IX. Role of Foreign Direct Investment in Boosting Productivity and Exports in the Southern euro area Economies1
The consensus view of the literature is that foreign direct investment (FDI) in general has a favorable impact on productivity and exports.2 FDI can be resource-seeking or market-seeking, and the former type boosts exports directly. But both types of FDI also have indirect impacts through positive externalities and spillover effects: they may bring capital and knowhow to domestic industries, have positive externalities on domestic companies through competition and reduced costs of inputs, and help host country exporters to gain access to foreign market. Although in theory FDI could adversely affect domestic producers by competing for markets and skilled employees, empirical evidence tends to support that the benefits of FDI significantly outweigh its costs for host countries.
In the current context of weak external performance of the five southern euro area economies (SEA-5),3 studying FDI becomes especially important since it is a forward-looking indicator. Investment undertaken in the past continues to affect future economic performance. Therefore the patterns of FDI to the SEA-5 economies in recent years provide signs of how productivity and trade are expected to evolve in the future. The literature has also identified a set of policy variables, which influence FDI. Examining these indicators not only helps explain the recent trend of FDI in the SEA-5 economies, but also points to how FDI performance could be improved, thus contributing to the competitiveness of these countries.
B. Recent Trends of FDI in SEA-5 Countries
The SEA-5 economies have experienced increasing FDI inflows in recent years, but the distribution was not even, and, in particular, Greece and Italy have been lagging (Figure IX.1). From 1996 to 2005, FDI inflows to France, Portugal, and Spain as a percent of GDP were at the average OECD level, while those to Greece and Italy were the lowest among the OECD countries. This pattern implies that FDI in general has not benefited the economies of Greece and Italy in the same way as might have happened in the other countries, and there is scope for promoting further FDI in Greece and Italy. It is worth noting, however, that FDI to Italy roughly doubled in 2001–05 compared with 1996–2000, while FDI in Greece remained stagnant.
Figure IX.1.FDI Inflows (Percent of GDP)
Much of the FDI to the SEA-5 economies has been in the service sector, in line with the experience of other OECD countries. In particular, manufacturing FDI to Portugal was smaller than to the other SEA-5 countries. Since service is largely nontradable, this would imply that the direct impact of FDI on Portugal’s exports was more limited. Italy had relatively large FDI inflows to the quarrying sector. The main source countries for these FDI flows are the U.S., European countries, and Japan.
C. Could FDI Help Productivity and Exports? A Sectoral Analysis
Although FDI inflows to France, Portugal, and Spain have been at about the OECD average, their impact on productivity and exports depends on the sectoral distribution of FDI. The technological level of domestic industry could benefit more from FDI with a higher technological content, which could result in better export performance. If the FDI is targeted toward the sectors facing rapid growth in world demand, it could help the host country to gain market shares in those markets. Furthermore, as FDI is largely in the service sectors and these areas, e.g., infrastructure, often provide inputs to the tradable goods production, it would be desirable for FDI inflows to locate in service areas with higher levels of productivity, which would then have a stronger positive effect on the productivity of the tradable sector.
Has the technological content of FDI to the SEA-5 economies been rising?
While the SEA-5 countries in general received larger amounts of medium-tech FDI than lowtech and high-tech FDI, with the exception of Spain, there is no evidence that the overall technological composition was upgraded. Figures IX.2 and IX.3 show the trends of the technological content of FDI inflows to the manufacturing sector, based on the classification of OECD (2005). 4 In France, medium low-technology FDI was replacing low-tech FDI, but medium high-technology FDI was also shrinking.5 In Italy, medium low-technology FDI was replacing high-tech FDI, while low-tech FDI remained stable. In Portugal, rising high-tech FDI was offset by increasing low-tech FDI. Overall, the technological compositions of FDI to these countries remained largely the same in the last decade. In Spain, however, there was a trend of disinvestment in low-tech industries and increasing medium-technology FDI.
Figure IX.2.Cumulative Inward FDI in Manufacturing (Millions of euros) Figure IX.3.Technological Content of FDI Inflows in Manufacturing
Sources: OECD; UNCTAD; and national authorities.
Note: Each column, from bottom to top, consists the shares of FDI to low-, medium-low-, medium-high-, and high-technology industries, computed from the trend of FDI in each category. The classification is based on OECD (2005).
Have the sectors facing fast growing world demand received expanding FDI inflows?
FDI appeared not to be targeted toward sectors with booming demand. Other things being equal, fast growing demand makes the investment more profitable. We calculate the sectoral trend of world demand based on COMTRADE data between 1997 and 2006. The fastest growing export markets in the world in the last decade are refined petroleum, metal products, chemical products, and certain high-tech sectors (medical, precision and optical instruments, electronic and communication equipments), while the demands for low-tech products (food, textile and footwear, and wood product) and computers have been growing slower. For each sector, Figure IX.4 plots the percent change of the sector’s share in FDI against the percent change of its share in world export demand. As can be seen, in all countries, there are no clear signs showing that sectors with faster growing demand received increasingly larger shares of FDI. Rather the opposite happened in Portugal and Spain, suggesting that FDI is not likely to contribute to boosting export performance in the most dynamic sectors.6
Figure IX.4.FDI Inflows to Manufacturing Sectors
Sources: OECD; UNCTAD; and national authorities.
Note: The sectors are:
A = Food products
B = Textiles and wearing apparel
C = Wood, publishing and printing
D = Refined petroleum and other treatments
E = Chemical products
F = Rubber and plastic products
G = Metal products
H = Mechanical products
I = Office machinery and computers
J = Radio, TV, communication equipments
K = Medical, precision and optical instruments, watches and clocks
L = Motor vehicles
M = Other transport equipments
Have service FDI inflows been associated with higher productivity sectors?
The share of FDI flows in the service sectors with high levels of productivity has largely remained the same in the SEA-5 economies (except France and Spain). In Figure IX.5, we split service sector FDI inflows into two groups, those in the sectors with intrinsically high productivity and with low productivity. Based on the data from the Klems database, the service sectors with the highest value-added per worker in EU-15 are identified as: insurance and financial sector activities; computer and communication services; business services, such as leasing, legal technical, and advertising; and water and air transport. It appears that in Greece, Italy, and Portugal, FDI inflows were rising at similar paces in both high- and low-productivity sectors. In France, and to some extent Spain, there is evidence that FDI was increasingly concentrated in the high-productivity service sectors.
Figure IX.5.Service Sector FDI (Millions of euros)
D. Scope for Further Attracting FDI in the SEA-5 Economies
What has contributed to low FDI inflows to Greece and Italy, and is there scope for further attracting FDI in all the SEA-5 countries? There is a vast literature on the determinants of FDI,7 suggesting that two types of factors are at play: nonpolicy factors (a country’s size and its distance to the source country) and policy variables, such as regulatory restrictions on FDI, labor market arrangements, product market regulations, and the business environment. A more restrictive policy environment would raise the production costs of the foreign and domestic firms and hamper competition and the flow of resources.
A salient observation is that the SEA-5 countries, especially Greece and Italy, score unfavorably in most of these indicators, suggesting a possible area for improvement. Figure IX.6 plots the main policy factors for the advanced OECD economies. The SEA-5 countries constitute the lowest five among OECD countries in the World Bank Ease of Doing Business Index. The bottom two—Italy and Greece—also ranked 82 and 109 among the 175 countries covered in the 2007 index. In the Economist Intelligence Unit’s Business Environment ratings, Italy and Greece ranked 40 and 43 among the 82 countries covered. OECD’s employment protection legislation indicator shows that the SEA-5 countries are among the strictest, and France and Italy are among the countries with very high tax wedges.8 OECD’s product market regulation index again shows that the SEA-5 countries are at the bottom, although these countries do not appear to have very high restrictions on FDI. These findings imply that the SEA-5 countries could make themselves more attractive to FDI by improving their business environments. For instance, the simulation in Nicoletti, et al (2003) suggests that lowering the product market restrictiveness to the level of the U.K. could result in 45–80 percent increase of their FDI positions from the levels in the 1990s for Portugal, France, Italy, and Greece.
With the exception of France and Spain, FDI patterns of the SEA-5 countries cast doubts on whether FDI has played as significant a role as it could be in boosting external performance. Although FDI inflows have been rising, the patterns were different among the five countries. France and Spain appear to be relatively well positioned. FDI flows to Greece and Italy were the lowest in the OECD. As a result, they are likely to have had only limited externalities on productivity and trade. Portugal, although being able to attract larger inflows, did not seem to have a sectoral distribution conducive to future growth and also had lower manufacturing FDI than the rest. Furthermore, scope exists in improving the policy environment for FDI, as the SEA-5 countries score unfavorably on most of the policy criteria.
BlonigenB. A.2005 “A review of the empirical literature on FDI determinants” National Bureau of Economic Research Working Paper No. 11299 pp. 1–37.
DemekasD. G.B.HorváthE.Ribakova and Y.Wu2005 “Foreign Direct Investment in Southeastern Europe: How (and How Much) Can Policies Help?” IMF Working Paper No. 05/110.
Economist Intelligence Unit2007World investment prospects to 2011.
LimE-G2001 “Determinants of, and the Relation Between, Foreign Direct Investment and Growth: A Summary of the Recent Literature” IMF Working Paper No. 01/175.
NicolettiG.S.GolubD.HajkovaD.Mirza and K.Y.Yoo2003 “Policies and international integration: influences on trade and foreign direct investment” OECD Economics Department Working Paper No. 359.
Prepared by Yuan Xiao.
France, Greece, Italy, Portugal, and Spain (southern euro area five, or SEA-5, henceforth).
Since FDI flows are extremely volatile, the FDI shares in Figure IX.3 are computed by first estimating a linear trend for each category over the sample period. Greece is excluded due to the short sample (2001–04).
However, the high-tech FDI in France could have been rising as France received FDI inflows in the aircraft industry in recent years. But the missing data for earlier years prevent this category to be included in Figure IX.3.
The caveat here is that high productivity firms could increase market shares in slower growing markets.