IV. Productivity spillovers associated with FDI mostly benefit the supplying industries

Intra-industry spillovers

There are two types of externalities associated with FDI. The most important type (from the host country’s perspective) are knowledge spillovers, which take place when knowledge created by a multinational enterprise is used by an indigenous firm without (full) compensation. Typically, knowledge spillovers happen through the demonstration effect (local firms obtain knowledge about new products, technologies, marketing and management strategies, or business opportunities in foreign markets by observing the actions of foreign affiliates), movement of labour (local firms hire workers trained by multinationals), or through the transfer of knowledge from foreign affiliates to their suppliers or customers (provided affiliates are not compensated for the transfer). The second type of externality, pecuniary externalities, take place through firm-to-firm interactions and occur through prices in a properly functioning market. In particular, the entry of foreign affiliates may change the market structure and increase the level of competition in a manner similar to trade liberalization, leading to competitive externalities. Similarly, foreign affiliates entering into downstream sectors may increase demand for inputs, which in turn gives local firms incentives to invest in product upgrading, cost-saving technologies, or increased capacity, all of which may improve performance.

Econometric studies of intra-industry spillovers from FDI are usually unable to distinguish between the various spillover channels. A typical study relates the total factor productivity of local firms to some measure of FDI presence in the same industry. This means that the empirical results capture both knowledge spillovers and competitive externalities. As pointed out by Aitken, Hanson, and AE Harrison (1997), if increased competition leads to local firms losing part of their market share and spreading their fixed costs over a smaller market, FDI presence may be negatively correlated with the indigenous firms’ performance in the short and medium run. However, in the long run, the weakest performers may exit, which then reverses the sign of the correlation. Thus, the overall effect of intra-industry spillovers from FDI depends on whether knowledge spillovers dominate competitive externalities or vice versa, which in turn depends on the time frame considered, characteristics of the host country and the type of FDI it receives.

The first rigorous study of intra-industry spillovers, conducted by Aitken, Hanson, and AE Harrison (1997) on more than 4,000 Venezuelan plants between 1976 and 1989, is a good illustration of how country conditions matter. The study concludes that FDI inflows lead to negative spillover effects: while foreign equity participation is positively correlated with total factor productivity in recipient plants with fewer than 50 employees (but not in other plants), increased FDI presence negatively affects the total factor productivity of domestic firms in the same industry. Their interpretation of the latter finding is that the expansion of foreign affiliates reduces the market share of local producers, forcing them to spread their fixed cost over a smaller volume of production, which results in a lower observed total factor productivity. As pointed out by Moran (2007), the finding that only some plants benefitted directly from an increase in foreign ownership suggests that FDI in Venezuela presented limited potential for productivity spillovers. Moran argues that this situation was due to heavy restrictions imposed by the government on foreign investors, which included strict joint venture and local content requirements. Further, foreign investors were forbidden from exercising confidentiality and exclusive use of trade secrets in their mandatory joint ventures, which lowered their incentives for technology transfer. During the time period considered in the study, Venezuela was pursuing an import substitution strategy, so indigenous producers were not exposed to significant competition from abroad. This can explain why FDI inflows could have had a large negative effect on market shares of indigenous producers.

The inability of the empirical literature to distinguish between knowledge spillovers and competitive externalities explains why literature surveys of intra-industry spillovers conclude that the results from the numerous existing studies are mixed (Gorg and Strobl 2001, Saggi 2002, Gorg and Greenaway 2004, Smeets 2008). However, some progress has been made by either trying to distinguish between the impact of FDI on prices, markups, and marginal costs, or by focusing on alternative outcomes. The Bircan (2019) study on Turkey (mentioned in Section III) finds that plants acquired by foreign investors increase competition by lowering output prices, which, as expected, is associated with higher physical productivity and lower prices at domestic plants in the same industry. Physical efficiency at domestic plants responds by a larger extent than price, which results in positive but insignificant spillovers onto revenue productivity. A back-of-the-envelope calculation suggests that increased multinational activity accounts for just over 10% of the rise in average physical productivity of domestic plants over the sample period. Kee (2010) takes a novel and interesting approach to examining intra-industry spillovers by identifying business relationships between Malaysian garment producers and their suppliers of intermediate inputs. Her results indicate that Malaysian firms become more productive as a result of sharing suppliers with foreign affiliates. She shows that an exogenous EU trade policy shock, which induced some foreign affiliates operating in Bangladesh to expand, led to better performance of the domestic firms that shared suppliers with foreign affiliates. Overall, the spillover effect from sharing suppliers can explain a quarter of the product scope expansion and a third of the productivity gains within domestic firms. Other studies that focus on spillovers taking place through the movement of labour, in the context of developing countries. Gorg and Strobl (2005) study firm-level productivity in Ghana, using data on the previous work experience of domestic firm owners. Their results suggest that firms that are run by owners who worked for multinationals in the same industry immediately prior to opening their own firm are more productive than other domestic firms. Poole (2013) uses matched employer-employee data from Brazil and studies wage spillovers, and finds that wages of incumbent workers in domestic firms are positively affected by the share of workers with prior work experience from multinationals.

 

Inter-industry spillovers

While there is no consensus on the intra-industry effects of FDI, the literature’s conclusions on inter-industry effects are more clear-cut. Using firm-level panel data from Lithuania, Javorcik (2004) finds evidence that FDI presence boosts the productivity of the supplying industries but not the industries in which foreign affiliates operate. She argues that while multinationals would like to prevent knowledge from leaking to their local competitors, they may want to assist their local suppliers. A one-standard-deviation increase in foreign presence in the sourcing sectors is associated with a 15% rise in productivity of Lithuanian firms in the supplying industry. This productivity effect originates from investments with joint foreign- and domesticallyowned firms but not from fully-owned foreign affiliates, which is consistent with a larger amount of local sourcing being undertaken by jointly owned projects. Positive spillovers from partially-owned foreign affiliates but not fully-owned affiliates were also found in Romania (Javorcik and Spatareanu 2008), and evidence of positive spillovers through backward linkages was also found in Indonesia (Blalock and Gertler 2008), and China (Liu 2008, Du, Harrison, and Jefferson 2011).

Typically, the studies of inter-industry spillovers from FDI do not distinguish between pecuniary spillovers and knowledge spillovers[1]. In a meta-study of inter-industry spillovers, Havranek and Irsova (2011) collect 3,626 estimates of spillovers produced by more than a hundred researchers. Their analysis suggests that model misspecifications reduce the reported estimates and that journals select relatively large estimates for publication (though this issue was not found in working papers). Taking these biases into consideration, they conclude that the average spillover effect from foreign affiliates to the supplying sectors is economically significant, whereas the spillover effect to the buying sector is small in absolute value (though statistically significant). Greater spillovers are received by countries that have underdeveloped financial systems and are open to international trade. Greater spillovers are generated by investors who come from distant countries and have only a slight technological edge over local firms. Almost all studies of inter-industry effects rely on industry-specific measures of foreign presence in downstream sectors. One exception is a study on the Czech Republic by Javorcik and Spatareanu (2009), which makes an explicit distinction between self-selection (i.e., the possibility that more productive firms become suppliers to foreign affiliates) and the learning effect (i.e., the productivity benefits accruing to suppliers from their interactions with affiliates). Their results are consistent with both high productivity firms having a higher probability of supplying affiliates as well as suppliers learning from their relationships with affiliates.

The studies mentioned so far focus primarily on manufacturing sectors, yet FDI inflows into the retail sector can also generate knowledge externalities and pecuniary spillovers. A case study by Javorcik, Keller, and Tybout (2008) finds that the entry of Wal-Mart into Mexico facilitated the modernization of the retail sector and stimulated fundamental changes in the relationship between retailers and suppliers of soaps, detergents, and surfactants. The entry of Wal-Mart pushed high-cost suppliers out of business, benefited surviving producers by providing access to a larger market, and prompted suppliers to introduce more innovations. Survey evidence from Romania confirms that, compared to firms that did not serve foreign retailers, firms supplying foreign supermarket chains were more likely to innovate, diversify their production, and improve the quality of packaging. An econometric analysis based on Romanian firm-level data also finds that the expansion of global retail chains led to a significant increase in the total factor productivity of supplying industries: a 10% increase in the number of foreign chains’ outlets was associated with a 2.4-2.6% boost to total factor productivity. This performance boost was driven by both within-firm improvements and between-firm reallocation (Javorcik and Li 2013). Another line of research considers alternative outcomes resulting from inter-industry spillovers. Javorcik, Turco, and Maggioni (2018) examine the relationship between the presence of foreign affiliates and product upgrading by Turkish manufacturing firms. Their analysis suggests that Turkish firms in sectors and regions more likely to supply foreign affiliates tend to introduce more complex products (using a measure of complexity developed by Hidalgo and Hausmann 2009).

 


[1] An exception is Javorcik (2004), who made some progress towards this goal by controlling for the demand from foreign affiliates based in downstream sectors.

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