The World Financial Review

By Tarun Khanna and Krishna G. Palepu

This article builds on our structural definition of emerging markets to equip managers with toolkits to spot and respond to institutional voids.¹ Emerging markets are hardly uniform in the nature and extent of their institutional voids. The development of business strategy in any economy is driven by three primary markets—product, labor, and capital—and institutional voids can be found in any, or all, of these markets in developing countries.

The advantage of an institutional approach to considering emerging markets is that it specifies the particular combination of features that prevents efficient exchange in each market. Some countries might lack specialized intermediaries in the labor market but have them in abundance in the capital markets. Others may have effective labor markets but distorted capital markets. Product and factor markets within developing countries often develop at different rates.

Chile is lauded for its capital market efficiency, whereas Korea’s financial markets remain constrained by the entanglement between banks and its chaebol business groups (see figure 1).

At the same time, Korea has undergone spectacular development in its product markets, as evidenced by its world-leading broadband penetration, while Chile’s communications infrastructure is not nearly as developed (see figure 2). Moreover, different industries are not uniform in the ways in which they rely on market institutions. Some industries are more institution intensive than others, so different industries within the same market are affected differently by institutional voids.

This structural definition has actionable implications for managers. Institutional voids have real and first-order effects on business strategy.² Companies rely on intermediaries both to raise the willingness to pay (WTP) of consumers and to lower companies’ own costs. Companies need the expertise of market research firms, for example, to understand customer preferences and then adapt their offerings to raise WTP. Identifying and segmenting the market are immeasurably more difficult without market research specialists acting as intermediary.

In terms of company operations, a firm’s options for supply chain management, for example, depend entirely on available logistics intermediaries. Operating in a market that lacks logistics providers has predictable and measurable effects on inventory carrying costs. Moreover, financing options depend on capital market intermediaries, such as commercial and investment banks. Raising external capital requires credibly convincing external capital providers that the money being sought will be used in the way that is intended. This would be highly difficult if there were no independent auditors and if there were no recourse mechanisms available to investors in the face of after-the-fact disputes. Human resource capabilities depend on intermediaries such as business schools and executive search firms. Identifying and screening candidates for managerial positions entirely in-house carry significant costs.

Therefore, for anyone interested in managing or investing in emerging markets, spotting institutional voids is a key first step. To facilitate this task, we have developed a series of questions shown in Toolkit 1.³ Systematically answering these questions can give an organization important insights into the way a particular emerging market is likely to work or not work.

Responding to institutional voids

Companies cannot operate in emerging markets without encountering institutional voids, but once they identify the voids that will shape the environment for their businesses, they can find ways to overcome them.⁴ Recognizing the costs of institutional voids, companies might decide to build a business to fill institutional voids.  Multinationals and emerging market based companies that do not build full businesses to fill institutional voids face a set of strategic choices and menu of options to respond to them (see table 1).

Persistent voids, anchored strategies

The responses to institutional voids described in this article are not mutually exclusive or irrevocable choices. They can be successfully employed simultaneously or in different sequences. As institutional contexts in emerging markets evolve, corporate strategies will often need to change accordingly. Strategic positioning based on institutional voids is likely to be sustainable to some extent, however, because of the likely persistence of institutional voids. Much as markets cannot be mandated into existence, institutional voids cannot be mandated out of existence.

Generally, government and private enterprise can fill voids only with the passage of time and experimentation, and not by fiat. As a result, challenges from market gaps—and opportunities to bridge them—persist. The presence or absence of intermediaries matters for strategy and the sustainability of competitive positioning.

There is no simple, straightforward formula for navigating the unique challenges of emerging markets, but companies operating in these markets will inevitably encounter institutional voids and they need not be paralyzed by them. Looking at institutional voids through commonsense approaches—assessing strengths and adapting accordingly, building capabilities, reshaping the environment, or biding time until the context changes—gives companies a palette of ways to assess and seize opportunities in these markets. Developing a more granular appreciation of an emerging market’s institutional context up front can help managers avoid easy-to-anticipate mistakes and even identify unexpected sources of competitive advantage.

Adapted with permission of the publisher Harvard Business Press, from Winning in Emerging Markets: A Road Map for Strategy and Execution by Tarun Khanna and Krishna G. Palepu. Copyright (c) 2010 by Tarun Khanna and Krishna G. Palepu

About the authors

Tarun Khanna is the Jorge Paulo Lemann Professor at the Harvard Business School. He joined the faculty in 1993, after obtaining an engineering degree from Princeton University (1988) and a Ph.D. from Harvard (1993), and an interim stint on Wall Street. During this time, he has served as the head of several courses on strategy, corporate governance, and international business targeted to MBA students and senior executives at Harvard. He currently teaches in Harvard’s executive education programs and is Faculty Chair for HBS activities in India. His book, Billions of Entrepreneurs: How China and India are Reshaping Their Futures and Yours, was published in February 2008 and has been translated into several languages.

Krishna G. Palepu is the Ross Graham Walker Professor of Business Administration and Senior Associate Dean for International Development, at the Harvard Business School. Professor Palepu’s current research and teaching activities focus on strategy and governance and has published numerous academic and practitioner-oriented articles and case studies on these issues. In the area of strategy, his recent focus has been on the globalization of emerging markets, particularly India and China, and the resulting opportunities and challenges for western investors and multinationals, and for local companies with global aspirations. 

Notes

1. Portions of this chapter have been adapted from Tarun Khanna and Krishna G. Palepu, “Spotting Institutional Voids in Emerging Markets, ” Note 106-014 (Boston: Harvard Business School Publishing, 2005).

2. Paragraph adapted from Tarun Khanna, “Local Institutions and Global Strategy,”  Note 702-475, (Boston: Harvard Business School Publishing, 2002).

3. The four-context framework, the application of the “spotting institutional voids” questions, and the full list of questions in the toolkit are drawn from Tarun Khanna, Krishna G. Palepu, and Jayant Sinha, “Strategies That Fit Emerging Markets,” Harvard Business Review, June 2005, 63-76.

4. This section has been adapted from Tarun Khanna, Krishna G. Palepu, and Kjell Carlsson, “Why Study Emerging Markets,” Note 706-422 (Boston: Harvard Business School Publishing, 2007).

5. Adapted and reprinted by permission of Harvard Business Review. From “Strategies That Fit Emerging Markets,” by Tarun Khanna, Krishna G. Palepu, and Jayant Sinha, June 2005. Copyright © 2005 by the Harvard Business School Publishing Corporation; all rights reserved.