The authors’ objective is to evaluate whether credit constraints impede the ability of Chinese firms to benefit from productivity spillovers arising from the operation of foreign-owned firms. Their findings reveal that benefits from this foreign firm activity accrue to non-state-owned Chinese firms operating in the same industry and province as the foreign firms. The mere presence of foreign firms, however, is not sufficient for domestic firms to benefit; productivity gains from spillovers accrue only to local firms that are not facing credit constraints.

The authors’ pioneering research demonstrates that credit constraints present a significant impediment to the absorption by Chinese firms of productivity spillovers (i.e., technological innovations, better management practices, or skilled employees) from foreign firms. Using a sectorial index of credit constraints, the authors find that non-state-owned Chinese firms operating in industries with external finance dependence below the median of the index have an elasticity of output, with respect to foreign activity in the same industry and province, of 0.047. This elasticity is in stark contrast to that of credit-constrained firms (i.e., firms with external finance dependence above the median), which do not benefit from the operation of proximate multinational firms in the same industry.

This negative relationship between external finance dependence and spillovers from foreign activity is particularly important for China because prior research has established that the efficiency of its financial system has lagged behind other developments in its economy. Therefore, improving the access of non-state-owned Chinese firms to formal sources of finance could result in meaningful productivity gains because China is likely to remain one of the most significant recipients of foreign investment in the world.

More broadly speaking, the authors’ findings should be of interest to policymakers in developing countries that are keen on attracting foreign direct investment in technology-intensive sectors. These industries exhibit relatively high reliance on external finance, and as such, they may not provide the maximum benefits for local producers unless financial markets are adequately developed to ensure the widespread absorption of productivity gains arising from the activities of foreign firms. Thus, the authors’ work provides important information on the conditions that enable firms to benefit from greater financial globalization.

The data are derived from the annual accounting reports in the Oriana database, compiled by Bureau Van Dijk, for the period of 2001–2005. The dataset contains information on value added, employment, input costs, geographic location, industry of operation, and foreign ownership status (i.e., distinguishing whether the source of foreign investment originates from Hong Kong, Macau, or Taiwan—HMT—or elsewhere). The final sample includes 78,509 firm-year observations, of which approximately 40% are foreign-owned enterprises.

The authors rely on an industry-level (ISIC-3) index of external finance dependence (EFD) to identify credit-constrained firms. The index, a popular proxy for the level of financial constraint, is constructed using the portion of capital expenditures not financed with cash flow from operations for the median public firm in each three-digit US industry, averaged over the 1980s.

To establish the existence of spillovers arising from the activity of foreign firms on their domestically owned counterparts in the same industry and province, the authors estimate a Cobb–Douglas production function that is augmented to account for spillovers from the presence of foreign firms. Based on the results from estimating this equation, the authors use the total value added accounted for by non-HMT, foreign-owned firms as their measure of spillovers when estimating their main empirical specification for the group of non-state-owned domestic firms.

As a robustness check, the authors estimate the regression using two different variants of the EFD index. They also test the continuous conditioning model in the regression against a dichotomous specification in which the sample is split at the median level of the EFD index, thus allowing for different effects above and below this threshold.

The authors offer an interesting connection between the impact of foreign direct investment in host countries and how financial development affects performance measures at the aggregate and microeconomic levels. Because most innovation remains concentrated in a few highly developed countries, developing countries seeking to benefit from foreign direct investment (through capital formation and the diffusion of foreign technology and ideas among domestic producers) should consider the importance of access to external finance for domestic firms.