Determinants of Fdi in China PDF

Journal of International Money and Finance
21 (2002) 79–113
www.elsevier.com/locate/econbase
Determinants of foreign direct investment

across China
Qian Sun a, Wilson Tong b,*
, Qiao Yu c, d
a
Division of Banking and Finance, Nanyang Business School, Nanyang Technological University,
Singapore, Singapore 639798
b
Department of Accountancy, Faculty of Business and Information Systems, The Hong Kong
Polytechnic University, Hong Hum, Kowloon, Hong Kong, People’s Republic of China
c
Department of Finance, Fudan University, Shanghai, People’s Republic of China
d
Department of Economics, National University of Singapore, Singapore, Singapore 119074
Abstract
We analyze the spatial and temporal variation in foreign direct investment (FDI) among
China’s 30 provinces from 1986 to 1998. Motivated by Naughton (Brooklings Pap Econo
Activ 2 (1996) 273), we distinguish our study from similar studies by examining changes in
importance of FDI determinants through time. We do find supporting evidence. This is due
to the shift in the nature of FDI in China. We also find that the cumulative FDI relative to
cumulative domestic investment has a negative impact on the new FDI. Provincial officials
have to improve the investment environment. Otherwise, multinational corporations may
choose to invest in provinces with fewer FDI competitors. Our analysis is robust across differ-
ent specifications. However, it explains the FDI distribution in the coastal provinces better than
it does for Central and Western provinces.  2002 Elsevier Science Ltd. All rights reserved.
JEL classification: F21; F30
Keywords: Foreign direct investment; Foreign portfolio investment; Location theory; Agglomeration;
China
* Corresponding author. Tel.: +852-2766-4399; fax: +852-2356-9550.

E-mail addresses: aqsun@ntu.edu.sg (Q. Sun); wilson.tong@inet.polyu.edu.hk (W. Tong).
0261-5606/02/$ - see front matter  2002 Elsevier Science Ltd. All rights reserved.
PII: S 0 2 6 1 - 5 6 0 6 ( 0 1 ) 0 0 0 3 2 - 8
80 Q. Sun et al. / Journal of International Money and Finance 21 (2002) 79–113
1. Introduction
Interest in the study of foreign direct investment (FDI) has grown rapidly. Existing
studies of FDI in the US help us to understand factors that are important to attracting
foreign investments across different states.1 In this paper, we examine if these factors
are also important for FDI distribution across different provinces in a developing
country, China. For sure, there are many studies of FDI on developing countries but
most of them are cross-country analyses.2 As such, the interwoven relationships
between social, cultural, economic, and political factors are difficult to delineate. By
focusing on only one country, we can make a cleaner study on the economic
determining factors that attract FDI.
Analysis of FDI in China is also timely. After China’s successful talks with the
US and the European Union on WTO and US granting China PNTR, China entering
into the WTO is almost a sure thing. China’s entering of the WTO would likely
sparkle another round of FDI projects. MNCs in Shanghai and Tianjin have already
planned to expand their investment scale in China. Erickson plans to double its
current investment amount of US$3 billion by 2001. On the other hand, China has
promised to open more of its servicing industries to foreign investments, especially
on areas like financial sector, insurance, telecommunication, trade, and tourism. In
fact, China has already been the second largest host of FDI in the world since 1994,
next only to the US. An American credit-rating agency projects that by 2005, annual
FDI in China will reach U$100 billion.3
However, there are only a few empirical studies on the overall FDI situation in
China. Wang and Swain (1995) examine the host country determinants of FDI in
China. They find that the FDI in manufacturing sector is positively related to China’s
GDP, GDP growth, wages, and trade barriers, but negatively related to interest rate
and exchange rate for the period of 1978–1992. Chen et al. (1995) study the effect
of FDI on China’s output and find that the FDI has a positive impact on the output
growth between 1978 and 1990. Using cross-country data, Wei (1995a,b) find that
despite the large amount of FDI China has received in recent years, the country still
appears to host too little FDI compared to an ‘average’ host country.
The present analysis focuses upon the spatial and temporal variation in FDI among
China’s all 30 provinces from 1986 to 1998. Such studies are minimal except a few
that use data at the city level with a relatively short time span. Heid and Ries (1996)
study 931 joint ventures in 54 cities from 1984 to 1991. They intentionally exclude
investments by overseas Chinese (Hong Kong, Macau, Singapore) which probably
have a different set of location determinants due to familial, linguistic, and cultural
ties. Their conditional logit regression shows that cities with good infrastructure,
established industrial base and foreign investment presence are more attractive to
1
See Coughlin et al. (1991), Graham and Krugman (1991), Lipsey (1993), Klein and Rosengren
(1994), Heid et al. (1995) and Hines (1996), among others.
2
See Kravis and Lipsey (1982), Edwards (1990) and Lipsey (1999) and the survey paper by De
Mello (1997).
3
Shenzhen Commercial, November 17, 1999.
Q. Sun et al. / Journal of International Money and Finance 21 (2002) 79–113 81
investors. Wei (1995a) also looks at individual cities. He finds clear evidence that
in the late 1980s, FDIs contribute to higher growth of the cities.
Kinoshita (1997) examines the data from a special survey conducted by the World
Bank in 1992 on 468 firms in eight cities in China (six located in coastal provinces
and two in inland cities). She investigates the possible effects of FDI on improving
a firm’s total factor productivity during the 1990–1992 period. She finds no evidence
that foreign investment helps increase the productivity growth of local firms via
foreign joint ventures, foreign linkages, and the mere presence of foreign firms in
the industry. Hence, she concludes that opening up to foreign investments is not
sufficient for a country to benefit from foreign technology spillovers.
Branstetter and Feenstra (1999) have an interesting working paper, which does
look at FDI in China at the provincial level. However, their focus is different. They
use 29 provincial data over the years 1984–1995 to estimate the structural parameters
of government’s welfare function. They want to examine the tradeoff between the
benefits of increased trade and FDI against the losses incurred by state-owned
enterprises as a result of such liberalization. Indeed, they find that the government
places much heavier weights on the output of the state-owned enterprises than on
consumer welfare, although such preference has declined somewhat over time. They
hence post skepticism on China’s entering into the WTO. Similar to our study is a
paper by Cheng and Kwan (1999). They look at data from 29 provinces from 1986
to 1995 and observe agglomeration effects of foreign capital stock.
However, there is an important fact that none of these studies has taken account
into, and that is the big differences in the scale and nature of FDIs in the 1980s and
the 1990s. In his important paper, Naughton (1996) points out the critical role that
Hong Kong and Taiwan has played on the FDI in Guangdong and Fujian provinces,
especially in the 1980s and early 1990s. The total FDI never exceeded 1 percent of
GDP before 1991 with over 40 percent of all FDI in Guangdong and 10 percent in
Fujian. This is probably due to the linguistic and cultural ties of Guangdong with
Hong Kong and Fujian with Taiwan. In fact, between 1984 and 1990, Hong Kong
accounted over 50 percent of China’s total FDI all along (Wei, 1995a,b). Naughton
(1996) also points out that until 1991 virtually all of the industrial output of FDI
was exported. Such lop-sided phenomenon began to fade away when China began
to offer significant domestic market access to foreign investors in 1992. The output
of these foreign-invested enterprises (FIEs) has increasingly been directed toward
the domestic market. Given this, it is conceivable that the factors drawing FDI into
China in the early period may not be the same, or at least may not be as important
as those in the later period. Pooling everything together under one regression model
hence ignores the possible dynamic complexity of the issue.
As an attempt to address Naughton’s point, our paper makes contributions on
this line of research by examining FDI determinants over different periods of time.
Furthermore, we contrast results based on the full sample of 30 provinces against
those based on 28 provinces, excluding Guangdong and Fujian. By doing so, we are
able to see if FDI determinants change through time and if Guangdong and Fujian,
two of the earliest provinces opening to and drawing in most of the FDI, have differ-
ent attributes attracting FDI.
Our results do show that the importance of the FDI determinants changes through
time. However, there is no evidence that Guangdong and Fujian are very different
from other provinces in terms of attracting FDI. Surprisingly, we find that the cumu-
lative foreign investment relative to the cumulative domestic investment has a nega-
tive impact on the new FDI. It provides implications to both policy-makers in China
and foreign investors interested in the China market. Specifically, provincial officials
have to improve the investment environment. Otherwise, multinational corporations
(MNCs) may choose to invest in provinces with fewer FDI competitors.
The analysis is organized as follows. Section 2 gives an overview of FDI develop-
ment in China. Section 3 discusses the conceptual framework. Data and empirical
methodology are described in Section 4. Section 5 presents the empirical results,
and Section 6 concludes the paper.
2. FDI in China
FDI is conventionally defined as a form of international inter-firm cooperation

that involves a significant equity stake in or effective management control of host
country enterprises. However, in China, FDI is considered to encompass also other,
non-equity co-operations such as contractual joint ventures, compensation trade, and
joint exploration.
2.1. Three stages of FDI development
China has attracted a spectacular amount of FDI since its opening to the outside
world in 1979. FDI jumps from virtually zero in 1979 to an amount of US$45.46
billion in 1998. Its development can be viewed as going through three stages. First
stage starts from 1979 when the “law of the People’s Republic of China on Joint
Ventures Using Chinese and Foreign Investment”, the first of its kind, was enacted.
A state foreign investment commission was established to direct and oversee the
investment process. Four special economic zones (SEZs) were quickly set up at
Shenzhen, Zhuhai, Xiamen, and Shantou in the early 1980s. In 1984, 14 more coastal
cities and Hainan Island were opened to foreign investment. Furthermore, three zones
were opened to FDI in early 1985: the Yangtze River delta, the Pearl River delta,
and the Zhangzhou–Quanzhou–Xiamen region. FDI hence spread out from the SEZs
but the boom ended in late 1985 due to high inflation. During this stage, foreign
investments were concentrated in small-sized assembling and processing for exports.
In response to a decline in FDI, the government promulgated the PRC Law on
Foreign Enterprises in April 1986, formally granting legal rights to wholly owned
foreign enterprises in China. This marks the beginning of the second stage of FDI
development. In October 1986, the State Council further issued the “Provisions for
the Encouragement of Foreign Investment” to encourage foreign investment, permit-
ting more freedom of independent operations for FIEs and granting more tax incen-
tives for foreign investment. Local governments were also given more authority in
reviewing the applications of foreign investment. In 1988, Hainan was incorporated
as another SEZ and the Chinese government further amended the joint venture laws,
which included a legal ban on expropriation, relaxed restrictions regarding expatri-
ation of profits and dividends, and allowed foreign nationals to be the chairman of
the board of directors in FIEs. Starting from a very low base, China experienced
double- or triple-digit annual growth of FDI from 1979 to 1988 and received a total
of US$12.05 billion actual FDI during this period. In contrast to the first stage, over
70 percent of FDI projects were involved in manufacturing industries in this stage.
The Tianman Square Incident slowed down the FDI growth rate to a single digit
in 1989 and 1990, which ends this second stage of FDI development. To reverse
the worsening investment climate, the Chinese government issued the Amendments
to the Joint Venture Law in April 1990. In 1991, the Income Tax Law for Enterprises
with Foreign Capital and Foreign Enterprises was passed. FDI situation was
improved and resumed double-digit growth in 1991. The third stage of FDI develop-
ment begins. Following Deng Xiaoping’s South China tour, actual FDI surged by
150 percent to US$11 billion in 1992. It surged another 150 percent in 1993 and
maintained the double-digit growth thereafter. In the 1980s, FDI mainly takes the
form of contractual or equity joint ventures. However, the wholly owned foreign
firm is the fastest growing form of FDI in the 1990s. It accounts for 40% of the
FDI value in 1996. The average capital size of FDI increases, with the main focus
shifting to large infrastructure and manufacturing projects.
The first few columns of Table 1 show the FDI and GDP figures of China.
Specifically, the ‘FDI/GDP’ column shows that FDI never exceeds 1 percent of Chi-
na’s total GDP during the early stages of FDI development. Deng’s South China Tour
in 1992 indeed stirs up the momentum of foreign capital inflow and the proportion of
FDI begins to climb up.
2.2. Characteristics of FDI in China
There are several characteristics of FDI in China. First, investments concentrate

on the secondary industry like manufacturing, utilities, and property development.
Between 1979 and 1998, number of foreign enterprises in secondary industry takes
up 75.76 percent with capital taking up 62.18 percent of the total.4
Second, foreign capital flows mainly from Asian countries. The ‘By Source’ col-
umn of the ‘Distribution of Foreign Capital Actually Utilized: FDI’ in Table 1 shows
that over 80 percent of the total foreign capital comes from Hong Kong, Taiwan,
Japan, Korean and other Southeast Asian countries.
Third, FDI is unevenly distributed across provinces within China. The provinces
in China are officially classified into three regions: the Eastern or Coastal, the Cen-
tral, and the Western. The ‘By Region’ column of Table 1 shows that from 1985 to
1998, the Eastern region received a lion’s share of the total FDI amount, more than
85 percent, while the Central and the Western regions together only received less
than 15 percent. Cheng and Zhang (1998) consider this as one of the reasons that
4
Economic Times, December 2, 1999.
84
Table 1
Basic features of FDI in China (source: DRI CEIC Database and various issues of the Statistical Yearbook of China)
Year Stage of GDP FDI FDI/GDP Distribution of foreign capital actually utilized: FDI
FDI Dev. (US$ m) (US$ m) (%)
By sourcea (%) By region By province (%)
Asia Western Others Eastern Central Western Guangdong Fujian Other

province
1979– 1st Stage 1083337 1166 0.11

1982
1983 307552 636 0.21
1984 307881 1258 0.41
1985 299387 1661 0.55 67 27 6 90.18 5.56 4.26 46 11 44
1986 2nd Stage 293466 1874 0.64 74 23 3 87.95 7.28 4.76 50 6 44

1987 316614 2314 0.73 84 14 3 88.58 6.02 5.40 36 4 59
1988 395046 3194 0.81 82 12 6 87.00 5.94 7.06 43 5 52
1989 437239 3392 0.78 77 14 9 92.16 3.84 3.99 38 11 51
1990 382949 3487 0.91 84 16 0 93.87 3.87 2.26 46 9 45
1991 399805 4366 1.09 82 13 5 92.46 4.48 3.06 44 11 45
1992 3rd Stage 468977 11007 2.35 90 8 3 91.30 6.82 1.89 34 13 53

1993 598771 27515 4.60 87 11 3 87.38 8.88 3.74 28 11 62
1994 541737 33767 6.23 84 13 3 87.83 7.85 4.31 28 11 60
1995 700666 37521 5.36 82 15 4 87.71 9.21 3.08 28 11 62
1996 821852 41726 5.08 80 15 5 88.04 9.52 2.45 28 10% 62
Q. Sun et al. / Journal of International Money and Finance 21 (2002) 79–113
1997 903451 45257 5.01 68 16 16 86.90 10.56 2.54 27 9% 64

1998 964528 45463 4.71 69 18 13 88.04 9.86 2.10 30 10% 61
a
The data are computed based on DRI CEIC Database, which groups FDI and other investments together. Hence, the base of the percentage given in this
column is FDI and other investments, not the ‘pure’ FDI figures shown in the table.
have led to the fast development of the coastal provinces in the east and the widening
of the gap in economic development between coastal and inland provinces since
1979. The increasing regional differences have created social and political problems.
In order to narrow or slow down the widening of the gap, China’s central government
has adopted a series of measures which includes encouraging FDI in the Central and
Western regions. The provinces in these regions also try to jump onto the bandwagon
to attract FDI. As a result, the share of FDI in the Central and Western regions have
been slowly increasing since 1989.
The concentration of FDI in the coastal region can be explained by many factors
(Cheng and Zhang, 1998). However, the fact that the coastal region has high popu-
lation density but poor natural resources, while inland provinces have low population
density but rich natural resources seems to suggest that the purpose of FDI in China
is mainly for the potential market and labor abundance but not natural resources.
2.3. Macroeconomic impacts of FDI
FDI is expected to help the development of the host countries in various aspects.
In China, FDI has significant impact on its trade flows. Sun (1999) notices that
China’s total trade volume (i.e. export plus import) relative to GDP rose from 15.4
percent in 1981 to 26.6 percent in 1995. During the same period, exports by FIEs
grew at an annual rate of 63.3 percent. In the coastal region, the contribution of
FIEs is even more significant. He concludes that FDI is trade-creating in China.
Chen (1999) runs cross-sectional regressions on 29 provinces in different years and
confirms that FDI has a positive impact both on promoting China’s host province
total trade flows with the rest of the world and on increasing the bilateral trade flows
between China and its trade partners.
Yet, about the FDI impact on technological development and economic growth,
empirical studies are not conclusive.5 In the case of China, Naughton (1996) casts
doubt that FDI engines China’s economic growth. He highlights a few facts that
limited the impact of foreign investment on the domestic economy. As stated above,
FDI was geographically concentrated, especially in the Guangdong province. Since
Guangdong is relatively small and remote, its benefits from Hong Kong investments
can hardly spillover to other provinces. Second, until 1991 virtually all of the indus-
trial output of FIEs was exported; from which it follows that the domestic market
presence of foreign firms was insignificant. Furthermore, foreign investment never
exceeded 1 percent of GDP before the 1990s. Hence, the external reforms are only
5
Early studies like those of Caves (1974) on Australia, Globerman (1979) on Canada, and Blomström
and Persson (1983) on Mexico have found a positive impact of FDI on the productivity of local firms.
However, later studies like those of Cantwell (1989) on European countries, Haddad and Harrison (1991)
on Morocco, Aitken and Harrison (1991) on Venezuela do not find that technological spillovers are
significant. More recent studies tend to find supporting evidence. See the studies of De Gregorio (1991)
on 12 Latin American countries, Blomström et al. (1992) on 78 developing countries and 23 developed
countries, Kokko (1994) on 216 Mexican manufacturing industries, Borensztein et al. (1998) on 69
developing countries, Hejazi and Safarian (1999) on the OECD countries.
secondary to the main progress of domestic economic reforms in the early stage of
China’s development. Foreign trade and investment only become important to Chi-
na’s economic growth in the 1990s. Kinoshita (1998) focuses on FDI impact on
factor productivity of Chinese firms. Although she finds both ‘catch-up’ and training
being important sources of productivity growth, the effects are more important for
local-owned firms than foreign-owned firms. Local firms give more training to work-
ers whereas foreign firms import intermediate inputs.
Yet, some other studies do find FDI impacts being important to China’s techno-
logical development and economic growth. Sit (1985) points out that FDI has pro-
vided a substantial impetus in modernizing China’s existing industries, including the
transfer of technological know-how, managerial expertise, and international market-
ing skill. Wei (1995b) also finds that in the late 1980s, the contribution to growth
comes mainly from foreign investment. Furthermore, the contribution of foreign
investment comes in the form of technological or managerial spillovers across firms
as opposed to an infusion of new capital. Based on time series data from 1960 to
1991, Zhao (1995) finds that imported technology has significantly enhanced China’s
technological build-up. Chen et al. (1995) study the role of FDI in China’s post-
1978 economic development. They find that FDI has positive association with econ-
omic growth. The pooled regression results of Sun (1998) on ten coastal provinces
from 1983 to 1995 confirm that FDI significantly promoted the economic growth of
China. Shan et al. (1999) apply a six-variable VAR model on China’s quarterly data
from 1985 to 1996 to examine the causality between FDI and economic growth.
They conclude that there is a two-way causality running between the two.
As seen, the impacts of FDI are quite controversial. However, our focus lies on
the provincial characteristics that draw in foreign capital.
3. Determining factors on FDI
As pointed out by Braunerhjelm and Svensson (1996), the theoretical foundation

of FDI is rather fragmented, comprising bits and pieces from different fields of eco-
nomics to elucidate the locational pattern of firms. Several theories have been put
forward to explain the FDI. Hymer (1960) views the MNC as an oligopolist. FDI
is considered to be the outcome of broad corporate strategies and investment
decisions of profit-maximizing firms facing worldwide competition. Dunning (1977)
and Rugman (1981) invoke transaction costs to explain firms’ internationalization,
putting emphasis on the intangible assets firms have acquired. Bhagwati and Srinava-
san (1983) and Grossman and Helpman (1991) use the international trade theory to
explain the allocative aspects of FDI. However, more relevant to our study is the
location theory, which is often used to explain why a MNC would choose to invest
in a particular host country. It can also be used to explain why foreign investors
would choose to invest in a specific location within a particular host country.
Previous researchers have identified quite a few determinants for the location of
FDI. In their study on state characteristics and the location of FDI within the US,
Coughlin et al. (1991) assume that a foreign firm will choose to invest in a particular
state if and only if doing so will maximize profit. The FDI in a particular state
depends on the levels of its characteristics that affect profits relative to the levels of
these characteristics in the other states. They identify state land area, per capita
income, agglomeration, labor market conditions (wage rates, the degree of unioniz-
ation, the unemployment rate), transportation network, taxes, and the state expendi-
tures to attract FDI as the determinants of FDI across the states within the US. Per
capita income and densities of manufacturing activities affect market demand that,
in turn, affects the revenue. State land area, labor market conditions, transportation
network, taxes and expenditures to attract FDI affect the cost. Their results indicate
that states with higher per capita incomes and higher densities of manufacturing
activities attract relatively more FDI. In addition, higher wages deter FDI, while
higher unemployment rates attract it. Overall, higher taxes deter FDI; more extensive
transportation infrastructures and larger promotional expenditures are associated with
higher FDI.
Similarly, Bagchi-Sen and Wheeler (1989) find that population size, population
growth, and per capita retail sales are important determinants of the spatial distri-
bution of FDI among metropolitan areas in the US. Friedman et al. (1996) find that
market potential, wage, skilled labor measured by per capita number of scientists
and engineers, construction cost, major port, and funds spent on attracting FDI have
significant impact on the location of foreign branch plants in the US. Braunerhjelm
and Svensson (1996) further show that agglomeration, exports, and R&D are
important factors affecting Swedish MNCs’ FDI location. Mody and Srinivasan
(1998) find that during the 1980s, US and Japanese multinationals were attracted by
some similar country characteristics like low wage inflation, low country risk, good
infrastructure, and an educated work force. Both groups of investors were also
strongly attracted to locations with significant past investment.
Xin and Ni (1995) conducted a survey to rank provinces of China with the best
investment environment. They identified eight variables with following weightings:
market scale 30%, wage level 20%, education level 10%, extent of industrialization
10%, transport facilities 10%, communication facilities 10%, living environment 5%,
and the level of scientific research 5%.
Built on the above findings, we identify eight potentially important determinants
of FDI distribution across provinces within China, as summarized in Table 2.
First of all, the market demand and market size has positive impact on the FDI
because it directly affects the expected revenue of the investment. In fact, one major
motivation for FDI is to look for new markets.6 The larger the market size of a
particular province is, other things being constant, the more FDI the province should
attract. Kravis and Lipsey (1982) and many other empirical studies find such positive
relationship. Blomström and Lipsey (1991) show a significant size threshold effect
for firms’ decision to invest abroad. We use GDP, GDP per capita, retail sales, and
retail sales per capita to capture demand and size effect. By doing so, we implicitly
assume away the possibility of the demand on a province’s FDI output coming from
6
See Shapiro (1998) for a detailed discussion on FDI motivations.
Table 2
The possible determinants of FDI distribution
Category Proxy
1. Market demand and market size GDP

GDP per capita
Retail sales
Retail sales per capita
2. Agglomeration
Infrastructure GDP per km2
Highway per km2 (Highway)
Railway per km2 (Railway)
Degree of industrialization Domestic investment (INV)
Domestic investment per worker (PERWI)
Level of foreign investment Cumulative domestic investment (CINV)
Cumulative FDI (CFDI)
CFDI/CINV
3. Labor quality RSET — number of research engineers, scientists and
technicians as a percent of the total employees
4. Labor Cost Average wage (Wage)
5. The level of scientific research R&D expenditures
Number of patents
Number of universities
6. Degree of Openness Total trade amount
Import/GDP
7. Country risk Risk ranking by political risk services
8. FDI substitutes Foreign portfolio investment
other provinces.7 According to Young (1997), the provinces in China have only
limited trade with each other and hence multinationals can only serve the market
where they locate. In fact, based on the firm interviews done by Branstetter and
Feenstra (1999), even local Chinese firms can hardly develop into truly ‘multi-prov-
incial’ enterprises.
Agglomeration refers to the concentration and co-location of economic activities
that give rise to the economies of scale and positive externalities. The level of
agglomeration of a particular province should be positively related to the FDI. Fol-
lowing Wheeler and Mody (1992), we use infrastructure quality, the degree of indus-
trialization, and cumulative foreign investment to capture the agglomeration benefits.
The GDP per square kilometer is proxied for the quality of infrastructure. Related
to infrastructure is the transportation network. More highway and railway mileage
per square kilometer are expected to relate positively with FDI. Domestic investment
per worker reflects the degree of industrialization. The cumulative FDI amount cap-
tures the possible ‘herding effect’ among foreign investors. Other than the absolute
measure, we construct also a relative measure, the ratio of the cumulative FDI rela-
tive to the cumulative domestic investment, CFDI/CINV. Since both CFDI and CINV
7
We thank the referee for pointing out the assumption we have made.
increase over time, the larger the ratio, the faster the accumulation of FDI relative
to that of domestic investment.
Labor quality should be an important factor for FDI consideration. It is proxied
by the number of research scientists, engineers and technicians per 1000 of the
employees (RSET) which has been used by Braunerhjelm and Svensson (1996). This
variable measures the relative endowment of skilled labor in each province and
should have a positive impact on FDI.
Labor cost, as measured by WAGE, is a negative factor to FDI. However, such
a measure is not without problems. Workers in the SOEs are typically provided with
housing benefits and health care whereas workers in the private sector get ‘pure’
salaries with cash bonuses (which may not be reported for tax purpose). That weak-
ens the ability of the variable to capture the true labor cost.8 On the other hand, in
recent years of fast economic development, China attracts foreign investment not
purely through cheap labor. As reflected in the model of Branstetter and Feenstra
(1999), multinational firms in China tend to pay a wage premium to their workers.
This may be because multinational firms want to hire quality workers. Higher wage
may well reflect higher labor quality. Hence, it is conceivable that wages in those
provinces that can attract relatively more FDIs can be higher, too. Furthermore, as
pointed out by Lipsey (1999), most studies show no evidence that low wages, asso-
ciated with low per capital real income, were the main attraction for FDI. We will
go back to this variable later.
The level of scientific research indicates the level of human capital and the level
of general development. Measured by R&D expenditures and the number of patents,
the higher level of scientific research should promote FDI in a province. Education
is another variable measuring human capital. It is commonly proxied by the percent-
age of population (or employee) who have received the secondary or above edu-
cation. Since such data are not available, we use the number of universities as a
rough proxy for the level of education. Of course, the level of education is expected
to have positive impact on the inflow of FDI.
The degree of openness has mixed blessings on FDI. On the one hand, a more
open economy attracts FDI because it welcomes foreign capital and foreign investors
are more familiar with the host economy. Edwards (1990) finds supporting evidence
on that. But on the other hand, openness can have a negative impact on FDI due to
keen competition. Wheeler and Mody (1992) find that Brazil and Mexico attracted
major US investment in their sample period despite these two countries have very
low ratings in openness. Hence, the exact relationship between the two is an empiri-
cal question. We use the ratio of total import over GDP of a province to measure
its degree of openness.9
Political risk is an important factor to consider, especially in developing countries.
However, as we are dealing with a single country, the difference in political risk
8
We thank the referee for pointing out this.
9
Using total trade value (summation of export and import value) divided by GDP may overstate the
openness of China. See footnote 4 of Naughton (1996) for some of the reasons. We use only the import
figure to hopefully reduce the noise of the proxy.
among different provinces should not be much. We use it only as a macro variable
and see how it affects the FDI through time. The variable is constructed using the
risk ranking provided by Political Risk Services.
The last factor to consider is the FDI substitutes. FDI brings in a lot of benefits
and one of those is the inflow of foreign capital. A province may not need much
FDI if it can tap the foreign capital market and use the money to invest in the local
industry. In this sense, other means of foreign capital inflow can partly substitute
the need for FDI. One major source we consider is foreign equity capital. We look
at the number of firms in each province that have B-share, H-share, and/or N-share
issues. These are means to raise foreign equity capital. The total number becomes
our variable of foreign portfolio investment, FPI. We expect the variable to be nega-
tively related to the amount of FDI within the province.
Certainly, there are other commonly used variables like number of tourists, number
of telephone sets, promotion expenditures for attracting FDI, tax structure, and the
special treatment offered to foreign investors that may have impacts, too. However,
such data are either not available or hard to measure. We use fixed effect panel data
analysis to control for that.
4. Data and methodology
Panel data analysis is adopted because we examine the determinants of FDI distri-
bution across provinces and over time. Most of the data used in this study are
obtained from various issues of China’s Statistical Yearbook. The Yearbooks provide
two figures of FDI, ‘Signed Agreement’ and ‘Actually Utilized’. We use the later
one, which is the actual amount of FDI invested in the province. The data on the
number of firms that issue foreign equity shares are from Datastream. Political risk
data are from Political Risk Yearbook published by Political Risk Services. They
give an 18-month forecast on the risk level of a country on several aspects. We look
at their forecasts on the risk level of Financial Transfer, Direct Investment, and the
Currency Market in China. During our sample period, their forecasts range from ‘A-
’ (lower risk) to ‘B-’ (higher risk). Our risk variable is constructed by assigning ‘1’
to ‘A-’, ‘2’ to ‘B+’, 3 to ‘B’, so on and so forth. As such, when the risk level goes
up, the variable becomes larger in value.
Due to the lacking of complete set of provincial variables in the early period, our
sample begins in 1986 and covers up to 1998. Since GDP, retail sales, domestic
investment, R&D expenditures, and wage are denominated in RMB (Chinese
currency) and the FDI in US dollars, we convert the FDI into RMB using yearly
average dollar/RMB exchange rate. The swap market rate is used for the period from
1986 to 1993 while China was still under the dual exchange rate system. Then all
monetary data are converted to 1990 constant RMB using the relevant deflater10.
The Cumulative FDI (CFDI) is the total sum of the FDIs in the previous years. For
10
Retail sales and wage are adjusted by CPI and the others are deflated by the GDP deflator.
instance, the 1990 CFDI is the sum of FDIs up to 1989. Since we do not have the
complete data history of China’s FDI figure, we take the FDI figure of 1985 as the
CFDI figure of 1986. We do not think this would constitute a serious problem as
the amount of FDI relative to the GDP level is very small in the early period anyway,
as mentioned before.11
A problem with this data set is the possible high correlation between the various
proxies. It is quite obvious that the proxies listed in Table 2 may overlap with one
another. This may lead to serious multicollinearity. In order to ascertain the degree
of multicollinearity, we calculate the correlation matrix between all the potential
determinants. We will exclude those highly correlated pairs. Specifically, we trans-
form all variables into the natural logarithm form and stack these transformed vari-
ables up across the 30 provinces, then calculate the correlation coefficients between
them.12 The results are presented in Panel A of Table 3.
As expected, high degree of correlation (correlation coefficient of 0.7 or above,
as highlighted) exists in many pairs of proxies. To avoid multicollinearity in the
subsequent analysis, we select only seven proxies in our panel regression model. For
Market Demand factor, we use only the GDP series. For Agglomeration factor, we
use railway length per squared kilometer (RLWAY) to capture the infrastructure
level. The annual domestic investment per worker (PERWI) is used to capture the
degree of industrialization. As CFDI is highly correlated with GDP, we use the
relative measure CFDI/CINV, which is the relative accumulation of foreign invest-
ment to domestic investment. For Labor Quality, we only use RSET.
Panel B of Table 3 gives the new correlation matrix for the seven selected proxies
and confirms that none of the variables are highly correlated now. Since we will add
two more variables, the foreign portfolio investment FPI and the degree of openness
OPEN that have a shorter data span from 1992 to 1998 into our second set of tests,
we also want to make sure they are not highly correlated with the seven chosen
variables. The correlation matrix of the nine variables shown in Panel C of Table 3
confirms that it is the case.
A general pooled regression model is used on these variables and is specified as
ln(FDIit) ⫽ ai ⫹ b1 ln(GDPit⫺1) ⫹ b2 ln(PERWIit⫺1)
⫹ b3 ln(WAGEit⫺1) ⫹ b4 ln(RSETit⫺1) ⫹ b5 ln(RLWAYit⫺1) (1)
⫹ b6RISKt ⫹ b7 ln(CFDI / CINV)it ⫹ ⑀it, (i ⫽ 1,2,...,30 and t
⫽ 1,2,...,12)
where subscript i refers to individual provinces, t refers to years from 1987 to 1998,
and ai is the intercept. Notice that all explanatory variables except RISK and
11
We have tried another approach. We have aggregate FDI figures beginning 1979. Using the provincial
proportion of FDI in 1985, we pro-rate the aggregate figures in these early years into different provinces.
The sum of the pro-rated FDI figures of a province from 1980 to 1984 with the 1985 figure becomes the
CFDI of that province in 1986. The results using this approach are qualitatively the same.
12
Since log 0 is undefined, 10⫺4 is used to replace the zero whenever it occurs in our data set.
92
Table 3
Correlation matrix for potential determinants
Panel A: All potential independent variables

GDP GDP/P INV CINV PER POP RTL RTL/P PAT UNIV WAGE RD RDSTF HI RL RISK CFDI CFDI/
WI NT WAY WAY CINV
GDP/P 0.45
INV 0.95 0.56
CINV 0.88 0.65 0.89
PERWI 0.24 0.84 0.47 0.48
POP 0.82 ⫺0.14 0.69 0.55 ⫺0.28
RTL 0.97 0.40 0.92 0.80 0.20 0.82
RTL/P 0.37 0.90 0.48 0.50 0.78 ⫺0.17 0.43
PATNT 0.86 0.53 0.84 0.84 0.36 0.61 0.83 0.46
UNIV 0.86 0.24 0.77 0.60 0.03 0.80 0.89 0.26 0.76
WAGE 0.21 0.73 0.33 0.58 0.66 ⫺0.24 0.13 0.59 0.31 ⫺0.12
RD 0.82 0.60 0.81 0.77 0.41 0.52 0.80 0.55 0.82 0.80 0.32
RDSTF 0.73 0.36 0.68 0.52 0.18 0.57 0.76 0.40 0.71 0.87 ⫺0.06 0.90
HIWAY 0.70 0.36 0.65 0.53 0.17 0.54 0.72 0.38 0.68 0.73 0.06 0.71 0.72
RLWAY 0.55 0.36 0.51 0.41 0.22 0.38 0.56 0.37 0.62 0.63 ⫺0.11 0.66 0.75 0.81
RISK ⫺0.28 ⫺0.43 ⫺0.36 ⫺0.52 ⫺0.42 ⫺0.03 ⫺0.15 ⫺0.20 ⫺0.30 0.00 ⫺0.58 ⫺0.32 ⫺0.01 ⫺0.06 ⫺0.01
CFDI 0.83 0.63 0.84 0.85 0.47 0.52 0.80 0.55 0.79 0.62 0.38 0.76 0.63 0.65 0.61 ⫺0.36
CFDI/CINV 0.64 0.49 0.65 0.58 0.38 0.40 0.65 0.48 0.62 0.52 0.17 0.62 0.59 0.62 0.64 ⫺0.18 0.93
RSET ⫺0.08 0.47 0.00 ⫺0.04 0.50 ⫺0.39 ⫺0.03 0.55 0.14 0.12 0.12 0.43 0.50 0.21 0.45 0.06 0.13 0.23
(continued on next page)
Table 3 (Continued)
Panel B: Independent variables included in the whole sample and first sub-sample regressions
GDP PERWI WAGE RLWAY RISK CFDI/CINV
PERWI 0.24
WAGE 0.21 0.65
RLWAY 0.55 0.22 ⫺0.11
RISK ⫺0.28 ⫺0.42 ⫺0.58 ⫺0.01
CFDI/CINV 0.64 0.38 0.17 0.65 ⫺0.18
RSET ⫺0.08 0.50 0.12 0.45 0.06 0.23
Panel C: Independent variables in the second sub-sample regressions

GDP PERWI WAGE RSET RLWAY RISK FPI OPEN
PERWI 0.32
WAGE 0.32 0.68
RSET ⫺0.03 0.53 0.13
RLWAY 0.52 0.30 ⫺0.08 0.52
RISK ⫺0.03 ⫺0.12 ⫺0.04 ⫺0.02 0.00
FPI 0.29 0.52 0.59 0.25 0.12 0.09
OPEN ⫺0.10 0.64 0.54 0.48 0.06 ⫺0.24 0.42
CFDI/CINV 0.57 0.42 0.21 0.29 0.64 ⫺0.01 0.30 0.33
93
CFDI/CINV are in one-period lag.13 The amount of foreign investment and the
explanatory variables may very likely affect each other. For instance, larger market
demand (captured by GDP) may attract FDI which, in turn, bring up the GDP of a
province. To avoid such endogeneity problem, we follow Blomström et al. (1992)
and use lag variables to ensure that we are looking at the impact of variables a year
earlier on the current FDI situation. The log linear specification allows us to interpret
the coefficient estimates as elasticities.
A major advantage of using the panel data method, as pointed out by Hsiao (1989),
is to resolve or reduce the magnitude of a key econometric problem that often arises
in empirical studies, namely, the omitted (mis-measured, not observed) variables that
are correlated with explanatory variables. In the application here, Eq. (1) allows for
fixed effects in the cross-section so that intercepts need not be identical across differ-
ent provinces. As such, unique but missing or unobserved factors driving the FDI
amount of individual provinces would be captured in the respective intercepts in
the equation.
Two major types of omitted variables are the individual time-invariant variables
and the period individual-invariant variables. The individual time-invariant variables
are variables that are the same for a given cross-sectional unit through time but vary
across cross-sectional units. Examples of omitted provincial specific variables in our
study are the geographical proximity and/or historical connection to the source coun-
tries or regions, special economic policies granted by the central government, the
degree of openness to the outside world, good sea and air linkages. The period
individual-invariant variables are variables that are the same for all cross-sectional
units at a given point in time but vary through time. Examples of these are changes
of political and macroeconomic policy, widespread optimism or pessimism. All these
omitted variables may correlate with the independent variables in Eq. (1). RISK in
the model is used to control for such omitted period individual-invariant variables.
However, the provincial specific omitted variables are more of our concern because
our main focus is FDI distribution across provinces.
The provincial specific characteristics may also give rise to cross-sectional het-
eroskedasticity. To cater for this, we follow Bekaert and Harvey (1997). The initial
estimation is done using OLS with the standard White (1980) correction for heterosk-
edasticity, then followed by GLS estimation which allows for heteroskedasticity
across provinces (‘group-wise heteroskedasticity’). However, we do not adjust for
autocorrelation. In view of the short time series and the long time interval, it does
not make much sense to use Prais–Winsten correction (Greene, 1993). We also do
regressions on the first difference data. Since our data are transformed into natural
logarithm, the first difference gives growth rate for the respective variables. This
allows us to test whether FDI growth is determined by the growth rate of GDP
and/or other factors. Note that the first difference also ‘sweeps out’ the provincial
specific intercept, ai.
13
Recall that we compute the accumulation of domestic and foreign investments of year t by summing
the past investment amount up to year t⫺1.
Other than estimating the full sample, we also split the sample into two periods,
1986–1991 and 1992–1998. As discussed at the beginning, it is important to cater
for the fact that the composition of investors and the nature of FDIs change signifi-
cantly before and after 1992, the year of the famous South China Tour of Deng
Xiaoping. Splitting the sample enables us to examine the possibility that the factors
drawing FDI into China before and after 1992 are different. Notice that for the latter
sample, we add two more variables into Eq. (1), FPI and OPEN, which we do not
have earlier data.
Along this line, there is also a concern that Guangdong and Fujian, having close
cultural and historical ties with Hong Kong and Taiwan, respectively, may have
distinct features in attracting foreign capital. In fact, from the last major column of
Table 1, it is seen that the two provinces draw in half of the total FDI of China,
especially during the early stages. To cater for this possibility, we run a separate set
of tests excluding them to see if the results with and without the two provinces
would be different.
5. Results
5.1. Full sample period: 1986–1998
Table 4 reports the estimation results of Eq. (1) for the entire sample period. Panel
A gives the results for the full sample of 30 provinces and Panel B gives the results
of 28 provinces excluding Guangdong and Fujian. Within the panel, Model (1) is
the fixed effect regression with a different intercept for each province. Model (2) is
the regression with common intercept and Model (3) is the pooled regression on the
differencing data. Within each model, both OLS and GLS results are reported.
In Panel A, the OLS estimates for Model (1) are not quite significant in general
except for GDP and RISK. A 1% increase in GDP leads to a 2.89% increase in FDI.
This supports the hypothesis that the market size and general development level of
a province have a positive impact on attracting FDI. This is also consistent with
previous findings in the US and other countries. RISK is a very important factor.
One-level jump in the political risk ranking in China leads to 56% drop in FDI.
RSET and RLWAY enter only marginally significant into the regression at the 10
percent level.
However, as a proxy of the level of industrialization, PERWI shows no signifi-
cance in the regression. Since this variable is used to capture the agglomeration
effect, the result is not supportive to the agglomeration argument. The second vari-
able to capture the effect is the level of the relative cumulative FDI amount,
CFDI/CINV. The result is surprising. A 1% increase in CFDI/CINV leads to a 0.30%
decrease in FDI. Although a t-value of ⫺1.23 indicates no statistical significance,
this seems to suggest that FDI cannot create a ‘herding effect’. The more FDI
accumulated relative to the domestic investment accumulated, the less FDI to come.
We will come back to this point later.
OLS regression with White adjustment cannot adjust for group-wise heteroskedas-
96
Table 4
Pooled regression results (1987–1998). The pooled regression model is
ln(FDIit) ⫽ ai ⫹ b1 ln(GDPit⫺1) ⫹ b2 ln(PERWIit⫺1) ⫹ b3 ln(RSETit⫺1) ⫹ b4 ln(WAGEit⫺1) ⫹ b5 ln(RLWAYit⫺1) ⫹ b6 ln(CFDIit / CINVit)
⫹ b7RISKt ⫹ ⑀it, (i ⫽ 1,2,...,30 and t ⫽ 1,2,...,12)
where FDI and GDP are in millions RMB, PERWI is defined as domestic investment divided by the employment and is in thousands of RMB per worker,
RSET is the total number of research engineers, scientists and technicians divided by the employment, W is the wage rate in thousands of RMB, CFDI/CINV
is the cumulative foreign direct investment in millions of RMB divided by the cumulative domestic investment in millions of RMB, and Risk takes the value
of 1–4 according to the ranking in the Political Risk Yearbook and International Country Risk Guide for the period of 1987–1998. All RMB are in 1990
constant price. i refers to individual provinces and t refers to each year in the sample period. White Heteroskedasticity-consistent t-statistics in parentheses
Panel A: 30 provinces (full sample) Panel B: 28 provinces (excluding Guangdong and Fujian)
Fixed effects (Model 1) Common Int. (Model 2) Diff. data (Model 3) Fixed effects (Model 1) Common Int. (Model 2) Diff. data (Model 3)
OLS GLS OLS GLS OLS GLS OLS GLS OLS GLS OLS GLS
Constant ⫺1.156236 ⫺0.053953 ⫺1.4295 ⫺1.9017

(⫺0.5018) (⫺0.0497) (⫺0.562) (⫺1.045)
GDP 2.89421 3.194055 1.163835 1.203408 2.837098 2.363072 2.948 3.5973 1.1688 1.263 3.1852 2.8972
(4.7445)*** (12.9016)*** (9.3742)*** (11.7483)*** (2.4957)** (7.4470)*** (4.660)** (9.202)** (11.02)** (13.26)** (3.446)** (5.314)**
Per Worker Inv. ⫺0.052999 ⫺0.113644 0.368463 0.335969 0.111353 0.106794 ⫺0.0064 ⫺0.0578 0.3679 0.2815 0.0819 0.0468
(⫺0.3303) (⫺1.4742) (2.7115)*** (4.6775)*** (0.4028) (1.0348) (⫺0.027) (⫺0.398) (2.320)** (2.508)** (0.31) (0.29)
Wage ⫺0.634059 ⫺0.751419 ⫺0.385717 ⫺0.450698 0.44454 0.144117 ⫺0.5996 ⫺1.0042 ⫺0.3847 ⫺0.3402 0.4342 0.1875
(⫺0.9195) (⫺2.9879)*** (⫺1.4106) (⫺3.4343)*** (0.3889) (0.3256) (⫺0.685) (⫺2.070)** (⫺1.167) (⫺1.531) (0.33) (0.24)
RSET 0.452918 0.777509 ⫺0.19788 ⫺0.090281 ⫺0.38834 ⫺0.11819 0.3563 0.6438 ⫺0.1743 ⫺0.0406 ⫺0.375 ⫺0.0961
(1.6450)* (5.8935)*** (⫺2.3806)** (⫺1.9430)* (⫺1.2884) (⫺0.8364) (0.81) (2.582)** (⫺1.492) (⫺0.524) (⫺0.803) (⫺0.346)
Railway 1.69318 1.824953 0.3632 0.161664 0.329052 0.87072 1.4744 1.4718 0.4327 0.2744 ⫺0.0241 0.2299
(1.6385)* (3.8274)*** (2.9199)*** (2.4185)** (0.3763) (1.7223)* (1.28) (1.813)* (4.033)** (2.933)** (⫺0.012) (0.20)

Table 4 (Continued)
Risk ⫺0.562067 ⫺0.50491 ⫺0.488982 ⫺0.376431 ⫺0.23606 ⫺0.2585 ⫺0.5717 ⫺0.5166 ⫺0.5187 ⫺0.4125 ⫺0.2339 ⫺0.2603
(⫺8.7383)*** (⫺21.1925)*** (⫺7.1433)*** (⫺13.7451)*** (⫺2.6964)*** (⫺9.4681)*** (⫺8.645)** (⫺13.03)** (⫺7.629)** (⫺9.443)** (⫺2.611)** (⫺4.978)**
CFDI/CINV ⫺0.303411 ⫺0.367945 0.859729 0.885817 ⫺1.72747 ⫺1.01131 ⫺0.3499 ⫺0.5275 0.7938 0.7655 ⫺1.7691 ⫺1.1029
(⫺1.2335) (⫺3.4146)*** (14.4494)*** (17.6827)*** (⫺5.0729)*** (⫺5.6097)*** (⫺2.210)** (⫺4.106)** (12.11)** (14.05)** (⫺7.967)** (⫺6.224)**
Adjusted R2 0.882476 0.973492 0.808963 0.892836 0.166164 0.142161 0.8732 0.9729 0.8485 0.9497 0.1712 0.159
DW 1.843917 1.854335 1.855999 1.873495 2.36993 2.08022 1.8474 1.8873 1.8519 1.8612 2.3749 2.0752
Note: *,**, and *** denote significance at the 10, 5, and 1 percent level, respectively.
97
ticity. In fact, a standard Lagrange multiplier test reveals that homoskedasticity across
provinces can be easily rejected at the 5 percent level. Using GLS approach is neces-
sary and gives much stronger results. All estimates on the full sample become highly
significant except for PERWI. For instance, a 1% increase in RSET leads to a 0.77%
increase in FDI, which is statistically significant at any conventional level. Recall
that this variable is the number of engineers, scientists, and technicians relative to
the total number of employees within a province. Its significance suggests that labor
quality is indeed important to FDI consideration. Wage variable enters significantly
negative into the regression. A 1% increase in WAGE leads to a 0.75% decrease in
FDI. That is to say, high labor cost deters the inflow of FDI. This is consistent with
Coughlin et al. (1991) and Friedman et al. (1996). RAILWAY that proxies for the
infrastructure level shows up to be a big attraction for FDI. A 1% increase in infra-
structure buildup almost doubles the inflow of FDI.
The most interesting result is that CFDI/CINV is significantly negative with a t-
value of ⫺3.41. A 1% increase in CFDI/CINV leads to a 0.36% decrease in FDI.
Such a result seems to suggest that the more the accumulated FDI, the less the
amount of FDI that will come. It is surprising given the fact that studies typically
find agglomeration effect of FDI.14 However, the interpretation has to be careful.
Recall that we use relative cumulative foreign investment and not absolute cumulat-
ive foreign investment, CFDI because CFDI is highly correlated with GDP. That is
to say, the major impact of CFDI is already captured in the positive impact of GDP
on FDI found in the regression results. Another important point to look into is the
linkage between CFDI and CINV. From Table 3, their correlation coefficient is as
high as 0.93. In fact, Borensztein et al. (1998) have found a strong ‘crowding-in’
effect of foreign investment on domestic investment. In the paper, they investigate
whether the inflow of foreign capital ‘crowds out’ domestic investment. But their
results show the opposite, a one-dollar increase in the net inflow of FDI is associated
with 1.5- to 2.3-dollar increase in total investment in the host economy. Now, if
such an effect in China is stronger than the agglomeration effect, i.e. FDI leads to
more accumulation of domestic capital than more inflow of foreign capital, a negative
relationship between FDI and CFDI/CINV will be observed. Hence, the result needs
not be inconsistent with the agglomeration argument.
Yet, it does indicate that existing FDI does not attract further inflow of FDI fast
enough. It may be that agglomeration has a limit. Beyond certain level, positive
externalities of investing in the same location turn into negative externalities. This
has several important implications. First, the FDI growth in China may not be sus-
tainable without creating more special incentives for FDI. Second, foreign investors
in general are not satisfied with the results of their investment in China. This is
consistent with many anecdotal stories and the survey results of Chen (1993) in
which 22 FDI firms in Tianjin and Shenzhen are asked to evaluate the investment
environment in China. The average score given for all evaluated items by these firms
14
For instance, Heid et al. (1995), Heid and Ries (1996) and Cheng and Kwan (1999) find support
evidence for the agglomeration effect of FDI in China.
are at the low end of the scale. Through firm interviews, Branstetter and Feenstra
(1999) find that the foreign invested enterprises compete with state-owned firms and
the Chinese government tries to impede the ability of foreign firms to compete in
the Chinese market. No wonder Wei (1995b) find that China has received too little
FDI compared to ‘an average host country’ although it has attracted large amount
in absolute terms.15 Finally, from the point of view of multinational enterprises, there
may be diminishing return for FDI in certain ‘hot’ provinces and it may be better
to invest in provinces that are not flooded with FDIs.
Although the fixed effect model seems to be a sensible model to use here and
gives significant results, one may query if it is due to the missing factors captured
by the intercepts of individual provincial groups. To see how much independent
variation remains in the explanatory variables, we take away the provincial fixed
effects by running a common-intercept regression. The results presented in Model
(2) show that the variables still give highly significant estimates and the model gives
an adjusted R-squared of 80 percent for the OLS regression and 89 percent for the
GLS regression. This clearly shows that the major explanatory power comes from
the independent variables, not the fixed effect. Yet, fixed effects do provide additional
explanatory power, as reflected in higher adjusted R-squared values. Anyway, we
should not pay too much attention on the common-intercept results as they are mis-
specified with omitted variable problems. In fact, some coefficients have signs differ-
ent from that of fixed effect regressions.
Model (3) examines whether FDI growth rate is affected by the growth rate of
the various determinants. For the OLS results, GDP, RISK, and CFDI/CINV are the
three variables enter significantly into the regression. Specifically, the FDI growth
of a province is positively related to its GDP growth, negatively related to the
increase inflow of FDI to the province and to the increase in political risk of China.
The GLS results are qualitatively the same except that the estimate for RAILWAY
is also marginally significant at the 10-percent level. This means that the FDI growth
of a province is positively related to the improvement in the province’s infrastructure.
Notice that the Durbin–Watson statistics do not show serious autocorrelation across
various models.
Since Guangdong and Fujian provinces draw in most of the FDI, they may be the
main driving forces for the results found so far. However, the results shown in Panel
B, which come from regressions excluding the two provinces, do not support such
view. The results are qualitatively the same as before. Specifically, results in Model
(1) show that large market (GDP), high labor quality (RSET), and good infrastructure
(Railway) are still found to be the significant attractions for FDI. On the other hand,
high labor cost (Wage), high risk (Risk) and too much FDI presence (CFDI/CINV)
are still big negatives to attract new FDI.
Results in Model (2) indicate that the explanatory power of the chosen variables
remains strong even without Guangdong and Fujian provinces. All in all, results in
15
A new working paper by Wei (2000) suggests that corruption is an important deterring factor for
FDI in China.
Panel (B) suggest that factors determining FDI in China are similar across provinces.
Guangdong and Fujian are not that special, especially after controlling for the fixed
effect, as reflected in the high adjusted R-squared values.
5.2. Sub-sample period: 1986–1991
As discussed earlier, FDI development in China takes several stages and the nature
and source of FDI are different in different stages. 1991 marks the end of the second
stage of FDI development. We hence split the sample into pre- and post-1991 periods
and examine individually to see if the relationship between FDI and the factors
behaves differently. The results of the earlier period from 1987 to 1991 are shown
in Table 5.
Both OLS and GLS results in Model (1) of Panel A again indicate that political
risk and the relative cumulative FDI have adverse effect in attracting FDI. However,
there are two notable differences from the previous results, GDP and WAGE. GDP
is no longer significant in this period whereas the labor cost factor, WAGE, now
enters significantly positive in the regressions. For the OLS regression, the WAGE
estimate is 6.06 with a t-value of 2.74. For the GLS regression, the estimate is 4.66
with a t-value of 6.72. Such a result is opposite from what is found in the full sample.
Recall that during this early period, most of the FDI originates from Hong Kong.
Other than the ethnic and historical linkage between the Mainland and the then Bri-
tish colony, one important reason for the influx of Hong Kong capital into China is
the exceedingly high costs of production in Hong Kong like land cost and labor cost.
During the 1980s, most of the Hong Kong manufacturers moved their factories into
the Guangdong province of China and maintained only the head offices in Hong
Kong. Since the Hong Kong manufacturing industry was export-oriented, goods pro-
duced by these Chinese factories were export out eventually. Quality control for
these export products was essential. In this period, factory managers with skilled
workers were sent to China to train up the local workers. Needless to say, it was
quite costly and hence Chinese skilled workers were in big demand. This situation
may explain why WAGE was positively related with the amount of FDI. The variable
captures more on the skill level of the workers than the labor cost, as the labor cost
in China in the 1980s was quite low anyway. The Hong Kong manufacturers were
too willing to give higher wages to quality workers than to station expatriates in
China to train the local workers.
Such interpretation is supported by other variables. RSET, the proxy for the labor
quality, also enters significantly positive into the GLS regression. A 1% increase in
RSET leads to 0.85% increase in FDI. On the other hand, the market demand proxy,
GDP, does not enter significantly in either the OLS regression or the GLS regression.
Since FDI from Hong Kong was essentially export-oriented, the size of the local
market would not be of serious concern.
In Model (2) where we force the provincial intercepts to be common, the results
again indicate that the variables have explanatory power, especially for the GLS
results. In Model (3), we look at the impact of changes in the variables on the
changes in FDI. Both OLS and GLS results show only RISK and CFDI/CINV being
Table 5
⫹ b7RISKt ⫹ ⑀it, (i ⫽ 1,2,…,30 and t ⫽ 1,2,…,5)
of 1–4 according to the ranking in the Political Risk Yearbook and International Country Risk Guide for the period of 1987–1991. All RMB are in 1990
constant price. i refers to individual provinces and t refers to each year in the sample period. White Heteroskedasticity-consistent t-statistics in parentheses
Constant ⫺8.682827 ⫺8.205007 ⫺4.7661 ⫺5.6771

(⫺1.1482) (⫺3.1843)*** (⫺0.561) (⫺1.313)
GDP ⫺0.080974 0.63982 1.302713 1.224527 ⫺1.9438 ⫺1.97092 ⫺0.3955 ⫺0.3978 1.3327 1.2618 ⫺2.0997 ⫺2.1392
(⫺0.0558) (1.5995) (5.0327)*** (8.5179)*** (⫺1.1010) (⫺0.9169) (⫺0.225) (⫺0.437) (6.480)** (8.871)** (⫺0.975) (⫺1.902)*
Per Worker Inv. 0.036787 ⫺0.055782 0.228532 0.189101 ⫺0.35418 0.238882 0.0985 ⫺0.115 0.1266 0.03 0.3282 ⫺0.2109
(0.0789) (⫺0.4897) (0.7771) (1.9588)* (⫺1.9498)* (0.3381) (0.14) (⫺0.372) (0.36) (0.17) (0.38) (⫺0.468)
Wage 6.062576 4.667018 0.671328 0.762889 ⫺1.134719 ⫺1.444421 6.5904 5.7109 0.1319 0.3725 ⫺1.5919 ⫺2.1152
(2.7479)*** (6.7241)*** (0.6619) (2.3193)** (⫺1.2204) (⫺0.5059) (2.566)** (4.136)** (0.11) (0.70) (⫺0.481) (⫺1.133)
RSET 0.517995 0.854237 ⫺0.159888 ⫺0.111335 ⫺0.100498 ⫺0.696517 0.4043 0.8077 0.0229 0.0428 ⫺0.8033 ⫺0.3529
(0.9475) (5.4296)*** (⫺0.8965) (⫺1.9746)** (⫺0.5008) (⫺0.9192) (0.50) (2.167)** (0.08) (0.35) (⫺0.866) (⫺0.752)
Railway 1.784075 3.946782 0.295265 0.201277 1.352906 ⫺0.72472 ⫺0.7883 2.3016 0.3184 0.2824 ⫺2.0077 1.0502
(0.7867) (5.9206)*** (1.5951) (2.6272)*** (1.6159) (⫺0.1690) (⫺0.150) (1.08) (1.59) (2.342)** (⫺0.271) (0.39)

101
102
Table 5 (Continued)
Risk ⫺1.167061 ⫺1.070434 ⫺1.037411 ⫺0.94974 ⫺1.296421 ⫺1.235211 ⫺1.1737 ⫺1.0188 ⫺0.9167 ⫺0.8902 1.2713 ⫺1.4204
(⫺4.6668)*** (⫺18.8367)*** (⫺4.3260)*** (⫺14.4696)*** (⫺3.4435)*** (2.7803)*** (⫺3.460)** (⫺6.650)** (⫺3.504)** (⫺7.664)** (2.766)** (⫺6.132)**
CFDI/CINV ⫺0.983432 ⫺0.886592 0.8603 0.844502 ⫺2.164398 ⫺2.422911 ⫺0.9979 ⫺0.8595 0.7545 0.7286 ⫺2.424 ⫺2.0968
(⫺2.5216)** (⫺4.6030)*** (8.6832)*** (16.2874)*** (⫺9.0889)*** (⫺5.5331)*** (⫺4.138)** (⫺4.165)** (6.315)** (11.82)** (⫺7.161)** (⫺6.843)**
Adjusted R2 0.870325 0.984443 0.779206 0.903881 0.365118 0.310792 0.8551 0.9806 0.7568 0.9732 0.3082 0.3568
DW 2.254817 2.07453 2.026641 1.864959 2.222257 2.297133 2.5601 2.0831 2.0119 1.9111 3.0097 2.2822
statistically significant and are negatively related to changes in FDI. The proxy for
degree of industrialization, PERWI, enters marginally significant at the 5 percent
level, which we do not think as of importance.
Panel B reports results on excluding Guangdong and Fujian provinces. Again, the
results are essentially the same. For instance, labor quality rather than potential mar-
ket demand is an important consideration. Higher quality, as reflected in higher labor
wages, attracts more FDI. Market size, as proxied by GDP, does not enter signifi-
cantly into the fixed-effect regressions. On the other hand, risk and relative cumulat-
ive FDI are strong deterring factors for new inflows of foreign capital.
5.3. Sub-sample period: 1992–1998
The current period from 1992 to 1998 allows us to consider two more interesting
variables, foreign portfolio investment in each province and the degree of openness
of China. As discussed before, we believe foreign portfolio investment would be a
substitute to FDI and the degree of openness will attract more FDI. The OLS and
GLS regressions of Eq. (1) are run again under three different settings, the fixed
effects (Model 1), the common intercept (Model 2), and the differencing data (Model
3). The results are given in Table 6.
In Panel A, Model (1) gives very interesting results. First, consistent with our
expectation, the degree of openness of China to the outside world enters significantly
positive into the regression. For the OLS estimate, the coefficient is 0.50 and the t-
value is 1.97. For the GLS estimate, the coefficient is 0.37 and the t-value is 7.68.
That is, openness does attract foreign investment. On the other hand, foreign portfolio
investment, FPI, has only marginal impact on FDI. The variable is significant in the
GLS estimation but at a statistical level of 10 percent only. The economic signifi-
cance is also minimal.
Another interesting result is that the market demand variable, GDP, now becomes
highly significant in both OLS and GLS regressions. In both estimates, a 1% increase
in provincial GDP will give rise to around 4.7% increase in FDI. This is quite differ-
ent from what is found in the early sample period. As discussed before, the continu-
ous opening of China to the outside world attracts foreign capital other than Hong
Kong and Taiwan. Direct investments from Japan, Europe and US play increasingly
important part. Furthermore, the nature of the investments is different. Instead of
export-oriented, the investments target mainly at local market demand within China.
Conceivably, provincial GDP becomes an important consideration for foreign
investing capital.
More interestingly, labor cost WAGE enters significantly negative into the
regressions. For the OLS result, 1% increase in labor cost reduces 3.23 percent of
FDI. For the GLS result, it sends FDI down by 2.75 percent. Recall that in the
previous sample period, the variable gives a significantly positive estimate. In recent
years, China has impressive, continuous economic growth. Since 1983, China has
maintained a two-digit per capita GDP grow rate with exceptions only in 1990, 1997,
and 1998. For the latter two years, the Chinese government intentionally slowed
down the growth to curb inflation. It is conceivable that the Chinese labor cost picks
104
Table 6
⫹ b7RISKt ⫹ b8 ln(FPIit⫺1) ⫹ b9 ln(OPENit⫺1) ⫹ ⑀it, (i ⫽ 1,2,...,30 and t ⫽ 1,2,...,7)
of 1–4 according to the ranking in the Political Risk Yearbook for the period of 1992–1998, FPI is the number of total B-, H- and N-shares available for
foreign investors, and Openness is defined as total import as a percentage of GDP. All RMB are in 1990 constant price. All RMB are in 1990 constant price.
i refers to individual provinces and t refers to each year in the sample period. White Heteroskedasticity-consistent t-statistics in parentheses
Constant 8.647761 8.444845 5.7009 6.2206

(2.0385)** (6.3035)*** (1.465) (2.809)**
GDP 4.691472 4.737627 1.055985 1.093751 9.674571 9.247752 3.248 2.844 1.0259 1.0394 4.7892 3.4136
(2.6911)*** (18.1825)*** (5.6724)*** (12.3831)*** (3.1522)*** (22.8026)*** (3.995)** (7.144)** (10.14)** (13.94)** (5.384)** (5.935)**
Per Worker Inv. 0.243811 0.028064 0.246181 0.223671 ⫺0.238025 ⫺0.269296 0.0877 ⫺0.0757 0.2419 0.134 ⫺0.1389 ⫺0.1014
(1.0440) (0.4979) (1.1269) (2.7820)*** (⫺0.9221) (⫺1.5238) (0.39) (⫺0.711) (1.56) (1.31) (⫺0.634) (⫺0.870)
Wage ⫺3.2331 ⫺2.753889 ⫺1.619164 ⫺1.60372 ⫺0.914114 ⫺0.813439 ⫺1.0811 ⫺1.0126 ⫺1.1911 ⫺1.2281 0.9829 0.9739
(⫺2.8886)*** (⫺13.2881)*** (⫺2.3830)*** (⫺10.1573)*** (⫺0.7347) (⫺2.3090)** (⫺1.032) (⫺1.826)* (⫺2.592)** (⫺4.709)** (0.76) (1.21)
RSET 1.154472 1.332576 ⫺0.355467 ⫺0.319258 1.215654 1.008052 0.8085 1.112 ⫺0.3202 ⫺0.3166 0.4444 0.3388
(1.7131)* (7.7773)*** (⫺2.5504)** (⫺7.4665)*** (2.2357)** (4.9836)*** (0.85) (2.670)** (⫺2.733)** (⫺4.675)** (0.47) (0.79)
Railway 1.056926 1.545166 0.557504 0.437804 0.307708 0.377866 1.2724 1.8925 0.5557 0.4524 0.6888 1.0998
(2.1033)** (4.2248)*** (2.1932)** (3.6348)*** (0.4100) (1.4026) (1.14) (3.494)** (5.085)** (5.413)** (0.45) (1.42)

Table 6 (Continued)
Risk ⫺0.36683 ⫺0.259744 ⫺0.259773 ⫺0.137516 ⫺0.160854 ⫺0.078645 ⫺0.3282 ⫺0.2735 ⫺0.2318 ⫺0.1452 ⫺0.1991 ⫺0.093
(⫺4.2044)*** (⫺16.0145)*** (⫺1.8356)* (⫺4.3092)*** (⫺1.3849) (⫺3.0766)*** (⫺4.396)** (⫺7.648)** (⫺3.342)** (⫺3.646)** (⫺1.789)* (⫺1.525)
CFDI/CINV ⫺0.66417 ⫺0.53086 0.780759 0.814422 ⫺2.15665 ⫺1.996246 ⫺0.4055 ⫺0.212 0.7948 0.8296 ⫺1.4018 ⫺0.8028
(⫺1.5608) (⫺8.4666)*** (7.4586)*** (14.2446)*** (⫺3.0199)*** (⫺19.0892)*** (⫺1.676)* (⫺1.652)* (11.00)** (18.45)** (⫺4.088)** (⫺3.565)**
FPI ⫺0.00705 ⫺0.007182 0.007642 0.008847 ⫺0.021673 ⫺0.017717 ⫺0.0119 0.0035 ⫺0.0003 0.0058 0.0163 0.022
(⫺0.44376) (⫺1.772829)* (1.452841) (3.812687)*** (⫺0.873141) (⫺2.1931)** (⫺0.477) (0.32) (⫺0.030) (0.98) (0.36) (0.86)
Openness 0.508833 0.37378 0.391054 0.395718 0.652732 0.693281 0.4595 0.3269 0.3206 0.39953 0.3758 0.4574
(1.969719)** (7.681227)*** (2.459535)** (8.445541)*** (2.103793)** (6.598367)*** (2.337)** (3.200)** (3.425)** (6.482)** (2.022)** (3.473)**
Adjusted R2 0.926192 0.99578 0.856518 0.907837 0.419859 0.741055 0.9249 0.9912 0.9027 0.9715 0.1715 0.2288
DW 1.794873 1.760374 1.672308 1.662592 1.866542 1.867958 1.7697 1.8042 1.5373 1.4269 1.7077 1.7624
105
up significantly in recent years, especially in comparison to that in the Southeast

Asian countries. More importantly, the products of joint-venture companies and
foreign enterprises are for the local China market. As a result, high labor cost means
high product cost which has direct adverse effect on the market demand. Labor cost
hence becomes negatively correlated with FDI in this sample period. Notice that
labor quality, as captured by RSET, is still a significantly determining factor for
FDI. So are other factors like infrastructure, political risk, and openness. It is worth
mentioning that cumulative FDI relative to cumulative domestic investment is always
negative to new FDI whereas PERWI is almost always insignificant to FDI. This is
inconsistent with the findings of Edwards (1999) that domestic investment and FDI
are complements, and does not support the agglomeration argument of FDI.
Model (3) on change in FDI posts the same picture. Both the OLS and GLS results
show that increase in market demand (GDP), labor quality (RSET), and country
openness (OPEN) significantly attract more FDI whereas increase in relative cumu-
lative foreign investment (CFDI/CINV) deters further inflow of FDI. Increase in
labor cost (WAGE) and political risk (RISK) are also found to be significant deterring
factors for FDI in the GLS results. Increase in foreign portfolio investment (FPI)
seems to substitute away some of real FDI. However, improvement in infrastructure
(RAILWAY) does not bear high enough t-values to indicate significant impact on
drawing in FDI.
Again, results excluding Guangdong and Fujian provinces, as shown in Panel B,
do not change the overall picture except for the labor cost variable, Wage. During
this period, labor cost does not seem to be an important consideration for foreign
investments although it tends to be an adverse factor. Such a result hence posts a
similar picture that in the earlier period (1987–1991), foreign investors concerned
more on labor quality than labor cost. Later, labor cost becomes more important.
Yet, it is mostly a concern for FDI in Guangdong and Fujian, the two earliest prov-
inces opening their doors to foreign investors. It is conceivable that intensive compe-
titions for quality workers drive up the labor cost. This is less serious a problem for
other provinces that open up later.
5.4. Model fitness
Before concluding this section, we would like to examine how well the predicted
FDI that is based on our model fits the actual FDI of each province. Specifically,
we look at the residuals generated by the GLS fixed-effect model applied to the full
sample period of 1987–1998. A standardized residual greater than 1.65 constitutes
a significant outlier. A positive outlier indicates that, after accounting for the impact
of the model, a province attracted more than its share of FDI in a particular year.
A negative outlier indicates that a province attracted less than its predicted amount
of FDI. Since the sum of time series residuals are forced to be zero by model con-
struction, we cannot identify, ceteris paribus, which provinces received higher or
lower than the average amount of FDI for the whole period. However, we calculate
the standard deviation of time series residuals for each province to identify the FDI
of which provinces can be better explained by our fixed effect regression model.
Table 7 presents the standardized residuals of individual provinces across time. The
time series standard deviation of residuals, denoted by s, for each province is shown
in the last column.
There is no discernible pattern of positive or negative residuals across the 30
provinces overtime. Among 360 standardized residuals, there are only 24 significant
outliers. This is consistent with the high goodness of fit of our model. However, the
outliers are almost exclusively concentrated in the Western region, while Eastern
provinces only have one and Central provinces have two. The standard deviations
shown in the last column also indicate that s is generally smaller for eastern prov-
inces than for central and western provinces. This means the model explains the FDI
distribution better for Eastern provinces than it does for the Central and Western
provinces. This may suggest that the FDI in the Eastern provinces is more predictable
because these provinces started earlier in receiving FDI and have a more matured
FDI receiving mechanism and more stable environment. By contrast, Central and
Western provinces did not start to get FDI until the mid-1980s. The less matured
mechanism and environment to attract FDI may make the FDI there less predictable.
6. Conclusion and further study
China’s economic reform has attracted worldwide attention. From the early stage
of pulling in exported-oriented industries from Hong Kong and Taiwan that lured
by cheap production cost in China to the later stage of drawing in real investments
from the Western world that eager to tap the huge domestic market, China has gradu-
ally opened up to the rest of the world. The most recent giant step is a series of
successful talks with the US and the European Union on getting into the WTO.
Our paper provides a timely study in this area. Motivated by Naughton (1996), we
differentiate our study from other similar studies on China’s FDI by looking at poss-
ible changes in importance of determining factors through time. As such, the study
advances our understanding in the factors affecting the level of FDI across provinces
in China.
Our study does provide evidence that the importance of the FDI determinants
moves through time. Wage has positive relationship with FDI before 1991 but has
a negative relationship after then. Similarly, provincial GDP bears no significant
relationship with GDP before 1991 but becomes highly positive after 1991. This
reflects the fact that the nature of FDI before and after 1991 is quite different.
Labor quality and infrastructure are also important determinants of the distribution
of FDI. High labor quality and good infrastructure attract foreign investors. For the
country as a whole, it political stability and its openness to the foreign world add
another important dimensions to drawing in foreign capital.
We have some mild evidence that foreign portfolio investments are substitutes of
FDI. A surprising but important finding is that cumulative FDI relative to cumulative
domestic investment has a negative impact on new FDI. We argue that it needs not
imply non-existence of the agglomeration effect. However, it does carry an important
policy implication that provincial officials have a lot more to do to improve the
108
Table 7
Standardized difference between actual and predicted FDI (based on GLS Fixed-Effect Model for 1987–1998) (*(**) denotes significant at 10(5) percent)
Province 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 s
Eastern Beijing 0.02 1.14 0.69 0.43 0.31 0.18 ⫺0.35 ⫺0.02 ⫺1.01 ⫺0.93 ⫺0.63 0.18 0.64
Tianjin ⫺0.52 1.07 ⫺0.93 ⫺0.61 0.32 ⫺0.21 0.14 0.24 ⫺0.22 ⫺0.12 0.28 0.55 0.55
HeBei ⫺1.04 ⫺0.34 ⫺0.42 ⫺0.20 0.18 0.39 0.50 0.45 ⫺0.22 ⫺0.05 0.32 0.43 0.46
Liao Ning ⫺0.35 0.20 ⫺0.53 0.31 0.64 0.63 0.32 0.09 ⫺0.66 ⫺0.74 ⫺0.17 0.24 0.48
Shandong ⫺0.31 ⫺0.24 ⫺0.18 ⫺0.20 ⫺0.10 0.96 0.55 0.54 ⫺0.01 ⫺0.24 ⫺0.11 ⫺0.65 0.45
Jiangsu ⫺0.64 ⫺0.49 ⫺1.05 ⫺0.53 ⫺0.18 1.11 0.51 0.74 0.25 ⫺0.11 0.29 0.10 0.62
Shanghai 0.21 0.17 0.08 ⫺0.43 ⫺0.66 0.05 0.73 0.35 ⫺0.30 ⫺0.28 0.07 0.02 0.37
Zhejiang 0.13 0.31 ⫺0.55 ⫺0.33 0.01 0.26 0.50 0.42 ⫺0.20 ⫺0.16 0.19 ⫺0.57 0.36
Fujian ⫺0.18 0.23 0.07 ⫺0.15 0.06 0.82 0.44 0.41 ⫺0.39 ⫺0.26 0.02 ⫺1.06 0.48
Guangdong 0.50 0.82 0.29 0.26 0.23 0.50 0.09 ⫺0.01 ⫺0.62 ⫺0.66 ⫺0.47 ⫺0.94 0.55
Guangxi 0.14 0.32 ⫺0.02 ⫺0.59 ⫺0.81 0.46 0.85 0.70 ⫺0.21 ⫺0.51 0.06 ⫺0.39 0.52
Hainan ⫺1.83* 0.23 0.01 0.08 0.32 1.05 0.36 0.57 ⫺0.09 ⫺0.38 ⫺0.06 ⫺0.25 0.69
Central Shanxi ⫺0.69 0.12 0.17 ⫺0.89 ⫺0.88 1.27 0.65 ⫺0.45 ⫺0.61 ⫺0.29 0.58 1.02 0.75
Inner 0.75 1.08 ⫺2.59** 0.86 ⫺1.11 ⫺0.32 1.10 0.34 ⫺0.26 ⫺0.27 ⫺0.12 0.55 1.06
Mongolia
JiLin 0.35 ⫺0.69 ⫺2.04** ⫺0.14 ⫺0.02 0.60 0.66 0.35 0.02 0.06 0.15 0.72 0.75
Heilongjiang ⫺0.21 0.49 ⫺0.39 ⫺0.38 ⫺0.68 0.26 0.24 0.40 ⫺0.10 ⫺0.18 0.31 0.24 0.37
Anhui 0.52 1.08 ⫺1.40 ⫺0.71 ⫺0.55 0.69 0.42 0.46 ⫺0.09 ⫺0.06 0.02 ⫺0.38 0.69
Jiangxi ⫺0.15 ⫺0.29 ⫺0.83 ⫺1.05 ⫺0.19 0.86 0.63 0.66 0.16 ⫺0.20 0.09 0.31 0.58
Henan ⫺0.51 0.39 0.21 ⫺0.96 0.21 0.07 0.44 0.42 ⫺0.13 ⫺0.28 0.14 ⫺0.01 0.42
Hubei 0.18 0.82 0.64 0.36 0.43
⫺0.03 ⫺0.62 ⫺0.48 ⫺0.07 ⫺0.20 ⫺0.35 ⫺0.20 ⫺0.05

Hunan ⫺1.60 ⫺0.68 ⫺1.52 ⫺0.95 ⫺0.31 0.86 1.04 0.71 0.32 0.45 0.84 0.84 0.97

Table 7 (Continued)
Province 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 s
Western Sichuan 0.30 1.24 ⫺1.51 ⫺0.91 0.72 0.34 0.67 0.85 ⫺0.31 ⫺0.74 ⫺1.05 0.40 0.88
Guizhou ⫺2.50** 0.79 0.31 ⫺0.04 0.94 0.83 0.60 0.62 ⫺0.23 ⫺1.00 ⫺0.41 0.09 0.98
Yunan 0.43 0.46 0.21 ⫺1.24 ⫺1.14 0.54 0.75 0.36 ⫺0.20 ⫺0.59 0.32 0.10 0.66
Tibet 0.13 3.16** 1.21 1.21 1.01 0.97 ⫺0.54 ⫺0.96 ⫺1.66* ⫺2.07** ⫺1.64 ⫺0.81 1.55
Shaanxi 0.82 1.32 0.86 0.20 0.19 ⫺0.36 0.09 ⫺0.33 ⫺0.79 ⫺1.18 ⫺0.39 ⫺0.44 0.73
Gansu ⫺2.46** 1.43 ⫺0.39 ⫺0.85 0.63 ⫺2.04** 0.01 1.42 0.64 0.65 0.15 0.81 1.24
Qinghai ⫺3.66** 2.94** ⫺3.04** ⫺2.83** ⫺3.12** 2.00** 2.34** 1.79* 0.63 ⫺0.07 0.98 2.03** 2.47
Ningxia 1.33 2.26** ⫺4.62** ⫺0.22 ⫺0.66 ⫺0.24 1.81 1.08 ⫺0.24 ⫺0.93 ⫺0.57 1.01 1.79
Xingjiang 2.76** 2.56** ⫺0.17 1.16 ⫺2.10** ⫺6.78** 0.88 1.23 0.44 0.38 ⫺0.12 ⫺0.22 2.50
Total ⫺1.48 3.84** ⫺3.41** ⫺1.86* ⫺1.25 1.20 3.12** 2.52** ⫺1.15 ⫺2.03** ⫺0.20 0.70
109
investment environment. On the other hand, MNCs may want to consider investing
in provinces not yet flooded with FDI competitors. In fact, accompanied with the
so-called ‘tilted policy’ towards developing the Western Region, the Chinese govern-
ment begins to encourage foreign capital to move investments into the inland and
the Western region by providing various incentive schemes like investment benefits,
tax benefits, and financing benefits.16
Our model is robust whether Guangdong and Fujian, the two early and major
provinces opening up for FDI, are excluded or not. Our model is also robust across
different fixed effect specifications and has a high goodness of fit. However, it
explains the FDI distribution in the coastal provinces better than it does for Central
and Western provinces.
Our study has several limitations that deserve further investigations. First, we have
not broken down the nature of the FDI. For instance, Wheeler and Mody (1992)
find that factors important to FDI in the electronics industry may not be important
to the manufacturing industry as a whole. There may be a clientele effect in the
sense that different provinces may attract different types of FDI industries. Lumping
them together may well conceal some important factors. Second, due to data limi-
tation, we are not able to consider the tax effect of FDI on China. Hines (1996)
demonstrates that in the US, higher state tax rates have a significantly negative effect
on investment. Third, Branstetter and Feenstra (1999) suggest that FDI in China are
competing with state-owned enterprises. Hence, opening up the domestic market to
foreign importers and investors means sacrificing the benefits gained by state-owned
enterprises. It would be quite interesting to examine empirically whether and to what
extent such a trade-off relationship exists. Fourth, Kinoshita and Mody (2000) sug-
gest a new and interesting perspective that private information of investing firms
about the host country is an important factor in making FDI decisions. On the other
hand, Wei (2000) suggests that the corruption and red tape problems are important
deterring factors that make China under-achiever as a host of FDI. These are very
interesting aspects that worth further investigations.
Acknowledgements
We would like to thank the anonymous referee for detailed comments and sugges-
tions. The paper was presented at the 2000 meeting of the FMA European Conference
in Barcelona and the Seventh Annual Asia Pacific Finance Association Conference
in Shanghai.
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Determinants of foreign direct investment

JEL classification: F21; F30

* Corresponding author. Tel.: +852-2766-4399; fax: +852-2356-9550.

FDI is conventionally defined as a form of international inter-firm cooperation

2.1. Three stages of FDI development

2.2. Characteristics of FDI in China

There are several characteristics of FDI in China. First, investments concentrate

By sourcea (%) By region By province (%)

Asia Western Others Eastern Central Western Guangdong Fujian Other

1979– 1st Stage 1083337 1166 0.11

1986 2nd Stage 293466 1874 0.64 74 23 3 87.95 7.28 4.76 50 6 44

1992 3rd Stage 468977 11007 2.35 90 8 3 91.30 6.82 1.89 34 13 53

1997 903451 45257 5.01 68 16 16 86.90 10.56 2.54 27 9% 64

2.3. Macroeconomic impacts of FDI

3. Determining factors on FDI

As pointed out by Braunerhjelm and Svensson (1996), the theoretical foundation

1. Market demand and market size GDP

4. Data and methodology

Panel A: All potential independent variables

Panel C: Independent variables in the second sub-sample regressions

5.1. Full sample period: 1986–1998

Constant ⫺1.156236 ⫺0.053953 ⫺1.4295 ⫺1.9017

(continued on next page)

5.2. Sub-sample period: 1986–1991

Constant ⫺8.682827 ⫺8.205007 ⫺4.7661 ⫺5.6771

(continued on next page)

5.3. Sub-sample period: 1992–1998

Constant 8.647761 8.444845 5.7009 6.2206

(continued on next page)

up significantly in recent years, especially in comparison to that in the Southeast

5.4. Model fitness

6. Conclusion and further study

⫺0.03 ⫺0.62 ⫺0.48 ⫺0.07 ⫺0.20 ⫺0.35 ⫺0.20 ⫺0.05

(continued on next page)

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