16.5 Institutional changes


Institutions are widely seen as crucial to the operations of a market economy and as facilitating business operations in emerging markets (see for example Harriss et al. , 1995). In Central and Eastern Europe the emergence of smoothly operating institutions has so far been sporadic, slow and uneven across countries. The widespread use of barter throughout the former Soviet Union, opaque legal and regulatory frameworks, the underdeveloped political and constitutional court systems of many countries , as well as corruption and bureaucratic inefficiency (see EBRD, 2001) imply high transaction costs when establishing new business relationships, which may inhibit future transactions. Weak institutional frameworks also increase search, negotiation and enforcement costs.

The development of laws regulating the establishment of businesses, competition, capital markets and other business transactions will reduce the transaction costs incurred by firms doing business in transition economies. The harmonization of the institutions, rules and regulations of accession countries with those of the present EU member states will have two consequences for business strategies. First, the lower transaction costs that will result from improved institutions will change the structure of industry, both domestic and foreign. Second, the lower transaction and entry costs incurred by foreign investors will lead to increased FDI inflows.

16.5.1 Changes to the structure of industry

In emerging markets around the world, from Chile to Korea and from India to Poland, large and diversified domestic conglomerates are major players in the domestic economy. In contrast, over the past three decades mature market economies such as the United States and Western Europe have seen the demise of such conglomerates. Khanna and Palepu (1999, 2000) argue that the prevalence of diversified firms is a result of high transaction costs in markets for financial and human capital. To overcome market failures, these firms rely on internal markets for capital and labour.

Market failures adversely affect financial markets that lack adequate disclosure rules or accounting and auditing standards, and where intermediaries such as investment bankers, venture capitalists and financial analysts may not exist. This increases transaction costs on the local capital market as investors have to invest more heavily in securing information and face a higher risk of debtor default. Large conglomerates can bypass this by setting up internal capital markets and creating internal labour markets for highly qualified personnel where external recruitment is difficult or costly (Khanna and Palepu, 2000). At the same time large conglomerate groups have a stronger bargaining position vis-a-vis corrupt bureaucrats (Shleifer and Vishny, 1993).

These transaction costs decline as countries reduce the scope for corruption and improve the efficacy of the institutions that regulate the markets and provide information on potential partner firms and employees . Hence the need for internal markets diminishes, as does the extent of unrelated diversification.

Diversified groups are particularly important in Russia, including the so-called financial “industrial groups, and firms with high horizontal or vertical integration are also common in Central Europe. In part this is a pre-1989 inheritance as central planning raised the cost of interfirm transactions (such transactions either had to involve the planning authorities, or had to be conducted in informal, semilegal ways). However there have also been examples of industrial conglomerates evolving during the industrial restructuring process, for example the Skoda Industry group .

The Khanna “Palepu argument suggests that the establishment of market institutions in accession countries will increase competition while lowering transaction costs in crucial markets (Khanna and Palepu, 2000). Capital and skilled labour will be readily available at competitive prices, and the exchange of intermediate products will be based on appropriate contracts in specialist markets. What will bind operations together in the business organization of the future will be shared knowledge-based assets and strategic interdependence in such operations as R&D, production and marketing. As a consequence diversified conglomerates will be reorganized into focused, specialist businesses and become subject to the global merger and acquisition activities that were behind the acceleration of global FDI in the 1990s (UN, 2000).

However in a defensive reaction domestic firms might merge in order to withstand increased foreign competition, as seen in some West European countries around 1992 and more recently in utilities sectors earmarked for liberalization. This would increase the barriers to entry and reduce domestic competition, which would in turn harm consumers. As a defensive measure such mergers would prolong the survival of domestic firms, but they would also hinder the development of new technological and managerial capabilities as there would be less competitive pressure to engage in innovation. As a consequence the firms would not be prepared for the dynamics of competition when it eventually arrived. In the longer term , such defensive conglomerates would face a second restructuring process when they were pushed by investors and by competition to focus on core competences “ often after a substantial financial crisis.

Whichever course is taken, the restructuring of industry towards more specialized, globally operating businesses is likely to accelerate both inward and outward FDI in the accession countries. Mergers and acquisitions are likely to increase as conglomerates sell non-core businesses while strengthening their core business areas.

16.5.2 Institution building and inward FDI

For firms contemplating foreign investment, the restrictions and incentives created by national and multilateral institutions

shift the playing field favoring some deals and opportunities while disadvantaging others. They force the investing firms to think strategically about how to avoid the limits imposed by domestic laws as well as how to reap the benefits that the law and particular circumstances are capable of providing. (Spar, 2001)

The range of policies of concern to foreign investors is wide. Direct investors have to adapt their strategies to local institutions (Peng, 2000), and Western businesses entering the transition economies face higher transaction costs than in mature market economies because of the incomplete institutional framework. Moreover these costs vary across the transition economies because their rates of progress differ and impact differently on potential source countries, whose firms have varying degrees of experience in operating in such environments.

The harmonization of institutions and the related liberalization of regulatory regimes will benefit service industries such as finance, telecommunication, utilities and transportation infrastructure. These industries are opening up to competition across Europe, while preferential treatment for national incumbents is gradually being eroded. In the accession countries many of these sectors require substantial upgrading, which may trigger considerable investment by suppliers to these industries, notably construction businesses.

On an aggregate level the effect of institution building on FDI flows to the CEE countries has been demonstrated in empirical studies. For instance Brenton et al. (1999) have shown that economic freedom is positively related to FDI flows from Western to Eastern Europe. Later Bevan et al. (2002) disaggregated the pertinent institutions and found that some but not all institutional changes have enhanced FDI receipts in transition economies. They have prompted (a) the development of privately owned businesses in place of state-owned firms, (b) the development of the banking sector but not necessarily the non-banking financial sector, (c) the liberalization of foreign exchange and trade but not necessarily of domestic markets and prices, and (d) the development of legal institutions but not necessarily competition policy.

Consequently FDI to accession countries can be expected to increase in industries where standards are harmonized and informal and formal barriers to FDI are being reduced.




Change Management in Transition Economies. Integrating Corporate Strategy, Structure and Culture
Change Management in Transition Economies: Integrating Corporate Strategy, Structure and Culture
ISBN: 1403901635
EAN: 2147483647
Year: 2003
Pages: 121

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