Labor Skills and Foreign Investment in a Dynamic Economy: Estimating the Knowledge‐capital Model for Singapore

• Author: Gnanaraj Chellaraj,Aaditya Mattoo,Keith E. Maskus
• Date: 01 November 2013
• Published date: 01 November 2013
• DOI: http://doi.org/10.1111/rode.12055

Labor Skills and Foreign Investment in a Dynamic

Economy: Estimating the Knowledge-capital Model

for Singapore

Gnanaraj Chellaraj, Keith E. Maskus, and Aaditya Mattoo*

Abstract

Singapore is an interesting example of how the pattern of foreign investment changes with economic devel-

opment. This paper studies inbound and outbound investment between Singapore and a sample of industri-

alized and developing countries over the period 1984–2007. Singapore’s investments from industrialized

nations shifted into skill-seeking activities, while its investments in developing countries became concen-

trated in labor-seeking production. The knowledge-capital model is used to analyze the determinants of

these shifts. The estimates suggest that a 10% increase in Singapore’s skill differences with developing

countries resulted in a 15.2% increase in outbound stocks of investment to the average recipient nation. A

10% decline in skill differences with industrialized countries after 1995 resulted in a 3.6% increase in

inbound stocks from the average parent nation.

1. Introduction

In this paper, we explore the influence of skills on foreign investment in Singapore, a

small, newly industrialized country (NIC). Singapore has been successful in attracting

foreign direct investment (FDI) during its period of rapid economic development. It

has also experienced significant deepening of its human capital stock during this

period. It is possible that the rapid growth of its skill endowments has been a signifi-

cant factor in attracting foreign investment. One framework within which to analyze

the role of skill endowments on FDI location is the knowledge-capital (KK) model.

This model has been applied to data in a number of industrialized countries, including

the USA (Carr et al., 2001). The KK model has, however, not been estimated for any

NIC.

From the time of independence in 1965, until the late 1970s, multinational enter-

prises (MNEs) invested in Singapore because of low wages (Low, 1999). As a result of

high economic growth and escalating wages, the government developed strategies to

attract high end FDI by focusing on developing the skills of the population. Between

1984 and 1998, Singapore rapidly closed its skills gap with most industrialized coun-

tries through the expansion of higher education and by facilitating the inflow of

* Maskus: School of Arts and Sciences and Department of Economics, University of Colorado, 275 UCB,

Boulder, CO 80309, USA. Tel: +1-303-492-7588; Fax: +1-303-492-8960; E-mail: keith.maskus

@colorado.edu. Chellaraj: Trade and Integration Unit, Development Economic Research Group, World

Bank, Washington DC 20433, USA. Mattoo: Trade and Integration Unit, Development Economic

Research Group, World Bank, Washington DC 20433, USA. We wish to thank James Markusen, Caroline

Freund, David Tarr, Shiva Makki, Sumner LaCroix, Shawn Arita, and other seminar participants at the

World Bank and the University of Hawaii and the anonymous reviewers for their comments, and Thamnu

Sishobhon, Polly Means, Q-H Zhao and Josette Vizmanons for their technical assistance. Financial support

from the Multi-Donor Trust Fund of the Development Economics Research Group at the World Bank is

also gratefully acknowledged.

Review of Development Economics, 17(4), 627–643, 2013

DOI:10.1111/rode.12055

© 2013 John Wiley & Sons Ltd

foreign talent.1The rapid economic development of Singapore may be partly attrib-

uted to these policies (Kee and Hoon, 2005).

Singapore transformed itself from a small, labor-abundant developing nation in the

mid-1970s to a larger, though still small (in terms of gross domestic product (GDP)),

skill-abundant NIC today. The nature of its inward foreign investment should have

shifted from a labor-seeking orientation to a skill-seeking orientation, while its

outward investments in developing countries should have become more focused on

low-wage locations. These primary questions have not been empirically studied,

which is the task we undertake here.

2. The Knowledge-capital Model and Prior Empirical Literature

Since Markusen (1984) and Helpman (1984), the general-equilibrium theory of MNEs

has focused on two motivations for FDI: to access markets to circumvent trade fric-

tions (horizontal FDI) and to employ low-wage labor for labor-intensive assembly

portions of the production process (vertical FDI). In the former case, multiple plants

making similar goods are located in different markets and produce either for local

markets or regional exports. In the latter, headquarters are split from assembly, and

goods are traded in different stages of fabrication.

Theoretical Overview

The general-equilibrium KK model of FDI (Markusen, 2002) makes three principal

assumptions. First, services of knowledge-based activities can be geographically sepa-

rated from production and supplied to production facilities at low cost. Second, these

knowledge-intensive activities are skilled-labor intensive relative to production.

These assumptions generate incentives for firms to fragment production into vertical

phases, locating R&D activities where skilled labor is abundant and production where

unskilled labor is well endowed. They also offer an incentive to locate production in

large markets if there are significant scale economies at the plant level, generating

horizontal or market-seeking FDI. The third assumption is that knowledge-based

assets are inherently joint inputs and may be deployed simultaneously at multiple pro-

duction facilities. This characteristic generates firm-level scale economies and sup-

ports horizontal investments in facilities that produce the same products in different

locations.

Specifically, the KK model combines factor endowments with complex economies

of scale to explain FDI location decisions. It presumes two countries and two homo-

geneous factors, unskilled labor and skilled labor, which cannot move across borders.

The model also assumes two homogeneous goods, one of which is labor intensive and

subject to constant returns to scale. The other is skilled-labor intensive and demon-

strates increasing returns to scale (IRS) at the plant level. Firms in this sector can

separate headquarters services from production plants, which may be located in either

the home or foreign countries, or both. These services can be shared across plants,

which support firm-level economies of scale in this sector. Finally, there are transport

costs in trading goods and fixed costs of investing in a new plant.

The model predicts the potential existence of several firm types in the IRS good in

equilibrium. First, there may be national firms that operate a single plant and head-

quarters in one country and may export to the other. Second, horizontal MNEs main-

tain plants in both countries but have headquarters in a single location. Finally,

vertical MNEs operate headquarters in one nation and a single plant in the other

country.

628 Gnanaraj Chellaraj, Keith E. Maskus, and Aaditya Mattoo

© 2013 John Wiley & Sons Ltd