FDI and Manufacturing for Export: Emerging Patterns and Opportunities for Sri Lanka

1. FDI and Manufacturing for Export:
Emerging Patterns and Opportunities for Sri Lanka
Pemachandra Athukorala
Arndt-Corden Department of Economics
Crawford School of Public Policy
Australian National University
prema-Chandra.Athukorala@anu.edu.au
Public Lecture 2
Excel World Auditorium, Colombo, 18 August 2016

2. Purpose/Motivation
Discuss the role of foreign direct investment (FDI) in the expansion of manufacturing
exports from developing countries in the context of the on-going process of economic
globalization
and
explore policy priorities for Sri Lanka
Motivated by,
• Contending, and often confusing, views on the subject in the Sri Lanka economic policy
debate

3. 3
Structure
• FDI and manufacturing exports: concepts and typology
• Production sharing and global economic integration
• Joining global production networks: policy priorities
• Sri Lankan experience
Policy context
Achievement and missed opportunities
• Concluding remarks

4. FDI and manufacturing exports: Concepts and typology
FDI is ‘The category of international investment that reflects the objective of a resident
entity in one economy to obtain lasting interest in an enterprise resident in another
country’
(IMF (1993), Balance of Payments Manual, p 86).
Here, ‘the resident entity in one country’ is the direct investor, the multinational
enterprise, MNE
Unlike other forms of international capital flows (such as portfolio investment, foreign
aid and commercial bank lending), FDI comes as a package of capital, technology,
managerial expertise, market links.
FDI is a central driver of global economic integration.
4

5. 5
Two types of FDI
Market-seeking FDI: investment in MNE affiliates engaged in serving the domestic market.
Also called ‘tariff jumping FDI’
Efficiency seeking FDI: investment in MNE affiliates engaged in production for the global
market.
Also called ‘export-oriented’ FDI

6. Production activities of efficiency-seeking FDI takes two district forms:
• Conventional manufacturing (‘horizontal specialisation’)
Production of a good entirely (from start to finish) in just one country.
- domestic-resource based products and
- consumer goods that are made to local specifications (such as handicrafts)
• Global production sharing (‘vertical specialisation’)
Splitting of the production process (of a good or a service) into discrete tasks, which are located in countries in
which factor prices are well matched to the factor intensity of the particular task
This is the prime mover (driving force) of modern day efficiency seeking FDI
Alternative terms: international production fragmentation, vertical specialization, slicing the value chain 6

7. Example 1: Nike Flyknit Shoe Collection
• Designed, and marketed worldwide by Nike Inc, USA
• The Machine for the seamless knitting of the upper was designed and produced by a German
company
• Ultra-light performance fabric for making the ‘upper’ is produced Trisha Fabric, USA
• Upper is knitted in MAS Technology Park, Thulhiriya, Sri Lanka
• Rubber sole is produced, and the shoe is assembled in Vietnam
MAS Holding has invested US$75 million in this factory; employ over 3000 workers. Nike assigned
this task to MASS because of the narrow-fabric Knitting skill/technology developed by Stretchline (a
MAS company) over the past three decade ]
Nike has set up an Innovation and Development Centre in the MAS Technology Park, Thulhiriya.

8. Example 2:
Thailand-centred hard
disk drive network
HDD exports from Thailand (in
2013):
US$ 18.5bn, which accounted for
15% of total merchandise exports
from Thailand and 70% of total
world HDD exports
But, HDD is not entirely made in
Thailand:
At least ten other countries
participate in its production

9. Example 3: Boeing 787 Dreamliner

10. Boeing 787 Dreamliner
Involves 43 suppliers spread over 135 sites around the world
Boeing itself accounts for only 10% of the material inputs, but holds rights to the 787 technology
Close to 70% of parts come from countries other than the USA
Wings: Japan
Engine: UK and USA
Flaps and ailerons: Australia and Canada
Fuselage: Japan, Italy and USA
Horizontal stabilizers: Italy
Landing gear: France
Doors: Sweden and France
(Only about 1% of Boeing 707, produced in the 1950s, was build outside the USA)

11. Global production networks (GPNs)
Interrelations among a set of firms specialising in different segments of
the production process of a given product as a single economic group
Based on the nature of the governance structure (the role of the ‘lead
firm’ ), GPNs can be grouped into two types:
Buyer-driven GPNs
Producer-drive GPNs
11

12. Buyer-driven GPNs
Common in the standard consumer goods industries such as apparel, footwear, travel goods,
toys and furniture
‘Lead firm’ in the value chain is the international buyer (a large retailer or a brand
manufacture).
Producers in developing countries can join the network through arm-length relations forged
with ‘value chain intermediaries’ (FDI is not a must; there is room for arms-length trade)
Normally, FDI is in joint-ventures with a local manufacturer (not fully-owned subsidiaries)
Input procurement is monitored by the lead-firm, but these is room for use of domestic inputs
if possible to meet the required quality standards

13. Producer-driven GPNs
Common in vertically integrated global industries such as electronics, electrical goods, automobiles, scientific
and medical devices
• ‘Lead firm’ is the manufacturing MNE
• The bulk of global production sharing takes place through intra-firm linkages within MNE network rather
than in an arms-length manner.
• Therefore foreign direct investment (FDI) plays a pivotal role in a country’s participation in producer drive
GPNs
• As production operations in host countries become firmly established, MNE subsidiaries may begun to
subcontract activities to local (host-country) firms to which they provide detailed specifications and even
fragments of their own technology.

14. Production sharing and global economic integration
Global production sharing opens up opportunities for countries to participate in a finer
international division of labour, to specialize in different slices (tasks) of the production process
in line with their relative cost advantage.
In a labour abundant economy, assembly activities within global production networks tend to be
relatively more labour intensive (and hence ‘pro poor’) compared to ‘conventional
manufacturing’ (production from start to finish in just one country) of the given final product
Successful integration of the manufacturing sector into production networks (in particular
producer-drive GPNs) has played a key role in employment generation and poverty reduction in
China and other high-performing East Asian countries
India versus China
Spread of East Asian production networks to Cambodia and Vietnam

15. Table 1: Production sharing in world manufacturing data: summary data
1999-2000 2012-13
World manufacturing exports, US$ bn (at 2005 price) 1457 5256
Share of GPN products 53.1 63.1
Buyer-drive 15.1 12.0
Producer-driven 38.0 51.1
Share of developing countries:
World manufacturing trade 32.3 51.3
World GPN trade 41.2 68.3
Buyer-drive 70.3 75.3
Producer-driven 35.3 62.6
Source: Compiled from UN Comtrade database.
For details on the methodology see Athukorala, P. ‘Global production sharing and trade patterns in East
Asia’, in N. and B. Singh (eds.) Oxford Handbook of Pacific Rim Economies, New York: Oxford University
Press, 334-360.

16. Determinants of a country’s success in joining global production
networks (emphasis here is on joining producer driven GPNs)
• Labour and human capital
• Service link cost
• Proactive investment promotion (‘marketing the country’)

17. Labour and human capital
• At the initial stage, prerequisite is the availability of trainable (unskilled) labour and middle-level
(supervisory/technical) manpower.
• In the long-run, availability of high-level technical and managerial manpower is required for moving into
higher-value creating tasks in the production process
• Human capital development is partly endogenous to a country’s engagement in GPNs; government-MNE
collaborative initiatives can play a role (experiences of Singapore and Penang (Malaysia)
Low wages has been a significant contributor to the growing importance of developing countries as a group in
GPN trade
But
difference in labour cost does not seem to explain differences among developing countries in their success in
joining global production networks (Table 2)
17

18. Service link cost
Service link cost: the costs involved in coordinating production blocks/tasks located
across borders.
Service link cost in a given country depends on a whole
range of factors impacting on the overall business environment:
(i) Infrastructure and trade-related logistics (air transport has become
increasingly important for electronics network trade)
(ii) political stability and policy certainty
(iii) Property right protection, including enforcement of contracts
(iv) Liberalisation of trade and investment policy regimes (elaborate in the next two
slide)
18

19. 19
Foreign trade and investment liberalisation
MNEs are the key players in producer-drive global production networks
Therefore, global production sharing makes a strong case for concurrent liberalisation of
trade and FDI policy regimes
FDI and trade polices are co-determinants of the location choice of MNEs within
production networks
Discuss:
China vs. India
Indonesia vs. Singapore, Malaysia, Thailand and Vietnam

20. Marketing the country
Need for proactive, well-targeted polices to attract foreign investors
• Attracting a big international player has ‘demonstration’ effect on others –
the so-called herd-mentality in global industries
• ‘Market failure in information’ about potential investment sites
• Evidence from Singapore, Ireland, Costa Rica, Penang (Malaysia),
Vietnam
20

21. ‘Barely a month goes by without some country’s leader contact me and
offer the likes of $1billion in tax credits and other incentives if we will
open an Intel plant and create jobs in that country’
Paul Otellini, the CEO of Intel
(Freedman and Mandelbaum 2012, p. 320)
• Winning an ‘investment tournament’ by a new host country requires
involvement/commitment at the highest political level.
21

22. The Sri Lankan experience
• Policy context
• Achievements
• Lost opportunities

23. Policy context
• Trade liberalisation and promotion of foreign investment, particularly in export-oriented manufacturing, were
the to pillars of Sri Lanka’s market oriented policy reforms since 1997.
The international media dubbed Sri Lanka ‘the new investment centre of Asia’, (Far Eastern Economic
Review, 23 October 1978)
• The investment promotion policy package offered to FTZ investors was comparable to, or more attractive
than, incentive packages of FTZs in most other countries.
• A guarantee against nationalisation of foreign assets without compensation was provided under the Article
157 of the new Constitution of Sri Lanka adopted in 1978.
• Export-oriented firms located in all parts of the country were accorded FTZ status (in addition to those within the
area demarcated by the original GCEC Act) in 1994.
- Since then the BOI policy regime is not a “enclave arrangement” that breed dualism in the economy: BOI
privileges are available to both foreign and local investors who meet the approval criteria (the prime one being
export orientation) and many BOI-approved firms now operate outside the FTZs.
23

24. There have been some disturbing developments in the FDI regime over past decade.
• A high degree of variability in incentives offered across various products/sectors and among firms (The
incentive structure provides ample room for the discretion of BOI officials over actual viability and national
economic gains).
• As against the original plan, many firms have become perpetual beneficiaries of tax holidays (Tax holidays
are not time bound)
• Nationalisation of some firms under the Revival of Underperforming Enterprises and Underutilized Assets
Act (2011) shattered investor confidence.
• The Minister’s discretion in investment approval under the Strategic Development Projects (SDP) enacted in
2011 greatly diminished the role of BOI.
(The status of BOI transformed from ‘the one stop’, as envisaged in the original BOI charter, to ‘one more stop’
for prospective investors)
24

25. Achievements and missed opportunities
• A notable diversification of the commodity composition of Sri Lanka’s exports following the
liberalization reforms initiated in the late 1970s (Figure 1)
• Sri Lanka’s share in world manufacturing exports increased continently until about the late
1990s (Figure 2)

26. Figure 1: Sri Lanka’s merchandise exports, 1965-2014
0
10
20
30
40
50
60
70
80
0
2,000
4,000
6,000
8,000
10,000
12,000
Manufacturingshare(%)
Exports,US$million
Total merchndise exports
Manyfacturing exports
Mnufactruing share ( %)
26

27. Figure 2: Sri Lanka’s Share in World Non-oil Exports and
Manufacturing Exports (%), 1988-2014
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.10
0.11
Worldexportshare,%
Total non-oil exports
Manufacturing exports
27

28. FDI has played a pivotal role in export expansion
• Having averaged less than half a million a year during 1970-76, net FDI inflows
increased rapidly in the first seven years of the post-reform period.
• The outbreak of the ethnic conflict in 1983 disrupted this impressive trend, but the
second-wave reforms and the temporary cessation of hostilities during the first half of
the 1990s witnessed some increase in FDI.
• There was a clear shift in FDI from domestic market-oriented to export-oriented
activities during the first three decades of reforms. By the late 1990s, export-oriented
firms accounted for over 90% of envisaged (approved) investment. in the mid-1990s to
less than 30% by the first half of 2010S.
28

29. • Export expansion has predominantly driven by joining buyer-drive GPNs, with heavy
concentration of exports in apparel (Table 2)
• Among the non-GPN products (horizontal exports), rubber based products, in particular
heavy-duty tyres, has shown impressive growth with FDI playing a pivotal role: the share
of natural rubber (the second largest of the traditional export ‘trio’ of the country) in total
exports has declined sharply as a result of rapid growth of rubber based manufactured
products .
• Sri Lanka lags far behind the East Asian countries in reaping gains by joining producer-
drive GPNs (Table 3)

30. Table 2: Sri Lanka: Commodity composition of manufacturing exports (%) (2-year averages)
Product group/product ( SITC coded in brackets) 1990-91 2000-01 2005-06 2010-11 2013-14
GPN products (buyer-driven + producer-driven) 70.87 81.12 74.30 73.00 75.66
Buyer driven 66.35 74.33 66.13 63.06 67.18
Garments 64.99 70.03 65.20 62.47 66.08
Footwear 0.93 1.16 0.35 0.30 0.80
Producer driven 4.52 6.79 8.17 9.93 8.48
Electronics and electrical goods ( SITC 75 76 and 77) 1.62 4.37 3.90 3.36 2.83
Transport equipment (SITC 78 and 79 1.14 1.28 2.58 3.24 1.98
Traditional (horizontal) products 29.13 18.88 25.70 27.00 24.34
Essential oil (SITC 551) 0.27 0.10 0.10 0.22 0.35
Activated carbon (SITC 59864) 1.16 0.44 0.45 0.99 1.16
Tyers (SITC 625) 1.19 2.46 6.08 7.34 7.88
Other rubber based products (SITC 62 - SITC 625) 0.74 0.74 1.02 1.70 1.97
Porcelain (SITC 666) 1.17 0.97 0.80 0.52 0.45
Diamonds, gems and Jewry (667) 13.26 4.32 7.59 7.39 5.30
Total exports 100 100 100 100 100
US$ million 1093 3723 4546 6167 7131
30

31. Table 3: Share of GPN products in manufacturing exports, 2012- 13 (%)
Buyer-driven GPN Producer-drive GPN Total
Developing East Asia 19.2 57.2 76.4
China 20.5 57.3 77.8
Taiwan 7.2 72.6 79.8
South Korea 8.3 69.9 78.2
ASEAN 14.0 61.2 75.2
Indonesia 23.2 14.2 37.4
Malaysia 6.3 69.3 75.6
The Philippines 13.2 64.1 76.3
Singapore 2.3 92.3 94.6
Thailand 12.4 59.4 72.3
Vietnam 23.5 34.3 57.8
South Asia 12.2 21.2 23.5
Sri Lanka 67.2 8.5 75.7
India 12.3 9.9 22.2

32. The special case of apparel
• Following the economic liberalisation reforms initiated in the late 1970s, Sri Lanka has emerged as a successful
participant in the global apparel value chain.
Trade –cum-FDI liberalisation unleashed national entrepreneurial capabilities; joint-ventures with foreign buyers
and foreign investors played a pivotal role
• In contrast to the various gloomy predictions made in the lead-up to the MFA phase-out, Sri Lankan apparel
industry has managed to sustain growth dynamism in the completive market conditions of the post-MFA era.
• The Sri Lankan apparel producers have carved out a niche in high-end markets for intimate apparel (lingerie and
panties) and fashion-basis casualwear with a strong customer base of leading brand marketers and speciality stores
(Figure 3).
• A number of Sri Lankan companies have become multinational enterprises in their own right; Colombo is now
consider technology/design hub of apparel in the region; the largest world producer of high-quality elastic (a key
input to the production of intimate apparel) is now a Sri Lankan firm.
(Athukorala, P. and R. Ekanayake (2016), ‘Repositioning in the Global Value Chain in the Post-MFA Era: Strategic
Issues and Evidence from Sri Lanka’, Development Policy Review (forthcoming)
32

33. 0
1
2
3
4
5
6
7
8
9
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Worldexportshare,%
Figure 3: Sri Lanka’s world market share in total apparel exports
and in the top 5 apparel products, 1999-20141 (%)
Men/boy trouser woven Women/g trousers woven Women/g panties knit
T-shirts/singlets knit Brassieres Total apparel 33

34. Sri Lanka in producer-drive GPNs: missed opportunities and some
promising signs
There is strong evidence that Sri Lanka missed the opportunity of becoming a assembly centre
within producer driven global portion networks because of political instability/uncertainty.
In terms of the other preconditions for joining producer-drive GPNs, Sri Lanka was
comparable to (or even better placed than) Thailand and Malaysia at the time (and even now!)

35. Reponses of two large electronics MNEs to the 1977 liberalisation reforms attested
to Sri Lanka’s attractiveness:
Motorola
In 1980 incorporated a fully-owned subsidiary company: initial employment of the assembly plant: 2624.
Harris Corporation
In the same year incorporated a fully-owned subsidiary company and even started building an assembly
plant: initial employment 1850
Both left within a few years as political instability and ethnic conflict set in, shattering Sri Lanka’s hopes
of becoming an electronics export hub.
* On Motorola in Sri Lanka:
Weigand, R. (1983), International Investment: Weighing the Incentives’, Harvard Business Review, 61,
146-152)

36. • A sizeable number (over 30, according to BOI records) fully export-opined medium scale firms are
currently operating in electronics, electrical and automotive industries.
(Employ over 20,000 workers (according to a survey conducted by the Export Development Board)
• Most of these firms are engaged in assembling parts and components which unlikely to be affected
by the so-called ‘robotisation’ threat.
• They consider availability of trainable labour as a major attraction of Sri Lanka - no complains
about high-level manpower shortages; the needed middle-rank supervisors are mostly trained on the
job.
Tables 4 and 5
36

37. Table 4: Sri Lankan Firms in Producer Drive GPNs
Age (years) Ownership Product Employment
Esjay Electro Mag 34 Japan/SL Electronics component, auto wire harnesses
and LED/CFL lighting
250
FDK Lanka 25 Japan/SL Magnetic head, printed circuits, optical
isolators
686
Tos Lanka 20 Japan/SL Printed circuit board/auto harnesses 250
Lanka Harness 22 Japan/SL Censor switches for seat belts and airbags 330
Okaya Electrics 8 Japan/SL Electric components, crystal display
modules, LED lighting devices
644
Aerosense 6 USA/Sweden/UK Sensors for Airbus 2000*
*planned
Cable Solutions 6 EU/India Specialised, customised cables ---
Harness Solutions 6 EU Customised cable harnesses ---
Variosystems 18 Switzerland/
US
Printed circuit board/auto harnesses 600
Metal Component
services
6 EU Metal components ---

38. Table 5: Main GPN exports from Sri Lanka:
Disaggregated (SITC-5 digit) data
SITC
Code product 2000 2005 2010 2011 2012 2013 2014
Products with exports>US$10mn in
2013/14
74492Lift truck parts --- --- 15.0 34.1 31.2 43.6 57.1
77313Vehicle ignition wire --- --- 37.0 40.6 37.2 36.1 36.1
77119Other elec. transformers 13.1 16.4 50.0 36.7 28.4 28.4 24.5
77282Switchgear parts 0.3 12.1 26.7 38.3 33.8 21.7 28.6
77261Switchboards etc <1000v 0.7 6.1 11.1 13.2 6.9 20.0 27.3
77281Switchboards etc unequip 8.1 14.2 12.4 17.3 11.8 12.6 17.2
77220Printed circuits 14.8 5.9 22.7 28.6 26.6 16.7 10.9
77812Electric accumulators 0.3 0.4 0.2 0.3 0.8 6.0 18.4
77866Paper/plastic capacitor --- --- --- 4.5 9.9 10.0 14.4
89281Labels paper,paperboard 1.7 4.6 10.2 10.7 8.5 11.3 10.3
Other 207.9 247.8 161.2 204.8 182.1 193.1 227.3
Total parts & components 246.8 307.5 346.4 429.2 377.1 399.4 472.1
Note: --- Zero or negligible

39. Concluding remarks
• Trade and investment policy reforms initiated in the late 1970s set the stage for globally integrating the Sri
Lankan manufacturing sector with FDI playing a pivotal .
• The Sri Lankan experience highlights the complementary role of investment liberalization for exploiting the
potential gains from trade liberalization: trade liberalization increased the potential returns to investment by
capitalizing on a country’s comparative advantage, while liberalization of foreign investments permitted
international firms to take advantage of such profit opportunities.
• The country failed to capture the full benefits of trade and investment liberalization because of the protracted
civil war that undermined the investment climate and macroeconomic stability.
• Sri Lanka’s immediate policy priority should be to restore policy emphasis on export-oriented industrialisation,
set up institutional safeguards to avert further backsliding from reforms, and continue with implementing the
incomplete reform agenda.
39

40. Two related policy issues
• FTAs and FDI in GPNs
• The use (and abuse!) of domestic value added/linkages as industry-policy criteria

41. Can FTAs promote FDI in GPNs?
The rise of global production sharing strengthen the case for multilateral (WTO-based) or
unilateral, rather than regional (FTA), approach to trade liberalisation:
• Production-sharing based international specialisation can’t be sustained as a regional
phenomenon because of the importance of extra-regional (global) markets for final
products.
• Formulation of rules of organ (RoOs) for GPN trade is rather complicated task (next
slide).
‘Bilateralism distorts flows of goods …. In structuring the supply chain, every country of
origin rule and every bilateral deal has to be tackled on as additional consideration, thus
constraining companies in optimising production globally’
Victor Fung, Financial Times, November 3, 2005.
• Most major trading nations are signatories to the WTO’s Information Technology
Agreement; FTAs are irrelevant for products covered by the agreement.
41

42. RoOs and Global Production Sharing
• The trade effects of any FTA depends very much on the nature of the rules of origin (RoOs)
built into it
• The conventional value added criterion is virtually inapplicable to this form of trade
because tasks undertakes by each country in the value chain normally generate rather small
domestic value addition
• The only viable option is to go for ‘change in tariff line’-based RoOs, but in most cases
trade in final goods and parts and components belong to the same tariff codes even at the
HS-6 digit level
• These administrative problems could result in unnecessary delays in customs clearance and
also open up opportunities for rent seeking through tweaking of RoOs
42

43. 43
The use (and abuse!) of domestic value added/linkages as
industry-policy criteria
Per unit value added/domestic input linkage is a misleading indicator of gains from GPN
exports
Input structure within global production networks is ‘relationship specific’
Policy interventions aimed at promoting domestic value added can be counter productive
(Can runs counter to the objective of employment generation/poverty reduction through
export-oriented growth)
The pertinent criterion should be ‘the volume factor’: ability to produce for a vast global
market and employment generation.
Contribution to the national output (GNP) depends on the volume factor, not on per unit
value added.