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Studies in Economic Transition

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The Technological Role
of Inward Foreign Direct
Investment in Central East
Europe
Johannes Stephan
Head, Department for Industrial Organisation and Regulation Economics,
Halle Institute for Economic Research, Germany, and Technische Universität
Bergakademie Freiberg, Germany (Habilitation thesis)
© Johannes Stephan 2013
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Contents

List of Tables vii

List of Figures ix
Acknowledgements xi
List of Abbreviations xii

1 Introduction 1
1.1 Motivation of the topic 1
1.2 Setting the research agenda: the technological aspect of
the ‘developmental role of inward manufacturing FDI’ 5
1.3 Conceptual framework for the analysis 12
1.4 Empirical evidence of inward FDI into Central East Europe 23
1.5 Structure of the book 32
2 The Database Used in the Empirical Analysis 35
2.1 The development of the IWH FDI Micro Database 36
2.2 The basic population for the IWH FDI Micro
Database 37
2.3 Survey sampling and implementation 39
2.4 Survey representativeness of the two IWH FDI
Micro Database waves 41
2.5 Survey questionnaires 43
3 Foreign Direct Investment Motives and the Match with
Locational Conditions in Central East Europe 45
3.1 Current state of the art in research 46
3.2 The data used for the analysis 49
3.3 Strategic motives of foreign investors investing in
Central East Europe 50
3.4 Summary of main results 65
4 Conditions of Internal Technology Transfer and Spillovers
between Foreign Investors and Foreign Affiliates in Central
East Europe 68
4.1 The current state of the art in research 69
4.2 The ‘role in the network’ and absorptive capacity:
a two-dimensional concept 77
4.3 The data used for the analysis 81

v
vi Contents

4.4 Characterisation of foreign affiliates in CEE within

the two-dimensional concept 83
4.5 Summary of main results 89
5 Central and East European Innovation Systems as
Knowledge Sources for Foreign Affiliates’ Own
Technological Activity in CEE 91
5.1 Internationalisation of technological activity in
transnational corporations 93
5.2 The current state of the art in research 97
5.3 The data used for the analysis and testable hypotheses 112
5.4 The importance of the host innovation system
for foreign affiliates’ own technological activity 116
5.5 Summary of main results 140

6 Foreign Affiliates as Knowledge Source for Host Regional

Innovation Systems in CEE 145
6.1 The current state of the art in research 147
6.2 The data used for the analysis and testable hypotheses 157
6.3 The importance of foreign affiliates for technological
activity in the host innovation system 161
6.4 Summary of main results 175

7 The Role of Intellectual Property Rights for Technology in

FDI into CEE 177
7.1 The current state of the art in research 181
7.2 The data and methods used in the analysis 188
7.3 Hypotheses development and empirical testing 193
7.4 Summary of main results 201
7.5 Annex (complete econometric test results) 203

8 Conclusions on the Technological Role of FDI into CEE 215

8.1 Conditions for inward FDI in CEE to have a
developmental impact via technology 216
8.2 The research programme – some vital ingredients
into a future research agenda 226

Annexes 233
9.1 The questionnaire for the 2006–2007 wave 233
9.2 The questionnaire for the 2008–2009 wave 244

Notes 256

References 269

Index 293
List of Tables

2.1 Country composition of the IWH FDI Micro Database,

waves 2006–2007 and 2008–2009 40
3.1 Investment motives of foreign investments into CEE,
distinguished by regions of origin 51
3.2 Investment motives, distinguished by the time of entry
of the foreign investor, 1989–2009 52
3.3 Investment motives, distinguished by host economies 55
3.4 Investment motives, distinguished by industry
classifications 56
3.5 Endowment with locational advantages, distinguished by
host economy 58
3.6 Endowment with locational advantages, distinguished by
industry classification 60
3.7 Endowment with locational advantages, distinguished by
strategic motives 62
3.8 Partial correlations between strategic motives and
locational conditions 64
4.1 Shares of foreign affiliates allocated into the four
quadrants of the taxonomy 87
5.1 Strategic investment motives of foreign affiliates,
by country 125
5.2 Pairwise rank correlation between all determinants 133
5.3 Determinants of host scientific institutions assuming an
important role for foreign affiliates’ own technological
activity – the analysis of CEECs 135
5.4 Determinants of host innovation system actors assuming
an important role for foreign affiliates’ own technological
activity – the analysis of CEECs 136
6.1 Pairwise rank correlation between all determinants 168
6.2 Determinants of foreign affiliates assuming an important
role in the technological activity of firms in the host
economy 170
6.3 Determinants of foreign affiliates assuming an important
role in the technological activity of firms in the host
economy 172

vii
viii List of Tables

7.1 Pairwise rank correlation between all determinants 194

7.2 IPR gaps and direct technology transfer embodied in
rather standardised products 196
7.3 IPR gaps and foreign affiliate technological activity 197
7.4 IPR gaps and importance of sources of knowledge and
technology for foreign affiliate technological activity 199
7.5 IPR gaps and technological embeddedness in the local
host economy 201
A1 IPR gaps and direct technology transfer embodied in
rather standardised products: partial correlation and
ordered probit results with tt.mnc 203
A2 IPR gaps and foreign affiliate technological activity:
partial correlation results with sh.R&D and sal.inno 204
A3a IPR gaps and importance of sources of knowledge and
technology for foreign affiliate technological activity:
partial correlation and ordered probit results with own.tech 206
A3b IPR gaps and importance of sources of knowledge and
technology for foreign affiliate technological activity:
partial correlation and ordered probit results with comp.HQ 207
A3c IPR gaps and importance of sources of knowledge and
technology for foreign affiliate technological activity:
partial correlation and ordered probit results with comp.FA 209
A4a IPR gaps and technological embeddedness in the local
host economy: partial correlation and log-OLS results
with comp.sal 210
A4b IPR gaps and technological embeddedness in the local
host economy: partial correlation and log-OLS results
with comp.sup 212
A4c IPR gaps and technological embeddedness in the local
host economy: partial correlation and ordered probit
results with comp.SI 213
8.1 WEF IPR levels of host countries and average sizes of IPR
gaps between home and host countries, by groups of
foreign affiliates according to their host countries 225
List of Figures

1.1 FDI inflow, in % of World FDI inflows 24

1.2 FDI outflow, in % of World FDI inflows 24
1.3 FDI inflow, in % of GDP 25
1.4 FDI outflow, in % of GDP 26
1.5 FDI inflow, in % of Gross Fixed Capital Formation 27
1.6 FDI inflow, in EUR per capita 27
1.7 Inward FDI stock, in EUR mn 28
1.8 FDI-related income outflow (income and its repatriation),
in % of inward FDI stock 29
1.9 Share of FDI inflows in gross fixed capital formation 29
1.10 Inward FDI stock by major home countries in end 2008 30
1.11 Inward FDI stock by economic activity in end 2008 31
1.12 FDI outflow, in 1000 EUR mn per capita 31
1.13 Outward FDI stock, in EUR mn 32
4.1 The conceptual taxonomy and potentials for technology
transfer 80
4.2 Average levels of autonomy in all seven technology-related
business functions of foreign affiliates across countries 84
4.3 Levels of absorptive capacities per host country 85
4.4 Graphical representation of empirical taxonomy 86
5.1 R&D activity of foreign affiliates across countries: share of
research-active foreign affiliates 117
5.2 R&D intensity of foreign affiliates across countries 118
5.3 Innovative activity of foreign affiliates across countries:
share of innovative firms 119
5.4 Innovative activity of foreign affiliates across countries:
intensity of product innovation 120
5.5 Innovative activity of foreign affiliates across countries:
intensity of process innovation 121
5.6 Aggregated share of sales attributable to new or
significantly improved products across countries 122
5.7 Importance of exploiting and augmenting strategies
across countries 124
5.8 Average shares of local supplies and sales of foreign
affiliates across countries 126

ix
x List of Figures

5.9 Average levels of autonomy in three technology-related

business functions of foreign affiliates across countries 127
5.10 Age and size of foreign affiliates across countries 128
5.11 Averages of levels of importance of host innovation
system actors for foreign affiliates’ technological activity 129
6.1 Average (short-term) cost curves o f domestic firms in a
situation of entry of foreign-owned competitors 150
6.2 Importance of foreign affiliates for technological activity
in the host innovation system 161
6.3 Averages of product and process innovation intensities
in comparison to competitors (inno), by host country 164
6.4 Importance of embodied technology received from the
foreign investors’ networks, by host country 165
6.5 Technological quality of the host innovation system from
the perspective of foreign affiliates, by host country 166
7.1 IPR indicators in Europe, East and West 179
7.2 Observed IPR gaps between host and home countries
(IPR.gap) of the IWH FDI Micro Database of 2006–2007 190
Acknowledgements

I would like to thank all my colleagues who are involved with common
research ventures around the IWH FDI Micro Database and the EU
projects. Particular thanks go out to the distinguished researchers
Wladimir Andreff, Horst Brezinski, Rolf Hasse, and Paul J. J. Welfens
for their constructive comments and testimonies provided during my
habilitation project. Many other colleagues have provided important
comments on the work presented here – my gratitude goes out to all of
them.
The publishers and I wish to acknowledge the premission given for
the reproduction of copyright material from ‘Does Local Technology
matter for Foreign Investors in Central and Eastern Europe? – Evidence
from the IWH FDI Micro Database’ which was published in the
Special Issue of the Journal of East West Business on Market Entry and
Operational Strategies of MNEs in Transition and Emerging Economies,
15/3&4, pp. 210–47 © Taylor & Francis 2009.

xi
List of Abbreviations

CATI computer assisted telephone interviews

CEE Central East Europe
CEECs Central East European Countries
CEFTA Central European Free Trade Agreement
CMEA Council for Mutual Economic Assistance
EU European Union
FA foreign affiliate of an FDI project
FDI foreign direct investment
HRSTO Human Resources in Science and Technology Occupation
IB international business (literature, theory)
ICT information and communication technology
IPA investment promotion agencies
IPR intellectual property rights
ISCO International Standard Classification of Occupations
IWH Halle Institute for Economic Research
MNC multinational company
MNE multinational enterprise
NACE Statistical Classification of Economic Activities in the
European Community
NIS National Innovation Systems
NUTS Nomenclature of Statistical Territorial Units in Europe
OLI Ownership, Localisation, and Internalisation Advantages
(Dunning’s concept)
OLS ordinary least squares
OPT outward processing trade
ROR Raumordnungsregion
R&D research and development
TFP total factor productivity
TNC trans-national corporation
TRIPS trade-related aspects of intellectual property rights
USA United States of America
WTO World Trade Organization

xii
1
Introduction

This book intends to assess the role that inward foreign direct
investment (FDI) can have on the technological development of the
recipient economy, in particular where the recipient country is in the
process of economic catching up. This focus positions the analysis in
the book between the body of literature testing the existence of
economic effects of inward FDI on the one hand, and the management
literature concerned with strategies of multinational enterprises in host
regions with lower levels of economic development, possibly transition
economies, on the other.
The book starts out with a fairly comprehensive introduction that not
only discusses the motivation of the topic and the analytical implica-
tions that emerge from this focus for empirical analysis, but also provides
some of the characterisation of the countries at hand and the issue of
FDI itself.

1.1 Motivation of the topic

When the ‘historical experiment’ of central state planning collapsed

in Central East Europe (CEE), it was widely assumed that the formerly
socialist countries would be able to swiftly catch up with the West
(Lipton and Sachs, 1990; Herr and Westphal, 1991; Sachs, 1992). The
Washington consensus (Williamson, 1989, 1993; for critique, see for
example Stiglitz, 2002; Rodrik, 2006) explored a path of comprehen-
sive liberalisation of all internal and external spheres of the economy
and assumed that entrepreneurial activity,1 having been subdued for
so long, would now thrive in the new pro-economic and competitive
environment. Alas, history took a different path: the ‘lost decades’ of
socialist planning had produced technological stagnation and had dried

1
2 The Technological Role of Foreign Direct Investment

out individual entrepreneurial behaviour (because it was not regarded as

a core competence (see Åslund, 2002, p. 283), and would also have run
counter to the constituting criterion of the economic plan, resulting in
a shortage economy unable to satisfy demand to a very large extent. The
liberalisation of the thenceforth ‘transition countries’ was therefore in
need of external help (to overcome the technology gap and to supply
demand) – yet help in terms of development aid would have been
inconceivable in the light of the large amounts that would have been
necessary: the financial ‘transfers’ invested into the East German new
Länder are an impressive case in point. Rather, foreign private economic
activity had to be the main engine of the transition process and of the
process of catching up at least during the first years. This is the role that
FDI assumed.
FDI was assigned a pivotal role in the catching-up process of the Central
East European countries (CEECs). The list of objectives to which FDI
can contribute to at times of systemic transition includes the following,
perhaps most prominent, points:2

● Alleviating capital shortage: even if doubtful in the medium term

(credit gives rise to capital in a monetary economy), this assertion
may possibly be acceptable in the case of CEE due to an environment
of insufficient trust in the financial spheres around currencies that
are newly establishing themselves in terms of international convert-
ibility and acceptance as legal tender.
● Supply of technology: the socialist countries existed in economic
autarky from the West within their own integration area of the
Council for Mutual Economic Assistance (CMEA), which was both
self-inflicted (or governed by the Soviet Union) and at the same time
forced upon them by the West, exemplified in the CoCom-list (see for
example van Brabant, 1980/2012). They were consequently delinked
from the kind of technical advance so characteristic of the develop-
ment processes in the West since World War II. Those had been broad
in the sense of emanating from all sorts of industries and fields of
science, were driven to a large extent by private risk-bearing economic
activity, and have been – to a large extent, and by consequence – in
coherence with demand by the users of new technology.
● Privatisation: who else should have (i) the necessary capital or ability
to raise capital to foot the bill of desperately needed recapitalisa-
tion and restructuring, and (ii) the management skills, knowledge,
and expertise to make the transforming economic entities in those
countries internationally competitive?
 Introduction 3

● Competition: central planning consistently excluded and necessarily

had to exclude competition from economic activity. It was foreign
trade liberalisation and inward FDI which was to assume the role of
enforcing competition on (formerly) state-owned monopolies.

Those four points can be directly deducted from the dichotomy in

the world during the socialist era: in economic terms, the distinction
between the two worlds, East and West, is best harnessed by characterisa-
tion of the constituting criteria of the two systems (see for example Riese,
1991, 1992): whilst the West was governed by competitive and (more or
less) free markets that incentivised private economic activity, the East
was governed by an overarching economic plan that transcended into
nearly all aspects of economic activity. Consequently, economic activity
was public and did not involve (or involved to only a very small extent)
privately organised economic activities.3 In the West, the coherence of
the economic sphere was based on competition4 and money. In the East,
it was administrative planning. The western world generated an envi-
ronment conducive to intensified economic foreign integration by way
of private foreign investment, private foreign trade and the cross-border
migration of labour; the conditions for those were framed in bilateral
and multilateral institutions such as the work of the then GATT and the
institution of international (reserve-)currency regimes, the International
Monetary Fund. The ‘communist bloc’, on the other hand, planned,
controlled, and executed external economic relationships through the
political administration such as the CMEA (see, for example, Brezinski,
1978), thereby not allowing the emergence of private internationalising
activities (private exporting and importing, outward or inward FDI with
internationally owned property rights, international licensing or fran-
chising etc.). Indeed, foreign ownership during socialist times rested by
default with the country hosting the property – no other legal arrange-
ment would have been consistent with the system of economic planning.
Where new firms were established involving cross-country ownership,
international production agreements in intergovernmental contracts
guaranteeing ‘inter-country socialist ownership’ had to align the respec-
tive economic plans of respective participants to preserve consistency of
the economic plans (see Brezinski, 1978, p. 172–3).5
Despite the obvious role that FDI could potentially play in the
transition process, the countries in CEE were in reality regarded as unat-
tractive locations for FDI in the early years, due to fears of a return to
communism and the significant political risks in some of the countries
(for example, the civil war in the former Yugoslavia, the uncertainties
4 The Technological Role of Foreign Direct Investment

souring the break-up of Czechoslovakia, the despotized political regime

in the early years of the Slovak Republic, and the non-transparent situa-
tion in Romania). When privatisation programmes in the CEE countries
started, they flooded the markets with institutionalised productive
capital to such an extent and in such a short period of time that prices
and values of to-be-privatised firms fell sharply (in Germany to symbolic
amounts, and even at times effectively negative due to guarantees and
state aid). It was to a large extent foreign capital that took advantage of
this (for an early account of the relationship of FDI and privatisation in
CEE, see Welfens and Jasinski, 1994, Chapter D). Once the worst tran-
sitional recession was overcome in the early 1990s and the economies
started on their process of catching up with Western European levels of
GDP per capita, CEECs became more interesting targets for FDI. This was
spurred not only by mass privatisation, but also by the expectation that
these countries would swiftly integrate their already industrialised and
now liberalised economies into the European economic area and hence
offer profit rates in excess of risk premia. The hope amongst CEECs was
that they would not only receive the capital needed to restructure their
industries but also that they would get access to modern western knowl-
edge and technology. Most of the CEECs adopted FDI policies based on
attracting as much FDI as possible without any concern about the quality
of investors (Rugaff, 2008). Over time and with rising stocks of produc-
tive capital and levels of economic development, wages also increased.
Where wage increases surpass productivity growth,6 the (unit labour)
cost advantages in CEECs melt away; yet now, two decades after the
transition process started, CEECs are still offering sizeable unit labour
cost advantages in comparison to the West.7 Where unit labour costs
are converging to western levels, strategic motives tend to shift towards
building industrial and service networks with the local host economies,
reaping localisation advantages beyond motives of pure efficiency.
Today, it is the technology-intensive networks that can be expected to
be particularly competitive not only as FDI projects, but also as drivers
of international competitiveness for the foreign investor in the home
country. An increasing number of foreign affiliates in CEECs assume
the character of ‘developmental subsidiaries’, build capacities of tech-
nological development, and become active drivers of knowledge and
technology in their own right.
This is the empirical starting point of this analysis. The starting
point unveils the overarching research question guiding the anal-
ysis: under what conditions can inward manufacturing FDI serve
as a panacea for transition and catch-up development in CEE?
 Introduction 5

This analysis cannot, of course, answer that ambiguous question to a

satisfactory extent, yet it contributes some important insights that
should help generate answers.

1.2 Setting the research agenda: the technological

aspect of the ‘developmental role of inward
manufacturing FDI’

This overarching question forms part of a wider research agenda on the

developmental role of FDI in general. The agenda has been evolving
for many decades in the bodies of literature on economic development,
international economics and, to a lesser extent, in the international
business literature. This has produced ‘conventional wisdoms’ that
over time have adapted to new empirical trends and research results
generated by more powerful methods and firm-specific data. Three sets
of ‘conventional wisdom’ are summarised in a volume edited by two
Washington institutions: the Institute for International Economics and
the Center for Global Development (Moran et al., 2005, p. 2):

● The ‘Washington consensus’ enthusiasm is shared mostly by multi-

national investors and business lobby groups. It holds that FDI always
has a positive effect on the host economy, hence countries should
attract as much inward FDI as possible.
● Academic scepticism however prevails over the relationship between
inward FDI and economic development. It may well be that the
effects of FDI will not yield beyond the effects of any other domestic
investment.
● ‘Dirigisme resurrected’ describes a contemporary tendency by
policy-makers in some developing countries to revert to heavy-handed
regulation of inward FDI. This may include provisions for minimum
technology transfer, compulsory licensing, local content require-
ments and other measures targeted at increasing technology transfer
and spillovers to the benefit of the economy that hosts inward FDI.

This list obviously lacks some more critical views that may not make
it to a Washington-accepted ‘conventional wisdom’ yet still remain
important in many host economies, and not only in the third world.
Those views direct attention to the possibility that inward FDI may
cause environmental damage and may deplete natural resources, and
there are allegations related to land grabbing and its potential risks for
the indigenous societies. Neglecting those points certainly makes an odd
6 The Technological Role of Foreign Direct Investment

compilation: they may not apply to a large share of inward FDI, they
may be overstated in some cases, they may have been more frequent
some years or decades ago, and yet they do exist today, and in some
cases put immense strain on the host countries (see, for example, the
problems associated with environmental damage from oil extraction
in some African countries, predominantly Nigeria, see also the critical
discussion about the role of recent FDI inflows originating from China
around the developing world).
Moran et al. (2005) see the benign effects of FDI to be conditional
on and driven by an open trade and investment policy framework that
gives rise to competitive markets.8 On the other hand, where foreign
affiliates operate behind trade barriers and without local competition,
FDI may even subtract from host country welfare (ibid., p. xii).9 Today,
the empirical literature on average and at the most general level assumes
a rather positive view of inward FDI: “FDI is generally associated with
positive technological spillovers, economic growth, and increasing
income inequality. [ ... ] In all three areas there are, however, significant
counter examples in the literature which must be respected.” (Clark
et al., 2011, p. 2). As much as the Washington consensus can be criticised,
it did contribute to generating a competitive and liberalised economic
environment for foreign investors, hence it secured the right kind of
incentives for efficient economic activity, upon which sustainable
economic growth and development can build. It may also be argued that
the prospect of EU membership had an even stronger disciplining effect
(see perhaps most prominently Lavigne, 1998, in a very large body of
literature). It is the securing of such an economic environment that gave
rise to the general contention that inward FDI into CEECs had so far
positively contributed to systemic change and catch-up development.
This already sets the research agenda for this book: the objective is to
assess the conditions that have to be fulfilled so that inward FDI can have
a positive and important role in the technological process of catching up in
CEE. A positive general developmental role, not restricted to the tech-
nological impact, may be rooted in a number of effects at very different
levels:

● Inward FDI increases employment opportunities for local workers,

inasmuch as the additional investment has increased the amount of
productive capital which is now in need of a new stock of labour
to complement it. The intensity of this effect obviously hinges on
the capital or labour intensity of the investment, and on whether
employees and managers, in addition to capital, are transferred to the
 Introduction 7

host location. Whilst foreign investment projects tend to pay higher

wages than domestic firms (often by trying to acquire the best avail-
able human capital embodied in the work force), the best paying jobs
are typically reserved for ‘expatriates’ of the foreign investor, and are
not accessible to domestic managers.
● Where inward FDI is associated with capital inflows (depending on the
definition of FDI) it increases the volume of capital investment in the
host economy – investment that possibly contributes to closing what
is called the savings gap10 in some of the traditional macro-economic
development literature (such as the Harrod–Domar growth model, or
Rostow’s Stages of Growth model, or Nurkse’s vicious circle).
● Inward FDI improves the host country’s current account via capital
imports and thereby contributes to closing the so-called foreign
exchange gap. This is obviously a one-off effect for each FDI project,
giving rise to no lasting improvements (see the recurring difficulties
of, for example, Hungary, where FDI inflow shortfalls keep generating
current account problems, or the contagion effects of the current
financial crisis, see Brezinski and Stephan, 2011). Moreover, FDI
will typically lead to profit repatriation at some stage (if successful,
this is after all amongst the most important raisons d`être for foreign
investment) and may turn this into a negative effect. This has
become a relevant issue in Central East Europe, with profit repatria-
tion amounting to around 10 per cent of FDI inflows (in Hungary,
this even peaked at slightly over 20 per cent in 2008: Hunya, 2010,
p. 13).
● Inward FDI may also have a potentially benign effect on the foreign
trade performance of host countries (in particular exports), assuming
that foreign firms are more expedient in conquering external markets
than are domestic firms (which is often assumed to be the case in
emerging markets). This effect, however, depends on transfer-pricing
behaviour of foreign investors: where FDI, for example, assumes the
character of outward processing trade or if relative corporate taxation
rules between countries motivate this, transnational corporations
(TNCs) will calculate higher prices for their imports from the internal
network and lower values for their exports. Local content rules may
reduce this effect where foreign investment is required to generate a
minimum share of the value of the products or services in the host
country.
● Inward FDI can have effects on competition and market structure
in host countries, which is particularly relevant in countries and/
or sectors where an insufficient endowment with domestic firms
8 The Technological Role of Foreign Direct Investment

competing for market shares results in low intensities of competition.

This was in fact an important issue in CEECs. This may equally,
however, turn out to be the opposite: if inward FDI involves entry
into oligopolistic markets and the foreign firm has more financial
leverage than domestic competitors, the foreign firm may rationally
try to compete away market shares of domestic firms in a Bertrand
competition scenario.
● Inward FDI can also alter sectoral structures,11 if foreign investment
is able to develop successful industrial clusters (which proved to be
particularly relevant in Central East Europe – in, for example, the
automotive sector in the Czech Republic) and if FDI flows into sectors
that were previously underdeveloped but which promise interesting
potential (that is, in need of substantial investment, in CEE the ICT
industry: Welfens and Borbély, 2009, and Welfens and Wziatek-Kubiak
et al., 2005).
● Traditionally, it is also argued that inward FDI will contribute to
government revenues of the host country by way of taxation of foreign
direct investment and their effects (for example, on employment).
Today however, particularly in emerging markets, governments offer
generous tax concessions to foreign investors (for example, in special
economic zones) and thereby forgo some of this benign effect.
● Inward FDI may transfer knowledge and technology previously
unavailable in the domestic economy, if the investment originates
from countries with higher levels of economic development and/
or from investors with higher levels of productivity. This knowledge
and technology may include anything from hard-core technology to
tacit knowledge (for example, technological skills and experience) to
management experience and entrepreneurial abilities. It may more-
over generate spillovers to the host economy, but only if a number
of conditions are fulfilled, such as: if the foreign investor chooses
to allow or even promote this in a positive sense, or is unable to
prevent the dissipation of its knowledge and technology in a negative
sense; if the affiliate of a knowledge-bearing foreign investor is able to
convey, teach, and explain the knowledge (even if it assumes a rather
tacit character); if the host economy is fit enough to absorb the alien
technology and make good use of it; and if the host economy’s insti-
tutional environment does not put the foreign owner’s intellectual
property at risk. Whilst this effect depends on many “ifs”, it is the
technological aspect that is most interesting for the case of inward
FDI into CEECs, due to the countries’ large technology gaps (see for
example Stephan, 2003).
 Introduction 9

● In addition to technology transfer and spillovers, FDI affiliates may

assume an important role as players in the national innovation
systems of the host economies. This is particularly relevant in host
countries where there is a technology gap between themselves and
the home countries of their inward FDI.
● Further, FDI may also have an effect on the distribution of income in
the host economy, on labour market structural issues (skills-upgrading,
brain drain), on the contribution of FDI to structural/sectoral change
(again a particularly important issue in CEECs due to their prior
distortion of sectoral structures, see for example Kalotay, 2010). (For
comprehensive overviews, see for example Blomström and Globerman
and Kokko, 2001; others.)

All the above effects (and possibly some more, not mentioned here)
have the potential to increase host economy growth and to spur
economic development (see for example Sapienza, 2009, in an appli-
cation on CEECs). However, each of these beneficial effects may also
become detrimental: where the foreign investor is dominant, domestic
firms are driven out of the market; foreign investments typically generate
more income for domestic groups with lower propensities to save;
foreign firms often use their established foreign suppliers (that often
follow their clients) and hence drive out domestic firms in upstream
industries; FDI projects may crowd out domestic investors seeking credit
by raising capital locally on an as yet underdeveloped market; etc.
Adding to these qualifications of potentially benign effects of inward
FDI, there are more philosophical or ideological arguments against
inward FDI that are nonetheless noteworthy in a discussion of economic
effects.12

● First, a substantial share of foreign-owned economic activity in large,

powerful and dominant firms gives rise to a dualistic economic
structure, where the host economy assumes the role of labourer and
the foreign investor that of capitalist. Such FDIs will influence host
governments, and their lobbying may not always be targeted to the
benefit of the local economy. Moreover, dominant FDI projects may
divert host economy resources away from ‘natural’ local compara-
tive advantages (much like the Dutch disease problem). This way,
much needed food production is replaced by production of goods
catering to the needs of local elites and/or foreign consumers, not the
local population at large. Dominant foreign investors may not only
drive out domestic indigenous firms, but may also suppress domestic
10 The Technological Role of Foreign Direct Investment

entrepreneurship and thereby inhibit the development of small-scale

domestic enterprises.
● Second, foreign investments in emerging markets often seek the
localisation advantage of lower labour costs, possibly lower labour
unit costs. Where investments are into labour-intensive production
technologies, their international competitiveness depends on low
wages, and may lock the host economy into a low-wage trap that
cannot be overcome without external stimulus. Alas, where invest-
ments are into capital-intensive production, the host economy is said
to suffer from an aggravated unemployment problem. Finally, where
inward FDI is motivated by a laxer protection of labour security, or of
the environment or the like, the private profits of the investor may
exceed social benefits – and in the worst cases the benefits to the host
economy may even turn out to be negative.
● Third, where inward FDI is into countries with less developed infra-
structure, it will typically locate in urban centres and hence aggravate
the already pressing problems of rural–urban migration.
● Finally, host governments competing for foreign investment projects
are able to acquire concessions in the form of excessive (and possibly
targeted) protection,13 tax rebates, investment allowances, and other
state aids, either overt or hidden. It is often argued that domestic enter-
prises do not have this lobby power, because their threat of investing
elsewhere is less powerful due to lower investment volumes.

It is obvious that such a discussion about the extent of beneficial and

detrimental effects of inward FDI on the host economy is highly subjec-
tive and depends to some extent on the individual perception on what
kind of economic development is desirable and what character of the
development process may on the one hand increase growth but on the
other be socially undesirable (see the discussion on the varieties of capi-
talism, for example Hall and Soskice, 2001; Coates et al. 2005; Cernat,
2006; Tridico, 2011; Myant and Drahokoupil, 2012).
To harness this broad field of interest to something manageable (as
well as selecting the issues that are of the greatest interest to the author
of this book), the analysis presented here restricts itself to manufac-
turing industries, because here the largest potentials for technology
and knowledge interaction and transfer can be assumed, and because
empirical analysis can make use of more robust proxies than would be
the case in for example services, where technology is much more about
management techniques, and prices and costs are much more diffi-
cult to substantiate. The analysis presented here focuses on technology
 Introduction 11

transfer and spillovers as the source of the developmental role via

inward manufacturing FDI. This is a controversial issue: considering the
conditions that prevail in CEE, will inward FDI in the manufacturing
industry assume an active and positive role for technological catch-up
development in those countries? How attractive is the region to inter-
national investors? What kind of investors does the region attract? Are
the manufacturing FDI projects dominated by ‘extended work benches’,
or ‘screwdriver industries’, or ‘outward processing trade’? Do FDI projects
originate from investors with the latest knowledge and technology at the
frontier area, with its foreign affiliates remaining excluded from this? Do
manufacturing FDI projects give rise to modernly equipped production
sites in the host economy? And if so, are these fully integrated into the
foreign investor’s network, that is, isolated from the domestic economy,
or do foreign affiliates trade with their host economy? Do affiliates of
foreign investors engage in their own technological activities such as
R&D and innovation in the host economy? Do they use local firms and
institutions in the regional innovation system to exchange knowledge
and technology? And finally, which firm- and region-specific factors
influence foreign investors’ decisions to locate technological activities in
a particular region and to source technology locally? Those questions
are all at the heart of the technological aspect of the developmental role
of manufacturing FDI (in the following, only FDI) and require analysis
both at the level of the host economies and at the level of the firm.
The emphasis is on the conditions of such a role and not on
constructing a general model or theory of technology transfer and spill-
overs. Indeed, a model-like description of the mechanisms behind the
transfer of knowledge and technology and their spillovers can only be
achieved if the concepts of ‘knowledge’ or ‘technology’ are treated as a
homogeneous goods of groups of homogeneous goods. Whilst this may
be applicable to the concept of ‘information’ to a large extent, knowl-
edge and technology are typically very heterogeneous both in their own
character (for example tacit vs tangible and codified, narrative vs formal,
trustworthy vs prejudice and misconception, etc.) and in their useful-
ness for each individual user, which – to complicate matters – may even
change over time. Whilst heterogeneities do not in general preclude the
development of theories that draw a general picture of a representative
average and the mechanisms involved, the many sources of hetero-
geneity both within the concepts of knowledge and technology and
between the many different foreign investors and their host economies
make this avenue a very complicated one, to say the least. The analysis
here is much less ambiguous, and confines itself to analysing the role
12 The Technological Role of Foreign Direct Investment

of FDI for the ‘technological’ dimension of the development process

by use of empirical firm-level data. The analysis makes use of some of
the latest theoretical and conceptual developments in the literature of
international business, strategic management, innovation economics,
institutional economics, and evolutionary economics.

1.3 Conceptual framework for the analysis

1.3.1 Technological development in economic theories

The ‘technological’ focus in theories of economic development tradi-
tionally operates at the macro-economic sphere and has in particular
been less concerned with the sources of technological developments
which originate at the firm level.14 Later additions to the theoretical
debates over technology and development integrate the institutional
dimensions of international and development economics. Most of these
theories are embedded in a world of general equilibrium. Regardless
of whether equilibrium is prevalent in reality at any point of time or
achieved/restored in the long term, or whether there is such a thing as
a tendency towards an equilibrium, those theories still largely remain at
variance with what may be considered to be at the root of dynamism
in a capitalist market system at the micro-level: that is, uncertainty,
transient gains and losses, adjustment costs in friction phases, the
stochastic and non-linear character of technical advance, and last but
very importantly, the diversity of firm characteristics, reactions, and
strategies (firm-heterogeneity, see for an early account Young, 1928). In
any dynamic or evolutionary theory, equilibrium cannot exist, because
everything keeps changing (see Nelson and Winter, 1982).
Indeed, it may be argued that there is a trade-off between those two
families of paradigms: general equilibrium models can be viewed as
theoretical benchmarks for assessing the mechanisms at work if the
economic system is largely frictionless (perfect competition), and com-
putable general equilibrium models help to assess the likely effects
of, for example, policy interventions. Dynamic micro-analyses on the
other hand command less sweeping assumptions, hence are closer to
the reality of a dynamic world, and yet are rather ill-equipped to predict
macro-effects of micro-phenomena (as for example the effects of inward
FDI), the outcome of political interventions for the whole economy
(even if policies are targeted at the firm level), or exogenous or asym-
metric shocks for the whole economy.
Somewhere in this middle ground between the two extremes of
macro- and micro-level analyses are meso-level analyses that assess the
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