divers east asian firm

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Strategic Management JournalStrat. Mgmt. J., 28: 101120 (2007)

Published online in Wiley InterScience (www.interscience.wiley.com) DOI: 10.1002/smj.572

Received 19 April 2002; Final revision received 3 July 2006

DIVERSIFICATION AND PERFORMANCE: EVIDENCE

FROM EAST ASIAN FIRMS

ABHIRUP CHAKRABARTI,1 KULWANT SINGH2* and ISHTIAQ MAHMOOD21 Fuqua School of Business, Duke University, Durham, North Carolina, U.S.A.2 Department of Business Policy, National University of Singapore, Singapore

We examine the impact of diversification on performance for firms operating in differentinstitutional environments during a relatively stable period and during a major economy-wide shock. We locate our study in six Asian countries at different levels of institutionaldevelopment. Results indicate that diversification negatively impacts performance in moredeveloped institutional environments while improving performance only in the least developedenvironments. Even in the least developed institutional environments, diversification offers limitedbenefits when an economy-wide shock strikes. Though successful diversifiers are sometimes

affiliated with business groups, diversification is associated with poorer performance for bothaffiliated firms and independent firms. In sum, we find that the outcomes of diversification areinfluenced by institutional environments, economic stability and affiliation with business groups.Copyright 2007 John Wiley & Sons, Ltd.

Several studies propose that diversification is morelikely to be profitable in emerging economies(Guillen, 2000; Khanna and Palepu, 1997; Kockand Guillen, 2001). The underlying argument isthat in emerging economies, intermediate insti-tutionssuch as financial and market intermedi-ariesare inefficient or absent (Alston, Eggerston,and North, 1996; Aoki, 2001; Aron, 2000). In suchenvironments, diversified firms can gain scopeand scale advantages from internalizing functionstypically provided by institutions and markets inadvanced economies. Evidence of extensive andapparently profitable diversification in some lessdeveloped institutional environments (Chang andHong, 2002) is consistent with the view thatfirms in these environments should diversify to a

Keywords: diversification; firm performance; institutionalenvironment; economic shock; Asia*Correspondence to: Kulwant Singh, Department of BusinessPolicy, National University of Singapore, 1 Business Link,Singapore 117592. E-mail: [email protected]

greater degree than firms in relatively developedinstitutional environments.

However, questions remain about the antece-dents and consequences of diversified operationsby firms in developing economic environments.First, will firms be able to manage their diversi-fied operations in environments characterized byeconomy-wide uncertainties? Specifically, wouldfirms in less developed institutional environmentsbenefit from being diversified when a major eco-nomy-wide shock radically alters the economicenvironment? By definition, diversified firms willbe affected by multiple environments simultane-ously undergoing major changes during an eco-nomy-wide shock, and may suffer from having todeal with multiple challenges at the same time.As economic shocks are symptomatic of weak-

nesses in emerging economies (Backman, 1999;Corsetti, Pesenti, and Roubini, 2001), it is impor-tant to establish the boundaries or conditionality ofthe proposition that diversification produces betterperformance outcomes in less developed institu-tional contexts.

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102 A. Chakrabarti, K. Singh and I. Mahmood

Second, do group-affiliated firms benefit moreor less from diversifying than independent firms?Many legally independent firms in less developedeconomies are affiliated with business groups, anetwork form of organization (Khanna and Rivkin,2001) that enables individual affiliates within a

group to share resources. To the extent that diver-sified groups act as internal markets for affiliatedfirms, there might be less need and fewer benefitsto affiliates diversifying themselves. Yet, access tothe groups resources may enhance the outcomesof affiliated firms diversification. The influenceof group affiliation on diversification is especiallyintriguing because of the expectation that diver-sification occurs at the group level and not atthe individual firm level (Chang and Hong, 2002;Khanna and Palepu, 1997; Kock and Guillen,2001), despite anecdotal and empirical evidence

suggesting that group-affiliated firms do diversify(Chang and Hong, 2002). It is therefore importantto establish whether theoretical arguments support-ing diversification in emerging economies apply toindividual firms affiliated with business groups.

In this study, we examine how diversifica-tion affects firm performance in different institu-tional environments, and how an economy-wideshock affects this relationship. Relying on exist-ing arguments, we hypothesize that diversifica-tion is more likely to be performance enhanc-ing in less developed institutional environments.Next, we argue that these benefits are predicatedon a relatively stable environment, and hypoth-esize that diversified firms are likely to performworse during an economy-wide shock. This argu-ment rests on the view that firms have difficultydealing with sudden and major changes (Green-wood and Hinnings, 1996; Hannan and Freeman,1984; Rajagopalan and Spreitzer, 1997) and thatfirms with more complex organizational architec-tures which diversified firms embody throughoperating in multiple businesseswill experience

greater difficulty when major changes occur (Han-nan, Polos, and Carroll, 2003). These difficul-ties offset the benefits of diversification, such asrisk spreading and resource sharing across busi-nesses, which decline substantially during systemicevents such as economy-wide shocks. Finally, weexamine the diversification performance relation-ship during an economy-wide shock across differ-ent institutional contexts, arguing that diversifiedfirms suffer greater performance declines during

an economy-wide shock in less developed institu-tional environments. We evaluate firm performancefor all analyses but examine the influence of busi-ness group affiliation.

We test these arguments using a sample of 3,117firms operating in Indonesia, Japan, Malaysia, Sin-

gapore, South Korea, and Thailand between 1988and 2003. These countries play an important rolein the development of East Asia, and are at variousstages of economic and institutional development.All suffered severe slowdowns during the majoreconomic shock that struck the region in 1997.This allows us to adopt a comparative institutionalperspective (Guillen, 2001; Hamilton and Biggart,1988) to evaluate the diversificationperformancerelationship across different levels of institutionaldevelopment during and outside an economy-wideshock. In examining the above questions, we seek

to clarify the diversificationperformance relation-ship and extend theory and research in Asia byadding to the limited empirical strategy researchon East Asia and emerging economies (Hoskissonet al., 2000; White, 2002).

THEORY AND HYPOTHESES

The extensive diversification literature documentswhy firms diversify, the circumstances under which

diversification can improve firm performance, andthe conditions under which firms face increasingcosts of diversification (see Montgomery, 1994;Palich, Cardinal, and Miller, 2000; Ramanujamand Varadarajan, 1989). Diversification can bedriven by a range of perceived benefits associatedwith greater market power, more efficient allo-cation of resources through internal capital mar-kets, utilization of excess productive factors, moreefficient utilization of existing resources in newsettings, or reduced performance variability byvirtue of a portfolio of imperfectly correlated set

of businesses. However, the benefits of diversifica-tion decline after expansion beyond an optimal orthreshold range, suggesting an inverted-U rela-tionship between performance and diversification(Markides, 1992). Greater diversification increasesmanagerial, structural, and organizational com-plexity, incurs greater coordination and integrationcosts, strains top management resources (Grant,Jammine, and Thomas, 1988), limits organiza-tional attention (Ocasio, 1997) and inhibits firms

Copyright 2007 John Wiley & Sons, Ltd. Strat. Mgmt. J., 28: 101120 (2007)

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Diversification and Performance 103

ability to respond to major external changes (Don-aldson, 2000; Greenwood and Hinnings, 1996;Hoskisson and Hitt, 1994). Other inefficienciesand costs arise from conflicting dominant logicsbetween businesses, internal capital market con-flicts, and increased control and effort losses due to

shirking (Markides, 1992). Hence, the difficultiesand costs of diversification increase with the scopeof operations, eventually offsetting the benefits offurther diversification. Empirical research in devel-oped economies has often concluded that diver-sification leads to poorer performance, and thuscarries a diversification discount (Montgomeryand Wernerfelt, 1988; Ramanujam and Varadara-

jan, 1989). In sum, these arguments suggest thatfirms can benefit from moderate diversification,but that broader diversification may harm per-formance (Dess et al., 1995; Hoskisson and Hitt,

1994; Montgomery and Wernerfelt, 1988; Palichet al., 2000; Ramanujam and Varadarajan, 1989).

Institutional context as a contingency: The

internal market hypothesis

Recent strategy research in emerging economyenvironments (Chang and Hong, 2002; Hoskissonet al., 2000; Khanna and Palepu, 1997; Wan andHoskisson, 2003) has raised interesting questionsabout how country differences affect the antece-

dents and consequences of firm diversification. Inthis section, we discuss the internal market hypoth-esis, which proposes that diversification providesgreater benefits for firms operating in less institu-tionally developed environments.

An important implication from existing researchis that the gains from diversification often relate tomarket failure. Market power arguments assumethat individual firms cannot contract among them-selves to match the advantages of the diversi-fied firm, while internal capital market argumentsrequire some failure in information and finan-

cial markets. The resource utilization argumentrequires that resources be imperfectly tradable,while the reduction of risk proposition requires thatshareholders value firms diversification because ofconstraints on their own ability to spread risks. Ingeneral, the potential returns from diversificationdecrease with market and institutional develop-ment, so that diversification would not improvefirm performance in perfect markets. Therefore, thedegree of market and institutional development is

an important determinant of the efficacy of diver-sification (Khanna and Palepu, 1997). Kogut et al.(2002) attribute differences in diversification pat-terns in five advanced countries (France, Germany,Japan, U.K., and U.S.A.) to nation-specific differ-ences. Matsusaka (1993) shows that in the United

States views toward diversification turned increas-ingly negative between the 1960s and the 1980s asfinancial institutions developed.

Khanna and Palepu (1997) argue that greaterdiversification may not harm performance inemerging economies because of insufficient mar-ket and institutional development. By diversifying,firms create internal markets that may be moreeffective than inefficient external markets (Ghe-mawat and Khanna, 1998; Khanna and Palepu,1997; Williamson, 1985). These firms enjoy scopeand scale advantages from internalizing func-

tions provided by external intermediaries or insti-tutions in advanced economies. As intermedi-aries are often absent or inefficient in developingeconomies, internalization may be viable and prof-itable. Diversified firms do not gain equally indeveloped institutional environments, as it is moredifficult for internal operations to match relativelyefficient markets. Similar arguments apply to thecosts of diversification. Efficient markets in devel-oped economies detect and penalize diversifica-tions costs more than the less efficient markets ofinstitutionally developing economies. This implies

greater net marginal benefits from internalizationin less developed institutional environments.

Kock and Guillen (2001) propose that protec-tionism and other barriers in the less economicallyand institutionally developed economies distort thevalue of resources, and make diversification moreviable than in competitive markets. They propose,for example, that contacts and connections aremore important than competencies and technologi-cal abilities for determining the incentives and out-comes of diversification in such environments. Asthese contacts are not business specific, firms will

exploit them by diversifying. Some observers (e.g.,Backman, 1999) note that for many Asian firmsdiversification is motivated by factors which mar-ket efficiency arguments do not adequately cap-ture, such as the exploitation of privileged accessto information, licenses, and markets. However,these advantages decline with development, sug-gesting that diversification is less beneficial inmore developed institutional environments (Kockand Guillen, 2001).


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Therefore, the outcomes of firm diversificationwill vary across countries, because of the influ-ence of the institutional environment within whichdiversification takes place. We expect that firmsin less institutionally developed economies willbenefit more substantially from diversification than

firms in more institutionally developed economies.

Hypothesis 1: The less institutionally developed

an economy, the greater the benefits of diversi-

fication for firm performance.

This section described the internal market hy-pothesis, that diversification may be more prof-itable in less developed economies. However, twoissues arise. First, institutional contexts can affectboth the benefits and the costs of diversification.Research examining the impact of institutional

environments addresses the benefits for diversifica-tion, but generally does not consider the manage-ment, organizational, and other costs of diversify-ing in underdeveloped institutional environments.In essence, this perspective views weak institu-tional environments as increasing the marginalbenefits of diversification but not marginal costs.We return to this issue in our discussion below.

The second issue relates to an assumption under-lying the internal market hypothesis, that firms candiversify non-systematic risk by moving resourcesacross unrelated units. It is less clear, however,

how diversification affects performance when risksare correlated, as in the case of a major economy-wide shock. Research has not evaluated whetherthe performance benefits of diversification in timesof relative stability transfer to when firms facemajor and broad external changes to the economy.

In the following sections, we discuss the impactof an economy-wide shock on firms to clarify theboundary conditions of the internal market hypoth-esis. We then examine how the effects of diver-sification on performance may vary with groupaffiliation.

Economic stability as a contingency:

Economy-wide shock

In this section, we argue that greater diversifica-tion is associated with poorer performance duringeconomy-wide shocks. We rely on two main argu-ments, that an economy-wide shock (1) reducesthe internal market benefits of diversification, and(2) increases management and organizational costs

more for diversified firms. We expect these effectsto have greater performance impact in less devel-oped institutional environments and that businessgroup affiliation will play an important role in thisissue, but consider these in following sections.

An economy-wide economic shock is a broad,

major, sudden, and unanticipated change in theeconomic environment. An economy-wide shockdiffers from other hostile environment changesin two respects. First, economy-wide shocks tendto be systemicbroadly affecting businesses andindustries in a country or regionin contrast tolocalized changes that only affect firms in specificindustries or technologies. Second, such shockstend to be radical, creating discontinuities that dis-rupt firms, industries, markets and economies, andcause fundamental changes in resource availabil-ity, demand conditions, and in the way economic

agents operate.Economy-wide shocks have two distinct andsequential effects on firms. First, firms typicallysuffer sudden and major disruptions to their busi-nesses, which often lead to declines in revenuesand profits. These primarily result from disruptionsin demand, markets, suppliers, and buyers; rapidincreases in financial costs and risks; and changesin exchange rates (Singh and Yip, 2000). Uncer-tainty about the depth, duration, and consequencesof the shock often compound these performancedeclines. Second, and usually after the causes,

extent, and consequences of the shock becomeclearer, firms restructure to adapt to the changedenvironment. In this paper, we focus on the firsteffect, the impact of the shock on firms before theyadapt.

The spreading of risks benefit of diversificationmay not apply during an economy-wide shock.Lubatkin and Chatterjee (1994) argue that the port-folio effect for securities is not directly appli-cable to firm diversification, suggesting limitedrisk-spreading benefits when economic conditionschange broadly. The advantages that diversified

firms enjoy in less developed institutional envi-ronments will also decline, as privileged access toresources and internal transfers provide relativelyfew benefits during periods of sudden, widespread,and drastic economic slowdown. When many or allof a diversified firms markets are affected duringan economy-wide shock, it will be less able to shiftresources from strong to weaker business. Somebusinesses that were viable because of resourcetransfers will suffer in their absence or reduction.


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An organizations architecture is determined byits formal structure, processes, rules, and coordi-nating and governance mechanisms (Hannan et al.,2003), with greater variety in these increasingorganizations architectural intricacy or complex-ity. Diversified firms embody greater architectural

complexity through the creation of separate struc-tures, processes, and rules for each operation andbusiness, and through the use of structural mech-anisms for coordination and governance. Hencediversified firms embody greater architectural com-plexity to have the requisite variety to deal withthe multiple environments they operate in (Ashby,1969). This complexity reduces their flexibility andresponsiveness to external change. Structural solu-tions, such as the adoption of the M-form structure,may moderate but will not eliminate architecturalcomplexity unless firms allow divisions to operate

independently; however, this prevents coordina-tion and resource sharing across divisions, limit-ing the benefits of diversification (Markides andWilliamson, 1996).

The cascading organizational change frameworkintroduced by Hannan et al. (2003) illustrates thescale and scope of challenges diversified firmsface during an economy-wide shock. During aneconomy-wide shock, actions by individual busi-nesses or units lead to a cascade of reactions inother units and businesses within the firm, witha greater cascade likely in firms with greater

architectural complexity. Consequently, diversi-fied firms are likely to face greater cascadesof strategic, organizational, resource, information,and management challenges than more focusedfirms during an economy-wide shock. These cas-cades of changes strain and divert managerialattention, and hinder appropriate response (Hannanet al., 2003; Ocasio, 1997).

The trend for diversified firms to deal withgreater architectural complexity by introducingrigid financial controls and routines furtherreduces their flexibility and responsiveness to

external change (Greenwood and Hinnings, 1996;Hoskisson and Hitt, 1994). Donaldson (2000)argues that diversified firms generally exhibitgreater misfit between structures and environmentsbecause of wider spans of control and the greatersupervisory burden of CEOs, and therefore areless able to change. Studies in the organizationalchange, restructuring, and ecology literaturesfurther indicate that firms have difficulty dealingwith sudden, broad, and major change (Greenwood

and Hinnings, 1996; Hannan and Freeman, 1984;Newman, 2000; Rajagopalan and Spreitzer, 1997).

Consequently, in addition to reducing the ben-efits of diversification, an economy-wide shockincreases the costs of diversification. An economy-wide shock decreases the benefits of diversification

by diluting the benefits of internal markets andincreases the costs of diversification by makingit more difficult to manage multiple challengesat the same time. Collectively, the fall in bene-fits and the rise in costs of diversification implythat broader exposure to simultaneous, sudden,and widespread adverse changes in their envi-ronments will cause diversified firms to suffergreater performance declines during an economy-wide shock.

Hypothesis 2: The more diversified a firm, the

greater the decline in its performance during aneconomy-wide shock.

Interface between economy-wide shock and

institutional contexts

The change in firm performance during an eco-nomy-wide shock will be influenced by inter-nal factors such as diversification as discussedabove, and by external factors such as the stateof institutional development, the subject of our

next hypothesis. In general, the difficulties thatdiversified firms face during a major economicshock are likely to be greater in less developedinstitutional environments. There has been littleempirical research on how the interface of firmdiversification and institutional environments influ-ences firm performance during an economy-wideshock.

In less developed institutional environments,institutions are likely to be less effective in mobi-lizing and provisioning resources to firms duringan economy-wide shock. The relatively unsophis-

ticated financial and market institutions in lessinstitutionally developed economies are likely tobe less effective at providing the liquidity firmstypically need during an economy-wide shock.The relative weakness of regulations and regula-tory agencies, and of professional and technicalintermediaries, may result in organizations hav-ing less information about the causes and impactof the shock, and less assistance in understand-ing and dealing with the consequences of such


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shocks. This will hurt the performance of diver-sified firms more because of the greater scopeof the challenges they face during an economy-wide shock. In essence, the institutional weak-nesses that permit firms to benefit more substan-tially from diversifying during relatively stable

periods will cause these firms to suffer greaterdeclines in performance when an economy-wideshock strikes.

The arguments leading to Hypothesis 2 suggestan economy-wide shock will reduce the benefitsand increase the costs of diversification. Here, weexpect the decline in the benefits and the increasein the costs of diversification during an economy-wide shock to be greater in less developed insti-tutional contexts. Thus, we expect the net per-formance benefits that diversified firms enjoy inrelatively stable environments to decline during a

shock, and to decline more in less developed insti-tutional environments.

Hypothesis 3: The less developed the institu-

tional environment, the greater the decline in

performance of diversified firms during an

economy-wide shock.

The impact of business group affiliation

Business groups are an important feature in many

less developed institutional environments (seeChang and Hong, 2002; Khanna and Rivkin,2001). Business group affiliation may significantlyaffect the outcomes of firm-level diversificationand the manner in which an economy-wide shockaffects group-affiliated firms because these firmshave access to network-level resources.

Business groupsnetworks of legally indepen-dent firms linked by a set of formal and infor-mal ties that coordinate their actionstypicallyattempt to overcome or exploit inefficient or absentmarkets and institutions in emerging economies

by diversifying broadly through the creation ofnetworks of related firms (Biggart and Hamil-ton, 1992; Khanna and Palepu, 1999; Kock andGuillen, 2001). Business groups comprise firmsoperating in different industries, whose activitiesare coordinated by a central firm or organization.Coordination centers on, but is not restricted to,resource transfers between affiliated firms, withresources moved to where they have the greatesteffect. The establishment of separate but affiliated

firms moderates problems associated with indi-vidual firm diversification, such as organizationalarchitecture complexity, conflicting dominant log-ics, and loss of focus.

This raises two issues related to groups anddiversification that have not been adequately ad-

dressed. First, why would group-affiliated firmsdiversify when their groups can do so more effec-tively?1 If business groups are efficient mecha-nisms for diversifying in less developed institu-tional environments, groups would diversifythrough the creation of firms for each business,reducing the incentive for these affiliated firmsto diversify. Yet, group-affiliated firms differ intheir scale, scope, and profitability of operations,suggesting varying levels and success of diversi-fication (Chang and Hong, 2002). The businessgroup literature has paid little attention to group-

affiliated firms diversification, perhaps implicitlyrelying on the proposition that group diversifica-tion substitutes for and precludes affiliated-firmdiversification.

Second, what are the outcomes of group-affiliated firms diversification? Group-affiliatedfirms may be able to diversify successfully byexploiting spillovers from group-level resourcetransfers. They may also be able to mobilizeresources more readily or at lower cost fromexternal agencies, because group affiliation mayprovide reputation benefits and privileged access.

Groups are also likely to develop greatermanagerial and organizational sophistication andresources from managing their more complexstructures and diverse operations. These may spillover into improved diversification competencies atthe affiliated-firm level. Collectively, these factorsmay improve the outcomes of diversification foraffiliated firms. However, group objectives mayrestrict affiliated firms diversification, limitingperformance gains. For example, affiliated firms

1 There are several reasons for doing so, all of which relate to

imperfect substitutability of group diversification for affiliated-firm diversification. These include the advantages of diversifyingon the basis of resources or competencies that are available in anaffiliated firm, but are not easily transferable or decomposable,even to related organizations (Siggelkow and Levinthal, 2003);the desire to reduce variance in the affiliated firms performance,which may be an important consideration for firms with concen-trated ownership (Thomsen and Pedersen, 2000); the possibilitythat market opportunities may be too small to justify the estab-lishment of a separate unit within the group; and agency-relatedissues at the firm level. We do not explore these motives inthis paper, but investigate their manifestation in the outcomes ofaffiliated firms diversification.


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diversification may be hindered by the needto contribute resources to the group (Lincoln,Gerlach, and Ahmadjian, 1996), or by constraintson expanding into businesses where otheraffiliated firms are incumbents or prospectiveentrants. It is an empirical issue whether group

affiliation provides net positive benefits for firmdiversification. We examine this as a researchquestion.

We next evaluate whether group affiliationbuffers the negative impact of an economy-wideshock. Spillover benefits from resource sharingwithin groups are likely to decline substantiallyduring an economy-wide shock, as most or allaffiliated firms will be affected simultaneously.Firms that relied on internal resource transfersto support their diversification will be affectedmore severely if such transfers decline because

of resource shortages. Firms less affected by aneconomy-wide shock may be required to shareresources with other affiliated firms, harming theoutcomes of their diversification. Other grouppolicies may restrict firm choices and flexibil-ity. Negative reputation effects from poorer groupperformance may cause affiliated firms to losethe privileged access they often enjoy to exter-nal resources as a result of their group affilia-tion. However, the converse is also possible, thatan affiliated firm may enjoy superior access toexternal resources during an economy-wide shock

because of its group affiliation. Meanwhile, diver-sified independent firms face similar challenges ofbroad exposure to an economy-wide shock, thoughwithout the burden or benefits of group affilia-tion.

In view of these conflicting effects, we exam-ine the net benefits of group affiliation during aneconomy-wide shock as an empirical issue. Wealso examine these effects across institutional envi-ronments, as institutional and business group dif-ferences may affect outcomes.

In summary, we propose that individual firms

operating in less developed institutional environ-ments benefit more from diversification than firmsoperating in more developed institutional envi-ronments (Hypothesis 1). However, these benefitsare limited to relatively stable periods, so thatdiversified firms will suffer greater performancedeclines during an economy-wide shock (Hypoth-esis 2), especially if they operate in less developedenvironments (Hypothesis 3). Finally, we evaluatehow business group affiliation influences affiliated

firms diversification, and whether such affiliationbuffers the impact of an economy-wide shock indifferent institutional environments.

DATA AND VARIABLES

We locate our study in six East Asia coun-tries Indonesia, Japan, Malaysia, Singapore,South Korea, and Thailandfor the 19882003period. These countries are important economiesin the region, are at various stages of economicand institutional development, and suffered broadand severe slowdowns during the major economicshock that struck the region in 1997. Our empiricalcontext provides a conservative test of the benefitsof diversification, as very rapid economic growthover the two decades prior to 1997 provided a

munificent environment that allowed even rela-tively inefficient firms to prosper (Corsetti, Pesenti,and Roubini, 1999).

We selected 19 manufacturing industries gen-erally represented in our sample countries usingall firms listed in the Osiris database (CompactCD-ROM, Disclosure, Inc.). Restricting the studyto an industrial sample controls for technologicalinfluences on diversification and allows better iso-lation of the relationship between diversification,performance and institutions. We included firmsthat entered our sample after our start year of

1988 and retained them until they exited from oursample. The final sample comprised 3,117 firms.Of these, 942 were single-business firms at somepoint during the study period. We obtained macro-economic and institutional data from EconomistIntelligence Units CountryData and CountryIndi-cators databases.

Measures

Diversification

We measured diversification with the widely usedentropy measure (Jacquemin and Berry, 1979;Palepu, 1985), calculated as follows:2

E =

N

i=1

Piln 1

Pi

2 We did not adopt the refinement of the entropy measureproposed by (Raghunathan, 1995) as the disaggregated datarequired were not available.


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where Pi is the share of the ith segmentoperationalized in Osiris at the four-digit SIClevel of the firms total sales. We used thequadratic measure of entropy to test for nonlinearrelationships. As an alternative measure of diver-sification, the Herfindahl Index, was highly corre-

lated with entropy, we only report results using theentropy measure.

Performance

We used return on assets (ROA) with a 1-year lagas the measure of firm performance for the test ofHypothesis 1. For Hypotheses 2 and 3, we use logof next period ROA as the measure of change inperformance. We discuss this measure below.

Institutional environment

Despite widespread acceptance of the concept andimportance of institutions, there are no theoret-ically established empirical measures of institu-tions (Aron, 2000). We therefore adopt a compar-ative approach to test the impact of institutionalenvironments, evaluating hypotheses by estimatingcountry-level models. Differences across countrieswould be indicative of institutional differences.

Table 1 provides information on institutionalenvironments across countries, summarizing threedifferent measures of institutional development

and one measure of economic development, percapita gross national income (GNI). This tableindicates substantial differences in institutional

development across countries, general conformityamong institutional measures, and equivalencebetween these measures and per capita GNI. Oneexception is that despite Japan having the high-est per capita GNI, all measures ranked it belowSingapore in institutional development.

Economy-wide shock

Most countries in South East and East Asia werestruck by their most severe economic shock indecades in 1997 and 1998 (Corsetti et al., 1999;Dornbusch, Park, and Claessens, 2000). The sud-denness and severity of the shock were unantic-ipated and caused countries to suffer rapid andsignificant adverse movements in exchange rates,foreign investment, and trade, leading to majoreconomic recessions. Foreign investors pulled out;

access to funds was curtailed, many firms defaul-ted, shut down or reduced their operations, andmany jobs were lost. The shock was a major cri-sis for all sample countries. Average ROA for oursample declined between 1995 and 1998, averag-ing 0.074, 0.071, 0.057, and 0.039, respectively.As we use a short window for this analysis, ourstudy design partially controls for the endogenouseffects of firm adaptation and external institutionalchange, allowing us to focus on the impact of theshock on firm performance.

We used three complementary measures of the

shock. The first is industry market capitalization,which we computed by summing the market cap-italization of all firms in our dataset in each

Table 1. Measures and rankings of institutional environments

EIU indicatora Euromoney countrycreditworthinessb

Composite ICRGrisk ratingc

Per capitaGNId

Singapore 8.81 (1) 93.7 (1) 92.5 (1) 20,690(2)Japan 7.39 (2) 93 (2) 87.3 (2) 34,010(1)S. Korea 7.12 (3) 80.3 (3) 79.3 (3) 9,930(3)Malaysia 7.06 (4) 79.4 (4) 76.3 (4) 3,540(4)Thailand 6.78 (5) 64.6 (6) 71.3 (5) 2,000(5)Indonesia 5.89 (6) 68.9 (5) 66.3 (6) 710(6)

a EIU Country Indicators database. Computed from 37 items rating various aspects of the political environment, the macro-economicenvironment, market opportunities, policies relating to free enterprise, competition and foreign investment, foreign trade and exchangecontrols, taxes, financing, labor markets, and infrastructure. Data presented are for 2003.b Assesses country risk based on nine weighted categories that include debt, economic performance, political risk, and access tofinancial and capital markets. Based on polls of economists and political analysts. Measured for 1997. Reported in World DevelopmentIndicators (1998).c Information on 22 components is grouped into three major risk classes: political, financial, and economic. These are transformed intoa single numerical risk measure. A score below 50 implies very high risk, and one above 80 implies very low risk based. Measuredfor 1997. Based on PRS Group monthly updates, and reported in World Development Indicators (1998).d Real per capita GNI for 2003, in thousands of U.S. dollars per year, obtained from Asian Development Bank.


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industry, within each country, for each year ofanalysis. We used a similar approach to measureindustry average ROA, our second measure of theshock. Industry market capitalization and industryaverage ROA control for differences in oppor-tunities and the impact of the shock. The third

measure was per capita GNI, which is a broadindicator of the economic environment. Collec-tively, these measures comprehensively indicatethe economic environment firms operated in beforeand during the shock. These measures also con-trol for variation in the economy-wide shock ineach country, as the shock affected firms mostdirectly through changes in industry-level opportu-nities and profitability. For the test of Hypotheses2 and 3, we use 1-year changes in these val-ues to detect the impact of the economy-wideshock.

Business groups

We used several different sources to complementthe Osiris database to identify business groupaffiliation, relying primarily on published papers,researchers, industry and market publications, andfirm websites. For Japanese business groups, wealso distinguished between horizontal and verticalbusiness groups, to account for potential differ-ences in strategies (Lincoln et al., 1996). Hori-zontal business groups tend to diversify broadly

across industries, which contrasts with verticalbusiness groups focus on forward or backwardintegration within the same industry. FollowingChang and Hong (2002), we distinguish betweenthe 30 largest business groups in Korea and

other business groups, to account for substantialdifferences in strategies, resources, and perfor-mance.

Control variables

We included several control variables. Firm size,based on total assets (millions of U.S. dollars,logged), controlled for size-related impact on per-formance and for the greater tolerance that largefirms may have to economy-wide shocks. Age(in years), current ratio (current liabilities/totalliabilities), and debt ratio (debt/equity) measuredresource availability and constraints for each firm,and indirectly controlled for affiliated firms use ofgroup resources (Chang and Hong, 2002). Finally,an indicator dummy variable in our test of Hypoth-esis 1 distinguished between the period prior to

the economy-wide shock (198896; pre-shock=1) and after it (19992003; pre-shock= 0). Con-cerns about time period effects were reduced byfindings of marginal time effects by Khanna andRivkin (2001), whose study included several ofour sample countries for overlapping time peri-ods.

Tables 2 and 3 present descriptive statistics.Table 3 shows that group affiliation was onlyassociated with lower diversification in a fewcases, confirming the value of testing diversifi-cations outcomes for affiliated firms. Affiliated

firms achieved lower ROA than independent firmsin most countries for both non-shock and shockperiods, a pattern consistent with earlier research.Khanna and Rivkin (2001) show that independentfirms achieved higher average ROA than groups

Table 2. Descriptive statistics

Variables N Mean S.D. 1 2 3 4 5 6 7 8

1 ROA 47,425 0.059 0.217 1.0002 Entropy 41,609 0.521 0.466 0.071 1.000

3 Size 48,947 11.755 2.116 0.050 0.177 1.0004 Debt ratio 49,033 0.596 10.963 0.040 0.034 0.035 1.0005 Credit ratio 48,924 1.971 6.455 0.002 0.025 0.037 0.094 1.0006 Age 49,033 35.430 23.355 0.125 0.241 0.555 0.007 0.033 1.0007 Industry ROA 49,033 0.059 0.056 0.255 0.159 0.216 0.009 0.004 0.305 1.0008 Industry market

capitalization49,026 0.575 3.414 0.017 0.047 0.041 0.014 0.003 0.056 0.061 1.000

9 GNI per capita 48,985 20.464 13.893 0.096 0.294 0.473 0.002 0.007 0.655 0.371 0.103

All values are in thousands of U.S. dollars (except age, debt ratio, current ratio).All values >0.01 or >0.01 are significant at the 0.05 level or lower.Number of firms = 3117.


DOI: 10.1002/smj


10/20


Table3.

Descriptivestatistics:ROAanddiversificationforgroup-affiliatedandnon-groupfirmsbycountry

Singapore

Japan

Korea

Malaysia

Thailand

Indonesia

Group

Non-

group

Horizontal

group

Vertical

group

Non

-

grou

p

Top30

group

Other

group

Non-

group

G

roup

Non-

group

Group

Non-

group

Group

Non-

group

Numberoffirms

46

164

328

231

844

95

242

540

69

312

36

107

47

56

Nonshockperiod(19882003

,excluding1997and1998)

ROA

0.077

0.103

0.014

0.038

0.04

5

0.058

0.050

0.082

0.101

0.095

0.131

0.071

0.105

0.80

(0.147)(

0.254)

(0.194)

(0.209)

(0.24

4)

(0.146)

(0.185)

(0.194)(0.142)

(0.206)

(0.202)

(0.293)

(0.307)

(0.340)

Significancetest

2.20

32.8

33.1

0.82

4.02

1.54

Entropy

0.358

0.345

0.727

0.645

0.67

2

0.587

0.504

0.547

0.307

0.234

0.084

0.190

0.354

0.247

(0.437)(

0.380)

(0.481)

(0.425)

(0.45

7)

(0.481)

(0.441)

(0.450)(0.425)

(0.348)

(0.256)

(0.349)

(0.352)

(0.325)

Significancetest

0.69

28.8

17.84

5.24

6.17

6.29

Shock(1997and1998)

ROA

0.057

0.105

0.016

0.028

0.04

5

0.038

0.038

0.073

0.061

0.076

0.086

0.037

0.077

0.070

(0.107)(

0.205)

(0.092)

(0.127)

(0.14

9)

(0.166)

(0.141)

(0.162)(0.114)

(0.186)

(0.128)

(0.225)

(0.277)

(0.308)

Significancetest

2.06

12.3

9.97

0.85

1.68

0.16

Entropy

0.367

0.301

0.724

0.634

0.67

1

0.554

0.487

0.532

0.330

0.220

0.095

0.204

0.354

0.241

(0.453)(

0.358)

(0.470)

(0.417)

(0.46

1)

(0.466)

(0.430)

(0.442)(0.440)

(0.341)

(0.231)

(0.350)

(0.356)

(0.322)

Significancetest

1.43

4.7

2.21

3.13

2.49

2.61

Datareportsmeansandstandarddeviations(inparentheses)foreachsample.

Significancetestsreportt-statistic

andsignificancelevelsforallpairedtests,andF-statisticandsignificancelevelsforJapanandKorea,fortestthatgroup-affiliatedandnon-group

meansaredifferent.

p

divers east asian firm

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