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This paper estimates the link between Japanese foreign direct investment (FDI) and the host country's patent rights protection (PRP) in 1985–2004. Regressions performed on data that are aggregated in a variety of ways identify a positive and significant link that is concentrated in countries with a high innovative (imitative) ability and technology-intensive industries. Firm-level logistic regressions show that the link is stronger for firms that depend more on patents to protect innovations than their industry peers. These patterns lend strong support to the argument that PRP and FDI are correlated across countries because the strengthening of PRP ameliorates investors’ concerns about the spillover of proprietary technology

The relationship between a country's patent rights protection (PRP) and its inflow of foreign direct investment (FDI) has considerable implications for national development policies and the location strategies of multinational corporations (MNCs). If PRP increases FDI inflows, as suggested by many authors and institutions [e.g., The World Bank (2002)], then policymakers designing national patent systems should consider this effect in addition to the traditional trade-off between domestic innovation and technology diffusion. However, if PRP is unimportant to the location decision of MNCs, then the merit of the TRIPS (Trade-Related Aspects of Intellectual Property Rights) agreement (and other international initiatives to strengthen global PRP) might be exaggerated, especially for countries with low innovative ability. A growing body of research has estimated the PRP–FDI link across countries, using mostly U.S. data. Consistent with the view that PRP stimulates FDI inflow by protecting investors from unintended spillovers of proprietary technology, many authors have identified a positive and statistically significant link between a country's PRP and FDI inflow from the U.S. (e.g., Lee and Mansfield, 1996, Maskus, 1998 and Smith, 2001). However, at least two issues remain unclear in this literature. The first is the role of foreign PRP in the geographical distribution of non-U.S. FDI. The second is whether the PRP–FDI link is caused by firms that depend largely on patents to protect innovations. If the link is not driven by the investment behavior of these firms, then the conventional wisdom becomes dubious because the link could merely reflect the collective effect of other policy and institutional factors coevolving with patent laws that remain uncontrolled for in these estimations (Primo Braga and Fink, 1998 and Lall, 2003). In this paper, I help resolve these ambiguities by using microeconomic data on Japanese FDI over two decades. Japanese FDI provides an interesting case because, as Mansfield's (2000) international survey of managers suggests, the location decision of Japanese MNCs is just as sensitive to foreign PRP as that of their U.S. counterparts. Nevertheless, no previous studies have estimated the effects of foreign PRP on the geographical distribution of Japanese FDI. Another unique feature of this study is that it takes a more detailed look at the cross-sectional variations of this PRP–FDI link. If PRP is correlated with FDI because of the direct effects of patent laws on the reduction of technology spillover, then the correlation should be particularly strong for the FDI of firms that largely depend on patents to appropriate innovations. On this critical issue, research has supplied only limited and mixed evidence at the industry level while supplying no evidence at the firm level. In this paper, I provide unusually detailed evidence on the heterogeneity of the PRP–FDI link across industries and firms. In particular, I estimate how a firm's sensitivity to foreign PRP varies with its innovative activities (especially patenting) by matching FDI and patent data at the firm level. My empirical focus is on FDI undertaken in 1985–2004 by industrial firms listed on the Tokyo Stock Exchange (TSE). I estimate factors influencing these firms’ FDI location in two steps. First, data are aggregated for cross-country regressions to estimate the country-level determinants of FDI flows. After controlling for geographical distance and a variety of development variables, I find a statistically and economically significant link between Japanese FDI and the host country's PRP. Consistent with Smith's (2001) findings for U.S. MNCs, this link concentrates in host countries with a high ability to imitate foreign technology. In addition, disaggregating FDI by industry reveals that the link is specific to technology-intensive industries such as chemicals and electric machinery. These results are consistent with the view that the strengthening of PRP alleviates foreign investors’ concerns about the spillover of proprietary technology and thereby increases the FDI inflow into a country. In the second step, I perform logistic regressions based on firm-level data to estimate a firm's likelihood of investing in a country. I find that after controlling for various country- and firm-specific factors, a country's PRP significantly increases the probability of a firm's investing in the country. In addition, the estimated pattern of inter-firm variation in PRP–FDI links is highly consistent with the direct effect of technology protection because the link is stronger for firms that depend heavily on patents as compared to their industry peers. An interesting result is that a firm's sensitivity to foreign PRP increases with its patent intensity, even in industries for which aggregate estimations fail to identify a positive PRP–FDI link. The PRP-sensitivity of FDI is therefore a function of the investing firm's technology strategy as well as industry characteristics. Regressions also reveal that PRP increases FDI inflow into a country mainly by affecting the initial investment decision of new investors rather than the expansion decision of incumbent firms. Taken together, my results are consistent with the notion that strengthening PRP to improve the appropriability of innovation increases the inflow of FDI. The finding that this effect is mainly driven by technology-intensive firms implies that PRP affects the quality as well as the quantity of incoming FDI. It is important to recognize that the effect of PRP in attracting FDI concentrates in countries with relatively advanced technological ability. Governments must carefully weigh the costs and benefits of strengthening PRP in light of their country's technological needs and capabilities. The organization of this paper is as follows. Section 2 reviews the background of this research. Section 3 introduces data. Section 4 performs cross-country regressions. Section 5 performs logistic regressions to estimate the PRP–FDI link at the firm-level. The final section concludes.

This paper provides detailed evidence for the effects of PRP on FDI inflows, based on Japanese data over two decades. I find an economically and statistically significant link between the Japanese firm's FDI and foreign PRP. Moreover, I find substantial evidence that the link is heterogeneous across countries, industries, and firms. My major findings are summarized as follows: (1) The positive PRP–FDI link concentrates in countries with a high ability to imitate foreign technology. In technologically less-sophisticated countries, the link disappears. (2) The link with foreign PRP is positive and significant only for FDI in technology-intensive industries, such as chemical and electric machinery. (3) The sensitivity of a firm's FDI to foreign PRP increases with its patent intensity relative to industry peers. The effect of PRP diminishes substantially when a firm has previous investment experience in the same country. These patterns suggest that the strengthening of PRP increases FDI inflow into a country as it mitigates investors’ concern about unintended spillovers of proprietary technology. They also suggest that PRP affects the quality as well as the quantity of FDI inflow because PRP mainly affects investment by innovative firms in technology-intensive industries. It is important to recognize that the effect of PRP to attract FDI varies considerably across countries. The strengthening of PRP can increase neither FDI inflow nor innovations by domestic firms if a country's innovative (imitative) ability is low. Governments must carefully weigh the cost and benefit of PRP in light of their country's technological capability and needs and the nature of foreign investment they wish to attract.