Does FDI increase product innovation of domestic firms? Evidence from China

Exploiting a change in policy governing the entry of foreign direct investment (FDI) in 2002, we apply the difference-in-differences model to estimate the effects of FDI on the product scope of domestic Chinese firms. In industries that experienced relaxation in FDI regulations, the average product scope increased by 5% which indicates more product innovation. Through vertical linkages, the product scope of firms is positively (negatively) affected by FDI in upstream (downstream) industries. The negative effect of FDI in downstream industries occurs because foreign firms engaging in processing trade rely more on imported inputs than inputs from domestic suppliers. The main channels of effect are firm-level R&D and industry-level technological distance, as FDI entry leads to an improvement in these variables. However, the positive effects of FDI on product innovation have limits, as new products are mainly introduced within the same industry rather than across different industries.