As foreign direct investment (FDI)(1) assumes growing importance in the globalizing world economy, countries are increasingly concerned with maximizing its benefits. For developing countries, one of the most effective ways to do this is to promote linkages between foreign affiliates and domestic firms, which provide the strongest channel for diffusing skills, knowledge and technology. This is the theme of this year´s World Investment Report(2),published today by the United Nations Conference on Trade and Development (UNCTAD). The Report looks at the positive impact of linkages on development and the policy challenge of how to promote linkages.
Linkages offer benefits to foreign affiliates and domestic firms, as well as to the economy in which they are forged. For developing countries, the formation of backward linkages with foreign affiliates assumes particular importance. From the standpoint of foreign affiliates, local procurement can lower production costs in host economies and allow greater specialization and flexibility, with better adaptation of technologies and products to local conditions. The presence of technologically advanced suppliers can provide affiliates with access to external technological and skill resources, feeding into their own innovative efforts. From the domestic suppliers´ side, the direct effect of linkages is generally a rise in their output and employment. Linkages can also transmit knowledge and skills between the linked firms. A dense network of linkages can promote production efficiency, productivity growth, technological and managerial capabilities and market diversification for the firms involved. The example of ENGTEK (see box 1) illustrates how linkages with foreign affiliates can act as springboards for the growth and internationalization strategies of domestic firms in developing countries. For the host economy as a whole, linkages can stimulate economic activity and, where local inputs substitute for imported ones, benefit the balance of payments. The strengthening of suppliers can in turn lead to spillovers to the rest of the host economy, contributing to a vibrant enterprise sector and making foreign affiliates less "footloose".
The current trends among transnational corporations (TNCs(3)) of focusing more on their core business and relying more on outsourcing represent new opportunities for firms to link up to the global production systems of TNCs. An average manufacturing firm may spend more than 50% of its revenues on purchased inputs. But becoming a supplier to a leading TNC is no easy task. Increased competitive pressure is forcing firms on all points of the supply chain to select suppliers that can meet stringent demands in terms of cost, quality and timely delivery. This often leads foreign affiliates in globally oriented industries (such as electronics and automobiles) to use other TNCs as suppliers rather than to rely on domestic sources.
WIR01 stresses that the extent to which foreign affiliates forge linkages with domestic suppliers depends on the costs and benefits involved, as well as on differences in firm-level perceptions and strategies. Probably the most important factor affecting the degree of local sourcing in developing countries is related to the availability of supply capacity. The lack of efficient domestic suppliers is a common obstacle to the creation of linkages, particularly in developing countries.
Recognizing the mutual benefits that linkages can provide, both TNC affiliates and host governments have set up supplier development and linkage programmes, as discussed in WIR01. Among the success stories are Saint Gobain´s supplier development efforts in India (box 2), the Irish linkage development programme (box 3) and the Local Industry Upgrading Programme of Singapore (box 4).
While TNCs have a self-interest in forging links with domestic suppliers, governments can play an important role in promoting linkages, notes the Report. The willingness of firms to use local suppliers can be influenced by government policies addressing various obstacles to the linkage formation process in order to raise the benefits and/or reduce the costs of using domestic suppliers. For example, TNCs may be unaware of the availability of viable suppliers, or they may find it too costly to use them as sources of inputs.
Drawing on the experience of a wide range of countries, WIR01 presents a menu of specific measures that have been used to promote linkages. These include the provision of information and matchmaking; encouraging foreign affiliates to participate in programmes aimed at upgrading domestic suppliers´ technological capabilities; establishing training programmes in partnership with foreign affiliates for the benefit of domestic suppliers; and various schemes to enhance domestic suppliers´ access to financing.
A few countries - such as Costa Rica, the Czech Republic, Ireland, Malaysia, Singapore and the United Kingdom - have set up comprehensive linkage development programmes involving a combination of different policy measures and targeting selected industries and firms. Such programmes have often met with considerable success.
Well-targeted government intervention can tilt the balance in favour of more linkages and thereby contribute to knowledge transfers from TNCs that can feed into the development of a vibrant domestic enterprise sector. Of course, like other development policies, linkage promotion efforts need to be adapted to the circumstances prevailing in each host country and should be undertaken in close collaboration with the private sector and other stakeholders. The more linkage promotion policies go hand-in-hand with small and medium enterprise (SME) development and targeted FDI promotion policies, the more they are likely to be successful.
Substantive inputs for policy makers seeking ways to maximize the benefits that can be derived from FDI are put forward in WIR01. It also contains concrete examples of TNC efforts to strengthen supplier linkages, examples that can be emulated by other firms and in other countries.
Box 1: ENGTEK
Some 25 years ago, what is now Eng Teknologi Holdings Bhd (ENGTEK) started with $200 in seed capital as a tiny family-run venture that produced jigs and fixtures in a makeshift backyard facility in Malaysia. Today, the company is a global supplier for the computer hard disk drive and semiconductor industries, with nine affiliates in four countries. Last year, its 2,000 employees generated total revenues of about $63 million. Since 1993, it has been quoted on the Kuala Lumpur Stock Exchange, moving to the main board in 1999.
Among the factors behind the successful internationalization of ENGTEK was an entrepreneurial drive and commitment by management, along with a national policy environment conducive to enterprise development and shared by the company. Another key factor was that ENGTEK was engaged in closely knit partnerships with TNCs. For example, Intel provided the financial and technical assistance needed by the company to produce semi-automated wire bonders in 1981. With such partners as Advanced Micro Devices (AMD), Bosch, Fujitsu, Hewlett Packard, Maxtor, Readrite and Seagate, ENGTEK has been involved in designing products, bringing its specific experience in product development and gaining a competitive edge over potential competitors. As a first-tier supplier company, ENGTEK has been able to link up to the global production systems of its TNC clients, moving up the value chain over time. Partnerships also helped ENGTEK to internationalize and to become a TNC in its own right.
Box 2: Saint Gobain
When the French company Saint Gobain decided to set up a float glass plant in Chennai, India, it ran into major technical problems with potential local suppliers. Firms were disorganized and scattered. Their technological capabilities were limited and they were unable to reach minimum standards unaided. Saint Gobain set up specialized teams to develop suppliers three years before even starting productive operations. The teams, comprising experts in several disciplines from India and abroad, provided assistance on raw material evaluation, engineering and technical services, information technology support, packaging materials development and logistics management. Each team worked with suppliers to develop cost and business models, train a largely illiterate labour force and educate firms in management concepts. The teams also acted as intermediaries to help firms obtain loans from financial institutions. Four years after the first teams were sent to India, 80% of the raw material requirements were met locally, and several suppliers began selling to other TNCs in India.
Box 3: Ireland´s National Linkage Programme
Enterprise Ireland, a government agency established in 1985 under the Ministry of Finance, has been operating various linkage programmes designed to promote the integration of foreign enterprises into the Irish economy. The idea is "to work in partnership with client companies to develop a sustainable competitive advantage, leading to a significant increase in profitable sales, exports and employment". The National Linkage Programme (NLP) functions primarily as a brokerage service to promote local sourcing by foreign affiliates. It attempts to match foreign affiliates´ sourcing requirements with the production profiles of local suppliers, and has increasingly turned to capacity-building to do so. Target industries include electronics, engineering, health care, and metal and plastic components. A key criterion in selecting Irish companies to participate in the supplier development programme is the attitude of the management teams of local firms, which should be "forward thinking, ambitious, and dynamic".
Between 1985 and 1997, Enterprise Ireland has involved an estimated 250 foreign affiliates in its linkage programme. During that period, affiliates operating in Ireland increased their local purchases of raw materials fourfold and more than doubled their purchases of services. Suppliers in turn saw their sales rise by 83%, productivity by 36% and employment by 33%. Several have become successful international subcontractors.
Box 4: The Local Industry Upgrading Programme in Singapore
Developing Singapore into a "hub of knowledge-driven industries" is the underlying objective of the government´s Local Industry Upgrading Programme (LIUP). Under this programme, TNCs are encouraged to enter into long-term contracts with local suppliers and help them upgrade their products and processes. The LIUP itself offers organizational and financial support to upgrade and develop vendors, operating with the close involvement of foreign firms. Participating TNCs, in turn, also see benefits from enrolling themselves in the vendor development programme.
The LIUP´s activities include a variety of support measures. Its Small Enterprise Development Board contributes to the salary of foreign affiliates´ representatives who are seconded to local suppliers to make the latter more competitive. Local suppliers are encouraged to expand internationally, such as by following their TNC customers when they establish plants elsewhere, notably in South-East Asia. In this manner, the government of Singapore can maintain its influence over the character and content of the capital upgrading process.
Under the programme, some local firms, such as Advanced Systems Automation and Manufacturing Integrated Technology, have managed to evolve from domestic suppliers into internationalized companies performing highly complex functions. Both these companies are today preferred global first-tier suppliers to their TNC customers. This would suggest that Singapore´s approach, combining a targeted FDI promotion strategy with a linkage programme, has had positive effects on the domestic enterprise sector.