Causes of the Increase in FDI Flows Across Countries

Growth literature

The significant increase in FDI flows across countries is a clear indication of globalization of the world economies over the past 2 decades. Neoclassical model of growth as well as endogenous growth models provides the basis for most of the empirical work on the FDI-GROWH relationship. According to the neoclassical growth theory, economic growth generally comes from two sources: factors accumulation and total factor productivity growth (Felipe, 1997). Growth is easier to quantity and analyse while difficulties abound in the measurement of the Total Factor Production growth due to the lack of appropriate economic modeling techniques as well as lack of appropriate data. Neoclassical growth projected that based on aggregate production function that relates the total output of an economy to the aggregate amount of the labour, human capital, physical capital and level of technology, poor countries will grow faster than rich countries. Neoclassical growth theory implies that return on capital stock should be higher in poor countries than in rich countries. This implies that the impact of FDI is limited to its output growth effect in the short run, with no change in the long run growth rate.

On the other hand, the Endogenous growth literature state that FDI can not only contribute to the economic growth through capital formation and technology transfers (Blomstrom et al.1996) but also do so through the augmentation of the level of knowledge through labour training and skill acquisition ( De Mello, 1999). Endogenous growth models emphasize on other channels including human capital accumulation and externalities or spillover effect through which FDI can promote growth in the long run. (Romer 1986, Loungani and Razin,2001). The three channels identify through which FDI affects growth; First, FDI increases capital accumulation in the host country by introducing new inputs and technologies (Dunning, 1993; Blomstrom et al. 1996). Second, FDI may stimulate knowledge transfers, both in terms of labour training and skill acquisition and by introducing alternative management practices and better organizational arrangements (De Mello, 1997).Third, FDI increases competition in the host country by overcoming entry barriers and reducing the market power of existing firms.

Channels of Growth

When a country’s foreign investment increase international production also increase rapidly, and thus investment only contribute towards the expansion of national markets but also larger scale regional and global markets( UNCTAD,1990). It is obvious that FDI will convey many benefits to the host country; one of them is economic growth. Hermes and Lensink(2000) has summarized different channels through which positive externalities related with FDI can arise namely: i)competition channel where increased competition is likely to result in increased productivity, investment in human and physical capital and efficiency. Increased competition may lead to changes in the industrial structure towards more competitiveness and more export oriented activities. ii) Training channel through increased training of labour and administration. FDI can also increase the quality of domestic human capital and improve the knowhow and managerial skills of local firms. (learning by watching effect) iii) Linkages channel whereby foreign investment is often accompanied by technology transfer. FDI can encourage the adoption of new technology in the production process through capital spillovers. According to De Mello (1997) and OECD (2002), FDI affect growth is likely to depend on the economic and technological conditions in the host country. Therefore, technological spillover is possible only when there is certain minimum or threshold level of human capital available in the host country (Borensztein, et al. 1998) iv) domestic firms imitate the move advance technologies used by foreign firms commonly termed as the ‘demonstration channel’. By adapting new technologies and ideas (i.e. technological diffusion) they may catch up to the levels of technology in developed countries. The use of new technologies may be important in contributing to higher productivity of capital and labour in the host country. Local firms have an opportunity to improve their efficiency by learning and interacting with foreign firms.

Benefits of FDI

The economic rationale for offering special incentive to attract FDI frequently derives from the belief that foreign investment produces externalities in the form of technology transfers and spillovers. Spillover effects may take place when the entry or presence of foreign firms leads to productivity and efficiency benefits in the host country’s local firms (Blomström and Kokko 1998).

There are two forms of spillover effects that foreign firms bring to the local industries which are Inter- and intra- industry spillover effects.

Horizontal spillover also called intra-industry spillovers correspond to technological externalities associated with specific knowledge, such as management strategy and know-how and superior production techniques. Kokko (1996) argue that domestic firms benefits from the entry of foreign firms competition, imitation and workers’ productivity. Local firms will allocate more resources to product development and quality assurance in order to remain competitive.

Gorg and Greenaway (2004) state that there are 4 channels through which horizontal spillover might occur

1. Imitation which involves simulation of exclusive technology, management and marketing skills of foreign firms such that it will improve the productivity of local firms( Halpenn and Murakozy,2007)
2. Human capital and labour turnover; Gory and Greenaway (2004) identify two mechanisms through which there is productivity spillover. First a direct spillover to complementary worker, as skilled labour working alongside labour tends to raise productivity of the latter.

Second, workers that move carry knowledge with them new technology, new management techniques and consequently can become direct agents of technology transfer.

3. Competition- as competition increase due to foreign firms, domestic firms have to introduce new technology in order to increase their efficiency(Glass and Saggi,2002)
4. Export- local firms can learn penetration tactics which are viewed as essential for the export market. Hence they may experience cost reduction with exportation

Recent studies based on micro-level panel data call into question the evidence of positive spillover and find either insignificant or negative intra industry spillovers. Haddad and Harrison (1993) find no significant relationship between the level of FDI and domestic firm’s productivity growth in the same sector for Morocco in late 80s. Aitken and Harrison (1999) find a negative relationship between the two variables for Venezuela manufacturing industries for the period 1970 to 1980.

Vertical spillover also known as inter-industry spillovers consists of externalities occurring due to FDI through backward and forward linkages to input market. Usually when MNE make transaction with local suppliers and customers it may lead to the transfer of technology and know-how which subsequently will improve the intermediate product.

MNE can increase the demand for the local input as a backward link to intermediate good suppliers hence increasing the productivity of domestic firms. Productivity can also be increase through forward linkages when domestic producers purchase more sophisticated intermediate goods from MNEs.

Moran (2001) states that there are case studies which show that knowledge is transferred from downstream foreign affiliates to upstream, training and assistance as well as supervision in implementation of new technologies