The FDI Effect: A Story of India’s Pharmaceutical Productivity

By Jaya Prakash Pradhan December 6, 2002 627

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Type	Journal article
Title	“FDI Spillovers and Local Productivity Growth: Evidence from Indian Pharmaceutical Industry”
Author	Jaya Prakash Pradhan
Published	2002 · Artha Vijnana, 44(3–4), pp. 317–332 · Gokhale Institute of Politics and Economics
Coverage	Indian pharmaceutical firms · 1989–90 to 2000–01 (panel data)
Read	Paper (PDF)

This is a plain-language summary of “FDI Spillovers and Local Productivity Growth: Evidence from Indian Pharmaceutical Industry” (Pradhan, Artha Vijnana, 2002).

In short:

A common hope about foreign investment is that domestic firms “catch” productivity gains just by having foreign competitors nearby. This study tests that in Indian pharma — and finds it isn’t automatic.
Foreign presence on its own did not raise domestic firms’ productivity. The gains appeared only for firms that had their own R&D capability or sufficient size.
The policy upshot is pointed: building local R&D and scale matters more than simply opening the door wider to FDI.

The question

There’s a hopeful theory behind much enthusiasm for foreign investment: when multinationals enter a market, local firms supposedly absorb their technology and management know-how just by competing and rubbing shoulders with them — so-called spillovers. This study by Jaya Prakash Pradhan puts that theory to a firm-level test in the Indian pharmaceutical industry, using panel data on a sample of firms from 1989–90 to 2000–01, and asks a sharp question: does foreign presence actually raise the productivity of domestic firms — and if so, for which ones?

Why pharma is a good test case

The Indian drug industry had already lived through a dramatic reversal, which is what makes it such a revealing setting.

In the protected years (1948–1970), foreign companies dominated — holding on the order of 80% of the Indian market — with high drug prices and little local manufacturing or technology transfer. Then the 1970 Patent Act (which recognised process but not product patents) opened the way for Indian firms to reverse-engineer drugs and build a domestic industry; by around 1990, domestic firms had captured roughly 70% of the market. So by the time of this study, India had a substantial home-grown pharma sector competing alongside foreign firms — exactly the conditions under which spillovers, if they exist, should show up.

The finding: presence isn’t enough

This is where the study departs from the optimistic script.

Measuring how efficiently domestic firms turned inputs into output, and relating that to the presence of foreign firms, the study found that foreign presence per se did not improve domestic firms’ productivity. What mattered was the local firm’s absorptive capacity: spillovers materialised only when a domestic firm had its own R&D activity or sufficient size to make sense of and apply what the foreign firms were doing. A small firm with little research capability, simply exposed to foreign competitors, gained little; a firm that invested in its own R&D, or had the scale to absorb new knowledge, could convert that same foreign presence into real productivity growth. The “learning a language” analogy fits: being surrounded by fluent speakers doesn’t teach you on its own — you need enough grounding to absorb what you’re hearing.

Why it matters

The conclusion cuts against a passive, open-the-doors view of FDI policy. If foreign presence only helps domestic firms that are already capable, then liberalising FDI on its own is not a productivity strategy. The study argues that policy effort is better spent encouraging domestic firms’ R&D and allowing some consolidation of scale, so that local firms can actually absorb the knowledge foreign investment brings — rather than assuming the spillovers will arrive automatically. It’s an early, India-specific contribution to a debate that the international economics literature would continue to wrestle with: foreign investment can lift local capability, but mostly for those equipped to receive it. The honest reading is that capability has to be built at home first; FDI rewards preparation, it doesn’t substitute for it.

Read the academic abstract

This study tests the FDI-spillover hypothesis in the Indian pharmaceutical industry using unbalanced panel data for a sample of firms over 1989–90 to 2000–01. It estimates firm-specific productive-efficiency growth for domestic firms from a frontier production function and relates it to a set of firm-specific attributes alongside measures of foreign presence. The study finds that the presence of foreign firms per se may not be important for the productivity growth of domestic firms unless it is complemented by the latter’s R&D activity or size. It therefore concludes that policy efforts to encourage R&D and some concentration of size among domestic firms may be more desirable than passively liberalising FDI policy, from the standpoint of raising the productive efficiency of local enterprises.