Using FDI to Upgrade and Diversify the Production and Export Base of Host Economies in the Developing World

Harsha Vardhana Singh – drawing on arguments developed by Dani Rodrik, Ricardo Hausmann, Justin Lin, and others – argues that industrial policy may have a key role to play in designing development strategy in the contemporary period.

Traditional views of industrial policy have typically begun with trade protection as a strategy to promote the creation of infant industries that grow to become viable international competitors. Following Lin’s Comparative-Advantage-Following (CAF) model, this paper adopts a perspective quite at variance with the older trade-protection approach, starting instead with foreign direct investment (FDI) promotion to attract multinational corporations into sectors that bring the host country immediately to the frontier of technology, management, and quality control.

The focus on harnessing FDI – in particular in manufacturing and assembly – to promote broad-based development complete with economic and social spillovers and externalities assumes special importance in light of the discovery that developing countries that diversify and upgrade their production and export base enjoy more rapid growth and greater welfare gains than those that simply do more and more of what they have always done.

As shown later, FDI in manufacturing offers target-rich opportunities for host governments that want to use it to bring structural transformation to the host economy. But this paper also points out that there are important market failures and tricky obstacles to attracting investors in higher-skilled and novel sectors in untried emerging market locales. This brings the analytic investigation back to the design of industrial policy in the contemporary period. What are the precise market failures and obstacles to using FDI to upgrade and diversify a would-be host’s production and export base? And what are the corresponding public sector interventions needed to achieve success?

Here is where this paper hopes to make an important contribution – the most significant market failures and obstacles to using FDI to upgrade and diversify the host production and export base are slightly – but significantly – different from what the Hausmann-Rodrik-Lin framework leads us to conclude. The design of industrial policy has to be refocused to deal with the empirical discoveries about market failures and obstacles that are introduced here. At the same time, some popular conclusions adopted by some of those who use the Hausmann-Rodrik-Lin framework – notably Rodrik but not Lin himself – can be shown to be counterproductive and even damaging to the prospects for development.

The resulting combination of new proposals for the design of industrial policy and new cautions about the design of industrial policy will bear directly on the role of “policy space” for the WTO to better address the needs of developing countries.

Implemented jointly by ICTSD and the World Economic Forum, the E15Initiative convenes world-class experts and institutions to generate strategic analysis and recommendations for government, business and civil society geared towards strengthening the global trade system. The E15 expert group on Reinvigorating Manufacturing: New Industrial Policy and the Trade System is co-convened with the National School of Development at Peking University.