CUADERNOS DE TRABAJO ESCUELA UNIVERSITARIA DE ESTADÍSTICA Multinationals and foreign direct investment: Main theoretical strands and empirical effects María C. Latorre Cuaderno de Trabajo número 06/2008

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CUADERNOS DE TRABAJO ESCUELA UNIVERSITARIA DE ESTADÍSTICA Multinationals and foreign direct investment: Main theoretical strands and empirical effects María C. Latorre Cuaderno de Trabajo número 06/2008 Los Cuadernos de Trabajo de la Escuela Universitaria de Estadística constituyen una apuesta por la publicación de los trabajos en curso y de los informes técnicos desarrollados desde la Escuela para servir de apoyo tanto a la docencia como a la investigación. Los Cuadernos de Trabajo se pueden descargar de la página de la Biblioteca de la Escuela y en la sección de investigación de la página del centro CONTACTO: Biblioteca de la E. U. de Estadística Universidad Complutense de Madrid Av. Puerta de Hierro, S/N Madrid Tlf Los trabajos publicados en la serie Cuadernos de Trabajo de la Escuela Universitaria de Estadística no están sujetos a ninguna evaluación previa. Las opiniones y análisis que aparecen publicados en los Cuadernos de Trabajo son responsabilidad exclusiva de sus autores. ISSN: Multinationals and foreign direct investment: Main theoretical strands and empirical effects MARÍA C. LATORRE* Departamento de Economía Aplicada II Universidad Complutense de Madrid ABSTRACT: This article provides a comprehensive synthesis and evaluation of the existing literature on multinationals (MNEs) and foreign direct investment (FDI). It covers both theoretical and empirical studies. On the theoretical side, it offers a chronological description of the main strands since the earliest perfect competition studies from the 1960s till new recent contributions such as the Knowledge-capital model or those on internalisation issues. On the empirical side, it concentrates on the effects of MNEs and FDI on host economies, given their controversy. It reviews their impact on foreign trade, domestic firms productivity, market structure, wages and GDP growth. It also analyses a nascent and less known literature on empirical computable general equilibrium models that include the activities of MNEs. Key words: Multinational enterprises, Foreign direct investment, Industry performance, Computable general equilibrium models. JEL Classification: F21, F23, L10. RESUMEN: Este artículo ofrece una síntesis y valoración de la literatura sobre empresas multinacionales (EMNs) y flujos de inversión extranjera directa (IED), desde una perspectiva tanto teórica como empírica. En su parte teórica desgrana las principales corrientes cronológicamente; desde los análisis de competencia perfecta de los años sesenta, hasta contribuciones más recientes como el Knowledge-capital model o modelos sobre internalización. En el plano empírico se centra en los controvertidos efectos de las EMNs y la IED en los países receptores, analizando su impacto sobre el comercio exterior, la productividad de las empresas nacionales, la estructura de mercado, los salarios y el crecimiento del PIB. También se analiza una literatura empírica pionera y menos conocida de modelos de equilibrio general computable que incluyen EMNs. Palabras clave: Empresas multinacionales, Inversión extranjera directa, Comportamiento de la industria, Modelos de equilibrio general aplicado. Códigos JEL: F21, F23, L10. *Acknowledgements: The author thanks Oscar Bajo-Rubio for helpful comments and suggestions on earlier drafts, and acknowledges financial support from the Spanish Ministry of Education and Science, through the project SEJ C The usual disclaimer applies. 0 1. Introduction Multinational enterprises (MNEs) are nowadays the focus of much attention as they are central players in the world economy. However, their scientific analysis constitutes a young discipline. Most studies begun in the 1960s, a period in which foreign direct investment (FDI) was experiencing an enormous growth, which attracted economists attention. This was not, however, the first moment in which FDI had grown dramatically. Baldwin and Martin (1999) describe two waves of globalisation which are related to a rise in FDI flows, among other aspects. The first wave had taken place in the period , and was characterised by North to South FDI in primary product sectors and railroads. The second wage initialised in the 1960s and still continues nowadays, involving FDI mainly among developed nations with a focus on manufacturing, services and outsourcing. What caused such remarkable growth of FDI in the past? What is causing it nowadays? Which are its consequences? The study of MNEs and FDI has been a fertile research topic. A number of authors have devoted their efforts to review the literature; see, among others, Agarwal (1980), Graham (1992), Markusen (1995), Blomström and Kokko (1997), Lipsey (2002), Barba Navaretti and Venables (2004), Feenstra (2004), Caves (2007) and Greenaway and Kneller (2007). This article offers a concise but comprehensive review and evaluation of the existing literature since its beginnings till new recent contributions. In our approach to the vast array of empirical and theoretical studies on MNEs and FDI we have two main targets in mind. First, we offer a chronological description of the main theoretical strands. In particular, we show that some of the earlier studies provided enlightening ideas, which are now being developed through more formal and sophisticated analyses, such as Markusen s (2002) Knowledge-capital model, or the recent studies on internalisation issues. 1 Second, the effects of MNEs have been very much debated, and there is still some controversy regarding their impact on host economies, as can be seen in the active antiglobalisation movements. Therefore, we take a look to the empirical studies on this matter. We find that this is a very fragmented area of the literature, in which there are dispersed contributions and different strands according to the particular effect of MNEs analysed. Thus, there is literature on their impact on wages, a different literature on their effects on foreign trade, another one on productivity, on market structure, and so on. Apart from the idea that MNEs are more productive and pay higher wages than domestic firms, the empirical studies seem rather inconclusive regarding many of their effects on the host economies. Can we see which economic forces prevail among the several simultaneous ones that MNEs unleash in a host economy? Facing such a fragmented literature, it seems difficult to obtain an economy-wide evaluation of their impact. Therefore, this study also looks at a less known and nascent empirical line of research which seems suitable for this type of analyses, namely, computable general equilibrium (CGE) models which have recently include the activities of MNEs. To this aim, this paper is organised as follows. We begin with the theory in the next section. We successively review the perfect competition approaches from the 1960s, which treated FDI as a mere capital movement (section 2.1); the imperfect competition approaches from the 1970s, in which MNEs aspects were added to FDI modeling (section 2.2); the imperfect competition approaches that appeared from the 1980s onwards, which differentiate between vertical and horizontal MNEs, including the knowledge capital model and heterogenous firms (section 2.3); and some new contributions on internalisation issues related to FDI (section 2.4). Section 3 goes on with the review of empirical studies. In its first part (section 3.1) we present some characteristics for which applied studies have found rather robust evidence. Next (section 3.2), we show some results on the impact of MNEs on foreign trade (section 3.2.1), domestic firms productivity (section 3.2.2), market structure (section 3.2.3), wages (section 3.2.4) and GDP 2 growth (3.2.5). In the last part (section 3.3.), we look at the results offered by computable general equilibrium models. Finally, some concluding remarks are presented in section Multinational firms and foreign direct investment: Main theoretical strands 2.1 Perfect competition approaches (1960s): Foreign direct investment as a capital movement The first formalisations of FDI tended to model it as capital (i.e., a production factor) moving across countries. This idea was a logical extension of the traditional theory of investment responding to differences in the expected rates of return on capital. This view, therefore, predicted that FDI would go from capital abundant countries (where its return was low) to capital scarce countries (where its return was high). Two early theoretical contributions in this line are Mundell (1957) and MacDougall (1960). Mundell (1957) analysed the effects of factor movements in a two-sector, two countries and twofactors (2 2 2) Heckscher-Ohlin model. Under this framework, unless factor endowments differences between the two countries are extreme, so that the factor price equalisation theorem does not hold, product and factor prices remain unchanged after a capital inflow. Another outcome stemming from his model is that the capital inflow reduces imports, i.e., trade and capital movements are found to be substitutes. This is why his contribution has been summarised in the idea that trade in factors is a substitute for trade in goods. The suggestion that capital flows do not have any effect on factor prices, obtained in a Heckscher-Ohlin model, is a rather surprising result. In fact, adding the assumption of specific factors to a simple (2 2 2) Heckscher-Ohlin model considerably changes the outcomes, as 3 capital inflows do affect factor rewards and gives rise to cross-hauled FDI flows, i.e., there will be two-way flows between pairs of countries (Caves, 1971; Jones, 1971; Neary, 1978; Brown et al., 2003; Caves, 2007). This is a nice characteristic which matches the empirical evidence of most developed countries simultaneously sending and receiving FDI inflows. Rather than analysing factor movements, as in Mundell (1957), MacDougall (1960) focuses on the simplest case of a capital inflow into a one-sector economy. FDI inflows in this setting lower the capital rent in the receiving economy, but also increase labour productivity. The latter effect predominates, increasing welfare for the receiving economy. Some findings from the models above, such as two-way flows of direct investment, or the potential substitution between trade and FDI are genuine intuitions. However, this theory does not seem to be convincing as an explanation of FDI. The bulk of FDI flows originates in (and is directed to) developed economies, which should be capital abundant (Barba Navaretti and Venables, 2004, chapter 1; Markusen, 2002; UNCTAD, several years). In fact, the share of developing economies in world gross FDI flows has usually been around percent since the 1970s onwards (Barba Navaretti and Venables, 2004, chapter 1). Furthermore, only a small number of developing economies receive these FDI inflows in the last years, e.g., China accounts for nearly one-quarter of the total, and a few economies in Asia and Latin America account for the rest, whereas flows going to Africa are nearly negligible (Barba Navaretti and Venables, 2004, chapter 1; UNCTAD, several years). This means that capital does not go to high return locations, i.e., developing countries with low capital endowments. Nevertheless, data problems may lead to defend that this theory still holds because it was tested using inappropriate variables. On the one hand, there are many problems to calculate the correct rate of return. Empirical analysis usually relies on profits calculated from an accounting point of view which differ from those derived from economic criteria. This is so because MNEs use transfer prices for transactions between the 4 parent and subsidiaries to make profits arise in countries with the most favourable tax environment, among other reasons. On the other hand, Yeaple (2003) maintains that aggregation biases might be behind the empirical outcome that FDI is not related to differences in capital endowments (and, consequently, on the rate of return of capital) across countries. In the 1960s and 1970s some economists worked on the empirical relationship between FDI, the rate of return and risk (Agarwal, 1980). The so called portfolio theory predicts a positive relation of FDI with respect to the rate of return and a negative one with respect to risk. Portfolio diversification may help to reduce the total risk involved, i.e., a firm can reduce risks by undertaking projects in more than one country. However, the portfolio theory is an extension of a vision of FDI as capital movements. In this sense, it is still incomplete. We see clearly nowadays, that the essence of FDI is that it is related to a particular type of firms production abroad. Each firm has a unique bundle of factors, competencies and procedures which get transferred to foreign operations when FDI occurs. Therefore, FDI is best thought of as movements of firms, rather than simple movements of capital (Graham, 1992; Lipsey, 2002; Markusen, 2002; Barba Navaretti and Venables, 2004, chapter 11; Feenstra, 2004). This idea had appeared earlier. Indeed, some authors abandoned the emphasis on FDI as capital movements and turn their attention to the MNE. We will come back to this shortly. Before continuing, however, we should comment that many theoretical and empirical models have treated FDI as capital flows. An example is Feenstra and Hanson (1996), which offers a variant of the Heckscher-Ohlin model in which they introduce skilled and unskilled labour, apart from capital, as factors of production. In their setting, MNEs headquartered in developed countries (North) send capital to open subsidiaries to developing countries (South). MNEs transfer to the South tasks that are less skilled-intensive than those of the North but more skilledintensive than those usually carried out by firms in the South. Their model yields an interesting 5 outcome regarding wages. Skilled labour wages will increase in the South and in the North, while unskilled wages lose in both areas. Their finding is consistent with their own econometric testing on Mexico s case in the 1980s. 2.2 Imperfect competition approaches (1970s): Adding multinationals The theories discussed above are based on the assumption of perfect competition in domestic factor and/or product markets. They belong to the traditional trade theory that has dominated for decades, based on competitive, constant-returns models. Hymer s (1976) work showed that the idea of FDI as a simple capital movement responding to rates of return (with or without risk) did not match the real characteristics of MNEs activities. His pioneering analysis was in his PhD Dissertation, which dates back to 1960, but was published much later, in The consequences of his contribution were and still are very important. He drew attention to the MNE, in particular, to the type of assets the MNE owned and to the difficulty of transferring those assets - due to market imperfections-. Two main types of market imperfections are relevant. One arises from MNEs advantages with respect to firms with no foreign operations (the differentiation between firm types -MNEs versus domestic- violates the assumptions of perfect competition); and the other is due to transaction costs. Let us briefly review both in turn. First, MNEs have some advantages compared to local firms. When establishing plants in a foreign country MNEs have some disadvantages compared with local firms (e.g., ignorance of customers preferences, legal system, institutional framework and the cost of operating away from the parent company). If, despite these disadvantages, MNEs decide to establish plants abroad, they must possess some advantages to which existing or potential local competitors have no access and that more than compensate the disadvantages. Second, the concept of transaction costs. Transaction costs arise from the difficulties of using the market to organise transactions 6 (e.g., it is hard to design a contract between the firm and its suppliers that contemplates all the circumstances that may arise in the future), therefore the firms internal procedures are better suited than the market to organise transactions. This point will be further developed later on. A different approach to FDI should also be mentioned: the product-cycle theory (Vernon, 1966). This theory gave useful explanations for the expansion of US MNEs after World War II. It explains FDI as a reaction to the threat of losing markets as a product matures, and as a search of cheaper factor costs to face competition. Its essence is that most products follow a similar life cycle. In a first stage, the product appears as an innovation which is sold locally in the same country where it is produced (the US). This is so in order to facilitate satisfying local demand while having an efficient coordination between research, development and production units. In a second stage, the product begins to be exported (to Western Europe). In a third stage, some competitors arise in Europe. If conditions are favourable the firm will establish foreign subsidiaries there to face the increased competition and it may also establish subsidiaries in less developed countries to have access to cheaper labour costs to enhance its competitiveness. Vernon (1979) himself recognised that the circumstances had changed rapidly since his theory was developed and that this had considerably weakened its predictive power. However, the product-cycle theory provided a framework under which a number of authors dealt with crucial questions about FDI. Hirsch (1976), for example, worked on the circumstances which influence a firm s decision on whether using exports or FDI to serve the foreign market. His model takes into account the costs of managing production abroad as well as the asset specificity of the capital owned by MNEs in a simple but complete framework. Other studies, this time empirically oriented, worked on the effects of tariffs on FDI and on the predominance of MNEs in industries characterised by differentiated output and more highly educated employees. Thus, we find some authors that, while being related to the product cycle theory, were already using 7 modern approaches to FDI, anticipating those of the 1980s. Before moving on to that period, though, we have to devote some attention to the important work of Dunning. The analysis of Hymer (1976) was given an important step forward by Dunning s work (1977, 1979, 2000). Dunning put together already existing elements in a coherent and unified framework. He provided a triad of conditions necessary for a firm to become a MNE. These three conditions constitute the basis of the eclectic or OLI paradigm, where OLI stands for ownership, location and internalisation. Ownership means the sort of advantages that MNEs should have in the same line of what has just been explained when talking about Hymer s contribution. Location gives the idea that for a MNE to establish a new plant in a foreign country, this country must have some advantages compared to the home country of the MNE. These advantages may be cheaper factors of production, better access to natural resources, a bigger market, and so on. Finally, the internalisation idea had also been noted by Hymer, when he dealt with transaction costs. It may be more beneficial for a firm to exploit its ownership advantages within its subsidiaries than to sell or license them to other independent firms. The central concepts of the OLI paradigm have also been introduced in a dynamic framework known as the Investment Development Path (IDP). This concept relates the inward and outward direct investment position of countries with their corresponding stages of development (Dunning, 1981; Dunning and Narula, 1996). It suggests that countries tend to go through five main stages of development. Each of the stages links the GNP level with the net outward investment (NOI) position, i.e., the difference between outwa
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