"There are three simple rules to remember," says Panos Kouvelis, Emerson Distinguished Professor of Operations and Manufacturing Management, Olin School of Business Washington University, St. Louis.
"One: Strongly depreciated home currency – when the dollar is down over a decisive period – favors an exporting policy. Two: Strongly appreciated currency – when the dollar is up – favors investment in production facilities in a foreign market.
"Three: If there’s a pronounced change in the exchange rate and immediate operating profits favor switching, the cost of switching between export and overseas ownership coupled with uncertainty about which way the dollar is headed will dictate how long it takes a company to change its production."
The study, "Exchange Rates and the Choice of Ownership Structure of Production Facilities" is by Prof. Kouvelis; Kostas Axarloglou, Babson College; and Vikas Sinha, the Fuqua School of Business, Duke University. It appears in the current issue of Management Science, an INFORMS publication.
The abstract of this study is available online at http://pubsonline.informs.org To access it, point your browser to Management Science in the left window and click on Volume 47, Number 8 in the right window.
The authors reached their conclusions using math-modeling techniques that are common to the discipline of operations research.
Joint Ventures vs. Wholly Owned Subsidiaries
For global firms, the choice of appropriate ownership structure for production facilities supplying the demand of foreign markets – whether to export, form joint ventures with local partners, or wholly own production facilities – is a critical success factor.
Although production strategies that consider development of production facilities in a foreign market normally require investments of an irreversible nature, the current study suggests that ownership decisions are more dynamic than previously thought.
A pronounced example of companies switching modes because of exchange rates dates back to Japan’s economic heyday, observes Prof. Kouvelis. When Japanese companies grew substantially in the 1980’s and the Japanese yen began appreciating, these companies began switching from export to joint ventures and wholly owned subsidiaries in the U.S. and other countries. The lag in switching modes lasted a good three years.
Scholars call the length of time a company waits before switching from export to some form of foreign production a " hysteresis band" (i.e. a zone of inaction motivated by a wait-and-see attitude). It is influenced by factors such as -
- Switchover costs
Any increase in these costs leads to a longer wait-and-see period.
- Production cost advantages
either because of supplier infrastructure, workforce skills, or product/process know-how. These advantages in the home country favor exporting strategies. Cost advantages in the foreign market favor direct investments in production facilities overseas.
- Volatility of the exchange rates is a major contributing factor to the length of time a company takes before reaching a decision.
- Demand
An increased foreign market demand provides favorable conditions for earlier switching to an exporting strategy in the case of a depreciated home currency – for the U.S., when the dollar is down. On the other hand, it favors a longer period of investment in overseas production for relatively appreciated home currencies – when the dollar is up.
Many firms view joint ventures as convenient intermediate platforms in serving foreign market demand while waiting for further resolution of exchange rate uncertainty. They do this, says Prof. Kouvelis, because joint ventures are "less irreversible" than wholly owned subsidiaries. In other words, joint ventures are like "mothballing" options in the context of ownership strategies in global production. As the "mothballing" of a ship or mine keeps alive the option to restart their operation, the joint venture platform keeps the firm’s foreign production presence alive, at a reduced commitment level, during unfavorable exchange rate regimes.
Data
The theoretical results obtained from the developed models were used to generate testable hypotheses, which were then rigorously tested against actual data. The authors used two data sets. One was the Harvard Multinational Enterprise database, which traces the economic characteristics of 180 U.S.-based multinational corporations around the world from 1901 to 1977. The data set includes information for 1,074 subsidiaries of U.S. multinationals operating in 14 different countries. The second data set depends on annual data maintained by the U.S. Department of Commerce’s Bureau of Economic Analysis. It records information on the economic activities of 2,272 U.S. multinationals with 18,899 foreign subsidiaries, for the period between 1983 and 1993. The empirical results validated all tested hypotheses, and confirmed the above presented intuition.
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