Jiang Zihan

8/2/2019 Jiang Zihan

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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


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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.


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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.


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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 China

23

3.2 Sectoral Distribution of FDI in China27

3.3. Economic growth in China30


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Chapter 4. Methodology34

4.1. Model description34

4.2. Data description38

Chapter 5. Empirical Results and discussion41

Chapter 6. Conclusion47

Bibliography51

Appendix62


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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


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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 4. Real GDP and growth rate of China, 1992-200531


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Abbreviations

EP Export Promoting

FDI Foreign Direct Investment

GDP Gross Domestic Product

HFDI Horizontal Foreign Direct Investment

IMF International Monetary Fund

IS Import Substituting

JV Joint Venture

MNEs Multinational Enterprises

OLS Ordinary Least Squares

UNCTAD United Nations Conference on Trade and Development

VAR Vector Auto Regression

VFDI Vertical Foreign Direct Investment


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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.


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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.


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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


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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.


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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.


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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.


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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 know-

how and knowledge they accumulated, which could also benefit domestic industry and

increase the productivity. This is consistent with the argument of Johnson (2006), who


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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.

2.2.2Empirical 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 ChinaIt 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,


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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


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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

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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

48%

36%

14% 2%

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


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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).


Percentage of total amount of cumulative FDI, 2007

58%

40%

2%

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

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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

Developing

Countries

China

1970s 0.46 0.43 0.61

1980s 0.64 0.62 0.72 0.63

1990s 1.4 1.25 2.08 3.77

2000s 2.57 2.38 3.12 3.52

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


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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 + 2L+ 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 coefficient2 represents the labor output elasticity.


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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


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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 variableHCis also

suggested in the model, denotes human capital.


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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 + 2L+ 3 Inv + 4 FDI +5 Y0 +6HC+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, if4 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, if4 is positive and 7is 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 7is 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


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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 ofL. 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, FDIratio 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, Y0is 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,


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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 theInv 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)

Model without FDI Model with FDIIndependent

Variables Coefficients t-Statistics Coefficients t-Statistics

L 1.167** 1.853 1.064* 1.68

INV 0.13*** 2.3 0.12*** 2.89

HC 1.43*** 3.94 1.412*** 3.94

Y0 -0.202** -4.41 -0.197** -4.63

FDI 0.13** 1.22

Adjusted R2 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 R2 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


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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)

Column 1 Column 2Independent

Variables Coefficients t-Statistics Coefficients t-Statistics

L 1.064* 1.68 1.04* 2.08

INV 0.12*** 2.89 0.104*** 1.96

HC 1.412*** 3.94 1.08*** 4.19

Y0 -0.197** -4.63 -0.17** -4.12

FDI 0.13** 1.22 0.117** 2.96

FDI*HC 0.07** 3.02

Adjusted R2 0.62 0.623

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)

Column 1 Column 2 Column 3Independent

Variables Coefficient t-Statistics Coefficient t-Statistics Coefficient t-Statistics

L 0.987** 1.68 1.102** 1.79 1.02** 2.12

Inv 0.109*** 3.02 0.106** 2.64 0.094*** 2.86

HC 1.082** 2.94 1.121*** 3.12 1.098** 2.88

Y0 -0.168*** -4.54 -0.162*** -3.98 -0.212*** -4.64

Primary FDI -0.066* -1.94

ManufacturingFDI

0.256** 2.42

Service FDI -0.029 -1.14

Adjusted R2 0.569 0.607 0.537

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

respectively.

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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 R2 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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Bibliography

Agrawal P. (2000), Economic impact of foreign direct investment in south Asia,Indira

Gandhi I

Jiang Zihan

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