Economics & Finance
• 7 minute read

Foreign Investments – A Matter of Head or Heart?

Makino, Shige

Besides economic factors, psychological factors, such as national sentiments, also have an impact on investments and trade

By Megan Li, PhD Candidate, Department of Management, CUHK Business School

Whether it was the negative sentiment of U.S. and Russia toward each other during the cold war era, or the positive sentiment of Vietnam toward France since World War II, or the negative sentiment Chinese people have toward Japan over the Diaoyu Islands conflict, national sentiments are real.

National sentiment refers to the socially constructed patterns of sensations, expressive gestures, and cultural meanings organized around a relationship to a country. It depicts the affect-laden judgements of one country toward another in either positive or negative ways.

While sentiment exists in any relationship between two countries, positive or negative, strong or weak, little has been known about how national sentiment exerts an influence on business, in particular, a country’s investments in another country.

Prior studies on the decision of foreign investments tend to emphasize on the role of economic factors such as market potential, production costs, business operation environment, etc.

However, a study conducted by the Chinese University of Hong Kong (CUHK) Business School takes a different perspective and investigates the influence of psychological factors on foreign direct investment (FDI). The working paper entitled “Does national sentiment matter?” was conducted by Shige Makino, Director of Center for International Business Studies and a professor in the Department of Management, and his PhD student Megan Li.

The Study

The study looks at an annual survey conducted by the Cabinet Office of Japan. The survey focuses on Japanese people’s affinity/non-affinity with other countries, such as China, Korea, Russia, the United States and others. After controlling the conventional factors like geography, economics and institutions, the results show that national sentiment has a significant influence on FDI.

“If we recall the conflicts over the Diaoyu Islands between Japan and China in the past, many Chinese citizens took to the streets and called for the boycott of Japanese goods. This act shows how business is controlled not just by economic factors but also by sentiment,” says Prof. Makino.

Variations of Sentiment Influences

According to the study, national sentiment is represented by the degree of people’s affinity or non-affinity with a foreign country. The finding shows that Japanese people’s positive sentiment towards a certain country facilitates its investment in that country, while their negative sentiment impedes the investment.

As the data analysis shows, 1 percent increase in Japan’s affinity toward a particular country will bring about 2 percent increase in Japan’s FDI in that country; while 1 percent increase in Japan’s non-infinity toward a country will cause a drop in its FDI in the country by about 3 percent. For example, Japan’s affinity toward the U.S. is almost three times as much as its affinity toward South Korea; resulting in Japan’s FDI in the U.S. at US$32,000 million versus its FDI in South Korea at US$4,000 million, as statistics in 2012 reveal.

However, one surprising finding from the study is that Japanese people’s negative sentiments toward China did not show significant influence on its investment in China. This can be explained by the high dependence of Japan’s economy on China’s economy. This high dependence relationship creates inertia in terms of trade partner choice, and hence makes the influence of sentiment less significant in a short period of time. Therefore, there is usually a time lag between conflicts that happened between the two countries and a decrease in the trade volume between them.

“However, if the conflict continues, the hard feeling between the two countries may bring negative influence on Japanese investment in China,” says Prof. Makino.

“It is the fundamental sentiment – the sentiment one country holds toward the other given its interpretation of the other’s deeds in the past years – that determines the level of inter-country trade to a large extent.”

Stronger Negativity, Higher Influence

The paper also shows that negative sentiment has a much higher influence on FDI than positive ones. That means that conflict between two countries may significantly reduce trade, but friendship may not significantly increase. This sheds interesting implications on China’s investment in other countries. As suggested by this study, China should put more effort to avoid conflicts with other countries rather than just build friendly relationships.

Just as the relationship between a married couple will consist of bitter quarrels and also sweet moments from time to time, they will be less likely to break up just because of small disagreements, but may do so after a long period of accumulation of negative sentiments. For example, one partner always criticizes the other for being unable to please her/him, or unable to earn enough money to raise a family, etc. As time goes by, these negative sentiments will begin to accumulate and even escalate. If the issue is not resolved, it could lead to a breakup.

Similarly, a temporary conflict between two countries may not reduce the trade between them. It is the fundamental sentiment – the sentiment one country holds toward the other given its interpretation of the other’s deeds in the past years – that determines the level of inter-country trade to a large extent. However, this does not mean that transient sentiment cannot exert an influence on FDI, as it takes time for the transient sentiment to change the fundamental sentiment one country holds toward another.

“This is like what we call the store-and-flow effect of a water tank. Although the water flow will not change the water storage to a great extent in just one second, it will do so in a few minutes,” explains Prof. Makino.

Implications on China Business Environment

According to the researchers, the finding is intriguing in that it brings the role of emotions into national trade, which is neglected by most of the previous studies. It implies that a rise in a country’s “soft power”, which is closely linked to other countries’ affinity with the focal country, can help to facilitate the trade between two countries. In another word, the friendship between two countries can enhance the economic integration of the two countries.

For example, China’s political visits to other countries and its cultural communication with another country can help to build positive sentiments between them, as well as facilitate the inter-country trade.

Another implication from the study is that China may have temporary conflicts with other countries but it should not allow the negative relationship to go on for a long period of time. Otherwise, it will turn into negative fundamental sentiments held by other countries. Once the negative fundamental sentiment is formed, it will take a longer time to change, and eventually may lead to a significant attenuating effect on the FDI of other countries in China.

Conclusion

Economic development is still China’s top priority at this moment. The country has been making proactive actions to facilitate the economic exchange across countries such as establishing the Asian Infrastructure Investment Bank (AIIB). As China becomes stronger in terms of economy and military, its relationship with the United States and Japan also becomes more intense. To ensure future growth and success, China should pay close attention to the significant influence of sentiments on the following two issues, in particular, the study suggests.

First, it should take the influence of national sentiment into consideration of foreign firms’ investment in China. As the country is still in need of foreign investments in its economic development, China should not take a purely economic perspective. It should not assume that decision makers in economy are rational and that politics and economy work independently. This is simply not true as the study reveals that sentiments clearly can have a significant influence on FDI.

Second, it should take note of the fact the influence caused by negative sentiments is much stronger than that by positive sentiments. Therefore, China should try to avoid conflicts with other countries, especially for a long period of time, as its effect goes beyond politics.

In conclusion, Prof. Makino says, “I really wish that China and Japan could put the past down, and take a more forward-looking perspective into the future development. If they just focus on splitting up a ten-inch cake, the most each of the countries can get is ten inches; however, if they can make a 20-inch cake together, each of them will enjoy a bigger piece of cake and benefit more.”

 


Makino, Shige

Professor

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