Imagine you’re a young entrepreneur and have built up a profitable IT business. You can expand either by going at it alone, or partnering with a more established, perhaps international firm. Which should you choose?
Sign up with the multinational.
That’s the advice of a new NBER Working Paper ‘Does Foreign Entry Spur Innovation?’ by three US trade economists, Yuriy Gorodnichenko, Jan Svejnar and Katherine Terrell. They find, using a large firm-level dataset of eighteen countries, that foreign direct investment (FDI) have a significantly positive impact on product and technology innovation of domestic firms in emerging markets. In other words, those domestic firms that receive FDI become more innovative over time than other domestic firms.
This isn’t surprising. Trade economists have long argued that increased trade and investment boosts domestic firms’ productivity. Foreign firms tend to bring new innovative ideas, technology and management practices that replace potentially inefficient practices of domestic firms. When SA opened up to the world after the isolation of the apartheid years, the argument goes, local firms’ productivity increased significantly because they suddenly had to compete against more competitive producers.
This was difficult to prove empirically: industry-wide statistics are often too vague to give reliable evidence that FDI has a positive impact, and some firms may close due to tougher competition. But this study uses firm-level data, measuring the size of spillover effects from the international partner to the domestic firm, and documents the impact on innovation instead of noisy productivity estimates.
The authors found that the benefits of FDI don’t accrue to other firms in the industry, but is localised to the domestic firms immediately connected to the foreign firms. They conclude: Simply being in an industry populated by foreign firms generally has a weak, if any, effect on innovation. In fact, if our entrepreneur doesn’t get a foreign partner but his competitors do, he may find himself out of business.
This study is important for policy makers too. Firstly, encouraging FDI is critical to growing an economy. Public (and political) sentiment is often against foreign competition; consider the long (and expensive) deliberations preceding the Walmart-Massmart merger. Let me be unequivocal about this: this study shows that foreign competition drives innovation in domestic firms, making them more competitive and longer-lasting. We need more, not less, of it.
The authors also found, in short, that FDI from rich countries is better. Again, this makes intuitive sense. Firms in the rich world already operate at the technological frontier. Now, for the first time, it has found empirical support. One wonders about SA’s attempts to cosy up to our BRICS partners instead of encouraging investment from our traditional (and still largest) trade partners. If we believe the results of this study FDI from China is less beneficial for SA than from the US or Germany.
Another, perhaps more controversial, finding: because the benefits of FDI only accrue to firms within the supply chain of the acquired domestic firm, it might mean that policies which require foreign firms to have significant local content (for example, a rule which states 20% of a firms’ inputs must be locally made) may be justified. Minister Rob Davies will be happy to hear this.
But he’ll first need to get foreign firms excited about SA. In late July, he introduced the Promotion and Protection of Investment Bill in parliament as an attempt to do just that. The bill aims to protect and promote investment, but, sadly, falls short. As Webber Wentzel’s Peter Leon argues, it contains few of the protections one would typically find in a bilateral investment treaty. ‘Fair and equitable’ treatment for investors, such as market value compensation in the event of expropriation, are missing.
The rapid growth of emerging markets over the last two decades seems to be tapering off. SA cannot rely on foreign firms entering the country seeking investment opportunities as had happened during the good times. We have to up our game and become more attractive. That means improving all sorts of things, like skills and infrastructure, but the low-hanging fruit of investment bills and secure property rights should be top priority.
*This column first appeared in the 1 October edition of Finweek.