Chile’s Exports/Imports 2000–2011 Is having a free trade market helping Chile’s economy?

Author: Anais Baez

Introduction

Chile was able to fight for their independence from Spain in 1818. After their independency they opted for a democracy that was later an oligarchy regime. Salvador Allende was able to earn the trust of its people to become president for three years.  His presidency was overthrown by a coup de’etat led by Augusto Pinochet in 1973. Pinochet placed a dictatorship for 17 years. In these 17 years he privatized many of the public companies and allowed free market in Chile. He stayed in power until Chileans was able to elect a democratic president Patricio Aylwin from the Concertacion Democratica Party. He continued the economic policies of president Pinochet but slow down the privatization. (Thomas White-Global Investing) A growth of 8% GDP was shown from 1991-1997 while Aylwin was in power in Chile. (Trading Economics) Due to global recession in 1998 trading decreased and economic policies were too fixed from trade. Chile learned from the global crisis that they needed to rearrange its economic policies. During 2004-2007 GDP grew to a 5.2% with President Ricardo Lagos. (Economist Intelligence Unit) Nonetheless due to another recession Chile’s real GDP decreased and fiscal balance decreased in 2008, having a rapid recovery in 2010 due to its new economic policies. Quickly the government and economic expertise started to rearrange their economic policies and pulled up from their recession in the beginning of 2008. (Trading Economics) Suddenly after the global recession Chile suddenly was hit by an 8.8 earthquake 70 miles from Concepcion and about 2000 miles southwest of Santiago. The government had to rearrange its policies implementing a $4 billion program to continue domestic consumption taken away from the $22 billion. It harmed one-eighth of Chile’s population, destroying $30 billion worth of property and placing a reconstruction plan of $8.4 billion in which many machinery imports have increased. (Economist Intelligence Union)

A South American country, Chile, has overcome many obstacles and earned many accomplishments. Chile was the first South American country to join the Organization for Economic Cooperation and Development (OECD) in 2010. Another achievement was having the highest nominal GDP in Latin America in 2006. The 2011 Index of Economic Freedom Chile is the 11th freest economy in the world. It is 21st among 178 countries for its transparency in the Corruption Index, 28th among 139 Global Competitiveness Index World Economic Forum, and 25th in 2011 in the world competitiveness yearbook. (KPMG)

Chile is the slimmest country in the world with a land of 2650 miles long and 221 miles wide in the corner of South America. Its land is shared with the driest desert of the world, glaciers, fjords, beaches, volcanoes, spouting geysers, (Thomas White-Global Investment) and 265,000 hectares for agriculture. It is also in the middle of the Atlantic and Pacific Ocean. The temperature of Chile varies depending on their location. In the central region it has a Mediterranean style climate where fruits and vegetables exporting to 70 markets. In the south they have the off-season production which exports to the north when it is winter in north. Chile is also benefitted from natural barriers that do not permit their animals to contain any parasites or diseases. These barriers are ocean, high mountains, deserts, and glaciers. (Doing Business in Chile)

  

Economy

Chile’s economy is one of the best is Latin American and the Caribbean. It also has one of the most open free trade economies in the world. 2.8% growth 2001 and 3.3% in 2002 increasing each year after that. (The Heritage Foundation)Ever since then Chile was receiving an increase in their GDP by 4%.However, due to the global recession the economy took a reverse and its imports and exports decreased in 2008. In 2010 Chile’s GDP went up to $203.44 billion US dollar. Its GDP is equivalent to .33% of the world economy. Copper accounts for 40% of its GDP. (KPMG) 5.1% GDP came from agriculture, 41.8% from industry and 53.1% from service composed 2011 GDP. (Central Intelligence Agency)

As Chile’s GDP increased so has the government budget. In 2011 the government budget had a surplus of 1.40% of its GDP. From 2000 to 2011 the government’s budget had an average of 1.8000% of GDP. Its highest point was in 2007 with an 8.8200% and its lowest was in 2009 with a -4.500%. The U.S. dollar is weak compared to Chilean pesos US$1 is equivalent to $500.75 in 2012. Inflation rate is of 3.50% in April 2012. Its lowest inflation rate was in 2010 with -1.3000% and its rate is of 5.00%. (Trading Economics)

Human Resource

Chile population on July 2011 is of 17,067,369 people made up of 95% European, and 5% others in which 80% of the 5% is composed by Mapuches. In the year 2011, 8,099 million people were working 13.2% in agriculture, 23% in industrial sector, and 63.4% in the service. Education in Chile is one of the highest qualities in Latin America. Its literacy rate for adults is 95.7%.  Poverty is below 11.5% (Central Intelligence Agency), universities have increased a 40%, and the country has no debt to service or social programs which is 70% of the countries expenses. (Thomas White-Global Investment)

Industrial Production has increased 0.20% in March, 2012. The industrial production includes manufacturing mining, and utilities. From 1997 to 2012 the average of productivity is 2.2400%. The industrial production shows the country inflation rate which is currently in 3.50%. The highest in 2011 with 30.9000% and the lowest being -17.4100% in 2010. (Trading Economics) Companies must provide some training for their employees through its companies, local, or abroad. Training is deducted in their corporate tax of 1%. Working hours for commercial is 45 hours and for non-commercial employees is 44 hours. (Economist Intelligence Agency) During the recessions of 2008-2009 unemployment peaked to a 9%-11% which was not Chile’s accustomed unemployment rate. (Economic Intelligence Agency) Although unemployment rate is low 6.6% in 2012 and the working sector seems high, there is 11.5% of people under the poverty line. In 2012 Chile’s consumer confidence went up to 46.5 in April from 31.6 in July, 2008.  The highest consumer confidence was in March 2006 with 59.3. (Trading Economics)

Job opening was due to Chile’s policy which enabled 487,000 jobs in 2010. They have also increased the minimum wage amount from 171,000 Chilean pesos to 182,000 Chilean pesos in July 2011. The government gave a subsidy to companies to recruit and retain their employees. Other policies are three program that are created to help the poverty percentage to decrease. Other program that will help the Chilean have a better life are three different bonuses. One is given as a bonus to qualified female workers of 15% in their monthly salaries. Second is given as a bonus to students in middle school and high school who are 15% highest in their class of 50,000 Chilean pesos. Third is a bonus of 10,000 Chilean pesos to each member of qualified family each month. (Economist Intelligence Agency)

Incentives

Chile has two programs that promote investors to import, export, or invest in foreign direct investment. These programs are called ProChile and InvestChile. ProChile is in 43 different countries mainly in those Chile has a free trade agreement with. It helps local and foreign companies by matching partners, market analysis, export markets and clients, and supply chains. (KPMG)

An incentive for investors to invest in Chile is that their government debt to GDP is relatively low, 11.20% of GDP. (Trading Economics) The government also incites investors to do business in Chile. They will give subsidies, financing, or tax credits are given for certain exports to international business that offshore business functions from Latin America, the United States, or Europe. Investors are able to enter the official foreign exchange market in Chile as soon as they enter the country. For fossil fuels the government gives companies tax breaks of 10-100% on machines, materials, and spare parts imported for operational needs. (Economist Intelligence Agency)

Exporters are benefitted from many incentives in order to export their goods. For example, local insurance companies provide them with insurance. Commercial banks offer many types of foreign currency and peso credit. Law 18,645 of 1987 states a loan of 50% “with a cap” to non-traditional exporters that are harder to obtain loans. The Corporacion de Fomento de la Produccion (Corfo), a state development agency, gives out long-term export credits for new good capital that acquire “at least 25% Chilean value added”. (EIU) Maturities of ten years or less is financed in dollars. These maturities are located towards 85% of the value of goods and services through fixed and floating rates. Chilean banks and Corfo repays the exporters in cash. There are no limits to investments and 20% of the exporter’s expenses can be refunded. (EIU)

Free Trade

In 1970 Chile mainly performed unilateral trade liberalization. It has free trade 57 countries in just 15 years through bilateral, association, partial, and complementation. In 1991 Chile began its free trade agreements with Mexico (1991), Colombia (1994), Australia, and others. (Economic Intelligence Agency) Chile also has an associate free trade which includes products except service with Mercosur which is consisted of Argentina, Brazil, Paraguay, and Uruguay signed in October 1996. Also that year Chile signed a bilateral free trade agreement with Canada. Other regional free trade is with CACM-Chile. It was signed in 1999 between Costa Rica, El Salvador, Honduras, Guatemala, and Nicaragua is the established Central American country, which included Chile after on. Republic of Korea and Chile signed a free trade agreement in 1998 facilitating Korea to be one of the top export partners for Chile. Another important free trade agreement for Chile was that of the United States and China. In 2003 Chile signed an important bilateral free trade agreement with the European Union. The European-Free-Trade Association (Iceland, Liechtenstein, Norway, and Switzerland) The US-Chile Free Trade Agreement was signed in 2004. (APEC) Other free trades are those complementation agreements which are products except services with Bolivia, Ecuador (1994), and Venezuela (1991). New Zealand, Singapore, and Brunei signed a free trade denominated by P4 with Chile. Also Chile signed partial trade preference agreements with Cuba and India. Currently there are negotiation with Thailand, signature with Vietnam, and ratifications with Malaysia. (Economic Intelligence Agency)

Exports

Their ocean level is low temperature which calls the attention of 1,016 different fish species such as the Chilean sea bass. (KPMG) It holds 34% of the world’s copper, has the largest copper mine, Chuquicamata. The largest copper mining company, CODELCO, in the world also produces rhenium and molybdenum. (Thomas White-Global Investment)Its major production in agriculture is grapes, apples, pears, onions, wheat, corn, peaches, garlic, asparagus, beans, beef, poultry, sheep, wool, fish, and wine. (Central Intelligence Agency) Exporter and it’s the fourth exporter for wine after Italy, France, and Australia.  (Thomas White-Global Investors) They have about 1, 061 species of fish whereas the most popular fishes are rainbow trout, Atlantic and Pacific Salmons, turbots, and mollusks, red abalone and Chilean oysters, jack mackerel, scallops, mussels, southern hake, and Chilean Sea Bass. Chile is also the biggest salmon producer, 187,000 tons of salmon in 2011. (KPMG) Fish production is equivalent to 45% of all their exports to 93 countries. Frozen seafood product is 45% of all their fish exports. Chile has a low demand for their wine so they are able to export 70% of their wine production. In 2011 Chile produce 1,046 million liters of wine. (Thomas White-Global Investment) Food production makes up for 24% of its GDP and over the past ten years it has increased a 10%. In 2010 Chile exported $11.6 billion from their food production. Their largest food production came from fresh grapes (29%), plums (23%), fresh fillets (22%), frozen pacific salmon (30%), avocados (16%), other frozen fish (10%), wine (5%), and frozen pork meats (5%). (KPMG)

In their industry they have an abundance of copper, lithium, gold, silver, iron, steel, ore, molybdenum, nitrates mining, 360 different types of wood and wood products like timber (KPMG), lumber, foodstuffs, fish processing, transport equipment, cement, textiles, paper and pulp, chemicals,.  (Central Intelligence Agency) Copper is accounted for one third of the world’s production and its main exportation commodity. (KPMG)

Imports

Chile has the highest prices for energy in South America, US$130, the double of Brazil. Its demand continues to grow 5.3% per year. (KPMG) Their imports are petroleum and petroleum products, chemicals, electrical and telecommunications equipment, industrial machinery, vehicles, natural gas. (Central Intelligence Agency) Chile has a strong production but is in need of a vital resource to continue their function which is their lack of energy. In 1995 Argentina settled with Chile to import natural gas. However, due to Argentina’s economic downfall their agreement was abolish in 2004. Ever since then Chile has imported much more commodity that would produce energy. The government was forced to change to diesel for its energy. It also helped the country to exploit their natural resource to get energy such as its geysers and steam fields. In 2010 nine companies were allocated to seventeen geothermal areas. (Thomas White-Global Investment)

Even though Chile has a good GPA standard its dependency on international trade is shown in its current account to GDP deficit of 1.30% in 2011. Its highest current account to GDP percentage was in 2006 with a 4.6000 from 1980-2011. Therefore Chile has a higher importation and personal consumption rate and low savings. Their current account deficit is of 1275 million US dollars in 2011. Its highest was in 2007 with a surplus of 3393.6000 million US dollar. Chile consumer confidence is based on 5 questions for the citizens of Chile. That explains how the citizens view the economy in the future. (Trading Economics)

Since Chile exports are mainly industrial and agriculture, they import many of their machinery for them to perform their work. Another machinery import function is for their food processing equipment. The country’s construction sector has increased because of the earthquake. For the construction Chile imports high-tech building materials and capital equipment. For energy usage non-traditional renewable energy sources are imported, biofuels being the most important. (U.S. Commercial Service) Other commodities imported is television, radio, parts for vehicles. (ECLAC)

Trade Balance

Trade balance changed from 2003 with US$2,341,795.638 to US$7,726,847.870 in 2004. This might have been caused by its U.S – Chile free trade agreement in 2004. In 2008 Chile trade balance went from US$20,816,904.40 thousand in 2007 to US$5,710,384.80 thousand.  Chile made a comeback in 2009 with US$12,529,639.071 from the recession in just one year. This was caused by the price of copper; the demand increased and so did the coppers price enabling more countries to increase its purchase. Both exports and imports increased in 2011 decreasing the trade balance of that year by US$6,504,054.525. Import increased because of the earthquake that damaged many of the infrastructures of the country. (ECLAC)

Partners

Chile’s top five export partners are China, the United States, Japan, Brazil, and Republic of Korea, consecutively. They are all countries that have a bilateral free trade agreement with Chile. Chile has been increasing their exports each year from 2002-2011. Being as it may 2002 was the lowest trade exports with all of its partners. The least exported to from the five was Brazil from 2002-2004, 2006, 2007, 2009 with US$694.00 million, US$838.89 million, US$1,402.60 million, US$2,758.36 million, US$3,356.24, and US$2,734.40 million, respectively. Currently, in 2011 Chile exports to Brazil US$4386.25 million value of products. Their 10 most exported commodities for Brazil were copper products such as alloys, ore, matte and cement; fresh or chilled fish excluding fillets; acyclic alcohols, mineral or chemical fertilizer, potassium, wine, parts and accessories for vehicles; ores and concentrates of other non-ferrous base metals. In 2005 Japan was the lowest exporting country with US$4,535.82 becoming the third largest partner in 2011 with US$8,825.61. Japan’s receiving commodity in 2011 were copper ores, concentrates, anodes, alloys, frozen fish, molybdenum, wood chips, particles, swine meat, iron ore agglomerates, and wine. In 2008, 2010 and 2011 the lowest partner was Republic of Korea with $3,601.7, US$4,086.34 and US$4,329.78 and in 2011 their import value from Chile was US$4329.78. Korea’s was copper, anodes, alloys, ores and concentrates; wood, chemical wood, pulp, soda; swine meat; fresh or dried grapes; ore, molybdenum, frozen fish except fillets; carbonates, per carbonates. The two highest exporting partners are China and the United States. From 2002-2006 the United States was its top partner ranging from US$3,484.40 to US$8,940.19 growing a small percentage each year. After Chile and China had their free trade agreement, China became Chile’s top importer from 2007-2011. In 2006 its exports was of US$4,933.15 jumping to a US$9,980.44. Its growth was continuously apart from a downfall in 2007. Even with the recession in 2009 China was able to purchase US$12,490.75 of commodities due to the increase of copper prices during that period. Last year China stayed as the top importer of Chile’s commodity with US$17,922.78. Chile imports to the United States and China the same commodities as the previous countries, adding tires, gold, and pneumatic to China as their top commodities. (ECLAC)

Although China is currently Chile’s top exporter, the United States is the top exporter to Chile. The United States has been Chile’s top exporter since 2002 excluding 2010. The US-Chile free trade agreement have greatly favored both countries by being Chile’s top exporter and importer. Argentina has continued to grow their imports to Chile with some minor exceptions from the yeas of 2006, 2007 and the recession year 2009. The growth has continued even though Argentina removed Chile’s most important and largest importation commodity in 2003. Chile has gradually increased their import decreasing all of their imports in 2009 when the recession hit. Be that as it may in 2010 their imports picked up rapidly for all their partners. Japan was the lowest importation partner from 2002-2011. From the preceding years the lowest years was 2002 with US$539.80 million. Chile procures US$2,731.02 in which the most goods bought were different types of vehicles and machinery. In 2011 Chile imported crude petroleum from Brazil and Argentina. Vehicles for public and private usage as well as machinery for production from Brazil, the United States, China, and Japan were imported to Chile. Bovine meat, polyethylene, irons, and paper is imported from Brazil. The United States exports coal, propane, airplanes, ether, alcohol peroxide, and polyethylene to Chile. Chile buys TV, radios, digital automatic data processing machines, children’s toys, clothes, and footwear. Other imports of Argentina are margarine, propane, food waste, animal feeds, grain sorghum, bovine meat, maize, butanes, and cereal grains. (ECLAC)

Trade Policy

Chile has one of the most transparent trading policies. Their tariffs are about 6% from countries that do not have a free trade agreement with them. Due to so many countries with free trade their tax is accounted by 1% of all imports in 2010. They do not have tariffs for exports. Chile trades, exports and imports losses of more than 20% in 2009. Although imports have low tariffs and some countries have no tax they are still charged 19% value-added tax on the cost-insurance freight (cif). CIF for capital goods, spare part or accessory should be and equivalent of US$3,813, transport vehicles a minimum of US$4,830.   Government can charge surcharges to dumping, minimum customs values, countervailing duties and import price bands. Import price bands are placed for sugar, vegetable oils, wheat, and wheat flour which aligns the prices of imports with the local ones. Capital goods such as machinery, vehicles, equipment and tools with a depreciation of three years are able to avoid customs duties for seven years. After paying the cif the custom duties should be paid in three equal period the third, fifth, and seventh years from the date of the good imports or in seven payments for passenger or cargo transport vehicles. Interest rate is included in every payment by the Executive Committee of the central bank. (Economist Intelligence Agency)

Institutions that are in charge of import regulations are the ComisionNacional de Distorsiones (CND), Dario Oficial (official gazette), Banco Central de Chile (central bank), and Customs Department. The central bank delivers the license for importers. Import report (informe de importacion) should be written for any import with the value of US$3,000. Imports is opened to all goods except used cars, used motorcycle and used re-treaded. A license from the central bank and a pro forma from the supplier of their purchase are required to import any good. For a foreign-exchange transfer must have a stamped declaration for the Customs Department and presented at a local commercial bank with original shipping documents. “Import permits are valid for 120 days.” (EIU)  The CND examines complaints about dumping. (Economist Intelligence Agency)

Requirements to enter the ports are license, commercial invoice and bill of lading or airway bill. Commercial invoice, free-on-board, and cost-insurance-freight, unit prices, license, are needed in freights, air cargos, or parcel-post shipments. For the shipments insurance coverage is wanted. Monitoring exports are the customs official duty. Companies wanting to export need to register before exporting, provide supply balance sheet, fill in the inscription card, and export form. 90 days for shipment after filling is necessary. Endangered species and historical relics are prohibited to export. Explosives, hazardous chemicals and weapons need to have permission from the government to be exported. (Economist Intelligence Agency)

Iquique and Punta Arenas are regions where there are free zones and Arica is a “free-zone extension privileges”. (EIU) Iquique and Arica are only able to export manufacturing, assembly and finishing of imported material yet Punta Arenas is involved in trade. Investors are able to place a 20% subsidy in the cif cost of the machinery and construction for setting up a project in Iquique. A 3% ad valorem tax is placed in the free ports instead of the tariffs. Companies around the zone are spare from the first-category income tax. Operations, Chilean exports and its components are discharged from the value-added tax (VAT). Tariffs are placed in other ports of the country. (Economist Intelligence Agency)

Laws regarding importation to Chile are the Ley de Salvaguardias (Safeguards Law) gives the CND the power to place import surtaxes if they find that the importers are harming the local production through dumping or subsidies. As part of the World Trade Organization (WTO)Chile is given the authority to Chile to increase their tariff by 25% if found guilty by their standards. Also the results of findings are published in the Diario fOficial (official gazette) by the commission’s technical secretary. The WTO gives 90 days to the accuser to show evidence. While in process the CND might ask for import deposits through the Ministry of Finance. If accuser is not able to pledge innocent they are obligated by the WTO to deliver a compensating duty. (Economist Intelligence Agency)

Conclusion

Chile has a great technique for trading. It learned to exploit what it is good on such as fishery, minerals, and fruits. They have also learned to gain more by importing what they have less comparative cost on. The country was able to come back after an earthquake and a recession in these couple of years which many countries still have not been able to do so. Chile is a country to learn from. It is still in the third world but it upfront from many of its neighbors in Latin America.

Appendix

Capture1

Capture2

Capture3

Capture4

Chile: trade balance with World, All years. (Thousands of dollars)
n year exports imports Balance

1

2011

81411129.303

74907074.778

6504054.525

2

2010

70631510.506

56220807.815

14410702.691

3

2009

53592172.262

41062533.191

12529639.071

4

2008

65664087.905

59953703.103

5710384.802

5

2007

67970692.694

47153788.294

20816904.400

6

2006

58679097.386

38406036.070

20273061.316

7

2005

41265945.087

32735070.975

8530874.112

8

2004

32520322.756

24793474.886

7726847.870

9

2003

21664187.379

19322391.741

2341795.638

10

2002

17423088.183

15383398.153

2039690.030

11

2001

18745414.508

16136155.354

2609259.154

12

2000

18214503.759

16619725.987

1594777.772

Chile: Export products to World, 2011. (Thousands of dollars and percentages)

n commodity name trade value % trade quantity unit

1

All Commodities

81411129.3

100

No Quantity

2

Copper;anodes;alloys

29231976.72

35.90661

3386483700

Weight in kilograms

3

Copper ores and concentrates

14304495.2

17.570688

1774763037

Weight in kilograms

4

Chem.woodpulp,soda,blch

2600178.876

3.1938863

3662837309

Weight in kilograms

5

Fruit,fresh,dried, nes

1790163.828

2.1989178

831769230

Weight in kilograms

6

Wine of fresh grapes

1704581.968

2.0937948

667404803

Volume in liters

7

Grapes, fresh or dried

1673375.67

2.055463

923578798

Weight in kilograms

8

Oreetc.molybdn.niob.etc

1472074.948

1.8081987

73935117

Weight in kilograms

9

Gold,nonmontryexcl ores

1450213.005

1.7813449

30830

Weight in kilograms

10

Fish,frozenex.fillets

1440764.283

1.7697387

285917069

Weight in kilograms

Chile: Import products from World, 2011. (Thousands of dollars and percentages)

n commodity name trade value % trade quantity unit

1

All Commodities

74907074.78

100

No Quantity

2

Special transactions, commodity not classified according to class

8835680.892

11.795523

No Quantity

3

Crude petroleum and oils obtained from bituminous materials

6497994.773

8.6747411

8743133632

Weight in kilograms

4

Passenger motor vehicles (excluding buses)

3782778.618

5.0499617

16161836

Number of items

5

Motor vehicles for the transport of goods or materials

2657286.197

3.5474436

3156824

Number of items

6

Petroleum gases and other gaseous hydrocarbons, nes, liquefied

2308462.679

3.0817686

4344130125

Weight in kilograms

7

Construction and mining machinery, nes

1442372.604

1.9255492

3394098

Number of items

8

Television, radio-broadcasting; transmitters, etc

1253561.702

1.6734891

16929351

Number of items

9

Other parts and accessories, for vehicles of headings 722, 781-783

1153615.642

1.5400623

59333500

Weight in kilograms

10

Other coal, not agglomerated

1139936.047

1.5218002

9134966008

Weight in kilograms

Exports 2011)

Capture5

Capture6

Capture7

References

(1)   Central Intelligence Agency. 2012. The World Factbook. June 8, 2012. <https://www.cia.gov/library/publications/the-world-factbook/geos/ci.html&gt;

(2)   KPMG International Cooperative.  2012 Edition. Doing Business in Chile. <http://www.kpmg.com/CL/es/IssuesAndInsights/ArticlesPublications/Documents/2012-01-kpmg-doing-business-in-chile.pdf&gt;

(3)   Economic Commission of Latin America and the Carribbean. Interactive graphic system of international economic trends. <http://www.eclac.org/comercio/ecdata2/index.html&gt;

(4)   Economist Intelligence Unit: EIU Country Commerce. 2012. Chile. January 1st 2012. <http://0-country.eiu.com.library.law.suffolk.edu/article.aspx?articleid=1058782290&Country=Chile&topic=Regulation&subtopic=Trade+policy&subsubtopic=Trade+policy%3a+Overview&gt;

(5)   International Monetary Fund. 2012. IMF eLibrary – Data. 2011. Chile. <http://0-elibrary-data.imf.org.library.law.suffolk.edu/FindDataReports.aspx?d=33060&e=141553&gt;

(6)   Trading Economics. 2012. Chile-National Statistics Data. April 2012. <http://www.tradingeconomics.com/chile/indicators&gt;

(7)   Thomas White-Global Investing: Capture Value Worldwide. 2010. Country Profile: Chile. June 2010. <http://www.thomaswhite.com/pdf/chile-country-june-2010.pdf&gt;

(8)   The Australian APEC Study Centre. 2009. A Complete Guide To The Regional Trade Agreements of the Asia-Pacific. Tim Martyn. March 2001. <http://www.apec.org.au/docs/martyn.PDF&gt;

(9)   The Heritage Foundation: Leadership for America. 2012. 2012 Index of Economic Freedom. #7 Chile.  <http://www.heritage.org/index/country/chile&gt;

U.S. Commercial Service: United States of America Department of Commerce. 2010. Doing Business in Chile. 2012. <http://export.gov/chile/static/CCG%20Chile%

Advertisements

Corporations’ Internationalization and the Adoption of CSR Practices

Author: Andrew Kovtun

INTRODUCTION

The contraction in communication and shipping times due to increased availability of information technology and transportation links has improved the viability of a global industrial process and has shifted labor and production bases away from the home country of a corporation’s headquarters towards locales that offer reduced labor costs and government regulation. However, as firms expand globally, they vary in the approaches they take to branch out into new markets during the internationalization process based on their size, industry, and corporate stakeholders. Different modes of foreign market entry can have important implications for a firm’s decision to adopt Corporate Social Responsibility (CSR) practices as several studies in this area indicate (Strike et al., 853). For example, a firm that owns and operates subsidiaries in a foreign country is more likely to be intensely exposed to local CSR practices than a firm that only engages in arm’s length transactions with foreign business partners. This is because foreign direct investment (FDI) through wholly owned subsidiaries requires that the MNC engages in more intense exchange relationships with local businesses and societal stakeholders, which tend to facilitate knowledge exchange and the absorption of local norms, including those concerning CSR. However, local norms and practices can also negatively influence foreign operations and may lead to delays in global CSR strategy implementation.

During the internationalization process, firms are faced with the choice of adapting to local customs and to “do as the Romans do”, even if the customs are not considered legitimate in the firms’ home countries, or to apply the same corporate standards worldwide, and risk appearing foreign and incompatible to local culture. In the foreign investment-intensive emerging economies, particularly the so-called BRIC nations (i.e., Brazil, Russia, India and China), foreign companies following internal policies or home-country laws forbidding tactics such as bribing officials or hiring relatives (nepotism) or friends can place themselves at a competitive disadvantage. It is sometimes the case that those companies that use local practices, even if at times unethical ones, such as gift-giving to local politicians in a given country, will be more likely to receive development grants, construction projects, and other competitive business permits.

Nevertheless, some large foreign MNCs are actively exporting their home country’s CSR practices throughout their global operations. Consequently, these firms frequently see a positive halo effect in the sale of products and services when the consumer markets perceive them as socially responsible.  The current concern, however, is that other firms lag behind the larger corporations in CSR implementation due to small size and a lack of resources (Greening and Gray 1994; Russo and Fouts 1997). In other cases, firms might choose to avoid CSR activities in their international operations because global expansion occurred for the sole purpose of utilizing countries as pollution havens (Rugman and Verbeke 1998). For example, firms such as Nike (Connor, 2001) or Apple (New York Times, 2012) can only remain price-competitive, market-leading corporations by continuing to take advantage of the lower labor costs of their international product manufacturers and suppliers, which have been found to be often associated with questionable labor practices in developing countries. Thus, it is evident that a variety of factors including size, industry, and varying stakeholder pressures influence MNCs’ internationalization and their adoption of CSR practices; it is necessary to review these factors to understand the processes that shape such important global trends today.

In this article, the relationship between a firm’s internationalization and its decision to adopt CSR practices are reviewed. In the remainder of the paper, a brief review of the key construct of interest (i.e., CSR and internationalization) is presented. Then some of the key articles that examine the relationship between internationalization and adoption of CSR practices are reviewed. Next, a few examples of how this relationship is important to improve our understanding of the benefits and challenges associated with a firm’s exposure to global markets is presented.

DEFINING THE KEY CONSTRUCTS: CSR AND INTERNATIONALIZATION

 This section defines and discusses the key concepts of CSR, its reverse CSiR, internationalization, environmental responsibility, and corporate competitiveness.

CSR is defined as “the set of corporate actions that positively affect an identifiable social stakeholder’s interests and does not violate the legitimate claims of another identifiable social stakeholder (in the long run)”(Strike et al.2006, 852).In his seminal work on the stakeholder approach to the firm, R. Edward Freeman defines a firm’s stakeholder “any group or individual who can affect or is affected by the achievement of the organization objectives” (2010,46).Firms’ stakeholder groups include, among the others, consumers, shareholders, local communities, governmental bodies, political groups, trade unions, employees, financiers, and suppliers.

The three domains that represent the most commonly measured dimensions of CSR are environmental performance, community relations and labor relations (Muller and Kolk 2010, 10).

Environmental responsibility is a key component of CSR and Dan Etsy, a well-known Yale scholar in green business circles, has even labeled it a business ‘megatrend’ (Reid 2010). “Consumers, shareholders, and supply chains [are placing increasing pressure] on organizations to operate responsibly” concurrently as escalated competition for natural resources in the 21st century has positioned environmental conservancy as a critical priority for governments and citizens internationally (Reid 2010, 1). According to Ralph Reid, VP of Corporate Responsibility at Sprint Nextel Communications, “a company’s commitment to environmental responsibility – bolstered by transparent goals and routine monitoring – is vital to the long- and short-term profitability of an organization”. For example, when a company, such as General Motors today, voluntarily purchases carbon offset credits in an effort to go “green”, it positively affects global communities and the environment by paying for clean energy initiatives and pollution cleanup efforts through environmentally responsible actions without inflicting harm towards any other entity (Kennedy 2012). Sprint Nextel Communications allows its customers to participate in mobile device ‘take-back’ and recycling programs that “dispose of electronics safely and responsibly” by eliminating potential e-waste while the company is able to generate cost-savings by re-selling and refurbishing certain devices and parts (Reid 2010, 1). Nevertheless, it is necessary to note that environmental stewardship is not the only area in which firms can prove themselves as leaders in CSR implementation.

Another example of CSR practices is a novel, innovative project of New Belgium Brewing Company, the brewer of famous Fat Tire craft beers. Recently, the company announced that its Employee Stock Ownership Program (ESOP) “has purchased the balance of company shares, making it 100% employee-owned”, meaning that a key stakeholder group, employees, now has direct involvement in corporate affairs and strategy as well as the opportunity to directly benefit from sustainable corporate success and growth (New Belgium 2013, 1).

An additional example of responsible corporate behavior is Quicken Loans’ recent initiative to buy delinquent mortgages and real estate in the urban decay areas of Cleveland, Ohio and Detroit, Michigan (Carey 2013). Quicken Loans’ initiative focuses on projects where real estate in inner-city neighborhoods can be transformed to accommodate educational centers, incubators for technology start-ups, and chic retail space in order to spark a gentrification movement to the urban cores where Quicken Loans has its roots (Carey 2013). Thus, local communities in the chosen urban areas are positively affected by the profit-generating corporate strategy of the company, while the company itself benefits from a positive corporate image and goodwill from city authorities during its business transactions.

One can even argue to an extent that there is no net negative impact to shareholders and investors of a corporation if the firm’s CSR initiatives are properly positioned and marketed to consumers, resulting in higher sales and income even if profit margins are slightly reduced by the initiative.

There is also a great deal of companies that negatively affect their stakeholders. Researchers have labeled this behavior as “Corporate Social irresponsibility”, or CSiR. Strike et al. (2006) define CSiR as “the set of corporate actions that negatively affects an identifiable social stakeholder’s legitimate claims (in the long run)” (852).

Stakeholders and society at large often pay a high price for corporations’ irresponsible behavior. Even where laws exist to prevent certain forms of CSiR, it is sometimes impossible to prevent accidents which may occur due to improper conduct of a corporations’ employees and/or overall weak corporate supervision, as was the case in the 2010 BP-Deepwater Horizon oil spill in the Gulf of Mexico (National Commission on the BP Deepwater Horizon oil spill and offshore drilling 2011). As a result of the accident, BP and its project partner Halliburton were forced to pay extensive legal settlement costs. BP was also required to allocate $20 billion for a collective cleanup fine after it was found that the drilling and oil firms did not properly inspect the drilling equipment used on the Deepwater Horizon oil rig (National Commission on the BP Deepwater Horizon oil spill and offshore drilling 2011). Reflecting on such incidents, it is evident that a lack of corporate responsibility, particularly in the area of environmental affairs, can lead to a loss in corporate profitability and competitiveness. However, there are situations where irresponsible firms have operations in countries with lenient safety and labor laws. Consequently, MNCs can dodge responsibility to stakeholders by simply replacing a single cheap supplier from a global supply chain- international retailer Wal-Mart chose to do this after a fire in a Bangladeshi factory with relaxed safety measures used by its supplier killed 112 workers (New York Times 2012). Thus, it is evident that as firms expand to become MNCs, incongruent international laws and regulations allow for irresponsible corporate actions to be taken where there is little risk involved.

Fortunately, the 21st century and the coinciding global economic integration have sparked a rise in support by many stakeholders to establish international CSR guidelines. “In 2005, the United Nations Secretary General invited a group of the world’s largest institutional investors to join a process in developing the Principles for Responsible Investment.” As of April 2012, over 1000 investment institutions have become signatories, with assets under management considered to be approximately $30 trillion. (United Nations)

Unfortunately, there has also been a rise in special interest groups that seek to avoid or navigate around established guidelines. A recent push for local products by consumers in the United States, Europe, and the developed world aligns with the societal concept that regional businesses are far more intertwined with local communities than diversified international conglomerates and thus will work to benefit their home market more than a MNC expanding in search of more profit (Palpacuer and Tozanli 2008). Lobbyist groups exist that work on behalf of regional coal-burning utilities and mine corporations that manipulate these rising consumer sentiments; they use evidence of their corporate clients’ benefit to the communities of the impoverished Appalachia region of the United States as a tool to strike down regulations and initiatives concerning the reduction of atmospheric emissions (American Coalition for Clean Coal).

The definition of internationalization has evolved from being considered a “process by which firms increase their involvement in international operations in an incremental fashion rather than in large spectacular strides” (Johanson and Vahlne 1977; Cavusgill 1980; Cavusgill and Nevin 1984) to a broader and more inclusive “expansion across the borders of global regions and countries into different geographic locations or markets” (Hitt et al., 1997).The former definition, labeled the ‘product cycle model’ (Vernon 1966) involves introduction, growth, maturity, and decline stages. During the introduction stage, a firm is domestic-focused, only exporting to other industrial countries in order to achieve economies of scale. The growth stage involves increased export activity and foreign direct investment (FDI) into international manufacturing sites by a firm experiencing significant demand for its product. In the time of maturity, a firm searches for low labor cost locations as the firm’s product is standardized and consumer markets are saturated. Finally, during the decline stage, a firm completely exits its manufacturing operations from its home country as it definitively establishes its low cost operations in a foreign market (Vernon 1966; Melin 1992). This internationalization model is far too specific to a single internationalization process and widely ignores the new realities of growing service industry MNCs. The latter definition, labeled the ‘internationalization process model’ (Johanson and Vahlne 1977), states that firms make a series of logical international moves based on the gradual attainment, integration, and implementation of knowledge and expertise of foreign markets and operations. Some firms form joint ventures in order to gain knowledge of local markets and share the burden of investment with a local business. Other companies partner with foreign suppliers to take advantage of reduced costs without direct liability or capital investment in foreign production. The remaining large corporations invest in and operate wholly owned foreign subsidiaries which they manage using significant capital holdings and in-house corporate expertise in an aim to maximize profit to the global operations of the Multinational Corporation (MNC). As discussed later in this paper, firms often commit to markets with similar customs, languages, and cultures to their home country before comfortably making the decision to expand elsewhere. This model of internationalization is more appropriate in describing current globalization developments and applies to the modern shift in global economic activity from the culturally homogenous ‘western world’ to the culturally distinct developing countries.

Internationalization is now more feasible than ever thanks to corporations’ ability to tap in to easily accessible financial and capital markets, existing global supply chains for product manufacturing and distribution, and product brand-generated premiums (China Labor Watch 2011). However, as one can see by the fall of once mighty corporate technology giants such as Palm, Inc. and Commodore International Ltd., a growing global market place also means that companies must remain flexible to ever-changing consumer tastes and act quickly to position products and services effectively in new markets.

 

LITERATURE REVIEW

 This section seeks to apply the previously defined constructs to a balanced review of academic literature studying the effects of various internationalization approaches on CSR strategies, comparing and contrasting companies of diverse size, origin, and industry, and identifying long-term trends during corporate internationalization.

Some CSR studies have found that the whole economics of globalization is likely to lead to many opportunities for a firm to act irresponsibly, because firms often seek out countries with lax social and environmental standards and weak governance (Strike et al., 2006; Low and Yeats, 1992; Lucas et al., 1992). For example, Connor (2001) reports that the watchdog NGO Global Exchange had collected evidence about some of Nike’s suppliers in developing countries forcing their employees to work excessive hours with very low pay and often intimidating them in order to suppress protests on labor abuses (Connor, 2001).Such anecdotal evidence ties directly into the phenomena previously outlined where MNCs are incentivized to pursue a CSiR strategy when incongruent international laws provide an opportunity to cut costs. However, other studies have found that the “globalization/ internationalization of companies did in fact improve CSR relative to domestic fiowe” (Chapple and Moon 2007, 184). For example, Chapple et al. (2006) used CSR penetration data statistics to show that international firms in seven newly developing countries (India, South Korea, Philippines, Malaysia, Thailand, Singapore, and Indonesia) have greater rates of CSR adoption when compared to domestic firms in the same industrial sectors.

Other studies emphasize the notion that cross-national studies bring different stakeholder expectations of business and different historical business roles in society (Chapple and Moon 2007) and can thus lead to discrepancies in the way we perceive the role that internationalization plays in responsible corporate behavior. Businesses are not evaluated relative to the foreign local stakeholders that are involved but rather to limiting Western criteria of proper CSR implementation; this limited evaluation method then designates companies as either successful or unsuccessful in taking responsible corporate actions. However, the focus should be not on polarizing the issue at hand, but on examining the factors influencing the decisions of MNCs’ different results in CSR strategy adoption and defining similarities amongst the stakeholder characteristics of MNCs with similar end results. As a result, it is necessary to examine the differences between Western and non-Western approaches to international diversification of corporate activity.

A study conducted by Erramilli et al. shows that our perception of the process of internationalization itself has been too focused on US-based MNCs and those in Nordic countries, while simultaneously ignoring the pattern of growth and expansion in Asian countries and developing economies. When empirical evidence is used from South Korean MNCs from 1973-1990 and compared using a longitudinal approach rather than a cross-sectional one, it is found that the theory of internationalization is supported when it comes to South Korean MNCs investing in psychically close countries and gradually increasing in the aggressiveness of the investments made- at first minor investments are made into foreign firms and then escalated into the creation of wholly-owned subsidiaries over time. (Erramilli et al. 1999) However, it is important to note that it was discovered that South Korean MNCs were more willing to enter markets with low populations before expanding into high population countries. Likewise, high-income markets were found to be more appealing for initial investments than low-income counterparts due to the potential for faster returns on investment and lower risk of market penetration; the economically attractive areas of the world were targeted with foreign direct investment first until reaching market saturation before moving to less attractive alternatives. (Erramilli et al. 1999) It is interesting that South Korean MNCs chose to operate wholly-owned subsidiaries in physically distant countries while investing in minority ventures in closer markets; this is unsurprising when examined from the South Korean perspective and compared to the classical approach to internationalization because the areas of lowest psychical distance to South Korea happened to be the most culturally similar and cheapest to invest into in the beginning of the internationalization process, but were not the high-income, low-population markets that MNCs sought out for high-margin sales and aggressive investment.

Although the path of internationalization by Asian firms follows a similar pattern to that of Western firms, the integration of CSR practices and the perception of socially responsible behavior by corporate managers differ amongst Asian and Western corporate leaders. For example, Chapple and Moon (2007) found that in industries where there still exists pressure to operate in irresponsible ways, Western MNCs are far more likely to pay attention to environmental and human rights issues than their Asian counterparts. In their study of seven Asian countries (i.e., India, South Korea, Philippines, Malaysia, Thailand, Singapore, and Indonesia) they found that Asian corporate managers, with the exception of Japanese managers, are more likely to pay attention to local cultural issues and national historical events when engaging in CSR activities but limit their stakeholder view to consumers’ and shareholders’ interests (Chapple and Moon 2007).They also find that religion plays a heavy role in guiding MNC corporate behavior, particularly in corporations influenced by the traditional Islamic focus on personal responsibility.

In addition to large MNCs, research has also investigated the relationship between internationalization and CSR among small and medium enterprises (SMEs). For example, Aguilera-Caracuel et al. (2010) find that SMEs engaged in international expansion are often more proactive towards in the environmental management arena. This is often related to their ability to accumulate skills and experience with different institutional requirements across the various countries where they operate. Their study also highlights the benefits associated with implementing innovative CSR initiatives in a homogenous and standardized manner across the various countries where the firm operates (Aguilera-Caracuel et al. 2010)

Some studies also highlight the benefits associated with proactive CSR behaviors, especially in the environmental management area. This view is supported by the study conducted byDam and Sholtens’ 2007 study, which shows that MNCs during internationalization “engage in ‘profit-maximizing’ CSR… are socially responsible… because they anticipate a benefit from these actions” (Dam and Sholtens 2007, 55). Large MNCs and firms with strict internal corporate environmental standards do not receive a comparative advantage from expanding to markets with lax environmental standards (Dam and Sholtens 2007). Only small and medium enterprises see a benefit from Pollution Haven Hypothesis (PHH) behavior where pollution-intensive industry is relocated to countries with low environmental standards. In this case, however, it is seen that there is actually a “race-to-the-top” phenomenon as briefly discussed before- the more an enterprise expands internationally, the more it targets high-income, low-population markets with high CSR standards, the more stakeholders weigh into its corporate governance, and thus environmental standards are raised with more knowledge and experience. It appears that the PHH behavior of small and medium enterprises of socially irresponsible corporations is limited to a certain segment of international growth before the corporations are once again pressured by new stakeholders to meet international standards and seek out environmentally friendly CSR policies due to profit-maximizing motives.

 

PRACTICAL RELEVANCE OF MNC INTERNATIONALIZATION ANALYSIS

 The literature reviewed above shows that local culture, size, industry, and consumer and shareholder pressures influence whether or not a corporation acts in a responsible manner. This information helps human rights, environmental, and labor agencies to develop appropriate tactics to pressure corporations towards a more homogenous and improved CSR approach throughout their global operations.  Contrary to the opinion of many anti-globalization unions and protestors such as those at World Trade Organization meetings in Seattle, Quebec City, and Hong Kong, it appears that increased exposure to international markets benefits corporations with high CSR standards and forces others to follow suit in the long run due to increased stakeholder exposure through expansion.

The case of Zhejiang Geely Holding Group, more commonly known as Geely offers an example of the positive relationship between a firm’s internationalization and CSR practice adoptions. In a very short period of time Geely moved from being a small domestic appliance maker to being a global automotive powerhouse, and expanded the range of its CSR initiatives. When Geely first began manufacturing automobiles, its products were reviewed as exceptionally unsafe and the company suffered from allegations of copyright and trademark rights violations from competing international automakers (Economist 2008). However, since its remarkable global expansion, which also included the purchase of venerable safety-distinguished automaker Volvo, Geely has managed to earn distinction as the “first among China’s self-owned brands in terms of CSR initiatives” from Ruder Finn, a leading independent communications agency, and Tsinghua University, one of China’s most renowned universities, and is awarded for its dedication to the development of its positive CSR strategy growth in China (Global Times 2013). The company donates funds to educational development initiatives at Zhejiang Geely Technician College, Beijing Geely University, and many other educational institutions to increase skilled employment in poverty-stricken regions of China (Global Times 2013). It has donated millions to disaster-relief funds in Taiwan and southern China in addition to improving the environmental and safety record of its vehicles (Global Times 2013). The founder and chairman of Geely, Li Shufu, proclaimed, “An enterprise without a sense of social responsibility will be kicked out of the market sooner or later, and it can never achieve sustainability” (Global Times 2013, 1).

Similar conclusions have been reached by observers in a fellow BRIC nation, Brazil. In the Brazilian corporate world, “generally speaking, the large and more globalized the [Brazilian] company, the more likely they are to have adopted CSR policies” (Bevins 2011, 1). “Brazilian companies have gone international, and that’s a new big pressure,” says Claudio Boechat, sustainability expert at the Fundação Dom Cabral, a prestigious business school. “When you go abroad, if you prove that you are more inclusive, you get more attention” (Bevins 2011, 1). Since 2003, as it gained more international exposure and yielded to the interests of the Brazilian government, Banco de Brasil has developed a regional development assistance portfolio in the sum of $6.2 million and doesn’t “take on clients involved in degrading work practices” or “assume the risk of credit with clients responsible for [serious environmental damage]” (Bevins 2011, 1).

Sberbank, the largest bank in Russia and Eastern Europe and the third largest bank in Europe, offers yet another example of the positive relationship between firm’s internationalization and adoption of CSR practices (Financial Times 2012). Today the company is known for its commitment to increase corporate transparency, environmental efficiency, and its larger investment into Russian science and education initiatives. Prior to its privatization and subsequent international exposure, Sberbank was the government-owned monopoly national bank of the USSR and provided all the necessary central bank services to the Communist-controlled state. Since its growth as an independent international banking institution, Sberbank has worked to improve the communication and transparency of its business dealings with stakeholders by developing its ‘Information Environment corporate project’ that provides extensive online and social media briefings by senior management to stakeholders on issues ranging from the signing of a new collective bargaining agreement to Sberbank’s involvement in preparations for Sochi 2014 (Sberbank 2010). The company has also aided in the development of an ‘Energy Efficient Neighborhood’ project in Tyumen, Russia, where plans are to achieve an average 25-30% reduction in energy use by eliminating inefficient sources of energy consumption and using state-of-the-art resource efficiency techniques (Sberbank 2010). Finally, Sberbank sponsors professional programs in the banking industry at leading Russian universities as well as hundreds of employee-led charity events that help children in orphanages overcome life challenges. Thanks in part to such initiatives, Sberbank has received the British magazine The Banker’s “2011 best banker in Central and Eastern Europe award” and a Russian National Banking Award as the bank with Russia’s “highest information openness”.

The evidence and literature reviewed in this paper suggest that firms with heightened global exposure, and especially large MNCs, need to adhere to the guidelines of a global corporate citizen or face banishment in the markets in the long run. Thus, action groups and stakeholder organizations that care about an increase in the diffusion of CSR practices worldwide should also encourage firms’ internationalization because it increases the likelihood of CSR practice adoption. While large MNCs are often reviled by the rhetoric of anti-global forces, active stakeholders have the opportunity to pressure growing and expanding MNCs to adopt homogenous CSR strategies in areas where CSR implementation is lacking. Stakeholders can expose work place, environmental, human rights, and ethical abuses and accidents to concerned consumers, government authorities, trade union leaders, and competitors. Thus, they may ensure that certain negative tendencies of globalization are reversed by further stimulating the development of a corporate culture whereby corporations compete not only on product and service quality and price, but also on their ability to deliver CSR and capture the limited goodwill of global stakeholders.

References

 Aguilera-Caracuel, Javier, Juan Alberto, et al. “The Influence of Environmental Diversification on the Proactive Environmental Strategy of Small and Medium Enterprises.” Progress in International Business Research. 5. (2010): 97-115. Web. 26 Mar. 2013. DOI: 10.1108/S1745-8862(2010)0000005009

 Bevins, Vincent. “CSR: Brazil’s CSR Leaders.” Latintrade.com. Latin Trade, 24 May 2011. Web. 26 Mar 2013. <http://latintrade.com/2011/05/csr-brazil’s-csr-leaders&gt;.

Bondy, Krista, and Ken Starky. “The Dilemmas of Internationalization: Corporate Social Responsibility in the Multinational Corporation.” British Journal of Management. (2012): 1-19. Web. 26 Mar. 2013. DOI: 10.1111/j.1467-8551.2012.00840.x

 Carey, Nick. “Mortgage lender Quicken bets on downtown Detroit’s survival.” Reuters.com. Reuters, 19 Feb 2013. Web. 25 Mar 2013. <http://www.reuters.com/article/2013/02/19/us-usa-detroit-downtown-idUSBRE91I00O20130219&gt;.

Chambers, Eleanor, Wendy Chapple, Jeremy Moon, and Michael Sullivan. “CSR in Asia: A seven country study of CSR website reporting.” International Centre for Corporate Social Responsibility. (2006): 1-46. Web. 26 Mar. 2013. <http://195.130.87.21:8080/dspace/bitstream/123456789/1094/1/09-CSR in Asia A seven country study of CSR website reporting.PDF>.

Chapple, Wendy, and Jeremy Moon. “CSR Agendas for Asia.” Corporate Social Responsibility and Environmental Management. 14. (2007): 183-188. Web. 26 Mar. 2013. DOI: 10.1002/CST.159

China Labor Watch . “Tragedies of Globalization: The Truth Behind Electronics Sweatshops.” China Labor Watch Special Report. (2011): 1-137. Web. 26 Mar. 2013. <http://chinalaborwatch.org/pdf/20110712.pdf&gt;.

Connor, Tim. “Still Waiting For Nike To Respect the Right to Organize.” CorpWatch. Global Exchange, 28 Jun 2001. Web. 25 Mar 2013. <http://www.corpwatch.org/article.php?id=619&gt;.

Dam, Lammertjan, and Bert Sholtens. “Environmental regulation and MNE’s location: Does CSR matter?” Ecological Economics. 67. (2008): 55-65. Print.

 Duhigg, Charles, and David Barboza. “In China, Human Costs Are Built Into an iPad .”New York Times. New York Times, 25 Jan 2012. Web. 22 Mar 2013.

<http://www.nytimes.com/2012/01/26/business/ieconomy-apples-ipad-and-the-human-costs-for-workers-in-china.html&gt;.

Erramilli, M. Krishna, Rajesh Srivastava, et al. “Internationalization theory and Korean multinationals.” Asia Pacific Journal of Management. 16.1 (1999): 29-45. Web. 26 Mar. 2013. <http://link.springer.com/article/10.1023/A:1015406118378?LI=true&gt;.

Financial Times. “Sberbank- the consumer’s choice.” Financial Times Lexicon. Financial Times, 17 Sep 2012. Web. 26 Mar 2013. <http://www.ft.com/intl/cms/s/77f54d42-00ce-11e2-9dfc-00144feabdc0&gt;.

Freeman, R. Edward. Strategic Management: A Stakeholder Approach. 2nd. Cambridge: Cambridge University Press, 2010. 46-47. Print.

Global Times. “Geely gains credit for its efforts in CSR.” Globaltimes.cn. Global Times, 23 Jan 2013. Web. 24 Mar 2013.

<http://www.globaltimes.cn/content/757729.shtml&gt;.

Graham, Bob, William K. Reilly, et al. United States of America. National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling. Deepwater: The Gulf Oil Disaster and the Future of Offshore Drilling. Washington, DC , 2011. Web. <http://www.oilspillcommission.gov/sites/default/files/documents/DEEPWATER_ReporttothePresident_FINAL.pdf&gt;.

 Greenhouse, Steven. “Documents Indicate Walmart Blocked Safety Push in Bangladesh.” New York Times. New York Times, 05 Dec 2012. Web. 22 Mar 2013.

<http://www.nytimes.com/2012/12/06/world/asia/3-walmart-suppliers-made-goods-in-bangladeshi-factory-where-112-died-in-fire.html&gt;.

Greening, D. & Gray, B. “Testing a model of organizational response to social & political issues”. Academy of Management Journal, 37 (1994): 467-498. Web. 25 March 2013.

Johanson, J. and J. Vahlne. “The internationalisation process of the firm: a model of knowledge development on increasing foreign commitments”, Journal of International Business Studies, (Spring-Summer 1977): 23-32. Web. 25 March 2013

 Kennedy, Bruce. “GM, US companies lead way on corporate carbon offsets.” Greenbiz.com. GreenBiz, 08 Jun 2012. Web. 22 Mar 2013.

<http://www.greenbiz.com/blog/2012/06/07/gm-us-companies-lead-way-corporate-carbon-offsets&gt;.

Melin, Leif. “Internationalization As A Strategy Process.” Strategic Management Journal. 13.Special Issue (1992): 99-118. Web. 26 Mar. 2013. <http://teaching.ust.hk/~mgto650p/meyer/readings/8/Melin.pdf&gt;.

Muller, Alan, and AnsKolk. “Extrinsic and Intrinsic Drivers of Corporate Social Performance: Evidence from Foreign and Domestic Firms in Mexico.” Journal of Management Studies. 47.1 (2010): 1-26. Web. 30 Mar. 2013. <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1350783&gt;.

New Belgium Brewing Company. “Values and Stories.” New Belgium Brewery Homepage. New Belgium Brewery, 17 Jan 2013. Web. 25 Mar 2013. <http://www.newbelgium.com/sustainability/stories/13-01-17/New-Belgium-Brewing-Becomes-100-Employee-Owned-Company&gt;.

PRI Association, . “About the PRI Initiative.” PRI: Principles for Responsible Investment. PRI Association, n.d. Web. 26 Mar 2013. <http://www.unpri.org/about-pri/about-pri/&gt;.

Reid, Ralph. “Environmental Responsibility: Toda’ys Business Megatrend.” Environmentalleader.com. Environmental Leader, 17 Aug 2010. Web. 25 Mar 2013. <http://www.environmentalleader.com/2010/08/17/environmental-responsibility-today’s-business-megatrend/&gt;.

Rugman, Alan M., &Verbeke, Alain. 1998. “Multinational Enterprises and Public Policy,” Journal of International Business Studies, Palgrave Macmillan, 29.1(1998): pages 115-136. 25 Mar 2013.

Russo, M.V. and P.A. Fouts. “A Resource-Based Perspective on Corporate Environmental Performance and Profitability,” Academy of Management Journal, 40.3(1997): 534–559.

SberbankRossii. “Social Responsibility Report.” Sberbank Annual Report 2010. 1 Dec 2010. Web. 26 Mar 2013. <http://report2010-sberbank.ru/reports/sberbank/annual/2010/gb/English/30/social-responsibility-report.html&gt;.

Strike, Vanessa M., JijunGao, et al. “Being Good While Being Bad: Social Responsibility and the International Diversification of US Firms.” Journal of International Business Studies. 37.6 (2006): 850-862. Web. 26 Mar. 2013. <www.jstor.org/stable/4540388>.

Symonds, Matthew. “Special Report: Cars in emerging markets: The home team.” The Economist. The Economist, 13 Nov 2008. Web. 24 Mar 2013. <http://www.economist.com/node/12544893&gt;.

Vernon, R. (May 1966). “International investment and international trade in the product cycle”. Quarterly Journal of Economics, pp 190-207.

THE EFFECT OF THE EUROZONE DEBT CRISIS ON THE FRENCH BANKING INDUSTRY

Author: Samantha Paquette

Abstract

The Eurozone debt crisis has inflicted a serious impact on the European financial sector and, due to the critical global position of the European economy, has developed into a widespread phenomenon. Because the French banks had been the most ambitious and acquisitive since the creation of the European common currency, the euro, they are now the largest holders of public and private debt in the euro area, making them the most vulnerable players within the crisis. As of June 2012, French banks held a total of $540 billion in debt from Greece, Ireland, Italy, Portugal, and Spain. In order to determine what effect this exposure has had on the French banking industry, data and information was gathered from various news sources, official bank reports, and publications from international organizations. Textbooks and other knowledgeable sources were used to help explain certain aspects or anomalies within the crisis, such as the crowding out effect. This paper attempts to analyze to what extent the Eurozone debt has impaired the banking sector and to investigate viable solutions for the industry.

Introduction

Business and economics are continually amalgamating on an international scale as trade, investments, currencies, information, and technology become more and more global. As a result of this increasing interconnectedness, when a major economy suffers, it tends to have a global effect.  Further economic integration leads to even harsher results when a crisis is at hand.  Such is the case with the current situation of Europe’s monetary union, the Eurozone.  The poor debt management and uninhibited government spending (primarily in the form of social expenditures and excess labor costs) of many of the member states of the Eurozone have caused a widespread recession and continue to weaken the healthier European economies, such as the Netherlands and France.  The most troubled members of the union include Greece, Ireland, Italy, Portugal, and Spain due to their extremely high debt levels and their volatility with regard to their risk of default.  The European Central Bank (ECB) and the euro area nations have been working together to try to save the Eurozone and its individual economies.  However, the leaders of the countries are struggling to come up with rescue packages large enough and realistic enough to reassure the markets, yet small enough to appeal to their own voters.  This discrepancy between the varying fiscal policies of each sovereign nation and the overarching monetary policy of the European Central Bank is a key factor in the ongoing recession.

The French banking industry has been greatly influenced by the Eurozone debt crisis because of its substantial exposure to the debt of the aforementioned problem countries.  Since the creation of the euro currency, the French banks had been the most active in acquiring and utilizing assets in the other euro-area markets.  By the end of 2010, French banks held $93 billion (65 billion euros) in Greek debt alone – compared to Germany who held, at that point, $57 billion (40 billion euros) in Greek bonds. (Fontevecchia, 2011)  As of June 2012, French banks held a total of $540 billion in private debt (debt from private institutions such as commercial and investment banks) and public debt (debt from government owned/controlled institutions) in Greece, Ireland, Italy, Portugal, and Spain after reducing it from $833 billion since 2009. As such, the French banks are the largest holders of private and public debt in the euro area, making them the most vulnerable in the event of a default. (Benedetti-Valentini, BNP Paribas Third-Quarter Net Doubles on Trading Gains, 2012)  According to Dylan McClain (2012), the assets of the French banks, which equaled 4.43 trillion euros in April 2012, are more than twice the size of the country’s economy, whose gross domestic product (GDP) for 2012 is estimated at 2.04 trillion euros.  Because the banks are so much larger than the French economy, it is impossible for the government to prop up the banks and provide the capital needed to get the industry back on track.  These dynamics validate the importance of understanding how the crisis has become as severe as it is and what actions the French government, the European Central Bank, and the other Eurozone countries have taken and must take in the near future in order to ensure the survival and success of the banking industry and the financial markets.

Literature Review

In 2001 Nigel Dodd, from the London School of Economics, published a report, “What Is ‘Sociological’ About the Euro?” on the sociological aspects of a European monetary union.  Dodd organizes his commentary into four sections: the economics of convergence, the politics of the European Central Bank, labor mobility and material interest, and money and culture.  In his report, Dodd investigates the issues with a single monetary policy and the concerns about the collaborative efforts (or lack thereof) of the sovereign governments and the European Central Bank.  Though the source was written prior to the Eurozone debt crisis, it provides a solid background on the creation of the Eurozone, such as the requirements to join and the structure, goals and responsibilities of the ECB.  In order to understand what is happening now, it is crucial to understand how and why the euro area formed as well as the social implications of a “Eurozone.”  Dodd concludes the article by stating, “We need to account for the ways in which the euro’s progress will be monitored by those who are using it,” (Dodd, 2001)  which is appropriate considering the lack of monitoring of the peripheral Eurozone members is a primary cause of the current financial crisis.

“A Very Short History of the Crisis,” written by Edward Carr, provides a solid foundation for understanding how the debt crisis developed.  Carr, the Foreign Editor for The Economist, elucidates that extreme government spending was not the main cause of high debt levels for frailer countries like Ireland and Spain.  He explains that the majority of their government expenditures, such as increased welfare and bank support, occurred as a result of slow growth and the burgeoning financial crisis.  The article suggests, however, that these same countries were running unsustainable, harmful current-account deficits that were bound to catch up to them; that is, they were importing far more than they were exporting.  The last part of the article discusses how far Europe has to go before it is restored to health, despite the measures already taken to abate the crisis. (Carr, 2011)

Dylan McClain’s article from The New York Times, “Understanding the European Crisis Now,” provides a brief but concise description of why the weakening of the European economies is hurting their banks, using data gathered from the European Central Bank, the International Monetary Fund, and Eurostat to support his claims.  The author explains that “the governments lack the ready resources to prop up banks in trouble” because the countries’ banking systems are significantly larger than their corresponding economies. (McClain, 2012)  As investors become more uncertain of the banks’ ability to pay back loans, they are financing less which means the banks have less capital and less possibility of sustaining necessary growth. He states that the more fragile banks have had to turn to other European countries (i.e. Germany and the Netherlands) for help, putting pressure on the banks of these stronger economies. This article offers a rudimentary perspective on the effect of the crisis on the Eurozone banking industry as a whole.

In March of 2012, Global Insight, the world’s largest economics organization, issued their annual report on current French economic policies in a publication called France Country Monitor.  They examine the recent developments in monetary (the ECB) and fiscal (French government) policies and their outlooks.  This source presents the data (e.g. changes in key interest  rates, changes in Eurozone and French GDP, growth in private loans, changes in national deficit and debt, etc.) and then provides an analysis of what the data indicates.  Many of the sources that are used in this paper offer information on events that have already happened, but this publication provides economic projections based on the available data.  While it is only speculation, it is important to understand the potential effects of the crisis on the banking industry in addition to the antecedent effects.

The article written by James Neuger, titled “EU Cuts 2013 Growth Forecast as Crisis Weighs on Germany,” provides a macroeconomic and fiscal outlook for France and the Eurozone.  Neuger, citing the European Commission, reports that “the 17-nation euro economy will expand 0.1% in 2013, down from a May [2012] forecast of 1%.” (Neuger, 2012)  This poor growth outlook follows a 0.4% contraction of the euro area economy in 2012.  European forecasters also decreased economic growth predictions for both Germany and France.  The data presented in this source demonstrates the effects of the crisis on the stronger European countries, explains how and why the crisis continues to worsen, and offers insight on France’s weakening competitiveness due to the economic decline.

“A Less Magnifique Era for French Banks,” written by Bloomberg reporter Fabio Benedetti-Valentini, focuses on the three largest French banks by market value: BNP Paribas, Société Générale, and Crédit Agricole.  The author reports that, due to their high exposure to Greek debt (Greek bonds), these banks have experienced about 5.4 billion euros in losses in the last year. (Benedetti-Valentini, 2012)  This source also addresses the job cuts that the French banks had to make in early 2012, signifying the macroeconomic consequences of the debt crisis.  According to Benedetti-Valentini, Société Générale cut 1,800 jobs in France during the first quarter of 2012, while BNP Paribas and Crédit Agricole cut 373 and 550 jobs, respectively, from their corporate and investment banking divisions. (Benedetti-Valentini, 2012)  The reporter asserts that these reductions of their “home” workforces are contributing to investor and depositor fears and, therefore, making it difficult for Paris to regain any business leadership.

Benedetti-Valentini also published three articles in November of 2012 via Bloomberg, which provide pertinent analyses of the third quarter results of BNP Paribas, Société Générale, and Crédit Agricole.  The first article, entitled “BNP Paribas Third-Quarter Net Doubles on Trading Gains,” explains that the bank was able to increase profits by disposing of risky assets, cutting jobs, and encouraging consumer banking.  In addition, the European Central Bank issued 1 trillion euros in long-term loans to the bank in September of 2012; these loans, which primarily took the form of bond buybacks, helped to stabilize the bank’s funding situation. (Benedetti-Valentini, BNP Paribas Third-Quarter Net Doubles on Trading Gains, 2012)  The second article, “SocGen Quarterly Net Falls 86% on Debt Charge, Greek Sale,” paints a different picture for France’s second largest bank.  According to a statement made by Société Générale, “net income for the bank dropped to 85 million euros from 622 million euros a year earlier.” (Benedetti-Valentini, SocGen Quarterly Net Falls 86% on Debt Charge, Greek Sale, 2012)  The author explains how the sale of the bank’s Greek unit, the losses amassed from the toxic assets remaining from the U.S. subprime mortgage crisis, and other debt write-downs contributed to their poor performance this quarter.  Benedetti-Valentini’s third article discusses Crédit Agricole’s extensive third quarter losses; Crédit Agricole is France’s third largest bank by market value.  The author states that the bank incurred a net loss of 2.85 billion euros ($3.62 billion) during the months of July, August, and September in 2012.  This was primarily due to the sale of the bank’s Greek unit, Emporiki, at a loss of 1.96 billion euros. (Benedetti-Valentini, Credit Agricole Posts $3.6 Billion Loss after Greek Sale, 2012)  The article identifies other sources of debt that contributed to the income losses and also how Crédit Agricole is attempting to curb these deficits in the coming months.  These articles offer a more in-depth understanding of the current state of France’s three largest banks and, therefore, illustrate the grander picture that is the French banking industry.

The International Monetary Fund publishes their comprehensive economic reports, the World Economic Outlook, semi-annually; these reports include crucial data on every country in the world and analyses of the global trends that are occurring at the time of publication.  Because the Eurozone debt crisis has become such a widespread epidemic, it has been a major topic in the last few publications.  The World Economic Outlook of October 2012 provided statistics on euro area unemployment levels, debt ratios, gross domestic product, current account balances, and other useful and insightful data.  The International Monetary Fund website where the publications can be found also allow visitors to create their own data tables.  This feature made it possible to compare the economic indicators of European countries with those of the United States.

French banks are required to publish annual reports that include details about their executive boards, their financial standings for the year ended, their plans and policy changes for the upcoming year, their social responsibility, etc.  BNP Paribas, France’s largest bank by total assets, and Société Générale, the country’s second largest bank, have made their reports available to the public on their websites.  These publications provide the data needed to quantify the effects of the debt crisis on these banking conglomerates; the banks also publish quarterly reports that offer more recent financial figures, which is crucial as the debt crisis continues its daily progression.  The annual and quarterly reports of BNP Paribas and Société Générale allow for comparisons between the previous years’ data with respect to net income profits and losses, earnings per share, and other figures that are necessary in order to tell the story of the Eurozone debt crisis.

Beginning of the Eurozone and the European Central Bank

The Eurozone was created on January 1, 1999.  The original members included Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland; Greece joined on January 1, 2001, and the last five countries joined between 2007 and 2011. Euro banknotes and coins were officially introduced in 2002. According to the official European Union website, in order to become a member of the monetary union, each country had to meet a specific convergence criteria, which includes price developments (e.g. maintaining inflation rate), fiscal developments (e.g. excessive deficit and debt procedures), and long-term interest rate developments (e.g. maintaining interest rates relative to member states). (Europa, 2006)

The European Central Bank, in collaboration with the central banks of the member states, was established to govern the Eurozone, with the primary task of maintaining the euro’s purchasing power and therefore maintaining price stability within the euro area. (The European Central Bank, 2012)  The principal administrative body of the ECB is the Governing Council, comprising the six members of the Executive Board and the governors of the national central banks of the seventeen Eurozone countries. (The European Central Bank, 2012)  Therefore, the governors of the national central banks are held accountable to the entire euro area as well as their own political sphere. In his report on the sociology of the euro, Nigel Dodd argues that, because the majority of the voting members of the Governing Council are actually governors of their own national banks, questions of accountability, interests, and outlooks should be raised. (Dodd, 2001, p. 28)

In 2004 the Greek administration admitted that the country joined the Eurozone in 2001 despite the fact that their budget deficit exceeded the obligatory limit (3% of GDP); Greece falsely recorded their financial figures from 1997 to 2001 so the deficit would appear lower than it was. (Greece admits fudging euro entry, 2004)  “The government initially disguised the true state of its finances with the help of U.S. bankers. Goldman Sachs, for example, did off-market currency trades with the government of Greece.” (Lewis, 2011)  Yet, Greece was still allowed to join the monetary union because other founding countries, such as Germany and France, had joined under similar pretenses, though their deficit levels were not nearly as high as Greece’s.  Once Greece had joined the Eurozone, the country was able to borrow money as easily as the more reliable countries like Austria and the Netherlands.  Jack Ewing explains that not only did Greece exploit this borrowing ability often, but Germany and France continued to lend money to the government despite being aware of the country’s debt discrepancies so that Greece, as well as Spain and Italy, could use the borrowed money to buy French and German exports. (Ewing, In Euro Crisis, Fingers Can Point in All Directions, 2012)  Moreover, these leading euro nations continually lent money to Spanish banks, property developers, and home-buyers; these loans helped fuel a real estate bubble in Spain in the years leading up to the crisis that inevitably popped when the Eurozone debt crisis began.  Consequently, the French and German lenders have been withdrawing their funds from the risky nations and moving them to safer places, which in turn oblige these countries to borrow even more money to replace the fleeing funds. (Knight, 2012)

The Eurozone Debt Crisis

In 2008 the Eurozone was beginning to feel the effects of the global financial crisis that began in the United States; in December of that year, EU leaders settled upon a 200 billion euro stimulus plan to encourage European growth and halt any concerns that their markets would be significantly influenced by the American crisis.  In the months following, the extent of Greece’s financial problems, and the other nations’ soon thereafter, became clear.  After revising the irregularities in their accounting procedures, the Greek budget deficit increased from 3.7 in 2008 to 12.7 in 2009 as a percent of the country’s GDP. (Timeline: The Unfolding Eurozone Crisis, 2012)  As the global economy weakened, interest rates rose, unemployment increased, and the financial sectors of the Eurozone incurred more and more debt.  The economies and banking industries of Ireland, Italy, Portugal, and Spain were more heavily influenced by the economic downturn because of the slow growth they had experienced over the last decade.  As stated in Carr’s article from The Economist:

Even where troubled euro-zone countries had not been profligate[1], they have been running unsustainable current-account deficits. Low interest rates fueled domestic spending and spurred inflation in wages and goods, which in turn made their exports more expensive and left imports relatively cheaper. (Carr, 2011)

Due to the increased risks of investing in these countries, their banks continued to weaken, bond prices fell, and growth came to a halt.  “Because the likelihood of a Greek default was increasing, investors demanded a higher yield on the Greek bonds they bought, pushing up the cost of borrowing for Greece and creating a vicious cycle.” (Burn-Murdoch, 2012)  This cycle of increased government borrowing/spending, increased interest rates, and decreased investments has created what is called the “crowding out effect.”  The euro area nations have borrowed so much capital in order to finance government debt that interest rates have increased for other types of borrowing, which has led to the crowding out of private consumption and investment. According to the secretary of the U.S. Treasury, Timothy Geithner, “higher borrowing costs for households and businesses discourage future private investment, lower capital stock, lessen economic growth, and depress the standard of living.” (Geithner, 2011)

 Capturex

Table 1. Debt to GDP Ratios in the Eurozone

Source: IMF World Economic Outlook Database (2012)

Bond investors, who underpriced the risk of Greek debt prior to 2010, and credit rating agencies are also major wrongdoers of the Eurozone debt crisis.  A credit rating is an evaluation of a country’s or institution’s ability to pay back its debt; a high credit rating indicates less risk so investors are more willing to invest in or lend to those governments or corporations with a higher rating. The foremost credit rating agencies are Standard & Poor’s (S & P’s), Moody’s, and Fitch.  These agencies, especially S & P’s, have had no qualms about downgrading countries and their banks at the first sign of risk or instability since the start of the crisis.  Even the credit rating of the ECB’s bailout fund, the European Stability Mechanism, has been reduced.  In his article from Forbes, Steve Schaefer argues that countries with impaired credit ratings have less capacity to support their banks; therefore, the ECB has begun to serve as lender-of-last-resort to Europe’s banks, much like the Federal Reserve of the United States. (Schaefer, 2012)  In January of 2012, Standard & Poor’s downgraded nine different euro area nations, including France.  France was just hit again by Moody’s in November of 2012, losing its prized rating of AAA.  The credit rating agencies cite the French banks’ vulnerability to the debt crisis as one of the reasons they reduced the country’s credit rating. The three largest banks in France have all received credit downgrades as well.  While it is crucial for investors to understand the risk involved when considering financial transactions, these downgrades have provided serious momentum to the vicious cycle of the debt crisis.  After a bank’s credit is relegated, the stock oftentimes drops and investors lose confidence in the institution, as has been the case with BNP Paribas, Société Générale, and Crédit Agricole, which only exacerbate a bank’s financial problems (e.g. lack of capital).

Over the last four years, the ECB, the IMF, and the sovereign countries have introduced a number of measures in an attempt to curb the crisis. By the summer of 2011, Portugal and Ireland had each received bailout packages from the ECB and the International Monetary Fund (IMF), while Greece had received two bailouts amounting to a total of 219 billion euros; the Eurozone and the IMF agreed on the first Greek bailout in May of 2010, and, after conditions worsened, agreed on a second bailout package in July of 2011. (Timeline: The Unfolding Eurozone Crisis, 2012)  To fund these bailouts, European leaders established a bailout fund called the European Stability Mechanism (ESM) that has a lending capacity of 500 billion euros.  However, Jack Ewing from The New York Times argues that the ESM will still not be enough to compensate for a downfall in investor confidence in both Spain and Italy. (Ewing, The Euro Zone Crisis: A Primer, 2012)  Since the end of 2011 and the inauguration of a new president, Mario Draghi, the Governing Council of the European Central Bank has steadily decreased its key interest rates as well as the minimum required reserve ratio (currently at 1%) for banks so that they are able to lend out more money.  On July 5, 2012, the ECB decided to lower its key interest rate to a historic low of 0.75%. (ECB: Timeline of the Financial Crisis, 2012)  These record lows are a sort of double-edged sword in that the low interest rates allow banks to borrow more easily and inexpensively, yet there is now little to no room left to use interest rates as economic stimulus.  To lower them any more could be just as detrimental as deflation becomes a real possibility. While the expansionary monetary policies, debt swaps, and bail-out packages are helping, the fragile euro area nations still lack the financial resources to support their weakening banks; the banks need capital, and, with so many credit rating downgrades, there are few investors willing to provide the necessary funds.

State of the Political and Economic Climate in France

In May of 2012, the conservative French president, Nicolas Sarkozy, was ousted by François Hollande, a member of the Socialist Party of France, by consistently advocating pro-growth economic policies.  Yet, just six months after being elected, the new president’s popularity had dropped to a record low of 36% of public support due to his administration’s communication errors and Hollande’s seemingly indecisive, inactive performance. (Chrisafis, 2012)  Nevertheless, the French president has been taking measures to stimulate business and reduce the country’s record trade deficit so as to improve the country’s competitiveness.  In November of 2012, President Hollande announced plans to lower labor costs, boost corporate investment, and facilitate small and medium-sized business expansion through fiscal incentives (i.e. tax cuts).  (Vinocur, 2012)  However, the competitiveness package has received much criticism as many believe that these measures will not be nearly enough to resuscitate French commerce.  Hollande is continuing Sarkozy’s work with German Chancellor Angela Merkel and the other euro area leaders to combat the debt crisis, and he has made promises to significantly reduce the French deficit.  Yet, because of the poor growth in 2012 and the negative projections made for 2013, the European Commission does not believe that France will meet “its target of cutting the budget deficit to the euro-area limit of 3 percent of GDP in 2013 and keeping it there in 2014.” (Neuger, 2012)  Hollande has stated that he prefers a partial pooling of debt through Eurobonds and has stressed that he wants “to see progress towards Eurozone-wide regulation of the banking sector before the end of the year [2012] as a prelude towards greater shared decision-making in all areas of economic and monetary policy.” (Eurozone ‘very near’ to end of crisis, says Hollande, 2012)  Hollande had plans to pass legislation in December of 2012 that would separate the French banks’ retail (commercial) and investment activities with the aim of isolating banks’ more speculative activities and thereby increasing domestic bank regulation. (Daneshkhu & Carnegy, 2012)  However, when the bank reforms were unveiled, they were found to be much less tough and much more timid than had been promised.  In the end, the reforms kept the French banks’ model of combined retail and investment banking intact.  One of the most controversial reforms from the bill was the creation of a resolution fund.  The law now requires French banks to collectively contribute 2 billion euros, rising to 10 billion euros by 2020, to a fund that will pay out if a bank begins to fail.  They may be obligated to increase their contribution if a bank bailout becomes necessary.  Some argue that this is an excellent way for banks to protect themselves against failures without depending on the French government, while others argue that this places a financial burden on the already struggling banks and requires them to help their competitors.  Nevertheless, with the changes made, the law has put “France in the leading position in Europe in regulating banking activity.” (Daneshkhu & Carnegy, 2012)

France is currently the second largest economy in Europe with a GDP of 2.17 trillion euros ($2.77 trillion) in 2011; Germany is the largest economy with a 2011 GDP of 2.76 trillion euros ($3.57 trillion). (The World Bank Group, 2012)  After seeing negative growth (-2.7%) in 2009, the French economy experienced positive growth (1.7%), albeit very slow, in 2010 and 2011. (Eurostat, 2012)  Growth dropped off even more in 2012, with the economy expanding only 0.5%. GDP is predicted to bounce back slightly with an estimated growth of 1.3% in 2013. (Eurostat, 2012)  In the third quarter of 2012, France’s GDP increased by a mere 0.2%, barely avoiding a recession as the country has not recorded any economic growth since 2011. (Di Lorenzo, 2012)  Because of its size and economic position, France is considered a core country of the Eurozone and of Europe as a whole. As the debt crisis worsens and European economies become more unstable, a lot of focus has turned to protecting and strengthening France.

By the summer of 2012, the unemployment rate in France had risen to its highest level in thirteen years.  “The rise in unemployment to 10.2 percent, measured according to the International Labour Organisation’s (ILO) criteria, comes as the Eurozone’s second-largest economy has posted three consecutive quarters of zero growth.” (Reuters, 2012)  Unemployment increased even more by the third quarter, rising to 10.8%.  This drop in employment is a major contributing factor to Hollande’s unpopularity. Furthermore, according to the French Finance Ministry, France’s high trade deficit (approximately 5 billion euros) and the sharp decline in the country’s competitiveness has diminished exports and caused around 750,000 factory jobs to be lost over the past decade. (Reuters, 2012)

Other factors that are hindering France’s competitiveness are the rigid labor laws and high labor costs.  Employees in France are only required to work thirty-five hours per week and receive several weeks of paid vacation time in addition to the many national holidays that the country celebrates.  Labor unions are a major player in French politics so changing the 35-hour law would most likely be the demise of President Hollande.  Because of the unions’ influence, it is also very difficult to let go of senior employees and hire younger, fresher applicants, which is why youth unemployment has reached 22.7% for French citizens aged 15 to 24 years old.

Conditions of the French Banking Industry

Since the Eurozone debt crisis began, France’s three largest lenders, BNP Paribas, Société Générale, and Crédit Agricole, have received credit rating downgrades due to the interrelated risks between France (whose credit rating was downgraded in January and November of 2012) and the other euro area nations, particularly Greece, Spain, and Italy. BNP Paribas now has an A+ rating from Standard & Poor’s, an A2 from Moody’s, and an A+ from Fitch. (BNP Paribas Group, 2012)  Société Générale has an A rating from Standard & Poor’s, an A2 from Moody’s, and an A+ from Fitch. (Société Générale Group, 2012) Crédit Agricole has an A rating from Standard & Poor’s, an A2 from Moody’s, and an A+ from Fitch. (Credit Agricole Group, 2012)  In comparison, Germany’s (and Europe’s) largest bank by total assets, Deutsche Bank, has an A+ rating from S & P’s, an A2 rating from Moody’s, and an A+ from Fitch. (Deutsche Bank, 2012)  The political and regulatory contingencies of the French Socialist government as well as their cross-border exposure to Italy, who is currently in a recession, have greatly influenced the credit agencies’ decisions to either downgrade the banks’ ratings or change the banks’ outlook from “stable” to “negative.” (Laurent, 2012)  However, the downgrades typically generate short-term effects, such as a drop in stock price, rather than any long-term consequences.

In March of 2013, Moody’s released a report that maintained the outlook for the top French banks’ as negative. The ratings agency cited the banks’ “continued reliance on wholesale funding[2]” as the primary reason for this outlook, as wholesale funds made up 35% of total cash on the balance sheets for the major banks at the end of 2012. (Plumb, 2013)  Though the credit ratings agencies predict the banks’ profits to recover in 2013, they still believe that France’s exposure to countries like Italy and Spain present too large of a risk to change their outlook.

Table 2. Bank Credit Ratings

Bank Present Credit Rating
BNP Paribas A+ (S&P’s), A2 (Moody’s), A+ (Fitch)
Société Générale A (S&P’s), A2 (Moody’s), A+ (Fitch)
Crédit Agricole A (S&P’s), A2 (Moody’s), A+ (Fitch)
Deutsche Bank A+ (S&P’s), A2 (Moody’s), A+ (Fitch)

Note.  S & P’s highest ratings: AAA, AA+, AA, AA- ; Moody’s highest ratings: Aaa, Aa1, Aa2, Aa3; Fitch highest ratings: AAA, AA+, AA, AA-

The net income of BNP Paribas, the largest French lender, actually increased by 2 billion euros between 2009 and 2010, but the bank experienced a 1.7 billion euro loss between 2010 and 2011.  In the third quarter of 2011 alone, the bank’s “net income fell 72% because of Greek [debt] write-downs and losses from selling European government bonds.” (Benedetti-Valentini, A Less Magnifique Era for French Banks, 2012)  That year, BNP Paribas took a total loss of 3.2 billion euros in write-downs on Greek government debt. (Benedetti-Valentini, BNP Paribas Third-Quarter Net Doubles on Trading Gains, 2012)  Though BNP Paribas’ Greek debt holdings severely hurt their financial standings in 2011, they were able to reduce their net Greek sovereign debt exposure from 1 billion euros to 0.2 billion euros just in the first quarter of 2012. (BNP Paribas Group, 2012)  According to the Fixed Income Presentation published by the bank, this was accomplished because the European Central Bank implemented a program that allowed the bank to exchange 15% of the face value of old Greek bonds for bonds issued by the ECB’s emergency loan fund called the European Financial Stability Facility (EFSF). (BNP Paribas Group, 2012)  In fact, BNP Paribas recently reported that their profits have more than doubled in the third quarter of 2012. However, at the end of the year, BNP Paribas performed a 298 million-euro “goodwill write-down” of its Italian unit, Banca Nazionale del Lavoro, resulting in a 33% decline in fourth-quarter profits. (Benedetti-Valentini, BNP Paribas Plans Cost Reductions as Fourth-Quarter Net Falls, 2013)  Crédit Agricole has an Italian banking unit as well, and it is this deep-rooted exposure to Italy’s suffering economy that has intensified investors’ fears. It is also important to note that, despite the debt write-offs and haircuts, BNP Paribas still holds a substantial amount of Greek private debt as well as public and private debt from other Eurozone countries.

In 2011, Société Générale reported 2.4 billion euros in net income[3], marking a 2.5% decrease in net income from 2010.  In an effort to reduce risks affiliated with Greece, Société Générale sold its Greek unit, Piraeus Bank SA, last quarter at a loss of 130 million euros.  The bank also “booked an accounting charge of 389 million euros tied to the theoretical cost of buying back its own debt as market prices fluctuate.” (Benedetti-Valentini, SocGen Quarterly Net Falls 86% on Debt Charge, Greek Sale, 2012)  Because Société Générale was already reporting significant losses from the Greek sale and other bad assets, it can be speculated that the bank decided to record this theoretical cost to avoid having to do so in the future.  Essentially, they could write off a lot of their debt and report one terrible quarter, and then focus on increasing profits and growth in the upcoming quarters.  In the third quarter of 2012, Société Générale was able to reduce their risk-weighted assets by 5.4 billion euros and has sold 16 billion euros of assets since June 2011 in order to create a capital buffer for the banking group. (Benedetti-Valentini, SocGen Quarterly Net Falls 86% on Debt Charge, Greek Sale, 2012)  The income losses from the third quarter led to the three main credit rating agencies changing Société Générale’s outlook from “stable” to “negative.”  Société Générale reported a fourth quarter net loss of 476 million euros following a goodwill write-down of its share in Newedge Group, a derivatives brokerage firm, and allocating 300 million euros for undisclosed legal issues. (Benedetti-Valentini, SocGen Posts Fourth-Quarter Loss on Newedge, Legal Expenses, 2013) Despite the bank’s significant profit decline, its stock price has been steadily increasing over the last few months indicating that investors have confidence in the growth prospects of the bank.

In addition to risky asset disposal, BNP Paribas, Société Générale, and Crédit Agricole made significant job cuts at the start of 2012.  Combined, the banks cut about 10% of their staff in their corporate and investment banking (CIB) units; Crédit Agricole’s CIB unit cut 550 jobs in France and 1,200 jobs abroad, while BNP Paribas laid off 373 employees in France. (Benedetti-Valentini, A Less Magnifique Era for French Banks, 2012)Société Générale notably laid off 14% of their French CIB unit employees and has continued to make cuts throughout the year.

Conclusion

Salvaging the banking industry is the most direct way to repairing the situation in the euro area.  Healthy banks facilitate growth by lending money to businesses, which allow them to hire more employees, expand operations, and even invest in the financial markets.  Well-functioning banks also lend to individuals/households and therefore increase personal consumption and investment.  A sound banking industry is crucial to maintaining effective financial markets which economists argue is the key to a healthy, progressive economy. While the recapitalizing of the banks by Eurozone nations has helped, simply injecting capital will not save the banks. The banks must restore investor confidence, improve their competitiveness, rebuild their personnel, and continue to reduce their risky assets.

France’s three largest banks have been taking the necessary steps to improve their financial standings and, in turn, the investors’ opinions of the banks.  BNP Paribas, Société Générale, and Crédit Agricole have performed significant Greek debt write-downs, and the latter two have both sold their Greek banking units in an effort to reduce their exposure to Greek debt/assets.  The French banks have been trimming their balance sheets over the last couple of years to dispose of toxic assets like subprime mortgages from the United States, Greek bonds, Italian bonds, and Spanish private loans.  By November of 2012, French banks were able to “cut debt holdings in Europe’s troubled periphery by more than 35 percent since the start of the euro-area crisis,” but they continue to struggle to ditch their image as refuges for the euro area’s troubles. (Benedetti-Valentini, BNP, SocGen Fight French Banks’ Euro-Crisis Proxy Label, 2012)  Because French banks have the largest exposure to Eurozone debt, they must tread very carefully throughout the remainder of the crisis so investors do not lose confidence in their ability to pay off their own debts.

An avenue that the banks and other French firms have begun to explore is that of American and Asian lenders.  France’s banks have been unwilling or unable to provide loans for small- and medium-sized companies so they have started to turn to the U.S. private debt market. (Plumb, 2012)  As the American economy has begun to improve, lenders are more capable of offering funds to French firms.  Asian lenders in progressive countries like China, Japan, and Singapore, have also shown their willingness to loan money to European banks and businesses.  In fact, in April of 2013, Iceland, whose economy is on par with that of Portugal, Spain, Italy and Ireland, became the first European country to sign a free trade agreement with China.  Iceland is not a member of the European Union or the Eurozone, but it is this kind of agreement that other European nations should consider to help mend their economies.  The free trade agreement between China and Iceland will eliminate most tariffs over the next few years and will open doors to bilateral investments. (Jolly, 2013)  By taking this first step, Iceland has created an opportunity for its financial institutions to find other sources of credit and funding.  If the French banks continue to demonstrate their methods of facilitating growth and increasing revenues, foreign markets, like China, will become more accessible creating a larger capital buffer for French institutions.

The Eurozone debt crisis has developed into a prolific, global phenomenon that is becoming increasingly relevant to the United States and the impending debt crisis, which renders this a very important topic to investigate and understand.  The Eurozone debt crisis evolves everyday so it is necessary to remain informed and up-to-date on the status of the euro area nations and their financial markets.  The implications of a “debt crisis” for economies as large as the U.S. and the Eurozone are huge, and finding viable solutions for the Eurozone is necessary if the U.S. is to avoid a similar situation.

References

Greece admits fudging euro entry. (2004, November 15). Retrieved October 2012, from BBC News: http://news.bbc.co.uk/2/hi/business/4012869.stm

ECB: Timeline of the financial crisis. (2012). Retrieved October 3, 2012, from The European Central Bank: http://www.ecb.int/ecb/html/crisis.en.html

Eurozone ‘very near’ to end of crisis, says Hollande. (2012, October 17). France24.

Timeline: The unfolding Eurozone crisis. (2012, June 13). Retrieved September 2012, from BBC News: http://www.bbc.co.uk/news/business-13856580

Benedetti-Valentini, F. (2012, January 30). A Less Magnifique Era for French Banks. Bloomberg Business Week, pp. 47-48.

Benedetti-Valentini, F. (2012, November 7). BNP Paribas Third-Quarter Net Doubles on Trading Gains. Bloomberg.

Benedetti-Valentini, F. (2012, November 30). BNP, SocGen Fight French Banks’ Euro-Crisis Proxy Label. Bloomberg.

Benedetti-Valentini, F. (2012, November 9). Credit Agricole Posts $3.6 Billion Loss After Greek Sale. Bloomberg.

Benedetti-Valentini, F. (2013, February 14). BNP Paribas Plans Cost Reductions as Fourth-Quarter Net Falls. Bloomberg.

Benedetti-Valentini, F. (2013, February 13). SocGen Posts Fourth-Quarter Loss on Newedge, Legal Expenses. Bloomberg.

BNP Paribas Group. (2012). 2011 Annual Report. Paris: BNP Paribas.

BNP Paribas Group. (2012). Fixed Income Presentation. Paris: BNP Paribas.

BNP Paribas Group. (2012). Results as at 30 September 2012. Paris: BNP Paribas.

Burn-Murdoch, J. Q.-H. (2012, March 6). Greece’s bailout bond swap explained. The Telegraph.

Carr, E. (2011, November 12). A very short history of the crisis. The Economist.

Chen, R. M.-F. (2012). External imbalances in the Euro Area. International Monetary Fund.

Chrisafis, A. (2012, November 1). Why Francois Hollande’s popularity has plummeted. The Guardian.

Credit Agricole Group. (2012, November 18). Ratings. Retrieved November 21, 2012, from Credit Agricole: http://www.credit-agricole.com/en/Finance-and-Shareholders/Debt/Ratings

Daneshkhu, S., & Carnegy, H. (2012, December 19). France unveils bank reforms. The Financial Times.

Deutsche Bank. (2012, November 10). Ratings. Retrieved November 20, 2012, from Deutsche Bank: https://www.db.com/ir/en/content/ratings.htm

Di Lorenzo, S. (2012, November 15). Frace avoids recession; GDP up 0.2 pct in Q3. Bloomberg Businessweek.

Dodd, N. (2001, March 2001). What is ‘sociological’ about the euro? European Societies, pp. 23-39.

Europa. (2006, July 12). Introducing the Euro: Convergence criteria. Retrieved October 16, 2012, from Europa: http://europa.eu/legislation_summaries/other/l25014_en.htm

Eurostat. (2012). France. Brussels: The European Commision.

Ewing, J. (2012, August 24). In Euro Crisis, Fingers Can Point in All Directions. The New York Times.

Ewing, J. (2012, May 22). The Euro Zone Crisis: A primer. Retrieved November 2, 2012, from The New York Times: Economix: http://economix.blogs.nytimes.com/2012/05/22/the-euro-zone-crisis-a-primer/

Flynn, D. (2012, September 6). French unemployment hits 13-year high. Reuters.

Fontevecchia, A. (2011, June 27). French Banks Hold $93B In Greek Debt As Sarkozy Announces Rollover Deal. Forbes.

France Country Monitor. (2012). Economic policy. Paris: Global Insight.

Geithner, T. (2011, May 17). Remarks by Secretary Tim Geithner . Retrieved November 19, 2012, from US Department of the Treasury: http://www.treasury.gov/press-center/press-releases/pages/tg1179.aspx

Gross, T. L. (2011, October 4). How The Financial Crisis Created A ‘New Third World’. Philadelphia, PA, USA.

International Monetary Fund. (2012). World Economic Outlook Database. Washington, D.C.: IMF.

Jolly, D. (2013, April 15). Iceland and China Enter a Free Trade Agreement. The New York Times.

Knight, L. (2012, May 18). Spanish economy: What is to blame for its problems? BBC News.

Laurent, L. R. (2012, October 26). French bank stocks drop after BNP downgrade. Reuters.

Lewis, M. (2011, October 4). How The Financial Crisis Created A ‘New Third World’. Philadelphia, PA, USA.

McClain, D. (2012, June 14). Understanding the European crisis now. The New York Times.

Neuger, J. (2012, November 7). EU cuts 2013 growth forecast as crisis weighs on Germany. Bloomberg Businessweek.

Plumb, C. (2012, November 12). French firms tap private US lenders as banks run dry. Reuters.

Plumb, C. (2013, March 25). Moody’s says French banks’ outlook still negative, cites funding. Reuters.

QFinance. (n.d.). QFinance Dictionary. Retrieved March 19, 2013, from QFinance: http://www.qfinance.com/dictionary/wholesale-funding

Reuters. (2012, November 8). French trade deficit narrows in September. Reuters.

Reuters. (2012, November 5). S&P on La Banque Postale. Retrieved November 6, 2012, from Reuters: http://www.reuters.com/article/2012/11/05/idUSWNA887920121105

Schaefer, S. (2012, January 17). Banks: The next domino to fall in European ratings game. Forbes.

Societe Generale Group. (2012). 2011 Activities and Results. Paris: Societe Generale.

Societe Generale Group. (2012). Quarterly Financial Information. Paris: Societe Generale.

The European Central Bank. (2012). ECB, ESCB and the Eurosystem. Retrieved October 4, 2012, from The European Central Bank: http://www.ecb.int/ecb/orga/escb/html/index.en.html

The World Bank Group. (2012). Countries and Economies. Retrieved September 29, 2012, from The World Bank: http://data.worldbank.org/country

Vinocur, N. (2012, November 5). France to unveil measures to boost competitiveness. Reuters.


[1] Spanish sovereign debt was only 36% of the country’s GDP in 2007, compared to Germany whose debt to GDP ratio was 65%. (Knight, 2012)

[2] Wholesale funding is a method of funding banks by short-term borrowing from other banks and financial institutions. (QFinance)

[3] Comparatively, BNP Paribas reported a net income of 6.1 billion euros in 2011. (BNP Paribas Group, 2012)

How Latin American Firms Reconcile Corporate Strategy with Government’s Regional Innovation Strategy

Author: Joseph J. Bingel

Introduction

This article analyzes how a Latin American business manages its own business strategy with government’s cluster strategy. This article also takes a look at what kind of incentives governments are using to increase collaboration in clusters. Why should a company respond to goals from a regional government to promote science and technology? Is participating in clusters worth it for the business? How effective is the regional innovation cluster strategy anyway? This innovation strategy comes with a variety of challenges. Indeed, on the micro level, it is difficult to get companies to work with government and coordinate strategies. On the macro level, government has trouble determining which clusters will be sound investments for the country’s future. The crux of this overall analysis is at what point do these two strategies intersect and work for both business and government. In particular, this paper will look at firms in Costa Rica and Argentina and how they operate within their clusters and work with governments’ goals.

Regional Innovation Clusters (RIC) Strategy

 What is a Cluster?

Before applying the cluster concept to business and government relations in Latin America, it would be helpful to have some background on what a cluster actually is and the increasing role it is playing in countries all around the world. According to Michael Porter, professor at Harvard University, a cluster is a “geographic concentration of competing and cooperating companies, suppliers, service providers and associatedinstitutions” (Porter).  The goal for policy makers is to encourage the collaboration and circulationbetween these masses of people that innovate, implement and financially support creative ideas (Florida).  Economist Charles W. L Hill states that RIC strategy is the first theory that develops a strong connection between the cluster actors on multiple dimensions (Smith). This strategy stems from Porter’s diamond. Porter devised this hypothesis to apply to firms at first. Today, this concept explains the forces that shape an industry and determine a region’s productivity. The four major conditions Porter outlines in his construct are demand conditions; firm strategy and competition; suppliers; and factor conditions (such as financial resources, human resources, natural resources and information technology) (Porter). Moreover, Porter’s Diamond model describes the role of federal government as a“catalyst and challenger; it is to encourage- or even push- companies to raise their aspirations and move to higher levels of competitive performance” (Diamond model).

Why do Clusters Matter?

Economist Richard Florida states that the world is becoming “more spiky.” This means that cities are the level of analysis and that fewer regions matter. Furthermore, this global change demonstrates that the meaning of space is crucial. Florida believes that these regions first need to attract talent. From there, the lifestyle incentives that emerge cause agglomeration which then leads to knowledge spillovers. The innovation that results from this snowball effect precipitates a robust regional economy (Florida). On a national scale, economists attribute 50 percent of US annual GDP growth to the overall development of innovation (measuring regional innovation) (Council). Of course, policy makers need to focus on existing clusters in order to bring about Florida’s vision (Cluster Observatory). The way to accomplish this is by tailoring public policy to specific regions; directing attention to their special strengths and assets (Porter).

People agglomerate at clusters because of economies of scale, knowledge spillovers and productivity advantages (Florida). In particular, traded clusters that attract talent with higher wages lift up satellite regions as well (Porter). Surely, driving up average wages in traded industries can bring about prosperity. Most people perceive these kind of industries as “high-tech” and knowledge-intensive, such as business and distribution services along with education.

The Face of Innovation

Many economists preach the need for innovation, but what does it actually look like? According to the National Innovation Initiative (NII), innovation means efficiency, multiple disciplines, collaboration and democratization. First, in the context of clusters, efficiency refers to the speed at which technology advances and commercializes. Second, innovation is multidisciplinary as many creative ideas can arise from the industries and fields that combine. Third, innovation involves collaboration and circulation of ideas between multiple groups. Lastly, innovation is not exclusive, but rather democratized where transportation and telecommunication can make creativity come from anywhere. Innovation also has three inputs: assets, networks and culture. Assets refer to the particular strengths and weaknesses of a region along with its infrastructure, R & D, human capital, legal environment and quality of life. Networks imply the partnerships between businesses, government and other entities. In particular, angel capitol networks have a tremendous impact on a region’s innovation. Culture is the last input that describes the attitude of the ecosystem that relates to risk-taking, openness and racial diversity (Michael).

Once government decides to build up a regional cluster, it also needs to measure innovation output. Innovation is manifest in the unemployment rate, employment growth rate, wages, cost of living index, number of initial public offerings (IPO’s), number of patents, value of venture capital and other metrics (Michael).

The Importance of Collaboration

Collaboration is the next step in sparking this chain reaction of innovation. Financiers, government agencies, universities, media and non-profit organizations all need to work together in order to generate creative solutions to complex problems. For instance, some cities and regions may house numerous researchers in the areas of science and technology (Council). Economists, however, find that these very regions may see slow commercial adaptation because of a lack of collaboration (Florida). R&D investment and research centers without communication between the regional actors will not guarantee innovation output. Staffan Bjurfulf, a regional advisor in Sweden, emphasizes that collaboration is a necessary social process. The ultimate objective is to build the essential trust between businesses and other entities. The success of a cluster depends on the synergy between all of these actors. A way for governments to build trust is by incentivizing local firm interaction (Michael). One program that already exists is Partnerships for Innovation through the National Science Foundation that supports inter-cluster effort (Feldman).

Why Clusters Fail Globally

Clusters fail globally for a variety of different regions. Three ways a cluster can go under is through the lack of collaboration between the cluster actors, decreasing demand in the cluster products, competition from other clusters or from or the ineffectiveness of the organizational structure. In general, there are two ways that a government can prevent these situations from happening. The first is called catalytic strategy, where governments will initiate the cluster development but leave the rest to individual cluster actors. However, government will follow up by encouraging efforts from the private sector.  The second is called supportive strategy, where government supplements catalytic policies with investments geared towards training, education, promotional support and infrastructure (Brocker).

Criticism of RIC Strategy

On a theoretical level, RIC strategy has received a lot of criticism. Some opponents claim that globalization renders this strategy uncertain. They say that because trade is more open and transportation more efficient, clusters cannot defend a country’s economy (Italian Industry). The belief is that the world is becoming flatter and that talent no longer needs to migrate to clusters. Friedman, a proponent of this idea, asserts that the world is more flat because of advances in technology. He claims the “global playing field has been leveled. You do not have to emigrate to innovate” (Feldman). Richard Florida, on the other hand, argues that the world only appears flat because “economic and social distances between peaks worldwide have gotten smaller.” This is because of the increased mobility of the “creative class,” which accounts for about 150 million people world-wide.4 Economist John Gray likens Friedman’s philosophy to Karl Marx, stating that “two different notions are commonly conflated: the belief that we are living in a period of rapid and continuous technological innovation (…) and the belief that this process is leading to a single worldwide economic system. The first is an empirical proposition and plainly true, the second a groundless ideological assertion. Like Marx, Friedman elides the two.” Gray emphasizes that globalization in reality does two things: it makes the world smaller and sections of it richer. It does not, however, make the world flat (Gray).

Another critic, Vivek Wadhwa, argues that Porter’s model is outdated. He claims that Porter’s diamond does not create real innovation and that “people” are what is missing from recipe. In fact, he cites a study of 1604 companies in Norway’s urban regions and states that creative and open-minded people are what make the cluster. Of course, Porter’s model does not explain everything; he devised this idea back in the 1990’s so it naturally would not address all modern-day forces. Regardless, it still serves as a solid foundation for cluster policy. Furthermore, Wadhwa is correct when he says a knowledge-based regional economy needs creative people. By building up clusters from the bottom up, however, wages and standards of living begin to increase which are what attract the creative people that clusters need in the first place (Wadhwa).

Latin American Economic Development

 Countries in Latin America are beginning to recognize that in order to stay competitive, they must focus on cluster development and channel their efforts toward constant learning and innovation. Typically, governments in Latin America play a role as a catalyst with clusters along with exerting a great deal of influence in providing training and education. Technology clusters are becoming increasingly important in Latin American economies due to its potential to propel innovation (Feser).

Cluster development in Latin American economies certainly has its challenges. Many countries struggle with the lack of investment capital, collaboration between firms, services related to business development. These three challenges make implementation of such a strategy very difficult for Latin American governments and prevent further development. This means that more than ever, governments are doing whatever it takes to incentivize “inter-institutional networking” between the individual cluster actors (Felzensztein).

Latin American governments have intervened a great deal in cluster development. For example, they have been working relentlessly to provide export assistance, training, marketing development, networking and infrastructure support. These governments’ three main targets for bolstering cluster development are promotion of exports, attracting “inward investment” and integration of companies’ value chains. Of course, the greatest challenge on a larger scale is how active or passive government should be about this kind of policy in general. Some governments strive for a “free market structural policy,” while others prefer a more activist approach. It is clear that these frameworks are helping governments employ useful strategies in combating their economic weaknesses and enhancing the individual competitiveness of their sectors (Felzensztein).

Argentinian Cluster Policy

Argentina is the fifth largest wine producer in the world with a domestic market concentration of 79% (Felzensztein). Government plays a proactive role in cluster development for wine as its Ministry of Agriculture aims to control, regulate, coordinate the cluster, along with providing promotion services as well. Figure 1 below shows how this policy benefits both suppliers and retailers. Government also wants to encourage education and research organizations to participate in this framework so they can guide the innovation as well (Emeraldinsight.com). While the government works on this endeavor, what benefits and externalities do businesses see in this cluster?

In the Argentinian wine cluster, there are multiple reasons for collaboration. The basic advantages are attracting new customers and increasing sales in the long-term; there is also significant opportunity to enter international markets as well. What else is there to consider? First, a business must take location into consideration. If we examine how useful it is to be located in a particular region of a country, benefits to think about are: enhanced reputation, skilled labor, specialized services, innovation, inter-cluster referrals, local market demand, customers for your company, international marketing demand, marketing knowledge.

Figure 1: Argentinian Wine Cluster

Capture1

According to a study conducted by La Universidad Adolfo Ibáñez, a business has the most to benefit from an enhanced reputation, innovation and inter- cluster referrals compared to the other externalities. Interestingly enough, this is not the case for wine clusters in Chile where the more important benefit is international market demand. Furthermore, the study concluded that when it comes to marketing, firms in an Argentinian wine cluster benefit the most from joint distribution services. On the other hand, joint promotion is a more significant benefit for a wine cluster in Chile. Figure 2 below demonstrates the indices used to quantify the marketing externalities for this cluster (Emeraldinsight.com).  When we look at both Argentina and Chile in comparison to a wine cluster in a country such as New Zealand, we see that with its high number of 4.24 that firms in that country see the greatest advantages to join promotion strategy.

This chart goes to show that Argentina needs to enhance its inter-firm collaboration in order to compete with clusters in other countries. This is where government can step in to bridge this gap by helping businesses realize the strategic advantages to cluster participation and engender trust (Emeraldinsight.com).

Figure 2: Marketing Externalities for the Argentinian Wine Cluster

Capture2

Costa Rican Cluster Policy

Costa Rica’s government also plays a proactive role in catalyzing its information technology cluster. The Costa Rican government generally focuses on export and investments promotion in order to bolster innovation. Below in figure 3, we see that the government not only wants to increase local competition by opening trade and FDI policies, but also works to improve every part of the industry cluster (Porter, Michael).

Overall, Costa Rica’s cluster demonstrates the government’s long-term vision for the industry and how it wants to “move the economy into a new level of partnership with private firms,” according to a study conducted by the University of Toronto. We see that a result of these efforts is exports of 44 Million US Dollars in medical equipment, 36 million US Dollars in communication equipment and 45 Million US Dollars in hair dryers (Singh). Of course, from this involved approach on cluster development, businesses can see the benefits from participating in this framework.

Overall Cluster Externalities for Businesses

After looking at cluster development in both Argentina and Costa Rica, what else should businesses think about when participating in a cluster? One benefit of a cluster is that businesses can increase market share by acquiring customers from a particular competitor and “locating beside that competitor” in the cluster. The premise is that “because consumers shop at the nearest center that carries the desired good, it is essential that retailers locate next to their competition so that they can be the first door consumers approach.” This may only benefit a company in the short-term, however, as other companies may move into this cluster for the same reason (Brown). Figure 4 below is an example of a SWOT analysis with other sample considerations and questions for a business operating in a cluster in Latin America.

A SWOT analysis like this can also help a cluster establish a viable strategy for innovation and job growth; at the same time, it can also be too broad. Other tools that should be considered are product and market segmentation, GAP analysis, value chain analysis, market trends analysis and competitive positioning analysis (The World Bank International Trade Department).

After thinking about the regional innovation cluster strategy for many companies and how this applies to Argentina and Costa Rica, we see the benefits that come from active participation and collaboration from businesses. Some businesses may be hesitant to engage in this kind of activity because they may not trust how the external economies of scale works with their business strategy. Government should play an even more proactive role in showing what marketing externalities arise from regional innovation strategy while also fostering a sense of trust between each of the cluster components.

Figure 3: Costa Rican Information Technology Cluster

Capture3

Figure 4: SWOT Template for businesses considering cluster participation

Internal Strengths Weaknesses
• What are our raw materialstrength?• What are our human resourcestrengths?

• What are locational

advantages?

• What are climatic advantages?

• What are our cost advantages

• What are our distributionweaknesses?• Do we have adequatefinancing and is this critical?

• How capable is the industry of working together?

• How effective are the public institution supporting or

regulating the industry?

External Opportunities Threats
• What are the growth aspects for the industry?• What communication mediums can be tapped formore info-internet portals and newsletters?• What key trends (market,

trade, and industrial policies)

are building new opportunities?

• Where are the product/industry segments that we directly

compete with? What are they doing?

• What is the competition doing?• What are the major domestic trends today?• What are the major global trends today?• Do we know how international markets view

us?

• Are we meeting international

labor standards?

• Are we meeting international

quality and consumer safety standards?

References

Porter, Michael. (2001). Clusters of Innovation Initiative: Regional Foundations of US

Competitiveness. Retrieved from:

http://www.compete.org/images/uploads/File/PDF%20Files/CoC_Reg_Found_national_c luster.pdf

Florida, Richard. (2005, October). The World in Numbers: The World is Spiky.

Retrieved from: http://www.theatlantic.com/past/docs/images/issues/200510/world-is-

spiky.pdf

Smit, AJ. (2010) The Competitive Advantage of Nations: Is Porter’s Diamond

Framework a New Theory that Explains the International Competitiveness of Countries?

Retrieved_from: http://www.unisa.ac.za/contents/faculties/service_dept/docs/SABVIEW14_1_chap5

.pdf

Diamond model- Michael Porter. (2011). Retrieved from:

http://www.valuebasedmanagement.net/methods_porter_diamond_model.html

Council on Competitiveness. (2005) Measuring Regional Innovation: A Guidebook for

Conducting Regional Innovation Assessments. Retrieved from:

http://www.compete.org/images/uploads/File/PDF%20Files/Regional_Innovation_Guide

book.pdf

Cluster Observatory. (2010). On Clusters (1-1 to 3-5). Retrieved from:

http://www.youtube.com/user/clusterobservatory#g/u

Michael E. Porter, Cluster Mapping Project, Institute for Strategy and Competitiveness,

Harvard Business School; Richard Bryden, Project Director. (2011). Job Creation by

Traded Cluster in the Austin-Round Rock, TX Economic Area, 1998-2008. Retrieved from:

http://data.isc.hbs.edu/isc/cmp_results.jsp?state=&economic=013%7EAustin- Round+Rock%2C+TX&metropolitan=&cluster=&datasetId=1990&x=40&y=17

Feldman, Maryann. (2011) Location, Location, Location: Creating Innovation Clusters.

Retrieved from: http://www.democracyjournal.org/21/location-location-location-creating-

innovation-clusters.php

Brocker, Johannes; Dohse, Dirk; Soltwedel, Rudiger (2003) Innovation Clusters and

Interregional Competition. Retrieved from: http://books.google.com/books?id=C0-gquW-

RtAC&pg=PA117&lpg=PA117&dq=innovation+clusters+in+argentina&source=bl&ots=

i_oz6vxcFa&sig=17iBg43zQ19eYkfCs3Ncu6GQ9k&hl=en&sa=X&ei=aS1FT9_4IuHf0

QH05OT1Aw&ved=0CDcQ6AEwAg#v=onepage&q&f=false

Italian Industry (2011, April 14). Clusters Flustered: Global Competition Seems to be

Weakening the Benefits of Being in a Cluster. The Economist.

Gray, John. (2005, December). The World is Round. Retrieved from:

http://business.twoday.net/static/foehrenbergkreis/files/20051218gray_world.pdf

Wadhwa, Vivek. (2011, July 14). Industry Clusters: The Modern-Day Snake Oil.

Retrieved

from:http://www.washingtonpost.com/national/on-innovations/industry-clusters-the-

modern-day-snake-oil/2011/06/19/gIQAMtx3EI_story.html-

Feser, Edward (2003, June). The Relevance of Clusters for Innovation Policy in Latin

America and the Caribbean.  Retrieved from:

http://www.urban.uiuc.edu/faculty/feser/Pubs/Relevance%20of%20clusters.pdf

Felzensztein, Christian (2011, April). International Marketing in Southern Hemisphere

Wine Clusters. Retrieved from:

http://www.clusterinnovation.com/doc/International%20Wine%20Clusters%20Southern

%20Hemisphere-%20BALAS%20presentation%20April%202011.pdf

Emeraldinsight.com (2002). Retrieved from:

http://www.emeraldinsight.com/content_images/fig/0430190303001.png

Porter, Michael E (2012, June 20-21). The Microeconomics of Development.

Retrieved from:

http://www.cid.harvard.edu/archive/andes/documents/presentations/caracas_0601/porter_competitivenessforum_062101.pdf

Singh, Indira (2003, September) Can Government Catalyze Clusters? Examples of

Government Actions. Retrieved from:

http://www.utoronto.ca/onris/research_review/…/Singh03_Catalyze.doc

Brown, Peter; McNaughton, Rob B.; Bell, Jim (2010) Marketing externalities in

industrial clusters: A literature review and evidence from the Christchurch, New Zealand

electronics cluster. Retrieved from:

http://www.springerlink.com/content/811m06910219k1g3/

The World Bank International Trade Department. (2009) Clusters for Competitiveness:

A Practical Guide and Policy Implications for Developing Cluster Initiatives. Retrieved

from: http://siteresources.worldbank.org/INTEXPCOMNET/Resources/cluster_initiative_pub_

web_ver.pdf

To Be, or Not to Be More Adaptive to a Local Environment

Author: Brian McMicheal

Introduction

The purpose of this study is to pinpoint how two similar companies from the same home country can enter into a host country and have completely different results due to their different adopted strategies for international expansion. By analyzing two similar companies in the same industry going to the same target country, it will be possible to evaluate the strategies they used and link these strategies to the performance of the international locations. This study will compare two different entrance strategies used by two companies and determine which one is more closely following proven business models. These two companies were McDonald’s and KFC, and the country they were entering was China.  This study will also cite possible reasons for the success as well as failure of these strategies in other countries vis-à-vis China, the target country. By positioning themselves differently in the I-R Framework developed by Bartlett and Ghoshal (Fan, D., Nyland, C., & Jiuhua Zhu, C., 2008) (Barlett & Ghoshal, 1991), these two companies experienced completely different results. One of these strategies had potential for long term success, while the other would need to be modified if the company hoped to gain an ability to be sustainable in the long term. By realizing the potential profits to be made by entering the Chinese market, due to its large population and no presence of a large quick service company, these two companies developed competing strategies to enter this market. This paper will outline the positive and negative aspects of each company’s decisions and demonstrate why one company’s strategy was more effective in gaining a competitive advantage in the Chinese market than the other’s. By analyzing different parts of these strategies and fitting them into different business models it will be possible to demonstrate how these strategies either do or do not follow proven business models.

Literature Review

In the 1960’s Stephen Hymer developed the theory of multinational enterprise which described why companies decide to go abroad. This theory has been the building block for almost all international business models, and was improved on by John Dunning’s Eclectic Paradigm. This model is characterized by the O-L-I, which describes three reasons why companies go international. The “O” stands for the ownership advantage that a company gains from the decision to go international and answers “why” companies go international. The “L” stands for the location advantage of the country being entered and answers “where” the company will be going. The “I” regards the amount of internalization a company will use in its international plans. This answers the question of “how” the company will go abroad. Later on, Bartlett and Ghoshal developed the I-R Framework which essentially describes four strategies a company can use when going into a foreign country depending on the amount of integration and local responsiveness a company uses in its international strategy (Barlett & Ghoshal, 1991). If a company were to use low integration and low local responsiveness, it would be characterized as an international firm just using an export model. To be successful, however, a company would need to either increase its local responsiveness, which would make it a multi-domestic firm, or it could increase its integration which would make it a global firm. Once a company has been defined as a global firm or a multi-domestic firm it would want to either increase its local responsiveness, if it is a global firm, or increase its integration, if it is a multi-domestic firm. This would result in the company being a transnational firm, and is the best structure for maintaining a long term competitive advantage. To determine if a company does in fact have a competitive advantage, the VRIO framework has been created to determine if something is valuable, rare, costly to imitate, and if the organization is set up to take full advantage of the asset (Barney & Hersterly, 2012) (Barney, 1991). This analysis can be used to determine the level of a company’s competitive advantage (Barlett & Ghoshal, 1991).

China

China is the second largest economy in the world with over 1.3 billion people. This county increases its GDP by 10 percent every year and has lifted more than 500 million people out of poverty. In spite of this growing economic situation China remains a developing country with low gross national income per capita of $6,091. This ranks China 90th in terms of gross national income per capita in regards to other countries (“The world bank,” 2013). With this growing number of people making more money the gap between the rich and the poor in China is also growing and more and more political friction between these groups is being created. Some areas of China, such as the eastern area of the country,  are experiencing a major shift in income due to the country going through industrialization while other areas, such as the northwest remains very undeveloped with mostly poor farmers populating the area. China is led by a communist state government which is called the People’s Republic. The leading political party in China is known as The Chinese Communist Party. This political party sets policies and creates committees for laws and regulations (Encyclopedia of the Nations, 2013).

Capture1

Source:  http://www.tradingeconomics.com/China/gdp-per-capita

China’s consumers are changing their lifestyle habits due to the growing economy and increasing per capita income. Traditionally consumers in China focused on eating mainly fish, pork and chicken, but now many of them are also eating more beef in their diets.  Some of these changing lifestyle habits relate to the quick service industry, sometimes called fast food. China is the number one meat consuming country in the world, creating a huge market for companies wishing to enter this industry. Many consumers in China are spending more and more on eating out. This has caused the restaurant industry to experience high growth in its revenues over the past years (Szulanski, Chen & Lee, 2012). Many foreign companies are entering into this market to reach this mass of consumers being created by their rise from poverty. Many people in China still have very little expendable income, however, with such a large population; there are also a significant number of individuals in this country who do in fact have a large enough amount of expendable income to justify entering this market.

For quick service industry companies there are many opportunities and threats associated with the entrance into the Chinese market. For the opportunities, as mentioned above, there is a huge market of consumers in this country who are gaining more and more expendable income every year as China’s economy grows. Although the large portion of these consumers are not yet to the point where they are able to afford such luxuries as eating out at western originated companies such as McDonald’s and KFC, the small portion of Chinese consumers whom can afford to accounts for a very large number of people. The huge popularity of meat consumption and the growing preference for beef in China also marks a very high potential for quick service restaurants entering this market that offer many products based around these meats, as many western restaurants do. Another opportunity for quick service industries looking to enter China is the changing lifestyles of these consumers and their growing preference to eat out which would favor companies in this industry.

Some threats to companies in the quick service industry would be the differing government policies in China compared to those in the United States. These different policies would possibly cause businesses to change some of their operations to function in line with these new laws. The change in currency is another threat to these potential entering firms since they will need to incorporate the Chinese Yuan into their accounting systems and monitor exchange rates to see how much money they are losing or gaining due to fluctuations in these exchange rates. Another potential threat to these companies is the fact that there were no other western restaurant chains in China so it was difficult to determine the reaction of these consumers to these new products. These is also the issue of the growing divide in the distribution of income in China and companies wishing to enter this country would have to know exactly where the best area to geographically place their restaurant to reach the maximum number of Chinese consumers willing and able to purchase their products.

Kentucky Fried Chicken

Kentucky Fried Chicken (KFC) is based in Louisville, Kentucky and is focused around a special recipe created by Colonel Harland Sanders almost 70 years ago (KFC, 2013). KFC is in the quick service industry and offers consumers a variety of recipes with focus on the Colonel Sanders secret 11 herbs and spices recipe. This company is owned by Yum! Brands, which is the same company owning other western quick service firms such as Taco Bell and Pizza Hut (KFC, 2013). KFC offers consumers a relatively limited variety of menu items mainly focused on chicken products specializing in different types of batter and condiments for these chicken products. This allows KFC to specialize on a single product and cut the extra costs associated with having many products on the menu. KFC is also able to provide consumers with a high quality product since these products offered by KFC have a very high consistency in flavor; however, KFC modifies its menu items and used different sources of materials depending on which country it is operating in, so its national products have consistency while its international products differ.

In 1987, KFC entered Beijing, China making it the first foreign quick service industry to enter China. This gave KFC the first mover advantage in this market and it was able to establish a positive brand name in China. To assist in the success in this new geographic market, KFC established a joint venture with Beijing Animal Production Company and Beijing Tourism Board. This action was to help KFC gain local supply chains for its products. This local supply chain would lower costs for KFC as well as allow it to establish relationships with local companies to better understand this new market. KFC also used many local ingredients in its products and catered its menu to fit with local preferences changing about 80% of its menu items to meet customer’s preferences. This is representative of a transnational company on the I-R framework. KFC hired local employees and paid them very large salaries in proportion to other jobs in the area, this tactic would ensure long lasting employees who would be enthusiastic to learn how to best perform their jobs and make a career out of it. This also made a high demand for these jobs and gave KFC the opportunity to choose from a very large pool of workers with the exact qualities it was looking for. The preferred employees were able to speak English, had education leveling high school graduation, and no prior restaurant experience, which ensured there were no previously learned work habits. KFC originally hired elites from neighboring Asian countries with high performance in the QSR industry as well as a high knowledge of Chinese customs, culture, habits, and language to be sure these employees have a good knowledge of this market and the consumers who will be served (Szulanski, Chen & Lee,  2012).

 Capture2

Source:http://www.Chinadaily.com.cn/bizChina/2009-06/17/content_8291814.htm

The strengths of KFC were its ability to adapt to the Chinese market. By being able to utilize local ingredients and supply chains KFC was able to cut costs as well as establish mutual beneficial relationships with local industries. KFC was also able to adapt its menu to fit the local taste and give the Chinese consumers a product that was familiar and preferable. By using locals to work in its restaurants and give them high salaries, KFC was able to gain knowledge on the Chinese customs and culture enabling it to know exactly what the customer wants and the high pay allowed KFC to choose from many employees and maintain them for long periods of time, which gave KFC a long lasting and knowledgeable staff. Some weaknesses of KFC were its high cost product compared to the majority of peoples salaries in the area. Although there was still a substantial number of potential consumers with enough income to afford KFC, the large majority of people in China could not afford it. Another weakness of KFC was its thinning bottom line, caused by the economic downturn in Asian countries during the time of KFC’s entrance into China.

KFC has realized the Chinese consumers were looking for a quick place to eat, and not necessarily looking for the western dining experience and for this reason KFC has changed most of its menu and used local ingredients to adapt to these local products and serve the consumers foods they are familiar with and have liked their entire lives. KFC capitalized on using local partners to gain familiarity with the country and using local employees to create an inviting place for locals. KFC researched the Chinese culture before entering China and wanted to offer these consumers something they knew, but at the same time, offering it in a way that was new and exciting to them. By utilizing a transnational strategy, KFC was successfully able to gain the confidence of the Chinese consumers and create a highly performing market presence in China. It is for this reason that KFC made a good choice in its development of its strategy. By working with the locals and knowing the people, KFC was able to create a great business model for the Chinese market.

The VRIO analysis (Barney & Hersterly, 2012) (Barney, 1991), of KFC’s entrance strategy shows it as being valuable since it is offering KFC a whole new market with a huge potential for profit. By entering China KFC has the ability to meet a huge market of consumers. This strategy is also rare since KFC would be the first western quick service industry to enter China, giving it the first mover advantage and allow it to set a standard for future companies wishing to enter this market. This entrance strategy is also costly to imitate since KFC has established working relations with local suppliers and distributers, as well as gaining a highly reputable brand image among the Chinese consumers. KFC has also organized itself to be able to take full advantage of this strategy by ensuring management is acting consistently with this entrance strategy and using its local employees to establish informal controls regarding the Chinese culture, language, and customs. By being highly adaptive and very carefully establishing the management and employees of these offshore restaurants, KFC has effectively organized itself to take full advantage of this strategy and possibly maintain a sustainable competitive advantage in China for years to come.

McDonald’s

McDonald’s was founded in 1955 and has been a major pioneer in the quick service industry. Not only has McDonald’s created favorite menu items such as the chicken nugget, but it is also responsible for creating an assembly line procedure in the preparation of food. McDonald’s used this assembly line procedure to fill customers’ orders quickly and effectively (McDonalds, 2013). McDonald’s used this fast production of food to make yet another ground breaking introduction to the quick service industry, the drive-thru window, which allowed customers to make orders and get their meal quickly without having to get out of their cars (McDonalds, 2013). McDonald’s keeps an extremely high consistency in its food items from restaurant to restaurant, ensuring a consumer will get the same experience no matter where they eat. McDonald’s uses a highly franchised business model where prospective owners will work with the company to establish a high traffic area with a great potential for success. These private investors were a major part of the McDonald’s business model since they account for 90% of the restaurants in the United States (York, 2013).

Three years after KFC’s entrance into China, McDonald’s also entered China; however, the entrance strategy utilized by McDonald’s was anything but similar. For logistics, McDonald’s used its global logistics partner, HAVI Foods, instead of teaming up with local companies. McDonald’s also used its global partners for food supplies as much as possible in the entry into China’s market. The reasoning behind this was to bring the Chinese consumers the globally consistent standards people in other countries have experienced. McDonald’s also kept its menu basically the same as its menu in the United States, with the Big Mac being its signature dish, while also adding a few items to attract local taste such as Vegetable and Seafood Soup, as well as Corn Soup. As McDonald’s realized that having local tasted items on the menu was important it introduced more locally inspired items to create a standard of 20% local items and 80% national items. McDonald’s had the desire to keep many of its items the same to give Chinese consumers the western style dishes in its restaurants. While McDonald’s relies heavily on franchising in the United States and in other areas around the world, accounting for 78% of its worldwide businesses, it was unable to pursue this franchising strategy right away in China due to government regulations and procedures (Szulanski, Chen & Lee, 2012). This prevention of a heavy franchising strategy caused McDonald’s to have to change its core business strategy in its Chinese outlets and directly control these restaurants.

The strengths of McDonald’s were its product consistency and western style dishes. McDonald’s uses its highly consistent product to give consumers all over the world the same experience when it comes to eating at one of these outlets. McDonald’s also prides itself by not changing too many menu items so it can give consumers in any country its classic western style dishes. The weaknesses of McDonald’s were its high reliance on franchising, which made it unable to effectively adapt in a situation where it is unable to use this strategy. Another weakness is the fact that McDonald’s does not work with any local suppliers and distributers, this may give McDonald’s a negative image to local consumers who may not like the fact that a company refuses to give business to any of their companies. Consumers may also not like the fact that McDonald’s doesn’t hire anyone locally because these non-local employees may not be as familiar with their language, customs, and culture as someone who lives in the area where the restaurant is. This opens possibilities of accidently insulting consumers and offering products nobody in the area would want.

The VRIO analysis of McDonald’s entrance strategy shows it as being valuable, since this huge market of consumers is beginning to eat out more and has a growing preference for beef. This makes this market have a lot of potential for profit for a company such as McDonald’s. This strategy is also rare since there is only one other western style quick service restaurant in China, which is KFC. This entrance strategy, however, is not costly to imitate for other quick service industries wishing to pursue the same strategy since McDonald’s is simply relying on its current operations and menu items to enter China. This strategy does not have any unique historical conditions, causal ambiguity, or social complexity, resulting in it being imitable and only a source of competitive parity at best. In order to make this strategy costly to imitate McDonald’s would have to be more adapting and willing to learn in this new market as well as work with local companies to make a product more desirable and fitting to the Chinese consumers. By establishing these socially complex relationships with other businesses and consumers McDonald’s could then better organize itself to take full advantage of its resources in China and create a sustainable competitive advantage in this market.

Comparing the two different entrance strategies in the Chinese market, both of these companies used the hierarchal governance form of operation since they were maintaining as much control as possible over these restaurants in China by creating wholly owned subsidiaries. Regarding the entrance strategy structure, McDonald’s used a centralized hub, since it retained all the decision making for strategic and operational decisions at its central headquarters, and did not delegate any decision making to the McDonald’s restaurants in China. KFC went a different way with the structure of its international entrance strategy by creating elites from nearby countries who have lots of knowledge regarding the Chinese customs, traditions, and language, and putting these elites into top management positions in order to coordinate the Chinese restaurants to operate in line with these aspects. This structure resembles the coordinated federation structure (Barney & Hersterly, 2012) (Barney, 1991), since KFC was delegating the operational decision making to these elites in China, while it maintained the strategic decision making in its corporate headquarters.

Capture3

Source: http://nrn.com/international/kfc-McDonald’s-among-most-powerful-brands-China

Strategy Effectiveness

Regarding the question of which of these two strategies were more effective in China, it is KFC’s adaptiveness and willingness to learn which makes it the better strategy. By being locally responsive while at the same time having high integration, KFC has made itself a transnational company, which gives it the highest potential for long term success in this market. It has been proven in many different business models that a transnational company has the most potential for long term success and those companies using other structures such as global, multi-domestic, and international should try to move to being a transnational company if they wish to experience long term success in the foreign country. KFC not only changed the necessary aspects of its menu to best serve these customers, but it also saved costs by utilizing its current marketing and branding as much as possible. This gave KFC an enormous advantage right away in China and allowed it to hit the ground running in its entrance into this market.

McDonald’s strategy can be defined as more or less a global strategy whereas it is using its same product with its same marketing. This strategy has proven effective to McDonald’s in the past and there was no reason for them to believe that it would not work in China at first glance. What McDonald’s missed, however, was the fact that KFC was not using an international strategy in China and since KFC was there before McDonald’s, it would have been possible to examine just what exactly KFC was doing before going into China. This would have allowed McDonald’s to gain knowledge on what the reasons were for KFC’s large success in the Chinese market, and then adapt its own strategy to incorporate these findings.

Using the global strategy in China may have had short term benefits, but in the long run it is susceptible to competition and imitation (Barney & Hersterly, 2012) (Barney, 1991). The best thing for McDonald’s to have done would be to increase its local responsiveness to transition into a transnational firm. This would not only give McDonald’s the short term success of the global strategy, but it would have also been able to capitalize on the benefits of an increase of local responsiveness. McDonald’s could then increase its integration to become a transnational company, this would allow it to be adaptive and at the same time cost efficient. By doing this McDonald’s would be set up for long term success in the Chinese market. Although McDonald’s

Capture4

Source: http://www.emeraldinsight.com/content_images/fig/0210311203002.png

international strategy has been proven successful in other countries, it cannot expect every country to be looking for the same benefits and that was demonstrated clearly here.

McDonald’s has been slow to adapt its menu, insisting it must give consumers a western dining experience, but is slowly realizing these consumers were more interested in their traditional food items, causing McDonald’s to slowly introduce more and more Chinese dishes on its menu. By noting the success and rapid expansion of KFC, McDonald’s could see it was possible for a western quick service industry firm to be very successful in China; the only question left was how they were doing it. By realizing that KFC had changed almost 80% of its menu, McDonald’s could see that these locals were not like the ones in other countries. This is because they were not necessarily looking for a western dining experience when they entered KFC or McDonald’s. Instead they were looking for a good place to eat a high quality meal quickly. However, they wanted to eat foods they knew and loved, as opposed to foods they have never tried before, since these food items being offered by KFC and McDonald’s were also relatively expensive to these consumers they were probably also hesitant to spend that much money on something they had never tried before or had not developed a taste for.

McDonald’s entrance strategy into other countries has been proven to be more effective than KFC’s. A possible explanation for this would be the fact that these other countries have many other quick service industries and the consumers local to these countries have had quick service experience for a while and were looking for different types of foods. The Chinese consumers were just coming into the amount of wealth necessary to be able to afford to eat out at these quick service restaurants and were mainly looking for a quick place to eat. With this distinction, consumers in other countries would be more receptive of McDonald’s strategy because it is offering a different type of food, the western style, so they can eat different things, much like American consumers eating at Mexican restaurants. This made it possible for McDonald’s to use its time tested strategy and offer these new consumers a dining experience that is the same in every country. McDonald’s prides itself in its ability to do this and wants to bring every consumer around the world the western dining experience. In countries where the consumers are looking for new experiences this works very well, however in China, the consumers were not necessarily looking for a new dining experience and just wanted something familiar to them, resulting in this strategy not being as successful as it had been in other countries.

KFC’s strategy of adapting to local ingredients and dishes is not always successful either. In many foreign countries consumers are looking for authentic cousins from other countries when they enter foreign restaurants, and KFC offering them their own dishes with their local ingredients is not as exciting to them. This strategy is also ineffective in the long term because it would not differentiate KFC from other restaurants in the country and therefore it would be hard for KFC to gain a competitive advantage against these other restaurants. Another reason why KFC was successful in China right away was the fact that many of its American menu items fit local taste such as the chicken wings, while McDonald’s menu items such as the Big Mac were not as in line with the local taste even though McDonald’s continued to use the Big Mac as its main item. In other countries, however, the local tastes differ and the Big Mac may be more in line with these consumers’ preferences than KFC’s chicken products.

KFC formulated its strategy around the needs and wants of the Chinese consumers. Once formulated this strategy proved successful to KFC and it was used for the entrance of other countries around the world. This was a mistake, however, because this strategy had been formed for the Chinese consumers, and not the consumers in other countries around the world. This adds to the reason on why KFC has not proven as successful in other countries. KFC should have not assumed this strategy would work everywhere and observed the companies in these other countries to determine just how they were approaching the issue on international expansion and just what strategies they were utilizing. By doing this KFC would be able to modify its own strategy for each country it entered and by doing so ensure that it was entering with a strategy which has been proven to be successful by other companies.

McDonald’s is on the flip side of this scenario. It had already been in other countries and had a working business plan which it assumed would work in China. Like KFC in other countries, McDonald’s did not examine what was going on in China and just used its time tested strategy. If China had been the first country McDonald’s had ever entered into the results would likely be much different because it would have not have its past knowledge of other counties working against it. Instead it would have studied the country in more detail and observed what the current restaurants in China were doing and adjust its strategy to incorporate this information. By doing so McDonald’s would be adopting a strategy very similar to the one KFC used and McDonald’s probably would have seen high profits and large potential for growth in China.

When entering a foreign market it is important to not only learn as much as possible about the consumer audience that is being targeted, but it is also important to make sure you are going in with a strategy which is in line with their needs and wants. KFC was right in using local suppliers and distributers in China because the people were looking for food dishes with familiar ingredients and recipes. It was also beneficial to use a local staff because it enabled KFC to gain insight on the local culture and customs of China and by doing so KFC was able to offer the consumers in this area exactly what they were looking for. It was the careful and well thought out entry into this country which made KFC highly successful in its entrance strategy. McDonald’s, however, decided to use its same time tested strategy in this new market and assumed the Chinese consumers would be looking for the exact same thing their other consumers around the world are looking for. It was not until later they learned that they had to add more local dishes to the menu and try to learn more about the consumer needs and wants of this market. The major lesson here was the fact that even though a strategy works in practically every other country it was employed in, it does not necessarily guarantee it will work everywhere. There are many factors affecting what consumers will prefer in one country compared to another and assuming there is one basic strategy which works with all would be incorrect.

In pursuing an entrance strategy into a foreign country it is important to use tactics from each of these entrance strategies to best fit with the needs and wants of the consumer. It would be important to make relationships with local companies such as suppliers and distributers because they would help you learn more about the country and the best places to operate. Another important factor would be to hire locally and build strong relations with these employees so someday they could be managers for the restaurant. Building strong relations with local employees is important because of the knowledge they are able to offer the company regarding the traditions, culture, and customs of their country. Depending on the other restaurants in the area and after doing research on the local consumers to find out their preferences, I would either use KFC’s strategy of changing most of the menu to fit local tastes, or McDonald’s strategy of only changing a small portion of the menu and keeping the rest authentic to the original dishes. To make this decision it would be important to know if consumers are looking for a quick place to eat food they’re familiar with or if they are looking for a different dining experience offering them the signature taste of another country.

Both of these strategies utilized by these two companies have their strengths and weaknesses, and can be effective, but the context in which either is effective is the most important thing to be aware of. By knowing when and where to adapt or stay the same is the solution to gaining competitive advantages internationally. McDonald’s had a tried and reliable strategy which had been very successful in other countries, but by not fully understanding the Chinese consumers and by having to change its strategy of franchising, it was unable to be as successful as KFC in China. This was because in this particular country, all of KFC’s decisions were coordinated exactly with the wants and needs of the Chinese consumers. It was this deep understanding of the consumer and the actions taken to implement an entrance strategy which took these consumer needs into account that was the reason for KFC’s high success in the Chinese market.

References

Barney. (1991). Firm resources and sustained competitive advantage. Journal of Management, 17(99-120)

Barney, J., & Hersterly, W. (2012). Strategic management and competitive advantage. (4th ed.).

Barlett. , & Ghoshal, (1991). Global strategic management: Impact on the new frontiers of strategy research. Strategic Management Journal, 12(5-16)

China gdp per capita. (n.d.). Retrieved from http://www.tradingeconomics.com/China/gdp-per-capita

Encyclopedia of the Nations. (2013). China: Politics, government, and taxation. Retrieved from http://www.nationsencyclopedia.com/economies/Asia-and-the-Pacific/China-POLITICS-GOVERNMENT-AND-TAXATION.html

Fan, D., Nyland, C., & Jiuhua Zhu, C. (2008). Strategic implications of global integration and local responsiveness for chinese multinationals: An area for future study. Retrieved from http://www.emeraldinsight.com/journals.htm?articleid=1752297&show=html

KFC. (2013). Taste why fresh is better. Retrieved from http://www.kfc.com/

McDonalds. (2013). McDonald’s. Retrieved from http://www.mcdonalds.com/us/en/home.html

Qingfen, D. (2006, June 17). Kfc expansion plans undeterred by economic crisis. Retrieved from http://www.Chinadaily.com.cn/bizChina/2009-06/17/content_8291814.htm

Ruggless, R. (2013, July 31). Kfc, mcdonald’s among most powerful brands in China. Retrieved from http://nrn.com/international/kfc-McDonald’s-among-most-powerful-brands-China

Szulanski, G., Chen, W., & Lee, J. (2012). Mcdonald’s and kfc: Recipes for success in China. Strategic Management and Competitive Advantage,

The world bank. (2013). Retrieved from http://www.worldbank.org/en/country/China/overview

York, E. (2013, April 16). Franchisee survey shows growing discord at McDonald’s. Retrieved from http://articles.chicagotribune.com/2013-04-16/business/chi-franchisee-survey-shows-growing-discord-at-McDonald’s-20130416_1_dollar-menu-mcwrap-janney-analyst-mark-kalinowski