Using FDI to build supply chains in middle-skilled manufacturing: What market failures and other obstacles must developing countries overcome?

Theodore Moran 30 January 2015

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The international communications technology revolution has lowered the cost of coordinating complex activities at great distances and rendered the geographical dispersion of supply chains feasible and profitable (Baldwin 2014). In contrast to the decline in transportation costs that propelled trade in goods in the late 19th and 20th centuries, this second unbundling features multinational investors bringing industries in emerging markets to the frontier of technology and management practices in a single leap. 

This simplifies development strategy for emerging market authorities – they do not have to build supply chains on their own; rather, they can join supply chains waiting for their participation.

In fact, multinational manufacturing investment offers many more target-rich opportunities for supply-chain development – especially supply-chains in middle- and higher-skilled industries -- than is commonly supposed. Conventional wisdom often characterises foreign direct investment in manufacturing and assembly as a global search for lowest-wage sites for low-skill production.  The reality in today’s world is quite different. The UNCTAD FDI database (2014) shows that, in the most recent period for which data are available (2009-2001), the flow of manufacturing FDI to medium-skilled activities such as transportation equipment, industrial machinery, electronics and electrical products, scientific instruments, medical devices, chemicals, rubber and plastic products is nearly 10 times larger than the flow to low-skilled, labour-intensive operations like garments, footwear, and toys; and this flow has been speeding up over time. The ratio between higher- and lower-skill-intensive activities was roughly five times larger in the period 1990-1992, and became approximately 14 times larger in 2005-2007.  These are valuable activities for developing economies to link into. Survey data from emerging market industry sectors show that foreign investors in higher-skilled activities pay their workers two to three times as much for basic production jobs and perhaps 10 times as much for technical and supervisor positions as employees in comparable positions in lower-skilled multinational operations (ILO 2007).

But attracting multinational manufacturing companies to invest in novel sectors in untried sites in the developing world has proven to be quite difficult.  Why so? One obvious answer is poor business conditions and harsh treatment of investors.  But there is more to it than this, argue Ricardo Hausmann and Dani Rodrik (2003, 2005) . Even those developing countries that are good reformers are often not good performers in securing middle- and higher-skill FDI.  The underlying problem in inducing manufacturing investors to try out unproven production locations springs from a combination of information asymmetries and the need for cost discovery in the midst of appropriation problems. The very reason why such cost-discovery is so important – uncovering new information about production that can be shared across the entire economy – accounts for why it is undersupplied. The cost of trying out novel activities is private and must be absorbed by the entrepreneur when unsuccessful, whereas the benefits that result from success are socialised as imitators rush in to take advantage of any profitable discovery.  The market failure that hinders self-discovery therefore is an appropriation problem for first-mover investors, which must be overcome by subsidising first-mover activity.

A look at the evidence, however, shows that the fundamental concepts in this model are slightly – but significantly – off-base, with important implications for host country policy design.

Evidence from four cases of successful supply chain development

To test the Hausmann-Rodrik model, it would be desirable to have a large database covering the experiences of individual countries trying to attract FDI, with micro-evidence about appropriability problems, about failures in information markets, and about coordination externalities through government policies.  Such a database does not exist, and proxies for such subtle variables are likely to be hard to identify.  So instead this column proceeds in the opposite direction, drawing on four case studies in which sufficient micro-details are available about how to attract foreign investment into novel middle-skilled and higher-skilled activities to permit identification of the precise market failures and impediments to supply chain development (Moran 2014). 

Costa Rica

Costa Rica offers perhaps the most thoroughly studied instance of a country trying to attract a higher skilled multinational – Intel – as an anchor investor to lead the country upward away from a production and export base of garments and textiles.  By the time President Jose Figueres took office in 1994, the country had already undertaken a series of reforms that today would be called upgrading doing-business indicators in the domestic economy.  The President himself directed the Costa Rican investment promotion agency – CINDE – to study the needs of the IT industry and target the semiconductor producer Intel for intense attraction.  

To say that information markets worked imperfectly would be an understatement in the experience of Costa Rica. Costa Rica was not on the company’s radarscope, and for more than two years Intel HQ would not even grant an appointment for CINDE to make the case for considering Costa Rica.  

Was the problem information asymmetry? CINDE did indeed provide detailed information about economic conditions, investment laws, and regulatory regimes to Intel negotiators.  But what finally dominated the 19 negotiating sessions between Costa Rica’s investment promotion agency and Intel was negotiation of measures to reassure Intel HQ that a new semiconductor fabrication plant in Costa Rica could be smoothly integrated into the global production network upon which Intel’s competitive position in international markets depended.  Such measures included renovation of the national airport with special facilities for Intel freight, plus a new power substation on the electrical grid dedicated to the prospective Intel semiconductor plant. Accompanying these infrastructure improvements, the Figueres administration formed a public-private partnership in which the national Technological Institute worked with Intel to co-design a training program for IT workers, supervisors, engineers, and managers. 

Malaysia-Penang

Aggressive investment promotion in Malaysia managed in the early 1980s to attract international electronics investors to business-friendly export-processing zones around the international airport in the state of Penang to assemble low-end products and mass-produce printed circuit boards.  Like Costa Rica, Malaysian authorities wanted to induce international electronics investors to upgrade their operations to more complex sub-assemblies and final products while assigning design functions into local plants.  To do so, the Penang Development Corporation supplemented its investment promotion responsibilities in 1989 with a complementary Penang Skills Development Corporation.  Under auspices of steering committee headed by Motorola, Hewlett-Packard, and Intel, it persuaded 24 founder firms to contribute equipment and assign executives to teach at the new campus financed by the state of Penang.  Within seven years – in 1996 – a USAID study ranked Penang Skills Development Corporation as one of the ten leading Workforce Development Institutions in the world.  In terms of infrastructure upgrades, Penang Development Corporation meanwhile added IT improvements to the industrial parks clustered around the international airport.  With intensive lobbying, the Malaysian central government began plans for the Multimedia Super IT Corridor, and in 2005 chose Penang to be the first in the country to be awarded Cyber-City status.  

Morocco

In Morocco, inward flows of FDI began to rise after the trade liberalization of 1994 and investment law reform of 1995, but such flows remained centred in lowest-skilled, lowest-wage activities.

The transformation of the export profile of Morocco toward higher-skilled manufacturing sprang to a certain extent from fortunate – even lucky – circumstances.  The spearhead for export upgrading originated in an unlikely sector – aerospace – and was launched by a Moroccan national named Seddik Belyamani, who had risen to become Boeing’s Executive President for Worldwide Sales in Seattle.  Beginning in 1997, M. Belyamani led an internal search within Boeing for more than a year to identify what aerospace components might be reliably produced in Casablanca.  Working with his counterpart senior executive in Royal Air Moroc, M. Hamid Benbrahim El-Andaloussi, the Boeing study led to creation of joint venture between Boeing, Royal Air Moroc, and a Moroccan firm Labinal – the JV took the name Matis -- to outsource assembly of wire harnesses to Morocco.  Morocco is the exception that proves the rule with regard to the need for aggressive and effective investment promotion. The Belyamani/El-Andaloussi partnership made up for what the World Bank rated as an extremely weak investment promotion agency (Investir au Maroc). They also undertook a vocational training initiative with the Union of Metallurgical Workers, and the Ministries of Labor, Industry, and Finance to co-found an Institute for Aeronautical Training. 

Shortly thereafter, in 2001, Morocco began planning a large expansion and renovation of the Tangier port facilities on the north coast off Gibraltar, finally completed in 2007. The Kingdom attracted Renault in 2009 as anchor investor in an auto hub in this Tangier-Med complex, with a public-private centre for automotive training alongside. Port construction in Tangier-Med Phase II is expected to reach full capacity by 2015 with the ability to move 8 million containers, 2 million vehicles, and 7 million passengers. A renovated Investment Promotion Agency (Agence morocaine de development des investissements), headed by the executive who gained prominence as the lead negotiator of the Morocco-EU and Morocco-US trade agreements, is targeting major auto-parts manufacturers to follow Renault to Tangier-Med.

Czech Republic

Founded in 1992, CzechInvest first reached out to investors in what it characterised as light industry.  In anticipation the accession of the Czech Republic to the EU, CzechInvest shifted its focus in 2001 to the attraction of investors with higher engineering-intensive operations, hiring staff with expertise in the automotive, aerospace, IT, and electronics sectors. The Czech Republic had traditionally been very strong in technical fields -- approximately one-third of all university graduates have a degree in a technical field.   CzechInvest launched public-private training partnerships involving foreign firms with the Czech Technical University in Prague and other engineering programs in Plzeň, Liberec, Pardubice, Brno, Zlín and Ostrava.

At the same time, CzechInvest gained central government authority to provide construction grants for the development of business parks, and became the country’s conduit for the co-financing of investment complexes using EU structural funds.  Between 2004 and 2013 it provided infrastructure support to more than 100 industrial zones, attracting some $28 billion in investment, principally in the automotive and precision engineering sectors. 

Conclusions and policy implications

These four case studies highlight the need for aggressive investment promotion to overcome serious imperfections in information markets.  But the key ingredient that pulls in first-mover investors is not more information that one side already has and the other does not (information asymmetry).  Rather what first-mover investors need is concrete reassurances that they can integrate new production sites smoothly into their global supplier networks, reassurances that take the form packages of infrastructure improvements plus public-private partnerships for vocational training.

Then, once such reassurances have been established, what is notable is what does not show up in these four case studies – there is no evidence of appropriation problems whatsoever.  In Costa Rica, first-mover Intel’s behaviour since its original investment of $115 million in 1997 does not appear to have been slowed by an inability to earn sufficient returns; if anything, Intel benefitted from cluster-effects as other investors moved in.  Intel followed its first plant with a second, and then added a global distribution centre.  In the decade and a half since 1997, Intel invested an addition $900 million in Costa Rica, while increasing the number of local employees from 500 to 2800, before deciding to shift from semiconductor assembly to software development in 2014.  In Malaysia, the US and European firms that led the upgrading of electronics operations – notably Motorola, Texas Instruments, Hewett Packard, and Philips – steadily added more complex operations and design functions. In Morocco, Boeing ramped up its local operations even as Airbus, SNECMA, Bombardier, and Embraer co-located in the same industrial parks.  In the Czech Republic, the build-up of automotive, electronics, and precision engineering plants grew uninterrupted from 2000 until the great recession hit in 2008.

The evidence here introduces a new perspective to the debate about subsidising first movers.  From the perspective of cost-accounting, an electric power outage, a delay at the port or airport, a shortage of technical workers, or a labour walkout to protest layoffs can be entered into a spreadsheet that shows added costs of doing business. But reassuring the investor about the quality-control in production, and the speed and reliability of incorporation into the firm’s global network, cannot be addressed by simply providing a larger financial subsidy, lowering tax rates, or offering sub-market input costs. Rather the would-be host needs to address the seamless-integration concerns of the investor head-on through concurrent infrastructure upgrades and vocational training initiatives. This has direct implications for the powers and resources assigned to the host investment promotion agency or the inter-ministerial investment promotion committee. It also means that there is an on-going role for external donors, including by the World Bank Group or regional development banks, to help design and fund the infrastructure and training packages needed to accompany effective investment promotion. 

References

Baldwin, R (2014). “Trade and industrialization after globalization’s 2nd unbundling: How building and joining a supply chain are different and why it matters”, Chapter 5, pp 165-215, in R. Feenstra and A. Taylor (eds), Globalization in an Age of Crisis: Multilateral Economic Cooperation in the Twenty-First Century, University of Chicago Press for NBER, Chicago.

Harrison, A and A Rodriguez-Clare (2010), "Trade, Foreign Investment, and Industrial Policy for Developing Countries", Handbook of Development Economics, Vol. 5: 4039-4214.   

Hausmann, R and D Rodrik (2003), "Economic development as self-discovery", Journal of Development Economics 72, no. 2: 603–33

Hausmann, R and D Rodrik.( 2005) Self-Discovery in a Development Strategy for El Salvador. Economia: Journal of the Latin American and Caribbean Economic Association, 6(1), Fall 2005, 43-102. 

ILO (2007), Decent Work: A Perspective from the MNE Declaration to the Present, Geneva: International Labor organization.

Moran, T H (2014), "Foreign Investment and Supply Chains in Emerging Markets: Recurring Problems and Demonstrated Solutions",  Washington, DC: Peterson Institute for International Economics.  Working Paper 14-1

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Topics:  Development

Tags:  FDI, trade, supply chains, development

Marcus Wallenberg Chair at the School of Foreign Service, Georgetown University

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