An increasing number of firms in many countries are now subject to integrated corporate strategies that span more than one country and involve not only headquarters but also domestic and foreign affiliates: they constitute parts of transnational corporate systems. Firms comprising these systems are becoming increasingly specialized with product mandates being given to individual firms and a tendency to locate discrete parts of the value-added chain in any part of the world where it yields the maximum benefit to the system as a whole. The intra-firm international division of the production process has become a necessary — if not imperative — element for firms that wish to compete in the international arena. Given the liberalization of trade, FDI and technology flows, it becomes increasingly difficult for firms to withdraw behind various types of barriers into the safe havens of their home markets.

The forces driving TNC systems to enhance their competitiveness have important implications for countries’ economic performance. To the extent that these firms bring with them tangible or intangible resources (including capital, research and development, technology and organizational and managerial practices) that increase the capacity of a country to produce a greater quantity or improved quality of goods and services, the performance of the country will be affected positively. Positive effects can also result from the expansion of market access that TNCs can bring about, directly or indirectly, as a consequence of intra-firm transactions or a greater ability to reach national and international markets, as well as from economic restructuring fostered by TNCs. To the extent that governments make it difficult for firms to develop fully their three principal sources of efficiency, they handicap them in international competition, ultimately harming global welfare and, under certain conditions, their own countries’ welfare as well.

Capital, innovation, technology, skilled human resources and efficient organizational and managerial practices are all important for the competitiveness of firms and, given an appropriate macroeconomic environment, can help to improve the economic performance of the countries that are host to them. Transnational corporate systems generate these resources and they disseminate them throughout their cross-border corporate networks in the normal course of their business operations.

While the units belonging to TNC systems have privileged access to the assets available through these systems, firms linked to them can have advantageous access to the same assets. This is particularly apparent — and important — in the area of technology. For example, collaborative agreements between TNC systems and indigenous firms can enhance the competitiveness of all the firms involved, by taking advantage of technological or knowledge complementarities. Similar arrangements may be made between TNC systems and local research institutions. Some foreign affiliates, for instance, sponsor research and development carried out by indigenous firms or institutions. As far as production technology is concerned, backward linkages (including through non-equity arrangements) with TNCs are an important means of acquisition of new or advanced technology by indigenous producers. Such arrangements can contribute substantially to competitiveness and the creation of national technological capabilities, as the experience in several East Asian countries attests.

It is an advantage of FDI that it provides a package of wealth-creating assets that become available directly for use in production activities and hence can enhance the economic performance of countries. Although the wealth-creating assets that are part and parcel of FDI may be acquired separately (provided that countries have the ability to do so), it is precisely because it comes as a package that FDI is increasingly welcomed by all countries.

The competitiveness of firms depends not only on their ability to obtain access to assets that complement and enhance their capacities to produce goods and services, but also on their ability to access markets that are large enough to exploit those assets fully and most efficiently. Foreign direct investment strengthens the capabilities of TNCs to reach international markets not only through cross-border trade but also through the sales of foreign affiliates (“establishment trade”). The latter allow TNCs to secure markets for goods and (especially) services that are impossible to reach without proximity to customers, to expand markets for goods and services that are difficult or costly to service from a distance and to respond rapidly to new or changing customer tastes and market conditions.

The efforts of TNCs to expand their sales and organize their production efficiently create market opportunities for other firms in host and home economies, if these other firms are linked to TNC systems. This applies especially to suppliers of parts and components and of producer services. It also applies to firms that utilize transnational trading corporations, which have played a particularly important role in providing suppliers of primary or manufactured goods with access to international markets. Thus, firms not being members of TNC systems, but being linked to them, can have advantageous access to the sizeable markets worldwide served by TNC systems, an opportunity that may give them a competitive edge over their rivals.

What does this mean for the economic performance of host and home country economies? For host countries, and especially developing countries, inward FDI not only contributes a package of resources that are often complementary to domestically available resources and hence expand their production capacities, but also expands the markets for output. Given a competitive environment, and one in which domestic producers are not simply overwhelmed by TNCs, inward investment should thus contribute to raising output of host countries directly as well as through linkage and competition. Where the last of these conditions is lacking, in particular, and one or more industries in a country become exclusively comprised of foreign affiliates, the sharing of the benefits between the host country — i.e., its consumers (through prices), producers (through spillovers and eventual capacity-building), labour and other domestic resources (through wages and other factor returns) and government (through fiscal revenues) — and TNCs become of particular importance. Maintaining competition becomes key.

The access to various resources and markets provided by TNCs, and its effects on the economic performance of countries, can produce — in interaction with domestic factors — performance-enhancing effects that go beyond the sum of the individual effects. In particular, TNCs can enhance a country’s ability to restructure its economy which, in turn, leads to higher productivity and income. The contributions that TNCs can make in this respect occur simultaneously at the firm, industry and sectoral levels, independently from the level of development of the host and home countries involved (see box 3).

Nowhere are the phenomena related to the positive role that TNCs can play in industrial restructuring more clearly visible than in parts of Asia, a region undergoing rapid structural transformation. It is a restructuring that involves, to various degrees, TNCs in many of these countries’ manufacturing industries. This role can be seen particularly in Indonesia, Malaysia, the Philippines and Thailand, but increasingly also in China and Viet Nam. But even in countries that are considered textbook cases of successful restructuring and development based principally on indigenous capabilities — Japan, the Republic of Korea and Taiwan Province of China — TNCs have played a role.

In the immediate post-war period, foreign TNCs helped turn Japanese light industries into internationally competitive industries, and Japanese automobile makers learnt the techniques of mass production in joint ventures with TNCs. This role, however, was short-lived: due to the Japanese ability to develop local capabilities, it soon gave way to looser links with foreign firms in non-equity forms which served mainly as a conduit for technology transfer. Much clearer and long-lived has been the role of the country’s own TNCs, in terms of helping restructure Japan’s manufacturing sector through outward FDI. Japan’s success in becoming a highly competitive economy owes much to its ability to restructure its manufacturing sector continuously from labour-intensive industries through resource-based heavy industries and assembly-oriented industries towards high technology industries.

By relocating assets that were no longer of use at home to neighbouring developing host countries that had a comparative advantage based on an abundance of cheap labour and certain skills — but which could not realize their comparative advantage fully in the absence of these assets — Japanese TNCs (and, for that matter, also United States TNCs) contributed to the building, upgrading and turning around of industries in the countries concerned. In particular, they turned inward-looking industries into export-oriented, internationally competitive industries, thus helping countries realize or enhance their comparative advantages. Even the Republic of Korea and Taiwan Province of China used some TNC-controlled assets in the initial phase of industrialization (as illustrated by the case of the textile and apparel industries; table 11), and more when they were moving up the ladder of industrial upgrading (as illustrated by the case of the electronics industry).

The successful restructuring of the first generation of newly industrializing economies created new home countries (and, hence, sources of FDI). Combined with the liberalization of inward FDI policies in the region, this has led to the growing importance of FDI in the restructuring process of other developing countries of the region, first Indonesia, Malaysia, the Philippines and Thailand, and, more recently, China and Viet Nam. Successful restructuring (including in countries relying largely on their indigenous capabilities such as the Republic of Korea and Taiwan Province of China), moreover, typically leads to a greater role of inward FDI because it involves a movement towards more knowledge-based industries (such as the electronics industry) usually dominated by TNCs.

Restructuring in Asia has taken place in and among countries that differed greatly as regards the degree of government intervention in the economy, forms of technology acquisition, and the role of FDI. But some conditions have been common to this process:

• The countries involved were at different levels of development, with corresponding factor endowments, cost structures and local capabilities; this provided a wide range of choices for TNCs to match host country capabilities with their own.
• The governments involved allowed restructuring to happen, including by letting phase out some firms or industries while letting phase in others, and allowed the emergence of their own TNCs.
• Restructuring was to be verified by the market.
• An enabling framework was created, permitting TNCs to deploy their assets between the countries involved and to play their restructuring role, at least for the industries targeted by governments for upgrading; this included especially the liberalization of external transactions (particularly FDI and associated trade) and a favourable investment climate.
• There was demand — international or domestic, or both — for the goods (and services) produced by new and restructured industries.

With policy regimes becoming increasingly open and, thus, similar, governments are making extra efforts to attract FDI (see table 2 and figure 4)and to strengthen linkages between foreign affiliates and domestic enterprises, with a view towards enhancing their countries’ economic performance.

Targeted promotion is important to attract capital, … Governments which actively seek investment also actively seek to improve their countries’ image within the investment community as a favourable location for investment. In doing so, they rely heavily on direct contact with prospective investors, especially important ones. In fact, successfully enticing one important TNC to locate in a country can trigger a chain reaction that leads to substantial sequential and associated investment.

The most obvious targets are firms already established in a country. Governments can strive to encourage sequential investment (including through reinvested earnings), which can also provide positive demonstration effects for potential new investors: a satisfied foreign investor is the best commercial ambassador a country can have. Policy makers should be concerned when foreign investors leave the host country due to deteriorating local conditions. Emphasis on afterinvestment and investment-facilitation services for current investors is therefore crucial.

The importance of FDI as a conduit for technology transfer has long been recognized by policy makers. However, today, policies in most countries focus on effective technology transfer, rather than regulating specific aspects of technology transactions. Consequently, a number of countries have not only liberalized their technology-transfer legislation relating to restrictions on contractual aspects, they have also focused more on improving the capacity to absorb and use new technologies. However, the actual policy instruments used in that regard can vary widely. Much depends on the existing and evolving levels of local skills and capabilities, and on the nature of the technologies concerned. What is desirable for a country such as the Republic of Korea may be inappropriate for Mexico and simply out of the question for a least developed country. Bearing that in mind, there are, however, two major types of policy instruments that can be said to facilitate technology diffusion.

Of special interest to governments wishing to attract technology intensive FDI is the establishment of infrastructural facilities to foster technology partnerships and encourage positive agglomeration effects. Science parks play a particular role in this respect. The current usage of these facilities, the extent of awareness of their existence on the part of TNCs, the identification of obstacles to their greater use, and the effectiveness of the available services and facilities are all aspects that need to be carefully assessed. Policies must, however, be consistent with a country’s mix of competitive industries, its stage of development, and the capacity of its firms and research institutions. Since not all countries have the resources necessary to develop science parks, regional or subregional initiatives may be useful to pool scarce scientific, technological, financial and institutional resources in specific sectors.

It is indispensable for improved national economic performance that human resources adapt to technical change and contribute to diffusing technology. This requires appropriate training. Lifelong education and retraining are also important, supported by policies that link the educational system to industry and encourage industry’s own efforts at training. For that to be effective, however, requires policies that encourage a nexus between pre-work education and on-the-job training. Among other things, this could involve institutional support to promote cooperative arrangements between TNCs and local learning institutions. Such programmes may require fiscal incentives or other public support, but it is also important that TNCs be encouraged to contribute to the development of human skills beyond their standard operating procedures. If fiscal incentives or public subsidies are to be granted, they should be differentiated on the basis of the expected benefits of training.

Education and training are, however, only part of the story. One of the most important determinants of a foreign affiliate’s impact on the technology and skills in a host country is the extent of its forward and backward linkages with local firms. More technology and skills will be transferred by FDI in linkage-intensive industries than by FDI in industries where such linkages are more difficult to develop. Thus, one policy approach is to encourage industries that lend themselves to local subcontracting through the purchase of parts and components from outside suppliers. Specific consideration might be given to the establishment of an “open school” for small and medium-size businesses, with seminars in various cities, lectures by TNC specialists, case illustrations, plant visits etc.

Many countries have adopted export-oriented strategies to promote their development. In pursuing such strategies, governments, typically, focus on trade and exchange-rate policies, but tend to neglect the FDI dimension (see box 4). Few explicitly recognize that inward and outward FDI can be an important means of accessing world markets. Yet, market expansion can be one of the most important contributions that FDI can make towards the performance of host economies, especially developing ones, since foreign affiliates provide privileged access to the large markets within TNC systems and advantageous access to other markets due to linkages with TNCs.

The implication for policy makers is straightforward: integrated investment and trade policies can facilitate access to international markets. Foreign-direct-investment policy should therefore have a trade component as TNCs are interested in whether a country is suitable for inclusion in their intra-firm division of labour; at the same time, trade policy should have an FDI component, precisely to take advantage of the market access that TNC systems provide. However, while many countries have liberalized their trade and investment policies, the two processes have tended to proceed at a different pace. When FDI policy is more open than trade policy, the type of investment that is attracted tends to take the form of stand-alone production units geared to the domestic market and often relies on trade protection.

The market access afforded by TNC systems need not be confined to their member firms. A key policy requirement for the successful establishment of linkages is the availability of local support services to potential small and medium-sized domestic subcontractors. Supportive macroeconomic policies are also important, particularly a stable exchange rate that is favourable to the production of tradeables, thereby encouraging local sourcing for TNC systems.

For analytical purposes, policies regarding the different components of the FDI package can be considered separately. Since FDI is a package, it should be treated as such. The composition of the package that can be attracted very much depends on a country’s characteristics, including its level of development. This suggests that each government needs to determine what the role of FDI is in its economy and what the potential is for further FDI; to what extent the regulatory framework in place for FDI facilitates the realization of this potential; and what improvements (perhaps supported, where appropriate, by a technical cooperation programme) are needed to make the regulatory framework more effective. UNCTAD has initiated a series of Investment Policy Reviews, to assist individual governments with these objectives in mind. At the same time, UNCTAD will assist the members of the newly established World Association of InvestmentPromotion Agencies (WAIPA) to benefit from each others’ considerable experience in this area.

International competition for FDI has led more and more governments to offer increasingly generous incentives to influence the locational decisions of TNCs (see figure 5). Incentives may be justified to cover the “wedge” between the social and private rates of return for specific FDI undertakings with positive spillovers and to reduce market distortions; they can thus serve a number of development purposes. However, they also involve economic, financial and administrative costs. Moreover, as governments compete for FDI, they may be tempted to offer more and larger incentives than is justified. Competing for FDI with incentives can thus lead to welfare costs exceeding the benefits an investment can bring.

Evidence suggests that the number and range of incentive programmes available to foreign investors has increased over the past ten years. For major investment projects, furthermore, incentives are often provided on an ad hoc basis, determined in negotiations with the investor. And as countries are orienting their development strategies towards exports, technology-intensive industries and higher value-added activities, incentives competition is especially strong in these areas. In fact, countries are deliberately changing their FDI-incentives programmes in the light of actions taken by other countries. Incentives play, however, only a relatively minor role in the locational decisions of TNCs (relative to much more important factors such as market size and growth, production costs, skill levels, infrastructure, political and economic stability and the nature of the FDI regulatory regime).

A number of approaches can be pursued to contain excessive incentive competition (table 12):

• National initiatives. To rationalize the use of incentives, governments could undertake national incentive reviews to determine, among other things, the complete array of FDI incentive instruments — including discretionary incentives — at all levels of government; whether any of these incentives are redundant; what have been the results obtained from the use of incentives and at what cost for the country; whether some incentives can be eliminated, or a ceiling placed on them; and whether a proper balance is being maintained between investment incentives and undertaking investment-promotion activities. The Investment Policy Reviews mentioned earlier are also meant to include an inventory of FDI incentives, with a view towards helping governments formulate more effective and efficient incentive policies. A more detailed and systematic review of incentives could be carried out on the basis of a manual prepared for use by governments.
• Bilateral initiatives. Some countries have used bilateral investment treaties to curtail the use of performance requirements in host countries; a reduction of these requirements could also moderate the use of incentives that are linked to them. Moreover, in the absence of a multilateral or regional approach, governments could consider investment incentives when negotiating bilateral treaties on investment or double taxation, so that the issue would at least be tabled for discussion. In fact, it might be possible to negotiate a conditional incentives-limitation clause in bilateral agreements that would only become operative if a specified number of countries adopted the same clause.

Historically, outward FDI was mostly undertaken by large firms from a small number of developed countries. More firms are however now establishing themselves abroad, including firms from developing countries and a growing number of small and medium-sized enterprises. For many firms, outward FDI has become a strategic option necessary to gain access to markets and resources. More governments recognize that outward FDI is a strategic option that should be left open to firms, lest they risk to impair the competitiveness of firms located on their territory — in fact, precisely the competitiveness of their strongest firms, namely those that have developed the ownership advantages that would allow them to establish themselves successfully abroad. Governments, too, have recognized that outward FDI can be to their countries’ benefit, precisely because of better access to resources and expanded markets and in their interest in economic restructuring and growth. Consequently, a process of liberalization of outward FDI regulations is taking place, although change in this respect has been distinctly uneven between developed and developing countries.

Developed countries have historically permitted and even promoted outward FDI. Where capital flows were restricted, countries used foreign exchange or capital-movement control systems with accompanying licensing or project-approval requirements. The usefulness and effectiveness of national exchange controls was undermined during the 1980s. At the same time, changes in exchange-rate policies — notably the adoption of floating exchange rates — and improved monetary management techniques reduced potential problems that could arise from the lifting of capital-control restrictions. By the end of 1994, only three developed countries maintained (limited) restrictions on outward FDI.

Few developing countries and economies in transition have paid much attention to outward FDI policies; typically these are subsumed under general capital-control policies which, in turn, are normally quite restrictive. The reasons appear self-evident:developing countries typically face a foreign exchange shortage and are capital constrained.