Introduction

CHAPTER 4

Knowledge Connectivity in South Asia and Its Impact on Outward Foreign Direct Investment

Introduction

Making decisions about engaging in international trading or undertaking international investments is difficult. Entrepreneurs need information about markets and potential partners in unfamiliar locations to take calculated risks. In developing economies, frictions in the flow of information and knowledge could be even more important obstacles to trade and investment than traditional trade frictions (Atkin and Khandelwal 2019). These knowledge frictions reflect the high costs of search and matching across borders and the high costs of market failures in the provision of channels or technologies with which to alleviate these frictions. Acknowledging the important role of knowledge connectivity, separate from other forms of traditional connectivity, is important because policies that reduce information frictions differ substantially from policies that reduce traditional trade costs.

The research presented in this report builds on the nascent understanding of the role of information for trade, with an application to the foreign investment decision. Although the importance of information barriers has been recognized (Anderson and van Wincoop 2004), international economists are just beginning to quantify the power of information (see Dickstein and Morales [2018] on exporters). For example, it is accepted that information about a prevailing price in a distant market acts as a demand signal for certain products (Allen 2014; Steinwender 2018);1 and information frictions lead to knowledge spilling over from foreign affiliates of multinational enterprises only

to domestic input suppliers (Javorcik 2004). Further, knowledge intermediaries may not exist, even though experiments show that firms benefit from their presence. For example, intermediaries that connect producers to foreign buyers or those that provide productivity-enhancing management practices improve productivity and profits, yet wholesalers take expensive international flights in search of innovative products, even with an established supplier abroad (Atkin, Khandelwal, and Osman 2017; Bloom et al. 2013; Pietrobelli and Staritz 2018).

This analysis relates to information and knowledge flows, which have been studied extensively in international business management. It includes interfirm information sharing; knowledge flows within a multinational enterprise between headquarters, foreign affiliates, and domestic affiliates; and knowledge flows among partners along a value chain (Szulanksi 2003).2

Information and knowledge connectivity are also related to trust, and it is this combination that could overcome contracting frictions in weak regulatory environments abroad. The importance of trust in trading and investment relationships has been documented (Arrow 1973; Da Rin, Di Giacomo, and Sembenelli 2018; Guiso, Sapienza, and Zingales 2009). Further, networks that reduce both matching and contracting costs increase bilateral trade flows, as documented for Chinese ethnic networks (Rauch and Trindade 2002).3 Thus, a lack of information and trust could lead to a dearth of the kinds of networks and relationship building that are needed for cross-border engagement. This concept also has implications for the development of cross-border value chains that rely on relational contracting and trust.

The case study research on regional pioneers provides unique insights into how entrepreneurs make investment decisions and the types of information important for them in forming expectations of profits to be earned in a foreign destination. These insights are used in this chapter to investigate the foreign investment participation decision.

Understanding the foreign direct investment (FDI) entry decision is vital because it is likely to drive much of the variation in investment volumes for most economies. FDI has relatively high fixed entry costs, which makes it less reversible and therefore a more stable form of foreign engagement compared with trade and portfolio investment.4 Thus, to predict how investment flows will change as a result of policy reform and changes in the investment climate, understanding the firm’s decision of whether to invest abroad is important.

This chapter presents the results of an econometric estimation of the outward investor entry decision, keeping in mind the simple framework on investment entry among heterogeneous firms outlined in chapter 2, the nature of South Asian investments, the investment policy landscape discussed in chapter 3, and the importance of information and networks distilled from case studies of investment pioneers. The collection of original data specifically for this report allowed the compilation of information and network-related variables that are not typically available in a standard data set. As in the simple framework for investment entry, information, networks, and trust are

analytically separated from traditional trade costs related to trade policy, trade facilitation, and transportation infrastructure. Information and networks are analyzed as primarily affecting the firm’s fixed entry costs of investing in a particular destination.

The chapter offers five findings on knowledge connectivity and learning as well as results on other factors important for outward investment by South Asian firms:

• Having knowledge connectivity, in the form of networks abroad, is important for investment entry.

• For services firms, knowledge connectivity may be more important than improving productivity.

• Investors were previous exporters, suggesting that exporting offers informational gains that reduce uncertainty and the fixed cost of investment entry.

• Information flows from related firms in business groups are also likely to induce investment by follower firms.

• Unrelated follower firms may face “sticky knowledge” or frictions in learning from knowledge spillovers from competitor pioneer firms.

Other results show that outward investment pioneers are large, high-productivity firms with surplus investible funds. They tend to invest closer to their home base, as reflected by the negative influence of trade costs on entry. Although the relationship between trade costs and investment is theoretically ambiguous, the results suggest that reduced trade costs would directly increase the probability of investing, and would also indirectly, through increased exporting, increase the probability of investing. This confirms the importance of both physical connectivity and digital connectivity. Investing firms tend to have founders or chief executives with high risk appetites. National policy factors, including a restrictive outward FDI (OFDI) policy and investment climate, are embedded in the fixed effects of the model.

The rest of the chapter is organized as follows: The next section uses the data on information and social capital collected from the South Asian Regional Engagement and Value Chains Survey to explore variation in average knowledge connectivity, networks, and trust across 56 bilateral pairs of countries in South Asia. Having established the existence of a knowledge connectivity problem and sufficient variation across bilateral pairs, the subsequent core section presents the results of an empirical estimation of the determinants of investment entry that incorporates information-related variables. Separate estimations are performed for three types of investments: trade-supporting services (such as representative offices), services operations, and goods production. A dynamic analysis of postentry behavior follows the key results. The penultimate section examines the key channels of awareness for the private sector, with a view to providing an understanding of the most appropriate way to contend with information barriers. The last section concludes.