Trust and foreign ownership: Evidence from intra‐European foreign direct investments

• DOI: http://doi.org/10.1111/roie.12378
• Author: Alessandro Sembenelli,Marina Di Giacomo,Marco Da Rin
• Published date: 01 February 2019
• Date: 01 February 2019

Rev Int Econ. 2019;27:313–346. wileyonlinelibrary.com/journal/roie © 2018 John Wiley & Sons Ltd

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313

© 2018 John Wiley & Sons Ltd

Received: 21 March 2018

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Revised: 18 June 2018

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Accepted: 11 August 2018

DOI: 10.1111/roie.12378

ORIGINAL ARTICLE

Trust and foreign ownership: Evidence from

intra‐European foreign direct investments

Marco Da Rin1

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Marina Di Giacomo2

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Alessandro Sembenelli3

Marco Da Rin is also affiliated with the European Corporate Governance Network (ECGI).

1Department of Finance,

Tilburg University, Tilburg,

The Netherlands

2Department of Economics

ESOMAS,University of Turin,

Turin, Italy

3Department of Economics

ESOMAS,University of Turin and

Collegio Carlo Alberto, Turin, Italy

Correspondence

Alessandro Sembenelli, Department

ESOMAS, University of Turin and

Collegio Carlo Alberto, Turin, Italy.

Email: alessandro.sembenelli@

unito.it

Abstract

We use a novel firm‐level dataset to test whether trust affects the

volume and the ownership structure of FDI across Europe. Our

methodology deals with the endogeneity of trust from the inves-

tor to the recipient country. We expect such a trust measure to

affect investment decisions, and the associated knowledge capi-

tal, differently across types of foreign investors. In particular, this

effect is expected to be stronger for industrial investors who pos-

sess transferable knowledge capital. The data confirm our predic-

tions. Higher trust increases the number and volume of FDIs, but

also the probability of co‐investing with a partner from the recipi-

ent country.

1

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INTRODUCTION

The importance of bilateral trust among nations for economic outcomes has been the object of a grow-

ing literature (for a survey, see Guiso, Sapienza, & Zingales, 2006). These studies build on the seminal

intuition by Arrow (1974) that trust is a fundamental determinant of human behavior, which shapes

economic transactions and affects organizational efficiency.

Studies at the macroeconomic level have established a positive relationship between trust among

nations and economic growth (e.g., Knack & Keefer, 1997; Temple & Johnson, 1998; Zak & Knack,

2001).1 Algan and Cahuc (2014) provide a comprehensive survey of this literature.

At the microeconomic level, studies have shown the importance of bilateral trust for specific eco-

nomic outcomes: the volume and synergies of cross‐border mergers (Ahern, Daminelli, & Fracassi,

2015), the contractual structure of syndicated loans (Giannetti & Yafeh, 2012), the degree of individ-

uals’ stock market participation (Guiso, Sapienza, & Zingales, 2008), and the structure and success

of venture capital investments (Bottazzi, Da Rin, & Hellmann, 2016). These studies document that

bilateral trust affects both the intensity of transactions and the way they are structured, for example in

terms of contractual clauses or pricing elements.

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In a recent contribution, Guiso, Sapienza, and Zingales (2009), using European data, show the

importance of bilateral trust for the aggregate volume of FDI. Studying FDI is particularly salient, as

they have long overtaken trade as the main engine of product market globalization. At the same time

their work on aggregate data suggests that it might be fruitful to build on the above microeconomic

studies, and learn more about how cultural values shape the structure of FDIs.

Our contribution takes it from here. We start by observing the increasing relevance of firm‐specific

intangible assets for foreign investments and the central role of foreign subsidiaries (the “FDI compa-

nies”) in the circulation of knowledge within multinational companies (Rugman & Verbeke, 2001).

Intangibility implies that the investor who commits assets to a foreign environment, and possibly to

a co‐investor, assumes considerable risk of leakage of internal knowledge beyond firm boundaries

(Carr, Markusen, & Maskus, 2001). Such risk is expected to be larger for corporate (“industrial”)

investors, who commit knowledge and intangible assets to a greater extent than financial or individual

investors. This brings into play trust from the investor country to the destination country (“origin‐to‐

destination” trust), as investors must trust in the possibility of realizing the gains from trade they are

investing for.

In this paper we therefore ask how origin‐to‐destination trust affects the structure of FDIs, focus-

sing on two issues. First, we ask whether the effect of origin‐to‐destination trust on FDI flows depends

on the type of the investor, who reflects their technological and managerial capabilities. The economic

literature points to the importance of the ownership of FDI companies, as corporate investors are more

likely to transfer valuable technology and managerial practices than financial or individual investors

(Bloom, Sadun & Van Reenen, 2012). Second, we examine whether origin‐to‐destination trust affects

the likelihood of observing different ownership structures for FDI companies, and specifically the

presence of destination country co‐investors. We also ask whether such an effect also varies with the

type of the investor. A co‐investor from the destination country can provide assets complementary to

those of the foreign investor, especially knowledge of the local market, but it also exposes the foreign

investor to the risk of leakages of intangible knowledge. We develop our hypotheses for these two

mechanisms in Section 2.

To bring our hypotheses to the data, we build an original sample of over 30,000 intra‐European

FDI companies created from 2000 to 2006 from the Amadeus database. An important feature of such

data is that we are able to identify the controlling (“ultimate”) owners of each company. We are also

able to obtain information on their nationality and their nature as to whether they are an industrial

company, a financial company, or an individual person. We use the total number and the cumulative

size of these companies as complementary proxies of the stock of FDI companies at country‐pair

level. We also identify the presence of co‐investors of different types as a measure of the ownership

structure of the FDI company. Such detailed data allow us to generate novel results on aspects that had

not previously been analyzed.

Our results show that origin‐to‐destination trust is important for the structure of FDIs. In par-

ticular, we find that the effect of trust on the stock of FDIs occurs primarily when the investor is

industrial. This is important, because corporates make larger investments, often in high‐tech man-

ufacturing industries. These effects are economically appreciable. For industrial investors, a change

in origin‐to‐destination trust from the first to the third quartile (which approximately corresponds to

one standard deviation change in trust) leads to a median increase in the number of investments in

FDI companies between 4.5 (OLS) and 12 (IV). Also for industrial investors, a one percentage point

change in origin‐to‐destination trust leads to an increase between 5.7% (OLS) and 8.2% (IV) in total

size of bilateral investments in FDI companies. Computed at the average size of bilateral investments

by industrial investors, this increase amounts to between €113 million and €162 million, which is how

much Denmark invested in Italy or Belgium over our sample period. Origin‐to‐destination trust also

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makes industrial investors more likely to find a co‐investor in the destination country, therefore facil-

itating the capture of strategic complementarities. Since we employ empirical methods that address

the endogeneity of bilateral trust, we can claim to uncover a genuinely causal effect of trust on FDI

decisions.

In the rest of the paper we first develop a conceptual framework that draws on economics and man-

agement studies to build the hypotheses that we bring to the data. We then describe the construction of

our sample. We start the empirical analysis by examining the data at the descriptive level, document-

ing some novel stylized facts. After discussing our econometric methodology, we test our hypotheses

and discuss our results and their implications.

2

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TRUST AMONG NATIONS, OWNERSHIP, AND FDI

2.1

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The economics perspective on FDI

Transaction cost economics (Coase, 1937) has been the first framework for interpreting FDI. Its view

is that organizations optimize their behavior by relying on market transactions when available, but by

internalizing them within their boundaries when markets for inputs, skills, or services, are imperfect.

Market imperfections may arise owing to market failures or contract incompleteness, and create un-

certainty about how transactions can be completed, leading to transaction costs such as information,

enforcement, and bargaining costs (Teece, 1986; Williamson, 1975). These inefficiencies may be

mitigated by organizing a firm’s activities internally, under common ownership. In the international

context, firms may choose between direct ownership of foreign subsidiaries vs. trading or operating

through a joint venture with other co‐investors.

The property rights theory of the firm (Grossman & Hart, 1986; Har t & Moore, 1990) takes a sim-

ilar view, stressing the importance of asset specificity rather than of transaction costs. It predicts that

assets that are difficult to contract upon get organized under common ownership, so as to avoid hold‐

up threats by separate owners. The strong uncertainty surrounding FDIs therefore makes them a good

testing ground for the effects of origin‐to‐destination trust on investment and organizational choices.

More recently, explicitly knowledge‐based theories of cross‐border investments have examined di-

rectly the importance of knowledge and intangible assets for FDI decisions (Carr et al., 2001; Yeaple,

2003). These theories incorporate foreign investment decisions that address both “vertical” (up‐ and

down‐stream) and “horizontal” (cross‐country expansion) integration challenges taking into account

the risk of leakage of internal knowledge beyond firm boundaries.

Economists have documented that companies with foreign investors typically have higher produc-

tivity, measured by either output per worker or total factor productivity, and that such a productivity

channel trickles down to the country level (Aitken & Harrison, 1999; Alcácer & Chung, 2007; Raff,

Ryan, & Stahler, 2012). Greenaway and Kneller (2007) survey this literature. This “own plant” effect

can be even larger than the “spillover” effect that motivates common joint‐ownership policies like

that of China (Harrison & Rodríguez‐Clare, 2010).2 Both the “own plant” and the “spillover” effects

have been found to be heterogenous since they depend on the amount of assets foreign investors pos-

sess and on their willingness to transfer them to organizations located outside of their own countries

(Zhang, Li, Li, & Zhou, 2010). These assets, including technological and organizational capabilities,

are largely intangible and their cross‐border transfer is prone to leakage of internal knowledge outside

firm boundaries. Such leakages might be especially harmful for corporate investors, which are char-

acterized by a high degree of complexity and asset specificity.