This paper examines the relationship between informal competition and innovation. In particular, we are concerned with how informal firms affect the product and process innovations of formal firms of South Asia. We introduce the moderating variables of innovation time off and R&D intensity as components of absorptive capacity theory to analyse this relationship. Our results show that informal competition negatively affects both product and process innovations of formal firms. Innovation time off and R&D intensity positively moderate the impact of informal competition for those firms that are innovating in both domains. Our findings suggest managers and owners of formal firms will benefit from providing free time to employees for creative ideas and investing in R&D activities to reduce the negative effect of the informal sector. Our findings also provide insight to policy makers to formulate policies that encourage innovative behaviour within the formal sector of South Asia.