4.6 Exporters Become Investors

investing more inclusive because, again, it is not only the largest firms that can afford to incur sunk entry costs of investment. Smaller firms with experience in exporting would also be able to do so, given that the entry costs of investment facing them are lower.

Consider the case illustrated in figure 4.6 of how exporters may eventually serve the foreign market through investment in plants abroad. The fixed entry costs of investing are higher than the fixed entry costs of exporting: fEX < fFDI. After one period of exporting, the fixed entry cost of investing drops to fFDI_EX. Assume that there are common entry costs involved in exporting and investing, such as the costs of developing a marketing strategy, fMS. Thus, at a minimum, an exporter’s sunk entry cost of investing becomes fFDI − fMS = fFDI_EX, which is less than the sunk entry cost that another potential investor with no experience in the market would face. The ordering of fixed entry costs fEX < fFDI_EX < fFDI is supported by research on the internationalization process of firms, such as that by Conconi, Sapir, and Zanardi (2016), who find that exporting precedes investment and attest to the complementarity of

FIGURE 4.6 Exporters Become Investors

a. Period 1: The medium-productivity firm only exports in the first period because it cannot cover the high fixed costs of investing b. Period 2: The experience of exporting last period reduces the medium-productivity firm’s fixed entry costs of investing. It is now profitable to incur the (now lower) entry costs of investing

Profits or fixed entry costs

fFDI

fEX π_FDI Profits

π_EX Profits π_FDI_EX Profits

π_FDI Profits

Profits or fixed entry costs

fFDI

fFDI_EX

fEX

Medium-productivity firm High-productivity firm ФProductivity Medium-productivity firm High-productivity firm ФProductivity

Source: World Bank. This is a highly stylized version of the Helpman, Melitz, and Yeaple (2004) framework. Note: The colored lines represent positive profits above respective fixed entry costs and identify the range of firms, by productivity, that could engage in exporting or investing. See figure 2.2 in chapter 2 for more details. Under a benchmark equilibrium scenario represented as “Period 1,” the medium-productivity firm exports and the highproductivity firm serves foreign markets by investing (marked by stars). The survival productivity cutoff for investment, ϕ* FDI (not shown) is obtained at the point at the x-axis where the profit line turns green. Period 2 considers a mediumproductivity firm with previous export experience compared with a high-productivity firm that has not previously participated in serving foreign markets. The case for the high-productivity firm is the same as in Period 1. Export experience reduces the fixed entry costs of investing for the medium-productivity firm (to fFDI_EX), which shifts the profit function to the left and results in a lower survival productivity cutoff ϕ* FDI_EX (not shown to avoid clutter). In the new equilibrium, both firms are investing abroad, and the profits for the medium-productivity firm are marked by an X. The pool of potential investors expands relative to the benchmark scenario of no exporting experience.

trade and investment. The information value of entry is confirmed by a study of Japanese multinationals, whose sales forecasts tend to suggest the presence of imperfect information and the benefits of entry—the forecast errors decline as experience in the destination market increases (Chen et al. 2020).

As seen in figure 4.6, the medium-productivity firm that becomes an exporter incurring the requisite fixed entry cost of exporting, fEX, in period 1 faces lower sunk entry costs of investment in period 2, fFDI_EX, which is much lower than what a potential investor who had no previous market knowledge would have to pay, fFDI. 10 As a result, the medium-productivity firm would become an investor in period 2. Thus, investors include high-productivity firms and medium-productivity firms with exporter experience. New firms with similar or higher productivity, but below the survival productivity cutoff ф*FDI (not shown in the figure), would export.

GRADUALIST APPROACH TO INVESTING UNDER UNCERTAINTY THROUGH LEARNING

Start small, learn big.

—Ajay Amalean, managing director of MAS Brands, on one of the key principles that guided him when entering the Indian market

Export experience leading to investment is consistent with the international business literature on the dynamics of firm internationalization and has wider implications. The Uppsala model explains internationalization as a gradual process of incremental engagement, which starts with some ad hoc exporting by firms (Johanson and Vahlne 1977, 2009). The uncertainty of foreign markets leads firms to commit only a small amount of capital to ventures abroad initially, and investment flows slowly increase through a gradual process of learning and network development. Similarly, Freund and Pierola (2010) document small export orders that reflect a trial-and-error approach to exporting.

This intuition applies to the experience of firms that want to enter using any strategy that has low entry costs for the purposes of learning. The quote from the managing director of MAS Brands (Sri Lanka) on his guiding principles when entering a market, “start small, learn big,” encapsulates the concept. He continued that it was okay to lose money (“but not too much!”), perhaps an indication of the value of the information acquisition that accompanies initial entry. MAS Brands started with sales of its Amanté brand of high-quality brassieres in department stores, and it was only after eight years in the Indian market that it opened its own retail shops in India, moving from being a brand owner to a brand retailer.

Similarly, Sri Lankan hoteliers initially entered Maldives through management contracts. Only after years of working under this arrangement did they pursue outward equity investment by leasing land and building their own hotels. The management

contract strategy allowed them not only to learn about the market but also to learn how to navigate the complex land leasing laws of the time. In attempts to capture some of the market for remittances transactions from migrant workers, some commercial banks initially developed partnerships with banks in the Middle East, then sent two or three personnel to handle the foreign remittances business in a bank-within-a bank business model, and finally opened their own bank branches abroad.

Additionally, Soorty Enterprises of Pakistan initially opened a marketing office to promote its denim cloth to local manufacturers in Bangladesh. As the business developed, a larger distribution office was set up. The company has since set up an apparel manufacturing plant in the Comilla Export Processing Zone. The opening of a tradesupporting office with low fixed entry costs, fFDI_TRAD_SUPP, compared with the entry costs of setting up a factory fFDI_PROD (with fFDI_TRAD_SUPP < fFDI_PROD), provided a period of information acquisition that reduced uncertainty and led to a production investment in which the fixed entry costs, fFDI_PROD_TRAD_SUPP, were lower than for a potential investor that had no previous engagement with the Bangladesh economy (fFDI_PROD_TRAD_SUPP <

fFDI_PROD).

In the survey sample, trade-supporting investments are the most common form of investment. They also lead to the largest amount of similar investments. The time span of the collected data on investment is not sufficiently large to estimate the impact of an initial investment of the trade-supporting type on investment in services operations and goods production.

The framework on uncertainty and gradualism would also suggest that firms are initially more likely to enter through a joint venture than through a wholly owned subsidiary, and more likely to enter through a greenfield investment than to purchase an existing firm in the host country. Joint ventures offer the advantage of requiring a smaller initial capital investment compared with going it alone, and the ability to reduce endogenous uncertainty through the use of the knowledge, networks, and influence of the usually host-based partner company. Greenfield investments may also be preferred because they allow sequential investment based on information acquisition and profit realization, whereas purchasing a locally based firm of optimal size involves the full disbursement of money at the time the transaction is settled.

Finally, a common strategy used by multinational enterprises to deal with uncertainty is imitation. Whenever there is uncertainty inherent in the potential destination country, companies tend to follow the choices of other home-country firms (Henisz and Delios 2001) and imitate their market entry strategies (Li and Yao 2010). These strategies are related to notions of learning from pioneer behavior.

INVESTORS ARE FOLLOWERS OF PIONEERS IN THEIR CONGLOMERATES OR BUSINESS GROUPS

In addition to learning from their own experience, firms can learn from others that have invested, given that learning from pioneer firms may reduce the entry costs of follower firms in the industry. Pioneering activities thus provide an information diffusion effect

from a pioneer firm to the home industry. Will regional pioneers automatically create a cascade or herd effect with a diffusion of regional transactions? Will these pioneers be the spark that ignites regional engagement? The understanding of the pioneer-diffusion framework here is informed by research on export discoveries (Hausmann and Rodrik 2003), export pioneers in Latin America (Sabel et al. 2012), Chinese export pioneers (Wei, Wei, and Xu 2017), and export catalysts (Rhee and Belot 1990).

The pioneer-diffusion framework is built on an information externality from a single pioneering firm that has entered foreign markets to the rest of the industry at home. Thus, the action of the first investor in a new market has a public good nature to it because it may reduce the fixed costs of entry into the same market for follower firms. The implication is that there could be a suboptimal number of pioneers, and governments should support the development of pioneers. This information externality applies to any entry mode and its impact on the likelihood of other home producers pursuing a similar mode of entry into the same market.

Some suggestive evidence of the pioneer-follower herd effect is the emergence of OFDI by pioneer-related firms (in the same conglomerate or business group) in different sectors or in different segments of the value chain. For example, OFDI in hotels has led to investments in travel agencies and logistics firms within the business group. Dabur India’s investment in fruit juice manufacturing in Nepal is maintained along with an investment in a nursery for plants with high health benefits, which it uses in its division for herbal medicinal products in India. A Sri Lankan furniture retail investment in India has expanded to include a tourism business. Tashi Group’s entry into processed food distribution in India in the 1980s facilitated the distribution of ferrosilicon a decade later. These examples suggest that pioneer firms are willing to share contacts, referrals, networks, and knowledge about markets with the other member firms within their own groups. This information flow is typically smooth and involves minimal frictions.

CONGLOMERATES AS KNOWLEDGE PROVIDERS

The introduction of a conglomerate dummy in the econometric exercises is important for services operations and goods production investments, which have greater capital requirements than trade-supporting investments (table B.12 in appendix B). The conglomerate’s role as a financier was borne out in the responses to the South Asian Regional Engagement and Value Chains Survey, in which the conglomerate’s financing role was considered its most important. The second most important role, according to managers, is as a source of information. The other relevant roles are listed in figure 4.7. This finding suggests that the business group is not only valuable as an internal capital market but also as an organizational structure that allows the sharing of cross-border knowledge within the group.

Thus, these results support and add to the business group literature (Colpan and Hikino 2010; Khanna and Yafeh 2007) that argues that the development of business groups is a response to “institutional voids” or market failures or frictions, particularly