The benefits of global economic integration have become increasingly evident over the last decades. Increased movement of goods, services, people and capital across international borders has helped many developing countries achieve fast and sustained economic growth. Many observers argue that foreign direct investment (FDI) has been a key ingredient in this process by facilitating transfer of productivity-enhancing techniques and knowledge from industrialised to developing nations (eg Hoekman and Javorcik 2006, Moran 2011). While the benefits of FDI inflows in terms of job creation, technology transfer to local affiliates, and productivity spillovers have been widely documented, there is little rigorous evidence on the implications of FDI inflows for the host country’s export structure.
FDI can boost exports of medium-skilled sectors in developing countries
In the popular view, foreign investors in developing countries focus mainly on simple and low-value-added tasks in order to exploit cheap labour costs and liberal regulatory regimes. Critics fear this can widen the income gap between countries rather than close it. However, Ted Moran (2011) presents data indicating that this view is inaccurate. He shows that the bulk of manufacturing FDI enters more advanced industrial sectors rather than garment, footwear, and other lowest-skilled operations. In fact, sectors requiring medium-skilled operations, such as autos and auto parts, industrial machinery, medical devices, scientific instruments, electronics and electrical products, chemicals, rubber, and plastic products received nearly 14 times more FDI inflows each year than low-skilled labour-intensive sectors in 2005-07. This predominance of FDI in more skill-intensive operations has also grown over time, as the same ratio was equal to five in 1989-91 (Moran 2011). FDI may, therefore, induce technological catch-up in developing countries and stimulate export growth in medium-skilled sectors.
FDI can also lead to export upgrading within sectors
In new research (Harding and Javorcik 2011a), we present complementary evidence suggesting that FDI can help developing-country exports catch up with the quality frontier. There are several reasons why FDI could contribute to upgrading the host country’s exports structure. First, products exported by multinationals may have higher unit values due to multinationals’ superior technology and marketing techniques. Second, local firms in the same industry may learn by observing what multinationals produce and export and in this way upgrade the quality of their own exports. Third, productivity spillovers to supplying firms may result in suppliers exporting higher-value products. Fourth, availability of higher-quality inputs resulting from FDI spillovers accruing to the supplying industries may benefit indigenous producers of final goods and allow them to upgrade their exports.
How to identify the effects of FDI on export quality?
Disentangling the effect of FDI on the unit values of exports is a challenging task because of potential endogeneity problems. It could be that the presence of foreign investors leads to higher unit values of exports, but it is also possible that country and sector characteristics responsible for high unit values of exports attract FDI inflows.
Our earlier work (Harding and Javorcik 2011b) provides evidence on the effectiveness of investment promotion efforts. We use data collected by the World Bank’s 2005 Census of Investment Promotion Agencies covering 109 agencies around the world. Particularly useful for our research purposes is the detailed information on sectors denoted as priority in national investment promotion efforts. Using a differences-in-differences specification, we examine whether sectors explicitly targeted by investment promotion agencies received more FDI than non-priority sectors during the same time period. Our analysis relies on within country-sector variation over time as the empirical specification controls for country-sector, country-year and sector-year fixed effects. The results suggest that sectors targeted by investment promotion agencies receive on average more than twice as much FDI inflows than non-targeted sectors.
To assess the change in unit values in response to FDI inflows, other factors that may affect the quality of exports are controlled for. First, the empirical specification takes into account the scale of exports of a particular product (export value at product level), size of the exporting economy (population), level of development (GDP per capita) and changes in the general price level (inflation). In addition, the specification controls for country-sector and product-year fixed effects. The former take into account time-invariant comparative advantage and other time-invariant factors potentially affecting unit values, while the latter account for products inherently having different unit values (eg cars versus trains) and for global shocks to product prices due to either demand shocks (eg CD players when the iPod took off) or supply shocks (eg China entering the world market in a particular product).
Our findings are consistent with a positive effect of FDI on unit values of exports in developing countries. The magnitude of the effect is economically meaningful. To give an example, if Slovenia targeted transportation equipment manufacturing (NAICS 336) in their investment-promotion efforts, the unit value of Slovenia’s exports of motor vehicles for the transport of goods (SITC 7821) would increase above the level found in Bulgaria, Mexico, and Israel. The results for developed countries are less robust than for the developing-country subsample, although a positive correlation is found for these countries as well. This is consistent with a catch-up mechanism, where FDI helps in narrowing the gap in production technology and marketing techniques between developing and developed countries. For developed countries there is less of a gap to fill and hence the less robust effects are expected.
What about export sophistication?
Is getting closer to the international quality frontier synonymous with increasing the overlap with the export structure of high-income economies, ie increasing the export sophistication? To answer this question the study focuses on two measures of export sophistication. The first one is based on the approach of Hausman et al (2007) and captures the “income level of a country’s exports” (EXPY in the authors’ terminology). In the work of Hausmann et al, it is a country-level measure defined as a weighted average of the GDP per capita level associated with each product exported, where the weights are the value shares of each product in the country’s total exports. Because investment-promotion activities vary at the sector level, we use the sector-level equivalent of EXPY. In other words, in our analysis, EXPY varies by country, sector, and year. The second measure is Wang and Wei’s (2010) index capturing the lack of export sophistication. This index, adapted to the context of the study discussed, measures the dissimilarity between the product structure of a country-sector’s exports and that of the same sector in high-income economies.
Each of the export-sophistication measures is regressed on the set of explanatory variables from the baseline model. The results indicate that there is no statistically significant correlation between targeted sectors and any of the export-sophistication measures. These findings are consistent with the results of Wang and Wei who conclude that FDI plays no role in increasing the similarity of Chinese exports to those of advanced countries, even though it contributes to raising the unit values of Chinese exports. In sum, while the results are consistent with FDI inflows leading to upgrading the quality of the host country’s export basket, there is no evidence of FDI increasing the similarity between the developing and the high-income export structure.
Conclusions and policy recommendations
To sum up, there is robust evidence indicating that inflows of FDI contribute to upgrading of exports in developing countries. This finding is in line with Hallak and Schott (2011), who show that the quality gap between high- and low-income countries’ exports narrowed relatively fast from 1989 to 2003, a period of rapid globalisation and strong growth in FDI flows. Given that investment promotion leads to more inflows of FDI, it presents an opportunity to developing countries to upgrade their export basket
Hallak, Juan Carlos, and Peter K. Schott (2011), “Estimating Cross-Country Differences in Product Quality,” Quarterly Journal of Economics 126:1, 417-474.
Harding, Torfinn and Beata S. Javorcik (2011a), “FDI and Export Upgrading”, The Review of Economics and Statistics, forthcoming.
Harding, Torfinn and Beata S. Javorcik (2011b), “Roll out the Red Carpet and They Will Come: Investment Promotion and FDI Inflows”, The Economic Journal, forthcoming.
Hoekman, Bernard and Beata S. Javorcik, eds. (2006), Global Integration and Technology Transfer, Palgrave Macmillan and CEPR.
Moran, Theodore (2011) Foreign Direct Investment and Development: Launching a Second Generation of Policy Research: Avoiding the Mistakes of the First, Reevaluating Policies for Developed and Developing Countries. Washington, D.C.: Peterson Institute for International Economics
Wang, Zhi, and Shang-Jin Wei (2010), “What Accounts for the Rising Sophistication of China’s Exports?,” in Feenstra, Robert, and Shang-Jin Wei, eds. China's Growing Role in World Trade, University of Chicago Press, Chapter 3.