Foreign Direct Investment (FDI) by multinational corporations (MNCs) has grown recently, especially penetrating middle-income countries. During the 1990s, the growth of FDI flows trebled the growth that was witnessed in international trade. Most FDI flows are concentrated in the developed nations with international trade transactions and inter-trade linkages. In present trends, the principal source of international finance to developing countries is in the form of FDI.
FDI has been widely recognized as a growth enhancing factor for host countries; it not only brings capital but also introduces advanced technology that can enhance the technological capability of the host country firms such that it can generate long-term and sustainable economic growth for the host countries. The technological benefit is not limited to locally-affiliated firms but it can also spread to non-affiliated firms. The latter benefit is usually referred as the technology spillover.
Technology has been seen as a major driving force in output growth and economic integration of the global economy. Neoclassical economic theory has focused on factor accumulation which refers to the source of factor expansion and factor productivity.
Technological progress is often treated as an exogenous factor. However, the recent research has treated the technological change in accounting for economic growth. The endogenous growth model suggests that innovation relies on knowledge resulting from cumulative R&D expenditure and at the same time it also contributes to the growth of knowledge stock of R&D activities, which drives economic growth by the creation of new products according to the horizontally differentiated input models; or improvement in the quality of existing ones according to the vertically differentiated input models. The non-rival characteristics of technology, which distinguishes it from other factor inputs make the marginal costs of technology to the additional firms negligible.
Technological investments not only confer benefits to the investors but also contribute to the knowledge base which is then publicly available to the firms/industry. These externalities are called “technology spillovers”.
The technology spillover effect is a driving force in economic growth and through different channels the technology diffuses across industries of a host country. Trade is a crucial conduit for technology transfer. With the rapid growth of FDI after the 1990s, an increasing tendency to develop R&D in the host country affiliated or non-affiliated firms has resulted in FDI which is seen as an engine of economic growth. Although the theoretical models for FDI and technology transfers are well developed, empirical studies provide mixed results. Another potential channel for technology spillover is information technology (IT), which is well known for improving the efficiency of production and reduce the cost of communication and monitoring among the distant firms.
Further, with easy access to modern communications technology, firms in all globalizing countries are under pressure to improve their productive efficiency in the face of competition from newly-emerging domestic firms on one the hand and foreign competition on the other. This is especially true in the case of India, which initiated major economic reforms in 1991, for shift towards an open economy along with privatization of a large segment of the economy. These reforms were phased over a number of years and several reforms have been recently implemented after 2000.
The removal of quantitative restrictions and trade barriers to entry has opened up the economy to international market forces which coupled with the rising economic and social aspirations of the population, has again led to the rapid emergence of a competitive environment especially in the industrial sector.1 Continuous improvement in productivity and efficiency is necessary particularly if India is to achieve a high growth rate and competitive target set for the industrial sector in the international market. International investors are now evaluating the different local business environment or investment climate (IC), geographical features, local labor laws, transport facilities offered by various regional areas, as well as capabilities and strategies of the local firms, etc. So the technology spillovers are varied across the firms of an industry located in different regional areas in India.
The technology spillover for the host country firms has been an important route of the outsourcing of knowledge, embodied in FDI brought in by the MNCs. So, the expectation of gaining technology spillover has persuaded many developing countries to offer various incentives to attract FDI. In fact, the results of empirical research to test the validity of technology spillover are far from conclusive. From the empirical findings, it appears that the positive technology spillover from FDI is not automatic, but it depends on both country-specific factors and policy environment. An analysis of the technology spillover impact of FDI on host economies has typically assumed this impact to occur in two linked steps: First, MNCs parent to subsidiaries international transfer of technology that is superior to the prevailing technology in the host economy; and Second, the subsequent spread of this technology to domestic firms in technological spillover effect.