The local benefits of foreign investment

The conventional thinking about the impact of foreign direct investment (FDI) in a developing country, is often that while FDI may create jobs, it crowds out and take away market opportunities from domestic enterprises and make the domestic firms less efficient.  These are the so-called negative spillovers of FDI and have been identified in Venezuela (Atkin and Harrison, 1999), the Czech Republic (Djankov and Hoekman, 2000) and Central and Eastern Europe (Konings, 2001).  In a recent study (Kee, forthcoming), I find that there could be a positive spillover of FDI to consider, i.e. the shared supplier spillover effect.

My intuition is based on a well-known paper by Goldberg et al. (2010) which shows that trade liberalisation in India in the early 1990s allowed domestic firms to gain access to a larger variety of imported intermediate inputs and enabled these firms to expand their product scope and productivity.  A similar benefit may also be at work in the context of FDI.  Typically, foreign and domestic firms share suppliers of intermediate inputs, locally. But since foreign firms are known to be “pickier,” their presence can create incentives for local suppliers to deliver higher quality goods (Javorcik 2004). Thus, domestic firms who share suppliers with foreign firms gain access to newer, better local inputs, allowing them to expand their product scope and productivity. Rodriguez-Clare (1996) nicely provides a theoretical mechanism to support such positive spillovers if the FDI firms use local intermediate goods intensively.  In an interview conducted as part of the study, a supplier of zippers used by both foreign and domestic garment firms explained how positive spillovers arise:

“Serving FDI garment firms was an important reason for us to set up our plant in Dhaka, EPZ. At the beginning, the share of FDI garment firms in our total sales was about 20%. Now it is 35-40%…. To comply [with] the standard of FDI garment firms [we were required] to upgrade and expand product range, capacity, efficiency, and to reduce our costs and lead time. Moreover, [we share] market intelligence…from our FDI garment clients regarding the latest product requirements and fashion trend with our other clients. Thus, the domestic garment firms that buy from us can further improve themselves based on the information.”

—Managing Director of LSI Industries Ltd., Bangladesh, November 2010.

Identifying shared suppliers spillovers of FDI

Of course, to empirically study the shared supplier effect, one would need a dataset that allowed foreign and domestic firms with shared local suppliers to be matched. With support from the Government of Bangladesh and World Bank, I conducted a random, representative survey of the garment industry in Bangladesh where each of 350 firms is asked to provide the names and contact information of their top three local input suppliers. Further, to avoid any bias in the analysis, I rely on an exogenous policy shock where products from Bangladesh were granted duty-free quota-free access under the EU’s Everything-But-Arms Initiative.

Findings: Domestic firms benefit as FDI expands

The study finds that when suppliers are shared, foreign firms benefit their domestic counterparts. As foreign firms expand their investment and market presence to take advantage of the Everything-But-Arms Initiative, the scope and productivity of domestic firms that share their suppliers also improves significantly, even when these domestic firms themselves do not export to the EU.  It suggests that, overall, the spillover effects of a shared supplier can explain 1/4 of the product scope expansion and 1/3 of the productivity gains within domestic firms during the period 1999-2003.

The study also finds that foreign firms helped promote local suppliers of intermediate inputs.  As the number of foreign garment firms grows, the number of local suppliers also rises (Figure 1).

Figure 1. Local suppliers grow with FDI growth

Implications: FDI policies given the shared supplier effect

For policymakers interested in promoting domestic firms through FDI, the shared supplier effect is a new avenue to consider. Furthermore, the study provides empirical support for the idea that designing policies to attract FDI with significant backward linkages may help promote intermediate input industries while also benefitting domestic final goods firms.

The shared supplier effect is not limited to developing countries or to the garment sector.  For instance, when Volkswagen took over AutoEuropa in Portugal in 2000, it adopted the just-in-time delivery system and distributed the attendant software to local suppliers.  This not only resulted in a more productive AutoEuropa, but also changed the automobile industry in Portugal. Local automakers now use the inventory practices of Volkswagen through these common local suppliers  (Automotive Design and Production).

Finally, while the presence of foreign firms promotes benefits domestic firms through shared suppliers, the reverse is true when they leave.  For instance, in Malaysia, a local supplier sold a special plastic resin to Panasonic for its fax machines but also to local manufacturers of cutter knives. When Panasonic closed the plant, manufacturers of cutter knives suffered too:

“When Panasonic closed down the fax machine plant, the local supplier also stopped selling the plastic resin, due to insufficient demand. As a result, our cutter knife production suffered. Now we are looking to import the material from Taiwan at a higher cost and have to face exchange rate and shipping uncertainties.”

—General Manager of SJD Industries (M) Sdn. Bhd., Malaysia, November 2011.

References

Aitken, Brian J. and Ann E. Harrison (1999). “Do Domestic Firms Benefit from Direct Foreign Investment? Evidence from Venezuela,” American Economic Review 89(3), 605-618.

Djankov, Simeon and Bernard Hoekman (2000). “Foreign Investment and Productivity Growth in Czech Enterprises.” World Bank Economic Review 14(1), 49-64.

Goldberg, Pinelopi K., Amit Kumar Khandelwal, Nina Pavcnik, and Petia Topalova (2010). “Imported Intermediate Inputs and Domestic Product Growth: Evidence from India,” Quarterly Journal of Economics.

Javorcik, Beata Smarzynska (2004). “Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In Search of Spillover Through Backward Linkages,” American Economic Review94(3), 605-627.

Kee, Hiau Looi (forthcoming). “Local Intermediate Inputs and the Shared Supplier Spillovers of Foreign Direct Investment,” Journal of Development Economics.

Konings, Jozef (2001). “The Effects of Foreign Direct Investment on Domestic Firms.” Economics of Transition 9(3), 619-633.

Rodriguez-Clare, Andres (1996). “Multinationals, Linkages, and Economic Development,” American Economic Review 86(4), 852-873.

Published in collaboration with VoxEU

Author: Hiau Looi Kee is a Senior Economist with the Trade Team at the World Bank Research Department.

Image: People pass the Bank of England in the City of London January 16, 2014. REUTERS/Luke MacGregor.