Productivity Spillovers of FDI in the Manufacturing Sector of Mauritius ...

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The Journal of Developing Areas Volume 49

No. 2

Spring 2015

PRODUCTIVITY SPILLOVERS OF FDI IN THE MANUFACTURING SECTOR OF MAURITIUS. EVIDENCE FROM A DYNAMIC FRAMEWORK Sheereen Fauzel Boopen Seetanah R. V. Sannasee University of Mauritius, Mauritius

ABSTRACT Using a dynamic vector error correction model, catering for dynamic, endogeneity and causality issues, the present study addresses the important question of whether foreign direct investment in the manufacturing sector enhances the productivity of the sector in Mauritius using time series data for the period 1980-2010. The results show that FDI in the manufacturing sector has indeed contributed to both total factor productivity and labour productivity in the long run. Analysing the short run results, we found that FDI in the manufacturing sector continues to influence productivity but the impact is very small. This result was mainly explained by the massive relocation of foreign firms from Mauritius to cheap labour destinations. Also, the results confirm the presence of bicausality and feedback effects in the FDI-Productivity relationship. Moreover, it also shows that FDI is positively related to the level of domestic investment suggesting the presence of “crowding in” effect as well. JEL Classifications: F21, F23, O40 Keywords: FDI & TFP manufacturing sector, VECM, productivity spillovers Corresponding Author’s email address: [email protected]

INTRODUCTION Foreign direct investment is an important channel through which developing countries can benefit from important flow of technology and transfer of knowledge. FDI has acquired considerable importance as a tool for the economic development of host countries and for accelerating their growth. Inward FDI boosts aggregate investment and the level of economic activity. Besides, it has numerous benefits which include employment creation, improved productivity, enhanced exports, integration in global market and firms’ development and reorganization. (Walfure and Nurudeen, 2010, Moura et al, 2010). As evidenced by Saqib et al (2013) and Osinubi and Amaghionyeodiwe, (2010), FDI help to boost the economic growth and development of developing countries by allowing an inflow of capital investment. It also results in an influx of revenue to the government through taxes, contribute towards improving the balance of payment position of the host countries and also help in diversifying the industrial base of the host economy. The consensus in the literature supports the view that FDI increases growth through productivity and efficiency gains by local firms. The empirical evidence is not unanimous, however. Available evidence for developed countries seems to back the idea

296 that the productivity of domestic firms is positively related to the presence of foreign firms. The results for developing countries are not so clear, with some finding positive spillovers (Blomstrom, 1986; Kokko, 1996; Blomstrom and Sjoholm, 1999) and others such as Aitken et. al. (1997) reporting limited evidence. Still others find no evidence of positive short-run spillover from foreign firms. Some of the reasons include the fact that MNCs tend to locate in high productivity industries and, therefore, could force less productive firms to exit (Smarzynska, 2002). Cobham (2001) also postulates the crowding out of domestic firms and possible contraction in total industry size and/or employment. Moreover, Wang (2009) advocates that another possible reason for this, is the use of total FDI, rather than FDI by sector to analyse the growth generating impact of FDI. Hence, the review shows that the debate on the impact of FDI on economic growth is far from being conclusive. It is noteworthy that most of the empirical works have been overwhelmingly focused on developed country case and also on the economic impact of FDI and its determinants. This study is believed to supplement the literature and explores the impact of FDI in the manufacturing sector on total factor productivity in the sector for the case of an African state, namely Mauritius, for the period 1980-2010. We also looked at the impact of domestic investment in the manufacturing sector, given its importance in the sector in Mauritius. The paper also methodologically departs from most of the previous empirical studies as it uses rigorous dynamic time series analysis, a dynamic vector error correction model (VECM), to carry out the investigation. This procedure ensures that the dynamic behaviour of the time series under consideration is properly captured, while simultaneously catering for endogeneity and causality issues. Any feedback and indirect effects which might be present will also be detected within the VECM. The paper is organized as follows: Section 2 provides a review of the literature followed by an overview of investment and TFP in Mauritius in section 3. Section 4 presents the model and the data used and in Section 5 we present the empirical results. Concluding remarks and policy implications are left to section 6. THEORETICAL REVIEW Over the past decade, FDI has acquired considerable importance as a tool for the economic development of host countries and for accelerating their growth. As such, inward FDI boosts aggregate investment and the level of economic activity, thereby giving positive signals as to the soundness of the host economy. FDI can potentially lead to economic growth resulting from capital accumulation and total factor productivity growth through transfer and dissemination of knowledge and technology. Other channels include the formation of human resources, integration into the global economy and firms’ development and restructuring. The theory of growth expressed in terms of Harrod – Domar growth equation where g = s/k laid emphasis on the importance of inward investment in a particular country. With respect to this analysis, we further note that the famous economist John Mayard Keynes outlined how investment in an economy can lead to multiple increases in national income through the multiplier effect. According to the neoclassical growth model, FDI is seen as a source of additional capital which increases the existing capital

297 stock of the host country. Thus an increase in FDI will lead to an increase in production further leading to an increase in output, thus, economic growth. FDI allows host countries to achieve investment that exceeds their own domestic saving and enhances capital formation. According to this theory, the potential beneficial impact of FDI on economic growth is confined to the short run. In the long run, given the diminishing marginal returns to physical capital, the recipient economy could converge to the steady state growth rate as if FDI had never taken place leaving no permanent impact on the growth of the economy. Therefore, this theory explains that FDI is significant only in the short run while in the long run, it becomes insignificant, a reason why many empirical evidences found an insignificant relationship between the two variables. Furthermore the theory developed by Frindlay (1978) explained that FDI enhances the rate of technical progress in the host country from the more advanced technology and management practices used by foreign firms. This is because foreign firms own and transfer their technology in the host country, where such technology is not available. These knowledge effects are known as FDI externalities or spillovers and are defined as an increase in productivity, thus economic growth. Analysing the modernization model or thesis which is based on economic liberalism, it is argued that the economy of developing countries benefit widely from the economic linkages with foreign firms. Thus, with foreign direct investment, the host countries gain access to export markets, capital and technology that are crucial for their development. Similarly, such economic linkages also benefit developed countries, as they acquire cheap raw materials, opportunities for investment and wider markets for their products. More so, as highlighted by Gilpin (1987), liberals are of the view that such trade openness divert factors of production where they generate the productivity gains and positive spillover effects for the host developing countries thereby resulting in economic growth. Empirical studies on the modernization thesis, supports the view that FDI promotes economic growth. For instance, this effect can be direct and indirect. It is noted that some studies such as Alfaro et al. (2004), postulates that FDI leads to economic growth depending on the country’s quality of local financial markets, whereas Borenzstein, de Gregorio, and Lee (1998) found that FDI leads to growth depending on the local country’s level of human resources. On the other hand, the dependency theory argues that if a country is dependent on FDI, then it will negatively impact on its economic growth. According to this theory, FDI creates monopolies in the industrial sector which results in underutilization of domestic resources. Also, the economy becomes highly dependent on foreign firms which only contribute to hinder the development of the local business. As postulated by Nielson and Alderson (2007), a strong FDI presence in a particular country leads to lower economic growth. As observed by dependence theorists, an economy having high dependence on FDI inflows to support its economy, eventually lead to a destruction of the local entrepreneurship, suppress technological innovation, and result in a crowding out of the domestic firms. Furthermore, such a situation can also lead to an increase in unemployment in the host country. (Feenstra and Hanson 1997) Moreover, turning towards FDI spillovers effect, we observed that there are different spillovers flowing from FDI to host countries that have been identified by various scholars. These FDI spillovers are mechanism that generate growth in the host countries. For instance, vertical spillovers are a consequence of the interaction between

298 the foreign firm and local suppliers. With high communication and transportation costs, MNCs prefer to purchase intermediate goods from local suppliers. Interestingly, they provide technical assistance and training to local suppliers or may even assist them in their purchase of raw materials to ensure that the products meet the required standards. Even without such direct involvement, domestic firms are forced to respond to the higher product quality and on-time delivery requirements. Such backward linkages are further enhanced by ‘local content requirements.’ More so, domestic suppliers also benefit from linkages with foreign affiliates. Primarily, linkages raise output and employment in linked supplier enterprises. The indirect effects on supplier capabilities are probably more important. Linkages can be powerful channels for diffusing knowledge and skills between firms. Inter-firm linkages nearly always entail an exchange of information, technical knowledge and skills. Strong linkages can promote production efficiency, productivity growth, technological and managerial capabilities and market diversification in supplier firms. They can often promote exports by linked enterprises and, under the right conditions; domestic firms may develop to become global suppliers. The strengthening of suppliers can in turn lead to various indirect effects and spillovers for the rest of the host economy. Another channel of FDI spillovers occurs through the transfer of product design and technical specifications. Such transfers can take the form of detailed technical specifications and designs to enable local suppliers to manufacture the required inputs. Some studies have found this to be the form of transfer of product related technology. (Wong 1992). Technical consultations with suppliers also improve performance and are also a form of spillover effect from foreign firms. Some affiliates provide advice to local suppliers on product characteristics or parameters. Such technical support activity helps local suppliers in adopting and absorbing new product related technology (Zhang & Markusen 1999). More so, foreign affiliates sometimes transfer machine-embodied process technology by providing the product to be purchased or testing equipment of quality control. EMPIRICAL REVIEW The significance of FDI lies in its primary difference from other forms of capital investment. In fact, empirical evidence suggests that FDI flows are relatively less volatile as compared to other capital flows (IMF, World Economic Outlook, 2007). Hence, it entails a longer duration of commitment (Barrell and Holland, 2000). The aim behind FDI is to form pan-commercial relations, while exerting significant managerial control over the foreign firm. Therefore, FDI consists of a combination of capital, technology, managerial skills, market access and entrepreneurship (Dunning, 1993). The numerous benefits derived from FDI have generated much interest among policymakers as regards the potential impact of foreign direct investment and policies which would affect FDI flows. Moreover, evidence suggests that, given specific country prerequisites, FDI indeed results in better growth outcomes (Borensztein, de Gregorio and Lee, 1998). Analysing the empirical studies on FDI-growth nexus, the study of Shan (2002) made use of a VAR model to assess the inter-relationships between FDI, industrial output growth and other variables in China as well. His results support the FDI-growth nexus. Yet certain studies have shown that for FDI to positively influence growth, certain

299 elements need to be present in the host country. For instance, the work by Borensztein et al. (1998), Xu (2000), and Alfaro et al. (2004) suggest that educational level, development of local financial markets, and other local conditions play a crucial role in allowing the positive effects of FDI to emerge. Blomstrom and Kokko (2003) settled from their review of the literature that spillovers are not automatic, and local conditions influence firms’ adoption of foreign technologies and skills. Furthermore, De Vita et al (2009) analysed the impact of FDI and portfolio investment flows on the economic growth of low-, lower middle- and upper middle-income countries. Using a large set of 126 countries and applying the system-generalized methods of moments (GMM) estimation approach; they found that only developing countries that have reached a minimum level of economic development and absorptive capacity that are able to capture the growth-enhancing effects of foreign investment inflows. Other studies support the view that FDI lead to economic growth depending on trade openness of the country, availability of stock of human capital and adoption of sophisticated technology. Investors will not be attracted to invest in countries having policies which restrict trade such as, the imposition of tariff and non-tariff barriers and restrictions on investors to repatriate profit and capital to their home country. However countries which do not impose such obligations on investors will be more able to attract huge investments like FDI. This is supported by Balasubramanyam et al (1996) who argued that the positive relationship between FDI and economic growth exists when trade openness is encouraged in a country. They are also of the view that a country which encourages open trade will promote allocative efficiency. The country will allocate its resources toward the production of those products where it has comparative advantage when trading between countries, thus cumulating economic growth. Zhang (2001) also support the view that FDI encourages economic growth. He further stipulates that this is possible when host countries adopt open trade policies, improve education and maintain economic stability. However, Mustapha et al (2008) found that the growth effect of FDI does not depend on trade openness for the case of Middle East and North African countries. Analysing the literature, we further found studies examining the direction of causation between FDI and economic growth. For instance, Choe (2003) found a significant and strong relationship between FDI and economic growth. The study showed that there is a two-way causation between FDI and growth. However the effects were more significant from growth to FDI rather than FDI to growth. Hansen and Rand (2006) observed a strong causal relation from FDI to GDP for a group of 31 developing countries. Their study showed that if a country is experiencing rapid economic growth due to good trade policies, skilled labour and adoption of technology, then the country would find an increase in its FDI since multinationals would want to establish in such countries and take advantage of the new profit opportunities. Thus increasing economic growth would attract more FDI. Moreover, Chakraborty and Basu (2002) examine the causality between FDI and output growth in India and found that the real GDP in India is not Granger-caused by FDI and the causality runs more from real GDP to FDI.

300 Empirical Evidence on Productivity Spillovers of FDI Analyzing some of the earliest empirical studies on productivity spillovers for Australian industries, Caves (1974) found that relatively high foreign ownership in the Australian manufacturing sectors is related to higher productivity of local firms. Similarly a study by Globerman (1979) for the Canadian manufacturing sector, found that labor productivity differences across Canadian-owned firms are positively linked to the industry’s capital intensity, labor quality, scale economies and the extent of foreign ownership. Using a sample of more than 1500 Chinese manufacturing plants, Filip et al (2007) show that the direct and indirect effects of foreign direct investment on measured firm level productivity depends on a number of firm specific features and institutional factors. They further concluded that domestic firms that engaged in a joint-venture with a foreign partner are on average more productive, as well as exporting plants and plants located in special economic zones. In addition, domestic firms benefits from horizontal spillovers from foreign firms on average. However, these spillovers depend on the structure and origin of ownership as well as on specific characteristics of the special economic zones. The study by Blalock and Gertler (2008) found that positive FDI spillovers occur through backward linkages while there is no strong evidence of positive spillovers through the horizontal and forward linkage channels. This was explained by the fact that MNCs try to restrict information leakage to their local competitors but would not necessarily do so to their local suppliers. Another paper by Javorcik (2004) concludes that the highest correlation of FDI to productivity is found where MNCs are only partially rather than fully foreign owned. Javorcik and Spatareanu (2008) found similar results for a sample of Romanian firms. It can thus be inferred that joint ownership creates more technology diffusion since wholly owned subsidiaries are likely to use technologies which are far too advanced for the local firms. Foreign investors may as well come to dominate the domestic industry, notably if the technological gap between them and their competitors is large. This can benefit consumers in terms of lower prices or better quality products. However, local firms may be crowded out, and stakeholders in those firms, notably employees, may lose their industry specific investment. Aitken and Harrison (1999) argued that the negative spillovers may arise from a ‘market stealing effect’, that is foreign investment reduces plant productivity in the short run by forcing domestic firms to cut production. If local firms are forced to exit, this can lead to oligopolistic market structures or even monopolistic market structures. In fact, evidence on research on productivity spillovers is mixed. Also, the major drawback of most previous studies on FDI spillovers is that they failed to examine the causality between FDI and productivity. Despite being acknowledged by several studies, very few attempt to address this issue. OVERVIEW OF INVESTMENT AND TFP IN THE MANUFACTURING SECTOR OF MAURITIUS The Mauritian economy has undergone remarkable transformations since independence. From a poor country with high unemployment exporting mainly sugar, Mauritius has become relatively prosperous and diverse, although not without problems. The 1970s

301 were marked by a strong government commitment to diversify the economy and to provide more high-paying jobs to the population. The promotion of tourism and the creation of the EPZs renamed as Export oriented enterprises (EOE) did much to attain these goals. The EOE sector has been very successful in creating jobs, foster export diversification and increasing the level of inward FDI in the country. In the late 1980s and 1990s, the EOE sector was the main source of employment creation, accounting for crudely one-third of total employment. (Vercillo, 2010). These development successes were a result of the stabilization and structural adjustment programs initiated with the assistance of the World Bank and the IMF. The programs incorporated successive devaluations of the local currency and in 1983, the adoption of a flexible exchange rate. By 1986, the gross value of exports from the EOEs amounted to almost 55 per cent of total export value, whiles the traditional export commodities, sugar and molasses were responsible for only 40 per cent of the value. (Rogerson, 1993) In the 1980s, the clothing sector accounted for over half of the Mauritian exports, with Mauritius ranking as the third largest exporter of woollen goods (Ramtohul, 2008) Furthermore, in the 1990s the textile and clothing sectors employed 87 per cent of the EOEs workforce. The EOE recorded high growth, overtaking sugar which was the main exportearning sector and employing more workers than the sugar industry. In 1986, Mauritius had its first trade surplus in twelve years. Tourism also boomed, with an expansion in the number of hotel beds and air flights. The economy had slowed down by the late 1980s and early 1990s, but the government was optimistic that it could ensure the long-term prosperity of the country by drawing up and implementing prudent development plans. The main reason behind the need to diversify the economy have been the threat to agriculture, mainly sugar, resulting from Europe's common agricultural policy and the likely harmful effects of the Agreement on Textile and Clothing on the textiles and clothing sector. Manufacturing Sector Looking at sectoral growth rate of the country, for the last 20 years, the tertiary sector has been an important driver of the economy. Such growth can be attributed to the booming tourism services coupled with the strong growth in transport and communication; financial services and the real estate sector. Conversely, the share of the primary sector (mainly agriculture) has been declining from 12% to 4% whilst that of the secondary sector has declined marginally by 5 percentage points. Sectoral analysis also reveals that the manufacturing sector alone is the main driver of the economy both in terms of GDP and employment. This can be analysed on the figure below which shows the sectoral composition of GDP in Mauritius from 1990 to 2010. From figure 1, we clearly observe that manufacturing sector contribute more to GDP as compared to other sectors.

302 FIGURE 1. SECTORIAL COMPOSITION OF GDP (1990-2010)

Source: Author’s Computation

The total value of production in manufacturing has grown mainly as a result of an increasingly rise in the production of “other manufacturing” in non-EOE sectors. The total production value in the EOE sector kept on dropping, from a high of 12.5 per cent in 1999 to a very low level in 2010. The share of manufactured sugar has also been falling over the years. These declining shares in the country’s traditional key manufacturing subsectors have been compensated by the growth in manufacturing production in the nonEOE sector. For instance we noted a significant contribution of the domestic oriented enterprises in the manufacturing sector. A rise in the exports of Fish and Fish Preparations has been observed which coincided with the government’s strategy to develop Mauritius as a world class seafood hub in an attempt to further strengthen the fishing industry and to create a new booming sector in order to sustain the economic development. Total Factor Productivity in the Manufacturing Sector The main drivers of growth in the country have been capital and labor accumulation, with TFP growth making a significant contribution. A study by Rojid and Seetanah (2009) provide evidence that TFP gains in Mauritius have reached a plateau. TFP growth averaged 1.4 percent in the 1980s, 1.0 percent in the 1990s, and 0.7 percent in the 2000s, but the TFP contribution to overall growth varies depending on the different growth rates.

303 The TFP change in Mauritius resulted from economic reforms and human capital improvements. FIGURE 2

Source: Statistics Mauritius

The main constraints identified to improvements in productivity levels in the Manufacturing sector are mainly the shortage of management, technical and skilled personnel, absenteeism and high labour turnover. Also, noted was the high labor cost which was increasing rapidly and which could not match the productivity of the EOE sector. This situation caused a notable decline in cost competitiveness over time. It was observed that to remain competitive, many of these manufacturing firms had to rely on a depreciating rupee and an increasing use of foreign labour to maintain their productivity levels. In that respect, the number of foreign workers which stood at 6,145 in the 90s, increased to 24,000 in 2012 with the majority employed in the textiles and clothing segment. Foreign Direct Investment and Domestic Investment in the Manufacturing Sector Referring to the MCCI, 2009 report, ‘FDI was important in the early stages of export development, contributing much to the take-off of the EOE sector. These foreign inflows led to export growth, technological transfer and job creation. However in 2000 the flow of FDI in the manufacturing sector fell considerably. This drop in FDI levels was associated to the delocalization of foreign investors after the ending of the multi-fiber agreement and government policies that aimed at encouraging a diversification of the economy through the promotion of the Offshore, the Tourism sector and the Information and Communication Technology sector.’

304 FIGURE 3

Source: MCCI 2009

FDI was crucial for the EOE sector; however its success would not have been possible without the substantial amount of domestic investment in the country. Domestic investment in the manufacturing sector has been very considerable in the past years. We can observe this on the figure below:

FIGURE 4

Source: Statistics Mauritius

An analysis of manufacturing domestic investment shows that the major share of investment was concentrated by the domestic oriented enterprises. In that respect, investment trend in the subsector was rather stable, exceeding that of export oriented enterprises during the period.

305 METHODOLOGY Model Specification The aim of this study is to investigate the extent to which FDI flowing in the manufacturing sector in Mauritius contribute towards increasing total factor productivity of the sector. Based on the principles of some earlier studies (Caves, 1974; Globerman, 1979, and Blomstrom and Sjoholm, 1999), the following functional form applies to the “productivity spillover models in the manufacturing sector” used in this research: Also, we incorporated a second model as well as a robustness check. The time period considered is 1980-2010. Model 1: TFPm = α0 + β1FDImt+ β2DInvtmt + β3HCt + β4INFt + β5INSTt + µt

(1)

Model 2: LPm = α0 + β1FDImt+ β2DInvtmt + β3HCt + β4INFt + β5INSTt + µt

(2)

Because of the variance stabilizing properties of log transformation, the log values of the variables are used. In fact, logged variables yield a more clear-cut interpretation of the coefficients in terms of percentage change. Converting all the variables in logarithmic terms yields: Model 1: tfpm = α0 + β1 fdimt + β2 Dinvtmt + β3 phct + β4inft + β5 inst + µt

(3)

Model 2: lpm = α0 + β1 fdimt + β2 Dinvtmt + β3 phct + β4inft + β5inst + µt

(4)

Where tfpm, lpm, fdim, phc, inf and tariff are the logs of total factor productivity, labour productivity in the manufacturing sector, foreign direct investment flowing in the manufacturing sector, domestic investment in the manufacturing sector, human capital (primary education), inflation and tariff(institutional variable) respectively. β1… β5 represent the parameter estimates and µt is the random disturbance term. Dependent Variable: TFPm This study uses the total factor productivity index for the manufacturing sector as produced by the digest of productivity and competitiveness statistics by Statistics Mauritius. ‘TFP index shows the rate of change in “productive efficiency” and is obtained as the ratio of output to total factor input that is a weighted combination of labour and capital inputs. TFP index is chosen over labour productivity index and capital productivity index. This is so, as these partial productivity attribute to one factor of

306 production changes in efficiency that are attributable to other factors. However, TFP reflects many influences including qualitative factors such as better management and improved quality of inputs through training and technology’. [Digest of productivity & Competitiveness Statistics, Statistics Mauritius, 2011] The methodology used to calculate TFP is as follows, TFP index =

Output index

x 100

Total factor input index Where Total factor input index is calculated as follows; A (t) = Q (t) x 100 {WL(t) x L(t)} + {WK(t) x K(t)} Where, A (t) = Total factor productivity index in time t Q (t) = Output index in time t WL(t) = Labour’s input share in time t (ratio of compensation of employees to value added)

L(t) = Labour input index at time t = Output index x 100 Labour input index WK(t) = 1 - WL(t) K(t) = Capital input index at time t =

Output index x 100 Capital input index

Independent Variables 1.

Foreign Presence in the manufacturing sector (FDIm)

The degree of foreign presence in the manufacturing sector is measured by FDIm and the proxy used is FDI in the manufacturing sector as a percentage of real GDP. FDI flowing in the manufacturing sector for Mauritius is extracted from Balance of Payments reports as provided by the Bank of Mauritius. As argued by previous studies, the more foreign investment in a country the greater will be the transfer of know- how and technology. Thus, the larger the share of foreign ownership in a sector, the greater is the potential for spillovers.

307 2. Tariff (Institutional Variable) Analysing sectoral productivity of FDI in Latin America, Tondl and Fornero (2010) found that tariffs are an important determinant in the manufacturing sector. It is seen that the lower the degree of protection by import tariff the more productive the sector is. Hence, we incorporated an institutional variable in the form of tariff in our model. 3. Domestic investment Dimmerman (2003) identified two internal channels basically educational attainment and domestic investment, to account for any productive activity that may be present within the set of countries investigated. The author argued that productive activity within the domestic economy will also lead to increases in a country's TFP. The present study included domestic investment in the manufacturing sector and the data is extracted from the national accounts as obtained from Statistics Mauritius. 4. Human Capital (PHC) In this section, we have used the primary enrolment ratio as a proxy for human capital. This is explained by the fact that the primary education is the minimum requirement for working in the manufacturing sector in Mauritius. Data for primary enrolment ratio is extracted from Statistics Mauritius database. 5. Inflation (INF) Inflation is seen to decrease total factor productivity. Bitros and Panas (2001) found that inflation reduces total factor productivity growth in two digit Greek manufacturing sector industries in a way which is both statistically and economically significant. Inflation can reduce the return on capital, and hence decrease investments on capital which would eventually reduce growth. Hence, there is an inverse relationship between inflation and TFP growth. We included inflation as measured by consumer price index as another independent variable in the study. Estimation Issues Before proceeding with the estimation of the model, it is important to investigate the time series properties of all the individual data series. We first investigated the unit roots properties of the time series, and once the order of integration has been determined, the possibility of a long run relationship among the variables of interest is also investigated. Both augmented Dickey-Fuller (ADF) (1979) and Phillips-Perron (PP) (1988) unit-roots tests were employed and the stationarity tests suggest that all our variables are integrated of order 1 and stationary in first difference. The Johansen Maximum Likelihood approach is subsequently used to test the presence of cointegration in a vector error correction model. Trace statistics λtrace and maximal eigenvalue are used to check the number of co-integrating vectors. These statistics test the null hypothesis of no cointegrating equations against the alternative of co-integration. The results show the presence of co-integrating vector and we thus conclude that a long run relationship exists between foreign investment in the manufacturing sector, local investment in the manufacturing sector, human capital, inflation, openness, tariff and total factor productivity. In examining the dynamic linkages between FDI in the manufacturing sector and its resulting impact on the sector’s productivity, we followed previous studies such as De Vita et al (2008) and Shan (2002), which used a Vector Autoregressive (VAR) model.

308 In fact the VAR model has proven to be useful for describing the dynamic behavior of economic time series and for forecasting. Moreover, it often provides better forecasts compared to those from uni variate time series models and elaborate theory-based simultaneous equations models. Forecasts from VAR models are also quite flexible because they can be made conditional on the potential future paths of specified variables in the model. Thus, given the endogeneity and causality issues, using a VAR model can prove to be highly advantageous. More so, by adopting a VAR Model, we can also correctly analyze the potential effect of foreign direct investment on total factor productivity in the manufacturing sector, any causality which might exist between them, and also investigate other feedback and indirect effects in the hypothesized link between FDI and TFP. In fact the VAR resembles a series of equation where each determinant comes as the explained variable in a system which is then solved simultaneously. However, since the variables are stationary only in first difference and are co integrated, we estimated a VAR in an error correction model (VECM). The VECM specification forces the long run behavior of the endogenous variables to converge to their co integrated relationships, which accommodates short run dynamics. In this study, the VECM is estimated using an optimum lag length of 1. EMPIRICAL RESULTS Table 1 report the results of Model 1 and 2. TABLE 1: ESTIMATES OF LONG RUN PARAMETERS Dependent Var :

ln TFPm

t-ratios

ln LPm

t-ratios

FDIm

0.105650*

1.702310

0.090065*

1.02331

Dinvtm

0.182167**

6.003050

0.129348*

1.77231

Phc

6.918044

13.5539

5.25681

6.57461

Inf

-0.151613**

-4.23056

-0.101267**

-4.28213

Tariff

-0.140991**

-3.67882

-0.10225**

3.599000

Constant

-35.58135

-27.43292

*significant at 10%, ** significant at 5%, ***significant at 1%

Table 1 above illustrates the long run relationship between productivity in the manufacturing sector and the main variable of interest that is foreign investment in the manufacturing sector. Two models are used where in Model 1, productivity is measured by total factor productivity in the sector and model 2 uses labour productivity in the sector as a productivity measure. The control variables are domestic investment in the manufacturing sector, inflation, human capital and tariff. Analysing the results of model 1, we found that FDI in the manufacturing sector does have a positive and significant

309 impact on total factor productivity in the sector in the long run. In fact a 1% increase in FDI in the manufacturing sector raises total factor productivity by 0.11%. Our results are in line with Woo (2009), who finds that the share of FDI flow in GDP increases TFP growth of the countries under study. Relating this result to the Mauritian framework, we observed that FDI in the manufacturing sector was crucial in the early stages of export development in Mauritius. The export-oriented manufacturing sector has been the backbone of the Mauritian economy for the past three decades. It contributed much to the take-off of the Export Processing Zone (EPZ). This sector has been a major constituent of the Mauritian economy and foreign investment in the sector ultimately led to various spillovers such as export growth, foreign exchange earnings, technological transfer and job creation. Also, interestingly we observed that domestic investment in the manufacturing sector has a positive and significant influence on the total factor productivity of the industry. Although FDI has been determinant to the takeoff of the EPZ, the success of the manufacturing would not have been possible without the substantial amount of investment provided by the local business community. However, while local investment in the manufacturing sector has been growing slowing over the period 1992-2003, its contribution in 2007 and 2008 has been higher compared to the previous years. (MCCI, 2009) Regarding the results of the other control variables, we observed that primary education does not influence total factor productivity in the manufacturing sector. The results are insignificant. This can be explained by the fact that education is not really important for the workers to work in the manufacturing sector. The coefficient of inflation is negative and significant suggesting that the higher the rate of inflation in the country, this would negatively affect the productivity level. Looking at the result of the institutional variable used in this study, that is tariff, we found that it negatively affect productivity in the manufacturing sector. This result is in line with Tondl and Fornero (2010), who found that lower tariff, can lead to particularly large productivity gains in manufacturing firms. Model 2 has been incorporated in the study as a robustness check in order to verify the validity of the findings. For instance, we used the labour productivity in the manufacturing sector (initially we have used total factor productivity) as an alternative measure of productivity. Qualitatively, the main results did not change and the positive spillovers are still found in the manufacturing sector. Hence, we note that in this study the productivity is determined by a number of factors including the presence of foreign firms. The evidence suggests that foreign enterprises do generate spillovers to the manufacturing sector but that such spillovers are not automatic. There are other factors which are important as well. To sum up, the results presented in Table 1 above suggest that on the whole, FDI in the manufacturing sector is favorable to productivity in the sector in the long run, irrespective of whether the latter is proxied by total factor productivity or labour productivity. This result is in line with various empirical studies done in the past. Also, domestic investment in the sector proves to be of paramount importance towards the contribution of productivity in the sector. Local investment proves to be crucial for both total factor productivity and labour productivity in the long run. In addition to that the result shows that both inflation and tariff negatively affect overall productivity.

310 THE SHORT RUN EQUATIONS As observed from the preliminary tests, the variables are co integrated, in the short run; deviations from the long run equilibrium will feed back on the changes in the dependent variables so as to force their movements towards the long run equilibrium state. The deviation from the long-run equilibrium is corrected gradually through a series of partial short term adjustments, the co-integration term or the error correction term. It indicates the speed of adjustment of any disequilibrium towards the long-run equilibrium. The empirical results of the short run estimates of the VECM are displayed in table 2 below. TABLE 2: SHORT RUN DYNAMICS: DEPENDENT VARIABLE: ΔLn TFPt Error Model

correction ∆ tfpm

∆ fdim

∆ dinvt

∆ phc

∆ inf

∆ tariff

Constant

0.02

-9.53

-0.73

-0.13

-0.23

-0.23

∆ tfpm t-1

0.38*

0.013*

1.24*

0.17*

-14.50

0.78

∆ fdim t-1

0.005*

0.19*

0.16*

0.01

-0.07

0.01*

∆ dinvt t-1

0.13**

0.31*

0.28*

0.018**

2.24

-0.17*

∆ phc t-1

-0.60

-17.60

-1.70

0.55*

-4.92

1.31

∆ inf t-1

-0.01**

-1.50*

-0.15**

-0.01

-0.34*

0.02*

∆ tariff t-1

-0.06*

-0.02*

-0.04*

0.04

1.80

1.50

√ t-1

-0.12***

-0.98*

-0.05***

-0.06***

-0.09***

-0.50

R2

0.53

0.64

0.55

0.85

0.49

0.67

1.75

1.40

2.02

1.98 1.88 1.99 DW stats *significant at 10%, ** significant at 5%, ***significant at 1%

The regressions perform rather well with relatively high R2. Ericsson et al., (1998) argued that weak exogeneity is a sufficient condition for the efficient inference on the parameters of interest in a conditional model. Weak exogeneity tests on each of the equations were performed and the Wald-test enables us to reject the null hypothesis of weak exogeneity at 5% significance level in all cases. The variables in the system are all endogenous, given that the lagged error-correction terms in the equations of the VECM are significant.

311 Table 2 is a composite table, where each column can be viewed and analyzed as an independent function, that is, each column in the table corresponds to an equation in the VAR/VECM. The variable named in the first cell of each column is viewed as the dependent variable. The estimated coefficient of the explanatory variables is reported in the cells. Results of the short run estimates turn out to be different from the long run ones. For instance, we observed that FDI in the manufacturing does influence productivity in the sector but the coefficient is very small (0.005). The lower coefficient in the short run might indicate that such capital might take some time to have its full effect on the economy. This result can also be explained by the winding obstacle course faced by the Mauritian manufacturing industry. As mentioned earlier, and according to the MCCI, 2009 report, FDI in the manufacturing sector was crucial in the early stages of export development, contributing much to the take-off of the EPZ. However, these inflows of foreign investment which eventually led to various spillovers became more inactive in 2000 compared to the total FDI brought in the country. This decrease in FDI levels was associated to the delocalization of foreign investors after the expiration of the multi-fiber agreement. The industry was thus faced with major declines that have severely shaken the bases on which it has initially built its development path. The rise in labour cost which has eroded its competitiveness in the textile industry and the phasing out of its preferential market access, that were critical for the development of the garment industry were among others challenging developments for the sector. Considering the domestic investment variable, it is observed that the result is also significant in explaining the short-run variation in productivity. Moreover the coefficient of the lagged error correction term is -0.12, which indicated that about 12% of the disequilibrium is corrected in the next period. Further analysis from the third column of the table suggests significant links between productivity and FDI in the manufacturing sector. FDI is also attracted by the level of domestic investment ultimately contributing to the favorable investment climate in the country. Further analysis from column 4 (domestic investment equation) shows that FDI has a “crowding in” effect on domestic investment and has, in fact, played an important role in promoting domestic capital accumulation confirming the existence of indirect effect. This is consistent with De Mello (1999). A 1 percentage-point increase in the growth rate of FDI leads to a 0.16 percentage-point increase in the growth rate of domestic capital after one year. Also a 1 percentage-point increase in the growth rate of domestic capital leads to a 0.13 percentage-point increase in the growth rate of productivity after one year. The latter two pieces of information taken together imply that a 1 percentage-point increase in the growth rate of FDI leads to a 0.02 percentage-point increase in the growth rate of output after two years. This might be interpreted as an estimate of the indirect effect of FDI on productivity in the short run via the domestic investment channel. STRUCTURAL ANALYSIS It is also possible from our framework to analyse the Granger-causal relation between a series of variables pairs. Granger-Causality is adopted to examine the direction of causality between FDI and TFP. The Granger-Causality test allows for the test of the null

312 hypothesis: variable X does not Granger-Cause variable Y, against the alternative that variable X does Granger-Cause variable Y. The results are given below where X → Y implies X Granger-Causes Y and ↔ indicates bi-directional causality. TABLE 3. PAIRWISE GRANGER –CAUSALITY TESTS Null Hypothesis

F Statistics

Probability

Direction of causality

FDIm does not granger cause TFPm

4.05122

0.067

4.96399

0.015

2.39678

0.096

2.31025

0.097

INF(Price stability) does not granger cause TFPm

1.1450

0.081

Inf →TFP

Dinvt does not granger cause FDIm

2.64730

0.075

Dinvt →FDIm

FDIm ↔ TFP

TFPm does not granger cause FDIm Dinvt does not granger cause TFPm

Dinvt ↔ TFP

TFPm does not granger cause Dinvt

Analyzing the Granger-Causality results of Model 1, which uses TFP as the dependent variable, we observe that the Pairwise Granger-Causality tests confirm the results obtained previously. For instance, the Granger-Causality test reveals that there is a bidirectional relationship between FDI in the manufacturing sector and total factor productivity. Another interesting result obtained is the bi-directional relationship between local investment and total factor productivity in the sector. Moreover, we also observe that local investment and price stability influences the flow of FDI. CONCLUSIONS The paper investigated the dynamic relationship between FDI flowing in the manufacturing sector and productivity in the sector for the case of Mauritius over the period 1980 to 2010 using a VECM approach. The results show that FDI in the manufacturing sector has eventually contributed to both total factor productivity and labour productivity in the long run. Relating this result to the Mauritian manufacturing sector, one can indeed argue that foreign investment has contributed to various productivity spillovers such as transfer of technology and job creation. However, analysing the short run results, we found that FDI in the manufacturing sector continues

313 to influence productivity but the impact is very small. Furthermore, the results confirm the presence of bi-causality and feedback effects in the FDI-Productivity relationship. Moreover, we analyzed that FDI is positively related to the level of domestic investment suggesting the presence of “crowding in” effect as well. Interestingly, domestic investment was found to be crucial for the country to attract FDI in the manufacturing sector. Results also suggest bi-causal relationship between productivity and domestic investment implying another important feedback and dynamic effect. Hence, the above results highlight the importance of FDI in generating productivity spillovers in the manufacturing sector and provide new evidences for the case of Mauritius using recent cointegration approach in a dynamic framework. The above results therefore clearly highlight the prevalent role played by FDI in fostering greater productivity and in inducing higher local investment; crucial elements which has undoubtedly contributed to the unequivocal economic success enjoyed by Mauritius over the last 30 years. Indeed, one could argue that the Mauritian experience in attracting a relatively substantial flow of FDI over such period is most commendable, even more so since the island is totally devoid of natural resources. In this regard, one should not understate the important role played by successive governments in adopting the right measures, policies and incentives which have served well in fostering inward FDI. Interestingly the wide array of measures used has evolved in line with the increased sophistication of the country’s manufacturing sector. From financial incentives at the onset of industrialization to measures promoting backward as well as forward linkages to help the firms enter the global value chains, governments have been able to attract higher value added operations rather than those of a footloose nature. Finally, the concurrent investments in developing both the physical and soft infrastructures to sustain and to maximize the spillover benefits from FDI have also proved crucial. REFERENCES Aitken, B., and Harrison, A., 1999, “Do Domestic Firms Benefit from Direct Foreign Investment? Evidence from Venezuela”, American Economic Review, 89 (3), pp. 605-618. Aitken, B., G. H. Hanson and A. E. Harrison 1997, “Spillovers, Foreign Investment and Export Behaviour”, Journal of International Economics 43: 103-132. Alfaro, L. and Rodriguez-Clare, A., 2004, “Multinationals and Linkages: Evidence from Latin America”, Economia 4, pp.113-170. Balasubramanyam, V., Salisu, M. and Sapsford, D. 1996, “Foreign direct investment as an engine of growth”, Journal of International Trade & Economic Development, 8 (1): 27 – 40. Barrell, R. and Holland, D., 2000, “Foreign direct investment and enterprise restructuring in Central Europe”, Economics of Transition, 8, 2, pp. 477–504. Bende-Nabende, A., J. Ford, B. Santoso, and S. Sen. 2003, “The Interaction between FDI, Output and the Spillover Variables: Cointegration and VAR Analyses for APEC”, 1965–99, Applied Economics Letters, 10 (3): 165–72. Blalock, G. & P. J. Gertler 2008, “Welfare gains from Foreign Direct Investment through technology transfer to local suppliers”, Journal of International Economics 74(2): pp. 402

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