2. Policies for improving FDI impacts on productivity and innovation

Value chain linkages and strategic partnerships involve knowledge spillovers from foreign MNEs to their suppliers, customers and partners

Value chain relationships include supply chain linkages both upstream and downstream that involve the spillover of knowledge from foreign affiliates of multinational enterprises (MNEs) to domestic suppliers and customers; and strategic partnerships, which involve formal collaborations beyond buyer-supplier relationships, for example in the area of R&D or workforce/managerial skills upgrading.

Backward linkages help domestic companies extend their market for selling (Figure 2.4) and raise the quality and competitiveness of their outputs. They generate knowledge spillovers when MNEs require better-quality inputs from local suppliers and are, therefore, willing to share knowledge and technology with them to encourage their adoption of better practices (OECD, 2022[23]). A recent study of New Zealand, for example, found that small firms do benefit from economies of scale when they supply foreign MNEs and, thereby catch up technologically with foreign firms (Doan, Maré and Iyer, 2014[24]). For such technology spillovers to happen, domestic firms require a certain level of absorptive capacity often defined in terms of technological proximity with foreign firms (see next sub-section). FDI spillovers are more commonly found in these vertical supply relationships than in the relationship between foreign MNEs and potential local competitors (horizontal spillovers), as rivalry is more naturally embedded in the latter (Rojec and Knell, 2017[25]; Javorcik, 2004[14]; Blalock and Gertler, 2008[26]) (see section on competition and imitation effects). Finally, having strong linkages with domestic firms can embed foreign affiliates more deeply into the economy, making it less likely that they will move operations elsewhere (OECD, 2022[23]).

Figure 2.4. Sourcing structure of foreign affiliates, by supplier type/origin, 2016

Source: OECD based on the OECD Analytical AMNE database, 2019, https://www.oecd.org/sti/ind/analytical-AMNE-database.htm

Affiliates of foreign MNEs operate in host countries as buyers of intermediate goods and as suppliers to domestic companies (forward linkages). Forward linkages between MNEs and local buyers have a positive impact on local enterprise productivity mostly through the acquisition of better quality inputs, which were not locally available before (Criscuolo and Timmis, 2017[27]). In addition, many MNEs, especially in industrial sectors such as machinery, often offer training to their customers on the use of their products as well as information on international quality standards (Jindra, 2006[28]).

The emergence of GVCs has brought new types of FDI-SME partnerships, especially in high technology and knowledge-intensive industries, which are based on the transfer of technology and the development of cross-border R&D projects. These strategic partnerships can take many forms, including joint ventures, licensing agreements, contract manufacturing, research collaborations as well as R&D and technology alliances (Andrenelli et al., 2019[29]; OECD, 2008[30]). Strategic partnerships are the result of a shift towards an open mode of innovation, which, as noted above, has made innovation more accessible to SMEs (OECD, 2019[5]). Open innovation has increasingly been seen as a way for accelerating internal innovation and expanding the markets for external use of innovation (Chesbrough, 2003[31]). Large firms have increasingly taken part in the open innovation transformation by developing strategic partnerships with smaller enterprises or by setting up innovation labs and accelerators where start-ups and other small firms can nurture new business ideas and business models. Foreign MNEs, in particular, often seek talent and specialised knowledge in local SME and start-up ecosystems.

A recent study based on firm-level data of OECD and developing economies finds that productivity spillovers from strategic partnerships, such as manufacturing/marketing agreements and joint ventures, depend on firm-level characteristics, such as firm size, (foreign) ownership, internationally recognised certifications and staff training. Larger and foreign-owned firms as well as firms that have internationally recognised certifications and engage in staff training are more likely to improve their productivity when foreign MNEs engage in partnerships. This is consistent with studies showing that knowledge and technology spillovers from foreign MNEs depend on SME absorptive capacities (see below).

The movement of skilled workers from foreign MNEs to domestic firms can bring new knowledge and skills to local economies

Labour mobility can be an important source of knowledge spillovers in the context of FDI, notably through the movement of MNE workers to domestic firms – either through temporary arrangements such as detachments and long-term arrangements such as open-ended contracts – or through the creation by MNE workers of start-ups (i.e. corporate spin-offs).

Existing evidence suggests that firms established by MNE managers are more productive than other local firms are (Görg and Strobl, 2005[32]). Similarly, evidence from manufacturing in Norway suggests that workers who moved from foreign-owned to domestic firms retain part of their knowledge and contribute 20% more to the productivity of their firm than workers without foreign firm experience (Balsvik, 2011[33]). Recent OECD research on Ireland shows that over the period 2009-2015 more than one in four employees at foreign-owned companies either moved to a domestic firm or became self-employed. In addition, more than one in three start-up founders had previously worked at a foreign-owned company (OECD, 2020[34]). Labour mobility within Ireland is also very common among highly skilled researchers who have produced patents. One out of two patent inventors changed employer at least once during the period 2006-2016. As most inventors are based in foreign-owned companies, FDI spillovers related to inventor mobility play an important role in Ireland (OECD, 2020[34]).

On the other hand, research on Portugal provides a more sceptical perspective on potential productivity spillovers on domestic firms resulting from the mobility of workers from foreign to domestic firms (Martins, 2011[35]). Domestic firms in Portugal tend to hire ‘below-average’ workers from foreign firms who take, on average, pay cuts (which is consistent with involuntary mobility). It suggests that worker mobility is unlikely to be a major source of productivity spillovers from foreign to domestic firms. However, movements from domestic to foreign firms translate into considerable pay increases in Portugal but also in other EU Member States (Becker et al., 2020[36]). This pay increase is consistent with a generally greater ‘generosity’ in the remuneration practices of foreign firms vis-à-vis their domestic counterparts (see Chapter 3). As foreign firms attract some of the best workers in domestic firms where they experience a wage increase and acquire new knowledge, productivity spillovers from worker mobility may also (or rather) occur from domestic to foreign firms.

Competition with foreign MNEs and imitation of their business practices provide significant learning and upgrading opportunities for domestic firms

The entry of foreign firms heightens the level of competition on domestic companies, putting pressure on them to become more innovative and productive – not least to retain skilled workers (Becker et al., 2020[36]). The new standards set by foreign firms – in terms of product design, quality control or speed of delivery – can stimulate technical change, the introduction of new products, and the adoption of new management practices in local companies, all of which are possible sources of productivity growth. Foreign firms can also become a source of emulation for local companies, for example by showing better ways to run a business. Imitation and tacit learning can therefore become a channel to strengthen firm productivity at the local level.

However, if local companies are not quick to adapt, competition from foreign companies may also result in the exit of some domestic firms. Increased competition for talent may also make it more difficult for local companies to recruit skilled workers (Lembcke and Wildnerova, 2020[37]). These effects are more likely to happen to local companies operating in the same sector or value chain of the foreign company. This is the main reason why horizontal spillovers from FDI are so rare and, when they happen, they mostly involve larger domestic companies (Gorodnichenko, Svejnar and Terrell, 2014[38]; Farole and Winkler, 2014[39]; Crespo and Fontoura, 2007[21]).

The industrial structure, specialisation and internationalisation of the domestic economy influence the potential to benefit from FDI’s presence

The industrial structure, economic specialisation and technological sophistication of the host country are primary determinants of FDI inflows. Differences in the comparative advantage of economies result in differing FDI profiles, with some countries attracting more knowledge-intensive investment than others do. Economies driven by sectors with higher average productivity levels and technological intensity are expected to have greater potential to absorb and utilise the knowledge and technology brought by foreign MNEs. Countries with more advanced industrial structures tend to attract FDI in higher value added activities, involving more productive and technology-intensive activities that allow them to further advance the industrialisation process (Benfratello and Sembenelli, 2006[40]; Criscuolo and Martin, 2003[41]). Conversely, countries at early stages of the industrialisation process may benefit more from investments in lower value added sectors where local producers, often SMEs, have a comparative advantage, allowing them to move up the value chain within those sectors into activities that are more complex.

Economic specialisations may differ even within countries, leading to different FDI impacts across regions. Specialisation patterns are often driven by natural endowments and regional assets that cannot be changed or can only be changed in the long run, such as geographic location, natural resources, urban or rural settings and demographics (OECD, 2007[42]). They are often the outcome of natural configurations, market dynamics and past economic and policy choices. For instance, metropolitan regions tend to have greater endowments of human and physical capital, including more favourable demographic structure, higher intensity of skills, and better infrastructure facilities. This leads to a high concentration of knowledge-intensive FDI in urban areas and therefore greater potential for market interactions with domestic firms compared to rural areas. Within OECD countries, there are rural regions that have higher rates of growth than urban regions (OECD, 2009[43]). These regions have found ways to exploit their resource endowment in an efficient manner – for instance through specialisation that takes into account place-based capabilities. Regional economies can, therefore, attract productivity-enhancing FDI with strong spillover potential based on location-specific comparative advantages.

Beyond economic specialisations, the exposure of an economy to international markets also matters for FDI impacts on productivity and innovation. Integration into GVCs is an important driver of aggregate productivity growth and can have important consequences on the ability (and incentives) of firms to exploit the knowledge transmitted through international production networks (Gal and Witheridge, 2019[44]). Domestic firms that are exposed to international markets (through forward and backward GVC participation) may be better equipped to develop linkages and partnerships with foreign investors.

The magnitude of knowledge spillovers often depends on the characteristics of FDI

There is emerging evidence that FDI concentration in high technology manufacturing is particularly beneficial for local SMEs. For example, in three Eastern European countries (i.e. Bulgaria, Poland and Romania), a recent study found that horizontal FDI spillovers (e.g. as a result of imitation and competition effects) are observed in labour-intensive sectors, while vertical FDI spillovers (e.g. related to buy and supply linkages) are mostly observed in high technology sectors (Nicolini and Resmini, 2010[45]). In the context of the United States, FDI spillovers are particularly strong in high technology sectors, while they are largely absent in low technology sectors (Keller and Yeaple, 2009[46]). Furthermore, low-productivity small firms benefit more from FDI spillovers than high-productivity larger firms do. FDI can however be isolated from the rest of the economy in high technology manufacturing. For example, Israel has succeeded in attracting many ICT R&D labs from large US-based MNEs (e.g. Intel, IBM, etc.); however, these labs are often self-contained and have developed limited relationships with the rest of the economy (OECD, 2016[47]; OECD, 2019[5]).

The type of FDI – greenfield investment or mergers/acquisitions – that a country attracts has implications on the extent of FDI linkages with the local economy. A greenfield investment is more likely to involve the implementation of a new technology in the host country and is therefore accompanied by a direct transfer of knowledge and technology from the parent firm to the new affiliate (Farole and Winkler, 2014[48]). On the other hand, the acquisition of a domestic firm allows foreign investors to primarily access the host country’s technology as well as the already established business networks and knowledge sharing relationships possessed by the acquired firm. In this case, the deployment of the foreign investor’s technology would be implemented more gradually, thus making knowledge spillovers to domestic firms less likely in the short term but may still occur in the longer term (Crespo and Fontoura, 2007[21]; Braconier, Ekholm and Knarvik, 2001[49]; Branstetter, Fisman and Foley, 2006[50]).

The degree and structure of foreign ownership is also an important factor affecting the strength of linkages between domestic and foreign firms. Empirical evidence shows that MNEs with fully foreign-owned affiliates exert greater control upon the technologies they transfer to their foreign locations and seek to avoid knowledge and technology leakages, thereby limiting the potential for FDI spillovers (Konwar et al., 2015[51]). In contrast, MNEs with more domestic participation may have greater potential for linkages with the local economy due to better knowledge of, and well-established relations with, domestic supplier networks (Farole and Winkler, 2014[39]). This is particularly the case for joint venture agreements, which have been found to have positive horizontal spillovers on local firms (Abraham, Konings and Slootmaekers, 2010[52]). However, as highlighted in the following sections, restrictions on foreign ownership as a means to achieve knowledge spillovers should be generally avoided as they have been found to deter FDI, especially when intellectual property rights are not protected (OECD, 2021[53]).

Turning to the motives of investments, foreign investors may enter a country to expand sales in a new, often large, market (i.e. market-seeking); to tap into natural resources (resource-seeking), which is often the case in commodity sectors and agribusiness; or to achieve efficiency (efficiency-seeking), either by reducing costs (e.g. labour costs) or by seizing new local assets in the form of technology, innovation and related skills. In general, FDI motives are often interlinked, so that they cannot be fully separated but rather emerge in combination.

Domestic firms with strong absorptive capacities are better positioned to integrate new knowledge and technologies into their production processes

Global production networks and the presence of foreign MNEs provide domestic firms with an important opportunity to increase their productivity and acquire new knowledge. Technology transfers are more effective when domestic firms possess previously accumulated knowledge and innovative capabilities. This set of knowledge and capabilities is generally identified by the literature as absorptive capacity (OECD, 2022[23]). More specifically, absorptive capacity is defined as the ability of the firm to acquire, assimilate and exploit the available information, knowledge and technology that comes through interaction with other firms (Cohen and Levinthal, 1990[54]; Todorova and Durisin, 2007[55]). It largely depends on the financial, human and knowledge-based capital of companies and their ability to access the strategic resources they need to adapt to market conditions, become more productive and innovate (i.e. access to finance, skills and innovation assets, including technology, data and networks).

Empirical evidence shows that the absorptive capacity of domestic firms is an important determinant of knowledge spillovers. Domestic suppliers with better technical capabilities tend to develop more knowledge-intensive types of linkages with foreign firms (Saliola and Zanfei, 2009[56]). FDI is also found to have a positive effect on domestic productivity growth when the technology gap between domestic and foreign firms is not too large (Nicolini and Resmini, 2010[45]). The absorptive capacity is typically measured in terms of performance gaps (e.g. productivity gaps) between foreign and domestic companies as illustrated in Figure 2.3 (OECD, 2019[2]; Gal and Witheridge, 2019[44]; Farole and Winkler, 2014[48]).

However, domestic firms vary in terms of size, business model, performance and ability to access and make use of the necessary strategic resources for their growth and upgrading. This heterogeneity means that different types of firms have different chances to enter into knowledge-sharing relationships with foreign MNEs. For instance, SMEs typically have greater difficulty in attracting skilled workers, face internal and external barriers in accessing finance, and often struggle to find the technology, information and networks that would enable them to participate in innovative activities with foreign MNEs (OECD, 2019[5]; 2020[57]; 2021[58]). Given that SMEs account for almost all enterprises in both OECD and developing economies, strengthening their absorptive capacities is key to enhancing FDI’s spillover potential for domestic productivity and innovation (OECD, 2022[23]).

Recent OECD work on FDI-SME linkages and spillovers in Portugal and the Slovak Republic shows that cross-country differences in SME productivity and innovation performance can explain differences in the sourcing strategies of foreign MNEs. In Portugal, foreign investors source extensively from the domestic market, reflecting the fact that SMEs are relatively more innovative and digitally savvy than those in many other OECD economies (OECD, 2022[59]). In contrast, foreign investors in the Slovak Republic rely mainly on imports for the sourcing of inputs, which could be linked to the poor productivity performance and innovation capacity of the Slovak SME population.

Economic geography factors shape agglomeration and network dynamics, which are key for domestic firms to benefit from FDI’s presence

Economic geography factors generate spatial and agglomeration effects. The localised nature of FDI means that geographical and cultural proximity between foreign and domestic firms affects the likelihood of knowledge spillovers, which often involve tacit knowledge, and whose strength decays with distance (Audretsch and Feldman, 1996[60]). Recent work confirms that when there are productivity spillovers from FDI, these are concentrated in the same region of the investment (Lembcke and Wildnerova, 2020[37]; Girma, Görg and Pisu, 2008[61]). When deciding where to invest, foreign firms are considering the specific factor endowment of a region – rather than just of the country. SME activity and performance are also unevenly distributed within countries, with high concentration of R&D and innovation activities and investments in few regions, and large cross-regional disparities in SME productivity (OECD, 2016[62]).

Agglomeration effects, notably through the presence of local industrial clusters, have been also reported to affect the volume of FDI and its potential for knowledge spillovers. Clusters embed characteristics such as industrial specialisation (through specialised skilled workers and suppliers) and geographical proximity that make knowledge spillovers more likely to happen, including from MNE operations. For the same reasons, MNEs can also expect to benefit from investing in local clusters, notably through the sourcing of local knowledge and technology. Evidence from the United Kingdom, Italy, Poland and Romania shows that firms located in clusters benefit from FDI, both in the same sector of the foreign affiliate and in other sectors. However, these benefits do not materialise for companies located outside the clusters (De Propris and Driffield, 2005[63]; Menghinello, De Propris and Driffield, 2010[64]; Franco and Kozovska, 2008[65]).

Ensure that national strategies can foster policy coherence and a whole-of-government approach to investment promotion, innovation and SME development

The institutional framework that governs the investment, innovation and SME development policy areas differs from country to country. Different governance arrangements are feasible as long as appropriate reporting mechanisms and communication channels are in place to ensure policy alignment among different institutions and tiers of government. To this end, clear responsibility and accountability among government institutions is a pre-condition for designing and implementing coherent and effective policies that strengthen the impact of FDI on productivity and innovation.

National strategies and action plans can be important instruments for policy coherence as they are crosscutting in nature and often require whole-of-government responses to ensure their effective implementation. Establishing a clear, overarching and comprehensive strategic framework for investment promotion policy allows to create an integrated vision across government and set out long-term strategic objectives, quantifiable targets, policy pillars, related programme actions and clearly defined roles for all the institutions involved in its implementation. Such a long-term and country-wide vision for inward investment attraction should sufficiently consider FDI’s contribution to productivity growth, innovation promotion and SME development, and identify specific policy priorities, short-term and long-term targets, and policy interventions to achieve these objectives.

It is also critical that investment promotion strategies are not developed in silos, but are sufficiently aligned with and include cross-references to national strategies addressing innovation, SME and industrial policy issues. Many OECD countries have dedicated national strategies on these policy areas, while others mainstream relevant policy priorities in economic reform programmes, sectoral action plans and national development strategies. As part of their policy response to the supply chain disruptions caused by the COVID-19 pandemic, both Ireland and the Czech Republic have recently developed dedicated SME and entrepreneurship strategies, focusing on strengthening their productivity, internationalisation and innovation including through linkages with foreign MNEs (OECD, 2021[8]). Conversely, many investment and innovation promotion strategies increasingly consider the role that FDI can play in strengthening the domestic R&D ecosystem. The national investment strategies of Norway, Spain, Slovenia and the UK include specific measures aimed at supporting the upgrading of SMEs in GVCs, while the Czech Republic’s National Research, Development and Innovation Policy Strategy (2016-20) foresees business support measures to help SMEs become more involved in international R&D collaborations (OECD, 2019[5]).

Ensure effective policy co-ordination and multi-level governance in the design and implementation of investment promotion, innovation and SME policies

Actions to improve the impact of FDI on productivity and innovation need to be aligned with the objectives and priorities set by government across different policy areas. This often entails co-operating with a number of government institutions at national and subnational levels. Although co-ordination is a fundamental and longstanding problem for public administration, much of the success or failure of attempts to co-ordinate appear to depend upon country contexts, including the complexity of the institutional setting and the co-ordination instruments at play. In many OECD and developing economies, the institutional framework governing investment promotion, innovation and SME policies is structured along lines reflecting different policy domains. In Belgium, Portugal and Canada, for instance, several implementing agencies operate across the three policy areas under the supervision of different ministries. Such institutional settings may induce more complex governance systems – i.e. higher risks of information asymmetry, transaction costs and trade-offs – and require strong inter-institutional co-ordination mechanisms to overcome potential policy silos. In contrast, other governments (e.g. Croatia, Finland, Lithuania, Luxembourg, and Slovenia) target the entire FDI-SME-innovation ecosystem through a single government entity to facilitate co-ordination and synergies among different policy domains.

Irrespective of the complexity of the institutional setting, the set-up of effective inter-institutional co-ordination mechanisms at the strategic and policy implementation level is key. Instruments of co-ordination can be formal or informal; based on regulation, incentives, norms and information sharing; top-down relying on the authority of a lead government body, or bottom-up and emergent. For instance, high-level government councils can bring together line ministries responsible for investment, SME, innovation and industrial policy issues, implementing agencies and regional and local governments to identify priority areas where cross-ministerial policy planning and decision-making is necessary. In many countries, some of these councils are also responsible for the co-ordination of national strategies while others have been given broader mandates to foster policy dialogue, convene stakeholders and issue opinions on legislative initiatives.

At the policy implementation level, the establishment of inter-agency working groups, committees and task forces can help policy makers pull resources from different parts of government to effectively advance specific policy agendas. Inter-agency joint programming can also facilitate the implementation of crosscutting measures that span several policy areas, in particular in countries with highly fragmented institutional settings (e.g. large number of public institutions involved in policy design and implementation). In these country contexts, the Centre of Government, i.e. the office serving the highest level of the executive branch of government (e.g. presidents, prime ministers), can also play an important role in bridging bureaucratic boundaries across ministries and improving the enforcement of policy decisions. Finally, informal channels of communication between officials or job circulation of civil servants can play an important role in improving co-ordination and often suggest a relatively well-developed culture of inter-agency trust and communication.

Beyond horizontal co-ordination, effective multi-level governance is also key to ensuring policy effectiveness. Given the localised nature of foreign MNEs’ operations and the economic geography factors affecting FDI spillovers, policies aimed at strengthening FDI impacts on productivity and innovation require synergies among various levels of government and complementary expertise from regional and local actors. Responsibilities assigned to different tiers of government should therefore be clearly defined to reduce potential duplication and overlaps. Subnational governments (e.g. regional authorities, municipalities, regional development agencies) have better knowledge of local market needs and greater potential to interact with local business enterprises, foreign or domestic. Their active involvement in the design and implementation of investment promotion, innovation and SME support policies can help unlock the growth potential of the territories where these are implemented by drawing on the knowledge and expertise of local actors and linking investment promotion and SME development priorities to regional and local development strategies.

Assess the impact of FDI and relevant policies on the productivity and innovation of the domestic economy and promote policy dialogue to enhance the effectiveness of policy interventions

Monitoring and evaluation (M&E) practices have been at the centre of governance frameworks as a result of the emergence of multi-dimensional policy issues and the increasing expectations over the effectiveness of public policy. The systematic collection of disaggregated data for the assessment of FDI impacts on productivity and innovation can help governments assess the economic and market conditions that underpin FDI-driven productivity growth, identify market failures and possible policy responses. The OECD FDI Qualities Indicators allow policy makers to make the necessary link between investment and host economy impacts, and assess how FDI supports national policy objectives with regard to productivity, innovation, SME growth and upgrading (OECD, 2019[2]).

Furthermore, a comprehensive framework for evaluating the impact of policies on foreign direct investors, local SMEs and other actors of the domestic research and innovation ecosystem (e.g. R&D organisations, technology parks, applied research centres, collaborative laboratories, universities) could play a crucial role as an “early warning mechanism” to identify potential policy gaps and take corrective action. For line ministries and implementing agencies responsible for investment promotion, it is critical that impacts on innovation, R&D and the capacities of domestic firms are sufficiently considered when measuring success in reaching the policy objectives of related investment promotion measures. In fact, 53% of OECD IPAs and 60% of MENA IPAs use innovation and R&D-related performance indicators when measuring the impact of their policy actions in the economy (OECD, 2018[70]). Policy impacts on the capacities of domestic firms are also evaluated by 22% of OECD IPAs and 60% of MENA IPAs.

For many OECD and developing countries, the development of better systems to track and collect reliable statistical data based on international standards is a pre-requisite to the development of more robust outcome indicators, including on productivity and innovation. The use of qualitative evaluation methodologies (e.g. surveys, benchmarking, consultations), and the establishment of data tracking tools and feedback processes can ensure that relevant and reliable data on the impact of policy interventions are available. Co-ordination and collaboration between investment promotion, innovation and SME agencies can facilitate the exchange of data, experiences and expertise. Apart from the use of quantifiable outcome-based performance indicators, a reliable assessment of policy impacts also requires strong internal capacity to plan, prepare and execute ex ante and ex post evaluations. Setting up dedicated evaluation units within implementing agencies and involving specialised staff with technical knowledge of M&E principles and implementation tools could strengthen internal competences and improve the effectiveness of their programmes.

Active engagement and consultation with foreign direct investors, local SMEs and R&D organisations is necessary for the effective implementation of relevant policies. Through their interactions with the private sector, public institutions are able to understand the challenges and expectations of foreign and domestic firms, receive feedback on the relevance of their policy programmes, and enrich policy making processes with insights from various stakeholders of the domestic research and innovation ecosystem. Mechanisms for regular public-private dialogue within specific sectors and supply chains should be combined with bottom-up communication processes to ensure that local level market needs and perspectives are fed into higher-level policy processes.

Ensure an open, transparent and non-discriminatory regulatory environment for productive and knowledge-intensive investment

An open and non-discriminatory regulatory environment can increase the amount and spillover potential of FDI and strengthen the absorptive capacities of domestic firms, in particular SMEs (Figure 2.5). Fewer restrictions for investments in more productive, innovative and knowledge-intensive sectors can increase the direct impact that foreign firms have through their own activities on sectoral and aggregate productivity growth. Openness to FDI may not only affect productivity in industries that get market access, but also those in downstream sectors that benefit from potentially better access to high quality inputs and services domestically. Recent OECD work on Southeast Asia shows that liberalising FDI in services is positively associated with productivity in downstream manufacturing industries, where SMEs benefit in particular (OECD, 2019[71]).

FDI spillovers also tend to be larger in countries that are more open towards trade (Meyer and Sinani, 2009[72]; Havranek and Irsova, 2011[73]; Du, Harrison and Jefferson, 2011[74]). A study on Thailand’s manufacturing sector, found that technology spillovers from FDI to the domestic economy happen predominantly in sectors with low trade restrictions, while evidence from China’s entry into the World Trade Organisation (WTO) suggests that vertical backward spillovers increased after its accession when tariffs were lowered and domestic content restrictions relaxed (Du, Harrison and Jefferson, 2011[74]). Trade openness can also shape the absorptive capacity of domestic firms, which are more exposed to international competition in an open trade regime, and therefore more likely to access new markets, participate in GVCs, and produce intermediate goods required by foreign investors (Havranek and Irsova, 2011[73]).

FDI-driven productivity growth and innovation may not automatically materialise just because a country is able to attract FDI (Alfaro, 2017[75]). Competition rules that ensure a level playing field for foreign and domestic firms facilitate the entry of foreign investors and, at the same time, incentivise domestic firms to become more productive, innovate and improve the quality of their products (Lembcke and Wildnerova, 2020[37]). Firms exposed to stronger competition might also be better prepared to imitate good practices from foreign firms. As described in Section 2.2, competition and imitation effects are an important channel through which knowledge and technology spillovers from FDI take place in the host economy. In this context, it is important to assess the degree to which laws and policies promote or inhibit competition in areas of the product and services markets where competition is viable.

Figure 2.5. FDI openness in services and productivity in downstream manufacturing sectors

Note: Analysis is based on firm-level data from 23 OECD and developing countries; see methodology in OECD (2019[71]). Services restrictions are based on the OECD FDI Regulatory Restrictiveness Index.

Source: OECD (2019[71]), OECD Investment Policy Reviews: Southeast Asia, http://www.oecd.org/investment/oecd-investment-policy-review-southeast-asia.htm

Policies that ensure intellectual property rights (IPR) protection are also important as they guarantee the appropriability of knowledge and innovation benefits, and determine the qualities of FDI that can be attracted. Empirical evidence suggests that where rights are strong, foreign firms are not only more likely to invest but are also more likely to engage in local R&D and more willing to share new technologies with local partners through joint ventures and licensing agreements (OECD, 2015[66]). Branstetter et al. (Branstetter, Fisman and Foley, 2006[50]) find that US MNEs respond to changes in IPR regimes abroad by increasing technology transfer to their affiliates in countries that undertake reforms to strengthen IPRs. Similarly, Javorcik (2004[14]) finds that, in Central and Eastern Europe, the strength of patent laws as well as the overall level of IPR protection increases the likelihood of attracting FDI in several high technology sectors where IPRs play an important role. Foreign investors are also found to be more likely to engage in local production, as opposed to focusing solely on setting up distribution networks, in countries with stronger IPR regimes, increasing therefore the potential for more linkages with the local economy.

Several countries have chosen to introduce local content requirements (LCRs) to induce foreign firms to use domestically manufactured goods or domestically supplied services in exchange for market access in certain strategic sectors. Recent OECD work shows that, while LCRs may help governments achieve certain short-term objectives in targeted industries (e.g. potential learning and technological spillovers, economies of scale), they undermine long-term competitiveness and may prove to be detrimental for FDI attraction and productivity growth in the long run (Stone, Messent and Flaig, 2015[76]). LCRs may restrain competition from imports, which might contribute to higher production costs and ultimately higher prices to downstream industries and consumers. The literature on the potential effects of LCRs also points to potential market distortions and inefficiencies arising from a suboptimal allocation of resources. They may undermine the original goals for imposing LCRs. Targeted incentives that generate less negative economy-wide effects and do not impede market access may be preferable to incentivise linkages between FDI and domestic firms (see section on financial support and technical assistance).

Consider the impact of laws and regulations on business capacity and incentives to engage in innovation and technology development

Firm size is a determinant of absorptive capacity and a critical factor shaping a firm’s ability to move towards high value added, knowledge-based production. OECD and developing economies are often dominated by SMEs with low productivity, which may find it difficult to grow and obtain a critical scale that would allow them to join GVCs, participate in innovation activities and become suppliers and partners of foreign firms. Overly burdensome regulations often perpetuate informality, particularly of smaller and less productive firms, which have less capacity to screen the regulatory landscape and allocate the necessary resources to address legal and regulatory requirements (OECD, 2018[77]). It is important that a conducive business environment is created and regulatory hurdles removed to enable small businesses to expand. These include areas such as the ease of registering a business, dealing with reporting and tax compliance requirements, trading across borders, resolving insolvency and dealing with licence and permit systems.

Stringent regulations can also deter innovation by imposing high compliance costs that reduce the attractiveness of R&D and limit the capacity of domestic entrepreneurs and foreign firms to experiment with alternative business and production models (Davidson, Kauffmann and de Liedekerke, 2021[78]). One option for encouraging FDI-driven productivity growth and innovation is to develop laws and regulations that are sufficiently flexible and forward-looking to anticipate and adapt to fast-changing technologies. This is particularly the case for regulations addressing issues related to digital innovation (e.g. use of AI applications, robotics, Internet of Things). Related technological standards should be also updated regularly to catch up with the latest market developments. Finally, regulatory impact assessment (RIA) tools and processes should move beyond assessing the economic impacts of regulations (e.g. impacts on competition, economic growth, etc.) to also cover impacts on SME competitiveness, innovation and the internationalisation of the economy.

In many countries, the simplification of the regulatory framework is often combined with targeted easing of the regulatory burden for certain types of investment. This usually comes in the form of special investment regimes granted to FDI projects that are deemed to be of strategic importance for the host economy, giving access to expedited administrative and licensing procedures. These special regimes are usually predicated on certain conditions such as creating a number of jobs, investing in knowledge-intensive and productivity-enhancing sectors, or benefitting specific geographic areas. In Portugal, for instance, the government has introduced several special regulatory regimes allowing investors to benefit from simplified licensing procedures, conditional to introducing innovative and technology-based production processes in co-operation with domestic R&D institutions (OECD, 2022[59]). Many developing countries have also established special economic zones (SEZs) as a tool to attract FDI that creates linkages with the local economy.

Evidence on the effectiveness of these regulatory measures has been mixed. Anecdotal evidence on their impacts, in particular of the SEZs, shows that they have often failed to sustain innovation and competitiveness over time, delivering little technological upgrading or new firm creation. In many instances, SEZs have been criticised for negative social and environmental impacts as a result of excessive competition between regions and a misuse of resources and land where the SEZs are located (Farole and Akinci, 2011[79]; OECD, 2018[80]). In principle, regulatory concessions should not be used as a substitute for improving the general investment climate but instead be embedded in broader national development strategies. Accompanying measures need to be in place to generate productivity spillovers on the rest of the economy, including supplier development programmes, business matchmaking services, and initiatives to engage the private sector and local education institutions in cluster building activities.

It is also critical that policy efforts to reduce the regulatory burden on business do not lead to a “race to the bottom” in terms of social and environmental standards (see chapters 3, 4 and 5). This becomes even more crucial for industries driven by digital innovation, which rely on alternative business models and often lead to new and more precarious forms of employment or weakened social protection conditions (OECD, 2020[81]). In fact, regulation should mitigate the potential socio-economic risks arising from the adoption of new, innovative and digitally enabled business models while at the same time ensuring that regulatory responses are proportional, set out some level of certainty and predictability, and do not stifle the innovation potential of the economy.

Ensure that labour market regulations facilitate FDI spillovers through labour mobility

Labour market regulations shape FDI impacts on productivity and innovation by affecting the potential for knowledge and technology spillovers through labour mobility (see section 2.2) and the availability of skills in the local labour force. Recent evidence from EU countries shows that less rigid labour markets with strong absorptive capacities are better positioned to moderate any adverse labour market effects of FDI, in particular the crowding out of employees in domestic firms, which occurs when foreign and domestic firms compete for the same scarce labour resources (Becker et al., 2020[36]). In contrast, the benefits for a local economy from FDI are lowest where there exist a combination of stringent employment protection legislation and low absorptive capacities. This is because foreign firms seek to attract local talent by offering higher wages that less productive domestic firms are unable to match. Increased wage disparities coupled with rigid labour market conditions limit the ability of domestic firms to retain and attract skilled workers, holding back labour mobility and the potential for knowledge spillovers that this entails.

These findings highlight the need to examine labour market regulations and their role in FDI-driven productivity growth by looking at how they relate to other drivers of FDI impacts, namely domestic SME performance and the availability (or lack) of skills in the local labour force. Spillovers from labour mobility cannot be fully leveraged unless structural challenges related to the absorptive capacities of domestic firms, in particular SMEs, are addressed, and the complexity of hiring regulations reduced (and with that the disproportionate impact they may have on small businesses). Targeted measures that allow micro and small firms to be exempted from certain procedural requirements or other hiring restrictions of the labour legislation can facilitate the movement of highly skilled workers from foreign affiliates to the domestic entrepreneurial ecosystem.

Encouraging the uptake of permanent employment can also have a positive impact on domestic firms’ willingness to invest in job training of their employees, which is an important component of a firm’s absorptive capacity. Evidence on the role of employment protection regulations in shaping the incentives of firms to invest in formal training shows that enforcing stricter hiring regulations for temporary contracts and less rigid regulations for dismissals of permanent workers is associated with higher investment by firms in the human capital of their employees (Almeida and Aterido, 2011[82]). Similarly, a stricter enforcement of employment protection regulation is found to have a positive impact on firms’ willingness to upskill their employees. This is mainly because firms have greater incentive to invest in firm-specific knowledge and skills for employees who stay longer on the job and seek to exploit the career advancement opportunities provided by the firm (OECD, 2020[83]). Chapter 3 provides a detailed analysis of the positive impacts that labour market regulations can have on human capital formation.

Linked to the need for a skilled labour force is the increasing number of governments that introduce regulatory incentives to encourage workforce skills development and facilitate the immigration of business talent as a way to help domestic economies address labour shortages. Some OECD countries have introduced statutory rights for employees for training leave – however, their take-up is generally not high with less than 2% of employees benefitting from such measures (OECD, 2019[5]). In recent years, there has been also an increase of entrepreneur visa programmes (e.g. Startup Visa, Tech Visa), which seek to attract innovative entrepreneurs and highly skilled workers by allowing them to obtain residence and employment rights. For the visa to be granted, entrepreneurs usually have to demonstrate solid business and financial plans and undertake innovative activities in knowledge-intensive sectors. The impact of these schemes on the productivity and innovation of domestic economies is not clear yet, but other factors such as labour market conditions, the presence of a thriving startup ecosystem, and the quality of the business environment are thought to be key determinants.

Ensure that financial market laws and regulations facilitate access to finance for innovative and technology-intensive activities

Well-functioning financial markets can facilitate FDI spillovers by enabling SMEs to access supply chain finance and secure investments for entrepreneurial activity. Studies find that well-developed financial markets can strengthen the absorptive capacity of domestic firms and provide the liquidity that SMEs need to export, develop new products and invest in technology upgrading (Farole and Winkler, 2014[48]). For many SMEs, the high fixed costs of establishing a distribution network and adjusting their products for overseas standards, often require external finance (OECD, 2020[57]). Similarly, access to finance is an important condition for foreign firms that seek to finance collaborative technology-based projects or enter into partnerships with domestic firms (for instance, through joint ventures).

Financial stability risks (e.g. low bank profitability, high sovereign and corporate debt) and structural market deficiencies (e.g. underdeveloped equity markets and credit rating systems, insufficient market liquidity, weak contract enforcement, inefficiencies in the judicial system, etc.) are often the most common causes that hold back the necessary capital that foreign and domestic firms need to expand their operations. Governments can play an important role in improving access to credit by creating a regulatory environment that provides flexible collateral options and transparent legal recourse in cases of default, and by establishing easily accessible financial support schemes (OECD, 2019[5]). Regulatory reforms that facilitate market-based long-term debt financing, increase the availability of alternative financing instruments, and promote access to equity capital through the stock market can help free up capital for innovative business projects. Raising awareness about alternative forms of financing such as crowdfunding, venture capital and business angels, and encouraging firms to source finance from equity markets can also further stimulate innovative business activities.

Integrate innovation and SME policy considerations into international investment agreements

Most investment treaties in force today do not contain provisions that seek expressly to promote productivity and innovation. Rather, they have tended to focus almost exclusively on providing legal protections to investors. Recent international investment agreements (IIAs) concluded in the past decade, especially free trade agreements (FTAs) that address investment issues, have covered broader policy areas beyond investment protection that pertain to fostering international co-operation on science, technology and innovation (STI) policy and strengthening the capacities of SMEs to engage in international trade and investment.

Recent IIAs address regulatory issues affecting host country SMEs by envisaging international co-operation and dialogue to promote investment opportunities for SMEs in the economies of the treaty parties (Clicteur et al., 2021[84]). SME-specific provisions may take the form of standalone chapters, or be mainstreamed across FTA chapters dealing with e-commerce, trade facilitation, procurement, investment and trade in services (Box 2.2). The degree of commitment that they require varies; from general principles emphasising the importance of SMEs in international trade and investment, to binding agreements on simplified administrative procedures for SMEs trading or investing abroad, and commitments to the establishment of dedicated SME Committees to ensure co-operation and information sharing among treaty signatories (UKTPO, 2020[85]; Lodrant and Cernat, 2017[86]). These initiatives may help SMEs to overcome a lack of familiarity with foreign markets as well as logistical, managerial and other challenges when trading or investing abroad. By facilitating the internationalisation of host country SMEs, these provisions can also increase the exposure of SMEs to international competition and improve their capacities to become suppliers and partners of foreign firms, including foreign direct investors located in their own countries.

The inclusion of STI provisions in bilateral investment treaties (BITs) and regional trade agreements (RTAs) is another channel through which governments often seek to signal their readiness to attract FDI in high-technology areas, promote international co-operation on technology transfer issues and strengthen domestic innovation capabilities. Provisions on intellectual property rights (IPRs) are the most commonly found STI provisions in IIAs (Stone, Kim and Engen, 2017[87]). They often include general principles stressing the importance of IPRs for innovation and economic growth; binding commitments on specific IP issues (e.g. minimum standards for IP protection, use and enforcement of IPRs, settlement of IP disputes); and bilateral or multilateral co-operation provisions. The economy-wide effects of including IPR provisions in RTAs or BITs have seldom been quantified, but it is widely accepted that they can support innovation in the treaty party economies to the extent that they lead to improvements in domestic laws in these areas (WTO, 2014[88]). New IIAs concluded over the past few years have been also increasingly incorporating more general provisions on the digital economy (e.g. data protection, cybersecurity, data localisation and online consumer protection rules) as well as STI co-operation (Stone, Kim and Engen, 2017[87]). The latter usually seek to facilitate the exchange of information on cross-border innovation programmes, the joint conduct of R&D projects; the exchange of country visits of specialised delegations, industry representatives, universities and research centres; and the promotion of public-private sector partnerships for the development of innovative products and services (Box 2.2).

Another feature of some recent IIAs that can affect productivity and innovation is disciplines on performance requirements. These provisions, inspired by the WTO TRIMs Agreement, prohibit treaty parties from imposing mandatory performance requirements on incoming foreign investors such as forced technology transfers, local content or R&D quotas. As outlined in the previous section, performance requirements have been found to deter FDI inflows and undermine the long-term competitiveness of the domestic economy. Some IIAs adopt a more nuanced approach by creating express exceptions or reservations in some areas (e.g. allowing governments to impose technology transfers on foreign investors as part of investment screening review processes) or allowing governments to attach certain conditions to non-mandatory advantages offered under domestic law (e.g. incentive schemes, tax breaks, subsidies, etc.) that would require foreign investors to perform in some way to benefit the domestic economy (e.g. locate production, train or employ workers, carry out R&D locally, etc.). The impacts of such policies need to be carefully weighed and examined alongside other factors that drive FDI spillovers such as the productive capacities of domestic firms and the availability (or lack) of skills in the local labour market.

Some recent IIAs also contain government commitments on market access, investment facilitation and promoting fair competition that may generate tangible impacts for productivity and innovation. Through the elimination of regulatory barriers to investment based on nationality, IIAs can stimulate more potential FDI primarily based on market considerations, which in turn can generate many benefits for host economies as described above. Greater openness to foreign competition can lead to new competition for local SMEs, which may stimulate greater productivity or lead to crowding-out effects depending on the maturity of the domestic market. In addition to market access barriers, businesses can face myriad other obstacles to effective entry and success of FDI in foreign markets. Recent IIAs have sought to alleviate these barriers through rules to address problems such as transfers and visas for personnel, clarity on different environmental and technical standards, a lack of transparency in regulatory procedures, or logistics issues.

Implement clearly defined, transparent and rules-based investment incentive schemes that target FDI in productive and knowledge-intensive activities

Investment incentives are widely used by governments to attract investors, promote investment in specific sectors or locations, and encourage or discourage certain types of business activities (Box 2.3). They can take many forms, including direct financial support, tax relief and regulatory concessions.1

Direct funding (e.g. grants, loans and guarantees, provision of infrastructure and land, other subsidised goods and services) is often used to compensate foreign investors for the perceived disadvantages of a particular location or subsidise the actual costs of relocating corporate units (e.g. job training costs, expatriation support, temporary wage subsidies). It represents a more selective form of public support as it allows governments to target investment projects that they consider to generate public goods (e.g. green technology, social innovation and other novel areas) or have a high potential for knowledge spillovers (OECD, 2015[91]; 2021[92]). Grants and other forms of direct support may therefore be valuable to promote mission-oriented innovation that offers high economic and social returns. Tax incentives, on the other hand, such as tax holidays, tax credits, accelerated depreciation allowances, consist of an easing of the tax burden on the investing companies (Table 2.2). They are usually granted to all firms that qualify for a set of pre-defined conditions, leaving the selection of supported projects to firms. In principle, their non-discretionary nature makes it easier and less costly for governments to administer.2 Ultimately, the optimal mix of investment incentives (i.e. direct versus indirect financial support) depends on the specific policy goals, market conditions and country contexts.

Investment incentives are not always aligned with the objective to enhance domestic resource mobilisation for productivity and innovation. They can distort competition and resource allocation, reduce the revenue-raising capacity of the public administration, increase administrative and compliance costs, and are not always cost-effective in attracting investment that creates linkages with the host economy (Celani, Dressler and Wermelinger, 2022[93]; IMF-OECD-UN-World Bank, 2015[94]). Transparency around investment incentives is also often lacking as responsibility for their granting is usually spread among multiple agencies and stipulated in numerous pieces of legislation. If used, governments should ensure that incentives address a well-identified market failure such as information asymmetries between foreign and domestic firms, the inherent risks and uncertainty arising from engaging in innovation, or the high fixed costs of undertaking technology-intensive activities (Martin and Scott, 2000[95]). The design, eligibility conditions, sectoral targeting and administration of incentive schemes should be also taken into consideration. Different types of incentives present advantages and disadvantages related to their financial and administrative costs, their impact on economic and social conditions, and their effectiveness in attracting productivity-enhancing FDI.

For instance, cross-country differences in the generosity of R&D tax incentives can lead to differences in the cost of capital faced by firms – and subsequently encourage or discourage them from increasing their R&D investment or locating their R&D functions in a given country (González Cabral, Appelt and Hanappi, 2021[97]; OECD, 2021[98]). Moreover, there is growing anecdotal evidence suggesting that income-based tax incentives (e.g. tax holidays, preferential tax rates), which reduce the rate applied to profits/income already secured, tend to attract mobile activities rather than long-term FDI projects that are more likely to create linkages with the local economy and generate knowledge spillovers (OECD, 2019[71]). Income-based tax incentives may also have limited effectiveness in attracting new investment and often come at a substantial cost to a country by resulting in windfall gains for projects that would already have taken place in the absence of the incentive. In contrast, expenditure-based tax incentives – such as tax deductions, tax credits, and accelerated depreciation – that lower the cost of specific inputs of production factors allow to link investments to performance criteria that support progress towards specific development objectives, including innovation promotion and linkages with domestic firms.

Beyond the type of incentive, more targeted approaches in terms of supported sectors and activities should be preferred (OECD, 2021[99]). Governments could consider making the granting of direct financial support and tax relief conditional to creating linkages with domestic SMEs, undertaking R&D locally, or investing in more productive, knowledge-intensive and high-tech sectors. Recent OECD evidence from 36 developing economies shows that an increasing number of countries are adopting tax incentives that include outcome conditions associated with the SDGs (e.g. export promotion, skills development, local linkages) (Celani, Dressler and Wermelinger, 2022[93]). The conditions and criteria for the granting of incentives should be transparent, clearly defined and rules-based to facilitate their verification, avoid discretionary and distortive granting decisions, and strengthen the link to the intended policy goal of increasing productivity gains for the domestic economy. When the provision of financial support depends on discretionary decisions by government agencies, selection processes must be competitive and designed so as to ensure efficiency, avoid rent-seeking activities and alleviate problems of adverse selection (OECD, 2015[91]).

Given the ever-changing nature of innovation and the fast pace of technological developments, investment incentives targeting R&D and high-tech activities should be also reviewed periodically to ensure that they continue to reflect the latest market developments and that their costs – in terms of revenue forgone and potential economic distortions – outweigh their benefits. Cost-benefit analysis prior to introducing incentives, robust monitoring frameworks, and systematic ex-post impact evaluations are crucial to ensure the continuing validity of their objectives and whether their targeting and design remain appropriate. One option to ensure periodic reviews is to make them mandatory by law or integrate them into the monitoring and evaluation framework of national investment promotion strategies.

Effective targeting may come at the cost of significant financial and administrative resource requirements. Serious policy consideration should be given to the impact that incentive schemes have on the complexity of the tax system and the capacity of the public administration to implement more targeted policy approaches. Targeted tax incentives, for example, require higher tax administration capacities and the necessary resources to monitor the compliance of beneficiaries to outcome-based criteria, carry out regular audits to avoid fraudulent behaviour, measure their costs and value-for-money and assess their overall effectiveness over time. Country contexts and institutional arrangements discussed in the previous section should be taken into account. For developing countries, where institutional capacities are lagging, a simple and unspecific incentives scheme (i.e. applying to all types of firms uniformly, targeting all types of activities, not requiring discretionary decisions by government agencies) may bring longer-term benefits to the domestic economy by creating more certainty for potential investors.

Provide financial support and technical assistance to strengthen the absorptive capacities of domestic firms, in particular SMEs

Governments can strengthen the absorptive capacity of domestic firms, in particular SMEs, not only by ensuring that the regulatory environment is conducive to business growth but also by implementing targeted measures that support the development of strategic assets and resources at the firm level (e.g. access to skills, finance, innovation and digitalisation, etc.) (OECD, 2021[8]). Such measures often involve financial support and technical assistance in diagnosing weaknesses in business performance, experimenting with and adopting alternative business models, and undertaking innovative, technology-based activities with foreign firms. In many cases, financial and technical support is supplemented with training and guidance on the skills, managerial and organisational changes that are required to strengthen firm productivity and innovation (Table 2.3).

Supplier development programmes can play a crucial role in enhancing the absorptive capacity of local SMEs and increasing their chances of becoming partners and suppliers of foreign firms. These programmes usually assess the need for upgrading SME capabilities in various aspects of their performance – management, production, sales and commercialisation, innovation, human resources and overall productivity – and provide coaching and training in quality control, product certification and foreign market standards. As part of these programmes, government agencies organise seminars, workshops and courses (e.g. SME academies) to help domestic firms become familiar with foreign markets, enhance their export capacities and explore alternative sales strategies based on the use of ICT tools (e.g. e-commerce). To maximise the effectiveness of supplier development programmes, it is critical that their scope is aligned with the investment facilitation and aftercare services offered to foreign firms to ensure that the goods and services of domestic suppliers respond to the needs of foreign direct investors, especially in FDI-intensive sectors.

Given the increasing digitalisation of supply chain management processes, supplier development programmes should be combined with technology extension services (TES) to improve the use of “new-to-firm” innovation by SMEs (Shapira, Youtie and Kay, 2011[101]). The main objective of these services is to facilitate the adoption of existing technology through diagnostic assessments of a firm’s operations, processes and technological maturity; information services to bring awareness of new business models and digitally enabled sale practices; benchmarking to identify areas for improvement; consulting, training and technical assistance to implement internal organisational changes.

Addressing the financing challenges of SMEs across all stages of their business cycle is also of particular importance to help them invest in technology upgrading and improve the quality of their products and services in line with the needs of foreign investors. Public support to SME financing can take a variety of forms, from loans and credit guarantees to grants, equity and quasi-equity schemes, which help SMEs invest in R&D, acquire new technologies, adopt digital tools and processes, and engage in innovation and internationalisation activities (OECD, 2019[5]). Tax relief measures can be also provided to support subgroups of the SME population such as young high-growth firms and startups to expand their business operations and join GVCs. Many of these financial support schemes often include additional financial incentives for the development of products and services through science-to-business (S2B) and business-to-business (B2B) collaboration, including with foreign firms, reflecting the importance of networks and strategic partnerships for FDI-driven knowledge transmission.

The G20/OECD High-Level Principles on SME Financing provide guidance to G20 and OECD governments for the development of cross-cutting policy strategies on SME financing, highlighting in particular the need for a diverse range of bank-based and alternative financing instruments and the importance of safeguarding financial stability, transparency and investor protection (G20/OECD, 2015[102]). Diversifying the finance mix of SMEs requires government action to address both demand-side barriers (i.e. insufficient market incentives for investors) and supply-side barriers (i.e. lack of financial knowledge and guarantees among SMEs). Given the challenges that many SMEs face in accessing traditional bank financing, governments should promote alternative financing instruments such as equity, venture capital and fintech solutions. Policymakers can provide incentives for collaboration between banks and other private investors; capacity building to improve the way SME managers present their business model to potential funders; public tenders to encourage joint financing between several investors; and establishing platforms with easily accessible information on financing tools for growth-oriented SMEs.

Measures that facilitate access to qualified human capital should be also available to domestic firms to strengthen their capabilities in areas that require highly specialised expertise and skillsets such as those involving the use of innovative production processes, automation and digitalisation. Small businesses tend to offer fewer training and upskilling opportunities than large firms due to the increased financial costs of organising tailored training programmes, the lack of internal organisational capacities, and lower levels of resources to anticipate skill needs. Many OECD countries provide tax exemptions to encourage small businesses to provide on-the-job training to their employees, while others offer direct subsidies such as training vouchers that allow SMEs to purchase training hours from accredited training and educational institutions (OECD, 2021[8]).

Managerial skill development programmes in the form of seminars, workshops and individual consulting should be part of technical support packages provided by investment promotion and enterprise development agencies. Canada’s Operational Efficiency Programme, for example, strengthens operational efficiency in manufacturing SMEs by enabling participating companies to benchmark and monitor their operational performance against the industry average (OECD, 2019[103]). Linking the development of SME workforce skills to vocational education and training (VET) frameworks can also foster greater collaboration between employers and vocational schools and help SMEs access highly skilled young employees through apprenticeship programmes. By combining school-based education and on-the-job training, apprenticeships can stimulate company productivity and profitability. Evidence from countries for which data are available show that more than half of all apprentices work in companies with 50 employees or fewer (Kergroach, 2021[104]). Work placement, employee exchange programmes and wage subsidies for highly skilled or R&D workers should be also used to ensure that SMEs have access to high quality human capital. For instance, the Portuguese investment promotion agency, AICEP, manages the INOV Contacto programme, which gives the opportunity to highly skilled graduates to conduct a short-term internship in a Portuguese company, followed by a long-term internship in a multinational company abroad. Such programmes play a crucial role in strengthening labour mobility and facilitating the transfer of knowledge and skills to domestic firms.

Ensure access to quality infrastructure to promote productive investment that creates linkages with the domestic economy

Infrastructure is a key enabler of agglomeration and connectivity and a pre-condition for the attraction of investment that contributes to productivity and innovation (OECD, 2015[105]). A well-functioning network infrastructure (e.g. transport and logistics, energy, ICTs) ensures secure and cost-efficient use of the host country’s resources, reduces operational costs and facilitates access to local and international markets for foreign and domestic firms.

The quality of the transport infrastructure influences the decisions of foreign MNEs about where to locate their investment projects. It also allows economically weaker regions of the host country to benefit from the concentration of FDI in more urban and developed areas (OECD, 2019[5]). By expanding commuting opportunities for workers and facilitating the integration of rural regions into the labour market of the cities located in their proximity, transport infrastructure can foster FDI spillovers through labour mobility and increase productivity gains for remote local economies. Information and communication technologies (ICT) infrastructure is also critical for promoting technology-intensive investment and attracting digital economy MNEs that can make use of the domestic IT infrastructure to set up their supply chain operations (Gestrin and Staudt, 2018[106]). High-speed digital networks also enable small domestic firms to build digital capacity and become suppliers and partners of foreign MNEs operating in high-tech sectors. Energy infrastructure also matters for MNE operations (see chapter 5). Affordable energy supply can influence the cost of doing business and improve energy efficiency at the firm level. The quality of the energy infrastructure also has implications for FDI location decisions. Recent commitments to green and renewable energy production mean that foreign MNEs involved in green innovation could be put off by the lack of sustainable and affordable green energy in a specific country or region.

The OECD Compendium of Policy Good Practices for Quality Infrastructure Investment provides a set of international good practices and measures relevant to policymakers and practitioners in both developed and developing economies to pursue quality infrastructure investment (OECD, 2020[107]). In order to develop quality infrastructure that helps attract productivity-enhancing FDI, governments need to establish procedures to assess infrastructure needs, build robust policy coordination mechanisms (e.g. through dedicated administrative units, inter-ministerial task forces), promote a diverse mix of financial instruments for infrastructure investment and ensure a credible regulatory and legal environment for contract enforcement and the functioning of infrastructure partnerships (OECD, 2015[66]). Developing comprehensive national infrastructure plans, communicating priorities and identifying infrastructure projects across sectors aligned with development objectives can make infrastructure networks attractive for private participation and increase value for money in the use of public funds for infrastructure development.

Although ensuring access to quality infrastructure is a joint challenge of all levels of government, subnational governments can play a vital role in the infrastructure landscape since they are often responsible for key policy areas such as spatial planning, local public transport networks, the energy grid, broadband and telecommunications systems (OECD, 2019[5]). Strengthening the involvement of regional authorities and municipalities in the design and implementation of local infrastructure development plans can help ensure that infrastructure planning is linked to an assessment of regional (or local) characteristics, competitive advantages, growth and innovation potential.

Mobilising sufficient financial resources is also important. In many countries, where the government owns a range of key economic and social infrastructure assets, the public sector will be a key driver of infrastructure investment. Developing economies, however, do not often have the fiscal capacity to increase public investment significantly. Private investment can supplement public investment including through public-private partnerships (PPPs). Securing the necessary financial resources and making infrastructure networks more attractive for private involvement is possible by improving the efficiency of public service delivery, facilitating investor access to land, and establishing a more level playing field between State-owned infrastructure operators and private investors (OECD, 2015[105]). A diverse range of financing instruments and vehicles, along with appropriate risk mitigation approaches, can broaden the investor base and reduce investment risks.

Establish intermediary organisations and specialised facilities to support business-to-business and science-to-business collaboration

The impact of FDI on productivity and innovation is also influenced by the domestic knowledge infrastructure, which may include technology transfer offices, applied research centres, collaborative laboratories, universities and other facilities that contribute to the creation and diffusion of knowledge through synergies. Knowledge co-creation, i.e. the joint production of innovation between industry, research and possibly other stakeholders of the entrepreneurial ecosystem, is increasingly acknowledged as an important mechanism to bring together complementary expertise and facilitate the transfer of tacit knowledge (Kreiling and Paunov, 2021[108]). The establishment of facilities that provide a physical environment for foreign firms to interact, network, exchange knowledge and collaborate with domestic actors can be instrumental for the development of knowledge-intensive partnerships. Local SMEs can also gain access to technological premises, equipment, manpower and activities provided by universities and public research institutes that they could not afford independently (OECD, 2019[5]).

Over the past decade, there has been a rapid increase of intermediary technology transfer organisations in many OECD countries (Rossi et al., 2020[109]). These infrastructures seek to address the market failure, which exists in taking innovative ideas forward to commercial application by providing resources, competences and expertise that SMEs often lack. Their role is to provide from the earliest possible moment hands-on support in innovation processes and help SMEs undertake foresight exercises, technology development, and manage intellectual assets. Governments should ensure that particular emphasis is placed on supporting collaborative projects that involve foreign firms, domestic entrepreneurs and R&D institutions. These intermediary organisations can play the role of an innovation broker and create “communities of innovators” that undertake joint R&D and product development activities.

Furthermore, establishing and operating business incubators and accelerators in regions and sectors with high innovation potential allows entrepreneurs and early-stage startups to experiment with new business models, access frontier expertise, and technologies that they can use to further develop their innovative ideas, often in collaboration with foreign firms. Business facilities and services supporting the startup ecosystem can also further boost knowledge-intensive FDI by facilitating acquisitions of innovative startups by foreign multinationals. In fact, startup acquisitions are a common practice among MNEs that seek to maintain their position in digital economy sectors by acquiring and exploiting the technological “inventions” and valuable data and information held by young high-growth firms. In Israel, for example, the number and value of M&As and buyouts involving innovative startups has continuously grown over the past decade to reach a total value of USD 21.7 billion in 2019, as local players and multinational corporations expanded open innovation activities in a wide variety of sectors (OECD, 2020[110]).

Implement cluster development programmes that facilitate business linkages, foster cross-sectoral interactions and take into account place-based capabilities

The development of effective network and knowledge infrastructure can foster the spatial proximity of firms, thereby generating agglomeration externalities that reduce production costs through economies of scale and network effects. Well-designed cluster development policies may encourage companies to group together for the development of joint projects, foster industry-science linkages, and enhance cross-sectoral interactions. When foreign direct investors are located in such clusters, they are likely to be more willing to collaborate with other local firms and organisations (Potter, 2001[111]). From a policy perspective, this means that cluster policies should be aligned with FDI promotion, SME and regional development policies to increase the potential of FDI for local productivity gains. Cluster policies can achieve meaningful impacts when they integrate sectoral priorities, keep regional and local actors involved (e.g. businesses, municipalities, universities), and provide support (e.g. technical assistance, funding, capacity building) that takes into account the diversity of regional economies and FDI-SME ecosystems.

Public support can take many forms depending on the stage of development of a country (or region) and the level of maturity of the cluster itself – ranging from mature export-oriented clusters in metropolitan areas and technology-centred clusters built around R&D organisations, to smaller agglomerations in niche fields and small-scale networks in less mature ecosystems. Recent evidence from France shows that cluster policies are more effective in promoting knowledge diffusion when they are implemented in regions with a minimum degree of specialisation (N’Ghauran and Autant-Bernard, 2020[112]). This means that other types of policy interventions may be needed in economically weaker regions before cluster policies are implemented (e.g. strengthening SME absorptive capacities or establishing basic infrastructure). Intra-regional effects should be also taken into consideration. Knowledge spillovers arising from cluster policies in one region may negatively affect innovation diffusion in other locations, in particular neighbouring regions (i.e. ‘beggar-thy-neighbour’ effects). Subnational governments can play a strong role in the design and implementation of cluster policies by pooling resources, mobilising local actors and ensuring that public action is aligned with local market characteristics.

The establishment of industrial, science and technology parks can also facilitate FDI spillovers by fostering agglomeration economies. These parks are location-specific and target both foreign and domestic firms, providing them with land or office space to set up their business activities. Apart from providing basic infrastructure, many industrial parks are often associated with the provision of other services such as incentives for entrepreneurs to grow, business diagnostic tools, and programmes involving public-private partnerships. The co-location of companies facilitates the development of networks and information sharing among firms and can be an important source of knowledge and technology spillovers. Evidence on the effectiveness of science and technology parks in attracting FDI and promoting intra-firm linkages is overall positive, at least through tacit learning and informal interactions among park tenants (Vásquez-Urriago, Barge-Gil and Modrego Rico, 2016[113]; Cantù, 2010[114]; Vaidyanathan, 2007[115]). Specialised parks that apply rigorous selection criteria and target sector-specific firms in line with the sectoral make-up of the local economy have been found to be more effective in facilitating knowledge spillovers, promoting on-park relationships and spurring innovation (Kocak and Can, 2013[116]; Lamperti, Mavilia and Castellini, 2015[117]).

Implement effective investment promotion strategies geared towards productive and knowledge-intensive investment with strong spillover potential

IPAs are key players in promoting productive and knowledge-intensive investment. Effective investment promotion includes raising potential investors’ awareness of the host country’s strengths, branding the country as an attractive investment destination, and directly reaching out to potential investors to generate leads and investment projects (OECD, 2018[70]). IPAs should review and identify specific economic activities where they see a potential to enhance productivity growth and strengthen the technological sophistication and knowledge base of the economy. On this basis, they can design investment promotion packages geared towards productivity-enhancing activities, combining a variety of investment generation tools such as intelligence gathering (e.g. raw data analysis, market studies), sector-specific events (e.g. road-shows, business fora and fairs, country missions), and pro-active investor engagement (one-to-one meetings, email/phone campaigns, enquiry handling). These activities should provide potential investors with information that allows them to identify investment opportunities with the highest potential for knowledge spillovers, including information on the host country’s knowledge infrastructure and the productive capabilities of domestic firms.

Implementing prioritisation strategies aligned with the economy’s industrial capabilities and innovation potential is another way through which IPAs can influence the impact of FDI on productivity and innovation. Most IPAs prioritise certain types of investments over others by selecting priority sectors, countries or investment projects, and allocating resources accordingly (OECD, 2018[70]). Such an approach allows governments to focus on investments that have a higher probability of being realised and may bring unique benefits to the host economy. Evidence from 97 IPAs worldwide shows that the prioritisation of specific economic activities translates into higher levels of FDI in the targeted sectors (Harding and Javorcik, 2011[118]). Recent OECD evidence from 32 OECD IPAs also shows that investment policy makers increasingly take into account sustainable development considerations when setting their prioritisation strategy, with 90% of them using productivity and innovation-related indicators to prioritise investment attraction (Sztajerowska and Volpe Martincus, 2021[119]).

To leverage the potential of FDI for productivity, IPAs can prioritise FDI in knowledge- and technology-intensive sectors, target potential investors in countries with higher average productivity levels, or focus on specific types of foreign firms such as top R&D performers. Targets and promotion activities should be coherent with policy priorities set out in national investment promotion, innovation and SME development strategies, and reasonably reflect the country’s production capacities and innovation potential. The use of prioritisation tools such as sustainability-related KPIs, scoring mechanisms, surveys and big data analytics, can help IPAs focus their limited resources on the most valuable deals (Sztajerowska and Volpe Martincus, 2021[119]).

Provide comprehensive investment facilitation and aftercare services to foster greater embedding of foreign firms in local economies

Investment facilitation and aftercare services can be instrumental in encouraging greater embedding of foreign affiliates in local economies and building relationships that contribute to greater use of local SME suppliers. They often involve accompanying investors in their project definition and during their establishment phase, ensuring that they identify local suppliers and clients, providing additional assistance once the project is implemented and encouraging expansions and reinvestments through aftercare. The aim of these services is to maximise the socio-economic benefits from investment.

Practically, IPAs have several options to bring down information barriers and help foreign firms identify local suppliers for future collaboration. Matchmaking services and B2B meetings allow representatives of foreign and domestic firms to meet and discuss potential local sourcing and business partnership opportunities. Many IPAs also use supplier databases to help foreign firms find information on domestically manufactured goods and domestically supplied services. Online matchmaking platforms can also serve as a single access point for B2B technology offers and requests, allowing companies to receive information on collaborative R&D projects. Measures to improve the quality of facilitation and aftercare services should therefore be at the centre of policy efforts to foster knowledge spillovers from FDI. IPAs should have sufficient resources and dedicated staff that is trained to identify the sourcing needs of foreign investors and steer FDI projects toward locations with the greatest potential for supporting supplier linkages. The development of clear objectives, a strategy and an action programme for embedding foreign investors in the local economy can help create policy momentum and mobilise public resources and relevant government actors.

Investment facilitation and aftercare services should be aligned with the priorities and objectives of supplier development programmes (see previous section) and combined with other types of support such as capacity building for local firms, training programmes for local staff, and cluster building initiatives. Evidence from OECD and developing economies shows that MNE-SME linkage programmes and other matchmaking services are often combined with policy initiatives aimed at promoting supply chain development and strengthening SME absorptive capacities. This mix of policy instruments allows aligning domestic supplier capabilities with the needs of foreign investors. It is therefore critical that governments increase the focus of investment promotion policy on FDI’s potential for supply chain development by strengthening the IPA’s policy footprint on issues that shape the capacities of domestic firms. This can be done either directly by integrating SME development into the mandate and mission of IPAs – as is the case with many European IPAs such as Enterprise Estonia, Business Finland, SPIRIT Slovenia – or indirectly by strengthening co-ordination and promoting joint programming between IPAs and government agencies responsible for SME and innovation policy.

MNE-SME linkage programmes and matchmaking services should be also integrated into wider regional development initiatives. Linkages between foreign and domestic firms are often location-specific and therefore depend on the availability of facilitation services at the local level. Recent findings from EU countries show that FDI responds better to the activity of IPAs operating in closer proximity to investors’ operations (Crescenzi, Di Cataldo and Giua, 2019[120]). Similarly, the availability of appropriate business development services is a local issue because SMEs and entrepreneurs generally access the services within a narrow local area. There are, however, wide cross-country disparities in the way national agencies operate at the subnational level. In some countries where inter-institutional co-ordination is limited, local presence in the form of secondary offices may be crucial to ensure the effectiveness of aftercare. In some countries, such as France and Canada, investment facilitation and aftercare services are provided by local autonomous agencies such as local regional development agencies, who possess knowledge of the local context. In these cases, co-ordination and collaboration with subnational governments and regional development agencies is necessary to ensure an end-to-end service to foreign investors.

The organisation of networking and knowledge exchange events is a common practice among government agencies responsible for investment promotion, SME and innovation policies. Such events strengthen FDI spillovers arising from the imitation of MNE activities by local firms. The demonstration effect resulting from the improved visibility of foreign firm practices and technologies and the informal sharing of views and ideas during conferences, seminars and site visits involves significant learning opportunities for local SMEs. For instance, Enterprise Ireland, the Irish SME agency, organises Best Practice Study Visits that allow Irish firms to visit the manufacturing plants of foreign firms and get first-hand experience on their business practices and processes. Similarly in Portugal, the national SME agency, IAPMEI, implements the Open Days i4.0 initiative, which aims to present the technological capabilities of innovative companies during stakeholder events and promote the sharing of experiences between market actors operating in the same value chain (OECD, 2022[59]). These public events include, in addition to moments of networking and information sharing, visits to the most advanced industrial plants in Portugal, presentations of innovative technologies, exhibitions of technological products and hands-on discussions between business representatives and other market stakeholders.