Elsevier

World Development

Volume 32, Issue 9, September 2004, Pages 1525-1544
World Development

Foreign Direct Investment, Vertical Integration, and Local Suppliers: Evidence from the Polish Dairy Sector

https://doi.org/10.1016/j.worlddev.2004.05.004Get rights and content

Abstract

Studies argue that foreign investment has negative implications for small local suppliers, as they cannot comply with higher standards or they are laid off to reduce transaction costs. We analyze the impact of FDI in the Polish dairy sector, a sector dominated by small suppliers and of crucial importance for poor rural households. The analysis shows that FDI does not cause a rapid consolidation of the supply base. Instead, foreign companies introduce farm assistance programs to overcome market imperfections. Through vertical and horizontal spillover effects, this leads to improved access to finance, increased investments, product quality improvements, and growth of small local suppliers.

Introduction

The public debate on globalization has renewed interest in the effects of foreign direct investment (FDI). Some see foreign investment as a beneficial factor that can be an important source of much needed capital, technology, knowledge etc. for poorer countries. Others point at the dangers of multinational companies crowding out local companies as well as introducing imperfect competition.

There is a growing empirical literature on the impact of FDI, which can be separated into two strands. A first group of studies focuses on horizontal spillover effects of foreign investment on domestic firms. The conclusions from these studies are mixed: some studies find positive effects (Hu & Jefferson, 2002; Liu, 2002), and others, no significant effect (Kokko, Tansini, & Zejan, 1996; Konings, 2001), and yet other studies conclude that the impact on local firms is negative (Aitken & Harrison, 1999). The difference in the findings comes from two opposing effects of FDI. On the one hand, FDI can introduce new products and technologies, and domestic companies can benefit from this through personnel turnover, demonstration effects and knowledge spillovers. These horizontal spillovers are however, only important if the technology gap between the foreign and domestic firms is not too large (Kokko, 1994). A negative FDI effect can come from FDI cutting into the local companies' market share. Hence, the different findings of the studies reflect the relative importance of these two factors in the various countries and sectors.

A second group of studies focuses on vertical spillover effects. Studies find that foreign firms facilitate the adoption of new technologies and can solve contract enforcement problems (Gow & Swinnen, 1998; Key & Runsten, 1999). Yet most studies conclude that the impact on local suppliers is mostly negative, in particular for small suppliers in developing countries (Dolan & Humphrey, 2000; Weatherspoon & Reardon, 2003). The latter often cannot comply with the higher standards and grading requirements for the supplied products (Farina & Reardon, 2000; Henson, Loader, & Brouder, 2000; Reardon, Codron, Busch, Bingen, & Harris, 1999). Moreover, foreign investors prefer to deal with a few large suppliers to minimize transaction costs, forcing consolidation of the supplier base and hence separating many small suppliers from their traditional outlets (Holloway, Nicholson, Delgado, Staal, & Ehui, 2000; Runsten & Key, 1996; Winters, 2000). Reardon and Berdegué (2002) show, in the case of retail investors in Latin America, how this process can lead to the rapid exclusion of thousands of small suppliers.

The first objective of this paper is to study the impact of foreign direct investment on suppliers, and in particular small suppliers, in transition countries. Many companies in transition countries are (or were) in severe need of restructuring and upgrading of capital, technology, and management. This holds across the transition world, but is especially pronounced in those countries which are now most open to external competition, either because trade restrictions were liberalized in the transition process, or, for several Central and Eastern European countries, because they will soon be integrated in a single EU market in which they will have to compete with other EU companies. At the same time, transition countries, and in particular those closer to the EU, have received a large inflow of FDI over the past years. For these reasons, studying the impact of FDI in transition countries can provide very useful insights.

The second objective of this paper is to analyze and understand the mechanism and process of how FDI affects the local economy, and in particular (small) suppliers. A major problem in transition countries is the breakdown of exchange systems and contract enforcement mechanisms (Blanchard, 1999; Konings & Walsh, 1999). Private institutional innovations have solved these problems in some countries (Johnson, McMillan, & Woodruff, 1999; Mcmillan & Woodruff, 1999). Case studies suggest that foreign investors have played an important role in this process through vertical integration (Foster, 1999; Gow, Streeter, & Swinnen, 2000). At least in some cases such FDI-induced vertical integration has contributed to improved access to finance and inputs, and productivity growth of suppliers (Gow & Swinnen, 2001). But, so far there is no representative statistical evidence on these effects. This paper will be the first to provide representative evidence on these effects, and to estimate econometrically the effect of these institutional innovations on the survival and growth of small suppliers.

Our empirical analysis uses data from Poland and specifically from the Polish dairy sector. To identify both the effects of FDI and the process through which these effects occur, we collected data at several levels. More specifically, we collected data through a series of in-depth interviews with domestic and foreign owned companies at the level where the foreign investment took place (dairy processing and marketing) as well as through a random survey of (potential) local suppliers (dairy farms) to these companies. We also interviewed some dairy equipment suppliers. In combination the collected information constitutes a unique dataset on the impact of FDI on (small) suppliers.

We selected the Polish dairy sector for several reasons. First, Poland is the largest of the EU accession countries, yet a small economy in the world market. Poland produced around 12 million tons of milk in 2000, which represents 2.5% of total production in the world. The accession of Poland alone would increase total milk output in the EU with 10% (FAO, 2003). Yet milk production and the dairy sector have been severely affected by the economic and institutional reforms over the past ten years. Milk production and the number of dairy cows fell by almost 30% during 1989–96. Productivity also declined initially but has turned around since 1992 and since 1997 yields are above their pre-reform level.1

Second, agriculture is a very important sector in the Polish economy and characterized by unfavorable structures and low incomes. Almost 20% of the population is employed in agriculture, mostly on small farms. Poland is unique among the transition countries in that it had a mixed institutional structure in agriculture under the Communist regime. Small private family farms survived the Communist collectivization and occupied 76% of total agricultural land.2 The remaining land was used by large-scale state farms.3 Hence, in contrast to other Communist countries where small farms resulted from the fragmentation and decollectivization of the former collective farms, both small farms and large farms have a strong historical and institutional basis in Poland.

Third, dairy plays an important role in Polish rural areas since many of the small farms have at least some milk production. Out of approximately 1.3 million dairy farms, 89% had only 1–4 cows in 1996 (see Table 1). Farms with fewer than 10 cows produced 75% of Poland's milk. Less than 60% of total milk production was delivered to dairies; the rest was used for self-consumption or directly sold on the local market. By 2000, 85% of Polish dairy farms still had fewer than five cows (GUS, 2001).

Fourth, the dairy sector––both the processing companies and the farms––were (and still are) in need of substantial restructuring in order to be competitive on the international market. In the early 1990s Polish milk production was generally characterized by low productivity and low quality. While the situation has improved importantly since the mid 1990s, even in 1999 only 20% of the 450,000 producers delivering milk to dairies delivered exclusively milk of the highest quality (Swedish Board of Agriculture, 2001). The small scale of the family farms creates specific investment problems for upgrading milk quality, as well as problems for investors in the dairy processing companies, because of transaction costs of milk collection.

Fifth, Poland has attracted significant FDI in the dairy sector,4 yet at the same time local companies continue to have a large share of the market. The liberalization of the Polish trade system and the privatization of the processing industry in the 1990s opened the Polish dairy sector to increased competition from abroad, allowed Polish exporters to search for new markets, and allowed foreign companies to invest in the Polish dairy sector.5 By 1999 there had been a total inflow of US$4.6 billion of foreign investments into the Polish agri-food sector, 5% of which has gone to dairy processing and dairy equipment companies.

The combined impact of privatization and FDI on the structure of the dairy sector has been modest (see Table 2): the total number of dairy processing companies with more than 50 employees decreased by 22% during 1993–99. The decrease was mainly in the number of cooperatives, as the number of (noncooperatively-owned) private companies doubled. Yet, cooperatives still controlled 70% of the dairy market by 1999. Twenty of the 50 privately-owned dairies had majority foreign investor ownership.

In combination, these characteristics make the Polish dairy sector a very interesting case and potentially a rich source of insights for the study of FDI impacts, in particular regarding vertical spillover effects and the impact on small suppliers. Moreover, continued FDI in the Polish dairy sector could have very significant repercussions for the sector, for the many small supplying farms, and obviously for rural welfare and development more generally. Therefore understanding the impacts is useful both for the study of Poland and for more general lessons.

The paper is organized as follows. In Section 2, we discuss the data that were collected both at the dairy-processing level and through a unique survey of local milk producers. Next, we discuss qualitative evidence on the impact of foreign direct investments and vertical integration in the dairy sector on supplier restructuring. In Section 4, we present an econometric analysis of the impact of FDI on survival and growth of local milk producers. Finally, Section 5 draws conclusions.

Section snippets

Data

To identify both the effects of FDI and the process through which these effects occur, we collected data through a series of in-depth interviews with domestic and foreign-owned dairy-processing companies and through a random survey of local dairy farms which are potential suppliers to these companies.

Foreign investment and vertical integration

Foreign companies played an important role in demonstrating the importance of supplier assistance programs and quality improvement strategies. For example, when Land O' Lakes invested in ICC Paslek in 1994, milk quality of its supplying farms––as everywhere in the region––was poor. From the start, the foreign investor set out a clear strategy to increase the quality of delivered milk. The strategy included basic changes and investments. One of the first changes was to invest in cooling tanks in

Model and variables

To complement our qualitative insights and econometrically to quantify the direct effect of foreign investment and the assistance programs on small suppliers, we estimate a model based on the firm growth literature. This literature starts from the “law of proportionate effects” or Gibrat's law, stating that firm growth rates are independent of initial firm size. Following Evans (1987), Hart and Oulton (1996) and Hall (1997) the supplier growth relationship is specified as follows.Si,t=[F(.,Si,t0

Conclusions

Previous studies argue that foreign investment leads to a rapid consolidation of the local supplier base with negative implications for those suppliers who cannot comply with higher standards and grading requirements, or who are cut out by the company in order to reduce transaction costs. Studies argue that this effect can be especially dramatic for small suppliers in developing countries.

The conclusions of our analysis are different. We do not find that foreign investment leads to either a

Acknowledgements

The authors thank Hamish Gow for discussions on the issues addressed here and for collaboration in part of the data collection. Furthermore we are grateful to Ewa Maciag, Mr. Klekotka, Dr. Uminski and students from the University of Gdansk for their help with the survey. This research was supported by the European Commission under its Phare/ACE Research Program (P98-1007-R). The opinions expressed in this paper are those of the authors only, and do not necessarily reflect those of the

References (46)

  • P. Bardhan et al.

    Development microeconomics

    (1999)
  • O. Blanchard

    The economics of post-communist transition

    (1999)
  • C. Dolan et al.

    Governance and trade in fresh vegetables: the impact of UK supermarkets on the African horticulture industry

    Journal of Development Studies

    (2000)
  • C. Edwards et al.

    The changing distribution of farms by size: a Markov analysis

    Agricultural Economics Research

    (1985)
  • European Commission (1998). Agricultural situation and prospects in the Central and Eastern European countries. Poland,...
  • D. Evans

    Tests of alternative theories of firm growth

    Journal of Political Economy

    (1987)
  • FAO (2003). FAOSTAT Agriculture Data [online]. FAO. Available at...
  • E.M.M.Q. Farina et al.

    Agrifood grades and standards in the extended Mercosur: their role in the changing agrifood system

    American Journal of Agricultural Economics

    (2000)
  • Foster, C. (1999). The impact of FDI in the upstream and downstream sectors on investment in agriculture in the NIS. In...
  • P. Garcia et al.

    Size distribution and growth in a sample of Illinois cash grain farms

    American Journal of Agricultural Economics

    (1987)
  • H. Gow et al.

    Agribusiness restructuring, foreign direct investment, and hold-up problems in agricultural transition

    European Review of Agricultural Economics

    (1998)
  • H. Gow et al.

    Private enforcement capital and contract enforcement in transition countries

    American Journal of Agricultural Economics

    (2001)
  • GUS (2001). Statistical Yearbook. Warsaw: Central Statistical...
  • Cited by (220)

    • Should I stay or should I go? The impact of nature reserves on the survival and growth of dairy farms

      2023, Journal of Environmental Management
      Citation Excerpt :

      Following these examples, a linear regression of the amount of growth (in dairy cows) was performed. As in Weiss (1999) and Dries and Swinnen (2004), the dependent variable in the OLS regression is the logarithm of the observed growth in dairy cows. This is because including the logarithm lowers the influence of potential outliers (Bradfield et al., 2020).

    View all citing articles on Scopus
    View full text