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Economics of Planning 31: 175194, 1998.

1998 Kluwer Academic Publishers. Printed in the Netherlands.

175

Foreign Direct Investment in China: Determinants


and Effects
STPHANE DEES
University of Montesquieu Bordeaux IV, Avenue Leon Duguit, 33608 Pessac Cedex (France) and
National Institute of Economic and Social Research (London)
Abstract. This paper attempts to assess the determinants of Foreign Direct Investment (FDI) in
China and its effects on the whole economy. After presenting the main theoretical contributions
and the previous works done about Chinas inward-FDI, an empirical study has been implemented
extending the previous ones with a different data set (more recent) and with different methodologies. The traditional determinants of FDI seem to be relevant for China: domestic market size, cost
advantages and openness to the rest of the world.
Concerning the consequences of FDI on the Chinese economy, our empirical evidence supports
the view that FDI affects Chinas growth through the diffusion of ideas. Through the introduction of
new ideas, multinational firms develop technical progress and hence long-run economic growth. The
transmission of ideas seems to have had a positive effect on the Chinese growth.
JEL classification: F23, O33, P33
Key words: Foreign Direct Investment, Technology Transfer

1. Introduction
The growth of Foreign Direct Investment (FDI) in China has been dramatic since
the beginning of the economic reforms in 1978. China is now the second largest recipient of foreign capital in the world (behind the United States). The expansion of
FDI in China has been accompanied by a rapid economic growth and an increasing
openness to the rest of the world.
It is important to ask why China has become one of the largest beneficiaries of
FDI in the world, what are the most important determinants of FDI to China, and
what are the effects of FDI on the Chinese economy?
We attempt in this paper to answer to these questions with an analysis of the
determinants and the effects of FDI in China, and through the implementation of
an empirical study based on the existing literature. Section 2 provides an overview of the development of FDI in China since 1979. Section 3 investigates the
determinants of the dramatic increase in FDI inflows into China. Section 4 studies
the effects of FDI on the Chinese economy and more particularly on economic
growth. Section 5 provides some concluding remarks.

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2. Foreign Direct Investment in China (19791995): An overview


FDI represents the most important source of foreign capital in China. It surpassed
foreign borrowing for the first time in 1992. Before 1979, no foreign-owned enterprises operated in China as foreign money was viewed with suspicion by Chinese
leaders. The Open Door Policy introduced by Deng Xiaoping in 1979 involved a
different attitude toward FDI. This change can be explained by two major factors
(Wei, 1995): the disastrous economic performance before 1979 and the successful
examples of Japan and the four Asian Tigers.
Soon after the Third Plenum of the 11th Central Committee of the Chinese
Communist Party, the prohibition of FDI in China, which had been in force since
1949, was lifted. Deng Xiaoping promoted FDI reforms, acknowledging that foreign investment might absorb foreign capital, attract advanced technology and
develop export products (Harding, 1987). In 1979, a foreign investment law was
adopted. The aim of this law was to limit the establishment of foreign firms in
China geographically to the four Special Economic Zones and in the coastal areas,
organisationally to equity joint ventures, and sectorally to hotel construction and
energy extraction. However, each of these restrictions was removed over time.
Every region is now eligible for FDI, every sector welcomes foreign investment
and investors can choose the organisational structure under which their capital is invested in China. The objectives of soliciting FDI, as mentioned in various Chinese
documents (Kamath, 1990) was to develop a diversified industrial base; introduce
and transfer new technology; stimulate economic growth; upgrade managerial and
labour skills; and increase exports, especially manufactured goods.
Despite the foreign investment law, the flow of FDI in China has not been as
rapid, nor has the outcome been as successful, as either the foreign investors or the
Chinese officials had hoped (Grub and Lin, 1991). Looking at the dynamic pattern
of FDI in China since 1979, we can distinguish three different phases (Figure 1).
The first phase, from 1979 to 1983, is a period of sluggish increase. From 1984 to
1991, the inflows of FDI attained an increasing trend. Since 1992, the large-scale
expansion of FDI has made China the second largest recipient of FDI in the world.
Before 1983, the growth rate of FDI was quite modest. The number of projects
was nearly constant, increasing only from 230 in 1979 to 396 in 1983 (the value
increased from $0.5 billion in 1979 to $1.5 bilion in 1983). During this first phase,
foreign investors took a wait-and-see attitude, looking for more information before
investing in China. The predominance of investors from Hong Kong and Macao
was mostly due to geographic and cultural proximity rather than to the incentives
offered by the Chinese authorities.
In 1983, with the extension of the legal framework and the enlarged flexibility
given to investors, foreign investment grew faster. However, the absorption of FDI
in China had been too low for the Chinese authorities. Furthermore, the nature of
the foreign funded enterprises (FFEs hereafter) had been unsatisfactory to Beijing
(Harding, 1987). These FFEs had been too small with low levels of capitalisation

FOREIGN DIRECT INVESTMENT IN CHINA

177

Figure 1. FDI inflow into China (millions of US dollars).

and non-advanced technology. The economic environment had not encouraged


foreign investors to build advanced-technology firms in China. The main reasons
were the convertibility issue, the incomplete legal system, the low quality of labour
and the difficulties in obtaining some raw materials. Some investors threatened
to withdraw from their projects in China if the investment environment did not
improve. In 1986, the Chinese leaders decided to restore investors confidence by
implementing incentives to the foreign business community. Four sets of incentives
were offered in October 1986 (Har Ling, 1987): there were reductions in land use
fees, taxes, the cost of some inputs, and the wage rates paid by FFEs; access to
inputs controlled by the state was improved (water, electricity, communication,
transportation and renminbi loans); there was an attempt to improve bureaucratic
efficiency (especially in foreign investment project authorisations) and greater flexibility was guaranteed in decisions on production, export, import and employment.
Between 1984 and 1991, FDI inflows into China grew 44% per annum in value
terms. In 1991, the realised FDI inflow reached $4.7 billion.
From 1992 the flow of FDI has increased dramatically, reaching $31.5 billion
in 1994 and $42 billion in 1996 (Work Bank, 1997).
Tables I and II present the distribution of FDI by source countries. Before 1984,
FDI was insignificant. The stock figures in Table I are computed by cumulating FDI
inflows from 1984. We split these figures into two periods (198489 and 199094)
so as to show the impressive acceleration of FDI in the 1990s. Table II gives figures
for FDI flows according to the major source countries.
Most FDI originates from the Asia-Pacific region (74.5% of total FDI stock
comes from the East Asian Newly Industrialised Economies NIEs hereafter).
Hong Kong has always been Chinas major investor. It accounts for 61% of FDI
stock in 1994. It has been concentrated in the traditional industries such as metal
products, garment manufacturing, textiles, electronics and plastic conversion. It is
worth noting that a substantial share of foreign investments is in fact domestic capital that has round-tripped its way through Hong Kong and back to the mainland
to take advantage of the tax privileges available to foreign investors (World Bank,

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1997). This leads to overvalued FDI inflows into China (one estimate suggests
that up to 20% of recent inflows were domestic capital that was round-tripped).
With 8.72% of the total accumulated inflows, Taiwan is the second most important
source of foreign capital in China. The Taiwanese began to invest massively in
China from the 1990s onwards. Before 1990, the government of Taiwan forbade
all direct investment in mainland China and Taiwanese enterprises had to invest via
Hong Kong or Macao if they wished indirect access to China (Shi, 1996). Japanese
direct investment in China has grown sharply since 1993. In 1995, Japan became
the second most important investor in China in terms of investment inflows (see
Table II).
The United States are an important investor with 8% of the FDI stock in 1994
(the third largest source). Even if Western European countries are the main source
in international direct investment in the world, their share in China is relatively
small; only the UKs share in FDI stock is above 1%.
The open-door-policy encouraged the dramatic development of FDI in China.
The growth of FDI was a key-element of the Chinese success, not only because
it had positive impacts on the economy, but also because it implied a change
in the way of thinking in the political sphere. China cannot continue to develop
without increasing openness to the rest of the world. FDI is probably the best way
to encourage the pursuit of the open door-policy and to sustain the economic
performance observed since 1978 in the future. However, the large scale expansion
of FDI that China has experienced in recent years seems to be limited in its duration. The high FDI inflows in China in 199395 were exceptional and have fallen
back to a more sustainable level in the long run (World Bank, 1997). Many reasons
explain this necessary reduction on FDI inflows. They include the elimination of
tax concessions for foreign investors in 1996 and the slowdown in the upsurge in
transfers of labour-intensive assembly operations from East Asian neighbours.

3. Determinants of Chinese inward FDI


3.1.

OVERVIEW

According to Zang (1995), the sharp rise of FDI since 1987 has been due to the
improving of the environment and to the impressive growth of the Chinese economy. However, prior to then, investors were reluctant to invest in China because
of the features peculiar to a Centrally Planned Economy that implied too high risks
as compared to profits. Huang and Shirai (1994) show that the pattern usually
observed for FDI in developing countries is appropriate for China. After a sluggish inflow and a period of fluctuation, FDI has grown rapidly. Once the degree of
uncertainty has declined, investors have been more attracted by the location of their
production in China, even if a lack of regional or industry-specific information is
an important remaining uncertainty. The role of the authorities is highly important

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FOREIGN DIRECT INVESTMENT IN CHINA

Table I. FDI stock by source countries (current prices)


Year 198494
US$
Share
Millions
(%)

Year 198489
US$
Share
Millions
(%)

Year 199094
US$
Share
Millions
(%)

NIEs
Hong Kong
Macao
Taiwan
Singapore
South Korea

70653
57646
1459
8269
2060
1219

74.50
60.78
1.54
8.72
2.17
1.29

8962
8724
79
0
159
0

61.73
60.10
0.54
0.00
1.09
0.00

61692
48922
1381
8269
1901
1219

76.80
60.90
1.72
10.29
2.37
1.52

USA

7567

7.98

1723

11.90

5844

7.28

Japan

7049

7.43

1894

13.00

5156

6.42

West Europe
UK
Germany
France
Italy
Netherlands
Switzerland
Norway
Belgium
Denmark
Austria
Sweden
Finland
Spain
Others

3985
1268
792
549
503
287
173
69
98
67
46
54
31
36
12

4.20
1.34
0.84
0.58
0.53
0.30
0.18
0.07
0.10
0.07
0.05
0.06
0.03
0.04
0.01

963
272
158
139
144
41
17
52
28
38
24
13
28
7
2

6.63
1.87
1.09
0.96
0.99
0.28
0.12
0.36
0.19
0.26
0.16
0.09
0.19
0.05
0.02

3022
997
634
410
359
246
156
17
70
28
23
42
3
40
3

3.76
1.24
0.79
0.51
0.45
0.31
0.19
0.02
0.09
0.03
0.03
0.05
0.00
0.05
0.00

Other DCs
Australia
Canada
New Zealand

1033
520
475
38

1.09
0.55
0.50
0.04

199
147
45
7

1.37
1.01
0.31
0.05

833
373
430
31

1.04
0.46
0.54
0.04

ASIAN
Thailand
Philippines
Malaysia
Indonesia

1462
630
302
323
297

1.54
0.66
0.32
0.34
0.22

73
53
15
3
2

0.51
0.36
0.11
0.02
0.02

1389
578
286
320
205

1.73
0.72
0.36
0.40
0.25

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Table I. Continued.
Other Asia

303

0.32

0.04

298

0.37

East Europe

145

0.15

27

0.19

118

0.15

Latin America

267

0.28

11

0.08

255

0.32

Africa

168

0.18

0.02

165

0.20

Others

2209

2.33

658

4.53

1551

1.93

Total

94840

100.00

14519

100

80323

100.00

Source: Chen (1996), China Statistical Yearbook, various issues.

Table II. FDI inflows: the major source countries (Actually used. US$ billion)
83

84

85

86

87

88

89

90

91

92

93

94

95

HK Macao
Taiwan
USA
Japan
Korea
UK
France
Italy

0.47

0.83
0.19

0.01
0.04
0.01

0.75

0.26
0.23

0.10
0.02
0.02

0.96

0.36
0.31

0.07
0.03
0.02

1.33

0.33
0.26

0.04
0.04
0.03

1.81

0.27
0.27

0.01
0.02
0.02

2.43

0.24
0.60

0.05
0.03
0.04

2.34

0.29
0.41

0.03
0.01
0.03

2.12

0.46
0.52

0.02
0.02
0.01

2.66
0.47
0.33
0.61

0.04
0.01
0.04

7.91
1.05
0.52
0.75
0.67
0.04
0.05
0.03

18.03
3.14
2.07
1.36
0.38
0.22
0.14
0.10

20.33
3.39
2.49
2.09
0.73
0.69
0.19
0.21

20.62
3.16
3.08
3.21
1.05
0.92
0.29
0.27

Total

0.92 1.42 1.96 2.24 2.65 3.74 3.77 3.75 4.67 11.29 27.77 33.94 37.81

Source: China Statistical Yearbook various issues.

in revealing new information and in improving the investment environment (Huang


and Shirai, 1994).
Grub et al. (1990) have used interviews and questionnaires to study the motivations of US firms who invest in China. Among the positive variables, they find
that the potential market and cheap labour are the most important determinants of
US investments. However, it was shown that investment incentives provided by the
Chinese authorities were only moderately significant for the US firms in making
investment decisions. Among the negative variables, foreign exchange problems
(non-convertibility of the currency and multiple exchange rate system? ) were most
serious for the US firms. The cumbersome bureaucracy as well as the lack of infrastructure facilities were also serious problems hindering US investments. Finally,
? Since 1994, there has been only one exchange rate.

FOREIGN DIRECT INVESTMENT IN CHINA

181

swings in economic policies and too many controls over FDI also discouraged US
investments.
It is worth noting that Chinese inward FDI is not a global phenomenon and that
there could be differences between the determinants of FDI in China accross source
countries. For instance, the motives of investors from developing countries (and
especially from East Asia) are quite specific. For Yue (1993), investments made
by the NIEs in China aim to capitalise on lower production costs, gain access to
natural resources, circumvent protectionist measures of developed countries, and
exploit firm-specific advantages such as lower managerial costs, better marketing
channels, more appropriate technology and better understanding of host countries
than investors from developed countries. Yue underlines also the role of geographical proximity, ethnic and cultural affinity in information flows between the NIEs
and China. Shi (1996) show that, initially, foreign investors (especially those from
Hong Kong and Taiwan) were attracted by cheap labour. FDI was used to produce
labour intensive goods in order to re-export them toward their traditional markets.
However, since the early 1990s, foreign investors have attached more importance
to the quality of workers in order to produce higher technological products. In
this case, labour quality could be another determinant of FDI. To sum up, the
motivations of the East Asian NIEs refer more to the factor cost advantage and
the growing demand of the Chinese market.
Some empirical evidence is available from econometric work. Using a panel
data set? Wei (1995) runs regressions for the flow and the stock of FDI. He finds
a positive and significant effect of the Chinese GNP: a 1 percent increase in the
size of a host country is associated with a 0.53 (0.74) percentage point increase
in the flow (stock) of FDI. He finds also a positive correlation between the inflow
of FDI and the stock of human capital in the host country (proxied by literacy).
Finally, the effect of distance between the investing country and China is negative
confirming the hypothesis that FDI is highly regionalised. Wei only studies the
Chinese inward-FDI coming from developed countries. Therefore, his work does
not take into account the growing share of the East Asian countries like Taiwan or
Korea and also Hong Kong, the largest investor in China.
In their study, Liu et al. (1997) analyse, through an error-component model, the
economic, political and cultural determinants of FDI in China. The panel data set
covers a time period of 19831994 and 22 countries/regions as well as mainland
China as the host. Hong Kong and the East Asia NIEs are taken into account as
investor countries. The results show that bilateral trade, cultural differences and
relative changes in market size, wage rates, and exchange rates are important explanatory variables for FDI in China. Country risk is not a significant determinant,
whilst geographic distance is significant but wrongly signed.
The previous econometric studies on the determinants of Chinese inward FDI
suggest that the use of panel data is appropriate to analyse such a topic. This
? The basic data set is outward FDI from the five largest countries (Japan, UK, USA, France and

Germany) in 198790 period.

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econometric technique is highly useful in this case because it takes into account
the diversity and the specificity of different investors.

3.2.

EMPIRICAL EVIDENCE

3.2. a) Theoretical discussion


The rapid growth of the East Asian economies has induced foreign firms to choose
to produce in these countries, and China attracts a part of this production. Two
questions need to be answered:
Why investors move a part of their production to China and not to other East
Asian Economies?
What are the reasons for choosing FDI instead of licensing agreements?
To answer the first question, two types of determinants could be defined. Investors
move a part of their production to China, because the Chinese market is so huge
that it could absorb a substantial part of this production. The Chinese choice may
equally be related to the relative cost between China and its East Asian neighbours.
To investigate these two types of determinants, we need to include GDP (proxing
the market size) and two costs indicators: a relative wage indicator defined as the
ratio of Chinese real wages to an average of East Asian real wages and the real
exchange rate (see Froot and Stein, 1991). Both real wage and real exchange rate
may be seen as cost advantage indicators.
To answer the second question, we must compare the advantages and disadvantages between FDI and licensing agreements. We have seen (e.g. Huang and Shirai,
1994) that investing in China requires a lot of information in order to minimise
risk. We assume that this cost component is a negative function of the knowledge
of the Chinese market in the home country. The more a country shares relationships
with China, the less are the costs of information. We proxy the importance of the
relationships between China and the home country by the share of the latter in the
Chinese GDP in terms of exports. Finally, the costs of licensing agreements must
also be taken into account even if they are not easily observable. Markusen (1995)
shows that most authors assess that the costs of such agreements are linked with
the extent to which firm-specific assets and knowledge are being transferred. Like
Barrell et al. (1996), we assume that licence costs are proportional to the source
country degree of innovation that we will proxy by the cumulative stock of patents
registered by each country investing in China.

FOREIGN DIRECT INVESTMENT IN CHINA

183

3.2. b) Results and interpretation


Our empirical work is based on a panel data which covers 11 countries: Hong
Kong,? Taiwan, United States, Japan, Singapore, South Korea, Thailand, United
Kingdom, France, Canada and Italy. The flows coming from these countries average almost 90% of the total in the period. Panel data is the methodology used and
the study period starts in 1983, because FDI was a minor phenomenon prior this
date. The end of the sample is 1995. The data are on an annual base. The variables
used are those determined by our theoretical discussion. We have added a dummy
variable reflecting the fall of FDI inflows in 1990 in order to take into account the
negative effect of the Tiananmen Square incident.
All these variables are assumed to be stationary throughout the period except the
endogenous variable (the stock of FDI), the market size variable (GDP), the relative
real wage rate (that has been falling down since 1983) and the real exchange rate.
To avoid running a regression with both stationary and non-stationary variables,
we estimate our equation in an error correction model. Since the period studied is
too short to implement the two-step analysis la Engle-Granger (1987), the error
correction model is estimated with only one step and the equation has the following
form:
1 ln(F DI )ij,t = i +1 ln(F DI )ij,t 1 +2 ln(GDP )j,t 1 +3 ln(RELW )ij,t 1


Xij,t
+ 4 ln(RER)ij,t 1 + 5 1 ln(P AT )i,t + 6 ln
GDPj,t
+ 7 DU M90 + ij,t
(1)
where F DIij,t is the stock of FDI from country i to China at time t; GDPj,t proxies
the Chinese market size; RELWij,t is the relative real wage rate; RERij,t the real
exchange rate; P ATi,t represents the stock of patents registered by the country i in
the United States; Xij,t is the export of country i toward China and DU M9O is a
dummy variable (equal to 1 in 1990, 0 otherwise). 1 symbolises the first difference
operator.??
The home country specific fixed effects i represents the constant unobserved
influences. All other influences are taken into account by the disturbance term ij,t .
The fixed effects are likely to catch factors such as ethnic influence that is not
reflected in the other exogenous variables. Concerning the choice between fixed
and random effects, Hsiao (1986) comments that it is not an easy question to answer. We have chosen the fixed effects model because we want to make inferences
conditional on the effects that are in the sample.
? The inclusion of Hong Kong could be subject to criticism because of its role in round-tripping.
However, in the empirical study, the difference between the exclusion and inclusion of Hong Kong
are too weak to justify such an analysis.
?? A technical definition and the sources of data are available in appendix.
The fixed-effects model is viewed as one in which investigators make inferences conditional on
the effects that are in the sample. The random-effects model is viewed as one in which investigators
make unconditional or marginal inferences with respect to the population of all effects (Hsiao, 1986).

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With this formulation, 1 is the coefficient of the error correction term. It is


expected to be negative and its size depends on the speed of adjustment between
short-term movements and long term equilibrium. The long-term elasticities of
GDP, relative wages and real exchange rate (2 , 3 , 4 and respectively) are defined
as follows:
2
3
4
2 = ;
3 = ;
4 = .
1
1
1
The elasticity with respect to GDP (in the short-run as well as in the long-run) is
expected to be positive. The growing size of the Chinese market is likely to have a
positive influence on the amount of investment made by foreign firms. The relative
real wage rate is expected to have a negative coefficient. In their decision to invest
in China, the foreign firms are influenced by the low costs of the Chinese labour
force compared with the labour costs of the countries in which these investors are
usually present. The real exchange rate influence is usually negative, i.e. a real
depreciation of the Chinese currency produces an increase in inward FDI in China;
then 4 is expected to be negative. The change in patents registered by the home
country firms should have a positive effect on FDI. In general, the more innovative
a country is, the more is it likely to invest abroad. The coefficient attached to the
change in the stock of patents must be positive. The effect of the trade variable
is expected to be positive, i.e. the larger the exports of the home country toward
China, the larger will be FDI from this country into China. Finally, the dummy
variable attempts to evaluate the effects of political events on FDI and it is likely
to be negative.
Table III presents the results of this empirical work. These results are consistent
with the theory and with previous works on the Chinese FDI. As the equations are
in logs we can interpret the coefficients as elasticities.
The level of GDP has a large positive effect on the stock of inward investment.
Its long-run elasticity is about 1.8 (1% increase in the size of the Chinese market
is associated with a 1.8 percentage point increase in the stock of FDI). It is larger
than the elasticity found by Wei (he finds an elasticity equal to 0.75). This can
be explained first of all by the difference among the other regressors used and,
above all, by the fact that Weis sample stops in 1990, not taking into account
the sharp acceleration in FDI in the 1990s. It is interesting to see that the role of
market size in the decision to invest in China is more important in the latter period.
Concerning the effects of relative we obtain a negative and significant coefficient.
The long-term elasticity is equal to 0.71 (1% decrease in the Chinese real wage
compared to that in its East Asian neighbours is associated with a 0.71 percentage
point increase in the stock of FDI).
The effect of real exchange rate is negative as expected (1% decrease in Chinas
real exchange rate is associated with a 1.5 percentage point increase in the stock
of FDI). A depreciation of the real value of the Chinese currency encourages
the growth of inward FDI. The value of the error correction term is negative as
expected.

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FOREIGN DIRECT INVESTMENT IN CHINA

Table III. The determinants of Chinese FDI


Dependent variable: 1 ln (FDI)ij,t
Sample period: 19831995
Number of observations: 143
ln(FDI)ij,t 1
ln(GDP)j,t 1
ln(RELW)ij,t 1
ln(RER)ij,t 1
1 ln (PAT)i,t
ln(Xij,t /GDPj,t )
DUM9O
R-squared
Adjusted R-squared
D-W Statistic
Std. error of regression
Long-run coefficients
Output
Relative wages
Real Exchange Rate

0.366 (11.46)
0.656 (5.13)
0.260 (1.97)
0.539 (2.28)
0.174 (5.74)
0.314 (3.62)
0.265 (2.12)
0.864738
0.846343
1.882750
0.373574

1.792
0.710
1.473

Notes : Variables are defined in the main text. T-statistics


are reported in parentheses.

The change in patent registration by the foreign firms has a positive effect suggesting that innovation in the home country is a determinant to invest abroad. This
corresponds to the effect expected and generally found in such works. The trade
relationships between the home countries and China have a positive influence on
FDI inflows. The decision to invest in China is linked with the share of the home
country export in the Chinese activity. Finally, the Tiananmen Square incident has
been a negative and significant impact on FDI in China. This event confirms the
importance of the political situation in the decision of the host country. In the case
of China, this event interrupted the growth of FDI only in the short-term, not calling
into question the long-term increasing trend.
4. Effects of Foreign Direct Investment on the Chinese Economy
4.1.

OVERVIEW

FDI has played an active role in the Chinese economic development. In terms of
contribution of FDI to GDP growth, the proportion of FFE output in total industrial
output rose from 2% in 1978 to almost 17% in 1995 (Table IV). There are several

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Table IV. Proportion of Foreign Funded Enterprise output in total


industrial output, 198795
Year

Total industrial
output
(bn yuan)

FFE output
(bn yuan)

Share of FFE output in


total industrial output
(in percentage)

1987
1988
1989
1990
1991
1992
1993
1994
1995

1,381.30
1,822.40
2,201.70
2,392.40
2,824.80
3,706.60
5,269.20
7,690.95
9,189.50

27.62
49.20
74.86
105.27
161.01
263.69
535.21
1,042.13
1,523.1

2.0
2.7
3.4
4.4
5.7
7.1
10.1
13.5
16.6

Sources: Zang (1995) and Chinese Statistical Yearbook (1996) for


1993-95.
Note: FFE Output includes output of joint-ventures and foreignwholly-owned enterprises.

positive impacts of FDI on the Chinese economy. First, since the early 1990s,
FDI has implied the import of advanced technology and equipment, narrowing
the technology gap between China and the rest of the world. Furthermore, via
technology transfer, FDI has improved the Chinese factor productivity (Liang and
Zhu, 1996, shows econometrically that about 32% of economic growth was contributed by total factor productivity from 1978 to 1994). The import of technology
is indispensable to improve the Chinese industrial efficiency and to put China on
equal footing with its Asian neighbours. Introducing modern technology to China
is also a good way for FFEs to penetrate the Chinese internal market (Chen and
Wong, 1995). Second, FDI has introduced new management serving as reference
for domestic enterprises. Third, the impact in state revenue and employment has
been substantial (FFEs employ more than 6 million people and taxes on foreign
businesses in 1992 were 10.7 billion yuan). Finally, the role of FDI in the balance
of payments has been quite important, increasing export of manufactured products
(Zang, 1995). The expansion of international trade and FDI have both played a
crucial role in the Chinese reforms. It has led to a rationalisation of the internal
price structure and prompted some fundamental changes in laws concerning the
ownership of enterprises (Hussain, 1996).
FDI also has an effect on growth through the contribution to capital. Table
V presents the share of FDI in total investment in China. This share has continually grown since 1983. In 1994, FDI accounts for more than one sixth of
total investment. This underlines the increasing role of foreign investors in capital
accumulation.

FOREIGN DIRECT INVESTMENT IN CHINA

187

Table V. FDI and Total Investment (in billion


of yuan)
Year

Total
investment

FDI
Value Share
in percent

1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995

143.0
183.3
254.3
302.0
364.1
449.7
413.8
444.9
550.9
785.5
1245.7
1704.3
2001.9

1.8
3.3
5.7
7.7
9.8
13.9
14.2
17.9
24.8
62.3
160
292.6
315.7

1.2
1.8
2.2
2.5
2.7
3.1
3.4
4.0
4.5
7.9
12.8
17.9
15.8

Source: China Statistical Yearbook, various


issues

Wei (1995) estimated the effects of FDI on the Chinese economy. His evidence
is based on a statistical analysis of a city-level data set covering the period 1988
90. He finds statistical evidence that FDI is positively associated with cross-city
differences in growth rates, after taking into account the growth of labour, physical
and human capital.
In his comment on Weis work, Woo (1995) thinks that the empirical procedures
used may greatly overstate the FDI contribution to growth ... one major reason why
FDI has an output effect beyond its expansion of the capital stock is that in general
FDI occurred in the cities that have liberalized and hence have raised their growth
potential the most. In short, FDI is correlated with total factor productivity (TFP)
growth because FDI is a good proxy for the degree of economic liberalization and
the greater the liberalization, the higher TFP growth.
4.2.

EMPIRICAL EVIDENCE

4.2. a) Theoretical foundations


The transformation of the Chinese economy may explain the dramatic growth that
has occurred in China since the beginning of the reforms. However, this view seems
to be inappropriate to explain the industrial development in the coastal provinces.
For Romer (1993), the initial under-development of the Chinese economy is not

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explained by an object gap (lack of valuable objects, like factories, roads and raw
materials), but rather by an idea gap (no access to the ideas that are being used in
industrial nations to generate economic value). For a developing country, idea gaps
are easier to solve than object gaps. Hence, the diffusion of ideas by multinational
firms allows a rapid convergence of developing countries toward the developed
countries standards. In the Chinese case, the notion of a purely domestic response
to policy reform misses the enormous flows of direct foreign investment that China
has received since the latter half of the 1980s (Romer, 1993). In other words,
through the introduction of new ideas, FDI may raise technical progress and hence
longevity in economic growth. Previous studies on FDI effects on growth suggest
that inflow of new technology and working practices from multinational firms
create a significant potential for spillovers to domestic firms in the host country
(Blomstrm and Kokko, 1996).
To assess the role of FDI in the Chinese economic growth, we define a constant
elasticity of substitution (CES) production function as follows:?
Q = [s(K) + (1 s)(Let ) ]1/p

(2)

where Q, K and L denote output, capital stock and labour, t technical progress,
a scale parameter and s the contribution of capital to growth. The elasticity of
substitution ( ) is given by 1/1+. Technical progress is assumed to be labour
augmenting. To estimate and , we use the labour demand equation that can be
derived from the first-order condition that marginal product of labour must equal
the mark-up adjusted real wage:
Q/L = (1 s)Q(1+) (Le t )(1+) et = (w/p)

(3)

where w, p and denote respectively wage, prices and the mark-up.


The log-form of the labour demand equation can be derived from (3) and can
be written as Equation (4)
(w/p) = (1 s)Q(1+) (Let )(1+) et
(w/p) = (1 s)(Q/L)(1+) et
ln + ln(w/p) = ln( ) + ln(1 s) + (1 + ) ln(Q/L) t
1
ln(L/Q) =
[ ln ln(w/p) ln( ) + ln(1 s) t]
1+
ln(L/Q) = ln ln(w/p) + ( 1) ln( ) + ln(1 s) + ( 1)t
(4)
The elasticity of substitution can be derived from (4) since it can be identified to
the long-run elasticity of labour demand with respect to real wages. Having defined
this elasticity, we can easily define the contribution of technical progress to growth
().
? This analysis is based on Barrell and Pain (1997).

FOREIGN DIRECT INVESTMENT IN CHINA

189

This framework will help us to investigate the role of FDI in technical change
through the effects of technological spillovers on growth. By technological spillovers, we mean, like Grossman and Helpman (1991), that (1) firms can acquire
information created by others without paying for that information in a market transaction, and (2) the creators (or current owners) of the information have no recourse,
under prevailing laws, if other firms utilize information so acquired. An abundant
literature attempts to endogenise the role of innovation in the growth process by
linking the productivity level of a country with the cumulative R&D expenses and
with the effective stock of knowledge. As pointed out by Coe and Helpman (1995),
in a world with international trade and FDI, a countrys productivity depends not
only on its own stock of knowledge but also on the stock of knowledge of its trade
partners and foreign investors. In a country like China where expenditure on R&D
is quite small compared to developed countries (0.5% of GDP in 1994? Chinese
Statistical Yearbook, 1995), the level of productivity is likely to be related to the
other economies innovations. Through trade and FDI, China can develop its own
productivity level via technological transfer.
Our empirical work will be built on the theoretical models of innovation-driven
growth in the line developed for instance by Grossman and Helpman (1991). We
assume that technical progress is a function of the stock of FDI, together with an
exogenous element proxied by a linear time trend. We add also an indicator of
openness, justifying its presence by the link existing between openness and capital
import. For Romer (1993), idea gaps can equally be solved by import of capital
(and more particularly by machinery import). Openness is proxied by the share of
import in GDP.
Hence, the TFP term (t) can be written as (5):
t = TIME T I ME + FDI ln(F DI )t 1 + M ln(M/GDP )t 1

(5)

This specification, as suggested by Barrell and Pain (1997) or Coe and Helpman
(1995), implies that technical progress will grow at a constant rate if direct investment and imports over GDP grow at a constant rate. We have assumed that the
effects of FDI and imports have impacts on technological change with a quarter
lag.
With Equation (5) we can re-write (4) as (6) which becomes the central equation
of our theoretical framework
ln(L/Q) = ln(w/p) + ( 1)(TIME T I ME + FDI ln(F DI )t 1
+M ln(M/GDP )t 1 )
(6)
where = ln{(1 s)/} + ( 1) ln( ).
? Major economies R&D expenditures (Figures as a percentage of GDP, 1995): Japan: 2.8; US:

2.4; France: 2.3; Germany: 2.3; UK: 2.1 (Statistical Abstract of the US for US and Japan; Eurostat
for European economies).

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4.2. b) Empirical results


Our empirical work starts with a dynamic model in which equation (6) can be
derived as the long-run solution. Equation (7) gives the formulation of the dynamic
model.?
1 ln(L/Q)t = 0 ln(L/Q)t 1 ln(w/p)t 1
+ ( )(TIME T I ME + FDI ln(F DI )t 1 + M ln(M/GDP )t 1)
+ dynamics
(7)
where 0 = . and = .; is the error correction coefficient.
This model has been used to assess the impact of FDI on the Chinese productivity. Results are given in Table VI. The long-run equation derived from estimates of
Table VI is:
ln(L) = ln(Q) + 0.85 0.30 ln(w/p) 0.70(0.026 T I ME
+0.016 ln(F DI )1 + 0.206 ln(M/GDP )1 )
The long-run equation of the labour demand function gives estimates for the production functions elasticity of substitution ( = 0.3) and for the coefficients of the
different components of the productivity term (T I ME = 0.026, F DI = 0.016 and
M = 0.206).
The positive, significant coefficients F DI and M clearly indicate that the impact of FDI and openness have been important to explain the Chinese TFP and
hence the long-run growth. Our empirical evidence shows that the impact of the
stock of FDI has been significant only for the 1990s suggesting that, in the 1980s,
technological transfers were satisfied only through the imports of machinery. The
huge amounts of FDI that China has accumulated since 1990 have helped to close
more rapidly the idea gap and to improve Chinese productivity. This confirms the
role of FDI in technical progress and shows that the flow of productive ideas via
multinational firms seems to have had a significant effect on the Chinese economic
growth.
5. Concluding Remarks
This paper has attempted to assess the determinants of FDI in China and its effects
on the whole economy. After presenting main previous work done on Chinese
inward-FDI, an empirical study has been implemented extending the previous ones
with a different data set (more recent) and with different methodologies. The
Chinese inward FDI is established as a function of the Chinese domestic market
? We have estimated (7) with non-linear least squares in order to impose the coefficient attached
to the technical progress term to be equal to ( 1) in the long term as suggested by (6):

( )/ = / 1 = 1

191

FOREIGN DIRECT INVESTMENT IN CHINA

Table VI. The Chinese labour demand


Dependent variable: 1 ln (L/Q)
Sample period; 1984Q2-199Q4
Number of observations: 43
Non-linear Least Square Estimation
Constant
ln(L/Q)1
ln(w/p)1
TIME
ln(FDI)1
ln(M/GDP)1
1 ln(Q)-2
DUM94b

0.45 (2.89)
0.53 (3.96)
0.16 (1.90)
0.026 (3.68)
0.016 (2.36)a
0.206 (2.75)
0.60 (3.78)
0.09 (6.17)

R2 = 0.51637
se = 0.020216
RSS = 0.015122
Serial correlation: F(1,31) = 1.3186
Functional form: F(1,34) = 2.8715
Normality: 2 (2)= 0.50191
Heteroscedasticity: F(1,41) = 0.27586
Note: a The stock of EDT is significant only for the period
1990Q11994Q4. The coefficient of ln(FDI)1 has been
estimated by multiplying the data of FDI stock by a
dummy variable equal to 0 for 1984Q1 to 1989Q4 and
equal to 1 afterwards. b Equal to one for the four quarters
of 1994; equal to zero otherwise.

size, the low cost of its labour force, its real exchange rate, its openness to the rest
of the world and the source country degree of innovation. The Tienanmen square
incident seems to have had a negative impact on the inward FDI in China.
Concerning the consequences of FDI on the Chinese economy, a CES production function has been used to assess its effects on growth. Through the estimation
of a labour demand equation we have investigated the role of FDI in technology
transfers and its effect on technical change. We have endogenised technical change
by assuming that technical progress is a function of the inflows of FDI, together
with an exogenous element proxied by a linear time trend. We have also added an
indicator of openness, justifying its presence by the link existing between openness
and capital import. Our conclusions support the view that FDI affects Chinese
growth through the diffusion of ideas. FDI has had a significant positive effect
on Chinese long-term growth through its influence on technical change (this influence is significant only in the 1990s). This conclusion is also confirmed by the

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significant positive coefficient attached to the openness indicator. The transmission


of ideas seems to have had a positive effect on Chinese growth.
The challenge for the next years will be to sustain the inflow of FDI and to
improve their efficiency (World Bank, 1997). Productivity gains will be an important factor of this challenge. In improving technological progress, FDI may develop
labour productivity and, hence, help China to remain competitive. The diversification of FDI-inflow is a condition of future success. FDI must be shifted toward
infrastructure and away from manufacturing and real estate. This governments
objective will be attained only if the investment environment is improved. Legal
and financial systems are being developed and the current reform measures seem
to be a good guarantee for the future development of the Chinese transition.

Acknowledgement
The author is grateful to Ray Barrell, Eric Girardin, Nigel Pain, Shujie Yao and
an anonymous referee for discussions and helpful comments. They are in no way
responsible for any errors in this paper. The work is part of a project financed by a
European Commission grant (contract number ERBFMBICT950260).

Appendix: Data Sources and Definition of Variables


1- DATA

USED IN SECTION

Stock of FDI:
GDP:

Relative wages:
Real Exchange Rate:

Patents:
Exports:

Cumulative FDI inflow in 1990 USD Million. World


Bank.
Chinese GDP in 1990 USD Million. International Monetary Funds, International Financial Statistics (IMF
IFS).
Ratio of real Chinese Wages to real East Asian wage
rates. ILO Yearbook of Labour Statistics.
Variable calculated with nominal exchange rate (home
country currency/USD and Yuan/USD) and consumer
price indices for each country. IMF IFS and Asian
Development Bank for Hong Kong and Taiwan.
Total number of patents registered in the United States.
US Patents and Trademark Office.
Home country export into China divided by Chinese
GDP (both variables in 1990 USD Million). OECD
Direction of Trade Statistics Yearbook and IMF IFS.

FOREIGN DIRECT INVESTMENT IN CHINA

2-

DATA USED IN SECTION

Production (Q):
Labour (L):
FDI:

M/GDP:

193

Industrial production in real terms. IMF IFS.


Social industrial labour force. Interpolated data. World
Bank.
Stock of Foreign Direct Investment in constant billion
of Yuan computed from the accumulation of FDI inflow
since 1984 deflated by the Chinese domestic prices (Li,
1994; IMF IFS and World Bank).
Ratio of imports of goods in billion of Yuan (deflated
by import prices) and Chinese real GDP. Computed
series from IMF IFS and World Bank.

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