4th FIW Workshop„Foreign Direct Investment – Determinants and Home Market Effects“

Vienna, March 7, 2008

Heinz Hollenstein

Characteristics of Foreign R&D Strategies of Swiss Firms

Implications for Policy

Background

Outward-investments increasingly pertain to R&D

We notice from casual observation and empirical research that the motives for performing R&D at foreign locations are changing (what also is reflected in theoretical thinking)

Technology/knowledge sourcing is gaining ground as a motive of foreign R&D as compared to more traditional motives

Concern in the public that foreign R&D may “erode” the domestic knowledge base (“relocation”, substitution)

On the other hand: Based on the belief that technology sourcing primarily is a means for augmenting strategic assets of (domestic) headquarters, it is hypothesised that foreign and domestic R&D are complements

Background and research questions

Research questions Which of the two competing hypotheses, on balance, is supported

by the data in case of the Swiss economy?

As the answer depends on the relative importance of alternative foreign R&D strategies: What strategies firms pursue in performing R&D at foreign locations? Which strategies are most prevalent?

Based on this analysis: what are the direct home-country effects of foreign R&D strategies of Swiss firms?

What do we know about indirect home-country effects? What are the determinants of (the extent of) knowledge spillovers? Is the Swiss economy in a good position to capitalise on spillovers?

What are the policy implications in the Swiss case?

Background and research questions

Outline

Background and research questions

Data

Identifying foreign R&D strategies Method Empirical results

Prevalence of alternative strategies

Home-country effects of foreign R&D Direct effects Indirect effects (knowledge spillovers)

Policy recommendations

Outline

Data

Firm-level data stemming from the Swiss Innovation Survey 2002

Sample Stratified by 28 industries and 3 industry-specific firm size classes Coverage: manufacturing, construction, commercial services

(firms with 5 or more employees)

Response rate: 40% = 2583 firms, of which: 1078 firms performing R&D 156 firms performing R&D at foreign locations

These 156 firms are the sample we use in our cross-section analysis In future research, we intend to analyse the topic based on four waves

of the Swiss Innovation Survey

Data

Starting point We assume that firms may (but must not) be driven to invest in

foreign R&D by more than one motive

Therefore, a firm’s foreign R&D strategy can be described by a specific combination of such motives (“mixed” strategy)

In order to identify different (mixed) R&D strategies we draw on information on the importance of seven motives of performing foreign R&D Assessments of the firms themselves 5-point Likert scale

Identifying foreign R&D strategies: method

Motives of performing foreign R&D % (highly)

important *

Supporting local production and sales 40

Proximity to leading edge universities 26

Proximity to highly innovative firms 35

Transfer of knowledge to the headquarter 26

Lower R&D costs 26

Higher public support for R&D activities 12

Ample supply of R&D personnel 38

* Value 4 or 5 on a five-point Likert scale

Identifying foreign R&D strategies: method

A two-step procedure to identify R&D strategies

Step I Cluster analysis of 7 motives of foreign R&D

We find four clusters each containing firms that are similar in terms of the combination of the underlying motives

One may conclude that the clusters represent four specific foreign R&D strategies

However, as cluster analysis is a purely statistical procedure (classification method), this interpretation only is preliminary

Step II In order to check whether the clusters identified in the first step

effectively may be interpreted as specific R&D strategies, we characterise them by a number of (mostly) theory-based sets of variables

Identifying foreign R&D strategies: method

Variables used in step II to characterise R&D strategies The motives used in the first step, i.e. the cluster analysis

A large number of variables representing the most important ingredients of the OLI paradigm of explaining FDI O-advantages: innovation input/output, use of external knowledge,

appropriability, technological opportunity, firm size, labour productivity

L-disadvantages: innovation barriers in Switzerland I-advantages: R&D co-operation, firm size

Market environment: demand prospects, intensity of price and non-price competition, number of principal competitors

Structural characteristics of the firm: industry affiliation, firm size and firm age, export orientation, company status

Identifying foreign R&D strategies: method

Four strategies of foreign R&D pursued by Swiss firms Firms pursuing a broad-based strategy in terms of motives, with

tapping into knowledge from universities and embodied in specialists as the most important elements (25% of firms, 11% of employment)

Firms strongly embedded in foreign networks of highly innovative firms, complemented by an intensive knowledge transfer to the domestic headquarter (24% of firms, 24% of employment)

Firms pursuing a strongly focused strategy, with foreign R&D almost exclusively used as a means to extend local markets (36% of firms, 57% of employment)

Firms pursuing, in terms of motives, a quite narrow-based strategy that aims at reducing R&D costs and gaining access to highly skilled personnel (15% of firms, 8% of employment)

Empirical results: 4 strategies

Characteristics of strategy I(broad-based strategy in terms of motives, with particular importance of knowledgesourcing (universities, specialists)

Strong O-advantages High internal research, development and other innovation expenditures

as well as very intensive use of external knowledge Intensive patenting activities and generation of many world novelties Favourable supply-side conditions (technological opportunities,

appropriability)

Several kinds of L-disadvantages In the first place: insufficient supply of highly/specifically qualified personnel In second instance: excessive regulation and insufficient financial

incentives for performing R&D in Switzerland

Structural characteristics Highly export-oriented medium-sized firms Younger than average Slightly over-represented in mechanical engineering and in services

The strategies in detail

Characteristics of strategy II(high relevance of knowledge sourcing within networks of very innovative firms;intensive reverse knowledge transfer)

Strong O- and I-advantages – excellent market perspectives Strongly research-oriented internal innovation activities based on an

excellent staff and intensive use of science-oriented external knowledge (journals, patent documents)

Tight network of R&D co-operation Surprisingly, supply-side conditions for generating innovations are only

average, whereas demand/market conditions are excellent

Hardly any L-disadvantages These firms actively search worldwide for complementary knowledge at the

most attractive locations rather than being pushed to perform R&D abroad

Structural characteristics Large share of very small, in many instances young companies;

however, some large MNE’s also pursue this strategy Pharmaceuticals, chemicals and services are over-represented Export-orientation is low (reflecting the high share of small firms)

The strategies in detail

Characteristics of strategy III(strongly focused strategy: foreign R&D almost exclusively is market-oriented)

Only moderate O-advantages – strong market growth Moderate internal innovation outlays (development-oriented), not matched by

tapping into external knowledge sources Quite extensive network of R&D co-operation Weak supply-side conditions for generating innovations, but strongly

growing markets characterised by fierce price competition with few competitors

Only few L-disadvantages Insufficient availability of highly-skilled personnel

Structural characteristics Very high share of large, well-established (old) companies Extremely high export-orientation Over-representation of manufacturing (with the exception of

pharmaceuticals/chemicals)

The strategies in detail

Characteristics of strategy IV(quite narrow-based strategy that aims at reducing R&D costs and gaining access tohighly skilled personnel)

Weak O- and I-advantages – market perspectives not promising High application-oriented internal innovation expenditures (engineering,

follow-up investments), Quite substantial use of knowledge generated by other firms along the same

value chain Given this pattern, firms pursuing this strategy are “incremental innovators” Slowly growing markets characterised by fierce price competition

Almost no L-disadvantages

Structural characteristics Very high share of small, in many instances, old companies Some over-representation of electrical engineering

The strategies in detail

Assessment of the empirical results The two-step procedure yields four clusters which safely

may be interpreted as specific “types of foreign R&D strategies”, as the results are satisfactory by statistical criteria

(cluster analysis)

well-founded in theory(OLI paradigm of FDI)

As hypothesised, it is sensible to conceptualise investments in R&D at foreign locations as “mixed” strategies” in terms of the underlying motives(although not all firms pursue broad-based strategies)

Assessment of the results

Prevalence of alternative strategies in the Swiss case The two “traditional”, (strongly) focused strategies 3 and 4 (market

and cost orientation) are still more prevalent than those for which knowledge/technology sourcing is either at the core (strategy 2) or, at least, is an important element (strategy 1) Number of firms 51% Employment 65%

Nevertheless, the two strategies that aim, among other things, at augmenting a firm’s strategic assets through knowledge sourcing have become highly relevant, in particular in terms of the number of firms (49%; employment: 35%)

Strategy 3 (exclusively focusing on extending foreign markets) and strategy 2 (combining technology sourcing and reverse knowledge transfer) dominate the pattern of foreign R&D of Swiss firms Number of firms 60% Employment 81%

Prevalence of alternative R&D strategies

Impact of foreign R&D on the Swiss economy In order

to assess whether foreign and domestic R&D, on balance, are substitutes or complements, and

to identify policy needs and recommend policy measures

we have to assess, in a first step, the impact of foreign R&D of Swiss firms on the domestic economy

The literature distinguishes to types of effects direct home-country effects: impact of FDI in R&D on the

domestic headquarter company(reflecting the prevalence of alternative strategies)

Indirect home-country effects (resulting from knowledge spillovers to other domestic firms)

Home-country effects of foreign R&D

Direct effectsIn view of the relative importance of the four strategies, we conclude that, in the Swiss case, foreign and domestic R&D, on balance, are complements:

Dominant role of the strongly market-oriented strategy 3, giving rise to firm-specific economies of scale in R&D at the headquarter

Low importance of cost-oriented strategy 4 (relocation of FDI is hardly relevant)

Reverse technology transfer is a core feature of strategy 2, thus enhancing the knowledge base at the (domestic) headquarter

Knowledge transfer does not play such an outstanding role in case of strategy 1, but is an important feature also in this case

Substitution vs. complementarity

Indirect effects

Positive indirect effects (knowledge spillovers to other domestic firms) would tilt the balance even further towards complementarity

The extent of knowledge spillovers depends on several factors, such as

– The ability of firms to prevent know-how from leaking to (domestic) competitors

– The willingness to share knowledge with other (domestic) firms (suppliers, users)

– Most importantly: spillovers are the larger, the higher the capacity of domestic firms to absorb external knowledge

– Spillovers are more likely if the R&D performing headquarter is strongly embedded in the domestic economy

Knowledge spillovers

What about spillovers in the Swiss case?

We argue that the Swiss economy is likely to benefit a lot from knowledge spillovers

Absorptive capacity of domestic firms is high

– The knowledge base is more widely distributed than elsewhere in Europe as Swiss SME’s are more innovative than those of all EU Member States

– Employment of highly qualified personnel is very high, what is partly due to immigration(the number of graduates per age-group is only average)

Knowledge spillovers

Firms performing R&D abroad are well embedded in the Swiss economy

– R&D co-operation is more widespread than in most EU countries and strongly science-based

– Technology transfer between science (which is of very high standard) and (high-tech) industry works well

– Promoting R&D co-operation between universities and industry is the core element of Swiss technology policy

– There are some important clusters of knowledge-intensive industries such as pharmaceuticals/biotechnology, instruments/electronics, financial services

Notwithstanding the positive assessment of both types of home-country effects, policy may support the Swiss economy to capitalise even more on Swiss firms’ foreign R&D

Knowledge spillovers

We propose five lines of policy action

Enhancing the domestic supply of highly qualified labour (education policy, etc.) Increasing the number of graduates (in particular scientists

and engineers) Promoting labour market participation of highly qualified

women Mobilising the intellectual potential of foreign children growing

up in Switzerland

Securing the high standard of university research and fostering new frontier research (science policy)

Policy recommendations

Promoting the application of the results of science in the business sector (technology policy) Promoting technology transfer and co-operation between

science and industry Avoiding a too restrictive regulatory framework for the

application of frontier technologies Providing an environment conducive to start-ups etc.

Promoting clusters of vertical and horizontal partners of the firms that invest abroad in R&D (embeddedness)

Policy recommendations

General measures to make Switzerland an even more attractive location for doing business (location policy) Low and incentive-oriented taxation Deregulation of (product) markets etc.

To conclude We recommend, as can be seen from our

proposals, a framework-oriented policy design rather than a more interventionist concept

Policy recommendation