Nicholes

Attar

Political Economics of FDI

Professor Pandya

April 3, 2018

The Future of FDI Created Pollution in China

Given that the Environmental Kuznets Curve (EKC) can be demonstrated for the left

side of the curve in China, it can be stated that, as China continues to receive Foreign Direct

Investment (FDI), the pollution created by the FDI will increase at a decreasing rate.

However, the EKC cannot be reliably demonstrated beyond the tipping point due to the

conflicting effects of greater levels of FDI so beyond that point, the environmental impact of

FDI can no longer be reliably calculated in China.

The EKC is an inverted U-shaped curve that demonstrates the relationship between

GDP per capita and the level of environmental degradation in a country (Panayotou, Ren,

Lui, Pao). That is, as the GDP per capita increases, environmental degradation will increase

and then begin to decrease once the GDP per capita passes a certain point. At low levels of

economic development, environmental impacts are limited to subsistence farming and

biodegradable waste so the EKC starts at the bottom left. As development increases,

resource extraction, which has a severe negative impact on the environment, increases and

waste products increase in quantity and toxicity. In addition to adding new pollution

generating industries, FDI will also often replace the subsistence farmers with corporate

mega-farms, which bring in synthetic fertilizers and pesticides that are often banned in

developed countries (O’Keef). This demonstrates the rise in pollution that is associated

with the left half of the curve. Beyond a tipping point, due to a structural change towards

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the service industry, increased environmental awareness and expenditure, and better more

efficient technology, environmental degradation begins to decrease (Panayotou). This

decreasing rate of pollution is demonstrated by the right half of the EKC.

It is difficult to tell how the EKC relates to China because the current estimates for

the tipping point vary and are inconclusive. However, the EKC provides a solid theoretical

framework to help describe the most likely short-term trajectory of pollution rates in China

if we can determine which side of the tipping point China currently falls on. My research

demonstrates that FDI has a positive effect on pollution, which demonstrates that China is

still on the left side of the tipping point and that pollution will continue to increase at a

decreasing rate.

I use FDI rather than GDP per capita because the pollution created by FDI follows an

EKC and there is a precedent for doing so in the studies that I’ve aggregated. FDI increases

pollution in less developed nations due to the Pollution Haven Hypothesis (PHH) until a

tipping point. Beyond that point, the Porter Hypothesis, and Halo Effect come into play

more significantly and the relationship between FDI and pollution becomes statistically

insignificant. This can be demonstrated empirically by the paper by Al-mulali et al. and

theoretically later in this essay. The paper finds no relationship between FDI and emissions

in the Gulf Cooperation Council Countries. The GDP per capita of all the GCC countries are

greater than the GDP per capita of China so they would fall further to the right on the EKC

and there would be a less significant relation, if any, between FDI and emissions.

The PHH states that Multinational Corporations (MNCs), especially pollution

intensive MNCs, are attracted to developing host countries where they can circumvent the

costly environmental regulations in their home countries. When companies are seeking

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places to invest, generally, the environmental costs are considered. Less developed

countries may be innocent pollution havens in that they don’t have the capital or ability to

implement or monitor environmental regulations or they may intentionally have lax

environmental regulations in order to attract FDI in the absence of other attractants such

as infrastructure or skilled labor (Pao). This hypothesis has been corroborated in low-

income countries by Hoffmann et al. as well as in China, which falls into the low-income

category, by Ren et al., He et al., Lui et al., and Pau et al. All of the authors use this

hypothesis to justify their experimental findings listed below on the impact of FDI on

pollution.

FDI Pollution* Author

1% increase in FDI net Increases CO2 emissions by Ren et al.
inflows 15.2% or 24.1%
1% increase in FDI capital Increase in SO2 emissions by He et al.
stock 0.098% or 0.126%
1% increase in FDI net Decrease in waste soot by Liu et al.
inflows 1.4%
Increase in SO2 emissions by 0.3% or
0.2%
Increase in wastewater by
0.9% or 1.0%
1% increase in FDI per Increase in per capita CO2 emissions by Pao et al.
capita 0.041%
*Many authors had multiple models. I am reporting the results that are significant at the 5% level or better

From the table, it is clear that China is currently on the left side of the EKC and the

conclusion drawn by Ren et al., Lui et al., and Pau et al. is that current rates of pollution are

headed towards an inflection point as predicted by the EKC.

The latter half of my claim, that beyond the tipping point, projections for the rate of

pollution in China will become muddled and insignificant in relation to FDI is due to the

Halo Effect and Porter Hypothesis. The Halo Effect is that MNCs will apply a universal

environmental standard to their subsidiaries in foreign countries that will tend to spread

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greener technology to those countries than the minimum that those countries mandate.

The Halo Effect has been argued to discredit the entire EKC by the theoretical argument

that the introduction of greener technology through FDI will decrease overall pollution.

Zhou et al. used the Halo Hypothesis to justify their findings that FDI decreases CO2

emissions in China.

However, this effect is only prominent as a country becomes more developed.

Adding any new FDI will increase pollution in a recipient country; it is only when inefficient

firms are replaced by more efficient FDI that pollution will begin to drop. China’s influx of

FDI has increased their pollution levels, as demonstrated in the table above, and as China

continues to develop and greener FDI replaces current inefficient industries, the Halo Effect

will become a more significant negative force in the relationship between FDI and

pollution. So the evidence for the left half of the ECK stands as reasonable in the face of this

objection. In the Zhou paper, FDI was substituted for “degree of openness”, which was the

proportion of FDI in terms of GDP rather than a true direct measure of FDI capital stock or

net inflows and only 3 out of 7 of their coefficients were significant at the 10% level. Given

that Zhou’s peers found the opposite results with more specific variables and at greater

levels of significance, it is safe to assume that the contrary findings are reasonable.

A second argument against the Halo Hypothesis decreasing levels of pollution comes

from the Khazzoom-Brookes Postulate, which states, paradoxically, that energy

consumption will increase as energy efficiency increases. This is due to the lowering of the

cost of the goods brought on by greater efficiency, which increases the demand for those

goods. If the Halo Hypothesis did have an effect on decreasing pollution due to an increase

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in efficiency, it is likely that that effect would be cancelled out by the increase in pollution

from greater levels of production.

The Porter Hypothesis states that countries with more stringent environmental

regulations encourage greater innovation and productivity from firms (Porter). Greater

regulation would increase the short-term costs but would result in less pollution, lower

total costs, and greater productivity due to innovations in production made by the firms.

This has also been used to discredit the EKC, as companies would favor environments

where regulation requires them to not only be efficient, but to innovate (Zhou). In his

argument, Porter cites Germany and Japan who, at the time of the paper, had tough

regulations and greater GNP and productivity growth rates than the US which suggests that

firms are better off in more regulated environments. If firms prefer more regulated

environments than they would not seek out pollution havens.

Porter only makes these points in reference to developed countries, as the type of

FDI that is attracted to developing countries is attracted due to the PHH. While other

authors, such as Zhou, have used this argument in the context of all countries, Porter only

intended it to be used for developed countries. His argument as a whole is also undermined

by the theoretical argument that if firms could innovate and become more productive with

regulation, then they would do so without the regulation (Wagner). His hypothesis rests on

the idea that firms are not constantly looking for ways to improve without regulation

forcing them to do so.

Lastly, while Panayotou’s work is in support of the EKC, the models that he

generated can explain very little of the data with adjusted R2 values for SO2 per capita and

NO emissions of only 0.33 and 0.35. As his work is foundational for the EKC theory, this can

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call into question the validity of the whole EKC model. However, the empirical evidence

that I have put forward as well as the work of multiple other unreferenced authors

confirms that FDI in China currently has an initial increasing then decreasing positive

relationship with pollution. We can say for certain that at least the left half of the curve is

correct in that FDI increases pollution and that the relationship slows as a tipping point is

approached. After the tipping point, the effect on the levels of pollution may become

distorted which could account for the low adjusted R2 values.

In conclusion, studies on the current relationship between FDI and pollution in

China show that there is a positive nexus between FDI and pollution and that the current

trend follows the EKC. I have expanded on their work by describing the mechanisms

behind the positive relationship and have argued that the future of pollution in China due

to FDI cannot easily be predicted by the EKC due to the conflicting effects from increased

FDI.

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 Citations

Al-mulali, Usama, and Chor Foon Tang. "Investigating the validity of pollution haven hypothesis in the gulf
cooperation council (GCC) countries." Energy Policy 60 (2013): 813-819.

He, Jie. "Pollution haven hypothesis and environmental impacts of foreign direct investment: The case of
industrial emission of sulfur dioxide (SO2) in Chinese provinces." Ecological economics 60.1 (2006): 228-
245.

Hoffmann, Robert, et al. "FDI and pollution: a granger causality test using panel data." Journal of
international development 17.3 (2005): 311-317.

Liu, Qianqian, et al. "Does foreign direct investment affect environmental pollution in China's cities? A
spatial econometric perspective." Science of the Total Environment 613 (2018): 521-529.

Mihalache-O'Keef, Andreea, and Quan Li. "Modernization vs. dependency revisited: effects of foreign
direct investment on food security in less developed countries." International Studies Quarterly 55.1
(2011): 71-93.

Panayotou, Theodore. "Empirical tests and policy analysis of environmental degradation at different
stages of economic development." (1993).

Pao, Hsiao-Tien, and Chung-Ming Tsai. "Multivariate Granger causality between CO2 emissions, energy
consumption, FDI (foreign direct investment) and GDP (gross domestic product): evidence from a panel
of BRIC (Brazil, Russian Federation, India, and China) countries." Energy36.1 (2011): 685-693.

Porter, Michael E. "Essay." Scientific American 264 (1991): 168-168.

Ren, Shenggang, et al. "International trade, FDI (foreign direct investment) and embodied CO2
emissions: A case study of Chinas industrial sectors." China Economic Review 28 (2014): 123-134.

Wagner, Marcus. The Porter hypothesis revisited: a literature review of theoretical models and empirical
tests. CSM, 2003.

Zhou, Xiaoyan, Jie Zhang, and Junpeng Li. "Industrial structural transformation and carbon dioxide
emissions in China." Energy policy 57 (2013): 43-51.