The Hindu Business Line : ‘MNCs invest abroad more for securing inputs for their final output’

A China may have attracted hundreds of billions of dollars in foreign direct investment on the promise of cheap labour costs. But if two Western academicians are to be believed, bulk of the FDI happens not for exploiting factor cost differential across nations. It is not also for the reason that it is easier to ship money for making cars than cars themselves — a reference to flow of goods encountering greater barriers than capital. They argue that companies invest abroad often for creating a secure source of supply of critical inputs.

In a working paper made available by the Harvard University under its ‘First Look’ series on new ideas, authors Ms Laura Alfaro of Harvard University and Mr Andrew Charlton of the London School of Economics argue that many of the foreign subsidiaries, ‘are in fact producing highly specialised inputs into their parents’ production… in sectors close to the parent firm’.

‘Vertical’ activities

They classify investments as ‘vertical’ activities as opposed to ‘horizontal’ activities, where the subsidiary produces the same product as the holding company. (For a parent automobile company a horizontal subsidiary would one that makes ‘motor vehicles’ while vertical subsidiaries are those that make sub systems such as engines, gear boxes carburetors, airbags, spark plugs etc.) They go on to say that not only are such (vertical) units more in number (1,12,939 to 1,04,057) they also employed more people (15.8 million to 11.9 million).

Classifying investments by products using four-digit standard industry classification they establish that MNC investments in subsidiaries are characterised by the existence of strong input-output relationships. They argue that the motivation for bringing an input inside the boundary of the firm (through parent-subsidiary relationship) does not lie in the nature of the product. Nor indeed, does it lie, in the characteristics of the country where it is produced. It lies in its position to the production chain of the end product itself.

Production process

Their data, they claim, supports the view that parent companies choose to own the stage in the production process, which is closest to their own. If this was not so the parent and subsidiaries would not be sharing the same industry code at the 2 digit or even the 3 digit level. Secondly, the skills levels would not be the same. (Comparable proportion of blue collar workers to the supervisory staff in the two sets of companies.)

‘Multinationals overwhelmingly source raw materials and inputs in the early stages of production from outside the firm but tend to own stages of production proximate to their final production giving rise to a class of high skill intra-industry vertical FDI,’ they conclude.

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