INTRODUCTION
While the traditional literature that
examines the performance of the multinational enterprise (MNE) has focused on
resources and capabilities possessed by the parent firm, the more recent
literature emphasizes the importance of resources and capabilities developed at
subsidiaries (e.g. Birkinshaw and Hood, 1998; and Birkinshaw, Hood, and
Jonsson, 1998). When a MNE is composed
of a number of subsidiaries and operates under a network of subsidiaries with
different characteristics (Ghoshal and Bartlett, 1990; and Nohira and Ghoshal,
1994), individual subsidiaries are likely to contribute to the MNE’s overall
performance through the development of new sets of capabilities. The process through which a subsidiary
develops new capabilities and accumulates resources is likely to be facilitated
by the establishment of R&D units in the subsidiary, which is, in turn,
determined by the subsidiary’s characteristics such as size and organizational
experience (e.g. Gerybadze and Reger, 1999; Kuemmerle, 1999; Frost, Birkinshaw,
and Ensign, 2002; and Belderbos, 2003).
Parallel to this line of literature, an
economic model developed by Markusen and Venables (1996) and Markusen (2002)
shows formally that the locations of the MNE’s R&D and production
activities are determined by the confluence of factors required to perform
these activities and location-specific factors.
What their model suggests is that the MNE shifts its R&D and/or
production units from the home country to host country, and the pattern depends
on such economic factors as country size, trade and investment costs, scale
economies, and factor content of specific activities, among others.
These two strands of literature clearly
indicate that the MNE’s performance is influenced by its subsidiaries’
capabilities and their geographic locations.
If individual subsidiaries contribute to the performance of the
enterprise as a whole, an important question that follows is what determines
the performance of individual subsidiaries.
While we believe this question is relevant empirically, thus far no
study has addressed this issue using systematic data. The existing literature on subsidiary
capability implies that subsidiary characteristics determine its capability and
thus its market performance. The main
purpose of this paper is then to address this question and identify the
determinants of subsidiary performance in terms of profitability.
While the issue of subsidiary performance is
important in general, this has become quite relevant and important for Japanese
firms and their foreign rivals as many Japanese firms currently face challenges
which force them to reevaluate their foreign direct investment strategies and
restructure their global operations.
This contrasts starkly with the situation during the latter half of the
1980s in which Japanese firms aggressively expanded their presence in North
America, Europe and Asia.
Our study is the first attempt in the
literature to examine the profitability of Japanese firms abroad during the
period directly following the era of rapid growth. This article tests several hypotheses to
identify key factors that determine the profitability of Japanese firms abroad
by using panel-data regression models on a new data sample covering 19,307
subsidiaries of 3,474 Japanese multinational enterprises (MNEs) over the
1990–1996 period.
While determinants of industry and firm
profitability have been sought and examined extensively in the fields of
industrial organization and business strategy, the profits reported by MNEs are
seldom examined empirically in the field of economic analysis of multinational
enterprise (e.g., Lecraw, 1983). The
paucity of statistical research on the profitability of MNEs is largely due to
the daunting task of obtaining profit data defined at the level of foreign
subsidiary. This article overcomes the
difficulty and goes beyond the existing study in several aspects. First, this
article presents the first evidence of the profits reported by Japanese firms
at the level of subsidiary distributed across a large cross-section of
industries. The performance of the overseas
subsidiary is an interesting research topic from a managerial perspective
because it provides measurement for manager evaluation. Second, the data covers all of the host
countries around the world, including North America, Europe and Asia where Japanese firms established subsidiaries. Previous evidence on the determinants of
profitability of MNEs was confined to a limited number of host countries. Third, the availability of longitudinal data
at the level of subsidiary allows us to construct a panel for the period of
1990–1996.
The results of this analysis show that the
determinants of subsidiary profits differ across host regions, suggesting that
the economic and institutional factors specific to host regions influence
significantly the profit performances of overseas subsidiaries. Some effects are common across markets, while
other effects, such as experience, local supplier networks, local sales and
macroeconomic conditions affect the performance of subsidiaries in a different
manner by region.
The remainder of this article is organized
as follows: The second section explains the data and presents some descriptive
statistics on the profits at the subsidiary level. The third section surveys the existing literature
and develops the hypotheses. Empirical
tests are provided in the fourth section in the form of regression analysis of
subsidiary profits. The final section
summarizes the main findings and concludes the article.
DATA AND DESCRIPTIVE STATISTICS
Data
The data used for this analysis is from the Survey of the Overseas Activities of
Japanese firms (the Survey), an annual survey conducted by the Ministry of
International Trade and Industry,
Japan
(MITI). The Survey covers 3000+ parent
firms and their overseas subsidiaries, whose response rate is approximately 80%
every year. Companies are asked to
report the data as of March 31 of each year.
We are able to obtain proprietary subsidiary-level data, matched with their
parent firm data. From the Survey we can
identify the country, the industry, the type of activities, and the basic
financial data of each subsidiary for each year. In addition to the basic annual survey, a
detailed survey is conducted once in every three years, including more detailed
financial data, the breakdown of intra-trade statistics and qualitative aspects
of the activities of foreign subsidiaries. Due to the condition imposed on the use of
the Survey, the identity of these firms is not disclosed, prohibiting us from
matching these data with firm-specific data from other sources. To our knowledge, however, this is one of the
most detailed data of the foreign subsidiaries to date.
A panel data
is constructed from the 1990–1996 Survey results. The panel is not balanced due to the missing
reporting. The panel covers 3,474
distinct parent firms and 19,307 distinct overseas subsidiaries, and the total
number of observations is 61,705. The
following statistical analysis of the profitability is based on 46,953
observations with which we can obtain the data of the return on sales. The reporting of the local procurement and
local sales is poorer, yielding 21,720 and 32,245 observations,
respectively. These observations include
subsidiaries in all the countries. In
our analysis, we focus on the ones located in the United
States, the European Union (EU), East Asia (which
includes China, Taiwan, Hong Kong and South Korea) and ASEAN due to the
importance of these regions for the Japanese FDI and the ease of the
interpretation of the results.
Patterns of Subsidiary Profitability
The most striking pattern that emerges from
our data of subsidiary profits is that the profits reported for subsidiaries
located in Asia are, on average, higher than the profits of subsidiaries in the
United States
and the EU. Figure 1 shows the behavior
of the profits (gross profits / sales) for subsidiaries located in the United States, the EU, ASEAN and East Asia in all industries between the 1990–1996
period. The profits of the subsidiaries
in ASEAN and East Asia move between 3.4% and 1.4%, while those in the United States
and the EU vary between 1.0% and -0.6%.
The profits reported for U.S.
subsidiaries are the lowest among the four regions in the figure during the
1990–1992 period.
For Japan’s four major manufacturing
industries, in terms of the extent of FDI, chemicals, general machinery,
electrical equipment, and transportation equipment, Figures 2–5 show that the
profits reported for subsidiaries in ASEAN and East Asia are consistently
positive and likely to be larger than those for the United States and the EU,
underlying the general pattern observed in Figure 1. This pattern is confirmed again for the
profits for wholesale and retail trade, and restaurants (Figure 6).
Looking at the profits reported for the U.S.,
European and Asian subsidiaries of Japanese firms, the behavior of profits over
time differs across industries. For
example, the U.S.
subsidiaries in chemicals, electrical equipment and transportation equipment
tend to report negative profit rates for 1990–1992 and positive rates for
1993–1996, while those in general machinery report negative profits only in
1994. The pattern of inter-industry
difference in the behavior of profits is not necessarily the same between
different host regions. Rather, the
behaviors of their profits tend to differ distinctively. Figures 2–5 indicate a pattern that the
profits for EU subsidiaries are higher than those of U.S. subsidiaries in 1990 and 1991
but start declining after 1992. Indeed,
the subsidiary profits in the EU are the lowest among the four regions during
the 1993–1996 period for chemicals, electrical equipment, and transportation
equipment and during the 1992–1995 for general machinery. This pattern, however, is not observed for
wholesale and retail trade, where the U.S. subsidiaries tend to earn low
profits.
Previous empirical studies that examine the
time-series patterns of industry and firm profits (e.g., Domowitz et al., 1986, for U.S. industry profit-margins; and Machin and Van
Reenen, 1993, for U.K.
firm profit-margins) have found that industry and firm profits tend to respond
to aggregate demand fluctuations and thus aggregate cyclical fluctuations. Using panel data, the U.S. and U.K. studies found that industry
profit-margins and firm profit-margins move pro-cyclically with aggregate
demand fluctuations.
While it is not unequivocally ascertained
here whether subsidiary profits move cyclically with macro-economic conditions
of host countries, we conjecture that our profit data are also influenced to
some extent by aggregate demand fluctuations.
For example, the U.S.
economy declined in 1990 and 1991, reducing annual real GDP growth rates from
3.9% in 1988 to 1.2% in 1990 and further to -0.7% in 1991. The economy recovered in the subsequent
period, increasing GDP growth to 2.6% in 1992 and 3.1% in 1994. On the contrary, the European economy was
still expanding relatively strong in 1990 at a rate of 3.7%. Her economy, however, contracted sharply in
1993. Such difference in the pattern of
aggregate demand fluctuations between the United
States and Europe may
provide a partial explanation to the difference in the behavior of profits for
subsidiaries located in these regions as observed above.
In sum, the preliminary analysis thus far
suggests that our subsidiary profit data vary across industries and over
time. In addition to these two sources
of variance, it varies importantly across host countries and regions. In the empirical analysis of this article, we
will specify estimation equations that determine profits by taking these different
sources of variance into consideration.
One of the hypotheses we are interested in testing is the hypothesis
that the determinants of subsidiary profits are different among host regions. We expect that they are different as implied
by the descriptive analysis.
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Figures 1 through 6
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Subsidiary’s Local Activities
One of the main features of MNEs’ activities
is their extensive use of intra-firm trade.
The previous empirical work on the extent to which MNEs trade goods
between parents and their affiliates has found that MNEs engage extensively in
off-shore procurement (Jarret, 1979), intra-firm trade of components and
semi-finished products (Casson and associates, 1986), and intra-firm exports of
finished goods to affiliates (Andersson and Fredriksson, 2000). A number of statistical studies that examine
the determinants of intra-firm trade found, in general, that the extent of
intra-firm trade is positively related to R&D intensity used as a proxy for
the importance of specialized assets involved in the transaction of goods in
question (e.g., Lall, 1978; Helleiner and Lavergne, 1979; Benvignati, 1990;
Andersson and Fredriksson, 2000).
Generally speaking, the decision to engage
in intra-firm trade for a subsidiary should affect its profits through its
impact on operating costs. A subsidiary
may engage in intra-firm trade because it enables the subsidiary to operate
under a circumstance in which it can choose an optimal combination of local and
import procurement. While the importance
of local procurement as a determinant of MNEs’ performance has been implied in
the previous literature of Japanese MNEs (e.g., Hackett and Srinivassan, 1998;
Belderbos et al., 1998), no study has
explicitly examined their effects on the profitability.
The database used in this study allows us to
test whether the extent of local procurement affect the profitability of
subsidiaries. Our data sample shows
clearly that the local procurement ratio varies not only across industries and
host regions but also changes over time.
For example, in transportation equipment whose major industries are
automobiles, the local procurement ratio in the United States increased over time
from 53% in 1990, 58% in 1992, and 70% in 1996.
This trend is presumably reflecting the response of the U.S.
subsidiaries of Japanese auto makers to the provision of the North American
Free Trade Agreement (NAFTA), which increased North American content requirement
from 50% to 62 % over an eight-year period.
The local procurement ratio varies widely
across industries as well. In 1996, the
local procurement ratio was, on average, quite high and exceeded 90% in raw
material intensive industries, such as foods, lumber and wood products, and
pulp and paper, while it was much lower in industries such as electrical
machinery and precision instruments. Not
surprisingly, the local procurement ratio in our data is strongly negatively
correlated with the ratio of subsidiary’s imports from Japan to total procurement.
As the subsidiary’s propensity to procure
locally is a potentially important determinant of profits, its propensity to
sell locally is also expected to influence profits through local demand
conditions. Therefore, we will introduce
a variable that measures the fraction of total subsidiary sales generated from
local sales: the local sales ratio. This
variable again varies across industries.
The manufacturing industries with the lowest local sales ratios in 1996
are petroleum products, lumber and wood products, pulp and paper, and
publishing and printing, while those with high local sales ratios are
transportation equipment, iron and steel, wooden furniture, metal products, and
tires and rubber products. Along with
the observation on the local procurement ratios, this provides evidence that is
consistent with the pattern that Japanese MNEs are more likely to export raw
material intensive products from host countries.
EMPIRICAL MODEL AND
HYPOTHESES
Specification and Hypotheses
A great deal of previous empirical research
on the determinants of firm profitability has been based on two
explanations. The first explanation is
based on the observation that a firm earns rents from two sources: superior
efficiency and market power. Since
superior efficiency and market power accrue to a firm from its possession of
proprietary assets, firm rents derive from such assets. To the extent that the firm size and market
share reflect a firm’s possession of such rent-yielding assets, large firm size
and market share are likely to predict higher firm profits. In the literature which focuses on the
resources firms possess, the attention has been paid on the explanation of how
differences in efficiency are sustained in the face of competition. The second explanation is based on the
observation that market structure shapes the behavior of firms within the
industry, which in turn determines their profits. Structural characteristics such as
concentration, barriers to entry and product differentiation are considered to
be important in determining firm profits.
Previous work on the performance of MNEs has
used these approaches of industrial organization and evaluated the issues of
market power and efficiency using variables such as market share and
concentration (Lecraw, 1983). While the
presence of both firm-specific effects and industry-specific effects in the
determinants of MNEs’ profits has been documented in the previous empirical
work, country-specific effects which are more inherent to the operation of MNEs
need to be elaborated further in empirical analysis.
Our profit equation incorporates these
factors and is given as:
Pi t = a + gj
+ lk
+ ft
+ Xi t ˘b1
+ Ym t ˘b2
+ ui t (1)
where Pi t is the measure of profitability defined
as the ratio of gross profits to sales for subsidiary i at time t, a
is an intercept, gj is an industry-specific fixed effect for
industry j in which subsidiary i operates, lk is a
country-specific effect for host country k in which subsidiary i operates, f
t is a time-specific effect, Xi
t denotes a set of subsidiary-specific variables, Ym t denotes
a set parent-specific variables, and ui t is a random error term.
The effects common to each subsidiary in
industry j and host country k are controlled for by gj and lk
,respectively. Industry effects
are modeled in a general way by incorporating a set of industry dummies in
estimation. The time-specific effect, ft,
is included to capture macro-economic effects common to each subsidiary. Both host country and time-specific effects
are modeled by including GDP-related measures.
The subsidiary-specific variables, Xi t , are included to test
several hypotheses on the determinants of subsidiary profits of Japanese
MNEs. One of the key features in our
empirical analysis lies in that we incorporate several new variables which
measure the extent and scope of MNEs’ local activities. This research design is based on the premise
that MNEs respond to location forces specific to the host country and adapt
their local operations accordingly.
Location forces such as factor price differences, skill formation, local
content rules, tax policy, and rules restricting the repatriation of profits
all affect the behavior of MNEs and the configuration of their business
activities. In addition, we consider
parent-specific variables, Ym t, which are common to firm m’s
subsidiaries. We consider the following
subsidiary-specific and parent-specific variables and corresponding
hypotheses.
Scale. As discussed above, the scale of a subsidiary
is a proxy for its market power and efficiency, and is likely to reflect its
possession of advantageous resources.
The subsidiary with a large-scale operation can also benefit from the
economies of scale on production and distribution activities. In addition, large scale might help enhance
the subsidiary’s reputation in the overseas market, because the large-scale
operation is an indicator of the subsidiary’s commitment to a host country. Thus we hypothesize:
Hypothesis
1. All else being equal, the scale of a
foreign subsidiary is positively associated with the profitability of the
subsidiary.
Experience. Past studies have suggested that the
experience in the local market positively affects the performance of foreign
subsidiaries, because foreign firms with experience in a host country usually
have more information about the local environment and accumulate better
location-specific skills and know-hows than first-time foreign entrants. Li (1995) shows that first-time foreign
entrants to the U.S.
computer and pharmaceutical industries are more likely to fail than repeat
entrants. Kogut and Chang (1996) find
that the previous investments of Japanese electronics companies in the United
States induces following investments, suggesting that initial investment serves
as a platform for subsequent entry. Moreover,
the experience of parent firms in operating overseas subsidiaries can be
transferable to subsidiaries in different countries (Johanson and Vahlne, 1977),
because managers may build organizational routines that allow firms to
efficiently expand abroad in many markets (Westney, 1998; Madhok, 1997). These
arguments suggest that operational experience in foreign markets can be
accumulated at the firm level as well as the subsidiary level. Thus we hypothesize:
Hypothesis
2-1. All else being equal, the
experience of a foreign subsidiary in a host country is positively associated
with the profitability of the subsidiary.
Hypothesis
2-2. All else being equal, the
experience of a parent firm to operate foreign subsidiaries is positively
associated with the profitability of the subsidiary.
Local
Procurement. The high level of
supplier involvement in product development and production has been identified
as one of the major sources of superior performance by Japanese automobile
assemblers (Asanuma, 1985; Clark and Fujimoto, 1991). As Japanese firms increasingly invest in
overseas markets, many firms successfully replicate the Japanese-style tight
supplier networks and practices in host countries (Cusumano and Takeishi,
1991). The establishment of supplier
networks requires relation-specific investments (Dyer, 1996), and so it takes
time to successfully develop such networks.
The high local procurement ratio alone does not give us a clear
prediction of its impact on subsidiary profitability. When host countries have factor price
advantages, the high local procurement ratio can contribute to the subsidiary
profitability. When Japanese
subsidiaries are required to meet the local content requirement, a high local
procurement ratio could negatively affect their performance, especially in the
early stage of subsidiary development with undeveloped supplier networks. Thus we hypothesize:
Hypothesis
3. All else being equal, the local
procurement ratio of a foreign subsidiary with a long experience in a host
country is positively associated with the profitability of the subsidiary.
Local
Sales. For foreign subsidiaries,
which are established to serve local markets, the greater local sales ratio is
an indicator of the degree of penetration to local markets. When Japanese MNEs have advantages over local
firms, the greater penetration should result in higher profits. Such a case is likely to occur in developed
markets. For subsidiaries which are
established to take advantage of low factor costs and are intended as export
bases to the third countries, however, the low local sales ratio (i.e., the
high export ratio) contributes to the high profitability. This situation is likely to occur for
subsidiaries in developing countries. Thus
we test the following hypotheses:
Hypothesis
4a. All else being equal, the local
sales ratio of a foreign subsidiary is positively associated with the
profitability of the subsidiary when it is located in a developed country.
Hypothesis
4b. All else being equal, the local sales ratio of a foreign subsidiary is
negatively associated with the profitability of the subsidiary when it is
located in a developing country.
Equity Ownership. The greater equity involvement of parent
companies to foreign subsidiaries allows parent firms to maintain greater
control. Especially, when the source of advantages of MNEs is R&D
or marketing know-how, their overseas operation requires detailed product
knowledge, brand-development capabilities, updated technological information,
and extensive after-sales service. The
assets necessary for these activities, including the specialized knowledge and
working relationship, tend to be transaction-specific and develop over time
through agent interaction (Williamson, 1979).
These activities also involve frequent exchanges of tacit knowledge and
require high-level intra-firm coordination (Kogut, 1988), in turn requiring a
high degree of control over subsidiaries.
Therefore, this type of MNE seeks tighter control over foreign
activities. It has been identified that
the accumulation of intangible assets by Japanese firms Granger causes FDI (Berry and Sakakibara, forthcoming),
motivating Japanese firms to maintain their control over foreign subsidiaries
to achieve better performance. In
addition to receiving parent firms’ capabilities, foreign subsidiaries can
develop their own capabilities. Bartlett
and Ghoshal (1989) argued that foreign subsidiaries which face various environments
have opportunities to learn from these environments and develop competencies. Such competencies can be utilized within an
MNE worldwide through its integrated network.
A high degree of equity ownership would help capability building and
retention in subsidiaries, resulting in their better performance. Thus we hypothesize:
Hypothesis
5. All else being equal, the Japanese
equity ownership ratio of a foreign subsidiary is positively associated with
the profitability of the subsidiary.
R&D
Intensity. It has been argued that
technological know-how constitutes the basis of the competitive advantages of
many MNEs (Hymer, 1960; Caves, 1971; Buckley and Casson, 1976). The R&D intensity of parent firms
indicates its superior technological capabilities. Thus we hypothesize:
Hypothesis
6. All else being equal, the R&D
intensity of a parent firm is positively associated with the profitability of
the subsidiary.
Control
Variables.
Host-Country
and Time-Specific Effect. Host-country
conditions such as market size, purchasing power, sophistication of markets and
skilled workforces affect the profitability of foreign subsidiaries. Macroeconomic conditions of host countries,
most notably business cycles, also affect their profitability. We control for these effects by including variables
which reflect macroeconomic conditions of host countries. When a host country
is not a major market for a subsidiary, these effects might be limited. When a host country is a major market, however,
conditions of a host country directly affect the profitability of a foreign
subsidiary. Therefore we include the interaction
variable between the variable which reflect host countries’ macroeconomic
conditions and the local sales ratio.
We also include a subsidiary’s degree of
local manufacturing to test if there is any differential in profitability
between manufacturing subsidiaries and others (mainly distribution
subsidiaries) due to the possible difference in their margin structure. Though we do not report the results, in some
specifications we included several subsidiary-level variables. Japanese employment ratio (the number of
Japanese employees / total number of employees) was included to control for the
degree of centralization of managerial control.
As Bartlett and Ghoshal (1989) argued, centralized organizational
structure is suitable to achieve global efficiency, while it can hinder local
responsiveness. Capital-labor ratio was
included to control for the difference in profitability due to capital
intensity. R&D intensity at the
subsidiary level was included to examine whether the subsidiary-level R&D
efforts, which can be used to localize the products or to build technological
capabilities of subsidiaries, contribute to their profitability. In order to control for regulatory
restrictions which could prevent subsidiaries from achieving their optimum
operation, a dummy variable for the local content requirement and a dummy
variable for the restriction on repatriation were included. These variables appeared not to be
significant.
Selection of Variables
Dependent Variable:
The
dependent variable is the return on sales, defined here as the gross profit
over total sales. This measure is chosen
because this is a pre-tax measure, hoping to minimize the effect of local tax
rules. Alternatively, the net profit over total
sales is considered as an independent variable, but the correlation coefficient
of both measures are 0.96 and both yield qualitatively similar results. Therefore, the results with the gross profit
over sales are reported here.
One might argue that the return on
investment is a better indicator of the profitability of a foreign
subsidiary. Since only the book value of
a parent company’s investment to a subsidiary (or the book value of total
assets) is available, this indicator introduces an upward bias to subsidiaries
established earlier. More practically,
the data of investment and assets are only available for 1990, 1993 and
1996. We therefore employ the return on
sales as the dependent variable in this analysis.
Explanatory Variables:
Scale.
The scale of a subsidiary is proxied for by the log of its sales,
deflated by using the GDP deflator in 1990 prices. Log is taken in order to avoid the identity
of the equation.
Experience. The age of a subsidiary, which is the years
passed after the establishment of a subsidiary is used as a proxy for the
experience of the subsidiary. The number
of overseas subsidiaries of a parent firm is used as a proxy for a parent
firm’s overseas experience.
Local Procurement. The local procurement ratio is defined as the
share of procurement from a host country in total procurement. In order to identify the effect of the local
procurement for the subsidiaries with a long local experience, an interaction
term is included in which the age of a subsidiary is multiplied by the local
procurement ratio.
Local Sales. The local sales ratio is defined as the share
of sales within a host country in total sales.
Equity Ownership. The Japanese equity ownership ratio is
defined as the sum of the equity ownership by Japanese investors over total
equity.
R&D Intensity. R&D expenditure over sales is used as a
proxy for a parent firm’s R&D intensity.
Host-Country and Time-Specific Effect. GDP and GDP per capita are used as proxies
for host-country conditions and business cycles. Both figures are deflated by using the GDP
deflator in 1990 prices. In addition to
these variables, interaction terms are included in which these variables are multiplied
by the local sales ratio.
Manufacturing Ratio. A subsidiary’s manufacturing shipment over
total sales is used as a proxy for the degree of local manufacturing.
All the
variables and their predicted signs are summarized in Table 1.
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Table 1 about here
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EMPIRICAL RESULTS
Estimation Methodology
We employ ordinary least square regression
analyses with fixed effects. The fixed
effect model assumes that differences across subsidiaries can be captured in
the constant term. Operationally, we
define transformations of our variables such that, for each subsidiary in each
year, we subtract the mean of the variables for that subsidiary over time. In the fixed effect model, all the
industry-specific effects, and unmeasured country-specific, parent-specific and
subsidiary-specific effects which might have been included in the error term
fall out in the process of the transformation of the variables (i.e., these
effects are controlled for), since they do not vary “within subsidiaries” over
time. This methodology allows us to
focus on the variables we are concerned, which change over time.
One might argue that this type of regression
analysis does not yield meaningful results because firms have the ability to
shift profits from subsidiary to parent (or vice versa) to some extent (e.g.,
Eccles, 1985). The fixed effect model
eases the potential data problems which arise from the different local taxation
policy and the resulting transfer pricing policy by Japanese MNEs. As long as the taxation/transfer pricing
policy does not change for a given subsidiary over the 1990–1996 period, this
effect falls out.
The observations described in the second
section indicate our data vary across host countries and regions. In order to address this issue, we run
separate regressions for each of four regions we are concerned — the United States, EU, East
Asia and ASEAN. The Chow
test rejected the hypothesis that all the coefficients are the same across four
regions at the .01 level, supporting the validity to run separate regressions
by region.
We also limit our empirical analysis to subsidiaries
in manufacturing industries. Our
preliminary regression results indicate there are major differences in the
results from manufacturing industries, service industries and primary
industries. By focusing on manufacturing
industries, we hope to obtain results that are easy to interpret.
The cost of this methodology is the reduced
number of observations. After these
limitations, we are still able to obtain the total of 9,657 observations.
The reporting of parent-level variables is sparser than the
subsidiary-level, so parent variables are used in selected specifications. Summary statistics and the correlation matrix
are presented in Tables 2 and 3. Another
cost of the fixed-effect estimates is that the standard goodness-of-fit
measures are not informative. Adjusted R2
values are reported as a reference.
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Tables 2 and 3 about
here
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The correlation matrix reveals that there is no high correlation between
the dependent variable and each of explanatory variables. The Japanese equity ownership ratio is highly
positively correlated with GDP per capita, suggesting that Japanese firms would
like to commit more to subsidiaries in a host country with favorable macro
conditions. Knowing this correlation, we
would like to maintain both variables in the models in order to test which
factor explains the profitability better.
Results
Table 4
reports the regression results when only subsidiary-level variables are
used. Columns 1 through 4 report the
results of the United States,
EU, East Asia and ASEAN, respectively, with
GDP as the indicator of host-country and macroeconomic conditions. The results show that the determinants of
subsidiary profits differ across host regions, suggesting that the economic and
institutional factors specific to host regions influence significantly the
profit performances of overseas subsidiaries.
Some effects are common across region. The coefficient of log(sales) is positive and
highly significant at the 1% level in all regions, indicating that size and
implied market power and efficiency are positively associated with the
profitability.
The local procurement ratio is positive and
significant at the 10% level in East Asia. This indicates that this region is a
favorable sourcing base for Japanese subsidiaries. In EU, local procurement ratio negatively
affects the performance of subsidiaries, suggesting the local content
requirements might negatively affect the performance. The age of subsidiaries is also negative and
significant, while the interaction term between age and the local procurement
ratio is positive and significant in EU at the 5% level, as predicted. A similar pattern is observed in ASEAN with
the weaker significance, where the age is negative and significant and the
interaction term between age and the local procurement ratio is positive and significant
at the 15% level (but not at the 10% level).
In these two regions, it appears that just operating for a long period
does not help profitability; rather it is the experience of dealing with local
suppliers that contributes to the profitability.
In EU, the finding on the effect of the
local procurement ratio is consistent with the often-cited difficulty of labor
relationships in Europe (Fujimoto et al., 1994). Strong unions, high wages, the difficulty to
implement Japanese-style management practices such as the just-in-time system
might prevent Japanese manufacturing subsidiaries from being profitable. Only experienced firms can effectively deal
with local suppliers. It also suggests
that in this region, the establishment of manufacturing subsidiaries is partly motivated
by meeting the requirements of voluntary export restraints and local content.
The equity ownership ratio positively and
significantly affects the performance in ASEAN.
The local sales ratio is not significant in any region. In ASEAN, contrary to the prediction, the
interaction term between GDP and the local sales ratio is negative and highly
significant at the 1% level. It appears that
at a given level of GDP Japanese subsidiaries are more profitable if they sell
products to Japan
or to the third countries.
In East Asia,
GDP is negative and highly significant.
This result and a previous finding on the positive effect of the local
procurement suggest that this region contributes to the profitability of
Japanese subsidiaries through their sourcing, not as their markets.
Columns 5 through 8 report the regression
results with GDP per capita. Overall,
the results are similar to previous results with some interesting
differences. The findings of the effect
of size, age, the interaction term between age and the local procurement ratio,
and Japanese equity ownership ratio remained to be similar.
In ASEAN, the coefficients of the local
sales ratio and GDP per capita are negative and highly significant, while the
interaction term between GDP per capita and the local sales ratio is positive
and highly significant at the 1% level.
This might indicate that local markets in ASEAN countries are attractive
to Japanese subsidiaries only if the local markets have a high level of
disposable income and sophisticated consumers who can afford and appreciate
products Japanese firms produce and sell in these markets.
In Tables 4, the coefficient of the Japanese
equity ownership ratio is not significant except for ASEAN. It appears the degree of the ownership does
not affect the profitability in more advanced economies, after controlling for
other factors. This issue requires
further investigation since the determinants of the mode of entry to foreign
markets have been extensively scrutinized in past literature.
Table 5 reports some results with
parent-firm variables. Columns 1 through
4 report the results with the number of subsidiaries by a parent firm. Note these results are not compatible with
Table 4 because the number of observations is reduced due to the data
availability. As predicted, the number of subsidiaries by a
parent firm is positive and significant in East Asia. Also, the inclusion of this variable improves
the explanatory power of some variables in this region, and now, as predicted,
the Japanese equity ratio and the interaction term between GDP and the local
sales ratio are positive and significant.
This indicates that this region is profitable as markets for Japanese
subsidiaries only if the economic condition is favorable. The inclusion of this variable also improves
the explanatory power of some variables in ASEAN, where the interaction term
between age and the local procurement ratio becomes positive and
significant. It appears the experience
to deal with local suppliers contributes to the profitability, as is observed
in EU in Table 4.
Columns 5 through 8 report the results with
the R&D intensity of parent firms.
This variable is positive and significant in the United States, indicating Japanese subsidiaries
are profitable in the United
States when they possess technological
capabilities. The inclusion of this
variable improves the explanatory power of the local sales ratio, GDP, and the
interaction term between GDP and the local sales ratio. It appears the United
States is an attractive market for Japanese firms, and
the favorable macroeconomic conditions in the United States contribute to its
profitability. The interaction term is
negative and significant, indicating that these effects independently, not
jointly, affect the profitability.
---------------------------------------
Tables 4 and 5 about
here
---------------------------------------
CONCLUSIONS
This article has contributed to the existing
literature by presenting new evidence on the pattern of subsidiary profits of
Japanese MNEs in the 1990–1996 period.
At least two innovative attempts were made in this article: (1) a new
panel of profits at the subsidiary level was presented; and (2) determinants of
subsidiary profits were examined by using variables measuring subsidiaries’
local activities. One of the most robust
results obtained in the empirical analysis is that the determinants of
subsidiary profits differ across host regions.
The estimated coefficients were found different jointly among
subsidiaries located in the United States,
Europe and Asia. This result suggests that economic and
institutional factors specific to host regions influence significantly the
local activities of Japanese firms and hence their profit performances.
The size effect on the subsidiary
profitability is present in all the regions, and it appears that subsidiaries
in East Asia are profitable when this region
is used as a sourcing and export base. ASEAN
is attractive as a market only if they exhibit favorable host-country market
conditions, and in general, this region contributes to Japanese subsidiaries as
an export base. In EU and ASEAN, we find
the local supplier networks contribute to the profitability of subsidiaries
with local experience. The experience of
parent firms to operate overseas subsidiaries has a positive effect on their
subsidiaries in East Asia. Japanese subsidiaries are profitable in the United States when they possess technological
capabilities, and the favorable macroeconomic conditions in the United States
positively affect the profitability.
This
article has important implications for managers. It has been argued that a firm’s FDI decision
can often be driven by an imitative behavior of close rivals (Knickerbocker,
1973). There are cases that an FDI
decision is made beyond the reasons that are justifiable from profit-maximizing
or strategic perspectives. This research
drives home the fundamental reality that the profitability of overseas
subsidiaries reflects the market and firm-specific conditions. A manager needs to take basic conditions into
account in the FDI decisions rather than adopting a follow-the-leader behavior.
The empirical analysis of this article is by
no means without deficiencies. There are
several omissions in terms of controls in the empirical specification, which
need to be addressed in the future.
First, while we used subsidiary size as a proxy to measure the extent of
market power and efficiency, it is crude at best for this purpose. Ideally, we need to incorporate variables
which measure the subsidiary’s competitive position relative to its rivals in
the market such as market share. Second,
the article also does not control the extent of local competition in the host
country’ market. The industry
concentration ratio such as the
Herfindahl Index is available only for a limited number of countries, and the
industry classifications do not correspond to what is used for the MITI data,
making the matching of both data difficult.
This article suggests the presence of
subsidiary- and parent-specific factors as well as the industry-specific and
region/country-specific factors which play important roles in explaining the
profitability of foreign subsidiaries. A
future research agenda includes an analysis of the relative importance of these
factors. At the same time, this article
shows that both the role of host countries for foreign subsidiaries and the
history of their local activities affect their performance. This suggests that treating foreign
subsidiaries equally across countries is misguided, and country- or
region-specific issues need to be taking into account. Further investigation into these issues is
soundly warranted.
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