a percentage of its global sales), the industrial relatedness of parent and affiliate (a dummy that takes a value of 1 when one of the affiliate’s products is also produced by its foreign parent), foreign parent’s degree of diversification (a dummy variable that has a value of 1 if the parent is a conglomerate diversified into unrelated business sectors), time trends separately for each country and country dummies. Table 1 shows the correlation matrix and descriptive statistics of the dependent and independent variables. Most correlations of the independent and the control variables with the entry mode choice are significant. Apart for the interaction terms, these correlations do not reach ranges for which multicollinearity would be a concern. Results We perform the econometric analysis with a Logit model in which the dependent variable is the mode of entry, and takes the value of 1 for Greenfield investments and a value of 0 otherwise.

This procedure estimates the probability that a foreign investor establishes a Greenfield investment

P(mode of entry = greenfield ) =

eY , 1 + eY




where Y is defined as Y=




X1 +


X2 + … +


X1, X2, … , Xn are the independent variables. All results are reported in Table 2.

The regulatory distance is highly significant and its sign is as predicted in Hypothesis 1a (Model 1). The impact normative distance has on MNEs’ propensity to set up Greenfield


investments is positive, but insignificant (Model 2). Consequently, as expected, Hypothesis 1b is not supported. When the normative distance is high, earning legitimacy with both local and parent environments becomes problematic. We conjectured that a similar result holds for the cognitive distance. Nevertheless, we find a strong support for Hypothesis 1c (Model 3). This would suggest that the negative impact that cognitive distance has on the transfer of MNEs’ practices might be easily overcome by providing adequate training to affiliate’s employees. When pulled together, the simultaneous impacts of the institutional distances on the entry mode choice are almost the same with their individual effects (Model 4). Wald tests on the individual and grouped coefficients show that each institutional distance should be retain in the analysis. Consequently all three institutional distances should be used simultaneously when analysing MNEs’ entry decision. Models 5 to 7 assess the impact of interaction terms on the entry mode choice. As predicted, the relative size of an investment with respect to MNE’s size is negatively related with the propensity to establish a Greenfield investment. Since a larger subsidiary commands more attention from its parent we expected that due to the adverse effect that normative and cognitive distance have on the outcomes of intercultural negotiations, these two aspects of institutional distances moderate the impact of relative size on the entry mode choice. This is confirmed for normative distance (Model 5). However, the interaction effect remains insignificant for cognitive distance. Apparently, the negative impact of cognitive distance on intercultural negotiations can be overcome by training the affiliate’s employees or by more active negotiations. We conjecture that it is easier to convince people of the value of new knowledge rather than to pursue them to change their norms and beliefs. Thus, Hypothesis 2 is partially supported. To gain further insights on the combined effects of normative distance and relative size, based on Model 5, we analyse the marginal effects by taking the first derivative of equation (1) 19

with respect to relative size holding all explanatory factors, except relative size and normative distance, constant at their mean value: ∂Y = −0.732 + 0.259 Hofstede_d . ∂Relative size


Thus, ceteris paribus, the overall impact of the relative size on the propensity to establish a greenfield investment is negative when the normative distance between FDI’s home and host country is small but turns positive once this distance becomes high enough (Hofstede_d > 2.825) (see Figure 2 where we defined “low” and “high”, values that are, respectively, 1 standard deviation above and below the mean).

When the normative distance between the host and

the home country is small, a high relative size is associated with acquisition or JV. However, when the normative distance is high, normative institutional constraints become more important than the Penrose constraint, and foreign investors set greenfield investments even when the relative size of the project with respect to the MNE is high. As far as regards the direct and moderating effect of prior commercial experience in developing countries, such experience increases foreign investor’s propensity to form JVs with local partners or to acquire a domestic firm. Since MNEs that have prior commercial experience in emerging market are likely to embrace a more cosmopolitan attitude and allow their affiliates to adopt more local practices even in very different environments, this tendency is reinforced for any given level of normative and regulatory distances. However, this is not anymore true for the cognitive distance. As we already pointed out, differences in cognitive aspects can be overcome by providing adequate training to affiliate’s employees, and therefore the adverse pressure that they exert on parent practice adoption seems to be insignificant. The fact that further international experience lessens this pressure does not bring additional value. Thus, Hypothesis 3 is partially supported.


Finally, using Wald tests for linear hypotheses, we identify the institutional distances and the interaction terms that are significant for the entry mode choice. Based on these tests, we construct a more parsimonious regression (Model 9). This final model has at least 18% higher explanatory power than all the other models that use only singular dimension of institutions (an 0.382 R2 against 0.323) and a 9% higher explanatory power than Model 4. Thus distance in all three dimensions together with their interaction with firm characteristics should be simultaneously considered.

DISCUSSIONS The concept of institutional distance helps explaining how differences between countries affect international business. We have in this chapter proposed that this concept is broader than the concept of cultural distance used in prior research; and that cognitive and regulatory aspects of distance may have quite different effects on business strategies. Our results confirm the opposite effects of different aspects of distance on entry mode choice, and the variation of interaction effects with firm and project specific variables. More specifically, we show that while an increase in the regulatory distance results in a higher propensity to set up a Greenfield investment, the opposite is true for high differences in cognitive aspects. Achieving internal consistency is impeded in highly distant normative, regulatory or cognitive institutional contexts. By setting up Greenfield investments MNEs can ease the transfer of strategic organizational practices to its affiliate. Meanwhile, legitimacy of the foreign operations is more difficult to attain when the normative and cognitive distances are high, but this may be overcome by entering with a local partner. The relative importance of external legitimacy and internal consistency often depends on specific contextual variables. We therefore hypothesised that the probability of a Greenfield investment is positively related to the regulatory


institutional distance, but negatively related to normative and cognitive institutional distance. Our empirical analyses confirm the opposite effects of regulatory and cognitive distance, while the normative (cultural) distance remains insignificant unless interaction effects are taken into account. MNEs appear to be able to overcome the obstacles of cognitive distance for the transfer of MNEs’ practices by providing training to affiliate employees. The relative importance of the pertinent operation and MNEs’ level of international experience moderate the impact of institutional distance on the entry decision. As larger affiliates command more attention from their foreign parent, MNEs that aim to establish large foreign operations are more incline to avoid problems stemming from intercultural negotiations by setting up Greenfield investments. Such intercultural communication problems arise with normative and cognitive distance, and we could confirm that normative distance is likely to deter Greenfield entry if the project is large. However, it seems that unlike normative differences, differences in cognitive aspects between intercultural negotiators are easier understood and accepted as cause for adaptation. With respect to international experience, we conjectured that since MNEs with prior experience in emerging markets have a less parochial attitude and allow their affiliates to adopt fewer corporate practices, the pressure that institutional distances have on parent practice adoption is eased. Therefore we expected that even in highly distant institutional environments an increase in MNEs’ international experience raises its propensity to set JVs or acquire local firms. With the exception of cognitive distance, we found that indeed, MNEs’ level of international experience moderates the impact of institutional distances on the entry mode choice. Since differences in cognitive aspects can be overcome by providing adequate training to affiliate’s employees, the adverse pressure that they exert on parent practice adoption seems to be


insignificant. Therefore, the fact that further international experience lessens this pressure might not add additional value. Our analysis reveals certain particularities of developing countries. When expanding into foreign countries MNEs tend to start from low levels of capital commitment and gradually increase this level. In developed countries Greenfield investments require a higher capital level than acquisitions or JVs. However, in a developing context, due to obsolete technology acquisitions might absorb a comparable amount of capital as Greenfield investments. In addition, problems with law enforcement further lessen the incentive to look for a local partner. Therefore, while in developed markets international experience has a positive effect on the propensity to set up a Greenfield investment, our results reveal an opposite linkage for developing countries.

LIMITATIONS AND FUTURE RESEARCH We have introduced measures of the institutional environment based on readily obtainable data, with the objective to offer an easily computable index that is available for a wide range of countries, including developing ones. This approach has however some weaknesses. Some relevant normative and cognitive aspects may not be captured by our measure (e.g. entrepreneurship orientation of individuals, managerial abilities, the quality of education, admiration for quality work). Moreover, we use culture as a proxy of the normative dimension. However, culture is a carrier not a component of the institutional environment (Scott, 1995/2001). Even though Hofstede’s (1980) measure of culture captures mainly normative aspects, some cognitive characteristics like entrepreneur’s ability to deal and manage risk are also encapsulated in this construct. Further research may wish to develop an alternative construct for the normative environment. In our empirical analysis we have studied the relation between entry mode choice and the 23

institutional distance using a dataset that consists from FDI in manufacturing industry. However, scholars have shown that because of their peculiarities (e.g. low capital intensity), service firms’ might choose their entry modes based on different criteria than manufacturing firms. In further research scholars might want to investigate the relevance of the institutional distance for the entry mode choice in services.

CONCLUSIONS Previous research has shown that country similarities influence the entry mode choice. To account for differences in host and home countries context, scholars have used the concept of psychic distance, mostly measured by Hofstede’s (1980) dimensions of culture. In this study, we show that besides cultural factors, cognitive and regulatory dimensions “create” country distances that are highly relevant for international business strategies. Different institutional aspects impact the entry mode decision in different ways and therefore, in order to capture the whole pressure that distance exerts on MNEs’, researchers should consider all these aspects together. In addition, institutional distances interact with MNE and project characteristics in determining the entry strategy. Thus, the impact of MNEs’ and project’s characteristics on the entry decision is moderated by country differences to such extent that an increase in distance might even reverse the direction of this impact. The fact that scholars have ignored these interactions might explain the conflicting results obtained in previous research. We encourage others to use a more comprehensive distance measure the cultural distance, and to account for the interaction of country differences with foreign investor and subsidiary characteristics. This is particularly important when studying international business strategies in developing countries, where institutional distance between host countries and the investors’ source country is often very large.


Figure 1:

Regulatory distance Normative distance Cognitive distance

Figure 2: Probability of greenfield..

Normative distance * Relative size 0.6 0.5 0.4 Low normative dist


High normative dist

0.2 0.1 0.0 low

high Relative size

Table 1: Descriptive Statistics and Correlation Matrix Variable 1 Greenfield 2 Hofstede_d 3 Hofstede_d*Relative size 4 Hofstede_d*Experience 5 Regulatory_d 6 Regulatory_d*Relative 7 size Regulatory_d*Experience 8 Cognitive_d 9 Cognitive_d*Relative size 10 Cognitive_d*Experience 11 Experience 12 Market seeking 13 Source of main resource 14 Relative size 15 Related 16 R&D intensity 17 Diversification

Mea *** 2.38 7.21 2.20 1.62 5.36 1.47 3.88 12.0 4 3.56 0.91 70.9 9 59.0 7 3.16 0.86 3.48 0.15

SD *** 0.99 5.06 1.16 0.96 5.18 1.02 1.58 8.62 1.88 0.29 41.1 7 42.7 5 1.84 0.35 2.01 0.36

1 1 0.09 0.18 -0.06 0.34 0.31 0.16 -0.07 0.08 -0.17 -0.23 -0.28 0.24 0.11 0.16 0.08 -0.20












1 0.47 0.82 0.27 0.05 0.28 0.35 0.04 0.33 0.13 -0.03 0.08 -0.17 0.12 0.04 -0.05

1 0.33 0.28 0.64 0.21 0.12 0.69 0.06 -0.06 -0.28 0.03 0.72 0.17 0.05 -0.15

1 0.20 -0.02 0.47 0.30 -0.02 0.58 0.60 -0.02 0.09 -0.22 0.05 0.12 -0.05

1 0.72 0.84 0.19 0.24 0.16 0.00 -0.37 0.21 0.14 0.08 -0.10 0.09

1 0.54 0.08 0.66 0.00 -0.11 -0.45 0.13 0.70 0.17 -0.07 -0.07

1 0.21 0.16 0.42 0.46 -0.29 0.22 0.04 0.02 0.01 0.11

1 0.48 0.80 0.07 -0.16 0.01 -0.08 0.01 0.07 -0.16

1 0.29 -0.11 -0.36 -0.02 0.77 0.08 0.05 -0.21

1 0.60 -0.11 0.02 -0.17 -0.02 0.13 -0.12

1 0.02 0.04 -0.19 -0.08 0.17 0.04

1 -0.08 -0.27 -0.05 0.02 0.08





1 0.00 1 0.04 0.11 1 0.16 0.00 0.01 1 -0.04 -0.15 -0.17 -0.05


Table 2: Entry Mode Choice – Institutions and Interaction Effects Logistic Regression Results (Greenfield = 1) Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8 0.765** 2.831** 0.882*** Regulatory_d (6.49) (4.55) (7.08) Regulatory_d*Relative 0.024 size (0.04) -2.311* Regulatory_d*Experience (3.5) 0.140 0.480 0.693 Normative_d (0.52) (0.41) (0.81) 0.255** Normative_d*Relative 0.259** (4.92) (4.32) size * -1.244 -1.262* Normative_d*Experience (3.13) (3.21) *** -0.406 -0.720 -0.515*** Cognitive_d (8.91) (2.4) (10.06) 0.038 Cognitive_d*Relative size (0.33) 0.229 Cognitive_d*Experience (0.3) *** *** *** *** -2.547 -2.404 -2.465 -2.891 -0.261 -0.332 -3.287* -0.776 Experience (13.2) (12.2) (11.91) (13.94) (0.03) (0.06) (3.79) (0.27) -0.010* -0.011** -0.011** -0.012** -0.010* -0.009* -0.011** -0.010* Market seeking (3.75) (4.57) (4.75) (5.23) (3.68) (3.24) (4.18) (3.64) 0.010** 0.010** 0.010** 0.010** 0.011** 0.011** 0.010** 0.011** Source of main resource (4.88) (5.39) (4.54) (4.84) (5.65) (5.8) (4.83) (5.36) -0.126 -0.122 -0.183 -0.170 -0.157 -0.732** -0.317 -0.765** Relative size (1.23) (1.19) (2.56) (2.02) (0.48) (6.08) (1.44) (5.96) 0.531 0.443 0.347 0.302 0.359 0.320 0.350 0.141 Related (0.84) (0.6) (0.36) (0.24) (0.37) (0.3) (0.36) (0.05) 0.197* 0.165 0.240** 0.271** 0.206* 0.149 0.242** 0.254** R&D intensity (3.6) (2.58) (4.8) (5.73) (3.75) (1.99) (4.82) (4.72) *** ** *** -1.616 -1.308 -1.568 -2.083*** -1.715*** -1.592** -1.552*** -2.481*** Diversification (6.96) (4.98) (6.82) (10.07) (7.12) (6.15) (6.64) 11.3 ** * ** 1.208 2.199 4.178 3.059 -0.675 2.231 5.327 3.090 Constant (0.54) (1.93) (6.36) (2.87) (0.09) (1.05) (5.22) 1.76 84.44 78.08 87.37 97.52 89.82 87.51 87.94 106.26 Chi-square (df) (15) (15) (15) (17) (17) (17) (17) (19) 2 Pseudo R 0.304 0.281 0.314 0.351 0.323 0.315 0.316 0.382 Variables

Note: * =10%, ** =5%, *** =1%; Wald tests are reported in pharantheses. We had 208 observations in each regression. The regression included country dummies and time trends for each country. All the regressions (Model 1 to Model 9) also included industry dummies, but since none of them was significat and since our sample is small we decided to drop them.


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