Should foreign direct investment in retail be allowed or not? Reams have been written on the possible ill-effects of allowing entry to giant retailers such as Walmart and Tesco. Equally, a great deal has been said about how it would give a boost to local manufacturers, improve the supply chain and so on.

Even as the debate simmers and the government dithers, here's a paper from Mexico that looks at the impact of Walmart's entry into Mexico on Mexican manufacturers of consumer goods.

In a study called Supplier Responses to Wal-Mart's Invasion of Mexico ( NBER Working Paper No. 17204 ), Leonardo Iacovone, Beata Smarzynska Javorcik, Wolfgang Keller, and James R. Tybout show how Walmart de Mexico (Walmex) provides access to a larger market. But, at the same time, it puts continuous pressure on its suppliers to improve their products' appeal; and it forces them to accept low prices relative to product appeal. Mexico opened its doors to foreign investors in 1986 and Walmart entered the country in 1991 through a joint venture with a major Mexican retailer. After six years of explosive growth, Walmart took majority control and by 2003, it had become Mexico's largest private employer.

Study model

What were the effects of this mercurial rise and ascendance? The authors have used something called an industrial evolution model.

Its distinctive feature is that a bag of heterogeneous producers can choose in every period whether to sell their output through Walmex or through traditional retailers.

Those who opt for Walmex reach a larger consumer base, but they have to accept Walmex's pricing schedule, and this generally leads to lower mark-ups.

The authors say their modelling exercise was informed by a series of interviews on the impact of Walmart's entry they conducted with Mexican firm representatives and industry experts.

Those interviewed frequently mentioned that Walmex's entry had considerably sharpened the distinction of high versus low performing firms. They also stated that among firms choosing to deal with Walmex, the productivity effects were often positive.

direct effects

According to the authors, simulations of the model also showed that the arrival of Walmex had separated potential suppliers into two groups — those with relatively high-appeal products and those with lower-appeal products — and that both reacted differently.

The former choose Walmex as their retailer, whereas those with lower-appeal products do not. “High-quality firms will invest in upgradation and innovation in order to sell their products through Walmex, while low-quality firms will not.

At the industry-level, the model predicts that productivity and the rate of innovation may increase, both because market shares are reallocated to the stronger firms and because within-firm performance improves,” say the authors.

The regression results are strongest on sales and productivity. High quality firms sold more and became more productive in response to Walmex' FDI in Mexico, while low-quality firms lost ground in both dimensions.

The study results are less clear on pricing, where the authors admit their analysis does not yield a clear pattern. “Future work will have to clarify whether this finding is unique to the behaviour of Mexican plants or not; in the latter case the model will have to be modified so that the decision to sell through Walmex depends not only on quality, but also on additional factors, such as the specific geographic location of the supplier relative to both Walmex retail stores and Walmex distribution centres,” they say.

Indirect effects

The study shows that trade and FDI liberalisation may also have important indirect effects. Not only did the FDI deregulation of the North American Free Trade Agreement (NAFTA) reshape the country's retail market by facilitating Walmart's entry into Mexico, it also had a major impact on the upstream manufacturing industries.

On the retail front, Walmex acted as a catalyst for good business practices in the sector. Following its lead, the industry modernised its warehousing, distribution and inventory management.

On the supply chain front, Walmex not only introduced the system of channelling deliveries from suppliers through centralised warehouses, it also required delivery trucks to have appointments and drivers to carry standard identification cards. Audits, fines and quality standards were introduced.

Thanks to these changes, there was a significant decline in distribution costs faced by Mexican suppliers. Critically, Walmart's spectacular reach helped suppliers reach a larger segment of the Mexican market.

Negative fall-out

But against the positive effects, “one must weigh the capital losses imposed on entrepreneurs whose profitability is reduced, sometimes to the point of exit, and the welfare losses of consumers who preferred the brands driven out of the market,” note the authors.

The relationships studied by the authors reveal that performance improvements in the goods-producing sector may have had their source in other sectors of the economy.

This is important because most formal analysis to date had focused on the goods producing sector, which is shrinking rapidly in many advanced economies while, in contrast, other sectors of the economy are much less understood.

So, the authors conclude, there may be high returns in identifying the exact reasons for changes in companies' performance in response to trade and FDI liberalisation.

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