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The Impact of Inward FDI on
Host Countries: Why Such
ROBERT E. LIPSEY and FREDRIK SJÖHOLM A substantial body of literature has grown around the question of how
inward foreign direct investment (FDI) affects host countries. On almost
every aspect of this question there is a wide range of empirical results in
academic literature with little sign of convergence. At the same time, policymakers seem to have made their own judgments that inward FDI is valuable to their countries. The United Nations Conference on Trade and
Development (UNCTAD) publishes annual data on “changes in national
regulations of FDI” and reports that from 1991 through 2002, over 1,500
changes making regulations more favorable and fewer than 100 making
regulations less favorable to FDI were made (UNCTAD 2003, 21, table 1.8).
The same document reports that “the use of locational incentives to attract
FDI has considerably expanded in frequency and value” (UNCTAD 2003,
124). Given the amount of academic literature on the issue, why has it made
so little impression on policymaking? Are all these countries foolishly pursuing an ephemeral fad? Are the questions asked in academic literature
irrelevant to policy? Are the relevant questions answerable? For that matter,
what are the relevant questions? Robert E. Lipsey is emeritus professor at the City University of New York and a research associate and
director of the New York office of the National Bureau of Economic Research. Fredrik Sjöholm is
associate professor and researcher at the European Institute of Japanese Studies at the Stockholm School
23 2668-02_CH02.qxd 04/14/05 08:42 Page 24 There are many possible effects of FDI inﬂow on a host country. Since it
is generally taken for granted that investing ﬁrms possess some technology superior to that of host country firms, higher-quality goods and services could be produced at either lower prices or in greater volume than
previously available, resulting in higher consumer welfare. Another possible effect would be that inward investment adds to the host country capital stock, thereby raising output levels. Although this issue has been
explored, especially in earlier literature determining whether inward investment or aid supplements or displaces local investment, it is not speciﬁc to
direct investment. Speciﬁc attention to direct investment has been devoted
to the question of whether inward investments do involve superior technology and, if they do, whether it “spills over” to domestically owned ﬁrms
rather than being retained entirely by the foreign-owned ﬁrms. A related
set of questions is whether the foreign-owned ﬁrms pay higher wages for
domestic labor, whether those higher wages raise the average wage level
in the host country, and whether these higher wages spill over to domestically owned ﬁrms. For both wages and productivity, the spillovers to
domestically owned ﬁrms or establishments could be either positive or
negative. Wage spillovers could be negative if, for example, the foreignowned ﬁrms hired the best workers, at their going—or higher—wages,
leaving only lower-quality workers at the domestically owned ﬁrms.
Productivity spillovers could be negative if foreign-owned ﬁrms took market shares from domestically owned ﬁrms, leaving the latter to produce at
lower, less economical production levels.
Survey articles have found inconclusive evidence in the literature regarding the most important effects of inward FDI, especially with respect to
spillovers. For example, on wage spillovers, Görg and Greenaway (2001)
reported that panel data showed negative spillovers, while cross-sectional
data reported positive spillovers. The same research paper found, with
respect to productivity spillovers from foreign-owned to domestically
owned ﬁrms,“ only limited evidence in support of positive spillovers. . . .
Most work fails to ﬁnd positive spillovers, with some even reporting negative spillovers . . .” (Görg and Greenaway 2001, 23). Görg and Strobl (2001)
concluded that the crucial determinant of the ﬁndings in 21 studies was
whether cross-section or time-series data had been used, with the former
typically ﬁnding positive spillovers and the latter often negative ones.
Lipsey stated that “the evidence for positive spillovers is not strong”
(2003, 304) and concluded a review of the literature by saying that “the
evidence on spillovers is mixed. No universal relationships are evident”
(2004, 365). With respect to effects on host country economic growth,
Carkovic and Levine (2002) found no signiﬁcant effect of FDI inﬂows over
the entire 1960–95 period and only irregularly signiﬁcant effects in ﬁve-year
intervals. None of the variables found in other studies consistently determine
the effect of FDI on growth, although some are signiﬁcant in some combination of conditioning variables. For instance, Lipsey found it “safe to
24 DOES FDI PROMOTE DEVELOPMENT? 2668-02_CH02.qxd 04/14/05 08:42 Page 25 conclude that there is no universal relationship between the ratio of inward
FDI ﬂows to GDP and the rate of growth of a country” (2003, 297).
A crucial feature of these surveys is that the summarized studies do
not individually find that wage or productivity spillovers do not exist.
Mostly, they find evidence for either positive or negative spillovers. In
this chapter, we try to understand why different investigators find contradictory results. Is it that the statistical techniques are different? Are the
countries they examine different? Are they asking different questions
under the same labels of wages, productivity, or spillovers? We try to
answer these questions in two ways. One is to review the individual studies
themselves to clarify the questions asked and the data used. The other is
to survey studies on data for Indonesia, which cover a long period and
are both detailed and accessible, in order to test the implications of different definitions and methods. The studies we review in this chapter
examine the effects of FDI on ﬁrms and their workers. They are all producer
oriented. However, future statistical studies could look at consumption
effects. For example, has FDI growth in retailing reduced the price of
food and other consumer goods? Has FDI growth in utilities reduced the
price of telephone service or home heating and lighting? These possible
effects of FDI are almost totally absent from the literature but should be
studied. Wage Spillovers
We begin with the studies of wage spillovers, which are not as numerous
as those on productivity. There are several general issues that run through
almost all the wage studies. One issue is that wage levels are calculated as
total wages or total compensation per worker, but the only measure of
skill is a division between production and nonproduction or blue-collar
and white-collar workers. Within those categories, almost no studies can
distinguish between differences in skill or education level or between
employees of foreign-owned and domestically owned plants from differences in wages for identical workers. Similarly, they cannot distinguish
between differential changes in skills between the two ownership groups
and differential changes in wages for identical and unchanging workers in plants owned by the two ownership groups. A second issue is
whether wage comparisons should take account of characteristics that
are correlated with foreign ownership but not intrinsically related to it.
For example, foreign-owned firms or establishments are typically much
larger on average than domestically owned ones, even in developed
countries. Especially in developing countries, foreign-owned firms or
establishments are more capital intensive and use more purchased materials or components for their production than domestically owned firms.
The question is whether these characteristics should be treated as conTHE IMPACT OF FDI ON HOST COUNTRIES 25 2668-02_CH02.qxd 04/14/05 08:42 Page 26 trols—and their inﬂuence eliminated—or are they so bound up with foreign ownership that they should not be controlled for? As Aitken,
Harrison, and Lipsey (1996, 368) point out, a host country may not care
whether higher employee wages in foreign-owned plants result from the
fact that they are foreign owned or from the fact that they are large and
use capital-intensive technology and/or import-intensive technology.
Size, capital intensity, and import intensity may all be elements of the
foreign-owned ﬁrm’s technology.
Empirical studies provide strong evidence of a wage premium in foreignowned firms (Lipsey 2004). Foreign firms pay higher employee wages
in both developed and developing countries, after controlling for firmspeciﬁc characteristics. It is of course possible that high employee wages in
foreign-owned ﬁrms are caused, or at least biased, by foreign takeovers of
high-wage domestic ﬁrms. In a recent study (Lipsey and Sjöholm 2002)—
using a 25-year panel of Indonesian manufacturing establishment data
and lacking la-bor force education data, but including most of the typical independent variables—we were able to lay this issue to rest, at least
for this one country. Foreign-owned ﬁrms did tend to acquire domestic
plants with higher than average blue-collar wages for their industries, but
the margins over the averages were far too small to account for the wage
differential between domestically owned and foreign-owned plants. Thus,
selectivity in take-overs could not account for the wage gap. Further evidence included the discovery that after a foreign takeover of a domestically
owned plant, both blue-collar and white-collar wages rose strongly, in
absolute terms and relative to their industries. Takeovers of foreign-owned
plants by domestic ﬁrms had the opposite effect on wages, illustrating that
foreign takeovers, rather than takeovers in general, produced wage
increases. Econometric analyses using the whole panel of establishments
found large wage differences in favor of foreign ﬁrms at every level of
industry and geographical detail, and the differentials remained large even
when plant characteristics, such as size and the use of purchased inputs,
were introduced into the wage equations. The ﬁnding that employee
wages were higher in foreign-owned plants and became higher when
domestically owned plants became foreign owned was not dependent on
the use of cross-section rather than panel data.
Although the literature on wage comparisons between foreign- and
domestically owned ﬁrms is large, relatively few studies examine the effect
of FDI on wages in domestically owned ﬁrms. Görg and Greenway (2001)
review six studies on wage spillovers and report that of those with conclusions, three panel studies found negative spillovers and two cross-section
studies found positive ones. They do not include the information that some
of the cross-section estimates for Mexico and Venezuela also give negative
coefﬁcients for spillovers, suggesting that the choice of cross-section or panel
estimation may not be so crucial.
26 DOES FDI PROMOTE DEVELOPMENT? 2668-02_CH02.qxd 04/14/05 08:42 Page 27 Other subsequent studies have reported more evidence that wage spillovers occur. Figlio and Blonigen (2000) concluded that the effect of a large
new foreign investment in South Carolina on aggregate wage levels was
so large that it could not have been solely the result of the high employee
wages in the foreign-owned plants but must have involved spillovers to
domestically owned plants. Their study differed from most others because
it concentrated on geographical effects, rather than the effects within the
industry of the investment. Indeed, in the only wage study we know of that
uses education as a measurement of the quality of the labor force (Lipsey
and Sjöholm 2004b), we made a variety of calculations of spillovers in
a cross section of Indonesian manufacturing establishments. Assuming
national labor markets within broad industry groups, we found signiﬁcant
wage spillovers to domestically owned plants. Assuming national labor
markets within narrower industry groups also revealed signiﬁcant spillovers, albeit smaller ones. In addition, assuming that an industry within
an individual province represented a labor market still revealed that spillovers to domestically owned establishments occur. The combination of
higher wages in foreign-owned plants and spillovers to domestically
owned plants meant that higher overall wages were associated with
foreign ownership. Further evidence that the distinction between crosssection and panel data studies is not the crucial determinant of results on
wage spillovers can be found in Drifﬁeld and Girma (2002), which uses a
panel of establishments in the UK electronics industry from the Annual
Respondents Database (ARD) from 1980 to 1992. Drifﬁeld and Girma found
intraindustry and intraregion wage spillovers from FDI on wages in general, and the effect was larger for skilled than for unskilled workers. A
study by Girma, Greenaway, and Wakelin (2001), using ﬁrm, rather than
establishment, panel data for almost 4,000 ﬁrms in the United Kingdom
from 1991 to 1996, also found some evidence of wage spillovers. On average, when spillovers were assumed to be identical across industries and
ﬁrms, Girma, Greenaway, and Wakelin found no signiﬁcant evidence for
them. However, when the effects were permitted to vary across industries,
wage spillovers were found and were higher in industries where the productivity gap between foreign and domestic ﬁrms was lower. One way this
study differs from our earlier research (Lipsey and Sjöholm 2002) is that it
excludes ﬁrms that changed ownership, thereby eliminating one way in
which foreign ownership affects wages. The effects of shifts to foreign ownership had been found in an earlier study to be positive in the United
Kingdom, as they were in Indonesia.
The accumulation of studies since the earlier surveys seems to have put
to rest the suspicion that the ﬁndings of wage spillovers were solely the result
of ignoring firm differences in cross-section studies, since the spillovers
did appear in panel studies. Something else must account for the negative
spillovers or lack of spillovers found in some developing countries. Aside
from Indonesia, the positive spillovers have been found most frequently in
THE IMPACT OF FDI ON HOST COUNTRIES 27 2668-02_CH02.qxd 04/14/05 08:42 Page 28 developed countries. Even in the United Kingdom, large differences in productivity between foreign-owned and domestically owned ﬁrms reduced
or eliminated spillovers. One possible cause for the negative results in
some developing countries is that the gap between foreign-owned and
domestically owned ﬁrms is too large for one group to inﬂuence the other.
Another possibility is that the labor markets in some developing countries
are too segmented for wages in one group to inﬂuence the other. If we compare Mexico and Venezuela, two countries reported to show negative wage
spillovers from foreign ﬁrms, with Indonesia, the United Kingdom, and the
United States, for which positive spillovers were found, labor market conditions do seem different. An “employment laws index” produced by the
World Bank (2003), and based upon the work of Botero et al. (2003), had a
range in which a high number indicated very restrictive labor laws on hiring, ﬁring, and conditions of employment. On the basis of this index,
Mexico and Venezuela were ranked among the most restrictive countries,
with index numbers of 77 and 75, respectively. The United Kingdom was
rated at 28 and the United States at 22. Indonesia was in between at 57, not
ﬂexible by developed-country standards, but relatively ﬂexible for a developing country.
Another topic not always considered is how the relevant labor market is
deﬁned. Most studies implicitly deﬁne a labor market as an industry—at
whatever level of detail industry is reported. Some deﬁne the market as an
industry within the narrowest geographical area at which industry data are
available. That may be appropriate for some countries or industries, but
there may also be national labor markets within an industry, or local labor
markets that straddle many industries (national labor markets may also
straddle many industries). These differences in deﬁning the labor market
may affect findings on spillovers. Therefore, consideration of the industry and geographic construction of FDI measures is needed, and the conclusion might be different for wages from what it is for productivity. For
wages, the appropriate deﬁnition depends on the range of a labor market
within which wages tend to be equalized, or at least within which one
ﬁrm’s wages inﬂuence those in other ﬁrms. The answers might be different in different countries or industries and at different times. In a recent study
(Lipsey and Sjöholm 2004b), we tested the effect of different deﬁnitions of a
labor market by using different industry and geographic classiﬁcations to
examine the sensitivity of the results. They used FDI measures at two-,
three-, and ﬁve-digit industry levels and at both the national and province
levels to examine the effect of foreign presence on the wages in locally owned
Indonesian plants. The results for these various deﬁnitions of a labor market
are shown in table 2.1. The coefﬁcients vary substantially, but they remain
statistically signiﬁcant in all speciﬁcations.1 The largest coefﬁcients are for 1. See Lipsey and Sjöholm (2004b) for the complete empirical speciﬁcations and results.
28 DOES FDI PROMOTE DEVELOPMENT? 2668-02_CH02.qxd 04/14/05 08:42 Page 29 Table 2.1 Wage spillovers in Indonesian manufacturing
FDI variable Blue-collar wage White-collar wage 1.07
(16.42)*** Three-digit national 0.28
(5.43)*** Five-digit national 0.16
(11.46)*** All sectors province 1.05
(28.27)*** Two-digit province 0.47
(12.26)*** Three-digit province 0.39
(12.12)*** Five-digit province 0.24
(13.12)*** Two-digit national *** = signiﬁcance at the 1 percent level
Note: t-statistics are in parentheses.
Source: Lipsey and Sjöholm (2004b). deﬁnitions of the relevant market as either national, at the two-digit industry
level, or provincial, for all manufacturing industries combined. However,
there is concern that these coefﬁcients may represent the tendency of foreign ﬁrms to move into either high-wage geographical locations or highwage industries. Those possible biases are reduced by further geographical
breakdown—by province—and by successively greater industry detail, culminating in breakdowns by ﬁve-digit industry and province. The coefﬁcients are greatly reduced in size, but remain strongly signiﬁcant, showing
margins of a quarter for blue-collar and over a third for white-collar workers. The most detailed breakdown does not necessarily give the most accurate estimate of the effect of foreign ﬁrms’ presence, however. It may miss
the effect of higher wages and increased employment in foreign-owned
establishments in one industry or province on wages in other industries
and provinces—possibly a more important effect than any within the same
industry and province. Even the more aggregate measures may understate
the wage effect because they are conﬁned to manufacturing, ignoring any
impacts on agriculture, services, and trade. Productivity Spillovers
Many of the same issues that affect studies of wage spillovers occur in the
much larger body of literature studying productivity spillovers. In addition, there are broader problems with the productivity measurements. The
THE IMPACT OF FDI ON HOST COUNTRIES 29 2668-02_CH02.qxd 04/14/05 08:42 Page 30 objective is often described as measuring the spillovers of technology, or
knowledge, from foreign-owned to domestically owned ﬁrms. In order to
simplify measurement, technology is narrowly deﬁned to measure labor
productivity, total factor productivity, or differences in production functions. All three are reﬂections of technology, but they may be both too broad
and too narrow. The comparison of production functions, often cited as an
ideal method, assumes that there are no differences in technological knowledge involved in choices about factor combinations or plant size. Thus, the
operation of a large plant, as opposed to operation of a small plant, requires
no different technological mastery. The operation of a capital-intensive
plant requires no technological skill beyond that required for a laborintensive plant. The use of intermediate inputs from abroad or from a parent company involves no technology beyond that of using locally available
inputs. These are all assumptions implicit in production function comparisons, but if they are invalid, and locally owned plants do not have the technological skill to operate at the scale and factor combinations of foreignowned plants, true technological differences between foreign-owned and
domestically owned plants are hidden, disguised as differences in scale of
production or factor combination choices.
There is another respect in which the deﬁnitions of technology are too
narrow. For example, if foreign investors’ technological superiority consists of knowledge about consumers’ tastes in foreign markets, or about
marketing a product in local or foreign markets, this knowledge will not
be visible in productivity or production function comparisons. Rather, it
will be seen in comparisons of export performance, but those are a different set of literature not usually characterized as technology. A very different type of study that takes a broad view of technology is exempliﬁed
by Dobson and Chia’s (1997) country studies for Asia, Rhee and Belot’s
(1990) country- and industry-speciﬁc case studies of “the critical role of
transnational corporations (TNCs) in the transfer of technical, marketing,
managerial know-how to developing countries,” and Moran’s (2001, 2002)
many examples of technology transfer. All of these are basically case studies of particular transfers of technology, but not conﬁned to either intraindustry or interindustry transfers and not conﬁned to speciﬁc measures
of technology. All of them ﬁnd evidence for transfers of technology, but it
is difﬁcult to confront their evidence with the statistical studies described
later in this chapter because the questions are so different. The case studies ask whether there are examples in which technology was transferred
from foreign-owned to domestically owned ﬁrms, and the answer is “yes.”
In contrast, the statistical studies ask whether on average domestically owned
ﬁrms gain in a particular measure of technology because foreign-owned
firms operate in the same industry and the same country or the same
region, and the answer is “not universally.” Both of these answers could be
accurate; neither one contradicts the other, because they are answers to different questions.
30 DOES FDI PROMOTE DEVELOPMENT? 2668-02_CH02.qxd 04/14/05 08:42 Page 31 Case studies offer great ﬂexibility. The exact nature of the technology
transfer can differ from example to example, from industry to industry,
and from country to country. The length of time for the transfer to occur
and be measured need not be speciﬁed in advance and can vary widely.
The transfer can be within an industry, to supplying industries, or to consuming industries. This ﬂexibility is an advantage of the case study
method, but it comes at a cost: Firms that do not receive foreign technology are often omitted from case studies measuring the effect of transfers.
Thus, the universe for measuring effects is not always delineated, and the
universe from which the case studies are drawn is not always deﬁned. In
contrast, statistical studies tend to be rigid in specifying the length of time
over which effects are measured (whether it is a year or a set number of
years). They specify some particular deﬁnition of a technology transfer
(perhaps ignoring other important dimensions), and whether differences
among countries or industries are to be studied. Statistical studies assume
the relevance of some particular measure of FDI and some functional
form for its effects. The studies greatest advantage is that they tend to
examine effects on whole industries, including the unlucky or less competent losers, as well as the successes. With microdata, they can look at
the characteristics of firms changing ownership as well as those forced
out of an industry, those entering, and those remaining. A goal for case
studies might be to assemble a collection of unsuccessful ventures and to
compare them with successful ones, not only with respect to their own
characteristics but also, even more importantly, with respect to country
and industry environments. Baranson’s (1967) book on Cummins’ experience in India, for example, contains an analysis of the effects of importsubstitution policies that can be compared with experiences under more
liberal trade regimes.
A general problem with productivity comparisons and spillover studies,
compared to wage studies, is their greater need for data. Productivity
studies require output measures, usually sales or value added. Sales by
foreign-owned firms, particularly exports, are frequently intracompany
transactions. The values may not be the same as market values, because
there are many incentives to alter them to minimize tax liabilities, and the
incentives may be very different for foreign-owned firms from any that
domestically owned firms face. Any manipulation of sales values would
affect value added even more, and there are incentives to manipulate the
profit portion of value added in addition to those affecting sales values.
Furthermore, since value added includes profits, it may fluctuate far
more over time than any physical measure of production. The use of production functions requires measures of capital input, which are often
missing from census data. If measures of capital input are present, their
meaning is often questionable, especially in countries that have suffered
major inflations, because it is uncertain if and how historical values have
been adjusted to current price levels. As with wage spillovers, the Görg
THE IMPACT OF FDI ON HOST COUNTRIES 31 2668-02_CH02.qxd 04/14/05 08:42 Page 32 and Strobl (2001) and Görg and Greenaway (2001) surveys conclude that
the negative results from panel data studies are more reliable than those
for cross-sections, and that there is therefore little evidence of positive
spillovers from FDI. However, a number of new studies of productivity
spillovers based on panel data have appeared. As is true for wage spillovers,
these find more evidence for positive spillovers than the earlier ones. For
example, Haskel, Pereira, and Slaughter (2002) use a panel of UK manufacturing plants between 1973 and 1992 and find a positive and robust
spillover effect of inward FDI on productivity in local plants. Keller and
Yeaple (2003) also find positive and robust effects of inward FDI in the
United States on productivity in US manufacturing plants between 1987
and 1996. Girma, Greenaway, and Wakelin (2001), using the firm data
described above, find that there are spillovers and that they are greater
for firms in sectors in which local firms are technologically comparable
to the foreign firms. Labor productivity and total factor productivity
spillovers are similar in size. As with wage spillovers, the accumulation
of studies has eroded the basis for the hypothesis that the distinction
between cross-section and panel data studies explains the wide range of
In their panel data study of Venezuela, Aitken and Harrison (1999)
show what is probably the strongest evidence for negative productivity
spillovers. A rise in the foreign share of ownership in a sector reduced the
output of individual domestically owned establishments and reduced their
total factor productivity over one- to three-year periods. The ﬁrst-year negative effect was particularly severe for small domestically owned plants,
suggesting that they were the least efficient and most vulnerable to competition from the increasing efficiency associated with rises in foreign
ownership. Since Venezuela had been a relatively closed economy to both
trade and inward direct investment in manufacturing during this period,
it might have accumulated a larger than average stock of small, competitively weak firms.
In another panel study of a relatively closed economy Kathuria (2000)
used data for large firms in India from 1975–76 to 1988–89, before the
country’s period of liberalization. Technical efficiency was measured
from a function with value added as the production measure and labor
and capital as inputs, and was calculated as the distance between the ﬁrm
and the most efficient firm in its industry. Spillovers were deemed to
have occurred if the dispersion of efﬁciency levels among domestically
owned ﬁrms in the industries studied—in which foreign-owned ﬁrms
were the efﬁciency leaders—were reduced. The foreign source of the
spillovers was measured in two ways: the extent of foreign participation
in the industry, which was represented by the foreign-owned ﬁrms’ share
of sales, and the stock of cumulated purchases of foreign technology by
local ﬁrms. Foreign participation had a negative effect on the dispersion
of efficiency among domestically owned firms. This effect was inter32 DOES FDI PROMOTE DEVELOPMENT? 2668-02_CH02.qxd 04/14/05 08:42 Page 33 preted by the author as indicating negative spillovers. Kathuria points
out, however, that a negative spillover in these terms could result if both
the foreign firms and the domestically owned firms gained in efficiency
but the foreign-owned ﬁrms gained more—a result that would have been
interpreted as a positive spillover in the Aitken and Harrison framework.
The stock of foreign technological capital of the local ﬁrms was positively
related to their gains in efficiency. When the sample was split between
“scientiﬁc” and “nonscientiﬁc” industries, the spillover effects were conﬁned to the “scientiﬁc” group but were offset by a positive coefﬁcient for
the cross-product of foreign presence and the local ﬁrm’s research and
development (R&D) effort. The interpretation was that R&D-intensive
local ﬁrms might have gained, or lost less, from the foreign presence than
ﬁrms that did less R&D. Productivity Spillovers in Indonesia
One way of understanding the variety of results would be to apply the same
techniques to the identical types of data in different countries. Since we do
not have access to data from many countries, we instead review studies of
Indonesia and test alternative methods on that country’s data. One advantage of using Indonesian data for experimentation is that Indonesia collects consistent microdata on its manufacturing industry and these data have
been increasingly used by a number of authors for plant-level studies. A
number of studies on Indonesia show that foreign plants have higher productivity than locally owned plants (Takii and Ramstetter 2003; Okamoto and
Sjöholm 2005) and that plants that change ownership from local to foreign
ownership increase their level of productivity (Anderson 2000). In addition,
there are several plant-level studies on productivity spillovers from FDI in
Indonesian manufacturing, which are summarized in table 2.2. The ﬁrst three
studies on spillovers from FDI in Indonesia used cross-section analysis (see
table 2.2). For instance, Sjöholm (1999a) examined plants in 1980 and 1991
and found both the level and growth of labor productivity to be higher for
locally owned plants in sectors with a high foreign share of output. There
was no evidence of regional intraindustry spillovers from FDI, but some
indications of regional interindustry spillovers.
Sjöholm (1999b) used the same data as his earlier study to examine possible determinants of spillovers. The results suggested that spillovers were
positively affected by the technology gap between domestic and foreign
plants and by the degree of competition within the sector. Blomström and
Sjöholm (1999) examined spillovers from FDI in 1991. Their study differed
in design from the previous two mainly in the use of capital stocks rather
than investment ratios to control for capital intensity. There were positive
spillovers from FDI, and no differences in the spillovers from joint ventures
with minority or majority foreign ownership.
THE IMPACT OF FDI ON HOST COUNTRIES 33 2668-02_CH02.qxd 04/14/05 08:42 Page 34 Table 2.2 Studies on productivity spillovers from FDI
in Indonesian manufacturing
Author(s) Year(s) Dependent
variable Measure of
(1999) 1991 Value added
dummies + *** Sjöholm
(1999a) 1980, 1991 Growth in
characteristics + *** Sjöholm
(1999b) 1980, 1991 Growth in
Scale + *** Takii (2001) 1990–95 Value added Employment
effect + *** Todo and
(2002) 1995–97 Value added
effect + *** Blalock and
(2002) 1988–96 Output Output
effect + *** Blalock and
(2003) 1988–96 Output Output
effect *** = signiﬁcance at the 1 percent level
+ = positive
? = not statistically signiﬁcant 34 ? 2668-02_CH02.qxd 04/14/05 08:42 Page 35 Takii (2001) was the ﬁrst study on spillovers in Indonesia that used panel
data, which allowed him to control for plant-speciﬁc effects. He examined
spillovers during 1990–95 using a translog production function and found
positive effects on value added in local ﬁrms from the share of foreign
employment in the same three-digit International Standard Industrial
Classiﬁcation (ISIC) industry. Moreover, the results suggested that spillovers were relatively large in sectors with relatively new foreign plants and
with low gaps in labor productivity between foreign and domestic plants.
Takii also found that R&D positively affected spillover in locally owned
The study by Todo and Miyamoto (2002) differs from most of the others
by defining the FDI variable as the absolute amount of FDI in a sector.
They argued that this measure is more strongly related to the foreign
knowledge stock and therefore preferred over the foreign share of a sector.
The result showed a positive effect of FDI on local ﬁrms’ labor productivity
after controlling for R&D and training of the workforce.
Blalock and Gertler (2002) also used a translog production function to
examine spillovers between 1988 and 1996. Local ﬁrms in sectors within
regions with a high foreign share of output had high levels of productivity.
Moreover, they found a positive effect on spillovers from the technology gap
between domestic and foreign plants; spillovers were also positively affected
by local ﬁrms’ R&D and by high levels of education of workers in local ﬁrms.
In a second study, Blalock and Gertler (2003), using the same data and a
very similar translog production function, found no evidence of positive
intraindustry spillovers from FDI. A second measure of FDI in this study
is the main difference between the two: Blalock and Gertler (2003) measured FDI in upstream markets to capture spillovers from FDI to local suppliers. They found that downstream FDI was highly signiﬁcant in the
econometric estimations. This variable was constructed by using an inputoutput table at a sector level, which also includes purchases from its own
sector. Therefore, one possibility is that the variable on downstream FDI
also captured the effect of horizontal spillovers.
To summarize the results from these seven production spillover studies on
Indonesian manufacturing, all cross-section studies and three out of four
panel data studies found statistically signiﬁcant intraindustry spillovers. The
one study that failed to ﬁnd intraindustry spillovers found interindustry
spillovers from FDI instead. Judging by these studies of Indonesia, we conclude that the design of econometric studies does not cause the different
results found in the literature. Therefore, differences between countries or
ﬁrms may explain the extent of spillovers. The studies on Indonesia might
shed some further light on what these differences could be. Previous literature suggests that competition, the technology gap, and local ﬁrms’ absorptive capacity will affect the extent of spillovers. Starting with competition, the
studies by Sjöholm (1999b) and by Blalock and Gertler (2003) show that
spillovers are highest in sectors with high competition. The former study sugTHE IMPACT OF FDI ON HOST COUNTRIES 35 2668-02_CH02.qxd 04/14/05 08:42 Page 36 gests that it is domestic competition, as captured by a Herﬁndahl index, rather
than the degree of protection from imports that affects spillovers. The second
study suggests that competition will beneﬁt upstream local suppliers.
The effects of technology gaps on the extent of spillovers is unclear.
Takii (2001) found a negative effect on spillovers from the technology gap
between local and foreign-owned plants, which has also been found
in other countries (Kokko 1994, 1996). Sjöholm (1999b) and Blalock and
Gertler (2002) find a positive relation between the technology gap and the
degree of spillovers. One explanation for the different results could be
that the measure of technology gap differs between studies. Takii measured the technology gap as the difference in labor productivity between
domestically owned and foreign-owned plants.2 Sjöholm used the difference in labor productivity between domestically owned and foreignowned plants after controlling for the scale of operation and the investment
per worker ratio.3 Finally, Blalock and Gertler used the plant’s ﬁxed effect
in comparison to the mean fixed effect in the same industry. Another
reason why these, and other studies, produce such varying results could
be that the relationship is nonlinear. Some technology gap is presumably
required for any useful technology spillover to occur. However, it is also
plausible that if the gap is too large, the technology in foreign plants will
be of little practical use in locally owned plants pursuing very different
types of operations.
Differences in spillovers between countries may also be caused by
differences in sectors’ and plants’ absorptive capacity. The studies on Indonesia conﬁrm that such capacity might be important if a ﬁrm is to benefit
from spillovers. Takii (2001) and Todo and Miyamoto (2002) as well as Blalock
and Gertler (2002) found that a ﬁrm’s own R&D positively affected its ability
to beneﬁt from spillovers. The last study also found that plants with more
highly educated employees beneﬁt more from the presence of foreign multinational corporations (MNCs). A related question is whether the type of activities pursued by the foreign subsidiaries affects spillovers to domestically
owned ﬁrms. This issue has been rather neglected in the spillover literature
but Todo and Miyamoto (2002) ﬁnd a positive effect on spillovers from
R&D and human resource development in the foreign subsidiaries.
As evident from the earlier discussion, considerable attention has been
devoted to differences between econometric methodologies as one possible explanation for the different effects of spillovers among countries. A
related, but so far rather neglected, issue is how one should construct measures of FDI. Most studies use the foreign share of a sector’s economic 2. Takii also used the difference in capital labor ratios and the difference in size as alternative
measures of technology gaps. These measures gave inconclusive results.
3. The difference in investment ratios was used as an alternative measure but provided no
36 DOES FDI PROMOTE DEVELOPMENT? 2668-02_CH02.qxd 04/14/05 08:42 Page 37 activity as a measure of FDI.4 One problem with this measure is that the
foreign share of a sector might be endogenously determined if productivity spillovers expand activity in local firms. Moreover, this measure
assumes that increases of foreign and aggregate activity in the same proportion have no effect on local firms. Castellani and Zanfei (2002) argue
that this assumption might produce a downward bias on the estimate of
spillovers from FDI. Finally, it is not clear why we would assume the effect
from FDI to be linear in the foreign share of an industry’s economic activity: spillovers are not obviously maximized at a 100 percent foreign ownership share (Lipsey 2004).
Although the foreign share is widely used as an FDI measure, productivity spillover studies still differ in how this share is constructed. Some
measure it as the foreign share of employment, while others measure it as
a share of value added or output. Moreover, the foreign share is calculated
at different sector levels, ranging from two-digit to ﬁve-digit levels of ISIC.
Finally, some studies use the foreign industry share at a national level,
while others use it at a regional level.
The more narrow the deﬁnition of an industry, the more restrictive is our
assumption of how widely applicable knowledge from FDI can be for local
ﬁrms, and our assumption of which domestically owned plants face increased competition from FDI. If we construct the FDI measure on a twodigit level of ISIC, it implies that productivity spillovers might be present
between industries at a three- and ﬁve-digit level of ISIC but not from one
two-digit industry to another. If we construct our measure of FDI at a ﬁvedigit level of ISIC, it implies that productivity spillovers can only be captured
if they occur within these industries but not if they cross from one ﬁve-digit
industry to another. It is unclear what a properly deﬁned industry is for an
analysis of productivity spillovers. It seems that most studies favor a disaggregated deﬁnition of FDI, possibly to increase the variance in the FDI
variable. However, this might come at a cost if we miss out on spillovers
across narrowly deﬁned industries. Some technologies, such as computer
use in tracking sales and inventories, may be very general and easily transmitted across industries, while others may be speciﬁc to particular production processes. Clearly, the industry deﬁnition will also have implications for
what we attribute to interindustry versus intraindustry spillovers.
The choice to construct the FDI measure at a national level or at a regional
level might also be important. Choosing the most appropriate level to use
depends on whether the spillover has a spatial dimension—for example, if
it primarily beneﬁts plants within the same region. The Jaffe, Trajtenberg,
and Henderson (1993) study is often referred to when a regional measure
4. There are exceptions, see, for example, the previously discussed study by Todo and
Miyamoto (2002). See also Barrell and Pain (1997), who use aggregate FDI in a constant elasticity of substitution (CES) production function and ﬁnd positive effects from FDI on technical progress in EU countries.
THE IMPACT OF FDI ON HOST COUNTRIES 37 2668-02_CH02.qxd 04/14/05 08:42 Page 38 of FDI is used (Sjöholm 1999a, Blalock and Gertler 2002, Lipsey and
Sjöholm 2004b). Their study shows that university R&D primarily benefits other inventors within the same geographic area. Hence, their study
relates to innovation, and it is possible, but not certain, that the same
result also exists for spillovers. Whether or not spillovers are geographically concentrated depends on, for instance, whether imitation, competition,
or supply of linkage industries are enhanced by geographic proximity to the
If we believe that technology spillovers are geographically concentrated,
the next question will be: What is an appropriate geographic aggregation
level? Studies on Indonesia have used both districts (Sjöholm 1999a) and
provinces (Sjholm 1999a; Blalock and Gertler 2002, 2003). One methodological problem is that spillovers are not likely to follow administrative
units even if they are localized. For instance, the largest share of Indonesian
manufacturing is located in the province of Western Java. This is largely
because the industry sector has grown out of its original base in Jakarta.
Jakarta and the West Java cities of Bogor, Tanggerang, and Berakasi constitute one industrial cluster, the Jabotabek area (Henderson, Kuncoro, and
Nasution 1996). If technology spillovers from FDI exist, and even if such
spillovers are only effective with geographic proximity, a foreign ﬁrm in
Jakarta is likely to have positive effects on local ﬁrms within the whole
Jabotabek area. However, Jabotabek spreads out over two provinces and
about ten districts, which indicates the problem of using administrative
geographic units in constructing measures of regional FDI.
Spatial concentration of FDI may be another obstacle to analyzing regional
FDI measures. However, such concentration is common in most countries,
including Indonesia. For instance, about 80 percent of all FDI in Indonesian
manufacturing is located in 3 out of 27 provinces (East Java, West Java, and
Jakarta), which is a higher concentration than for manufacturing in general
(Sjöholm 2002, Sjöberg and Sjöholm 2004). If, for instance, we construct our
FDI measure at a province level and at a ﬁve-digit level of ISIC—including
about 300 industries—less than 25 percent of the region-industry combinations will have FDI. Thus, it may be desirable to take account of the selection of locations in analyzing the effects of FDI.
An experiment with different industry and geographical deﬁnitions of
the relevant scope for productivity spillovers is described in table 2.3.
Spillovers are estimated at the national level and the province level for all
sectors combined and at two-, three-, and ﬁve-digit industrial breakdowns.
More speciﬁcally, we used Indonesian plant level data for 1996 to estimate
the following expression:
Laborprodij = constant + FDI + Educationij + Capitalij + Sizeij + Publicij where Laborprod is value added per employee, Capital is energy consumption
per employee, Size is the total number of workers, Public is a dummy variable
38 DOES FDI PROMOTE DEVELOPMENT? 2668-02_CH02.qxd 04/14/05 08:42 Page 39 Table 2.3 Productivity spillovers in Indonesian
manufacturing (dependent variable:
value added per employee)
FDI variable Coefﬁcient of FDI Two-digit/national 0.28
(3.94)*** Three-digit/national 0.44
(5.55)*** Five-digit/national 0.19
(5.25)*** All sectors/province 0.94
(19.05)*** Two-digit/province 0.27
(5.44)*** Three-digit/province 0.44
(9.79)*** Five-digit/province 0.23
(6.44)*** *** = signiﬁcance at the 1 percent level
Note: t-statistics are in parentheses.
Source: Authors’ calculations. for public ownership, and Education is the share of employees with primary,
junior, senior, and university education for both blue- and white-collar
workers. For the sake of clarity, we show only the coefﬁcients of the different
FDI variables in table 2.3.
The main impression from the results in table 2.3 is that geographical
influences are minor; the spillover coefficients at the national level are
almost identical to those at the province level at each level of industry
detail. The industry level does make a difference. The coefﬁcient is highest at the all-sector level, indicating a greater inﬂuence of foreign presence
on domestic establishment productivity for manufacturing as a whole
than within two-, three-, or ﬁve-digit industries. The coefﬁcient is higher
at the three-digit level than at the two-digit level, as one would expect if
spillovers tended to be largest within a narrow industry. However, the
effect becomes smaller when we move to the five-digit industries. The
behavior of productivity spillovers contrasts with that of wage spillovers
(table 2.1), where going from the national to the province level raised the
spillover coefficient at the three-digit and five-digit industry levels. The
difference between the wage and productivity spillovers is mostly, although
not entirely, consistent with the idea that wage spillovers come through
competition for labor in geographically narrow labor markets, while productivity spillovers result from competition in countrywide product
THE IMPACT OF FDI ON HOST COUNTRIES 39 2668-02_CH02.qxd 04/14/05 08:42 Page 40 Conclusions
Why do studies of spillovers reach such diverse conclusions? With respect
to wage spillovers, the use of cross-section or panel data does not seem to
determine the result. As far as we can judge from Indonesia, the tendency
of foreign-owned ﬁrms to gravitate to high-wage industries, while it exists,
does not explain the apparent spillovers and neither does any tendency of
foreign ﬁrms to take over high-wage local ﬁrms within industries. Aside
from Indonesia, most of the evidence for wage spillovers comes from
developed countries, particularly the United States and the United Kingdom. One hint that differences in labor market institutions might be important for the degree of wage spillovers is that two countries found to have
negative spillovers were countries with very restrictive labor laws, while
the United States and the United Kingdom were among the least restrictive. With respect to productivity spillovers, an accumulation of panel data
studies has erased the previous unanimity of panel data results in showing negative or no spillovers. As with wages, ﬁrm-speciﬁc characteristics
do not explain all the higher productivity found for domestic ﬁrms in
industries where foreign-owned ﬁrms were important. The econometric
method does not seem to be the crucial determinant of the result.
An explanation that seems plausible at this point is that countries and
ﬁrms within countries might differ in their ability to beneﬁt from the presence of foreign-owned ﬁrms and their superior technology. There might be
countries or industries in which the domestically owned sector is too small
or unable to learn from foreign-owned ﬁrms. In those cases, the domestic
sector may be crowded out by competition from the more efﬁcient foreignowned ﬁrms. The state of the domestically owned sector might depend not
only on the stage of development of the economy, but also on the type of
trade regime. A heavily protected domestically owned sector might be
inefﬁcient and lacking in entrepreneurship. It makes sense that the arrival
of foreign ﬁrms with technology greatly superior to that of domestically
owned ﬁrms should inﬂict damage on at least some domestic ﬁrms. The
least efficient, perhaps often the smallest, might become unprofitable or
be forced out of the industry. One might view that outcome as favorable
for the host country as a whole if the average productivity of foreignowned and domestically owned ﬁrms together increased. Few studies take
account of both the exit and the entrance of new ﬁrms, both of which are
important for assessing the overall impact of inward FDI.
If country and industry differences are important to the impact of
inward FDI on host countries, the main lesson might be that the search for
universal relationships is futile. In that case, the question shifts from how
inward FDI affects every host country and industry to which types of
industries and host countries are affected, and what the impact is on each.
It is in identifying the characteristics of firms, industries, and countries
that promote the transfer of technology that case studies can be most
40 DOES FDI PROMOTE DEVELOPMENT? 2668-02_CH02.qxd 04/14/05 08:42 Page 41 valuable. Their ﬂexibility with respect to assumptions regarding timing
and types of technology transfer suggests what statistical studies should
look for and how the variables should be deﬁned, especially if they encompass a wide range of both successful and unsuccessful ventures.
Why has academic skepticism about the impact of FDI not inﬂuenced
policy more strongly? One reason is probably the diversity of ﬁndings.
Another is the narrow scope of technology in the statistical tests. It relies
on the assumption that the scale of operations and the import of components from abroad, and particularly from other related ﬁrms, do not constitute part of afﬁliate technology, but are simple inputs, accessible to local
as well as foreign ﬁrms. Policymakers may have found these assumptions
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