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Connecting Local Businesses with Multinational Corporations Amplifies the Development Impact of FDI

Jose Daniel Reyes's picture
On a macroeconomic level, openness to trade and investment is associated with aggregate productivity gains and economic growth (See for instance the work of Dollar 1992 ; Harrison 1996 ; Frankel & Romer 1999). However, globalization has important effects on local enterprises and workers: some people become richer while others see their slice of the pie reduced. Economists expect that, over time, workers will transition from tumbling firms to soaring ones and that economic gains will be eventually shared more broadly. Yet the transition process is long and could be painful for less skilled workers, and in some cases, may generate anti-globalization sentiments. Because of these adjustments, the arrival of multinational corporations (MNCs) to developing countries can sometimes be paved with drama, particularly in the retail sector.

Take the example of large supermarkets, like Walmart, investing across the globe. The company, one of the world’s largest private employers, is sometimes criticized for destroying local businesses by undercutting local retailers’ prices and replacing local production with cheaper imports. In response, Walmart argues that when it moves into a country, it increases its local purchases and helps local suppliers to meet its high standards of efficiency, thereby boosting those firms’ productivity more generally.
 
Photo Credit: Walmart
While the economic literature is relatively new, research does point to the benefits of FDI. For instance, Chinese cities tend to increase their exports following the opening of a Walmart store. This is attributed to an improvement in the productive capacity of local firms that supply goods to Walmart. In Mexico, Walmart’s entry shifted resources to more efficient firms and made those firms more productive and innovative. These positive effects on domestic firms’ performance are called FDI spillovers.

In the 2017/18 Global Investment Competitiveness Report, I examine two transmission channels in which FDI spillovers can be transmitted from MNCs to domestic firms:
  • Direct contractual linkages between local suppliers and MNCs allow local firms to learn directly from MNCs. Often, MNCs will share new technology or management techniques to help local firms meet their technical and quality requirements.
     
  • Spillovers can also occur indirectly through the “demonstration effect,” in which domestic firms imitate foreign technologies or managerial practices either through observation or by hiring workers trained by the firm. Workers who have received training from MNCs can take their knowledge with them to existing local firms, or can found their own businesses.
Analyzing information from about 70,000 firms in 122 developing countries reported by the World Bank Enterprise Surveys, I find that knowledge spillovers from MNCs occur mainly through direct contractual linkages, but their impact varies greatly across different type of domestic firms. Local high-growth firms, characterized by their ability to create jobs, typically capture the most benefits from FDI spillovers. The analysis indicates that an increase of 1 percentage point in the share of inputs sourced domestically by MNCs is associated with a 0.6 percentage rise in the output growth of high-growth firms. There is no statistically significant effect for other firms.

High-Growth Firms Benefit from the Presence of Foreign Firms
(Average impact of FDI spillovers on firm growth, by firm type)
 
Note: This figure shows the estimated coefficient of the linkages and demonstration channels on high-growth firms and the rest of businesses in a sample of 121 countries. Vertical lines capture 90% confident intervals. The estimates correspond to the estimation shown in column 7 in Table 3D in Chapter 2 of the Global Investment Competitiveness Report.

Capturing the Benefits of FDI
What is it about high-growth firms that enables them to capture spillover benefits from FDI?  These firms have the capacity to not only recognize the value of new information, but also to apply it to improve their production processes. Other firms lack this absorptive capacity.  

The potential of MNCs to generate spillovers to high-growth firms varies depending on the sector and a company’s motivation for investing in the host economy. MNCs embedded in global value chains generate larger spillovers than investments that seek to satisfy demand in the host economy. I have found no evidence that natural resource-seeking FDI generates spillover effects, as defined in the report.

What does this mean for policy? Harnessing linkages for inclusive economic growth
The World Bank Group advises client countries to pursue policies that strengthen the links between MNCs and local suppliers. Policymakers should take a comprehensive approach that enables and incentivizes MNCs to source locally in ways that make business sense. Compulsory local content requirements can lock out foreigners and prevent locals from taking advantage of global value chains.

Government can intervene to offset specific market failures, such as information asymmetries, or to increase the capabilities of potential suppliers to meet the scale and quality demanded by MNCs. Policy interventions to connect domestic firms with MNCs include supplier databases, match-making services, supplier development programs, tax incentives, and others. Effective investment policies do not favor foreign investments over domestic ones. Rather, they link the two, ensuring that a country can maximize development benefits.
 

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