According to Buckley, an axiom of internalization theory is that “firms grow by internalizing markets up to the point where the benefits of further internalization are outweighed by the costs” (1988: 182). From its early focus on foreign direct investment (FDI) versus other operating modes (Buckley & Casson, 1976; Hennart, 1982; Rugman, 1981), internalization theory has developed into one of the dominant and most comprehensive theoretical perspectives within the IB literature to understand key decisions related to cross-border activities (Grøgaard & Verbeke, 2012; Kano, 2018; see also Asmussen, Benito, & Petersen, 2009). Championed by Alan Rugman, “new” internalization theory enables us to understand and predict how MNEs set their firm boundaries to develop and utilize their FSAs when interacting with their external environments (Narula & Verbeke, 2015; Rugman & Verbeke, 2008). As Narula & Verbeke state, “internalization theory is meant to be a general theory on how to organize IB transactions, with considerable power to explain and predict regularities in IB governance choices. Such regularities involve, inter alia, the choice of operating mode…” (2015: 614).
Internalization theory proposes that FSAs influence firms’ foreign entry strategies. FSAs can either be transferable (non-location-bound) such as technological knowledge, or specific to a local context (location-bound) such as local market knowledge and access to local networks (Rugman & Verbeke, 2001). MNEs typically lack some key location-bound FSAs when entering a foreign market, reflecting a “liability of outsidership” (Johanson & Vahlne, 2009). Necessary complementary location-bound assets can be accessed through multiple types of markets (i.e., markets for asset services, markets for assets, and markets for firms). Seeking to exploit and develop FSAs successfully, internalization theory assumes that market actors are profit-seeking rational decision-makers, well illustrated by the following quotes from Buckley & Casson (1976): “The theory developed below… depends on the assumption of profit-maximisation” (p. 32); and “Our theory is based on … (1) Firms maximize profit in a world of imperfect markets…” (p. 33). This involves market entry decisions that minimize challenges with information asymmetry (bounded rationality) and safeguard against contractual failures due to opportunism or benevolent preference reversals (bounded reliability) (Narula & Verbeke, 2015).
Another key concept in internalization theory (following Rugman, 1981) is country-specific advantages (CSAs). CSAs cover a wide range of external factors that affect firm performance such as labor, technology levels, natural resources or the institutional environment. For MNEs, both home-country and host-country CSAs are relevant, and FSAs and CSAs are interlinked as MNEs tap into CSAs to utilize or develop their FSAs. CSAs have attracted renewed attention not least in the context of emerging market MNEs (Gugler, 2017; Hennart, 2012). In line with internalization theory, we expect that firms’ abilities to develop FSAs are influenced by their external contexts (Narula & Verbeke, 2015; Rugman & Verbeke, 2003). Previous studies have also found an important effect of home-country characteristics such as the strength of institutions on different aspects of internationalization (e.g., Bhaumik, Driffield, & Pal, 2010; Duanmu, 2014; Filatotchev, Strange, Piesse, & Lien, 2007; Gaur, Ma, & Ding, 2018; Shi, Sun, Yan, & Zhu, 2017). This should apply to SOEs as well as POEs.
Despite the prevalence of internalization theory in IB literature, its application to SOEs has been limited, perhaps reflecting an assumption that it does not fit with SOEs (Rugman, 1983). Instead, the IB literature on SOEs’ choice of foreign market entry and establishment modes has tended to take an institutional perspective, arguing that specific configurations of home and host-country institutional pressures may inter alia lead SOEs to take lower ownership positions (Cui & Jiang, 2012; Meyer, Ding, Li, & Zhang, 2014). Yet, given that SOEs are both economic and political creatures, institutional theory may not be able to provide the full picture. Foreign entry studies based on institutional theory have furthermore largely been based on the somewhat idiosyncratic case of China, while SOEs originate from a wide range of different home contexts.
While recognizing the insights provided by studies based on institutional theory, we posit that internalization theory can be extended to strengthen its capacity for explaining and predicting SOEs’ strategic decisions when entering competitive foreign markets. This requires, however, a broadening of the view of possible motivations for internalization to capture governments’ non-economic motivations and different time horizons and risk preferences. Moreover, more attention to the particular corporate governance mechanisms of SOEs is needed. On these issues, other economic theories of governance provide a useful complement to internalization theory in terms of their focus and key assumptions (cf. Buckley & Strange, 2011; Okhuysen & Bonardi, 2011). While internalization theory focuses on the boundaries of the firm in a broad sense, corporate governance theories such as agency theory have focused on issues such as diverging goals, risk preferences and incentives between actors (Eisenhardt, 1989; Buckley & Strange, 2011; Filatotchev & Wright, 2011) and explored particular features of the agency relationships in SOEs (e.g., Hart, Shleifer & Vishny, 1997; Martimort, 2006; Sappington & Stiglitz, 1987). Also, while internalization theory assumes profit maximizing decisions, economic theories of governance such as agency theory allow for owners to have non-economic motivations and for managers to have private motivations that deviate from those of the owners. Both of these assumptions are important to understand SOEs. Finally, both internalization theory and related economic theories of governance acknowledge the role of uncertainty and information asymmetry, while assuming purposeful contracting by rational market actors (Strange et al., 2009). However, while internalization theory implicitly assumes risk neutral decision-makers, risk preferences play an important role in economic theories of governance (Buckley & Strange, 2011; Chiles & McMackin, 1996; Eisenhardt, 1989; Elia, Larsen, & Piscitello, 2019).
The Corporate Governance of SOEs
Two key economic theories of corporate governance applied to firms in general and SOEs in particular have been agency theory and incomplete contracts theory (Martimort, 2006; Megginson & Netter, 2001). Although the corporate governance literature is diverse and continually developing (Bolton & Dewatripont, 2005; Laffont & Martimort, 2002), the broader agency-based corporate governance literature (Hoenen & Kostova, 2015) traditionally focused on the implications of delegating the running of companies from owners to managers and mechanisms for ensuring that managers maximize the returns for shareholders (e.g., Jensen & Meckling, 1976; Fama & Jensen, 1983). For SOEs, however, the owner’s objectives are not necessarily (only) profit seeking, but may also include addressing market failures, redistribution, and ideological motives (Cuervo-Cazurra et al., 2014). Moreover, the risk preferences and time horizons of state owners play key roles in economics literature on state ownership. In principle, due to its high degree of diversification, the state-owner is approximately risk neutral (Arrow & Lind, 1970). In principle being infinitely lived, a state may also have a longer time horizon than private owners. In particular, such analyses suggest that using state ownership, rather than contracting out the provision of the public service to a private firm, may be motivated by risk aversion or financial constraints of POEs. Furthermore, state ownership may be motivated by the inability to write complete contracts with POEs (Sappington & Stiglitz, 1987; Hart et al., 1997; Martimort, 2006). Recently, such arguments for state ownership have been applied to state-owned MNEs by Rygh (2018).
While the above arguments for state ownership assume “benevolent” politicians pursuing citizens’ interests when governing SOEs, the economic theory of governance literature has also qualified this view by exploring particular corporate governance issues in SOEs. State ownership is characterized by a multi-layered delegation structure where voters (the ultimate owners of an SOE) delegate control to politicians via bureaucrats to SOE managers. In this view, politicians and/or bureaucrats may also pursue private interests. The public choice approach to politics assumes politicians motivated mainly by re-election may use SOEs to reward political supporters (Shleifer & Vishny, 1994). Although these arguments were developed based on democratic countries with free elections, the arguments are also applicable with some modification to more autocratic settings. While the scope for using SOEs for self-interested purposes may be even greater (Clegg, Voss, & Tardios, 2018), autocratic leaders still depend on political support. As for the bureaucrats tasked with the daily monitoring of SOEs, they have weak monetary incentives to devote effort to monitoring, as their financial stake is insignificant, while SOEs’ multidimensional objectives make their governance more difficult.
Moreover, corporate governance mechanisms for disciplining managerial behavior such as stock market monitoring, the threat of takeovers, and bankruptcy (e.g., Fama & Jensen, 1983) are weaker or deactivated in SOEs. Further, in contrast to POEs that are restricted from spending financial funds beyond what their owners are willing to raise and risk, SOEs are less financially restricted as they may draw on state funds and may perceive that the owner-state will be reluctant to let an SOE go bankrupt as this may lead to political costs. This moral hazard issue, often associated with the idea of a SOE “soft budget constraint” (Kornai, 1979), may be another factor leading to a risk willingness of SOEs (Knutsen, Rygh, & Hveem, 2011; Vernon, 1979). These corporate governance issues in SOEs are generally perceived to result in economic inefficiencies and weaker FSAs (Shapiro & Globerman, 2012), which may be a further indirect reason why SOEs display different internalization strategies from POEs.
The Influence of Context on State Ownership
The discussion above has suggested that SOEs’ non-economic motivations, time horizons, different risk preferences and particular corporate governance features may all lead them to pursue different strategies in general, and different internalization strategies in particular. However, SOEs originate from widely different contexts. Moreover, while corporate governance and public choice arguments for SOEs tended to be seen as universal and independent of context, more recent literature has explored the implications of aspects such as the quality of the institutions that politicians and bureaucrats are functioning within, for state ownership (e.g., Cavaliere & Scabrosetti, 2008; Cuervo & Villalonga, 2000; Estrin et al., 2016).
Two aspects of the context of SOEs are of particular importance to our study. First, government quality is likely to be important by reducing the scope for politicians, bureaucrats and SOE managers to pursue their own interests at the expense of the social interest. Professional and independent government institutions will reduce the degree of (undue) political interference in SOE operations (Evans & Rauch, 1999), and ensure strong SOE corporate governance where the state owner is treated just like any other owner (e.g., Knutsen et al., 2011). Also, the scope for politicians and bureaucrats to pursue private goals using SOEs is likely to be smaller when home government quality is higher. Finally, moral hazard issues relating to a SOE soft budget constraint (Kornai, 1979) are also likely to be mitigated since the government’s credibility of SOE governance is increased, meaning that SOEs’ risk appetite could be reduced. In such a context, differences between SOEs and POEs should reflect social welfare-maximizing governments rather than politicians, bureaucrats and SOE managers pursuing their private interests (cf. Cavaliere & Scabrosetti, 2008).
Second, market orientation reflects preferences within a country regarding state intervention in the economy and hence the scope of non-economic objectives for SOEs. In market-oriented countries, the preferences of citizens and politicians themselves will circumscribe the scope for non-economic goals for SOEs. More broadly, a home-country market orientation also has SOE corporate governance implications, in terms of the scrutiny of SOEs to be efficient and market competition from private firms (Megginson & Netter, 2001; Goldeng, Grünfeld, & Benito, 2008). Countries with a strong market orientation also tend to have lower barriers for setting up business and encourage competition. SOEs from market-oriented contexts are thus pushed to improve their economic performance and develop strong FSAs, weakening another channel of differences in behavior between SOEs and POEs.
All else equal, a higher degree of government quality and market orientation will reduce the differences between SOEs and POEs. However, they are distinct dimensions, since government quality is required also to successfully implement non-economic objectives, while a strong market orientation may require well-functioning institutions to produce the desired results, as suggested by many countries’ privatization experiences (Cuervo & Villalonga, 2000).
Purchasing Stand-Alone Assets Versus Firms
Internalization theory assumes that MNEs choose establishment modes to minimize transaction costs and hence improve overall economic performance. When seeking exploration and production opportunities in oil and gas, MNEs may choose either to purchase stand-alone natural resource assets or registered firms. Stand-alone assets range from undeveloped land requiring extensive exploratory activity, which is characterized by higher risks, the potential need for significant investments over time, combined with highly uncertain payoffs (Bass & Chakrabarty, 2014), to more or less complete physical assets (developed land with equipment) that can be further combined and/or developed. While the latter is not necessarily exploratory activity, there are still significant risks involved when assets are purchased without attachment to a registered firm, supporting activities, or employees needed to create value from the assets. If exploratory stand-alone assets are successfully developed, they can lead to exponential growth, but are capital intensive before any economic benefits can be realized and require expertise to explore and develop. Registered firms typically have ongoing operations based on a portfolio of multiple assets. Although exploratory activities may be part of the overall portfolio when a firm is acquired, the direct impact of risks related to these assets is balanced and diversified by more predictable values of other assets that are part of the firm’s portfolio (Bass & Chakrabarty, 2014).
SOEs typically have a longer-term orientation, and SOEs in natural resource industries frequently pursue what Bass & Chakrabarty (2014) have termed resource security. Although firms may have both short- and long-term strategic intents of securing natural resources, we expect SOEs to differ from POEs in their focus and ability to pursue long-term resource security objectives, favoring stand-alone assets. Hence, state ownership points to a preference for assets that represent resources for the longer run and may have higher potential for growth and high returns, but also represent long-term capital intensive projects3 with significantly higher risk. Risk tolerance favors the development of stand-alone assets with larger long-term upside potential. This preference for stand-alone assets is amplified by softer budget constraints (Kornai, 1979; Boycko et al. 1996; Rygh, 2018) that allow SOEs to take on the risks associated with developing stand-alone assets without requiring immediate economic returns. The risk tolerance effect could be further strengthened to the extent that moral hazard leads SOE managers to take excessive risks in the expectation that they would be bailed out in the case of failed projects. The channels relating to long-term orientation, resource security goals, and risk tolerance would, all else equal, make SOEs more likely to acquire stand-alone assets for future development. In contexts with weaker control of politicians, there might be a stronger element of private motives of politicians (“empire building”), with politicians preferring spectacular actions that attract attention and boost national pride. “Hoarding” stand-alone assets abroad might be perceived by their constituencies at home as addressing important resource security issues.
In traditional internalization theory, corporate governance (ownership of the MNE) would not be part of the model, the (typically implicit) assumption being that firms are profit-maximizing POEs, so the theory would emphasize what factors would lead firms to prefer an establishment mode over another. Importantly, internalization theory predicts that the acquisition of firms may be particularly valuable when the MNE needs to access certain FSAs and CSAs in a host market. The purchase of stand-alone assets requires strong FSAs to orchestrate resources and activities successfully within or across assets. Hence, if the MNE brings strong FSAs to the host market, it is more capable of purchasing stand-alone assets to exploit these FSAs efficiently (Hennart, 2009).
The internalization theory perspective on FSA development would suggest that SOEs are less able than POEs to acquire and build up relevant knowledge and managerial competences (e.g., Lawson, 1994; Rugman & Li, 2007). If SOE managers or board members are appointed based on political factors rather than business or technological competence, this could be one reason for weaker FSAs in this area. SOEs are generally also characterized by less high-powered incentives, which could reduce the incentives of employees to gain certain types of business knowledge. More generally, some privatization studies have argued that private ownership can improve performance through certain changes in organizational culture and structure (see Cuervo & Villalonga, 2000), which could also influence FSAs. This could in turn imply that SOEs bring weaker FSAs to exploit stand-alone assets in foreign markets and therefore tend to prefer acquisitions of firms in order to access necessary (tacit) technological, managerial, or market-specific knowledge (Slangen & Hennart, 2007) held by POEs.
The balance between these counteracting effects of state ownership is likely to depend on the home-country context of the SOE. Higher government quality implies improved SOE governance, reduced undue political influence and that SOEs are allowed to focus on their core goals. Even if resource security (Bass & Chakrabarty, 2014) could be an accepted goal pursued by SOEs independent of home-country government quality, better government quality could mitigate excessive “hoarding” purported to address resource security. Moreover, higher government quality would likely reduce excessive risk-taking following from moral hazard issues; beyond any higher tolerance for risk governments would like to promote. We acknowledge the potential contradicting effect in that stronger corporate governance would reduce FSA deficiencies, but this effect may be weakened since stronger corporate governance would also reduce the incidence of less appropriate internalization decisions; SOEs, deviating from what would be optimal for a POE, could all else equal purchase firms to a lesser extent than a POE facing comparable FSA shortages. This implies that SOEs might have a lower propensity to purchase firms than an assessment of their FSAs would suggest from an efficiency-seeking perspective, a problem that would in turn be mitigated as government quality increases. Hence, our first hypothesis is as follows:
Hypothesis 1a:
Ceteris paribus, SOEs from home-country contexts with poor government quality are less likely (in comparison to POEs) to acquire firms rather than stand-alone assets. As home countries’ government institutions strengthen, the choices made by SOEs and POEs will tend to converge.
Second, the effect of state ownership is also likely to be smaller if the SOE originates from a market-oriented economy that enables private ownership and market competition (Goldeng et al., 2008). Home governments may differ in what goals they have for their SOEs. While some SOEs internationalize with a mandate to secure long-term access to natural resources for their home country (Bass & Chakrabarty, 2014), other SOEs pursue more business-oriented motives. In a market-oriented economy, the politically determined scope of the goals pursued by SOEs is likely to be more circumscribed, and there may therefore be less willingness to use SOEs to achieve resource security (which, we have argued in this context implies a preference for stand-alone assets). Thus we hypothesize:
Hypothesis 1b:
Ceteris paribus, SOEs from home-country contexts with weak market orientation are less likely (in comparison to POEs) to acquire firms rather than stand-alone assets. As home countries’ market orientation strengthens, the choices made by SOEs and POEs will tend to converge.
Degree of Ownership
Whether firms enter markets by acquiring stand-alone assets or firms, they must also choose the appropriate level of ownership (Brouthers & Hennart, 2007; Welch et al., 2018). Again, our enriched internalization theory perspective suggests an indirect effect of state ownership via FSAs as well as effects from non-economic objectives and risk tolerance; in this case, the arguments all point in the direction of lower ownership levels taken by SOEs. A firm’s success when entering and operating in foreign markets is typically contingent on its ability to access and recombine its own FSAs with necessary complementary assets and capabilities in the host market (Hennart, 2009). This can be achieved either through market contracts or partnerships. According to internalization theory, MNEs prefer strategic partnerships such as joint ventures if their own FSAs and the local complementary assets and capabilities are difficult to transact through contractual arrangements. In contrast, MNEs prefer high ownership and control when their own FSAs are difficult to transact, but necessary complementary assets and capabilities are easy to access through contractual arrangements in the host market (Grøgaard & Verbeke, 2012). Difficulties of transacting FSAs in host markets have been attributed to both asset specificity and information asymmetry (Brouthers & Hennart, 2007; Chi & Roehl, 1997).
If SOEs indeed suffer from weaker managerial and technical FSAs, they will rely more on local complementary assets and capabilities, and tend to choose lower levels of ownership. SOEs may also have weaker FSAs than POEs in transacting for local complementary assets and capabilities such as hiring qualified local people with specific location-bound competencies, suggesting they will to a greater extent seek joint ventures with firms possessing such capabilities. The ability to bundle complementary capabilities is particularly important in complex competitive environments such as the oil and gas industry (Garcia, Lessard, & Singh, 2014). Moreover, deficient corporate governance could imply internalization decisions that do not minimize transaction costs.
However, non-economic objectives could also imply that SOEs have different benefits of ownership than POEs, and achieving such objectives may require different levels ownership than pursuing purely economic objectives. As suggested by Bass and Chakrabarty (2014), in the case of oil and gas resources, the main objective for SOEs is likely to be ensuring long-term resource access. If so, SOEs may be content with a level of ownership that ensures this aim, which may be lower than an ownership level chosen by a POE for reasons of value appropriation.
Moreover, different risk preferences could also influence the choice of ownership level. If SOEs have greater risk tolerance, they may see a lesser need than POEs to protect their FSAs through internalization and would choose lower ownership levels. This is consistent with the argument that relatively risk-seeking agents avoid integration until higher levels of asset specificity (Chiles & McMackin, 1996). Pan, Teng, Supapol, Lu, Huang, and Wang (2014) argue that higher risk tolerances and additional support from home-governments reduce Chinese SOEs’ concern about potential transaction costs, finding that state ownership negatively moderates the relationship between host-country risk and ownership of foreign subsidiaries. Li and Xie (2013) find Chinese SOEs are less affected by variables related to information asymmetry in cross-border acquisitions such as target technology level, relatedness of industry, and cultural distance. They ascribe this to SOEs being less concerned with profit maximization and less subject to market selection mechanisms forcing firms to choose efficient operating modes, but their results are also consistent with the notion of non-economic motives for internalization and higher SOE risk tolerance.
Following Estrin et al. (2016), self-interested politicians may also prefer lower SOE resource commitment abroad if rent-seeking is easier for domestically based SOE assets. This might, all else equal, lead SOEs to take lower ownership positions in FDIs. Lower ownership positions among Chinese SOEs have been attributed the home-country’s preference for lower resource commitment modes (Lee, Hemmert, & Kim, 2014).
While these arguments suggest a lower ownership level taken by SOEs on average, again we expect the effect to be moderated by the home-country context. Higher home government quality will make the channel related to weaker FSAs of SOEs less relevant, by improving SOE governance. There would then be less need for SOEs to team up with private firms in order to compensate for their own (comparative) weaknesses, beyond the general expectation that firms’ success in foreign markets also relies on their ability to access valuable complementary resources. In addition, with better corporate governance we would expect that SOEs become more concerned about protecting a given set of FSAs through internalization, and hence also for this reason become more similar to POEs as home government quality improves. Finally, better government quality reduces the scope for politicians to restrict resource commitment abroad in order to pursue private motives by (Estrin et al., 2016), while managerial moral hazard issues leading to excessive risk taking will also be alleviated. Thus, we hypothesize:
Hypothesis 2a:
Ceteris paribus, SOEs from home-country contexts with poor government quality are more likely (in comparison to POEs) to choose a lower level of ownership in the investment object. As home countries’ government institutions strengthen, the choices made by SOEs and POEs will tend to converge.
A stronger home-country market orientation will have many of the same effects on FSAs and governance by promoting competition and increasing the pressure for good governance of SOEs. In addition, a stronger market orientation is likely to imply a shift from non-economic motives towards economic ones, making non-economic influences on ownership levels less important. This will lead to a choice of ownership level more similar to the benchmark represented by a comparable POE motivated by value appropriation. Thus, we hypothesize:
Hypothesis 2b:
Ceteris paribus, SOEs from home-country contexts with weak market orientation are more likely (in comparison to POEs) to choose a lower level of ownership in the investment object. As home countries’ market orientation strengthens, the choices made by SOEs and POEs will tend to converge.
Figure 1 summarizes our conceptual model and the four hypotheses.