84951 FEBRUARY 2014 • Number 135 Does FDI Work for Africa? Assessing Local Spillovers in a World of Global Value Chains Thomas Farole and Deborah Winkler The extent to which developing countries benefit from foreign direct investment (FDI) depends on whether they are able to realize the productivity-enhancing benefits of knowledge and technology spillovers from foreign investors. To date, the experiences in Sub-Saharan Africa have been largely disappointing. This is perhaps not surprising, bearing in mind the complex interplay of factors needed for spillovers to emerge. On top of the challenges of supply side capacity and the host country’s policy environment, the willingness and capacity of foreign investors to support spillovers vary hugely across sectors and firms, and are shaped by the dynamics of the global value chains (GVCs) in which they operate. This note summarizes the main findings from the new World Bank book Making Foreign Direct Investment Work for Sub- Saharan Africa and discusses the implications for policy makers hoping to harness the potential of FDI for better devel- opment outcomes. FDI to low- and middle-income countries expanded 30-fold Substantial research has been conducted on the exis- in the last 20 years, almost 6 times faster than in high-income tence and direction of spillovers from FDI, but questions countries and nearly 10 times faster than global gross domes- remain, many concerning the underlying mediating fac- tic product (GDP). This rapid growth resulted partially from tors and transmission channels facilitating FDI spillovers. liberalization in global trade and investment regimes and par- Moreover, there has been limited exploration of spillovers tially from advances in transport and communications, which in the context of low-income countries (LICs) and in Sub- together allowed multinational firms to extend their market Saharan Africa, particularly outside the manufacturing reach and expand the scale and scope of offshoring in GVCs. sector. Finally, the emergence of GVCs raises new ques- For recipient countries, FDI delivers immediate invest- tions about spillovers in developing countries. On one ment, employment, and foreign exchange. However, the most hand, GVCs create opportunities by allowing developing valuable contribution that FDI can make to growth and devel- countries to integrate rapidly into global networks. But at opment comes from its contribution to aggregate productivi- the same time, both value chain structures and supply side ty growth over the longer term. This contribution results barriers may make it difficult for these spillover opportuni- from “spillovers”—the diffusion of knowledge, technology, ties to be realized. and work practices from foreign investors operating near the This note summarizes the main findings from Making global frontier to local firms and workers. Spillovers can take Foreign Direct Investment Work for Sub-Saharan Africa (Farole place within the same industry (intraindustry, or horizontal and Winkler 2014), which aims to address some of these spillovers) or in another industry (interindustry, or vertical questions through a combination of quantitative analysis spillovers). In the latter case, they can affect local inputs or ser- and survey-based field research in eight countries (including vices suppliers in upstream sectors (backward spillovers) and five in SSA) across three sectors: agribusiness, apparel, and local customers in downstream sectors (forward spillovers). mining. 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise A Conceptual Framework incentives to upgrade their technology and may also diffuse knowledge to local firms. In addition, the multinationals may Based on the existing literature and empirical evidence, figure provide higher-quality inputs to domestic customers. Compe- 1 outlines a conceptual framework for exploring the determi- tition between local firms may increase and local firms may nants of spillovers from FDI. The framework is built on an try to imitate the multinational’s products and practices. In understanding of the mediating factors that shape the nature addition, knowledge embodied in labor can transmit from and extent of spillovers, specifically: (i) the spillover potential foreign to local firms through labor turnover. of foreign investors; (ii) the absorptive capacity of local agents This note summarizes the key findings of the research, (firms and workers); (iii) and how these two factors interact built around the three transmission channels: supply chains; within specific host country institutional environment and labor markets; and the market forces of competition, demon- the transmission channels. stration, and collaboration. The transmission channels through which FDI spillovers Supply Chain Links can be generated include: (i) supply chains, (ii) labor turnover, and (iii) changing market forces. In short, multinationals tend Local sourcing is the critical channel for delivering positive to demand higher-quality inputs, which gives local suppliers spillovers. Supply chains, particularly backward links Figure 1. The Role of Mediating Factors for FDI Spillovers: A Conceptual Framework foreign firm characteristics domestic firm characteristics • degree/structure of • technology gap foreign ownership • research and • FDI motive host country factors and development • global production and institutional framework • human capital sourcing strategy • labor market regulations • scale • technology intensity • intellectual property • firm location • FDI home country rights • exporting • entry mode • access to finance • sector dynamics • length of presence • learning and innovation • competition infrastructure • type of ownership • trade, investment, and industrial policy absorptive capacity FDI spillover potential • governance transmission channels supply chains • demand effect • assistance effect • diffusion effect • availability and quality effect labor turnover market restructuring • competition effect • demonstration effect actual FDI spillovers Source: Farole, Staritz, and Winkler (2014, 24), extending the framework of Paus and Gallagher (2008). 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise through local sourcing, appear to offer the most direct Global supply chain management trends are reducing channel for short- and long-term gains from FDI spillovers. opportunities for local supply participation. Across all value They also tend to be the most visible and easiest to quantify, chains reviewed in the study, there is a clear trend toward which increases their importance for policy makers. In the global supply chain management, which tends to result in the mining sector, for example, one-third of all surveyed local most strategic and high-value purchases being coordinated on suppliers of foreign investors in Ghana and 42 percent in a global or regional level. This could potentially create oppor- Chile started to export directly as a result of supplying for- tunities in countries that may be regional source markets. eign investors. And behavior within the supply chain mat- However, for most LICs, it will impose significant limits on ters: assistance of foreign investors to local supply chain spillovers through domestic supply links. Moreover, foreign partners has an important impact on spillover outcomes investors are less likely to give assistance to local suppliers (table 1). when supply contracts are ad hoc (rather than formalized and The experience of supply chain links has been generally long term). poor in LICs, but evidence suggests it is possible to build Short-term opportunities come through outsourcing meaningful links over time. Evidence from surveys and case of noncore services. But there is a trade-off, because these studies indicates low levels of purchasing of goods and ser- activities are less likely to deliver spillovers. For example, in vices from local suppliers in developing countries, particu- Lesotho and Swaziland, the most common activity pro- larly in African countries and in the apparel sector. However, vided by domestic suppliers was security services—beyond Ghana’s experience in the mining sector, for example, shows these were cleaning, basic maintenance, and catering. But that it is possible to develop some local presence in foreign across countries, findings show that provision of assistance supply chains over time by establishing the right conditions to local suppliers was much more likely when the goods and market incentives and building on existing local capacity. and services they provide are core parts of the upstream A clear finding from the surveys is that foreign investors value chain. For example, in the agribusiness sectors, local would much prefer to not have to rely on importing goods firms that provide raw materials for agriprocessing are and services, but would rather have suppliers with whom most likely to receive assistance, and in the apparel sector, they can interact on a face-to-face basis and that can respond cut-make-trim subcontractors are most likely to receive as- quickly when needed. sistance. Assistance effects in supply Table 1. The Effect of Factors within Supply Chains on Suppliers’ Probability of chains tend to be limited and nar- Starting to Export, Probit row in their focus, but emphasis on quality and standards still rep- Dependent variable: exp_startisc resents an important area of po- (1) (2) (3) (4) (5) (6) tential for upgrading for domes- 0.8551** 0.9166* tic firms. Overall, the level of auditisc (0.049) (0.071) assistance provided from FDI to imprisc 0.3366 -0.1203 local suppliers was found to be (0.468) (0.827) low across countries and sectors. assistisc 1.3256*** 1.4075*** Moreover, these efforts are con- (0.008) (0.008) centrated on issues that are relat- 1.2506*** 0.8537 ed to their specific needs—for ex- devisc (0.006) (0.138) ample, financial support would 1.2387** 0.8975 focus on meeting short-term licenseisc (0.014) (0.105) working capital (to avoid delays -6.9418*** -6.4233*** -6.0867*** -7.3373*** -6.0867*** -7.7367*** in production and delivery), but constantisc (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) not on longer-term finance, Country-sector FE Yes Yes Yes Yes Yes Yes which would enable suppliers to Adj. R2a -0.219 -0.267 -0.161 -0.172 -0.197 -0.121 invest in improving productivity and embedding spillover bene- Observations 55 55 55 55 55 55 fits. Support tends to be linked to Source: Winkler (2014, 105). compliance issues, such as health, Note: All regressions control for country-sector fixed effects. Standard errors are robust to heteroscedasticity. FE = fixed effect. Subscripts i, s, and c refer to supplier, sector, and country. *p < 0.1, **p < 0.05, ***p < 0.01 (p values in parentheses). safety, and environmental and a. McFadden’s adjusted pseudo R2. quality. However, even when Dependent variable: Probability of starting to export as a result of supplying to a foreign investor (exp_start). Explanatory variables: Dummy taking the value of 1 if supplier received technical audits (audit), if the foreign customer quality and standards are firm required the supplier to make improvements (impr), if supplier received assistance from the foreign customer to meet any requirements (assist), if supplier developed product jointly with the foreign customer (dev), if supplier licensed technology from specific, they are often built on the foreign customer (license), and 0 otherwise. 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise global foundations and have the potential to upgrade the ca- outstripping positive productivity spillovers from competi- pacities of local suppliers, enabling them to serve other inves- tion and demonstration effects. A large part of the explana- tors or to start exporting. tion is probably temporal—that is, positive spillover effects take time to emerge, whereas the impacts of negative compe- Labor Market Links tition effects can be observed more quickly. But it may also Foreign investors make relatively greater use of local skilled be that LICs’ lack of absorptive capacity restricts their poten- staff than they do of local suppliers in developing countries, tial to benefit from positive competition and demonstration but this varies significantly across countries. In Chile’s mining effects. sector, for example, 70–80 percent of workers in skilled posi- Demonstration effects are most prominent in tightly or- tions are local, while across surveyed African countries, the ganized supply chains, where the local supply base is large and share ranges from 30 to 50 percent. In agribusiness, 75–85 fragmented. Foreign investors have an incentive to promote percent of management, supervisory, and technical workers demonstration where providing individual technical assis- in Kenya and Vietnam were local, while the figures were 10– tance is prohibitive and/or inefficient. This is most apparent 15 percentage points lower in Ghana and Mozambique. Fi- in the agribusiness value chain, where foreign investors ac- nally, in apparel, while more than two-thirds of management tively promote demonstration effects by supporting the up- and technical staff are local in Kenya, less than 20 percent are grading of their suppliers through establishment of demon- local in Swaziland. stration plots and nucleus farms. Localizing skilled positions is constrained by supply. Sur- But spillovers from demonstration are constrained by vey results indicate that by far the biggest constraint perceived limited collaboration between foreign investors and domestic by foreign investors to hiring more local staff in technical and firms in the same sector. Findings indicate that in most coun- managerial positions was the lack of skilled labor. There are, tries sector collaboration is weak, particularly between for- however, some caveats to this finding. Foreign investors also eign-owned and domestic firms. Of the three sectors studied, continue to reserve certain positions for foreign nationals for only agribusiness showed any significant levels of collabora- reasons of corporate culture; when there is a significant lan- tion between foreign firms and the domestic sector, particu- guage gap between the host country and the foreign investors; larly through links with national training centers and research or when the costs of supporting foreign workers (including institutes. relocation costs) are relatively low. While setting standards is important, direct technical as- In developing countries, spillover benefits through labor sistance appears to be most critical for supporting spillovers. markets are constrained by limited labor mobility and entre- Survey evidence indicates that demand effects alone—for ex- preneurship. Employment in foreign-owned firms tends to ample, requiring that local suppliers make specific changes to offer significant advantages over domestically owned firms, products or processes—may have limited impact on spillovers including higher pay and benefits, opportunities for career in LICs. Instead, technical assistance, with or without corre- advancement, international mobility, and prestige. This can sponding requirements of suppliers, resulted in greater spill- act as a barrier to skilled labor turnover. As a result, diffusion overs (table 1). This suggests that while the proliferation of of knowledge tends to be largely restricted within the FDI sec- global standards within GVCs may create an opportunity for tor. The situation is aggravated by relatively low levels of en- firm upgrading, most firms in LICs will require active support trepreneurialism in many LICs, restricting the potential for in order to take advantage of the opportunity. diffusion through firm spin-offs. Policy Implications Training offers an important channel for knowledge dif- fusion, yet this too is constrained by labor market factors and Finally, some of the main policy implications concerning FDI by an emphasis on firm-specific rather than transferrable spillovers impacts on supply chains are organized around skills. While FDI normally covers some training, it tends to three sequential areas of policy: (i) attracting the “right” for- focus on company-specific skills, which may limit transfer- eign investors; (ii) promoting FDI–local economy links; and ability. Partly for this reason, and also because of labor turn- (iii) establishing an environment that maximizes the absorp- over, foreign investors tend to make limited use of local train- tion potential of local actors. ing facilities, even when they are available at low cost. Attracting the “right” foreign investors Spillovers from Competition, Mediating factors matter—not all foreign investors are the Demonstration, and Collaboration same when it comes to their potential to deliver spillovers (see figure 1). Therefore, given the increasing priority being placed In LICs, competition effects may result in negative rather on generating spillovers from FDI, governments need to take than positive short-term spillovers, although this may be due into account the optimization of spillovers more explicitly to the fact that positive spillovers take more time to material- when developing investment promotion strategies and poli- ize. Findings indicate that negative competition effects are cies. Some factors to consider include: 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise • The best spillovers policy is a good business climate. Policies • Introduce local content regulations only under the right to attract strategic GVC-oriented FDI should focus on conditions and when defined clearly. The focus should ensuring an attractive general investment climate, not be on encouraging in-country value addition rather just for foreign investors, but also for domestic firms. than in-country ownership. But regulations can only • Recognize the diversity in spillover potential. Investment be effective when the domestic supply side is actually policy, promotion, and linkage programs should specifi- up to the task of being a competitive supplier, other- cally consider the nature of investment and the motiva- wise they may simply weaken the competitiveness of tions of FDI, as their potential for spillovers will vary. investors, undermining the overall objectives. In any • Assess technology contribution as an element of the FDI eval- case, setting strict local content targets can be counter- uation process. This could include a focus on the degree to productive and difficult to enforce. Instead of rigid lo- which the technologies that investors may bring are likely cal content requirements, the focus should be on col- to be absorbed into the economy, given current capacity. laborative development of flexible localization plans • Avoid bidding away the benefits of spillovers by excessive in- where investors come up with their own proposals on centives. Incentives tend to be most commonly associated how they will deliver spillovers to the local economy with attracting export-platform investment (given its (box 1). footloose nature), but this type of investor may be the • Establish a comprehensive framework for supporting the least likely to deliver spillovers. upgrading of domestic firms. This includes bridging in- • Facilitate joint ventures (JVs), but avoid coercion. JVs ap- formation gaps by facilitating exchange of informa- pear to be an effective channel for facilitating spillovers, tion on investor needs and local supplier capacity, as particularly of older technologies. However, this should well as addressing gaps in domestic contract enforce- not be misread to argue for attempting to force investors ment and other barriers to formal contracting with to engage in JVs with local partners. The correlation local suppliers. clearly depends on the FDI motive, and demand-led JVs • Establish incentives for foreign investors to engage in collabo- are more likely to involve open knowledge sharing than ration with local universities, research institutes and forced partnerships. training institutes, such as the creation of research funds, • Use industrial policy in a light-handed way. Weaknesses in matching grant programs, or fiscal incentives (for exam- institutions, in private sector capacity and organization, ple, tax deductions) for conducting research and devel- and in skills and absorptive capacity raise an array of chal- opment in the host country. It may also include support- lenges to fostering links in LICs. The trick is to focus on ing internships, outplacements, and joint training and overcoming market failures or capturing coordination curriculum development. externalities, including packages of infrastructure and Establishing an environment that maximizes the absorption public-private vocational training initiatives. potential of local actors Promoting FDI–local economy links Attracting investors and integrating them into the domestic Having brought foreign investors into the country, the next economy should create optimal conditions for local firms and set of policy considerations involves integrating them into the workers to benefit from spillovers of knowledge and technol- domestic economy. The logic here is that strong links— ogy. But the degree to which local firms and workers ultimate- through supply chains, labor markets, and other forms of col- ly benefit depends crucially on the absorptive capacity of do- laboration—should result in greater diffusion of knowledge, mestic actors (see figure 1). This is the area of spillover policy technology, and know-how from foreign investors. Policies where government has the most important role to play, by can include the following: building the absorptive capacity of firms and workers and • Ensure the incentives used to attract investors do not create a helping them to access opportunities. bias against local integration, for example, by giving for- • Focus supply side capacity-building efforts on high-potential, eign investors privileged access to import tax and duty high-capability firms. Government programs should focus concessions or duty drawbacks. Similarly, avoid reserving on upgrading technical capacity of the firms in the best export-processing zone access to foreign-owned compa- position to serve FDI markets and outline clear require- nies, which can create barriers to supply by domestic ments for firm participation. firms. • Combine supply side efforts to address technical and busi- • Leverage the power of incentives to promote actions that sup- ness upgrading. Building absorptive capacity of local port spillovers by requiring investors to engage in activities firms requires investments to upgrade technical capac- to support spillovers as a condition of receiving fiscal in- ity and achieve quality standards, including technolo- centives. Such activities may include local supplier devel- gy licensing. The biggest gap in support, however, is opment, provision of technical assistance, training of likely to be in basic business and financial manage- workers, joint research, and others. ment areas. 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise nities for developing countries. But simply attracting FDI is Box 1. Newmont Ghana’s Local Procurement Policy not enough. The real benefits lie in taking advantage of the Newmont ran the successful Ahafo links program in Ghana productivity-enhancing potential of FDI, which in turn relies from 2007 to 2010, which trained 53 local suppliers in the on greater integration of FDI and local economies. But mak- area immediately surrounding the Ahafo mine, resulting in ing this work in practice is difficult. Governments need to be US$14 million in local procurement. More recently, New- realistic about the degree of spillovers that can be achieved in mont has rolled out a broader local procurement policy in the short term and the degree of leverage they have to make it Ghana, which outlines areas of support and preferences to be given to various categories of companies based on geo- happen. But government does have an important role to play, graphical location and level of Ghanaian ownership. Under as a policy maker, a regulator, and a facilitator. With the right the local content policy, Newmont aims to increase local ex- approach, over time, government can help leverage the power penditure each year, with a higher share of this going to of FDI for development. Ghanaian firms with highest local value added. Some of the support areas include: Acknowledgments • Increasing Newmont’s awareness of goods manufac- The authors would like to thank our co-contributors: Corne- tured in Ghana through formal supplier registration and lia Staritz, Stacey Frederick, and Kaiser Economic Develop- identifying local products currently being purchased by ment Partners. We would also like to acknowledge the guid- other mining companies. ance and support of Mona Haddad (Sector Manager, • Broadening access to opportunities for potential suppli- PRMTR), under whose supervision this project was carried ers through: (i) supplier open days; (ii) greater use of out. The project received generous financial support from the open tendering; (iii) advertising available contracts via the Internet; and (iv) publishing data on the local spend Bank-Netherlands Partnership Program (BNPP). profile on a quarterly basis. About the Authors • Applying preference in assessing tenders, in the follow- ing order (all else being equal): “local-local” compa- Thomas Farole is a Senior Economist in the World Bank’s Policy nies; Ghanaian-owned; Ghanaian participation; Ghana- Reduction and Economic Management (PREM) Network, Africa registered; and international. Region (AFTP1). Deborah Winkler is a Consultant Economist in • Building capacity of local companies through the devel- the World Bank’s International Trade Unit (PRMTR). opment of collaborative partnerships between industry, nongovernmental organizations, and existing foreign- References and Ghana-registered companies. Farole, T., C. Staritz, and D. Winkler. 2014. “Conceptual Frame- Source: Kaiser Economic Development Partners (2014, 140), based on work.” In Making Foreign Direct Investment Work for Sub-Saharan Newmont Ghana (2010). Africa: Local Spillovers and Competitiveness in Global Value Chains. Edited by T. Farole and D. Winkler, 23–55. Washing- ton, DC: World Bank. • Invest in education and skills for short- and long-term results. Farole, T., and D. Winkler, eds. 2014. Making Foreign Direct Invest- Both industry-specific and general education policy are ment Work for Sub-Saharan Africa: Local Spillovers and Competi- tiveness in Global Value Chains. Washington, DC: World Bank. critical to achieving spillovers in the long term—reducing Kaiser Economic Development Partners. 2014. “Sector Case Study: the technical and managerial skills gap with FDI should Mining.” In Making Foreign Direct Investment Work for Sub-Saha- be a priority. This includes active engagement of univer- ran Africa: Local Spillovers and Competitiveness in Global Value sities and research institutes to embed spillovers. Chains, ed. T. Farole and D. Winkler, 117–62. Washington, • Openness is critical for localization in the long term. A poli- DC: World Bank. Newmont Ghana. 2010. “Local Procurement Policy and Action cy of openness, not only on access to imported goods and Plan.” http://www.newmont.com/sites/default/files/newmont_ services, but, more controversially, on access to (import- ghana_local_procurement_policy.pdf. ed) skilled workers, is likely to pay off in the long run by Paus, E., and K. Gallagher. 2008. “Missing Links: Foreign Invest- improving the sophistication and competitiveness of lo- ment and Industrial Development in Costa Rica and Mexico.” cal firms. Studies of Comparative International Development 43 (1): 53–80. Winkler, D. 2014. “Determining the Nature and Extent of Spill- Conclusion overs: Empirical Assessment.” In Making Foreign Direct Invest- ment Work for Sub-Saharan Africa: Local Spillovers and Competi- In a world of integrated GVCs, exports and FDI are becoming tiveness in Global Value Chains, ed. T. Farole and D. Winkler, increasingly interconnected. This creates significant opportu- 87–114. Washington, DC: World Bank. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 6 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise