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20
Foreign Direct Investment and Growth
L. Alfaro*†, M.S. Johnson{
*Harvard Business School, Boston, MA, USA
†
NBER, Cambridge, MA, USA
{
Boston University, Boston, MA, USA
O U T L I N E
The Evidence and Impact of Financial Globalization 299 # 2013 Elsevier Inc. All rights reserved.
http://dx.doi.org/10.1016/B978-0-12-397874-5.00016-6
300 20. FOREIGN DIRECT INVESTMENT AND GROWTH
0
1970 1975 1980 1985 1990 1995 2000 2005
–1
FIGURE 20.1 FDI inflows as a percent of gross domestic product: 1970–2007. Courtesy of UNCTAD.
in developing countries include wholesale trade and pe- or growth, and Blomström and Kokko’s (2003) review
troleum as well as transportation equipment (Harding of the literature leads them to conclude that spillovers
and Javorcik, 2007). are not automatic because of the degree to which local
What benefits do proponents expect a country to reap conditions influence domestic firms’ adoption of foreign
from FDI inflows? Because it embodies technology and technologies and skills.
know-how as well as foreign capital, FDI can benefit host There thus appears to be a significant lack of consen-
economies through knowledge spillovers as well as link- sus between practitioners and the empirical literature re-
ages between foreign and domestic firms. Potential pos- garding the existence of positive FDI externalities. Do the
itive effects include productivity gains, technology negative results impugn government policies that attract
transfer, exposure of domestic firms to new processes, FDI? Should developing countries shun, rather than at-
managerial skills and know-how, enhancements to em- tract, FDI? Any answer to such questions must be in-
ployee training, development of international produc- formed by an understanding of the evolution of the
tion networks, and broader access to markets. When literature on FDI, an overview which reveals two recent
new products or processes are introduced to the domes- trends to be of particular importance. One is the recogni-
tic market by foreign firms, domestic firms may benefit tion that benefits generated by FDI are not exogenous,
from the accelerated diffusion of new technology.3 In but rather conditional on the presence of complementary
some cases, this might occur simply by domestic firms policies and conditions by which such benefits are facil-
observing foreign firms, and in other cases through labor itated and absorbed. The other is the effort to understand
turnover as domestic employees hired by foreign firms the mechanisms through which FDI affects growth, in
move to domestic firms. These benefits, together with particular the linkages generated between foreign and
direct capital financing, suggest an important role for domestic firms.
FDI in modernizing national economies and promoting While the literature has evolved to more carefully
economic development. measure the relationship between FDI and growth, lim-
Empirical evidence that FDI generates positive effects itations remain that make it difficult to derive clear pol-
for host countries is, however, surprisingly ambiguous icy implications. Macro-level studies typically offer a
at both micro and macro levels. Hanson’s (2001) survey better understanding of the role of local conditions in eli-
of the literature finds only weak evidence that FDI gen- citing positive benefits from FDI to materialize, but they
erates positive spillovers for host countries, and Görg continue to be limited by identification issues or the very
and Greenaway’s (2004) review of the micro-level anal- plausible possibility that growth might itself spawn
ysis literature on spillovers from foreign to domestically more FDI. This potentially endogenous relationship
owned firms reports the effects to be mostly negative. implies that any estimates are likely to overstate the pos-
Lipsey’s (2002) survey of macro-level empirical research itive impact of foreign investment on growth. Micro-
finds no consistent relation between the size of inward level studies can avoid such identification issues, but
FDI stocks or flows and gross domestic product (GDP) available firm-level datasets tend to cover specific and
3
See Caves (1996) and Blomström and Kokko (1998).
4
For the remainder of the chapter, the terms MNE and FDI are used interchangeably.
5
Javorcik (2009) points out that this productivity discrepancy holds for FDI in the form of both ‘greenfield’ and equity purchases.
6
The evidence of positive spillover effects tends to be more favorable in developed countries. Haskel et al. (2007), for example, find
positive spillovers from foreign to local firms in a panel dataset of firms in the United Kingdom. This discrepancy suggests that local
conditions may matter for spillovers to materialize, an idea we discuss in the next section.
7
For example, these studies correct for the biases that result from the dependence of firm exit and factor inputs on productivity levels.
Newer studies also control for time-invariant differences in plant productivity through fixed effects estimation and for time-variant
productivity shocks likely to affect plant productivity using approaches such as the semiparametric estimation proposed by Olley and
Pakes (1996).
sectors, but there is no evidence of positive externalities such as strong financial institutions, which are dis-
within the same industry.8 cussed at length in the following section.
With respect to human capital, FDI could have ambig-
uous effects. If skilled labor is scarce, and since MNEs
FDI, Capital, and Labor
typically hire relatively skilled workers, FDI could re-
FDI can further a host country’s development not only duce the stock of human capital for domestic firms. More
through technological improvements but also via factor positively, though, FDI could improve the national wel-
accumulation – that is, by expanding its stock of physical fare if the wages paid by MNEs were higher than those
or human capital, or both. Foreign capital injected into a paid by domestic firms. In instances where the earlier-
host economy can contribute to physical capital forma- mentioned robust finding that productivity tends to be
tion, employee training, or skill development. But here, higher for MNEs than for domestic firms in the same sec-
again, the empirical evidence shows that neither of these tor prevails, FDI might be expected to contribute to
benefits can be presumed. higher GDP. Were MNEs to pay market wages, they
Of particular interest is the effect FDI has on local would entirely capture any increase in GDP and the na-
capital markets. The rationale advanced by some pol- tional welfare would, hence, not be improved. But there
icy makers that foreign investment can add to scarce is ample evidence that MNEs pay above-market wages
capital for new investment in developing countries is (Aitken et al., 1996; Haddad and Harrison, 1993;
based on the assumption that foreign investors who es- Lipsey, 2002), and it is thus likely that higher productiv-
tablish new enterprises in local markets bring in addi- ity is to some degree shared between the firms and their
tional capital with them. But Kindleberger (1969), workers.
Graham and Krugman (1991), and Lipsey (2002) show However, several confounding issues make pinpoint-
that investors often fail to fully transfer capital upon ing any precise wage premium paid by MNEs over do-
taking control of a foreign company, tending instead mestic firms a difficult task: MNEs could be selectively
to finance an important share of their investment in hiring more productive workers, or MNEs could be con-
the local market.9 Increasing volatility in exchange centrated in industries that pay higher wages. Harrison
rates, moreover, has prompted many foreign investors and Rodrı́guez-Clare (2011) survey the literature on FDI
to hedge by borrowing from local capital markets, and wages and find that the ‘unconditional’ wage gap, or
which can exacerbate financing constraints on domes- the gap between wages in foreign and domestic firms
tic firms by effectively crowding them out of domestic with no controls for biases, is as high as 50%. However,
capital markets. This latter effect has been tested by after adjusting for firm and worker characteristics, they
Harrison and McMillan (2003) and Harrison et al. conclude that foreign firms pay a small wage premium
(2004) using an Euler equation approach combined of between 5% and 10% higher than those paid by do-
with a generalized method of moment estimation. mestic firms.
The former, a country case study that analyzed the be- Furthermore, anecdotal evidence suggests that FDI
havior of mostly French multinationals operating in can contribute to skill upgradation for domestic workers,
Cote d’Ivoire, found that, in a context characterized as MNEs often make substantial efforts to educate local
by market imperfections and rationed access to credit, workers and provide more training opportunities for
foreign investors did, indeed, crowd domestic enter- technical workers and managers than do local firms.10
prises out of local credit markets. On the other hand, Such training is sometimes provided in cooperation with
the latter, which examined company-level data across host country institutions, as in the case of Intel in Costa
a panel of countries that varied in the strength of their Rica contributing to local universities and Singapore’s
credit markets, found that the amount of credit avail- Economic Development Board collaborating with MNEs
able to domestically owned firms increased with for- to establish and improve training centers.11 An empirical
eign investment. These contrasting results point to analysis of a panel of countries by Te Velde and
the important role played by policy complementarities Xengoiani (2007), however, found FDI to enhance skill
8
Similarly, Blalock and Gertler (2008), using a panel dataset of Indonesian manufacturing establishments from 1988 through 1996, find
evidence not only of positive vertical externalities but also that downstream FDI increases output and firm value-added while reducing
prices and market concentration.
9
The industrial organization literature suggests that firms engage in FDI not because of differences in the cost of capital, but because
certain assets are worth more under foreign than local control. If lower cost of capital were the only advantage a foreign firm had over
domestic firms, it would still not explain why a foreign investor would take the trouble to operate a firm in a different political, legal, and
cultural environment instead of simply making a portfolio investment.
10
See discussions in Alfaro and Rodrı́guez-Clare (2004) and Alfaro et al. (2009).
11
Spar (1998).
12
The importance of context specificity has been discussed in related fields. Harrison and Rodrı́guez-Clare (2011) emphasize the relevance
of complementary aspects of the policy regime, such as labor-market policies or ease of entry and exit, to the success of a trade policy.
‘Appropriate development policies,’ observe Rodrik and Rosenzweig (2009), ‘typically exhibit high degrees of complementarity.’ See
Kalemli-Ozcan and Villegas-Sanchez (2010) in this volume for a complementary overview of the recent literature on FDI and growth.
In a later study, Alfaro et al. (2009) investigate that Czech firms that supply multinationals tend to be
whether the effects of FDI on growth operate via capital less liquidity-constrained than other firms. The authors
accumulation or total factor productivity (TFP). The au- find that this is due to the self-selection of less liquid-
thors run regressions similar to Eq. (20.2) but change the ity-constrained firms into supplying relationships with
dependent variable to measure the extent to which var- MNEs, implying that liquidity-constrained firms are
iation in FDI and financial development can explain hindered from becoming MNE suppliers. This micro
variation in investment, human capital, or TFP growth. evidence further suggests, consistent with the formaliza-
Their results suggest that the interaction of FDI and fi- tion in Alfaro et al. (2010), that in the absence of well-
nancial development has no significant effect on capital functioning financial markets, local firms may find it
accumulation – physical or human – but that it positively difficult to access the funding necessary to initiate busi-
and significantly affects TFP growth.13 ness relations with MNEs and reap the benefits of pro-
The importance of well-functioning financial institu- ductivity spillovers.
tions to economic development has been recognized Most barriers to foreign investment today are in ser-
and discussed extensively in the literature. Researchers vice, rather than goods, sectors. The considerable empir-
have shown that well-functioning financial markets, by ical evidence on the impact of FDI on the productivity of
lowering the costs of conducting transactions, ensure manufactured goods is being complemented by a na-
that capital is allocated to the projects that yield the high- scent empirical literature that studies the effects of ser-
est returns and therefore enhance growth rates.14 Fur- vices liberalization on manufacturing productivity16.
thermore, as McKinnon (1973) states, the development Arnold et al. (2006) examine, in the Czech Republic,
of capital markets is ‘necessary and sufficient’ to foster the link between services sector reforms and the produc-
the ‘adoption of best-practice technologies and learning tivity of manufacturing industries that rely on services in-
by doing.’ In other words, limited access to credit mar- puts and find a positive relationship between services
kets restricts entrepreneurial development. If entrepre- sector reform and the performance of domestic firms in
neurship facilitates assimilation and adoption of best downstream manufacturing sectors. Similarly, Arnold
technological practices made available in the context of et al. (2008) attribute positive productivity effects on the
FDI, then the absence of well-developed financial mar- manufacturing sector to service reform in India. The effects
kets limits the potential for positive FDI externalities. Al- and complementarities associated with reducing barriers
though some local firms might be able to finance new to services and goods remain important topics for future
requirements with internal financing, the greater the research.
technological-knowledge gap between current practices
and new technologies, the greater the need for external
financing, which, in most cases, is restricted to domestic CHANNELS, MECHANISMS, AND
sources.15 LINKAGES
Causal but indirect results found by researchers at
the micro level further emphasize the complementarily Identifying complementarities, that is, which local
of FDI and financial development. Desai et al. (2008) conditions and policies are necessary to reap the benefits
show that, in currency crises, MNE affiliates substan- of FDI, helps us to understand when, but not how, FDI
tially increase their sales, assets, and investment relative generates positive spillover effects. Through what mech-
to local firms, and they find that this discrepancy owes anisms does FDI contribute to a country’s development
in large part to the MNE affiliates’ ability to draw upon efforts? Absent from many studies that seek to identify
the internal capital markets of their parent company productivity externalities is any attempt to understand
whereas local firms face financing constraints. Thus, the mechanisms through which they occur. Empirical
FDI can potentially help to offset the negative shocks studies have by and large produced indirect evidence
of crisis and volatility in host countries with weaker of externalities, examining, for example, whether the
financial markets. Javorcik and Spatareanu (2007) find increased presence of MNEs in a country or sector
13
There is clearly a potential for endogeneity in such regressions, as higher growth could spawn more FDI. However, in a robustness
check, Alfaro et al. (2009) switch the regression to make FDI the dependent variable and growth the independent variable, and they find
there is no statistically significant effect.
14
See King and Levine (1993).
15
Alfaro and Charlton (2007), using data for OECD countries at the industry level, show the relation between FDI at the industry level and
growth to be stronger for industries more reliant on external finance. These results, apart from being consistent with the existing macro
literature and hypothesized benefits of FDI, are further evidence of important cross-industry differences in the effects of FDI.
16
For a more thorough discussion of FDI in service industries, see Kalemli-Ozcan and Villegas-Sanchez, 2010.
17
The authors discuss the merits of combining the propensity score and difference-in-difference method, explaining that the difference
between the treatment and control group proxies for the counterfactual: that is, for what would have happened had a plant targeted for
FDI remained domestically owned.
example, MNEs were to behave as enclaves, importing have a lower domestic input share (as they are more
their inputs and restricting their local activities to the hir- likely to import inputs), but higher intensity coefficients
ing of labor, demand for domestic inputs might decrease (as they are more likely to use more advanced and pro-
as MNEs increased in importance relative to domestic ductive technologies).
firms, resulting in a reduction in input variety and Do foreign and domestic firms exhibit differences in
specialization. the ‘linkage coefficient?’ Using plant-level data for Brazil
As discussed in Alfaro and Rodrı́guez-Clare (2004), (1997–2000), Chile (1987–99), Mexico (1993–2000), and
however, it is necessary to consider the model’s key as- Venezuela (1995–2000), Alfaro and Rodrı́guez-Clare
sumptions and how their violation might affect the (2004), consistent with earlier evidence, find in all coun-
potential for multinationals to create linkages. One im- tries the share of inputs sourced domestically to be lower,
portant assumption in the model is nontradability of but the intensity coefficient to be higher, for foreign firms.
intermediate inputs and, by extension, that the input- In Brazil, Chile, and Venezuela, the linkage coefficient
sourcing behavior of domestic and foreign-owned plants (i.e., the product of the input share and intensity coeffi-
is identical. Only demand for nontradable inputs gener- cients) was higher for foreign firms, but in Mexico the dif-
ates meaningful linkages in the model. Moreover, given ference was not statistically significant. Another important
the higher import intensity of foreign-owned firms’ in- result was that entrant foreign firms tended to have a
puts (Arnold and Javorcik, 2009), the assumption of non- lower linkage coefficient, which tended to increase over
tradability of inputs and identicality of input-sourcing time, highlighting the importance of the study’s duration
behavior is evidently overly restrictive and would al- (as well as timing: studies closer to FDI liberalization
most certainly bias any empirical results. As observed efforts being more likely to produce negative results).
by Barrios et al. (2009), the assumption of identical The evidence from Javorcik and Spatareanu (2007) sug-
input-sourcing behavior ‘goes against the very premise gested a more robust financial sector increases the poten-
underlying the search for spillovers arising from FDI, tial for such linkages to develop. Alfaro et al. (2010)
namely, that foreign multinationals are different (from) elucidate this idea in a theoretical framework by model-
their domestic counterparts in production organization ing the presence of positive linkages to be dependent
mode.’ In any case, though, data constraints make it on the extent of the development of the local financial sec-
impossible to take into account only purchases of non- tor. In their model, to operate a firm in the intermediate
tradable inputs for research purposes.18 goods sector, entrepreneurs must develop a new variety
With these caveats in mind, what is the best way to of intermediate good, a task that requires upfront capital
measure such linkages? The traditional interpretation investments. The more developed the local financial mar-
of the finding, frequently reported in the empirical liter- kets, the easier it is for credit-constrained entrepreneurs to
ature, that the share of inputs bought domestically is start firms, and the more firms, the more varieties of inter-
lower for MNEs than for local firms (Görg and Ruane, mediate goods.20 The backward linkages between foreign
2001) has been that fewer linkages are generated by and domestic firms thus occasion, through the agency of
MNEs than by domestic firms. Theory, however, sug- the financial markets, positive spillovers to the final good
gests that the share of inputs bought domestically is sector. The positive externality, thus, does not necessarily
not a valid indicator of the linkages MNEs can gener- flow from MNEs to suppliers, but rather should lead to a
ate.19 A more appropriate measure, which we can call horizontal externality from MNEs to other firms who use
the ‘linkage coefficient,’ is the ratio of the value of inputs the same inputs in the same industry.
bought domestically to the total number of workers Even so, evidence of horizontal spillovers from FDI
hired by the firm, which can also be defined as the prod- remains elusive. Why do not we observe a positive exter-
uct of two terms: the share of inputs sourced domesti- nality from MNEs to other firms in the same industry? Pos-
cally times intensity (inputs per worker). MNEs may sible answers include the quality of data, measurement
18
There are other important caveats in this framework to consider. That only demand for inputs that exhibit increasing, as opposed to
constant, returns to scale entails linkages would be problematic if domestic firms use mostly inputs with increasing returns and
multinationals mostly inputs with constant returns. Furthermore, linkages are stronger for inputs with a low elasticity of substitution than
those with good substitutes. Lastly, linkages may be less likely if foreign and domestic firms are competing for scarce skilled labor. See
Arnold and Javorcik (2009) for more details.
19
Barrios et al. (2009) show that whether MNEs generate positive linkages depends heavily on the choice of the backward linkage
measure. The authors also discuss in detail the assumptions that underlie the prior literature’s traditional measure of linkages (see also
Alfaro and Charlton, 2009).
20
Hirschman (1958) argues that linkage effects are realized when one industry can facilitate the development of another by easing
conditions of production, thereby setting the pace for further rapid industrialization. He further argues that in the absence of linkages,
foreign investments could have limited or even negative effects on an economy (the so-called enclave economies scenario).
Glossary Blalock, G., Gertler, P.J., 2008. Welfare gains from foreign direct invest-
ment through technology transfer to local suppliers. Journal of
Complementarity The idea that certain policies (like FDI) will not have International Economics 74, 2402–2421.
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they are accompanied by changes in certain other parts of the overs. Journal of Economic Surveys 12, 247–277.
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Multinational enterprise A firm that owns and controls production Institute for International Economics, Washington, DC.
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Charlton, A., Davis, N., Faye, M., Haddock, J., Lamb, C., 2004. Industry
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