ARTICLE IN PRESS

Management
S C A N D I N AV I A N J O U R N A L O F

Scand. J. Mgmt. 23 (2007) 107126 www.elsevier.com/locate/scaman

The strategy of multinational enterprises in the light of the rise of China$

Peter J. Buckley
Centre for International Business, University of Leeds, Maurice Keyworth Building, Leeds LS2 9JT, UK

Abstract This paper examines the strategy of multinational enterprises in the global economy with particular emphasis on their strategies in and about China. It outlines the rise of globally distributed manufacturing, services and marketing under the control of a focal rm (the global factory) and applies this analytical framework to strategies in China. The paper outlines the constraints on future growth in China and the interacting effects of these constraints with the strategies of foreign rms. r 2007 Elsevier Ltd. All rights reserved.
Keywords: Multinational enterprises; Foreign direct investment; China; Global strategies

1. Introduction This paper examines the development of strategies of multinational rms against the background of the globalisation of markets. It is argued that markets are integrated globally at differential speeds and that this provides opportunities for multinational rms who are also key drivers in the processes of globalisation. Location and ownership strategies are analysed in detail together with policies concerning the crucial role of knowledge creation and management. The concept of the global factory is introduced as an integrated network (often controlled by a focal rm) that combines core functions, distributed manufacturing and service operations and marketing networks. The paper then examines the rise of China as a world economic power. The challenges facing China are
This article is based on the authors Viipuri Prize Lecture in Lappeenranta University of Technology, Finland, 7th September 2006. Tel.: +44 113 343 4646; fax: +44 133 343 4754. E-mail address: pjb@lubs.leeds.ac.uk. 0956-5221/$ - see front matter r 2007 Elsevier Ltd. All rights reserved. doi:10.1016/j.scaman.2007.02.007
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delineated with particular attention to the challenges facing multinational rms in China. Constraints on Chinese growth are examinedit may seem strange to investigate such constraints when China is growing at an historically unprecedented rate but severe restrictions are appearing on its future growth potential. This then leads on to the crucial needs of the Chinese economy and to the role that multinational rms can play in the future. The nal section examines strategy in the current Chinese context. 2. The conict of markets with national policies in the global economy As Sideri (1997, p. 38) says Globalisation is essentially a process driven by economic forces. Its immediate causes are: the spatial reorganisation of production, international trade and the integration of nancial markets. It is not therefore uniform across economic spacethe segmentation of the manufacturing process into multiple partial operations which combined with the development of cheap transportation and communication networks, has brought the increasing division of production into separate stages carried out in different locations. The strategies of multinational rms are therefore crucial to the causes and consequences of globalisation. We can examine globalisation as a conict between markets and management (policies). Fig. 1 identies three levels of marketsnancial markets, markets in goods and services and labour markets. Each of these is moving at a different speed towards global integration. Financial markets are already very closely integrated internationally, so that no individual national capital markets can have a sustainable independent existence. However, attempts at national regulation do persist (Laulajainen, 2000) and the role of localities in the nancial markets still provides differentiation (Berg & Guisinger, 2001; Tickell, 2000). Despite this, it is legitimate for analytical purposes to hypothesise a single integrated global capital market. Regional economic integration (REI) is becoming increasingly effective in integration goods and services markets at the regional level.

MARKETS INTERNATIONAL

MANAGEMENT Conflict of national policies (locational)

CAPITAL MARKET

Capital flows GOODS & SERVICES MARKETS Labour Services LABOUR MARKETS
N A T I O N A L N A T I O N A L N A T I O N A L N A T I O N A L N A T I O N A L N A T I O N A L

REGIONAL

REGIONAL

REGIONAL

Integration, Harmonization and protection regional policies

National employment Training and fiscal policies

Fig. 1. The differential speed of globalisation.

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The relationship between company strategy and policy making within regional blocs such as the EU is a fascinating area for the development of new research streams (Chapman, 1999; Raines & Wishlade, 1999; Wood, 2003). Labour markets, however, are functionally separate at the national level and here integration is largely resisted by national governments (Buckley, Clegg, Forsans, & Reilly, 2001). While the largest multinational enterprises are already perfectly placed to exploit these differences in the international integration of markets (Buckley, 1996), however, REI offers both large and small rms the opportunity to enjoy the advantages of a large home market, whether it is their native home or their adoptive home. The operation of international capital markets (which allow rms to drive their capital costs down to a minimum) have largely transcended policy on regional integration, although each region would hope to retain its own regional nancial centre. It is primarily in the arena of the creation and fostering of regional goods and services markets, that enable rms to exploit economies of scale across several countries, that REI offers the most substantial size-ofcountry benets. However, regional integration that encompasses countries with differential labour markets is becoming increasingly benecial. This regional integration enables costs to be reduced by locating the labour-intensive stages of production in the cheaper labour economies within the integrated area. Firms that serve just one regional market, as well as those that serve several of the regional goods and services markets of the world through horizontally integrated foreign direct investment (FDI), are able to complement this with vertically integrated FDI in quality-differentiated labour markets. Vertical integration also reects the spatial distribution of supplies of key inputs and raw materials. The multinational enterprise achieves advantages through both vertical and horizontal integration. Each strategy is promoted by the size of country benets of REI in goods and services markets, which reduce or eliminate articial barriers to trade between the members. This maximises the ability of rms to exploit intra-regional differences in factor abundance, including differentiated human capital. At industry level, globalisation can be shown to have an increasing impact. Gersbach (2002) denes globalisation at the micro-level as the exposure of a productivity follower industry in one country to the productivity leader in another country (p. 209). The transmission mechanisms of change across country borders are trade and FDI. Gersbach found a strong relationship between globalisation and productivity differences with the most efcient producers. He concludes that globalisation matters and that its inuence spreads beyond a single region (e.g. Europe, North America). More attention has been paid to vertical relationships (the supply chain). The differentiation of labour markets is most acute between advanced and less-developed countries which are typically not part of the same regional bloc. The managers of MNEs are increasingly able to segment their activities and to seek the optimal location for increasingly specialised slivers of activity. This ability to separate and relocate stages of production has led to a boom in manufacturing in China and service activities (e.g. call centres) in India. MNEs are also increasingly able to co-ordinate these activities by means of a wide variety of mechanisms from wholly owned FDI through licensing and subcontracting to market relationships. The more precise use of location and ownership strategies by MNEs is the very essence of increasing globalistion. In parallel with the growth of the globalisation of production, globalisation of consumption has accelerated and it is perhaps this which has excited most opposition. The alleged globalisation of tastes provokes nationalistic protectionist sentiments and is here

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analysed in terms of the balance of strategies within MNEs between local and global pressures on the rm. The process of globalisation is thus not only reorganising power at world level but also at national and subnational levels (Alden, 1999; Dunning & Wallace, 1999; Graham, 2003; Peck & Durnin, 1999; Pike, 1999; Yeung, 2003). As domestic rms move part of their production to other countries, technology, knowledge and capital become more important than land, the traditional source of state power, and this redenes the function of the state (Rosecrance, 1996; Sideri, 1997). The loss of sovereignty to supra-national regional institutions is more acceptable than to international institutions which are more remote. The EU is an example of such regional integration and governance (Bressand, 1990). Social programmes within the EU are enforcing major re-distributions of revenue between the individual nations. The nation state as the possessor of the sense of identity is being replaced by subnations and internal regions as government is devolved. Subramanian and Lawrence (1999) found that national locations remained distinctive. Policy barriers at the borders, differences in local cultures in their widest sense and nature and geography contribute to distinctiveness. This, together with the ability of incumbents to keep outsiders at a disadvantage (Buckley et al., 2001) and the rst entrant benets of local rms, reinforce the differentiation of national economies. International competition remains imperfect and international price differences persist because arbitrage is costly. Domestic market conditions largely determine prices and wages. Multinational rm afliates remain rmly embedded in their local economy and such local rms identify closely with the national government. Subramanian and Lawrence (1999) conclude that national borders still matter. Borders continue to engender and to coincide with important discontinuities stemming from government policies, geography and societal differences. The authors stress information discontinuities which coincide with national boundaries and so create search and deliberation problems for trading and manufacturing rms. These issues also account for the alleged home bias of multinational rms. FDI is the key tool by which multinationals bridge cross-border discontinuities. The two contrasting paradigms of a world made up of self-contained national economies and a borderless world are incomplete and capture only part of a complex and subtle story. Lenway and Murtha (1994) examine the role of the state as strategist along four dimensions: authority vs. markets, communitarianism vs. individualism, political vs. economic objectives and equity vs. efciency. They state that international business scholarship places a benchmark value on efcient international markets and tends to regard states as causes of deviation from this ideal (p. 530). 3. Location and ownership strategies of multinational rms The traditional MNE was a vertically, as well as horizontally, integrated rm. In consequence, each division of the rm was locked into linkages with other divisions of the same rm. As global competition intensied, there was growing recognition of the costs of integration of this kind. Commitment to a particular source of supply or demand of any product, intermediate good or service is relatively low-cost in a high-growth scenario, since it is unlikely that any investment will need to be reversed. It is much more costly in a lowgrowth scenario, where production may need to be switched to a cheaper source of supply, or sales diverted away from a depressed market. The desire for exibility therefore discourages vertical integrationwhether it is backward integration into production, or

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forward integration into distribution. It is better to subcontract production and to franchise sales instead. The subcontracting of production is similar in principle to a putting out arrangement, but differs in the sense that the subcontractor is now a rm rather than just a single worker. A network does not have to be built around a single rm, of course. A network may consist of a group of independent rms instead. Sometimes these rms are neighbours, as in the regional industrial clusters described by Best (1990), Porter (1990) and Rugman, DCruz, and Verbeke (1995). Industrial districts, such as Toyota city, have been hailed as an Asian innovation in exible management, although the practice has been common in Europe for centuries (Marshall, 1919). As tariffs and transport costs have fallen, networks have become more international and virtual. This is demonstrated by the dramatic growth in intermediate product trade under long-term contracts. For example, an international trading company may operate a network of independent suppliers in different countries, substituting different sources of supply in response to both short-term exchange rate movements and long-term shifts in comparative advantage. By establishing a network of joint ventures (JVs) covering alternative technological trajectories, the rm can spread its costs whilst retaining a measure of proprietary control over new technologies. The advantage of JVs is further reinforced by technological convergence, for example, the integration of computers, telecommunications and photography. This favours the creation of networks of JV(s) based on complementary technologies, rather than on the substitute technologies described above (Cantwell, 1993). JVs are important because they afford a number of real options (Trigeorgis, 1996) which can be taken up or dropped depending upon how the project turns out. The early phase of a JV provides important information which could not be obtained through investigation before the venture began. It affords an opportunity later on to buy more fully into a successful venturean opportunity which is not available to those who have not taken any stake. It therefore provides greater exibility than does either outright ownership or an alternative involving no equity stake. (Buckley, Casson, & Gulamhussen, 2002). 3.1. Global knowledge diffusion As Buckley and Carter (2002) point out, problems in the global organisation of MNEs are frequently presented as oppositions. Typical are global/local, centralise/decentralise, standardisation vs. adaptation, and efciency vs. responsiveness. These issues are not independent of knowledge management. Global/local issues centre on the costs of managing knowledge ows and the combination of general company-wide knowledge and separable, spatially xed local-specic knowledge. Spatial questions are one part of dealing with knowledge-intensive organisations, but spatial issues are bound up with a whole set of temporal, organisational, strategic and process issues (Buckley & Carter, 2002, p. 46). As Murtha, Lenway, and Bagazzi (1998) show, strategy emerges from mind-sets which are changing over timeglobal and local issues are capable of synthesis. The role of management knowledge is a crucial and underresearched phenomenon of globalisation. Global management of knowledge does enable the separation of key activities which can be therefore managed in different ways. This has led to strategies of outsourcing, mass customisation and de-duplication of functions which can be spatially separated, bundled and differentiated and consolidated respectively. Murtha, Lenway, and Hart (2001)

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examine the process of global knowledge creation and dissemination in a fascinating, detailed industry case study of the type that can be replicated and extended. The goal of a modern sourcing strategy is to obtain the optimum combination of inputs from the variety of opportunities open in the global market. Normally, this will be geographically diverse and the means of procurement will be varied. Thus, both the location factor (where the inputs are acquired) and the internalisation/externalisation choice of means of procurement will vary with circumstances and will change over time. The ability of ms to mix and match their sourcing strategy has been greatly enhanced by the use of the internet for procurement and the increasing use of outsourcing whereby external offers can be compared to internal courses of supply, and the scope of the rms internal activity adjusted accordingly. These strategies enable increased specialisation and localisation to enhance the division of labour globally and for individual rms to benet from this in creating a global business network which encompasses many locations for activities with mixed ownership/contracting modes of procurement. The reduced need for co-location locationally diversies the rms production base. Similarly, the market servicing strategy comprises a mix of exporting, licensing/ contracting and investment activities, again suggesting a mix of ownership and location strategies in different spatial and temporal circumstances. Here, too, different functions (more housing, distribution, advertising) can be either centrally and globally organised or differentially localised. Ownership too may be fully internal, JV/alliance or outsourced. The interaction of the supply and demand side have yet to be fully studied, but it is safe to assume that large markets exercise a locational pull on inputs, and key input sources encourage local marketing. MNEs thus seek optimal locations for raw materials, intermediate goods, services brain arbitrage and assembly plants. They also seek entry and exit strategies for markets as they wax and wane over time. This is a suitably complex subject for detailed analysis. 3.2. Global/local operations There has always been a tension between the pressures to globalise and the need to stay local and to serve individual customers in the strategic decisions of multinational rms. The advantages of global operations are cost based, maximising economies of scale and reducing duplication, thus achieving efciency. The advantages of localisation are revenue based, allowing differentiation to reach all customer niches and achieving responsiveness. The tension can be summed up in the phrase the cost advantages of standardisation vs. the revenue advantages of adaptation. (Fig. 2). Much of the strategy of the multinational rm can be explained by the attempts of management to reconcile these pressures (Devinney, Midgley, & Venaik, 2000). Over time, rms have (been advised to) switch their organisation so as to balance these pressures one example is the transnational type of organisation advocated by (Bartlett & Ghoshal, 1989). However, pressures in different industries push rms towards a strategic imperative (scale in electronics, local demand differences in consumer goods) and different functions require different balances of global/local orientation (nance, production, sales functions). The hub and spoke model below is a key method of attempting to reconcile these conicts. Global and local oppositions are shown in Fig. 2. Cultural differences are of great importance in determining the extent of this balance.

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GLOBAL Cost Efficiency Centralisation Standardisation GLOCAL?

LOCAL Revenue Responsiveness Decentralisation Adaptation

Fig. 2. The global/local divide.

The globalisation of markets has been a major factor in the growth of volatility (Buckley & Casson, 1998). A feature of many global markets is the use of regional production and distribution hubs, where several neighbouring countries are serviced from the same location. The regional hub, like the IJV, can be understood as a strategy that offers superior exibility. Just as an IJV offers a compromise ownership strategy, a regional hug offers a compromise location strategy. Because the hub is nearer to each market that is the home location, it reduces transport costs, and offers better information capture too. Yet, because it is close to several markets, it avoids exclusive commitment to any one. If one market declines, production can be switched to other markets instead provided the shocks affecting the national markets are independent (or less than perfectly correlated, at any rate) the hub provides gains from diversication. These are real gains that only the rm can achieve, as opposed to the nancial gains from unrelated product diversication, which have proved disappointing in the past because they are best exploited through the diversication of individual share portfolios instead. 3.3. Location and ownership strategies revisited: hub and spoke strategies The two strategies of IJV and hub can be combined. (Fig. 2). Since one (the IJV) is an ownership strategy and the other a location strategy they can, if desired, be combined directly in an IJV production hub. Closer examination of the issues suggests that this is not normally the best approach, however. The model suggests that a combination of a wholly owned production hub supplying IJV distribution facilities in each national market is a better solution. A hub facility is too critical to global strategy to allow a partner to become involved, because the damage they could do is far too great. Even with a wholly owned hub facility, the combination still affords considerable exibility to divest or withdraw from any single market. The advantage of the combination is that when divesting, the distribution facility can be sold to the partner, while the production capacity can be diverted to markets elsewhere. These options for divestment are combined with useful options for expansion too. This example illustrates the crucial role that the concepts of exibility and volatility play in analysing foreign market entry in the modern global economy. Without these concepts it is impossible to fully understand the rationale for IJVs and production hubs. It is also impossible to understand why these strategies have emerged at this particular historical juncture and not before Fig. 3.

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Warehousing and Adaptation IJV Wholly Owned Production and Warehousing Hub

Distribution IJV

Warehousing Distribution and Adaptation IJV

Fig. 3. Hub and spoke strategies: an example.

Warehousing Distribution and Adaptation IJV

3.4. Outsourcing and logistics Many input functions are now viably outsourcedeven human resources departments and procurement (Economist 1.12.2001 out of the back room pp. 7576). Digital delivery of product is analogous on the output side. The danger is the loss of core competencies (outsourcing IT loses part of companys brain). This development contributes to volatility and increases the mobility of activities internationally, as a great deal of outsourcing functions are competed for on a global basis. The policy of promoting linkages (forward as well as backward) followed by many agencies of national and local government needs to account for these changing decision making parameters. As is always the case, disintegration of established supply chains, is followed by reintegration and consolidation. The trend to outsource (disinternalise) manufacturing by major multinationals led initially to subcontracting to independentsmany of them located in South East Asia (and Mexico). Contract manufacturing (Factories for hire Economist 12.02.2000, p. 81), has been growing by 20%/year in the late 1990s and early part of this century. However, contract manufacturers are rapidly consolidating, through mergers, and are expected to reach an oligopolistic equilibrium, with around six rms dominating the global market. These rms are becoming supply chain managers, sometimes even organising distribution and repair. These links between customers and suppliers are, of course, facilitated by the use of the Internet. Contract manufacturers, ensured of future contracts are thus able to achieve economies of scale and to become more capital intensive, replacing unskilled labour by high tech capital equipment. This trend is accelerated by the competitive imperative becoming speed to market, not cost. A linked supply of available factories in different national locations mean that the contract manufacturers can switch production lines between these units. Flexibility is achieved by moving these shell factories between principalsentire production lines can be own in from another location.

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Vertical disintegration is thus accompanied by specialisation. The principle concentrates on R&D, design and marketing, while the contract manufacturer provides a service to the global supplier. Companies with a strong manufacturing culture, and a commitment to a xed location, may be out competed by more agile virtual rms owning no manufacturing facilities at all. Mass customisation is an important method of reconciling scale and differentiation (efciency and responsiveness). An example is the textile industry where bespoke garments are ordered en masse from offshore sites with rapid delivery. This is associated with Lean retailing where distribution and design centres are linked to production centres by electronic means. Electronic ordering and automated distribution centres and inventory management systems linked to customers enable rapid response to customer needs. This combines information technology, speed and exibility with low labour costs. So the custom made vs. bulk manufacture divide becomes ne. (Cyber consumers expect to be able to customise everything). De-duplication of function becomes possible where electronic links allow single locations to service the whole rms needs. Rather than a call centre for each division or country, a single one can serve all. There is also a tendency for re-integration of the supply chain from independents back to the major manufactures or in specialist subcontracting rms as e-commerce matures. 3.5. The global factory The above review suggests that the manufacturing system of the future will use distributed manufacturing (Economist 23.02.02 Incredible shrinking plants) where products are more responsive to customer needs through exible factories. In exible factories, all plants within the system can make all the rms product models and can switch between models very quickly by a combination of software and robots. The global factory will be the very antithesis of Any colour as long as its black. It will have a single factory design for its distributed global plants and attention to staff training so that replication and perfect substitutability between plants is achieved. Customers will be able to dictate which parts, subassemblies or add-ons they require in the nal assembly and the distributed manufacturing function will resemble Fig. 4, where production is pushed from the hub into the spoke. Brand owners will control design, engineering and marketing while outsourcing large areas of production to parts suppliers and they may well contract out nal assembly. Thus built to order products will be produced close to the nal customer. Globalisation implies location near the customer, not a single large scale plant. It is the high xed costs of existing factories which compel manufacturers to achieve large-scale production, and a reduction of xed costs means that production can be more easily tailored to nal demand. 4. The rise of China The determination of the Chinese people and government to achieve a modern, worldclass economy is encapsulated in the following quotation. For 18 of the past 20 centuries, China has boasted the biggest economy in the world. Many Chinese see the past 200 years of underdevelopment and colonial occupation as an aberration that must be addressed. (Financial Times 03.12.2002, p. 17).

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Parts Supplier Parts Supplier Parts Supplier

Contract Assembler

Design Engineering Branding Marketing BRAND OWNER

Outsourced Parts Supplier

Contract Assembler Warehousing, Distribution and Adaptation

Engineering Contractor

Design Contractor

Parts Supplier

R&D Contractor Core Functions

Parts Supplier

Distributed Manufacturing

Local market Adaptation

Fig. 4. The global factory.

To this end, policies are implemented that enable rapid economic growth without destabilising the political control of the Communist Party. This combination is difcult to sustain, particularly in issues concerning the freedom vs. control of informationthe rst is necessary for economic development, the second for one-party control. These are not the only challenges facing China. Chinas economic challenges are many and varied:

       

the shock of normal economic restructuring across all sectors, following rapidly intensifying competition, especially from overseas competing on a global level playing eld with a highly concentrated global business system the IT revolution and modern production systems on employment the drastic impact of the global media revolution upon Chinese culture for its peoples self-esteem, should it fail to establish a collection of powerful indigenous corporations dealing with the dominating presence of foreign-owned corporations societal disparities (urban vs. rural, western vs. coastal) institutional reform at all levels of government and administration

When these challenges are translated into business and economic conditions, they pose difculties for foreign enterprises as we shall see. Among the most serious are:

Supply chain issuesdifculties of subcontracting in China, importing etc. leads to excessive internalisation and over investment.

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Partnership issuesnature and outlook of partner (JVs vs. wholly owned subsidiaries). Business culture and difculties of corruption and misperception. Protecting intellectual property and intangible assets. Technology transfer to China. Personnel and workforce issuesalready a skills shortage in certain areas and regions of China. Uncertain and insecure property rights. Making and remitting prots

Despite its outstanding recent annual growth rates (and it is difcult to believe the exact gures), China faces some severe constraints on its future growth. These are: political constraints, the availability of the unnecessary inputs, bilateral and multilateral diplomacy, labour issues, rigidities and bottlenecks in the domestic economy, the environmental impact of growth and innovation related issues. In terms of political constraints on economic growth, the primary issue is the political and social contradictions between Communist central control and the ssiparous forces behind a free trade environment. There are intense rivalries between Provinces, regions and cities which have distorting effects. The process of economic growth in China has led to major inequalitiesthe most obvious ones being between rural and urban areas, the interior and the rapidly developing coastal areas and between different classes of workers and the elite. Although the central government has managed the transition to a modern economy skilfully, this has meant restrictions on freedom such as freedom of movement within China and, most seriously, on freedom of information. There is also rising dissatisfaction with corruption. Externally the Taiwan issue remains an unresolved area of tension. Finally, these strains are only alleviated by the rapid rate of growth. Rising expectations are currently being fullled, but were the growth rate to falter, it would be more difcult for the Government to cope with its potential political difculties. Second, the rapid growth of China requires a huge input of resources. The rising cost of energy and raw materials is a major consequence of Chinas growth. This has led China to seek relationships with key providers globally and is a major motivation for Chinese outward direct investment (Buckley et al., forthcoming). China is thus led into relationships with some unsavoury regimes such as Sudan in order to secure long-term access to key resources. The costs of inputs are thus rising politically as well as economically. Third, Chinese bilateral and multilateral diplomacy needs to be of a very high order to sustain its access not only to inputs but also to nal markets. Its competitors (ASEAN and India for instance) are concerned at the loss of their markets domestically and globally and at Chinas huge share of inward direct investment. Its customers are concerned at Chinas market share of their markets. The fruits of Chinas success are currently ploughed into US nancial assets leading to concern about future liquidation. All these issues threaten future instability if not carefully managedand the management of some of these issues is outside Chinas control. Fourth, China faces severe problems with labour. The availability of a cheap, hard working labour force remains a key competitive advantage for China. However, there are strong signs that in certain areas, skilled labour shortages are beginning to emerge. Table 1 shows that for certain key types of workers, Chinese costs are overtaking those in India by a considerable amount. Training requirements in China are huge and will be increasingly

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118 P.J. Buckley / Scand. J. Mgmt. 23 (2007) 107126 Table 1 China/India wage comparisons2005 wages in multinational rms China ($) Project managers Financial analysts Production worker Customer care 23,409 13,194 2334 2418 India($) 10,039 8408 1853 1601

NB: average pay rises in multinationals in past 5 years: China 7.5%, India 11.5%. Living costs in Chinese coastal cities greater than in India. Chinese pay is higher for 95% of 42 job categories considered in the study but the pay differential is less stark at lower levels. Wage costs, of course, are only one factor in the investment decision. Source: Mercer Human Resources Consultancy as reported in Financial Times 15.11.05, p. 10.

costly as Chinese industry upgrades. There are also indications that Chinese workers are becoming more demanding and they are ceasing to accept inequalities. Issues of health and safety are also beginning to emerge. Chinese labour costs will, inexorably, rise. There are severe rigidities and bottlenecks in the Chinese economy which slow growth and will increasingly do so unless solutions are implemented. The Chinese banking system is inefcient and outmoded. Indeed, the overall inefciency in the capital market is severe and is one reason why FDI is so vital to Chinas development. Banks are one aspect of unreformed state owned enterprises (SOEs) that are such a burden to the economy. The infrastructure of China, particularly transport, requires huge investment to cope with the expansion of the economy and creates bottlenecks in supply and distribution. Internal migration is strictly managed and the question must be asked as to how long this can co-exist with increasing liberalisation of markets. Finally, we should not forget that China has a huge (and largely unreformed) agricultural sector in which, still, a majority of workers is employed. The deleterious environmental effects of Chinas rapid growth cannot be escaped. Pollution is already at dangerous levels in most centres of population. Regulation is as yet weak and unsystematic largely as a result of fears that environmental improvements will show growth. This issue represents possibly the major challenge for Chinese policy makers and multinational forms. Finally, China faces an innovation challenge. So far its growth has been based on subcontracting from foreign rms and imitative domestic growth. In future, China needs to be creative, to develop and nurture R&D and to secure the development of domestic brand names. This requires a different approach from Government level down to individual rms and entrepreneurs. It also requires a rm and fair system of intellectual property protection. Nurturing creativity poses a major challenge to the current political system, requiring more openness, freedom of information, more liberal education and a shift in values. 5. Application of strategies to China 5.1. Location and ownership strategies The response of MNEs is differential across national markets. Even in the globalised economy, national markets are not equal. China is a market that matters to the

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multinationals. It is also endowed with large quantities of workers whose real wage productivity is high (this efciency wage is effective because of low wage rates when expressed in hard currency). Further, it has large supplies of basic resources. China can therefore attract FDI which is market orientated, cost orientated and input orientated. This might be deemed to be sufcient explanation of its massive share in hosting world FDI. However, imperfections in the domestic market are responsible for a considerable proportion of this inow, as we shall see. A reduction of these imperfections would reduce Chinas share of world FDI but increase its output efciency. The choice of FDI over other forms of foreign market servicing strategy is the rst stage of an entry strategy. After FDI has been chosen, the rm faces other key decisions. It has to choose between a wholly owned subsidiary (not allowed in China before 1986) or a JV and between a takeover or a greeneld venture. Below, we examine these choices in general and then apply the analysis to the special case of China. All markets are to some extent unique, or at least idiosyncratic. Special factors in China include the nature of JVs, especially forced JVs which impact on the strategies of entrant rms, supply chain problems and the reform process. (Buckley, Clegg, & Tan, 2003). 5.2. Ownership entry strategies Entry strategy in China has three clear forms of ownershipwholly owned subsidiaries, freely chosen JVs and forced JVs, where JVs are a second best strategy from the point of view of the entrant MNE, but where legislation or local pressure makes JVs the only viable choice. This tripartite distinction applies particularly to FDI aimed at the domestic market. Many MNEs are trying to unravel their Chinese JVsUnilever, Alcatel and Michelin have already done so. This is reminiscent of the double-entry method of market servicing which the author observed in Japan some time ago (Buckley, Mirza, & Sparkes, 1995) where a later WOS replaces an earlier JV in the same market (often, after competing with it). This is not smooth dynamic entry! It should also be pointed out that not all JVs are unsuccessful. Honda is reported to make its most protable Accord model in China. VW has half of the Chinese market for passenger cars (although this is aided by local favouritismShanghai makes sure that the citys taxis are Santanas!). (Economist 13.4.02, p. 71). 5.3. Dynamic market entry Investment attraction (and retention) requires attention to be paid to dynamic market entry. Investment agencies need to take a long-term view of the foreign market servicing strategies and sourcing strategies of multinational rms. This includes both locally owned rms and foreign investors. There is a worrying trend of declining protability of MNEs in ChinaBeamish and Jiang (2002) report this decline for Japanese MNEsand although larger MNEs take a long run view of their investments, ultimately this problem will deter inward FDI. In China, the dynamic market entry model outlined above faces challenges in implementation. There are high switching costs between strategies in China. Ownership strategy has not been a free choice until recently in many industries. JVs with local entities were de facto or de jure the only means of entry. Once established, it is difcult for an MNE to extricate itself from its partners clutches. In addition, it is generally difcult to effect entry via takeover. M&As are difcult in China except where the current owner (usually a state body) wishes to ofoad a quantity of unwanted assets onto the incomer.

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Switching costs are high and entry choices are limited. Moreover, exibility is limited by the stickiness of the Chinese environment and of government policy. Imperfections limit the range of choices and often prevent the type of exibility in entry and development outlined above. Although now legal in some areas, mergers and acquisitions are still difcult and costly to carry out in China. 5.4. Integrating China into a global strategy Agencies concerned with inward FDI should understand the hub and spoke strategy and monitor its development. Attraction of hubs with higher order activities (R&D, nance) is particularly attractive, but spokes may well develop into hubs or subhubs. This may involve supporting or fostering international JVs between local rms with the ability to develop complementary skills and foreign rms. Investment may not always be greeneld ventures on a new site but mixed forms with JVs and takeovers as key entry strategies. A more sophisticated attitude to takeovers is implied by this approach. As a large country physically and in population, MNEs will eventually develop such a strategy within China. From the domestic policy point of view, location decisions create a two-dimensional problem. First, there is concern to attract MNEs into China. Second, there is excessive competition between cities and regions in China. The second aspect can reduce, or eliminate, the benets of the rst. Competition between the Pearl River Delta, the Yangtze River Delta and cities such as Shenzen and Shanghai can be counter-productive. National regulations can be subverted by regional or local deals (e.g. Shenzen has also moved ahead of Chinas WTO commitments in areas such as logistics, allowing companies such as US retailer Wal-Mart to set up a wholly owned global procurement centre in its jurisdiction Financial Times 11.12.02, p. 6 Reforms dull prospects for Pearl Rivers worker army). There is much more competition for footloose FDI projects. The entry of China as a major location for labour-intensive projects has created major difculties for those countries trying to compete as a location for export-orientated projects. Many countries are engaged in attempting to upgrade their offer to potential inward investors. This may include direct cost competition or attempts to attract higher order activities and skilled labour/knowledge-intensive projects. The switch of footloose FDI to China from competing locations may have permanent repercussions. In competing for high tech inward investment China still has areas of disadvantage. In comparing China with India as a location for software development UBS Warburg (2002) found that language barriers, the lack of relationships in the US and Europe and the lack of scale and fragmented units in the Chinese industry were serious disadvantages. Chinas period of isolation from the global economy has meant that repatriation of skilled engineers and managers has not occurred (unlike India). Past piracy of software and lingering worries about the made in China label continue. Management difculties are still prevalent. The UBS Warburg (2002) report comments on the apparent inability of top managers to engage in multiple projects simultaneously (p. 13). This contrasts with other studies of Chinese managers and management style which are usually praised for their ability to hold contrasting views simultaneously. There are, however, real signs of success. Motorolas China Software Centre was set up in 1993 and the company currently has three such centres in China. Taken together, this is

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the second largest R&D software centre for Motorola outside the USA (after India). The Centre carries out a series of high-tech co-operation projects with local software companies. Here is evidence of an MNE led high tech hub. Despite the above pessimism, subcontracting into China in IT and growth in demand for basic manufactures (e.g. automobiles) continues to drive growth in China (IT puts re in the belly of dragon economy and Auto industry could soon be driving Chinese expansion Times 12.12.2002, p. 30). Domestic policy on infrastructure (roads, motorways) continues to support the massive growth in middle-class demand (GM overtaken by Chinas love affair with the car Financial Times 2.12.02, p. 25) such as Chinese (underscale) plants cannot cope with the demand. The entry of China as a global economic superpower and super-location for inward FDI may be consolidated by its membership of the WTO and its policy of increasing openness. Chinas range of exporting industries covers the spectrum from cheap labour intensive products like toys to sophisticated ones like computer chips. China may have areas of absolute advantage, but trade is based on comparative advantage. Further, as Chinas trade balance becomes increasingly positive, its exchange rate will rise. The growth of Chinas domestic purchasing power will also provide opportunities for importers to tap this new consumer base. The era of massive new greeneld projects designed for export may be passing. Much more likely are incremental changes in MNE congurationthe results of de-duplication, outsourcing, offshore production and re-investment. The volatility of strategy increasingly makes FDI a two-way bet unless strong investment retention policies are in place. The rationalisation of facilities by MNEs is ongoing and relentless. Chinas accession to the World Trade Organisation is likely to have major effects for MNEs operating there. First, internal reforms are likely to accelerate. Second, the service sector will become more open, liberalised and efcient. Third, China will become more integrated into the global economy. (Huang, 2001). All three of these effects will create opportunities for domestic rms If they are allowed to take these opportunities, privately owned rms will be able to remove some of the imperfections to which MNEs react in China. Private rms are currently constrained by lack of capital and ofcial disapproval (Huang, 2003). The removal of articial capital market constraints on local rms will allow them to compete more effectively with foreign owned ones, who benet disproportionately from their ability to exploit (and in some cases, reduce) imperfections in Chinese domestic markets. There are several key imperfections in the Chinese domestic sector which interact with the strategies of multinationals. One important area is the existence of SOEs across wide swathes of the Chinese economy causing overcapacity in (for example) chemical fertilisers, steel construction materials and coal. SOEs exhibit a lack of understanding and a lack of resources for modernising and marketising. Although, in some cases, the enterprises themselves may be willing to restructure, the Central Government will not allow this to happen for fear of rendering their workforces useless. Further, local governments often lobby for and protect their SOEs against those in other cities (e.g. ofcials in Wuhan have given tax breaks to anyone who buys a car made in the local car plant (Economist 13,4.02, p. 71). SOEs are generally overdiversied (unspecialised) and difcult to evaluate in performance terms because their accounting procedures are so awful. The elimination of this inefciency by M&A is hampered by political interference, protectionism and lack of transparency. MNEs are therefore, rightly, cautious when

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considering acquiring privatised SOEsand perhaps they should be more cautious when involving SOEs in JVs. Chinas development is very much manufacturing sector driven, following the pattern set by Japan and then the newly industrialising economies of Southeast Asia. At current exchange rates, China is the fourth largest producer of manufactured goods in the world (BNP Paribas Pereguine, 2002). The service sector, including (critically) banking, lags in development and for legislative and logistical reasons, remains much less open to FDI than manufacturing. The key message of this paper is that volatility in the global economy is increasing. IJVs for instance are likely in general to be short-lived but variable in longevity. There will not be massive successes in attraction of new greeneld investments or massive failures in closure, but the search for exibility will mean that incremental shifts will be many and cumulatively profound. Switching costs for MNEs in achieving exible strategies are increasing in importance. 5.5. Impact on the strategy of MNEs Domestic distortions in China interact with the strategy of MNEs in the following ways: 1. Ownership strategy becomes crucial. Initial entry determines the availability of strategic choices in the life of the Chinese investment for MNEs. 2. Flexibility in altering ownership choice in China is limited because the switching costs are high. It is often difcult to move out of a JV as option strategy would suggest and an inefcient second entry may be required. 3. Location choices within China may be determined by political, not commercial and economic, factors. 4. Problems of outsourcing may in the short run at least provoke excessive internalisation of activities where the choices of establishing a purchasing network and/or importing are ruled out by quality and regulatory problems. Similar forced overextension of activities may occur in distribution, too. The result of these distortions is that the rst best operational structure of MNEs is impossible in China. The Economist alleges that not a single car plant in China benets from economies of scale (13.4.02, p. 72). Many in-house operations are suboptimal and too costly because of excessive internalisation due to the lack of efcient external markets. JVs are often forced rather than free choices. The lure of the Chinese market and low-cost operation outweigh these factors in many rms global strategies but they will not necessarily always do so in the face of competition from other locations. Many rms would prefer to outsource and subcontract production to Chinese rms and to keep their xed assets elsewhere. It is only domestic distortions which prevent a new equilibrium with more local Chinese ownership, less FDI, and more non-ownership modes of MNE operation from prevailing. This suggests that China should focus on creating local rms which can act as factories for hire, allowing MNEs to subcontract production to them and ensure quality outputs. The analysis here suggests that, for labour intensive export goods, MNEs increasingly face the choice of FDI in China or subcontracting production to super subcontractors elsewhere. The balance may shift away from China as exibility increases in importance.2

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6. Conclusion John Dunnings OLI (Ownership, Location and Internalisation) framework can be used to organise the conclusions of this analysis. 6.1. Location factors Globalisation and improved management techniques including the use of e-commerce, have meant that MNEs are much more capable of accessing the best locations for each of their constituent activities. The increased exibility analysed in this paper means that locations are more competitive with each other both between and within nations. This may also imply unhealthy race to the bottom in which locations desperate for inward FDI compete in removing environmental, social, scal and labour legislation in an attempt to win a bigger share of footloose global FDI. In China, there is a major regional disparity between coastal locations and the interior. In time, policy makers may take a dualistic view of inward FDI policy, following a Singapore strategy of upgrading the quality of FDI in the coastal regions, whilst following a relatively undifferentiated attract FDI at all costsparticularly labour-intensive FDI to the interior. Several MNEs may be induced by this strategy to relocate labour-intensive activities to the interior, whilst upgrading their coastal activities. For such an upgrading strategy to proceed, the quality of inputs and infrastructure will have to be improved, and imperfections removed. There is also a major challenge for China in moving FDI beyond the labour-intensive stage. As the analysis above showed, for export orientated products speed to market and other non-price factors, such as design, are becoming more important in many sectors than cost. Improved infrastructure, transport and communication in particular are becoming key competitive advantages even in industries hitherto reliant on unskilled labour to achieve price competitiveness. The size and growth of the Chinese market will remain important in attracting FDI aimed at local market servicing. 6.2. Ownership Ownership is a critical variable in both entry and operation in China (Buckley et al., 2003). Restrictions on the preferred ownership strategy of MNEs will deter inward FDI and will introduce distortions. China has relaxed the policy of forced JVs and allowed the operation of wholly owned subsidiaries in an increasingly large area of industry and commerce. Services remain largely restricted however and forced IJVs, particularly with inefcient (state owned) entities remain problematic. The source of MNEs remains a major factor in determining their impact on the Chinese economy. Investors from the Chinese diaspora are very different in type, structure and impact from those from the West. Inward FDI is still inuenced by policy-induced distortions, such as round tripping. Where agents in one province move investment out of the country in order to re-invest it in another Chinese province and/or to receive the benets accorded to foreign direct investors. In the medium to long run, outward FDI by Chinese multinationals and the encouragement of domestic entrepreneurship are key factors. Linkages, learning effects

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and stimulation of domestically owned rms are important measures of both the impact of inward FDI and its generation of outward investment on the lines of the investment development cycle (Buckley & Castro, 1998; Dunning, 1981a, b, 1986; Dunning & Narula, 1996). 6.3. Internalisation The changing boundaries of the rm are both a cause and a consequence of globalisation and e-commerce and a reection of changing managerial imperatives in MNEs. The potential for vertical disintegration allows MNEs to seek out not only the best locations for each activity but the best internalisation/externalisation choices. As distortions are removed in the Chinese economy MNEs are likely to switch to contractual modes of doing business such as subcontracting or licensing, rather than relying on internalised modes of operation such as FDI. The elimination of excessive internalisation will (paradoxically) reduce inward FDI but increase operational effectiveness in China as MNEs outsource activities which they have been compelled to internalise by imperfections in external markets (Buckley & Casson, 1976). 6.4. Summary At the moment, there are severe distortions in each of the above OLI factors. Location is distorted by (often competing) regional incentives and political inuences. Ownership is distorted by forced JVs. Internalisation is distorted by the excessive internalisation used in response to created imperfections in markets. The pattern of FDI would be very different (and will be in the future) as these distortions diminish. China still needs an industrial policy. Removal of the key distortions is often a job for government and a free-for-all policy is unwarranted and probably dangerous (see the analogue for East and Central Europe (Buckley & Ghauri, 1994; Casson, 1994). The structure of incentives created by current policy favours MNEs rather than domestic rms. Despite the distortions, China has been outstandingly successful since the beginning of the open-door policy. It still has a long way to go in releasing its potential economic power and inward FDI is both a signal of this success and a sign that current policies have in-built biases, which in the medium term are costly for China, inefcient and ultimately growth inhibiting for the domestically owned sector. References
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