Trade orientation and mutual productivity spillovers between foreign and local firms in China.

• Author: Wei, Yingqi

ABSTRACT

This paper argues that multinational firms can benefit from indigenous knowledge diffusion in a host developing country so that there can be two-way productivity spillovers between foreign and local firms even in the developing world. This new argument is confirmed by a very large firm-level data set from the Chinese manufacturing sector. After grouping firms based on their trade orientation, we find that foreign firms have a positive impact on local-market-oriented Chinese firms. When the degree of foreign presence is sufficiently high, there will be negative productivity effects on export-oriented Chinese firms. On the other hand, local Chinese firms have a positive impact on export-oriented foreign invested firms. After dividing foreign firms according to their sources, we find that the beneficial spillovers between OECD and local Chinese firms are much greater than those between Hong Kong/Macao/Taiwan and local Chinese firms.

Key Words: Foreign Direct Investment, Indigenous Knowledge, Export-Oriented, Local-Market-Oriented, Mutual Productivity Spillovers

INTRODUCTION

The early theoretical discussion of productivity spillovers or external effects from foreign direct investment (FDI) can be dated to MacDougall (1960). Since then, quite a large number of empirical studies have been conducted for developed and developing countries. The central question of these studies is whether the presence of multinational corporations (MNCs) leads to productivity or efficiency benefits in local firms in a host country. Blomstrom and Kokko (1998), Gorg and Strobl (2001) and Gorg and Greenaway (2004) provide detailed surveys of this literature. One recent development is the recognition of reverse productivity spillovers. The hypothesis as it stands suggests that firms decide to invest abroad not so much to exploit advantages they already possess but to acquire new technological knowledge. As a result they might benefit from technological spillovers when they locate close to market leaders. As developed countries are leaders in technology, reverse spillovers are naturally thought to be the phenomenon in developed countries only, and hence both theoretical and empirical studies so far are confined to the developed world.

Different from the existing studies, the current study argues that reverse productivity spillovers can occur in a developing country. Although technological capabilities are generally lower in developing than in developed countries, MNCs can benefit from indigenous knowledge (local knowledge and indigenous technology) in a host developing economy. Indigenous knowledge diffusion contributes to productivity enhancement in foreign subsidiaries. A further contribution of the paper is that we investigate the role of trade orientation in productivity spillovers. We attempt to answer two questions with respect to this: Do firms of different trade orientation benefit differently from spillover effects? Do firms of different trade orientation generate different spillover effects?

This paper is organized as follows. Section 2 discusses the possible impact of indigenous knowledge on productivity of foreign firms in a developing country, and possible channels for indigenous knowledge acquisition by foreign firms. It also assesses the possible impact of trade orientation on productivity spillovers. This provides the theoretical underpinning of the study. Empirical models and data sources are described in section 3. Econometric estimation results are presented in section 4. Finally, section 5 offers concluding remarks and discusses policy implications.

INDIGENOUS KNOWLEDGE SPILLOVERS AND TRADE ORIENTATION

The literature on productivity spillover has so far focused on spillovers from MNCs to local firms in a host country. While a few papers have demonstrated that local firms can benefit from the very presence of MNCs (Blomstrom and Kokko, 1998; Gorg and Strobl, 2001; Gorg and Greenaway, 2004), it is necessary to consider whether MNCs also learn from local firms. Recent literature suggests that MNCs can benefit from the knowledge possessed by local firms. This literature can be divided into two strands. The first focuses on the importance of local knowledge in international joint venture (IJV) performance in developing countries and the second is concerned with MNCs' technology sourcing from local firms in developed countries. If these two strands of thought are further developed and synthesized, a new hypothesis of indigenous knowledge diffusion can be put forward so that mutual productivity spillovers in developing countries can be recognized.

Investing abroad implies that the firm has the disadvantage of being foreign (Hymer 1976). The ownership, location and internalization (OLI) framework developed by Dunning suggests that the success of foreign subsidiaries in a host country requires firms possessing not only O advantage which is often due to advanced technology, but also L advantage which is often related to indigenous knowledge (local knowledge and indigenous technology).

Local knowledge is the understanding of local market, cultural and environmental conditions (Inkpen and Beamish, 1997), including cultural traditions, norms, local business practices, values and institutional differences, operating conditions, laws, government policies and regulations and general knowledge of the economy. Local knowledge also includes a local firm's skills and capabilities to negotiate with the local government; its access to, and skills in negotiating with, the local elite; its ability to manage the local labor force and unions; and its competence with respect to local market access, product quality, branding and market reputation. Not every firm that invests abroad possesses a whole set of knowledge required for a successful operation in the host country. Local knowledge can complement the foreign parent's ownership advantages (Makino and Delios, 1996). A stock of local knowledge can mitigate the disadvantages of being foreign and hence improve IJV performance (Makino and Delios, 1996). Thus, to establish operational success in a country, a firm must access local knowledge as a means of overcoming market uncertainties (Stopford and Wells, 1972).

The other element of indigenous knowledge refers to indigenous technology. Wells (1977, 1981, 1983) suggests that O advantages of firms from less developed countries (LDCs) arise from their abilities and skills to develop small scale, labor intensive, and flexible processes and products which are more suitable to the LDC markets, and to find ways to substitute locally available inputs. Lall (1983) also suggests that the technologies used by firms from LDCs can be different from those used by firms from developed countries. These technologies are either the result of firms' own innovation or the assimilation and adaptation of advanced technologies from developed countries. Although the technologies are not new or advanced, they are more relevant to LDC conditions. Local firms also have advantages in production of their traditional products.

Three channels can be identified for indigenous knowledge acquisition: forming a JV with a local firm, transferring it from the parent's stock of host country experience, and accumulating it from operational experience in the host country (Makino and Delios, 1996). In the first channel, indigenous knowledge is transferred from a local JV partner to the foreign JV partner. The local partner is the immediate source of indigenous knowledge, which can complement the foreign investor's ownership advantages. The second and the third channels are both a within-firm transfer of indigenous knowledge. These channels are important for a foreign firm to obtain indigenous knowledge. However, there is one significant channel which is largely neglected: foreign firms can benefit from the very presence of indigenous firms. Indigenous knowledge here is an externality and foreign firms can simply learn by watching. Business operations by local firms can exert demonstration and competition effects on foreign invested firms and therefore affect their productivity.

The second strand of analysis argues that firms have incentives to invest abroad in order to seek advanced technologies rather than exploit their own firm-specific advantages. Fosfuri and Motta (1999) argue that laggard firms might benefit from technological spillovers when they locate close to market leaders. Due to the presence of reverse spillovers, FDI might be a channel for acquiring technological knowledge. This hypothesis of reverse...