Regional Pioneers and the Determinants of Investment Entry: Which Firms Succeed and Which Firms Do Not?

reported by Europeans. However, these scores may not be strictly comparable, given that even though the survey question is the same, the European score was recorded for a random sample of the general public as opposed to this survey’s sampling of the business community.

An empirical estimation of a South Asian firm’s entry decision to a particular destination facilitates the characterization of pioneer investors. The determinants of entry for production investments, services investments, and trade-supporting services investments are estimated separately. Information, networks, and trust are analytically separated from traditional trade costs related to trade policy, trade facilitation, and transportation infrastructure. Information and networks are analyzed as primarily affecting the firm’s fixed entry costs of investing in a particular destination. The estimation is based on a flexible framework of a firm’s international engagement decision. Different engagement options have varying sunk entry costs, fixed costs, and trade costs. Sunk costs include market research, acquisition of knowledge of government regulations, and due diligence, and are unrecoverable fixed costs if the investment is not made. Two types of variation in sunk costs are important for this framework.

First, sunk entry costs vary across engagement modes. Sunk costs are related to the fixed costs of the engagement and are ranked such that the entry costs of exporting are lower than the entry costs of investing. Further, entry costs for a trade-supporting investment (such as a representative office) are lower than for other types of investment (such as a factory or hotel). These points can be summarized thus:

Fixed Entry Costs EXPORT < Fixed Entry Costs TRADE-SUPPORTING FDI

< Fixed Entry Costs PRODUCTION OR SERVICES FDI

Second, sunk costs vary across firm-destination pairs for the same engagement mode, which is how information barriers and differences in access to information across firms are introduced. All else equal, firms with better knowledge connectivity to a particular destination will have lower entry costs. These points can be summarized thus:

Fixed Entry Costs NETWORKED OR HIGH-KNOWLEDGE-CONNECTIVITY FIRM < Fixed Entry Costs UNNETWORKED OR LOW-KNOWLEDGE-CONNECTIVITY FIRM

The key findings are the following:

Pioneer investors are high-productivity, large firms with investible surplus funds. High-productivity, large firms are the ones that invest abroad. They have the volume of production that provides the funds to incur the sunk costs of entry. This finding

applies to all types of investments. The higher the sunk costs, the higher would be the level of firm productivity needed to cover the sunk costs (thereby restricting the activity to a few large firms). Most of the investment is financed through internal funds and funds from within a conglomerate. Additional financing from home commercial banks is important only for production investment.

Pioneer investors are located nearby. Lowering traditional trade costs (using distance as a proxy) induces investment entry. Theoretically, the direction of the relationship is ambiguous: high trade costs reduce the incentives for vertical investment but increase incentives for horizontal investments that help avoid these costs. The finding of a negative empirical relationship between trade costs and investment suggests the dominance of vertical investments (that is, those that need trade costs to be low to be profitable). From an investment perspective, this finding validates the trade and transportation infrastructure and trade facilitation initiatives that seek to reduce trade costs. Investments in physical connectivity are important. Trade costs continue to be important, controlling for exporting, which suggests that the distance variable is likely capturing the importance of communications costs and digital connectivity for investment. The importance of distance is significantly greater for services investments compared with goods production (agriculture and manufacturing) investments, which is consistent with findings on the greater importance of cultural sensitivity in provision of services compared with goods.

Pioneers are well-networked abroad. Regional pioneers have information networks abroad, and these networks make investing more inclusive. Firms with founders or chief executive officers with ethnic or visible social networks abroad tend to have a higher probability of investing. Networks allow for variation in sunk entry costs across firms, implying that the additional information that firms possess reduces entry costs by reducing information frictions and uncertainty. Networks tend to be more important for services and trade-supporting services investments. Again, this evidence is consistent with the finding that cultural sensitivity is more important for services industries.

For services investments, the presence of a network tends to be more important than productivity improvement. Networks make the investing activity more inclusive, given that lower-productivity, networked smaller firms may also invest abroad, thus widening the pool of potential investors. Case study evidence supports this result, with almost all pioneers having an ethnic or social link to the first OFDI destination.

Pioneer investors are exporters. Learning through exporting increases the likelihood of investing abroad. In a dynamic setting with uncertainty, the entry costs incurred during the exporting exercise enable the acquisition of market knowledge and the formation of business networks, thereby reducing the higher entry costs of investing in the following period and increasing the likelihood of investing. Exporting also makes investing more inclusive, because again it is not only the largest firms that can afford to incur the sunk entry costs of investment. Smaller firms with experience in exporting would also be able to do so because the entry costs of investment facing them are lower. This finding further validates the importance of reducing trade costs: lower trade costs

would increase FDI by making export experimentation to learn about foreign markets less costly.

Investors are followers of pioneers in their conglomerate or business group. In addition to learning through their own experiences, follower firms can learn from pioneering firms that have already invested. Information spillovers from pioneer firms within a business group reduce the entry costs of related follower firms, even in different sectors. Thus, conglomerates perform not only a financing function but also an informationsharing role in stimulating OFDI.

Unrelated follower firms are less likely to succeed due to “sticky knowledge.” Sticky knowledge is one explanation for the “case of the missing herd” in South Asia. In theory, the information spillover from pioneer activities should reduce entry costs for competitor follower firms and induce a herd effect or cascade after the entry of the pioneers. Although follower firms gain awareness from the experiences of national (and global) competitors, there does not appear to be enough knowledge flow to reduce the entry costs sufficiently to spur investment. The report argues that sticky knowledge prevents transfers from pioneer firms to unrelated home follower firms in the same industry, accounting for the missing herd. Sticky knowledge may be due to motivational barriers to sharing information as well as knowledge barriers.

Investing entrepreneurs have higher risk appetite. Higher risk appetite of the entrepreneur is associated with higher likelihood of investment entry. The risk appetite of the entrepreneur was measured by whether the founder belonged to a business community or a well-known business family, and the results indicate a positive relationship between investment and risk appetite. The intuition is that a person raised in a household in which family businesses routinely succeed and fail is more likely to be open to taking risks.

South Asian investors take a gradualist path. South Asian investors’ behavior is consistent with investors that face high uncertainty, have scarce capital, are new to investing overseas, and are risk averse. Investors invest gradually following different dynamic paths of learning. Firms can learn from their own experience as well as from the experiences of other related and unrelated firms. First, there is a firm’s own learning through lower-fixed-entry-cost engagements, such as exporting or nonequity engagements (for example, management contracts and franchising). Even within different forms of investing, a firm may start with an investment with a low fixed cost (for example, opening a trade-supporting office to learn about the market and build relationships with industry and government) before proceeding to invest in a factory with higher fixed costs. Second, in addition to learning through their own experience, firms can learn from other pioneers, given that information spillovers from pioneers reduce the entry costs of follower firms. The information flows from related firms within a business group or conglomerate are relatively smooth and lead to related-firm entry at the same destination, either in a different sector or in another activity along the same value chain. Knowledge flows from pioneers to competitors at home may be “stickier” and reduce entry costs only marginally.