Nebojša Stojčić, PhD

Assistant professor
University of Dubrovnik
Department of Economics and Business Economics
E-mail: [email protected]

Edvard Orlić, PhD

Bournemouth University
Faculty of Management
E-mail: [email protected]

FOREIGN DIRECT INVESTMENT AND

STRUCTURAL TRANSFORMATION OF EXPORTS

UDK / UDC: 339.727.22

JEL klasifikacija / JEL classification: F21, F23, M16
Izvorni znanstveni rad / Original scientific paper
Primljeno / Received: 30. rujna 2016. / September 30, 2016
Prihvaćeno za tisak / Accepted for publishing: 7. prosinca 2016. / December 7, 2016

Abstract
Sizeable efforts are invested across the globe in attraction of foreign investors.
These activities are motivated with theoretical predictions and empirical evidence
from numerous countries on beneficial effects of foreign direct investment (FDI)
on host economy. Among spillover channels of FDI, one that is particularly
important for open economies is improvement of export competitiveness and
productivity. Through knowledge and technology transfer, integration in parent
company distributor and supplier network and horizontal and vertical spillovers
to other firms in host economy FDI can ease access to international market for
producers from host economy but more importantly the sophistication of their
exported goods and services. The objective of this paper is to explore how FDI
influences structural transformation of exports (improvement in export
sophistication) in short and long run of almost 100 world economies. Evidence
reveals differences in export sophistication between different groups of countries
and point to beneficial effect of FDI on export sophistication.
Keywords: FDI, export sophistication, dynamic analysis

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1. INTRODUCTION
Recent popularity of endogenous growth and new trade models has
pointed to the importance of production structure for growth and development. It
is now taken as stylised fact that specialization in knowledge and technology
intensive commodities offers much higher growth prospects than production of
standardised goods and services. Actions of policy makers across the globe seem
to follow these theoretical predictions. Growth and development strategies of
many nations and supranational associations are built around notion of
knowledge-driven economy. These issues are particularly important for less
developed economies. Structural transformation of production and exports is for
these countries an imperative and precondition of catching up with their
developed counterparts.
The importance of export structure for growth and development has
triggered research on channels for structural transformation of exports. Among
these channels inflow of foreign direct investment (FDI) stands as particularly
important. Recent World Bank data reveals that over 19 billion USD of FDI
inflows have circulated in global economy over past decade. Although majority
of these inflows targeted developed and rapidly developing economies of OECD
and BRIC countries, a substantial amount of evidence from across the globe
witnesses beneficial effect of FDI on enterprise restructuring, export
competitiveness and productivity growth. These effects do not seem accrued
solely to subsidiaries of foreign companies but rather spread throughout the
economy on rivals, suppliers, distributors and all other business entities via
horizontal and vertical spillover channels. For this reason FDI attraction strategies
are ranked high on agenda on economic policy measures in many modern
economies and significant efforts are being invested in attraction of foreign
investors.
Bearing in mind the importance of structural transformation of exports
for growth and development as well as efforts invested in attraction of foreign
investors it is worth to examine whether incentives provided to latter are
warranted and whether countries should continue to pursue structural
transformation of exports through promotion of FDI. To this end, the paper uses
data on 99 world economies over 2007-2015 period to explore how inflow of FDI
influences sophistication of exported commodities. Unlike majority of studies in
the field that determine structure of exports on the basis of available industrial
classifications this paper adopts a more complex approach. The level of export
sophistication is determined with means of an index that reflects productivity
embodied in exported commodities. For this reason, the data on over 5000
commodities at the most detailed 6-digit level of aggregation are used.
The findings of paper offer support to the thesis about positive impact of
FDI on export sophistication. It appears that the complete realization of positive
FDI effects takes place over lengthier period of time. Such finding stands as an
important policy implication for less developed economies on the path of

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catching up with their advanced counterparts. Their ability to initiate FDI-driven

structural transformation of exports shall depend not only on reversal of FDI
inflow trends observed in paper from developed economies but also on
strengthening of local absorptive capacity. The paper is structured as follows.
Next section discusses importance of structural transformation of exports for the
economic development. The relationship between export sophistication and
foreign direct investment is discussed in section three. Fourth section provides
overview of recent trends in FDI and export sophistication while the model and
methodology of investigation are discussed in section five. Discussion of findings
obtained through dynamic panel regression analysis is provided in section six.
Finally, section seven concludes.

2. STRUCTURAL TRANSFORMATION OF EXPORTS

AND DEVELOPMENT
Our study is related to the literature on export sophistication and the
literature of host country effects of FDI. Existing research shows that variety of
goods that a country produces and exports is affected by knowledge spillovers
and specialization (Hausmann et al., 2007; Rodrik, 2006). Specialization and
production and export of goods with higher value added has important
implications for productivity and economic growth. Specialization promotes a
better reallocation of resources from (relatively) inefficient nontradable sectors to
higher productivity export-oriented sectors, while enabling comparative
advantages and increase in domestic production (Andraz and Rodrigues, 2010). A
country’s specialization reflects different structural phenomena such as factor
endowments, economies of scale, technology and productivity gaps and specific
advantages of firms and industries such as the level of innovativeness (Santos-
Paulino, 2010).
The link between country export performance and economic
development has long been analysed by international trade literature. This
literature broadly encompasses two strands. The first strand argues for export
specialization. In the Ricardian model, the levels of technology explain trade and
specialisation patterns between countries (Dornbusch et al., 1977). According to
Heckscher–Ohlin theory country’s factor endowments determine the relative
costs of production and hence the patterns of specialization and the composition
of a country’s export basket. Hence, countries with abundant natural resources are
expected to export natural resources or labour intensive goods. Similarly, more
developed countries are expected to export more sophisticated capital- and
technology-intensive products such as pharmaceuticals, chemicals, automobiles,
and electronic machinery (Schott, 2008). For example, Gaddy and Ickes (2010)
have argued that Russia should focus on exploiting its natural resource base more
efficiently, rather than seek to divert resources toward the development of new
industries.

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Second strand of international trade literature advocates for export

diversification. According to Singer (1950) and Prebisch (1950) concentration on
primary products is subject to commodity shocks, price fluctuations and declining
terms of trade since the income elasticity for primary products is relatively low.
They argue for vertical diversification in manufacturing goods which would
enable higher rates of economic growth. By increasing the number of export
sectors can increase the stability of export earnings and reduce the risks of export
instability (Ferreira, 2009). The additional benefit of export diversification is
related to knowledge spillovers arising from improved production techniques,
new management practices and labour training which can benefit other industries
and improve aggregate productivity (Herzer and Nowak-Lehmann, 2006; Naudé
et al., 2010).
Although diversification is necessary it is not a sufficient condition for
development and economic growth. Rodrik (2007) argues that the share of
manufacturing export matters as well. The increasing share of manufacturing
export in GDP generates stable and well paid employment, reduces inequality and
helps boost domestic demand by increasing purchasing power (Reinert, 2007). In
addition, it is important that countries move towards more sophisticated exports
as countries which export higher value added goods achieve higher rates of
growth (Hausmann et al., 2006).1 Export of more sophisticated goods also leads
to more efficient management practices while stimulating innovation and
technological advance (McCann, 2007). Differences in countries’ ability to
upgrade their production and diversify into complex goods appear to explain why
they progress or remain poor (McMillan and Rodrik, 2011). According to
Hidalgo and Hausmann (2011) numerous and exclusive capabilities are required
to move toward new activities associated with higher productivity levels.
New trade theory has proposed models explaining how developing
countries should benefit from import and foreign advanced technology. Grossman
and Helpman (1994) discuss three main modes of technology acquisition:
learning by doing, investment in research and development, and diffusion and
spillover effects. New growth theory emphasizes that knowledge capital is the
engine and stimulus of economic growth in the long run (Romer, 1990).
Knowledge capital can be created from indigenous knowledge creation or
acquired through the access, transfer, and assimilation of international knowledge
through participation in international trade and openness to FDI (Zhu and Fu,
2013). However, learning and adoption of technology are costly process as the
ability to produce and export goods is determined not only by factor endowments
but also by existing capabilities. In other words, it depends on the ability to
manage technology in an efficient manner (Jarreau and Poncet, 2010).

1
Sophistication “has a multitude of interpretations but it broadly aims to capture the productivity level
associated with a country’s production, empirically mirrored in exports data” (Mishra, Lundstrom, and
Anand 2011, p. 2).

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In contrast with neoclassical theory where technology is easily priced,

codified and imported by producers ready to be exploited, in new trade theory it
is tacit. Moreover, the process of learning new technologies involves the costly
process of learning where the comparative advantage of a country lies and it is
subject to externalities (Hausmann and Rodrik, 2003; Hausmann et al., 2007).
Therefore, Hausmann et al. (2007), Reinert (2007) and Rodrik(2007) argue that
while factor endowments are clearly of considerable importance, government
policy encouraging technology learning and the investment by firms can also
move a country toward more sophisticated export activities citing the example of
East Asian countries. For example, countries behind the technological frontier can
imitate existing technology and national policy should then focus on facilitating
the absorption of technology. However, as argued by Nelson and Pack (1998)
successful technological imitation and absorption also require institutional
innovation.
The above discussion can be summarized as follows. The expansion of
exports alone, without structural transformation of the export sectors may not lead
to sustainable economic growth. This is particularly true if export is concentrated
on few markets and few products leading to potential vulnerabilities in terms of
instability in foreign exchange earnings and investment planning, inflation and
capital flight (Lederman and Maloney, 2002). The advocates of export
diversification argue that the vulnerability of country to external shocks can be
reduced if country diversify its exports across products and markets, either
horizontally or vertically (Harrison and Rodriguez-Clare, 2009). In order to
obtain the benefits associated with export diversification and upgrade technology
content of their export, many countries have attempted to attract FDI. For
example, Rodrik (2006) and Klinger and Lederman (2006) argue that FDI play an
important role in the discovery of new methods and products as well as in
changing the technology content of exports. Next section sheds more light on
expected effect of FDI on export upgrading.

3. FOREIGN DIRECT INVESTMENT AND EXPORT

SOPHISTICATION
The attraction of FDI has often been seen as an important tool in
promoting product upgrades to the country product structure. Moran (2010)
argues that MNCs can act as channels of transformation for the local economies
in which they invest through their contribution to productivity in existing
industries and firms. In addition, they can also bring new ideas and best practices
to start exploring new production activities, that is, they engage in “cost
discoveries” (Hausmann and Rodrik, 2003).
The entry of MNCs is expected to affect export through two main
channels. First channel is direct and associated with quality upgrades of country’s
export structure. MNCs are more export intensive and engage in production of

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more sophisticated and higher quality goods (Iacovone and Javorcik, 2010; Wang
and Wei, 2010). They can contribute to an increase in intensive margin of exports
(rise in export volume of existing products or increase in the number of trading
partners) and extensive margin (rise in the number of export products). Xu and Lu
(2009) find that China’s rising export sophistication is significantly explained by
an increasing presence of foreign owned MNCs. Similarly, Arnold and Javorcik
(2009) show that foreign acquisitions in Indonesia lead to large increases in the
export intensity in the acquired plants. Jayaweera (2009) also reports a positive
association between a rise in the levels of FDI and export diversification using
data on 29 low income countries and employing instrumental variable technique.
Alemu (2008) employed Feasible Generalized Least Squares when examining the
effect of FDI on export diversification and concludes that FDI is the key factor in
speeding up both the vertical and horizontal diversification of exports in East
Asia.
Wang and Wei (2010) developed a proxy for country’s industrial
sophistication, based on data on a country’s export bundle. They develop an
index for a lack of sophistication, called export dissimilarity index (EDI), which
estimates the distance between a country’s export structure and that of high-
income economies such as Japan, the United States and the European Union.
They find that FDI plays no role in increasing the similarity of Chinese exports to
those of advanced countries, even though it contributes to raising the unit values
(quality) of Chinese exports. Exports by MNCs in China (beyond promoting
processing exports) tend to have systematically higher unit values than domestic
firms, suggesting that they produce higher-end product varieties.
Harding and Javorcik (2012) investigated the relationship between FDI
and export upgrading in both developed and developing countries, export
upgrading being measured as unit values of exports measured at the 4-digit SITC
level. Using a sample of 105 countries over the period 1984-2000, they have
obtained evidence of a positive effect of FDI on unit values of exports in
developing countries, but found a mix of evidence for high-income economies. In
addition, by using sector-level equivalent of Rodrik’s (2006) measure of export
productivity (EXPY) and Wang and Wei’s (2010) export dissimilarity index
(EDI) they are not able to find any positive effects on productivity level
associated with the host developing country’s export basket nor improvements in
similarity in export structure between developing and developed countries.
Amighini and Sanfilipo (2014) focused on African economies to explore
whether FDI and imports contribute to upgrading African countries' exports. They
have considered the particular impact of South-South and North-South FDI and
imports. The results suggest that South FDI brings technology that is more likely
to be adopted by host countries and therefore appears to exert a positive and
higher effect on diversification of export baskets of African economies and on the
improvement of export quality of these countries, when compared to the same
flows originating from the North. Recently, Henn et al. (2015) have undertaken
an empirical analysis of the determinants of the growth rate of product quality

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through product-level cross-country panel regressions using new estimates of

export quality based on large sample of 178 countries. They found that export
quality converges over time to the world frontier within any given product line
and improvement in export quality is driven by institutional quality, liberal trade
policies, FDI inflows, and human capital. However, the results vary by sector.
The above results suggest that the effects of FDI on export
diversification and sophistication are far from uniform and depend on
econometric methodology, sample period and sample composition. In addition, in
most studies FDI inflow was used instead of stock. The former are subject to
periodic fluctuations due to changes in FDI policy environment and if not
properly controlled may result in spurious results (Tadesse and Shukralla, 2013).
In addition, assumption of linearity and econometric method used is not able to
capture differences in levels of export sophistication among countries or different
patterns of FDI. For these reasons, Tadesse and Shukralla (2013) took a
somewhat different approach when investigating the impact of FDI on horizontal
diversification. Using two different estimation approaches: a quantile regression
method that accounts for the variation in the diversification among the countries
included in the study, and a semi-parametric method that does not a priori impose
any restriction on the functional form. Results from quantile regression suggest
that the impact of FDI on export diversification to be non-existent or negative,
particularly in countries either at the lower or upper tail of diversification scale
and positive only around median levels. Results from pooled semiparametric
technique suggest that the overall impact of FDI on export diversification is
indeed nonlinear. A relatively larger proportion of the countries where positive or
negative effect of FDI is observed are developing countries.
Apart from direct influence, second channel of FDI impact on country’s
export structure is through various spillovers that facilitate the upgrading of
domestic firms. Since MNCs are more productive, R&D intensive, possess
superior management and marketing skills, know how it is expected that some of
that knowledge and technologies will spill over to domestic firms due to inability
to protect the leakage of knowledge (Caves, 1996). This is expected to influence
export competitiveness of domestic firms in two ways. First, through technology
spillovers which increase the productivity and competitiveness of domestic firms
through two main channels: horizontal and vertical. The former one is related to
demonstration and imitation effects, competition effects and labour mobility.
However, the effects will vary depending on domestic absorption capacity and
production activities of MNCs which should be technology or skill intensive
(Sjoholm, 1999). Another type of technological spillovers is associated with
backward and forward linkages. In backward linkages MNCs are cooperating
with domestic suppliers of intermediate inputs and directly transfer knowledge
about product design, quality control and inventory management and provide
financial and procurement assistance (Zanfei, 2012). In forward linkages,
customers of MNCs can benefit from spillovers and knowledge embodied in
products, processes and technologies as well as improved access to enhanced or

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previously unavailable inputs and products (Jindra et al., 2009). In each of these
cases, a growing presence of foreign firms may improve the quality and diversity
of products offered by local firms. Crespo and Fontoura (2007) indicate that
effects of FDI spillovers depend on a number of factors: the technological gap
between foreign firms and their domestic counterparts, the absorptive capacity of
domestic firms, geography and policy variables related to trade, intellectual
property rights and labour mobility. In addition, the effective occurrence of such
spillovers is conditional on investors origin (Javorcik and Spatareanu, 2011),
inputs sourcing policy (Farole and Winkler, 2014), motivations of investors
(Driffield and Love, 2007).
In addition to technology spillovers, MNCs can generate export
information spillovers relating to export market intelligence, international
marketing know-how and export operations from foreign to domestic firms (Fu,
2011). This can occur thorough either demonstration or worker mobility
mechanisms. Many theoretical and empirical papers show that exporting firms
represent a small fraction of active firms. This is due to sunk costs such as the
establishment of distribution and logistics channels, product compliance with
regulations, market research to acquire information about consumer preferences
and market structure in foreign countries (Fu, 2011). Export information
spillovers from MNCs can lower such costs and enable domestic firms to access
new markets or improve performance on the existing ones. In the export model by
Rauch and Watson (2003) increased concentration of MNCs create learning
effects that may increase the survival probabilities of domestic exporters, since
information on international markets and customers will allow local firms to
make better judgments about the quality of potential new trade relationships.
Krautheim (2012) is one of the few theoretical works on export spillovers, where
proximity to other exporters is assumed to reduce the fixed export cost thanks to
the endogenous formation of informational networks between exporting firms.
However, the effect of FDI on export activities of domestic firms
depends on the type of trade MNCs are engaged in. In case of processing trade,
the entire supply chain and international marketing activities of processed
products is controlled by MNCs while domestic firms are locked in low valued
added and labour intensive activities. This provides limited scope for technology
spillovers because most of the technology is embedded in imported components
while the level of technical expertise is low (Fu, 2011). Moreover, foreign firms
engaged in processing trade activities might be less embedded in local
environment (Mayneris and Poncet, 2013). For example, Milberg (2007) found
that less than 10 percent of inputs is sourced locally in developing countries. In
contrast to technology spillovers, export information spillovers are expected to
have positive effects on export participation of domestic firms. This is due to
lower sunk costs of export market entry in processing industries and the fact that
majority of supply chain activities are controlled by foreign firms. However, if
foreign firms engage in processing activities themselves the competition effects
arising from better availability of inputs and other high quality components may

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exert strong crowding out effects on domestic firms (Fu, 2011). Further,
increased local labour demand due to the expansion of multinational operations
raises production costs as local wages rise. Hence, as FDI spillovers are
transmitted through a variety of channels their overall effects can only be
assessed through empirical analysis.
While number of studies has engaged in analysis of FDI productivity
spillovers, relatively few of them investigated export spillovers. In a seminal
work, Aitken et al. (1997) show that export propensity of domestic firms is
positively associated with proximity to MNCs. This has also been confirmed by
Kneller and Pisu (2007) for UK market. Banga (2006) finds that US FDI flows to
India have a statistically significant positive impact on the intensity of the Indian
manufacturing exports. By contrast, Barrios et al. (2003) do not find clear
evidence of export spillovers from foreign firms in Spain, while Ruane and
Sutherland (2005) find that the export intensity of foreign owned firms is
negatively correlated with the export decision and export intensity of domestic
firms in Irish manufacturing. Several studies related to China argue that foreign
firms engaged in processing trade activities have an important role in the skill
content upgrading of China’s manufacturing exports (Amiti and Freund, 2010;
Xuand Lu, 2009). On the other hand, Jarreau and Poncet (2012) find that the
positive association between GDP per capita growth and export sophistication at
the province level is limited to ordinary export activities undertaken by domestic
firms.
Although, there may not be direct gains from foreign export upgrading,
Mayneris and Poncet (2013) argue that there is considerable gain from export
spillovers. Swenson (2008) and Chen and Swenson (2014) relate the probability
of export of domestic firms and presence of MNCs and found that MNCs
enhanced export capabilities of domestic firms mainly via information spillovers.
Mayneris and Poncet (2013) took a step further and analysed domestic firms’
capacity to start exporting new varieties to new markets and found a positive
relationship with activity of neighbouring foreign firms. Foreign export spillovers
are also found to emanate mainly from ordinary trade activities. In a similar
study, however, Poncet and De Waldemar (2013) using panel data on Chinese
cities and export sophistication index developed by Hidalgo and Hausmann
(2009) found no direct gains emanating from the complexity of goods produced
by either processing-trade activities or foreign firms. They interpret these results
as evidence of lack of local embeddedness and structural and geographical
disconnections between ordinary activities and those based on imported
technology and foreign firms.

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4. TRENDS IN FOREIGN DIRECT INVESTMENT AND

EXPORT SOPHISTICATION
Globalization of economic activity has facilitated the flow of capital
between countries. According to recent World Bank figures, the inflows of FDI at
global level exceed 19 billion US dollars (USD) over 2007-2015 period. The
largest proportion of this inflow went to high and middle income countries
(Figure 1) with less than 1% of world FDI inflow being directed to low income
economies.

Figure 1 Foreign direct investment inflow by income level of recipient countries

2007-2015
Source: World Bank WDI database

The greatest recipients of FDI when one observes groups of countries

over this analysed period were OECD member states and BRIC (Brasil, Russia,
India and China) countries which together accounted for 77% of total world FDI
inflows. The concentration of FDI in small number of countries is even more
evident if one notes that the USA and European Union alone received almost half
of total world FDI over mentioned period.

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Figure 2 Biggest recipients of FDI 2007-2015

Source: World Bank WDI database

In a parallel development, the world has witnessed an increase in

international trade. Compared to its 2007 levels, the exports of goods and services
increased for almost a quarter (Figure 3). The developments with respect to
exports have partially followed those observed in previous FDI analysis. About
98% of exports of goods and services in terms of value originated from high and
middle income countries.

Figure 3 Share of world exports value in goods and services 2007-2015

Source: World Bank WDI database

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The value of exports is frequently associated with its quality. It is

generally considered that more sophisticated goods bear higher value added and
thus can be delivered to global market at higher price. The concept of exports
sophistication has been much debated over recent years. Widespread approach is
based on the classification of industries (sectors) by their intensity of technology
in case of manufacturing and knowledge intensity when it comes to services.
However, the cross-country division of production chain means that product
components of different value are being produced and assembled across number
of countries. The consequence of such vertical division of production chain is that
certain product components of low added value can be categorised as products of
high technological intensity and thus not reveal true level of export sophistication
from a given country.
Another approach to analysis of export sophistication was recently
introduced by Hausmann, Hwang and Rodrik (2007). The underlying premise of
export sophistication index developed by these authors is that all products traded
at global market embody certain level of productivity. Through ranking of goods
and services by their embodied productivity it is possible to derive an index of
export sophistication that is more accurate than information obtained on the basis
of industrial classification. Supposing that the overall exports of country j
consists of n goods the total export X of country j can be written as:
=∑ (1)
The productivity level associated with given good i produced by n
countries can be constructed as:

=∑ ∗ (2)
∑

In (2) the numerator reflects share of each individual good in total

exports of each country. The denominator is aggregate of these shares across all
countries exporting particular good. Hence, this part of expression presents a
revealed comparative advantage of each country in good i. The revealed
comparative advantage is multiplied with GDP per capita of each country
exporting given good. The overall index of productivity embodied in good i is
then constructed as aggregate of weighted GDP per capita across countries where
revealed comparative advantages are used as weights. Hausmann, Hwang and
Rodrik (2007) note that such construction of index eliminates the effect of
country size as it weights country’s income more heavily for those countries
exporting larger proportions of each given good.
As noted previously, the productivity embodied in particular goods can
be used to construct country-wide index of export sophistication. Let export
basket of country j consist of n goods. From there the export sophistication index
can be calculated as:

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=∑ (3)

In equation (3) export sophistication index is weighted sum of

productivity embodied in each exported product where shares of individual
products in total export basket of country j are used as weights.
The accuracy of previously described index depends on the level of
aggregation at which products are defined. At lower levels of aggregation the
accuracy of the index will be higher than at more aggregate levels that encompass
wider group of goods and services. For the purpose of this paper data is obtained
from United Nations Comtrade database at 6-digit Harmonised System (HS)
commodity classification. More than 5000 commodities are assigned code at this
level. The data was obtained for 99 countries for which information was available
throughout an entire period of analysis.

Figure 4 Export sophistication and GDP per capita 2007-2015

Source: Authors calculations

The visual analysis of EXPY index in Figure 4 reveals interesting fact.

The plot of EXPY against GDP per capita of analysed countries makes it clear
that highest values of index are found in more developed countries. Such finding
supports common thesis that producers from less developed countries are
specialised in less sophisticated goods while their counterparts from more
advanced economies export knowledge and technology intensive goods which
fall under umbrella of sophisticated exports. How does EXPY relate to FDI

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inflows? Figure 5 provides plot of export sophistication index against FDI inflow
over analysed period. The Figure reveals positive relationship between two even
though the observed relationship can be driven with few outliers (China, USA,
Netherlands).

Figure 5 Export sophistication and FDI 2007-2015

Source: Authors calculations

To further investigate the relationship between FDI and EXPY,

suspected outlier observations are excluded from analysis. Here, the positive
relationship between the two becomes even more visible (Figure 6). More
importantly, it is evident that all countries belonging to group of developed or fast
developing countries are characterised with higher values of both FDI and EXPY.

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Figure 6 Export sophistication and FDI 2007-2015 (without outliers)

Source: Authors calculations

Overall, these findings suggest that highest level of productivity and thus
sophistication is embodied in goods and services exported by more developed
countries and countries that are highest recipients of FDI. it is likely therefore that
spillover channels of FDI such as knowledge and technology transfer from parent
company to its subsidiary, easier access to logistic networks of parent company
and vertical and horizontal spillover effects on the rest of economy have
beneficial effect on overall level of export sophistication from a given country.
The rest of paper explores this issue in more detail with means of econometric
analysis.

5. MODEL OF INVESTIGATION AND

METHODOLOGY
To investigate the impact of FDI inflows on export sophistication a
model is developed in the form:
= + + + + +
+ +∑ + + (4)

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where the dependent variable is defined as the natural logarithm of

previously defined export sophistication index EXPY. The right hand side
includes lagged value of dependent variable. The inclusion of this variable is
motivated with intention to control for dependence between the current values of
EXPY and its past realizations. It can be expected that due to the learning by
exporting effect and the lengthy process of export upgrading the improvements in
export sophistication take place over longer period of time. The key variable of
interest in the model is the FDI, the percentage of net foreign direct investment
inflow in GDP of country i in year t. As noted previously, it is expected that the
intra-firm knowledge and technology transfer, access to logistic network of parent
company as well as vertical and horizontal spillovers to rivals, suppliers,
distributors and other firms in the host economy all together pave the way for
beneficial effect of FDI on the export sophistication. The variable enters model as
two year lagged value. The reason for this is the fact that the impact of FDI
spillovers on export sophistication takes place over time rather than being
instantaneous. Furthermore, through inclusion of variable in two year lagged
form a potential endogeneity due to correlation between variable and
unobservable time-invariant component of the error term is mitigated. A positive
sign is expected on this variable.
The model also includes several control variables recognised as potential
determinants of export sophistication. The level of GDP per capita in form of
natural logarithm is intended to control for the level of development. In line with
earlier literature a positive sign can be expected on this variable. We also include
natural logarithm of the share of imports in GDP. Higher share of imports could
affect domestic demand and alter consumer preferences towards more
sophisticated goods which will have beneficial effect on export sophistication. In
a parallel development, higher share of imports can also signal higher proportion
of intermediate goods used in production of final goods and services that can later
be used as exports. In case of more sophisticated exports a positive sign can be
expected on this variable while opposite may hold for countries specialized in
standardised goods. For this reason, there is no a priori expectation on the sign of
this variable. Two categorical variables are included to control for groups of
countries identified in earlier part of paper as highest recipients of FDI on global
level, namely OECD and BRIC countries. A positive sign is expected on these
variables as well. Finally, the model includes set of annual dummy variables to
control for universal cross-sectional shocks.
The estimation is undertaken with the means of dynamic panel system
estimator econometric technique (Arellano and Bover, 1995; Blundell and Bond,
1998). The advantage of such methodology is possibility of control for short and
long run effects of regressors on regressand, the modelling of dynamics of
dependent variable as well as the ability to control for potential unobserved
correlation between the dependent variable and unobserved time-invariant
components of disturbance. In the estimation, Windmeijer correction was used for

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downward biased standard errors. All variables for which such transformation
was possible enter model in logarithmic form.

6. FINDINGS FROM REGRESSION ANALYSIS

The starting point in regression analysis was investigation of model
validity. Several tests are conventionally used to establish whether obtained
findings can be considered valid or not. Table 1 provides diagnostics on several
of these tests. Starting with Hansen J test it can be seen that there is insufficient
evidence to reject hypothesis about the validity of instruments. From m1/m2
Arellano-Bond tests one can identify existence of first order autocorrelation but
the lack of second order autocorrelation. The number of instruments is several
times smaller than the number of groups (in our case countries) and the Wald test
rejects hypothesis about joint insignificance of explanatory variables. Overall,
one can say that model diagnostics provide support to the chosen model.

Table 1
Model diagnostics
Diagnostics Value
Number of observations 792
Number of groups (countries) 99
Number of instruments 19
Wald test 3169***
Hansen J test (p>chi2) 5.31 (0.38)
Arellano-Bond test first order (p>chi2) -2.94 (0.00)***
Arellano-Bond test second order (p>chi2) -0.79 (0.43)

Source: Authors calculations

***,** and * denote statistical significance at 1%, 5% and 10% level respectively

Turning to obtained results, a positive and significant coefficient is

obtained on the lagged dependent variable. It suggests that an 1% increase in the
value of export sophistication index in the past explains about 0.5% of its
increase in the current period. Such finding can be considered as an evidence of
relationship between current export sophistication and its past realizations and
another evidence in favour of thesis about time requirement for improvement in
the structure of exports. Our most important variable, however, is the share of
foreign direct investment in GDP of country which enters model in original form
due to negative values on some observations. Overall, the increase in share of

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FDI in GDP for 1% leads to the 0.02% increase in the export sophistication. The
effect is more than two times greater in the long run. We can conclude from there
that all previously described channels of FDI for improvements in export
sophistication are functional.

Table 2.
Results of estimation
Variable Short run Long run
Lagged dependent variable 0.52*** -
FDI 0.0002** 0.0005**
GDPpc 0.14*** 0.29***
Imports share 0.03* 0.07**
OECD 0.03 0.06
BRIC 0.18** 0.38***
Constant 3.29*** -

Source: Authors calculations

Note: ***, **, * denote statistical significance at 1%, 5% and 10% level
respectively; p-values estimated with two-step dynamic panel estimator with
Windmeijer robust standard errors corretions. Annual time dummies included.

Among control variables positive sign is observed on both level of GDP

per capita and share of imports in GDP. The former suggests that more developed
economies have higher levels of export sophistication. Such finding is somewhat
expected as investment in high technology intensive or sophisticated goods
requires sizeable financial, human and capital resources which are difficult to
obtain for less developed economies. The positive coefficient on the share of
imports in GDP can be interpreted as an evidence of both the indirect impact
through changes in preferences of domestic consumers and the role of reexport in
improvements in export sophistication. Finally, among control variables for
groups of countries only control for BRIC group is positive and significant.

7. CONCLUSION
Growth of modern economies is closely related to their performance on
international market. It is argued by many academics nowadays that the structure
of export basket is behind faster growth of some economies than others. The
premises of endogenous growth theory and new trade models have taught us, if
anything, that knowledge and technology intensive commodities embody higher
levels of productivity and sophistication that manifests itself in their added value.

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These predictions have found their place in modern economic policies as well.
Across the globe, policy makers invest significant effort in building of
knowledge-driven economies and promotion of knowledge-driven, sophisticated
exports hoping that such strategies can pave way to higher growth rates and better
standard of living of their citizens. Among strategies for upgrading of exports
particularly important place belongs to attraction of foreign direct investment. It
is considered that knowledge and technology transfer as well as horizontal and
vertical spillovers to other firms and industries have beneficial effect on structural
transformation of exports and building of international competitiveness.
Bearing in mind the importance attached to structural transformation of
exports and efforts invested in attraction of foreign investors by policy makers
around globe the objective of this paper was to explore whether incentives
provided to FDI are warranted with respect to its impact on export sophistication.
Our findings reveal positive influence of FDI on improvements in export
sophistication. It was also established that this process takes place over time with
its full effects being visible only in the long run. Such findings provide support to
efforts of all those policy makers aiming to facilitate structural transformation of
their exports and encourage economic growth through attraction of foreign direct
investment. The importance of these findings is particularly pronounced in case
of less developed countries that struggle to catch up with their more developed
counterparts. Yet, as our evidence reveals majority of FDI inflow is concentrated
in few highly developed and rapidly developing economies. The reversal of this
trend remains challenge that needs to be addressed for diminishing of
development differences in global economy.

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Dr. sc. Nebojša Stojčić

Docent
Sveučilište u Dubrovniku
Odjel za ekonomiju i poslovnu ekonomiju
E-mail: [email protected]

Dr. sc. Edvard Orlić

Bournemouth University
Faculty of Management
E-mail: [email protected]

IZRAVNE INOZEMNE INVESTICIJE I STRUKTURNA

TRANSFORMACIJA IZVOZA

Sažetak
Stvaraoci ekonomske politike diljem svijeta ulažu značajne napore u privlačenje
inozemnih investitora. Te su aktivnosti motivirane teoretskim predviđanjima i
empirijskim dokazima iz brojnih zemalja o pozitivnim učincima izravnih
inozemnih investicija (FDI) na gospodarstvo zemlje primatelja. Među učincima
prelijevanja FDI-ja za otvorena gospodarstva osobito je važan utjecaj na
poboljšanje izvozne konkurentnosti i proizvodnosti. Prijenos znanja i tehnologije,
integracija u distribucijsku i dobavljačku mrežu matičnog poduzeća te
horizontalni i vertikalni učinci prelijevanja na druga poduzeća olakšavaju pristup
poduzećima iz zemlje primateljice FDI-ja na međunarodno tržište te unapređenje
sofisticiranosti njihova izvoza. Cilj je ovog rada istražiti kako izravne inozemne
investicije utječu na strukturnu transformaciju (poboljšanje sofisticiranosti)
izvoza više od 100 svjetskih gospodarstava u kratkom i dugom roku. Rezultati
istraživanja upućuju na postojanje značajnih razlika u sofisticiranosti izvoza
između pojedinih skupina zemalja te na pozitivan utjecaj FDI-ja na
sofisticiranost izvoza.
Ključne riječi: izravne inozemne investicije, sofisticiranost izvoza, dinamička
analiza
JEL klasifikacija: F21, F23, M16

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