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«January 16, 2006 Howard Pack Kamal Saggi The Wharton School Department of Economics University of Pennsylvania Southern Methodist University 1400 ...»

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D. The international dimension: role of exports and FDI For small developing countries, the case for industrial policy is rarely a purely domestic one. International considerations are fundamental in many respects but the role of exports (on the part of domestic firms) and inward foreign direct investment (FDI) has received considerable attention. A potential rationale for industrial policy in the context of exports arises when product quality is unknown to foreign consumers. The informational asymmetry can lead to market failure that can then potentially justify some form of intervention. Adding an explicit process of reputation acquisition may be an objective of policy (Mayer, 1984, Grossman and Horn, 1988). The results differ as the latter focus on reputation acquisition at the firm level whereas Mayer focuses at the country level. In the Grossman/Horn view, Toyota can affect only its own reputation in foreign markets whereas in Mayer’s model, the experience with Toyota also determines how foreign consumers view other Japanese companies such as Honda. The difference matters because returns to reputation acquisition are appropriable in the Grossman and Horn model whereas they are not in the Mayer model.9 Now we discuss how an argument for industrial policy might arise in the context of FDI. Policy intervention with respect to FDI has a long history and the rationale for such intervention has frequently been the effects of FDI on productivity of local firms via technology transfer as well as linkage effects. The literature on FDI, technology transfer, and linkages has been surveyed extensively in Saggi (2002) and here we confine ourselves to those aspects of FDI that relate intimately to local industrial development and its linkage effects since these correspond quite well to the coordination failure rationale for industrial policy.

There exists a voluminous informal as well as empirical literature on backward linkages. For example, the 1996 issue of the World Investment Report was devoted entirely to the effects of FDI on backward linkages in host countries. However, analytical models that explore the relationship between multinationals and backward linkages in the host country are hard to come by. Two prominent examples of such models are Markusen and Venables (1999) and Rodriguez-Clare (1996a). Both models emphasize the demandcreating effects of FDI on the host economy: multinationals generate derived demand for intermediate goods, thereby promoting industrial development of the intermediate goods sector in the host country.10 As noted earlier, a common problem with analytical models in this area (as well those dealing with coordination failures) is the assumption that intermediates are nontradable. These models assume no trade in intermediates and then use FDI as the channel that either provides some of those intermediates or increases demand for local intermediate goods producers. As a result, they are likely to overstate the impact of multinationals on industrial development.

Mexico’s experience in the automobile industry is illustrative of how FDI can The complexity of these issues is underlined by the fact that still other conclusions are reached by Bagwell and Staiger (1989) who argue that if asymmetric information blocks the entry of high quality firms, export subsidies can improve welfare by breaking the entry barrier facing high quality firms. Thus, whether or not an export subsidy is desirable hinges very much on the nature of the distortion that is caused by the presence of asymmetric information.

It is worth nothing that if production is intended primarily for a protected domestic market, local suppliers, especially if there are local content requirements, may have costs above world prices, raising the possibility that greater linkages may lower the value of domestic output.

contribute to industrial development in the host country though Mexico’s favorable experience was facilitated by the NAFTA agreement. (Laderman, Maloney, and Serven, 2003). Initial investments by US car manufactures into Mexico were followed by investments by not only by Japanese and European car manufacturers but also by firms who made automobile parts and components.11 As a result, competition in the automobile industry increased at multiple stages of production thereby improving efficiency and Mexican exports in the automobile industry boomed. The pattern of FDI behavior in Mexico (i.e. investment by one firm was followed by investment by others) probably reflects strategic considerations involved in FDI decisions. Most multinational firms compete in highly concentrated markets and are highly responsive to each other’s decisions. An important implication of this interdependence between competing multinationals is that a host country may be able to unleash a sequence of investments by successfully inducing FDI from one or two major firms. However, the concentration of inward FDI into a handful of LDCs suggests that only a few countries can benefit from this process – Tanzania and Egypt are not China.

A recent comprehensive case study of the effects of Intel’s investment in Costa Rica by Larrain et. al. (2000) finds evidence that local suppliers benefited substantially from Intel’s investment. Similar evidence exists for other sectors and countries and such evidence is discussed in great detail in Moran (1998 and 2001). For example, in the electronics sector, Moran (2001) notes that in Malaysia, foreign investors helped their local subcontractors keep pace with modern technologies by assigning technicians to the suppliers' plants to help set up and supervise large-volume automated production and testing procedures. In a broader study, Batra and Tan (2002) use data from Malaysia’s manufacturing sector to study effect of multinationals on inter-firm linkages and productivity growth during 1985-1995. Their results show that not only are foreign firms more involved in inter-firm linkages than domestic firms but also that such linkages are associated with technology transfer to local suppliers. Such technology transfers were found to have occurred through worker training and the transmission of knowledge that helped local suppliers improve the quality and timeliness of supply.

Extensive backward linkages resulted from FDI in the Mexican automobile industry and foreign producers also transferred technology to domestic suppliers, (Moran, 1998).

Javorcik (2004) examines backward linkages and technology spillovers using data from Lithuanian manufacturing sector during the period 1996-2000. She finds that firm productivity is positively affected by a sector’s intensity of contacts with multinational customers but not by the presence of multinationals in the same industry. Thus, her results support vertical spillovers from FDI but not horizontal ones. Furthermore, she finds that vertical spillovers realize only when the technological gap between domestic and foreign firms is moderate. Blalock (2001) uses a panel dataset from Indonesian manufacturing establishments to check for the same effects. He finds strong evidence of a positive impact of FDI on productivity growth of local suppliers showing that technology transfer from multinationals indeed takes place. He also plausibly suggests that since multinationals tend to source inputs that require relatively simple technologies relative to the final products they produce, local firms that manufacture such intermediates maybe in a better position to learn from multinationals than those that compete with them.

Suppose one accepts the optimistic view regarding the effects of FDI (indeed some of the evidence discussed above suggests that there are reasonable grounds for doing so). Does this have implications for industrial policy? Our answer is a qualified yes. Basic economic theory tells us that it is optimal to subsidize an activity if it generates positive externalities -- i.e. the activity benefits agents other than those directly involved in the activity itself. The potential for positive externalities from FDI surely exists and available evidence exists that often this potential is realized. Incentives to attract FDI may be justified on the grounds of such externalities from inward FDI but the magnitude of some of the incentives being used seems difficult to justify (Moran, 1998). However, such policies are not typically what proponents of industrial policy have in mind – indeed the thrust of such arguments is typically in favor of encouraging the development of indigenous firms. It is worth keeping in mind that investment incentives and tax breaks to multinational investors work against their local competitors. Thus, if there exist local firms that could potentially compete with multinationals, the adverse effect of tax incentives to multinationals on such firms needs to be taken into account. The efficacy of investment incentives is also unclear – such policies could easily end up transferring rents to foreign investors without affecting their investment decisions.

F. Government Knowledge Requirements This review of arguments for industrial policy suggests the enormous difficulties of implementation of industrial policies quite apart from the possibilities for rent-seeking.

The range and depth of knowledge that policy makers would have to master to implement a successful policy is extraordinary. They would have to understand the relevance of, and be accurately informed about, a huge range of complex questions and have the ability to accurately evaluate very subtle differences. A subset of the issues on which policy

makers would have to be knowledgeable derived from the preceding discussion includes:

• which firms and industries generate knowledge spillovers

• which firms and industries benefit from dynamic scale economies – what is the precise path of such learning and the magnitude of the cost disadvantage at each stage of the learning process

• which sectors have a long term comparative advantage

• knowledge of the size of scale economies of different firms and sectors in order to facilitate investment coordination.

• an ability superior to that of individual firms to learn about their potential competitiveness

• the nature and extent of capital market failures

• the magnitude and direction of inter-industry spillovers

• the relative amount of learning by individual firms from others and from their own experience

• the extent to which early entrants generate benefits for future entrants

• the extent of heterogeneity of firms’ learning abilities

• whether consumers learn the quality of a good only after consuming rather than inspecting it

• whether firms that are trying to reduce production costs also begin a simultaneous effort to improve their product’s quality to obtain a better reputation.

• the potential effects of FDI or international trade in solving some of the coordination problems, including a detailed knowledge of which of tens of thousands of intermediates are tradable

• a forecast of which firms can create new knowledge and discover better production methods.

• the spillover effects of FDI as well as the likely intensity of their purchase of domestic intermediates It is possible that government officials might be this omniscient but the performance of the portfolio managers in developed country stock markets suggests that few of the very well trained (and remunerated) equity analysts can evaluate even much more certain and grosser characteristics of existing firms and industries with long track records. Nor do industrial firms themselves have the ability to successfully forecast such developments. Acknowledging that a first best policy would argue for the government to address such market failures or externalities, the task is daunting. Quite apart from the dangers of optimal policy being subverted by industries and firms that would benefit, the sheer knowledge and skill requirements would exceed that possessed by almost any institution including the best consulting firms. On a far more circumscribed set of tasks, measuring and explaining the sources of lower total factor productivity for a small number of sectors in South Korea and Brazil relative to the United States, McKinsey & Co., a preeminent consulting firm spent several years and employed dozens of people whose qualifications exceed those possessed by officials in most developing countries (McKinsey Global Institute, 1998a, 1998b).

No study has attempted to assess whether governments have been successful in mastering these fifteen questions (or others that can be derived from our discussion) that have to be addressed. The evaluation of industrial policy has to determine its efficacy on the basis of the realized results of either firms or industries that have been encouraged.

The underlying market failures or externalities that contributed to the decision to foster a firm or sector cannot be identified from the policy such as subsidized directed credit, only the effects of the policy can be assessed. We now turn to this task.

3. Does industrial policy work?

As noted earlier, it is impossible to offer a single agreed upon counterfactual to evaluate the past success of industrial policy targeted to individual industries. Thus there have been a number of research strategies pursued to provide an empirical evaluation of industrial policy. These have been reviewed in Noland and Pack (2003). Researchers have examined, inter alia, the impact of: (1) trade protection; (2) subsidies to R & D; (3) general subsidies; and (4) preferential lending rates on the evolution of productivity, capital accumulation, and sectoral structure. Few of the empirical analyses find that sectoral targeting has been particularly effective.

Consider some of the evidence. In Japan, more than 80 percent of on-line budget subsidies were devoted to agriculture, forestry, and fisheries in the 1955-80 period, the peak of Japan’s industrial policy efforts.12 Implicit tax subsides for investment were highest in the mining sector, and quite low in the high technology sectors. Government subsidies to R&D were also small. Unless elasticities of investment and R & D with respect to subsides were implausibly high, their effect was limited. Industries that were encouraged did not experience significantly faster rates of TFP growth than others and R & D subsidies were largely ineffective.

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