The macro governance environment of any society — namely its laws and regulations (or the lack thereof) — will shape the governance of organisations therein. In a society where the laws are fair, where contractual information is publicly verifiable and where the state can impartially enforce contracts based on public laws and information, people and organisations tend to have high confidence and trust in public rules and will rely on them to resolve disputes. This rule-based governance system has been adopted by all societies with a mature democratic and free-market system.
Opposite to this are societies where the laws are opaque and selectively applied and where judges are influenced by personal connections or bribes. When disputes arise in such societies, involved parties tend not to go to the courts; instead, they resort to private means to resolve their disputes, including using political connections, bribery, or even violent means such as kidnapping. This is a relation-based governance system.
To establish a well-functioning rule-based system, a society needs to make large investments over a long period of time to build public infrastructure for rule enforcement, including a law-making body, a court system and an effective and efficient enforcement branch. The costs of building this infrastructure are sunk and fixed, but such a system can support large volumes of transactions and contracts with minimal incremental costs. In contrast, a relation-based system can work effectively and efficiently without such investments in the infrastructure for public rule enforcement — but only as long as the scale and scope of transactions are small (among friends and family members, for example).
The negligible need for governance investment is a key driver for relation-based economies to quickly take off without a fully developed legal system. But when the markets and firms in a relation-based society expand internationally, the cost advantage of a relation-based system disappears, since markets and firms now have to deal with new people in uncharted territories. The cost of building a privately enforceable relationship with strangers is much higher than with friends and relatives. Globalisation forces relation-based economies and firms to become more rule-based.
China is a relation-based society, and Chinese firms have been operating in a relation-based way. But as China goes global, its society and firms must learn the rule-based way. That raises the question of whether Chinese firms undertaking outward foreign investment are learning from rule-based markets and firms.
In rule-based markets, Chinese overseas investments tend to be acquisitions rather than greenfield projects, as rule-based economies are more transparent and therefore enable a better ex-ante evaluation and ex-post integration of the target firms. This allows a more effective transfer and absorption of resources, knowledge and technology. Conversely, in relations-based countries, greenfield direct investment allows an investor to directly create and govern the assets and thus more easily acquire and protect know-how.
Firms with more diverse international experiences (as measured by the number of different countries in which the firm had investment projects) tend to make acquisitions as opposed to investing in greenfield projects. This suggests that experience in multiple countries boosts such firms’ confidence in executing and learning from acquisitions in rule-based host countries.
From this, it appears likely that governance learning is taking place in the Chinese firms undertaking overseas foreign direct investment. If true, this is a welcome sign: such learning will help the Chinese economy to transition towards a rule-based system. This transition will be slow and painful, as it will dent the vested interests in the relation-based system and will weaken the all-powerful state bureaucracy.
As current trade frictions show, the main complaints about China’s economic conduct is that China does not follow the rules of the international trading system. From this perspective, if China and its firms become more rule-based, it will not only benefit China and its firms but will also be conducive to restoring a fair and efficient global trade order. The policy implication for industrialised, rule-based countries is that opening to Chinese investment may well hasten the much-needed transition to a rule-based system in China.
Shaomin Li is a Professor of International Business at the Strome College of Business, Old Dominion University (ODU).
Ilan Alon is Professor of Strategy and International Marketing at the University of Agder (UiA).
Stefano Elia is Assistant Professor at MIP Politecnico di Milano.
This is an abridged version of a paper presented by the authors at the 2017 European International Business Academy annual conference.