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What Causes Inflows of Foreign Direct Investment to China: Some Empirical Evidence

Dimitrios Kyrkilis a ! Kostas "elent#as $ %antelis %antelidis c &a'iarchis Delis a


Department of Balkan, Slavic and Oriental Studies, University of Macedonia, 156, Egnatia Str , 5!" "6 #$essaloniki, %reece b Department of Economics, University of Macedonia, 156, Egnatia Str , 5!" "6 #$essaloniki, %reece c Department of Economics, University of &iraeus, '", (araoli and Dimitriou Str , 1'5 )! &iraeus, %reece

($stract During the three decades following the economic reforms of 1978, China became the FDI (Foreign Direct Investment) largest reci ient countr! among develo ing countries" China#s FDI annual inflows increased from $%D1&9 million in 1979 to $%D1',8(1 million in )&&7" FDI attraction is an im ortant com onent of China#s state olic! of economic transition to a mar*et s!stem of economic organisation" %ince the reform the +astern, Central and ,estern -egions of China have made remar*able rogress in economic develo ment" .he current a er aims at investigating what determines the inflow of FDI to China" .he research includes a literature review and a database anal!sis" / model has been built, com rising FDI e0 lanator! variables established as such b! theoretical and em irical studies su lemented b! variables a ro0imating s ecific economic, ro riate econometric institutional, and other characteristics of China" .he model is tested in its logarithmic form using a techni1ues for the eriod 1978 2 )&&7" /nnual data are derived b! various sources, mainl! b! the International 3onetar! Fund (I3F) and the China#s %tatistical 4earboo*s" .he results indicate that e0ce t certain economic variables such as 5 enness, 6roduction cost, 3ar*et %i7e, etc" institutional factors such as 6ro ert! -ights, 8egal %tate 6olic! on foreign investments and membershi to the ,orld .rade 5rganisation have some relationshi with incoming FDI to China"

*E+ classification,-.1, -.), O5) (ey/ords, Foreign Direct Investment (FDI) in China, Determinants of FDI

!) Introduction

Corres onding author" .el"9 : ('&) )'1& 891(7', e;mail9 *!r*ilis<uom"gr"

China has ado ted a gradual a

roach for its transition to a free mar*et economic

s!stem" In the almost three decades, which have ela sed since economic reforms were initiated in 1978, China became the largest FDI reci ient among develo ing countries absorbing in the 199&#s about half of all FDI inflows to all develo ing countries" .his is a notable success, considering that (a) China is a socialist countr! with olitical institutions that differ from those in ca italist develo ed countries and (b) there are still man! unresolved issues about both business and investment climate" =owever, FDI attraction is an im ortant com onent of China#s state olic! of economic o enness and liberalisation as well as economic growth and world mar*et integration (4ao and ,ei, )&&>)" FDI annual inflows were $%D1&9 million in 1979 com ared with $%D 1',8(1 million in )&&7" Figure 1 resents the evolution of inward FDI flows to China in the last three decades" .he figure shows clearl! that FDI inflow to China follow an increasing trend, which is more otent in the 198&#s rather than the following decades" ?evertheless, inward FDI ste s u in the first half of the 199&#s moving on a rather steadil! slo ing curve thereafter" Figure ! .he .rend of /nnual FDI Flowing into China, 1979;)&&7
1( 1) 1& log(FDI) 8 > ( ) & 1978 1981 198( 1987 199& 199' !ear 199> 1999 )&&) )&&@ )&&8

Sourse, I3F"

.he aim of the


a er is to e0 lore the determinants of inward FDI to

China" .here is an e0tensive literature both theoretical and em irical on the issue of

what determines FDI atterns in individual host countries" Dunning (198&, 199', and )&&1) argues that if both ownershi advantages) are s ecific advantages and internalisation resent then FDI is determined b! the distribution of location roduction costs, availabilit! of natural

advantages between otential reci ient countries" /s location advantages have been ro osed both mar*et si7e and growth, resources, availabilit! of an educated and trained labour force with ade1uate s*ills and s ecialisations, an institutional framewor* that guarantees a ro business climate, well organised mone! and credit mar*ets, well defined ro ert! rights, low transaction costs, etc" as well as factors related to geogra h!, histor! and culture, olitical stabilit! and attitudes" +m irical research, although e0tensive do not give final answers on the issue of what location factors determine inward FDI" In man! cases statistical results are fairl! fragile, some other research a ers have develo ed and tested h! otheses about when a otential determinant should be significant and when it should not be significant, and some others identif! of how data issues affect inter retation of the results" =owever, it seems there is some consensus that mar*et si7e andAor growth, roduction costs, 1ualit! of labour, and an institutional develo ment threshold are among the most im ortant FDI determinants'" +m irical research on what motivates FDI to flow into transition countries suggests that FDI o erations see* for countries with rather o en trade regimes, which allow multinational enter rises to build globall! andAor regionall! integrated vertical and horisontal value;chain networ*s" .his *ind of FDI o erations ma! be efficienc! see*ing andAor mar*et see*ing" .herefore, labour costs, mar*et si7e e0isting and availabilit! of local resources, and a business o u otential, ro er level and 1ualit! of state regulation of f FDI flows to develo ing countries

as maBor determinants of inward FDI (" %imilar results arise from

em irical research investigating the motives


/s ownershi s ecific advantages are defined those tangible andAor intangible assets owned b! individual firms e0clusivel!, the! are the roduct of im erfect mar*ets, and the! refer to technolog! and *now;how related not onl! to the roduction rocess per se but to all com lementar! roducts and services necessar! for the roduction and mar*eting of final roducts" Internalisation advantages are created when firms gain full rents from the further utilisation of alread! e0isting ownershi s ecific advantages b! using them internall!, within the same firm, rather than leasing them through regular mar*ets" Internal use means the creation of an internal mar*et that o erates under the fiat of the firm#s own administration s!stem and not at arm#s length rices" Internal use across national borders means the establishment of subsidiar! firms in host countries, i"e" FDI" ,hich countries would be chosen as host countries de ends on their location advantages, which should com lement both ownershi and internali7ation advantages of the investing foreign firms" 3 For a surve! see Caves (199>) and Clonigen ()&&@)" 4 %ee indicativel! 5+CD (199()D +C-D (199()D 6aliwoda (199@)D 8an*ers and Eenables (199>)D 3e!er (1998)D Cevan and +strin ()&&&)D Faribaldi et al ()&&1)D -esmini ()&&&)D 3erlevende and %choors ()&&()D G!r*ilis and 6antelidis ()&&8)"

including China@, though there is some controvers! on the ro er s ecification of the variables e0 ecting to determine inward FDI flows>" In the current a er a model is been constructed com rised b! FDI e0 lanator! variables ro osed b! both theor! and em irical re rather search, ertaining to s ecific economic and institutional characteristics of China" .he variables are s ecified ta*ing into account two criteria9 first, accurate a ro0imation of the theoretical variables as the former are indicated b! theor! and racticeD and, second, the availabilit! of time series data for the whole eriod of investigation, i"e" 1979 ; )&&7" .he a er includes a section anal!sing the e0 ected determinants of FDI inflows to China, their s ecifications, and the e0 ected sign of their relationshi with the de endent variable" .he ne0t section summarises the em irical model, resents the data set, and the econometric methodolog! for testing the h! otheses" .he results of the em irical a lication of the model and its discussion are resented in another section, while the final section includes the conclusions of the a er" *) &he Determinant of FDI Inflows 0ost 1ountry Openness FDI is defined as the transfer of a ac*age of com lementar! in uts, e"g" technolog!, ca ital, *now;how, intermediate in uts, etc" across national borders" In addition, multinational enter rises tend to develo regional or even global value chains, whose each art is located in different sites according to local com etitive advantages aiming at ma0imi7ing their global rofits rather the rofits of individual roduction units or subsidiaries in general" Eertical andAor hori7ontal roduction and mar*eting networ*s integrated within the same multinational enter rise give rise to intra;firm trade between subsidiaries of the same multinational enter rise but located in different countries" Intra;firm trade ertains to raw materials, intermediate in uts, technolog!, ca ital etc" it substitutes the traditional international trade between different legal entities located in different countries, and it re1uires the countries where the value roducing units are located to have established free trade regimes allowing for free im ort and e0 ort of goods and services necessar! for the o eration of the multinational value chains" It is e0 ected that free trade regimes would increase a countr!#s world mar*et integration through both e0 ort orientation and im ort e0 ansion, therefore the volume

%ee indicativel! -oot and /hmad (1979)D %chneider and Fre! (198@)D .revino et al" ()&&))D /dreoso;5#Callaghan and Cassid! ()&&')D 8iu et al" (1997)D 5+CD ()&&&)D %un et al" ()&&))D %wain and ,ang (1997)D ,ei and 8iu ()&&1) Hhang and %ong ()&&&)D Hhang ()&&1)D Hhang (199()D 6 For a discussion see Clonigen ()&&@)"

of its international trade, i"e" e0 orts economies of scaleD hence it advances

lus im orts would grow"

=owever, e0 ort otential

orientation e0 ands mar*et si7e, which in turn increases the utili7ation of

roductivit!, and, therefore, national out ut

grows" Increasing im orts, i"e" in uts of higher 1ualit! and variet!, modern technolog!, etc" contribute to the same end through im roving the com etitiveness of e0 orts and national roduction in general" .o ta*e account for the out ut growth, increasing o enness means that the volume of international trade e0 ands at a faster rate than the growth rate of FD6" In that res ect, a countr!#s degree of o enness ma! be measured b! the share of its international trade to the Fross Domestic 6roduct (FD6)" /nd because, the more o en national economies are the higher the robabilit! is for them to attract FDI, increasing degree of o enness is e0 ected to be associated with increasing FDI inflows" &roduction 1ost +fficienc! see*ing FDI including e0 ort latform FDI, as the! are investments underta*en within an intra;firm verticall! andAor hori7ontall! integrated global value chain see*ing cost minimi7ation is located according to favorable cost factors, among which labor has been e0tensivel! investigated as a location determinant of FDI es eciall! in emerging mar*ets7" /t the same time roduction costs ma! function as su lementar! motives of mar*et see*ing FDI, the otential growth" rimar! determinant of which is roduction mar*et si7e and its 8abor cost is one of the most im ortant

roduction cost items in cases of labor intensive andAor ca ital intensive

where technolog! is standardi7ed and embodied in ca ital goods, therefore, its transfer cost is low" 3ultinational enter rises tend to locate such roduction t! es mainl! in emerging mar*ets where wages are relativel! low and the labor force is in abundant su l!" In addition, because labor has received some minimum trainingD it is able to roductivit! levels com arable to o erate conventional technologies and to achieve international standards" 8abor cost ma! be a ro0imated b! the monthl! average wage" If it is acce ted that labor roductivit! differentials are minimal between different emerging locations but labor costs are distributed unevenl! between the same locations, it is e0 ected that increasing average wages in a average wages"

articular national location would tend to discourage

inward FDI to this countr!, diverting FDI flows to other locations with relativel! lower

%ee indicativel! Eernon (19>>, 1979)D Carrell and 6ain (199>)D Chantasasawat et al" ()&&')"

E2ternal Economies +0ternal economies in the form of availabilit! of infrastructure, out ut of s ecific industries that ma! be used as intermediate in uts through forward and bac*ward roduction lin*ages, and industrial out ut that e0 ands mar*et si7e e0 loitation of both economies of scale and agglomeration economies ermitting the ma! sha e

roduction costs reducing trans ortation costs and im roving mar*et access, increasing roductivit!, hence, com etitiveness, im roving the 1ualit! and rice of both h!sical and intangible roduction in uts" -educing roduction costs and im roving the com etitiveness of a countr!#s econom! ma! be a motive for inward FDI see*ing efficienc!" Cuilding e0ternal economies re1uires investments in infrastructure, in manufacturing, in business services, etc" Investments add to the e0isting level of ca ital stoc*, therefore, total gross ca ital formation ma! be used for measuring the level of e0ternal economies e0isting in a e0 ected to increase" Market Si3e 8arge domestic mar*ets attract mar*et see*ing FDI roducing standardi7ed goods roducts become ta*ing advantage of economies of scale" /s the ma*ing of such articular econom!" /s ca ital formation advances so it does the level of e0ternal economies, therefore, FDI inflows are

com etitive e0 orts activit! ma! come as a ne0t or arallel ste " .he inflow of FDI creates e0ternal economies either through increasing em lo!ment, labor roductivit!, and finall! wages8 or through the building of roduction clusters and agglomeration economies" .his mechanism is e0 ected to have a ositive effect on the growth of national out ut, thus increasing the mar*et si7e" In turn, that gives rise to the sco e of inward FDI roducing differentiated goods for both domestic and e0 orts mar*et, thus feeding another circle of increasing mar*et si7e and eventuall! increasing inward FDI9" 3ar*et si7e ma! be a ro0imated b! domestic consum tion" .he latter includes consum tion of im orted goods, thus the otential of im ort substitution through local roduction on the art of inward FDI is being ta*en into account" /lso, given that China

Foreign firms em lo! more advanced technolog!, achieve higher labor roductivit!, and a! higher wages than domestic firms, and through com etition and the demonstration effect technolog! is diffused to the rest of the host econom!, and domestic firms im rove labor roductivit!" For a discussion of this issue see G!r*ilis ()&&9)" 9 .here is evidence that there is a mutual causalit! between FDI inflows and mar*et si7e in the case of China" %ee .seng and Hebregs ()&&))"

is an emerging mar*et, inward FDI is more robable to be associated with labor and ca ital but of standardi7ed technolog! intensive roduction manufacturing consumer In that urchasing ower of the goods including consumer durables, and consumer electronics, even cars" res ect consum tion, and because it is de endent on the o ulation is a rather more accurate a rather more a .herefore,

ro0imation of mar*et si7e than FD6" It is ro riate a ro0imation for

ro riate to normali7e consum tion levels for an! o ulation increases" Increasing er ca ita consum tion is e0 ected to be ositivel!

er ca ita consum tion levels ma! be an a

consum tion levels"

related with increasing mar*et si7e and otential, then with FDI inflows" 4nstitutional -actors Flobali7ation is rogressivel! testing the abilit! of regional economies to adBust and maintain their com etitive edge" Coth the lessening of barriers to FDI freel! flowing into a countr! and olicies aiming at im roving both the domestic business climate and the institutional and legal framewor* regulating and under inning the smooth function of mar*ets, regulating and defining reducing red ta ro ert! rights, establishing trans arenc! and ing and corru tion la! a *e! role in attracting FDI to both transition

and develo ing counties, because it creates a business conducive environment and it contributes towards a countr!#s international com etitiveness b! reducing both mar*et frictions and failures, and transaction costs" .he Chinese government did ta*e a significant olic! ste in 1991;199) aiming at clarif!ing the legal environment of FDI, rela0ing government controls and reducing state intervention,


ractical assistance, as well as

olitical and legal

consistenc! " In addition, China#s accession to the ,orld .rade 5rgani7ation in )&&1 ;)&&) a resents a decisive and rather irrevocable ste towards further world mar*et integration and the establishment of a ro mar*et o en economic regime" For

ro0imating the two events two dumm! variables are introduced res ectivel!"

+) Empirical ,odel and Data .he revious discussion leads us to an e1uation that ta*es the following general -D4 I f (Open, &11O5, %1-, 678, DUM1, DUM.) ,here, -D4 I /nnual foreign direct investment flows into China" (1)

functional form9


For an anal!sis see Fu (1998)"

Open I 5 enness, defined as the ratio of total international trade (annual e0 orts lus annual im orts) to annual FD6" &11O5 I /nnual er ca ita consum tion which is a ro0! for mar*et si7e and otential" %1- I /nnual gross ca ital formation" 678 I /nnul average wage, which e0 resses labour cost" DUM1 I Dumm! variable defined as9 1 values for the !ears 199);)&&1 and & otherwise" 1991" DUM. I Dumm! variable defined as9 1 values for the !ears )&&);)&&7 and & otherwise" It a ro0imates China#s accession to the ,.5" It a ro0imates the maBor government olic! brea* in

Data for all variables, e0ce t both dummies are annual" %ummar! statistics of the variables included in this stud! are re orted in .able 1" /ll data, e0ce t these measuring /E, are sourced in the I3F#s ublication 4nternational -inancial Statistics, various !ears" .he source for /E, is 1$ina9s Statistical :ear;ook, various !ears" /ll values are e0 ressed in $% dollars" In cases that the initial data set was in China#s national currenc!, i"e" 4$/? values were recalculated in $% dollars using the bilateral average annual e0change rate" &a$le ! %ummar! %tatistics for the %am le 6eriod 1979;)&&7 Eariable FDI 5 en 6CC5? FCF /E, 3ean )8"@@> &,'( ')&,'@ ''(">>& 9)8,'( %td" Deviation ')"'>@ &,1@ )18,>) '@'")'& 77),&> Coef" of Eariation 1,1' &,(@ &,>8 1,&> &,8' 3inimum 1&9 &,11 1)7,)) 7>"7)9 '(8,'9 3a0imum 1'8"(1& &,>( 9@),>7 1"((&"@17 '")91,9

Sources, .he I3F International Financial %tatistics 4earboo* (various !ears) and China#s %tatistical 4earboo* (various !ears)"

In order to anal!7e the im act of the e0 lanator! variables, which are included in e1uation (1) on FDI inflows, the de endent variableD the following em irical model is estimated, wherein all variables e0ce t D$31 and D$3) are in logarithmic form9 log(-D4)t I Jo : J1 log(Open)t : J) log(&11O5)t : J' log(%1-)t : J( log(/E8)t : : J@ DUM1t : J> DUM.t : et, ())

where et is an error term and t denotes the !ear" /ll coefficients denote the elasticit! of the de endent variable with res ect each inde endent variable" .he econometric method for the em irical testing of the model is the standard 58% techni1ue, and the eriod of investigation is 1979 2 )&&7" /s discussed above, the coefficients J1, J), J', J@ and J> are e0 ected to be ositive, and J( is e0 ected to be negative" -) Estimation .esults .he estimation results of the e1uation ()) for FDI inflows to China are re orted in .able )" .he fit of the model is ver! good in terms of the significance of the -;statistic, its e0 lanator! ower is ver! high (99 ercent) and there are no signs of multicollinearit!" /ll e0 lanator! variables with the e0ce tion of the second dumm! that a ro0imates for China#s accession to the ,.5 are statisticall! significant" .he second ercent level of dumm! is marginall! statistical significant, i"e" almost at the 1@

significance" /ll statisticall! significant e0 lanator! variables have the e0 ected signs" 5verall, the em irical testing of the model verifies all h! otheses formulated in %ection )" &a$le * +stimates of Determinants of FDI Flows to China, 1979;)&&7 Eariable log 5 en log 6CC5? log FFC log /E, D$31 D$3) Constant Coefficient 1"7'@1 '"88&8 1"@88) ;("@19( &"@98'@ &"@(((9 ;&"@9&&( %td" +rror &")1>@ &"78'' &"@9>> &">1)> &"))(@ &"'>8) '"@71& t;%tatistic 8"&1@ ("9@@ )">>) ;7"'77 )">>> 1"(79 ;&"1>@ 6rob" &"&&& &"&&& &"&1( &"&&& &"&1( &"1@' &"87&

?o of observations I )9, /dBusted <. I &"99, S E I &"8(, -;statistic I @)&">(K&"&&&L D 8 I 1"97

/) Concluding .emarks

FDI in China is labour su

rimaril! efficienc! see*ing, i"e" it ta*es advantage of an abundant

l!, of low cost relativel! to international standards, and of ade1uate

roductivit!" Foreign investors aim at e0 orting but increasingl! so at servicing the domestic mar*et favoured b! the e0 anding mar*et si7e, es eciall! in terms of urchasing ower e0 ressed as rising er ca ita consum tion" 3ar*et see*ing FDI com lements efficienc! see*ing FDI" /n increasingl! o en trade regime allows free im orting of technologies, intermediate roduction in uts, and raw materials, therefore, it ermits local roduction to integrate within the global value chains of multinational enter rises, and ac1uire the 1ualit! and standards suitable for international mar*eting" .he countr!#s accession to the ,.5 guarantees its world mar*et integration and favours FDI integrated within global roduction and mar*eting networ*s" .he efficienc! of FDI in China advances due to the growing availabilit! of e0ternal economies in the host econom! in the form of both infrastructure and agglomeration economies" Finall!, government olicies aiming at im roving the institutional and legal framewor* either directl! through referential olicies favouring the free entr! of foreign investors andAor indirectl! creating ro; mar*et institutions that romote the smooth function of mar*ets and the investment climate not onl! su ort the inflow of FDI but the! advance the countr!#s com etitiveness, thus, enhancing its attractiveness to foreign investors" It is characteristic that in the aftermath of the introduction of new legislation in 199) FDI inflows ic*ed u greatl!, as it is shown in Figure )" .he average annual inflows were $%D '>1& million in the eriod rior to the introduction of the new legal regime in 199), i"e" the 1988 ;1991 eriod com ared with $%D )(@7>"7@ million in the conse1uent four !ears eriod, i"e" 199) 2 199@" In 199) alone FDI annual inflows grew more than )"@ times with res ect the revious !ear"

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