Synopsis—Optimizing Local Content Requirements Under Technology Gaps

Governments of developing countries have long been using local content requirements (LCRs) to regulate foreign firms operating within their boundaries. LCRs are provisions, usually under a law or regulation, requiring foreign firms to meet a minimum threshold of goods or services that must be purchased locally. For instance, in order to boost the local component industries for 4G smartphones, Indonesia mandated an LCR of 30% on foreign smartphone manufacturers in 2016, raising from 20% required in previous years. In 2011, Russia imposed a 60% LCR on foreign automobile original equipment manufacturers (OEMs), increasing from 30% in prior years. LCRs can also be imposed in the retail sector. For example, India requires single-brand retailers that are more than 51% foreign-owned to buy at least 30% of their manufacturing materials from local vendors. As a result, Apple Inc.’s plan to open retail stores in India has been met with hurdles as its manufacturing is mostly done by Foxconn in China. In 2016, the company asked the Indian government to waive the local sourcing requirement but the proposal was rejected. Although the aforementioned policies are implemented in developing countries, many developed countries have also adopted LCR policies. For example, Canada, France, Italy, Spain, and the United States have imposed LCRs in their renewable energy sector. See Figure 1 for the worldwide distribution of implemented LCRs.

Figure 1. Share of Implemented LCRs by Country

Annotation 2019-09-03 110208

Source. Global Trade Alert

One of the primary rationales for an LCR is to protect domestic suppliers who possess less advanced manufacturing technology in producing certain intermediate goods, and thus, have lower cost efficiency than the best suppliers available in the global market. Over recent decades, the use of an LCR has been widespread globally. According to a report from the Peterson Institute of International Economics (Hufbauer et al. 2013), since 2008 over 100 new LCR policies have been proposed or implemented with 84 in developing countries and 34 in developed countries, and the United States alone has imposed 14 new LCR policies. In general, developing countries are more likely to impose an LCR because they tend to have underdeveloped intermediate goods industries that are competitively disadvantaged in the global market.

Today’s LCR policies often apply to complex final products with multiple components. For example, automobile and electronic products are assembled from hundreds of components, which may have different sourcing costs and technology gaps between local and global suppliers. In spite of this, most LCR policies implemented in practice are set at the product level—they impose a minimum local sourcing percentage on all components combined. As a result, foreign firms have the freedom to source any components from local suppliers as long as they meet the minimum local sourcing requirement at the product level. Recently, some governments started to experiment with imposing LCRs at the component level or adding component-specific restrictions to existing LCR policies. For instance, in 2016 the Indonesian government started to offer several options for smartphone manufacturers to use different combinations of hardware and software to meet the 30% LCR mandate. In 2009, the government of Ontario, Canada, implemented an LCR policy in its renewable energy sector, and set specific percentage values, the so-called “qualifying percentages,” for different activities and materials that can be sourced locally to comply with the LCR imposed on solar and wind energy projects. Some argued that such component-level LCRs could give governments flexibility in making targeted policies in the component industries.

Against the backdrop of these new LCR trends in the real world, some important policy questions remain unanswered: How should a government set its LCR policies to regulate the sourcing activities of multicomponent products? Recognizing that foreign firms have the freedom to choose the best combination of components sourced locally and globally from their own perspective, should a government impose LCRs at the product level or at the component level? How would LCR policies be affected by market size, competition, corporate tax rate, as well as the technology gaps between local and global suppliers?

Cui and Lu (2019) attempt to answer these questions. To capture the strategic interactions between governments and foreign firms, they construct a game–theoretical model in which foreign OEMs operate in the domestic market of a developing country. The country has underdeveloped component industries that can supply to the OEMs. By analyzing the government and the OEMs’ optimal decisions in this model, they generate the following policy insights:

Insight #1: From a welfare standpoint, imposing LCRs at the component level may be unnecessary.

Insight #2: Governments should consider raising LCRs when their domestic market grows.

Insight #3:  When more foreign OEMs operate in a developing country, its government should consider lowering LCRs.

Insight #4: The emergence of local OEMs should give governments an incentive to raise LCRs.

Insight #5: The carrot-and-stick approach makes sense when implementing LCR policies---LCRs should be set low (or high) when the corporate tax rate is high (or low).

Despite the gradual breakdown of trade barriers in the past few decades of globalization, the use of LCRs has been widespread in various geographical regions and in a range of different industries. As developing countries are expanding their domestic markets, an effective use of local sourcing requirement is essential to the advancement of their domestic manufacturing sectors that lack competitiveness in the global market. The aforementioned insights may assist policymakers of developing countries to install appropriate LCR polices that help increase the social welfare.

It is worth noting that prior studies on LCR policies tend to overlook the component complexity of LCR-regulated products. In this study, Cui and Lu (2019) attempt to deepen the understanding of LCRs to a more granular level, that is, product component. Incorporating this operational detail leads to novel insights into LCR policymaking. For example, they show that product-level LCR policies are as effective as component-level LCR policies by achieving the same maximum social welfare. However, when replacing a product-level LCR policy with a component-level one, governments should increase the LCR level for components that have relatively small technology gaps between local and global suppliers. By contrast, governments should decrease the LCR level for components that have relatively large technology gaps between local and global suppliers.

References

Cui S, Lu LX (2019) Optimizing local content requirements under technology gaps. Manufacturing Service Operations Management 21(1):213–230.

Hufbauer GC, Schott JJ, Cimino C, Vieiro M, Wada E (2013) Local content requirements: Report on a global problem. Report, Peterson Institute for International Economics, Washington, DC.

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