Global Trends in R&D-Intensive FDI and Policy Implications for Developing Countries

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Global Trends in R&D-Intensive FDI and Policy Implications for Developing Countries

Global Trends in R&D-Intensive FDI and Policy Implications for Developing Countries

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  • 1. Global trends in R&D-intensive FDI and policy implications for developing countries1 José Guimón, PhD Department of Economic Structure and Development Economics Universidad Autónoma de Madrid, Spain jose.guimon@uam.esAbstract: This paper reviews recent global trends in the international allocation ofcorporate R&D centers and discusses the policy implications for developing countries.First, in recent years global R&D networks are becoming more multi-polar, with agrowing relevance of developing countries both as destinations and as sources of R&D-intensive FDI. However, this is largely associated with the growing importance ofChina and India in corporate innovation networks, while many developing countriesremain excluded. Second, the fast growth of R&D-intensive FDI during the 1990s maybe shifting towards a period of stagnation given the maturation of corporate R&Dnetworks and the effects of the 2007-2010 economic crisis. Third, the changing strategicmotivations behind R&D-intensive FDI are discussed. Building on these trends, thepaper concludes with a discussion of some policy options available to attract and embedR&D-intensive FDI.Keywords: absorptive capacity, FDI, innovation, multinational companies, R&D,spillovers1. IntroductionThe growing relevance of R&D-intensive foreign direct investment (FDI) reflects widertrends in the global economy. Multinational companies (MNC) are gradually modifyingtheir strategies and spatial organization, involving an on-going fragmentation of theirinternational value chains in the search of sustainable competitiveness. This applies totheir manufacturing, logistics, sales or administrative functions, and increasingly also toR&D activities. Indeed, corporate R&D is gradually evolving from a centralized andhierarchical node of global supply chains towards one that builds upon an open networkof geographically dispersed R&D centres. As a result, R&D-intensive FDI has grownsubstantially since the early 1990s, albeit with significant differences across industriesand countries. Given that MNCs undertake the bulk of global R&D expenditure, theirlocation decisions determine to a large extent the geography of R&D activity (Jaruzelskiand Dehoff, 2008).R&D-intensive FDI can be defined as an investment involving a lasting interest andcontrol by a resident entity in one economy in an enterprise resident in another economy1 This paper builds heavily on a background report prepared by the author for a High-Level PolicyWorkshop organized by the World Bank (“Innovating Through the Crisis”, Dubrovnik, Croatia, June2011). The usual disclaimers apply. 1
  • 2. for the purpose of deploying R&D activities (UNCTAD, 2005). This may occur throughgreenfield investments (creation of a new R&D center overseas by a multinationalcompany or expansion of an existing subsidiary), through transnational mergers andacquisitions (M&A) (full or partial acquisition of a domestic company active in R&Dby a foreign company) or through transnational joint ventures (joint ownership of anR&D center by foreign and domestic entities). In addition to these different possibleentry modes, there are many different types of R&D activities that MNCs mayinternationalize, reflecting different strategic motivations. The R&D activities may bedemand-driven, supply-driven or efficiency-seeking; global, regional or local in scope;radical or incremental; product or process oriented; autonomous or highly integratedinto the global R&D value chain; and so forth (Bas and Sierra, 2002; Florida, 1997;Kuemmerle, 1999; Sachwald, 2008).This implies that R&D-intensive FDI is a very heterogeneous phenomenon; inparticular, one must consider the different strategic motivations and entry modes inorder to better frame its developmental impact and policy implications for hosteconomies. Moreover, although we focus on R&D-intensive FDI as defined above, itshould be understood as part of a wider process that can be characterized as theglobalization of technological innovation (Archibugi and Iammarino, 2002). Thisincludes not only R&D-intensive FDI but also international collaboration in R&D,transnational technology contracts and licensing, international technological alliances,and international trade of high technology products. Indeed, from a development andpolicy perspective the critical issue is the nature and extent of cross-bordertechnological linkages, rather than whether these linkages are organised intra-firm(through FDI) or inter-firm (through contracts and alliances). Moreover, it should alsobe acknowledged that MNCs may undertake other modes of innovation other thanR&D, which may have an equivalent effect on learning, innovation and competencebuilding in host economies. Under a broad view of innovation, the role of MNCs is notlimited to its contribution to R&D efforts but also to organisational change and newbusiness models; marketing, branding and design; etc.R&D-intensive FDI is expected to bring significant benefits to host countries byenabling an upgrading of technological capabilities as well as a better access tointernational markets (Cantwell and Piscitello, 2000; Carlsson, 2006; Santangelo, 2005).In view of the potential benefits, attracting (and embedding) R&D-intensive FDI isbecoming a critical concern for policymakers across developed and developingcountries alike. But the benefits associated with R&D-intensive FDI do not accrueautomatically; a threshold level of absorptive capacity is required in order to tap intothe potential externalities2. The impact of R&D-intensive FDI on host countriescomprises direct and indirect effects (Görg and Strobl 2001; Narula and Dunning,2010):Direct effects are associated with a net increase in domestic R&D activity, involvingmore R&D expenditure and the quick creation of job opportunities for highly skilledlabor. The direct benefits will be larger when the subsequent R&D activities of MNCsubsidiaries complement (rather than replace) the R&D activity of local companies.Still, some extent of crowding-out of the technological activity of local firms can be2 Absorptive capacity can be defined as the firm‟s (or country‟s) ability to acquire, assimilate and exploitknowledge developed elsewhere (Cohen and Levinthal, 1989). 2
  • 3. expected through intensified competition for limited specialized assets, includinghuman capital. The risk of crowding-out is especially acute in the case of transnationalM&As, where the only short term effect for the host country is a change of ownership,while in the medium- to long-run there is a trade-off between the potential for expansionand upgrading, on the one hand, and the risk that the acquirer ends up reducing thesubsidiary‟s R&D mandate to avoid duplicities with other pre-existing R&D centerswithin the MNC‟s global network, on the other hand.Indirect effects relate to the impact of innovative MNC subsidiaries on other actors ofthe national innovation system through different types of formal and informal linkagesand knowledge spillovers. Among other indirect effects, R&D-intensive FDI mayenable locally produced components to be incorporated at the design stage of newproducts, opening up new markets for local suppliers and new opportunities tocollaborate with MNCs. R&D-intensive FDI facilitates the transfer of tacittechnological knowledge, which is hard to acquire by other means. Besidescollaborative agreements with local firms and research centers, knowledge spilloversalso unfold through indirect employment effects, whereby the host country benefits fromtraining provided by MNC subsidiaries to their employees, who subsequently becomeavailable to local firms through the job market or may establish new venturesthemselves (Fosfuri et al., 2001). Other sources of indirect benefits are demonstrationand competition effects, because the presence of innovative MNC subsidiaries spursdomestic firms to engage in R&D and enhance the efficiency of their operations to beable to compete. In contrast with direct effects, indirect effects may be larger in the caseof M&As, given that the acquired subsidiary will tend to be more embedded in the localeconomic in terms of vertical and horizontal linkages with local firms, universities andagencies.Measuring R&D-intensive FDI is not straightforward, since the indicators and statisticalsources available are limited. Moreover, there are different ways of measuring R&D-intensive FDI, depending on whether the objective is to measure the flows or the stocks.R&D-intensive FDI flows are the new FDI projects during a certain year(s) which areconnected to R&D. The problem is that official statistics (from national governments,UNCTAD, etc.) do not provide a functional breakdown of FDI; at best they inform ofits industrial distribution. There are, however, other databases3 that provide detailedinformation about new FDI announcements, allowing the analyst to identify the specificFDI projects where the main activity concerned is R&D. In contrast, when analyzingR&D-intensive FDI stocks, the unit of analysis is the R&D activity of the wholepopulation of MNC subsidiaries located in the country concerned. Thus, the mainindicator of R&D-intensive FDI is the R&D expenditure by MNC subsidiaries, oftenexpressed as a percentage of total business expenditure in R&D4. The R&D intensity offoreign-owned subsidiaries can be compared with the R&D intensity of nationally-owned firms5. Further comparisons of the innovative behavior of MNC subsidiariesversus national firms can be performed using the information provided by official3 For example, the fDi Markets database of Financial Times or the European Investment Monitor databaseof Ernst and Young.4 The OECD compiles this indicator since the early 1990s, although not all OECD countries are covered.5 Aggregate comparisons of R&D-intensities need to be done with care, controlling by industry and firmsize as well as considering the potential distortive effect of corporate transfer pricing strategies (Barry,2005). 3
  • 4. innovation surveys (e.g. the Community Innovation Survey, for EU countries) orthrough new surveys developed for specific research purposes. An additional possibilityfor measuring the internationalization of corporate R&D is to use patent data, as patentapplications inform of the address of both the inventor and the applicant, such that whenthey are located in different countries this generally reflects the internationalization ofMNCs innovative activities (Guellec and Pottelsberghe, 2001).In this paper we use data on R&D expenditure of foreign-owned subsidiaries from theOECD and then rely on the fDi Markets database to further analyze geographical andindustrial trends. This database comprises greenfield FDI project announcements,excluding M&As. The information in the database is compiled by the Financial TimesGroup through global, national and regional media; financial information providers;corporate websites; and government websites. Despite its limitations, this is one of thefew sources to identify R&D-intensive FDI projects, because it provides informationnot only of the sector but also of the business activity associated with each investmentannouncement. By selecting only the FDI projects where the business activity is R&Dthe flows of R&D-intensive FDI can be proxied6. This database provides a sample of2275 announcements of FDI in R&D project announcements around the world startingin 2003 and is updated several times per year.Building on an analysis of these statistical sources and on a literature review, the rest ofthis paper discusses some key global trends which may be relevant to shape governmentpolicies aimed at attracting and embedding the R&D of multinational companies.Section 2 argues that the fast growth in R&D-intensive FDI during the 1990s may beshifting towards a period of stagnation given the maturation of corporate R&D networksand the effects of the 2007-2010 economic crisis. Section 3 shows that in recent yearsglobal R&D networks are becoming more multi-polar, with a growing relevance ofemerging countries both as destinations and as sources of R&D-intensive FDI. Section 4elaborates on the evolution of strategic motivations behind R&D-intensive FDI. Finally,Section 5 attempts to translate these global trends into a set of policy implications fordeveloping countries.2. Is the recent growth of R&D-intensive FDI coming to an end?Although it is not a new phenomenon, the internationalization of R&D acceleratedsharply during the 1990s, partly as a side effect of the internationalization of productionand of the rise in transnational M&As, and partly as a deliberate strategy of building upglobal innovation networks by MNCs. A study by Booz Allen Hamilton, a consultingfirm, indicates that the largest 1000 companies by R&D expenditure allocate on average55 percent of their R&D budget outside the countries where they are headquartered(Jaruzelski and Dehoff, 2008). Other interesting findings of this study are that 916 This implies underestimating to a certain extent the R&D that occurs through FDI, because projects thatare classified in a different business activity such as manufacturing may also bring along some associatedR&D expenditure even if it is not the main focus of the project (besides R&D, other business activities inthe database include sales, marketing & support; manufacturing; business services; retail; distribution &transportation; customer contact centers; extraction; retail; headquarters; and others). Moreover, thedatabase is not exhaustive: there may be some other FDI projects that are not accounted for by fDimarkets database because they do not appear in the primary sources used to gather the data. 4
  • 5. percent of MNCs conduct some R&D in their subsidiaries abroad and that their totalnumber of overseas R&D sites increased by 6 percent from 2004 to 2007.Global estimates from the United Nations Conference for Trade and Development showthat in 2002 firms allocated 15.9 percent of their R&D expenditure in their subsidiariesabroad, up from 10.3 percent in 1993 (UNCTAD, 2005). This implies that the R&D offoreign-owned subsidiaries grew much faster than the R&D of local firms. More recentestimates show that the internationalization of corporate R&D continued growing from2002 to 2006 in most OECD countries (OECD, 2009). A similar picture emerges bylooking at other indicators of the internationalization of corporate R&D, such as theshare of total patents that originate from foreign-owned MNC subsidiaries (Guellec andPottelsberghe, 2001).The growing relevance of foreign MNC subsidiaries in domestic R&D effort iswidespread, but there are large differences across countries in the actual level of foreignparticipation, reflecting not only their different attractiveness for R&D-intensive FDI,but also their degree of openness and the intensity of R&D by national firms. In 2006the share of foreign affiliates in domestic business R&D was 5.4 percent in Japan, 13.8percent in the US, around 30 percent in most European countries7, and over 60 percentin Slovakia and Ireland (OECD, 2009). Table 1 shows the evolution of this indicatorfrom 1994 to 2006 in a set of OECD countries. It is worth noting that the relevance offoreign subsidiaries in domestic R&D expenditure rose in all countries of the sampleand that this trend is especially intense in Eastern European countries.*** TABLE 1 HERE ***With regard to industrial trends, it can be expected that R&D-intensive FDI willconcentrate in the most global and high technology sectors such as pharmaceuticals andICT. However, the internationalization of R&D extends across many different sectors,as illustrated in Table 2 by the specific case of inward R&D-intensive FDI into the EU.Therefore, although it makes sense to design specific policy strategies for the dominantindustries, it is worth also to be open-minded and look for opportunities in other marketniches. Another trend to consider is the growing importance of R&D in the servicessector: in contrast to R&D in manufacturing, which has shown little growth in recentyears, R&D in services is growing rapidly in most countries, and this trend also reflectsitself in the internationalization of corporate R&D (European Commission, 2007).*** TABLE 2 HERE ***With the global economic crisis that started in 2007, there was a sharp decline in globalFDI flows, albeit with a slight recovery starting in 2010 (UNCTAD, 2010). It can beexpected that R&D-intensive FDI flows also declined or at best stagnated. Indeed,between 2007 and 2010 a total of 1004 greenfield FDI in R&D projects were recordedglobally, compared with 1271 from 2003 to 2006, which represents a 26.6 percentdecline (Source: fDi Markets database).7 The figures for EU countries include intra-EU investment flows, i.e. when a firm based in a EU countryconducts R&D in another EU country. Therefore they are not directly comparable with the US, whereinter-State flows are excluded. 5
  • 6. Even before the crisis unfolded, Gammeltoft (2006) argued that “the fire growth inR&D internationalisation, well documented in the previous literature, may have come toan end” and that the focus is now shifting towards the “organisational consolidation ofthe existing complex international R&D structures”. Similarly, Hegde and Hicks (2008)spoke of a “maturation” of globalized corporate R&D.After the fast expansion of global innovation networks during the 1990s - sometimesfuelled by international M&As rather than by deliberate R&D internationalizationstrategies - in many cases the resulting structures turned out to be overly complex andunmanageable, leading many MNCs to streamline their organisations and exert a largerhierarchical coordination (Gammeltoft, 2006). It is reasonable to assume that the crisishas further spurred the restructuring of global R&D networks in search for efficiency,possibly resulting in divestments in some countries but expansions in others. In a surveyof the 1000 largest EU companies by R&D expenditure, over half of respondents madechanges to the management of their R&D investments as a result of the economic crisis,concentrating their research agenda via reallocation of resources, narrowing of focus,and higher outsourcing of R&D work (European Commission, 2010). Filippetti andArchibugi (2011) show that, within the EU, MNC subsidiaries located in EasternEurope are those that have suffered the larger cuts in R&D activity following the 2007-2010 economic crisis, compared to the more important R&D nodes placed in theWestern Europe.3. The shift towards developing countriesR&D-intensive FDI was formerly a triadic rather than global phenomenon, with bothinflows and outflows heavily concentrated in the US, Western Europe and (to a lesserextent) Japan. However, during the last decade the relevance of developing countries inglobal innovation networks has increased substantially8. This can be ascribed largely tothe sharp increase in new R&D investments by MNCs in China and India during the lastdecade, although starting from a very low base: the number of R&D centers owned byforeign MNCs rose from only 100 in each of the two countries in 2001 to 1100 in Chinaand 780 in India by the end of 2008 (Bruche, 2009). According to Jaruzelski and Dehoff(2008) eighty-three percent of all new R&D sites opened between 2004 and 2007 by thelargest 1000 MNCs by R&D expenditure were located in China or India.Based on Ernst and Young‟s fDi Database, Table 3 shows the geographical distributionof FDI in R&D projects from 2003 to 2010. From 2003 to 2010 there were a total of2275 announcements of new FDI in R&D projects in the world, out of which 43 percentwere located in Asia-Pacific. Western Europe attracted almost 25 percent of all new FDIin R&D projects during that period, while the share of North America was around 13percent9. The table also indicates the share of R&D projects in total inward FDI byregion. For example, in Western Europe around 2.3 percent of all new FDI projectswere directly related to R&D, while in the rest of Europe the share was below 1 percent.It is worth noting that R&D-intensive FDI projects are not employment-intensive: on8 It is important here to differentiate between flows and stocks: although developing countries areattracting a growing share of new flows of R&D-intensive FDI in recent years, they still represent a lowershare of the total stock, and thus of the total overseas R&D expenditure by MNCs.9 However, it should be noted that the EU figure includes intra-EU investment flows (see note 3). 6
  • 7. average, each new R&D center opened by foreign-owned firms in EU 27 countriesbetween 2003 and 2010 created just 86 new jobs.** TABLE 3 HERE **From a different perspective, with outward FDI from developing countries rapidlyincreasing, emerging market multinationals have also become important sources ofR&D-intensive FDI (Sauvant et al., 2010). For example, Chinese and Indian companiessuch as Huawei, Tata or Lenovo operate large R&D centers in the US and Europe in aneffort to enhance their global competitiveness by tapping into foreign sources ofknowledge and leading technological clusters. This also applies to other developingcountries (e.g. Brazil, Russia, South Africa), newly industrialized countries (e.g.Singapore, South Korea, Taiwan) and oil producing Arab countries.Developing and transition economies are increasingly aware of the importance of R&D-intensive FDI and its role as a mechanism for technological transfer and catching-up.But a critical challenge is that many developing countries lack the absorptive capacity,large markets and specialized clusters that MNCs are looking for when deciding whereto locate their international R&D activities. Moreover, corporate R&D has the tendencyto be sticky, implying that MNCs tend to display a strong inertia towards maintainingtheir most strategic R&D activities in already existing locations (Narula, 2002). Indeed,path-dependencies, agglomeration economies and first mover advantages act as barriersfor latecomers. As argued by Lall (2004), “the cumulative nature of capabilities meansthat once FDI takes root in particular locations and global sourcing systems becomeestablished, it becomes more difficult to newcomers to break in, particularly in the morecomplex activities and functions”.4. The evolving strategic motivationsThe motivations underlying R&D-intensive FDI may be demand-driven, supply-drivenor efficiency-seeking. Demand-driven R&D is associated with knowledge-exploitingmotivations and primarily oriented towards the adaptation of products, services orprocesses to overseas markets. This kind of R&D is often closely connected to theinternationalization of manufacturing operations and attracted by large and dynamicmarkets. In contrast, supply driven R&D is related to knowledge-augmentingmotivations, i.e. to tapping into foreign sources of knowledge. In this case the locationdecision is driven by the quality of local universities, human capital, researchinfrastructure and the presence of specialized clusters, rather than by the size ordynamism of the domestic market. In other circumstances the international allocation ofR&D is driven mainly by efficiency-seeking motivations, where certain segments of theR&D value chain are relocated to lower cost locations. These different strategicmotivations are closely related to the distinction between competence creating andcompetence exploiting mandates of MNC subsidiaries (Cantwell and Mudambi, 2005).In practice, the different R&D motivations are often hard to differentiate, and a singlesubsidiary may undertake different R&D projects, some of them demand-driven, otherssupply-driven, etc. Moreover, the strategic content of international R&D mandatesevolves through time in response to changes in corporate strategies and subsidiarycompetencies. 7
  • 8. Demand-driven R&D tends to be more footloose and highly dependent on thecontinuation of manufacturing or sales activities, while supply-driven R&D tends to bemore autonomous and knowledge-intensive, and implies a greater reliance on domesticknowledge sources. The internationalization of corporate R&D was primarily demanddriven in the past, following the internationalization of manufacturing and sales(Mansfield et al., 1979). But, even though demand driven motivations remain importanttoday, in recent years supply driven motivations are gradually growing in importance(Carlsson, 2006; Hegde and Hicks, 2008). Indeed, the role of subsidiaries in globalinnovation networks is becoming more active, involving not only incrementalinnovations but also multi-technology product development and even basic research.However, while the number of supply-driven R&D centers may have increased in recentyears, MNCs often operate with just a few of such global R&D labs in carefullyselected locations, with the historical core R&D unit in the country of origin oftenholding a coordinating role (Sachwald, 2008). Demand-driven and efficiency-seekingR&D centers are the most numerous and geographically dispersed, constituting themajority of overseas R&D centers.In principle, developing countries are more likely to attract demand-driven orefficiency-seeking rather than supply-driven R&D, given their lower technologicalcapabilities relative to developed countries. Along these lines, Thursby and Thursby(2006) show that the kind of R&D activities by MNCs in emerging countries normallyentails familiar science (i.e. applications of science currently used by the firm and/or itscompetitors) rather than new science (i.e. novel applications of science), which remainsconcentrated in the core developed countries. Beyond mere adaptation of existingproducts and processes, another possible demand-driven motivation which is gainingimportance in recent years is related to the design of new products for low costmanufacturing, in order to tap into the vast market of low income customers who cannotafford products such as refrigerators or clothes washing machines within the range ofexisting high-end options designed for the middle classes of developed countries(Eyring et al., 2011). It is more likely that engineering talent and new business modelsto design new, lower-end options to meet those needs will come from developingcountries. Another example concerns the race to design a low-cost, high-quality car thatcan be affordable to the “middle market” of developing countries. These kinds ofmotivations are closely connected with the growing interest of firms in innovation forthe bottom of the pyramid (Kaplinsky, 2011).Demand-driven and efficiency-seeking R&D subsidiaries tend to focus initially inlower-end and routine R&D activities (Manning et al., 2008). Puga and Trefler (2010)suggest that developing economies normally engage initially only in incremental (ratherthan radical) R&D, related to addressing production-line bugs and suggesting minorproduct improvements. But these lower-end R&D activities may act as a seed in thesense that, with time, they may enable a shift towards higher value adding R&Dactivities following learning and competence building in the subsidiaries (Chaminadeand Vang, 2008; Medcof, 2007; Puga and Trefler, 2010). Indeed, the developmentalimpact of demand-driven and efficiency-seeking R&D should not be neglected. Rather,such R&D activities should be seen as an invaluable opportunity for an evolutionaryupgrading of technological capabilities. 8
  • 9. Whatever the strategic motivations, R&D mandates normally emerge as a sequentialprocess where pre-existing manufacturing or customer support subsidiaries getprogressively engaged in R&D, and in subsequent phases may further expand thecompetence and scope of their R&D activity. This reflects that R&D-intensive FDInormally occurs through the upward evolution of existing subsidiaries rather thanthrough completely new investments (Costa and Filippov, 2008; Guimón, 2009;Mudambi and Mudambi, 2005). R&D mandates are often assigned through acompetitive bidding process involving several potentially-capable subsidiaries of theMNC already present in different countries and regions. This kind of intra-corporatecompetition to attract R&D is becoming more intense as global innovation networkshave become more mature and as a growing and more diverse set of locations haveacquired the threshold level of technological capabilities and infrastructure required forhosting R&D facilities. MNCs are continuously rationalizing and restructuring theirinternational network of R&D units, often resulting in an increase in R&D expenditureoverseas but a reduction in the total number of R&D units, through strategies such asregional integration of R&D efforts (e.g. one dominant R&D center for Europe, with asmaller network of collaborating units).5. Conclusions and policy implications for developing countriesSome emerging countries like China and India are attracting increasing flows of R&D-intensive FDI. Their specialization in manufacturing and other activities like businessprocess outsourcing shows signs of evolution towards more knowledge intensivesegments of corporate value chains, including R&D. However, many developingcountries (and peripheral regions within developed countries) lack the large anddynamic markets that BRIC countries can use as a bargaining tool to attract the R&D ofMNCs, and they also lack the technological infrastructure, human capital andspecialized clusters that MNCs are looking for when deciding where to locate theirinternational R&D centers (Narula and Guimón, 2010). Indeed, although the emergingnew geography of corporate R&D is clearly becoming more multi-polar, this does notnecessarily imply that it will be inclusive. Countries that fail to raise their technologicalcapabilities in line with MNC needs risk becoming marginalized from global innovationnetworks. According to Velde (2001) pro-active and strategic FDI policy interventionsaffecting the dynamic pattern of national comparative advantages become necessary inorder to avoid the risk of a low-skill, low-income trap. Lall (2004) also argues that theneed for policy intervention has become stronger given the fast pace of globalizationand technological change. Attracting R&D-intensive FDI requires a more proactive kindof intervention, unlike generic FDI policies which can rely largely on investmentliberalisation along with marketing and promotion.Developing and peripheral countries normally face more difficulties in attracting theR&D of MNCs and see a higher need of government intervention because of marketfailures or systemic inefficiencies. An example of market failure is that those whodecide the allocation of R&D centres within global innovation networks lack perfectinformation about all potential countries and regions, which implies that their locationdecisions may be biased. This would justify policy intervention in the form of FDIpromotion. Another market failure in R&D investment is that firms are not sensitive tothe positive externalities of knowledge creation and, if left to the market, they wouldtend to under-invest in R&D due to appropriability concerns and to the duration and risk 9
  • 10. inherent in R&D projects. This applies arguably to a larger extent to the specific case ofMNC subsidiaries in developing countries, given that the risk of knowledge spilloversmay be perceived as higher. This would justify policy interventions to improve theintellectual property rights regime. In addition to market failures, the literature oninnovation systems has played an important role in shaping a new policy approach,bringing along the notion of systemic failures, beyond market failures, as a rationale forinnovation policies (Smith, 2000). Under this framework policy makers are expected tointervene when the system of knowledge generation and diffusion does not achieve itsobjectives of contributing to innovation and technological progress in an efficientmanner, because of the lack of well developed networks between the different actors ofthe system, because of institutional weaknesses, because of an inadequate provision ofresearch infrastructure, and so on. Thus the role of governments extends further tofacilitating linkages and enhancing the dynamism of the national innovation system.Table 4 provides an overview of the key policy objectives and instruments associatedwith the attraction of R&D-intensive FDI. The implementation of this kind of policystrategies requires a close interplay of innovation policy and inward investmentpromotion (Costa and Filippov, 2008; Guimón, 2009). On the one hand, the role ofinnovation policy is to improve the investment climate for R&D by identifying andacting upon the strengths and weaknesses of the national innovation system. On theother hand, the role of inward investment promotion is to improve the image of thecountry as an R&D location and to provide targeted services to both potential andexisting foreign investors in R&D. Another policy objective at the intersection betweenFDI and innovation policy is to build clusters and stimulate linkages around existingMNC subsidiaries. The goal is to enhance the benefits for the domestic innovationsystem and to increase the strategic importance of the subsidiary to the MNCheadquarters, such that sequential investments become increasingly knowledgeintensive.*** TABLE 4 HERE ***Attracting R&D-intensive FDI can be interpreted as an evolutionary and sequentialprocess following the development of local capabilities. The objective guiding FDIpolicies would be to create the conditions that enable existing subsidiaries to penetrateinto higher value-added segments of global value chains, and in particular into R&D, byproviding the necessary infrastructures, public R&D and human capital development, inaddition to fiscal and financial incentives to private firms undertaking R&D. Animportant policy to attract R&D-intensive FDI is the non-discrimination of foreign-owned firms against indigenous firms in national technology programs and R&Dfunding. Initially, the kind of R&D being attracted will be local and incremental inscope, motivated by demand-driven or efficiency-seeking strategies. But with time theseR&D mandates might expand to more sophisticated, supply-driven activities followinglocal learning and competence building. This may culminate in a self-reinforcingprocess where dynamic and innovative clusters emerge through the upgrading of localcapabilities and MNC subsidiaries‟ mandates in tandem, and where the subsidiariesbecome simultaneously deeply integrated within the MNC global structure and deeplyembedded within the domestic innovation system; a situation that has been defined asdual embeddedness (Meyer et al., 2011). 10
  • 11. From a systemic approach, policy interventions should aim at stimulating linkages andbuilding clusters around MNC subsidiaries. This kind of policies are based on thepremise that the opportunities for upgrading and the benefits for the host country aremagnified when MNC subsidiaries become embedded in the domestic milieu bycollaborating with other agents of the national innovation system. Empirical studieshave shown that spillovers of R&D-intensive FDI (measured in terms of increasedproductivity in local firms) tend to be positive through vertical linkages (i.e. withsuppliers or customers) but inexistent or negative through horizontal linkages (i.e. withcompetitors) (Javorcik, 2002). The existing literature also sustains that the potential forlinkage creation is closely related to the scope assigned to the subsidiary within theMNC global structure and to the subsidiary‟s initiative and upward influence(Birkinshaw, 1997; Jindra et al. 2009; Santangelo, 2009). In order for linkages tounfold, governments should focus on improving the quality standards of domesticsuppliers, such that they turn more likely to become suppliers of MNC subsidiaries.Many countries such as the Czech Republic and Ireland have successfully used linkageprogrammes to support the development of supplier networks and technology clustersaround MNC subsidiaries. The role of governments as linkage facilitators and skillscoordinators is not limited to promoting linkages between MNCs and domesticsuppliers or partners; it should extend further to linkages with universities and publicresearch centres. This includes joint-research projects as well as subcontracting ofcertain research activities. Universities and public research centres also offer MNCstechnical services for testing and consultancy. In addition, training-oriented linkagesbetween MNCs and local universities should also be encouraged.With regard to investment promotion policies, beyond advertisement and pre-investment services, countries targeting R&D-intensive FDI place a higher emphasis inproviding customized value-added services to foreign investors in R&D. This implies ahigher focus on aftercare services, which makes sense given that the R&D mandates ofMNC subsidiaries tend to occur sequentially rather than overnight. Along these lines,investment promotion agencies should evaluate the existing stock of foreignsubsidiaries in order to identify specific opportunities for upgrading, which would befollowed by enhanced dialogue and collaboration with subsidiary managers and by theoffering of customized aftercare services and incentives. The identification ofprospective companies for policy intervention is followed by efforts to gain audienceswith decision-makers in these companies but, in the words of Loewendahl (2001, p. 22),“approaching companies should not be seen as a methodical exercise: it is not aboutone-off approaches to a fixed number of companies each day, but rather a marketintelligence gathering and relationship building campaign”. These efforts should aim atidentifying new ways in which host country governments might assist MNC subsidiarymanagers in upgrading towards higher value adding R&D mandates. In addition, animportant role of investment promotion agencies is to provide advice to other spheres ofgovernment in order to better guide policy reform towards the dynamic technologicalneeds of MNCs.Policies to attract R&D-intensive FDI cannot be isolated from wider FDI and industrialdevelopment strategies, and it is important to consider possible tradeoffs. For example,Mudambi and Mudambi (2005) show how FDI policies aimed at maximizing R&D andtechnology transfer do not contribute to reducing regional disparities, since knowledge-intensive subsidiaries will gravitate towards the most technologically advanced regions. 11
  • 12. Moreover, they find that subsidiary operations with high R&D content generate loweremployment levels, suggesting some extent of quality/quantity trade-off. This trade-offbecomes more apparent in the current times of global economic crisis whereemployment and capital accumulation return to the top of the policy agenda. While froma long-term perspective the target might remain on R&D-intensive FDI that generateslarger knowledge inflows and linkages, FDI policy is also subject to short-term politicalpressures. The need for more obvious and easily measurable local benefits, such asheadcount employment, often drives policy making and evaluation.While the case for public intervention may be strong, governments should set realistictargets to guide their policies by coupling their country‟s potential location advantageswith the dynamics of global innovation networks. Attracting R&D-intensive FDI is notan easy task because it requires advanced technological infrastructure and capabilitiesand because competition among countries is becoming more intense, within a context ofcontinuous restructuring and segmentation of global value chains. Policy-makers areconfronted with the challenge of selecting specific policy interventions to improve thelocation‟s attractiveness and to promote and embed the R&D of MNCs. Clearly, thereare no magic formulas that can be applied across the board; each individual countrywould require a different mix of policies depending on its technological andinstitutional profile. The aim then is to design a coherent and efficient policy mix thatencompasses the right set of policies considering the country‟s circumstances anddevelopmental strategies. Specific government actions and strategies should followfrom an intelligence gathering and technology foresight exercise in continuous dialoguewith the managers of existing MNC subsidiaries. But determining the optimal policymix is a very difficult task because it involves different government departments andagencies and because the relative efficiency of the different policy instruments isuncertain ex ante and hard to evaluate ex post. Some of the policy instruments may havea short term impact, such as fiscal and financial R&D incentives, while others such asimproving the education system will only have visible effects in the long run aftersustained investments. The policy mix is not a static structure: it necessarily changesthrough time in response to structural transformations of markets and technologies andto changes in broader economic development strategies.With regard to outward R&D-intensive FDI, the governments of some developingcountries like South Korea and China are increasingly aware of its benefits as amechanism for reverse technology transfer, while others remain neutral (rather thanpromoting it explicitly) in view of the potential negative effects in terms of crowding-out of intra-mural business expenditure in R&D. In any case, policies towards R&D-intensive FDI remain in an experimental phase and very underexplored in the existingliterature (Edler, 2008), especially in the specific case of developing countries. 12
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  • 16. Table 1. R&D expenditure of foreign subsidiaries (% of business expenditure in R&D) 1994 2006Ireland 66.8 75.9Slovakia 4.1 64.1Czech Republic 20.9 58.6Hungary 22.6 57.8Belgium n.a. 56.8Portugal n.a. 47.4Sweden 19.3 42.3United Kingdom 29.1 38.4Germany 13 38.3Spain 30 35.6Netherlands 20.4 27.5Italy n.a. 26.6Poland 10.3 21.7France 14.2 20.8Finland 13.9 17EU average 23.7 38.5United States 13.3 13.8Canada 29.8 34.7Japan 1.5 5.4Notes: The EU average is an unweighted mean for the EU countries included in the table; no informationavailable from the sources on other Member States; n.a. means not availableSources: OECD (2009) for 2006 and UNCTAD (2005) for 1994. 1995 for Czech Republic, Finland,Germany, Ireland, Spain and Sweden. 1997 for Poland and Netherlands. 2005 for Belgium, Germany,Hungary, Ireland, Portugal, Slovakia, Spain and Sweden. 2004 for Netherlands. Manufacturing sectoronly for Germany, Ireland, Portugal, Slovakia and Spain, across all years 16
  • 17. Table 2. Distribution by sector of inward R&D-intensive FDI in the EU 27 (percentage of eachsector in total number of projects, 2003-2010)Pharmaceuticals 20.7 Metals 1.9Software & IT services 15.8 Plastics 1.7Biotechnology 12.8 Healthcare 1.6Communications 5.8 Business Services 1.4Automotive Components and OEM 5.0 Aerospace 1.3Chemicals 4.5 Consumer Electronics 1.3Electronic Components 3.9 Building & Construction Materials 0.9Industrial Machinery, Equip. & Tools 3.8 Alternative/Renewable energy 0.8Semiconductors 3.4 Business Machines & Equipment 0.8Medical Devices 3.0 Coal, Oil and Natural Gas 0.8Food & Tobacco 2.7 Engines & Turbines 0.8Consumer Products 1.9 Other sectors 3.6Notes: Based on number of greenfield FDI announcements per sector where the main business activity isR&D, without considering the quantity of the investment. M&As are excluded. Sample size of 639greenfield FDI projects in the 27 Member States of the EU. “Other sectors” comprises several sectorsrepresenting less than 0.8 percent of the total: Ceramics & Glass; Financial Services; Minerals; Non-Automotive Transport OEM; Paper, Printing & Packaging; Rubber; Space & Defence; and TextilesSource: Author‟s calculations based on fDi Markets database 17
  • 18. Table 3. Distribution by region of inward R&D-intensive FDI (2003-2010) Number of FDI Percentage of Percentage of in R&D projects world total total FDI projectsAsia-Pacific 987 43.4 13.8Western Europe 566 24.9 2.3North America 289 12.7 7.1Middle East 209 9.2 1.3Rest of Europe 132 5.8 0.8Latin America & Caribbean 68 3.0 1.3Africa 24 1.1 0.1World total 2275 100 2.1Note: Based on number of greenfield FDI announcements per sector where the main business activity isR&D, without considering the quantity of the investment. M&As are excludedSource: Author‟s calculations based on fDi Markets database 18
  • 19. Table 4. Policies towards inward R&D-intensive FDI Policy objectives Selected policy instruments Enhancing the R&D investment - Universities, public research centers, science and technology climate parks - Human capital and attraction of foreign talent - Fiscal and financial incentives to business R&D - Systemic policies to stimulate linkages and interaction - Intellectual property rights regime Targeting R&D in FDI promotion - International promotion of national technological capabilities - Pre-investment services to MNCs - Post-investment (“aftercare”) services to MNCs Reaping the benefits from inward - Building clusters and linkages around MNC subsidiaries R&D-intensive FDI (supplier upgrading and technology linkage programs) - Promoting collaboration through R&D incentive schemes 19