Do Governments Favor Foreign Firms over Domestic Ones?Published: April 21, 2004 in Knowledge@Wharton
Indeed, governments may actually favor foreign companies, particularly over politically weak domestic firms, according to preliminary research presented by Yasheng Huang, professor of international management at MIT’s Sloan School of Management, during a Wharton conference on Management Strategy and the Business Environment. In general, the foreign privilege phenomenon seems to be more pronounced in Latin America and Eastern and Central Europe, although it exists in East Asia as well.
Huang’s research challenges the view that governments use their regulatory powers to protect domestic businesses from foreign competition in a system commonly known as national preference. “The foundation of this view goes back to the 1950s when many governments in developing countries did impose restrictions on multinational corporations. [My] paper asks the question whether the view formed in 1960s and 1970s still applies today,” said Huang in presenting a paper entitled, “Are foreign firms privileged by their host governments? Evidence from the 2000 World Business Environment survey.”
Using the World Bank survey – a compilation of subjective evaluations by 10,000 firms operating in 81 countries – Huang analyzed the data across several regulatory areas including taxes and regulation, business licensing, labor laws, and foreign currency and exchange policies.
“There is strong and consistent evidence that there are substantial regulatory advantages to being a foreign firm operating in these 81 economies as compared with an average domestically-owned firm,” Huang writes in his paper. A second finding is that the regulatory advantages enjoyed by foreign firms are only present when compared to politically powerless domestic firms.
Foreign privilege also appears to be greater in more corrupt countries, although it is not absent in countries with strong institutions, said Huang. He cited evidence from his research using institutional indicators developed for the World Bank Governance Project.
Huang evaluated 38 countries making up the bottom 25th percentile across four variables: control of corruption, government effectiveness, voice and accountability and the rule of law. On average, across all four measures, foreign firms reported fewer constraints than domestic companies.
“There are powerful empirical and conceptual reasons why FDI theories believe there is national preference,” Huang noted during his presentation. Empirically, in the 1950s through the 1970s, companies did impose restrictions on foreign firms, including export regulations, limits on foreign ownership and local-content provisions. Conceptually, he said, the idea of national preference is rooted in political theory hinging on the fact that foreigners do not vote. “Because domestic residents don’t benefit financially from the equity holdings held by foreigners, the government or politicians – to maximize electoral success – have a greater incentive to appropriate income from foreign firms rather than domestic firms,” said Huang. “The limitation of this view is that it is only looking at the vote. What about money? What about campaign contributions?” he asked.
Huang emphasized that the paper he presented is still undergoing revisions, and that the dataset on which it is based has limitations that prevent more detailed examinations. In addition, the “policy implications” of the findings are tentative at this point, he said, and may be affected by later research.
Political Dynamics of Authoritarian Regimes
According to Huang, the link between earlier studies documenting national preference when studying foreign direct investment (FDI) does not give enough weight to what happens in authoritarian regimes. “Until the 1990s the foreign direct investment flow mainly took place among OECD (Organization for Economic Cooperation and Development) or western countries. What about the political dynamics of less perfect democracies? To think that voting determines policy may apply with less force in democracies with lesser quality.”
The paper notes that even if countries wanted to favor domestic firms, it is difficult because foreign capital is more mobile than domestic capital. “To entice the same level of investment, a host government may have no choice but to treat foreign firms better,” he writes. “… Some of the most authoritarian countries in the world – China now and Singapore in the 1970s and 1980s – are among the top recipients of FDI in the world. In authoritarian countries, foreign equity holders do not vote but nor do domestic equity holders.”
Huang also raised the possibility that foreign firms’ relative lack of participation in the social and cultural affairs of a nation may actually make them more likely to be favored. “Precisely because foreigners do not participate in some countries, politicians like them more. If politicians seek to maximize control and domestic firms participate in politics, then maybe the politicians want foreigners to come. They don’t want [domestic] firms to meddle with their policymaking.”
The view that foreign firms are discriminated against by governments more than domestic firms are may stem from their greater visibility. “We know more about the treatment of foreign firms than domestic firms, particularly the politically weak domestic firms,” he commented at the conference. “Boeing and McDonald’s are more prominent than the average Indian, Chinese or Brazilian firm.”
The apparent disconnect between the belief in national preference and Huang’s research findings reflect a changing policy environment, he said. Many governments have moved away from policies designed to extract payment or gain technology transfer from multinationals and have adopted policies to encourage FDI. “FDI is now commonly viewed as an engine of growth,” he writes in the paper. “At least, it is worth asking whether the national preference claim is still an empirically accurate description of the world in the 21st Century … Policies have changed dramatically in the 1980s and 1990s.”
Regional Examples of Foreign Preference
The paper argues that it is possible for governments to favor domestic firms while at the same time courting FDI. He points to research in Asia showing how local business groups grew based on certain privileges from government, such as exclusive import or export rights, protection from foreign competition and procurement of government contracts. However, Huang points out that Asian countries were among the most open to FDI. Citing United Nations data, the paper states: In 1985, before FDI promotion became fashionable, the FDI stock/GDP ratio reached 28.2% in Indonesia, 23.2% in Malaysia, and 73.2% in Singapore. In comparison, the average ratio for developing countries was 13.9% and for developed countries, 6.2%.”
Huang pointed to some regional examples of foreign preference. In Latin America in the 1970s, governments favored foreigners who could bring technology and capital to build capital-intensive industries. One policy outcome was to suppress populist and consumption demands by the national bourgeoisie, professionals and members of the middle class. This exclusion, he suggests, encouraged the rise of authoritarianism.
Multinationals encouraged to invest in Latin America were not given free rein, writes Huang, but they did develop an affinity with the national oligopolies and state-owned corporations, creating disincentives to local capitalists.
Huang also cited his own work in China: “In the 1990s, I argued, the Chinese government, for political reasons repressed or suppressed the domestic private sector. The country was running short of entrepreneurial capacity and private initiatives. That forced them to import FDI to make up for that deficit.”
He said his findings challenge the conventional wisdom that China is a “shining example of economic success.” China’s support of its inefficient state-owned enterprises (SOEs), he told the conference, choked off the competitiveness of the most efficient domestic private firms. “The Chinese government then expended considerable financial and policy resources to court FDI and foreign firms in order to make up for the shortcomings of its own corporate sector,” Huang writes. Foreigners wound up with substantial advantages over domestic private firms. He cites a former Chinese legislator who pointed out that of China ’s 80 broad economic sectors, foreign firms are allowed entry in 60 of them compared with 40 for domestic private firms.
In Malaysia, Huang said, the government favored outside firms with its New Economic Policy (NEP) in order to diminish the economic power of domestic firms controlled by ethnic Chinese. Scholars, he added, have dubbed Malaysia ’s policies “an ethnic-bypass strategy.”
NEP was enacted after race riots in 1969 demanding income and wealth parity between the bumiputra majority and Malaysia ’s affluent Chinese minority. For example, Chinese businesses had to transfer 30% equity to bumiputra-contolled firms after reaching a certain size. Over time, local companies teamed with Japanese, Korean and other foreign firms and FDI rose from 11% of gross capital in 1970 to 25% in 1992. Over the course of the 1970s, Chinese corporate equity fell from 70% to below 30% as Chinese investors moved their holdings out of the country, the paper states.
Even though some World Bank research also indicates a pullback from the national preference system, Huang said the bank and other international institutions have not pursued the question more vigorously. He suggested that officials trying to promote free trade through the elimination of government barriers use the notion that foreign firms are victimized by government policy to promote their goals. “Many of them are in the business of pushing FDI liberalization,” he said. “The findings don’t sit well with them.”
Huang acknowledged the data set is not ideal. For example, he said it is difficult to differentiate a truly private company from a state-owned enterprise in China. He also said that large foreign firms, with more than 500 employees, make up a disproportionate amount of the survey base. Those firms may be better managed and more efficient and present a “rosy” picture of government preferences. “If you are better-performing, you will be more positive about the business environment.”
He also noted that the research assumes foreign and domestic firms’ perceptions of the business environment can be compared. “In the 1990s, the possibility for this perception bias was not trivial,” Huang writes in his paper. “Many governments in developing countries undertook reforms and improved their business environments against historical standards.”
In a discussion about the paper, other questions were raised. Raymond Fisman, a business professor at Columbia University ’s Graduate School of Business, suggested Huang look at cross-country variables, and questioned whether foreign firms tended to be large and powerful and could negotiate better conditions in a competition among countries for new investments.
Fisman also said it would be interesting to look at the data to determine the level of sunk costs – such as factories and equipment – a foreign firm had in a country and its responses to the business environment survey. “If the foreign firm is in financial services it can pick up and go,” he noted. Firms with heavy sunk costs in a country may respond more like domestic firms.
Witold Henisz, professor of management at Wharton, suggested it might be valuable to know how many of the foreign firms surveyed were working with politically connected partners overseas, which could reduce their regulatory hassles.
As for policy implications, Huang’s paper suggests that FDI could in itself be a force for deregulation of an economy. “Championing FDI is an indirect way to deregulate an economy whereas improving the regulatory environment for both foreign and domestic firms is more straightforward,” he writes. “But one could argue that deregulation by stealth is politically expedient.”