Do supplier switching costs differ across Japanese and US multinational firms?

ELSEVIER

Japan and the World Economy 10(1998) 13 32

F_L-ONOMY

Do supplier switching costs differ across Japanese and US multinational firms? S t e v e n C. H a c k e t t a'~, K r i s h n a S r i n i v a s a n b'* "School of Business and Economi~s, Humboldt State University, Arcata, CA 95521. USA btnternational Monetary Fund, Washinqton, DC 20433, USA Received November 1994; accepted October 1995

Abstract

We examine the relative sensitivity of investment by Japanese and US multinational firms to host country policies that require manufacturing subsidiaries to switch to local component suppliers. We find that foreign direct investment by Japanese multinationals is much more sensitive to local content requirements and restrictions on component imports than that of US multinationals. While our empirical analysis cannot address supplier switching costs directly, our findings are consistent with the notion that the Japanese keiretsu system of industrial organization leads to stronger vertical relationships, and" thus higher supplier switching costs, than those of firms from the US. © 1998 Elsevier Science B.V.

Keywords: Supplier switching costs; Keiretsu; Multinational firm JEL class![ication: D23; F23; L23

1. Introduction Investment in foreign p r o d u c t i o n facilities by multinational firms is an increasingly i m p o r t a n t element of international trade and e c o n o m i c development. The United Nations" World Investment Report 1992 notes that there are more than 35000 multi-

*Corresponding author. E-mail: KSRINIVASAN(a imf.org. 1E-mail: SH2(a axe.humboldt.edu.

0922-1425/98/$19.00 ,4"~ 1998 Elsevier Science B.V. All rights reserved PII S 0 9 2 2 - 1 4 2 5 ( 9 6 ) 0 0 2 1 4 - 9

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s.c. Hackett. K. Srinivasan / Japan and the Worm Economy 10 (1998) 13-32

national firms, which together have in excess of 150 000 foreign subsidiaries. The report estimates that aggregate foreign direct investment (FDI) by multinational firms in foreign subsidiaries amounted to $225 billion in,' 1990, and that during the period from 1985 to 1990 global FDI grew at twice the rate of aggregate domestic investment. Transactions between multinational firms and their foreign subsidiaries are estimated to account for approximately 25% of world trade. Countries seeking to increase domestic growth and employment from investment projects often fashion policies (performance requirements) such as local content requirements (LCRs) and restrictions on imports (RIMs) that require subsidiaries of multinational firms to switch to local component suppliers. The success of such policies depends critically on the supplier switching costs these policies impose on multinational firms. Aspects of supplier switching costs include the loss of existing relational quasi-rents, the costs of finding satisfactory host country suppliers, negotiating contract terms and safeguards, and adapting production processes to the locally supplied component. 2 This raises some interesting questions. Do such host country policies deter investors from different countries to the same degree? Furthermore, conditional on other traditional factors explaining FDI location, are supplier switching costs still important in influencing FDI location? It is argued in the multinational firm literature that the vertical k e i r e t s u system of industrial organization in Japan features far stronger vertical relationships with input suppliers than those that exist between US firms. As we describe in greater detail below, the vertical keiretsu system links a dominant parent firm with component suppliers and distributors by practices such as reciprocal stock holdings, and facilitates information flows and coordination through the sharing of employees, managers, and directors across corporate boundaries. Members of the keiretsu tend to specialize in complementary activities such as R&D, parts manufacture, and assembly. Vertical relations are further strengthened by a culture of preferential treatment of vertical keiretsu members over outsiders. There is thus a strong incentive for overseas manufacturing subsidiaries of Japanese firms to maintain component supply relationships with keiretsu members. For example, Kreinin (1988) and Froot (1991) find that Japanese manufacturing affiliates in Australia and the US rely much more heavily on imports of components from home-country suppliers than do affiliates of multinationals from other countries. Also, as argued by Srinivasan and Mody (1994), the Japanese multinationals have shown an inclination, at least in the incipient stages of locating abroad, to locate their subsidiaries in countries where there exist cultural ties. Preference for cultural ties imposes a further cost when switching from home country supplier to a supplier in the host country. Thus we hypothesize that manufacturing subsidiaries of Japanese multinationals have higher supplier switching costs than do the manufacturing subsidiaries of US multinationals. Having examined the above hypothesis using a non-parametric analysis, we re-examine the relative importance of 2Williamson (1976) uses switching costs to explain why local governments may not want to use repeated bidding as a means of disciplining monopoly serviceproviders.Klemperer(1987)points out that endogenous switching costs (e.g., frequent flier programs) can be used to limit future market competition. For a more general discussion see von Weizs/icker(1984).

S.C. Hackett, K. Srinivasan / Japan and the World Economy 10 (1998) 13 32

15

supplier switching costs after conditioning for other factors that potentially affect F D I location. As we point out in Section 2, there have been relatively few studies attempting to estimate the effects of individual host country policies on the behavior of multinational firms, in part because of the difficulty involved in obtaining measures of policy restrictiveness? The policy restrictiveness measures that we use are derived from annual "country scores" assigned by the Country Assessment Service of the firm Business International, Inc. (BI). Scores range from 0 to 10, with higher scores corresponding with policies imposing fewer restrictions on the foreign subsidiaries of multinational firms, This policy data set is relatively unexplored. 4 As we describe in greater detail in Section 3 below, the analysis below uses country scores for host country policies and country characteristics, and manufacturing F D I flows from Japanese and US firms to these host countries, to evaluate the supplier switching cost hypothesis. Our analysis finds that F D I by Japanese multinationals is much more sensitive to import restrictions and local content requirements than are US multinationals, which supports the comparative prediction on supplier switching costs. In particular, consider the statistical hypothesis that the underlying process generating the distribution of F D I across host countries with particular LCR and R I M country scores is the same for both Japanese and US multinationals. This hypothesis is rejected at well below 1% level in all cases. In each case, the hypothesis is rejected because the share of overall F D I by US multinationals going to countries with more restrictive LCR and R I M policies (lower scores) is significantly greater than that of Japanese multinationals. When we condition for other factors affecting F D I location, we still find LCR and RIM to be important, with their marginal effects being larger for F D I by Japanese multinationals. Previous studies of the keiretsu system have focused on its effects in limiting access by foreign firms to the Japanese market. 5 Our study differs in that it identifies a linkage between the relatively strong vertical keiretsu system of relational contracts a m o n g Japanese firms, and the implications these vertical relationships have on how Japanese versus US manufacturing firms site foreign production facilities. We are not aware of another empirical study that addresses the question supplier switching costs for multinational firms.

2. Brief overview of the literature Transaction-cost theories of the multinational firm have identified a number of circumstances in which particular types of transactions are efficiently organized internally between a multinational and its foreign subsidiary - rather than at arms 3We briefly discuss the transaction-cost literature on the multinational firm in Section 2 below. 4The only other empirical study of which we are aware that has utilized this data set is Wheelerand Mody (1992), and they focus on agglomeration economies rather than internalization costs. 5See for example Lawrence(1991) and the discussion in Gerlach (1992).

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S.C. Hackett, K. Srinioasan / Japan and the Worm Economy 10 (1998) 13-32

length between a multinational and a foreign firm. Thus FDI (the creation of foreign subsidiaries) is predicted in those circumstances most favorable to intrafirm transactions. For example, McManus (1975), Buckley and Casson (1976), Rugman (1981), and Caves (1982), among others, have argued that an independently owned host country firm is more difficult to monitor and control through an arms-length contract than is an integrated subsidiary. When monitoring and controlling are important, such as in transactions involving knowledge-based assets (technology) where agency problems may be particularly acute, transaction costs are more likely to be minimized when the multinational firm owns the foreign facilities that it utilizes in production. 6 Empirical support for this hypothesis is somewhat mixed. Mansfield and Romeo (1980) and Davidson and McFetridge (1984) find that the probability of intermediate goods being transferred internally rather than through an arms-length contract is higher when newer technology is to be transferred. In contrast, Gatignon and Anderson (1988) find only a weak linkage between technology transfer and the extent to which international transactions occur within a firm rather than at arms-length. Benvignati (1990) offers evidence that undercuts the control-based advantage of the multinational-subsidiary organizational arrangement. Benvignati finds that the presence of shared reputational assets or high technology contribute little added explanation for the observed pattern of internal versus arms-length exchanges. Another situation that is thought to favor the acquisition of an ownership stake in foreign production facilities arises from firm-specific reputational assets shared by the parent firm and the foreign subsidiary. These transaction-cost issues have been studied in the context of services franchising, where parent firm ownership of retail outlets is most likely when the incentive to underinvest has the greatest potential for damaging the reputational asset. 7 Hennart (1992) and Horstmann and Markusen (1987) develop models in which FDI rather than franchising (licensing) arises to attenuate the transaction-costs associated with underinvestment by foreign franchisees who are difficult to monitor and control. Gatignon and Anderson (1988) and Gomes-Casseres (1989) find that ownership stakes rise as a function of advertising intensity, which is consistent with the notion that advertising creates a product-specific asset, and that internalization protects that asset. Thus our empirical analysis of the hypothesis that supplier switching costs are relatively higher for Japanese firms, to which we now turn, offers a new approach to evaluating transaction-cost theories of multinational enterprise.

6See Ethier and Markusen (1992) for a detailed theoretical model addressing the FDI issues associated with knowledge-based assets. Their model predicts integrated foreign subsidiaries based on a complex set of factors including the importance of knowledge-based assets relative to physical assets, discount rates, exporting costs, wages, and industry structure. 7Firms may also choose to own foreign production facilities because of small number of problems in the host country. As Williamson (1975) has argued, unified ownership (FDI) may be an organizational structure that minimizes the transaction-costs associated with opportunistic ex-post renegotiations.

S.C. Hackett, K. Srinivasan / Japan and the World Economy I 0 (1998) 13 - 32

17

3. Predictions, analysis, and results We begin with a description of the vertical keiretsu system in Japan, and the predictions that we draw for supplier switching costs. We next describe the data and analytic techniques and how they relate to the supplier switching costs hypothesis. We end by discussing the results of our analysis. 3.1. The vertical keiretsu system in Japan, and its implications f o r supplier switching costs

Keiretsu is a term commonly used to refer to interfirm enterprise groups or alliance structures in Japan. As Gerlach (1992) points out in his comprehensive study of keiretsu groups, they are "only the most formal of a wide variety of cooperative groupings that dominate the Japanese industrial landscape" (p.4).8 The keiretsu groups grew out of the pre-war Zaibatsu family-based industrial groups, of which Mitsui, Mitsubishi, and Sumitomo are prominent. As Vernon (1985) observes: "Until World War II, 6 or 8 clusters- the so-called Z a i b a t s u - made up most of Japan's modern industry. After World War II, Japanese firms continued to be linked in a large number of clusters of a looser sort - the so-called Keiretsu. One consequence of that structure was that most Japanese firms which were users of intermediate materials were linked to Japanese suppliers by vertical ties..." (p.11). The various types of keiretsu enterprise groups represent interconnected institutional structures that together govern the process of loan capital acquisition, production, marketing and exporting, and distribution. Keiretsu groups facilitate coordination through interlocking ownership (e.g., reciprocal share holdings) and through the sharing of managers and directors across corporate boundaries. For example, Gerlach finds that nearly 40% of equity interlocks in Japan are combined with other simultaneous relationships such as board of directors, intermediate-good trade, and debt. 9 Gerlach also argues that: "[a]mong the most prominent features of the keiretsu is a layered set of personnel connections that serve as a conduit for information transmission between companies...Employee transfers are common.., among large manufacturers and their subcontractors" (p. 104). There are several types of keiretsu groups in Japan. As Gerlach points out: "The vertical keiretsu organize suppliers and distribution outlets hierarchically beneath a large, industry-specific manufacturing concern. Toyota Motor Corpor8Aoki (1987) finds that over one half of Japan's medium to small manufacturing businesses serve as subcontractors to larger companies, and that the use of keiretsu structures to link relativelysmall firms is increasing (Aoki, 1988). 9Along these same lines Mody (1993)argues that "[t]fie Japanese firm is the best-documentednexus of network alliances"(p.154).

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S.C. Hackett, K. Srinivasan / Japan and the World Economy 10 (1998) 13-32

ation's chain of upstream component suppliers is a well-known example of this form of vertical interfirm organization (p.4)... The upstream supplier firms and downstream distributors introduce at the interfirm level some of the characteristics one associates with standard hierarchical organization (notably a degree of centralization of product-related decision making, which is managed by the parent firm) (p.xviii)... These large manufacturers are themselves often clustered within groups involving trading companies and large banks and insurance companies [intermarket keiretsu groups]" (p.4). Other Japanese industry analysts offer similar descriptions of vertical keiretsu groups. For example, Lawrence (1993) describes the vertical keiretsu as a group: "Composed of one or more large industrial concerns and their subsidiaries, allied firms, important customers and subcontractors. These so-called vertical keiretsu are usually concentrated in a single or limited number of industries, like Toyota and Nissan in autos; Nippon Steel in metals; and Hitachi, Toshiba, and Matsushita in electronics" (p. 11). Similarly, Aoki (1984) reports that much of Japanese industry has been organized around vertical keiretsu groups that link a dominant parent corporation with many satellite subcontractors through reciprocal relationships. Examples include extensive interfirm trade credits, networks created by members holding various degrees of ownership in one anothers' firms, and mutual favoritism (kashi-kari-kankei). Members of the vertical keiretsu group tend to specialize in complementary activities such as R&D, parts manufacture, and the assembly of these parts into final products. Vertical keiretsu thus are powerful examples of the "minisocieties" of strong-form relational exchange described by Macneil (1978). Cable and Yasuki (1985) describe some of the benefits of the vertical keiretsu structure: "Trading relationships between members of the same [Japanese] business group would be subject to less uncertainty and risk than with outsiders, because of the greater information held by each trading partner about the other, and the feelings of group loyalty that are likely to exist between them... IT]he diversified nature of the groups' activities means that the scope for securing intermediate goods supplies and market outlets within the group will often be large" (p.404). From a more transaction-cost perspective, Goto (1982) suggests that keiretsu and other alliance groups in Japan have the advantage of avoiding some of the diseconomies (e.g., lack of entrepreneurial initiative) associated with hierarchical vertical integration, while maintaining the information exchange advantages of integrated structures. Coordination is "secured by a set of tacit, informal rules that emerge through a long history of exchange of information and recognition of interdependence, substantiated by financial linkages and interlocking directorates" (p.61). Antitrust restrictions limit the ability of US firms to replicate these organizational structures. The dominant role of vertical keiretsu and other cooperative industrial alliances in Japan implies vertical ties that are generally much stronger than among US firms. Gerlach points out that while the affiliations and long-term relationships that occur

S.C. Hackett, K. Srinivasan / Japan and the World Economy 10 ( 1998 ) 13 32

19

within the extended network of the vertical keiretsu system are not unique to Japan, "what distinguishes Japan from the United States (which perhaps lies at the other extreme of the transactional continuum) is their pervasiveness and continuing visibility" (p.4). Froot (1991) offers evidence that the multinational-component supplier relationship is stronger for Japanese firms than for multinationals from other countries: "Japanese manufacturing affiliates tend to avoid using domestic suppliers, importing roughly three times as much per worker as other foreign manufacturing affiliates in the US. Evidence on Japanese affiliates in Australia suggests that they purchase their capital goods almost exclusively from Japan, whereas other foreign affiliates in Australia purchase from nations other than their home" (p.22).1° Gerlach similarly argues that Japanese overseas business relationships follow patterns of domestic relationships. There is thus strong evidence of the powerful relationships in vertical keiretsu groups. We build on that work by empirically investigating its implications when Japanese firms invest in foreign production facilities and are confronted with host country policies requiring use of locally supplied components. The hypothesis we investigate is that Japanese multinational firms will be relatively more sensitive to host country policies that require them to replace component suppliers from the vertical keiretsu with host country component suppliers. Another way to put the argument is that the costs borne by multinationals in the process of sacrificing the coordinating advantage of keiretsu-member supply, finding satisfactory host country suppliers, negotiating contract terms and safeguards, and adapting production processes to the locally supplied component, will be relatively higher for Japanese firms. There are thus greater gains to avoiding supplier switching costs for Japanese firms, which should be reflected in less manufacturing F D I in host countries with restrictive LCR and R I M policies for Japanese firms relative to firms from the US and other countries. This we hypothesize will be true even if we condition for other factors affecting F D I location. Ozawa (1991) states that in some cases entire keiretsu groups have been investing in overseas facilities. Thus an alternative hypothesis is that such keiretsu-level investment is a low cost means for Japanese firms to avoid otherwise high supplier switching costs, in which case there should be little difference in the sensitivity of manufacturing F D I by Japanese and US firms. We now turn to a description of the data, the methods of analysis, and how they relate to the supplier switching costs hypothesis.

1°Also see Kreinin (1988) for an earlier analysis of this data set. Kreinin finds that most of the 22 Americanowned subsidiaries in Australia are managed by Australians, as are most of the 20 European subsidiaries. In most cases, subsidiaries of American and European multinationals have full autonomy with respect to purchases and sourcing. In contrast, only one of the 20 Japanese subsidiarieswas managed by an Australian, and were generally tightly controlled by the Japanese parent company. Similarly the American and European-owned subsidiaries procured capital equipment (usually through competitive bidding) from a wide variety of countries, with no one source being dominant, while in 75% of the Japanese companies either all or at least 80% of the capital equipment was of Japanese origin (absent competitivebidding).

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S.C. Hackett, K. Srinivasan / Japan and the World Economy 10 (1998) 13 - 3 2

3.2. Description of data and methodology The only comprehensive source of information that we are aware of on host country characteristics relevant to the location of FDI projects are the annual host country scores provided by the Country Assessment Service of BI. 11 These variables are measured on a 0 - 10 scale, and the higher the score the more favorable it is for FDI. Note that BI first forms categories based on summary statements of policy restrictiveness, and assigns score numbers to these categories. Two score numbers are generally assigned to each category, allowing for more subtle distinctions in policy restrictiveness.12 The Japanese data on FDI are not published, and were made available to us by the Japanese Ministry of Finance. The US FDI data are tabulated by the US Department of Commerce and published in the Survey of Current Business. Before we describe the methods of analysis, we first need to describe the nature of the BI data. The ranked BI country scores data qualify as ordinal measures of a country's attributes, just as "win-place-show" provides ordinal measures of performance in a horse race. In statistics, order methods are used when evaluating hypotheses with ordinal-scaled data. Regression analysis requires data measured on an interval scale, which in the horse race example means that we must know both the rank order as well as the stretch of time between win and place, and between place and show. While the BI data scoring system was undoubtedly constructed to create meaningful intervals between rank levels, the BI country scores may not fully qualify as interval-scaled data. We therefore use two methods to analyze the importance of supplier switching costs in influencing a firm's FDI location decision. We first examine the relative sensitivity of FDI by Japanese and US multinationals to import restrictions (e.g., on intermediate goods) and local content requirements imposed by the host country by employing a non-parametric test that employs order methods. Order methods represent a class of statistical technique that allow for hypothesis testing based on ranked data that are measured on an ordinal rather than interval scale. The particular statistical method appropriate for our purposes is known as the K o l m o g o r o v - S m i r n o v ( K - S ) test (Kolmogorov, 1941). To see how the K - S test is used, note first that score observations can be thought of as classes of observation. Two variables relevant to the supplier switching cost hypothesis are restrictions on imports RIMs and local content requirements LCRs. RIMs are policies specifically directed at the subsidiaries of foreign multinational firms, and are designed to restrict (in varying degrees) component imports by these subsidiaries. LCRs are also specifically directed at subsidiaries, and require (in varying degrees) ~The BI data are the best source of information on host country policies that we are aware of. Another source of information on the restrictiveness of RIM and LCR polices is provided by the Benchmark Survey of US Investment Abroad, published by the US Department of Commerce. These data give the total number of FDI projects by the US multinationals in various host countries, and the proportion of these projects that are subject to RIM and LCR policies. This proportion gives a rough measure of the restrictiveness of host country policies. We find that these proportions are significantly correlated with the country scores provided by BI (0.4524 for RIM and 0.4753 for LCR, both significant at below the 1% level). We use the BI data, however, because they more directly assess the restrictivenss of host country policies. ~2Ranks 9 - 1 0 do not differ.

S.C. Hackett, K. Srinivasan / Japan and the World Econom.v 10 (1998) 13-32

21

subsidiaries to use components produced locally. The scoring criteria that measure the restrictiveness of LCR and RIM policies are described in Table 1. For a given policy (e.g., LCR), one can then compute two sample cumulative relative frequencies - one for the sample of FDI by Japanese firms, and one for the sample of FDI by US firms. For the years 1982 and 1989 we were able to get data on all manufacturing FDI by both US and Japanese firms to projects in host countries scored by BI. For the intervening years 1983 1988 the available US data only gives FDI in majority-owned foreign affiliates. Each cumulative relative frequency describes the cumulative share of FDI that goes to countries whose country score is less than or equal to a particular score class. One could then test the null hypothesis that the two sample cumulative relative frequencies are generated by the same underlying process. In the K - S test one first computes the maximum absolute difference between the cumulative frequencies at a given class. Given the smaller of the two sample sizes and the size of the maximum absolute difference, one can then determine, using a table of critical values developed by Amssey (1951) and reprinted in Hays (1988), the significance level at which the null hypothesis can be rejected. Evidence that supplier switching costs are higher for Japanese firms

relative to US .firms is found when one can reject the null hypothesis because the cumulative frequency of FDI by Japanese firms is smaller than that for US firms at the point of maximum absolute difference. A central limitation of order methods lies in the inability to condition for other factors that can potentially affect FDI location. Multiple regression analysis offers an alternative methodology that conditions for the influence of other factors that can affect FDI location. While regression analysis offers insight into the possible interactive effects of factors influencing the location of FDI projects, there are at least two potentially serious limitations to the available data that together imply some caution should be used in interpreting the regression results. First, as we mentioned above, the BI data may not be fully interval-scaled. Second, recall that over the period 1983 - 1988 the available US data give FDI for only majority-owned affiliates of US firms, while the Japanese FDI data cover both majority and minority-owned Japanese affiliates. Thus the available Japanese and US data sets are not perfectly comparable. The panel data we use in our regression analysis includes FDI by Japanese and US multinational firms in 30 countries over the entire period 1982 - 1988. We are able to include 1982 because in that year U S FDI data were collected for both majority-owned affiliates and for all affiliates. Thus the regression analysis for US FDI uses majorityowned affiliates data. To condition for other factors affecting FDI location, we use two sets of factors that have been identified by earlier studies as influencing FDI location. The first set consists of traditional economic factors, and includes host country market size, cost of local labor, level of corporate tax, the stock of FDI the Japanese and US firms already have in particular host countries, and the quality of host country infrastructure. In the second set, we include other policy variables that have been identified to influence FDI location. These include limits on foreign ownership, currency convertibility restrictions imposed by the host country, export requirements imposed by the host country, the provision of a privileged environment for local firms by the host country, and the possibility of expropriation of a foreign affiliate by the host country. We have tried to incorporate a wide gamut of factors based on results

10- 9

None

None

Score value

Restrictions on imports (RIMs)

Local content requirements (LCRs)

Table 1 Policy variables

Pressure to use local components

Minor restrictions on a small number of imports

8- 7

Specific selective requirements for local content

Significant restrictions on a few key imports from time to time

6- 5 Substantial restrictions on wide range of imports from time to time General requirements for a specified percentage of local content

4- 3

Substantial restrictions continuously applied to most imports Strictly enforced requirements for fully utilizing local content

2- 1

No outside components allowed

Stiff restriction and occasional outright banning of most imports

0

I

t~

r~

t,J t~

S.C. Hackett, K. Srinivasan / Japan and the World Economy 10 (1998) 13 32

23

obtained in earlier studies (see Graham and Krugman, 1991; Kravis and Lipsey, 1982; Srinivasan and Mody, 1994; Wheeler and Mody, 1992). The scoring criteria used by BI for the "other factors" are described in Tables 2 and 3. Using the panel data we estimate below a log-linear foreign investment function that regresses the logarithm of $FDI on the logarithm of each independent variable, enabling us to interpret the regression coefficients as measures of elasticity.

3.3. Analysis of results Cumulative relative frequencies for total manufacturing FDI by Japanese and US firms are given in Figs. 1-4. These frequencies are given for the 1982 and 1989 benchmark years using country score classes for restrictions on imports RIMs and local content requirements LCRs. We first focus attention on 1982 and 1989 because, as we mentioned above, data are available for these benchmark years on FDI by US firms in both minority and majority-owned affiliates, while for the intervening years data are available only for FDI in majority-owned affiliates. Note first that FDI by both Japanese and US multinational firms is directly related to country score - multinational firms regardless of their country of origin invest more than proportionately in countries with the most favorable RIM and LCR policies. The question we ask, however, is the relative responsiveness of Japanese and US multinational firms to policy restrictiveness. In each case we are able to reject the null hypothesis that the FDI distributions are the same. Moreover, in each case the null is rejected when the cumulative frequency of FDI by Japanese firms is significantly smaller than that for US firms at a less than maximum score value. First consider 1982 data, where Japanese firms had manufacturing FDI in 37 countries evaluated by BI, while US firms had manufacturing FDI in 39 countries. As seen in Fig. 1, the maximum absolute difference in cumulative frequencies for RIM scores was 0.3 at a score of 8, and given the sample size this difference is significant at below the 1% level. Note from Fig. 1 that while for RIM scores below 7 cumulative FDI frequencies for Japanese firms slightly exceeds that for US firms, it is important to recognize that the difference is not significant at even the 10% level. Moreover, this is the only situation in the benchmark years in which cumulative frequencies for Japanese firms exceeds that of US firms by other than trivial amounts. The results illustrated in Figs. 2 - 4 also reveal the greater sensitivity of Japanese multinationals to import restrictions and local content requirements. In Fig. 2 one can see that the maximum absolute difference in cumulative frequencies for LCR scores was 0.301 at a score of 8, and is also significant at below the 1% level. These findings are replicated in the 1989 data, where Japanese firms invested in 38 countries evaluated by BI, while US firms invested in 36. For RIM scores the difference is 0.431 at a score of 8, while for LCR scores the difference is 0.408 at a score of 8. The analysis finds that for relatively low country scores, cumulative FDI frequencies by Japanese and US multinational firms are remarkably similar - multinational firms do not appear to do much investing in host countries with RIM and LCR scores much below 5. For low-scoring countries the investment shares of firms from both countries

Very high; large investments in many sectors

> $250 billion

Excellent transportation, communication, and energy services available

Market size

Quality of infrastructure

20.1 25%

Existing stock of FDI

<20%

Corporate tax rate

$0.51$1.00

10-9

<$0.50

Avg. hourly manufacturing wage

9

Variable

10

Variable

Table 2 Measures of traditional economic variables

Normally good services but specific shortcomings

Widespread shortcomings but basically adequate

$75 - $99.9 billion

$100-$249.9 billion

6- 5

35.1 40%

$2.01$2.50

6

Moderate; broadly based

30.1 35%

$1.51$2.00

7

High; broadly based

8- 7

25.1 30%

$1.01$1.50

8

40.145%

$2.51$3.00

5

Inadequate infrastructure; only a few adequate services

$50 - $74.9 billion

Moderate; selective sectors

4- 3

45.150%

$3~01$4.00

4

50.1 55%

55.1 60%

$5.01$6.00

2

Totally inadequate overall infrastructure

$20- $49.9 billion

Low

2- 1

$4.01$5.00

3

65.1 70%

$7.01 $8.00

0

Practically no infrastructure to support business activity

< $20 billion

Very low

0

60.1 65%

$6.01$7.00

1

i,,,a

x.._

~

~-

~"

e,

~. ~

r,o

-~ .~

.~

i-o

None

None

None

None

None

Convertibility to foreign currencies~

Export requirements

Expropriation

Limits on foreign ownership

Privileged environment for local firms

Selective protection of a few local firms

Pressure for local ownership shares; some obstacles to expansions

Govt, patticipation in and control of certain firms

Pressure to generate exports

Minor restrictions

8-7

Generally Protectire of local firms

Majority local ownership required

Selective, sporadic govt. takeover of some firms

Selective requirement to export a certain percent of domestic production

Strict controls on specific transfers

6-5

Significant privileges for local firms

Strict joint venture requirements; general policy against expansion

Compensated takeover of numerous firms

General requirements to export a certain percent of domestic production

Prior approval for all transfers

4-3

Foreign-owned firms uncompetitive due to excessive protection

Foreign minority position or even divestiture required; rigid policy against expansion

Takeover of numerous firms; little or no compens.

Strict requirements to primarily produce for export

Inconvertible on a sporadic, shortterm basis

2-1

Foreign-owned firms not allowed to compete

No foreign ownership allowed

Almost total elimination of private sector

Foreign-owned firms only allowed to produce for export

Inconvertible for practical purposes

0

These are the subset of general currency convertibility and import restrictions that are applied separately for transactions inw~lving foreign-owned firms.

I0-9

Variable

Table 3 Measures of "Other Policy Variables"

t,,,a

I

oo

.-,..

Cumulative FDI Distribution 1

0.7

-

0.6 0.5 0.4 0.3 0.2 0.1

~ 2

3

4

5

6

7

8

9

10

Country Score FDI, Japanese Firms

-e-

FDI, US Firms

Greater Score => Fewer Host Country Restrictions on Component Imports

Fig. 1. Cumulative FDI by RIM score 1982 host countries aggregated by score.

Cumulative FDI Distribution 1, 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

=

2

=

3

-~

4

-

5

6

7

8

9

10

Country Score FDI, Japanese Firms

-e-

FDI, US Firms

Greater Score => Fewer Host Country Local Content Requirements

Fig. 2. Cumulative FDI by LCR score 1982 host countries aggregated by score.

Cumulative FDI Distribution 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 2

3

4

5

6

7

8

9

10

Country Score ~ L . FDI, Japanese Firms

~

FDI, US Firms

Greater Score => Fewer Host Country Restrictions on Component Imports

Fig. 3. Cumulative FDI by RIM score 1989 host countries aggregated by score. Cumulative FDI Distribution 0. c, 0.8

j

0.7 0.6 0.5 0.4 0.3 0.2 0.1

3

4

5

6

7

8

9

10

Country Score FDI, Japanese Firms

-e-

FDI, US Firms

Greater Score => Fewer Host Country Local Content Requirements

Fig. 4. Cumulative FDI by LCR score 1989 host countries aggregated by score.

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S.C. Hackett, K. Srinivasan / Japan and the Worm Economy 10 (1998) 13-32

are similarly small, and increase with country scores in similar ways. The difference we identify in the investment behavior of Japanese and US firms develops at moderately high score values. US firms are relatively insensitive to score variation at scores above 7, while the great majority of investment by Japanese firms occurs in those countries that have perfect country scores of 10 for both RIM and LCR. Note that even though some keiretsu group-level FDI may have occurred as a means of avoiding these supplier switching costs, as Ozawa (1991) suggests, the analysis here suggest that the practical difficulties involved in using such moves as a 9eneral response to LCR and RIM policies are simply another reflection of supplier switching costs. We also compare cumulative FDI frequencies by Japanese and US multinationals for the intervening years of 1983-1988. Because available US data are for majorityowned affiliates while the Japanese data are for all affiliates, the results should be viewed with some caution. Nevertheless, our findings are the same as in the benchmark years of 1982 and 1989. In particular, based on the K o l m o g o r o v - Smirnov test we find in each case that we are able to reject the hypothesis that the Japanese and US FDI cumulative frequencies are the same. In each case, the cumulative frequencies differ significantly under conditions where significantly less Japanese than US FD1 occurred in countries with less than perfect LCR and RIM scores. US firms engage in significantly more FDI in countries with RIM and LCR scores between 7 and 9; elsewhere the differences are insignificant. While the data are not perfectly comparable, the results for 1983- 1989 provide a limited robustness test for our results. With the available panel data we use multiple regression analysis to estimate a foreign investment function that conditions for factors unrelated to supplier switching costs, but which nevertheless can be expected to influence FDI project location. Through the use of diagnostic tests (the LM and Hausman) we reject both pooled and fixed effects models, and therefore report the results of the best fitting random effects model in Table 4. Note that we have also estimated the model to take into account the possibility of autocorrelation, and fail to reject the hypothesis of no autocorrelation based on the Durbin-Watson test. The central question addressed in this paper is whether FDI by Japanese multinational firms is more sensitive to restrictions on imports and local content requirements relative to their US counterparts, as suggested by the supplier switching cost hypothesis. Evidence consistent with this hypothesis is revealed in the regression analysis. It can be noted that local content requirements are estimated to have no significant effect on FDI by US firms, while in contrast local content requirements have highly significant and very large elasticity effects on FDI by Japanese firms. Second, while import restrictions do have highly significant effects on FDI by US firms, the estimated elasticities are less than one-third the size of those estimated for Japanese firms. These differences in the influence of policies specifying import restrictions and local content requirements on Japanese and US multinational firms are largely consistent with those predicted to occur as a consequence of the tight keiretsu organizational network in Japanese industry. Among the other factors included in the analysis, quality of infrastructure in the host country and restrictions on currency convertibility imposed by the host country are found to have an important bearing on Japanese FDI location, while for the US

S.C. Hackett, K. Srinivasan / Japan and the World Economy It) (1998) 13 32

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Table 4 Log-linear estimates of US and Japanese investment function (Time period: 1982-1988)

Constant Restrictions on imports Local content requirements Convertibility of currency Export requirements Expropriation Limits on foreign ownership Privileged environment for local firms Host country market size Cost of local labor Quality of infrastructure Level of corporate tax Stock of previous FDI

United States

Japan

0.134(0.2) 0.526** (4.1) - 0 . 3 8 8 (1.1) 0.175 {1.0) - 0 . 3 3 7 (l.5) 0,001 (0.01) 0.008 (0.3) 0,164 {O5~

- 1.501 (0.8) 1.740"* (3.9) 2,669** (2.1) - 1,172"* (2.0) 1258 (1.5) 0,553 (0.4) - / ) . 2 9 6 (0.4) 0.324 (0.41

0.396** (2.7) - 0 . 1 0 7 {1.1) 1.536"* (4.0) 0.006 (0.1) 0.160 (1.1) N = 208 82 = 0.66 L M = 333.96 Hausman = 30.25

0,525* (1.6) 0.293 (1.1) 4.470** (4.3J 0,348 (0.81 1,547"*(2.5) N = 182 N umber of Countries = 30 R 2 = 0.47 LM = 30.34 H a u s m a n = 45.39

Durban Watson Statistic: 1.9

Durban Watson Statistic: 2.1

Number of Countries = 30

** a n d * indicate significance at the 5% and 10% levels respectively; t-statistics in parentheses.

multinational firms host country market size and quality of infrastructure are important in directing investment flows abroad. A large market allows a multinational firm to reap economies of scale in production, while good quality of infrastructure allows the firm to benefit from economies of agglomeration. Our findings support the results obtained by Srinivasan and Mody { 1994) who show that a large size of the host country market and the availability of infrastructure play a very important role in influencing FDI flows over the long-run. Fewer restrictions on currency convertibility allows multinational firms to repatriate profits with ease and thereby provides them with an added incentive to locate in countries with higher scores for currency convertibility. Finally, the level of the existing stock of FDI is found to significantly increase current FDI flows for Japanese firms, but no significant effects are found for US firms.

4. Discussion and concluding comments We began with the hypothesis that Japanese multinational firms seeking to invest in production facilities in foreign countries will be more sensitive to host country policies requiring a switch to local component suppliers relative to US firms. This hypothesis follows from the Japanese keiretsu system of vertical relationships, in which manufacturing firms develop and maintain strong linkages with component suppliers in the same vertical keiretsu network. We confronted this hypothesis with a non-parametric

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S.C. Hackett, K. Srinivasan / Japan and the World Economy 10 (1998) 13-32

and regression analyses of data on manufacturing FDI by Japanese and US firms to host countries for which we have country score data on the degree of restrictiveness of local content requirements and restrictions on (component) imports. We are able to strongly reject the statistical null hypothesis that the distribution of Japanese and US FD1 by country score are the same, finding instead a much lower frequency of Japanese FDI to countries with less than perfect policy scores. It is also important to point out that the results hold over a period of time (1982- 1989) when total manufacturing FDI by Japanese firms grew from approximately $2 billion to $16 billion. 13 The non-parametric analysis is further supported by regression analysis using panel data on US and Japanese FDI to 30 countries over the period 1982-1988. Restriction on imports and local content requirements are found to significantly affect the direction of FDI flows from the US and Japan, other factors withstanding, with their relative importance being greater for the Japanese multinational firms. To what extent does our empirical analysis support the hypothesis that the keiretsu system of Japanese industrial organization leads to higher supplier switching costs than those experienced by US multinational firms? While our results support this hypothesis, it is important to point out that our analysis is only suggestive, as we cannot directly observe supplier switching costs borne by Japanese and US multinationals. We believe that our results are strongly suggestive, however, since a central (though perhaps not the only) reason for multinationals to limit direct investment in host countries that have relatively restrictive local content requirements and restrictions on component imports is that these policies require switching to local suppliers, and supplier switching is costly. Examples of supplier switching costs include the process of search for a suitable local supplier, the negotiation of contractual safeguards, and possible process and product revisions in manufacturing to accommodate the local components. Given the suggestive nature of our findings, and the prominent role of Japanese firms (and the keiretsu system) in international trade and policy, further research that uncovers the microanalytic detail of supplier switching seems clearly called for. Much attention has been given to the role of keiretsu groups in limiting foreign firms' access to domestic Japanese intermediate-good markets, distribution channels, and consumers loyal to the goods of the keiretsu group that employs them. 14 One contribution of our paper is to offer a somewhat different approach to the study of keiretsu groups as organizational forms, and their performance implications. There has been relatively little empirical research addressed to the question of whether host country policies forcing foreign subsidiaries of multinational firms to use local sources of component supply have differential effects on FDI flows by Japanese and US firms. The difficulty of measuring the restrictiveness of individual host country policies directed at foreign subsidiaries is a formidable barrier to such research, t5

13Total investment by US firms grew from $21.7 billion to $37.6 billion during this same period. X4For example, Lawrence (1991) finds that Japan's manufactured imports are about 40% lower than if they were as open as the average developed country. 5One exception is a survey study by Schollhammer (1974), who contacted 140 multinational firms from France, Germany, the U K and the US, asking them to rank in order of importance over 75 country-specific factors affecting their investment decisions.

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By providing evidence consistent with the notion that supplier switching costs are higher for Japanese firms than for their US counterparts, we offer a fresh approach to evaluating transaction-cost explanations for the nature of the multinational enterprise.

Acknowledgements We would like to thank an anonymous referee at this journal, as well as Adi Brender, Keith Crocker, Tom Lyon, Ashoka Mody, Paul Joskow, Horst Raft, Ram Shivakumar, Pravin Trivedi, and Jay Wilson for their comments and encouragement. We are also grateful for the assistance of Dimitra Poulis of Business International, Inc., and the Japanese Ministry of Finance. The views expressed here are those of the authors and do not necessarily reflect those of their affiliated institutions.

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