The Composition of Foreign Direct Investment and Protection of Intellectual Property Rights: Evidence from Transition Economies

Author:Beata Smarzynska Javorcik

    A version of this chapter was published in the European Economic Review in 2004 (48(1):39-62). The author wishes to thank Andy Bernard, François Bourguignon, Carsten Fink, Aart Kraay, Jenny Lanjouw, Phil Levy, Keith Maskus, Walter Park, Nadia Soboleva, T. N. Srinivasan, and two anonymous referees for their comments and Hans Peter Lankes for making the results of the European Bank for Reconstruction and Development survey available.

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I Introduction

Protection of intellectual property rights (IPRs) has been a prominent item on the international policy agenda. Despite the introduction of the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), many developing economies are not eager to strengthen their IPR legislation and its enforcement, fearing that the losses resulting from this action would outweigh the benefits. This chapter contributes to a better understanding of potential gains from strongerPage 134 IPR protection by providing empirical evidence indicating that the extent of IPR protection in a host country affects the composition of the foreign direct investment (FDI) it receives. More specifically, this study finds that a weak IPR regime deters foreign investment in high-technology sectors, where intellectual property rights play an important role. Moreover, it tilts the focus of FDI projects from manufacturing to distribution.

The relationship between IPR protection and FDI is quite complex. On the one hand, a weak IPR regime increases the probability of imitation, which makes a host country a less attractive location for foreign investors. On the other hand, strong protection may shift the preference of multinational corporations from FDI toward licensing. As surveys of multinationals have shown, the importance of IPR protection varies between industries. The concern about the IPR regime also depends on the purpose of an investment project. Concern is highest in the case of research and development (R&D) facilities and lowest for projects focusing exclusively on sales and distribution (see Mansfield 1994, 1995).

This chapter investigates two hypotheses that emerge from the above studies. First, it tests whether foreign investors in IPR-sensitive sectors (as indicated by Mansfield 1995) are more affected by the extent of intellectual property protection in a host country than are investors in general. Second, it examines whether the IPR regime influences a foreign investor's choice between setting up production facilities and engaging in activities focused solely on distribution.

A unique firm-level data set used in this study allows for a more in-depth examination of this phenomenon than was possible in the earlier literature, which concentrated mostly on aggregate inflows and case studies. The data set was compiled from a worldwide survey of companies conducted by the European Bank for Reconstruction and Development (EBRD) in 1995. The survey recipients were asked whether they had undertaken FDI in 24 economies in Eastern Europe and the former Soviet Union and, if so, what types of projects they were engaged in. Those responses were supplemented with information on firm characteristics and variables specific to the host countries.

This study uses two measures of IPR protection. The first one is the index capturing the strength of patent rights developed by Ginarte and Park (1997) and extended by the author to include more transition economies. Although the Ginarte-Park measure is quite detailed, it focuses only on laws present on the books, not on their enforcement. Therefore, a second index, which was developed specifically for this study, is also used. The second index is cruder in nature but takes into account all IPR laws on the books as well as their enforcement.

The empirical analysis confirms the hypotheses, thus indicating that weak protection of IPRs has a significant effect on the composition of FDI inflows. First, itPage 135 deters foreign investors in four technology-intensive sectors: drugs, cosmetics, and health care products; chemicals; machinery and equipment; and electrical equipment. Those are the sectors in which, according to survey studies, IPRs play a particularly prominent role. Second, weak protection encourages foreign investors to set up distribution facilities rather than to engage in local production. Interestingly, this effect is significant in the case of all investors, not just those in sensitive industries. Finally, the results suggest that investors respond to both laws on the books and their enforcement. These findings are robust to controls for privatization, transition progress, corruption level, and effectiveness of the legal system.

In addition to an intrinsic interest in transition, a focus on Eastern Europe and the former Soviet Union can offer insights into the broader question of the role of FDI in economic development throughout the world. Although investment in other developing regions has been studied extensively, one finding of that research has been the importance of previous investment experience as a determinant of current FDI flows (see Hallward-Driemeier 1996). Thus, the effect of current policy variables may be obscured and overcome by a long history of past policies, for which it is difficult to control. Transition economies offer almost a natural control since FDI in the region was negligible before 1989. Therefore, the results of this chapter suggest that the importance of IPR protection in developing countries may have been understated in past research.

This study is structured as follows: The next section briefly reviews the related literature and formulates the hypotheses to be tested. The following section describes the econometric specifications and the data set. Then, empirical results are presented. The last section concludes the study.

II Related Literature and Hypotheses to Be Tested

The connection between technological capabilities of a firm and its decision to undertake FDI is highlighted in Dunning's (1993) OLI paradigm, which explains activities of multinational corporations in terms of ownership (O), localization (L), and internalization advantages (I).1 When selling its products abroad, a firm is at least initially disadvantaged relative to local producers. Thus, to compete effectively with indigenous firms, a foreign producer must possess some ownership advantages. They can take the form of a superior production technology or improved organizational and marketing systems, innovatory capacity, trademarks, reputation, or other assets. Ownership advantages ensure a firm's ability to enter the host country's market, but they do not explain why the foreign presence should be established through production rather than exports. This issue is, inPage 136 turn, addressed by localization advantages that arise because of differences in factor quality, costs and endowments, international transport and communication costs, host government policies, and ability to overcome trade restrictions. The last advantage, internalization, explains why a foreign firm prefers to retain full control over the production process instead of licensing its intangible assets to local firms. This decision may be attributable to high transaction costs involved in regulating and enforcing licensing contracts.

Weak IPR protection increases the probability of imitation, which erodes a firm's ownership advantages and decreases localization advantages of a host country. At the same time, a weak IPR system increases the benefits of internalization, because it is associated with a greater risk of the licensee's breaching the contract and acting in direct competition with the seller. An inadequate IPR regime, therefore, deters FDI and encourages exporting. A strong IPR system may also have a negative impact on FDI by making licensing a viable alternative to direct investment.2 Thus, the overall relationship between the level of IPR protection and FDI is ambiguous.

The results of empirical studies exploring the effect of IPR protection on FDI lead to mixed conclusions. Ferrantino (1993) finds no statistically significant relationship between the extent of U.S. affiliate sales in a foreign country and that country's membership in an international patent or copyright convention. Similarly, Maskus and Konan (1994), who use the Rapp and Rozek (1990) index of IPR protection, as well as Primo Braga and Fink (2000), who use the Ginarte and Park (1997) index, do not obtain statistically significant results. Lee and Mansfield (1996), however, show that the strength of a country's IPR protection, as perceived by 100 U.S. firms surveyed, is positively correlated with the volume of U.S. FDI inflows into that country. Smith (2001) also finds a positive correlation between sales of U.S. affiliates and the strength of IPR protection in a host country. However, none of those studies looks at the effect of the IPR regime on the composition of FDI inflows.

Intellectual property rights do not play an equally important role in all sectors, or even in all technology-intensive industries. For instance, Mansfield (1995) mentions that IPR protection may be less crucial in sectors such as automobile production, in which firms frequently cannot use a competitor's technology without many complex and expensive inputs. However, the IPR regime is likely to be important for sectors such as drugs, cosmetics, and health care products; chemicals; machinery and equipment; and electrical equipment.3

Additionally, a survey of U.S. manufacturing firms conducted by Mansfield (1994) revealed that the importance of IPR regimes for investment decisions depends on the purpose of the investment project. For example, in the case of investment in sales...

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