This World Bank Policy Research Working Paper evaluates the heterogeneous impact of spillovers from multinational corporations (MNCs) to domestic enterprises in the developing world.

The paper focuses on the impact of spillovers on high-growth firms, which are enterprises with high job creation rates and, therefore, assumed to have high absorptive capacities. The paper also evaluates spillovers stemming from MNCs with different motivations to invest in developing countries.

The results have important implications for policy design, as public funding in developing countries is often directed to support programs that seek to connect domestic suppliers with MNCs.

Introduction

Foreign Direct Investment (FDI) enables economic growth, job creation, and poverty reduction. Countries that are more open to trade and investment tend to be more productive and grow faster. Policymakers seek to attract FDI to create jobs, bring in cutting edge knowledge and technology, connect to global value chains, and diversify and upgrade their economies’ production capabilities. The potential transmission of knowledge between foreign firms and local enterprises is an additional benefit of FDI that can improve the productivity of domestic enterprises and, therefore, make economic growth more inclusive.

The effects of Multinational Corporations (MNCs) on the host economy are therefore a crucial element in a country’s development strategy. These FDI spillovers can be positive or negative, depending on whether local firms improve or worsen their performance due to the presence of MNCs. The reason for this ambiguity is that FDI brings two opposite forces to the market. On the one hand, it brings foreign technology and frontier knowledge that, if successfully transmitted to the local firms, can improve their productivity. On the other hand, foreign firms may compete with local incumbents in input and output markets and, therefore, have a pro-competitive effect that can negatively affect some firms. The balance between these two forces determines the overall effect of MNCs on individual local enterprises. At the sectoral level, tougher competition results in the efficient reallocation of resources from less productive to more productive firms, thereby increasing sectoral productivity over the long run.

This paper evaluates two main channels through which horizontal FDI spillovers can be accrued by indigenous firms in the developing world. First, contractual linkages between MNCs and local suppliers could entail a formal transmission of foreign firms’ knowledge and practices that may help domestic suppliers to upgrade their technical and quality standards – the linkages channel.

Second, domestic firms can imitate foreign technologies or managerial practices either through observation or by hiring workers trained by the foreign company – the demonstration channel. The analysis employs firm-level information from around 71,000 firms from 122 developing economies across 50 sectors, using the World Bank Enterprise Surveys (WBES) to construct sectoral measures of these transmission channels and relates them to the performance of indigenous enterprises operating in the sector. The proxy for the linkages channel is the average share of inputs that MNCs source domestically; the proxy for the demonstration channel is the share of MNCs’ output in total sectoral output.

The paper shows that high-growth firms internalize spillovers through both avenues and that contractual linkages are the most powerful transmission channel. FDI embedded in global value chains generates larger spillovers to high-growth domestic firms than investment that seeks to serve the host economy. There is no evidence that natural resource-seeking FDI generates spillovers.

From a policy perspective, developing countries are interested in enhancing the benefits of FDI to the local economy. The evidence presented shows that linkages programs to connect high-potential local suppliers with foreign firms provide a means of achieving this goal. The design of programs that identify and connect high potential suppliers with MNCs seems critical to create FDI spillovers. Manufacturing sectors with MNCs operating within regional or global value chains are more prone to generate knowledge transmission to the host economy, but the automatic creation of domestic linkages may be hampered by market failures, such as information asymmetries, low scale, and quality constraints.