Abstract：This paper studies how foreign direct investment (FDI) affects innovation in the host country,using matched firm-level patent data of Chinese firms. The data contain multidimensional informationabout patent counts and citations, which, together with an identification strategy based on Lu et al. (2017), allows us to measure innovation comprehensively and to uncover the causal relationship. Our empirical analysis shows that FDI has positive intra-industry effects on the quantity and quality of innovation, as well as radical innovation, by Chinese firms. We show that these positive effects are driven by increases in competition, rather than by knowledge spillovers from FDI which is measured by patent citations between domestic firms and foreign investedenterprises (FIEs). We further investigate the inter-industry effects of FDI and find that FDI has positive vertical effects on innovation in upstream sectors through backward knowledge spillovers.

Key Words: FDI, Innovation, Patent, Competition, Spillover