Foreign Direct Investment, Backward Linkages, And .
Public Disclosure AuthorizedPublic Disclosure AuthorizedIN FOCUSPublic Disclosure AuthorizedPublic Disclosure AuthorizedForeign Direct Investment,Backward Linkages,and Productivity SpilloversWhat Governments Can Do toStrengthen Linkages and Their ImpactFINANCE,COMPETITIVENESS &INNOVATIONJacob Jordaan, Wim Douw, and Christine Zhenwei QiangINVESTMENT CLIMATE
2020 The World Bank Group1818 H Street NWWashington, DC 20433Telephone: 202-473-1000Internet: www.worldbank.orgAll rights reserved.This volume is a product of the staff of the World Bank Group. The World Bank Group refersto the member institutions of the World Bank Group: The World Bank (International Bank forReconstruction and Development); International Finance Corporation (IFC); and MultilateralInvestment Guarantee Agency (MIGA), which are separate and distinct legal entities eachorganized under its respective Articles of Agreement. We encourage use for educational and noncommercial purposes.The findings, interpretations, and conclusions expressed in this volume do not necessarily reflectthe views of the Directors or Executive Directors of the respective institutions of the World BankGroup or the Governments they represent. The World Bank Group does not guarantee the accuracyof the data included in this work.Rights and PermissionsThe material in this publication is copyrighted. Copying and/or transmitting portions or all ofthis work without permission may be a violation of applicable law. The World Bank encouragesdissemination of its work and will normally grant permission to reproduce portions of the workpromptly.All queries on rights and licenses, including subsidiary rights, should be addressed to the Officeof the Publisher, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA;fax: 202-522-2422; e-mail: pubrights@worldbank.org.Jacob Jordaan is a World Bank Group consultant and Assistant Professor at the Utrecht School ofEconomics. Wim Douw (wdouw@ifc.org) is Senior Private Sector Specialist and Christine ZhenweiQiang (cqiang@worldbank.org) is the Practice Manager for the Investment Climate Unit within theEquitable Growth, Finance and Institutions Practice Group of the World Bank Group. They would liketo thank the following colleagues: Peter Kusek, Ulla Heher, Ivan Nimac, and Abhishek Saurav for theirvaluable inputs and contributions.Editing: Nancy MorrisonDesign and Layout: Aichin Lim JonesPhoto Credit: Shutterstock.com
Table ofContentsINTRODUCTION3MNC AFFILIATES AND PRODUCTIVITY SPILLOVERS3BACKWARD LINKAGES6INTER-FIRM LINKAGES AND TECHNOLOGY TRANSFERS7MNC AFFILIATES AND PRODUCTIVITY SPILLOVERS AMONG LOCAL SUPPLIERS8FDI LINKAGES AND PRODUCTIVITY SPILLOVERS: MARKET FAILURES, CONSTRAINTS, ANDTHE SCOPE FOR POLICYMAKING9HOST ECONOMY POLICYMAKING: SOME GUIDING PRINCIPLES12CONCLUSION13REFERENCES15FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS 1
2 FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS
IntroductionThis note provides an up-to-date summary of the academic evidence around the drivers and channelsfor technology transfer and productivity spillovers by multinational corporations (MNC) operatingin host economies. Foreign direct investment (FDI) is a major contributor to development. Besidesthe direct benefits FDI brings in terms of increased capital, employment and exports, the presence andoperations of MNCs can also help improve the productivity of local firms through backward linkages andoffer an important channel for the integration of local firms into global value chains (GVC). However,several market failures exist that get in the way of these linkages and spillovers fully materializing.This note highlights the main challenges as well as some policy recommendations for host economyGovernments to consider.Despite the growing popularity of attracting FDI asa development strategy, the large body of empiricalevidence shows that productivity spillovers do notoccur automatically and are context specific. Twomain factors influence the degree of spillovers fromMNC affiliates. The first factor is variations in thecharacteristics of both foreign and domestic firms(firm-level heterogeneity), which influence theextent of use of local suppliers, the nature and levelof technology dissemination, and the performanceimprovements that domestic firms may make. Thesecond factor consists of host economy conditionsand government policies. The attraction of asufficient level of MNC investments is necessarybut not sufficient to ensure that domestic firmsbenefit from productivity spillovers. Host economygovernments need to provide an economicenvironment in which MNC affiliates and domesticfirms can operate efficiently and where the extentand effects of inter-firm linkages between these twotypes of firms are facilitated.1This note presents and discusses the main findingsfrom an extensive survey of the recent literature onproductivity spillovers from FDI through supplierlinkages (Jordaan, Douw, and Qiang forthcoming).It then uses these findings to construct a frameworkthat shows the various phases that underlie theattraction, sourcing behavior, and spillover impactof MNC affiliates to identify key areas wherehost economy governments can implement “soft”industrial policies to foster the extent and impactof linkages between FDI and local suppliers. Thefinal sections present several guiding principlesfor effective policy making and provide someconclusions.MNC Affiliates and ProductivitySpilloversMNCs play an important role in growthprocesses of most developing and emergingeconomies. MNC affiliates can generateIn this document, a multinational company (MNC) refers to a company with one or more affiliates located in countries (hosteconomies) other than where the company’s headquarters are located (home economy). MNC affiliates refer to the affiliateslocated in host economies. Local and domestic firms refer to companies that are indigenous to the host economies.FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS 3
a number of direct positive effects in hosteconomies by fostering higher levels of capitalinvestment, introducing new industrial activities,creating direct and indirect employment effects,and stimulating international trade. Furthermore,indirect effects occur when domestic firms improvetheir performance as a result of the presence andoperations of MNC affiliates. These indirect effects,which arise in the form of productivity spillovers,are a central feature of the economic benefitsprovided by MNC affiliates.Technology dissemination creates productivityspillovers. MNC affiliates incorporate modernand advanced knowledge, technologies, andmanagement practices. Productivity spilloversoccur when domestic firms absorb and implementthese technologies and new skills and improvetheir performance. Productivity spilloverscan be transmitted via several channels (Görgand Greenaway 2004). One channel is thedemonstration effect, whereby domestic firmslearn about, observe, and copy technologies thatare used by MNC affiliates. Another channel isinter-firm labor mobility, whereby domestic firmsbenefit from employing workers that previouslyworked for MNC affiliates, bringing with themnew knowledge, skills, and experience that theygained while working for foreign-owned firms.The third channel is inter-firm linkages, throughwhich domestic firms obtain new knowledge andtechnologies from MNC affiliates that purchaseinputs from them or MNC affiliates that supplyinputs to them.Backward spillovers are the most importanttype. The original interest in FDI spilloversfocused on horizontal spillovers, referring to caseswhereby domestic firms absorb and implementknowledge and technologies from MNC affiliatesoperating in the same industries. The vast body ofevidence indicates that horizontal spillovers areeconomically not important (Havranek and Irsova2012). In contrast, there is substantial evidence ofpositive vertical FDI spillovers. One type consistsof forward spillovers, caused by technologydissemination by means of MNC affiliates thatsupply inputs to domestic firms. The other typeconsists of backward spillovers, created bytechnology dissemination between MNC affiliatesand domestic suppliers. The evidence showsthat backward spillovers occur most frequently,indicating that input-output linkages between MNCaffiliates and domestic suppliers constitute the mainchannel of productivity spillovers.Input-output linkages between FDI and localsuppliers create productivity spillovers forvarious reasons. First, MNC affiliates exercisestronger demands on local suppliers regarding thequality of inputs, cost-effectiveness, and so on. Evenin the absence of technology dissemination, thiscan lead to productivity spillovers, when domesticfirms respond to these stringent demands byimproving their performance. Second, markets forintermediate inputs can facilitate the unintentionaldissemination of knowledge and technologies,as firms frequently share information on productspecifications and production processes. Also,MNC affiliates screen and evaluate (potential)suppliers, providing information, feedback, andsuggestions for improvement to these suppliers.Third, MNC affiliates are often actively involvedin the provision of support and the disseminationof new technologies to their suppliers in return forhigher-quality and more cost-effective inputs.The process underlying backward spillovers canbe decomposed into three related parts. Figure1 depicts the process and its main components.The first component relates to the level of sourcingby MNC affiliates in host economies. The secondcomponent concerns the degree and types oftechnology transfer that MNC affiliates provide totheir local suppliers, fostering the disseminationof new knowledge and technologies. The thirdcomponent is the degree to which technologydissemination leads to productivity improvementsamong domestic firms. Table 1 lists a number offactors that are important for these components. Allthree components are influenced by characteristicsof MNC affiliates and domestic firms, and by aset of additional factors related to host economyconditions.4 FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS
Figure 1. Local Inputs, Technology Dissemination, and Productivity SpilloversInputsProductivity SpilloversMNC AfflilateDomestic SupplierNew Knowledge,Technologies & StandardsTable 1. Factors Influencing Backward Linkages, TechnologyDissemination, and Productivity SpilloversUse of Local SuppliersMNCAffiliatesMNC-related factors Market-seeking Percent of foreign ownership Level of autonomy Nationality Cultural and institutional proximity tohost economyOther firm characteristics Size, age, and productionprocessesTechnology TransfersMNC-related factors Efficiency-seeking Percent of foreign ownership Level of local sourcing Level of autonomy Company policyOther firm characteristics SizeProductivity SpilloversMNC-related factorsMarketseeking Percent of foreign ownership Nationality Distance to home country Cultural proximity to host economy Level of development homeeconomyDomesticSuppliers Lack of availability of inputs Quality of inputs Cost competitiveness Reliability of supply Limited scale of productionprocesses Firm size Experience with supplying MNCaffiliates Experience with internationalmarkets Commitment to develop linkageswith foreign-owned clients Participation in global value chainsAbsorptive capacity Firm size Export status R&D involvement Technology gap with client firmsAdditionalFactors Level of economic development ofthe host economy Geographical proximity betweenMNC affiliates and domestic firms Sector Infrastructure Quality of institutions (such ascontract enforcement, and red tape) Nature of input-output market Selection process to identifysuitable domestic suppliers Access to finance for suppliers tomake investments that supporttechnology transfers Agglomeration of economic activity Geographical proximity betweenMNC affiliates and domestic firms Human capital Trade openness Level of economic developmenthost economy Access to financeSource: Based on the survey of empirical findings in Jordaan, Douw, and Qiang, Fortchoming.FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS 5
Backward LinkagesSeveral characteristics of MNC affiliatesinfluence their use of local suppliers. Marketseeking FDI (MNC affiliates that operate in hosteconomy markets to serve host economy markets)tend to use more local suppliers than efficiencyseeking FDI (MNC affiliates that operate in hosteconomies to produce intermediate inputs andproducts more efficiently). An important reasonwhy market-seeking FDI uses more local suppliersis that these suppliers can adjust products to localconditions. However, there are indications thatthe investment motive is becoming less importantas a factor influencing local sourcing. One reasonfor this is that growing levels of trade openness ofhost economies increase the pool of internationalsuppliers accessible to MNC affiliates. Anotherreason is that a growing number of MNC affiliates ininternational production networks are characterizedby both market-seeking and efficiency-seekingmotives to varying degrees, valuing both access tohost economy markets and the efficient use of hosteconomy resources (Baldwin and Okubo 2014).Familiarity with domestic firms facilitates localsourcing. MNCs can enter a host economy invarious ways: by creating a new production facility,acquiring an existing domestic firm, or establishinga new production facility together with a domesticfirm in the form of a joint venture. The availableevidence indicates that MNC affiliates with somelevel of local participation use more local suppliers.One reason may be that participating domestic firmsare more familiar with the host economy, facilitatingthe identification and use of local suppliers.MNC affiliates that have a high level of sourcingautonomy within the MNC organizations to whichthey belong generally have higher levels of localsourcing. In contrast, affiliates of MNCs that operatecentralized sourcing policies have much less scopeand flexibility to change their use of local suppliers.Other business functions where the level ofautonomy has been found to increase local sourcinginclude supply, logistics, production development,and marketing activities.Nationality or country of origin can influence the useof local suppliers in several ways. MNC affiliatesuse more local suppliers when the affiliates’ homeand host economies are culturally and institutionallymore similar. Another reason why country of origincan affect the use of local suppliers is that hightransportation costs can prevent MNC affiliatesfrom using suppliers from their home economies.Finally, the nationality of MNCs can also play amore indirect role by influencing other affiliatecharacteristics such as investment motive, mode ofinvestment, and an affiliate’s level of autonomy.Several other characteristics of MNC affiliatesthat do not relate to their affiliation with MNCsinfluence the level of use of local suppliers. LargeMNC affiliates tend to source a lower percentageof their inputs in host economies, as they demandinputs at volumes that usually exceed the capacityof most local suppliers. Firm age or experiencealso matters; it takes time to identify suitablesuppliers and create local linkages. The literaturesurvey confirms that MNC affiliates that have beenoperating in host economies for a number of yearshave higher levels of local sourcing. The natureof production processes is also important. MNCaffiliates with production processes characterisedby assembly-style operations tend to source fewerinputs in their host economies. In contrast, MNCaffiliates with production processes that rely moreon the processing and use of intermediate parts andcomponents source more inputs locally. Severalstudies also report substantial differences betweenindustries regarding the degree that MNC affiliatesuse local suppliers.Characteristics of domestic firms also helpdetermine whether MNC affiliates will use themas local suppliers. Evidence points to the importantconcept of ‘absorption capacity’ of local firms inpredicting productivity spillover outcomes fromengagement with MNC affiliates. World BankGroup research also shows that high growth status,exporter status, R&D expenditure and geographicproximity to MNC affiliates are among the importantindicators that increase the likelihood of a local firmbecoming a supplier to MNC affiliates. However,the primary factor that limits the level of local6 FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS
sourcing is the unavailability of inputs. Regardinginputs that are (or could be potentially) sourced inhost economies, MNC affiliates often indicate thatproblems related with the quality of inputs, theircost-competitiveness, the reliability of supply andthe limited scale of suppliers’ production volumesall limit their use of local suppliers. Ongoingprocesses of economic liberalization and decreasingtrade costs increase the importance of these barriersbecause they make it easier for MNC affiliates touse international suppliers instead of local suppliers.Inter-firm Linkages and TechnologyTransfersCharacteristics of MNC affiliates influencetechnology transfers. MNC affiliates that producefor international markets tend to have a strongercommercial motivation to support their localsuppliers. Because product specifications andrequirements are often more stringent for productsdestined for international markets, MNC affiliatesare more inclined to offer support to local suppliersto ensure the quality of their inputs.MNCs may have company policies to promoteeconomic development. Case study research showsthat there can be marked differences betweenMNC affiliates in terms of their overall level ofsupportiveness and their underlying intentionsto help local suppliers improve their structuralperformance. The cause of such differences canbe traced back to explicit company policies ofsome MNCs to create positive impacts in the hosteconomies in which their affiliates operate.Fully foreign-owned MNC affiliates are lesslikely to provide technology transfers. MNCaffiliates that have some level of host economyparticipation tend to provide support more oftenthan MNC affiliates that are fully foreign owned.As with the level of use of local suppliers,increased familiarity with domestic suppliersfacilitates the provision of support.The relation between the level of use of localsuppliers and technology transfers is not uniform. Ingeneral terms, it is assumed that MNC affiliates witha high level of local sourcing also provide a highlevel of supportiveness. However, the relationshipbetween local sourcing and the provision oftechnology transfers is more complex. One reasonwhy high local sourcing can occur with low levelsof support is that high levels of local sourcing arethe result of technology transfers that MNC affiliatesprovided in earlier phases when they were helpinglocal suppliers improve their production processes.Another reason is that MNC affiliates may besourcing mainly low value-added commodities androutine inputs from local suppliers, which does notprovide any incentives to the foreign firms to createsupportive linkages (Amendolagine et al. 2019).The level of autonomy of MNC affiliates enhancestechnology transfers. Similar to the level of useof local suppliers, the evidence also indicates thataffiliates that operate with a certain amount ofautonomy within their MNC organization are moreengaged in providing technology transfers to theirlocal suppliers.Large MNC affiliates tend to be more involved inproviding support to their local suppliers. Largerfirms have more resources to provide technologytransfers and help their local suppliers improvetheir performance.Technology transfer is grea
Table 1. Factors Influencing Backward Linkages, Technology Dissemination, and Productivity Spillovers Use of Local Suppliers Technology Transfers Productivity Spillovers MNC Affiliates MNC-related factors Market-seeking Percent of foreign ownership Level of autonomy Nationality Cultural and institutional proximity to host .
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