Does Foreign Direct Investment Improve the Productivity of Domestic Firms? Technology Spillovers, Industry Linkages, and Firm Capabilities

Abstract

Many developing countries attract foreign investment in an attempt to improve the productivity of domestic industries. However, it is unclear whether local firms learn from foreign direct investment, and if so, which local firms benefit, what forms of foreign direct investment are most beneficial, and why these effects occur. This paper explores how industrial linkages, firm capabilities, and the geographic location of domestic firms affect the diffusion of technology brought by foreign direct investment. I hypothesize that local firms are more likely to improve efficiency when they receive better product inputs from foreign suppliers and technology support by foreign customers, and such transfer of knowledge is more effective when the recipient has high absorptive capacity and is located near the source of knowledge. I analyze plant-level data in China for over 20,000 plants between 1998 and 2005. I find positive productivity spillovers between foreign suppliers and their domestic customers. However, there are not positive spillovers from foreign-owned customers or competitors. Domestic firms’ in-house R&D capital facilitates learn from foreign firms. Local firms learn from both joint ventures and wholly-owned foreign subsidiaries and the effects are larger from wholly-owned subsidiaries.