Foreign Divestment – Crisis or Chance for China's Innovation Edge?

• Published date: 01 November 2022
• Author: Guopei Fang,Holger Görg,Aoife Hanley,Haiou Mao
• Date: 01 November 2022
• DOI: http://doi.org/10.1111/cwe.12444

China & World Economy / 1–33, Vol. 30, No. 6, 2022 1

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License, which permits use and distribution in any medium, provided the original work is properly cited, the use is non-commercial

and no modifi cations or adaptations are made.

© 2022 The Authors. China & World Economy published by John Wiley & Sons Australia,

Ltd on behalf of Institute of World Economics and Politics, Chinese Academy of Social Sciences.

Funding Statement: Open Access funding enabled and organized by Projekt DEAL.

*Guopei Fang, PhD Candidate, School of Economics, Huazhong University of Science and Technology,

China. Email: gpfang1990@163.com; Holger Görg (corresponding author), Professor, Kiel Centre for

Globalization, Kiel Institute for the World Economy and University of Kiel, Germany. Email: holger.goerg@

ifw-kiel.de; Aoife Hanley, Professor, Kiel Centre for Globalization, Kiel Institute for the World Economy and

University of Kiel, Germany. Email: Aoife.Hanley@ifw-kiel.de; Haiou Mao, Associate Professor, College

of Economics and Management, Huazhong Agricultural University, China. Email: maohaiou77@163.com.

Haiou Mao would like to express her gratitude to the National Natural Science Foundation of China (No.

72203067) and the Central University Basic Research Fund of China (No. 2662021JGQD007). Holger Görg

gratefully acknowledges fi nancial support from the Riksbankens Jubileumsfond.

Foreign Divestment – Crisis or Chance for

China’s Innovation Edge?

Guopei Fang, Holger Görg, Aoife Hanley, Haiou Mao*

Abstract

The recent move towards decoupling from China, prompted by the 2018 trade confl ict,

has implications for the innovativeness of Chinese firms. Using patent data from the

Chinese State Intellectual Property Offi ce, together with comprehensive fi rm-level data,

and applying an inverse propensity score reweighting methodology to deal with selection

bias, we estimated changes in the patenting activity of firms following ownership

transition to Chinese owners, linking these changes to the diff erential taxation incentives

off ered to foreign investors. Far from crippling innovation, divestment has sparked an

increase in patent applications – including higher end invention patents – and other

innovation measures. Together with robustness checks, our estimations suggest a real

improvement in innovation rather than just a window-dressing exercise. We suggest that

one possible explanation may be an eff ort by the new Chinese owners to reduce their

tax burden. Our supplementary fi ndings on tax payments and subsidy receipts following

divestment appear in line with this interpretation.

Keywords: China, foreign divestment, innovation, patents, research and development

JEL codes: F23, G34, O31

I. Introduction

The US trade confl ict with China commenced in 2018 and cast a long shadow. This

legacy of the Trump presidency is predicted to continue, despite the change in the

US administration (Bloomberg, 2020; Reuters, 2020). The new global dynamic –

Guopei Fang et al. / 1–33, Vol. 30, No. 6, 2022

2

Legal Statement: This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs

License, which permits use and distribution in any medium, provided the original work is properly cited, the use is non-commercial

and no modifi cations or adaptations are made.

© 2022 The Authors. China & World Economy published by John Wiley & Sons Australia,

Ltd on behalf of Institute of World Economics and Politics, Chinese Academy of Social Sciences.

Funding Statement: Open Access funding enabled and organized by Projekt DEAL.

a move towards increased decoupling from China – may have implications for the

operations of foreign multinational firms, which may reduce their engagement in

China. This, in turn, has consequences for the innovativeness of domestic Chinese

firms. However, in the absence of empirical evidence, it is difficult to tell how

serious this will be.

China has actively used policy measures to encourage foreign investors to set up

technology-intensive affiliates.1 These policies included the establishment of special

economic zones, tax concessions, and subsidies (Long, 2005). For years, China has been

the recipient of the second largest share of foreign investment in the world, after the US.

However, along with the inflow of new foreign firms, substantial numbers of foreign

multinationals have been divesting their affi liates from China − even before the trade

confl ict with the US emerged. From 2005 to 2007, our period of analysis, 79,459 foreign

affi liates were closed, compared with 123,407 newly established foreign affi liates.2 From

2009 to 2018, after the global fi nancial crisis, 142,501 foreign affi liates were closed, and

300,840 new foreign affi liates were established.

The importance of foreign divestment, which accompanies new investments, has

been largely overlooked by academic research. Such ownership transfers also have

not featured strongly in the policy debate. However, these transfers raise important

questions, not least about the innovation trajectory of firms following the transition

to local ownership. Two issues deserve our particular attention. First, a relatively

straightforward question – what happens to innovation in the affi liate after the foreign

owner’s withdrawal? Second, how will the newly divested affi liates adjust to the loss of

incentives, which, certainly in the case of China, are strongly linked to its technological

performance and only made available to foreign owners? Unfortunately, the existing

literature does not answer these questions.

We can glean, from past studies and anecdotal evidence, some clues as to what

happens to the divested affi liates. A commonly held view is that divestment is merely

1Many countries expend vast eff ort to entice foreign fi rms, especially those with cutting-edge technologies or

strategic products, and China is no exception to this. An important rationale for such measures, often in the

form of tax concessions or outright subsidies, is that it facilitates knowledge spillovers to the local economy

(Görg and Greenaway, 2004; Meyer and Sinani, 2009). The arrival of foreign fi rms also generally boosts the

innovation of foreign-owned affi liates (Girma et al., 2008; Bertrand, 2009; Guadalupe et al., 2012).

2The diff erence between registered foreign fi rm capital in year t and year t − 1 is the net new foreign fi rm

amount, which is the result of new foreign establishments and foreign divestments. By using the amount of

net new foreign fi rms minus gross number of new established foreign fi rms, we can calculate the amount of

foreign divestment. The number of newly established foreign fi rms is extracted from the Chinese Foreign

Investment Statistics Bulletin (Ministry of Commerce of China, 2007). The number of registered foreign fi rms

is taken from China Trade and External Economic Statistical Yearbook (NBS, 2007).

Foreign Divestment and Innovation 3

Legal Statement: This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs

License, which permits use and distribution in any medium, provided the original work is properly cited, the use is non-commercial

and no modifi cations or adaptations are made.

© 2022 The Authors. China & World Economy published by John Wiley & Sons Australia,

Ltd on behalf of Institute of World Economics and Politics, Chinese Academy of Social Sciences.

Funding Statement: Open Access funding enabled and organized by Projekt DEAL.

the reverse of an acquisition by a foreign owner.3 Studies examining the transfer of

ownership from domestic to foreign owners have reported increases in their innovation

performance, attributed to technology transfers from the parent (e.g., Bertrand, 2009;

Guadalupe et al., 2012). By extension, selling off an affi liate to local owners is expected

to result in a freeze in technology transfers. This technology freeze could trigger a

deterioration in the performance of the divested firm – a view advanced by Javorcik

and Poelhekke (2017) and Mohr et al. (2020). In both studies, the focus was on how

divestment affected the overall performance of the affiliate, where performance was

measured as output, productivity, and exports. However, neither of these studies

considered the special case of innovation.4 Using Chinese data, Bao et al. (2020) looked

at the performance of local firms terminating joint ventures with foreign companies.

They showed that such local fi rms experienced higher productivity, export propensity,

and export intensity, but there was no significant effect on innovation (which they

measured as sales of new products).

Apart from the studies mentioned above, we can illustrate the processes of

divestment in practice. The Chinese fi rm Foshan Chiral Pharmaceuticals was acquired

in 2005 and divested in 2014 by the US multinational Actavis. Data from the State

Intellectual Property Office of China revealed that Foshan applied for six patents

between 2005 and 2014, all of which were design patents (one of the least disruptive

types of innovation). Following the transition to Chinese ownership, the fi rm applied

for 26 patents between 2015 and 2018, including 11 inventions, 11 utility, and 4 design

patents, respectively. Foshan also shifted its business away from pharmaceuticals

toward traditional Chinese medicine. This strategic shift was refl ected in some of the

new invention patents. Accordingly, neither the quantity nor the quality of patents was

adversely affected in Foshan – quite the contrary. However, Foshan is only one firm

of many. A more definitive assessment of what happens to innovation following the

withdrawal of foreign owners necessitates a more careful empirical assessment, which

we attempt to provide in this paper.

3As early as the 1980s, Boddewyn (1983a, b) examined what determines foreign divestment. Some studies

showed that changes in economic or institutional conditions in the host country, such as economic growth

(Benito, 1997), labor cost (Belderbos and Zou, 2006), employment protection (Dewit et al., 2019), terrorism

(Liu and Li, 2020), and corruption (Sartor and Beamish, 2020) mattered for the divestment decision,

whereas others focused on subsidiaries’ own characteristics such as ownership structure, human capital,

productivity, size, and international performance (Duhaime and Baird, 1987; Mata and Portugal, 2000;

Engel et al., 2013; Tan and Sousa, 2018).

4Numerous studies have looked into the eff ect of foreign divestment on the performance of the multinational

parent fi rm in the home (but not host) country (e.g., Borde et al., 1998; Engel and Procher, 2013; Zschoche,

2016).