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date: 20 November 2019

Foreign Direct Investment and International Technology Diffusion

Summary and Keywords

Foreign direct investment (FDI) plays an important role in facilitating the process of international technology diffusion. While FDI among industrialized countries primarily occurs via international mergers and acquisitions (M&As), investment headed to developing countries is more likely to be greenfield in nature; that is, it involves the establishment or expansion of new foreign affiliates by multinational firms. M&As have the potential to yield productivity improvements via changes in management and organization structure of target firms, whereas greenfield FDI leads to transfer of novel technical know-how by initiating the production of new products in host countries as well as by introducing improvements in existing production processes.

Given the prominent role that multinational firms play in global research and development (R&D), there is much interest in whether and how technologies transferred by them to their foreign subsidiaries later diffuse more broadly in host economies, thereby potentially generating broad-based productivity gains. Empirical evidence shows that whereas spillovers from FDI to competing local firms are elusive, such is not the case for spillovers to local suppliers and other agents involved in vertical relationships with multinationals. Multinationals have substantially increased their investments in research facilities in various parts of the world and in R&D collaboration with local firms in developing countries, most notably China and India. Such international collaboration in R&D spearheaded by multinational firms has the potential to accelerate global productivity growth.

Keywords: foreign direct investment, multinational firms, technology transfer, research and development, technology diffusion

What is FDI?

The United Nations Conference on Trade and Development (UNCTAD) defines “foreign direct investment” (FDI) as an investment made by an investor in a foreign country to “acquire lasting interest in a local enterprise.” Generally, when undertaking FDI, an investor’s primary purpose is to gain an effective voice in the management of the enterprise receiving the investment. Since control of an enterprise can be gained only by acquiring a sufficiently large stake in it, FDI is usually distinguished from portfolio investment based on whether or not a foreign investor holds greater than a 10% stake in the local enterprise. Thus, from the perspective of host countries, the key distinguishing feature of FDI is that it entails transferring control of local enterprises to foreign hands. Sometimes FDI occurs via the establishment of brand new wholly owned subsidiaries of multinational firms, whereas at other times it involves mergers and acquisitions (M&As) between foreign and local firms. While M&As typically yield productivity improvements via changes in the management and organization structure of acquired firms, so-called greenfield FDI leads to direct transfer of production expertise either in the form of entirely new products or via improvements in local production processes introduced by foreign firms. Thus, FDI is important not just because it can inject much needed capital into host countries but also because it can serve as a major channel of international technology transfer (Saggi, 2002).

This article discusses the literature investigating several fundamental questions related to FDI and the central role it plays in international technology diffusion. To set the stage, the article first describes the recent evolution of global FDI flows and stocks and their allocation across the world. Next, it discusses the economics of the multinational firm, addressing both the choice between exports and FDI and the question of when and why multinationals prefer to internalize transactions by establishing wholly owned subsidiaries in foreign markets as opposed to interacting with local firms via arms-length channels such as technology licensing. This is followed by a discussion of the crucial role multinationals play in global R&D and of the various channels through which technologies introduced by multinational firms tend to diffuse locally in host countries. Both analytical and empirical research addressing such diffusion are discussed. Finally, the article describes policy implications of the literature on FDI and international technology diffusion.

Global Distribution of FDI

Over the years, FDI has become an increasingly important aspect of the global economy. During 2016, global flows of inward FDI stood at approximately $1.7 trillion (measured in current dollars). Because international capital flows through several channels, the following question arises naturally: How large are FDI flows relative to other types of international capital flows such as portfolio investment? Available data indicate that these two major types of capital flows are roughly of equal importance; for example, in 2017 global FDI was approximately 2.4% of world GDP whereas international portfolio investment (including both debt and equity) was about 2.5% (UNCTAD, 2018).

Foreign Direct Investment and International Technology DiffusionClick to view larger

Figure 1. Global FDI flows as a percentage of world GDP, 1996–2016.

Figure 1 illustrates global FDI inflows as a percentage of world GDP for 1996–2016. As the figure makes clear, although the importance of FDI to the global economy has increased over this time period, the story is not one of steady and sustained increase. For example, FDI inflows declined sharply during the early part of the new millennium (from a high of 4% of global GDP in 2000 to roughly 1.5% in 2003) followed by a robust recovery during 2003–2007 and another collapse in 2007. Thus, despite FDI being less reversible in nature than short-term portfolio investment, aggregate FDI flows can vary significantly from year to year.

How are global FDI inflows allocated across the world? To address this question, it proves convenient to utilize the United Nation’s (UN) country classification, which partitions the world into two disjoint groups: developed economies and developing economies, where the latter set includes the least developed countries, which tend to have the lowest per capita incomes and high degrees of economic vulnerability, and all transition economies. It is worth noting that, unlike the other major classification of countries commonly used in the literature (i.e., the World Bank’s classification in its World Development Indicators dataset) the UN classification is not based solely on per capita income. Figure 2 presents a five-year moving average of the share of global FDI inflows invested in developed and developing countries during 1995–2016. The figure shows that the share of global FDI headed to developed countries declined substantially during the sample period while that going to the rest of the world increased. It is worth noting that the developed countries’ share of global FDI inflows was only slightly higher than 50% over 2010–2014; that is, during these years the developing world collectively received roughly the same amount of FDI as the developed world. This is a significant and unprecedented phenomenon. As figure 2 shows, the share of global FDI flowing into developed countries fell sharply from roughly 66% during 1990–1994 to around 50% over 2010–2014. Finally, the share of least developed countries (LDCs) in global FDI inflows almost tripled during 1995–2016, although the absolute level of FDI going to these countries remains rather low.

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Figure 2. Shares of global FDI inflows (five-year moving average).

Traditionally one thinks of capital flowing from where it is abundant (i.e., developed countries) to where it is scarce (i.e., developing countries). However, somewhat surprisingly, the increase in economic capabilities of many developing countries has also seen them become major source countries for FDI. Figure 3 shows that while developed countries continue to account for the bulk of FDI outflows in the global economy, their relative importance in this regard has declined substantially over the years.

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Figure 3. Shares of global FDI outflows (five-year moving average).

Prior to 2010, in a typical year developed countries accounted for more than 80% of global FDI outflows. By contrast, since 2015 they have tended to account for about 67% of FDI outflows. This decline in the status of developed countries as major source countries of FDI is mirrored by an elevation in the status of developing ones. Somewhat surprisingly, LDCs have also become relatively more important sources of global FDI. From 1995 to 2016, the share of global outflows originating in LDCs increased by a factor of 2.5. Together, Figures 2 and 3 paint a consistent picture of the increasingly prominent role that developing countries have come to play in the domain of FDI.

The observed changes in the level and pattern of inward FDI flows have direct implications for the evolution of global FDI stocks over time and space. The global stock of FDI stood at roughly $25.2 trillion in 2015, which was roughly 33% of global GDP for that year. Table 1 provides information on how the allocation of the global stock of FDI has evolved over time. Developed countries saw their collective share of global FDI stock decline from 76.7% in 1990 to 63.6% in 2015, whereas developing countries saw their share increase from 22.8% to 35.3%. These changes in the global distribution of FDI stocks are smaller in magnitude relative to changes in FDI flows since, historically, developing countries have tended to attract less FDI than developed ones.

Table 1. Distribution of the Global Stock of Inward FDI

Country group

1990

1995

2000

2005

2010

2015

LDCs

0.5%

0.5%

0.5%

0.9%

0.9%

1.2%

Developing countries

22.8%

23.5%

22.5%

24.8%

32.7%

35.3%

Developed countries

76.7%

76.0%

77.0%

74.3%

66.4%

63.6%

Source: UNCTAD.

Changes in outward stock of global FDI reported in Table 2 tell perhaps an even more remarkable story. While developing countries accounted for only 6.2% of the outward stock of global FDI in 1990, their share had increased to almost 23% by 2015.

Table 2. Distribution of the Global Stock of Outward FDI

Country group

1990

1995

2000

2005

2010

2015

LDCs

0.0%

0.0%

0.0%

0.0%

0.1%

0.1%

Developing countries

6.2%

7.8%

10.2%

11.2%

16.1%

22.9%

Developed countries

93.8%

92.1%

89.8%

88.7%

83.8%

77.0%

Source: UNCTAD.

Virtually all countries are engaged in FDI as both recipients and sources, but global FDI flows tend to be concentrated among a handful of countries. For example, during 2012–2016, the top five recipient countries (the United States, China, Hong Kong China, Ireland, and the United Kingdom) accounted for more than 42% of global FDI inflows. The concentration on the supply side of FDI is even more pronounced, with the top five source countries (the United States, Japan, China, the Netherlands, and Hong Kong China) accounting for more than 52% of global FDI outflows. Of course, this concentration in FDI activity is a reflection of the fact that global GDP is itself concentrated among a handful of countries, all of which play are heavily involved in FDI.

It is useful to consider the relative importance of the two main modes of FDI: greenfield entry and mergers and acquisitions (M&As). Long-term data are difficult to obtain, but Figure 4 presents a snapshot of the relative importance of these two modes of entry over the last decade or so, and that at the global level greenfield FDI has generally been much larger in magnitude than M&A FDI. Perhaps the most obvious and important conclusion that jumps out of Figure 4 is that, relative to M&As, developing countries tend to attract far more greenfield FDI than M&A FDI whereas the two modes are of roughly equal importance to developed countries. This may be because there are relatively fewer attractive target firms in developing countries that foreign investors can acquire (or merge with) when seeking to enter their markets. By contrast, developed countries are likely to have more mature industries and a greater selection of firms that can serve as potential M&A targets for foreign investors. Furthermore, M&As are likely to be more important in the manufacturing sector then in the services sector, which tends to be relatively smaller in developing countries. Roughly two-thirds of the global flows of greenfield FDI in 2016 were absorbed by developing countries. The story with respect to M&A FDI is almost the reverse: approximately three-fourths of global M&A FDI inflows in 2016 went to developed countries.

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Figure 4. Ratios of greenfield to M&A inflows (three-year moving average).

Figure 5 illustrates the relative magnitudes of greenfield and M&A FDI from the perspective of source countries. At the aggregate level, developed and developing countries look quite similar to each other. Outflows of greenfield FDI from both sets of countries tend to exceed M&A FDI, with greenfield FDI being typically about twice as large as M&A FDI. The ratio of greenfield to M&A FDI outflows is smaller than the corresponding ratio in the context of FDI inflows because developed countries attract more FDI and greenfield FDI is not as dominant in their markets as it is in the markets of developing countries.

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Figure 5. Ratios of greenfield to M&A outflows (three-year moving average).

These stylized facts pertaining to the two major types of FDI and their relative importance to different groups of countries naturally raise the question of how foreign investors choose between alternative modes of serving foreign markets. There is a large, sophisticated literature that seeks to explain when and why a firm seeking to sell abroad finds it advantageous to do so by establishing a wholly owned foreign subsidiary as opposed to doing so via exports or arms-length arrangements such as technology licensing. The next section provides a discussion of the main insights of this literature.

Economics of the Multinational Firm

With a detailed picture of the trends in aggregate FDI inflows and stocks in hand, we now turn our attention to more micro-level issues. Broadly speaking, FDI can be either horizontal or vertical in nature. Horizontal FDI arises when a firm undertakes the same production activity in its home country as in a foreign one, whereas vertical FDI occurs when a firm chooses to fragment its production process internationally, locating each stage of production in the country where it can be conducted at the lowest cost. In other words, under horizontal FDI, firms choose to serve foreign customers by establishing subsidiaries in those markets as opposed to serving them via exports, whereas under vertical FDI different stages of the production process are spread out internationally in order to exploit differences in international cost conditions. In what follows, we focus mostly on horizontal FDI for two reasons. First, this focus is justified because a substantial amount of empirical evidence indicates that horizontal FDI arises relatively much more frequently than vertical FDI in the current world economy. Second, much of the theoretical literature on FDI has tended to investigate the choice between exporting and horizontal FDI.

Figure 6 plots the ratio of world exports of goods and services to total sales of foreign affiliates during 1996–2016. As is clear from this figure, affiliate sales exceeded exports throughout this time period, with the gap between the two in 2016 much larger than that in 1996—a fact that attests to the increasing importance of FDI as the preferred channel for meeting foreign demand.

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Figure 6. Ratio of total world exports to sales of foreign affiliates.

Firm-level evidence on the export propensities of multinational firms supports the aggregate trends illustrated in Figure 6. In an important early paper based on data on foreign affiliates of U.S. multinationals provided by the U.S. Bureau of Economic Analysis, Brainard (1993) shows that in 1989 such affiliates exported only 13% of their overseas production back to the United States. Similarly, the U.S. affiliates of foreign multinationals were found to export even a smaller share (only 2%–8%) of their U.S. production back to their parent firms with roughly 64% of it being sold in the U.S. market. Figure 7 shows how the share of total global sales of affiliates of multinational companies that are exported evolved during 1996–2016. This figure makes it patently clear that affiliates of multinationals export only a small proportion of their sales, with an overwhelming share of such sales targeting local consumers in host countries. For example, during 2010–2016, less than 25% of affiliate sales was exported to other markets. This is strong evidence in favor of the importance of horizontal FDI.

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Figure 7. Export share of sales of multinational affiliates.

Ramondo, Rappoport, and Ruhl (2016) utilize the U.S. Bureau of Economic Analysis data on all U.S. parents and their foreign affiliates for the year of 2004 to provide evidence of intrafirm trade of U.S. multinationals. They find that intrafirm trade in U.S. multinationals is highly concentrated and involves mostly between major multinational firms and their large affiliates; in fact, the median affiliate in the sample engages in zero intrafirm trade. Second, the magnitude of intrafirm trade is not related to the degree of vertical fragmentation as measured by the input-output relationship between the parent firm’s and the affiliate’s operating industries.

When considering horizontal FDI into a particular market, a firm confronts two fundamental and distinct questions. The first concerns the location of production: Is it better to produce the good in the home country and export it to the foreign market or is production abroad preferable? Second, if it is preferable to locate production abroad, how should technology be transferred overseas? In this context, firms can choose from a variety of arrangements that differ in their relative use of markets and organizations. At the one extreme lie technology transfers to wholly owned subsidiaries while at the other lie transfers to unrelated parties via technology licensing.

The OLI framework developed by John Dunning (1973) argues that the existence of multinational firms can be explained by three factors: ownership (O), location (L), and internalization (I). First, a multinational must possess an ownership advantage or a firm-specific asset (such as a well-recognized brand name, a unique product design, or a novel production technology) that allows it to compete successfully with local firms that tend to have much greater familiarity with the local environment. Second, there needs to be a reason that production in the same location as consumption is preferable to producing at home and shipping abroad. Such a locational incentive often arises due to the presence of trade impediments such as tariffs or transportation costs. Third, the multinational must prefer establishing a wholly owned subsidiary (i.e., transferring technology internally) to entering into an arms-length arrangement (e.g., technology licensing) with a local firm. A motive for such internalization can arise due to the incomplete nature of contracts or the existence of market failures (such as asymmetric information between buyers and sellers of technology) that hamper arms-length trade in technology (Saggi, 2002).

Location of Production: Exports Versus FDI

The choice between exports and FDI has received a great deal of attention in the economics literature. The manner in which the location question is usually posed inherently assumes that exports and FDI are substitutes for each other. Is this necessarily the case? While intuitively plausible, a first reading of the empirical literature on the question suggests otherwise. Most early existing empirical work uncovered a complementary relationship between exports and foreign affiliate sales (see Lipsey & Weiss, 1981, 1984; Grubert & Mutti, 1991). The evidence does not necessarily imply that most theoretical models of FDI are based on a flawed premise. A reasonable interpretation of the existing evidence, as suggested by Blonigen (1999), is simply that such studies are finding net complementarity; that is, aggregation bias in the data simply buries the substitution effects emphasized in theoretical models. Blonigen (1999) provides an insightful analysis of the relationship between exports of parent firms and sales of foreign affiliates using product level data on Japanese production and exports to the United States for two types of products: automobile parts and automobiles. This study is particularly useful in the context of Japanese firms, which import relatively large amounts of parts from Japan and seem quite unwilling to substitute U.S. parts. Only a study of this type can really help sort out the complementary nature of trade between intermediate goods and affiliate sales on the one hand and the substitutability of exports of final goods and FDI on the other. It turns out that Blonigen’s (1999) results conform nicely to the theory: exports of intermediate goods and sales of affiliates are complements whereas exports and sales of final goods are substitutes.

Existing theoretical models have also argued that strategic considerations influence the choice between exports and FDI (see Horstmann & Markusen, 1992; Motta & Norman, 1996). It is clear that the use of import tariffs and other trade policy barriers by a country makes exporting to its market more costly for foreign firms, thereby creating a tariff-jumping motive for FDI on their part. Bhagwati, Brecher, Dinopoulos, and Srinivasan (1987) and Bhagwati, Dinopoulos, and Wong (1992) have argued that the mere threat of future trade restrictions may lead to anticipatory investment (termed “quid pro quo” investment) by foreign firms. Existing research has also emphasized the interdependence of decision making among multinational firms. For example, when two firms are exporting to a foreign market, a switch from exports to FDI by one creates an incentive for FDI on the other firm’s part, which finds itself at a competitive disadvantage (Lin and Saggi, 1999, call this the “competitive incentive” for FDI). In a similar vein, an old tradition in the management literature describes the interdependence of decision-making among large multinationals as “follow the leader” behavior (Caves, 1996).

Although the literature provides important insights into the one-time choice between exports and FDI, in the real world firms face a dynamic problem and can switch between the two activities over time. Furthermore, firms sometimes rely on both exports and FDI to serve their customers in a given market. Unfortunately, formal models exploring the dynamics of optimal entry strategies regarding foreign markets are rather scarce. An important paper by Roberts and Tybout (1997), while not exploring the choice between different entry strategies, does highlight the role of sunk costs in determining the dynamic behavior of exporters. Using data for Colombian manufacturing plants, Roberts and Tybout (1997) show that prior exporting experience is an important determinant of the current tendency to export as well as the profitability of exporting. Their findings show that sunk costs are indeed relevant for exporting behavior and that learning is subject to strong depreciation: the entry costs of a plant that has never exported do not differ significantly from plants that have not exported for more than two years.

Roberts and Tybout (1997) do not consider other modes of serving foreign markets, yet their insight regarding the importance of sunk costs can be utilized in a more general context. One can view the choice between exports and FDI as a choice between two different technologies, where exports entail a higher marginal cost and a lower fixed (sunk) cost than FDI. Under uncertainty, when firms face such a cost structure, an interesting dynamic relationship between exports and FDI can emerge. Saggi (1998) builds a two-period model to examine a firm’s choice between exports and FDI in the face of demand uncertainty. First-period exports yield information about demand in the foreign market. As a result, first-period exports have an option value: If a significant portion of the fixed cost of FDI is sunk, it is optimal for a firm to export in the first period and switch to FDI if and only if demand abroad is great enough.

In a noteworthy paper, Rob and Vettas (2003) consider a dynamic scenario where a firm chooses between exports and FDI in a market environment in which foreign demand grows stochastically over time. Since the firm chooses capacity in their model, an attractive feature of their approach is that the firm has the option of serving the foreign market via exports and FDI—a scenario that obtains when demand abroad exceeds the capacity installed by the firm in the foreign market. Rob and Vettas (2003) show that due to the irreversible nature of the entry cost associated with FDI, the firm typically waits and enters via FDI only when demand has reached a sufficiently high level. Post FDI, the firm invests in additional capacity if demand grows over time. Furthermore, if the firm finds it optimal to rely on both exports and FDI then the two modes play complementary roles. FDI is used to satisfy proven demand whereas exports help explore uncertain demand.

Of course, generalizing the preceding argument to the case of multiple firms also creates the possibility of informational externalities among investors because experience of one firm can impart lessons to others. Such externalities may be particularly relevant for FDI into countries that may have recently opened their markets to foreign investors (such as India in the early 1990s and China in the late 1980s). By definition, foreign firms have little prior operational experience in newly liberalized countries. This lack of experience coupled with the complexity surrounding the FDI decision implies that firms seeking to invest in these markets can learn valuable lessons from the successes and failures of others. FDI involves making decisions that require adequate information about hiring foreign labor, setting up a new plant, meeting foreign regulations, and developing new marketing plans. In this context, decisions made by rival firms can lower a firm’s fixed cost by helping them avoid mistakes. Lin and Saggi (1999) construct a duopoly model in which the firm that is first to switch from exporting to FDI confers a positive externality on the subsequent investor by lowering its fixed cost of FDI.

In their survey of Japanese firms planning investments in Asia, Kinoshita and Mody (1997) found that information, both private and public, plays an important role in determining investment decisions. They argue that information regarding many operational conditions (such as functioning of labor markets, literacy and productivity of the labor force, timely availability as well as quality of inputs, etc.) may not be available publicly. Such information is either gathered through one’s own direct experience or through the experience of others. Indeed, their empirical analysis finds that a firm’s current investment is strongly affected by its own past behavior as well as investments by its rivals.

While the degree of fixed/sunk costs may play a role in determining the choice between licensing, joint ventures, and FDI, other considerations are probably more important. A new foreign plant is the primary contributing factor behind higher fixed/sunk costs of FDI relative to exports, and this factor is unlikely to be of first-order importance in determining the choice between entry modes that are differentiated primarily by the extent of foreign ownership.

Economics of Internalization

A major question in the theory of the multinational firm is when and why firms choose to internalize technology transfer thereby forgoing the option of utilizing market-based alternatives such as technology licensing. The relevant economics literature regarding internalization has been discussed extensively in comprehensive but dated surveys by Markusen (1995) and Caves (1996). Markusen and Maskus (2002) have suggested that the literature that attempts to link the emergence of multinational firms with firm- and country-level characteristics can be understood to emerge from a common underlying model—the “knowledge-capital” model. This model rests on the public good nature of knowledge, that is, it can be utilized by multiple agents or in multiple locations simultaneously. Thus, an innovation can then be fruitfully applied at plants dispersed all over the world, giving rise to horizontal multinational firms. Markusen and Maskus (2002) show that there is indeed strong empirical support for this horizontal model of multinationals.

How does the knowledge-capital model explain internalization? It turns out that the public good nature of knowledge once again occupies a central role. If licensees (or local partners under a joint venture) can access the multinational’s proprietary knowledge, the value of its knowledge-based assets can be dissipated either because of increased competition (Ethier & Markusen, 1991; Saggi, 1996, 1999) or because the local partner has inadequate incentives to protect the multinational’s reputation (Horstmann & Markusen, 1987). The incentive to prevent the dissipation of knowledge-based assets is reflected in the fact that multinationals transfer technologies of new vintage via direct investment, preferring to license or transfer their older technologies via joint ventures (see Mansfield & Romeo, 1980). Alternatively, it may be easier to trade older technologies via the market: potential buyers are likely to be better informed about well-established technologies relative to brand new ones.

Javorcik (2004a) focuses on intra-industry differences in R&D intensity as a determinant of mode of entry chosen by firms investing in Eastern European countries. Like past work, this study finds that a firm’s R&D expenditure is negatively related to the probability of a joint venture and positively related to greenfield entry. Furthermore, a firm’s R&D expenditure relative to the rest of the industry is found to be positively correlated with the probability of greenfield entry in high-technology sectors. More interestingly, however, higher relative R&D expenditure by a firm in a low-technology sector actually increases the likelihood that it chooses a joint venture over greenfield entry. Thus, a firm’s R&D expenditure relative to other firms in the industry and the aggregate R&D expenditure of the industry relative to other industries may interact in subtle ways to influence the choice between alternative entry modes. Javorcik (2004a) argues that protecting one’s technology is of greater concern in high-technology industries, thereby encouraging technological leaders to adopt direct entry. However, it is also possible that in industries characterized by fast-paced technological change, any technology leakage will hurt a firm for only a short period of time. Furthermore, the formation of joint ventures may be easier in relatively mature host industries because suitable local partners can be found more easily. Thus, Javorcik’s (2004a) results call for a careful interpretation and raise some interesting questions for future research.

Horstmann and Markusen (1996) argue that a potential licensee in the host country may have better information about local demand and can use this information to extract rents from the licenser. Such agency costs can also be utilized to explain the dynamics of optimal entry modes. In his studies of British multinationals, Nicholas (1982, 1983) found that 88% of firms sold their products via a contract with a local agent before converting to directly owned sales or production branches. Furthermore, the decision to terminate the licensing arrangement was based on a desire to avoid agency costs. Once the multinational had acquired the information it needed via its alliance with the local partner, continuing the agency relationship was no longer attractive. Similarly, in their survey of Japanese multinationals in Australia, anecdotal evidence suggests that 60% of the firms used a local agent before making a direct investment and 69% exported to Australia before making a direct investment of any sort. One can view such temporary licensing as a method of information acquisition on the part of the foreign firm, as opposed to the local firm seeking superior production technology.

In Horstmann and Markusen’s (1996) model, when a multinational firm’s fixed cost of investment is high relative to the agent’s and there is risk of large losses due to low demand, the firm opts for an initial licensing contract that becomes permanent ex post in case of low demand. This analysis can be applied to examine the choice between a joint venture and a wholly owned subsidiary, except that cost uncertainty may be more relevant for this scenario than demand uncertainty. For example, if the productivity of foreign labor is in doubt, forming a joint venture may present a low (fixed) cost option. If labor productivity turns out to be high, an acquisition of the foreign partner may be optimal ex post, resulting in the establishment of a wholly owned subsidiary.

Mattoo, Olarreaga, and Saggi (2004) develop an oligopolistic model to examine a multinational firm’s choice between two modes of entry: direct (or greenfield) entry, wherein it establishes a wholly owned subsidiary, or an acquisition of one of the existing firms. In the model, the degree of technology transfer and the intensity of market competition depend upon the mode of entry chosen by the multinational. While the competition-enhancing effect of FDI is greater under direct entry, one mode does not unambiguously dominate the other in terms of technology transfer. On the one hand, the relatively larger market share that the multinational enjoys under acquisition increases its incentive for transferring technology. On the other hand, the strategic incentive to transfer technology in order to wrest market share away from domestic rivals can be stronger in a more competitive environment. Mattoo et al. (2004) found that divergence between the foreign firm’s choice and the welfare interest of the host country can create a basis for policy intervention.

Firm Heterogeneity and FDI

While much of the formal literature we have discussed thus far assumes that firms engaged in international trade and investment are homogeneous, recent empirical evidence shows that, even within narrowly defined industries, firms differ substantially from one another in terms of their productivity. It follows that such productivity heterogeneity can affect firms’ choices between exporting and FDI as alternative means of serving foreign markets. In an important paper, Helpman, Melitz, and Yeaple (2004) build on the seminal model of trade under firm heterogeneity developed in Melitz (2003) by allowing firms to serve foreign markets through either exporting or horizontal FDI. They show that whether firms choose to conduct FDI depends on their relative position in the industry in terms of productivity. In particular, only the most productive firms choose to serve foreign markets through FDI, with the less productive firms opting to export. Firms whose productivity levels are lower than those of exporters tend to sell only in domestic markets, while the least productive firms do not produce at all (i.e., exit the industry). The authors also use firm-level data to provide an empirical confirmation of these theoretical insights. Furthermore, they show that the ratio of aggregate FDI to exports increases in the degree of productivity dispersion because an increase in such dispersion leads the most productive firms to undertake more FDI.

Antràs and Helpman (2004) further explore the implications of within-industry productivity heterogeneity for firms’ decisions regarding their ownership structures and the location of their suppliers. The authors develop a north-south model wherein northern firms choose whether and where to outsource the production of intermediate goods. The analysis is therefore relevant for vertical FDI wherein a northern firm chooses to locate the in-house production of intermediate goods in the South. As with horizontal FDI, the authors find that vertical FDI is also undertaken by the most productive northern firms in the industry. On an aggregate level, the model predicts that vertical FDI is more prevalent in industries where headquarter services are more important for production and within-industry dispersion of productivity is greater. It is worth noting that the main theoretical predictions of Antràs and Helpman (2004) find support in subsequent empirical studies, such as Tomiura (2007), whose analysis of Japanese firms shows that while firms engaged in outsourcing or exporting are less productive than those that undertake FDI, they are indeed more productive than those operating only domestically.

Economic research has also shed light on how firm-level heterogeneity affects individual firms’ choices between greenfield and M&As FDI. Nocke and Yeaple (2007) develop a model of FDI in which firms are heterogeneous with respect to their mobile and nonmobile capabilities, where mobile capabilities are defined as production resources that can be transferred across borders and nonmobile capabilities can only be employed within a country. They find that as capabilities become less mobile, firms tend to conduct more cross-border M&As relative to greenfield FDI. Moreover, the nature of firm heterogeneity is an important driver of the types of firms that choose M&As. In particular, when firm heterogeneity arises from mobile capabilities, the most productive firms engage in M&As, but when it arises due to differences in nonmobile capabilities, M&As involve the least productive firms in the industry. In a related study, Nocke and Yeaple (2008) develop a model in which firms are heterogeneous in terms of their corporate assets and show that firms that choose to engage in greenfield FDI are systematically more productive that those that opt for M&As—a finding that is supported by data on outward bound FDI from the United States.

Most recently, Guadalupe, Kuzmina, and Thomas (2012) examine how firm heterogeneity affects the likelihood of local firms being acquired by foreign multinationals. The authors uncover a positive selection effect of cross-border M&As: multinationals tend to acquire the most productive firms in host countries. Moreover, multinationals also invest more in innovation conducted by acquired firms when such firms have high initial productivities.

All in all, although existing literature provides important insights on a one-time choice between various modes of serving foreign markets and how variations in firm capabilities drive that choice, dynamic issues remain underexplored and are therefore poorly understood. Several central questions deserve further research: What determines the sequencing pattern of different activities (e.g., how often do firms first form joint ventures and then proceed with direct investment)? Do host country welfare and the rate of technology diffusion depend on the sequencing pattern? To what extent do the dynamic choices of foreign firms result from their efforts to restrict the diffusion of their proprietary technologies while at the same time maximizing the acquisition of valuable information from local firms? Further research aimed at these questions can substantially help expand the reach of the existing literature on internalization.

Multinational Firms in Global Research and Development

Multinational activity occurs primarily in industries that are characterized by a high ratio of R&D to sales and by large shares of professional, scientific, and technical workers (Markusen, 1995). Indeed, as noted earlier, multinational firms rely heavily on intangible assets, such as superior technology and well-established brand names, to offset the logistical and other disadvantages of operating in multiple countries and to successfully compete with host country firms that are better acquainted with the local economic environment.

The scale of the technology activities of major multinational firms can be difficult to grasp. For example, in 2009 the total R&D expenditures of Toyota exceeded that of India, a country of roughly 1.2 billion people (UNCTAD, 2010). Similarly, in a typical year, more than 20 multinational firms invest more in R&D than Turkey, a country of roughly 75 million people. These facts are a sharp reminder of the uneven nature of the global technology terrain. However, this lopsided environment is precisely what creates the potential for securing large productivity gains by encouraging FDI and international technology transfer to developing countries.

Royalties and licensing fee receipts pertaining to international exchange of technologies between firms provide one way of measuring the value of global flows of technology. Figure 8 illustrates a comparison of global royalty payments and world income (as measured by world GDP). The value of each series in 1996 has been set to 1 to compare their relative growth. While global income in 2016 was approximately 2.5 times that in 1996, total royalty payments were more than seven times as much.

Foreign Direct Investment and International Technology DiffusionClick to view larger

Figure 8. World royalty payments versus global income.

Much of the global action in technology transfer occurs within developed countries and lies within the boundaries of multinational firms. Estimates vary, but in a typical year more than 80% of global royalty payments for international transfers of technology are made between subsidiaries and their parent firms. At a global level, the royalties and licensing fee receipts accruing to multinational firms increased from $29 billion in 1990 to $311 billion in 2014.

In recent years, there has also been substantial growth in the number and scale of foreign affiliates of multinational firms conducting R&D in foreign countries. These research affiliates and R&D facilities can have several purposes: modifying products for local markets, situating R&D close to growing markets, using lower-cost research personnel, and establishing centers of original innovation. While most such new facilities have been set up in developed economies, some of the larger developing countries have become major host countries in recent years. For example, China and India have been among the top ten recipients of R&D facilities involving multinational firms in recent years. In 2009, Japanese multinationals allocated 38% of their R&D activities abroad to developing countries, a significant increase from 6% in 1993.

Has this shift in global R&D by multinationals shown any concrete results? Branstetter, Li, and Veloso (2015) examine data on patents issued by the United States to foreign residents and find that a majority of patents granted to China and India were to researchers working for subsidiaries of multinational corporations. They argue that the general rise of international coinvention reflects an expanded international division of labor within global R&D networks, much like the slicing of the global production chain across the world. The authors also compare the quality of patents (as measured by citations) granted to Chinese or Indian indigenous inventions with those granted to (a) coinventions with inputs from advanced economies and to (b) coinventions with inputs from advanced economies under the sponsorship of multinational firms. They find that coinvented patents tend to be of higher quality, as are patents developed under the sponsorship of multinationals.

Table 3 presents the shares of R&D expenditure by foreign affiliates of U.S. parent companies in various developing countries. U.S. companies have been increasing the share of R&D expenditure in developing countries. In particular, this share rose substantially from 7.4% in 1997 to 19.6% in 2013. Nevertheless, within developing countries the pattern of R&D spending of U.S. companies varies considerably. The exceptional performers have undoubtedly been China and India. In 1997 the two countries together accounted for only 5.4% of the R&D expenditure in developing countries. Their combined share surged to 49.5% in 2013. Such a strong expansion of U.S. foreign affiliate R&D did not occur in other major developing countries such as Brazil, Russia, and South Africa.

Table 3. Shares of R&D Expenditure of Foreign Affiliates of U.S. Parent Companies

Country

1997

2000

2005

2010

2013

Brazil

3.0%

1.2%

1.5%

3.5%

2.5%

China

0.2%

2.5%

2.4%

3.8%

4.5%

India

0.2%

N/A

1.2%

4.3%

5.2%

Russia

N/A

0.0%

0.1%

0.2%

0.3%

South Africa

0.2%

0.1%

0.1%

0.2%

0.2%

Developing countries

7.4%

11.2%

10.9%

19.8%

19.6%

Developed countries

90.8%

86.0%

87.1%

77.6%

77.2%

Source: U.S. Bureau of Economic Analysis.

Developing countries hope not only to import new foreign technologies via FDI, but also to improve the productivity of local firms via technological spillovers. A large literature has tried to determine whether host countries enjoy spillovers from FDI. This important issue is addressed in the next section.

Local Technology Diffusion and Spillovers from FDI

At the outset, it is important to be clear about what we mean by the word “spillover.” A distinction can be made between pecuniary externalities, which result from the effects of FDI on market structure and prices, and other pure externalities, such as the facilitation of technology adoption induced due to proximity that may result from inward FDI. A strict definition of spillovers that counts only the latter is employed here.

Channels of FDI Spillovers

The central measurement problem is that spillovers do not leave a paper trail; by definition, they are pure externalities that the market does not take into account. Nevertheless, several studies have attempted the difficult task of quantifying spillovers. What are the potential channels through which such spillovers from FDI might arise?

At the micro level, the literature suggests the following potential channels of spillovers:

  1. (1) Demonstration effects: Local firms may adopt technologies introduced by multinational firms through imitation or reverse engineering.

  2. (2) Labor turnover: Workers trained or previously employed by the multinational may transfer important information to local firms by switching employers, or may contribute to technology diffusion by starting their own firms.

  3. (3) Vertical linkages: Multinationals may transfer technology to firms that are potential suppliers of intermediate goods or buyers of their own products.

Empirical Evidence on Horizontal FDI Spillovers

In its simplest form, the demonstration effect argument states that exposure to the superior technology of multinational firms may lead local firms to update their own production methods. The argument derives from the assumption that it may simply be too costly for local firms to acquire the necessary information for adopting new technologies unless they are first introduced in the local economy by multinationals (and hence demonstrated to succeed in the local environment). Clearly, geographical proximity is a vital part of the demonstration effect argument. Geographical proximity may indeed be crucial for those countries that are not particularly well-integrated into the world economy and therefore have fewer alternative channels for absorbing foreign technologies.

Early efforts in search of horizontal spillovers from FDI proceeded by relating the intra-industry variation in productivity to the extent of FDI (Blomström, 1986; Blomström & Persson, 1983; Caves, 1974; Globerman, 1979). By and large, these studies find that sectors with a higher level of foreign involvement (as measured by the share of the labor force in the industry employed by foreign firms or the extent of foreign ownership) tend to have higher productivity, higher productivity growth, or both. The fact that these studies involve data from different countries (Australia for the Caves study, Canada for Globerman, and Mexico for Blomström) lends a strong degree of robustness to this positive correlation between the level of foreign involvement and local productivity at the sector level.

Correlation is not causation, however, and, as noted by Aitken and Harrison (1999), this literature may overstate the positive impact of FDI on local productivity. Investment may be attracted to the more productive sectors of the economy instead of being the cause of the high productivity in such sectors. In other words, the studies ignore an important self-selection problem. What do empirical plant-level studies find with respect to spillovers from FDI? Haddad and Harrison’s (1993) study was the first to employ a comprehensive data set at the level of the individual firm over several years. The data came from an annual survey of all manufacturing firms in Morocco. An important result of this study was that foreign firms exhibited higher levels of total factor productivity, but their rate of productivity growth was lower than for domestic firms. In addition, when sectors were divided into high and low tech, the effect of FDI at the sector level was found to be more positive in low-tech sectors. The authors interpret this result as indicative of the lack of absorptive capacity on the part of local firms in the high-tech sector, where they may be further behind multinationals and unable to absorb foreign technology.

Aitken, Harrison, and Lipsey (1996) argue that technology spillovers should increase the marginal product of labor and this increased productivity should show up as higher wages. They investigate this idea by employing data from manufacturing firms in Venezuela, Mexico, and the United States. They find that for both Mexico and Venezuela, a higher share of foreign employment is associated with higher overall wages for both skilled and unskilled workers. Furthermore, royalty payments to foreign firms from local firms are highly correlated with wages.

Most important, the study finds no positive impact of FDI on the wages of workers employed by domestic firms. In fact, the authors report a small negative effect for domestic firms, whereas the overall effect for the entire industry is positive. These findings differ from those for the United States, where a larger share of foreign firms in employment is associated with both a higher average wage as well as higher wages in domestic establishments. Putting the findings of Aitken et al. (1996) into context, it is clear that wage spillovers from foreign to domestic firms are associated with higher productivity in domestic plants. Conversely, the absence of wage spillovers appears to accompany the existence of productivity differentials between domestic and foreign firms.

Using annual census data on more than 4,000 Venezuelan firms, Aitken and Harrison (1999) provide another test of the spillover hypothesis. Since each plant was observed over a period of time, the self-selection problem of past sector-level studies (i.e., FDI goes to the more productive sectors) could be avoided in their study. The authors find a positive relationship between foreign equity participation and plant performance, implying that foreign participation does indeed benefit plants that receive it.

However, this own-plant effect is robust for only small plants that employ fewer than 50 employees. For larger plants, foreign participation results in no significant improvement in productivity relative to domestic plants. More interestingly, they find that productivity in domestic plants declines with an increase in foreign investment. In other words, the authors find evidence of negative spillovers from FDI and suggest that these could result from a market-stealing effect. Put another way, foreign competition may have forced domestic firms to lower output and thereby forgo economies of scale. Nevertheless, on balance, Aitken and Harrison (1999) find that the effect of FDI on the productivity of the entire industry is weakly positive.

Haskel et al. (2007) use plant-level panel data for all U.K. manufacturing from 1973 through 1992 to reexamine the issue of horizontal spillovers from FDI. As the authors note, there can be little doubt that local firms in the United Kingdom possess sufficient absorptive capacity to benefit from the introduction of newer technologies by multinationals. So if spillovers do not materialize, they cannot be attributed to the limitations of domestic firms. Across a wide range of specifications, the authors find that there are positive spillovers from FDI at the industry level. More precisely, they find that a 10% increase in foreign presence in a U.K. industry raises the total factor productivity of that industry’s domestic plants by about 0.5%.

Using plant-level panel data from the Chilean manufacturing sector over 1995–2001, Ramondo (2009) investigates how the entry of foreign plants affects resource reallocations in the host industry. The data represent all Chilean manufacturing plants with more than 10 employees, and each year there are more than 4,000 plants in the data set. Like previous studies, the author finds that upon entry foreign plants are larger, more productive, and capture greater market shares than domestic plants. Moreover, the entry of foreign plants makes it more likely that domestic plants, especially those that are relatively less productive, exit the market. Finally, Ramondo (2009) finds that the presence of foreign plants leads to higher average productivity gains for domestic plants in the same industry.

In a recent paper, Lu, Tao, and Zhu (2017) use a novel instrumental variable approach to identify the spillover effects of horizontal FDI. In particular, the authors study China’s accession to the WTO in 2001, which made only a subset of manufacturing industries more open to FDI. Using the differential policy change across industries as an instrument, the authors find that FDI has a negative and significant effect on the productivity of domestic firms in industries that became more open to FDI. They also find that the degree of horizontal spillover of FDI depends on the interaction between a negative competition effect and a positive agglomeration effect: positive spillovers arise only when the positive agglomeration effect dominates the negative competition effect.

Role of Labor Turnover

Labor turnover differs from the other channels of technology transfer because knowledge embodied in the labor force moves across firms only through the physical movement of workers. The relative importance of labor turnover is difficult to establish because it requires tracking individuals who have previously worked for multinationals and then determining their impact on the productivity of their new employers. As result, direct evidence on labor turnover as a channel of FDI spillovers is rather limited. Furthermore, the available evidence on labor turnover itself is mixed. For example, although Gershenberg’s (1987) study of Kenyan industries finds limited evidence of labor turnover from multinationals to local Kenyan firms, several other studies document substantial labor turnover of this kind. UNCTAD (1992) discusses the case of the garment industry in Bangladesh (see also Rhee, 1990). Korea’s Daewoo supplied Desh (the first Bangladeshi firm to manufacture and export garments) with technology and credit. Thus, Desh was not a multinational firm in the strict sense; rather, it was a domestic firm that benefited substantially from its connections with Daewoo. Eventually, 115 of the 130 initial workers left Desh to set up their own firms or to join other newly established garment companies. The remarkable speed with which the former Desh workers transmitted their know-how to other factories clearly demonstrates the role labor turnover can play in technology diffusion.

Pack (1997) discusses evidence documenting the role of labor turnover in disseminating the technologies of multinationals to local firms. For example, in the mid-1980s, almost 50% of all engineers and approximately 63% of all skilled workers that left employment at multinationals located in Taiwan left to join local Taiwanese firms. By contrast, Gershenberg’s study of Kenyan industry reports smaller figures; of the 91 job shifts studied, only 16% involved turnover from multinationals to local firms.

In a recent study of Brazilian industry, Poole (2013) provides convincing evidence of the spillovers that labor turnover from multinationals to local firms can generate. She finds that workers in domestic establishments hiring a larger share of former multinational workers earn higher wages, an indication of their higher productivity. Poole’s work also shows that higher-skilled former multinational workers are more effective at transmitting information to local firms, just as higher-skilled incumbent domestic workers are better able to absorb it.

In order to synthesize these empirical findings, the observed cross-country variation in labor turnover rates itself requires an explanation. One possible generalization is that in countries such as Brazil, South Korea, and Taiwan, local competitors are less disadvantaged relative to their counterparts in many African economies, thereby making labor turnover easier. Thus, the ability of local firms to absorb technologies introduced by multinationals may be a key determinant of whether labor turnover occurs as a means of technology diffusion in equilibrium (see Glass and Saggi, 2002, for a formal model).

Furthermore, the local investment climate may be such that workers looking to leave multinationals in search of new opportunities (or other local entrepreneurs) find it unprofitable to start their own companies, implying that the only alternative opportunity is to join existing local firms. The presence of weak local competitors probably goes hand in hand with the lack of entrepreneurial efforts because both may result from the underlying structure of the economic environment.

Cho (2018) studies manager transfer as a particular channel through which knowledge is transferred internationally within multinational firms and investigates whether such transfers benefit foreign affiliates. The author uses a unique data set on foreign affiliates of Korean multinational corporations over 2005–2010. A key feature of this data set is that it contains information about employee assignment, which makes it possible to track manager transfer within multinational firms. The author finds that most parent companies do transfer managers to their foreign affiliates. Furthermore, although the number of managers transferred is generally small, such international movement of managers within multinationals is positively associated with the productivity growth of foreign affiliates.

Vertical Technology Spillovers From FDI

For quite some time, analysts have recognized that multinationals may benefit the host economy through the backward and forward linkages that they generate. However, merely documenting extensive linkages between multinationals and local suppliers or buyers is insufficient for arguing that net benefits accrue to the local economy as a result of FDI. Vertical technology transfer has been documented to occur when firms from industrialized countries choose to buy the output of firms in many Asian economies in order to sell it under their own name (Hobday 1995; Rhee, Ross-Larson, & Pursell, 1984).

Pack and Saggi (2001) provide an early formal analysis of vertical technology transfer in the context of international outsourcing. They construct a model in which a single firm in a developed country (DC) may choose to engage in vertical technology transfer by outsourcing basic production and transferring its proprietary technology to firm in a less developed country (LDC). Under exclusive outsourcing, the DC firm transfers technology to a single LDC firm and markets its product in the DC market. A key feature of the model is that once the technology is transferred, some of the relevant knowledge can seep out to a nonaffiliated firm(s) in the LDC market. Pack and Saggi (2001) show that if other LDC firms lack the ability to successfully market their products in the DC market, technology diffusion in the LDC market actually benefits the DC firm since it increases competition among its suppliers. Furthermore, even when the decrease in price due to technology diffusion in the upstream LDC market induces entry into the downstream DC market, the adverse effects of such increased downstream competition on profitability of the original DC firm are not necessarily strong enough to dissuade it from transferring technology to the LDC market. In fact, the diffusion of technology among LDC suppliers accompanied by entry in the downstream DC market can actually benefit both firms involved in the initial technology transfer. The intuition for this surprising result is as follows. In the absence of diffusion upstream and entry downstream, the two original firms are in a bilateral monopoly and impose a pecuniary vertical externality upon each other by charging a price above marginal cost. Diffusion upstream brings the LDC price closer to marginal cost and benefits the DC firm while entry downstream brings the downstream price closer to marginal cost and benefits the original LDC firm. As a result, as long as the competition resulting from diffusion upstream and entry downstream is not too severe, both firms gain from technology diffusion in the upstream LDC market. An important implication of this analysis is that vertically integrated multinational firms may be more averse to technology diffusion in upstream markets than firms involved in arms-length arrangements with their foreign suppliers.

Mexico’s experience with the maquiladora sector and its automobile industry provide a good illustration of the phenomenon of vertical spillovers from FDI. Mexico started the maquiladora sector as part of its Border Industrialization Programme, which was designed to attract foreign manufacturing facilities to the U.S.-Mexico border. Most maquiladoras began as subsidiaries of U.S. firms that shifted labor-intensive assembly operations to Mexico because of its low wages relative to the United States. However, the industry evolved over time and the maquiladoras now employ sophisticated production techniques, many of which have been imported from the United States.

In Mexico’s dynamic automobile industry, FDI resulted in extensive backward linkages: within five years of initial investments by U.S. firms, there were hundreds of domestic producers of parts and accessories. U.S. firms and other multinational firms transferred technology to these Mexican suppliers, including industry best practices, zero defect procedures, production audits. These technological improvements increased productivity. As a result of increased efficiency and competition, Mexican exports in the automobile industry boomed. Thus, although direct competitors of multinational firms may not realize technological benefits (as evidenced by Aitken et al., 1996), suppliers of intermediate goods are likely to benefit substantially.

In a broader study, Batra and Tan (2002) use data from Malaysia’s manufacturing sector to study the effect of multinationals on interfirm linkages and productivity growth during 1985–1995. Their results show that not only are foreign firms more involved in interfirm linkages than domestic firms but also that such linkages are associated with technology transfer to local suppliers. Such technology transfers were found to have occurred through worker training and the transmission of knowledge that helped local suppliers improve the quality and timeliness of supply.

Using data from the annual enterprise survey conducted by the Lithuanian Statistical Office, Javorcik (2004b) attempts to identify FDI spillovers that occur through vertical linkages between downstream foreign firms and their upstream suppliers in the manufacturing sector. The major finding is that while positive backward spillovers from FDI exist, there is no evidence of horizontal or forward spillovers to firms that multinationals supply. Moreover, the positive backward spillovers from FDI originate from joint ventures rather than fully owned foreign affiliates, a finding that suggests that local participation can be an important determinant of the productivity effects of FDI.

In his study of FDI spillovers, Kugler (2006) develops a new econometric framework that can identify general equilibrium effects of FDI and not only the benefits of knowledge sharing between multinationals and their local suppliers. Using panel data on Colombian manufacturing firms that cover the period 1974–1998, Kugler shows that there are interindustry but not within-industry FDI spillovers. In particular, such spillovers are generated through backward linkages that occur in the outsourcing relationships between multinational firms with local downstream suppliers.

Interpreting the Empirical Evidence

To recapitulate, several studies have cast doubt on the view that FDI generates positive horizontal spillovers for local firms. However, such findings need not imply that host countries have nothing significant to gain (or must lose) from FDI. Domestic firms should be expected to suffer from an increase in competition; in fact, part of the benefit of inward FDI is that it can help weed out relatively inefficient domestic firms. Resources released in this process will be put to better use by foreign firms with superior technologies, efficient new entrants (both domestic and foreign), or some other sectors of the economy. However, such reallocation of resources cannot take place instantaneously. Existing studies of spillovers may not cover a long enough period to accurately determine how FDI affects turnover rates (entry and exit).

In a critical discussion of the plant-level studies of horizontal spillovers from FDI, Moran (2005) argues that there is a substantial difference in operating characteristics between subsidiaries that are integrated into the international networks of the parent multinationals and those that serve protected domestic markets and are prevented by policy restrictions (such as mandatory joint venture and domestic content requirements) from being so integrated. These different operating characteristics include size of plant, proximity of technology and quality control procedures to industry best practices, speed with which production processes are brought to the frontier, efficiency of operations, and cost of output. He argues that while the former have a positive impact on the host country, often accompanied by vertical backward linkages and externalities, the latter may actually have a negative impact. Drawing upon a wealth of case studies and econometric evidence, Moran (2005) argues this contrast in performance holds across different industries, countries, and time periods.

It is also worth bearing in mind that spillovers from FDI may be of an entirely different nature: in that local firms may enjoy positive externalities from foreign firms that make it easier for them to export. Such externalities may come about because better infrastructure (transportation, storage facilities, and ports) emerges in regions with a high concentration of foreign exporters. Aitken, Hanson, and Harrison (1997) provide direct evidence on this issue. They conducted a detailed study of 2,104 manufacturing plants in Mexico. In their sample, 28% of the firms had foreign ownership and 46% of the foreign plants exported. Their major finding is that the probability of a Mexican-owned plant exporting is positively correlated with its proximity to foreign-owned exporting plants. Such spillovers may result from informational externalities and are more likely to lower fixed costs rather than marginal costs of production.

Harding and Javorcik (2012) empirically examine the effects of FDI on the quality of a host country’s exports. They use a cross-country data set that contains information on exports of 105 countries during 1984–2000. Using the difference-in-differences approach, the authors find that sectors that are more exposed to inward FDI induced by favorable government policy have 11% higher unit values of exports. However, this positive impact of FDI on the host country’s export quality is found only for low- and middle-income countries, but not for high-income countries.

Havranek and Irsova (2011) conduct a meta-analysis of vertical FDI spillovers and find robust evidence in favor of economically significant backward spillovers, small but significant forward spillovers, and no horizontal spillovers. The authors also identify a publication bias (i.e., positive results are more likely to be published) in the case of backward spillovers. Furthermore, they find that FDI from more distant countries generates greater spillovers, a result consistent with Javorcik and Spatareanu (2011). In addition, countries more open to international trade and having underdeveloped financial systems enjoy greater spillovers, joint ventures lead to more spillovers than fully owned foreign affiliates, and firms in service industries receive fewer spillovers than those in manufacturing.

Javorcik and Poelhekke (2017) address a fundamental question that is overlooked by most studies, that is, are positive technology spillovers from foreign ownership due to one-time technology transfer or from continuous injections of knowledge from parent firms? To this end the authors examine the effects of divestments, which involve local owners buying foreign affiliates, on productivities of local firms. Using plant-level data on Indonesian manufacturing firms during 1990–2009, the authors find that divestment is associated with a fall in total factor productivity, which is accompanied by reduced outputs, markups, and export and import intensities. These findings indicate that benefits from foreign ownership are probably due to continuous transfers of knowledge from foreign parents to local affiliates.

Although micro-level evidence does not provide strong support for the notion of horizontal technology spillovers from FDI, there is strong empirical support for the idea that FDI stimulates economic growth in host countries. Balasubramanyam, Salisu, and Sapsford (1996) find the growth-stimulating effects of FDI are stronger for countries that pursue export promotion rather than import substitution policies. So trade policy seems to affect the benefits of FDI, although trade orientation could proxy for other unmeasured differences across countries. For export-promoting countries, FDI stimulated growth more than domestic investment. Borensztein, De Gregorio, and Lee (1998) find that FDI contributes more to economic growth than domestic investment for countries that have a sufficient stock of human capital. Countries with insufficient human capital presumably lack the ability to absorb technologies. Xu (2000) finds that countries need to achieve a minimum level of human capital in order for the technology transferred by U.S. multinational firms to contribute to productivity growth, but most LDCs do not satisfy the required threshold.

Policy Implications

While governments around the world are involved in supporting basic R&D in a variety of ways, the commercialization and globalization of technology is largely in the hands of private agents, the most important of which are multinational firms. That multinationals are pivotal in introducing new technologies to markets in which they invest is beyond dispute. However, lagging countries need not only to obtain novel foreign technologies but also learn how to fully exploit them. Furthermore, access to foreign technologies via FDI is only one mechanism by which developing countries can boost their technological capabilities. Ultimately, we care about technological improvements only to the extent they help raise people’s standard of living. The central determinant of a country’s long-run standard of living is its productivity. From this perspective, it is useful to make a distinction between initial international technology transfer via FDI and subsequent technology diffusion within host countries. This distinction is not just semantic. Some policies could promote technology transfer but deter local technology diffusion, or they could do the opposite.

With respect to the contribution of FDI to local productivity, the news is rather mixed. The bad news is that because multinationals lose from further horizontal diffusion of their technologies to local competitors, they have an incentive to take actions that thwart that process. The good news is that technology transfer to local suppliers is incentive-compatible for multinationals and a plethora of empirical evidence indicates that vertical linkages between multinationals and their local suppliers play a crucial role in the industrial development of host countries. If there is a robust finding on technology spillovers from FDI, this is it. An important policy implication of this finding is that host countries are better off facilitating processes that are incentive-compatible for multinationals. In other words, a developing country should perhaps be less concerned about being able to produce an automobile of its own and more concerned about developing a competitive network of suppliers that can serve (and gain from) interaction with multinationals. It is in this mutually beneficial exchange that the most productive policy intervention may lie.

Of course, if both sides are indeed willing participants, policy intervention would be “light” as opposed to “heavy.” Furthermore, it would not be targeted in nature. Instead, it would ensure that local businesses have access to adequate infrastructure and skilled workers and their expansion or downsizing decisions are not hampered by burdensome regulations. In our view, this is another good reason to pursue policies that take proper account of the incentives multinational firms have (and do not have) to encourage industrial development in host countries.

Multinational firms are only one part, although perhaps the most important one, of global innovation networks that incorporate many other agents such as startup companies, universities and public research laboratories, as well as foundations, nongovernmental organizations, and government agencies. Within such innovation networks there are potential gains from specialization (e.g., basic research versus commercialization) and collaboration (e.g., in licensing, pooling information and intellectual property, and cross-border research alliances). Private firms and public entities should seek greater participation in such global innovation networks in order to boost competitiveness, growth, and technology transfer.

Further Reading

Antràs, P. (2016). Global production: Firms, contracts, and trade structure. Princeton, NJ: Princeton University Press.Find this resource:

Antràs, P., & Yeaple, S. R. (2014). Multinational firms and the structure of international trade. In G. Gopinath, E. Helpman, & Kenneth Rogoff, (Eds.), Handbook of international economics, vol. 4 (pp. 55–130). Amsterdam, The Netherlands: North-Holland.Find this resource:

Bernard, A., Jensen, B., Redding, S., & Schott P. (2007). Firms in international trade. Journal of Economic Perspectives, 21(3), 105–130.Find this resource:

Bernard, A., Jensen, B., Redding, S., & Schott P. (2018). Global firms. Journal of Economic Literature, 56(2), 565–619.Find this resource:

Caves, R. E. (1996). Multinational enterprise and economic analysis. Cambridge, UK: Cambridge University Press.Find this resource:

Javorcik, B. S. (2012). Foreign direct investment and international technology transfer. In G. Caprio Jr., T. Beck, S. Claessens, & S. L. Schmukler, (Eds.), The evidence and impact of financial globalization (pp. 311–319). Amsterdam, The Netherlands: Elsevier.Find this resource:

Keller, W. (2004). International technology diffusion. Journal of Economic Literature, 42(3), 752–782.Find this resource:

Markusen, J. R. (1995). The boundaries of multinational enterprises and the theory of international trade. Journal of Economic Perspectives, 9, 169–189.Find this resource:

Moran, T.H., Graham, E.M., & Blomström, M. (2005). Does foreign direct investment promote development? Washington DC: Peterson Institute for International Economics.Find this resource:

Saggi, K. (2002). Trade, foreign direct investment, and international technology transfer: A survey. World Bank Research Observer, 17(2), 191–235.Find this resource:

Saggi, K. (2016). Trade, intellectual property rights, and the World Trade Organization. In K. Bagwell & R. Staiger, (Eds.), Handbook of commercial policy, vol. 1 (pp. 433–512). Amsterdam, The Netherlands: North-Holland.Find this resource:

UNCTAD. (2018). World investment report 2018: Investment and new industrial policies. New York, NY: United Nations.Find this resource:

References

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