Liquidity Constraints and Firms' Linkages with Multinationals

The role of financial sector development in fostering economic growth has received considerable attention in recent years. In an influential paper, Rajan and Zingales (1998) demonstrate that industrial sectors that are relatively more in need of external finance grow disproportionately faster in countries with more-developed financial markets, suggesting that financial sector development reduces the costs of external finance to firms.

More recent research has argued that access to financing may promote economic growth by allowing firms to tap into new sources of knowledge from selling in foreign markets or becoming suppliers to multinational corporations (MNCs). In a theoretical contribution, Chaney (2005) shows that if firms must pay entry costs to sell in a foreign market and if they face liquidity constraints in financing these costs, only firms with sufficient liquidity will be able to export. While some other firms could profitably export, they are prevented from doing so by their lack of sufficient liquidity. Manova (2006) provides empirical support for this view by showing that countries with better developed financial systems tend to export relatively more in industries highly dependent on external capital and in sectors with fewer collateralizable assets. A theoretical model and a calibration exercise by Alfaro and others (2006) suggest that well-developed local financial markets are needed in order for host countries to benefit from spillovers from foreign direct investment (FDI). The reason is that access to financing allows local entrepreneurs to start supplying multinationals and thus to benefit from knowledge spillovers from FDI. In a cross-country growth regression, Alfaro and others (2004) find that FDI inflows contribute to faster economic growth only where financial markets are well developed.

The relationship between facing financing constraints and supplying MNCs could go either way. If a firm needs some investment in order to supply multinationals (say, to upgrade product quality or increase the scale of production), then the causality goes from the absence of liquidity constraints to becoming a supplier of multinationals. However, it is also possible that receiving a contract from a multinational increases a supplier's creditworthiness and thus makes it easier to obtain a loan or other outside financing.

This article uses the approach pioneered by Fazzari, Hubbard, and Petersen (1988) to examine the relationship between facing liquidity constraints and being a supplier to an MNC. The analysis is possible thanks to a unique data set collected by the World Bank through two surveys of domestic and foreign companies in the Czech Republic in 2003 and 2004. The surveys make it possible to identify companies selling to multinationals operating in the country and provide detailed information about the duration and characteristics of these relationships. The survey responses are supplemented with panel data on firms' balance sheets and profit and loss statements from the commercial database AMADEUS (Bureau van Dijk Electronic Publishing 2005). The data set spans 1994–2003 and includes 319 Czech firms, 88 of which are suppliers of MNCs and are observed both before and after starting the relationship with multinationals.

The Czech Republic is a suitable place to study this question for several reasons. Since starting its transition from central planning to a free market economy, it has received large inflows of FDI. At the end of 2003 (the last year of the sample), its stock of FDI reached $45.3 billion or $4,439 per capita. Survey evidence suggests that multinationals are actively engaged in local sourcing in the Czech Republic, purchasing about half their intermediate inputs (in value terms) from Czech suppliers. The virtual absence of FDI before the beginning of transition also means that supply relationships between multinationals and Czech firms are of a relatively new vintage. Finally, as in all transition economies, many local firms tend to be liquidity constrained (Konings, Rizov, and Vandenbussche 2003).

Survey evidence suggests that before signing a purchase order, multinationals often explicitly require their future Czech suppliers to make some improvements or investments. This was the case for more than a quarter of suppliers surveyed in 2004.¹ The prospect of a contract from a multinational also induced Czech suppliers to undertake improvements on their own. Some 36 percent of suppliers reported making improvements with the explicit purpose of finding a multinational customer.² Also striking, 17 percent of Czech companies surveyed reported getting a quality certification (such as ISO 9000) in order to become suppliers to multinationals. These firms constituted 40 percent of all companies reporting having such a certification. In sum, complying with the expectations or requirements imposed by multinationals may be more difficult or even impossible for potential suppliers without access to credit. And indeed credit constraints faced by Czech companies were mentioned by multinationals as one of the top factors preventing them from sourcing more inputs locally (Javorcik and Spatareanu 2005).

At the same time, contracts from multinationals (or the prospect of such a contract) may have eased credit constraints for potential or actual suppliers. Almost a quarter (31 of 137) of multinationals surveyed in 2003 reported providing their suppliers with advance payments and financing. Similarly, a quarter of suppliers reported that being a supplier of multinationals helped them obtain a bank loan.

The results of the empirical analysis, presented in this article, indicate that Czech firms supplying multinationals tend to be less liquidity constrained than other firms. However, an examination of the timing suggests that the result is due to the self-selection of less liquidity constrained firms into supplying relationships rather than to suppliers benefiting from the links with multinational customers. The data suggest that suppliers of multinationals are less liquidity constrained before starting their relationship with a multinational and continue to be less liquidity constrained for the duration of the relationship.

This finding is not driven by multinationals extending credit to their future suppliers, as the results are robust to excluding from the sample suppliers that had received this type of assistance from their multinational customers. The results also hold after excluding from the sample firms reporting that a supply relationship with a multinational had helped them obtain financing from a Czech or a foreign bank. Further, a higher liquidity ratio is found to be a robust predictor of supplying status. Finally, the results from models instrumenting for supplying status show that firms doing business with multinationals do not differ from other firms in liquidity constraints.

Understanding how firms become suppliers to multinationals has important policy implications in the context of recent empirical findings that linkages between multinationals and their local suppliers are the key channel through which indigenous firms benefit from inflows of FDI (Moran 2001; Javorcik 2004; Moran, Graham, and Blomström 2005; Blalock and Gertler 2008; Javorcik and Spatareanu 2008). The findings of this study suggest that in the absence of well-functioning credit markets, local firms may find it difficult to start business relationships with multinationals and thus may not be able to reap the benefits of productivity spillovers that such relationships can bring.

Caution is warranted, however, when interpreting these findings. While the results suggest that well-functioning credit markets are important in facilitating business relationships between local firms and multinationals, they do not suggest that a well-developed financial market is a sufficient condition for such relationships. Other factors, such as a certain level of sophistication of the local manufacturing sector, may be needed for these relationships to materialize.

This study is structured as follows. Section I presents the data and the summary statistics. Section II reviews the related literature. Section III discusses the estimation strategy and the results. Section IV presents some policy implications.

I. Data and Summary Statistics

Examining the questions asked by this study poses big data challenges. Information on the type of customers supplied by firms (and hence their supplying status for multinationals) is typically not collected by statistical agencies, tax authorities, or commercial databases. While time-varying information on relationships with multinational customers can be obtained through firm-level surveys, such surveys cannot be used to collect long spans of historical data on firm balance sheets and profit and loss statements. Thus to conduct this study, enterprise survey information was combined with historical firm-level data from a commercial database, creating a unique data set that can be used to examine the relationship between financial constraints and supplying multinationals.

The enterprise surveys were conducted in the Czech Republic in 2003 and 2004 by a professional polling company in face-to-face interviews with senior managers at respondents' workplaces. All respondents were guaranteed full anonymity. The data were collected for 857 Czech firms and 256 foreign-owned firms operating in the country. The first survey focused on manufacturing firms, and the second covered both manufacturing and services industries. About one-fifth of respondents were located in the capital city of Prague, while the rest were distributed across all regions of the country. As the primary interest of this article is the linkages between local firms and multinationals, the analysis relies on the data for Czech firms only.

The survey data identify firms that supply multinationals operating in the Czech Republic and contain information on the duration of these relationships and other company characteristics. The 2003 survey asked respondents to indicate the year in which they became suppliers to multinationals. The 2004 survey distinguished between the date of signing the contract and the date of making the first delivery. The date of signing the contract is used in this study as the date of becoming a supplier to multinationals. Of 857 Czech firms in the sample, 390 are suppliers to multinationals (331 suppliers operate in the manufacturing sector, while 59 are services firms).³ The analysis focuses on the manufacturing sector because new investment in physical assets is more likely to be important for manufacturing firms wanting to become suppliers to multinationals than for services companies.

The surveys are supplemented with financial information on interviewed firms, taken from the commercial database AMADEUS, compiled by Bureau van Dijk Electronic Publishing (2005). The additional financial information, including figures on sales, tangible fixed assets, depreciation, and profit (loss), is available for approximately two-thirds of surveyed firms. This rich database contains detailed firm-level information for 1994–2003. Deleting incomplete or inconsistent data and extreme outliers⁴ leaves 2,136 firm-year observations on 386 Czech manufacturing firms, 155 of them were suppliers to multinationals. Because of concerns about the self-selection of firms into supplying relationships, suppliers that cannot be observed before they start their relationship with multinationals are excluded, leaving 1,735 firm-year observations on 319 Czech firms, 88 of them supplying to multinationals. All suppliers to multinationals are observed both before and after starting their relationship. Suppliers to multinationals are distributed across many industries, including food products and beverages, machinery and equipment, fabricated metal products, and rubber and plastic products.

Summary statistics on suppliers and nonsuppliers show that suppliers are somewhat larger in terms of employment, tend to invest more (relative to their capital stock), and have a higher debt to capital stock ratio and a higher liquidity ratio (table 1). They also tend to be older and have higher labor productivity. They are more likely to export, have an ISO certification, and employ managers speaking a foreign language. However, they tend to experience slower sales growth.

The Czech Republic is an ideal setting for this analysis for three reasons. First, as mentioned, the country has received large inflows of FDI. In the early years of transition, food, beverage, and tobacco sectors and some other consumer goods industries received large FDI inflows as many multinationals entered the country hoping to secure a first mover advantage in a newly open market. Because of the Czech Republic's central location, reputation for high-quality engineers, and the fast progress of reforms, the country also attracted many multinationals wishing to establish export platforms supplying the neighboring European Union. By the end of the sample period (2003), 21 percent of manufacturing FDI stock was in the automotive industry; 14 percent in petroleum, chemical, rubber, and plastic products; and 12 percent in other nonmetallic products. The opening of services industries to FDI stimulated massive inflows into financial intermediation, real estate, and wholesale and retail trade. From the mid-1990s on FDI flows into services exceeded those into manufacturing.

Second, MNCs operating in the Czech Republic appear to be relying heavily on Czech suppliers. Most (90 percent) multinationals interviewed in the 2003 survey reported purchasing inputs from at least one Czech company.⁵ The median MNC had a sourcing relationship with 10 Czech suppliers, while a multinational in the top quartile had such a relationship with at least 30. Asked about the share of inputs purchased from each type of supplier (in value terms), multinationals indicated sourcing on average 48.3 percent of inputs from Czech enterprises, 33.3 percent from firms in the European Union/Eastern Europe, and 12.6 percent from multinationals in the Czech Republic. The share of inputs sourced from other regions appeared to be negligible. Fifty-five of 114 MNCs that answered this question reported buying at least half of their inputs from Czech suppliers. More than one-tenth of respondents acquired all of their intermediates from Czech enterprises. Around 40 percent of multinationals expected to purchase more inputs from Czech suppliers in the future.⁶

Third, while the Czech Republic possessed reasonably developed financial markets during the period under study, their sophistication and the level of competition (at least in the first half of the sample period) were still below those in industrialized countries. For instance, during the first year covered by the sample (1994), the ratio of bank deposits to GDP, a common measure of financial intermediation, was 0.58 in the Czech Republic, much higher than the average of 0.36 for upper middle-income countries that same year but lower than the average of 0.67 for high-income economies (Beck, Demirgurc-Kunt, and Levine 1999). The Czech private bond market was much less well developed. The ratio of private bond market capitalization to GDP (the ratio of total outstanding domestic debt securities issued by private domestic entities to GDP) was 0.02, compared with 0.07 in upper middle-income countries and 0.34 in high-income countries. In the ratio of bank overhead costs to total assets, the Czech Republic ranked with high-income countries (0.03) and appeared much more efficient than an average upper middle-income economy (0.05). The banking sector in the Czech Republic appeared to be highly concentrated, however, with the ratio of the three largest banks' assets to total banking sector assets at 0.78, compared with 0.64 in high-income economies and 0.67 in upper middle-income economies. During the period under study, the Czech banking sector experienced significant restructuring, privatization, and entry of foreign investors.

II. The Role of Cash Flow

Ever since the influential paper by Fazzari, Hubbard, and Petersen (1988), numerous studies have examined the effects of liquidity constraints on investment. These studies challenged the neoclassical theory of investment that posits that the decision to invest is driven solely by relative prices and that a firm's financial structure is irrelevant since external funds provide a perfect substitute for internal capital. Or, as Modigliani and Miller (1958) put it, with perfect capital markets, a firm's investment decision is independent of its financial condition. The alternative research agenda, proposed by Fazzari, Hubbard, and Petersen (1988), was based on the burgeoning literature on information asymmetries: in an environment with information asymmetries, external funds may be more costly and thus provide an imperfect substitute for internal capital. The difference arises to compensate lenders for the adverse selection and moral hazard problems associated with borrowers. If this is the case, investment should respond positively to increases in internal funds available for investment.

The primary way of testing this hypothesis is to estimate the investment equation including a measure of the expected profitability of the firm along with a measure of its net worth. Researchers have concluded that to the extent that the measure of net worth (usually cash flow) predicts investment behavior, financing constraints exist.

The link between investment and cash flow is a subject of ongoing debate. One thread of the literature—starting with Fazzari, Hubbard, and Petersen (1988) and followed by Hoshi, Kashyap, and Scharfstein (1991), Lizal and Svejnar (2002), and others—argues that investment sensitivities to cash flow can be interpreted as evidence of financial constraints. However, Kaplan and Zingales (1997, 2000) question that approach and provide evidence that because of nonmonotonicities investment sensitivity to cash flow is not a measure of liquidity constraints. Fazzari, Hubbard, and Petersen (2000) challenge that conclusion and derive the conditions under which the relationship between investment and cash flow is monotonic. They argue that if the a priori classification of firms is based on criteria that result in large differences in the marginal cost of external funds across groups, constrained firms with a large cost of external financing will have larger investment sensitivity to cash flow than the relatively unconstrained firms with very small cost of external funds. Although the debate is still unresolved, this study follows the Fazzari, Hubbard, and Petersen (1988) argument.⁷

III. Empirical Analysis

The goal of the analysis is to examine the link between access to credit and multinational supplier status. A priori, having a contract from a well-known MNC would be expected to increase the creditworthiness of Czech suppliers and thus ease their financing constraints. Therefore, multinational suppliers would be less dependent on their internal cash flow than nonsuppliers. To examine this effect, cash flow is interacted with the indicator variable for multinational suppliers. If firms supplying MNCs are not liquidity constrained, the sum of the coefficients α₂ and α₃ would be expected to equal 0.

It is also possible that firms' ability to obtain external financing and to become multinational suppliers is driven by other factors. For instance, more productive firms may be better positioned to become suppliers and may be identified by lenders as lower risk borrowers. To attenuate this concern, the analysis controls for labor productivity (defined as the log of the value added per worker) and its interaction with cash flow. Similarly, exporters may possess qualities that make it easier for them to obtain multinational contracts while their relationships with buyers abroad may make them lower risk borrowers. Therefore, survey data are used to control for the firm's exporting status and its interaction with cash flow. Finally, a dummy variable is used to capture different investment behavior of state-owned enterprises and an interaction of the dummy variable with cash flow is used to capture the possibility that state enterprises may enjoy soft budget constraints (for evidence, see Lizal and Svejnar 2002). State enterprises in the sample are identified by responses to survey questions on whether a company was established as a state enterprise and whether (and when) it was privatized.

The model also includes several firm-specific time-varying factors that might influence the level of investment. The analysis controls for a firm's size, measured by employment and expressed in log form, the log of a firm's age, and the level of long-term debt normalized by capital stock. To control for unobserved heterogeneity across firms, a model is estimated using firm fixed effects (α_i). Year fixed effects (α_t) are also included. They capture aggregate conditions affecting the cost of capital in a particular year, so controls for interest rates or tax rates are unnecessary.

A common concern with the cash flow sensitivity approach is that the cash flow variable may pick up more than pure liquidity effects. However, this article focuses on comparing cash flow sensitivity across firms, and so as long as such a bias does not vary systematically by multinational supplier status, it is not a major concern.

The estimation results from the baseline specification are presented in table 2. Regression 1 tests for the direct effect of cash flow on investment. The results suggest that firms operating in the Czech Republic are liquidity constrained. The coefficient on the cash flow variable is positive and statistically significant at the 1 percent level, reflecting that internal funds are an important determinant of the investment decision. As expected, the sales growth coefficient is also positive and statistically significant.

Regression 2 repeats the exercise using lagged cash flow. The conclusion is the same, although the magnitude of the coefficient is somewhat smaller. While it might be preferable to employ lagged rather than contemporaneous values of cash flow, doing so would have significantly reduced the sample size.

Regression 3 examines whether the link between cash flow and investment differs between multinational suppliers and other firms. The model includes a dummy variable that takes the value of 1 in each year in which the firm supplies an MNC operating in the Czech Republic and 0 otherwise. The dummy variable is also interacted with cash flow. If firms with linkages to multinationals find it easier to obtain credit, the sum of the coefficients on cash flow and the interaction term should not be statistically significant. While cash flow continues to bear a positive and statistically significant coefficient, the interaction term is negative and statistically significant at the 1 percent level. The F-test indicates that the hypothesis that the sum of the two coefficients is equal to 0 cannot be rejected, suggesting that, unlike nonsuppliers, multinational suppliers do not face liquidity constraints. Neither labor productivity nor its interaction with cash flow reaches conventional significance levels. The supplier dummy variable is not statistically significant, suggesting that multinational suppliers do not differ in their investment behavior from other firms.⁸

Next, the analysis tests for whether the finding that multinational suppliers are less credit constrained is due to firms being exporters rather than to their being multinational suppliers. Exporting firms may be less credit constrained because of a steady stream of income from more creditworthy foreign customers, and their experience dealing with foreign buyers may better position them to become multinational suppliers. Potential firm-level determinants of investment behavior (size, age, and debt level) are also controlled for.

The findings are robust to these additional controls. The coefficient on the interaction between the multinational supplier dummy variable and cash flow remains negative and statistically significant at the 1 percent level. As before, the F-test suggests that multinational suppliers do not face liquidity constraints. In contrast, exporters appear to be as liquidity constrained as other Czech firms. The interaction term is not statistically significant, and the F-test rejects the absence of a link between investment and cash flow.⁹ The likely explanation is that many Czech firms that continued to sell to their Slovak customers after Czechoslovakia split in 1993 are considered to be exporters, yet their Slovak buyers are unlikely to be more creditworthy than Czech buyers. This also explains why such a high percentage of observations in the sample pertain to exporters.¹⁰ The additional controls for size, age, and debt level do not appear to be statistically significant.

Lizal and Svejnar (2002) find that state enterprises in the Czech Republic were facing soft budget constraints in the 1990s. As there are only 19 state enterprises in the sample, many of which were privatized during the period considered, there is little concern that their presence affects the main findings. Nevertheless, regression 5 adds a state enterprise dummy variable and its interaction with cash flow. Neither variable appears to be statistically significant, but as expected the F-test cannot reject the hypothesis that state enterprises are not credit constrained. The finding on multinational suppliers remains unchanged.

The last column in table 2 includes all the controls listed in equation (1) and confirms the earlier conclusions. The cash flow variable has a positive and statistically significant coefficient, and its interaction with the multinational supplier dummy variable is negative and significant at the 1 percent level. Based on these coefficients and the F-test, Czech firms in general appear to be liquidity constrained, but multinational suppliers do not. As before, the results suggest that state enterprises may be subject to soft budget constraints.

Are Future Multinational Suppliers Less Credit Constrained?

The estimation results of equation (2) are presented in table 3. Regression 1 looks at whether multinational suppliers were liquidity constrained one year before they started their relationship with an MNC. As before, the coefficient on cash flow is positive, though slightly larger, and statistically significant at the 1 percent level. The interaction terms between the multinational supplier dummy variable and cash flow and between future supplier and cash flow are both negative and statistically significant at the 1 percent level. F-tests suggest that, unlike Czech firms in general, neither current nor future multinational suppliers face liquidity constraints.

Regression 2 considers the two-year period before starting a relationship with an MNC. The interactions of cash flow with 1 yr before and supplier remain negative and statistically significant. The coefficient on the interaction with 2 yrs before is negative, though not statistically significant. F-tests cannot reject the hypothesis that multinational suppliers are not liquidity constrained and that this lack of constraints is already present in the two-year period before becoming a supplier.

Regression 3 shows that the findings are robust to controlling for firm size, age, and debt level. In sum, the findings are suggestive of unconstrained firms self-selecting into becoming multinational suppliers.

To take into account a currency crunch that took place in the Czech Republic in 1999–2000 following a banking crisis (see Pruteanu 2004), an interaction of the supplier dummy variable with a dummy variable for year 1999 (and 2000) is added to the specification. Doing so will shed light on whether multinational suppliers were affected differently by the credit crunch: multinationals with their global distribution networks are less affected by changes in the Czech market and thus less likely to adjust their relationships with their suppliers. As evident from regression 4, however, there is no indication of any different investment behavior among multinational suppliers than among other firms during the credit crunch period. Neither interaction term is statistically significant. Other conclusions remain unchanged.

To account for the possibility that firms in growing sectors might be more likely to be both multinational suppliers and not liquidity constrained, interactions between dummy variables for two-digit NACE codes (18 in total) and the cash flow variable are added. Only two of these interaction terms are statistically significant (furniture; computer, electronic, and optical products). The results confirm the previous findings that suppliers to MNCs are not liquidity constrained and that the effect is already present two years before signing a contract with an MNC. This specification also finds a significant positive coefficient on the debt variable and a significant negative coefficient on the interaction between cash flow and labor productivity.

One may wonder about the results of F-tests based on the interaction of cash flow and labor productivity as well as the interaction of cash flow and current (or future) supplying status. F-tests taking into account the average labor productivity among current (or future, as appropriate) suppliers support the earlier conclusions: both current and future multinational suppliers do not appear to be credit constrained.

Finally, additional robustness checks (not reported to save space) show that the conclusions are not affected by dropping observations with negative values for cash flow or by including industry-year fixed effects.

Another way to shed light on the link between credit constraints and multinational supplying status is to estimate a probit model that aims to explain the supplying status with the lagged liquidity ratio, gross profit (logged), and debt (normalized by capital). Supplier_it is the dependent variable. Liquidity ratio is defined as the difference between current assets and current liabilities divided by total assets. This specification also controls for firm size (number of employees), age, and labor productivity (all in logs) as well as three-digit industry and year fixed effects.

The results show a positive and statistically significant link between lagged liquidity ratio, lagged gross profit, and the probability of being a multinational supplier (table A-1). Coefficients on debt, employment, and labor productivity are not statistically significant. As this last finding is somewhat puzzling, firm performance was also measured using total factor productivity estimated by the sector-specific production function (ordinary least squares or the Olley–Pakes 1996 method). Once liquidity ratio, gross profit, and debt are controlled for, firm productivity is not a statistically significant predictor of supplying status. Finally, the data also indicate that younger firms are more likely to supply MNCs.¹¹

In sum, the findings suggest that firms not facing liquidity constraints self-select into becoming multinational suppliers. This is consistent with the observation that to obtain contracts from MNCs firms need to meet the stringent requirements of multinational customers and that only firms with access to financing may be able to do so. The survey data are in line with these conclusions. Most suppliers make improvements within the 12-month period before signing a contract with an MNC. The most frequent changes include improvements to product quality, staff training, and productivity enhancements. Many of these changes are probably made to obtain ISO certifications. More than 40 percent of suppliers reported being required by prospective multinational customers to obtain ISO certification. As the certification process is quite costly, usually involving the services of a specialized consulting firm, it would not be surprising if only firms that were not liquidity constrained were able to complete it.

Robustness Checks

To eliminate the possibility that the findings could be driven by MNCs extending credit to future suppliers, the 15 Czech firms that reported receiving some financial help from their multinational customers were removed from the sample. The results confirm the earlier pattern. Multinational suppliers were not liquidity constrained two years before supplying an MNC, and they remained unconstrained while supplying the multinational (table 4, regressions 1 and 2).

To examine whether the findings are due to the possibility that future multinational suppliers have a lower credit risk because of a contract with an MNC, Czech suppliers that reported that having a relationship with an MNC helped them obtain financing are dropped from the sample. Eliminating these 24 firms does not affect the results (regressions 3 and 4). The finding that multinational suppliers are less credit constrained is thus confirmed, and the evidence suggests that less constrained firms self-select into becoming multinational suppliers.

Instrumental Variable Approach

With the evidence suggesting self-selection by less credit constrained firms into supply relationships with MNCs and the possibility that some explanatory variables are endogenous, the final step is to apply an instrumental variable approach. The analysis uses the generalized method of moments (GMM) system estimation (proposed by Blundell and Bond 1998) and instruments for sales growth, labor productivity, supplier status, cash flow, and cash flow interactions with supplier status and with labor productivity. The GMM estimator combines a differenced and a level equation. Lagged levels of endogenous variables are used as instruments for contemporary differences, and lagged differences are used as instruments for the level equation.

Several additional instruments are also used. Firms whose managers speak a foreign language or who have worked for foreign companies before are likely to be better positioned to obtain contracts from multinationals. Thus, dummy variables reflecting these two characteristics are used as instruments for supply status. Level of language proficiency was determined by whether the manager can conduct business negotiations in a foreign language or can understand a business agreement in a foreign language, as reported in surveys. As exporters may find it easier to become multinational suppliers because of their experience of dealing with foreign customers, the second lag of exporting status is also used as an instrument.

The proportion of sector j's output supplied to a downstream sector k based on the 1999 input–output matrix of the Czech Republic (α_jk) is used to weight multinational presence in each downstream sector k. As the formula indicates, inputs supplied within the sector are not included. Thus, the greater the foreign presence in sectors supplied by industry j and the larger the share of output supplied to industries with a multinational presence, the higher is the value of the variable.¹² The calculations are based on all firms included in the AMADEUS database, not just the firms in the sample. Cash flow interactions with the instruments mentioned above are used to instrument for the interaction of cash flow with the multinational supplier dummy variable. Table 5 lists the instruments included in a given specification.

The number of observations in GMM regressions is smaller than in the previous specifications. Because the model is expressed in first differences an additional year of data is lost. Further years of data are lost because the instruments are based on second and further lags.

While the results should be treated with caution because of the small number of observations, they are nevertheless informative. The Hansen test for overidentification restrictions shows that the null hypothesis cannot be rejected at conventional significance levels (see table 5). The Arellano–Bond test shows that the null hypothesis of no second-order serial correlation also cannot be rejected. These specification tests suggest that the regressions yield consistent estimates.

The GMM results suggest that supplier status has no significant impact on a firm's liquidity constraints, once self-selection is taken into account. The interaction term between cash flow and supplier status is not statistically significant in any of the regressions (or in many other regressions estimated but not reported here to save space). In all specifications, the F-test rejects the absence of a relationship between cash flow and investment for multinational suppliers. As expected, the cash flow variable remains statistically significant in all regressions, suggesting that domestic firms are liquidity constrained. In summary, the evidence suggests that suppliers differ from nonsuppliers in liquidity constraints, but the effect appears to be due to self-selection rather than to a relationship with an MNC leading to an easing of the supplier's financial constraints.

IV. Policy Implications

Many countries around the world strive to attract FDI, believing that foreign investors not only bring capital but also serve as a channel of knowledge transfer across international borders. Policymakers, expecting some of this knowledge to result in externalities that benefit domestic producers, are willing to offer often generous incentive packages to foreign investors. For instance, 59 of 108 countries surveyed by the World Bank reported offering some type of incentives for FDI in 2004 (Harding and Javorcik 2007).

A recent survey of the empirical literature on spillovers from FDI concludes that such spillovers are most likely between MNCs and their local suppliers (Görg and Greenaway 2004). Thus, understanding what factors allow local firms to become suppliers to MNCs could have strong implications for understanding knowledge spillovers and public policy choices.

Two main findings emerge from the study. First, in contrast to Czech firms in general, which face financial constraints, multinational suppliers do not appear to be liquidity constrained. Second, the data suggest that the lack of liquidity constraints is present before firms enter into a supplier relationship with MNCs, which is consistent with unconstrained firms self-selecting into supplying multinationals.

Caution is required, however, in interpreting these findings. While the findings are robust to a number of controls that may be driving both access to credit and the ability of firms to supply multinationals, the possibility remains that the list of controls is incomplete. Further, even though the results suggest that well-functioning credit markets are important in facilitating business relationships between local firms and MNCs, they do not suggest that a well-developed financial market is a sufficient condition for such relationships. Many other factors, such as a certain level of sophistication of the local manufacturing sector, a match between the skill endowment of the host economy and the sourcing needs of MNCs, and a good business environment, may be needed in order for these relationships to materialize. Thus, the findings could plausibly be generalized to other upper middle-income economies, but probably not to low-income economies.

Funding

The authors are grateful to the World Bank's Research Support Budget for financial assistance for the project “Vertical Relationships between Multinationals and Local Firms in the Czech Republic.”

Acknowledgments

The authors thank Thorsten Beck, Steve Fazzari, Jose Luis Groizard, Leonardo Iacovone, Yue Li, Inessa Love, Jan Svejnar, three anonymous reviewers, participants in the workshops Regional and Micro-level Effects of Globalization in Tübingen, FDI and the Consequences in Ghent, Eastern Economic Association Annual Meetings in New York City, Midwest Conference on Economic Theory and International Trade in Columbus, OH, and the LICOS seminar at Catholic University Leuven for helpful comments and suggestions.

Appendix A

References