Complementarity between FDI and trade policies: Evidence from India

During liberalization episodes, oftentimes economies undergo a bunch of simultaneous reforms and changes in policies. Looking back at some of the most recent liberalization episodes such as Chile (1974), Brazil (1968-1973), China (1993-2005) and India (1991), two major reforms were consistently concurrent: tariff reductions and FDI openness. And although there is a rich literature on the impact of each reform individually on the liberalizing economy, no attention was given to the impact of having the two reforms simultaneously. The main idea of this paper is to investigate if the effects of trade liberalization on firm performance are exacerbated by the presence of foreign affiliates. Studying the complementarity between Trade liberalization and FDI policies and the mechanisms at play could be of great interest to policymakers.

Trade liberalization has been one of the most heavily studied topics in international economics. The increased competition in the final product market, in case of tariff cuts on final goods, and access to new technologies embedded in imported inputs subsequent to a tariff cut episode on intermediate goods, are the main channels affecting firms’ performance. On one hand, the increased competition on final goods’ market following trade liberalization will push the least productive firms out of the market and hence increase aggregate productivity within-sector (Melitz, 2003). Within-firm productivity gains could also arise from foreign competition if firms are forced to increase their efficiency through process improvements in order to stay on the market (Hicks, 1935 and Pavcnik, 2002). On the other hand, tariff reductions allow firms to import materials and machinery that were previously unavailable or unaffordable. It is also reasonable, in the context of developing countries, to assume that imported inputs are of better quality and are embedded with higher technology. Hence, firms may benefit from a transfer of technology from the country of origin of the imported intermediate goods (Amiti and Konings, 2007).

Multinationals are considered a major source of technologies, innovation and business practices (Keller and Yeaple, 2009), hence, it’s not surprising that Governments spend large amounts of resources to attract FDI based on the belief that such companies generate positive externalities to domestic firms. Developing countries are more likely to be the destination of multinational activity than the source (Antràs and Yeaple, 2014); therefore it is more relevant to investigate spillovers in the context of a developing country, such as India. This study is motivated by a simple theoretical mechanism that has not been yet investigated. Conceptually, since foreign firms are bigger and more productive, they are able to afford relatively more imported inputs. And since they invest more in R&D and adopt superior technologies relative to domestic firms, it’s safe to assume that they have better knowledge of the varieties of imported inputs to choose and how to use these inputs compared to domestic firms. If this technical know-how is transferred to domestic firms through exposure, vertical integration or labor mobility, it will generate positive spillovers associated to imported inputs. Based on these conceptual arguments, we would expect the technical know-how channel to be more pronounced for high-tech industries.

Furthermore, multinationals are known to be an important source of business practices. They are leading in terms of corporate governance such as the structure, principles and best practices. The increased competition while being exposed to multinationals provides a learning opportunity for domestic firms to improve efficiency of their production process and management, and consequently increase TFP. Considering the fact that larger firms are harder to structure and manage efficiently, the order of magnitude of this channel -process improvement- is expected to increase with the size of the firm.

In this sense, the impact of a shock such as trade liberalization on domestic firms may be heterogeneous depending on exposure to multinational firms. To the best of my knowledge, no previous study has attempted to disentangle these channels of FDI spillovers. This study is using Indian firm-level data, Prowess, for the period (1989-1997). This dataset is particularly well suited for the analysis as it spans the trade liberalization episode and FDI reforms that occurred in 1991. Data on FDI reforms are obtained from Aghion et al. (2008).

Firstly, I estimate TFP relying on the methodology of Levinsohn and Petrin (2003) where TFP is derived from a Cobb-Douglas production function. Electricity expenditures are used to control for unobserved productivity
shocks to eliminate any simultaneity bias in the estimation of firms’ production
function. Secondly, I rely on the decomposition of tariffs following Bas and Berthou (2017). Tariffs are decomposed into input and output tariffs using Input-Output tables provided by the WITS. Thirdly, in order to establish the causal effect between multinational firms’ presence and Total Factor Productivity (TFP) of domestic firms, I deviate from existing literature by using a Difference-in-Differences methodology that exploits the exogenous changes in FDI policy that came as part of the IMF program consequent to the debt crisis in India in the early 1990s. Finally, the spillover channels are identified through interactions of FDI policy with the level of input and output tariffs.

Controlling for observable industry and firm level characteristics, and unobserved heterogeneity at the industry and firm levels through fixed estimation, results suggest positive technical know-how spillover effects through imported inputs that are stronger for more capital-intensive industries as well as positive process improvements correlated with the increased competition that are most pronounced for large firms.


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