In 2009, an EU-based chemical manufacturer opened a plant inside one of FYR Macedonia’s recently-established special economic zones. The plant began production of catalysts, a type of emissions-control component used in automobiles. Two years later, this investment drove chemical products to the third-highest spot on Macedonia’s export list, lessening the country’s reliance on metals and textiles.
In Nicaragua, low labor costs and high security compared to its neighbors have led zonas francas to expand dramatically, attracting producers of electronic wires and medical devices and expanding the country’s exports beyond an already-strong apparel sector. Between 2006 and 2008, for example, ignition wiring sets for vehicles were the country’s fourth biggest export.
These two examples demonstrate a new trend in small economies. Increasingly, as global value chains grow in importance, countries such as Macedonia and Nicaragua have access to investments that would not have been possible before. As economist Richard Baldwin asserts in a new paper , with global value chains, “exporting is easy.” No longer is a lack of industrial complexes an impediment to attracting “born to export” firms. Because the economies are small, these investments have the power to shape the level and composition of exports the countries produce. Both Macedonia and Nicaragua have enjoyed substantial increases in exports and diversification away from traditional industries.
But if the benefits of this new trend are accentuated in small economies, the risks are also heightened. Global supply chains make industrialization easier, but as Baldwin points out, they also make it shallower. Macedonia may have a successful auto components factory, but it does not have a complex, integrated auto industry. The jobs are specific to a single specialization, not diverse and apt to foster the spread of industry-related knowledge. In fact, the jobs may have little to do with specialization or skills at all, but may simply be a function of relative wages. Put simply, the risk is that the host country becomes no more than a source of cheap labor.
Working with regional teams and using a tool called the Trade Competitiveness Diagnostic (TCD)  to assess countries’ trade environments, we in the World Bank’s International Trade Department have seen firsthand both the opportunities and challenges this new environment brings. In some ways, the phenomenon is an extension of the long-established experience of “offshoring” basic production functions – sequestering them in enclaves such as export processing zones (EPZ), where companies receive tax benefits and other targeted incentives. In recent decades, small economies throughout Central America (including Honduras, Nicaragua, and El Salvador) have watched offshore investments by a small set of firms, mainly those manufacturing clothing for the US market, transform their exports. Now, however, the offshoring process has spread beyond textiles and clothing to include the automotive value chain, services and other products.
This reality poses a whole new set of policy questions. While job creation is valuable in its own right, without additional spillovers, the value of jobs created by foreign investment may be outweighed by the incentives the government offers to attract the investment in the first place. If the country offers little more than cheap labor, it might not retain “footloose” investors without restraining wages over the long term. But by keeping wages down, the country reduces its chances of development and significant poverty reduction. The foreign investments – from the catalyst plant to garments factories – are integrated into global value chains, but not necessarily into their domestic economies. Without linkages between foreign direct investment and the domestic economy, the foreign company cannot transmit newly acquired skills, knowledge and increased productivity to other sectors.
In broad terms, the World Bank Group has been working to help countries see more sustainable, deeper benefits from foreign investment. In the trade department, we are working on a detailed study of the linkages of foreign direct investment (FDI) to local economies in Sub-Saharan Africa, focusing on the mining, agriculture and apparel sectors. More widely, the Bank works across various sectors to develop effective policy options for countries hoping to foster stronger linkages between foreign investment and their local economies.
Providing the right incentives without establishing counterproductive and unrealistic targets for local content requires careful balance. Governments can create attractive conditions, facilitate contacts, and provide incentives for foreign investors to use local sources for production inputs. Recent research (Ari Van Assche, forthcoming) argues that, in the fragmented global-value-chain environment, governments can boost their positions by establishing: 1) clear rules and enforcement (to enable risk-free contracting); and 2) effective institutions.
To maximize the benefits of export-driven growth, countries should go beyond attracting ready-to-export FDI such as the catalyst-manufacturing company in Macedonia. They should pursue wider-ranging strategies, including cultivating locally-owned, small- and medium-sized enterprises (SMEs) that can become suppliers to FDI companies and integrate into global supply chains themselves. The widely-recognized connection between productivity and exporting suggests that SMEs could improve through a learning-by-exporting dynamic, and countries would thus facilitate the emergence of agile, mid-sized exporters. A focus on SME competitiveness in exporting will require governments to intervene in a more in-depth and targeted way to build competitive firms while avoiding the traditional regulatory mindset or the compulsion to “pick winners.” It can be viewed as creating programs for “export enterprise development.” With this approach, perhaps Macedonia’s catalyst-production could, in the long run, catalyze more than exports and jump-start local enterprises.