Innovation Spillovers From Foreign Direct Investment in Developing Countries: Evidence From Firms in Ethiopia

We estimate the impact of foreign direct investment (FDI) firms on the innovation likelihood of domestic firms in Ethiopia in the manufacturing and services industries. Our novel shift–share instrumental variable, constructed from Chinese FDI to neighbouring countries to address endogeneity and self‐selection, reveals that foreign firms have a strong negative crowding‐out effect on the innovation likelihood of domestic firms, particularly in overall innovation activity and process innovation. Furthermore, our analysis highlights significant endogeneity and selection biases in standard LPM estimations, which tend to overstate the spillover impact of FDI on domestic firms' innovation activities. Importantly, when we restrict our sample to domestic manufacturing firms only, we find evidence for positive spillovers. This highlights an important but heretofore neglected aspect of heterogeneity in spillovers on domestic manufacturing and services firms.