Performance of foreign subsidiaries: Does psychic distance matter?

International Business Review 18 (2009) 38–49

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Performance of foreign subsidiaries: Does psychic distance matter? Desislava Dikova University of Groningen, Faculty of Economics, Department of International Economics and Business, P.O. Box 800, 9700 AV Groningen, The Netherlands

A R T I C L E I N F O

A B S T R A C T

Article history: Received 25 January 2007 Received in revised form 15 June 2007 Received in revised form 14 July 2008 Received in revised form 4 November 2008 Accepted 17 November 2008

Psychic distance paradox emerged from studies that found a positive effect of psychic distance on subsidiary performance. Recently, it was argued that international experience influences the relationship between psychic distance and performance. We propose that the effect of market-specific knowledge, rather than general international experience, should be examined because it negates the effect of psychic distance. We study 208 foreign direct investments made by west-European MNEs in the CEE (Central and Eastern European) region between 1996 and 2002 and find that positive relationship between psychic distance and subsidiary performance is observed only in the absence of marketspecific knowledge. Psychic distance has no effect on subsidiary performance when the MNEs have CEE investment experience or have established the subsidiary with a local partner. ß 2008 Elsevier Ltd. All rights reserved.

Keywords: Market-specific experience Psychic distance paradox Subsidiary performance Transition economies

1. Introduction Psychic distance has received significant attention in international business (IB) research (Dow & Karunaratha, 2006)—it is among the most commonly applied constructs in the research field of MNEs’ internationalization activities. The initial concept was coined by Johanson and Vahlne as ‘‘the sum of factors preventing the flow of information to and from the market’’ (Johanson & Vahlne, 1977: 24), and broadened by Nordstrom and Vahlne (1994) who suggested that psychic distance reflects factors that prevent or disturb firm’s learning about and understanding of a foreign environment (Nordstrom and Vahlne, 1994). The notion of psychic distance was mostly used to explain firms’ internationalization strategies such as selection of foreign markets (Benito & Grisprud, 1992; Stottinger & Schlegelmilch, 1998; Whitelock & Jobber, 2004) and entry strategies (Brouthers, 1995; Ellis, 2007). A few studies have tackled the issue of psychic distance’s influence on organizational (subsidiary) performance. Some found a negative relationship between psychic distance and performance (Stottinger & Schlegelmilch, 1998) others found a positive relationship that is often referred to as the psychic distance paradox (Evans & Mavondo, 2002; O’Grady & Lane, 1996). The direct relationship between psychic distance and performance that was suggested in the past contradicts the original concept of psychic distance because it overlooks the influence of factors that stimulate organizational learning about the local environment. It also assumes that all firms suffer from psychic distance in a similar way. Recently, a couple of studies addressed this limitation. In a qualitative study, Yamin and Sinkovics (2006) suggest that international experience and the reliance on host country partners reduce psychic distance effects. In a larger scale quantitative study, Evans, Mavondo and Bridson (2008) argued that the amount of experience acquired when operating in foreign markets is likely to have an effect on the firm’s perception of the similarities and difference between markets. However, the study produced insignificant results and concluded that international experience did not influence psychic distance. The possession of experimental knowledge by the investing firm may influence the relationship between psychic distance and subsidiary performance because such knowledge facilitates firm’s learning about and understanding of a foreign

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environment. A close examination of Johanson and Vahlne’s (1977) work provides an indication to what type of knowledge is likely to influence psychic distance. The authors argue that general experimental knowledge is not market-specific as it concerns firms’ general abilities to handle international operations—such knowledge involves common business operations such as purchases, sales, payments, employees, etc. irrespective of location (Carlsson, Nordegren, & Sjoholm, 2005). Therefore, the amount of accumulated general international experience should not matter much for the reduction of psychic distance effects because psychic distance is brought about by market (country) differences. Experimental market-specific knowledge is the most critical type of experimental knowledge in a firm’s internationalization (Penrose, 1959). A possession of market-specific information means that the investing firm understands the specific market and its characteristics such as business climate, culture, structure of the market system, and individual customers (Carlsson et al., 2005). In other words, when such crucial market information is available to the investing firm, psychic distance no longer exists, as there are no obstacles to understanding the foreign market. Here we suggest that local market knowledge, which can be acquired by the parent MNE through own (prior) investment experience or through the involvement of a local partner, negates the effect of psychic distance on subsidiary performance because such market knowledge eliminates the factors that prevent a firm’s learning about a foreign environment. Hence, psychic distance exists only for firms which lack market-specific knowledge because such firms face a variety of factors that prevent the flow of information to and from the market (Johanson & Vahlne, 1977). To empirically test our proposition, we examine 208 foreign direct investments made by west-European MNEs in the CEE (Central and Eastern European) region between 1996 and 2002. The results demonstrate that the positive relationship between psychic distance and subsidiary performance suggested by past research is observed only in the absence of marketspecific experimental knowledge, that is, when the investing MNEs have either no prior investment experience in the CEE region, or have established the subsidiary without a local partner. Psychic distance has no effect on subsidiary performance when the MNEs have previously invested in CEE or have shared the ownership of the focal subsidiary with a local partner. These findings stress the importance of market-specific experience, not considered in past studies which investigated the effect of psychic distance on organizational performance. In the following sections, we discuss the theory and build our hypotheses. Next, we describe our empirical analysis and interpret our model results. Finally, we discuss the implications and limitation of the current study. 2. Theory and hypotheses 2.1. Psychic distance measurement The concept of psychic distance puts an emphasis on the extent environmental differences between home- (of the investor) and host countries inhibit information flow and create barriers to learning about these markets (O’Grady & Lane, 1996). Firms expanding their current operations to a foreign market are often disadvantaged in relation to indigenous firms because of their unfamiliarity with the local business environment. This environmental unfamiliarity of the foreign firm creates high levels of uncertainty that ‘‘impedes effective decision making and leads to difficulties in dealing with local governments and partners’’ (Pedersen & Petersen, 2004: 103). Psychic distance is a result of differences in local consumers preferences, cultures, and business systems which reduce the level of understanding of the local market conditions. There have been numerous attempts to measure psychic distance in the past. The result is an on-going debate whether psychic distance should be measured as individual perceptions or whether it should be measured using country-specific information. The measure of psychic distance as a perception of environmental differences expressed by key decision makers has an advantage in that many of the management decisions associated with psychic distance, such as foreign market entry mode choice, are made based on the manager’s perceptions at the time (Dow & Karunaratha, 2006). However, Dow and Karunaratha (2006) point out several limitations to such an approach—there is the problem of determining the direction of causality, that is, it is not always possible to discern whether the post-decision experience influenced the individual perceptions of psychic distance or vice versa. To resolve the problem of causality, an alternative measure can be used to measure psychic distance—it comprises of macro-level factors identified by researchers such as Johanson and Vahlne (1977), Boyacigiller (1990), Evans, Treadgold, and Mavondo (2000), and Evans and Mavondo (2002). Dow and Karunaratha (2006) suggest a name for this alternative measure: psychic distance stimuli. Languages, culture and business environment are among the most commonly cited estimates of psychic distance stimuli. We apply this method of measuring psychic distance as an answer to a suggestion by Evans et al. (2000) to move beyond the direct measurement of perceptions and begin to explore the factors driving those perceptions as this will ultimately make research more valuable to both policy makers and managers. 2.2. Psychic distance paradox and experimental knowledge Differences in language and business practices incur learning costs (Ellis, 2008). Hence, some authors have proposed in the past that international operations in psychically close countries should improve a company’s chances of success in those markets (O’Grady & Lane, 1996). In line with such logic, operations in similar markets should be easier to manage hence, an inverse relationship between psychic distance and firm’s performance in those markets can be suggested (Ellis, 2008).

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To the contrary, Evans and Mavondo (2002) argue that when firms enter psychically distant markets they are likely to perceive a high level of uncertainty. In order to reduce uncertainty, firms undertake more extensive research and planning, which consequently improves the foreign market entry strategy and ultimately, the subsidiary’s organizational performance. If differences in formal institutional environment do not discourage firms from entering the distant market, these foreign firms would be more cautious and seek to acquire more knowledge of the local market regulations, legal system and law-enforcement procedures in order to reduce the uncertainty of the unknown environment. This extensive pre-investment preparation will eventually exert a positive effect on performance. To the opposite, managers investing in psychically proximate markets assume similarities, may not perform in-depth research activities prior to the market entry and therefore can overlook subtle but important market differences. This in turn may have a negative effect on subsequent subsidiary performance. Because psychic distance is neither fixed nor the same for all firms investing in a particular market, and it ‘‘diminishes in tandem with international experience’’ (Ellis, 2008: 356), an examination of a direct relationship between psychic distance stimuli and subsidiary performance may bias the results. Hence, it was suggested that the effect of psychic distance stimuli is influenced by a firm’s or a manager’s sensitivity to psychic distance, and this sensitivity is determined by factors such as international experience (knowledge) and decision maker’s personal background (Dichtl, Koeglmayr, & Mueller, 1990). Having acquired experience in one market, managers can transfer such experimental knowledge to other similar markets and as a result reduce the level of uncertainty about operating in these markets (Ellis, 2007; Mitra & Golder, 2002). Such learning effect is consistent with Nordstrom and Vahlne’s (1994: 42) conceptualization of psychic distance as ‘‘factors preventing or disturbing firms’ learning about and understanding a foreign environment’’. In line with organizational literature’s focus on the experience of the organization rather than of the individual (Cohen & Levinthal, 1990), we examine the moderating effects of firm-specific knowledge. With experience the liability of foreignness is reduced. As noted by Evans et al. (2008) despite the lack of research in this area, it can be argued that organizations with limited international experience can overestimate the similarities between their home market and the foreign market ‘‘on the basis of superficial observations that are often made from a distance’’ (Evans et al., 2008: 38). In contrast, because of the superior market-sensing capabilities of internationally experienced firms, such firms are capable of understanding the unique subtleties in each foreign market (Evans et al., 2008). However, relying solely on general international experience may be insufficient to overcome the obstacles of psychic distance. As argued before, general international knowledge is knowledge about how to handle international operations but it is not marketspecific (Carlsson et al., 2005). The market-specific knowledge about business climate, individual customers and suppliers, culture etc. is critical in overcoming the psychic distance hurdles. Therefore, when the effect of psychic distance stimuli on subsidiary performance is examined, market-specific experience has to be considered. In the context of the on-going discussion on regional versus global drivers of internationalization (Rugman & Verbeke, 2004), a consideration of regional experience rather than country-specific experience has a number of advantages. Firstly, regions rather then countries became the basis of competition (Buckley & Ghauri, 2004). Secondly, only a few companies among the Fortune Top 500 can be considered as operating on a truly global basis—researchers report that most international competition takes place on a regional basis (Rugman & Verbeke, 2004). Thirdly, entering a new cultural bloc is challenging and such an international expansion is likely to suffer from liability of foreignness (Hymer, 1975). Although Ronen and Shenkar (1985) did not identify CEE region as a separate cultural bloc, the grouping of the CEE countries is based on the shared recent history of experience with communist regime and the liberation there-from (Barkema & Drogendijk, 2007). In addition to the similarity of experiences with communism, the countries in the CEE region share commonalities in the transition process towards market economic systems (Peng & Heath, 1996). Feichtinger and Fink (1998) refer to the transition process of CEE region as a ‘‘collective culture shock’’ which contributed to the creation of a distinct ‘‘bloc culture’’ (Meyer & Peng, 2005: 611). Finally, CEE countries are often treated as one bloc both by supra-national institutions such as UNCTAD and by researchers (Barkema & Drogendijk, 2007). Hence, based on recent developments in IB research, in the context of international investments in the CEE region, we chose to examine the influence of regional experience on the relationship between psychic distance stimuli and performance. Western companies investing in the CEE region after 1989 had to learn how to deal with common problems related to market liberalization, political democratization, and processes of social and cultural change implying ‘‘similar liabilities of foreignness and solutions for how to handle them’’ (Barkema & Drogendijk, 2007). Companies entering a new cultural blocs typically need to learn new concepts, and to translate their experimental learning into strategies, rules, procedures and conventions that are effective in the new cultural setting (Barkema & Drogendijk, 2007). We suggest that a prior investment in the CEE bloc stimulates the specific type of organizational learning which eliminates the factors that interrupt the understanding of the local environment. The accumulated market knowledge negates the influence of psychic distance stimuli on subsidiary performance. Reversely, we echo the proposition by Evans and Mavondo (2002) that those firms inexperienced in doing business in the CEE bloc, which did not get discouraged by differences in the formal and informal institutional environment, would be more cautious entering these markets and would seek to acquire more knowledge of the local market in order to reduce the uncertainty of the unknown. We suggest a positive effect of psychic distance stimuli on subsidiary performance for firms lacking prior experience in CEE. Hypothesis 1. Psychic distance stimuli are positively related to subsidiary performance for MNEs with no prior CEE investment experience.

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It has already been established that conditional on the level of regional experience, the costs of doing business in psychically distant countries could be high. However, apart from relying on own experience, there are other strategies firms can use to mitigate such costs. Ownership strategy is a useful tool in reducing unfamiliarity hazards. Shared ownership can reduce the costs associated with liability of foreignness or environmental uncertainty—with superior local knowledge and local connections local partners can assist foreign subsidiaries in reducing their unfamiliarity with the environment and in enhancing local legitimacy (Gaur & Lu, 2007). Since most of the knowledge necessary to operate in a foreign market is tacit, local partners can be quite helpful in providing this type of knowledge. Establishing a local partnership can therefore eliminate the effect of psychic distance on subsidiary performance. Reversely, past research has found that choosing a local partner in unfamiliar environmental is challenging (Anderson & Gatignon, 1986). In the context of managing joint operations in an unfamiliar environment, that is, under great uncertainty, it can be more difficult to find trustworthy partners as they may act opportunistically, requiring higher levels of monitoring and coordination (Gomes-Casseres, 1990). Regardless, if a local partnership is chosen to facilitate the foreign market entry by reducing the unfamiliarity hazards (for example, the liability of foreignness costs), it could be that the costs of preventing relational hazards exceed the benefits of reducing environmental uncertainty. Therefore, with an increasing institutional distance, some authors suggest that MNEs should aim at achieving higher levels of ownership because a tighter control over the subsidiary enhances its survival chances (Gaur & Lu, 2007). In line with these findings, we propose a positive relationship between psychic distance stimuli and subsidiary performance for MNEs which have established a wholly owned operation in CEE region. Hypothesis 2. Psychic distance stimuli are positively related to subsidiary performance for MNEs which have established a wholly owned subsidiary. 3. Methodology 3.1. Data To test the above hypotheses, an international mail survey was conducted in May 2003 among internationally experienced western European companies which established a subsidiary in CEE between 1996 and 2002. Pilot-tests with managers in four Dutch companies were carried out to improve the clarity and precision of the questions asked. The Englishlanguage questionnaire was sent for feedback to academics with expertise in the field. The final version of the questionnaire was then translated into three additional languages (German, French and Italian) and then for greater precision, backtranslated into English by native-speakers with sufficient understanding of the subject. In total, initially 2798 questionnaires were mailed out to all registered in Amadeus database companies based in the then 15 members states of the EU with at least a ten per cent ownership stake1 in a branch/subsidiary located in any of the following countries: Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia. Thirty-five questionnaires were returned as non-deliverable, which compressed the sample size to 2763 questionnaires. In addition, the initial sample size was further reduced by 43 firms due to either expressed unwillingness to participate in the survey or completed questionnaires concerning investments in Ukraine, Russia or East Germany. We received 208 usable questionnaires, representing an overall response rate of 7.5 per cent.2 Table 1 summarizes the number of questionnaires received by country and presents the number of observations (subsidiaries) per industry. The questionnaires were completed by a business-unit top manager accountable for and knowledgeable of the latest CEE expansion. As a result of missing data in various questionnaires, we could use 193 of them in the current study. To test the representativeness of our sample, we conducted a t-test comparing the firm size of our sample to a random selection of the firm-population, which revealed no statistically significant differences in the two means. This shows that that our survey sample is representative for the larger population. Furthermore, from the Amadeus database we downloaded available objective information on firm size (number of employees worldwide) and total (worldwide) sales for 155 of the firms in our sample. We performed statistical tests to compare our primary data with these pieces of secondary-source information. Paired-sample t-tests showed that the differences in means between the survey-collected information and the Amadeus data were insignificant for both firm size (t = .54, df = 137 and p = .58) and total sales (t = 1.40, df = 151 and p = .15). The number of observations included in both tests differs due to missing primary data: occasionally, managers consider certain firm information sensitive or confidential and as a result many of our questionnaires were returned incomplete. In addition, following Uhlenbruck and DeCastro (2000), we determined a reliability coefficient for both couples of primary and secondary variables. To obtain this coefficient, we used the general form of the Spearman–Brown prophecy formula and incorporated the standard deviations and correlations of .98 (size) and .92 (sales) between the archival data and our survey information. The coefficients of 0.99 for size and 0.96 for sales confirm the reliability of our primary data.

1 We comply with the majority of empirical studies that use a stake of 10 per cent and above in a foreign enterprise as a minimum to qualify as a foreign direct investment (Padmanabhan and Cho, 1999; Larimo, 2002). 2 International mail surveys aiming at an industrial population have a history of vary low response rates: regular mail surveys without a telephone precontact or a follow-up achieve response rates between 6 and 16 per cent (Dawson and Dickinson, 1988; Ghoshal and Nohria, 1993; Harzing, 1997; Shiphandler, Terpstra, & Shaheen, 1994).

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Table 1 Establishments by host country and industry. Host country Panel A: Foreign entries by host country Poland Czech Republic Romania Hungary Slovakia Bulgaria Estonia Lithuania Slovenia Latvia Total

Total 64 42 40 21 10 9 7 7 5 3 208

Panel B: Number of observations by industry Manufacturing Food products and beverages Textiles, leather and footwear Wood, pulp and paper products Basic metals and fabricated metal products Non-metallic mineral products Machinery and equipment Chemical products (excluding pharmaceuticals) Various Total

Number of observations 15 12 15 24 11 23 19 34 163

Non-manufacturing Wholesale and retail Other

28 17

Total

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3.2. Variables The dependent variable of this study is managerial satisfaction with subsidiary’s performance. Information on firms’ profits, output or value added is often used to measure performance (Carlsson et al., 2005). The problem with such measures is that information can be affected by transfer pricing, by the variety of ways firms report royalties, management fees and by differences in accounting standards across countries and firms (Buckley, 1996). In addition, Carlsson et al. (2005) argue that surveys that offer the possibility to managers to evaluate their own subsidiary performance tend to generate higher response rates. Another reason that determined the use of subjective measure is that a substantial number of questionnaires refer to investments made after the year 2000 (41% of the total number of questionnaires received). Several authors suggest that increased financial performance may not occur for a number of years after initial foreign market entry, but that other measures of performance may help to determine the effectiveness of the investment (Anderson, 1990; Geringer & Hebert, 1991). This argument may hold true particularly in case of ‘‘young’’ investments. Subjective measures in the form of management evaluations are preferred when non-financial performance is examined or when objective financial measures are not available (Brouthers, 2002; Dess & Robinson, 1984; Geringer & Hebert, 1991). We adopted the approach of previous studies and asked respondents to rate their satisfaction along eight performance dimensions: sales level, sales growth, profitability, market share, marketing, distribution, reputation, and market access (Brouthers, Brouthers, & Werner, 1999, 2000, 2003; Geringer & Hebert, 1991). Respondents evaluated each performance measure on a scale ranging from 1, ‘‘very dissatisfied’’, to 10, ‘‘very satisfied’’. To assess the dimensionality of managers’ satisfaction with subsidiary’s performance and to reduce the number of variables, a factor analysis was performed which resulted in a single factor outcome—the scale reliability tests produced a satisfactory value of Cronbach Alpha (0.91). We measure psychic distance stimuli by two variables: formal institutional distance and informal (cultural) institutional distance. The first independent variable, Formal institutional distance is a composite measure obtained from the World Bank’s Governance Indicators (Kaufmann, Kraay, & Mastruzzi, 2005), which provide a score on items such as voice and accountability (measuring political, civil and human rights), political stability (measuring the likelihood of violent threats to or changes in government), government effectiveness (measuring the competence of the bureaucracy and the quality of public service delivery), regulatory quality (measuring the incidence of market-unfriendly policies), rule of law (measuring the quality of contract enforcement, the police, and the courts, as well as the likelihood of crime and violence) and corruption control (measuring the exercise of public power for private gain). The composite measure ranges from 2.5 to 2.5, with higher scores

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corresponding to higher institutional advancement. We use these indicators because to date, these indicators encompass the broadest range of institutional issues, comparable across developed market economies and transition economies. To estimate the distance, we apply the formula by Kogut and Singh’s (1988), which was originally developed to measure cultural distance. In a similar manner, we calculate Informal institutional distance using Hofstede’s (2001) updated national culture scores. To date Hofstede’s study is the only one providing cultural distance indices for most of the CEE nations. These indices measure the degree to which norms and customs in one country differ from those in another country. The purpose of the independent variables CEE experience and Ownership is to split the sample into (1) MNEs with CEE experience and no CEE experience, and (2) MNEs which established subsidiaries with shared ownership and MNEs which established wholly owned subsidiaries. CEE experience is obtained from our survey questionnaire—respondents indicated whether their company had previous investments in any of the CEE countries. We produced a dummy that takes the value of 1 in case of previous investment experience and 0 in case of no previous investment experience in the CEE bloc. Ownership is a dummy variable that indicates if the subsidiary was established as a wholly owned outlet (=1) or as a joint operation with a local partner (=0) and is also obtained from the questionnaire. Twelve control variables are included. Technological intensity is measured by asking the respondents a five-point Likerttype of question as to the percentage of sales spent on R&D and advertising activities (ranging from very low to very high), because it was believed that the surveyed sample of managers would be unlikely to answer adequately or at all questions regarding a monetary estimation of the annual R&D budget (official secondary data on such expenditures were unavailable). Another firm-level characteristics that is likely to affect satisfaction with subsidiary performance is the type of MNE’s organizational strategy—according to Bartlett and Ghoshal (1989), global companies strive to maximize standardization of production and create replicas of the parent company abroad. In contrast, as multidomestic firms develop strategies for national responsiveness, they adapt marketing and production strategies to specific local context. Therefore, we introduce a control variable International strategy, obtained by asking two sets of multi-scale questions describing multidomestic and global strategies.3 A cluster analysis was performed, which resulted in a two-cluster grouping of the four constructs as multidomestic and global (available upon request). The type of international strategy is captured by a dummy variable taking the value of 1 if the strategy is predominantly global and 0 if it is predominantly multidomestic. Previous research has found that firm size influences performance: an individual subsidiary is less important to a large firm than to a relatively small one, and therefore may receive less attention and support (Slangen, 2004). Hence, a control variable Relative size of the investment was included, measured by dividing the initial number of employees of the subsidiary by the number of employees worldwide. We include Establishment mode dummy variable that takes a value of 1 if the foreign entry was via a greenfield establishment, and 0 if the entry was through an acquisition—subsidiary performance is likely affected by the type of establishment mode because greenfields and acquisitions require, among other things, different amount of capital and time to establish. Years of experience in a particular industry sector in a given host country are expected to exert a substantial influence on performance (Oliver, 1997). To control for such experience, a variable Subsidiary age was created by calculating the years of existence since the establishment of the subsidiary. Furthermore, Christensen and Montgomery (1981) associated performance effects specifically with relative industry growth. Hence, a host country’s Industry growth rate variable was included. Due to the heterogeneity of the observations and the significant range of industries of investment, secondary data on industry growth in all host countries were either unavailable or incomparable. Therefore, it was obtained by asking the respondents to estimate, with a five-point Likert-type answer scale, the host country’s growth rate of the industry of their investment. General International experience is introduced, to control for effects investigated in past studies. It is a composite measure of (1) the number of subsidiaries the MNEs have established in number of countries worldwide and (2) the number of years since the establishment of the first international subsidiary, prior to the focal investment in CEE. This type of experience was included as a control variable because according to Padmanabhan and Cho (1999), the lack of such experience will have a negative effect on subsidiary’s performance. Finally, a dummy called Manufacturing was created to capture differences between subsidiaries in manufacturing industries (value of 1) and subsidiaries in service industries (value of 0). 3.3. Statistical methods In order to determine whether our data is subject to common method bias, we used the Harmon one-factor test (Podsakoff, MacKenzie, & Podsakoff, 2003). This test required that we load all items used to measure both independent and dependent variables into a single exploratory factor analysis. The analysis produced two factors with eigenvalues greater than 1. Taken together, these factors explained 56% of the variance in the data, with the first extracted factor accounting for 34% of the variance in the data. Given that more than one factor was extracted and less than 50% of the variance can be attributed to the first factor, common method bias is unlikely to be a significant issue with our data. To test our hypotheses, five ordinary least-squares multiple regression analyses with SPSS 14.0 were performed. The first model introduces the main effects of the variables. As already mentioned, to test our hypotheses we split the full sample into (1) a sub-sample of MNEs without CEE experience and a sub-sample of MNEs with prior experience in CEE (models 2 and 3), and (2) a sub-sample of MNEs which established a wholly owned subsidiary and a sub-sample of MNEs which established a

3

Adapted from Harzing (2000).

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jointly owned subsidiary (models 4 and 5). The variable CEE experience was retained as a control in models 4 and 5 and Ownership is controlled for in models 2 and 3. We chose this approach to entering a standard interaction term between psychic-distance and both the CEE experience dummy and the Ownership dummy because the results are somewhat easier to interpret in respect to our propositions—we suggested a positive effect only for (a sub-sample of) MNEs which had no regional experience, and no effect for MNEs which were regionally experienced or had involved a local partner in their foreign operation. In addition, this approach avoids multicollinearity problems in interactions. Finally, splitting the sample allows the regression coefficients of the controls to vary across the two samples which may yield additional insights. For each of the regression runs, variance-inflation factors (VIF) were examined to determine any potential multicollinearity bottleneck. All of the VIF scores were below 2, thus confirming that multicollinearity is not an issue here (Hair, Anderson, Tatham, & Black, 1995). Tests for heteroskedasticity and correlation of error terms showed that neither of these problems were present in the data. 4. Results Table 2 contains the descriptive statistics of all variables and their correlations. The regression results are presented in Tables 3 and 4. Evidently, models 2 and 4 perform much better than the models 3 and 5. In the sub-samples of MNEs with prior CEE investment experience and of MNEs which established subsidiaries with shared ownership the insignificance of F shows that models 3 and 5 have no significant predictability. In this case, we cannot reject the null hypothesis of no linear relationship of Table 2 Means, standard deviations and correlations among all variables. Variables

Mean

S.D.

1

2

3

4

5

6

7

8

9

10

11

12

1. Performance 2. Technological Intensity 3. Industry Growth 4. Global Strategy 5. Relative size 6. Age subsidiary 7. Manufacturing industry 8. International Experience 9. Establishment mode 10. CEE experience 11. Ownership (WO = 1) 12. Formal inst. distance 13. Informal inst. distance

45.54 2.07 3.20 0.42 0.54 5.05 0.66 0.00 0.65 0.50 0.69 5.33 1.85

14.40 1.07 1.06 0.49 4.28 3.41 0.47 1.01 0.50 0.50 0.46 2.31 1.70

.091 .166* .094 .130 .026 .015 .010 .000 .135* .025 .167* .197*

.102 .110 .080 .112 .211 .004 .029 .004 .062 .013 .009

.007 .151* .240** .036 .025 .085 .222** .032 .109 .033

.010 .049 .220** .038 .124 .068 .025 .028 .019

.070 .007 .045 .018 .114 .017 .050 .002

.144* .012 .032 .363** .059 .068 .143*

.031 .012 .041 .149* .065 .066

.169* .182* .158* .066 .031

.060 .296** .129 .049

.041 .067 .173*

.030 .004

.635**

* **

Correlation is significant at the .05 level (two-tailed). Correlation is significant at the .01 level (two-tailed).

Table 3 Multiple regression results: subsidiary performance. Variables

Constant R&D intensity Industry growth Global strategy Relative size Subsidiary age Manufacturing International exp. Establishment mode (greenfield = 1) CEE experience Ownership (wholly owned = 1) Formal institutional distance Informal institutional distance N F Adjusted R2

Model 1: Full sample

Model 2: No CEE exp.

Betas t-stat

Betas t-stat

***

2.84 (6.37) 2.00* (1.00) 3.27** (1.04) 4.03y (2.23) 0.16 (0.51) 0.80 (2.20) 2.47 (2.30) 0.20 (0.05) 3.67 (2.35) 0.72 (2.23) 7.57 (4.97) 1.29** – 193 2.184* 0.35

Betas t-stat ***

3.14 (5.91) 2.12* (1.01) 3.22** (1.07) 3.01 (2.26) 0.10 (0.52) 0.87 (2.30) 2.38 (2.35) 0.30 (1.05) 3.11 (2.39) 0.31 (2.36) 8.23 (5.02) – 1.80** (0.61) 189 2.200* 0.36

Two-tailed tests. y p < .10. * p < .05. ** p < .01. *** p < .001 (unstandardized beta coefficients and t-statistics presented).

1.08 (0.94) 1.93* (1.51) 5.48*** (1.45) 8.11* (3.17) 0.60 (0.51) 6.44* (3.15) 4.94 (3.45) 5.42* (2.61) 3.27 (4.42) – 1.70* (6.80) 1.66* (0.77) – 99 2.962** 0.30

Model 3: Prior CEE exp.

Betas t-stat y

1.40 (0.87) 1.34 (1.54) 5.34** (1.47) 9.28** (3.30) 0.61 (0.51) 6.49* (3.20) 4.26 (3.56) 5.50* (2.63) 1.57 (3.48) – 1.51* (7.13) – 2.61** (0.96) 94 3.210** 0.33

Betas t-stat ***

4.34 (7.69) 0.71 (1.34) 2.17 (1.53) 0.88 (3.25) 6.63 (8.44) 6.27y (3.42) 1.70 (3.08) 0.68 (1.25) 1.22 (3.41) – 6.86y (3.52) 0.93 (0.60) – 95 1.650 0.16

Betas t-stat 4.67*** (7.08) 0.75 (1.31) 1.91 (1.51) 0.18 (3.12) 7.30 (8.37) 6.65y (3.38) 1.80 (3.08) 0.81 (1.22) 1.75 (3.27) – 7.02* (3.51) – 1.11 (0.79) 94 1.602 0.16

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Table 4 Multiple regression results: subsidiary performance (continued). Variables

Constant R&D intensity Industry growth Global strategy Relative size Subsidiary age Manufacturing International exp. Establishment mode (greenfield = 1) CEE experience Ownership (wholly owned = 1) Formal institutional distance Informal institutional distance N F Adjusted R2

Model 4: Wholly owned

Model 5: Shared ownership

Betas t-stat

Betas t-stat

Betas t-stat

Betas t-stat

2.73*** (6.68) 1.98y (1.18) 4.45** (1.32) 4.04 (2.71) 7.99 (8.33) 2.82 (2.87) 0.36 (2.90) 0.22 (0.07) 0.53 (3.30) 0.39 (2.96) – 1.88** – 107 2.727** 0.21

3.46*** (5.97) 2.01y (1.18) 4.19** (1.32) 3.80 (2.69) 4.83 (8.41) 3.41 (2.87) 0.56 (2.19) 0.23 (0.05) 0.90 (3.27) 2.10 (2.90) – – 2.41** (0.79) 107 2.541** 0.20

2.68*** (9.57) 1.73 (1.86) 2.56 (1.96) 1.31 (4.00) 0.09 (0.54) 0.27 (4.19) 4.70 (3.92) 1.32 (3.50) 1.66 (3.41) 9.37* (4.08) – 1.17 (0.79) – 85 1.422 0.22

3.17*** (8.14) 1.62 (1.86) 2.05 (1.92) 2.12 (3.95) 0.06 (0.54) 1.09 (4.14) 4.28 (3.87) 0.87 (3.51) 2.68 (3.33) 9.78* (4.06) – – 1.39 (0.95) 85 1.412 0.22

Two-tailed tests. y p < .10. * p < .05. ** p < .01. *** p < .001 (unstandardized beta coefficients and t-statistics presented).

the dependant variable to the independents. In other words, the set of variables in these models is not appropriate to satisfactory predict subsidiary performance. In the sub-sample of MNEs with prior investment experience in CEE and the sub-sample of MNEs which established subsidiaries with shared ownership a different set of independent variables could predict the dependent variable better than the current set of predictors. Despite the insignificant F values and the low values of R2, the insignificant coefficient of both predictors of psychic distance in models 3 and 5 demonstrate that psychic distance stimuli have no effect on subsidiary performance for regionally experienced MNEs and MNEs with local partnerships. As far as control variables are concerned, most of them are not associated with significant estimates at all—the only exception is the marginally significant and negative coefficients of Subsidiary age and Ownership in model 3 and the positive and significant coefficient of CEE experience in model 5. For the sub-sample of MNEs with prior CEE experience, older subsidiaries and subsidiaries with entirely foreign ownership seem to perform worse than younger subsidiaries and subsidiaries with shared ownership. In addition, in the sub-sample of MNEs which established subsidiaries with shared ownership, prior CEE investment experience has a significant and positive effect on performance because such experience gained from establishing other subsidiaries in the region may mitigate the magnitude of possible conflicts between the MNE and the local partner in the focal subsidiary. The significant value of F in models 2 and 4 allows us to conclude that the model is significantly better than would be expected by chance and we reject the null hypothesis of no linear relationship of the dependent variable to the independents. Evidently, in model 2, the positive and significant coefficients of both estimates of psychic distance stimuli (formal institutional distance p < 0.5 and informal institutional distance p < 0.01) affect subsidiary performance in the predicted direction. This provides support to Hypothesis 1 which predicted a positive relationship between psychic distance stimuli and subsidiary performance. The effects of the controls reveal that the coefficient of Industry growth is consistently significant and positively affecting performance (in models 1, 2 and 4). In model 2, the coefficient of Global strategy control variable is negatively related to subsidiary performance. This is quite an interesting observation as it suggests that multidomestic strategic orientation which aims at matching products and services to local context is likely to bring about greater satisfaction with subsidiary performance. The coefficient of Subsidiary age control is positively related to subsidiary performance which is in line with theoretical predictions of a positive effect of experience in a particular industrial sector (Oliver, 1997). International experience is positively related to performance because when MNEs do not possess market-specific knowledge they tend to rely more on their general international experience which may have positive effects on subsidiary performance. Last, it seems that the wholly owned entry mode for MNEs with no CEE experience has a positive effect on subsequent subsidiary performance—when MNEs lack market-specific experience, finding a reliable business partner in a different culture bloc may be problematic hence such MNEs may be better off with a wholly owned subsidiary. For model 4, that is, for the sub-sample of MNEs that established wholly owned operations in the CEE bloc the coefficient of psychic distance is significant and in the predicted direction (formal institutional distance p < 0.01 and informal institutional distance p < 0.01). This brings support to Hypothesis 2 which predicted a positive effect of psychic distance stimuli on subsidiary performance. Finally, in model 1 (full sample) the main effects of both regional experience and ownership in respect to subsidiary performance are insignificant. Market-specific experience on its own does not directly influence subsidiary performance: it only determines the circumstances under which psychic distance may positively

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impact subsidiary performance. When both types of MNEs – experienced and not-experienced in the CEE region – are examined in a single model, that is, there is no discrimination between the two types of MNEs, the results repeat the findings of Evans and Mavondo (2002) who reported a positive effect of psychic distance stimuli on subsidiary performance. 5. Discussion This study sought to re-examine the controversial issue of psychic distance influence on subsidiary performance. The controversy of this issue has two aspects—a conceptual and a methodological aspect. The methodological controversy lies in the discussion about what the best way to measure psychic distance is—whether psychic distance should be measured as perceived by an individual or whether it should be measured using macro-level variables (Dow & Karunaratha, 2006). We did not specifically tackle the issue of micro- versus macro-level estimations of psychic distance, but rather chose to follow the latest developments in IB research. We examined the effects of psychic distance stimuli on performance and by doing so we avoided the constraints of the measure of psychic-distance as managerial perceptions. As argued by Dow and Karunaratha (2006) it is rather problematic to determine the direction of causality between perceived psychic distance and performance—whether the perceptions of psychic distance influenced a managerial decision (which would be the desired causality) or the post-investment experience subsequently influenced the managerial perception of psychic distance. For example, it could be that a relatively good performance of a psychically distant subsidiary positively affects the managerial perception of psychic distance which will ultimately appear as a diminished effect of psychic distance. The roots of the conceptual contradiction can be found in the intuitive appeal of a negative relationship between psychic distance and organizational performance. The direction of this relationship has been conceptually challenged in the past and some empirical support has been found to support a positive effect of psychic distance on performance, mostly referred to as psychic distance paradox. One of the most referenced studies on psychic distance paradox is the one by Evans and Mavondo (2002) who argued that firms entering psychically distant markets face higher levels of uncertainty. This uncertainty prompts firms to undertake more extensive research and planning which helps their strategic-decision making and ultimately improves performance. As pointed out earlier, there is a limitation in the study by Evans and Mavondo (2002) because it suggested a direct relationship between psychic distance stimuli and organizational performance. In other words, the study by Evans and Mavondo (2002) considered psychic distance to be a static concept as they did not take into account that the effect of psychic distance is affected by factors that facilitate the flow of information to and from the market. The magnitude of psychic distance effect decreases in respect to firm’s international experience (Ellis, 2008), therefore the influence of general international experience on psychic distance were further examined by Evans et al. (2008). However, the propositions of Evans et al. (2008) received no empirical support. In the current paper we argued that the influence of psychic distance stimuli on subsidiary performance is conditional on MNEs’ sensitivity to psychic distance. MNEs’ sensitivity to psychic distance stimuli is determined not by MNEs general international experience but rather by MNEs local market experience and by a ‘‘substitute’’ for own market experience—a joint operation with a local partner. We did not focus on the influence of general international experience for two reasons. Firstly, market-specific knowledge, rather than general international knowledge, is the most critical in a firm’s internationalization process (Penrose, 1959). Secondly, all the firms in our sample have some international experience. All firms are multinational enterprises with established subsidiaries in a number of foreign countries ranging from 2 to 150 (mean = 18; S.D. = 26.5), but only 49 per cent of the firms had investment experience in the CEE bloc and only 85 MNEs had established jointly owned subsidiaries. Hence, any possible variation in the influence of experimental knowledge can be observed in the context of CEE-specific experience, not general experience. We demonstrated empirically the importance of regional experience as a factor that facilitates the flow of information to and from the market of investment. The possession of critical knowledge how to deal with common regional problems related to market liberalization, political democratization and processes of social and cultural change (Barkema & Drogendijk, 2007) stimulates organizational learning about the new market and ultimately eliminates the effect of psychic distance. Relying on a local partner to provide critically important market-specific knowledge has a similar effect on the relationship between psychic distance and performance—the effect of psychic distance stimuli is nullified for the MNEs which established subsidiaries with a local partner. From the results of this study we can conclude that psychic distance stimuli affects positively subsidiary performance only when the MNE lacks previous investment experience in the region of investment or has established a wholly owned operation. This provides an additional support to the psychic distance paradox suggested by O’Grady and Lane (1996), Evans and Mavondo (2002) and Evans et al. (2008)—it is likely that the high uncertainty firms face in psychically distant markets, prompts them to spend more time researching and learning about these markets, which triggers better subsidiary performance. Furthermore, when MNEs lack market-specific experience, they tend to rely more on general international experience. The accumulation of this type of international experimental knowledge provides general market-sensing capabilities that create awareness of unique subtleties in each foreign market, which in turn affects positively subsequent subsidiary performance. We also demonstrated empirically that an examination of a direct effect of psychic distance on performance may be misleading—the results from the analysis of our full sample (showing the main effects of the predictors) did support the psychic distance paradox. However, the psychic distance paradox was not supported for the sub-samples of firms with prior market-specific experience or jointly owned subsidiaries. This finding adds an addendum to dominant literature on psychic

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distance paradox, that is, when the effects of psychic distance stimuli on performance are examined it is of utmost importance to account for managerial or firm sensitivity to psychic distance stimuli rather than examine direct effects of psychic distance stimuli on performance. This study has several limitations which point out to interesting possibilities for future research. First, the survey method applied resulted in significant data loss due to the numerous incompleted questionnaires. A better response rate and a larger sample size allows a generalization of the outcome of the study and can be achieved by avoiding paper-based surveys and developing an electronic survey with a lock-in system that allows the submission of completed questionnaires only. Second, we could only conclude that some of our models could not predict subsidiary performance and a better set of predictors needed to be selected in order to increase the predicting probability of these models. We did not take the step further to find out that different set of independent variables which would serve better the models testing subsidiary performance of MNEs with regional experience. Third, the insufficient number of respondents by industry prevents us from investigating in-depth the industry-level predictors of performance, yet industry effects have been shown in the past as drivers of organizational performance. Hence, we could not present a complete environmental picture that incorporates industry-specific predictors as well, which could have significantly improved the predictability of all the models. Fourth, we could only use a primary measure of subsidiary performance which ideally should be complemented by subjective performance measures. Unfortunately, such measures were widely unavailable for our sample of CEE investments. Alternatively, as suggested by Hult and colleagues, in studies on performance ‘‘longitudinal data should be used to assess the influence of a predictor variable on the criterion variable’’ (Hult et al., 2008: 1073). Longitudinal data on subsidiary performance were also impossible to obtain for this study. Finally, our sample is limited to investments that were extant at the time of our survey: because we contacted only firms with active subsidiaries we could not observe the performance of exited subsidiaries. Evidently, the interest in the psychic distance influence on internationalization and subsequent subsidiary performance did not diminish some 30 years after the inception of the concept. Perhaps one of the reasons for the continuous interest is the inconsistency of findings in respect to the negative or positive effect of psychic distance, or the inconsistency in selecting factors that may influence psychic distance’s effects on performance. Another reason could be a methodological one— researchers tend to disagree on the issue which measure should be recognized as the ultimate estimation of psychic distance: individual perceptions or macro-level estimates. Future studies could possibly resolve these issues by first, attempting a comprehensive examination of a variety of factors that may influence the effect of psychic distance on both foreign market entry strategy choice and subsequent subsidiary performance, and second, by applying in single study individual perception measures and macro-level measures of psychic distance in a comparative way.

Appendix A. Appendix: Subsidiary performance measure (taken from the questionnaire)

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