India should welcome Chinese investment but not overlook the possibility for innovation spillbacks

A recent paper on Chinese FDI by Jennie Bai of Georgetown University, Yaojun Ke of Nanyang Technological University, Luc Laeven of the European Central Bank and Hong Ru of the Massachusetts Institute of Technology unpacks several insights into the wave of Chinese FDI, and thus deserves to be read by Indian policymakers, especially as the government has switched to a softer view of Chinese FDI with the recent changes in Press Note 3.

The four economists have trawled through data on 161,773 companies in 159 countries and traced capital movements through offshore tax havens to map out corporate ownership through many layers of holdings.

Their first big revelation is that in 2021, Chinese investments beyond the borders of the country were at $2.1 trillion (and $3.3 trillion if Greater China is considered).

This is “a global footprint substantially broader than global FDI statistics” reveal.

The usual way FDI is measured is by looking at the last jurisdiction from which capital is allocated, rather than the original one from where capital is sent via a network of subsidiaries. China uses Cayman Islands as a major conduit, the authors show in their research.

Most of this money has gone into firms in North America and Europe, which suggests that Chinese outbound investments seek strategic goals rather than just access to lower labour costs.

However, the recent increase is driven by private sector firms rather than state-owned enterprises. And Chinese FDI is now concentrated in knowledge-intensive sectors, especially after its government announced its Made In China programme in 2015 to transform the country from a low-cost manufacturer into a high-tech industrial powerhouse by dominating ten strategic sectors, including robotics, aerospace and semiconductors.

What follows is especially interesting.

The four economists have tracked the innovation activity of acquired firms through time by creating a longitudinal database. In short, a firm acquired by a Chinese company spends more on research and development. However, the number of patents that they apply for do not increase in tandem. The increase is statistically insignificant.

Meanwhile, the Chinese company that has taken control tends to see an increase in its own patent filings. The authors describe this as a ‘spillback,’ though they point out that what they have noticed is correlation rather than causation. Yet, the pattern is unusual.

The process of technology spillbacks seen in the case of Chinese FDI is very different from the sequence of events in the usual technology spillovers that we traditionally think about in the case of foreign investment in local firms or greenfield projects.

When a foreign company sets up operations in a new country, it often brings better technology, smarter processes and stronger management practices with it. Local firms, simply by being nearby, tend to pick some of this up. It could be because they hire workers who move between companies, reverse-engineer products or have to compete harder.

This leakage of knowledge from foreign to domestic firms is called a technology spillover. To be sure, much depends on how large the gap between foreign and domestic firms is to begin with.

These findings have significant implications for the rest of the world at a time of heightened geopolitical rivalry. China has massive amounts of capital to allocate beyond its borders, thanks to its trade surpluses.

Countries that are in need of capital cannot wish this fact away.

However, some of this capital is being used strategically to acquire new technology, even while China makes strides in areas such as electric vehicles or new energy. “We provide evidence of systematic innovation spillbacks, where the primary beneficiaries of these investments are parent firms in China,” the authors write, adding that their work suggests that “state-led capital can fundamentally reallocate the geography of intangible assets within an industry.”

India lags China in terms of new technology, but it is no tech minnow either, especially in select areas. A balance between seeking Chinese investments and staying wary of innovation spillbacks will have to be maintained.

The author is executive director at Artha India Research Advisors.