Foreign Direct Investment as a Conduit for Technology Transfer: The Case of Vietnam Sajid Anwar University of the Sunshine

Coast & Lan Phi Nguyen State Bank of Vietnam Abstract

By making use of panel data that involves 23 manufacturing industries over the period 1995-2005, this paper examines the impact of foreign direct investment generated spillovers on total factor productivity in Vietnam. Following the existing literature a positive relationship between foreign direct investment and total factor productivity is viewed as evidence of technology transfer. Unlike most existing studies, this paper focuses on the impact of spillovers that take place through both horizontal and vertical linkages. The results presented in this paper suggest that FDI spillovers generate strong positive impact on Vietnams total factor productivity through backward vertical linkages. The effect of backward linkages is strengthened by the size of human capital stock. Specifically, industries with larger stock of human capital gain more benefits from FDI spillovers through backward linkages and hence these industries experience a higher level of technology transfer.

Keywords: Foreign Direct Investment; TFP Growth; Technology Transfer; Vietnam

Postal Address: Faculty of Business, University of the Sunshine Coast, Maroochydore, QLD 4558, Australia. Email: SAnwar@usc.edu.au; Tel: 61-7-5430-1222. The views expressed in this paper do not necessarily reflect the view of the State Bank of Vietnam.

1. INTRODUCTION The costs and benefits of foreign direct investment (FDI) in the context of developing countries have been debated over a very long period of time.1 Owing to the perceived benefits, developing countries tend to attract FDI by offering tax breaks and other regulatory concessions to multinational corporations (MNCs). Generally speaking, FDI not only increases the supply of capital but, given the appropriate host-country policies, it can also facilitate technology transfer. Technology transfer can contribute to human capital formation and vice versa.2 Spillovers from FDI can be divided into two categories: horizontal and vertical. Horizontal spillovers are intra-industry linkages whereas vertical spillovers are inter-industry linkages. FDI leads to the introduction of advanced technology and superior management skills in host economies which can benefit domestic firms. However, FDI also increases competition which can reduce the market share of domestic firms (Baldwin and Gu, 2004). In others words, FDI can have offsetting effects on domestic firms. For example, FDI can lead to positive knowledge spillover effect as well as negative market share competition effect. Knowledge spillover effect can take place via labour turnover from MNCs to domestic firms and also via learning from participating in conferences, exhibitions, etc. Transfer of managerial skills takes place when the local workers trained by the foreign firms move from foreign to local firms or when these workers start their own business (see Myers, 2003). Blomstrom and Kokko (1998) have argued that knowledge spillover can also occur through learning by doing. MNCs tend to introduce modern technologies and new products into host countries. This forces domestic firms to look for new technologies. In some cases domestic

See Keller (2004), Myers (2003), Lipsey (2002) and Marino (2002) for an interesting survey.

Blomstrom (1986), among others, has argued that spillovers from FDI are the most important channel for the diffusion of modern technology.

firms simply attempt to imitate technologies that are used by the foreign firms. Thus, knowledge spillovers can be positive. However, if the competition effect dominates then the overall effect of FDI on domestic firms can be negative. In fact, MNCs can hinder the rate of technological improvement enjoyed by the local firms in the short term. Aitken and Harrison (1997, 1999) have argued that within the imperfectly competitive markets, firms have to incur significant fixed costs. However, due to superior technology, foreign firms marginal cost of production is likely to be lower as compared to the domestic firms. Accordingly, foreign firms are likely to capture a larger market share. Additionally, MNCs have an incentive to prevent technology leakage and spillovers from taking place which is facilitated by the formal protection of their intellectual property and trade secrecy laws. In general, foreign firms pay higher wages to prevent labour turnover. If the negative effect on local firms is sufficiently strong then the overall effect of FDI on productivity of domestic firms can be negative. As a result, the local firms may end up experiencing a technological decline. Vertical spillovers (i.e., inter-industry linkages) can also facilitate technological progress in host countries (Rodriuez-Clare, 1996). Such linkages can be backward or forward. Backward linkages include interaction between MNCs and their local suppliers. Such links can promote technological advancement among local firms through several channels. Backward spillovers can occur via direct knowledge transfer from foreign customers to local suppliers. Javorcik (2004) argues that MNCs often provide technical assistance to their suppliers. The aim of such assistance is to (i) improve the quality of their suppliers products and (ii) encourage or facilitate innovation. Moreover, MNCs also organise training courses to enhance local suppliers production management skills. Spillovers also take place through higher requirements for product quality and on-time delivery from MNCs. This forces local firms to upgrade technologies and production

management techniques to meet demand for higher quality and on-time delivery. The entry of foreign firms increases the demand for intermediate products, which allows local suppliers to exploit economies of scale economies (Javorcik, 2004). Similarly, the presence of foreign firms can also facilitate technological progress in the host country via forward spillovers. For example, domestic firms can become more productive because of gaining access to new or less costly intermediate inputs produced by MNCs in upstream sectors. MNCs may also be able to provide better customer service which may not be available if the same inputs are imported (Javorcik, 2004). Most available empirical studies have mainly focused on FDI spillovers through horizontal linkages.3 These studies provide mixed evidence. It can be argued that mixed evidence arises from the fact that FDI spillover effects depend on the characteristics of domestic firms, industries and indeed the host country. These characteristics can be categorised as absorptive capacity which includes human capital, financial market development and technology gap. Wang and Gu (2006) have shown that absorptive capacity of the host country plays an important role in capturing FDI spillover benefits.4 While a number studies have examined the effect of FDI on labour productivity and GDP growth, few studies have considered the technology spillover effect of FDI.5 Damijan, Knell and Rojec (2003) have examined the impact of vertical and horizontal spillovers on productivity arising from FDI in ten advanced transition economies. They found that vertical effects are more important than the horizontal spillovers from FDI. Wang and Gu (2006) have examined the effect of FDI on total factor productivity (TFP) growth in Canadian
3

See Liu and Wang (2003), Damijan, Knell and Rojec (2003), Javorcik (2004) and references therein.

4 Borenzstein, De Gregorio and Lee (1998) have argued that the level of economic development of host countries plays a crucial part. 5 Studies that have considered the effect of FDI on labour productivity and GDP growth include Caves (1974), Globerman (1979), Blomstrom and Persson (1983), Kokko (1996), Koko, Tansini and Zejan (1996), Borensztein, De Gregorio and Lee (1998) and Marino (2002).

manufacturing industries over the period 1973-1977. Wang and Gu found that FDI generates strong and positive spillover effects on TFP growth through both backward and forward linkages. Bitzer, Geishecker and Grog (2007) have considered the effect of horizontal and vertical spillovers through the industry level data for 17 OECD and Central and Eastern European countries (CEEC). They find that there is evidence of spillovers through vertical backward linkages. But this effect is much higher for CEEC. They also found that the effect of horizontal linkages is positive. Liu (2008) has shown that FDI has resulted in significant vertical spillovers in China. In a very interesting paper, while examining the extent of economic integration, Huang and Sharif (2009) have considered the impact of spillover effects in Chinas Guangdong province, Hong Kong, Macau and Taiwan. The existing studies have emphasized that technology spillover from FDI depends on local firms and host country specific characteristics such as human capital stock, technology gap and financial market development. Accordingly, the impact of FDI spillovers on TFP and hence technological progress in host countries can vary from country to country and from industry to industry. To the best of our knowledge, none of the existing studies have considered the impact of FDI generated spillovers on TFP of Vietnamese firms through both backward and forward linkages. Thus, this paper attempts to fill this gap in the literature.6 This paper examines FDI spillovers through both horizontal and vertical linkages in Vietnam. Vietnam offers a particularly interesting case study for several reasons. Firstly, among the developing economies, Vietnam has experienced a high level of economic growth and also attracted significant amount of FDI since 1986. However, the debate on the role of FDI in promoting technological progress among the domestic firms in Vietnam is far from settled. Secondly, FDI in Vietnam is mostly concentrated in the key economic regions while

Le (2005) has examined the effect of FDI on labour productivity on 29 Vietnamese manufacturing industries over the period 1995-2002. Le found that FDI has a positive effect on productivity of Vietnamese firms. However, her study only considers the effect of FDI on productivity of Vietnamese firms through intra-industry linkages.

remote regions receive only a small fraction of FDI. This can influence the magnitude of both horizontal and vertical linkages of FDI. Thirdly, in order to attract more FDI in Vietnam as well as to promote technology transfer from MNCs, Vietnamese government promulgated Law on Foreign Investment in 1987. An important aim of this law is to encourage increase in productivity of domestic firms through technological progress. Thus, a study on Vietnam is likely to enhance our understanding of the effectiveness of government policy. In addition, this paper also investigates the role of absorptive capacity in enhancing FDI spillovers. Following the existing literature (for example Liu and Wang, 2003), we view the positive effect of FDI on TFP as evidence of technology transfer. The rest of this paper is organized as follows. Section 2 contains a description of the model and data. Empirical analysis is presented in section 3, whereas section 4 contains some concluding comments.

2. THE MODEL AND DATA The aim of this paper is to examine the effect of FDI on total factor productivity (TFP) of Vietnamese manufacturing industries. An increase in TFP can be interpreted as technological progress. In stage one, TFP is calculated by estimating the following CobbDouglas production function.7
Yit = Ait K it Lit

(1)

where Yit is the real output of industry i in period t; Kit is the real book value of fixed assets;8 Lit is the number of workers; A is the total factor productivity; and and respectively are the production elasticity of capital and labour. Following the existing literature (for example

Jones (2005) has shown that the Cobb-Douglas functional is a valid approximation for the underlying firm production functions. Most available studies including a recent study by Fleisher, Li and Zhao (2009) have estimated the TFP by making use of a Cobb-Douglas production function. Following Blomstrom and Sjoholm (1999), the book value is used as a proxy for capital stock.

Liu and Wang, 2003), we view the positive effect of FDI on TFP as evidence of technology transfer. TFP can be calculated by rewriting equation (1) in logarithms as follows:
Log ( Ait ) = Log (Yit ) Log ( K it ) Log ( Lit )

(2)

In stage two, the impact of FDI spillovers and other control variables (i.e., absorptive capacity) on TFP is evaluated by estimating a log-linear version of the following relationship.9
Log ( Ait ) = f [ Log ( H it ), Sit ,Cit , Tit , FDISit ]

(3)

Where Hit is human capital which is approximated by real expenditure on education and training; Sit is sales of industry i relative to the total sales; Cit is a measure of competition in each industry, which is measured by the share of State Owned Enterprises (SOEs) in total output of each industry; Tit is technology gap which is measured by the difference in the average productivity of domestic and foreign firms in percentage terms in the same industry; FDISit is FDI spillovers (horizontal, backward vertical and forward vertical). By making use of the existing literature, for example Wang and Gu (2006), the FDI spillovers are measured as follows: The horizontal spillover in industry i at time t, say H_FDIit, is calculated as the proportion of output accounted for by foreign firms in that industry. The vertical backward spillover in industry i at time t is computed as follows:
B _ FDI it =

k i

ki

H _ FDI ki

(4)

where ki is the proportion of sector is output supplied to industry k. It is assumed that the greater the proportion of output supplied to an industry with foreign multinational presence, the greater the degree of linkages between foreign and local firms.

The choice of control variables is dictated by the availability of reliable data for the period 1995-2005. Summary statistics of all variables is provided in Appendix 1.

The vertical forward spillover in industry i at time t is calculated as follows:

F _ FDI it =

k i

ki

H _ FDI ki

(5)

where ki represents the proportion of sector ks output supplied to industry i. This measure captures the extent of forward linkages between foreign firms in downstream and local firms in upstream sectors. The values of and are obtained from the Input-Output Tables of Vietnam published by the General Statistic Office of Vietnam (GSO). The stock of human capital is expected to positively affect the TFP. In other words, an increase in the stock of human capital leads to Hicks neutral technological progress. An increase in competition increases TFP. The level of competition in each industry is measured by measured by the share of SOEs in total output of each industry. An increase in the share of SOEs reflects decline in competition which negatively affects the TFP. The impact of the spillovers on TFP can be either positive or negative. Because of the lack of data, the interaction between financial development and three types of FDI generated linkages (horizontal, vertical backward and vertical forward) have been ignored. The empirical analysis is conducted by means panel data for 23 manufacturing industries over the period 1995-2005. Most of the data are collected from Vietnams Ministry of Industry (MOI). All nominal variables are measured in 1994 prices. A log-linear version of equation (3) can be estimated by three methods: simple pooled regression, fixed effects (FE) pooled regression and random effect (RE) pooled regression. The simple pooled regression assumes that the intercepts and slope coefficients are the same across industries and time. Based on Hausman test, we were able to exclude the simple pooled regression method. The Hausman test was also used to compare fixed and random effect models. The Hausman test found the fixed effect estimator to be more efficient than the random effect estimator. Accordingly, the impact of FDI soillovers and absorptive capacity on TFP is estimated by means of FE pooled regression with correction for heteroskedasticity. 7

3. EMPIRICAL RESULTS AND ANALYSIS TFP was calculated by estimating equation (2). Equation (2) was estimated by means of OLS with correction for heteroskedasticity. The estimated coefficients are reported in Table 1 which shows that both physical capital and labour are statistically significant at 1 percent level. Table 1: Estimated Production Function
Independent Variables Ln(K) Ln(L) Constant Adjusted R2 Sample Size Estimated Coefficients 0.77606 (18.49)* 0.22104 (7.76)* 2.18646 (2.95)* 0.86 242

Notes: (i) Robust t-statistics in parentheses; (ii) * significant at 1%

The estimated production elasticity of capital is more than three times larger than the labour elasticity. The estimated t-values suggest that both physical capital and labour are important determinants of output of Vietnamese manufacturing industries. TFP was calculated by making use of equation (2). TFP of the top ten industries in 2005 is reported in Table 2. Table 2: Estimated TFP of Top 10 Industries in 2005
Rank 1 2 3 4 5 6 7 8 9 10 Industries Radio, television and telecommunication devices Iron, steel and non-ferrous metal basic industries Computer and office equipment Chemicals and chemical products Rubber and plastic products Coke and refined petroleum products and nuclear fuel Motor vehicles and trailers Fabricated metal products, except machinery & equipment Other non-metallic mineral products Electrical machinery apparatus, appliances and supplies TFP 13.32039 13.24033 13.21593 13.18364 13.16066 13.14191 13.05669 13.04376 13.01828 13.00464

The estimated log-linear version of equation (3) is summarised in Table 3. Equation (3) was estimated after including time and industry dummies.10 However, for simplicity, the estimated coefficients of these dummies are not shown. The model was also tested for the presence of multicollinearity (see Appendix 2).

Table 3: The Effect of FDI on TFP in Vietnam

Independent Variables Human Capital Scale (S) Competition (C ) Technology Gap (T) Horizontal FDI Spillovers Vertical Backward FDI Spill Vertical Forward FDI Spill Human Capital* Horizontal Human Capital* Backward Human Capital* Forward Technology Gap* Horizontal Technology Gap* Backward Technology Gap* Forward Time Dummies Industry Dummies Hausman test: 2(1) Sample Size R-Squared Yes Yes 49.45* 242 0.25 Yes Yes 92.44* 242 0.45 (1) 0.34401 (2.26)** 3.64286 (1.73)*** -1.61138 (-7.52)* -0.00098 (-0.42) -0.00642 (-3.20)* 0.00624 (1.90)** 0.00147 (0.72) (2) 3.40901 (7.59)* 2.16845 (1.19) -0.59979 (-2.36)** 0.00255 (1.18) -0.00392 (-1.59)** -0.00925 (-2.51)** 0.00211 (0.96) 0.00523 (1.07) 0.09674 (5.33)* -0.01381 (-1.46) (3) 0.37557 (2.42)** 3.56821 (1.68)*** -1.52699 (-6.80)* -0.00217 (-0.31) -0.00730 (-3.36)* 0.00600 (1.62)*** 0.00216 (0.88)

0.00017 (1.06) -0.00008 (-0.34) -0.00011 (-0.91) Yes Yes 31.35* 242 0.25

Notes: (i) Robust t-statistics in parentheses; (ii) *** significant at 10%, ** significant at 5%, and * significant at 1%

10

The inclusion of dummy variables tends to reduce the severity of endogeneity problem. This problem arises from the fact that industries that are known to be highly productive, in relative terms, are likely to attract more foreign and domestic firms. The industry capital and human capital stocks of foreign and domestic firms may be correlated with the error term. Therefore, we include industry dummies as regressors. This helps to remove the error terms industry-specific unobservable effect that may be correlated with the industry stock variables.

Table 3 shows that the null hypothesis of Hausman test can be rejected at 1 percent level. This implies that FE estimator is appropriate. The estimated results from Table 4 indicate that among three measures of FDI, only the vertical backward FDI variable has a positive and statistically significant (at 5 percent level) effect on TFP. The effect of horizontal FDI on TFP is negative and statistically significant, while the effect of the vertical forward FDI is positive but insignificant (see column 1 of Table 3). The negative effect of horizontal linkages suggests that the presence of foreign firms in Vietnam has resulted in a decrease in TFP of the local industries through the competition effect. This appears to suggest that foreign firms owing to their advanced technology are able to increase their sales at the expense of the local firms that are unable to compete. In other words, due to the presence of productive foreign firms, local firms have become relatively unproductive. In overall terms it appears that the negative competition effect outweighs the positive effect of demonstration and imitation generated by the presence of foreign firms. The estimated coefficient of backward linkages shows that backward linkages positively influence TFP of the Vietnamese manufacturing industries. The positive effect of backward linkages appears to suggest that Vietnamese manufacturing industries are benefiting from new technologies and production management techniques that have been introduced by MNCs. However, the forward linkages between foreign and local firms are not strong. Among the control variables, the estimated coefficient of human capital is positive and statistically significant at the 1 percent level. It implies that an increase of 1 percent in expenditure on education and training is likely to increase the TFP by 0.34 percent. The effect of domestic competition on TFP, which is proxied by the share of SOEs in total output of each industry, is negative and significant. This suggests that a reduction in competition through the expansion of the inefficient SOE sector leads to a significant decline in TFP of

10

Vietnamese manufacturing industries. The coefficient of technology gap is negative but statistically insignificant (see column 1 of Table 3). It has been suggested that the presence of FDI generated technology spillover effects also depend on the absorptive capability of domestic firms in host economies (Cohen and Levinthal 1990). In order to examine this hypothesis we consider the impact of the interaction between (i) technology gap and FDI spillovers and human capital and FDI spillovers on TFP. This allows one to examine the extent to which absorptive capacity (as measured by technology gap and human capital) affects technology spillovers. The results of empirical estimation are summarised in columns (2) and (3) of Table 3. Column 2 of Table 3 shows that the coefficient of the interaction between human capital and backward linkages is positive and statistically significant at the 1 percent level. This suggests that manufacturing industries with higher human capital gain more benefits from backward linkages. Column 3 of Table 3 shows that the estimated coefficients of the interaction between technology gap and two indices of FDI spillovers (backward and forward linkages) are negative and statistically insignificant while the coefficient of interaction between technology gap and horizontal linkages is positive but statistically insignificant. Based on the results presented in Table 3, it is possible to conclude that human capital contributes significantly to capturing vertical spillovers from FDI in Vietnamese manufacturing industries and industries with higher human capital tend to have higher TFP. The existing literature suggests that the effect of FDI on TFP varies from industry to industry. This is because the link between TFP and FDI spillovers is affected by industry specific characteristics. Thus, in the rest of this section we focus on industry structure. Specifically, we divide our sample into two categories [(i) low and (ii) medium & high technology industries] and re-estimate the log-linear version of equation (3). The results of this exercise are summarised in Table 4.

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Table 4: The Impact of the Industry Structure on TFP in Vietnam

Independent Variables Low Technology Medium and High Technology 2.05930 (6.72)* 17.09734 (3.66)* -0.30927 (-0.68) 0.00114 (0.41) -0.00856 (-3.16)* 0.00701 (1.90)*** 0.00139 (0.62) Yes Yes 65.33* 129 0.38

Human Capital Scale (S) Competition (C ) Technology Gap (T) Horizontal FDI Spillovers Backward FDI Spillovers Forward FDI Spillovers Time Dummies Industry Dummies Hausman Test: 2(1) Number of Observations R-Squared

0.38224 (2.20)** 0.65160 (0.34) -1.74875 (-6.86)* -0.00352 (-0.85) 0.00783 (1.19)*** -0.00897 (-1.72)*** -0.00112 (-0.31) Yes Yes 33.53* 108 0.51

Notes: (i) Robust t-statistics in parentheses; (ii) *** significant at 10%, ** significant at 5%, and * significant at 1%

Table 4 summarises the empirical results obtained from the econometric model. The results indicate that horizontal and vertical linkages in different industries are very different. In low technology industries, the presence of foreign firms generates positive effect on TFP of domestic industries, whereas the effect on TFP of medium and high technology industries is negative but the coefficient of horizontal linkages is statistically significant. In terms of backward linkages, the estimated results show that the domestic industries with medium and high technology benefit from the backward linkages while the industries with low technology gain no benefits from backward linkages. Table 4 also shows that medium and high technology industries in Vietnams manufacturing sector derive much larger benefit from human capital as compared to low technology industries. This suggests that technology transfer takes place mainly through medium and high technology industries. These findings support the view that impact of FDI spillovers on TFP varies across industries.

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4. CONCLUSION The effect of FDI on a host country can be divided into two categories: (i) the direct effects and (ii) the indirect effects. The indirect effects are also known as the spillover effects. FDI generated spillover effects can take the form of horizontal and vertical linkages. Some theoretical studies have argued that that FDI can also facilitate technolog transfer to host countries through upstream and downstream industries (i.e., through vertical linkages). In other words, vertical linkages are also an important source of FDI spillovers.11 However, few empirical studies have considered the role of vertical linkages. It is well known that the magnitude of spillover effects depends on absorptive capacity of the host industries. In other words, the size of spillovers depends on the extent to which domestic firms respond positively to factors such as technology gap and human capital (Liu and Wang, 2003). This paper considers the impact of FDI generated spillovers on TFP growth experienced by Vietnams manufacturing industries. In order to focus exclusively on growth arising from technological advancement, the paper focuses on the link between TFP and FDI generated spillovers. An increase in TFP can be interpreted as Hicks neutral technological progress. Based on the existing literature, a positive relationship between FDI and TFP can be viewed as evidence of technology transfer. The empirical analysis presented in this paper is based on panel data that covers 23 manufacturing industries over the period 1995-2005. Unlike most existing studies, this paper considers both horizontal and vertical linkages. The paper also considers the role of absorptive capacity as well as the structure of Vietnams manufacturing industries. The results presented in this paper suggest that backward linkages are an important channel of technology transfer from foreign to domestic firms in Vietnam. However, the effect of backward linkages on TFP depends on domestic industries absorptive capacity.

11

The need for further research in this area has also been highlighted by Keller (2004).

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Industries with higher stock of human capital gain more benefits from FDI spillovers. It appears that the Vietnamese manufacturing industries have not significantly benefited from horizontal linkages. It can be argued that the presence of foreign firms has generated significant negative competition effect which has more than offset the positive knowledge spillover effect. The impact of forward linkages is positive but insignificant. Policy makers in Vietnam need to consider ways of rectifying this situation.

Appendix 1: Summary Statistics Variable Description Mean Standard deviation TFP H S C T H_FDI TFP Human Capital Scale Competition Technology Gap Horizontal FDI Spillovers B_FDI Vertical Backward FDI Spillovers F_FDI Vertical Forward FDI Spillovers 22.202 20.657 0.186 86.144 21.461 11.266 3.258 59.102 12.908 8.1100 0.045 0.153 4.776 34.825 0.492 1.165 0.057 0.148 7.665 25.993 10.234 3.849 0.0003 0.001 -0.931 0.001 14.358 10.784 0.325 0.954 53.221 100.000 Minimum Maximum

Appendix 2: Testing for Multicollinearity12 SQRT Variable Log(TFP) VIF 2.33 VIF 1.53 Tolerance 0.4285 RSquared 0.5715

12

As a rule of thumb, if the VIF of a variable exceeds 10, which will happen if R exceeds 0.90, that variable is said be highly collinear (Gurajati 2006).

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Human [Log(H)] Scale

Capital 1.79 1.85 1.3 1.07 2.11 3.01 1.76 1.9 1.34 1.36 1.14 1.04 1.45 1.74 1.33 0.5595 0.5412 0.7705 0.9324 0.474 0.3318 0.5684 0.4405 0.4588 0.2295 0.0676 0.526 0.6682 0.4316

Competition Technology Gap Horizontal Backward Forward Mean VIF

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