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Chapter 4
MNEs & Linkages with Local Firms
Links between multinational and local firms
This section focuses on the effects of MNEs in a host economy through firm-to-firm linkages, including both links where the MNE is the supplier to local buyers and links where the MNE is the customer to local suppliers.
MNEs generating spillovers to domestic firms can be firms with partial to full foreign ownership — i.e. the ownership threshold varies from any positive share to shares of 50% or higher — and firms that are explicitly affiliates of foreign-owned MNEs. While we loosely label all firms with at least some foreign ownership as MNEs, the precise ownership structure can drastically affect the estimates of spillovers.
The literature on spillovers from MNEs (or FDI) tends to use the term “spillovers" liberally to refer to effects on the receiving economy that are not mechanically linked to the activity of the MNEs (e.g. the MNEs creating formal employment or making an investment in R&D). The core emphasis is on spillovers to productivity, though other outcomes are also sometimes reported. At the same time, the term spillovers is sometimes used as a synonym for externalities. However, showing that a given effect captures an externality is challenging as it requires data typically unavailable to the researcher. This section reviews previous research under a broad definition of ‘spillovers’ - even if it does not claim that the documented effect is a spillover - and emphasises throughout whether documented effects are capturing externalities or not.
All measures of productivity used are (to our knowledge) revenue-based measures of total factor productivity (see De Loecker and Goldberg 2014, for a review of measurement problems).
Linkages between MNEs and their domestic competitors
‘Horizontal linkages’ are those between MNEs and their domestic competitors (typically in terms of their outputs). The common practice to identify which domestic firms are competitors uses the firms’ primary industry code.[1]
The increasing importance of MNEs in an industry can both negatively and positively affect domestic firms’ performance. On the negative side, MNEs may reduce the demand of domestic firms and – if economies of scale are important – may increase their average costs. If inputs are industry-specific, MNEs can also restrict access or bid up the price of such inputs for domestic firms.[2] On the positive side, the knowledge of MNEs (embodied in their products, their production and management practices, etc.) might spill over to domestic firms. Such 'spilling over' could happen via direct observation and imitation of the MNE (as in Brambilla et al. 2009) or indirect access to the knowledge of the MNE via worker mobility[3] or sharing suppliers (more on this particular channel below).
Aitken and Harrison (1999) employ firm-level panel data and explore whether increased foreign ownership in an industry benefits the plants in that industry. To that end, the authors use a sample of about 4,000 Venezuelan plants between 1976 and 1989 and define an industry as the primary ISIC four-digit industry of each plant. Aitken and Harrison (1999) find that more foreign ownership in an industry is associated with a fall in the productivity of domestically owned plants.[4] This intra-industry estimate of a negative correlation between foreign ownership and domestic firms’ performance amalgamates market-based competitive forces and actual externalities (pecuniary or not).
The empirical literature since Aitken and Harrison (1999) has yet to reach a consensus on the effects of horizontal linkages (Görg and Strobl 2001). The sign and magnitude of these effects depend on which force dominates, the host country (e.g. Haskel et al. 2007, find positive intra-industry effects on domestic firms in the United Kingdom) and the type of FDI (Javorcik 2015). Another central concern for intra-industry empirical studies is the deliberate choice of the industry and timing of MNE entry. Without credible instruments or natural experiments, most intra-industry estimates are hard to interpret as causal.
Both the empirical and theoretical literature on spillovers from MNEs have emphasised one channel in particular through which MNEs can affect their domestic competitors, namely the shared-supplier linkages channel. This shared-supplier linkages channel was first formalised by Rodriguez-Clare (1996). The paper is based on three key ideas. First, producers of final goods become more efficient when they can use a wider range of specialised inputs. Second, for many of these inputs, it is important for the supplier and user to be located close to each other. Finally, the variety of inputs available is limited by the size of the market.
Therefore, by increasing the demand for inputs, a final-good firm helps bring forth a greater variety of specialised inputs, thus generating a positive externality to other final-good producers. Carluccio and Fally (2013) then brought an additional theoretical insight: the externalities to domestic competitors are affected by potential technological incompatibilities between foreign and domestic technologies.[5] Finally, Kee (2015) brought empirical backing to these model-based conjectures. The paper uses a sample of Bangladeshi garment firms to highlight that local intermediate inputs may also enhance domestic firms’ performance through the shared supplier spillovers of MNEs.
While various types of linkages between MNEs and domestic firms in the same industry fall under the 'spillovers' umbrella, only some facilitate externalities. Current data and research designs have not allowed researchers to narrow in and establish the existence and relative importance of intra-industry-manifesting externalities (see again the exception in Kee 2015). This endeavour and the need to address the endogeneity of MNE entry into an industry are at the frontier of research on 'horizontal linkages'.
Linkages between MNE buyers and their domestic suppliers
A second type of firm-to-firm linkage between MNE affiliates and domestic firms is that in which the MNE affiliate is a buyer of inputs (manufactured inputs or services) from a domestic supplier of such inputs. This type of linkage has customarily been called a 'backward linkage'. One can easily rationalise any positive spillovers from MNEs to their domestic suppliers, as MNEs stand to directly benefit from improvements in their suppliers’ efficiency, product quality, product scope or business practices (though they might also be at risk of knowledge leakage to competitors through shared suppliers).[6]
Historically, papers on 'backward linkages' used the data available at the time, namely firm-level panel data and sector-level input-output tables. The typical finding was that an increase in foreign presence at the sector (or sector-by-region) level was associated with increases in standard measures of productivity of nearby domestic firms in upstream sectors (the so-called "spillovers from backward linkages"). The seminal paper in this literature (Javorcik 2004b) uses firm-level panel data for 1996-2000 from Lithuania to show that a one-standard-deviation increase in foreign presence in the sourcing sectors is associated with a 15% rise in output of each domestic firm in the supplying industry. Productivity benefits were found to be associated with partially, but not fully, owned foreign projects. The author interprets this finding as consistent with the intuition that partially owned foreign projects are more likely to source locally than fully owned projects. Subsequent work further dug into the predictors of stronger gains in upstream sectors (such as the role of local financial markets, as in Alfaro et al. 2010). Giroud et al. (2012) used a survey of MNE affiliates to show that their technological capability, the extent of local sourcing and autonomy in sourcing decisions vis-à-vis their headquarters are positively related to benefits for domestic firms in upstream sectors.
Backward linkages – according to a number of reviews[7] – have been met with overwhelming optimism as the main plausible conduits of knowledge transfers.
The main concern with the sector-level proxies of backward linkages to MNEs is their imprecise measurement, which hinders both the identification and interpretation of the estimates (Barrios et al. 2011). Alfaro-Ureña et al. (2022) show that sector-level backward linkages predict less than 1% of the actual firm-level linkages between MNEs and their suppliers (observed in the universe of formal firm-to-firm transaction data in Costa Rica).
The first step in moving away from a sector level towards a firm-level measurement of the actual linkage status was to survey a sample of firms and construct their networks based on their answer. Newman et al. (2015) used a survey of manufacturing firms in Vietnam to separate the productivity gains along the actual supply chain of MNEs (gains reliant on direct transfers of knowledge between linked firms) from productivity effects via indirect spillovers (gains for firms in upstream sectors that are not themselves supplying MNEs,but that might be affected by the direct suppliers, say, through competition). Kee (2015), already discussed above, is another paper that traces buyer-supplier linkages via surveys.
More recently, the availability of within-country firm-to-firm transaction data has allowed researchers to zoom in on the domestic firms that establish linkages with MNEs and do so at the level of the entire economy. This rich data has opened new opportunities to address some of the identification concerns of the industry-level estimations and gather additional insight into the anatomy of starting to supply to MNEs.
Alfaro-Ureña et al. (2022) provide the first estimates of the effects of becoming a supplier to MNEs based on tax data tracking firm-to-firm transactions within a country (Costa Rica). Their event-study estimates reveal that domestic firms experience strong and persistent gains in performance after supplying to a first MNE buyer. Four years later, domestic firms employ 26% more workers and have a 4 to 9% higher productivity. Moreover, first-time suppliers to MNEs experience a large drop in sales to all other buyers except the first MNE buyer in the event year, followed by a gradual recovery. The dynamics of adjustment in sales to others suggest that firms face short-run capacity constraints that relax over time. Four years later, the sales to others grew by 20%. Most of this growth comes from acquiring new buyers, who tend to be “better buyers" (e.g. larger, more internationally engaged, and with more stable supplier relationships) than the pre-existing ones.
In terms of the interpretation of the effects, Alfaro-Ureña et al. (2022) first show that the long-term effects of “placebo" demand shocks (from the government, a large domestic buyer, or a domestic exporter) diverge decisively from those of demand shocks from an MNE. Second, they provide evidence that the results are unlikely to be explained by changes in tax reporting after the first linkage with an MNE. Third, they show that, on average, domestic firms in manufacturing, who supply a core input to the MNE and/or have a stronger first interaction with the MNE are those who gain the most from their relationship. Moreover, it is most beneficial to supply MNEs in manufacturing and services, smaller MNE affiliates, and/or MNEs whose headquarters country has a higher GDP per capita and better management practices.
Subsequent studies using similar firm-to-firm transaction data from other countries confirm the positive effects experienced by first-time suppliers to MNEs and add further nuance. Masso and Vahter (2022) use Estonian firm-to-firm transaction data for 2015-2019 to show that starting to supply to MNEs increases the value added per employee, scale of production and the capital-labour ratio of first-time domestic suppliers. These first linkages to MNEs are not found to affect the productivity of domestic firms, which the authors attribute to the short panel and the fact that the productivity effects might take time to materialise. The authors also look at second tier suppliers (the suppliers of the suppliers) but do not find effects of the first-tier linkages on the second-tier suppliers. Direct linkages to MNEs appear necessary for the performance boost. Another novel result is that the performance of suppliers does not deteriorate, on average, after decreasing or ending supplier relationships with MNE buyers.
In Uruguay, Carballo et al. (2023) investigate whether starting to supply to MNEs affects domestic firms’ export outcomes. This work shows that selling domestically to an MNE is associated with a significant increase in the probability that a firm starts exporting. Moreover, they find that supplying domestically to an MNE with another affiliate in a given country makes it more likely to begin exporting to precisely that country. The evidence also suggests that these exports are both directed to the other affiliate of that same MNE buyer in the foreign country and other unaffiliated firms.
Amiti et al. (2023) show that, on average, first-time domestic suppliers to MNEs experience surprisingly similar positive effects in the context of a developed economy, Belgium in this case. For instance, the estimate of the medium-run productivity boost of 8% in Belgium is remarkably similar to the 4-9% in Costa Rica. This paper puts forward two particularly valuable and new insights. The first insight from Amiti et al. (2023), unlike the findings for Costa Rica, is that they find equally large productivity gains from starting to supply to other large firms (who do not need to be MNEs or even exporters). The authors conjecture that it isn’t the MNE nature of the firm that matters, but the 'superstar' nature – it just so happens that the only superstar firms in developing countries are MNEs. Future work should settle on the importance of the MNE status for the documented productivity gains. The second insight is that a large share of the increased ability (of first-time suppliers to superstar firms) to match with new buyers is explained by new buyers being within the network of the initial superstar buyers (a 'dating agency' effect). This result points to an essential role of a supplier’s reputation in matching with 'good' buyers.
In sum, the consensus so far from firm-to-firm transaction data is as follows. First, the average effect on measures of firm size of first-time suppliers to MNEs is positive and large (the magnitude depends on the time horizon and the size measure used). Second, the average effect on medium-run proxies of productivity is in the range of 4 to 9% (depending on the proxy used and context). Third, the medium-run average effect on the business performance with other buyers is also large and positive (here we include other MNE buyers, domestic buyers, and buyers abroad). Fourth and last, the average effects mask critical dimensions of heterogeneity (e.g. the buyers in manufacturing and the more technology-intensive buyers are those triggering the most gains for their suppliers). This last finding is a note of caution regarding the type of MNE affiliates and linkages to these firms that governments might want to support.
Figure 1 summarises the firm-to-firm channels through which MNEs can affect the performance of domestic firms.
Figure 1: Summary of Potential Firm-to-Firm Linkages between Domestic Firms & MNEs
Linkages between MNE suppliers and their domestic buyers
A third type of firm-to-firm linkage between MNE affiliates in a country and domestic firms is that in which the MNE affiliate is a supplier of inputs (manufactured inputs or services) to a domestic buyer of such inputs. This type of linkage has customarily been called a 'forward linkage'. Forward spillovers could occur if MNE affiliates in a country supply inputs that embody new technologies or processes.
As in the case of “backward linkages," most of the research to date has used the data available at the time, namely firm-level panel data and sector-level input-output tables. In contrast to the studies on backward linkages, the studies on forward linkages only find a weak positive relationship between increases in foreign presence at the sector level and standard measures of productivity in downstream sectors (Havranek and Irsova 2011).
One potential reason why this literature has not developed as much as the one on backward linkages (in addition to the weaker evidence on positive effects from forward linkages) was the conjecture that buying locally from MNE suppliers is a plausible close substitute to importing (where barriers to import are lower than to export) – a conjecture that remains to be formally tested. Nonetheless, this close substitute argument does not apply to less tradeable services.
Policy implications and next steps
Future research is necessary to shed light on the following four issues. First, further research should seek to establish whether the results about linkages between the MNE and domestic competitors are driven by the firm's foreign ownership or merely by its large size.
Second, first-time suppliers to MNEs experience a series of interdependent improvements in efficiency, product scope, quality, and reputation. Estimating the magnitudes of each of these effects separately and their contributions to firm performance requires even richer data than the firm-to-firm transaction data and the adjacent data used in the papers cited above, and a controlled empirical environment, such as one provided by a randomised control trial.[8] Alfaro-Ureña et al. (2022) and Carballo et al. (2023) ran surveys to the first-time suppliers to MNEs that attest to the wide-ranging changes that they experienced after the first linkage with MNEs. According to the survey in Alfaro-Ureña et al. (2022), most first-time suppliers to MNEs undergo a series of interrelated changes, which include better managerial and organisational practices, expansions in product scope with higher-quality products, and improved reputation. These changes arise from interactions during which MNEs communicate expectations and advice, and from the effort exerted by new suppliers to deliver on their contracts. According to the survey in Carballo et al. (2023), first-time suppliers report channels that are coherent with both firm-level transformations (improving quality standards and internal procedures) and destination-specific mechanisms (helping with new commercial opportunities and helping sell to other affiliates of the same MNE). A related shortcoming of the research to date is that the productivity gains are not explicitly shown to arise as externalities. The estimated productivity gains could also result from market transactions (i.e. knowledge transfers that are paid for in one way or another) and not externalities. The distinction is essential, as only externalities warrant government interventions.
Third, MNE affiliates tend to be heavy importers, which limits the opportunities for domestic firms to start supplying to these multinationals and experience the benefits documented above. More research is needed into the extent to which MNE affiliates actually rely on local supply chains, the reasons behind their low reliance, and the scope for policymakers to intervene to increase this reliance.
Fourth, this literature needs a (tractable) general equilibrium analysis of the gains from MNEs in a context with firm-to-firm knowledge transfers and/or externalities. It is high time that the theoretical literature (with notable exceptions in Rodriguez-Clare 1996, Carluccio and Fally 2013) catches up with the empirical progress of recent years.
Finally, opening to FDI in service sectors such as banking, insurance, telecommunications, and electricity provision is likely transformative for domestic firms in downstream sectors. Our conjecture on the scant work in this space is the likely endogeneity of these FDI liberalisation episodes and the more concentrated market structure in these particular service sectors. An exception is the literature about retail FDI - though the emphasis there has been more on gains to final consumers and less on the gains to domestic buyer firms (see, for instance, Atkin et al. 2018). Work that appropriately deals with the endogeneity of these liberalisations and estimates their effects on domestic buyer firms is welcome.
Spillovers from MNEs through high-skilled immigration
Multinational activity is deeply interconnected with the movement of workers across borders. On the one hand, as migrants move across the world, they help reduce communication and information frictions between their origin country and the country they migrated to. The immigrant diaspora abroad helps promote trade and FDI, and boosts economic activity at the origin country. On the other hand, there can be a substitution effect between migrants and FDI, where whenever migration increases, there are less incentives for MNEs to offshore operations abroad. In addition to that, migration of high skill workers could cause a 'brain-drain' for the origin country by having emigrants work and consume abroad. However, migrants sometimes return to their home countries after a short period of migration, bringing newly gained skills that increase productivity.
The literature on migration and FDI has found both positive and negative effects for immigrant-sending countries. Using evidence from the United States, Kugler and Rapoport (2007) suggest that the data is consistent with migration and FDI being substitutes in the short run and complements in the long run. In the short run, larger stocks of immigrants increase the local workforce at the destination country and decrease the need for offshoring tasks abroad. However, as time goes by, immigrants form social and cultural connections that help increase FDI flows.
Tradeoff between migration and offshoring
There is ample evidence in the literature that larger availability of immigrants reduces offshoring in the years following the migration flow. While the term “offshoring” includes both FDI and activities outsourced abroad, outside the boundary of the firm, data availability often prevents this distinction. For this reason, we focus here on the relationship between migration and offshoring, with the understanding that the latter is a broader concept than FDI.
Glennon (2023) focuses on the H-1B visa programme for college graduates in the US. She shows that for every H-1B visa rejection, MNEs hire 0.4 more employees abroad, and the effect is stronger for MNEs with larger worldwide operations. Immigration restrictions in the US in 2004 led to a relocation of high-skill jobs to China, India and Canada. Similarly, Olney and Pozzoli (2021) use the random assignment of refugees across Danish provinces to study how offshoring by firms located in different provinces changes when they receive more immigrants. They find that a one percentage point increase in the share of immigrants reduces the probability of a firm doing offshoring by 6.4% and reduces the amount of offshore output by 12.1%. When immigration increases, aggregate offshoring goes down, but offshoring toward the origins where migrants come from goes up. High-skill migrants increase the probability of offshoring between countries, but have no effect on the quantity of offshoring.
A related area of research considers both immigration and offshoring as potential substitutes for native labour in receiving countries. Ottaviano et al. (2013) argue that immigrants tend to work in the least complex tasks, while offshore services tend to satisfy the middle-complexity tasks and native workers the high-complexity tasks. Hence, offshoring has the potential to replace both immigrant labour (taking over the most complex tasks among the low-complexity tasks) and native labour (taking over the least complex tasks among the high-complexity tasks). They also find that more immigration reduces offshoring and has no impact on native employment. Using a quantitative model, Mehra and Kim (2023) also point out that large firms are more likely to offshore when immigration is restricted.
Immigrants help build and reinforce FDI links
Immigrant diasporas can also encourage FDI and trade by lowering communication costs and information frictions between the origin and destination countries. This pattern has been widely documented for international trade, where an increase of immigrants from a given origin increases trade between the origin and destination countries (Gould 1994, Head and Ries 1998, Rauch and Trindade 2002, Combes et al. 2005, Ottaviano and Peri 2018, Bonadio 2023, Choi et al. 2023). As for the relationship between migrant diasporas and FDI, evidence is more limited. Javorcik et al. (2011) document a positive relationship between the number of immigrants from a given country in the US and FDI from the US into that country. They find the effect is stronger for those immigrants with a tertiary education. Establishing a causal relationship between immigration and FDI is difficult, since origin countries that send immigrants to the US can also experience productivity shocks that make them more appealing for FDI. Javorcik et al. (2011) deal with this issue by using an instrumental variable approach, but, since they only have aggregate data for the US by country of origin, they cannot control for immigrant origin-specific shocks.
Burchardi et al. (2019) overcome this issue by looking into FDI flows between US counties and foreign countries. Using data from Orbis, they compute the number of companies in a given US county that are headquartered abroad (inward FDI), as well as the number of subsidiaries abroad that are headquartered in each US county (outward FDI). Using variation at the US county-foreign country level allows them to control for both shocks to the local economy at the county-level and shocks to the immigrant’s origin country abroad. To establish the presence of immigrants from a given country across US counties, they construct a measure of “immigrant ancestry" that is independent from local productivity shocks and origin country shocks. Ancestry not only captures the current stock of immigrants but also those who migrated to the county in prior decades since the 19th century. They find that if the number of individuals with ancestry from a given country is doubled, the probability of having a firm engage in FDI with that country (either inflow or outflow) increases by 4 percentage points. They find evidence that both current immigrants and descendants of immigrants lower information frictions. The persistence of this effect beyond first generation immigrants indicates that immigrants transmit to their children information on social norms, language, social ties and culture that encourage FDI.[9]
Migrants as a vehicle for knowledge transfer
MNEs also benefit from migrants as a channel to transfer knowledge across borders. Morales (2023) finds that MNEs in the US disproportionately apply for H-1B visas for their home-country workers relative to other origin countries. This effect is large for most FDI origins and is particularly strong for countries where communication barriers with the US are higher. For example, countries that don’t have English as a prominent language and those that are far away from the US hire relatively more home-country immigrants. Using a unique dataset from Korean MNEs, Cho (2018) documents that MNE subsidiaries abroad employ Korean workers disproportionately in management positions and gradually hire a larger share of domestic managers as the subsidiaries grow. Both of these papers point out that home-country managers and high-skill workers, even in small numbers, have a positive impact on productivity and growth of MNEs.
Foreign managers act as intermediaries for knowledge transfer between the headquarters and the subsidiaries of an MNE. Guillouet et al. (2023) run an experiment with MNEs in Myanmar to test the implications of easing language barriers between domestic and foreign managers. They find that providing domestic managers with English training increases communication with foreign managers. They show that such increased contact allows domestic managers to acquire soft skills such as problem solving, negotiation, and customer relations, among others. Such transfer of management skills is a key benefit of migration for developing countries. Giorcelli (2019) studies a policy where Italian managers were sent to US firms for management training. She finds that those firms whose managers participated in the programme increased their productivity by 11.5% relative to non-treated firms even ten years after the programme. Treated firms were more likely to adopt American managerial practices and improve work and safety conditions than non-treated firms.
While migration encourages knowledge transfer across borders, sending countries could experience a brain-drain by losing skilled workforce to developed countries, which could harm their long-run productivity growth. However, migration is temporary in many cases, with migrants returning to their home countries after acquiring new skills abroad. Ding et al. (2022) provide an example of the skills returnees bring back, by looking at the foreign country experience of managers and board members of Chinese firms. Those who were international migrants and returned to China are more likely to promote outward FDI, particularly to the country where they previously migrated. Building on previous survey-based evidence in Gibson and McKenzie (2010) and theoretical insights summarised in Docquier and Rapoport (2012), Khanna and Morales (2023) suggest that —in addition to return migrants— migration prospects can increase human capital acquisition for those at the sending country. They suggest that the US demand for immigrant IT workers in the 1990s led to a 'brain-gain' in India. Many Indians studied computer science with the prospects of migrating, but ended up staying in India and helped develop the IT sector in the late 2000s.
Finally, migrants can be a channel for innovation within an MNE. Foley and Kerr (2013) look at the patenting behaviour and FDI of US MNEs. For each patent granted to MNEs, they assign an ethnicity to each inventor based on their names. They find that whenever an MNE has inventors from a given ethnicity, it increases its operations in foreign countries with such ethnicity. While US MNEs perform a majority of their R&D domestically, Foley and Kerr (2013) find that ethnic inventors also increase the probability of the MNE to perform R&D abroad. Bahar et al. (2022) look at work-related migration reforms across countries and their impact on the location of MNE innovation. They find that whenever a country imposes restrictions to migration, MNEs decrease innovation in that location and relocate R&D elsewhere. They argue that migration reforms in emerging markets such as China, India, Korea and Taiwan contributed to the relocation of global patenting by MNEs to those regions from 5% of total patents in 1990 to 25% in 2015.[10]
Policy implications and next steps
To sum up, while there is some degree of substitution between migration and offshoring, in the long run, migrants increase connections across regions through trade and FDI. They lower information frictions that help develop and maintain FDI links and also facilitate the transfer of knowledge across borders by bringing skills that lower communication costs and increase production. Academic research on this area has focused predominantly on the effects for the receiving economies, in large part because of data availability constraints. Sending countries rarely collect data on emigrants or identify return migrants in administrative data, which makes it hard to identify firms and regions that experience migration spillovers. To increase our understanding of this issue, we advocate for future research using data with information on which workers, firms and regions in the origin country are exposed to the FDI connections that migrants build.
In terms of policy, developing countries can find it beneficial to encourage migration as a strategy to increase trade and FDI links with developed countries. A potential policy could be to provide scholarships for college students to acquire skills abroad as well as supporting training programs for managers that foster learning from firms in developed countries. Tax incentives for return migration can also encourage migrants to work and innovate at their home country and increase local productivity. However, such policies have a tradeoff in terms of short versus long run outcomes: productivity increases in the home country of returning immigrants, while it may decrease in the country immigrants left.[11]
MNEs’ spillovers on finance and technology adoption
This section explores the link between finance and technology adoption by firms in general, and MNEs in particular. The development of financial markets and institutions plays a pivotal role in encouraging FDI and facilitating the establishment of MNEs, and in the upgrading of existing firms to multinational status. For example, Levine (1996) highlights how well-functioning financial systems can attract FDI and stimulate economic expansion. In the same direction, the findings in Rajan and Zingales (1998) reveal that strong financial markets can reduce barriers to FDI and encourage entrepreneurship. Similarly, Wei (2000) underscores the role of financial transparency and sound institutions in attracting foreign investors. Furthermore, Alfaro et al. (2009) examine the intricate connections between FDI and local financial markets, shedding light on the mechanisms that drive economic development through FDI inflows.
These contributions collectively stress the critical role of financial systems in fostering FDI and the growth of MNEs, underlining the significance of robust financial infrastructure for economic advancement. In this context, the role of technology and innovation also serves as a catalyst for FDI by expanding the reach of the financial sector and enhancing firm productivity.
As such, the synergy between financial development and technological progress plays a crucial role in shaping the global landscape of foreign investment and MNE expansion.
We start this section by describing the relation between the financial sector and technology adoption; then we study the role of technology adoption related to MNEs; lastly, we consider the role of technology adoption in the context of FDI promotion and spillovers. We conclude with some remarks on avenues for future research and policy.
Financial sector and technology adoption
The financial sector plays a prominent role in allowing local firms to adopt new technologies, to develop in size and productivity, as well as reaching new markets and countries. If local firms are financially constrained or facing inefficient financial markets, they may not adopt innovative technologies in spite of their profitability, or upgrade to a multinational dimension. Existing research supports this notion. First, Cole et al. (2016) show that technologies are not adopted by local firms when their financing requires long term contracts and the commitment of financial institutions to oversee the investment. Second, Buera et al. (2011) show that financial frictions disrupt the distribution of capital and entrepreneurial expertise among different production units. This results in a negative impact on measured productivity, particularly pronounced in sectors with a high degree of financial dependence, such as manufacturing. Third, Choudhary and Limodio (2022) show that when banks face an increase in their liquidity risk, due to intense deposit fluctuations and dysfunctional liquidity markets, they then reduce their supply of long-term finance. This leads to an overall reduction in investment, especially prominent for long-term projects.
However, in recent decades, the financial sector has undergone dramatic transformations due to technological innovations, with low- and middle-income economies being especially impacted. Hjort and Poulsen (2019) study the impact of the arrival of high-speed internet in Africa through fibre-optic submarine cables from Europe in the late 2000s and the early 2010s, which dramatically reduced the operating costs of internet connection in the continent.[12] The authors find important effects on labour and employment, as well as a notable increase in direct exports, since fast internet led to an increase in employment rate and created a new type of high-skilled jobs. Similarly, Hjort et al. (2020a) studied a training programme that taught small and medium-sized Liberian businesses how to sell to large multinational companies. They found that the programme had a big impact, especially on businesses with internet access.
At the same time, the advent of high-speed internet has revolutionised the banking and credit landscape, facilitating access to financial services for new segments of the population. According to D’Andrea and Limodio (2023), high-speed internet has played a prominent role in expanding the reach of banks and broadening credit availability in Africa. A central factor contributing to this expansion has been the adoption of a financial technology targeting commercial banks, the real-time gross settlement system (RTGS), a platform designed to reduce the costs and risks associated with inter-bank transactions, thus fostering quicker and more secure payments. This research leverages the presence of multinational banks to disentangle the effects of credit demand from those of credit supply, ultimately concluding that high-speed internet has been central in driving the enduring adoption of the RTGS technology, thereby promoting banking services and increasing access to finance, loans, and sales for firms.
Exploring changes in the financial sector is crucial, not just for their role in enhancing firms’ technology investments, but also because these changes introduce innovative technologies that reshape how firms transact and access new markets, ultimately contributing to their progression into MNEs. Verhoogen (2021) provides a comprehensive review of these mechanisms. The introduction of new payment systems, like debit cards or mobile money, affected how people save, borrow, and make financial decisions (Jack and Suri 2014, Brunnermeier et al. 2023). The adoption of these technologies crucially depends on network externalities. Essentially, a consumer’s benefit is indirectly determined by the widespread adoption among other consumers, as this increases the likelihood of suppliers adopting the technology (Katz and Shapiro 1986). Two important studies provide clear evidence on how coordination and externalities may boost fintech adoption. Higgins (2024) explores a Mexican government programme distributing about one million debit cards to recipients of a conditional cash transfer programme, which caused a large localised increase in consumer adoption of this payment method and a supply-side response, which in turn induced a shift in payment and consumption patterns. Exploiting the Indian demonetisation of 2016, Crouzet et al. (2023) show that this temporary shock led to a sustained increase in the use of electronic wallets, with roughly half of the total adoption response being due to complementarities among adopters.
While advancements in the financial sector due to fast internet bolster local economies, they also pave the way for FDI and the entry of MNEs—an understudied area of research. Such investments can act as conduits for technology diffusion in developing countries, amplifying the efforts of local firms in regions where human and physical capital are limited. Next, we explore how foreign direct investment may affect knowledge and technology diffusion in developing economies.
MNEs, FDI, and technology adoption
Research shows that FDI has generally positive impacts, albeit heterogeneous, on innovation (Javorcik et al. 2018), labour participation (Alessandria et al. 2021), and — as already summarised in Section 4.1 — local firms (Crescenzi and Limodio 2021). This section provides an overview of these effects, with special emphasis on knowledge and technology spillovers in developing countries.
The identification and quantification of spillovers from multinational companies to local firms has been challenging in the literature, since firms investing in low- and middle-income countries have a technological advantage and low incentive to share their knowledge with competitors (‘horizontal spillovers’). Lu et al. (2017) find that FDI in China had a negative impact on productivity of local incumbent firms and no sign of new technology adoption. On a different note, Javorcik (2004) shows that most of the positive spillovers of FDI are transferred vertically through the supply chain. Evidence from Lithuania during the post-Soviet privatisation process shows that firms benefiting from foreign direct investment (FDI) are not direct competitors. Instead, it is the companies supplying intermediate inputs to multinational corporations that compete with each other.
The benefits of FDI are not limited to European economies, and the case of Chinese FDI in Ethiopia provides interesting insights. Brautigam et al. (2013) interviewed foreign and Ethiopian-owned firms operating in the leather sector and found evidence of technological transfer, but also proof that local incumbents struggled to compete with Chinese firms. In this respect, Crescenzi and Limodio (2021) provide additional evidence of vertical positive externalities stemming from Chinese FDI in Ethiopia in both upstream and downstream markets, while local firms faced intense competition and shrank their operations.
Relying on 20 years of satellite data on night lights as a proxy for economic activity, Crescenzi and Limodio (2021) find that Chinese FDI had no instantaneous impact on growth, yet, over the medium term, there were positive and lasting effects, consistent with the hypothesis that local firms needed time to take advantage of knowledge spillovers. In complementarity with this study, the paper of Abebe et al. (2022) finds that FDI in Ethiopia has positive effects also on local incumbents through technology licensing from the foreign firm, or through informal spillovers, such as product imitation, hiring workers who previously worked for the foreign plant, and establishing contacts with customers and suppliers of MNEs.
FDI in Africa usually consists of a company building its operations from the ground up (greenfield investments). In other countries, foreign direct investment may also manifest in brownfield investments, where a MNE purchases local existing production plants. Indonesia represents an interesting case study: since the 1980s, trade barriers were eliminated and multinational corporations started to buy local firms. Arnold and Javorcik (2009) show that MNEs chose to acquire local production plants that were already more efficient than local competitors, and after the change of ownership their performance in terms of TFP and labour productivity increased even more. Such improvements stem from capital investments and technology, the adoption of innovative organisational practices, and the attraction of productive workers, who are paid higher wages. Blalock and Gertler (2008) use data on Indonesian FDI to describe a novel mechanism that complements the above-mentioned literature on vertical technology transfer.
As Javorcik (2004) points out, foreign-owned firms transfer technology to local suppliers, not competitors. The key to this process is that multinational companies benefit from these technology transfers only if they are shared among several suppliers and potential new market entrants, boosting competition in upstream markets and lowering prices. However, if the suppliers are not limited to selling inputs only to the foreign firm but also supply local companies, the foreign firm unintentionally spreads technology and lower prices to its competitors.
Despite the evidence that developing economies benefited from FDI, technology transfer may be limited by several factors. Local suppliers may need to finance their capital investment to develop new product varieties to supply the entrant multinational customer. Therefore, technology diffusion in developing economies may be limited by the level of development of local financial markets (Alfaro et al. 2010). MNEs tend also to relegate manufacturing in developing economies, while maintaining R&D in their home country (Arkolakis et al. 2018). When they actually invest in R&D abroad, they generate technology transfer and innovation clusters. However, the more technologically advanced corporations tend to more effectively prevent technology spillovers, as they can offer higher wages to retain their employees, and they invest strategically in countries with a limited ability to absorb their knowledge (Crescenzi et al. 2022).
FDI offers pronounced benefits to developing economies, yet its impact is nuanced by local constraints and MNE strategies. Understanding them is important for evaluating the positive effects of such investments. We explore these issues next.
Policy implications and next steps
Governments actively compete to attract foreign direct investment, as it is a catalyst to promote technology adoption, productivity, and economic prosperity. Yet, the competition for FDI is intense, and low- and middle-income countries often find themselves at a disadvantage compared to more advanced economies due to corruption (Wei 2000), lack of financial development (Desbordes and Wei 2017) and information asymmetries (Daude and Fratzscher 2008). In this subsection we analyse a few financial sector reforms that can promote FDI and the activity of MNEs.
One of the most successful policies promoting FDI is the liberalisation of the capital account, defined as the relaxation of restrictions on the flow of international capital (Bau and Matray 2023). Larrain and Stumpner (2017) in Eastern European countries and Bau and Matray (2023) within and across Indian states find that greater access to foreign capital fostered the development of their financial system and firms by improving the access to capital for more productive firms, with these firms, in turn, experiencing higher productivity.
At the same time, policies promoting trade liberalisation can promote FDI and the expansion of MNEs through a corporate finance channel via boosting mergers and acquisitions of firms. The work of Neary (2007), Bertrand and Zitouna (2006) and Breinlich (2008) show through theoretical and empirical work that opening to trade induces more efficient firms from countries with comparative advantage to expand by acquiring or merging with firms below the frontier in other countries, promoting the creation of MNEs. This is the case in the United States and Canada with the Canada–United States Free Trade Agreement (CUSFTA) of 1989, as found by Breinlich (2008), in the European Union, as in Stiebale (2016), but also for MNEs from China and India, as shown by Stiebale and Vencappa (2018) and Sun et al. (2012).
Another promising way to promote FDI and attract MNEs is to promote the expansion of multinational banks. Claessens and van Horen (2021) find a vital role played by foreign banks in facilitating international trade and investment. Multinational banks offer an established network of financial services and expertise, reducing information asymmetry and transaction costs for both investors and firms looking to expand into foreign markets. This, in turn, promotes cross-border capital flows and fosters a more favourable environment for FDI. MNEs often find it advantageous to operate in regions with an established presence of international banks, as it offers them access to a stable and comprehensive financial infrastructure, simplifying their entry and operational processes, which is in line with the findings of Aldatmaz et al. (2023) for international buyout investments.
At the same time, it is important to note a final point related to finance. Information asymmetries play a notable role in MNEs’ investment decisions. Besides government policies and financial sector reforms, technological innovation and foreign investments may also be affected by other decentralised factors. Immigration, for instance, can diminish information barriers and thereby boost FDI as studied in previous sections. Another important set of policies that have shown to have positive effects on attracting FDI through a plausible mechanism of reducing information asymmetries are investment promotion initiatives. These bundle various efforts by governments to attract investments through targeted outreach and international image building (Crescenzi et al. 2021, Harding and Javorcik 2011), and tariff reductions (McCaig 2011, McCaig et al. 2022).
In summary, there is evidence in the literature that several types of policies can be successful at attracting FDI. Some of these policies are directly related to the financial infrastructure of a country, like the liberalisation of the capital account and banking liberalisation policies.
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