GIGA Working Paper

The Positive Effects of Foreign Investment

More and more foreign firms are investing in the economies of sub-Saharan Africa. In many cases, local businesses can learn and benefit from the accompanying foreign expertise. Investments from other developing countries are especially advantageous in this respect, find Birte Pfeiffer, Holger Görg and Lucia Perez-Villar.

It is generally accepted by policymakers that outward foreign direct investment (FDI) can contribute to economic development in host countries via knowledge spillovers to the domestic economy. Given that multinational corporations (MNCs) possess technological or managerial advantages, they can generate positive externalities through the diffusion of knowledge to domestic firms.

This knowledge transfer can occur horizontally, if firms in the same sector benefit from the presence of multinationals, or vertically, if upstream or downstream domestic sectors gain from the presence of foreign investors. Yet, whereas the FDI literature has reached a certain level of agreement that vertical relationships with local suppliers generate positive productivity spillovers, the evidence on horizontal spillovers is still mixed and inconclusive, and estimates differ in terms of statistical significance and magnitude (Havranek and Irsova 2013).

These inconsistencies derive largely from differences in the measurement of foreign presence and the type of data used – cross-sectional versus panel – across studies (Görg and Strobl 2001). Further, there are determining factors at the firm and country level that enhance the realization of spillovers and need to be taken into account. Görg and Greenaway (2004) show that studies accounting for the heterogeneity of domestic firms, and especially their absorptive capacity, tend to report positive results.

Some consensus has now been reached among researchers that domestic firms’ absorptive capacity is a crucial precondition for these firms’ ability to capture gains from FDI. Importantly, absorptive capacity depends not only on domestic-firm capabilities but also on the appropriateness of the foreign knowledge in terms of complexity as well as product and process similarity. In this regard, for local firms to be able to benefit from the presence of MNCs, a certain knowledge base is needed. Moreover, technological differences with respect to foreign firms need to be relatively small. As empirical studies have consistently found, overly large technological gaps hinder the materialization of positive horizontal spillovers.

Therefore, and as concluded by Havranek and Irsova (2013), the nationality of foreign investors matters for spillovers as the technology endowments of firms differ across source countries. This suggests that the effects of South–South FDI flows – that is, FDI flows originating from and going to developing countries – may be different from those of North–South FDI flows, which are FDI flows from industrialized to developing countries.

In the last decade, FDI from developing countries has increased dramatically. In 2012, emerging multinationals represented 31 percent of global FDI outflows. Most outward FDI from developing countries flows to developing countries. Specifically, FDI inflows to sub-Saharan African countries are on the rise and becoming more widespread in the manufacturing sector (UNCTAD 2013). Moreover, knowledge transfers from FDI are considered to be crucial to the process of structural change and industrialization in sub-Saharan Africa; however, the region still faces significant challenges regarding the development of domestic-firm capabilities and the overall business climate (Farole and Winkler 2014).

Since South–South and North–South FDI differ in terms of motivation and technological content, it seems reasonable to expect that they entail different potentials for horizontal spillovers. Accordingly, we argue that southern FDI flows may be a particularly relevant source of capital, technology, and management skills for the sub-Saharan African region, as the technologies and business models of foreign firms from developing countries may be better adapted to local markets and better fit domestic-firm needs than those from more industrialized countries. Therefore, given the smaller technology gap, technology absorption and other beneficial linkages in sub-Saharan African countries are expected to be greater in the case of South–South investments (UNCTAD 2006).

We compile a unique panel data set of manufacturing firms in 10 sub-Saharan African countries, taken from the World Bank Enterprise Surveys, and we analyze how horizontal productivity spillovers to domestic firms from South–South FDI compare with those from North–South FDI. Also, thanks to the richness of the data set, we are able to provide detail on the specific productivity effects according to investors’ region of origin and to account for a number of domestic firm characteristics. Our findings, which are consistent with the literature, suggest that firms in sub-Saharan Africa generally benefit from the presence of foreign firms in terms of horizontal productivity spillovers if they have sufficient absorptive capacity. Additionally, we find a slight advantage for regional South–South FDI in the magnitude of the spillovers.

The contribution of the study to the literature is threefold: First, we shed light on the host-country horizontal effects of heterogeneous FDI – an area where the empirical evidence is still inconclusive and presents mixed results, particularly regarding developing countries. Second, we are able to provide evidence of FDI effects in sub-Saharan Africa, a least developed region where FDI is expected to be a crucial catalyst for structural change and industrialization. Previous empirical work on this question has been limited due to firm-level data-availability constraints. Third, we contribute to the still-scarce literature on the effects of South–South FDI by accounting for the role of investors’ origin.

The rest of the paper is organized as follows: In Section 2 we present our analysis and relate it to the extant literature. Section 3 describes the data and the methodology. Section 4 describes the estimation results, and Section 5 concludes. [...]

Read on: Birte Pfeiffer, Holger Görg, Lucia Perez-Villar, The Heterogeneity of FDI in Sub-Saharan Africa – How Do the Horizontal Productivity Effects of Emerging Investors Differ from Those of Traditional Players?, GIGA Working Paper, No. 262, December 2014

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