From which Foreign Direct Investment Channels can Domestic Firms Benefit the most in Developing Countries?

Table of content

1 Introduction

2 Foreign Direct Investment (FDI)
2.1 Definition
2.2 Types of FDIs
2.3 Horizontal vs. vertical FDIs

3 Potential impact of FDIs on domestic firms’ growth
3.1 FDI efficiency measures
3.2 Spillovers through FDIs
3.3 Growth determinants

4 Conclusion

5 References

List of abbreviations

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List of figures

Figure 1: FDI inflows by country groups + China 1990-2017

Figure 2: Indicators of Chinas economic rise between 1978 and 2017

Figure 3: Types of FDI

Figure 4: Vertical forward and backward FDI

Figure 5: Overview on FDI interdependencies

1 Introduction

In the wake of globalization, the importance of Foreign Direct Investments (henceforth FDI) has strongly increased. From 1990 to 2017 the amount of FDI inflows in the world has increased sevenfold.

Most FDI expenditures flow between industrialized countries. But also developing countries show a strong Especially China became attractive for FDIs in the past years after reducing FDI restrictions (UNCTAD Data). In the year 1978, before substantial reforms, almost no FDIs were made in China. 39 years later, in 2017, approximately 9.5% of the worldwide FDIs were conducted in China. In the same period, the Gross Domestic Product (GDP) per capita of China has increased fifty-six-fold. At the same time, the export ratio of China has increased from approximately 4.5 % to paradigm”, there are three conditions which must be fulfilled so that companies make an investment in a foreign country. First, the ownership advantage which means that a company must have an exclusive competitive advantage over competitors in the foreign market. Second, the location advantage which means that a company must benefit from the differences between home and host countries for example through lower wages or factor costs and third, the internalization advantage which means that a company must exploit its specific competitive advantages itself and not sell them to existing companies, e.g. in the form of licenses (cf. Dunning, 1977). Assuming Dunning's paradigm is applied; we find in the condition of ownership advantage the reason why governments of developing countries attract their economies for FDI. The idea of this government policy is that FDIs bring in both, capital and technology as well as management and marketing expertise. Furthermore, they hope that domestic firms can benefit from those companies through positive spillovers. Having in mind that a company that conducts FDIs wants to internalize its competitive advantage (third condition of Dunning: internalization advantage) we can assume that they want to prevent spillovers unless they benefit from them. It is obvious that there is an existing conflict of interests between the investing company and the company that receives the investment.

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Figure 1: FDI inflows by country groups + China 1990-2017 increase in FDI inflows Source: UNCTAD, FDI/MNEdatabase (www.unctad.org/fdistatistics)

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Figure 2: Indicators of Chinas economic rise between 1978 and 2017 Source: Own representation created with data of World Bank national accounts data, and OECD National Accounts data files.

This paper sheds light on different types of FDIs. Their potential effects on domestic firms in developing countries are determined in order to investigate if FDIs can potentially be a driver for economic growth. Furthermore, it will be outlined which type of FDI has possibly the strongest effect on firms’ growth in developing countries. In addition, it will be analyzed which factors can influence the effects of FDIs. As developing countries are different to developed countries in terms of e.g. the technological level, knowledge, access to capital markets, management and marketing know-how, there are various factors that may have an impact on the magnitude of spillovers caused by FDIs. However, when it comes to FDIs and their potential spillovers there are two main channels through which they can appear, horizontal and vertical.

This thesis will test the hypothesis that vertical FDIs have a greater effect on domestic firms’ growth in developing countries than horizontal FDIs have. This may be because in the case of horizontal FDI the investing firm has an incentive to prevent spillovers from their domestic competitors to fully internalize its competitive advantage. While in the case of a vertical FDI the investing firm may potentially have an advantage if spillovers pass over to domestic firms. Spillovers potentially enable domestic firms to produce intermediate goods of higher quality, higher level of sophistication and in a more efficient manner. Thus, the foreign firm which invests via FDI can probably benefit from that and increase its efficiency and profitability.

The paper is structured as follows. Section 2 gives a brief introduction about what FDI is. It provides a widely used definition of FDI, presents the different types of FDI and outlines a distinction between horizontal and vertical FDIs. Section 3 focuses on different efficiency measures of FDI as well as on potential impacts of FDIs on domestic companies’ growth in developing countries. Furthermore, section 3 shows different effects of FDI and how they depend on the respective channel. Section 4 summarizes and concludes the paper.

2 Foreign Direct Investment (FDI)

2.1 Definition

In the first place, it is necessary to define what FDI is. For reasons of consistency the FDI definition of the Organisation for Economic Co-operation and Development (OECD) is used in this paper which is also widely used in the literature. The OECD defines FDI as follows: ’’Foreign direct investment reflects the objective of establishing a lasting interest by a resident enterprise in one economy (direct investor) in an enterprise (direct investment enterprise) that is resident in an economy other than that of the direct investor. The lasting interest implies the existence of a long-term relationship between the direct investor and the direct investment enterprise and a significant degree of influence on the management of the enterprise. The direct or indirect ownership of 10% or more of the voting power of an enterprise resident in one economy by an investor resident in another economy is evidence of such a relationship. [...] Direct investment includes the initial equity transaction that meets the 10% threshold and all subsequent financial transactions and positions between the direct investor and the direct investment enterprise, [...].” (OECD Benchmark Definition of Foreign Direct Investment: Fourth edition,2008, p. 48f)

2.2 Types of FDIs

FDIs can have various forms. First, FDIs can be divided into two major categories: greenfield investments and cross-border mergers and acquisitions (henceforth M&A). A greenfield investment takes places if an investor builds a new firm from scratch in a foreign country or if the investor extends existing production capacities. This type of FDI is the one with the highest degree of control but it also implies the highest risk.

A current example for a greenfield investment is the engine production plant of VW in Silao, Central Mexico opened in 2013.

The second category is cross-border M&As. It takes place if a firm merge with or acquires an existing firm in a foreign country. Cross-border M&As can be subclassified into horizontal and vertical investments.

A horizontal M&A takes place if the investor duplicates its home country activity to a foreign country within the same industry e.g. the merger of the two oil companies Exxon and Mobil in 1998. Whereas a vertical M&A takes place if the investor firm locates different stages of production in different countries. If the investor invests into a company which is one step further in the production chain than the investing company, it is called forward FDI e.g. a car producer buys a tire manufacturer. If the investor invests into a company which is one step behind in the production chain than the investing company, it is called backward FDI e.g. a car producer buys a car distributor.

2.3 Horizontal vs. vertical FDIs

In the latter section, the different types of FDIs are outlined. This distinction is essential to examine the effects of FDIs in a differentiated way. The following section lines out the different effects of horizontal and vertical FDI and provides potential explanations why those differences exist. The majority of FDI research stated that there is in average no positive effect of horizontal FDIs on firms’ growth in developing countries. Several authors, such as Eck and Huber (2016) for Indian firms, Javorcik (2004) for Lithuanian firms, Javorcik (2017) for Turkish firms and others, found no evidence of positive horizontal spillovers on domestic firms. Aitken and Harrison (1999), Konings (2001) and Hu and Jefferson (2002) even found a negative influence of horizontal FDI on domestic firms in developing countries. To explain the negative impact of FDI on firms’ growth it is necessary to introduce the concept of the so-called agglomeration and competition effect. The agglomeration effect describes the positive impact that FDI may have on domestic firms’ growth. The idea is that due to agglomeration of firms, especially multinational enterprises (henceforth MNE), domestic firms can benefit from knowledge spillovers and labor pooling as well as of better supply options. The downside of the agglomeration effect is the competition effect. The entrance of an MNE implicates an increase of competition in the same industry. MNEs tend to be more productive which may lead to a reallocation of market shares between MNEs and domestic firms because domestic firms potentially cannot compete with the marginal costs of MNEs. If the latter is the case, competition negatively affects the growth of domestic firms’ (cf. Aitken and Harrison, 1999). On the other side, an increase in competition can incentivize domestic firms to get more productive or to encourage innovation. This positive impact may lower the magnitude of the negative competition effect. To examine whether FDIs have a positive or negative impact on domestic firms’ growth, it is essential to determine which effect, the competition or agglomeration effect, dominates.

However, if you focus on vertical FDI, there are numerous studies that found a positive correlation between an increase of FDI inflows and firms’ growth in developing countries. Eck and Huber (2016) found a positive correlation between vertical FDIs and the level of product sophistication of Indian firms caused by knowledge spillovers while Javorcik (2004) found evidence of an increase of productivity of Lithuanian firms caused by vertical FDIs.

To understand these different effects of FDI it is necessary to analyze the different incentives of companies that either chose to invest horizontal or vertical. A company that considers investing horizontal will seek to fully internalize its competitive advantage. Therefore, the company has an incentive to prevent spillovers. This prevention can be achieved by for example paying higher wages to prevent migration of employees to domestic firms, through formal protection of firms’ intellectual property or by locating in countries with low abilities to handle spillovers (cf. Javorcik, 2004). In contrast to this, a company that considers investing vertical has an incentive to create spillovers to a certain extent. One explanation for this is that the investing company potentially benefits from better input factors, in the case of backward vertical FDI, or from better e.g. selling skills, in the case of a forward vertical FDI (cf. Javorcik, 2004). Referring to the car producer example of section 2.2 if the car producer invests in a tire manufacturer it has the objective to obtain the highest possible quality of its intermediate goods as well as of high efficiency. The only way to influence the quality of the intermediate goods and efficiency is to provide technology, knowledge and management skills. Hence, the car producer has an incentive to allow spillovers to its subsidiary. The tire manufacturer

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