FDI inflows and export quality: Domestic competition and within-firm adjustment

Product quality is widely regarded as an important determinant for economic development. This paper investigates whether horizontal foreign direct investment (FDI) improves or deteriorates the quality of domestic firms' exports. We use China's FDI regulation changes in 2002 as an instrument variable (IV) for FDI penetration in China to identify the causal impact and introduce a theoretical model to rationalize our empirical work. We find that FDI inflows exert a significantly negative effect on Chinese firms' export quality. The mechanism of the negative effect is that FDI intensifies the domestic market competition, which induces within-firm adjustment of product mix and lowers domestic firms' incentive to invest in the quality of new products. In particular, while domestic firms drop some existing products and introduce new products, they invest less in the quality of new products and maintain the quality of continuing products.