By Klaus E. Meyer

State enterprises were widely believed to be doomed in the 1990s. With the fall of the iron curtain, privatization was sweeping from the Elbe to the Pacific: state-owned enterprises (SOEs) were perceived as inefficient mammoths unable to compete in a market economy. Yet, history has proven forecasters wrong: some SOEs have become important international players.

In China, for example, SOEs make up a major share of outward direct investments. So while private investors have gradually increased their share, many of the largest investment projects are still undertaken by SOEs. A question that readily springs to mind, therefore, is how does state ownership influence the strategies and operations of Chinese MNEs?

At home, Chinese SOEs benefit from the political support of their owners who can, for example, ease access to financial resources. While these owners typically expect the company to operate profitably (though not necessarily to maximize profits), they also expect contributions to political objectives. These additional resources and performance expectations primarily play out at the domestic level. It's less obvious how state-ownership affects operations outside of China.

That's why in two studies I've done with co-authors Ding Yuan, Zhang Hua (both of China Europe International business School) and Jing Li (Simon Fraser University, Vancouver) we look at how state ownership affects Chinese multinationals' outward investment strategies.

The issue of trust

In our first study, we focus on the reception SOEs get in host countries. In countries with a strong free-market ideology, such as the USA, SOEs are often seen as an anomaly and their legitimacy may be challenged due to a combination of ideological conflict, perceived threats to national security, and claims of unfair competitive advantage due to government support of home-grown competitors. These challenges directed specifically at SOEs induce them to adapt their foreign entry strategies to reduce potential conflicts and enhance their legitimacy.

In any country, foreign investors have to conform to the host country's rules and belief systems to establish local legitimacy. That's why when reflecting on his first experiences in Germany after taking over the ailing sewing machine maker Dürkopp-Adler in 2005, Mr. Zhang Min of the ShangGong Group summarized his experience by saying: "Nobody trusted us at that time". Only through persistent investment in the company, and delivery on early promises, did Mr. Zhang build up trust among the workforce, and within the local community.

Ideological inconsistencies are likely to emerge where firms entering a foreign market are closely associated with their home governments. This is especially true in countries where a strong rule of law limits direct government interference in business. As a result, state-owned MNEs often need to work extra hard to earn the local stamp of approval, but it can be done. For example they can try aligning organizational practices to local norms and regulation, adopting organizational structures to imitate incumbents, or cooperating with local partners who've already earned the nod of approval from local players.

SOEs may also avoid a lot of scrutiny and pressure by investing in greenfield projects, rather than acquiring local firms. Our study shows that in countries where their legitimacy may be challenged, they prefer low-level equity investments and greenfield operations that provide a lower public profile. Acquisitions tend to receive more attention in local media, and they potentially involve short-term job losses. In contrast, greenfield investments typically bring more visible benefits such as new production capacities and new jobs. Hence, since more stakeholders in the host country are directly affected by foreign acquisitions than by greenfield investments, acquisitions face more public scrutiny.

But there is one way for investors who do use acquisition as their entry strategy to alleviate concerns about their legitimacy: through the degree of equity control. A lower level of equity makes a low-profile strategy possible and provides an important signal that an investor is working with local partners to align with the norms of the host country. Moreover, a low level of control limits the owners of the investing firm's ability to impose their objectives onto the local operations, and thus alleviates the suspicions of local stakeholders. Shared ownership also helps investors leverage the legitimacy of the local co-owner, and facilitates local regulatory approval where that's needed.

Diplomacy helps SOEs, sometimes

Our second study focuses on the impact that diplomatic relations between countries have on multinational enterprises. Good diplomatic relations between nations can enhance investment opportunities by lowering political risks and reducing some barriers to entry, for example by providing early access to information on policy changes or public tenders. However, MNEs vary in their ability to benefit from these cordial relations at the diplomatic level. Those with stronger political connections at home may have an edge, as they can transfer these connections via diplomatic channels. So while diplomatic relations are important to SOEs, this may not necessarily be true for private firms.

The nature of the host country also matters. A transfer of 'political capital' via diplomatic relationships is more useful where a country's weak rule of law makes it less likely that there will be impartial treatment of foreign investors. In these countries, government power is less constrained, which increases political risks and entry barriers. By leveraging the political influence of their home government, well-connected MNEs can reduce the risks and barriers in the host country.

In terms of policy implications for Europe, our study implies that diplomatic activity at the national level is probably not a major factor when the Chinese are deciding whether or not to invest in the EU. There are two reasons for this. First, most of the investments that European countries try to attract are privately owned, and thus less responsive to the vagaries of diplomatic relations. Second, the EU competition policy framework establishes a fairly level playing field for competition and this curtails national authorities' scope for providing subsidies or preferential access to public sector procurement. Therefore, it's more difficult in the EU to convert political and diplomatic ties into competitive advantages than it is in many other parts of the world.

Further challenges

Our research shows that state-ownership may either help or hinder SOEs' outward expansion. It's clear that many SOEs in today's China have more in common with German private firms than with the state conglomerates in the Soviet bloc of the 1980s. However, there are also important variations between them. First, many SOEs are listed entities in which a state agency maintains a substantive ownership stake, but not necessarily majority control; their strategies are thus influenced by an interplay of political and business actors. Second, SOEs under the authority of local governments are often acting more like private firms and are only indirectly subject to national policy directives. Finally, it's worth bearing in mind that even private businesses in China usually need to maintain friendly relationships with the authorities when they pursue ambitious growth strategies. This is true both at home and abroad.

Resources:

Klaus E. Meyer, Ding Yuan, Jing Li & Zhang Hua, 2014, Overcoming distrust: How state-owned enterprises adapt their foreign entries to institutional pressures abroad, Journal of International Business Studies, Vol. 45, No. 8: pages 1005-1028.

Jing Li, Klaus Meyer, Ding Yuan & Hua Zhang, 2015, Who Cares about Diplomacy? International relations and the Geography of Multinational Enterprises, working paper, China Europe International Business School.

Klaus E. Meyer is Philips Chair in Strategy and International Business and Co-Director of Centre for Globalisation of Chinese Companies at the China Europe International Business School (CEIBS).

This article was first published by The Economist Intelligence Unit.