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The wealth effect of international joint ventures: the case of U.S. investment in China.

Today's world market is more dynamic, complex and competitive than that of the 1970's. With China and Eastern European countries joining the world economic and commercial community, and the integration of the European Community in 1992, the market will change at an even faster pace in the 1990's. To maintain their competitive edge in this changing market, multinational corporations are turning more and more to transnational alliances. International joint venture has emerged as a major form of business and has been widely used by multinationals. While studies on mergers and acquisitions have occupied the center stage of finance research, other forms of corporate governance, such as joint ventures, have received relatively little attention in the published literature. This is particularly true with recent international joint venture activities in nonmarket economies. This paper offers the first study on the wealth effect of U.S. investment in China through international joint ventures.

Since China opened its door to the outside world in 1979, it has approved more than 21,000 foreign investment projects. About 90% of them are joint ventures. During the same period, U.S. firms signed about 850 joint venture agreements. U.S. investors' primary interests are the Chinese domestic markets (U.S.-China Business Council [31]). With more than one billion people, China is a potentially vast and fast-growing market. For example, in the past ten years, China's total foreign trade grew from $20 billion in 1978 to over $100 billion in 1990. This market is accessible to foreign investment enterprises if their products can substitute for previously imported goods. Even if they have to export some of their products, foreign joint ventures will benefit from relatively low costs of production, tax breaks, and other incentives. Thus, China's decision to attract private foreign investment presents opportunities for foreign investors. Yet, foreign investors also face challenges. (1)

Given the opportunities and challenges, should U.S. firms enter the Chinese markets through joint ventures? If wealth is created for U.S. shareholders, what is the source of the wealth gain? This paper attempts to answer these questions.

Previous studies find that the wealth gain of international expansion is due to host countries' general level of development, tax haven status, the efficiency of their financial markets, and other factors that augment the synergy and expansion effect of international joint ventures (Doukas and Travlos [7], Fatemi [10], Lee and Wyatt [18], Lummer and McConnell [19], and Mathur and Waheed [20]). Although attempts have been made to pinpoint the source of the gain, the results are not satisfactory because the contemporaneous factors cannot be eliminated when data of multiple host countries are used. This study examines international joint ventures formed in a single country -- China. The research design provides the capability to better differentiate among competing interpretations of the wealth gain of international joint ventures.

The rest of the paper is organized as follows: Section I reviews previous literature of joint ventures and multinationals; Section II discusses foreign investment in China and develops research hypotheses; Section III describes the sample and research methodology; Section IV presents and interprets the results of the event study of U.S.-Chinese joint venture activities; and the final section sets forth concluding remarks.

I. A Review of Previous Research

Prior literature on joint ventures is drawn from the valuation effects of establishing domestic and international joint ventures. Joint ventures are formed when two or more firms pool their resources into a common legal entity. They are used to create synergies through combining resources, increasing market power, sharing risks, cutting costs, and improving efficiency. The corporate synergy hypothesis prescribes that announcements of joint ventures should result in abnormal returns for the participating firms' stocks. McConnell and Nantell [21] find significantly positive abnormal returns at joint venture announcements, thereby concluding that joint ventures create synergy and increase shareholders' wealth. [2]

Lummer and McConnell [9] show that the formation of international joint ventures, on average, increases a firm's value. Finnerty, Owers and Rogers [11] test the joint hypothesis of synergy and diversification effects against a sample of 110 international joint ventures and find little evidence of the valuation effects. Lee and Wyatt [18] report significantly negative stock price reactions associated with U.S.-foreign joint venture announcements.

In the international business literature, Kogut [17] argues that the multinational firm benefits from establishing a globally maximizing network. Through building the network, the multinational firm can create wealth from three sources. First, it can arbitrage institutional restrictions; second, it can capture informational externalities; and third, it can improve production efficiency. In Kogut's model, the multinational firm possesses a string of valuable options allowing it to take advantage of institutional barriers in global markets. For example, the multinational firm operating in several countries can minimize taxes through intra-firm transactions and financial packaging. It has the option to reduce production costs by shifting its production to low-cost sites. Similarly, it can shift exports from a country whose currency is appreciating to another country. Since the future state of the world is uncertain, possession of these options is valuable. Therefore, the positive-multinational-network hypothesis predicts that firms expanding into international markets should experience positive valuation effects. (3)

In addition to testing the valuation effect of an international joint venture, other studies have attempted to explain the source of the effect. Doukas and Travlos [7] empirically test the positive-multinational-network hypothesis, and find that firms making acquisitions in new foreign markets experience a positive valuation effect. Mathur and Waheed [20] find a similar positive geographic expansion effect. Lummer and McConnell [19] report that the wealth gain is positively related to the size of the investment made in international joint ventures. Furthermore, international joint ventures with foreign firms create significantly larger value increases than those with foreign governments. Errunza and Senbet [8, 9], Hirschey [13], DeFusco, Philippatos and Choi [6], and Morck and Yeung [24] document that multinationals create value for investors. (4)

In summary, prior research suggests that positive wealth gains are associated with a firm's expansion of its multinational network. However, studies on the wealth effect of international joint ventures have presented mixed results. Failure to detect the positive expansion effect may be due to the fact that most studies are unable to isolate other contemporaneous factors, such as host countries' general level of economic development, efficiency of markets, and other joint venture specific factors.

II. Foreign Investment in China and

Proposed Hypotheses

Prior to the 1980's, the only commercial tie between China and the outside world was through foreign trade. Direct foreign investment was not permitted. After the ten-year cultural revolution in 1976, China started its economic revitalization program, referred to as the "Four Modernizations." Its goal was to improve agriculture, industry, national defense, and science and technology. This ambitious program required foreign capital. In 1979, China passed its first Law on Joint Ventures Using Chinese and Foreign Investment. Since then, the Chinese government has approved more than 21,000 foreign investment projects exceeding US$40 billion (U.S.-China Business Council [31]).

In the same time period, U.S. companies signed 952 agreements, amounting to US$4.01 billion. Although wholly owned subsidiaries are allowed in China, the majority of the projects, 849 (89.2%), are joint ventures. The U.S.-China Business Council, a Washington-based private organization, has constructed a database providing firm level information on 517 U.S. investment projects in China [31]. According to the council's database, large U.S. multinationals make up about 25% of 517 investment projects in China; medium-sized companies, 20%; and small firms and entrepreneurs, the rest. About 70% of the investments were made in the mid-1980's. The average dollar investment by U.S. firms in each project is US$2.45 million (median = US$0.28 million). In terms of percentage of foreign ownership, the mean is 31.73% (median = 30%). The council's report also indicates that U.S. companies' interests are clearly in developing long-term manufacturing joint ventures aimed at the Chinese domestic markets.

U.S. firms' value will be enhanced by their entry into the Chinese markets. In Kogut's model of multinational network, one of the three sources of wealth gain is the cost savings obtained by joint production. Low labor cost is an important factor attracting foreign investments in China. A recent survey conducted by the council [31] reports that the average monthly compensation from foreign-invested enterprises for local workers in 1989 and 1990 is RMB508 and RMB520, respectively, which is about 50 cents per hour when converted into U.S. dollars, Establishing joint ventures means huge production-cost savings for U.S. firms.

The second source of wealth gain is the ability of multinationals to capture externalities in information. Multinationals spend an enormous amount of resources in acquiring information about global markets, recruiting internationally skilled personnel, and analyzing social and political situations in foreign countries. Entering Chinese markets through joint venture, U.S. firms can rely on local partners for information on political situations, economic conditions, legal framework, and vital business information, such as sources of materials and financing, distribution channels, labor-management relationships, etc. Given that China was closed to the rest of the world for decades, and is still operating with a system different from that of the U.S., local partnership is a logical first step for the U.S. multinationals.

Finally, an important source of wealth gain is a collection of valuable options which give multinationals the discretionary choice of altering real economic activities or financial flow from one country to another. Undoubtedly, U.S. firm benefit from enhancing their ability to arbitrage institutional barriers by extending their networks into China. Moreover, Myers [26] and Kester [16] emphasize the value of another set of options which allows investing firms to explore future growth opportunities. Investing in China may not provide firms with immediate cash flow. However, it does create options which allow firms to make profitable follow-up investments. The high level of uncertainty involved in doing business in China makes these options more valuable for U.S. firms.

Foreign investment in China provides opportunities and risks. First, China is a socialist country with a centrally planned economy. Nearly all Chinese enterprises are publicly owned. This leaves multinationals with no choice but to form joint ventures with government partners. Both theory and empirical evidence have shown that joint ventures with state enterprises should be avoided (Hennart [12], and Raveed and Renforth [27]).

Second, a developing economy, such as China's, is typified by the inadequacy of its infrastructures. Foreign investors are often troubled by poor transportation and communication facilities. Scarcity of foreign exchange, nonexistence of local financing, low labor quality, short supply or raw materials and energy, soaring operating and overhead costs, and lack of access to the Chinese markets are common problems experienced by multinationals. Finally, foreign joint ventures are often plagued by government interference, inadequate legal framework, political instability and cultural confrontation.

The preceding discussion suggests that U.S. firms investing in China may benefit from saving production costs, capturing informational externalities, and possessing real options to arbitrage institutional restrictions and explore future growth opportunities. The first two components, low cost of labor and local partners' knowledge of Chinas's environment, combined with capital, technology and management skills from U.S. firms, should create synergy. However, the benefit of synergy can be offset by costs incurred by the investing firms. It is the third component, real options, that can bring large wealth gains. The benefit can be nontrivial because multinationals have the flexibility to decide where to declare taxes, where to shift production, and when to make follow-up investments. Based on these analyses, we propose a hypothesis predicting that U.S. firms announcing formation of international joint ventures in China should experience a positive wealth effect.

A testable hypothesis about the source of the wealth gain can also be identified. If the wealth gain stems from options, positive excess return should be negatively related to the size of initial investment made by U.S. firms. The value of real options comes from flexibility, timing, and asymmetry of gains and losses. While moderate initial investment preserves options' value, early commitment of a sizable amount of funds destroys it. Kester [16] correctly point out that real options are valuable because firms can wait until the last minute to commit funds, thus protecting themselves from costly and avoidable mistakes. Any earlier than necessary commitment of funds will sacrifice the value of the real options. Occidental Petroleum's investment in Antaibao Coal Mine serves as a good example. In 1985, the firms signed a joint venture contract with the Chinese government. The firm invested US$180 million in the US$750 million mining joint venture. Since then, the venture has been plagued by production problems and drops in world coal prices. In 1990 alone, the company lost US$31 million. Moreover, the company salvaged only a tiny percentage of its investment when it pulled out of the partnership. Such a costly mistake can be avoided if a company does not commit a large initial investment.

III. Sample and Methodology

A list of U.S.-Chinese joint ventures was obtained from the U.S. Investment Database provided by the U.S.-China Business Council. The database contains information on a total of 517 U.S.-Chinese investment projects established between 1979 and 1990. The database was cross-validated with the Annals of China's Enterprises Register: Directory of Foreign Investment Enterprises, 1979-1987 (Ministry of Foreign Economic Relations and Trade, and State Administration of Industry and Commerce [22]). The register contains a description of 7,928 foreign-invested operations in China. (5) The cross-validation check shows the council's database is largely accurate, but not complete. Moody's Corporate News (58 announcements) and S & P Daily Corporate News (126 announcements) provided 184 additional observations, thus yielding a total of 701 observations in our initial sample.

In order for any firm to be included in the final sample, the following criteria had to be met. First, the firm must be listed on the New York or American Stock Exchange, and its common stock excess rates of return file must be available from the CRSP Daily Excess Return File. Five hundred and twenty-four observations in the initial list did not satisfy these requirements and were deleted. The attrition was expected because most investment projects involve medium- and small-sized firms and entrepreneurs. Large multinationals make up only 25% of investors in the council's database (U.S.-China Business Council, [31]). Since data on stock prices for smaller and private firms were not available, this study investigates the wealth effect of joint venture investment made by large U.S. firms. Second, investments must be made by a U.S. firm in the form of a joint venture. Four more observations were removed. Third, announcements of joint venture formation must be listed in the Wall Street Journal Index, the S&P Daily Corporate News, or Predicasts F&S Index. (6) Eighty-five duplicate announcements form multiple sources were eliminated from the sample. These screening procedures yielded a sample of 88 joint venture announcements made by 56 U.S. companies from 1979 to 1990.

Exhibit 1 provides the frequency distribution and descriptive statistics of the final sample. As indicated in Panel A, 64.7% of the joint ventures were formed between 1984 and 1986. Panel B reports that the median annual sales volume of U.S. parent companies investing in China is about $3.5 billion. About 80% of these U.S. firms are Fortune 500 size firms. Although the parent companies are large, their investments in chinese joint ventures are relatively small. The median dollar investment from U.S. parent companies is $2.86 million, representing a meager 1.24% of the total capital expenditure in the entry year. It is also interesting to note that the median duration of the joint venture agreements is fairly long, 18 years, with a maximum of 30 years. Understanding the difficulty of reaping immediate profits in China, the strategy of U.S. multinationals is to make small investments to gain a foothold in the market and explore the long-term growth opportunities. The last group of statistics shows the investing firms' degree of international involvement. The media foreign sales percentage is about 30%, indicating most U.S. firms are extensively involved in foreign markets. Surprisingly, while the U.S. multinationals have an avegare of 36 foreign subsidiaries worldwide, their presence in the Far East is negligible, with a median of only one subsidiary in the region. Investing in China may indeed represent U.S. multinationals' expansion into the once neglected market.

Exhibit 1. Frequency Distribution by Year of 88 U.S.-China Joint Venture Announcements Made by 56 U.S. Parent Companies and Descriptive Statistics of the Parent Companies' Size, Investment in the Joint Ventures, Joint Venture Duration, and Degree of International Involvement
Panel A.Frequency Distribution by Year of 88 Joint Venture
Year Frequency %
1979 1 1.1
1980 2 2.3
1981 3 3.4
1982 4 4.5
1982 4 4.5
1983 5 5.7
1984 20 22.7
1985 25 28.4
1986 12 13.6
1987 4 4.5
1988 6 6.8
1989 5 5.7
1990 1 1.1
Total 88 100.0
 Panel B.Descriptive Statistics of U.S. Parent Companies' Size,
 Investment in the Join Ventures, and Degree of
 International Involvement
 Mean Deviation Median
Sales (in millions) 7627.93 9289.12 3521.00
U.S. investment
(in millions) 10.84 31.77 2.86
U.S. investment as
% of Capexp 3.18 4.28 1.24
Duration (in years) 18.79 6.18 18.00
Foreign sales as %
of sales 33.97 19.49 30.47
Total Foreign
subsidiaries 35.75 46.55 22.50
Total Far East
subsidiaries 3.02 4.36 1.00
 (i) Sales = annual sales of U.S. parent companies in the year
of forming joint
ventures (Source: The Value Line Data Base-II
 (ii) U.S. investment = Amount of capital agreed on by the U.S.
parents to invest in
the joint ventures (Source: U.S. Investment Database and
Statement of Sino-Foreign
Joint Ventures, 1979-1989, from the Ministry of Foreign Economic
and Trade of the Peoples's Republic of China).
 (iii) Capexp = Annual capital spending plus other investments
(Source: The Value
Line Data Base-II).
 (iv) Duration = Operational duration of joint ventures
(Source: Statement of Sino-Foreign
Joint Ventures, 1979-1989).
 (v) Foreign sales = Annual sales of foreign operations
(Source: The Value Line Data
 (vi) Total foreign subsidiaries = Total number of foreign
subsidiaries the U.S.
parents had in the year of forming joint ventures (Source:
Moody's Industrial,
Transportation and Bank & Finance Manuals, various editions).
 (vii) Total Far East subsidiaries = Total number of foreign
subsidiaries in the Far
East the U.S. parents had in the year of forming joint ventures.

The event study methodology was employed to test if joint venture announcements have any significant effect on security returns. For each firm in the sample, calendar time was translated into event time. Day 0 is the day of public announcement. (7) The days prior to day 0 are the event days-1,-2, and so on, and similarly +1, +2, and so on, are used to denote the days after day 0. To assess the announcement effect on security prices, securities of sample firms were formed into a portfolio, and cross-sectional average excess daily rates of return were analyzed. The estimation period consisted of 90 daily returns (-150 to-30), and the event period of 21 daily returns (-10 to + 10). The excess daily returns were obtained from the CRSP Daily Excess Return File. The test procedure used in this study is similar to that in Asquith [2] and Ryngaert [29], and has its origin in Brown and Warner [4].

IV. Empirical Results

A. Overall Sample

Exhibit 2 presents the portfolio excess returns (PERs) and cumulative portfolio excess returns (CPERs) for the event period of the full sample of 88 U.S.-China joint venture announcements. WE find that, on average, the joint venture announcements are associated with positive excess returns, As shown in Panel A, the PER on dat 0 is 0.52%, the largest one-day excess return over the entire 21-day event period, and is statistically significant at the 0.01 level (with a t-statistic of 2.60). CPERs for various event windows are given in Panel B. The CPER of days-1 and 0 is 0.71% and is statistically significant at the 0.01 level (with a t-statistic of 2.53). The positive PER of 0.52% on day 0 detected in this study is higher than Doukas and Travlos [7] found for their subsample of firms expanding into new geographic markets. They report a significantly positive abnormal return of 0.31% on day 0. Additionally, the two-day (-1,0) CPER of 0.71% documented here is higher than that of 0.40% which Lummer and McConnell [19] found for their international joint ventures.

Another way to assess the wealth effect of joint venture announcements is to convert excess returns into a measure

Exhibit 2. Portfolio Excess Returns and Cumulative Portfolio Excess Returns of 88 Joint Venture Announcements Made by U.S. Multinationals, 1979-1990
 Panel A. Portfolio Excess Returns and Cumulative Portfolio
 Returns for 88 Joint Venture Announcements
Event PER CPER % of Positive
 Day (%) (%) PER
 -10 0.11 0.11 52.3
 -9 0,06 0.17 48.9
 -8 0.23 0.40 51.1
 -7 0.06 0.34 48.9
 -6 0.10 0.44 58.0
 -5 0.33 0.77 61.4
 -4 -O.35* 0.42 45.5
 -3 0.15 0.57 54.5
 -2 0.26 0.83 48.9
 -1 0.20 1.03 51.1
 0 0.52** 1.54 51.1
 1 0.13 1.68 54.5
 2 -0.11 1.56 44.3
 3 -0.14 1.42 46.6
 4 0.11 1.54 47.7
 5 0.18 1.73 52.3
 6 0.28 2.01 50.0
 7 0.12 2.13 53.4
 8 -0.24 1.88 42.0
 9 -0.21 1.67 45.5
 10 -0.30 1.37 43.7
 Panel B. Cumulative Portfolio Excess Returns for Various
 Surroundings the Joint Venture Announcements
 Cumulative Portfolio
Interval Excess Returns t-statistic
(-10,-2) 0.83 1.40
(-5,-2) 0.39 0.99
(-1,0) 0.71 2.53**
(+1, +5) 0.17 0.34
(+1, +10) -0.17 -0.25
 Note: A single asterisk indicates significance at the 0.05
level (one-tailed
test), and a double asterisk indicates significance at the 0.01

of scaled gains. To construct the gain, we first calculated the absolute dollar wealth created from the announcements by multiplying each firm's excess return on day 0 with its total market value of equity on day -1. We then computed the scaled gain by dividing the dollar wealth of each firm by its dollar investment in joint ventures. The average gain fro 50 joint ventures, where data on the initial dollar investment in the joint ventures are availabel, is 15.78 (median = 2.15). The figure remains as high as 3.70 (median = 0.94) even when we removed the top and bottom 5% of observations. The finding suggests that, on average, the wealth gain created from investing in China through joint ventures is 3.7 times the initial investment committed by the investing firms.

In sum, the evidence suggests that investors favorably reacted to news regarding U.S. firms entering the Chinese market through joint ventures. The finding is consistent with the positive-multinational-network hypothesis, which predicts that expansion into a new foreign market produces a positive wealth effect.

Given that other firm-specific concurrent events may have been released during the event period, we searched the Wall Street Journal Index for major news releases regarding dividends, earnings, merger activities, and financing and investment activities over the event window from -10 to +10 days. Subsequently, we removed the "contaminated" announcements from the full sample and repeated the statistical tests on a reduced sample of 51 announcements. As shown in Exhibit 3, the results of the noncontaminated sample are essentially the same as those of the full sample. The PER on day 0 is 0.60% (compared with 0.52% for the full sample) and is statistically significant at the 0.05 level (with a t-statistic of 2.25). CPERs of various intervals around announcement dates indicate nonsignificant excess returns except for the day-1 and 0 interval. The two-day (-1,0) CPER has a value of 1.03% and is significant at the 0.01 level (with a t-statistic of 2.71). The result leads us to conclude that the positive excess returns are not driven by concurrent events.

We also conducted a binomial sign test to determine if the results are affected by outliers. (8) Although the number of stocks with positive excess returns is greater than those with negative returns (the fraction of stocks with positive excess returns for the full sample i8s 51.1% and for the noncontaminated sample is 56.9%), the z-statistics of the full (0.20) and noncontaminated sample (1.07) do not allow us to reject the null hypothesis that the proportion of positive excess returns on the announcement date is the same as that of the estimation period. To evaluate if the results are driven by a few outliers, we examined the

Exhibit 3. Portfolio Excess Returns and Cumulative Portfolio Excess Returns for the Noncontaminated Sample of 51 Joint Venture Announcements Made by U.S. Multinationals, 1979-1990
 Panel A. Portfolio Excess Returns and Cumulative Portfolio
 Returns for 51 Noncontaminated Announcements
Event PER CPER % of Positive
 Day (%) (%) PER
 -10 0.12 0.12 51.0
 -9 0.28 0.40 54.9
 -8 -0.10 0.30 45.1
 -7 -0.16 0.13 45.1
 -6 0.29 0.43 60.8
 -5 0.21 0.64 66.7
 -4 0.19 0.44 49.0
 -3 0.03 0.47 51.0
 -2 0.05 0.52 43.1
 -1 0.43 0.95 52.9
 0 0.60* 1.55 56.9
 1 -0.02 1.53 56.9
 2 -0.11 1.42 41.2
 3 -0.19 1.23 39.2
 4 0.26 1.48 49.0
 5 0.28 1.76 52.9
 6 -0.05 1.71 47.1
 7 -0.13 1.58 49.0
 8 -0.27 1.31 49.2
 9 -.31 0.99 45.1
 10 -0.30 0.69 40.0
 Panel B. Cumulative Portfolio Excess Returns for Various
 Surroundings the Joint Venture Announcements
 Cumulative Portfolio
 Interval Excess Returns t-statistic
(-10,-2) 0.52 0.65
(-5,-2) 0.09 0.17
(-1, 0) 1.03 2.71**
(+1, +5) 0.21 0.30
(+1, +10) -0.86 -0.93
 Note: A single asterisk indicates significance at the 0.05
test), and a double asterisk indicated significance at the
0.01 level.

distribution of excess returns on the announcement date. As shown in Exhibit 4, although the distribution is skewed towards the right, there are no extremely large excess returns in either sample.

To ensure that the few relatively large excess returns did not drive our results, we repeated the tests after removing the top and bottom 5% of observations with large


excess returns. This resulted in removing eight and four observations from the full and noncontaminated samples, respectively. Results for the full sample show that on day 0 the PER is 0.42% (compared with 0.52% without removing the observations with large excess returns) and its still significant at the 0.05 level (with a t-statistics of 1.99). The PER for the noncontaminated sample is 0.50% (compared with 0.60% when the relatively large excess returns were not removed) and its statistically significant at the 0.05 level (with a s-statistic of 1.81). Given the distribution of the excess returns and these test results, we conclude that the positive wealth effect on the announcement date was not predominatly affected by outliers, but by other factors that led investors to systematically revalue the stock prices of the investing U.S. firms. Although in our designs, we controlled for host country differences, variations in the excess returns could have been caused by other factors, such as the size of initial investment in the joint ventures. We now focus our attention on why some joint ventures annoucements enjoy favorable reaction from the the shareholders while others do not.

B. The Source of the Positive Wealth Effect

In section II, we argued that if there is a positive wealth effect, the principal source should be a collection of real options, rather than synergy, diversification, and other effects. If the wealth gain indeed stems from synergy, we would expect the gain to be positively related to the amount of investment made in the joint ventures, as documented by Lummer and McConnell [19]. However, if the main source of the wealth effect is real options, the gain is expected to be negatively related to the amount invested.

We partitioned the entire sample into two groups by the size of U.S. investment in the joint ventures. Sample firms with investment in joint ventures exceeding the median investment of the entire sample are designated as the "large investment group", and others as the "small investment group". The median investment in a joint venture for the small investment groups is $0.60 million (mean = $1.02 million), and that of the large investment group is $6.12 million (mean = $20.66 million).

We repeated the tests for the two groups separetely and the results are shown in Exhibit 5. The positive wealth effect is clearly associated with the small investment group. As shown in Panel A, on the announcement date, the PER for the small investment group is 0.91%, statistically significant at the 0.01 level (with a t-statistic of 2.30). Further, the CPER during days -1and 0 is 1.38%, highly significant at the 0.01 level. To ensure the robustness of the result, we also repeated the binomial sign test. On the announcement date, the fraction of the positive excess returns for the small investment group is 70.4%, statistically significant at the 0.05 level (with a z-statistic of 2.17), permitting the rejection of the null hypothesis of equal proportions of positive excess returns during event and estimation periods. The result indicates that the significant positive wealth effect found within the small investment group is not driven by outliers. In contrast, neither PERs nor CPERs around the annoucements for the large investment group are significantly different from zero at any acceptable significance level. We conducted the same tests using noncontaminated sample and found similar results. (9) The finding lends strong support to our argument that positive portfolio excess returns are negatively related to the size of initial investment in joint ventures.

In addition to the initial investment, the positive wealth effect may be caused by other factors, such as the investing firm's prior presence in the Far East markets, international involvement, and size of the parent firms. In general, the firm actively involved in international business has accumulated [TABULAR DATA OMITTED]

experience that can save it from costly mistakes. Greater level of prior involvement should bring more benefits to the firm. On the other hand, the firm with little international presence may benefit more by expanding across borders because the expansion represents a major step in developing its global network. The gain may also be related to the size of parent companies. Large firms possess the capacity for absorbing large start-up costs and exploring long-term strategic advantages in China. Errunza and Senbet [9] report that a multinational's excess value is positively related to its size. To examine the effect of these variables on the wealth gain, we estimated the following cross-sectional regression:

[CER.sub.i] = [b.sub.0] + [b.sub.1.INVST] + [b.sub.2.ASIAMKT] + [b.sub.3.INVLMNT] + [b.sub.4.SIZE] + [e.sub.i], where [CER.sub.i] is the two-day (-1, 0) cumulative excess return for firm i; INVST is a dummy variable equal to one if a firm's initial investment is greater than the sample median investment, and zero otherwise; ASIAMKT is a dummy variable equal to one if a firm's prior presence in the Far East markets measured by the number of its subsidiaries in the region is more than the sample median, and zero otherwise; INVLMNT is a dummy variable equal to one if a firm's prior international involvement measured by its percentage of foreign sales is greater than the sample median, and zero otherwise; and SIZE is a dummy variable equal to one if a firm's size measured by its annual sales volume is greater than the sample median, and zero otherwise.

Exhibit 6 presents the regression results for a sample of 50 joint venture announcements whose data on the initial investment, number of subsidiaries in the Far East markets, percentage of foreign sales, and annual sales volume are available. The estimated coefficient for INVST is -0.016, statistically significant at the 0.05 level (with a


t-statistic of -2.064). The regression model has an F-statistic of 4.26, significant at the 0.05 level. The result is consistent with our hypothesis that the wealth gain is negatively related to the initial investment made in the Chinese joint ventures. We then injected ASIAMKT and INVLMNT in our regressions 2 and 3, respectively. While none of these entering dummies is statistically significant, the coefficients for INVST in both regressions remain negatively related to the wealth gain, and are statistically significant at the 0.05 level.

In regression 4, we included the SIZE dummy in addition to the variables of a firm's prior presence in the Far East markets and international involvement. Although the sign of the SIZE coefficient is positive as expected, the coefficient is not different from zero at any conventionally acceptable significance level. We noted that the sign, the significance and the magnitude of INVST are preserved. The results suggest that the wealth gain associated with joint ventures in China stems primarily from the value of a collection of options. The options give firms the flexibility to arbitrage institutional barriers and explore future growth opportunities.

V. Conclusion

For a sample of 88 U.S.-China joint venture announcements made from 1979 to 1990, we find statistically significant positive portfolio excess returns(0.52%) on the announcement date for the investing U.S. firms. Additionally we find that the average scaled gain of the announcements is 3.70. The results lend strong support to the positive-mutinational-network hypothesis that expanding firms' global network, in our case, establishing joint ventures in China, creates positive wealth gains for shareholders.

The positive wealth gain is found to be negatively related to the size of foreign investment. Cross-sectional regression results indicate that prior presence in the Far East market, the number of foreign subsidiaries and the size of parent firms, cannot explain the positive wealth gain. We argue, instead, that the real option framework is more appropriate in explaining the results. Firms making small investments in China have the option of making larger investments when future opportunities arise in the market place. At the same time, these firms limit their losses to the size of their investments. It is easy to understand why shareholders are lukewarm about large investments in China. These investments contain an added element of risk even though all foreign firms have to operate in the highly uncertain market condition in China. Large investments reduce the flexibility to expand and increase the downside risk. Based upon the results of this study, it would seem safe to suggest to U.S. investors that they should actively explore opportunities in China through joint ventures, while at the same time they should by prudent and start small.

(1) China's infrastructure is inadequate for most business operations. Foreign investors have to operate in China's nonmarket economy. Prices for goods and services, and financial labor, and product markets are largely controlled by the central government. Foreign joint ventures must also deal with government interference, political instability, and cultural differences.

(2) Finnerty, Owers and Rogers [11] provide little evidence of abnormal returns at the formation of 80 joint ventures in their sample. Ravichandran and Sa-Aadu [28] examine 72 joint ventures in the real estate industry where firms undertake joint ventures to raise capital and to pool special skills and technical knowledge. They find significant positive announcement effects at the joint venture formation. However, Corgel and Rogers [5] report no significant average abnormal returns in their study of 76 real estate joint ventures.

(3) Myers [25, 26] and Kester [16] provide a similar argument that firms often make strategic investments create options for valuable future investments.

(4) In the related literature of international diversification, Agmon and Lessard [1], Hughes, Logue, and Sweeney [14], Fatemi [10], and Errunza and Senbet [9] provide evidence that multinationals offer diversification benefits for their investors. However, Jacquillat and Solnik [15], Senchack and Beedles [30], and Brewer [3] suggest that investing in multinationals is a poor substitute for international portfolio diversification.

(5) Since the Register covers only to 1987, we can check the accuracy of the council's listing only from 1979 to 1987. After 1987, we rely on the data provided in the council's database.

(6) To ensure precise event dates when using Predicasts F&S Index, we included only joint venture announcements made in daily newspapers. The exception is the Asian Wall Street Journal Weekly. Phone calls were made to verify that the newspaper is always printed on the previous Friday and delivered the following Monday. Since the earliest public available day is every Monday, it can be safely used as the event date. The following are sources of announcements in the final sample of 88 joint venture announcements: 41 were from the Wall Street Journal (46.6%); 34 were reported in the S&P Corporate Daily News (38.6%); two appeared in the Asian Wall Street Journal Weekly (2.3%); the remaining announcements were from other daily newspapers, such as the New York Times(6.8%), the Journal of Commerce(3.4%), and Nachrichten fur Asussenhandel, a German newspaper (2.3%).

(7) We used the date when the joint venture announcements appeared in the Wall Street Journal as the announcement date. In the case where S&P Corporate Daily News was used, day 0 is the date following the news wire report. This is because the news wire date usually precedes the date of the printed report in the Wall Street Journal by one trading day. If the announcements were made on nontrading days, the following trading days were defined as day 0.

(8) The sign test used here is computed as z=(p - nr)/[n(1 - r)r][sup.1/2], where p is the number of positive excess returns on day 0, n is the total number of individual returns in the portfolio on day 0, and r is the fraction of positive excess returns during the estimation period. The z-test determines if the proportion of positive excess returns on day 0 is statistically different from those during the estimation period.

(9) To ensure our results are not caused by the size of the parent companies, in that large firms tend to invest larger amounts than small firms, we divided the size of investment in joint ventures by the capital expenditures of the parent companies in the entry year. We then partitioned the entire sample by this ration and repeated the tests. The result is similar to that presented in Exhibit 5. The positive wealth effects, is negatively related to the ratio of investment in the joint ventures to the capital expenditures.


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[29] M.D. Ryngaert," Firm Valuation, Takeover Defenses, and the Delaware Supreme Court," Financial Management (Autumn 1989), pp. 20-28.

[30] A.J. Senchack and W.L. Beedles, "Is Indirect International Diversification Desirable?" Journal of Portfolio Management (Winter 1980), pp. 49-57.

[31] U.S.-China Business Council, Special Report on U.S. Investment in China, The China Business Forum, Washington, D.C, 1990.

Haiyang Chen is with the Department of Accounting and Finance, Youngstown State University, Youngstown, Ohio; Michael Y. Hu is with the Department of Marketing, Kent State University, Kent, Ohio; and Joseph C.P. Shieh is with the Department of Financial Management, National Chengchi University, Taipei, Taiwan.
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Title Annotation:International Finance Special Issue
Author:Chen, Haiyang,; Hu, Michael Y.; Shieh, Joseph C.P.
Publication:Financial Management
Date:Dec 22, 1991
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