Does FDI increase product innovation of domestic firms? Evidence from China

Exploiting a change in policy governing the entry of foreign direct investment (FDI) in 2002, we apply the difference-in-differences model to estimate the effect of FDI on the product scope of domestic Chinese firms. In industries that experienced relaxation in FDI regulations, the average product scope increased by 5% which indicates a rise in product innovation. FDI's spillovers along vertical linkages are also important, as we find that the product scope of firms is positively affected by FDI in upstream industries, but negatively affected by FDI in downstream industries. Further analysis shows that the negative effect of FDI in downstream industries is mainly concentrated in industries with a high level of processing trade, as firms in those industries rely more on imported inputs and have less contact with domestic suppliers. The main channels of effect are firm-level R&D and industry-level technological distance, as the entry of FDI leads to an improvement in these variables. Positive effects are found in medium- and low-tech industries but not in high-tech industries, indicating that indigenous effort is important for product innovation in high-tech industries.