Baldwin Okubo WE2014

The World Economy
The World Economy (2014)

doi: 10.1111/twec.12116
Networked FDI: Sales and Sourcing

Patterns of Japanese Foreign Affiliates
Richard Baldwin1 and Toshihiro Okubo2
1
Graduate Institute, University of Oxford, Geneva, Switzerland and 2Faculty of Economics, Keio
University, Tokyo, Japan
1. INTRODUCTION
T HE theory of multinational corporations answers two questions: Why is production multi-

national, and why is it owned by one corporation? Canonical foreign direct investment
(FDI) theory concentrates on the first question and proposes two answers that define two types
of FDI: horizontal (Markusen, 1984) and vertical (Helpman, 1984). The former has production
being multinational to avoid trade costs (‘market seeking’); the latter has production stages
dispersed to exploit cost differences (‘efficiency seeking’). See Antras and Yeaple (2013) for
a survey. The relative importance of the two motives is an empirical question whose answer
has evolved. The first modern tests identified motives by correlating measures of FDI with
host nation size (market seeking) and host–home nation costs differences (efficiency seeking).
These studies find horizontal motives to be dominant (Carr, Markusen and Maskus, 2001;
Blonigen et al., 2003; and Markusen and Maskus, 2002). See Blonigen (2005) and Navaretti
and Venables (2004) for surveys.
More recent empirical work reveals difficulties with the two-way division. One set of studies
uses the characteristics of parent-affiliate pairs to identify motives. Feinberg and Keane (2006) –
looking at trade – and Alfaro and Charlton (2009) – looking at production – find that few parent-
affiliate pairs fit neatly into the horizontal or vertical categories. Hanson et al. (2001, 2005), doc-
ument three additional types of FDI where affiliates (i) produce for export to third markets
(export-platform FDI), (ii) add value to inputs sourced from their parents or (iii) act as wholesale
distributors. Yeaple (2003a, 2003b) finds many affiliates with mixed motives and places them in
a catch-all category called ‘complex FDI’.1 Ekholm et al. (2007) document the importance of
‘export-platform FDI’. Arnold and Javorcik (2009) show that foreign ownership makes plants
both less horizontal (more export oriented) and more vertical.
The principle contributions of our paper are threefold. First, using Japanese affiliate data
for all sectors and all nations, we confirm the shortcomings of the horizontal-versus-vertical
distinction. Second, we apply a novel empirical approach to characterising the horizontal-ness
and vertical-ness of affiliates. Our method focuses on the trade behaviour of affiliates rather
than on parent-affiliate characteristics or affiliates’ sales; it is best thought of as an empirical
implementation of Yeaple’s complex FDI concept.
In its simplest form, our method plots each affiliate in a ‘sales-sourcing box’ that has the
share of local sales on the y-axis and the share of local sourcing of intermediates on the
We thank Gordon Hanson, Andy Bernard, Beata Javorcik, Kalina Manova, Nicolas Berman, and Peter
Egger for constructive and incisive comments that have improved the paper. The access to microdata
was arranged by RIETI. This research was partly financed by Grant-in-Aid for Scientific Research (Grant
Number 21730194).
1
Important syntheses and theoretical extensions of Yeaple’s distinctions include Egger et al. (2004),
Grossman et al. (2006) Ekholm et al. (2007), and Ito (2013).
© 2013 John Wiley & Sons Ltd 1051
1052 R. BALDWIN AND T. OKUBO
x-axis. We associate low levels of local sourcing with vertical motives. When affiliates import
intermediates for further processing, it is likely that the further processing is cheaper in the
host nation, but the intermediates are cheaper abroad – a clear indication that the affiliate’s
location is at least in part motivated by efficiency seeking. Following this logic, we define an
affiliate’s vertical-ness as its non-local-sourcing share. By contrast, we associate high levels
of local sales with horizontal-ness; if most output is sold locally then market seeking was
probably an important motive. We define an affiliate’s horizontal-ness as its local sales share.
In this way, each affiliate is associated with a measure of vertical-ness and a measure of
horizontal-ness.
Using this perspective, we establish: (i) Japanese FDI in almost all sectors and almost all
nations involves some ‘vertical-ness’, and some ‘horizontal-ness’; (ii) North American affili-
ates are far more ‘horizontal’ than those in Asia and Europe; and (iii) between 1996 and 2005
affiliates became more vertical in most nations and sectors. Moreover, using a four-way sales
and sourcing split (host nation, home nation, other nations in the region and rest of world),
we find a pattern that suggests many affiliates are part of international production networks –
especially in Asia. We call this ‘networked FDI’ to shift the emphasis from the characteristics
of individual affiliates and parent-affiliate pairs to interactions among affiliates.
One implication of networked FDI is the notion of ‘regional comparative advantage’. That
is, the FDI attractiveness of one host nation may be boosted by the existence of related affili-
ates in the region – with both sales and sourcing mattering (FDI equivalent of backward and
forward linkages). We conjecture that such considerations could be important in informing
developing nations’ industrialisation policy. For example, it suggests that Vietnam’s experi-
ence with FDI and international supply chains may have little relevance to, say, Uruguay’s
FDI prospects since Vietnam is in the midst of a dense FDI network while Uruguay is not.
Such third-nation effects have been explored and documented (Baltagi et al., 2005; Blonigen
et al., 2007; Garretsen and Peeters, 2009) but only on the sales side (backward linkages).2
Third-nation effects on the sourcing side (forward linkages) may also be in operation and are
likely to be especially important in sectors where production unbundling is particularly impor-
tant. These have not, to our knowledge, been explored empirically.
The third contribution of our paper is to suggest how our continuous measures of horizon-
tal-ness and vertical-ness could be used to test various hypotheses in the FDI literature. The
rest of the introduction reviews the relevant literature in more detail.
a. FDI Literature and Our Paper

The first empirical tests of FDI motives were based on the intuitive observation that trade
and FDI should be complements under vertical motives but substitutes under horizontal
motives. Most studies found them to be complements (e.g. Lipsey and Weiss, 1981; Clausing,
2000). The first modern evidence for horizontal motives came with the testing of the proxim-
ity-versus-scale hypothesis. Brainard (1997) found that higher trade costs induced firms to
sacrifice scale economies (splitting up production) in exchange for greater proximity to cus-
tomers. The first theory-based tests that allowed for both motives came by considering
whether FDI activity was greatest between big nations (market seeking) or between nations
with big differences in endowments and/or factor prices (efficiency seeking). Here, the main
2
See also Coughlin and Segev (2000) for spatial econometric analysis.
© 2013 John Wiley & Sons Ltd

NETWORKED FDI 1053
papers are Blonigen (2001), Carr et al. (2001), Markusen and Maskus (2002), Blonigen et al.
(2003), Yeaple (2003b), Helpman et al. (2004), Braconier et al. (2005), Davies (2008), and
Irarrazabaly et al. (2013). Most studies using this identification strategy found horizontal to be
the dominant motive.
As mentioned above, more recent studies tend to find evidence that the vertical motive is
present in most cases, so the two-way classification is inadequate. One important paper that
uses trade data to investigate the horizontal versus vertical issues is Feinberg and Keane
(2006). The authors focus on US-Canada parent-affiliate trade. They show that few parent-
affiliate trade patterns correspond to pure horizontal or pure vertical motives with most
reflecting mixed motives. One paper that is close to ours in its use of firm-level data and its
focus on production networks is Antras and Fritz Foley (2009). Using US data, these authors
examine the impact of the Asian Free Trade Agreement (AFTA) on US affiliates in the
region. They find that AFTA raised the number and size of affiliates in the area compared to
other Asian host nations. They also found that the share of sales to third nations (i.e. not the
home or host nation) rose with AFTA, suggesting it fostered network-like integration rather
than just host–home linkages. While this focus on the sales pattern of affiliates is similar to
ours, the authors do not present information on the sourcing patterns as we do.
Arnold and Javorcik (2009) are also related as it shows how horizontal-ness and vertical-
ness are changed when an Indonesian plant is acquired by a foreign owner. Their main finding
is that foreign ownership boosts local-plant productivity. They suggest that one channel for
such improvement is the reduction in horizontal-ness and increase in vertical-ness. Another
paper that looks at production network aspects of FDI using firm-level data is Alfaro and
Charlton (2009). Their focus differs from ours in its use of parent-affiliate production classifi-
cation rather than sales and sourcing data. The authors use Standard Industrial Classification
(SIC) codes reported for each affiliate and its parent to classify each affiliate-parent pair as
horizontal, vertical or complex. Firms report up to six SIC categories for each entity. If the
parent-affiliate pair shares any code, the authors call it horizontal FDI. If the affiliate has a
code that is an input into one of the parent’s codes, it is vertical FDI (an input–output table is
used to determine inputs). If the pair meets both criteria, they call it complex FDI. The
authors do not question the three-way classification of FDI. Their main finding – like Hanson
et al. (2001) – is that earlier studies have misclassified much vertical FDI as horizontal.
Our paper focuses on the trade behaviour of Japanese foreign affiliates.3 Other papers also
focus on affiliates’ trade but use US data which include information that is more limited. For
instance, Hanson et al. (2005, p. 665) study affiliates’ imports from US parents but remark:
‘our data are not well suited to examine production networks in their entirety’. These authors
find trade costs and wage differences are important determinants of parent-affiliate trade. Ber-
nard et al. (2005) present evidence of US parent’s trade with their affiliates in the context of
a broad portrait of US exports and imports at the firm level, but they focus only on parent-
affiliate sales and sourcing. Borga and Zeile (2004) study the US parent’s intermediate exports
to their affiliates. Our work looks at broader indicators of affiliate sales and sourcing.
A separate literature, which is not usually viewed as part of the FDI literature but which
does speak to production networks, focuses on fragmentation as measured by trade in parts
and components (Kimura and Ando, 2005; Athukorala and Yamashita, 2006; Athukorala,
3
In terms of Japanese manufacturing FDI, Head et al. (1995) investigate location choice and agglomera-
tion effects. See also Head and Ries (2003, 2005) on Japanese FDI determinants.

2012). In line with these studies, we confirm that Asian fragmentation is mainly present in
the electrical and mechanical machinery sectors.4
Finally, our paper has some qualifications that we leave for future research. One important
missing point concerns FDI’s impact on the local economy. Using microdata, the spillover
impact of FDI on local economy is investigated by Javorcik (2004), Barrios et al. (2005),
Javorcik and Spatareanu (2008), and Arnold and Javorcik (2009).5 Another important missing
aspect in our investigation is consideration of firm heterogeneity, especially the link between
sales and sourcing patterns and firm size.6
b. Plan of Paper
Section 2 presents a brief overview of mainstream FDI theories and proposes a new dia-
gram for organising thinking about FDI categories. We also show how the diagram can be
used to organise thinking about the classic substitute-or-complement view of trade and FDI
and about development-linked FDI policies. Section 3, presents data on Japanese affiliates’
sales and sourcing patterns using a two-way (local-versus-non-local) division of sales and
sourcing patterns. Section 4 looks at four-way sale and sourcing patterns. Here, the main
result is that most FDI is networked regionally rather than globally. Section 5 discusses test-
able empirical hypotheses. Section 6 presents our concluding remarks.
2. ANALYTIC FRAMEWORK
Foundational thinking about FDI was shaped by two-nation models that excluded interme-
diate goods (Helpman, 1984, Markusen, 1984).7 This was natural since the theory arose just
before the massive transformation of production known the second unbundling (Baldwin,
2006). This transformation has changed the motives behind and nature of FDI, but before
turning to these new developments, we present a thumbnail sketch of the 1980s FDI theory.
The canonical model works with two nations, no intermediate goods, and a market struc-
ture with no multimarket effects. In this setting, a firm may find it advantageous to produce
abroad for only two reasons: lower trade costs and/or lower production costs.8 By satisfying
each market from a local factory, horizontal FDI avoids trade costs, so FDI is a substitute for
trade. Vertical FDI in its purest form involves final good production with value added in both
nations, but goods production in only one. In Helpman (1984), for example, skill-intensive
‘headquarter services’ are undertaken in the home country, while physical production occurs
in the host country. Here, FDI and trade in goods (and invisibles) are complements.
4
Kimura and Ando (2005) and Athukorala and Yamashita (2006) use product-level SITC trade data to
estimate the determinants of trade in parts and components in machinery sectors using the gravity equa-
tion and find evidence of substantial fragmentation and production networks in Asia. Jones et al. (2005),
Kimura et al. (2007) and Athukorala (2012) and provide related evidence. An early influential paper in
this line of work is Ng and Yeats (2003).
5
G€
org and Strobl (2001, 2002), using Irish micro-data, show that the presence of FDI has life-enhanc-
ing effect on local firms in high-tech industries. See Girma et al. (2001, 2002) and Girma and Wakelin
(2001) for similar results in UK data.
6
For surveys of literature on firm heterogeneity in export and FDI, see Greenaway and Kneller (2007)
and Wagner (2007).
7
See Helpman and Krugman (1985) Chapter 12 and 13, or Feenstra (2004) Chapter 11.
8
For FDI motivated by strategic reasons rather than costs, see Baldwin and Ottaviano (2001).

NETWORKED FDI 1055
As trade and investment became increasingly entwined in the late twentieth century, theory
evolved to account for the changes. The seminal paper by Yeaple (2003a) stepped beyond the
horizontal-or-vertical paradigm. In a simple three-nation model, he studied ‘complex’ FDI
strategies, that is, individual firms engaging simultaneously in horizontal and vertical FDI. He
elucidated how a firm’s investments in various host nations can be complements or substi-
tutes, and how trade and FDI may act as complements or substitutes. Ekholm et al. (2007),
and Grossman et al. (2006) generalised and confirmed Yeaple’s results in richer models.9 The
papers from the 2000s allow for third countries and thus opened the door to third-nation
effects – that is, locational choices influenced by something other than home and host nation
factors. Baltagi et al. (2005) provided clear empirical evidence that third-country effects are
important. Following development of the ‘new new trade theory’ (Melitz, 2003), Helpman
et al. (2004) introduced firm heterogeneity that allows for the co-existing of multiple forms of
FDI.
a. Classifying FDI by Trade Flows: The Sales-Sourcing Box

The modest empirical innovation in our paper is to classify affiliates according to their
trade behaviour. Given the complexity of modern international supply chains, especially in
East Asia, we believe that it is increasingly difficult to determine why a particular plant is set
up abroad rather than at home. For example, in a world where final goods involve many
inputs and intermediate goods producers sell to each other, the efficiency-seeking and market-
seeking dichotomy is blurred. Plants producing intermediates may locate near other intermedi-
ate producers both to be near their suppliers (efficiency seeking) and to be near their custom-
ers (market seeking) à la Krugman and Venables (1995). By focusing on the import and
export behaviour of Japanese affiliates, we admit both motives matter and measures of both
for each affiliate. We do not develop a formal model as it would be a simple extension of
existing work.10
The two dimensions are shown in the sales-sourcing box (Figure 1); the canonical form
show up on the edges.11
Pure horizontal FDI is the northeast corner; affiliates sell all output locally and source
all intermediates locally (in the early 1980s theory, intermediates were ignored by
implicitly bundling them into the production function).
Pure vertical FDI (Helpman, 1984) is the western border since all intermediates (head-
quarter services) are sourced from abroad, but some of the final good output is exported
back to the home nation.
Pure export-platform FDI (i.e. outward processing) is the southwest corner; all intermedi-
ates are imported, and all output is exported.
9
The first draft of Yeaple (2003a) was submitted to the Journal of International Economics in 2001;
the first drafts of Grossman et al. (2006) and Ekholm et al. (2007) came in 2003.
10
A conceptually straightforward generalisation of Yeaple (2003a) – for example a many-nation version
of Grossman et al. (2006) – would permit a much more complex range of FDI and trade outcomes. In
such a model, we can envisage foreign affiliates engaging in local and export sales as well as local and
import sourcing of intermediate inputs.
11
Also see Ando and Kimura (2005) which suggest a different two-dimensional classification with the
axes being physical distance of the affiliate from the headquarters and tightness of corporate control over
the affiliate.

FIGURE 1
The Sales-sourcing Box Diagram
Share of Output
Sold Locally Pure Horizontal
Local Assembly
FDI
FDI
100%
tit g e
bs sin rad
Su rea & T
ut ly
es
In DI
‘Networked’
F
c
FDI Increasingly Efficiency Seeking

FDI
Pure ‘HQ’
Vertical FDI
(Trade in
Invisibles)
Pure Outward
Processing FDI Resource Extraction
(i.e. Export FDI
Platform)
FDI Increasingly Market Seeking
Share of
0% 100% Intermediates
Sourced Locally
Tariff-jumping assembly FDI (e.g. assembly of final autos from kits) is the northwest
corner since all intermediates are imported and all output is sold locally.
The last corner represents pure resource extraction (cash-crop agriculture, mining, fishing,
etc.) where all intermediate inputs (if any) are sourced locally, and all output is exported. In
many cases (e.g. oil drilling), some intermediates are imported, so the point would be on the
bottom edge but near the southeast corner. We label affiliates marked by intermediate levels
of local sales and local sourcing as ‘networked FDI’; these facilities are most naturally viewed
as part of international supply chains.
The substitutability of FDI and trade increases along the southwest to northeast diagonal.
At one extreme, pure horizontal FDI extinguishes all trade, while at the other extreme, out-
ward processing FDI maximises trade in both intermediates and final goods. The horizontal-
ness of affiliates rises as we move northwards in the box and the vertical-ness rises as we
move westwards.
Of course, this is a very rough classification and many nuances are hidden. One impor-
tant aspect that we cannot get at with our data is the role of technology. Authors such as
Fosfuri and Motta (1999), Siotis (1999), and Carvalho et al. (2010) stress that multinationals
(MNCs) may place affiliates abroad to exploit existing, firm-specific technology advantages
(technology exploiting; see Driffield and Love, 2003; Love, 2003), but others do so to
acquire technology (technology acquiring). Our approach would be much improved if we

NETWORKED FDI 1057
could get a handle on the role of technology in FDI motives. This is a topic for future
research.
b. FDI and Development Strategies

The sales-sourcing box can also illustrate typical development strategies involving FDI
(Figure 2). The traditional import-substitution strategy, for example, involves starting with
local assembly and pushing multinationals to produce more intermediates locally. The even-
tual goal is to achieve export competitiveness with a high degree of local sourcing. This
would show up as a move from the northwest corner towards the southeast corner.
The twenty-first century version of this – pursued by China and other East Asian nations –
starts from the southwest ‘outward processing’ point and seeks to induce multinationals to
source more intermediates locally. This is a pure ‘eastward’ move from the lower left-hand
corner. In some cases, there is also a desire to develop the local market for the final good.
This would be a push to move affiliates’ position north-eastwards.
3. JAPANESE AFFILIATES’ SALES AND SOURCING: AGGREGATE DATA

Our data includes extensive firm-level information on Japan’s foreign affiliates called ‘The
Survey on Overseas Business Activities’ prepared by the Research and Statistics Department
FIGURE 2
FDI and Development Strategies
Share of Output
Sold Locally Pure Horizontal
Local Assembly or Tariff-jumping FDI
FDI
100%
Import-substitution
Industrialisation
Pure ‘HQ’
Vertical FDI
(Trade in
Invisibles)
Pure Outward
Processing FDI
(i.e. Export ‘Moving Up the Value Resource Extraction
Platform) Chain’ Industrialisation FDI
Share of
0% 100% Intermediates
Sourced Locally

TABLE 1
Number of Affiliates by Region by Sector, 2005
Africa Asia EU Middle North Oceania South Sector

East America America Total
Services 82 3,365 1,570 56 1,511 284 541 7,409

Machinery 27 3,425 702 10 968 57 188 5,377
Chemical 4 698 177 2 209 14 26 1,130
Primary 7 421 94 2 158 133 74 889
Metal & metal 7 503 31 1 127 11 18 698
products
Light manuf. 1 580 27 50 11 20 689
Region total 128 8,992 2,601 71 3,023 510 867 16,192
Note:
See the Appendix for list of sectors under each of the six broad headings.
of the Japanese Ministry of Economy, Trade and Industry (METI).12 The yearly survey is
conducted by METI using a questionnaire based on survey forms and covers all Japanese
affiliates in all sectors and in all nations. The parent firm and each foreign affiliate are sur-
veyed separately. The reply rate of parent firms is almost universal; that of affiliates is about
70 per cent in 2005 and 59 per cent in 1996 (the first year in which the data are in electroni-
cally accessible form). The data, which are confidential, are prepared and managed by METI.
The survey questions asked cover a very broad range of economic issues including the num-
ber of employees, assets, purchases and some intellectual property indicators, etc. While the
basic questions are constant across years, there are some annual variations in a subset of ques-
tions. The trend has been for the survey to be simplified in recent years.
The sector classifications used in the survey do not correspond to international practices
(e.g. UNIDO or OECD classifications), but they are broken down into 80 sectors in 2005. In
earlier years, the classification scheme involved more sectors, but their decomposition was
slanted towards ‘old’ industries.
In this paper, we focus on the sales and sourcing patterns of firms, but we start with a few
summary statistics.13 Table 1 shows that the biggest sectors, by far, are services and machin-
ery. The biggest host regions are Asia, North America and the EU; Asia’s total exceeds that
of the sum of all other regions.
Looking across sectors, we see a typical Pareto distribution of the importance of the sec-
tors. Using data for 2005, we see that in terms of assets and workers employed a handful of
sectors account for the lion’s share of global totals. The most important in terms of assets are
wholesale trade, financial and insurance, auto parts, communication equipment, motor vehi-
cles, electronics and chemicals. In terms of employment, the ordering is somewhat different,
but electronics and financial services are significantly lower, while clothing and retail trade
are significantly higher. Using either metric, the biggest FDI sectors are electrical and
mechanical machinery, clothing, and certain types of services that require local presence.
Figures for the total number of nations with at least one affiliate present a broadly similar
picture.
12
It is Kaigai Jigyou Katsudou Kihon Chousa in Japanese.
13
The questionnaire of the data asks about imports or local purchases of intermediate inputs and raw
materials (i.e. sourcing) and exports or local sales of final products.

NETWORKED FDI 1059
a. The Sales-sourcing Patterns: Affiliates’ Trade Patterns

While we have data by nation by sector for each affiliate, we work with figures aggregated
across all affiliates within a country or region to bring the data’s dimensionality to a manage-
able level. This helps us develop empirical hypotheses that can be tested econometrically on
the firm-level data.
The first task is to see how Japanese affiliates are placed in the sales-sourcing box diagram.
Specifically, we characterise each sector (aggregating over all affiliates in all nations) accord-
ing to the share of its output sold locally as well as by the share of its intermediate purchases
that are acquired locally (these purchases do not concern factors of production like labour,
capital and technology). Each sector is plotted as a point in the sales-sourcing box. In keeping
with the two-nation worldview, we aggregate the sales and sourcing information into local
(i.e. from or to the host nation) and non-local. This gives us 68 data points (one for each two-
digit sector), each with two characteristics – the share of local sales and the share of local
intermediates. These are displayed in a scatter plot (Figure 3).
Figure 3 confirms that the canonical horizontal or vertical distinction is useful but inade-
quate. In 1996, the horizontal motive covers a large number of sectors as can be seen from
the mass of data points along the north-eastern corner and eastern edge more generally.
Indeed, if we ignored data on affiliate’s sourcing patterns, then 1996 would suggest that most
affiliates were examples of horizontal FDI. This feature of the data probably explains why
early empirical work, such as Brainard (1997), found that horizontal FDI was dominant. Such
studies focused only on the sales patterns of affiliates. To see this, we collapse all points onto
the box’s eastern edge to get a histogram of horizontal-ness (Figure 4). This shows the pre-
dominance of sectors that sell 90 per cent or more of their output locally.
FIGURE 3
Sales and Sourcing, Japanese Affiliates, All Host Nations, 1996
I Pu
FD re
Ho
bly 1996 riz
sem on
As 1 tal
cal FD
Lo I
0.9
0.8
Local Sales of Output
0.7
0.6
0.5
0.4
0.3
0.2
0.1
DI
Ou
0 F
ion
tw
0 0.2 0.4 0.6 0.8 1 t

ac
ard
tr
Ex
Pr
Local Sourcing of Intermediates

rce
oc
ou
es
s
sin
Re
g

FIGURE 4
Dominance of Local Sales, 1996
Histogram of Local Sales Share

100
90
80
70 Frequency
Frequency (%)
60 Cumulative
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 More
Local Sales Share by Sector (%)
Moving away from the box’s eastern edge, we see that many data points display intermedi-
ate shares of both local sales and local sourcing. In Yeaple’s terms, this is ‘complex’ FDI. It
is also interesting to note that in 1996, there were no sectors in the outward processing corner
(remember we have aggregated across all affiliates in all regions so even if many affiliates in,
say, IT equipment, were engaged in outward processing, the average need not show up in the
southwest corner).
As production unbundling advanced, the sales-sourcing patterns of Japanese FDI change
dramatically, as the comparison between 1996 and 2005 in Figure 5 and Figure 3 shows.
Although the sector classifications changed between the two years, the broad picture is clear –
most sectors saw a decrease in the local sourcing of intermediates. The idea here is that pro-
gress in information and communication technology made it increasingly economic to spa-
tially unbundle production and disperse production stages to locations with attractive
production costs (Baldwin, 2006). A few sectors remain as classic horizontal sectors, but there
a greater mass of sectors in the centre.
In particular, Figure 5 shows the emergence of what we called ‘networked FDI’ – that is,
FDI where the affiliates import substantial shares of their intermediates and export substantial
shares of their output. In this sense, trade and investment became far more entwined between
1996 and 2005.
b. Focus on Sectors
As might be expected, the sales-sourcing patterns vary according to the sector of the affili-
ate. After all, the key determinant of market-seeking versus efficiency-seeking FDI depends
upon sector-varying characteristics such as scale economies, natural and manmade trade fric-
tions, and modularity of the production process. Figure 6 divides our two-digit sector points
into six broad categories: light manufacturing, chemical, metal and metal products, machinery,
service and primary sector. The charts contain some surprising features.
Focusing on 2005 data (left panel), we see that service sectors are the sectors with patterns
closest to the tradition horizontal or vertical FDI. For example, hotel and restaurant, real
estate, and advertising rely almost entirely on local intermediates and sell virtually all output

NETWORKED FDI 1061
FIGURE 5
Sales and Sourcing, Japanese Affiliates, all Host Nations, 2005
I Pu
FD re
Ho
m bly 2005 riz
se on
l As 100% tal
ca FD
Lo I
90%
80%
Local Sales of Output
70%
60%
50%
40%
30%
20%
10%
Ou 0% I
tw 0% 20% 40% 60% 80% 100% n FD
ar
d Local Sourcing of Intermediates c tio
Pr x tra
oc
es eE
sin urc
so
g Re
FIGURE 6
Sales and Sourcing by Sector, 2005 (left) and 1996 (right)
100 100
90 90
Local Sales of Output (%)
80 80
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
0 20 40 60 80 100 0 20 40 60 80 100
Local Sourcing of Intermediates (%) Local Sourcing of Intermediates (%)
Light Manufacturing Chemicals Primary Light Manufacturing
Metal and Metal Products Machinery Chemicals Services
Services Primary Machinery Metal and Metal Products
Note:
See Appendix A for list of sectors under each of the six broad headings.

locally. More generally, service sectors tend to have extreme sales-sourcing patterns. The
communications industry, for example, sources only 5 per cent of intermediates locally, but
sells 95 per cent to the local market. The transportation-service sector sources only 16 per
cent locally and sells only 14 per cent locally.
Primary sectors also tend to be extreme in their trade patterns, generally showing up on
the eastern edge of the box. Extractive sectors such as forestry and metal mining have very
low local sales, but very high local sourcing of intermediates. Note that we are measuring
intermediates as total purchases other than those related to labour, capital and technology.
There is also a group of primary sectors that closely fit the trade pattern of pure horizontal
FDI. Beverage manufacturing, construction and food manufacturing are examples of sectors
with very high local sourcing and sales shares.
The classic FDI sectors – manufacturing of consumer and capital goods, which account for
the bulk of FDI by value – tend to have more intermediate sales-sourcing configurations.
Interestingly, the machinery sectors tend to be stretched out along the 45 degree line with
their sales and sourcing shares tending to rise or fall together. On the high side, Motor vehi-
cles as well as auto parts and accessory manufacturing have sales and sourcing shares around
60 to 70 per cent. Other transportation equipment, by contrast, has scant local sales and sourc-
ing; the numbers are 17 and 22 per cent, respectively. Such low shares suggest that these
affiliates are adding value at intermediate production stages and passing their output down the
international supply chain.
Chemicals tend to display high local sales shares with variable local sourcing shares. For
example, medicines, chemical fertilisers and cosmetics have local sourcing shares under 30
per cent but local sales shares over 80 per cent. Finally, light manufacturing sectors (e.g.
textiles, clothes, wood and paper products) tend to have patterns that are shifted towards the
resource extraction corner (100 per cent local sourcing and 0 per cent local sales) compared
to heavy-industry sectors.
The pattern for 1996 is difficult to compare exactly to 2005 given the changes in sector
definitions, but many of the sector features in 2005 are also found in the 1996 data. For exam-
ple, services and primary sectors have extreme sales-sourcing patterns, and light manufactur-
ing sectors generally have higher local sourcing shares than machinery sectors. One big
change is the truncation of variation in machinery sectors. In 1996, many machinery sectors
had local sales and sourcing shares over 80 per cent. By 2005, however, no machinery sectors
had more than 80 per cent sales and sourcing shares. This surely reflects the internationalisa-
tion of supply chains in the machinery sector.
c. Regional Variations
The patterns depicted hereto reflect an average across all nations. As it turns out, there are
important differences among the sales-sourcing configurations of Japanese affiliates in the
three major host regions – Asia, North America and the EU. Figure 7 shows the 2005 figures
for sectors located in EU nations (left panel) and in Asian nations (right panel). Note that here
local means sales within the individual host nation, not within the region (e.g. EU or Asia).
Both panels show that FDI in both regions is what might be called ‘networked’ FDI (exclud-
ing primary and service sectors). That is, the affiliates are very outward oriented in that they
import the bulk of their intermediates and export the bulk of their output (Figure 8).
For the EU, very few sectors have local sales shares over 50 per cent or local sourcing
shares over 60 per cent. This is a natural consequence of Japanese firms viewing the EU as a

NETWORKED FDI 1063
FIGURE 7
Sales and Sourcing by Sector, EU and Asia, 2005
EU Asia
100 100
90 90

80 80
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
0 20 40 60 80 100 0 20 40 60 80 100
Local Sourcing of Intermediates (%) Local Sourcing of Intermediates (%)
Primary Light Manufacturing Primary Light Manufacturing

Chemicals Metal and Metal Products Chemicals Metal and Metal Products
Machinery Services Machinery Services
Note:
See Appendix A for list of sectors under each of the six broad headings.
FIGURE 8
Sales and Sourcing by Sector, North America, 2005
North America
100
90
80
70
60
50
40
30
20
10
0
0 20 40 60 80 100
Local Sourcing of Intermediates (%)
Primary Light Manufacturing
Chemicals Metal and Metal Products
Machinery Services
Note:
See Appendix for list of sectors under each of the six broad headings.
single market; they tend to place a facility in a limited number of EU nations, exporting from
these to other EU members. Likewise, the local sourcing is limited given the relatively small
nature of many EU nations (this limits the range of available intermediates).

The sectoral sales-sourcing patterns in Asia are fairly similar to the EU patterns. Services
and primary tend to have extreme patterns. However, the Asian pattern for services seems to
reflect the more fragmented nature of Asian national markets for services. That is, many of
the services appear to be examples of pure horizontal FDI with mostly local sourcing and
sales. In the EU, by contrast, many of the service sectors sell less than 70 per cent locally
and about half of them source less than 50 per cent locally. When it comes to the big volume
FDI sectors – machinery – the Asia and EU pictures are both marked by the networked fea-
tures, namely intermediate shares of local intermediate purchases and intermediate shares of
local sales.
The North American sales-sourcing patterns are strikingly different, especially for manu-
facturing sectors (chemicals, light manufacturing and machinery). The most salient feature is
the dominance of local sales. Almost every sector sees more than 50 per cent of output sold
within the host nation (i.e. within US, Canada or Mexico). This outcome is probably due to
the vast size of the US market, which is almost as large as the EU market but which consists
of one nation rather than dozens.
4. THE MULTINATION SALES-SOURCING PATTERNS
Hereto we have used the two-nation perspective; sales and sourcing is either home or for-
eign. This was a natural point of departure for our analysis since the canonical theory – which
still shapes today’s theory and empirical work – was cast in a two-country world. Given the
extensive literature on global value chains, the next nature step is to turn to a more refined
categorisation of the sales-sourcing patterns. Fortunately, our data allow us to take a step in
this direction. In particular, we turn to a four-fold categorisation of the sales and sourcing pat-
terns: to/from local, to/from Japan, to/from other nations in the region, to/from rest of world.
To provide a backdrop for our investigation of sector variations, we first consider the
aggregate sales and sourcing patterns of all Japanese affiliates in all sectors and all nations.
The left bar of Figure 9 decomposes the destination of foreign affiliate sales into local sales,
sales back to Japan, sales to other nations in the region and sales to all other nations (RoW).
FIGURE 9
Sales and Source by Region, 2005, All Sectors and Nations
100
7
12
90
18
80 16
70 14
60 To or From RoW
50 61 To or From Region
33
40 To or From Japan
39 To or From Local
30
20
10
0
Sales (%) Sourcing (%)

NETWORKED FDI 1065
The regions here are North America, Asia, South America, the EU, Oceania and Africa. The
right bar provides the same geographical breakdown for purchased inputs (intermediates).
A key fact shown by Figure 9 is that 25 per cent of sales are to neither the home nation
(Japan) nor the host nation. Moreover, 28 per cent of purchased inputs are not from home
or host nations. Both facts sit uncomfortably with the two-nation thinking and suggest that
empirical tests based on this home-or-foreign aggregate will lead to misleading results. For
example, looking only at sales, the horizontal FDI story would look good (60 per cent of
sales to host market), but looking only sourcing the horizontal FDI story looks bad (only
39 per cent of inputs purchased locally). The two-nation vertical story also struggles to
account for the main facts as only 33 per cent are sourced from the home nation. Of course
squashing our data to fit the two-nation model, we would add the sourcing from Japan, the
region and RoW to get a feeling for the non-local content. The result would be that the
vertical story looks much better than the horizontal story as 60 per cent of intermediates
are non-local.
a. Sectoral Perspective
The average numbers in Figure 9 hide massive cross-sector variation. The figures for all
our sectors (again aggregated across all Japanese affiliates worldwide) are shown in Figure 10.
The sectors have been ordered according to a crude ‘networked FDI index’ which reflects the
average share of sales and sourcing from third nations. This is a very rough measure of the
extent to which production chains are internationalised in complex ways.
Quite a few sectors at the top of the chart – that is, sectors with large shares of non-local,
non-Japanese sales and sourcing – are generally viewed as being thoroughly involved in net-
worked production chains. These include electronic equipment, textiles, chemicals and
machinery sectors. There are also some surprises, for example the high ranking of the finance
and insurance sector.
(i) Focus on Machinery

The production unbundling phenomenon has mostly occurred in the machinery sectors –
especially in the mechanical machinery and electronics sectors. Here, we focus on the sales
and sourcing patterns in these sectors, again aggregating across all firms in all regions. In
essence, Figure 11 pulls out and magnifies several bars from Figure 10.
The chart arranges the sectors by order of importance of local sales. The motor vehicles
sector is the top sector on this dimension (largely due to trade, investment and industry poli-
cies aimed at promoting local production, or at least local assembly, of autos and small
trucks). Averaging across all host nations, over 80 per cent of outputs are sold locally, but
only 60 per cent of the inputs are purchased locally. At the other end of the scale, we have
office and household machines where only about a fifth of output is sold locally. A very large
share is sold to Japan and about 15 per cent is sold to third markets. The networked feature
of FDI in this sector can be seen by noting that about 40 per cent of the inputs are imported.
This strongly suggests that affiliates in this sector are involved in an international production
network where some parts are imported from Japan or third nations in the region, while the
best part of output is sent back to Japan.
Electronic equipment is another sector where FDI seems to be networked. Almost 75 per
cent of intermediates are imported (about half of this from Japan) and about 70 per cent of
the output is exported – mostly to other nations in the region. Similar patterns can be found

FIGURE 10
Four-way Sales-Source Pattern by Sector, 2005, All Nations
Sales Sourcing
Other Transportation Equipment
Finance and Insurance
Petroleum Refining
Railway Transport, Road Passenger…
Other Services
Printing and Allied Industry
Chemical Fibres
Chemical fertilisers
Wholesale Trade
Woven Fabric Mills, Knit Fabrics Mills
Fisheries and Aquaculture
Electronic Equipment
Silk-reeling Industry, Spinning Mills
Professional Services
Other Electrical Machinery Equipment…
Goods Rental and Leasing
Metal Mining
Household Electric Appliances
Electronic Parts and Devices
Other Precision Instruments and…
Communication Equipment and Related…
Organic Chemicals
Non-ferrous Metals Worked Products
Pulp, Paper
Electronic Data Processing Machines,…
Manufacturing Industries, N.E.C.
Smelting and Refining of Non-ferrous…
Optical Instruments and Lenses
Office, Servce Industry and Household…
Special Industry Machinery
Metal Working Machinery
Inorganic Products
Industrial Electromechanical Apparatus…
Oil and Fat Products, Soaps, Synthetic…
Auto Parts and Accessory Manufacturing
Glass and its Products
Plastic Products
Motor Vehicles
Other Fibres Manufacturing
Other Ceramic, Stone and Clay Products
Cosmetics, Toothpaste, and Other Make-…
Cement and its Products
Other General Industry Machinery and…
Other Fabricated Metal Products
Lumber and Wood Products
Rubber Products
Iron and Steel
Furniture and Fixtures
Miscellaneous Iron and Steel
Food Manufacturing
Other Chemical and Allied Products
Communications Industry
Retail Trade
Other Petroleum and Coal Products
Apparel and Other Textile Products
Fabricated Constructional and…
Warehousing Etc
Watches, Clocks, Clockwork-operated…
Forestry
Beverage Manufacturing
Drugs and Medicines
Paper Products
Construction
Internet Supplementary Services
Electricity, Gas, Heat Supply and Water
Information Services
Broadcasting Industry
Restaurants
Advertising Industry
Lodging Industry
Real Estate
Prepared Animal Foods and Organic…
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%100% 0% 50% 100%
To or From Local To or From Japan To or From Region To or From Row

NETWORKED FDI 1067
FIGURE 11
Four-Way Sales-pattern, Machinery Sectors, 2005, All Sectors and Nations
Sales Sourcing
Motor Vehicles
Auto Parts and Accessory Manufacturing
Other General Industry Machinery and Equipment
Special Industry Machinery
Metal Working Machinery
Communication Equipment and Related Products
Optical Instruments and Lenses
Industrial Electromechanical Apparatus Manufacturing
Household Electric Appliances
Other Electrical Machinery Equipment and Supplies
Other Precision Instruments and Machinery
Watches, Clocks, Clockwork-operated Devices and Parts
Electronic Parts and Devices
Electronic Data Processing Machines, Digital and…
Other Transportation Equipment
Electronic Equipment
Office, Servce Industry and Household Machines
0% 20% 40% 60% 80% 100% 0% 50% 100%
To Local To Jpn To Region To RoW
in computers (electronic data process machines), electronic parts and devices, other transport
equipment and precision instrument sectors (watches and other precision instruments).
(ii) Focus on Electronics in Asia and Europe

To zoom in more closely on a sector where we expect network FDI to feature strongly in
the data, we narrow our focus to the three electronics sectors in our data and limit the analysis
to 2005. As we are only looking at three sectors, we can breakdown sales-sourcing patterns
by nation (but aggregating over all affiliates in each host nation). We start with the most net-
worked region, namely Asia.
Starting with the sales pattern for phones and related products (top left panel marked
1,501), we see that except for China, most of Japanese affiliates’ sales are not local. Much is
exported back to Japan, to other Asian nations, or to the EU or the US. The export to non-
Asian markets however is quite marginal; the vast majority of sales are regional. An even
more extreme regionalisation of the supply chain shows up on the sourcing side (top right
panel). Virtually, all the inputs purchased by affiliates located in an Asian nation are from
Asia itself. Local purchases are small (except in Hong Kong).
This is clear evidence that ‘global value chains’ is a misnomer; value chains in Asia are
regional, not global. The regionalisation of sales and sourcing in computers (two charts in the
middle panel) is even more marked. With the exception of Singapore, very little of the com-
puter production is sold locally – almost all of it is exported to other Asian nations with Japan
being a very large importer. When we compare the sales pattern with the sourcing pattern, we
see that Japan is also a very large supplier of intermediate inputs for computers. Taken
together, this suggests that computers are a classic case where Japanese computer makers
offshored some aspects of their production line to nearby, low-cost Asia locations but main-
tain substantial production of intermediates at home (Figure 12).
As showed in the bottom panels, the sector marked 1,503 (electronic parts and devices sec-
tor), displays a high local sales share but also very high import shares of inputs from other Asian
nations, especially Japan. As these are parts, the local sales must be feeding into a supply chain.
The networked FDI features we saw in Asia are partly present in the EU, as Figure 13
shows. When it comes to parts (bottom panel marked 1,503), most of the output is exported,
with most of it going to other EU nations. The UK is an exception with local parts sales

FIGURE 12
Networked FDI in Asia, Electronics Sectors, 2005
1501 China China
Korea Korea
Vietnam Vietnam
Taiwan Taiwan
Hong Kong, China Hong Kong, China
Philippines Philippines
Indonesia Indonesia
Thailand Thailand
Singapore Singapore
Malaysia Malaysia
India India
0 200,000 400,000 600,000 0 200,000 400,000
To Local To Japan To Region To RoW From Local From Japan From Region From RoW
1502 China China

Korea Korea
Vietnam Vietnam
Taiwan Taiwan
Indonesia Indonesia
Singapore Singapore
Malaysia Malaysia
0 100,000 200,000 0 50,000 100,000 150,000 200,000
1503 China China

Korea Korea
Vietnam Vietnam
Taiwan Taiwan
Indonesia Indonesia
Thailand Thailand
Singapore Singapore
Malaysia Malaysia
0 200,000 400,000 600,000 800,000 0 200,000 400,000 600,000
Note:
The left panels show sales; right panels show sourcing; 1501 is ‘communication equipment and related products’ (final
goods including phones, fax, radio, TV, stereo, tape recorders, karaoke machines, etc.; 1502 ‘electronic data processing
machines, digital and analogue computer, equipment and accessories’ final goods, and 1503 is ‘electronic (parts and
devices’ parts and components such as semiconductors, tuners, transistors, condensers, etc).
dominating. The sales of phones (top panel marked 1,501) and computers (middle panel
marked 1,502) show a remarkable emphasis on local and regional sales. Apart from small
slivers of sales back to Japan, virtually all of the output of these sectors is sold in the EU.
Among the EU nations, however, there are important differences. Some nations, like Italy, the
Czech Republic and Hungary, are classic export platforms with basically all their output
exported to other EU nations. Others, however, such as Germany, France and the UK, show a
mix of local and export sales.
The pattern for computers (middle panel) is quite stark. The UK is the dominant host
nation and it imports almost all of its intermediates from Japan while exporting almost all of

NETWORKED FDI 1069
FIGURE 13
Networked FDI in the EU, Electronics Sectors, 2005
Czech R 1501 Czech R
Hungary Hungary
Russia Russia
Spain Spain
Italy Italy
Germany Germany
France France
UK UK
0 100,000 200,000 300,000 400,000 500,000 0 100,000 200,000 300,000 400,000 500,000
1502
Spain Spain
Germany Germany
UK UK
0 20,000 40,000 60,000 80,000 0 10,000 20,000 30,000 40,000 50,000
Slovakia
1503 Slovakia
Denmark Denmark
Italy Italy
Netherlands Netherlands
Germany Germany
France France
UK UK
0 50,000 100,000 150,000 200,000 0 50,000 100,000 150,000
Note:
See note to Figure 12 for category definitions.
its output to other EU nations. This suggests that the manufacturing of Japanese computers in
the UK is basically an assembly operation.
(iii) Focus on Electronics in the US: The Odd Man Out

The broad similarity of sales-sourcing patterns in Asia and the EU stands in stark contrast
to the US pattern.14 In short, Japanese affiliates in the US do not seem to be engaged in
14
We note that this discussion hinges on the boundary of nations and regions. The US is a large econ-
omy and composed of 50 states. If the data are disaggregated at the state level, results might change and
be closer to EU case. Likewise, if EU (or Euro) member countries are aggregated as one country, our
results in the European case might change.

FIGURE 14
Electronics FDI in the US, Electronics Sectors, 2005
1501, 1502, 1503
US (1503) US (1503)
US (1502) US (1502)
Mexico (1501) Mexico (1501)

US (1501) US (1501)
0 1,000,000 2,000,000 3,000,000 0 1,000,000 2,000,000

Note:
See note to Figure 12 for category definitions.
international production chains. The pattern is much more reminiscent of import-substitution

assembly. Figure 14 shows the facts.
Since the FDI pattern in North America is so simple (it is mostly in the US), we can show
all three electronics sectors in one figure. In the parts sector (1503) and computers (1502), the
US-based affiliates buy almost 100 per cent of their intermediates from Japan and they sell
almost 100 per cent of the output in the US. In essence, the US-based FDI is basically assem-
bling parts from Japan into final goods – presumably to avoid importing the final goods
directly. This is not pure horizontal FDI, since there is almost no local purchasing of interme-
diates. In the phone sector (1501), however, the US-based Japanese affiliates buy about a third
of inputs locally with the rest imported from Asia, with Japan playing the dominate role. On
the sales side, the pattern is almost 100 per cent local sales.
The only hint of networked FDI in North America is found in Mexico, where the affiliates
import 100 per cent of their inputs from the region (which must mean from the US given the
lack of Canadian production).
(iv) Focus on Auto Sectors

To give a flavour of the vast range of multinational activities – and thus strengthen our
warning against the broad generalisations that often emerge in the empirical literature – we
look more closely at the auto sector nation by nation (grouped by the three main FDI hosting
regions, Asia, the EU and the US).
Figure 15 shows the facts for motor vehicles and auto parts for the eight Asia nations with
significant FDI production by Japanese affiliates. Looking at the left panels, we see that sales
in the auto sectors are dominated by the local market. This is the polar opposite of the electron-
ics industry where exports are the main business of the affiliates. The local market emphasis is
stronger in final vehicles than it is in parts, but in both sectors, the lion’s share of sales is made
inside the host nation. Thailand is an exception with about a third of its sales exported, much
of it to the US and the EU. The sales pattern in autos is more international on the whole and
some Asian nations, such as Vietnam and the Philippines, export their entire output. Another
key difference is the importance of the Japanese market as a destination for auto parts. While
this is always a moderate share (except for Vietnam), it is significant in most host nations.
Vietnam is perhaps the classic example of what seems to be the offshoring of one segment of a

NETWORKED FDI 1071
FIGURE 15
Sales and Sourcing, Auto Sectors, Asia, 2005
Motor Vehicles Motor Vehicles
Vietnam Vietnam
Thailand Thailand
Taiwan Taiwan
Pakistan Pakistan
Indonesia Indonesia
India India
China China
- 400,000 800,000 - 200,000 400,000 600,000 800,000
Auto Parts Auto Parts

Vietnam Vietnam
Thailand Thailand
Taiwan Taiwan
Singapore Singapore
Malaysia Malaysia
Korea Korea
Indonesia Indonesia
India India
China China
- 200,000 400,000 - 100,000 200,000 300,000 400,000
Japanese auto production line. Japanese affiliates in the country import basically 100 per cent
of intermediates from Japan and sell basically 100 per cent of their output back to Japan.
The sourcing side (right panels) shows more elements of production networks, with Japan
playing the largest role. However, with some exceptions (Philippines, Pakistan), a very large
share of intermediates are sourced locally; the share is usually over 50 per cent.
Corresponding numbers for the EU are shown in Figure 16. On the sales side (the left pan-
els), we see a dominance of local and regional markets as in Asia, but in Europe, it is even
stronger. There are only negligible sales of motor vehicles or auto parts beyond the region.
On the sourcing side, the pattern differs sharply between final goods and parts. In several of
the nations, especially the Netherlands, Hungary and Turkey, an important fraction of interme-
diates comes from local or regional sources. This suggests that there is something of a regio-
nal production network going in the EU when it comes to final autos. Auto parts, however, is
marked by more of a local assembly pattern. With the exception of affiliates located in
France, all of the host nations import the bulk of their intermediates from Japan or from the
rest of the world (mostly Asia).
Finally, we turn to North America in Figure 17. Here, auto FDI looks very much like pure
form of horizontal FDI, at least from the regional perspective. As the left panels reveal, the
vast majority of auto sector outputs, both parts and final vehicles, are sold inside North Amer-
ica. Japanese affiliates in final autos are clearly acting as export platform for the US market.
On the input side, local purchases dominate parts and final goods production in Canada,
Mexico and the US, although a fifth of the intermediates are from Japan.

FIGURE 16
Sales and Sourcing, Auto Sectors, EU, 2005
Turkey Turkey
Spain Spain
Portugal Portugal
Netherlands Netherlands
Hungary Hungary
Germany Germany
Belgium Belgium
- 100,000 200,000 300,000 400,000 - 100,000 200,000 300,000

UK UK
Turkey Turkey
Sweden Sweden
Spain Spain
Slovakia Slovakia
Portugal Portugal
Poland Poland
Italy Italy
Hungary Hungary
Germany Germany
France France
Czech R Czech R
Belgium Belgium
- 200,000 400,000 600,000 800,000 - 200,000 400,000 600,000 800,000
FIGURE 17
Sales and Sourcing, Auto Sectors, US, 2005
US US
Canada Canada
- 500,000 1,000,000 1,500,000 - 500,000 1,000,000 1,500,000
US US
Mexico Mexico
Canada Canada
- 1,000,000 2,000,000 3,000,000 - 500,000 1,000,000 1,500,000 2,000,000

NETWORKED FDI 1073
Overall, we see that auto sector FDI sales are highly regionalised on the sales side. Most
of the vehicles and parts made in a region are purchased in the same region. On the sourcing
side, Asia and North America are quite regionalised, that is, most of the purchased inputs are
from the region itself. In motor vehicles, Europe is the outlier on the sourcing side; most of
its purchased inputs come from outside the region.
5. TESTABLE HYPOTHESES
Our ascribing a measure of horizontal-ness and vertical-ness to each affiliate suggests a
direct way of testing FDI theories. To give a couple of extreme examples, consider the case
of Vietnam in the auto parts sectors. Japanese affiliates in that nation import 100 per cent of
their intermediates and re-export 100 per cent of their output back to Japan. Given this pat-
tern, and the nature of the sector (intermediate goods), it is obvious that this FDI is efficiency
seeking rather than market seeking. The key clue, however, is not in Vietnam’s factor endow-
ment – it is in the sales-sourcing pattern of the affiliates. At the other extreme, Japanese affili-
ates in the auto parts sector buy only 24 per cent of intermediates from outside NAFTA and
sell 93 per cent of their output inside NAFTA. Again this is plainly a case of market-seeking
FDI, but the tell-tale lies not in macro indicators – it lies in the trade behaviour of affiliates.
More generally, under pure horizontal FDI, production is placed abroad to economise on
trade costs – not to take advantage of the host nation’s comparative advantage. Under pure
vertical FDI, production is placed abroad only to lower production costs. The most obvious
empirical lever to separate the two motives is the existence of trade in intermediates between
the home and the host nation. In the knowledge capital model, it would be simple to prove a
theorem that states that even minor trade costs mean that no intra-firm trade arises unless the
FDI is motivated in part by efficiency seeking. If the foreign affiliate buys any intermediates
at all from the home nation, we know that the multinational has found it advantageous to
divide the production process between the home and host nation. Straightforward revealed-
preference arguments would then tell us that the cost of dividing production must be below
that of producing the product all in the home or all in the host nation. Since this exploitation
of multi-nation comparative advantages is the hallmark of vertical FDI, we know that the
presence of any sourcing of intermediates from the home nation indicates that the FDI is at
least in part vertical FDI. This line of reasoning needs to be developed more fully, but it
seems that using affiliates’ sourcing and sales behaviour will provide a more refined test of
FDI theories.
The most obvious hypotheses to test are linked to the classic hypotheses that market size
and trade frictions foster horizontal-ness while comparative advantage differences foster verti-
cal-ness. Our measures provide new left-hand-side variables for the classical regressions sug-
gested by Carr et al. (2001). The two characteristics are determined simultaneously, so a
system estimation strategy is called for. A further robustness check would involve estimating
the system separately for sectors that clearly produce intermediate goods and those that
clearly produce final goods; vertical motive should be stronger in the former than the latter.
Another set of hypotheses are related to third-nation effects or backward and forward link-
ages. The pattern of sourcing should be affected by regional sales of other Japanese affiliates
in the region, while the pattern of sales should be affected by regional sourcing of other Japa-
nese affiliates in the region. This could be one way to separate demand-linked and supply-
linked third-nation effects on affiliate local.

One critical question in the literature is the impact of FDI on local variables such as wages
and productivity. Reflections upon the possible channels for these effects suggest that the nat-
ure of the local FDI might affect the impact. For example, affiliates with high degrees of ver-
tical-ness might be thought of as have a larger impact on local productivity than affiliates
with a high degree of horizontal-ness.
A decade of empirical studies focusing on firm size suggests another set of hypotheses.
Our data would allow a search for systematic size differences in the degree of horizontal-ness
and vertical-ness. We conjecture that large firms would be more likely to engage in networked
FDI as they can amortise the fixed cost of organisation over more units sold. In other words,
we conjecture that larger Japanese multinationals should have more intermediate values of our
horizontal-ness and vertical-ness indices. Smaller firms should have simpler FDI patterns fit-
ting more neatly into the two-fold classification.
Another fruitful line of investigation would be to use the affiliate data by nation and across
sectors to study how and whether multinational production in developing nations has ‘moved
up the value chain’ – at least as far as Japanese affiliate source practices are concerned. Of
particular interest would be changes in the share of intermediates sourced locally, the share
sourced from Japan and the share sourced regionally. Indeed, it would seem possible to build
a map of the development of the Asian production network using the increase in the number,
size and sales and sourcing patterns of Japanese affiliates. This would be a partial picture as it
would be limited to Japanese MNCs; however, the unique combination of FDI and trade
information at the affiliate level should provide a very valuable window on to the develop-
ment of regional value chains.
6. CONCLUDING REMARKS
Early modelling of FDI focused on two motives for placing plants abroad: market seeking
and efficiency seeking. Numerous empirical strategies have been developed to identify the
importance of the two. The earliest studies found evidence for a preponderance of vertical
motives (Lipsey and Weiss, 1981) – a conclusion that was reversed in the 2000s (Carr et al.,
2001). More recent work finds that most FDI involves a blend of horizontal and vertical
motive (Feinberg and Keane, 2006; Alfaro and Charlton, 2009).
Our paper offers three main contributions. First, we use Japanese affiliate data to confirm
the preponderance of mixed motives in FDI. Second, we introduce a novel way of measuring
motives by assigning a degree of vertical-ness and a degree of horizontal-ness to each affili-
ate. Using this method, we find a vast heterogeneity in the internationalisation strategies of
Japanese multinationals. These strategies vary across regions and across sectors (and by
region-sector pairs) in intuitive ways. For example, the auto industry in Asia and Europe
seems to involve much more internationally networked production structures than it does in
the US.
The paper documents a large number of stylised facts, but three stand out. First, FDI in
almost all sectors and almost all nations involves some ‘vertical-ness’, and some ‘horizontal-
ness’. The variance is so great that we suspect econometric studies aimed at establishing the
predominance of one motive are not constructive. Second North American affiliates are far
more ‘horizontal’ than those in Asia and Europe. Third, affiliates in most sectors and most
nations became more vertical between 1996 and 2005.
The paper also explores the presence of regional production networks and sounds of note
of caution in relying on parent-affiliate pair characteristics to describe multinational activity.

NETWORKED FDI 1075
We show that 25 per cent of Japanese affiliate sales are to neither the home nation nor the
host nation and 28 per cent of purchased inputs are not from home or host nations. In many
of the classic outsourcing sectors, the shares of intermediate purchases from third nations in
the region are often in the double-digit range. The share of sales to third nations in the region
is often even greater. These facts suggest that third-nation effects could be important in deter-
mining the location of affiliates. In short, it seems like backward- and forward- linkage forces
are important in FDI. The point has been documented for backward linkages (sales) but not
forward linkages (sourcing). This in turn should help inform developing nation policies with
respect to sectoral FDI policies. It should be easier to get FDI in sectors where related affili-
ates already existing in nearby nations.
In closing, we hope that the focus on the sales and sourcing patterns of affiliates opens
the door to future empirical research on the complex and fast-paced evolution of trade and
investment.
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APPENDIX A
CLASSIFICATION OF SECTORS
TABLE A1
6-way classification of sectors
Primary Machinery
Forestry Metal working machinery

Fisheries and aquaculture Special industry machinery
Metal mining Office, service industry and household machines
Construction Other general industry machinery and equipment
Food manufacturing Industrial electromechanical apparatus manufacturing
Beverage manufacturing Household electric appliances
Prepared animal foods and organic fertilisers Electronic equipment
Light manufacturing Other electrical machinery equipment and supplies
Silk-reeling industry, spinning mills Communication equipment and related products
Woven fabric mills, knit fabrics mills Electronic data processing machines, digital and
analogue computer, equipment and accessories
Other fibre manufacturing Electronic parts and devices
Apparel and other textile products Motor vehicles
Chemical fibres Auto parts and accessory manufacturing
Lumber and wood products Other transportation equipment
Pulp, paper Optical instruments and lenses
Paper products Watches, clocks, clockwork-operated devices and parts
Chemicals Other precision instruments and machinery
Chemical fertilisers Furniture and fixtures
Inorganic products Printing and allied industry
Organic chemicals Plastic products
Oil and fat products, soaps, synthetic Rubber products
detergents, surface-active agents and paints
Drugs and medicines Manufacturing industries, n.e.c.
Cosmetics, toothpaste and other make-up Services
goods
Other chemical and allied products Electricity, gas, heat supply and water
Petroleum refining Communications industry
Other petroleum and coal products Broadcasting industry
Metal and metal products Information services
Glass and its products Internet supplementary services
Cement and its products Railway transport, road passenger transport, road
freight transport, water transport, air transport
Other ceramic, stone and clay products Warehousing, services incidental to transport
Iron and Steel Wholesale trade
Miscellaneous iron and steel Retail trade
Smelting and refining of non-ferrous metals Finance and insurance
Non-ferrous metals worked products Real estate
Fabricated constructional and architectural Restaurants
metal products, including fabricated plate
work and sheet metal work
Other fabricated metal products Lodging industry
Professional services
Goods rental and leasing
Advertising industry
Other services

NETWORKED FDI 1079
Table version of Figure 10
To To To To From From From From

Local Japan Region RoW Local Japan Region RoW
(%) (%) (%) (%) (%) (%) (%) (%)
Prepared animal foods and organic 100 0 0 0 100 0 0 0

fertilisers
Real estate 100 0 0 0 100 0 0 0
Lodging industry 97 3 0 0 100 0 0 0
Advertising industry 100 0 0 0 100 0 0 0
Restaurants 100 0 0 0 99 1 0 0
Broadcasting industry 44 56 0 0 92 7 0 0
Information services 82 18 0 0 43 57 0 0
Electricity, gas, heat supply and water 99 0 0 0 87 13 0 0
Internet supplementary services 94 6 0 0 98 0 1 0
Construction 97 0 1 0 96 2 1 0
Paper products 97 2 0 0 89 6 1 2
Drugs and medicines 90 7 1 1 10 85 3 0
Beverage manufacturing 91 0 2 2 97 2 0 0
Forestry 9 82 0 4 100 0 0 0
Watches, clocks, clockwork-operated 39 53 3 1 46 53 1 0
devices and parts
Warehousing etc. 68 24 4 0 96 1 0 1
Fabricated constructional and 82 14 2 0 86 7 2 2
architectural metal products, including
fabricated plate work and sheet metal
work
Apparel and other textile products 34 60 1 1 68 26 2 1
Other petroleum and coal products 95 1 2 0 69 22 0 4
Retail trade 93 1 3 0 78 15 3 1
Communications industry 97 1 1 0 5 82 0 7
Other chemical and allied products 89 3 2 2 66 25 4 1
Food manufacturing 71 21 2 2 90 2 2 2
Miscellaneous iron and steel 86 11 1 0 60 27 3 3
Furniture and fixtures 49 47 1 1 74 12 6 1
Iron and steel 86 1 6 1 58 38 1 1
Rubber products 75 13 4 2 65 30 2 1
Lumber and wood products 29 55 1 7 93 5 1 0
Other fabricated metal products 78 10 5 1 52 41 2 1
Other general industry machinery and 69 14 7 1 50 44 2 1
equipment
Cement and its products 98 0 0 1 76 2 0 11
Cosmetics, toothpaste and other make- 82 4 7 0 27 62 5 0
up goods
Other ceramic, stone and clay products 71 18 4 1 60 25 2 5
Other fibre manufacturing 59 21 7 3 70 22 1 3
Motor vehicles 76 6 6 3 58 29 5 1
Plastic products 66 17 8 1 59 28 6 0
Glass and its products 71 9 9 0 21 67 4 1
Auto parts and accessory 72 7 9 2 57 33 4 1
manufacturing

Table version of Figure 10 Continued
To To To To From From From From

Local Japan Region RoW Local Japan Region RoW
(%) (%) (%) (%) (%) (%) (%) (%)
Oil and fat products, soaps, synthetic 78 3 6 3 55 26 6 3

detergents, surface-active agents and
paints
Industrial electromechanical apparatus 54 28 8 1 41 40 9 1
manufacturing
Inorganic products 75 6 2 8 49 33 4 5
Metal working machinery 63 8 12 2 32 59 2 3
Special industry machinery 63 3 3 14 40 49 4 1
Office, service industry and household 21 55 9 3 60 20 8 2
machines
Optical instruments and lenses 57 16 13 1 8 72 10 0
Smelting and refining of non-ferrous 66 29 2 1 55 1 1 20
metals
Manufacturing industries, n.e.c. 60 16 8 4 46 29 7 5
Electronic data processing machines, 27 39 14 3 22 63 7 0
digital and analogue computer,
equipment and accessories
Pulp, paper 36 28 4 14 75 11 0 6
Non-ferrous metals worked products 67 10 10 1 45 28 11 2
Organic chemicals 61 9 11 4 64 17 8 1
Communication equipment and related 63 10 10 4 32 45 8 4
products
Other precision instruments and 43 15 15 6 39 51 4 1
machinery
Electronic parts and devices 37 28 15 3 27 55 8 1
Household electric appliances 53 13 10 7 45 33 10 1
Metal mining 13 42 3 19 87 1 0 6
Goods rental and leasing 41 0 30 0 98 2 0 0
Other electrical machinery equipment 47 15 12 7 43 34 10 2
and supplies
Professional services 77 12 0 5 30 19 26 0
Silk-reeling industry, spinning mills 50 17 11 5 64 5 9 6
Electronic equipment 21 23 5 23 59 32 4 1
Fisheries and Aquaculture 17 53 8 8 50 12 10 9
Woven fabric mills, knit fabrics mills 34 25 10 11 55 16 9 6
Wholesale trade 55 16 11 4 24 32 11 11
Chemical fertilisers 80 6 7 0 21 19 12 18
Chemical fibres 40 8 19 8 48 27 5 8
Printing and allied industry 59 3 9 10 35 22 11 10
Other services 42 19 13 6 43 15 13 8
Railway transport, road passenger 14 21 28 5 16 59 12 1
transport, road freight transport, water
transport, air transport
Petroleum refining 18 80 1 1 8 3 43 1
Finance and insurance 65 0 13 4 13 0 34 10
Other transportation equipment 22 6 31 5 17 25 16 12

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The World Economy

The World Economy (2014)

Networked FDI: Sales and Sourcing

T HE theory of multinational corporations answers two questions: Why is production multi-

a. FDI Literature and Our Paper

© 2013 John Wiley & Sons Ltd

© 2013 John Wiley & Sons Ltd

© 2013 John Wiley & Sons Ltd

a. Classifying FDI by Trade Flows: The Sales-Sourcing Box

© 2013 John Wiley & Sons Ltd

FDI Increasingly Efficiency Seeking

© 2013 John Wiley & Sons Ltd

b. FDI and Development Strategies

3. JAPANESE AFFILIATES’ SALES AND SOURCING: AGGREGATE DATA

© 2013 John Wiley & Sons Ltd

Africa Asia EU Middle North Oceania South Sector

Services 82 3,365 1,570 56 1,511 284 541 7,409

© 2013 John Wiley & Sons Ltd

a. The Sales-sourcing Patterns: Affiliates’ Trade Patterns

0 0.2 0.4 0.6 0.8 1 t

Local Sourcing of Intermediates

© 2013 John Wiley & Sons Ltd

Histogram of Local Sales Share

© 2013 John Wiley & Sons Ltd

Local Sales of Output (%)

© 2013 John Wiley & Sons Ltd

© 2013 John Wiley & Sons Ltd

Local Sales of Output (%)

Primary Light Manufacturing Primary Light Manufacturing

© 2013 John Wiley & Sons Ltd

4. THE MULTINATION SALES-SOURCING PATTERNS

© 2013 John Wiley & Sons Ltd

(i) Focus on Machinery

© 2013 John Wiley & Sons Ltd

To or From Local To or From Japan To or From Region To or From Row

© 2013 John Wiley & Sons Ltd

To Local To Jpn To Region To RoW

(ii) Focus on Electronics in Asia and Europe

© 2013 John Wiley & Sons Ltd

1502 China China

0 100,000 200,000 0 50,000 100,000 150,000 200,000

1503 China China

0 200,000 400,000 600,000 800,000 0 200,000 400,000 600,000

© 2013 John Wiley & Sons Ltd

0 20,000 40,000 60,000 80,000 0 10,000 20,000 30,000 40,000 50,000

0 50,000 100,000 150,000 200,000 0 50,000 100,000 150,000

(iii) Focus on Electronics in the US: The Odd Man Out

© 2013 John Wiley & Sons Ltd

Mexico (1501) Mexico (1501)

0 1,000,000 2,000,000 3,000,000 0 1,000,000 2,000,000

international production chains. The pattern is much more reminiscent of import-substitution

(iv) Focus on Auto Sectors

© 2013 John Wiley & Sons Ltd

Auto Parts Auto Parts

© 2013 John Wiley & Sons Ltd

- 100,000 200,000 300,000 400,000 - 100,000 200,000 300,000

Auto Parts Auto Parts

- 500,000 1,000,000 1,500,000 - 500,000 1,000,000 1,500,000

Auto Parts Auto Parts

- 1,000,000 2,000,000 3,000,000 - 500,000 1,000,000 1,500,000 2,000,000