How to assess the impact of FDI on an economy? by Gábor Hunya, wiiw, September 2006, 1st draft As part of the FDI statistics project, this paper draws upon the main databases available in countries with standard statistical systems. The aim is to show how statistical resources can be used to support economic policy and government decision-making. The policy are under discussion is the impact of FDI on the host economy. First we go through all main chapters of available statistical resources and point out to what purpose and with what methodology they can be analyzed (Part I.). This part presents simple methods of analysis and the ways how different data resources can be linked. In addition to official statistical resources as the FDI survey of the national bank (Section A.) and the foreign investment enterprise database (Section B.) we also refer to the use of special questionnaires and company surveys (Section C.). Second, we present the current stage of empirical research concerning the impact of FDI on a host economy based on the international literature (Part II.). These sources are sophisticated in their methodology, but rely on more simple, internationally available data than those available for national governments. We include sources from two main lines of FDI research, international economics and international business. The methods outlined in the quoted papers can easily be adapted to the situation in single countries. Third we selected a few examples from the literature demonstrating advanced econometric methods (Part III.). This part is illustrative and may not be used in the final paper. I. FDI impact analysis supported by national and company data A. Analysis using FDI data from the balance of payments and the international investment position (national bank data) 1) Net FDI position Find out your country’s position along the investment-development path. FDI inflow and outflow data, the net FDI shows the country’s position along the investment-development path. (See Dunning and Narula, 1996 and Bellak, 2001) Countries in the process of development take-off usually receive more FDI inflow than the amount they invest abroad. At an advanced stage, countries become net FDI exporters, or their investment position fluctuates around neutral. FDI data for the countries in the world can be taken from the UNCTAD World Investment Report. For CEE and SEE countries one can use the wiiw Database on FDI (Hunya and Schwarzhappel 1005). These source of data can be used for all other analysis in this section. 2) Relative size of the FDI inflow The size of the country and its development level influence the size of FDI it receives. For international comparison it is appropriate to use the relative size of FDI. The most wide-spread indicators are FDI per capita and FDI per gross fixed capital formation. 3) Inward FDI stock The historic amount of FDI in a country reflects its longer term attractiveness. International comparison can be done in per capita terms or per GDP. 4) FDI potential and performance 1-3 presents the overall position of a country in international comparison. To get a more sophisticated picture it is necessary to calculate the FDI potential and FDI performance indices It is published in the annual UNCTAD World Investment Report. Policymakers can find out whether the country’s attractiveness is below or above its potential. It can also trace the reason for this by comparing the components of each indicator. 5) Impact of FDI on economic growth For impact analysis on growth, exports, etc. there is a wide literature for various regression models. Most of these use the FDI flow or stock data and relate it to various economic and social indicators. See Section II. 6) FDI flows by form (equity capital, reinvestment, other capital) See what kind of FDI is arriving, which kind of FDI is more stable or more volatile. Mature economies get more FDI in form of reinvestment than new equity. Investment promotion must be aware of differences between the behaviour of each investment type. 7) FDI by investing countries All the above exercises can be repeated with bilateral FDI data which reveals the specific behaviour of investors from one or the other country. Specific FDI impacts or forms can imply specific promotion strategies. If important investing countries are missing in a host country, the specific reasons can be found out and corrected. 8) FDI inward stock and inflow by economic activity The more detailed the available breakdown of inflows and stock, the better. NACE 2 digit is basic, 3 digit can be more useful. Trends in time and comparison with similar target countries can reveal weak the specialization of your country and the weak point in specialization. Manufacturing industries can be grouped into technological levels. There is a whole literature about structural shifts, upgrading (Damijan and Rojec, 2004). A comparison of the FDI structure with the structure of exports is useful. Econometric studies can help to more precisely find out the impact of FDI on exports. For these studies it is better to use manufacturing sector FDI than total FDI, as it is mainly manufacturing that produces internationally traded goods. 9) FDI related incomes Income outflow related to inward FDI in the form of profits and other earnings is available from the current account. Calculate the relative size of income related to FDI stock, it shows the rate of return enjoyed by the owners of FDI capital. This reminds that FDI is no free lunch, the inflow of capital implies the outflow of earnings. Look at the breakdown of FDI income into repatriated and reinvested earnings. High share of repatriation suggests that investors are not satisfied with the business environment and the growth prospects in your country. 10) FDI by entry mode This information is available if asked in the questionnaire which surveys companies to receive FDI data. Equity capital can be sorted by entry modes: establishing a new firm, privatization, M&A of private firm and these can be follow-up investments also in these three types. It may be available only for the equity investment. Different types in different industries can be revealed. If green-field FDI is missing in manufacturing it may need promotion. Problem with all such data is that we do not have much international comparison and we do not have a standard, what type of investment to what extent is too little or too much. 11) Further information The questionnaire of the national banks which surveys the FDI inflows and forms may ask more than just the standard questions. It may identify individual companies by FDI entry-mode, greenfield investments vs. M&As. This is very useful for promotion purposes which targets greenfield FDI. One can also ask further information for production, employment, exports, investments with their mode of establishment. This shows the impact of FDI by the two forms of entry on other indicators. The analysis can be carried out by industry and in time. Relevant question to be answered is e.g. what it the development of employment in foreign acquired firms 1,2,3, etc years after foreign takeover? (See impact analysis below) Example on the possible information concerning the entry mode of FDI and the types of foreign affiliates: Croatian National Bank database: The equity inflows are broken down into 8 categories in respect of the transaction type or mode of entry. First of all, each reporting FIE obliged to report its direct investment is required to define the foreign direct investor's mode of entry and it could be: - newly established company completely owned by foreign investor(s) - newly established company partly owned by foreign investor(s) (10% threshold is applied for an individual investor) - privatization related mode of entry - acquisitions other than privatization related This FIE type information is further combined with individual equity transaction code describing the transaction type and it could be: - set up capital - new (fresh) capital - privatization related transaction - acquisition other than privatization If we neglect impossible combinations i.e. set up capital for privatized company, the combination of above classifications brings us to 12 possible equity investment types and those are: 1. set up capital into newly established FIEs completely owned by foreigners 2. set up capital into newly established FIEs partly owned by foreigners 3. new (fresh) capital into newly established FIEs completely owned by foreigners 4. new (fresh) capital into newly established FIEs partly owned by foreigners 5. acquisition of newly established FIEs completely owned by foreigners 6. acquisition of newly established FIEs partly owned by foreigners 7. privatization related equity transaction 8. new (fresh) capital into privatized FIEs 9. acquisition of previously privatized FIEs 10. acquisition other than privatization 11. new (fresh) capital into acquired FIEs 12. further acquisitions of already acquired FIEs Information from this database has been widely analysed by Hunya and Skudar (2006) in the framework of the current project. The Austrian National Bank (2005) publishes the results of the annul FDI survey in the form of a supplement to its monthly statistical reports which contains among other indicators employment, turnover and intra-firm trade data of Austrian subsidiaries abroad and of foreign subsidiaries in Austria. This database is then used by research to point out various characteristics and develop policy conclusions (Siebner 2006). B. Analysis using foreign investment enterprise data Information on the employment, output and other balance sheet data of foreign investment enterprises (having at least one foreign owner which holds 10% or more in the company) or on foreign affiliated companies (having more than 50% foreign share ownership) is necessary to acquire detailed information on the foreign sector and to compare its characteristics with those of domestically owned firms. The EU Eurostat started to publish its data on foreign affiliations. This is the primary international source. Wiiw collects such data for CEECs on an ad hoc basis. Data are available nationally but are usually not published but can be accessed for research and government decision-making purposes. The data can be available from three sources: 1) Companies report their financial statements to statistical offices or tax authorities. These database may identify ownership and thus allow to sort data by foreign and domestic ownership. E. g. the Hungarian Central Statistical Office (2005) publishes NACE 2 digit information on the foreign affiliates in the country. 2) If the financial statements do not include information on ownership, this information has to be taken from the National Bank matching the company codes. This linking of data is done in the offices responsible for collecting the statistics keeping in mind rules of confidentiality. (Hunya and Skudar 2006) 3) As a third alternative, the FDI questionnaire of the National banks may ask for information beyond the amount of FDI. This may include the information otherwise available from balance sheets (Austrian National Bank 2005). Whatever the source of data, the database would contain the following Indicators: number of companies, nominal or own capital, foreign investment in the nominal capital, total assets, foreign assets, output or sales, value added, average number of employment, annual average monthly wage, or annual wage fund per employee, revenues from exports or export sales, profits before tax, profits after tax, value of investment outlays The type of indicators will be: absolute numbers, values in national currency. Computed data include the share of foreign affiliates in total, share of industry in total. It is useful to calculate labour productivity, capital productivity, profit rate, export propensity etc. One can use the database aggregated at NACE 3 or 2 digit level to point out characteristic in each industry, to measure structural dispersion of data across industries and to see the speed of structural change. Also firm level data must be made available in the form of panel data for econometric research. Most of the contemporary literature on FDI impact analysis relies on company level data. But researchers usually do not have access to the data collected by governments and rely on privately collected data e.g. the Amadeus database. It is in the interest of decision-makers to rely on the findings of these new methods of research and supply reaserch with the necessary data. The company level data is used in an anonymized form for panel analysis, thus it would not harm the rules of confidentiality. Aggregate NACE 2 digit data can be used in descriptive work pointing out specialization patterns (Hunya 2001) or using simple econometric methods for the same purpose (Damijan and Rojec 2004). Application to the analysis of the employment impact of FDI is provided in (Radosevic, Varblane, Mickiewicz, 2003). Firm level data can be used in econometric analysis which select one or the other indicator as dependent variable. Also the research that uses company level data from surveys can be repeated relying on this more comprehensive database and delimiting the exercise on one specific country (see e.g. Bosco 2001). An application to innovation, where innovation survey and FIE data are combined is presented in Balcet and Evangelista 2005. C. Analysis using firm-level information and company surveys Data and information collected at the national level is not always satisfactory to find answers to specific research questions. In order to find specific answers to specific questions, companies can be surveyed directly. A review of press reports and international company databanks may be used as supplementary source of information. Questionnaires and in-depth interviews can be applied. The main questions to be addressed to companies include: - motivation of investing in the country, investment barriers and the significance of FDI policy. This can provide feedback concerning the efficiency of policy tools. (Holland et al. 2000, Bosco 2001) - status of the FIE concerning its mandate and level of competence in the multinational framework. The autonomy and deep integration into the TNC both help long-term development of the subsidiary, its development perspective possibility for spillovers and local linkages. (Majcen, Radosevic, Rojec, 2003, Damijan and Rojec, 2004) - mapping domestic and international networks and clustering of FIEs. In order to generate spillovers, upstream and downstream linkages are necessary and may be supported by government policy. Mapping international linkages may be used as orientation for foreign (economic) policy. - investigation of company strategies, R&D, production, investment and employment plans. Firm strategies aare necessary to develop government strategies to improve the business environment assess and support technological development and other line policies. - firm surveys can also be used to get feedback concerning the economic policy of governments (see e.g. Hong and Grey, 2003) II. FDI impact analysis in the economics and international business literature This section relies on work by Julia Wörz, wiiw 1) Impact of FDI on economic growth: the theoretical background Economic theory provides us with many reasons why foreign direct investment may result in enhanced growth performance of the receiving country. In the neo-classical growth literature, FDI is associated positively with output growth because it either increases the volume of investment and/or its productivity and thus puts the economy on a path of higher long-term growth. In an exogenous growth model, FDI has only a level effect in the steady state and no permanent impact on the growth rate, except during the transitional dynamics to the new steady state. The potential role for FDI is much greater in endogenous growth models. In a neoclassical production function, output is generated by using capital and labour in the production process. With this framework in mind, FDI can exert an influence on each argument in the production function. FDI increases capital, it may qualitatively improve the factor labour (explained below) and by transferring new technologies, it also has the potential to raise total factor productivity. Further, as discussed in more recent theoretical growth models (e.g. by Grossman and Helpman, 1991) by raising the number of varieties for intermediate goods or capital equipments, FDI can also increase productivity (see Borensztein et al., 1998 for an empirical analysis of this channel).1 Thus, in addition to the direct, capital-augmenting effect, FDI may also have additional indirect and thus permanent effects on the growth rate. Most importantly, FDI can permanently increase the growth rate through spillovers2 and the transfer and diffusion of technologies, ideas, management processes, and the like. The literature mentions basically four channels that allow for technological spillovers from FDI to the host economy (Kinoshita, 2001; Halpern and Muraközy, 2005): - First, the classical indirect channel for the transmission of technology from FDI to the domestic economy functions via imitation. The effect of FDI depends crucially on factors such as the legal system, regulations, infrastructure and human capital endowments, as well as the complexity of the technology. - Secondly, and often considered to be the most important channel, the training of local workers in foreign-owned firms generates positive spillovers through the acquisition of human capital. The empirical evidence concerning the labour market implications of foreign-owned firms is mixed. On the one hand, foreign firms spend on average more on training of workers than do local firms. On the other hand, foreign-owned firms may skim the market of well-trained workers and – at least in the short run – free-ride on previous training by domestic firms. The smaller the wage differential between foreign and domestic firms, the greater the scope for positive spillovers, since this would allow also domestic firms to attract well-trained workers from foreign firms. An important question relates also to the specificity of the knowledge acquired through training in foreign-owned firms. Based on meta-analysis, Görg and Strobl (2002) find evidence that the managerial 1 The same effect can also be achieved through imports of such goods. In this sense, FDI represents an alternative means to increase the number of available varieties in addition to trade, even if there are qualitative differences between the two. 2 Spillovers occur when multinationals are unable to capture all the productivity effects that follow in the host country’s local firms as a result of the presence of the multinational (Caves, 1996). - - skills of owners of domestic firms who were previously employed by multinationals were industry-specific but not firm-specific, which points towards a large potential for intraindustry spillovers. Thirdly, foreign presence increases competition in a market. The impact of FDI on the market structure depends on the size of the technology gap as well as on entry and exit behaviour in the market. Fourth, there are vertical or backward spillovers. By purchasing intermediates from foreign suppliers or by selling output to foreign firms, local firms will be affected positively in terms of efficiency and quality of output. Thus, the increased variety of intermediate goods may induce a more effective international specialization in production and this, together with increasing returns to scale in production, will result in higher productivity growth. A potential problem at the micro-level, where the spillovers arise, is the evidence for self-selection bias: while there is a general consensus that FDI increases the productivity of receiving firms, part of this effect is in fact due to FDI selecting better firms as targets for takeover (Bellak, 2004). At the more aggregate level, this translates into the imminent causality or endogeneity problem, faced by all empirical studies on the effects of FDI. 2) The absorptive capacity of host economies – how to become attractive for FDI While in theory, the nexus between FDI and growth (in terms of output and productivity) is in general positive, the empirical literature is far less conclusive. Some studies find positive effects from outward FDI for the investing country (Van Pottelsberghe and Lichtenberg, 2001; Nachum et al., 2000), but suggest a potential negative impact from inward FDI on the host country. This results from a possible decrease in indigenous innovative capacity or crowding out of domestic firms or domestic investment. Thus, in their view and in line with the standard literature on the determinants of FDI (i.e. Dunning’s OLI paradigm, see Dunning, 1988) inward FDI is intended to take advantage of host country (locational) characteristics instead of disseminating new technologies originating in the sending country. Other studies report more positive findings: Nadiri (1993) finds positive and significant effects from US-sourced capital on productivity growth of manufacturing industries in France, Germany, Japan and the UK. Also Borensztein et al. (1998) find a positive influence of FDI flows from industrial countries on developing countries’ growth. However, they also report a minimum threshold level of human capital for the productivity enhancing impact of FDI, emphasizing the role of absorptive capacity. Absorptive capacity or minimum threshold levels in a country’s ability to profit from inward FDI is frequently mentioned in the literature (see also Blomström et al., 1994). Consequently the effect of FDI depends among other things to a large extent on the characteristics of the country that receives FDI. The resulting issue of cross-country heterogeneity, however, has so far largely been neglected in the literature, with few exceptions. Blonigen and Wang (2005) stress explicitly cross-country heterogeneity as the crucial factor which determines the effect of FDI on growth. Further, Nair-Reichert and Weinhold (2001) and Mayer-Foulkes and Nunnenkamp (2005) explicitly take up this aspect in their analysis. The importance of absorptive capacity – often captured by differences in the stage of development between donor and host country – has been a central finding in many empirical studies on the FDI-growth link (Blonigen and Wang, 2005; Borensztein et al., 1998; De Mello, 1999). There are also theoretical justifications for the importance of a certain amount of absorptive capacity. For example, Markusen and Rutherford (2004) develop a three-period model where they show that the speed and degree of positive spillovers from FDI is positively related to the absorptive capacity of the host country. In an earlier paper and using a new economic geography model, Rodriguez-Clare (1996) relates the developmental impact of multinational firms to the type of the linkages which they create. Positive linkage effects are the stronger the more intensive the multinational is in the use of intermediate goods, the larger the costs of communication and trade between headquarters and local plants and the more similar home and host country are in terms of the variety of intermediate goods produced. This implies stronger linkages – and thus greater positive effects – if the developmental gap between donor and host country is smaller. For all of the channels outlined above, one may argue that positive spillovers will only occur in a suitable setting. If the host economy does not provide an adequate environment in terms of human capital, private and public infrastructure, legal environment and the like, many of the spillovers that may potentially arise from FDI cannot materialize. Public infrastructure such as educational institutions and publicly funded R&D collaborations can significantly support potential spillovers. A high structural match between the donor and the host country would imply a proximity in stage of development and thus also a good precondition for the absorptive capacity of the receiving country to be high. Potential for positive spillovers does not solely depend on a country’s overall absorptive capacity, but also on the industrial structure of the economy (Castejon and Wörz 2006). Thus, the impact of FDI differs depending on country-specific absorptive capacity or stage of development as well as on the sectoral and industrial structure and allocation of FDI. Since the two are in general related, this implies a relationship between the industrial pattern of inward FDI and its effect on the host country. The economy-wide effect of industry-specific FDI inflows will then further depend on the extent of intra-industry versus inter-industry spillovers. 3) Export-oriented and local market oriented location factors Export-oriented subsidiaries are set up by a vertically integrated multinational company in a host country with the aim to lower production costs, seeking, securing and diversifying resources (Narula and Dunning, 2000). Export-oriented FDI involves fragmenting the production process geographically by different stages based on labour intensity and resource endowment. The important location factors that influence this type of FDI include labour costs, physical resources abundance, infrastructure, trade barriers, exchange restriction, and FDI favourable policies. Local market-oriented FDI is set up by horizontally integrated multinationals to penetrate a market, increasing market share, diversifying the source of sale, and minimizing competition risk (Zhang and Markusen 1999). The determinants of this type of FDI include local market size, the level of human capital, infrastructure, political stability, FDI policy, and cultural barriers. Export-oriented FDI is more footloose, because the locational requirements are less specific. Competition may rise among the countries that can provide the same resource at the same cost for the same production stage. As most of the FDI is in non-tradable services, local market orientation characterizes the major part of FDI. Only a low, but undisclosed part of the services is internationally oriented and attracts customers from abroad. Generally available sources for FDI impact analysis methods and international findings In this section we select reference web sites and scientific papers which discuss the available literature. 1.) A recent survey in Bloningen 2005 discusses the literature on the determinants of FDI, the motivation of multinational companies in their location choice. Other main issues, research findings and methodology is included in Bora (ed.) 2002. 2.) A list of recent literature can be selected from the World Bank homepage http://rru.worldbank.org/PapersLinks/ by choosing Foreign direct investment: its impact. Here one finds a list of papers, web sites and case studies in the fields of: FDI impact on growth, trade effects, employment and skills development, technology diffusion and upgrading, linkages and domestic firms. 3.) A methodological paper pointing out the benefits and shortcomings of surveys and econometric analysis is provided in Holland, et al. 2000. III. Methodological examples for empirical research into the labour market effect of FDI 1) Gravity model (based on Hunya and Geishecker 2004) Evidence indicates that foreign direct investment and production sharing. Foreign direct investment appears to be primarily undertaken by horizontal multinational firms. In order to examine this hypothesis more thoroughly we assess the determinants for foreign direct investment in Europe in an multivariate gravity model. We evaluate the role of overall market size, market size differences, endowment differences, trade costs and unobserved characteristics as determinants for bilateral FDI. But the determinants of FDI should, differ between different economic sectors. To test this hypothesis we decompose FDI into manufacturing and non-manufacturing FDI and asses the determinants separately. We estimate a gravity equation for an unbalanced bilateral panel of 27 reporting and partner countries (including the NMS and CC of Bulgaria, Czech Republic, Estonia, Latvia, Lithuania, Poland, Romania, Slovak Republic) for which the FDI inward stock in manufacturing and nonmanufacturing industries is available from Eurostats New Cronos Balance of Payment statistics. Following and expanding on Carr et al. (2001) we specify the following model: FDI ijt = α + β GS GDPsumijt + β GD GDPdiff ijt + β ED ENDOWdiff ijt + β GED (GDPdiff * ENDOWdiff ) ijt + β TCI IMPT jit + β TCE + EXPTijt + β TED ( IMPT * ENDOWdiff ) ijt + δ t + ϑij + ε ijt where FDIijt denotes the total inward stock of foreign direct investment from country j in country i at time t in real terms. GDPsum denotes overall bilateral market size and GDPdiff the difference in market size. According to the knowledge-capital-model we expect total market size to have a positive impact on foreign direct investment. Dissimilarities are however expected to lower foreign direct investment according to the model. ENDOWdiff denotes endowment differences, which we approximate by absolute GDP per capita differences following conventional literature. The term IMPT denotes trade costs for imports from country j. Since in the model horizontal foreign direct investment and trade are substitutes we expect a positive impact of trade cost on foreign direct investment. The term EXPT on the other hand denotes export costs. If the coefficient is significant at all, we expect a negative sign as vertical foreign direct investment should be negatively affected by export costs. The model also includes the interaction terms of size and endowment differences (GDPdiff*ENDOWdiff) and import costs and endowment differences (IMPT*ENDOWdiff) to take account of model nonlinearities. Finally we decompose the error term into time specific ϑ δ ε components t and bilateral fixed components ij . The remaining error term ijt is assumed to be idiosyncratic. Allowing for bilateral fixed effects as well as common time effects allows us to avoid omitted variable bias by comprehensively controlling for macro economic influences and institutional and cultural factors such as investment regulations and language that may determine foreign direct investment. 2) Assessing the Skill Bias of FDI (based on Hunya and Geishecker 2004) To clarify what labour demand effect is attributable to international outsourcing and knowledge spill-overs through FDI we expand on the existing literature and control for both determinants simultaneously. We estimate industry level employment share equations for low-, medium and high-skilled workers separately utilising a large three-way country/industry panel . We define low, medium and high-skilled workers on the basis of occupational placement utilising country and industry level data from the European Labour Force Survey. Following Berman et al. (1998) we then assess the impact of FDI on the skill composition of employment by estimating the following three way panel model for the employment share of high-, medium- and low-skilled workers respectively: S ijtS = α 0 + β Y ln Yijt + β C ln C ijt + β FDI ln FDI ijt + β IMPF ln IMPijtf + β IMPM ln IMPijtm + β EXPF ln EXPijtf + β EXPM ln EXPijtm + υ jt + δ t + λ j + µ i + ε ijt where s indexes she skill level, i industry, j country and t time. Y and C denote output and capital and FDI represents the stock of foreign direct investment. Imports (Exports) of final and intermediate goods are denoted by IMPf (EXPf) and IMPm (EXPm). Furthermore we allow for country specific time effects υ jt that capture country specific factors such as changing relative wages. The remaining error term is decomposed into a time specific component λ µ δ t , a country ε ijt specific component j , an industry specific component i and an idiosyncratic error term . 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