International technology transfer, FDI and development

Kamal Saggi

Since most developing countries lack the resources to invest heavily in research and development (R&D), a technology gap separates them from the developed world. International transfer of technology helps close this gap and, along with investments in human and physical capital, is likely our best hope for raising living standards across the developing world. Such technology transfer makes eminent economic sense: it keeps poorer countries from spending their already scarce resources on ‘reinventing the wheel’.

Economists regard knowledge (and its application in the form of technology) as a ‘non-rival good’, meaning that knowledge can be simultaneously accessed by more than one person. However, the non-rival nature of knowledge does not imply that it can be acquired or transferred free of cost. Rather, all it means is that if two parties are willing to pay the cost of adopting a new idea or a technology, they can do so without interfering with each other’s decisions. Indeed, substantial empirical evidence indicates that international technology transfer does not come cheap and economic policies should aim to lower its costs rather than increasing it.

While the allocation of R&D across the world is changing continually, most of the world’s R&D still takes place in industrialised countries and is carried out by multinational corporations. The results of this R&D are transmitted globally through many channels. Perhaps the most important such channel is Foreign Direct Investment (FDI) – investment projects whose ownership and control lie in the hands of overseas investors. For example, if a US automobile company such as Ford sets up a factory in India, the investment counts as FDI. By contrast, the purchase of a small amount of stock in an Indian company by an individual foreign investor does not.

FDI flows to developing countries have increased substantially during recent decades, with China being the stand-out performer. Today, roughly one third of the global stock of FDI is in developing countries. While this is an impressive figure, it is not as large as it should be since FDI, particularly in services, is often subject to major policy restrictions. For example, India has been hostile to FDI during much of its existence as an independent country and has only recently begun to take on the difficult but important task of liberalising its FDI policies in the retail sector.

Restrictions on inward FDI hamper a country’s ability to update its production technologies, organisational structures, and management techniques. Of course, FDI is not the sole channel of achieving these objectives: private sector channels such as technology licensing and joint ventures between foreign and local companies can substitute for FDI to some degree. Furthermore, technology transfer does and can occur without any participation from those that originally created the technologies: imitation or ‘reverse engineering’ allows local entrepreneurs and companies to replicate foreign products and technologies without paying any royalties or fees to creators. However, if one is constrained to pick among those channels of technology transfer that involve willing exchanges between market participants on both sides of the market for technology, there really is nothing to talk about. The game pretty much begins and ends with FDI: over 80 per cent of fees and royalties paid in a given year for licensing of technology are intra-firm in nature, i.e., involve exchanges between parent firms and their overseas subsidiaries.

Reverse engineering of foreign technologies and products has played an important role in the industrial development of India, particularly in its thriving pharmaceutical industry. But, looking ahead, reverse engineering is not a sustainable strategy for several reasons. First, developed countries have started to increasingly demand stronger enforcement of intellectual property rights across the world, as is indicated by the ratification of a multilateral agreement on intellectual property rights by the World Trade Organization in 1995. Second, to continually raise living standards, at some point a country must make the leap from imitation to innovation. A case can be made that India is ready to do so in several major industries and local policy must adjust to meet this new reality.

From the perspective of economic development, one of the great strengths of FDI is that it can generate substantial benefits for both consumers and local companies in developing countries. Benefits to consumers include access to higher-quality goods or completely new goods that are simply not produced locally due to technological constraints. Benefits to local companies include what is known as the ‘demonstration effect’, in which local firms adopt a technology from overseas after observing its successful introduction by a multinational. Similarly, people trained or previously employed by multinational firms can provide added benefit to local business by helping with technology transfer when they change jobs or start new firms. Last but not the least, multinationals often willingly transfer technology to firms that either supply them with necessary intermediates or buy their finished products. An example can be found in Mexico’s automobile industry. After the North American Free Trade Agreement (NAFTA) was ratified in 1992, US car companies set up manufacturing plants in Mexico. Within five years this had led to hundreds of domestic producers of car parts and accessories springing up. US and other multinational corporations transferred technology to these Mexican suppliers who, as a direct result, gained expertise in industry best practices and quality control.

All this is not to say that the multinational firms are charitable institutions whose goal is to encourage economic development in host countries. It goes without saying that multinationals engage in FDI to maximise their own profits. If transferring a technology strengthens a company’s local rivals, it should be expected to thwart the process of technology diffusion to some degree. For example, a multinational worried about losing a technological innovation to local rivals may choose not to invest locally, and may simply export the product from its home market or may only transfer tangential technologies. But such trade-offs do not always exist, particularly when one considers relationships between multinationals and their local suppliers. Furthermore, multinationals compete vigorously with each other and have an incentive to use their best available technologies globally.

FDI brings tangible benefits to host countries even when the scope for technology spillovers to local firms is limited. Indeed, in today’s world economy, FDI just might be the best way of integrating local suppliers into the global production chain thereby enhancing their quality and export prospects. Not to mention the direct employment that is created by large scale projects undertaken by multinational firms. Indeed, multinationals typically pay higher wages than their local competitors.

In today’s world of rapid international capital flows, another attractive feature of FDI from the viewpoint of host countries is that it is relatively less reversible than other forms of foreign investment. Such irreversibility lowers uncertainty for local workers and suppliers engaged in economic relationships with multinationals producing locally.

Despite its many benefits, historically FDI has often met with resistance in many host countries. For example, in several Asian countries, technologies in the private sector were transferred frequently through technology licensing between independent firms rather than internally through multinational firms since local policy restricted inward FDI. This may have allowed some countries such as Japan and South Korea to obtain foreign technologies at relatively low prices. To some extent, China too has been able to leverage its large domestic market to force foreign firms to share their technologies as a precondition for access.

While such policies are not necessarily the most desirable ones in the long run, they are surely preferable to an excessive focus on self-reliance, a slogan that defies the logic of comparative advantage and makes little sense in today’s integrated global economy. Chasing self-reliance led India to pursue a policy regime that protected local industries from foreign competition. Such protection encouraged investments in local technologies that were invariably far below the global state of the art and forced domestic consumers to endure goods that fell short of international quality standards. India’s youth, raised in the age of Facebook and Google, cannot appreciate the extent to which foreign manufactured goods were sought after by previous generations: not only were such goods far superior in quality to their domestic counterparts, they were essentially unavailable locally due to severe trade and investment restrictions imposed by the Indian government.

Developing countries such as India are likely to maximise the benefits of FDI and technology transfer by investing more in local education and infrastructure development while giving multinational firms relatively unrestricted access to their markets. Protectionist attitudes may have been a legitimate response to colonialism during the first three to four decades of independence but modern India can ill afford them today. Like colonialism, they too must become a thing of the past.

India must continue on the path of increased integration with the global economy if it is to take its rightful place in the world order and fulfill its promise as a great modern nation. Its citizens should settle for nothing less.