Climbing up versus climbing down the institutional ladder

A look at the implications of distance for multinational corporations.

Challenges from afar

There has been great discussion about the world being (or not being) “flat” in the globalisation of commerce. Over the past couple of decades, the centre of gravity in economic activities has shifted to emerging markets. This means that more and more multinational companies (MNCs) have been moving their operations to these countries to access greater markets and profits. However, this is not all easy. Managing a foreign subsidiary at a “distance” brings its own challenges due to the new regulatory and cultural environments that must be faced. The farther the subsidiary from the MNC’s home environment, the greater would be the challenges, despite the benefits.

Dr Palitha Konara and Dr Vikrant Shirodkar’s research into the issue suggests that greater differences in institutional strengths (i.e. “institutional distance”) between the MNC’s home country and the host country can create both opportunities and challenges for MNCs, ultimately affecting the performance of their foreign subsidiaries located in the host country. Opportunities arise from the likely economic gains such as cost savings due to institutional differences (called “arbitrage effects”). Challenges arise from the likely costs of “learning” about the new institutions of the host country and “unlearning” certain business practices imprinted from their home institutional environment that may not be transferrable to the host country.

In theory, the “institution-based view” of strategy suggests that companies’ performance is influenced and shaped by the institutional context within which the company operates. Stronger institutions, such as laws and regulations, reduce uncertainties for companies making it easier for them to operate. Emerging markets are characterised with relatively weaker institutions as compared to developed countries. In practice, such differences in institutions would require companies to deal with issues such as weaker labour laws, lesser regard for human rights and greater levels of corruption (to name a few) as these can be prevalent in many emerging markets.

Prior research on how institutional distance would affect MNCs has focussed on MNCs originating from developed countries operating in emerging markets. This is what Palitha and Vikrant term “climbing down the institutional ladder” (or simply, downward distance). In recent times, more and more MNCs are arising from emerging markets and are investing in developed countries. Take, for example, India’s Tata Group or China’s Huawei. These companies are, according to the researchers, “climbing up the institutional ladder” (or facing upward distance). They suggest that prior research has assumed a symmetric view of the effects of institutional distance, largely because MNCs from emerging markets were ignored.

Palitha and Vikrant suggest that the challenges associated with institutional distance to MNCs would be different when climbing down as compared to when climbing up the institutional ladder. That is, a company from an institutionally stronger country setting up a subsidiary in an institutionally weaker country, such as a US company setting up a subsidiary in India, would face a different effect of distance when compared to the other way round, i.e. an Indian company setting up a subsidiary in the US.

Overall, they argue that, at the same degree of institutional distance, the implications of distance on foreign subsidiary performance would be relatively more positive when firms are climbing down the institutional ladder as compared to when firms are climbing up the institutional ladder. This is because, when investing in the upward direction, for managers of MNCs, the costs of both learning the new ‘rules of the game’ of the host country as well as unlearning inferior business practices imprinted from the MNC’s home institutions would be relatively higher, and the potential to transfer the MNC’s home-based capabilities would be relatively lesser, than that in the downward direction.

Whilst distance is known to create challenges for MNCs, how can these corporate giants overcome them? Palitha and Vikrant reveal that there are ways to reduce the impact of these challenges. Partnering with a local company as against taking full ownership of the foreign subsidiary is one such way. By examining how the abovementioned implications of institutional distance on foreign subsidiary performance can differ according to the type of subsidiary ownership (fully owned vs. partially owned), they also suggest that full subsidiary-ownership (as opposed to partial ownership) is likely to be more beneficial. This is particularly the case for subsidiary performance when MNCs are climbing down the institutional ladder, but also implies that for MNCs climbing up the ladder (i.e. MNCs from emerging markets investing in distant developed countries), subsidiary performance can be improved via partnering with local firms rather than taking full ownership by the parent.

This study involved tracking the performance of 1936 MNCs over the 12-year period: 2002 – 2013, representing 70 host countries and 66 home countries.