Foreign Investment and Supply Chains in Emerging Markets: Recurring Problems and Demonstrated Solutions

Multinational corporations account for 80 percent of all transfers of goods and services across borders, either within their own affiliate transactions or through networks with independent providers. As a result, the term supply chains is rapidly becoming the new norm in discussing the spread of trade and investment around the globe. From the point of view of developing countries, however, the ability to link host economies into international supply chains is anything but normal. There are important market failures and tricky obstacles that inhibit creation of supply chains in emerging markets. This working paper identifies the most important market failures and impediments that hinder the spread of supply chains in developing economies--with findings quite at variance with much conventional wisdom--and examines how some host governments have been successful in overcoming these obstructions. The evidence provides a useful perspective on the debate about the need for something that might be called industrial policy for countries that want to use foreign direct investment (FDI) to diversify and upgrade their production and export base. A sample of six diverse case studies--chosen because they offer detailed information about information asymmetries, market failures, and coordination externalities--shows clearly that developing country authorities should not merely sit back and wait to see what international market forces bring to them. The public sector "support" that is needed takes the form of creating effective investment promotion agencies and funding industrial parks, reliable infrastructure, and vocational training with curricula designed by companies that wish to employ the graduates. These interventions surely qualify as a kind of industrial policy, and definitely cost public money. This approach might be called light-form industrial policy to harness FDI to development and generate backward linkages as deep as possible into the host economy. This light-form industrial policy contrasts with policies that target specific domestic industries for special government support and protection while excluding foreign investment altogether from the targeted industries or subjecting foreign firms therein to performance requirements in the form of domestic content mandates, joint venture mandates, and/or other technology-sharing pressures. This latter approach could be called heavy-form industrial policy. Country experiences, including evidence from China, reveal counterproductive outcomes from the imposition of explicit performance requirements on foreign investors. To a certain extent, emerging market hosts can carry out policy interventions on their own. But the evidence presented here shows that external support is often crucial to success. Contemporary policy discourse often implies, indeed sometimes assumes, that with the explosion of international private sector investment flows there is less need for developed country donors and multilateral financial institutions to support growth and development programs--as opposed to pure poverty reduction programs--especially in middle-income emerging markets. But the evidence introduced in this working paper shows that there is a vital role for external donors, including the aid agencies of developed countries, the World Bank Group, and the regional development banks, to work with host country governments to improve the functioning of markets so that emerging countries can better harness FDI for development.