University College London

School of Slavonic and East European Studies

MA Comparative Business Economics

Institutions matter

- In the context of FDI in China and Russia

September 2015

Supervisor: Dr Filipa Figueira

Student Name: Xiaohua Lin

Student Number: 14023334

Word count: 11100

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Declaration

I, Xiaohua Lin, confirm that the work presented in this thesis is my own.

Where information has been derived from other sources, I confirm that this has been

indicated in this thesis.

Signature:

Student Number:

Date:

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Acknowledgement

I wish to express my sincere gratitude to Dr Filipa Figueira for her guidance in carrying out

this dissertation.

I also sincerely thank my family members and friends for encouraging me during the period

of my dissertation.

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Table of Contents

Declaration...............................................................................................................................2

Acknowledgement....................................................................................................................3

Abstract....................................................................................................................................4

1. Introduction.................................................................................................................5

2. Literature reviews.......................................................................................................8

2.1. Institutional economic perspective.............................................................................9

2.1.1. Rules of the games...................................................................................10

2.1.2. Evolution of institutions..............................................................................11

2.2. International business perspective...........................................................................12

2.2.1. MNEs: determinants of FDI.......................................................................12

2.2.2. Host country: strategic FDI policy..............................................................14

2.3. Reconciling views.....................................................................................................15

2.3.1. Institutions as a determinants of FDI.........................................................16

2.3.2. Institutions as an instrument of strategic FDI policy..................................17

3. Towards a new model: an evolutionary approach....................................................19

3.1. Macro institutional level: societal sectors.................................................................19

3.1.1. Transition paths.........................................................................................20

3.1.2. Political risk...............................................................................................22

3.2. Meso institutional level: organizational fields...........................................................25

3.2.1. Financial systems......................................................................................26

3.2.2. Corruption..................................................................................................30

3.3. Micro institutional level: MNEs / IBS.........................................................................33

3.3.1. Types of FDI..............................................................................................34

3.3.2. Spillovers...................................................................................................36

4. Conclusions..............................................................................................................38

4.1. For host country.......................................................................................................39

4.2. For foreign investors.................................................................................................39

5. Bibliography..............................................................................................................41

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Abstract

This paper explores the interplay between the host country and foreign investors,

with the reference to transitions in China and Russia. The discussion is construed

upon the foundation of institutional economics and international business, in particular, the

industrial policy in the host country and the locational decisions of FDI. This paper is the first

attempt to reconcile institutional economics and international business in an evolutionary

way. More specifically, both formal and informal institutional elements are discussed at

macro, meso and micro institutional levels. The main findings confirm the importance of

institutions for the strategic decision-making of host economies and MNEs. In particular, the

macro institutional stability, the meso institutional coordination and the micro institutional

capability during the economic reform in China have insightful implications for its substantial

aggregate level of inward FDI and remarkable economic growth. In comparison, various

domains of formal and informal institutions in Russia indicate deficiency in catching up with

its rapid transition, repressing domestic economic growth and deterring foreign investors.

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1. Introduction

Foreign direct investment (FDI) inflows are important for any country to stay vigorous and

competitive in the global stage, since they not only introduce more capital into an economy

but also underpin the exchange of understandings and the move towards

internationalization. In the global contest of capital, the flows of FDI are affected not only by

the attractiveness of host economy, but fundamentally by the motivations of firms. While

institutional economics provide insightful frameworks to understand the domestic institutions,

international business theories concentrate on the global strategy of multinational

enterprises (MNEs) in a more specific way. Built upon the existing literatures of institution

economics and international business, this dissertation is the first attempt to describe,

explain and predict the role of institution by applying evolutionary methodology. More

specifically, I explore the puzzles of FDI inflows and transitions in China and Russia, by

drawing implications from their macro, meso and micro institutions. To capture the most

significant differences between these two giant transition economies, the formal institutions

used at each level are transition paths, financial systems and types of FDI respectively, while

the informal institutions are political risk, corruption and spillovers respectively.

By reconciling the interrelationship between rules and players of the game, the evolutionary

approach points to the role of institutions for the host country to attract higher level of FDI

and to materialize the growth-enhancing potentials. This approach also stresses the

importance of institutions for MNEs to evaluate the where, how and why of their overseas

investments. In the case of China and Russia, their reforms provide excellent clues to

discover the evolution or co-evolution of institutional transitions and foreign investment. The

main findings attribute the roles of macro institutional stability, meso institutional coordination

and micro institutional capability to the high aggregate level of FDI inflows in China,

compared with those in Russia.

In this comparative study, China and Russia are used as examples, given the fact that both

of them have undertaken reforms from the planned economy to market economy. In the

context of institutional transition, China follows a gradual path since the reform in 1949, it is

formally a state economy while informally rather mixed. Compared with it, Russia applies a

rapid path after the breakdown of the former Soviet Union in 1992, it state itself as a market

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economy yet the informal institutions have still not catch up with the market mechanism.

Most economic measures suggest that the gradual reform in China provide relatively stable

and sustainable macroeconomic environment, which is reflected from the positive annual

GDP per capita growth over years; while Russia has witnessed some negative growth during

the first decade after its big bang reform, as summarised in Figure 1.

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

2014

-20

-15

-10

-5

0

5

10

15

20

China Russia

Figure 1. GDP per capita growth, annual %, 1990-2014, World Bank

Although China and Russia share the similar communist past, they have different

comparative advantages for MNEs, such as resource endowments and policy designs. As

displayed in Figure 2, the historical records indicate the small amount of FDI at the beginning

of their reforms, but China has been receiving larger amount of FDI inflows than its Russian

counterpart in all stages. The puzzle has been that why outsiders hold such different views

for these two transition countries, despite the fact they have so many things in common? To

understand the China-Russia comparison in connect with their transition at home and their

attractiveness to outsiders, I review both institutional economic analysis and international

business literatures, as well as the overlapping areas of these two branches of studies. Then

a macro-meso-micro institutional framework is applied for the first time explore the

interactions between host economies and foreign investors, refer to the stylish facts in China

and Russia.

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19821984

19861988

19901992

19941996

19982000

20022004

20062008

20102012

20140

50,000,000,000

100,000,000,000

150,000,000,000

200,000,000,000

250,000,000,000

300,000,000,000

350,000,000,000

400,000,000,000

China Russia

Figure 2. FDI, net inflows (BoP, current US$), 1982-2014, World Bank

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2. Literature reviews

Multinational enterprises (MNEs) are defined as companies taking up foreign direct

investment (FDI) in other countries (Cave, 1996. Pp.1). Compared with foreign portfolio

investment (FPI), FDI involves direct control of value-added business activities, thus attract

more attentions and require more consideration when deciding to invest abroad. Although

MNEs are becoming an increasingly important part in the institutional analysis of the host

country, they usually lack of sufficient dynamism in describing them in the overall picture of

the economy. Complementally, although international business studies have recognized the

significant role of institutions, they often concentrate so heavily on adapting to local

institutional environment that miss the which, why and how these institutions are formed

(Jackson and Deeg, 2008). Therefore, despite the deviation of theoretical assumptions and

analytical methodologies in these two areas of studies, institutional foundations can be seen

as competitive advantages that MNEs access in the host country, while strategic

considerations of the MNEs can be seen as an useful element when understanding the

setting-up of local institutions.

This paper is the first try to reconcile these overlaps in the context of FDI in China and

Russia, by taking into account their transitional natures in an evolutionary approach. The

following of literature reviews are organized around the perspectives of institutions

economics and international business respectively, and also supplement with the existing

two analytical views in incorporating institutions into the business strategy and policy design

of FDI.

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2.1. Institutional economic perspective

With the insight of transaction cost economies, the Coase Theorem states that in the

absence of transaction cost, the profit-maximizing nature of organization ensures that

alternative property right assignments can equivalently internalize conflicts and externalities

(Coase, 1937, 1960). Given this scenario, institutional studies aiming to reach such

assignments are requested in order to achieve efficient allocation and to internalize any

externalities, including legal, social and economic institutions.

In particular, traditional institutionalism has emerged on the study of the motivations of

industrial production (Veblen, 1904, 2005), the legal foundation of capitalism (Commons,

1924), the technology core of institutions (Ayres, 1952, 1953), the meaning of education and

liberalism to social change (Dewey, 1937, 1963), the corporate governance of big business

(Berle, 1931, 1965), the material wealth to vote against the common good (Galbraith, 1958),

the contribution of public policy to economic efficiency (Bromley, 1989a, 1989b). In short,

institutional economics fundamentally concentrate on the role of different institutions in

crafting the behaviours of economic agents, and the evolutionary process of institutions and

social development (Hodgson, 1988b). Within this perspectives, the definition of institutions

and the concept of institutional transition are presented as below.

2.1.1. Rules of the games

Institutions are the rules of the game, they are the humanly devised constraints that shape

incentives and craft interactions of human behaviours (North, 1990, pp.3-5). While North

identified ‘formal rules’ as ‘legal rules enforced by courts’ which is formalized and written;

informal rules exist in norms, values and ethics are ‘enforced usually by your peers or others

who impose costs on you if you do not live up to them’ (Hodgson, 2006). Thus, both of them

have impacts on individual behaviours (North, 1997, pp.6), and understanding both the

written and unwritten rules in the host country is important for MNEs to success. For

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example, given two major modes of transacting in markets, one is rule-based transaction

and another is relationship-based business (Peng, 2003, pp.275-296), the networks depend

on the developmental stage of market-supporting formal institutions. Thus, missing out the

interpretation of host country institution structure and transition can bring difficulties for

MNEs’ overseas business, and create incomplete interpretations of the host country’s policy

design.

There are a vast number of institutions in an economy; Scott (1995, pp.33) defines them as

‘regulative, normative, and cognate structures and activities that provide stability and

meaning to social behaviour’. In this sense, the role of institutions is to reduce uncertainty

and risk as well as to build people’s willingness and confidence to make commitments.

These are essential for contractual relationship between business partners, and for

sustainable development of the overall economy. Despite their various forms, the main

characteristics of these institutions are their rule-like nature, their ability to facilitate and

constraint the relations among individuals and groups, and their predictability (Nabli and

Nugent, 1989). Given such traits, institutions can be evaluated as instruments to describe,

explain and predict the behaviours of economic agents, which are in this case the host

country authority and the foreign MNEs.

Since the economy is a web of institutions of various kinds and of agents with diverging

interests (Hodgson, 1998b), to reconcile the differences in interests and to pursue higher

welfare gain for the society as a whole, government boards and industrial commissions can

work as the mediators between the conflicting groups (Commons, 1931). From the view of

foreign investors, the attitudes and actions of host country authorities are of great

importance, whether they are implemented at macro, meso or micro institutional levels. We

will explore these interrelations in more details in the main body of this paper.

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2.1.2. Evolution of institutions

The impacts of institutions on economic development are various and complex (Chang and

Evans, 2005; Chang, 2011). In transition countries, there are fundamental and

comprehensive changes in both formal and informal rules, and these institutional transitions

influence the way in which firms and governments make strategic decisions. Meyer (2001,

pp. 716-759) summaries the major evolutions in transition market economy as emergence of

new institutions, changes of coordination mechanism from hierarchy to market, privatization

and corporate governance issue, organizational transformation, and growth of

entrepreneurial start-ups.

Understanding economic activity is never an easy task, because the process of market-

capitalism is restless (Ramlogan and Metcalfe, 2006), together with the fact that an

economic system is also embedded in a broader scope with political, social, physical rules.

Neoclassical economists contribute to the remarkable idea of equilibrium and the

contemplation of mathematical logic. However, we should notice their deficiency in defining

and explaining the concepts in social or biological science, and the fact that the aggregate

consequence does not necessarily equal to the sum of individual choices (Mieowski, 1989).

Besides, the rationality assumption is less adaptable in an economy with substantial

transformation (Potts, 2000, Chapter 2). To understand clearly the origination, diffusion and

retention of these evolutions, an analytical framework has been developed with a micro-

meso-macro architecture (Dopfer, 2004). This evolutionary framework contributes to the

clear thinking about the nature of coordination and change in open system and complement

to the powers and scopes of algebraic analyses in the field of economics (Dopfer et al.,

2004). In this evolutionary framework, microeconomics and macroeconomics focus on how

agents interpret rules within the complex and changing systems, in individual level and

aggregate level respectively; while the meso-economics is the conceptual heart of structural

instability. This evolutionary framework overcomes the doubt of aggregating micro decisions

to macro variables, or disaggregating the macro environments to micro units in neoclassical

economics.

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2.2. International business perspective

International business involves cross-border transfers of resources, goods, services,

knowledge and skills, resulting in stronger interdependence of nations via the business

activities of multinational companies (Hill, 2008). Studies in this field are usually conducted

from the aspect of firm, as exemplified by Barney (1991), it is firm-specific differences that

drive strategy and performance. Followings are the elements that determine the global

contest of direct capitals, related to the locational decision of MNEs and the attractiveness of

host economy.

2.2.1. MNEs: determinants of FDI

The most widely used framework in the controversial determinants of FDI is the OLI

paradigm developed by John Dunning. According to the OLI framework (Dunning, 2009),

FDI is the most appropriate form of international business if the firm can possesses

ownership advantages, if the local conditions provide locational advantages and if the firm is

able to gain internalization advantages of organizing activities within a multinational firm

rather than using a market transaction. He further purposes that the eclectic paradigm is

highly contextual, and can be seen as an envelope for economic and business theories of

MNE activities (Dunning, 2000). Complementary, Empirical researchers have identified

several controversial determinants of FDI, mainly including in the cost-based view and

resource-based view.

From the cost-based view, many academic scholars consider incomplete markets as the

main reason for FDI, since foreign investors have to overcome the lack of information and

the addition costs of transportation relative to local firms (Wernerfelt, 1984; Conner, 1991).

For example, higher trade costs and barriers hinder international trade while induce

investment (Mundell, 1957), since it becomes more costly to trade than to produce overseas.

However, although the classical assumption of zero transaction cost apparently fail in the

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real world, the actual impacts of market imperfection are less clear. For instance, the effects

of trade barriers on FDI are quite diverse among countries, it could be positive (Schmitz and

Bieri, 1972; Lunn, 1980), negative (Culem, 1988), or insignificant (Blonigen and Freenstra,

1996). The reasons may depend on the bargaining power of the host countries, whether it is

a sizeable economy and what are its comparative advantages. Nevertheless, other

measures of costs such as distance, defined as measured by the proximity to markets or

customers, ranked the second important in determinants of FDI in China and other selected

countries (OECD, 2013), because it consistently leads to lower trade costs.

Another components of the cost-based view is labour costs, but the results are mixed given

the fact that agglomeration benefits depends not only on factor cost differential among

countries, but also on firms and industries difference in factor intensity. Although some

researchers found significant positive correlation between labour costs and FDI

(Goldsbrough, 1979; Flamm, 1984), this relationship indicates to be insignificant in later

studies (Owen, 1982; Lucas, 1993; Tsai, 1994). Moreover, the impact of labour costs

somehow turn to be positively correlated with FDI with the combination of risk (Wheeler and

Mody, 1992). Besides, when globalisation is taken into account, the availability of local skills

is becoming more important in attracting FDI in developing countries (Nunnenkamp, 2002);

that is why we find MNEs in industries with ownership advantages, not simply low labour

costs. Therefore, ‘cost’ alone is not sufficient to explain firms’ behaviour.

From the resource-based view, the traditional determinants of FDI mainly attribute MNEs’

locational decisions to the host country fundamentals. For MNEs, market size and income

level are important (Dunning, 1993), because they need to ensure the purchasing power of

the host country. The empirical findings are mostly positive for this argument (Dunning,

1980; Billington, 1999). In addition, the domestic market growth potential ranked the first in

OECD 2013 report; it is important because investors want to be sure that the markets are

still be there in the longer term. However, the empirical findings are again quite mixed. While

the conventional empirical researches confirm these positive correlations (Lunn, 1980;

Culem, 1988), it turns to be insignificant after taking into account the simultaneity problem

(Tsai, 1994). Meanwhile, some studies suggest the possibility of a bi-directional causality

between growth and FDI (Chowdhury and Mavrotas, 2006). For developing countries, it is

also important to emphasis on infrastructure development and resource available (Shapiro

and Globerman, 2001), although some researchers suggest that they have already been

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good (Ha-Joon Chang, 2002). Thus, interpreting ‘resource’ as a determinant requires more

careful and details considerations.

To sum up with the cross-country empirical study by Avik Chakrabarti (2001), most

controversial determinants other than market size (captured by GDP per capita) show

considerable sensitivity to small alternations in conditioning information set. Therefore, a

general rule for MNEs to decide the location is unrealistic. Nevertheless, indicators such as

openness to trade still show considerable ‘likelihood to be correlated with its FDI’. In which

sense that there are rooms for the host country to promote FDI via a series of policies. Two

main concerns of MNEs, therefore, are where to make internal decisions that deliver the

maximum present value of their investments, and how to evaluate external business

environment that safeguards these profits.

2.2.2. Host country: strategic FDI policy

FDI inflows bring various benefits to the host economy, whether they are direct or indirect. In

addition to be one of the most stable capital flows to developing countries, foreign

investment work as a channel to promote technological contents and therefore total factor

productivity (Bénassy‐Quéré et al., 2007). Furthermore, FDI creates more opportunities for

local employment, enhances domestic demand for intermediates, and functions as a catalyst

for host country industry (Navatetti and Venables, 2004). Thus, two questions for the

authorities are how to attract more FDI, and how to materialize the benefits of FDI.

As a feasible and quick way to improve its attractiveness to foreign investors, host country

especially those in the developing category show attempts to promote FDI incentives.

Relevant promotions include fiscal incentives and financial incentives (Blomstrom and

Kokko, 2003). The former package typically includes subsidized infrastructure and land in

export processing zones, tax holiday and lower taxes for MNEs (Madani, 1999; McLure,

1999); the later package usually contains preferential loans to foreign firms; while other

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incentives range from market preferences to allowance of monopoly power (Taylor, 2000).

However, the empirical findings are quite sensitive to the selection of samples and

methodologies. There are evidences that taxes can be positively (Swenson, 1994) or

negatively (Hartman, 1984; Billington, 1999) correlated with FDI, or insignificant (Wheeler

and Mody, 1992). Likewise, openness is positively correlated with FDI (Kravis and Lipsey,

1982; Culem, 1988), while others found it insignificant (Schmitz and Bieri, 1972). These

results point to the importance to explore the interaction between strategic FDI policies in a

case-to-case basis.

As we will explore later in more details, better institution quality is favourable to MNEs to

operate their overseas business, and it is also essential for host economy to stay capable in

learning and gaining from FDI. To larger extend, mature rules regardless they are formal or

informal, maintain higher degree of macroeconomic stability, which is highly valued

(Globerman and ShaShapiro, 1999). But for specific impacts, there is no general guideline to

benchmark each economy. For instance, in terms of trade deficit, empirical results show

positive (Culem, 1988; Tsai, 1994) or negative (Lucas Jr, 1993) correlation among different

countries. Therefore, if the host country authority is honestly in behalf of the overall welfare

of the nation, it should not overemphasises or overlooks the importance of each institutions,

whether they are at macro, meso or micro levels.

2.3. Reconciling views

While Douglass North (1994) wrote to emphasize the interaction between institutions and

organizations in crafting the institutional evolution of an economy, his demarcation defines

institutions as the ‘rules of the game’, while an organization as a group of people and their

governance arrangements against other organizations (including firms, political parties and

so on). The other way around, organizations are groups of people who are binding together

by common purpose, while institutions are the rules they play to achieve certain objectives.

The distinction between generic rules and the population of actualization is similar to the

distinction between economic structure and the agents within (Archer, 1995; Hodgson,

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2004). With this insight, institutional economic analysis provides broader scope for

international business, which focuses on organizations (in particular, multinational

enterprises). Indeed, many scholars have been increasingly aware of the importance of

institutions and many attempts have been made to incorporate traditional business

consideration with the broader business environment. For example, Peng (2013, pp.15)

establish a framework of firm’s global strategy, in which three branches of elements (namely

the industry-based competitions, firm-specific resources and capabilities, as well as

institutional conditions and transitions) jointly determine their strategy, and therefore firm

performance. To understand how the rules affect the game-playing of the relevant agents,

attempts have been made to incorporate the role of institutions from the standpoint of MNEs

and of the host country authorities.

2.3.1. Institutions as a determinants of FDI

Kinoshita and Campos (2003) view institutions as one of the determinants of FDI in the case

of transition economies. Poor institutions such as corruption is additional costs to FDI (Wei,

2000b). Besides, the vulnerable nature of FDI to uncertainty and risk increase foreign

investors’ concern of sunk cost (Blanton and Blanton, 2007), thus they ask for more sound

legal system to protect their property rights. Further investigated by Stein and Daude (2001),

they reclaim that the quality of institutions is positively correlated with FDI, by applying

Kaufmann et al. (1999) at bilateral stocks of FDI. They found that political instability and

violence, government effectiveness, regulatory burden, rule of law and graft are

determinates of FDI. The other way around, market-unfriendly policies, excessive regulatory

burden, and lack of commitment on the part of the government can deter FDI inflows. In

particular, corruption has been widely recognized as a significant impediment to FDI inflows

(Wei, 1997, 2000b).

Another interesting view from ‘psychic proximity’ suggests that similar institutions between

the host and home country encourage more FDI, as MNEs perceive lower degree of

uncertainty or learning cost about their target countries (Habib and Zurawicki, 2002).

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Moreover, absolute difference of the corruption index between investors and the host

country has a negative impact on (bilateral) FDI. This argument is consistent with the

attempt of Aizenman and Spiege (2002) in applying the principle-agent framework, where

institutional distance between the origin and host country should have negative impact on

bilateral FDI, thanks to the lower costs perceived by MNEs. Institutional difference, therefore,

may be a source of comparative advantages and enhance more international trade as well

as direct investments, especially on more ‘institution-intensive’ factors (Levchenko, 2004).

2.3.2. Institutions as an instrument of strategic FDI policy

The quality of host country institutions has been recognized as a key of different growth rate

and GDP per capita among countries (Acemoglu et al., 2005); especially the efficient

protection of property rights, high level of political freedom and low level of corruption.

Fundamentally, as good institutions reduce uncertainty and raise expected return, they

promote productivity growth in the host country, and protect FDI from turning into sunk cost

of MNEs.

The actual results of traditional approaches to the issue of FDI and host economies remain

statistically unclear, due to the potential of reverse causality. While the positive impact of

institutions on growth is found to have endogeneity bias (Hall and Jones, 1999), Acemoglu et

al. (2001, 2002) further prove such problem with the use of innovative instrumental variables.

In contrast, the relationship between institutions and FDI seems to free from endogeneity

bias, suggested by Larraín and Tavares (2004), who instrument FDI with a gravity model

and access the impact of FDI on the extent of corruption. In general, it is suggested that

higher volumes of FDI encourage the host country to build better institutions (Selowsky and

Martin, 1997).

But there is difficulty in identifying the true driving forces of FDI, whether it is indeed the

quality of institutions or the income per capita. As discussed above, theories in the traditional

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determinants of FDI suggest that higher income per capita induces greater amount of inward

FDI. If better institutions indeed facilitate higher growth and income level, the correlation

between institution and FDI may because of the positive impact of institutions on income

level. That is to say, it may be income level, rather than the quality of institutions, which

determinates the inflows of FDI.

To analysis the changing nature of institutions and their complex interactions with MNEs, the

micro-meso-macro framework can be viewed as an evolutionary approach. In his institutional

network approach for international business strategy, Han Jansson (2007, pp.37-40)

suggests an institution model which is constructed on the categories of societal institutions,

organizational fields, and the MNE/IBS (international business strategy) level. However, the

difference from economic perspective is that the meso institutions here are not conceptual,

but viewed as an entity of four components: product/service market, financial market, labour

market and the government. The macro institutions in this international business model

include country culture, education/training system, family/clan, religion, business mores,

political system, legal system, professional and interest associations that, together with

meso institutions, create an institutional framework in the host country for MNEs. The MNEs

or IBS are considered as specific micro institutions within organizational fields.

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3. Towards a new model: an evolutionary approach

The diverse implications from institutional economics and international business provide

possible foundation to investigate the interplay between host countries and foreign investors

from a border perspective. Although there are increasing numbers of scholars making

reconciliation between these two areas of study, most of them focus on how economic

agents adopt and adapt to the rules of the game, rather than the dynamism or co-evolution

between them. This paper further contributes to the understandings of these overlaps,

through exploring of the interrelations between host country authorities and MNEs in the

transitions of China and Russia. The analytical framework is constructed in macro-meso-

micro order, with references to both formal and informal institutions at each levels.

3.1. Macro institutional level: societal sectors

There are two sorts of important factors in evolutionary macroeconomics, one are the self-

ordering and self-organization stemming from the meso institutions, the other is the quasi-

statistic nature (Dopfer, 2004). The first factor implicates that macro institutions are not the

behavioural aggregations of choices of the micro institutions, but instead the consequence of

interaction in meso level. The second factor results from the bimodality of each meso

component, in terms of coordination problems between generic rules and the manifest effect

in the structure of rules. Usually the focus on coordination failure has been narrowed down

to market failure instead of the gaps in generic rules (Dopfer, 2004), and the discord in the

structure of meso units causes fluctuations in the economy such as the mismatch of effective

demand and supply in the income-expenditure flows (Foster, 1992). The analogy of macro

units in international business is a variety of societal sectors. The impacts of macro

institutions are various given a variety of components in these sectors. And the stabilities in

the macro systems depend on the adaptability and rigidity of meso organizational fields.

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From historical, political and economic aspects, scholars such as Nolan (1995) have

compared the rise of China and the fall of Russia in book-length analysis. These two

transition economies are similar in terms of large geographical scale ranked the third and the

first in the globe, enriched endowments of natural resources for industrial development,

cheap labour force and considerable market potentials for foreign investors. In addition, they

have the same aim of approaching marketization, and ultimately integrating into the global

capital and product markets (Sachs et al, 1995).

Although both China and Russia have undergone significant changes in macro institutions,

the transition methods they have taken are quite different, so as to the causes and

consequences. As an advocate for gradualist transition, China has applied economic

reforms without mass privatization or significant democratization. The results are that foreign

investors incrementally have a relatively important role to play in forms of joint ventures

(JVs) with the reformed state-owned enterprise (SOEs). Compared with its Chinese

counterpart, Russia has embraced rapid approaches in industrial privatization and

democratic reforms. With the conflicts in the domestic political and social environment, and

the control of insider managers of most manufacturing firms, MNEs seem to be deterred by

the combination of high risk and low returns.

To compare China and Russia from the macro institutional level, we shall look at some

similarities between them. And more importantly, how they differ in a systematic way that

help us understand the difference in aggregate levels of FDI. In particular, transitional paths

are used to capture most of the formal changes in rules, while political risk is applied to

represent more informal fluctuations.

3.1.1. Transition paths

When comparing the success of their economic transformation, for example GDP growth

rates, we need to specify the start points of relevant reforms. In China, in addition to the

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Reform and Opening policy implemented from 1978, some researchers may view the

Cultural Revolution between 1969 and 1976 as an alternative turning point. Likewise, in

Russia, instead of taking the collapse of the Former Soviet Union in 1992 as a break in the

timeline, scholars can takes into account the Gorbachev’s effects from 1985 to 1991.

Nevertheless, to the extent of relevance with the economic emphasis on transition and

foreign investments, I agree with Malle’s (2008) opinion in taking 1978 and 1992 events as

the start points for Chinese and Russian transitions, respectively.

At the beginning of their reforms, both nations inherited similar political and economic

ideologies from the Stalimist and Maoist histories, with strong party control and bureaucratic

power, high defence budgets and subsidized public services, heavy industry preference and

large industrial enterprises, as well as tariff protection against manufactured imports (Buck et

al., 2001). Both prereform China and Russia were in need of initiate market-based

revolutions to arise the productivity level in industry. This section continues by comparing the

transition methods in both countries, emphasizing the authorities’ concerns and MNEs’

choices via the design of industrial policies.

In China, the economic reforms have been gradual and partial, with spreading localized

experiments in place of central planning. The authorities allowed for various forms of

ownerships, including collective firms owned by local governments, foreign-invested firms,

and private start-ups (Peng, 2003). In particular for foreign investors, they have a role to play

in the transiting China via joint venturing with selected SOEs. Despite of the availability of

physical and human capitals in this emerging market, however, majority foreign ownership of

JVs has been allowed only after 10 years of Chinese transition and still subjected to State

approval (Tan, 1997). For host country, local business mainly comprising SOE managers

and state representatives prevent foreigners from taking large stakes in JVs (Boisot and

Child, 1988). But the target projects might limit the best use of domestic physical and human

resources, which was not beneficial for foreign investors or for local economy as a whole.

In Russia, after long periods of communism, centralized and mass privatization in

manufacture industry was called for in order to replace the state control with private

ownership in an irreversible way (Filatotchev et al., 1996). As a result, ‘manager-controlled,

employee-owned’ firms have emerged (Earl and Estrin, 1996, p.33). These enterprise

22 | P a g e

insiders resisted selective asset acquisitions through JVs and instead demanded foreign

investors to adopt high level of commitments, including taking responsibility over assets,

liability and all affairs of the entire privatized firms (Buck et al., 2001). Given the limited

feasibility for outside owners, there is evidence that holdings of foreign investors increased

from 20% in 1994 to 39% in 1997 (Estrin and Wright, 1999). However, it might be difficult to

distinguish these investments from Russian managers’ personal business, for example their

‘pocket companies’ set up in Cyprus (Blasi et al., 1997).

Comparatively, the gradual formal changes in Chinese macro institutions brought diverse yet

restricted choices for foreign investors, allowing for ‘cherry-picking’ via various forms of JVs

in the host economy. While in Russia, centralized privatization introduces substantial

opportunities for MNEs, yet at the same time huge challenges via high level of commitments.

3.1.2. Political risk

The interpretation of informal macro institutions is as important as formal ones, but they are

more subtle in nature and their interplays are more indirect. For example, the coordination

problem and manifest effects in political and economic systems are less conclusive when

taking into account the influence of culture (Hofstede, 1994). Given this insight, I will refer to

the aspect of culture and its role in shaping the domestic institutions, in particular the political

systems. Throughout the discussion we will have a better understanding of how MNEs

interpret the political risks in China and Russia.

Culture is defined as a collective phenomenon sharing among individuals who live or lived in

the same society, which is where it was developed and learned; it is described as the

collective programming of mind distinguishing the member of one group from other groups

(Hofstede et al., 1997, pp.5). As an important influence on business activities, national

culture is embedded in institutions such as education and training systems, industrial

relations and job satisfaction, which are likely to be designed and implemented to accordant

23 | P a g e

with the self-interest and cultural orientations of powerful societal actors (Lane, 1989). In this

case, the bureaucratic control in China and Russia come to play.

Hoon-Halbauer (1994, pp.290) have explored Hofstede’s five cultural dimensions in China,

summarized as a nation with high power distance, low uncertainty avoidance, low level of

individualism, medium to high masculinity, and a long-term view of life from Confucianism.

Chinese citizens, as interpreted using these indicators, seem to be open-minded to changes.

In additions, they are likely to accept the unequally-distribution of power and pursue their

personal value from life-long perspective. Under this social environment and powerful party

inherited from the Maoist period, the central authority is strong and unchallenged (Whitley,

1992). With serious implements to cut down disagreements and doubt, the Chinese

transition goes along without democratization or significant changes in political institutions.

The Communist Party remained in power and selected SOEs to form JVs with foreign

investors.

Compared with its Chinese counterpart, Russia is a nation with high level of collectivism and

uncertainty avoidance, and low power-distance (Naumov and Puffer, 2000). It can be

interpreted that the Russian citizens are less likely to accept risks or unequal distribution of

power. These characteristics might be the social reflections of lasting and radical economic

crisis, and might be historical consequences of authority’s tolerance of ‘black’ market

activities. As mentioned above, privatization reallocated the control over manufacturing

industry from the state to Russian insiders, in form of ‘manager-controlled, employee-owned’

firms (Buck et al., 1998); while high-commitment requirement restricted the role that foreign

investors could have in Russian economy. The reason of such reforms might be that

Russian insiders tried to avoid uncertainty and threats, while concerned about foreigners to

be asset-strippers (Filatotchev et al., 2000). As a result, the political risk in Russia ranked

highly in the 1990s.

Historical records suggest that China has been more successful in being a destination of

foreign investment. And with higher level of aggregate FDI, China catches up with

international standards of manufactured goods, taking up 81% of its exports (World Bank,

1996, p.110). Compared with it, Russian transition seems to continue relying on its raw

24 | P a g e

resources exports and fail in promoting its ability in manufactured products, accounting to

merely 8% of total exports (EBRD, 1997, pp.65).

There are also further implications from macro institutions, regarding the participations of

outsiders. Internationalization theory suggests that the ideal entry mode of foreign investors

depends on the host country risks (Andersen, 1993). In China where transitions was more

stable and political risk was relatively low, foreign investors theoretically preferred higher

level of commitment and larger degree of control over business, for example in forms of

greenfield investment or merge and acquisitions of local firms. However, in reality their

preferences were limited by Chinese government within hybrid entry mode such as joint

ventures. In the long run, JVs are potentially unstable in corporate governance, since

responsibility for performance is shared between partners in a subtle way (Peng and

Shenkar, 2002). In addition, less advanced technological contents and mature managerial

knowledge in JVs may deter foreign investors from engaging in research and innovation,

thus hinder the materialization of foreign investment.

In Russia, given the fact that transition was embedded with higher level of instability and the

political risk was extremely high, foreign outsiders would be unwilling to commit too much but

rather go for arms-length deals such as exporting. However, in practice their choices were

restricted by the Russian authority with the demand for high level of commitment such as

large stake of the assets and liabilities of new private firms. The sudden extend of stakes to

full acquisitions may cause problem in governance due to the difficulties created by insiders

in obtaining corporate information and board representation (Wright et al., 1998).

These macro institutions in China and Russia underpin a mismatch in strategies between

host country government and foreign investors. For host countries, both transition

economies could attract more FDI by adjusting their industrial policies. For MNEs, lessons

from societal sectors point to the need of adopting entry requirements and the concerns of

corporate governance problems.

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3.2. Meso institutional level: organizational fields

The controversial micro-macro framework is built on the assumption of meso ‘equilibrium’ or

‘invisibility’, but the only possible general equilibrium would then be a state of total

randomness without the essential role of meso institutions (Chen, 2004). In the evolutionary

analysis, meso-economics is the conceptual central that its changing nature comes from the

interplay between ongoing degeneration in rule structures, and inherent human curiosity as

well as experimentation (Dopfer et al., 2004). More specifically, it is the meso institutional

instability that influences coordination between micro and macro units.

Two important varieties in evolutionary meso-economics are the generic rules and the

relevant populations of actualization (Dopfer, 2011), for example the financial markets and

financial institutions respectively. To examine from the meso perspective the fluctuations and

coordination, logistic diffusion is a feasible approach (Foster, 1997), for instance the impact

of change in capital requirements on the speed of diffusion across banks’ off-balance sheet

activities (Jagtiani et al., 1995). Another analytical method is replicator dynamic principal

(Young, 2001), in search of the best rules with a probability proportional to the difference in

realizations (Schlag, 1998).

The economic conceptions of meso institutions are similar to ‘markets’ or ‘intermediates’ in

international business, in the way that they are connecting the overall business environment

and firms within it; in the way that they are ‘smaller’ than economic system as a whole while

‘larger’ than individual economic players; and in the way that their maturity and rigidity have

impacts on host country’s policy design and MNEs’ business activities. Therefore, it is

reasonable to embody the concept of meso institutions on organizational fields, which is

viewed as a system consisted of various markets. To illustrate the stylish facts of China and

Russia in the following part of this section, I will firstly emphases on how financial system

can be interpreted as a formal refraction of meso institutions; then supplement with

corruption behaviour as an informal instrument to explore the meso structural instability.

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3.2.1. Financial systems

The empirical study of Alfaro et al. (2004) helps justify the use of financial market as an

institutional aspect to interpret the issue of FDI. They apply cross-country data of 20 OECD

countries and 51 non-OECD countries ranging from 1975 to 1995, to test the contribution of

inward FDI flows and stocks to economic growth of the host countries. Their result points to

the important role domestic financial systems in materializing the benefits of foreign

investment. While FDI alone has an ambiguous role to play in enhancing GDP growth, its

impact turns to be significantly positive given well-developed financial markets. This result is

robust after taking into account various controls and solving potential endogeneity, but the

limitation is the assumed monotonic impacts of FDI on growth with financial development.

Further explored by Azman-Saini et al. (2010) the dynamic between these three variables,

they prove with a sample of 91 countries over the 1975-2005 period that the positive effect of

FDI on growth ‘kick in’ only after financial market development exceeds a threshold level.

Given empirical studies of the statistically significant relationship between financial

development, FDI and growth, I refer financial systems in China and Russia to de-concept

formal institutions at the meso level. More specifically, financial markets can be interpreted

as the generic rules at the meso level, while financial institutions can be viewed as the

population of actualization.

A mature financial system are important for MNEs’ business activities, given five market

functions in facilitating risk management, allocating resources, exert corporate control,

mobilizing savings, easing trading of goods and services, and providing appropriate controls

(Levine, 1997). The better foundation of financial market contributes to investors’ confidence

in starting and operating investment projects. However, transition economies inherited from

a planned economy the underdeveloped and inefficient financial system, the role of money

and finance are largely influenced and repressed by central planning officers. As a result,

financial development and therefore economic performance is crafted by policy (Beck et al.,

2008). In the study of institutions’ role in realizing the benefits of FDI on the host economies,

Demetriades and Law (2006) use data of 72 countries ranging from 1978 to 2000 to test the

interplay between institutional quality and financial development. Their result indicates that

growth-enhancing effects of FDI is the most potent among middle-income countries where

institutional quality has improved significantly.

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Financial development occurs when financial instruments, markets, and intermediaries

mitigate the effects of imperfect information, limited contract enforcement, and transactions

costs, and do better job in providing the five financial function (Levine, 2005). An insight from

the financial development of China and Russia help understand their colossal moves

towards a more market-based system. There are various measures to benchmark a financial

system, in terms of the depth, access, efficiency and stability of financial institutions and of

financial markets as a whole (Cihak et al., 2012). In particular, the following analysis

concentrates on the development in the size of financial systems and the change in financial

structure.

To measure the size or depth of financial institutions, the most widely used indicator in

empirical literature is private credit. According to IMF, it is the credit that the deposit money

bank issued to the private sectors, excluding those to governments and public enterprises.

Figure 3 indicates that the shares of private credit to GDP in China and Russia both

experience ascending tendency during their transition process, which means that financial

institution size have been growing in both countries. Yet the gap between them is significant.

After 10 years of its economic reform, the size of Chinese financial institution has already

reach 70% of its GDP, while Russia in 2002 was still low in 16%. Until recently, this figure

rises to 120% in China, and approximately 50% in Russia. In straightforward language, the

overall size of financial institutions in China is relatively larger than that in Russia.

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19871989

19911993

19951997

19992001

20032005

20072009

20110.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

ChinaRussia

Figure 3. Financial institutions size: Private credit by deposit money banks to GDP (%)

Financial markets include that of stock and of bond, this paper emphasizes the stock market

development. The relevant indicator is the stock value traded as percentage to GDP, which

measures the value of stock market transactions and reflects both its size and activity. As

shown, China has experienced larger value of stock markets and also higher degree of

fluctuation. During the year 2007/2008, China has witnessed its stock value traded soaring

from 41% to 160% of GDP, followed by a decrease to 112% until 2011. By comparison,

Russia saw a relatively low but stable growth in its stock market, from near zero in 1996 to

54% until 2011. One implication can be that Chinese stock market is in itself more fast-

growth and volatile than Russian stock market, while other possible interpretations refer to

the greater expectations of global investors before the financial crisis, or the consequence of

growing interests of market participants and corresponding policy of Chinese authority.

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19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

180.00

ChinaRussia

Figure 4. Financial markets size: stock value traded to GDP (%)

In addition to financial depth, another way to understand the features of financial markets is

to distinguish them into capital market-based financial system or credit-based financial

system (Whitley, 1992). In the former system, financial intermediation is controlled by the

market and transactions are impersonal and relatively short-term. In the latter system,

financial intermediations take place through long-term network relationships between banks

and specific large borrowers. More specifically, the relative size of financial institutions and

financial markets is called ‘financial structure’ (Demirguc-Kunt and Levine, 2001). To explore

whether a financial system is more market-based or bank-based, we can refer to the relative

size of banks and financial markets. Figure 5 reveals that although the initial financial system

in China was dominated relatively heavily by banks, both Chinese and Russian financial

systems transit from being more bank-based towards being more market-based, keeping in

line with their transition from financial repression to market liberalisation.

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19921994

19961998

20002002

20042006

20082010

0

5

10

15

20

25

30

35

40

45

ChinaRussia

Figure 5. Financial structure = Financial institution size / Financial market size

From the above indicators, we can see that China has a relatively developed financial

system in size and depth, while Russia shows huge gap to improve. This is consistent with

the greater aggregate FDI inflows in China than its Russian neighbour, since better financial

infrastructure enables lower costs and higher efficiency in macro and micro levels. In

addition to the attractiveness of the host economies, the level of financial market

development is also important in materializing its positive influences (Azman-Saini et al.,

2010). Therefore, both countries can potentially benefit from the improvements of domestic

meso institutions.

3.2.2. Corruption

One of the fundamental characteristics of the central planning system is that bureaucracy,

instead of the markets, facilitates economic activities and coordination among economic

agents (Ericson, 1991). Corruption, in particular, is an additional institution applied by

individuals or groups to have impacts over the actions of bureaucratic control (Leff, 1964).

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Corruption is defined as the abuse of public power for private benefits (Rodriguez et al.,

2004; Vernard, 2009). To describe and explain the corrupting behaviour, Teorell (2007)

argues that the controversial principal-agent model is less applicable, thereby it is more likely

to interact with informal elements thus forms an informal system within organizational fields.

With the light of its influential existence, I apply corruption as an informal instrument to

understand the meso institutions. Transiting from the Communism, both China and Russia

have experienced the wave of corruption. Nevertheless, Chinese economy is among the

most successful reformed socialist counterparts without significant negative effects of

corruption (Østergaard and Petersen, 1991). But in terms of Russian economy, corruption is

commonly blamed as a primary reason of transition failure (Gelb et al., 1998; Hillman, 2000).

Taking into account the institutional changes in a society, Sun (1999) identifies two sets of

circumstances that induce corrupt behaviour: the presence of opportunity and the presence

of motivations. The first set results from the extensive role and intensive power of

governments, as well as ambiguity and prevalence of regulations. The second set contains

grey areas in changing values and moral judgements, as well as in the access to powers.

China and Russian have different stories to tell regards to both branches of circumstances.

In terms of opportunity for corruption, the combination of changes in political system and in

economic foundation leads these two countries to different situations (Goldstein, 1995;

McMillan et al., 1992). On the one hand, the time-withstanding power of Chinese Communist

Party and its gradualist economic reform contributed to relatively lower degree of

opportunism. On the other hand, the comprehensive collapse of the Soviet Union and the

rapid changes in industrial policy induced more opportunities for corrupt behaviours during

Russian transition. As a result, although the emergence of a new sector posed challenges to

the socialism (Prybyla, 1991), China was able to maintain it outside the planned economy in

localized forms of township and village enterprises, thus heading towards a sustainable and

mix stage (Chen et al., 1992). But in Russia, since the exchange of political power cause

potential bureaucratic problem in nature (Åslund, 1991), it was difficult to build appropriate

non-state institutions like China has done (Goldman, 1993). Besides, given that the

boundaries between political and private business was subtle (Levine et al., 2000), Russia

suffered more heavily from corruption and the mafiya came to place during its transition

(Goldman, 1996). In addition to larger potential opportunities to corrupt, the resulting political

representative from the breakdown of Soviet system and the Gorbachev’s period was

32 | P a g e

politically ‘weaker’ than the withstanding Chinese Communists in regulating their agencies,

thus leading to higher degree of corruption (Shleifer et al., 1994).

In terms of motivations to corrupt, for a self-serving officeholder, he controls marketing and

public relations channels (Galbraith, 2015), and manipulates the distribution of a ‘good’ or

the avoidance of a ‘bad’ to the private sectors (Rose-Ackerman, 1999). For a profit-

maximizing enterprise who cares about the net present value, offering a bribe can be a

better strategy to obtain larger amount of benefits than paying taxes or following regulations

without corruption (Boddewyn, 1988; Boddewyn and Thomas, 1994). Given that better

outcome of reform is in line with the interests of the Chinese politicians and the fact that non-

state firms are well-defined, the motivation in China would be to facilitate the redistribution of

resources and to remove market imperfections in an efficiency-improving way. While in

Russia, corruption is surged in law enforcement of the ill-defined sector. In addition, as we

have noticed in the previous chapter that better formal institutions such as well-functioning

financial system in China also support market transactions and competition, therefore hinder

potential non-competitive behaviour such as corruption.

Nevertheless, understanding the actual consequences of corruption is not easier than

getting close to a taboo. In the 1970s, it has been viewed as a tool to stress structural

deficiencies in the developing nations (Bayley, 1966). More specifically, corruption and

bureaucracy could be beneficial to the society via ‘greasing the wheels’ and ‘cutting real

tape’, both politically (Leff, 1964; Nye, 1967) as well as economically (Huntington, 1968,

pp.69). However, the glorification of corruption in overcoming market imperfections is

doubtful, given the difficulties in measuring the scale of economics and implementing the

welfare-oriented policies. Therefore corruption is more likely to distort market competition

and resource allocation, reflecting at the higher degree of poverty inequity (Myrdal, 1968)

and lower level of economic growth (Mauro, 1995). These negative impacts on the

development of a civil society are proved in the cases of China (Johnston et al., 1995) and

Russia (Handelman, 1995).

In addition to placing constraints on the utilization of the domestic capital and resource, high

corruption and low transparency also deter foreign investors (Zhao et al., 2003) and

therefore repress the host country from utilizing its potential. Besides, there is further social

33 | P a g e

waste when the honest authorities implement anti-corruption actions (Olson, 2000).

Therefore, as an extra legal institution at the meso level, corruption is systematically costly

both to China and Russia, although to different degrees.

To explore the various economic implications of FDI in the subject of corruption, the context

that intervenes its materialization requires more considerations and comparisons. In

particular, Larsson (2006) suggests that, in relation to corruption, China and Russia are

different in comparative advantage, organization of corruption and nature of rents. More

specifically, China’s low-tech production, strong anti-corruption enforcement and growth-

enhancing rents are in contrast to Russia’s knowledge-intensive production, weak political

governance and growth-reducing rents. Therefore, the institutional development fits better to

the actual transitional progress, leading to less harmful influences of corruption in China than

in Russia. Institutional economic frameworks suggest that since formal rules have not yet

been well developed, informal rules come as a substitute. In transition economies where

there are excessive or undeveloped regulations, corruption allows the replication of the

market mechanisms (Huntington, 1968; Leff, 1989). When the value of access to goods is

higher than the cost of a bribe of access, then MNEs are willingly to pay this extra fee (Lui,

1985). Therefore, in the absence of well-developed formal rules, corruption in China may in

fact enhance FDI activities and raise the aggregate level of inward FDI.

Empirical studies found the negative effects of corruption of FDI (Wei, 2000a, 2000b). As

perceived by MNEs, international business theories predict that corruption deters foreign

investors because in increases the cost and uncertainty of investments. To this extend,

Cuervo-Cazurra (2008) distinguishes the type of corruption perceived by MNEs as one way

to explain different aggregate levels of FDI among transition countries. According to their

visibility and prevalence, corruption includes pervasive form and arbitrary form. While the

former is certain and widespread, it increases the perceived costs of investing; the latter is

uncertain and unknown, therefore interpreted as the uncertainty of operating. In this sense,

pervasive corruption has greater negative influences in FDI inflows than arbitrary corruption

does. Although corruption is generally unwelcomed in international business, outsiders feel

relatively comfortable with an unknown evil in form of arbitrary corruption when they have to

handle it. In the comparison between China and Russia, investors are more likely to interpret

corruption as to be arbitrary in the former given its combination of less opportunities and

lower motivations, while to be perceived in the latter given its larger likelihood to corrupt.

34 | P a g e

To sum up in terms of meso informal institutions, China is comparatively ‘clearer’ and

‘stronger’ in the issue of corruption, than its Russian counterparts.

3.3. Micro institutional level: MNEs / IBS

The above analysis segments two major institutional systems that affecting the MNE:

societal sectors and organizational fields. In terms of microeconomic institutions,

evolutionary approach focuses on the individual behaviour of applying rules, under the

systems of connections and during the processes of changes (Dopfer et al., 2004).

Institutions at the micro level is a part of a broader system specialized with internal and

external structure, which are the capabilities of the agent itself and the interaction with other

agents, respectively. This approach provides a perspective of production to be closely linked

to incentives, coordination and knowledge creation; drawing on changes rather than the

distribution of resources in an assumed static state (Winter, 2005). In other words, the

analytical method at the micro institutional level concentrates on the process that how an

economic agent carries a generic rule.

In terms of international business, micro institutions are specific to MNEs within

organizational field (Jansson, 2007, pp.38). In a world where imperfection and fractions

exist, firms agree upon incomplete contracts that resolve incentive problem and minimize

transaction costs (Alchian and Harold, 1972). Within this insight, the internal structure of the

micro unit is designed against contractual hazard and the external structure in this domain is

developed to safeguard the agents against hold-up problems (Hart and Moore, 1990).

Furthermore, while a firm struggling to develop its competitive advantages, institutions

directly determine the options available for the design of strategy (Ingram and Silverman,

2002:20). In this section, I refer to the types of FDI in order to understand how MNEs

formally utilize internal decision-making to adopt and adapt to the actual conditions in China

and Russia. Beside, as the main externalities of FDI, spillovers are emphasized as an

informal institutions at micro level.

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3.3.1. Types of FDI

There are many ways to classify the types of FDI. Based on the underlying motives of

multinational enterprises, Jack Behrman (1972) has distinguished four major types of them,

which later borrowed and extended by Dunning and Lundan (2008) as natural resource

seekers, market seekers, efficiency seekers and, strategic asset or capability seekers. This

classification is closely link to the motivations and operations of foreign investment. But it is

still difficult to make judgements and justification of different seekers’ behaviours, because

the attractiveness of a host economy is partly determined by the motivation of FDI (Gencturk

and Aulakh, 1995), while such motivations for each type of investment differ (Brouthers et

al., 1996). That is to say, a MNE may have multiple motives when invest overseas, which

are not only crafted to fit other parts of its business, but also embedded by industrial

characteristics and shaped by national supervisions. Therefore, the attractive of host

economy to FDI does not only reflect the country on its own, but also the motivations and

willingness of the MNEs. Given that the attractive of host economies are subject to different

purpose for FDI (Loree and Guisinger, 1995), I concentrate on resource-seeking and market-

seeking FDI as they reflect more systematic difference between China and Russia.

The motivations for resource-seeking and market-seeking FDI are not the same (Nachum

and Zaheer, 2005). The former is motived by lower costs of resources that are costly or

unavailable in their home countries, therefore it can be viewed as driven by supply-oriented

motivation. Since the aim for resource-seeking FDI is to obtain reliable input suppliers and

competitive labour costs (Bartlett and Ghoshal, 1988), it depends on resource endowments

and comparative advantages of the host economies. In this sense, China’s cheap human

resource and Russia’s rich natural endowments seem to be attractive to MNEs, though in

different industries. In general, resource-seeking FDI is usually larger and immobile than

other types of investment (Nachum and Zaheer, 2005), and therefore also sensitive to

stability and accessibility to resource in the host economy. As illustrated in the previous

chapters, we know that while China is able to maintain relatively stable conditions for foreign

investors, Russia seems to fail to make commitment on this grand. For example, higher level

of corruption introduces extra costs or distorts reliable means of obtaining resources

36 | P a g e

(Argandona, 2005). Therefore, it is reasonable to expect lower level of resource-seeking FDI

in Russia than it would have been.

In terms of market-seeking FDI, it aims to directly supply goods or services to host markets

or adjacent countries. Since larger size and greater wealth of the host economies attract

more market-seekers (Aaker and Day, 1986; Henisz and Delios, 2001), this type of FDI can

be viewed as driven by demand-oriented motivation. In theory, large markets create

opportunities for new entrants and underpin higher returns (Arnold and Quelch, 1998);

wealthy markets allow for specification and economies of scale (Gupta and Govindarajan,

2000; Mitra and Golder, 2002). In practices, however, MNEs also concern about the

possibility to increase market penetration in the host markets (Nachum and Zaheer, 2005).

In the case of China and Russia, the degrees to which they are willing to allow for foreign

participations are different. While China encourages foreign investors to form JVs with local

SOEs and thus facilitate the exchange of understandings, Russia’s ‘manager-control,

employee-own’ firms leave little feasibility for foreign investors.

The Russian puzzle has been a combination of rich endowments and low FDI inflows (Fabry

and Zeghni, 2002). At micro institutional level, because resource-seekers have less

information of the host economy and less prepared for instability (Pan and Chi, 1999),

because their final products are traded elsewhere and not able to adjust the price (Brouthers

et al., 1996), they are deterred by ill-functioning formal institutions. For market-seekers,

informal institutions such as corruption induce the higher prices, lower demand and less

profit for the MNEs, and also difficulties for them to gain penetration (Anand et al., 2005).

3.3.2. Spillovers

As part of the external economies, spillovers occur when FDI increases the productivity in

the domestic market, yet its present value of returns is not internalized in the benefits for the

foreign investors and for the host government (Globerman, 1979). Micro-oriented studies

have identified three main types of effects that FDI have on host economies: size effect,

technology effect and structural effect (Fortanier, 2007). While some of these benefits such

as the growth of product and factor markets can be observed directly, most impacts of FDI

37 | P a g e

on host economies are largely indirect and external (Baldwin et al., 1999). Theoretical

analysis suggests various causation mechanisms that spillovers enhance the productivity of

domestic firms. For instance, it occurs through potential technology transfer (Liu, 2008;

Wang and Blomstrom, 1992), greater labour mobility (Fosfuri, 2001) and higher degree of

competition (Markusen and Venables, 1999). Empirical researches, indeed, confirm that FDI

could transfer advanced technologies and managerial skills through demonstration effects,

labour migration and linages (Branstetter, 2006). At micro institutional level, I refer to

spillovers as informal micro institutions between MNEs and the host country in the evaluation

of FDI.

On the one hand, FDI promotions can have a positive role in generating greater benefits

from spillovers if they are placed correctly in the markets with imperfections and externalities

(Haaland and Wooton, 1999). On the other hand, however, the actual degree to which host

economies can gain from FDI inflows depends on the overall political infrastructure and

market functions (UNCTAD, 2001). Therefore, it is important for the host country to not only

attract higher level of aggregate FDI but also to materialize larger degree of spillovers. In

addition, Flamm (1984) argues that the incentive-driven investors are likely to easily move

among countries, compared with fundamental-driven MNCs, the importance of institution

pose challenges to policy design. Therefore, the best policy to gain benefits from FDI on the

grand of the whole society is to construct better institutions that remove obstacles for foreign

investors, rather than to deliver incentive regimes that may potentially distort the markets

(Markusen and Venable, 1999).

Although FDI can potentially lead to higher overall productivity (Lipsey and Sjoholm, 2003;

Haskel et al., 2007), these benefits seem to subject to specific industrial structures and

national conditions (Keller and Yeaple, 2009; Sinani and Meyer, 2004). For the host

economy, Coe et al. (2009) suggest that institutional difference are important determinants

of total factor productivity and of the degree of FDI spillovers. In particular, more eases of

doing business, higher quality of tertiary education system, strong property right protection

and sound legal system are positively related to greater indirect benefits of FDI on the

domestic firms. As we have seen from the macro institutional comparison, Chinese authority

creates a more business-friendly environment for foreign investors than its Russian

counterpart, which at least in theory promotes more indirect gains from FDI. Another

important institutional condition is the efficiency of financial markets (Alfaro et al., 2004), as

38 | P a g e

we have discussed in the analysis of meso institutions. In terms of spillovers, a well-

functioning financial system is the base that the host economy can materialize FDI spillovers

to a higher degree.

4. Conclusions

The relation between the host country and foreign investors has been studied in the

literatures of institutional economics and international business, and they complement each

other with background and dynamism. This dissertation is built upon their overlap and further

39 | P a g e

expands through macro-meso-micro institutional approach, comparatively exploring the

interplay between transitions and FDI in China and Russia. Under the formal and informal

rules of the game, host country is interested in attracting and realizing FDI while foreign

investors are concern about the where to invest and how to obtain expected return.

Institutions have substantial explaining power in the China-Russia puzzle of transition and

FDI. At macro institutional level, gradual transition in China and medium political risk create

a more business-friendly societal foundation for MNEs, while rapid reform and high political

instability deter outsiders from investing in Russia. At meso institutional level, both countries

indicate corresponding moves from bank-based towards market-based financial systems

during their transitions. Yet corruption as an informal rule seems to be more harmful in

Russia than in China. At micro institutional level, different abundant resources and market

penetration imply that China is attractive to both resource-seeking and market-seeking FDI

while Russia is likely to receive lower aggregate level of FDI than it could.

Given the fact that institutions are diverse and various in forms and numbers, this analytical

framework is not perfect in taking into account all of them. Nonetheless, it delivers useful

implications for host economy and for MNEs.

4.1. For host country

FDI can be beneficial for national welfare, by bringing capita to faster the transition, and by

introducing advanced knowledge and managerial skill that are not familiar to the previous

command economy. To improve attractiveness of the host economy, it is not enough to

merely concentrate controversial FDI determinants. With the existence of imperfect markets,

potential investors are be deterred by additional costs and therefore keep the level of FDI

may below its optimal. Better institutions, whether formal or informal, need to be constructed

to improve MNEs’ interests and confidence.

40 | P a g e

The role of FDI in enlightening the transition process is conditional to the domestic

institutions, in terms of macro stability, meso coordination, and micro capability. Therefore,

FDI promoting policies need to be incorporated in the overall transitional development

progress. Because larger volume of foreign capital can enhance the host economic vigour

on the one hand, and greater amount of foreign control may introduce political and economic

instability on the other hand.

4.2. For foreign investors

In addition to resource and competition, institutions are also important in determining firm

performance. For managers, the idea of institutions should be implemented throughout the

whole investment process. Before entering the host country, knowledge of formal and

informal rules affecting the firm performance is necessary. During the investment circle,

fluctuations in the political, economic and social institutions need to be taken into account

when making firm-level strategies. In addition, in countries where relationships and

connection are emphasised, or in markets where the formal rules have not yet been

developed, mastering in informal institutions will gain the company greater and more stable

expected returns.

Controversial analytical methods in international business in relation to institutions often take

the rules of the game as given or fixed, and come up with the best strategy that ‘fit’ the

conditions of host country. In practice, MNEs have ‘bargaining power’ in the sense that they

decide where and how much to invest; and the importance of MNEs’ motivations as well as

willingness are magnified in the global contest of capital. In addition, the substantial changes

in transition economies make the presumption of static rules are less applicable. Therefore,

the inclusion and interpretation of the co-evolution between domestic institutions and FDI

cannot be ignored when designing international business strategies.

41 | P a g e

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