Changes in international production organisation and consequences for local industrial

For the host governments, efforts to attract flagship foreign firms, of the kind we saw in the previous chapter, are only the first step towards development. Indeed, one of the reasons that the spillovers garnered so much attention in policy and academic literature is that they are a direct response to one of the longest-standing concerns about FDI: that without strong links to the local industry, integration into multinationals’ production networks will result in incomplete development, locking the host country in a less desirable position in the

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international division of labour (Valenzuela & Valenzuela 1978; Evans 1979; Gallagher &

Chudnovsky 2009). Incomplete, “hollow” or “truncated” industrialization can manifest in several ways. Where the local market is the main source of attraction, a multinational may set up final assembly in the host country, but import all or most of the important components from abroad. But even where the multinationals are eager to use the host country as a source of exports, they may choose to locate there only the most labour intensive and cost-sensitive production, which has low technological intensity, little scope for upgrading, and is also more vulnerable to relocations.

In the early 1990s, falling trade barriers meant that tariff-jumping assembly for developing country markets was becoming less common, as they could now easily be served through exports. This could have led to fewer investments in the peripheries, but the disappearing trade barriers, together with falling transportation costs, had also made them more attractive as low-cost production locations. Cost considerations were just gaining primacy in European automobile industry, owing to a combination of market factors, and for a while this seemed to reinforce the division of labour which pushed developing countries towards specialization in low value-added activities.

In the developed world, the two oil shocks and the rising competition from East Asian, especially Japanese producers, had turned the once prosperous industry into a trench fight for maturing markets. In the US, the structure of demand allowed domestic producers to escape through upward adjustment towards ever larger off-road and luxury vehicles, but lifestyle changes and urban congestion in Europe actually shifted the demand back towards smaller cars. The crisis of profitability which hit the industry in the early 1990s demanded severe adjustments in terms of production efficiency and costs, and shifted production of the smallest, least profitable vehicles towards low-wage countries.

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In addition to direct relocation of smaller and cheaper models by final manufacturers, a number of changes in production organisation which took place in this period also favoured outsourcing towards peripheral locations. Efforts to decrease intermediate costs, such as inventories, pushed more responsibility on suppliers for quality control and organisation of deliveries. Moreover, they were now also becoming responsible for a larger share of production, organisation of smaller sub-suppliers, as well as research and development, as the carmakers tried to streamline their operations by divesting non-core competencies (Lung & Volpato 2002; Herrigel & Wittke 2005; Humphrey & Salerno 2000). By mid 2000s, close to 80% of a car’s value was sourced from the outside, and the carmakers made ample use of their market power to drive down component prices, forcing even the long-term suppliers to compete for new contracts and asking them to commit to

“continuous cost reductions”, i.e. to lower the price of their supplies by 4-7% every year (Lung 2004; Roland Berger 2008).

All of this created enormous pressure on suppliers to lower production costs, which often meant relocation of parts of production to low-wage countries. Within Europe, relatively low transportation costs and few market barriers seemed to favour a clear division of labour between the technologically advanced core and low cost peripheries.

Early observers of industrial revival of East Central Europe under the leadership of foreign direct investment indeed warned that the region was on the way to becoming a cheap

“maquilladora” for Western multinationals: marginally incorporated into the European production systems and entrusted only with the simplest, labour intensive processing tasks (Ellingstad 1997; Martin 1998).

However, the same processes which forced the diffusion of production towards low-cost locations also prevented such a simplistic division of tasks (Freyssenet et al. 1998;

Lung 2004). Outsourcing of a large share of inputs also created new problems in terms of

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delivery and quality control. Larger and bulkier components were still expensive to transport, even within Europe, and the “just in time” supply regime made production at the point of sale more attractive for the complex parts. This limited the pressure towards relocations, but also ensured that once the carmakers themselves began to settle in the periphery, agglomeration forces attracted all categories of suppliers, including those of more sophisticated components.

Adding to this was a revolution in car design, which reduced possibilities for hierarchical differentiation of production across core and periphery locations. To mitigate the costs of research and development, vehicle manufacturers tried to boost the economies of scale, spreading the costs across as many markets as possible. The “world car”, i.e. a single model to be sold simultaneously in all regions of the world was most enthusiastically pioneered by Fiat in the early 1990s, but it soon turned out to be an overly ambitious strategy: differences in consumer tastes, purchasing power and governmental regulations left a single global model a distant dream (Camuffo & Volpato 2000; Camuffo 2004).

Nevertheless, it inspired a number of intermediary solutions, the most promising of which involved standardization of various systems of internal components into “platforms”. These are effectively the invisible parts of the car architecture, which can comprise up to 70-80%

of inputs, but still allow for customizations of certain features such as the engine size and type, style of bodies and accessories etc. (Lung et al.1999, Pries 2003). Due to these external variations, platforms can be shared among a wide range of vehicle models by the same manufacturer, and sometimes even between manufacturers. The Volkswagen Group, which now owns eight brands of passenger cars with very different market appeal, makes a total of 240 car models on just 16 platforms. Even though peripheral locations may still specialize in smaller and less profitable products, the difference between them and the more complex,

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higher value-added ones is much smaller, and product upgrading can be achieved with minimal adjustments.

This double movement in the restructuring of automotive production - on the one hand, greater fragmentation of production and cost sensitivity, on the other the pressures for agglomeration and standardization – has also changed the logic of industrial development in the periphery. In some ways, their prospects now appeared more promising than ever. Vehicle manufacturers were now willing to outsource a larger share of value added, and cost considerations pushed both carmakers and their suppliers to step up the share of exports from developing country locations. At the same time, coordination issues limited the trends towards fragmentation of production, and helped the rise of agglomeration economies in selected locations. The combination favoured especially the

“near peripheries”, i.e. low cost regions in proximity of established manufacturing centres, such as Mexico or East Central Europe. Moreover, efforts to standardize components across a large range of products eliminated fixed hierarchies between low- and high-cost locations, and opened up greater opportunities for upgrading. However, while all this meant that FDI could lead to strong development of local industry, the same was not true of its impact on locally owned firms. In fact, it was precisely the processes which helped the flow of investments towards developing country locations that also raised barriers to entry into higher industry ranks out of reach for most local businesses.

To meet the demand for lower costs the suppliers also tried to increase the scale of production, and the 1990s saw an enormous wave of mergers and acquisitions - with the result that some of the most prominent component manufacturers are even larger than their customers. At the same time, strong tendencies towards industry concentration are also a consequence of rapid internationalization. Since the bulk of components is now standardized across various products and markets, the desire of component makers to

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protect their intellectual property, and of the car manufacturers to limit coordination costs, have pushed the established suppliers to follow their customers to new markets (Collins et al. 1997).

For the aspiring developing country firms, this meant not only that they now had to contend with formidable foreign competitors in their own markets, but also that if they wished to displace them, they had to be ready to do so also at the international level (Sturgeon & Florida 2000; Boudier-Bensebaa 2008). This would explain the lack of spillovers to domestic enterprises: the barriers to entry into the higher league have become enormous, and the local firms are either replaced or taken over by the foreign competitors, or pushed onto the lower ranks of supplier hierarchy where there is less scope for upgrading. Thus the overall effect can be negative even if the firms which manage to win the supplier status do experience strong positive spillovers. In a rare empirical study which examines directly the relationship between local suppliers and multinational customers in the Czech Republic, Javorcik and Spatareanu (2005) found precisely that: firms supplying MNCs exhibited definite signs of learning, and improved their productivity faster than non-suppliers. However, the same study failed to find overall positive spillovers in the supply industry, which probably means that the gains to a few direct beneficiaries are offset by the negative impact on a large segment of firms which fail to enter multinationals’ supply networks. This is also in line with the repeated finding that backward spillovers are more strongly associated with certain types of FDI such as joint ventures or FDI from distant locations (Javorcik and Spatareanu 2011; Javorcik 2004; Damijan et al. 2008) which are more likely to engage with local firms than, as opposed to relying on established home networks.

The last observation suggests that the disadvantage of domestic firms is not only structural, but also institutional. On the one hand, their failure to break into the multinationals’ value

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chains is clearly related to their inability to raise a large amount of capital to expand their operations quickly enough, or the fact that they lack technology to compete with established suppliers. However, even when they are sufficiently capable and productive to take over some operations at least at the local or regional level, they have worse chances of gaining access to the carmakers. As already noted, decentralization of production has been accompanied by greater concentration of some other activities, such as research and development and purchase. Most vehicle manufacturers conduct centralized screenings for the bulk of components – very few affiliates have the competence to select suppliers independently, except for the most generic parts (Williams et al. 2008; Janovskaia 2008).

Even before they get a chance to compete for a contract, the prospective applicants must live up to certain standards of production management, and have them certified by an independent audit company, at their own expense. The selection of such companies is if anything even more centralized than that of suppliers. For the latest quality management certificate in automotive industry, ISO/TS 16949:2009, the global association of vehicle manufacturers, International Automotive Task Force (IATF) granted the right to conduct audits and issue certificates to only 45 firms globally, all but four of which come from developed countries (the other three are from China, Brazil and India and Malaysia).

In other words, developing country firms are doubly disadvantaged in the game of transnational manufacturing: on the one hand, changes in international organisation of production had raised tremendously the barriers to entry of local firms, on the other hand they are also outsiders to the networks of private governance and information circuits which underpin this restructuring process. At the same time, as we have seen in the introduction, changes in the scope for public regulation of foreign investment did nothing to compensate them for these disadvantages.

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While the governments now have fewer means to compel multinationals to take on local firms, it is also unclear whether they really feel the need to do so. With the changes in the international production organisation favouring a rise in exports from developing countries, the interests of domestic capital are less readily identified with those of the national economy. Indeed, difficulties of the local companies are almost precisely the reverse of the processes leading to successful localization of foreign capital – greater amounts of foreign investment on all levels of the supply chain, clusters of prominent transnational suppliers, and production of the latest models destined for exports, not for domestic markets. It follows that domestic capital would need to have much political clout in order to convince the governments that its own growth is worth interfering with the processes that appear to be solving of their own accord some of the most difficult problems of late industrial development.