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Little evidence of positive spillovers from FDI

by Chakravarthi Raghavan

Geneva, 17 Oct 2000 - There is “weak evidence” that foreign direct investment (FDI) into developing countries generates positive spillovers for host economies, and countries are likely to be better served by being cautious about promoting FDI until there is strong empirical evidence that “the social rate of return on FDI exceeds the private rate of return.”

This is the broad conclusion of a study by Prof. Gordon Hanson, of the Department of Economics and School of Business Administration at the University of Michigan (USA) and National Bureau of Economic Research.

The Hanson study, “Should Countries Promote Foreign Direct Investment?”, has been prepared for the Group of 24 (the developing-country group at the IMF and the World Bank) and was discussed at technical level by the G-24 on the eve of the recent Fund/Bank meetings at Prague. The study is expected to be published by the UN Conference on Trade and Development in its Studies on International Monetary and Financial Issues. The study is part of the research programme coordinated by Prof. Dani Rodrik of the JFK School of Government at Harvard University.

The study brings out that there is “weak evidence, at best,” that FDI generates positive spillovers for host economies, and there is “little evidence” at the firm or plant level that FDI raises the productivity of domestic enterprises.

“Indeed, it appears that plants in industries with a larger multinational presence tend to enjoy lower rates of productivity growth,” the study says, adding: “Empirical research thus provides little support for the idea that FDI is warranted on welfare grounds.”

There is clearly a need for much more research on host-economy consequences of FDI, and the impression from existing academic literature is that countries should be skeptical about claims that promoting FDI will raise national welfare.

The study notes that there is a presumption among many academics and policy-makers that (inward) FDI is something special and that FDI helps accelerate the process of economic development in host countries.

But there seems to be little empirical evidence to back this presumption, on the basis of which developing countries have reduced barriers to inward FDI and created a policy infrastructure to attract multinational firms and FDI, including through extension of tax holidays, exemption from import duties and the offer of direct subsidies.

For FDI to merit special treatment, there needs to be market failure specific to production by multinational firms, Hanson notes, mentioning several examples of market failure mentioned in the literature—asymmetric information (as between domestic and foreign investors) and the possibility of FDI generating productivity spillovers for the host economy (through forward and backward linkages between multinationals and host-country firms).

While these and other types of market failure are plausible, says Hanson, each is also subject to controversy. Spillovers associated with FDI are supported by “casual evidence” from many countries, but their existence and magnitude are difficult to establish empirically.

“Indeed, micro evidence from large samples of manufacturing plants in developing countries fails to support the existence of positive productivity spillovers related to FDI.”

There is also reason to believe that multinationals exert market power in their respective industries. Whether or not they share rents with employees in their foreign affiliates is an empirical question. Attracting FDI may shift a portion of the rents that the multinationals earn to the host economy, but it may also reduce the profits of local firms that compete with multinationals at home or abroad.

Other research suggests that FDI may be detrimental to the host economy. There is some empirical evidence for the view that once established, multinationals favour high trade barriers and will lobby host-country governments to raise tariffs.

Does FDI generate positive spillovers for the host economy?

Theory identifies several channels through which multinationals generate externalities that raise the productivity of host-country factors of production.  But it is entirely possible that the net effect of such linkages on the host-country welfare is negative, once the impact of FDI on the profitability of domestic firms is taken into account. Whether spillovers from multinationals raise host-country welfare is an empirical question.

Most empirical studies on spillovers and productivity increase in host economies use cross-section data on average industry characteristics. However, a positive simple correlation between industry productivity and the presence of multinationals is in principle just as likely to mean that multinationals are attracted to high-productivity industries as it is to mean that multinationals raise host-country productivity, observes Hanson.

Citing several studies that have used micro-level time-series data on individual manufacturing plants, Hanson says the results give a story that is quite different from the one many have when looking at older, industry-level analyses.

The story that comes out is that multinational firms concentrate in high-productivity sectors and that domestic plants in these sectors, while having high relative levels of productivity, may experience lower growth in productivity relative to plants in other sectors.

“Micro-level data, then, appears to undermine empirical support for positive net productivity spillovers from FDI, perhaps indicating that multinationals confine competing domestic firms to less profitable industry segments,” observes Hanson.

The Hanson study examines three cases of FDI promotion - two in Brazil (relating to the projects by General Motors and Ford to build auto-production plants) and one in Costa Rica (the Intel project to build semiconductor chips).

Observes Hanson: “A preliminary evaluation of the three cases of FDI promotion suggests that the case for subsidies to GM and Ford in Brazil was weak and that subsidies to Intel in Costa Rica would have been difficult to justify.”

If the benefits of FDI for host countries are insufficient to justify FDI promotion policies, why do host-country governments continue to offer multinationals special treatment?

Hanson suggests some factors that may be motivating these actions.

One answer is that governments feel compelled to offer concessions given that multinationals subject their location decisions to bidding by potential host-country governments.

The appropriate response is not to validate auctions of this type but instead to seek international cooperation among governments to prevent multinationals from extracting all gains associated with their presence in host-country economies.

A second reason is that promoting FDI serves the interest of host-country politicians. Attracting TNCs may benefit specific constituencies from whom politicians derive support or may fit into political strategies of empire-building.

“Whatever the explanation, countries are likely to be better served by being cautious about promoting FDI, until we see strong empirical evidence that the social rate of return on FDI exceeds the private rate of return.” –SUNS4763

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