explain why there is more evidence for horizontal spillovers in developed than in developing economies. Glass and Saggi (1998) find that the greater the technology gap between local and foreign firms, the lower the quality of technology transferred and the lower the potential for spillovers. Kokko et al. (1996) find that in Uruguay there were productivity spillovers to domestic firms with moderate technology gaps but not where the gap was large. Borensztein et al. (1998) and Lipsey (2000) emphasize the need to improve educational capacity in the host economy as a means of strengthening absorptive capacity to incorporate positive spillovers. Kinoshita (2001) finds that in the Czech Republic it is only domestic firms that undertake their own R&D that enjoy horizontal FDI spillovers. Further, distinguishing between ‘the two faces of R&D’ analyzed by Cohen and Levinthal (1989), Kinoshita finds that R&D performing domestic Czech firms benefit not only from innovations produced by that R&D, but also by being better able to learn and absorb knowledge from the outside. This learning effect is several times larger than the own-innovation effect.

Todo and Miyamoto (2006) observe that the extent of horizontal FDI spillovers to domestic firms also depends on the level of R&D undertaken in the host country by foreign firms. The employees of foreign affiliates that perform local R&D are likely to learn more than those in foreign firms that do not, and this knowledge can diffuse to local firms through job turnover, work-related discussions and so on. They find that domestic Indonesian firms in 1994-97 received positive spillovers only from R&D performing foreign firms, but none from non-R&D performing foreign firms. Taken together, the Kinoshita and Todo and Miyamoto studies suggest that domestic ‘in-country’ R&D may be important both for foreign affiliates to generate spillovers and also for domestic firms to absorb such spillovers.

In contrast to the case of horizontal spillovers, foreign firms are likely to be less concerned about or may have a positive incentive to transfer knowledge to their local suppliers or customers through vertical linkages. As with OEM type supplier-customer relationships, these vertical or inter-industry knowledge flows, can take place through direct knowledge transfer, for example through training programs, technical support and collaboration on production and design issues, indirectly through movement of workers between customers and suppliers or simply through higher standards for product quality and on-time delivery, that provide an incentive to domestic suppliers to upgrade their technology. (Local suppliers may also reap the benefits of economies of scale because of increased demand for intermediate products from new multinational customers, although this is not a knowledge transfer in the strict sense).

Blalock and Gertler (2004) find strong support for vertical technology transfers from MNC customers to local suppliers in Indonesia, as does Javorcik (2004) in Lithuania. Saggi (2002) finds that Mexican maquiladoras which began as producers of labor-intensive products later adopted more sophisticated production techniques from their US customers. The size of the effects is generally meaningful. Javorcik (2004) finds that a one-standard deviation increase in foreign presence in the purchasing sector of the economy in Lithuania is associated with a 15 percent rise in output of local firms in supplying sectors. However, as noted in the earlier discussion of OEM type contracts, the potential for vertical transfers is conditional to some extent on domestic firms already having sufficient technological capabilities to meet demanding quality, cost and delivery requirements and be chosen as suppliers for MNC affiliates in the first place, as well as to be capable of technological learning through vertical spillovers once they are chosen. Blalock and Gertler (2004) find, for example, that it is domestic Indonesian firms with high levels of human capital that are the prime beneficiaries of vertical knowledge transfers.

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