DIME Second Research Activity Line (RAL2) The Creation, Accumulation and Exchange of Knowledge in Networks, Sectors and Regions Working papers Series Regional Dimension of the Impact of Foreign Direct Investment on the host economy: a case of Ukraine Victoria Kravtsova Vienna Institute for International Economic Studies (WIIW) Oppolzergasse 6 A-1010 Vienna, Austria [email protected] Abstract This paper contributes to the methodology of evaluating the impact of FDI on the host country by taking into account the impact of FDI on the regional level. The methodology also accounts for both impact on the technical and efficiency change of domestic firms. The empirical analysis of the economic development with regard to FDI in Ukraine suggests that foreign presence has positive impact on the efficiency change of domestic firms in the Eastern regions of Ukraine, but has a negative effect on the technical change of the firms. At the same time there is a positive spillover effect on the firms operating in the Western regions of Ukraine in terms of technical change. Different impact of foreign presence on the performance of firms in two parts of Ukraine might reflect deep institutional divergence of the West and the East. Key words: FDI, Regional Spillover Effect, Malmquist Productivity Index JEL codes: C67, D24, F2, O3 1. Introduction Some economists argue that internationalization has reduced the importance of national borders and that “the advanced nations have come to share a common technology” (Nelson and Wright, 1992). However, the results of empirical analysis of technology creation and transmission by large corporations to different countries are ambiguous. Recent empirical studies on transition economies provide evidence that technology has been transferred to firms primarily through FDI, but no significant spillover effects of FDI have been found (see Djankov and Hoekman, 1998, Damijan at el., 2001, Konings, 2001). The evaluation of spillover effect via commonly used econometric methods is less sensitive to the institutional differences between countries and regions, which are hard to be captured by the empirical eye. This study goes beyond the existing literature by examining the regional aspect of spillovers from foreign to domestic firms. Furthermore, in diverse parts of the country, characterized by different attitude to FDI, the impact of foreign presence is hypothesized to have different effects on the technical and efficiency change of domestic firms of the region. In this study the technical and efficiency change has been evaluated by the decomposition of a Malmquist Productivity Index. As an empirical case, the manufacturing sector of Ukraine has been chosen for two main reasons. Firstly, much FDI into the manufacturing sectors (and especially into export- oriented sectors,) comes from offshore bank havens and is suspected to originate from illegal activity inside Ukraine itself - FDI as money laundering. The warning comes from the official government media representative Ukrinform: “According to State Tax Administration Vice Chairperson Mykola Katerynchuk, …, 65 percent of their (metallurgical plants) exports were through commercial deals which involved offshore zones. In this way, … , this scheme allows financial-industrial clans to launder huge sums of money.” This fact alone is expected to impact the way FDI influences domestic firms in the host economy. The share of investment consisting of money laundering that returns to Ukraine via FDI is hypothesized to have low technological value and therefore weak spillover effects on the performance of domestic firms. Secondly, recent economic and political developments in Ukraine provide grounds to believe there is a strong division between the East and the West of the country. Historically, the eastern part of the country has been under the influence of Russian empire, while the other, more western regions were part of Austro-Hungarian Empire and have been more strongly influenced by the West. The presumption that seventy years of Soviet Union regime did not remove the institutional differences between the two parts of one country is strong. The difference is striking when it is applied to attitudes towards FDI declared by the leading political parties in these two agglomerative parts of Ukraine. While the pro-western political wing is more welcoming to FDI, the eastern block is more inward-oriented and prefers domestic investment as opposed to FDI, especially when foreign investment comes in a form of mergers and acquisitions (M&A). These regional differences are hypothesized to influence the pattern of behavior of foreign investors in two parts of the country and potentially lead to the diverse spillover effect. Hence, the purpose of this paper is to examine whether evident regional distinction can capture difference in the impact of foreign presence. The paper is set out as follows: section 2 discusses previous studies on FDI, regional aspect of FDI spillovers and empirical studies on transition economies, while section 3 presents an overview on FDI in Ukraine and its regions. Section 4 provides a data description followed by section 5 with methodology strategy. In section 6 the main results are discussed and then main conclusions are drawn in section 7. 2. Literature review It is well established in the FDI literature that the entry or presence of foreign MNC affiliates does not benefit the host country automatically. In order for FDI to be a catalyst of economic development, and not a detrimental force, some essential characteristics of both the local economy and the foreign firms have to be in place. While the existing gap in technological development between countries represents “a great promise” for growth (Gerschenkron, 1962) it is difficult to fulfill these expectations, and requires from the more backward countries “a significant amount of effort and institution building” (Fagerberg, 1994). In most of the cases MNCs carry out their technological activity in the home country, reducing the potential for such knowledge to spill over to local firms in other markets (Patel and Pavitt, 1997, Kuemerle, 1999). Domestic firms have to make their own investment in R&D and employee training and they must adapt organizational structures that permit innovation (Kinoshita, 2000). The level of development of the home country’s innovation system is found to be a determinant of the kind of knowledge foreign companies bring to the host economy (Kvinge, 2000). Different types of knowledge have different levels of susceptibility to spilling over. Marketing and management knowledge, for example, is less tacit than product and process technology, and is therefore more likely to spill over. There is a greater prospect for domestic firms to internalize organizational knowledge by interacting with foreign firms that operates in the same region or district. Here, the inter-industry spillover effect is much likelier to occur if suppliers and consumers (forward and backward linkages) are operating in the same region. This is more likely to happen if the foreign affiliate is oriented towards the local market and is biased towards transport cost minimization (see Kokko and Kravtsova, 2006 for the more extended discussion on the determinants of innovative behavior of foreign affiliates in transition economies).Product and process technology are more difficult to transfer to the affiliate as well as being better protected by MNC affiliates in transition economies. The recent statistical analyses of FDI spillovers, particularly in transition countries, have yielded mixed results. Empirical studies by Djankov and Hoekman (1998), Damijan at el. (2001), Konings (2001) provide evidence that technology has been transferred to firms in transition economies primarily through FDI, but no significant, and sometimes negative spillover effects of FDI have been found1. Among the main explanations for these results, the methodological issue of difference in intra and inter industry effects have recently been examined by Smarzhinska (2004a). Since multinationals have an incentive to prevent information leakage that would enhance the performance of their local competitors in the same industry, it is more likely 1 Negative spillover effect, or ‘crowding out’; is related to situation when less efficient domestic firms are forced to leave traditional market after the entrance of foreign competitors. that local firms in the host county may benefit from transferring knowledge via linkages to their local suppliers (Smarzhinska, 2004b). Some studies find that the presence of foreign multinational companies may raise the productivity of locally owned firms in other industries, presumably through various linkages, but only if they are located in close proximity of the foreign multinationals (Sjöholm, 1999). The geographical proximity of foreign firms to the local market is one of the important determinants of FDI spillover effects (Torlak, 2004; Audretsch and Feldman, 1996). Spillovers are found to be regionally confined and decrease with distance. This is not surprising, since key channels for FDI spillovers such as labor turnover, demonstration effects, competition and cooperation with upstream suppliers (backward linkages) and downstream customers (forward linkages) - are geographically restricted in many industries. Furthermore, the farther the traditional suppliers from MNC abroad, the higher the probability that foreign affiliates will seek to install linkages with local suppliers (Rodrigues-Clare,