Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In Search of Spillovers through Backward Linkages

Many developing and transition economies prioritize foreign direct investment (FDI) hoping that the economy will benefit from the introduction of new technology, marketing techniques, management skills, and knowledge spillovers. Existing literature has not fully supported the idea that positive externalities result from FDIs. A number of case studies that pertain to particular FDI projects or specific countries have been conducted but they cannot be generalized. In the same manner, industry-level studies that rely heavily on cross-sectional data cannot establish causality. Research based on firm-level panel data gives doubt on the existence of spillovers from FDI in developing countries. No significant evidence was found supporting the effect of the presence of multinational corporations on domestic firms in the same sector (although the picture is more optimistic in the case of industrialized countries).

Researchers may have been looking for spillovers in the wrong place. It is conceivable that spillovers take place between domestic suppliers of intermediate inputs and their multinational clients, not between competitors. It is also possible that spillovers from multinational presence in upstream sectors exist.

Overview of Spillover Channels

Spillovers from FDI take place when the entry or presence of multinational companies improves the productivity of domestic firms in a country and the multinationals do not fully internalize the value of these benefits. This happens by copying technologies of foreign affiliates operating in the local market either through observation or by hiring workers trained by affiliates companies. Spillovers may also occur if multinational entry intensifies competition in the host country market and forces local firms to use their resources more efficiently or to search for new technologies.

Multinational firms have an incentive to prevent technology leakage and spillovers from benefiting their competitors. They do this through formal protection of their intellectual property, trade secrecy, paying higher wages to prevent labor turnover, or locating in countries or industries where domestic firms have limited imitative capacities.

On the other hand, multinationals let the upstream sector to profit from spillovers as this may improve the performance of intermediate input suppliers. Hence, backward linkages—contacts between multinational firms and their local suppliers—is the possible channel through which spillovers take place. This can be manifested through direct knowledge transfer from foreign customers to local suppliers; higher requirements for product quality and on-time delivery introduced by multinationals; and multinational entry increasing demand for intermediate products. Transition countries have experienced spillovers through backward linkages. Domestic firms may also benefit from forward linkages, wherein they become more productive as a result of gaining access to improved intermediate inputs produced by multinationals in upstream sectors.

An enterprise survey conducted in Latvia by the World Bank (2003) show that positive spillovers take place through backward linkages but are ambiguous with respect to the intraindustry effect. It also illustrated that Aitken and Harrison’s (1999) theory that knowledge spillovers within an industry may be counterbalanced by the competition effect (i.e. domestic firms lose market share to foreign entrants) Hence, the reported increase in competition levels due to foreign entry is consistent with the lack of intraindustry spillovers.

Different types of FDI projects may have different implications for vertical spillovers. Affiliates established through mergers and acquisitions or joint ventures are likely to source more locally than greenfield projects (UNCTC, 2001). While the latter still have to put time and effort into developing local linkages, the former can already take advantage of the supplier relationships of the acquired firm or its local partners. When full foreign ownership is a proxy for greenfield projects, it is expected that fully owned foreign affiliates will rely more on imported inputs, while investment projects with shared domestic and foreign ownership will source more locally. It is expected that larger spillovers will be associated with partially rather than fully owned foreign projects.

Data and Estimation Strategy

The data came from the annual enterprise survey conducted by the Lithuanian Statistical Office. Lithuania and other transition countries from Eastern Europe are suitable subjects of FDI spillovers because of their high endowment of skilled labor, which makes them particularly likely locations for productivity spillovers.

About 85 percent of the data in each sector are included in the sample. It contained an unbalanced panel covering the period 1996–2000. The study focused on manufacturing firms (2,500 to 4,000 firms per year). Sample size was further reduced due to missing values and observations that failed to pass basic error checks. The final sample size varies between 1,918 and 2,711 firms in a given year. Firms with foreign capital participation amount to 10 percent of the data.

The ordinary least squares (OLS) method with White’s correction for heteroskedasticity was used to examine the correlation between firm productivity and FDI in the same industry or other sectors. The dependent variable was the natural logarithm of firm real output while the independent variables are the natural logarithm of capital, the natural logarithm of wage divided by minimum wage, the natural logarithm of material inputs, firm’s total equity owned by foreign investors, foreign presence of a sector in a particular time (variable for horizontal spillover), and the foreign presence in the industries that are being supplied by a sector (variable for backward spillover).

For the horizontal spillover variable, the greater the foreign presence in sectors supplied by a particular industry and the larger the share of intermediates supplied to industries with a multinational presence, the higher the value. The forward variable, on the other hand, is defined as the weighted share of output in upstream (or supplying) sectors produced by firms with foreign capital participation.

Significant variation was observed across sectors and time in all variables. The value of the horizontal variable ranges from 71.5 percent in other transport equipment and 65 percent in electrical equipment and apparatus to 6.6 percent in leather and leather products. The value of the backward variable rises from 3.6 percent in 1996 to 6 percent in 1998 and 8.1 percent in 2000. The forward proxy ranges from 25.6 percent in manufacturing wearing apparel to 1.65 percent in manufacturing textiles. The horizontal and forward variables both increase over time.

Results indicate that Lithuanian firms with foreign capital tend to be more productive than pure local firms. Significant and positive coefficients were observed on both backward and horizontal variables. However, the third spillover variable, forward, does not appear to be statistically significant. The results are consistent with productivity spillovers from FDI both taking place within industries and flowing from multinational customers to their domestic suppliers.

The semiparametric estimation procedure suggested by Olley and Pakes (1996) was employed, which allowed for firm-specific productivity difference exhibiting distinctive changes over time. It was assumed that at the beginning of every period, a firm chooses variable factors and a level of investment and capital that determines the capital stock at the beginning of the next period. The Olley-Pakes (1996) hypothesis suggests that the observable characteristics of the firm can be modelled as a monotonic function of the productivity of the firm

A production function with the Olley-Pakes (1996) correction is estimated for each industry separately. From the estimation, the measure of total factor productivity (the difference between the actual and predicted output) is estimated and used in the basic model. The Olley-Pakes (1996) correction procedure successfully corrects for biases, as a decrease in coefficients on labor and material inputs as well as an increase in the capital coefficient relative to the OLS results was observed.

Estimation Results from a Model in Differences

Estimating a model in first differences produces results that are consistent with domestic firms benefiting from the foreign presence in sectors they supply. The backward variable coefficients were positive and significant in both the full sample and the subsample of domestic firms. A one-standard-deviation increase in the foreign presence in the sourcing sectors (an increase of 4 percentage points in the backward variable) yields a 15-percent rise in output of each domestic firm in the supplying industry.

There is little evidence indicating that spillovers take place through the other channels. The horizontal variable does not appear to be statistically significant; this verifies the positive intraindustry effect in developing countries. The forward variable, on the other hand, bears a negative sign but appears to be statistically significant in only two regressions.

As for the other control variables, there is no noteworthy positive association between changes in foreign equity share and productivity growth. The foreign share variable is positively correlated with productivity levels but not with growth rates. Procyclical productivity effects are present as evidenced by a positive coefficient of demand in downstream sectors. There is also a positive correlation between industry concentration and productivity growth, but the results are statistically significant in only two cases.

A model in second and fourth differences is estimated to check the robustness of the results. The backward variable bears a positive and significant coefficient in all specifications but the forward variable appears insignificant in the majority of cases. While results on the long differences suggest the existence of intrasectoral spillovers, caution must be taken in interpreting this result because the data only contains a few observations.

To determine whether backward linkages associated with partially owned foreign projects lead to greater spillovers than linkages associated with wholly owned foreign affiliates, two measures of backward linkages are calculated for the two types of foreign investments. Results show that a significant and positive correlation is found between changes in output of domestic firms and backward linkages associated with partially foreign-owned projects but not wholly foreign-owned affiliates. This support the observation that projects owned jointly by domestic and foreign entities are more likely to source locally, thus creating greater scope for spillovers to firms operating in upstream sectors.

The other variables show the same pattern observed in the previous results except for the forward measure, where foreign presence in upstream sectors has a negative impact on the performance of local firms in using industries. This may be a result of foreign owners buying out domestic firms in supplying sectors, upgrading production facilities and then manufacturing more products that are sold at a higher price. Control over company operations may also be a factor.

To check if the results on the effect of backward linkages are mainly influenced by the level of concentration in purchasing industries rather than genuine knowledge spillovers from FDI, a model is estimated testing whether a differential effect of foreign presence in two types of downstream industries exists. Results indicate that foreign presence in both types of upstream industries leads to positive spillovers to supplying sectors. In all models, there is no statistically significant difference between the magnitude of the backward linkage effect for the two types of sectors, showing that the level of concentration in upstream sectors is not a concern in the model.

To examine whether the export orientation of foreign affiliates is of importance to spillovers, two measures of backward linkages are calculated: one for affiliates focused on exporting and one for foreign firms targeting the domestic market. Results suggest that both types of foreign affiliates are associated with spillovers to upstream sectors. There is some indication of domestic-market-oriented FDI projects being correlated with greater productivity spillovers to their local suppliers, but the evidence is not very strong.

To correct for potential biases in coefficients on variable factor inputs, the share of foreign capital as well as other sectoral variables was included in the first stage of the Olley-Pakes (1996) procedure. The results from this estimation, however, led to exactly the earlier conclusions. No significant changes to the results were observed because foreign entry and foreign presence only affect investments.

Conclusion

Productivity spillovers take place through backward linkages. A one standard deviation increase in the foreign presence in downstream sectors is associated with a 15-percent rise in output of each domestic firm in supplying industries. Productivity advantages are found to be associated with partially but not fully owned foreign projects. This is consistent with the evidence suggesting a larger extent of local sourcing undertaken by FDI through partially owned foreign projects. Finally, no evidence of intrasectoral spillovers is found. Nor is there any indication of spillovers coming from multinational presence in sectors supplying intermediate inputs.

Source:

Javorcik, Beata Smarzynska, “Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In Search of Spillovers Through Backward Linkages.” The American Economic Review (June 2004), Volume 94, Number 3, pp. 605-627.