When Firms Turn Weakness Into Strength

Firms based in countries of weaker state institutions tend endogenously to build more informal institutions, says SMU Professor Chang Pao Li.

AsianScientist (Sep. 25, 2019) – By Kareyst Lin – Singapore is a country that is often ranked among the top in terms of good governance, which is why when the Singapore and Chinese Governments jointly developed the China-Singapore Suzhou Industrial Park in 1994, it was greeted with great enthusiasm from the investment community. Investors were optimistic about the prospects of the coming together of Singapore-style governance with the vast resources available in China.

Therefore, it came as a surprise when the partnership proceeded to sour in 2001. In just five years, the venture fell heavily into debt, undermined by local officials who had set up a rival park close by, forcing Singapore to cut its interests in the original project. What went wrong?

“There were no typical barriers in terms of language, ethnicity or cultural origin. But as the Singaporean Government later reflected, they had misjudged the importance of relationships with the local authorities,” said Singapore Management University (SMU) Professor Chang Pao Li, speaking at the International Economics Workshop held at the INSEAD campus on 20 June 2019.

In particular, Singapore had underestimated the extent of latitude that the Chinese local officials had versus Beijing in altering the terms of competition. They had failed to realize that a deal sealed in Beijing had to be executed by the local government – one with its own interests to protect.

The fading dominance of North-based companies

At the workshop, Professor Chang presented her paper, ‘Informal Institutions and Comparative Advantage of South-Based MNEs: Theory and Evidence’, which highlights the importance of informal institutions in foreign direct investments (FDIs).

Traditionally, it was believed that multinational enterprises (MNEs) headquartered in the North were more likely to succeed because of the comparatively superior technological know-how of countries north of the equator.

“While it is possible to have MNEs originating from all countries, theoretical literature often implies a dominance of MNEs based in the North,” Professor Chang said.

“This supposition is understandable, but increasingly incongruent with facts,” she noted, pointing to an increase in the outflow FDI by countries in the South.

From 2006 to 2010, about 17 percent of world FDI outflow originated from South; by 2013, that number had grown to about 39 percent.

Indeed, poor governance in the South could turn out to be a source of comparative advantage for South-based MNEs when investing in developing countries, said Professor Chang.

“The literature has proposed a variety of reasons and potential explanations for this advantage,” she said, highlighting examples such as the experience of firms in managing difficult conditions, as well as their familiarity and complementarity with the norms of the host country.

The power of informal institutions

Professor Chang proposes that in cases where the host country’s formal institutions are weaker, the private sector tends to build more informal institutions to substitute for the former.

Defining informal institutions, Professor Chang said, “The term has been used in the literature to refer to many things ranging from customs and norms, to religion and culture. But in this case, we define it as socially shared rules – usually unwritten – that are created, communicated, and enforced outside of officially sanctioned channels.”

These informal institutions fall into three categories: economic, legal and political. In the case of informal institutions that are economic in nature, relational contracting and trade credit gain prevalence where market-supporting institutions such as contract enforcement and bank credit are lacking. Meanwhile, in cases where the state legal institution is weak, the private sector turns to informal legal institutions such as private patrols, private protection agencies or informal courts to substitute for police protection and judicial systems. Finally, where the state’s bureaucratic system is inefficient and regulatory quality poor, firms tend to build political connection with politicians and government officials, or directly participate in politics.

“Informal political institutions are perhaps the most controversial of the three, given its many faceted implications,” Professor Chang explained. “For instance, these political connections may help firms reduce their regulatory burden (such as requiring fewer days to obtain a business permit, fewer agencies to register with, or fewer on-site inspections), secure property rights (such as lower expropriation via tax or fines) and enforce contracts.”

In general, firms may engage in all three types of informal institutional building. For example, a study inferred that the entertainment and travel costs of Chinese firms consist of grease money to obtain better government services, protection money to lower tax rates, and also business expenditures to build relational capital with suppliers and clients, Professor Chang said.

It’s all in the context

In spite of investing heavily in informal institutions to substitute for a lack of strong formal institutions, firms based in the South are still at a disadvantage compared their peers in the North, Professor Chang said.

Nonetheless, Professor Chang developed through theory and supported the proposition via empirical study, using a worldwide firm-level FDI dataset for the period 2009-2016, that South-based MNEs have a comparative advantage and tend more likely to conduct FDIs in countries of poorer state institutions than their peers in the North. This is due to their heavier investments in informal institutions, and the fact that such informal institutions are more effective in reducing production costs in environments of poorer formal institutions.

“As we can see from the example of the Singapore-China SIP case study, institutional endowments of an investor (what it is endowed with in formal institutions and what it develops in informal institutions) play a non-negligible role in the operation and outcome of FDIs,” Professor Chang said.

Asian Scientist Magazine is a media partner of the Singapore Management University Office of Research & Tech Transfer.


Copyright: SMU Office of Research & Tech Transfer. Read the original article here; Photo: Kareyst Lin.
Disclaimer: This article does not necessarily reflect the views of AsianScientist or its staff.

A premier university in Asia, the Singapore Management University is internationally recognized for its world-class research and distinguished teaching. Established in 2000, SMU’s mission is to generate leading-edge research with global impact and produce broad-based, creative and entrepreneurial leaders for the knowledge-based economy.

Related Stories from Asian Scientist