TECHNOLOGY SPILLOVERS FROM FOREIGN DIRECT INVESTMENT THE CASE OF VIETNAM intermediate macroeconomics midterm paper

TECHNOLOGY SPILLOVERS FROM FOREIGN DIRECT INVESTMENT THE CASE OF VIETNAM intermediate macroeconomics midterm paper

FOREIGN TRADE UNIVERSITY FACULTY OF ECONOMICS AND INTERNATIONAL BUSINESS

TECHNOLOGY SPILLOVERS FROM FOREIGN DIRECT INVESTMENT:

Hanoi, May 2015

Contents

1 Theory 3

1.1 Foreign Direct Investment 3

1.1.1 Definition 3

1.1.2 Types of FDI 4

1.2 Spillover Effects of FDI 5

2 Foreign Direct Investment (FDI) in Vietnam 10

2.1 Overview of Vietnam’s Economy 10

2.2 Recent Trends in FDI of Vietnam 11

2.3 The Roles of FDI on Vietnam’s Economy 14

3 Researches of Technological Spillovers from FDI in Vietnam 16

4 Conclusion 19

5 Appendix 20

6 References 22

7 Groupwork Assessment 23

1 Theory

1.1 Foreign Direct Investment

1.1.1 Definition

According to World Bank, foreign direct investment (FDI) are “the net inflows of investment

to acquire a lasting management interest (10 percent or more of voting stock) in an enterprise

operating in an economy other than that of the investor It is the sum of equity capital,

reinvestment of earnings, other long-term capital, and short-term capital as shown in the

balance of payments” (World Development Indicators, n.d.) On other words, it is a category

of investment that “reflects the objective of establishing a lasting interest by a resident

enterprise in one economy (direct investor) in an enterprise (direct investment enterprise) that

is resident in an economy other than that of the direct investor The lasting interest implies the

existence of a long-term relationship between the direct investor and the direct investment

enterprise and a significant degree of influence on the management of the enterprise The

direct or indirect ownership of 10% or more of the voting power of an enterprise resident in

one economy by an investor resident in another economy is evidence of such a relationship

Some compilers may argue that in some cases an ownership of as little as 10% of the voting

power may not lead to the exercise of any significant influence while on the other hand, an

investor may own less than 10% but have an effective voice in the management Nevertheless,

the recommended methodology does not allow any qualification of the 10% threshold and

recommends its strict application to ensure statistical consistency across countries” (OECD

Benchmark Definition of Foreign Direct Investment, 2008)

To be more specific, the investing company may make its overseas investment in a number of

ways - either by setting up a subsidiary or associate company in the foreign country, by

acquiring shares of an overseas company, or through a merger or joint venture

The accepted threshold for a foreign direct investment relationship, as defined by the OECD,

is 10% That is, the foreign investor must own at least 10% or more of the voting stock or

ordinary shares of the investee company

An example of foreign direct investment would be an American company taking a majority

stake in a company in China Another example would be a Canadian company setting up a

joint venture to develop a mineral deposit in Chile

1.1.2 Types of FDI

- Horizontal: where the company carries out the same activities abroad as at home (for

example, Toyota assembling cars in both Japan and the UK

- Vertical: when different stages of activities are added abroad Forward vertical FDI is where

the FDI takes the firm nearer to the market (for example, Toyota acquiring a car

distributorship in America) and Backward Vertical FDI is where international integration

moves back towards raw materials (for example, Toyota acquiring a tire manufacturer or a

rubber plantation)

- Conglomerate: where an unrelated business is added abroad This is the most unusual form

of FDI as it involves attempting to overcome two barriers simultaneously - entering a foreign

country and a new industry This leads to the analytical solution that internationalization and

diversification are often alternative strategies, not complements

FDI can take the form of greenfield entry or takeover

Greenfield entry implies assembling all the elements from scratch as Honda did in the UK,

whereas foreign takeover means the acquisition of an existing foreign company - as Tata’s

acquisition of Jaguar Land Rover illustrates

Foreign takeover is often covered by the term 'mergers and acquisitions’ (M&As) but internationally, mergers are vanishingly small, accounting for less than 1 per cent of all

foreign acquisitions

This choice of entry mode interacts with ownership strategy – the choice of wholly owned

subsidiaries versus joint ventures to give a 2x2 matrix of choices – greenfield wholly owned

ventures, greenfield joint ventures, wholly owned takeovers and joint foreign acquisitions -

giving foreign investors choices that they can match to their own capabilities and foreign

conditions

(Definition of foreign direct investment, n.d.)

1.2 Spillover Effects of FDI

The studies on spillover effects of FDI are based on the common recognition that

multinational corporations possess superior organizational and production techniques

compared to the domestic firms (Hymer, 1976) Wang and Blomstrom (1992) developed a

model in which international technology transfer through multinational corporations develops

endogenously by means of the interaction between a foreign subsidiary and a host country

firm They have found that:

 The higher the level and cost efficiency of a domestic firm’s learning investment, the faster the technology transfer

 The lower the subsidiary’s discount rate, the more rapid the technology transfer The higher the operation risks—for example, political instability or low potential economic

growth—the more reluctant foreign firms will be to transfer technology

 The less costly the technology spillovers from the parent to subsidiary firms, the faster the technology transfer

Figure 1 Channels of Technology Transfer and Spillover from FDI

Multinational corporations can transfer technology through various means like licensing, trade,

FDI, subcontracting, franchising and strategic alliances Eventually, multinational

corporations are preferably to transfer technology through FDI since it can internalise the

transfer of superior technological assets at little or no extra cost and regarded as the best way

to keep control over the technological knowledge (Caves 1996) Moreover, to the side of the

host economy, it is possible that a portion of the technologies and experiences transported by

multinational corporations will be diffused from their affiliates to the indigenous

establishments

According to Javorcik (2004, p 607), “Spillovers from FDI take place when the entry or

presence of multinational corporations increases the productivity of domestic firms in a host country and the multinationals do not fully internalize the value of these benefits”

Business projects of multinational corporations provide learning opportunities for the

domestic firms They could reduce the costs of innovation and imitation for local firms, which

in turn speed up productivity improvement (Helpman, 1999) FDI may heighten productivity

levels of domestic firms in the industries they entered by improving the allocation of

resources in those industries

Vertical Spillover Franchising

Strategic Alliances

This is neo-classical view on spillover effects The spillover effects from the FDI can be

broadly classified as intra-industry/horizontal spillovers and inter-industry/ vertical spillovers

o intra-industry/horizontal spillovers

FDI may lead to an increase in the productivity of the host economy in the same industry

through various means

First, demonstration effects refer to the copying or the imitation of foreign firms’ technology

and organisational practices by the domestic firms Since new technologies are introduced to

the host country, domestic firms can observe foreign firm’s actions, skills or techniques and

‘imitate’ them or make efforts to achieve these techniques and apply them, which results in production improvements (Wang and Blomstrom, 1992)

Second labour mobility effects occurs when workers and managers employed in foreign

affiliates who have been trained with advanced technical and managerial skills move to other

domestic firms or open their own enterprises (Fosfuri, 1996) These workers are carriers of

multinational corporations’ technology Multinationals can prevent the flow of labour by

paying higher wages On the contrary, there is a possibility of reverse labour effect when

employees of domestic firms can move to foreign firms

Third, competition effects refers to a situation in which entry of foreign firm forces the

domestic firms to increase their efficiency by improving the existing methods of production or

adopt new ones Competition is considered as the drive of innovation From the point of view

of the consumer, competition effects are certainly beneficial thanks to the availability of the

higher quality of products In contrast, in an industry consisted of weak and small domestic

firms, the entry of foreign firms may eventually lead to an exit of those host firms

o inter-industry/ vertical spillovers

Spillovers effect is not just confined within industries It can appear as a result of interaction

across industries The inter-industry spillover arises mainly by the consumer-supplier

relationship between foreign firms and domestic firms According to Dunning (1993, p.456),

“the presence of FDI has helped to raise the productivity of many domestic suppliers, and this

has often had beneficial spillover effects on the rest of their operations”

Vertical spillover mechanism operates both at the upstream and downstream sector

multinational corporations usually source their raw materials and components from domestic

suppliers The incentive for the multinational corporations to source from the domestic market

arises in the case of high transportation costs as well as certain regulations imposed by the

local government The multinational corporations usually assists the local suppliers to achieve

technical and organisational competence by providing technological assistance as well as

training programmes for employees of local supplier firms (Lall, 1978) As a result, the

domestic supplier firms improve their quality of products and production process The entry

of foreign firms may increase the demand for intermediate inputs by local firms Therefore

through backward linkage mechanism, productivity of domestic firms may improve

o Negative spillover

On the contrary to positive effects of spillovers discussed above, it is also argued that FDI

may create negative spillovers to domestic firms’ productivity and this effect may be large enough to offset the above positive ones A multinational corporations enter the market, their

advantages on technology and know-how may take in the market of the domestic firms and

make them produce in less efficient scales, which leads to less productiveness of domestic

firms (so-called ‘market stealing effects’) As a result a negative vertical spillover can arise in

such a situation On the other hand, Markusen and Venables (1999) in a theoretical model

show that as a result of the contact with multinational firms, local input suppliers can be

strong enough in the long run to make the multinational corporations leave the market We

can conclude that the net effects of horizontal and vertical spillover can be either positive or

negative

In summary, foreign firms can have productivity “spillover” effects on local competitors

(horizontal spillovers) as well as on upstream and downstream domestic firms (vertical

spillovers) The transfer of technology (broadly defined as managerial practices, production

methods, marketing techniques or any other knowledge embodied in a product or service) can

occur through a number of channels For example, local firms may learn to imitate a new

process or improve the quality of their product through observation, interaction with foreign

managers in business chambers, and from former employees of foreign multinational

corporations Local firms may also benefit from the entry of new professional services or

suppliers as a result of the multinational corporations entry Foreign firms may act as catalyze

domestic suppliers to improve the quality or time efficiency of their good or service by

demanding higher standards On the other hand, foreign firms may have a negative effect on

domestic firms’ output and productivity, especially in the short run, if they compete with domestic firms and “steal” their market or their best human capital As domestic firms cut back production they may experience a higher average cost as fixed costs are spread over a

smaller scale of production (Aitken and Harrison, 1998)

2 Foreign Direct Investment (FDI) in Vietnam

2.1 Overview of Vietnam’s Economy

The development of Vietnamese Economy is divided into two major phases: before 1986

(pre-reform) period and after 1986 (post-reform) In the previous phase, Vietnam is a

centralized economy, in which government determined all economic targets and prices Since

the political and economic reformed after 1986, Vietnam has transformed from one of the

poorest countries in the world , with per capita income below $100, to a lower middle income

country within about 25 years with per capita income of over $2000 by the end of 2014

For more than a decade, Vietnam’s growth rate has averaged 6.4% per year since 1990, living

standard improves, poverty reduced from almost 60% in the 1990s to less than 3% in 2014, a

lot of achievements have been made in education and Vietnam ranks high as of UNDP

Human Development Index (HDI) There was a recession during 1997-1999 period after

Asian currency crisis, however, the economy has recovered since 2000 Another recession

occurred in 2009 due to world economic crisis, nevertheless, the economy has picked up the

next year (Figure: GDP Growth Rate) Among factors leading to these successes, it is

believed that FDI has been played a crucial role to the economic development of Vietnam

(Source: World Bank, 2013)

2.2 Recent Trends in FDI of Vietnam

After the introduction of open door policy or Doi Moi in 1986, Vietnamese economy was

restructured Since the approval of the Law of Foreign Investment (LFI), which opened the

economy to foreign investment and was passed in December 1987, FDI inflows to Vietnam

have increased substantially Foreign companies found that Vietnam is a potential market

which has cheap and plentiful labour, therefore, they started establishing business in this

developing country, opening FDI trend in Vietnam As a matter of fact, Vietnam has so much

potential for economic growth and its young and energetic and knowledgeable population

who are willing to favorable attitudes to multinational companies Aware of it, Vietnamese

government uses FDI as a business development strategy According to Multinational

business review, in a survey among 3 countries, Korea, Indonesia and Vietnam, when being

asked about evaluation of foreign companies’ impact on their own countries, Vietnamese government showed the approval with highest mark, which means that FDI plays an

important role in the economy in recent years Vietnamese Ministry of Planning and

Investment (MPI) acknowledged these forms of FDI in Vietnam:

 Joint venture: parties have mutual agreement about equity contribution to form a new entity Joint venture companies are mainly in tourism, transportation and other industries

 100% foreign owned: the foreign companies are parent ones which own 100% stock common

 Business Corporate Contract: parties enter legally binding agreement BCC are mostly in oil and telecommunications

 Other forms such as Built-Operation-Transfer (BOT), Built-Transfer-Operation (BTO), and Built-Transfer (BT), stock company, and conglomerate company The latest data

issued by MPI show that, based on the number of projects, 100% foreign owned and

venture forms rank 1st and 2nd What’s more, local areas in Vietnam that attract foreign

companies’ investment are main cities which has facilities and huge population force: Ho