Evidence from BEEPS V and MENA ES suggests that the first of these effects tends to dominate in the transition region and that foreign ownership is associated with an increased likelihood of innovation and higher levels of spending on in-house R&D. Foreign-owned firms are defined here as firms where foreign investors hold a stake of 25 per cent or more – that is to say, at least a blocking minority. The percentage of such firms that have introduced new products is significantly higher than the percentage of locally owned firms that have done so. The same is true of process innovations, as well as marketing and organisational innovations (see Chart 3.4).

Indeed, in the case of marketing and organisational innovation, the impact of foreign ownership is pronounced even when foreign investors own a small stake that falls short of a blocking minority (in other words, between 0 and 25 per cent), while foreign ownership does not have a clear impact on product and process innovations until that stake reaches the 25 per cent mark. This suggests that foreign owners may be an important source of information about new organisational arrangements and marketing methods. At the same time, sharing technological know-how requires stronger incentives and assurances, which come with a stake of a certain size in a company.

The results also suggest that increased innovation by foreign-owned firms is a result of a mixture of “make” and “buy” strategies when it comes to acquiring external knowledge. The percentage of foreign-owned firms that invest in R&D (thereby pursuing a “make” strategy) tends to be higher than the percentage of domestic firms that follow this strategy (see Chart 3.5). This is the case in virtually every country in the transition region. Foreign-owned firms also tend to spend more on R&D (see Case study 3.1 for details of a joint venture in the Turkish automotive sector with an active domestic R&D programme). Overall, these findings run counter to the view that foreign takeovers undermine domestic R&D.

Not only do foreign firms “make” more knowledge, they are also more likely to engage in the acquisition of external knowledge (through the purchasing or licensing of patents and non-patented inventions and know-how) than locally owned firms (see Chart 3.5).

The formal regression results in Table 3.1 confirm that the relationship between foreign ownership and innovation holds when other firm-level characteristics are also taken into account. Everything else being equal, a majority foreign-owned firm is, on average, 2.3 percentage points more likely to introduce new products or processes (see column 2) and 4.3 percentage points more likely to introduce organisational or marketing innovations (see column 3).7 This is a sizeable difference, given that the average probability of a majority domestic-owned firm introducing new or improved products or processes is 17.5 per cent, while the probability of it introducing organisational or marketing innovations is almost 27 per cent.

In contrast, majority state-owned firms are significantly less likely to introduce new products or processes than locally owned private firms or foreign firms, and this effect is even larger in the case of new processes. This may reflect the fact that managers of state-owned firms have weaker incentives to achieve efficiency savings and improve productivity. Their remuneration, for example, is not necessarily linked to their firm’s performance, and these firms can typically rely on the state to bail them out in the event of poor performance.

Exporting can also expose domestic producers to stronger competition from foreign products, thereby providing an incentive to innovate (see Box 3.3 for a discussion of the complex relationship between competition and innovation).8 Furthermore, firms’ participation in global value chains, which involves the exporting of either intermediate or final goods, facilitates the adoption of foreign technologies, particularly in emerging markets9 (see Box 3.2).

BEEPS V and MENA ES data confirm the importance of export markets for innovation. Firms that export their products directly appear to be more likely to engage in R&D and introduce new products, processes, marketing methods and organisational innovations than firms that only serve their domestic markets (see Chart 3.6).

Similar differences can be observed in firm-level regressions. The estimates in Table 3.1 suggest that once various other firm-level characteristics are taken into account, exporters are around 3 percentage points more likely to innovate than non-exporters. This is a sizeable impact, as the probability of a non-exporter introducing a new or improved product or process is 15 per cent.

The differences between exporters and non-exporters are particularly large when it comes to in-house R&D and process innovation.10 Regression results indicate that exporters are 6 percentage points more likely to engage in R&D. This may be explained by the fact that exporting and entering new markets can help firms to improve their knowledge of production processes, while R&D can help firms improve their ability to absorb new technologies.11

Of the firms that do not export, those that primarily sell in the national market are more likely to introduce new products, processes and marketing methods than firms that operate primarily in the local market. Similar forces may be at play here: a national market provides a broader customer base, making it easier to justify the fixed costs of developing new products and processes, while the higher levels of competition in the national market provide stronger incentives to seek productivity gains.

Investing in R&D has the largest impact on the probability of introducing a new product in high-tech manufacturing sectors such as electrical equipment or pharmaceuticals (see Chart 3.7). In these sectors R&D increases the probability of product innovation on average by 26 percentage points, while in less knowledge-intensive service sectors (such as catering or sales) R&D has virtually no impact on the probability of introducing a new product.

While R&D is closely linked to product innovation in high-tech manufacturing sectors, R&D in low-tech manufacturing has a large impact on process innovation, which involves the optimisation of the production of existing products (for instance, a clothing manufacturer that replaces the manual cutting of fabric with an automatic fabric-cutting machine). Conducting R&D in these sectors increases the probability of introducing a new process by an average of 20 percentage points (compared with an average of 11 percentage points in high-tech manufacturing sectors).

While a firm’s human capital reflects its recruitment decisions, it is also, to a large extent, shaped by the availability of skills in the market. There is further cross-country analysis of this issue later in the chapter.

Information and communication technology Firms that use email to communicate with their clients or suppliers are, on average, 9 percentage points more likely to introduce new products or processes and 14 percentage points more likely to introduce organisational or marketing innovations (see Table 3.1, column 3). This attests to the importance of both modern organisational practices and supporting information and communication technology (ICT) infrastructure in facilitating innovation.

ICT’s largest impact is on the probability of introducing product and process innovations in high-tech and medium-high-tech manufacturing sectors (see Chart 3.8). At the same time, in low-tech manufacturing sectors (such as textiles or food and beverages) and less knowledge-intensive services (such as catering or sales), use of ICT has a large impact on the probability of implementing marketing and organisational innovations.

When it comes to innovation, firms may also benefit from the expert advice of external consultants (see Box 3.4). Lastly, the availability of finance also plays an important role, as firms may abandon the development of new products if the requisite funding cannot be obtained. Chapter 4 discusses these issues in more detail.

However, a highly skilled diaspora can contribute to economic development through a variety of channels (such as remittances, trade, foreign direct investment and knowledge transfers), helping innovators back home to access knowledge accumulated abroad.22 Most successful start-ups from the transition region are now developing their businesses in the United States or the United Kingdom, but have development centres somewhere in eastern Europe.23

The net effect ultimately depends on the country’s economic development, the degree of transparency within government and public administration, the business environment, and employers’ business practices in terms of recruitment and selection.24 It also depends on how good the country is at establishing links with its citizens abroad.25 One option here would be to put expats in contact with one another through social media and networking events and help them to return home if they so wish.

There are numerous examples of companies from the transition region that have moved abroad at an early stage.

Toshl Inc., the creator of a personal financial assistant app, was established in Slovenia in 2012, but moved its headquarters to Silicon Valley after joining the 500 Startups accelerator programme later that year. Another example is Double Recall, which helps publishers to increase the profitability and efficiency of paywalls by monetising social media, search and email traffic using simple advertisements that connect and engage with users. The company was established in Slovenia in 2010, but then graduated from Y Combinator (an American seed accelerator) in 2011 and now has its headquarters in New York.

Likewise, Croatian-Slovenian start-up Bellabeat (previously BabyWatch), the creator of pregnancy tracking system Bellabeat, participated at Startupbootcamp Berlin and raised funds via angel investors and an Indiegogo campaign in 2013. It graduated from the Y Combinator accelerator in March 2014 and relaunched its product in the US market after successfully completing the seed round. Its headquarters are in Silicon Valley.

Croatian start-up Repsly, a field management software company that was founded in 2010, moved its headquarters to Boston in 2014 after securing funding from Launchpad Venture Group, First Beverage Group and K5 Ventures.

GrabCAD, a company established in 2009 that has created a collaborative product development tool that helps engineering teams to manage, view and share CAD files in the cloud, moved its headquarters from Tallinn to Boston in 2011 in order to benefit from the start-up scene there.

Codility, which produces software used for testing candidates for developer positions and was founded in London by a group of Poles in 2009 after winning the Seedcamp competition, is an example of movement in the opposite direction. Most of the team is now based in Warsaw, where they have an R&D centre, although they still have an office in London.

RealtimeBoard, which has developed a cloud-based whiteboard that facilitates collaboration, was founded in Perm, in Russia, in 2011, but it now has its headquarters in Las Vegas. Similarly, Jelastic, a cloud computing service that provides networks, servers and storage solutions to software development clients, enterprise businesses, original equipment manufacturers and web hosting providers, was founded in Zhitomir, in Ukraine, in 2010. It received funding from several Russian venture funds, but moved its headquarters to Silicon Valley in 2012.

It is interesting to note that several of these start-ups were given an initial (financial) push by seed financing or boot camp accelerator programmes in Berlin or London, but nevertheless moved across the Atlantic to the United States. The pull of the US innovation hubs and the large US market remains too strong for Europe to compete with, particularly as there are still many barriers to the free movement of online services and entertainment across national borders in the EU.

However, in certain circumstances GVCs can also hamper innovation within participating firms. This is most likely to occur where firms in developing countries are involved solely in the assembly of foreign intermediate goods. As this is the least skill-intensive stage of the value chain, the potential for technological spillovers is minimal and it is unlikely that participation in the GVC will encourage these firms to introduce new products of their own.

Chart 3.2.1 shows the percentage of innovative BEEPS V firms that are part of a GVC. GVC firms are defined as those that both import at least 10 per cent of their intermediate goods and export at least 10 per cent of their output.28

We can see that GVC firms tend to be more innovative than other firms across all five measures of innovation. In particular, 44 per cent of GVC firms responding to BEEPS V have introduced a new product in the last three years, compared with only 31 per cent of firms that do not participate in an international supply network. Equally striking is the fact that there is a 15 percentage point difference between the two when it comes to the percentage of firms that spend money on R&D or use technology via a licensing arrangement.

In order to check that these substantial differences are not driven by other factors, such as firms’ ownership structures or their access to finance, Table 3.2.1 presents the results of a multivariate regression analysis. It shows that these differences in R&D, the licensing of technology, product innovation and process innovation continue to be observed when other firm-level characteristics are controlled for.

This analysis also determines the precise source of the positive impact that GVCs have on innovation. All measures of innovation – with the exception of the acquisition of external knowledge – are positively and significantly correlated with the importing of at least 10 per cent of total intermediate goods. However, only product innovation is positively and significantly associated with the exporting of at least 10 per cent of total output.

These results suggest that GVCs help firms to expand their product ranges and upgrade technology primarily by giving them access to better quality inputs, rather than by expanding the size of their markets.

The detailed innovation module in BEEPS V can help to shed more light on the mechanisms that are at work here. Firms that reported the introduction of a product or process innovation or the acquisition of external knowledge were asked whether they were able to do so as a result of working with domestic or foreign partners (such as clients or suppliers). Chart 3.2.2 shows that 22 per cent of GVC firms reported working with foreign partners on innovation, compared with only 10 per cent of non-GVC firms. This suggests that the higher levels of innovative activity among GVC firms can indeed be attributed to their easier access to foreign technology and knowledge. An important policy implication is that firms in emerging markets cannot hope to become more innovative simply by importing physical inputs. Instead, they need to invest in longer-term relationships with foreign suppliers and clients in order to allow a continuous flow of knowledge and know-how.

Chart 3.2.3 shows the impact that participation in GVCs has on the probability of firms innovating. Here, firms are grouped together on the basis of the relative skill endowments of the countries where they operate (measured as the percentage of the workforce that has completed secondary education). This chart suggests that the marginal probability of innovating on account of participation in a GVC increases with the quality of the workforce that is at the firm’s disposal. Firms in countries with higher skill levels are given – via GVCs – more skill-intensive tasks with greater scope and need for technological spillovers.

However, caution is warranted when it comes to the type of involvement that firms have in GVCs. As mentioned above, participation in GVCs may hinder innovative activity and prevent positive spillovers if it only involves the assembly of components.

All in all, the analysis in this box shows that where participation in GVCs goes beyond simple assembly, it may allow firms to reap substantial productivity benefits through international spillovers of technology and know-how. A good example of this is the automotive industry in central and eastern Europe.29 In CEB countries where this sector has seen high levels of foreign direct investment and local car producers are well integrated into GVCs – such as Hungary and the Slovak Republic – labour productivity in the automotive sector is substantially higher than the average for the manufacturing industry as a whole. By contrast, in countries where foreign investors play no meaningful role in the car industry (such as Bulgaria), the opposite is true.

The challenge, then, remains unchanged: not only replicating, but also improving on this paradigm across a variety of industries in the region, in order to help countries move up the value chain.

The combination of these two effects may lead to a non-linear relationship between competition and innovation (such as an inverted U-shape).31 This shape may reflect the existence of two broad types of industry: “neck-and-neck” industries, in which companies operate with similar levels of technology, and “unlevelled” industries, in which a technological leader competes with a group of followers.

In neck-and-neck industries, competition encourages firms to innovate, because it allows them to move ahead of their competitors and increase their market share. In contrast, tougher competition discourages laggard firms in unlevelled industries from innovating, as the laggard’s reward for catching up with the technological leader declines. An inverted U-shape may emerge where neck-and-neck industries are more prevalent at low levels of competition, but then, as competition intensifies, more industries become unlevelled and further competition starts to put a break on innovation.

BEEPS V and MENA ES data broadly confirm the existence of an inverted U-shape in transition economies (see Chart 3.3.1). This chart plots innovative output in the SEE and CEB regions against the distribution of the number of competitors, showing that the average percentage of firms introducing a new or improved product or process initially increases with the number of competitors, before then declining in the third and fourth quartiles of the distribution. The chart also shows that the inverted U-shaped relationship between competition and innovation translates into a similar relationship between competition and firms’ growth.

Empirical evidence suggests that the positive impact that competition has on innovation is stronger for older firms. This is consistent with the view that older firms are inherently less likely to innovate unless they are spurred on by competition.32 Overall, the literature seems to conclude that some degree of market power appears necessary for stimulating innovation activity, coupled with competitive pressure (especially pressure from foreign competitors).

Competition policy

There is a broad consensus that well-designed and properly enforced competition policies are beneficial to innovation. Competition-enhancing policies can be broadly divided into two groups. First, product market deregulation aims to remove barriers to entry, trade and economic activity, as well as limiting the state’s direct interference in economic activity. Second, competition laws provide a legal framework for the prosecution of anti-competitive conduct, cartels and the abuse of dominant positions, as well as reducing the anti-competitive effect of mergers.

Product market deregulation has consistently been found to increase the adoption of state-of-the-art production techniques, as well as the introduction of new technologies. As a result, deregulation may ultimately translate into stronger total factor productivity growth.33

Conversely, restrictive product market regulations limit the productivity of the industries concerned. This is particularly true of industries that are a long way from the technological frontier. In these industries, restrictive regulations tend to halt the catching-up process.

Recent analysis also shows that anti-competitive product market regulations in upstream sectors curb productivity growth even in very competitive downstream sectors. In other words, a lack of competition in upstream sectors can generate barriers to entry that curb competition in downstream sectors as well, reducing pressures to improve efficiency in those sectors. For example, tight licensing requirements in retail or transport sectors can restrict access to distribution channels, while overly restrictive regulation in banking and financial sectors can reduce sources of financing, affecting all firms in the economy.34

When it comes to the enforcement of competition law, the existence of a complex relationship between competition and innovation has sometimes been interpreted as meaning that more lenient standards should be adopted when it comes to innovative industries. The complicated relationship between competition and innovation does call for a more comprehensive assessment of the impact that specific actions have on market participants’ ability to innovate and the incentives they have. However, it does not justify the blanket dismissal of all concerns about anti-competitive behaviour in industries that are deemed to be innovative.

A proper assessment of innovative industries requires well-designed competition laws and competent competition authorities. The enforcement of competition law can play an important role in supporting innovation by allowing actions that promote innovation (such as mergers) and prohibiting actions that hamper it. Recent evidence from OECD countries points in this direction, showing that sound competition policies lead to stronger total factor productivity growth (which may be seen as a proxy for innovation).35

Data for the transition region show the positive effect that competition-enhancing policies have on innovation. Chart 3.3.2 shows that there is a positive relationship between the quality of competition-enhancing policies (as measured by the EBRD’s competition indicator, which assesses the quality of competition law, the institutional environment and enforcement activities)36 and innovation. While the chart does no more than indicate a correlation between the two, this nevertheless points to a link between the quality of competition policy and the strength of innovation.

All in all, while the relationship between competition and innovation is a complex one, well-designed competition policies can help to provide the right business environment, allowing companies to fulfil their competitive potential and having a positive impact on innovation.

Across the region as a whole, 61 per cent of firms that have introduced a new product in the last three years also hired a consultant during that period, compared with 20 per cent of firms that did not innovate. Consultants also assisted 63 per cent of firms that introduced new or improved organisational management practices.

These relationships do not appear to be driven by particular industries or specific types of firm. Even when firm-level characteristics are taken into account, there remains a positive and highly significant correlation between the use of consultants and all types of innovation – product, process, organisational and marketing innovations. This is consistent with evidence that external consultants can help small and medium-sized firms to improve their productivity.40

Despite these apparent advantages, many firms choose not to use consultants when developing new products or processes. One reason for this is that every consultancy contract involves transaction costs, which may take resources away from the innovation itself. Firms may also be concerned about leaking information regarding new products and processes, particularly in countries where intellectual property rights are poorly enforced.41

However, the main reason why firms in the transition region do not hire consultants is that they simply see no need for them. Interestingly, exposure to consultancy services seems to change this belief: once firms have employed consultants once, they typically do so again. Indeed, BEEPS firms that use external consultants have done so an average of four times in the last three years. Moreover, where clients of the EBRD’s Small Business Support team have never worked with a local consultant before, nearly half of these clients then undertake a second consultancy project independently within a year. Since firms that hire consultants also tend to be more innovative, their exposure to external know-how seems to be an important channel in the fulfilment of their innovation potential.