FDI and Manufacturing for Export: Emerging Patterns and Opportunities for Sri Lanka

Pemachandra AthukoralaArndt-Corden Department of Economics

Crawford School of Public PolicyAustralian National University

prema-Chandra.Athukorala@anu.edu.au

Public Lecture 2Excel World Auditorium, Colombo, 18 August 2016

Purpose/Motivation

Discuss the role of foreign direct investment (FDI) in the expansion of manufacturing exports

from developing countries in the context of the on-going process of economic globalizationandexplore policy priorities for Sri Lanka

Motivated by,

• Contending, and often confusing, views on the subject in the Sri Lanka economic policy

debate

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Structure

• FDI and manufacturing exports: concepts and typology

• Production sharing and global economic integration

• Joining global production networks: policy priorities

• Sri Lankan experience Policy context Achievement and missed opportunities

• Concluding remarks

FDI and manufacturing exports: Concepts and typology

FDI is ‘The category of international investment that reflects the objective of a resident entity in one economy to obtain lasting interest in an enterprise resident in another country’ (IMF (1993), Balance of Payments Manual, p 86).

Here, ‘the resident entity in one country’ is the direct investor, the multinational enterprise, MNE

Unlike other forms of international capital flows (such as portfolio investment, foreign aid and commercial bank lending), FDI comes as a package of capital, technology, managerial expertise, market links.

FDI is a central driver of global economic integration. 4

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Two types of FDI

Market-seeking FDI: investment in MNE affiliates engaged in serving the domestic market.

Also called ‘tariff jumping FDI’

Efficiency seeking FDI: investment in MNE affiliates engaged in production for the global market.Also called ‘export-oriented’ FDI

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Production activities of efficiency-seeking FDI takes two district forms:

• Conventional manufacturing (‘horizontal specialisation’)

Production of a good entirely (from start to finish) in just one country.

- domestic-resource based products and

- consumer goods that are made to local specifications (such as handicrafts)

• Global production sharing (‘vertical specialisation’)

Splitting of the production process (of a good or a service) into discrete tasks, which are located in countries in

which factor prices are well matched to the factor intensity of the particular task

This is the prime mover (driving force) of modern day efficiency seeking FDI

Alternative terms: international production fragmentation, vertical specialization, slicing the value chain

Example 1: Nike Flyknit Shoe Collection

• Designed, and marketed worldwide by Nike Inc, USA• The Machine for the seamless knitting of the upper was designed and produced by a German

company• Ultra-light performance fabric for making the ‘upper’ is produced Trisha Fabric, USA • Upper is knitted in MAS Technology Park, Thulhiriya, Sri Lanka• Rubber sole is produced, and the shoe is assembled in Vietnam

MAS Holding has invested US$75 million in this factory; employ over 3000 workers. Nike assigned this task to MASS because of the narrow-fabric Knitting skill/technology developed by Stretchline (a MAS company) over the past three decade ]Nike has set up an Innovation and Development Centre in the MAS Technology Park, Thulhiriya.

Example 2: Thailand-centred hard disk drive network

HDD exports from Thailand (in 2013): US$ 18.5bn, which accounted for 15% of total merchandise exports from Thailand and 70% of total world HDD exports

But, HDD is not entirely made in Thailand: At least ten other countries participate in its production

Example 3: Boeing 787 Dreamliner

Boeing 787 Dreamliner

Involves 43 suppliers spread over 135 sites around the world

Boeing itself accounts for only 10% of the material inputs, but holds rights to the 787 technology

Close to 70% of parts come from countries other than the USAWings: JapanEngine: UK and USAFlaps and ailerons: Australia and CanadaFuselage: Japan, Italy and USAHorizontal stabilizers: ItalyLanding gear: FranceDoors: Sweden and France

(Only about 1% of Boeing 707, produced in the 1950s, was build outside the USA)

Global production networks (GPNs)

Interrelations among a set of firms specialising in different segments of

the production process of a given product as a single economic group

Based on the nature of the governance structure (the role of the ‘lead

firm’ ), GPNs can be grouped into two types:

Buyer-driven GPNs

Producer-drive GPNs11

Buyer-driven GPNs

Common in the standard consumer goods industries such as apparel, footwear, travel goods, toys and furniture‘Lead firm’ in the value chain is the international buyer (a large retailer or a brand manufacture).

Producers in developing countries can join the network through arm-length relations forged with ‘value chain intermediaries’ (FDI is not a must; there is room for arms-length trade)

Normally, FDI is in joint-ventures with a local manufacturer (not fully-owned subsidiaries)

Input procurement is monitored by the lead-firm, but these is room for use of domestic inputs if possible to meet the required quality standards

Producer-driven GPNs Common in vertically integrated global industries such as electronics, electrical goods, automobiles,

scientific and medical devices

• ‘Lead firm’ is the manufacturing MNE

• The bulk of global production sharing takes place through intra-firm linkages within MNE

network rather than in an arms-length manner.

• Therefore foreign direct investment (FDI) plays a pivotal role in a country’s participation in

producer drive GPNs

• As production operations in host countries become firmly established, MNE subsidiaries may

begun to subcontract activities to local (host-country) firms to which they provide detailed

specifications and even fragments of their own technology.

Production sharing and global economic integration Global production sharing opens up opportunities for countries to participate in a finer international division of labour, to specialize in different slices (tasks) of the production process in line with their relative cost advantage.

In a labour abundant economy, assembly activities within global production networks tend to be relatively more labour intensive (and hence ‘pro poor’) compared to ‘conventional manufacturing’ (production from start to finish in just one country) of the given final product

Successful integration of the manufacturing sector into production networks (in particular producer-drive GPNs) has played a key role in employment generation and poverty reduction in China and other high-performing East Asian countries

India versus China

Spread of East Asian production networks to Cambodia and Vietnam

Table 1: Production sharing in world manufacturing data: summary data1999-2000 2012-13

World manufacturing exports, US$ bn (at 2005 price) 1457 5256

Share of GPN products 53.1 63.1 Buyer-drive 15.1 12.0 Producer-driven 38.0 51.1

Share of developing countries: World manufacturing trade 32.3 51.3 World GPN trade 41.2 68.3 Buyer-drive 70.3 75.3 Producer-driven 35.3 62.6Source: Compiled from UN Comtrade database.For details on the methodology see Athukorala, P. ‘Global production sharing and trade patterns in East Asia’, in N. and B. Singh (eds.) Oxford Handbook of Pacific Rim Economies, New York: Oxford University Press, 334-360.

Determinants of a country’s success in joining global production networks (emphasis here is on joining producer driven GPNs)

• Labour and human capital

• Service link cost

• Proactive investment promotion (‘marketing the country’)

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Labour and human capital

• At the initial stage, prerequisite is the availability of trainable (unskilled) labour and middle-level (supervisory/technical) manpower.

• In the long-run, availability of high-level technical and managerial manpower is required for moving into higher-value creating tasks in the production process

• Human capital development is partly endogenous to a country’s engagement in GPNs; government-MNE collaborative initiatives can play a role (experiences of Singapore and Penang (Malaysia)

Low wages has been a significant contributor to the growing importance of developing countries as a group in GPN trade

But

difference in labour cost does not seem to explain differences among developing countries in their success in joining global production networks (Table 2)

Service link cost

Service link cost: the costs involved in coordinating production blocks/tasks located across borders.

Service link cost in a given country depends on a whole range of factors impacting on the overall business environment:

(i) Infrastructure and trade-related logistics (air transport has become increasingly important for electronics network trade) (ii) political stability and policy certainty(iii) Property right protection, including enforcement of contracts(iv) Liberalisation of trade and investment policy regimes (elaborate in the next two slide)

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Foreign trade and investment liberalisation

MNEs are the key players in producer-drive global production networks

Therefore, global production sharing makes a strong case for concurrent liberalisation of trade and FDI policy regimes

FDI and trade polices are co-determinants of the location choice of MNEs within production networks

Discuss:

China vs. India

Indonesia vs. Singapore, Malaysia, Thailand and Vietnam

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Marketing the country

Need for proactive, well-targeted polices to attract foreign investors

• Attracting a big international player has ‘demonstration’ effect on others – the so-called herd-mentality in global industries

• ‘Market failure in information’ about potential investment sites

• Evidence from Singapore, Ireland, Costa Rica, Penang (Malaysia), Vietnam

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‘Barely a month goes by without some country’s leader contact me and

offer the likes of $1billion in tax credits and other incentives if we will

open an Intel plant and create jobs in that country’

Paul Otellini, the CEO of Intel

(Freedman and Mandelbaum 2012, p. 320)

• Winning an ‘investment tournament’ by a new host country requires

involvement/commitment at the highest political level.

The Sri Lankan experience

• Policy context• Achievements• Lost opportunities

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Policy context• Trade liberalisation and promotion of foreign investment, particularly in export-oriented manufacturing, were

the to pillars of Sri Lanka’s market oriented policy reforms since 1997. The international media dubbed Sri Lanka ‘the new investment centre of Asia’, (Far Eastern Economic Review, 23 October 1978)

• The investment promotion policy package offered to FTZ investors was comparable to, or more attractive

than, incentive packages of FTZs in most other countries.

• A guarantee against nationalisation of foreign assets without compensation was provided under the Article 157 of the new Constitution of Sri Lanka adopted in 1978.

• Export-oriented firms located in all parts of the country were accorded FTZ status (in addition to those within the area demarcated by the original GCEC Act) in 1994.

- Since then the BOI policy regime is not a “enclave arrangement” that breed dualism in the economy: BOI privileges are available to both foreign and local investors who meet the approval criteria (the prime one being export orientation) and many BOI-approved firms now operate outside the FTZs.

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There have been some disturbing developments in the FDI regime over past decade. • A high degree of variability in incentives offered across various products/sectors and among firms (The

incentive structure provides ample room for the discretion of BOI officials over actual viability and national economic gains).

• As against the original plan, many firms have become perpetual beneficiaries of tax holidays (Tax holidays are not time bound)

• Nationalisation of some firms under the Revival of Underperforming Enterprises and Underutilized Assets Act (2011) shattered investor confidence.

• The Minister’s discretion in investment approval under the Strategic Development Projects (SDP) enacted in 2011 greatly diminished the role of BOI.

(The status of BOI transformed from ‘the one stop’, as envisaged in the original BOI charter, to ‘one more stop’ for prospective investors)

Achievements and missed opportunities

• A notable diversification of the commodity composition of Sri Lanka’s exports following the liberalization reforms initiated in the late 1970s (Figure 1)

• Sri Lanka’s share in world manufacturing exports increased continently until about the late 1990s (Figure 2)

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Figure 1: Sri Lanka’s merchandise exports, 1965-2014

19651967

19691971

19731975

19771979

19811983

19851987

19891991

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20012003

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20130

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Total merchndise exports

Manyfacturing exports

Mnufactruing share ( %)

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Figure 2: Sri Lanka’s Share in World Non-oil Exports and Manufacturing Exports (%), 1988-2014

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Total non-oil exports

Manufacturing exports

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FDI has played a pivotal role in export expansion

• Having averaged less than half a million a year during 1970-76, net FDI inflows increased rapidly in the first seven years of the post-reform period.

• The outbreak of the ethnic conflict in 1983 disrupted this impressive trend, but the second-wave reforms and the temporary cessation of hostilities during the first half of the 1990s witnessed some increase in FDI.

• There was a clear shift in FDI from domestic market-oriented to export-oriented activities during the first three decades of reforms. By the late 1990s, export-oriented firms accounted for over 90% of envisaged (approved) investment. in the mid-1990s to less than 30% by the first half of 2010S.

• Export expansion has predominantly driven by joining buyer-drive GPNs, with heavy concentration of exports in apparel (Table 2)

• Among the non-GPN products (horizontal exports), rubber based products, in particular heavy-duty tyres, has shown impressive growth with FDI playing a pivotal role: the share of natural rubber (the second largest of the traditional export ‘trio’ of the country) in total exports has declined sharply as a result of rapid growth of rubber based manufactured products .

• Sri Lanka lags far behind the East Asian countries in reaping gains by joining producer-drive GPNs (Table 3)

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Table 2: Sri Lanka: Commodity composition of manufacturing exports (%) (2-year averages)

Product group/product ( SITC coded in brackets) 1990-91 2000-01 2005-06 2010-11 2013-14

GPN products (buyer-driven + producer-driven) 70.87 81.12 74.30 73.00 75.66 Buyer driven 66.35 74.33 66.13 63.06 67.18 Garments 64.99 70.03 65.20 62.47 66.08 Footwear 0.93 1.16 0.35 0.30 0.80

Producer driven 4.52 6.79 8.17 9.93 8.48 Electronics and electrical goods ( SITC 75 76 and 77) 1.62 4.37 3.90 3.36 2.83

Transport equipment (SITC 78 and 79 1.14 1.28 2.58 3.24 1.98

Traditional (horizontal) products 29.13 18.88 25.70 27.00 24.34

Essential oil (SITC 551) 0.27 0.10 0.10 0.22 0.35 Activated carbon (SITC 59864) 1.16 0.44 0.45 0.99 1.16 Tyers (SITC 625) 1.19 2.46 6.08 7.34 7.88 Other rubber based products (SITC 62 - SITC 625) 0.74 0.74 1.02 1.70 1.97 Porcelain (SITC 666) 1.17 0.97 0.80 0.52 0.45 Diamonds, gems and Jewry (667) 13.26 4.32 7.59 7.39 5.30

Total exports 100 100 100 100 100 US$ million 1093 3723 4546 6167 7131

Table 3: Share of GPN products in manufacturing exports, 2012- 13 (%)

  Buyer-driven GPN Producer-drive GPN Total

Developing East Asia 19.2 57.2 76.4

China 20.5 57.3 77.8

Taiwan 7.2 72.6 79.8

South Korea 8.3 69.9 78.2

ASEAN 14.0 61.2 75.2

Indonesia 23.2 14.2 37.4

Malaysia 6.3 69.3 75.6

The Philippines 13.2 64.1 76.3

Singapore 2.3 92.3 94.6

Thailand 12.4 59.4 72.3

Vietnam 23.5 34.3 57.8

South Asia 12.2 21.2 23.5

Sri Lanka 67.2 8.5 75.7

India 12.3 9.9 22.2

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The special case of apparel • Following the economic liberalisation reforms initiated in the late 1970s, Sri Lanka has emerged as a successful

participant in the global apparel value chain. Trade –cum-FDI liberalisation unleashed national entrepreneurial capabilities; joint-ventures with foreign buyers

and foreign investors played a pivotal role • In contrast to the various gloomy predictions made in the lead-up to the MFA phase-out, Sri Lankan apparel

industry has managed to sustain growth dynamism in the completive market conditions of the post-MFA era.

• The Sri Lankan apparel producers have carved out a niche in high-end markets for intimate apparel (lingerie and panties) and fashion-basis casualwear with a strong customer base of leading brand marketers and speciality stores (Figure 3).

• A number of Sri Lankan companies have become multinational enterprises in their own right; Colombo is now consider technology/design hub of apparel in the region; the largest world producer of high-quality elastic (a key input to the production of intimate apparel) is now a Sri Lankan firm.

(Athukorala, P. and R. Ekanayake (2016), ‘Repositioning in the Global Value Chain in the Post-MFA Era: Strategic Issues and Evidence from Sri Lanka’, Development Policy Review (forthcoming)

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

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Figure 3: Sri Lanka’s world market share in total apparel exports and in the top 5 apparel products, 1999-20141 (%)

Men/boy trouser woven Women/g trousers woven Women/g panties knit

T-shirts/singlets knit Brassieres Total apparel

Wor

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Sri Lanka in producer-drive GPNs: missed opportunities and some promising signs

There is strong evidence that Sri Lanka missed the opportunity of becoming a assembly

centre within producer driven global portion networks because of political

instability/uncertainty.

In terms of the other preconditions for joining producer-drive GPNs, Sri Lanka was

comparable to (or even better placed than) Thailand and Malaysia at the time (and even

now!)

Reponses of two large electronics MNEs to the 1977 liberalisation reforms attested to Sri Lanka’s attractiveness:

MotorolaIn 1980 incorporated a fully-owned subsidiary company: initial employment of the assembly plant: 2624.

Harris CorporationIn the same year incorporated a fully-owned subsidiary company and even started building an assembly plant: initial employment 1850

Both left within a few years as political instability and ethnic conflict set in, shattering Sri Lanka’s hopes of becoming an electronics export hub.

* On Motorola in Sri Lanka:Weigand, R. (1983), International Investment: Weighing the Incentives’, Harvard Business Review, 61, 146-152)

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• A sizeable number (over 30, according to BOI records) fully export-opined medium scale firms are currently operating in electronics, electrical and automotive industries.

(Employ over 20,000 workers (according to a survey conducted by the Export Development Board)

• Most of these firms are engaged in assembling parts and components which unlikely to be affected by the so-called ‘robotisation’ threat.

• They consider availability of trainable labour as a major attraction of Sri Lanka - no complains about

high-level manpower shortages; the needed middle-rank supervisors are mostly trained on the job.

Tables 4 and 5

Table 4: Sri Lankan Firms in Producer Drive GPNsAge (years) Ownership Product Employment

Esjay Electro Mag 34 Japan/SL Electronics component, auto wire harnesses and LED/CFL lighting

250

FDK Lanka 25 Japan/SL Magnetic head, printed circuits, optical isolators

686

Tos Lanka 20 Japan/SL Printed circuit board/auto harnesses 250

Lanka Harness 22 Japan/SL Censor switches for seat belts and airbags 330

Okaya Electrics 8 Japan/SL Electric components, crystal display modules, LED lighting devices

644

Aerosense 6 USA/Sweden/UK Sensors for Airbus 2000* *planned

Cable Solutions 6 EU/India Specialised, customised cables ---

Harness Solutions 6 EU Customised cable harnesses ---

Variosystems 18 Switzerland/US

Printed circuit board/auto harnesses 600

Metal Component services

6 EU Metal components ---

Table 5: Main GPN exports from Sri Lanka: Disaggregated (SITC-5 digit) data

SITC Code product 2000 2005 2010 2011 2012 2013 2014

Products with exports>US$10mn in 2013/14

74492Lift truck parts --- --- 15.0 34.1 31.2 43.6 57.177313Vehicle ignition wire --- --- 37.0 40.6 37.2 36.1 36.177119Other elec. transformers 13.1 16.4 50.0 36.7 28.4 28.4 24.577282Switchgear parts 0.3 12.1 26.7 38.3 33.8 21.7 28.677261Switchboards etc <1000v 0.7 6.1 11.1 13.2 6.9 20.0 27.377281Switchboards etc unequip 8.1 14.2 12.4 17.3 11.8 12.6 17.277220Printed circuits 14.8 5.9 22.7 28.6 26.6 16.7 10.977812Electric accumulators 0.3 0.4 0.2 0.3 0.8 6.0 18.477866Paper/plastic capacitor --- --- --- 4.5 9.9 10.0 14.489281Labels paper,paperboard 1.7 4.6 10.2 10.7 8.5 11.3 10.3

  Other 207.9 247.8 161.2 204.8 182.1 193.1 227.3

  Total parts & components 246.8 307.5 346.4 429.2 377.1 399.4 472.1

Note: --- Zero or negligible

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Concluding remarks• Trade and investment policy reforms initiated in the late 1970s set the stage for globally integrating the Sri

Lankan manufacturing sector with FDI playing a pivotal .

• The Sri Lankan experience highlights the complementary role of investment liberalization for exploiting the potential gains from trade liberalization: trade liberalization increased the potential returns to investment by capitalizing on a country’s comparative advantage, while liberalization of foreign investments permitted international firms to take advantage of such profit opportunities.

• The country failed to capture the full benefits of trade and investment liberalization because of the protracted civil war that undermined the investment climate and macroeconomic stability.

• Sri Lanka’s immediate policy priority should be to restore policy emphasis on export-oriented industrialisation, set up institutional safeguards to avert further backsliding from reforms, and continue with implementing the incomplete reform agenda.

Two related policy issues

• FTAs and FDI in GPNs

• The use (and abuse!) of domestic value added/linkages as industry-policy criteria

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Can FTAs promote FDI in GPNs?

The rise of global production sharing strengthen the case for multilateral (WTO-based) or unilateral, rather than regional (FTA), approach to trade liberalisation:• Production-sharing based international specialisation can’t be sustained as a regional

phenomenon because of the importance of extra-regional (global) markets for final products.

• Formulation of rules of organ (RoOs) for GPN trade is rather complicated task (next slide).

‘Bilateralism distorts flows of goods …. In structuring the supply chain, every country of origin rule and every bilateral deal has to be tackled on as additional consideration, thus constraining companies in optimising production globally’ Victor Fung, Financial Times, November 3, 2005.• Most major trading nations are signatories to the WTO’s Information Technology

Agreement; FTAs are irrelevant for products covered by the agreement.

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RoOs and Global Production Sharing

• The trade effects of any FTA depends very much on the nature of the rules of origin (RoOs) built into it

• The conventional value added criterion is virtually inapplicable to this form of trade because tasks undertakes by each country in the value chain normally generate rather small domestic value addition

• The only viable option is to go for ‘change in tariff line’-based RoOs, but in most cases trade in final goods and parts and components belong to the same tariff codes even at the HS-6 digit level

• These administrative problems could result in unnecessary delays in customs clearance and also open up opportunities for rent seeking through tweaking of RoOs

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The use (and abuse!) of domestic value added/linkages as industry-policy criteria

Per unit value added/domestic input linkage is a misleading indicator of gains from GPN exports

Input structure within global production networks is ‘relationship specific’

Policy interventions aimed at promoting domestic value added can be counter productive (Can runs counter to the objective of employment generation/poverty reduction through export-oriented growth)

The pertinent criterion should be ‘the volume factor’: ability to produce for a vast global market and employment generation.

Contribution to the national output (GNP) depends on the volume factor, not on per unit value added.