MNCs and Spillover Effects: Impacts on Host Country

1. MNCs and Spillover Effects: Impacts on Host Country Lecture 5

2. Lecture Outline • Overview • MNCs Trend • Factors to explain the rapid growth of MNCs activity • Key issues regarding the role and Impact of MNCs • How foreign investment or MNCs affects host country? • How to Attract the MNCs Investment? • Summary

3. Overview • Multinational Corporations (MNCs) play a pivotal role in the development of many emerging markets - linking rich and poor economies, transmitting capital, knowledge, ideas and value systems across borders. • Their interaction with institutions, organizations and individuals is generating positive and negative spillovers in host countries. • Become focal points in the debate on the merits and dangers of globalization, especially on developing countries.

4. A solid understand of the role of MNCs in host countries is vital for both policy makers and for MNCs themselves. • Policy makers are influencing the regulatory regime under which the MNC as well as local business partners operate. • Policy makers are interested to understand how MNCs influence local firms, economic development and national welfare. • They need to understand how policy instruments may induce MNCs to act in ways that benefit the host economy.

5. MNCs Trends • There are some 82,000 MNCs worldwide, with 810,000 foreign affiliates - plays a major and growing role in the world economy. For example: • exports by foreign affiliates of MNCs are estimated to account for about a third of total world exports of goods and services, and • the number of people employed worldwide totalled about 77 million in 2008 – more than double the total labour force of Germany.

6. However, their international stature has not insulated them from the worst global recession in a generation. • The 4.8% reduction in inward FDI stock worldwide was reflected in the decline in value of gross product, sales and assets and employment in 2008, a marked contrast to huge double-digit growth rates in 2006 and 2007. • The 100 largest MNCs worldwide continue to represent a sizable proportion of total international production by the universe of MNCs.

7. Over the three years from 2006 to 2008 these 100 companies accounted for, on average, 9%, 16% and 11% respectively, of estimated foreign assets, sales and employment of all MNCs. • And their combined value-added accounted for roughly 4% of world GDP, a share that has remained relatively stable since 2000. • In terms of the sectoral composition, the majority of the largest MNCs continued to be in manufacturing. • General Electric, Toyota Motor Corporation, and Ford Motor Company were among the biggest manufacturers.

8. MNCs from the services sector - increasing their share among the top 100. There were 26 companies on the 2008 list, as opposed to 14 in 1993, with Vodafone Group and Electricité de France among the biggest. • Primary sector MNCs — such as Royal Dutch/Shell Group, British Petroleum Company, and ExxonMobil Corporation — ranked high in the list. • As for MNCs from developing countries, 7 featured in the list - Hutchison Whampoa and CITIC Group, as well as important electronics manufacturers like LG Corporation and Samsung Electronics.

9. Factors to explain the rapid growth of MNEs activity • (1) the development of new technologies of communications, more reliable transportation networks and innovative techniques, of management and organization. • (2) Progressive elimination of restraints on capital flows, the reduction of tariffs made direct investment more attractive and encouraging multinational expansion. • (3) tastes of products, costs and prices same – more sales mean more profit.

10. (4) Transfer prices are the prices that MNEs set for intra-firm exports and imports across national boundaries. Manipulate transfer pricing to maximize global profit and minimize total costs by avoiding or reducing taxes. • (5) MNEs locate in cheaper costs of production and sell in markets where they can demand higher price.

11. Key Issues about the Role and Impact of MNEs

14. How Foreign InvestmentAffects Host Countries 1. Spillovers of MNC Technology • The simplest example of a spillover - the case where a local firm improves productivity by copying some technology used by MNC affiliates operating in the local market. • Another kind of spillover occurs if the entry of an affiliate leads to more severe competition in the host economy, so local firms are forced to use existing technology and resources more efficiently; • a third type of spillover effect takes place if the competition forces local firms to search for new, more efficient technologies.

15. Empirical Evidence on Spillovers • The earliest discussions of spillovers in the literature on foreign direct investment date back to the early 1960s by MacDougall. • Case studies showed that foreign MNCs may: • contribute to efficiency by breaking supply bottlenecks (but that the effect may become less important as the technology of the host country advances); • introduce new know-how by demonstrating new technologies and training workers who later take employment in local firms; • break down monopolies and stimulate competition and efficiency;

16. create a more monopolistic industry structure, depending on the strength and responses of the local firms; • transfer techniques for inventory and quality control and standardization to their local suppliers and distribution channels; and, • force local firms to increase their managerial efforts, or to adopt some of the marketing techniques used by MNCs, either on the local market or internationally

17. Case studies present mixed evidence on the role of foreign investment in generating technology transfer to domestic firms. • In Mauritius and Bangladesh, studies suggest that the entry of several foreign firms led to the creation of a booming, domestically-owned export industry for textiles (Rhee and Belot, 1990). • Mansfield and Romeo (1980) – found in a survey of 15 MNCs that only a small share had accelerated access to process technology for local competitors. • OECD (1970) – 65 subsidiaries in 12 developing countries found almost no evidence of technology transferred to local competitors.

18. The lack of spillovers to domestic firms was attributed to factors likes: • limited hiring of domestic employees in higher level positions, • very little labor mobility between domestic firms and foreign subsidiaries, • limited subcontracting to local firms, • no R&D by the subsidiaries and • few incentives by MNCs to diffuse their knowledge to local competitors. Blomstrom and Persson (1983), Blomstrom (1986) and Blomstrom and Wolff (1989) – in Mexico – find that sectors with higher foreign ownership exhibited higher levels of productivity, faster productivity growth and faster convergence of productivity levels to US norms

19. 2. Linkages between MNCs and Local Firms • Some of the spillovers operate via the linkages between the MNC's foreign affiliate and its local suppliers and customers. • The spillovers occur when local firms benefit from the MNC affiliate's superior knowledge of product or process technologies or markets, without incurring a cost. • Backward linkages arise from the MNC affiliate's relationships with suppliers, while forward linkages stem from contacts with customers.

20. Forward and backward linkages can generate productivity spillovers in industries related to the foreign investor. • Backward linkages create spillovers through several mechanisms (Lall 1978, Smarzynska 2002): • Foreign investors may transfer knowledge directly to local suppliers by training and even joint product development. • Lall (1978) observed that MNEs improve the productivity of indigenous firms: by providing technical assistance and training of employees to increase the quality of suppliers products’; helping in management and organization, and assisting them in purchasing of raw materials.

21. Foreign-owned customers may set higher requirements regarding product quality and service-aspects of the supply relationships, such as just in time delivery - providing incentives for improving product quality and production processes. • Multinationals acquiring local firms may break existing supplier linkages in favor of sourcing internationally. This increases import competition and force local firms either to upgrade or to exit (Meyer 2000).

22. Empirical evidence on Backward Linkages • Some of the "complementary activities" that may create spillovers through backward linkages are identified in Lall (1980) - notes that MNCs may contribute to raise the productivity and efficiency in other firms as they: • help prospective suppliers (domestic as well as foreign) to set up production facilities; • provide technical assistance or information to raise the quality of suppliers' products or to facilitate innovations; • provide or assist in purchasing of raw materials and intermediaries; • provide training and help in management and organization; and • assist suppliers to diversify by finding additional customers.

23. Reuber et al. (1973), in a comprehensive survey of MINC affiliates in developing countries, note that over a third of the total value of goods and services purchased by all affiliates included in their survey were provided by local firms (local content in MNC production). • McAleese and McDonald (1978), studied Irish manufacturing industry (1952-1974), show that local purchases of inputs increase as the MNC affiliates mature. Several factors contribute to the gradual development of linkages such as • further production processing stages are added over time, • the autonomous growth of the manufacturing sector brings up new suppliers, and • some MNC take deliberate action to attract and develop local suppliers.

24. In addition to the linkages and spillovers that result from cooperation between affiliates and local firms, there are effects that occur as suppliers are forced to meet the higher standards of quality, reliability, and speed of delivery of the MNCs. For instance, • Brash (1966), in a study of the impact made by General Motors on its Australian local suppliers, emphasizes the importance of the MNC's stricter quality control, which also had an impact on the suppliers' other operations.

25. Katz (1969) reports that foreign MNCs operating in Argentina "forced their domestic suppliers to adopt productive processes and techniques used by the suppliers of their main firms in their country of origin". • Watanabe (1983) notes complaints from small local producers in the Philippines about the large foreign firms' tough requirements on both product characteristics and prices.

26. Some less optimistic conclusion on the effects of linkages suggested by Aitken and Harrison (1991), examined Venezuelan manufacturing between 1976 and 1989 – conclude that the effect of foreign investment on the productivity of upstream local firms is generally negative. • Argued that foreign firms divert demand for domestic inputs to imported inputs, meaning that the local supplier firms are not able to benefit from potential economies of scale. Their results differ from most other findings in this respect.

27. Forward linkages have received less attention in the literature, yet downstream businesses can benefit through similar, complementary channels: • Local firms acting as marketing outlets for foreign investors may receive considerable support in form of training in sales techniques and supply of sales equipment such as umbrellas or refrigerators • In more complex form, local firms may operate under a franchise agreement with a multinational brand, thus receiving extensive training and marketing support (Altenburg 2000: 12-13)

28. Local industry may benefit from supplies of intermediate goods and machinery from multinational firms if these provide better quality products, and more comprehensive after-sales services than previous local suppliers. • FDI in infrastructure and business services has a direct impact on productivity. In industries such as telecommunication, foreign investment leads to substantial improvement of services required by businesses; in accounting or IT services, foreign investors provide services previously not available locally.

29. Empirical evidence on Forward Linkages • There is much less evidence of forward than backward linkages. • Only a minority of the firms studied by Reuber et al. (1973) claimed to have contributed significantly to the development of local distributors and sales organizations. • McAleese and McDonald (1978) report that forward linkages in the Irish economy grew in much the same way as backward linkages. Many MNCs commenced operations with heavy export-orientation but that the importance of the home market has increased over time.

30. Summarizing, there is much evidence of the existence and potential of backward linkages, and a suspicion about the growing importance of forward linkages as well. • Some of the host country characteristics that may influence the extent of linkages - and thereby the extent of spillovers are: • market size, local content regulations, and the size and technological capability of local firms. • Linkages are likely to increase over time, as the skill level of local entrepreneurs grows, new suppliers are identified, and local content increases.

31. These backward and forward linkages are created by various forms of co-operation between foreign investors and local suppliers, from arm-length contracts to technology contracts like licensing, to strategic alliances. • Whether this creates a spillover depends also on the relative bargaining power of the partners, which in turn depends on the firms’ resources and capabilities contributed to the relationship.

32. 3.Training of Local Employees in MNC Affiliates • The transfer of technology from MNC parents to affiliates is not only embodied in machinery, equipment, patent rights, and expatriate managers and technicians, but is also realized through the training of the affiliates' local employees. • Training affects most levels of employees, from simple manufacturing operatives through supervisors to technically advanced professionals and top-level managers. • Types of training: on-the-job training, seminars and more formal schooling to overseas education, perhaps at the parent company, depending on the skills needed.

33. The evidence on spillovers from the MNC affiliates' training of local employees is far from complete, and comes mainly from developing country studies. • Studies in developing countries have recorded spillovers of both technical and management skills. For instance, • Gerschenberg (1987) examines MNCs and the training and spread of managerial skills in Kenya - concludes that MNCs offer more training of various sorts to their managers than private local firms do, although not more than joint ventures or public firms.

34. Chen (1983), in a study of technology transfer to Hong Kong, chooses to emphasize training of operatives. In three out of four sampled industries, the MNCs' incidence of undertaking training and their training expenditures were significantly (several times) higher than those for local firms. • Concludes that "the major contribution of foreign firms in Hong Kong manufacturing is not so much the production of new techniques and products, but the training of workers at various levels.

35. How to Attract the MNCs’ Investment • MNEs can contribute to economic development and growth. All governments want to attract it. • Economic determinants remain key role: • 1. Policy framework • Liberalizing national policies to establish hospitable regulatory framework for FDI by • relaxing rules regarding market entry and foreign ownership, • improving the standards of treatment accorded to foreign firms and • improving the functions of markets.

36. 2. Business Facilitation: • Include investment promotion, investment incentives, after-investment services, improvements in social amenities, and measures that reduce the ‘hassle costs’ (related to corruption and administrative efficiency) of doing business. • 3. Economic determinants: 3 groups • Market-seeking • Market size and per capita income, market growth, access to regional and global markets, country specific consumer preferences, structure of markets.

37. Resource/ asset seeking • Raw materials, low-cost unskilled labor, skilled labor, technological, innovative, brand names, physical infrastructure) • Efficiency-seeking • Costs of resources and assets, adjusted labor productivity, other input costs such as transport and telecommunication costs, intermediate products, membership of a regional integration agreement conductive to the establishment of regional corporate networks.

38. Summary • A tentative conclusion of the review is that foreign direct investment may promote economic development by contributing to productivity growth and exports in their host countries. • However, the exact nature of the relation between foreign MNCs and their host economies seems to vary between industries and countries. It is reasonable to assume that the characteristics of the host country's industry and policy environment are important determinants of the net benefits of FDI.