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Foreign Manufacturing Investment in China: The Role of Industrial Agglomeration and Industrial Linkages
Canfei He *
Abstract This paper investigates the forces that determine the industrial distribution of foreign manufacturing investment. It highlights the importance of industrial agglomeration and industrial linkage in attracting foreign investment to manufacturing industries.Using panel data for two-digit manufacturing industries in Beijing during the period of 1999 2004, this study finds that geographically agglomerated industries with strong intra-industrial linkages are indeed attractive to foreign investment. Previous foreign investment has led to the current industrial concentration of foreign investment. Investors also favor capital-intensive and technology-intensive industries, and they tend to be attracted to the most profitable and exporting industries, but avoid industries with high real labor costs and high entry barriers. Competitive local industries that possess comparative advantages are critical for attracting foreign investment. The existence of industrial clusters certainly enhances a city !s attractiveness to foreign investment.

Key words: Beijing, foreign direct investment, industrial agglomeration, industrial linkage JEL codes: F21, L60, R10

I. Introduction
With the liberalization of foreign direct investment (FDI) restrictions and the acceleration of economic reform, there has been a remarkable surge of FDI inflows into China since the late 1970s. As the largest developing host economy of FDI, China approved 552 942 foreign

* Canfei He, Associate Professor, Department of Urban and Regional Planning, Peking University, Beijing, China. Email: hecanfei@urban.pku.edu.cn. This research was supported by a grant from the Natural Science Foundation of China (No. 40401015).
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projects, with an accumulatively realized FDI value of US$622.43bn during the period of 1979!2005. In 2005, China attracted 18 percent of the US$334bn total FDI flowing into the developing economies (UNCTAD, 2006). Over the past two decades, there have been significant changes in the sectoral distribution of FDI in China. In the early 1980s, a large part of FDI in China was directed to geological prospecting, real estate and tourism. Foreign projects in manufacturing sectors were only concentrated in labor-intensive sectors, such as food, electronics, construction materials, textiles and toys. In the late 1980s, foreign manufacturing investment accounted for more than 70 percent of the total FDI flowing into China; investment continued to increase rapidly, reaching more than 80 percent around 1990 (NBS, 1991). With increasing experience in the Chinese market, and accumulated knowledge about China"s industrial structure, foreign firms extended their business scope into physical infrastructure facilities, including construction, energy, transportation and capital-intensive and technology-intensive machinery and equipment. Such investments involved more technological inputs, higher start-up costs, and larger financial commitments and, therefore, foreign firms faced greater risks. With China"s accession to the WTO, other sectors, especially services, have become popular to foreign investors. In China, FDI is highly agglomerated. It favors cities where targeted industries are fairly developed (Belderbos and Carree, 2002). Marshall (1898) proposes that the pool of specialized skilled labor, trade of intermediate inputs, and spillovers were driving forces of industrial agglomeration. Porter (2000) argues that industrial clusters increase the productivity of constituent firms, upgrade the capacity of cluster participants for innovation and productivity growth, and stimulate new business formation. Because of the lack of local knowledge, foreign investors encountered so-called #disadvantage of an alien status$ in China. Industrial clusters have helped foreign investors to attenuate these disadvantages (He, 2002, pp.1030). Therefore, foreign investors like to select geographically agglomerated industries with strong localized business linkages. Traditional FDI theories (Hymer, 1976; Kojima, 1978; Dunning, 1980) suggest that industrial distribution of foreign investment depends on comparative advantages in host economies and the ownership-specific advantages that multinational corporations (MNCs) hold. Dunning (2000) argues that factors influencing MNC industrial choices have gone beyond the natural endowments in the era of globalization, and that benefits from industrial agglomeration are playing an increasingly important role. Therefore, industrial distribution of FDI in host economies might be influenced by industry-specific external economies, which arise from geographical proximity of related firms and localized business linkages. There is some published literature concerning industrial patterns of FDI in host economies. Caves (1974), for instance, considers foreign firms" shares in Canadian and UK manufacturing industries in the 1960s and emphasizes the importance of intangible capital,
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advantages accruing from the operation of multiplant enterprises and the strength of entrepreneurial resources. Ratnayake (1993) concludes that foreign ownership of industry tends to be higher in skill-intensive and technology-intensive industries and those in industries enjoying high-level protection in Australia. Aswicahyono and Hill (1994) examine determinants of foreign investment shares in the Indonesian manufacturing sector and find product differentiation, technological capacity, skill intensity, absolute capital requirements, economies of scale and domestic policy regime to be significant in driving FDI. Driffield and Munday (2000) investigate the relationship between comparative advantages in UK industries and new inward investment into these industries. They find revealed industrial comparative advantage, R&D intensity, advertising intensity, presence of economies of scale, past profits, absolute sales and industrial growth to be important in attracting FDI. Furthermore, strong indigenous capital investment and industrial concentration have discouraged inward FDI. Because of data limitations, few studies have examined the industrial distribution of foreign investment in China. Huang (1999) determines that foreign enterprises tend to populate industries with a low ratio of #knowledge workers$, low value added per employee, high sales expenses, high product differentiation, and industries characterized by a large absolute capital requirement and significant economies of scale. Controlling for industrial characteristics, foreign enterprises populate those industries in which state-owned enterprises incur low profit margins, carry high debt on their books, and have a great degree of local control. Overall, the existing studies on industrial distribution of FDI concern mostly traditional industrial attributes, and have not paid sufficient attention to the importance of industrial agglomeration and industrial linkages. Taking Beijing as an example, the present study investigates the determinants of industrial distribution of foreign manufacturing investment and stresses the role of industrial agglomeration and industrial linkages in attracting FDI. This paper is structured as follows. Section II presents a theoretical perspective on the industrial distribution of FDI. Section III discusses the geographical agglomeration of manufacturing industries in Beijing. Section IV investigates determinants of industrial distribution of foreign manufacturing industries, highlighting the role of industrial agglomeration and linkages. Finally, our major findings and conclusions are provided in Section V.

II. Industrial Distribution of Foreign Direct Investment: A Theoretical Perspective

Theoretically, industrial distribution of FDI depends on the monopolistic advantages of
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MNCs or comparative advantages in host economies (Hymer, 1976; Kojima, 1978; Dunning, 1980, 2000). In the era of globalization, the importance of resource endowments has been declining, whereas localized industrial competitive advantages have become increasingly important for industrial development. According to Porter (1990), competitive advantages of local industries depend on four factors, which can be effectively represented by a diamond-shaped diagram (see Figure 1). These four factors are factor conditions, demand conditions, context for firm strategy and rivalry, and presence of competitive related and supporting industries. In addition, external factors and government also play an important role in influencing industrial competitive advantages. Dunning (1993) criticizes Porter for ignoring the significant role of MNCs in improving industrial competitive advantages and internationalize Porter"s diamond by adding MNC influence. The original interrelated influences in Porter"s diamond in the host economies all affect the investment decisions of foreign investors, including decisions regarding location, entry mode and industrial selection (see Figure 1). The present study emphasizes the importance of competitive-related and supporting industries in attracting foreign investment. Clustered firms benefit significantly from a pool of skilled workers, trade of intermediate inputs, and easy flow of information and ideas among firms (Marshall, 1898). More specifically, Henderson (1986) points out that localized external economies relate to four elements: (i) economies of intra-industry specialization where increased industry size permits greater specialization among firms in addition to a greater availability of specialized intermediate inputs suppliers, business services and financial markets; (ii) labor market Figure 1. Local Industrial Competitiveness and Multinational Corporations (MNCs)
Chance
Related and supporting industries

MNCs

Factor conditions

Demand conditions

Firm strategy and rivalry

Sources: Porter (1990) and Dunning (1993).

Govern ment

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economies resulting from a larger pool of trained, specialized workers reduce searching costs for skilled labors; (iii) economies of scale for networking among firms; and (iv) economies of scale in providing public goods and services that have been tailored to the needs of a specific industry. Venables (1996) identifies vertical linkages between upstream and downstream firms as forces for agglomeration of industries in one location. Upstream firms are close to downstream firms as these are the main sources of demand for their goods. Downstream firms want to be close to a large number of upstream firms because this allows them to find cheaper intermediate inputs. For example, car components firms are located close to car assembly firms as a result of demand linkages and car assembly firms are close to car components firms because of cost linkages. Demand and cost linkages reinforce each other, leading to the agglomeration of car components and car assembly firms in one location (Amiti, 1998). Geographical proximity of raw material suppliers, intermediate goods and professional services can significantly lower production and transaction costs, and improve productivity and industrial competitiveness (Porter, 2000). Benefits from the geographical proximity and business linkages of related firms are particularly important for foreign investors, whose decision-making processes are considerably affected by internal and external uncertainties. Business risks usually arise from inadequacy of information or from an unpredictable business environment. Unlike domestic investors, foreign investors encounter significant disadvantages, such as lack of local knowledge of social, political and economic conditions and lack of stable intermediate suppliers. Foreign investors face additional business risks in transitional economies because of unpredictable policy and institutional changes. Information asymmetry and business uncertainties, however, can be attenuated by entering geographically agglomerated industries with strong localized business linkages (He, 2002). Studies have showed that foreign investors could significantly benefit from industrial clusters (Head and Ries, 1996; Kinoshita and Mody, 2001; Belferbos and Carree, 2002; Yeung et al., 2006). First, foreign investors could gain market information from related firms and other foreign firms, especially information from the earlier entrants concerning the performance of labor markets, the foreign investment regulatory policies, partnership selection strategies, and access channels to the local labor market, distribution channels of commodities, infrastructure and raw materials required for the business operation (Kinoshita and Mody, 2001; He, 2003). Second, foreign firms can realize economies of scale by taking advantage of business networks as suppliers or buyers, thus lowering costs through localized trade linkages, and avoiding uncertainties of input supply and market demand (Belderbos and Carree, 2002; Yeung et al., 2006). Third, foreign firms can share transportation and telecommunication infrastructure and professional services, such as training, logistics
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and governmental services, with related firms (Head and Ries, 1996). Finally, geographically agglomerated industries tend to develop strong local business linkages. Therefore, foreign investors could easily join localized business networks by entering these industries, reducing transaction costs and business risks (Yeung et al., 2006) The above discussion shows that industrial agglomeration and linkage could reduce production and transaction costs and business risks through market and nonmarket mechanisms. Foreign investors favor geographically agglomerated industries and those with strong localized business linkages to attenuate their disadvantages of being foreigners or late-comers. The following section will test this theoretical proposition using foreign manufacturing investment data for Beijing during the period of 1999!2004.

III. Geographical Agglomeration of Manufacturing Industries in Beijing

1. Measurement of Industrial Agglomeration This section applies the index proposed by Maurel and Sedilot (1999) to quantify the degree of industrial agglomeration. This index has a more natural specification than other similar indices, and it is derived directly from the probability model (Maurel and Sedilot, 1999). The empirical index proposed by Maurel and Sedilot (1999) is as follows:
MS =
^

( si2 xi2 ) /(1 xi2 ) H

i i i

1 H

GMS H 1 H

(1)

where xi and si are the fractions of aggregate employment and industry employment in question located in region i. H is the industry Herfindahl index, defined as: H = z 2j , where
j =1 N

z j is the share of employment in plant j. G MS measures the raw geographical concentration of industries. A positive value of means that clustering forces dominate dispersing forces and related plants are agglomerated. A negative value of indicates that plants are scattered. The index can be interpreted as the excess of raw geographic concentration on productive concentration and, therefore, can be regarded as an index of industrial geographical agglomeration, controlling for the distribution of employment size in enterprises (Maurel and Sedilot, 1999). With this index, an industry will not be considered as localized only because its employment is concentrated in a small number of plants.

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2. Testing Geographical Agglomeration of Manufacturing Industries in Beijing MS , GMS and H were computed for each of two-digit, three-digit and four-digit industries at the county level using data from the 1996 and 2001 census of basic units in Beijing (NSB, 1998, 2003). Strong positive correlations between GMS and H are confirmed, indicating that geographic concentration of industries can be largely accounted for by industrial concentration. The correlation coefficients between GMS and H in 1996 were 0.85 and 0.86 in 2001 for three-digit classified industries and 0.90 in both 1996 and 2001 for four-digit classified industries. The correlation coefficient between MS and H was much weaker and insignificant. Table 1 presents the overall agglomeration of Beijing manufacturing industries. The more disaggregated industries are more geographically agglomerated. In 1996, the mean values of MS were 0.07, 0.08 and 0.09 for two-digit, three-digit and four-digit classified industries, respectively. The mean values of MS in 2001 were 0.04, 0.05 and 0.07. They are greater than 0.02, indicating that manufacturing industries in Beijing are fairly agglomerated. On average, industries were more dispersed in 2001. Based on classification standards proposed by Ellison and Glaeser (1997), approximately 12.36 percent of four-digit industries belonged to the category of #somewhat agglomerated$ (0.02 < < 0.05) and 35.74 percent of them were #very agglomerated$ ( > 0.05) in 1996, whereas the corresponding values were 11.41 and 36.88 percent in 2001. Industrial distribution of foreign manufacturing investment and industrial agglomeration at the two-digit level was the main focus of the present paper and the corresponding MS Table 1. Result of Agglomeration Indices at Various Disaggregated Levels
MS?
4-digit 1996 2001 3-digit 1996 2001 2-digit 1996 2001 Mean 0.09 0.07 0.08 0.05 0.07 0.04
MS

Number of industries Kurtosis 6.24 9.59 8.36 14.26 16.10 21.00

MS

Skewness 2.46 2.79 2.62 3.33 3.82 4.32

<0

0<

MS

< 0.02

0.02 <

MS

< 0.05

MS

> 0.05 188 194 62 50 10 4

192 209 45 62 4 6

80 62 30 32 10 12

65 60 28 21 5 7

Source: Calculated by the author.

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are listed in Table 2. At the county level, there were 25 industries with positive MS in 1996. The most spatially agglomerated industries include petroleum refining and coking, ferrous metal processing and smelting, electronics and telecommunication equipment, timber processing, textile, medical and pharmaceutical products, special purpose machinery, transportation equipment, furniture making, and the chemical industry, all with MS greater than 0.05. Some industries are characterized by strong internal economies of scale, stimulating the formation of industrial clusters around the core enterprises. For instance, many enterprises located around the Shoudu Iron and Steel Company conduct activities associated with ferrous metal processing and smelting industry in the Shijingshan district. Others have strong industrial linkages, and benefit from localized linkages and external economies of scale, stimulating related firms to agglomerate in a given area. Electronics and telecommunication equipment manufacturing is one such industry. Tobacco processing, beverages, chemical fiber, papermaking and paper products and miscellaneous products are the most spatially dispersed. These industries are either close to their localized markets or they require local resource inputs or support by local governments. During the period between 1996 and 2001, most manufacturing industries in Beijing became more spatially dispersed. In 2001, only ferrous metal processing and smelting, electronics and telecommunication equipment, petroleum refining and coking and special purpose machinery were #very agglomerated$, with MS greater than 0.05. The number of #very agglomerated$ industries was 10 in 1996. The MS for petroleum refining and coking fell from 0.78 in 1996 to 0.13 in 2001. Chemical materials and products, medical and pharmaceutical products, timber processing and furniture making, textile, and transportation equipment moved from the category of #very agglomerated$ to #somewhat agglomerated$. On the one hand, the government in Beijing worked hard to relocate manufacturing plants from the inner city to the suburbs during this period, leading to the dispersion of industries. On the other hand, every county or district was eager to develop high-technology industries and modern manufacturing industries and they made significant efforts to attract domestic and foreign investments to their industrial parks. For example, transportation equipment industries in Beijing are located in Shunyi, Huairou, Changping, Chaoyang and Daxing. The electronic equipment industry has been favored by all industrial parks in Beijing. Some other industries have been more agglomerated since 2001, including chemical fiber, rubber products, ferrous metal processing and smelting, metal mineral products, general-purpose machinery, special purpose machinery, and telecommunication and electronic equipment industries. These industries are characterized by strong internal and
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Table 2. Industrial Agglomeration of Two-digit Manufacturing Industries in Beijing

Industry Food processing Food manufacturing Beverage Tobacco processing Textiles Clothing and other fibers Leather and fur Timber processing Furniture making Paper making and products Publishing and copying Cultural, education and sports goods Petroleum refining and coking Chemical materials and products Medical and pharmaceutical products Chemical fiber Rubber products Plastic products Non metal mineral products Ferrous metal smelting and pressing Non ferrous metal smelting and pressing Metal mineral products General purpose machinery Special purpose machinery Transportation equipment Electrical machinery and meters Electronics and telecommunication equipment Instruments and meters Miscellaneous products Code 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 40 41 42 43 "MS (1996) 0.0066 !0.0010 !0.0175 !0.0523 0.0676 0.0141 0.0476 0.1254 0.0707 0.0029 0.0139 0.0292 0.7828 0.0566 0.0917 !0.0005 0.0067 0.0188 0.0031 0.3759 0.0346 0.0078 0.0155 0.0742 0.0728 0.0214 0.1503 0.0350 0.0000 Rank 22 27 28 29 9 18 11 4 8 24 19 14 1 10 5 26 21 16 23 2 13 20 17 6 7 15 3 12 25 "MS (2001) 0.0040 !0.0177 !0.0083 !0.0957 0.0465 !0.0037 0.0131 0.0253 0.0390 0.0015 0.0073 0.0075 0.1316 0.0228 0.0137 0.0220 0.0136 0.0055 0.0013 0.6505 !0.0202 0.0083 0.0176 0.0948 0.0440 0.0060 0.1599 0.0261 !0.0042 Rank 21 27 26 29 5 24 15 9 7 22 18 17 3 10 13 11 14 20 23 1 28 16 12 4 6 19 2 8 25

Source: Calculated by the author based on Equation (1).

external economies of scale. Geographical clustering improves productivity and lowers production and transaction costs. In short, some manufacturing industries in Beijing are more spatially agglomerated than others. Because of the cost-savings from geographical proximity to related firms, agglomerated industries might be more competitive in attracting foreign investment. The following section examines the industrial pattern of foreign manufacturing investment and tests the significance of industrial agglomeration for industries to attract foreign investment.

IV. Industrial Distribution of Foreign Manufacturing Investment in Beijing

In 2004, Beijing actually utilized US$1.127bn of FDI in its manufacturing industries, accounting for 36 percent of total FDI (Beijing Statistical Bureau, 2005). Up to 2004, the major FDI recipients in Beijing included electronics and telecommunication equipment,
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30.00

Figure 2. Industrial Distribution of Cumulated Foreign Direct Investment (FDI) in Manufacturing Industries in Beijing (Up to 2004)
Percent

Percentage
Industrial Share Industrial share of Contracted of contracted Foreign foreign Projects projects Industrial Share of of Contracted FDIFDI Industrial share contracted

25.00

20.00

15.00

10.00

5.00

0.00 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 40 41 42 43

Industrial code

Sources: Beijing Municipal Burea of Commerce (2004) and Beijing Municipal Bureau of Industrial Development (2005). Note: See the industrial code listed in the second column in Table 2.

electrical machinery and equipment, transportation equipment, special-purpose equipment, medical and pharmaceutical products, chemical materials and products, non-metal mineral products and food manufacturing. Figure 2 shows the industrial distribution of cumulative contracted foreign projects and contracted foreign investment up to 2004. Clearly, foreign investments in Beijing strongly favor capital-intensive and technology-intensive industries, which are geographically agglomerated with strong localized business linkages. During the period between 1999 and 2004, foreign manufacturing investment also flowed mainly to electronics and telecommunication equipment, medical and pharmaceutical products, transportation equipment and machinery for special purposes, which is consistent with Beijing"s comparative advantages in market size, technology, information, services and highly educated and productive labor. The question is, why are some industries more attractive to foreign investment than others. This deserves further investigation. 1. Model Specification and Variables The purpose of this subsection is to explain the industrial variation of foreign manufacturing investment by examining variables associated with industrial agglomeration and industrial linkages and other industrial attributes. Based on discussion in Section II, we assume that
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the amount of FDI flow to industry i in a particular year t is a function of a number of industrial attributes that are likely to influence foreign investors" industrial choice. The model takes the following form: ; (2)
FDI it = f ( MSit 1, INTRAit 1 , INTERit 1 , EXPTit 1 , KLit 1 , LCOSTit 1 , CFDI it 1, PRFTit 1 , HERTit 1 )

that is, industrial distribution of FDI depends on industrial agglomeration (MS), intraindustrial linkage (INTRA), inter-industrial linkage (INTER), export intensity (EXPT), fixed asset per employee (KL), effective wage rate (LCOST), share of industrial output by foreign enterprises (CFDI), sales profit margin (PRFT) and industrial concentration (HERF) ( see Table 3). To avoid the endogeneity issue, all explanatory variables are lagged by 1 year. This analysis focuses on the industrial FDI flows from 1999 to 2004. As discussed above, foreign investors might favor agglomerated and linked industries. To test this hypothesis, we introduce three variables into the empirical model. MS quantifies the degree of industrial agglomeration. INTRA and INTER measure the intra-industrial and inter-industrial linkages, respectively. All three variables are expected to have positive regression coefficients. The census of basic units was conducted only in 1996 and 2001 and, therefore, MS cannot be computed for the years in between. Hence, we take the 1996 MS values as the variable MS during the period of 1999!2001 and the 2001 MS values for the period of 2002!2004. The variables of INTRA and INTER during the period 1999!2002 were computed based on the Beijing 1997 input!output table and those in 2003 and 2004 were calculated based on the Beijing 2002 input!output table. INTRA is defined as the ratio of intermediate inputs from an industry to total inputs. INTER is the average of two shares; that is, the share of intermediate inputs from other manufacturing industries in total inputs and the share of intermediate sales to other manufacturing industries in total outputs. Table 3. Definitions of Explanatory Variables and Their Expected Signs
Variables MS INTRA INTER EXPT KL LCOST CFDI PRFT HERF Definitions MS index Intermediate inputs from own industry/total inputs ([Intermediate inputs from other manufacturing industries/total inputs] + [intermediate sales to other manufacturing industries/ total output])/2 Exports/gross industrial output Total fixed assets/total employee Average wage/value added per employee Industrial output by foreign enterprises/gross industrial output Sales profits/sale revenues Herfindal index of plant employees Expected sign + + + + + ! + + !

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It is believed that FDI might be concentrated in industries with matched comparative advantages. The present paper introduces and examines another three variables to study industrial comparative advantages in Beijing: EXPT, KL and LCOST. EXPT is the ratio of exports to gross industrial output, KL represents the fixed assets per employee, and LCOST the ratio of average wage to value added per employee. An exporting industry has significant revealed comparative advantage in international markets. Industries with larger fixed asset per employee are usually capital-intensive and technology-intensive. LCOST quantifies real labor cost: productive but low-cost workers are one of the key sources for comparative advantages. Positive coefficients on EXPT and KL and a negative coefficient on LCOST indicates that the industries have comparative advantages and are attractive to foreign investment. Past FDI performance also influences an industry"s attractiveness to new FDI. There are many possible reasons why FDI might be concentrated in some industries. There might be sequential investments from foreign investors and investments from followers who have established strong business linkages with the early entrants. The previous foreign investment also has demonstration effects, information spillover effects and experience effects, which can drive new foreign investments to particular industries (Liu, 1990). To test the significance of past FDI performance, the present study quantifies FDI presence in an industry as the ratio of industrial output by foreign enterprises to gross industrial output (CFDI), which is expected to have a positive coefficient. In addition, FDI is profit-driven. Foreign investors prefer profitable industries in host economies. Industrial profitability has been included in the model and is defined as the ratio of sale profits to sale revenues (PRFT). This variable is expected to have a positive effect. Finally, foreign investors also encounter a variety of entry barriers, including restricted industrial policies, economies of scale and industrial concentration. Industries with significant economies of scale require foreign investors to make more resource commitments in the host economies, which increases investment risk. Foreign investors might face more difficulties in entering a domestic market dominated by several large companies. Industrial policies are rather difficult to quantify. The present study introduces the Herfindahl index (HERF), which measures the distribution of plant employee size in an industry to represent entry barriers. The larger the Herfindahl index value, the greater the entry barrier. Foreign investors tend to avoid industries with high entry barriers. Like the variable MS, HERF can only be computed for the years 1996 and 2001. Following the treatment for the variable of MS, the 1996 Herfindahl index values of are used for HERT from 1999 to 2001 and the 2001 Herfindahl index for HERT from 2002 to 2004. The present study took the yearly contracted FDI inflows and contracted foreign
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projects in 28 two-digit manufacturing industries during the period of 1999!2004 as the dependent variable. FDI data were collected from various issues of the Survey of Beijing Foreign Economic Relations and Trade (Beijing Municipal Bureau of Commerce, 2004) and the Beijing Industrial Yearbook (Beijing Municipal Bureau of Industrial Development, 2005). The present study considers the following panel data regression model:
FDI it = 1 MSit 1 + 2 INTRAit 1 + 3 INTERit 1 + 4 EXPTit 1 + 5 KLit 1 + , 6 LCOSTit 1 + 7CFDI it 1 + 8 PRFTit 1 + 9 HERTit 1 + i + t + it

(3)

where i denotes industry, t denotes time, i and t the unobservable industrial and time effect, and it the residual stochastic disturbance term. There are three statistical models for a pooled time-series and cross-sectional dataset: the OLS model, the random effects model (REM/GLS) and the fixed effects model (FEM/LSGV). The choice between OLS and LSGV/GLS is made based on the traditional Lagrange multiplier (LM) test, whereas selection between LSGV and GLS is based on the Hausman"s test. The following subsection presents the regression results based on the estimations of OLS, LSGV and REM. 2. Empirical Results Table 4 presents the Spearman correlation coefficients between explanatory variables. The correlation coefficient between KL and LCOST is !0.74, indicating that capital-intensive and technology-intensive industries bear lower real labor costs, and other correlations are fairly small. To avoid the collinearity problem, KL and LCOST are included separately and the model has been computed twice. Because the two separate model runs produced similar results, only the model results with the LCOST variable are reported here. The estimations were performed based on OLS, GLS and LSGV methods, but LM tests suggest that either GLS or LSGV estimation was necessary. Our analysis is based on the OLS results. Breusch! Pagan tests indicate the existence of heteroskedasticity and results are corrected using the White"s heteroskedasticity method. The F-tests are significant at the 0.01 level, indicating that the explanatory variables explain the industrial variation of foreign investment in Beijing. In particular, the model could account for some 27 and 37 percent of industrial variation in contracted FDI and contracted foreign projects, respectively. Table 5 summarizes the estimated results. Statistical results suggest that industrial agglomeration improves an industry"s attractiveness to foreign investment. This is shown by the highly significant and positive coefficients on MS. The more geographically agglomerated industries can attract more FDI, suggesting that foreign investors take advantage of geographical proximity of related firms in their decisions. INTRA also has a very significant positive coefficient in all model
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Table 4. Spearman Correlation Coefficients between Independent Variables

MS INTRA INTER CFDI EXPT KL LCOST PRFT HERT MS 1.00 INTRA 0.15 1.00 INTER 0.11 !0.17 1.00 CFDI !0.13 0.08 !0.28 1.00 EXPT 0.10 !0.09 0.06 0.40 1.00 KL 0.08 0.45 !0.12 !0.23 !0.38 1.00 LCOST 0.17 !0.26 0.19 0.06 0.33 !0.74 1.00 PRFT !0.25 !0.19 0.15 !0.07 !0.18 0.12 !0.19 1.00 HERT 0.23 0.13 !0.02 !0.46 !0.15 0.38 !0.13 0.01 1.00

Sources: Calculated by the author.

Table 5. OLS, GLS and LSGV Regression Results

Variable Constant MS INTRA INTER EXPT LCOST CFDI PRFT HERF Number of observations R2 F D-W B-P Test Contracted FDI inflows REM FEM OLS (GLS) (LSGV) !1698.92 !2087.25 13926.28*** 13890.67*** 14006.11** *** *** 15320.37 15365.45 15372.18** !2745.18* !2880.44* !2929.50** 10129.38 9206.12 8871.18 !16858.23** !15829.44** !15452.74** 14722.75*** 14786.98*** 14811.90** 26666.12 28330.41 28803.06*** !2459.47 !2225.36 !2145.27 168 0.27 7.31*** 2.00 559.63*** LM = 0.20; 168 0.27 7.31*** 168 0.29 4.81*** Contracted foreign projects REM FEM OLS (GLS) (LSGV) 11.07 11.06 23.45** 23.47** 23.86*** ** ** 18.63 18.63 18.49** !11.46*** !11.47*** !11.64*** 32.57** 32.49** 31.05** !47.28*** !47.17*** !45.20*** 24.87*** 24.88*** 24.95** 102.35*** 99.18*** 100.46*** !31.45** !31.44** !31.22*** 168 0.37 11.74*** 1.79 42.42*** LM = 2.74*; 168 0.37 11.74*** 168 0.37 7.04***

Hausman = !0.05

Hausman = 0.98

Notes: Results corrected for heteroskedasticity. *, **, ***, represent significance at the 0.10, 0.05 and 0.01 levels, respectively. D-W, Durbin! Watson; B-P, Breusch ! Pagan; REM, random effects model; FEM, fixed effects model.

specifications, indicating that foreign investors strongly favor industries with significant localized intra-industry linkages. For instance, the electronics and telecommunication equipment industry in Beijing has many linked sub-industries through the value chain. Industrial clusters of electronics provide a large number of suppliers and also attract the largest share of inward FDI flows in Beijing . Surprisingly, stronger inter-industrial linkages occur to discourage inward FDI, as shown by the significant negative coefficients on INTER. In Beijing, industries with strong inter-industrial linkages are resource-based industries, such as ferrous metal processing and smelting, nonmetal mineral products, rubber and plastic products, petroleum processing and coking. These industries currently hold certain scale advantages, but are not suitable
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for Beijing"s development in the long term. Beijing is trying to become a global city by encouraging the development of professional services, high-technology industries and environmentally-friendly industries. Therefore, to reduce business risks, foreign investors will try to avoid investing in resource-based industries because these industries demand substantial resource commitments, and foreign investors might also encounter significant institutional and policy barriers. Statistical results show that geographical agglomeration of related firms is attractive to FDI and strong localized business linkages among related firms improve an industry"s attractiveness to FDI. Foreign investors tend to look closely at industrial competitive advantages in their investment decisions. These advantages are closely related to localization economies and demand or cost linkages. The development of automobile and electronics and telecommunication equipment manufacturing industries illustrates the importance of agglomeration and localized business linkages in attracting FDI. For instance, the Shunyi district has attracted more than 30 suppliers of car components and parts since the introduction of Korean Hyundai in 2002. Some are from South Korea and have established strong business linkages with Korean Hyundai. The Xinwang industrial park in Beijing Economic and Technology Zone houses a manufacturing cluster of mobile telecommunication equipment centered on Nokia (Yeung et al., 2006). Among the variables associated with industrial comparative advantage, EXPT has the expected positive coefficients in all model specifications, but higher shares of exports are only significantly associated with more contracted foreign projects. This indicates that revealed industrial comparative advantages might influence foreign entry but not the amount of investment. The negative coefficients on LCOST but positive coefficients on KL suggest that foreign investors avoid industries with high real labor costs or low productivity, and significantly favor capital and technology intensive industries. The investment decisions of foreign investors are consistent with Beijing"s comparative advantages embedded in a highly-educated and skilled labor force, and in technology and capital. Such comparative advantages make it possible to attract global giants like Hyundai, Nokia, Siemens, Motorola, Sony, HP and IBM. The combination of comparative advantages and monopolistic advantages of multinational corporations together determines the industrial distribution of foreign manufacturing investment in Beijing. This is consistent with the argument in Dunning"s eclectic paradigm (Dunning, 1980, 2000). Statistical results show that higher shares of industrial output by foreign enterprises help an industry to attract more FDI. An industry"s past FDI performance indeed influences its potential to attract new foreign investment. The industrial specific FDI cumulative effect is associated with the evolutionary entry strategy of many MNCs, localization economies and spillover effects. The coefficient on PRFT is positive and significant, suggesting that foreign investors favor profitable industries, confirming the profit-driven behavior of MNCs
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in Beijing. However, foreign investors do encounter significant entry barriers. Industrial concentration significantly discourages foreign investors"entry in Beijing, as shown by the negative coefficients on HERT. Monopolistic industries such as tobacco processing, ferrous metal processing and smelting, petroleum processing and coking are difficult for foreign investors to enter because of institutional and policy restrictions imposed by the Chinese Government, and market barriers.

V. Conclusions
Foreign direct investment in China has been a hot research topic since the early 1990s. However, insufficient attention has been paid to the issue of industrial distribution of FDI. The present study illustrates the importance of industrial agglomeration and localized business linkage in attracting foreign investment. This study finds that up to 2004 the major FDI recipients in Beijing were electronics and telecommunication equipment, electric machinery and equipment, transportation equipment, special-purpose equipment, medical and pharmaceutical products, chemical materials and products, nonmetal mineral products and food manufacturing. Using a panel dataset of two-digit manufacturing industries in Beijing during the period of 1999!2004, the present study finds that geographically agglomerated industries with strong intra-industrial linkages have attracted most of the foreign investment. Previous foreign investment has had demonstration effects, information spillover effects and linkage effects, leading to industrial concentration of foreign investment. The marriage between comparative advantages in the host economies and MNCs" monopolistic advantages has driven FDI into capital-intensive and technology-intensive industries and to those with significant revealed comparative advantages. Foreign investors are drawn to the most profitable and to exporting industries, but avoid industries with high effective wage rates and high entry barriers. The present study supports the argument that competitive and comparative advantages of local industries are critical for attracting foreign investment and the presence of industrial clusters enhances a city"s competitiveness to attract investments from abroad. The empirical results have important policy implications. To further attract foreign investments, especially those from MNCs, the local governments should cultivate business networks, promote local business linkages, and encourage geographical agglomeration of related firms. References
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(Edited by Zhinan Zhang)

2008 The Author Journal compilation 2008 Institute of World Economics and Politics, Chinese Academy of Social Sciences