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Publisher : Elsevier - Science Direct (الزویر - ساینس دایرکت)
Journal : International Review of Economics & Finance, Volume 15, Issue 3, 2006, Pages 346–363
This paper analyzes the effects of exchange rate volatility of both the host country and the parent country on host-government policy related to local content requirement (LCR) on export-oriented foreign direct investment (FDI) in the context of an oligopolistic market in a third country. We, inter alia, find that an increase in the volatility foreign exchange rate decreases optimal LCR both under free entry and exit of foreign firms and when the number of foreign firms is fixed. We also find that the government uses a less strict LCR policy when the number of foreign firms is endogenous than when it is exogenous.
Over the last two decades, the world economy has witnessed a dramatic increase in direct investments by transnational corporations (TNCs), and also a radical change in the conception about the benefits of foreign direct investment (FDI). In fact, FDI has grown significantly faster than trade flows, particularly among the world's most developed economies, and according to UNCTAD (2000) the combined inward and outward FDI stocks made 31.7% of global GDP, and FDI's export accounted for 46% of global exports of goods and non-factor services in 1999. The new generalized view about FDI has moved governments to dismantle many barriers in order to attract foreign investment. However, some recurrent practices of intervention and a number of important qualifications proposed by trade researchers have led over recent years to an abundance of theoretical and empirical research which examines this issue, using a diverse range of analytical approaches. Different economic models have been constructed to analyze the effects of a wide range of policies on TNC behavior and on host country welfare. These models point out the interrelationships between different economic variables and issues such as labor demand, income distribution, market-share rivalry, technology spillover effects, environment degradation, etc. However, the study of FDI behavior under conditions of uncertainty has not had the same degree of attention. This paper attempts to contribute to the theoretical literature in this direction. The main objective of this paper is to examine the behavior of TNCs and a host government when the latter applies local content (or sourcing) requirements (LCR) on foreign firms under conditions of uncertainty about exchange rates. LCR becomes an issue when a firm establishes operations abroad but buys most of inputs from the firm's ‘home’ base, thus failing to build interdependent or complementary linkages in the host country. Under such situations, LCR may have desirable domestic welfare effects, since this policy could help to raise employment level and economic growth in the host country.1 Two points need to be noted here. First, a stricter LCR policy may drive some TNCs out of the country and thus reduce employment and growth. Second, in the presence of competing domestic firms, a host government may use LCR as a strategic instrument as these requirements are limited to foreign owned firms producing in the host country and thereby give local firms a competitive advantage. Our model which is based on an imperfectly competitive market for a final good, analyzes the impact of LCR on employment level. A number of foreign firms compete with domestic firms for the oligopolistic market of a homogeneous good in a third consuming country. Thus, FDI in this paper is purely export-oriented. Furthermore, in making its policy decision, the host government takes into consideration the effect of uncertainty of exchange rate variations on the variables of the model. The relevant literature can be divided into two categories. The first category considers the relationship between FDI and LCR. An early analytical contribution is Grossman (1981) who, under a partial equilibrium framework with a competitive firm, finds that LCR raises the price of the domestic input, thus benefiting input suppliers but harming the final-good producer.2 Later, Richarson (1993) showed that, under a general equilibrium framework, LCR may induce foreign firms to invest in the input-producing sector, and therefore the price-raising effect of LCR could be mitigated to some extent. The second group of studies is about the relationship between FDI and exchange rate uncertainty. The effects of exchange rate uncertainty on FDI have been examined, among others, by Cushman (1985), Goldberg and Kolstad (1995) and Hongmo and Lapan (2000). The scope of the papers is restricted to the analysis of the effects of uncertainty on TNC decisions such as where to buy inputs, where to produce and where to sell output, and where to finance capital acquisitions from. Kenneth (1990) examines how a TNC can potentially contribute to the explanation of excessive exchange rate volatility, through their ability to move capital.3 However, none of these papers analyze the issue of LCR. The model most directly relevant for the present one is that in Lahiri & Ono, 1998 and Lahiri & Ono, 2004.4 They develop a partial equilibrium model where the number of domestic firms is fixed but the number of foreign firms that locate themselves in the host country is endogenous. The two sets of firms compete in the oligopolistic market for a non-tradeable homogeneous good in the host country. The host government uses LCR and profit taxation to maximize welfare which is affected by both employment and the price of the good. Optimal LCR is low when foreign firms are significantly more efficient than domestic firms, and when the domestic industry is highly oligopolistic. Here the effect of lower prices dominates the effect on employment. Optimal LCR is higher when foreign firms are inefficient relative to domestic firms, and when the domestic industry is highly competitive. In this case, the employment effect is dominant. Finally, when the LCR is zero (i.e., no employment effect), optimal policy is to subsidize FDI if the domestic industry is highly oligopolistic, to obtain benefits of lower prices.5 Like Lahiri & Ono, 1998 and Lahiri & Ono, 2003, we analyze optimal LCR policy. However, there are a number of important differences. Most importantly, unlike them we consider exchange rate volatility. Second, unlike Lahiri and Ono, in our analysis consumers' surplus is absent as FDI is purely export oriented. In addition, unlike Lahiri and Ono, we do not consider another producing country and strategic interaction with it. An important part of our analysis is to examine the role of free and exit of foreign firms on optimal policies and how that interacts with exchange rate uncertainty. One of our findings is that an increase in the volatility foreign exchange rate increases optimal LCR under both free entry and exit of foreign firms and when the number of foreign firms is fixed. We also find that the government uses a less strict LCR policy when the number of foreign firms is endogenous than when it is exogenous. The lay out of the paper is as follows. The formal structure of the model is spelled out in the next section. The effects of exchange rate uncertainty on equilibrium variables are examined in Section 3. Section 4 is concerned with optimum public policy with respect to LCR. The last section offers some concluding remarks.
نتیجه گیری انگلیسی
The aim of this paper has been to investigate the implications of exchange rate volatility on optimal local content requirement (LCR) on foreign firms in an oligopolistic market setting. Two main issues have been addressed in this paper. First, we have examined how changes in the volatility of exchange rates affect the equilibrium quantities and price. Second, we have characterized optimum host-government policy on local content requirement and examined how it is affected by exchange rate volatility. Uncertainty in exchange rates generates extra costs, and firms have to adjust outputs appropriately. The costs are incurred on two fronts: via revenue and via unit costs of production. The effects via the revenue channel are symmetric. A firm's exports are affected negatively if the volatility of domestic exchange rate increases, but positively if it increases. Furthermore, when the number of foreign firms is endogenous, a higher domestic exchange rate volatility makes the market more competitive by increasing the inflow of FDI. However, if foreign exchange rate volatility increases, the number of foreign firms falls. The effect via the second channel is not symmetric, as an increase in the volatility of either exchange rate increases the unit cost of production of each foreign firm (which imports some of its inputs from the host country) but does not affect the unit cost of domestic firms (which buy all their inputs domestically). Because of this, the volatility of domestic exchange rate has ambiguous effects on output levels and the number of firms, but as far as the foreign exchange rate is concerned, the effects via the revenue channel is reinforced by that via the costs channel. For the same reasons, an increase in the volatility of domestic exchange rate has an ambiguous effect on optimal LCR. However, an increase in the volatility of the foreign exchange rate unambiguously decreases optimal LCR. The qualitative results are the same whether the number of foreign firms is exogenous or endogenous. However, optimal LCR is unambiguously lower when there is free entry and exit of foreign firms than when the number of foreign firms is exogenous.