Spillovers from Foreign Direct Investment: Within or between Industries?*

Spillovers from Foreig Direct Ivestmet: Withi or betwee Idustries?* Maurice Kugler @ September 2005 Abstract This paper cotributes a estimatio framework to measure both techological ad likage exteralities from foreig direct ivestmet (FDI). Empirical research dealt maily with itra-idustry spillovers from FDI with restrictive treatmet of iter-idustry effects util recetly. However, as optimal orgaizatio of the multiatioal corporatio (MNC) ivolves miimizatio of profit losses due to leakage of techical iformatio to competitors, host coutry firms withi the MNC s sector experiece limited productivity gais esuig FDI. Host-coutry producers i other sectors may beefit. For example, MNCs trasfer kowledge to local dowstream cliets, or outsource to local upstream suppliers. Hece, FDI substitutes withi-sector domestic ivestmet but complemets it across sectors. The et impact o aggregate capital formatio by host-coutry producers higes o the iteractio betwee likages ad spillovers. Estimatios based o the Colombia Maufacturig Cesus yield the sectoral patter of FDI spillovers displayig kowledge propagatio betwee but ot withi idustries. The fidigs reveal outsourcig relatioships of MNCs with local upstream suppliers as a chael of diffusio. JEL Codes: O41, F43, F21, F23, C52. Keywords: Foreig direct ivestmet, iter-idustry spillovers; geeric techology; vertical likages; absorptive capacity. * The author appreciates isightful advice from Praab Bardha ad Paul Romer as well as very valuable commets by two aoymous referees, Ke Arrow, Magus Blomstrom, Guillermo Calvo, Brad DeLog, Riccardo Faii, Jeffrey Frakel, David Greeaway, A Harriso, Joatha Haskel, Nick Hope, Wolfgag Keller, Adriaa Kugler, Larry Lau, David McKezie, Ro McKio, Grayham Mizo, Klaus Neusser, Roger Noll, Howard Pack, Adres Rodriguez- Clare, Pablo Spiller, Eresto Stei, Jorge Toro, Jim Tybout, Jota Uribe, Akos Valetiyi, Herado Vargas, Toy Veables, Thierry Verdier, Josef Zweimueller, Joh Zyzma ad semiar participats at Baco de la República de Colombia, Ecoometric Society Meetigs, Federal Reserve Bak of Sa Fracisco, Lodo Busiess School, Lodo School of Ecoomics, Staford Uiversity, Uiversidad de los Ades, UC Berkeley, UC Sata Cruz, Uiversity of Sa Fracisco, Uiversity of Southampto, World Bak, ad World Trade Orgaizatio. Data access was made possible by Departameto Nacioal de Estadística (DANE) ad Baco de la República i Colombia. Support from a grat by the Federal Reserve Board of Goverors ad the America Ecoomics Associatio as well as the kid hospitality ad research fudig from Baco de la República de Colombia ad the Staford Ceter for Iteratioal Developmet are ackowledged. @ Departmet of Ecoomics, Uiversity of Southampto, Southampto, SO17 1BJ, U.K. E-mail: mdk1@soto.ac.uk

1 Itroductio Foreig direct ivestmet (FDI) by multiatioal corporatios (MNCs) has grow without precedet recetly, especially peetratig middle-icome coutries. Durig the 1990 s, the growth of FDI flows trebled the growth i iteratioal trade. Most FDI flows occur amog idustrialized atios, as do iteratioal trade trasactios. Yet, presetly, the mai source of iteratioal fiace to developig coutries is FDI. This tred has revitalized the ogoig debate over the ecoomic impact of FDI o less developed coutries. I this paper we ivestigate empirically whether foreig direct ivestmet (FDI) i a developig coutry geerates positive exteralities o local producers. Ecoometric evidece of their existece is rather scarce. Iitial measuremets of spillovers with pael data have yielded limited evidece of improvemets i domestic productivity esuig FDI partly because oly itra-idustry spillovers were cosidered, without allowace for iter-idustry diffusio (e.g. Aitke ad Harriso, 1999). Sice MNC s locate their subsidiaries to avoid ret erosio due to local competitio, other thigs equal, the MNC s deploymet of subsidiaries via FDI is desiged to miimize the risk of propagatio of specific techical kowledge to potetial competitors. I particular, itra-idustry kowledge spillovers for host-coutry firms from maufacturig activities by subsidiaries are ulikely. Furthermore, evidece about spillovers from idustrial R&D, as well as urba ecoomic orgaizatio studies, reveals importat techology diffusio betwee but ot withi idustries. I a recet paper, Bloom, Schakerma ad Va Reee (2005) icorporate i the aalysis of techology diffusio betwee firms, associated with R&D, both the positive spillover ad the egative rivalry effect. The latter accouts for the loss of market share whe R&D by other firms i the idustry itesifies competitio (i.e. busiess stealig by iovatig firm). I the cotext of FDI spillovers, the rivalry effect is more likely to domiate spillovers withi the MNC s idustry tha betwee idustries. Thus, the scarcity of empirical fidigs of itra-idustry spillovers stemmig from FDI is ot surprisig. If there is leakage of techical kowledge from the subsidiary to domestic producers, such spillovers are most likely to geerate productivity improvemets i o-competig ad complemetary sectors. The evidece of absece of itra-idustry FDI spillovers i pael data studies is importat because it suggests the excludability of techical kowledge. However, evidece i other cotexts hits at the importace of cosiderig iter-sectoral kowledge flows. Scherer (1982) fids R&D spillovers to diffuse across idustries. I the cotext of kowledge diffusio i cities, Glaeser et al. (1992) foud importat spillovers betwee rather tha withi sectors suggestig returs to cross-fertilizatio of ideas i diverse istead of specialized eviromets. To complemet existig studies, measuremet of techological exteralities allowig for iteridustry spillovers requires a multisectoral dyamic set up. I the preset paper, a ecoometric framework is developed to explore whether FDI geerates exteralities o maufacturig i the host 2

coutry. Oe advatage of this approach is that, i cotrast to other studies of FDI spillovers, the geeral equilibrium effects of FDI are idetified ad ot oly the beefits of kowledge sharig betwee MNCs ad local suppliers. To apply this framework, a sectoral pael database was costructed mergig data from the Colombia Maufacturig Cesus with FDI data, derived from Cetral Bak trasactio records. We use the dataset (1) to estimate the extet of ew techological opportuities for domestic maufacturers stemmig from MNC operatios, (2) to explore the determiats of whether esuig adoptio occurs, (3) to assess how FDI complemets domestic capital formatio through spillovers ad likages. While itra-idustry FDI spillovers are ot to be expected, iter-idustry spillovers are likely. First, if the MNC has domestic vertical likages i the host coutry, subsidiaries will beefit from kowledge sharig with both cliets ad suppliers. O the oe had, local market peetratio geerates forward likages ad iformatio flows betwee the subsidiary ad the users of its output are beeficial to the MNC. O the other had, outsourcig yields backward likages leadig to kowledge trasfer to upstream sectors. Hece, the vertical propagatio of kowhow that creates ew techological opportuities for host-coutry producers iduces iter-idustry spillovers but idustry specific kowledge flows are boud to be limited i scope. Secod, cost-reducig opportuities to producers i sectors other tha the subsidiary s ow do ot iduce ret losses to the MNC. The icetive to use resources for trade secrecy to avoid diffusio of geeric kowledge is small. Therefore, geeric techology, which ca be deployed i productio across sectors, is more likely to propagate tha sector-specific techology. Third, the techiques that ca be adopted from geeric kowledge i maufacturig activities geerally require less absorptive capacity tha specialized high-tech processes. Beyod icreasig domestic techological opportuities, etry by MNC subsidiaries ca cause productivity gais for host-coutry producers though icreased competitio. First, the settig up of the MNC subsidiary raises maagerial icetives i host-coutry eterprises to make efficiecy-ehacig ivestmets because of the icreased risk of a loss of market share. Ad secod, there is a selectio effect that icreases average productivity of operatig plats sice oly the fittest survive the subsidiary s competitio. The pro-competitive impact of MNC etry is primarily itra-idustry. It will ted to be deleterious to iefficiet domestic producers who caot challege the MNC ad lose market share util evetually closig dow. To avoid ret loses, the MNC will target FDI to locatios i which domestic competitors are ulikely to cope i the short-ru eve if i the very log-ru the domestic idustry might become more efficiet. The paper is orgaized as follows. After this itroductio, Sectio 2 reviews ad discusses the related literature. The theoretical ad empirical research o FDI spillovers is surveyed. With regard to the sectoral patter of spillovers, a sythesis of the implicatios of the literature is provided. I Sectio 3, the structural ecoometric framework ad the backgroud facts are provided, icludig a descriptio of the data. The, Sectio 4 cotais the diagostics ad estimates from the multisector ecoometric 3

framework that characterizes the impact of FDI. The results obtaied from measurig the techological gap ad quatifyig the iteractio amog MNCs ad domestic owed firms are used to aalyze the extet ad determiats of spillovers. Fially, Sectio 5 cocludes. 2 Related Literature This sectio starts with a review of the theoretical literature o MNC strategy ad the implicatio for the impact of FDI o the host coutry. The geeral presumptio about the sectoral patter of spillovers to domestic maufacturig that emerges from these models is oe of absece of itraidustry exteralities but a likely positive impact at the iter-idustry level. The, a sythesis is provided of evidece from cross-sectio ad pael data. The discussio of the ecoometric evidece documets that the higher expected propesity for iter-idustry effects has ot featured promietly i previous research o the impact of FDI o domestic maufacturig i the host coutry. 2.1 Theoretical Backgroud A survey of the theoretical literature about the impact of FDI o host-coutry idustrial orgaizatio reveals that the modeled mechaisms are more likely to operate at the iter-idustry rather tha the itra-idustry level. First, there is a body of literature o the choice by the MNC to use FDI as a mode of market peetratio. The strategic cosideratios due to the risks of imitatio ad evetual replacemet faced by the subsidiary are itroduced (see e.g. Helpma, 1984; Ethier, 1986; Ethier ad Markuse, 1996; Markuse ad Veables, 1998). Secod, there are models about the pecuiary exteralities from FDI via the backward likages to iput markets that MNC etry ca geerate (see e.g. Rivera-Batiz ad Rivera-Batiz, 1990; Rodriguez-Clare, 1996; Markuse ad Veables, 1999). Fially, research has focused o the impact of etry by a eterprise with techological opportuities superior to local oes, such as a MNC, o icumbet domestic idustry whe differet types of market structure prevail (see e.g. Bardha, 1982; Varia, 1996). First, the literature o the optimal market peetratio strategy by the MNC emphasizes the miimizatio of the probability of imitatio, especially uder imperfect itellectual property rights i the host coutry. Orgaizatioal choices ca be used to delay the emulatio by domestic producers with absorptive capacity. I a icomplete cotracts eviromet, resource ad iformatio trasfer withi the MNC miimize trasactio costs (Ethier, 1986). Also, ecoomies of scope stemmig from product-specific R&D ca explai the vertically itegrated ature of MNCs (Helpma, 1984). Trade secrecy ad efficiecy wages are also used to mitigate techology leakage from FDI. Over time, the dissipatio of techical kowledge rets if itra-idustry spillovers materialized is mitigated as the MNC 4

orgaizes productio to maximize the imitatio lag (Ethier ad Markuse, 1996). The locatio of the MNC subsidiary miimizes ret erosio due to copyig by local firms. Proximity to potetial competitors with absorptive capacity to reverse egieer proprietary techology would be detrimetal to the MNC, ad subsidiaries will be set up where potetial rivals caot erode its market share (Markuse ad Veables, 1998). Sice the MNC ca beefit from kowledge diffusio whe it reaches dowstream cliets ad upstream suppliers, it will ecourage vertical flows of geeric kowledge leadig to iter-idustry spillovers. Likages ca be a propagatio mechaism for techological exteralities above ad beyod the pecuiary exteralities highlighted by Hirschma (1977). Secod, some of the literature o backward likages emphasizes the static effect of the icreased demad by the MNC for local itermediate iputs (Rivera-Batiz ad Rivera-Batiz, 1990). More recet models emphasize the dyamic effect o host-coutry productivity esuig expasio of both the demad ad supply of itermediate iputs ad services (Markuse ad Veables, 1999). Not oly do icumbet upstream sector producers beefit but also the MNC, may start providig goods or services that were previously uavailable i the host coutry. Thus, MNC operatios ca iduce local availability of ew itermediate services ad iputs, ad thereby a exus betwee FDI peetratio ad growth i the productivity of dowstream maufacturers (Romer, 1994; Rodriguez-Clare, 1996). Hece, the impact of FDI goes beyod the chage i utilizatio of the host-coutry factor edowmet that improves allocative efficiecy, the type of static effect traditioally emphasized i trade theory, ad may iclude improvemets i techical efficiecy. As the etry of the MNC iduces the supply of ew itermediate iputs, the productivity of dowstream local firms ca be ehaced due to a feasible icrease i specializatio. The direct demad effect o upstream sectors is primarily a iteridustry pheomeo. The idirect iput-availability effect o dowstream sectors is likely to be stroger at the iter-idustry level tha itra-idustry. If outsourcig ca beefit the competitive frige i ways that caot be avoided through exclusive cotracts, i-house supply will be chose. Fially, whether the potetial beefits of FDI materialize or ot depeds o the market structure i the host coutry. Whe demad i the host coutry is ielastic because of reduced availability of substitute goods, FDI yields higher rets for the MNC as local presece facilitates market peetratio. The, limited domestic competitio relative to iteratioal competitio meas that FDI is more profitable to the MNC. Furthermore, competitio from imports limits the attractiveess of imitatio for domestic eterprises (Bardha, 1982). Other thigs equal, the MNC will seek to set up subsidiaries i coutries i which the market structure yields less direct competitio withi its idustry but i which upstream sectors are competitive. Hece, FDI will be associated with situatio i which there are few direct competitors ad may iput suppliers resultig i limited itra-idustry spillovers but a positive impact at the iter-idustry level. The models i the literature imply that iter-idustry positive exteralities to host-coutry producers are much more likely tha itra-idustry gais i productivity esuig FDI. For the MNC, 5

techological spillovers from FDI represet a beefit whe they diffuse dowstream ad upstream but a loss whe they diffuse withi the subsidiary s idustry. Hece, the subsidiary will be deployed so as to miimize horizotal spillovers of idustry specific kowhow to competitors while ecouragig vertical flows of geeric kowledge to complemetary sectors. Yet, the higher expected propesity for iteridustry effects has ot featured promietly i empirical research about the impact of FDI o domestic maufacturig i the host coutry. Furthermore, the large positive gap i terms of absorptive capacity required to adopt specific vis-à-vis geeric techologies meas that diffusio betwee rather tha withi sectors is more likely. 2.2 Empirical Evidece Due to data limitatios, util recetly, empirical evidece o FDI spillovers was made up of case studies. The picture that emerged from the early literature has bee importat i guidig progress i the theory of FDI. The evidece has provided us with iformatio about the mechaisms whereby MNC etry ad presece ca affect idustrial orgaizatio i the host-coutry. This research emphasized likages, labor turover ad demostratio effects. Recetly database developmet has afforded the possibility of ecoometric testig o spillovers ad dyamic aalysis has bee coducted as pael data has replaced cross-sectio data. 2.2.1 Evidece from Cross-Sectio Data Iitial efforts to coduct ecoometric testig of FDI spillovers were limited i scope due to lack of data. I particular, oly cross-sectio databases were available, or i the best of cases collectios of cross-sectios for a few years. Therefore, it was ot possible to follow over time what the impact of MNC etry ad permaece was o domestic eterprises. Sice techological diffusio is essetially a dyamic pheomeo, the coclusios that ca be draw i these studies based solely o cotemporaeous effects have serious limitatios. I particular, these fidigs are subject to simultaeity ad edogeeity biases. Therefore, it is ot possible to establish causality with ay cofidece. Yet, this early ecoometric literature is importat as a first approximatio to quatify the mechaisms documeted i case studies. The ecoometric examiatio of spillover patters started with the use of cross-sectio sectoral data. Pioeerig studies searched for itra-idustry spillovers i Australia ad Caada respectively (Caves, 1974; ad, Globerma, 1975). The approach was to estimate sectoral productio fuctios, with the share of MNC affiliates as a explaatory variable. I both cases, there is a positive 6

correlatio betwee domestic eterprise productivity ad subsidiary productivity. Although this patter is cosistet with FDI exteralities, the aggregated results lack statistical power to discer the causal ature ad magitude of spillovers. Mexica data reveal the same patter (Blomstrom ad Persso, 1983). Subsequet aalyses cojectured that spillovers are more likely i some idustries tha others. I cocetrated idustries, where there is a wide techology gap betwee local producers ad MNCs, exteralities from MNC presece are ulikely to materialize. Ideed, it is foud that i Mexica maufacturig, there is a positive correlatio betwee foreig presece ad local productivity oly i sectors where the market share of MNC affiliates is low (Kokko, 1994). A similar patter for Uruguaya maufacturig is foud (Kokko, Tasii ad Zeja, 1996). Fially, there is evidece that the icetives for the MNC to trasfer state-of-the-art techology are higher whe the host-coutry competitive frige faces lower barriers to etry. Blomstrom, Kokko ad Zeja (1992) fid that i cosumer good idustries, with relatively low itesity i complex techology ad with low capital requiremets, MNCs deploy more advaced techologies to overcome the disadvatages of alie status. The way for MNCs to outdo competitors is to keep oe step ahead. I priciple, as the authors coclude, a more competitive local market structure leads to a icrease i the potetial for spillovers due to the icrease i techology flows. However, the authors do ot test whether it is the case that there is local adoptio of these more advaced techiques. 2.2.2 Evidece from Pael Data By ad large the first pael studies about FDI spillovers i less developed coutries, coducted i the 1990 s, fid the absece of a positive itra-idustry productivity effect (Haddad ad Harriso, 1993; Harriso, 1996; Hoekma ad Djakov, 1998; Aitke ad Harriso, 1999). The empirical fidigs are derived respectively from pael data of maufacturig plats i Morocco, Cote d Ivoire, the Czech Republic ad Veezuela. The empirical patter ucovered where icreases i MNC market share are detrimetal to local producers i the subsidiary s idustry is deoted eclave formatio. These results are ot surprisig i light of the above discussio of the theoretical literature, which predicts iter-idustry rather tha itra-idustry spillovers. However, oe of these studies cosiders the empirical possibility of iter-idustry exteralities i the ecoometric estimatio. It is revealig that the oe study that cosiders the diffusio of geeric rather tha idustry-specific techology fids evidece cosistet with FDI spillovers. The operatio of export orieted MNC subsidiaries i Mexico is associated with a higher propesity for domestic eterprises to eter foreig markets (Aitke, Haso ad Harriso, 1997). The fidig highlights the potetial positive effect o host-coutry maufacturig 7

of the diffusio of MNCs geeric kowhow about how to export, icludig iformatio o stadards, market access ad distributio chaels. The reported fidigs about FDI spillovers i Cote d Ivoire, the Czech Republic, Morocco ad Veezuela costitute the first attempts to measure exteralities from MNC activities usig logitudial data. The stylized fact of spillover absece emergig from these studies cotrasts with previous evidece of spillovers i cross-sectioal data. However, the exclusively itra-idustry character of possible exteralities allowed i the specificatio of the empirical estimatios is limitig. While the positive cotemporaeous correlatio betwee highly aggregated sectoral productivity ad sectoral FDI flows i cross-sectioal data could reflect a causal relatio i either directio, the opositive (i.e. egative or isigificat) correlatio i pael data cofirms oe of the implicatios from the theoretical literature. 1 The importace of iter-idustry spillovers has bee recogized ad documeted for a log time i studies about R&D ad productivity (e.g., Romeo, 1974; Scherer, 1982). More recetly Glaeser et al. (1992) have provided robust evidece showig that importat kowledge spillovers occur betwee rather tha withi idustries. The fidig cofirms Jacobs (1969) cojecture that iovatio is more likely to prosper i diverse rather tha specialized eviromets. I the cotext of FDI spillovers, oly recetly, i Kugler (2000), was the eed to allow for iter-idustry effects i pael data studies recogized. Otherwise it is ot possible to verify the sectoral patter described above about the impact of FDI o host-coutry idustrial orgaizatio. Sice the, the fidig of limited itra-sectoral spillovers but ample iter-sectoral effects from FDI via backward likages has bee documeted also for Idoesia (Blalock, 2001), Lithuaia (Smarzyska, 2004) ad Mexico (Lopez, 2003). The estimatio of the extet of ew techological opportuities for domestic maufacturers stemmig from MNC operatios icludes potetial effects withi the subsidiary s sector as well as across other sectors, but is ot limited to backward likages. FDI impacts upo domestic producers both directly through backward likages to suppliers, as documeted i the papers metioed above, ad idirectly through ehaced iput availability. By stimulatig upstream sectors MNCs may also beefit other dowstream local producers as cheaper iputs become available, as poited out i Kugler (2000) ad Blalock ad Gertler (2004). The structural estimatio framework specified ext allows for ot oly for techological spillovers but also the latter pecuiary exteralities. Hece, we will idetify ot oly the direct beefit from FDI o the MNC s local suppliers but also the geeral equilibrium effect arisig from ehaced itermediate iput availability. 1 I their study about the impact of FDI o domestic productivity usig pael data for the UK maufacturig sector, Haskel, Pereira ad Slaughter (2002) actually fid evidece of a positive itra-idustry effect whe a sufficietly propagatio lag is allowed for. This fidig illustrates the importace of absportive capacity to make imitatio, albeit with a delay, possible. More recetly, Keller ad Yeaple (2003) have documeted evidece cosistet with itra-idustry spillovers. 8

3 Estimatio Framework ad Data Descriptio I this sectio a stochastic multisectoral dyamic geeral equilibrium model is set up i which firmlevel ivestmets ca geerate spillovers both withi ad across sectors. The characterizatio of exteralities, i the model, is based o the Arrow-Romer specificatio of Marshallia exteralities leadig to aggregate icreasig returs (Arrow, 1962, ad Romer, 1986). But as suggested by Jacobs (1969), Scherer (1982) ad Glaeser et al. (1992) productivity of maufacturig i ay sector ca be potetially iflueced by ivestmet i other sectors heterogeeously. The possible sectoral cofiguratios of exteralities from ivestmet by MNC subsidiaries that results from our reduced form are very geeral. The aalytic solutio which leads to the structural estimatio framework allows for both iter- ad itra-idustry exteralities. The reduced form derived parameterizes the iteractio of likages ad spillovers. First, the techology ad prefereces are set up. The, the dyamic programmig problem is solved ad the competitive equilibrium with exteralities is characterized. Fially, coditios to rule out idetermiacy are idetified to derive the balaced growth path ad the estimatio framework. The estimatio framework is desiged to aalyze the dyamics of spillover diffusio ad is based o the error correctio model represetatio of a bivariate vector auto-regressio of sectoral domestic productivity ad sectoral capital formatio by MNCs. The reduced-form set up is related to that used i Kugler ad Neusser (1998) to aalyze the lik amog fiacial developmet ad productivity growth, ad follows the methodology proposed by Johase (1991). The aalysis of shortru ad log-ru dyamics is used to estimate the persistet impact of FDI ad to establish the causal lik betwee capital formatio fiaced through FDI ad the productivity of domestic maufacturers i the host coutry. 3.1 A Model of Sectoral FDI Spillovers The model is oe of competitive equilibrium with edogeous techological chage. 2 Kowledge is a iput with icreasig margial productivity created as a observable by-product of ivestmet by idividual firms (Romer, 1986). The model is multisectoral ad allows for both learig by doig ad learig by observig, withi as well as betwee idustries. There are complemetarities amog the ivestmet paths of various maufacturers because the kowledge from accumulated experiece dissemiates yieldig cross-fertilizatio. Learig from productio geerates techological progress that diffuses ad geerates icreasig returs exteral to the firm. Whe ew kowledge is sector specific, the icreasig returs are iteral to the idustry. If ew kowledge is geeric ad ca be deployed across idustries, it ca geerate aggregate icreasig returs ad edogeous growth. 2 The sectoral structure is based o the models of Log ad Plosser (1983) ad Neusser (2001). 9

Furthermore, backward ad forward likages appear whe output from oe sector serves as a iput i buildig capital i aother sector. These likages provide a potetial diffusio chael of sector-specific kowledge through both profitable kowledge exchage ad embodied productivity ehacemets. 3.1.1 Techology Suppose that there are sectors i the ecoomy, with producers differetiated amog domestic ad foreig. There is perfect competitio ad the productio fuctio for each atomistic producer with headquarters i h, home or abroad, i each sector i is give by, α Yiht ihteihk i 1 α i = ξ ihthiht Xiht (1), where the first term is a techology shock, E ih is a fixed effect, K it ad H it are the stocks of physical ad huma capital respectively, ad X captures techological spillovers to be specified below. The motio equatio for capital accumulatio is give by, K it iht+ 1 = Kiht 1 dih ) + it+ 1 + ( η δ I (2), for i = 1,...,, where K ih0 is give ad I h ijt deotes gross ivestmet i good j for accumulatio of capital for productio i sector i i a firm with headquarters i h, domestic or foreig. Exteralities are specified i the Arrow-Romer fashio as, X iht where the matrix { γ } 0 = j= 1 γ ijh ad ijh ijd jdt j= 1 j= 1 ijf ihj h ijt γ K + γ K (3), jft γ is a measure of the techological spillover emaatig from ivestmet i sector j by firms headquartered i h to productivity i sector i. 3.1.2 Prefereces The itertemporal prefereces of the represetative aget over the stochastic sequeces of the cosumptio profile {C t } t >0={(C 1t,..,C t) } are to choose the pla that maximizes the expected utility fuctioal t E 0 t= 0 β U ( Ct ), with β < 1. Also, assume that istataeous utility is separable over goods, U ( C t ) = θ l C, (4), j= 1 j jt with θ j 0. If this coditio is bidig, the good j has o value for direct cosumptio. Suppose that at least some j has cosumptio value ad θ > 0. I particular, θ ( θ,..., θ )' 0. 3.1.3 Resource Balace j = 1 > The model is closed with the appropriate resource balace coditios. We assume that the rate of trasformatio amog cosumptio ad ivestmet is perfect so that, 10

C jt + i= 1 I ijt = Y jt for each sector j. With respect to the iitial capital stock ( K K ) 0 10,..., 0 (5), K =, a iitial distributio amog cosumers is assumed. The solutio strategy we follow is the oe proposed by Romer (1986). The competitive equilibrium is computed i two phases. First, the optimal policy rules for ivestmet i each sector ad the cosumptio profile chose by the represetative aget are derived takig the path of exteralities as give. Secod, the sectoral capital accumulatio path, give the aggregate exteralities implied by idividual optimal decisios, is characterized o the basis of the policy rules derived i the first phase. It is the verified that the sectoral paths satisfy the resource balace coditios to isure that there is mutual cosistecy amog the aggregate equilibrium ad idividual optimality. The state of the ecoomy i period t is give just by the sectoral capital stocks as the techology shocks of the precedig p periods are white oise, S t = ( K1 t,..., K t ). The exterality patter i period t is give by, X t+1 = X ( K t+1 ) = X (K t, η t+ 1 ). With this otatio i had, the first step cosists i solvig the Bellma Equatio of the represetative aget s problem at each poit i time. To solve the problem first we ote that the above fuctioal is statioary, V ( S; X ) = max ( ) ( ( ) θ j l C j + βev S'; X ' s.t. C j + I ij Y j (7), Iij, Hi j= 1 ) i= 1 where the expectatio is formed with regard to the techology shocks ad primed variables are ext period s. I particular, V ( St ; X t ) = max ( ) ( ) ( ) ( ) θ j l Y jt I + i= ijt β V St+ 1; X t+ 1 Q St, X t ds t+ 1 (8), I ijt, Hit i j j= 1 1 1, where Q(.,.) is the trasitio fuctio implied by the Markov process of the shocks to productio ad accumulatio. Note that i this problem, X(.) is exogeous. The, from the first order ecessary coditios the followig optimal policy rules for ivestmet ad cosumptio are obtaied as, I ij = θ j βb δ + β i ij Y j = ϕ ijy j (9), b i =1 iδ ij ad C j = (1 θ j ϕ ij ) Y j = Y j (10), θ + β b δ i= 1 j i= 1 i ij 11

where b i α θ i i = + d i β j = 1 1 α δ j ij (11), is the private shadow price of sectoral capital derived from the Beveiste-Scheikma equatio ad which is completely idepedet of the extet of kowledge spillovers. Sice agets take exteralities as give, the private value of capital ivestmet is lower tha the social value. O the balaced growth path of the competitive equilibrium with exteralities accumulatio is suboptimal (Romer, 1986). 3.1.4 Equilibrium Path These solutios imply the followig reduced form for accumulatio o the equilibrium path, future sectoral capital stocks are determied by the primitive parameters characterizig prefereces ad techology, by the capital vector from the previous period, βδ ihjbih k + + + + + + iht 1 = ( 1 dih) kiht + η iht 1 + δij ξ = jht α jhk jht (1 α jh) hjht γ jhlk (12). lht i 1 = = θ j + β δ h D F l i= ihjbih, 1 1 The Cobb-Douglas techology implies that the allocatio of huma capital is statioary. I particular, where the aggregate huma capital stock is ormalized, h ( 1 α i )( θ i + β ) l= 1 ( 1 α j )( θ j + β ) i = δ b j= 1 l = 1 lj l δ b Chages i productivity due to techology shocks are exactly offset by chages i prices that preserve the margial reveue product uchaged. The reduced form of the capital accumulatio process ca be viewed as a operator that trasforms X(.) ito the correspodig competitive equilibrium. Cocavity guaratees that the operator has a uique fixed poit. The fixed poit is foud idetifyig the path of the capital stock vector resultig from the optimal policy rules i (10) with the give exteralities beig replaced by the multisector effects from the actual capital accumulatio choices. The logarithm of the state variable, amely the sectoral capital vector, with domestic stocks stacked up o top of foreig, ca be characterized by the followig first-order differetial equatio, lj l (13). k (15), t + 1 = c k + ( A I ) k t + ε t+ 1 i which c k is a 2-dimesioal vector of costats, A is a 2 x 2 matrix of costats ad ε t+ 1 is a 2-dimesioal vector of MA(1) processes. 12

Therefore, {k t } t > 0 has the structure of a vector-autoregressive process except that the iovatio is ot white oise. I fact, the iovatio is a MA (1) process ad therefore {k t } t >0 is a vector autoregressio (VAR) with compoets followig ARMA (1,1) processes. I particular, aggregate growth depeds o both sector-owership ih specific icetives for ivestmet, such as depreciatio ad the output elasticity with respect to capital, as well as o the structure of sectoral iterdepedece. The iter-idustry effect arises potetially because of both likages to upstream ad dowstream sectors as well as techological spillovers. The matrix A determies the growth patter of the system. For example, if for all ih, α < 1, balaced growth implies some techological exteralities. Covergece to a balaced growth path requires that the diagoal elemets of A are strictly positive, ih a ihi = d ih + δ ihi α ih + δ ihl γ lih > 0 (16). h= D,F l=1 This iequality is violated if ad oly if simultaeously there is istataeous depreciatio (d ih = 0), there are o withi idustry itermediate iputs (δ ihi = 0), ad for each sector j, either the sector does ot ay geerate exteralities ( γ lih = 0 ) or does ot geerate itermediate iputs for ay other sectors (δ ihl = 0 ). Hece, the estimatio framework does ot rule out itra-idustry spillovers. The off diagoal elemets are give by, a ihj δ h= D, F l= 1 ihlγ ljh = δ α + (17). ihj jh The first term captures the forward likage effect, i.e. with δ > 0, FDI i sector j ehaces iput supply for domestic firms i sector i ad this iduces more domestic ivestmet. The later sum of terms captures the effect of FDI through the iteractio of likages ad spillovers. For example, if δ > 0 so that output from sector l is a iput for domestic producers i sector i ad γ > 0 so idl that there are spillovers from MNC s i sector j to producers i sector l, the FDI i sector j will idirectly beefit sector i domestic producers by makig sector l more productive. Studies o backward likages as a propagatio mechaism for FDI spillovers cocetrate solely o the iformatio flow of the MNC subsidiary o its direct local suppliers. Here, we also cosider the idirect effects of FDI due to the iteractio betwee the upstream MNC supplier ad other domestic producers. I order to explore the impact of FDI o the techological opportuities of host-coutry maufacturig across sectors, it is ecessary to tie the sectoral structures of capital accumulatio ad total factor productivity (TFP). To do so, the correspodig VAR ad vector error correctio represetatio (VECR) are derived to characterize both coitegratig ad causal relatios amog ivestmet ad techical progress. The diffusio of exteralities from FDI implies causatio, i the idj ljf 13

Wieer-Grager sese, of FDI iflows TFP growth i domestic maufacturig across sectors. I particular, establishig log ru co-itegratio betwee capital accumulatio by MNCs i some sectors ad productivity i others is ot sufficiet to coclude that spillovers take place. It could be that the high productivity of domestic maufacturers reflects abudace of factors i which the MNCs techologies are itesive, thereby stimulatig FDI iflows. To provide evidece corroboratig the importace the diffusio of exteralities from FDI, the causatio of higher cross-sectoral local productivity by FDI must be show. 3.1.5 Estimatio Framework For the estimatio, we ote that the stochastic process {y t } t > 0 has the same umber of stochastic ad determiistic treds ad therefore the same umber of coitegratig relatios as {k t } t > 0. Furthermore, the total factor productivity process is give by {z t } t > 0 { y αk ( 1 α)h } t > 0, ad ca be related to capital accumulatio as follows, z t t t ( α ) h = ξt + e γ k t = y α k 1 l + (18), where lower-case variables are vectors of logarithms of upper-case oes, with sectoral domestic values stacked up o top of foreig oes. Furthermore, whe the sectoral capital stock ad TFP observatios are combied, the system ca be writte as, I AL γ 0 k I z t t = c c k z + I 0 t δl lηt I lξt where c z e = ( l E1D,...,l ED,l E1F,...,l EF )', ad i particular, k z t t = c c k z + A γl 0 k 0 z t t 1 t 1 + εt lξt (19), 1 (20). This expressio implies a coitegratig relatioship amog capital accumulatio ad productivity. The multisectoral structure of ivestmet is liked to the dyamics of ecoomic growth. I particular, i the VECR below it will be apparet that the reduced form of the structural model implies causatio of higher domestic productivity growth by FDI iflows but ot vice versa. Backward ad forward likages amog sectors impact aggregate physical capital accumulatio through pecuiary exteralities. Also, both learig by doig ad demostratio effects captured by iter-idustry spillovers geerate techological exteralities, which drive productivity growth. These implicatios will be explored ecoometrically. 14

The causality aalysis of the coitegrated system is based o the approach due to Johase (1991). Assume that the 2-dimesioal stochastic process {X t } is geerated by a Gaussia k-th order VAR. By makig the appropriate defiitios, the VAR derived i (19) above ca be writte as a VECR which is its Wold represetatio: ( L) ψ ( ) Λ t Λ t k u 12 L 1, 1 π11 π12 1, 1, t ( ) ( ) + + L ψ L Λ2, t 1 Λ2, t k u 22 π21 π22 2, t Λ1, t ck ψ11 Λ ( ) t = κ + Ψ L Λt +ΠΛt k + ut = = + (21), 1 Λ2, t cz ψ 21 where κ is a vector of costat drifts, π ij (L) are polyomials of order k-1 i the lag operator L, ad Λ 1 ad Λ 2 are the sectoral capital stock ad productivity vectors. This ca be used to assess the causal structure of the system. To establish that the comovemet amog the ivestmet patters of MNCs ad the TFP of domestic maufacturers is due to the diffusio of exteralities from FDI, the ull hypothesis H : π 21( L) 0 must be rejected, ad H : ψ ( 21 L) 0 for short-ru causality. 0 = 3.2 The Data 0 = Due to the dyamic ature of the diffusio process, FDI spillover estimatio requires to follow sectors logitudially. Cosequetly, the iformatio eeded to aalyze FDI spillovers icludes a pael database with sufficiet variables for productivity measuremet, ad also iformatio o foreig owership structure. To costruct such series, data from the Colombia Maufacturig Cesus were merged with Cetral Bak data o recorded FDI trasactios. A iterestig aspect about the Colombia case, beyod the availability of high quality data, is the liberalizatio of ivestmet flows, which took place i 1991. Fiacial reform affected the FDI statute. Law 9 of 1991, elimiated restrictios affectig FDI, established atioal treatmet, ad elimiated the requiremet of obtaiig prior approval. Additioally, existig limits o the percetage of profits that foreig firms could trasfer to headquarters were also elimiated. I this sectio, the ature of the merged data is explaied. Also, summary statistics are provided. The, some idustrial dyamics idicators are summarized o turover rates ad the age distributio of plats. Fially, the productivity measuremet methodology is developed ad discussed. The data set developed for the preset study icludes iformatio from the Colombia Maufacturig Cesus ad the records that those MNCs egagig i FDI i Colombia are legally boud to register at the Cetral Bak. The Cesus is based o aual surveys by the Natioal Statistics Bureau of Colombia of firms with more tha te workers. Data are recorded o each plat s geographic locatio, idustry, age, capital structure, ivestmet flows, expeditures o labor ad materials, ad value of output sold. The variables i the plat-level pael database yield a wide rage of observable characteristics. The records of idividual FDI trasactios are kept i the Cetral Bak ad the variables derived from them are the amout of the trasactio, the coutry of origi ad the idetity of the recipiet firm. 15

3.2.1 The Maufacturig Cesus The Cesus covers maufacturig plats sice 1974 util 1998. For each plat there is iformatio o (1) employmet ad employee compesatio of differet types of workers, (2) book values, purchases ad sales of differet types of capital iputs, (3) sales, productio ad value added ad (4) iformatio o other plat characteristics icludig locatio ad age. Each plat has a idetificatio code, which allows for plats to be tracked over time. O average plats i the sample are small. Over the period of the Cesus, 58% of the plats have less tha 50 employees ad 34% have less tha 20 employees. Oly 7% of the plats have more tha 200 employees. The smaller plats ted to exhibit the highest turover. The plats cotiuously preset i the sample accout for a average share of the workforce over 1974-1991 of 63% ad a average share of the product of 71%. This implies that larger plats are more stable ad productive. The geographic distributio of plats over metropolita areas is also very stable. Plats are cocetrated i the two largest cities, which are i the iterior Adea regio. O average over the years, 32% of plats have operated i Bogotá ad 19% i Medelli. Of the remaider, Cali, the largest city i the Pacific regio, has bee host to 11% of the maufacturig plats ad 7% of the plats have located i the two largest cities i the Caribbea regio, Barraquilla ad Cartagea. Hece, we have that 51% of the plats i the Cesus are i the two largest cities ad 69% i the five largest metropolita areas. Over the period of study, the idustries with the largest umber of plats, accordig to the ISIC 3 digit groupigs, have bee food, beverages ad tobacco (31), textiles ad apparel (32) ad metal products (38). However, the tred has a clear break i 1991 whe iteratioal trade ad foreig ivestmet were liberalized. I the textile ad metal products idustries, there were widespread shutdows. I textiles, foreig competitio drove may local producers ito bakruptcy. I basic metals, tariff-jumpig FDI ceased because of the possibility of importig. Foreig owed operatios were closed. I cotrast, the umber of establishmets i the food idustry grew i spite of the competitio from foreig products. I fact, this idustry was recipiet of substatial iflows of FDI. For the years from 1976 to 1979 we have a variable that reports the year i which operatios bega. For plats that are ot observed over this period, we determie the age accordig to the first year i which the plat appears. The umber ad percetage of plats older tha 20 years grows steadily from beig about 16% of the total i 1974 to 38% i 1998. The proportio of plats youger tha 5 years remais early costat about 29%. Therefore, the attritio rate for some plats has grow over time, especially of those betwee 5 ad 20 years old. This rise i the failure rate beyod the iitial stages of developmet of the plat is cosistet with two mechaisms that select productive plats: firms lear about their ow efficiecy over time (see e.g. Jovaovic, 1982; ad Hopehay, 1992) ad stroger competitio due to icreasig opeess of the Colombia ecoomy. 16

The joit distributio of plats accordig to age ad employmet was characterized over five year itervals. The average plat employmet rises with age. I particular, the plats with more tha 100 employees are mostly older tha 10 years. Also, 68% of plats older tha 15 years have more tha 50 employees. The patter that emerges is oe i which survivig plats grow over time. This is cosistet with both selectio mechaisms highlighted above. 3.2.2 The FDI Data The series for sectoral FDI are built o the basis of trasactio records kept at the Cetral Bak s Iteratioal Exchage Departmet. These records cotai iformatio o all direct ivestmets made by foreig corporatios i Colombia sice the 1970 s. The iformatio available icludes the amout of the trasactio i US dollars, the coutry where the ivestig firm is based ad the idetity of the firm i which the ivestmet is beig made. Hece, ot oly ca the yearly iflows of FDI be classified by sector ad coutry of origi but also the firms i the Maufacturig Cesus which have bee recipiets of FDI ca be idetified. This disaggregatio is very importat i the measuremet of how MNC s impact domestic idustrial orgaizatio. The sectoral ad geographical patters of FDI iflows to Colombia have show a fair amout of chage durig the period of study. This reflects both idustrial evolutio ad importat policy regime shifts over the past two decades. Durig the 1970 s, a average of 73% of FDI iflows where targeted to maufacturig. Ivestmet was cocetrated i chemicals (35), equipmet ad machiery (38), basic metals (37) ad food (31). About half of these iflows origiated i the US with the remaider comig almost all from Europe. I the 1980 s, miig attracted more tha double the amout of FDI tha did maufacturig. Withi the maufacturig idustry, FDI cocetrated i the same four sectors as it had i the previous decade. The geographical patter of FDI also chaged. The source of most FDI was still the US with the rest origiatig i Europe but the US share rose to a average of 92%. After the market orieted reforms of 1991, FDI iflows have rise. The idustries that have registered the highest growth i FDI iflows are bakig ad maufacturig. The deregulatio of the fiacial system coupled with the removal of restrictios i the trasactios by MNCs lead to a substatial flow of ivestmet by foreig baks. I maufacturig, the iflows of FDI grew expoetially over the five years after the reforms with a fourfold icrease of FDI i 1998 relative to 1991. While ivestmet from abroad disappeared i basic metals, it surged i the paper ad publishig sector. Also, FDI icreased rapidly i, chemicals, equipmet ad machiery as well as food processig. The patter of geographic origi of FDI chaged substatially i the 1990 s relative to the previous two decades. The share of FDI from the US fell although the level of FDI iflows to Colombia origiatig i the US rose somewhat. The fall i the US share of FDI, to its observed value 17

i the 1970 s, was made up by staggerig icrease i both the share ad level of FDI origiatig i the Caribbea. The US share was 48%; the Caribbea share 31% ad the Europea share 17%. Sice the Caribbea share origiates maily from coutries that are tax haves ad which are used for purely fiacial trasactios, it is ot clear how the removal of barriers to FDI has iduced chages to this geographic patter. 3.3 The Measuremet of Techical Efficiecy I the measuremet of techical efficiecy as a residual, we attempt to remove from the productivity estimate all cotributios that are ot techological. The cotributio of various factors i the productio of output is to be decomposed. Both the labor force ad the capital stock cotribute to productio depedig upo their quality. The quality of the iputs correspods to attributes embodied i them ad ot strictly to the productio techology i use but is ot observed directly. Although the quality of iputs ad the techology are distict, there is a idetificatio problem i discerig them quatitatively from the productivity residual because they both are decided as part of the plat s optimal pla. But, eve if huma ad physical capital are measured without error, to estimate techical efficiecy from the productivity residual accout must be take for returs to scale ad capacity utilizatio (See e.g. Hall, 1988). If these are ot cotrolled for, chages i productio may be wrogly attributed to chages i techology. Aother potetial source of bias i productivity measuremet is the imputatio of factor shares as elasticities ormally performed i costructig Divisia idices. Whe iput markets are imperfect, factor shares do ot ecessarily reflect iput product elasticities. Sice labor ad capital markets are ot likely to be perfect i Colombia, techical efficiecy is estimated from a productio fuctio framework. Ideed, average factor remueratios do ot match elasticities. The labor share for various types of workers is such that the margial reveue product of labor is greater tha the wage plus other compesatio. 3.3.1 Huma Capital We weigh workers i differet categories by their relative wages to adjust for quality, thus obtaiig a huma capital idex (See e.g. Griliches ad Rigstad, 1971). The labor force of the plats i the Cesus is classified i five categories: maagemet, oproductio employees, local techicias, foreig techicias, ad productio workers. The estimatio of the huma capital idex cosists of a weighted average of workers by categories where the weights are give by the ratio of per capita wages i the category to per capita wages for productio workers. I estimatig the idex, a implicit assumptio is that the labor market 18

values workers accordig to their productivity or ability to trasform iputs ito value added. Eve is the labor market is ot perfectly competitive, it is plausible to assume that wages ad productivity are liked. 3.3.2 Physical Capital Throughout the period 1974-1998, we cosider four types of physical capital: buildigs ad structures; trasport equipmet; machiery ad equipmet; ad office equipmet. 3 The perpetual ivetory methodology was used to costruct capital stocks. Costat depreciatio rates were imputed based o assumptios about the useful lifetime of differet types of capital. I particular, the expected lifetime of buildigs was set to be 50 years, of trasport equipmet as well as machiery to be 20 years, ad for office equipmet the assumptio was of 10 years before scrappage. 4 For the iitial value of capital we used the book value reported i the first year of the sample. The method assumes perfect substitutability across vitages of capital ad costat decay of the capital stock. Therefore, the retiremet rate of machiery is idepedet of the age distributio of the capital stock. Techical obsolescece iduced by iovatio is ot take ito accout. The physical stock of capital ot oly deteriorates due to wear ad tear but also loses value as the vitage is older. However, as Hulte ad Wykoff (1981) have show, there is a idetificatio problem i tryig to separate these effects ecoometrically eve if we had the asset prices of each vitage for differet types of capital. Thus, we use the plats iitial operatios date to get a idea of the importace of the vitage effect. Other thigs equal, if the vitage effect were domiat, ewer plats should have more moder capital i operatio eve takig ito accout retoolig ad scrappig by old firms, the older plats machiery should still be older. Ad, if the vitage effect were strog eough, it would show up i the productivity differetial across plats. Yet, it is ot the case that productivity is higher amog youger plats. Our calculatios reveal that sice 1975 util 1996 there have bee chages i the compositio of ivestmet. Out of total real et ivestmet the share of machiery has rise steadily from 68% to 81%. The share of office equipmet has also icreased from 5 % to 11%. I cotrast, the share of both trasport equipmet ad structures has falle. The former had a drop i participatio from 13% to 2%. The ivestmet i buildig ad structures wet from accoutig for 14 % of real et ivestmet by maufacturig plats i the cesus to accout for 6 %. This patter is revealig of the importace of 3 Lad is ot used because its valuatio is affected by aspects irrelevat to the productio process, which are likely to itroduce oise i our estimatio. 4 Harberger (1969) obtaied these estimates for Colombia maufacturig. For the US, Hulte ad Wycoff (1981) have estimated yearly depreciatio rates of 0.036 for buildigs ad 0.1179 for equipmet. Usig a perpetual ivetory methodology, expected lifetimes of 30 years for buildigs ad 8.5 years for equipmet result. The respective figures derived by Harberger for Colombia are reasoable if we take ito accout that obsolescece sets i much slower i developig coutries. 19

embodied techology. The itesity of use has shifted from physical plat ad trasportatio to equipmet ad computers. Ivestmets i the latter categories are the most likely to report productivity improvemet ad the distributio of ivestmet suggests it. 4 Techological Opportuities ad FDI I this sectio, the empirical results with respect to the diffusio of exteralities from FDI are aalyzed. First, the statioarity of the sectoral series for productivity ad capital formatio is assessed. The the evidece o coitegratio amog FDI ad TFP across sectors is used to ascertai the cofiguratio of spillovers. Next, follows a discussio of the implicatios of the evidece for absorptive capacity ad diffusio. Fially, the fidigs o causality amog FDI ad iter-sectoral TFP are used to reject the alterative hypothesis to FDI spillovers, also cosistet with the coitegratio evidece, that FDI flows ad sectoral productivity patters are drive by a commo factor but are ot iterdepedet. 4.1 Capital Formatio ad Productivity Growth I Table 1, the sectoral average growth rates i the 1974-1998 period of the capital formatio ad TFP series, for both domestic maufactures ad MNCs, are preseted. By ad large the growth rates are positive. Amog domestic producers, aggregate ivestmet has grow yearly by more tha 3% but TFP just over 1%. Average yearly ivestmet has bee eve across sectors. I terms of productivity, the two domestic leadig sectors have bee paper products ad food ad beverages. The slowest sectors i productivity ehacemet have bee basic metals ad textiles. Amog MNCs, capital ad especially productivity have grow much faster over the 25 years of the sample. FDI has bee cocetrated i four sectors, amely food ad beverages, chemicals, basic metals ad equipmet ad machiery. The first stage i the estimatio cosists of assessig the statioarity of the series. If the series have uit roots, the it is appropriate to proceed with the co-itegratio aalysis. The Dickey-Fuller statistics with a time tred are computed. The results are preseted i Table 2. With few exceptios the ull hypothesis of ostatioarity caot be rejected. At the sectoral level, oly for three series ca this ull hypothesis be rejected leadig to the coclusio that the geeratig process is statioary. 5 Give the ostatioary ature of the capital accumulatio ad TFP series, the VAR aalysis is based o Johase s (1991) dyamic characterizatio of coitegratio relatioships. The motivatio is that all sectors coected through spillovers ad likages share a stochastic tred. 6 5 The autoregressio lag order was foud usig the procedure desiged by Ng ad Perro (1995). Startig with a high order, a covetioal t-test is used to discard lags isigificat at the 10% level. This procedure is less biased tha AIC. 6 The legth ad frequecy of the series do ot permit a simultaeous aalysis of all sectors, due to isufficiet degrees of freedom. The implemeted methodology cosists of estimatig all possible bivariate VARs ad performig a coitegratio test of the reduced system. 20

4.2 Spillover Cofiguratio I Table 3, the log ru relatioships betwee capital accumulatio ad productivity growth withi ad across sectors, amog domestic plats oly, are characterized empirically. It is surprisig that there is complete absece of a commo tred amog capital formatio i the chemical sector ad productivity i the wood sector. This is perhaps due to the fact that the former is domiated by MNC subsidiaries. These idustries together with the ometallic mieral sector seem isolated from the growth dyamics likig the other sectors. I geeral, a commo tred is observed likig capital formatio ad productivity growth withi sectors. This observatio could reflect a selectio effect whereby capital itesive techologies exhibit the highest TFP growth. However, the comovemet is also cosistet with the existece of positive accumulatio exteralities amog domestic producers i the same sector. O the other had, the evidece rejects the possibility of exteral icreasig returs across sectors. Now that the ature of sectoral iterdepedece amog domestic firms has bee established, the impact of the presece of MNC subsidiaries ca be established. I Table 4, the impact of FDI o domestic productivity is summarized both at the itra- ad iter-idustry levels. The observed patter reveals that while MNC activities are substitutes for domestic maufacturig withi the subsidiary s sector, they ca complemet maufacturig i other sectors. I particular, the hypothesis of o coitegratio betwee FDI fiaced capital formatio ad domestic maufacturig TFP caot be rejected at the itra-idustry level but it is widely rejected at the iter-idustry level. This fidig corroborates the cojecture that FDI may crowd out domestic ivestmet withi the sector of the MNC but ca provide positive exteralities across other sectors. The evidece o coitegratio is cosistet with itra-idustry exteral icreasig returs i domestic capital formatio ad iter-idustry spillovers from FDI. To assess the geerality of this fidig, each sample is pooled ad pael coitegratio tests are performed. First, for ivestmet by domestic maufacturers, each bisectoral pairig of the capital stock ad TFP i each year is take to be geerated by a commo process across sectors. Likewise, each bisectoral pairig of FDI fiaced capital formatio ad TFP across years is pooled i a commo sample. The results i Table 5A show that the coitegratio for domestic ivestmet i itra-idustry observatios, which accout for 12.5% of the sample, caot be geeralized. I cotrast, the coitegratio for FDI i iter-idustry observatios ca be geeralized. Across sectors there is evidece of comovemet betwee ivestmet by MNCs ad the productivity of domestic maufacturig eterprises over the 25 years of the sample. This is cosistet with diffusio of exteralities from FDI that is widespread across sectors. The FDI that geerates positive spillovers i the greatest umber of sectors is cocetrated i the followig idustries: paper, chemicals, metallic machiery, ad basic metals y ometallic mierals. The 21

sectors that seem most proe to beefit from the presece of MNCs are: paper ad pritig as well as food, beverages ad tobacco. Although the growig tred i the productivity of MNC subsidiaries idicates that they implemet better techiques over time, domestic producers withi the subsidiaries sector seem uable to beefit from spillovers of sector specific techical kowledge deployed via FDI. O the other had, the evidece of iter-idustry spillovers is cosistet with the diffusio of geeric kowledge. This patter emerges whe the absorptive capacity of domestic maufacturers lags behid that of MNCs. I this case, the adoptio by host-coutry competitors of sector specific techologies deployed through FDI is ot feasible. But, the adoptio of geeric techologies by hostcoutry maufacturers, which does ot represet a loss of market share to the MNC, is viable as the absorptive capacity requiremet is modest. 4.3 Absorptive Capacity ad the Diffusio of Exteralities I this sectio, the relative growth i the absorptive capacity of domestic maufacturers compared to that of MNCs is assessed. If the absorptive capacity of the host-coutry competitive frige stagates, the MNCs ca use this lag to exclude others from usig their sector specific kowledge by deployig sufficietly advaced techologies. Whe domestic competitors caot reverse egieer ad adopt profitably the MNCs core techologies, they caot appropriate beefits from FDI spillovers. Hece, the optimal strategy to deploy FDI will lead to choices of locatio ad techology that limit itraidustry spillovers but allow for iter-idustry spillovers. The MNC will avoid iformatio flows to competitors by its locatio choice ad also through trade secrecy. Below, a assessmet is made as to whether the coitegratio evidece of the latter diffusio patter of exteralities from FDI could ideed be due to a wideig gap i absorptive capacity betwee host-coutry maufacturers ad MNCs. First, ote that labor productivity growth will remai uaffected by TFP growth if physical capital ad huma capital per worker both stagate. I particular, if icreasig labor productivity is accouted for solely by TFP growth, the iputs per worker, amely physical ad huma capital, must be statioary. I particular, the level of labor productivity rises but it will ot grow ay faster. Without resources to trasform techological improvemets ito value added, the adoptio of ew techiques has o impact o productio opportuities for maufacturers. Absorptive capacity growth is reflected by the expasio of labor productivity beyod improvemets i techology. The ecoometric properties the relatio betwee physical ad huma capital accumulatio per worker, o the oe had, ad average labor productivity ad TFP growth, o the other, etail that absorptive capacity is statioary if the logarithms of labor productivity ad TFP are perfectly coitegrated. Both huma capital per worker ad physical capital per worker stagate, ad improvemets i the state of techology do ot yield higher growth of value added per worker. 22

I table 5B, the results of the pael coitegratio tests for labor productivity ad TFP withi sectors reveal statioarity of absorptive capacity for host coutry maufacturers ad oergodicity for MNCs. While the domestic maufacturig capabilities to adopt ew techologies have remaied stagat, those of MNCs have expaded over time. The evidece shows a wideig gap i absorptive capacity that ca accout for the sectoral diffusio patter of FDI spillovers apparet from the coitegratio evidece. I particular, the absece of diffusio of sector specific techology that could result i itra-idustry spillovers coupled with the prevalece of iter-idustry exteralities, likely due to the dissemiatio of geeric kowhow, poit to limits i absorptive capacity i host-coutry maufacturig. 4.4 FDI as a Source of New Techological Opportuities The evidece o coitegratio corroborated the presumptio that the absece of itra-idustry spillovers is cosistet with presece of iter-idustry exteralities. Furthermore, the results from the pael coitegratio test cofirmed that the scope for withi-sector kowledge flows is limited by absorptive capacity. The compariso betwee the techologies of foreig ad domestic firms reveals a gap. Also, there appears to be a impact of the demad of MNCs for itermediate iputs o the productivity of local firms. The results are cosistet with both the theoretical ad empirical literature o exteralities from FDI. Furthermore, by emphasizig the sectoral diffusio patter of exteralities, as well as the role of absorptive capacity, the empirical methodology developed cotributes to the measuremet of FDI spillovers by focusig o the eglected iter-idustry exteralities. The latter ca reverse the coclusio from purely itra-idustry studies that FDI crowds out domestic ivestmet. I particular, the fidig of comovemet amog sectoral FDI ad productivity i other sectors is cosistet ot oly with iter-idustry exteralities but also with some commo factor stimulatig FDI iflows ad TFP growth. To assess whether FDI geerates ew techological opportuities across maufacturig, the causality from sectoral FDI to TFP across sectors is tested i terms of the predictive power of each variable o the other. Wieer-Grager causality from {k it } to {z jt } amouts to a ozero coefficiet i the VECM i π L i the bivariate VAR represeted i equatio equatio (20) emaatig from the polyomial ( ) 21 (20). The ull hypothesis of o causality ca be tested by stadard methods (e.g. by a F-test) if the VAR is stable. With itegrated processes the situatio becomes itractable because the asymptotic distributio of the test statistic is i geeral ostadard ad ivolves uisace parameters (Toda ad Phillips 1991; 1993). Fortuately, the problem simplifies as {k it } ad {z jt } are both oe-dimesioal ad coitegrated, so that bi-sectoral causality tests ca be performed. I this circumstace, the 2 covetioal Wald test statistic coverges to a χ distributio uder the ull hypothesis of o causality (Toda ad Phillips, 1993; Sims, Stock, ad Watso, 1990) such that covetioal testig 23

procedures ca be applied. The same hold for a test of reverse causality. To establish whether the comovemet amog the ivestmet patters ad the TFP of domestic maufacturers is caused by exteral icreasig returs from capital formatio geerally, ad the diffusio of FDI exteralities i particular, the issue of simultaeity must be dealt with. The ull hypothesis H π 0 must be tested. If the latter hypothesis is rejected, causality 0 : 12 = from FDI to TFP across sectors implyig iter-idustry spillovers caot be ascertaied. I this case, all that would be kow is that FDI ad TFP ca be used to predict each other i a cross-sectoral fashio. For example, domestic efficiecy i oe sector, idicated by a high TFP could be associated with FDI if the domestic sector provides a itermediate iput to MNCs. However, if it the ull hypothesis that domestic productivity i sector i caot predict FDI iflows to sector j is ot rejected, while FDI iflows to sector j predict TFP growth i sector i, the cross-sectoral comovemet i FDI ad TFP is likely to stem from the diffusio of exteralities from the operatios of MNCs. First, the results reveal o causality from domestic capital formatio to withi sector TFP, with the sole exceptio of the ometallic mierals idustry. Hece, the evidece poits to higher techological developmet beig associated with higher capital itesity rather tha exteral icreasig returs from domestic ivestmet. Secod, there is comovemet amog FDI ad TFP i 59% of all possible bisectoral pairigs. I these cases, whe capital formatio by MNCs i oe sector is coitegrated with TFP i aother sector, i 71% of the bivariate series FDI Grager-causes domestic productivity improvemet. Over time, FDI iflows geerate TFP growth across sectors but ot withi sectors. 7 Although oly geeric ad ot specific techical kowledge from MNCs diffuses, FDI geerates maufacturig productivity rises. To rule out simultaeity as a explaatio for this patter, reverse causality tests were performed. Of the bisectoral series i which FDI ad TFP are coitegrated, oly i 11% does domestic productivity predict FDI ad i 9% there is evidece of Grager-causality i both directios. Hece, the evidece of geeralized iter-sectoral TFP growth esuig FDI caot be explaied away by simultaeity. 4.5 Sectoral Spillover Diffusio through Likages The evidece discussed so far strogly supports the cojecture that there is diffusio of iteridustry exteralities from FDI. Here, techological spillovers are measured by estimatio of the structural parameters of the productio fuctio. I particular, equatio (17) ca be expressed as, z D F D D it = ei + xit + xit + it = ei + γ l li k 1 lt + = l = 1 l ξ γ k + l ξ, F li F lt it 7 Oly i the machiery ad equipmet sector is there evidece of a positive itra-idustry associatio amog FDI ad domestic TFP. The evidece poits to simultaeity for geeratig this fact. 24

i which domestic TFP is decomposed i terms of a sectoral costat, FDI spillovers ad a techological shock. 8 The matrix γ F maps the sectoral allocatio of FDI fiaced capital formatio ito the impact if spillovers o domestic sectoral TFP. It is estimated by the partial caoical correlatios amog the vector of deviatios of domestic TFP from the sectoral average ad the sectoral vector of capital fiaced with FDI. 9 The estimated matrix i Table 9 quatifies the spillovers already foud through diagostics tests. The fitted elasticities of TFP with respect to FDI rage from 28% to 1.5% with several sectors close to 20%. All the sigificat positive estimates correspod to istaces of iteridustry spillovers ad costitute 41% of all potetial cases. Aother iterestig aspect of the diffusio of FDI exteralities is to explore if the iter-idustry spillovers foud traslate ito higher maufacturig growth. To aswer this questio we ca decompose the motio equatio (15) of the state variable to differetiate the impact of the allocatio of domestic ivestmet from that of FDI. The impact across sectors of capital formatio by MNCs i sector j o growth i sector i is give by, a F ij k y = k x F F i j i l δ ijα j + δ l ilγ lj = +. 10 = 1 l = 1 F I il k j I il k j Hece, spillovers traslate ito growth if the sectors to which exteralities diffuse provide iputs to other idustries. I other words, backward likages ad spillovers are complemets i the geeratio growth. Note that if the sectors recipiet of techical iformatio from MNCs do ot provide iputs to other sectors, the ivestmet i other sectors is ot affected. Hece, oly to the extet that the sector beefitig from FDI spillovers is upstream will there be widespread iter-idustry exteralities. I other words, the establishmet of backward likages by MNCs plays a major role i facilitatig diffusio of its techology. Without local outsourcig by MNCs, for example if all subsidiary iputs were either imported or produced i-house, widespread FDI spillovers would ot materialize. The beefits from FDI techology diffusio iclude ot oly the direct effect to suppliers but more importatly to other local producers, which like the MNC are dowstream from local iput providers. To quatify the effect of backward likages combie the estimate of the itesity of crossidustry spillovers from the above expressio of equatio (17) with the coefficiets of cross-sectoral demads, for both domestic ad multiatioal producers, imputed etries from the from Iput/Output (I/O heceforth) table available from atioal accouts util 1994. For the latter years i our sample, a ew methodology was put i place for the atioal accouts, ad I/O tables were replaced by output-use ad output-supply matrices. Therefore, from 1994 to 1998, we rely o output-use matrices to determie cost 8 Potetial exteralities from other domestic producers are ot icluded as the coitegratio ad causality tests caot reject the isigificace of exteral icreasig returs, both withi ad across sectors, esuig domestic ivestmet. 9 Johase (1988) sets up the estimatio as a reduced rak regressio. 10 k The itra-idustry effect is i x l aii = di + δ ii( αi + γii) + δ l i ilγli = di + δii( αi + γ ii) +. l i I k il i 25

ad sales shares, ad o output-supply matrices to determie sectoral output. It is also importat to ote that I/O tables do ot use ISIC codes to classify idustries. The level at which cocordace could be created correspods to the 2-digit ISIC codes. 11 Table 10 shows that the positive impact of FDI i oe sector o the productivity of domestic plats i some other idustry may or may ot spur ivestmet. At the same time, FDI may complemet capital formatio i aother sector eve without affectig its productivity. While FDI techological spillovers ad complemetarity of FDI with domestic capital formatio are clearly related, they are distict processes. Absece of likages ca preclude ew techological opportuities to be exploited through ew ivestmet projects. The evidece poits to a crowdig out effect of FDI o domestic competitors ad i may cases iter-sectoral complemetarity via backward likages. Whe MNCs import some itermediate iputs, crowdig out of local upstream suppliers also occurs. The estimates o the rows 3 ad 4 ad colums 3 ad 4 for the wood ad paper sectors i Tables 9 ad 10, quatify how vertical spillovers operate while horizotal effects are abset. I particular, there is strog evidece i Table 9 that FDI i both sectors leads to substatial TFP improvemet i the other sector (elasticities betwee 20% ad 30%) but o sigificat itra-idustry effect is apparet o TFP. I cotrast, i Table 10, there is a egative itra-idustry effect o ivestmet from FDI. At the same time, the iter-sectoral spillover o ivestmet is strog, with a elasticity of 8%, from FDI i the paper sector to domestic producers i the wood sector but relatively weak, with a elasticity of 1%, from FDI i the wood sector to domestic producers i the paper sector. This patter shows spillovers beig trasmitted alog backward likages but ot alog forward likages ad is cosistet with other evidece i the literature. Table 10 reveals that the domestic row sectors that beefit most from FDI are i order metallic equipmet, chemicals ad wood. The first two of these sectors are primarily providers of itermediate iputs. As such the producers i these idustries are upstream relative to MNC subsidiaries ad most likely to be recipiets of spillovers through backward likages. As for the wood sector, it is also upstream to most idustries via its likage with the paper sector. The pulp, paper, ad paperboard sector is a major ed-user of raw materials. I particular, chemical processed ad atural wood pulp represet approximately 45% of the total raw materials used by the sector. At the same time, the packagig idustry is also a major ed-user of paper. For example, approximately 11% of paper productio is used for the maufacturig of paper bags for cemet packagig. Packagig, both carto ad paper, is also a importat compoet i the food, beverages ad textile idustries, ad others. These sectoral elasticities iclude ot oly the direct effect o sectors supplyig MNCs but also the idirect effect due to ehaced widespread iput availability associated with FDI. I particular, MNCs techology trasfer beefits upstream local suppliers, ad also domestic plats which are dowstream from those local suppliers. Most recet studies of iter-idustry FDI spillovers oly 11 For further descriptio o this methodology, the reader is referred to the accout i Eslava, Haltiwager, Kugler ad Kugler (2004), pp. 344-345. 26

iclude the direct effect ad eglect the latter (see e.g. Blalock, 2001, Lopez, 2003, ad Smarzyska, 2004). 12 The evidece preseted i Table 10 o backward likages clearly demostrates their importace i explaiig iter-sectoral FDI spillovers. At the same time, forward likages do ot appear to chael iformatio flows from MNCs. 5 Coclusios I theory, there are three chaels through which FDI ca geerate productivity growth for hostcoutry producers. These are techical kowledge spillovers, likage exteralities ad competitio. Case studies show examples i which each of these chaels impacts domestic maufacturig. Ecoometric aalyses have tried to ascertai the geerality of these examples. Empirical cross-coutry estimatios reveal cotemporaeous correlatios amog FDI iflows ad domestic productivity cosistet with the diffusio of exteralities from MNC operatios. However, this evidece is also cosistet with the cocetratio of FDI i coutries where productivity is high i geeral, ad maufacturig TFP i particular, eve if FDI had o impact o domestic producers. For example, this could happe if huma capital abudace attracts FDI iflows. To deal with this simultaeity problem, logitudial ecoometric aalysis was eeded. The availability of pael databases has made it possible to explore i more detail the extet of spillovers. By ad large, iitially the ew evidece focused o the rejectio of itra-idustry FDI spillovers. The, a study foud evidece of diffusio of geeric kowledge, amely spillovers of exportig kowhow from MNCs to eighborig Mexica maufacturers (Aitke, Haso ad Harriso, 1997). This suggested that the absece of itra-idustry FDI spillovers does ot rule out the prevalece of iter-idustry spillovers. O the basis of both the optimal locatio strategy by the MNC to miimize market-share loss ad the low absorptive capacity requiremet for the adoptio of geeric techical kowledge, theory predicts that i equilibrium oly iter-idustry FDI spillovers materialize. Exteralities across sectors could explai evidece of cotemporaeous correlatio amog FDI flows ad TFP growth. Igorig the possibility of the diffusio of exteralities across sectors may lead to the coclusio that FDI substitutes domestic ivestmet. The evidece that there is o diffusio of exteralities withi sectors is importat because it idicates that MNCs have some cotrol to exclude use of their techology ad thereby appropriate the beefits, i such coutries as Cote d Ivoire, the Czech Republic, Morocco ad Veezuela. The evidece i the preset paper shows ot oly that there are limited itra-idustry exteralities but also that there are widespread iter-idustry spillovers from FDI. Hece, while FDI seems to afford excludability of its kowhow to the MNC, this excludability is partial i that it applies oly to specific but ot to geeric techologies. The absece of a positive impact from FDI o the domestic competitors of MNCs stems from the lack of dissemiatio of 12 The exceptios are Kugler (2000) ad Blalock ad Gertler (2004). 27

sector-specific techologies. The prevalece of a positive impact amog other domestic producers i geeral is due to the diffusio of geeric techical kowledge spurred partly by likage effects. Hece, the structural ecoometric framework used to aalyze Colombia maufacturig data i this paper delivers results that match the presumptio of FDI spillovers i the literature as well as the recet fidigs of abset itra-idustry exteralities i may coutries. Although some logitudial aalyses seemigly poited i the opposite directio because of eglect of the possibility of exteralities across sectors, the cojecture that FDI complemets domestic ivestmet through spillovers is bore out by the evidece i this paper. It is importat to idetify the source for the absece of spillovers. The missig observable improvemets o the productivity of host-coutry eterprises i the wake of FDI could be caused by lack of ovel techique utilizatio by MNC subsidiaries, by successful MNC strategy to cotai potetial competitors to its subsidiaries, or by the lack of idigeous absorptive capacity ecessary for ew techology adoptio. I the latter case, eve if the domestic huma capital stock is sufficiet to absorb the ew techique, limited access to specialized equipmet ad machiery, which partly embodies best practice, could preclude adoptio by domestic producers. The probable cause limitig the ability for domestic etrepreeurs to adopt ew techologies is the ufeasibility to acquire equipmet ad machiery. It may be due to restrictios i both fiacig ad importig. As discussed above, this will be a problem mostly for specific as opposed to geeric techologies. While geeric techologies, such as computer-automated desig (CAD) ad local area etworks (LAN), require some machiery, it is more accessible tha the labs or high-accuracy equipmet used with specialized techologies. For example, computer umerically cotrolled (CNC) equipmet for assembly requires specifically tailored desig, maiteace ad traiig. But, geeric productio techiques such as justi-time-ivetories (JIT) ad total-quality-maagemet (TQM) do ot require the acquisitio of ew equipmet ad machiery, ad ca be deployed with limited resources. I this cotext, the implicatio of absece of itra-idustry spillovers prevailig from lessdeveloped coutry evidece is ot that kowledge trasfer associated with FDI is egligible. Neither should we coclude that a correlatio amog weighted FDI averages, usig a host coutry iput-output table, ad domestic productivity implies that spillovers are exclusively preset whe MNCs outsource domestically. Such fidigs for Idoesia, Lithuaia ad Mexico do ot rule other alterative mechaisms outright. FDI spillovers ca be drive by the geericity of kowledge that facilitates itersectoral diffusio through low absorptive capacity requiremet. Also, as poited out by Scherer (1982) ad Glaeser et al. (1991), oe cause behid the spillovers betwee sectors is the cross-fertilizatio of ideas, while likages provide icetives to share techical iformatio. Fially, Rodriguez-Clare (1996) has argued that there ca be a importat idirect effect whereby domestic idustry gais due to the emergece of high productivity iput suppliers to MNCs. This is characterized i the estimatio framework ad measured i the curret paper i Table 10 which provides estimates of the impact o 28

capital accumulatio associated with the spillovers documeted i Table 9. Backward likages ad spillovers are complemets i the geeratio growth. I particular, to the extet that direct FDI spillover recipiets are primarily upstream suppliers of the MNC, there will also be idirect effects to other domestic producers utilizig itermediate iputs produced by these upstream suppliers. I this sese, the establishmet of backward likages whe MNC subsidiaries outsource locally gives rise to potetial widespread iter-sectoral FDI spillovers as the evidece i this paper shows for the Colombia maufacturig sector. The aggregate impact goes beyod the vertical spillovers typically idetified i this literature, which refer to the rise i productivity for MNC iput providers. The other compoet of the aggregate impact of FDI here characterized, amely the higher efficiecy for all dowstream domestic producers usig these MNCs ew iput providers, is show to be quatitatively importat. As i the case of the direct vertical FDI spillovers, the idirect impact due to ew ad better iputs takes place betwee rather tha withi sectors. Due to strategic cosideratios, MNCs optimally egage i exclusive supplier cotracts i the case of specific iputs to avoid itra-idustry FDI spillovers. At the same time, iovatios i other iputs used across several idustries will ot hamper MNCs ad thus geerate idirect iter-idustry spillovers, i additio to the vertical techology diffusio to upstream producers. 29

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Data From plat-level data of the Aual Maufacturig Cesus a pael of 10 sectors (ISIC 3-digit level) for the period from 1974 to 1998 was costructed. Plats are classified as domesticallyowed or MNC subsidiaries. The latter are those for which the fiacig from FDI costitutes a share above ivestmet of at least 10%. The sectors are labeled as follows, where the first category ecompasses all below: (1) MAN = maufacturig (2) FBT = food, beverages & tobacco; (3) TEX = textiles; (4) WOD = wood; (5) PAP = paper & pritig; (6) CHE = chemicals, rubber, & plastics; (7) NMM = o-metallic mierals (except oil); (8) MTL = basic metals; (9) MEM = Metallic equipmet & machiery; (10) OTR = other maufacturig 33

Table 1 - Average Growth Rates: 1974-1998 Sector Domestic Capital Stock Domestic TFP MNC s Capital Stock Foreig TFP MAN 3.1 (0.6) 1.2 (0.4) 1.7 (0.9) 5.2 (1.4) FBT 3.3 2.8 5.2 4.6 (0.5) (0.5) (1.1) (0.8) TEX 2.4 0.7 1.2 4.7 (1.1) (0.6) (1.2) (1.0) WOD 3.6 1.2 3.5 3.9 (0.7) (0.9) (1.1) (0.9) PAP 2.7 3.3 3.8 4.2 (1.0) (0.4) (1.0) (0.5) CHE 3.2 1.8 4.8 4.3 (1.9) (1.0) (1.5) (0.6) NMM 2.1 2.1 3.4 3.8 (1.1) (0.7) (0.9) (0.6) MTL 1.3 0.4 4.8 2.9 (0.8) (0.7) (1.1) (0.8) MEM 3.2 1.5 4.4 1.4 (0.7) (0.6) (0.9) (0.5) OTR 2.8 1.7 2.6 3.3 (0.5) (0.4) (0.8) (0.4) Notes: Percetage average growth rates with stadard errors are reported i parethesis. They are corrected for autocorrelatio usig the quadratic-spectral kerel with pre-whiteig, as suggested by Adrews ad Moaha (1992). Stadard errors are reported i parethesis. 34

Table 2 Statioarity of the Series Sector Domestic Labor Productivity Domestic Capital Stock Domestic TFP MNC s Labor Productivity MNC s Capital Stock MNC s TFP MAN -3.36 * (2) -3.76 (4) -3.40 * (2) 2.80 (3) 0.40 * (2) -2.31 (3) FBT -1.07-2.46-1.76-1.75-2.38-2.66 (1) (3) (2) (4) (4) (2) TEX -2.32-1.64-2.10-1.01-2.84-2.21 (3) (2) (1) (4) (1) (4) WOD -1.60-0.90-3.17-3.65 * -2.23-2.92 (4) (2) (3) (1) (2) (3) PAP -1.95-2.16-1.37-0.73-3.28-1.55 (3) (4) (1) (3) (2) (3) CHE -3.46 * -2.68-3.20-1.50-2.56-2.64 (1) (3) (4) (2) (3) (4) NMM -2.69-1.78-2.48-1.28-3.00-3.02 (2) (2) (3) (1) (1) (1) MTL -2.07-2.84-1.98-2.48-3.05-2.50 (4) (3) (2) (3) (3) (2) MEM -1.97-1.09-1.75-2.96-1.27-2.05 (3) (1) (2) (4) (2) (4) OTR -3.23-4.33 * -2.86-3.26-2.32-2.28 (3) (2) (3) (1) (1) (2) Notes: The Augmeted Dickey-Fuller Test statistics here are for the ull hypothesis that the series i questio have o uit roots. * ad ** idicate sigificace at the 10% ad 5% sigificace levels respectively. The lag legth selectio is data depedat ad yields the order of the autoregressive polyomial idicated i parethesis, followig Ng ad Perro s (1995) procedure. All regressios iclude a costat ad a liear time tred. 35

Table 3 - Coitegratio betwee Ivestmet ad Techical Progress amog Domestic Producers withi ad across Sectors Sectoral Capital Stock Fiaced Domestically Domestic Sectoral TFP FBT TEX WOD PAP CHE NMM MTL MEM FBT 13.21 * 12.75 * 7.63 6.01 7.30 6.10 5.24 8.13 (2) (4) (1) (2) (3) (3) (1) (2) TEX 8.28 16.05 ** 7.15 8.04 6.66 5.54 1.66 10.24 (1) (3) (4) (2) (1) (2) (4) (2) WOD 6.82 5.91 11.47 * 17.41 ** 7.99 8.38 9.35 7.71 (2) (4) (1) (3) (2) (4) (3) (4) PAP 7.58 6.46 14.22 * 10.84 6.33 6.14 8.07 7.90 (3) (3) (2) (2) (4) (3) (2) (1) CHE 8.73 13.67 * 13.08 * 8.71 12.29 * 5.27 5.30 22.66 ** (4) (1) (4) (3) (4) (3) (2) (3) NMM 16.97 ** 7.36 13.29 * 11.93 11.81 14.54 * 13.24 * 19.93 ** (2) (3) (3) (4) (1) (2) (4) (2) MTL 6.89 16.32 ** 5.64 12.70 * 9.09 20.31 ** 15.30 * 5.40 (1) (4) (3) (1) (2) (3) (1) (2) MEM 12.75 * 11.33 7.92 16.55 ** 4.67 15.24 * 8.21 19.64 ** (2) (3) (4) (2) (1) (4) (3) (3) Notes: The ull hypothesis is that there is o coitegratio. The order of the uderlyig VAR is i parethesis. * ad ** idicate sigificace at the 10% ad 5% sigificace levels respectively. The critical values are take from Osterwald-Leum (1992). 36

Table 4 - Coitegratio betwee FDI ad Local Productivity Growth withi ad across Sectors Sectoral Capital Stock Fiaced through FDI Domestic Sectoral TFP FBT TEX WOD PAP CHE NMM MTL MEM FBT 2.44 8.38 16.17 ** 23.41 ** 13.92 * 10.67 9.40 12.59 * (3) (4) (2) (2) (1) (3) (2) (1) TEX 6.42 8.41 13.90 * 12.73 * 14.06 * 8.41 11.10 * 7.07 (2) (3) (2) (3) (1) (2) (4) (3) WOD 13.58 * 18.92 ** 7.80 19.32 ** 7.80 13.99 * 18.38 ** 9.35 (1) (4) (4) (3) (2) (1) (3) (3) PAP 12.52 * 11.95 * 16.39 ** 7.03 16.56 ** 16.04 ** 8.92 12.33 * (3) (3) (4) (1) (2) (2) (1) (2) CHE 12.68 * 15.74 * 16.07 ** 13.79 * 11.69 7.45 20.13 ** 12.38 * (2) (1) (3) (4) (3) (4) (1) (4) NMM 18.43 ** 5.27 14.08 * 9.42 6.11 5.02 11.68 * 13.13 * (4) (2) (3) (2) (4) (1) (3) (1) MTL 15.24 * 17.49 ** 9.74 8.25 12.64 * 8.02 5.77 8.34 (3) (4) (1) (2) (3) (2) (3) (2) MEM 19.04 ** 11.95 * 18.69 ** 9.35 13.07 * 19.23 ** 8.55 14.34 * (2) (2) (4) (3) (1) (3) (4) (3) Notes: The ull hypothesis is that there is o coitegratio. The order of the uderlyig VAR is i parethesis. * ad ** idicate sigificace at the 10% ad 5% sigificace levels respectively. The critical values are take from Osterwald-Leum (1992). Pael Coitegratio Evidece 37

Table 5A Spillover Cofiguratio Test Statistic Sectoral domestic capital formatio ad domestic TFP across all sectors Sectoral FDI fiaced capital stock ad domestic TFP across all sectors Autoregressio Test -19.43-31.53** t-test -7.04-9.72** Note: The ull hypothesis is that there is o coitegratio amog the capital formatio ad productivity series for i the sample of all bi-sectoral possible pairigs. The critical values are obtaied by iterpolatio from the small sample Mote Carlo study i Pedroi (2004). The 5 ad 10 % critical values for the autoregressio test are -30.60 ad -28.53 for the first colum, ad for the secod colum -30.37 ad -28.32 respectively. For the t-test the 5 ad 10 % critical values are -8.31 ad -7.96 for the first colum, ad -8.46 ad -8.09 for the secod colum. * ad ** idicate sigificace at the 10% ad 5% sigificace levels respectively. Table 5B Absorptive Capacity ad Techology Diffusio Test Statistic Labor productivity ad TFP withi sectors amog domestic firms Labor productivity ad TFP withi sectors amog MNCs Autoregressio Test -25.25-33.81** t-test -7.04-8.69* Note: The ull hypothesis is that there is o coitegratio amog the labor productivity ad TFP series withi each sector for a sample poolig all sectors. The critical values are obtaied by iterpolatio from the small sample Mote Carlo study i Pedroi (2004). The 5 ad 10 % critical values for the autoregressio test are -35.62 ad -30.81 for the first colum, ad for the secod colum -32.78 ad -29.34 respectively. For the t-test, the 5 ad 10 % critical values are -9.08 ad -8.25 for the first colum, ad -9.31 ad -8.52 for the secod colum. * ad ** idicate sigificace at the 10% ad 5% sigificace levels respectively. 38

Table 6 Evidece o whether Domestic Ivestmet Geerates Exteral Icreasig Returs FBT TEX WOD PAP CHE NMM MTL MEM FBT 4.04 3.52 N/A N/A N/A N/A N/A N/A TEX N/A 2.38 N/A N/A N/A N/A N/A N/A WOD N/A N/A 1.70 7.96 ** N/A N/A N/A N/A PAP N/A N/A 4.22 N/A N/A N/A N/A N/A CHE N/A 2.03 1.67 N/A 2.68 N/A N/A 5.36 * NMM 1.41 N/A 3.44 N/A N/A 5.02 * 2.69 1.93 MTL N/A 1.56 N/A 2.30 N/A 3.27 4.11 N/A MEM 1.72 N/A N/A 3.45 N/A 2.19 N/A 3.83 Note: The ull hypothesis is that there is o causality from domestic ivestmet i the colum sector to domestic productivity i the row sector. Whe both series are coitegrated, the ull hypothesis of o causality coverges to Chisquare ad ca be tested with the F-statistic. If the series are ot coitegrated, the test is ot applicable. * ad ** idicate sigificace at the 5% ad 1% sigificace levels respectively. 39

Table 7 Causal Evidece of Iter-Idustry Spillovers from FDI FBT TEX WOD PAP CHE NMM MTL MEM FBT N/A N/A 4.98 * 4.01 7.30 * N/A N/A 2.48 TEX N/A N/A 4.75 * 9.82 ** 8.24 ** N/A 1.66 N/A WOD 5.88 * 10.06 ** N/A 12.34 ** N/A 7.59 * 11.47 ** N/A PAP 4.23 * 12.55 ** 5.09 * N/A 8.22 * N/A N/A 5.13 * CHE 9.90 * 1.40 10.12 ** 4.28 * N/A 3.46 7.27 * 3.94 NMM 6.39 * N/A 2.81 N/A N/A N/A 3.13 1.76 MTL 0.74 6.65 * N/A N/A 9.09 * N/A N/A N/A MEM 5.69 * 11.28 ** 4.91 * N/A 4.67 * 1.04 N/A 12.87 ** Note: The ull hypothesis is that there is o causality from FDI i the colum sector to domestic productivity i the row sector. Whe both series are coitegrated, the ull hypothesis of o causality coverges to Chi-square ad ca be tested with the F-statistic. If the series are ot coitegrated, the test is ot applicable. * ad ** idicate sigificace at the 5% ad 1% sigificace levels respectively. 40

Table 8 Evidece o Possible Simultaeity i the Relatioship betwee TFP ad FDI across Sectors FBT TEX WOD PAP CHE NMM MTL MEM FBT N/A N/A 1.02 2.74 4.11 N/A N/A 3.35 TEX N/A N/A 4.03 3.96 0.88 N/A 5.47 * N/A WOD 2.31 0.59 N/A 10.74 ** N/A 1.68 1.92 N/A PAP 3.15 4.07 7.86 * N/A 2.29 N/A N/A 8.91 * CHE 3.36 2.87 1.40 9.05 * N/A 0.98 4.13 11.58 ** NMM 1.74 N/A 4.62 N/A N/A N/A 3.41 2.97 MTL 2.40 4.03 N/A N/A 0.89 N/A N/A N/A MEM 3.55 0.96 1.77 N/A 2.31 3.69 N/A 10.24 ** Note: The ull hypothesis is that there is o causality from domestic productivity i the row sector to FDI i the colum sector. Whe both series are coitegrated, the ull hypothesis of o causality coverges to Chi-square ad ca be tested with the F-statistic. If the series are ot coitegrated, the test is ot applicable. * ad ** idicate sigificace at the 5% ad 1% sigificace levels respectively. 41

Table 9 The Magitude of Techological Spillovers FBT TEX WOD PAP CHE NMM MTL MEM FBT.017.008.015 *.024.109 **.066.032.178 ** (.021) (.010) (.006) (.037) (.046) (.058) (.029) (.081) TEX.023.012.020 *.146 **.086 **.071.044.083 (.035) (.011) (.009) (.028) (.017) (.063) (.042) (.076) WOD.026 *.041 **.035.218 **.057.069.090 *.074 (.012) (.016) (.028) (.075) (.081) (.039) (.037) (.055) PAP.063 *.057 **.283 **.002.119 *.052.061.028 (.029) (.018) (.051) (.063) (.044) (.074) (.092) (.026) CHE.042.083.095.131 **.026.019.004.057 (.089) (.124) (.063) (.093) (.021) (.015) (.013) (.052) NMM.017 *.037.022.024.013.086.079.041 (.007) (.048) (.011) (.035) (.047) (.052) (.069) (.028) MTL.003.064 **.010.048.096 **.008.062.018 (.052) (.030) (.019) (.054) (.034) (.018) (.072) (.031) MEM.026 *.051 **.072 *.056.047 *.081.016.059 ** (.012) (.017) (.029) (.038) (.021) (.055) (.046) (.014) Note: The estimates are based o partial caoical correlatios betwee domestic TFP i the row sector ad FDI i the colum sector. The procedure used is described by Johase (1988). Stadard errors are i parethesis. * ad ** idicate sigificace at the 5% ad 1% sigificace levels respectively. 42

Table 10 Elasticity of Domestic Capital Formatio w.r.t. FDI FBT TEX WOD PAP CHE NMM MTL MEM FBT -.012 **.015.016.025.026.017.016.042 (.003) (.022) (.019) (.034) (.042) (.059) (.021) (.057) TEX.023 -.031 **.031.021 -.037.019 -.005 -.013 * (.042) (.016) (.048) (.029) (.042) (.031) (.027) (.008) WOD.016 ** -.038 ** -.023 **.082 **.021.058 -.018 *.065 (.009) (.017) (.028) (.035) (.031) (.071) (.010) (.093) PAP.008 *.024.009 ** -.024 *.010 * -.021.039.020 * (.005) (.038) (.003) (.011) (.006) (.047) (.081) (.012) CHE.043 *.015 *.011 *.128 *.017.013 *.028 * -.046 (.022) (.008) (.008) (.076) (.023) (.007) (.016) (.071) NMM.006 -.023 -.014.045.013.064 **.079.029 ** (.013) (.029) (.018) (.062) (.047) (.025) (.068) (.006) MTL.031.004 * -.026.031.048.008.042 **.073 ** (.064) (.002) (.039) (.044) (.041) (.018) (.014) (.025) MEM -.016 **.012 **.006 *.036 **.017 *.059 **.009 ** -.084 ** (.007) (.005) (.004) (.017) (.009) (.027) (.002) (.037) Note: The estimates are based o partial caoical correlatios betwee domestic ivestmet i the row sector ad FDI i the colum sector. The procedure used is described by Johase (1988). Stadard errors are i parethesis. * ad ** idicate sigificace at the 5% ad 1% sigificace levels respectively. 43