# **2.4. The Mediating Role of Policies That Target Business Climate**

# **_Business Climate and Institutions_**

A country’s _business climate_ —particularly the protection of foreign assets—has a large influence on a country’s location attractiveness for foreign investors. Those drivers affect a country’s participation in GVCs, regardless of their governance structure. The strength of intellectual property rights in a host country, for example, may help attract high-quality foreign investment initially and, therefore, create the potential for FDI spillovers (Gorodnichenko, Svejnar, and Terrell 2007; Javorcik 2004b). But some people argue that although strong intellectual property rights may help attract such investment and allow knowledge and technology to be transferred to the affiliate, they may also hinder the transmission of those advances beyond the local market (Havranek and Irsova 2011).

Competitive pressures from GVC participation might be lower if the local firm already faces a higher level of _competition_ at the sectoral level. Local firms in competitive sectors might have a lower incentive to improve, resulting in lower benefits from GVC spillovers. Sinani and Meyer (2004) confirmed that more sectoral competition, both of foreign firms and of domestic firms, has a positive impact on the growth of sales on local firms in Estonia, but does not control for the interaction of competition with FDI. On the other hand, local firms could be better equipped to benefit from positive demonstration effects. Barrios and Strobl (2002) found that less sectoral competition, captured by a higher Hirschman-Herfindahl index, increases the productivity gains from FDI for Spain, pointing towards a lower incentive to improve.

_Weak institutions_ —including corruption, red tape, intellectual property rights, and contract enforcement—are linked to protection for local firms, network-driven business practices, and inefficient markets, which, possibly, constrains foreign investors from fully exploiting their competitive advantages. That drawback may influence the type of FDI and nonequity mode of investment that is initially attracted, as well as domestic firms’ absorptive capacities. Empirical evidence is mixed. Firm-level data for 17 emerging countries, during 2002–05, reveal no evidence that the degree of corruption or red tape affects the extent of FDI spillovers (Gorodnichenko, Svejnar, and Terrell 2007). Evidence also shows that a country’s transparency has a U-shaped effect on FDI spillovers: countries with a medium level of transparency benefit least from FDI, whereas countries with low and high levels show stronger FDI spillovers (Meyer and Sinani 2009).

# **_Financial and Labor Markets_**

_Financial markets_ in developing countries may also be a factor in absorption of GVC spillovers (Alfaro and others 2010). Multinationals can have an ambiguous impact on access to finance for local firms: they may ease such access by bringing in scarce capital to developing countries; but if multinationals borrow locally, they may increase local firms’ financing constraints (Harrison, Love, and McMillan 2004). That, in turn, can influence local firms’ absorptive capacity, and well-developed markets may facilitate domestic firms’ absorptive capacity links (Aggarwal, Milner, and Riaño 2011).

_Low wages_ may be a way for countries to enter GVCs. According to firm surveys, costs (production, labor, transport, investment) and tax incentives are major drivers of lead firms’ decisions to invest or to source production in developing countries. Indeed, wage differentials have been primary drivers of the globalization of production. But costs encompass a wide range of drivers and the goal should be higher labor productivity and higher wages, allowing the country to remain cost competitive despite rising living standards (Taglioni and Winkler 2016).

_Labor market regulations_ may influence the effect of GVC integration on domestic firms through various channels. Higher absolute and relative labor market flexibility than in the foreign investor’s home 10