56703 Globalization and Technology Absorption: Role of Trade, FDI and Cross-Border Knowledge Flows Itzhak Goldberg, Lee Branstetter, John Gabriel What is Technology Absorption and Why is it Goddard and Smita Kuriakose Important? Key Messages1 Absorption is a costly learning activity that a firm can Countries in Europe and Central Asia (ECA) employ to integrate and commercialize knowledge and region can accelerate industrial technology that is new to the firm but not new to the world. development, worker productivity and Development of new-to-the-world knowledge can be economic growth by improving their ability considered innovation. In other words, innovation shifts a to tap into the global technology pool. notional technological frontier outward, while absorption moves the firm closer to the frontier. Examples of Trade flows, foreign direct investment (FDI), absorption include: adopting new products and research and development (R&D), and labor manufacturing processes developed elsewhere; upgrading mobility and training, are key channels for old products and processes; licensing technology; domestic knowledge absorption. improving organizational efficiency; and achieving quality certification. Table 1 defines some key terms that refer to Many of the Commonwealth of Independent absorption and innovation. States (CIS) and Southeast European countries (SEE) need to restructure Table 1: Taxonomy of Absorption and Innovation enterprises, ease the entry and exit of firms, improve access to credit, and accelerate the Absorption versus Innovation: New to the Firm versus "behind the border" reforms to benefit from New to the World trade openness to enable greater technology Absorptive capacity: a firms capacity to assess the absorption. value of external knowledge and technology, and make necessary investments and organizational changes to Introduction absorb and apply this in its productive activities. Examples of absorption: adoption of a new product or Improving the ability of ECA countries to tap into the process; upgrading of an old product or process; global technology pool is an important mechanism for utilization of a technology license. accelerating their industrial development, worker productivity and economic growth. Trade flows, foreign Product innovation: development of new products direct investment (FDI), research and development (R&D), representing discrete improvements over existing ones. and labor mobility and training, are widely accepted as key Process innovation: redesign of products or services; mechanisms for knowledge absorption. "soft innovation" (for example, reorganization of layouts, transport modes, management, and human resources). 1 This Knowledge Economy Study is part of an ongoing Regional Working Paper Incremental innovation: innovation that builds very Series sponsored by the Chief Economists Office in the Europe and Central Asia closely on technological antecedents and does not Region of the World Bank. involve much technological improvement upon them. ECA Knowledge Brief R&D, a key input for innovation, is an input into absorption reflect the extent to which ECA inventors are connected to as well. There are important complementarities between the global technological mainstream. innovation and absorptive capacity. Innovation promotes absorptive capacity because the generation of human capital While openness to trade and foreign investment allows and new ideas and the associated knowledge spillover firms to tap into and benefit from the global pool of effects help build absorptive capacity. Conversely, the knowledge, patent co-inventions can also help build these absorption of cutting-edge technology inspires new ideas global linkages, and in turn, create knowledge spillovers. and innovations. Within ECA, there are differences across countries, with Innovation and absorption of knowledge, which are central four clear leaders: Hungary, the Czech Republic, the forces behind economic growth, are in turn determined by Russian Federation, and Poland. Among these four, economic conditions and policies. Trade, FDI, R&D, and Hungary and the Czech Republic fare significantly better patents are ,,channels of absorption, providing conduits for than Russia and Poland (Figure 1). diffusion of knowledge between countries and absorption within firms. Different degrees of exposure to international Figure 1: U.S. Patents Granted by Country best practices through these channels affect absorption (per million population) outcomes. 9 U.S. patents granted per million 8 Properly designed economic policies can significantly 7 influence the degree to which a country absorbs new 6 Russia technology, as well as the decisions by firms to undertake population 5 Hungary investments that do so. The channels of technology 4 Poland absorption - trade, FDI, R&D - need a stable and conducive 3 Czech Republic policy framework and a business-friendly investment 2 1 climate. At the same time, a firms ability to absorb this 0 technology and knowledge depends on its organization and 2002 2003 2004 2005 2006 the skills of its workforce. Year patents granted Sources: USPTO Cassis CD-ROM, December 2006 version and World Technological Absorption in ECA Development Indicators, World Bank Patent Citations, International Co-invention, and From 1993 through the end of 2006, Russia, Hungary, Multinational Sponsorship of Local Invention Poland, Slovenia, the Czech Republic, Bulgaria, and Ukraine (ECA-7) obtained 5,489 U.S. patents, whereas The wealth of detailed information that patents and patent India-based inventors alone obtained 3,331, and China- citations contain offers a useful window into the based inventors obtained 4,063. The performance of the technological absorption process in ECA. While patents are ECA-7 countries has been much better on a per-capita basis. viewed as a form of intellectual property right over some of However, ECA-7 patenting in the United States has not an economys innovative outputs, patent citations provide a grown significantly in recent years, while India and China convenient metric of how existing ,,pieces of patented have surged ahead. There is also statistical evidence in knowledge have contributed to the creation and many ECA countries of the relative isolation of the R&D appropriation of new patented knowledge. The data on community from international technological trends: patent citations from the European Patent Office (EPO) and indigenous patents generally make fewer citations to the the U.S. Patent and Trademark Office (USPTO) can be used existing state-of-the-art than comparable patents filed in as proxy for the knowledge absorption process in order to other parts of the world, and they cite inventions that have a study flows of knowledge within ECA, and between ECA lesser impact in terms of citation patterns. Moreover, the and the rest of the world. The data can also help explore the number of indigenous patents in the ECA region is low knowledge flows and ,,spillovers present by tracing the relative to the level of R&D investment.2 citation pathways that link ECA inventions to prior inventions created in ECA and elsewhere in the world. The extent to which ECA inventors cite new technologies may indicate the extent to which inventors are grounded in the 2 While China and India spend 1.23 percent and 0.8 percent, respectively, of their recent state of the art. Patents created by teams that include GDP on R&D expenditures (see http://www.financialexpress.com/news/India- lags-China-in-RampD-spending-Sibal/283583/), the ECA-7 countries as a whole both ECA-based inventors and those in other regions can spend under 1 percent of GDP on R&D (see http://europa.eu/rapid/pressReleasesAction.do?reference=STAT/08/34&format=H TML&aged=0&language=EN&guiLanguage=en ). ECA Knowledge Brief On the positive side, international R&D collaboration has and 5 in several ECA countries, there are negative outliers allowed the ECA region to partially sidestep the handicap of such as Romania and Russia. Their TRIs are over three its own low R&D productivity, a problem rooted in the times higher than newly industrializing Indonesia and the regions insufficient grounding in the recent advances in the TRI of the United States. In terms of FDI inflows (see state of the art. A large fraction of ECA patents obtained in Figure 2), there is a visible intraregional disparity among the European Patent Organization are ,,co-invented with ECA countries. The 10 EU member countries from Central inventors in Western economies, and Germany plays a and Eastern Europe (EU10) and Southeast Europe (SEE), particularly important role. A co-invented patent is one such as Estonia and Bulgaria, are attractive for FDI. where at least one named inventor is located in the ECA Resource-rich countries such as Azerbaijan, and middle- region, and at least one inventor is located outside the income countries including Ukraine, are also attractive FDI region. destinations. However, countries like Belarus and Macedonia have been unable to attract much FDI. Foreign firms appear to be making a significant contribution Uzbekistan had zero FDI inflows in 2005. to ECA-region inventive activity. The local R&D operations of these firms, and their sponsorship of local inventors, Figure 2: FDI Inflows as a Percentage of GDP, 2005 generate a large fraction of the total patents emerging from Estonia ECA countries. This process of international co-invention Azerbaijan not only contributes to the quantity of ECA patents, but also Bulgaria raises the quality of ECA inventive efforts. Whereas Ukraine indigenous ECA patents lag behind other regions in terms Moldova of the degree to which they build on prior inventions and Georgia extend it, the ECA patents created through multinational Romania sponsorship are better connected to global R&D trends and Hungary generally represent inventions of higher quality. Armenia Croatia Science and innovation policy in the region should Latvia encourage ECA countries to promote international Slovak Republic collaboration and should support a greater role for the Lithuania private sector in knowledge generation. Governments Turkey should encourage foreign R&D investment and international Kazakhstan R&D collaboration. Bosnia and Herzegovina Trade and FDI in ECA and Their Link to Albania Poland Knowledge Absorption Tajikistan Kyrgyz Republic Openness to foreign trade and investment is critical to the Russian Federation process of technological absorption and diffusion, not only Macedonia, FYR for the competitive pressure it exerts on management and Slovenia corporate governance, but also for the exposure to global Belarus best practice technology and management techniques Uzbekistan provided to local firms. Exporting is another channel through which firms based in open economies can acquire 0 5 10 15 20 25 foreign knowledge about technologies and products. FDI as a percentage of GDP Source: World Development Indicators, 2007 While tariff barriers on trade are not high in many ECA countries, there remains a large, unfinished ,,behind the border structural and institutional policy agenda that would Survey and Case Study Analysis likely increase FDI and trade, and the related technology absorption. Enterprise surveys in ECA show that firms that sell to multinationals or engage in cooperative activities with ECA compares poorly with innovation comparators, multinationals seem more likely to introduce new (to the according to the World Banks World Trade Indicators firm) products and processes, upgrade existing products and database. The Trade Restrictiveness Index (TRI) captures processes, acquire new (to the firm) product or process the barriers to trade, with a higher TRI implying a greater technologies, and engage in a range of behaviors associated degree of restrictiveness. While the TRI averages between 4 with increasing technological sophistication. ECA Knowledge Brief Absorption requires tough decisions and large investments, Russian business environment. Many of these are a function as firms need to spend resources on modifying imported of government policies that limit FDI inflows and foreign equipment and technologies, and reorganizing production firm operations, especially in the services sector. Another lines and organizational structures. Case studies of ECA country where reform is needed is Kazakhstan, which privatized enterprises in Serbia highlight the important role has done more to lower its tariffs on goods than it has to of foreign investors in knowledge absorption, whether liberalize its barriers to FDI in the service sector. acquired through capital goods imports, exporting, hiring consultants and other knowledge brokers, or from licensing The Challenges Ahead for ECA technology. In conclusion, there is persuasive new evidence of the The Serbian case studies targeted FDI based on acquisition importance of trade openness, FDI, human capital, R&D, of existing assets from the government (privatization), or and knowledge flows for innovation and absorption in ECA. from private owners, rather than ,,greenfield3 FDI. The The countries in the region differ in their remaining reform analyses suggested, in general, that companies sold to agendas, both in general terms and in these areas in domestic investors were not able to increase exports in a particular, as well as in the relevant resource endowments significant way, while comparable firms receiving FDI did needed to effect the transition toward a more dynamic and much better. In addition, more significant changes in globally competitive knowledge economy. Additional product mix and manufacturing occurred in companies efforts toward the following objectives would contribute to bought by foreign investors. New directors were brought in knowledge absorption in ECA: from the multinational enterprises (MNE), the domestic investors holdings, from rival companies, or promoted Intensified international R&D collaboration and from within. In companies acquired by foreign investors, foreign R&D investment to enhance the integration the comparative advantage for R&D was in the adaptation of ECA in the global R&D community. of products and machinery to local conditions, rather than in innovation. For example, advanced formulas or product Progress on the unfinished ,,behind the border trade designs are transferred from the MNEs and adapted locally reform agenda to increase the openness of several ECA countries to global trade networks. so that the products can be manufactured efficiently in the acquired plants. Further opening to FDI to play an important role in encouraging knowledge absorption, The spillovers of FDI to other firms, or to the whole notwithstanding the opposition to FDI in some ECA economy, whether by diffusion of technological and other countries. knowledge, or by sharpening the incentives for domestic The rapid technological catch-up experienced in the more firms to upgrade their productivity, play a central role. The reformed economies is indicative of the fact that within-firm critical role of ,,brownfield4 FDI is to restructure the productivity improvements, rather than reallocation of acquired companies as expeditiously as possible. Early in resources, are increasing in importance as a source of the transition process, indigenous firms need the help of growth in ECA. The countries that are now member states foreign investors to acquire new technical competencies. In of the European Union increasingly participate in FDI- such cases, the beneficial role of FDI is seen in the company driven intra-industry trade, which is conducive to in which the foreign firm has invested. technology absorption. But many of the CIS and SEE Reduction of the remaining barriers to FDI in ECA could countries still need to restructure enterprises, ease the entry increase FDI and, given the positive relationship between and exit of firms, improve access to credit, and accelerate absorption and FDI, facilitate absorption. For example, the ,,behind the border reforms to benefit from trade Russia fares worse than other countries in the region, openness, and thus from technology absorption. attracting one of the lowest per-capita levels of FDI inflows. World Bank research has pointed to key shortcomings in the About the Authors ______________________________ Itzhak Goldberg, Former Advisor; Smita Kuriakose, Consultant; 3 Greenfield investment is de novo investment in a previously undeveloped site, John Gabriel Goddard, Economist; Private and Financial Sector where no facilities or plant existed. Development, Europe and Central Asia Region, World Bank. Lee 4 Brownfield investments are the acquisition of existing companies/facilities by Branstetter, Associate Professor, Carnegie Mellon University. foreign investors. "ECA Knowledge Brief" is a regular series of notes highlighting recent analyses, good practices and lessons learned from the development work program of the World Banks Europe and Central Asia Region http://www.worldbank.org/eca