What is the most important reason for a country to encourage foreign investment?

But in the long run, the most important benefit FDI can bring is not through things so easily observable like jobs and taxes, but through the “spillover” of technology and knowledge (such as management and organizational practices) to local firms and workers. Such spillovers can help transform local economies by raising the level of productivity. But spillovers are not guaranteed. In too many countries, Lesotho and Swaziland included, FDI operates as an enclave, with few links to the domestic economy. Indeed, foreign investments may even have negative impacts on domestic competitiveness, at least in the short run; it might crowd out local investment, out-compete domestic firms, or corner the market for skilled workers. It turns out that foreign investment is not unambiguously good. Rather, how advantageous it is depends on a number of conditions.

In new research published last month through the International Trade Department, we explore the specific qualities of firms and government policies that make foreign investment beneficial. Our working paper examines the impacts of these factors on domestic firms’ labor productivity in a cross-section of more than 25,000 domestic manufacturing firms in 78 low- and middle-income countries.

We find that the type of foreign ownership is important in facilitating spillovers. Firms that are partially foreign-owned – that is, they involve a partnership between a foreign and local partner – are more likely than those that are fully foreign-owned to improve productivity in the local economy, presumably because these partnership firms are more likely to share technology and have links with local suppliers. The strategic objective of the foreign investor also matters. Foreign firms that invest with an aim of selling their goods in the local market have a positive effect on local firms’ productivity, as do foreign firms that buy significant inputs from the local market. Those foreign firms that invest in a country to establish an ‘export platform’ – where all output is destined for foreign markets rather than being sold locally– are less likely to deliver spillovers.

But it’s not only the foreign firm that matters in facilitating spillovers. There are two sides in the knowledge transfer process, after all, and the characteristics of domestic firms are also important. Our research suggests that domestic firms with lower productivity to begin with benefit more from foreign presence than firms with higher productivity. This may be because higher-productivity domestic firms have less scope to improve, or because these high-productivity firms are more likely to face the negative impacts of FDI, through competition for workers and customers. Besides productivity, other local firm characteristics also make FDI spillovers more likely. Among them are: a low gap between a domestic firm’s technology and that of the foreign firms; a high technology level in the domestic firm; a high number of employees in the domestic firm; the domestic firm’s geographic proximity to many other firms; and a high percentage of exports in sales by the domestic firm.

The host country’s institutions also matter for FDI impact. Greater openness in trade and investment makes it more likely that the introduction of foreign investment increases domestic firm productivity. In addition, countries that spend more money on education and those that have a higher degree of financial freedom (i.e. banking efficiency and independence) benefit more from FDI.

There are interactions between all of these factors, as well. This gets a little bit complicated. For example, our research shows that if a foreign investment has some domestic ownership, the country’s institutional environment matters more for increasing the productivity of domestic firms. Put another way, the ability of a shared foreign-domestic firm to transmit helpful skills and knowledge to local companies depends heavily on government-controlled aspects of the business environment such as local education spending, trade policies, and financial freedom. Spillovers from fully foreign-owned firms, on the other hand, are less sensitive to these factors. In the case of investment by a firm that is fully foreign-owned, the country’s financial market openness and education spending have no impact on local firm productivity. This may be because fully foreign-owned investments are more likely to operate in enclave environments like special economic zones, which sit outside the domestic institutional environment.

These results have implications for policies in developing countries such as Lesotho and Swaziland. Governments in these countries naturally want to attract FDI, which could be a boon for development. But the general observations above and more specific analyses of the countries’ industries show that the governments should be strategic in both the type of firms they court and the ways in which they design the institutions that make FDI spillovers more likely.

In Swaziland, for example, working with Africa region’s Private Sector Development team at the government’s request, we examined the potential for information- and skills-transfer between foreign and local companies in three industries – textiles and garment, light manufacturing and agribusiness. Specifically, we surveyed and interviewed local producers and suppliers to find out how foreign investors are linked to domestic small and medium-sized enterprises (SMEs). We hoped to identify the sectors that, if targeted in an FDI-attraction strategy, offered the best potential to facilitate growth of domestic suppliers and upgrading of local workers.

We found that the textiles and garment industry had the most foreign-owned presence in Swaziland, but was on the decline. It also had little success in generating spillovers beyond low-skill employment; expatriates held most of the managerial and technical positions, and most staff members moved between foreign companies but rarely worked in local enterprises. Light manufacturing was strongly linked to the garment industry, and so had suffered a similar decline. In addition, the foreign-owned manufacturing firms were small, so unlikely to have a big impact on domestic firm productivity.

The agribusiness sector, on the other hand, was a more promising candidate for encouraging productive interaction between foreign investors and local firms. The FDI presence was large, and the sector made up half of the country’s exports. In addition, subcontracting local firms was a well-established practice in many agricultural products: sugar, meat, baby vegetables, cassava, and forestry. Interviewees noted the possibility of coordinating among local firms to produce some inputs competitively, such as packaging. Already, an industry association had developed in pork production and helped transfer knowledge from foreign firms to local producers.

All of this shows that in Swaziland, existing conditions make agribusiness a better candidate for FDI spillovers than the country’s other major industries. But in encouraging the transfer of knowledge and skills to local firms, our research shows that policy-makers would be well-served to look beyond just the industry. They should also think about types of firms they want to attract, keeping in mind ownership structure and the local sources the foreign firms could use. Though it is a broader endeavor, they should also keep in mind the institutions they build – the money they spend on education, the financial freedom they legislate and the trade policies they enact – if they want their local businesses to benefit from foreign presence.

Why is increasing foreign investment important?

What is the major reason behind the foreign direct investment?