Within the endogenous growth framework, we offer an explanation on how foreign direct investment (FDI) generates externalities in the form of technology transfer. We distinguish between the level and rate effects of spillovers on the productivity of domestic firms. A new insight gained from the theory is that the level and rate effects of spillovers can go in opposite directions. The negative level effect underscores the fact that technology transfer is a costly process—scarce resources must be devoted to learning. The positive rate effect indicates that technology spillovers enhance domestic firms' future productive capacity. Using a large panel of Chinese manufacturing firms, we find suggestive evidence that an increase in FDI at the four-digit industry level lowers the short-term productivity level but raises the long-term rate of productivity growth of domestic firms in the same industry. We also find that spillovers through backward and forward linkages between industries at the two-digit level have similar effects on the productivity of domestic firms, and backward linkages seem to be statistically the most important channel through which spillovers occur.