Make Exports Great Again? Not So Fast

By Dr Chaoqun Zhan

As Donald Trump’s tariff policy sends shockwaves through global markets, the role of foreign direct investment (FDI) is back under scrutiny. For decades, economists have argued that innovation drives growth, and that improving product quality is often the most powerful form of innovation. After all, in competitive markets, quality is what separates leaders from laggards. Surely, then, FDI inflows should be an unmitigated blessing for host economies. Not so fast, say the authors of a new paper[1], as they suggest that, in some cases, an influx of foreign capital can actually lower product quality. The question is: how, and why? 

Examining the effects of horizontal FDI liberalization—that is, the entry of foreign firms competing directly within the same industries—on the quality of Chinese exports between 2000 and 2006, a period when China’s WTO accession unleashed a wave of foreign investment and intense domestic competition, the authors trace how companies adjusted their product mix and quality in response to rising foreign presence within their industries. 

Their results challenge a long-held assumption. While FDI often brings technology transfers and managerial know-how, it also intensifies competition, forcing domestic firms to reallocate resources in ways that don’t always favor quality. 

In sectors with significant FDI inflows, intensified competition and reduced market shares increase survival pressures, ultimately incentivizing the production of lower-cost, lower-quality goods.”

Strikingly, the study finds that the quality of new products introduced after FDI liberalization is often lower than that of those produced before. This “within-firm adjustment” effect accounts for most of the decline in export quality. The magnitude is not trivial: the paper estimates an overall quality drop of nearly 11% between 2000 and 2006, based on a novel integration of firm-level production data, sectoral FDI liberalization, and customs information on export prices and destinations.

The findings point to a clear mechanism. As competitive pressures intensify, the expected returns to technology investment decline, leading firms to reduce investments in product quality. The impact of China’s 2002 FDI policy reform is predominantly observed among newly introduced products, while the quality of continuing and dropped products remains unchanged. Notably, product scope stays constant, as firms replace discontinued lines with new, lower-quality ones. In other words, the overall decline in export quality stems not from firms abandoning high-quality lines but from introducing new, lower-quality ones. The authors note that this pattern is robust across different measures of product quality and FDI intensity.

Thus, the evidence suggests that FDI inflows do not automatically raise the technological frontier. Under intense competition, firms may shift from creative upgrading to defensive cost-cutting, resulting in a measurable decline in export quality. For policymakers aiming to lift export performance, the lesson may well be that FDI alone does not guarantee a move up the value chain.

Reference:

[1]  Qiu, Q., Qiu, L. D., & Zhan, C. (2024). FDI inflows and export quality: Domestic competition and within-firm adjustment. Journal of Development Economics, 167, 103293. https://doi.org/10.1016/j.jdeveco.2024.103293