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INSTITUTIONAL ESCAPISM AND INTERNATIONALIZTION OF SMES:

EVIDENCE FROM CHINESE PRIVATE FIRMS

PING DENG
Monte Ahuja College of Business
Cleveland State University
Cleveland, OH 44115

BING WU
East China University of Science and Technology

INTRODUCTION

Firms are generally motivated to seek market, resource, efficiency, and strategic assets
while going abroad so as to strengthen their global competitive advantages (Dunning, 1998). The
fundamental assumption is based on the experience of Western multinationals (MNCs), which,
however, may not necessarily be applicable to emerging market firms (EMFs). As more and
more EMFs undertake outward foreign direct investment (OFDI) as an escape response to the
misalignments between firm needs and home country institutional conditions (Boisot & Meyer,
2008). Such institutional escape may lead to a unique form of firm internationalization (Witt &
Lewin, 2007). So far, institutional escapism is only a conceptual premise and lacks empirical
supporting. On top of that, we have limited knowledge about the mechanism behind such forced
internationalization and also how forced international firms (FIFs) choose their entry modes.
To fill the above gap, we develop a theoretical model of international arbitrage by
drawing from and building links between institutional escapism and the varieties of capitalism
(VOC) literature (Hall & Soskice, 2001; Hancke, 2009). Institutional arbitrage refers to the
situation where a firm is able to exploit differences between two institutional environments
across national borders (Boisot & Meyer, 2008; Ledyaeva et al., 2015), with its theoretical
foundations rooted in the institutional framework of the varieties of capitalism (VOC) approach
(Jackson & Deeg, 2007; Peck & Zhang, 2013). The key insight of the VOC perspective is that
national institutional framework engenders interaction effects that shape in different ways the
behavior of economic actors according to the particular combination of institutions found in the
national setting (Hall & Soskice, 2001; Hancke, 2009). Through the analytical lens of
institutional arbitrage grounded in the VOC approach, we seek to build bridges between the
macro-characteristics of institutional comparative advantage of national economies and the
microeconomics of firm behavior in the context of Chinese private SMEs who are forced to
internationalize because of increasingly hostile home country institutional conditions.
This paper makes three valuable contributions. First, our study is the first of its kind to
link forced internationalization to the perspective of the VOC by arbitraging cross-country
institutional differences. Second, we go further by identifying specific entry mode choices, thus
deepening our knowledge of how FIFs operationalize their internationalization after escaping
institutional misalignments domestically. Third, we discuss the boundary conditions for
internationalization of SMEs and contribute to the multi-level research by taking into account the
interactive effects between country-level institutional factors and firm-level resources and
capabilities. Given that there is no systematical study of how SMEs arbitrage national
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institutional differences, this finding lends novel empirical support to the key insight of
institutional arbitrage theoretically rooted in the VOC approach.

THERETICAL MODEL AND HYPOTHESIS DEVELOPMENT

In the context of China, institutional environment is more statist in orientation and state
control generates an institutional hindrance to private firms for survival (Huang, 2008).
Compared to SOEs that have a monopolistic position at home, Chinese private firms face major
resource constraints because they lack privileged access to strategic resources such as political
support and capital from state-owned banks (Deng et al., 2011; Zhu et al., 2012). As private
firms struggle to survive with limited legitimacy in China, going abroad provides them with
some buffer against domestic institutional deficiencies and policy discrimination by increasing
access to needed resources while minimizing government interference (Buckley et al., 2007; Wei
et al., 2015). So far, the notion of institutional escapism was derived from deductive analysis or
aggregated country level data (Witt & Lewin, 2007), ignoring the mechanism that spurs firms to
pursue favorable institutional systems overseas. On top of that, empirical analysis of why EMFs
are forced to internationalize and how they operationalize the strategic exit of home countries is
limited. To fill the gap, we introduce institutional arbitrage as the functioning mechanism of
firms’ institutional escape. For our research purpose, institutional arbitrage refers to the situation
where a firm is able to exploit differences between different institutional environments (Boisot &
Meyer, 2008; Ledyaeva et al., 2015). Due to lack of solid theoretical rationale, however,
institutional arbitrage is rarely adopted in the literature on the EMF internationalization.
Theoretically rooted in the VOC approach, we introduce institutional arbitrage as a novel
concept in this study. In essence, EMFs originating from a country with unfavorable institutional
conditions may go abroad to arbitrage institutional differences across national borders.
The VOC approach represents an attempt to synthesize comparison of particular home
and host country institutions as building block into a broader theoretical lens to understand
institutional diversity as having comparative institutional advantages rooted in different
institutional contexts (Hall & Soskice, 2001; Hancke, 2009). Given its key insight into
institutional comparative advantages of nations and the specific nature and interactions between
particular institutions (Hall & Soskice, 2001), the VOC approach is well suited to explain why
and how EMFs arbitrage between diverse sets of institutions, thus providing solid theoretical
rationale for institutional arbitrage. In essence, institutional diversity shapes the potential for firm
strategies based on arbitrage between different institutional systems. On the other hand, the VOC
approach lacks a specifically spatial dimension (Buckley et al., 2015; Hancke, 2009); its
integration with the concept of international arbitrage allows adding a new dimension and
extending the VOC theory with spatial factors. Based on the above arguments, we develop our
conceptual framework of institutional arbitrage, as illustrated in Figure 1.

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Insert Figure 1 about here
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In this study, we aim to examine the role of institutional arbitrage in the search for
favorable institutions via the internationalization of EMFs. In this sense, institutional arbitrage
acts as an integrating point for institutional escapism as forced internationalization and the
revised VOC model of why and how the FIFs operationalize their international activities.
10.5465/AMBPP.2016.135

Accordingly, we are specifically interested in exploring four interrelated questions: (1) in

contrast to mainstream FDI theory, are FIFs more likely to choose target markets with higher
degree of institutional distance (H1), showing strategic exist from home countries (i.e.,
institutional escapism), or choosing those destinations with high level of economic development
(H2), showing strategic entry into foreign markets? (2) After the location choice decision, will
FIFs choose mode of entry with low-resource commitment for survival so as to mitigate liability
of foreignness because of the disadvantage of institutional escape from home countries (H3)? (3)
Is the choice of entry mode affected by the location choice decisions taken by FIFs (H4 and H5)?
And (4) what is the moderating role of founder’s international experience in the decision-making
of entry mode choice (H6 and H7)? More specifically, we argue that Chinese private SMEs have
institutional incentives to escape from home country misalignments and they are motivated by
institutional arbitrage which we define as interplay of differing institutional environments.

Location Choice by FIFs and Institutional Distance

After deciding to invest abroad for survival, the first and foremost question that a firm
must consider is: where to expand internationally, that is, the choice of location of target
markets. Based on FDI theory, firms are most likely to choose locations which are similar to
their home institutional environments in terms of lower distance of culture and institution as well
as government supports (Luo et al., 2010; Yamakawa et al., 2008 Institutional distance is defined
as the extent to which the institutions in the home and host countries differ from one another,
conceptualizing the challenges faced by MNCs seeking to establish operations in different
countries (Kostova, 1999; Xu & Shenkar, 2002). The greater institutional distance, the more
difficult to build external legitimacy and transfer organizational practices from the parent to the
subsidiary because a large institutional distance triggers the conflicting demands for external
legitimacy in the host country and internal consistency within the MNC system (Bruneel, Yli-
Renko, & Clarysse, 2010; Xu & Shenkar, 2002Although a different institutional environment
means more unfamiliarity and potentially higher transaction costs and higher capabilities to
conquer these liabilities (Kostova, 1999), the fear of failure in similar institutional contexts
cannot drive firms to escape from one detrimental institutional context to the same one.
Hypothesis 1: The more firms are forced to internationalize due to institutional escapism,
the more likely they choose different institutional environment.

Degree of Development of Target Markets

Unlike multinationals from developed countries, EMFs also encounter with the choice of
location in their internationalization: going to invest in developed countries (DCs), the so-called
"upstream" OFDI, or going to invest in less developed countries (LDCs), the "downstream"
OFDI (Makino, Lau, & Yeh, 2002). This directional choice implies the gap of the degree of
development behind the upstream and downstream OFDI and also the gap of resources and
capabilities between EMFs and other firms. For example, upstream OFDI means that FIFs may
have to face fierce competition and struggle to conquer the liabilities of foreignness originated
from political systems, economic gap, cultural and geographic distance (Zaheer, 1995). Although
FIFs may make an optimal decision to avoid the deterioration of their operations after entering
the target markets, entering DCs means relatively better institutions which tend to treat foreign
investors fairly, as well as better resources and strategic assets. In line with the logic of
institutional escapism, FIFs may aggressively escape to DCs to arbitrage for favorable
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institutional arrangements. FIFs may have competitive advantages in undertaking downstream

OFDI because of relatively lower competitive pressure in LDCs (Cuervo-Cazurra & Genc,
2008). However, entering into LDCs may be dangerous in encountering the similar munificent
environment as domestically, that is, institutional misalignment. Therefore, we argue that FIFs
tend to weigh DCs over LDCs as target countries.

Hypothesis 2: The more firms are forced to internationalize due to institutional escapism,
the more likely they choose developed countries (DCs).

Choice of Entry Mode

When investing overseas, the choice of entry mode into target host countries is another
critical decision that firms must to make. Extant literature classifies entry modes by level of
control, resource commitment, and structure of equity (Makino et al., 2002) and "the most
appropriate entry mode is a function of the tradeoff between control and the cost of resource
commitment" (Anderson & Gatignon, 1986, p. 1). Given that institutional arbitrage mainly
reflects the transition of resources and capabilities from home country to host country, entry
mode categorized by resource commitment may be more appropriate for analysis of the
phenomenon of institutional escapism. EMFs generally lack firm-specific advantages but possess
country-specific advantages (CSAs) (Rugman & Li, 2007). As a result, mergers and acquisitions
(M&As) are arguably the preferred entry mode by many Chinese firms for fast market entry,
acquiring strategic assets (Peng, 2012). Meanwhile, EMFs can take aggressive springboard
behaviors to acquire strategic resources so as to compensate for their competitive disadvantages
(Luo & Tung, 2007). For most private firms and especially for FIFs from emerging economies
such as China, due to lack of CSAs and home country institutional supports (Rugman & Li,
2007), FIFs are more likely to use internationalization as an escape response to home
institutional barriers to seek living space. Such situation is more true for FIFs, otherwise, they
should operate well domestically. In addition, most cases of high-resource entry modes by large
EMFs fail to enhance their shareholder value (Lebedev et al., 2015). To avoid serious challenges
in overseas markets, FIFs are more likely to be risk-aversion by using low-resource commitment
modes (e.g., exporting or licensing) rather than high-resource commitment modes (e.g.,
greenfield investment or M&As) to enter target host markets.

Hypothesis 3: The more firms are forced to internationalize due to institutional escapism,
the more likely they choose entry modes of low-resource commitment.

Moderating Effects of Institutional Distance on Entry Mode

If Hypothesis 3 stands, does the location choice have impact on FIFs' subsequent choice
of entry modes? In the following, we intend to explore the role of location choice and degree of
development of target market in FIF's choice of entry modes into target markets. The choice of
entry modes is related to institutional distance between home country and target country
(Hernandez & Nieto, 2015; Xu & Shenkar, 2002). If a firm enters into a new country with
different institutional context, it is expected to possess sufficient resources and capabilities so as
to tackle the liabilities of foreignness (Cuervo-Cazurra, 2008). Without the knowledge of
operating in a different institutional setting, firms tend to adopt a stepwise process to penetrate
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into target markets (Johanson & Vahlne, 1977). Specifically, although greater institutional
distance means that the target market has stronger market-supporting institution relative to
China's, FIFs are likely to choose entry modes of low-resource to gradually learn about the target
markets so as to avoid more serious liabilities of foreignness. Therefore, the greater the
institutional distance, the more concerns FIFs will have due to the escape pressure from domestic
market and unfamiliarity with the local institutions and host environment.

Hypothesis 4. The greater the institutional distance from the target markets, the more
likely firms choose entry mode of low-resource commitment.

Moderating Effects of Degree of Development of Target Market

Different target markets reflect different location characteristics (Dunning, 1998). Prior
studies indicate that, due to significant institutional, cultural, and technological differences, when
EMFs expand to developed countries, they are more likely to experience higher competitive
disadvantages (Cuervo-Cazurra, 2008; Wright et al., 2005). Because EMFs do not have strong
abilities for international operations, it is unlikely that they can completely adapt themselves to
target markets. For EMFs, entering developed countries also means a relatively larger gap in
terms of technology, managerial expertise, and competitiveness (Peng, 2012). Higher transaction
costs of in terms of technology and labor suppliers are also unfavorable to FIFs' development.
Therefore, EMFs will adopt entry modes of low-resource commitment such as exporting or
contract agreement when entering DCs. On the other hand, it is relatively easier for EMFs to
expand to other LDCs. Because the home- and host-country markets have similar national
business systems with relatively small differences in technology and regulations, EMFs can
transfer their knowledge and experience to target emerging markets. On top of that, LDCs tend
to maintain good relationships with other underdeveloped countries (Buckley et al., 2007). As a
result, FIFs are likely to exploit such resources and advantages and choose high-resource
commitment entry modes so as to reap generous profits when entering LDCs.

Hypothesis 5a: If target markets are DCs, the more firms are forced to internationalize,
the more likely they choose entry modes of low-resource commitment.
Hypothesis 5b: If target markets are LDCs, the more firms are forced to internationalize,
the more likely they choose entry modes of high-resource commitment.
Moderating Effects of Founders’ International Experience

Most studies focus on the firm-level experience and argue that firms’ prior experience in
foreign markets acts as a unique capability and significantly affects entry-mode decisions
(Benito, Petersen, & Welch, 2009). However, existing literature tends to overlook the role of
personal experience of top management teams (TMTs) (Deng, 2012). For firms to
internationalize, prior foreign experience of founders or TMTs serves as important firm-level
resources and capabilities which significantly impact choice of entry modes (McDougall et al.,
2003). As SMEs normally have high levels of family ownership and the founders tend to play an
authoritative decision-making role, the internationalization process of SMEs reflects distinctive
characteristics of founders (Brothers et al., 2015). Facing a target market with a higher degree of
institutional distance and also the reality of forced internationalization, founders are likely to
carefully consider the risk and disadvantages in international operations and choose an entry
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mode of low-resource (Bruneel et al., 2010; Child, Rodrigues, & Frynas, 2009). On the other
hand, when the institutional distance is smaller, founders may believe that their international
experience is adequate to manage potential challenges and hence choose entry modes of high
resources.

Hypothesis 6. If founders have more international experience and the institutional

distance from the target market is greater, the more firms are forced to internationalize,
the more likely they choose entry modes of low-resource commitment.

When entering advanced markets, founders with prior foreign experience are more likely
to be aware of the gap in technology, managerial expertise, and reputation between their firms
and counterparts from DCs (Autio et al., 2011). In these circumstances, FIFs tend to choose entry
modes of low resources to avoid risks associated with such competitive disadvantages. When
entering LDCs, founders’ international experience will make it easier to apply firm's practices to
host countries and enable them to exploit their ability in exploring those markets (Child et al.,
2009; Filatotchev et al., 2009). In this sense, FIFs will choose high-resource entry modes when
investing in LDCs.

Hypothesis 7a. If founders have more international experience and target markets are
DCs, the more firms are forced to internationalize, the more likely they choose entry
modes of low-resource commitment.

Hypothesis 7b. If founders have more international experience and target markets are
LDCs, the more firms are forced to internationalize, the more likely they choose entry
modes of high-resource commitment.

DISCUSSION AND CONCLUSIONS

By developing the lens of institutional arbitrage as functioning mechanism behind this

unique form of firm internationalization, we conduct a survey of 327 private SMEs in China. In
so doing, we not only empirically verify the institutional “escape” view and but also
substantialize the emerging line of research by identifying several distinct features of forced
internationalizing firms (FIFs). Specifically, firms can utilize OFDI as an effective means of
institutional arbitrage, which is aimed at circumventing home country institutional constraints
and, at the same time, for institutional shopping at host countries for gaining access to favorable
institutions. That is, escape to avoid misalignments between firms’ needs and home country
institutional conditions represents an additional explanatory factor for OFDI and the observed
variation in the levels of OFDI among SMEs. Using systematic survey data, we find that
national-level predictors explain additional variance in the motivations of firm
internationalization, above and beyond firm- or industry-level predictors, add further evidence
that how institutional arbitrage offers valuable and new insights into exploiting institutional
diversity of nations.

REFERENCES AVAILABLE FROM THE AUTHORS