Foreign Direct Investment, Backward Linkages, and Productivity Spillovers IN FOCUS What Governments Can Do to FINANCE, COMPETITIVENESS & Strengthen Linkages and Their Impact INNOVATION Jacob Jordaan, Wim Douw, and Christine Zhenwei Qiang INVESTMENT CLIMATE © 2020 The World Bank Group 1818 H Street NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org All rights reserved. This volume is a product of the staff of the World Bank Group. The World Bank Group refers to the member institutions of the World Bank Group: The World Bank (International Bank for Reconstruction and Development); International Finance Corporation (IFC); and Multilateral Investment Guarantee Agency (MIGA), which are separate and distinct legal entities each organized under its respective Articles of Agreement. We encourage use for educational and non- commercial purposes. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Directors or Executive Directors of the respective institutions of the World Bank Group or the Governments they represent. The World Bank Group does not guarantee the accuracy of the data included in this work. Rights and Permissions The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. All queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: pubrights@worldbank.org. Jacob Jordaan is a World Bank Group consultant and Assistant Professor at the Utrecht School of Economics. Wim Douw (wdouw@ifc.org) is Senior Private Sector Specialist and Christine Zhenwei Qiang (cqiang@worldbank.org) is the Practice Manager for the Investment Climate Unit within the Equitable Growth, Finance and Institutions Practice Group of the World Bank Group. They would like to thank the following colleagues: Peter Kusek, Ulla Heher, Ivan Nimac, and Abhishek Saurav for their valuable inputs and contributions. Editing: Nancy Morrison Design and Layout: Aichin Lim Jones Photo Credit: Shutterstock.com Table of Contents INTRODUCTION 3 MNC AFFILIATES AND PRODUCTIVITY SPILLOVERS 3 BACKWARD LINKAGES 6 INTER-FIRM LINKAGES AND TECHNOLOGY TRANSFERS 7 MNC AFFILIATES AND PRODUCTIVITY SPILLOVERS AMONG LOCAL SUPPLIERS 8 FDI LINKAGES AND PRODUCTIVITY SPILLOVERS: MARKET FAILURES, CONSTRAINTS, AND THE SCOPE FOR POLICYMAKING 9 HOST ECONOMY POLICYMAKING: SOME GUIDING PRINCIPLES 12 CONCLUSION 13 REFERENCES 15 FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS | 1 2 | FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS Introduction T his note provides an up-to-date summary of the academic evidence around the drivers and channels for technology transfer and productivity spillovers by multinational corporations (MNC) operating in host economies. Foreign direct investment (FDI) is a major contributor to development. Besides the direct benefits FDI brings in terms of increased capital, employment and exports, the presence and operations of MNCs can also help improve the productivity of local firms through backward linkages and offer an important channel for the integration of local firms into global value chains (GVC). However, several market failures exist that get in the way of these linkages and spillovers fully materializing. This note highlights the main challenges as well as some policy recommendations for host economy Governments to consider. Despite the growing popularity of attracting FDI as This note presents and discusses the main findings a development strategy, the large body of empirical from an extensive survey of the recent literature on evidence shows that productivity spillovers do not productivity spillovers from FDI through supplier occur automatically and are context specific. Two linkages (Jordaan, Douw, and Qiang forthcoming). main factors influence the degree of spillovers from It then uses these findings to construct a framework MNC affiliates. The first factor is variations in the that shows the various phases that underlie the characteristics of both foreign and domestic firms attraction, sourcing behavior, and spillover impact (firm-level heterogeneity), which influence the of MNC affiliates to identify key areas where extent of use of local suppliers, the nature and level host economy governments can implement “soft” of technology dissemination, and the performance industrial policies to foster the extent and impact improvements that domestic firms may make. The of linkages between FDI and local suppliers. The second factor consists of host economy conditions final sections present several guiding principles and government policies. The attraction of a for effective policy making and provide some sufficient level of MNC investments is necessary conclusions. but not sufficient to ensure that domestic firms benefit from productivity spillovers. Host economy MNC Affiliates and Productivity governments need to provide an economic environment in which MNC affiliates and domestic Spillovers firms can operate efficiently and where the extent MNCs play an important role in growth and effects of inter-firm linkages between these two processes of most developing and emerging types of firms are facilitated. economies. MNC affiliates can generate In this document, a multinational company (MNC) refers to a company with one or more affiliates located in countries (host 1 economies) other than where the company’s headquarters are located (home economy). MNC affiliates refer to the affiliates located in host economies. Local and domestic firms refer to companies that are indigenous to the host economies. FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS | 3 a number of direct positive effects in host supply inputs to domestic firms. The other type economies by fostering higher levels of capital consists of backward spillovers, created by investment, introducing new industrial activities, technology dissemination between MNC affiliates creating direct and indirect employment effects, and domestic suppliers. The evidence shows and stimulating international trade. Furthermore, that backward spillovers occur most frequently, indirect effects occur when domestic firms improve indicating that input-output linkages between MNC their performance as a result of the presence and affiliates and domestic suppliers constitute the main operations of MNC affiliates. These indirect effects, channel of productivity spillovers. which arise in the form of productivity spillovers, are a central feature of the economic benefits Input-output linkages between FDI and local provided by MNC affiliates. suppliers create productivity spillovers for various reasons. First, MNC affiliates exercise Technology dissemination creates productivity stronger demands on local suppliers regarding the spillovers. MNC affiliates incorporate modern quality of inputs, cost-effectiveness, and so on. Even and advanced knowledge, technologies, and in the absence of technology dissemination, this management practices. Productivity spillovers can lead to productivity spillovers, when domestic occur when domestic firms absorb and implement firms respond to these stringent demands by these technologies and new skills and improve improving their performance. Second, markets for their performance. Productivity spillovers intermediate inputs can facilitate the unintentional can be transmitted via several channels (Görg dissemination of knowledge and technologies, and Greenaway 2004). One channel is the as firms frequently share information on product demonstration effect, whereby domestic firms specifications and production processes. Also, learn about, observe, and copy technologies that MNC affiliates screen and evaluate (potential) are used by MNC affiliates. Another channel is suppliers, providing information, feedback, and inter-firm labor mobility, whereby domestic firms suggestions for improvement to these suppliers. benefit from employing workers that previously Third, MNC affiliates are often actively involved worked for MNC affiliates, bringing with them in the provision of support and the dissemination new knowledge, skills, and experience that they of new technologies to their suppliers in return for gained while working for foreign-owned firms. higher-quality and more cost-effective inputs. The third channel is inter-firm linkages, through which domestic firms obtain new knowledge and The process underlying backward spillovers can technologies from MNC affiliates that purchase be decomposed into three related parts. Figure inputs from them or MNC affiliates that supply 1 depicts the process and its main components. inputs to them. The first component relates to the level of sourcing by MNC affiliates in host economies. The second Backward spillovers are the most important component concerns the degree and types of type. The original interest in FDI spillovers technology transfer that MNC affiliates provide to focused on horizontal spillovers, referring to cases their local suppliers, fostering the dissemination whereby domestic firms absorb and implement of new knowledge and technologies. The third knowledge and technologies from MNC affiliates component is the degree to which technology operating in the same industries. The vast body of dissemination leads to productivity improvements evidence indicates that horizontal spillovers are among domestic firms. Table 1 lists a number of economically not important (Havranek and Irsova factors that are important for these components. All 2012). In contrast, there is substantial evidence of three components are influenced by characteristics positive vertical FDI spillovers. One type consists of MNC affiliates and domestic firms, and by a of forward spillovers, caused by technology set of additional factors related to host economy dissemination by means of MNC affiliates that conditions. 4 | FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS Figure 1. Local Inputs, Technology Dissemination, and Productivity Spillovers Inputs MNC Afflilate Productivity Spillovers Domestic Supplier New Knowledge, Technologies & Standards Table 1. Factors Influencing Backward Linkages, Technology Dissemination, and Productivity Spillovers Use of Local Suppliers Technology Transfers Productivity Spillovers MNC MNC-related factors MNC-related factors MNC-related factorsMarket Affiliates • Market-seeking • Efficiency-seeking seeking • Percent of foreign ownership • Percent of foreign ownership • Percent of foreign ownership • Level of autonomy • Level of local sourcing • Nationality • Nationality • Level of autonomy • Distance to home country • Cultural and institutional proximity to • Company policy • Cultural proximity to host economy host economy • Level of development home Other firm characteristics economy Other firm characteristics • Size • Size, age, and production processes Domestic • Lack of availability of inputs • Firm size Absorptive capacity Suppliers • Quality of inputs • Experience with supplying MNC • Firm size • Cost competitiveness affiliates • Export status • Reliability of supply • Experience with international • R&D involvement • Limited scale of production markets • Technology gap with client firms processes • Commitment to develop linkages with foreign-owned clients • Participation in global value chains Additional • Level of economic development of • Nature of input-output market • Agglomeration of economic activity Factors the host economy • Selection process to identify • Geographical proximity between • Geographical proximity between suitable domestic suppliers MNC affiliates and domestic firms MNC affiliates and domestic firms • Access to finance for suppliers to • Human capital • Sector make investments that support • Trade openness • Infrastructure technology transfers • Level of economic development • Quality of institutions (such as host economy contract enforcement, and red tape) • Access to finance Source: Based on the survey of empirical findings in Jordaan, Douw, and Qiang, Fortchoming. FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS | 5 Backward Linkages Nationality or country of origin can influence the use of local suppliers in several ways. MNC affiliates Several characteristics of MNC affiliates use more local suppliers when the affiliates’ home influence their use of local suppliers. Market- and host economies are culturally and institutionally seeking FDI (MNC affiliates that operate in host more similar. Another reason why country of origin economy markets to serve host economy markets) can affect the use of local suppliers is that high tend to use more local suppliers than efficiency- transportation costs can prevent MNC affiliates seeking FDI (MNC affiliates that operate in host from using suppliers from their home economies. economies to produce intermediate inputs and Finally, the nationality of MNCs can also play a products more efficiently). An important reason more indirect role by influencing other affiliate why market-seeking FDI uses more local suppliers characteristics such as investment motive, mode of is that these suppliers can adjust products to local investment, and an affiliate’s level of autonomy. conditions. However, there are indications that the investment motive is becoming less important Several other characteristics of MNC affiliates as a factor influencing local sourcing. One reason that do not relate to their affiliation with MNCs for this is that growing levels of trade openness of influence the level of use of local suppliers. Large host economies increase the pool of international MNC affiliates tend to source a lower percentage suppliers accessible to MNC affiliates. Another of their inputs in host economies, as they demand reason is that a growing number of MNC affiliates in inputs at volumes that usually exceed the capacity international production networks are characterized of most local suppliers. Firm age or experience by both market-seeking and efficiency-seeking also matters; it takes time to identify suitable motives to varying degrees, valuing both access to suppliers and create local linkages. The literature host economy markets and the efficient use of host survey confirms that MNC affiliates that have been economy resources (Baldwin and Okubo 2014). operating in host economies for a number of years have higher levels of local sourcing. The nature Familiarity with domestic firms facilitates local of production processes is also important. MNC sourcing. MNCs can enter a host economy in affiliates with production processes characterised various ways: by creating a new production facility, by assembly-style operations tend to source fewer acquiring an existing domestic firm, or establishing inputs in their host economies. In contrast, MNC a new production facility together with a domestic affiliates with production processes that rely more firm in the form of a joint venture. The available on the processing and use of intermediate parts and evidence indicates that MNC affiliates with some components source more inputs locally. Several level of local participation use more local suppliers. studies also report substantial differences between One reason may be that participating domestic firms industries regarding the degree that MNC affiliates are more familiar with the host economy, facilitating use local suppliers. the identification and use of local suppliers. Characteristics of domestic firms also help MNC affiliates that have a high level of sourcing determine whether MNC affiliates will use them autonomy within the MNC organizations to which as local suppliers. Evidence points to the important they belong generally have higher levels of local concept of ‘absorption capacity’ of local firms in sourcing. In contrast, affiliates of MNCs that operate predicting productivity spillover outcomes from centralized sourcing policies have much less scope engagement with MNC affiliates. World Bank and flexibility to change their use of local suppliers. Group research also shows that high growth status, Other business functions where the level of exporter status, R&D expenditure and geographic autonomy has been found to increase local sourcing proximity to MNC affiliates are among the important include supply, logistics, production development, indicators that increase the likelihood of a local firm and marketing activities. becoming a supplier to MNC affiliates. However, the primary factor that limits the level of local 6 | FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS sourcing is the unavailability of inputs. Regarding a high level of local sourcing also provide a high inputs that are (or could be potentially) sourced in level of supportiveness. However, the relationship host economies, MNC affiliates often indicate that between local sourcing and the provision of problems related with the quality of inputs, their technology transfers is more complex. One reason cost-competitiveness, the reliability of supply and why high local sourcing can occur with low levels the limited scale of suppliers’ production volumes of support is that high levels of local sourcing are all limit their use of local suppliers. Ongoing the result of technology transfers that MNC affiliates processes of economic liberalization and decreasing provided in earlier phases when they were helping trade costs increase the importance of these barriers local suppliers improve their production processes. because they make it easier for MNC affiliates to Another reason is that MNC affiliates may be use international suppliers instead of local suppliers. sourcing mainly low value-added commodities and routine inputs from local suppliers, which does not Inter-firm Linkages and Technology provide any incentives to the foreign firms to create supportive linkages (Amendolagine et al. 2019). Transfers Characteristics of MNC affiliates influence The level of autonomy of MNC affiliates enhances technology transfers. MNC affiliates that produce technology transfers. Similar to the level of use for international markets tend to have a stronger of local suppliers, the evidence also indicates that commercial motivation to support their local affiliates that operate with a certain amount of suppliers. Because product specifications and autonomy within their MNC organization are more requirements are often more stringent for products engaged in providing technology transfers to their destined for international markets, MNC affiliates local suppliers. are more inclined to offer support to local suppliers Large MNC affiliates tend to be more involved in to ensure the quality of their inputs. providing support to their local suppliers. Larger MNCs may have company policies to promote firms have more resources to provide technology economic development. Case study research shows transfers and help their local suppliers improve that there can be marked differences between their performance. MNC affiliates in terms of their overall level of Technology transfer is greater among domestic supportiveness and their underlying intentions firms the actively try (self-select) to become to help local suppliers improve their structural domestic suppliers to MNC affiliates. Just performance. The cause of such differences can as MNC affiliates screen and select their local be traced back to explicit company policies of suppliers, domestic firms also undergo a process some MNCs to create positive impacts in the host of self-selection, whereby domestic firms with economies in which their affiliates operate. more capabilities (try to) become suppliers to MNC Fully foreign-owned MNC affiliates are less affiliates (Javorcik and Spatareanu 2009). The likely to provide technology transfers. MNC effectiveness of technology transfers that MNC affiliates that have some level of host economy affiliates provide is enhanced by this selection effect participation tend to provide support more often because these domestic firms are more committed than MNC affiliates that are fully foreign owned. to creating successful linkages and are better able to As with the level of use of local suppliers, benefit from technology dissemination and support. increased familiarity with domestic suppliers Global value chains (GVCs) are not automatically facilitates the provision of support. conducive to the dissemination of technologies The relation between the level of use of local and the creation of productivity spillovers. suppliers and technology transfers is not uniform. In The growing importance of GVCs in world trade general terms, it is assumed that MNC affiliates with is offering firms in developing countries a new FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS | 7 mode of export-based development. By joining these affiliates use are more suitable to production international production networks, they obtain processes of local suppliers, facilitating their access to international markets and become exposed dissemination and absorption. to new knowledge and technologies that can foster learning and technological development (Taglioni MNC affiliates with some level of host economy and Winkler 2016). However, firms in most participation generate larger productivity developing economies that participate in GVCs spillovers, much of the evidence on the effect of the provide commodities and simple material inputs degree of foreign ownership of MNC affiliates on and services, limiting the scope for such effects. productivity spillovers suggests. MNC affiliates that Furthermore, GVCs where domestic suppliers are not fully foreign owned tend to purchase more provide commodities and routine inputs are usually local inputs and provide more support, increasing characterized by pure market transactions (buying the exposure of domestic firms to new knowledge and selling) between MNCs and domestic firms— and technologies. transactions that are not conducive to technology Evidence on the effect of nationality or country dissemination. MNCs also have little incentive of origin is largely similar to the findings on to provide support to such suppliers when they drivers of the level of use of local suppliers. experience difficulties in meeting product standards Some studies find that cultural proximity between and specifications. This challenge seems especially MNC affiliates and host economies results in prevalent in so-called “buyer-driven” GVCs, such larger productivity spillovers. Other evidence as e.g. the global Apparel industry and value chain. indicates that a large distance between the home and host economy of MNC affiliates leads to MNC Affiliates and Productivity larger productivity spillovers, as it fosters the use Spillovers among Local Suppliers of local suppliers Also, there is some evidence indicating that the level of development of the Productivity spillovers occur most frequently. home economy of MNC affiliates has a positive Most of the quantitative evidence on backward effect on productivity spillovers, suggesting spillovers consists of positive associations between that MNC affiliates from more developed home the scale of the presence of MNC affiliates and economies incorporate technologies that have productivity of domestic firms in industries that more potential to create spillovers. supply inputs. Although less plentiful, there is also evidence that local suppliers are more likely The absorptive capacity of local suppliers to start exporting or intensify existing exporting is important for productivity spillovers. It is activities. Similar evidence exists indicating that increasingly recognized that productivity spillovers MNC affiliates can also exercise positive effects on are facilitated or even conditional on domestic firms innovation and on the levels of complexity of the possessing a sufficient level of absorptive capacity, products of local suppliers (Javorcik, Lo Turco, and allowing them to absorb technologies and benefit Maggioni 2018). from support from their foreign-owned client firms. As absorptive capacity is not directly observed, Characteristics of MNC affiliates are associated evidence that indicates its importance consists of with productivity spillovers. MNC affiliates that positive effects of several firm-level characteristics produce for host economy markets are usually found related to absorptive capacity on productivity to create larger spillovers among local suppliers. spillovers. An example is a recent study by the An explanation for this may be that MNC affiliates World Bank that finds for a large sample of domestic that produce for host economy markets use more firms in 122 developing and emerging economies local suppliers, increasing the exposure of domestic that only the more economically dynamic domestic firms to modern technologies and technological firms—measured by relative employment growth— support. Also, it may be that the technologies that experience positive backward spillovers (World 8 | FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS Bank 2018). Other domestic firm characteristics that FDI Linkages and Productivity are found to exercise a positive effect include firm Spillovers: Market Failures, size, whether suppliers have experience producing for international markets, their level of human Constraints, and the Scope for capital, and whether they are involved in research Policymaking and development (R&D) activities. There is ample scope for host economy governments to implement policies that foster A large technology gap increases the scope for inter-firm linkages and their effects, given productivity spillovers. In most cases, MNC that characteristics of MNC affiliates, domestic affiliates are technologically more advanced than firms, and host economies all affect the extent and domestic firms. The size of technological differences impact of backward linkages. Successful policy between FDI and domestic firms—the technology making must address a number of market failures, gap—influences the type and extent of productivity constraints, and conditions that influence the various spillovers. Very large technological differences components of the processes underlying linkages between FDI and local suppliers make it difficult and productivity spillovers. Figure 2 depicts the for any productivity spillovers to occur. However, a processes underlying the creation of linkages and small technology gap between foreign and domestic productivity spillovers, distinguishing between four firms implies that there is only a limited scope areas: attracting and facilitating MNC investments; for suppliers to learn, reducing any productivity backward linkages between MNC affiliates and spillovers that may arise. In contrast, a somewhat domestic suppliers; technology dissemination, larger technology gap may result in more substantial absorption, and performance improvements among productivity spillovers because there is much more local suppliers; and host economy characteristics scope for domestic suppliers to learn and improve that affect the operations and performance of FDI (Jordaan 2017). Of course, a large technology and domestic firms (Jordaan, Douw, and Qiang gap also implies that it can be more difficult for forthcoming). productivity spillovers to occur, underlining the importance that local suppliers possess a sufficient Host economy governments need to target level of absorptive capacity. suitable MNC investments. The attraction of a sufficient level of MNC investments is a prerequisite Agglomeration and geographical proximity for meaningful productivity spillovers. However, foster productivity spillovers. Agglomerations of host economy governments also need to target those economic activity result in productivity premiums MNC investments that are likely to create inter-firm because they facilitate inter-firm linkages and linkages and productivity spillovers. They need knowledge spillovers (Duranton 2015). MNC to learn about MNCs to understand their attitude affiliates that locate in a geographic area or sector about local sourcing and supporting local suppliers. characterized by an agglomeration of economic Furthermore, a number of firm- level characteristics activity within a host economy will find it easier of MNC affiliates and domestic firms influence the to identify local suppliers and create linkages with use of local suppliers and the creation of technology them, resulting in a higher level of local sourcing. transfers. Host economy governments need to Geographical proximity between domestic and examine these characteristics in order to identify foreign-owned firms also facilitates communication MNC investments that are prone to creating linkages and technology dissemination, thereby nurturing and have the potential to generate performance and enhancing productivity spillovers (Jordaan and improvements among domestic suppliers. Monastiriotis 2018). In contrast, domestic firms that are not located close to MNC affiliates will find Efforts by government to attract MNC it much more difficult to operate as suppliers and investments and by MNCs to increase FDI are benefit from knowledge spillovers. limited by information asymmetries. MNCs often FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS | 9 Figure 2. Attracting and facilitating MNC investments: Backward linkages between MNC affiliates and domestic suppliers Imports MNC Investment Foreign Supplier Located Inputs in Host Economy MNC MNC Productivity Domestic Afflilate New Knowledge, Spillovers Supplier Technologies & Standards Host Economy Characteristics FDI policies, economic development, economic liberalization, education, infrastructure, financial sector, trade openness, legal institutions have incomplete and imperfect information about becomes even more constraining when domestic possible locations for new investments. Similarly, firms need to improve their performance before they host economy governments that want to attract new are able to meet any (potential) demand by MNC MNC investments have imperfect information about affiliates for local inputs. Because it is costly and all the location factors that are important for MNCs. time-consuming to solve these informational market Such imperfect information will lower levels of failures, they often result in fewer linkages between MNC investments into host economies (Harding MNC affiliates and domestic firms. and Javorcik 2011), reducing opportunities for local sourcing and productivity spillovers. By engaging The liberalized international economic with MNCs, providing them with more information, environment increases the importance of solving and learning about their specific investment needs, market failures in local input markets. MNC host economy governments can address this market affiliates can obtain economic benefits from solving failure and attract higher levels of MNC investments market failures in input markets, as local sourcing (Heilbron and Aranda Larrey 2020; Heilbron and facilitates communication and coordination and Whyte 2019). lowers transport costs. However, due to decreasing trade costs and the growing liberalization of the Imperfect information and information asymmetry international economic environment, the use of also hamper efforts by MNC affiliates to use local foreign suppliers that are either located in host suppliers, and for local firms to work with MNC economies or in other countries is increasingly affiliates. Especially when MNC affiliates are new seen as viable alternative sourcing strategies. to a host economy, input markets provide incomplete This is the case especially for more sophisticated information about the availability and quality of inputs—precisely the types of inputs that are domestic suppliers. Similarly, domestic firms often do more likely to be associated with technology not know what types of inputs the affiliates may want dissemination and productivity spillovers. The to source locally, what their product standards and liberalized international economic environment requirements are, and so on. This lack of information increasingly places domestic suppliers in direct 10 | FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS competition with foreign suppliers, making it more Governments can play an important role as important that market failures and constraints in facilitators of technology dissemination. The local input markets are addressed to increase the provision of technology transfers by MNC affiliates competitiveness of local suppliers. is motivated by clear cost-benefit considerations, comparing the costs of providing technological Governments can implement a variety of support with the benefits of obtaining higher quality policies to address market failures in local and more cost-effective local inputs in return. Host input markets. To lower the costs associated economy governments can work together with with identifying (potential) demand and supply MNC affiliates and local firms to identify the types of inputs, governments can create databases of technological support that are most important containing sector-specific information about local and assist in devising ways to deliver this support firms that want to become suppliers to MNC efficiently, thereby lowering costs for the foreign affiliates. This can be done in combination with firms. Various incentive instruments have been tried the provision of qualification and certification and tested by governments to support MNC affiliates programs for domestic firms that make it easier in this process (Sabha et al.). Also, host economy for MNC affiliates to identify suitable local governments can create systematic supplier suppliers. Match-making and networking events development programs in which MNC affiliates also facilitate the creation of backward linkages. and domestic firms jointly participate, ensuring that They bring MNC affiliates and domestic firms into the support provided by the foreign firms is used direct contact, allowing them to share information by participating domestic firms to produce higher about potential input demand and supply and quality and more cost-effective inputs. explore the possibilities for business relationships. Governments can help domestic firms benefit Governments can support the extent of backward from technology dissemination. The strong linkages by improving the local supplier base. evidence that the absorptive capacity of domestic The use of local suppliers can create important cost firms plays a central role in achieving productivity savings for MNC affiliates. Therefore, policies that spillovers indicates that policies that help domestic improve the capabilities and competitiveness of firms absorb new technologies will be particularly local suppliers of available inputs can increase the beneficial. Improving the absorptive capacity of extent of backward linkages. The lack of availability domestic firms is important—especially because of inputs is the primary factor limiting local the scope for productivity spillovers is most sourcing by MNC affiliates. Thus, it is important favorable when there are substantial technological that policies to improve the supplier base are differences between MNC affiliates and domestic based on a thorough understanding of the industry- firms. Governments can disseminate information specific needs and possibilities of MNC affiliates about new technologies and provide training and domestic firms and have well-grounded goals. programs to enable domestic firms to benefit A solid understanding of economic sectors and from technology transfers. Moreover, MNC consultations with MNC affiliates will help in affiliates that provide technology transfers expect determining the feasibility of promoting the local domestic firms to make investment themselves provision of new types of inputs, especially in the to benefit from these transfers and become better context of competition from international suppliers. suppliers. Governments can implement policies to As alternative, host economy governments may help domestic firms access necessary funding or consider attracting foreign firms that are able to financing to target investments so that the effects of provide these inputs, thereby improving the local technology dissemination are strengthened. supplier base and increasing the attractiveness of the host economy for further MNC investments. FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS | 11 Host economy governments need to provide economies include infrastructure, labor markets, an economic environment that allows MNC financial institutions, and research and development affiliates and domestic firms to operate efficiently activities. In designing and implementing policies to and that is conducive to inter-firm linkages and invest in these areas, it is important for governments technological development. Three dimensions to work with MNC affiliates and domestic firms of the host economy are particularly important for to find the right balance between ensuring that the linkages and productivity spillovers. effects of these investments are generally available (nonexcludable), while addressing the specific First, there has to be a clear FDI policy in place that needs of MNC affiliates and local suppliers. creates a business environment that is conducive to the entry, start up, and long-term operations of MNC affiliates. Host economy governments need to pursue Inter-firm Linkages and Policy- transparent and long-term policies that support new making: Some Guiding Principles and existing MNC affiliates and provide a variety The varied evidence on the occurrence and of services that address the specific conditions and the drivers of productivity spillovers through needs of these foreign firms. backward linkages indicates that there is ample Second, the economic environment needs to enable scope for host economy governments to enhance foreign and domestic firms to operate efficiently. This these linkages and their effects. It is increasingly direction is in line with contemporary development recognized that host economy governments should strategies that are based on creating open and not aim to do this through the implementation of liberalized economies that allow for the most restrictive and interventionist measures. Instead, efficient and productive firms to grow and thrive. It host economy governments need to focus on is also important that economic institutions are in designing a range of “soft” industrial policies place that support such an economic environment, (Harrison and Rodriguez-Clare 2010), fostering including the pursuit of investment and trade backward linkages, and helping domestic firms policies that promote nondiscriminatory access compete and benefit from productivity spillovers. to international markets and a reliable legal and Some guiding principles follow. regulatory framework that facilitates the integration Pursue policies that will enhance the of global value chains through FDI or the integration competitiveness of MNC affiliates. The use of local of local firms in supply chains. suppliers is directly linked to the competitiveness Third, host economy governments need to invest of MNC affiliates. MNC affiliates use cost-benefit in elements of the economic environment that considerations to decide on the level and nature provide public goods and/or are characterized of local sourcing. They will increase their use by indivisibilities. A good example is education. of local suppliers when doing so improves their Although individual MNC affiliates can contribute competitiveness. Policies to increase the extent of to improving the level of human capital by providing backward linkages between MNC affiliates and educational and training programs to their workers, domestic firms need to aim at lowering the costs the scale of these investments is necessarily limited and increasing the benefits that foreign firms can compared to the overall returns to a country or region obtain from using more local suppliers. in investing in quality education. Therefore, host Target appropriate MNC affiliates. Host economy governments need to invest in providing economy governments need to focus on attracting education programs that allow entire sectors and and facilitating the operations of MNC affiliates industries to benefit from a well-trained workforce. that have an interest in increasing local sourcing Other areas where such aggregate investments and improving local suppliers. Attracting MNC can be made that improve the functioning of affiliates that are technologically substantially more individual firms as well as entire industries and advanced than domestic firms ensures that there is 12 | FOREIGN DIRECT INVESTMENT, BACKWARD LINKAGES, AND PRODUCTIVITY SPILLOVERS sufficient scope for local suppliers to benefit from Establish and maintain long-term goals and productivity spillovers. commitment. Host economy governments must recognize that it takes time for MNC investments Target appropriate domestic firms. Host economy to be targeted, inter-firm linkages with domestic governments need to target policy making at those firms to be established, and productivity spillovers domestic firms that are (potentially) the best suited to occur. This is especially important in cases to act as long-term suppliers to MNC affiliates and where governments need to invest in developing improve their capabilities to maximize productivity the capabilities and absorptive capacity of domestic spillovers. Policies should be targeting those local firms—often before any meaningful economic firms that (potentially) have high levels of absorptive effects from backward linkages have occurred. capacity, show a clear commitment to want to Governments need to devise and openly commit work with MNC affiliates, and are willing to take to long-term goals in their policy making aimed ownership of the performance improvements that at supporting backward linkages between MNC are required to create successful sourcing linkages affiliates and domestic suppliers. and productivity spillovers. Ensure that technology dissemination benefits Conclusion both MNC affiliates and domestic firms. Policies Productivity spillovers do not happen automatically that aim to enhance technology dissemination and are context specific. Variations among firms (firm are most effective when they ensure that MNC heterogeneity) is very important, as characteristics affiliates benefit from providing support. Supplier of both MNC affiliates and domestic firms influence development programs in which domestic firms the level of use of local suppliers, the nature and commit themselves to using technology transfers to degree of technology dissemination, and the extent create better-quality and more cost-effective inputs to which domestic firms are able to benefit from for MNC affiliates will increase the magnitude and productivity spillovers. Furthermore, host economy quality of technological support that affiliates are conditions also influence productivity spillovers, willing to provide. affecting efficiency levels of both types of firm as Address market failures at the micro (firm) level. The well as the extent and impact of backward linkages. extent and effects of backward linkages are affected The variability of evidence across firms, industries, by a number of market failures in the areas of and host economies on the extent of backward linkages information and coordination. Government policies and productivity spillovers indicates that there is that aim to solve market failures that obstruct substantial scope for host economy governments to linkages and limit technology dissemination and implement policies that foster backward linkages productivity growth need to be targeted at the firm and their effects. Suitable policies include attracting level where possible. the right type of MNC investments; assisting MNC Recognize that location matters and support affiliates in identifying and establishing linkages localized development policies. Agglomeration of with suitable domestic suppliers and providing economic activity enhances the creation of linkages, support to them; and helping domestic suppliers technology dissemination, and productivity benefit from technology dissemination and create spillovers. Policy making aimed at attracting MNC performance improvements. 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