ISLANDS of the WORLD VIII International Conference “Changing Islands – Changing Worlds” 1-7 November 2004, Kinmen Island (Quemoy), Taiwan
Foreign Direct Investment and the Creation of Local Linkages in Pacific Island Economies Robert Read1, Nigel Driffield2 1 2
Department of Economics, University of Lancaster, UK Aston Business School, UK
ABSTRACT The role of foreign direct investment (FDI) in small states is an issue that has been relatively neglected until relatively recently. In spite of the low levels of absolute inflows of FDI into small states however, foreign capital has the potential to create backward and forward linkages with local firms and also stimulate competition and exports. This paper analyses the extent of linkages and spill-over effects arising from FDI in small states based upon recent case-study research in the Pacific. It attempts to identify the potential contribution of FDI with respect to firm-level case studies in Fiji and Samoa and considers the policy implications of FDI inflows for small states in general. Key words: small states, FDI, local linkages, spill-overs.
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1.FDI in Small States, Inferences for the Pacific Island Economies A sizeable proportion of all states in the world economy can be regarded as being relatively small, many of which are also developing economies. It is only recently however, that academics and policy-makers have paid attention to the critical factors influencing the growth performance of small states and, in particular, the potential contribution of FDI. Any discussion of the impact of FDI inflows therefore needs to consider the specific economic characteristics of small states.
The Critical Economic Characteristics of Small States There is now a substantial literature concerning the nature and implications of the critical economic characteristics of small states for their growth performance (reviewed in Armstrong & Read, 2003). These characteristics can be summarised as being: • The small size of the domestic market. • The limited domestic resource base. • The narrowness of domestic output, exports and export markets. • Their high degree of structural openness to trade. • Additional transport and communication costs of being islands, archipelagos or land-locked. These characteristics have important implications for the economic performance of small states, which can be considered in the context of key variables identified in endogenous growth models: • Openness to trade. • Human capital formation. • The quality of endogenous policy. • Convergence clubs. The empirical analysis of the economic performance of small states suggests that growth success is positively related to the sectoral structure of their domestic economic activity as well as being influenced by their location. Being an island or archipelago is not necessarily a constraint on their growth. In addition, many small states have demonstrated that, in spite of the adverse growth implications of their critical economic characteristics, that they have been able to devise appropriate domestic policies that promote growth (Armstrong et al, 1998; Armstrong & Read, 1998a; Armstrong & Read, 2002; Read 2002).
The Ability of Small States to Attract Inflows of FDI to Small States Inflows of FDI to small states can be expected, in general, to be relatively small in absolute value terms. As a consequence, the literature on FDI has not been especially concerned with the determinants of FDI flows to small states, particularly those that are still developing. Further, very little is known about the impact of such FDI inflows and their interaction with the key economic characteristics of small states. Of critical importance in the context of this paper is the ability of small states, particularly small developing ones, to attract inflows of FDI. The literature addresses the issue of the determinants of FDI inflows through the identification of advantageous factors that are specific to
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particular host locations – generally referred to as ‘location advantages’ (Dunning, 1979). The principal sources of location advantage that may potentially be possessed by host small states are: • The low cost availability of raw materials and/or intermediate inputs, including labour. • The low cost availability of specific labour skills (human capital). • Agglomeration economies arising from the presence of clusters of related producers and/or suppliers. • Supportive government policies, including economic and political stability. • A familiar business, cultural and legal environment.
The Motives for FDI in Small States The FDI literature also identifies four major factors that drive inflows of investment into particular host countries so as to capture the benefits of these location advantages. Resource-Seeking FDI This is driven by the availability of particular resources in a host country, including natural resources, low costs labour and specific skills. In the case of small states, this type of FDI is unlikely to be seeking abundant low cost labour generally associated with labour-intensive manufacturing activities. Such FDI however, may make use of relatively low cost labour as a complementary input in production during the initial stages of development when the local labour supply constraint is relatively slack. Small island states, such as those in the Pacific, may possess access to abundant natural marine resources given their Exclusive Economic Zones (EEZs). Natural resources including sunshine, scenery and beaches as well as cultural artefacts may also attract tourism, which is reliant upon complementary inputs of relatively low-skilled labour. Efficiency-Seeking FDI This is driven by the international competitiveness (comparative advantage) of a host country as a location for export-oriented (export-platform) production. This type of FDI is most commonly associated with labour-intensive manufacturing but is increasingly a feature of FDI in labourintensive service activities such as data processing and offshore call-centres. There may therefore be some degree of overlap between resource- and efficiency-seeking FDI. Small states however, are unlikely to be major beneficiaries of efficiency-seeking FDI since it is founded upon interaction between scale economies and the international division of labour that tends to favour more populous developing countries. Theoretical inference, supported by large-scale cross-section empirical evidence, suggests that the comparative advantage of small states is instead likely to lie in niche manufacturing and service activities, including tourism (Armstrong et al, 1998; Armstrong & Read, 1998a, 2002). Market-Seeking FDI This type of FDI is driven by the existence of an extensive and prosperous domestic market that requires firms to be located in proximity to their customers. This also suggests that there are likely to be potential gains from economies of scale in production and distribution activities as well as in servicing the market. Tariffs and other barriers to trade may also encourage such investment. In general, market-seeking FDI is unlikely to be attracted to small states because of the small size of their domestic markets, regardless of per income levels. Instead, their markets will be supplied if at all by exports from low cost supply sources.
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Strategic Asset-Seeking FDI This type of FDI is driven by the strategic objectives of multinational enterprises to pre-empt the acquisition of strategic assets by their competitors. This strategy is often revealed in the purchase of dominant local firms in emerging markets. Access to natural resources may also be regarded as a strategic asset. It is unlikely therefore that small states are major recipients of such FDI inflows.
Inflows of FDI to Small States: Empirical Evidence The international distribution of FDI has been subjected to extensive empirical analysis over the last four decades. Much of the focus of this literature has been investment in the leading industrialised countries, which comprises the greater part of global flows of FDI – over 80 per cent. There also exists a less substantial literature on FDI in developing countries. The issue of FDI inflows to small states has not been addressed with the exception of a recent investigation by Read & Soopramanien (2003). This empirical neglect is hardly surprising given the very low absolute levels of FDI flows to small states. In the context of the analytical literature on the economic performance of small states however, this is an important omission since even small inflows of FDI are likely to have significant potential impacts on small host economies. The Read & Soopramanien study investigates three principal hypotheses in the context of the determinants of FDI inflows to small states: • That the absolute and relative volume of FDI inflows to small states are lower than might otherwise be expected because of their small size. • That FDI inflows to small states are lower than might otherwise be expected for any given level of income, both national and per capita. • That the sectoral distribution of FDI inflows to small states will follow the sectoral pattern of specialisation identified in the empirical growth literature. The empirical analysis of FDI inflows to small states suffers from severe data limitations. Statistics on FDI inflows are only available for a limited set of small states - such that there is sample selection bias – and there is no comprehensive global data set on FDI inflows by sector. In spite of these data constraints, Read & Soopramanien find that FDI inflows are, as expected, lower in absolute terms but not necessarily in relative terms than in larger states (Read & Soopramanien, 2003). Further, aggregate and per capita income levels appear to have little impact on their own although this effect is much greater when taken in combination with population. This result suggests that the income determinant of FDI dominates the size determinant. Given that it is data for the smallest and poorest small states that is generally missing, these effects are likely to be more significant in actuality. The sectoral FDI results have greater significance and tend to confirm the sectoral growth findings. FDI inflows are positively associated with the existence of substantial natural resource and service sectors but inversely related to agriculture. As in the empirical growth models, the results for manufacturing are inconclusive.
Inferences for FDI Inflows to Pacific Island Economies The above theoretical and empirical discussion generates several inferences with respect to the prospects of small states, and Pacific Island economies in particular, to attract inflows of FDI. • Small economies generally are likely to attract less FDI inflows in both absolute and relative terms because of their small market size, such that they are unlikely to attract market-seeking FDI. • The low absolute and relative levels of FDI inflows are likely to be particularly acute for small developing states, such as those in the Pacific Region, because of their low incomes.
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• Small states are most likely to attract resource-seeking FDI based upon their comparative advantages in natural resources and services, notably tourism. • Efficiency-seeking (ie, export-platform) FDI in small states is likely to be severely constrained by low economies of scale and labour supply issues. • Export-platform FDI in Pacific Island economies is likely to be additionally constrained by high transport costs resulting from their relative isolation unless founded primarily upon low-cost local inputs. • The impact of any inflow of FDI to small developing states, such as to Pacific Island economies, has the potential to generate a significant local impact in both absolute and relative terms. • Pacific Island economies and small developing states in general therefore need to maximise the benefits of any inflows of FDI that do occur.
2.FDI Inflows and Local Linkages in Small States The theoretical and empirical literature on the impact of inflows of FDI on host economies focuses on the creation of local linkages. This Section outlines the principal means by which local linkages are created by FDI inflows and considers the potential for such effects in the context of the economic characteristics of small states. The literature on the creation of local linkages identifies several types of linkages that may potentially be created in the host country economy as a result of FDI inflows. These arise as a result of both direct impacts in terms of employment and technology transfer as well as indirect impacts through the generation of positive and negative externalities in the host country economy.
Direct Linkage Effects of FDI Inflows: Employment Creation & Technology Transfer The positive employment effects of FDI inflows are the most direct form of local linkage creation in host country economies. These linkage effects can be measured very simply in terms of aggregate employment impact of any particular FDI inflow. The employment creation effects of FDI inflows may also have local multiplier effects in terms of technology or productivity spillover effects. This is based upon the general expectation that the technologies employed are in some way superior to those available domestically and will raise the productivity of the local labour employed. FDI inflows may however, have a ‘crowding-out’ effect on the local labour market if the availability of particular skills is constrained. This effect is likely to be greater in developing countries because of potential skill shortages and in small states because of potential labour shortages.
Indirect Linkage Effects: Externalities & Spillovers Inflows of FDI may have beneficial developmental impacts over and above its direct employment and technology effects as a consequence of externalities and spillovers. These are expected to generate increased production and allocative efficiency in a host-country. Technology Spillovers FDI inflows often introduce new technology to a host-country. This new technology may then be accessed by domestic firms through several mechanisms: buyer-supplier linkages, licensing, subcontracting, labour mobility and training. These mechanisms are both dependent upon, as well as indicative of, the extent of linkages between the foreign and domestic sectors. Less formal spillovers linked to agglomeration and demonstration effects may also occur whereby domestic firms learn improved management and/or organisational techniques.
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Agglomeration Economies An important indirect spillover effect is the extent to which agglomeration economies occur. These arise from the geographic proximity of similar, technologically advanced enterprises. The presence of multinational enterprise as leaders in both technological and capital accumulation serves to further stimulate the possibility for agglomeration. This increases the potential for technology transfer and therefore for improvements in the technological capabilities of domestic firms. Agglomeration also promotes the creation of a localised pool of specialised labour skills and the potential for sub-contracting. Both of these effects may give rise to additional positive externalities through demonstration effects via the transfer of knowledge and managerial skills. Knowledge Economies Foreign investors generally possess an array of non-technological advantages that may improve the efficiency and competitiveness of host country production activities through beneficial spillovers. These include managerial abilities, organisational economies of scale and scope and greater efficiency in resource co-ordination. Perhaps the greatest potential for knowledge spillovers lies with the ‘demonstration effect’ upon local firms. Competition Effects
Inward investment may also improve aggregate productivity through competition effects. These are the result of domestic firms responding to FDI inflows by seeking to become more productive and cost-efficient, which may include beneficial demonstration effects. Increased competition arising from the presence of foreign firms may however, have negative externality effects if they ‘crowd-out’ local firms rather than stimulate domestic competition. Small states are especially vulnerable to competition problems arising from the small size of their domestic markets (Armstrong & Read, 1998b). This suggests that small states are greatly exposed to these potentially negative externality effects. FDI & the Scope for Local Linkages in Small States The theoretical and empirical review of the literature on small states suggests that their growth is constrained by several key factors. These factors have important implications for the ability of small states to attract inflows of particular types of FDI. Together, these effects mean that the scope for the creation of beneficial local linkages in small states is also likely to be limited. Their small size means that their domestic economic structures are both narrow and shallow, so restricting the potential for linkage and spillover effects. In addition, linkages that are particularly associated with market-seeking FDI are unlikely to be developed. Employment & Technology Effects of FDI Inflows in Small States The employment effects of FDI inflows in small states are expected to be positive but limited. The capacity constraint on the local supply of labour means that FDI is unlikely to take place in largescale labour-intensive activities. Flows of FDI to small states are most likely to be natural resource- and/or efficiency-seeking, targeting some resource-based, manufacturing and service activities. The consequent employment effects will therefore be determined by interaction between the nature of the technology employed, including scale economies, and relative labour costs. The greater the domestic stock of human capital, the greater the likely technological intensity of the FDI in small states. Direct Linkage Effects of FDI Inflows in Small States The direct effects of inflows of FDI are expected to generate positive spillover effects through the creation of vertical linkages. These work through quality and volume effects on both upstream local firms supplying inputs and downstream on local firms and consumers of outputs. The scope for creating these direct linkages in small states however, can be expected to be limited by the
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‘shallowness’ of their economies. This is caused by the small size of their domestic markets and the size constraints on the array of feasible domestic activities. This does not rule out the creation of direct linkage effects but rather suggests that they are likely to be much smaller than would be expected in the case of a larger economy. In some circumstances, the creation of direct linkages may lead to the emergence of vertically-integrated enterprises. In a small economy, these could have potentially anti-competitive implications for local suppliers and customers. Indirect Linkage Effects of FDI Inflows in Small States The indirect linkage effects of FDI inflows arise from the positive and negative externalities generated by the local activities of foreign firms. These spillover effects depend upon the presence of other firms, local and/or foreign, producing similar goods or services leading to beneficial technology, competition and labour skill effects. In small states however, the small domestic market size and the consequently small number of incumbent firms suggests that there is limited scope for such externality effects. FDI in this case may in fact generate adverse effects if domestic firms are ‘crowded-out’ by the intensification of competition in the local market. The positive indirect linkage effects can be expected to be greatest in magnitude for export-oriented resourcebased and efficiency-seeking activities in small states that are sustained by the international market. Local Linkages in Small States: Concluding Comments This discussion suggests that the beneficial linkage effects of FDI inflows in small states, a priori, are likely to be greatly constrained by the limited absorptive capacity of their domestic economies. The greatest potential for the creation of positive local linkages lies in export-oriented activities based upon inflows of resource- and/or efficiency-seeking FDI. As identified earlier, these are the principal types of FDI attracted to small states, primarily because of their small domestic market size and openness to international trade. The case study foreign investments in resource-based and manufacturing activities in two Pacific island economies discussed in this paper therefore provide an important opportunity to establish the nature and empirical magnitude of these potentially beneficial linkages.
3.Evidence of Local Linkage Creation from FDI in Pacific Island Economies The primary objective of the research was to identify and establish the magnitude of local linkages and other spillovers generated by selected resource-based and manufacturing foreign investment in Pacific Island economies, based upon evidence from Fiji and Samoa. There have been few, if any, empirical analyses undertaken of these types of industrial activity in small states and certainly none that attempt to quantify their linkage effects. The study has therefore generated findings and policy-recommendations that are of relevance to the host-countries concerned but are also generalisable to other Pacific Island economies and small states elsewhere.
Research Methodology The research methodology was based upon five case studies of firms established by foreign investors in Fiji and Samoa. The specific focus being downstream natural resource processing and manufacturing activities given that these two countries can be viewed as being representative examples of Pacific Island economies for the investigation of linkage and spillover effects. Commercial and financial information was collected from foreign investors was collected through questionnaires to provide a means of quantifying the magnitude and extent of their linkages with domestic firms. This data was supplemented by additional information and details on the nature of their linkages derived from structured face-to-face interviews with the case study firms’ senior management.
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Additional supporting information was derived from interviews conducted with representatives from government ministries, agencies and other concerned institutions. These provided an alternative perspective on critical policy issues as well as an understanding of the rationale behind various policies and initiatives, not always evident from secondary sources.
The Principal Findings Concerning the Creation of Local Linkages The principal findings of the study are summarised in Table 1, which sets out the magnitude of the local linkages according to the productive activity and the type of linkages being generated. These findings provide the first empirical evidence of the generation of local linkage effects in small states resulting from FDI inflows Employment & Technology Effects The principal sources of linkages arising from inflows of FDI in the case study firms are employment and technology. The magnitude of these linkages is determined by the relative labour intensity of the activities located in the host-country and the associated technology. A critical problem evident in both Fiji and Samoa is the shortage of skilled labour. This problem is more pressing in Fiji, given its larger size and the more sophisticated nature of its domestic technology and production activities. This scarcity of skills adversely affects the productivity of the labour employed directly by investors and also inhibits the development of local supply industries. This has resulted in the case-study firms initiating their own training schemes as well as substituting capital for labour in some activities, ie de-skilling. The study findings suggest that the magnitudes of the technology and employment effects are constrained by the scarcity of specialist technical and vocational skills in local labour markets. Although the governments of both Fiji and Samoa are investing in skills acquisition through formal training schemes and vocational education, important skill-shortages and mismatches still remain in local labour markets. This situation is exacerbated by high rates of emigration among highly qualified local people while, at the same time, foreign investors are forced to rely upon expatriates with the requisite technical skills and know-how. This problem is typical for many Pacific Island economies. Direct Linkage Creation Direct linkages relate to the use of local supply sources for inputs by foreign investors as well as their securing of downstream markets for their output. The narrowness and shallowness of domestic economic activity in many developing countries, and small developing states in particular, means that local sourcing may not be possible because of a shortage of suitable inputs. This view is confirmed by the fact that most of the case study firms are reliant upon relatively costly imported inputs. The primary exceptions to this are the investments based upon local natural resource processing. These case study firms make significant contributions to their host economies in return for these resources, either in the form of direct payments to local producers or as rents in the form of licences. Most of the complementary inputs in production however, are imported. There is some evidence of the local sourcing of complementary inputs by nearly all of the case study firms. In general, these inputs are of support services, such as packaging and transportation. In one case however, the foreign investor also engages in a relatively high degree of sub-contracting with local manufacturers that also give rise to beneficial indirect spillover effects and agglomeration economies. All of the case study firms are highly export-oriented such that very little evidence of the creation of downstream direct linkage effects is found. This is not particularly surprising, given the small size of the domestic markets in Fiji and Samoa as well as the case study firms’ resource- and efficiency-seeking motivations for their investments. Small states cannot be expected to derive significant benefits from the downstream linkages of FDI inflows.
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Indirect Linkage Creation The indirect linkages generated by FDI inflows arise from beneficial spillover effects as a result of labour turnover among skilled workers, technological upgrading by local firms and the increased intensity of domestic competition. It is evident from the firm case studies that labour turnover among key skilled workers is extremely low with the exception of some relatively low-skilled employees. This means that the positive spillover effects with respect to skills transfers are also relatively low. Further, the low technological capacity of many local firms (where they are present) inhibits the potential benefits of the transfer of technology and know-how as well as the scope for competition spillovers. In the specific case where a relatively high degree of local sub-contracting by the foreign investor is found, this is likely to have created beneficial indirect spillover effects. These are in the form of positive quality control, organisational and managerial effects on its local suppliers. Evidence is also found of potentially negative competition spillover effects in Samoa arising from the market power of foreign investors in the local sector. Competition problems are not unusual in small states because of the impact of scale economies in a small market. There is no evidence to suggest that the dominance of one case study firm in Samoa has had adverse effects to date. In fact, it may have had a beneficial impact in that it has facilitated local entry to the sector by reducing some entry barriers. There is some evidence to suggest that another case study firm in Samoa has had an adverse competitive effect on the access of local firms to domestic supplies of a shared natural resource. This is because the relatively inelastic response of local producers to price incentives has created a local supply constraint. These two cases highlight the importance of monitoring competition in small states, regardless of whether firms are foreign or locally owned. Agglomeration Economies Agglomeration effects generate beneficial domestic linkages as result of the spatial concentration of firms related to a particular sector. These include external economies of scale and scope through the creation of a large pool of specialist skilled labour as well as attracting firms supplying inputs and support services. The case study findings highlight the potential for agglomeration economies in some sectors as a result of FDI inflows. To date, these effects have been greatest in Fiji where local sub-contracting has been developed between the case study firm and specialist local firms. Agglomeration economies in other sectors however, have failed to develop in spite of their potential. This is primarily because of the reluctance of local firms in the sector to co-operate in joint-purchasing and sub-contracting. The generation of agglomeration economies in activities that include local input suppliers are believed to be important factors in attracting further inflows of foreign investment into these sectors.
Constraints on the Creation of Linkages by the Case Study Firms The general level of the linkage and spillover effects found in this study are much lower than might be expected on the basis of empirical work on larger more developed economies. Several reasons can be identified for the failure of these linkages and spillovers to develop to their full extent in Fiji and Samoa and, possibly, therefore elsewhere in the Pacific Region. The Size of the Host Economy Theoretical inference concerning the limited potential for the generation of linkage and spillover effects in small states appear to be confirmed by the case study findings from Fiji and Samoa. The size of these host economies appears to have three separate but inter-dependent effects on linkage creation. • The general level of development of the host economy. The types of FDI attracted to developing states and the forms of linkages that they are able
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to support are much more limited than in the case of more industrialised economies. • The types of FDI inflows attracted to small states are likely to be confined to resource- and efficiency-seeking as opposed to the full range of foreign investment in larger states. • The narrow and shallow economic structures of small states hosting FDI further limit the potential scope for creating local linkage and spillover effects. Industry Characteristics It is not possible to divorce the impact of inward investment from its underlying motivations. Resource-seeking investments are largely concerned with the basic processing of locally-sourced natural resources which are then exported. The local linkage effects of resource-based FDI are generally related to the high levels of local inputs of that resource but are often coupled with low levels of domestic value added beyond a price mark-up prior to exporting. The findings from the firm case studies in Fiji and Samoa tends to support this view. Efficiency-seeking investments in developing countries are concentrated mainly in the manufacturing sector and tend to be attracted by low labour costs. A common problem of this type of investment is that its primary focus is to stimulate exports; as such, they often tend to be simple export-oriented assembly operations processing imported semi-finished goods. The aim of this FDI is to minimise costs such that these investments cannot be expected necessarily to generate significant beneficial local linkage and spillover effects. The findings of the firm case studies suggest that the principal contribution of these foreign investments is their direct employment effects. There is also however, some evidence of additional linkage and spillover effects, both actual and potential, arising from local sub-contracting and local sourcing of key inputs. The Availability of Local Skills The case study evidence suggests that these inflows of FDI have introduced some new technologies into the two host-countries but also that technology transfer between the inward investors and domestic firms has been minimal. A critical constraint on successful technology transfer is the extent to which the domestic sector in a host-country is able to assimilate these externalities. This is, in turn, dependent upon the technological competence and skill intensity of the local producers. The local labour forces in Fiji and Samoa do not appear to have the requisite skills necessary to support inflows of FDI. This contrasts with countries such as Ireland, Malaysia and Singapore, where inward investment has encouraged the development of indigenous firms in associated industries. The case study findings for Fiji and Samoa however, indicate that the firms have experienced significant skill shortages and these have inhibited the growth of local labour productivity. Crucially, the activities where local firms and workers have gained most from FDI inflows are those where there is public provision of high level training. The case study firms have undertaken the internal training of manual labour to ensure that workers are competent but they all employ expatriate contractors to maintain and repair machinery. This suggests that there is a need for substantially increased quantity and breadth of the public provision of vocational training and the acquisition of technical skills. The lack of local labour with good engineering skills is a problem in both countries. The indirect spillover effects from the movement of skilled labour between the foreign and domestic sector are also found to be low in Fiji and Samoa. This is because the general level of labour turnover in the case study firms is very low. Foreign investors in general tend to pay the highest wages in host countries and the case study firms here are no exception to this. Nevertheless,
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labour turnover and therefore indirect skill spillovers are also low because of limited alternative employment opportunities, high unemployment or under-employment – notably in Samoa – and the low level of embodied skills of many of the local employees. Existing Policies to Create Local Linkages Government policies that seek to encourage inward investment purely on the basis of export and capital subsidies tend to succeed in attracting export-oriented FDI inflows that have little interaction with local firms. This is also the type of investment that generates the most ‘crowdingout’ of the domestic sector. Several of the case study firms here imported much of their technology and capital equipment second-hand. While there are good reasons for doing so in some cases, it does suggest that very little in the way of ‘leading-edge’ technology is being employed by the inward investors. The findings of this study also highlight the fact that, in many cases, the extent of the linkages and spillovers being created and their potentially beneficial effects are not being maximised in the host-countries. This is a critical issue and the challenge for policy-makers in these circumstances is to find the means to maximise the local content of these activities. Elsewhere, inward investment incentives have been linked, not only to local content requirements but also, to sub-contracting arrangements or technology transfer agreements. These types of arrangements however, require a threshold level of industrial infrastructure, which may be lacking, particularly in small developing countries such as the Pacific island economies. It is reasonable to assume that, over time, inward investors naturally increase local inputs as they find local sources or the economy shifts resources to meet demand. It should be possible however, to speed up this process through Government policy initiatives.
4.Conclusions & Policy Implications of the Findings for Pacific Island Economies The case study findings demonstrate that small states, such as those in the Pacific Region, are able to attract inflows of FDI and also generate an array of local linkage and spillover effects with domestic firms. These linkages include sub-contracting, joint-purchasing and agglomeration effects. Domestic firms have also gained access to imported technology and superior logistic and transport networks. These effects have developed in spite of the limited potential for small states to create such linkages. The challenge for governments and foreign investment agencies in the Pacific region is twofold: to attract inflows of FDI and to see this inward investment as a means by which the general level of technology employed in their economies can be increased. The five case studies analysed here provide substantial evidence of the creation of these effects resulting from the foreign-owned firms becoming increasingly embedded in the local economy. Attracting ‘Appropriate’ Inflows of FDI The growth success of small states is closely related to their high degree of openness to international trade. The small size of their domestic markets means that development strategies based upon import-substituting industrialisation are unlikely to be sustainable in the long term. Openness to trade promotes export-oriented growth founded upon underlying comparative advantage. Inflows of FDI to small states can therefore be expected to be primarily confined to resource-based and export platform activities. Most Pacific island economies are quite similar in terms of their domestic economic activities and factor endowments, such that they have similar patterns of specialisation. This suggests that they are likely to be competing with each other for the limited funds available for potential resource-seeking investments in the region. Even if they are successful in attracting such inflows,
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the ‘fallacy of composition’ may intensify inter-island competition in these products in the region’s principal consuming markets. The relatively close proximity of some Pacific island economies, such as Fiji and Samoa, to the high wage economies of Australia and New Zealand however, suggests that there is some potential for efficiency-seeking investment subject to the availability of appropriate labour. In spite of the success of the Foreign Trade and Investment Board (FTIB) in Fiji in attracting some FDI inflows, government policy towards established foreign investors has been inconsistent and, at times, discriminatory. These mixed signals are likely to deter many new potential investors. Government policies have tended to favour foreign firms that are less well embedded. Red tape and administrative inertia are also a problem in Fiji. Samoa has only attempted to attract inflows of FDI more recently. The country therefore needs to establish a track record on foreign investment and a reputation for treating inward investors in a consistent manner. The current revisions to Samoa’s Foreign Investment Act regulations have created a degree of uncertainty leading to likely delays in new investment decisions. There is also evidence that the Government has extended preferential treatment in terms of duty-free access to imported inputs and other fiscal incentives to favoured investors. This strategy is clearly inconsistent with Samoa’s policies towards other foreign investors and domestic firms. Fostering Local Linkage Creation Policies that are designed to foster the creation of domestic linkages by foreign investors are generally separate and distinct from those designed to promote increased inflows of FDI. Many countries in Sub-Saharan Africa and Southeast Asia have established free trade or export processing zones (EPZs) to attract inward investment. The Kalabo Industrial Estate was originally set-up along these lines by the Fijian Government. A critical shortcoming of this strategy however, is that it fails to distinguish between the quantity and quality of inflows of foreign investment. These zones and their associated regulations are prone to encouraging enclaves of inward investors operating in isolation from the host-country economy. Many such firms generally process imported components or materials for re-export such that the only locally sourced input tends to be labour. It can also be argued that the export-oriented downstream processing of natural resources has a similar enclave effect that is more difficult to avoid and which inherently limits the generation of local linkages. The challenge to attract inflows of high ‘quality’ foreign investment is particular pertinent in the case of small states. The generally shallow nature of domestic activity means that it is possible to source only a few inputs locally. In this context, the local linkages and spillover effects generated by the case study firms in Fiji are therefore extremely interesting examples. The resource-based case study firms in Fiji and Samoa have generated only limited linkage and spillover effects, apart from direct employment, but also involve transfer payments that represent rents on their natural resources. The substantially greater benefits to be derived from attracting high quality foreign investment mean that Government and institutional policies towards inflows of FDI cannot be divorced from those seeking to foster local linkages. There is little evidence from the case studies that government initiatives have themselves resulted in increased linkages between the foreign and indigenous sectors in either Fiji or Samoa. Those local linkage and spillover effects that have been created are the results of commercial decisions being made by the case study firms. Nevertheless, there still remains further scope for creating linkages, partly because the inward investors have either failed or been unable to develop them. In addition, the very nature of spillovers means that they are indirect effects arising from the presence of foreign firms. From a policy perspective, attracting inflows of FDI is insufficient in itself to foster beneficial linkage and spillover effects. Maximising the potential of FDI inflows instead requires concerted
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policy action on the part of Government and/or investment agencies to encourage the creation of these beneficial linkages. This requires the formulation of investment support strategies to encourage and assist in the development of further linkages. The case study evidence suggests that all of the investing firms have succeeded, to varying extents, in generating positive linkage and spillover effects. Without institutional policy support however, the full domestic economic growth potential of these investment inflows may not be achieved. This supports the view that there is a pressing need for ‘aftercare’ to be extended to FDI inflows. That is, that the full benefits of foreign investments may take some time to be achieved. Further, there is no guarantee that all of the potential linkage and spillover effects will emerge in response to market forces and a passive policy stance. Markets do not always work perfectly, particularly in developing economies, and effective intervention may therefore be necessary to deal with distortions and market failures. The health and beneficial impacts of existing investments are therefore as important as attracting new inflows of FDI.
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Table 1:
Summary of Local Linkages Generated by FDI by the Case Study Firms in Fiji & Samoa
Case Study /Linkage Type
Technology
Employment
Backward
Forward
Indirect
Marine Resource 1 – Fiji
99
99
99
9
9
Marine Resource 2 – Samoa
99
99
99
99
99
Agricultural Resource – Samoa
99
9
999
x
9
Manufacturing 1 – Fiji
99
99
9
x
9
Manufacturing 2 – Fiji
999
999
99
x
99
Source: Table 1, Read & Driffield (2004).Notes:
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9, limited; 99, some; 999, substantial; x, none.
ISLANDS of the WORLD VIII International Conference “Changing Islands – Changing Worlds” 1-7 November 2004, Kinmen Island (Quemoy), Taiwan
Notes Department of Economics, Lancaster University Management School and Aston Business School, UK. This is a draft paper and should not be quoted without the permission of the corresponding author (Robert Read), e-mail:
[email protected]. The authors acknowledge funding for this research from the Foreign Investment Advisory Service (FIAS) of the World Bank/International Finance Corporation (Sydney) on behalf of the Pacific Islands Forum Secretariat. The authors are grateful to Sean Duggan of FIAS for his detailed comments and constructive advice and to the participants at the Pacific Region Heads of Investment Promotion Authorities Meeting (HIPAM), Tokyo, 24 and 25 September 2003.
References Armstrong, HW, R Jouan de Kervenoael, X Li & R Read (1998), ‘A comparison of the economic performance of different micro-states and between micro-states and larger countries’, World Development, vol 26, no 4, pp 539-56. Armstrong, HW & R Read (1998a), ‘Trade and growth in small states: the impact of global trade liberalisation’, World Economy, vol 21, no 4, pp 563-85. Armstrong, H.W., & R. Read (1998b), ‘Trade, competition and market structure in small states: the role of contestability’, Bank of Valletta Review, no. 18, pp. 1-18, December. Armstrong, HW & R Read (2002), ‘The importance of being unimportant: the political economy of trade and growth in small states’, in SM Murshed (ed), Issues in Positive Political Economy, London: Routledge, pp 71-88. Armstrong, HW & R Read (2003),The determinants of economic growth in small states’, The Round Table, vol XCII, no 368, pp 99-124. Dunning, JH (1979), ‘Explaining patterns of international production: in defence of the eclectic theory’, Oxford Bulletin of Economics & Statistics, vol 19, no 1, pp 1-29. Read, R (2002), ‘Growth, economic development and structural transition in small vulnerable states’, in SM Murshed (ed), Globalisation & the Obstacles to the Successful Integration of Small Vulnerable Economies, London: Routledge, pp 171-84. Read, R & N Driffield (2004), Linkages & Flow-On Impacts of Foreign Investment in Pacific Island Economies: Final Report, Report for the Pacific Islands Forum Secretariat, Suva, Fiji, Sydney: FIAS. Read, R & D Soopramanien (2003), ‘FDI in small states: an exploratory investigation’, paper presented at the 28th IESG Annual Conference, International Factor Mobility, Trade & Growth, University of Birmingham, 9 & 10 September, mimeo.
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