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SEPTEMBER 20, 2014 vol xlIX no 38 EPW Economic & Political Weekly 56
FDI and Firm Competitiveness
Evidence from Indian Manufacturing
Sanghita Mondal, Manoj Pant
This paper is based on the MPhil and PhD research work of Sanghita
Mondal. We thank the reviewer of the paper for the useful comments
and suggestions in improving the paper.
Sanghita Mondal (msanghita@gmail.com) is a doctoral student
at the Jawaharlal Nehru University, New Delhi and Manoj Pant
(mpant101@gmail.com) teaches at the Centre for International Trade
and Development, JNU.
As developing countries are increasingly opening
up their economies to foreign direct investment,
one of the principal objectives has been to enhance
competitiveness of domestic firms using their network,
technology and organisational skill. This study on India
shows that competitiveness is more likely to be achieved
with the presence of foreign firms rather than by simple
purchase of foreign technology. Absorptive capacity
of firms and institutional factors (namely, competition
in the industry) induce competitiveness among firms.
It is seen that both the degree of competition and the
absorptive capacity of firms have strong effects on
indirect benefits from FDI in enhancing competitiveness.
1 Introduction
O
ne of the major changes in the international arena in
the last two decades or so has been the increasing im-
portance of foreign direct investment (FDI) for devel-
oping countries. Two main factors have accounted for this.
First, the decline in ow of aid in terms of Ofcial Develop-
ment Assistance to developing countries and its replacement
by ows of portfolio investment and FDI. Generally developing
countries have preferred FDI rather than portfolio ows as
it is considered more stable and growth augmenting for the
domestic economy (Haddad and Harrison 1993; World
Investment Report 1999). As a consequence, the competition
among developing countries for wooing FDI has increased
considerably.
In the 1990s, for example, of all changes to bilateral invest-
ment treaties, about 95% have been in favour of further liber-
alising entry norms for FDI (World Investment Report 1999).
Moreover, we see a lot of costly programmes like tax holidays;
subsidised industrial infrastructure and duty exemptions are
adopted by the developing countries to attract FDI (Blalock
and Gertler 2008). Second, most of the economies and espe-
cially for developing countries, FDI is now viewed as a major
source of technology for enhancing productive capacity and
competitiveness (Aitken and Harrison 1999; World Investment
Report 1999).
An impediment to direct technology transfer (through pur-
chase of drawings and designs, etc) is that it tends to be limited
by patent laws. This makes it costly for domestic rms to
appropriate the full benet of technological capability generated
abroad. In this scenario, the benet of FDI is viewed indirectly
as a channel for technology spillover. It has been argued that if
transnational corporations introduce new products or proc-
esses in the host country, technology diffuses to the domestic
rms which are competitors in production or suppliers of in-
puts to the foreign companies (see, for example, Aitken and
Harrison 1999; Kathuria 2000).
Imitation of technology and production techniques by the
domestic rms, labour turnover from foreign multinationals,
supply chains with the domestic rms and most importantly
competition brought by foreign rms enhances productive
capacity of the domestic rms given the favourable economic
and social conditions of the country, industry or rms. The
appropriation of these benets is subjected to the level of absorp-
tive capacity of the rms, available human capital in the coun-
try and competitive environment of the industry. As a result of
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Economic & Political Weekly EPW SEPTEMBER 20, 2014 vol xlIX no 38 57
these positive technological spillovers, FDI can be seen as a
major source of technology and other rm-specic benets
(networks, organisational skills, etc) which result in increasing
productivity and competitiveness among the domestic manu-
facturing rms.
The early literature on FDI in developing countries had con-
centrated on direct benets of FDI in the form of employment,
exports, etc (World Investment Report 1999; Aaron and Andaya
1998). It is only recently that the literature has focused its
attention on the indirect benets of FDI on the manufacturing
sector of the developing economies. Indirect benets generally
come in the form of technology spillover. In this context, India
too has been wooing foreign technology via the FDI route since
the 1980s. The Technology Policy statement in 1982, which
was a part of foreign investment policy of India in the 1980s,
stressed the need to promote the purchase of foreign techno-
logy via technical collaborations with Indian rms. The general
idea was that technical collaborations would induce techno-
logy transfer via purchase of drawings and designs by Indian
rms. Although this was a major move towards technological
modernisation, later studies have argued that the policy was
found to be a failure in practice as most Indian rms tended to
import outdated technology (Pant 1995).
The rst major change in Indias policy towards FDI came
after the Industrial Licensing Policy of 1993. For the rst time,
it was recognised that FDI was the preferred mode of foreign
investment compared to the traditional inows of loans and
portfolio investment. Moreover, the long-term industrial
licensing and regulations completely wiped competitiveness
and efciency from the Indian industrial sector. Therefore,
while the Indian policy on FDI has been liberalised remarkably
in recent years, the focus on FDI as a source of international
competitiveness has now gained even political acceptance.
Therefore in this study, we will examine the channels of com-
petitiveness and also try to see whether the presence of FDI has
enhanced Indian manufacturing rms competitiveness given
the domestic institutional conditions.
This paper is organised as follows. Section 2 presents a brief
overview of the literature on the concept of competitiveness
and its sources. In Section 3, we present a discussion about the
methodology and denitions of variables used in our empirical
analysis. This is followed by a discussion of the data and a brief
comparison of foreign and domestic rms in the Indian manu-
facturing sector in Section 4. The main results of our estima-
tion are presented in Section 5; while some concluding obser-
vations are given in Section 6.
2 Competitiveness and Sources of Competitiveness
2.1 Concept of Competitiveness
By the term competitiveness, we imply the relative efciency
in producing tradable goods. The concept of competitiveness
has been highly debated and is often controversial among
empirical scholars. We will briey highlight some of these well-
known debates and arguments below. There seems to be no
consensus in the literature regarding what the concept really
means, especially at the national level. For instance, competi-
tiveness and comparative advantage are used interchangeably.
Although both are related, there are certain distinctions be-
tween them. Comparative advantage is driven by differences
in the cost of inputs such as labour or capital. While competitive
advantage is driven by differences in the capacity to transform
these inputs into goods and services at maximum prots
(Kogut 1985). According to Siggel (2006) the distinction bet-
ween competitive advantage and comparative advantage
depends upon the measurement of costs. But these two concepts
are closely related because competitive advantage is built to
some extent upon the factors that determines comparative
a dvantage and how one manages to maintain this advantage.
Another major reason behind this controversy is that com-
petitiveness is often identied at three levels: national, indus-
try and rm level. At the national level, the most common
acceptable denition of competitiveness is the ability of a
country to produce goods and services that meet the test of inter-
national markets and simultaneously to maintain and expand
the real income of its citizens (OECD 1992). According to
Haque (1995) an economy is competitive if it is able to grow
without being constrained by balance of payment difculties
and market share is maintained. Some scholars, for example,
Chaudhuri and Ray (1997) have dened competitiveness at the
national level as absolute or relative productivity advantage in
producing a particular commodity by the nation. Productivity
is assumed to capture the quality and product feature as well
as production efciency in the manufacturing sector.
The usage of productivity to reect competitive perform-
ance has been well advocated by many economists. Krugman
(1996), one of the leading critiques of the usage of competitive-
ness at the national level argues that it is rms that compete
for market share and not countries. He further notes that econ-
omies simply do not compete with each other as corporations
do and that increases in productivity rather than international
competitiveness are all that matter for increasing the standard
of living of a nation. At the same time, Krugman (1994) also
argued that the notion of competitiveness at the national level
makes no sense, and claimed that the term was becoming, in
fact, a dangerous obsession. Instead of competitiveness, he
preferred to use productivity as the major indicator of per-
formance of nations.
The issue of competitiveness is less controversial at the in-
dustry and rm level. Competitiveness at the rm level can be
dened as the ability of rm to design, produce and/or market
products superior to those offered by competitors, considering
the price and non-price qualities (DCruz and Rugman 1992).
The notion of competitiveness as the ability to compete in mar-
kets for goods or services ts the most with rms (Musik and
Murillo 2003). According to Chesnais (1986), the international
competitiveness of nations is built on the competitiveness of
the rms which operate within national borders. Competitive-
ness is the dynamism of domestic rms and their capacity
to invest and innovate by using own research and develop-
ment (R&D) and technology developed elsewhere. To quote
Porter (1998), It is the rms, not nations, which compete in
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SEPTEMBER 20, 2014 vol xlIX no 38 EPW Economic & Political Weekly 58
the international markets. Nations can compete only if rms
are competitive (Ambastha and Momaya 2004). Therefore,
studies regarding competitiveness should focus on the competi-
tiveness of rms rather than nations. Firm-level competitive-
ness generally focuses on the capacity of a company to increase
prot and grow on a sustainable basis (Onyemenam 2004).
Apart from the debate over dening competitiveness, an-
other important issue concerning competitiveness is its meas-
urement at the rm level. Various researchers have used dif-
ferent indicators to identify rm-level competitiveness. Gener-
ally, protability, cost, productivity and market share are used
to denote rm competitiveness. For instance, Ramasamy
(1995) perceives competitiveness as the ability of a rm to seg-
ment market share, prot and growth in value added to re-
main competitive in the long run. Kumar and Chadee (2002)
stress export protability and market share as the main indica-
tors of competitiveness. Similarly Gorynia (2001) used rms
market share and nancial condition as an indicator of com-
petitiveness. Some authors view competitiveness with a com-
petency approach. They emphasise the role of factors internal
to rms such as rm strategy, structures, competencies, capa-
bilities to innovate, and other tangible and intangible resources
(Bartlett and Ghoshal 1989; Hamel and Prahalad 1989). This
view is particularly accepted in the resource-based approach
to competitiveness (Barney 1991; Grant 1991; Prahalad and
Hamel 1990).
However, in recent rm-level literature, the main argument
has been that monitoring the level of productivity within the
rm is very important to keep the rm competitive in todays
marketplace. Productivity is the measure which might be
termed as revealed competitiveness (Gardiner et al 2004;
Roshli 2010). Porter (1990) dened competitiveness at the
organisational level as the productivity growth that is reected
either by lower cost or by differentiated products that com-
mand premium prices. Productivity is seen as the value of a
nations products and services, measured by the prices they
can command in the open market and the efciency with
which they can be produced (Porter and Ketels 2003). There-
fore, true competitiveness is measured by productivity so that
higher productivity means improved competitiveness. Krug-
man (1994) argued that, if competitiveness has any meaning
then it is just another way of dening productivity so that
growth in the national living standards is essentially deter-
mined by the growth rate of productivity. The company,
industry or the nation with the highest productivity could
then be seen as the most competitive (McKee and Sessions-
Robinson 1989).
2.2 Sources of Competitiveness
We can see that the competitiveness of rms in developing
countries is severely constrained by poor and inadequate eco-
nomic infrastructure. The lack of technological infrastructure,
in terms of knowledge-creating institutions, business develop-
ment services, and access to technology are major obstacles to
rms ability to innovate. Acquiring technological capabilities
is not an automatic process in response to market signals. It is
a costly and invariably time-consuming process which is very
much dependent on country-specic factors. In this context,
FDI can help developing countries in domestic capital accumu-
lation and gain access to technology, skills and managerial
know-how (Smeets 2008). Some of the positive benets of
inward FDI to developing countries like India are briey
discussed below.
FDI may contribute directly to the competitiveness of local
rms by being the vehicle for penetrating international pro-
duction and marketing networks. It increases foreign capital
and opens accessibility to international nance. FDI can have
positive indirect benets in forms of reverse engineering and
labour turnover to the domestic rms. FDI can also have posi-
tive indirect benets in terms of increasing the contestability
of host markets, improving the efciency of local rms and in-
dustry by reallocating the resources towards effective sectors
(allocative efciency as termed by Caves 1974) and lowering
prices. Competition and technology transfer from FDI reduces
the X-inefciency of the domestic rms and improves produc-
tivity of the local rms (Gorg and Greenaway 2004; Smeets
2008). On the other hand, competition from foreign rms may
force the inefcient domestic rms to leave the market, lead-
ing to lower competitiveness among the local rms (Aitken
and Harrison 1999). Linkages with foreign and domestic rms
enhances productivity of domestic rms as foreign rms sup-
ply technology and train local labour to improve the quality
of products. Moreover, multinational corporations (MNCs)
encourage diffusion of knowledge and technology among local
suppliers to avoid dependence on a single rm (Javorcik 2004).
Evidence suggests that efciency-seeking FDI rather than mar-
ket-seeking or natural-resource-seeking FDI yields the greatest
improvements in local rm competitiveness and market share
(Marin and Sasidharan 2010).
However, the realisation of the potential benets of FDI de-
pends critically on the initial conditions in the local market.
FDI cannot substitute for domestic efforts. If there are no local
rms with which MNCs can interact, there can be no transfer of
knowledge and technology and there are unlikely to be any
changes to the host economys dynamic competitive advantages.
This suggests that achieving a more widespread diffusion of
MNC technologies and creating interlinkages with local rms
requires specic interventions such as skills development, sup-
port for R&D, a competitive environment, and the provision
and upgradation of economic infrastructure to promote local
capacity development. There is a growing body of literature
which shows that FDI has become an important source of higher
productivity and in turn competitiveness (for example, see
Bhattacharya et al 2008 for India; Chuang and Lin 1999 for
Taiwan; Gorg and Strobl 2002 for Ireland, among others).
The institutional- and rm-level factors that not only aug-
ment rm competitiveness but also facilitate spillover from FDI
are discussed below:
(a) Use of Inputs: Use of power and the capital has been the
major facilitator of productivity and thus competitiveness
(Onyemenam 2004).
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Economic & Political Weekly EPW SEPTEMBER 20, 2014 vol xlIX no 38 59
(b) R&D and Imported Technology: Innovation is the process
of introducing and exploiting a new technological advancement,
designing and engineering differentiated products (Grupp
1997). And, R&D is considered the heart of innovation, which is
the key source of dynamic competitiveness. Therefore, R&D
can be viewed as the major source of competitiveness. More-
over, imported technology as an intellectual property becomes
a primary asset of the rm and plays a major role in competi-
tive strategy (Kumar and Chadee 2002; Roshli 2010). In this
context, we have to note that the ability of the domestic rm to
absorb new technology depends on the level of R&D and the
quality of human capital available to the rms (see, for example,
Girma 2005; Kathuria 2010).
(c) Competitive Market Environment: In a market economy,
rms compete with each other to gain market share and prot.
Competition provides an incentive for rms to perform the
best, producing high-quality goods and services at the cheap-
est price. Competition encourages entrepreneurial activity
and market entry by new rms by rewarding efcient rms
and eliminating inefcient rms. In ideal market conditions
rms react exibly and quickly to changing market demands
and entry of the new rms. The entry of new rms provides
the necessary stimulus for adjustment, while the ability of the
rm to adjust and the speed at which they do so is the measure
of their efciency or in other words, competitiveness. Thus, we
can see that competition and competitive pressure are the key
drivers of competitiveness (Li et al 2001; World Investment
Report 1999).
This discussion has highlighted several potential effects of
FDI on rm competitiveness. There are few studies on India,
for example, Kathuria (2000, 2002 and 2010), Sasidharan and
Ramanathan (2007), and Goldar (2004) which have mainly fo-
cused on productivity spillover of Indian manufacturing rms
from FDI. Among these studies, while Kathuria (2000, 2002
and 2010) found that FDI has not much impact on enhancing
productivity, other studies found positive-spillover benets
from FDI. However, the studies found that R&D and competi-
tion are very important factors in enhancing productivity in
India (Kathuria 2000, 2002). Therefore, in the next section,
we will spell out the empirical methodology for assessing the
role of FDI and other potential factors on the competitive per-
formance of Indian manufacturing rms.
3 Methodology
We have used a proxy for rm competitiveness by using its rel-
ative distance from the most productive rm of the industry.
We assume that the higher the competitiveness, lower would
be the gap between the frontier (most productive) and laggard
rms. In order to derive rm productivity, we have estimated
the rm-level production function. Unlike other partial pro-
ductivity measures (labour productivity or capital productivity),
we measure total factor productivity (TFP) of the rms. The
key issue in the estimation of the production function is the
potential correlation between unobservable productivity shocks
and input levels of rms. In the case of positive productivity
shocks, we know that prot-maximising rms respond by ex-
panding output which requires additional inputs. The correla-
tion between the input level and productivity shock leads to a
simultaneity problem in production estimation. Ordinary least
square (OLS) estimates ignore this correlation between inputs
and this unobservable factor.
Therefore, OLS estimates of the production function will
produce biased and inconsistent results. To resolve this prob-
lem, Olley and Pakes (1996) developed an estimator that uses
investment as a proxy for unobservable shocks. However, the
method is valid only when rms report non-zero investment.
Investment is a costly state variable; therefore, costs for adjust-
ment sometimes generate problems for estimation (Levinsohn
and Petrin 2003).
Thus, we have used the Levinsohn and Petrin intermediate
input proxy method to estimate productivity for rms. Levin-
sohn and Petrin use panel data for the entire time series of
observations for the rms in the bootstrapped sample. The
sample is complete when the number of rm year observations
equals the number of the rm year observation in the original
sample. This process has few benets over other processes:
(1) rms at least always report positive use of electricity or
m aterial (in our case we use power and fuel expenses as the
intermediate input); (2) use of intermediate inputs simply links
the economic theory and estimation strategy, because inter-
mediate inputs are not typical state variables.
The production function estimation using inputs to control
for unobservables, production technology is assumed to be
Cobb-Douglas:
Y
it
= A
it
K
it
k
L
it
l
M
it
m
E
it
e
...(1)
where

Y
it
represents the output of the rm i at period t. A
it
is
the productivity level of the rm i at period t. K
it
, L
it
, M
it
, E
it

respectively represent the state variable capital, free variable
labour and raw material, and the proxy variable for intermedi-
ate input, energy which is correlated with unobserved prod-
uctivity. Taking natural logs the production function can be
written as:
y
it
=
o
+
l
l
it
+
k
k
it
+
m
m
it
+
e
e
it
+
it
+
it
...(2)
y
it
= logarithm of rm is output
l
it
, m
it
, k
it
, e
it
represent logarithm of free variables labour
and raw material, state variable capital, proxy variable energy.

it
= the transmitted productivity component related to the
state variable or in other words productivity, and

it
= error term uncorrelated with input choices
We take energy as a proxy to take care of the endogeneity
bias. Levinsohn and Petrin assume that intermediate input
(here, energy) demand function, e
it
= e
it
(k
it
,
it
) is monotoni-
cally increasing in productivity given its capital stock. This al-
lows inversion of energy demand function as
it
=
t
(k
it
, e
it
).
Thus the unobservable productivity term
it
depends solely on
two observed inputs, k
it
and e
it
. Rewriting equation (2) gives us:
y
it
=
l
l
it
+
m
m
it
+ (k
it
, e
it
) +
it
...(3)
where (k
it
, e
it
) =
o
+
k
k
it
+
e
e
it
+
t
(k
it
, e
it
) and the error
term,
it
is not correlated with the input. The Levinsohn and
Petrin method uses a two-stage procedure to estimate the
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parameters of equation (2). From the estimated equation, the
observed
it
s are our measure of TFP. The Levinsohn and
Petrin method gives estimates which are unbiased and consistent.
Using the estimated coefcients of the production function,
we can calculate the productivity of Indian manufacturing
rms as follows:
1
ln TFP
it
= y
it

l
l
it

k
k
it

m
m
it

e
e
it
...(4)
where ln TFP
it
is the logarithm of total factor productivity of
the ith rm, in the jth sector (for the notational ease we kept j
unpronounced till the equation 3) at tth year.
3.1 Measure of Competitiveness
As already discussed, if the rms become competitive, the gap
between the most efcient rm and the laggard rms would
decrease over time. It is assumed that the rm which has the
highest level of productivity is the most efcient (and competi-
tive) rm. The other rms which have not yet reached the
frontier (the highest level of productivity) are considered to be
the laggard rms.
The level of the TFP of a rm can be examined relative to the
productivity level as achieved by the most efcient rm in
each industry j. For N number of rms, there would be N
estimates of productivity within each industry j, given by a
1jt,

a
2jt,,
a
Njt
. From here, we can get a
jt
= max (a
ijt
), as the pro-
ductivity of the most efcient rm in the industry j for the year
t. Then, the dispersion from the most efcient rm or the rela-
tive inefciency of each rm can be calculated as:
Z
ijt
= a
jt
a
ijt
(i = 1,2, , N;j = 1,2,, 5; t = 2001, ,2007)
A high value of Z
ijt
implies that the rm i is very inefcient
(less productive) relative to the most productive rm in the in-
dustry j at the time t. The relative deviation of the rm-level
productivity from the best-practice frontier can be measured
by P
ijt
= Z
ijt
/a
jt
where, P
ijt
denotes the relative-productivity de-
viation of a rm from the highest productive rm in the indus-
try. This variable, i e, P
ijt
has been used as the dependant vari-
able for our estimation. For the most productive or efcient
(most competitive) rm P
ijt
should be zero and equals 1 for the
most inefcient (least competitive) rm. Hence, P
ijt
actually
measures the competitiveness of the rms. In the rest of the
paper, we have used efciency, competitiveness and inefciency
interchangeably to represent rms competitive behaviour.
3.2 The Model
As we have mentioned earlier, competitiveness is affected by
FDI and competition in the industry; R&D, input use, and im-
ported technology by the rm, therefore, we can write:
P
ijt
= F (FDI, K/L, CONC, R&D, TECH, MAT) (5)
where FDI represents the foreign presence variable, K/L
represents the capital-labour ratio of the rm, CONC represents
the concentration (inverse of competition) in the industry, R&D
represents the R&D expenditure, TECH represents imported
technology and MAT is the material expenditure of the rms.
However, as argued by Tong and Hu (2003), Kathuria (2000,
2002) and Wang and Blomstrom (1992), indirect benet from
FDI can be internalised if the institutional and rm-level acti-
vities mutually support each other. As most of FDI impacts are
indirect in nature, the competitive nature of the industry and
R&D of the rm helps to acquire more benets from FDI. Same
happens for the imported technology. As all the rms do not
import technology, therefore learning effect works if other
rms also incur R&D and the industry is competitive. There-
fore, interaction of R&D and competition with FDI and import-
ed technology can be regarded as important factors of produc-
tivity enhancement or in turn competitiveness. However, till
now the impact of the interaction between the degree of com-
petition and FDI (and imported technology) on competitive-
ness has been hardly addressed empirically. In our model, we
included these interaction terms as well.
Therefore, our nal model (with expected signs) is:
( ) ( ) ( ) ( ) ( + )
P
ijt
= +
1
FDI
jt-1
+
2
TECH
ijt-1
+
3
(K/L)
ijt
+
4
MAT
ijt
+
5
CONC
jt-1

( ) ( ) ( )

+
6
R&D
ijt-1
+
7
(FDI
jt-1
* R&D
ijt-1
)+
8
(TECH
ijt-1
* R&D
ijt-1
)
( + ) ( + )
+
9
(FDI
jt-1
* CONC
jt-1
) +
10
(TECH
ijt-1
* CONC
jt-1
) +
ijt
(6)
where (FDI
jt-1
* R&D
ijt-1
) = the interaction term between the
foreign presence in the jth industry at time period t-1 and R&D
of the ith rm in jth industry at time period t-1.
(TECH
ijt-1
* R&D
ijt-1
) = the interaction term between the tech-
nology import by the ith rm in jth industry at time t-1 and R&D
of the ith rm in jth industry at time t-1.
(FDI
jt-1
* CONC
jt-1
) = the interaction term between the foreign
presence in the jth industry at time period t-1 and concentra-
tion in the jth industry at time period t-1.
(TECH
ijt-1
* CONC
jt-1
) = the interaction term between the tech-
nology import by the ith rm in the jth industry at time period
t-1 and concentration in the jth industry at time period t-1.

ijt
= Normally distributed random error term which captures
other inuences on P
ijt
The expected signs in parenthesis on the right hand side of
(6) are given keeping in mind that P
ijt
represents the level of
inefciency and not efciency. From equation (6), we expect
that higher FDI, technology imports, capital and R&D intensity,
use of materials will reduce the level of inefciency of the
rms. On the other hand, higher concentration will increase
the relative inefciency of rms. We have introduced a time
lag in the variables for FDI, TECH, CONC and R&D. This reects
the presumption that these variables are likely to affect pro-
ductivity with a time lag. Moreover, a lag is important to cor-
rect for any endogeneity problems. We will test this model in
our empirical estimation given in Section V. However, we will
estimate the model without interaction terms (Models 1 and 2)
and with interaction terms (Models 3 and 4).
From equation (6) it is clear that
1,

2,

7
,
8
,
9
and
10
are of
particular importance to us. For example, P
ijt
/ FDI
ijt-1
=
1

+
7
R&D
ijt-1
+
9
CONC
jt-1
measures the impact of foreign pres-
ence on relative inefciency when the interaction between
CONC, R&D and the foreign presence variable (FDI) is also con-
sidered. Statistically signicant values of
7
and
9
would indi-
cate that the impact of foreign presence in the industry on dis-
persion of productivity would depend on the R&D expenditures
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Economic & Political Weekly EPW SEPTEMBER 20, 2014 vol xlIX no 38 61
by rms and the market concentration of the industry. In other
words, even if
1
is signicant, the overall impact of FDI on pro-
ductivity may be limited because of the level of R&D and CONC.
We will discuss this in more detail later on.
3.3 Construction of the Explanatory Variables
Foreign Firm: A foreign rm has been dened as the rm
where the foreign equity participation is more than or equal to
10% (Pant and Pattanayak 2005). This is used to dene the
various explanatory variables relating to foreign rms and
shown below.
(K/L)
ijt
: Capital-Labour Ratio of the ith rm in the jth industry
at the time period t. Capital is proxied by the gross xed assets
of the rm. Employment data is not available in the PROWESS
database and, therefore, wages and salaries paid by a rm are
used as a proxy for the labour.
MAT
ijt
: Share of ith rms expenditure on raw material and
power and fuel in total sales turnover of the ith rm in jth
industry for the year t (Aitken and Harrison 1999).
R&D
ijt-1
: R&D intensity measured as ratio of total R&D expendi-
ture (current and capital) to the total sales turnover of the ith
rm which belongs to jth industry for the year t-1.
TECH
ijt-1
: This variable captures technology imports. It is meas-
ured as the ratio of the royalties, technical fees and licensing
fees to total sales turnover of the ith rm in the jth industry for
each year t-1 (Kathuria 2000 and 2002).
FDI
jt-1
: This variable is measured as the share of foreign rms
sales in total sales of a particular industry for a particular year.
It is a measure of the foreign presence in any industry.
CONC
jt-1
: The Herndahl-Hirschman Index (HHI) is measured
as:
n
i=1
(p
i
)
2
where p
i
= q
i
/Q where q
i
is the sales of the ith
rm, Q is the total sales of the industry and n is the number of
the rms in the industry. CR4 (a concentration ratio) is the
share in sales of the top-four rms in the industry.

Before implementing the model in equation (6) it is useful
to look at some features of our database and a comparison of
domestic and foreign rms. This is done in the following
section.
4 Data Source and Industry Description
The data has been retrieved from PROWESS database provided
by the Centre for Monitoring Indian Economy (CMIE). The data
consists of ve two-digit industries of the manufacturing
s ector which account for most of the FDI in India. These indus-
tries are: electrical goods, power and fuel, industrial machin-
ery, transport equipments and chemical industry. Our initial
sample consisted of 3,779 rms. Some of the rms were
dropped from the initial sample because of the discontinuity of
data for several years for important variables like gross xed
assets, sales, etc, or due to the negative values of gross value
added. A total of 2,611 rms were thus dropped from the initial
sample. The nal sample consisted of 1,168 rms from the ve
industries: power and fuel (37 rms), chemical industry (505
rms), industrial machinery (231 rms), electrical equipment
(176 rms) and transport equipment (219 rms).
The study period covers the years from 2000-01 to 2006-07.
This time period was chosen as FDI surged during 2002 and
India fully liberalised the FDI policy regime. Moreover, data
adequacy during this period was more than previous years.
Therefore, our sample used for the estimation constituted a
balanced panel. A brief comparison of domestic and foreign
rms reveals some interesting insights. For this we have used
the full set of 3,779 rms. Since this includes rms that may
have exited or entered during the sample period, we feel this
may give additional insights not available in the balanced
p anel used for the econometric estimation. Table 1 gives a
comparison of the number of foreign and domestic rms.
Inspection of Table 1 clearly reveals that the largest numbers
of foreign rms are in the chemical industry and the least in
power and fuel. This is probably due to the high capital re-
quirements in the power and fuel segment so that entry into
this sector is not easy. This sector is also quite tightly control-
led by the government. It is also interesting to note that the
percentage of foreign rms has remained more or less con-
stant over the sample period. It is also instructive to compare
some of the variables we are interested in for the two sets of
rms, domestic and foreign. Of interest is the importance of
the foreign-owned rms in our groups of industries. This is
shown in Table 2. It gives the ratios of foreign rm sales to total
industry sales over our study period. We can note that the rela-
tive sales of foreign rms have increased over the period ex-
cept for the industrial machinery sector. It may also be noted
that the increase has been highest for transport equipment
and chemical industry. However, domestic rms still account
for the largest of domestic sales.
5 Estimation Results
As we have noted, implementation of the model requires us
to rst generate residuals from production function esti-
mates and then generate our dependent variable, P
ijt
. We
have used panel estimation techniques for this and our main
estimating equation (2). The results of our estimation are
Table 1: Number of Foreign and Domestic Firms (2001 to 2007)
Industry Name and Code Total No of the No of the % of Foreign % of
Firms Foreign Foreign Firms Firms Foreign Firms
Firms (2001) (2007) (2001) (2007)
Chemical (24) 1,165 56 55 4.81 4.72
Electrical and
non-electrical (31 & 32) 603 27 25 4.48 4.15
Industrial machinery (29 & 30) 693 33 33 4.76 4.76
Transport equipment (34 & 35) 520 24 26 4.62 5.00
Power and fuel (23) 107 6 6 5.61 5.61
Source: Authors calculation based on firm-level data collected from PROWESS, CMIE.
Table 2: Shares of Foreign Firms in Total Industry Sales (2001-07)
Year 2001 2002 2003 2004 2005 2006 2007 Average
(2001-07)
Industry
(1) Industrial machinery 0.18 0.18 0.17 0.16 0.13 0.12 0.12 0.15
(2) Power and fuel 0.04 0.04 0.04 0.03 0.04 0.06 0.06 0.04
(3) Transport equipment 0.22 0.2 0.21 0.3 0.3 0.3 0.31 0.26
(4) Chemical industry 0.2 0.2 0.18 0.22 0.24 0.26 0.28 0.23
(5) Electrical goods 0.22 0.24 0.21 0.2 0.19 0.19 0.24 0.21
Source: Authors calculation from firm-level data collected from PROWESS, CMIE.
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SEPTEMBER 20, 2014 vol xlIX no 38 EPW Economic & Political Weekly 62
shown in Table 3. It is clear that the overall signicance is fairly
high. The usual Hausman tests indicated the relative efcacy of
the xed e ffects model and the results are shown in Tables 3 and 4.
The explanatory variables did not exhibit any multi-collinearity.
Table 3 shows that our model performs fairly well in that
most of the coefcient signs are as discussed in Section 3. The
results are also statistically signicant. Thus high levels of R&D
correlated with low inefciency, which gives some credence to
the usual hypothesis that R&D expenditure probably enables
domestic absorption of technology and hence increases rm
competitiveness. Our hypothesis that lack of competition in-
hibits entrepreneurial activities of the rms is established
from the estimation. This holds true for both the denitions of
competition used, namely, CR4 and HHI. The negative coef-
cients for the K/L variable indicate that rms with low K/L
r atio are also those with relatively low levels of productive
e fciency. This may indicate the relatively lower efciency of
labour in Indian manufacturing rms leads to a lower level of
rm competitiveness. The variable MAT is not understandable.
This variable has shown a surprising result.
However, our main focus in this paper is the impact of FDI
and imported technology on competitiveness. Our results
clearly indicate that foreign presence has strong positive im-
pacts on competitiveness. Our results are important given that
in the empirical literature this conclusion is not supported by
any of the studies for India. In fact most studies nd that for-
eign presence has either insignicant or negative impact on
rms productivity. We think this is probably due to the small
volume of FDI in the pre-2002 period.
Second, the usual presumption that licensing of technology
will induce learning by doing for Indian rms is not supported
by our results. Our results indicate the opposite. A similar re-
sult was obtained in Kathuria (2002). The coefcient TECH is
statistically signicant and positive indicating that import of
technology tends to increase inefciency. This result is impor-
tant given the policy focus in the 1980s to promote technical
collaborations in preference to FDI in India. Our results
indicate that imported designs and drawings did not contri-
bute to competitiveness probably because the technology was
either obsolete or inappropriate. This is also supported by
some other empirical evidence (Pant 1995). Hence, our results
indicate that competitiveness seems to come more from the
general presence of foreign rms rather than from purchase of
imported technology.
One issue which has received some attention in the litera-
ture on India is the impact that the absorptive capacity of
rms has on their ability to benet from foreign presence.
This has important implications for the general issue of the
absorptive capacity of Indian rms. We measure this effect as
the inter action of the FDI and R&D variables. From Table 3 we
can see that the coefcient of FDI*R&D is negative and statisti-
cally signicant. This indicates that while FDI by itself has a
positive spill over impact via reducing the productive inef-
ciency, this impact is larger for rms with higher R&D expend-
iture. This indicates that higher the absorptive capacity of the
Indian rms, the higher the ability of rms to benet from
foreign presence.
Similar conclusions were reached in Kathuria (2010), and
Basant and Fikkert (1996). The rst study measures absorptive
capacity by the technology gap whereas we argue that the
Table 3: Fixed Effects Panel Estimation Results with Lag 1: (Dependant
Variable: P
ijt
), All Firms
Variables Model 1 Model 2 Model 3 Model 4
(HHI) (CR4) (HHI) ( CR4)
FDI -.0037271 -0.003463 -0.014624 -0.011017
(-5.24)*** (-4.82)*** (-9.27)*** (-4.8)***
TECH .0416768 0.03991 0.03554 0.03749
(2.29)** (2.05)** (1.72)* (1.68)*
R&D -.1570293 -0.15422 -1.145602 -1.15245
(-2.27)** (-2.24)** (-2.72)*** (-2.84)***
CONC 3.524551 1.65408 1.78844 1.27433
(7.27)*** (9.72)*** (3.07)*** (5.84)***
K/L -.0003778 -0.000375 -0.000377 -0.000375
(-10.37)*** (-10.33)*** (-10.67)*** (-10.49)***
MAT 0.0828445 0.08331 0.07954 0.08133
(7.38)*** (7.36)*** (7.05)*** (7.12)***
FDI*R&D - - -0.085205 -0.075956
` (-2.94)*** (-3.08)***
TECH*R&D - - 0.14128 0.01696
(0.11) (0.12)
FDI*CONC - - 0.14003 0.0226
(7.15)*** (3.17)***
TECH*CONC - - -4.672436 -3.176201
(-0.89) (-0.72)
Constant 0.786003 0.48356 0.90147 0.61434
(34.36)*** (10.39)*** (30.48)*** (9.71)***
In Table (3), columns 2 and 3 present the results without the interaction terms while
these terms are included in columns 4 and 5. Models 1 and 3 define concentration as HHI
while models 2 and 4 employ the CR4 definition. ***, ** and * represent 1%, 5% and 10%
significance levels respectively.
Table 4: Fixed Effect Panel Estimation Results with Lag 1: (Dependant
Variable: P
ijt
) Domestic Firms
Variables Model 1 Model 2 Model 3 Model 4
(HHI) (CR4) (HHI) (CR4)
FDI -0.002862 -0.002556 -0.015138 -0.011753
(-3.53)*** (-3.13)*** (-8.97)*** (-4.68)***
TECH 0.04318 0.04149 0.03629 0.03835
(2.4)** (2.21)** (1.78)* (1.72)*
R&D -0.182041 -0.1791 -1.453117 -1.405596
(-2.47)** (-2.46)** (-2.99)*** (-2.95)***
CONC 3.26596 1.69715 1.37921 1.23685
(5.98)*** (8.75)*** (2.14)** (5.07)***
K/L -0.000376 -0.000373 -0.000375 -0.000374
(-10.21)*** (-10.15)*** (-10.54)*** (-10.34)***
MAT 0.09526 0.09576 0.09107 0.09317
(7.42)*** (7.42)*** (7.08)*** (7.16)***
FDI*R&D -0.194704 -0.092296
(-3.22)*** (-3.12)***
TECH*R&D 0.25521 0.2698
(0.14) (0.15)
FDI*CONC 0.22032 0.02758
(7.17)*** (3.49)***
TECH*CONC -4.320478 -3.489759
(-0.70) (-0.57)
Constant 0.77164 0.44907 0.90122 0.60786
(29.64)*** (8.53)*** (27.59)*** (8.71)***
In Table (4), columns 2 and 3 we present the results without the interaction terms while
these terms are included in columns 4 and 5. Models 1 and 3 define concentration as HHI
while models 2 and 4 employ the CR4 definition. ***, ** and *represent 1%, 5% and 10%
significance levels, respectively.
SPECIAL ARTICLE
Economic & Political Weekly EPW SEPTEMBER 20, 2014 vol xlIX no 38 63
absorptive capacity depends on the R&D expenditure. We may
also note that R&D does not seem to affect the ability of domestic
rms to benet positively from imported technology. In our
estimation the coefcients of the variables TECH*R&D is statis-
tically insignicant. Once again, the statistical insignicance
of the TECH*R&D variable indicates that even higher absorp-
tive capacity does not imply that domestic rms can benet
from imported technology probably because the technology is
either obsolete or inappropriate.
Another focus of our study has been the role of institutional
factors in interacting with variables like foreign presence and
technology import. The positive and statistically signicant
coefcients of the variable FDI*CONC indicates that measures
that reduce market concentration (HHI) also lead to a higher
impact of foreign presence on competitiveness. This is true
whichever denition of competition (market concentration) is
used. We interpret this to imply that higher competitive pressure
in an industry also enhances the competitiveness of the rms
from foreign presence in that industry. This role of institutions
has so far not been studied in the Indian context. However, it is
particularly important today after the passage of the Competi-
tion Act, 2002. From May 2011 the Indian regulator, the Com-
petition Commission of India, has been fully em powered to
regulate competition. Our results indicate that it can signi-
cantly inuence the competitiveness of domestic companies. It
is possible that our results are dominated by the presence of
foreign rms in our sample. In other words, spillover impacts
apply mainly to foreign rms and this is driving the overall re-
sults. To test this we implemented our model for the set of only
domestic rms. The results are shown in Table 4.
Table 4 indicates that none of our earlier results are altered
when the model is implemented for the set of only Indian rms.
The signicance of foreign presence remains the same and so
does the interaction of this variable with R&D and CONC.
6 Conclusions
In this article we have argued that the concern about competi-
tiveness in the host country rms has moved away from tradi-
tional channels to spillover impacts. In the light of strengthen-
ing patent regimes, this issue is of particular importance to
developing countries which have been opening up to FDI in a
big way in recent decades. It is thus imperative to see what
factors determine a rms competitiveness. In this study we
have concentrated on Indian manufacturing rms, for which
there is a dearth of empirical studies probably because of the
insignicant volume of FDI prior to 2002. For the measure of
competitiveness of rms, we measured relative inefciency of
the rms relative to the highest productive rms in the indus-
try. Our study has used semi-parametric Levinsohn and Petrin
(2003) method to measure the productivity of the rms in the
industry as it provides unbiased and consistent estimates of
rm productivity by taking into account the problem of endog-
eneity from unobserved shocks.
Our results support the view that foreign presence and as-
sociated demonstration effects are more likely to lead to higher
competitiveness than attempts to buy foreign technology. It
may be noted that in India the policy towards foreign collabo-
rations in the 1980s was biased towards purchase of foreign
technology. Our results thus indicate that the abandoning of
this policy in the 1990s was the right move. Second, our results
also support the view that rm competitiveness is highly de-
pendent on the absorptive capacity of the rms. This absorp-
tive capacity is reected in our model in the R&D expenditure
of rms. Unfortunately, the spending on R&D by Indian rms
has been fairly low with the possible exception of the pharma-
ceutical sector.
None of the previous studies on India have looked at the en-
abling role of institutional factors which can facilitate the im-
pact of variables like foreign investment and R&D on rm-level
competitiveness. In our study we have looked in particular at
the role that a competitive environment plays. It is seen that
the higher the degree of competition in the industry the greater
the extent of competitiveness. In addition, our study indicates
that while foreign presence does have a positive impact on
e fciency, this impact is positively affected by the level of com-
petition and the absorptive capacity of rms. In other words,
the government has an important enabling role in determin-
ing competitiveness of local rms by investing or encouraging
investment in R&D and improving the market environment for
rm-level competition.
Finally, we see that attempts at importing drawings and de-
signs to boost the domestic technology base are futile. This is
probably because imported technology is either obsolete or in-
appropriate to local conditions. Therefore, we can argue that
developing countries like India should always decide and re-
search properly before importing technology.
Note
1 However, the estimation requires several steps
and, since taking care of variances and covari-
ances of estimates at each stage is quite tedious
job, estimates have been bootstrapped to draw
inference. The bootstrap technique re-samples
the empirical distribution of the observed data
to construct new bootstrapped samples. The
value of the statistic is computed for each of
these samples and the distribution of estimates
so generated provides the bootstrap approxima-
tion to the sampling distribution of the statistic.
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pp 137-55.
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