Was FDI Inflows a Significant Determinant of Export Growth in 12 CEE Countries - Research Paper Example

Introduction Since the late 1980s, Central and Eastern European (CEE) countries switched from a centrally planned economic system to one based on market forces. They privatized many state-owned enterprises, signed foreign trade agreements with other countries in the region, and have generally achieved a significant level of macroeconomic stability with improved growth rates. Some of these countries became full European Union (EU) members in May 2004. They also experienced a significant increase in foreign direct investment (FDI). As a consequence, the ratio of inward FDI stock to the 12 CEE countries studied here in total world inward FDI stock increased more than three-fold, from 0.81% in 1994 to 2.89% in 2004. (1) Over the same period, these countries also achieved a substantial increase in their exports, especially towards Western Europe. The question we address in this paper is whether FDI inflows have been a significant determinant of export growth in 12 CEE countries. To do so, we use a pooled data for the period between 1996 and 2004 and attempt to account for the effects of FDI on host economy exports. We separate the potential effects into supply-increasing effects (capacity effects) and FDI-specific effects. The supply-increasing effects arise when FDI inflows induce increases in the host country's production capacity, which, in turn, increases export supply capacity. The FDI-specific effects arise because foreign capital inflows may incorporate different competitive advantages, such as superior knowledge and technology and thus, higher productivity, or better information about export markets as compared to local firms. We believe that differentiating between these two effects of FDI on exports is especially important in terms of policy implications. It is often argued that successful FDI-promoting policies should lead to, among other things, a significant increase in the host country's exports. However, if evidence indicates that FDI increases exports only through increasing export supply capacity, then FDI inflows are not special in that policymakers could increase exports through alternative means as well, such as promoting domestic investment, rather than FDI. If, on the other hand, one finds that there are direct FDI-specific positive effects of foreign capital inflows on exports, this would mean that specific efforts aimed at attracting further FDI would be justified. In the following section, we provide a discussion of potential channels through which FDI may affect exports. Based on the discussion in this section, we present our empirical model in the next section. The empirical results are presented and compared to those of previous studies in the penultimate section. The last section concludes the paper. Effects of FDI on Exports - Theoretical Arguments This section discusses some theoretical arguments regarding the different potential effects of FDI on the host country's exports. Theory of Multinational Enterprise The theory of multinational enterprise (MNE) examines conditions under which firms may undertake FDI and become MNEs. (2) Such decisions may have consequences for host country's exports and it is a goal of this section to review parts of this theory that predict effects of inward FDI on host country's exports. Overall, the theory indicates that positive effects of inward FDI on a host country's exports may be expected when the host country and a home country have different factor intensities. In this case, the MNE may outsource some segments of its production process to the host country and export these (intermediate) products back to the home country (as well as other countries). Similarly, when the host country has a cost advantage and costs of trade are low (as compared to the trade costs of the home country), the host country may be used by the MNE as an export platform for serving its home market, as well as other markets. The starting point for the theory of MNE is the idea that firms must have certain advantages in order to become multinational companies. Dunning (1993) organized these advantages in three basic groups: (1) Ownership advantage that refers to the case where the MNE has a product or a production process that provides it with market power in the foreign market, (2) Location advantage that indicates that the multinational needs to locate production abroad to maintain its competitive advantage, and (3) Internalization advantage that suggests that the MNE has an incentive to exploit its ownership advantage internally. In order to analyze the effects of FDI on a host country's exports, it is useful to distinguish between horizontally and vertically integrated multinational firms. (3) In the case of horizontal integration, the MNE produces the same product in multiple plants located in more than one country, while vertical integration implies that different segments of the production process are carried out in different countries. Horizontally integrated firms often arise because of trade barriers in the form of tariffs ('tariff jumping investment'), or high transport costs. The multinational firm basically faces the dilemma of either building an additional plant in the host country (FDI) to supply the host country's market, or exporting to host country from the (existing) plant in the home country. In a model with oligopoly competition, FDI is favoured relative to exports (of home country) under three conditions: (i) high transport and tariff costs, (ii) relatively large firm-level economies of scale, compared to those of plant-level economies, and (iii) countries similar in size and their relative endowments (Markusen and Venables, 1998; Markusen, 2002, p. 103). In the analysis of vertically integrated MNEs, which includes trade in intermediary products, models suggest that the production process is likely to be geographically fragmented if the countries have factor-price differences and the stages of production are associated with different factor intensities) Since the segments of the production process occur in different countries, intermediate products need to be traded. As the portion of intermediate products produced by the foreign affiliates in the host country is typically shipped back to the home country (Zhang and Markusen, 1999; Markusen, 2002, p. 189), it is expected that FDI has a direct positive effect on host country's exports, which arises endogenously under specific conditions within the formal models of vertically integrated FDI. Most of the models on MNE investigate the effect of FDI on trade flows between home and host countries. However, it is quite often that a foreign subsidiary of MNE is used to supply the markets of third countries. For example, a US MNE may set up a plant in Hungary and supply all the Central European markets from this production site. In this case, Hungarian exports to third countries would increase. Ekholm et al. (2003) analyse such situation in which the MNE invests in one country and uses this production site as an export platform for supplying other markets. This section describes other channels through which FDI may affect host country's exports, in addition to those described in the theory of MNE. The impact of FDI on host country exports is not only direct, through the exports of the foreign affiliates, but there may be important side effects, which may influence the export performance of domestic producers indirectly. (5) The extent of the spillovers and indirect effects of FDI on exports may depend (at least in some industries) on the initial technological and human capital level of the domestic producers (Girma et at., 2007; Barrios et al., 2005), on the intensity of competition in domestic markets, as well as on the government policies promoting linkages between domestic and foreign firms (Barry and Bradley, 1997). (6) As noted in Helpman et al. (2004), MNEs tend to have higher productivity than other companies, including exporters, which are, on the other hand, more productive than non-exporters. (7) This higher productivity of MNEs may be viewed as a reflection of their firm-specific competitive assets, which create the ownership advantage of MNEs. Such assets, which include production process, innovative products, human capital of employees, or patents, are often referred to as MNEs' superior technology or knowledge (Girma et at., 2007; Markusen, 2002, p. 18). Thus, when an MNE transfers its competitive assets to its affiliate in the host economy, there is the possibility of knowledge spillovers to domestic firms in the host country (indirect effect, which is specific for FDI). One specific channel through which domestic firms may increase their productivity and export competitiveness in tradable goods and services industries is simply by copying the operations of the foreign producer. This may be facilitated by the mobility of workers previously trained in the MNE's affiliate. Some of the other potential channels of MNE's influence on domestic companies have been analysed theoretically, but not in the specific context of exporting domestic companies. One of the potentially important indirect MNE's effects on domestic producers is the competition effect. The entry of an MNE in one sector of the host economy increases the intensity of competition in this sector, which may force some domestic companies to leave the market (Markusen and Venables, 1999; Barrios et al., 2005). Such an effect is less pronounced with export-oriented MNEs and domestic producers; but, in the case of exporting domestic companies, this may lead to negative effects of inward FDI if the loss of exports by domestic companies is not compensated for by new exports of the MNE's local affiliate. However, MNE entry may also have positive indirect effects on the export performance of domestic companies. For example, an additional channel through which productivity of local firms may be increased is the so-called forward linkages, which occur when foreign affiliates sell goods or services to domestic firms. Improved products and services (and/or lower prices) in the downstream sector of a domestic firm (incurred through more intense competition due to an MNE's entry in that sector, or because of higher quality of inputs produced by foreign producer) may improve the domestic firm's own productivity and competitiveness as well. This implies that FDI inflows into a non-exporting sector may improve performance of domestic exporters. Another type of linkage between foreign and domestic producers consists of backward linkages to the suppliers. If the presence of a foreign producer creates additional demand for local inputs, then the supply industries may be strengthened. Markusen and Venables (1999) show that strengthening the supply industries may benefit the domestic producers in the MNE's industry, through the mechanism of forward linkages, and that this positive side effect can be stronger than the competition effect in the MNE's sector. In a similar setting, Barrios et al. (2005) show that despite the initial negative competition effect of MNE's entry, the indirect positive effect may prevail when the number of foreign firms is sufficiently high. They also argue that these positive indirect effects are more likely to dominate over the negative competition effect if domestic companies are export oriented. In addition, MNEs may facilitate access to foreign markets for the domestic producers by processing information about their home economies, or by lobbying for favourable treatment of exports from the host economy in their home countries (UNCTAD, 1999, p. 240). All this may reduce the costs of entering foreign markets for domestic producers. Also, there is a possibility that the links of foreign affiliates to MNE's intra-firm markets spread to (some of) the local suppliers. Empirical Model The above discussion suggests that FDI may have an impact on exports. FDI may contribute directly to increased domestic supply and it may strengthen other producers even in related sectors in the host economy. To this end, FDI is no different than domestic investment that increases supply and potentially changes the demand and supply conditions in related domestic industries. However, the impact of FDI may be particularly important due to the MNE's superior knowledge about foreign markets or technology and its contacts to parent firm and intra-firm markets. These are the FDI-specific effects. We believe that differentiating between these two types of effects of FDI on exports is especially important, since it is often argued that successful FDI-promoting policies will boost host country exports. However, if one finds that FDI increases exports only by increasing export supply capacity, then any policy that promotes domestic investment will lead to higher exports as well as FDI inflows do. If, on the other hand, one finds that there are additional FDI-specific positive effects on exports, then countries' efforts in attracting FDI are warranted. In this section, we try to capture the above effects by using a popular empirical model of exports. In our model, based on the theoretical discussions above, we include a proxy for the supply capacity of host countries that positively affect export supply capacity. We use FDI stock data to capture the FDI-specific effects. We propose to include both variables in the same specification to see whether FDI has an additional impact on exports beyond its impact on exports through the domestic supply capacity variable. Empirical Results We use pooled data for the period between 1996 and 2004. All estimations are presented for two country groups: the first sample includes eight countries that belong to the group of new European Union (NEU) members, and additional four countries that are Southeast European countries, while the second sample consists only of the eight new EU member states. Two samples are used in order to check for robustness given the (potentially) heterogeneous sample of all countries. A GLS estimation method, with country dummies, is used to estimate the model specifications above. The use of country dummies is appropriate because of some unobserved (and/or omitted), country-specific variables, which influence countries' export performance. The most important examples are geographic location and infrastructure (accessibility), or natural resource endowments, but there may also be relevant policy variables not included in any of the above specifications. The estimations are robust with respect to heteroskedasticity and serial correlation. The results imply that, for all the countries in our sample, FDI has significantly contributed to higher exports, through increased supply capacity, that is, potential output. When potential output is controlled for, the contribution of FDI is statistically significant only for the group of new EU countries, however. This implies that, for these countries, the positive impact of FDI goes beyond increasing supply capacity in that there are additional indirect, positive effects from inward FDI. As it can be seen from the results, for the NEU countries, a 1% increase in FDI stock leads to 0.16% increase of exports in short term, and 0.42% [0.16/(1-0.62)] in long term, through FDI-specific effect only. (9) Possibly, the foreign investment into new EU countries created a higher level of competitive advantage, which spread to the domestic producers. Another factor that may explain the different results for the two groups of countries is that the official statistics on FDI inflows may be misleading because they may include the inflows of capital of local owners, which may be returning back into the country in terms of FDI to hide the identity of its owners. In this way, the owners are more strongly protected against having their property expropriated by the government if it was acquired in illegal way. (10) These capital inflows, however, cannot be expected to have the same impact on local companies as an investment by some multinational companies. Comparison with Other Studies We conclude this section by briefly summarizing empirical evidence from related studies and comparing it to our findings. The papers from Sun (2001), Zhang and Song (2000), and from Goldberg and Klein (2000) are especially related to this study, because they try to capture the overall effects of FDI on trade at the macroeconomic level. (11) Sun (2001) examines the different impact of foreign investment on exports in three regions of China in a period from 1984 to 1997 and finds that the effects of FDI vary across the three regions. The impact is positive and the strongest in the coastal region. Zhang and Song (2000) address the same research question for China at the provincial level. They also find that higher levels of FDI are consistent with higher provincial exports. It is worth noting that the positive effect of FDI on exports in China has mostly been due to the fact that China has largely been used as an export platform by MNEs. Goldberg and Klein (2000), on the other hand, analyze the impact of FDI from the United States in the manufacturing sectors of individual Latin American countries on the net exports of those and other sectors. The results vary across sectors and host countries, reflecting the importance of the specific conditions in individual countries and industries. The fact that the results are mixed makes it impossible for the authors to draw a strong and clear conclusion on the relationship between the FDI flows and trade. Unlike the above econometric studies, Barry and Bradley (1997) analyze the effects of FDI on Irish exports in a more descriptive way. They conclude that there has been a significant direct contribution of foreign producers to increasing Irish exports because the FDI in Ireland has mostly been export oriented. (12) They also mention the possibility of additional influence through spillovers, but no attempt was taken to show it empirically. As for studies on spillovers, Gorg and Greenaway (2004) review the recent relevant literature. Out of 40 studies concerned with intra-industry productivity spillover effects from FDI on domestic firms in developed, developing, and transition economies, 19 report statistically significant and positive spillovers, 15 studies do not find any significant effects, while six papers find some evidence of negative effects. Interestingly, many studies on FDI spillovers in transition countries find some evidence of negative spillovers. The evidence of positive horizontal, that is, intra-industry spillovers, is even weaker if one considers some methodological drawbacks such as potential bias of the cross-section estimates used in many of the reviewed studies. The evidence on positive FDI productivity spillovers on forwardly and backwardly linked industries is somewhat more convincing than for the horizontal effects. Two recent studies of indirect effects of FDI on domestic producers are especially important in the context of our study. Girma et al. (2007) explicitly test the effect of inward FDI on the productivity of exporters in the UK that have been acquired by the foreign companies. This is important since much of the FDI inflow in the transition countries was for the acquisition of existing companies (mostly through privatisation). This study shows that FDI affects the productivity of acquired firms; however, the magnitude and significance of this impact depends on the time elapsed since acquisition. Without controlling for the initial productivity, Girma et al. (2007) find that, 1 year after acquisition, FDI has had significant and positive influence on average productivity growth of acquired companies (no significant effect was found in the year of acquisition). When controlling for pre-acquisition productivity, only the acquired firms with relatively high productivity before acquisition experienced productivity gains in the year of acquisition, reflecting the importance of absorptive capacity for (immediately effective) effects. The companies with lower initial productivity, on the other hand, benefited more from FDI 2 years after acquisition. This shows that it takes time for the acquired firms to benefit from FDI, especially for the domestic firms with lower initial productivity, which is important in the context of the present study. In addition to Girma et al. (2007), we would like to stress the empirical findings of Barrios et al. (2005). They tested their theoretical prediction that, at first, negative competition effect from FDI is stronger, but with more inward FDI, the positive externalities dominate the initial negative effect (the u-curve overall effect of FDI on domestic companies). This is empirically confirmed on their sample of Irish companies implying that the sufficient accumulation of foreign capital plays a crucial role for the effectiveness of indirect effects on domestic companies. Our results show that, as in China, Ireland, or in some industries in some Latin American countries (Sun, 2001; Zhang and Song, 2000; Barry and Bradley, 1997; Goldberg and Klein, 2000), FDI contributed to increasing exports of host transition economies. Since other studies do not differentiate between supply-increasing and FDI-specific effects of FDI inflows on exports, a direct comparison of results is not possible. Our results on FDI-specific impact, which is significant only in NEU countries, reveal the importance of findings by Girma et al. (2007) and Barrios et al. (2005), which suggest that indirect impact of FDI on host countries (which, to some extent, should coincide with FDI-specific effects) depends on the initial situation in the host economies, that is, initial productivity of acquired firms (Girma et al., 2007), and on the accumulated amount of FDI inflows (Barrios et al., 2005). Since NEU countries are, on average, more developed than the Southeast European countries, they are expected to have relatively more productive companies. Also, they have received more FDI, which can additionally (at least partly) explain why such effects are significant only for this group (NEU) of countries. Conclusion and Suggestions for Further Research In this paper, we estimate the impact of FDI inflows on export performance in 12 transition economies, including some new member states of the EU. FDI can contribute to higher exports by increasing supply capacity and/or through FDI-specific effects as MNEs may have better knowledge about foreign markets, superior technology, and better ties to the supply chain of the parent firm than do local firms. It is important to distinguish between these types of effects, since the supply-increasing effects may arise as a consequence of domestic investment as well, making an FDI-promoting policy reluctant in the absence of FDI-specific impact. We find that, during 1996-2004, FDI inflows contributed to higher supply capacity in all 12 countries, leading to more exports. On the other hand, evidence for FDI-specific effects is mixed. The results suggest that this effect has been present mainly for the new EU member states, reflecting, among other things, the higher amount of FDI inflows received by these countries relative to Southeast European countries, as well as the potentially higher initial productivity of domestic companies acquired by MNEs. Our results have important implications for policymakers and other transition economies. First, our results support the notion that the MNE has an important advantage over local firms that it brings to the host economy. Hence, policymakers need to support FDI inflows by designing appropriate policies and reforms. However, it seems that the amount of FDI stock accumulated over time matters for the positive FDI-effects on exports. In our sample of countries, the new EU countries received the larger amount of FDI relative to other transition economies and hence have been able to better take advantage of the FDI-specific effects than the rest of the countries, leading to more exports. References 1. Barrios, S, Gorg, H and Strobl, E. 2005: Foreign direct investment, competition and industrial development in the host country. European Economic Review 49: 1761-1784. 2. Barry, F and Bradley, J. 1997: FDI and trade: The Irish host-country experience. The Economic Journal 107: 1798-1811. 3. Brada, J, Kutan, AM and Yigit, T. 2006: The effects of transition and political instability on foreign direct investment inflows: Central Europe and the Balkans. Economics of Transition 14: 649-680. 4. Dunning, JH. 1993: Multinational enterprises and the global economy. Addison-Wesley Publishing Company: Reading, MA. Read More