Volume 12 Issue 3 Article 2 12-31-2010 Does a foreign subsidiary’s network status affect its innovation activity? Evidence from postsocialist economies Jože P. Damijan Črt Kostevc Matija Rojec Follow this and additional works at: https://www.ebrjournal.net/home Recommended Citation P. Damijan, J., Kostevc, Č., & Rojec, M. (2010). Does a foreign subsidiary’s network status affect its innovation activity? Evidence from postsocialist economies. Economic and Business Review, 12(3). https://doi.org/10.15458/2335-4216.1247 This Original Article is brought to you for free and open access by Economic and Business Review. It has been accepted for inclusion in Economic and Business Review by an authorized editor of Economic and Business Review. 167 ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010 | 167–194 DOES A FOREIGN SUBSIDIARY’S NETWORK STATUS AFFECT ITS INNOVATION ACTIVITY? EVIDENCE FROM POST- SOCIALIST ECONOMIES* JOŽE P. DAMIJAN** ČRT KOSTEVC*** MATIJA ROJEC**** ABSTRACT: Questionnaire survey among 809 foreign subsidiaries in fi ve post-socialist economies (East Germany, Poland, Romania, Slovenia and Croatia) is used to study deter- minants of innovation activity of foreign subsidiaries. Findings demonstrate that foreign subsidiaries are relatively independent as far as innovation activity is concerned, while at the same time subsidiaries with better access to foreign parent companies R&D results are more likely to innovate. Important diff erences are found in factors that determine product and process innovation: subsidiaries that invest more in R&D exhibit higher probability for product but not for process innovation; transfer of responsibilities from headquarters to subsidiaries is conducive to process innovation; market-seeking motivation of foreign investors has a negative impact on product innovation status. Keywords: Research and development, innovation, foreign subsidiaries, knowledge spillovers, post-socialist econo- mies JEL Classification: F21, F23, O31, O33 1. INTRODUCTION Internationalisation of R&D is one of the prevailing features of the globalisation proc- esses in the last decade. R&D performed in foreign subsidiaries is the most obvious type of the internationalisation of R&D. In 1995-2003, R&D expenditures of foreign subsidi- aries in the OECD area increased from USD 34 billion to USD 71 billion, i.e. an increase * Paper prepared within the Sixth Framework Programme project Understanding the Relationship between Knowledge and Competitiveness in the Enlarging European Union (U-Know). ** University of Ljubljana (Faculty of Economics); LICOS, KU Leuven, Belgium, e-mail: joze.damijan@ ef.uni-lj.si *** University of Ljubljana (Faculty of Economics), e-msil: crt.kostevc@ef.uni-lj.si *** University of Ljubljana (Faculty of Social Sciences); Institute for Macroeconomic Analysis and Develop- ment, Ljubljana, e-mail: matija.rojec@gov.si ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010168 by 110%, compared to 77% increase of their turnover. In all OECD countries apart from Spain, foreign subsidiaries increased their R&D expenditures by up to four times more than domestically-controlled fi rms. As a result, the share of foreign subsidiaries in total business sector R&D expenditures of OECD has become quite signifi cant. In 2004 this share was in the range between 50%-70% in Ireland, Hungary and Belgium, between 30%-50% in Czech Republic, Sweden, Australia, United Kingdom and Canada, and between 20%-30% in Netherlands, Germany, Italy, France, Portugal, Slovakia (OECD, 2008). Still, looking at the innovation activity of foreign subsidiaries, their superiority over domestic companies is not obvious. Empirical evidence goes both ways. Falk and Falk (2006) observe that innovation intensity of foreign subsidiaries in Austria is lower than that of domestic fi rms. Griffi th et al. (2004) fi nd that British-owned multinational enter- prises (MNEs) account for larger share of R&D activity in UK as compared to foreign- owned MNEs, Ebersberger and Lőőf (2005) claim that R&D intensity of domestically owned MNEs in Sweden is signifi cantly higher than in any other ownership types of fi rms. Th e situation in Norway and Finland has been the same, except for Anglo-Saxon foreign-owned MNEs. Similarly, Almeida and Fernandes (2006) suggest that majority foreign-owned fi rms in developing countries are signifi cantly less likely to engage in technological innovations than minority foreign owned or domestic-owned fi rms. On the other hand, Damijan et al. (2006) for Slovenia, Balcet and Evangelista (2005) for Italy, Gűnther (2006) for East Germany, and Girma et al. (2006) for China fi nd that foreign subsidiaries have higher propensity to innovate than domestic companies. One cannot explain much of the diff erence by foreign ownership itself but rather by the fact that foreign subsidiaries are overrepresented in higher technology intensive industries, that they are larger in size (Balcet and Evangelista, 2005), more export intensive, have more modern equipment etc. Once these factors are controlled for, foreign ownership tends not to have signifi cant impact on the propensity to innovate. Th us, according to Gűnther (2006), foreign subsidiaries play a positive role for innovation in a host country since fac- tors, which positively infl uence innovation – e.g. size, R&D, export intensity, more recent technology – particularly benefi t foreign subsidiaries. Th e objective of this paper is to ascertain how much does foreign subsidiary’s status aff ect its innovation activity in fi ve post-socialist economies.1 We build our study on a detailed questionnaire survey of innovation activity among 809 foreign subsidiaries with a particular focus on indicators refl ecting foreign subsidiaries status within the MNE network. Th e existing literature on foreign subsidiaries’ innovation activity concentrates on the comparison of innovation activity of foreign subsidiaries and domestically-con- trolled fi rms and on a foreign-parent company network as a source of knowledge which may stimulate innovation activity of a subsidiary. Th e literature that explicitly deals with the determinants of foreign subsidiaries’ innovation activity is, however, almost non-ex- istent. Th e notable exception is Kokko and Kravtsova (2008) who analyse determinants of innovative capability in MNE subsidiaries in four transition countries (Estonia, Hun- 1 Of which four are new EU member states (NMS: East Germany, Poland, Romania, Slovenia), while Croatia is a EU candidate country. J. P. DAMJAN, Č. KOSTEVC. M. ROJEC | DOES A FOREIGN SUBSIDIARY᾽S NETWORK STATUS AFFECT ... 169 gary, Poland, Slovenia). Th erefore, in looking for the theoretical background of foreign subsidiaries’ innovation activity one has to refer to various other streams of literature, i.e. those related to determinants of fi rm innovation activity, knowledge transfer within MNE, subsidiary’s position within its foreign parent company network, and heterogene- ity of foreign investors and foreign subsidiaries. Th is paper tests fi ve propositions. Th e fi rst is that innovation activity of a foreign sub- sidiary basically depends on the same factors as that of any other fi rm. Th erefore, the fi rst set of determinants of foreign subsidiaries innovation activity relates to generally identifi ed determinants of a fi rm innovation activity. Th e second proposition is that in- novation activity of a foreign subsidiary is co-determined by the extent of knowledge transfer within its foreign-parent company network. Th is is the fi rst key feature, which diff erentiates foreign subsidiaries from domestically-controlled fi rms. It is expected that this knowledge transfer, in principle, improves foreign subsidiary’s innovation ca- pacity as compared to a domestically owned fi rm. Th e third proposition is that innova- tion activity of a foreign subsidiary is dependent on a specifi c position within its foreign parent company network. Th is is the second key feature, which diff erentiates foreign subsidiary from domestically-controlled fi rm. Th is position can work both ways as far as foreign subsidiary’s innovation activity is concerned. Th e fourth proposition is that various sources of heterogeneity of foreign investors and foreign subsidiaries aff ect the innovation activity of foreign subsidiaries. Th e fi ft h proposition is that host-country and host-market characteristics also infl uence the innovation activity of foreign sub- sidiaries. Our empirical strategy is as follows. Compared to related literature, we take into account a much broader set of determinants. We follow the classical approach by explicitly bring- ing in the empirical model the ‘traditional’ determinants of fi rm innovation activity and then gradually adding foreign-subsidiary specifi c determinants. Our fi ndings confi rm that, compared to average fi rms in the analysed countries, surveyed foreign subsidiar- ies are much more innovative in terms of the fraction of product and process innova- tors in overall number of fi rms. While foreign subsidiaries in the analysed countries are relatively independent in terms of innovation activity, the subsidiaries with better access to foreign parent companies R&D results are more likely to innovate. We fi nd, however, signifi cant diff erences in factors that determine product and process innova- tion of subsidiaries. Most notably, market-seeking motivation of foreign investors has a negative impact on product innovation status fi ndings, while transfer of responsibilities from headquarters to subsidiaries is conducive to process innovation. Th e remainder of the paper is structured as follows. Section two provides the theoretical background and existing empirical evidence on foreign subsidiaries innovation activity. Section three presents the model, section four describes the data and sample character- istics and descriptive statistics, while section fi ve provides estimations of the model, i.e. of the importance of various sets of determinants on foreign subsidiaries’ innovation activity. Th e last section concludes. ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010170 2. THEORETICAL BACKGROUND AND EXISTING EMPIRICAL EVIDENCE ON THE DETERMINANTS OF FOREIGN SUBSIDIARIES’ INNOVATION ACTIVITY Innovation activity of foreign subsidiaries is essentially determined by two sets of factors. Th e fi rst set is traditional fi rm-innovation activity determinants, which are of relevance to any fi rm regardless of whether foreign or domestically owned. Th e second, which is the focus of our interest, are the determinants arising from the fact that a fi rm is a for- eign subsidiary. Th e latter is in the focus of our interest. Within this context one has to refer to various streams of literature. First, to the literature on the determinants of fi rm innovation activity which relates to the fi rst set. Second, to the literature on knowledge transfer within MNEs, subsidiary’s position within its foreign parent company network, heterogeneity of foreign investors and foreign subsidiaries, which altogether relate to the second set of determinants. Th e literature that explicitly deals with the determinants of foreign subsidiaries’ inno- vation activity is almost non-existent. Th e notable exception is Kokko and Kravtsova (2008) who analyse determinants of innovative capability in MNE subsidiaries in Es- tonia, Hungary, Poland and Slovenia. According to them, the innovative capability of MNE subsidiaries depends on three sets of determinants: (i) the role of the subsidiary in the MNE’s international production network; (ii) some other subsidiary characteristics, like size, age, and industry of origin; and (iii) host country and host industry character- istics, including the development level of the host industry and the competitive pressure exerted by local fi rms. Th e main fi nding of Kokko and Kravtsova (2008) is that innova- tive capability in product and process technology seems to be determined by a diff erent set of variables than capability related to marketing and management knowledge. Th e most independent subsidiaries are also those that have the strongest innovative capabil- ity in product and process technology. At the same time subsidiaries in high technology industries recorded lower levels of innovative capability. For marketing and manage- ment capability, the pattern is almost reversed. Th e highest levels of innovative capability are recorded in subsidiaries that are closely tied to the parent company, with high foreign ownership shares and substantial exports back to the parent company. 2.1 Determinants of fi rm innovation activity Proposition one: Innovation activity of a foreign subsidiary depends on the same factors as that of any other fi rm. Th erefore, the fi rst set of determinants of foreign subsidiaries innovation activity comprises of generally identifi ed determinants of fi rm innovation ac- tivity. Th e issues/factors which are in the centre of attention here are own R&D, external sourcing of knowledge, absorption capacity plus a number of other fi rm innovation activity determinants. Own R&D and other standard explanatory variables. Own R&D is the crucial determinant of fi rm‘s innovation capacity and of fi rm‘s capacity to absorb external knowledge (Cohen J. P. DAMJAN, Č. KOSTEVC. M. ROJEC | DOES A FOREIGN SUBSIDIARY᾽S NETWORK STATUS AFFECT ... 171 and Levinthal, 1989; Romer, 1990; Grossman and Helpman, 1991; Aghion and Howitt, 1992, 1998 etc.). Other most oft en tested explanatory variables of fi rm’s innovation activity are fi rm size, industry characteristics, market concentration, technology characteristics, product diversifi cation and market position (export orientation) (Veugelers and Cassi- man, 1999; Cohen and Levinthal, 1989). Th e relationship between innovativeness and size is positive, but not necessarily linear, and it depends on industry characteristics. Industry characteristics are the determinant of fi rm’s innovation activity in the sense that higher- tech industries exhibit higher innovation activity. Industry variable captures several di- mensions, i.e. scope for future demand, opportunities for technological innovations and cumulativeness of knowledge, indicating to which extent current innovation build further on previous R&D (Veugelers and Cassiman, 1999: 65). Th e model of Veugelers and Cassi- man (1999: 70-75) for Belgian manufacturing fi rms confi rms that large and more export oriented fi rms in high tech industries are more likely to innovate, while results of Mairesse and Mohnen (2006) for French manufacturing fi rms do not fully support these fi ndings. Th eir main fi nding is that R&D is positively correlated with all measures of innovation output, and, all other things equal, more correlated than size to innovation. Innovation is generally more sensitive to R&D in low-tech sectors than in the high-tech sectors. In our approach, own R&D and other standard explanatory variables of fi rms’ innovation activity will be analysed through: (i) share of R&D expenditures in total sales, (ii) type of product with respect to its technological intensity, as a proxy for industry characteristics, (iii) number of employees as a proxy for size. External sourcing of knowledge. Th e second set of factors which co-determine fi rm’s innovation activity is external sourcing of knowledge in its various forms, i.e. licensing agreements, contracting out of R&D, buying of equipment (imports), innovation coop- eration, knowledge spillovers from other fi rms and learning-by-exporting. Th e issue of external sourcing of knowledge is usually considered within the transfer of technology issue, but rarely within the context of innovation-activity determinants. Th e examples of the latter are Veugelers (1997), Veugelers and Cassiman (1999), Frenz and Ietto-Gilles (2007), and Damijan et al. (2006). Th ey all recognise that own R&D is the most im- portant for innovation activity, but external sources are also relevant. One of the main conclusions here is that external sourcing does stimulate fi rm’s own R&D but only if a fi rm possesses adequate absorptive capacity (Veugelers, 1997). Th is points to the com- plementarity between in-house R&D and external know-how (Allen, 1986; Cohen and Levinthal, 1990); it is diffi cult to be a good ‚buyer‘ when one is not also a ‚maker‘ (Rad- nor, 1991). Th at is why Veugelers and Cassiman (1999) fi nd it is more appropriate to talk about ‘make and buy’ and not ‘make or buy’ innovation strategy of fi rms. Th e following possible sources of external knowledge will be analysed: (i) acquisition of external knowledge (via licensing agreements and by contracting out R&D activities), (ii) acquisition of external knowledge by importing, (iii) learning by exporting. Licensing agreements are one of the basic channels of international technology transfer (Eaton and Kortum, 1996), but nowadays provide a less important source, as the latest ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010172 and most valuable technologies are not available on license (UNCTAD, 2000). As far as contracting out of R&D activities is concerned, Veugelers (1997) claims that it does signifi cantly stimulate own R&D but only when absorptive capacity is present. Imports of intermediate products and capital equipment may also work as a channel of technol- ogy transfer (Feenstra et al., 1992). Empirical research suggests that imports are an im- portant source of technology, in that much knowledge and R&D is embodied in goods that are imported, especially capital goods and machinery (Hoekman and Smarzynska Javorcik, 2006; Keller and Yeaple, 2003; Keller, 2004; Eaton and Kortum, 2001; Coe and Helpman, 1995; Coe et al., 1997; Xu and Wang, 1999; Keller, 2000; Lumenga-Neso et al., 2001; Keller, 2002; Kraay et al., 2001). Th e concept of learning-by-exporting says that more intensive competition on export markets stimulate exporters to strengthen their growth and performance (Van Biese- broeck, 2003). Via their international contacts, exporters acquire knowledge on new pro- duction methods, inputs and so forth (Aw et al., 1998). Th e literature is not unanimous about the existence of learning-by-exporting eff ects; they have been found in the case study literature, whereas authors of econometric studies take a much more sceptical view (Keller, 2004). Where only a small minority of authors fi nd support for the learning- by-exporting hypothesis, the vast majority of studies fail to fi nd any evidence of fi rms’ productivity benefi ting from exporting activities (see Greenaway and Kneller, 2007 for a survey) External sourcing of knowledge tends to stimulate fi rm’s own R&D and innovation if a fi rm possesses adequate absorptive capacity (Veugelers, 1997). Most of the litera- ture on absorption capacity relates to FDI spillovers. Th e predominant conclusion is that technology spillovers from MNEs tend to occur more frequently when the tech- nological and social capabilities of the host country and the absorptive capacity of fi rms in the economy are high enough (Blomström, 1986; Kokko, 1994; Kokko et al., 1996; Cameron, 1996; Imbriani and Reganati, 1997; Borensztein, De Gregorio and Lee, 1998; Cameron et al., 1998; Kinoshita, 2000; Keller and Yeaple, 2003; Damijan et al., 2003a; Glass and Saggi, 1998; Girma et al., 2001; Girma and Gőrg, 2002; Griffi th et al., 2004; Lim, 2001; Halpern and Murakozy, 2006; Abraham et al., 2006).2 Far the most frequently quoted determinant of absorption capacity is human capital (Borensztein, De Gregorio and Lee, 1998; Hoppe, 2005; Kneller and Stevens, 2006; Gorodnichenko et al., 2006). In our exercise, absorption capacity will be proxied by the extent of own R&D. 2.2 Knowledge transfer within MNE Proposition two: Innovation activity of a foreign subsidiary relies upon the extent of knowledge transfer within its foreign parent company network. Th is is the fi rst key feature, which diff erentiates foreign subsidiary from a domestically-controlled fi rm. It is expected 2 In contrast, a handful of authors claim that bigger technological gap off ers more room for technological spillovers (Findlay, 1978; Haskel et al., 2001; Castellani and Zanfei, 2003). J. P. DAMJAN, Č. KOSTEVC. M. ROJEC | DOES A FOREIGN SUBSIDIARY᾽S NETWORK STATUS AFFECT ... 173 that this knowledge transfer, in principle, improves foreign subsidiary’s innovation capac- ity as compared to domestic fi rms. Th e issue of technology and technology transfer from parent companies to their foreign subsidiary, as well as organization of technology, is at the heart of the theories of inter- national production and MNEs (see, for instance, Dunning, 1993; Bartlett, 1986; Bar- tlett and Ghoshal, 1989; Perez, 1998). In the transaction cost (internalisation) approach (Coase, 1937; Williamson, 1975, 1981, 1985; Buckley and Casson, 1976), one of the main reasons for the existence of international production is the presence of market failures in technological transactions (Williamson, 1981). Technology also has the central position also in the macroeconomic development approach to international production, i.e in the product life cycle hypothesis (Vernon, 1966) and in the fl ying geese model (Kojima, 1978; Kojima and Ozawa, 1985). In looking at the theoretical foundations of knowledge transfer within MNEs it seems appropriate to apply resource based, as well as organizational and institutional perspec- tives. Such an eclectic approach encompasses the whole complexity of the relationship between foreign parent and its subsidiary. Th e resource-based theoretical perspective fo- cuses on idiosyncratic resources and capabilities of fi rms as drivers of their performance. Several studies point that FDI in transition economies oft en requires a massive resource transfer (managerial, fi nancial, knowledge etc) from the foreign parent to the local sub- sidiary. A major stream of literature researches how foreign investors can facilitate or- ganisational learning (Steensma and Lyles, 2000; Lane et al., 2001) and how this, in turn, infl uences fi rm performance (Lyles and Salk, 1996; Dhanaraj et al., 2004). Organisational and institutional theory is the second way to approach knowledge transfer within MNEs. Th e underlying assumption of the knowledge complementarity concept (Buckley and Carter, 2004) and the dynamic capabilities approach (Teece et al., 1997) is that a subsidi- ary cannot develop idiosyncratic resources nor dynamic capabilities independent from the MNE headquarter or other parts of the MNE. Gupta and Govindarajan (1994) sug- gest that within the same MNE, strategic roles can be expected to diff er in terms of the extent and directionality of knowledge fl ows between foreign subsidiary and the rest of the corporation (more on that in section 2.3). Although it is far from guaranteed that all activity carried out by MNEs in host countries will lead to technology transfer, empirical evidence on technology transfer from MNEs to foreign subsidiaries in terms of higher productivity levels and growth is ample.3 On the other hand, empirical evidence on the impact of FDI on foreign subsidiaries’ innova- tion activity is more scarce. According to Cantwell and Molero (2003: 5-7), there is little evidence of any great diff erence in the innovation behaviour of foreign-owned compared to domestically-owned fi rms. Th e diff erence between the two groups is more a result of structural diff erences, such as a larger average size of foreign subsidiaries and their great- 3 Empirical studies, using fi rm-level panel data, include Haddad and Harrison, 1993; Blomström and Wolff , 1994; Blomström and Sjöholm, 1999; Aitken and Harrison, 1999; Blalock, 2001; Girma et al., 2001; Alverez et al., 2002; Barry et al., 2002; Girma and Görg, 2002; Damijan, Knell, Majcen, Rojec, 2003b; Arnold and Smarzynska Javorcik, 2005. ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010174 er presence in high-tech sectors (Molero and Heys, 2002). However, innovation strategies require increasingly more global sourcing and parent MNEs more oft en tend to integrate their subsidiaries in their innovation strategies. More innovation active foreign subsi- diaries will tend to source more know-how from local sources and, at the same time, will become more interesting vehicles for technology diff usion to the local economy. But this may also lead to the situation when valuable know-how leaves the country, while the subsidiary R&D remains too dependent on the assimilation of know-how developed elsewhere in the parent company (Sanna-Randaccio and Veugelers, 2003: 17-18). In our empirical approach, knowledge transfer within MNEs will be proxied by the subsid- iaries’ own judgement of the importance of headquarters R&D for subsidiary’s R&D and innovation. 2.3. Subsidiary’s position within its foreign parent company network Proposition three: Innovation activity of a foreign subsidiary is co-determined by its spe- cifi c position within the parent company network. Th is is the second key feature, which diff erentiates foreign subsidiaries from a domestically-controlled fi rm. Transfer of technology from foreign parent to its subsidiary and innovation activity of a subsidiary inter alia depend on subsidiary’s position in parent company’s network. Th e literature on subsidiary’s strategy focuses on the process through which foreign subsidi- aries enhance their resources and capabilities, and in so doing increasingly add value to the MNE network as a whole (White and Poynter, 1984; Bartlett and Ghoshal, 1989; Young et al., 1988; Birkinshaw and Hood, 1998). One of the most widely used subsidiary typologies within this stream of literature is the one by White and Poynter (1984). Th ey distinguish between the following types of subsidiaries: marketing satellite, miniature replica, rationalised manufacturer, specialised producer and strategic independent. Th e strategic roles of a subsidiary in White and Poynter’s typology change according to its technological capacity (Couto et al., 2003), where moving to more advanced forms of subsidiaries typically involves their higher autonomy and innovative capability (Kokko and Kravtsova, 2008). Gupta and Govindarajan (1994) suggest that within the same MNE, strategic roles can be expected to diff er in terms of the extent and directionality of knowledge fl ows be- tween foreign subsidiary and the rest of the corporation. Th ey fi nd that innovation by foreign subsidiaries is more typically the results of autonomous initiative rather than strategic directives issued from the corporate headquarter. For example, if a subsidiary operates as a centre of excellence or has been assigned a world product mandate, it is likely to have the autonomy to develop, manufacture, and market a product-line world- wide. Birkinshaw et al., (1998) contrast such ‘high contributory role subsidiaries’ with the implementer and rationalised subsidiary types, which lack autonomy, authority, and capabilities to generate independent competencies (Young and Tavares, 2004). However, the relation between technological capabilities and autonomy in the foreign subsidiary is J. P. DAMJAN, Č. KOSTEVC. M. ROJEC | DOES A FOREIGN SUBSIDIARY᾽S NETWORK STATUS AFFECT ... 175 not clear-cut (Young and Tavares, 2004). On one hand, subsidiaries with greater R&D ca- pabilities may be less technologically dependent on their headquarters and hence display higher levels of autonomy (Birkinshaw and Morrisson, 1995; Pearce, 1999; Taggart and Hood, 1999). On the other hand, strategic sensitiveness of knowledge-related activities can lead to tighter control by headquarters (Bartlett and Ghoshal, 1989; Martinez and Jarillo, 1991). Moreover, strong headquarter assignments may not only facilitate control but also effi ciency of the MNE’s internal market (Mudambi, 1999; Egelhoff et al., 1998). In our exercise, the position of subsidiaries in their foreign parent companies networks will be analysed via: (i) integration of subsidiary into foreign parent company network via customer-supplier relations of subsidiary with other parts of its MNE group (share of susb- sidiary’s exports/imports to foreign parent company network in total exports/imports), (ii) transfer of responsibilities from foreign investor to its subsidiary, (iii) the division of control between subsidiaries and their foreign parent companies in various business functions. 2.4. Heterogeneity of foreign investors and foreign subsidiaries Proposition four: Various other sources of heterogeneity of foreign investors and foreign subsidiaries impact the innovation activity of foreign subsidiaries. Heterogeneity of foreign investors and foreign subsidiaries may also infl uence the in- novation activity of foreign subsidiaries. Likely the most important source of this het- erogeneity are diff erent positions of subsidiaries within their foreign parent companies networks. Still, there are other sources of heterogeneity. To the best of our knowledge there is no literature that would directly tackle the impact of foreign investors and for- eign subsidiaries heterogeneity on the latters’ innovation activity. However, the issue is broadly covered in the literature on FDI spillovers, which can be usefully applied for our purpose. Th e most important sources of foreign subsidiaries heterogeneity relates to domestic ver- sus export market orientation of a subsidiary (Smarzynska, 2003: 6; UNCTAD, 2001; Altenburg, 2000; Belderbos et al., 2001; Sgard, 2001; Tytell and Yudaeva, 2005; Moran, 2005), acquisition versus greenfi eld type of FDI (UNCTAD, 2001; Belderbos et al., 2001; UNCTAD, 2000; Toth and Semjen, 1999) and joint venture (local equity participation) versus wholly foreign owned subsidiaries (Smeets and de Vaal, 2006; Smarzynska Javor- cik and Spatareanu, 2006; Abraham et al., 2006; Almeida and Fernandes, 2006; Gorod- nichenko et al., 2006). Studies on sources of heterogeneity of foreign investors which infl uence the intensity of FDI spillovers as a rule concentrates on the home country of foreign investors (Abraham et al., 2006; Perez, 1998; Graham and Krugman, 1989; Levy and Dunning, 1993). Time dimension is another source of heterogeneity in FDI spill- overs literature (Kosova, 2006; Cantwell, 1989). In our exercise, the following sources of fi rm heterogeneity will be taken into account: (i) subsidiaries’ heterogeneity: motivation of foreign investor, share in equity held by foreign ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010176 investor, (ii) foreign investors’ heterogeneity: type of foreign owner, (iii) time dimension: year of entry of foreign investor. 2.5. Host country characteristics Proposition fi ve: Host country characteristics also infl uence the innovation activity of for- eign subsidiaries. It is widely accepted that host country characteristics have an impact on the type of FDI and foreign subsidiaries. Th e most obvious way to proxy host country’s absorption capacity is to look at its overall level of development (Blomström et al., 1994; Xu, 2000; Kokko and Kravtsova, 2008). Economists oft en conceive absorptive capacity as a certain level of human capital and education capacity (Borenzstein, De Gregorio and Lee, 1998; Kokko and Kravtsova, 2008); the higher the level of human capital the better are chances for technology transfer via FDI and innovation activity of subsidiaries. Another possible determinant of host country’s absorption capacity is investment and business climate. Liberal investment and business climate is more likely to attract more dynamic FDI with more technology transfer etc. (Moran, 1998; Lim, 2001: 4-9; Kokko and Blomström, 1995; Balasubramayam et al., 1996, 1999; Ernst, 1998). Also, Kinoshita and Lu (2006) show that technology spillovers via FDI in developing countries take place only when the host country has the suffi cient level of infrastructure. Kokko and Kravstova (2008) quote Rugman and Douglas (1986), Egelhoff et al. (1998), and Walsh et al. (2002) as those who claim that market structure, infrastructure and education are likely to encourage upgrading of affi liates. In our exercise, a host country dummy will be used to take account of host country char- acteristics. 3. MODEL Based on the above propositions, we estimate the following empirical model (1) where Inovit stands for innovatory activity at time t. We employ three diff erent vari- ables to account for innovatory activity, namely dummies for product and process in- novation as well as information on the share of new or signifi cantly improved products in fi rm’s total sales. Firms’ innovatory activity is explained by six sets of explanatory variables: a/ Innovation determinants (Inov.detit-1) represent classical determinants of innovation, where we use the share of R&D expenditure in total sales and fi rm size, as measured P(Inovit = 1) = α + β1(Inov.detit–1) + β2(know.transf.exterit–1) + β3(know.transf.interit–1) + β4(sub.positionit–1) + β5(heterog)it–1 + β6(host.country) it + εit J. P. DAMJAN, Č. KOSTEVC. M. ROJEC | DOES A FOREIGN SUBSIDIARY᾽S NETWORK STATUS AFFECT ... 177 by total employment. We expect both variables to have a positive impact on subsidi- aries’ innovatory activity. b/ External sources of knowledge are included under know.transf.extert-1. In order to control for possible sources of knowledge outside the fi rm and the MNE network, we employ the share of imports in total supplies, the share of exports in total sales (learning-by-exporting) as well as subsidiaries’ own opinion on the importance of acquisition and purchase of external knowledge for their innovatory activity. We ex- pect all three variables to have a positive impact on subsidiaries’ innovatory activity. c/ Importance of knowledge transfer within the MNE network (know.transf.interit) is estimated with the inclusion of the observed importance of R&D activities performed at the MNE headquarters for subsidiaries’ innovatory activity. We expect headquar- ters R&D to have a positive impact on subsidiaries’ innovatory activity. d/ sub.positiont-1 serves as a measure of the role of subsidiary’s position within the MNE network on subsidiary’s innovatory activity. Subsidiary’s position within the MNE network is, fi rstly, measured by the share of subsidiary’s exports to other parts of the network in its overall exports and the share of imports from network in overall imports. Th is helps indicate the reliance of a subsidiary on selling/buying from the network and, consequently, on its integration in the network. Secondly, we intro- duce subsidiaries’ perception of the degree of transfer of new responsibilities (related to new geographical markets, products and business functions) from headquarters to a subsidiary. Th irdly, subsidiaries’ perception of the degree of control they have over operational, marketing and strategic business functions is included. We expect the higher the subsidiaries’ responsibilities and control over business functions the higher their innovatory activity. e/ Heterogeneity of subsidiaries and foreign investors is captured under heterogit and proxied by: (i) strategic motivation of foreign investors, which is divided into mar- ket-seeking, effi ciency-seeking and strategic-asset-seeking, (ii) foreign share in total equity as a proxy for foreign control, (iii) year of entry of foreign investor to control for length of foreign presence, and (iv) diff erent types of foreign investors, i.e. multi- national (MNE) groups (present in several countries and having above 250 employees or EUR 50 million in turnover), small and medium-sized foreign fi rm, and foreign fi nancial investors. We expect effi ciency and strategic-asset seeking FDI to have a positive impact on innovatory capacity and the opposite for market-seeking FDI. We also expect MNEs as foreign parents to have a positive impact on innovatory capac- ity. f/ host countryti is a host country dummy, used to take account of host country charac- teristics. All regressors are lagged one period to mitigate the issues of endogeneity. Dependent variables therefore represent values for year 2006, while our independent variables in the preferred regression represent the 2005 values. In the Appendix we present results with a longer lag for the regressor variables as they taken on values from 2002 instead. Th e results do not diff er signifi cantly from results with one period lags, therefore only focus on the former. ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010178 4. DATA, SAMPLE CHARACTERISTICS AND DESCRIPTIVE STATISTICS To evaluate the impact of diff erent groups of determinants of innovation on both in- novation status and innovation intensity of fi rms we use data from the IWH FDI Micro Database. Th e Database encompasses 809 manufacturing (NACE Rev 1.1, industries 15 to 37) foreign subsidiaries (fi rms with 10 per cent or higher foreign equity share) with about 214,000 employees from fi ve countries, i.e. Croatia, East Germany, Poland, Ro- mania and Slovenia, which were surveyed by a comprehensive questionnaire in 2007. Th e selection of countries tries to balance country size, geographic location and level of economic development. Th e data relate to 2005, for some variables the data for 2002 and 2005 were collected, and for some for ‘at entry’ and ‘today’. Th e survey questionnaire was centrally designed and followed the same pattern in all fi ve countries. Altogether a population of 6,833 fi rms were approached, of which 11.84 per cent responded. In terms of employment, the response rate was 19.05%. In terms of the number of fi rms the three largest sectors in the total population are food products and beverages, wearing apparel and dressing, and fabricated metal. In terms of employment the three largest sectors are again food and wearing apparel, and this time manufacturing of motor vehicles, trailers & semi-trailers. Th e deviations of the indus- try shares in the sample compared with the relevant population equivalents are up to 3 percentage points, if we consider the share of an industry in the total number of fi rms, and up to 5 percentage points if we take into account the shares of employment by indus- try.4 In terms of distribution of fi rms across size classes, the sample is underrepresented for micro (1-9) and small enterprise (10-49), and consequently over-represents medium seized (50 - 249) and large (above 250) fi rms. Table 1 below presents the shares of foreign subsidiaries questioned undertaking product and process innovations. About two thirds of the fi rms surveyed claimed they have made product innovations in the past three years. Similarly, about two thirds of fi rms claimed to have introduced process innovations. Country wise, the share of product innovators fi rms is the highest in Poland, followed by East Germany – West Germany (EG-WG) MNEs, East Germany and Slovenia. Croatia and Romania lag somewhat behind. As far as process innovations is concerned, Slovenia is in the lead, followed by EG-WG MNEs, Poland and East Germany. Again, Croatia and Romania lag behind.5 Th ere is a considerable diff erence of sample foreign subsidiaries’ innovatory activity according to the type of their foreign parent companies. 60.7% of subsidiaries with MNEs as foreign parent companies claimed that they were innovatory active in the last three years, while the corresponding shares for small or mediums sized fi rms is 27.1% and for fi nancial investors only 4.3%. 4 Share of sector 18 (clothing) in the total number of fi rms is 9.21% in the population of fi rms and 5.93% in our sample, with the deviation of 3.27 percentage points representing the highest deviation of all sectors. On the other hand, sector 34 (Manufacture of motor vehicles, trailers and semi-trailers) has the highest deviation in terms of the share of employment at 5.25 percentage points (with the sample employment share understating the population share). 5 Foreign subsidiaries from the sample seem to be much more innovatory active than enterprises in the ana- lysed countries on average. According to Eurostat (2008: 103), the share of innovatory enterprises in all enter- prises is 24.8% in Poland, 26.9% in Slovenia, 19.5% in Romania. J. P. DAMJAN, Č. KOSTEVC. M. ROJEC | DOES A FOREIGN SUBSIDIARY᾽S NETWORK STATUS AFFECT ... 179 TABLE 1: Share of innovatory fi rms among surveyed foreign subsidiaries Country No. of fi rms Share of product innovatorsa Share of process innovatorsb East Germany 222 68.9% 68.9% EG-WG MNEs 73 76.7% 74.0% Croatia 144 59.0% 60.4% Poland 110 79.1% 70.9% Romania 220 57.7% 57.3% Slovenia 40 65.0% 75.0% Total 809 67.1% 66.3% Source: IWH FDI Micro Database and own calculations. a Product innovators are fi rms that succeeded in introducing new or signifi cantly improved products or serv- ices in the past three years. Product must be new to the surveyed fi rm, not necessarily to the market. b Process innovations are new or improved production or delivery methods including e.g. changes in tech- niques, equipment and/or soft ware. Th e numeric variables, most of which appear as regressors in (1) are described in Table 2. Th e only variable in Table 2 that serves as a regressant is the approximate share of new and signifi cantly improved products in total fi rm sales (in %), where the mean and me- dian values are relatively low, but display a very high standard deviation. Still, if one faces high share of product innovators among the surveyed fi rms (67.1%) with much lower average share of new products in the surveyed fi rms sales (14.3%, with median value of only 5.0%), it is obvious that new or signifi cantly new products only rather gradually gain importance for subsidiaries overall activity. In addition to fi rm size, as measured by the average number of employees in 2005, we also use the share of R&D expenditures in total sales as standard determinants of innovation. On average, surveyed fi rms spend 4.8% of their sales for R&D, with the median value of only 0.8%. Importance of acquisition of external knowledge is an or- dinal variable, whereby the respondents were asked to rank its importance for the fi rm from 1-not important to 5-extremely important. Both the average and median values for this variable are close to 2.5, which is in the middle between 2-little important and 3-important. On average, the surveyed subsidiearies are highly export and import oriented, with 50.6% share of exports (median value is 50%) and 45.8% share of im- ports (median value is 40%) in sales. Th e importance of R&D undertaken by the MNE headquarters was, again, assessed on an ordinal scale ranging from 1-not important to 5-important. Here the average values (as measured by the mean and median) are near to 3-important, i.e. somewhat higher than was the case with acquiring external knowledge. ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010180 TABLE 2: Descriptive statistics of numeric variables Variable N Mean Median Std. Dev. Min Max Share of new products in total fi rm sales (in %) 633 14.250 5.0 37.251 0 100 Standard determinants of innovation R&D expenditure share in total sales (in %) 662 4.830 0.8 11.23392 0 80 Total employment (No. of employees) 803 266.781 101 532.9778 1 6505 External sources of knowledge Importance of acquisition of external knowledge (from 1=not important to 5=extremely important) 446 2.482 2.5 1.180227 1 5 Share of imports in total supplies (in %) 772 45.767 40 35.75004 0 100 Share of exports in total sales (in %) 780 50.591 50 38.53494 0 100 Knowledge transfer within MNE Importance of head quarters R&D (from 1=not important to 5=extremely important) 717 2.796 3 1.462888 1 5 Subsidiary’s position within MNE network Share of exports to network in total exports (in %) 780 7.935 1.7 12.15206 0 100 Share of imports from network in total imports (in %) 660 39.711 28.6 40.15911 0 100 Transfer of responsibilities from headquarters (from 1=no transfer to 4=full transfer) 722 1.871 1.7 0.884919 1 4 Operational control (from 1=fully controlled by subsidiary to 4=fully controlled by foreign investor) 786 1.570 1 0.83143 1 4 Marketing control (from 1=fully controlled by subsidiary to 4=fully controlled by foreign investor) 771 2.314 2 1.11311 1 4 Strategic control (from 1=fully controlled by subsidiary to 4=fully controlled by foreign investor) 720 2.326 2.4 0.881323 1 4 Heterogeneity Market-seeking strategy (from 1=not important to 5=extremely important) 758 2.815 3 1.095932 1 5 Effi ciency-seeking strategy (from 1=not important to 5=extremely important) 767 3.020 3 1.313073 1 5 Strategic-asset seeking strategy (from 1=not important to 5=extremely important) 751 2.521 2.5 1.027249 1 5 Share of foreign equity (in %) 797 87.885 100 22.19562 0 100 Year of foreign investor entry 787 1997.546 1998 4.738325 1970 2006 As far as subsidiary’s position within MNE network is concerned, may be the most out- standing feature is a low share of subsidiaries’ exports to other affi liates within the MNE network relative to overall exports, which is dwarfed by much higher share of imports from the network in total imports (the respective mean values are approximately 8% and 40%). Obviously, subsidiaries are much more integrated in their foreign parent compa- nies’ network on the supplies than on the sales side. In other words, subsidiaries do not J. P. DAMJAN, Č. KOSTEVC. M. ROJEC | DOES A FOREIGN SUBSIDIARY᾽S NETWORK STATUS AFFECT ... 181 seem to produce intermediate products for other parts of their network, but products for arms length buyers. Th us, within their foreign parents’ networks, subsidiaries are responsible for certain markets and/or for certain products. Th ese responsibilities seem to be related to subsidiaries right at the entry of foreign investor, as since then only quite limited transfer of responsibilities has happened. Th e extent to which responsibilities have been transferred to subsidiaries since the entry of foreign investor, was measured on an ordinal scale ranging from 1-no transfer to 4-full transfer. Th e interviewees assess the extent of transfer as being on average under the range of ‘limited transfer’. Yet another indicator of subsidiaries position within foreign parent companies’ networks is division of control over individual operational, marketing and strategic business func- tions.6 Th is indicator was also measured on an ordinal scale ranging from 1=fully con- trolled by subsidiary to 4=fully controlled by foreign investor. As expected, foreign in- vestors are more eager to control strategic and marketing business functions than the operational ones. Within the ‘heterogeneity’ variables we look into motivation of foreign investors, foreign share in total equity and age. Wholly foreign owned subsidiaries dominate, while the av- erage foreign share in the equity is 87.9%. Foreign investors’ motives have been grouped into market-seeking, effi ciency seeking and strategic-asset seeking ones. Th e importance of these is evaluated by the subsidiaries on an ordinal scale from 1-not important to 5-extremely important. Effi ciency-seeking motivation seems to be the most frequent, closely followed by market-seeking and the least frequent being strategic-asset-seeking motivation. Average value of strategic-asset-seeking motive, which serves as a proxy for being motivated by an acquisition of subsidiary’s knowledge, is in the range between 2-little important and 3-important. 5. RESULTS We estimate (1) by using a simple probit in cases where the dependent variables are either the probability to product innovate (columns 1 and 4) or the probability to process inno- vate (columns 3 and 6), while we employ standard OLS for the case when the dependent variable is share of new or signifi cantly diff erent products in total sales (columns 2 and 5). Results are presented in Table 3. Columns 1 to 3 present estimates without industry dummies, while columns 4-5 include industry dummies Results presented in Table 3 reveal several key fi ndings. Within all the analyzed sets of determinants (standard determinants of innovation, external sources of knowledge, knowledge transfer within MNE, subsidiary’s position within MNE network and het- 6 Operational control is proxied by the interviewees’ perception of the division of control between subsidiary and foreign parent company as far as production and operational management is concerned. Marketing con- trol is proxied by control over market research and marketing, while strategic control is proxied by control of a combination of business functions, i.e. basic and applied research, product development, process engineer- ing, strategic management and planning, investment project and fi nance. ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010182 erogeneity) there are individual determinants which signifi cantly impact the innovatory activity of foreign subsidiaries: a/ Standard determinants of innovation. One of the key determinants of innovation is expectedly the share of R&D expenditure in sales indicating that fi rms that spend more on R&D are more likely to product innovate and will be able to base a larger share of their sales on newly developed products. Th is, however, is not the case for process innovation, where fi rm size exhibits statistically signifi cant impact (albeit with a very low value of the ratio) on the likelihood of innovation. Th is is likely relat- ed to the fact that larger scale producers tend to benefi t more from process innovation than smaller fi rms. Compared with low tech industries, more advanced industries do not seem to be more likely to innovate, on the contrary, when industry dummies are included, high-tech fi rms are even signifi cantly less likely to process innovate than low-tech fi rms. TABLE 3: Impact of affi liate characteristics on innovation activity Product innovation status Share of new products Process innovation status Product innovation status Share of new products Process innovation status 1 2 3 4 5 6 Standard determinants of innovation R&D expenditure share in total sales 0.031* [0.017] 0.033*** [0.012] 0.006 [0.012] 0.029* [0.016] 0.033*** [0.013] 0.004 [0.013] Total employment 0.0001 [0.0001] 0.0001 [0.0001] 0.0004** [0.0002] 0.0001 [0.0001] 0.0000 [0.0001] 0.0005** [0.0002] High-tech industry dummy 0.474 [0.485] 0.409 [0.489] 0.217 [0.528] 0.02 [0.716] 0.178 [0.786] -1.278* [0.734] Medium-tech industry dummy 0.108 [0.214] 0.416** [0.212] -0.061 [0.212] -0.284 [0.513] 0.713 [0.733] -1.09 [0.843] External sources of knowledge Importance of acquisition of external knowledge 0.108 [0.108] 0.177 [0.115] 0.202* [0.108] 0.151 [0.116] 0.213* [0.120] 0.174 [0.119] Share of imports in total supplies -0.006* [0.003] -0.006** [0.003] -0.005 [0.003] -0.005 [0.004] -0.005 [0.004] -0.006* [0.004] Share of exports in total sales -0.001 [0.004] -0.002 [0.004] -0.001 [0.004] -0.001 [0.004] -0.002 [0.004] 0.001 [0.004] Knowledge transfer within MNE Importance of headquarters R&D 0.209** [0.082] 0.082 [0.085] 0.135* [0.080] 0.236*** [0.084] 0.095 [0.088] 0.163* [0.085] Subsidiary’s position within MNE network Share of exports to network in total exports 0.001 [0.011] -0.003 [0.012] -0.009 [0.012] 0.002 [0.012] -0.004 [0.012] -0.006 [0.012] Share of imports from network in total imports -0.001 [0.003] 0.000 [0.003] -0.003 [0.003] -0.002 [0.003] 0.094 [0.297] -0.003 [0.003] Transfer of responsibilities from headquarters 0.091 [0.109] 0.006 [0.113] 0.275** [0.109] 0.108 [0.113] 0.001 [0.121] 0.322*** [0.112] Operational control 0.192 [0.134] 0.146 [0.141] 0.053 [0.131] 0.211 [0.139] 0.178 [0.152] 0.054 [0.135] J. P. DAMJAN, Č. KOSTEVC. M. ROJEC | DOES A FOREIGN SUBSIDIARY᾽S NETWORK STATUS AFFECT ... 183 Marketing control -0.053 [0.142] 0.094 [0.149] 0.206 [0.142] -0.046 [0.147] 0.095 [0.153] 0.193 [0.145] Strategic control -0.252 [0.189] -0.263 [0.206] -0.21 [0.184] -0.28 [0.195] -0.272 [0.214] -0.12 [0.192] Heterogeneity Market-seeking strategy -0.142 [0.089] 0.127 [0.094] -0.046 [0.088] -0.177* [0.099] 0.094 [0.100] 0.011 [0.095] Effi ciency-seeking strategy 0.060 [0.077] 0.019 [0.079] 0.121 [0.081] 0.072 [0.081] 0.031 [0.087] 0.091 [0.079] Strategic-asset seeking strat. 0.134 [0.098] 0.027 [0.098] 0.030 [0.099] 0.138 [0.104] 0.017 [0.108] 0.018 [0.104] Share of foreign equity -0.003 [0.004] 0.006 [0.005] -0.001 [0.005] -0.003 [0.005] 0.007 [0.005] -0.002 [0.005] Owner foreign MNE -0.144 [0.245] 0.096 [0.259] 0.523** [0.239] -0.096 [0.257] 0.070 [0.277] 0.545** [0.258] Owner small or medium sized enterprise -0.154 [0.250] 0.390 [0.259] 0.185 [0.242] -0.171 [0.260] 0.330 [0.276] 0.261 [0.250] Owner fi nancial investor 0.151 [0.489] 0.607 [0.521] 0.137 [0.480] 0.242 [0.475] 0.711 [0.519] 0.370 [0.490] Year of foreign-investor entry -0.024 [0.020] -0.048** [0.021] -0.035 [0.022] -0.037* [0.022] -0.059** [0.023] -0.047** [0.023] Host-country dummies YES YES YES YES YES YES Industry dummies NO NO NO YES YES YES Observations 256 239 256 250 237 254 Pseudo R-squared# 0.13 0.17 0.17 0.16 0.20 0.23 Note: Dependent variable in columns 1 and 4 is an indicator variable of product innovation, dependent vari- able in columns 2 and 5 is the share of sales attributed to a new product, while in columns 3 and 6 it is a proc- ess innovation indicator variable. Robust standard errors in brackets. * signifi cant at 10%; ** signifi cant at 5%; *** signifi cant at 1%. # except columns 2 and 5, where we report the adjusted R-squared. b/ External sources of knowledge. Although the importance of acquiring external knowl- edge has a positive impact on the probability of innovation and its measurable impact, the coeffi cient is only signifi cant for process innovation when industry dummies are excluded and for the share of new products with industry dummies. On the contrary, there is some evidence that fi rms with a higher share of imports in total supplies will be less likely to innovate and will also benefi t less from innovation in terms of the share of new products in total sales. c/ Knowledge transfer within MNE. R&D activities of the foreign parent company head- quarters seem to be quite important for subsidiaries’ likelihood to innovate. Head- quarters’ R&D activities have positive and signifi cant impact on subsiadiries’ innova- tion activity with the ratio of 0.163 for process and 0.236 for product innovations, if industry dummies are included. d/ Subsidiary’s position within MNE network does not really seem to have a very impor- tant impact on subsidiary’s innovation activity. Of all the variables tested within this set of determinants, it is only the transfer of responsibilities from headquarters to subsidiaries, which is conducive to process innovation. Division of control between ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010184 headquarters and subsidiaries, or subsidiaries trade with the network do not prove to have any impact on subsidiaries’ innovatory activity. All these, as well as low share of subsidiaries’ exports going to parent network, seem to indicate that foreign subsidiar- ies in new EU member states function as fairly independent entities as far as innova- tory activity is concerned. Th eir innovatory activity is motivated by the increase of their own competitiveness and not by some broader parent company goals. e/ Heterogeneity. Market-seeking motivation of foreign investors has a negative impact on product innovation status. In other words, FDI looking for the local market are not conducive to product innovation activity of the subsidiaries. Still, there is no in- dication that effi ciency or strategic asset-seeking FDI would have a positive impact on subsidiaries innovation activity. On the other hand, it is important who is a foreign investor, since it is only MNEs, and not small or medium sized enterprises or fi nan- cial investors, who have signifi cant and positive impact on process innovation status of subsidiaries. Also, the length of foreign presence in a subsidiary has a positive impact on innovation and also the share of new products in total sales. It therefore seems that a foreign investor needs some time to initiate innovation activities in a subsidiary. Foreign share in equity, as a measure of foreign control, does not impact subsidiary’s innovation activity. Th is is in line with the lack of impact of division of control of business functions on the innovation activity (see above). 6. CONCLUSIONS From a host country point of view, increased R&D and innovation activity of foreign subsidiaries means more opportunities for knowledge transfer in the host economy; fi rstly directly to the subsidiaries under foreign ownership and control and, secondly, in- directly to other fi rms in the host economy through spillovers. Th erefore, identifi cation of the determinants of foreign subsidiaries’ innovation activity is of direct relevance for host country policy makers. In other words, apart from FDI spillovers, attracting of R&D intensive FDI with high innovation capabilities is defi nitely the most legitimate reason for a government to promote inward FDI. According to the latest CREST report (Euro- pean Union, 2008: 12), FDI in R&D is high on the political agenda of most EU member states, although the R&D part is usually included in more general FDI polices. Although only a limited number of countries have specifi c policy instruments in place to stimulate spillovers from FDI in R&D there is a rising awareness to innovate policy measures in order: (i) to take advantage of inward FDI in R&D by means of embedding (former) high- tech enclaves with little knowledge diff usion in the local environment and to generate spillovers without hollowing out the local research base; (ii) to capture the scientifi c ben- efi ts of outward FDI in R&D (back) to domestic R&D environments; (iii) to adapt policy measures to the rationale of knowledge competition rather than cost competition. Our fi ndings confi rm that FDI tend to have a positive impact on a host country’s innova- tion activities. Compared to average fi rms in the analysed countries, surveyed foreign subsidiaries are much more innovative in terms of the fraction of product and process innovators in overall number of fi rms. Roughly two thirds of the surveyed subsidiar- J. P. DAMJAN, Č. KOSTEVC. M. ROJEC | DOES A FOREIGN SUBSIDIARY᾽S NETWORK STATUS AFFECT ... 185 ies undertook product and process innovations in the last three years, Still, new or sig- nifi cantly new products only rather gradually gain importance for subsidiaries overall activity, as their share in total sales is only 14.3% in terms of mean and 5.0% in terms of median value. Taking account of a wide array of information on standard determinants of innovation, external sources of knowledge, knowledge transfer within MNE, subsidi- ary’s position within MNE network and heterogeneity, we come to several interesting fi ndings. First, subsidiary’s position within MNE network does not really seem to have a very important impact on subsidiary’s innovation activity. Only, transfer of responsibilities from headquarters to subsidiaries is conducive to process innovation, while division of control between headquarters and subsidiaries, or subsidiaries trade with the network do not prove to have any impact on subsidiaries’ innovatory activity. Foreign subsidiaries in new EU member states seem to be relatively independent ventures as far as innovatory activity is concerned. Second, there are diff erences in factors that determine product and process innovation. Subsidiaries with higher R&D expenditures and more transfer of R&D results from head- quarters do more product innovations; company size and acquisition of external knowl- edge do not impact product innovation activity. Situation with process innovations is diff erent. While R&D activities of the headquarters remain to have positive and signifi - cant impact on subsidiaries’ innovatory activity, the size of own R&D expenditures does not. 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ROJEC | DOES A FOREIGN SUBSIDIARY᾽S NETWORK STATUS AFFECT ... 193 APPENDIX: Impact of affi liate characteristics on innovation activity with longer lags on the control variables Product innovation status Share of new products Process innovation status Product innovation status Share of new products Process innovation status 1 2 3 4 5 6 Standarad determinants of innovation R&D expenditure share in total sales 0.027 [0.018] 0.04 [0.018]** 0.004 [0.014] 0.021 [0.018] 0.044 [0.020]** 0.003 [0.015] Total employment 0.000 [0.000] 0.000 [0.000] 0.001 [0.000]* 0.000 [0.000] 0.000 [0.000] 0.001 [0.000]** High-tech industry dummy 0.173 [0.495] 0.1 [0.483] 0.093 [0.499] -0.244 [0.751] 0.175 [0.781] -0.861 [0.833] Medium-tech industry dummy -0.149 [0.223] 0.383 [0.232]* -0.272 [0.227] -0.457 [0.596] -0.09 [0.883] -1.983 [0.975]** External sources of knowledge Importance of acquisition of external knowledge 0.123 [0.122] 0.263 [0.132]** 0.193 [0.128] 0.146 [0.131] 0.34 [0.151]** 0.166 [0.136] Share of imports in total supplies -0.64 [0.350]* -0.625 [0.354]* -0.01 [0.357] -0.449 [0.397] -0.542 [0.424] -0.335 [0.411] Share of exports in total sales 0.068 [0.401] 0.029 [0.405] -0.402 [0.413] 0.024 [0.470] -0.081 [0.456] -0.071 [0.481] Knowledge transfer within MNE Importance of headquarters R&D 0.197 [0.091]** 0.046 [0.089] 0.100 [0.089] 0.208 [0.097]** 0.026 [0.092] 0.12 [0.100] Subsidiary’s position within MNE network Share of exports to network in total exports -0.008 [0.012] -0.009 [0.013] -0.002 [0.013] -0.01 [0.013] -0.015 [0.013] 0.002 [0.013] Share of imports from network in total imports 0.206 [0.290] 0.218 [0.318] -0.327 [0.306] 0.096 [0.300] 0.355 [0.351] -0.348 [0.326] Transfer of responsibilities from headquarters 0.119 [0.120] -0.114 [0.120] 0.281 [0.122]** 0.132 [0.127] -0.153 [0.133] 0.371 [0.132]*** Operational control 0.049 [0.146] 0.19 [0.152] -0.182 [0.145] 0.046 [0.150] 0.25 [0.162] -0.223 [0.149] Marketing control 0.077 [0.159] 0.051 [0.161] 0.117 [0.158] 0.109 [0.162] 0.076 [0.167] 0.08 [0.159] Strategic control -0.227 [0.216] -0.264 [0.221] 0.113 [0.213] -0.25 [0.224] -0.284 [0.230] 0.284 [0.226] Heterogeneity Market-seeking strategy -0.157 [0.105] 0.032 [0.101] -0.134 [0.104] -0.207 [0.119]* -0.004 [0.107] -0.102 [0.110] Effi ciency-seeking strategy 0.049 [0.086] 0.012 [0.084] 0.164 [0.094]* 0.081 [0.093] 0.008 [0.095] 0.121 [0.092] Strategic-asset seeking strat. 0.158 [0.103] 0.03 [0.100] 0.076 [0.107] 0.169 [0.110] 0.009 [0.115] 0.083 [0.114] Share of foreign equity -0.003 [0.005] 0.004 [0.005] -0.009 [0.005] -0.003 [0.005] 0.005 [0.006] -0.01 [0.006]* ECONOMIC AND BUSINESS REVIEW | VOL. 12 | No. 3 | 2010194 Owner foreign MNE -0.05 [0.271] 0.373 [0.257] 0.487 [0.265]* 0.029 [0.297] 0.398 [0.290] 0.462 [0.294] Owner small or medium sized enterprise -0.242 [0.279] 0.469 [0.268]* 0.005 [0.273] -0.199 [0.295] 0.498 [0.297]* 0.075 [0.293] Owner fi nancial investor -0.546 [0.620] 0.332 [0.627] -0.264 [0.605] -0.405 [0.652] 0.336 [0.563] -0.331 [0.640] Year of foreign-investor entry -0.035 [0.025] -0.014 [0.026] -0.033 [0.027] -0.053 [0.027]* -0.026 [0.027] -0.044 [0.030] Host-country dummies YES YES YES YES YES YES Industry dummies NO NO NO YES YES YES Observations 214 209 214 208 207 212 Pseudo R-squared# 0.13 0.14 0.19 0.15 0.21 0.26 Note: Dependent variable in columns 1 and 4 is an indicator variable of product innovation, dependent vari- able in columns 2 and 5 is the share of sales attributed to a new product, while in columns 3 and 6 it is a proc- ess innovation indicator variable. Robust standard errors in brackets. * signifi cant at 10%; ** signifi cant at 5%; *** signifi cant at 1%. # except columns 2 and 5, where we report the adjusted R-squared.