The Influence of Financial Markets on
Spillover from Foreign Direct Investment
Master
International Financial Management 2013/2014 Faculty of Economics and Business
University of Groningen Supervisor
Dr. B. J. W. Pennink
Content
Abstract ... 3
Keywords ... 3
Classification code ... 3
1. Introduction... 4
2. Method of selecting and reviewing literature ... 6
2.1. Literature review ... 6
2.2. Scope ... 6
3. Literature review on FDI, spillover, financial markets and their relation on different levels ... 8
3.1. Foreign Direct Investment: definition and measurement ... 8
3.2. Spillover: definition and measurement ... 8
3.3. Relationship between FDI and different channels of spillover ... 9
3.3.1. Vertical spillover ... 9
3.3.2. Horizontal spillover ... 10
3.3.3. Overview of the FDI-spillover relation ... 12
3.4. Financial market ... 14
3.4.1. Definition and measurement ... 14
3.4.2. Influence of the financial market ... 14
3.4.3. Investment effect ... 15
3.4.4. Efficiency effect ... 16
3.4.5. Threshold ... 17
3.4.6. FDI and the financial market ... 17
3.4.7. Overview of financial market development influence on FDI spillover ... 18
3.5. Updated conceptual model ... 19
3.6. Spillover and financial market influence at different levels ... 20
3.6.1. Definitions ... 20
3.6.2. Subnational level ... 21
3.6.4. Horizontal spillover on subnational level ... 22
3.6.5. Financial market ... 23
3.7. Conceptual model ... 25
4. Discussion of findings and missing information ... 26
4.1. Discussion of the conceptual model ... 26
4.2. Spillover at local level ... 27
4.3. Financial market at local level ... 27
5. Conclusion ... 29
5.1. Answer to the research question ... 29
5.2. Limitations ... 29
5.3. Recommendations for future research ... 30
References ... 31
Articles ... 31
Website ... 35
Appendix A ... 36
Abstract
This thesis reviews the relationship between foreign direct investment (FDI) and spillover, and the influence of financial market development. There are different channels for FDI spillover. The signs (positive/negative) and strength of the spillovers are different when measured at national or subnational level. For positive spillover to occur, the financial market must reach a certain threshold level of development. The proposition is made that the local financial market is particularly important to small local firms, by enabling them to utilise FDI spillover. These findings imply that firms looking to benefit from FDI spillover should consider their location in regard to the FDI. The findings also imply that economic development policies should not only attract FDI, but also take measures to develop the financial market.
Keywords
Foreign direct investment; FDI; spillover; financial development; financial market
Classification code
1. Introduction
Foreign direct investment (henceforth: FDI) is welcomed by most countries. In fact, policy makers are eager to attract FDI (Alfaro et al., 2004; Javorcik, 2004; Narula and Portelli, 2004; Utting and Marques, 2009). But the literature is still divided on whether FDI has a positive or negative effect on domestic firms (Lehnert et al., 2013). This effect from FDI on domestic firms is referred to as spillover. Previous research has been conducted to find differences in types of spillover and other factors as ways in which FDI influences the domestic firm.
This thesis specifically investigates whether the level of financial market development matters: through mediation of FDI or spillover, or moderation of the FDI spillover relationship. This is particularly interesting because there are two opposing arguments: one is that in areas where the financial market is well-developed, there is less left to learn from FDI and thus less spillover occurs (Havránek and Iršová, 2011). The other argument supports the idea of positive influence of financial market development on spillover, for the reason that a certain level of development is necessary for domestic firms to be able to respond to the FDI (Alfaro et al., 2004).
An aspect that has so far been underexposed in the literature on FDI spillover, is the level at which it occurs. As policies are made not only at national level but also at lower levels, the subnational level spillover and financial market influence is also addressed in this thesis.
The research question is: “How does the financial market influence spillover from FDI on national and subnational level?” The starting point is the model in figure 1. This will be extended as more is uncovered about the variables: different kinds of spillover, and relationships: different ways in which the financial market exert influence. Finally, there will be some aspects within the model on which there is little to no literature available (local level FDI spillover and financial market influence). Based on the updated model, arguments will be presented on how those relations probably occur at the local level.
The findings presented in this thesis are useful for improvement on national and subnational policies. Also firms who are looking to benefit from FDI spillover may find it interesting to learn, amongst others, what type of spillover may benefit or hurt them.
2. Method of selecting and reviewing literature
2.1. Literature review
Scholar search engines PiCarta, Purplesearch, and SmartCat were used to find relevant and reliable literature. The search engines’ results are limited to peer reviewed scientific journals. Key terms that were used include: “FDI” “foreign direct investment” “findev” “financial development” “financial market” “spillover” “regional” and “local”.
Articles were then selected based on the information from the title and abstract. Subsequently, ScienceDirect (accessed through PiCarta) offered related articles which were reviewed in a similar manner. More recent research was preferred, but in case of very relevant content, articles from before 2000 were also included. References were also found through the bibliography of articles. In addition to the university database, Google Scholar has been used to find citations and full text files. This resulted in an overall selection of 87 articles.
Evidence tables were made to sort the literature and identify the important categories of spillover and financial market influence. Quotes that conveyed the findings and/or arguments from all articles concerning one of the categories were collected and additional relevant information, such as method, measurement and definitions, was added to the tables. This enabled identification of similar and dissimilar arguments, complimentary and contradictory findings. A section of an evidence table is shown in appendix A.
2.2. Scope
A few things to keep in mind while reading before continuing to the literature review. In particular the restrictions of the scope of this research. Financial market development is but one factor out of a plethora of factors that influence FDI spillover. The author has chosen not to include a list of all factors that are mentioned in the literature as part of the absorptive capacity of a community, region or country. For instance, the term ‘absorptive capacity’ is used in various ways and the definition was often lacking in articles. Therefore a complementary literature review on absorptive capacity would have be required to give an accurate and comprehensive description. Rather, it suffices to point out that financial market development is but one of several variables that determines the absorptive capacity.
Current practice is to use only GDP as dependent variable to measure1 the impact of FDI. Lehnert et al.
(2013) object to this: They note that most studies focused on narrow and direct economic impact rather than examine overall welfare impact, which would include not only economical but also social effects. However, the social effects are outside of the scope of this thesis: spillover here refers only to the impact on the domestic firm in accordance with the current literature.
3. Literature review on FDI, spillover, financial markets and their
relation on different levels
This section reviews what is known about FDI, spillover and financial market development, and how they are related. First, the definition of foreign direct investment and spillover are discussed, followed by the different forms of spillover (summarised in figure 2) and their relationship. Then the influence of financial markets on this matter is discussed (summarised in figure 3). Followed by a review of what is known about the variables and their relationship on different levels, national, regional and local. This information is used to develop the initial model (figure 1) into a conceptual model on national level (figure 4) and a model that differentiates between national and subnational level (figure 5).
3.1. Foreign Direct Investment: definition and measurement
Foreign direct investment (FDI) are investments from companies abroad (Poelhekke, 2011). Such investments include green field investments as well
as acquisitions of existing firms (Poelhekke, 2011). For those acquisitions to count as FDI, a lasting management interest needs to be acquired represented by 10% or more of voting stock (Worldbank, 2013).
The size of foreign direct investment is measured as gross inflow as percentage of GDP (Hermes and Lensink, 2003; Lehnert et al., 2013) or as net FDI inflow (Alfaro et al., 2004). The World Development Indicators database contains four FDI measurements:
Net balance of payments (in US$)
Net inflows (as % of GDP)
Net inflows (in US$)
Net outflows (as % of GDP)
Here, FDI is calculated as the sum of reinvestment of earnings, equity capital, other long-term capital, and short-term capital as shown in the balance of payments (Worldbank, 2013). In this thesis, FDI refers to FDI inflow only.
3.2. Spillover: definition and measurement
Generally said, spillover is “…the impact or effect of an interaction between
the MNC and the local firm.” (Rugraff and Hansen, 2011: 16). The multinational company (henceforth MNC) is the entity making the FDI. For the use of this research, we use the Rugraff and Hansen (2011) definition.
a production function (Eapen, 2013; Meyer and Sinani, 2009). For example, Görg and Greenaway (2004) test for change in productivity, wage and export. In turn, this productivity increase or decrease is typically measured as the change in GDP. Increased productivity of local firms can for instance, be the result from spillover through the knowledge from FDI, and the disturbance of the status quo that FDI presents (Blomström and Sjöholm, 1998). Thus: spillover is the effect of FDI on domestic firms that makes them more productive.
3.3. Relationship between FDI and different channels of
spillover
There are many channels through which the effect manifests. The most
important ones are discussed for a number of reasons. Primarily, to develop a better understanding of the FDI-spillover relationship. This is useful when examining the influence of financial development on this relationship and/or on the variables. Secondly, because incorrect identification of spillover can lead to over- or underestimation of its effect (Eapen, 2013). Thirdly, to form the base for proper propositions on how the relation may differ, from national to subnational level.
The following sections discuss different channels through which FDI spillover occurs. Examples thereof are productivity increase, knowledge transfer, specific skills, increased efficiency, organisational innovation, and more. These are explained in this section (3.3), categorised into vertical (inter-industry) and horizontal (intra-industry) spillover. Within vertical spillover the distinction between up- and downstream is made, and horizontal spillover is split into competition, imitation and labour mobility. At the end of this section (in 3.3.3), you will find an overview of these channels, presented in figure 2.
3.3.1. Vertical spillover
Vertical spillover occurs between firms within the same value chain, between suppliers, buyers (Iršová and Havránek, 2013) and distributors (Rugraff and Hansen, 2011). As an illustration, take a MNC that invests abroad by setting up a plant in a host country; the vertical spillover thereof is the impact of the FDI on firms within the same value chain. Within vertical spillover a distinction can be made between upstream (suppliers) and downstream (distributors and buyers)2 (Crespo et al., 2009; Rugraff and
Hansen, 2011). Positive vertical spillover is thought to occur more than positive horizontal spillover (Damijan et al., 2013) because firms up- or downstream of the MNC are less likely to compete with them and thus technology and know-how are shared more often (Javorcik, 2004; Rugraff and Hansen, 2011).
2 Havránek and Iršová (2011) use the terminology directly opposite: downstream are suppliers, and upstream
3.3.1.1. Upstream
Positive upstream spillover occurs via productivity spillover (Javorcik, 2004) and knowledge spillover to the supplying industries (Javorcik and Spatareanu, 2011). Increased demand leads to productivity spillover, and because of the requirements that the MNC has for the product or services they acquire, knowledge spillover is created. Geographic location matters in this sense: The further the MNC is from its home country, the more resources they will acquire from local suppliers and the more knowledge spillover is found (Javorcik and Spatareanu, 2011).
Upstream spillover does not necessarily occur coincidentally. By transferring technology to their suppliers, MNCs can increase quality and lower costs of non-labour input (Blalock and Gertler, 2008). By offering the technology to multiple suppliers, they decrease supplier-dependence and increase competition amongst supplier-firms. Another form of upstream spillover comes from a case study in Poland that revealed increased access to financing, which increased investments and substantial quality improvements in suppliers (Dries and Swinnen, 2004).
Upstream spillover thus occurs through increased productivity and knowledge, and more access to financing for the domestic firm.
3.3.1.2. Downstream
The literature search found that only two of the spillover articles discussed downstream spillover in depth. Rugraff and Hansen (2011) briefly mentioned that downstream spillover occurs through subcontracting, outsourcing, licensing and franchising. However, the rest of the article is focused on upstream spillover. Javorcik (2004) found no indication for downstream (forward) spillover, but noted that this could be due to their small sample size. Hansen and Schaumburg-Müller (2006) reported that MNC resources are invested into training distributors, agents and service providers. That way, the downstream firms acquire marketing and technological skills. These two channels are noted in figure 2 as ways in which downstream spillover could occur, if it does. In the conceptual model (figure 5) the spillover is denoted as insignificant, as there is no convincing research that proves otherwise.
3.3.2. Horizontal spillover
3.3.2.1. Competition
The first category of horizontal spillover described here is competition. Domestic companies that operate in the same sector as the FDI face increased competition. The MNC presence pressures them to meet this competition through reduced inefficiency, improved productivity or introduction of new technologies (Görg and Greenaway, 2004; Halpern and Muraközy, 2007). When the competition cannot be met, the spillover is negative and firms are pushed out of the market by the MNC (Halpern and Muraközy, 2007). To give an example: when the MNC can produce at lower marginal costs, they take away market share of domestic firms and decrease domestic firms’ productivity (Sinani and Meyer, 2004). Another threat occurs when the size of the MNC enables them to control the market, limit the choice for customers and limit competition (Lehnert et al., 2013).
MNCs appear to anticipate spillover and consider this in their decision of host country for FDI (Feinberg and Gupta, 2004). In cases the MNC can also decide the incentive to avoid or prevent spillover to competitors is insufficient. For instance, when the technological gap is so large that it already effectively prevents spillover (Narula and Portelli, 2004).
FDI can thus lead to positive spillover when the domestic firm becomes more productive, efficient and adopts new technologies to meet the competition. Negative competition spillover is when they lose market share to the MNC.
3.3.2.2. Demonstration and imitation
Additionally, the domestic firm that operates in the same industry may also benefit from the FDI by looking at and copying what they do, and how. In other words: through demonstration and imitation. This happens mostly in the area of technology and imitation of managerial and organisational innovations (Halpern and Muraközy, 2007). Technologies are adapted by the domestic firm because the uncertainty that made new technologies and techniques too expensive and risky for domestic firms, is reduced when it is first successfully implemented by the MNC (Crespo et al., 2009). Moreover, FDI leads to lower cost of innovations because it is cheaper to imitate than to innovate (Hermes and Lensink, 2003). This encourages domestic firms to adopt through imitation. Principles of management practices, managerial innovations and organisational innovations are also adopted through imitation (Görg and Greenaway, 2004). Here, the effect of FDI on the domestic firm is thus that the latter imitates the MNCs technologies and practices, and benefits from uncertainty reduction.
3.3.2.3. Labour turnover and -mobility
A third channel for horizontal spillover is through the workforce. The typical approach is that labour mobility generates positive spillover because domestic firms can hire former employees of the MNC (Crespo et al., 2009). Employees who are trained by the MNC, take along their technological, managerial and marketing skills as well as knowledge they acquired (Fosfuri et al., 2001; Nunnenkamp, 2004). MNCs typically pay higher wages to prevent this spillover and losing their staff, which in turn lowers labour mobility (Sinani and Meyer, 2004). A too large technological gap between domestic firms and the MNC can also inhibit spillover through labour mobility (Fosfuri et al., 2001) because the domestic firm cannot apply the greater skill, knowledge and experience in their own processes. These factors thus limit the positive labour spillover of skills; knowledge; experience, but also increase wages and limit the negative labour spillover. Negative labour spillover is when the higher wages stimulate the most skilled and knowledgeable employees to switch from domestic firms to the foreign firms (Sinani and Meyer, 2004).
3.3.3. Overview of the FDI-spillover relation
Combining and organising the information from sections 3.1 to 3.3 into a diagram results in figure 2. It shows that FDI spillover can be
distinguished into vertical and horizontal spillover and that those channels can be drawn down into further detail. Most of the mentioned spillovers are positive for the domestic firms. Exceptions are loss of market share and loss of skilled workers, which are negative to firms. Uncertainty for investments is denoted by a minus because the uncertainty decreases with the presence of FDI. Downstream spillover is noted as occurring through the transfer of marketing and technological skills. But research is sparse and inconclusive on this type, and thus it is uncertain whether such spillover does take place to a significant degree.
Having discussed what FDI and spillover is, and the relationship between them, we now progress to the third factor from the conceptual model: the financial market, in section 3.4.
3.4. Financial market
To see whether there is more, less or equally as much spillover from FDI when the financial market is more or less developed, articles that discussed the influence of the financial market were reviewed.
First an introduction to what is meant by the financial market in this thesis is given. This is followed by what is known from literature to be the influence of the financial market on the factors in our conceptual model and the relationship between them. This thus aims to answer the question marks from the conceptual model from the variable financial market to FDI and to spillover (financial market as moderator), and to the line between FDI and spillover (financial market as mediator). In Section 3.4.7 you will find the conceptual model (figure 3) that concludes this section’s findings.
3.4.1. Definition and measurement
In this thesis, financial market refers to the banking sector of a country. There are studies, like Alfaro et al. (2004) that also include the stock markets in their definition of the financial market, besides the banking sector (credit). Because we specifically want to look to the influence on the regional and local levels, the stock market is excluded. For the reason that at these lower levels, firms and people do not have access to the stock markets. This is supported by Azman-Saini et al. (2010) who state that, especially in developing countries, bank credits are the only reasonable source of financing.
The variable “financial market” is measurable as the level of financial market development. This is measured in different but similar ways: Hermes and Lensink (2003) use the log of private credit as percentage of GDP. Iršová and Havránek (2013) and Havranek and Irsova (2011) take the domestic credit to the private sector as percentage of GDP. Choong (2011) gives a more detailed description3 of
the variable, but not one that changes the meaning of the concept. A deviating interpretation comes from Meyer and Sinani (2009), who measure the per capita GDP as proxy for financial development. Concluding that ‘financial development’ is the measurement of financial market in terms of credit extended to the private sector.
3.4.2. Influence of the financial market
Interestingly, as detailed as Alfaro et al. (2004) researched the influence different aspects of financial market, their explanation thereof is more or less limited to the following:
3 1: currency plus demand and interest-bearing liabilities of banks and nonbank financial institutions) divided by
“In a nutshell, the argument goes that well-functioning financial markets, by lowering costs of conducting transactions, ensure capital is allocated to the projects that yield the highest returns, and therefore, enhances growth rates.” (Alfaro et al., 2004: 91)
Looking into how this influence works more specifically may help to better understand the relationship and to be able to deduce how the relation would work on the different (national; regional and local) levels. Following Choong (2011), the ways in which financial market may influence the FDI-spillover relationship, have been divided into investment effects and efficiency effects.
3.4.3. Investment effect
The investment effect refers to GDP-growth following increased FDI due to additional investments in the country. The effect has two interpretations: Firstly, the investment variable can be used to separate the part of GDP-growth that is caused only by the investment of the MNC, measured by the logarithm of investment share in GDP (Hermes & Lensink, 2003). Alternatively, Choong (2011) regard the investment effect of developed financial markets as their mobilisation of savings, which raised resources to finance investment projects. Thus, following the first interpretation, the investment effect is caused by foreign capital and the second by mobilised domestic capital. By separately including the investment variable, researchers have been able to attribute the resulting FDI coefficient to efficiency effect (see section 3.4.4).
3.4.3.1. Access to credit
A more developed financial market also relaxes credit constraints of foreign firms, which enables them to extend innovative activities in the host country (Ang, 2008; Omran and Bolbol, 2003). This in turn increases the (technological) spillovers for domestic firms (Choong, 2011; Hermes and Lensink, 2003). The investment effect is thus not only the added worth of the FDI to the GDP. It is also the increase of spillover through better access to credit for domestic firms who have the funds to respond to the FDI, promotion of entrepreneurs, and access to credit for foreign firms who then invest and innovate more.
3.4.4. Efficiency effect
The efficiency effect refers to the ways in which a developed financial market, in relation to spillover, contributes to GDP-growth through increased efficiency in the market.
Developed financial markets cause for better credit allocation by ensuring that financial resources are allocated to the most productive, highest return projects (Alfaro et al., 2010; Ang, 2008). In addition, a financial market offers screens and monitors investment projects (Choong, 2011; Omran and Bolbol, 2003). Through efficient allocation of capital and the screening and monitoring a well-developed financial market improves the absorptive capacity of a country (Hermes and Lensink, 2003) and thus the spillover potential. On the other hand, Xu (2012) argues that it is the Chinese financial system that hinders efficiency of credit allocation, thereby inhibiting spillover.
Financial market development is also said to reduce the cost of transactions (Choong, 2011) as well as the cost of external financing (Alfaro et al., 2010, 2004). Lower cost of financing promotes growth in a manner similar to the access of credit (Rajan and Zingales, 1998) as discussed in section 3.4.3.1. The higher costs imposed by a lack of financial development is a threshold for newcomers (Rajan and Zingales, 1998) and we would argue this goes especially for domestic entrepreneurs.
There is also the argument that countries with a more developed financial market are better able to utilise spillover potential (Ang, 2008; Lee and Chang, 2009). For one, because it is better able to absorb the benefits of FDI (Ang, 2008). Or because of upstream linkages between MNC and domestic firms that lead to improved production efficiency (Ang, 2008; Lee and Chang, 2009). These upstream linkages have positive spillovers to the rest of the economy (Lee and Chang, 2009).
A more developed financial market of the host country is also considered to be better able in reducing the risks of technology investments (Hermes and Lensink, 2003), thereby increasing technological spillover potential.
Ang (2008); Azman-Saini et al. (2010); Choong (2011); Havránek and Iršová (2011); Hermes and Lensink (2003); Lee and Chang (2009); Omran and Bolbol (2003) and Xu (2012) tested whether the domestic financial market development mattered for the spillover. All but one conclude that it has a positive impact; Havránek and Iršová (2011) found that greater spillover appear to be realised in countries with an underdeveloped financial market. They support this by arguing that domestic firms that supply to the MNC are helped to get credit by the latter.
In contrast to the literature mentioned above, Iršová and Havránek (2013) concluded that the degree of financial market development does not have an important influence on spillover. The difference between their 2011- and 2013-research is that the first concerns vertical spillover and the second horizontal spillover. They reach this conclusion because the variable is unstable and dependent of the control variables that were included. There was not accounted for a possible threshold level of financial market development.
3.4.5. Threshold
Hermes and Lensink (2003) and Omran and Bolbol (2003) already found that there was a minimum, or threshold level of domestic financial market development that must be achieved for FDI benefits to be realised. More recently Azman-Saini et al. (2010); Choong (2011) and Lee and Chang (2009) also found that there is a threshold level. One explanation for this threshold is that the financial market is an important intermediary for businesses (Choong, 2011). Another is that, below the threshold level the access to credit and the allocation of funds is insufficient for new and potential entrepreneurs to respond to the FDI (Omran and Bolbol, 2003).
Although all conclude that above the threshold there is positive spillover, there are different findings of the relationship below that level. According to Azman-Saini et al. (2010) and Hermes and Lensink (2003) there are no FDI-benefits below the minimum level. But Alfaro et al. (2010), who distinguish between low, medium and high levels of financial market development, find strong negative effects from FDI at the low levels.
3.4.6. FDI and the financial market
3.4.7. Overview of financial market development
influence on FDI spillover
Figure 3 presents an overview of the findings on the influence of financial market development. Firstly, a bidirectional positive
relation between FDI and financial market development, as FDI stimulates financial market development, which attracts FDI. The influence on FDI spillover is divided into investment effect and efficiency effect. These are further specified in the model below. Two opposing arguments on influence of the financial market on spillover from FDI were presented in the introduction: financial market development as an indication that firms in the area have little left to learn and on the other hand that a certain level of development is needed by the firms if they are to respond to the FDI. The literature study shows how the latter argument is backed up, by explaining in what ways financial market development matters to the domestic firms with regard to spillover. For the notion that areas with less developed financial markets had more to gain in terms of spillover from FDI could not be elaborated upon by the literature.
In addition to the previous sections, note that the methods mostly enhance FDI spillover by enabling domestic firms to utilise the spillover potential present. The only channels through which a developed financial market appears to increase the spillover potential is by attracting FDI and by enabling investing and innovation by the MNC in the host country.
With regards to the conceptual model (figure 1): there are indications for a line between financial market and FDI; as well as for the moderating influence on the FDI-spillover relation. The latter is shown in figure 3 by the lines from financial market development to spillover potential and utilise spillover. There was no indication for a moderating influence by the financial market on the variable spillover. These findings are translated to fit the conceptual model in the following section.
3.5. Updated conceptual model
The research question can partly be answered now: The financial market influences FDI spillover by attracting FDI, and this relationship is bidirectional. The financial market it also enables domestic firms to utilise the spillover that FDI brings by, amongst others, creating access to credit and lowering cost of external financing. The domestic firms utilise spillover by supplying to or buying from the MNC (vertical); by being stimulated by the competition, learning from workers who formerly worked at the MNC and by demonstration effects. There is also negative spillover: domestic firms losing market share and skilled workers to the MNC. Figure 4 shows the updated conceptual model, combining figure 2 and 3. Whereby the upper-right box shows the ways in which the financial market influences the FDI spillover relationship and the lower-right box shows the different channels of spillover.
3.6. Spillover and financial market influence at different
levels
After FDI, spillover, financial market and the relationship between them as described in the current literature, we shift our focus to different
levels; national, regional and local, at which the FDI spillover and financial market influence occur. This section explores what is known about FDI-spillover and the influence of financial market development on different levels. First an overview is given of how the levels are used in the current literature and how this differs from the use in this article. Then a literature research follows on how the relations shown in the updated conceptual model (figure 4) are different or similar on national and subnational level. The findings lead up to the final conceptual model (figure 5), where the relationships are translated into signs: positive: +; negative -; not known: ?, and compared between the levels: stronger negative: - - or stronger positive: ++ relation.
3.6.1. Definitions
In this article we apply the following set of level definitions: Following Pennink (2013), national level is defined by country-borders and local level refers to a city or community. Regional level is the scope between national and local and is best defined by provinces or counties.
We distinguish between local and regional level because the local level is an important, but often forgotten playfield for economic development (Pennink, 2013). This also goes for literature concerning FDI spillovers, which is reflected in the use of the terms ‘region’ and ‘local’. In some articles, the authors explain what is meant by ‘region’ and predetermined areas are used. Examples are: the regions and districts of the Venezuelan Manufacturing Census (Aitken and Harrison, 1999); the Nomenclature of Territorial Units for Statistics (NUTS) (Javorcik and Spatareanu, 2011) NUTS2 (Driffield, 2004); the Marshallian Industrial Districts (MID) (Menghinello et al., 2010) and counties and all directly neighbouring counties (Crespo et al., 2009) or provinces (Xu and Sheng, 2012). In other articles, the meaning of ‘region’ is implied to be based on political boundaries (Halpern and Muraközy, 2007; Scott and Storper, 2003; Tomlinson, 2003), distance (Crespo and Fontoura, 2007; Hamida, 2013) or an area with a certain set of characteristics (Driffield, 2006). Then there are also articles that imply no more detail than region being any level below national (Iršová and Havránek, 2013), or that apply it to global level (Javorcik and Spatareanu, 2011; Poelhekke, 2011).
The term ‘local’ is not used to address a distinct level, but rather to depict something as being located in the region. For example, variation of: a local firm in the region (Aitken and Harrison, 1999; Hamida, 2013; Menghinello et al., 2010; Scott and Storper, 2003; Xu and Sheng, 2012). Often, local and region(-al) are used interchangeably (Crespo et al., 2009; Driffield, 2006; Javorcik and Spatareanu, 2011). To
overcome these differences in terminology, the following sections present literature findings on subnational level, without the distinction between regional and local level.
3.6.2. Subnational level
There are a number of reasons to consider the levels, even though there is only scarce evidence on FDI-spillover on regional level (Crespo et al., 2009) and most of the studies have been country analyses (Hamida, 2013). For one, Aitken and Harrison (1999) suggested that spillovers on a smaller than national scale might be too small to offset overall national impact. And Crespo et al (2009) found that omitting a regional dimension in the FDI-spillover relationship, leads to biased national level results. Positive spillover is primarily determined by the motivation and capability of local firms to respond to the entry of MNCs (Meyer and Sinani, 2009). These variables are not measured on a national level. Using aggregate, national level data also omits small firm data, which skews the results because small firms arguably miss the absorptive capacity to benefit from potential positive spillover (Eapen, 2013). It may alternatively skew the results in the other direction, since Sinani and Meyer 's (2004) results show that small firms benefit more from spillovers and Damijan et al. (2013) show this goes for horizontal spillover.
Girma (2005) lists another four reasons why FDI-spillover would be found particularly in the direct environment of the FDI. For one, because skilled workers who are trained by the MNC, are more likely to get future employment in the same region due to regional mobility. Second, demonstration effects particularly require close observation for imitation and would thus occur locally. Third, MNCs may prefer to work with local firms to minimise transport costs and facilitate communication. Finally, knowledge transfer occurs more effectively over small distances.
3.6.3. Vertical spillover on subnational level
For vertical spillover from FDI, there is a difference among the levels:
On subnational level, upward spillover is found to be significant and positive whereas the relation is insignificant at the national level (Crespo et al., 2009). Downstream spillover was found on neither level. Halpern and Muraközy (2007) argue that upward spillover may be more positive in closer proximity to the FDI because of lower transport costs. However, the positive upward spillover they measure on national and subnational level is very similar, suggesting level does not matter for vertical spillover. Hamida (2013) argues that these similar results are due to the homogeneous character of Hungarian regions. And thus that a difference will be measured when regions are more dissimilar. Negative and distance sensitive vertical spillovers were found by Xu and Sheng (2012) but they note this could be attributed to unique Chinese policy. Thus, the literature does not provide a clear answer to whether and how vertical spillover is different on national and subnational level. This may be due
to the relatively short period in which vertical spillover has been a topic in research. Fewer research is conducted on vertical- than on horizontal spillover, because it has only become a more popular topic since the publication of Javorcik (2004) (Havránek and Iršová, 2011). With respect to our conceptual model we would say that at national level upward spillover is positive (+); downward spillover is not present (x) and for both the sign is unknown at subnational level (?).
3.6.4. Horizontal spillover on subnational level
Distance does matter for horizontal spillover through competition, labour mobility and imitation (Halpern and Muraközy, 2007). The further a domestic firm is located from the foreign firm, the less intense the positive horizontal spillover becomes (Xu and Sheng, 2012). Menghinello et al. (2010) add that the area-specific characteristics, as well as the quantity of FDI in the area are important factors for spillover. They find that there needs to be a critical mass of FDI in the area before horizontal spillovers take place there. Crespo et al.'s (2009) results show that level matters in the analysis of horizontal spillovers so much that a negative effect at subnational level annuls positive effect at national level. Reason for this may be that the channels for this spillover are differently affected by distance.
3.6.4.1. Competition
Competition is one of the channels for FDI-spillover, as discussed in section 3.3.2.1. There are contradicting stances of the level on which (spillover through) competition takes place. Scott and Storper (2003) claim it is widely acknowledged that competitiveness is not so much nationally but rather regionally based. On the other hand, Lipsey and Sjöholm (2005) state that competition for product markets on a national level but competition for labour on a regional level. Breaking spillover through competition further down into productivity, efficiency, technology and market share reveals where these different findings may come from. We would argue that technology spillover is greater over smaller distances because neighbouring local firms are the first to capture spillovers, which then gradually spills over to more distant firms (Aitken and Harrison, 1999). But scale is reduced for firms near the FDI (Crespo et al., 2009; Driffield, 2006, 2004) which leads to higher average costs (Aitken and Harrison, 1999) and lower efficiency and productivity (Crespo et al., 2009). Thus: positive technology spillover increases the smaller the distance: (+) at national and (++) at subnational level. But negative scale, and through that productivity, efficiency and market share spillover, are larger when domestic firms face foreign competition in their area: (-) at national and (- -) at subnational level.
3.6.4.2. Labour mobility
limits the transfer of skills, knowledge and experience through labour mobility. In other words; spillover through labour mobility is predominantly captured by nearby domestic firms (Aitken and Harrison, 1999; Hamida, 2013). Moreover, employment effects are particularly regional (Crespo et al., 2009), which leads us to suggest that increase in wages but also loss of skilled workers is also stronger over smaller distance to the FDI.
For small distance spillover, labour most important factor, whereas for larger distances competition plays a larger role (Halpern and Muraközy, 2007). For the conceptual model this means that at national level labour spillover is positive (+) and more strongly so at subnational level (++).
3.6.4.3. Demonstration / imitation
While it has been argued that tacit spillover such as information and technology is too important and forceful to be restricted by city borders or spatial distance, the difficulty of codifying it makes the spillover effect thereof decrease as distance increases (Audretsch and Feldman, 2004). As such, Hamida (2013) found no significant demonstration spillover on national level, but did find it to be positive and significant at the regional level. Demonstration spillover can cross larger distances for firms that invest in their absorptive capacity (Hamida, 2013).
Imitation spillover also works through social networks; the density thereof is more important than the distance, but those factors are typically related (Audretsch and Feldman, 2004; Halpern and Muraközy, 2007). Moreover, the knowledge and ideas present in an area are an important input for innovation (Audretsch and Feldman, 2004) and thus level matters for innovation spillover from FDI. This leads to the idea that demonstration spillover is positive (+) at subnational level and relatively insignificant (x) at national level.
3.6.5. Financial market
Revisiting section 3.4, financial market development influenced FDI
spillover through the investment effect (access to credit for domestic and foreign firms) and the efficiency effect (lower cost of external financing and transactions, better credit allocation and lower investment risk). The following paragraph discusses whether the influence is different on differing levels. But as little is written on the influence of financial market development on overall FDI spillover, even less is written on about that relationship on subnational level. For instance, the term ‘local’ refers to the host-country in Poelhekke (2011), rather than to a city or community. Not for all factors in the conceptual model could information on subnational relation be found.
It was found that banks from the same global region were more likely to small domestic firms than foreign banks were (Berger et al., 2001); Poelhekke (2011) suggests that this is due to soft knowledge being more easily acquired by ‘local’ banks. In line of these findings, we propose that for the financial
market to stimulate domestic firms to utilise FDI spillover on subnational level, it has to be developed at that same level. Berger et al. (2005) found that small firms lend to more difficult credits and are more effective at alleviating credit constraints because they have better access to soft information. This is because the loan collector can gather information through face-to-face interaction and better understands the local business environment than a distant bank officer could. At the same time, collection of hard information is as easy to gather from small or larger distance. Access to credit efficient credit allocation and monitoring and screening would thus increase when the local financial market is better developed. Small and locally owned banks are important to local business development (Brickley et al., 2003). Moreover, credits to small firms are a very productive credit category through which not only growth is promoted by also FDI benefits are magnified (Xu, 2012). This thus stresses the importance of the development of subnational financial markets.
3.7. Conceptual model
Elaborating on figure 4, figure 5 includes the different influences on national (N) and subnational (S) level.
The types of spillover that affect domestic firms do seem to be different on either level. Take technology spillover: strong at the subnational level but supposedly insignificant at national level. This would indicate that indeed studies that do not distinguish between levels when measuring spillover, risk mixing up the actual impact of FDI spillover and reach incorrect conclusions. Technology scale is the most extreme example; negative scale spillover and positive labour spillover are merely stronger at subnational level. This also goes for the influence of the financial market through access to credit and efficient credit allocation. For vertical spillover, no conclusion could be drawn for the subnational relation due to inconsistency in the current literature. As for financial market influence, no clues were found in the literature on whether cost of external financing or of transactions and investment risks are differently affected by the level of financial market development at national or subnational level.
Subnational level
4. Discussion of findings and missing information
Although at first sight it may appear to be a subject of clear scope and boundaries, spillover has proven to be a quite broad subject: There are different channels through which FDI generates spillover to domestic firms, which are in turn different at different levels. Also, financial market development is shown to have a positive influence on FDI spillover but very little is known about this on national and subnational level. The conceptual model as presented in section 3.7 is discussed in this chapter and ideas on the missing local level relations are given.
4.1. Discussion of the conceptual model
For almost all of the channels through which the FDI-spillover relation is moderated and how spillover manifests, the effect is stronger at the subnational level. Exceptions are those of which the effect is unknown at the lower level and the overall horizontal spillover. The latter is positive at national and negative at subnational level, according to previous literature. An explanation could be that the negative scale effect that FDI has is too large to be offset by the positive spillovers; technology, labour and demonstration.
The spillover effect for either up- or downstream firms at subnational level is not known. But based on the explanation for other spillovers and current literature, it can be argued that upstream spillover would be stronger and positive at subnational level. The still inconclusive research results have been explained as being caused by research specific reasons (homogeneous regions (Hamida, 2013); Chinese policy (Xu and Sheng, 2012)), rather than a generally non-existent effect. The argument of lower transportation costs seems plausible for a stronger subnational relationship. Another reason for a stronger positive effect could be lower transaction costs, as the supplier could be monitored more closely. However, there are also arguments to the contrary which have not been made in the literature; when the FDI requires specialised or sufficiently large suppliers, they may not always find these in their region and thus contract suppliers from a larger area. The area in which upward spillover occurs may thus be dependent on the size of the FDI and the degree of specialised input it acquires from outside parties.
As shown in figure 5, information is missing on cost of credit, cost of transactions and investment risks as ways in which financial market development moderates FDI spillover at the subnational level. It is suspected that transaction costs and investment risk are also more strongly affected, similar to the two factors (access to credit and credit allocation) of which we do have an idea of the subnational level relation. The effect on cost of credit may not change as much compared to national level, because of national level factors that influence the cost of credit.
4.2. Spillover at local level
Spillover at local level need not be any different than that which we see at the subnational level. One could argue that it is likely that labour and competition spillover are just as strong locally as they are at subnational level. Labour mobility because workers would travel outside of their community but within their region for a new job. For competition spillover because of the expectation that firms that are large enough to compete with an FDI, have a customer base that is at least regional. Also, competition spillover requires a domestic firm in operating in the same sector: for example Hamida (2013) found positive spillover specifically there where manufacturing firms were located in the same regions as their foreign counterparts, and no significant spillover effects on a national level. Demonstration that is typically between firms from the same sector may for similar reasons be regional rather than local. But demonstration spillover may not be restricted to same-sector firms and also extend to other sectors. Managerial innovation and organisational innovation in specific may spill over to local firms, albeit with some adaptations. If such is the case, the arguments for stronger demonstration effects at subnational level also go for the local level; the smaller distances, social networks and more face-to-face connections would lead to more positive demonstration spillover. Besides the suppliers, customers and competitors, the author notes that the business support sector was not mentioned in the articles on spillover. However, when spillover is defined as “…the impact or effect of an interaction between the MNC and the local firm” (Rugraff and Hansen, 2011: 16), the support sector ought not to be excluded. The support sector includes businesses such as hotels, caterers and other facilities. Spillover to this sector would arguably occur particularly near the FDI, because these services are not things that are procured from far but in the proximity. An example of the impact a FDI has on the service sector is presented in appendix B.
4.3. Financial market at local level
within their community, rather than seeking one within their region. In line with the notion that larger firms take on large, national or even bigger banks and smaller firms take smaller banks, the proposition is that the level of development of small, local banks matter most to the small and locally operating firms. In fact, Schoenmaker and Werkhoven (2013) say that a country should have banks of different sizes to accommodate their different functionalities, which this thesis would link to the needs of the smaller versus larger firms.
5. Conclusion
5.1. Answer to the research question
Revisiting the research question: “How does the financial market influence FDI-spillover on national and subnational level?”, it can now be answered that this influence works on a number of ways: Firstly influence occurs through the bidirectional relationship between FDI and financial market development. A better developed financial market attracts FDI, and FDI stimulates financial market development. Secondly, a better developed market stimulates MNCs to innovate and thereby increase spillover potential. Thirdly by enabling domestic firms to utilise the spillover potential. There are different ways in which FDI leads to spillover, through extending knowledge but also as an example for domestic firms and a source of trained employees. There were no indications of financial market influence on the specific spillover channels, for instance that certain types of spillover were more present the more developed the financial market.
The level of financial market development at lower levels appears to be of particular importance to small firms, because they get credit extended from local financial institutions rather than large national banks. At the lower levels, the FDI spillover works differently than at national level, a matter that has been underexposed in the current literature. Amongst others, positive spillover through labour and technology spillover are stronger at subnational level, but negative scale spillover as well. It is not known what the net effect at subnational level is.
This study has thus revealed gaps in the current knowledge and gives reason to re-evaluate the attraction of FDI by policy makers. The findings imply that first the business environment should be studied: are there right firms present that could utilise the spillover potential? Would negative spillover from FDI be outweighed by the positive spillover? And is the financial market at each level developed well enough for firms at those levels to reap the benefits from the FDI? These are questions both policy makers and businesses ought to ask.
5.2. Limitations
What also must be noted is that the literature on which the conceptual model is based, contained contradicting findings on a number of subjects, even at national level. Especially for the subjects on which already little was written it was a real obstruction for determining the correct relationship. As for the FDI spillover it can therefore mainly be concluded that there is reason to believe different relations on different levels, rather than confidently state the given signs per spillover channel and level are the exact correct ones.
Finally, availability of literature created a limitation to the research. Because in general there was little literature on financial market influence on FDI spillover, a further focus was not possible. Focus on for example developing countries would have been interesting. This research does show that there is this gap and uncovers the general influences, which are probably just as true for developing countries.
5.3. Recommendations for future research
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Appendix A
Articles on the influence of the financial market on FDI-spillover Influence FinMarket on
FDI-Spillover Article Threshold accounted x Alfaro et al. (2004) No x Ang (2008) No x Choong (2011) Yes
x Omran & Bolbol (2003) Yes
x Xu (2012) No
x Hermes & Lensink (2003) No
x Alfaro et al. (2004) No
x Alfaro et al. (2010) Low/Med/High
x Spatareanu and Javorcik (2008) No
x Ang (2008) No
x Choong (2011) Yes
x Omran & Bolbol (2003) Yes
x Havránek and Iršová (2011) No
x Xu (2012) No
x Lee and Chang (2009) Yes
x Hermes & Lensink (2003) No
x Ang (2008) No
x Omran & Bolbol (2003) Yes
x Hermes & Lensink (2003) No
x Choong (2011) Yes
x Ang (2008) No
x Lee and Chang (2009) Yes
x Ang (2008) No
Lower risk associated with
investment x x Hermes & Lensink (2003) No
Attract more FDI x Lee and Chang (2009) Yes
Better able to absorb capital x x Lee and Chang (2009) Yes
No (important) influence - - x Iršová and Havránek (2013) No
FinMarket more important than
FDI - - x Lee and Chang (2009) Yes
Bi-directional FDI-FinMarket
relation - - x Lee and Chang (2009) Yes
FDI promotes FinMarket, which x x x Lee and Chang (2009) Yes
Cyclical relationship x Lee and Chang (2009) Yes
Lower transaction costs x x Poelhekke (2011) No
x Alfaro et al. (2004) No
x Rajan and Zingales (1998) No
x Alfaro et al. (2010) Low/Med/High
x Choong (2011) Yes
x Alfaro et al. (2010) Low/Med/High
x Ang (2008) No
x Choong (2011) Yes
x Havránek and Iršová (2011) No x Omran & Bolbol (2003) Yes
x Xu (2012) No
x Lee and Chang (2009) Yes
x Azman-Saini et al. (2010) Yes x Hermes & Lensink (2003) No
Efficiency/ Investment
Theoretical/ Tested
Better credit allocation x
Access to credit for domestic
firms x
Acces to credit for foreign firms x
Better able to utilise spillover
potential x
Lower cost of capital x
Influence FinMarket on
