The effect of business groups on innovation and exports in China

Business groups (i.e. independent firms, usually operating in multiproduct and multiple markets, that are bound together by formal and informal ties) exist in both advanced and emerging economies. Relative to other countries’ business groups such as Japan’s keiretsus and zaibatsu, South Korea’s chaebols, India’s business houses, Russia’s oligarchs and Latin America’s grupos, business groups in China are less understood. My co-authors (Lichao Wu and Chengang Wang) and I investigated the role of business groups in facilitating Chinese firms’ exporting, and leveraging innovation for exporting. 

Business groups in an emerging-economy context 

The role of business groups to their affiliated firms is complex. Group-affiliated firms are, in general, in a better position than stand-alone firms with regard to accessing a variety of resources, and therefore are more able to capture growth opportunities. However, this may be a mixed blessing when it comes to their export strategy.  

Taking into account the institutional context of emerging economies (e.g. institutional voids, institutions in transition, and state interventions), our paper proposes that business group affiliation has a positive impact on firm export performance. Business groups receive extensive institutional support, in particular, support from the state, e.g. low-interest rate finance, access to foreign currency, direct and indirect subsidies, domestic tax breaks and access to research institutions. In return, they must adhere to state signals and often act as pioneers in implementing the recommended policies.  

In emerging economies, institutional changes have been made to encourage and support firm exports, including exchange rate system reform, processing trade policy, tax rebates, the removal or reduction of trade and non-trade barriers and participation in regional economic integration or the World Trade Organisation. Group-affiliated firms, thus, have a strong incentive to operate in export markets, not only because of the resource advantages they possess for exporting, but also because of their need to gain institutional legitimacy by acting in line with the state’s export promotion policy.  

In addition, such an institutional context can mitigate the negative impact of business group affiliation on firm exports. The institutional transition in emerging economies gradually improves market functions, reduces agency problems, resource misallocation and rent-seeking, and stimulates competition, which diminishes some of the advantages that business groups hold. While their home market status is challenged, group-affiliated firms can leverage home market power for foreign market growth opportunities.  

The network effects have a dual role to play. They may keep group-affiliated firms at home, but they may also pull group-affiliated firms together to export due to their business interdependence and their legitimacy need which is evidenced by taking similar actions.  

As business groups’ governance structure may make them more beholden to a particular interest, from the managers’ perspective, group-affiliated firms’ deep embeddedness in the domestic institutional environment means that they undertake exporting activities, whenever possible, irrespective of whether they are economically sound. By taking action, managers maintain their legitimacy in the eyes of the government, which helps them protect their own interests and achieve their personal and organizational goals. The peculiarities of the institutional setting in emerging economies therefore suggest group-affiliated firms have higher export performance than stand-alone firms. 

Innovation and exports 

In contrast to the positive role indirectly impacting on exports, business group affiliation may undermine the value of innovation to exports in the emerging economy institution context. The benefits of innovation for exporting are recognised as including: the development of differentiated products and services, improving quality, reducing costs and adjusting internal structures to respond to technological changes and environmental uncertainty. This helps to facilitate firms’ entry into, and expansion within, export markets.  

In return for the institutional backing, business groups not only play the role of economic agent, seeking economic outcomes, but also have a social function. For example, in China, group-affiliated firms face the task of providing employment in order to ensure social stability, at the same time improving innovation and firm performance in order to fuel economic growth. Providing employment would mean keeping redundant human resources on the payroll and spending on non-productive resources. This phenomenon is not unique to China, but common among emerging economies.  

Despite the ability to mobilize internal markets for resources, no business groups have unlimited resources. Balancing the conflicting institutional pressures and economical objectives is, from the resource perspective, a challenging task as firms have to assign resource portfolios to meet both economic and normative rationality, which often result in economic suboptimal decisions.  

In the context of the innovation-exporting nexus, diverting resources from productive, value-adding activities undermines group-affiliated firms’ ability to optimize the utilization of resources to capture the positive effects of innovation on exports. In other words, the positive value of innovation to exports in group-affiliated firms may not be as high as that in stand-alone firms whose focus is more on economic rationality and efficient use of resources. 

What also does not help is the inherently complex governance arrangements in business groups. Both exporting and innovation are subject to dynamic environments and require systems in place to identify opportunities and respond to them. Innovation and exporting are often conducted by separate units of an organisation. Responding to changes in the external environment for innovation alone, or for exporting alone, may not generally be hard. However, facilitating innovation to stimulate exports places additional requirements on organizational systems.  

Firms need to have enough strategic and operational flexibility to promptly allocate resources so as to modify existing activities or embark on new courses of action in response to changes. The opaque governance of business groups may undermine group-affiliated firms’ ability to effectively take advantage of innovation for exporting.  

Group-affiliated firms may benefit from buffering effects against the uncertainties and risks they face in international markets, and thus engage in exporting. However, superior export performance may not be innovation-based, but in line with the vent-for-surplus model which argues that export growth is the result of using surplus resources that would have remained idle in the absence of exports.  

In view of the institutional pressures of providing employment and accommodating the growing workforce in emerging economies, group-affiliated firms therefore follow the export promotion path as is advocated by the state, but the governance constraints present them with a challenge to maximize the value of innovation for exporting.      

The research study and implications 

Examining Chinese manufacturing firms, we found that both innovation and business group affiliation have a positive impact on exports, but business group affiliation plays a negative role in the innovation-export relationship.  

After 40 years of economic reform, China’s position as a leading trading nation has been well-established. China has also become a serious contender in the world of innovation. R&D expenditure in 2017 was up 43-fold in comparison to data in 1996. Patent applications in the domestic market saw a growth of 43-fold and patents granted a growth of 38-fold between 1998 and 2018. These achievements are in contrast to another prevalent belief that China’s international competitiveness is mainly fueled by low labour costs and high levels of investment in physical capital.  

From the policy perspective, our findings highlight the need to take a joined-up approach and work across departments in policy making. Our evidence of institutional pressure on business groups helping with exports, but working against effectively utilizing innovation for exports. Therefore, the impact of policies is complex. Merely stimulating exporting is an ineffective approach when the country is moving away from cost-leadership to competitiveness based on knowledge and innovation.  

Policymakers need to be aware of business groups as a micro-institutional tool which can be used to achieve political and economic goals. More concerted, coordinated efforts by policy makers in different departments may be a way forward, promoting the positive role of business groups in both export promotion and the effective utilization of innovation for exporting.  

For managers, the finding that innovation significantly affects firm export performance suggests that firms need to strategically engage in innovation, and leverage innovative outputs to improve export performance. Innovation provides an avenue for Chinese firms to catch up to advanced economies. The innovation strategy of a firm should be planned in conjunction with their foreign market strategy.  

This study points to the benefits and costs Chinese firms can derive from business group affiliation. Business group affiliation, a success driver behind exports in the past, could become a liability if firms want to become innovation-led exporters. Business strategies should pay attention to the target specificities and credibility of the national institutional system and be aware of conflicting institutional pressures when leveraging innovation for exports.   

This blog post is based on the journal article: “Disentangling the effects of business groups in the innovation-export relationship” by Wu, L; Wei, Y; and Wang, C, which will be published in Research Policy, 50 (1) in January 2021.