Foreign Direct Investment and Its impacts on Economic Growth: An Empirical study on China

PROGRAMME: Msc in International Banking and Finance

Jiang Zihan

DATE: 01/09/10

WORD COUNT: 14060

Abstract

Since 1980s, foreign direct investment (FDI) has experienced a dramatically increase in the world. Compared to developed countries, the importance of FDI in developing countries is even higher, although the total amount is less. China, as a leading country in developing world, even experienced a more significant increase in FDI. Coming from the planned economy, China now has become the largest FDI recipient country in the developing world. Among numerous literatures, whether FDI could affect Chinese economy in a positive or negative method continue to be debated. While theoretical research tends to support that there is a positive correlation between FDI and economic growth, empirical evidences appear to have different results. This dissertation extends the previous study, adopting an econometric method based on data from Chinese provincial level. It tends to support that although FDI indeed could be regarded as a crucial factor in Chinese economic growth, its importance is not significant. In particular, when divide FDI into different categories, manufacturing FDI appear to have significant positive impacts on economic growth. Primary sector and service sector, however, have the negative effects. Finally, it suggests that human capital could be regarded as an important factor in economic growth and FDI inflows.

Acknowledgement

First and foremost I would like to warmly thank my supervisor, Dr Cline Azmar. Her detailed comments, constructive suggestions, great patience and sincere encouragement helped me to write my dissertation in a more systematic and comprehensive way.

I would also like to thank the academic staff at the Economics Department, University of Glasgow, for their help during the whole year of my master study. Particularly, I have benefited a lot from lectures given by Dr Luis Angeles, Dr Joe Byrne, and Dr Mario Cerrato. Also, my gratitude extends to administrative staff in the department, particularly to Christine Athorne, for her sincere help and support.

Finally, I would like to thank my parents, providing me this opportunity to study in this great university. Thank all my friends and relatives, who have given me support.

Table of contents

Chapter 1. Introduction1 Chapter 2. Literature review4 2.1. Theoretical relationship4 2.1.1 Exogenous and endogenous economic growth theory4 2.1.2 Potential Channels5 2.2. Empirical evidence11 2.2.1 Empirical evidence in the world11 2.2.2 Empirical evidence in China15 2.2.3 Reasons for the debate21 Chapter 3. The role of FDI in Chinese economy 23 3.1. FDI inflows into China23 3.2 Sectoral Distribution of FDI in China27 3.3. Economic growth in China30

Chapter 4. Methodology34 4.1. Model description34 4.2. Data description38 Chapter 5. Empirical Results and discussion41 Chapter 6. Conclusion47 Bibliography51 Appendix62

List of tables
Table 1. FDI to GDP ratio, 1970s 2000s, (%)32 Table 2. OLS panel data results estimations: 1998-200741 Table 3. OLS panel data results estimations: 1998-2007 (with interaction term)44 Table 4. Economic growth and FDI by sector: OLS results45

List of figures
Figure 1. Inward FDI inflows and cumulative FDI in 1992-200525 Figure 2. Percentage of total amount of cumulative FDI, 198527 Figure 3. Percentage of total amount of cumulative FDI, 200729 Figure 4. Real GDP and growth rate of China, 1992-200531

Abbreviations
EP FDI GDP HFDI IMF IS JV MNEs OLS UNCTAD VAR VFDI Export Promoting Foreign Direct Investment Gross Domestic Product Horizontal Foreign Direct Investment International Monetary Fund Import Substituting Joint Venture Multinational Enterprises Ordinary Least Squares United Nations Conference on Trade and Development Vector Auto Regression Vertical Foreign Direct Investment

Chapter 1: Introduction

Foreign Direct Investment (FDI) can be defined as a category of international investment, which reflects the objective of a resident in one economy acquiring a lasting management interest in an enterprise from another economy. Generally, the lasting interest indicates that the relationship between the direct investor and direct investment enterprise should be long-term, and normally direct investor should occupy at least 10% of the ordinary shares or voting power of an enterprise abroad (Patterson et al, 2004).

Since 1980s, levels of FDI began to increase dramatically, and now it is regarded as a crucial source of investment for many countries. According to the data of UNCTAD (2008), during the period from 1970s to 2007, FDI has experienced a dramatically growth across the globe. In 1970s, the annual FDI inflows across the world only had US $ 23.97billion, then it increased to US$ 92.70 billion in the 1980s, almost grew as much as four times. After that, it kept growing and in the 1990s, it reached an annual average of US$ 402.05 billion. During the period from 2000 to 2007, the average annual FDI inflows reached US $ 1041.2 billion in the world. In particular, the data from OECD separated the country to developed countries and developing countries, and it shows that the total share in developing countries grew slightly faster than FDI inflows into developed countries, indicating that FDI play a more significant role in developing countries.

Among developing countries, China has become the largest FDI recipient country since 1992. In 2002, China even surpassed US with inflows of US $ 53 million. Its FDI-GDP ratio, which measures the significance of FDI, is also much higher than average level. At the same period, China also achieved an impressive economic growth with an average rate over 9% since 1980s. According to Zhang (2006), the achievement can be attributed to FDI inflows to a great extent.

Due to the importance of FDI, this issue attracts numerous research, both on developed countries and developing countries. Although the amount of literatures in this field seems to increase in recent years, research focuses on impacts of FDI inflows on Chinese economy is still limited, which may be mainly because Chinese government initiated the open-door policy relatively late. Among the literatures based on China, systematic treatments of the role of FDI in Chinese economy are still limited (Zhang, 2006). In particular, most of the research based on China is largely descriptive, and very few studies have conducted in empirical analysis. In addition, based on the existing literatures, whether FDI inflows into China could have positive impacts is still controversy. For instance, Wei (1994) believes that FDI indeed plays a dominant role in accelerate the economic growth. Similarly, Chen et al (1995) finds FDI have some obvious positive impacts on Chinese economy in their research. However, other researchers, such as Braunstein and Epstein (2002), suggest that FDI inflows could not cause real economic growth in China.

This dissertation attempts to investigate the relationship between FDI inflows into China and its economic growth. There are two features characterize in this dissertation. First, as
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most of the research based on Chins is largely descriptive, this dissertation adopts econometric methodology, attempts to fill the gap by providing evidence on impacts of FDI inflows on Chinese economy through quantitative assessment. Second, based on the former literatures, the dissertation collect data in recent decade, from 1998 -2007. Additionally, the estimation is made based on panel data, which could include more information and makes the results more reliable.

To achieve this objective, this dissertation mainly includes 5 parts. In Chapter 2, in order to better understand the former research, it will outline the main literatures on this issue. In particular, this chapter will review the literatures in both theoretical and empirical perspectives. It will first provide a description of exogenous and endogenous economic growth theory, and then potential channels that FDI inward can stimulate economic growth will be provided. After that, empirical evidences will be represented, including China and other countries. Since the issue continues to be debated, the reason for this debate will be briefly analyzed. Then in Chapter 3, the role of FDI in Chinese economy is presented. It mainly states the different stages of FDI inflows and Chinese economic growth in China. The differences of FDI distribution will also be presented. In Chapter 4, methodology will be provided. It will establish an economic growth model with possible variables, mainly based on the model of Zhang (2006), in order to investigate the correlations between economic growth and other explanatory variables. The measurement of data and its sources will also be introduced. After that, in Chapter 5, results will be presented and it will provide an analysis based on the results. Finally, Chapter 6 will provide a conclusion.

Chapter 2: Literature Review

The issue of whether foreign direct investment can be helpful for spur economic growth has been one of the fundamental questions and it attracts a great deal of research, both on developed countries and developing countries. Some are largely descriptive, supported by statistical data, and others based on econometric analyses. However, it appears that this issue still has been debated. This chapter attempts to provide some main influential former literatures, including both theoretical and empirical perspective.

2.1 Theoretical relationship

2.1.1Exogenous and endogenous economic growth theory

To investigate the reason for economic growth, most of the early research follow the exogenous economic growth theory, proposed by Solow (1956). Basically, the accumulation of productive factors and the existence of diminishing returns are included in the exogenous theory, in the form of production function. The production function indicates that the amount of output could be produced by the various combinations of inputs, mainly by capital and labor. In other words, the model uses such production function to investigate how output grows with the inputs increases (Mare, 2004). Although the model has great contribution to the economic study, as it predicts, the model could not hold in long run. In case of FDI investigation, since the diminishing returns to the physical

capital, the impact of FDI on economic growth is constrained. In other words, FDI could only exert a level effect on the growth per capita, rather than a rate effect (Falki, 2007). In addition, treating FDI as exogenous variable could be problematic because it is possible that although FDI could have impacts on economic growth, conversely, such growth in host countries can also affect FDI.

In the contrast, the endogenous growth theory, proposed in 1980s, could provide a framework for investigate the correlation between FDI and economic growth. According to Johnsons (2006), by adopting endogenous growth theory, characteristics of FDI can be taken into account and therefore the chances of confirming the theoretical correlation by empirical evidence can be increased. Research on this field has explained various channels of FDI affect economic growth, mainly including capital formation, trade, and technology transfer.

2.1.2 Potential Channels

According to Lim (2001), although there is no consensus on the relationship between FDI and economic growth, an increasingly number of recent literatures appear to support that the correlation between them is positive, especially in theoretical perspective. Theoretically, FDI inward can have positive effects on domestic economic growth via several channels, mainly including capital formation, trade and technology transfer.

Firstly, it is argued that FDI inward could raise capital formation, and it can also create more employment opportunities, which could be considered as the most direct effect (Zhang, 2006). Since the inflows of investment into host country, capital will be generated and industrial output can be increased. According to De Long and Summer (1991), capital formation can be regarded as an essential economic input, which can increase the level of economic growth in the long run. Balasubramanyam et al (1999) also claim that a low level of capital formation could lead to low rate of growth and even become a barrier. In case of China, Zhang (2006) suggest FDI inflows increase the investment at a negligible level. The ratio of FDI inflows to gross domestic investment grew from 7% in 1992 to 17% in 1996. Moreover, the contribution of foreign invested enterprises to the industrial output increased from 7% in 1992 to 36% in 2004, more than five times as much as before.

In addition, since it is unlikely to bring a large number of labors from home country, it is expected that more jobs will be created. In addition, the inflows of capital could also generate tax revenue, which could alleviate the deficit pressure. Recently, based on the research of Fiji, Singh and Jayaraman (2007) obtain similar results as Zhang (2006). They argue that FDI indeed added domestic savings to Fiji, and cushioned them against current account deficits. Moreover, it also creates more jobs, helped the domestic government to reduce unemployment pressure. However, Johnson (2006) holds different view by claiming that if foreign investment takes the form of brownfield FDI, it is common that multinational corporations might reduce a substantial incumbent labour force as usually done during privatisations. Therefore, he argues that FDI is not supposed to stimulate economic growth through these aspects.

Furthermore, it is claimed that FDI inflows could stimulate economic growth through promoting manufacturing exports. The most debated issue in this field might be whether the relationship between FDI and international trade is substitution or complementary. To discuss the relationship, it is necessary to classify the two types of FDI. According to the motivation of firms for affiliate operations abroad, FDI can be classified as two types, horizontal FDI (HFDI) and vertical FDI (VFDI). VFDI refers to the case where a firm attempts to pursue FDI in order to take advantages of international differences, often by locating their labor-intensive process abroad and keeping capital-intensive input production and knowledge-intensive designing in home country. In other words, firms try to locate different stages of production in different countries, which could probably reduce the costs and provide more benefits. On the other hand, HFDI arises when a firm can reduce their trade costs by establishing foreign affiliates abroad. Unlike VFDI, firms often almost duplicate roughly the same activities as parent firm when conducting HFDI (Lee et al, 2005). Therefore, it can be argued that the trade costs and the access to local markets are the main motivation for firms to choose HFDI.

Since the different types of FDI, the relationship between FDI and trade can also be different. Based on the assumption of similar condition between the home country and host country, Brainard (1993) claims that whether to choose HFDI or trade depends on the tradeoff between proximity and concentration. If countries differ in conditions, such as market size, or technology level, and if disadvantaged countries develop, advantaged countries tend to establish subsidiaries. As the development of host and home countries, they could become more similar. It is possible that multinational production will substitute
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for trade when the countries become similar (Brainard, 1997). Moreover, Blonigen (2001) argues that if a firm has intangible assets, such as advanced technology or managerial skills, which are impossible to export, the relationship between FDI and trade can be considered as substitution. Because it is unlikely to properly appropriates rents from such assets through contracts with a third-party, which leads the corporations to establish their own facilities abroad. In addition, when there are sufficient transaction costs on exporting or licensing, FDI also could replace international trade (Blonigen in Lee et al, 2005).

While traditional trade theory seems to support substitution relationship, more literature appears to suggest a complementary correlation between FDI and international trade (Lee et al, 2005). For instance, when a firms production presence in a foreign market with one product can increase total demands for all products, the relationship between them can be considered as complementary. In other words, it is possible that the presence itself could help the firm to know more about the market, and then can tilt customer preferences.

Therefore, it could be concluded that the linkages between FDI and trade are still complex and unpredictable. Blonigen (2001) argues that both relationships could make sense. Dunning (1998) suggests that the relationship between them is conditional on both type and place. Petri (1994) classifies investments into three types, which are market-oriented investments, production-oriented investments, and trade-facilitating investment. Since production-oriented investments are attracted to low cost sites and trade-facilitating investment are motivated by the need to provided services to exporting activities, they tend to increase trade. Market-oriented investments, however, tend to substitute trade.

In case of China, Zhang (2006) argues that the most prominent contribution of FDI is the expansion of Chinas manufacturing exports. What is more, he claims that FDI inflows not only increase the volume of exports, but also upgrade its export structure. Zhang (2006) argues that in 1980, Chinas exports ranked as the 26th in the world, with the volume of US $ 18 billion and 47% of them are manufactured goods. With the development of FDI inflows, in 2005, the volume increased to US $ 762 billion and 93% as manufactured goods, ranked in the 3rd place in the world.

Among all the channels that FDI inflows could possibly stimulate economic growth, technology transfer and spillover effects may be considered as the most influential channel, especially for developing countries and transition economies. According to Stanisic (2008), technology transfer and the so-called spillover effects, which refer to FDI inflows bring a technological boost and then spread through the whole economy, play an important role in economic growth. He argues that this knowledge diffusion can lead to improvements in local through several ways. For instance, local firms could copy advanced technology from multinational corporations directly. Additionally, this technology from foreign firms could increase the competition pressure in host countries, which could force the local firms use the existing technology and resources in a more efficient way, or they might also be forced to innovate. Multinational enterprises (MNEs) could also bring new know-how and managerial skills to host countries, and this could also have spillover effects. As people leave the corporations, they leave with the knowhow and knowledge they accumulated, which could also benefit domestic industry and increase the productivity. This is consistent with the argument of Johnson (2006), who

claims that technology spillovers from MNEs to domestic markets provide the most significant and positive relationship between FDI inflows and economic growth. In case of China, Huang (1995) claims that FDI has induced Chinese economic growth and introduced advanced operation and management experiences, especially the advanced technologies.

However, some researchers seem to hold the opposite view, they argue that rather than promote technology level in host countries, it could have crowding out effects on host countries. For instance, it occurs when domestic corporations are not able to compete with these foreign firms, which with more advanced technology and managerial skills. Additionally, since foreign corporations usually have higher wage levels for their employees, this might force domestic firms to increase their wage in order to attract capable employees. However, it is possible that domestic firms cannot cover the wage increase with the growth of productivity, which may lead to the reduction of their competitiveness. As a result, foreign enterprises might possess the monopoly position in the market and domestic firms could be crowded out of the market. In case of China, Zhang (2006) have similar results, and he claims that since foreign enterprises might possess the dominance position in the market, their management know-how and advanced technology might in fact inhibit developing local resources.

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2.2 Empirical evidence

2.2.1 Empirical evidence in the world

Existing empirical studies attempt to examine whether FDI inward could affect economic growth on host countries and the extent of the impacts adopt different estimation methods and data, and therefore it is not surprising that results are still controversy. Based on a sample of 46 developing countries, Balasubramanyam et al (1996) examine the relationship between trade strategy, FDI and economic growth in developing countries in the context of new growth theory. Following the hypothesis proposed by Bhagwati (1978), which claims that the volume and efficacy of FDI inward could be vary according to different trade strategies. Balasubramanyam et al (1996) classify trade strategies as two types. Export promoting strategy (EP) could be defined as one that average effective exchange rate on exports and imports are roughly equated. In other words, EP strategy could be considered as trade neutral or bias free. In contrast, import substituting strategy (IS) is the one that effective exchange rate on imports exceeds effective exchange rate on exports, which means it is biased on import substitution activities. By characterising different trade policy regimes and adopting cross-section data and OLS regression, Balasubramanyam et al (1996) concludes that for those countries adopts EP strategy, FDI has a positive effects on economic growth. However, for countries adopt IS strategy, the relationship between FDI and economic growth is weaker.

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Similarly, research conducted by Agrawal (2000) focuses on five Asia countries: India, Pakistan, Bangladesh, Sri Lanka, and Nepal. By undertaking time-series cross-section analysis, He finds that the impact of FDI inflows is negatively related to GDP growth rate before 1980. Then the relationship is positive for early 1980s and becomes increasingly positive in late 1980s and early 1990s. He also proposes some possible explanation for the change. In 1960s and 1970s, most South Asian countries followed the IS policies and had a high import tariffs. Then in the following decade, most countries began to largely abandon these IS policies in favor of more international trade. This is consistent with the result obtained by Balasubramanyam et al (1996). Besides, Kohpaiboon (2004) conducts his research based on the data from Thailand during the period from 1970-1990 and obtains similar results. He suggests that impacts of FDI on economic growth in EP trade regime appear to be greater than import substitution regime.

Borensztien et al (1998) also make the research based on developing economies, utilizing data from 69 developing countries in a cross-country regression framework. Compared with above research, they emphasize the role of technology transfer on economic growth rather than the different trade strategy. Based on the data, they suggest that compare to domestic investment, FDI is a significant vehicle for technology transfer, contributing more to the economic growth. In addition, the most robust finding of their research is that the extent of effect of FDI on economic growth relies on the amount of human capital available in the host countries. They find a strong positive interaction between FDI and the level of educational attainment, which is not significant in domestic investment. In other words, FDI could only have positive effects on economic growth if there is sufficient human capital available in host countries. This result is consistent with the research conducted by Olofsdotter (1998). His regression results suggests that the positive effects
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of inward FDI are stronger in countries with a higher level of institutional capacity, as measured by the degree of property rights and bureaucratic efficiency in host countries.

Moreover, both Blomstrom (1986) and Kokko (1994) adopt econometric method and find positive correlation between FDI and economic growth in Mexico. In addition, Sjoholmn (1999) suggest similar results based on the data from Indonesia. Bengos et al (2003) analyse a sample of 18 Latin American countries from 1970-1999 and their result also show a positive relationship between FDI and economic growth, as long as the host country has adequate human capital, economic stability and liberalized markets.

More research appears to emphasize the importance of human capital. According to Borensztein et al (1995), host countries receiving FDI have to achieve a certain level of human capital. Since if the level is relatively low, it is difficult for countries to initiate and operate advanced technologies, and new managerial skills could also be restricted, which means that low level of human capital can become the barrier for the economic development in host countries. Nelson and Phelps (1966) explain that education could enhance ones ability to receive and understand information, which is important for the performance in the job. As a result, knowledge transfer and diffusion can spread to the whole economy, and therefore enhance the economic development. Furthermore, Balasubramanyam et al (1999) claim that FDI can be beneficial to the economic growth in host countries if appropriate supplementary measure are adopted, rather than entirely relying on the positive spillover effects of FDI.

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Empirically, Borensztein et al (1995) find that FDI can have significantly positive impacts on economic growth if the human capital level in host countries is above a certain level. Similarly, Keller (1996) also suggests that economic growth rates could not be increased if the level of human capital remains unchanged. His model shows that host countries with low level of human capital could constrain the ability to take advantages of advanced technologies from foreign enterprises. Research conducted by Glass and Saggi (1998) have similar results. By constructing study in a cross-country level, they suggest that areas with higher quality of educated labors are more likely to take advantages from positive spillovers effects from FDI. Therefore, it could be concluded that human capital plays an important role in economic growth.

Although there are numerous literatures arguing that FDI inflows can have positive effects on host counties economic growth, it still cannot be concluded that there is universe relationship between FDI and economic growth (Lipsey, 2003). An early literature doubts the positive correlation might be the research conducted by Brecher and Alejandro (1977), they provide evidences and argue that foreign capital can lower the economic growth because a country will earn excessive profits with severe trade distortions, such as high tariffs. Similarly, Aitken and Harrison (1991) can only find a limited correlation between FDI and economic growth in Venezuela. Additionally, based on the data from 32 developed and developing countries during 1970 to 1990, De Mello (1999) utilizes time series, but he can only find weak relationship between FDI and economic growth.

In addition, Zhang (2001) uses data from 11 developing countries in Latin America and East Asia, and he finds 5 out of 11countries in the sample has positive relationship
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between FDI and economic growth, however, they are conditioned by trade regimes and macroeconomics stability. Furthermore, Choe (2003) finds little evidence to prove FDI can cause host country economic growth.

Furthermore, another important research in this field is conducted by Cakovic and Levine (2002), they collect the data covering 72 developed and developing countries. Methodologically, they adopt both OLS regression and dynamic panel procedure with data averaged over five year periods during the period from 1960 to 1995. After the analysis, they cannot find any robust linkage between inward FDI and host countries economic growth.

2.2.2 Empirical evidence in China

Since China operated its open-door policy relatively late, literatures on this field is limited, especially for the empirical analysis. Wei (1994) might be the first researcher attempt to analyses this issue by econometric measures. Since China has only experienced 12-year reform, it is difficult to do the statistical analysis based on limited aggregate observations. In order to make the results more reliable, Wei (1994) employs the city level data, 434 and 74 cities in two data sets respectively, covering the period from 1980 to 1990. He claims that there is clear evidence that more exports are positively correlated with the higher growth rate across Chinese cities during 1980 to 1990. In particular, in the late 1980s, the contribution to Chinese economic growth mainly comes from foreign investment, mainly
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in the form of technological and managerial spillover effects, as opposed to infusion of new capital. In addition, he also explains the reason for the faster growth rate in coastal cities than national average. He suggests that the extra growth rate comes almost entirely from their ability to attract more foreign direct investment and effectively utilization of those investments. In other word, after taking into account of the growth rate of labour, physical capital and human capital, Wei (1994) believes that FDI indeed plays a dominant role in accelerate the economic growth.

In the same period, there are also other literatures focus on the association between FDI and economic growth in China. For instance, Mody and Wang (1997) adopts data on 23 industrial sectors in seven coastal regions over the period from 1985 to 1989, attempting to investigate the correlation between FDI and economic growth. Overall, they find that industry-specific features, which measure the degree of specification and competition, could only explain a limited portion of variance in economic growth. Compared to this, much of the growth comes from regional specific influences and regional spillover effects. They explain that regional influences mainly contain the open door policies and specific economic zones that successfully attracted investment. In particular, they emphases that existing regional strengths, especially the high-quality human capital can play an important role in economic growth. Even a higher percentage of secondary school enrollment rates have a significant contribution to the economic growth.

In addition, Chen et al (1995) argue that FDI has some obvious positive impacts on Chinese economy. For instance, it contributed to economic growth through augmenting resources available for capital formation. In addition, FDI also expand Chinese exporting

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volume, and advanced technology and managerial skills from foreign enterprises also have contribution to domestic economy. Although FDI may entail some political risks in China, its overall impacts should still be viewed as beneficial. Moreover, by using the traditional regression model and panel data, Sun (1998) argues that there is a significantly positive relationship between FDI and domestic investment. This indicates that FDI can increase the exports demand from host countries, which could attract more investment in the export industries. This result is consistent with the research by Shan (2002). He uses a Vector Auto Regression (VAR) technique of innovation accounting to analyses the various interrelationships between FDI, industrial output growth, and other economic variables in China. He suggests that there is a significant positive impact of FDI on Chinese economy when ratio of FDI to industrial output increases.

Most early literatures tend to support that FDI could be beneficial to Chinese economy through several different ways. However, some doubts have generated about their research in the following years. According to Wei and Balasubramanyam (2004), there is a common problem in most early studies in China, including Wei (1994), Chen et al (1995), Mody and Wang (1997), and Sun (1998). They treat FDI as an exogenous variable in the regression models. Demurger and Berthelemy (2000) have the same doubts. They argue that most of the former research based on the hypothesis, which is fundamental in statistical terms, that the explanatory variables are exogenous. In particular, they fail to propose the possible existence of reciprocal correlation between FDI and economic growth. However, it is possible that although FDI could have impacts on economic growth, conversely, such growth in host countries can also affect FDI. According to Wang and Swain (1995), the principle determinants shaping FDI in China during the 1980s is its economic conditions and characteristics of labour markets. Zhang (1995) has consistent
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results as Wang and Swain (1995), and therefore, it can be concluded that the size of China, including its land area, population, GDP level, makes itself an attractive market.

As discussed above, FDI could have positive impacts on Chinese economic growth, at the same time, China in turn becomes an attractive environment to foreign enterprises. Zhang (1999) and Shan et al (1999) all find a bi-directional correlation between FDI and economic growth. (Zhang (1999) and Shan et al (1999) in Wei and Balasubramanyam, 2004). In addition, to avoid an ad hoc specification of the intermediate-sector function, Demurger and Berthelemy (2000) estimate a simultaneous equation model, taking into account the dynamics between FDI and economic growth. By colleting the data from 24 Chinese provinces covering the period from 1985 to 1996, they confirm that FDI indeed has played a fundamental role in Chinese economic growth, although the magnitude of FDI is small, and they also emphasis the importance of potential for future growth in foreign investment decisions. Furthermore, a new important evidence is found in their research. By using an original variable reflecting the stock of primary and secondary educated people, they suggest that human capital may contribute to economic growth when it adopts foreign technologies. Finally, they find that when both exports and foreign investment are introduced in the growth regression, direct impacts of exports tend to disappear. This is contrast with the work of Prime and Park (1995), who find support evidence that exports growth contributes income growth in China (Prime and Park (1995) in Demurger and Berthelemy, 2000).

Husain and Anuradha (2000) adopt a different method to measure the correlation between FDI and economic growth. They separate the data set into three sub-periods, and then

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conduct the panel study, attempting to identify possible structural variations over time. They separate the period into 1978-1997, 1983-1997, and 1988-1997. They conclude that during the period from 1993 to 1997, the relationship between FDI and economic growth appears to be positive and the result tends to be more significant than other periods. From 1988 to 1992, the correlation is not significant. Similarly, Zhang (2001) uses the same method. In his research, over the periods of 1984-1988, 1989-1993, and 1994-1998, with the increase in FDI, the impact of FDI on economic growth in China tends to increase in response.

Despite the proponents, who tend to support that FDI could have positive impacts on Chinese economic growth, there are also some opponents of FDI, who believe FDI can be detrimental to Chinese economy. A representative research in this view can be considered as Braunstein and Epstein (2002). To test the correlation between FDI and economic growth, they choose four variables, which are wages, job creation, investment and tax generation. They collect the data from 1986 to 1999, running a panel regression model analysis on provincial level data. They argue that contrary to the former conventional supportive evidence, they find that FDI inwards could crowd out domestic investment in China. Rather than providing significant positive relationship between FDI and economic growth, they find that FDI has relatively small positive impacts on wage levels and employment opportunities. However, inward FDI is negatively correlated with domestic investment and total tax revenue.

Furthermore, Huang (2003) analyse this issue through the legislative and regulatory perspective. After his research, he believes that the legislative development for foreign and
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domestic firms occurs at a very different pace. He argues that in many significant aspects, the legislative and regulatory framework developed for foreign enterprise appears to be superior for domestic firms, especially for domestic private firms. In other words, Huang (2003) believes that Chinese investment policies are more friendly to foreign enterprises than to domestic firms, and therefore foreign enterprises has a better business circumstance. As a result, Chinese partners are more eager to organize firms with foreign investors, and these types of firms can exploit preferential policies and even possess privileges in competing for local scarce resources. Consequently, in this perspective, it is possible that FDI will crowds out domestic firms (Selvanathan et al, 2008).

Recent influential literatures include Zhang (2006), Selvanathan et al (2008), Hu (2008) and Mah (2010). Zhang (2006) develops a growth model, collecting provincial data covering the period from 1992 to 2004. Similar as Husain and Anuradha (2000), he also separates data sets into three sub-periods. He finds a favorable impact of FDI on Chinese economy growth rate, measured by Chinese real GDP growth rate in all three sub-periods. Furthermore, he points out that FDI inward appears to positively affect Chinese economic growth through direct effects, such as expanding export volumes and promoting domestic productivity. Other positive externality effects, including facilitating transition and technology transfer also play an important role in economic growth. During the period he has researched, impacts of FDI have increased and the effects on costal regions seem to be greater than inland area.

Moreover, Selvanathan et al (2008) attempt to investigate the causal linkage between FDI, domestic investment and economic growth. By adopting the data from China from 1988 to

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2003, they use the VAR system with error correction model and innovation accounting technique. Rather than the crowding out effects proposed by Braunstein and Epstein

(2002) and Huang (2003), they find FDI has a complementary relationship with domestic investment. Therefore, they argue that FDI can have positive effects on Chinese economic growth, not only through overcoming the shortage of capital, but also through complementing domestic investment in China. Based on the results they have found, they suggest that less-developed countries should encourage and promote FDI inflows, and at the same time, appropriate policies and regulations are also required.

A more recent research conducted by Mah (2010) seems to have opposite results as Zhang (2006) and Selvanathan et al (2008). Their empirical results suggest that FDI inflows could not cause real economic growth in China, while in turn Chinese economic growth appear to have positive effects on FDI. He claims that compared by FDI, other reasons, such as export, private property rights, and smooth transition tend to have more important effects on economic growth in China.

2.2.3 Reasons for the debate

Because of the adoption of different methodologies and analysis approaches, empirical evidences have shown that the debate on the impacts of FDI on economic growth is far from being conclusive, and FDI inflows can have positive, insignificant, or even negative impacts on economic growth in host countries. According to Ali (2010), a possible explanation of the mixed results is that not all types of foreign investment can provide

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positive impacts on host country economic growth. One important research in this field can be considered as Alfaro (2003).

By adopting cross-country data covering the period from 1981-1999, she conducts her study on FDI inflows into different sectors, including primary sector, manufacturing sector and services sectors, and she finds different results for each sector. She argues that FDI inflows into the manufacturing sector tend to have a positive effect on economic growth, while FDI inflows into primary sector appear to have negative impact. Evidences of FDI inflows into services sector tend to be ambiguous. Therefore, it is concluded by Alfaro (2003) that benefits of FDI varies greatly across different sectors.

Another important explanation for the mixed results is the absorptive capacity. In other words, not all host countries have the ability to fully reaping positive externalities offered by FDI (Ali, 2010). The term absorptive capacity contains several factors, such as human capital, degree of financial management, level of economic development. Teece (1977) argues that due to the high absorptive capacity in well established firms, they are more likely to benefit from the positive impacts from FDI inflows. However, there also exist some doubts about this explanation. For instance, Carkovic and Levine (2005) argues in their research that even taking into account the role of the absorptive capacity, it cannot be helpful for reduce the inconclusiveness of the correlation between FDI inflows and economic growth.

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Chapter 3: The role of FDI in Chinese economy

3.1 FDI inflows into China It is claimed that China plays a leading role in the developing countries. Coming from the planned economy, China has experienced a series of changes in economy. For the FDI development in China, it could be classified as four main stages: the experimental stage (1979-1983); the growth stage (1984-1991); the peak stage (1992-1993) and the adjustment stage (1994-present) (Wei and Liu, 2001).

During the early stage, China began to operate the reforms and formulated the open-up policy in 1979, aimed at attracting foreign capital, advanced technologies and management skills to upgrade the industry structure and stimulate economy. However, it enacted and promulgated a series of regulations and laws governing FDI (Wei and Liu, 2001). Moreover, due to both the ideological reasons and lack of experiences, FDI inflows into China were fairly low at the beginning, with only a total of US $ 1.8 billion in three years from 1979-1982. In 1983, the total volume of FDI inward was only US $ 0.9 billion. What is more, at this period, the FDI inflow into China had large limitation in both geographical and industry. For instance, it only concentrated in four specific economic zones such as Guangdong and Fujian Provinces, and only joint venture (JVs) type and export-oriented industry can be focused by foreign investors (Wei and Balasubramanyam, 2004). For the provinces in other regions, however, FDI inflows are still at limited level. According to Coughlin and Segev (2000), the non-convertibility of Chinese currency,
23

difficulties in accessing Chinese market become the barrier in deterring the foreigners investing in Chinese market.

After the experimental stage, after recognizing the potential benefits of FDI, Chinese government operated a number of measures and established a series of laws and regulations to improve the business environment and attract foreign investment, which pushed China into the growth stage. In 1984, rather than focusing on four specific economic zones, the Central Committee of the Communist Party and the State Council decided to open 14 more costal port cities, including Dalian, Qinhuangdao, Tianjin, Yantai, Qingdao, Lianyungang, Nantong, Shanghai, Ningbo, Wenzhou, Fuzhou, Guangzhou, Zhanjiang and Beihai. They are chosen because at that period, these 14 cities are the more prosperous areas in China. The main purpose to open these cities is to attracting foreign funds, improving the markets, updating the existing technologies, and strength the competitive abilities of domestic firms (Wei and Liu, 2001). As a result, during this period, China has experienced a steady increase. The total volume of FDI inflows grew from US $ 1.4 billion in 1984 to US $ 4.4 billion in 1991, with an average annual growth of 20% (Wei and Balasubramanyam, 2004).

Between 1992 and 1993, due to Deng Xiaopings tour of southern provinces and the openness of new sectors and areas for FDI, China stepped into the peak period, experienced a surge of FDI inflows. Figure 1 below represents the FDI inflows and cumulative FDI of China, covering the period from 1992 to 2005. It can be seen from the table, in 1992, 132,201 enterprises with foreign investment were approved by Chinese government and the total volume of realised FDI inflows attained US $ 11 billion, which
24

was nearly three times as much as the previous year (Wei and Liu, 2001). In 1993, the figures for contracted FDI and realised FDI even exceeded the total number of previous 13 years, with a 150% growth rate.

Figure 1. Inward FDI flows and Cumulative FDI in 1992-2005

Sources: Zhang, (2006) From 1994 onwards, the growth rate FDI inflows began to decline. The total number of new projects decreased around 40%, from 83, 437 in 1993 to 47, 594 in 1994. (Wei and Balasubramanyam, 2004). Wei and Liu (2001) try to explain the reasons for the decrease. They argue that the first reason for the decline might be the increasing competition from other countries. For instance, Vietnam, Laos, India, Pakistan, and other central and eastern European transition economies all provided attractive business environment to absorb FDI (Jiao, 1998 in Wei and Liu, 2001). Second, the State Council announced in 1995 that for

25

imported machinery, equipment, and other materials from foreign enterprises, it would be re-imposed the duties. Zhang (1998) argues that such changes in taxes system inevitably discouraged new foreign investors into Chinese market, and the reinvestment of existing enterprises would also decline due to the increase of taxes. What is more, in order to change the structure of FDI inflows into China, government classified FDI into three categories, including encouraged FDI, restricted FDI and forbidden FDI (Wei and Liu, 2001). This classification would also discourage foreign investors from entering into Chinese markets.

Although the growth rate seemed to fell since 1994 to 1999, its total volume still kept growing, and it reached US $ 46.9 billion in 2001. Nowadays, China has become the largest recipient in developing countries and the second largest in the world. Particularly, in 2002, it even surpassed US, and by the end of 2005, the accumulated FDI inflows in China have reached US $ 622 billion (Zhang, 2006). The most recent report from Ministry of Commerce of China shows that by the end of April, 2004, 7506 more foreign enterprises establish investment in China, and the volume of FDI inflows increased 11.28% as compared with the same period in last year (Ministry of Commerce of China, 2010).

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3.2 Sectoral Distribution of FDI in China

Although the volume of FDI inflows in China keeps increasing since China have conducted the open-door policy, the structure of FDI seems to be problematic. Figure 2 below shows the sectoral distribution of FDI in the first two periods. Figure 2. Percentage of total amount of cumulative FDI in 1985

Percentage of total amount of cumulative FDI in 1985

14%

2% 48%

36%

Energy exploration, transport service, metallurgy, manufacture of machinery, electronics, chemicals, telecommunication equipment, construction materials Light industries, textiles, foodstuffs, pharmaceuticals Tourism and service industry Agriculture, animal husbandry, fishery, forestry Source: Chu (1987), in Wei and Liu (2001)

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It can be seem from the figure 2 that the investment into the hotels and buildings in tourism and service sector possesses the leading position, with nearly half amount of the total volume of investment. Compared to the large portion of FDI in service sector, FDI into other sectors tend to be small. Energy explorations, manufactory of machinery, electronics, and raw materials industry were the industries that Chinese government most encouraged. However, FDI inflows into those sectors only possessed 36% of the total amount. What is worse, the primary sector, including agriculture, animal husbandry, fishery and forestry industry, accounting the smallest portion of total FDI inflows, which is only 2%.

According to Wei and Liu (2004), the reasons for the dominance position of tourism service industry can be attributed to the encouragement of Chinese government. Since China just opening up to the outside world, there is a significant shortage of suitable hotels and apartments. In order to attract more foreigners for business, Chinese government made more efforts in this industry to accommodate the potential investors. As a result, surplus high level hotels and apartments were built in Beijing and Shanghai, and even more in Shenzhen and Guangzhou.

After realizing this problem, Chinese government readjusted the structure of FDI in China. Rather than encouraging tourism service industry, they made more efforts to attract foreigners to the technically advanced enterprises and export-oriented industries (Wei and Liu, 2004). Due to the new policies and encouragements, the structure of FDI inflows changed in the following periods. For instance, the total amount of FDI inward into

28

manufacturing sectors increased from less than 50% in 1985 to 60%, 75%, 85% in the following three years, respectively (Wang, 1990). During the last decade, the distribution of FDI inflows into China has become more reasonable. Figure 3 below shows the distribution of FDI inflows into China in 2007. It can be seen from the figure 3 that manufacturing sector, including construction, gas and electricity and other manufactory industry still in the leading position, accounting for more than half of the total amount of FDI. Service Sector is in the second place, including transportation service, education, financial sectors, and other main service sectors. The total amount of FDI inflows into this sector is around US $ 300 billion in 2007, possesses about 40% of the total amount. Finally, FDI inflows into the primary sector are still low. Only 2% of the total FDI amount inflows into this sector (National Bureau of Statistics of China, 2008). Figure 3. Percentage of total amount of cumulative FDI, 2007

Percentage of total amount of cumulative FDI, 2007

2% 40% 58%

Service sector Primary sector Manufacturing sector Source: China Statistical Yearbook, (2009)
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3.3 Economic Growth in China

Since the open-up to the outside world policy, China has achieved an impressive economic growth. Measuring the economic size, china is surpassed today only by US, Japan, Germany and France. It is estimated that its share in global growth during 1995 to 2002 is around 25% (Holz, 2005). Additionally, China is also the nation with the largest exporter and the second importer of goods. Considered the GDP growth rate, the statistics seem to be more pervasive. Figure 2 shows the Chinese real GDP and its growth rate from the period 1992 to 2005. According to IMF (2009), in 1980, the beginning of Chinas economic reform, its GDP only has US $ 309. In that period, China has even experienced several times of decrease of GDP. Then in the following years, it can be seen from the figure that GDP grew steady, with an average growth rate of 9.37% every year. According to the latest statistics from National Bureau of statistics of China, GDP of China in 2009 attained US $ 4757.743 billion, with a growth rate of over 9%. Now, China has become the worlds fastest growing major economy. Based on the data of last few decades, it is forecasted that Chinese economy will keep growing in the following years and it might surpasses US in purchasing power terms between 2012 and 2015. It is also predicted that by 2025, China is likely to be the largest economic power by almost any measure in the world (Holz, 2005).

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Figure 4: Real GDP and growth rate of China, 1992-2005

(Source: Zhang, 2006)

According to Zhang (2006), the achievements in Chinas economy growth could be attributed to the adoption of the encouragement of inward FDI to a great extent. One method to illustrate the significance of FDI is to measure the FDI to GDP ratio. Table 1 below demonstrates FDI to GDP ratio in the world, developed countries, developing countries, and China, covering the period from 1970s to 2000s. It can be seen that in 1970s, globally, increased from 0.46% in the 1970s to 2.57% in the 2000s. In particular, the data also shows that the ratio of developing countries is slightly higher than the ratio of developed countries in all the periods, which implies that although developing countries have lower total volume than developed countries, its significance of FDI inflows to their local economies is higher. The last column shows the data of China. Since China operated open-door policy in last 1970s, the first data cannot be accounted. In 1980s, although the ratio is still below the average ratio in developing countries, it already surpasses the

31

average ratio of developed countries. Then in 1990s, the peak period, the ratio grew to 3.77%, almost six times as much as the last decade. Compared to other countries, its ratio is significantly higher. In 2000s, although the ratio is slightly lower than 1990s, it is still higher than other countries, in the leading position. Table1. FDI to GDP ratio, 1970s-2000s, (%) World Developed Countries 1970s 1980s 1990s 2000s 0.46 0.64 1.4 2.57 0.43 0.62 1.25 2.38 Developing Countries 0.61 0.72 2.08 3.12 0.63 3.77 3.52 China

Source: UNCATD World Investment Report (2008), China Statistical Yearbook (2009)

In response to the issue of whether FDI can affect economy growth and how deeply the impacts are, an increasing number of literatures have appeared to developing and testing the theories. Although there is a great deal number of literature concerning about FDI and its impacts on economic growth on host countries, literatures focused on FDI inflows into China and its effects are still limited, which might be mainly because China started its opening-up policy is relatively late. In particular, very few of these literatures attempt to test the issue empirically (Zhang, 2006). Moreover, based on the existing research, the results of this issue are still debated. Although most literatures seem to support that FDI have positive effects on economic growth, there are still some research find negative

32

relationship between them, and some researchers cannot find significant correlation. Therefore, more research needed to be made to examine the role of FDI on Chinese economy, especially in a quantitative method.

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Chapter 4: Methodology

This chapter attempts to establish a model based on the former research, to investigate the relationship between FDI inflows and economic growth in China. It also provides a brief description about the collection of data.

4.1 Model description

In order to investigate the contribution of FDI inflows to the Chinese economic growth, a growth model is established to analyse. It mainly base on the work conducted by zhang (1996). Following the standard procedure of former literatures, the data is taken by natural logarithm form. By including the constant term 1 and an error term , the benchmark model specification is obtained in the following form, which describes the main basic determinants of the economic growth rate: Growth = 1 + 2 L+ 3 Inv + 4 FDI +

(1)

In this model, Growth is the dependent variable, denotes the average economic growth, measured by the average of GDP per capita growth. L denotes the labor input, which is claimed to be helpful for promote the total productivity and therefore boost the economic growth. Its coefficient 2 represents the labor output elasticity.

34

Inv denotes the domestic investment, which is measured by the share of gross fixed capital formation in GDP. It is taken into account since it is a key determinant of economic growth (De Long and Summer, 1991). They suggest that capital could be considered as an essential economic input, and it is also a crucial factor for achieving increasing levels of long-run economic growth. This is confirmed by Klenow and Clare (1997), and they claim that capital can combine other factors of production and therefore argument total output levels and boost economic growth. Many influential empirical research have included capital formation as an important factor in economic growth model. For instance, based on their sensitive analysis of cross country growth regressions, Levine and renelt (1992) find a positive and robust correlation between the share of investment in GDP and economic growth. More recently research conducted by Ali (2010) also confirm this robust correlation between investment share in GDP and economic growth. Another reason for including this variable is that it can be helpful for make comparison between domestic investment and foreign direct investment, whether the contribution of FDI is greater or smaller than domestic investment. Moreover, FDI denotes the foreign investment inflows, in the form of FDI to GDP ratio. Then the coefficient 3 and 4 reflects the marginal products of domestic investment and foreign investment, respectively.

More recently, the work of Barro (1991) and Mankiw (1992) have become more influential in economic growth theory, which derives a model including initial income level to control the conditional convergence hypothesis. It is argued that countries per capita growth rate tends to be inversely correlated with its starting level of economic. In
35

particular, if two countries have similar level of structural parameters for preferences and technology, then the poorer country tends to have a faster growth rate than the richer country (Barro, 1991). In addition, Ali (2010) also includes this variable when building his model on FDI and economic growth, and similarly, he also finds a negative relationship between economic growth and its initial level. Therefore, this variable, expressed by Y0, is included in the growth model.

Another important variable suggested in recent literatures is human capital. An influential research in proposing the importance of human capital is Barro (1991). He argues that human capital plays a special role in endogenous economic growth model. Barro and Lee (1994) included this variable in their growth model and they find a direct relationship, and they conclude that since human capital may generate ideas and promote productivity, they can always have significant impacts on economic growth. From that period, many researchers have taken this variable into account. For instance, Mody and Wang (1997) emphasize that highly quality human capital, as an existing regional strengths, can play a significant role in economic growth. Similarly, Demurger and Berthelemy (2000) also suggest that educated people can have positive impacts on economic growth. Moreover, Borensztein et al (1995) find a complementary relationship between FDI and human capital and they suggest that FDI inflows can have significant impacts on economic growth when human capital is above a certain level. Therefore, another variable HC is also suggested in the model, denotes human capital.

36

In order to investigate the potential linkage between FDI and human capital, an interaction term of FDI and human capital is added in the model. Then the final version of the model becomes the following form: Growth = 1 + 2 L+ 3 Inv + 4 FDI +5 Y0 +6 HC +7 (FDI * HC) +

(2)

Through this model, it is able to find the relationship between each variables and economic growth in China. In particular, correlation between FDI and human capital can also be investigated. There are three possible results in the model. Firstly, if 4 and 7 are both positive, then FDI has an unambiguous impact on economic growth, and human capital could enhance this impact. Conversely, if they both are negative, then FDI could have adverse impacts on economic growth and human capital could enhance this impact. Secondly, if 4 is positive and 7 is negative, then FDI inflows still have positive impacts on economic growth. However, with the increase in human capital, the extent of the impact will diminish. Finally, if the 4 is negative and 7 is positive, then the results could be more ambiguous and complex.

In particular, according to Alfaro (2003), FDI inflows into different sectors can have completely different impacts on economic growth. By establishing the model, he finds that while FDI inflows into manufacturing sector is positively related to economic growth, the correlation between FDI inflows into primary sector and economic growth appear to be negative. What is more, FDI inflows into service sector are ambiguous. More recently, Ali (2010) also confirms the results by Alfaro (2003), based on the data including both developed countries and developing countries. In case of China, FDI inflows distribution is significantly different. While manufacturing sector account for more than half of the
37

total amount, the primary sector only has 2% (National Bureau of Statistics of China, 2009). Therefore, to make the model more accurate and more reliable, it attempts to divide the FDI into different sectors. As a result, it is possible for investigate the correlation between economic growth in China and FDI inflows into different sectors.

The model is analyzed by ordinary last square method (OLS) in Eviews software, attempting to investigate the coefficient of each variable. Particularly, in order to make comparison, two variants are estimated, one is without FDI and the other one is with FDI. In this way, it is able to find whether FDI can be considered as an important factor in economic growth.

4.2 Data description

The equation (2) above provides the basis for cross-sectional and panel data analysis for the correlation between FDI inflows and economic growth. The data is on the provincial level, which is shown in appendix I. It includes four provinces from eastern region (Jiangsu, Fujian, Shandong, and Zhejiang), two provinces from central region (Henan and Hunan), and two provinces from western region (Sichuan and Shanxi). In addition, three municipalities, including Beijing, Tianjin and Shanghai are also taken into account, because they have provincial status and they all attract a large portion of FDI inflows in the past decades. Other provinces, such as Qinghai, and the autonomous region of Tibet are dropped from the sample since FDI inflows into those areas are scarce and the data is unavailable.

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Data are mainly collected from China Statistical Yearbook, covering the period from 1998 to 2007. Growth is measured by the real GDP growth rate in China. According to Zhang (2006), due to the inter-province floating population, the growth rate of population is collected as the measurement of L. Moreover, Human capital (HC) is measured by the ratio of secondary school enrollment in total population, and the secondary schools include both the regular schools and the technical schools.

Inv is attempted to measure the ratio of domestic investment, and therefore it is computed by the nominal gross fixed capital formation divided by the total nominal GDP. Since the data in this aspect cannot be found in China Statistical Yearbook, the data are collected from each Provincial Statistical Yearbook, published by each provincial government. Similarly, FDI ratio is computed as the ratio of nominal realized FDI inflows to nominal GDP. In particular, because the FDI inflows are always reported by US $, and the nominal GDP is in Chinese Yuan, they are converted into the same currency by the average exchange rate of each year. Furthermore, Y0 is measured by the initial level of economic development, which is the per capita GDP in 1998.

For the data of FDI inflows into different sectors, the categories of sector follow the research of Alfaro (2003). Primary sector includes agriculture, fishery and forestry industry. Manufacturing sector includes the construction, gas and electricity industry and other manufacturing industry. Finally, service sector contains industries that related to the service, such as real estate, hotel and catering service, public transportation service,

39

education and financial sectors. The data in this part is collected from Statistical Yearbook of each provinces and Statistical report from Ministry of Commerce of China. They are also measured by the ratio to GDP.

Based on the former research, it is predicted that FDI inflows can have positive impacts on China economic growth. What is more, the human capital could be an important variable in the correlation and it is estimated that human capital can enhance the impacts. In addition, the initial level of development Y0 is predicted to be inversely correlated with economic growth due to the results provided by the former research. Furthermore, both the Inv and L are expected to be positively related to the economic growth. Finally, while manufacturing FDI is expected to be positively related to economic growth, service FDI and primary FDI are predicted to have a negative correlation according to the former research. In particular, the significance of manufacturing FDI is expected to be higher than total FDI.

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Chapter 5: Empirical Results and Discussion

The ordinary last square (OLS) method is adopted to analyze the model. The coefficient results and T-statistic are shown in following tables.

Table 2 : OLS panel data results estimations: 1998-2007 (Dependent variable: average of GDP per capita growth rate) Independent Variables L INV HC Y0 FDI Model without FDI Coefficients 1.167** 0.13*** 1.43*** -0.202** t-Statistics 1.853 2.3 3.94 -4.41 Model with FDI Coefficients 1.064* 0.12*** 1.412*** -0.197** 0.13** t-Statistics 1.68 2.89 3.94 -4.63 1.22

Adjusted R 2

0.5379

0.62

Notes: The asterisks ***, **, and * denotes the levels of significance at 1%, 5%, and 10%, respectively. Table 2 shows the comparison between model with FDI and model without FDI. It can be seen from Table 2, the adjusted R 2 is 0.5379 without FDI, and after taking into account of FDI, the adjust R square increase to 0.62, which is around 15% higher than the results without FDI. This means that FDI should be considered as an important factor in Chinese economy and it indeed has positive impacts on economic growth.

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Although the results confirm the positive correlation between FDI and economic growth, the coefficient of FDI is not significant. This is inconsistent with the research conducted by Zhang (2006), who find significant correlation on both cross-section data and panel data analysis based on 28 provinces in China. However, Mansfield and Romeo (1980) argues that although theoretical literatures tend to believe FDI inflows can be beneficial to host countries, empirical evidence seems to be less pervasive. Moreover, this result is similar with Aitken and Harrison (1991), who can only find a limited relationship between FDI and economic growth. Similarly, De Mello (1999) also confirms this result because the correlation in his research is also weak. This insignificance of correlation might due to the inflows to different sectors of the economy. According to Alfaro (2003), FDI inflows to different sectors can have different effects on economic growth. In his research, he finds that FDI inflows into the manufacturing sector tend to have positive impacts on economic growth, however, FDI inflows into primary sector appear to have the opposite effects. What is more, for the service sector, the effects of FDI inflows tend to be ambiguous. Therefore, it could be argued that the insignificance of the coefficient of FDI might be because the different sectors.

Except for FDI, all other variables have the right sign as predicted, and they turn out to be significant. For instance, the coefficient of human capital is 1.43, which indicates a significant positive correlation with economic growth. This confirms the importance of human capital. In addition, the initial level of economic development tends to be inversely related to the economic growth, which is consistent with the research by Zhang (2006) and Ali (2010). This indicates that countries with lower level of initial economic development

42

tend to have higher economic growth rate.

After the first estimation, the interaction term is included in the model, in order to investigate the relationship between FDI and human capital. The results are presented in Table 3. It can be seen that although the results are not significant, both the sign of FDI and the interaction term are positive. This is consistent with the expected results. Although the coefficient of interaction term is not significant, it still indicates that FDI indeed can have positive impacts on economic growth, and human capital can enhance the impacts. In other words, it could be argued that there might exist some complementary relationship between human capital and FDI inflows.

This is highly consistent with the research conducted by Borensztein (1995), which confirms this complementary correlation. In particular, they cannot find the similar correlation between domestic investment and human capital. This might suggest that compared to domestic investment, FDI have superior capacity in increasing the domestic technology and then the subsequent economic growth. Similarly, Balasubramanyam et al (1999) suggest even though FDI contains positive externalities, it can only be beneficial if the country adopt complementary methods for economic development, rather than entirely relying on the spillover effects of FDI. In other words, if human capital in a host country is below a certain level, even though FDI inflows can possibly provide benefits, its low level of human capital could become the barrier of economic development.

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Table 3: OLS panel data results estimations: 1998-2007 (Dependent variable: average of GDP per capita growth rate) Independent Variables L INV HC Y0 FDI FDI*HC Adjusted R 2 0.62 Column 1 Coefficients 1.064* 0.12*** 1.412*** -0.197** 0.13** t-Statistics 1.68 2.89 3.94 -4.63 1.22 Column 2 Coefficients 1.04* 0.104*** 1.08*** -0.17** 0.117** 0.07** 0.623 t-Statistics 2.08 1.96 4.19 -4.12 2.96 3.02

Notes: Notes: The asterisks ***, **, and * denotes the levels of significance at 1%, 5%, and 10%, respectively.

Finally, in order to observe the different impacts of FDI inflows into different sectors, FDI inflows are classified into the primary FDI, manufacturing FDI and service FDI. The results based on different sectors are presented in table 4 in the below. It can be seen from the table that all the coefficients have the right sign as predicted, with a positive sign in manufacturing FDI and negative signs in primary FDI and service FDI. Coefficients of other variables still remain unchanged. For primary FDI, although the sign is the same as predicted, the coefficient is still not significant, with -0.066. However, Alfaro (2003) finds a robust negative correlation, with a significant coefficient range from -0.28 to -0.13. For service FDI, the coefficient shows in the table is -0.029. Similar with primary FDI, it contains the right sign but without significant coefficient.

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For manufacturing FDI, which accounts for the largest portion of total FDI inflows into China, results tend to be more significant. Compared with the coefficient of total FDI in Table 4, the coefficient increased almost twice as much as before, from 0.117 to 0.256. This result is the same as expected. It indicates that compared to FDI inflows into other sectors, FDI inward to manufacturing sector has the most contribution to the economic growth. This is consistent with the results obtained by Alfaro (2003), which also finds a robustness correlation and confirms the importance of FDI inflows into manufacturing industry. What is more, Alfaro (2003) gives some possible explanation for this result. He argues that the most mentioned benefits generated by FDI, such as technology transfers, new managerial skills, and employee training tends to be more related to the manufacturing sector. By comparison, the linkage between these potential benefits and primary or service sector are relatively weak. Table 4: Economic growth and FDI by sector: OLS results (Dependent variable: Average of GDP per capita growth 1998-2007) Independent Variables L Inv HC Y0 Primary FDI Manufacturing FDI Service FDI Adjusted R 2 0.569 0.607 Column 1 Coefficient 0.987** 0.109*** 1.082** -0.168*** -0.066* t-Statistics 1.68 3.02 2.94 -4.54 -1.94 0.256** 2.42 -0.029 0.537 -1.14 Column 2 Coefficient 1.102** 0.106** 1.121*** -0.162*** t-Statistics 1.79 2.64 3.12 -3.98 Column 3 Coefficient 1.02** 0.094*** 1.098** -0.212*** t-Statistics 2.12 2.86 2.88 -4.64

Notes: The asterisks ***, **, and * denotes the levels of significance at 1%, 5%, and 10%, respectively.

45

Therefore, it could be concluded that not all FDI inflows can be beneficial to economic growth in China. While manufacturing FDI tends to have positive impacts on economic development, FDI inflows into primary and service sectors appear to be negatively related to the economic growth.

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Chapter 6: Conclusion

Foreign direct investment has increased dramatically in the last several decades, and now it is regarded as a crucial factor of economic growth. Due to the importance of FDI, it attracts numerous research, attempting to investigate the relationship between FDI inflows and domestic economic development. Since the different data and methodologies, it is not surprising that the result of the correlation is still controversy. Many literatures are largely descriptive and they tend to support that FDI inflows can be beneficial to the domestic economic development. Theoretically, it is argued that FDI inflows can stimulate domestic economy mainly through three channels. First, FDI could argument capital formation, which could be regarded as an essential economic input, and subsequently increase the economic growth level (De Long and Summer, 1991). What is more, since it is unlikely to bring a large number of labors from home country, it is expected that more jobs will be created. As a result, it could decrease the employment pressure in host countries. In addition, the inflows of capital could also generate tax revenue, which could alleviate the deficit pressure.

Second, it is claimed that FDI inflows can boost economy of host countries by international trade. Whether the relationship between FDI inflows and international trade is substitute or complementary is still controversy. On the one hand, the correlation can be substitution if home countries establish their subsidiaries in countries, which have similar condition (Brainard, 1997). Moreover, if firms contain intangible assets, such as advanced technology or managerial skills, which is impossible for export, the relationship can also be regarded as substitution. Finally, under the condition of high transaction costs on
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exporting or licensing, FDI could also replace trade (Blonigen in Lee et al, 2005). While traditional theories support substitution correlation, more research tends to suggest complementary relationship. Dunning (1998) concludes that the relationship between them is conditional on both type and place, and it is complex and unpredictable.

Third, it is believed that FDI inflows can increase economic growth of host countries by advanced technology transfer, which is regarded as the most influential channel. It is argued that technology diffusion can lead to improvement in host countries and subsequently boost the whole economy. Furthermore, FDI inflows could also bring new know-how and managerial skills to host countries. As the knowledge accumulated, it can be beneficial to the whole industry and increase the productivity.

In case of China, since it conducted the open-door policy relatively late, research based on China is still limited, especially in the quantitative method. This dissertation takes the econometric method, attempting to find some empirical results of relationship between FDI inflows and Chinese economic growth. The econometric model includes five variables, labor, domestic capital formation, foreign investment, human capital, and initial level of economic development, and an interaction term between human capital and FDI.

By adopting the ordinary least square method, the results shows that except for initial level of economic development, all other variables are positively related to economic growth. The adjusted R 2 is 15% higher when including the FDI variable, which implies that FDI indeed can be considered as a factor in economic growth. What is more, when including

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the interaction term, both FDI and interaction term sign are positive. This indicates that human capital can enhance the positive correlation between FDI and economic growth. Finally, by dividing the FDI into three categories, which are primary sector, manufacturing sector and service sector, results tend to be different. For both service sector and primary sector, the coefficients are negative. Although results are not significant, it still indicates that FDI inflows into these two sectors are more likely to have negative impacts on economic growth. For manufacturing sector, results appear to be opposite. The coefficient is not only positive, but also significant. Compared with the total FDI inflows, the coefficient increased nearly twice times. This implies that FDI inflows into manufacturing sectors can have positive impacts on economic development in China. Alfaro (2003) explains that this is because the potential benefits of FDI are more related with manufacturing industry rather than primary and service sector.

However, this dissertation still exist some limitation. First, data is not complete. The data is collect in provincial level, however, several provinces, such as Tibet or Qinghai, are not taken into account due to the unavailability. Second, since there is no accurate number of inter-province floating population, the measurement of variable of L may be problematic. Similarly, since the data on average schooling years is not available in provincial level, the human capital is measured by the enrollment shares in total population, which is also less accurate. Moreover, this model only narrowly focused on the impacts of FDI on economic growth. Therefore, other variables, which are also considered to have contribution on economic growth is not included in the model. For instance, the level of financial system can be regarded as an important factor on growth, since a highly developed financial system can provide an attracting business environment to foreign investment, which could be beneficial to the whole economy. Other variables, such as inflation, exchange rate,
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could also have impacts on economic growth, however, they are not taken into account in this model.

Overall, this paper tends to support that FDI indeed is an important factor in economic growth, with a positive correlation. While manufacturing FDI can have significant positive impacts in Chinese economic growth, primary and service FDI tend to have the opposite effects. In addition, human capital, as an essential factor, can enhance the positive impacts of FDI on growth. Therefore, host countries could make more efforts to enhance the ratio of human capital to total population ratio, making the environment more attractive and more efficient. Further research might need to collect more accurate data, and more variables should be included in the model, which could make it more complete.

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Appendix

List of provinces included in the empirical analysis Eastern region Jiangsu Fujian Shandong Zhejiang Central Region Henan Hunan Western Region Shanxi Sichuan Municipalities Beijing Shanghai Tianjin

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