Industry Relatedness, FDI Liberalization and the Indigenous Innovation Process in China

This paper employs a structural innovation model to study the effects of relatedness on the process of indigenous innovation in China. Specifically, I rely on a measure of product relatedness to proxy for interconnections among co-located firms to study the effects of relatedness on firm’s innovation investments, innovation output and productivity, respectively. The results show that relatedness helps to promote indigenous innovation in China, although the effects are heterogenous across different types of firms and at different stages of the innovation process. An identification s trategy i s f urther d eveloped t o b etter i dentify the effects of relatedness by exploiting the arguably exogenous changes in China’s ownership restrictions. The results reveal that FDI liberalization is more successful at promoting innovation, especially in areas that have higher pre-existing levels of relatedness. A key implication is that as industries are allowed to open up to outside investments, the benefits of new incoming foreign knowledge and expertise are more easily shared in areas with a denser network of related industries. Such benefits include, but are not limited to, helping firms to recombine knowledge from related industries to bring forth proprietary ideas, processes or concepts.