Exposure to foreign firms can induce knowledge transfers to domestic firms in close geographical proximity
There seems to be a consensus in the literature that domestic firms primarily learn from foreign firms through supplier relationships. Yet, in a very poor country like Ethiopia where domestic supply chains are underdeveloped, the benefits of exposure to foreign firms (FDI) are more likely to come through other channels, at least in the short run. For example, domestic firms can learn by hiring workers previously employed by foreign firms. This learning may not be restricted to domestic firms operating in the same industry as the foreign firm. Bloom et al. (2018) report that knowledge spillovers from large manufacturing plants in the US enhance the management practices of smaller manufacturing plants in a variety of industries. Alfaro-Urena et al. (2022) find that the a majority of the domestic firms which benefit from supplying to FDI are not in the manufacturing sector, but instead sell services to foreign firms and are mostly situated in nearby locations.
When put in these terms, the similarity between research that investigates knowledge diffusion between foreign and domestic plants and research on agglomeration externalities becomes evident. The central idea of this literature is that geographic proximity plays a key role in the acquisition of skills and that one of the benefits of agglomeration is the facilitation of learning. Motivated by these observations, our recent work (Abebe, McMillan and Serafinelli 2022) examines spillovers from foreign to domestic plants at the district (Woreda) level in Ethiopia over the period 1996-2013.
Causal estimates of FDI on domestic firms’ productivity
To identify the causal relationship between the opening of a foreign plant and domestic plants’ productivity, we compare changes in total factor productivity (TFP) among domestic plants in ‘treatment’ districts to changes in TFP in ‘control’ districts. Treatment districts are defined as districts in which a large greenfield foreign plant opens. Control districts are defined as locations in which a foreign plant in the same industry applied for a license around the same time, got approval, but then did not produce during the period in which the foreign plant was operating in the treated district. Bureaucratic hurdles are the most cited explanation for the lag in operationalising investments (World Bank 2014). We find no evidence of differential trends in productivity between treatment and control districts prior to the opening of a foreign plant. This lends credibility to our identifying assumption that plants in the control districts form a valid counterfactual for the plants in treated districts.
Our baseline estimates show an increase in TFP for treated domestic plants following the start of production of a greenfield foreign plant. Over the four years, starting with the year in which the foreign plant opens, the average increase in the TFP of domestic plants is 11%. We obtain qualitatively similar results using an alternative strategy exploiting the assignment of land for FDI by the Ethiopian Government, in combination with an event study research design.
Our results are robust to alternative specifications addressing the issue of the endogeneity of inputs and do not appear to be driven by attrition of domestic plants or higher output prices. A potential threat to our identification strategy is the fact that Ethiopia has been undergoing a major overhaul in its infrastructure which will impact the efficiency of domestic and foreign firms alike. To alleviate this concern, we control for government spending on capital improvements and infrastructure investment which varies by district and year; our results are robust to their inclusion.
Employment and the number of firms increase but wages do not
The productivity gains for domestic plants associated with FDI may incentivise new domestic plants to locate in districts with FDI. Thus, an indirect test of knowledge spillovers is a test for plant entry in treated districts. We find that following the entry of the foreign plant in a district, there is an increase in the number of domestic plant openings. These results are consistent with the estimated increases in TFP and indicate that foreign plants attract new economic activity in the manufacturing sector of treated districts. We also document an increase in employment in treated domestic plants.
To test for competition in the labour market, we explore changes in wages in domestic plants exposed to FDI. We find little evidence of an impact of FDI entry on wages, possibly due to the relative abundance of unskilled labour in Ethiopia. An important caveat is that we do not have worker characteristics or wages broken down by skill level, which leaves open the possibility that wages for some skill groups might have increased.
Tests for attrition and employment changes serve as indirect tests for the relative importance of competition between FDI and domestic plants in both input and output markets. Competition could lead to relatively more attrition of domestic plants in the treatment group. It could also lead to layoffs. We find no evidence for differential attrition by treatment status and as previously noted, instead of layoffs, we find evidence of employment expansion by plants in treated districts.
Qualitative evidence about how upgrading occurs
Domestic plant managers were surveyed in 2014 to better understand how the presence of foreign plants in Ethiopia impacts their performance. 15.7% of plant managers reported technology upgrading because of competition from FDI. 12.1% of plant managers report directly adopting production techniques from observing or copying foreign plants in the same four-digit industry. This suggests that domestic plants need not be in a formal relationship with a foreign plant to benefit from FDI. Around 10.1% of plant managers report licensing technology from foreign plants. A further 6.2% of plant managers report benefiting from hiring workers who previously worked in foreign plants. Only 4.3 (1.7) % of plant managers reported upgrading through a relationship with foreign customer plants (by purchasing inputs from FDI). These findings are in line with the idea that the benefits from FDI in a poor country are less likely to come through input-output linkages. However, a note of caution is in order because we do not have data on the provision of services by local firms to foreign firms in Ethiopia.
Our results are generally supportive of an industrial policy that seeks to attract foreign direct investment for the purposes of upgrading domestic plants’ capabilities. Our results also underscore the importance of geographic proximity for realising these gains. Special Economic Zones (SEZs) – a key albeit relatively recent element of Ethiopia’s industrialisation strategy – could limit interactions between foreign and domestic plants. This may happen if foreign plants locate in highly secure and relatively remote locations or if foreign plants are given preferential access to SEZs because, for example, they export. This concern is not only relevant to African countries; SEZs are among the most popular instruments for attracting FDI and the number of SEZs has grown rapidly over the past ten years, with many more planned (UNCTAD 2018).
Editors’ note: This article is based on this PEDL research.
Abebe, G, M McMillan and M Serafinelli (2022), “Foreign direct investment and knowledge diffusion in poor locations”, Journal of Development Economics 158
Alfaro-Ureña, A, I Manelici and J P Vasquez (2022), “The Effects of Joining Multinational Supply Chains: New Evidence from Firm-to-Firm Linkages”, The Quarterly Journal of Economics 137(3): 1495–1552.
Bloom, N, E Brynjolfsson, L Foster, R Jarmin, M Patnaik, I Saporta-Eksten and J V Reenen (2019), "What Drives Differences in Management Practices?", American Economic Review 109 (5): 1648-83.
United Nations Conference on Trade and Development (UNCTAD) (2018), World Investment Report: Investment and New Industrial Policies.
World Bank (2014), “4th Ethiopia Economic Update: Overcoming Constraints in the Manufacturing Sector”, The World Bank Group.