IDE Research Columns
The Need for an Integrated Approach to Foreign Direct Investment and Global Value Chains
This column attempts to summarize the main arguments of Murakami and Otsuka (2020) to elucidate the need to integrate the quantitative approach of foreign direct investment (FDI) studies with insightful but descriptive studies of global value chains.
Defects of FDI Studies
I believe that nothing is more problematic than empirical studies of the impact of FDI on the development of local industries in developing countries. Although the issue is of utmost practical importance, there are at least two major defects in most existing studies. As discussed by Murakami and Otsuka (2020), those studies statistically analyze the productivity effects of FDI on local firms i. Researchers commonly assume, without testing, that the presence of foreign firms enhances the productivity of local firms, because of the spillover effect of the advanced knowledge of production from foreign firms. The spillover effect is the external effect, which is assumed to affect the level of productivity without conscious transaction of knowledge. Visual inspections of improved products manufactured by foreign firms, learning by reverse engineering of such products, and stealing ideas by poaching workers from foreign firms are examples of the spillover effects. The following questions arise: (1) Does the common statistical analysis make sense? and (2) Is the spillover effect really important?
The presence of foreign firms may provide new useful information to local firms, which increases productivity but would not significantly affect productivity level. To clarify this issue, an analogy may be made with the relationship between learning new knowledge of mathematical formulas and test scores of mathematics. Assuming that a student’s expected test score before learning new knowledge is 80% and after learning useful knowledge, this student’s expected score increases to 85%. The effect of learning new useful knowledge is 5 points (i.e., 85–80) but not 85 points. Similarly, the effect of the presence of foreign firms should affect an increase in productivity but not the productivity level. However, FDI studies typically examine the relationship between the presence of foreign firms and productivity level.
The correct methodology is to examine the relationship between changes in productivity and the presence of foreign firms. Thus, the existing studies must obtain a biased estimate of the impact of FDI. Murakami and Otsuka (2021) highlighted this fundamental issue, but their paper had been rejected for publication by many journals before it was published in the Developing Economies. Sadly, based on my experience, critical review articles tend to be rejected in our profession.
Information Spillovers or Conscious Information Transactions
The common findings of the existing studies on FDI are that the presence of foreign firms in downstream industries positively affects the productivity of local firms in upstream industries. Thus, the presence of foreign assemblers increases the productivity of local part-suppliers. Apart from the bias of the estimation discussed above, the critical question is whether there is a significant spillover effect from foreign to local firms. My answer is no. Although my personal observation may not be representative, I observed in the motorcycle and automobile industries in Thailand, India, and South Africa that foreign assemblers assist local part-suppliers that deliver parts through contracts by providing useful knowledge. It is reasonable to assume that the provision of knowledge in such a case is not a “free gift,” i.e., external effect, but a part of a conscious transaction. I also found that a large number of local firms in Thailand and India employ ex-employees of Japanese firms as advisers and pay surprisingly high salaries. These observations indicate that advanced knowledge is “purchased” by local firms.
Researchers interested in global value chains (GVCs) have more down-to-earth knowledge and have identified that a close interfirm relationship is intimately related to the flow of relevant information from foreign to local firms (e.g., Humphrey and Schmitz 2002; Gereffi, Humphrey, and Sturgeon 2005). In my opinion, their studies are far more reliable and informative than FDI studies. Likely, many GVC researchers visit foreign subsidiaries and local firms in developing countries themselves, whereas FDI researchers do not. However, a crucial shortcoming of GVC studies is the lack of quantitative analyses. Thus, after revising incorrect specifications of their statistical analysis, Murakami and Otsuka (2020) attempted to integrate excellent insights of GVC studies using the quantitative approach of FDI studies.
The Need for Further Inquiry into FDI
Whether the spillover effect of information or conscious information transfer is important has totally different policy implications. If the spillover effect is important, developing countries should invite FDI as much as possible. If successful, the local industry will grow automatically because of the “free information” that flows from foreign firms. If the conscious efforts to transfer technology are important, developing countries should facilitate transactional relationships between foreign and local firms to stimulate information transfer. As local firms may not possess appropriate knowledge of advanced technologies and management methods, it is essential for the government to provide training programs to local firms.
As FDI is a critical source of economic development in developing countries, we must acquire accurate knowledge of the role of FDI in developing countries. Unfortunately, the current knowledge is far from satisfactory because of the analytical mistake committed by FDI studies and the shortage of efforts to explore the “true” mechanism of knowledge transfer from FDI. The potential effect of FDI will never be fully realized until we achieve a better understanding of the role of FDI in economic development.
Gereffi, Gary, John Humphrey, and Timothy Sturgeon. 2005. “The Governance of Global Value Chains.” Review of International Political Economy 12(1): 78–104. https://doi.org/10.1080/09692290500049805.
Humphrey, John, and Hubert Schmitz. 2002. “How Does Insertion in Global Value Chains Affect Upgrading in Industrial Clusters?” Regional Studies 36(9): 1017–27. https://doi.org/10.1080/0034340022000022198.
Murakami, Yoshimichi, and Keijiro Otsuka. 2020. "Governance, Information Spillovers, and Productivity of Local Firms: Toward an Integrated Approach to Foreign Direct Investment and Global Value Chains." The Developing Economies 58(2): 134–174. https://doi.org/10.1111/deve.12232.
i Typically, the productivity of local firms is regressed on the presence of foreign enterprises in the same industry and downstream industries (e.g., assembling).
* The views expressed in the columns are those of the author(s) and do not represent the views of IDE or the institutions to which the authors are attached.
** Thumbnail image: Managers and workers having teambuilding meeting inside factory（Getty images）