Innovation in the Host Country and the Structure of Foreign Direct Investment: Evidence from Japanese multinationals

In this study, we investigate how the innovative performance of local firms in host countries affects the structure of foreign direct investment (FDI) by multinational enterprises (MNEs) using Japanese firm-level data and patent application data for host countries of Japanese FDI at the United States Patent and Trademark Office for the period from 1995 to 2006. The structure of FDI is measured by the shares of local transactions and transactions with the source country and a third country by foreign affiliates of Japanese MNEs. Our estimation results imply that innovation by local firms in the same and related industries in host countries in Asia and Europe strengthens forward and backward linkages. We also find that innovation in the host country encourages transactions with the source country when the former is technologically advanced. Finally, our findings suggest that, in Asia, the innovative performance of local firms contributes to the development of regional production networks.