FDI spillovers on innovation and productivity : evidence from foreign and domestic firms in the Indian manufacturing sector

Abstract

The global economy has experienced several waves of globalization in its‘ history. Each wave led to a growing interdependence among countries through increasing amounts of foreign trade, cross-border financial flows, and migration. One of the main features of the globalization at the end of the 20th century was the rapid increase in FDI. The upsurge in FDI has given rise to debates, both in academia and public space, regarding the impacts of FDI on developing countries. The proponents of globalization associate inflows of FDI with a series of benefits for host countries. However, others view FDI as a new form of colonialism or imperialism. The debate on globalization, though previously centered on direct effects of FDI on macroeconomic variables such as GDP, employment, and balance of payments, has now shifted towards the indirect effects on microeconomic variables like productivity and innovation at the firm level. These indirect effects usually go under the heading of spillovers. Spillovers occur when FDI generates outcomes that become available to other firms at no cost. In other words, spillovers are externalities that arise from the activities of foreign companies in the host country, benefitting domestic companies, without receiving any compensation. It is imperative to mention that externalities resulting from multinational (MNC) entry by no means are automatic. In fact, in most of the cases, local incumbents have to bear additional costs so as to benefit from these externalities. However, this extra cost does not necessarily correspond to a direct payment to a MNC in returnfor the supply of some specific assets. In particular, to assimilate the FDI spillovers, domestic firms, apart from improving their absorptive capacity, need to invest in R&D, skilled workers, and organizational practices. The empirical research on the possible effects of FDI on host economies started with the seminal works of Caves (1974) and Globerman (1979). Since then, a sizeable amount of empirical studies focusing on FDI spillovers on productivity have surfaced. While the theoretical foundations for such spillovers are generally accepted, empirical work, however, does not present unanimous findings. Several studies report significant productivity gains induced by the presence of foreign-owned enterprises in the host country; others find adverse or nonsignificant effects on domestic productivity. This divergence between theory and empiricism as well as the lack of unanimity within the latter probably increases the relevance and need for furthering the research on spillover effects.Besides productivity, FDI inflows could have a potential impact on the R&D activities and therefore, on innovation output of incumbents in many ways. Irrespective of whether MNCs spend on R&D or not in the host location, enhanced competition due to the entry of MNCs may have a direct effect on the R&D efforts of the incumbent firms (Caves 1974). Alternatively, to face the competition from MNCs, local companies may acquire technological imports; however, such import still necessitates R&D to adapt the to local conditions. FDI entry may also entrench R&D and innovation culture among local companies. For instance, MNCs R&D activities in many countries have spurred an R&D drive among the domestic firms, and some of these companies (e.g. softwarecompanies) directly compete with MNCs (UNCTAD 2006). Furthermore, MNCs through joint ventures and R&D collaborations with local firms provide ample opportunities for the latter to learn how to conduct R&D and make it commercially successful.Against this backdrop, we attempt to analyze spillovers from FDI on the innovative activity of firms operating in Indian manufacturing sector. Instead of simply adding another single country study on productivity spillovers, we go a further step by empirically estimating the existence of spillovers on domestic innovation arising from components of FDI (horizontal and vertical FDI). While examining FDI spillovers, the thesis takes into account the location of incumbents vis-àvis to the best practice frontier. Three questions the thesis addresses are: (1) Like productivity spillovers, does FDI-related spillovers manifest on innovation? (2) Does incumbent status as a supplier, client or competitor affect the absorption of spillovers arising from FDI? (3) Does incumbents proximity to the best practice frontier or distance from it conditions spillovers arising from FDI? Literature Review Theoretical works suggest that MNCs produce both pecuniary and knowledge externalities, and such external effects arise through four main channels of competition, demonstration and imitation, worker mobility and spin-offs, and backward and forward linkages. From the theoretical point of view, one canidentify the different types of externalities and the various roles played by these channels in mediating such external effects. The number of empirical studies investigating the existence of FDI spillovers and their impact on domestic firms is much higher than the theoretical studies. While empirical studies have been conducted on macro as well on the micro-level, the results obtained, however, are contradictory. The macroeconomic studies use aggregate data for a single country or a group of countries, and systematically obtain a positive impact of FDI on economic growth of hosts. These studies, although popular, provide a limited scope for interpretation of spillovers. Microeconomic studies, on the other hand, can reveal more in detail the complexity of spillover mechanism. The micro studies consider the effects on the productivity of local firms while taking into account their linkages with foreign companies. In contrast to macro studies, which often argue in favour of a positive effect, the findings of micro studies are mixed. For instance, Aitken and Harrison (1999) and Djankov and Hoekman (2000) find that FDI adversely affects local productivity while as Caves (1974), Globerman (1979), Blomstrom (1986) and Javorcik (2004) claim that FDI positively affects the productivity of local firms. The third category of empirical works, for instance, Girma et al. (2007), at loggerheads with the studies mentioned above, however, argue that impact of FDI on local productivity is insignificant. It is evident that the empirical literature hitherto has failed to establish an unambiguous link between FDI and local productivity. Most scholars often invoke this empirical inconclusiveness as the main motivation for furthering the research on spillover effects.