Foreign Direct Investment and Technology Spillovers - Case Study Example

Introduction Multinational corporations are important labor employers across the world economy (Mickiewicz et al. 2000, p. 5). Mickiewicz et al. argue that aside from their effects on aggregate employment, foreign direct investments (FDIs) have strong direct impact on domestic employment through types of jobs created, regional distribution of new employment; wage levels, income distribution, and skill transfer, which in turn are complemented by indirect or spillover effects. Indirect effects take place through movement of trained labor from foreign firms to other sectors as well as through the increase of employment in domestic subcontractors. Moreover, the integration of foreign direct investment (FDI) into a local economy results often in a deep social change. Mirza (1998) states that movement of labor and links with domestic subcontractors enable transmission of business culture, which involves corporate values, organizational structures and management practices (qtd. in Mickiewicz et al. 2000, p. 5). Michalet (1997, p.1) tells that over the last two decades, more and more developing countries have changed their attitude towards foreign direct investments that instead of fearing, limiting or even banning the entities, they have not only welcomed it but are competing to attract them. Importance of FDIs on Central and Eastern European Economies Foreign direct investment is an important source of external finance in transitional economies particularly those in Central Europe (Lansbury et al. 1996, p.104) as it helps to cover the current account deficit, fiscal deficit [in case of privatization-related FDI], and supplements inadequate domestic resources to finance both ownership change and capital formation (Krkoska 2001, p.1). Since 1988, around 70 per cent of FDI in transitional economies has been channeled into these countries. Deutsche Bank Research (EU Monitor 2005, p.14) reports that foreign direct investment in Central and Eastern European countries (CEECs) rose almost tenfold between 1994 and 2003 - from USD 20 bn to USD 197 bn. It also reported that in terms of FDI in relation to GDP, there was an impressive increase from 6.9 per cent to 33.2 per cent.1 Lansbury et al. also contend that FDIs may have played an important role in transforming the formerly centrally planned economies of Central and Eastern Europe as FDIs provide an important source of investment for modernizing the industrial structure of these countries and improving the quality and reliability of infrastructure. Sader (2000, p.2) states that because public industrial structure have relatively low priority for cost-effectiveness and profit generation [which is the opposite for private firms], excess staffing and low-quality service provision results. FDIs, through private lenders and equity investors, provided infrastructure services around the world through full-scale privatization of public sector entities, the construction of new facilities with private capital on the basis of build-operate-transfer (BOT)-type investments, lease arrangements, and operation and management (O&M) contracts (Sader 2000, p.2). A study done by Dimelis and Lauri (2004) using Greek firms as samples confirms that an effect of foreign direct investment on host economies is increases in productive efficiency. Lansbury et al. add that new investments may also bring badly needed skills and technologies into the host economy. Evidences compiled by Lane (1994) in Hungary show that multinational firms had a higher propensity to trade and invest than purely indigenous ones (qtd. in Lansbury et al. 1996, p.104). Foreign direct investment is important not only as generator of new employment but also as agent that can change the structure of employment in the direction that would be more favorable for a long-term growth of CEECs, that is, more likely to happen if FDI is diversified, according to Mickiewicz et al. (2000, p.7). In their study on the employment effects of FDI on four sample CEECs2, Mickiewicz et al. found out that foreign direct investment operated as an important buffer by either generating new or preserving the existing employment and thus preventing further erosion of employment.3 FDI as a Positive Contributor to Economic Growth According to Deutsche Bank Research, recent research by Neuhaus (2005)4 confirms that foreign direct investment was the engine of growth in Central and Eastern Europe in the last 10 years. It contributed 2.3 percentage points to economic growth of 3.5% on average i.e.74%. Furthermore, the results of the analyses show the growth contributions of FDI in each individual country of Central and Eastern Europe and how quickly foreign investment has been absorbed. For the future, this means that foreign investors will shift their focus from the more advanced countries to the next EU candidate countries (EU Monitor 2005, p.14). The European Bank for Restructuring and Development [EBRD] (2000) reports that until recently, the transition countries had not received significant amounts of foreign direct investment, which was not welcome in centrally planned economies. In 1990, only Hungary was reporting a significant amount of FDI inflows but the total for all transition countries in that year was below US$ 500 million. By 1998 FDI inflows to central and Eastern Europe increased to almost US$ 20 billion, but still accounted for less than 10 per cent of total FDI inflows to the developing countries or less than 20 per cent of FDI inflows to developing countries in per capita terms (Krkoska 2001, p.3). Deutsche Bank Research also identifies the various effects of foreign direct investment has on economic growth in the recipient country: as many foreign companies are producers of consumer and capital goods, their business activities lead to an increase in output aside from positive effects on employment. While consumer goods production mainly enhances the product range in many emerging markets, the production of capital goods plays a key role with regard to the diffusion of technological progress. As many multinationals have the technological lead in their market segments, the capital goods produced are of very high quality and thus boost the efficiency of the production process also for the domestic end-producers. Also the mere presence of foreign companies can result in positive external effects (known as "knowledge spillovers"), where local companies benefit from the transfer of knowledge and independently develop new products and technologies. Furthermore, if foreign firms, for example, train their local staff locally, this also increases the human capital available in the recipient country (EU Monitor 2005, p.14). Using Neuhaus's (2005) output, Deutsche Bank Research made use of the pooled mean group procedure, a dynamic panel method, to estimate the rate of per-capita GDP growth to see if foreign direct investment boosts growth for a group of Central and Eastern countries5 across several time periods [1991-2002]. It reported that the impact of FDI is outstanding. Foreign investors contributed 2.3 percentage points to the average economic growth figure of 3.5 per cent. Domestic investment, by contrast, had barely any impact on growth. The average growth contribution of 0.4 of a percentage point even fell to zero following the exclusion of Albania, which showed by far the biggest contribution. Moreover, it concluded that capital accumulation due to foreign direct investment has played an instrumental role in the growth process in Central and Eastern Europe. This applies not only to the whole region on average, but also to most of the 13 countries (EU Monitor 2005, p.18). Economic Policy towards Foreign Direct Investment in the CEECs Host-country institutions and policies affect the entry decision of multinational firms in all countries. Besile et al. (2005, p.8) identified that national institutional variables that have a significant effect on inward FDI can be grouped in six categories, namely: 1) labor market arrangements, 2) corporate taxation, 3) bureaucratic efficiency and corruption, 4) legal system and intellectual property right protection, 5) product market regulation and 6) openness to foreign direct investment. Besile et al. cite Grg's (2002), Gross and Ryan's (2004), Javorcik and Spatareanu's (2005), and Nicoletti et al.'s (2003) findings that evaluated product lists (EPL) and labor taxes adversely affect relative returns from investing in a country with a tight regulation, whereby discouraging foreign direct investment (2005, p.8).6 In the case of Poland, Kaminski (1999, p.33) concluded that many weaknesses of Poland's foreign trade policy stem from institutional design that is not conducive to sound policies as the foreign trade policy process has been increasingly captured by narrow sectoral interests. Kaminski narrates: [] the containment of protectionist pressures will become increasingly difficult. In order to prevent this outcome, institutional measures should be adopted ensuring that economy-wide impact of foreign trade policy decisions is taken into account and that the foreign trade policy making process is insulated from private lobbying. Best international practice suggests that this objective can be achieved only when domestic actors depending on imports or exports can voice their views in the policy setting process on an equal footing with import-competing producers (1999, p.33). The corporate tax system has an obvious theoretical relation with inward FDI: higher tax rates increase the cost of doing business in a country, whereby reducing the attractiveness of such location (Besile et al. 2005, p.9). In fact, the tax treatment of FDI, according to Mintz and Tsiopoulos (1992, p.v), is a potentially important part of the policy framework in Central and eastern European countries. In their study on how their sample CEE countries7 can consider for the development of their corporate income tax policies, Mintz and Tsiopoulos suggested that if tax holidays were eliminated, thereby reducing the corporate tax to around 20 per cent, or allowing investment tax allowances of around 20 per cent, would preserve the tax competitiveness of regimes in the countries analyzed. Moreover, they also noted that investment tax allowances or credits would probably be more cost-effective than tax holidays for attracting foreign direct investment without undue revenue losses to the treasuries of the CEE countries (Mintz and Tsiopoulos 1992, p.vii). Corrupt behavior among government officials is an informal institution that can arise when market economy institutions are underdeveloped, and produce high transaction costs that increase the multinational enterprises (MNE)'s costs of doing business in the host country. Such extra-costs decrease the expected profitability of an MNE direct investment and tend to deter foreign investors from starting production in the host country (Besile et al. 2005, p.9). Broadman et al. (2004, p.252) recommends policy measures that will deepen the separation between politicians and firms as they found out in their analysis that in the case of the South Eastern European countries, the lingering involvement of the state can interfere with the value-producing function of productive enterprises [e.g. managers of partially state-owned firms complaining of the amount of time they have to spend dealing with state officials rather than pursuing the creation of value, state-owned firms performed consistently worse than privately owned firms, either foreign or domestic]. According to Broadman et al., this will involve policy measures ranging from further privatization in countries where significant portions of the productive economy remain partially or fully state-owned, to establishing clear governance mechanisms that moderate conflicts of interests [e.g. politicalization of a firm that arises from having politicians on the firm's board (2004, p.252). On legal system and intellectual property rights (IPR) protection, Besile et al. provide that there is a dilemma on the level of implementation. On one hand, a weak protection increases the probability of imitation and thus it makes a host country less attractive for foreign investors. On the other hand, strong protection may shift the preference of MNEs from FDI towards licensing (2005, p.10). Besile et al. cite Javorcik's (2004) examination on the impact of intellectual property protection on the volume of FDI using a firm-level data set from Eastern Europe and the former Soviet Union and demonstrated that weak protection deters foreign investors in technology-intensive sectors where intellectual property rights play an important role. More generally, the extent to which a country can enforce property rights can be a key determinant of its attractiveness towards foreign investors. In fact, a strong IPR protection system needs to be implemented through an efficient legal system, which ensures that firms can have their contracts, trademarks and patents enforced without entering into exhausting trials lasting several years (Besile at al. 2005, p.10). Most importantly, tax burdens and policy requirements only form a part of investment. The country's economic climate and political stability can also be a crucial factor. According to Michalet (1997, p.15), this stability is a precondition for being able to base decisions on investment plans and calculated expected returns. Sader (2000, p.71) states that "key components of the contractual arrangement that will determine the success [or failure] of a particular project during construction and operation are beyond the control of the investors, depending on the political decisions instead." Mintz and Tsiopoulos (1992, p.1) also provide instances wherein the country's economic climate is a crucial factor for FDIs to enter: If the interest rate that a company uses to discount future benefits is high, then the current value of write-offs given for depreciation will be low. In general, when interest rates are high, a company has less incentive to spread deductions over a period of time. Similarly, if inflation rates are high and accounting does not allow assets and liabilities to be revalued accordingly, future deductions such as those for depreciation or losses carried-forward amounts are indexed for inflation. On the other hand, high inflation can reduce taxes for companies that finance investments by debt unindexed for inflation. With the deductibility of high nominal interest, unadjusted for inflation, the business is able to write off not only the "real" portion of the interest but also the rest, which is in fact an adjustment for inflation's effect on the value of the principal. Because of these effects, the actual value of taxes paid usually differs from the tax rate indicated in the law (Mintz and Tsiopoulos 1992, p.1-2). Finally, the United Nations Center on Transnational Corporations (UNCTC 1985, p.12) pointed out that national policies must be supplemented by international standards. In support to this, Broadman et al. (2004, p.253) assert the importance of adopting of International Accounting Standards (IAS) and the use of independent external audits to promote financial transparency. If relations between governments and transnational corporations are to evolve in a mutually beneficial manner, it is essential, as a minimum, that the expectations, rights and responsibilities of all sides should be known, understood, and respected (UNTC 1985, p.12). Reference List Basile R, Benfratello L & Castellani D 2005, Attracting Foreign Direct Investments in Europe: Are Italian Regions Doomed. Retrieved February 3, 2006, from http://www.feweb.vu.nl/ersa2005/final_papers/148.pdf Broadman, H, Anderson, J, Claessens, C, Ryterman, R, Slavova, S, Vagliasindi, M, & Vincelette, G 2004, Building Market institutions in South Eastern Europe, Comparative Prospects for Investment and Private Sector Development , The International Bank for Reconstruction and Development/The World Bank, Washington DC. Deutsche Bank Research 2005, Foreign Direct Investment: The Growth Engine in Central and Eastern Europe. Retrieved February 3, 2006, from http://www.dbresearch.com/PROD/DBR_INTERNET_EN_PROD/PROD0000000000189215PDF Dimelis, S & Louri, H 2004, Foreign Direct Investment and Technology Spillovers: Which Firms Really Benefit. Retrieved February 3, 2006, from http://www.statec.lu/html_fr/bibliographie/Periodiques/WELTWIRTSCHAFTLICHES_ARCHIV.html Kaminski, B 1999, The Role of Foreign Direct Investment and Trade Policies in Poland's Accession to the European Union, World Bank Technical Paper No. 442, The International Bank for Reconstruction and Development/The World Bank, Washington DC. Krkoska, L 2001, Foreign Direct Investment Financing Of Capital Formation In Central And Eastern Europe. Retrieved February 3, 2006, from http://www.ebrd.com/pubs/econo/wp0067.pdf Lansbury, M, Pain N, & Smidkova K 1996, Foreign Direct Investment in Central Europe Since 1990: An Econometric Study. Retrieved February 3, 2006, from http://econwpa.wustl.edu/eps/mac/papers/0404/0404002.pdf Michalet, CA 1997, Strategies of Multinationals and Competition for Foreign Direct Investment, The Opening of Central and Eastern Europe, Foreign Investment Advisory Service Occasional Paper No. 10, The International Finance Corporation and the World Bank, Washington DC. Mickiewicz, T, Radosevic, S, & Varblane, U 2000, The Value of Diversity: Foreign Direct Investment and Employment in Central Europe During Economic Recovery. Retrieved February 3, 2006, from http://www.one-europe.ac.uk/pdf/slavoW5.PDF Mintz, J & Tsiopoulos, T 1992, Corporate Income Taxation and Foreign Direct Investment in Central and Eastern Europe, Foreign Investment Advisory Service Occasional Paper No. 4, The International Finance Corporation, the World Bank, and the Multilateral Investment Guarantee Agency, Washington DC. Sader, F 2000, Attracting Foreign Direct Investment, Why is it so Difficult, The International Finance Corporation and the World Bank, United States of America. United Nations Centre on Transnational Corporations 1985, Transnational Corporations in World Development: Third Survey, The United Nations, Cambridge. . Read More