There is no consensus about the benefits and drawbacks in foreign direct investments. In the aggregate, is there an economic logic to attracting it? Kasper Vrolijk studies the case of Uganda and finds both positive technology spillovers and negative market competition effects, with the latter occurring mostly through domestic buyer-supplier linkages. The Ugandan case shows that policies that curb some of the negative effects may be needed.
Many governments adopt costly policies and actively compete to attract foreign direct investment (FDI). Particularly for developing countries, attracting foreign investment – and with it the benefits of cooperation with multinational corporations – may be a promising strategy to engage in global supply chains and increase firm productivity and employment. However, given contrasting empirical findings, there remains a lively public and academic debate about the benefits and drawbacks of foreign investment. While there is growing evidence on its single effects, one of the outstanding questions is whether in the aggregate there is an economic logic to attracting FDI.
In a new paper, I make progress on this challenge and examine the gains from foreign investment, comparing two main but opposing channels: (positive) technology spillovers and (negative) market competition. The idea is that FDI may bring about technology spillovers that benefit domestic firms through the sharing of knowledge, blueprints, etc. On the other hand, foreign firms may have market competition effects, which could be ambiguous: either foreign firms outcompete domestic firms from the market, or they improve productivity among domestic firms as these firms try to compete. To study this, I develop a measure of ‘closeness’ in technology and product markets to measure spillovers between firms more precisely and operationalise these measures with administrative firm data from Uganda.
I find that the entry of foreign firms in Uganda reduces sales, wage expenditure, input purchases and number of employees at domestic firms. I also find that the knowledge and market competition effects from FDI spillovers are salient – the negative effects on domestic firms are much larger if controlling for spillovers. This suggests that, in the absence of spillovers, the negative effects of foreign entry are indeed much larger. When I further control for network (indirect) effects – these are effects that propagate through domestic buyer and supplier networks – sales and input purchases actually show to be positively affected by foreign firms. This suggests that the negative effects we see in the basic analysis are largely occurring through negative shocks that ripple to other firms in domestic production networks. The main reading of this seems to be that direct spillovers amplify foreign entry effects, while indirect spillovers capture the majority of negative effects observed.
The Ugandan context
Uganda is a relevant context to study FDI because it’s characterised by large foreign investment inflows. Net foreign inflows increased from US$ 160 million in 2000 to US$ 1266 million in 2019, or from 1.7 per cent to 3.6 cent of GDP, well above the sub-Saharan average at 1.8 per cent of GDP in 2019 (World Bank, 2023). The increase in investment was also characterised by improvements in investment policy. Since 1991, when the Uganda Investment Authority was introduced, the government has provided multiple fiscal incentives to foreign investors (Demena & van Bergeijk, 2019) and used trade fairs, foreign missions and investment conferences to attract foreign investment (Ajaegbu, 2014). Uganda is also characterised by important drivers of foreign entry, for example, an increasing middle class and well-developed transport infrastructure. As in most other lower-income countries, a large share of investment flows towards extractive industries and agriculture (UNCTAD, 2020), which may not aid economy-wide (productivity) growth.
Spillovers regulate firm performance
I first study the effects of foreign entry on domestic firm performance without looking at the role of spillovers. I find that the entry of foreign firms in Uganda results in negative effects on labour earnings, sales, number of employees and input purchases at domestic firms. In contrast to other studies showing positive FDI effects I find that the entry of foreign firms tends to lower production and employment at domestic firms. These effects are significant only for particular sectors, notably mining and transportation, meaning this is where most of the effects are occurring.
In a second step, I introduce technology and market competition spillovers to the analysis to study the degree to which these spillovers moderate foreign entry effects on firm performance. These spillover measures capture at firm-level the likelihood that knowledge and competition spillovers occur between a foreign entrant and domestic firms. The intuition is that knowledge spillovers occur between firms when they are exposed to one another, that is when they operate in the same “technology space” (e.g. car manufacturing). In the case of market competition spillovers, each encounter between firms in the same product space generates market competition, because it leads to leakage of information that allows firms to compete with other firms in the same product space.
I find that, conditional on spillovers, the reported negative effects are much larger. The reductions in firm sales, input purchases and employees among Ugandan firms are in the range of 1-2.5 times larger compared to the initial analysis. That is, controlling for spillovers, effects of foreign firms entering Uganda are indeed much more significant. The main takeaway from this is that spillovers seem to capture sizable parts of foreign entry effects on domestic firms, albeit the results suggests its largely the competition spillovers driving this result.
In a final step, I use data that records each buyer and supplier of each domestic firm to construct the domestic production network. The aim is to study how spillovers to domestic firms propagate to other domestic firms that don’t see foreign entry themselves but may experience indirect shocks through their buyer-supplier linkages. I find that sales and input purchases become positive after controlling for production network effects. This means that at soon as we control for any effects through buyer-supplier linkages, foreign entry effects are indeed positive. That is, most of the negative effects seen in the initial analysis are in fact coming from negative effects that propagate through domestic production networks.
Interestingly, manufacturing is an important sector in which these direct and indirect spillovers occur. This follows a larger evidence base showing that productivity growth in an economy is largely driven by the manufacturing sector, where there are several ways in which knowledge and technology can be transferred and applied.
Can positive spillovers be enhanced?
The study’s result suggests several policy interventions. First, direct spillovers between foreign and domestic firms are important. There seems a need to introduce policies that curb some of the negative effects of foreign firms outcompeting domestic firms. One option is to introduce social protection measures that provide temporary income assistance when workers switch jobs and are temporarily jobless. The results also suggest that positive knowledge spillovers relieve some of the negative effects of foreign firms entering a domestic market. In addition to curbing negative effects, this suggests aiding knowledge transfer and other positive spillovers is a necessary field of intervention. Second, most of the negative effects of FDI seem to come from indirect (as opposed to direct) spillovers. This means it’s essential for government to understand how negative shocks to one firm (or sector) propagates potentially to other firms (or sectors). As with direct shocks, governments may need to introduce policies that help domestic firms absorb temporarily negative shocks or that prepare them better against such potential shocks.
- This blog post is based on The Gains from Foreign Direct Investment: Technology and Competition Spillovers in Uganda.
- The post represents the views of its authors, not the position of LSE Business Review or the London School of Economics.
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