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1

This paper was prepared while working in the IMF’s Middle Eastern Department as a Senior Economist. I am grateful to Pierre Dhonte, Klaus Enders, and Paul Duran for helpful comments. All errors are my own.

2

Studies of spillovers are usually done at the firm, industry, or sectoral levels.

3

Productivity is total factor productivity (TFP)—for Morocco for instance, TFP are firm-level residuals in production function estimation.

4

This suggests that some types of FDI, such as enclave-type oil/natural resources, may have less of an impact on growth than others. In an extreme, hypothetical case, where there is zero scope for positive spillovers, the FDI contributes to growth in a limited sense—by generating income. For instance, income and revenue from the development of an enclave-type one commodity (for instance, oil) economy will contribute to growth by supporting the government sector as well being the foundation for growth of the private nontraded services sector—but from a dynamic perspective, the contribution to growth may end there, since economic growth may subsequently tend to reflect largely developments in the oil (one commodity) sector.

5

A related issue is the speed of adoption of foreign technology by local firms. Here, the important factor appears to be the degree of competition introduced by the MNC. McFetridge (1987) finds that new technology is frequently introduced sooner by MNC affiliates but greater competition spurs quicker adoption of the innovation by local firms. Chen (1983) finds a positive association between the speed of technological diffusion and the share of foreign ownership in four Hong Kong industries.

6

For instance, foreign subsidiaries began by subcontracting work on machinery prototypes to indigenous suppliers, often with the engineers of the subsidiaries first supervising and monitoring the engineers of the local suppliers. Later, however, engineers of both sides together drafted plans for the machinery which the local suppliers then produced on their own.

7

The scenario with a domestic content-restricted FDI operating very inefficiently in a small, heavily protected host market, and generating negative spillovers could be consistent with the malign view of FDI commonly expressed in the past. According to this view, MNCs are oligopolistic companies locating in protected markets with high barriers to entry and increasing market concentration. They extract rents, siphon off capital through preferred access to local capital markets, and drive domestic producers out of business (Brecher and Diaz-Alejandro, 1977). In addition, they repatriate profits and drain capital from the host economy. Far from encouraging economic growth and efficiency spillovers, these FDIs support a small oligarchy of indigenous partners and suppliers, use inappropriate capital intensive technology in a labor surplus context, producing a small labor elite while many workers remain unemployed or underemployed.

8

It should also be noted that while Moran (1998) is very critical of mandatory joint partnership, licensing, and domestic content requirements, he observes that export requirements have played a positive role in some instances by pushing MNCs into setting up world-scale, export-oriented facilities along the lines of international comparative advantage. (Mexico is one such example). Export requirements played this role because the MNCs were moving very slowly (showing stickiness in decision-making) to reorient their corporate strategy by incorporating new but viable and cheaper cost production sites into their global/sourcing and production networks. Moran attributes this stickiness in decision-making partly to political pressures applied by labor leaders and elected officials in the MNCs’ home countries; and partly to the type of behavior modelled in the Dixit-Pindyck (1994) framework for irreversible investments under uncertainty. In this framework, investors are more cautious about constructing a new facility than in abandoning an old one—because there is value in delaying (similar to the value of financial options) large new investments while the firm waits to receive and assess new information as to whether the new pattern of production would be superior to the old. However, Moran also postulates that a type of market failure is possible here by posing the question: what if the new information emerges too slowly (suboptimally) or the learning is suboptimally slow? This may happen if the gaps in information can be filled only by trying out the site for an extended period of time— analogous to the decision process in Akerlof’s lemons model for the buying and selling of used cars (Akerlof, 1970). In Akerlof’s model, identifying which products (used cars) are good and which are defective is extremely difficult for buyers—unless they try the product for an extended period of time. This problem tends to drive potential buyers toward a common price for all such products which is far too low, or in our case of FDIs, toward a common too uninterested stance in new production sites, that is, excessive and suboptimal delays. In the Mexican and Southeast Asian case studies he cites, Moran argues that export requirements helped to push the MNCs into incorporating those sites into their international sourcing strategies—to speed the MNCs in the direction they were eventually heading anyway, that is, investing along the lines of comparative advantage. However, despite his postulate of market failure, Moran has not generalized from these case studies to advocate export requirements as a systematic FDI strategy because “one cannot conclude from these success stories…that the use of export performance requirements will always produce as favorable or as powerful an outcome as witnessed here.”

9

In general, the theory of FDI answers the question as to why a firm would want to produce in a foreign location (where indigenous firms have superior knowledge of the local market, consumer preference, and business practices) instead of exporting or entering into a licensing arrangement with a local firm. Dunning (1977, 1988) argues that three conditions must be satisfied for a firm to engage in FDI. First, the firm must possess ownership of some firm- specific tangible or intangible asset or skill that gives it an advantage over other firms (ownership advantage); otherwise, it would not be able to overcome the additional costs of foreign production such as the costs of dealing with foreign administrations, regulatory and tax systems, and customer preferences, and would become noncompetitive vis-à-vis- indigenous firms. Second, it must be more beneficial for the firm to use or exploit the firm-specific asset itself than to sell them or lease and license them to other firms; for instance, the firm-specific asset might be a brand name or a nonpatentable technical/managerial skill or process, which the firm might find in its interest to keep internally instead of licensing (internalization)—in order to prevent the asset from being replicated by competitors. Third, it must be more profitabe to use these advantages in combination with at least some factor inputs located abroad (locational advantage); otherwise, the foreign market could be served exclusively through exports.

10

FDI is proxied as the ratio of overseas affiliate production in the host country relative to U.S. exports to the country.

11

This was a survey of the chief executives in these respective industries in Ireland.

12

A risk in using extensive fiscal incentives is the possibility of distortionary effects on the economy that may result from the incentives. For instance, incentives can lead to highly distorted decision making by domestic and foreign firms because they may discriminate (e.g., via tax holidays) between firms that show losses in early years and those that do not, and between relatively capital-intensive activities and relatively labor-intensive activities (Shah, 1995). In addition, incentives given to a selected few priority sectors often led to pressures from other industries for similar treatment. Over time, these incentives proliferated, as in Brazil, Indonesia, and Mexico in the early 1980s (Shah, 1995), until the tax system became so complex that its ability to raise revenues in an equitable and less distortionary manner also became impaired. Such a situation then induces tax avoidance and evasion. Thus while incentives properly designed and executed could attract FDI, administrative and institutional weaknesses in developing countries and the complexities of designing effective incentive structures could also create a substantial risk of distortionary side effects, thereby significantly limiting the efficacy of these tools. Moran (1998) and Shah suggest that the appropriate fiscal regime for FDI should inter alia highlight simplicity in tax structures, adjustment of corporate tax rates so that they are similar to those of the capital exporting countries, and nondiscrimination between foreign and domestic investors.

13

As measures, Lecraw used an index constructed by Business Environment Risk Intelligence (BERI), while Nigh used an index that tried to capture for eight Latin American countries conflict and cooperation both within the host nation and between it and the United States. In another study, Nigh and Schollhammer used an index of intranational conflict.

Determinants of, and the Relation Between, Foreign Direct Investment and Growth: A Summary of the Recent Literature
Author: Mr. Ewe-Ghee Lim