International Business Strategy and

Emerging Markets
Gravity Models, Distance and CAGE

Christine Cote, Saul

Estrin, Roger Fon
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Lecture Outline Outline

 Characteristics of emerging economies (last week’s lecture)

 FDI
• Patterns of FDI
• Emerging markets and FDI
• Types of FDI
 Gravity models

 The literature: evidence on the determinants of FDI

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 Characterising Emerging Markets
Empirically

The business opportunities- the potential upside

Growth and rising living standards
Improved health, education
The problematic areas – risks and threats
Institutions
Inequality

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There is plenty of upside…

•Fast Growth (market size)

•Declining Poverty, Fertility, Mortality, Infectious
Diseases, Illiteracy

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Fore example, China

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GDP and Growth

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Growth in GDP per capita

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Convergence in Asia to US

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Declining poverty in Asia….

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Business threats in emerging markets

But there are plenty of downsides a

nd risks too:
Heterogeneity of experience
Weak institutions
high inequality

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Heritage Foundation: “quality of institutions”

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Corruption Perception Index 2018

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Income Inequality: the Kuznets curve

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Gini Coefficients

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FDI – global patterns

FDI inflows

FDI outflows

Developed and emerging economies

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FDI Inflows to developed and emerging economies (UNCTAD)

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Foreign direct investment inflows, top 20 host economies
2017 and 2018 (Billions of dollars)

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Foreign direct investment outflows, top 20 home economies
2017 and 2018 (Billions of dollars) UNCTAD data

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FDI: THE FOUR MOTIVES FOR FDI - DUNNING

• market size;
• market growth;
Market Seeking • access to global/regional
markets

Resource Seeking • raw materials; oil, gas,

minerals, timber

• cost of resources and assets,

Efficiency Seeking e.g. labour, skills, technology.
• input costs e.g. transport,
communication

Strategic asset • Innovation ecosystems,

seeking research labs
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Poll 1: for (developed economy) MNEs undertaking FDI into
emerging economies, what is the dominant motive?

Efficiency seeking

Resource seeking

Market seeking

Strategic asset seeking

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Distribution of motives (K. Wach, 2014)

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Poll 2: Choose which one best captures distance effects?

1. symmetric between rich and poor countries

2. Rather limited or non-existent
3. Greater as income per capita rises
4. The between all pairs of countries
5. Driven primarily by transport costs
6. Driven primarily by differences in institutions

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 The World is Not Yet Flat: Distance
Matters

Most economic
activity occurs within
countries and
most cross-border
economic activity
occurs within regions
 Trade is With Neighbours

Canada UK
Merchandise Exports, 2015

Most Canadian trade is with the US; most UK trade is with

Europe

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 Trade is With Neighbours

US Germany

Merchandise Exports
Most US trade is with the Canada and Mexico; most German trade is with
Central Europe

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Borders also matter

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Poll 3: Modelling gravity effects:

1. the attraction of FDI is greater when economies are smaller

2. The attraction of FDI is greater when the host economy is large
3. The attraction of FDI is larger when distance is larger
4. Distance has no effect on FDI

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Gravity Model
The gravity model is named
and modeled after Newton’s
Universal Law of Gravitation
from physics:
F = Gm1m2/r2

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Gravity Model1 Gravity Models

 Newton’s “Law of Universal Gravitation” (1687): The attractive force (Fij)

between i and j

MiM j
Fij  G 2
Dij

 Mi, Mj are the masses

 D is distance between two objects Mi Mj
 G is gravitational constant
D

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Gravity Model 2 Gravity Models

 
Mi M j
Fij  G 
Dij
 Fij is the flow from i to j
 M’s are measure of economic mass
 D is the distance

Model can be used to explain many social interactions; e.g. migration,

tourism, trade, FDI

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Formal Gravity Model

TIJ = AYIYJ/DIJ
TIJ ≡ value of FDI (or trade) between
countries I & J
YI ≡ GDP of country I
YJ ≡ GDP of country J
DIJ ≡ distance between countries I & J
A ≡ constant term
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 Gravity Model
Fig. 2-2: The Size of
European Economies, and
the Value of Their Trade
with U.S.
size matters
country’s GDP directly related to
volume of imports & exports
exports: larger economies produce
more goods & services (more to sell)
imports: larger economies generate
more income (more to buy)

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 Gravity Model
Fig. 2-2: The Size of
European Economies, and anomalies
the Value of Their Trade
with U.S.
Netherlands & Belgium:
geography (near mouth of Rhine,
Western Europe’s longest river)
Ireland:
cultural affinity & multi-national
corporations (low corporate taxes)

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 Gravity Model
Fig. 2-3: Economic Size and
Trade estimates of model
with the United States
1% increase in distance causes
0.7% to 1% decrease in trade
Canada & Mexico are much
closer to the U.S. than Europe,
so there is much more trade
(also the U.S., Canada, &
Mexico have a free trade
agreement: NAFTA)
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From host economy characteristics to distance

 Thus, far, we have characterised location choice in terms

of the characteristics of the host economy.
 However, the IB literature often instead focuses on the
idea of “distance”, the difference in characteristics
between the home and host economy.
 Johanson & Vahlne (1977) conceptualized distance as
“psychic distance”, defined as “the sum of factors
preventing the flow of information from and to the market.
Examples are differences in language, education, business
practices, culture, and industrial development.”

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The CAGE distance comparative framework

• Ghemawat’s model: CAGE distance comprises

• Cultural distance ( approximately North’s informal institutions)
• Administrative distance (similarities or differences between countries
policies)
• Geographic distance – reflecting differences in transactions costs
• Economic distance - reflecting differences in wealth, income and the cost of
labour

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International Business
scholars have relied on
broader measures of
“distance”, linked to the
Liability of Foreignness
(LOF). Ghemawat CAGE

Evidence suggests that

lower CAGE distance
increases trade and FDI.

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 What is Distance?: The CAGE Framework

Source:
Ghemawat,
2001

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Gravity effects: example of Canada and the UK 1

• Canada total trade mostly with the US (70% exports, 52% imports)

• UK total trade mostly with EU countries (43% exports, 54% imports)

• Canada-UK total trade is limited (3-5% of total, depending on measure)

• Canada-UK services trade also limited (6% exports, 5% imports)

• There are no strong trends over time in the country composition of overall or service trade
patterns for either country

• Canada-UK FDI stocks are also limited (8-10%) and display no long run trend

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 CAGE distance 2: UK and Canada and main trading partners

CAGE Value s UK Canada UK Germany Canada US Source

Common Language * 1 1 1 0 1 1 CIA

Religion ** 1 1 1 1 1 1 PEW

Cultural distance (6 indices, Mahalanobis method) 1.33 1.33 6.15 6.15 0.98 0.98 Hofstede, 1980

Legal Origin *** 1 1 1 0 1 1 CIA

Property, Judicial, Government Integrity, average 88 81 88 78 81 76 Heritage Foundation

Colonial legacy **** 1 1 0 0 0 0 CEPII

Labour Freedom (Heritage Foundation) 74.4 71.3 74.4 53.3 71.3 80.0 Heritage Foundation

Financial Freedom (Heritage Foundation) 80 80 80 70 80 91 Heritage Foundation

Country size (Land Area, sq.km) 241,930 9,093,510 241,930 348,900 9,093,510 9,147,420 World Bank

Contiguous ***** 0 0 0 0 1 1 CEPII

Distance between capitals, km 5,365 5,365 936 936 737 737 CEPII

GDP per capita, PPP, current int. $ 43,268 46,704 43,268 50,638 46,704 59,531 World Bank

GDP, $ 2,622,433 1,653,042 2,622,433 3,677,439 1,653,042 19,390,604 World Bank

Gini Coefficient ****** 33 34 33 31 34 41 World Bank

* Country s core s 1 if Englis h is its principal language , and 0 if it's any othe r language
** Country s core s 1 if it's principal re ligion is Chris tianity, re gardle s s of the de nom ination
*** Country s core s 1 if its le gal origin is com mon law, and 0 if it's civil law
**** Country s core s 1 if it has colonial le gacy with its partne r country and 0 if the re is no colonial le gacy
***** Country s core s 1 if it s hare s a com m on borde r with its partne r country, and 0 if the re is no borde r
****** Gini coe fficie nts are give n for 2013

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CAGE Distance 3

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Gravity effects 4; Another example

 Trading with an economy which is five times larger than another will be associated with imports
and exports also approximately five times larger.
• Hence, if we ignore distance, the UK’s trade with China might be expected to be slightly
less than five times larger than trade with France.

 However, distance effects are nonlinear (quadratic).

• Consider two countries of equal size, one twice as far away as another. The non-linear
distance effect means that for the host economy, trade with the further country will be one-
quarter of trade with the closer.
• If the distance is measured by miles between capital cities, then London to Paris is
approximately 300 miles and London to Beijing is approximately 5000 miles. The pure
geographic distance effect implies that the distance effect will reduce trade between the UK
and China, relative to that between the UK and France, by a factor of (16.6) squared, or
around 277 times.

 Thus, the impact of distance can more than offset the benefits of trading with larger economies.

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Estimating Gravity Models Gravity Models

 High Explanatory Power of gravity model estimates:

• R2 between 0.65 and 0.95
• Explanatory variables usually significant

 This suggests using gravity as a benchmark for volume of trade, FDI,

migration, etc.

We can then use gravity based benchmark to evaluate economic

policy; estimates of effects of institutions, corruption, FTAs etc

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Estimating Gravity Models 2 Gravity Models

 Economic Mass: usually measured using GDP

 theoretical explanations predict coefficient equal to one

 Estimates for trade are often not significantly different from 1, but
range is from 0.7 to 1.1
 Distance usually measured using great circle distance based on latitude
and longitude
 Head (2000) averages results from 62 regressions in eight papers,
for sample years ranging from 1928 to 1995
• Average distance effect is 1.01
• E.g. doubling distance halves trade

 Estimates for other economic variables can assume different ranges.

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Evidence from the Literature I: Inflow analysis FDI
Determinants

Industry and firm determinants of FDI

 Brainard 1997 finds affiliate sales are large relative to exports in

industries with large firm level economies of scale and smaller in
industries where plant level economies of scale dominate

 Firm specific intangible assets e.g. knowledge about product

design/production methods or reputation for quality or brand image –
provide firm specific advantages
 Brainard 1997 finds advertising intensely increases affiliate sales
relative to exports
 Lall 1980 finds extent of foreign operation and share of affiliates
positively related to R & D intensity of industry

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Evidence from the literature II FDI
Determinants

Efficiency and MNEs

 Helpman et al, 2004, argue that higher fixed costs of operating
abroad must be recouped by higher sales and lower marginal costs.
They find MNE’s are 15% more productive (lower cost) than
exporters

Production costs
 Very mixed evidence on impact of production/labour costs. Often
insignificant effect and sometimes perverse

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Evidence from the literature III FDI
Determinants

Tax differentials and FDI promotion policies

• Brainard 1997 suggests tax differentials have negligible effect on FDI
• Hines 1999 survey – argues that FDI pattern sensitive to tax
• Evidence on promotion policies very mixed – no clear cut evidence of
significant impact

Regional integration
• Increases “effective” market size i.e. NAFTA, EU
• Evidence that integration does increase FDI i.e. Barrell and Pain 1999

Agglomeration effects
 proximity to other FDI – role of industrial clusters
 Wheeler and Mody 1992 – US outsourced FDI affected by quality of
infrastructure, degree of industrialisation, level of increased FDI

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Determinants of FDI to Emerging Markets: Institutions FDI
Determinants

Corruption:

Wei (REStat,2000) finds that:

 A rise in either the tax rate on multinational firms or the corruption
level in a host country reduces inward foreign direct investment
(FDI).
 An increase in the corruption level from that of Singapore to that of
Mexico would have the same negative effect on inward FDI as
raising the tax rate by fifty percentage points.
 Despite the U.S. Foreign Corrupt Practices Act of 1977, American
investors are not more averse to corruption than average OECD

Javorcic and Wei (JIMF 2009) find
• Corruption reduces inward FDI and shifts the ownership structure
towards joint ventures.
• Thus corruption increases the value of using a local partner 51
Determinants of FDI to Emerging Markets 2 FDI
Determinants

Institutions:

Benassy-Quere, Coupet,Mayer, World Economy, 2007

 Find that a wide range of institutions, including bureaucracy,
corruption, but also information, banking sector and legal institutions,
significantly affect inward FDI independently of GDP per capita.
 Weak capital concentration and strong employment protection also
reduce inward FDI.
 Institutional proximity between the origin and the host country also
matters.

See also Globerman and Shapiro, 2002

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