Why do firms settle subsidiaries abroad? Many theories have been put forth to explain this phenomenon known as foreign direct investment (FDI). According to some of these theories, firms invest abroad because they possess some product differentiation ability, a monopoly power, patents, trademarks, etc... These special assets are known to be the outcomes of successful research and development (R&D) activities. I then propose to test empirically these theories by checking whether there is a long-run equilibrium relationship between Canadian direct investment abroad and our gross domestic R&D expenditure. The R&D expenditure I consider are those in National Science and Engineering funded and performed the Canadian business enterprise sector. I use, in turn, three series on Canadian direct investment abroad: (1) the net flows, i.e., the investments abroad by Canadian firms minus their divestments, (2) the outflows, i.e., the investments abroad net of the reinvested earnings, and (3) the earnings made abroad and reinvested abroad by Canadian firms. These series are plotted in the figure below for the period 1970-2011.
The figure shows a co-movement between each of the three measures of Canadian direct investment abroad and the R&D expenditure. By co-movement, I mean when the R&D expenditure goes up or down, the measures of Canadian direct investment abroad also follow the movement. Some simple linear regression exercises indicate that the R&D expenditure explains respectively 59 % and 64 % of the variability observed in the net flows and the outflows of Canadian direct investment abroad. It accounts for 74 % of the variability observed in outflows of Canadian firms’ reinvested earnings abroad. The relationship between each of the three measures of Canadian direct investment abroad and R&D expenditure also turns out to be a long-run equilibrium one.
R&D activities generate what is called knowledge spillover, i.e., any firm can freely use the knowledge underlying previous innovations to devise new and distinct products or idea. So, foreign firms may want to settle in Canada in order to benefit from the know-how of our domestic firms. I have found that the flows of FDI in Canada are also positively correlated with our gross domestic expenditure on R&D. This latter variable explains respectively 31 % and 49 % of the net flows and the inflows of FDI in Canada. It explains 72 % of the profits reinvested by foreign firms in Canada. It is also worthwhile recalling here the positive correlation between Canadian direct invest abroad and FDI in Canada I mentioned in my November 28, 2013’s blog. The correlation coefficient between these two variables is about .8.
To finish with, note that:
- A reason why Canadian firms go abroad is because they are endowed with a specific know-how acquired through R&D,
- A government policy aiming at encouraging R&D activities in Canada will boost growth, enhance the performance of our firms outside the country, and will attract more FDI in our country.