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UPPSALA UNIVERSITY 2007-01-
Department of Business Studies Master Thesis
Evaluating Emerging Markets
Swedish MNCs and their Evaluation Behavior
Authors: Professor: Christofer Andersson Rian Drogendijk Fredrik Lundström
Abstract
Country portfolio analysis, a commonly used tool among companies when evaluating potential target markets, only focus on potential sales instead of including cost and risk into the equation. However, some researchers today have become aware of the importance of taking these costs and risks into account. One of these researchers is Pankaj Ghemawat, who has developed a framework called CAGE which is supposed to be a complementary tool to the country portfolio analysis model. In this thesis we study if Swedish MNCs consider the factors suggested in the CAGE-framework when evaluating emerging markets. Furthermore, we suggest some adjustments to the evaluation process.
Data have been collected through a web-based questionnaire. The respondents were all headquarter managers in Swedish multinational corporations (MNCs). Our results show that the two most overlooked distances of the CAGE-framework are the cultural and the geographic distances. Hence, the two most considered were the economic and administrative distances. This is in partial accordance with Ghemawat’s theory, in which he states that the cultural distance is one of the two most overlooked distances. However, he presents administrative distance as the second most overlooked distance, which means that our thesis shows a somewhat different result than Ghemawat’s findings.
A company evaluating an entry into an emerging market needs to consider the CPA-model, but this is not enough. They also need to take other factors into account. These are previous as well as future growth of the market, predicted growth for the specific product or service in the market in question, and the competitive situation in the emerging market. A consideration of these factors gives the company a complete picture of a market regarding profit potential. Thereafter, this potential needs to be adjusted for the distances in the CAGE-framework.
1. Introduction
In this section we will start with a short introduction of the characteristics of emerging markets, which opportunities these markets have, and which problems that could arise for companies deciding to enter emerging markets. At the later part of this section the main theory on which this thesis is based will be briefly presented, and finally we will present the problem statement.
As markets in developed countries have matured and shown a relatively low level of growth (Lamy 2006), companies looking to expand are turning to emerging markets (EMs) in hope of profitable business (O’Reilly 1988; Peak 1992; Goetzmann & Jorion 1999; Rosling 2005). In fact, the opportunity in the emerging markets of the world might be even bigger than what has previously been acknowledged. Prahalad and Hart (2002) argue that the market potential in the future will not lay in the wealthy few in developing countries or in the rising incomes of the middle-class, instead, the market potential lies in the billions of poor people who are settling in into a market economy for their first time. This view is also supported by other researchers such as Alon and Welsh (2001), who state that 80 percent of the world’s population live in what is commonly called emerging markets. In addition, 75 percent of world growth in trade is expected to be generated from these markets. Another example of the increasing interest in EMs is the fact that foreign direct investment (FDI) into EMs was U.S. $13 billion in 1985 and has risen to $267 billion in 2003 (Rosling 2005). Companies from Western Europe have realized this potential and see Eastern Europe (which includes emerging markets such as the Czech Republic and Poland) as their future primary market of growth, closely followed by China. India and Russia are also expected to generate great growth possibilities. (Accenture 2005)
However, where there exists potential for great returns there are usually also considerable risks at stake. Emerging markets are not an exception, there are problems in these markets which are important for companies from developed countries to consider if they wish to enter an EM. Examples of such problems are lack of developed communication infrastructure (Khanna & Palepu 1997), relatively underdeveloped financial markets, high volatility in the countries’ economic progress, difficulties in finding suitable business partners, (Hitt, Tina Dacin, Levitas, Arregle & Borza 2000) and several EMs have problems with high levels of
corruption (Khanna, Palepu & Sinha 2005). We argue that these problems create a distance between an EM and a developed country, which western companies need to adapt to. Hence, companies need to consider opportunities (potential sales) as well as threats (cost and risk) when evaluating an emerging market. Furthermore, we argue that the opportunities and threats are both greater in an EM than in a developed country.
Ghemawat (2001) states that previous research in evaluation of potential target markets, e.g. the CPA-model, has primarily focused upon potential turnover (e.g. GDP, market size, and per capita income) and has therefore failed to recognize the costs and risks related to the various non-business distances between markets. However, researchers such as Luostarinen (1979), Miller (1992), Ghemawat (2001), and Dow & Karunaratna (2006) acknowledge these distances. Ghemawat has presented the CAGE-framework, which takes into account Cultural (C), Administrative (A), Geographic (G), and Economic (E) distance. This framework will be the basis for this thesis.
1.1 Research Question
In this thesis we want to determine if the evaluation behavior of MNCs from developed countries, in regards to EMs, corresponds to the adjustments suggested by the CAGE- framework for the CPA-model. Are there any other factors that MNCs consider in this evaluation process? We have chosen Swedish MNCs as an example of multinational corporations from developed countries and aim to investigate which factors they consider when evaluating emerging markets for entry.
2.2 Swedish MNCs and Emerging Markets
Some Swedish multinational corporations (MNCs) have been established in emerging markets for a long time, e.g. Ericsson, which started its operations in India in 1903 (Swedish Trade Council 2006), and Sandvik which established itself in Mexico in 1961 (Sandvik 2006). Though, it was not until after 1985 that Swedish companies started to increase their foreign direct investments in a substantial manner (Nationalencyklopedin 2006) and it is not until recent years that several Swedish companies have started to expand into emerging markets on a large scale. There are many examples of Swedish MNCs that recently have started to move into different EMs, or have increased their previously established presence in these markets. A few of them will be presented below, and they are stated as evidence of the increasing interest from Swedish MNCs regarding emerging markets.
A Swedish company which recently has established itself in China is Haldex. They decided to start manufacturing locally to be able to better seize the business opportunities in the growing Chinese market. Their goal is to increase the sales in China from MSEK 100 as of today to MSEK 1000 within a five-year period. (NordicAudi 2006) Another fact pointing to the increasing importance of this EM is that in 2003 the country passed Japan as Sweden’s most important trading partner in Asia. (Riksbanken 2006) The Swedish manufacturing group Sandvik sees great potential in Asia, where China is the most interesting country. According to Vice President Lars Pettersson, the interest in China and Eastern Europe will continue to grow. The long term growth for Sandvik will, according to Lars Pettersson, take place in Asia, Eastern Europe, and Russia. He goes on saying that China is Sandvik’s tenth largest market today, but will become one of the largest in the near future. (Dagens Industri 2006) A number of other Swedish MNCs have also realized the great potential in China and have established themselves in a large scale, e.g. ABB, Electrolux, Getinge, Volvo, SKF, Atlas Copco, and Trelleborg (E24 2006).
Another example from the manufacturing industry is the Swedish steelworks group SSAB, which recently has established itself in another emerging market, Brazil. The company finds it important to give its customers fast access to the company’s products and therefore, a warehouse should not be further away than 48 hours. (Dagens Industri 2006)
IKEA is another MNC which sees emerging markets as an interesting way of expanding the company’s business. Their hope is to enter the Indian market within 5-10 years, and the company believes that India could become a new important country for IKEA. (Privata Affärer 2006) Another issue pointing to the relevance of India becoming an even more important market for Swedish MNCs than before is that the Swedish Trade Council helps establish one new Swedish company in India every month, which is a big surge compared to previous years. (Swedish Trade Council 2006)
Besides from firms in the manufacturing industry, another area of business where the interest for EMs has grown is the financial industry. Swedish banks are starting to gain interest in Russia because of an increase in the Russian demand for housing- and car loans, which is due to rising prices in housing, and because the Russian people have regained trust in its own banking system. (Realtid 2006)
2.3 Distances between Emerging and Developed Markets
Even though there exist great opportunities in EMs, there are also difficulties inherent in doing business in these countries. One aspect is the lack of developed communication infrastructure, which, in combination with often high levels of illiteracy, makes it harder for companies to communicate with consumers (Khanna & Palepu 1997). On the contrary, western countries like the U.S. and the countries in the European Union have a well developed communication infrastructure, e.g. widely spread Internet and telephone access (Khanna et al. 2005). Another problem is that emerging markets have relatively underdeveloped financial markets, high volatility in their economic progress, and the institutions for distribution of capital are not as strong as in developed countries. This leads to the notion that capital is not highly available and that it comes at a high cost in emerging markets. (Hitt et al. 2000) Compared to EMs, the financial markets in developed countries are well developed and characterized by e.g. access to venture capital, transparency in accounting standards, and a properly functioning banking system (Khanna et al. 2005). Additionally, if a company wishes to enter an emerging market through a strategic alliance, a suitable partner can be hard to find. This is mainly due to the fact that companies in EMs lack the experience in exploring and exploiting partnership opportunities. (Hitt et al. 2000) Another problem with EMs is that the competence and skill of available people to hire is sometimes difficult to
3. Theoretical Background on Evaluation of Markets
Country portfolio analysis, a commonly used tool by many companies when deciding on which market to enter, will be presented in this section. After that a discussion follows of the flaws of this tool, and a description of a more dynamic tool called the CAGE-framework.
A theory that is widely used by companies when deciding on where to compete is the country portfolio analysis (CPA). As shown in figure 1, the CPA model takes into consideration the per capita consumption of the product/product group (Y-axis) a specific company sells and the per capita income of host markets (X-axis). This specific figure shows potential markets for an American fast food group, i.e. Tricon Restaurants International. The different circles represent different markets, and their location symbolizes how attractive they are when considering income per capita and how much every individual consume of the product in question. The size of the circles represents each country’s GDP and their total consumption of the product being discussed. Hence, the circle estimates potential turnover for the product in the specific country. (Ghemawat 2001)
Figure 1
Source: Ghemawat 2001
However, this analysis needs to be adjusted for the various distances earlier mentioned. Researchers such as Luostarinen (1979) have pointed to the importance of taking different distances into account. Luostarinen mentions that, traditionally, researchers have thought of distance as a one-dimensional measure but he states that it should be viewed as a four- dimensional one. Like Ghemawat (2001), Luostarinen points to the importance of looking at the economic, cultural, geographic, and administrative distances. However, he does not use the same labels for these distances as Ghemawat. Luostarinen calls these distances economic, physical, cultural, and institutional distance. Economic and cultural distance of the two frameworks is the same. The physical distance in Luostarinen’s framework is similar to Ghemawat’s geographical distance but it is defined a bit narrower and only includes the physical remoteness of a country. Furthermore, institutional distance in Luostarinen’s framework is the equivalent of administrative distance in Ghemawat’s framework.
The four distances affect the possibility of running a profitable foreign operation in several ways, e.g. cultural distance can be a barrier to entering and functioning in a foreign market (Swift 1998). For instance, a company from a developed country and a company from an EM who do not share a common language will have difficulties in communicating and hence, functioning well together. Furthermore, policies of the host country, included in the administrative distance , can affect a company in the sense of political risk, e.g. risk for expropriation (Friedman & Kim 1988). Additionally, geographic distance will affect the evaluation of markets in the sense that e.g. the host country’s transportation and communication infrastructure is likely to affect how easy it is to transport products or how easy the communication flows within the corporation, and should therefore also be evaluated in advance. Finally, Ghemawat (2001) states that economic distance will be large for companies relying on economies of scale, experience or standardization if they do not concentrate their efforts on countries which are similar in an economic sense. However, if they do, it will be easier for the company to utilize their competitive advantage due to the similarities in cost and quality of resources and also due to similarities in consumer income.
Miller (1992) also points to the importance of taking additional factors into account than income and consumption. Unlike Ghemawat and Luostarinen, he calls these factors uncertainties instead of distances. The scope of these uncertainties is also a bit narrower than the distances suggested by the other two researchers. In addition to the basic criterions that the
has approximately the same content as Ghemawat’s framework but since the latter’s article is much more recent we chose this one. Furthermore, Luostarinen’s “geographic” distance is much narrower and only includes physical remoteness as a parameter while Ghemawat also includes e.g. size of country, and transportation and communication links. Dow and Karunaratna (2006) present eight dimensions that companies should consider when evaluating markets but it still has roughly the same content as the CAGE-framework. We chose the latter theory over the former since it takes in the same content but in fewer dimensions/distances, which makes the theory easier to understand.
3.1 The CAGE Distance Framework
The CAGE-framework evaluates which markets to enter from a specific country and, as mentioned before, it takes into account Cultural (C), Administrative (A), Geographic (G), and Economic (E) distance. The framework was developed by Pankaj Ghemawat (2001) to shed light on the fact that the analytical tools that managers use when evaluating foreign markets to invest in constantly underestimate the costs and risks of operating internationally. Ghemawat argues that an analysis over possible markets to enter need to consider not only potential sales, but also the costs and risks which it entails of doing business in a new market. Furthermore, Ghemawat argues that these costs and risks are the result of barriers created by four different types of distances between two countries, namely cultural, administrative, geographic, and economic distance. See figure 2 for a list of all attributes creating distance in the CAGE-framework.
Figure 2
Source: Ghemawat 2001
When the distances of the CAGE-framework are taken into account (changes in the size of the circles are based on estimations by Frankel and Rose 1 ), the result of the evaluation becomes significantly different (See figure 3). This becomes especially apparent for the circles of e.g. Canada and Japan. The former went from the third most attractive country, to become the most attractive country to enter, while the latter falls from the most attractive country, to not even making the top three. This evidently shows the importance of taking the distances of the CAGE framework into account if a company wants to make a correct evaluation of potential markets. (Ghemawat 2001)
Figure 3
Source: Ghemawat 2001
The term cultural distance includes differences in factors such as religious beliefs, social norms, language, and race. Ghemawat states the example of countries that have a common language and that the trade between these countries will be three times greater than between countries that do not share a language. Hence, there is a distance inherent in speaking different languages that we argue is also relevant when considering which country to enter, e.g. there are costs entailed in miscommunication, lack of understanding and also more obvious ones such as the cost of hiring a translator. Miscommunication and a lack of understanding between headquarters and a subsidiary in an emerging market can create
(^1) These estimations are e.g. sharing a common language which will increase trade with 200 percent, and having a common regional trading bloc which will increase trade with 330 percent. These estimations are written in several different articles by Frankel and Rose.
It is these four distances that Ghemawat suggests need to be considered to avoid the mistake of only focusing on potential revenue instead of looking at the whole picture, which also includes cost and risk. He argues that taking the factors of these distances into account can noticeably change the outcome of an evaluation of markets. Furthermore, he states that the two most overlooked distances are cultural and administrative. (Ghemawat 2001)
As previously mentioned, we want to determine if the evaluation behavior of Swedish MNCs, in regards to EMs, takes these four distances, suggested by the CAGE-framework for the CPA-model, into account. Are there any other factors that MNCs consider in this evaluation process? Furthermore, we aim to investigate which factors they consider when evaluating emerging markets for entry.
4. Method
This section starts with a description of the quantitative approach of analysis that we have chosen. Thereafter, we describe our questionnaire, sample, and respondents.
4.1 Quantitative Approach of Analysis
The most appropriate approach for answering the research question in this thesis is a quantitative one. With this method it is possible to, from a larger sample, find out how Swedish MNCs evaluate potential in emerging markets, or more specifically, if the companies’ evaluation takes into account the different distances suggested by the CAGE- framework or if their evaluation criteria differ. (Denscombe 2000)
A case study or a qualitative survey of a few companies would not provide a sufficient amount of data to be able to draw any conclusions about how Swedish MNCs evaluate emerging markets in general (Johannessen & Tufte 2003). A reason to why a quantitative approach of analysis suits the purpose of this thesis best is the fact that the aim of the study is to look at how important different distances are for Swedish MNCs, and from this data be able to derive a mean of these factors’ importance. (Holme & Solvang 1996) Surveys are a suitable method for gathering quantitative data, and by using this approach there is a better base for making generalizations from the data than from a qualitative way of research.
4.2 The Questionnaire
This quantitative approach of analysis was carried out through a web-based questionnaire, in which the respondents were asked to evaluate how important different distances, based on the CAGE-framework, are on a scale of 1 to 5. In the questionnaire 1 implied that the factor was “irrelevant”, 2 referred to “not so important”, 3 meant that the factor had “some importance”, while 4 indicated an “important” factor, and 5 corresponded to “very important”. Included in the questionnaire were also questions regarding the respondents’ level of education, what position they hold, and their personal experience from EMs. Furthermore, the respondents were asked to state which industry their company is established in. One advantage of using a
identity, which, although they did not have to state their names in the questionnaire, could be interpreted from the open-ended questions mentioned above.
The open-ended questions were followed by a series of fixed questions, where every question represented one factor from the four distances of the CAGE-framework. The respondents could choose one of five alternatives according to what relevance they felt different factors had for their company’s evaluation of which EM to enter. By using a five point Likert type scale, the results could easily be quantified and analyzed (Denscombe 2000). As mentioned above, the last question in the questionnaire was also an open-ended question where the respondents could add information if they considered other variables which were not included in the questionnaire.
4.3 Sample and Respondents
The sample of EMs was based upon the list Alon (2006) used to evaluate emerging markets (see appendix 1). The list consists of 20 emerging economies and includes all the major EMs such as Brazil, Russia, India, and China. Thereafter, the Swedish Trade Council’s webpage in these 20 different countries respectively was considered, in order to gather information about which Swedish companies were established in these countries. Subsequently, companies with less than 1000 employees were eliminated from the sample since the interest of this study is to focus upon large Swedish MNCs. Furthermore, companies with less than 50 percent Swedish ownership were eliminated. Firstly, it would be hard to motivate that they were actually Swedish, and secondly, the headquarters are likely to have less influence on and knowledge about the evaluation if they are not majority owners. Finally, companies who only had representation offices in EMs were left out since these have less of a commitment to the market. The 40 companies in the sample, corresponding to these demands, come from a wide range of industries, from medical equipment and chemicals to cosmetics, and construction machinery (see appendix 3).
Some emerging markets were not listed by Alon (2006) but even though the list excludes some EMs, the scope of this thesis is wider since the companies taking part in the survey are established not only in one EM, but usually in several.
The final list consisted of 60 respondents from 40 Swedish MNCs (see appendix 3). The fact that there are more respondents than companies is due to, in some organizations there were more than one employee who was appropriate for answering the questionnaire. This occurred in companies with a structure based on global regions. One example is Assa Abloy, which has both an executive vice president of “the Americas” and one of Asia Pacific. Since both of these regions contain EMs, it was possible to ask two executives in companies with this structure. We determined the list of potential respondents by visiting the companies’ websites, or, where this information was not available, by contacting the information department at the respective company, looking for members of the executive board and executive management. When we had found the headquarter managers, an e-mail was sent out to these respondents, asking them to fill out a web-based questionnaire (see appendix 2). That all respondents are headquarter managers, with positions ranging from president and vice president to head of corporate strategy and regional director, is important since choosing which market to enter is a top management issue.
4.4 Modifications to the CAGE-framework
All fixed questions were based on the factors from Ghemawat’s (2001) CAGE-distances (see figure 2). We made small modifications to the CAGE-framework in our questionnaire in order to fit the purpose of Swedish MNCs. The factor “absence of colonial ties” was left out since this is not relevant for Swedish firms because Sweden has not had any colonial ties with any of the EMs in question in the past. Sweden has only had colonial ties with islands and small parts of countries, usually forts. The question of “absence of shared monetary or political association” was also changed to “absence of political association”, since Sweden is not part of the European Monetary Union or has the same currency as any other country. The last factor that was excluded in the survey is “lack of a common border” since Sweden does not share borders with any country that is defined as an emerging market. We kept the factor “different languages”, which might seem odd since none EM has Swedish as an official language, and therefore, it will always be a different official language when considering distances to emerging markets. However, the distance can still be interesting since the majority of Swedes speak English, which they also do in some EMs, e.g. South Africa and India. Since speaking the same language can affect the evaluation it is a relevant variable to study.
