Foreign direct investment in R&D and domestic entrepreneurship in China’s manufacturing industries

Abstract

This paper argues that internationalization of innovation and the related spillovers can also affect the likelihood of firm entry and exit into an industry. By making use of firm-level panel data from China over the period 2005 to 2007, this paper examines the impact of foreign direct investment (FDI) in research and development (R&D) and the related linkages on entry and exit likelihoods of domestic firms in (i) transport equipment and (ii) electrical machinery and equipment manufacturing industries. In order to evaluate the region-of-origin effect, this paper also separately examines the impact of FDI in R&D originating from (i) all countries except Hong Kong, Macau and Taiwan and (ii) Hong Kong, Macau and Taiwan. Furthermore, the impact of FDI in R&D on entry and exit of Chinese firms in the two industries is examined by splitting the data into large and small firms within the two industries. The results of the pooled probit regression reveal that FDI in R&D and the related spillovers can have a significant impact on the likelihood of entry and exit of domestic firms in transport equipment and electric machinery and equipment industries. The empirical analysis also suggests that the impact of changes in FDI in R&D and the related spillovers varies across firm size.

Keywords:

• internationalization of innovation
• R&D
• entry
• exit
• China
• probit regression

JEL Classification:

• B23
• F15
• F23

Acknowledgements

This paper has greatly benefitted from very helpful comments and suggestions received from two anonymous reviewers. We are also grateful to Robert Alexander and Don Kerr for their suggestions. However, we are responsible for all remaining errors and imperfections.

Notes

¹ An interesting review of literature on the motives and determinants of MNC innovation activities in host countries can be found in Narula and Zanfei (2005), Rama (2008) and Dachs and Pyka (2010).

² The importance of FDI-linked spillover effects has also been highlighted by several empirical studies (see Meyer and Sinani, 2009). Tian (2010) argues that spillovers can be reduced through selection of entry modes.

³ Entry is defined as a situation where a firm starts producing a product that it has not previously produced or when a firm sells product at a new geographical location. Exit occurs when a firm stops producing a product or stops selling at a different geographical location (Siegfried and Evans, 1994). It has been argued that entry occurs in profitable markets that are expanding. Exit is more frequent in markets where profits are declining and where sunk costs are high.

⁴ Narula and Zanfei (2005) argue that multinational firms tend to concentrate their relatively more strategic innovation activities at their home location.

⁵ Strictly speaking R&D expenditures are not investment in the sense of FDI. FDI in R&D in this paper refers to foreign investor’s R&D spending. However, the spillover effects arising from such spending are almost identical to FDI-related spillover effects.

⁶ Other changes to guidelines for foreign investment in China to take effect from 30 January 2012 include (i) further opening up of the services sector to foreign firms and (ii) the automobile industry is mostly closed to foreign investment (Roos, 2012).

⁷ For an excellent review of literature that deals with the impact of domestic factors on domestic entrepreneurship, see Siegfried and Evans (1994).

⁸ Some existing studies have considered the qualitative aspects of a wide range of linkages. These linkages include competitive pressures induced by the foreign firms on domestic competitors, which could force domestic firms to improve the quality of their products and, in some cases, might force them to exit the industry (e.g. see Scott-Kennel, 2007; Giroud and Scott-Kennel, 2009). Jindra et al. (2009) suggest that knowledge spillovers arising from vertical supply chain linkages between foreign subsidiaries and domestic firms can contribute to the economic development of host countries.

⁹ The level of market competition depends on a number of factors. For example, Colantone et al. (2010) argue that opening of international trade leads to increased competitive pressure on domestic firms, which contributes to exit of some domestic firms.

¹⁰ Other related studies include Almeida and Phene (2004), Huang and Rice (2012), and Anwar and Sun (2013, 2014).

¹¹ In addition, following the existing studies, such as Driffield (1999), it can also be argued that the probability of both entry and exit depends on FDI in R&D and the related spillovers that can affect expected future profits.

¹² It should be noted that, owing to data constraints, our definition of firm exit (see Section IV) is affected by sample attrition and unobserved exit behaviour of entry firms at the end of sample period (i.e. 2007). We are thankful to a reviewer for highlighting this issue.

¹³ The model is estimated after including the relevant time and industry dummies.

¹⁴ Within the context of oligopolistic rivalry, Colantone et al. (2010) have shown that import competition can increase the exit rate of domestic firms. However, the market structure in the Chinese industries that are considered in this paper is close to competitive – the number of domestic firms in each industry is quite large.

¹⁵ A complete list of these industries can be found at the NBS website (http://www.stats.gov.cn).

¹⁶ Note that the sample size in Table 1 is different from that reported in Tables 2–7 because the estimated equations involve 1-year lagged values.

¹⁷ Equations 7 and 8 were also estimated by means of instrumental variable probit technique but the estimated value of the Wald statistic was in almost all cases statistically insignificant, indicating that the null hypothesis of exogeneity cannot be rejected. This suggests that the results of probit estimation are highly reliable. A good discussion of the statistical methods employed in this paper can be found in Greene (2012).

¹⁸ This suggests that the estimated results concerning the main hypotheses that are being tested are robust.

¹⁹ While the sample was split into two groups of large and small firms, firm size still appears as a control variable in the empirical model. The impact of firm size within each group is found to be statistically significant. This follows from the fact that the sample size is very large and there is a large variation with each group. In other words, some of the small (large) firms are in relative terms very small (large).