Location factors and governance mechanism design for foreign direct investment of SMES in China.

Location factors and governance mechanism design for foreign direct investment of SMES in China.
In this paper we treat foreign direct investment as a complex transaction and discuss two strategic decisions, consideration of location factors and the arrangement of governance mechanisms, affecting foreign direct investment of Taiwanese small and medium-sized manufacturing firms in China. The results show that a higher technology risk makes investors adopt higher-level equity and structural control, and asset specificity does lead to higher structural control and socialization mechanisms to adapt to the outside disturbance; however, the opportunism possibility of exchange partners makes investors reduce the use of socialization mechanisms. Further, transaction characteristics significantly influence the consideration of location factors. In addition, investment risk reduces the motivation for equity control; however good location conditions positively impact the arrangement of governance mechanisms. The results also show that structural control, such as empowerment and the power to assign top management teams, constitutes the most critical governance mechanism for accessing foreign strategic resources.

Keywords: location factor, governance mechanisms, transaction characteristic, cluster effect

1. INTRODUCTION

Conventional internationalization theory views foreign direct investment (FD) as an extending behavior of market forces by MNEs to exploit firm-specific assets in foreign markets (Hymer, 1960). Consequently, FDI has become the preferred method for foreign investors to organize their investment activities (Dunning, 2002). This phenomenon can explain well the internationalization of large MNEs, but is not suitable for the foreign investment of small and medium-sized enterprises (SMEs) such as Taiwanese manufacturing firms' investment in China in recent years.

In reality, many foreign investors are small and have very limited assets, especially those from developing countries. Consequently, SMEs have played a significant role in overseas investment (Chen and Chen 1998). Do these firms invest with different incentives? The contemporary motivations for companies to invest abroad include securing key supplies, market-seeking, accessing low-cost factors of production and seeking strategic assets (Barlett et al 2003; Dunning, 2000). However, strategic linkage theory (Nohria and Garcia-Pont, 1991 discounts market-seeking and focuses on input--a perspective that seems well-suited to interpret the motivation and mechanisms for SMEs. To satisfy such motivations or to obtain a competitive advantage, consideration of location factors and arrangement of governance mechanisms become the critical issues when firms organize foreign-based activities to improve their international operation performance.

Dunning (1981) suggested that the consideration of location factors for FDI is based on the location advantages that maximize the value of firm-specific assets beyond set-up costs. Location choice factors depend on the location advantage, and the sources of location advantage are those involving competence and risk. Scholars have recently demonstrated the importance of cluster effects from industry networks and interpersonal relationships to access and deploy relational capital (Porter, 1998; Kale et al, 2000). Chen et al (2004) argue if in search of distinctive and inimitable resources, an investor does invest more in local linkages to reduce investment risks. Besides the location factor, institutional arrangement is another important decision for foreign operational activities. When we treat foreign equity investments as a foreign transaction, the design and functions of governance mechanisms would affect the ability of oversea investors to settle related transaction problems. In addition to dominant equity control (Root, 1983), Cannice et al (2004) proposed that companies focus not only on ownership structure, but also on alternative ways of managing the international technology transfer risk.

According to the report "United Nations Conference on Trade and Development", until the end of 2003, China's accumulating FDI capitals surmounted that of the U.S.A., and became the largest FDI-accepted country in the world. Another document, "Industrial Department & Investment Center Ministry of Economic Affairs" reveals that, from 1991 to 2004, Taiwanese investments in Chinese increased every year. The main industries attracting foreign investment are in manufacturing, and most of these firms are SMEs. Comparing to large multinational corporations (MNCs), SMEs possess fewer strategic resources; therefore, to economize the overseas investment activities of SMEs becomes a critical issue. Consistent with strategic linkage theory (Nohria and Garcia-Pont, 1991) and rethinking the motivation for SMEs, this paper examines the relationship of factors of location choice and arrangement of governance mechanisms for the overseas investment of SMEs in China. We proceed by asking the following questions:

1. How do transaction characteristics affect the consideration of location factors for foreign investment in China?

2. How do transaction characteristics and location factors affect the arrangement of governance mechanisms for foreign investment in China?

The paper uses Taiwanese manufacturing enterprises as a sample to investigate the foreign investment of SMEs. In the next section, we begin with the transaction cost economy (TCE) perspective, to review the impact of transaction characteristics on the consideration of location factors, and then we examine the relationships among transaction characteristics, location factors, and governance mechanisms. Following the discussion of our data collection and methodology, we present the empirical results and conclusion. We end with a discussion of limitations and thoughts about future research.

2. THEORETICAL FRAMEWORK AND HYPOTHESES DEVELOPMENT

2.1 Transaction Characteristics and Location Factors

As Dunning (1988) argued, FDI will occur when three conditions are met: ownership-specific advantage, location-specific advantage, and internalization incentive advantage. According to conventional FDI theory, firms engaged in FDI must be strong in a specific area of competence or own significant strategic resources. Most of these firms are either large or unique in their product lines. In reality, many international investors are small and possess limited resources, and such a theory cannot well interpret the motivation and mechanisms of their FDI behavior. Another valuable way to interpret the FDI of small and medium-sized firms is to treat it as an attempt to access external resources to offset the weakness of the investing company (Chen and Chen, 1998). If so, two other conditions Dunning (1988) mentioned, location-specific and internalization incentive advantages, shows their value for our study. If the location contains specific resources, these investors can link to some strategic resources and get more advantage beyond domestic markets (Teece, 1986). We will discuss more location factors from the annual report of TEEMA in this section. Secondly, since FDI itself is a transaction procedure, the incentive for international investors to reduce transaction cost (TC) is very important. We will later interpret the sources of TC and possible solutions the challenges it often faces.

Though TC has been applied to entry selection in a growing number of studies, it is less clear what effects TC variables have on performance by entry mode decisions(Brouthers et al, 2003). With respect to the transaction characteristic, Williamson (1981, 1985) suggested that the critical dimensions of transactions are uncertainty, frequency, and asset specificity. Williamson (1985) distinguished between "non-strategic" forms of uncertainty and behavioral uncertainty. Non-strategic uncertainty includes primary and secondary uncertainty, such as technology or market uncertainty; behavioral uncertainty arises from the difficulty in predicting the actions of other relevant actors, particularly in view of the potential for opportunistic behavior. Asset specificity can arise in any of three ways: site specificity, physical asset specificity, and human asset specificity that arises from learning by doing. Brouthers et al (2003 argued that except for specificity of the assets and behavior uncertainty, TC variables generally involve economic uncertainty.

The research of "Taiwanese Electrical and Electronic Manufacturers' Association" (TEEMA) suggests that Taiwanese firms investing in China have to consider the investment risks and competition involved in specific locations (2003). To smooth international investment, investors have to appropriately link transaction characteristics and location factors, which can yield higher levels of satisfaction with firm performance (Brouthers et al, 2003). Basing on strategic linkage theory, if the uncertainties of technology and market were high, the investment risks of location will not be the critical issue to concern SMEs seeking to access strategic resources or suppliers. Location advantage and cluster effect are more important than the consideration of risk. Firms will choose the location with high location competition and a complete industry network where resources are embedded, to reduce the impact of uncertainty. If the opportunism of either external partners or a firm's employees were high, the location competition and industry network will not be critical factors; foreign investors will prefer the location with lower investment risks to adapt or defend against possible opportunism from exchange partners. If the specificity of critical assets for the foreign investment project were high, firms will select the location with lower investment risks, higher location competition, and more complete industry network. Based on the above, we have the following hypothesis:

Hypothesis 1: In foreign investment involving higher risk transaction characteristics, investors are likely to choose the location with lower investment risks, higher location competition, and more complete industry network.

2.2 Transaction Characteristics and Governance Mechanisms

Hennart and Park (1994) suggest two types of variables simultaneously affecting a firm's decision to invest abroad. The first includes those factors that determine the optimum location of production (location factors), and the other involves those determining the optimal governance structure for exploiting those advantages (governance factors). Hennart and Park 1994 argue that, apart from location factors, governance factors constitute the most critical issue impacting the performance of foreign investment. Hennart (1991) argues that TCE has been used extensively to develop a theory of the MNE, which deals with the entry mode choice--the commitment to jointly own the venture as decided by the equity position places the partners in a mutual hostage situation whereby opportunistic behavior can be minimized. In the process of gathering new competencies, or looking to develop future potential core businesses or markets, an organizational model emphasizing such combination as alliances, collaborative equity businesses and joint ventures seems a better fit with internationalization (Lemoine and Dagnaes, 2003). Hence, the suggestion of Erramilli and Pao (1993) that service firms prefer full-control modes in foreign markets is another valuable insight. Dominant equity interests (whether a wholly-owned subsidiary or a majority shareholder) are expected to offer the highest degree of control to the entrant business (Root, 1983).

However, when the level of uncertainty and technological complexity is rising, developing a complete investment contract is impossible. Further, dominant equity control also has limited ability to prevent opportunism from foreign external or internal partners. Residual control (Chi, 1994), a right not stipulated in the contract but applied to managers who are trusted to arbitrate and coordinate conflicts, becomes very important to facilitate the foreign operation. It lets managers own the right of discretion to undertake the responsibility of risking the enterprise's operation. Ghoshal and Nohria (1989) suggest that the proper structure of the headquarters-subsidiary relationship in each contextual category is a correspondingly differentiated combination of the following elements: (1) centralization (the lack of subsidiary autonomy in decision-making); (2) formalization (the use of systematic rules and procedures in decision-making); and (3) socialization (normative integration leading to shared values, thus mitigating potential conflicts). Obviously, socialization plays the role of social control mechanisms in a cooperative network to safeguard against possible shirking or opportunism. As governance mechanisms for foreign-based activities, these offer the highest degree of control (Root 1983), and there are other alternatives to manage the international investment risk (Cannice et al, 2004). For complex investment abroad, we agree with previous research (Bradach and Eccles, 1989; Gulati, 1998) that resolving diversified exchange problems requires a multi-mechanisms design. The various combinations of transaction characteristics and location factors will shape the pattern of governance mechanisms for foreign investment.

From the TCE perspective, any governance mechanism is designed to resolve possible transaction problems due to transaction characteristics. The theory's central claim is that transactions will be handled in such a way as to minimize the costs involved in carrying them out. David and Han (2004) conclude, as does Williamson (1991,1985) that as asset specificity increases, hybrids and hierarchies become preferred over markets, and at high levels of asset specificity, hierarchy becomes the preferred governance form. Further, Cannice et al (2004) argue that companies rely not only on dominant equity control to protect against technology misappropriation, but also on such alternatives and complements to ownership structure as residual control on personnel management. According to transaction cost theory, the entry mode that firms select will be the most efficient form of governance. Based on the above, we have the following hypotheses:

Hypothesis 2-1: In foreign investment with higher technology risk and market uncertainties, and given asset specificity, the foreign investors are likely to adopt a lower-level structural control, as well as higher-level equity control and socialization mechanisms.

Hypothesis 2-2: In foreign investment with higher behavior opportunism from exchange partners and higher asset specificity, the foreign investors are likely to adopt a lower-level socialization mechanisms, but higher-level equity control and structural control.

2.3 Location Factors and Governance Mechanisms

Porter (1998) defined a cluster as a geographic concentration of interconnected companies and institutions in a particular field. Strategic networks potentially provide a firm with access to information, resources, markets, and technologies, and allow firms to achieve strategic objectives (Gulati et al, 2000). According to the TEEMA study (2003), the critical elements of location choice consist of competition and risk factors. Location competition focuses on the convenience of infrastructure, harmonious labor relationships, financial stability, and institution efficiency, but investment risks focus on public order, as well as consistency and stability of local administrative and national decrees, and cost to build-up a factory and other relevant facilities. Rasheed (2005) suggests firms using an equity-based mode have a higher rate of growth than export modes when foreign risk is higher. However, legal risks and ambiguous operational costs are critical investment considerations in developing countries like China, especial for legal risks. Ambiguous operational costs influence the total costs of foreign investment, but legal risks affect the equity structure and the assignment of the top management team.

Although at high levels of uncertainty and asset specificity, hierarchy becomes the preferred governance form (Williamson, 1991), national or legal risk can moderate such effects. The study of TEEMA (2003) focuses on location competition and investment, but the industry network or cluster effect (Porter, 1998) was measured only indirectly. Porter (1998) argues that the productivity benefits from clusters include better access to employees and suppliers, specialized information, complementarities, institutions, and better motivation and measurement. Chen et al (2004) treat local linkages as investments in local relationships, and they find that local linkage intensity differs by the nature of the production network in which an investor is embedded. Network linkages can be divided into internal (intra-form)and external (inter-firm), and external linkages can be further separated into strategic and relational linkages (Chen and Chen,1998). Chen et al. (2004) find investment in local linkage always begins with the original business network. As Ghoshal and Barlett (1990) point out, a MNC can be viewed as an interorganizational network that is embedded in a web of external networks. Such complex industry networks are similar to the concepts of relational and structural embeddedness (Granovetter, 1992) or cluster. Among such network, socialization shows its value and reduces the necessity of structural control to coordinate exchange behaviors among network. Based on the above, we have the following hypotheses:

Hypothesis 3-1: The lower the investment risk, the higher the location competition, or higher-level complete industry network, the more likely foreign investors are to adopt a higher-level equity control and socialization mechanisms, but lower-level structural control.

Hypothesis 3-2: The higher the investment risk, the lower the location competition, or lower-level complete industry network, the more likely foreign investors are to adopt a lower-level equity control and socialization mechanisms, but higher-level structural control.

3. METHODOLOGY AND DATA

3.1 Sample

This research focuses on the direct investment of Taiwanese manufacturing firms in China. Taiwanese manufacturers that were setting up factories in China during the period of our study constituted the research subjects, and we used questionnaires to collect the data. The sample is drawn from "Taiwanese investments in Mainland China" published by "China Credit Information Service, LTD.", which lists a total of 2,239 manufacturing firms, including over-the-counter or unlisted companies. Because of our focus on the location factors and governance mechanisms of foreign investment for SMEs, we selected unlisted companies as our sample. Subtracting the 244 listed companies and 127 over-the-counter companies from the total of 2,239 companies, the number of sampled companies was 1,968. Limited by time and financial resources, we choose a proportionate stratified sample based on 22 categories, such as machinery, electric components etc. Within each category we adopted random sampling, which resulted in 984 companies being chosen as our sample. We asked the respondents to choose a representative project involving investment in China during the period 1999~2005 as a reference when answering the questionnaire. From the 984 samples, 111 questionnaires were returned, three of which were invalid; thus, a 10.9% response rate was achieved in this study.

3.2 Measures

Our construction, measurement and operation of variables was based on earlier studies. We asked the leader of the foreign investment team or contact window to be the respondent, so the validity should be accepted. This research used a Likert scale ranging from 1 to 5, which was applied to the relevant variables. These are discussed below, along with the reliability for the empirical data.

Transaction characteristics. The five dimensions of transaction characteristics measured were technology risk, market risk, external opportunism, internal opportunism, and asset specificity. Exhibit 1 provides the definitions of each Construct, and Appendix 1 shows the composite reliability. External opportunism is measured by three items (composite reliability=0.88). Asset specificity is likewise measured by three items (composite reliability=0.75).

Location factors. Location factors consist of three dimensions, including investment risk, location competition, and industry network. Investment risk is measured by four items (composite reliability=0.87). Location competition is measured using

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