Foreign Direct Investment and Intellectual Property Rights Under CPEC [Part 3]
In the last two articles, the basic elements of foreign direct investment and FDI’s relationship with various factors was explored with reference to research papers. This article will take the discussion further and touch upon other modes of entry available to a multinational enterprise (MNE), knowledge spillover, technology transfer and the relationship between intellectual property rights (IPRs) and FDI. References will mostly be made to empirical studies.
Why FDI?
FDI is one of the modes available to an MNE to invest in another country. The decision to invest in a foreign country depends on various factors. MNEs typically prefer the route of FDI as it gives them an informational advantage by giving them access to the local market. One of the main reasons why Japanese manufacturers established their manufacturing units in the USA in 1980s and 1990s was to obtain better marketing information.[1] FDI also helps MNEs jump the tariff barrier by investing in the local market by way of a subsidiary.[2] MNEs consider what are called ‘location advantages’ which include demand patterns of the local market, size of the market and its growth, distance from the markets and costs of transportation, low wage costs in relation to labour productivity, trade protection which may stimulate “tariff-jumping” investments, and abundance of natural resources.[3] However, there is a growing trend of countries signing free trade agreements (FTAs) which help them overcome trade barriers such as tariffs, as a result of which such impediments are becoming increasingly insignificant. Other location advantages include low input prices and the ease of accessing a distribution network and the host country’s regulatory environment.[4]
Although FDI is a widely adopted method of investment, it is certainly not the only option that MNEs have. Using John Dunning’s ownership-location-internalisation (OLI) framework[5], it has been demonstrated that even if favourable location advantages exist, MNEs still have other options as to how to enter the foreign market. Other modes of entry include exporting products to the foreign market, joint ventures with local firms and ‘arm’s length’ technology licensing[6]. The decision of choosing the mode of entry depends on various factors including the host country’s regulatory environment, the extent of control an MNE wants to retain, and the ease with which business can be done in the host country. FDI enables MNEs to retain control whereas licensing only earns them rents.
Knowledge Spillover and Technology Transfer
Well-established MNEs usually possess expertise in different fields. Their experts can transfer technical know-how and knowledge to the labour force of the host country. Large MNEs have realised the significance of research and development (R&D), thus their expenditure on R&D has significantly increased over time. Romer[7], Lucas[8], and Grossman and Helpman[9] all agree that knowledge diffusion is an essential mechanism that underlies endogenous economic growth (endogenous growth theory posits that economic growth primarily depends on endogenous factors and not external factors).
Through FDI, these large MNEs also transfer technology to developing host countries. Technology transfers can provide capabilities to the host country which can be applied for further development. China is the best example which benefited from the technology transferred to it via FDI, which it then used to develop its own capabilities. This was also noted in the UNCTAD Secretariat Note, 2001, which stated that the business relations and such dealings and interactions could result in the transfer and dissemination of technology and skills. It also states that backward linkages between foreign and domestic firms could boost technology transfer. The Note further observes that foreign affiliates also assist their domestic counterparts to raise their standards, consequently improving their potential. This effect, the Note states, is more pronounced in developing countries.[10]
The gap in the technological potential between developing and developed countries is viewed as a reflection of their respective economies. FDI, especially in the manufacturing and industrial sectors can actually play a role in bridging this gap and increasing the fortune of a country in terms of technological capabilities. Alfaro[11] has observed that along with direct capital financing, FDI may act as a source of very valuable and precious technical know-how and technology for the host developing nations by strengthening associations with local firms. As stated in the UNCTAD Note (cited above), technological advancement in developing countries has surpassed that in developed countries by 40% to 60%.[12]
FDI can create new job opportunities in the host country. Besides employment, the labour force can also receive training and learn more efficient methods of operations. The training of domestic labour force coupled with the transference of expertise and better know-how can create a highly skilled workforce for the developing host country.
Academics and scholars have also distinguished between ‘horizontal’ FDI and ‘vertical’ FDI. In horizontal FDI, MNEs use their establishments in foreign economies for the production of similar or the same goods for the regional markets of that economy.[13] On the other hand, MNEs, through their establishments, produce outputs which can act as inputs in other nations. Distribution FDI, a third type of FDI, includes investment in regional offices such as sales, distribution networks and other service facilities.[14]
Horizontal MNEs (MNEs which choose ‘horizontal FDI’) might be able to transfer comparatively advanced technology abroad, but it should not be inferred that it will also result in more knowledge spillover. Moreover, although there exists a higher chance for knowledge spillovers, the local firms might not be sufficiently equipped for the absorption of advanced technology. Therefore, it is the technology policy of the host country which can determine which genus of FDI can result in the highest knowledge spillover. Thus, horizontal MNEs are likely to preclude such spillovers from occurring.
Nevertheless, published literature posits that horizontal FDI will result in more knowledge spillovers than vertical FDI. Despite the foregoing, foreign firms usually have the disadvantage in terms of insufficient knowledge of local markets, business practices and consumer preferences. This element of ‘foreignness’ is compensated by the competitive advantage that foreign firms possess over local firms. To ensure this, foreign firms transfer some of their knowledge capital to a subsidiary in the local market, which eventually increases the chances of knowledge spillovers. On the other hand, vertical FDI is mostly concerned with attaining efficiency gains, thus resulting in less knowledge transfer and lower chances of spillovers.[15]
Roording and Vaal[16] are opposed to the view that horizontal FDI results in higher spillovers than vertical FDI. To demonstrate that, they developed a simple model that endogenized the difference in spillovers between horizontal and vertical FDI, suggesting that knowledge spillovers relied on the determination of a host of factors which included the potential of local firms to absorb technology, the strategy adopted by the MNE and the host country’s technological stance.
To enhance the potential of knowledge spillovers, the technology potential of the host country must be less sophisticated than that of the country of origin of the investor. Technological primitivity increases spillovers. Simultaneously, the host country must possess what is termed as a ‘minimum threshold of technology’ to absorb and integrate the technology of the MNE.[17]
Javorcik[18] found that spillovers existed because of FDI and that incentivising FDI led to those spillovers taking effect. Other studies have demonstrated that low levels of education and absorptive capacity preclude the spillover effect from taking place.[19]
FDI and IP – Influence of IPRs on the decision of MNEs
The state of IPRs in the host country may influence the decision of the MNE to choose one of the modes of entry mentioned above. It must be borne in mind that IPRs are only one of the factors which can influence the inflow of FDI. Other factors include taxation, trade policies, competition rules, production incentives[20] along with factors mentioned in previous articles. According to Maskus, it is the ‘existence of pro-competitive business environment’[21] that plays a vital role in attracting FDI. Frischtak[22] has empirically demonstrated using surveys of OECD (Organisation for Economic Co-operation and Development) nations that IPRs are a key component in the decision of choosing FDI. However, Frischtak also points out that other elements, including the overall business environment of the host country, play a significant role in the decision-making.
For our purposes, only the decision of investment of knowledge-based assets (KBAs) or technology transfer will be treated. The seminal work in this field is that of Lee and Mansfield (1996).[23] In 1991, Mansfield selected a sample of 100 US firms across 6 manufacturing industries. Each firm was asked whether the intellectual property regimes of the 14 countries in the list (Argentina, Brazil, Chile, Hong Kong, India, Indonesia, Mexico, Nigeria, Philippines, Singapore, South Korea, Taiwan, Thailand and Venezuela) were sufficiently weak to prevent them from transferring their most novel and efficacious technology to an absolutely owned subsidiary there.[24] The response rate was a staggering 94% and the results demonstrated a positive relationship between the strength of IPRs and the inflow of FDI, and that the countries with stronger IPRs attracted significantly higher FDI inflows. Others who found evidence to support this proposition includes Maskus (1998)[25], Maskus and Yang (2000)[26] and Branstetter et al.[27]
MNEs typically choose vertical FDI when they have to invest in low-income developing countries. And they choose horizontal FDI while investing in other developed countries.[28] Lee and Mansfield[29] have also explained that while investing in sectors like sales and distribution and other processes like assembly in countries with weak IPRs, MNEs typically do not regard the status of IPRs as relevant. MNEs typically prefer to invest in countries with stronger protection regimes while investing in the R&D sector and other manufacturing sectors. Heald has identified that the decision to invest in the R&D sector is also influenced by factors such as education, training and the skill level of the regional workforce, the condition of financial and legal sectors and the level of transparency in government operations.[30]
Another distinguishing feature is the type of industry the MNE wants to invest in. A survey by Lee and Mansfield[31] demonstrated American chemical (including pharmaceuticals), electrical and machinery equipment industries to note that the strength or weakness of IPRs of the host country, especially in terms of R&D, components and complete product manufacturing sectors, significantly affected their decision to invest. MNEs belonging to transportation, metals and food manufacture industries did not consider the state of IPRs to have a significant effect on their decision to invest in the host country. Furthermore, MNEs preferred FDI when the type of technology they were transferring to the host country with weaker IPRs was complex and could not be easily copied. The imitative ability of the host country also becomes relevant in such circumstances. Vishwasrao[32] has shown that the quality of technology transferred is directly proportional to the strength of IPRs.
However, the data and views of academics are spread all over the spectrum. Mansfield’s work is not immune to criticism. More recently, Heald (2003)[33] has examined the work of Mansfield both critically and skeptically and has identified many deficiencies present in Mansfield’s methods. Braga and Fink (2000)[34] could not find evidence to conclusively demonstrate the positive correlation between the state of IPRs and the inward FDI. Javorcik (2004)[35] has demonstrated that the positive correlation only exists with respect to high-technology sectors while evidence for other sectors cannot be found. Glass and Saggi (2002)[36] have empirically demonstrated that stronger IPRs discourage inward FDI. This may seem counter-intuitive, but it holds true as strong IPRs would rather encourage licensing as the MNEs would not fear imitation. Nunnenkamp, Peter, Spatz, Julius (2003)[37] state that stronger IPRs also raise the level of the quality of FDI.
The next article will explore the relationship of FDI and IPRs further and touch upon the Belt and Road Initiative and CPEC.
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References
[1] Feenstra, R. C. (2000). “International trade and investment.” NBER Reporter: 1.
[2] Wang, K.-C. A., et al. (2016). “Intellectual property rights, international licensing and foreign direct investment.” Asia-Pacific Journal of Accounting & Economics 23(3): 291-305.
[3] Maskus, K. E. (1998). “The role of intellectual property rights in encouraging foreign direct investment and technology transfer.” Duke J. Comp. & Int’l L. 9: 109.
[4] Braga, C. A. P. and C. Fink (1998). “The relationship between intellectual property rights and foreign direct investment.” Duke J. Comp. & Int’l L. 9: 163.
[5] Dunning, J. H. (1979). “Explaining changing patterns of international production: in defence of the eclectic theory.” Oxford bulletin of economics and statistics 41(4): 269-295; Dunning, J. H. (1982). Explaining the international direct investment position of countries: towards a dynamic or developmental approach. International Capital Movements, Springer: 84-121.
[6] Yu, P. K. (2007). “Intellectual property, economic development, and the China puzzle.”
[7] Romer, P. M. (1986). “Increasing returns and long-run growth.” Journal of political economy 94(5): 1002-1037.
[8] Lucas Jr, R. E. (1993). “Making a miracle.” Econometrica: Journal of the Econometric Society: 251-272; Lucas, R. E. (1988). “On the mechanics of economic development.” Journal of monetary economics 22(1): 3-42.
[9] Grossman, G. M. and E. Helpman (1991). “Trade, knowledge spillovers, and growth.” European economic review 35(2-3): 517-526.
[10] Foreign direct investment, the transfer and diffusion of technology, and sustainable development; TD/B/C. II/EM.2/2
[11] Alfaro, L. (2003). “Foreign direct investment and growth: Does the sector matter.” Harvard Business School 2003: 1-31.
[12] Ibid
[13] Braga, C. A. P. and C. Fink (2000). “International transactions in intellectual property and developing countries.” International Journal of Technology Management 19(1-2): 35-56.
[14]Kennedy, K. C. (2003). “A WTO Agreement on Investment: A Solution in search of a Problem.” U. Pa. J. Int’l Econ. L. 24: 77.
[15] Beugelsdijk, S., et al. (2008). “The impact of horizontal and vertical FDI on host’s country economic growth.” International Business Review 17(4): 452-472.
[16] Roording, N. and A. d. Vaal (2010). “Does horizontal FDI lead to more knowledge spillovers than vertical FDI?”
[17] Ibid 15
[18] Javorcik, B. (2010). “Foreign direct investment and international technology transfer.” Encyclopedia of Financial Globalization.
[19] Duarte, R. G., et al. (2014). “FDI inflows, transfer of knowledge, and absorptive capacity: The case of Mozambique.” African Journal of Business Management 8(1): 14.
[20] Maskus, K. E. (1998). “The role of intellectual property rights in encouraging foreign direct investment and technology transfer.” Duke J. Comp. & Int’l L. 9: 109.
[21] Ibid 19
[22] Frischtak, C. R. (1993). “Harmonization versus differentiation in intellectual property right regimes.” Global dimensions of intellectual property rights in science and technology 89: 103-105.
[23] Lee, J.-Y. and E. Mansfield (1996). “Intellectual property protection and US foreign direct investment.” The review of Economics and Statistics: 181-186.
[24] Ibid 22
[25] Maskus, K. E. (1998). “The role of intellectual property rights in encouraging foreign direct investment and technology transfer.” Duke J. Comp. & Int’l L. 9: 109.
[26] Maskus, K. E. and G. Yang (2000). “Intellectual property rights, foreign direct investment and competition issues in developing countries.” International Journal of Technology Management 19(1-2): 22-34.
[27] Branstetter, L., et al. (2011). “Does intellectual property rights reform spur industrial development?” Journal of international Economics 83(1): 27-36.
[28] Ibid 26
[29] Ibid 24
[30] Heald, P. J. (2003). “A Critical Analysis of Mansfield’s Canonical 1994 Survey.”
[31] Ibid 24
[32] Vishwasrao, S. (1994). “Intellectual property rights and the mode of technology transfer.” Journal of Development Economics 44(2): 381-402.
[33] Ibid 31
[34] Ibid 13
[35] Javorcik, B. S. (2004). “The composition of foreign direct investment and protection of intellectual property rights: Evidence from transition economies.” European economic review 48(1): 39-62.
[36] Glass, A. J. and K. Saggi (2002). “Intellectual property rights and foreign direct investment.” Journal of international Economics 56(2): 387-410.
[37] Nunnenkamp, P. and J. Spatz (2003). “Foreign direct investment and economic growth in developing countries: how relevant are host-country and industry characteristics?”
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