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Asian Development Outlook 2004 : III. Foreign Direct Investments in Developing Asia
Impact of Foreign Direct Investment Overview Supporters of FDI contend that foreign investors introduce a package of highly productive resources into the host economy, including production and process technology, managerial expertise, accounting and auditing standards, and knowledge of international markets. The challenge for the host economy is to benefit from the MNE presence, and to appropriate some of the increased income accruing from the resultant productivity growth. The large literature on FDI impacts3 concludes that the host economy benefits are quite uneven, both across and within countries. This suggests that host country policies are an important factor in the distribution of these benefits. Of particular relevance here, as postulated in this literature, are the commercial environment, institutional quality, and supply-side capacities. It should be emphasized that many FDI impacts are inherently difficult to measure. The academic literature typically approaches the issue in one of three ways. The first is in the context of the determinants of growth (Box 3.1). In international comparisons of economic growth, FDI, or some other measure of foreign presence, is introduced as an explanatory variable, together with a range of interactive or “conditional” variables (e.g., trade orientation, human capital, institutional quality). The hypothesis is that, other things being equal, a larger presence is associated with faster economic growth. The other two methodologies focus on technology spillovers within countries, from foreign to domestic firms, as measured either through firm-level case studies or an analysis of cross-section industry data. Both provide only a proximate and partial picture: the former is limited by the sample size and the flows are generally not quantified; the latter is presumptive and inferential rather than demonstrated. The relative importance of the various channels through which spillovers occur-emulation, interfirm worker mobility, subcontracting networks-is generally not demonstrated conclusively. A range of non-equity channels (international labor migration, international buying groups, licensing arrangements) could be just as important as FDI in some circumstances. A related set of literature attempts to draw a distinction between positive, “crowding-in” effects of FDI, and negative, “crowding-out” effects. Among the former are the positive technology and trade effects alluded to above, together with various dynamic externalities such as clustering and country reputation. The latter draws attention to a range of possible outcomes: anticompetitive impacts (e.g., displacement of domestic firms or investment), bidding scarce resources (e.g., skilled labor, credit) away from domestic firms, or squeezing out domestic supply networks as new foreign entrants bring with them integrated upstream and downstream supply chains. It is now generally accepted that the distinguishing characteristics of FDI are its stability and ease of service relative to commercial debt or portfolio investment, as well as its inclusion of nonfinancial assets in production and sales processes. Aside from increasing output and income, potential benefits to host countries from FDI inflows include the following: (i) Foreign firms bring superior technology. The extent of benefits to host countries depends on whether the technology spills over to domestic and other foreign-invested firms. (ii) Foreign investment increases competition in the host economy. The entry of a new firm in a nontradable sector increases industry output and may thereby reduce the domestic price, leading to a net improvement in welfare. (iii) Foreign investment typically results in increased domestic investment. In an analysis of panel data for 58 developing countries, Bosworth and Collins (1999) found that about half of each dollar of capital inflow translates into an increase in domestic investment. Their findings suggest a foreign resource transfer equal to 53-69% of the inflow of financial capital. However, when the capital inflows take the form of FDI, there is a near one-for-one relationship between the FDI and domestic investment. (iv) Foreign investment gives advantages in terms of export market access arising either from foreign firms’ economies of scale in marketing or from their ability to gain market access abroad. Besides their contributions through joint ventures, foreign firms can serve as catalysts for other domestic exporters. In an empirical analysis, the probability that a domestic plant will export was found to be positively correlated with proximity to multinational firms (Aitken et al. 1997). One implication is that governments may encourage potential exporters to locate near each other by (i) creating special economic zones (SEZs-see Box 3.2) or export processing zones, or promoting clusters, or by (ii) conferring special benefits, such as duty-free imports of inputs, subsidized infrastructure, or tax holidays, to help reduce costs for domestic firms in breaking into foreign markets. (v) Foreign investment can aid in bridging a host country’s foreign exchange gap. Two gaps may exist in the economy: insufficient savings to support capital accumulation to achieve a given growth target, and insufficient foreign exchange to purchase imports. Often investment requires imported inputs. If domestic savings are insufficient, or face barriers in being converted to foreign exchange to acquire imports, they may be insufficient to guarantee growth. Capital inflows help ensure that foreign exchange will be available to purchase imports for investment. For countries with relatively easy access to international capital markets (such as Korea) or with substantial holdings of foreign reserves (such as the PRC or India), the nonmonetary benefits of FDI, such as (i)-(iv) above, still make it an attractive source of investment.
Foreign Direct Investment and Trade A capital inflow can lead to increased demand in the host country, in turn leading to a rise in the prices of nontradable goods and services relative to those of imported goods and services facing world market prices. If world demand for the country’s exports is perfectly price elastic, the price of nontradables will rise relative to the price of exports as well. Consequently, the change will affect the returns to factors that are used intensively in either tradable or nontradable sectors. Thus, a capital inflow-induced terms-of-trade effect may affect real income for any given level of real output, while the output level may or may not be affected. When the price of nontradables rises relative to the prices of imports and exports, “Dutch disease” may result, in which resources are drawn from production of tradables to nontradables, and exports fall as the macroeconomy adjusts to a new equilibrium with corresponding changes in factor demand and prices. Distributional effects will result (Cooper 2002). When there are “lumpy” adjustment costs for new investment and economies of scale exist in the investment technology, trade openness can trigger discrete changes in the terms of trade and thereby lead to discrete jumps in the level of investment. However, it can also lead to boom-bust cycles of investment where multiple equilibria are supported by self-fulfilling expectations (Razin et al. 2002). As foreign investors search for the location that will provide the highest returns on their investment, they may be drawn to countries with abundant natural resources but low-quality institutions. Weak and inefficient institutions allow the extraction of natural resources at a pace faster than that required for sustainable development. As a result, ethnic communities are sometimes harmed as the environment, their main source of livelihood, is damaged or destroyed. Foreign investment-led growth also promotes Western-style consumerism, which could have serious potential consequences for the health and food security of the host population (French 1998). Nevertheless, MNEs are playing an ever more prominent role in the global economy, with crucial implications for countries pursuing an export-oriented development strategy. Compared with a decade or more ago, FDI will now typically (i) be more export oriented, (ii) be less likely to be attracted by the old tariff factory model of production for a protected domestic market, and (iii) account for an increasing share of host economy exports.4 Two factors have been driving these trends. The first has been the more or less simultaneous liberalization of both trade and FDI regimes. The second has been technological advances in transport costs and production technologies. The rise of the “global factory” has been made possible by much reduced international transport costs and by disaggregated, transborder production processes, particularly in MNE-intensive industries such as electronics and automobiles. In the most successful cases of these industrial clusters, notably southern coastal PRC and to a lesser extent the Singapore-centered SIJORI-Singapore-Johore (Malaysia)-Riau (Indonesia)-triangle, production operations constitute a seamless web in which national boundaries virtually disappear. It is now much more difficult for late-comer industrializers to achieve high rates of export growth without MNE participation (Urata 2001), the more so for transitional economies with a history of international commercial isolation. The earlier literature on this subject, in which Nayyar (1978) was a major study, argued that MNE involvement in export expansion from the newly industrializing economies was mostly low by international standards. (As a corollary, therefore, developing countries could achieve rapid economic development while maintaining relatively restrictive FDI policies, especially with purchases of technology.) While this generally remains the case for Korea and Taipei,China, it is important to note that in both economies the MNE share in exports did increase significantly from about the mid-1970s to the mid-1980s, relative to the figures reported by Nayyar for the late 1960s. In any case, however, and contrary to Nayyar’s arguments, there is clear evidence that the strong export performance of developing countries since the 1970s has been closely associated with MNE involvement. By linking individual country data on MNEs’ shares in exports with general export data, Nayyar estimated the share of MNEs in total manufactured exports from developing countries to be not more than 15% around 1974. Moreover, he found that the share had not registered any significant increase since 1966. By contrast, a similar calculation, based on unpublished estimates prepared by Chandra Athukorala of the Australian National University, suggests that MNEs accounted for 24% of total manufactured exports from developing countries around 1980. This figure had increased to 36% around 1990. When Hong Kong, China; Korea; and Taipei,China are excluded from the calculations, the latter estimate increases to 45%. Given the huge increase in manufactured exports from the PRC, and the increased share of MNEs in this export expansion (from 17% to 48% over this decade), this figure would have surpassed 50% by 2000. Two additional observations on MNE trade impacts are relevant. One is that the earlier concerns about “immiserizing growth”-as expressed by, e.g., Bhagwati (1973)-are less relevant. This analytical paradigm, motivated by the experience of India and other highly distorted economies, postulated that FDI that entered highly distorted industries would generate negative value added at international prices, in addition to any fiscal incentives offered to attract MNEs (Brecher and Diaz-Alejandro 1977). More open trade regimes alleviate these concerns. Second, in any case, what matters is the efficiency of MNE investments rather than their trade orientation. As in the case of the PRC, some government officials still worry about whether MNEs generate a trade surplus or deficit. However, “deficits” and “surpluses” carry no normative implications; they can be either “good” or “bad” depending on the efficiency of firms’ operations. As it happens, the trade of MNEs in the PRC is shifting from deficits to surpluses as reform progresses and the “dual regime” becomes less important. That is, the initial concentration of MNEs in joint ventures with uneconomic state-owned enterprises (SOEs) was a major explanation for the observed “deficits.” The trade orientation of MNEs has changed rapidly as export-oriented firms have begun to predominate. Thus, the trade orientation of MNEs is largely influenced by the domestic policy environment. Here the East Asian and South Asian comparison is striking. MNEs account for a trivial share (about 3%) of Indian exports, compared with the 50% or more found in many East Asian economies. Skeptics might argue that the East Asian figures are overwhelmed by lower domestic value added in intensively traded goods such as electronics, or that East Asian governments have been more successful in imposing export performance requirements as a condition of entry. While the former does inflate both export-to-GDP ratios and MNE export shares, the differences fundamentally reflect the fact that the East Asian economies offer more congenial commercial environments: entry is simpler and less restrictive, and export/import procedures are less complex. The more protected South Asian markets offer more incentive for rent seeking. In countries where MNEs dominate host country exports, there is some concern over the potential loss of economic policy sovereignty. Malaysia, where MNEs account for about 75% of exports, exemplifies this issue. Decisions that are made in far-off corporate headquarters, it is alleged, might not reflect host economy interests and priorities. Threatening large-scale exit, highly mobile MNEs might exact very generous tax concessions. Intra-MNE export restrictions and franchises may inhibit export growth. The international evidence supporting these allegations is not persuasive, however. MNEs tend to put down roots in congenial environments, and FDI is not as mobile as other forms of foreign capital. MNE interaffiliate export decisions are fundamentally driven by the same considerations as market-based ones. Of course, regime instability and nationalist sentiment will discourage FDI, as they do domestic investment. As a country loses comparative advantage in labor-intensive activities, MNEs will shift their low-end activities to other locations. But domestic firms will do likewise, and the challenge for policy makers is to play a creative role in managing the upgrading process.
Employment, Distribution, and Poverty The social and distributional impacts of FDI depend principally on host country policies and institutions. For example, employment outcomes depend on the flexibility of the labor market. The growth-poverty relationship depends on the extent to which governments have pursued policies that enable low-income groups to take advantage of growth opportunities. Similarly, regional (subnational) impacts will be shaped by the spatial distribution of complementary production inputs, such as physical and social infrastructure. The employment impacts of FDI illustrate this proposition. The more open and less distorted Malaysian and Thai economies have experienced chronic labor shortages since the late 1980s, necessitating very large imports of mainly unskilled labor.5 This phenomenon was only briefly interrupted by the Asian economic crisis. The predominant location of MNEs in labor-intensive, export-oriented industries, combined with rapid economic growth in general, hastened the emergence of labor scarcity and, consequently, rising real wages. By contrast, in less open and in transitional economies, labor market outcomes, complicated by history and institutions, have been less satisfactory. In the PRC, there is some evidence suggesting negative employment effects of FDI. The problems appear to be concentrated in MNE joint ventures with state enterprises. Thus, the root cause lies in the overstaffed SOEs, and the solution is reform of this sector rather than restricting FDI. Indeed, the entry of export-oriented, labor-intensive FDI is facilitating the necessary process of structural adjustment. Moreover, the freeing up of the domestic labor market is enabling workers from poor hinterland regions to seek employment in the booming FDI-connected coastal regions. While this migration has considerable and sometimes disruptive social implications, and may create unemployment of the Harris-Todaro variety,6 it is also an important mechanism for equalizing the benefits of spatially uneven growth. Similarly, the employment effects of FDI in India have been mixed. With its earlier emphasis on heavy industry and the modest export performance of labor-intensive industries, until recently India largely missed out on East Asian-style export-oriented industrialization. This was the central conclusion of the one major (albeit dated) comparative study of this issue (Little et al. 1987). Moreover, as a corollary, India has not enjoyed the equity dividend that flows from such a broad-based participation in the industrial workforce. If both labor and capital are fully employed before and after the capital movement, the total and average returns to capital increase, and total and average returns to labor decrease in the source country, changing the distribution of income among factors of production. While the source country gains as a whole, income is redistributed from labor to capital. Meanwhile, in the recipient country, income is redistributed from capital to labor, as total and average returns to capital decrease and total and average returns to labor increase. The result is potentially a win-win situation for both countries. However, capital inflows do not always increase welfare in the host country. For example, when capital flows to an industry in which an existing firm has monopoly power in the world market, an increase in output from the new competition lowers the price of the exportable, thus reducing the terms of trade and lowering welfare in the host country. Also, the benefits from foreign investment are usually evaluated under the assumption that host countries can absorb a large inflow of capital without large declines in its rate of return. But if capital grows much faster than the productivity of labor, its productivity will fall, which might reduce its rate of return. Under full employment, a capital inflow that reduces the relative scarcity of capital and raises the productivity of labor in the host country can raise real wages across the board and reduce income disparity within the host country. However, the question of distribution also arises with respect to the sharing of gains between foreign capital and host country factors. Traditionally, foreign investment was geared toward primary commodity exports. During the colonial period in Indonesia, for instance, foreign investment in Java was concentrated in tea and sugar export sectors and in Sumatra in rubber and oil exports. In some cases, this led to capacity expansion, productivity growth, declining prices of exportable commodities, and deterioration in the host country’s terms of trade, possibly leading to welfare losses. In addition, there were (and are) generally few spillovers to the rest of the host economy from primary commodity production. The resulting view was that the gains from capital inflows favor the source economy more than the host economy. Many new foreign investments in developing countries are in process manufacturing because of lower labor costs, such as Nike’s shoe factories across developing Asia. The host countries often import unfinished components and export finished goods or refined components for further processing elsewhere. While wages may rise throughout the work force in host countries and reduce income disparity, in practice wages are likely to rise only for a small fraction of the labor force employed by the foreign investor. By creating a favored local group, this can lead to greater income disparity within the host country. Generally, this favored group belongs neither to the lowest nor highest income group. The result can be to improve the absolute and relative condition of workers within this favored group, in the process aggravating income inequality in society. Over time, however, and given a conducive policy environment, linkages and leakages emerge, creating a country reputation that influences other potential investors. The Singapore story (discussed in the subsection Enabling Policy Framework, below) is a case in point. With regard to spatial impacts, foreign investors are attracted to regions with good social and physical infrastructure, and business-friendly environments. In these respects, they behave no differently from domestic firms. However, MNEs are likely to exhibit greater spatial concentration than their domestic counterparts for at least three reasons. First, MNEs are generally more trade intensive, and therefore more likely to locate in regions that are better connected to the global economy. Second, to the extent that MNEs operate in more skill- and capital-intensive activities, they are more likely to locate in regions with stronger endowments of these attributes. Thirdly, MNEs will not generally have the operating history of local firms in the host economy, and therefore will be less “historically attached” to particular regions. Technology and Productivity Spillovers Technology and productivity spillovers are central to the study of FDI impacts. They constitute the core of MNE competitive advantages, and they feature prominently in host government expectations of FDI. The major general conclusion from Asian country studies is that these spillovers are positive, both economy-wide and for specific industries. However, there are questions about the (i) magnitude of these impacts, (ii) speed of technology transfer, and (iii) government development of an enabling policy framework. Each of these is now considered in turn. Magnitude of Impacts Both the aggregate and case study approaches usually, though not always, point in the same direction. In the case of Thailand, Archanun (2003) found that spillovers from foreign- to domestically owned firms in manufacturing industries were significant. He also concluded that they were more likely to occur in less protected sectors, both because these sectors are more attractive to MNEs and because of the presumed competitive spur of lower protection. As in most other countries, MNEs have played a key role in the automotive industry in Thailand. The country is now the Southeast Asian leader in the industry, with major clustering effects evident among both assemblers and suppliers. Two factors appear to explain its success. It possesses a relatively large domestic market, which initially attracted MNEs during the earlier import-substitution phase. In addition, it reaped an early mover advantage in being the first country in the region to enact major trade reform in the industry, thus quickly building up a strong export-oriented supplier base. By contrast, although Thailand has attracted much export-oriented FDI in electronics, it has not emerged as a major player in this industry. The explanation is that Thailand was slower to provide the major prerequisites required in this MNE-dominated, internationally integrated industry: export zones with high-quality infrastructure, linked in a seamless manner to international markets, and allowing 100% foreign ownership. It is important to note that MNEs have not been central to all of Thailand’s export successes. The country’s agro-based exports, including seafood, have performed very well, and foreign-based MNEs have not been major players in most cases, compared with several large domestic firms, most notably the Charoen Pokphand group (now an MNE itself). This illustrates a more general proposition, that MNEs are particularly important in industries that are characterized by high levels of cross-border vertical integration, and where knowledge of international market chains may be firm specific. The literature on FDI in the PRC generally concludes that it has been beneficial for growth.7 This has occurred through the usual channels: augmenting investment, connecting firms in the PRC to global markets (very important for a country which hitherto had experienced several decades of international commercial isolation), and facilitating a rapid transition from uneconomic SOE-dominated heavy industry investments. While its reforms are much more recent, Viet Nam’s FDI impacts appear to be broadly similar to those in the PRC. Much of the early FDI went into uneconomic joint ventures with SOEs and nontradables such as hotels and construction.8 More recently, following policy reform and disappointment with some early investments, MNEs have shifted to labor-intensive, export-oriented investments. A common feature of FDI experiences is impatience with the apparently slow pace of local linkage formation. Malaysia was one of the earlier countries to attract the MNE-dominated export-oriented electronics industry. The literature on FDI in that country generally concludes that the impacts have been positive. However, it is alleged that MNEs have been slow to develop a local supplier base, have undertaken little research and development (R&D), have remained largely confined to the export zone enclaves, and much of the local content is in reality intra-MNE.9 The Malaysian experience well illustrates the challenges associated with maximizing technology transfers in the context of an MNE and export-led development strategy that is initially based on export zone enclaves. Linkage development and spillovers proceeded slowly, as would be expected. Malaysia’s industrial history is recent; its human capital base was quite limited, especially so for technical skills; firms had great difficulty complying with government requirements to hire bumiputra employees, or source from their companies; and the incentives regime anyway discouraged firms in the zones from sourcing outside the enclave. But the evidence suggests that, over time, MNEs began to put down local roots, particularly as supply-side capacities improved. By the 1990s, the country was quickly losing its comparative advantage in labor-intensive activities, although the Government sought to prolong this advantage by opening up the labor market. From a low base, expenditure on R&D has been increasing rapidly, and is now approximately 0.5% of GDP (compared with 3.0% in Korea). MNEs are shedding low-skill activities, and shifting to higher-value segments. Although the Government will arguably have to be more activist in developing supply-side capacities,10 Malaysia’s experience with FDI and electronics has clearly been more successful than with the auto industry, where a highly protected monopoly has achieved few of the original technology and export objectives. This pattern of enclave-based FDI will inevitably remain important as long as dual policy regimes (discussed in the subsection Dual Policy Regimes below) persist. For example, the Vietnamese Government may be disappointed at the absence of strong linkages from MNEs beyond the export zones. In fact, firms within the zones have powerful incentives not to cultivate commercial linkages beyond them. Customs and other administrative procedures are complex and often corrupt. Infrastructure is poor. The choice of local partners may simply be either a bureaucratic and inefficient SOE, or a legally insecure and occasionally harassed private firm. Not all investments by MNEs lead to technology transfer and positive spillovers. In their desire to protect the technology of the parent company, MNEs may limit the production of affiliates in host countries to low value-added activities, thereby reducing the scope for technical change and technological learning. MNEs may also restrict vertical integration by relying completely on foreign suppliers for their inputs. As would be expected, MNEs’ local linkages are quite selective, and are much more developed in conducive environments. In the PRC, for example, the spillovers seem to be more pronounced in the case of the township and village enterprise sector than with the SOEs (see Fan [2003] for a case study). Typically, there is also considerable regional diversity in these linkages. In Malaysia, the state of Penang, for example, has been an outstanding performer, as the home of the earliest export-oriented investments, and where the strongest small and medium enterprise (SME) subcontracting base in the country has developed. Penang’s commercial and business history, together with effective political leadership and public institutions, are generally regarded as the keys to its success.11 It also needs to be emphasized that local linkages in themselves are not inherently desirable. For example, there is concern in India about the apparently limited linkages between MNEs and local firms, and the fact that these linkages may even be declining in a statistical sense. Such a trend could, rather, be interpreted positively, as indicative of Indian firms connecting on their own to the global economy as the national economy opens up. Indeed, it would be surprising if this did not occur as liberalization progresses. In other words, the interpretation of linkages is no simple matter: the former Soviet Union had the most “developed” domestic linkages in the world; Singapore has perhaps the least. But Singapore has the most important linkage, i.e., international trade and, in consequence, international standards of efficiency. There is also debate about the most effective policy options to promote efficient linkages. Case studies in the Indian context generally endorse past interventionist strategies, including restrictive MNE entry, conditionality, and export obligations (Box 3.3). There can be no doubt that some technological advances have resulted from these policies. But they have come at a cost of deterring potential MNE entrants. The most striking Indian success has been in information technology software rather than manufacturing hardware. Here it appears that the keys to success have been a base of domestic competence and strong human capital connections to international centers of excellence, but limited FDI. A major puzzle in the Indian story is why this success has not been replicated in more manufacturing sectors. Presumably the explanation is that the East Asian exporters enjoy the agglomeration and international reputation benefits of reforming earlier, together with the fact that the facilitating Indian reforms are still at an early stage. It is clear that, in assessing FDI impacts, the stages of development and commercial histories matter. For countries with prolonged commercial isolation, attracting MNEs is a key indicator that they are being recognized as entering the global economy. This especially applies to centrally planned states such as the PRC and Viet Nam, but it is also a broader phenomenon.12 It also explains why these late reformers frequently “overdo” their FDI liberalizations, and offer excessively generous fiscal incentives, at the expense of domestic firms. The expectations of host countries toward FDI differ over the course of economic development. For low-income countries, the principal attraction is employment generation. As noted above, when governments adopt export-oriented strategies, MNEs may play a very important role in exploiting a country’s (hitherto latent) comparative advantage in labor-intensive activities. For countries shifting out of this phase of development, or with a stronger domestic R&D base, interest focuses on the potential contribution of FDI to enhance the process of structural adjustment toward higher value-added activities. These shifts are amply illustrated among the sample of countries. In Malaysia, for example, the focus on MNE impacts is principally to do with technological upgrading issues. For Viet Nam, it is employment and exports, together with managing the foreign presence in the context of limited bureaucratic expertise. India seeks to build on, and modernize, its domestic R&D strengths. In this context, policy makers are concerned that MNEs may be reluctant to undertake local R&D. In Thailand, for example, foreign firms appear to undertake less R&D than local firms.13 Similar concerns are voiced in India. The explanation presumably is that much of the R&D carried out by MNEs is embodied in their investments and staffing, and thus is not formally recorded in local (host country) R&D statistics. Moreover, the international evidence is that the R&D activities of MNEs are being internationalized, but quite slowly, and that they remain typically heavily concentrated in their headquarters (Dunning 1998). Where these activities do go abroad, they are likely to go to countries whose R&D human capital is internationally cost-competitive (e.g., India or the Russian Federation), or whose governments offer generous fiscal incentives for such activities (e.g., Singapore). An additional concern in India is whether MNE entrants may be motivated by a desire to appropriate domestic R&D strengths. India’s research base is (like the PRC’s) unusually strong due to its scale and concerted public policy interventions. Yet international experience suggests that interactions between domestic and foreign R&D can potentially be mutually beneficial, as the Singaporean experience (next subsection) demonstrates. Much depends on how R&D is managed. It also needs to be noted that spillovers are not just about production technology or commercial expertise. There may also be broader implications for institutional development and the quality of corporate governance. MNEs are presumed to employ higher standards of accounting, auditing, and reporting than most existing host country firms. In a liberalized FDI regime, international providers of these business services may also establish local operations. The entry of foreign banks in various economies, for example, appears to have raised standards in the industry locally, in addition to increasing competitive pressures and providing access to a broader range of risk-sharing portfolio instruments. Of course, certain caveats need to be attached to this argument. The causality between MNE entry and institutional quality is arguably bidirectional, that is, better quality institutions are both a cause and a consequence of an increased MNE presence. Moreover, considerable evidence suggests that MNEs adapt, often quite quickly, to local corporate cultures: if the prevailing rules of the game are characterized by extensive corruption and poor corporate transparency, MNEs tend to adjust their behavior accordingly.
There is finally the question of the extent to which host economies may “leverage” the MNE presence. In an open economy context, two main factors appear to be significant here. One is the propensity of MNEs to establish deep local roots, which in turn is determined by the nature of the host economy’s commercial and policy environment.14 The second is whether, and how, an activist approach to tapping the MNE presence may achieve success through emulation, local R&D programs, and advanced training facilities. Singapore is a leader in developing Asia in both these respects, and its strategy is therefore worthy of brief mention.15 The Government has displayed an ability to adjust the policy settings as the economy has shifted quickly from its labor-intensive industrialization phase to one that is increasingly knowledge and technology intensive. The Government anticipated the shift out of low-wage activities, and developed several programs to upgrade local capacities. In addition to its excellent infrastructure, critical for highly trade-intensive industries, the Government introduced a Local Industry Upgrading Program, as a means of tapping into MNEs’ expertise. Technical skills were upgraded continuously through high-quality technical, vocational, and tertiary education. As the country began to lose comparative advantage in labor-intensive sectors, the Government worked with MNEs to induce them to stay and upgrade, while shedding uncompetitive segments. On-the-job training was facilitated by the Skills Development Fund, funded in part by a levy on foreign workers. The Economic Development Board introduced schemes to fund MNEs’ local R&D activities. The Board was highly attentive to these firms’ requirements, and was also willing to target specific MNEs that it considered would be useful for future industrial growth. Some commentators feel that, as a tiny, heavily managed city state, Singapore’s experience is not internationally replicable. However, while the country’s geography, history, and political economy are unique, there is no reason why other countries cannot learn from its success, in which at least five features would appear to deserve emphasis: • Its economy is open, and so firms are immediately subjected to some sort of market discipline and test. • As part of the package to induce MNEs, it offers some of the world’s best physical infrastructure, and a predictable and business-friendly investment climate. • The Government has demonstrated a clear capacity to recover and learn from mistakes. A highly open economy reveals these mistakes quickly, and Singapore’s largely meritocratic Government is not hostage to the usual set of vested interests that constrain governments from adopting first-best solutions. • The Government has revealed a willingness to open its labor market to an extent that is rare among modern nation states. At least 25% of its work force are foreign, and a higher percentage were born overseas. With its high salary structure, it is able to recruit in the most cost-efficient labor markets regionally and internationally. • Singapore has a high-quality, professional civil service. Its public sector remuneration is one of the highest in the world, and the civil service is insulated from political pressures. Thus, a selective industrial policy is more likely to be successful there than in practically any other country in the world. Competition and Concentration The evidence concerning FDI impacts on competition, concentration, and profitability in the six economies focused on is mixed, as it is in the general literature (see the section Six Asian Case Studies, below). A priori, FDI entry might be expected to lower concentration simply because a new entrant means more producers. Of course, in the longer term, concentration could rise if the foreign firms were able to drive out local competitors, or if they located in oligopolistic industries (as they often do, to exploit firm-specific advantages). In addition, here too the host country’s trade policy matters: MNEs are more likely to be attracted to countries with outward-oriented regimes to be able to fully exploit their vertically integrated international production activities. Thus, if their primary motivation is export orientation, as it normally is, competition issues are largely irrelevant. Moreover, in open economies, high concentration levels per se are not necessarily a problem, certainly for tradables activities, as the industry is exposed to foreign competition. Of course, even in the most open of economies, there are public policy concerns in activities that may be characterized as natural monopolies, or that are essentially nontraded. However, it remains the case that there is much less discussion or concern about monopolies in, for example, the open Malaysian economy, compared with countries with more interventionist regimes. In reality, much of the analysis of concentration, including FDI impacts, focuses on a commercial environment featuring state-sanctioned monopolies combined with restrictive trade barriers. In other words, the “competition problem” has more to do with the removal of government privileges, barriers to new entrants, and import protection. In the PRC and Viet Nam, SOEs continue to receive much special assistance, some in the form of restrictions on competition. Where these SOEs form joint ventures with foreign firms, MNE entry may thus appear to cause increased concentration, whereas in fact the fundamental problem lies with the regulatory regime. Although their SOE sectors have been historically smaller, similar general comments apply to Korea and India. The promotion of chaebol (conglomerates) in Korea has resulted in high levels of concentration and an underdeveloped SME sector. India’s highly interventionist industrial planning regime has stifled competition. For this reason also, studies of FDI impacts in the prereform period provide little indication of likely contemporary effects. It also needs to be emphasized that the extent of competition is best measured by some notion of “contestability,” rather than the more standard indicators of concentration (such as 4-firm ratios or the Herfindahl index). This proposition is illustrated in Thailand. After its recent FDI liberalization, concentration fell significantly in the banking industry, but it may have risen in the retail sector as large international companies pushed out local petty traders. In the latter case, however, although there may have been some adverse social consequences, competitive pressures through the possibility of further new entrants appear to have lowered retail margins. In some cases, MNEs, by their sheer size, can even eliminate competition by crowding out domestic producers. As integral parts of global value chains, MNEs have a built-in advantage (e.g., economies of scale and scope) over their local competitors. No absolute consensus on the positive effects of FDI have been reached by all governments or the general public, reflecting differences in economic conditions, specific histories of utilizing FDI, cultural variation, and ideological differences. However, greater flows of FDI across borders have increased the impact of FDI on national economies and the international economy as a whole, with the view widely held in Asia that the net effect was positive. It is notable that the policy framework everywhere plays an important role in determining the effects of FDI on a host country.
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