Does inward foreign direct investment deregulation enhance innovation quality in domestic firms? Evidence from China

Chinese firms are facing a dilemma where innovation is growing rapidly in quantity but is of low quality. This paper utilizes the revision of the ‘Catalogue for the Guidance of Foreign Direct Investment (FDI) Industries’ in 2002 as a quasi-natural experiment and examines the effect of FDI deregulations on the innovation quality of domestic firms using firm-level data from 1998 to 2007. Employing a difference-in-differences strategy, we find that FDI deregulations significantly expand the firms’ patent breadth, indicating an enhancement in innovation quality. Our empirical evidence further indicates that FDI deregulations do not lead to significant negative competition effects; instead, technology spillovers play a dominant role. FDI inflows strengthen firms’ absorptive capacity and promote the shift of labor from foreign-invested enterprises to domestic firms. More importantly, we distinguish between two types of FDI liberalization policies and find that policies encouraging FDI entry serve as a driving force for enhancing firm innovation quality. This paper emphasizes the significance of FDI deregulations for firm innovation, offering empirical evidence on how developing countries can undertake FDI regulatory reforms to enhance innovation quality.