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In the wake of globalization and shifting technological landscape, many international businesses have opted to seek markets in emerging economies. The prevalence of increased avenues for information dissemination is a definite trend that favors foreign trade as people continue to share ideologies via modern information and communication technology. Such technological advancement accelerates the spread of intellectual ideas from one part of the world to another. Besides the central role of technology in the contemporary world, various vital factors underpin the development of ideas into profitable international businesses. These factors comprise informal and formal institutions. They control business strategies based on social, economic, and political landscapes of the international market. This paper critically examines the role of institutions regarding the interventions of venture capitalists in foreign direct investments (FDIs).
Describing Institutions in the Context of Business Strategy
Business institutions can be classified into formal and informal types depending on strategic decisions. The former comprises laws, regulations, and rules that are regulated by the coercive power of the government. The latter entails norms, cultural, and ethical factors that are supported by the normative and cognitive pillars. According to Peng, Wang, and Jiang (2008), the normative pillar refers to how norms leverage the behavior of individuals and businesses. A cognitive pillar in the context of business strategy defines the organizational propositions and values that govern the internal and external environment of a firm. The chief role of these institutions is to reduce uncertainty for foreign investors. There are two forms of economic transactions in which business institutions reduce uncertainty namely relational contracting and arm’s length transaction. Firstly, the informal exchange is whereby the firms or individuals conduct business in a friendly manner (Peng et al., 2008). For instance, there is no need for signing an IOU note in the event of borrowing money from friends to start up or expand a business. This form of transaction is governed by informal norms and cognitive beliefs based on the real meaning of friendship. It is also referred to as a personalized exchange transaction (Peng et al., 2008). Secondly, economic transactions can be facilitated by the arm’s length form. In this case, the transaction is formal and entails impersonal exchange with third-party enforcement. This practice is adopted when the scale and scope of economic transactions are high in a way that warrants enforcement through third-party formal market-supporting institutions.
Role of Institutions in Foreign Market Entry
According to Kaufmann and Roesch (2012), institutions play a crucial role when firms strive to enter a foreign market. Based on the institutional theory, national culture underpins the recognized context of society. Culture is responsible for modeling the legitimate social and business activities in particular environments. Different business cultures result from diverse organizational practices and employee expectations. International business scholars regard the variations amongst national systems as cultural distance. Kaufmann and Roesch (2012) affirm that the cultural gap can result in increased transactional costs for MNCs in both regional and international markets. For instance, various studies reveal that cultural distance can potentially increase the costs of internal communication. Since the scope of communication is based on multifarious business archetypes, the efficiency of information exchange will be significantly reduced when it is applied across different cultures. Communication barriers prevent parent companies from transferring firm-specific benefits to foreign subsidiaries. Campos and Lootty (2007) posit that implicit routines and knowledge that are necessary for internationalization are harder to apply in some multinational corporations. At the outset, interacting with foreign associates results in a cultural distance that increases the operational costs by eroding mutual understanding. Therefore, foreign firms find themselves engulfed in the challenges of identifying and interpreting unfamiliar business environments (Campos & Lootty, 2007; Xuegong & Liyan, 2013). This situation costs foreign firms a fortune. It can take years for them to adapt to different cultural patterns. Furthermore, a likely misunderstanding can arise between foreign investors and native actors due to their discrepancy in terms of societal expectations. Therefore, mutual trust can diminish before the accomplishment of the business objectives due to the existence of social conflicts. The wider the cultural distance between foreign and host countries, the higher the transaction costs, and perceived uncertainty by foreign investors. The propensity of MNCs to invest in foreign markets is dictated by the cultural patterns of the host country. Even in the wake of accelerated global integration and cultural globalization, local cultures still have a significant effect on the location choice of MNCs (Campos & Lootty, 2007).
Formal institutions also influence the investment practices of multinationals. They set up the rule of the game in a regular way by defining prospective business activities. Cultural systems together with the formal institution build an overarching industry framework that affects economic activities (Peng et al., 2008). This objective is achieved through the manipulation of political and economic dimensions. The two perspectives govern both social and business activities more explicitly than the culture. The formal institutional risk has a direct influence on the operating efficiency of international businesses. The risks of political institutions refer to creditability and volatility of policies. However, the government’s strictness to the enforcement of unbiased business law determines the commitment of firms to the global market. In contrast, companies will avoid investing in countries that are characterized by corruption and a lack of legal enforcement (Xuegong & Liyan, 2013). Political instability raises operational costs and returns impediments. Also, unanticipated policy changes have significant effects on the operations of multinationals. A less stable political regime promises a reduced amount of investment returns.
Furthermore, economic institutions also support the formal business framework. The market direction and economic compositions form the foundations of a suitable international business environment (Campos & Lootty, 2007). For instance, national economic formal arrangements provide unique enticements and barriers to corporate operations. Economies that are characterized by freedom and low risks attract foreign direct investments. Low formal institutional risks and less hazardous political and economic factors are vital baits for foreign investors. Some MNCs from countries that do not have proper intellectual protection provisions tend to move abroad to seek them. As a result, emerging market multinationals (EMNEs) tend to choose countries with flawlessly established formal institutions for their investments. Peng et al. (2008) posit that institutions that are established well encourage the entry of unfamiliar investors since they enjoy business protection due to the existence of a developed institutional framework. Also, entrepreneurs can borrow money from the local banks of the host country that do not charge exorbitant transaction costs. In such favorable business climates, economies gain an opportunity to expand enormously. On the contrary, countries that have unfavorable business laws shun away from foreign investors.
For instance, a country such as Somalia in Eastern Africa that has been involved in terrorist activities for nearly two decades cannot attract international firms from countries such as the US. This situation is a clear indication that countries with unstable governments and formal institutions shun away investors (Xuegong & Liyan, 2013). They are characterized by lawlessness and the unavailability of stable banks. Such states of affairs force potential entrepreneurs (both local and international) to reconsider investment decisions. In Somalia, informal institutions have not been established properly due to a lack of trust among the citizens themselves. As a result, financiers dread lending money to entrepreneurs since terror gangs can ambush them. The economy of Somalia has remained crippled for over twenty years; hence, the availability of substantial lenders to finance businesses in such environments is extremely skeptical (Xuegong & Liyan, 2013).
Entering a foreign market is not an easy task. The process is underpinned by numerous institutional factors that can be very complicated. This review reveals that the existence of local culture creates a cultural distance between foreign investors and local actors of the host country, even with a wave of globalization inevitably defining modern business practices. Furthermore, formal institutions have the potential to control the business climate of a country. This situation can either favor or prevent foreign investments. Both political and economic dimensions form the basis of government regulations. These factors influence the level of certainty and operating costs for foreign businesses in the host countries; hence, they determine the economic viability of such markets. This state of affairs affects foreign direct investment decisions significantly.
Campos, N., & Lootty, M. (2007). Institutional barriers to firm entry and exit. Economic Systems, 31(4), 346-63.
Kaufmann, L., & Roesch, J. (2012). Constraints to Building and Deploying Marketing Capabilities by Emerging Market Firms in Advanced Markets. Journal of International Marketing, 20(4), 1-24.
Peng, M., Wang, D., & Jiang, Y. (2008). An institution-based view of international business strategy: a focus on emerging economies. Journal of International Business Studies, 39(1), 920-36.
Xuegong, S., & Liyan, G. (2013). Market entry barriers for foreign direct investment and private investors. East Asian Energy System Management Challenges, Energy Strategy Reviews, 2(2), 169-75.