Song, S 2015, Inter-country exchange rates and intra-firm trade flow within

global network of multinational corporation, Management International

Review, vol. 55, no. 1, pp. 122.

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Manag Int Rev (2015) 55:122
DOI 10.1007/s11575-014-0233-4

RESEARCH ARTICLE

Inter-Country Exchange Rates and Intra-Firm Trade

Flow Within Global Network of Multinational
Corporations

Sangcheol Song

Received: 1 June 2012 / Revised: 13 October 2014 / Accepted: 1 December 2014 /

Published online: 16 January 2015
Springer-Verlag Berlin Heidelberg 2015

Abstract This study examines how effectively multinational corporations

(MNCs) respond to changing external environments by intra-firm shifts of products
under the influence of divergent currency changes among countries. We test main
hypotheses using a panel dataset of Korean FDI and feasible generalized least
square model on STATA 10. We find that more counterpart affiliates with opposite
directional exchange rate change, lower transportation costs of product shipping,
lower labor cost growth rates, and higher portfolio ownership control are positively
associated with the subsidiary intra-firm sales. By examining the actual mecha-
nisms whereby MNCs can realize operational flexibility through intra-firm trade
among their foreign subsidiaries, this study extends the multinational operational
flexibility literature. We show that the magnitude of intra-firm trades within the
MNCs subsidiary network reflects the level of its operational flexibility.

Keywords MNCs
FDI
Exchange rate
Transporation costs
Labor cost

Ownership control

1 Introduction

Since macro-economic uncertainties in countries significantly affect the cost of

doing business, one of the most important strategies for multinational corporations
(MNCs) must involve effectively managing such uncertainty. Since MNCs cannot
anticipate exactly how the future will unfold in a changing environment, it is crucial
for them to be able to change established strategies without incurring significant
costs (Kogut and Kulatilaka 1994; Lee and Makhija 2009a, b). Such flexibility
allows MNCs to achieve higher competitive advantage over their competitors that

S. Song (&)
College of Business, Saint Josephs University, Philadelphia, USA
e-mail: ssong@sju.edu

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2 S. Song

lack the same level of flexibility (Allen and Pantzalis 1996; Chung et al. 2010; Fisch
and Zschoche 2011, 2012; Lee and Song 2012).
The literature on multinational operational flexibility, therefore, focuses on
flexible management to cope with surging uncertainty. It argues that, particularly in
times of uncertainty, MNCs benefit from the ability to adjust their value-chain
activities, which include production and sales among affiliated firms located in
different countries (Cohen et al. 1989; Cohen and Lee 1989; Chung et al. 2010;
Hodder and Jucker 1985; Huchzermeier and Cohen 1996; Pantzalis et al. 2001). In
other words, MNCs with operations in multiple countries are better able to respond
to unexpected changes in their investment countries macro-economic conditions by
exploiting cost differentials on a global scale and coordinating their productions
within the subsidiary network (Allen and Pantzalis 1996; Cohen et al. 1989; Cohen
and Lee 1989; Huchzermeier and Cohen 1996; Tang and Tikoo 1999). These
arguments are similar to the real options argument that MNCs can preserve upside
potentials and curb downside risks with the help of flexible responses to favorable
and unfavorable changes in macro-economic conditions of their investment
countries (Kogut and Kulatilaka 1994; Lee and Song 2012; Pantzalis et al. 2001).
However, in spite of increasing interest in this topic, few empirical studies
directly test MNCs operational flexibility. We argue that without directly
examining how MNCs transfer resources or relocate their value-chain activities
among affiliated firms, it would be difficult to determine whether MNCs actually
exercise multinational operational flexibility using their portfolio of subsidiaries.
Additionally, few studies examine how MNCs operational flexibility is realized at
the subsidiary level. Thus, we address the following question: How do MNCs
foreign subsidiaries respond flexibly to uncontrollable changes in macro-economic
factors in their host countries and take advantage of their parent companys
operational flexibility?
To answer this question, we first examine the impact of a host countrys currency
depreciation on a foreign subsidiarys intra-firm product sales to its affiliates in
other countries undergoing a currency appreciation. We also examine environmen-
tal and organizational factors that help foreign subsidiaries exploit their parent
MNCs operational flexibility. One way to analyze MNCs operational flexibility is
to examine intra-firm trade flows within the MNC subsidiary network. In this paper,
intra-firm trade refers to the sales and purchase of products among affiliated firms
within the same MNCs network; it also indicates how closely the firms are
operationally linked via cross-border product shifts (Kiyota et al. 2008; Makhija
et al. 1997; Rangan 1998). Thus, we expect that a subsidiarys intra-firm sales to its
affiliates in other countries will be affected by contingent factors arising in both its
host country and other countries. Specifically, its intra-firm sales out of its host
country will be affected by the host countrys labor costs as another production
factor and its own ownership-based control over its operations. The cross-border
product shifts will also be affected by other countries conditions, including the
number of affiliated firms with opposite directional exchange rate changes (i.e.,
currency appreciation) and the transportation costs of cross-border product shifts via
intra-firm trade.

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Inter-Country Exchange Rates and Intra-Firm 3

We believe that this study contributes to the literature on multinational

operational flexibility, which is being studied in greater depth by real options
theorists in the international business field. The literature does not pay enough
attention to contingent factors in production and sales, as well as the conditions of a
country relative to other countries. This study is expected to provide a coherent and
comprehensive framework for understanding how MNCs and their foreign
subsidiaries take advantage of their international network and realize the real
options value embedded in their international investments.

2 Theory and Hypotheses

2.1 Environmental Uncertainty and Multinational Flexibility

In their global production, MNCs are exposed to diverse sources of environmental

uncertainty including those resulting from foreign exchange rates or demand
(Cuypers and Martin 2010; Goldberg and Kolstad 1995). Under the influence of
environmental uncertainty in their host countries, MNCs flexibility becomes even
more important (Kogut 1991; Kogut and Kulatilaka 1994; Lee and Makhija 2009a).
In other words, since changes in macro-economic conditions in host countries
require MNCs to make quick but costly adjustments in their strategy, it is important
that they make cost-effective adjustments in their productions in a timely manner to
ensure good firm performance and survival (Cohen et al. 1989; Cohen and Lee
1989; Chung et al. 2010; Hodder and Jucker 1985; Huchzermeier and Cohen 1996;
Lee and Makhija 2009a).
The multinational operational flexibility perspective argues that thanks to their
global operations MNCs are able not only to cope with uncertainty, but also are able
to exploit uncertainty by shifting their resources and/or relocating their value-chain
activities from more costly production sites to less costly production sites (Fisch and
Zschoche 2011, 2012; Huchzermeier and Cohen 1996; Kogut and Kulatilaka 1994;
Lee and Song 2012; Pantzalis et al. 2001). For example, changes in exchange rates
across countries trigger MNCs product shifts using their international network
(Kogut and Kulatilaka 1994; Lee and Song 2012). Huchzermeier and Cohen (1996),
and Pantzalis et al. (2001) argued for asymmetric payoffs, i.e. maximizing profits in
favorable currency situations while curbing downside risks in unfavorable currency
situations. In similar logic, Fisch and Zschoche (2011, 2012) tested cross-country
shifts of labors as a production factor under the influence of differing labor costs
across countries.
Given that multinational flexibility is retained and realized within a portfolio of
MNC subsidiaries, the operational links among subsidiaries play an important role
in MNCs flexible responses to divergent macro-economic changes across countries.
MNCs are able to adjust their production volume by transferring products from
unfavorable locations to favorable locations via their internal product market. This
internal product market allows MNCs to reduce transaction costs, increase
efficiency, and enhance flexibility. Intra-firm trade, meaning internal product
transactions among an MNCs subsidiary network (Feinberg and Gupta 2009;

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4 S. Song

Kiyota et al. 2008), therefore, reflects the operational linkages or relationships

among all companies within the same MNC network, or the degree of the MNCs
global integration (Kobrin 1991; Makhija et al. 1997). It implies that isolated
subsidiaries cannot provide switching options, whereas subsidiaries connected by
intra-firm trade transactions to other subsidiaries allow the parent firm to retain its
operational flexibility using dispersed subsidiaries across countries.
The flexible response to different currency movements in the form of intra-firm
trade indicates the positive impact of the internal product market of an MNCs
multinational subsidiary network. This is consistent with Buckley and Cassons
(1976) argument that internal sourcing of major products enables MNCs to have a
competitive advantage; this argument is supported by Kotabe and Murray (1990)
and Kotabe and Omura (1989). In addition, it is in line with the finding that foreign
subsidiaries capture the benefits of cheaper finance from internal capital markets, as
suggested by (Foley et al. 2007) and Foley et al. (2008). Regarding the relationship
between the network position of foreign subsidiaries and their performance
(Monteiro et al. 2008) and Chung et al. (2010) pointed out the negative aspect of
subsidiaries that are isolated from their international network, since the isolation
prevents them from exploiting the positive network effect, including cheaper
finance using the internal financial market.
Considering that multinational operational links are reflected in intra-firm trades
in the same MNC network, we examine below the environmental and organizational
factors that allow MNCs foreign subsidiaries to enjoy a buffer against unpredict-
able changes in currencies and, further, to take advantage of cross-country cost
differentials associated with relative value changes in exchange rates.

2.2 Host Countrys Currency Depreciation and Intra-firm Sales

Currency fluctuations in countries where an MNCs subsidiaries are operating are

commonly considered the most influential factor affecting the MNCs price
competitiveness (Goldberg and Kolstad 1995; Miller and Reuer 1998; Pantzalis
et al. 2001). According to international trade theory, favorable currency change (i.e.,
when its host countrys currency depreciates) enhances the price competitiveness of
a subsidiarys product and thus spurs its export out of its host country to other
countries experiencing opposite directional currency change (i.e., currency appre-
ciation). On the other hand, an unfavorable change (i.e., when the host countrys
currency appreciates) has opposite effects on the price competitiveness of produced
goods and exports.
The multinational operational flexibility perspective also argues that an MNC
experiencing divergent currency changes in its subsidiary network is motivated to
shift its products between less costly locations and more costly ones, using its
portfolio of foreign subsidiaries. When the currency of a country where a subsidiary
is located depreciates, the enhanced price competitiveness of its output will favor
more its local production and export to other countries with relatively low price
competitiveness. In countries with currency appreciation, other affiliated firms can
sell the imported goods from the focal subsidiary at a lower price in their host
countries. From a parent MNCs standpoint, it would be valuable to respond flexibly

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Inter-Country Exchange Rates and Intra-Firm 5

to cross-country cost and value differentials associated with exchange rates by

adjusting its production and sales volume via intra-firm product shifts from
depreciating currency countries to appreciating currency countries.
Based on these arguments, we hypothesize as follows:
Hypothesis 1: The currency depreciation in a foreign subsidiarys host
country is positively associated with an increase in intra-firm sales to the
subsidiarys affiliates in countries where there is currency appreciation.
We expect that a subsidiarys intra-firm sales to its affiliates in other countries
will be affected by contingent factors associated with other affiliates countries
conditions, its host countrys economic condition, and its own control over cross-
border intra-firm trade. Specifically, its intra-firm sales across borders will be
triggered by other countries demand for the same product, its host countrys labor
costs as another environment factor, and its ownership-based control over its cross-
border intra-firm trade decisions. We examine below the impact of these contingent
factors on a subsidiarys intra-firm sales out of its host country.

2.3 Number of Affiliates with Currency Appreciation

We expect that multinational operational flexibility is not uniformly advantageous

to every MNC. According to the operational flexibility literature, intra-firm product
shifts are more likely to be used by MNCs with a widely dispersed set of
subsidiaries in many countries rather than those with subsidiaries concentrated in
one country (Chung et al. 2010; Lee and Makhija 2009b; Pantzalis et al. 2001; Tang
and Tikoo 1999). Operational flexibility allows MNCs to keep their options open by
investing resources in multiple countries; when an unexpected challenge arises in
one subsidiary, the resources in other subsidiaries can be exploited to address that
subsidiarys difficulties. The more subsidiaries that are available as options for an
MNC, the more likely that MNC will be able to resort to intra-firm product shifts
and take advantage of foreign exchange fluctuations rather than suffering from them
(Kiyota et al. 2008).
Since the existence of subsidiaries in foreign locations is a prerequisite for intra-
firm product shifts (Cho 1990), we expect that the more subsidiaries are dispersed
over different countries the greater will be the MNCs potential to take advantage of
cross-country intra-firm product shifts (Mol et al. 2004; Park 2000). On the other
hand, concentrated subsidiaries in a smaller number of countries limit an MNCs
opportunities for product shifts. Since competitive advantage comes from the
internal sourcing of major products (Buckley and Casson 1976), MNCs are likely to
resort to product shifts within their international networks.
Prior research indicates that an MNC with high FDI breadth (i.e., an MNC having
foreign subsidiaries in more countries) enjoys greater operational flexibility (Allen
and Pantzalis 1996; Chung et al. 2010; Lee and Makhija 2009b; Pantzalis et al.
2001; Tang and Tikoo 1999). Particularly, if a subsidiary is part of an MNCs
network where more affiliated subsidiaries experience currency appreciation
relative to their host countrys currency, the subsidiary can more easily use intra-
firm sales of the same product to those affiliates. In other words, the magnitude of

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6 S. Song

intra-firm trade increases with the number of counterpart subsidiaries having the
same product and opposite directional currency change (Caves 1996; Willmore
1992).
Therefore, we hypothesize the following:
Hypothesis 2: A subsidiarys cross-border intra-firm sales in a host country
whose currency has depreciated is positively moderated by the number of its
affiliates in countries where the currency has appreciated.

2.4 Transportation Costs

International trade is affected by transportation costs associated with the geographic

distance between exporters and importers (Bernard et al. 2006; Faeth 2009; Jones
et al. 2005; Xing 2007). Transportation costs account for a high portion of all costs
related to international trade and thus affect trade flows, target countries, and
transported items (Keane and Feinberg 2007; Kimura et al. 2007). Transportation
costs convey an advantage to producers in proximity to the local market that are
engaged in horizontal integration and whose strategic orientation is to establish
similar production processes in different locations (Baltagi et al. 2007). Lower trade
costs enhance firms productivity (Bernard et al. 2006; Kimura and Ando 2005;
Munroe et al. 2007).
For that reason, in the case that a foreign subsidiary plans to export the same
product to affiliated firms in other countries, the subsidiary should consider the
transfer costs of shifting the product. If the subsidiary faces high transportation
costs, it may be disinclined to engage in cross-border trade of its product. In
contrast, lower transportation costs would encourage cross-border product shifts
among subsidiaries exposed to opposite directional currency changes.
In sum, lower trade costs associated with cross-border product shifts may
encourage a subsidiary to supply the same product to the local market by purchasing
from counterpart subsidiaries in distant locations (Fujita and Thisse 2006). In
contrast, costly transportation costs offset the benefits of importing the same product
from affiliates in distant locations. Hence, we hypothesize as follows:
Hypothesis 3: The cross-border intra-firm sales of a subsidiary in a host
country whose currency has depreciated will be positively moderated by the
lower transportation costs of cross-border intra-firm sales.

2.5 Host Countrys Labor Costs

A foreign subsidiarys production and sales associated with its product price
competitiveness are affected by labor costs as well as currency changes in its host
country. Labor cost is considered another important production factor (Belderbos
and Zou 2009; Fisch and Zschoche 2011, 2012). If a subsidiary experiences rising
labor cost in its host country, its production costs also increase, and thus, the price
competitiveness of its output is lost. Subsequently, its export of a product out of its
host country will be negatively affected. In that situation, the positive impact of
currency depreciation on its cross-border sales will be offset by the negative impact

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Inter-Country Exchange Rates and Intra-Firm 7

of rising labor costs. In other words, host country currency depreciation is expected
to promote cross-border intra-firm sales, whereas its rising labor cost is expected to
hold cross-border intra-firm sales back.
On the other hand, if labor costs were consistent or decreased, the impact of
currency changes would be more obvious and affect a subsidiarys cross-border
intra-firm trade as expected above, leading us to our fourth hypothesis:
Hypothesis 4: The cross-border intra-firm sales of a subsidiary in a host
country whose currency has depreciated will be positively moderated by the
lower labor cost growth of the host country.

2.6 Portfolio Ownership Control

A subsidiarys ownership reflects its management control over its operation in its
host country. The decision to make intra-firm sales to its affiliates in other
countries out of its host country is an important one from the standpoint of both
the subsidiary itself and its parent MNC. The cross-border shifts of products
require timely and effective decision making, and a subsidiary with high levels of
ownership has the ability to quickly and expeditiously make intra-firm trade
decisions (Pan 2002). On the other hand, a subsidiary lacking decision-making
authority cannot take advantage of its parent MNCs operational flexibility. For
instance, partially owned or joint venture subsidiaries have to achieve consensus
with their partners. Co-ownership sometimes requires that a great deal of time and
effort be put into coordinating and orchestrating different views on cross-border
intra-firm trade decisions (Rycroft 2003; Tong and Reuer 2007). Further, such
decisions may sometimes be hindered or rejected by a partners objections. From
their parent MNCs standpoint, this condition applies likewise to a subsidiarys
counterpart affiliates, since cross-border intra-firm trade takes place between two
subsidiary parties within the same MNC network (Pan 2002; Tang 2003). In the
case that each counterpart affiliate in a host country having currency depreciation
enjoys high levels of ownership control, each can help its counterparts in countries
undergoing currency appreciation via intra-firm product sales.
In sum, a portfolios ownership status will reflect the managerial control over
cross-border intra-firm trade. Higher ownership levels of both a subsidiary and its
counterpart affiliate will positively facilitate product shifts across the border. Hence,
we hypothesize as follows:
Hypothesis 5: The cross-border intra-firm sales of a subsidiary in a host
country whose currency has depreciated will be positively moderated by a
higher level of ownership-based control over the subsidiarys operation.

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8 S. Song

3 Research Methodology

3.1 Data

We have 18 years of observations of Korean MNCs from 1990 to 2007. Among

Korean manufacturing companies publicly listed on the Korean stock exchange in
1990, we include 201 Korean MNCs that possessed at least one foreign subsidiary in
our empirical testing. We use total of 2,404 subsidiary observations in 41 host
countries for our panel data analyses. We believe that this long time horizon and
number of host countries can address MNCs responses to differing levels of
currencies, as well as their ability to spread any relevant costs of cross-border
product shifts over time and take advantage of multinational operational flexibility
(Aabo and Simkins 2005; Goldberg and Kolstad 1995; Huchzermeier and Cohen
1996).
We located the information of foreign subsidiaries of Korean MNCs from several
sources. For the financial information of all publicly-traded firms on Korean stock
exchange, we referred to DataPros dataset which Korean researchers in finance and
accounting employ. For the information of Korean FDIs, we referred to The Status
of Foreign Investments, published initially by the Bank of Korea and later by the
ExportImport Bank of Korea. We additionally referred to information provided by
Korea Trade Investment Promotion Agency (KOTRA), the Korea Listed Companies
Association (KLCA), or the Korea Information Service (KIS) website.

3.2 Dependent Variable

Intra-firm trade indicates purchase and sales of products among sister companies
within the same MNC network (Kiyota et al. 2008; Lee and Makhija 2009a). This
intra-firm trade information allows us to examine whether or not an MNC actually
shift their resources or relocate their production and sales activities using its
international subsidiary network under differing macro-economic conditions. In
order to examine whether currency depreciation in a subsidiarys host country
triggers more exports of the subsidiarys product via intra-firm sales to its affiliated
subsidiaries in other countries with currency appreciation, we count the ratio of the
subsidiarys volume of intra-firm sales of the same type products to other affiliates
having lower price competitiveness associated with currency appreciation out of its
total sales volume. For the information of Korean MNCs intra-firm trade, we
referred to annual audit reports provided by Retrieval and Transfer System (DART),
Korean electronic disclosure system, and TS2000 Warehouse database of the Korea
Listed Companies Association (KLCA).

3.3 Independent Variables

Host Countrys Currency Depreciation In order to address the direction of

currency changes based on the monthly exchange rate data of an MNCs investing
countries including its home country, we calculate the magnitude of the annual

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Inter-Country Exchange Rates and Intra-Firm 9

percentage change in each country currency. The currencies for each country year
by year are obtained from the International Monetary Fund.
The Number of Affiliates with Currency Depreciation We counted the number
of a subsidiarys affiliated companies (1) whose countries are appreciated against
the subsidiarys host countrys currency, and (2) which are in the same industry to a
focal subsidiary. We expect that the more subsidiaries with opposite directional
currency change, the more a subsidiary is likely to shift its product to those affiliates
in other countries. Considering that this measure captures the directionality of both
intra-firm trade and relevant countries exchange rate changes, we believe it is a
better measure than a traditional one for FDI breadth used in other studies which
measure FDI breadth as the number of countries only that at least a foreign
subsidiary operates (e.g., Allen and Pantzalis 1996; Lee and Makhija 2009b; Tang
and Tikoo 1999).
Transportation Costs of Product Shifts To examine the impact of cost of
transporting a subsidiarys product to other countries, we measured transportation
cost as the averaged ratios of weight to value of shipments by industry segment
between a focal subsidiary and each of its counterpart affiliates (Mauri and Phatak
2001). We took the negatives of the original ratios to examine the impact of lower
transportation costs. We followed Mauri and Phataks (2001) measure and located
the ratio of weight to value of shipments by industry segment from the Census of
Transportation. We believe this measure is more product-specific and time-varying
than geographic-distance based one (Clark 2007; Martinez-Zarzoso and Nowak-
Lehmann 2007).
Host Countrys Labor Costs By incorporating growth rates of its host countrys
labor cost, we examined potentially counter-veiling impact of rising labor costs in a
subsidiarys host country on the positive impact of its host countrys currency
depreciation on its product export to other countries. We measured it as the annual
percentage in unit labor costs in manufacturing in its host country. For empirical
testing, we used the negative value of the original sum in order to examine the
impact of lower labor cost growth rates. We located the data of labor costs from the
International Labor Organization website.
Portfolio Ownership Control In order to check how much peer affiliates are
able to control for their cross-border intra-firm trade, we measure portfolio
ownership level as the ratio of the number of cases that both a focal subsidiary and
its counterpart affiliate possesses more than 50 % ownership in each operation out
of all available two-country pairs between the focal subsidiary and each of
counterpart subsidiaries. For example assuming that a focal subsidiary (A) has three
subsidiaries (B, C, D) in other countries subject to currency depreciation and A, B,
C have majority ownership positions, the ratio would be 0.67 (two country pairs (A
B, AC) out of three country pairs (AB, AC, AD). We expect the higher control
over cross-border intra-firm trade, the more easily relevant affiliates will be able to
conduct their cross-border intra-firm product shifts for their own benefits.

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10 S. Song

3.4 Control Variables

First we incorporated relevant subsidiary-level variables. First, we controlled for

subsidiary performance measured as its return on asset (ROA). Second, we included
subsidiary age measured as the time difference between its establishment year and
t - 1. Third, considering that subsidiary size reflects the overall capability and slack
resources of a firm, we included this variable. We measure subsidiary size as the log
of its total assets (Aabo and Simkins 2005). Considering that when the input such as
raw materials is also imported from the international market, the price competive-
ness gained from currency depreciation can be largely offset, we controlled for the
ratio of input imported from the international market out of total inputs. We located
the local and international sourcing of Korean MNCs from each MNCs annual
audit report provided by Retrieval and Transfer System (DART).
We also considered some host-country variables. First, we included currency
appreciation as a control variable to examine how it affects intra-firm sales with
respect to currency depreciation. Second, we included GDP per capita differences
between a currency depreciation country and a currency appreciation country to
see whether product are not differentiated across markets and can be easily sold in
other markets without adaption according to differing GDP per capita. We expect
that similar GDP per capita may facilitate more intra-firm sales of the sample type
product between counter-partnering subsidiaries. Third, we included GDP growth
rate differences between a currency depreciation country and a currency
appreciation country to examine whether larger GDP growth rate in a currency
depreciation country is positively associated with more demand of a focal
subsidiarys product and thus negatively associated with exports out of the
country. We refer to the GDP statistics from the Organization of Economic
Cooperation and Development (OECD) and World Bank websites. Fourth, we
included country risk which is expected to negatively affect production and sales
activities of a foreign subsidiary. We used each countrys country risk score from
EUROMONEY magazine.
We also incorporated two parent MNC-level variables. The first one is parent
firm size measured in the log of the parent firms total assets. This variable reflects
parent firms ability to support its foreign subsidiarys production and sales
activities. The second one is parent firm international experience. The more
experience its parent firm has accumulated in international markets, the easier it will
be able to assist or coordinate its foreign subsidiaries production and sales
activities. We measured this variable as the sum of operating years of all foreign
subsidiaries in the same MNC network, following prior studies including Delios and
Beamish (2001), and Padmanabhan and Cho (1999).
Finally, in order to solve problems relating to any unobserved heterogeneity we
include three dummy variables associated with the fixed effects of firm, industry,
and country. Since firms that practice dispersed production and/or product shifting
may simply be superior firms, we include firm dummy variables in order to control
for firm fixed effects. Since firms operating in different industries may require
different flexibility strategies under different competitive environments (Rangan
1994; Tang and Tikoo 1999; Tong and Reuer 2007), we also include industry

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Inter-Country Exchange Rates and Intra-Firm 11

dummy variables based on the Korean Standard Industry Code two-digit level
industry classifications. We also included country dummies in order to take into
consideration unobserved differences country by country.
Table 1 presents the definitions, measures, and data sources of all variables.

3.5 Analytical Procedures and Model Specifications

Considering the endogeneity issue associated with each subsidiary intra-firm trade
engagement, we used the Heckmans two stage model. In the first stage, we run a
probit model to regress intra-firm trade choice on relevant predictors. We used
subsidiary size and age, and parent MNCs size and international experience, and
Chaebol (Korean Conglomerate) membership as the predictors for intra-firm trade
choice as the dependent variable. From the first regression, we obtained the Inverse
Mills Ratio as the correction factor for potential endogeneity and included it into the
second stage.
In the second stage, we used a STATAs xtgls command and ran a feasible
generalized least squares (FGLS) model addressing the three potential problems
relating to panel data: panel heteroscedasticity, contemporaneous correlation, and
serial correlation. FGLS allows us to examine the time-series component of the
analysis as well as maximize the degrees of freedom (Lee et al. 2008) by producing
the residuals used to estimate the unit-specific serial correction of the errors before
transforming the model into one with serially independent errors (Beck and Katz
1995). We also add the STATA option, force corr(psar1), to xtgls in order to
address potential problems related to unequally-distributed observations or repeated
units over time.

4 Results

Table 2 presents the mean and standard deviation for each variable and the
correlation coefficients among variables. In order to check for potential multicol-
linearity problems we use variance inflation factors (VIF) to see how much a given
predictor affects other coefficients variances (Hamilton 2006). The highest VIF in
this sample is 1.97, lower than the commonly-used cut-off point of 10 or 4 as the
more conservative one. This index means that multicollinearity is not a significant
concern in our sample.

4.1 Testing for Main Hypotheses

Table 3 contains the results of the FGLS model relating to the degree of intra-firm
sales of a foreign subsidiary exposed to its host countrys currency depreciation.
Model 1 only includes the control variables, Model 2 adds five primary independent
variables, Model 3 through 6 present coefficients and significance of two-way
interaction terms between currency appreciation and each of independent variables.
Model 7 incorporates all interactions terms. Wald Chi square test statistics show that

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 Table 1 Summary of variables
12

Variables Definitions and measures Data sources

123
Dependent variables
Intra-firm sales Annual percentage change in intra-firm sales to subsidiaries exposed to Annual audit report provided by Retrieval and Transfer System
currency appreciation) (DART)
Independent variables
Host country currency Annual percentage change in host country currency Exchange rate statistics of International Monetary Fund
depreciation
The number of Negative averaged values of annual percentage changes in GDP growth
subsidiaries with rates for past 3 years
currency
appreciation
Lower transportation Negative averaged ratios of weight to value of shipments by industry The Census of Transportation
costs segment
Lower labor cost Annual percentage in unit labor costs in manufacturing in its host country Labor cost statistics from the International Labor Organization
growth rate
Subsidiary ownership Ratio of the number of cases that both a focal subsidiary and its The Bank of Korea, The Export and Import Bank of Korea, Korea
counterpart affiliate possesses more than 50 % ownership in each Trade Investment Promotion Agency, The Korea Listed
operation out of all available two-country pairs between the focal Companies Association
subsidiary and each of counterpart subsidiaries
Controls
Subsidiary Return on asset The Bank of Korea, The Export and Import Bank of Korea, Korea
performance Trade Investment Promotion Agency, The Korea Listed
Subsidiary age Subsidiarys total operating years Companies Association
Subsidiary size Log of subsidiarys total assets
Imported input ratio Imported inputs/total inputs Annual audit report provided by Retrieval and Transfer System
(DART)
Currency appreciation Negative values of annual percentage change in host country currency Exchange rate statistics of International Monetary Fund
GDP per capita GDP per capita difference between currency depreciation and appreciation GDP statistics from the Organization of Economic Cooperation
differences country (in one thousand US Dollar) and Development (OECD) and World Bank websites
S. Song
 Table 1 continued

Variables Definitions and measures Data sources

GDP growth rate GDP per capita difference between currency depreciation and
differences appreciation country
Host country risk Euromoney risk index EUROMONEY
Parent firm size log(total assets) DataPros financial information of all publicly-traded firms on
Experience Sum of all operating years of all subsidiaries as of the end of each year Korean stock exchange
Inter-Country Exchange Rates and Intra-Firm
13

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 14

Table 2 Descriptive statistics and correlation matrix

Mean SD VIF 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

123
1 0.07 0.12 1.00
2 0.04 2.14 1.00 0.02 1.00
3 5.45 7.91 1.02 0.02 0.01 1.00
4 15.9 2.53 1.20 0.03 0.00 0.10 1.00
5 0.16 0.21 1.86 -0.01 0.01 0.02 0.02 1.00
6 0.04 0.06 1.48 -0.04 -0.01 0.01 -0.02 0.05 1.00
7 2.78 4.20 1.54 -0.02 0.01 -0.02 0.05 -0.02 -0.00 1.00
8 0.42 0.29 1.28 0.06 0.04 0.06 0.07* -0.01 -0.02 0.02 1.00
9 5.07 3.88 1.24 -0.03 0.01 0.04 -0.02 0.03 0.04 -0.00 -0.17* 1.00
10 20.6 1.94 1.70 0.08* -0.00 -0.03 0.05 -0.00 0.02 -0.02 -0.22* 0.02 1.00
11 2.13 1.35 1.86 0.04 -0.02 -0.16* 0.04 0.03 0.02 -0.01 -0.33* 0.08 -0.00 1.00
12 0.02 0.10 1.12 0.07* -0.01 -0.02 0.02 -0.00 -0.02 0.03 -0.05 0.02 0.02 0.00 1.00
13 2.41 5.67 1.20 0.08* 0.03 0.04 0.01 0.02 0.05 -0.00 0.01 -0.02 0.05 -0.02 -0.00 1.00
14 -0.14 0.34 1.62 0.06 -0.01 0.07* -0.03 -0.03 0.03 0.01 0.02 0.03 0.02 -0.02 0.03 -0.01 1.00
15 -0.08 -0.12 1.20 0.03 0.03 -0.03 -0.02 0.01 0.02 0.02 -0.05 0.05 0.05 0.03 -0.04 0.00 0.01 1.00
16 0.66 0.40 1.74 0.10* -0.00 -0.01 -0.00 0.02 -0.04 0.05 -0.04 0.07* 0.00 0.04 0.01 -0.02 0.04 0.01 1.00

1: Intra-firm sales, 2: Subsidiary performance, 3: Subsidiary age, 4: Subsidiary size (in million US dollar), 5: Imported input ratio, 6: Currency appreciation, 7: GDP per
capita difference between currency depreciation and appreciation country (in one thousand US Dollar), 8: GDP growth rate differences between currency depreciation and
appreciation country, 9: Host Country risk, 10: Parent firm size (in one million US dollar), 11: Parent firms international experience, 12: Host country currency
depreciation, 13: The number of subsidiaries with currency appreciation, 14: Lower transportation cost 15: Lower labor cost growth rate, 16: Subsidiary ownership
* p \ 0.05: A STATA option, sidak sig, is used for controlling for multiple comparison fallacy in Pearson correlation. It identifies the handful that is significant at the
0.05 level (Hamilton 2006)
S. Song
 Table 3 Results for hypotheses testing
Model 1 2 3 4 5 6 7

Subsidiary performance 0.28 (0.88) 0.24 (0.74) 0.22 (0.72) 0.24 (0.76) 0.22 (0.74) 0.24 (0.86) 0.28 (0.92)
Subsidiary age 0.07 (0.85) 0.09 (1.09) 0.10 (0.51) 0.11 (1.23) 0.09 (1.09) 0.05 (0.57) 0.07 (0.66)
Subsidiary size 0.82 (2.48)** 0.94 (2.44)** 0.92 (2.38)* 1.04 (2.44)** 0.98 (2.40)** 1.02 (2.18)* 1.04 (2.30)**
Imported input ratio -0.12 (1.78) -0.10 (1.76) -0.10 (1.78) -0.11 (1.80) -0.12 (1.76) -0.10 (1.78) -0.10 (1.76)
Currency appreciation -0.24 (2.04)* -0.22 (2.02)* -0.22 (1.98)* -0.24 (2.00)* -0.22 (2.02)* -0.20 (2.00)* -0.18 (2.04)*
GDP per capita difference -0.03 (0.86) -0.04 (0.90) -0.04 (0.92) -0.04 (0.88) -0.04 (0.90) -0.04 (0.88) -0.06 (0.94)
GDP growth rate difference -0.06 (1.88) -0.06 (1.86) -0.06 (1.86) -0.06 (1.88) -0.07 (1.92) -0.06 (1.88) -0.06 (1.86)
Country risk -0.04 (1.04) -0.04 (1.09) -0.04 (1.08) -0.05 (1.09) -0.05 (1.09) -0.06 (1.06) -0.07 (1.02)
Parent size 0.10 (1.96)* 0.12 (1.94)* 0.10 (1.94)* 0.10 (1.98)* 0.10 (1.98)* 0.10 (1.96)* 0.11 (2.00)*
International experience 0.06 (0.30) 0.08 (0.56) 0.10 (0.88) 0.10 (0.94) 0.12 (1.10) 0.14 (1.14) 0.16 (1.10)
Inter-Country Exchange Rates and Intra-Firm

Industry dummy Included Included Included Included Included Included Included

Country dummy Included Included Included Included Included Included Included
1. Host country currency depreciation 1.82 (1.92)* 1.76 (1.92) 1.78 (1.94)* 1.76 (1.92) 1.74 (1.94) 1.84 (1.90)
2. The number of subsidiaries with 0.14 (0.82) 0.13 (0.84) 0.16 (0.86) 0.16 (0.80) 0.18 (0.90) 0.20 (0.98)
currency appreciation
3. Lower transportation costs 0.56 (2.00)* 0.52 (1.98)* 0.48 (2.02)* 0.50 (2.00)* 0.52 (2.02)* 0.54 (2.04)*
4. Lower labor cost growth rates 0.24 (0.40) 0.22 (0.44) 0.32 (1.48) 0.28 (0.46) 0.20 (0.38) 0.16 (0.36)
5. Subsidiary ownership 0.38 (1.76) 0.28 (1.74) 0.32 (1.84) 0.32 (1.76) 0.26 (1.84) 0.30 (1.88)*
1*2 3.78 (3.56)** 4.56 (4.50)***
1*3 2.18 (2.14)* 2.28 (2.54)**
1*4 1.96 (1.98)* 2.16 (2.12)*
1*5 3.12 (2.58)** 3.62 (2.88)**
Inverse mills ratio 0.10 (0.30) 0.08 (0.32) 0.08 (0.28) 0.08 (0.30) 0.08 (0.30) 0.10 (0.30) 0.12 (0.32)
No. of observations 2,568 2,568 2,568 2,568 2,568 2.568 2.568
Wald v2 130.56*** 164.23*** 228.34*** 184.68*** 202.56*** 194.62*** 278.90***

p \ 0.10; * p \ 0.05; ** p \ 0.01; *** p \ 0.001
15

123
16 S. Song

all models are highly significant and the models with the added variables show
better fits.
Hypothesis 1 posits that under the influence of currency depreciation in its
host country a foreign subsidiary is more likely to increase its intra-firm product
sales to its affiliates in other countries experiencing currency appreciation. The
empirical results show that the variable is positively associated with increase in
intra-firm sales of the focal subsidiarys product to other subsidiaries exposed to
currency appreciation at the 10 % significance level (Model 2: b = 1.82,
p \ 0.05, Model 7: b = 1.84, p \ 0.10). Therefore Hypothesis 1 is marginally
supported.
Hypothesis 2 expects a positive moderating impact of more subsidiaries in other
countries with currency appreciation. Under that situation, a foreign subsidiarys
intra-firm sales to those subsidiaries are expected to increase. This two-way
interaction term shows expected positive sign and is significant (Model 3: b = 3.78,
p \ 0.01, Model 7: b = 4.56, p \ 0.001) in Table 2.
Hypothesis 3 is about the positive moderating effect of lower transportation costs
associated with a subsidiarys sales of its product to other affiliates suffering from
currency appreciation. This hypothesis is also supported at the 5 % (Model 4:
b = 2.28, p \ 0.05) or 1 % (Model 7: b = 2.18, p \ 0.01) level.
Hypothesis 4 argues for positively interactive relationship between currency
depreciation and lower labor cost growth rate in a subsidiarys host country. We
expect that rising labor cost growth rates in its host country may offset the positive
impact of currency depreciation on a subsidiarys intra-firm sales to other country
subsidiaries. This variable has a positive sign in the 5 % significance level (Model
5: b = 1.96, p \ 0.05, Model 7: b = 2.16, p \ 0.05).
Hypothesis 5 supports the positive impact of a subsidiarys high ownership-based
control for its cross-border intra-firm trade in cases that its host country has
depreciated currency while other affiliates countries have appreciated currencies.
This relationship is also supported and significance in terms of its interactive impact
on increase in the subsidiarys intra-firm sales across the border (Model 6: b = 3.12,
p \ 0.01, Model 7: b = 3.62, p \ 0.01).

4.2 Robustness Checks

In order to confirm that our measurements of primary variables are robust with
respect to alternative measurements, we conduct several robustness checks.
Host Countrys Currency Depreciation To examine not only the magnitude of
exchange change but also the volatility of the exchange rate, we rerun the regression
models using two other measures: one is the average of monthly exchange rates, and
the other is the conditional variances of the monthly exchange rates from a
generalized autoregressive conditional heteroscedasticity (GARCH) model follow-
ing Lee and Makhija (2009a, b). Using the conditional variances, we additionally
conduct cross-derivative tests for the interaction term between annual percentage
change and exchange rate volatility between two split samples of all contingent

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Inter-Country Exchange Rates and Intra-Firm 17

variables.1 Similar to our primary results, these two measures support that favorable
currency changes in host countries are positively associated with increases in intra-
firm sales.
The Number of Affiliated Firms with Currency Appreciation In addition to the
number of a subsidiarys affiliated companies whose countries currencies are
appreciated relative to the subsidiarys host countrys currency, we consider the
relative changes in currencies. We use the weighted annual percentage change in
each appreciated currency by the actual export volume to each currency country. For
example, assume that three countries currencies are appreciated against a focal host
by 30, 20, and 15 % respectively, and that export volumes to those three countries
were 10, 5, 3). The sum would be (-0.45 = -0.3 9 10 ? (-0.2 9 5) ?
(-0.15 9 3)). This new measure does not affect our results significantly.
Labor Cost For each countrys longitudinal labor cost data, we referred to
Freeman and Ostendorps Occupational Wages around the World (OWW) database.
The OWW dataset covers country labor costs industry by industry. We also located
each countrys longitudinal labor cost data from homepages of the International
Labor Organization (ILO), the OECD, and the United States Department of Labor.
Ownership Level In addition to 50 % as a cut-off for effective control by each
subsidiary, we tested with 80 or 95 % which is often used to differentiate joint
ventures from wholly-owned subsidiaries. Three cut-offs produce qualitatively same
results presumably because parent MNCs control over their foreign subsidiaries
based upon majority ownership positions account of a large portion of Korean FDI.

5 Discussion and Conclusion

By examining the actual mechanisms by which MNCs can realize operational

flexibility through changes in intra-firm trades among their subsidiaries, this study
adds value to the multinational operational flexibility literature. Intra-firm trade
within an MNCs subsidiary network demonstrates that MNCs actually shift
products among subsidiaries according to divergent currency changes across
countries. Operational hedging via intra-firm trade as a flexible response to different
currency movements indicates the positive impact of an internal product market in
an MNCs multinational subsidiary network. This finding is consistent with Buckley
and Cassons (1976) argument that internal sourcing of major products endows
MNCs with a competitive advantage; this argument is supported by Kotabe and
Murray (1990) and Kotabe and Omura (1989). It is also consistent with the finding
that foreign subsidiaries capture the benefits of cheaper finance from internal capital
markets, as suggested by Foley et al. (2007, 2008).

1
The split sample method does not assume identical unexplained variance between the two split groups
(Belderbos and Zou 2009; Hoetker 2007 and thus is considered a more general test for comparing inter-
group coefficients. Relevantly, a cross-derivative test allows us to examine whether the moderating effect
was positive or negative for all observations, as well as what percentage of the observations was
significant (Belderbos and Zou 2009).

123
18 S. Song

In empirical testing, we find that when more subsidiaries are exposed to currency
appreciation in their investment countries, a subsidiary exposed to currency
depreciation in its own country carries out intra-firm sales of its product to those
subsidiaries. Our finding confirms that under a currency change, an MNC subsidiary
configuration conducive to operational flexibility such as high FDI breadth is
associated with an increase in intra-firm trade. MNCs that are ready for uncertainty
through their subsidiary network structure (i.e., high FDI breadth) may have an
easier time engaging in intra-firm trade when it is most needed. This ability to adjust
production and sales activities across their investing countries provides these MNCs
with a ready-to-go structure that allows them to both gain and sustain competitive
advantages during times of uncertainty when other MNCs are struggling. However,
our measure of FDI breadth as a favorable condition for multinational operational
flexibility allows us to consider both the directionality of currency changes across
countries and intra-firm trade among subsidiaries. On the other hand, the traditional
index for multinationality or FDI breadth (i.e., the number of countries where a
foreign subsidiary at least operates) used in some prior studies (e.g., Allen and
Pantzalis 1996; Reuer and Leiblein 2000; Lee and Makhija 2009b; Tong and Reuer
2007) is too broad to capture those directionalities.
In addition to suggesting direct evidence of multinational operational flexibility
via intra-firm shifts of products across countries, this study empirically tests the
contingencies where intra-firm trades take place, from production sites under
favorable conditions to those under unfavorable conditions. Specifically, this study
examines host market conditions such as labor costs besides the important
production factors with respect to currency changes. Meanwhile, past studies
examined two factors separately. For example, Lee and Song (2012) studied the
impact of favorable currency change in a host country on the adjustment of
production volumes in other subsidiaries experiencing unfavorable currency change.
(Fisch and Zschoche 2011) examined the impact of rising labor costs in a host
country on employment shifts to other countries with lower labor costs.
This study also tests the level of ownership-based control necessary for cross-
border intra-firm trade. Concerning the impact of higher ownership on downside
risks associated with multinationality, Tong and Reuer (2007) examined the impact
of higher ownership level at an MNC portfolio level and found no significant
influence on curving downside risks owing to high control and coordination of
dispersed operations across countries. Meanwhile, this study examines the impact of
subsidiary-level ownership-based control over cross-border intra-firm trade among
subsidiaries. We find that subsidiaries with higher ownership are better able to
increase their intra-firm sales to other country subsidiaries that need the same
product for their sales in their host countries when there is currency appreciation.
This implies that we need to compare the impact of ownership as the main control
tool at each subsidiary level with that at the MNC level.
Our main arguments and findings in this paper provide some managerial
implications. First, managers in charge of global businesses should carefully
consider real options views related to their geographic configuration and coordi-
nation when it comes to their global production. If they focus on growth
opportunities in specific countries only, they might be exposed to abrupt changes in

123
Inter-Country Exchange Rates and Intra-Firm 19

macro-economic conditions in those countries and suffer huge losses in extreme

cases. In addition to this risk, they would be unable to take advantage of cross-
country cost differentials as they enter more countries. International business
managers careful attention to changing conditions in macro-economic factors
across countries enables them to take advantage of multinational operational
flexibility in their international investment. As a way to prepare for an uncertain
future, they need to structure their FDI such that their built-in investments carry
both growth options and switching options with which they are able to relocate
production from costly production sites to less costly ones.
Our findings also imply that isolated subsidiaries cannot provide switching
options, whereas subsidiaries connected by intra-firm trade transactions to other
subsidiaries allow the parent firm to retain its operational flexibility using dispersed
subsidiaries across countries. Regarding the relationship between the network
position of foreign subsidiaries and their performance (Monteiro et al. 2008) and
Chung et al. (2010) pointed out the negative aspect of subsidiaries that are isolated
from their international network, since the isolation prevents them from exploiting
the positive network effect, including cheaper finance using the internal financial
market. In that sense, international business managers need to consider the roles of
each subsidiary in designing their global strategy.
Although this paper contributes to the literature on MNC operational flexibility,
additional studies that may broaden the scope of analyses to other MNCs are
required to reach any further conclusions regarding our findings. As an extension of
our research on the relationship between an MNC and its foreign subsidiaries, it
would be useful to analyze the different globalization strategies of firms. It would
also be worthwhile to examine individual countries and explore the factors that may
affect different subsidiaries within them; this would require a different unit of
analysis and a measurement of product shifts specific to each country. It would also
be useful to consider other non-currency factors related to product shifts. For
instance, if depreciation of a currency in a country is due to significant political
unrest, the legal rights of MNCs may not be protected, and thus, MNCs may face
major risks in this country. In such a case, MNCs will not be motivated to shift
products into that country. Furthermore, other costs of product shifts relating to
government tariffs or instantaneous production capacity increases should also be
considered. Relevantly, better proxies for our contingent variables can be
developed. For instance, transportation costs are affected by many other factors
including fuel price, trade imbalance, volume of trade, competition among carriers,
piracy and risk, etc.

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