University of International Business and Economics

Assignment

Special Topics on International Business Management PhD Program

How the Multinational corporations (MNCs) should cope with uncertainties and enhances competitiveness in their internationalization drive in the context of globalization in general and under the current global financial crisis in particular?

Submitted To Chunguang Ma Professor of International Business

Submitted By Nabeel Safdar Fall Semester, 2012

School of Business University of International Business and Economics (UIBE)

How the Multinational corporations (MNCs) should cope with uncertainties and enhance competitiveness in their internationalization drive in the context of globalization in general and under the current global financial crisis in particular?
An economic crisis in a firms market can cause unpredictable, fundamental downward shifts in the level of demand and in the relative costs of inputs, causing firms mess up to adjust or even to fundamentally reconfigure their value chains in response to threats to profitable production (Kogut, 1991). During the recessionary period of 2008 and 2009, there was an adverse impact of economic uncertainty on the worldwide macro-economic indices like gross domestic product (GDP) growth, inflation, per capita income, and employment rate. The cause of economic crisis in 2008 was a loss of confidence in the banking system. The effect of financial crisis of 2008 did not limit to the banking sector and the housing market, however, the lack of credit had a dominant shock on the real economy. The reason behind all of this was that banks are not lending and investing while consumption had fallen, adding fuel to fire and making a serious economic downturn. Fall in global macro-economic indices like GDP growth, inflation, per capita income, and employment rate made a financial crisis into an economic crisis (UNCTAD 2009) In recent decades, the global business environment has been growing dramatically. We are living in a more than ever interdependent world. Many firms involve in the process of internationalization, engaging their operations outside the boundary of their home country. The level of involvement of firms in international process can be specified by different types of foreign market entry modes ranging from import/export, contractual and investment entry modes. Multinational corporations (MNCs) cope with uncertainty and enhance competitiveness by a variety of investments that develop the range of possible actions, however major decline in their operating setting, for instance an economic crisis (Sanchez, 1993). Downturn is the perfect time for product and process innovation. Amram and Kulatilaka, (1998) argued that research and development (R&D) may be an option in the recession period which permit the firm to change product attributes more quickly than their competitors. It is a fact that even during the downturn, there is a demand for innovative products and services and the consumers are ready to give premium on such products. Apple has set an example of product innovation with new products coming out of its stable with a regular frequency. There is an instant need to control the costs during the recession. Cost burden can be reduced by an organization with optimization of existing resources as a strategy. Organizations have an opportunity to quickly respond the market demand by enlarging the warehouse and storage capacities in growth periods. In contrast downturn is the time when there is need of consideration for re-configuration of distribution network. The facilities which are not contributing to revenues can be reduced, particularly when such a facility is rented. Transportation is also an important cost which can be controlled by getting into long term
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contracts and building better networks. Networks played an important role especially for global players to control and reduce cost of transportation. To maintain competitive advantage, multinational enterprises (MNCs) must make rapid adjustments to their international investments in response to fluctuating global market demands and competition. A major challenge for MNCs is reconfiguring their value chain activities in a timely fashion to address volatile contingencies in the countries where they operate subsidiaries. The real options literature emphasizes flexibility for MNCs trying to cope with heightened uncertainty. MNCs adjust product configurations to uncertain future demand by flexible manufacturing capabilities. In the same way, MNCs international investments can be considered as source of flexibility, providing better access to rent-enhancing future opportunities across national contexts. International investments, including those relating to exporting and foreign direct investment have been familiar as providing flexibility under uncertainty by a number of researchers, including Broll (1999), Lee and Makhija (2009), Chung et al. (2012), and others. MNCs with well-known exporting infrastructure allowed them to react quickly to unexpected downward changes in demand in both domestic and international markets (Lee and Makhija 2009) by changing sales from the less valuable markets to new customers in other more valuable markets. Broll (1999) argued that international sales as a source of real options value under exchange rates volatility because they have ability to offer benefits of both diversification and stabilization of revenues. Firms which are not previously engaged in exporting relationships, however, cannot instantly begin exporting. As other investment, there are sunk costs associated with exporting and export-related knowledge without which exporting cannot be started likewise supported with previous researches non exporters have big misconceptions about exporting. MNCs can enjoy benefits from their capacity to shift production locations when having multiple countries production facilities in reaction to unexpected adverse changes in any given country, such as increase in political risks and labor costs or exchange rate volatility (Chung et al. 2012). MNCs can also hedge currency to avoid uncertainties of exchange rate volatility. Decreased manufacturing costs can make subsidiaries candidates for production shifts, but the potential is lower when subsidiaries in the same network experience similar cost decreases in other words, when considerable macroeconomic overlap exists in multiple locations This fits with description of multinational as a bundle of options whose value grows as differences across options increase. When MNC subsidiaries in different countries have little overlap, the resulting diversity gives the greatest advantages to subsidiaries oriented toward the acrosscountry option in other words; the combination of a strong focus on the across-country option and dispersal across multiple countries with diverse macroeconomic conditions provides superadditive synergies during times of uncertainty. In such scenarios, joint value becomes greater than the sum of the two combinations
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MNCs can take benefit of multiple countries production facilities in reaction even in case of exchange rate volatility. MNC that has made investments in exporting is able to allocate sales of its domestic production among both domestic and foreign markets. MNCs when faces exchange rate fluctuations or sharp decline in domestic demand, the firms ability to shift lost domestic sales to foreign markets increases the worth of its exporting related investments. For example, when the domestic currency depreciates significantly relative to another currency, exporting can be increased in line with more advantageous realized prices elsewhere. When the domestic currency appreciates relative to another currency, exporting can be switched to other more promising markets that are less affected by this change, or to the domestic market. When the exchange rate once again permits profitable exports, the firm resumes exporting. MNCs can take benefit from opportunities to get well the losses of decreased domestic or foreign demand by focusing on other markets in which it has already established exporting infrastructure. Lee et al. (2009) examined how sudden shrinkage of domestic demand affects firm-level export performance using the Asian economic crisis as a natural experiment, They supported empirically that while the industrial organization (IO) economics and resource-based view (RBV) apply well in the pre-crisis period, the real options perspective does a better job in explaining firms efforts to increase exports in the post-crisis period. Specifically, using a real options perspective, Lee et al. (2009) found how sudden change in domestic demand provides benefits to those firms that have invested in flexible capabilities while those firms that are locked in with inflexible resources fail to change. Two types of real options are represented in the literature: incremental and operational flexibility (Chung et al. 2010) Incremental options consist of put and call options. When a firm sees little potential in an investment, it may exercise a put option and reduce its exposure, and when an opportunity emerges it may exercise a call option and expand its commitment. Examples of incremental options include divesting acquiring stakes in joint ventures decreasing/increasing investments in existing facilities or technologies. According to the operational flexibility option, firms maintain open options for change in preparation for future uncertainties; since uncertainty limits planning effectiveness, operational flexibility is considered complementary to planning This option can be analyzed as a bundle of interdependent options: two examples are retaining multiple suppliers in order to cope with future supply fluctuations and investing resources in multiple locations so that certain outlets can come to the rescue when one encounters problems. Chung et al. (2010) applied incremental vs. operational flexibility options to the MNC context and identified two real options: a within-country option which, by establishing a grand label or simple knowledge of the market, provides a platform for the introduction of new products and an across-country option provided by operational flexibility The primary difference is that the first is based on belief in a host countrys economic growth potential and the second
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emphasizes operational flexibility across multinational networks. MNCs often exercise withincountry options upon learning about a countrys economic potential, and use an existing subsidiary in that country as a sensor for deciding when to increase or decrease a commitment. In this scenario, local responsiveness and chains of incremental options in individual subsidiaries are central to maintaining the within country growth option. The across-country option maximizes operational flexibility by shifting production and sourcing among affiliated subsidiaries according to changes in host-country economies, with the most important factors being integration and interaction with other subsidiaries within the MNC network. According to this option, when one subsidiary encounters difficulties, its problems may be solved through interaction with sister subsidiaries in its multinational network. MNC flexibility can therefore be conceptualized as an opportunity cost, in that a cross-country options investment may mean giving up a degree of local responsiveness in exchange for operational network flexibility Lee et al. (2009) found that the positive relationship between a firms domestic market position and export intensity becomes stronger in the post-crisis than the pre-crisis period. They also found a positive relationship between non-location-bound flexible capabilities such as R&D and export intensity and a negative relationship between location-bound inflexible capabilities such as advertising and export intensity. These relationships become more pronounced in the postcrisis period. Research and development (R&D) may be an option in the recession period which permits the firm to change product attributes more quickly than their competitors. It is a fact that even during the downturn, there is a demand for innovative products and services and the consumers are ready to give premium on such products. Chang (2003) argued economic crisis of 1998 acted as a double-edged sword for Korean firms. On the one hand, the crisis substantially reduced the size of the domestic market. This economic turmoil led to massive competitive pressure on virtually all Korean industries, and threatened the survival of Korean firms. The loss in the value of the Korean currency after the crisis allowed Korean firms to capitalize on the price-competitiveness of their products in foreign markets. Alfaro and Chen (2011) stresses two main types of MNC subsidiaries: horizontal, which duplicate the production activities of parent firms, and vertical, which share an input-output linkage with parent firms. While horizontal subsidiaries share a substituting relationship with parent firms, the production of vertical subsidiaries complements that of parent firms In a time of crisis, when a host country experiences a decline in demand, the two types of linkages can lead to sharply different impact, for horizontal MNC subsidiaries, the ability of MNCs to shift production back home will likely result in more volatile performance. For vertical subsidiaries, the intra-firm demand from parent firms will help absorb the negative demand shock in the host country, leading to more elastic responses to the crisis. This stabilizing role of vertical production linkages should be particularly pronounced in host countries with large negative demand shocks. They constructed a direct measure of production linkages by examining the input-output relationship between the primary products of the subsidiaries and parent firms i.e., the input-cost share of the subsidiary's primary product category in the parent firms final

good production. Subsidiaries sharing stronger vertical production linkages with the parents are expected to exhibit more elasticity during the crisis. Alfaro and Chen (2011) found that MNC subsidiaries responded on average better to the Global Financial Crisis than local controls with similar economic characteristics. Moreover, the advantage of foreign ownership was clearly pronounced during the crisis, but relatively muted during non-crisis years. Compared to local controls, MNC subsidiaries exhibited greater flexibility to the crisis but not significantly better performance during normal economic periods. They also found that establishments sharing stronger vertical production linkages with foreign parent firms exhibited more flexible performance during the crisis, especially in host countries with greater negative demand shocks. Horizontally linked establishments, in contrast, performed no better than the control establishments. Further, the role of vertical production linkages is found significant only during the crisis period. In the non-crisis period, vertical MNC subsidiaries did not perform differently than local matches while horizontal subsidiaries fared slightly better. A multinational corporation (MNC) that has subsidiaries in different countries can be overwhelmed by the complexity of coordinating different operations. Which may reduce the benefits of operational flexibility that the MNC hopes to have it may also be the case that the value of nationally dispersed international investments reflects the benefits of diversification rather than operational flexibility. In this sense, just having subsidiaries in different countries may not be enough for assessing operational flexibility. Instead, it is important to measure the actual flexibility associated with international investments, indicated in the literature as the ability of the firm to quickly shift production to different international locations or shift sales to new international customers. Conclusion: Multinational corporations (MNCs) cope with uncertainty and enhance competitiveness by a variety of investments that develop the range of possible actions, however major decline in their operating setting, for instance an economic crisis. Downturn is the perfect time for product and process innovation. MNCs can take benefit from opportunities to get well the losses of decreased domestic or foreign demand by focusing on other markets in which it has already established exporting infrastructure. The industrial organization (IO) economics and resource-based view (RBV) apply well in the pre-crisis period; the real options perspective does a better job in explaining firms efforts to increase exports in the post-crisis period. To maintain competitive advantage, multinational enterprises must make rapid adjustments to their international investments in response to fluctuating global market demands and competition. A major challenge for MNCs is reconfiguring their value chain activities in a timely fashion to address volatile contingencies in the countries where they operate subsidiaries. The real
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options literature emphasizes flexibility for MNCs trying to cope with heightened uncertainty. Economic volatility and uncertainty is a reality of life in new trends of globalized World. Organizations carry on and grow irrespective of economic cycles that are well prepared for meeting the consumer demand under uncertainty. References: 1. Alfaro L. and Chen M. (2011) Surviving the Global Financial Crisis: Foreign Ownership and Establishment Performance, NBER Working Papers, no. 17141. 2. Amram M, Kulatilaka N. (1998). Real Options: Managing Strategic Investment in an Uncertain World. Harvard Business School Press: Boston, MA. 3. Broll U. 1999. Export as an option. International Economic Journal 13(1): 1926. 4. Chang, S. (2003). Financial crisis and transformation of Korean business groups. Cambridge, MA: Cambridge University Press. 5. Chung, C., Lee, S.-H., & Beamish, P., Isobe, T. (2010) Subsidiary expansion/contraction during times of economic crisis. Journal of International Business Studies, 41: 500-516 6. Chung, C., Lee, S.-H., Beamish, P., Southam, C., & Nam, D. (2012). Pitting real options theory against risk diversification theory: International diversification and joint ownership control in economic crisis at Journal of World Business, forthcoming. http://dx.doi.org/10.1016/ j.jwb.2012.06.013 7. Kogut B. (1991) Joint ventures and the option to expand and acquire. Management Science 37: 1933. 8. Lee, S.-H., Makihija, M., & Paik, Y. (2008) The value of real options investments under abnormal uncertainty: The case of the Korean economic crisis. Journal of World Business, 43: 16-34 9. Lee, S.-H., Beamish, P., Lee, H., & Park, J. (2009) Strategic choice during economic crisis: Domestic market position, organizational capabilities and export flexibility, Journal of World Business, 44: 1-15. 10. Lee, S.-H., & Makhija, M. (2009) Flexibility in internationalization: Is it valuable during an economic crisis? Strategic Management Journal, 30: 537-555. 11. Sanchez R. 1(993) Strategic flexibility, firm organization, and managerial work in dynamic markets. Advances in Strategic Management 9: 251291. 12. UNCTAD (2009). The global economic crisis: systematic failures and multilateral remedies. United Nations Publication ISBN 978-92-1-112765-2.