Globalization, Liberalization, and Development in China - Essay Example

Introduction Globalization and the process of liberalization induced the development of growth in China. As China opened up its economy it started receiving foreign direct investments (FDI). This process received a further impetus with China’s accession into world trade organization (WTO). As inward FDI increased, the domestic Chinese companies gained confidence and competence to venture overseas because of the technical know-how learned from the multinational companies in China (Bhuyian, 2011). This process, known as ‘inward internationalization’, allows domestic firms to gain access to MNCs embedded knowledge, organizational skills and capabilities (Wang, Boateng and Hong, 2012). Inward FDI also resulted in massive foreign exchange reserves, which was also a reason for Chinese companies to move overseas (Andersson and Wang, 2011). However, these push factors do not explain the true motives for the Chinese firms to internationalize. Earlier the theories of internationalization focused on the eclectic paradigm developed by Dunning and the Uppsala Model of internationalization. Firms then believed in new theories of trade such as market-seeking or resources-seeking motive (Liu and Buck, 2009) to internationalize. Today “going out” is the name that China calls its strategy of ODI (The Economist, 2012). The motivation to go out could range from market-seeking strategy to avoidance of country-of-origin effect (Salidjanova, 2011) and is not restricted to strategic-asset seeking motives. In short, China invests in any business where it serves China’s interest, according to Salidjanova (2011). Based on the theories of internationalization, this paper seeks to evaluate the motives for Chinese firms to move overseas. China’s ODI Chinese outward FDI (ODI) gained impetus in 2004 and by 2010 it ranked 5th among all economies in terms of outward FDI flows (UNCTAD, 2011). From 2004 to 2011 it grew from $5.5 billion a year to $65 billion a year and is expected to reach $150 billion by 2015 (The Economist, 2012). This significant jump in ODI is shown in the chart below. Initially the ODI from China was in neighbouring developing nations requiring limited resources (Liu and Buck, 2009). The pull factors that induced ODI from China were natural resource endowments and market potential (Biggeri and Sanfilippo, 2009). The largest ODIs came from Chinese state-owned enterprises (SOEs) such as China Petroleum & Chemical Corporation (SINOPEC) and China National Petroleum Corporation (CNPC) (Andersson and Wang, 2011). Drivers and impediments to China’s ODI An empirical study of China’s ODI conducted by Cheung and Qian (2009) revealed that drivers of investment in developed and developing countries differ although both market seeking and resource-seeking motives exist. China’s ODI does have implications for the economic development of the world economy and the developing economies in particular, but it was not restricted to developing economies such as Africa based on resource-seeking motives alone. China had started overseas investment initially to Hong Kong in the 1990s but the track record was not good. The investments failed to fetch the desired results due to lack of investment know-how, lack of information about the host country regulations and corruption. The Chinese firms faced several bottlenecks in ODI such as lack of management tools and expertise. They also faced difficulties in research and development mechanism as well as customer-facing capabilities. However, firms still surged overseas in the middle market through mergers and acquisitions (Gadiesh, Leung and Vestring, 2007). They started buying western established brands regardless of whether they had the managerial expertise to handle the issues. For instance, TCL, a major Chinese consumer electronics manufacturer, seeking to build a strong brand name, acquired the well known French firm Thomson which had several well-known brands. In a bid to quickly acquire the French company, TCL did not analyze that Thomson also owned some high-cost unproductive manufacturing facilities as a result TCL lost phenomenally. This is an example of how Chinese companies simply forged ahead without analyzing whether they have the necessary experience and tools. This explains the “going out” strategy at any cost but with disastrous results. Motives for Internationalization This brings up the issue of why firms internationalize. Initially it was believed that ODI takes place as firms seek to enhance their profits and hence expansion took place in low cost countries where risks of expansion were negligible (Assunção, Forte and Teixeira, 2011). Subsequently Hymer and Kindleberger demonstrate that market imperfections push firms overseas. However, risks in overseas investments are inherent and hence firms must have ownership advantages to offset these disadvantages. This is based on Dunning’s eclectic paradigm. Dunning postulates that there are advantages in choosing ODI when a firm simultaneously has all the advantages – ownership, location and internalization. As the business environment changed, new theory of trade emerged which combined the OLI advantages with the country’s characteristics in a coherent manner. The ‘going out’ strategy of China differs from the mainstream modes of expansion. Dunning (2000) discusses four main types of foreign based MNE activity. They could be resource seeking, market seeking, strategic asset seeking or efficiency seeking. Strategic asset seeking There are different motives which induce internationalization, and these will be discussed later. Strategic asset seeking is the fastest growing of the different motives for overseas investment (Castro, n.d.). Firms decide to expand overseas when they seek tangible and intangible assets that are not available at home, yet these assets are critical for a long-term strategy. Strategic asset seeking does not lead to exploitation of any existing ownership advantage of the firm. On the other hand, strategic asset seeking becomes a tool to build the ownership advantages of the firm as well as support long-term expansion both overseas and in the home market. Dunning (2000) explains that when intellectual capital is located in more than one country, firms would adopt strategic asset seeking as it would be economically viable to create these assets overseas. It can also involve other strategic-assets such as brand name or R&D capacity and output. Salidjanova (2011) also agrees that Chinese firms look for bargains in the developed markets. Chinese firms invest in firms that are in urgent need of funds but have strong brand recognition. This helps them get a foothold in the developed markets and acquire marketing skills. ODI rather than Exports of licensing However, the Chinese firms have been internationalizing for reasons other than strategic asset seeking motives. Export and licensing are the simplest form of expanding overseas but Chinese firms have been using other modes of internationalization. The Hymer-Kindleberger hypothesis suggests that FDI is about international transfer of proprietary and intangible assets such as technology, knowledge and skills (Castro, n.d.). In fact they claim that the existence of FDI is because of market imperfection of the international market for these assets. Firms exploit their ownership advantages rather than licensing or exporting, because according to Hymer (1968: pp. 966-970), FDI is the most efficient internationalization strategy if the advantage is based on technology or some intangible asset (cited in Castro, n.d.). Firms would avoid exports uncertainties and risks in foreign investments. They make use of external market by working with a sales agent. However, in sectors where after-sales service, and repairs and maintenance service counts, and this may not be adequately supplied by the local agent, the firm may want to set up marketing and distribution facilities (Dunning and Lundan, 2008). Licensing has its own drawbacks such as sharing valuable technical know-how with foreign competitors, or the firm may have no control over any of the business functions such as marketing, manufacturing and strategy. However, Chinese firms had limited technology or intangible assets. In fact most FDI has been resource-seeking or strategic asset seeking, which explains why Chinese firms did not resort to exports or licensing when internationalizing. FDI also eliminates the cost of defining or managing a licensing agreement. FDI thus could maximize profits because it is possible to sell oligopolistic power (Castro, n.d.). In fact, vertical FDI can, not just exploit market imperfections but they can exploit the ownership advantage to create market imperfections. Market Imperfections – driver of ODI Market imperfections calls for internalization and internalization is the tool which helps to exploit a proprietary advantage without putting at risk the monopoly (Castro, n.d.). The difference between ownership and location advantages explains why firms prefer ODI over licensing and exporting. According to Dunning, a firm would engage in FDI if three conditions were satisfied – it possesses net ownership advantages compared to firms from other countries, internalization of these advantages is better than to use the market to pass them on to foreign firms, and ownership advantage in foreign countries also provides some location advantages. Ownership advantage is the most important criterion and this can be achieved through excessive access to inputs, intangible assets or markets. Ownership factors are dynamic and volatile and when these are internalized, they enable a firm to cross borders and become MNEs. However, capital market imperfection in China has also led to unconstrained expansion and supports the going out strategy. Capital market imperfection means that capital is available at below market rates on long-term basis which the potential outward investors exploit. Thus market imperfections are transformed into ownership advantage by emerging economy firms. China had inter-related imperfections as the SOEs received preferential interest rates and support over private enterprises (Buckley et al, 2007). The preferential treatment to SOEs is evident from the ODI data. Because of the support that SOEs receive the bulk of ODI (67.6%) came from centrally-controlled SOEs while private enterprises accounted for a mere 0.6 percent of the total ODI flow (Salidjanova, 2011). However, as they receive support, Chinese MNEs have to abide by institutional constraints (Sutherland, 2010). Most enterprises in China are family-owned and hence they have access to cheap capital from the family members (Buckley et al, 2007). In efficient banking system can also result in capital market imperfections. Overbidding is also common among Chinese enterprises that venture overseas and this has been attributed to lack of technical and commercial know-how, limited fear of failure, low cost of capital and government support. In fact the failure of TCL can be attributed to overbidding. Other reasons that induced Chinese firms to go out have been the inability of the government, the banks and other financial institutions to impose exit or restructuring regulations on these firms. Venture capital was provided to China International Trust And Investment Corporation (CITIC) to explore overseas investment opportunities in priority resource sectors (Buckley et al, 2007). The Beijing steel producer, Shougang Group was permitted to start a bank with the assurance that hard budget constraints would be removed. Thus, market imperfections have supported the go out attitude of Chinese businesses thereby enabling the firms to undertake both natural resource seeking and strategic asset seeking FDI. Efficiency-seeking Efficiency pertains to low cost of operations, which is not likely to the cause for Chinese firms to internationalize, according to Buckley at el (2007). However, Chinese firms invest overseas to acquire advanced technology and managerial know-how. This strategy helps them jump a few steps towards development. Lenovo’s purchase of IBM’s personal computer division in 2005 was an efficiency-seeking strategy as it gained access to managerial and commercial experience in international marketing and advertising (Salidjanova, 2011). High transportation costs and trade barriers make FDI preferable to exports. Haier is an example of efficiency seeking enterprise which wanted to increase its efficiency by transferring its production overseas. Transportation cost was a barrier to exports and internalization. In oligopolistic industries (limited number of large firms in an industry) FDI outflows at the same time indicates strategic rivalry in the global marketplace. This also depends upon the product life cycle. When local demand in advanced countries is large enough to support local production, firms invest in such countries and then shift production to low-cost developing countries (example Haier). The Uppsala Model of Internationalization Johanson and Vahlne (1977) also describe the incremental process of internationalization based on geographic and psychic distance. This is the Uppsala Model of internationalization which explains why firms first start with countries that are geographically close and where knowledge, relationships and experience have been established through prior trade business and other interactions. However, the original model had to be revised in the changed business environment. Johanson and Vahlne have added ‘recognition of opportunities, which is actually a subset of knowledge. Knowledge also includes needs, capabilities, strategies and networks of directly or indirectly related networks. Markets are network of relationship and firms must develop a relationship of trust and commitment before entering into any simple or complex relationship. The process of developing relationship provides potential for learning. Since internationalization depends upon the firm’s relationship and networks, the focal firm will go overseas, based on its relationship with important partners Johanson and Vahlne, 1977). This has been observed in the case of BYD Electronics which moved overseas because of its strong association with Nokia. Based on the related knowledge base, BYD entered networks overseas and could exploit and identify newer opportunities. The focal firm can venture overseas when there is mutual trust, commitment and knowledge sharing. Internationalization of Chinese Firms Wang, Boateng and Hong (2012) evaluated whether internationalization strategies and processes of MNEs from emerging economies differ from those of developed countries. The study found that both R&D and advertising resources are not important for Chinese firms. Chinese firms internationalize at a very early stage when their control over strategic assets is much lower than global rivals. Chinese firms have been internationalizing due to market imperfection and their competitive capability is weak. They lack brand development and market capability and hence try to acquire firms overseas that offer brand value. Chinese firms gain advantage through imitation of technology and knowhow developed elsewhere. Internationalization is a means to acquire technology and thereby strengthen product differentiation. Chinese firms cannot exploit the existing advantages because they have none. However, the Chinese firms may be weak as they do not have specific advantages but they can still internationalize, they have internationalized. Wang et al state that possession of strategic assets is not a necessary condition for Chinese firms to create sustainable competitive advantage. However, the authors only focus on domestic market saturation as a driver of internationalization; they do not take into account the true motives and drivers of internationalization of Chinese firms. Government’s unconstrained support for ‘onward journey’ China’s ODI has been planned and realized as the government encourages Chinese enterprises to invest overseas to gain access to raw materials and advanced technology from overseas. It is also aimed at increasing foreign exchange earnings and to induce exports from China. These modes of internationalization do not fall under any mainstream western theories of internationalization. This has been called ‘spring-boarding’ by Luo and Tung (2007 cited in Sutherland, 2010). In addition, round-tripping is very common among Chinese firms. Salidjanova (2011) contends that describing China’s ODI is a challenge because the motives are numerous. Most ODI is supported by the government but many private enterprises have invested abroad, particularly in Hong Kong and Macau only to seek tax benefits and then reinvest the funds back in China. In 2009, 79 percent of China’s ODI was received by Hong Kong, Cayman Islands and the British Virgin islands. However, the money earned through these investments were reinvested back in China in order to qualify for special tax breaks reserved for foreign investments, particularly through Hong Kong. Sutherland (2010) refers to such offshore havens as a means to onward journey. Extensive literature by Sutherland (2010) suggests that Chinese ODI is driven more by the desire of Chinese firms to ‘springboard’ via acquisition of strategic assets. To catch up with their developed counter parts, the Chinese firms seek specific assets such as brand identity, managerial and marketing competence and technological competence. Acquisition of strategic assets enables them to catch up with the global giants. Besides, access to these resources would not be available to them unless they expanded overseas. However, expansion in Hong Kong is the not the ultimate aim or destination Chinese firms. Hong Kong is only used as a spring board as, being a developed offshore financial centre, it provides access to capital through various links. Therefore Hong Kong plays a critical role in the onward journey of Chinese firms but with the tax laws changing in China, the repercussions would soon be evident. The Chinese firms focused on Hong Kong as a trading and sales outlet (based on market seeking ODI). The Chinese firms also extensively invested in South East Asia, which were motivated by efficiency and market seeking. BYD Electronics grew by supplying components to branded mobile phones in China. This is a vertically integrated group and they can provide virtually the full range of products and services to the OEMs (original equipment manufacturers). It is now planning global production platforms that would facilitate servicing its OEM clients. They have acquires a company in Hungary that supplies Nokia with handset housings while also making several green-field investments in India. It is going to further expand its production as it plans to expand its global customer base, develop new markets and reinforce the existing ones. Since firms like Nokia wanted ‘custom made’ products from the suppliers, they would enter into contractual agreement, suggest Dunning and Lundan (2008). This helped BYD to develop into a global player in its own right. Their expansion was based on supply of value-added activity because of the non-standard intermediate products. BYD started off with inward internationalization, developed competencies internally and then started its onward journey. However, Shenzhou International set up a wholly-owned garment manufacturing unit in Cambodia with a registered capital of $30 million. China had trade barriers and was restricted from exporting apparel. Hence this was a strategic investment to counter these restrictive measures. Shenzhou plans to increase its investments in the US and Europe aimed at expanding its customer base, aimed at supplying to Adidas and Nike. Like BYD Electronics, Shenzhou also plans to strengthen its customer base and develop new customers. Shenzhou’s expansion was more out of capital market imperfection and not strategic asset seeking. Shenzhou merely ‘spring boarded’ its way to international competitiveness through this strategy of countering restrictive measures. There is no evidence to suggest that Chinese firms actually expand overseas as strategic asset seeking, with the exception of companies such as Lenovo and Haier (Sutherland, 2010). Their onward journey ODI of China’s private businesses any particular strategic asset seeking motivation. Most companies demonstrate efficiency and market seeking motivations. Dunning and Lambaud also confirm that resource seeking MNEs would pursue a different path than the market and efficiency seeking firms. In the first phase, firms may engage in transactions across national borders either to acquire income-generating assets or to protect existing or seek new markets. In fact Chinese ODI also suggests an escape mechanism. Since domestic institutions are weak the costs of doing business domestically is high. It is relatively easier to expand overseas than doing business at home. Fifty seven in the study by Sutherland (2010) used Hong Kong as a spring board only to carry on their onward journey and most of the capital raised came back to China (round-tripped back). Many scholars argue whether this should be considered ODI when the purpose is to evade tax. Round tripping is done with the primary purpose of raising capital overseas and boost domestic market expansion. There are no official estimates of such round-tripping money flows but Rosen and Hanemann (2009) cite that some scholars believe that this could be one-third of all inward FDI. As per MOFCOM data around 80 percent of Chinese stock ODI lies in Hong Kong or tax havens. The geographical contribution of China’s ODI stock shown in the chart below confirms the round-tripping strategy of the Chinese firms. Source: Rosen and Hanemann (2009) Chinalco-Rio Tinto Case Study Resource-seeking FDI from emerging economies is aimed at acquiring raw materials supply and energy sources that may be in short supply in the home market (Buckley et al, 2007). Chinese ODI in Australia and Canada was with such objectives. Market-seeking strategy is also a driver of ODI from China. The saturated and competitive domestic markets encourage overseas expansion in addition to the attraction of achieving first-mover advantage in untapped overseas markets. Overseas investments also help avoid foreign quotas, tariffs and other barriers to Chinese-made goods. Market-seeking FDI enables companies to gain access to distribution networks or facilitate exports of domestic produce (Buckley et al, 2007). The failed joint venture of Chinaclo, China’s state-owned aluminum producer, and Rio Tinto, an Anglo-Australian iron ore producer, reveals the anomalies in government mechanism to go global. To ensure that exports of ores from China to Rio Tinto, was not affected, Chinalco, wanted to invest $14 billion to get 9 percent shares in Rio Tinto. This FDI was aimed at stopping Bhp-Billiton to take over Rio Tinto as this would reduce exports of ores from China. However, this bid did not come through despite the support of the Chinese government. Similarly, Shanghai Baosteel, one of China’s largest steel producers, acquisition of a 15% stake in Aquila Resources, Australia in 2009 was aimed at expanding its raw material projects (Salidjanova, 2011). China’s ODI is concentrated in the hands of a small number of large business groups. Chinalco was one such national champion but it could not match the western counterparts in terms of technology and managerial competence. Chinalco is a large industrial corporation with many subsidiaries, enjoying monopolistic power in the aluminum industry. The successful growth of the company encouraged Chinalco to aggressively pursue the takeover of Rio Tinto. Chinalco’s first investment in 2008 proved to be disastrous as it was followed by economic downturn when Chinaclo ended up with losses amounting to 70% of the value on paper (Yao, Sutherland and Chen, 2010). This affected Chinalco’s national image and self-esteem. This was China’s largest-ever foreign investment which even killed BHP’s bold US$ 147 billion move for Rio. As Rio was in need of urgent funds because it had incurred huge debts after buying Canada’s Alcan in 2007, Chinalco further incurred US$ 19.5 billion strategic partnership with Rio (Sutherland and Yao, 2009). However, soon the Australia’s Federal Investment Review Board (FIRB) discovered anomalies and questioned the terms of investments. The FIRB did not consider one single investment, from a Chinese company, a prudent move in the interest of its shareholders. Rio went in for a Rights Issue and joint venture with BHP, to meet the short-term funds requirements. This strategy also strengthened its bargaining position with Chinese steel makers. Firms seeking ODI must have some sort of advantage over the host country competitors. Chinalco had none of the advantages such as technology, management skills or knowledge and experience in overseas business. However, the desire to become vertically integrated with Rio was based on maintaining China’s ore supplies to Rio. However, the losses in investments in Rio were massive and had it been a western company it would have been close to bankruptcy. Despite its poor performance, four of the biggest Chinese state-owned banks agreed to extend further loan to Chinalco, at such terms, which demonstrates capital market imperfections (Yao, Sutherland and Chen, 2010). The amount of US$ 21 billion was granted to Chinalco by these four banks which was much more than what was needed (Sutherland and Yao, 2009). The interest rate was below average and no time was set to repay back the loan. This also shows that ODI is associated with country-specific characteristics because China treats state-owned banks and businesses as the left and right arms of the state. As stated by Salidjanova (2011) China invests in any business where its interests are served. The investments strategies are not driven by firm-level motivations but they are related to national politics and economic considerations (Sutherland and Yao, 2009). The pattern of large groups in China has been similar. They grow domestically due to monopoly and due to easy access to capital. Once they become large they attempt foreign investments but without any preparedness, as a consequence they may or may not be able to cope with competition in the world market place. These firms have the support of the policy makers to turn China into a world business power. Besides, by making quick overseas acquisitions, they are able to avoid the lengthy process of developing new mines (Sutherland and Yao, 2009). Between 1995 and 2006 about 20 such mega mergers exceeding US$ 1 billion each took place (Sutherland and Yao, 2009). By 2008, about 150 companies, including Chinalco had been selected as national champions to receive state support. Most of China’s national Champions are owned by the State-owned Assets Supervision and Administration Commission (SASAC) and naturally these champions received financial and other support to skip stages and attempt quick acquisitions. As a result, within a decade each of these companies achieved a growth of 25 percent per year in sales and assets, and profits at 40% a year. They gained privilege access to stock market listings and bank finance. The Chinese mode of expansion thus represents a dynamic model where increasing foreign market commitments are made but without knowledge development. Moreover, the acquisition strategy of Chinalco did not take into account the psychic distance between China and Australia which suggests that the international expansion of China defies all known and standard theories of internationalization. The Uppsala model of internationalization suggests that markets are networks of relationships. Johanson and Vahlne (1977) further assert that firms are linked together in various and complex forms. Relationships offer potential for learning, for building trust and commitment, both of which are essential for success in internationalization. The fact that Rio Tinto ultimately opted for Rights Issue and investments from BHP suggests that Chinalco did not attempt to build relationship before investing in a foreign environment. Trust and commitments were not developed and established which, is a prerequisite for success in a foreign environment. This is perhaps, which the earlier Uppsala model had suggested, to reduce the psychic distance before internationalizing. Johanson and Vahlne also suggest that commitment may even decline or cease if performance and prospects are not promising. This also suggests that internationalization would take place of prospects and performances are promising. This principle thus explains the failure of Chinalco in acquiring Rio. In fact all the theories and principles are interlinked. Had trust and commitment been developed, prospects could have been brighter, and performance achieved. Dunning and Lundan (2008) assert that expansion or restricting of existing ODI would depend upon industry- and country-specific characteristics. An evaluation of the internationalization of Chinese firms suggests that the country-specific characteristics are more relevant in case of China. However, despite unconstrained support by the government and the financial institution, Rugman and Li (2007) do not foresee the Chinese firms to go global or even bi-regional firms in the next two decades. This suggests that the ‘go global’ policy of the government has been ineffective as the companies seeking to move overseas were not informed of the risks and uncertainties, or the difficulties and the costs of investments. Besides, while MNEs from developed countries venture overseas to exploit either firm-specific assets (FSAs) or country-specific assets (CSAs), the MNEs from China have no such assets that they can carry overseas. Rugman and Li assert that the prerequisite for international success for Chinese firms is domestic efficiency and very few firms have been able to achieve this. Therefore, it can be said that they have not been following the Uppsala model of internationalization also. Conclusion There are several reasons why firms engage in international activities and the key appears to be market imperfections. Market imperfections and capital market imperfection appear to be the country-specific characteristics that have encouraged firms in China to extend their reach overseas disregarding any deficiencies. This is in the context of Chinese firms because their motives and process of internationalization or ODI differs from those of the developed countries. The internationalization of Chinese firms also defies the mainstream western theories of internationalization. ODI from China is motivated to acquire technology, managerial competence and brands; it is not motivated by existing competencies. The Chinese firms exploit the ownership advantages with the support of the banks, the government and the financial institutions. Within the domestic markets also firms would engage in similar strategies and activities but as far as strategic asset seeking motives, are concerned, these cannot be obtained in the home market. Thus, strategic asset seeking is the only motive for internationalization that can add to the competitive advantage of firms. However, the motives of Chinese firms has not been strategic asset seeking. Very few firms have ventured overseas as efficiency seeking or market seeking. In fact, strategic asset seeking does not explain why Chinese business groups internationalise their operations. References Andersson, R and Wang J (2011). "The internationalization process of Chinese MNCs: A study of the motive for Chinese firms to enter developed countries". University of Gothenburg. 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