Concepts of Distance and Impact on FDI Flows - Essay Example

Concepts of Distance and Impact on FDI Flows Bilateral foreign direct investment (FDI) flows is considered as an important driver of economic development in both developed and developing countries. However, the level of FDI is affected by the distance between countries engaged in business transaction. In order to make an an analysis of the level of international business, researcher have devised various concepts of distance. This essay is based on the analysis of cultural distance, administrative distance, geographic distance, economic distance and psychic distance as some of the concepts of distance impacting international business. Cultural distance The concept of cultural distance in FDI is based on the analysis of different aspects of culture to determine the extent to which they are similar or dissimilar to one another. Cultural belief systems characterized by religious beliefs, race, social norms and languages are capable of creating distance between one country and another (Ghemawat, 2001). Cultural practices of people in a given country affect the entry mode of multinational corporations as it determines the impact of the firm in a new country (Dow and Ferencikova, 2010). Impact of cultural distance is experienced on the level of consumers’ identity with particular product where for instance English language programming introduced by Star TV failed to gain audience in China due to lack of local content (Ghemawat, 2001). Literature on the relationship between FDI and cultural distance has identified a number of areas of relationship with implication on the level of engagement between countries. Primarily, the relationship between FDI and culture distance has been addressed in terms of its effect on the sequence of investment between countries. The theory of familiarly has emerged to explain the decisions of foreign firms to invest in a country with proponents arguing that a firm was less likely to invest in a culturally distant country (Shenkar, 2001). In this case, increased business between the United States and both Britain and Canada has been attributed to cultural similarities as opposed to explanations based on geographical proximity, reduced tariff barriers and market size. Secondly, cultural distance has implications on the level of control by a foreign multinational enterprise. When conducting business between culturally distance countries, foreign forms are likely to loosen control in order to reduce information cost and uncertainty that comes with investing in such markets. The loosening of control has been attributed to factors such as difficulties in validating assertions by culturally distant agents, as they are mostly made based on unfamiliar territories; thus, difficult for multinational enterprises to confirm. Thirdly, cultural distance has implications on the performance of affiliates with researchers noting affiliates dealing with foreign business partners originating from culturally divergent territories are more likely to fail (Shenkar, 2001). For instance, Huawei is a technological company originating from China. The company has increased its global presence in the past decade by investing in a number of countries including the United States. One of the strategies adopted by Huawei in the United States market is cooperation and partnership with suppliers. However, the strategy has not been effective in meeting Intellectual Property Rights requirements in the United States as the company has been accused of infringing into patent rights possessed by its suppliers. One of the reasons for this infringement is the cultural distance existing between China and the United States is that while western culture emphasis on individualism in ownership of ideas, the Chinese culture perceives knowledge and ideas as being artistic expressions that should be shared instead of being owned and exploited (Peng, 2013). Administrative distance Administrative distance refers to the extent to which a number of factors including colonial ties, shared monetary policies, level of political associations and collaboration in government policies are aligned to those of countries in comparison. When assessing the impact of administrative distance on FDI, the integration of the European Union is one of the best, examples where in order enhance the level of cooperation among member countries; the EU was formed based on deliberate effort to diminish administrative distance by removing trade barriers among partner countries (Ghemawat, 2001). Different countries can also adopt measures to enhance their administrative in order to protect domestic industries from competition occasioned by entrance of multinational enterprises into domestic markets. Countries create barriers through measures that include introduction of trade tariffs, trade quotas, capping levels of FDI and preferential treatment of domestic firms by offering subsidies and practicing favouritism in different aspects of regulations and procurement process. In such a case, the flow of bilateral FDI between countries will be affected negatively as foreign firms find it increasingly difficult to compete with firms that are domestically owned. Countries can also promote the economic activities of domestic firms by supporting their efforts to internationalize; however, such moves might weaken the firms, as they remain indebted to their home governments. Other negative administrative aspects of the government such as conservative attitudes might also curtail the firm’s ability to explore entrepreneurial opportunities (Child and Rodrigues, 2005). Apart from administrative distance created through government policies, weak institutional infrastructure is also an aspect that can negatively affect the level of FDI flow between countries. For instance, weak administrative infrastructure will provide ground for increased corruption and social conflicts, which lead to fears that firms might not recoup their investments (Kuo and Fang, 2009). Psychic Distance The concept of psychic distance relates to factors such as language, culture, political systems, status of education and economic development among others that might prevent the flow of goods and services or/ and payment from one country to another or between businesses and markets (Berry, Guillén and Zhou, 2010). For instance, the flow and cost of products and payment for business organizations operating between the United States and Canada is high, as the two countries have developed to have their culture and rest of identified factors similar. However, multinational corporations from the United States dealing with countries such as North Korea might face increased difficulty due to some of the factors such political systems being incompatible. Countries whose psychic factors are closely related are said to have a low psychic distance and can therefore easily develop closer business ties. When multinational business organizations make decisions on where to invest their funds, analysis of existing opportunities in foreign countries is done by firstly considering host countries with closer psychic distance to that of home country before venturing into countries with greater psychic distance. There has been several attempts by scholars to develop effective methods for measuring psychic distance between countries for easier analysis of multinational organizations’ decisions to enter a foreign country with Hofstede (2001) being such an example. To make an improvement to Hofstede’s cultural dimensions, Dow and Karunaratna (2006) a new framework that includes all the factors covered in psychic distance. The new model has been found to extensively cover important factors in psychic distance as it responds to factors such as language, religion, and education, industrial development, degree of democracy and political ideologies, which account for differences in countries, therefore determines whether a country gets FDI from interested multinational corporations. Geographic distance Geographical distance refers to existing natural barriers hindering level of engagement between countries and measured by consideration of the “great circle distance from the geographic centre of each country pair” (Beugelsdijk and Mudambi 2013, p. 415). Apart from the physical distance, other factor affecting the level of FDI flow between countries include the existence of a common border, access through sea or river, existence of transportation and communication links and difference in climate. Long geographic distance negatively affect the level of FDI in terms of expenses incurred in transport and coordinating activities when people are highly dispersed between the two regions (Ghemawat, 2001). Foreign firms dealing for instance with bulky or perishable goods will avoid countries with great geographical distance between sources and markets for the products, which will in effect limit the level of FDI flow between such countries. Multinational companies that have experienced barriers to international trade due to geographic distance have shifted focus to investment in local plant and equipment as a means of reaching targeted markets. Such investment options have negative effect on investment flow and trade flow between countries as access information networks and transportation infrastructures becomes difficult. Economic distance Economic distance refers to the difference in level of development between countries with Berry, Guillén and Zhou (2010) noting three areas of differences including income level (GDP per capita), inflation rates at a particular time, and the level of multilateral trade (exports and imports as a ratio of overall GDP). In this sense, economic distance between countries is measured in terms of consumer incomes in addition to cost and quality of existing factors such as infrastructure and financial, natural and human resources (Kuo and Fang, 2009; Ghemawat, 2001). Existence of these factors and resources in rich countries increases the ability of firms to engage in heightened levels of cross-border economic activity than for those from developing countries. The level of business engagement between firms from reach countries is also high due to their ability to marshal funds for investment in different sectors. However, FDI between economically developed countries and less developed countries are in favour of the former. Developing countries attract increased FDI from firms originating from developed countries as these organizations face less competition from domestic firms. Domestic firms in less developed countries are disadvantaged in terms of their technological, managerial, and marketing capabilities. Without introduction of government protective measures, domestic firms cannot compete with forms from economically developed especially in a market-based economic system (Tsang and Yip, 2007). Therefore, economic distance has a considerable impact on the level of FDI flow as it determines the ability of firms to take advantage of resources existing in host nations. From the foregoing analysis of different aspects of distance affecting bilateral FDI flow between countries, multinational enterprises must be ready to conduct a thorough analysis of their markets before entry into a different country. This is because the concept of distance that include cultural distance, administrative distance, geographic distance, economic distance, and psychic distance have significant impact on the level of economic activities conducted between two countries. Based on the analysis of the different concepts of distance, psychic distance and cultural distance appear to be important for business organizations as effective assessment of the two will be important in determining compatibility of the business environment in the host country to that of the home country. While other factors have certain level of impact on DFI flow between countries, psychic and cultural distances provide explicit information about the markets and type business that will function effectively in a given environment. While other factors can be dropped when making an analysis of a given market, multinational corporations cannot avoid cultural the inclusion of explicit variable controlling for cultural distance. However, based on the assessment of these aspects of distance, administrative distance can be identified as being central to the level of DFI flow between countries. The importance of administration distance lies in the ability of those holding political powers in partner states to align various factors influencing their levels of engagement. Administration distance is an aspect with greater flexibility to react to different conditions affecting the level of trade between particular countries. This flexibility is experienced when the authorities introduce measures to either promote or restrain the level of FDI. Therefore, administrative distance should be considered as the most important in determining the level of FDI. References Berry, H., Guillén, M. F., & Zhou, N., 2010. An institutional approach to cross-national distance. Journal of International Business Studies, 41(9), pp.1460-1480. Beugelsdijk, S., & Mudambi, R., 2013. MNEs as border-crossing multi-location enterprises: The role of discontinuities in geographic space. Journal of International Business Studies, 44(5), pp.413-426. Child, J., & Rodrigues, S. B., 2005. The internationalization of Chinese firms: A case for theoretical extension. Management and organization review, 1(3), pp.381-410. Dow, D., & Ferencikova, S., 2010. More than just national cultural distance: Testing new distance scales on FDI in Slovakia. International Business Review, 19(1), pp.46-58. Dow, D. & Karunaratna, A., 2006. 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