Mode of Entry in Transition Economies

Abstract Main emphasis in research on economic transition in CEE is on manufacturing sectors. However, due to the total neglect of services in socialist economies upgrading the quality of service industries is crucial in economic transition in Central and Eastern Europe. In this restructuring process foreign investors play an important role. This paper looks at the issue from a service industry’s point of view, hotel business being the industry in case. The paper draws on two lines of research.

First, studies on internationalization patterns and foreign entry modes characteristic to the global hotel business, and second, literature on foreign entry strategies in transitional economies. This literature is used as a backdrop against which data collected on foreign hotel companies operations in Russia is mirrored. The paper aims at finding out to what degree the chosen entry modes are determined by the companies’ global strategies and to what extent the transition-specific factors in Russia have affected decision-making.

Introduction According to the socialist ideology services were a neglected sector of the Soviet economy. Therefore, the development and transformation of service industries is an integral part of the economic transition of Russia. In the transformation process foreign investors play an important role by providing both know-how and financing. One of the emerging service industries in Russia is the hotel sector, due to the actual and potential growth of tourism and tourism-related business in the country.

The Russian market is considered too large for the international hotel companies to ignore. Some international hotel management companies were present on the market already in the communist era, but it has been during the 1990s they have entered the market to a greater extent, although the success and pace of entry has not been as good as expected. This paper discusses the entry strategies of international hotel companies operating in Russia and aims at pointing out those transition-specific factors,

which affect the choice of entry mode in the hotel sector of Russia. The data on Russian hotel sector is collected from secondary sources, such as industry reports and interviews of managers of international hotel companies, published in Russian newspapers. Furthermore, previous literature on internationalization and operation modes in the hotel industry are reviewed, as well as studies on entry motives to Central and Eastern European countries in transition. The paper is structured as follows.

First, operation modes in the global hotel industry are overviewed. Second, motives for hotel companies’ investment in CEE are discussed. Third, the current degree of privatization, and ownership patterns in the Russian hotel industry are described. Finally, operation modes chosen by foreign hotel companies operating in Russia are analyzed. Operation Modes in Global Hotel Industry Several strands of theory have been used to explain the internationalization and modal choice in the global hotel industry.

The theories applicable include market entry literature from the marketing and international business fields and approaches from organization theory literature (Contractor and Kundu 1998). The first profound attempt to explain the forms of TNC involvement in the international hotel industry was made by Dunning and McQueen in 1981 leaning on the eclectic theory of Dunning (1981, 1988, 1989). The eclectic theory is an attempt to pull together the various strands of explanation for the growth and activities of TNCs.

It concentrates on ownership effects, internalization strategies and location costs. According to the eclectic theory, enterprises with headquarters in one country will undertake production outside their national boundaries whenever they have competitive or ownership advantages over firms of other nationalities, and find it profitable to combine their mobile assets with the immobile factor endowments located in foreign countries.

They internalize the market for these assets in order to secure the full economic benefits from them and become transnational. For the hotel industry, the role of location elements is especially important, and the ways of achieving the internalization advantages are quite different from manufacturing and other service industries. (Buckley and Geyikdagi 1996) The hotel industry’s internationalization patterns are characterized by the importance of non-equity modes of involvement, such as franchising agreements and management contracts.

Contractor and Kundu (1998) define a management service contract as a long term agreement, whereby the owner of the property and real estate enter into a contract with the hotel firm to run and operate the hotel on a day to day basis, usually under the latter’s internationally recognized name. In the literature on internationalization of services there has been discussion of whether this kind of operation modes can be labeled as investment at all, or are they merely service trade. According to MNE definitions, foreign direct investment includes ownership (of factors of production overseas) and control over their use.

(Boddewyn et al. 1986) Traditionally, ownership has often been considered a necessary means to secure control over the operation. However, in international hotel industry control can be reached without equity by non-equity operation modes. The importance of management contracts highlights the fact that ownership and control should not be viewed as perfectly correlated. (Esperanca 1992) The operation modes and their share of international hotel operations are presented in the following table.

According to a recent study by Contractor and Kundu (1998), the hotel properties located outside of the home country of the firm are distributed by modal type as follows: Table 1 Distribution of International Hotel Operations by Modal Type Modal Choice • EQUITY Fully owned Partly owned (Joint Ventures) • NON-EQUITY Management Service Contract Franchise Agreement TOTAL Source: Contractor and Kundu (1998) Per cent 34,6 of which 18,8 15,8 65,4 of which 37,0 28,4 100 The data supports the proposition that non-equity modes of involvement dominate the business.

In addition to how, the internationalizing hotel companies have to decide where to invest. The following section discusses the location- (or host country) specific factors explaining foreign investment in a country’s hotel industry. Location-Specific Factors Explaining Foreign Investment in Hotel Industry As Contractor and Kundu (1998) point out, the modal choice in international hotel business is affected by both company- and market specific factors. Buckley and Geyikdagi (1996) have discussed the location advantages explaining foreign investment in Turkey’s tourism industry.

International investors surveyed by them mentioned following location factors: • • • • • Factors determining the size and growth of tourism demand to a particular place The general infrastructure for tourism The availability and quality of inputs, including personnel The policy of the host government towards FDI in general The general political, social and economic stability of the host country When looking at the above mentioned factors in the case of Russia, it is no wonder that the foreign involvement in the country’s hotel industry has remained low.

Discussing the problems related to these factors to a more detail is not the purpose of this paper, but one can conclude that Russia has room for improvement in all these areas. Although there is potential for growth of tourism in Russia, there are several factors hindering it. However, despite of the conditions, there has been interest among the international hotel companies to invest in Russia. The following section attempts to explain, what could be motives to enter the Russian hotel industry. Hotel Companies Motives for Investment in Economies in Transition.

The motivations for investment in CEE has not been studied in the case of the hotel industry, but it can be proposed that they can be found among the general motives of service company internationalization in CEE, which Kostecki (1996) has classified as follows. As a hypothesis, the most obvious reasons for the presence of hotel companies in Russia are bolded by the author. A. Market 1. Eastern Europe is (potentially) a promising market for the firm’s services. 2. Presence in Eastern Europe helps to gain a competitive edge in the West (global service network is required by the clients).

B. 1. 2. 3. 4. Firm’s competence Superiority of the firm’s service concept, process and technology. Experience in management of multi-country operations. Familiarity with the East European environment. Corporate culture permitting flexibility to implement unconventional business approaches in Eastern Europe. Strategic concerns Expansion in Eastern Europe is a unique opportunity Expansion in Eastern Europe permits to exploit the economy of scale. We are a global firm and have to be present in Eastern Europe.

We have to position ourselves in Eastern Europe vis-a-vis our market leader and other competitors. C. 1. 2. 3. 4. D. Factors of production 1. Low (labor) cost in Eastern Europe. 2. Favorable access to inputs (skilled labor, local technology, raw materials). Source: Kostecki (1996) The former mentioned motives find support in the literature on overall motivations of foreign firms for investing in the CEE. Nachum (1999) has drawn together various studies and classified the motivations into several categories.

Among these are found strategic motivation, that is, some TNCs cannot maintain their global competitive position without including the region in their portfolio. Furthermore, Nachum mentions the motivation of customer’s following, typical for professional service industries. In short, it can be proposed that in despite of the non-favorable business environment of Russia for a foreign tourist company, global hotel chains just can not afford not being present in Russia. The potential for growth in tourism and under-capacity of accommodation sector keep the companies interested in Russia, although the investment climate and tourism infrastructure is not favorable.

Furthermore, the hotel companies often have to follow their customer. The biggest global hotel companies origin from countries that generate most tourists and their competitive edge is partly reached by the geographic coverage of the hotel services. However, as discussed further in this paper, although the companies have entered Russia, they have not always been able to do it by the mode preferred due to the factors specific to Russian business environment. The following section discusses the privatization and ownership patterns of Russian hotel industry

Degree of Privatization and Forms of Ownership in Russian Hotel Industry As all other spheres of the socialist economy, hotels in the Soviet Union were owned and run by the state, through various organizations. The hotels were organized under various ‘lines’, like Intourist, Central Soviet for Tourism and Excursions, Sputnik and Aeroflot. Intourist was responsible for hotels offered to foreign tourists and its hotels were seen as most high-class ones. (Semenov et al. 1985) The hotel capacity in the major cities of Russia is well below world standards.

For example, as European countries with a population more than 500 000 people have from 14 to 18 hotel places for every 1000 residents, St Petersburg has only six. (Borisova 1998) renovation. Furthermore, most hotel properties are in a need of The privatization process in the hotel industry has not proceeded as it could have been expected. A peculiarity of Russian hotel market is that the city administration has stayed as a shareholder in most privatized hotel properties. Therefore, entering by acquisitions has been practically impossible strategy in Russia.

According to Trew (1997) foreign hotel companies would prefer acquiring hotels by chain basis in CEE, but so far they have had to proceed in hotel-by-hotel basis. Furthermore, according to Kurakina (1999) the Russian legislation does not even recognize the conception of hotel chains. For example, the fees paid to the chain operator are not cited as operating costs as they should be by Western practice. However, there have been efforts to privatize the hotel properties. According to Gudbergsen (196) this has occurred in two ways, according to the hotel categories. 1.

In the Soviet Union, approximately 20 per cent of the hotels were managed by various ministry departments and large state enterprises, such as Aeroflot, the Soviet Ministry of Foreign Affairs, the Ministry of Internal Affairs and the Committee for State Security (KGB). These hotels were closed to the public, and guests were admitted only through these organizations. After the collapse of the Soviet Union hotels previously managed by ministries and state enterprises either remained affiliated with these organizations or were privatized with their management and employees as the new shareholders.

Some of these properties have been renovated to an international level by foreign investors. 2. The majority of hotels, like those of Intourist, were allocated to local and regional authorities during the privatization process. In some cases, ownership was further given over to the management and employees of the individual properties. The local authorities, such as Moscow and St Petersburg governments, have formed joint ventures with foreign partners – in some cases with the foreign companies as managers providing expertise and supervision of significant renovation programs.

However, in spite of the privatization efforts the private and especially foreign involvement has remained low. Table 2 shows the ownership structure of Russian hotel industry as 1999 according to Russian sources. Table 2 The Ownership Structure of Russian Hotel Industry in 1999 Form of ownership Institutional (municipal, corporate, organizational) Private Mixed (without foreign shareholders) With foreign shareholders Total Percentage of hotels 47,2 28,4 23,1 1,3 100 Source: Kvartal’nov 1999 The table shows that the foreign involvement concerns only roughly a per cent of hotels in the whole country.

In total, there are approximately 4000 hotels in the Russian Federation at the moment (Kvartal’nov 1999). The hotels with foreign involvement are mainly located in the two major cities Moscow and St Petersburg. The ownership patterns and degree of privatization have also regional differences. According to Kvartal’nov (1999) in the cities 61 % hotels are owned by either the city administration or have mixed ownership without foreign involvement, whereas in the province 54 % of hotels are already in private ownership. In Moscow the city owns wholly 20 hotels, whereas 114 hotels are owned by various ministries and administrative organs.

Furthermore, only 12 hotels are partly or wholly in foreign ownership and 34 hotels are turned into limited companies, in which the city is a shareholder in 30 cases. (Kommersant, ref. Suomalais-venalainen kauppakamari 1999) Those hotels in foreign ownership are high-end ones, whereas international three-star hotel chains have been turning off by too high prices asked by the city. However, some efforts are being made in order to encourage mid-class hotel reconstruction and building. (Zvereva 1999) The city has plans to sell its hotels in order to finance the renovation of old and building of new hotels.

In St Petersburg, the bulk of the city’s hotel industry is also under the control of the city government. Of St Petersburg’s 150 accommodation facilities, the city owns all or part of 20 hotels, but those 20 account for three-fourth of the entire industry (Shcherbakova 1999), as these hotels are the former Intourist hotel giants with 700-800 rooms.

According to a local newspaper, the current privatization policy is that the city officials have decided to increase the value of the hotels before selling them, but the obvious problem is the lack of money. (Shcherbakova 1999) However, there have been signs of changes in the privatization policy as the City Property Fund recently announced the sale of a 60 per cent share in the hotel Rossiya (Shcherbakova 2000). Entry Strategies of Foreign Hotel Companies in Russia.

The strategies of foreign hotel companies present in Russia vary from joint ventures to consultancy contracts. According to Karpova and Kovalev (1998) consultancy contract is a mode peculiar to Russia. The contract allows the property owner (usually the city administration) to keep the control over the daily management of the hotel. The property owner nominates the hotel management and hires foreigners to act as consultants.

Furthermore, because the standard of Russian hotels is low, excessive capital investments would be required for upgrading the hotel properties. According to Trew (1997) as foreign investors have stayed away from the country due to high political and economic risks, some of the hotel management companies present in Russia have chosen to invest themselves into properties, although this is not their general strategy. There are risks involved in joint ventures with Russian investors as well, most notorious example being the contract killing of American Paul Tatum, the constructor of the high-class hotel Radisson Slavyanskaya in Moscow in 1996.

On the other hand, entry by franchising in Russia has been restricted by the unreliable service and management standards. The entry strategies of foreign hotel companies in Russia can be mirrored against a model suggested by Contractor and Kundu (1998). The model aims to explain the effect of certain environmental factors on the mode of entry. Figure 1 Modal Preference as a Function of Income Levels and Political/ Economic Risk in Host Nations Political / Economic Risk HIGH Non-Equity Modes Preferred N/A LOW Equity-Based Modes Preferred LOW Non-Equity Modes Preferred HIGH GDP Per Capita Source: Contractor and Kundu (1998)

According to the model based on profound empirical data collected by Contractor and Kundu (1998) non-equity modes, such as franchising and management service contracts, are preferred in higher risk environments, where the real estate investment and business risk is substantially on the shoulder of local investors. As a business environment, Russia falls into this category. However, as mentioned earlier, entry by franchising requires certain level of service and management standards in the host country. Therefore, it can be proposed that primary non-equity mode preferred in Russia is management contract.

This is supported by data collected by Dunning and McQueen (1981), according to which franchising is more popular in developed than in developing economies. Therefore, the preferring of non-equity modes in high-income low-risk countries can partly be explained by the popularity of franchising agreements. According to Bailey (1998) six hotel companies with the highest global presence in 1997 were Accor, Best Western, Inter-Continental, Holiday Inn, ITT Sheraton and Marriott. Since then, Inter-Continental and Holiday Inn have merged into Bass hotels.

All of them are present in Russia as well, but for this paper there were no data available of every company. Following table shows the entry modes of some international hotel companies in Russia and their general expansion strategies. In addition to existing foreign hotel operations in Russia presented in Table 3, there have been recently several projects, which have been postponed or cancelled (Kitov 2000). Furthermore, entry to Russia has not always been successful, the best example of which being the Austrian group Marco Polo Hotels and Resorts, which was in the early 1990s the biggest foreign hotel operator in Russia with its five hotels.

The parent company of the group put equity into Russian hotels and the group operated them. However, the entry proved not as successful and the group had to withdraw from the market. (Trew 1998) Table 3 Entry Modes in Russia and General Expansion Strategies of Global Hotel Companies* Company / Brand Best Western Bass Hotels and Resorts Holiday Inn Inter-Continental Starwood Lodging ITT Sheraton Kempinski Marriott International Marriott Hotels, Resorts and Suites Renaissance Radisson.

N:o of Hotels in Mode of Operation / Russia Entry in Russia 3 marketing network, locally managed 2 1 consultancy contract 1 consultancy contract 2 2 management contract 2 management contract, joint venture 4 3 franchising 1 2 joint venture (acquisition of share) joint venture, franchising Main Strategy of the Company / Brand marketing network, locally managed franchising management contract management contract management contract management contract, franchising management contract, franchising franchising *Mother companies, subsidiaries or brands Sources: Bailey, M.

(1998), Borisova (1997), Heath (1999a, 1999b, 2000a), Karpova et al. (1998), The TTG World Hotel Handbook (1997) The table shows that the companies have entered Russia with a variety of modes. As it comes to overall strategies of the companies, the data supports the evidence presented earlier that non-equity modes are dominating the expansion strategies of international hotel companies. In reference to study of Contractor and Kundu (1998) management contracts should be the dominant operation mode in Russia, as Russia represents a country with high risk/low income in their typology.

According to the data on foreign companies’ entry modes into Russia, management contracts indeed seem to be the dominant mode of operation in Russia. On the other hand, in most of the cases the entry strategies chosen to Russia differ from the overall expansion strategy of the company. This can partly be explained by factors specific to Russian business environment. First, there are some consultancy agreements instead of ‘pure’ management contract. This can be explained by the local governments’ reluctance to involve foreigners ‘too deeply’ in the hotels reported by Trew (1997).

However, some companies like Sheraton and Hilton, the later of which is going to open its first hotel in 2001, have reported that they rather postpone the entry until they manage to negotiate a real management contract rather than agree to enter a consultancy contract (Heath 1999a, 2000b). Second, companies that normally do not put equity on the properties they manage have done so in Russia. The reason for equity investment has been the lack of finance characteristic for economies in transition. Third, due to the problems connected to privatization, the acquisition of hotel properties has been virtually impossible.

Furthermore, due to the lack of land degree in Russia construction of new hotels on a greenfield basis is a risky variant. Finally, companies’ interest to enter Russia by franchising is limited by the unreliable service and management standards of the local hotel industry. The only franchisor in the sample, Marriott, has as franchisee another foreign hotel operator, the Interstate. Conclusion and Suggestions for Further Research On the basis of existing data it can be concluded that foreign hotel companies have modified their entry strategies due to the factors specific to the Russian business environment.

In many cases, the entry mode chosen for Russia does not follow the general expansion strategy of the company. It can be suggested that the strategic choices to be made when entering the Russian market are connected to the question, how far the company is ready to give up its strategic preferences in order to get a foothold on the market? As presented earlier, there are two kinds of strategic choices made. Some companies, like Inter-Continental, have entered the Russian market early but have had to make strategic concessions by entering a consultancy contract instead of a pure management contract.

Others, like Sheraton and Hilton, have preferred to stick to their general strategies and postpone the entry to Russia until they have managed to negotiate a real management contract. Therefore, it can be concluded that the environmental factors in Russia have at least as great influence to the choice of entry mode as have companies’ strategies. Existing research has discussed the environmental factors affecting foreign entry modes in the hotel industry on a fairly general level. The distinction between developed and developing countries or high-risk and low-risk countries ignores the economies in transition as a special case.

Therefore, the models found in existing literature can not be adopted as such when studying the Russian hotel industry. However, since the data on foreign hotel companies operations in Russia presented in this paper is of secondary nature the conclusions presented in the former section are only tentative. Furthermore, the paper presents entry strategies chosen by the companies but does not discuss the success of them. In order to find out, which entry mode is the best in the case of Russian hotel industry, empirical research is needed. Most studies of economic transition have largely ignored the service sector.

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