FLEXIBILITY IN INTERNATIONALIZATION IS IT VALUABLE DURING AN ECONOMIC CRISIS

FLEXIBILITY IN INTERNATIONALIZATION: IS IT VALUABLE DURING AN ECONOMIC CRISIS? Seung-Hyun Lee University of Texas at Dallas School of Management 2601 N. Floyd Rd. Box 830688 JO 5.1 Richardson, TX 75083-0688 Tel: (972) 883-6267 Fax: (972) 883-2799 E-mail: lee.1085@utdallas.edu Mona Makhija Fisher College of Business The Ohio State University 724 Fisher Hall 2100 Neil Avenue Columbus, OH 43210 Tel: (614) 292-8692 Fax: (614) 292-7062 makhija.2@osu.edu July, 2008 Forthcoming at Strategic Management Journal We thank Asli Arikan, Ilgaz Arikan, Jay Barney, Dong Lee, Michael Leiblein, Seongyeon Lim, Anil Makhija, Mike Peng, Jeff Reuer, Oded Shenkar, and Heli Wang and participants at the Fisher College of Business seminar series for their helpful comments on previous versions of this paper. We also thank Ed Zajac and two very thoughtful reviewers for their insightful observations regarding this manuscript. This research was supported by the Graduate School of The Ohio State University. FLEXIBILITY IN INTERNATIONALIZATION: IS IT VALUABLE DURING AN ECONOMIC CRISIS? Abstract This paper investigates the value of the strategic flexibility provided by firms’ international investments during an economic crisis, defined here as an unanticipated significant downturn in the economy. To avoid below par performance, firms need to adapt quickly to this significant change in their environment, making real options very valuable to them. Although firms’ international investments can potentially provide such flexibility, this issue has not been empirically examined in a context of such dramatic negative change. We consider two types of international investments by firms in this regard, foreign direct investments and export-related international investments, developing two measures that directly assess the flexibility derived from each that are new to the literature. Based on these measures, we find evidence that both types of international investments provided valuable flexibility for Korean firms during the economic crisis conditions. This study contributes to the literature by showing that firms with real options investments in place have a greater ability to flexibly adapt its overall operations in line with unforeseen negative environmental change, in contrast to firms without such investments. FLEXIBILITY IN INTERNATIONALIZATION: IS IT VALUABLE DURING AN ECONOMIC CRISIS? An economic crisis in a firm’s market can cause unpredictable, fundamental downward shifts in the level of demand and in the relative costs of inputs, causing firms to scramble to adjust or even to radically reconfigure their value chains in response to threats to profitable production (Kogut, 1991, 1994). The dilemma is that the likelihood of such a threat occurring is mostly unknown to the firm, making it difficult to know in advance how to configure its current investments so that they can be addressed. Researchers have noted that successfully competing in markets characterized by such instability requires resources, capabilities and strategies that are fundamentally different from those that are likely to lead to success in more stable markets (Bowman and Hurry, 1993; Kogut, 2001). In particular, a firm with the flexibility to respond advantageously to unanticipated adverse changes in its environment will be better off than a firm locked into a single course of action (Foss, 1998; March, 1991). Firms can make a variety of investments that expand the range of potential actions they can take to deal with unanticipated yet significant downturn in their operating environment, such as an economic crisis (Sanchez, 1993, 1995). Investments in research and development, for example, allow the firm to change product attributes more rapidly than their competitors (McGrath, 1997; Pakes, 1986; Amram and Kulatilaka, 1998). Flexible manufacturing capabilities let the firm adapt product configurations to unknown future demand (Worren, Moore and Cardona, 2002). Similarly, firms’ international investments can also be vehicles of strategic flexibility, providing preferential access to rent-enhancing future opportunities across national contexts (Mello, Parsons and Triantis, 1995; Tang and Tikoo, 1999; Allen and Pantzalis, 1996). Firms with an established exporting infrastructure allows them to respond rapidly to unanticipated downward changes in demand in both domestic and international markets (Roberts 2 and Tybout, 1997), by shifting sales from the less beneficial markets to new customers in other more beneficial markets. By the same token, firms can use their existing configuration of international investments, consisting of both foreign direct investments (Campa, 1994; Dunning, 1980) and exporting investments (Broll, 1999; Roberts and Tybout, 1997), to adapt their operations to unanticipated threats in ways not possible without such investments already in place (Tang and Tikoo, 1999). Firms with production facilities located in multiple countries can benefit from their ability to change production locations in response to unexpected adverse changes in any given country, such as increases in labor costs or exchange rate volatility (Reuer and Leiblein, 2000; Kogut and Kulatilaka, 1994), as well as increased political risks (Makhija, 1993). Despite ample evidence in the literature that managers are primarily concerned with mitigating the downside effects of uncertainty (Kahneman and Tversky, 1979; Miller and Reuer; 1996), there is relatively little empirical evidence on the value of options associated with international investments that give rise to flexibility under such conditions. This is understandable in light of the challenging requirements for a viable experiment to test for this issue, which include: (1) a sizeable sample of firms that differ in their configuration of international investments, (2) a definable moment when the rate of change shifts in a dramatically adverse direction, permitting comparisons of periods reflecting economic stability and economic crisis, and (3) measurable ex post performance outcomes for the differing ex ante strategies. If international investments help firms to exercise flexibility under unanticipated adverse conditions, this flexibility would be associated with higher firm value under such conditions, allowing them to outperform firms without such investments. Since international flexibility is less beneficial under conditions of relative stability, we would not expect it to be 3 associated with higher firm value during this time. The purpose of this paper is to investigate this issue. Specifically, our objectives are (a) to assess whether firms’ international investments provide flexibility under the downside conditions of uncertainty, and (b) to analyze whether the flexibility afforded by these international investments are associated with higher firm value under these conditions. We examine these objectives in the context of a naturally occurring experiment embedded in the Asian economic crisis experienced by Korean firms. We utilize a large sample of 552 publicly traded firms listed on the Korean Stock Exchange (KSE) during 1996-1998, which includes the period of the Asian economic crisis that began suddenly towards the end of 1997 and became full-blown in 1998. According to analysts' and news reports at the time, the crisis was highly unanticipated (Ang and Ma, 2001), providing another crucial feature for our investigation. Given the prevalence of both exporting and foreign direct investments by Korean firms, our sizeable sample permits a study of the differential flexibility effects of both types of international investments, which has not been previously considered. To do so, we develop two new measures of flexibility relating to each type of investment, one reflecting shifts in production among firms’ foreign subsidiaries, and the other reflecting the proportion of export sales to new and non-routine customers. These measures provide a more direct assessment of flexibility than previously demonstrated in the literature. These measures contrast with those in prior research that simply impute flexibility from the level of international investments by a firm. Our findings lend credence to the argument that international investments provide valueenhancing flexibility benefits in an economic crisis in comparison to conditions of stability. 4 PRIOR WORK ON INTERNATIONAL INVESTMENTS AND FLEXIBILITY Conceptual Underpinnings International investments, including those relating to exporting and foreign direct investment, have been recognized as having the ability to provide flexibility under uncertainty by a number of researchers, including Broll (1999), Kogut (1983, 1985), Bowman and Hurry (1993), and others. The underlying argument is generally based on real options logic. For example, a firm that has made investments in exporting is able to allocate sales of its domestic production among both domestic and foreign markets. In the face of extreme exchange rate change (Broll and Eckwert, 1999), or a rapid decline in domestic demand, the firm’s ability to shift lost domestic sales to foreign markets increases the value of their exporting related investments. The flexibility inherent in a firm’s exporting infrastructure can be seen in the case of currency fluctuation. When the domestic currency depreciates significantly relative to another currency, exporting can be increased in line with more advantageous realized prices elsewhere. When the domestic currency appreciates relative to another currency, exporting can be switched to other more markets that are less affected by this change or to the domestic market. When the exchange rate once again permits profitable exports, the firm resumes exporting (Broll and Eckwert, 1999). In either case, the firm has opportunities to recover the loss due to decreased domestic or foreign demand by focusing on other markets in which it has already established exporting infrastructure. In contrast to export-related investments, foreign direct investment involves the establishment of subsidiaries or affiliates in foreign locations. Due to the fact that its operations are distributed across multiple geographic locations, a multinational firm can respond to country- 5 specific negative environmental shocks and fluctuations by shifting factors of production across national borders (Kogut and Kulatilaka, 1994). Direct investments have several features that give rise to flexibilities that are different from pure exporting investments. First, they can maximize profit by shifting production to locations with more beneficial cost structures (Tang and Tikoo, 1999). For example, if an environmental change causes the labor costs in a given location to rise, a firm with operational flexibility can shift labor-intensive operations to other lower-cost locations. As noted by Little (1986: 46), firms with operations in multiple countries “possess an extra degree of flexibility in adjusting to a new competition situation. These multinationals can … expand output where relative production costs are falling… Accordingly, intra-firm trade might be expected to adjust more quickly to an exchange rate change than would trade between unaffiliated and noncooperating firms.” Second, multinational firms may be able to vary the locations in which to declare profits, depending on differential taxation and permissible transfer pricing policies in the countries in which they operate. Third, they can modify the locations in which to concentrate market power, depending on competitive forces. Hamel and Prahalad (1995) also note that multinational firms have the ability to cross-subsidize their operations, flexibly allocating profits of some subsidiaries to support others experiencing unexpected environmental downturns. Due to such cross-border intra-firm linkages, it is possible for multinational firms to take a sudden downturn of an economy as an opportunity to produce at low cost and expand production at the low-cost subsidiaries while decreasing production in high-cost subsidiaries (Tang & Madan, 2003). While such operational flexibility is of potential value to the firm, it must be recognized that managing a multinational network of subsidiaries is associated with higher costs as well (Rangan, 1998). The complexity of managing such a network can offset the benefits of the flexibility of multinational network. Hitt, Hoskisson and Kim (1997) point to the large 6 transactions costs associated with the myriad of country-specific transactions in a given subsidiary, including those associated with the number of suppliers, customers, distributors and government agencies, to name a few. In addition, the implementation of decisions to transfer production is not typically clear cut. Transportation costs, changes in export and import duties, and variations in deals made with the government, for example, may make it difficult to determine the true costs of switching production from one location to another. Finally, the ability to transfer production from one location to another depends on the nature of the specific operations in each country. To the extent that the firm's factories in different countries are geared towards satisfying country-specific demand, the potential for transferring production from one country to another is greatly limited (Rangan, 1998). In sum, while the potential for operational flexibility may be enhanced by multinational operations across multiple countries, firms need to configure operations in a way that such benefits exceed the costs of managing the multinational network. Prior Empirical Evidence on the Operational Flexibility of International Investments The empirical evidence on the operational flexibility of international investments is both limited and mixed. For example, both Allen and Pantzalis (1996) and Tang and Tikoo (1999) find support for operational flexibility in their studies of breadth and depth of multinational networks. They indicate that firms with a broad distribution of subsidiaries across many national contexts are associated with higher market value than those characterized by a higher concentration of subsidiaries in a single country. Miller and Reuer (1998) also show some evidence of benefits of flexibility derived from exchange rate risk in the pricing strategies of a small percentage of U.S. manufacturing firms. In contrast, Reuer and Leiblein (2000) observe that greater multinationality does not help firms to reduce downside risk. Instead, they find that 7 such investments result in higher bankruptcy and income stream risks. Rangan (1998) finds that firms attempt to manage flexibly, but the need for localization in their foreign direct investment has the effect of impeding intended flexibility. In addition, Campa's (1994) study on multinational investment under uncertainty provides support for the notion that such firms invest abroad for the purposes of risk diversification rather than operational flexibility. Clearly, the conflicting findings of these studies point to the need for further investigation of the value of flexibility stemming from firms’ international investments. Since real options researchers have argued flexibility is of greater value when firms face higher uncertainty, the external conditions under which international investments are examined is extremely important. Miller and Reuer (1996), however, point out that managers are not simply concerned about uncertainty per se. Drawing on the literatures of behavioral decision theory, finance and management, they note that the primary concern of managers is to minimize the potential for downside outcomes, as these are likely to result in below target performance. Despite this, much of the prior empirical work discussed above has not tended to examine multinational flexibility under specific conditions of unanticipated environmental downturns, and instead, are concerned with a general notion of uncertainty. At the same time, it is often assumed that exchange rate risks are the greatest source of uncertainty faced by multinational firms. It is not clear if exchange risk is always a source of great uncertainty, however, especially when firms are often able to hedge these risks (Allayannis and Ofek, 2001; Click and Coval, 2002). In contrast, extreme and negative unanticipated changes in industry context, political risks, and operational conditions are likely to have larger implications for the firm’s need for flexibility (Allen and Pantzalis, 1996; Tang and Tikoo, 1999). In line with this argument and those of Miller and Reuer (1996) above, it would be useful to examine operational flexibility in the context of an unanticipated yet significant economic 8 downturn, such as an economic crisis. A focus on an economic crisis reflects the downside aspects of uncertainty, and in doing so, better reflects the concerns of decision makers within firms and the circumstances under which they would most highly value flexibility. Nonetheless, no research thus far has utilized such a context to investigate international flexibility. It is also interesting that past research, while informative, has tended to treat firms’ possession of international investments the same as firms’ having operational flexibility. As noted by Rangan (1998), however, the two need not be the same. International investments that are designed to maximize local responsiveness, for example, are not likely to provide the firm with the ability to switch operations from one country to another. An MNC that has subsidiaries in different countries can be overwhelmed by the complexity of coordinating different operations (Rugman & Verbeke, 2004; Tong & Reuer, 2006), which may reduce the benefits of operational flexibility that the MNCs hope to have (Doukas & Pantzalis, 2003; Roth, Schwiger, & Morrison, 1991; Tong & Reuer, 2006). It may also be the case that the value of nationally dispersed international investments reflects the benefits of diversification rather than operational flexibility (Rugman, 1979). In this sense, just having subsidiaries in different countries may not be enough for assessing operational flexibility. Instead, it is important to measure the actual flexibility associated with international investments, indicated in the literature as the ability of the firm to quickly shift production to different international locations or shift sales to new international customers. However, to date no research has directly measured international flexibility in this manner. It is also important to note that, since virtually all of the prior studies have focused only on foreign direct investment, the literature currently offers little or no evidence on the value of exporting, or on the relative flexibility benefits of differing combinations of international investments. While exporting entails fewer costs and is the preferred mode of entry for firms 9 without extensive international experience (Broll, 1999), foreign direct investment is associated with potentially higher costs and benefits (Aulakh et al., 2000; Chang, 1995; Chang and Rosenzweig, 2001). It remains an empirical question, then, which is a preferable source of flexibility for firms. In addition, because firms often use a combination of the two, there may be synergistic benefits among them. In this research, we attempt to address each of these concerns. The next section develops three sets of testable hypotheses assessing the value of flexibility stemming from two types of international investments of Korean firms, followed by tests using two new direct measures of international flexibility in the context of a severe economic crisis. HYPOTHESES DEVELOPMENT Value of Flexibility Afforded by Exporting Investments As we noted earlier, exporting involves production in one national market, often the home country of a firm, and sales in other national markets. In order to engage in exporting, firms must invest in overseas relationships and the infrastructure necessary for selling their products. The investment costs associated with exporting include market research, procurement of export licenses that involve governmental review processes, the development of a distribution network possibly facilitated through local distributors, training and machinery for adapting the product as necessary to local tastes and requirements, among others. These costs, while nontrivial, allow the firm to initiate the exporting process. Without such investments in position, opportunities that arise due to unanticipated changes in exchange rates, economic conditions or consumer demand, cannot be taken advantage of immediately. In this way, the investing firm obtains preferential access to opportunities compared to competitors who did not make these investments. 10 In comparison to foreign direct investment, exporting investments typically require lower initial and subsequent capital outlays. These lower capital outlays are due to the fact that a single domestic factory can usually provide a production platform geared towards several other countries. In contrast, both wholly-owned and joint venture foreign direct investments In addition, necessitate upfront investment into productive capacity in specific countries. exporting investments are significantly oriented towards building of relationships with distributors and partners in other countries, which also reduces the risks of adverse outcomes. Such relationships not only help the firm to share risks associated with market entry, they also allow the firm to focus on its own core capabilities and benefit from those of its partners. Exporting investments provide the firm with flexibility by providing a foothold into another country’s market. It can take the form of a trial entry into the country, without necessarily having to be large. Structuring the investment in this manner cushions downside risks of future investment in the following way. If conditions in one country become adverse to the firm, as in the event of an economic crisis, the firm may elect to stop further investment and limit losses to the (relatively low) sunk costs associated with the discontinued project (McGrath, 1997). Instead of being tied down to a market characterized by such a downturn in demand, it can use this opportunity to expand its initial investments in other more promising markets. Firms can now use its already existing investments to switch sales to new customers located in these markets. Without the initial foothold investment, however, it would be difficult for the firm to identify and lock onto new customers in these markets. The procuring of significant new international customers requires a priori investments into market research and distributor relationships. In this way, a priori exporting investments allow firms to maintain high sales in the face of an unanticipated economic crisis. In light of this argument, we present the following hypothesis: 11 Hypothesis 1: During a period of economic crisis, flexibility afforded by firms’ exporting investments will be positively associated with firm value. It is important to note that, in contrast to the above, firms would not benefit as much from the flexibility created by export-related investments during periods characterized by relative economic stability. Since there is no need for flexibility under such conditions, the possession of flexibility-creating investments would therefore not provide firms with additional value. Under conditions of stability, then, the flexibility associated with export-related investments would likely be associated with negligible firm value. Value of Flexibility Afforded by Foreign Direct Investments Firms can also invest in productive capacity across multiple countries, creating a multinational network that draws from localized factors of production as well as intra-firm leveraging of relationships, assets and capabilities (Rangan, 1998). Although such foreign direct investment may also require the firm to invest in local market research and distribution relationships in a manner similar to exporting investment, a main distinction between the two is the role of investment in country-based productive assets. Once in place, foreign direct investments provide preferential access to opportunities from which the firm would otherwise be isolated. Some of these are similar to exporting, including those stemming from changed economic conditions or consumer demand. However, they also allow the firm to benefit from an enhanced understanding of the local environment, and the deeper relationships with government officials, universities, workers and other local entities (Boasson, Boasson, MacPherson and Shin, 2005). The firm is also in a better position to exploit differences in production, labor, transportation and storage costs, etc. It may even reduce capital costs through better banking relations locally. Such benefits, which also could not occur without 12 the investment in place, allow the firm to take advantage of newly emerging local conditions more rapidly and with greater effectiveness than its competitors. As we noted above, rapidly changing global conditions can be a threat to the strategy of a firm. It is very difficult for firms to accurately forecast the direction of economies due to the inherent complexity underlying such change. Since the 1970s to the present, the number of countries undergoing economic crises has continued to be high, whether due to banking sector collapse, rapid currency devaluation, or some other issue (Dreher and Rupprech, 2007). In light of this, a critical feature of foreign direct investments can be the ability to wait and see how future conditions develop, and then adapt the investment accordingly. The initial investment made in the foreign country serves to hold the opportunity open for subsequent full scale commitment there. For example, a firm may wish to enter the large market of Russia. However, the path of the Russian economy has been unpredictable, government policies amenable to change, and the nature of capitalism evolving there quite unique. In light of this, such a firm wishing to take a long term view would find it valuable to make investments in a manner that preserve the right to take action in the future. Thus, foreign direct investments can confer the right to later decisions, made “when the time is right,” which would not have been feasible without prior investment. This includes abandoning the investment with only limited sunk cost if circumstances prove to be unpromising. While the initial capital outlays associated with foreign direct investment are likely to be substantially higher than those related to exporting, due to the need to invest in productive assets in each country and accompanying costs of hiring and training personnel and establishing operations in that country, firms derive important benefits that limit their downside risk. A multinational firm can spread its investments, keeping investments in any one country relatively low. It has the ability to leverage and arbitrage factors of production across national borders 13 (Kogut, 1983, 1985). In the event of negative changes in local demand, the firm can shift sales to other locations where prices are higher and/or demand is increasing. If input costs increase locally, production can also potentially be shifted elsewhere. These benefits help the firm throughout its value chain, rather than only its sales. This ability to flexibly shift production from one subsidiary location to other locations can be observed in changes in the firm’s intrafirm trade. In light of the arguments above, we expect that firms with foreign direct investments will have greater ability to exercise valuable flexibility in the event of an economic crisis. This flexibility stems from the ability derived from such investments to shift production from less beneficial markets to those that are more beneficial. Thus, Hypothesis 2: During a period of economic crisis, flexibility afforded by firms’ foreign direct investments will be positively associated with firm value. In contrast, we do not expect that in periods characterized by relative economic stability, the flexibility created by international investments will yield significant benefits to the firm. This is due to the fact that firms would not need to take advantage of flexibility under such periods. For this reason, under stable conditions the flexibility associated with such investments will add negligible firm value. The Relationship between Exporting and Foreign Direct Investments It has been noted that the value of a portfolio of options differs from that of individual options, by adding or subtracting additional value to individual options in line with characteristics of underlying assets and uncertainty conditions (Vassalo, Anand, & Folta, 2004). This is likely to apply in the case of those associated with international investments as well. Our discussion above noted overlapping benefits of flexibility associated with exporting and foreign 14 direct investments, particularly in terms of access to overseas markets. Both types of investments allow the firm to gain flexibility by limiting initial investments. In both cases, firms benefit from the ability to differentially apportion sales across multiple markets rapidly in response to threatening changes in demand in any given market. Once invested, firms are well situated to gain important insights into environmental conditions that can negatively affect their operations beyond those achieved by competitors who are not so well situated. At the same time, the two forms of international investments provide firms with differing benefits. As noted earlier, firms with overseas exporting relationships benefit from lower initial setup costs as well as reduced coordination costs in comparison to foreign direct investment. Export-related benefits also stem from the potential to increase efficiency of capital-intensive domestic operations. On the other hand, foreign direct investments provide benefits stemming from differentiated production capability across geographical locations. The ability to produce in specific overseas markets may reduce exchange rate exposure in comparison to exporting, due to lower need to export production across national boundaries (Williamson, 2001). This allows firms to benefit from the flexibility of exporting from other countries in which they have production-related investment, providing incrementally greater flexibility to the firm. Closer involvement with the local environment should also allow direct investors to engage in more learning in comparison to firms with only exporting related investments. In this way, the increased market-related knowledge and learning afforded by one type of investment can be leveraged to fine-tune the options associated with the use of the other type of investment. Such benefits can influence the adoption of globally integrated strategies on the part of firms, in which both exporting and production-related investments play a prominent role (Kobrin, 1991; Makhija et al., 1997). 15 In sum, we argue that the combination of the two types of international investments provides additional benefits of flexibility in comparison to those afforded by a single type of investment, since the options provided by one can enhance the value of the options provided by the other. We therefore expect a positive interaction effect between the two during an economic crisis (McGrath and Nerkar, 2004), reflecting the incremental additional value derived from the possession of both types of international investments. hypothesis: Hypothesis 3: During an economic crisis, there will be a positive interaction effect between the flexibility afforded by exporting and foreign direct investments on firm value. As we have noted before, under conditions of stability, firms' need for flexibility is far less important, and is likely to take a back seat to other goals associated with international expansion. Thus, the enhanced flexibility associated with the combination of exporting and foreign direct investment provides little incremental value to firms at this time. Thus, we propose the following DATA AND METHODS Data and Measurement of Variables The purpose of this research is to examine whether firms’ international investments provide them with valuable flexibility. To do so, we focused on Korean firms over (a) a period of relative economic stability (1997), and (b) the highly unstable period of the Korean economic crisis (1998). Although the Korean economic crisis began in late 1997, it was the year 1998 in which the economic crisis became full-blown, and therefore, the year of significant negative economic conditions for Korean firms. This crisis was largely unanticipated, as could be seen in numerous articles in both the Korean and international business press in the months and days 16 leading to the crisis. The Korean currency experienced unprecedented devaluation in comparison to other hard currencies, declining to less than 40% of its value by 1998. A massive decline in GDP also occurred in 1998 after years of extremely high growth rates, while inflation and unemployment rates more than doubled. Appendix A contains a more complete description of the origins of the Korean economic crisis. In comparison to 1998, the years of 1996 and 1997 reflect a period of relative stability. For this reason, this case provides an excellent opportunity to test the value of flexibility of Korean firms’ international investments under unanticipated adverse conditions. We use the WISEfn database of Korean firms, consisting of all publicly listed firms in the Korea Stock Exchange (KSE), and the Korea Listed Companies Association (KLCA) foreign affiliate database, covering the period of 1996-1998. Financial services firms are omitted due to differences in their accounting practices that make them incompatible with firms in other industries (Chang and Hong, 2000). Thus, the number of firms included in the analysis ranged from 455 in the 1996-97 period to 459 in the 1997-98 period. We control for chaebol membership in our analysis to take into account this unique organizational feature of Korean firms, identified through the Korea Fair Trade Commission (KFTC). Totals of 105 and 104 chaebol-affiliated firms were identified for the years of 1996 and 1997, respectively. In order to measure the flexibility afforded by firms’ international investments (the independent variables of concern), we required detailed information relating to the firms’ exports and intra-firm trade. We obtained this data from the quarterly and annual auditor reports provided by WISEfn.1 The data included total firm exports, transactions among all subsidiaries and parent, as well as export sales to existing long-term customers, for the firms listed in the KSE. While the auditor reports had intra-firm trade information, they did not include information 1 The authors would like to express their gratitude to WISEfn for giving them access to this data source. 17 on the location of the subsidiaries. We therefore undertook further investigation to determine their location, including whether they were domestic or foreign subsidiaries. Because we are interested in examining the value of intra-firm trade, we dropped transactions among the domestic subsidiaries. To find country information for each intra-firm transaction, we examined the company homepage and further searched for company news and affiliate/country information using LEXIS/NEXIS, and the KSE information website. Dependent Variable Due to our interest in assessing the value of the flexibility afforded by international investments, we use Tobin’s q as the dependent variable. As shown below, Tobin’s q is a standardized measure of the value ascribed to a firm by investors. While the denominator represents the investment input in the firm, the numerator captures the value created by the firm with these inputs. This is a particularly appropriate measure for assessing the value of flexibility because it is a “forward looking” measure that adjusts for risk. Alternative measures such as return on equity (ROE) are expected to differ across firms depending on the risk of the firm. Tobin’s q allows us to capture the value created from investments in flexibility after controlling for other traditionally recognized sources of value.2 We calculate Tobin’s q for 1997-98 in the manner suggested by Chung and Pruitt (1994), as follows: Market value of common stock+ book value of preferred stock + book value of debt Book value of total assets 2 Tobin’s q is a widely used measure of value creation because it incorporates market valuation relative to investment input (book assets). Because the gain in market value over the book value also represents the growth potential of the firm, the interpretation of Tobin’s q is consistent with the growth potential associated with flexibility. Another interpretation of Tobin’s q is that the market value of the firm depends on the growth potential and the efficiency of management to actualize it. This interpretation of Tobin’s q as a performance measure is also consistent with our needs, as it reflects the ability of the firm to take actions in the future. On empirical grounds, the Chung and Pruitt (1994) measure proxies the strict definition of Tobin’s q, which replaces replacement value in the denominator with book value of total assets. Even so, the Chung and Pruitt measure is known to be highly correlated (over 90%) with this strict measure. 18 Market value of common stock is calculated as the year-end share price multiplied by the number of shares outstanding. Independent Variables: Flexibility Associated with International Investments Measure of flexibility relating to exporting investments. The flexibility of a firm’s exporting investments is seen in the extent to which the firm is able to sell its products abroad (i.e., export) to non-routine and new international customers. To assess this using the available data, we first subtracted the firm’s export sales to its foreign subsidiaries and to existing longterm customers from its total export sales. We then divided the resulting value by the firm’s total export sales. The resulting value provides us with proportion of the firm’s export sales that was newly developed to cope with the sudden downturn of the Korean economy. Thus, the following measure is used to proxy exporting flexibility: [total exports — (exports to foreign subsidiaries + exports to significant and regular foreign customers)] / total exports. Measure of flexibility relating to foreign direct investments. In order to assess the firm’s activities of shifting or switching its production or sales from one location to another (i.e., act flexibly), we developed a measure that takes into account changes in the firm’s intra-firm sales from the previous period to the focal period (i.e., 1997 to 1998, 1996 to 1997).3 Intra-firm trade is measured as the total of all the transactions (both sales and purchase) among foreign subsidiaries and between subsidiaries and headquarters in Korea in a given year (for a similar measure, see Kobrin, 1991). The inclusion of the transactions between headquarters and foreign subsidiaries is particularly relevant since the economic crisis occurred in Korea. Thus, our measure of multinational flexibility for 1997 is (intra-firm sales in 1997 — intra-firm sales in 1996) / intra-firm sales in 1996. For 1998, it would be (1998-1997)/1997. 19 Note that for both measures of flexibility, a one-year lag was used to measure change, consistent with the expectation that flexibility-affording investments already in place allow firms to respond extremely rapidly to future unforeseen events. For this reason, a longer time window would not be as satisfying a test of this theoretical perspective. Measure of interaction between exporting and multinational flexibility. In developing the interaction between the two variables above, exporting flexibility and multinational flexibility, we centered the two variables by using deviations around the mean to minimize potential multicollinearity following Ito (1997) and Neter, Wasserman, & Kunter (1985). . Independent Variables: Control Variables To separate out the value effects of international investments from those stemming from other factors, we include a number of control variables in our analysis. The firm's past performance, for example, can confound current performance, and we therefore controlled for it by including the firm’s prior year Tobin's q in the equation. Inclusion of past performance as a control variable also serves as an insurance against omission of important determinants of firm profitability in a stable period, so that we can focus on the contribution of the value of flexibility afforded by international investments in a period of an economic crisis. Firm size may affect performance in that larger firms contain resources that can mitigate the effects of an adverse environmental condition such as an economic crisis. We therefore control for this effect by including the log of total assets, converted to 1998 US$ at the current exchange rate based on International Financial Statistics (IMF, 1998). Firm indebtedness can also influence our results. On the one hand, higher leverage may convey financial distress, which would predict a negative sign. On the other hand, greater debt holdings in the capital-poor environment of the economic crisis may reflect confidence and certification on the part of banks 3 Rangan (1998) also refers to a similar construct, but at the country level. Others that have used intra-firm trade as a 20 and other lenders (Cole and Park, 1983; Saraswathy and Chatterjee, 1984; Makhija, 2003). 4 Lower age of a firm may reflect an inability to develop a network of international investments, but may also reflect the agility of a more entrepreneurial or new firm, so this was controlled for as well. Chaebol firms differ significantly from other Korean firms in a number of ways. They tend to be larger and more international, and may also enjoy preferential treatment and cheaper loans during this period (Cole and Park, 1983). Because these attributes may influence their international strategies, we chose to control for this type of membership as well. We also controlled for the number of foreign countries in which the firm had investments to control for other potential benefits coming from investing abroad (Allen & Pantzalis, 1996; Mansi & Reeb, 2002; Rugman, 1979). Finally, since industry attributes can influence the value of international investments, we control for this effect by including industry competition and industry capital intensity. While greater rivalry may imply a negative effect on 1998 Tobin's q, it may also be that firms facing greater competition are likely to display more aggressive and flexible responses during crisis compared with other firms in less threatening environments. To better represent the firms in an industry, for our sample we totaled the domestic firms listed in KSE and KOSDAQ plus the number of foreign firms in each industry. Data from KOSDAQ (equivalent to NASDAQ in the United States) was also acquired from WISEfn. Information on foreign firms in Korea was collected using Foreign Business Contacts in Korea 2003, including only those firms that were established by 1996. Industries are classified according to the Korean Standard Industrial Classification (KSIC) at the two-digit level. By the same token, capital intensity of the industry may influence the firm’s tendency to pursue international strategies for the purposes of economies of scale, so this was controlled for construct are Eichengreen and Bayoumi (1999) and Rana (2007). 21 as well. Industry capital intensity is measured by average industry fixed capital as a proportion of average industry total assets. Finally, we controlled for the number of countries in which the firm operates. Doing so allows us to assess the extent of the firm’s international presence. The approach taken here is arguably a conservative one since this and other control variables (e.g., size) may have multicollinearity with the variables of interest, relating to international flexibility. Test Specification The relationships outlined in the hypotheses are tested with a cross-sectional linear regression methodology, with White’s adjustment for heteroskedasticity (STATA 7, 2001). Following Miller and Leiblein (1996), we use separate equations for the two different years representing the periods of relative stability and economic crisis. The specific cross-sectional regression equation with the variables related to hypotheses 1 and 2 are as follows for firm i (with the eight control variables listed first): Tobin’s q 1998 = α + β Tobin's q 97 + γ Firm Age97 + δ Log of Total Assets97 + ε Debt/Assets 97 + ζ No. of Competitors97 + η Cap Intensity97 + θ Chaebol dummy + ι No. of subsidiaries + κ Exporting Flexibility 98 + λ Multinational Flexibility 98 + e The equation relating to hypotheses 3 takes the following form: Tobin’s q 1998 = α + β Tobin's q 97 + γ Firm Age97 + δ Log of Total Assets97 + ε Debt/Assets 97 + ζ No. of Competitors97 + η Cap Intensity97 + θ Chaebol dummy + ι No. of subsidiaries + κ Exporting Flexibility 98 + λ Multinational Flexibility 98 + µ interaction term + e where the interaction term is Exporting Flexibility98*Multinational Flexibility98. (2) (1) 4 We chose debt/fixed assets as our measure of leverage as it better captures investment-related debt of Korean firms. 22 RESULTS AND DISCUSSION Prior to testing our three sets of hypotheses, we examine the potential for multicollinearity in Table 1 with correlation coefficients between our independent variables. According to Judge, Griffith, Hill and Lee (1980, p. 459), the rule of thumb for problematic multicollinearity is a correlation coefficient value of 0.8 or more. The mean variance inflation factor (VIF) is 1.31, with the highest VIF being 2.10. This suggests that multicollinearity is of little concern due to the fact that the VIF values are less than 10, which is the cutoff usually used to check for problematic multicollinearity. Overall, multicollinearity does not appear to be an issue for our set of independent variables. Insert Table 1 The Base Model We begin by discussing the results for the base model, which contains only the control variables, for each of the two periods of interest. Table 2 contains these findings, with Panel A relating to the economic crisis period of 1998 and Panel B to the relatively stable period of 1997. Estimation 1 shows that during the crisis period, three of the eight control variables contributed significantly to firm value. Although we do not make explicit predictions regarding our control variables, we find that some of them played the role we might expect, while others did not. The coefficient for "tobin's q 1997" is positive and significant at the 1% level, indicating that the past year's profitability influences 1998 profitability. It appears that, during a crisis age may be a liability, seen in its negative coefficient, significant at 1%. We also find that number of competitors affects firm, but in a positive direction, significant at 5%. This suggests that firms that are used to dealing with competition are likely to have skills that are helpful to them during crisis times. We find, however, that firm size does not make a difference to firm profitability, in 23 light of the fact that “log of assets” remains insignificant. Our findings also show that the level of “firm debt” does not play a significant role in our analysis, despite evidence in other research that firms with greater debt have a stronger certification from banks and other lenders (Cole and Park, 1983; Saraswathy and Chatterjee, 1984; Makhija, 2003), which may be of value in a period of flux. We had controlled for “industry capital intensity" to address the possibility that firms in industries with high capital intensity may have greater benefit in exploiting economies of scale and reduced costs. However, this variable did not show itself to be significant in the analysis. We had also controlled for the number of countries in which the firm operates, and found that, interestingly, this variable does not influence firm value during a crisis. Thus, the international presence of the firm per se does not contribute to value during such conditions. The findings for control variables remained largely consistent across estimations for the period of economic crisis. Insert Table 2 In contrast to the one for the period of economic crisis, the base model for the period of stability in estimation 4 indicates that virtually all the control variables are important in explaining firm value. We find that several of the control variables that were not significant above are now significant, along with Tobin’s q for 1996 and age. This interesting finding suggests that flexibility effects associated with smaller size, greater ability to procure funding, potential to reap economies of scale, and international presence, are not adequate sources of value in a period of economic crisis, but they are during a period of stability. The significance of international presence, measured by number of countries in which the firm has a presence, may reflect diversification benefits of international operations (Rugman, 1979). These results underscore the differences in the sources of firm value under conditions of economic stability and crisis, and the importance of considering other sources of flexibility for the firm under 24 conditions of economic crisis. It is clear that traditional sources of firm flexibility, reflected in our control variables, are not adequate in helping firms cope under conditions of extreme change. In our sample of Korean firms, the presence of chaebol members can also potentially influence our results. The value of chaebol members may differ from that of other firms during economic crises, simply because they are uniquely structured. Researchers have noted that membership in such an extensive network is valuable due to access to resources not available to other firms during such crises (Guillen, 2002; Chang, 1995; Axelsson and Johanson, 1992). Consequently, we included a (0,1) dummy variable for chaebol membership. Throughout our analysis, however, this dummy is statistically insignificant. We do not find that chaebol membership itself contributes to additional value in this period of economic crisis. It may be the case that firms are unable to reap additional benefit from their membership in chaebols during a period of such great flux, since all member firms are experiencing the same negative conditions. Hypothesis 1: Value of Flexibility afforded by Exporting Investments under Economic Crisis In Table 2, Panel A, we test hypothesis 1 in which we argued that the flexibility afforded by firms’ exporting investments are valuable under conditions of an economic crisis. Along with the set of control variables, the variable of particular interest for this hypothesis is "exporting flexibility." As can be seen in estimation 2, the coefficient for "exporting flexibility" is positive (coefficient value of 3.882) and significant at the 5% level. Given a mean value of Tobin’s q of 1.00 for 1998, the exporting flexibility afforded by firms’ international investments adds an economically meaningful 3.88% to the value of the firm during this period of economic crisis. Hypothesis 1 is therefore supported by our findings. These and other results are examined for their economic significance in a subsequent section, and are found to be meaningfully valuable. 25 In relation to Hypothesis 1, we also argued that exporting flexibility would not contribute to firm value during a period of stability. Estimation 5 in Panel B, Table 2, shows findings in relation to this notion. In contrast to those of Panel A, the results for “exporting flexibility” here show that this variable in fact has a negative, albeit weak, influence on firm value (coefficient of -4.519), significant at 10%. While exporting flexibility provides value to firms in an economic crisis, they appear to destroy some value in a period of stability. It suggests that dropping established export customers for new ones during stable times is not a valuable endeavor (Mascarenhas, 1986; Ito, 1997). We find these findings to be consistent with our argument. Hypothesis 2: Value of Flexibility afforded by Foreign Direct Investments under Economic Crisis Hypothesis 2 was concerned with the flexibility benefits of firms’ already established foreign direct investments under conditions of an economic crisis. The variable of interest in this case is “multinational flexibility,” which reflects the change in intra-firm trade occurring within the firm’s multinational network of subsidiaries. The findings associated with this hypothesis are seen in estimation 2 in Table 2, Panel A. The findings indicate that for the period of the economic crisis, “multinational flexibility” is both positive (coefficient is .001) and highly significant at 1%. These results support the notion that the flexibility afforded by firms’ foreign direct investments contribute significantly to firm value during a period of economic crisis. Thus, hypothesis 2 is supported. In relation to Hypothesis 2, we argued that firms’ already established foreign direct investments would not contribute to firm value in a period of stability. The finding in relation to this argument can be seen in estimation 5 in Panel B. flexibility” loses significance completely. In this estimation, “multinational This finding supports our argument that firms’ multinational network does not contribute valuable flexibility during a period during stability. 26 Hypothesis 3: Interaction between Exporting and Multinational Flexibility According to hypothesis 3, we should expect a positive interaction effect between the flexibility afforded by exporting and foreign direct investment during an economic crisis. This is because each type provides benefits that are complementary as well as overlapping, enhancing the flexibility of any one type that will be valuable during such unsettled conditions. We introduced an interaction term between exporting flexibility and multinational flexibility in estimation 3 of Table 2, Panel A. We find that this term has a significant (at 5 percent) and positive (coefficient is 5.451) relationship to firm value in this estimation. This suggests that there is an important additive effect of one type of flexibility on the other, and that firms with both types of international investments are able to use the combination of the two more successfully for achieving flexibility than firms with only one type in an economic crisis. Thus, hypothesis 3 is supported as well. Note that, as expected, the value-enhancing role of exporting and multinational flexibility continues to be supported. In relation to Hypothesis 3, we had noted that the above relationship would not hold in a period of relative stability. That is, the interactive effects of the flexibility afforded by a combination of exporting and foreign direct investment would not be valuable during such a period. We expect this to be the case due to the argument that firms do not need increased flexibility during periods of stability. This result is given in estimation 6 of Table 2, Panel B. We find that the interaction term is insignificant here, supporting our argument. Marginal Effects In order to assess the economic significance of the firm’s international flexibility, we also examined the marginal effects of new export, intra-firm trade, and their interaction term on the 27 value of the firm. Economic significance of marginal effects depends on the magnitude of change in the independent variables (Nickerson & Silverman, 2003). We report the marginal effects at the mean and one standard deviation (SD) above the mean while holding all the continuous variables at the mean and the dummy variables at zero. Because the year 1998 equation is significant and 1997 is not, we obtained the marginal effects for the year of 1998 only. Table 3 presents the marginal effects of independent variables of interest. The results indicate that the Tobin’s q changes from 1.02 to 1.24 when we changed the mean value of new export to one standard deviation above the mean. Similarly, one standard deviation upward change in intra-firm trade leads the Tobin’s Q change from 1.03 to 1.34. Likewise, one standard deviation upward change in the interaction between new export and intra-firm trade, the value of Tobin’s Q moves from 1.02 to 1.29. These results are consistent with our argument that both new export development and shift of production are associated with economic value at the time of economic downturn. Both new export development and shift of production among production facilities are associated with more than 20% increase in the firm value along with the interaction of the two. Insert Table 3 Robustness Check: Examination of the Herfindahl Index Our analyses above showed that in the period of the economic crisis, firms were able to use their international investments to engage in activities that increased their flexibility, contributing to the value of the firm. In order to further understand the adjustments undertaken by firms during this period, we examined additional aspects of the pattern of changes in sales for their foreign subsidiaries. We utilized the Herfindahl Index to assess whether firms’ multinational networks experienced greater concentration of sales during the crisis. An increase 28 in concentration would imply that only specific markets, those judged to be the most attractive, would become target markets within the firm. Rather than a general dispersion of sales across this network, it would be consistent with a flexibility argument that the firm’s multinational network allows it to “pick and choose” where reallocation of sales would be most beneficial. Indeed, the Herfindahl Index for sales among the foreign subsidiaries increased from a mean value of 0.1866 for the year 1997 to 0.2326 for the year 1998. This increase of 0.0461 was significant at 5%. This finding supports our argument relating to the flexibility benefits of firms’ international investments in an economic crisis. In all, our findings show that international investments of Korean firms provide valuable flexibility during a period of unanticipated economic volatility but not under stability. CONCLUSIONS AND IMPLICATIONS OF THIS RESEARCH The main motivation in this paper was to examine whether or not international investments provide valuable flexibility to firms under conditions of unanticipated yet significant economic downturns, such as an economic crisis, using a sample of Korean firms over the 199698 period. Our findings generally affirm that international investments provide such flexibility, the value of which is heightened during a period of economic crisis. A firm with such investments in place has a greater ability to flexibly adapt its overall operations in line with unforeseen negative environmental change, in clear contrast to firms without such investments. Conceptually, we may expect firms to find new outlets for exports and flexibly increase or decrease intra-firm sales with relative ease, but as past research reminds us, such shifts are in fact not easy to undertake rapidly (Rangan, 1998). In this regard, this research demonstrates how prior managerial choices relating to the firm’s international investments influence its later actions and performance. In doing so, the study contributes to both the international strategy and 29 strategic flexibility literatures, since the former is concerned with the structuring of international investments and the latter with the structuring of investments under uncertainty. Numerous researchers have pointed out the potential of international investments to provide firms with necessary flexibility, yet few have directly measured any type of flexibility afforded by international investments. This research contributes to the literature by providing key measures of international flexibility that are theoretically linked to two major types of international investments. In contrast to the indirect measures seen thus far in this literature, we employed direct measures of flexibility, relating to the firm’s ability to shift production among their foreign subsidiaries and to develop new overseas customers in varying environmental contexts. We believe that these measures, which are specifically concerned with firms’ overseas activities, can enhance future research relating to international investment flexibility. The literature has emphasized that environmental uncertainty is a key antecedent for assessing strategic flexibility (Campa, 1993, 1995; Worren et al., 2002), yet the environmental conditions have often remained assumed or weakly measured in previous empirical work. In the international arena, factors such as exchange rate volatility are often easily and routinely hedged by firms (Allayannis and Ofek, 2001; Click and Coval, 2002), and under ordinary circumstances, do not necessarily provide a compelling context of uncertainty within which to examine flexibility. Nonetheless, currency fluctuation remains the primary measure of uncertainty in the MNC flexibility literature. In contrast, this research has gone much further to differentiate the important boundary conditions of predictability versus unpredictability. We used a natural experiment setting of an economic crisis, a context of dramatic adverse change that was not only unanticipated but also “unhedgeable.” Including the periods just prior to and during the Korean economic crisis into our research setting allowed us to isolate a sharp change for the worse in the economic environment for a large set of firms, thus making it possible to examine the value of 30 flexibility in international investments of firms under conditions of appreciably different levels of predictability. Other researchers, such as Rana (2007) and Eichengreen and Bayoumi (1999) have also noted the relevance of this setting in affecting firm strategies. We believe that further consideration and employment of such natural experiment settings will benefit the literature on strategic flexibility. An important contribution of this research is that it takes into consideration and provides evidence on the fact that firms’ international strategies encompass more than foreign direct investment, which has been the primary focus in the literature. Multinational firms engage in and clearly derive flexibility from their exporting investments as well. The two types of international investments, however, provide different benefits in this regard. Consistent with the nature of these investments, a primary benefit of firms’ foreign direct investments is the ability to shift production from one location to another in response to negative changes in the environment, while an essential advantage of exporting investments is the ability to rapidly identify and sell to new customers in foreign locations. To assess these issues, we developed measures of each type of flexibility. Our findings indicated that both types of international investments are indeed able to provide firms with such flexibility, which are valuable under conditions of economic crisis. An investment strategy involving a combination of both exporting and foreign direct investment is seen to provide additional value under such conditions, in light of our finding that the interactive effect of the two types of flexibility positively influenced firm value. These findings point to both separate and synergistic flexibility benefits from the two types of investments. As noted above, this research benefited from the use of a severe economic crisis as the backdrop from which to examine flexibility effects. While we were able to observe the flexibility benefits under conditions of an unanticipated negative event, we would expect that other forms of uncertainty, relating to not only negative but also positive events, are also relevant 31 for firms in this regard. In particular, firms are likely to be influenced by those pertaining specifically to their own industries, involving technological disruptions, policy change or new competitors. Incorporating such effects may in fact elicit different relationships between We believe that it would be useful to flexibility-related investments and performance. empirically compare firms’ strategic flexibility under not only differing levels but also differing types of uncertainty. Our sample used a large set of Korean firms with differing configurations of international investments, allowing us to fully examine the effects of international strategies on flexibility. We believe that replication of this study using samples of firms from other countries would provide additional insight into the relationships of interest, and particularly whether they hold for firms across institutional contexts. For example, it may be that firms in other countries pursue different types of international strategies than those of Korean firms due to differing levels of development, domestic opportunities or competitive advantages. How would such features influence the firms’ ability to derive flexibility from their international investments? The consideration of such issues would also help us to understand the role of firms’ national contexts in influencing strategy. In addition, while this research has focused on a firm’s international investments, other types of investments thought to yield flexibility benefits, such as manufacturing modularization or R&D, can also make use of such settings. Finally, the dependent variable in this research assessed the value of investments, which allows us to focus on expected rather than actual performance changes from the flexibility associated with those investments. 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Age a a 1.04 0.98 32.88 12.05 1.60 61.00 0.52 0.17 1.23 1.00 0.97 4. Size 5. Debt/Fixed assets 6. Competition 7. Capital intensity 8. Chaebol 9. No. of countries invested 10. Exporting flexibility 11. Multinational flexibility a Logged † p<0.1;* p<0.05; ** p<0.01 0.04 -0.41** -0.01 0.03 -0.13** 0.01 -0.29** -0.07* 0.02 -0.03 0.00 0.01 -0.05 0.01 -0.02 0.27** 0.02 0.06* 0.05 0.07* 0.00 39 Table 2 Effects of Exporting and Multinational Flexibility on Firm Value in an Economic Crisis Period of economic downturn (Tobin’s q 1998) 1 Tobin’s q Agea Sizea Debt/Fixed assets Competition Capital intensity Chaebol 0.63 (4.99)** -0.01 (3.11)** 0.023 (0.99) -0.042 (0.97) 0.001 (2.22)* 0.166 (0.34) 0.016 (0.22) -0.005 (0.55) 2 0.627 (4.99)** -0.007 (3.14)** 0.026 (1.05) -0.042 (0.98) 0.001 (2.23)* 0.175 (0.36) 0.014 (0.19) -0.006 (0.62) 3.882 (2.44)* 0.001 (3.64)** 3 0.628 (5.01)** -0.007 (3.15)** 0.028 (1.13) -0.045 (1.03) 0.002 (2.37)* 0.195 (0.4) 0.015 (0.2) -0.007 (0.76) 15.559 (2.80)** 0.015 (2.48)* 5.451 (2.34)* -15.384 (2.67)** 459 0.33 14.44** 40 Period of economic stability (Tobin’s q 1997) 4 0.643 (5.07)** -0.005 (4.34)** -0.025 (1.29) 0.185 (3.29)** 0.001 (2.08)* 0.821 (2.40)* -0.021 (0.44) 0.022 (2.52)* 5 0.618 (5.61)** -0.005 (4.30)** -0.026 (1.33) 0.156 (4.12)** 0.001 (1.72)† 0.666 (2.68)** -0.021 (0.48) 0.024 (2.73)** -4.519 (1.75)† 0.000 (0.30) 6 0.615 (5.64)** -0.005 (4.36)** -0.023 (1.23) 0.152 (4.10)** 0.001 (1.72) † 0.65 (2.66)** -0.021 (0.48) 0.023 (2.62)** -3.903 (1.68)† -0.001 (0.62) 0.478 (0.85) 4.115 (1.74)† 455 0.5 8.85** No. of countries invested Exporting flexibility Multinational flexibility Exp flexibility*Mult flexibility Constant Observations R-squared F-statistics a Logged 0.473 (0.98) 459 0.32 8.37** † p<0.1;* p<0.05; ** p<0.01 -3.68 (2.12)* 459 0.33 13.90** 0.074 (0.33) 455 0.45 8.51** 4.735 (1.82)† 455 0.49 9.29** TABLE 3 Marginal Effects of Exporting and Multinational Flexibility on the Value of the Firms in 1998 Explanatory variables Exporting Flexibility Multinational Flexibility Exp Flex*Mult Flexibility At the mean 1.02** 1.03* 1.02* 1 SD above the mean 1.24** 1.34* 1.29* †p < 0.10; *p < 0.05; **p < 0.01 41 Appendix A Origins of the Korean Economic Crisis in 1998 From the period of 1985 to 1997 prior to the crisis, Korea's GDP annual growth rates had remained very high, ranging from 5.0 to 9.2 percent. In response, foreign portfolio investors invested heavily in the Korean economy to take advantage of its strong growth and stability. By 1997, such private flows to Korea had increased five-fold over 1990. During this period, Korea was considered to be one of the safest places to invest (Krugman, 2000). The huge inflow of investment funds affected the Korean economy in a number of ways. Because these investment flows were denominated in foreign currency, they needed to be converted into local currency. This resulted in a surge in demand for the won, causing the value of the won to increase relative to other currencies. However, the won was pegged to the dollar, and in order to keep the value stable, the government increased the money supply (i.e., printing more money). Via the multiplier effect, the result was an expansion of credit in the economy due to both foreign loans and the increased money supply. Slowly, this “easy” credit led to excessive investments in lower quality investments such as office buildings, real estate, and factories, whose rate of return was not as high, as well as speculation. Foreign investors began to slow their rate of investment. At the same time, increased imports reflected Koreans’ economic prosperity. While this had the effect of reducing the relative demand for the won, the Korean government managed to defend the value of the won using its international reserves, keeping it on par with the dollar for most of this time. While there was some indication of a slowdown in the years 1996 and 1997, the growth rates averaged during this period, 6.8 and 5.0 percent, respectively, were nonetheless still very high in comparison to those experienced by most other countries. Athough the average exchange rate for the won/$ registered a depreciation of the currency in comparison to previous periods (804.5 and 951.3 for 1996 and 1997, respectively), it was not alarmingly so. Both inflation (4.9 and 4.4 percent) and unemployment (2.0 and 2.6 percent) rates held steady at low rates during this period. On November 17th in late 1997, the won suddenly plummeted in value, taking most analysts by surprise, according to numerous news reports and journal articles during this period. By 1998, the value of the won dropped to only 60 percent of what its value had been in 1997. Along with this rapid change in the value of the currency, which registered as low as 1401.4 in 1998, the Korean economic environment changed dramatically in a number of other ways that were also unforeseen by Korean and Western analysts. In huge contrast to the prior years of unabated high growth that characterized the Korean economy, there was a contraction of the economy (-6.7%) in 1998. Inflation nearly doubled and unemployment tripled in 1998 in comparison to 1997. According to numerous reports at this time, perceived uncertainty was at an all-time high. 42