Foreign direct investment, innovation, and domestic value‐added in exports: Firm‐level evidence from China

Abstract This paper analyzes the effect of foreign direct investment (FDI) entry on the domestic value‐added ratio (DVAR) in exports using data on Chinese firms between 2000 and 2007. We adopt the difference‐in‐difference method to estimate instrumental variables regressions, treating the adoption of the Revisions to the Catalogue for the Guidance of Foreign Investment Industries in 2002 as a policy shock. Our analysis yields a few findings. First, FDI entry suppresses firm DVAR, a result that continues to hold after taking into consideration the randomness of the policy treatment group, other policy shocks, firm entry and exit, and the use of alternative measures. Second, FDI entry exerts a greater impact on the DVAR of foreign rather than domestic firms, non‐state‐owned enterprises (SOEs) rather than SOEs, and firms located in the eastern rather than central and western regions. Third, FDI entry negatively affects DVAR mainly through its horizontal spillovers after taking into account FDI entry in upstream and downstream industries. Fourth, compared to FDI from Hong Kong, Macao, and Taiwan (HMT), foreign investments from non‐HMT regions are less likely to inhibit firm DVAR. Lastly, we find that value capture capacity, as measured by firm innovation, plays an important role in mediating the impact of FDI entry on DVAR. Taken together, these findings suggest that sustainable domestic economic development cannot rely solely on the introduction of foreign investment and should instead emphasize the importance for firms to improve value capture capacity so as to better capitalize on the positive spillovers generated by foreign investment.