Institutional changes and organizational transformation in developing ...

Journal of International Management 14 (2008) 209 – 216

Introduction to the Special Issue

Institutional changes and organizational transformation in developing economies Preet S. Aulakh a,⁎, Masaaki Kotabe b b

a Pierre Lassonde Chair in International Business, Schulich School of Business, York University, Toronto, ON, Canada M3J 1P3 The Washburn Chair Professor of International Business and Marketing, Temple University, The Institute of Global Management Studies, 349 Speakman Hall (006-00), Philadelphia, PA 19122, United States

Accepted 10 April 2008 Available online 3 August 2008

Abstract An important component of globalization during the last two decades is the increased participation of developing economies in the global economy both as markets for goods and services as well as production sites. Institutional changes emanating from evolving political landscapes within individual countries and pressures from supra-national bodies have been instrumental in the liberalization of developing countries' economies and their integration into the global economy. A growing body of research has focused on the transformation of state-owned enterprises as they are privatized, with particular focus on the role of organizational and national heritages that enhance or constrain the evolution of these firms within a market-based institutional environment. In this introduction, we review this literature stream, introduce the papers in this special issue, and highlight the theoretical approaches that help explain how organizations in distinct national contexts overcome the pressure emanating from institutional changes in developing economies. © 2008 Elsevier Inc. All rights reserved. Keywords: Institutional changes; Business groups; Privatization; Economic liberalization; Strategic transformation; Developing economies

1. Introduction A significant aspect of the changes in the global economy in the last two decades is the economic liberalization of protected markets and the further liberalization of market economies. Institutional changes emanating from evolving political landscapes within individual countries and pressures from supra-national bodies such as the World Trade Organization (WTO), International Monetary Fund (IMF), and the World Bank have been instrumental in the liberalization of developing countries' economies and their integration into the global economy. As part of these reforms, a number of developing countries implemented policies aimed at encouraging competition in the domestic marketplace, urging domestic firms to build international levels of competitiveness, and allowing multinational enterprises (MNEs) to enter their erstwhile protected markets. Increasing integration in the global economy has meant

⁎ Corresponding author. E-mail addresses: [email protected] (P.S. Aulakh), [email protected] (M. Kotabe). 1075-4253/$ - see front matter © 2008 Elsevier Inc. All rights reserved. doi:10.1016/j.intman.2008.04.001

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P.S. Aulakh, M. Kotabe / Journal of International Management 14 (2008) 209–216

changed competitive landscapes for organizations from developing countries as well as multinationals operating in these economies, thus necessitating organizational transformations to deal with new competitive dynamics. For instance, indigenous firms from developing economies now have to compete without the protectionist umbrella prevalent during the earlier periods. In the context of these institutional reforms, a critical question faced by local firms in developing countries is how to respond to the challenges presented by a radically changed competitive environment. The nature of local firms' strategic responses in this changed environment has strong implications for the perceived success or failure of economic reforms undertaken by developing country governments (Aulakh, 2007; Meyer, 2004; Ramamurti, 2004). The 8th Annual International Business Research Forum on the theme, “Institutional Changes and Organizational Transformations in Developing Economies,” was held at Temple University in Philadelphia on April 21, 2007. We invited papers that examine the interactions/impact of institutional changes at various levels on the organizational transformations of firms in developing economies. We were interested in papers that explored transformation of indigenous firms from these economies, including business groups, private and public enterprises and nongovernmental organizations as well as foreign multinationals operating in these economies. After a first round of blind reviews, a dozen papers out of more than thirty submissions were initially selected for presentation at the Research Forum. Authors were then asked to revise their papers based on various critiques and comments received during the forum. Those revised papers were further subjected to a second round of up to two more reviews. Eventually, six of these papers have been selected for inclusion in this special issue. In the following paragraphs we first review the past literature on institutional changes and organizational transformation and then introduce the six papers as they intervene and expand on our understanding beyond the extant research. 2. Literature review: institutional changes and organizational responses An important study examining organizational transformation in emerging economies was a conceptual paper by Newman (2000). She argued that institutional changes in Eastern and Central Europe in the 1990s “initiated a period of intense social, political, and economic change in the region” that “destroyed the underlying assumptions of economic activity” (Newman, 2000: 602). Such monumental changes required second-order organizational learning (defined as change in the core values, templates and archetypes). However, it was speculated that firms which were more embedded with the past institutional environment were less likely to accomplish second-order transformation necessitated by changed “rules of the game.” This view finds empirical support in a study on Lithuania. Kriauciunas and Kale (2006) surveyed 67 firms to assess the factors that influence transition economy firms to change their operating know-how and knowledge sets (i.e., second second-order learning defined by Newman (2000) to compete in a changed environment). Their findings suggest firms that were formed during the socialist era (thus having a “socialist imprinting”) were less able to change their operating knowledge. In addition firms that were able to access external sources of knowledge were better able to meet the “demands of the new market-oriented environment” (Kriauciunas and Kale, 2006: 659). One way for organizational transformation and to access outside resources (including capital, technology, and managerial know-how) is through the privatization of state-owned enterprises in a number of developing economies as part of the liberalization process. As stated by Zahra et al., 2000: 509–510), “[b]y placing the means of production outside of state ownership and control, privatization unleashes the forces and discipline of the free market…. Privatization, therefore, has the potential to transform national economies, industries, and organizations by infusing a spirit of entrepreneurial risk taking. These changes are in process currently across the world's six major continents, making privatization an integral part of emerging, developing, and developed countries' twenty-first-century strategic agendas. Effective privatizations however … without creating significant unemployment and related disruptions, are difficult to achieve.” In this regard, a number of studies have examined strategic transformation through privatization of state-owned enterprises (SOEs). Ramamurti (2000) proposed a multi-level theoretical model incorporating firm, industry and country level factors to explain the likelihood of a particular SOE being privatized and how they impact post-privatization performance of these firms. Johnson et al. (2000), Cuervo and Villalonga (2000) and Dharwadkar et al. (2000) use institutional, public choice and agency theories, respectively, to address managerial level transformation in privatizing organizations through restructuring of reward and incentive structures as well as overall corporate governance aspects. Spicer et al. (2000: 630), using the case study of privatization in Central Europe, suggest that “entrepreneurship is better fostered through gradualist policies permitting negotiated solutions to restructuring, as opposed to market-driven reforms.” Konings et al. (2005) use panel data


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of Bulgarian and Romanian manufacturing firms and suggest that creation of competitive markets and privatization go hand-in-hand. The general approach of gradualist reforms and transformation is seen in the liberalization model followed by China where state-owned enterprises continue to play an important role. However, organizational transformation in a marketbased regime is accomplished through accessing external resources through inter-organizational collaborations and changes in intra-organizational norms and culture. Using a sample of Chinese state-owned pharmaceutical firms, White (2000) examined the impact of a set of internal and external factors on how the state-owned enterprises acquire new technology by make, buy or ally decisions. The external factors considered are suggested by transaction cost and resource dependency perspectives and the internal factors are suggested primarily by an organizational capabilities perspective. One of the key findings of the study was that these factors were primarily based on subjective managerial perceptions of the threat of opportunistic behavior by other organizations and the required marginal investment in organizational capabilities. Ralston et al. (2006) examine the transformation of Chinese state-owned enterprises from hierarchical and bureaucratic structures to market-oriented forms through a change in organizational cultures. Peng and Luo (2000) demonstrate that Chinese firm managers' micro personal ties with other executives and government officials helped improve organizational performance. Hitt et al. (2000) study the resource acquisition and learning opportunities for emerging economy firms through international alliances. Their main contribution was that partner selection criteria are context-dependent and vary across emerging and developed economies. In particular, they find that the firms from emerging markets place greater importance on financial assets, technical capabilities, intangible assets and willingness to share expertise as criteria for partner selection. On the other hand, firms in developed markets are found to stress unique competencies, knowledge and access to local markets. In a follow-up comparative study of firms from China and Russia, Hitt et al. (2004: 173) find that “China's more stable and supportive institutional environment has helped Chinese firms take a longer-term view of alliance partner selection, focusing more on the potential partner's intangible assets along with technological and managerial capabilities. In contrast, the less stable Russian institutional environment has influenced Russian managers to focus more on the short term, selecting partners that provide access to financial capital and complementary capabilities so as to enhance their firms' ability to weather that nation's turbulent environment.” The institutional changes experienced in the centrally planned command economies such as China and Eastern European countries manifested through full privatization of state-owned enterprises (e.g., Eastern Europe) or partialprivatization (e.g., China through the mode of equity joint ventures). This, in turn, brought about dramatic increases in inflows of foreign direct investment (FDI) and led to high rates of growth, primarily driven by inward FDI. A number of other emerging economies such as India, Brazil, and Mexico initiated liberalization through opening up their markets and general deregulation of key sectors. This resulted in stronger competition from domestic and foreign players and the issue of strategic transformation in these economies is fundamentally different. Aggarwal (2000) examined the innovation strategies of Indian firms in the pre- and post-liberalization era. She finds that “unlike in a regulated regime where technology imports [were] viewed important for filling gaps in domestic technological capabilities, in a deregulated regime technology up-gradation seems to be the major role of technology imports (p. 1081).” Peng (2000) examined strategic choices during institutional transitions. Severe institutional transitions pose a challenge to organizations as they can cope when the new rules are not completely known. In such circumstances, organizations face two broad strategic choices — a network-based strategy emphasizing managers' inter-personal ties as well as the firm's inter-organizational relationships with other firms; and a market-based strategy that relies on the firm's unique competitive resources and capabilities. Also during such transitions, three types of firms emerge — incumbent firms, entrepreneurial start-ups and foreign entrants. In the initial phases of transitions, all the three types of firms are likely to compete on the basis of networks and relationships rather than competitive resources and capabilities. In this phase, in order to pursue network-based strategies even foreign entrants are more likely to form joint ventures and alliances. During the later phases of transitions, except old incumbent firms that continue to compete based on relationships, all other types of firms such as new, young incumbent firms, start-ups and foreign entrants will move towards competing based on competitive resources and capabilities through restructuring and transformation. In the developing economy contexts, firms are known to form networks and their strategies and performance are posited to be strongly influenced by these networks. Using three longitudinal cases from China, Peng (1997) explores whether growth of the firm in transitional economies has a distinct theoretical explanation compared to the Western theories given the vast differences in the institutional environments. Top managers of three Chinese firms representing different ownership-types were interviewed over the 1989–96 period. Based on these case studies, Peng

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(1997) posits that in a transition economy such as China, firms adopt a network-based strategy. This involved a process of what the author calls as ‘boundary blurring' through development of inter-organizational relationships with other firms. This unique strategy of growth has enabled the firms to avoid the tricky issue of ownership transfer of assets while allowing them access to complementary assets in the uncertain period of transition. This hybrid strategy, which is neither market nor hierarchy, was adopted by firms due to constraints on generic expansion or acquisitions imposed by the institutional environment. Elango and Pattnaik (2007) study the role of networks in the internationalization of Indian firms. Using a panel data of 794 firms, they find support for their hypothesis that international experiences of their parental and foreign networks help these firms to build capabilities to succeed in international markets. Similarly, Garg and Delios (2007) explore the role of business group affiliation on the performance of foreign subsidiaries of emerging economy multinationals. Operationalizing performance as subsidiary survival, they find that advantages associated with business group affiliation are more transferable in other developing countries (with similar institutional environments) than in developed country markets. Yiu et al. (2007) examine the internationalization strategies of Chinese enterprises and conclude that “the roles of business networks, for example, in sharing market information and securing control over a supply chain, constitute a weaker direct effect on international venturing, as compared with institutional networks. The findings show that institutional networks play a more important role at this stage of economic development of the country under study. This indicates that institutional networks may help firms in emerging economies such as China to cope with the transitioning institutional environment better” (p. 12.). 2.1. Business groups as micro-institutions A rich body of work has established the significance of business groups in the socio-economic landscape of developing economies (Strachen, 1976; Amsden, 1989; Keister, 1998; Khanna and Palepu, 1997, 1999; Ghemawat and Khanna, 1998). Ranging from Korean Chaebols, Turkish families, Latin American and Spanish grupos to Indian business groups, they have been defined as “a set of firms which, though legally independent, are bound together by a constellation of formal and informal ties and are accustomed to taking coordinated action” (Khanna and Rivkin, 2001, p. 47). While the focus of earlier research was to understand the rationale behind business groups, and relate their underlying characteristics to different country contexts (e.g., Khanna and Palepu, 2000a, 2000b; Guillen, 2000; Kock and Guillen, 2001), recent studies have been motivated by an attempt to understand their strategic responses to institutional transformations that potentially undermine the very reasons for group formation in the first place (e.g., Hoskisson et al., 2004; Hoskisson et al., 2005; Yiu et al., 2005). One view is that business groups emerge as a response to strategic factor market imperfections in developing economies (Khanna and Palepu, 2000a; Khanna and Rivkin, 2001). Due to information asymmetries, poor contract enforcement, and imperfect regulatory structures, institutional voids tend to develop in product, labor and capital markets. The absence of intermediary institutions increases transaction costs in acquiring inputs such as technology, finance and managerial talent. In response, business groups emerge. Performing the role of missing institutional intermediaries, business groups fill these voids by generating their own internal markets for financial capital and managerial talent. Member firms of a group are thus able to leverage their group's scale, scope, track record and reputation and benefit from sheer availability and lower input costs of scarce resources. Guillen (2000) offered an alternative view on the rationale for business groups. Claiming that the prevailing predominant explanations for existence of business groups in emerging economies – market imperfections, authority structures or late development – were not convincing enough, the author offers a resource-based view explanation. Guillen posits that firms and entrepreneurs create business groups when they acquire and possess resources and capabilities to enter new industries quickly and in a cost effective manner. Also, it is argued that this capability will be inimitable only under conditions of asymmetric foreign trade and investment which limit this capability to a select few firms. Findings of an empirical study based on cross-sectional data on business groups from nine emerging economies indicate that asymmetries in foreign trade and investment are associated with business groups after controlling for alternative explanations. In a recent study on business groups, rejecting the established view that business groups in emerging markets exist primarily to fill institutional voids, Yiu et al. (2005) attempted to integrate the resource-based view with the institutional view by proposing that the value created by the business groups varied depending on the type of resources and capabilities they were able to acquire. Unlike most studies on business groups that were conducted at the member firm


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level, this study examined directly a sample of 224 largest business groups in China. Yieu et al. (2005) proposed that there were two kinds of potential resources and capabilities that a business group could possess — endowed and acquired/developed resources. Age of the group, government ownership, top management background etc. were classified as endowed resources whereas those acquired through mergers and acquisitions, development of internal capabilities, international diversification and so on were classified as acquired/developed resources. The results of the study indicated that most of the endowed resources did not help business groups to create a competitive edge. Instead, the business groups that had sought to develop new capabilities through acquisitions, internal development, or international diversification showed better group performance. In spite of their benefits, some associated costs of business groups have also been identified (Keister, 1998; Khanna and Palepu, 2000a,b). While controlling families have been known to interfere in both tactical and strategic decisionmaking, member firms tend to suffer from conflict of interests between controlling (typically family) and minority shareholders. Bertrand et al. (2002) found evidence that controlling shareholders of Indian business groups engage in tunneling, or moving profits from firms where they have low cash flow rights to those where they have high cash flow rights. Further, due to inequity and nepotism, inefficient compensation systems tend to develop across group companies, with detrimental effects on market for talent. Coupled with the security that group affiliation offers, managers of group-affiliated firms typically have weaker incentives to run their firms efficiently (Khanna and Rivkin, 2001). As variety of the businesses within a group increases, the dominant logic of the traditional businesses may prove to be increasingly inadequate when applied to emerging initiatives, thus leading to sub-optimal decisions and organizational inertia. Recent research has queried the relevance as well as the ability of business groups to respond to disruptive institutional changes arising due to economic liberalization. As emerging economies continue to improve their economic institutions, largely as a consequence of market reforms, the performance of many large business groups, which acted as market-substitute mechanisms, has been reduced (Hoskisson et al., 2005). Business group affiliation, which was considered a plus during periods of underdeveloped capital markets and protectionist regimes that hindered the inflow of required technological know-how and other resources, is thus being questioned in a post-liberalization era. Local firms require second-order organizational changes in response to market reforms, which in turn requires greater emphasis on both exploratory and exploitative learning (Newman, 2000). Firms that are embedded in past institutional frameworks are, however, less likely and slower to undertake transformations when faced with environmental changes than firms that are less so (Greenwood and Hinings, 1996; Newman, 2000; Kriauciunas and Kale, 2006). For instance, Hoskisson et al. (2004) find that while business group group-affiliated firms were more responsive in restructuring their assets than non-group-affiliated firms to environmental contingencies that arose from domestic opportunities, they were less responsive than independent firms to regulatory changes and new competition. Similarly, given their market power and institutional positioning, business groups are more likely to follow sustaining strategies than independent firms during periods of environmental upheaval (Hoskisson et al., 2005). Khanna and Palepu (2000a) examine the issues of the future of business groups, especially in the changing institutional context brought about by a wave of deregulation in the emerging economies. The paper offers evidence from Chile, which has undergone significant changes in its institutional context, through a study of changes in the value creation by business groups between late 1980s and mid 1990s. Contrary to the evidence from studies in the western context, the authors find support for their hypothesis that marginal increases in group (unrelated) diversification will lead to marginal increase in firm performance, though the net benefits are found to kick in after the diversification reaches a threshold. This threshold was found to rise as market institutions evolve over time. The authors also find a non-diversificationrelated net positive effect of group affiliation, which however diminished over time as emerging markets evolved. The authors conclude that the value-creating potential of business groups is reduced gradually with the evolution of the institutional context. Kim et al. (2004) propose an evolutionary model of the business groups by tracing the evolution and restructuring of two large business groups in Korea — the LG group and Hyundai Motor. The 30 largest Chaebols formed the backbone of Korean economy, but many of them suffered severe financial problems during the Asian crisis in 1997. Many of the Chaebols undertook restructuring measures either on government directive or on their own. The authors propose that the sources of value-creating potential of business groups change and evolve along with its institutional environment and the strategy-structure fit is a key determinant of the performance of the diversified business groups. Initially, under weak market environments, the internal market capability of Chaebols (mainly unrelated business groups) under the organizational structure of co-operative M-form served as a rare and valuable resource. However, with increased

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competition and evolution of markets, the value of the internal market capability diminished. The Chaebols have two restructuring options — either change their structure to competitive M-form or refocus themselves into related businesses. 3. Papers in the special issue As the above literature review shows, there has been a flurry of research on developing economy firms during the last decade. While this research collectively has provided important insights into the evolution of organizations in the face of economic liberalization, there are a number of emerging trends that necessitate further examination of the linkages between organizational transformations and institutional changes. First, much of the extant research has focused on the privatization of state-owned enterprises (mostly in Eastern Europe) and the evolution of state-owned firms in a semi-liberalized environment (e.g., China). A number of developing economies have initiated reforms that do not necessarily involve a reduced role of the public sector in the new environment, but more through deregulation of the internal environment and open trade policies. In these economies (e.g., Brazil, Mexico, India, South Africa), the institutional changes are qualitatively different, and thus one would expect organizational responses to such changes would take different trajectories. Second, much of the extant research has identified factors that constrain strategic transformation as a response to institutional changes (e.g., pace of change (Newman, 2000), governance (Filatotchev et al., 2003), factor markets (Spicer et al., 2000), historical imprinting (Kriauciunas and Kale, 2006)). Thus as suggested by Uhlenbruck et al. (2003), future research needs to examine factors that explain firm level heterogeneity in fostering organizational transformation in light of macro- and micro-institutional changes. Third, the extant research has primarily used theoretical lenses honed in the developed country markets to understand organizational transformation in developing economies. This has inadvertently led to relating successful transformation to firm level resource and capability configurations similar to firms in developed countries. There is however increasing evidence that developing economy firms possess unique resources and capabilities that can be combined with new ones to sustain competitive advantages in an environment of market-based competition. The six papers in the special issue complement existing research by addressing some of these existing gaps. A summary of these papers is provided in Table 1. In the first paper, Malik provides a theoretical framework of organizational adaptation by developing economy firms to economic liberalization. Using a dynamic capability theoretical lens, he argues for the importance of examining organizational transformation from the perspective of evolutionary fit and suggests that initial firm level resources at the time of market liberalization determines the strategic

Table 1 Summary of the articles in the special issue Author(s) Malik

Research focus

Diversity of strategic responses to economic liberalization; role of firm level core and complementary capabilities Perez-Batres and Advance concept of ‘liability of localness’ Eden and relate it to survival of domestic firms during periods of regulatory punctuations Chittoor, Ray, Internationalization as the engine of growth Aulakh and Sarkar as a response to domestic and global institutional changes Dieleman and Advance evolutionary concept of Sachs ‘economies of connectedness’ as the basis for organizational responses to institutional changes Lorenzen and Taeube Examine the evolution of India's film industry (Bollywood) in an era of globalization and regulatory pressures. Kshetri and Ajami Propose a framework of antecedents of institutional reforms in the Gulf Cooperation Council countries; identifies economic change agents in developing countries

Theoretical approaches

Methodology

Dynamic capabilities; Theory building RBV; evolutionary fitness Liability of foreignness; punctuated equilibrium; diversification Resource-based view; growth models

National/industry contexts Developing economy firms

Industrial organization; networks; social capital

Longitudinal panel Mexico; Banking data of 37 banks (1991–2004) Aggregate industry India; pharmaceuticals data (1995–2005); trend analysis Historical case Indonesia; business groups study

Evolutionary economics; social network theory

Interviews and archival sources

India; film industry

Institutional theory

Theory building; Regional analysis

Gulf countries


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path followed by a particular firm. Depending on the combination of existing core and complementary capabilities, a firm could use domestic competitive conditions, access international resources through alliances or use political leverage to create a fit conducive to post-liberalization conditions. He provides anecdotal evidence to build the theoretical arguments and develops propositions that can be empirically tested in diverse national and industry settings. The following two papers, respectively using the contexts of Mexico and India, examine internationalization as a strategic response to market liberalization in these two countries. Perez-Batres and Eden develop the concept of ‘liability of localness' that emerges in the post-liberalization environment. They suggest that “in a protectionist environment it is difficult to uncover the liabilities that local firms face when doing business in their home market…. When liberalization and privatization occur, and these artificial barriers are removed, the inefficiencies of local firms become visible. These firms incur a liability of localness, that is, added socio-political and relational costs or hazards of adjusting to the ‘now’ being different from ‘then’.” They further suggest that overcoming the liability of localness entails international diversification (especially through foreign acquisitions) and test and find support for their hypotheses on panel data of Mexican banks. Chittoor, Ray, Aulakh and Sarkar study the Indian pharmaceutical industry as it faced economy-wide market liberalization and changes in the intellectual property regime in the 1990s, which together took away historical competitive advantages of domestic Indian firms. The industry renewed itself by aggressively participating in international resource and product markets which were facilitated by the overall globalized context of the industry. They contrast the Indian institutional changes with those of other developing economies during the same period and speculate on the possible factors explaining the ‘indigenous' growth model of this industry. The following two papers draw attention to the role of existing networks of individuals and firms in coping with institutional changes. Dieleman and Sachs use a case-study approach to understanding the transformation of an Indonesian business group in light of the 1997 Asian financial crisis. Proposing the concept of ‘economies of connectedness' as a complement to traditional economies of scale and scope, they suggest the shifting relative importance of these in evolving institutional contexts (Peng, 2003). Lorenzen and Taeube examine the domestic and international growth of the Indian film industry, Bollywood, in the post-liberalization period beginning in the early 1990s. They suggest the importance of understanding the interplay between the structure of social networks and environmental conditions to assess unique industry evolutions in emerging economies. While the first five papers attempt to understand organizational transformations as a response to a diversity of institutional changes, the last paper by Kshetri and Ajami pushes the analyses into a different direction, that is, what are the factors that push institutional reforms compatible with free-market economics. Placing their paper in the context of the Gulf Cooperation Council countries in the Middle East, they identify societal structure, internal and external change agents, the nexus between economic and political actors, and external political relations influencing the nature and extent of institutional reforms in these countries. They provide extensive policy and managerial implications of their proposed framework. 4. Epilogue We would like to thank the authors of the six papers for their contributions to the special issue and their willingness to revise their manuscripts based on reviewer comments and discussions during the research forum in which they presented their work. We are also indebted to the reviewers who reviewed the papers under time constraints and provided useful feedback for the papers' development. We appreciate the effort of Arvind Parkhe, Ram Mudambi, Ronaldo Parente and Robert Hamilton who served as discussants at the research forum and helped build connections between the various papers. Finally, we would like to thank the Temple and George Washington University CIBERs for supporting this endeavor and providing the financial support for the research forum and Kim Cahill and her staff for providing their support in putting together the forum and this special issue. 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