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Multinational Corporations and the Developing Countries

Sukumar Nandi
Indian Institute of Management Lucknow
Practical men, who believe themselves to be quite exempt from any
intellectual influence, are usually the slaves of defunct economist.
Madmen in authority, who hear voices in the air, are distilling their
frenzy from some academic scribblers of a few years back.
! ". M. #eynes, General Theory of Employment, Interest
and Money]
$he degree of integration of the capital markets of different countries has
increased in recent times with the tremendous surge of capital mobility across political
boundaries. $his phenomenon has also increased the role of multinational corporations in
the economic development of the developing countries. %onceptually there are five ways
in which a multinational corporation &M'%( can serve a foreign market)
& i( invest directly by a *reenfield venture,
&ii( invest directly by acquiring a local firm,
&iii( invest directly by starting a +oint venture with a local firm,
&iv( enter into a strategic alliance with a local firm.
$he ,
alternative is no direct investment in the host country, but the M'% can serve the
host country market by exports or giving license to the local firm. $he first four
alternatives involve foreign direct investment &-./( on the part of M'%. 0hether the
latter will go for -./ or the ,
alternative depends on both the economic conditions of the
host country and the business strategy of M'%. /n the case of developed countries like
12%. economies, the M'% has a free choice among the first four alternatives. 3ut in
case of developing countries and transition economies
there are restrictions and the
choices are limited. $his is because capital markets in most of the developing countries
are not open and their currencies are not fully convertible. $his places restraints on the
behaviors of the M'%s who aspire to enter into such countries.
$hese are former command economies like 5ussia, 6krain, Poland and other east 2uropean countries, %/7
countries like 6zbekistan and others, %hina and 8ietnam. $he significant change of economic policies of
these economies has changed the perception of foreign capital and -./ is welcome now.
/n developing countries with a developed capital market and large industrial
sector, the acquisition of private firm is a realistic alternative to *reenfield entry
. 2xcept
in countries like south #orea with an advanced technology base, merger with local firms
are troublesome because of huge gap in the level of technology, size and management
philosophy. $he same problem remains with strategic alliance with local firms of host
/n the early phase of liberalization of the transition economies, the state owned
firms are often put on sale and M'%s see it easy to acquire the state owned firms and
thus they enter into the market of the host country. :fter that *reenfield entry becomes
more feasible with merger and acquisition remaining for the future. $he behavior of the
M'% regarding their entry and operations in the developing countries has attracted
attention in the literature. $he literature has identified three aspects regarding the M'%
; target country characteristics
; investment characteristics , and
; industry characteristics
$he most common framework is the transaction cost analysis, that is, M'% chooses the
mode of entry that involves minimum cost. $he findings in the literature can be put in the
following form)
-irst, larger M'%s are more prone to acquire than small ones. <owever, in recent
times, smaller firms also have become more prone to acquire as the transaction cost of
merger and acquisition & M = :( has reduced.
7econd, M'%s with lower 5=. intensity are more likely to buy technological
capabilities abroad by acquisition, and firms with strong technological advantages are
likely to set up *reenfield ventures.
$hird, the greater the cultural and economic differences between the home and
the host countries, the less the probability that M'% will go for acquisition. *enerally,
M=: concentrate in countries with similar cultural and business practices.
-ourth, acquisitions by M'% are encouraged by capital markets imperfections
that lead to the undervaluation of the assets of firms. $he same thing may happen in times
of economic crisis like the :sian %urrency %risis of 4>>?.
-ifth, horizontal acquisitions are driven by the search for new markets, products
and brand and seldom for cost rationalization. 3ut such acquisitions may lead to asset
rationalization of the acquired firm and this often damages the capabilities of the latter.
7ixth, *reenfield investments offer the M'% greater control and more ability to
mould affiliate structure, system and culture than acquisition. 2verything can be
replicated from the investing country.
/n sum, the entry of M'% in the developing countries induces certain important
changes including technology transfer to the host country. 3ut over time there is more
reciprocal process of technology transfer and sharing of intangibles like tacit knowledge
&3ressman et al, 4>>>(. -rom the investor perspective, M=: offer certain advantages
over *reenfield investment of rapid entry and access to existing proprietary assets. /n
0here the M'% start new enterprise with the import of both capital and technology. $his is done to take
advantage of cheap labour and @or source of raw materials.
the case of developing countries, M=: create advantage of rapid entry, access to local
market knowledge and distribution system. /t also create contacts with the governments,
suppliers and the consumers, and also it may be the only form of -./ where other
opportunities are absent.
7ometimes established cultural and organizational inertia may create problem for
M'% after acquisition of firms in host country and M'% may find it costly for the
necessary assimilation process. 2ven valuation of assets of the firms in host country for
acquisition may be difficult as the capital market is often imperfect and not developed.
7uch problems generally emerge in large developing countries that are opening to
international competition for the first time. /n such situations, *reenfield investment will
be more suitable for the M'%s.
Greenfield Investment and M&A a comparison
3oth the developing countries and the transition economies are rapidly integrating
their economies to the world economic order. /n the process the firms in such countries
face intensifying competition, accelerating technological change and increasingly
integrated world production. $hey seriously lack two things) capital and new technology.
<ere lies the importance of the entry of M'%. 'ow a comparison of two principal modes
of entry A -./ in *reenfield investment and M=: route A can be made from the
perspective of the host country.
/t is recognized that -./ inflow in the developing country help in upgrading
competitiveness. /t is a powerful tool in case of countries where domestic technological
capabilities and skill are weak and that can not be raised at international level within a
short period. 2ven when the country is strong in availability of skill, the pace of
technical change at global level is so strong that without M'% participation it becomes
difficult for the developing country to compete effectively& 6'%$:., 4>>>(. /n this case
M=: as a mode of -./ inflow is an important way to restructure and upgrade
competitive capability of the host country firm.
-./ investment in both the modes A M=: and *reenfield way A adds to financial
resources of the host country as neither is financed by raising resources domestically.
0hile *reenfield investment adds new productive facility which is an addition to
existing production capacity of the economy, M=: transfer the ownership of existing
asset into foreign hands. 3ut money flows in both cases and the M=: transfer resources
to the existing owners that can be invested in the economy. 7o the net financial effects are
the same in normal times except in one situation, when the acquired company is broken
up and different components are sold separately at a much higher price. $his is known as
asset stripping in the literature. $his is a sign of imperfect capital market as the latter fails
to assess the true value of the assets.
3ut in crisis situation &as in south :sia in 4>>?;>B( many firms are sold at
depressed prices and foreign capital acquires firms in host country through M=:
cheaply. $his involves a cost to the host country. $he cost increases and becomes a net
loss to the host country if the firm acquires through M=: is sold later when markets
become normal and asset value increases. $his can be prevented if the host country can
manage extra liquidity in crisis time when -./ through *reenfield investment becomes
!echnolog" Issue
$he inflow of -./ is associated with the inflow of new and frontier technology to
the host country. $he effects of technology transfer to the host country will be same in
normal situation in either type of entryD*reenfield investment and M=: mode. :
*reenfield investment involves the setting up of a new facility that brings new
technology with new capital. $he running of this new plant requires new and improved
skill formation. $his may not happen in case of M=: at least in the short run. -or this
*reenfield investment is preferred in the developing country.
/n case of M=:, the acquired firm may need considerable technological
upgrading to bring it to the world level. :s a result, it may experience rapid change
compared to the new facility under *reenfield mode that is already using frontier
technology. $he evidence for :sia and Eatin :merica shows that M=: can lead to
considerable technological upgrading and M'% can boost expenditure on 5=. if the
acquired firm already possess research capabilities & 0/5, 4>>>(. Moreover, M=: may
lead to the preservation and increase of technological capabilities in firms under
competitive pressure in an open economy.
7ometimes -./ through M=: mode may lead to the downgrading of 5=.
activity and status of the acquired firm if the latter does not possess technological assets
regarded as valuable by the foreign company. /n this case M=: brings negative effects to
technology of the host country. $his is evidenced in 2ast 2urope and Eatin :merica,
where affiliates under simpler activity and put less emphasis on 5=..
/n normal circumstances a M'% will tend to preserve the 5=. base of a newly
acquired firm and maintain links with local technological resources. 7ometimes it goes
further and tries to strengthen local technological efforts and linkages for the absorption
of technology in host country. $his is known as asset seeking FDI, and this type of -./
in the 67: has been used by Mexico, 7outh #orea and $aiwan to improve their domestic
technological base. $he results in term of defusing new and improved technology and
knowledge locally depend on the strength and economic efficiency of the linkages
established by the acquired firms. 0hen these are positive, M'%s will retain and
strengthen these, and in this case -./ through M=: mode will lead to better diffusion
than the mode of *reenfield investment in the short run. 3ut when the linkages are weak
and inefficient, -./ through M=: will lead to less diffusion, and that makes little
difference compared to the *reenfield mode.
$he interaction between the existing domestic firms and the new foreign firms
either through M=: mode or through *reenfield investment is complex and dynamic
over time. 0ang and 3lomstrom &4>>9( isolate two channels for this interaction process.
$he interaction leads to the spill;over of superior technology across the firms having
strong linkages. $he more disembodies aspects of superior technologies used by foreign
firms can spread to domestic firms through the mobility of trained workers and managers,
and through technical guidance provided to vertically;linked domestic suppliers. $hus,
the mere presence of foreign firms exposes domestic firms to superior technologies) this
is the demonstration effect. $wo, competitive pressure exerted by foreign firms &in the
form of lower prices or higher product quality( forces domestic firms to improve their
technologies. Productivity gains materialize only if competition is effective ;; that is, it
encourages domestic firms to catch up, and if domestic firms have the ability to innovate
or imitate successfully. $he latter requires that the technological gap should be small
enough relative to learning capabilities of domestic firms. /f it is not, isolated instances
of foreign entry can degenerate into foreign monopoly. :t the same time, the extent of
spillovers may be limited by the tendency of multinational firms to concentrate their
5=. activity in their developed country headquarters ;; the so called Gheadquarters
effectG. $he relative importance of these effects may explain why spillover effects have
been stronger in some countries and for some sectors.
Indian Case
.id the foreign;controlled firms in /ndia differ from domestic firms in terms of
their conduct and performanceH $he literature reveals discriminating characteristics of
domestic and foreign;controlled firms and it is found that as a proportion of sales,
foreign;controlled firms spent less on 5=. &presumably because they rely on technology
imports( than domestic firms, but expenditure on advertising was broadly similar for the
two groups of firms & #umar, 4>>F(. <owever, foreign;controlled firms were
significantly more profitable in their operations, a result corroborated by other studies,
#umar &4>>F( concluded that the profitability of foreign;controlled firms was protected
by entry;barriers) in knowledge ; and skill;intensive industries, their technological
strength, access to global marketing networks and brand names gave them a clear edge
over domestic firms. <e found that degree of seller concentration did not seem to affect
profitability but there was market segmentation) foreign;controlled firms competed on the
high value end of the market while domestic firms concentrated on the low;value end.
<ow did the multinationals defend these profit marginsH :dvertising
intensity, measured as the ratio of advertising expenditure to net sales, was greater for
foreign;controlled firms , but domestic firms relied more heavily on selling commissions.
1f course, different industrial sectors differ in the advertising intensity) the overall
difference in marketing strategies might reflect the difference in industrial concentration
of foreign;controlled and domestic firms. :lso it is seen that domestic firms have
increased their expenditure on technology imports, especially in recent years, and have
overtaken foreign firms in this respect. 6nfortunately, we do not have comparable data
for 5=. expenditure, but these were typically quite small for all manufacturing firms in
/ndia. 1n the whole, the observable differences in conduct were not that large.
Market Structure and Competition
.uring the last two decades -./ has been a powerful instrument for the
developing countries to exploit their existing comparative advantage and also create new
competitive power in their effort to enhance their participation in world trade. $his has
been possible as long as the countries are able to create new skills and capabilities and
attract the M'%s into higher value activities &0/5, 4>>>(. /n the process the entry of
M'%s has certain effects on the domestic market structure of host country, though the
effects are not clear. 6sual measures like concentration ratios are misleading indicators,
particularly when the country is open to import competition and M'%s concentrate in
industries that are scale and technology intensive. :gain, the entry of large M'% poses
serious challenge to competition policy. <ere the host country should be cautious with
rules and regulation to maintain competitive conditions for the domestic firms.
*enerally speaking, the relationship between openness to foreign investment and
market structure is complex. %aves &4>>I( notes the positive relationship between the
extent of foreign investment and the degree of market concentration found in empirical
studies. /n theory this could be due to rent;seeking foreign investment being especially
attracted to sectors or countries with high concentration &and high profitability(. 2ven so,
the short;run effect of foreign entry, especially when it is *reenfield investment, is to
increase the number of firms and reduce concentration. $he long;run effects depend on
the nature of competition between entrants and incumbents. /f incumbent firms are
moderately competent, there may well be virtuous cycles of technological competition.
1n the other hand, inefficient domestic firms with poor learning capabilities would lose
market share to foreign firms. /nsurmountable technological barriers and economies of
scale may drive incumbent firms to the fringes. -oreign entry might thus increase market
concentration through mergers and acquisitions, and occasionally, through predatory;
$he above discussion gives the perspective which the domestic firms should think
seriously before the country opens up for foreign direct investment &-./(. 1nce the
government is committed to economic liberalization, it can not discriminate between a
domestic firm and a foreign firm. :s a host country it should be policy neutral. /t is now
the financial strength and the grip over frontier technology that determines the hold of the
original owner over the effective control on the firm.