Foreign entry and domestic innovation

Yuriy Gorodnichenko, Jan Svejnar 26 September 2015

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A major question that has arisen in the last few decades is whether domestic firms have become stronger or weaker with the opening up of most economies to foreign trade and investment. More specifically, has the efficiency of firms in emerging market economies improved with the growing presence of foreign direct investment (FDI) within their borders and the opening of these economies to trade? While there is substantial evidence that multinational enterprises are more productive than domestic firms, Gorg and Greenaway (2004) observe that the evidence on productivity spillovers of FDI and trade remains mixed.

The mixed evidence points to the need to understand better the mechanisms through which horizontal and vertical relationships with foreign firms and international trade improve or hamper efficiency of domestic firms.

New evidence

Innovation is the presumed conduit through which globalisation affects productivity, yet there has been little research testing the relationship between globalisation and innovation. In recent work (Gorodnichenko et al. 2015), we provide the first analysis based on industry-level (indirect) and firm-level (direct) data to address this question.

Foreign firms may have efficiency and other spillover effects on local competitors (horizontal spillovers) as well as on upstream and downstream domestic firms (vertical spillovers). Most studies examine horizontal spillovers and do so at the industry level. The evidence from this research is mixed.  Most studies of developing countries suggest that the horizontal spillover effect is nil or negative.  On the other hand, several studies find positive horizontal spillovers in the more developed economies such as the UK.  Hence, there is a puzzle that is of considerable interest.

Until recently there were few empirical studies on vertical spillovers. This is surprising given the early analysis by Lall (1980) of the positive backward linkage effects of foreign firms on the Indian trucking industry.  Moreover, vertical spillovers are more likely to be positive than horizontal spillovers, since multinationals have an incentive to improve the productivity of their suppliers rather than that of their competitors. The empirical papers that have appeared recently do indeed find evidence that is consistent with the view of technology transfer through backward linkages in the manufacturing sector. However, these studies rely only on a variable that is constructed from input-output tables at the industry level, rather than a direct firm-specific measure. More recently, Gorodnichenko et al. (2010) use firm-specific linkage variables to examine the productivity effects of sales to multinationals.

There has been considerable advancement within the productivity spillover literature, but the mixed results suggest that one needs to (a) examine directly the effect of FDI and trade on innovation; and (b) assess whether the widely used industry-level linkage measures (e.g. Javorcik 2004) provide an adequate approach, or whether it is preferable to employ firm-level linkage measures in addressing these issues.

The direct examination of the effect of FDI and trade on innovation is attractive because theories usually make predictions about the effects on innovation by firms rather than about the (derived) productivity effect. The comparison of the indirect effects based on (aggregate) industry-level linkages and direct effects based on firm-level (micro) linkages is highly desirable because it is not clear that the typical measures of vertical linkages at the industry level, which rely on input-output tables, provide a sufficiently precise measure of the linkage.

We carry out this analysis by combining the rich ORBIS™ database of firms with the 2002 and 2005 Business Environment and Enterprise Performance Surveys (BEEPS) of firms in 18 emerging market (transition) economies and Turkey. In addition, we use industry-level input-output data that we have collected individually from national statistical offices and international organisations.

The combined data set enables us to provide the first study of innovation effects of both industry-level (input-output) and firm-level (micro) measures of horizontal, backward and forward linkages of local firms to multinationals. As mentioned earlier, we also include in the analysis of vertical spillovers the concept of selling to or buying from firms outside of the country – i.e. importing and exporting – since vertical spillovers need not be constrained to linkages with foreign firms within the host country alone. The advantage of our approach derives from the fact that we analyse vertical linkages as sales to multinationals, as well as exports and imports, and that unlike other studies we carry out our analysis on many countries with different institutional environments.

Second, we are able to provide much larger comparative evidence on more heterogeneous firms than has been possible in this area to date.  For example, our analysis covers firms in both the service and manufacturing sectors, while existing studies tend to focus on manufacturing. This is important because most of the recent FDI is in services.  We are also able to estimate the effects separately for small firms, while much of the existing evidence is for medium and large firms. Being able to cover smaller firms is important because smaller firms tend to be the new entrepreneurs and engines of growth in many emerging market economies. Finally, we also test for differences in spillovers among new and old firms – in our case firms that existed prior to 1990 (before the fall of the communist regime) and those that started afterwards. 

Findings

We find that FDI and trade have strong positive spillover effects on innovation by domestic firms. Specifically:

  • Our results indicate that the spillover effects can be detected with micro data at the firm level, but using linkage variables computed from input-output tables at the industry level yields much weaker, and usually insignificant, estimated effects.

Whether we use input-output matrices to calculate immediate linkages to industries with strong foreign present or to calculate total linkages across industries (based on the inverse of input-output matrices) appears to make relatively little difference to the estimates of the industry-level effects. Thus, the spillover effects on innovation appear to be localised rather than broad based. That is:

  • Spillover effects on innovation from foreign firms to domestic firms appear to be limited to domestic firms immediately connected to foreign firms.

Simply being in an industry populated by foreign firms or an industry buying from or selling to industries with strong foreign presence generally has a weak effect, if any, on innovation.

  • An immediate policy implication of these findings is that popular requirements of foreign firms to have significant local content (i.e. a certain fraction of value added or inputs has to be local) may be justified.

We also document heterogeneity in the strength of the effect across sources of foreign presence. For example, while our firm-level data do not permit us to distinguish between the effects of FDI from more advanced (OECD) and less advanced (non-OECD) countries, we are able to do so at the level of the industry (input-output) linkages. Our estimates suggest that the presence of OECD firms, as compared to non-OECD firms, has a positive horizontal linkage effect on product innovation in the sample of all firms, as well as in subsamples of various types of firms.

Concluding remarks

Our results have important implications for interpreting the existing literature, which has focused on the effects of FDI and trade on (total factor) productivity rather than on innovation, has tended to use the industry-level rather than firm-level measures of horizontal and vertical linkages, and has usually used data from a single country.

Since measured productivity (a) captures the effects of both market power and efficiency (rather than just efficiency) of firms; (b) is a noisy outcome variable; and (c) suffers from endogeneity problems in estimation, our focus on innovation provides potentially more direct estimates of the true effects of foreign presence on the performance of local firms.

References

Gorg, H and D Greenaway (2004) “Much Ado about Nothing? Do Domestic Firms Really Benefit from Foreign Direct Investment?”, World Bank Research Observer, 19(2): 171-197.

Gorodnichenko Y, J Svejnar and K Terrell (2010) “Globalisation and Innovation in Emerging Markets”, American Economic Journal – Macroeconomics 2(1), 194–226.

Gorodnichenko Y, J Svejnar and K Terrell (2015) “Does Foreign Entry Spur Innovation”, CEPR Discussion Paper 10757.

Javorcik, B (2004) “Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In search of spillovers through backward linkages”, American Economic Review 94(3): 605-627.

Lall, S (1980) “Vertical Inter-Firm Linkages in LDCs: An Empirical Study”, Oxford Bulletin of Economics and Statistics, 42:203-226.

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Topics:  Productivity and Innovation

Tags:  FDI, multinationals, spillovers

Professor in the Department of Economics, University of California – Berkeley

James T. Shotwell Professor of Global Political Economy and Director of the Center on Global Economic Governance, Columbia University; Research Fellow, CEPR

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