Performance of foreign subsidiaries: Does psychic distance matter?

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Abstract

Psychic distance paradox emerged from studies that found a positive effect of psychic distance on subsidiary performance. Recently, it was argued that international experience influences the relationship between psychic distance and performance. We propose that the effect of market-specific knowledge, rather than general international experience, should be examined because it negates the effect of psychic distance. We study 208 foreign direct investments made by west-European MNEs in the CEE (Central and Eastern European) region between 1996 and 2002 and find that positive relationship between psychic distance and subsidiary performance is observed only in the absence of market-specific knowledge. Psychic distance has no effect on subsidiary performance when the MNEs have CEE investment experience or have established the subsidiary with a local partner.

Introduction

Psychic distance has received significant attention in international business (IB) research (Dow & Karunaratha, 2006)—it is among the most commonly applied constructs in the research field of MNEs’ internationalization activities. The initial concept was coined by Johanson and Vahlne as “the sum of factors preventing the flow of information to and from the market” (Johanson & Vahlne, 1977: 24), and broadened by Nordstrom and Vahlne (1994) who suggested that psychic distance reflects factors that prevent or disturb firm's learning about and understanding of a foreign environment (Nordstrom and Vahlne, 1994). The notion of psychic distance was mostly used to explain firms’ internationalization strategies such as selection of foreign markets (Benito & Grisprud, 1992; Stottinger & Schlegelmilch, 1998; Whitelock & Jobber, 2004) and entry strategies (Brouthers, 1995, Ellis, 2007). A few studies have tackled the issue of psychic distance's influence on organizational (subsidiary) performance. Some found a negative relationship between psychic distance and performance (Stottinger & Schlegelmilch, 1998) others found a positive relationship that is often referred to as the psychic distance paradox (Evans & Mavondo, 2002; O’Grady & Lane, 1996).

The direct relationship between psychic distance and performance that was suggested in the past contradicts the original concept of psychic distance because it overlooks the influence of factors that stimulate organizational learning about the local environment. It also assumes that all firms suffer from psychic distance in a similar way. Recently, a couple of studies addressed this limitation. In a qualitative study, Yamin and Sinkovics (2006) suggest that international experience and the reliance on host country partners reduce psychic distance effects. In a larger scale quantitative study, Evans, Mavondo and Bridson (2008) argued that the amount of experience acquired when operating in foreign markets is likely to have an effect on the firm's perception of the similarities and difference between markets. However, the study produced insignificant results and concluded that international experience did not influence psychic distance.

The possession of experimental knowledge by the investing firm may influence the relationship between psychic distance and subsidiary performance because such knowledge facilitates firm's learning about and understanding of a foreign environment. A close examination of Johanson and Vahlne's (1977) work provides an indication to what type of knowledge is likely to influence psychic distance. The authors argue that general experimental knowledge is not market-specific as it concerns firms’ general abilities to handle international operations—such knowledge involves common business operations such as purchases, sales, payments, employees, etc. irrespective of location (Carlsson, Nordegren, & Sjoholm, 2005). Therefore, the amount of accumulated general international experience should not matter much for the reduction of psychic distance effects because psychic distance is brought about by market (country) differences.

Experimental market-specific knowledge is the most critical type of experimental knowledge in a firm's internationalization (Penrose, 1959). A possession of market-specific information means that the investing firm understands the specific market and its characteristics such as business climate, culture, structure of the market system, and individual customers (Carlsson et al., 2005). In other words, when such crucial market information is available to the investing firm, psychic distance no longer exists, as there are no obstacles to understanding the foreign market.

Here we suggest that local market knowledge, which can be acquired by the parent MNE through own (prior) investment experience or through the involvement of a local partner, negates the effect of psychic distance on subsidiary performance because such market knowledge eliminates the factors that prevent a firm's learning about a foreign environment. Hence, psychic distance exists only for firms which lack market-specific knowledge because such firms face a variety of factors that prevent the flow of information to and from the market (Johanson & Vahlne, 1977).

To empirically test our proposition, we examine 208 foreign direct investments made by west-European MNEs in the CEE (Central and Eastern European) region between 1996 and 2002. The results demonstrate that the positive relationship between psychic distance and subsidiary performance suggested by past research is observed only in the absence of market-specific experimental knowledge, that is, when the investing MNEs have either no prior investment experience in the CEE region, or have established the subsidiary without a local partner. Psychic distance has no effect on subsidiary performance when the MNEs have previously invested in CEE or have shared the ownership of the focal subsidiary with a local partner. These findings stress the importance of market-specific experience, not considered in past studies which investigated the effect of psychic distance on organizational performance. In the following sections, we discuss the theory and build our hypotheses. Next, we describe our empirical analysis and interpret our model results. Finally, we discuss the implications and limitation of the current study.

Section snippets

Psychic distance measurement

The concept of psychic distance puts an emphasis on the extent environmental differences between home- (of the investor) and host countries inhibit information flow and create barriers to learning about these markets (O’Grady & Lane, 1996).

Firms expanding their current operations to a foreign market are often disadvantaged in relation to indigenous firms because of their unfamiliarity with the local business environment. This environmental unfamiliarity of the foreign firm creates high levels

Data

To test the above hypotheses, an international mail survey was conducted in May 2003 among internationally experienced western European companies which established a subsidiary in CEE between 1996 and 2002. Pilot-tests with managers in four Dutch companies were carried out to improve the clarity and precision of the questions asked. The English-language questionnaire was sent for feedback to academics with expertise in the field. The final version of the questionnaire was then translated into

Results

Table 2 contains the descriptive statistics of all variables and their correlations. The regression results are presented in Table 3, Table 4.

Evidently, models 2 and 4 perform much better than the models 3 and 5. In the sub-samples of MNEs with prior CEE investment experience and of MNEs which established subsidiaries with shared ownership the insignificance of F shows that models 3 and 5 have no significant predictability. In this case, we cannot reject the null hypothesis of no linear

Discussion

This study sought to re-examine the controversial issue of psychic distance influence on subsidiary performance. The controversy of this issue has two aspects—a conceptual and a methodological aspect. The methodological controversy lies in the discussion about what the best way to measure psychic distance is—whether psychic distance should be measured as perceived by an individual or whether it should be measured using macro-level variables (Dow & Karunaratha, 2006). We did not specifically

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