The impact of interpersonal trust and power distance on the flow of foreign direct investment.doc

THE IMPACT OF INTERPERSONAL TRUST AND POWER DISTANCE ON THE FLOW OF FOREIGN DIRECT INVESTMENTStephanie Thomason, Florida Atlantic UniversityThis paper empirically tests the influence of power distance and interpersonal trust on the flow of FDI over five years across 33 countries. Findings suggest that the inward flow of FDI is significantly negatively related to the level of power distance in a country, while the outward flow of FDI is moderately related to countrys level of power distance. The flow of FDI is not related to a countrys level of interpersonal trust, however, although power distance and interpersonal trust were found to be significantly inversely related. IntroductionForeign direct investments can be the economic lifeblood of a country as such investments increase the employment, capital, and trade balance within a country. FDI has typically been favored within free market economies and heavily restricted in economies which were state-planned, Communist, pragmatic Nationalists, or under religious Authoritarianism. Since the fall of Communism in Eastern Europe, however, FDI has become increasingly recognized as an important contributor to the economic well-being of nations. For this reason, many governments encourage FDI through special policies and incentives. Many factors have contributed to the recent increase in FDI, including increased globalization, free trade agreements, and privatization. Additionally, many variables impact the likelihood that a country will be the inward recipient of foreign direct investment, or would be the outward source of foreign direct investment. These variables could extend beyond the traditional economic variables used to explain FDI. Understanding both the traditional and cultural variables which influence inward and outward FDI could therefore be important to both a government and its people, who ultimately gain or lose from changes in FDI.This paper proposes that the inward and outward flow of FDI varies by a countrys level of power distance and interpersonal trust. Greater levels of power distance could decrease the inward and outward flow of FDI, while lesser levels could increase the flow of FDI. Furthermore, greater levels of interpersonal trust could increase levels of overall trust, which could increase the inward and outward flow of FDI. Literature Review The extant literature on FDI has consistently found that levels of FDI can be explained by economic factors, including country size, consumer purchasing power, open economy, the network of economies, (Habib and Zurawicki, 2002) macroeconomic stability, the privatization method, government barriers, natural resource endowments, trade liberalization, the level of economic reforms (Gabibaldi et. al., 2001), corruption (Habib and Zurawicki, 2002; Husted, 1999) and industry clusters (Mariotti and Piscetello, 1995). Some authors have linked national culture or cultural distance with different aspects of FDI (Chui, Lloyd, and Kwok, 2002; Kogut and Singh, 1998, Mezias et. al., 2002). Others have linked trust to economic variables (Chiles and McMackin, 1996. Knack and Kiefer, 1997) market incompleteness (Luo, 2002), balanced asset specificity (Young-Ybarra and Wiersema, 1999) and modes of FDI (Shane, 1994, Curral and Inkpen, 2002). Few have linked latent variables, such as trust or power distance directly to the inward and outward flow of foreign direct investment. Linking these cultural variables to FDI could add to current knowledge of the underlying influences impacting the inward and outward flow of FDI. Researchers and analysts commonly refer to FDI flows and stocks when compiling data on multinational corporations. FDI flows reflect the sum that foreign companies invest in affiliates over a certain time period, of which the affiliates may spend to acquire current and fixed assets. FDI stock refers to the overall investment position under the control of foreign investors and is used as an approximation of international production and value adding activities. This research focuses on the flow of FDI, as this represents investments on a year-to-year basis rather than the cumulative position of a company. Gabibaldi and his colleagues (2001) found that foreign direct investment in transition economies can be explained by economic fundamentals, including variables reflecting macroeconomic stability, the level of economic reforms, natural resource endowments, the privatization method, direct barriers to inward direct investment, trade liberalization, and a measure of government "red tape" that reflects obstacles to investment and entrepreneurship and is closely related to corruption. Habib and Zurawicki (2002) also found that economic variables, such as consumer purchasing power, country size, open economy, and network of economies positively affect FDI, while corruption negatively impacts FDI.Luo (2002) notes that uncertainty in an emerging foreign market affects the trust-performance link and variables such as local parent ownership type (state vs. non-state-owned) and alliance location (open region vs. non-open region) influence trust building. Das and Teng (2001) note that strategic alliances are adopted over greenfield investments to control the uncertainties and risks in the environment. By pooling the risks involved, companies can reduce the uncertainties involved in entering a new market (Das and Teng 2001, Brouthers, 2002). Kogut and Singh (1988) used an aggregated measure of Hofstedes (1980) national culture dimensions to create a measure of cultural distance. The index they used measured the distance between countries, correcting for differences in the variances of each of the dimensions. The authors found that cultural distance leads to more joint ventures relative to greenfield investments and acquisitions, and determined that cultural distance between societies increases transaction costs and reduces the tendency to select some markets for foreign direct investment. Benito and Gripsrud (1992) in contrast, found that FDIs located in countries that are culturally distant tend to be greenfield investments to a larger extent than for FDIs in culturally closer countries. The direction of the effect of cultural distance on the choice between licensing and foreign direct investment has not been established with any degree of confidence (Shane 1994). Different business entry modes are impacted by cultural distance and interpersonal trust. Park et. al. (2002) found that different business entry modes have the potential to significantly influence the degree of commitment and interpersonal trust of managers due to the degree of identification, or lack thereof, of the managers with the organizational parents.Cultural Influences on FDI In 1980, Hofstede created a cultural framework which has arguably spurred the most research in cross-cultural relations and which forms a basis from which many authors have built. Using cross-cultural business surveys of 53 countries from an IBM database, Hofstede developed four dimensions of cultural values that together describe national culture: individualism/collectivism (the relationship between the individual and the collectivity that prevails within a given society), uncertainty avoidance (uncertainty about the unknown), masculinity/femininity (the relationship between ego and social goals), and power distance (inequality in power). He later added a fifth dimension, Confucianism (long-term versus short-term orientation) (Hofstede, 2001). Literature proving the validity of his measures has been well-documented (Shane 1994, Kogut and Singh, 1988). While Hofstedes research is not without its critics, many scholars use his data to determine cross-cultural variations. This paper further explores Hofstedes dimension of power distance to develop theory behind the cultural influences of FDI. Power distance represents human inequality in laws, rights, rules, prestige, wealth, and power and can be applied to all levels of aggregation: from the small group to society as a whole. “Culture sets the level of power distance at which the tendency of the powerful to maintain or increase power distances and the tendency of the less powerful to reduce them will find their equilibrium” (Hofstede, 2001, p. 83-84). While Hofstedes power distance index comes from data from the late sixties and early seventies, others have empirically correlated his index to newer data, suggesting that change in the index applied to cultures over the past several decades is not a critical factor (Hofstede, 2001). Hoppe (1993) administered the 1982 Values Survey Module in 1993 and 1994, which contained three of Hofstedes power distance (PDI) questions, to 1,590 high level elites from seventeen different countries plus Turkey and the United States who held positions in areas of academia, government, the arts and professions, the media, not-for-profit industries, business and industry. Using the Spearman rank correlation, results indicated that the PDI questions were highly correlated with Hofstedes original results, r =.67* (Hofstede, 2001). Helmreich and Merritt (1998) administered the same questions to more than 15,000 commercial airline pilots from 36 companies in 23 countries between 1993 and 1997. Once again, the results were highly correlated with Hofstedes original results (r =.76*) (Hofstede, 2001).Shane and Venkataraman (1996) administered the original power distance questions in a survey of more than 6,000 employees of six organizations in 28 countries in 1991 and 1992. Correlations between these results and Hostedes original results were significant (r = .59*) (Hofstede, 2001). These correlations provide evidence of the validity of the power distance dimension and warrant further exploration into the impact of large or small power distance within a county. Small power distant societies feel that inequalities among people should be minimized, parents and children should treat each other as equals, more educated persons hold less authoritarian views than less educated persons, hierarchy in organizations means an inequality of roles, decentralization is popular, and there should be interdependence between less and more powerful people. In contrast, in large power distant societies, inequalities among people are expected and desired. Centralization and hierarchies are popular, the ideal boss is a benevolent autocrat or good father, children treat parents with respect, parents teach children obedience, and hierarchy in organizations reflects the existential inequality between bosses and subordinates.Power distant societies can be characterized as more hierarchical and bureaucratic (Shane, 1994). Small power distant societies are more likely to be market-oriented and less likely to be bureaucratic than large power distant societies (Shane, 1994). Large power distance results in greater transaction costs which discourage FDI (Heuer, et. al. 1999). In large power distant societies, for any given transaction, transaction costs are greater than in small power distant societies (Shane, 1992). Transaction costs, bureaucratic controls, and hierarchies could adversely impact both the inward and outward flow of FDI. Based on these theories, this research proposes that in small power distant societies, the inward and outward flow of FDI could be greater than in large power distant societies. HYPHOTHESIS 1: The inward flow of FDI will be greater in small power distant societies than in large power distant societies. HYPOTHESIS 2: The outward flow of FDI will be greater in low power distant societies than in high power distant societies.Hofstede (1980) found that power distance, which represents the extent to which the members of a society expect power to be distributed equally in organizations and institutions, also represents societal trust. He noted that large power distant societies exhibit low interpersonal trust and a great need for controls on individual behaviors. This finding supports evidence from other researchers (Shane 1994). Knack and Keefer (1997) note that small power distance along lines of class and ethnicity is associated with the development of cooperative norms and trust. Micro-level trust relations are constrained and enhanced by macro processes (Rousseau et. al., 1998). Therefore, interpersonal and inter-organizational trust could be constrained and enhanced by institutional or societal trust (Rousseau et. al., 1998). Based on the hypotheses that power distance is inversely related to levels of interpersonal trust, this research proposes that large power distant societies are characterized by lower levels of trust, while the inverse is true for small power distant societies. HYPOTHESIS 3: Large distant societies are characterized by low levels of interpersonal trust, while small power distant societies are characterized by higher levels of interpersonal trust.The concept of trust has received significant attention from scholars from various fields, which include social psychology, sociology, organizational behavior, strategic management, international business, and economics (Luo, 2000). This very complex phenomenon has many facets and levels, which include multilevel trust (individual, group, firm, and institutional), multi-disciplinary, the multiple causal roles of trust (trust as a cause, outcome, and moderator), and trust as impacted by organizational change (Rousseau, 1998). Young-Ybarra and Wiersema (1999: p.445) found that “the social exchange literature suggests that two main sources of trust exist. One is a result of reputation while the other resides in sharing similar values.” They further found that communication and shared values were significant factors influencing trust, while previous relations and attachment were insignificant. This finding relates to results from studies of cultural distance. Theory on cultural distance posits that cultures with more similar values have less cultural distance (Kogut and Singh,1988), and similar values are a source of trust (Young-Ybarra and Wiersema, 1999). When cultural distance between two parties is shorter, cultural blending becomes easier (Luo 2002), which stimulates the development of common values and norms and strengthens existing trust (Das and Teng 1998). Trust has also been linked to the institutions and demographics of a country. Knack and Keefer (1997) employed a measure of interpersonal trust from the World Values Surveys (Inglehart et. al., 1998), and found that interpersonal trust is stronger in nations with higher and more equal incomes, with institutions that constrain predatory actions of chief executives, and with better educated and ethnically homogeneous populations. Greater trust results in greater levels of cooperation and lesser levels of opportunism within and between cultures. Doney and her colleag