Daniel Prosi is a fifth-year doctoral researcher at the EUI Department of Economics. In his working paper titled ‘FDI, Forward Linkages and Services Inputs’— co-authored with EUI Professor Bernard Hoekman, Visiting Fellow and Professor at the University of Torino Marco Sanfilippo, and EUI Research Fellow Rohit Ticku— he analyses the role of foreign investments in development. Their research specifically focuses on the so-called ‘forward linkages’: sales from foreign investors to domestic firms in developing countries, allowing local businesses to buy high-quality inputs and skill-intensive services directly from foreign investors.
Daniel highlights that the role of foreign investment in the development of industrial bases and capacities in developing economies has been studied since at least the 1950s. “In developing countries,” he comments, “the fastest way to be able to produce goods and services that previously had to be imported is to attract foreign firms that already possess the knowledge. This way, foreign investment plays an important role in development beyond just providing the capital investment needed for growth.”
The researcher explains that sustained development beyond the confines of the investing foreign firm requires that local businesses benefit from the presence of the foreign firm in the country. “This happens either by hiring employees who were previously employed in the foreign firm, by learning from the foreign firm through observation or directly, or by gaining access to products provided by the foreign firm that then enable the domestic firm to be more efficient and effective.”
Daniel emphasises that the last two channels are much more likely to occur when domestic firms begin interacting directly with the foreign investor. He adds that these direct interactions take one of two forms. The first one is when “the domestic firm starts selling intermediate inputs to the foreign investor. We call this 'backward linkages' because the foreign investor creates a linkage backwards in the supply chain with a domestic provider of intermediate inputs.”
He stresses that knowledge spillovers through backward linkages have consistently been observed in cases where the investing firm aims to produce cheaply in a developing country and then export its products to international markets. These dynamics are predominantly found in emerging economies located near major ports and trade routes. However, he adds that many developing countries, especially in Sub-Saharan Africa, do not meet those conditions. “In Sub-Saharan Africa, investment is mostly market-seeking, which means that the investor enters the market to sell their products locally or regionally’’, Daniel notes.
“For market-seeking investment, most direct linkages with domestic firms are forward linkages—the investor selling their goods and services to local businesses.” This is the second modality of interactions between domestic firms and foreign investors.
He specifies that, “'forward linkages' are sales from the foreign investor to domestic firms – forward in the supply chain. Domestic firms can benefit from forward linkages if the foreign-owned firm gives them access to higher-quality inputs or previously unavailable services that allow the domestic firm to increase its productivity in its line of work or even expand into making new products altogether.” He underlines that forward linkages are particularly relevant for accessing services, including those typically used as inputs by other firms. Some production services, e.g. financial services, ICT, consulting, logistics or other business services, are unlikely to be provided locally at international standards. Such service inputs may be particularly important for economic performance.
The research that led to the working paper seeks to determine whether these forward linkages are associated with similar gains in economic capacity for local firms as backward linkages are in the context of export-driven investment. Daniel shares that Rwanda was an interesting case study for him and his co-authors, as the small landlocked country in Sub-Saharan Africa has created a very business-friendly environment over the past decades, successfully attracting many foreign investors across both the industrial and services sectors. “The diversity of investment is very interesting,” he emphasises, “because it allows us to study the effect of interactions not only in industrial production, which has been the focus of much development policy, but also in services, which may well prove to be an important aspect of future development strategies. Since the main obstacles to investment are often bureaucratic red tape, corruption, or political uncertainty, the Rwandan case can be an example of what dynamics can emerge in Sub-Saharan African economies if these barriers are reduced.”
Daniel and the other EUI scholars found that, first, most interactions between foreign investors and domestic firms in Rwanda are forward linkages – with domestic firms primarily buying inputs from the foreign investor. Secondly, they discovered that after domestic firms begin sourcing these inputs, they expand their operations and become more productive. “Those effects are not concentrated in individual industrial sectors,” Daniel explains, “Instead, they appear across inputs of both goods and services provided by foreign firms in very different economic sectors—though possibly for different reasons.” He notes that for physical inputs, foreign firms tend to supply higher-quality options, even when those inputs are originally imported from abroad. For services, foreign firms provide specialised expertise that local businesses are unable to supply in the quantities demanded by the domestic economy. This includes, for instance, data processing and analytics services that can substantially improve a domestic firm's efficiency.
“The reason why certain goods produced and sold domestically by a foreign firm drive more domestic growth than simply importing the same goods from a country that can produce them cheaply,” he clarifies, “is that the usefulness of the goods for domestic production is often intertwined with services provided jointly with them.” He illustrates this concept with the example of electric motorbikes produced for small taxi businesses. Electric motorbikes only become a cheaper mode of transportation when paired with infrastructure that allows drivers to quickly swap batteries and keep working, rather than waiting for a full recharge. The ability to provide these accompanying services locally can thus be crucial in determining whether a foreign investor chooses to physically enter a market rather than merely export products to developing countries. Likewise, the growth potential from sourcing these new inputs for domestic firms may only unfold when the foreign firm accompanies its sales of goods in the country with the provision of such services.
The findings from this research point to several concrete policy directions. First, Daniel notes that they have implications for development strategies and the role of investment promotion agencies in Sub-Saharan African countries. These government bodies actively approach investors and design tax or other incentives to attract foreign capital. He adds that the results of this study suggest that, for a country like Rwanda, export-oriented development strategies aimed at integration into Global Value Chains—especially in the industrial sector—are currently ineffective.
“However, that does not mean that foreign investment does not play an important role in the development of the local economy,” Daniel points out. “The fact that forward linkages do lead to the growth of downstream domestic firms implies that development strategies aimed at improving the quality and availability of inputs needed to fulfil local and regional demand may be a more achievable approach—at least when considering investment and development at scale.”
Daniel stresses that this insight supports certain aspects of the Rwandan government's development strategies, such as the “Made in Rwanda Policy,” which focuses on domestic production in sectors with strong local demand. It also recognises the need to alleviate bottlenecks in the availability of sector-specific inputs for domestic production.
“Our findings highlight the role of foreign-owned firms in providing certain skill-intensive services to the local economy,” Daniel reveals. “Export-driven growth may currently be achievable mostly through trade in services consumed within Rwanda—such as the growing tourism sector—and in certain sectors aimed mostly at exporting to other regional markets, predominantly in East Africa.”
He adds that “this also reflects the potential that growing populations and economies in East Africa hold for regional development within more integrated economic areas, such as the East African Community. A largely export-led development strategy with a strong focus on integrating into Global Value Chains and exporting globally might be a more effective focus at later stages of development.”
On a personal note, Daniel shares that researching this topic has been a fascinating and eye-opening experience. His field trip to Rwanda—– enabled by a STEG research grant —was incredibly valuable for connecting the insights from the highly granular data he was analysing to the reality on the ground. It also sharpened his understanding of the challenges that investors can unexpectedly face in the country.
“While I was in Kigali, there was an outbreak of the Marburg virus in the city,” Daniel recalls. “Although the authorities’ containment of the virus was quick and effective, the uncertainty associated with the situation meant that I had to completely upend parts of my research agenda while in Rwanda. It nonetheless made me appreciate the resilience that the people and the economies have built when reacting to the frequent disruptions that developing economies encounter—not to speak of the natural and cultural beauty of this part of the world.”
Photo: Morning traffic in Kigali city centre, Rwanda (by Jennifer Sophie on Shutterstock).
Daniel Prosi is a doctoral researcher at the EUI Department of Economics. His thesis, 'Essays on the Economics and Econometrics of Production Networks in Development', is supervised by former EUI Professor Alexander Monge-Naranjo and co-supervised by EUI Professor Giancarlo Corsetti.
Read the working paper ‘FDI, Forward Linkages and Services Inputs,’ co-authored by Daniel Prosi, Bernard Hoekman, Marco Sanfilippo, and Rohit Ticku.