Foreign Direct Investmentand Contract Enforcement

particu-success of the project in the …rst period depends on unveri…able e¤ort by each …rm.Furthermore, we consider the possibility that, through cooperation in the …rst period,the local

Foreign Direct Investment

Zhigang TAOSchool of BusinessThe University of Hong Kong

Susheng WANGDepartment of EconomicsHong Kong University of Science and Technology

July, 1998

Suggested running head: Foreign Direct Investment

Correspondence to: Susheng WANG, Department of Economics, Hong KongUniversity of Science and Technology, Clear Water Bay, HONG KONG Tel: (852)2358-7630

1 We would like to thank sincerely Editor John Bonin, three anonymous referees and Danyang Xie Their invaluable comments and suggestions have contributed to substantial improvement of the paper.

We would also like to acknowledge …nancial support from the Research Grants Council of Hong Kong.

A long-standing deterrent to foreign direct investment in developing tries is weak enforcement of binding contracts A local …rm may learnbusiness skills from a cooperating multinational …rm and subsequently dobusiness on its own based on the acquired skills In a two-period double-moral-hazard model, non-binding contracts are shown to be preferred byall parties, implying that contract enforcement is unnecessary Our resultsshed light on the puzzling phenomenon that substantial FDI has been car-ried out under contractual arrangements in developing countries in whichcontract enforcement is problematic They can also explain some interest-ing stylized facts of contractual joint ventures between multinationals andlocal …rms in the early stage of an economic transition

coun-Keywords: foreign direct investment, contract enforcement, contractual joint tures, double moral hazard, learning by doing

ven-Journal of Economic Literature Classi…cation Numbers: D2, F2, L2

1 Introduction

In the past three decades, foreign direct investment (FDI) has increased tially In particular, during the eighties, FDI worldwide grew faster than GDP andtrade by a factor of four and three respectively (Neven and Siotis, 1993) Not surpris-ingly, almost all outward FDI comes from developed countries Developing countriesare attracting an increasingly larger share of inward FDI.2 Multinational corporationsfrom developed countries are looking for markets as well as sources of low-cost produc-tion in developing countries through either ownership arrangements, e.g., wholly-ownedsubsidiaries and equity joint ventures (EJVs), or contractual arrangements, e.g., con-tractual joint ventures (CJVs)

substan-In recent years, FDI has played an important role in the economic transition ofEast Asian countries, East European countries and the former Soviet Union A long-standing deterrent to FDI3in many developing countries is weak contract enforcement.4

Companies in developing countries try to master trade secrets from their partnersthrough cooperation and conduct business on their own based on the acquired knowl-edge Indeed, some governments in developing countries have declared openly that theabsorption of superior technologies is a key condition for the approval of a FDI project.Weak contract enforcement, especially regarding the penalty for violation of bindingcontracts, is thought to deter FDI in developing countries Evidence reveals that, indeveloping countries even with poor contract enforcement, a substantial amount of FDIhas been carried out under contractual arrangements For example, when China began

to attract FDI in 1979, the law for EJVs was enacted in anticipation that the form ofEJV would be widely used by foreign investors.5 Interestingly, the form of CJV wasinstead more widely used even though there was no law for CJVs until 1988.6 In fact,from 1980 to 1987, CJVs outnumbered EJVs, see Wang (1992)

2 Developed countries supplied 97 to 99% of the total FDI throughout the period 1960–1985 mels and Stern, 1994) On the other hand, developing countries have obtained an increasingly larger share, 21% in 1993 and 40% in 1994, of total inward FDI (Banks, 1995).

(Hum-3 Other deterrents to FDI include restrictions on foreign ownership and requirements for local content, both of which are beyond the scope of this paper.

4 In this paper, short-term contracts and long-term non-binding contracts on veri…able revenues are always enforced What we mean by weak contract enforcement is that of long-term binding contracts (see (Grout, 1984) for contract enforcement problem of short-term contracts) For ease of exposition, contracts in this paper, both binding and non-binding, are meant to be long-term unless otherwise speci…ed.

5 In an EJV, participating …rms have equity shares The venture’s pro…ts are split among the participating …rms according to equity shares that are constant throughout the cooperation unless they are voluntarily exchanged.

6 The de…ning feature of CJVs is the absence of equity shares so that the pro…ts are split according

to the revenue shares speci…ed in the contracts.

Table 1: Contractual Joint Venturesa

Confectionery 6 years 50/50 for …rst 3 years Packaging machinery,manufacturing from 1983 55/45 for last 3 years imported from Japan

Kitchen equipment 8 years 0/100 for …rst 3 years NA

for restaurant from 1985 40/60 for next 2 years

60/40 for last 2 years

manufacturing from 1985 over and above repayment

capital to HK side

aThis table is adopted from Thoburn et al (1990)

b Chinese revenue share compared to foreign revenue share

Substantial FDI using contractual arrangements, despite weak contract ment, presents a puzzle to economists as well as to legal scholars Hall (1992) high-lights the puzzle in his discussion of economic transition in Asia and Eastern Europe

enforce-In an attempt to solve this puzzle, we investigate contractual arrangements for FDI

in settings in which the enforcement of binding contracts is problematic In lar, we consider a foreign …rm that provides technology or know-how and a local …rmthat provides complementary inputs, both involved in a joint two-period project The

particu-success of the project in the …rst period depends on unveri…able e¤ort by each …rm.Furthermore, we consider the possibility that, through cooperation in the …rst period,the local …rm may learn the necessary skills from the foreign …rm, in which case thelocal …rm may conduct business on its own in the second period.7 If the good tech-nology is provided by the foreign …rm, the possibility of learning is determined by thelocal …rm’s e¤ort in the …rst period, which is a characterization of learning by doing.The two …rms can sign either a two-period binding contract under which the local

…rm is not allowed to do business on its own upon learning the technology or a period non-binding contract under which the local …rm is allowed to leave the contractarrangement upon learning the technology Note that the former requires contractenforcement whereas the latter does not We show that the equilibrium non-bindingcontract is preferred by both partners to the equilibrium binding contract Thus,contract enforcement is unnecessary We also …nd that, under the equilibrium non-binding contract, the foreign …rm’s revenue share is decreasing or constant over theduration of the cooperation Interestingly, this theoretical result is consistent with thepuzzling empirical fact of decreasing foreign revenue share for CJVs in China, see Table

two-1 for examples

Learning is a key incentive device in our model of FDI because it depends onendogenously determined e¤ort in the …rst period Under the non-binding contract,the local …rm works harder in the …rst period in order to learn the technology and theforeign …rm extracts a larger revenue share in the …rst period to compensate for itspotential second-period loss from learning On balance, both …rms are better o¤ underthe non-binding contract

A surprising implication of our results is that contract enforcement is not a requisite for FDI in developing countries, especially in the early stage of economicdevelopment The …nding sheds light on the puzzle that there has been substantialFDI in developing countries in which contract enforcement is problematic It mayalso explain why FDI under CJVs was popular in China despite its weak contractenforcement, at least in the early stage of the country’s economic reform

pre-However, we stress that our conclusions depend crucially on some important stylizedfacts We consider a scenario in which the foreign …rm’s know-how does not have anyimmediate application without some complementary inputs or skills from the local

…rm This captures a characteristic feature of FDI in developing countries in whichonly the local …rm has access to certain inputs and resources so that the foreign …rmmust cooperate with the local …rm to obtain the resources During the cooperation,

7 A survey of CJVs in China reveals that multinational …rms generally provide technologies that are not too complex or sophisticated for Chinese …rms to learn See Table 1 for some examples.

however, it is di¢cult for the foreign …rm to protect its know-how, e.g., managementskills and style, market knowledge and experience, from being acquired by the local

…rm Indeed, a substantial portion of FDI by foreign …rms is for sources of cost production; the technologies and know-how involved are conventional and easy tolearn, see Table 1 for some examples Moreover, since the foreign …rm’s know-how isembedded or di¢cult to transfer, the local …rm needs to work with the foreign …rm for

low-a certlow-ain time period in order to lelow-arn the technology Such lelow-arning-by-doing implies

a lag and creates an incentive for the foreign …rm to cooperate with the local …rm,which is in turn willing to give up a large share of revenue to the foreign …rm in theinitial period of their cooperation Our model and its implications are most suitablefor the early stage of economic development

In Section 2, FDI is modeled as a two-period moral-hazard problem with learningand various contractual arrangements are discussed Sections 3 and 4 investigate equi-librium non-binding and binding contracts, respectively Section 5 presents the mainresult Section 6 highlights the special characteristics of the equilibrium contracts.Finally, the paper concludes with some general remarks

from the local …rm : For simplicity, the success probability of the project is assumed

to be p1 = E1e1; where E1 is 0 or 1 and e1 2 [0; 1]:8 The foreign …rm’s e¤ort isinterpreted as providing either good technology, E1 = 1 with cost C1 > 0; or badtechnology, E1 = 0 with zero cost The local …rm’s e¤ort is interpreted as developingthe foreign …rm’s technology or know-how into a product with cost c(e1) = 1+¯¯ e

1+¯

¯

1 ;where ¯ > 0: Since c0(e1) = e1=¯1 and e1 2 [0; 1]; 1=¯ represents the local …rm’sproductivity.9 Once successful, the project generates observable and veri…able revenue

R1 > 0; otherwise it has zero revenue

8 The simplifying assumption of discrete E 1 re‡ects the fact that the multinational …rm provides technology or know-how rather than labor e¤ort.

9 This speci…c form is chosen for the simplicity of derivations Cost can be written as c(e) = Ae °

for a closed-form solution, where A and ° ¸ 0:

Through cooperation in the …rst period, the local …rm may learn the foreign …rm’stechnology The probability of doing so is given by Á = ke1E1; where k2 [0; 1]:10 Ifthe foreign …rm provides good technology, the harder the local …rm works in the …rstperiod, the more likely it is to succeed in learning the technology The probability oflearning depends on an exogenous parameter k that may be interpreted as the speed

of learning As k increases from 0 to 1; learning becomes more likely On the otherhand, e1 and E1 are endogenously determined in equilibrium Hence, learning has anendogenous component, i.e., learning by doing, that is based on the e¤orts expended

by the local and foreign …rms in the …rst period

Our model focuses on the possibility that the local …rm will learn the foreign …rm’sknow-how through cooperation and do business on its own afterwards This situationapplies to the early stage of economic development, e.g., the early years of China’seconomic transition, when foreign …rms’ technologies and know-how are conventionaland easy to learn and local …rms are given exclusive access to certain inputs andresources by their governments

If the local …rm has learned the technology in the …rst period, the success probability

of the project in the second period, p2; depends solely on the local …rm’s e¤ort in thesecond period e2; i.e., p2 = e2; where e2 2 [0; 1]: If the local …rm does not learn thetechnology, the success probability depends again on the foreign …rm’s e¤ort, E2; andthe local …rm’s e¤ort, e2; i.e., p2 = e2E2; where e2 2 [0; 1] and E2 = 0 or 1: Inthe second period, the foreign …rm provides either good technology, E2 = 1 with cost

C2 > 0; or bad technology, E2 = 0 with zero cost The local …rm incurs cost c(e2):Once successful, the project generates observable and veri…able revenue R2 > 0 in thesecond period; otherwise it has zero revenue

Without losing generality,11 assume that the foreign …rm designs the contract In astandard principal-agent model, the principal does not provide any input; if the agent

is risk-neutral, the optimal contract has the agent paying a lump-sum fee or franchisefee upfront and then getting all the revenue, see Hart and Holmström (1987) In ourmodel, both the local and the foreign …rms must provide costly e¤orts In particular,the foreign …rm can provide good technology at positive cost or bad technology at zerocost If the quality of the foreign …rm’s technology can be veri…ed by a third partysuch as a court, our problem would be subsumed in the standard principal-agent modeland the optimal solution would be the franchise fee The franchise fee constitutes the

…rst-best solution as the local …rm has the maximum incentive to supply e¤ort whilethe foreign …rm is induced to provide the good technology

10 This learning structure can be generalized to the Cobb-Douglas form, see Remark 4 in Section 6.

11 See Remark 2 in Section 5 for the case in which the local …rm designs the contract.

Our model is concerned with a situation in which the quality of the foreign …rm’stechnology cannot be veri…ed when the technology is delivered This is characteristic

of FDI in developing countries (Marin and Schnitzer, 1995) While the quality of theforeign …rm’s technology cannot be veri…ed, it could be inferred by the local …rm.However, the crucial point is that the local …rm cannot verify its inference to a thirdparty because the success of the joint project depends on both the quality of theforeign …rm’s technology and the local …rm’s e¤ort It is impossible for a third party

to determine whether a failure of the joint project is due to the foreign …rm’s badtechnology or the local …rm’s low e¤ort

In the above situation, the franchise fee solution will not work The foreign …rmwould accept the franchise fee and supply bad technology at zero cost, because theforeign …rm knows that the local …rm cannot prove to a third party that the technology

is of low quality Given the inferiority of the franchise fee solution, share contractsemerge as optimal contracts in our model.12 Under such contracts, the foreign …rmobtains payo¤s only when the project is successful; thus, it provides good technology

if it has a signi…cant share

We consider two possible share contracts First, the foreign …rm can write a binding contract that allows the local …rm to do business on its own upon learningthe technology Speci…cally, if the project is successful in the …rst period, the foreignand local …rms get X1 and R1 ¡ X1; respectively In the second period, the local

non-…rm will work on its own if it has learned the technology; otherwise it will be in both

…rms’ interests to continue their cooperation In the former case, the local …rm getsthe entire amount R2 if the project is successful; in the latter case, the foreign …rmand the local …rm get X2 and R2¡ X2; respectively, if the project is successful.Second, the foreign …rm can write a binding contract that prevents the local …rmfrom doing business on its own upon learning the technology Speci…cally, if the project

is successful in the …rst period, the foreign and local …rms get X1 and R1 ¡ X1;respectively In the second period, regardless of whether or not the local …rm haslearned the technology, i.e., regardless of whether or not the foreign …rm is needed

to provide good technology, the foreign and the local …rms get X2 and R2 ¡ X2;respectively, if the project is successful

12 We model foreign direct investment as a team moral hazard problem; we would like to thank an anonymous referee for bringing the existing literature to our attention Holmström (1982) shows that the …rst-best outcome can be achieved if contingent violation of the team’s budget constraint is allowed and credibly implemented by an outsider who receives the di¤erence between the total surplus and payo¤s to the team members The incentive schemes for achieving …rst-best outcomes require the team members to post bonds Such schemes may not be feasible for foreign direct investment in developing countries in which the local …rms face initial capital constraints The literature also establishes the solution to the team moral hazard problem if the game is repeated inde…nitely Our paper studies scenarios in which weak contract enforcement and poor protection of intellectual property rights make

it practically impossible for the foreign and local …rms to cooperate inde…nitely.

The di¤erence between binding and non-binding contracts lies in the …rms’ period payo¤s Under the binding contracts, the foreign …rm always gets X2; even ifthe local …rm has learned the technology in the …rst period and the foreign …rm’s e¤ort

second-is no longer needed in the second period In contrast, under the non-binding contracts,the foreign …rm gets X2 only when the local …rm has not learned the technology in the

…rst period and the foreign …rm’s e¤ort is still needed in the second period Clearly,binding contracts require contract enforcement whereas non-binding contracts do not

3 Non-Binding Contracts

3.1 E¤ort Choices

To derive the equilibrium non-binding contract, we analyze …rst the choice of e¤orts

by the two …rms for a given contract (X1; R1¡X1; X2; R2¡X2): In the second period,

if the local …rm has learned the technology, the success of the project depends only

on the local …rm’s e¤ort Under non-binding contracts, the local …rm will choose towork on its own to capture all the revenue The local …rm chooses e2 to maximize itssecond-period pro…t:13

e¤2;F = R¯2; ¼¤2;F = 1

1 + ¯(e

¤ 2;F)1+¯¯ :This solution will be shown to be the …rst-best solution, so it is denoted by the subscriptF:

If the local …rm has not learned the technology, it may be bene…cial for both …rms

to continue the cooperation in the second period Speci…cally, given the foreign …rm’se¤ort E2; the local …rm chooses an e¤ort to maximize its second-period pro…t:

On the other hand, given the local …rm’s e¤ort e2; the foreign …rm’s expected pro…t

is ¦2 = E2(e2X2¡ C2): The foreign …rm would provide good technology, ^E2 = 1; ifand only if

In the …rst period, the foreign and local …rms again choose their e¤orts ously Speci…cally, given the foreign …rm’s e¤ort E1; the local …rm chooses e¤ort tomaximize total pro…t:

where ke1E1 is the probability that the local …rm has learned the technology in the

…rst period, and ± is the discount factor Here, the subscript N is used to denote thenon-binding contract The solution of (3.4) is:

E1 = 0; if and only if

e1X1¡ C1+ ±(1¡ ke1) ^¦2 ¸ ± ^¦2;or

±^¼2: When conditions (3.5a) and (3.5b) do not hold, neither …rm has the incentive

to cooperate in the …rst period However, the two …rms may still cooperate in thesecond period, as speci…ed in (3.1) through (3.3) Thus, the …rms’ total pro…ts are notnecessarily zero

3.2 Contract Design

We now analyze the design of the contract (X1; R1¡X1; X2; R2¡X2) to maximizethe foreign …rm’s pro…t Under conditions (3.2a), (3.2b), (3.5a) and (3.5b), which implyNash equilibrium e¤orts of (3.3) in the second period and Nash equilibrium e¤orts of(3.6) in the …rst period, the foreign …rm solves:

X 1 ; X 2 2(¡1; 1) ^e1X1¡ C1+ ±(1¡ k^e1) ^¦2

¤

2)1+¯¯ ¡C2:

Under the optimal choice of X1 and X2; constraints (3.2a) and (3.5a) are

automati-cally satis…ed Constraints (3.5b) and (3.2b) are equivalent to ¦¤

1;N ¸ 0 and ¦¤

2 ¸ 0;

respectively, which de…ne a feasible set of (R1; R2; ¯; C1; C2) for the equilibrium

non-binding contract If either ¦¤

1;N < 0 or ¦¤2 < 0; there will be no cooperation in eitherthe …rst period or the second period These cases will be dealt with in Section 5.1 In

summary,

1;N ¸ 0 and ¦¤

2 ¸ 0; there exists anequilibrium non-binding share contract (X¤

1;N+ ±ke¤

1;N¦¤

2;and its expected discounted second-period pro…t is ±¦¤

2¡±ke¤ 1;N¦¤

2: As ±ke¤

1;N¦¤

2 is theforeign …rm’s expected second-period loss from learning, ¦¤

1;N and ¦¤

2 can be preted as the ‘learning-free’ pro…ts Thus, under the equilibrium non-binding contract,

inter-the foreign …rm extracts a larger revenue share in inter-the …rst period to compensate for

its expected second-period loss from learning

Notice that, in the …rst period, the local …rm’s payment to the foreign …rm may

exceed the total revenue (X¤

1;N > R1) when the local …rm learns fast (with a largek): Hence, the local …rm may need liquidity to pay the foreign …rm in the …rst period

Compared with borrowing money to pay a franchise fee for a technology of uncertain

quality, it should be easier if the revenue is realized in the …rst period and more revenue

is expected in the second period

If the local …rm has not learned the technology, the success of the project depends

on both …rms’ e¤orts The analysis is the same as Section 3.1, with the outcomes given

by ^e2; ^E2; ^¼2 and ^¦2:15

In the …rst period, given the foreign …rm’s e¤ort E1; the local …rm chooses an e¤ort

to maximize its total pro…t: