What Causes Inflows of Foreign Direct Investment to China: Some
Empirical Evidence
Dimitrios Kyrkilis a,1 , Kostas Velentzas b, Pantelis Pantelidis c, Taxiarchis Delis a
a
Department of Balkan, Slavic and Oriental Studies, University of Macedonia, 156, Egnatia Str.,
540 06 Thessaloniki, Greece
b Department of Economics, University of Macedonia, 156, Egnatia Str., 540 06 Thessaloniki,
Greece
c Department of Economics, University of Piraeus, 80, Karaoli and Dimitriou Str., 185 34
Piraeus, Greece
Abstract
During the three decades following the economic reforms of 1978, China became the
FDI (Foreign Direct Investment) largest recipient country among developing countries.
China’s FDI annual inflows increased from USD109 million in 1979 to USD13,841
million in 2007. FDI attraction is an important component of China’s state policy of
economic transition to a market system of economic organisation. Since the reform the
Eastern, Central and Western Regions of China have made remarkable progress in
economic development.
The current paper aims at investigating what determines the inflow of FDI to
China. The research includes a literature review and a database analysis. A model has
been built, comprising FDI explanatory variables established as such by theoretical and
empirical studies supplemented by variables approximating specific economic,
institutional, and other characteristics of China.
The model is tested in its logarithmic form using appropriate econometric
techniques for the period 1978 – 2007. Annual data are derived by various sources,
mainly by the International Monetary Fund (IMF) and the China’s Statistical Yearbooks.
The results indicate that except certain economic variables such as Openness,
Production cost, Market Size, etc. institutional factors such as Property Rights, Legal
State Policy on foreign investments and membership to the World Trade Organisation
have some relationship with incoming FDI to China.
JEL classification:F21, F23, O53
Keywords: Foreign Direct Investment (FDI) in China, Determinants of FDI
1
Corresponding author. Tel.: + (30) 2310 891473, e-mail: kyrkilis@uom.gr.
1
1. Introduction
China has adopted a gradual approach for its transition to a free market economic
system. In the almost three decades, which have elapsed since economic reforms
were initiated in 1978, China became the largest FDI recipient among developing
countries absorbing in the 1990’s about half of all FDI inflows to all developing
countries. This is a notable success, considering that (a) China is a socialist country
with political institutions that differ from those in capitalist developed countries and (b)
there are still many unresolved issues about both business and investment climate.
However, FDI attraction is an important component of China’s state policy of economic
openness and liberalisation as well as economic growth and world market integration
(Yao and Wei, 2006). FDI annual inflows were USD109 million in 1979 compared with
USD 13,841 million in 2007. Figure 1 presents the evolution of inward FDI flows to
China in the last three decades. The figure shows clearly that FDI inflow to China
follow an increasing trend, which is more potent in the 1980’s rather than the following
decades. Nevertheless, inward FDI steps up in the first half of the 1990’s moving on a
rather steadily sloping curve thereafter.
Figure 1
The Trend of Annual FDI Flowing into China, 1979-2007
14
12
log(FDI)
10
8
6
4
2
0
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
year
Sourse: IMF.
The aim of the present paper is to explore the determinants of inward FDI to
China. There is an extensive literature both theoretical and empirical on the issue of
2
what determines FDI patterns in individual host countries. Dunning (1980, 1993, and
2001) argues that if both ownership specific advantages and internalisation
advantages2 are present then FDI is determined by the distribution of location
advantages between potential recipient countries. As location advantages have been
proposed both market size and growth, production costs, availability of natural
resources, availability of an educated and trained labour force with adequate skills and
specialisations, an institutional framework that guarantees a pro business climate, well
organised money and credit markets, well defined property rights, low transaction
costs, etc. as well as factors related to geography, history and culture, political stability
and attitudes. Empirical research, although extensive do not give final answers on the
issue of what location factors determine inward FDI. In many cases statistical results
are fairly fragile, some other research papers have developed and tested hypotheses
about when a potential determinant should be significant and when it should not be
significant, and some others identify of how data issues affect interpretation of the
results. However, it seems there is some consensus that market size and/or growth,
production costs, quality of labour, and an institutional development threshold are
among the most important FDI determinants3.
Empirical research on what motivates FDI to flow into transition countries
suggests that FDI operations seek for countries with rather open trade regimes, which
allow multinational enterprises to build globally and/or regionally integrated vertical and
horisontal value-chain networks. This kind of FDI operations may be efficiency seeking
and/or market seeking. Therefore, labour costs, market size existing and potential,
availability of local resources, and a proper level and quality of state regulation of
business pop up as major determinants of inward FDI4. Similar results arise from
empirical research investigating the motives pf FDI flows to developing countries
2
As ownership specific advantages are defined those tangible and/or intangible assets owned
by individual firms exclusively, they are the product of imperfect markets, and they refer to
technology and know-how related not only to the production process per se but to all
complementary products and services necessary for the production and marketing of final
products. Internalisation advantages are created when firms gain full rents from the further
utilisation of already existing ownership specific advantages by using them internally, within the
same firm, rather than leasing them through regular markets. Internal use means the creation
of an internal market that operates under the fiat of the firm’s own administration system and not
at arm’s length prices. Internal use across national borders means the establishment of
subsidiary firms in host countries, i.e. FDI. Which countries would be chosen as host countries
depends on their location advantages, which should complement both ownership and
internalization advantages of the investing foreign firms.
3 For a survey see Caves (1996) and Blonigen (2005).
4 See indicatively OECD (1994); EBRD (1994); Paliwoda (1995); Lankers and Venables (1996);
Meyer (1998); Bevan and Estrin (2000); Garibaldi et al (2001); Resmini (2000); Merlevende and
Schoors (2004); Kyrkilis and Pantelidis (2008).
3
including China5, though there is some controversy on the proper specification of the
variables expecting to determine inward FDI flows6.
In the current paper a model is been constructed comprised by FDI explanatory
variables proposed by both theory and empirical re rather search, pertaining to specific
economic and institutional characteristics of China. The variables are specified taking
into account two criteria: first, accurate approximation of the theoretical variables as the
former are indicated by theory and practice; and, second, the availability of time series
data for the whole period of investigation, i.e. 1979 - 2007.
The paper includes a section analysing the expected determinants of FDI inflows
to China, their specifications, and the expected sign of their relationship with the
dependent variable. The next section summarises the empirical model, presents the
data set, and the econometric methodology for testing the hypotheses. The results of
the empirical application of the model and its discussion are presented in another
section, while the final section includes the conclusions of the paper.
2. The Determinant of FDI Inflows
Host Country Openness
FDI is defined as the transfer of a package of complementary inputs, e.g. technology,
capital, know-how, intermediate inputs, etc. across national borders.
In addition,
multinational enterprises tend to develop regional or even global value chains, whose
each part is located in different sites according to local competitive advantages aiming
at maximizing their global profits rather the profits of individual production units or
subsidiaries in general. Vertical and/or horizontal production and marketing networks
integrated within the same multinational enterprise give rise to intra-firm trade between
subsidiaries of the same multinational enterprise but located in different countries.
Intra-firm trade pertains to raw materials, intermediate inputs, technology, capital etc. it
substitutes the traditional international trade between different legal entities located in
different countries, and it requires the countries where the value producing units are
located to have established free trade regimes allowing for free import and export of
goods and services necessary for the operation of the multinational value chains.
5
See indicatively Root and Ahmad (1979); Schneider and Frey (1985); Trevino et al. (2002);
Adreoso-O’Callaghan and Cassidy (2003); Liu et al. (1997); OECD (2000); Sun et al. (2002);
Swain and Wang (1997); Wei and Liu (2001) Zhang and Song (2000); Zhang (2001); Zhang
(1994);
6 For a discussion see Blonigen (2005).
4
It is expected that free trade regimes would increase a country’s world market
integration through both export orientation and import expansion, therefore the volume
of its international trade, i.e. exports plus imports would grow.
However, export
orientation expands market size, which in turn increases the utilization of potential
economies of scale; hence it advances productivity, and, therefore, national output
grows. Increasing imports, i.e. inputs of higher quality and variety, modern technology,
etc. contribute to the same end through improving the competitiveness of exports and
national production in general.
To take account for the output growth, increasing
openness means that the volume of international trade expands at a faster rate than
the growth rate of GDP. In that respect, a country’s degree of openness may be
measured by the share of its international trade to the Gross Domestic Product (GDP).
And because, the more open national economies are the higher the probability is for
them to attract FDI, increasing degree of openness is expected to be associated with
increasing FDI inflows.
Production Cost
Efficiency seeking FDI including export platform FDI, as they are investments
undertaken within an intra-firm vertically and/or horizontally integrated global value
chain seeking cost minimization is located according to favorable cost factors, among
which labor has been extensively investigated as a location determinant of FDI
especially in emerging markets7. At the same time production costs may function as
supplementary motives of market seeking FDI, the primary determinant of which is
market size and its potential growth.
Labor cost is one of the most important
production cost items in cases of labor intensive and/or capital intensive production
where technology is standardized and embodied in capital goods, therefore, its transfer
cost is low. Multinational enterprises tend to locate such production types mainly in
emerging markets where wages are relatively low and the labor force is in abundant
supply. In addition, because labor has received some minimum training; it is able to
operate conventional technologies and to achieve productivity levels comparable to
international standards.
Labor cost may be approximated by the monthly average wage. If it is accepted
that labor productivity differentials are minimal between different emerging locations but
labor costs are distributed unevenly between the same locations, it is expected that
increasing average wages in a particular national location would tend to discourage
7
See indicatively Vernon (1966, 1979); Barrell and Pain (1996); Chantasasawat et al. (2003).
5
inward FDI to this country, diverting FDI flows to other locations with relatively lower
average wages.
External Economies
External economies in the form of availability of infrastructure, output of specific
industries that may be used as intermediate inputs through forward and backward
production linkages, and industrial output that expands market size permitting the
exploitation of both economies of scale and agglomeration economies
may shape
production costs reducing transportation costs and improving market access,
increasing productivity, hence, competitiveness, improving the quality and price of both
physical and intangible production inputs. Reducing production costs and improving
the competitiveness of a country’s economy may be a motive for inward FDI seeking
efficiency.
Building
external
economies
requires
investments
in
infrastructure,
in
manufacturing, in business services, etc. Investments add to the existing level of
capital stock, therefore, total gross capital formation may be used for measuring the
level of external economies existing in a particular economy.
As capital formation
advances so it does the level of external economies, therefore, FDI inflows are
expected to increase.
Market Size
Large domestic markets attract market seeking FDI producing standardized goods
taking advantage of economies of scale. As the making of such products become
competitive exports activity may come as a next or parallel step. The inflow of FDI
creates external economies either through increasing employment, labor productivity,
and finally wages8 or through the building of production clusters and agglomeration
economies. This mechanism is expected to have a positive effect on the growth of
national output, thus increasing the market size. In turn, that gives rise to the scope of
inward FDI producing differentiated goods for both domestic and exports market, thus
feeding another circle of increasing market size and eventually increasing inward FDI9.
8
Foreign firms employ more advanced technology, achieve higher labor productivity, and pay
higher wages than domestic firms, and through competition and the demonstration effect
technology is diffused to the rest of the host economy, and domestic firms improve labor
productivity. For a discussion of this issue see Kyrkilis (2009).
9 There is evidence that there is a mutual causality between FDI inflows and market size in the
case of China. See Tseng and Zebregs (2002).
6
Market size may be approximated by domestic consumption. The latter includes
consumption of imported goods, thus the potential of import substitution through local
production on the part of inward FDI is being taken into account. Also, given that China
is an emerging market, inward FDI is more probable to be associated with labor and
capital but of standardized technology intensive production manufacturing consumer
goods including consumer durables, and consumer electronics, even cars. In that
respect consumption, and because it is dependent on the purchasing power of the
population is a rather more accurate approximation of market size than GDP. It is
rather more appropriate to normalize consumption levels for any population increases.
Therefore, per capita consumption levels may be an appropriate approximation for
consumption levels.
Increasing per capita consumption is expected to be positively
related with increasing market size and potential, then with FDI inflows.
Institutional Factors
Globalization is progressively testing the ability of regional economies to adjust and
maintain their competitive edge. Both the lessening of barriers to FDI freely flowing into
a country and policies aiming at improving both the domestic business climate and the
institutional and legal framework regulating and underpinning the smooth function of
markets, regulating and defining property rights, establishing transparency and
reducing red tapping and corruption play a key role in attracting FDI to both transition
and developing counties, because it creates a business conducive environment and it
contributes towards a country’s international competitiveness by reducing both market
frictions and failures, and transaction costs.
The Chinese government did take a significant policy step in 1991-1992 aiming
at clarifying the legal environment of FDI, relaxing government controls and reducing
state intervention, providing practical assistance, as well as political and legal
consistency10. In addition, China’s accession to the World Trade Organization in 2001 2002 presents a decisive and rather irrevocable step towards further world market
integration and the establishment of a pro market open economic regime. For
approximating the two events two dummy variables are introduced respectively.
3. Empirical Model and Data
The previous discussion leads us to an equation that takes the following general
functional form:
10
For an analysis see Fu (1998).
7
FDI = f (Open, PCCON, GCF, AVW, DUM1, DUM2)
(1)
Where, FDI = Annual foreign direct investment flows into China.
Open = Openness, defined as the ratio of total international trade (annual
exports plus annual imports) to annual GDP.
PCCON = Annual per capita consumption which is a proxy for market size and
potential.
GCF = Annual gross capital formation.
AVW = Annul average wage, which expresses labour cost.
DUM1 = Dummy variable defined as: 1 values for the years 1992-2001 and 0
otherwise.
It approximates the major government policy break in
1991.
DUM2 = Dummy variable defined as: 1 values for the years 2002-2007 and 0
otherwise. It approximates China’s accession to the WTO.
Data for all variables, except both dummies are annual. Summary statistics of
the variables included in this study are reported in Table 1. All data, except these
measuring AVW are sourced in the IMF’s publication International Financial Statistics,
various years. The source for AVW is China’s Statistical Yearbook, various years. All
values are expressed in US dollars. In cases that the initial data set was in China’s
national currency, i.e. YUAN values were recalculated in US dollars using the bilateral
average annual exchange rate.
Table 1
Summary Statistics for the Sample Period 1979-2007
Variable
Mean
Std. Deviation
Coef. of Variation
Minimum
Maximum
28.556
32.365
1,13
109
138.410
0,34
0,15
0,45
0,11
0,64
PCCON
320,35
218,62
0,68
127,22
952,67
GCF
334.660
353.230
1,06
76.729
1.440.517
AVW
928,34
772,06
0,83
348,39
3.291,9
FDI
Open
Sources: The IMF International Financial Statistics Yearbook (various years) and China’s
Statistical Yearbook (various years).
In order to analyze the impact of the explanatory variables, which are included in
equation (1) on FDI inflows, the dependent variable; the following empirical model is
estimated, wherein all variables except DUM1 and DUM2 are in logarithmic form:
8
log(FDI)t = αo + α1 log(Open)t + α2 log(PCCON)t + α3 log(GCF)t + α4 log(AVW)t +
+ α5 DUM1t + α6 DUM2t + et,
(2)
where et is an error term and t denotes the year. All coefficients denote the elasticity of
the dependent variable with respect each independent variable.
The econometric method for the empirical testing of the model is the standard
OLS technique, and the period of investigation is 1979 – 2007. As discussed above,
the coefficients α1, α2, α3, α5 and α6 are expected to be positive, and α4 is expected to
be negative.
4. Estimation Results
The estimation results of the equation (2) for FDI inflows to China are reported in Table
2. The fit of the model is very good in terms of the significance of the F-statistic, its
explanatory power is very high (99 percent) and there are no signs of multicollinearity.
All explanatory variables with the exception of the second dummy that
approximates for China’s accession to the WTO are statistically significant. The second
dummy is marginally statistical significant, i.e. almost at the 15 percent level of
significance. All statistically significant explanatory variables have the expected signs.
Overall, the empirical testing of the model verifies all hypotheses formulated in Section
2.
Table 2
Estimates of Determinants of FDI Flows to China, 1979-2007
Variable
Coefficient
Std. Error
t-Statistic
Prob.
log Open
1.7351
0.2165
8.015
0.000
log PCCON
3.8808
0.7833
4.955
0.000
log GFC
1.5882
0.5966
2.662
0.014
log AVW
-4.5194
0.6126
-7.377
0.000
DUM1
0.59835
0.2245
2.666
0.014
DUM2
0.54449
0.3682
1.479
0.153
Constant
-0.59004
3.5710
-0.165
0.870
No of observations = 29, Adjusted R2 = 0.99, S.E. = 0.84, F-statistic = 520.64[0.000]
D.W. = 1.97
9
5. Concluding Remarks
FDI in China is primarily efficiency seeking, i.e. it takes advantage of an abundant
labour supply, of low cost relatively to international standards, and of adequate
productivity. Foreign investors aim at exporting but increasingly so at servicing the
domestic market favoured by the expanding market size, especially in terms of
purchasing power expressed as rising per capita consumption. Market seeking FDI
complements efficiency seeking FDI.
An increasingly open trade regime allows free
importing of technologies, intermediate production inputs, and raw materials, therefore,
it permits local production to integrate within the global value chains of multinational
enterprises, and acquire the quality and standards suitable for international marketing.
The country’s accession to the WTO guarantees its world market integration and
favours FDI integrated within global production and marketing networks. The efficiency
of FDI in China advances due to the growing availability of external economies in the
host economy in the form of both infrastructure and agglomeration economies. Finally,
government policies aiming at improving the institutional and legal framework either
directly through preferential policies favouring the free entry of foreign investors and/or
indirectly creating pro- market institutions that promote the smooth function of markets
and the investment climate not only support the inflow of FDI but they advance the
country’s competitiveness, thus, enhancing its attractiveness to foreign investors. It is
characteristic that in the aftermath of the introduction of new legislation in 1992 FDI
inflows picked up greatly, as it is shown in Figure 2. The average annual inflows were
USD 3610 million in the period prior to the introduction of the new legal regime in 1992,
i.e. the 1988 -1991 period compared with USD 24576.75 million in the consequent four
years period, i.e. 1992 – 1995. In 1992 alone FDI annual inflows grew more than 2.5
times with respect the previous year.
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