Inward FDI, Spillover Effect and Financial Constraints -Theory and Evidence from China

Abstract

This paper constructs a two-stage sequential game model to investigate the spillover effect of inward FDI on the efficiency improvement of domestic firms across different ownership types in host countries. Our model shows that given the optimal spillover policy made by foreign firms, the impact of spillover effect of inward FDI is contingent upon the level of financial constraint between the domestic private and state-owned firms (SOEs). In particular, we argue that the spillover effect of FDI inward would be negatively varied with the level of financial distress level faced by both firms, but such effect differs across different ownership types of firms. We demonstrate that the negative spillover effect of inward FDI on SOEs, mainly measured by innovation, is smaller than that of domestic private firms because of the higher financing distress cost faced by the latter. Since domestic SOEs get easier access to the financing support from the state, thus allowing them to learn much more quickly from foreign firms in terms of technological advancement compared with private firms, which in turn the negative spillover effect with regard to the financial distress would be mitigated. We employ firm-level data of Chinese listed firms from 2007 to 2016 to test our hypothesis and find that our theories are broadly consistent with the empirical results.