Inflows of foreign direct investment (FDI) can act as a catalyst for domestic firms to develop sophisticated manufacturing products, according to a study of Turkey by Beata Javorcik, Alessia Lo Turco and Daniela Maggioni. Their research, published in the September 2018 issue of the Economic Journal, concludes that investment promotion policies can play a key role in facilitating upgrading of the national production structure.

The authors comment:

‘Our findings matter for policy. Enhancing the economy’s productive capabilities across an increasing range of more sophisticated manufactured goods is an integral part of economic development.’

‘Our results imply that FDI inflows can act as an important catalyst for this process. Thus, there is room for investment promotion activities, a policy that is known to be effective in developing countries.’

‘In contrast to many other industrial policies, investment promotion (as distinct from fiscal incentives) is relatively inexpensive and causes few distortions. Therefore, there is little downside even if the government gets it wrong.’

There is growing evidence that inflows of foreign direct investment (FDI) make it more likely that host countries will upgrade production. The new study examines the link between FDI and the complexity of new products introduced by domestic firms.

The authors focus on Turkey, a country that experienced a spectacular surge in FDI inflows during the 2000s and is one of the few countries to have dramatically improved the sophistication of its productive structure in recent decades.

The concept of product complexity is best illustrated by analogy with Lego, the plastic construction toy. Imagine that a country is represented by a bucket of Lego pieces with each piece representing the capabilities available in the country. The set of products (Lego models) a country can produce depends on the type, diversity and exclusiveness of the pieces in the bucket.

A bucket containing Lego pieces that can only be used to build a toy bicycle probably does not contain the pieces to create a toy car. But a bucket containing Lego pieces that can build a toy car may also have the necessary pieces to build a toy bicycle.

While two buckets may be capable of building the same number of models, these may be completely different sets of models. Thus, determining the complexity of an economy by looking at its products amounts to determining the diversity and exclusivity of the Lego pieces in a bucket by looking at the Lego models it can build.

Anecdotal evidence suggests that foreign affiliates operating in Turkey may be stimulating product upgrading among their suppliers. For example, Indesit is an Italian white goods producer – recently acquired by Whirlpool – that has been active in Turkey since the 1990s. Its plant, located in Manisa, produces refrigerators.

At the outset of its operations in Turkey, Indesit imported most of the components needed to make the final products. Now, Indesit sources almost all the main components locally. More than half of its supplier base is in Turkey, mostly in the same industrial district as its Manisa plant.

Geographical proximity to suppliers is important for keeping down transport costs and allowing more productive collaboration with suppliers. Indesit regularly conducts audits of its suppliers and also helps them to start production. Its resources of engineering know-how and previous experiences working with local suppliers elsewhere in the world are shared with Turkish business partners.

In 2012, Indesit built a new plant producing washing machines. To become a supplier to this new plant, a local company purchased new presses and automated its production process.

This allowed the company to start producing a new and more sophisticated product, and increase efficiency and production volume. It became the only supplier to Indesit in Turkey capable of making a complex product: the flange of a washing machine basket.

Stainless steel components like a washing machine flange are among the most complex products in the industry. For example, the flange is twice as complex as a stainless sink, which in turn is more complex than a pot scourer.

The flange needs to be produced with no aesthetic defects by an 800-1,000 tonne metal press. The component’s drawings are statistically controlled for correct assembly with the rest of the washing machine basket. They also need to withstand the stress of between 1,000 and 1,400 revolutions per minute while remaining within a certain range of vibration and noisiness.

Indesit played a central role in the upgrading process of its supplier. Indesit shared some essential tacit knowledge, information processes, instructions and control procedures with the local company. This stimulated and supported the supplier’s complexity upgrading.

Inspired by this anecdotal evidence, the researchers examine the link between the presence of foreign affiliates and production upgrading by Turkish firms located in the same region and active in the input-supplying industries.

The presence of foreign affiliates does not seem to affect the propensity of Turkish firms to innovate. But their presence is positively correlated with the complexity level of products newly introduced by Turkish firms active in the supplying industries and located in the same region.

The estimated effect is economically meaningful. A 10-percentage point increase in foreign presence translates into the average complexity of products newly introduced in the supplying industries increasing by 0.297, which implies moving about halfway from the production of pot scourers to producing stainless steel sinks.

In a similar way, an increase of about 17 percentage points in FDI in the relevant sectors would be necessary to move from the production of stainless steel sinks to the production of washing machine flanges.

When the researchers investigate the change in the overall complexity of the firm’s portfolio of products, the data corroborate the finding of a positive relationship between the presence of foreign affiliates and increasing sophistication of Turkish manufacturers in supply industries.

New and Improved: Does FDI Boost Production Complexity in Host Countries?’ by Beata Javorcik, Alessia Lo Turco and Daniela Maggioni is forthcoming in the Economic Journal.