Lectures 11-12Foreign direct investment, models, types, and

growth

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Globalization and productivity growth

Solow growth model emphasizes importance of productivity growth – in a hypothetical closed economy

Open-economy Solow: (i) intermediate inputs Original aggregate production function:

Y = A•ƒ(K, L)

With intermediate inputs (N): assume

Y = A•ƒ(K,L)•N

==> More N more output and more productive K & L==> If intermediates are dominated by imports, then

lowering costs of importing N has positive effects on economic growth

Example: demand for N = ND = PN-1, so Y = A•ƒ(K,L)/PN

Then –∂Y/∂PN has an effect proportional to ∂Y/∂A; lowering the domestic cost of N raises TFP.

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Globalization and int’l capital transfer

Open-economy Solow: (ii) imported capital (= FDI)Original capital growth equation:

Δk = s•ƒ(k) – (d + n)•k

Savings in closed econ: S = I; s = I/Y.

In open econ: S = I + FDI, s = (I + FDI)/Y

==> Imported capital (FDI) also adds to capital stock

==> Lowering the cost of importing capital is equivalent to raising the domestic savings rate, which increases economic growth

FDI may also interact with other factors (human capital, productivity) as discussed in previous class.

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Focus on FDIAugments capital stocks in poor

economies- alters comp. advantageMay be “bundled” with tech. transfers,

sourcing and sales networks, etc. By moving factors across borders, acts as a

substitute for trade in goodsIntroduces distinction between GDP and

GNIGross national income (GNI) = GDP +/- factor

earnings from/to abroad

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r1

r1A

r*

01 KA K*

MPPK1 MPPK2

• MPPKj = marginal product of capital; rj = price, in j• K exporter reads from right, K importer from left • FDI = int’l flow equal to qty KAK*, equalizes r at r*

a

b

c

d

e

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r1

r1A

r*

01 KA K*

MPPK1 MPPK2

a

b

c

d

e

abd = rise in 1’s GNI; bcd = rise in 2’s GNIr1 falls and r2 rises, but what about w1 and w2?

Why does capital move? DetailsTransfer of KAK* from country 2 to country 1:

GDP in 1 rises by KAadK*, cost of capital falls to r*GDP in 2 falls by KAcdK* but repatriated profit on

investment pays KAbdK*Net gain = acd:

abd = rise in 1’s GNIbcd = rise in 2’s GNI

This theory says that world welfare is raised by capital flows: more efficient use of scarce resources

Cost of capital falls in importing country, rises in exporting country. What do we expect happens to wages in each country?

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M

X

pW

• FDI in M sector shifts its prod’n function upward (left panel)• This moves PPF out asymmetrically• Why does X sector output fall? (n.b.: pW unchanged)• By how much does aggregate income grow? Consumer welfare?

• FDI in M sector shifts its prod’n function upward (left panel)• This moves PPF out asymmetrically• Why does X sector output fall? (n.b.: pW unchanged)• By how much does aggregate income grow? Consumer welfare?

L

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M

e f

pW

• At const. pw, X output falls from b to a as cd labor reallocated to M• Aggregate income increases by less than the rise in the value of production ef (some profits are repatriated)

• At const. pw, X output falls from b to a as cd labor reallocated to M• Aggregate income increases by less than the rise in the value of production ef (some profits are repatriated)

L a bc d

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Types of international capital flows

FDI: acquisition of managerial control over productive assets. Tradable but typically illiquid (not easily moved) assets. Spillovers to rest of economy?

Equity portfolio investment: acquisition of shares in listed companies. Tradable and liquid

Bond finance: private or public issues with future payments (like loans) similar to portfolio investment, may include gov’t bonds

Commercial bank (or non-bank) lending: non-tradable assets; liquidity varies (e.g. with term of loan)

The big picture on magnitudesFDI most important foreign capital flow for

developing countries in past 20 yearsRemittances from migrants is the most

dynamic source in past decadeBoth of these were somewhat jeopardized in

2008-9 crisis, for somewhat different reasons.A look at the numbers on FDI

internationally….

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International capital flows

13Mostly ODA until recently, with some FDI

14Mostly ODA and FDI, like Sub-Saharan Africa – until 2006.

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FDI is the dominant source since mid-1990sNote also that FDI in Latin America is 10x larger than other regions above.

16FDI also dominates foreign capital flows in E Asia and is greater than ROW.

17China is single largest recipient of FDI; levels that rival all of LA or EAP

Why do private companies invest abroad?

Efficiency rationale (seeking access to abundant endowments, cheap labor, human capital, lower transport costs, etc.)

Secure access to raw materials such as minerals or oil (resource and strategic rent rationale)

Access to local markets (non-tradables or inside trade barriers)

Other reasons?--> Various “types” of FDI in developing countries

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Benefits of FDI

Increased output (higher GDP)Higher labor productivity; more jobs; maybe

higher wagesMore exports & foreign exchange

Value of add’l exports should exceed earnings by foreign capital owners, so net gain to host country

Scale economies, technological, managerial and skill spillovers

FDI may create competition and undermine domestic monopolies (e.g. in telecoms, air travel)

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Why might FDI be bad for development?

Market-access type FDI may create monopoly Technology and factor use intensity may be

mismatched with local econ.Transfer pricing: intra-firm price

manipulation to avoid taxesRent capture and market concentration;

policy and institutional distortions (corruption)

Limited spill-in of technologyLoss of control over domestic policy

E.g. large MNCs in small economiesAre such constraints on policy always bad?

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Impacts of FDI on Poverty

Poverty effects depend directly on whether returns to factor endowments of low-income households are enhanced by FDI and/or if prices (quality) of key consumer goods are reduced (improved)

Incomes of poor households: mostly labor

Which FDI types are most likely to reduce poverty?Returns to labor are critical impact of FDI, so efficiency

rationale perhaps best for reducing poverty.FDI for resources if ownership is broadly distributed or well

regulated, but that probably lowers incentive for FDI (rents)FDI for market access most likely to have positive

price/quality impacts if under “competitive” conditions.

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Does FDI alleviate poverty?

In most dev. countries, substantial FDI inflows are a recent phenomenonDoes FDI follow economic success, rather than the other

way around?Globally, poorest countries receive least FDI

Claimed benefits via tech transfer, etc increase labor productivity for FDI in labor-intensive activities

Sectoral targets for FDI are critical:Mining & other extractive industries, vs. labor-intensive or

technology-intensiveRegulatory, policy & institutional settings in host

countries are critical “Financial development” (monetization) is good indicator

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Does FDI alleviate poverty?To fully understand this, we also need to

know something about labor mobility.We’ll return to this at end of today’s class.

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FDI & Growth

Back to the Solow Model and what drives growth?

Y = Aƒ(K, S, L)Where does FDI enter into this conception?

Increase in K, which drives growthWhat about A?What about S?

3 links to assess – capital stock, technology, and human capital. Let’s discuss each.

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FDI and Capital Stock - 1

Link between FDI and capital stock seems clear from model presented earlier. Increases capital availability for investment which raises production and wages.

Is this always true?What if the FDI is capital that is raised locally (via loans)?What if it involves joint venture investments?Simple point – may not be 1:1 increase in domestic capital?Over time, what if FDI leads to profit drain out of country?When is this more likely to be the case?

Still, seems as if FDI should ‘add’ to domestic capital stock in most cases.

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FDI and Capital Stock - 2

Does it matter what ‘type’ of FDI occurs?- Efficiency-seeking vs Market Access vs Resource-seeking?- Solow model does not distinguish between types of capital or

sectors of the economy.- What issues might arise in terms of growth effects of different

types of FDI?

Which type seems most likely to contribute to growth? Why?

Concerns with market access FDI?- Market power, restrict output

Concerns with resource-seeking FDI?- Same as market access plus ‘resource rents’ are in play.

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FDI Inflow and GDP Growth in China, 1985-2007

GDP Growth

Source ： China Statistical Yearbook, own presentation.

Sources of FDI in China, 2000-2007

(in % of total)

2008 2000 Total 100 100 Hong Kong, China 37.05 38.07

Korea 4.92 3.66

Japan 4.80 7.16

Singapore 4.26 5.34

United States 3.50 10.77

Taiwan, China 2.37 5.64

other 43.10 29.37

Source：China Statistical Yearbook

Hong Kong has traditionally been the most important source of FDI

into China.

Sectoral Distribution of FDI in China(in % total, 2007 )

Manufacturing

Real Estate

Leasing and Business Services

Wholesale and Retail Trades

Transport, Storage and Post

other

Source ： China Statistical Yearbook, own presentation.

The largest portion of FDI is for manufacturing, which took up

almost 55 percent of total FDI. Next is real estate at 23%.

China & FDI (Is Vietnam similar?)

FDI predominantly in manufacturing, some real estate but lots of ‘investment’ there.

Almost nothing in natural resources – very little struggle over ‘resource rents’

Lots from elsewhere in Asia, linked to higher tech goods through assembly first and then moving to more sophisticated stages of manufacturing

Diversified national origin (not dominated by US FDI, as in Mexico).

FDI and Technological Change

Solow Model: A is technological change :Does it increase with FDI? Why would it? What would we want to assume about the spread or

spillover of FDI in the economy? What factors would make that spillover more likely?Does type of FDI matter again?What local or domestic factors might make spread

more likely?Does the form of FDI (e.g., joint venture) matter?

Why or why not?

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FDI and Technological Change - 2

What would enhance the potential for FDI or other forms of absorption of foreign technology?

Active R&D support/infrastructure in country for both capacity and resource.

Coordination among firms encouraged by state and other institutions. How can that be done? Incentives (+ and -).

State sponsorship of training of workers and managers, such as here at university.

FDI and other foreign contracts tied to tech transfer, again like the UW-Madison working with the Hanoi University of Agriculture.

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China consumer electronics & auto partsRodrik develops this example:

FDI key role in technology transfer Lots of joint ventures and domestic capacity

built “interactions with domestic companies” have been

important sources of productivity growthChina has taken advantage of good

“fundamentals” (e.g. macroeconomic stability) and a determined government effort to acquire capacity and build domestic industry.

FDI and TFP: Rodrik’s conclusions

China unusual export profile, rapid movement to higher tech goods than predicted (see EXPY, yesterday’s class).

Critical contribution to faster economic growth.Active industrial policy important to overcoming

uncertainty and technological and informational “spillovers” associated with what will and won’t work.

Secret is not to “pick winners” but not keep on feeding losers. Need to overcome externalities.

Implications for other countries? China is not a special case (Japan, Korea, Singapore, Taiwan). Vietnam can learn from China but recognize that it is smaller country and will need to cultivate high tech profile.

FDI vs Licensing

Pros of FDI:Investment, competition

Pros of licensingMore spillovers by design because licensing

involves a foreign firm transferring knowledge, equipment, and so forth to domestic firms.

Strategic Perspective on MNC FDI Decisions & Technology

Consider multinational corporation with a technology facing a market opportunity – e.g., China or Vietnam

Opportunity? Consumer market, labor, and/or resources.

Options? Export from home FDI – internalize via an owned subsidiary License to an existing firm in China

What are the tradeoffs involved with each option?

What happens if the MNC licenses or undertakes a joint venture?

Advantages?

Existing partner has better knowledge of local cultureMarketing channels may be establishedLocal management of workersLocal knowledge of “adaptation” paths for new tech.Friendly government policies likely inc. subsidy, tax

breaks, loans, infrastructure, etc.

What happens if the MNC licenses or undertakes a joint venture?

Disadvantages?Creates strong competitors in longer run,

especially if the licensees directly or indirectly enhance local research capacity.

Knowledge spillovers via more complete transfer of technology

Contract that limit the future use of technology might be difficult to enforce. Why?

Should the MNC use FDI instead?

AdvantagesProtect technology ownership and knowledgeImprove market presence and control qualityMore of profits via controlling tech dynamic option?

DisadvantagesIncrease competition and lowers rentsMay not be a high profit area for them or have

capacity to make FDI work well.In practice: more FDI, less licenses but some

countries (Korea, China) push for joint ventures.

Preferred path for developing economies?

If licensing is the fastest, most direct path to learning, then would they not first encourage JVs and licensing over FDI?

Japan, Korea, and Taiwan limited FDI but encouraged licensing.

But, Singapore, Thailand, and Malaysia relied heavily on FDI, though they were a host for lots of Japanese investment as well as US and European.

China has also relied lots on FDI but has played US vs European vs other FDI efforts off on another (e.g., insurance university by Chubb, Microsoft help develop Chinese software industry in exchange for “entry”.) Why might China have bargaining position?

FDI and Human Capital (H)

Solow Model: Y = AF(K, L,H). Does H increase with FDI?How might FDI and H have positive feedback effects?

Does higher human capital attract FDI? Why?Does higher FDI improve H? Direct and indirect effects?

Direct effects: Learning about new technologies, markets, organizational approaches, management practices and so on.

Indirect effects: FDI raises wages, or potential wages, attracting more private and public investment in human capital.

Potential source for successful endogenous growth strategy especially in labor abundant regions with relatively high levels of human capital? Why?

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FDI, Human Capital, and Policy

What can the state do? Education Technical training, and Support for private and public investment

When are they more likely to do so?Growth, taxation, and industries and activities that

use human capital (manufacturing and services), but what about ag/nat resource products?

Does type of FDI matter again to public and private investment? Should, because it may reward or not more human capital.

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Poverty impact of FDI depends on labor mobilityWhy does labor migrate?What happens in each economy when it moves

between them?Gains/losses in GDP and GNIWages in each economy

Labor mobility need not be between national economiesChina’s experience of internal migration

restrictionsHukou acts like a tax on rural labor

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Poverty impact of FDI depends on labor mobilityAnalysis: (i) effects of FDI on labor demand;

(ii) response of the labor market (e.g. rural-urban migration)

Poverty is most widespread in rural areasLabor market may be “segmented”How will gains of FDI-led growth be

distributed?

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w1

w10

w*

01

w2

w*

w20

02 LA L*

VMPL1 VMPL2

• MPPL = marginal product of labor (demand), with K fixed in each sector• Outmig. area reads from right, L importer from left • Migration = flow equal to qty LAL* equalizes w. Notice w1 must fall to achieve this-- unless MPPL2 rises for some reason

a

b

c

d

e

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w1

w10

01

w2

w20

02 LF

VMPL1

VMPL2

• No migration – labor fixed at LF, wages do not equalize• FDI raises L demand in sector 1, what happens to wages in 1? To wages in 2? To poverty, assuming that’s in sector 2?

a

c

Review & questionsWhat’s the difference between FDI and

portfolio inv?Suppose capital productivity rises in one

country – due to technological change for example. What will happen to FDI flows?

How does uncertainty affect FDI flows?Macro instability (inflation/exchange rate)Risk of expropriation (nationalization) as in

Venezuela?

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