Published on All About Finance

What Explains Firm Innovation in Developing Countries?

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Many economists agree that innovation is essential for economic growth.  But the little we know about firm innovation is based on the study of large, publicly-traded firms in developed countries.  As Moisés Naím, editor-in-chief of Foreign Policy magazine, pointed out at the recent Financial and Private Sector Development Forum, large, publicly-traded firms have served as the basis for a lot of formal economic analysis, but they are much less typical of developing countries.  This is a problem, since we know from existing studies that small and medium size firms play an important role in developing countries.

What might explain the likelihood of these firms to innovate?   Here are some of the key issues that deserve closer scrutiny:

  • Are certain types of firms more innovative than others?
  • What is the role of finance, governance and competition?
  • Is ownership or corporate form important?
  • Does foreign competition or trade openness matter?
  • And what about the education and experience of managers and workers?

My co-authors Meghana Ayyagari, Vojislav Maksimovic and I try to address these questions using enterprise surveys of over 19,000 firms across 47 countries.  One great advantage of these surveys is their broad coverage of the extent of innovation that the firms undertake.  When studying innovation in developing countries, imitation and adaptation of already-created and tested innovations typically play a more important role than cutting-edge technological innovations.  The enterprise surveys allow us to capture innovation in this broad sense, including not only core activities such as the introduction of new products and technologies, but also other types of activities, such as joint ventures with foreign partners or new licensing agreements, opening a new plant, bringing in house a previously out-sourced activity and so on.

What do we find?

First, firm characteristics, industry and country factors all matter in explaining firm innovation.

  • Firm Characteristics:  Larger firms are more innovative.  Controlling for size, younger firms also innovate more. For a given size and age, incorporation is associated with more innovative activity of all types.  Firms that operate at greater capacity (given their existing technology and labor utilization) also tend to be more innovative.
  • Industry Factors:  Not every industry is equally innovative.  Controlling for firm and country characteristics, of the 26 industries in these 47 countries, we see that those firms that are in electronics, metals and machinery, chemicals and pharmaceuticals, telecommunications, auto and auto components are the most innovative.
  • Country Factors:  There is great deal of variation across countries.  In no single country are firms uniformly less or more innovative across different categories.  Nevertheless, when we look at aggregate indexes of innovation activity, firms in Cambodia, Brazil and South Africa are the most innovative.

Second, even after controlling for firm characteristics and industry and country fixed effects, finance, governance, competition and human capital all remain important in explaining differences in firm innovation.

  • Access to finance is crucial.  The greater the proportion of investment a firm finances externally, the more innovative it is.  To the extent this financing comes from banks, there is again more innovative activity.  Firms are also more innovative if a greater share of their borrowing is in foreign currency.  Only the state-owned firms are an exception – they are likely to innovate less when they make greater use of external finance.
  • Governance matters.  Privately owned firms are, in general, more innovative than state-owned enterprises.  The identity of the controlling shareholder also matters – individual and family-owned firms and those with managerial ownership are more innovative firms.  Foreign-owned firms also tend to be more innovative.
  • Competition and firm innovation are also closely associated.  In particular, firms that face foreign competition are more innovative.  Reinforcing these results, exporters are more innovative than non-exporters.  In contrast, competition from state-owned firms seems to have no effect on firm innovation.
  • Managerial education and experience and the education level of the workers make a difference.  The higher the education level of the top manager and the larger percentage of workers who have completed university education or higher, the more innovative the firm is. 

These results do not establish causality, since this is not possible to do with a cross-section such as this.  However, they provide broad insights from a large set of firms and countries, which can help guide and frame the analysis of these important issues in future research.

What about policy implications?  There are quite a few:

  • First, by establishing a link between external finance and innovation, our results provide new evidence on a potential channel through which access to finance contributes to overall growth.
  • Second, these findings emphasize the importance of privatization in emerging markets.  State-owned firms appear to be less innovative than private firms along all dimensions, even if they have access to external finance or are exposed to foreign competition.  Our results also have implications for the evolution of industry structure since we find that having state firms as competitors in the product market is not associated with higher innovation rates.
  • Finally, our results have positive implications for the role of globalization and foreign trade in exposing firms to foreign competition.  Exposure to dynamic foreign competition in product markets affects not only the largest companies and exporters in emerging markets, but also small and medium enterprises, forcing them to innovate to survive in a constantly changing environment. These results suggest that in countries where standard corporate governance mechanisms are ineffective, foreign market competition is crucial for firm innovation and may even serve to partially substitute for the lack of good governance.

Further reading:

Ayyagari, Meghana; Asli Demirgüç-Kunt and Vojislav Maksimovic, “Firm Innovation in Emerging Markets: The Role of Finance, Governance, and Competition.” Working Paper.


Asli Demirgüç-Kunt

Former Chief Economist, Europe and Central Asia Region

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