Intangible assets, internalisation and foreign production: Direct investments and licensing in...

Intangible Assets, lnternalisation and Foreign

Production: Direct Investments and Licensing

in Indian Manufacturing

By

Nagesh Kumar

C o n t e n t s : I. Introduction. - II. Theory and Hypotheses. - I I I . Empirical Analysis. - IV. Conclusions. - Appendix.

I. Introduction

T he increasing replacement by arm's length licensing' of foreign direct investments (FDI) as a major mode of foreign production in the period following the mid-1960s led to the development of the intemalisation

approach. The ownership of intangible assets which largely explained FDI in the early post-war period due to imperfections in the external markets for these assets [h la Hymer, 1960; Kindleberger, 1969; Caves, 1971] was no longer considered to be adequate reason for undertaking foreign production through FDI [Dunning, 1985]. According to the new theory FDI would be a preferred mode of foreign production only if the external markets of intangible assets in question are subject to high transaction costs and hence internalisation incentives are present [Buckiey, Casson, 1976; Dunning, 1981, Ch. 4; Rugman, 1981; 1982]. In other cases the licensing may be the prime modality. FDI in host countries should, therefore, be found concentrat- edin those branches of manufacturing where intangible assets characterised by high transaction costs provide competitive edge to the owning finn. If the assets with relatively low transaction costs are the source of competitive edge, the licensing should be the preferred mode of foreign involvement in the industry.

A rigorous test of these predictions has not yet been possible, perhaps due to the difficulty in classifying the intangible assets between those with high

Remark: The author benefitted from extensive discussions with and advice of N.S. Siddharthan and comments of ].H. Dunning, A.M. Rugman, V.R. Panchamukhi, K.L. Krishna, S.]. Patel, H. Katrak and EB. Nayak on an earlier draft. The author alone is responsible for the remaining errors and views expressed.

' Licensing in this paper refers to all those contractual agreements between business firms of two countries involving the transfer of some intangible asset such as right to use brand name, patent, transfer of technology, turnkey plant construction in which the licensor does not hold controlling shares (defined to be 25 per cent or more of the voting stock).

326 Nagesh Kumar

and low internalisation incentives 2. This paper makes an attempt to classify the broad categories of intangible assets on the basis of relative transaction costs which may be involved in their potential market transfer. It then examines whether they are able to explain the variation in the intensities of FDI and licensing across 49 (3-digit) Indian manufacturing industries according to the predictions of the theory.

The plan of the paper is as follows: Section II adapts the contemporary theory of foreign operations into a more simple and testable form. It also seeks to classify the intangible assets on the basis of relative transaction costs. Section III presents the empirical analysis. Section IV summarises and concludes the paper.

H. Theory and Hypotheses

According to the intangible assets approach of horizontal foreign expansion of firms originally put forward by Hymer [1976], Kindleberger [1969] and Caves [1971; 1974], a firm operating abroad must possess advantages which are adequate enough to more than offset the handicaps to be faced in an alien atmosphere and to cover the greater risks. These advantages are often referred to as monopolistic advantages and emanate from ownership of some proprietary intangible assets possessed by firms such as goodwill in the form of brand names, technology patented or otherwise, managerial and marketing skills, access to cheaper sources of capital and raw materials etc. In the first phase of the "product cycle" the advantages are exploited abroad through exports from the country of origin [Vernon, 1966]. In the second phase local production through FDI is undertaken because locational advantages which make it more profitable than exports start emerging. These advantages emanate from factors such as the tariffs and quantitative restrictions imposed on imports by host countries, communication and transport costs, inter-country differences in input/factor prices and productivity etc. FDI should, therefore, be found concentrated in those branches of manufacturing where the intangible assets complemented by locational factors are important a. Because of imperfections ih the markets for knowledge, the ownership and locational advantages c~ ld usually provide sufficient condi-

2 Telesio [1979], Contractor [1984], Davidson, McFetridge [1984; 1985] have attempted to analyse the role of firm characteristics, host country and industry factors, and characteristics of technology and host government policy respectively in explaining the choice between FDI and licensing as a mode of foreign operation by U.S. MNEs.

3 A number of studies explaining industry distribution of intensity of FDI in host countries have tested this hypothesis e.g. Caves [1974a] in Canada and the U.IC; Caves et al. [1980], Saunders [1982], Owen [1982], and Gupta [1983] also in Canada; La[l, Mohammad [1983] in India; LaU, Siddharthan [1982] in the U.S. Baldwin [1979], Bergsten et aL [1978], Pugel [1981], and Lall [1980] have used a similar framework to explain industry variation in outward FDI from the U.S.

lnternalisation and Foreign Production 327

tion for FD] flows during the early post-war period. In the period following the late 1960s the standardisation of a wide variety of technologies and hence increasing competition coupled with improved bargaining position of host country governments provided arm's length licensing of intangible assets as an alternative to FDP [Dunning, 1983]. Mere ownership of intangible assets and presence of locational advantages were no more sufficient, though still necessary, conditions for FDI. These developments, therefore, led to a new stream of theorising which makes FDI conditional to presence of ownership, locational and intemalisation advantages as necessary and sufficient conditions. After the initial proposition by McManus [1972] and Buckley, Casson [1976], the internalisation approach has been enriched by the contributions of Dunning [1981, Ch. 4], Magee [1977], Rugman [1981], Teece [1981; 1983], Williamson [1981], Casson [1979], Caves [1982], and Hennart [1982]. The approach draws from the market failure and information asymmetry hypotheses of Coase [1937], Arrow [1962], and Williamson [1975]. The (external) markets of intangible assets are often inefficient channels of their transfer because of a number of infirmities which emanate from the characteristics of the intangible assets. Firstly, because of their public goods like nature marginal cost of their use elsewhere is close to zero and hence these are inefficiently priced [Magee, 1977; Caves, 1982, p. 5]. Secondly, a severe information asymmetry exists which results from the inability of the seller to make a convincing disclosure about the intangible asset [Williamson, 1981]. This is particularly true in case of unpatented process know-how. Thirdly, the unaffiliated firms abroad may fail to recognise the productive potential of technological developments taking place in a country [ibid.]. Fourthly, there may be buyer's uncertainty about the claims of the supplier about the potential value of the intangible asset [Caves, 1982]. Fifthly, there may be problems with codification of knowledge. Certain kinds of knowledge may be embodied in the skills of personnel or may have a high "tacit" component [Teece, 1981; 1983]. Finally, arm's length market may fail to ensure uniform quality standards which are important particularly in the case of transfer of goodwill assets like brand names [Giddy, Rugman, 1979]. These infirmities lead to high cost of market transactions (transaction or governance costs) of the intangible assets. Firms tend to avoid these costs by using internal markets, in other words, by internalising the transactions of the intangible assets. Firms which internalise transactions across the national boundaries through FDI become multinational. Foreign investments under this theory, therefore, are a special case of horizontal expansion [Buckley, Casson, 1976; Hennart, 1982]. Internalisation eliminates transactions and hence their costs. However, there are certain costs associated with it. Firstly, coordination of

4 Buckley, Davies [1981] provide evidence of licensing fast gaining significance as a mode of foreign production by British firms in the 1970s,

Wr Archly Bd. CXXIII. 9

328 Nagesh K u m a r

manufacturing units located in geographical areas separated by national boundaries entails certain information costs. Secondly, the host country government policy may have a discriminatory treatment to the enterprises under foreign control and hence there may be certain "political" costs. In addition there are administration costs of internal markets depending upon the professionalisation of management [Buckley, Casson, 1976]. Therefore, the economies arising from intemalisation of transactions have to outweigh the cost associated with internalisation. Otherwise the transaction will take place through external markets. The net economies arising out of the elimination of transactions thus represent internalisation incentives or advantages.

It must be pointed out that external markets for not all the intangible assets are subject to the same degree of market failure and hence costs involved in arm's length transactions also vary. Some of them can profitably be licensed at arm's length. For instance, the new proprietory process technology as opposed to product technology is more easily transferred at arm's length [Caves et aL, 1980]. For the process technologies which are standardised and can be "written down and transmitted objectively, licensing may be a prime vehicle" [Caves, 1974b, p. 19]. On the contrary, those process technologies that are embodied in the skills of employees of the owning firm, that is, that have a high tacit component, are not easily codified or embodied in capital goods are difficult to be licensed [Teece, 1981]. Therefore, "propen- sities to internalise vary between industries" depending upon the costs of the market transaction of intangible assets involved [Dunning, 1981, p. 97].

In short, the new propositions to the theory of FDI predict that the incidence of FDI may be high in those branches of industry in which intangible assets characterised by locational advantages and internalisation incentives are important. These developments in theory may be more simply put as follows:

The intangible assets approach (~ la Hymer, Kindleberger, Caves) predicts:

FS--FS (OWN, LOC) (1) + +

where FS is the share of foreign controlled enterprises in industry sales as a proxy of incidence of FDI; OWN is a vector of proprietary intangible assets; and IZ)C is a vector of locational advantages including the host government policy factors. The signs below the variables indicate the nature of relationships.

In the light of the transaction cost minimisation theory (1) can be modified as:

FS = FS (OWNi, LOC) (2) + +

where OWN~ is a vector of those intangible assets whose market transfer

Intemalisation and Foreign Production 329

entails high transaction costs and hence internalisation incentives are present. OWN~ is a subset of OWN.

That is, transfer of only those intangible assets which are characterised by high internalisation incentives will take place through FDI. In all other cases, arm's length licensing may be resorted to. It therefore, naturally follows that

LCG = LCG (OWNn,LOC) (3) q- +

where LCG is a proxy of incidence of transfer of intangible assets through arm's length licensing; OWNn is a vector of those intangible assets whose market transfer involves relatively lower transaction costs and hence internalisation incentives are absent. OWNn is a subset of OWN.

The major problems to be solved before attempting a verification of the postulates of the thus modified theory of FDI are: (i) to classify the elements of vector OWN between O W N i and OWNn depending upon the transaction costs involved in their potential market transfer and (ii) to identify variables which can proxy the significance of different elements of vectors OWN and LOC for the industry. While for the latter one can draw upon the existing studies, the former is a more tricky issue being subject to qualitative judgements. In what follows we attempt to examine the issues concerning the determination of costs irwolved in market transfer vis-a-vis FDI of different intangible assets in order to reach a tentative classification between OWNi and OWN.. The variables proxying the significance of these intangible assets for the industries normally used in the literature are also indicated alongside.

1. Class i f ica t ion of In tangib le Assets

a. Product Differentiation and Goodwill

The ability of the firm to differentiate its products through brand names and trademarks which enjoy consumer loyalty is considered to be among the most important intangible assets. In the case of brand/trade names, strict quality control is necessary because ultimately the proprietor firm's goodwill depends upon it. If fights to use brand/trade names are transferred to un- associated parties abroad, the firm runs the risk of dissipation of goodwill in case the licensees fail to maintain the quality up to the original standards [Giddy, Rugman, 1979]. Hence the transaction costs tend to be high because of the necessity to supervise the quality standards of the licensee. Further- more, product differentiation may also be characterised by other market failures such as buyer's uncertainty due to lack of knowledge of the brand name's potential value with the prospective licensee [Caves, 1982, Ch. 1]. Presence of these factors leads to cost of market transfer to be high, hence

9*

330 Nagesh Kumar

making it a less efficient mode of transfer of goodwill assets for the owning firm.

Selling a differentiated product under brand/trade names usually necessitates sales promotion/advertising to create its demand by communicating its differential features to the potential buyers. Hence inter-industry variation in the intensity of advertisement expenditures can proxy such variation in the extent of product differentiation. Therefore, advertisement intensity (ADS) has been widely used to capture the extent of product differentiation in various studies, for instance, Caves [1974a]. We shall also follow the same practice.

b. Knowledge

Possession of knowledge, be it in the form of new technology or superior managerial or marketing skills, is again considered to be one of the most valued intangible assets. Market transactions of different kinds of knowledge are subject to market failures of different intensities, as observed above. Two types of knowledge will be distinguished here in view of availability of proxies: knowledge embodied in employee skills, and knowledge embodied in capital goods.

a. Knowledge Embodied in Skills

Market transfer of idiosyncratic knowledge is subject to high transaction costs because it necessitates physical transfer of the personnel. Therefore, internalisation incentives may be high in activities which depend more on learned or tacit skills [WiUiamson, 1981; Teece, 1981; 1983].

Measurement of the industry's requirement of idiosyncratic knowledge can be proxied by the proportion of non-production workers (NPW) in total work force which include supervisory staff, and managerial, marketing, quality control, research personnel, the latter including those responsible for trouble shooting. Such measurement has already been used in the literature [Caves, 1974a; Lall, Siddharthan, 1982] to capture industry's requirement of organisational and managerial skills, and is used here also to proxy industry's requirement of tacit knowledge.

Being based on numerical proportion of overhead personnel, NPW does not take note of qualitative difference or level of sophistication of such personnel. Therefore, another variable which possibly takes note of both quantitative and qualitative aspects (of skill requirements) i.e. the proportion of earnings of high salaried employees (i.e. those drawing Rs. 3,000 per month or more) in total wage and salaries bill (HIEMP) will be used as an alternative proxy of skill intensity. It has also been employed by Lall, Mohammad [1983] for similar purposes.

Internalisation and Foreign Production 331

6. Knowledge Embodied in Capital Goods

Market transfer of knowledge embodied in the capital goods does not suffer from the market failures of the kind that embodied in human skills does. The information asymmetry does not arise because the knowledge is embodied in the basic design of the capital goods. The potential buyer's uncertainties about the performance are usually taken care of by the guarantees given by the suppliers 5. Therefore, the transaction costs do not seem to be high resulting in weak incentive to internalise in the case of knowledge embodied in capital goods.

The intensity of production process in the use of capital goods (plant and machinery) may proxy the extent of knowledge embodied in them. Hence plant and machinery to sales ratio (PMS) will be employed to capture the intensity of industry in knowledge embodied in capital goods.

c. Access to Sources of Capital

MNEs' access to capital markets all over the world is considered to be an important intangible asset. Therefore, they might enjoy an advantage in the industries requiring heavy capital investments. Horst [1972] and Bergsten et al. [1978] have found a positive relationship between the capital requirements for establishing a minimum economic size plant and the extent of outward FDI from the U.S. The access to sources of capital, however, does not seem to be an intangible asset with high transaction costs as markets for portfolio investments are well developed. Internalisation incentives, therefore, appear to be weak in the case of access to the sources of capital.

The larger the volume of capital required for setting up a plant in an industry, the greater would be the attraction of having an access to the sources of capital. Hence, average capital requirements in the industry (AKR) will be used to proxy the significance of access to capital sources as an intangible asset.

The three broad categories of intangible assets have, therefore, been classified on the basis of expected transaction costs involved in potential market transfer in the subsets OWNi and OWN, of vector OWN as summa- rised in Table 1.

2. L o c a t i o n a l A d v a n t a g e s

Here we shall attempt to identify the locational advantages and the variables proxying them. These advantages determine whether intangible

s In the case of developing country firms, however, which usually do not enjoy reputation, the buyer's uncertainty may persist inspite of the guarantees. Hence, markets are often internalised [Wells, 1983]. This is usually not the case with advanced country investors with whom we deal here.

3 5 2 Nagesh Kumar

Table I - Classi[ication of Intangible Assets According to Transaction Costs

Intangible asset Measurement Transaction Sub-vector cost

ADS 1. Product differentiation (goodwill)

2. Knowledge a) embodied in human skills

b) embodied in capital goods ..

3. Access to sources of capital

NPW (extent) HIEMP (extent and sophistication)

PMS

high

high

low

low

OWN i

OWN i

OWN n

OWN n

assets would be exploited in home country or abroad and not whether FDI or licensing would be a mode of operation [Aliber, 1970]. These may include various components of the host government policy which either makes imports costly or subsidises local production and may also include the communication/transport costs and inter-country differences in factor prices and productivity. Since we deal here with the variation in the incidence of FDI and licensing across different industries within a country, the factor-price differentials and transport costs, etc. are not considered to be important. For our purposes, therefore, elements of government of India's trade and industrial policies are more relevant locational factors.

Foremost among the government policy factors relevant for local production in India are the import substitution programmes and protection accorded to the local manufacturing. Ever since the Independence, the government of India has pursued a vigorous programme of industrialisation based on import substitution. Heavy emphasis placed on import substitution which was enforced through quota restrictions on imports and high tariff walls persuaded the erstwhile foreign suppliers to undertake local manufacture instead of exporting to India. Local manufacture on the other hand was subsidised by the government through a host of incentives including cheap credit and infrastructure facilities. Because of these factors local production in India not only became more attractive than exporting from home countries but sometimes even a necessity for an MNE to keep its market in India intact. In a survey of British firms operating in India, Davies [1977] found import restrictions as an incentive for local production in an overwhelming number of cases.

Although the import substitution and protection have enjoyed an outstand- ing place in the public policy framework in India, their direct measurement at industry level poses problems. Since the coverage of the Indian import substitution programme extended to almost everything that was not produced in the country, the proportion of imports in total supplies in the early phase of


industrialisation could be a reasonable proxy of import substitution (ISP). The degree of protection accorded to an industry is measured here in terms of the effective rates of protection (ERPs). ERPs in India have, however, been changing over the years depending upon the intensity of local requirements and production [Panchamukhi, 1978] and this should be taken into account while interpreting later the results.

The Indian government's policy has always sought to restrict foreign collaboration in the areas where local skills were available. Most of the industries where India was technologically self-sufficient produced consumer goods incorporating relatively simpler technologies. Therefore, the government policy is supposed to have discouraged foreign collaboration in these industries. To capture the possible influence of this policy, we shall distin- guish consumer goods industries through a dummy variable DCON.

Another component of public policy which may be of some consequence to the industry distribution of local production is industrial policy of government of India which seeks to direct the flow of investible resources of foreign companies in addition to those of the Indian firms covered under the Monopolies and Restrictive Trade Practices Act, 1969 (MRTP Act) to selected capital intensive intermediate industries which were called "core sectors" because of their crucial importance for the industrialisation. The first step to mobilise investments of foreign and MRTP Companies for specified industries was taken formally only in 1973 [India, Ministry of Industry, 1982]. In the case of foreign companies, this policy, however, has two pitfalls. Firstly, the foreign companies for the purpose of enforcement of this policy are those registered under the Foreign Exchange Regulation Act (FERA), 1973, viz. those having over 40 per cent foreign ownership. But this category of (FERA) companies is of a self-liquidating character because once they have diluted the foreign equity to 40 per cent as per FERA directives (barfing some exceptions), they would cease to be categorised as "foreign" and would be free to expand their activities in any industry [Kumar, 1982]. Secondly, it is applicable only to the further expansion of the existing companies and to those entering India after 1973. Thus scope of this policy has been limited. It may still be interesting to examine the influence of this component of government policy which could direct investible resources of both MNEs who may undertake FDI and large local companies to the specified industries. These industries specified by the government will be distinguished with the help of a dummy variable DCORE.

Having identified the elements of vectors OWNi, OWNn, and LOC, we can now formulate the hypotheses. By substituting the specific elements of vector OWN i and Is in (2) one would predict FS to be significantly and positively related with ADS, NPW/HIEMP, ISP, ERE DCORE, and inversely with DCON. The components of vector OWNn i.e. PMS and AKR are not expected to have a significant relation with FS if the postulates of the transaction cost

334 Nagesh Kumar

minimisation theory are correct. Similarly, elements of OWNn and LOC viz. PMS, AKR, ISP, ERE DCON, DCORE alone and not ADS and NPW/ HIEMP should explain the variation in LCG. Hence the verification of the theoretical postulates can be done by including variables belonging to both (OWN~ and OWNn) groups among the explanatory variables for both FS and LCG and examining their statistical significance.

Most studies explaining inter-industry variation in foreign share in Ca- nada have used R&D intensity of the industry in the U.S. to capture the innovativeness or technology intensity of the industry and have usually found a positive relationship. Such proxy cannot be tried in India's case because no distinct country dominates her FDIs as the United States in Canada. We have data on R&D intensity of Indian industry. However, if a country depends for most of the innovations on foreign sources, as most developing countries including India do, the local R&D intensity may not reflect the innovativeness or technology intensity of the industry. On the contrary, the amount spent on R&D in the host country which is usually of adaptive nature, might reflect the level of domestic technological capabilities at least in adapting/absorbing technology. If such is, indeed, the case then foreign collaboration, particularly FDI, may be excluded from such industries because the selective policy, which the government of India pursues, does not normally allow foreign collaboration in the industries where certain local technological capability has been built up. Therefore, the usual prediction applicable to technological intensity will not be valid in the case of local R&D intensity. Nonetheless, it would be interesting to examine the relationship between local R&D intensity (RDS) and foreign collaboration (FS and LCG) which we shall do without making a definite prediction.

Therefore, the final equations which will be subjected to empirical estimation are:

FS = FS (ADS, NPW, HIEMP, PMS, AKR, ISP, ERE DCON, DCORE, RDS) (4)

where the coefficients of ADS, NPW, HIEMP, ISP, ERE and DCORE are all predicted to be positive and significantly different from zero; that of DCON to be statistically significant with negative sign; that of PMS and AKR are predicted to be not significantly different from zero; and no prediction is made regarding the sign and significance of the RDS coefficient.

I/2G = LCG (PMS, AKR, ADS, NPW, HIEMP, ISP, ERP, DCON, DCORE, RDS) (5)

where the coefficients of PMS, AKR, ISP, ERP and DCORE are predicted to be positive and significantly different from zero; that of DCON to be statistically significant with negative sign; that of ADS, NPW and HIEMP are predicted to be not significantly different from zero; and sign and significance of the RDS coefficient are uncertain.


HI. Empirical Analysis

The hypotheses put forward above are sought to be verified by fitting (4) and (5) with data on dependent and independent variables for larger non-government public limited companies in 49 three-digit Indian manufacturing industries e. The dependent variables in both the equations viz. FS and LCG ~ are non-negative ratios. When fitted in their original form, their predicted values for some observations were found to be negative. Logarith- mic transformation was, therefore, applied to constrain the predicted values from becoming negative. ,All the independent variables, except dummy variables, were also expressed in logarithms, which necessitated adding small positive values to the observations having zero values.

Table 2 - Correlation Matrix (Log x Log; n = 49)

FS LCG ADS HIEMP NPW PMS AKR RDS ISP ERP DCORE DCON

FS 1.000 LCG .079 1.000 ADS .176 -.127 1.000 HIEMP .520 .293 .104 1.000 NPW .445 .244 .085 .697 PMS .108 .455 -.372 .078 AKR .207 .304 -.246 .286 RDS -.197 .526 .018 .146 1SP .582 .290 .083 .467 ERP .138 -.080 .367 -.145 DCORE .277 .679 -.272 .389 DCON -.208 -.540 .419 -.092

1.000

-.017 1.000 .192 .447 1_000 .204 .178 .052 .507 .150 .078

-.198 .087 .192 .284 .324 .327 .164 -.347 -.205

1.000 .015 1.000

-.041 -.132 1.000 .249 .388 -.233 1.000

-.256 -.353 .266 -.572 1.000

The correlation matrix is provided in Table 2. The correlation between FS and LCG is almost insignificant (r = 0.0797) reassuring the independence of FDI and licensing. Bucldey, Davies [1981] have also reported similar independence of FDI and licensing in the foreign production by British firms. The alternative measurements of idiosyncratic knowledge viz. NPW and HIEMP are highly correlated (r = 0.698) as expected. Several other independent variables are also found to be correlated. The proxies of knowledge embodied in capital goods (PMS) and capital requirements (AKR) are significantly correlated which is plausible. Relationships between policy variables

6 Data sources and measurement of variables are provided in the statistical appendix.

7 Two inconsistencies of measurement of dependent variables must be kept in mind. For one thing, there may be some overlapping between FS and LCG as sometimes companies with FDI also remit royalty or technical fees. For another thing, unlike FDI, the technical and licensing agreements

are of limited duration (usually 5 to 7 years). Hence while FS reflects cumulative position, LCG relates to current licensing contracts.

3 3 6 Nagesh Kumar

and structural variables may throw some light on the nature of public policies in India. For instance, ISP is significantly related with HIEMP, NPW, DCORE with positive sign, and with DCON with negative sign. It implies that a potential of import substitution existed in skill-intensive and capital or intermediate goods industries which have also enjoyed high priority under the industrial policy. DCORE is also significantly related with HIEMP, PMS and AKR implying that priority sector industries require much capital and are

Table 3 - Regression Equations Explaining Variation in Intensity of FDI and Licensing in Indian Manufacturing

Dependent variable

Explanat. FS LeG

variable (i) (ii) (iii) (iv) (i) (ii)

!ADS

HIEMP

NPW

PMS

AKR

RDS

ISP

ERP

DCORE

DCON

Constant

~2

F

D.E

.348 b (2.426)

2.267 a (4.062)

.2O2 (.739)

-.313 a (-3.210)

-1.575 a (-2.886)

-7.980 a (-3.835)

.475

7.78 a

43

.278 r (1.917)

2.441 a (4.618)

-.466 (-1.069)

-.299 a (-3.064)

-1.703 a (-3.1o5)

-7,368 a (-5.325)

.482

8.01"

43

.295 b (2.006)

1.517 c (1.743)

.352 (1.298)

-.273 b (-2.694)

.310 b (2.367)

.355 (.590)

-.678 (-1.047)

-10.645 a (-3.476)

.504

5.96 a

41

.271 (1.667)

3.041 a (3.665)

.183 (.611)

-.325 a (-3.207)

.799 (1.517)

-1.575 a (-2.747)

-16.586 a (--4.332)

.451

5.75 a

42

.170 (.934)

-.444 (-.412)

.4O9 (1.218)

.438 a (3.485)

.055 (.341)

2.699 a (3.679)

-1.189 (-1.484)

-4.947 (-1.304)

.634

10.17

41

.262 (1.276)

.102 (.125)

1.199 b (2.031)

.109 (.285)

.385 a (3.148)

-.016 (-.102)

.004 (.007)

2.633 a (3.523)

-1.122 (-1.395)

-2.834 (-.738)

.669

8.79

39 Note: Figures in parentheses are t-values. - Superscripts indicates levels of significance

(two-tailed tests) as follows: a = 99 per cent; b = 95 per cent; and c = 90 per cent.


intensive in knowledge of both kinds: idiosyncratic and that embodied in capital goods. ERP is significantly correlated with ADS implying that relatively higher tariffs have been imposed on finished goods which are usually sold under brand names coupled with advertising.

The regression results for the two dependent variables are presented in Table 3. Because of multi-collinearity between alternative measurements of the same variable and between some other variables, a few alternative combinations had to be tried. The fitted regressions are significant at the one per cent level in terms of F-statistics and the industry characteristics identified here are able to explain over half of the variation in the intensities of FS and LCG. The rest of the variation in their intensities must have been due to industry characteristics which we fail to specify and to firm and technology specific factors such as the age, size, past experience, extent of geographical and product diversification of the firm, the degree of sophistication of the technological advance etc. as observed by Telesio [1979] and Davidson, McFetridge [1984]. Furthermore, the host government may influence the FDI/licensing choice through negotiations at the time of entry. The Indian government has issued from time to time illustrative lists of items where only technical collaboration and those where FDI may be permitted. Possible influence of these enforcements on the mode of local production by MNEs, however, could not be captured in the present exercise due to their being at specific product, and not at broader industry, level. Davidson, McFetridge [1985] have observed the host governments' ownership restrictions, scree- ning procedures to be reducing the probability of FDI as mode of transfer. Results pertaining to different sets of variables are dealt with below.

1. In tangib le Assets

The product differentiation variable ADS turns out to be with positive sign and has a statistically significant coefficient in all the equations explaining variation in FS except in (iv). Inclusion of ERP in (iv) adversely affects level of significance of ADS because of their mutual correlation. On the contrary ADS remains insignificant throughout in all the equations explaining variation in LCG. These findings are in line with the theoretical prediction and, therefore, uphold the hypothesis that market transfer of goodwill assets are subject to high transaction costs due to buyer's uncertainty, and due to quality supervi- sion costs in the absence of which the asset owning firm runs the risk of dissipation of its goodwill. Therefore, markets for such intangible assets tend to be internalised through FDI.

The variables proxying idiosyncratic knowledge viz. NPW and HIEMP are both significant with positive signs in equations explaining FS. Inclusion of ISP which is correlated with both HIEMP and NPW also affects level of their

338 Nagesh Kumar

significance adversely (as in iii). On the other hand, none of the human skill variables is significant in explaining variation in LCG. This finding again ratifies our hypothesis. Licensing seems to be an inefficient channel of transferring knowledge when it is embodied in the skills of personnel and hence FDI is resorted to.

The variable proxying knowledge embodied in the capital goods viz. PMS remains insignificant with negative sign while explaining variation in FS. In the equations explaining I~G, however, it turns out to be significant with positive sign throughout. This finding affirms that the cost of external market transaction is not too high when knowledge is embodied in the capital goods, to make it an inefficient mode of transfer. Licensing and not FDI is, therefore, a preferred mode in such cases.

The variable capturing ownership advantage of an access to sources of capital viz. AKR is not significant in the equations explaining FS. In equations explaining LCG, AKR has positive sign but is not significant. Failure of AKR to achieve significance in both cases seems to suggest that an access to sources of capital is no more a source of monopolistic advantage for MNEs which gives them an edge over their local counterparts. This may be due to the development of capital markets and the emergence of government sponsored industrial development banks and financial institutions particularly in India.

The variable proxying R&D intensity viz. RDS is significant in both sets of equations but with different signs. In the case of FS it has a negative sign while it turns out with a positive sign in LCG equations. This finding can be explained in terms of the evidence on the nature of in-house R&D in India from other studies. Desai [1980] has found that the R&D activity of Indian firms normally consists of minor adaptations to the imported technology made to suit local tastes, market size and raw materials. Further, Katrak [1985] concludes from his study of R&D in India that the propensity to adapt the imported technologies decreases with its complexity. Hence the proportion of local R&D spending may be inversely related to the complexity of technology. More complex technologies may be difficult to be transferred through external markets because of limitations of absorptive capacity of developing country firms apart from other market failures. Hence, they may be transferred through package of FDI. That is how there might exist an inverse relationship between FS and local R&D and a positive association between LCG and RDS. However, a more detailed work on the nature and characteristics of in-house R&D activity in India and its relationship with technology transfers is needed before a more definitive statement on this relationship can be made.


2. Locat iona l Advantages

The potential of import substitution variable is positive and significant in explaining variation in FS. The effective protection variable, though with positive sign, marginally falls short of the 10 per cent significance level in terms of t-value in the FS equation. ISP and ERE however, are never significant in explaining variation in IX2G. While the performance of ISP in the FS equation is as per hypothesis, its insignificance in the Is case may be attributable to differences in the measurement of FS and Is As pointed out in footnote 7 unlike FS, LCG relates to more recent period. The import substitution potential which existed in the late 1950s cannot be expected to be related to foreign technical collaborations approved during the last 5 to 7 years.So far as ERPs are concerned, apart from the limitations of measurement in adequately reflecting the changing levels of protection over the years, they have been found to be insignificant in most of the studies on Canada [Caves, 1974a; Caves et al., 1980; Owen, 1982; Gupta, 1983]. In the case of the U.S., however, ERP was found to be the only significant explanatory variable of FS [Lall, Siddharthan, 1982].

Of the other policy variables, the consumer goods dummy variable DCON has negative signs in both FS and LCG equations and is significant in absence of ISP with which it is collinear. The performance of DCON is, therefore, as per expectation. The selective policy towards foreign collaborations (both FDI and licensing) which the government of India has followed throughout the post-Independence period seems to have discouraged them in consumer goods sectors where local skills have been available. The other policy variable capturing the effect of industrial policies, DCORE is with positive sign in both sets of equations but is significant only in explaining IX2G. One reason of its failure in the case of FS may be that this policy is applicable to further expansion of only those enterprises which had more than 40 per cent foreign equity. Such companies constitute only a part of those defined as foreign controlled enterprises here. Furthermore, this policy was evolved only during the 1970s and hence could not be expected to have influenced in a significant manner the industrial pattern of cumulative FDI, which FS reflects.

The above findings, therefore, show that the theoretical predictions emanating from the recent propositions of the theory of FDI are able to explain inter-industry differences in intensities of FDI and licensing in Indian manufacturing successfully. FDI has been found to be a dominant mode of operation in the industries characterised by a high level of product differentiation and those with high skill requirements. In contrast, industries which are intensive in the use of capital goods, and those with less complex technologies are dominated by licensing. The access to sources of capital no more seems to provide an edge to the MNE in Indian market.

540 Nagesh Kumar

IV. Conclusions

The present paper has made one of the first attempts to verify the predictions emanating from the recent internalisation approach to foreign operations of firms. The empirical results obtained for the Indian industries suggest, in line with our hypotheses, that FDI has concentrated in those branches of manufacturing which are characterised by a high degree of product differentiation making goodwill a formidable competitive advantage and in those industries which are intensive it: the use of idiosyncratic knowledge. On the contrary, licensing seems to be a dominant mode in industries which are intensive in the use of knowledge embodied in capital goods. The access to sources of capital is important for neither FDI nor licensing. It, therefore, seems to have lost its importance as an intangible asset capable of giving an edge to MNEs in Indian market. It may be due to the development of capital markets and the emergence of a number of government sponsored financial institutions in India.

The R&D intensity of local industry is found to be inversely related with intensity of FDI but positively with that of licensing. This finding has been interpreted in light of the earlier findings that local in-house R&D in India is usually of adaptive nature and that the tendency to adapt decreases with the complexity of technology. As more complex technologies may be difficult to be transferred through licensing, FDI is a preferred mode. However, need of more detailed work on this aspect is necessary before any definitive inference is drawn.

FDI is also found to have been concentrated in import competing sectors. Hence, the import substitution programme of the government of India seems to have encouraged the erstwhile exporters to the country to set up local production facilities. The selective policy which the government has followed seems to have discouraged foreign collaboration of either kind in consumer goods sectors where local skills were available to some extent. The industrial policy of the government of India attaching priority to industries with high linkages to other industries seems to have attracted considerable investments as also technology transfers to those sectors. All policy factors together have provided locational advantages to the local production either through FDI or licensing.

The intangible assets and locational factors considered in the present exercise are able to explain over half of the total variation in the dependent variables. The rest of the variation may be on account of firm-specific factors and the government policy in India which plays a significant role in determining the mode of foreign involvement through entry regulations and through reservation of certain industrial sectors for the public sector.

lntemalisation and Foreign Production 341

Appendix

Most of the variables employed are derived from an unpublished data base made available to us by the Reserve Bank of India. This data base includes financial statistics in respect of each of the non-government, non-financial companies with paid-up capital of Rs 10 million or above and a sample from the smaller companies each with paid-up capital of Rs 0.5 million or more for the years 1976/77-1980/81. In all, it includes 1720 companies accounting for 86 per cent paid-up capital of all public limited companies in the private sector in 1979-1980. Out of these 1720 companies, 1334 were in the manufacturing sector. For the purposes of the present study, we confined ourselves to these manufacturing companies. Each one of these companies was assigned a three-digit industry classification code on the basis of the manufacturing activity accounting for at least one half of its turnover. In all, there were 62 such industry groups. However, five industry groups had to be left out. Levels of competition were not representative in three of them: in safety matches, and tobacco products (other than cigarettes) due to reservation for the small scale sector; and in iron and steel, for the public sector. The other two industry classes were miscellaneous categories. Some regrouping was found to be necessary for the remaining 57 industries which finally yielded 49 industry classes. An attempt was made by us to classify a company as "foreign controlled" if the proportion of foreign equity was 25 per cent or more. This definition is in tune with the Reserve Bank of India's definition of a "foreign controlled rupee company" used in its various studies. Industry aggregates were generated by adding up respective values for all the companies included in the industry group (in the data base). Measurements of the variables are as follows. Unless otherwise indicated, variables have been derived from the above data base.

(i) FS = share of foreign controlled companies (with 25 per cent or more foreign equity) in net sales of all companies included in the data source in an industry, averaged over three years 1978/79-1980/81 to suppress random yearly variations

(ii) L C G = total royalty, technical or other professional fees paid abroad as a percentage of net industry sales, averaged over 1978/79-1980/81

(iii) A D S = percentage share of advertisement expenditure in net industry sales, averaged over 1978/79-1980/81

( iv) R D S = percentage share of R&D expenditure in net industry sales, averaged over 1978/79-1980/81

(v) NPW = percentage share of non-production workers in total workforce in 1978/79 (The Annual Survey of Industries: Census Sector Summary Results, 1978/79, Govt. of India)

(v/) HIEMP = percentage share of earnings of employees drawing Rs 3000 or more p.m. in total wages and salaries bill, averaged over 1978/79- 1980/81

342 Nagesh Kumar

(vii)

(viii)

(ix)

(x)

(xi)

(xii)

PMS = gross book value of plant and machinery to net sales ratio in 1980/81 AKR = average total capital employed per firm, averaged over 1978/79-1979/80 ISP = ratio of imports (c.i.f.) to total industry output in 1960/61, calculated on the basis of data compiled in Bharat-Ram [1982] from government of India sources ERP = effective rates of protection for 1979/80 (National Council for Applied Economic Research, New Delhi) DCORE = a dummy variable which is equal to one if the industry was included in the Appendix I of "Industrial Policy-Government Deci- sions" 1973, and zero otherwise DCON = a dummy variable which is equal to one if the industry was supplying consumer goods (both durables and non-durables), and zero otherwise

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Zusammenfassung : Immaterielle Verm6genswerte, Internalisiernng und ausliindische Produktion: Direktinvestitionen und Lizenzvergabe in Indien. - Ausl//ndische Direktinvesti- tionen sollen entsprechend den neuen Theorien nur in solchen Industriezweigen eine Form der ausl~indischen Produktion sein, in denen immaterielle VermiSgenswerte, die durch Inter- nalisierungsanreize gekennzeichnet sind, die Grundlage der Wettbewerbsvorteile bilden. In anderen Fallen wird man auf die Lizenzvergabe zu Marktpreisen zuriickgreifen, ohne dag das lizenzvergebende Untemehmen eine Sperrminorit~t erwirbt. In diesem Aufsatz wird versucht, immaterielle Verm/Sgenswerte zu Idassifizieren und die erv~hnten Hypothesen empirisch zu verifizieren. Die Ergebnisse fiir 49 indische Industrien deuten darauf hin, dag sich ausliindische Direktinvestitionen auf solche Industrien k0nzentrieren, die in starkem Mage eigene Spezialkenntnisse verwendeten und Produktdifferenzierung betrieben. Lizenz- vergabe kam haupts~chlich in den Industrien vor, die inkorporiertes Wissen nutzten.

R6sum6: Actifs immat~rielles, internalisation et production ~trang~re: Investissements directs et concession de licence en production manufacturi~re indienne. - Suivant des


th6ories nouvelles, l'investissement direct 6tranger (IDE) est une mani~re de la production 6trang~re seulement dans les industries manufacturi~res ofa les incitations d'intemalisation sont la source de l'avantage comp~titif. Dans les autres industries la concession de iicence

,,arm's length~ est appliqu6e. Dans cet article l'auteur essaie de classifier des actifs intangibles et de v6rifier empiriquement les hypotheses mentionn6es. Les r6sultats empiriques obtenus pour 49 industries indiennes sugg~rent que I'IDE s'est concentr6 dans les industries qui utilisent intensivement la connaissance idiosyncratique et la diff6renciation des produits; la concession de licence a domin6 dans les industries qui utilisent intensivement la connaissance incorpor6e.

R e s u m e n: Acfivos intangibles, intemalizaci6n y producci6n extranjera: inversi6n directa y licencias en la industria manufacturera de la India. - Segtin teorfas recientes la inversi6n extranjera directa (IED) seria una forma de producci6n extranjera s61o en aquellas ramas en las que activos intangibles caracterizados por la intemalizaci6n de incentivos sean fuente de ventajas comparafivas. En los demos casos se recurrin'a a otorgar licencias a empresas nacionales. En este trabajo se intenta clasificar a los activos intangibles y verificar empfrica- mente las predicciones nombradas. Los resultados obtenidos para 49 industrias manufactu- reras de la India sugieren que la lED se ha concentrado en ramas intensivas en el uso de conocimientos idiosincr~isicos y diferenciaci6n de productos. El sistema de licencias ha predominado en industrias intensivas en conocimientos incorporados.

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