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«Beata Smarzynska Javorcik∗ and Mariana Spatareanu** Published in Does Foreign Direct Investment Promote Development?, T. Moran, E. Graham and M. ...»

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DISENTANGLING FDI SPILLOVER EFFECTS:

WHAT DO FIRM PERCEPTIONS TELL US?

Beata Smarzynska Javorcik∗

and

Mariana Spatareanu**

Published in Does Foreign Direct Investment Promote Development?, T. Moran, E. Graham and

M. Blomstrom, eds., Institute for International Economics, Washington DC, 2005

The World Bank and CEPR, Development Economics Research Group, 1818 H St, NW; MSN MC3-303;

Washington DC, 20433. Email: bsmarzynska@worldbank.org ** The World Bank, Development Economics Research Group, 1818 H St, NW; MSN MC3-303; Washington DC,

20433. Email: mspatareanu@worldbank.org.

The views expressed in the paper are those of the authors and should not be attributed to the World Bank or its Executive Directors.

Introduction Policy makers in developing countries place attracting foreign direct investment (FDI) high on their agenda, expecting FDI inflows to bring new technologies, know-how and thus contribute to increasing the productivity and competitiveness of domestic industries. Many governments go beyond national treatment of multinationals by offering foreign companies, through subsidies and tax holidays, more favorable conditions than those granted to domestic firms. As economic rationale for this special treatment, they often cite positive externalities generated by FDI through productivity spillovers to domestic firms.

Despite being hugely important to public policy choices, there is little conclusive evidence on whether domestic firms benefit from foreign presence in their country. Research based on firm-level panel data, which examines whether the productivity of domestic firms is correlated with the extent of foreign presence in their sector, tends to produce mixed results and often fails to find a significant effect in developing countries. The picture is more optimistic in the case of vertical spillovers, namely those taking place through contacts between multinationals and their local suppliers of intermediate inputs, as several existing studies demonstrate that the productivity of domestic firms is positively correlated with the presence of multinationals in downstream industries.

The purpose of this paper is to shed some light on the difficulties facing researchers tackling the issue of FDI spillovers. To motivate our discussion, we examine horizontal and vertical spillovers in the context of Romania and the Czech Republic and demonstrate how starkly the conclusions may differ depending on the country analyzed, despite the fact that the same methodology and comparable data are employed. Then we proceed to discuss potential explanations for these differences in findings arguing that a plethora of issuesmay have prevented researchers from reaching clear-cut conclusions on the subject.

In the context of intra-industry (or horizontal) spillovers the challenge facing researchers lies in disentangling the positive impact of knowledge flows from the potentially negative shortrun effect an increase in competitive pressures due to foreign entry may have on some domestic firms.1 Since it is difficult to capture each phenomenon separately, in a vast majority of cases the empirical results reflect the combined effect of the two forces. To demonstrate that the two effects actually occur, we choose a somewhat unconventional approach and focus on perceptions of local firms on how foreign presence in the same sector has affected their performance. The perceptions, collected in surveys commissioned by the World Bank in Latvia and the Czech Republic in 2003, confirm the existence of knowledge transfer both through the demonstration effect and the movement of labor. They are also consistent with the presence of the competition effect, which in the short run may have an adverse effect on some firms. Moreover, they illustrate that the relative prevalence of the two effects differs across countries and thus provide a plausible explanation for the lack of uniformity in the results obtained for different economies.

The situation is no less complex in the case of vertical spillovers from multinationals to their local suppliers, as several scenarios are possible here as well. The first possibility is “cherry picking,” that is multinationals simply award contracts to the best local firms that already posses the required level of sophistication and thus no spillovers take place. The second scenario is that potential suppliers experience a positive productivity shock after which they reach the productivity level sufficient to obtain a contract from a multinational. This shock may be a result of help extended by the foreign customer before starting a sourcing relationship, a result of own One needs to keep in mind that spillovers are only one of many ways in which FDI inflows affect the host economy. Thus even if spillovers result in a negative distributional effect on a particular group (e.g., shareholders in local businesses in this case), the host economy as a whole may benefit from the presence of foreign investors.

efforts on the part of a local firm motivated by the prospects of a new business relationship or may be completely unrelated to either. The third option is that local suppliers improve their performance after starting to supply a multinational due to higher requirements imposed on them or assistance provided by the foreign customer. Finally, a combination of these mechanisms may occur. All, except the first scenario, would lead researchers to conclude that the presence of foreign firms in downstream industries is positively correlated with the productivity of domestic firms in the supplying industries. And all, apart from the “cherry picking” scenario, can be viewed as broadly defined spillovers. However, the analysis relying on industry-level proxies for vertical spillovers does not allow for pinpointing which of the above mentioned channels is at play. Doing so would be interesting and useful as each mechanism may have different policy implication. To learn about the plausibility of each scenario we again turn to the survey data for help.





Finally, we review several recent studies suggesting that the existence and extent of FDI spillovers may be driven by the composition of FDI inflows, adding to the difficulties facing researchers examining this question. For instance, spillovers may be affected by the incidence of wholly-owned subsidiaries relative to projects with shared domestic and foreign ownership as well as by the nationality of foreign investors.

In the face of difficulties associated with capturing spillover effects and the multitude of factors that can influence the extent of spillovers in each economy, we caution researchers about drawing generalized conclusions about the existence of externalities associated with FDI in developing countries.

The Tale of Two Countries and Two Spillover Patterns A brief look at the relevant literature Spillovers from FDI take place when the entry or presence of multinational corporations increases the productivity of domestic firms in a host country and the multinationals do not fully internalize the value of these benefits. Spillovers may take place when local firms improve their efficiency by copying technologies or marketing techniques of foreign affiliates either through observation or by hiring workers trained by the affiliates. Another kind of spillover occurs if multinational entry leads to more severe competition in the host country market and forces local firms to use their existing resources more efficiently or to search for new technologies (Blomström and Kokko, 1998).

To the extent that domestic firms and multinationals operating in the same sector compete with one another, the latter have an incentive to prevent technology leakage and spillovers from taking place. This can be achieved 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 to begin with. Several studies, for instance, Aitken, Harrison and Lipsey (1996), Girma, Greenaway and Wakelin (2001), have documented that foreign firms pay higher wages than domestic enterprises. Multinationals have also been found to be sensitive to the strength of intellectual property rights protection in host countries (Javorcik, 2004a).

However, multinationals have no incentive to prevent technology diffusion to upstream sectors, as they may benefit from the improved performance of intermediate input suppliers.

Thus contacts between multinational firms and their local suppliers are the most likely channel through which spillovers would manifest themselves. Such spillovers may take place through: (i) direct knowledge transfer from foreign customers to local suppliers; (ii) higher requirements for product quality and on-time delivery introduced by multinationals, which provide incentives to domestic suppliers to upgrade their management or technology; and (iii) multinational entry increasing the demand for intermediate products, which allows local suppliers to reap the benefits of scale economies.

And indeed the existing literature has found more evidence in favor of vertical rather than horizontal spillovers in developing countries. For instance, studies by Aitken and Harrison (1999) on Venezuela, Djankov and Hoekman (2000) on the Czech Republic, and Konings (2001) on Bulgaria, Romania, and Poland, cast doubt on the existence of horizontal spillovers from FDI in these countries. These researchers either fail to find a significant effect or produce evidence of negative spillovers. In other words, the presence of multinational corporations is found to either have no impact or to negatively affect domestic firms in the same sector. This result, however, does not appear to generalize to all developing countries, as for example, Damijan et at. (2003) detect the presence of positive intra-industry spillovers in Romania but not in six other transition economies, including the Czech Republic. At the same time, Kinoshita (2001) reports that R&D intensive sectors in the Czech Republic benefit from horizontal spillovers.2 The evidence on vertical spillovers taking place through contacts between multinationals and their local suppliers appears to be stronger. The results consistent with the existence of such spillovers in developing countries have been produced by Blalock and Gertler (2004) for Indonesia, Javorcik (2004b) for Lithuania, and Schoors and van der Tol (2001) for Hungary.

However, as will be discussed in the later part of this chapter, not all types of FDI appear to be associated with vertical spillovers.

For a survey of the literature on horizontal spillovers see Gorg and Strobl (2001).

Searching for spillovers in Romania and the Czech Republic To give an example of differences in findings on horizontal and vertical spillovers we examine this question in the context of Romania and the Czech Republic. To make the results as comparable as possible, we draw on the same data source (Amadeus database), use the same time period (1998-2000) and the same methodology. Both countries share the common heritage of more than forty years of central planning, both started transformation to a free market economy in the early 1990s and both enjoy relatively high endowment of skilled labor. Their transition paths have, however, been different: as the Czech Republic made large strides at the beginning of the last decade, reforms in Romania have lagged behind. As a result, the Czech Republic has been receiving large FDI inflows for ten years while foreign investors have been more cautious with respect to Romania and started entering the country on a larger scale only in the second half of the 1990s.

For each country we estimate a production function regression in which we allow foreign firms to affect the productivity of domestic enterprises through horizontal and backward linkages. We estimate the model in first differences and employ the semiparametric estimation procedure suggested by Olley and Pakes (1996) to calculate the total factor productivity (TFP).

Since we are interested in the effect foreign presence has on the local economy, we estimate the model on the sample of domestic firms. Further, we include time, industry and region dummies and correct standard errors to take into account the fact that the measures of potential spillovers are industry specific while the observations in the data set are at the firm level.3 The results for Romania, presented in the first two columns of Table 1, provide the evidence consistent with the existence of intra-industry spillovers from FDI. The magnitude of More details about the dataset, variable definitions and other methodological issues can be found in Javorcik and Spatareanu (2003).

the effect is economically meaningful as a one-standard deviation increase in the presence of multinationals in the same sector results in 3.3 percent increase in the value added of each domestic firm. The presence of a positive effect confirms the results of Damijan et al. (2003) who examined this question using the Romanian data from the same source but concentrated on the earlier period (1994-1998) and employed a different methodology. As for vertical spillovers, we do not find a significant effect in our preferred specification with the Olley-Pakes correction and thus conclude that FDI in downstream sectors has no effect on the productivity of domestic firms in the supplying industries.

The results for the Czech Republic (presented in Columns 3 and 4), contrast with the findings for Romania. The proxy for intra-industry effects is not statistically significant, which is again consistent with the results of Damijan et al. (2003). Further, there appears to be no evidence of spillovers operating through the vertical channel.

How can we explain the differences between the findings for Romania and the Czech Republic? While it is possible that they can be attributed to differences in the host country characteristics, the short period covered by the analysis or the shortcomings of the dataset, in the remainder of the paper we focus on other potential explanations.



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