The Diffusion of Externalities from Foreign Direct Investment: Theory ahead of Measurement*

In this paper a structural estimation framework is developed to assess whether inward foreign direct investment (FDI) generates technological externalities. The econometric model is implemented in an empirical investigation with data from Colombia’s Manufacturing Census. So far, evidence of new technological opportunities for host-country firms arising from the operations of multinational corporations (MNCs) has been rather scarce. This is due to serious limitations in the way in which spillovers have been measured. In particular, empirical research has focused almost exclusively on intra-industry externalities while no allowance has been made for inter-industry technological externalities. But, in theory, the optimal location and organizational strategies by a MNC are chosen to minimize the risk of losing profits due to the leakage of technical information to potential competitors. Therefore, the host-country firms within the MNC subsidiary’s sector will tend to experience limited technological gains ensuing FDI, whereas producers in other sectors may benefit, especially if the MNC outsources to local upstream suppliers. While FDI may substitute investment by domestic plants within the MNC subsidiary’s sector, it can complement investment in other sectors. Hence, spillovers from FDI should be primarily inter-industry and not intra-industry. This conjecture is corroborated by testing of the mutisectoral model of FDI spillover diffusion on Colombian manufacturing data. Furthermore, both generic knowhow spillovers and linkage externalities are sizable.